Corporate Finance 5162

Corporate Finance 5162

Spring 2015

Professor:Don Cunningham, PhD

Office Hours:11:00-11:30 and 1:00- 3:00 T 11:00-11:45Th

9-11:30 on Wednesday before exam,

Other times by appointment

Office:Graduate Center

Homepage:

E-Mail:

Telephone:254-710-6152 (office)

COURSE MATERIAL

Textbook: Principles of Corporate Finance by Brealey, Myers, and Allen – Concise Edition or Ninth edition of non-Concise edition

BAYLOR UNIVERSITY HONOR SYSTEM

Ethics are an integral feature of all personal, social, and professional considerations. Competency in thinking ethically and accepting responsibility for one's actions is essential to personaland professionaldevelopment. Baylor graduates are committed to their intellectual, ethical, professional, and social development throughout life.

Baylor MBA students have affirmed their commitment to ethical and professional conduct specifically agreeing in writing to the following:

Affirmation of Expectations of Professional and Academic Conduct

Guidelines for Citations and References
Constitution of the Baylor University Honor System

CLASS ATTENDANCE

University policy concerning absenteeism is detailed in the Class Attendance section of the Student Handbook. The policy states: "A student who misses more than 25 percent of the class meetings of a course automatically fails." As per university policy: "The student bears the responsibility for the effect absences may have upon class participation, announced and unannounced examinations, written assignments, reports, papers and other means of evaluating performance in a course."

On-time attendance is required for all classes. Students must be in their seats and ready for class at the scheduled start time of the classin which they are officially enrolled. A late arrival to a class will be counted as an absence from the class and, therefore will be subject to the university absenteeism policy.

PLAGIARISM

Students agree that by taking this course, all required papers, exams, class projects or other assignments submitted for credit may be submitted to turnitin.com or similar third parties to review and evaluate for originality and intellectual integrity. A description of the services, terms and conditions of use, and privacy policy of turnitin.com is available on its web site: Students understand all work submitted to turnitin.com will be added to its database of papers. Students further understand that if the results of such a review support an allegation of academic dishonesty, the course work in question as well as any supporting materials may be submitted to the Honor Council for investigation and further action.

COURSE DESCRIPTION

This one-hour module continues the study of how firms should optimally select their investment projects. Because the firm’s projects and the firm’s stock are traded in markets with different levels of efficiency, the roles of efficient and inefficient market operations are discussed and compared. Nest we determine how firm’s should determine a project’s cost of capital for discounting project cash flows. This determination requires an understanding of how individuals should invest (portfolio theory) and how securities are priced (Capital Asset Pricing Model), which we investigated in FIN 5161. The module concludes with an introduction to derivative securities. Students investigate the difference applications of calls, puts, futures, and forwards, how they are priced, and how they are used in hedging strategies.

MBA LEARNING GOALS

The learning goals for the MBA program are:

1. To understand and apply theoretical knowledge in integrated fundamental areas of accounting, economics, finance, information systems, marketing, operations management, organization behavior, quantitative business analysis, and strategic management;

2. To think critically, to solve problems effectively, and make decisions strategically across functional areas;

3. To work collaboratively with others in cross-functional teams, and to motivate, lead, and mentor others;

4. To articulate ideas and information effectively and persuasively in every business context.

5. To apply core ethical values of integrity, accountability, and service in all circumstances.

COURSE OBJECTIVES

FIN5162 Learning Objectives:

To contribute to the achievement of the MBA Program Learning Goals cited above, the following learning objectives are established for FIN5162:

a)To recognize the essential elements of market efficiency and to understand the implications of market efficiency for developing sound management practices within publicly traded firms.

b)To derive an appropriate discount rate for use in a firm’s capital budgeting decisions (NPV analysis).

c)To understand the essential elements of derivative securities, their implicit leverage, and the variables that affect derivative prices. To relate the micro-level understanding of derivatives to a broader view of how the firm should be managed. Develop the ability to identify and evaluate derivative-like situations in business transactions.

