I confess. I send out a lot of emails and I am sure that you don't read some of them. Since they sometimes contain important information as well as clues to my thinking (deranged though it might be), I will try to put all of the emails into this file. They are in chronological order, starting with the earliest one. SThey are in chronological order, starting with the earliest one. So, scroll down to your desired email and read on, or if the scrolling will take you too long, click on the link below to go the emails, by month:
Happy new year! I hope you have a wonderful break (good news: it is still break..) and that you will come back tanned, rested and ready to go. This is the first of many, many emails that you will get for me. You can view that either as a promise or a threat. I am delighted that you have decided to take the corporate finance class this spring with me and especially so if you are not a finance major and have never worked in finance. I am an evangelist when it comes to the centrality of corporate finance and I will try very hard to convert you to my faith. I also know that some of you may be worried about the class and the tool set that you will bring to it. I cannot alleviate all your fears now, but here are a few things that you can do to get an early jump:
I will also be posting the contents of the site (webcasts, lectures, posts) on iTunes U. If you have never used it, here is what you need: an Apple device (iPhone or iPad), the iTunes U app on the device and you need to link to the link below:
Now for the material for the class. The lecture notes for the class are available as a pdf file that you can download and print. I have both a standard version (one slide per page) and an environmentally friendly version (two slides per page) to download. You can also save paper entirely and download the file to your iPad or Kindle. Make your choice.
One final point. I know that the last few years have led you to question the reach of finance (and your own career paths). I must confess that I have gone through my own share of soul searching, trying to make sense of what is going on. I will try to incorporate what I think the lessons learned, unlearned and relearned over this period are for corporate finance. There are assumptions that we have made for decades that need to be challenged and foundations that have to be reinforced. In other words, the time for cookbook and me-too finance (which is what too many firms, investment banks and consultants have indulged in) is over. To close, I will leave you with a YouTube video that introduces you (in about 3 minutes) to the class.
As the long winter break winds down, I first hope that you are far away from the snow and slush in New York, some place warm. I also hope that you are ready to get started on classes and that you got my really long email a weeks ago. If you did not, you can find it here:
1. Website: In case you completely missed this part of the last email, all of the material for the class (as well as the class calendar) is on the website for the class:
2. Pre-class prep: Are you kidding me? What kind of twisted mind comes up with a pre-class prep for the very first class. Just relax, have fun this weekend and try to be in class. If you cannot make it, never fear! The webcast for the class will be up a little while after the class, but it just won't be the same as being there in person.
For those of you who have not got around to checking, class is scheduled from 10.30-11.50 in Paulson Auditorium on February 1. See you there!
I don’t know whether you signed up for this, but class has not even started and this is the third email that you are getting from me (if you missed the last two, check this link: http://www.stern.nyu.edu/~adamodar/New_Home_Page/cfemail.html). However, since class is just around the corner, I decided to send you both a final reminder and to perhaps give you some advance warning about what’s coming in these next few weeks.
See you on Monday! I hope that this class will excite you, but if that fails, I will settle for provoke, even anger or incite you, but I hope never to bore you. That, too me, is the one unforgivable teaching sin.
I promised you with a ton of emails and I always deliver on my promises... Here is the first of many, many missives that you will receive for me….. First, a quick review of what we did in today's class. I laid out the structure for the class and an agenda of what I hope to accomplish during the next 15 weeks. In addition to describing the logistical details, I presented my view that corporate finance is the ultimate big picture class because everything falls under its purview. The “big picture” of corporate finance covers the three basic decisions that every business has to make: how to allocate scarce funds across competing uses (the investment decision), how to raise funds to finance these investments (the financing decision) and how much cash to take out of the business (the dividend decision). The singular objective in corporate finance is to maximize the value of the business to its owners. This big picture was then used to emphasize five themes: that corporate finance is common sense, that it is focused, that the focus shifts over the life cycle and that you cannot break first principles with immunity.
On to housekeeping details.
I know that it is the first week of this class but it is never too early to start thinking creatively. This week’s puzzle is built around the corporate life cycle structure that I introduced in class yesterday, and particularly around what to do with Microsoft. Start by reading the description of the puzzle:
If you have the time, do read the two blog posts referenced in the puzzle:
In today's class, we started on what the objective in running a business should be. While corporate finance states it to be maximizing firm value, it is often practiced as maximizing stock price. To make the world safe for stock price maximization, we do have to make key assumptions: that managers act in the best interests of stockholders, that lenders are fully protected, that information flows to rational investors and that there are no social costs. We started on why one of these assumptions, that stockholders have power over managers, fails and we will continue ripping the Utopian world apart next class.
1. Administrative Stuff: I went through the structure for the class and mentioned the quiz dates. As noted in class, if you are going to miss a quiz, the 10% from that quiz will be moved to the rest of the exam grade for the class and if you take all three, your worst quiz will get marked up to the average on your remaining exams. Here are a few other details:
2. Other People's Money: Just a few added notes relating to the class that I want to bring to your attention. The first is the movie Other People's Money, which is one of my favorites for illustrating the straw men that people like to set up and knock down. You can find out more about the movie here:
3. DisneyWar: In next week’s session, I will be talking about the dysfunctional state of Disney in the 1990s. If you want to review these on your own, try this book written by James Stewart. It is in paperback, on Amazon:
4. Company Choice: On the question of picking companies for your group, some (unsolicited) advice:
If you want to print off the financial statements for your company, I would recommend that you start with the annual report for the most recent year. You should be able to pull it off the website for the company, under investor relations. If you want to keep going, and it is a US company, go to o the SEC site (http://www.sec.gov). If it is a non-US company, you will have to find the equivalent regulatory body in your country. For some of your companies, you will find less data than on others. Don’t fret. This too shall pass. More on this in tomorrow’s email.
It is never too early to start nagging you about the project. So, let me get started with a checklist (which is short for this week but will get longer each week. Here is the list of things that would be nice to get behind you:
On a different note, I want to update you on three TAs for the class, their office hours and the review sessions that they are planning to hold.
|2/5/16||As promised, here is the first of the weekly in-practice webcasts. These are 10-15 minute webcasts designed to work on practical issues in corporate finance. This week’s issue is a timely one, if you are working on picking companies for your project (as you should be..). It is about the process of collecting data for companies, the first step in understanding and analyzing them. The webcast link is below:
I don’t think it is too painful to watch and you may even find it useful. I have also put the link up on the webcast page for the class:
The webcasts for the first two classes should be on there, if you missed (physically, metaphysically or mentally) and the links to the project and syllabus that I handed out in the class. At the risk of nagging, please do get the lecture note packet 1 printed off or bought before Monday’s class. It is now available (or was at least yesterday) in the bookstore.
The sun is out and I hope that you are enjoying your weekend. I won’t ruin it with a long email but the first newsletter is attached. Not much news but it provides some perspective on where we are (not far) and where we are going.
Attachment: Issue 1 (February 6)
|2/7/16||As you get ready for the Super Bowl party, a quick preview of the week to come. This week, we will continue with our discussion of corporate governance, focusing first on where power in a company rests (stockholders, managers, labor, the government) and the consequences for corporate finance. We will then move on to lenders/bondholders and how left unprotected, they can be exploited, and on to financial markets, examining both the predilection of firms to delay/manage bad news and investor reactions to it. Having laid bare the limitations of the assumptions that underlie traditional corporate finance, we will examine alternatives to stock price maximization. In Wednesday’s class, we will start on the big question of what comprises risk, how to measure it and convert it into a hurdle rate. Have fun and I hope that you enjoy watching the game as much as you do assessing the quality of the advertising.|
Today's class extended the discussion of everything that can wrong in the real world. Lenders, left unprotected, will be exploited. Information can be noisy and markets can be irrational. Social costs can be large. Relating back to class, I have a couple of items on the agenda and neither requires extensive reading or research. I would like you to think about market efficiency without any preconceptions. You may believe that markets are short term, volatile and over react, but I would like you to consider the basis of these beliefs. Is it because you have anecdotal evidence or because you have been told it is so or is it based upon something more concrete? i also want to think about how managers in publicly traded companies can position themselves best to consider the public good, without being charitable with other people's money, as a precursor to the next class. We have spent a couple of sessions being negative - managers are craven, markets are noisy and bondholders get ripped off. In the next class, we will take a more prescriptive look at what we should be doing in this very imperfect world. As always, reading ahead in chapter 2 will be helpful.
