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Corporate Financial Decisions Introduction Timothy A. Thompson

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Goal of the Course Application of Financial Principles to Strategic Decision MakingApplication of Financial Principles to Strategic Decision Making

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Principles of Finance ValuationValuation Discounted cash flow (DCF) Discounted cash flow (DCF) Option valuation Option valuation Risk and return modelsRisk and return models Capital asset pricing model (CAPM) Capital asset pricing model (CAPM) Capital structure theoryCapital structure theory Tradeoff theory/pecking order hypothesis Tradeoff theory/pecking order hypothesis Risk managementRisk management

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Valuation What is the valuation principle? 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 flowsValue 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

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What are strategic corporate decisions? What investments should firm make? What investments should firm make? Capital budgetingCapital budgeting Identity of the firm Identity of the firm Should firm conglomerate or focus?Should firm conglomerate or focus? Growth vs. harvesting Growth vs. harvesting Grow via acquisitions vs. internal growthGrow via acquisitions vs. internal growth Financing policy Financing policy Target debt/equity policyTarget debt/equity policy Internal/external equityInternal/external equity How to finance current plans?How to finance current plans?

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What does “value” have to do with strategic decision-making? Should corporate decisions pursued with a goal of maximizing shareholder value? 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.If so, we need to know how to calculate SHV and how to assess the impact of our strategic decisions on SHV.

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What about other constituencies? Employees Employees Communities Communities Unions Unions Management Management Board of directors Board of directors

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We need to understand SHV Stakeholders framework Stakeholders framework Even 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 shareholdersEven 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 shareholders Shareholder influence Shareholder influence Hostile acquisitions relatively rare, butHostile acquisitions relatively rare, but Shareholder proxies, activist institutional holders, etc.Shareholder proxies, activist institutional holders, etc.

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Is shareholder value the same as stock price? If markets are strong form efficient, yes. If markets are strong form efficient, yes. Are markets strong form efficent? Are markets strong form efficent? No. Corporate insiders often have important information about strategy, etc., that market doesn’t have. 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). 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? Sooner or later, stock price is arbiter. But how soon?

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Valuation and risk CF t E(CF t ) Probability

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DCF and risk We discount expected cash flows We discount expected cash flows Not pessimistic, not optimisticNot pessimistic, not optimistic Expected cash flows weigh all the possibilities by their respective probabilities (total risk)Expected 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 flows Discount these at a discount rate that is appropriate for the risk of the cash flows V 0 = E(CF t )/(1+r i ) tV 0 = E(CF t )/(1+r i ) t Matching principle: match the discount rate to the riskiness of the cash flow Matching principle: match the discount rate to the riskiness of the cash flow

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Capital asset pricing model CAPM asserts that the discount rate should be based only on systematic risk CAPM asserts that the discount rate should be based only on systematic risk Non-diversifiable, general economic riskNon-diversifiable, general economic risk Measured by betaMeasured by beta Not total risk, because much of the “risk” of the cash flows can be diversified awayNot total risk, because much of the “risk” of the cash flows can be diversified away r = r f + ß i (r m – r f ) r i = r f + ß i (r m – r f )

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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. 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 CF t ?” 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 CF t ?” Call the certainty equivalent cash flow CECF t and discount it at r f. Call the certainty equivalent cash flow CECF t and discount it at r f.

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Which is better? In theoretical models typically applied (e.g., CAPM) they are equivalent In theoretical models typically applied (e.g., CAPM) they are equivalent DCF for project/firm valuation typically uses the first method (expected cash flows and a risk- adjusted discount rate) DCF 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 Option pricing, in contrast, uses the certainty equivalent method

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Capital structure and valuation What is the impact of capital structure on valuation? What is the impact of capital structure on valuation? No impact? (Modigliani-Miller, 1958)No impact? (Modigliani-Miller, 1958) Interest expenses are tax deductible to the corporation, whereas payments to equity are notInterest expenses are tax deductible to the corporation, whereas payments to equity are not We can calculate the value of tax shields of debt policy We can calculate the value of tax shields of debt policy Higher debt leads to greater expected costs of financial distressHigher debt leads to greater expected costs of financial distress Difficult to estimate, but conceptually offset some of benefits of debt such as tax shields Difficult to estimate, but conceptually offset some of benefits of debt such as tax shields

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Syllabus goals Bed Bath & Beyond Consider pros and cons of using leverage in capital structure Consider pros and cons of using leverage in capital structure Valuation of tax shields of debt in the capital structure Valuation of tax shields of debt in the capital structure Estimate in dollars: uses Adjusted Present Value Method (define later)Estimate in dollars: uses Adjusted Present Value Method (define later)

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Syllabus goals, continued Marriott Marriott While 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) While 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 capital Nuts and bolts of estimating WACC as the cost of capital John Case Company John Case Company What cash flows do you use to calculate the enterprise value of a company? What 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? 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 Contrast this method to entrepreneurial/venture capital/private equity methods

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Syllabus goals, continued Pinkerton (A) Pinkerton (A) Valuation in M&A Valuation in M&A Multiples: Comparable transactions methodMultiples: Comparable transactions method Premiums paidPremiums paid Discounted cash flow depends on perspective and strategy (Value to the acquirer)Discounted cash flow depends on perspective and strategy (Value to the acquirer) Stand alone plus synergy value plus value added/lost due to financing terms Stand alone plus synergy value plus value added/lost due to financing terms Pepsi-Quaker Pepsi-Quaker Puts together all the pieces. Puts together all the pieces.

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