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. So, scroll down to your desired email and read on...
August 8, 2007
I hope you have have a wonderful summer 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...
Let me start off with a confession. I have not taught Financial Management (I think that is the official title for this class) before and I intend to put my own imprint on it. This is a corporate finance class. In fact, it is identical to the corporate finance class that I have taught in the MBA program the last 15 years. I believe that you are as smart and as motivated as the typical MBA and I don't plan to compromise on either content or material.
With that said, I am delighted that you have decided to take this class 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 importance 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.
a. Get a financial calculator and do not throw away the manual.
b. The only prior knowledge that I will draw on will be in basic accounting, statistics and present value. If you feel insecure about any of these areas, I have short primers on my web site that you can download by going to
And trust me... We will get through this together...
Having got these thoughts out of the way, let me get down to business. You can find out all you need to know about the class (for the moment) by going to the web site for the class:
The syllabus has been updated and you will be getting a hard copy of it on the first day of class but the quiz dates are specified online. (There is no final exam date scheduled yet, but I will put in online as soon as it is...) If you click on the calendar link, you will be taken to a Google calendar of everything related to this class. You will note references to a project which will be consuming your lives for the next four months. This project will essentially require you to do a full corporate financial analysis of a company. While there is nothing you need to do at the moment for the project, you can start thinking about a company you would like to analyze and a group that you want to be part of.
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.
If you prefer a copied package, the first part (of two) should be in the bookstore in about a week. You do have to pay for it at the bookstore.
The book for the class is "Applied Corporate Finance", the publisher is John Wiley & Sons and you need the second edition. Needless to say, I agree entirely with the author of this book and think that he does an extremely good job in presenting the material (but I may be biased on this count). If you want to start reading ahead, go on. It is not required, but it may help you get a jump on the class.
That is about it. I am looking forward to this class. Corporate Finance has always been one of my favorite classes to teach and I would like to make it the best class you have ever taken... I know that this is going to be tough to pull off but I will really try. I hope to see you in a few weeks in class. Until next time!
September 4, 2007
I guess summer is officially done! In advance of tomorrow's class, here are a few notes, reminders and recommendations:
1. Website for the class: If you did not get a chance to check your last email, the website for the class is
Please take a look at it (even if you do not want to delve into it) when you get a chance.
2. Lecture notes: The first lecture note packet for the class is available at the book store. You can also download it and print it off on your own from the website. If you do the latter, please try not to clog up the printers at school. I hear from the computer folks when you do.
3. Book for the class: The book for the class is Applied Corporate Finance, Second edition,John Wiley and Sons. While I think that the book is very useful and supplements the class well, you can live without it, if you cannot afford to spend the money.
4. Calculator: While I had suggested that you get a financial calculator in my last email, I have no strong views on which one is better. As far as I am concerned, they all pretty much do (and should do) the same thing. As long as your calculator has a present value function, it works for me.
5. Pre-reading for tomorrow's class: Got you there, didn't I? There is no pre-reading, homework or assignments for tomorrow's class (Do some teachers actually have pre-work before they teach their first classes? What exactly do you work on?) Just be there (alert, awake and caffeinated, if necessary!)
One final note. The class is in Schimmel Auditorium and is at 3.30. I hope to see you in person!
September 5, 2007
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.....
1. Please join a group as soon as you can. Try to stay within the size constraints that I have suggested in your group project description - between 4 and 8.
2. Each person in the group should think about a company to analyze and try to stay. The guidelines for picking the companies are in the project description as well. To summarize, here are the guidelines:
a. Pick a theme for your group and find companies that match the theme. For instance, if your theme is entertainment, you can pick companies like Time Warner, Netflix, Clear Channel and Lucas Arts as your companies. If you want to sound out a theme with me, that is fine.... Try to pick as diverse a group as you can - large and small companies, US and non-US....
b. Avoid financial service firms, firms that have been listed for less than a year and money losing companies.
c. Don't sweat the details too much. If you don't like the company you pick, you can change it anytime over the first few weeks.
I will talk a little more about the group project on Monday but try not to wait until then to pick your company.
3. The web cast for the first class is up and running...
Try it out and let me know what you think. The handouts from today's class are also online...
4. I know this is a large class but I would really like to meet you at some point in time personally. So, drop by when you get a chance... I don't bite....
Until next time...
September 8, 2007
Hope that the process of finding a group and picking companies is going smoothly. I should probably stay above the fray and let you make your own choices, but I cannot resist providing some advice. The advice is not about finding a group: you know the drill there. Try to find a group of people who will pull their weight, are likable (you will be around them a lot), practice good hygiene and don't howl at the full moon (or grow fur..)... But here are some things to consider when picking your companies:
(1) Define your theme broadly: Don't define your theme as newspapers. The companies that you pick will be too similar for interesting analyses. Define it as publishing- you will find more companies.
(2) Go for diversity: Try to find large and small firms, growth and mature firms in the business. In other words, if your theme is the airline business, don't pick five money-losing airlines as your group. Pick Continental Airlines, Southwest, Jet Blue, Travelocity and Embraer.... Three very different airlines, a travel service and a company that supplies aircraft to the airlines.
(3) Do not worry about making a mistake: If you pick a company that you regret picking later, you can go back and change your pick.... If you do it in the first 5 weeks, it will not be the end of the world.
(4) Take a risk and pick a foreign company: If you are leery about picking a foreign company, pick one that has a listing (called an ADR) in the US. It will make your life a little easier. You should still use the information related to the local listing (rather than the ADR).
(5) Increase your payoff: If you want to kill two birds with one stone, pick a company that you already own stock in or plan to work for or with .....\
(6) Don't prejudge businesses: There are no boring businesses. Every business has interesting aspects to it....
Hope this helps! Until next time!
I will assume that you have got the backlog of emails and are ready to move on. Assuming that you have picked your company, here is the next step:
1. Start by assessing the board of directors (and making judgments on how effective or ineffective it is likely to be). To help in this process, I am attaching the original article in 1997 that covered the best and the worst boards as well as a more recent article detailing what Business Week looks at in assessing boards.
There are a number of interesting sites that keep track of directors and their workings. I have listed a few below:
http://www.corpgov.net/links/links.html : This is a general site listing corporate governance links
http://www.ecgi.org/ : Covers corporate governance in Europe
Institutional Shareholder Services is an outfit that measures corporate governance scores for individual firms (which Yahoo! Finance reports for companies). Here is the link to their site:
Look under articles... They have a few interesting ones.
Here is a fun site that allows you to look at individuals who sit on multiple boards.
For a site that takes a particularly cynical and negative view of what boards do - they are even more dyspeptic in their assessments of directors than I am - try the following:
They provide all the dirt you will ever want to read about directors and their limitations.
2. Start collecting data on your company. In particular, find the Bloomberg terminals, which I believe are located in L-101. Once you have found the terminals and are able to get on them, print off the following for your company:
a. HDS page: Print off page 1 (lists top 17 stockholders in your company)
b. BETA page: just one page
c. DES pages: print off pages 1-10
If you have no idea what a Bloomberg is, there was a packet that you probably picked up in the first session that describes the process in excruciating detail. If you did not, the handout is available online under updated data.
One more important detail. There are two TAs for the class - Albert Bonilla and Anurag Poddar. They are emininently qualified to answer your questions about the topic and the data, since I put them through the torture last Spring (when they excelled in this class). Their email addresses and office hours are listed below:
Albert Bonilla firstname.lastname@example.org Tuesday 1.30-3.30 KMEC 7-158
Anurag Poddar email@example.com Tuesday and Thursday, 11-1 KMEC 7-158
Anurag will be hanging out near the Bloomberg terminals in L-101 tomorrow during his office hours, in case you run into trouble.
Until next time...
P.S: If you have trouble with the attachments, check under readings (under
the corporate finance class) for the articles. (Even if you can read the articles,
check under readings for more articles...)
September 12, 2007
A couple of quick notes in advance of today's class.
1. Please bring your lecture notes: If you have not bought a packet yet or printed off one, try to print off at least pages 16-40.... Bring the notes to class.
2. If you have picked a company, print off the list of who is on your board of directors (should be in your annual report) and the HDS page from Bloomberg (just page 1). If you cannot get to a Bloomberg, you can also get the relevant data by going to Yahoo! Finance, typing in the symbol of your company (in the get quote box) and then clicking on Major Holders. In fact, try to do this even if you have the HDS page from Bloomberg. (The Yahoo route will work only for US companies...
3. If you are close to picking a company but have not decided yet, print off the same items for the company you are thinking about
4. If you have not even thought about a company, time to start thinking now... For the moment, try to print the items for any company (pick one at random or because you are interested in it...) and bring them to class. You can transfer what you learn from the process to the company you actually end up picking.
See you in class!
September 13, 2007
Let me start off by fulfilling my "nagging" responsibilities. Have you found a group yet? Picked a company? Cleaned your room? Made your bed? Called your mother? (Even if you have not done the last three, do the first two..)
If you have picked a company, there are two orders of business you have for this weekend:
a. How much power do you as an individual stockholder have over the management of this company?
To make this assessment, you want to start by looking at the board of directors and examining it for independence and competence. I know that there are lots of unknowns here, but work with at least what you know - the size of the board, the appearance of independence, the (perceived) quality of these directors. With US companies, you can get more information about the directors from the DEF14 (a filing with the SEC that you can get from the SEC website). With non-US companies, you may sometimes find yourself lacking information about potential conflicts of interests, but what you cannot find is often more revealing than what you can find out; it points to how little power stockholders have in these companies. Also look at subtle ways in which power is shifted to managers at the expense of stockholders including anti-takeover amendments (poison pills, golden parachutes), if you can find reference to them.
b. Are there other potential conflicts of interests between inside stockholders and outside stockholders?
In some companies, you will find that there are large stockholders in the company who also play a role in running the company. While this may make you feel a little more at ease about managers being held in check (by these large stockholders), consider who these large stockholders are and whether their interests may diverge from yours. In particular, the largest stockholder in your company can be a founder/CEO, a family holding, the government or even employees in the company. What they might want managers to do may be very different from what you would want managers to do... Look for ways in which these inside stockholders may leverage their holdings to get even more power (voting and non-voting shares for inside stockholders, veto powers for the government...)
While it may seem like we are paying far too much attention to these minor issues, I think that understanding who has the power to make decisions in a company will have significant consequences for how the company approaches every aspect of corporate finance - which projects it takes, how it funds them and how much it pays in dividends. So, give it your best shot...
A final note. I am still getting a few stragglers without groups. If you need additional members in your group, please let me know. Until next time!
P.S: The Bloomberg terminals are in the computer room. Please get to them sooner rather than later.
