Making Money in Corporate Finance: Basic Principles

1. Making Money in Corporate Finance: Basic Principles James S. Ang Florida State University For Presentation at Xiamen University, May 2009

2. Finance is about making money from money. • Firms could derive Profits from real assets and profits from financial assets or both.

3. The Sources of Profitable Opportunities: • 1. Use information outsiders do not have on real assets. • 2. Exploit disagreements among outsiders – different expectations. • 3. Exploit other parties’ Mistakes • 4. Cheating: manipulation and fraud. • The means to extract profit is through the method of arbitrage, and the vehicle is the corporation.

4. Understanding and harvesting NPV • I shall start with the most basic: NPV analysis • Example: • PV of inflows is $120mm, or a future value of $150mm. • PV of all costs is $100mm, or a future value of $120mm. • NPV = 120 – 100 = 20mm. • NFV = 150 – 120 = 30mm.

5. But think of yourself as an entrepreneur. • This means that an entrepreneur needs to: • Raise $100mm of OPM (other people’s money), a combination of debt and equity, and when discounted at the cost of capital, should yield $100mm in PV or 120 in FV. • Pocket the $20mm in NPV.

6. There are two ways: • The entrepreneur may sell (give up the right to) all future cash flow of (FV=150mm) for (PV=120mm). Since it only takes 100mm to invest in the project, the entrepreneur can pocket the difference: 120-100 = 20. • Examples are developers pre-sell housing units, businessmen sell ownership to firms, etc.,

7. 2: OPM • The second way is realize that the entrepreneur has a claim on 150-120 = 30 in the future after the OPM are paid (= 120mm). This means that the entrepreneur owns (30/ 150)= 20% of the firm’s cash flows, and can therefore issue 80% of the firm’s stocks for 100mm to finance the project, and own 20% without putting up own money. • Alternatively, the entrepreneur may use the equivalent of 20% ownership as the firm’s equity and borrow debt (use leverage) to be supported by the cash flows to the other 80%. • Examples include IPO, or earnouts.

8. NPV • To summarize, receiving 20mm now, or hold 20% cost free represents arbitrage profit to the entrepreneur. • The entrepreneur takes a long position on the asset (The asset generates high cash flows due to patent protection, sole ownership of a land to develop properties, right to exclude other users, or political influence, etc.) And issue debt and equity to others (short). • The really interesting question how the entrepreneur can extract the arbitrage profit?

9. The essence of arbitrage • Smart bets have these characteristics: • No cost, or Commit no own funds (OPM). • No risk, or position is a perfect hedge (perfect or near perfect correlation in returns) • No loss, or position generates either profit or breakeven.

10. Effective arbitrage requires a set of simultaneous transactions: • Buy (Long) undervalued securities and sell (short) overvalued, but highly correlated securities. • The important point is that a short position is needed. • Sell short means a two parts transactions: a) Sell a security one does not own, b) Buy back the same security later to close out the position. • It is equivalent to: a) Take money now, b) Return them later. • But, selling short is difficult for investors.

11. An implication • Stock market may persist to be inefficient if there are ‘limits’ to arbitrage, especially in the ability to short.

12. Limits to arbitrage: • Search for stock lenders may be costly and time consuming. • Stocks on loan are subject to recall risk. • Additional collateral needs be posted. • Security lending market may be illiquid. • Execution risks, or lack of close substitutes. • Counter party risk. • Synchronization risks. • Noise trader risk. • Transaction costs. • Holding costs. • Liquidation costs and premature liquidation risks. • Fundamental risk. • Wealth constraint, if fund flow depends on short-term performance.

13. Question:If investors could not profit, who could? • The answer is the corporation. • They are better in exploiting mispricing in the market/ arbitrage opportunity than individual investors. • This is the main idea underlying my talk today:

14. Corporations have more arbitrage opportunities • The following is a list of assets investors normally may not be able to acquire: • Assets that have to purchased in bulk, not fractional ownership/ shares: buildings factory, etc., • Assets that are not publicly traded: privately held companies, subsidiaries of other corporations, state owned companies, cooperatives, and mutual organizations. • Assets that require active management and ownership rights: restructuring (layoff, asset sales, change top management), breaking up (corporate fission), bundling (corporate fusion), realize synergy (information technology, production skills, human capital, cheap capital), positive NPV, improve governance, etc., • Real assets that require change in ownership to change market expectations. • Assets that require large information costs, which corporations, as bulk buyer, can better afford and can also perform due diligence investigations.

15. Examples of Corporate Arbitrage • A. Long undervalued asset and short undervalued securities. • Mergers and acquisitions: • Acquire undervalued target (long ) with own stocks (short) in a stock for stock exchange. • Leverage buyout • Take private a public firm (buy/long all stocks) and issue highly levered debt (short). • Corporate fission (breakup deals) • Acquire a firm (long) and sell pieces or restructure as several separate legal entities to sell securities (short), as in spin off and split up. • Corporate fusion (bundling of assets) • Acquire several assets to form a single corporation and sell securities based on the now more valuable combined firm (short). • IPO and SEO • Sell over priced stocks as IPO in hot markets (short) and invest the proceeds (long).

