Transcript BSL 4: Corporate finance - University of Illinois College

Business strategy for lawyers
Chapter 4:
Corporate finance
Prof. Amitai Aviram
[email protected]
University of Illinois College of Law
Copyright © Amitai Aviram. All Rights Reserved
S14D
Business strategy & finance
Business managers compete in three markets
• Market for corporate control
– Maintaining their position in the firm
• Product markets
– Maximizing the firm’s profits
• Capital markets
– Raising money for the firm from investors
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Addressed in
BA2
Business strategy & finance
Business managers compete in three markets
• Market for corporate control
– Maintaining their position in the firm
• Product markets
– Maximizing the firm’s profits
• Capital markets
– Raising money for the firm from investors
3
© Amitai Aviram. All rights reserved.
Addressed
throughout
this course
Business strategy & finance
Business managers compete in three markets
• Market for corporate control
– Maintaining their position in the firm
• Product markets
– Maximizing the firm’s profits
• Capital markets
– Raising money for the firm from investors
4
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Topic of this
section
Corporate finance
Overview of Chapter 4
a) Capital markets
b) Valuation
c) Financial engineering
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Capital markets
Thinking of finance as a product
• The product: return on an investment
– Ownership in a business (equity)
– Lending money to a business/government (debt)
– Ownership of a physical asset (gold, oil, art)
• Basis of competition (what makes a product good?)
–
–
–
–
Return on equity (RoE) [equity – the money you put at risk]
Risk
Price (fees)
Convenience
• Ease of access
• Personal treatment
• Access to investment research / explanations for novices
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Capital markets
Types of risk
• Operational risk
– Risk that business activities fail
• Leverage risk
– Financing business with debt increases risk of the equity investment
– We will see an example later in this section, in Calvin’s hypo
• Liquidity risk
– Harder to sell illiquid assets (quick sale causes big loss)
– But illiquid markets likely have lower market efficiency
• Concentration risk
– Too many investors employing the same strategy (enter/exit at same time)
– Strategy’s popularity gives false sense of lower liquidity risk
• Transparency risk
– Difficulty to understand/valuate complex financial products
– Results in inaccurate valuations
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Capital markets
Efficient Capital Markets Hypothesis
• Competing assumptions (called forms/levels of market efficiency)
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Random
prices
Weak-form
efficiency
Semi-strong form
efficiency
Strong-form
efficiency
Prices reflect no
information
Prices reflect
previous price info
Prices reflect all
public info
Prices reflect all
info
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Capital markets
Investing to match the market
• Jane expects the S&P 500 (an index of 500 publicly-traded
companies) to rise 5% in the coming year
• Is there a way that she can invest her money so that she
makes exactly the same return as the S&P 500 – If the market is weak-form efficient?
– Semi-strong form efficient?
– Strong-form efficient?
• To facilitate this kind of investing, there are special type of
mutual funds called index funds
– Index funds try to match the market index, not beat it
– They do not pick the best stocks, but invest in all of them
– Very low fees: <0.1%
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Capital markets
Investing to match the market
• Calvin likes to live on the edge. He wants to invest so that
he makes ten times what the S&P 500 does. I.e.:
– If S&P 500 goes up 5%, Calvin profits 50%
– If S&P 500 goes down 5%, Calvin loses 50%
• He borrows $100 from a bank;
buys units in an S&P 500 index fund
– For simplicity, assume 0% interest
• Bank holds as collateral:
– The index fund units
– $10 of Calvin’s own money (margin)
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Capital markets
Investing to match the market
• If S&P 500 went up by 5%
– Calvin sells units for $105
– Pays back $100 for loan
– Profit: $5 off of a $10 investment → 50%
• If S&P 500 went down by 5%
–
–
–
–
Calvin sells units for $95
Owes bank $100 for loan
Bank keeps $95 proceeds + $5 out of the margin
Profit: -$5 off of a $10 investment → -50%
• How much does this arrangement cost?
• Will it work in efficient capital markets?
