Presentation on theme: "Corporate Financial Decisions"— Presentation transcript:
1 Corporate Financial Decisions IntroductionTimothy A. Thompson
2 Goal of the CourseApplication of Financial Principles to Strategic Decision Making
3 Principles of Finance Valuation Risk and return models Discounted cash flow (DCF)Option valuationRisk and return modelsCapital asset pricing model (CAPM)Capital structure theoryTradeoff theory/pecking order hypothesisRisk management
4 Valuation What is the valuation principle? Value of an asset (security, strategy, firm, etc.) is the present value all the future cash flows (expected) deriving to the owners of the asset discounted at a rate of return (expected) commensurate with the riskiness of the future cash flows
5 What are strategic corporate decisions? What investments should firm make?Capital budgetingIdentity of the firmShould firm conglomerate or focus?Growth vs. harvestingGrow via acquisitions vs. internal growthFinancing policyTarget debt/equity policyInternal/external equityHow to finance current plans?
6 What does “value” have to do with strategic decision-making? Should corporate decisions pursued with a goal of maximizing shareholder value?If so, we need to know how to calculate SHV and how to assess the impact of our strategic decisions on SHV.
7 What about other constituencies? EmployeesCommunitiesUnionsManagementBoard of directors
8 We need to understand SHV Stakeholders frameworkEven if decisions are made to weigh the interests of different groups, we need to be able to value alternative courses of action from the perspective of shareholdersShareholder influenceHostile acquisitions relatively rare, butShareholder proxies, activist institutional holders, etc.
9 Is shareholder value the same as stock price? If markets are strong form efficient, yes.Are markets strong form efficent?No. Corporate insiders often have important information about strategy, etc., that market doesn’t have.Maybe not. Sometimes it looks like the market is really out to lunch (e.g., Internet stocks).Sooner or later, stock price is arbiter. But how soon?
11 DCF and risk We discount expected cash flows Not pessimistic, not optimisticExpected cash flows weigh all the possibilities by their respective probabilities (total risk)Discount these at a discount rate that is appropriate for the risk of the cash flowsV0 = E(CFt)/(1+ri)tMatching principle: match the discount rate to the riskiness of the cash flow
12 Capital asset pricing model CAPM asserts that the discount rate should be based only on systematic riskNon-diversifiable, general economic riskMeasured by betaNot total risk, because much of the “risk” of the cash flows can be diversified awayri = rf + ßi (rm – rf)
13 Certainty equivalent method DCF assumes that the “riskier” a future cash flow is the higher the discount rate should be applied to the “expected value” of the future cash flow.Alternatively, we could ask “what cash flow received with certainty at time t would make you indifferent between that certain cash flow and the risky CFt?”Call the certainty equivalent cash flow CECFt and discount it at rf.
14 Which is better?In theoretical models typically applied (e.g., CAPM) they are equivalentDCF for project/firm valuation typically uses the first method (expected cash flows and a risk-adjusted discount rate)Option pricing, in contrast, uses the certainty equivalent method
15 Capital structure and valuation What is the impact of capital structure on valuation?No impact? (Modigliani-Miller, 1958)Interest expenses are tax deductible to the corporation, whereas payments to equity are notWe can calculate the value of tax shields of debt policyHigher debt leads to greater expected costs of financial distressDifficult to estimate, but conceptually offset some of benefits of debt such as tax shields
16 Syllabus goals Bed Bath & Beyond Consider pros and cons of using leverage in capital structureValuation of tax shields of debt in the capital structureEstimate in dollars: uses Adjusted Present Value Method (define later)
17 Syllabus goals, continued MarriottWhile BBBY allows us to calculate the value added to the company by use of debt in its capital structure, this is normally not done using APV, but via the weighted average cost of capital (WACC)Nuts and bolts of estimating WACC as the cost of capitalJohn Case CompanyWhat cash flows do you use to calculate the enterprise value of a company?What is the difference between DCF valuation of a project and the DCF valuation of a company?Contrast this method to entrepreneurial/venture capital/private equity methods
18 Syllabus goals, continued Pinkerton (A)Valuation in M&AMultiples: Comparable transactions methodPremiums paidDiscounted cash flow depends on perspective and strategy (Value to the acquirer)Stand alone plus synergy value plus value added/lost due to financing termsPepsi-QuakerPuts together all the pieces.