Finance Notes
Finance Notes© 2008
J.V. Rizzi
36
Finance Notes
I Finance Overview
A. Main Decisions – finance, valuation and governance
1. Objective Function: what are we to maximize?
2. Investment Decision: how do we invest and manage and why?
3. Dividend Decision: level (and form) of funds returned to the shareholders?
4. Capital Structure: how do we fund ourselves?
5. Governance: who decides? Firm substitutes authority for prices.
B. Fundamental Building Blocks
1. Efficient Capital Markets - price behavior in speculative markets.
2. Portfolio Theory - optimal security selection procedures.
3. Asset Pricing Models - determining asset prices by investors utilizing portfolio theory. Replicate complex securities through arbitrage free strategies involves simple instruments.
4. Option Pricing Theory - pricing of contingent claims.
5. Agency Theory - incentive conflict when benefits are concentrated but costs are disbursed. Heightened by moral hazard when you cannot observe behavior. Enhanced by behavioral bias.
a) Information asymmetries: heightened conflict between agent/mgnrs and principals/investors
1. Chance vs uncertainty
2. Ignorance vs adverse selection
3. Dishonesty vs moral hazard
Note: SOX criminalizes agency conflicts
b) Moral hazard = f (private benefit from misbehaving, 1/verification)
(1) Insufficient /(2) Over invest
(3) Entrenchment
(4) Self dealing
c) Adverse selection
d) Responses
(1) Signaling – debt level, dividends, reputation
(2) Incentives
(3) Monitoring
(4) Contracts – warranties, deductibles, pricing
e) Value implications – wedge between value and income pledge, between opportunity and financing
(1) Value – may not be externally determined
(2) Financing – agency problems/concerns may deprive firms form financing. Borrowers may make concessions to lender to achieve funding
(3) Pecking order: chose financing with lowest assymmetrics/discount
6. Game Theory: economics of decision making; uncertainty lies in the intention/reaction of others. Focus on how individuals behave, anticipate and respond. Components – players, action, motives, and rules.
7. Behavioral Finance: prices influenced by herd vs. lead steers. The issue is whether markets are inefficient or just noisy. Requirement: arbitrage limit + learning disability
a) Bias:
Optimism
Over confidence
Confirmation
Illusion of control
b) Heuristics:
Representation
l/n equal weight
Availability – overweight recent
Anchoring – overweight initial
c) Framing – reference points
d) Manifestations:
Winners curse – You paid too much
Gamblers fallacy – Law of small numbers
Sunk cost – regret avoidance (Prospect theory), Reputation loss
Valuation – Single workable scenario vs range
8. Arbitrage – law of one price – equal rate of return principle
C. Separation Principles/Decision Rules
1. Market Value Rule: Maximize shareholder wealth. Separating ownership from management raises conflict issues. Control mechanisms:
a) Management incentive compensation contract provisions
b) Management ownership interest
c) Management labor market (Reputation)
d) Market for corporate control
e) Internal control mechanisms (Board of Directors)
note: resource allocation mechanism similar to the invisible hand
2. NPV Rule - choose projects whose returns exceed their cost of capital (r ≥ c*). Need to consider multiple risk adjusted discount rates and option value of strategic investments. Discount rate is a function of the risk class. Note problems re: optionality.
3. Dividend Irrelevance (except for agency cost, signaling and option pricing issues)
4. Capital Structure Irrelevance (except for taxes, agency costs, signaling and option pricing issues)
D. Statistics: beware data mining, which is prevalent in non experimental sciences lacking controlled experiments
1. Reliance on past as (prolog vs history)
2. Descriptive vs predictive
3. Issues – normality, survivorship, stationary, independence
4. Movements – go beyond mean and variance to skew and tails
5. Beyond the data – out of sample issues
6. Correlations – state dependent and lack integrating model covering both default and spread widing
7. VAR – best of worst. Need expected shortfall analysis to get into tail
8. Mean reversion
9. Goodhart’s law – sociological uncertainty principle – when a measure becomes a target it cease to be a good measure (behaviour change)
10. Gamblers ruin
Note: 2007 Structured Finance Meltdown
E. Financial Markets
1. Merton – neoclassical benchmark
Anomalies/inhibitions/transactions cost
Institutional solutions – overcoming inefficiencies to get back to benchmark. Means of creating missing markets
2. Machines – converting danger (uncontrollable damages) into risk (decision related controllable damage) which can be traded or transferred. Focus on unintended consequences and conservation of risk principle
F. Decisions as risk (DAR)
II. VALUATION: COMPETING MODELS OF THE FIRM: ACCOUNTING VS. ECONOMIC. CONVERTING PERFORMANCE ESTIMATES INTO PRICE ESTIMATES.
