Transcript How Money are made in Corporate Finance

Making Money in
Corporate Finance: Basic
Principles
James S. Ang
Florida State University
For Presentation at Xiamen University,
May 2009
Finance is about making
money from money.
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Firms could derive Profits from real
assets and profits from financial assets
or both.
The Sources of Profitable
Opportunities:
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1. Use information outsiders do not have on
real assets.
2. Exploit disagreements among outsiders –
different expectations.
3. Exploit other parties’ Mistakes
4. Cheating: manipulation and fraud.
The means to extract profit is through the
method of arbitrage, and the vehicle is the
corporation.
Understanding and harvesting
NPV
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I shall start with the most basic: NPV analysis
Example:
PV of inflows is $120mm, or a future value of
$150mm.
PV of all costs is $100mm, or a future value
of $120mm.
NPV = 120 – 100 = 20mm.
NFV = 150 – 120 = 30mm.
But think of yourself as an
entrepreneur.
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This means that an entrepreneur needs
to:
Raise $100mm of OPM (other people’s
money), a combination of debt and
equity, and when discounted at the cost
of capital, should yield $100mm in PV
or 120 in FV.
Pocket the $20mm in NPV.
There are two ways:
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The entrepreneur may sell (give up the
right to) all future cash flow of (FV=150mm)
for (PV=120mm). Since it only takes
100mm to invest in the project, the
entrepreneur can pocket the difference:
120-100 = 20.
Examples are developers pre-sell housing
units, businessmen sell ownership to firms,
etc.,
2: OPM
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The second way is realize that the entrepreneur has
a claim on 150-120 = 30 in the future after the OPM
are paid (= 120mm). This means that the
entrepreneur owns (30/ 150)= 20% of the firm’s
cash flows, and can therefore issue 80% of the firm’s
stocks for 100mm to finance the project, and own
20% without putting up own money.
Alternatively, the entrepreneur may use the
equivalent of 20% ownership as the firm’s equity and
borrow debt (use leverage) to be supported by the
cash flows to the other 80%.
Examples include IPO, or earnouts.
NPV
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To summarize, receiving 20mm now, or hold
20% cost free represents arbitrage profit to
the entrepreneur.
The entrepreneur takes a long position on the
asset (The asset generates high cash flows
due to patent protection, sole ownership of a
land to develop properties, right to exclude
other users, or political influence, etc.) And
issue debt and equity to others (short).
The really interesting question how the
entrepreneur can extract the arbitrage profit?
The essence of arbitrage
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Smart bets have these characteristics:
No cost, or Commit no own funds
(OPM).
No risk, or position is a perfect hedge
(perfect or near perfect correlation in
returns)
No loss, or position generates either
profit or breakeven.
Effective arbitrage requires a set
of simultaneous transactions:
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Buy (Long) undervalued securities and sell (short)
overvalued, but highly correlated securities.
The important point is that a short position is needed.
Sell short means a two parts transactions: a) Sell a
security one does not own, b) Buy back the same
security later to close out the position.
It is equivalent to: a) Take money now, b) Return
them later.
But, selling short is difficult for investors.
An implication
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Stock market may persist to be
inefficient if there are ‘limits’ to
arbitrage, especially in the ability to
short.
Limits to arbitrage:
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Search for stock lenders may be costly and time consuming.
Stocks on loan are subject to recall risk.
Additional collateral needs be posted.
Security lending market may be illiquid.
Execution risks, or lack of close substitutes.
Counter party risk.
Synchronization risks.
Noise trader risk.
Transaction costs.
Holding costs.
Liquidation costs and premature liquidation risks.
Fundamental risk.
Wealth constraint, if fund flow depends on short-term
performance.
Question: If investors could
not profit, who could?
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The answer is the corporation.
They are better in exploiting mispricing
in the market/ arbitrage opportunity
than individual investors.
This is the main idea underlying my talk
today:
Corporations have more
arbitrage opportunities
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The following is a list of assets investors normally may not be able to
acquire:
Assets that have to purchased in bulk, not fractional ownership/ shares:
buildings factory, etc.,
Assets that are not publicly traded: privately held companies,
subsidiaries of other corporations, state owned companies,
cooperatives, and mutual organizations.
Assets that require active management and ownership rights:
restructuring (layoff, asset sales, change top management), breaking
up (corporate fission), bundling (corporate fusion), realize synergy
(information technology, production skills, human capital, cheap
capital), positive NPV, improve governance, etc.,
Real assets that require change in ownership to change market
expectations.
Assets that require large information costs, which corporations, as bulk
buyer, can better afford and can also perform due diligence
investigations.
Examples of Corporate
Arbitrage
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A. Long undervalued asset and short undervalued securities.
Mergers and acquisitions:
Acquire undervalued target (long ) with own stocks (short) in a stock for stock
exchange.
Leverage buyout
Take private a public firm (buy/long all stocks) and issue highly levered debt
(short).
Corporate fission (breakup deals)
Acquire a firm (long) and sell pieces or restructure as several separate legal
entities to sell securities (short), as in spin off and split up.
