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. They 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 use this enroll code: EXC-JJS-XEA. Alternatively, try this link:
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 gray weather in New York, some place warm and sunny. 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:
For those of you who have not got around to checking, class is scheduled from 10.30-11.50 in Paulson Auditorium on January 31. See you there!
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.
|1/31/17||As promised, here is the first weekly challenge. It is about corporate governance at one of India’s oldest and best regarded family groups, the Tatas. The group which has been around since 1868, has more than a hundred companies under it, and has had only seven heads over its 150-year life, most of whom came from the Tata family. In 2012, Ratan Tata stepped down and Cyrus Mistry was named the new head. While not an immediate Tata family member, he is related by marriage to the family and he himself comes from a family with deep connections to the group going back in time. It is perhaps because of the group’s history that people were shocked when Cyrus was fired on October 24, 2016, and Ratan Tata reinstated as the head. You can start with the blog post that I had on the group in November:
That lays out my views not just on the Tata group but on family groups in general. Once you have that read, you can then look at the specifics of this week’s puzzle, where I bring the story up to date.
Once you have read these pieces (and other links), there are four questions that I would like you to answer:
1. What do you see as the pluses and minuses of family group control of publicly traded companies?
2. Can you use that trade off to explain why family group companies grew to dominate Asian and Latin American markets? Can you use it to look at the challenges that family groups will face in the future?
3. Given the Tata Group's current standing and the evolution of the Indian economy/market, do you think that the pluses still outweigh the minuses?
4. Do you believe the governance problem has been resolved with the appointment of Mr. Chandrasekaran as the new CEO of Tata Sons? Why or why not? If no, what would you like to see done at the company to make you feel more comfortable with your investment in a Tata company?
As you can see, these are open ended questions where there is no right answer. To be clear, there is no grade attached to answering these weekly puzzles but I believe that there is a payoff in understanding. I have created a forum on NYU classes (this may be one of the few things that I use NYU classes for) where, if you feel the urge to share, you should. Until next time!
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:
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.
|2/2/17||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:
Project hub: To find out pretty much anything you need to about the project, get questions answered or look at past project reports, here is where you should go: http://people.stern.nyu.edu/adamodar/New_Home_Page/cfproj.html
Find a group: If you have trouble finding one, try the orphan spreadsheet for the class (https://docs.google.com/a/stern.nyu.edu/spreadsheets/d/1ZQhI4GzHT4DJSN4RGBUvy7r_I3QLl545nqm6VG5Z-ts/edit?usp=sharing ). If you have a group and need an orphan to adopt, try the spreadsheet as well.
Pick a company/theme: This will require some coordination across the group but pick a company and find a theme that works for the group. Each person in the group picks a company and the companies form the theme.
Annual Report: Find the most recent annual report for your company. If it is a US company, also download the 10K from the SEC website.
Updated information: If your company has quarterly reports or filings pull them up as well.
Board of Directors: Get a listing of the board of directors for your company & start your preliminary assessment.
In doing all of this, you will need data and Stern subscribes to one of the two industry standards: S&P Capital IQ (the other is Factset). It is truly a remarkable dataset with hundreds of items on tens of thousands of public companies listed globally, including corporate governance measures. I believe that you have automatic access to Capital IQ and you should fine it in your Stern Life Dashboard. You will not regret it and it will not only save you lots of time in the future but will give you another weapon you can use in analysis. That’s about it, for now.
|2/3/17||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. One final note. I had mentioned that you had access to S&P Cap IQ yesterday but I did receive a couple of emails from people who were unable to access it still. Let me work on that today.
As you start the weekend, I decided to butt in with the first of my newsletters. As you browse through it (and I hope you do), you will realize that this is not really news or even fake news. It is more akin to a GPS for the class telling you where we’ve been and where we plan to go. It is a good way to get a sense of whether you are falling behind on either the class or the project, especially as we get deeper into the class. So, enjoy your Super Bowl parties and I will see you on Monday!
Attachment: Issue 1 (February 4)
|2/5/17||I am sure that you are at a Super Bowl party now and if you bet on the New England Patriots, not feeling that great! So, I’ll keep this short. This week, we will complete our discussion of the objective function in corporate finance, continuing with stock price maximization tomorrow and alternatives to that objective thereafter. Along the way, we will look at shareholder wealth maximization and corporate sustainability and I may kill a few sacred cows along the way. I also noticed that last semester’s corporate finance orphan list has become mixed up with this one. So, here is a new link for this year’s sheet. I am sorry but that was a Google malfunction on my part:
If you had added your names to the last list, please put them on this list and if you are looking for group members, please look on this list. I will see you in class tomorrow!
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? We closed by talking about how managers in publicly traded companies can position themselves best to consider the public good, without being charitable with other people's money. Again, plenty to think about while you are sitting in your CSR 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.
Staying on corporate governance, we will continue tomorrow with our discussion in class and return to the Disney story, picking up with Michael Eisner finally getting pushed out of the firm in 2005 and a new CEO, Bob Iger, coming in. Iger was the ant-Eisner, a CEO who seemed to embrace more openness and willingness to listen to shareholders. It is now 12 years later and this story in the Wall Street Journal about Iger captures how much things have changed:
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.
This email has gone on way too long already, but one final note. A little more than two years 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.
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. I have never done this before, but I think it would be useful to keep tabs on numbers that you get for your company as we go through the class. It may help you keep tabs on where you are in the project, relative to everyone else.
Since you have a long weekend ahead of you, with nothing to do but binge watch The Walking Dead and old episodes of Game of Thrones, 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.
I hope that you get a chance to not only watch these webcasts but try them out on your company.
I know that you don’t want to spend too much time on this email. So, let me cut to the chase. Second newsletter is attached, hope you have picked a company and checked out your S&P Cap IQ access. Also, one more nag, when you get a chance, please go in and enter your company choice into the shared Google sheet.
Attachments: Issue 2 (February 11)
|2/12/17||I hope that you survived the miserable weather this weekend. If you did not, you would not be reading this email anyway, and since you are, I will assume that you have either become one of the Walking Dead or that you are a survivor. Tomorrow, we will complete our derivation of the CAPM and talk about alternatives to it, in hyper speed for two reasons. One is that I have zero interest in reinventing modern portfolio theory and showing the mechanics of correlation and covariance. The second is that while I use the CAPM as a tool to estimate hurdle rates, I am not wedded to it and accept all kinds of alternatives (some of which we will talk about tomorrow). If you are still shaky about even the assumptions that underlie the model, my suggestion is that you read chapter 3 from the applied corporate finance book before tomorrow’s class. On Wednesday, we start on the fun stuff of applying the model, starting with what should be a slam dunk (risk free rates) which is increasingly not and then turning to the equity risk premium, a number that analysts often turn towards services to look up but really has deep implications for both valuation and corporate finance. So, much to do and I hope that you come along for the ride. And a final nag: if you have not picked a company, do! If you have, enter the name into the Google shared spreadsheet, please!|
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. You may want to look at the in-practice webcast I sent on the topic last Friday (and is also posted on the webcast page for the class), if you get stuck.