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Capital markets
Thinking of finance as a product
• Because investing to earn market’s RoE is “produced” differently than
investing to beat the market, we should treat them as different
markets, or at least different segments of market
• Competition for providing market RoE
– Entry problem: anyone can make investments with same return (risk-adjusted)
as market as a whole
– Result: Low “price” (fees) (~0.1% per year on index mutual fund)
– Fees cap supplier’s overhead (0.1% is not enough to attract talent)
• Competition for providing above-market RoE
– ECMH: because everyone is trying to beat the market, any info that affects
price of investment will immediately be incorporated into the price
– So, challenge is to overcome ECMH & earn above-market RoE
– To explore how, consider first some financial terminology…
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Capital markets
Beta
• In finance theory, the correlation between an investment &
the market is known as Beta (β)
• β=1: Investment acts exactly same as the market
– E.g., an index fund aims to have β=1
• β=10: Investment rises & falls 10 times as much as the
market
– E.g., Calvin’s investment
• β=0: Investment is not correlated with the market at all
– E.g., lottery ticket
• β=-1: Investment acts exactly opposite of the market
– E.g., selling short S&P index fund units
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Capital markets
Beta return
• The beta return means the portion of the return
that is explained by what the market as a whole did,
adjusted for investment’s risk
– I.e., the return that is cheap to create
• Example: if the S&P 500 went up 5%, then
– the “beta return” for an investment with β=1 is 5%
• This is cheap to create, as Jane did
– the “beta return” for an investment with β=10 is 50%
• This is cheap to create, as Calvin did
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Capital markets
Alpha & investment performance
• The portion of the return that is not explained by the
market is called Alpha (α) (sometimes called “abnormal return”)
• This is the part of the return that requires expertise to create
Beta
Alpha
• A money manager earned a return of 20%. What is her α if
–
– the portfolio’s beta is 1?
– the portfolio’s beta is 10?
• Based on her performance, does she deserve a
higher fee than what an index fund charges?
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Capital markets
Alpha & investment performance
•
To know Alpha, you need to know β (the risk of the
investment)
– Infer β from past behavior
•
•
But investments may act differently in the future
Also, new investments have no past record track
– Calculate β for the past year & pay at end of year
•
A single year may not be representative
– Calculate β for the past 10 years & pay then
•
•
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But no money manager will wait that long to be paid
And few investors will invest for that long
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Capital markets
Creating alpha
•
How do you earn an abnormal return (α)?
– Creating a β return is easy & inexpensive
•
How do you create a Beta return?
– But this means that it’s not enough money for an
expert money manager
– To justify high fees, a money manager needs to create
an alpha return
•
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Three ways to create alpha…
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Capital markets
Creating alpha
1. Entrepreneurship
• Control the enterprise & make it work better. E.g.
–
–
•
Venture capitalism: take an inventor & idea and turn into
professionally run business
Shareholder activism: buy unpopular (cheap) company, replace
its management with one that the market trusts more, sell when
prices rise
Why aren’t profits competed away?
–
Requires continuous, active involvement
•
–
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Limits manager to a small number of ventures
Requires new ideas
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Capital markets
Creating alpha
2. Valuation
• Identify underpriced investments & invest in them
• Requires market efficiency < strong
–
–
•
Less liquid markets (few buyers/sellers); or
Faster trading technology than rivals
Also requires better valuation skills than rivals
–
–
•
Nonpublic information (w/o it, mkt eff must be <semi-strong)
Better analysis skills
Why aren’t profits competed away?
–
Scale of investment
•
–
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Requires significant investment in collecting/analyzing info
Time scope of investment (Harder to exit an illiquid investment)
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Capital markets
Creating alpha
3. Financial engineering
• Improve efficiency of firm’s use of capital; or • Create new financial products appealing to investors
–
Example: Mutual funds. Before mutual funds, middle class
investors were unable to diversify, and so bore a higher risk
•
•
Why aren’t profits competed away?
