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Finance 2 Review. Section C, 2010. Review Materials. Case and class notes Review problems (weekly) Quizzes (each module) Module Overviews (each module) Practice Exam (Nova Chemical) These slides. Three Pillars of Fin 2. Technical proficiency Technical judgment Managerial judgment.

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Finance 2 review

Finance 2 Review

Section C, 2010

Review materials
Review Materials

  • Case and class notes

  • Review problems (weekly)

  • Quizzes (each module)

  • Module Overviews (each module)

  • Practice Exam (Nova Chemical)

  • These slides

Three pillars of fin 2
Three Pillars of Fin 2

  • Technical proficiency

  • Technical judgment

  • Managerial judgment

Three pillars of fin 21
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

Technical proficiency

Technical Proficiency

Correctly construct models and apply analytic tools and concepts, given appropriate inputs

Technical proficiency valuation you should be able to
Technical Proficiency—ValuationYou 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)

Technical proficiency valuation you should be able to1
Technical Proficiency—ValuationYou 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

Technical proficiency financial policy you should
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

Technical proficiency financial policy you should1
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?]

Technical proficiency derivatives you should know how to
Technical Proficiency—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

Technical proficiency derivatives you should know how to1
Technical Proficiency—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

Technical proficiency m a you should know how to
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

Technical judgment

Technical Judgment

Make and support reasoned technical assumptions when faced with an ambiguous environment

Technical judgment law of one price
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?

When do the loop relationships hold
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

Technical judgment valuation
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)

Technical judgment negotiation
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

Technical judgment market responses announcement effects
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!

Technical judgment fiduciary responsibilities
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

Managerial judgment

Managerial Judgment

Use technical proficiency and technical judgment to design an integrated set of actions to address the problem at hand

Managerial judgment financial policy
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

Managerial judgment value creation
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

Managerial judgment risk management
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

Managerial judgment negotiations
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?

Managerial judgment philosophy
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

Managerial judgment core beliefs
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