I hope that your search for a group has ended well and that you are thinking about the companies that you would like to analyze. Better still, perhaps you have a company picked out already. If you do, try to find a Bloomberg terminal (there is one in the MBA lounge and there used to be one in the basement)... If you do find one vacant, jump on it and try the following:
If you cannot find a Bloomberg terminal or don't have access to one, try going on Yahoo! Finance and type in the name or symbol for your company. Once you find your company, find the tab that says Holders and click on it. You should get a listing of the top stockholders in your company. In fact, while you are on that page, take note of the percent of your company's stock held by insiders and by institutions. I have also attached the post class test and solution for today's class.
It is Tuesday and time for the second weekly challenge. In the utopian world, maximizing a company's stock price is equivalent to maximizing it's value, since markets are efficient. But what if they are not? What if markets are driven by short term considerations and investors? In that case, maximizing prices is not the same as maximizing value. This puzzle is built around a letter than Laurence Fink, head of Blackrock, sent to the S&P 500 companies advising them to play the long game. The details of the puzzle are at the link below:
The objective function matters, and there are no perfect objectives. That is the message of the last two classes. Once you have absorbed that, I am willing to accept the fact that you still don't quite buy into the "maximize value" objective. That is fine and I would like you to keep thinking about a better alternative with three caveats. First, you cannot cop out and give me multiple objectives - I too would like to maximize stockholder wealth, maximize customer satisfaction, maximize social welfare and employee benefits at the same time but it is just not doable. Second, your objective function has to be measurable. In other words, if you define your objective as maximizing the social good, how would you measure social good? Third, take your objective (and the measurement device you have developed) and ask yourself a cynical question: How might managers game this system for maximum benefit, while hurting you as an owner? In the long term, you may almost guarantee that this will happen. On the theme of investor time horizon and stockholder composition, here is an interesting read: http://bit.ly/YrNIMX
If you have picked a company, there are two orders of business you have for this weekend:
Finally, I mentioned a paper that related stock prices to corporate governance scores in class today. You can find the link to the paper below:
This email has gone on way too long already, but one final note. A little more than a year ago, I took a look at Petrobras, just as a cautionary note on what happens to a company when its objective function becomes muddled (with national interest constraints). You can read it here.
I am also attaching the post-class test & solution for this session.
As for the project & class, time sure does fly, when you are having fun... We are exactly 15.38% (4 sessions out of 26) through the class (in terms of class time) and we will kick into high gear in the next two weeks. I am going to assume for the moment that my nagging has worked and that you have picked a company to analyze. Here is what you can be doing (or better still, have done already):
On a related note, I will not keep tabs on your company choices officially, since I leave the choice up to you and will let you live with the consequences. It would be interesting though (to me and to everyone else in the class), if we could see the choices. So, I am opening a shared Google spreadsheet for you to use to enter the names of the people in your group and the company choices that you have made.
Since you have a long weekend ahead of you, with nothing to do but binge watch The Walking Dead (ahead of the season opener on Sunday), I thought I would get in two in-practice webcasts this week and nag you about your project (yet again). Since these webcasts are directly connected to what you will or should be doing on the project, the best way to use them is to pick a company and use the webcasts to get the relevant parts of the project done.
1. Assessing Corporate Governance: This webcast looks at ways to assess the corporate governance at your company, using HP from 2013 as an example. I use HP's annual report, its filings with the SEC and other public information to make my assessment of the company.
2. Stockholder Holding Assessment: This webcast is on assessing who the top stockholders in your company are and thinking through the potential conflicts of interest you will face as a result. The webcast went a little longer than I wanted it to (it is about 24 minutes) but if you do have the list of the top stockholders in your company (the HDS page from Bloomberg, Capital IQ, Morningstar or some other source), I think you will find it useful.
Finally, if you do get a chance, please reflect and comment on the weekly challenge (on YellowDig) and enter your group details in the shared Google spreadsheet (https://docs.google.com/a/stern.nyu.edu/spreadsheets/d/17uwl0LZutgAs2KtCf1N2qnGEnSve2iPGX-XydjIWoBg/edit?usp=sharing). I do have a couple of people who have had trouble finding groups. So, if you have room for one more person in your group, please let me know.
As you get ready for the long weekend (or are already deep into it), I will keep this short. Weekly newsletter is attached. Read it, if you can. Find a group. Pick a company. Start collecting data. Make your bed. Clean your room. Brush your teeth. (Sorry… Got carried away with the task list..)
Attachment: Issue 2 (February 13)
I hope that you had a great weekend, though the snow and the ice yesterday probably put a damper on it. Time for this week’s puzzle: Tomorrow, we start on our discussion of risk and return models in finance, and they are all built on the presumption that marginal investors are diversified. While the argument for diversification is always a slam dunk in class rooms, with statistical evidence at its base, it is surprisingly contested. Thus, there is a significant subset of investors who believe that diversification hurts investors rather than helps them, and while it is easy to dismiss them as uninformed, I think we make a mistake by doing so. In fact, I can see why some investors may be better off with more concentrated portfolios and I captured the essence of the trade off in a blog post that I did a while back:
Some of you may be regretting the shift from the soft stuff (objectives, social welfare etc.) to the hard stuff, but trust me that it is still fun.. If it is not, keep telling yourself that it will become fun. Anyway, here are a few thoughts about today's class.
If you can, try to make your assessment of whether the marginal investors in your companies are likely to be diversified. Look at both the percent of stock held in your company and the top 17 investors to make this judgment. If your assessment leads you to conclude that the marginal investor is an institution or a diversified investor, you are home free in the sense that you can now feel comfortable using traditional risk and return models in finance. If, on the other hand, you decide that the marginal investor is not diversified, we will come back in a few sessions and talk about some adjustments you may want to make to your beta calculations. Finally, if you are up for the challenge, try to estimate the risk free rate in the currency of your choice. Of course, if this is US dollars, not much of a challenge... It is a good exercise to try a more difficult currency. I will be posting a webcast on Friday on doing this. So, stay tuned. I have also attached the post class test & solution for today...
A couple of reading suggestions, if you get a chance. One relates to the puzzle that I mailed out for this week on risk and in particular, on whether diversification is good or not. The link is here:
|2/18/16||This week, we started on what I like to call the “meat and potatoes” part of corporate finance, not very appetizing if you are a vegan, but essential nevertheless. I am going to assume, at this stage, that my nagging has worked and that you have picked a company. This week, your tasks are simple ones:
Pick a currency that you would like to do the analysis in. For most of you, the choice will be easy, and the currency that you will do the analysis in will be the currency in which the financials are reported, which, in turn, will be the currency of the country in which your company is incorporated. For some of you the choice will be a little more complicated, since the currency in which the financials are reported may not match the currency of the country in which the company is incorporated. This is the case, for instance, with commodity companies which often report their financials in US dollars, even though they may located in the UK or Latin America. Finally, there will be companies where the reporting may be in the local currency (Rubles, Nigerian Naira) where you decide that discretion is the better part of valor and you decide to do your analysis in an alternate currency (say US dollars or Euro) because getting inputs (on risk free rates and inflation) is easier.
Get a risk free rate in that currency: Remember that, at least for corporate finance purposes, a risk free rate is a long term (10-year), default-free rate. If you have a government that is Aaa rated that issues bonds in that currency, your task is very simple. Find a 10-year bond issued by that government and look up the rate on that bond. Thus, in US dollars, the US Ten-year T.Bond rate today, and in Euros, the German 10-year Euro bond rate, can be used as risk free rates. If there is no Aaa rated government bond in your currency, your task just got messier. You will have to back out the default spread for that government out of the government bond rate. We will be getting to this at the start of class next Monday, but you can get a jump if you watch the in-Practice webcast tomorrow. For the moment, here are some resources you can use to get started:
Local Currency Government bond rates: http://www.tradingeconomics.com/bonds
Moody’s Sovereign Ratings, by country: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/sovrCDSFeb16.pdf
Sovereign CDS spreads, by country: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/MoodysFeb16.xls
My lookup table on ratings and default spreads: http://www.stern.nyu.edu/~adamodar/pc/datasets/sovratingspreads.xlsx
|2/19/16||If you have picked a company, you should be able to pick a currency to do your analysis. Most of the time, the most pragmatic choice is to stick with the local currency, in which the financials are reported. Note, though, that if you have a commodity company, the conventional practice is often to report everything in US dollars, even for non-US companies. Once you pick the currency, you should try to get a risk free rate. As I promised, I do have a webcast on estimating the risk free rate that you may or may not find useful.