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… If it is in an emerging market currency, more so since you need default spreads (either from a sovereign rating or a sovereign CDS spread). Here are links to the latest versions of both:
It is time for this week’s puzzle: Yesterday, we talked about risk and return models in finance, and how 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 this week’s challenge, I would like you to think about diversification intuitively and personally. In particular, read the full challenge here:
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:
Then, please try to answer the following questions:
We started today’s class by tying up the last 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 key lesson is that much as we would like to believe that riskfree rates are set by banks, they come from fundamentals - growth and inflation. I have a post on risk free rates that you might find of use:
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 2017 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:
|2/16/17||If my nagging is paying off, you should have picked a company by now and if you have, you can move on to the equity risk premium part of your project. The first step is to review the material from yesterday’s class first, so that you understand the basics of equity risk premium estimation. Once you have done that, you should print off or download (I prefer the latter) the annual report or 10K for your company. As you browse through the document, look for any information that the company gives you on where it does business. Most companies will give you a breakdown of revenues geographically, though not always at the level of detail that you like, and some may even go further and give you EBITDA or assets geographically. Take what you can get and stick with revenues as your measure of geographic exposure. Your final task is to create a weighted average of the equity risk premiums and while you can use the equity risk premium spreadsheet below and your task can range from simple to slightly messy, depending upon your regional breakdowns:
1. If you have your company’s exposure to individual countries: Your task is simple. You can use the equity risk premiums that I have for those countries and take a weighted average.
2. If you have your company’s regional exposure and it matches my regional breakdown: I computed weighted averages for Asia, North America, South America, Western Europe, Eastern Europe/Russia, Asia and Australia/NZ. If your company breakdown is similar or close, you can use my weighted averages.
3. If you have your company’s regional exposure but it does not match mine: You will have to be ingenious, but it is not too difficult to do. Within the country risk premium spreadsheet, you will notice a worksheet that says regional weighted averages, with GDP and ERP for every country, classified by region. Set the GDPs of any country/ region you don’t want to count in your average to zero and the spreadsheet will compute the ERP for your designated region. Thus, if you has a US company that breaks down revenues into the US and the rest of the world, all you need to do is set the GDP for the US to zero and the global weighted average that you get will now be for the rest of the world. If you have no idea what I am talking about, watch the in-Practice webcast which will be put up tomorrow. And one more nag: please remember to enter your company name in the Google shared spreadsheet. We are moving slowly in filling it up but we are getting there:
In advance of a long weekend, I thought I would be delusional and give you the tools to get caught up on the project (as if there is any chance of it happening). There are two in-practice webcasts for this week, one on estimating risk free rates in a currency and the other on computing an ERP for a company:
2. ERP for a company: This webcast 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:
I hope that you get a chance to take a look at one or both.
As you begin a long weekend, I am sorry to intrude (not really, but I thought it was the polite thing to say anyway). The newsletter for the week is attached. It contains scintillating writing, breaking news and mind-blowing insights. I know that we have not got to valuation yet, but I have always believed that you don’t need to take valuation to understand valuation. You can test out that proposition by reading my Snap IPO valuation, if you have the inclination:
Attached: Issue 3 (February 18)
|2/19/17||I should probably give you a day off, since the weather is amazing and you have a long weekend, but I cannot help myself. I will keep it short, though. Since we have only one class this week, we will start on our discussion of relative risk (or beta, if you prefer Greek). In advance, it would really help if
1. You have picked a company
2. Downloaded the financials for the company
3. Chosen a currency to do your analysis in
4. Estimated a risk free rate in that currency
5. Estimated an ERP for your company, given its operating exposure
6. Printed off the beta page for your company from a Bloomberg terminal (If you don’t know where to find one, there are a few in the MBA lounge.)
In fact, if you are well along in this process, please go to the Google shared spreadsheet and enter your company details (so far).
I will be reaching out tomorrow to those of you who have not visited the page and that is not a threat, just a promise!
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, though the links to free risk assessment services are no longer free. There are, however, plenty of risk aversion tests online. Here are a couple that you can try at no cost:
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:
|2/24/17||In keeping with project Thursday, 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
Adjusted Beta = Raw Beta (.67) + 1.00 (.33)
I mentioned in class that I initially was curious about where these weights were coming from but I think I have found the original source. It was a paper written more than 30 years ago (which I have attached to this email) that looked at how betas for companies change over time and concluded based upon a small sample and data from 1926-1940 (I am not kidding!) that they converged towards one, with roughly the magnitudes used by Bloomberg. Why has it not been updated with larger samples and better data? Well, that is what happens when "here when I got here" becomes the response to questions about numbers we use all the time. I have also forwarded this email to the beta calculation guy at Bloomberg. I hope that they have let him out of that basement room, where he was locked up. Tomorrow’s second In-Practice webcast will cover how to read a regression beta.
I went through the Bloomberg regression beta page in class and suggested that you try doing the same with your company. In this week’s 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:
Attachment: Risk Checker spreadsheet
|2/26/17||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.|
We spent most of today's 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:
|2/28/17||I hope that you are out in the park or on that walk down fifth avenue, testing out your beta reading skills. This week’s challenge is on betas and I have used two companies, Valeant and GoPro as my lab experiments. First, check out the description of the puzzle (with the beta pages for both companies):
Once you have browsed through it, here are the questions that I would like you to consider:
For Valeant, list out the key regression statistics (alpha, beta and R squared) in the four regressions. Do you notice any patterns? Can you explain them?
If you are analyzing Valent and were required to use one of these regression betas, which one would you use and why?
With the beta that you decided to us, estimate the range on the beta and what it means for your estimate of cost of equity.
During the period of the regression, Valeant lost almost 80% of its market value and was involved in multiple scandals and management turnover. What effect, if any, do you think this crisis has had on your estimated regression betas (increased them, decreased them, left them unchanged)? Explain why.
With GoPro, why is the standard error on the beta so high? What are the consequences for using GoPro's regression beta?
On a different note, the first quiz is on March 6 (next Monday). Here are a few notes on the quiz:
What it will cover: The quiz will cover all the material we get through before tomorrow’s class (roughly side 174 or 175 in the packet). It will be on risk free rates, equity risk premiums and betas for the number crunching part and there will be a section on corporate governance, for those of you like the fuzzy stuff. In chapters in the book, it will cover from chapter 1 through midway in chapter 4, when I estimate betas for companies.
How to prepare: The best start, if you have missed a class or classes, is by watching that class. If you start early, I would also recommend working through the post class test and solution for each class. Once you feel comfortable with that, you can start on the past quizzes. The quizzes go back to 1997 and I would suggest starting with the most recent quizzes and working backwards. The links are below:
Past quizzes: http://www.stern.nyu.edu/~adamodar/pdfiles/cfexams/prqz1.pdf
Past quiz solutions: http://www.stern.nyu.edu/~adamodar/pdfiles/cfexams/prqz1sol.xls
Quiz Review: I am truly sorry that I will not be able to do the quiz review in person (and I promise that I will be back to doing that on the next two quizzes) but I have leave for Lagos, Nigeria, right after my afternoon class tomorrow and won’t be back until Sunday. Don’t worry! I will still be checking emails and answering questions, if you have any. However, I do have the review session from last year recorded on YouTube and you can watch it when you get a chance. The slides that I used are also in the attachment:
Review webcast: https://youtu.be/ZPo46wQGfe0
Review slides: http://www.stern.nyu.edu/~adamodar/pptfiles/acf3E/reviewQuiz1.ppt
TA review sessions: The TAs are all incredibly knowledgeable and helpful. Please avail yourself of the TA review session on Thursday. The sign up sheet is at this link: https://docs.google.com/a/stern.nyu.edu/spreadsheets/d/1EU5ifKxB3uep697TLSjdkO0od-TDbPOsK9InHLa-u1w/edit?usp=sharing.
