Money & Capital Markets

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Feb 5, 2003 ... Markets. Firms. Individuals. Financial. Intermediaries. Curr assets. Fixed assets ... If it decides to invest, what is the most valuable investment?

Finance Theory II (Corporate Finance) Katharina Lewellen February 5, 2003

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Today ƒ Preliminaries ƒ Introduction to the course ¾ Corporate finance ¾ Types of questions ¾ Course outline ¾ Course requirements

ƒ Case of Unidentified Industries 2

Preliminaries ƒ Texts − Brealey & Myers, Principles of Corporate Finance, 7th edition − Higgins, Analysis for Financial Management, 7th edition − Case and Readings Packet

ƒ Professor − Katharina Lewellen

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Introduction Corporate finance

ƒ Investment policy

How the firm spends its money (real and financial assets)

ƒ Financing and payout policy

How the firm obtains funds (debt, equity) and disposes of excess cash

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Balance sheet view of the firm Assets

Current Assets

Liabilities Current Liabilities

Long-term debt Fixed Assets 1. Tangible 2. Intangible

Shareholders’ Equity

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Introduction, cont. But we also need to understand…

ƒ Capital markets ¾Types of securities (stocks, bonds, options…) ¾Trade-off between risk and return ¾Pricing

ƒ Taxes and government regulation

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Financial markets

Firms Curr assets

Debt

Fixed assets

Equity

Financial Markets Individuals Financial Intermediaries

Government

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Introduction, cont. Finance is really about value ƒ Firms ƒ Projects and real investments ƒ Securities Common characteristic ƒ Invest cash today in exchange for cash (hopefully) in the future Central question ƒ How do we create value through investment and financing decisions? 8

Types of questions Investment and financing decisions

ƒ At the end of 1999, GM had $11.4 billion in cash. ¾ Should it invest in new projects or return the cash to shareholders? ¾ If it decides to return the cash, should it declare a dividend or repurchase stock? ¾ If it decides to invest, what is the most valuable investment? What are the risks?

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General Dynamic ƒ Major contractor in the defense industry ƒ Doing well during 1980s (cold war) ¾ Growth in sales ¾ Reasonable profitability ¾ R&D and capital investment

ƒ Beginning of 1990s ¾ The end of cold war ¾ Likely decline in defense spending ¾ Strategy??? 10

General Dynamics $1,000 $800 $600

Net Inc R&D + Cap Exp

$400 $200 $0 -$200

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

-$400 -$600 11

Value of $100 invested in Jan. ‘80 $500

Market $400 $300 $200 $100

GD

$0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 12

General Dynamics Investment, 1980 – 1990 R&D + Capital expenditures: If invested at 10%:

$3.7 billion $5.5 billion

Ending market value:

$1.0 billion

Value destroyed:

$4.5 billion

Sales grew from $4.7 billion to $10.2 billion Earnings in 1990 = -578 million

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New strategy in 1991 William A. Anders (new CEO):

ƒ Cuts capital expenditure and R&D ¾ Cap. Exp. drops from $321 million in 1990 to $81 million in 1991

ƒ Sells off divisions and subsidiaries ƒ Cuts workforce ƒ Distributes cash to shareholders ¾ From 1991 through 1993, GD returns $3.4 billion to shareholders and debtholders

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General Dynamics: 1987 – 1997 $1,000 $800

CapEx + R&D

$600 $400 $200 $0 -$200 -$400

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Net Inc

-$600 15

Value of $100 invested Jan. ‘91 $700 $600

GD

$500 $400 $300

Market

$200 $100 $0 1987

1988

1989

1990

1991

1992

1993

1994 16

Types of questions Investment and financing decisions

ƒ Your firm needs to raise capital to finance growth. ¾ Should you issue debt or equity or obtain a bank loan? ¾ How will the stock market react to your decision? ¾ If you choose debt, should the bonds be convertible? callable? Long or short maturity? ¾ If you choose equity, what are the trade-offs between common and preferred stock?

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Types of questions, cont. Investment and financing decisions ƒ IBM recently announced that it would repurchase $2.5 billion in stock. Its price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response?

ƒ Motorola wants to build a new chip factory in Ireland. How will

fluctuations in the foreign exchange rate affect the value of the project? What are the risks? What actions can Motorola take to hedge the risks? More importantly, should it hedge the risks? What are the costs and benefits?