While the spreadsheet uses (and links) to the sovereign ratings and CDS spreads from March 2013, I sent you the updated sovereign CDS spreads, Moody’s ratings and updated lookup table yesterday but I listing them again, just in case.
Local Currency Government bond rates: http://www.tradingeconomics.com/bonds
Moody’s Sovereign Ratings, by country: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/sovrCDSFeb16.pdf
Sovereign CDS spreads, by country: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/MoodysFeb16.xls
My lookup table on ratings and default spreads: http://www.stern.nyu.edu/~adamodar/pc/datasets/sovratingspreads.xlsx
I know that this webcast is a little ahead of where we are in the class, but watching it will help you in the first part of class tomorrow.
|Not much to add to my emails from this week, but the latest newsletter is attached. If you are interested, I did three posts on my blog this week, pairing of companies: Apple vs Alphabet on Monday, Amazon and Netflix on Wednesday and Facebook and Twitter on Friday, looking at them as businesses, investments and trades.
Apple vs Alphabet: http://aswathdamodaran.blogspot.com/2016/02/race-to-top-duel-between-alphabet-and.html
Amazon vs Netflix: http://aswathdamodaran.blogspot.com/2016/02/the-disruptive-duo-amazon-and-netflix.html
Facebook vs Twitter: http://aswathdamodaran.blogspot.com/2016/02/management-matters-facebook-and-twitter.html
I hope that you enjoy them
|2/21/16||This will be a big week, as we start with risk free rate tomorrow, move on to estimating equity risk premiums and then measure the relative risk of an investment. By the end of the week, you should be able to compute a cost of equity for any publicly traded company, no matter how complicated and where it is located in the world, I promise. For the moment, though, relax and tell yourself it is not that complicated (because it is not). If that does not work, start reading chapter 4, not because you will get revelations but because you will fall asleep and then you will not be stressed out any more.|
We started today’s class by tying up the las loose ends with risk free rates: how to estimate the risk free rate in a currency where there is no default free entity issuing bonds in that currency and why risk free rates vary across currencies. The rest of today's class was spent talking about equity risk premiums. The key theme to take away is that equity risk premiums don't come from models or history but from our guts. When we (as investors) feel scared or hopeful about everything that is going on around us, the equity risk premium is the receptacle for those fears and hopes. Thus, a good measure of equity risk premium should be dynamic and forward looking. We looked at three different ways of estimating the equity risk premium.
2. Historical Premiums: We also talked about historical risk premiums. To see the raw data on historical premiums on my site (and save yourself the price you would pay for Ibbotson's data...) go to updated data on my website:
3. Implied equity premium: Finally, we computed an implied equity risk premium for the S&P 500, using the level of the index. If you want to try your hand at it, here is my February 2016 update:
4. Company revenue exposure: As a final step, see if you can find the geographic revenue distribution for your company. You can then use my latest ERP update to get the ERP for your company
Beta reminder: Pease do try to find a Bloomberg terminal. Click on Equities, find your stock (pinpoint the local listing; there can be dozens of listings....) and once you are on your stock's page of choices, type in BETA. A beta page should magically appear, with a two-year regression beta for your company. Print if off. If no one is waiting for the terminal, try these variations:
The post class test and solution for today are attached.
Both economics and finance are built on the pillar of risk aversion, i.e., that investors need to be paid extra (over and above an expected value) to take risks. That notion of risk aversion has been challenged and modified over time, but it still is at the heart of how we measure risk and come up with expected returns. Economists agree that not only does risk aversion vary across individuals but it also varies, for the same individual, across time. In this puzzle, which has no right answer, I would like you to wrestle with the question of how risk averse you, explanations that you can offer for that risk aversion and the consequences for your business and investment decision making. You can find the full details of the puzzle here:
One of the side products of the growth of robo advisors is a proliferation of tools that investors can use to assess how risk averse they are. This article in the New York Times nicely sets the table. In the article, the writer references two services that have made their tools available for readers to try out. Here the links to the two:
On a different note, there is an article about JP Morgan’s trading fiasco in London, titled the Big Whale. The trader who was “flagged” as responsible is speaking up and naming names, and guess what? I agree with him that this was not a solo operation. In fact, adding to my suggestion yesterday about hiring the mothers of traders to sit behind them when they trade, perhaps we should do this up and down the management ranks. Here is my original post, if you are interested.
Today's class covered the conventional approach to estimating betas, which is to run a regression of returns on a stock against returns on the market index. We first covered the estimation choices: how far back in time to go (depends on how much your company has changed), what return interval to use (weekly or monthly are better than daily), what to include in returns (dividends and price appreciation) and the market index to use (broader and wider is better). We also looked at the three key pieces of output from the regression:
If you can get your hands on the beta page for your company, you should be able to make these assessments for your company. You can also get a guide to reading the Bloomberg pages for your company by clicking below:
Finally, I have also attached the post-class test and solution for today.
On the second front, I hope that you have had a chance to print off the Bloomberg beta page for your company. Once you have it, do check the adjusted beta and confirm for yourself that it is in fact equal to
In yesterday’s email, I suggested to you that you estimate the equity risk premium for your company. Since you are so good about following my directions, I know that you have already done what you need to, but in case you run into trouble, the first webcast might be helpful. It looks at both how I estimate equity risk premiums for countries and how to estimate the equity risk premium for an individual company, even one that uses an eclectic geographic breakdown of revenues:
In the second webcast, I take a look at Disney's 2-year weekly regression (from February 2011- February 2013). I have the Bloomberg page attached. I am also attaching the spreadsheet that I used to analyze this regression, which you are welcome to use on your company. The webcast is available at the link below:
Two quick notes. First, the newsletter for the week is attached. Second, I know that Capital IQ has been spotty and downright unreliable. In fact, I have lost my Capital IQ connection, at least for the weekend. I have reached out to the IT people in charge of this and hope to get it resolved by next week. Have a great weekend!
Attachment: Issue 4 (February 27)
|2/28/16||I apologize again for scaring you about the first quiz earlier today. Nevertheless, the first quiz is coming a week from tomorrow, but this week, we will continue with our discussion of regression betas. Tomorrow, we will look at alternatives to regression betas starting and that discussion will spill into Wednesday. Along the way, we will look at how to estimate the beta of a company after a merger and the betas for different parts of a multi-business company. If you want to read ahead in chapter 4 of the book, please do so. It is one of the most critical parts of the class, especially since it will feed into almost everything else we do later in the class. Until next time!|
We started class today by connecting the three pieces that we have talked about so far in class, the risk free rate, the equity risk premium and beta to an expected return and how that expected return becomes a cost of equity. We spent the rest of the class talking about the determinants of betas. Before we do that, though, there is one point worth emphasizing. Betas measure only non-diversifiable or market risk and not total risk (explaining why Harmony can have a negative beta and Philip Morris a very low beta).
1. Betas are determined in large part by the nature of your business. While I am not an expert on strategy, marketing or productions, decisions that you make in those disciplines can affect your beta. Thus, your decision to go for a price leader as opposed to a cost leader (I hope I am getting my erminology right) or build up a brand name has implications for your beta. As some of you probably realized today, the discussion about whether your product or service is discretionary is tied to the elasticity of its demand (an Econ 101 concept that turns out to have value)... Products and services with elastic demand should have higher betas than products with inelastic demand. And if you do get a chance, try to make that walk down Fifth Avenue...
2. Your cost structure matters. The more fixed costs you have as a firm, the more sensitive your operating income becomes to changes in your revenues. To see why, consider two firms with very different cost structures
3. Financial leverage: When you borrow money, you create a fixed cost (interest expenses) that makes your equity earnings more volatile. Thus, the equity beta in a safe business can be outlandishly high if has lots of debt. The levered beta equation we went through is a staple for this class and we will revisit it again and again. So, start getting comfortable with it.
I also introduced the notion of betas being weighted averages with the Disney - Cap Cities example. I worked out the beta for Disney under two scenarios: an all-equity funded acquisition of Cap Cities and their $10 billion debt/ $8.5 billion equity acquisition. As an exercise, please try to work out the levered beta for Disney on the assumption that they funded the entire acquisition with debt (all $18.5 billion). The answer will be in tomorrow's email.