Correlations between Course Objectives and

MBA Healthcare Administration SpecializationCompetencies

Objective(below) refers to specific Leaning Objective cited above

DOMAIN 2 – Critical Thinking and Analysis
1. Critical Thinking and Analysis: The ability to understand a situation, issue, or problem by breaking it into smaller pieces or tracing its implications in a step-by-step way.
Objective: b
2. Innovative Thinking: The ability to apply complex concepts, develop creative solutions, or adapt previous solutions in new ways. Objective: c
DOMAIN 3 – Business and Management Knowledge

Financial Skills: The ability to understand and explain financial and accounting information, prepare and manage budgets, and make sound long-term investment decisions. Objective: a

COURSE REQUIREMENTS

Exams:

Two exams are offered for this module; however, only the first is required. The first exam is comprehensive and is given at the end of the 5 week module. If you are satisfied with the grade on the exam, then it will determine 80% of your grade. If you are not satisfied with your performance on this exam, then you have the option of taking a second comprehensive exam one week later. If you take both exams, then the first counts 40% and the second counts 40%, for a total grade contribution of 80%.

Class Contribution:

Class participation counts the remaining 20%. At the end of the module I will assign a numerical grade for participation based on my assessment of whether you were:

Thoughtful and engaging with content questions = 90 - 100,
Responding to my questions = 85 - 90,
Asking other questions = 80 - 85, (better than no questions)
Present and taking notes = 75 -80
Not present = < 75

Your participation grade is lowered if you respond, read, send email messages during class or play computer games. However you are welcome to bring your computer to class for taking notes and performing other class related activities.

GRADING SCALE

A92 -100 pointsC+78-79

A-90-91 “C72-77

B+88-89 “C-70-71

B82-87 “D50-69

B-80-81 “F49 and below

DAILY CLASS SCHEDULE AND ASSIGNMENTS

Learning Objectives
TuesdayMarch 31 – How well Capital Market function, aka Market Efficiency (EMH)
Introduction to Market Efficiency
Aka Efficient Market Hypothesis (EMH)

Review historical perspective of EMH
Compare the characteristics of Perfect Markets to Efficient Markets
Conclude on causes for price patterns in Perfect versus efficient markets

Thursday April 2 – continue EMH

Devise three forms of the EMH
Identify three security analyst types and relate their analysis to the three forms of EMH
Conclude: What is the meaning of the phrase “Beat the Market”
Apply EMH principle to forecasting the weather

Discuss the paradox of efficiency, legality, and the purpose of Insider Trading Laws

Practice applying the EMH

TuesdayApril 7– How Managers useEMH and the CAPM

Equate LHS and RHS of Firm’s Balance Sheet to Portfolios
Critique GAAP-based financial statement issues
Critique tax issues with debt versus equity
Critique diversification issues
Evaluate the pricing efficience of LHS and RHS of Balance sheet
Assess quality of information from LHS versus RHS accounts
Formulate a Cost for Debt Capital
Formulate a cost for Equity Capital

ThursdayApril 9 – WACC Application

Devise Cost of Capital for the Firm – WACC model
Revise WACC model to adjust for accounting, taxes and diversification issues
Apply WACC model to evaluate Abbott’s Cost of Capital
Investigate extensions of CAPM to WACC
Devise solutions to practice exercises

Tuesday April 14 – University Holdiay (Diadelosa)
Thurday April 16 –Derivatives

Review Derivative terminology

Tuesday April 21–continue Derivatives

Develop graphical presentations of long call, long put, short call, short put
Explore investor motivations and expected returns for each derivative position
Compare a Call option to a levered investment with a numerical example

Tuesday April 23 – Combining Derivatives

Formulate a terminal Payoff matrix for single securities and single derivatives
Combine securities and derivatives and compare combination payoffs to single holding payoffs
Utilize a long stock and short call (s) combination to derive an option pricing model

Tuesday April 28 – Derivative Applications

Practice applying and pricing derivatives

Thursday April 30

Final Exam

Tuesday – May 5

Final Exams available for Review

Friday – May 8

Retake Exam or another time if scheduling conflicts

/ Textbook and outside Readings,
Simulation Exercises,
Projects, and practice exercises
An Interview with Eugene Fama (2010)
An Interview with Robert Shiller (2014)
Read a few articles from an internet search of “Fama wins the Nobel Prize.” You might add “Bloomberg” to your search phrase. They have a good summary article on the recent Nobel prize recipients.
Do an Internet search of Efficient Markets, or Eugene Fama. Also search for Behavorial Finance and read a few of the following articles
Visit information-packed website is maintained by IFA investment
advisory firm affiliated with DFA mutual funds. Investmentsand information are based on efficient market research. David Booth, DFA founder, endowed the University of Chicago business school with $300 million in 2008. He was a PhD student under Eugene Fama in the 1970’s.
Power Lunch video on Insider Trading at:

Marginal Investors (2014)
Why Actively Managed Funds aren’t Dead (2014)
Are Stock Prices Determined by Facts or Human Nature (2011)
Bull or Bear Marker? Technical Analysis – The Golden Cross (2012)
Legal Insider Trading (2015)
To Beat Index Funds, Luck is Your Best Hope (2009)
Index Funds Win Again (2009)
Can any Money Manager Beat the Market? (2008)
Economists Debate Market Efficiency (2004)
Prosecution of Mike Milken (1994)
Efficient to Behavioral Finance (2002)
The Man Your Fund Manager Hates (1999)
How the Really Smart Money Invests (1998)
Market Meets Technical Resistance – Moving Averages (12-2011)
The SEC's Fight with Itself (1987)
Ch 11: Q: 4, 6, 7, 8
PQ: 9, 10, 11, 14, 16
Chapter 11, Solutions
Chapter 9
How Firms Estimate Cost of Capital (2011)
AVG vs Geometric mean Returns - sprdsheet
Pure Play Method (2002)
Pick a publicly Traded company and use data from Yahoo finance, Morningstar, and Treasury.gov to calculate its WACC
ABT Bond Yields @ Morningstar
Treasury Yields @treasury.gov
ABT Balance Sheet @ Yahoo finance
Fama and French Three Factor Model

Average long-run returns (nominal)
Average long-run returns (real)
Handout #1
Handout #2
Data link for finding industry Betas :

Chapter 16, 17
An excellent tutorial on derivatives –
From Chicago Board of Exchange
Untangling the Derivatives Mess (1995)
CDOs in Plain English (2004),
Option Returns (2000),
Extraco Advertisement,
The Reckoning-How the Thundering Herd Faltered (2008)
Black Scholes Model
PQ 13,16,21,22,23,27
Ch 17 Q 6, 7
Sample Exam – FIN 5162
Sample Exam with answers

PROBLEM SOLUTIONS

Chapter 16

Chapter 17

Bibliography

Barber, Brad M., and Terrance Odean. 2000. “Trading Is Hazardous to Your Wealth.” Journal of

Finance 55 (April), pp. 773-806.

Black, Fischer. 1975. “Fact and Fantasy in the Use of options.” Financial Analysts Journal 31

(July/August), p. 36-41, 61-72.

Black, Fischer, and Myron S. Scholes. 1973. “The Pricing of Options and Corporate Liabilities.”

Journal of Political Economy 81 (May/June), pp. 637-654.

Daniel, Kent, and Sheridan Titman. 1997. “Evidence on the Characteristics of Cross Sectional

Variation in Stock Returns.” Journal of Finance 52 (March), pp. 1-33.

Desai, Hemang, and Prem C. Jain. 1995. “An Analysis of the Recommendations of the ‘Superstar’

Money Managers at Barron’s Annual Roundtable.” Journal of Finance 50 (September), pp.

1257-1273.

Ederington, Louis H., and Jae Ha Lee. 1993. “How Markets Process Information: News Releases

and Volatility.” Journal of Finance 48 (September), pp. 1161-1191.

Fama, Eugene F. 1965. “The Behavior of Stock Market Prices.” Journal of Business 38 (January),

pp. 34-105.

_____. 1970. “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of

Finance 25 (May), pp. 383-417.

Fama, Eugene F., and Kenneth R. French. 1992. “The Cross-Section of Expected Returns.”

Journal of Finance 47 (June), pp. 427-465.

_____. 2002. “The Equity Premium.” Journal of Finance 57 (April), pp. 637-659.

Fama, Eugene F., Lawrence Fisher, Michael C. Jensen, and Richard Roll. 1969. “The Adjustment

of Stock Prices to New Information.” Internaltional Economic Review 10 (February), pp. 1-

21.

Fama, Eugene F., and Marshall E. Blume. 1966. “Filter Rules and Stock-Market Trading.” Journal

of Business 39 (January), pp. 226-241.

_____. 1999. “The Corporate Cost of Capital and the Return on Corporate Investment.” Journal of

Finance 54 (December), pp. 1939-1967.

Fama, Eugene F., and Michael C. Jensen. 1985. “Organizational Forms and Investment

Decisions.” Journal of Financial Economics 14, pp. 101-118.

Gibson, Scott, AssemSafieddine, and RamanaSonti. 2004. “Smart Investments by Smart Money:

Evidence from Seasoned Equity Offerings.” Journal of Financial Economics 72 (June), pp.

581-604.