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:
Catching up with past promises, 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)
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 2-60, which is a bigger room and here is the seating arrangement for the quiz:
Three very quick notes.
2. Class yesterday:
And this email is from Nigeria.
|3/3/17||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:
United Technologies 10K: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/Bottomupbeta/UT10K.pdf
Spreadsheet to help compute bottom up beta: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/Bottomupbeta/bottomupbeta.xls
The last spreadsheet has built into it the industry averages that I have computed for different sectors in the US in 2015. You can easily replace it with the global averages from 2016 that I also have on my site and tweak the spreadsheet. Give it a shot!
As I get emails about the quiz, I thought it would be a good idea to pull together a list of the top emailed questions that I have received so far.
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.
Attached: Issue 5 (February 25)
|3/5/17||Just a last minute reminder about the quiz tomorrow. It is from 10.30-11 and the seating is as follows:
If your last name begins with Go to
A -J KMEC 2-60
K - Z Paulson
Please let me know before 10.30 tomorrow, if you will be missing the quiz. The quiz is open book, open notes but not open laptops. You can use your iPads for your lecture notes but without connectivity and without Excel. There will be class after the quiz.
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 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 29 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 know that you can’t wait to get your quizzes back and I am happy to oblige. Before you rush up, here are some general notes/directions:
I hope that you have been able to pick up your quizzes, but first things first. I sent out the case yesterday as an attachment and it is due March 29, as a group assignment. The attachment but the email link was not, since it directed you to the wrong version of the case. Here is the correct link, with my apologies:
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.
I 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.
|3/10/17||No nagging about the project today. Just enjoy your spring break and come back rested and ready. I will not send you an email (and that is a promise) until late next week. So, if you have serious withdrawal issues, check the email chronicles. Be safe and be good!|
You must admit that I showed immense restraint, not emailing you for the week, but your respite is over and I am back!!! Three separate notes to just get you caught up.
The Project: I know that you have been working hard on your project during the spring break. (I know.. I know.. but we are playing make believe here). In case you feel the urge to get caught up and estimate the cost of debt, I have posted an in-practice webcast on the webcast page. The webcast is from a few years ago 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...)
Attachment: Issue 6 (March 18)
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 first revisiting the hurdle rate for the Rio Disney theme park, separating those risks that we should be bringing into it from those that we should not. We then started the move from earnings to cash flows, by making three standard adjustments: add back depreciation & amortization (which leaves the tax benefit of the depreciation in the cash flows), subtract out cap ex and subtract out changes in working capital. Finally, we introduced the key test for incremental cash flows by asking two questions: (1) What will happen if you take the project and (2) What will happen if you do not? If the answer is the same to both questions, the item is not incremental. That is why "sunk" costs, i.e., money already spent, should not affect investment decision making. It is also the reason that we add back the portion of allocated G&A that is fixed and thus has nothing to do with this project. I have attached the post class test for today, with the solution. In the final part of the class, we looked at time weighting cash flows, why and how we do it.
On a separate note, I would strongly encourage you to read the Home Depot case, if you have not already, and start building your analysis. The reason that I use the word “building” is that your mission is to decide whether Home Depot should enter the furniture business and you should marshal the many “facts” in the case to reach that conclusion. This is not just a modeling exercise (though it will require you to build a financial model), an accounting exercise (though you have to forecast accounting numbers) but a decision-making exercise. It can be fun to flex your judgment skills, but only if you don’t get mired in small details.
Finally, the in-practice webcast that I sent you on Saturday was missing an attachment (the excel spreadsheet to compute ratings and the market value of debt). If you did notice that and wanted the spreadsheet, it is attached. Remember that this is from 2013 and that if you plan to use this for 2017, you should use the updated default spread numbers from 2017 and that spreadsheet is also attached.
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:
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. WUltimately, 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:
I also promised you a primer on statistical distributions for using Crystal Ball more sensibly and you can find them here:
|3/23/17||Today is usually the day that I write to you about your project, but if you are budgeting your time to immediate priorities, you should be working on the case. 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 (15-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 furniture business and Home Depot’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 Home Depot should invest in the furniture business 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.
On a completely unrelated note, I have had a few queries about when the final exam will be (I guess that you just went to get the class behind you). It is scheduled for May 12.
|3/24/17||I know that you are working on the Home Depot 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.
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. Incidentally, the case is on Home Depot entering the furniture business (and not about Netflix building a studio). If you have no idea what I am talking about, just ignore the last sentence.
Attachments: Issue 7 (March 25)
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 Home Depot Furniture case. Please send your group project report as a pdf file with “The Furniture Case" 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 (with the finite live and the longer life scenarios) 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). Post class test & solution also attached. Until next time!
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 12 from 10 am -12 pm. There will be an early final for those who want to use that option on May 10, 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. We have been talking, in class, about investment decisions and how best to make them. While we laid out the framework of forecasting cash flows and computing NPv, 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:
The bulk of today's class was spent on the HD Furniture 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 just about to start grading the cases and you should be getting yours back today, tomorrow or sometime over the weekend. 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. Finally, on how to read the scores, the case is out of 10 and the scoring is done accordingly. I hate to give letter grades on small pieces of the class, but I know that I will be hounded by some until I do so. So, here is a rough breakdown:
Attachment: Case Grading Template
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 Home Depot, 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 Home Depot'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 HD US building supply stores 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 Home Depot was 4% (the riskfree rate + default spread). On the debt ratio, on leases, there were variations on how you dealt with the lump sum after year 5, but I think pretty much everyone discounted at the pre-tax cost of debt (the right thing to do).
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 12 for computing the distribution investment. Many of you either ignored the savings in year 12 or attempted to allocate a portion of the investment in year 5, 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 15-year life and longer life scenarios, you have a problem...) Though some groups did realize this, they often started the capital maintenance in year 16, 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. Until next time!
As the second quiz approaches and you get a chance to digest your case feedback, a few quick notes:
Attachments: Issue 8 (April 1)
I hope that you are having a good weekend, winds and cold notwithstanding. As you prepare for the second quiz, I think it would be useful to restate a few central themes that animate how we think about investments in corporate finance.
Theme 1: Cash flow, not earnings
Investment decisions should be based upon cash flows rather than earnings. That said, you need to understand how to compute earnings (both operating and net income, and if you still don’t grasp the difference, try my accounting primer) partly because you have to do them to compute your taxes dues (which are a cash flow) and partly because they represent the starting point for cash flow computation.