If you are ready to get started on preparing for the first quiz, here are the links that you need:
First, a few administrative details. There was a problem with yesterday’s webcasts, but it got fixed this morning. I put the streaming link and the audio link up and will add the video download and YouTube links later. Second, the first quiz is coming up and I will be doing a review session on Friday from 12-1 in KMEC 2-60. As you may know, that room fits only 170 and if everyone shows up, we are in trouble. I do know that some of you will not be able to show up and that review session will be recorded and the webcasts will be available shortly thereafter.
I also thought it would be useful to use this week’s puzzle to take a closer look at regression betas: how they are estimated, why they vary across services and what they tell us about risk in firms. I have used Volkswagen as my illustrative example, and you can see the details of the puzzle here:
Moving right along, I know that today's class was a grind with numbers building on top of numbers. In specific, we looked at how to estimate the beta for not only a company but its individual businesses by building up to a beta, rather than trusting a single regression. With Disney, we estimated a beta for each of the five businesses it was in, a collective beta for Disney's operating businesses and a beta for Disney as a company (including its cash). If you got lost at some stage in the class, here are some of the ways you can get unlost:
Finally, if you remember, we looked at the beta for Disney after its acquisition of Cap Cities in the last class. The first step was assessing the beta for Disney after the merger. That value is obtained by taking a weighted average of the unlevered betas of the two firms using firm values (not equity) as the weights. The resulting number was 1.026. The second step is looking at how the acquisition is funded. We looked at an all equity and a $10 billion debt issue in class and I left you with the question of what would happen if the acquisition were entirely funded with debt. (If you have not tried it yet, you should perhaps hold off on reading the rest of this email right now)
One final point. I mentioned that there the class will be spilt on Monday for the 10.30-11 quiz slot. I was lucky enough to get KMEC 1-70, which is a bigger room and here is the seating arrangement for the quiz:
A few different items to bring to your attention today.
2. Class yesterday:
3. The Case
Attachment: Quiz Review Slides
The quiz review is up and ready to access online on the webcast page for the class. The direct link to the webcasts are below:
I know that you are in no mood for in practice webcasts or working on your project, but I have a webcast on the mechanics of estimating bottom up betas. I use United Technologies to illustrate the process and I go through how to pull up companies from Capital IQ. Even if you don't get a chance to watch it after the quiz, it may perhaps be useful later on. Here are the links:
Remember last week, when I sent you the top ten questions on the quiz, by accident. Since most of you probably deleted that email right away, I am sending it again, and I hope it makes more sense now, since you may have one of these questions:
1. Why do we use past T.Bill rates for Jensen's alpha and the current treasury bond rate for the expected return/cost of equity calculation?
2. How do you decide whether to use a historical or an implied equity risk premium?
3. How do you estimate a riskfree rate for a currency in an emerging market?
4. How do you adjust for the additional country risk in companies that have operations in emerging markets?
5. Why do you use revenues (rather than EBIT or EBITDA) as the basis for your weighting?
6. Why do you use the average debt to equity ratio in the past to unlever a regression beta?
7. What is the link between Debt to capital and debt to equity ratios?
8. How do you annualize non-annual numbers?
9. What is the cash effect on beta? Why does it sometimes get taken out and sometimes get put back in?
Alternatively, you can use the net debt to equity ratio and cut it down to one step
To get to the bottom up equity beta for a company: You start with the unlevered betas with the businesses and work up to the equity beta in the following steps:
10. Why do you weight unlevered betas by enterprise value (as you did in the Disney/Cap Cities acquisition) and in computing Disney's bottom up beta?
I have also attached the newsletter for this week. That is about it... Hope I have not added to your confusion. Relax.. and I will see you soon.
Attachment: Issue 5 (March 5)
I know that it is tough to sit in on a class, after you have taken a quiz and I appreciate it that so many of you did come to class. We started class today by looking at how betas and costs of equity have to be adjusted for private companies, where the owners and potential buyers may not be diversified. We then moved on to what makes debt different from equity, and using that definition to decide what to include in debt, when computing cost of capital. Debt should include any item that gives rise to contractual commitments that are usually tax deductible (with failure to meet the commitments leading to consequences). Using this definition, all interest bearing debt and lease commitment meet the debt test but accounts payable/supplier credit/ underfunded pension obligations do not. We followed up by arguing that the cost of debt is the rate at which you can borrow money, long term, today and then looked at ways of coming up with that number from the easy scenarios (where a company has a bond rating) to the more difficult ones (where you have only non-traded debt and bank loans and no rating). I have attached the post class test & solution. You will notice a few questions relate back to something we talked about in the prior class, total betas, since I did not get a chance to include those in my last post class test.
One final note. If you have checked your Google calendar, you will notice that there is a group case due on March 30 just before class (at 10.30 am). I know that this is way in advance of that date, but that case is also now available to download. I am attaching the case to this email but I will send you another one specifically about the case and what you might be able to get started on in the near term. Back to grading quizzes.
The quizzes are done and ready to pick up. To get them, here is what you need to do.
As you review the quizzes, a few notes on the solutions.
One final note. Before you take your quiz score too far in either direction, remember that it is not only just 10% of your grade. Thus, if you did really well, there is lots left to do. If you did badly, this could become your freebie quiz that will be replaced by your average score on the remaining exams.
|3/8/16||I know that you are getting ready for Spring break and I hope that you have lots of fun. Just in case, you are missing your weekly puzzle (I would suggest seeing a psychiatrist), here is this week’s puzzle.
While risk and return models try to measure risk using regressions of stock returns against market indices, it is only during crisis periods that you really see the differential risk across sectors or businesses. One simple way to back out a measure of market risk exposure (an implied beta) is to take a periodwhere markets were in crisis (say January-February 2016) and look at differences in returns across sectors. It is dangerous to base everything on a month but it is an interesting technique. Here are the questions worth exploring;
Based upon just the YTD returns, what was the riskiest sector in the market and which one was the safest?
Why might you want to be cautious about generalizing this finding?
If you had this data for the worst 50 months in the market, would you be able to use it to get a measure of the relative risk of each sector and convert it into a number that looks like a beta?
know that some of you were in Spring break mode already, but today's class represented a transition from hurdle rates to measuring returns. We started by completing the last pieces of the cost of capital puzzle: coming up with market values for equity (easy for a publicly traded company) and debt (more difficult). We then began our discussion of returns by emphasizing that the bottom line in corporate finance is cash flows, not earnings, that we care about when those cash flows occur and that we try to bring in all side costs and benefits into those cash flows. Defining investments broadly to include everything from acquisitions to big infrastructure investments to changing inventory policy, we set the table for investment analysis by setting up the Rio Disney investment. We will return to flesh out the details in the next session (after the break). The post class test and solution are attached.
I also emailed you the case last week. Just in case you did not get it (or skipped over that email), you can get the case by going to the link below:
I know that spring break is not officially over but my hiatus from sending your emails is over and I do have a couple of notes on the case and the project, First, on the case. I know that most of you have not had a chance to read the case, let alone analyze it, but if you did read it, I hope that you will get started on it soon. (If your reaction is what case?, you may want to click on this link:
Second, on the project. I know it has been put on the back burner and will probably stay there until the case analysis is done. Just in case, you have some extra time on your hands, it would be great if you can get the cost of capital for your company done. This will of course require that you estimate a bottom up beta for your company and compute the market value of debt (and leases). I thought that a webcast on estimating the pre-tax cost of debt and the value of debt would come in useful. The webcast is from last year but I used Home Depot as my example for the analysis and it does providing an interesting test of getting updated information. The most recent 10K for the Home Depot at the time of the webcast was as of January 29, 2012. Since a new 10K was due a few weeks after the webcast, I used the 10Q from the most recent quarter (as of the time of the webcast) to update information. (Most of you will get lucky and your most recent 10K or annual report will be ready to use, but just in case it is not...)
Attachments: Issue 6 (March 19)
|3/20/16||I hope that you are back, rested and ready to go. I know that it has been ten days since our last class, a long enough period for you to have forgotten where we are. Well, we were just starting on the Rio Disney theme park analysis and had set the table. Tomorrow, we will start with projections of future earnings and returns on capital and then move on to cash flows, incremental cash flows and time weighted incremental cash flows. Since the case is all about a project (Netflix investing in a studio), I would suggest at least reading it before tomorrow’s class, since there might be parts of the class that you will find useful. Looking forward to tomorrow (and I hope that I am not the only one..)|
I know that it is probably tough to get back into school mode, but I hope that you are making the transition. In today's class, we started by stating our ideal measure of return: it should be based upon cash flows, focus on just the incremental and be time weighted. After defining project broadly as including any type of investment, small or large, revenue generating or cost cutting, we started on the Rio Disney theme park analysis. We laid out the initial costs for the theme park and the assumptions about expenses, both direct and allocated. We began the class today by extending the return on capital concept to entire companies and argued that notwithstanding its accounting limitations, comparing the return on capital to the cost of capital provides us with a basis for measuring whether a company’s existing investments are good (or not).
