EFB343

Should you delay investment expenses?

Committing capital before it is absolutely necessary gives up the option to make a better decision once uncertainty is resolved.

Should you immediately exercise an in the money real option?

The option to delay may be worth more than the NPV of undertaking the investment immediately.

What are the two types of acquisition

asset or share

What is a horizontal takeover

takeover of a company in the same line of business: one newspaper taking over another.

What is creeping?

gradual acquisition, acquirer must hold 19% of the target for least 6 months, then it can acquire an additional 3% every 6 months. Rare.

What is a high P/E due to?

high price or low earnings

What is a vertical takeover?

takeover of a company which is a link in the chain from producer to customer: farmer, miller, wholesaler, baker, distributor, retailer.

What is a Conglomerate takeover

takeover of a target in an unrelated business.

What is the Dysfunctional corporate governance with the separation of ownership and control?

Lack of transparency Level Tenuous link between performance and compensation Accounting manipulations

Define a Limited Liability Company or Corporation

Legal entity, owned by shareholders Can make contracts, carry on business, borrow, lend, sue, and be sued Shareholders have limited liability and cannot be held personally responsible for corporation's debts

What is the main goal of a corporation

Maximize the value of shares

What can a corporate do when bankrupt?

Reorganization - Emerged as a new firm (public or private), sold, restructured (sold some line of business and keep the core), etc. Liquidation - Sale of assets or business for debt payment.

What are the four real options?

Option to expand Option to abandon Timing option Flexible production facilities There are four types of real options—option to expand, option to abandon, timing option, and flexible production facilities. A project becomes more valuable with any or all of these options.

What is the option to expand?

Option to expand provides future possibilities for expansion like the FedEx Company's option to buy airbuses in the future.

What is the standard model for share valuation?

Performs a valuation by projecting dividends to some finite point in time "n" and the selling price at time "n". This price is sometimes called the "terminal value" or "horizon value". Could include perpetuity, constant growth or multiplier

Is there a link between board size and performance?

Researchers have found the surprisingly robust result that smaller boards are associated with greater firm value and performance. The likely explanation for this phenomenon comes from the psychology and sociology research, which finds that smaller groups make better decisions than larger groups. Other researchers argue that there is no standard board structure fits all firms. They show that complex firms are better off with larger board than simple ones and R&D intensive firms are better off with more insider directors

What is free cash flow?

Revenue minus expenses without interest or changes in working capital

What is post audit?

Review of project to see if met forecasts. Learn from the past. Postaudits are reviews of the projects to see how closely they met forecasts.

What is scenario analysis?

Scenario analysis is used to analyze a project for a given set of assumptions.

How do we value debt securities?

Securities which offer fixed interest payments and repayment of face value may be valued using the same approach as shares

What is the protection of shareholder rights?

The degree to which investors are protected against expropriation of company funds by managers and even the degree to which their rights are enforced vary widely across countries and legal regimes.

How do we value growth potential?

Young firms versus mature firms: Young firms have higher weight on growth options. Those growth options opportunities can be viewed of as a collection of real call options on potential projects.

Define proxy fight

a competitive struggle between two corporate factions for the proxy votes from shareholders needed to control a corporation

What is an on market takeover?

acquirer arranges for a broker to buy all shares (cash) in the target offered during a set period (1 to 12 months) for a specified offer price (may be varied).

What is an off market takeover?

acquirer makes a formal offer for the shares of the target.(Cash and/or shares).

What is cross-holdings?

While in the United States it is rare for one company's largest shareholder to be another company, it is the norm in many countries. In Japan, groups of firms connected through cross-holdings and a common relation to a bank are known as keiretsu. In Korea, huge conglomerate groups comprise companies in widely diversified lines of business and are known as chaebol.

If you calculate a discount rate before interest can you value a firm?

Yes - this discount rate values the firm

What is a captured board?

Describes a board of directors whose monitoring duties have been compromised by connections or perceived loyalties to management

Define buyout

A buyout is the acquisition of a controlling interest in a company - and is used synonymously with acquisition. If the stake is bought by the firm's management, it is known as a management buyout and if high levels of debt are used to fund the buyout, it is called a leveraged buyout.

What is tunneling in relation to pyramid structures?

A conflict of interest that arises when a shareholder who has a controlling interest in multiple firms moves profits (and hence dividends) away from companies in which he has relatively less cash flow toward firms in which he has relatively more cash flow rights ("up the pyramid")

What is a merger? Why would you merge?

A merger is an agreement that unites two existing companies into one new company. There are several types of mergers and also several reasons why companies complete mergers. Mergers and acquisitions are commonly done to expand a company's reach, expand into new segments, or gain market share. All of these are done to please shareholders and create value.

What is a termination value and how is it relevant to company valuation?

A terminal value is required as a matter of practicability. See share valuation in your introductory finance subject. Imagine a valuation problem where the cash flows are estimated for a finite time period and then it is assumed that a perpetuity exists thereafter. The terminal value is found using a perpetuity (it may be constant or growing).

What is a pyramid structure?

A way for an investor to control a corporation without owning 50% of the equity whereby the investor first creates a company in which he has a controlling interest This company then owns a controlling interest in another company. The investor controls both companies, but may own as little as 25% of the second company. The following slide details an actual pyramid controlled by the Pesenti family in Italy as of 1995. The Pesenti family effectively controls five companies even though it does not have more than 50% ownership of any one of them.

How is agency conflict managed?