September 13, 2007
I mentioned in yesterday's email that the assessment of your company's corporate governance (the independence and the intellingence of the board of directors) would be primarily qualitative. In the last few years, there have been attempts to start quantifying this measure, primarily because institutional investors are interested in it. Yahoo! Finance provides a measure of corporate governance strength on its web site
Type in the symbol for your firm and check under profile. There should be a corporate governance score for your company, if it is a US company... Don't put too much weight on it. It is a judgment call made by one service (Institutional Shareholder Services) but it can one more piece of information that you use in your assessment.
On a different note, I have attached an interesting article on poison pills in Japan... Turns out Japanese managers share some characteristics with their US counterparts. They must like spitting in their fries (or sushi) as much as my daughter does...
September 14, 2007
Now that the first full week of class has come to a close, it is time to take stock. This is where I hope you are right now. You are part of a group, you have picked a company and you have found where the Bloomberg terminals are in the building... This is what I hope you start doing over the weekend. You start examining your company's power structure using all the data that you have at your disposal - the board of directors, the corporate governance score, the existence or non-existence of information on conflicts of interests. If you have any issues or questions, I will be glad to answer them.
As for next week, here is what is coming. We will continue examining the problems with maximizing stock prices as an objective on Monday. In fact, we will start Monday's class with an assessment of whether you trust markets to get it right and if not, what the alternatives are. By Wednesday, we should have the objective function fully behind us and will start on the "meat and potatoes" part of corporate finance - assessing risk. While I will not call on you to scale the heights of statistics and mathematics, some basic knowledge of statistics will be useful for this part of the discussion. If you have truly forgotten every last little piece of your Stat 101 class (and who would blame you), I have a very short primer on statistics at the end of the applied corporate finance book that you can browse through. It is also available online:
Finally, I have attached the second newsletter to this email. If you did not get a chance to see the first newsletter, it is available online at
September 17, 2007
If you remember the discussion of Berkshire Hathway stock last class, I was wrong in my contention that the company did not have shares with different voting rights (and you were right...). I did find the letter that Warren Buffett sent stockholders in the company about the shares in 1999. I find it both interesting and hypocritical that Buffett (a defender of shareholder rights) would countenance differences in voting rights. I know that his defense would be that this allows smaller investors to partake in the stock, since once share of class A stock trades for almost $120,000, but that is a self-inflicted wound.
On a more general note, we will continue with out discussion of the objective in corporate finance. If you still do not have your lecture notes, we will start on page 36 and get through slide 55 (give or take a couple of pages). I hope you have also had a chance to read chapter 2 in the book and that your group seeking and company picking is behind you...See you in class!
September 18, 2007
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 two 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? I have attached an article on stock price maximization and alternatives to it.
Building on the theme of social good and stockholder wealth a little more, there are a number of fascinating moral and ethical issues that arise when you are the manager in a publicly traded firm. Is your first duty to society (to which we all belong) or to the stockholders (who are your ultimate employers)? If you have to pick between the two and you choose the former, do you have an obligation to be honest and let the latter know? What if you believed that the market was overvaluing your stock? Should you sit back and let it happen, since it is good for your stockholders, or should you try to talk the stock price down?
A final point. I argued that the best way to make companies socially responsible is to make it in their best economic interests. I think this article from Businessweek, titled "Beyond the Green Corporation", makes the case much better that it can. It is an easy read. I especially found the section on Innovest, an agency that rates companies on corporate responsibility from AAA to C interesting. I found their web site and while much of the stuff they do is for sale (Ironic, in a way, that a company that evaluates social responsibility is also an old-fashioned business)), it provides an interesting perspective.
See you tomorrow! Until next time!
Beyond The Green Corporation
Jan 29, 2007
Imagine a world in which eco-friendly and socially responsible practices actually help a company's bottom line. It's closer than you think
Under conventional notions of how to run a conglomerate like Unilever, CEO Patrick Cescau should wake up each morning with a laserlike focus: how to sell more soap and shampoo than Procter & Gamble Co. (PG ) But ask Cescau about the $52 billion Dutch-British giant's biggest strategic challenges for the 21st century, and the conversation roams from water-deprived villages in Africa to the planet's warming climate.
The world is Unilever's laboratory. In Brazil, the company operates a free community laundry in a São Paulo slum, provides financing to help tomato growers convert to eco-friendly "drip" irrigation, and recycles 17 tons of waste annually at a toothpaste factory. Unilever funds a floating hospital that offers free medical care in Bangladesh, a nation with just 20 doctors for every 10,000 people. In Ghana, it teaches palm oil producers to reuse plant waste while providing potable water to deprived communities. In India, Unilever staff help thousands of women in remote villages start micro-enterprises. And responding to green activists, the company discloses how much carbon dioxide and hazardous waste its factories spew out around the world.
As Cescau sees it, helping such nations wrestle with poverty, water scarcity, and the effects of climate change is vital to staying competitive in coming decades. Some 40% of the company's sales and most of its growth now take place in developing nations. Unilever food products account for roughly 10% of the world's crops of tea and 30% of all spinach. It is also one of the world's biggest buyers of fish. As environmental regulations grow tighter around the world, Unilever must invest in green technologies or its leadership in packaged foods, soaps, and other goods could be imperiled. "You can't ignore the impact your company has on the community and environment," Cescau says. CEOs used to frame thoughts like these in the context of moral responsibility, he adds. But now, "it's also about growth and innovation. In the future, it will be the only way to do business."
A remarkable number of CEOs have begun to commit themselves to the same kind of sustainability goals Cescau has pinpointed, even in profit- obsessed America. For years, the term "sustainability" has carried a lot of baggage. Put simply, it's about meeting humanity's needs without harming future generations. It was a favorite cause among economic development experts, human rights activists, and conservationists. But to many U.S. business leaders, sustainability just meant higher costs and smacked of earnest U.N. corporate- responsibility conferences and the utopian idealism of Western Europe. Now, sustainability is "right at the top of the agendas" of more U.S. CEOs, especially young ones, says McKinsey Global Institute Chairman Lenny Mendonca.
MORE THAN PR
You can tell something is up just wading through the voluminous sustainability reports most big corporations post on their Web sites. These lay out efforts to cut toxic emissions, create eco-friendly products, help the poor, and cooperate with nonprofit groups. As recently as five years ago, such reports—if they appeared at all—were usually transparent efforts to polish the corporate image. Now there's a more sophisticated understanding that environmental and social practices can yield strategic advantages in an interconnected world of shifting customer loyalties and regulatory regimes.
Embracing sustainability can help avert costly setbacks from environmental disasters, political protests, and human rights or workplace abuses—the kinds of debacles suffered by Royal Dutch Shell PLC (RDS ) in Nigeria and Unocal in Burma. "Nobody has an idea when such events can hit a balance sheet, so companies must stay ahead of the curve," says Matthew J. Kiernan, CEO of Innovest Strategic Value Advisors. Innovest is an international research and advisory firm whose clients include large institutional investors. It supplied the data for this BusinessWeek Special Report and prepared a list of the world's 100 most sustainable corporations, to be presented at the Jan. 24-28 World Economic Forum in Davos, Switzerland.
The roster of advocates includes Jeffrey Immelt, CEO of General Electric Co. (GE ), who is betting billions to position GE as a leading innovator in everything from wind power to hybrid engines. Wal-Mart Stores Inc. (WMT ), long assailed for its labor and global sourcing practices, has made a series of high-profile promises to slash energy use overall, from its stores to its vast trucking fleets, and purchase more electricity derived from renewable sources. GlaxoSmithKline (GSK ) discovered that, by investing to develop drugs for poor nations, it can work more effectively with those governments to make sure its patents are protected. Dow Chemical Co. (DOW ) is increasing R&D in products such as roof tiles that deliver solar power to buildings and water treatment technologies for regions short of clean water. "There is 100% overlap between our business drivers and social and environmental interests," says Dow CEO Andrew N. Liveris.
Striking that balance is not easy. Many noble efforts fail because they are poorly executed or never made sense to begin with. "If there's no connection to a company's business, it doesn't have much leverage to make an impact," says Harvard University business guru Michael Porter. Sustainability can be a hard proposition for investors, too. Decades of experience show that it's risky to pick stocks based mainly on a company's long-term environmental or social-responsibility targets.
Nevertheless, new sets of metrics, which Innovest and others designed to measure sustainability efforts, have helped convince CEOs and boards that they pay off. Few Wall Street analysts, for example, have tried to assess how much damage Wal-Mart's reputation for poor labor and environmental practices did to the stock price. But New York's Communications Consulting Worldwide (CCW), which studies issues such as reputation, puts it in stark dollars and cents. CCW calculates that if Wal-Mart had a reputation like that of rival Target Corp. (TGT ), its stock would be worth 8.4% more, adding $16 billion in market capitalization.
Serious money is lining up behind the sustainability agenda. Assets of mutual funds that are designed to invest in companies meeting social responsibility criteria have swelled from $12 billion in 1995 to $178 billion in 2005, estimates trade association Social Investment Forum. Boston's State Street Global Advisors alone handles $77 billion in such funds. And institutions with $4 trillion in assets, including charitable trusts and government pension funds in Europe and states such as California, pledge to weigh sustainability factors in investment decisions.
Why the sudden urgency? The growing clout of watchdog groups making savvy use of the Internet is one factor. New environmental regulations also play a powerful role. Electronics manufacturers slow to wean their factories and products off toxic materials, for example, could be at a serious disadvantage as Europe adopts additional, stringent restrictions. American energy and utility companies that don't cut fossil fuel reliance could lose if Washington joins the rest of the industrialized world in ordering curbs on greenhouse gas emissions. Such developments help explain why Exxon Mobil Corp. (XOM ), long opposed to linking government policies with global warming theories, is now taking part in meetings to figure out what the U.S. should do to cut emissions.
Investors who think about these issues obviously have long time horizons. But they encounter knotty problems when trying to peer beyond the next quarter's results to a future years down the road. Corporations disclose the value of physical assets and investments in equipment and property. But U.S. regulators don't require them to quantify environmental, social, or labor practices. Accountants call such squishy factors "intangibles." These items aren't found on a corporate balance sheet, yet can be powerful indicators of future performance.
If a company is at the leading edge of understanding and preparing for megatrends taking shape in key markets, this could constitute a valuable intangible asset. By being the first fast-food chain to stop using unhealthy trans fats, Wendy's International Inc. (WEN ) may have a competitive edge now that New York City has banned the additives in restaurants. McDonald's Corp. (MCD ), which failed to do so, could have a future problem.