First things first. I know that many of you have asked about this and I am sorry that I have not responded with specifics, but I was trying to nail down the exact times. The regularly scheduled final for this class is May 13 from 9 am -11 am. There will be an early final for those who want to use that option on May 11, though the time and the room have not been nailed down yet.
I know that you are probably busy working on the case (or should be) but here is the weekly puzzle for this week. Yesterday, we started on our discussion of how to measure returns. While we will lay the framework out for how best to make investment decisions, the reality is that you make the best decisions that you can, with the information that you have at the time, and the real world then delivers its own surprises. In this week’s challenge, I confront this issue head on by looking at Chevron’s $54 billion investment in a natural gas plant in Australia. The decision was made in 2009, when oil and gas prices were much higher and rising, and the plant is just going to start production. Take a look at the challenge:
In today's session, we started by looking at two time-weighed cash flow returns, the NPV and IRR. We then looked at three tools for dealing with uncertainty: payback, where you try to get your initial investment back as quickly as possible, what if analysis, where the key is to keep it focused on key variables, and simulations, where you input distributions for key variables rather than single inputs. Ultimately, though, you have to be willing to live with making mistakes, if you are faced with uncertainty. I also mentioned Edward Tufte's book on the visual display of information. If you are interested, you can find a copy here:
|3/24/16||I know that you have lots of other stuff on your plate right now and are not really thinking about corporate finance (I find that hard to believe but then again, I am biased..) In case your fascination with corporate finance leads you to work on the case, here are a few suggestions on dealing with the issues.
Do the finite life (10-year) analysis first. It is more contained and easier to work with. Then, try the longer life analysis. It is trickier...
If you find yourself lacking information, make reasonable assumptions. Ignoring something because you don't have enough information is making an assumption too, just a bad one.
When you run into an estimation question, ask yourself whether you need the answer to get accounting earnings or to get to incremental cash flows. If it is to get to earnings, and if your final decision is not going to be based on earnings, don’t waste too much time on it.
I think the case is self contained. For your protection, I think that you should stay with what is in the case. You are of course not restricted from wandering off the reservation and reading whatever you want on the movie business and Netflix’s future, but you run the risk of opening up new fronts in a war (with other Type A personalities in other groups who may be tempted to one up by bringing in even more outside facts to the case) that you do not want to fight. And please do not override any information that I have given you in the case. (I have given you a treasury bond rate and equity risk premiums, for instance.)
There are tax rules that you violate at your own risk. For instance, investing in physical facilities is always a capital expenditure. At the same time, make your life easy when it comes to issues like depreciation. If nothing is specified about deprecation, use the simplest method (straight line) over a reasonable life.
There is no one right answer to the case. In all my years of providing these cases, I have never had two groups get the same NPV for a case. There will be variations that reflect the assumptions you make at the margin. At the same time, there are some wrong turns you can make (and i hope you do not) along the way.
Much of the material for the estimation of cash flows was covered yesterday and in the last session. You can get a jump on the material by reviewing chapters 5 and 6 in the book. The material for the discount rate estimation is already behind us and you should be able to apply what we did with Disney to this case to arrive at the relevant numbers.
Do not ask what-if questions until you have your base case nailed down. In fact, shoot down anyone in the group who brings up questions like "What will happen if the margins are different or the market share changes?" while you are doing your initial run…
Do not lose sight of the end game, which is that you have to decide based on all your number crunching whether Netflix should invest in this studio or not. Do not hedge, prevaricate, pass the buck or hide behind buzz words.
The case report itself should be short and to the point (if you are running past 4 or 5 pages, you either have discovered something truly profound or are talking in circles). You can always have exhibits with numbers, but make sure that you reference them in the report.
|3/25/16||I know that you are working on the case right now and that the project is on the back burner. When you get back to it, though, one of the questions that you will be addressing is whether your company's existing investments pass muster. Are they good investments? Do they generate or destroy value? To answer that question, we looked at estimating accounting returns - return on invested capital for the overall quality of an investment and the return on equity, for just the equity component. By comparing the first to the cost o capital and the second to the cost of equity, we argued that you can get a snapshot (at least for the year in question) of whether existing investments are value adding. The peril with accounting returns is that you are dependent upon accounting numbers: accounting earnings and accounting book value. In the webcast for this week, I look at estimating accounting returns for Walmart in March 2013. Along the way, I talk about what to do about goodwill, cash and minority interests when computing return on capital and how leases can alter your perspective on a company. Here are the links:
Walmart: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/ROIC/walmart10K.pdf (10K for 2012) and http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/ROIC/walmart10Klast year.pdf (10K for 2011)
Spreadsheet for ROIC: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/ROIC/walmartreturncalculator.xls
I hope you get a chance to watch the webcast. It is about 20 minutes long…
I will keep this brief. The weekly newsletter is attached, the case is due on Wednesday before the class (at 10.30 am) and spring is here. Until next time!
7 (March 26)
In the week to come, we will continue and complete our discussion of investment returns, starting tomorrow with a comparison of NPV versus IRR and then moving on to look at side costs and side benefits. A big chunk of Wednesday's class will be dedicated to discussing the case (If you ask, "What case?", you are asking for retribution...) By the end of Wednesday's class, we will be done with packet 1. Packet 2 is ready to be either downloaded online or can be bought at the bookstore. To download it, go to the webcast page for the class and check towards the top of the page:
Anyway, speaking about the case, here are some closing instructions:
We started today's class by looking at mutually exclusive investments and why NPV and IRR may give you different answers: a project can have more than one IRR, IRR is biased towards smaller projects and the intermediate cash flows are assumed to be reinvested at the IRR. As to which rule is better, while NPV makes more reasonable assumptions about reinvestment (at the hurdle rate), companies that face capital rationing constraints may choose to use IRR. We then compared projects with different lives and considered how best to incorporate side costs and side benefits into investment analysis. In the meantime, you have all of the tools you need to address the Netflix Studio project. Please send your group project report as a pdf file with “To studio or not to studio" as the subject before 10.30 am on Wednesday. Please put the decision you made on the investment (Accept or Reject), the cost of capital that you used and the NPV of the project on the cover page. Also, please fill out the attached spreadsheet with your numbers and send them back to me when you have them (or as early as you can).
We talked about sunk costs in class in the last week, and how difficult it is to ignore them, when making decisions. You can start your exploration of the sunk cost fallacy with this well-done, non-technical discourse on it:
Finally, I know that you are probably busy working on your case (spare me my illusions) but in case you have some time, I would like to pose a hypothetical, just to see how you deal with sunk costs. Before you read the hypothetical, please recognize that I am sure that the facts in this particular puzzle do not apply to you, but act like they do, at least for purposes of this exercise:
|3/29/16||Just a quick reminder, if you have not done it already. Please send me your summary numbers in the attached summary sheet. And when you submit your final project, please do include “To studio or not to studio” in the subject. I am sorry for being nit-picky about this but I am on the verge of receiving about 130 group reports from two different classes between today and tomorrow morning at 10.30 and I want to make sure that I keep things organized.|
The bulk of today's class was spent on the Netflix Studio case. While the case itself will soon be forgotten (as it should), I hope that some of the issues that we talked about today stay fresh. In particular, here were some of the central themes (most of which are not original):
I have put the presentation and excel spreadsheet with my numbers online:
In the last part of the class, we tied up some loose ends relating to investment analysis, starting with valuing side benefits and synergies and then taking a big picture perspective of the options that are often embedded in project analysis that may lead us to take negative NPV investments. The post class test and solution for today are also attached.