–
Requires constant innovation
•
–
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Investors pay in fees some of the costs the funds save them
Once a new idea becomes known, others copy it
Requires expertise & marketing ability
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Capital markets
Creating alpha: entrepreneurship
• Making the business more profitable
– This is the topic of all other sections of this course
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Capital markets
Creating alpha: valuation
• Works only in less efficient markets, and only if investor has
superior valuation skills
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Capital markets
Creating alpha: financial engineering
• Improve efficiency of firm’s use of capital
– Creating new financial products is beyond scope of this course
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Corporate finance
Overview of Chapter 4
a) Capital markets
b) Valuation
c) Financial engineering
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Valuation
Piemonte v. New Boston Garden Corp. [Mass. 1979]
• Court needs to determine value of Boston Garden Arena
Corp. (“Garden Arena”)
– Boston Bruins & Boston Braves hockey franchises
– Boston Garden Sports Arena (sports/entertainment facility)
– Operator of food & beverage concession @ Arena
• Lower court judge uses “Delaware block approach”
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Valuation
Market value
• Variation 1: Share price
– Only works for a public company
– Doesn’t work for valuation of a segment of a company
• Garden Arena is a public company
– Between 1968-1972, shares traded between $20.50 & $29
– Last sale prior to merger was for $26.50
• Why isn’t this the end of the valuation process?
– Any reason market value won’t be the correct valuation?
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Valuation
Market value
• Variation 2: Trading comps
– Comparison to other publicly traded companies
• Example: Suppose that Garden Arena is not publicly traded, but
Acme (which also owns a hockey franchise & sports arena) is
publicly traded
– Suppose Acme’s market value is $100M
– Pick a relevant criteria to compare Acme to Garden Arena
(earnings, assets, number of season ticket holders, etc.)
– Suppose that Acme has twice the earnings of Garden Arena
– Garden Arena’s valuation would therefore be $50M
• Weaknesses of this method?
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Valuation
Market value
• Variation 3: Deal comps
– Comparison to other company acquisitions
• Example: Suppose that no hockey teams are publicly traded, but
Acme (which also owns a hockey franchise & sports arena) was
recently acquired for $100M
– Pick a relevant criteria to compare Acme to Garden Arena
(earnings, assets, number of season ticket holders, etc.)
– Suppose that Acme has twice the earnings of Garden Arena
– Garden Arena’s valuation would therefore be $50M
• Weaknesses of this method?
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Valuation
Earnings vs. cashflow
• Cashflow: cash or assets that can readily be turned into cash (e.g.,
money in the firm’s bank account, liquid securities) that firm receives
during specified period, less cash or equivalents that firm pays during
same period
• Earnings: revenues - expenses, based on accounting rules
• Why do cashflow & earnings differ?
– Revenues are recorded when a sale is made (not when money is paid)
• E.g., A delivers widget to B, who will pay $100 next year; $100 revenue is
recorded now
– Expenses recorded are those incurred in generating the revenues that were
recorded for that time period
• E.g., This year A produced two widgets @ total cost of $120, but only one
widget was sold; A records expenses of $60
• So, cashflow was -$120, but A recorded earnings of $60
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Valuation
Earnings vs. cashflow
• Why do cashflow & earnings differ? (continued)
– The cost of assets used long-term (capital assets) is not recorded as an
expense; instead, it is depreciated over its lifetime
• Example: A buys widget-producing machine for $10,000 in cash. The
machine is expected to have a lifespan of 10 years
• Each year, a depreciation expense of $1,000 ($10K/10 years) is recorded;
after the 10th year, the machine is fully depreciated and no more
depreciations are recorded
• Cashflow: -$10K in first year, no changes in later years unless new machine
is needed
• Earnings: -$1K/year for 10 years
• Cashflow fails to capture aspects of the “living business”, but earnings
are easier for managers to manipulate
– E.g., decide machine’s life span is 5 yrs. or 20 yrs. to double or halve the
depreciation expense
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Valuation
Earnings / cashflow (comps)
• Variation 1: Earnings multiplier – 2 steps
– Determine appropriate price/earnings (P/E) ratio (multiplier)
– Value = Multiplier x company’s average earnings in past 5 yrs.
• Multiplier
– Judge decides appropriate multiplier is 10
– Comparison to other firms (publicly traded or acquired)
• Earnings
– Earnings should exclude extraordinary gains/losses
– Judge includes payments from expansion teams
• Weaknesses of this method?
