Advanced Corporate Finance & Strategy Lectures
Advanced Corporate Finance and Strategy (FEM11006)
Erasmus Universiteit Rotterdam
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Advanced Corporate Finance & Strategy [Lecture slides]
Lecture 1 Strategy
Building Blocks: overview
Value drivers and strategic planning:
External approach: Porter’s five forces industry analysis (1)
Rivalry among existing firms Industry competitors
- Threat of new entrants Potential entrants
- Bargaining power of suppliers Suppliers
- Bargaining power of customers Customers
- Threat of substitute products or services Substitutes
External approach: strategic conflict and game theory (2)
Internal approach: resource based view (3)
Valuation methodologies: a taxonomy of common corporate real options > Timing – the option to delay an investment until more market information becomes known > Growth – the option to grow when an initial investment is made and a strategic position is acquired > Operating – the option to abandon, temporarily shut down, contract and expand capacity etc.
Financial markets assign a value to growth Equity value = assets in place + PVGO
Equity value : known from financial markets (=stock price * #shares outstanding) Net assets in place : present value of earnings (as an annuity) generated by the assets in place PVGO : ‘back solve’ for the value of the growth opportunities from the stock price (PVGO = EV – assets in place)
Portfolio planning of growth opportunities Expanded (strategic) NPV = Direct NPV + PVGO
Lecture 2 Corporate real options
Lecture outline
Overview of common real options
Bidding on a license
Soup-to-nuts application of oil explorations investments
Overview of common real options
Timing (simple) Growth (compound) Operating
Project Variable Call option Present value of expected cash inflows
V Stock price
Present value of investment outlays I Exercise price Length of deferral time T Time to maturity Time value of money r Risk free rate Volatility of project’s returns σ 2 Variance of stock returns The (simple) option to defer
Opportunity to invest C=p∗C+¿+
( 1 −p)∗C−¿
1 +r ¿¿
Risk neutral valuation: p(chance)=( 1 +r)V 0 −
V−¿
V+¿−V
−¿¿
¿
¿
Shared option to defer > the (proprietary = gepatenteerd) option to wait is particularly valuable in resource extraction industries, farming, paper products, and real estate development due to the high uncertainties, long investment horizons and limited competitive erosion. > shared investment opportunities. ...
Project Variable Call option (expand) Put option (contract) Fraction of project value e% (c%) of V e% Stock price c% stock price Present value of investment outlays
Exercise price -
Present recovery value Rc - Exercise price Length of deferral time T Time to maturity Time value of money r Risk free rate Risk free rate Volatility of project’s returns σ 2 Variance Variance Option to expand or contract production capacity
Option to expand: C = max[NPV of expansion (eV-I), 0] Option to contract: P = max[NPV of contraction (Rc-cV), 0] max[0, (eV-I), (Rc-cV)]
Options: If + : If - : Expanded PV = static PV + value of the options
The option to abandon production capacity
Project Variable Put option (contract) Resale value A Exercise price
Expanded present value = static value V + max[abandon (A-V), continue]
- Bidding on a license
- Soup-to-nuts application (the valuation of oil exploration)
Nested options and resolved uncertainty The exploration phase > the option to start test drilling > the option to invest in appraisal wells The production phase > the option to invest in development > the abandonment option Resolved uncertainty > uncertainty in the quantity of reserves > uncertainty in oil prices
Valuing the production phase Estimating Brent crude futures prices: Ft = St (1+r-δt)(T-t) ...
Valuing the exploration phase ...
Summary > Application as a mindset: It is essential to properly translate the qualitative discussion of projects into an options structure and identify its strategic elements. > As a valuation tool: The valuation part can create additional value by quantifying the merits of strategic alternatives and helping assess tradeoffs quantifying the merits of strategic alternatives and helping assess tradeoffs and attach price tags in investment decisions. The framework can provide clear management recommendations and executable actions. > Real-life projects are often more complex, and may involve a collection of interacting real options. Sometimes there may be a synergistic effect, but the combined value typically is less than the sum of the parts.
Lecture 3: Game theory and strategic decisions
Lecture outline
Principles of game theory > taxonomy (hiërarchisch ingedeelde ordening) of basic games
Thought experiments
Competitive reaction in quantity and price competition
Application: valuation of airport expansion
Principles of game theory
Rules of the game
The strategic environment The rules The assumptions Players Strategies Payoffs
Timing of moves Nature of conflict and interaction Informational conditions Enforceability of agreements or contracts
Rationality Common knowledge
The strategic environment Players > everyone who has an effect on your earnings Strategies > what actions are available to each player? > complete plan of action > tactics vs. strategies vs. moves Payoffs > numbers associated with each possible outcome > expected payoffs if outcomes are uncertain
The rules Timing of moves > what is the order of play > are the moves simultaneous? Sequential? Nature of conflict and interaction > are players’ interest in conflict? Cooperation? > will players act once, or repeatedly? Informational conditions > is there full information? Advantages? Enforceability of agreements or contracts > can agreements to cooperate work?