I am about half way through the grading and some of you should have your cases back already and the rest should be on their way either today or tomorrow. As you look at the case and my grading, I will make a confession that some of the grading is subjective but I have tried my best to keep an even hand. I have put together a grading template with the ten issues that I am looking for in the case. When you get your case, you will find your grade on the cover page. You will see a line item that says issues, with a code next to it. To see what the code stands for look at the attached document. In the last column, you will see an index number of possible errors (1a, 2b etc...) with a measure of how much that particular error/omission should have cost the group. I have tried to embed the comment relevant to your case into your final grade. So, if you made a mistake on sunk cost (4, costing 1/2 a point) and allocated G&A (5, costing 1/2 a point) in your analysis. On the front page of your case, you will see something like this in your grade for the class (Overall grade; 9/10; Issues: 3b,9a) I hope that helps clarify matters. It is entirely possible that I may have missed something that you did or misunderstood it. You can always bring your case in and I will reassess it.
First, my thanks for the time and sweat that went into the case reports. I appreciate it and if you are disappointed with your grade, I am truly sorry. think all the cases are done and you should have got them already. It is entirely possible that a couple slipped through my fingers. If so, please email me with your case attachment again (with no changes of course.. I will go back and find your original submission in mailbox and get it graded. I am attaching that grading code that I had sent you before, so that you can make some sense of your grade. If you feel that i have missed something in your analysis, please come by and make your argument. I am always willing to listen. After 70+ cases, I am a so sick of Netflix, I might cancel my subscription... and I am sure you are too, but I thought that it would be a good time to talk about some key aspects of the case:
1. Beta and cost of equity: The only absolute I had on this part of the case was that you could not under any conditions justify using Netflix's beta to analyze a project in a different business. However, I was pretty flexible on different approaches to estimating betas from the list of movie companies. Also, if you consolidated your cash flows from the studio and cost savings, you are using the same cost of capital on both. I did not make an issue of it in this case, since the cost savings were so small, but something to think about.
2. Cost of debt and debt ratio: If there was one number that most groups agreed on, it was that the cost of debt for Netflix was 5% (the riskfree rate + default spread). On the debt ratio, on leases, there were variations on how you dealt with content commitments. Some of you chose to ignore those commitments, albeit on shaky grounds. I would treat it as debt, but here to, I did not take any points off for not considering content commitments.
3. Cash flows in the finite life case: I won't rehash the arguments about why we need to look at the difference between investing in year 5 and year 8 for computing the server investment. Many of you either ignored the savings in year 8 or attempted to allocate a portion of the investment in year 3, a practice that is fine for accounting returns but not for cash flows. But here were some other items that did throw off your operating cash flows:
4. Cash flows in the infinite life case: The key in this scenario is that you need more capital maintenance, starting right now. (Here is a simple test: If your after tax cash flows from years 1-10 are identical for the 10-year life and longer life scenarios, you have a problem...) Though some groups did realize this, they often started the capital maintenance in year 11, by which point in time you are maintaining depleted assets. Those groups that did not include capital maintenance at all argued that they felt uncomfortable making estimates without information. But ignoring something is the equivalent of estimating a value of zero, which is an estimate in itself. Also, you cannot keep depreciation in your cash flows (in perpetuity) and not have capital maintenance that matches the depreciation, since you will run out of assets to depreciate, sooner rather than later. The basis for capital maintenance estimates should always be depreciation and your book capital; tying capital maintenance to revenues or earnings can be dangerous.
Finally, and this is a pet peeve of mine. So, just humor me. Please do not use the word "net income" when you really mean after-tax operating income. Not only is it not right but it will create problems for you in valuation and corporate finance. Also, try to restrain your inner accountant when it comes to capital budgeting. As a general rule, projects don't have balance sheets, retained earnings or cash balances. Also, if a project loses money, don't create deferred tax assets or loss carryforwards but use the losses to offset against earnings right now and move on.
Now that the case is behind us, time to get ready for a busy week coming up. On Monday, we will start on financing choices tomorrow and continue with the trade off between debt and equity after the quiz on Wednesday. So, please do bring packet 2 to class with you. Oh, and one more thing. I did put up an in-practice webcast about finding a typical project for a company on the webcast page for the class.
As the second quiz approaches and you get a chance to digest your case feedback, a few quick notes:
In today's class, we started our discussion of the financing question by drawing the line between debt and equity: fixed versus residual claims, no control versus control, and then used a life cycle view of a company to talk about how much it should borrow. We then started on the discussion of debt versus equity by looking at the pluses of debt (tax benefits, added discipline) and its minuses (expected bankruptcy costs, agency cost and loss of financial flexibility). Even with the general discussion, we were able to look at why firms in some countries borrow more than others, why having more stable earnings can make a difference in how much you can borrow and why having intangible assets can affect your borrowing capacity. After the quiz on Wednesday, we will continue with this discussion. The post class test relates mostly to session 15 (last session on synergy and side benefits), but it is worth doing just to get that part under your belt. I am also attaching the slides for tomorrow’s review session, scheduled for 12-1 in KMEC 2-60.
First, before I forget, here is the seating for tomorrow’s quiz:
Second, the quiz review webcast is up and running. Here are the links:
Attachments: Review Presentation
|4/5/16||I know what you are thinking… Right? He wants me to prepare for a quiz after a week of working on the case and he expects me to do a puzzle on top of that! Not happening! I understand but nevertheless, just in case you feel the urge, this week’s puzzle is up and running. It revolves around the tax benefit of debt and in particular, the perversity of the US tax code. You can find the puzzle here:
As you can see the puzzle is structured around the recent attempt by the US Treasury to stop the inversion phenomenon, where US companies try to merge with foreign companies and move their domiciles to more friendly tax climates. If you get a chance, please take a look at it.
I want to start off by apologizing for being unfair to those of you who spent lots of time preparing for the quiz and still ran into a time constraint. It was uncharitable and unfair to say that it was only a matter of finding the right way to answer questions and that you would not have a time constraint. As I grade through your quizzes, I recognize how many different ways (and I am constantly surprised by this) that small tangents can end up sucking up large amounts of time and with 30 minutes, you don’t have much time. It is also particularly difficult, if your background is not in numbers and you have to work through them. So again, I am sorry. When I grade the quizzes, I am cognizant of this constraint and try to bring it into the grading. In the session that followed the quiz, I look at the Miller Modigliani theorem through the prism of the debt tradeoff. I then move on to looking at how the cost of capital can be used to optimize the right mix of debt and equity. We will continue with this discussion next week.
The quizzes are done and are ready to be picked up. They are in the usual space (the entry to the finance department, just before you get to the door) and are in three neat alphabetical stacks. Please leave them in the same order. I have attached the solutions and the grading distribution below.
As you look at the distribution, you will notice that the average and median scores are about a point and a half lower than on the last quiz and that is where my mea culpa comes in. (It sounds so much better to say that it was my mistake in latin). I do think that I put too many moving parts in this quiz, and while each of them was not a big deal, the sum total proved to be overwhelming for some of you. Some of the problems can be attributed to the time constraint and that taking a couple of wrong turns can very quickly eat into 30 minutes, but some are conceptual and I will take responsibility for not delivering the message clearly enough. Here are some of the key issues:
If you did well on this quiz, I commend you, since it suggests that both these concepts have taken root. If you did not, please take a look at why. If it is purely a time issue and having an extra ten minutes would have made the difference, let’s talk since there are ways in which you can reclaim some of that time. If it is deeper, the solution is (unfortunately) working through the concept with more examples. I will do my part to reduce the number of moving parts in the next quiz, to stop the numbers overload that some of you felt on this one.
I know that you just got back your quiz and you are in no mood for corporate finance but this is a great weekend to get caught up with your big project. We are in the capital structure section and the first thing you can do (if you remember what company you are analyzing) is to take it through the qualitative analysis, i.e., the trade off items on capital structure:
Today's in practice webcast takes you through the process of assessing this trade off, with suggestions on variables/proxies you can use to measure each of the above factors. If you are interested, here are the links:
I will keep this really short, since I am sure that you are sick of me. Last week, we began our discussion of capital structure by laying out the trade off between debt and equity for all businesses. That trade off, with tax benefit and added discipline as pluses and expected bankruptcy and agency costs as minuses, sets up the framework that we will build on in the coming week to find the right mix of debt and equity for any business. The newsletter is attached.
Attachment: Issue 9 (April 9)
In today's class, we continued our discussion of the cost of capital approach to deriving an optimal financing mix: the optimal one is the debt ratio that minimizes the cost of capital. To estimate the cost of capital at different debt ratios, we estimated the levered beta/ cost of equity at each debt ratio first and then the interest coverage ratio/synthetic rating/cost of debt at each debt ratio, taking care to ensure that if the interest expenses exceeded the operating income, tax benefits would be lost. The optimal debt ratio is the point at which your cost of capital is minimized. Using this approach, we estimated optimal debt ratios for Disney (40%), Tata Motors (20%), Vale (30% with actual earnings, 50% with normalized earnings), Baidu (10%) and Bookscape (30%). Disney was underlevered, Tata Motors was over levered and Bookscape was at its optimal. We closed the class by looking at an extension of the cost of capital approach, which allowed us to bring in expected bankrutpcy costs into the discussion.