Rising investor demand for information on sustainability has spurred a flood of new research. Goldman Sachs, Deutsche Bank Securities (DB ), ubs (UBS ), Citigroup (C ), Morgan Stanley, and other brokerages have formed dedicated teams assessing how companies are affected by everything from climate change and social pressures in emerging markets to governance records. "The difference in interest between three years ago and now is extraordinary," says former Goldman Sachs (GS ) Asset Management CEO David Blood, who heads the Enhanced Analytics Initiative, a research effort on intangibles by 22 brokerages. He also leads Generation Investment Management, co-founded in 2004 with former Vice-President Al Gore, which uses sustainability as an investment criterion.
Perhaps the most ambitious effort is by Innovest, founded in 1995 by Kiernan, a former KPMG senior partner. Besides conventional financial performance metrics, Innovest studies 120 different factors, such as energy use, health and safety records, litigation, employee practices, regulatory history, and management systems for dealing with supplier problems. It uses these measures to assign grades ranging from AAA to CCC, much like a bond rating, to 2,200 listed companies. Companies on the Global 100 list on BusinessWeek's Web site include Nokia Corp. (NOK ) and Ericsson (ERICY ), which excel at tailoring products for developing nations, and banks such as hsbc Holdings (HBC ) and abn-Amro (ABN ) that study the environmental impact of projects they help finance.
Some of Innovest's conclusions are counterintuitive. Hewlett-Packard (HPQ ) and Dell (DELL ) both rate AAA, for example; market darling Apple (AAPL ) gets a middling BBB on the grounds of weaker oversight of offshore factories and lack of a "clear environmental business strategy." An Apple spokesman contests that it is a laggard, citing the company's leadership in energy-efficient products and in cutting toxic substances. Then there's Sony Corp. (SNE ) vs. Nintendo. Wall Street loves the latter for a host of reasons, not least that its Wii video game system, the first to let users simulate actions such as swinging a sword or tennis racket, was a Christmas blockbuster. Sony, meanwhile, has a famously dysfunctional home electronics arm, and was embarrassed by exploding laptop batteries and long delays in bringing out its PlayStation 3 game console. Nintendo's stock has more than tripled in three years; Sony's has languished.
WEIGHING THE EFFORTS
Viewed through the lens of sustainability, however, Sony looks like the better bet. It is an industry leader in developing energy-efficient appliances. It also learned from a 2001 fiasco, when illegal cadmium was found in PlayStation cables bought from outside suppliers. That cost Sony $85 million, says Hidemi Tomita, Sony's corporate responsibility general manager. Now, Sony has a whole corporate infrastructure for controlling its vast supplier network, helping it avert or quickly fix problems. Nintendo, a smaller Kyoto-based company focused on games, shows less evidence of the global management systems needed to cope with sudden regulatory shifts or supplier problems, says Innovest. A Nintendo spokesman says it meets all environmental rules and is "always reviewing and considering" the merits of new global sustainability guidelines.
BP seems to disprove the sustainability thesis altogether. CEO John Browne has preached environmentalism for a decade, and BP consistently ranked atop most sustainability indexes. Yet in the past two years it has been hit with a refinery explosion that killed 15 in Texas, a fine for safety violations at a refinery in Ohio, a major oil pipeline leak in Alaska, and a U.S. Justice Dept. probe into suspected manipulation of oil prices.Browne has recently announced his retirement. BP's shares have slid 10% since late April. Exxon's are up around 12%.
Innovest still rates BP a solid AA, while labeling Exxon a riskier BB. And PetroChina? Innovest gives it a CCC. Here's why: BP wins points for plowing $8 billion into alternative energies to diversify away from oil and engages community and environmental groups. Exxon has done less to curb greenhouse gas emissions and promote renewables and has big projects in trouble spots like Chad. "I would still say Exxon is a bigger long-term risk," says Innovest's Kiernan. Petro- China is easier to justify. Begin with its safety record: A gas well explosion killed 243 people in 2003; another fatal explosion in 2005 spewed toxic benzene into a river, leaving millions temporarily without water. PetroChina has been slow to invest in alternative energy, Innovest says, and its parent company has big bets in the Sudan.
Do Innovest's metrics make a reliable guide for picking stocks? Dozens of studies have looked for direct relationships between a company's social and environmental practices and its financial performance. So far the results are mixed, and Kiernan admits Innovest can't prove a causal link. That's little help to portfolio managers who must post good numbers by yearend. "The crux of the problem is that we are looking at things from the long term, but we're still under short-term review from our clients," says William H. Page, who oversees socially responsible investing for State Street Global Advisors.
TALKING A GOOD FIGHT
Yet Kiernan and many other experts maintain sustainability factors are good proxies of management quality. "They show that companies tend to be more strategic, nimble, and better equipped to compete in the complex, high-velocity global environment," Kiernan explains. That also is the logic behind Goldman Sachs's intangibles research. In its thick annual assessments of global energy and mining companies, for example, it ranks companies on the basis of sustainability factors, financial returns, and access to new resource reserves. Top-ranking companies, such as British Gas, Shell, and Brazil's Petrobras (PBR ), are leaders in all three categories. For the past two years, the stocks of elite companies on its list bested their industry peers by more than 5%—while laggards underperformed, Goldman says.
Still, BP's (BP ) woeful performance highlights a serious caveat to the corporate responsibility crusade. Companies that talk the most about sustainability aren't always the best at executing. Ford Motor Co. (F ) is another case in point. Former CEO William C. Ford Jr. has championed green causes for years. He famously spent $2 billion overhauling the sprawling River Rouge (Mich.) complex, putting on a 10-acre grass roof to capture rainwater. Ford also donated $25 million to Conservation International for an environmental center.
But Ford was flat-footed in the area most important to its business: It kept churning out gas-guzzling SUVs and pickups. "Having a green factory was not Ford's core issue. It was fuel economy," says Andrew S. Winston, director of a Yale University corporate environmental strategy project and co-author of the book Green to Gold.
The corporate responsibility field is littered with lofty intentions that don't pay off. As a result, many CEOs are unsure what to do exactly. In a recent McKinsey & Co. study of 1,144 top global executives, 79% predicted at least some responsibility for dealing with future social and political issues would fall on corporations. Three of four said such issues should be addressed by the CEO. But only 3% said they do a good job dealing with social pressures. "This is uncomfortable territory because most CEOs have not been trained to sense or react to the broader landscape," says McKinsey's Mendonca. "For the first time, they are expected to be statesmen as much as they are functional business leaders." Adding to the complexity, says Harvard's Porter, each company must custom-design initiatives that fit its own objectives.
Dow Chemical is looking at the big picture. It sees a market in the need for low-cost housing and is developing technologies such as eco-friendly Styrofoam used for walls. CEO Liveris also cites global water scarcity as a field in which Dow can "marry planetary issues with market opportunity." The U.N. figures 1.2 billion people lack access to clean water. Dow says financial solutions could help 300 million of them. That could translate into up to $3 billion in sales for Dow, which has a portfolio of cutting-edge systems for filtering minute contaminants from water. To reach the poor, Dow is working with foundations and the U.N. to raise funds for projects.
Philips Electronics (PHG ) also is building strategies around global megatrends. By 2050, the U.N. predicts, 85% of people will live in developing nations. But shortages of health care are acute. Among Philips' many projects are medical vans that reach remote villages, allowing urban doctors to diagnose and treat patients via satellite. Philips has also developed low-cost water-purification technology and a smokeless wood-burning stove that could reduce the 1.6 million deaths annually worldwide from pulmonary diseases linked to cooking smoke. "For us, sustainability is a business imperative," says Philips Chief Procurement Officer Barbara Kux, who chairs a sustainability board that includes managers from all business units.
Such laudable efforts, even if successful, may not help managers make their numbers next quarter. But amid turbulent global challenges, they could help investors sort long-term survivors from the dinosaurs.
September 20, 2007
Some of you may be regretting the shift from the soft stuff (objectives, social welfare etc.) to the hard stuff, but trust me that it is still fun.. If it is not, keep telling yourself that it will become fun. Anyway, here are a few thoughts about today's class.
1. The Essence of Risk: There has been risk in investments as long as there have been investments. If you have the time, pick up a copy of Against the Gods by Peter Bernstein, John Wiley and Sons. It is a great book and an easy read. If you want more, you should also pick up a copy of Capital Ideas by Peter as well... That traces out the development of the CAPM....
2. More on Models: If you want to read more about the CAPM you can begin with the chapter in the book on risk and return models and then move on to the readings at the end of the chapter.
3. Diversifiable versus non-diversifiable risk: The best way to understand diversifiable and non-diversifiable risk is to take your company and consider all of the risks that it is exposed to and then categorize these risks into whether they are likely to affect just your company, your company and a few competitors, the entire sector or the overall market. The essence of diversifiable risk is that it affects only one or a few companies whereas non-diversifiable risk is more pervasive and affects all or most companies. Thus, non-diversifiable risk will come from macro economic factors - interest rates, inflation and the overall economy whereas diversifiable risk will be from more company specific factors (whether a movie or theme park does better or worse than expected...)
4. The Marginal investor: I know that some of you are puzzled about why I introduced the notion of the marginal investor and the significance of that investor. Let me recap. The marginal investor is the investor likely to be setting prices for the stock - that is why we required the investor to own a lot of stock and trade on that stock. Since these investors set prices, their view on how risky a company is should be the view adopted within the company. If the marginal investor is a diversified, institutional investor, the risk of any individual stock (Disney, Google or SAP) will the risk that it adds to a portfolio. As we noted in (3), the only risk that matters then is the non-diversifiable risk and the company should consider only non-diversifiable risk when setting hurdle rates. If the marginal investor was an undiversified individual investor, the risk of the an individual stock will be the total risk which includes diversifiable and non-diversifiable components.
If you can, please 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. Until next time!
September 21, 2007
As we talk about firm specific and market risk, it is easy to get lost in abstractions. Here are two simple ways in which you can can getting a handle on the distinction between these risks:
1. Try to list out the risks that your firm (I hope you have picked one) is exposed to and then start categorizing the risks into risks that will affect only the company or a sub-set of companies and risks that will affect most companies. That is what I was trying to do with Disney when I listed the risks:
- Risk that a movie (Pirates of the Caribbean) will not measure up to expectations (Firm specific)
- Risk that a new theme park (California Adventure) will not deliver the visitors that you thought it would because people do not like it (Firm specific)
- Risk that theme parks collectively will see a drop in attendance because the economy slows (Market wide)
- Risk that theme parks in the US will see a drop in revenue because the dollar strengthens (Gray area: depends on how many firms are affected)
- Risk that revenues at ABC will be affected by new congressional laws covering cable access (Firm specific, since only a few companies will be impacted)
Give it your best shot. You will not be able to list every risk or categorize it, but the process will help.