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Our Approach What we will do

ƒ Acquire a set of general tools that are crucial to sound business decision ¾ Financial managers ¾ General managers

ƒ Apply and confront them to a number of real business cases ¾ Usefulness ¾ Limitations

What we won’t do

ƒ Pretend to be experts in any industry, financial or other

ƒ Discuss many institutional aspects in detail

ƒ Discuss in detail stuff you could learn just as well reading a book or an article (see “readings”)

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Outline: Theory + Applications ƒ Part I: Financing − Capital structure − Payout policy

ƒ Part II: Valuation − Project valuation (FCF, PV, Real Options) − Company valuation (M&A, Start-ups)

ƒ Part III: Selected topics in corporate finance − Corporate governance − Hedging/Risk management

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The tools of finance (15.401) ƒ ƒ ƒ ƒ ƒ ƒ ƒ

Time Value of Money Portfolio Theory Asset Pricing Theory Efficient Markets Hypothesis Option Pricing Theory The Concept of No-Arbitrage Agency Theory (Micro-economics, Incentives and Contracts)

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Course Requirements ƒ Class Participation (10%) ƒ Case Memoranda (30%) ¾ Teams up to four people ¾ Hand in all write-ups except two write-ups of your choice ¾ A professional memo to the decision maker

ƒ Midterm (30%) ƒ Final (30%)

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The Case of the Unidentified Industries

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Advertising Agency Computer Software Developer Health Maintenance Org. Retail Drug Chain

Airline Department Store Chain Meat Packer Retail Grocery Chain A

Line

B

C

Commercial Bank Electric & Gas Utility Pharmaceutical Manufacturer D

E

F

G

I

J

77 7 0 3 9 4 100

9 28 13 3 35 13 100

67 9 2 2 17 2 100

19 13 12 6 48 1 100

2 13 1 12 29 14 0 5 24 100

0 32 3 2 0 1 0 11 51 100

0 15 6 13 19 6 0 24 18 100

0 6 6 5 0 0 0 28 55 100

7 5 2 8 15 1 0 16 46 100

0.63

1.1

2.35

1.58

4.72

2.31

0.4 NA 27 0.44 0.66 0.83 0.01 0.01 5.77 0.07

1.04 8.6 6 0.31 0.48 2.61 0.02 0.05 3.43 0.17

2.28 NA 13 0.00 0.00 2.03 0.13 0.27 1.62 0.43

1.5 47.6 16 0.19 0.32 6.47 0.02 0.10 2.39 0.23

4.59 7.5 37 0.00 0.00 0.87 0.25 0.21 1.21 0.26

2.03 2 74 0.22 0.18 0.64 0.11 0.07 1.61 0.11

#1 2 3 4 5 6 7

Balance Sheet Percentages Cash and marketable securities Account receivables Inventories Other current assets Plant and equipment (net) Other assets Total assets

5 85 0 1 2 7 100

12 55 0 4 7 23 100

2 4 1 2 77 15 100

1 15 24 2 55 3 100

4 7 43 4 37 5 100

4 6 0 6 71 13 100

3 4 22 2 41 29 100

8 9 10 11 12 13 14 15 16 17

Notes payable Accounts payable Accrued taxes Other current liabilities Long-term debt Preferred stock Other liabilities Capital stock and capital surplus Retained earnings Total liabilities and stockholder equity

62 18 2 0 7 4 2 2 4 100

3 63 2 0 6 8 0 10 7 100

0 3 0 4 29 21 5 11 28 100

2 17 1 9 38 5 3 1 23 100

0 18 1 17 0 10 0 3 51 100

4 5 0 17 40 17 0 12 5 100

1.11

1.03

1.31

1.46

1.59

1.1 NA 3,278 0.69 0.09 0.10 0.14 0.01 14.10 0.19

0.97 NA 381 0.10 0.24 0.52 0.05 0.03 5.84 0.14

0.98 16.7 30 0.29 0.40 0.46 0.12 0.05 2.31 0.12

1.4 5.6 31 0.40 0.57 1.82 0.02 0.04 3.61 0.13

1.49 5.2 8 0.00 0.00 3.18 0.03 0.10 1.85 0.18

18 19 20 21 22 23 24 25 26 27 28

Selected Financial Data Current assets/current liabilities Cash, marketable securities and accounts receivable/current liabilities Inventory turnover (X) Receivables collection period Total debt/total assets Long-term debt/capitalization Net sales/total assets Net profit/net sales Net profit/total assets Total assets/net worth Net profit/net worth

H

K

24

Industry Groups Service providers ƒ Advertising agency ƒ Airline ƒ Commercial bank ƒ HMO