The assumptions Rationality > players aim to maximize their payoffs (self-interested and selfish, just like everyone else) > players are perfect calculators Common knowledge > each player knows the rules of the game > each player knows that each player knows the rules > each player knows that each player knows that each player knows...
Solving the game: the equilibrium > find dominant strategies > eliminate dominated strategies > find Nash-equilibrium in pure strategies > find Nash-equilibrium in mixed strategies > use backward induction to solve sequential games > find a subgame perfect equilibrium > use real options or certainty-equivalent valuation in backward inductions for sequential games under uncertainty
Innovation race: Prisoners’ dilemma Simultaneous innovation race dominate strategy Sequential investment game backward induction “burning the bridges” Simultaneous innovation game – under incomplete information
- Thought experiments - psychological biases
Acquisition price – game theory
Price – the bidding game Explanations when rival’s bid is exceedingly high Rational explanations: the value of future opportunities (real options) justifies the bid Irrational explanations: price exceeds expected value > thought experiment: confirmation bias > thought experiment: over confidence > remember thought experiment: the winner’s curse > how sophisticated might one think?
Commitment What would you bid for an asset with a known value? > the value of the asset is known > English auction (highest bidder) > the final offer will be paid by both the winner and the second highest bidder
Summary > With game theory a complex strategic problem can be reduced to an analytical structure with 5 dimensions.
> A general criticism is that by trying to rationalize known behavior in a stylized way, standard game theory models often fail to produce testable predictions (the insights from the analysis can be self- evident (vanzelfsprekend) in stable environments ).
> Particularly relevant in oligopolistic markets e., Unilever and Procter and Gamble Coca Gamble, Coca-Cola and Pepsi or Boeing and Airbus When combined with real Cola and Pepsi, or Boeing and Airbus. When combined with real options theory novel insights can be gained for uncertain environments.
- Application: valuation of an airport expansion
Lecture 4: corporate valuation
Outline lecture
Introduction to corporate valuation
Corporate valuation using the DCF-framework
Corporate valuation based on multiples
Conclusion
Introduction to corporate valuation
The corporate valuation process encompasses 5 steps
Understand industry dynamics
Understand competitive position & strategy
Analyze historical performance |
Perform discounted cash flow valuation |
Perform multiple valuation | focus of today
Understanding historical performance Ratio analysis to analyze historical performance > revenue analysis > COGS analysis > other operating costs > profitability analysis > capex spending > working capital analysis > tax analysis > capital structure analysis > cash flow generation > per share data ratios
EVA measures value creation over a period Capital charge = operating capital * WACC ROCB/ROIC = NOPAT / operating capital EVA = NOPAT – capital charge EVA = (ROCB/ ROIC) * operating capital EVA = (ROCB – WACC) * Operating Capital
Estimation of the WACC The weighted average cost of capital is the composite forward looking after tax cost of capital
WACC = Ke * Le + Kd (1-Tc)* Ld + Khs * Lhs
Methodologies to estimate residual value > based on a perpetuity method (e. a constant growing FCF) > based on the liquidation/replacement value > based on some exit multiple
Model type Formula Assumptions
Aggressive growth formula NOPAT
WACC−E(g)
The company generates a return on new investments which is approaching infinity
Unrealistic and not to be used
Value driver model
NOPAT∗( 1 −
E(g)
ROIC
)
WACC−E(g)
Return on new investments higher than the WACC
Converge model NOPAT
WACC
Generates a return on new investments equal to the WACC
Estimation of the growth rate after the planning period should be based on the following formula: > E(g) = ROIC * reinvestment ratio > reinvestment ratio = net investments / NOPAT > Net investments = investment in net working capital + total capex – depreciation Check: inflation + real growth industry
Perform scenario analysis on value > base case high growth margin improvement low case
- Multiple Valuation
Principles about multiple valuation > the valuation of an asset that is based on the prices currently being paid for assets that are comparable
Different type of multiples > earnings multiples > sales multiples (caveat: does not take into account profitability) > market to book multiples > industry specific multiples (does not take into account profitability and is related to sales multiples)
Example of multiple calculation note: enterprise value = market capitalization equity + preferred equity + net debt
Normalization of multiples
- PEG ratio normalizing PE for differences in growth
Regression analysis on multiples > regress multiple against the variable you want to normalize the multiple for > problem is that regressions are often very noisy (low R2)
Final remarks multiple valuation
- forward looking multiples > historical multiples
- EBITA, EBIT > EBITDA, closer to FCF
- median > average
- sales multiples are dangerous to use do not differentiate between profitability
- smaller companies trading at lower multiples than bigger companies more risky, however, the can have more growth
Cost of hybrid securities Cost of preferred equity If it pays a constant dividend: kps = dividend / market price if it pays a growing dividend: kps = dividend / (market price + growth rate)
Hybrid > strip the security in straight debt/equity/options > calculate as separate components > market value weighted average of the components
- Capital structure
The optimal capital structure definition: the optimal financing mix that maximizes firm value (or minimizes the cost of financing). In theory it is often represented as a trade-off between debt and equity financing.