2. Take a look at the stories on the front page of the WSJ today. (I have attached a pdf copy) Go down the list and try your best to put the story into one of three categories: Firm specific (and diversifiable), Market risk (and non-diversifiable), Gray area (may be one or the other depending...) The question that you are asking with each story is whether there is information there that will affect only a subset of companies or is there market information?
We will start Monday's class with this discussion.
September 23, 2007
The latest newsletter is attached and online. Hope that your group-forming and company-picking is behind you... Have a great weekend! See you on Monday!
P.S: You will get a duplicate of this email tomorrow . Feel free to ignore
it. I am testing the vagaries of the Stern Email system
P.S2: If you can, you can read ahead to chapter 4 in the book... but first get chapter 3 read...
September 25, 2007
I hope that you are settled in your group and with a company to analyze. We are now done with the corporate governance and the marginal investor sections and you can feel free to get your work done on both those sections. As you work through, here are some things to keep in mind (at least for these sections):
1. The information you have to assess corporate governance (the power of the board vs managers, social responsibility etc.) will vary widely across your firms. Some of your firms will have corporate governance scores on Yahoo!, substantial information on the board of directors and detailed sections on corporate governance on them, whereas others will have no outside measures of governance and little information on the board. While those of you have picked the latter may feel at a disadvantage, the absence of information is often more revealing than its presence. After all, the reason you have corporate governance scores and detailed corporate governance reports at some firms (especially large cap US firms) is because of pressure from stockholders. The fact that this information is not available to a firm can be viewed as evidence that stockholders are unable to exert the same pressure at other firms.
2. As you tty to assess where the power in your firm lies, you will find yourself having to make your best judgment based upon the evidence that you have in front of you. In other words, there will be no quantitative score or definitive proof that the power rests with managers, but you can still come to conclusions. For instance, I can look at News Corp's dual voting structure, the imperial power of Rupert Murdoch and the fact that his wife and children hold significant management positions in the firm as evidence that I as a stockholder in News Corp have relatively little power in the firm. Conversely, I can look at another firm where the CEO has recently been forced to step down by the board or where there have been recent changes to the corporate charter increasing stockholder rights and conclude that stockholders have power in the firm.
3. Assessing a firm's social standing is tougher since it is only the outliers that get in the news. In other words, most firms operate under the radar, paying lip service to social responsibility, while pursuing their commercial interests. The firms that stand out are the ones that violate this social compact (Exxon after the Valdez oil spill, the tobacco companies) or the ones that trumpet their virtues (Ben and Jerry's, The Body Shop). So, don't be surprised if you find little to go on when you look at your company. Your conclusion will be bland (the firm is neither a saint nor a demon)... but that is not a bad thing.
Assuming that you get this section done, you can try your hand at estimating the riskfree rate that you will be using in your analysis. Recapping what was said in class today, an investment is riskfree only when it is free of both default risk and reinvestment risk. In practical terms, you can get away using the 10-year default-free bond rate as a riskfree rate for the rest of this class (since almost everything we do is long term). The choices then become:
a. For US dollar based valuations: Ten-year treasury bond rate (WSJ top of front page, NY Times Business section....)
b. For Japanese yen, British pound, Canadian dollar, Swiss Franc...: Ten-year government bond rate in those currencies (available under Benchmark Governments in the Financial Times)
c. For Euros: The lowest 10-year government bond rate in Euros - currently the German : Look in the Financial Times section; you have to know which governments are Euro-denominated but use the handout from yesterday's class if in doubt
d. For emerging markets: This is a little more involved:
i. Find a local currency (not a US $) bond issued by the government and the yield on that bond.
ii. Find the sovereign rating for the country on http://www.moodys.com
iii. Use the attached spreadsheet to look up the default spread for the rating
iv. Subtract the default spread from the yield in step a
v. Rinse and repeat cycle...
See you in class tomorrow! Until next time!
September 26, 2007
Ola! (I am so tired of just saying Hi!)
So, how risk averse are you really? Hopefully, you have grappled with that
question after today 's class. If you want to follow up on the discussion of
risk premiums this morning, here are a few things you can try. You can get
historical risk premiums by going to:
Scroll down the page to data pages and you will find the historical data (and don't forget to plug it to those who are paying Ibbotson for the data). If you want to try to estimate the updated implied equity risk, try the attached excel spreadsheet. You will have to enter the updated S&P 500 index level and the treasury bond rate, but the rest of the data should automatically update. Follow the instructions for the implied premium. (I have updated the growth rate
for S&P 500 earnings for the next 5 years). If you want to get a better sense of what drives this premium, change one number at a time (S&P 500, dividends, riskfree rate) and see what the effects are on the risk premium.
A bit of unfinished business from my last email. I thought I had attached an excel spreadsheet with default spreads for country ratings to it, but I thought wrong. I have really attached that spreadsheet to this email. You will need it not only to get riskfree rates in those currencies but also for estimating country risk premiums for emerging markets. Until next time!
P.S: Don't worry about the Macro question that pops up when you open the excel
spreadsheet. You can either enable or disable the macros. It will make no difference
in your ultimate calculation. (When it asks you for a risk premium, just enter
the historical premium of 4.91%)
September 29, 2007
Two very quick notes. The first is that the latest newsletter is attached. The second is a reminder to print off the Beta page for your company and bring it to class with you on Monday. If you are still waffling about a company, the latter is an impossible task...So, please choose a company fast and get to the Bloomberg terminal soon...
October 3, 2007
II want to spend this email 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 strategic terminology 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
Firm A Firm B
Revenues 100 100
- Fixed costs 90 0
- Variable costs 0 90
Operating income 10 10
Consider what will happen if revenues rise 10%. The first firm will see its operating income increase to 20 (an increase of 100%) whereas the second firm will see its operating income go up to 11 (an increase of 10%)... that is why looking at percentage change in operating income/percentage change in revenues is a measure of operating leverage.
3. Financial leverage can affect equity betas.... We did not get a chance to get to the mechanics of this today, but you can read ahead in the book and we will start the next class with it...
One final point. We have a week off before the next class. Now is a good time to get caught up on your project - pick a company and work it through the risk and return section. I will be in India for the next 4-5 days but I will check my email if you get stuck. Have a great extended weekend! The first quiz, for those of you who have not been checking the calendar, is a week from Monday (on October 15). You should consider starting your preparations for that quiz. The best place to start is to go the website for the class, clcik on the past exams and take a look at the past quiz 1s. (Don't try quiz 2 or 3 yet) There will be a review session next Friday (October 12) .... More in a different email. Until next time!
October 1, 2007
Strike while the iron is hot... Right... While the regression diagnostics on Disney are still fresh (Let's face it... Its not going to get any fresher), you should try to analyze your company's beta regression (using the Bloomberg page). To see the questions that need to be answered, go to page 122 of the lecture note packet. Once you have answered them, you can check your answers by using the spreadsheet that I have attached.... One of the inputs that you require for Jensen's alpha is the average T.Bill rate from the last 5 years. If you want to do this precisely, you can visit the Federal Reserve site at St. Louis:
You can get approximate answers using the annual averages I have included in the attached spreadsheet. I have used the average from 2005-2007. which should be the time period for your regression. If you are analyzing a foreign firm, this will not be quite right, but it should be close enought...
You can get the industry averages for Jensen's alpha and R-squared by sector by going to updated data on my site. It it under performance measures (The R-squared is in the same file as the Jensen's alpha). I had also mentioned the Morningstar site this morning for Jensen's alphas for mutual funds. I just discovered that a big chunk of the site has become premium and you have to pay to get it.. The way of the world, I guess, but it is a pity.
Once you have your regression beta, you should try to go ahead and estimate the expected return on the stock. To do this calculation, you will need the current 10-year bond rate (dollar, euro, BP, etc..) and the equity risk premium. If you are wondering why you use current 10-year T.Bond rates for expected returns and T.Bill rates for the Jensen's alpha, it is a matter of perspective. When estimating expected returns, you are looking at a long term return for the future and hence you use the 10-year T.Bond rate today . When analyzing Jensen's alpha, you are looking at an investor who bought and sold each month for the last 5 years and hence you use the average T.Bill rate over the last 5 years.... Until next time!
October 4, 2007
I know that I scared some of you with the mention of the first quiz in my last email. To make amends, here is a four step plan that may help:
Step 1: Review the lecture notes. We will get through slide 160 or so in the
note packet. Go over the notes and watch the web casts if necessary.
Step 2: Browse through chapters 1 through 4 in the text book. All of the examples
in the book are available as excel spreadsheets online in the web site for
Step 3: Work through the problems at the end of the chapters in the book (the
solutions are also on the web site listed above). Time is obviously a constraint
but try to avoid checking out the answers as you look at the problem. The solution
is always obvious once you see it.
Step 4: You are now ready to run an experiment. Pull up the practice quizzes
off the class web site and take a quiz. Give yourself exactly 30 minutes. (It
would be even more realistic if you could find a room packed with 250 people
with uncomfortable seats.... Perhaps on the subway). If you have serious trouble,
go back to step 3.
As I noted, there will be a review session next Friday from 12-1. The session will be webcast and accessible almost immediately after. I will send you a presentation for the session later next week.
Finally, here are two other questions about past quizzes that seem to keep
1. Why is 5.5% the risk premium in past quizzes and problems?: As you work through a lot of the past exams, you have probably noticed that a 5.5% risk premium magically pops up when you look at the solutions. This is why. If you are not given a risk premium for equity in a problem, you should look it up in your notes and use the historical premium or the implied equity premium and specify what you did. If you were doing that today , you would be using 4.91% (which is the geometric premium for stocks over T.Bonds) or 4% (implied equity premium). At the time that these quizzes were worked out, that historical premium was closer to 5.5%.
2. Is it possible that some of the problems lend themselves to multiple interpretations?
If you read a problem and are not sure about something, make an assumption
and state it. When grading the quiz, I will consider your assumption.
Until next time!
October 6, 2007
The latest newsletter is attached.. Hope that the weekend is going well... Until next time!
October 9, 2007
I hope your break was fun and productive, in that order. I know that many of you have been working at catching up on your project, while also getting started on the quiz preparation. The two are not mutually exclusive. Working on the project is excellent preparation for the quiz. Here are a few thoughts to keep in mind:
1. Beta regression : I know that many of you are going back and forth on how best to run your regression, what to use as an index etc. My advice is that you do not spend too much time on this question. Run your regression or use the Bloomberg default regression and go through the regression diagnostics. The regression betas can be strange looking (remember the standard error on them) but you will not be using them to come up with costs of equity for your firm anyway. Tomorrow , we will develop an alternative to regression betas.
2. Present value and calculators : I do not cover present value in this class but I will expect everyone to know how to compute the present value of single cash flow or an annuity. You may not need it for the first quiz but you will need it for the rest of the class. So, get a hold of the manual for your financial calculator and start getting caught up. (I have an appendix on present value in the book and a few practice problems online..)