Zero inventories ƒ A, B, F, H

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A

Group 1:

ƒ Advertising Agency

ƒ Airline ƒ Commercial

Line #1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Bank 18 19

ƒ HMO

20 21 22 23 24 25 26 27

B

F

H

Balance Sheet Percentages Cash and marketable securities Account receivables Inventories Other current assets Plant and equipment (net) Other assets Total assets

5 85 0 1 2 7 100

12 55 0 4 7 23 100

4 6 0 6 71 13 100

77 7 0 3 9 4 100

Notes payable Accounts payable Accrued taxes Other current liabilities Long-term debt Preferred stock Other liabilities Capital stock and capital surplus Retained earnings Total liabilities and stockholder equity

62 18 2 0 7 4 2 2 4 100

3 63 2 0 6 8 0 10 7 100

4 5 0 17 40 17 0 12 5 100

0 32 3 2 0 1 0 11 51 100

1.11

1.03

0.63

2.35

1.1 NA 3,278 0.69 0.09 0.10 0.14 0.01 14.10

0.97 NA 381 0.10 0.24 0.52 0.05 0.03 5.84

0.4 NA 27 0.44 0.66 0.83 0.01 0.01 5.77

2.28 NA 13 0.00 0.00 2.03 0.13 0.27 1.62

Selected Financial Data Current assets/current liabilities Cash, marketable securities and accounts receivable/current liabilities Inventory turnover (X) Receivables collection period Total debt/total assets Long-term debt/capitalization Net sales/total assets Net profit/net sales Net profit/total assets Total assets/net worth

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Identified Industries in Group 1 A B F H

Commercial Bank Advertising Agency Airline Health Maintenance Organization (H.M.O.)

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Group 2

C

D

E

I

J

3 4 22 2 41 29 100

9 28 13 3 35 13 100

67 9 2 2 17 2 100

0 18 1 17 0 10 0 3 51 100

2 13 1 12 29 14 0 5 24 100

0 15 6 13 19 6 0 24 18 100

0 6 6 5 0 0 0 28 55 100

1.46

1.59

1.1

1.58

4.72

1.4 5.6 31 0.40 0.57 1.82 0.02 0.04 3.61 0.13

1.49 5.2 8 0.00 0.00 3.18 0.03 0.10 1.85 0.18

1.04 8.6 6 0.31 0.48 2.61 0.02 0.05 3.43 0.17

1.5 47.6 16 0.19 0.32 6.47 0.02 0.10 2.39 0.23

4.59 7.5 37 0.00 0.00 0.87 0.25 0.21 1.21 0.26

#1 2 3 4 5 6 7

Balance Sheet Percentages Cash and marketable securities Account receivables Inventories Other current assets Plant and equipment (net) Other assets Total assets

2 4 1 2 77 15 100

1 15 24 2 55 3 100

4 7 43 4 37 5 100

ƒ Meat packer

8 9 10 11 12 13 14 15 16 17

Notes payable Accounts payable Accrued taxes Other current liabilities Long-term debt Preferred stock Other liabilities Capital stock and capital surplus Retained earnings Total liabilities and stockholder equity

0 3 0 4 29 21 5 11 28 100

2 17 1 9 38 5 3 1 23 100

ƒ Pharmaceutical

18 19

1.31 0.98 16.7 30 0.29 0.40 0.46 0.12 0.05 2.31 0.12

ƒ Computer

software dev.

ƒ Dept. store ƒ Electric & gas utility

manufacturer

ƒ Retail drug ƒ Retail grocery

Line

20 21 22 23 24 25 26 27 28

Selected Financial Data Current assets/current liabilities Cash, marketable securities and accounts receivable/current liabilities Inventory turnover (X) Receivables collection period Total debt/total assets Long-term debt/capitalization Net sales/total assets Net profit/net sales Net profit/total assets Total assets/net worth Net profit/net worth

G

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Group 2: Inventory turnover ƒ Computer

software dev.

ƒ Dept. store ƒ Electric & gas utility

ƒ Meat packer ƒ Pharmaceutical manufacturer

ƒ Retail drug ƒ Retail grocery

Industry I C G J D E K

Inventory turnover 47.6 16.7 8.6 7.5 5.6 5.2 2.0 29

Group 2: Receivables collection period ƒ Computer

Industry

ƒ Dept. store

Collection period

K

74

ƒ Pharmaceutical

J

37

D

31

ƒ Retail drug

E

8

ƒ Retail grocery

G

6

software dev.

manufacturer

30

Group 2: Inventory & PPE ƒ Computer

Industry INV (%) PPE (%)

ƒ Dept. store

D

24

55

ƒ Pharmaceutical

K

12

48

J

2

17

software dev.

manufacturer

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The Identified Industries A B C D E F G H I J K

Commercial Bank Advertising Agency Electric & Gas Utility Department Store Chain Retail Drug Chain Airline Retail Grocery Chain H.M.O. Meat Packers Software Developer Pharmaceutical Manuf.