A. Capital Markets
1. Role - opportunity cost background; comparison of returns on passive capital with returns from active capital. Capital market returns are a hurdle rate against which corporate returns must be compared. (Firm as a passbook)
2. Risk and Return: mkt prices risk proportionate to covariance with aggregate risk.
a) Portfolio Theory - Portfolio risk is not the weighted average of individual variances. Co-variances give rise to risk reduction through diversification. (Impacts denominator but not numerator; θ Ε(v) discounted at lower rate is still zero) - Remember, in a crisis, all correlations go to one (Hurricane example).
b) Distinguish - Systematic from unsystematic risk.
(hedge) (diversify)
note: systematic risk is the only risk form compensated because diversified investors willing to pay a higher price. Note – consider 3rd/4th movements – skew/tail (tail risk created by feedback loops)
3. Interest Rates
a) Determination - i = r + E (∆P) + IRP (inflation rate risk premium)
b) Term Structure - yield compared to maturity/credit curve
4. Price Setting Process: cash flow, risk, timing
a) Basis - risk and return i.e. share value based on expected cash return discounted at risk adjusted rate.
b) Efficiency - market quickly reflects available information. Based on competition that quickly eliminates systematic deviations. (Note: Chaos mechanism: fundamental + technical factors)
c) Technical factors – can overwhelm fundamentals in short term
note: mkts. As efficient learning systems (complex adaptive systems). Priors are arbitrary vs. correct and are updated.
d) Complex adaptative systems – complex (nonlinear) with tight coupling (amplication)
5. Asset Pricing Models
a) CAPM - r = rf + B (Rm - Rf)
Units of risk Price per unit of risk
b) APM - r = Aj + BjI1t + B2jI2 + ... BnjI nt + E jt +
- factors - term structure (Bonds-Bills), ∆GNP (Survey), and default premium (Bds - Gov)
F/F - r = f (1/Size, B/M, Momentum) à Returns = F (market, HML, SMB, WML)
Fed Model: E/P – T10
Key elements: luck, skill information, risk
B. Accounting Model of the Firm: Convert from accrual to cash basis, and from cost to market value (i.e. mark to market). Balance sheets are a scorecard for money spent and not value.
P/E = (1+ g)/(Ke-g) ⇒ 1/Ke when g=0 } M/B = P/E x ROE
M/B= (ROE-g)/(Ke-g) ⇒ ROE/Ke when g=0 }
MTM B/S - RHS @ Public
MTM B/S - LHS @ Private
NWCFA
PVGO / Debt
Equity
C. Economic Model of the Firm: Firms compete in two markets, product markets for customers and financial markets for capital. They trade at two difference prices within financial markets, a lower passive intrinsic value and a higher control price.
1. Valuation Overview - V = MAX (liquidation, Going Concern, Third Party Sale) - method used depends on point of life cycle and market conditions - value of asset with no cash flow is only what someone will pay you for it [Sardine theorem]
2. Discounted Cash Flow/Going Concern
a) Traditional Adjusted Cost of Capital (ACC/WACC): use after tax WACC and adjust for interest tax benefit in cash flow to that of an all equity financed firm. Developed for situations involving a constant capital structure. (measure asset cash flows independent of how financed)
VEN = VS + VD VS = Max (0,V – x)
VS = VO + NOC - VD VD = Min (V, X)
VO=(NOPAT/WACC)+[I(ROA-WACC)T÷WACC(1+WACC)]
(assets in place) (growth)
(Forecast Period) (Residual / TV)
Inputs: sales growth, operating profit margin, working capital rate, CAPEX rate, tax rate, and WACC
NOPAT=EBIT (1-τ) = NI + Int (1- τ) = EBIAT - (Int (τ))≈EBIAT if use τs
FCF=NOPAT-WCI+DEP-I=EBDITA - (τ+WCI+CAPEX+Int(τ))
WACC=[Kd (1-τ)XD/D+E]+[KexE/D+E]
Weights: market or forward targets
Note: leveraged firms ⇒ ∆ D/Cap use target D/Cap to avoid understating WACC assume return to BBB ≈ 50%D/Cap
Application: limited to assets in the same risk class as the firm
Ke = Rf + B (Rm-Rf) ≅ 2xRf
R m-Rf ≈ 5 - 7%; equity premium puzzle (Resolution – tail / extreme events)
Keu=RF+BU(RM-RF)
note: equity risk premium as a duration measure/ DF= DA - DL
= DA – (DD + DE)
- expands during bear mkt.
- contracts during bull mkt.
Adjust – B – use industry average to offset low individual R2 (Bloomberg, VL, …)
Downside Beta
Ke
Weights
Forecast Period: period in which ROA>WACC; REFLECT ENTIRE CYCLE; MEAN REVERSION
note: length should not affect value; merely allocation
Residual: normalize with cyclical firms
Average margin over cycle x sales
Alternative Ke based on opm
Ke = Kd + Put Spd
Startups: Market Size x Share = Revenues; then apply OPM convergence: RV=NOPATn÷WACC
other: book value, capitalization, liquidation
NOC: non-operating capital e.g. securities, unconsolidated sub
Country Risk Premium = default spread x [σ stocks / σ gov]
b) Compressed: use adjusted unleveraged pretax discount rate Reu and after tax cash flows. Best for leveraged firm with rapidly changing capital structures as the debt is repaid.