3. Statistics : I will not be calling on you to compute standard deviations, variances or covariances from raw data, but I will expect you to know how to read the numbers... Thus, you should be able to explain to me what a positive correlation implies as well as what a slope of a regression measures.
4. Open book and open notes : As I noted on the first day of class, all exams for this class are open book, open notes. You can access as much material as you want (but you operate under a time constraint) and any calculator you want. You cannot use laptops....
As for tomorrow's class, we will be turning our attention to a better way to estimate betas.
Until next time!
P.S: I apologize for any of you who emailed me yesterday and did not get a response. I was on a non-stop flight that lasted forever (about 16 hours plus) and had no access to email...
October 10, 2007
I know that today's session was a little intense at times, and I thought I should rehash some of the arguments for bottom-up betas and some basic estimation questions.
Why use bottom-up betas instead of regression betas?
There are three arguments. The first and most persuasive one is that bottom-up betas are more precise than regression betas. By averaging across a large number of regression betas, you reduce the standard error of the estimate. If beta estimates for individual firms are uncorrelated with each other, the savings in standard error can be written as follows:
Standard error of average = Average standard error across betas/ Square root of no of firms in sample
The savings will be smaller if the beta estimates are correlated, but they will still be there; the more firms you have in your sample, the greater the savings. The second and almost as persuasive an argument is that you can reflect your firm's current business mix and current financial leverage. A regression reflects your company's mix over the last 5 years whereas you determine the weights to use in a bottom-up beta.The third is that it allows you to estimate betas for divisions, which you cannot do with regression betas.
Do you give up something when you throw away the regression beta for the firm? Yes. You do throw away some firm-specific information but much of this information should not affect beta anyway; beta measures market risk and not firm-specific risk. In other words, given a choice between two imperfect estimates - a bottom-up beta where you may have made errors in identifying comparable firms and a regression beta where you have a very large standard error - I would take the former over the latter. Note that this is true even if your firm is in only one business.
Notwithstanding their greater precision, bottom-up betas will still give you estimates of the true beta and you will still make mistakes. Keep your perspective, though. If you can estimate the cost of equity to the nearest percentage point, you are doing well. Thus, if your true cost of equity is 10.4% and you estimate it to be 10%, the world will not end. In fact, even if you could come up with a way of estimating the cost of equity to the second decimal point, you have to ask yourself whether it is worth substantial effort. The precise cost of equity that you estimated can very easily shift in five minutes if the riskfree rate and the risk premium change.
What are comparable firms?
You can define comparable narrowly and look for firms just like yours not only in terms of business but also in terms of size but you run the risk of having a very small sample. You can define comparable broadly and come up with a larger sample. Again, I think that the trade off favors the latter over the former. If you are in a small market (say Portugal or Greece), you should go outside your market to get regression betas.
How do you get the betas for the comparable firms?
You run regressions for each firm against a market index. Optimally, you would use the same index (say the MS Capital Index) and monthly returns for each firm's regression. As an approximation, though, the betas estimated against different indices using different return intervals (say weekly) can still be used as long as you have a large sample.
Once you get the betas, how do you get an unlevered beta for the business?
You first average out across the firms in the business to get an average levered beta and then use the average market debt to equity ratio (If there are outliers, you can aggregate the debt and the market equity of the comparable firms and compute one debt to equity ratio) of the comparable firms to get an unlevered beta. You should use the average tax rate of these comparable firms as well. (There is nothing wrong in theory with unlevering each beta but it can result in strange numbers if the beta is misestimated in the first place.)
Should you use simple or weighted averages?
Again, there is no conceptual or theoretical answer. Empirically, you get bigger savings in standard error if you use simple averages. Another reason to avoid using weighted averages is that your betas reflect those of the largest companies in the sector rather than the average company. Thus, Microsoft's beta will become the beta for the software business.
Can you adjust bottom-up betas for different operating leverage?
You can, as long as you can get data on the fixed and variable costs for every firm in your sample. If you can, you can break the unlevered beta down further into a business beta and an operating leverage effect:
Unlevered Beta = Business Beta (1 + (Fixed Costs/ Variable Costs))
Note that this looks just like the financial levered beta equation with one difference. Since both fixed and variable costs are tax deductible, there is no (1-t) attachd to this equation.
Once you get bottom-up betas, how do you weight the different businesses you
have in your firm?
Optimally, you should use value weights but what you usually have available is either operating income or revenue by business. You can multiply these values by a typical multiple at which firms in the sector trade at to get an estimated value. For instance, if you have revenues of $ 1 billion for your chemical firm and chemical firms typically trade at (this is the value of equity + debt) at 2.5 times revenues, your estimate of value for the chemical division will be $2.5 billion.
Until next time!
October 11, 2007
As you prepare for the quiz, let me tie up a few loose ends.
1. If you remember, we started the class on Wednesday with an analysis of the beta for Disney after its acquisition of Cap Cities. 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 option 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)
Debt after the merger = 615+3186 + 18500 = $22,301 million ( Disney has to borrow $18.5 billion to buy Cap Cities Equity)
Equity after the merger = $31,100 (Disney's equity pre-merger does not change)
D/E Ratio = 22,301/31,100= 0.7171
Levered beta = 1.026 (1+ (1-.36) (0.717)) = 1.49
Note that I used a marginal tax rate of 36% for both companies - that is where the 0.64 on the page 143 comes from.
2. I have attached the review presentation for the session on Friday. The time for the review session has changed because something else is scheduled for the room from 12.30. The review session will be from 11.15-12.15 in Schimmel Auditorium. It will be webcast. I will also be in my office for an hour before the review session and right after the review. I have a meeting at 1 pm that I have to go to.
3. As you start working through past quizzes, you will find that the last question - about betas and what happens after firms restructure - is always the toughest one. A couple of suggestions that may ease your passage. First, separate the effects of changes in business mix from changes in financial leveral. For the former, you work with unlevered betas and firm values. For the latter, you look at debt to equity ratios. For instance, divesting a business changes your business mix because it replaces an operating asset with cash. Paying that cash out as a dividend will affect both your business mix (by taking cash out of the business) and reducing your equity.
4. I know that even Schimmel will feel a little cramped for the quiz, for a class of this size. I have been able to gain access to a second room nearby ( ). The seating assignment for the first 30 minutes on Monday are as follows:
If your last name begins with Go to
5. Remember that there is regular class after the quiz in Schimmel...
October 12, 2007
I know that many of you are working today and were unable to get to the review session. The webcast (and presentation) for the review session are now up and running and you can find the link and the presentation by going to
I have also attached the analyses of actions (the very last page of the review packet) to this email. Take a look at it when you get a chance.
One final question that seems to bedeviling those working through past quizzes is the interplay between debt to capital and debt to equity ratios. Here are a few things to keep in mind:
a. The debt to equity ratio = Debt/Equity whereas debt to capital = Debt/ (Debt + Equity)
b. If you are given one, you can always back out the other. In other words, if the debt to capital ratio is 20%, you have debt of $ 20 for every $ 100 of capital. That must mean that you have $80 in equity. The debt to equity ratio is therefore 20/80 = 25%/ If you have a debt to equity ratio of 50%, you have debt of $ 50 for every $ 100 in equity, which will give you a debt to capital ratio of 50/(50+100) = 33.33%.
c. The problem will usually specify whether you are given a debt to equity ratio or a debt to capital ratio. If I am excessively casual and just say debt ratio, I mean debt to capital.
Also use the financial balance sheet that I talked about in the review session for all the restructuring/merger problems.
One final note. The two TAs have very kindly agreed to have office hours over the next three days to help those in need. Anurag Poddar (firstname.lastname@example.org) will be in tomorrow from 4-5.30 in KMEC 7-158. Alberto Bonilla (email@example.com) will be at the KMEC fourth floor rotunda from 9-10.30. Please come bearing gifts for them (capuccinos, uppers and downers (as needed), cash (with a beta of zero)). They are gong well beyond the call of duty. Do not try to kidnap them and torture them to find out what is on the quiz. To protect them, I did not send them the quiz in advance. However, they both did ace the quizzes that they took in the corporate finance class last semester...
I hope you get a chance to look at the review, work through a few problems and get a good night's sleep. See you on Monday at 10.30.
October 12, 2007
The quiz is Monday from 3.30 -4 (I made a mistake on the last email on the time..) Please do review your seat assignments for the quiz.
October 12, 2007
I don't mean to bury you in emails today , but a few final notes before the weekend. First, the latest newsletter is attached. It is very unlikely that you will even open if, but I am obsessive about getting these newsletters out anyway. Second. I am still getting a few straggling emails about the 5.5% in prior quiz solutions. Rather than repeat what I said in the review session today , I would direct you to the review session webcast, where I did deal with the question. Third, I seem to be getting emails from a lot of you offering to trade Buenos Aires for Berlin, Mumbai for Beijing and Toronto for Timbuktu... I am sure this has to do with your study abroad options but I will not be switching with you... . Finally, for those of you who are not reading my emails all the way to the end, the seating assignment for the quiz is as follows:
If your last name begins with Go to
Nothing more to add... Have fun this weekend!
October 13, 2007
Well, I guess I have pretty much ruined your weekend and I am sorry (Not really
but even fake remorse is better than no remorse at all..) Anyway, hope that
the quizzes a re getting a little easier as you keep at them and that the skies
are starting to open up.. In fact, the theme for this song should be emerging:
Do hold out one exam and take it in real time (without the solutions next to you). Relax and don't stress out too much! Until Monday!
October 14, 2007
Two quick notes. The first relates to adjusting betas for cash. As some of you have noted, the way we adjusted betas for cash, when computing the bottom-up betas for Disney's individual businesses was by dividing the unlevered beta by (1- Cash/ Firm Value). In the quizzes, in a couple of problems (LaPlace and Apocalypse Inc), the unlevered beta for the company is computed as
Unlevered beta for the company = Unlevered beta for business (Steel, whatever) (1- Cash/ Firm Value) + Unlevered beta for cash (0) (Cash/ Firm Value)
Here is how you resolve any confusion. In the Disney example, we had the unlevered betas for the comparable companies and were trying to estimate the unlevered beta for the business. To do it, we had to divide the unlevered beta of the company by (1- Cash. Firm Value)
In the examples in the quizzes, you are given the unlevered beta for the business and trying to estimate the unlevered beta for the company...
On a different note, I know that you are busy doing other stuff, but save this article to read later (after the quiz)!
BUSINESS | October 14, 2007
Fair Game: The Owners Who Can't Hire or Fire
By GRETCHEN MORGENSON
Why is it so hard for investors to have a say?
Hope the link works.. Otherwise, you will have steal a copy of the Sunday Times and look at the front page of the Business section.