Now, to the project, which I know has been on the back burner for a while. I know that some of you are way behind on the project, and as I mentioned in class today, I will offer you a way to catch up. In doing so, I will be violating “The Red Hen Principle”. If you have no idea what I am talking about, try this link: http://www.amazon.com/Little-Red-Hen-Golden-Book/dp/0307960307/ref=sr_1_1?s=books&ie=UTF8&qid=1460414914&sr=1-1&keywords=the+little+red+hen. If you get a chance, please try the optimal capital structure spreadsheet (attached) for your firm and bring your output to class on Wednesday. It will help if you have a bottom up beta (based on the businesses that your company operates in) and an ERP (given the countries it gets its revenues from) but if you don’t, use a regression beta and the ERP of the country in which your company operates (for the moment).
|4/12/16||In this week’s puzzle I decided to use Valeant to illustrate both the good side and the bad side of debt. Valeant was an obscure Canadian pharmaceutical company in 2009 but grew explosively between 2009 and 2015 to get to a market capitalization of $100 billion, primarily using debt-fueled acquisitions to deliver that growth. You can read the weekly puzzle here:
In the last year, Valeant’s fortunes have taken a turn for the worse. Not only has its business model crumbled, but it has had both managerial problems and information disclosure issues that have added to the troubles. It’s CEO is on the verge of leaving, but not before he delivers testimony in front of a Congressional committee, its lead investor, Bill Ackman, has his reputation and lots of money on the line and there is a real chance that if it does not release its long-delayed financial filing (due in February) by April 29, that debt covenants would be triggered. Its bond rating is now below investment-grade and Valeant is now seeing the other side of the debt sword. If you get a chance, take a look at the weekly challenge and please try to answer the four questions:
What role did debt play in allowing Valeant to be so successful between 2009 and 2015? Where was the value added?
What is Valeant's optimal mix of debt and equity? (Try the optimal capital structure spreadsheet)
Valeant's debt is clearly now operating more as a negative than a positive. Is there a way to estimate the costs to Valeant of having borrowed too much? (Think about the feedback effect it may be having on Valeant's operations and the indirect bankructy costs)
Assume now that the new filing is made, that revenues and earnings are down and that Valeant has too much debt. What are the options for reducing this debt load and which one would you pick?
Until next time!
In today’s class, we continued our discussion of the cost of capital approach to optimizing debt ratios by looking at the determinants of the optimal. In particular, it was differences in tax rates, cash flows (as a percent of value) and risk that determined why some companies have high optimal debt ratios and why some have low or no debt capacity. We then looked at the Adjusted Present Value (APV) approach to analyzing the effect of debt. In particular, this approach looks at the primary benefit of debt (taxes) and the primary costs (expected bankruptcy) and netted out the difference from the unlevered firm value. If you are interested in trying this out, I have attached an APV spreadsheet which you can use on your company (with your own judgment call on what the indirect bankruptcy cost is as a percent of value).
We closed the discussion of optimal by noting that many firms decide how much to borrow by looking their peer group and argued that if you decide to go this route, you should use more of the information than just the average. If you can plug in the numbers for the optimal debt ratio into the optimal capital structure, it would be a giant step forward on your project. More on the project tomorrow.. . Until next time!
I know that I have been sending you serial emails on the project over the whole semester and that some of you are way behind. Since it may be overwhelming to go back and review every email that I have sent out over time, I thought it would make sense to pull all the resources that I have referenced for the project into one page, which you can use as a launching pad for starting (or continuing) your work on the project.
1. Resource page: I put the link up to the corporate finance resource page, where I will collect the data, spreadsheets and webcasts that go with each section of the project in one place to save you some trouble:
2. Main project page: I had mentioned the main page for the project at the very start of the class, but I am sure that it got lost in the mix. So, just to remind you, there is an entry page for the project which describes the project tasks and provides other links for the project:
3. Project formatting: I guess some of you must be starting on writing the project report or some sections thereof. While there is no specific formatting template that I will push you towards, I do have some general advice on formatting and what I would like to see in the reports:
Note, in particular, to put muscle behind my plea for brevity. I have put a page limit of 25 pages on your entire written report (You can add appendices to this, but use discretion), if you have five companies or less. If you have more than five companies, you can add 2 pages for each one.
I know that I have been nagging you to get the optimal debt ratio for your firm done. To bring the nagging to a crescendo, I have done the webcast on using the cost of capital spreadsheet, using Dell as my example. You can find the webcast and the related information below:
In a sign that the end game is getting closer, I also have been thinking about the final exam. As you well know, the final is scheduled for May 13 from 9 am -11 am and there will be an early final offered on May 11 from 1.30 to 3.30 pm. Since there are only 120 seats in the room that I have for the early final, I am going to ask for sign ups for the early final in this Google shared spreadsheet.
|4/16/16||I hope that I have not ruined your entire weekend with the project, because it is way too nice a day to be stuck inside. The weekly newsletter is attached.
Attachments: Issue 10 (April 16)
As we approach the closing weeks for the class, we will build on the optimal debt ratio that we estimated last week and look at the next step: whether to move to the optimal and if so, how quickly and what the right type of debt for a firm should look like. We will them move on to the basics of designing the perfect debt for a firm, both in intuitive terms and by using a quantitative approach. So, if you have the optimal debt ratio for your firm worked out, bring it to class with you tomorrow.
Also, in case it got lost in the email I sent on Friday, I have created a hub for all of the materials related to the project. Visit it, when you get a chance.
See you in class tomorrow.
In today's session,we looked at applying closure to the optimal debt ratio analysis by looking at how quickly you should move to the optimal and what actions to take (recap versus taking projects), drawing largely on numbers that we have estimated already for the company (Jensen's alpha, ROC - Cost of capital). We then followed up by examining the process of finding the right debt for your firm, with a single overriding principle: that the cash flows on your debt should be matched up, as best as you can, to the cash flows on your assets. The perfect security will combine the tax benefits of debt with the flexibility of equity.
At this stage in the class, we are close to done with capital structure (chapters 7,8 &9) and with all of the material that you will need for quiz 3 (which is not until a week from Wednesday). Thus, you can not only finish this section for your project but start preparing for the quiz at the same time. Quiz 3 and the solution to it are also up online, under exams & quizzes on the website for the class:
I have also attached today's post class test & solution.
In today's class, we looked at the design principles for debt. In particular, we noted the allure of matching up debt cash flows to asset cash flows: it reduces default risk and increases debt capacity. We then looked at the process of designing the perfect debt for your company, starting with the assets you have, checking to see if you still get your tax deduction, keeping different interest groups happy and sugarcoating the bond enough to make it palatable to bond holders. We then went through three basic approaches to debt design: an intuitive assessment of a company's products and pricing power, an analysis of expected cash flows on a single project and a macro economic regression of firm value/operating income against interest rates, GDP, inflation and exchange rates.
In the second half of the class, we started on our discussion of dividend policy. We began by looking at some facts about dividends: they are sticky, follow earnings, are affected by tax laws, vary across countries and are increasingly being supplanted by buybacks at least in the United States. We will continue the discussion of how much companies should return to investors in the next session. The post class test & solution for today is attached.
One final note. I skipped the puzzle for yesterday on the assumption that you would be too busy, but I decided to put it back in anyway, since some of you still may be able to give it a shot, if you get some time. Specifically, the perfect financing for a firm will combine the best of equity (the flexibility it offers you to pay dividends only when you can afford them) with the best of debt (the tax advantages of borrowing). While this may seem like the impossible dream, companies and their investment bankers constantly try to create securities that can play different roles with different entities: behave like debt with the tax authorities while behaving like equity with you. In this week's puzzle, I look at one example: surplus notes. Surplus notes are issued primarily by insurance companies to raise funds. They have "fixed' interest payments, but these payments are made only if the insurance company has surplus capital (or extra earnings). Otherwise, they can be suspended without the company being pushed into default. The IRS treats it as debt and gives them a tax deduction for the interest payments, but the regulatory authorities treat it as equity and add it to their regulatory capital base. The ratings agencies used to split the difference and treat it as part debt, part equity. The accountants and equity research analysts treat it as debt. In effect, you have a complete mess, working to the insurance company's advantage.