FCF=NI+D+A+∆DT+Int-(CAPEX+WCI)
=EBITDA+∆DT-(CAPEX+WCI+TP)
TP=(EBITA-I)xτ
V=NI+D+A+∆DT+Int-(CAPEX+WCI)÷[Rf+7.0)-g)]
=EBITDA+∆DT-(CAPEX-WCI+TP)÷[Rf+7.0)-g)]
note:
Alimitations on use of DCF - merely a proxy for market value based on current use of assets and strategy; does not reflect takeover premium and alternative higher value added strategies
Breality check: confirmation of value range by all three techniques and calibration (beware 1/n heuristic)
c) EVA = (ROA - WACC) x BC - backward looking vs DCF forward looking
d) APV:
3. Option Pricing (ROV): DCF applicable for traditional firms with cash cow characteristics (i.e. relatively predictable cash flows). Firms with high risk characteristics from either financial difficulty (telecom) or growth firms (Internet) have unpredictable cash flows that are difficult to evaluate using DCF methodology. These situations are better valued using option pricing.
a) Call Option Valuation
C = F(S,SD,X,T,Rf,D); C ≥ max (0,S - Xe-rt - De-rt)
C = disE((S)S>X) x Prob(S>X) - dis X ⋅ Prob (S>X)
C = SN (D1) – KRfT N (D2)
Hedge ratio Discounted Probability
strike option exercised
P (S>k)
D1 - Hedge ratio - ∆OP/∆P - approaches 1 when option is in the money
D2 - Probability that option will finish in the money (i.e. S>X)
Note: implies probability of default
Intrinsic value - value of right to buy at exercise price (i.e. S-X). Time value - possibility of achieving value at a later date; equal to premium minus intrinsic value (P - (S-X)).
Put / call parity:
b) Covenants: F(S, [σ]1, [D]2, Rf, [T,X]3)
(1) Asset Sub
(2) Dividend Payout
(3) Payment Priority
c) Issues: distinguish options from opportunities
(1) Scope Options: enter new markets in business
(2) Timing Options: reacting to new information
High NPV ⇒low time option value
4. Market Value Approach - break-up analysis; even though assets generate sufficient returns, the assets may be worth more to others.
a) fit test - assets are worth more to someone else
b) focus test - negative synergies from dissimilar operations, reduces value (management as an off balance sheet liability)
5. LBO: affordability test
6. Strategic valuation
a) Industry viability – Asset values, MTM B/S
Viable – replacement value à exceed BV
Not viable – replacement value à below BV
b) Earnings power
Normalized EBIT
(Maintenance dep / Capex)
(Taxes)
Earnings power (EP)
c) Economic value = EP / WACC
d) Growth
Value enhancing à EP > Asset
III PERFORMANCE: TRANSLATES INTO PRICE
A. Strategic Framework: Firm policies + industry structure = financial results.
Notes: golden triangle – growth, profitability and liquidity
1. Levels - Corporate: Where to compete? (BCG - firm as internal capital market)
Business Unit: How to compete?
2. Questions:
Where are we now?
Where do we want to go?
How will we get there?
3. Process
a) Industry attractiveness - identify threats and opportunities
(1) Forces - buyers, suppliers, entrants, substitutes, and competitors.
(2) Competitive rivalry - demand growth, fixed cost intensity, exit barriers, product differentiation, switching costs, and market shares.
(3) focus - risk of commodity pricing; stage in life cycle; stability.
b) Competitive position - strengths and weaknesses along value chain. Issue of whether firm’s position is dominant, strong, viable, weak or nonviable.
c) Competitive advantage - means chosen to gain a meaningful competitive position.
(1) Options - cost leadership or differentiation.
(2) Scope - across industry or within niche.
(3) Tests - sustainable, comparative, active
B. Market to Book Model M/B ≈ r/c* ≈ ROE/Ke = P/E x ROE
Note: distortions re: intangible assets and expensing investments
F ranchise growth
factor
1. Shareholder value:
TAXOPM
ATO
LEV
DPR /
Note: Returns = F (industry growth, HHI)
HHI ≥ 4000 à concentrated
≤ 2000 à fragmented
C. Growth -focus on the quality of growth (i.e. ROA, σ) - consequence not goal of value max behavior.
1. Options - related or diversification
2. Mode - Internal or external
3. Sustainable Growth - internally sustainable with fixed capital structure and dividend policies
g* = ROE (1 – Payout)
4. Agency Conflict - pay is strongly tied to size. Encouraged in mature firms because sustainable growth capacity exceeds available positive NPV investment opportunities.
D. Expectations – You create value by beating expectations vs an objective hurdle. Key: EBM = A(EP) – E(EP). It is hard to beat expectations. Use to set strategy:
E. Reverse Engineering – use to uncover expectations value gap:
1. Value management plan