October 16, 2007
Your quizzes are done and can be picked up on the 9th floor, at the entrance of the Finance department (KMEC(,,, As you come of the elevator, walk straight towards the doors and look to your left before you go through the doors. They will be on the ground. To preserve confidentiality and prevent chaos, please try to do the following:
1. I graded all the quizzes. Please do not go to the TAs, if you have issues. They are completely innocent.
2. The quizzes are in neat piles and in alphabetical order. Once you take your quiz out, please leave the pile in good order.
3. The quizzes are face down to preserve a modicum of confidentiality. Please do not browse, review or edit the quizzes of your compatriots. This is not a book store...
4. Once you have your quiz, check against the solution that is attached to this spreadsheet. Note that there are two solutions, depending on which quiz you got. The easiest way to tell is to look at the name of the acquiring company in problem 3. If it is Patilla, you have quiz A. If it is Suave, you have quiz B. . I have listed the points I have taken off for different errors and have tried to stay consistent...
5.The distribution is attached. Please take the grades with a grain of salt. This is 10% of a much bigger assessment.
6. Unlike the Pope, I am fallible. If I have screwed up on grading your quiz, and it is entirely possible that I have missed some critical insight you had or an assumption you listed, please don't stew about it. Bring your quiz in and I will fix my mistake.
(The exams, solutions and distribution are also online in the website for the class) I will be in this afternoon, though I have a few phone calls to make and meetings to attend... Until next time!
October 16, 2007
Now that you have had a chance to pick up your quiz (you have, haven't you?) and gone through the requisit celebration/ mourning period, it is time to get back to work. Let's talk about bottom-up betas. Here are the basis steps involved in estimating them:
Step1: You have to get a breakdown of the businesses that your firm is in. You can get this by downloading your firm's 10K from the SEC web site.
Once you have it, browse through it (I would say read it but that would be a painful exercise) to find the breakdown of your firm's business. Usually, the company will give you at least revenue and operating income by business. If you have a non-US company, you should be able to find this information in their annual report. Also keep in mind that your firm may be in only one business. You can still estimate a bottom-up beta for that business.
Step 2: Estimate bottom-up unlevered betas for each business. There are four
routes you can follow, depending on how much time you are willing to spend
on the process-
a. The Easy Route (5 minutes): You can use the unlevered betas that I have computed by business on my web site. You can get to it by going to updated data and looking for levered and unlevered betas by business- I have them as separate datasets for the US, Europe, Emerging Markets and Japan. The advantage is that it is easy to do... The disadvantage is that you will not get the wonderful experience of doing it yourself and the breakdown may not be detailed enough for you.
b. The Slightly more involved route (20-30 minutes) : At the top of the updated data page, you will find the complete excel datasets of the 20000+ companies that I used to construct the industry average tables. You can download the datasets (Do it on a high-speed line because it is a very large dataset) and then create your own group of comparable firms. All of the raw data on the company is provided - betas, debt, equity and cash - and you have to construct your own unlevered beta. Try it if you have a chance.
c The online way (5 minutes) : Go the Reuters web site;
Enter the symbol for your firm and check the ratios (look under the symbol). One of the numbers that they report is the beta for your company and the betas for the industry and sector (they have their own categorization). The beta they report is a levered beta but on the same page, they report a book debt to equity ratio and a price to book ratio. You can compute an average debt to equity ratio for the industry by dividing the book debt to equity by the price to book...
Market debt to equity = Total debt to equity/ Price to book ratio
Since the tax rate is reported for the industry, you can compute an unlevered beta. The problem with this approach is it is difficult to do this for multiple businesses but it works if you have a single business company.
d. The Bloomberg Way (30 minutes - 2 hours, depending) : After all, real finance mavens use Bloomberg. You can get the information to estimate unlevered betas by getting on a Bloomberg terminal and typing QSRC. You can then screen across markets and industries to pick firms in particular markets. Once you have your sample ready, you can modify the output page to contain the information you need - betas, debt, equity, cash and tax rates, for example. The advantage is that you can do this for non-US stocks. The disadvantages is that Bloombergs are notoriously user unfriendly and you can get only a paper printout. (We don't pay enough for a download function)
Step 3: Compute the values of each of the businesses that your firm is in.
I would recommend using revenues as the starting point. If you are not comfortable
using pricing ratios, weight the businesses based on revenues. If you would
like a more precise estimate, go back to the comparable firms you pulled up
in step 2 and compute the value to sales ratio for the industry
Enterprise Value to Sales = (Market value of Equity + Debt - Cash) / Revenues
Multiply the revenues from each of the businesses by these value to sales ratios to get estimated values, and use them to compute weights.
Step 4: Compute a bottom-up unlevered beta for your company by taking a weighted
average of the betas in step 2 with the weights in step 3..
Finally, I have attached a document on bottom-up betas that tries to answer pretty much every question you may have on the topic.
Until next time!
October 18, 2007
I know I am probably running way ahead of you on the project, but save this email and look at it when you get back to working on the project. In this email, I want to review some of what you will need to do to come up with a cost of debt and estimates of market value for debt and equity:
1. Get the raw data on interest bearing debt: In particular, take a look at the balance sheet and identify the interest bearing debt. It is not always easy to do since you will see ambiguous items such as long term liabilities. Include both bank loans and corporate bonds, short term and long term debt. (It is possible that your firm has no debt. Don't ruin your eyes looking for something that does not exist. A clue that your firm has no debt will be in your income statement if your interest expenses are zero).
2. Collect lease commitment data: For US companies, the lease commitments (if any) should be in a footnote. The current year's lease payment will be in close proximity. These lease commitments are also called rental commitments....
3. Check to see if your company is rated by S&P or Moody's: If you have access to a Bloomberg terminal, you can do this by clicking on CORP and then typing in the name of your company. If noting shows up, you don't have a rating. If something does, you can click on any of the bonds and look up the actual rating.
4. Get a synthetic rating: For firms without a rating, this will be your primary basis for estimating the cost of debt. For firms with an actual rating, it will give you a basis for comparison. You can continue to use the actual rating, but be aware of the synthetic rating as well. I have attached a spreadsheet that will do dual duty - estimate the synthetic rating and convert lease commitments into debt for you... It also gives you the default spread to use with the rating and thus the pre-tax cost of debt for your firm. Just make sure that the riskfree rate you are using is the same 10-year default free rate you used earlier on your cost of equity (Thank you...thank you... I aim to please)
5. Estimate the market value of the interest bearing debt: To do this, you will have to figure out the average maturity of the debt. This will not be given, but there should be a table in the footnotes specifying when the debt comes due. Enter the face value of the debt coming due in 1 year, 2 years etc... and take a face-value weighted average. The process of computing the market value of debt is simple. To do so on your financial calculator, do the following:
a. Clear the registers (Sorry about stating the obvious...)
b. Enter the Financial model
c. Enter the following numbers in your PV mode:
FV = Book value of debt from step 1
PMT= Interest expense in most recent year
n = Average maturity of debt
r = Pre-tax cost of debt for your firm from step 4
Hit the PV button, and presto... you should have market value.
6. Get a marginal tax rate to use on your cost of debt: I have attached a link to the page on my website that has the marginal tax rates by country
One final note... I had mentioned that I would not give the case out until Monday but I have had a few emails from people who are anxious to get started. While the printed version will not be given out until Monday, the case is available for you to download online right now. So, if you really, really want to get started, go for it!
Until next time!
October 20, 2007
I know that you have lots of other stuff on your plate right now and are not really thinking about corporate finance (I find that hard to believe but then again, I am biased..) In case you fascination with corporate finance leads you to crack open the case, here are a few suggestions on dealing with the issues.
a. Do the finite life (10-year) analysis first. It is more contained and easier to work with. Then, try the longer life analysis. It is trickier...
b. If you find yourself lacking information, make reasonable assumptions. Ignoring something because you don't have enough information is not a good choice.
c. I think the case is self contained. For your protection, I think 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 apparel business, Nike's social problems and Michael Jordan, 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 you 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 a risk premium, for instance.)
d. There are accounting and tax rules that you violate at your own risk. For instance, investing in production capacity 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.
e. There is no one right answer to the case. No two groups will 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.
f. Much of the material for the estimation of cash flows will be covered in the next 3 sessions. 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.
g. Do not ask what-if questions until you have your base case nailed down. In fact, shoot 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...
Until next time!
P.S: The newsletter for this week is attached...
October 23, 2007
So, did you get a chance to look up Winston Groom online? Just to show you that I am with it, I have attached his Wikipedia page.
I am thinking of going in and adding a section on how he trusted accountants and paid a price for it.
The next thing I wanted to mention relates to the Disney theme park investment that we introduced in class. We worked our way to the return on capital numbers, but there are a lot of numbers. You can download the excel spreadsheet containing all of the numbers for this project by going to
You will see the spreadsheet under chapter 5. Download it and take a closer look at the numbers.
As for the case, I screwed up and forgot to put the box with the copies outside my office before I bolted yesterday. They are out now. I apologize profusely and will lash myself until I bleed - just like the house elves in the Harry Potter books. Another screw up in the case itself. The lease commitments are provided for the next 5 years. As the case reads right now, the first year is 2008, the second year becomes 2007 and then strange things happen thereafter to the years. I have not found the secret to reversing time and I blame Microsoft Word's auto numbering system for this. I have forwarded the complaint to the EU and requested that the software engineer responsible for this feature in Microsoft be quartered and forced to listen to Britney Spears singing "Oops, I did it again" over and over again. The years should actually read
Year Lease commitment
2009 220 million
2010 183 million
2011 157 million
2012 128 million
Beyond 587 million
Mea culpa ( It is so much easier saying I am sorry in Latin...)
October 23, 2007
Hi, I know that you are busy and I am sorry to add another to-do to your list
but this should not take more than a few minutes to do before tomorrow's class.
I would like you to compute the return on capital for your entire company.
To do this, here are the numbers you need
1. Operating income for the most recent financial year (Not Net Income)
2. Marginal tax rate for the country your company operates in
3. Book value of equity (shareholder's equity) number for the previous year (This will include paid-in capital, retained earnings...)
4. Book value of interest bearing debt for the previous year
Thus, if your most recent financial year is 2006, you should look up operating income for 2006 and book value of debt and equity at the end of 2005.
The return on capital is computed as follows:
Return on capital = Operating income (1- marginal tax rate)/ (Book value of debt + Book value of equity)
You can also compute it with cash netted out of the denominator. If you succeed at doing this, please bring it to class with you tomorrow. Until next time!
October 25, 2007
I plan to make this email a general one about computing capital invested, the meaning of return on capital and the use of pre-debt versus after-debt cashflows. I am sure you will read the sub-text for implications for the Nike case...