Theme 2: The Incremental test
Investment decisions should be based upon incremental cash flows, i.e., cash flows that are caused by the project. The easiest way to check to see if something is incremental is to ask two questions: What will happen if I take the project? What will happen if I don’t? If the answer is the same, it is not incremental, and it is precisely why we ignore sunk costs and reverse allocated expenses that would be there anyway. It is also the test that led us to consider not only the cost of the server in year 5, with the Home Depot investment, but the savings in year 12, which is the full incremental effect.
Theme 3: Death and taxes
All analyses are done on an after-tax basis. That is why we go through the trouble of computing depreciation, even though it is a non-cash expense, because it does save taxes (which is a cash effect). In fact, with all regular income and expenses, the after-tax effect is the amount (1- tax rate). In the discount rate, it is why we use the after-tax cost of debt in the cost of capital.
Theme 4: The Essence of Risk
I hate to be a broken record on this topic, but the discount rate for a project should reflect the risk of the project. Thus, if you are in a project where the government sets a payment schedule and guarantees that payment, you would use the risk free rate as your discount rate. When a multi-business company (like Disney) looks at a project (say a theme park in Rio), it should not only use a beta that reflects the business risk (of a theme park) but the geographical risk exposure of that theme park (Brazil or perhaps even Latin American ERP).
Theme 5: Cash flow consistency
Finally, it is critical that you match your discount rate to your cash flows. Thus, if your cash flows are in Mexican peso, your discount rate has to be in pesos as well. (Get comfortable with moving from one currency to another, using the differential inflation). If your cash flows are pre-debt cash flows (before interest expenses and debt payments), your discount rate has to be the cost of capital. If they are post-debt, your discount rate has to be the cost of equity.
As for the quiz, here are some specifics.
Seating: The quiz will be in the first 30 minutes on Wednesday and we have two rooms. The breakdown for the quiz is as follows:
If your last name starts with Room
K- R KMEC 2-60
A -J, S-Z Paulson
Review session will be in KMEC 2-60 from 12-1 on Tuesday.
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. 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:
f your last name starts with Room
K- R KMEC 2-60
A -J, S-Z Paulson
Second, the quiz review webcast is up and running. Here are the links:
I have attached the presentation. I will see you tomorrow at the quiz (and I am sorry if that sounds like a threat.. It was not meant to be..).
Attachment: Quiz Review Presentation
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. As talk about rewriting the tax code heats up in Washington, I hope that you find something useful in here to make sense of the political posturing. You can find the puzzle here:
As you can see the puzzle is structured around the attempts 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.
I hope that you are recovering or recovered from the quiz. In the session that followed the quiz, I look at the Miller Modigliani theorem through the prism of the debt tradeoff and followed up by using the financing hierarchy that companies seem to move down, when they think about raising fresh financing. 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 second quiz is ready to be picked up in the usual spot (ninth floor of KMEC, as you get off the elevator, to your right before you get to the front door). They are in three neat piles. Please leave them in the same condition. I have attached the quiz solutions (Quiz a has Supra in problem 1 and Quiz b has Capri in problem 1) and the distribution for the quiz. As always, if you feel that I have messed up on your grading, bring your quiz in and I will fix my mistake.
|4/6/17||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 am also attaching two spreadsheets: one contains the updated marginal tax rates by country and the other has the 2017 version of average effective tax rates by sector for US as well as for Global companies. Hope you find them useful!
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.
Attached: Issue 9 (April 8)
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). Disney was underlevered and Tata Motors was over levered.
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 Little 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).
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 biggest booster and investor, Bill Ackman, just took his losses on the stock and apologized to investors in his fund for the “mistake” he made investing in the company. Last week, the stock price, which was close to $200 a couple of years ago, dropped below $10 and the company is clearly seeing the dark side of debt. Here are my questions:
In today’s class, we continued our discussion of the cost of capital approach to optimizing debt ratios by first looking at enhancements to the approach and then 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.. .
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:
It also has sample projects from prior years that you can browse through. If you look at the projects, you will see that the formats vary. Some use Word and one is in Powerpoint. They all emphasize comparative analysis and go beyond the numbers. So, be creative, put it in the format that best fits how you want to deliver your narrative and have fun with it. 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 every additional company.
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:
Dell optimal capital structure spreadsheet: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/optdebt/dell10K2013.pdf
You will notice that the Dell capital structure spreadsheet which is from a few years ago has a few minor tweaks that make it different from this year's version, but it is fundamentally similar. In particular, take note of the fact that the spreadsheet will not work unless you have the iteration box checked.
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 12 from 9 am -11 am and there will be an early final offered on May 10 from 10 am to 12 pm in KMEC 3-65 for those who have to be out of New York by or before the final exam date. Since there are only 60 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.
I know it is early to be thinking about this, but time passes fast these last few weeks
It is way too nice a day to be stuck inside. So, get out and enjoy the sun! In yesterday’s email, I got the time for the regular final exam off by an hour. It is still on May 12 but it is from 10-12 pm, not 9-11. Sorry about that!
On yesterday’s email with the In Practice webcast, I had put the wrong link for the spreadsheet that contained the Dell spreadsheet. The correct links are below, in case you decide to watch the webcast:
Dell optimal capital structure spreadsheet: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/optdebt/dellcapstru.xls
The weekly newsletter is attached.
Attachment: Issue 10 (April 15)
|4/16/17||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.|
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. The best way to reinforce the concept is to try and apply it to your own company (that you are following for the project). Trust me! This is not rocket science.
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:
Past Quiz 3s solutions: http://www.stern.nyu.edu/~adamodar/pdfiles/cfexams/prqz3sol.xls
I have also attached today's post class test & solution.
|4/18/17||In yesterday’s class, we talked about the perfect security as one that preserves the flexibility of equity while giving you the tax benefits of debt. 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.
What are surplus notes? http://en.wikipedia.org/wiki/Surplus_note">Surplus notes: What are they?
The IRS view of surplus notes: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/weeklypuzzles/surplusnotes/taxview.pdf
The legal view of surplus notes: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/weeklypuzzles/surplusnotes/courtview.pdf
The ratings agency view of surplus notes: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/weeklypuzzles/surplusnotes/ratingsviewnew.pdf
The regulator's view of surplus notes: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/weeklypuzzles/surplusnotes/regulatorview.pdf
The accountant's view of surplus notes: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/weeklypuzzles/surplusnotes/GAAPview.pdf
After you have read all of these different views of the same security, try addressing some of the questions in the weekly challenge.
n 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.