Citicorp Interpublic Consolidated Edison Dayton-Hudson Walgreen AMR Corp. American Stores U.S. Healthcare IBP, Inc. Microsoft Novo Nordisk 32

Any Comments? Bank Advertising E & G Dpt Store Drug Airline Grocery HMO Meat Software Phama. Agency Utility Chain Chain Chain Packers Developer Manuf. Line #1 2 3 4 5 6 7

Balance Sheet Percentages Cash and marketable securities Account receivables Inventories Other current assets Plant and equipment (net) Other assets Total assets

5 85 0 1 2 7 100

12 55 0 4 7 23 100

2 4 1 2 77 15 100

1 15 24 2 55 3 100

4 7 43 4 37 5 100

4 6 0 6 71 13 100

3 4 22 2 41 29 100

77 7 0 3 9 4 100

9 28 13 3 35 13 100

67 9 2 2 17 2 100

19 13 12 6 48 1 100

8 9 10 11 12 13 14 15 16 17

Notes payable Accounts payable Accrued taxes Other current liabilities Long-term debt Preferred stock Other liabilities Capital stock and capital surplus Retained earnings Total liabilities and stockholder

62 18 2 0 7 4 2 2 4 100

3 63 2 0 6 8 0 10 7 100

0 3 0 4 29 21 5 11 28 100

2 17 1 9 38 5 3 1 23 100

0 18 1 17 0 10 0 3 51 100

4 5 0 17 40 17 0 12 5 100

2 13 1 12 29 14 0 5 24 100

0 32 3 2 0 1 0 11 51 100

0 15 6 13 19 6 0 24 18 100

0 6 6 5 0 0 0 28 55 100

7 5 2 8 15 1 0 16 46 100

1.03

1.31

1.46

1.59

0.63

1.1

2.35

1.58

4.72 4.59

2.31 2.03

0.97 NA 381 0.1 0.24 0.523

0.98 16.7 30 0.29 0.4 0.464

1.4 5.6 31 0.4 0.57 1.822

1.49 5.2 8 0 0 3.175

0.4 NA 27 0.44 0.66 0.828

1.04 8.6 6 0.31 0.48 2.61

2.28 NA 13 0 0 2.032

1.5 47.6 16 0.19 0.32 6.473

7.5 37 0 0 0.867

2 74 0.22 0.18 0.643

18 19

20 21 22 23 24

Selected Financial Data Current assets/current liabilities 1.11 Cash, marketable securities and accounts receivable/current liabilities 1.1 Inventory turnover (X) NA Receivables collection period 3278 Total debt/total assets 0.69 Long-term debt/capitalization 0.09 Net sales/total assets 0.095

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Leverage

American Airlines Dayton Hudson American Stores Consolidated Edison Novo Nordisk IBP Interpublic Walgreens Microsoft US Healthcare

Industry Airlines Department Stores Grocery Stores Combination Utility Services Pharmaceuticals Meat Products Advertising Agencies Drug Stores Prepackaged Software HMOs

Firm 0.44 0.40 0.31 0.29 0.22 0.19 0.10 0.00 0.00 0.00

Total Debt/Total Asset Industry Industry Industry Mean Std Dev Median 0.32 0.20 0.31 0.29 0.17 0.30 0.35 0.20 0.32 0.35 0.05 0.35 0.24 0.92 0.08 0.31 0.24 0.30 0.08 0.06 0.09 0.24 0.18 0.27 0.07 0.19 0.01 0.09 0.11 0.04

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Balance Sheet

Firm A %

Firm B %

Cash and marketable securities Accounts receivable Inventories Other current assets Plant and equipment (net) Other assets Total assets

58 0 5 3 5 30 100

2 3 52 3 28 12 100

Notes payable Accounts payable Accrued taxes Other current liabilities Long-term debt Other liabilities Preferred stock Capital stock and capital surplus Retained earnings Total liabilities and stockholder equity

0 17 0 7 54 0 0 47 (25) 100

0 28 2 15 14 4 0 29 9 100 35