1. Measuring Capital Invested : We looked at return on capital in two contexts yesterday . One was to compute the return on capital for an entire firm and the other was in computing return on capital for a prospective project. The way we compute return on capital and how we use it is different under the two scenarios:
a. Return on capital for an individual project:
How it is computed : The return on capital for an individual project is computed using the projected operating income after taxes in the numerator and the projected capital invested in the project in the denominator. To compute the former, you subtract out operating expenses, including depreciation and allocated expenses, but not financial expenses (such as interest expenses on debt or lease expenses) from revenues; you multiply this number by (1- Marginal tax rate), since the project adds operating income at the margin to estimate the after tax operating income. To compute the latter, you want to stay focused on only the capital investments made in the project. In general, the capital invested in any year can be computed by taking the capital invested at the beginning of the year and adding to it any new capital expenditures made during the year and subtracting out the depreciation expense for the year. If there are working capital investments made, I would that to capital invested as well. For instance, take the Disney theme part example from yesterday . We started with $ 2.5 billion in capital invested at the start of year 1; during the year, we made an additional $ 1 billion in new capital expenditures to arrive at an ending value of $3.5 billion. In year 2, things get messier because depreciation and working capital make their entrance:
Capital invested at the beginning of year 2 = $ 3.5 billion
Capital invested at the end of year 2 = Capital at start + New Cap Ex (including maintenance cap ex) - Depreciation + Change in WC = 3500 + 1269 - 537 + 63 = 4294 (New cap ex is 1000, maintenance cap ex is 50% of depreciation and thus 269; there is some rounding error)
Note that there is no retained earnings or traditional double entry stuff. Projects don't have balance sheets. Any excess cash from the project goes to the company and does not build up within the project.
You have a choice of computing return on capital based on just the capital invested at the beginning of the year or the average for the year. I used the average for the theme park.
How it is used : The return on capital is a return on the overall investment in a project and is compared to the cost of capital for the project. If the return is greater, the project looks good (at least on an accounting basis)
b. Return on capital for the entire firm
How it is computed : The return on capital for an entire firm is computed using the after-tax operating income of the firm and the capital invested in all of its existing assets. To measure the former, we usually start with the operating income in the most recent year and apply a tax rate to it. Since this is the entire operating income for the business (rather than income added at the margin), using an effective tax rate is defensible albeit dangerous if the effective tax rate is volatile; I prefer to use the marginal tax rate here as well to compute the after-tax operating income. To measure capital invested in existing assets, I go to the balance sheet and look up the book value of debt and equity in the firm, making the assumption that this must be the capital invested in the assets that generate the operating income. If the company had a substantial cash balance, it makes sense to net this number out of the book value, because cash does not generate operating income.
Return on capital for a firm = EBIT (1-t)/ (Book value of debt + Book value of equity - Cash)
Here again, you have a choice of using the number from the beginning of the year or an average.
How it is used : You can compare a company's return on capital to its overall cost of capital. If it is higher, the company, on average, has taken good investments. If lower, it has destroyed value. The caveat, though, is that you are trusting accounting estimates of earnings and capital invested.
2. Capital, Equity and Mismatching: The key to good investment analysis and
to consistent valuations down the road is to first match cash flows to discount
rates and to avoid double counting items. Thus, in the measures of returns
above, we used operating income and compared the resulting return on capital
to the cost of capital. Here is a simple table on consistency:
To Earnings measure Accounting Return Cash Flow Measure Discount Rate/Hurdle Rate used
Firm Operating income after-tax Return on capital Cash flow to firm (before debt payments) Cost of capital
Equity Net Income Return on equity Cash flow to equity (after interest and principal) Cost of equity
The return on equity is based on book equity invested in a project or a firm, as opposed to book capital.
Hope this has been helpful (or at least not hurtful)! Until next time!
October 26, 2007
I know that you are working on the case and that it is eating up your time. Rather than waste your time with an endless email, let me suggest a few things you should keep in mind:
a. A ssumptions are not explici t: If assumptions are not explicit (growth after year 12, capital maintenance etc.), it is intentional. I want you to make reasonable assumptions when faced with uncertainty.
b. Excellitis : It is easy to get sucked into the inside details of a spreadsheet and lose sight of the big picture. At regular intervals, step back and look at what you are doing. Remember that your mission ultimately is to tell Nike whether they should invest (not churn out a bigger spreadsheet) in this expansion or not...
c. T hink like a business person : Assumptions are easy to make in Excel. Increasing the growth rate or lowering costs is trivial on a spreadsheet. Ask yourself the operational question of what you would need to do to pull this off in real life.
And relax! There is no one answer that you should all be getting. So, don't compare your numbers with those from another group... Until next time.
P.S: The beta stated in the case (0.67) is different from both the raw (0.55)
and adjusted betas (0.70) on the Bloomberg printout. Do not read anything profound
into the differences. They reflect differences in time. I wrote the case a
week before I printed off the exhibits and used the beta on the description
page in the write-up. By the time I printed the beta page, the numbers had
changed slightly. The beta in the case is the adjusted beta for Nike.
P.S.2: I screwed up on point 7 when I projected out capacity usage in year 2. It should be 66.15% (not 66.3%)...
P.S.3: The newsletter for this week is attached.
October 27, 2007
I know.. I know.. The last person you want to hear from. Just as a break from building Excel spreadsheets and tearing your hair out, I thought I would forward you this from Vijay Bachani, Stern alum and an old student:
From Vijay's email:
Hope all is well. I see that they have you teaching the undergraduates as well as the graduate students. I was wondering if you could do me a favor and forward the links below to all your students (graduate and undergraduate). Our subsidiary company, Clear Indexes, is running an ETF competition which is currently aimed at students of NYU, Columbia, and Lehigh University. It is a great chance for students to learn about ETFs and the top prize is $4000 as well as a paid internship at our company. Below is a link to today’s article in Marketwatch as well as a link to our company’s website talking about the contest. If your students have any questions they can email firstname.lastname@example.org.
October 28, 2007
From the torrent of emails I have been getting and deflecting this week, I am fully aware that there are some things in the case that are not explicitly addressed. In fact, let me save you the trouble and list all the things that I have left as loose ends:
1. In the case where the project lasts longer than 12 years, how much longer? (20 years, 30 years, forever...)
2. In the case where the project lasts longer than 12 years, what is the growth rate after 12 years? (no growth, inflation rate, higher than the inflation rate..)
3. What is the maintenance cap ex?
4. How many years of lease payments are in the "beyond year 5" in Nike's leases?
I have left the last one unanswered because that is the way Nike and all other companies report their lease commitments in the US. The number reported is a nominal value and you have to make a reasonable assumption about how many years are in there (It is not a total guess, since you do know what the lease commitments look like in the first 5 years). I have left the first 3 unspecified because this is where a combination of common sense, basic accounting and your understanding of capital budgeting will come into play. While there are a range of reasonable answers you can come up with to each question, what matters more is whether you are internally consistent in how you answer the three questions. That is about as strong a hint I can give and no more...
It is true that I could have given you explicit assumptions for all of these. That would saved both you and I a lot of trouble, but made this a pure exercise in modeling. While that is a useful skill, working through to an answer, torturous though it feels right now, is a fare more valuable exercise. So, I feel your pain...
October 30, 2007
Yesterday's webcast is missing one key component - audio. I have been in conversations with the media people all day and they have concluded that there has been a fatal error... i.e. there is no chance that they can retrieve the audio. You have three choices:
1. Watch the webcast and see how good your lip reading skills are.
2. Read the lecture notes/text book and come and talk to me if you have any questions
3. Watch this webcast from last semester that covered roughly the same pages
I am sorry about the screw up. I will promise you that it will not happen again but I have no way of ensuring that...
October 31, 2007
I know that you are busy and I will try to keep this short and it is pertinent to the case. As you work through the numbers, here are some suggestions for formatting the case report.
1. Cover page: Please include the following
- Names of group members (in alphabetical order: it makes my job of entering grades easier)
- Cost of capital used for project analysis
- NPV, IRR and ROC (for finite life case)
- NPV (for infinite life case)
- Recoomendation: Invest in this business or Don't invest in this business
2. Written analysis: Please keep brief, summarizing your numerical findings, key assumptions and backing for your recommendation. Please make a hard copy of the analysis....
3. Base Case analysis: Full print out of your forecasted earnings and cashflows by year, including details on individual items (G&A, Capacity etc....)
4. Any what-if analysis, scenarios and graphs you want to add on.....If you are interested in emulating Tufte (remember the Napoleon fiasco... ), you can find the graph online by going here:
You can also find the book on Amazon.com.. The title is "The Visual Display of Information". He has another book that claims that Powerpoint makes you stupid (but I would not read that while you are taking a class where you see 550 slides...)
As a general rule, if you do not reference an item in the appendix in your written analysis, please have mercy and do not include it... Until next time!
November 2, 2007
I won't take up too much of your time but I want to clear up some questions that seem to be coming up repeatedly over the last few days. Since they have more to do with mechanics and less to do with concepts, I will try to answer them so that you can move on to the big questions:
1. What is the difference between the sunk cost treatment in the Disney and Nike cases?
In the Disney case, the expenses already incurred pasted the tax rule requirements to be treated as capital expenditures. Hence, they were part of book capital and affected return on capital. The Nike case explicitly states that the test marketing expenses are not only sunk but have already been expensed. Hence, they will not enter the capital invested computation.
2. How do we compute capital invested each year?
The capital invested each year represents the aggregation of three items: (a) Capital expenditures made during the year increase capital invested (b) Depreciation during the year reduces capital invested (c) Working capital investments are part of capital invested. If you look at my email from October 25, I describe how I computed capital invested in the Disney case.
3. Do capital maintenance expenditures affect capital invested?
Absolutely. That is the essence of capital maintenance. It is true that this creates some measurement issues, since depreciation in subsequent years will be affected by capital maintenance this year. Try to keep your analysis from spinning out of control by making simplifying assumptions.
4. If we have to make an investment in distribution capacity, how do we allocate the cost to the apparel project?
Allocation is an accounting judgment (not a corporate finance one). Think like an accountant and allocate based on something tangible (revenues, operating income). While you consider how best to allocate, also keep in mind that allocating items affects operating income but has no impact on cash flows. If your final decision is going to be based on incremental cash flows and not return on capital, your allocation judgment may not make an iota of difference on it.
5. Is the investment in distribution capacity a capital expense?
Yes. While it may be better for your cash flows (and easier on you) to expense the investment, that is not a choice that you can make. When you invest in capital assets, you have to treat it as a capital expense. This will of course also mean that you have to assume a life for the capacity (my advice is to give it a long life) and a depreciation method (keep it simple and use straight line).