Corporate fusion (bundling of assets)
Acquire several assets to form a single corporation and sell securities based on
the now more valuable combined firm (short).
IPO and SEO
Sell over priced stocks as IPO in hot markets (short) and invest the proceeds
(long).
Examples of corporate
arbitrage
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B. Short overvalued assets and long
undervalued securities
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Sell overvalued asset/ subsidiaries (short) to
buyback stocks (long).
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Repurchase stocks
Debt refunding
Retire high interest cost existing debt (long)
and replace with lower interest cost debt
(short).
The Sources of Arbitrage
Opportunities:
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The market/ investors make mistakes:
mispricing.
Other companies make mistakes.
Your company help the market makes
mistakes.
- manipulating information and
expectations to committing fraud.
Where do profitable
opportunities in corporate
finance come from
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1. Smart money taking from dumb
money.
Based on their source, these opportunities,
many are results of mistakes by others, may
be classified as originated from:
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A. Markets/ Investors.
B. Managers of other firms.
C. Government.
More on profitable
opportunities
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2. Helping hand.
Or, finance in steroids, it gives the firm short term boost, but
may result in long term harm. In the meantime, there are
telltale signs, and would not pass closer examination.
A. Catering (also knows as following fads and fashion,
pseudo market timing, herding, etc., )
Examples:
1. Increase or initiate dividends when dividend paying
stocks are selling at a premium.
2. Corporate name change. Add dot com when in fashion,
and remove dot com after bursting of dot com bubble.
3. Buy or sell assets base don prevailing trend; Increase
investment when regarded as a growth stock.
Manipulate market
expectations
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Earnings smoothing (to give semblance
of consistent growth) and manipulation.
Fraud.
Keep up the appearance.
Examples of helping hand:
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When to boost earnings:
Before IPO, SEO, mergers to be financed with own stocks
and prior to debt renewal, extension and refinancing.
2. When to depress earnings:
Repurchase stocks, and management lead LBO.
3. Take value destroying actions to keep up appearance.
Suppose the market overprices your stock, implying it
expects your company to deliver higher growth than you are
capable of.
The strategy is to: a) Issue stocks at inflated price, and to
keep up the appearance of growth, would invest in inferior or
value destroying projects (NPV<).
Opportunities as mistakes
made by the market :
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Irrational
1. Investors following simple
heuristics as portfolio strategy,
such as market to book, EPS, buy
winners (momentum investing),
buy losers, etc.,
2. Herding,
3. Responding to noise, including
rumors.
Rational
1. Following price trend leading to bubble, in a ‘If you can’t beat
them, join them’ and “ I am smarter than the rest and know when to
bail out” strategy.
Given bad information by the companies
Opportunities from or
mistakes made by the
government.
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Tax arbitrage:
Buy (long) low taxed assets, e.g., tax
law passed to give tax credit for new
investments, and short (borrow) liabilities
with tax deductible interest.
Buy tax free bonds, financed with tax
deductible debt.
Acquire companies with large tax loss
carry forward..
Mistakes made by
managers
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A. Behavioral
1. Over optimism, e.g., illusion of control.
2. Overconfident, e.g., attribution bias.
3. Limited capacity to process information,
e.g., bounded rationality,
representativeness, availability, narrow focusing,
B. Agency
1. Poor governance.
2. Unnecessary diversification, done on behalf of
less diversified managers
Misplaced trust in market
efficiency.
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When the securities of the firm are over priced, cost
of capital may appear ‘too low’ to the insiders/
managers, and the company may be induced to
accept too many inferior projects (NPV<0). Thus, we
have a situation in which over optimism by the
market leads managers to act as if they, too, are
over optimistic.
The opposite is also true. Too pessimistic market
results in low security prices. Raise the perceived
cost of capital, and too few investments may be
undertaken. I.e., some NPV>0 may be foregone.
mistakes
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Sentiments of the stock market, whether too
optimistic or pessimistic, may affect managers’
actions in the same direction, i.e, sentiments are
contagious.
Unwittingly, the investment behavior of the of
corporations caters to please the market.
What a long term value maximizing firm can do?
-It may not rely on short term market prices to
calculate capital costs.
- When market prices are too high (or too low), risk
premium may appear too low (too high), and even
beta may appear too low (high).
To Summarize
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Idea #1: All profits, other than that are
needed to compensate for risk taking, may be
formulated as a result of an arbitrage.
Idea #2: Capital market may remain
inefficient because of limits to arbitrage by
investors.
Idea #3: Corporations are better in exploiting
mispricing in the market/ arbitrage
opportunity than individual investors.
ideas
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Idea #4: Making money in corporate finance
means knowing how to let other people take
risks, as in OPM, and risk management
strategies.
Idea #5: Arbitrage opportunities arise from
action taken to correct mistakes by others.
Idea #6: There are long term versus short
term arbitrage profits; those involving
attempts to change market expectations or to
follow the market could only produce short
term gains.