16. Examples of corporate arbitrage • B. Short overvalued assets and long undervalued securities • Repurchase stocks • Sell overvalued asset/ subsidiaries (short) to • buyback stocks (long). • Debt refunding • Retire high interest cost existing debt (long) and replace with lower interest cost debt (short).

17. The Sources of Arbitrage Opportunities: • The market/ investors make mistakes: mispricing. • Other companies make mistakes. • Your company help the market makes mistakes. • - manipulating information and expectations to committing fraud.

18. Where do profitable opportunities in corporate finance come from • 1. Smart money taking from dumb money. • Based on their source, these opportunities, many are results of mistakes by others, may be classified as originated from: • A. Markets/ Investors. • B. Managers of other firms. • C. Government.

19. More on profitable opportunities • 2. Helping hand. • Or, finance in steroids, it gives the firm short term boost, but may result in long term harm. In the meantime, there are telltale signs, and would not pass closer examination. • A. Catering(also knows as following fads and fashion, pseudo market timing, herding, etc., ) • Examples: • 1. Increase or initiate dividends when dividend paying stocks are selling at a premium. • 2. Corporate name change. Add dot com when in fashion, and remove dot com after bursting of dot com bubble. • 3. Buy or sell assets base don prevailing trend; Increase investment when regarded as a growth stock.

20. Manipulate market expectations • Earnings smoothing (to give semblance of consistent growth) and manipulation. • Fraud. • Keep up the appearance.

21. Examples of helping hand: • When to boost earnings: • Before IPO, SEO, mergers to be financed with own stocks and prior to debt renewal, extension and refinancing. • 2. When to depress earnings: • Repurchase stocks, and management lead LBO. • 3. Take value destroying actions to keep up appearance. • Suppose the market overprices your stock, implying it expects your company to deliver higher growth than you are capable of. • The strategy is to: a) Issue stocks at inflated price, and to keep up the appearance of growth, would invest in inferior or value destroying projects (NPV<).

22. Opportunities as mistakes made by the market : • Irrational • 1. Investors following simple • heuristics as portfolio strategy, • such as market to book, EPS, buy • winners (momentum investing), • buy losers, etc., • 2. Herding, • 3. Responding to noise, including • rumors. • Rational • 1. Following price trend leading to bubble, in a ‘If you can’t beat them, join them’ and “ I am smarter than the rest and know when to bail out” strategy. • Given bad information by the companies

23. Opportunities from or mistakes made by the government. • Tax arbitrage: • Buy (long) low taxed assets, e.g., tax law passed to give tax credit for new investments, and short (borrow) liabilities with tax deductible interest. • Buy tax free bonds, financed with tax deductible debt. • Acquire companies with large tax loss carry forward..

24. Mistakes made by managers • A. Behavioral • 1. Over optimism, e.g., illusion of control. • 2. Overconfident, e.g., attribution bias. • 3. Limited capacity to process information, • e.g., bounded rationality, • representativeness, availability, narrow focusing, • B. Agency • 1. Poor governance. • 2. Unnecessary diversification, done on behalf of less diversified managers

25. Misplaced trust in market efficiency. • When the securities of the firm are over priced, cost of capital may appear ‘too low’ to the insiders/ managers, and the company may be induced to accept too many inferior projects (NPV<0). Thus, we have a situation in which over optimism by the market leads managers to act as if they, too, are over optimistic. • The opposite is also true. Too pessimistic market results in low security prices. Raise the perceived cost of capital, and too few investments may be undertaken. I.e., some NPV>0 may be foregone.

26. mistakes • Sentiments of the stock market, whether too optimistic or pessimistic, may affect managers’ actions in the same direction, i.e, sentiments are contagious. • Unwittingly, the investment behavior of the of corporations caters to please the market. • What a long term value maximizing firm can do? • -It may not rely on short term market prices to calculate capital costs. • - When market prices are too high (or too low), risk premium may appear too low (too high), and even beta may appear too low (high).

27. To Summarize • Idea #1: All profits, other than that are needed to compensate for risk taking, may be formulated as a result of an arbitrage. • Idea #2: Capital market may remain inefficient because of limits to arbitrage by investors. • Idea #3: Corporations are better in exploiting mispricing in the market/ arbitrage opportunity than individual investors.

28. ideas • Idea #4: Making money in corporate finance means knowing how to let other people take risks, as in OPM, and risk management strategies. • Idea #5: Arbitrage opportunities arise from action taken to correct mistakes by others. • Idea #6: There are long term versus short term arbitrage profits; those involving attempts to change market expectations or to follow the market could only produce short term gains.