Determinants of optimal capital structure Green > tax shields on interest > disciplines management (fixed commitments, interest and repayments, often result in more efficient working capital and investment policies) Red > bankruptcy costs (as financial leverage increases, both bankruptcy cost and the probability of going bankrupt increase) > agency costs (debt financing may give rise to conflicts between debt and equity holders) > loss of financial flexibility
Four methods to determine the optimal capital structure (OCS) in practice
WACC-method
Maximizing the present value of financing side effects
Scenario analysis
Target rating approach
WACC-method objective: minimize the WACC for different levels of debt
maximizing present value of financing side effects PV of financing side effects = PV of debt induced tax shields minus cost of financial distress tax shield: marginal effective tax rate * debt level financial distress: probability of distress * value loss when in distress
> effective tax rate decreases as operating profits are not high enough to fully utilize tax shield on interest > probability of financial distress increases as debt level increases > loss of value when in distress is industry specific
Scenario analysis > Develop a downside forecast that includes all investments that are critical to the firm’s strategy > Calculate the free cash flows resulting from that scenario > Identity minimum cash balance necessary to run operations (ignoring financing costs) > Identify optimal repayment terms required by lenders > Calculate the maximum amount of debt that a: meets the lender’s requirements b: maintains minimum cash balance c: covers critical investments d: uses available tax shields
target rating approach > based on some heuristic rule of thumb, the optimal capital structure should lie between a bond rating of A+ - A- > there is a relationship between debt/EBITDA and rating, however this is industry specific > calibrate the debt level to the debt/EBITDA and rating target specific
Criteria New issue EUR 250m in bonds New issue EUR 250m in shares
Flexibility Low, corporate rating to BBB High (remains), rating at A
Risk Exposure is high Exposure is low
Income DCF value per share higher DCF value per share lower
Control Tight covenants, but no voting dilution
No tight covenants, but voting dilution
Timing
Other Signal of confidence and optimism and indication that shares are undervalued
Signal of conservative financing policy and indication that shares are undervalued
Practical example of trade off different financing alternatives
Valuing a firm with changing capital structure > According to the WACC-method, the D/E ratio is fixed over time > In reality, leverage changes over the forecast period adjusted present value (APV) method: Enterprise value = PV (FCF @ unlevered cost of capital) + PV (Financing side effects)
Present value of tax shields
Lecture 7 Final Lecture
Objectives of the course
- building blocks of corporate finance and strategy
- market value
- value drivers
- strategic planning
- valuation methodology
- Capita Selecta
- company valuation
- debt capacity and cost of capital
- leveraged buyouts
- mergers & acquisitions
Question 1: strategic management a. bargaining power of suppliers bargaining power of customers threat of potential entrants threat of substitute products rivalry among existing firms Direct competition comes from rivalry among existing firms in the same industry. The intensity of rivalry and competition within the industry is affected by the threat of substitute products, threat of potential entrants, bargaining power of suppliers and customers. b. Yes, in analyzing strategic priorities, managers should look for buy and build options in which scale improves the competitive forces. Increases barriers to entry and increasing bargaining power towards suppliers and customers.
Question 2: real option valuation
Question 3: game theory
Industry analysis 1. strategic substitutes downward sloping, quantity competition, contrarian strategic complements upward sloping, price competition, reciprocating 2. strategic substitutes, because there are contrarian reactions (quantity competition) 3. Likely to shift upwards, such that firm A sets a higher quantity and firm B a lower one
Advanced Corporate Finance & Strategy Lectures
Vak: Advanced Corporate Finance and Strategy (FEM11006)
Universiteit: Erasmus Universiteit Rotterdam
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