Keeping in mind the objective of matching debt to assets, think about the typical investments that your firm makes and try to design the right debt for the project. If your firm has multiple businesses, design the right kind of debt for each business. In making these judgments, you should try to think about
- whether you would use short term or long term debt
- what currency your debt should be in
- whether the debt should be fixed or floating rate debt
- whether you should use straight or convertible debt
- what special features you would add to your debt to insulate the company from default
Your objective is to get the tax advantages without exposing yourself to default risk. If you want to carry this forward and do a quantitative analysis of your debt, I will send you a spreadsheet tomorrow that will help in the macro economic regressions. 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. In the meantime, if you are interested in what dividend policy around the world looks like, try this post of mine from earlier this year:
|4/20/17||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:
Give it a shot and download the FRED app on your iPad and iPhone. You can dazzle (or bore) your acquaintances with financial trivia. You can enter the data for your firm and the spreadsheet will compute the regression coefficients against each. You can use annual data (if your firm has been around 5 years or more). If it has been listed a shorter period, you may need to use quarterly data on your firm. The data you will need on your firm are:
- Operating income each period (this is the EBIT)
- Firm value each period (Market value of equity + Total Debt); you can use book value of debt because it will be difficult to estimate market value of debt for each period. You can also enterprise value (which is market value of equity + net debt), if you are so inclined. I know that you should be including the present value of lease commitments each period, but that would require doing it each year for the last ten. The easiest way to get this data is to use the FA function in Bloomberg or from S&P Capital IQ.
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.
Attachments: Duration 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:
WMT financial summary: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/debtdesign/WMTFAsummary.pdf
WMT macrodur.xls spreadsheet: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/debtdesign/WMTmacrodur.xls
The updated macroduration spreadsheet with data through 2015 was attached to yesterday’s email but I am attaching it again, just in case! Hope you find it useful.
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. On a different note, the third quiz is on Wednesday and if you want to try your hand at prior year’s quizzes, you can find them here:
Past Quiz 3s solutions: http://www.stern.nyu.edu/~adamodar/pdfiles/cfexams/prqz3sol.xls
As you can see, it will be focused on the capital structure section (which is lecture note packet 2, until just after page 140).
Attachment: Issue 11 (April 22)
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:
1. Seating arrangement: The seating for Wednesday's quiz is as follows:
If your last name starts with Go to
A-R Paulson Auditorium
S -Z KMEC 2-60
2. Review session: I had originally scheduled the review session for tomorrow from 12-1 but unforeseen events have entangled my calendar. Rather than keep you in suspense and risk not making it to the review session, I decided to go with the “oldies” recordings and send you the links to the quiz 3 review from last year. Here are the links:
The quizzes from past years are available at the links below:
Old quiz solutions: http://www.stern.nyu.edu/~adamodar/pdfiles/cfexams/prqz3sol.xls
I have attached the review session slides to this email.
3. Content: The quiz will cover capital structure; Lecture note packet 2: 1-142; Chapters 7-9 in the book
I am sorry about not being able to do a live review session today but the logistics turned out to be too daunting. I hope that the review session from last year helped but as you can see, the material is compact (covering only capital structure) but it does draw on material from quizzes past (like levering and unlevering betas). That said, please do review the mechanics of how changes in capital structure play out in the cost of capital, how value changes as debt ratios change and the mechanics of matching asset duration to debt duration. If the last item brings back memories (bad or good), it is because this is exactly how we computed asset and equity betas for the first quiz. Just like beta, duration is a value-weighted average. I will see you in class tomorrow and just as a final reminder on the seating:
If your last name starts with Go to
A-R Paulson Auditorium
S -Z KMEC 2-60
I hope that you have recovered from the quiz. As I mentioned in class today, I have to make a day trip to Chicago tomorrow and since I will not be able to make it into my office, the quizzes will not be ready to be picked up until Friday. I am sorry. After the quiz, 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 applied this framework to the Disney and Vale.
|4/27/17||I am done grading your quizzes but since I will not be able to get them to you until tomorrow, I am going to hold off on sending you the solutions. Instead, I would like to focus on the project. 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
1.1: Estimate the cost of capital at different debt ratios.
Use capstru.xls, if you need to.
1.2: If you want to augment the analysis by using the APV approach (apv.xls), do so. Clearly, these approaches will add value only if you have a sense of how operating income will change as the ratings change for your company or the bankruptcy cost as a percent of firm value.
1.3: Assess how your firm's debt ratio compares to the sector. You can just compare the debt ratio for your firm to the average for the sector. If you feel up to it, you can try running a regression of debt ratios of firms in your sector against the fundamentals that drive debt ratio (Look at the entertainment sector regression I ran for Disney in the notes).
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:
2.1. The heart of debt design should be the intuitive analysis, where you look at what a typical project/investment is for your firm (perhaps in each business it is in) and design the most flexible debt you can, given the risk exposure.
2.2. The quantitative tools (the regression of firm value/ operating income versus macro variables) may or may not yield useful data. The bottom-up approach (using sector averages) offer more promise. If you have a non-US company, a US company with little history or get strange results, stick with just the intuitive approach. Use the spreadsheet at this link to do both:
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.
3.1: Examine whether your company has returned cash to its stockholders over the last few years (5-10 or whatever time your firm has been in existence) and if yes, in what form (dividends or stock buybacks). The information should be in your statement of cash flows.
You can watch the webcast I will be posting tomorrow, if you run into questions.
3.3: Make a judgment on whether your company should return more or less cash to its stockholders.
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 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). Repeating a link that I gave you a couple of weeks ago:
I prefer brevity and I want to emphasize the page limit of 25 pages on the report (plus 2 pages for each additional company over 5). 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 8. U
In case you were waiting with bated breath, the quizzes are ready. Even in the case you were not, they still are and can be picked up at the usual spot. The quiz solutions and distribution are attached and as always, if you have issues with my grading, please don’t stew in your own juices. Just come in and get it cleared up (one way or the other).
company is a good candidate for paying dividends or increasing them). 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:
Annual Report: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/dividends/IntelAnnualReport.pdf
Historical data: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/webcasts/dividends/IntelBloomberg.pdf
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:
The good news is that this is the last newsletter. The bad news is that this means the end is near. By the way, if you had trouble with the dividend spreadsheet link from yesterday/s email, it is now fixed. If you have no idea what I am talking about, it is still fixed.
I hope that you had a productive weekend and that you still managed to get some time outside. That said, the last full week of classes is approaching and I thought I should give you heads up of what’s coming. Tomorrow, we will complete our assessment of dividend policy and start on the last part of the class, valuation. Since I will not be teaching valuation in the next academic year, choosing to suffer most of the year on the beach in La Jolla, I am going to try to fit as much of what I know about valuation into tomorrow and Wednesday’s classes. That should not be difficult, since corporate finance is the backbone of valuation and we have done the heavy lifting already.
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).
If cash returned > FCFE, check to see whether the company is digging a hole for itself and whether you can find a way for them to exit as painlessly as possible. Remember that if you found your company to be under levered, you want them to pay out more than their FCFE at least in the near term.We also looked at how most companies set dividends, which is by looking at what everyone else in the sector is doing. I have attached the sector averages for dividend policy (in two files). If you want to see my dividend market regressions, click on the link below:
Note the low R-squareds before you use the regression.
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 on the topic at the Museum of American F
It is really long, but you can watch a little bit of it, if you are so inclined. We ended the class by talking about the distinction between valuing equity and valuing an entire business and the way we estimate cash flows and discount rates in each case. Finally, the post class test and solution are attached.