– Cashflow multiplier valuation done in same way
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Valuation
Earnings / cashflow (DCF)
• Variation 2: Discounted cash flow (DCF)
– Not in Piemonte case
– Predict future net cash flows (inflows - outflows)
• Considers cashflow, not earnings
• Predicting future figures avoids bias of
misrepresentative past earnings, but future
estimates may be speculative
– Determine appropriate discount rate
• I.e., money’s loss of value over time
– Discount future earnings by discount rate
& add them up
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Valuation
Earnings / cashflow (DCF)
• Example (discount rate: 10%)
Year
Outflow Net cashflow Discount
DCF
2000 $50
$250
-$200
1.00
-$200
2001 $300
$100
$200
0.90
$180
2002 $350
$50
$300
0.81 (0.9x0.9)
$243
2003 $400
$50
$350
0.73 (0.9x0.9x0.9)
$255.50
2004 $450
$50
$400
0.66
$264
2005 $500
$50
$450
0.59
$265.50
2006 $500
$50
$450
0.53
$238.50
Total $2,550
$600
$1,950
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Inflow
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$1,246.50
Valuation
Earnings / cashflow (LBO)
• Variation 3: LBO feasibility
• Also not in Piemonte case
• Example: Valuation of Target Corp.
– Assumptions
• Target has a stable cashflow of $90M/yr.
• Acquirer corp. can borrow money at 10% interest
• Lender insists that Acquirer put in $100M of its own money; can use
borrowed money for the remainder of the acquisition (Why?)
– Acquirer can borrow up to $900M while paying interest
exclusively from Target’s cashflow ($900M x 10% = $90M)
– Target’s valuation is $1B ($900M borrowed + $100M equity)
– In what way does this tell you how much Target is worth?
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Valuation
Asset value
• Net asset value: Value of all assets – all debts
• Problem: Value of assets based on accounting standards –
not necessarily representing the market value of the assets
or their value to the business
– Example 1: New car purchased for $30K. Expected life: 10 years
• After 1 year, book value is $27K, but car worth far less
• After 10 years, book value is $0, but car is still worth something
– Example 2: Law firm leases office space @ fair market value, owns
furniture/computers worth $100K; profit: $2M/year
• Asset value clearly doesn’t represent business value of firm
• Accounting concept of goodwill is a crude approximation
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Valuation
Asset value
• Example 3: Garden Arena purchased the Arena on May
1973 (½ year before valuation) for $4M, with $3.4M
mortgage
– If the Arena is worth $4M, then it would add $600K to Garden
Arena’s net asset value
• Prior to purchase, Garden Arena leased the Arena with a fixed
maximum rent & an obligation on the lessee to pay only ⅔ of local realestate tax increases
• Lease had 13 more years to run; inflation was high & real-estate taxes
were rising
– Court: “The existence of the lease would tend to depress the
purchase price.” Why?
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Valuation
Weighting of valuations
• Last step is to give each valuation method a weight
• Judge gives 10% to market value; 50% to asset value
– Market unreliable because of low flotation (freely-trading shares)
• Less trading means less accurate valuation (inefficient market)
• Even acquiring entire flotation wouldn’t give any control in company, so
market price discounts benefits to controlling SHs
– Earnings value less reliable than asset value because:
• “Garden Arena had been largely a family corporation in which earnings
were of little significance”
– What does that mean? Owners don’t care about making money?
• “Garden Arena had approximately $5,000,000 in excess liquid assets; and…
substantial real estate holding in an excellent location.”
– Why does this make asset value better than earnings value?