6. What happens if I get a negative NPV?
Reject the project. Not all projects are good projects.
7. What happens if I get a negative IRR?
It can happen (but I would check the numbers).
On a personal note, I have to be on the road starting at about noon today and will not be back until Sunday night. I will try to check email when I am away but if you do not hear from me, it is because I am a secret location.
November 4, 2007
I am sorry for some of the terse responses you have been getting to your emails this week. In addition to being in a secure location, I also was using my Blackberry, and my typing skills on that device are awful... Anyway, i hope that you are putting the finishing touches on your case... I would like you to do me a favor, if you get the time tonight or even tomorrow morning, could you please fill out the attached excel spreadsheet with the final numbers from your analysis? (It should take only a minute and asks for the following - your cost of capital, your ROC, your finite life NPV (in millions), your infinite life NPV (in millions) and your project decision (accept or reject)). I will pulling these spreadsheets together before class tomorrow. Thank you!
November 5, 2007
I know that you are still recovering from your case work, but file this email
away under "No rest for the wicked". Anyway, here are some details
on the second quiz:
1. What will it cover?
It will cover the parts of chapter 4 that we did not cover on the first quiz (cost of debt, estimating market value of debt, leases and cost of capital), chapter 5 and chapter 6 (other than the option parts). Another way of thinking about what it will cover is to think of what you did on the case.
2. When is it?
Day after tomorrow in the first 30 minutes of class (3.30-4). Open book, open notes.
3. When is the review session?
Tomorrow, from 11-12 in Schimmel. I know that many of you have other classes at the time. Please do not miss those classes for the review. It will be webcast by 1 pm.
4. Where is the review presentation?
It is included with this email.
5. What should I focus on for the next 48 hours?
Try working through past quiz 2s.... they cover pretty much what this quiz will cover.
6. Where should I go for the quiz?
The quiz will be spread across three rooms:
If your last name starts with Go to
A-F, M-Z Schimmel
Until next time!
P.S: You can turn in your case analysis at the beginning of class. No need to make a special trip to my office, if you do not want to.. If you do, not a problem either...
November 5, 2007
A very quick note before you get back to work on the quiz. The case solutions are up online as is the presentation or the case... You can get to them by going to the following site:
Until next time!
November 6, 2007
The review session is online and can be accessed by going to
Note that the server that holds the webcast can accomodate only 50 viewers at a time. If you have trouble accessing the webcast, it is because dozens are trying at the same time... Wait a little while and try again... Until next time....
November 6, 2007
I have put most of the cases in front of the doors to the finance department and you can pick the up (Same place as the quiz). Two notes of caution. They are in no specific order (since it is tough to alphabetize by group). There is also a single sheet inside each case with short notes on the grading. Please don't make a complete mess of the cases and let your group members know when you have picked them up.
P.S: I have about a dozen cases that I am still grading. If you don't see your case, that may be the reason... I promise by tomorrow morning...
November 6, 2007
I hope that you have had a chance to pick up the quiz and share the news with your group. As I mentioned in my last email, I have the last dozen with me and will not be able to get them to you until about 9.30 tomorrow morning. I am sorry! Anyway, here are the answers to some questions about the case, with relevance to the upcoming quiz as well:
1. What was the average grade on the case?
The average grade was between 8 and 8.5... There were only a handful of perfect cases (I think there were 4 out of 72).
2. I don't understand why we lost points on the case.. Can we come talk to you?
I tried to make the grading on the case as transparent as I could make it.... If you feel that I have missed something, please do bring it to my attention.
3. How much is the quiz worth?
10% of your overall grade.
Turning to the quiz, here are some things to think about.
Here are some computational issues relating to the case that may also matter for the quiz:
a. How do we compute the market value of the debt?
Treat the book debt as if it were a bond, with the book value = face value, interest expenses = coupon payment and the average maturity of the debt = maturity for the bond. Use the pre-tax cost of debt as the discount rate, since you are discounting pre-tax interest expenses. You can do this on your financial calculator in one step or on your scientific calculator in two. In fact, it is a good exercise to take the numbers I have for Nike in the case and see if you can get the same market value ($606 million) that I did..
b. How do you convert operating leases to debt?
By discounting the lease commitments back to the present, again using the pre-tax cost of debt as the discount rate (you are discounting pre-tax lease commitments). As an exercise,
c. Are there different ways of dealing with the opportunity cost of the distribution system?
There are at least three ways of dealing with the opportunity cost that should give you equivalent answers.
One is to do what I did: show the negative cash flow of -1126 million in year 6 and the savings of +1243 million in year 11
The second is to take the difference between 1126 and the discounted value of 1243 (discounted back 5 years at the cost of capital) in year 6. This will give you a negative cash flow of -344 million in year 6.
The third is to discount both numbers back to the present and show the difference (1126 discounted back 6 years - 1243 discounted back 11 years = - $197 million ) in year 0.
The one thing you cannot do (even if coincidentally gives you the same answer) is allocate this expense.
Finally, if you do get a chance, click on the link below to remind yourself of the key components in the Nike case:
Sorry about the long email... Until tomorrow!
November 8, 2007
The quizzes are done and can be picked up outside the front door to the finance department. I am attaching the solutions (a, if you have Yahoo and b, if you have Microsoft) as well as the distribution. I also noticed that there were a few who missed the quiz without letting me know ahead of time. (If you miss a quiz and don't let me know, the quiz score is a zero. The rules were clearly specified up front and repeated several times during class...) Until next time!
November 9, 2007
I know that you are tired of corporate finance and need to turn your attention elsewhere. If you do have the time, though, please do try to get your project up-to-date. You should have the cost of capital for your company as well as have computed the return on capital for the investment analysis section. Next week. we will be beginning the next phase of both the class and the project when we start taking a closer look at the financing mix used by the company. In the meantime, the newsletter for this week is attached (and is online). On a completely unrelated note, I have had queries about the schedule for the final exam. The exam is scheduled for December 19 from 4-5.50 pm.
November 14, 2007
If you feel up to it, you can compute the optimal capital structure for your firm. Gather up your financial statements, cozy up to your computer and then do the following.
1. Go online to
Download the excel spreadsheet called capstru.xls and save it. If you are working on a financial service firm, you should download the other capital structure spreadsheet (capstruo.xls) For those of you are who have trouble, I am attaching the file, just in case...
2. Before you input any numbers, go into preferences in excel, open the calculation option and make sure that there is a check in the iteration box. This will allow excel to do what we did manually in class in terms of iterations.
3. Read the Read me worksheet in the spreadsheet
4. Go to the input page and input the numbers for your firm. Each input box has a comment in it. Read the comment before you input the value. You can start off using the most recent year's numbers but may want to come back and normalize some of the numbers (EBITDA) later.
5. Make sure you update the riskfree rate and risk premium to match up to what you have been using in the project so far.
6. For the moment, leave the answers to the last two questions on the input page at their default levels. (Yes and Yes)
7. Go to the output page. You should see the current and optimal debt ratio for the firm as well as the current cost of capital and the optimal cost of capital. You will also see the entire schedule of ratings and costs of equity for every debt ratio. I also calculate the change in value per share for your firm and do your laundry while I am it.... (Hey... What can I say? I am a full service operation)
8. If you find DIV/0 or VALUE! errors all over your sheet, go back to step 1... Sorry...
Here is the good news for those of you who are lagging on the project. This
spreadsheet will get you caught up with your hard working teammates.. I know
this violates the "little red hen" principle but better caught up
than not. For those of you who have no idea what management book, the "little
red hen principle" is in, here is a link:
November 17, 2007
Admit it... I did give you a respite for a couple of days, but I thought I should start my nagging again. I have attached the latest newsletter to this email. It contains numerous reminders that the end of the semester is fast approaching and that it is time to catch up on your project, if you have not already... Please, please do try to run the optimal capital structure spreadsheet for your company when you get a chance (If your reaction is "What optimal capital structure spreadsheet?", check your emails from Wednesday). I also want to note that we are sticking with classes on Monday and Wednesday, since my proposal for longer classes on Monday ran into some opposition. Until next time!
November 20, 2007
I hope you get a chance to try the optimal capital structure spreadsheet on your firm soon. (Some of you are having trouble getting marginal tax rates. There is a table on my website, under updated data, that lists marginal tax rate by country... Use it, if you are unable to find information on a marginal tax rate) Please try to enter the numbers for your firm into the spreadsheet (I promise you it is only a 15 minute process) and estimate the optimal debt ratio for your firm. If you get the optimal, try to also estimate or collect the following for your firm because it will help you explain why your optimal debt ratio is zero, low or high:
1. EBITDA / (Market value of equity + Market value of debt): This is a measure of the cash flow generated by your firm. Firms with a high ratio of cash flow to firm value should be able to sustain higher optimal debt ratios. This is the reason why Google's optimal debt ratio was only 10% whereas Conoco's optimal debt ratio was 80%. (In case you did not get the handout in class, I have attached it to this email.
2. Tax Rate: The higher the marginal tax rate for your firm, the higher the optimal debt ratio will be. If, like Carnival Cruise Lines and Ryanair, you have a low tax rate, you will end up with a low optimal debt ratio.
3. Variability in earnings at your firm: Take a look at your firm's history. If its operating income has been volatile (remember Aracruz from yesterday's class), you should be cautious about moving to the optimal. In fact, try doing what if analysis on the operating income and checking to see how your optimal debt ratio shifts. Alternatively, you can constraint the bond rating (to BBB or A) and see what your optimal would be.
If you can, do bring the following data items (from earlier sections) to class with you tomorrow. It will help close the deal.
1. Jensen's alpha for your firm (This should be in the risk and return section you did earlier)
2. EVA for your firm:
I do want to expand on how the spreadsheet deals with operating leases (for those of you working with retailers) and negative operating income:
a. Operating leases: If you enter "yes" to the operating leases question and input your operating lease commitments into the worksheet, I will incorporate the present value of your operating leases into your total debt. The actual debt ratio that you will see on the output page will then be inclusive of operating leases. The optimal debt ratio and all of the variables that drive it (bond ratings, betas) etc. will also be inclusive of operating leases. If the optimal debt ratio for Wal-Mart is 20%, this is the optimal with operating leases considered as debt.
b. Negative operating income: If your firm has an operating loss, your optimal debt ratio will be zero. While this is not surprising, you may find it uninteresting. There are two things you can do if you want to add depth to your analysis. The first applies if your firm had operating income in prior years but a loss in the most recent year. You can use the average operating income over the last 5 years to compute your optimal. The second applies if your firm has never made money and is more speculative. If your firm expects to make money in the near future (like next year), you can use the forecasted operating income to get your optimal.
That's it for now. If you will be in class tomorrow, I will see you there. If not, have a great Thanksgiving! Until next time!