I am sure that things are piling up on your plate (literally and figuratively) as the final week of class approaches but a few notes of things to come:
1. Early Final Exam: The early final exam is scheduled for next Wednesday (May 10) from 10 am -12 pm. While I had originally scheduled one room and capped the number at 60, the demand exceeded the supply. So, we now have two rooms (3-50 and 3-65), with a capacity of close to 90. The early sign up sheet is now at 78 and we should be okay. If you have not signed up already, please do at this link:
If your last name starts with Go to
A -M 3-50
N - Z 3-65
This is only for the early exam.
2. Regular Final Exam: The regular final exam is scheduled for next Friday (May 12) from 10-12. Since we have a lot of people taking the early final exam, everyone else will be in Paulson for the final exam.
3. Project: Since the project is due in less than a week and you may still have not done the valuation part, I decided to provide a helping hand on it. The spreadsheet that I used to illustrate the process is the fcffsimpleginzu2017.xls ( http://www.stern.nyu.edu/~adamodar/pc/fcffsimpleginzu2017.xls) that I had sent in an email last week and the company. 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.If you are working on the project and are at the valuation part and struggling, I made a webcast this morning on the spreadsheet this morning. It turned out to be longer than I hoped it would be (about 30 minutes) but it could help you understand both the craft and practice of valuation. The link is below:
Finally, if you do get the numbers together for your company, please put them into the attached spreadsheet and get them back to me by Sunday, at the latest, and earlier will be better.
In today's class, we looked at valuation as the place where all of the pieces of corporate finance come together - the end game for your investment, financing and dividend decisions. After drawing a contrast between valuation and pricing, we looked at the four drivers of value: cash flows, growth rates, discount rates and when your company will be a stable growth company. We then looked at how these numbers can be different depending on whether you take an equity or firm perspective to valuation and what causes these numbers to change. In particular, we argued that while no one can lay claim on the "right" value, we still need to be internally consistent with our assumptions. High growth generally will be accompanied by high reinvestment and high risk, and as companies mature, their growth and reinvestment characteristics should change. Ultimately, though, the best way to learn valuation is by playing with the numbers and seeing how value changes. I did talk about the presence of uncertainty and how it affects how you approach the numbers and if you are interested, you may find my blog post relevant for that discussion:
I also closed the class with a valuation of Deutsche Bank. On the off chance that you want to dig deeper, here is my take on Deutsche in October 2016:
I hope you get done with your number crunching in the next day or two. Once you have the numbers done, could you please fill out the attached spreadsheet with your numbers and send them to me. In the last class, I hope to summarize all of your findings and present them to you - the ten most under levered companies in the class, the ten most over valued companies in the class... It is fun, but I can do it only I have your numbers. While it make the logistics easier, if you sent me the numbers for everyone in the group in one go, I will take what I can get. Thus, if four out of five members have their numbers ready, but the fifth is lagging, I will take the four companies that you have the data for. Since it will take me a little time to pull these numbers into a summary sheet and analyze them, please do get them to me by Sunday evening at the latest and earlier would be better... Post class test and solution are attached.
As your project winds down (or up), I am sure that there are loose ends from earlier sections that may bother you. In the interests of brevity, I have listed a few of the questions that seem to be showing up repeatedly in emails:
1a. I just discovered that my company lists revenues from "other businesses". How should I treat these in bottom-up beta computations?
If your company tells you what the other businesses are, you can try to incorporate their betas into your bottom up beta. If all you have is a nebulous 'other businesses', I would ignore it in beta computations.
1b. I just discovered that my US company has revenues from other countries (including emerging markets) and in other currencies. How does this affect my cost of equity/debt/capital?
First, if you have chosen to do your analysis in a currency (say US dollars), your riskfree rate will be the riskfree rate in that currency (US treasury bond rate), even if the company has revenues in multiple currencies. Second, your cost of debt will still be that of a domestic company. Coca Cola will not have to pay an Indian country default spread when it borrows money in rupees. If it had to, it would just borrow in the US and use currency derivatives to manage risk. Third, and this is the only place it may make a difference, it may change the equity risk premium you use. Instead of using the mature market premium, you may decide to incorporate the additional risk of some of the countries that you operate in. Note that this is likely only if you know your revenue exposure in some detail and you get significant revenues from emerging market countries (with less than AAA ratings).
1c. What should I be doing with the cash balance that my company has when computing the unlevered beta?
Adjusting betas for cash creates more headaches and confusion than perhaps any other aspect of discount rates. Back up, though. To get the unlevered betas of the businesses that your company is in, you should always start with the average regression beta for the companies in the sector, unlever the betas using the average gross D/E ratio and then adjust for the average cash balance at these companies. (That will yield the unlevered betas corrected for cash for each of the businesses that your company is in).
Now, comes the tricky part. You can compute an unlevered beta for just the operating businesses that your company is in, by taking the weighted average of the unlevered betas of the businesses. You can also compute an unlevered beta for the entire company, with cash treated as an asset/business with a beta of zero. The latter will always be lower than the former. My suggestion is that you compute both.
If you are now computing a cost of equity as an input into the cost of capital, you want to use the unlevered beta of just the operating assets of the business as your starting point for levered beta and cost of equity. That is because the cost of capital is a discount rate that we apply to operating cash flows (and to value the operating assets). In fact, we add the current cash balance to this value, because cash has been kept separated from operating assets. (If you use the lower unlevered beta that you get with cash incorporated into the calculations to get to a cost of capital, you will end up at least partially double counting cash, once by lowering the beta and the cost of capital, and again when you add cash at the end).
When would you use the beta for the company (with the cash beta of zero incorporated into your calculation)? Rarely. Here is one scenario. Let's assume that you are looking at a discounting the dividends of a company or an overall cash flow that is estimated from net income. These cash flows reflect cash flows from all of the company's assets (not just its operating assets) and it is appropriate to use the lower company beta with the cash effect built in.
(If you find this too abstract, go back to lecture note packet 1 and check out pages 160 & 161, where I estimated Disney's beta and cost of capital)
2. If I have no or little conventional debt and significant operating lease commitments with no rating, how do I compute a synthetic rating?
If you use just conventional interest expenses and operating income to compute the interest coverage ratio and the synthetic rating, you will overrate companies with lots of leases. You should try to adjust both the operating income and interest expenses for leases. Before you panic, let me hasten to add that all of the spreadsheets that incorporate leases (ratings.xls, capstru.xls and the valuation spreadsheet) do this for you already. If you did build your own spreadsheet, check and make sure that you are incorporating leases.
3. I have a negative book value of equity. How do I compute ROE and ROC?
First the book equity you should use for ROE and ROC should be the total shareholders equity, which can be a negative number. With a negative book value of equity, you cannot compute ROE. You should still be able to compute return on capital, since adding the book value of debt to negative book equity should still lead to a positive book capital. If book capital is negative, though, you cannot estimate return on capital either.
4. My ROE > Cost of equity and my ROC < Cost of capital (or vice versa). How is this possible and how do I explain it?
There are two reasons why the two measures may yield different conclusions:
1. The net income includes income/losses from non-operating assets including cross holdings in other companies. If you have cross holdings that are making you a lot of money, you can end up with a high ROE, even though ROC looks anemic. If you have cross holdings that are losing you money, the reverse can happen. Net income is also affected by other charges (restructuring, impairment etc.) and other income... I trust the ROC measure more when it comes to answering the question of whether the company takes good investments.