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Valuation
Keep a healthy skepticism…
• Valuation uses crude approximations to come up with very
precise results
– Like deciding whether a team has a first down in football
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Corporate finance
Overview of Chapter 4
a) Capital markets
b) Valuation
c) Financial engineering
39
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Financial engineering
Private equity
• Private equity firms (“PE”) are businesses that specialize in
identifying attractive businesses (often public companies),
acquiring control in them, making changes to improve their
value, and after a few years sell them & distribute profits to
the PE firm’s investors
– Unlike other investors, PE emphasizes ability to improve the
company, not just spot undervalued companies (i.e., alpha comes
from entrepreneurship, not just beating the capital market)
– Some value comes from improved financial engineering – better
(or more risky) use of capital
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Financial engineering
Private equity
• Process
– PE firm owned by highly respected financial experts
– PE firm opens a fund; solicits investors
• Investors invest in fund
• Fund has limited lifespan; withdrawal rights restricted
• Fund managed by PE firm; draws fees
– Fund uses money to buy control in several businesses
• Makes changes to business to increase value
– Fund sells improved business
– When time is up, fund dissolves & distributes profits
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Financial engineering
Posen, If Private equity sized up your business
• According to Posen, 5 ways PE increases firm’s value
–
–
–
–
–
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Reduce idle cash
Financial engineering
Optimize capital structure
EntrepreImprove business plan; monitor performance better
neurship
Better incentives for management
Reducing agency
problem
Better board member selection
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Financial engineering
Reducing idle cash
• RoE = return (i.e., profit) / amount investor puts at risk
• RoE can be increased by either:
– Increasing Return on Assets (RoA)
• Managing the business better (entrepreneurship)
– Reducing the amount of equity (investor’s money at risk)
• Reducing idle cash
• Optimizing capital structure (leveraging)
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Financial engineering
Reducing idle cash
• Return tends to be correlated with risk
– If investment is more risky, investors demand higher return
– What’s likely to be more risky: the company’s main
business, or money the company has in the bank?
• If investor wants a safe investment (with a low
return), she doesn’t need the company to make it
– Why pay executives’ salaries, office space, etc., just to earn
interest on bank account?
• So why do companies keep spare cash?
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Financial engineering
Reducing idle cash
• Spare cash levels offer a trade-off:
– Spare cash reduces RoE
– But higher chance to survive financial difficulties & exploit
business opportunities
• Management has incentive to keep a lot of cash
– Gives them more flexibility to manage the company
– Executive compensation tied to size of company
– If company fails, they lose their jobs; on the other hand,
management doesn’t directly benefit from higher RoE
• So, high cash levels may signal an agency problem
• But, it also may be a prudent thing for firm to do
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Financial engineering
Optimizing capital structure
• Even when the firm has no spare cash, it can reduce the
amount of capital invested by borrowing money and
returning it to investors
– Dividends
– Repurchasing shares
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Financial engineering
Optimizing capital structure
• Example: Acme has $10M of assets; earns a profit of
$1M/year (RoA = 10% [$1M/$10M])
• Originally, Acme has no debt (all equity)
– RoE=10% [$1M/$10M]
• Acme borrows $8M from bank @ 5% (paying $250K/yr),
offering its assets as collateral
– Acme then gives its SHs a $8M dividend (equity is now $2M)
• Or, Acme purchases $8M of its shares (again, equity=$2M)
– Acme now has a profit of $750K
– RoE=37.5% [$750K/$2M]
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Financial engineering
Optimizing capital structure
• Modigliani & Miller: Capital structure shouldn’t matter if:
–
–
–
–
Capital markets are efficient
No information asymmetry between firm, SHs & lenders
No bias caused by tax laws
No bias caused by bankruptcy laws
• Why wouldn’t capital structure matter?
– Because firms that have less capital and more debt are riskier, so
lenders would charge higher interest rate from firm, reducing
profits and therefore RoE
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Financial engineering
Optimizing capital structure
• So why does capital structure matter?
1. Mispriced capital: capital markets are not always efficient
and information asymmetries exist
– When credit is underpriced, firm benefits from higher leverage
2. Tax laws
–
Interest is deducted from profits; dividends are not
3. Bankruptcy costs
4. Restricting free cash flow to control agents
–
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Interest reduces free cash flow, limiting managers’ ability to
engage in wasteful expenditures (managers must return to
capital markets to raise more money)
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Corporate finance
Alpha & market efficiency
• Entrepreneurship
– Only works in less efficient product markets
• Otherwise, competition erodes profits
• Valuation
– Only works in less efficient equity markets
• Otherwise, ECMH suggests you can’t make abnormal profits
• Financial engineering
– Only works in less efficient debt markets
• Otherwise, Modigliani & Miller suggest financial structure
doesn’t matter
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