Goetzmann, William N., and Roger G. Ibbotson. 1994. “Do Winners Repeat?” Journal of Portfolio

Management 20 (Winter), pp. 9-18.

Graham, John R. 2001. “The Theory and Practice of Corporate Finance: Evidence from the Field.”

Journal of Financial Economics 60, pp. 187-243.

Lee, Dwight R., and James A. Verbruge. 1996. “The Efficient Market Thrives on Criticism.” Journal

of Applied Corporate Finance 9 (Spring), pp. 35-40.

Malkiel, Burton G., and William J. Baumol. 2002. “Stock Options Keep the Economy Afloat.” Wall

Street Journal (April 4), p. A18.

Merton, Robert C. 1973. “Theory of Rational Option Pricing.” Bell Journal of Economics 4 (Spring),

pp. 141-183.

Modigliani, Franco, and Merton Miller. 1958. “The Cost of Capital, Corporation Finance, and the

Theory of Investment.” American Economic Review 48 (June), pp. 261-297.

Myers, Stewart C., and Nicholas S. Majluf. 1984. “Corporate Financing and Investment Decisions

When Firms Have Information the Investors Do Not Have.” Journal of Financial Economics

13, pp. 187-221.

Ofek, Eli, and Matthew Richardson. 2003. “DotCom Mania: The Rise and Fall of Internet Stock

Prices.” Journal of Finance 58 (June), pp. 1113-1138.

Sharpe, William F. 1964. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of

Risk.” Journal of Finance 19 (September), pp. 425-442.

Shiller, Robert J. 1981. “Do Stock PricesMove Too Much To Be Justified by Subsequent Changes

in Dividends?” American Economic Review 71 (June), pp. 421-436.

Corporate Finance

Comprehensive Case[1]

Allete Energy Inc. (ALE) is considering an expansion into wind farms. Currently, natural gas is its primary source for electricity production. However, several executives think that a wind farm venture would offer valuable diversification benefits. Other executives believe they could exploit the company’s downstream customer channels to efficiently market wind-produced electricity. The Vice President of shareholder relations, however, is concerned that cash flow projections are volatile and might, in the short run, require a dividend reduction to assure the company’s overall positive cash flow position. She emphasizes that a dividend reduction could agitate shareholders and jeopardize the stock price. Shareholder surveys indicate that a majority of Elite’s shareholders invest for its high dividend yield.

The CEO noted the magnitude of this strategic decision (a 20% expansion of productive assets) and directed the COO to meet with all members of the executive committee, analyze the prospective project, and recommend the best course of action at the next executive committee meeting.

The wind farm venture will cost an estimated $386 million. The facility will have 257 turbines with a total capacity of 360.5 megawatts (mW). Wind speeds fluctuate, but most wind farms expect to operate at an average of 35% of their rated capacity. With an electricity price of $55 per megawatt hour (mWh), the project will produce revenues in the first year of $60.8 million (i.e. .35 x 8760 hours x 360.5 mW x $55 per mWh). Accounting estimates maintenance and other costs will be about $18.9 million in the first year of operation. Thereafter, revenues and costs should increase by roughly 3% per year.

Power stations can be depreciated using 20-year MACRS, and most power stations have a payback period of 8 years. The firm’s tax bracket is 35%. The project will last 20 years. Municipal and federal tax breaks amount to $20 million, all in the first year.

The capital budgeting department estimates the project has a payback period of 8 years, an aveage rate of return of 10%, and an internal rate of return of 11%. The department’s present value calculations assume a cost of capital of 12%, even though Allete’s bonds are currently yielding 5%. Stock market returns average 11% and treasury bill returns average 3.5%.

Balance sheet, income statement, and other key financial information is available under the firm’s quote symbol (ALE) at .

The CFO reports that the company’s investment banking firm thinks it can comfortably raise sufficient capital to finance the wind farm project with either a bond offering or a stock offering. The bonds would probably float at a rate of 5.5%.

The CFO’s department’s initial projections show that interest expense from bond financing would reduce net income by $21 million as compared to a stock offering. However, with fewer shares outstanding (i.e. less dilution) a bond offering would increase EPS by $.55 more than a stock offering. The CFO recommends a bond offering because the greater increase in EPS in combination with the firm’s current dividend payout ratio, would keep dividends unchanged and address the stockholder agitation issue that was raised by the shareholder relations VP.

Currently, there are 37.3 million shares outstanding at a price of $41.50.

Corporate Finance

Comprehensive Case[2]