2. The ROE reflects the actual interest expense on debt. To the extent that you are borrowing money at rates lower than what you should be paying (given your default risk and pre-tax cost of debt), you are exploiting lenders and making equity investors better off. Thus, you can take bad projects with "cheap" debt and emerge successful as an equity investor. (Think of the LBOs done earlier this year.)
5. My Jensen's alpha is positive (negative) and my excess return is negative (positive). How do I reconcile these findings?
Market prices are based on expectations of how well or badly you will do in the future. To the extent that you beat or fail to meet these expectations, stock prices will rise or fall. Thus, if you are a company that is expected to earn a 30% ROC and you earn a 25% ROC, you will see your stock price go down (negative Jensen's alpha) even though you have a healthy positive EVA. Conversely, if you are a company that is expected to make only a 2% ROC and you make a 3% ROC, you will see your stock price go up (positive Jensen's alpha) while your EVA will be negative.
6. How do I come up with the cash flows and characteristics of a typical project?
I really do not expect you to come up with cash flows. Just describe in very general, intuitive terms what a typical project will look like for your company. For Boeing, for instance, you would describe a typical project in the aerospace business as being very long term, with a long initial period of negative cash flows (when you do R&D and set up manufacturing facilities) followed by an extended period of positive cash flows in multiple currencies.
7. The cost of capital is higher at my optimal debt ratio than at my current debt ratio. Why does that happen and what do I do?
Try the "FAQ" worksheet in the capital structure spreadsheet.
8. If my firm is already at its optimal debt ratio, do I still need to go through the debt design part?
Yes. You still have to determine whether the debt the company already has on it's books is of the right type. The only scenario where you can skip this is if both your actual and optimal debt ratios are zero percent.
9. I cannot do the macro regression (because my company has been listed only a short period or is non-US company). What do I do about debt design?
Skip the macro regression. You can still use the bottom up estimates for the sector in which your firm operates. To do this, you need an SIC code which your non-US company will not have. Look up a US competitor to your company and look up its SIC code. You can also still do the intuitive debt design. (I would do the same if you are getting absurd or meaningless results from your macro regression...)
10. My macro regression is giving me strange look output. What should I do?
Take a deep breath. The macro regression is run with 10 or 11 observations and you can get "weird" output because of outliers. That is why you should look at the bottom up estimates and bring in your views on what a typical project for a company looks like.
11. My company pays no dividends. Should I bother with dividend analysis section?
Yes. Paying no dividends is a dividend policy. You will have to estimate the FCFE to check to see if this policy makes sense. (If the FCFE <0, it does...)
12. I have a non-US company. How do I get market returns and riskfree rates for the dividend analysis section?
On this one, I am afraid that the fault is mine for not giving you a way to pull up the data on other markets. To compensate, I will be okay with you using the US data for non-US companies.
13. I am getting strange looking FCFE for my company... What's going on?
Check the signs of the numbers you are inputting into the spreadsheet. If you are entering cap ex as a negative number, for instance, I will flip the sign around and add cap ex instead of subtracting it out...
14. We have a problem group member. Are we allowed to take punitive measures?
Yes, as long as you do not violate the Geneva Conventions. If you are new to this type of business, you can review this scene from The Marathon Man for ideas (http://www.youtube.com/watch?v=dG5Qk-jB0D4). I must warn you that this may violate the Stern Honor Code.
15. My value is very different from the price. What's wrong?
First, very different is in the eye of the beholder. i have valued companies and obtained values that are less than one fifth of the price and five times more than the price. The reason is sometimes in my inputs but it can also be a massively under or over priced stock. So. check your numbers and if you feel comfortable with them, let it go.
16. When will this torture end?
Four days from today (5 pm on May 8)... but the memories will last forever…
As you embark on the valuation phase of the project, here are a couple of things to keep in mind:
1. Stick with the simpler version of the ginzu spreadsheet,
2. Recognize that you always have to make assumptions about the future to value companies. In other words, you will not find these numbers in 10Ks, annual reports or SEC filings. That is the bad news. The good news is that I don't have a crystal ball either. So, as long as your estimates are internally consistent, you are okay.
3. I have built the spreadsheet to protect you by setting in default settings at the safest levels. I do give you the options to release these defaults but do so only if you understand the consequences
4. Once you are done with your valuation, you will check it against the market price. If it is different, you will get the urge to go back and tweak your inputs to get your value to be closer to the price. Try to fight that impulse, though it is tough to do.
I know that this is shaping up as the weekend from hell for some of you and I share some (or all) of the blame. Anyway, it is too late for me to be offering you "substantive" help on the project, at least on a collective basis, but here is a list of "to dos" for you and me over the weekend:
1. Finish the number crunching for the project.
2. Fill in the attached summary sheet with the numbers and get them in to me in an email. In the subject heading, please list “The Fat Lady is waiting”.
3. Work on writing up the project report. Don't get fixated on format or on small details. Think big picture. In fact, think of yourself as someone who has been asked to look at your company and address what it does well and badly on each dimension - investment analysis, capital structure and dividend policy. If your company is doing everything well, don't feel the urge to change it.
4. On Monday morning, around 10 am, check your email. You should find a presentation (see my tasks below) for the class attached to the email.
5. Come to class on Monday. I know that some of you have not been in class the last couple of weeks and I understand that there are finals and projects due in other classes. However, Monday's class is special. If this were a play, it would be when the fat lady sings. While I may be neither fat nor a lady nor can I hold a tune, I will do my best impersonation.
6. Turn in your project report by email by 5 pm on Monday (May 8), as an attachment (pdf preferably, though I can take MS Word). In the subject, please list "The torture ends".
1. Send nagging emails every few hours asking for your summaries and providing updates.
2. Pull your summaries together in a master spreadsheet.
3. On Sunday night, do assorted magic on the summaries
4. Put into a final presentation (see above) and send to you by Monday morning at 10 am
5. Show up in class and do the "fat lady song"
6. Wait for your final project reports
7. Start grading…
I know exactly what you are working on and won’t intrude. But here is the update:
Company updates received: 11
Companies yet to come: 291
So, if you have not sent in your summaries yet, you have lots of company. But if you have the numbers for your company, please send them in with “The Fat Lady is waiting” in the subject.
Thank you for all the summaries (I got 290 out of 302…) and I have the presentation done. I will try make some copies for class but the pdf version is attached. See you in class (in person, not virtually, I hope..) And the fat lady is singing:
Again, thank you for sending me your summaries and helping me put together the presentation for today's class. If you were not able to make it to class (and I don't blame you for sleeping in, especially if you were the person sending your summary in at 6.01 am), I have attached the presentation to this email as well as the summary numbers for every company in the class. In class today, we looked at the big picture of the class, using the project findings to illuminate each part from corporate governance to risk to investment analysis to capital structure, dividend policy and valuation. I have posted the summary numbers for the entire class online and attached it to this email as well. The review session for the final exam will be on Wednesday (May 10) from 12-1 in Paulson Auditorium and it will be webcast, if you cannot make it. I have attached the slides for the review session. The final exam is on Friday (May 12) from 10-12 and will be only in Paulson. The early final, by invitation or permission only, is on Wednesday (May 10) from 10-12 in two rooms:
If your last name starts with Go to
A -M 3-50
N - Z 3-65
The CFEs should be open tomorrow through Thursday. If you have never done a CFE before, I will send you details tomorrow.
