Download Ability to decide what a manager should do

Finance 2 Review
Section C, 2010
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Review Materials
 Case
and class notes
 Review problems (weekly)
 Quizzes (each module)
 Module Overviews (each module)
 Practice Exam (Nova Chemical)
 These slides
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Three Pillars of Fin 2
 Technical
proficiency
 Technical judgment
 Managerial judgment
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Three Pillars of Fin 2

Technical proficiency
– Ability to correctly apply finance tools, formulas, concepts, e.g.,
» What is Free Cash Flow?
» What is CAPM rate of return given Rf, Beta, MRP?
– Review problems, quizzes

Technical judgment
– Ability to decide on inputs or ranges for technical analysis, e.g.,
» What is a reasonable LT growth rate?
» What how did MRP change during financial crisis?

– Needs supporting reasons and evidence
Managerial judgment
– Ability to decide what a manager should do, e.g.,
» High cost financing from Warren Buffett? (Fin 2, Day 1)
» Hostile tender offer for Genentech, at what price? (Fin 2, Day 27)
– No right answer, careful reasoning, weighing of pros and cons
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Technical Proficiency
Correctly construct models and apply
analytic tools and concepts, given
appropriate inputs
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Technical Proficiency—Valuation
You should be able to …
 Forecast
Income Statement, Balance Sheet
and Free Cash Flow outcomes based on
assumed operating ratios
 Calculate discount rates (and know when to
use each one)
– CAPM: Rf, Re, Ra, Rd, WACC
– Yield (or promised rate)
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Technical Proficiency—Valuation
You should be able to …
 Calculate
(and interpret) risk parameters
– Beta of equity, Beta of assets, Beta of debt,
– Volatility
 Calculate
Enterprise, Equity and Per Share
Values
– Using WACC or APV methods, as appropriate
 Value
Interest Tax Shields
 Value Synergies
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Technical Proficiency—Financial
Policy — You should …
 Know
the rules of priority for debt
– Tranches: senior, junior
– Secured vs. unsecured
– Rules of bankruptcy
 Know
the mechanics of dividend payments
and stock repurchases
– Announcement, ex-date, payment date
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Technical Proficiency—Financial
Policy—You should …

Be able to assess the capital structure and liquidity
of a company
– Relative to competitors
– Relative to potential shocks, e.g.,
» increase in price of gold
– Relevant measures are
» D/V [how much of enterprise market value is pledged to debt]
» Interest coverage, eg, EBIT/Int
» Cash/ST Financing [can company withstand a bank run?]
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Derivatives—You should know how
to …
Short sell stock
 Estimate the expected payoff from buying
insurance
 Analyze the payoff functions of

– Forward sales and purchases
– Simple options (puts and calls)
– Complex/composite options
» Spread collars
» Local collars

Calculate exposure to margin calls
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Derivatives—You should know how
to …

Calculate the value of
– Forwards
– Options (simple puts and calls)
– Composite positions
»
»
»
»
»
Floor
Cap
Spread collar
Local collar
Cash + collar
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Technical Proficiency—M&A—
You should know how to …

Calculate properties of a stock-for-stock exchange
– Exchange ratio
» Zero premium
» Non-dilutive (to each side)
–
–
–
–
–
% Ownership (both sides)
Acquisition Premium
Wealth Transfer
Downside Protection
Deal NPV
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Technical Judgment
Make and support reasoned technical
assumptions when faced with an
ambiguous environment
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Technical Judgment—
Law of One Price
 Modigliani-Miller
capital structure
irrelevance
 M-M dividend irrelevance
 Replication of option payoffs via
dynamically updated portfolio
 Covered interest parity
When must these LOOP relationships hold true?
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When do the LOOP relationships
hold?
 In
a “perfect” market
– No taxes
– No transaction costs
– No asymmetric information
 In
imperfect markets, get deviations from
LOOP  arbitrage opportunities for traders
– As long as LOOP is eventually restored
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Technical Judgment—
Valuation
 Selection
of comparable companies
 Selection of future operating ratios
– Revenue growth, cost, asset efficiency
 Tax
rates
– Tax payer or not? (MCI)
– Tax holiday (Geita mine in Ashanti)
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Technical Judgment—
Negotiation

Reservation prices
– Can be based on public information
– May change based on confidential, i.e. asymmetric
information

ZOPA “Zone of positive agreement”
– Range of values (or exchange ratios) between the
buyer’s and seller’s reservation prices
– Deals should fall within the ZOPA unless one or the
other side (or both) receives new information
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Technical Judgment—
Market Responses/Announcement Effects
New information causes a reassessment of value
 Market prices change as a result
 Announcement effects are large for

– New issues of equity (signals)
– Mergers (synergies)
– Anything reflecting on creditworthiness

Market is always second-guessing managers… get
used to it!
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Technical Judgment—
Fiduciary Responsibilities

Who has them?
– Officers, director and controlling shareholders

What is required of fiduciaries?
– Duties of care, loyalty, and transparency (LCA)
– Act in the best long-run interest of “corporation”
– If corporation will cease to exist in the short run,
maximize value of shares
» Revlon duties apply to cash acquisitions only
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Managerial Judgment
Use technical proficiency and
technical judgment to design an
integrated set of actions to address the
problem at hand
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Managerial Judgment—
Financial Policy

How much debt can a company carry?
– Short run? Long run?
When should a company issue equity (or not)?
 How should it finance a project or an acquisition?
 When should a company

– Pay regular dividends
– Pay a special dividend
– Repurchase shares
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Managerial Judgment—
Value Creation


What is the value (NPV) of a capital project (like Ashanti’s
Geita mine)?
What is the value of an enterprise
– To a buyer in an auction (Berkshire-Carters)
– To the seller in an auction (Burger King A)

Does the combination of A and B create value? How?
(Cost savings, cross-selling, market power)
–
–
–
–
–
–
JPMC-Bear Stearns
BNY-Mellon
PepsiCo-Quaker
Wine Country combinations
Roche-Genentech
MCI with Verizon or Qwest
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Managerial Judgment—
Risk Management

What risks should I insure (pay to avoid)
– Systematic to me, unsystematic to others, eg, rainfall in India

What risks should I hedge (via derivatives)
– Can be cheaper than purchasing insurance
– Introduces new risks, ie, basis risk and margin calls

What controls should I place on my traders/risk managers?
– OSG currency hedging policy
– Ashanti hedgebook became a profit center and then blew up
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Managerial Judgment—
Negotiations

In a two-way negotiation, what is my bargaining
power?
– Which end of the ZOPA should I aim for?
» BNY vs. Mellon –will BNY really walk from the deal?
» PepsiCo Round 1 vs. Round 2
» Roche-Genentech pre and post tender offer

What tactics will I use?
– Headline vs. intrinsic value?
– First vs. final offer?
– Can I use price protection (floors, caps, collars) to make
the deal more attractive to my counterparty?
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Managerial Judgment—
Philosophy

In a three-way negotiation, am I willing to be the party
“left out”?
– Short-term Pstk increase vs. long-term performance (Wine Country)

When should I walk away from the table?
– BNY, PepsiCo, Roche

When should I come back?
– PepsiCo, Roche

Should I bailout a failing company?
– JP Morgan-Bear Stearns

Should I use high-cost emergency financing to survive and
live to play another day?
– Williams/Buffett loan
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Managerial Judgment—
Core Beliefs

Does my firm have a mission different from or in
addition to shareholder value maximization?
– Congressional Oversight Panel — mission to represent
the US public
– BASIX — mission to bring capital markets to rural
India
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