One final note. The TA review session for next week has been moved by popular demand to Tuesday, April 26, from 4.30-6.
On the project, if you have done the intuitive analysis of what debt is right for your firm, you can try to do a quantitative analysis of your debt. I have attached the spreadsheet that has the macroeconomic data on interest rates, inflation, GDP growth and the weighted dollar from 1986 to the present (I updated it to include 2013 data. The best place to find the macro economic data, if you want to do it yourself, is to go to the Federal Reserve site in St. Louis:
I have to warn you in advance that these regressions are exceedingly noisy and the spreadsheet also includes bottom-up estimates by industry. There is one catch. When I constructed this spreadsheet, I was able to get the data broken down by SIC codes. SIC codes are four digit numbers, which correspond to different industries. The spreadsheet lists the industries that go with the SIC code, but it is a grind finding your business or businesses. I am sorry but I will try to create a bridge that makes it easier, but I have not figured it out yet. My suggestion on this spreadsheet. I think it should come in low on your priority list. In fact, focus on the intuitive analysis primarily and use this spreadsheet only if you have to the time and the inclination. My webcast for tomorrow will go through how best to use the spreadsheet.
I know that you are busy but I have put the webcast up on debt design, using Walmart as my example, online (on the webcast page as well as on the project resource page). Here are the details on the webcast:
On a different front, a few of you have noticed that I have not been updating my Jensen’s alpha, by sector. One reason is that I switched to Capital IQ from Value Line and getting to a Jensen’s alpha has become much more difficult. If you want to come up with a good proxy, here is what I would suggest that you do. Pick a time period and compare the returns on your stock (total) to the returns on the sector it is in. You can get the latter online on Yahoo Finance, Google Finance and multiple other sites, like this one:
Bad news: Another weekly newsletter for you. Good news: It is the second to last one, which is my not-so-subtle way of telling you that the end of the semester is fast approaching.
Attachment: Issue 11 (April 23)
We spent all of the session setting up the trade off on dividends, starting with the argument that Miller/Modigliani made that dividends don't matter (in a world where investors are taxed at the same rate on dividends & capital gains & stock issuance is costless) to the dividends are bad school (built on the almost century long higher tax on dividends) to the dividends are good school. We closed by looking at two bad reasons for paying dividends (that they are more certain, that you had a good year) and three potentially good reasons (to signal to market, to make your clientele happy and to take advantage of debt holders). However, most of you are are probably focused on the third quiz and a few quick notes:
2. Review session: The review session will be in Paulson from 12-1 tomorrow. The review presentation is attached. So, please print it off when you get a chance, since I will not be able to make copies for tomorrow.
3. Content: The quiz will cover capital structure; Lecture note packet 2: 1-142; Chapters 7-9 in the book
The review session for the quiz is up and running. You can get to it by going to one of the links below:
Today, in class, we moved on to look at how much a company can afford to pay out as dividend. This measure, that I titled FCFE, is the cash left over after taxes, reinvestment needs and net debt payments. When a company pays out less than its FCFE, it is accumulating cash, and we laid the foundations for analyzing dividend policy by asking the key question: do you trust managers with your cash? During the session, we applies this framework to the Disney and Vale. Post class test and solution attached.
The quizzes are done and can be picked up in the usual spot. As you review the grading, there are a couple of points that I want to make that may explain the grading, especially on problem 1. Don’t just check the answer, since your answer may match mine, but for the wrong reasons. The key to this problem is recognizing what a special dividend will do to equity. Let me back up. Depending on the quiz that you took, your firm was an all equity funded firm with $150 million in market value of equity (or 500 million if you got quiz b). The financial balance sheet looks as follows:
I hope you have had a chance to pick up your quiz. As you look at the calendar, there is some bad news and some good news. The bad news is that you have three class sessions and two weekends left in the class. I know that you may be in a bit of a panic, but here is what needs to get done on the project. (I am going to start off from the end of section 5, since I have nagged you sufficiently about the steps through that one).
1. Optimal capital structure: You need to compute the optimal debt ratio for your company
2. Debt design: As you work your way through or towards the debt design part, here are a few sundry thoughts to take away for the analysis:
2.3: Compare the actual debt to your perfect debt (either from the intuitive approach or from the quantitative approach) and make a judgment on what your company should do.
3. Dividend analysis: We developed a framework for analyzing whether your company pays out too much or too little in dividends in class yesterday. You can read ahead to chapter 11, if you want, and use the spreadsheet at the link below to examine your company.
The next section has not been covered yet in class, but you can get a jump on it now, if you want.
4. Valuation: This is a corporate finance class, with valuation at the tail end. We will look at the basics of valuation next week and you will be valuing your company. Since we will not have done much on valuation, I will cut you some slack on the valuation. It provides a capstone to your project but I promise not to look to deeply into it. Knowing how nervous some of you are about doing a valuation, I have a process to ease the valuation: Download the fcffsimpleginzu.xls spreadsheet on my website. It is a one-spreadsheet-does-all and does everything but your laundry.
You will notice that the spreadsheet has some default assumptions built in (to prevent you from creating inconsistent assumptions). I do let you change the defaults and feel free to do so, if you feel comfortable with the valuation process. If not, my suggestion is that you leave the inputs alone.
You will notice that I ask you for a cost of capital in the input page. Since you already should have this number (see the output in the optimal capital structure on section 1), you can enter it. If you want to start from scratch, there is a cost of capital worksheet embedded in the valuation spreadsheet. There is a diagnostic section that points to some inputs that may be getting you into trouble. I also ask you for information on options outstanding to employees/managers. That information is usually available for US companies in the 10K. If you cannot find it, your company may not have an option issue. Move on.
5. Project write-up and formatting: If you are thinking of the write-up for the project and formatting choices, you can look at some past group reports on my site (under the website for the class and project). I prefer brevity and have imposed a page limit of 25 pages on the report (plus 2 pages for each additional company over 5). Please keep your report to that limit. As a general rule, steer away from explaining mechanics - how you unlevered or levered betas -and spend more time analyzing your output (why should your company have a high beta? And what do you make of their really high or low return on capital?).
Ah, where is the good news? You will be done with the project exactly 11 days from today. It is due by 5 pm on May 9.
As we work through the analysis of dividend policy, you have to look at the trade off on traditional dividends (and whether your company is a good candidate for paying dividends or increasing them). The first webcast looks at the question, using Intel as an example:
You have to follow up by assessing potential dividends and whether your company is returning more, less or just about the same amount as that potential dividends. The second webcast looks at the question, again using Intel:
The spreadsheet that goes with these webcasts is an old one. So, use the updated version that I sent you yesterday which has data through 2015:
I hope you get a chance to take a look at both webcasts.
The end is near!!! Repent, repent!!! The last newsletter is attached. Read it, if you want. Don’t, if you don’t.
Attachment: Issue 12 (April 30)
In today's class, we put the closing touched on dividend policy analysis by going through the possess of estimating FCFE, the cash flow left over after capital expenditures, working capital needs and debt payments. My suggestion is that you estimate the aggregate FCFE over 5 years (or as many years as you have data) and compare it to the cash returned. If the cash returned = FCFE, you have a rare company that pays out what it can afford in dividends. If cash returned <FCFE, your company is building up cash and you should follow through and look at how much you trust the management of the company with your cash (use the EVA and Jensen's alpha that you have estimated for your company).
In the second half of the class, we laid the foundations for valuing companies by talking about the importance of narrative and connecting them to numbers. If you are interested, here is the talk that I gave to the CFA annual conference on the topic two years ago:
Since the project is due in less than a week and you may still have not done the valuation part, I decided to move up the in practice webcast four days and post the links today. The spreadsheet that I used to illustrate the process is the fcffsimpleginzu.xls that I had sent in an email last week and the company I have used is Apple in May 2013. Here are the links:
While there are other more elaborate and involved valuation spreadsheets, this one has three advantages. First, it requires relatively few inputs to value a company. Second, it is versatile and will value companies across the life cycle, from young, money losing start ups to companies in decline. Third, I have tried to set default options in the spreadsheet that protect you from your overreaching. I know that you are capable of protecting yourself, and if you feel comfortable, please go ahead and turn off the defaults.
Attachments: Valuation Spreadsheet