In case you have not checked, you can now do the CFE for the class. For a purely selfish reason, I would encourage you to do it as soon as you can, since if you do not, you will not be able to check your grades (which then creates side costs for me). Here are the details on how to do a CFE.
Student Instructions for Completing Online CFEs
Please do it soon, before you forget. I know that you are busy but it should take only a few minutes.
As you get ready for the final exam tomorrow or on Friday, a couple of quick note.
1. PV of an annuity: Notwithstanding my repeated entreaties that you be able to compute the present value of an annuity on your calculator, many of you are still working through the present value one cash flow at a time. Since this will become an issue in the final and some of you will never overcome your calculator hijinks, I opted for an old-world solution. The attached sheet gives you the present values of annuities, as a function of time and discount rate. Print it off and bring it with you to the exam, if you don’t trust your calculator.
2. To (1+g) or not to (1+g)
No. I am not channelling my inner Hamlet, but this may be a question that is bugging you. When you compute firm value (in the terminal value equation) or the change in value in capital structure, the present value of a growing perpetuity is
PV = Expected cash flow next year/ (r -g)
The key is that the numerator should be the expected cash flow next year. Thus, if you are told that a firm expects to generate $ 100 million in cash flows next year, the present value is
PV = 100/ (r -g)... No need for (1+g) since you already have next year's number
If you are given the cash flow in the current or most recent year, though, and you are told that cash flow will grow at the stable growth rate, you have to put in a (1+g)
PV = 100 (1+g)/(r-g)
Most generally in valuation, if you are computing cash flows on your own, you generally cannot take the cash flow in your last year and multiply by (1+g). Instead, you should start from the earnings (net income or after tax operating income), compute a new reinvestment rate or retention ratio in stable growth and estimate a terminal value:
PV = Earnings in year n+1 (1- Reinvestment rate in year n+1)/ (r -g)
In the context of cost of capital changes and computing firm value, it is a little hazy as to what you are estimating when you multiply firm value by the change in the cost of capital.
a. If you are multiplying today's firm value (market value of equity + debt) by the change in the cost of capital, you are getting the savings over the next year. Consequently, you don't need to multiply by (1+g). This is what I assumed in computing the increase in firm value for Disney and there is no (1+g) in the equaitonl
b. If you are multiplying the firm value from the end of the last financial year (which may be 4,6 or even 9 months ago), you are getting a saving from the last year and you should multiply by (1+g)
Needless to say, this is confusing. So, to make things simple, it nothing is stated about the point in time that firm value is computed at, you should ignore the (1+g). I plead guilty to not being entirely consistent on the past quizzes and I am sorry. In these examples, I would accept either answer but please specify what you are assuming.
If you were not able to make it to the review session, it is now up and running. Here is the recording:
The slides are also attached.
You probably don’t need this reminder but the final exam is tomorrow from 10-12. I had originally planned to have everyone take the exam in Paulson, since I expected about 80 people to take the early option. Since only 59 took the early exam, I think that trying to fit the remaining 243 into Paulson will be tricky. So, change of plan. The final exam tomorrow is back to being in two rooms.
If your last name begins with Go to
A - E KMEC 2-70 (not 2-60)
F - Z Paulson
The final exam review is up and running. Also, I have returned most of the projects. In fact, I have returned all of the projects with the right subject (The torture ends..). If you had the wrong subject, you should be getting your project back today. I want to thank you for the effort that you clearly expended on this project. I don’t say it often enough but I really appreciate the work you put in and I hope that it pays off (if not right away, soon!).
Your final exams are done and can be picked up in the usual spot. They are in three neat alphabetical piles and I hope that you leave them in order. The solution is attached with the grading template. I have also attached a distribution of the final exam but since your final grades will go up in a few hours (I will send you an email when they are up), I have not bothered to attach a grade to the final exam score. The most challenging question on the final exam was the Uber question and it is worth providing some perspective on the question. I am convinced that the sharing economy (Uber, Airbnb and the rest) is here to stay and that the businesses that they are disrupting (yellow cabs, hotels) will feel the pain but I also have this nagging feeling that the sharers in the sharing economy are not fully pricing in their costs. That was brought home to me when I got into an Uber car in Chicago a couple of weeks ago and as is my wont, I started peppering the driver with questions about Uber. He told me that he drove about 800 hours a year and made about $12 after covering gas and maintenance costs and paying taxes and that this supplemented the income he earned on a regular job. I then noticed that he was driving a Lexus and commented on it, and he mentioned that he would normally have bought a Celica for personal use but had upgraded to the more expensive Lexus for his Uber driving and that even the Lexus, given the number of miles that he was putting on it, would need to get replaced sooner because of the miles that he was putting on it. When I asked him whether he had put this cost into his calculus (for computing his $12 after taxes), he looked baffled and said that he had not. The cost of upgrading the car and the wear and tear (showing up as a shorter life) are clearly costs that should be charged to Uber, and this problem was my attempt to quantify how much that cost was. As you look at the grading, you will notice that I was generous with my partial credit and gave you most of the credit if you were looking at ways to bring these additional costs into your income computation. And better still, the next time you get in an Uber, Lyft or Didi car, or stay at an Airbnb, I would like you to think about these “uncosted” costs that the sharing economy will have to face up to, sooner rather than later.
The grades are officially in and you should be able to check them online soon. In the interests of transparency, I have attached a spreadsheet where you can enter your scores on the quizzes, the final exam, the case and the final project and see your final grade computation. (Note that the spreadsheet does not contain your scores and that you have to enter them to update the spreadsheet). On a more general note, I want to thank you for the incredible amount of work you put into this class. You made it easier for me to teach and I really appreciate it. I know that I buried you under emails (this is the 127th of the class), assignments, projects and weekly puzzles and I also know that most of you were unable to keep up. However, the material for the class will stay online and on iTunes U for the foreseeable future. If you want to review parts of the class, please do go back and review the lecture, look through the notes and even try that week's puzzle. If you really, really want to master corporate finance, don't waste too much time reading books & papers or listening to lectures. Pick another company (preferably as different as you can get from your project company) and take it through the project analysis. Each time you repeat this process, it will not only get easier and more intuitive, but you will always learn something new. I still do!. I would normally invite you to take valuation next year but since I am on sabbatical, I have to retract that invitation. I am sure that you will be in good hands, no matter what class you take and I truly wish you the best. And finally, remember to work on your weak side! If you are a story teller, build up your number crunching skills, and if you are a number crunching, let your imagination run loose!
Finally, in return for reading all (many, most, some) of my emails this semester, I have something to offer in return. If you have a question in corporate finance, valuation or investments, where you think I can be of use, you are welcome to always reach out to me. I hope that you have a wonderful summer planned out and that those plans come through. I wish you the best and I hope that you are able to find joy in whatever you choose to do!
Attachments: Grading spreadsheet