Academic studies have supported the notion that greater managerial ownership is associated with fewer value-reducing actions by managers. But while increasing managerial ownership may reduce perquisite consumption, it also makes managers harder to fire.

What are the limitations of sensitivity analysis?

Ambiguous results arise from the definition of "optimistic" and "pessimistic". E.g marketing department may interpret it very differently to production department. Isolation of interrelated variables causes unrealistic estimation. E.g the interrelation between market size and unit price. If market demand is high, you will not only have larger shares, but also higher unit price. Alternative way to deal with interrelated variables: Scenario Analysis Sensitivity analysis shows that the project is sensitive to market share, variable costs, and unit price as the NPV of the project could turn negative under pessimistic states. At this stage it may be worthwhile to explore those areas further. The table shows the NPV values under possible outcomes.

What is an acquisition

An aggressive takeover An acquisition is a situation whereby one company purchases most or all of another company's shares in order to take control. An acquisition occurs when a buying company obtains more than 50% ownership in a target company. As part of the exchange, the acquiring company often purchases the target company's stock and other assets, which allows the acquiring company to make decisions regarding the newly acquired assets without the approval of the target company's shareholders

What is shareholder voice?

Any shareholder can submit a resolution that is put to a vote at the annual meeting. In Australia, the Corporations Act 2001 section 233 provides protection for minority shareholders, not just majority shareholders for oppression from directors.

Explain the benefits and costs of separation of ownership and control

Benefit: Permanence. The corporations tend to survive even if the mangers quit or are dismissed and replaced. Ownership changes will not disrupt the operations of the business. (The oldest corporation: Hudson's Bay Company since 1670). Downside: Agency problem. The misalignment between interests between the principles (shareholders) and the agents (managers).

What is the corporate main management team

Board of directors Elected by the shareholders to monitor and advice the management decision makings with ultimate authority. CEO, CFO, and COO

What is break even analysis

Break-even analysis shows the level of sales at which the firm starts making a profit.

Define a Sole Proprietorship

Business is owned and run by one person Typically has few, if any, employees

Is there any value in waiting before deciding on a real option?

By waiting for uncertainty to resolve you can make better decisions.

What is net working capital?

Cash + Inventories + Accounts Receivables Accounts Payable. = Current Assets - Current Liabilities. As NWC increases more cash is bound and unavailable to be paid to firm owners Large Cash, which earns interest should not be taken into account. On an project basis, need to estimate impact on working capital. On firm basis one often uses ratios, eg. There might be the need to hold 7% of sales in form of working capital.

What is the multiplier approach?

Common in practice Earnings x Multiplier = Value of Firm N.B. Earnings is future earnings, not current earnings.

What is the tradeoff of corporate governance?

Corporate governance is a system of checks and balances that trades off costs and benefits. This tradeoff is very complicated. No one structure works for all firms. Good governance is value enhancing and is something investors in the firm should strive for.

What are some takeover procedures

Creeping Off Market (On) Market Partial Takeover

What is a decision tree?

Diagram of sequential decisions and possible outcomes Help companies analyze options by showing various choices and outcomes Option to avoid a loss or produce extra profit has value Ability to create option has value that can be bought or sold Decision trees are used for making sequential decisions. Decision trees help firms visualize real options associated with a project. Real options to avoid loss or produce extra profit have additional value.

What are the abbreviations for cash flows and what do they mean? e.g. EBIT

EBIT(Earning before interest and tax) EBIAT= EBIT*(1-t). (Earning before interest and after tax) EAIBT=EBIT-interest payment NPAT=(EBIT-interest)*(1-t)

What are the objectives of takeover legislation?

Efficient and competitive market for equity. Shareholders a takeover bid have equal access to information to assess offer's merits. Premium for control (synergy) is shared by all. Prevent directors from frustrating an offer before shareholders are able to assess it. Market manipulation is detected promptly.

What is the ASX corporate governance council?

Established in 2002, the ASX corporate governance council provides recommendations on listed firms' corporate governance practice . Unlike U.S Sarbanes-Oxley Act that there was enforcement on corporate governance practice, Australian firms need to voluntarily adopt the corporate governance practice. Even though it's not mandatory, most of large Australia public firms tend to adopt the council's recommendation.

Do out of the money real options have value?

Even if an investment has a negative NPV, if there is a chance it could be positive in the future, the opportunity is worth something today.

What is a public corporation

Firms listed on stock exchange and shares are publicly traded. e.g. Apple

What is a flexible production facility option?

Flexible production facilities provide the firm with the ability to change the production facility to suit the demand.

What is a partial takeover?

For 51% or Less - Rare

What is the circularity problem with multipliers?

For a public company if we use the published current earnings and the published price earnings ratio we end up with the current price which is published in the press. Why not just read the price from the newspaper? The P/E ratio is based on current data. Current Earnings is a reported book value, which depends on reporting practices. When using P/E ratio to value a company, you shouldn't be using the current P/E ratio for the firm, but the P/E ratio you believe to the company will trade at in the future

What is the value of a firm comprised of?

Fundamental value and growth potential

What is corporate governance?

In 1932, Berle and Means document the separation of ownership and control as a starting point for subsequent academic thinking of corporate governance. The system of controls, regulations, and incentives designed to minimize agency costs between managers and investors and prevent corporate fraud.

What is inflation and how is it relevant to company valuation? i.e. how does inflation effect depreciation and tax?

In most cases the valuation is done with nominal values. Analysis in real terms useful when big inflation uncertainty. Note that depreciation does not change with inflation, as it refers to the initial book value of the assets. Tax is paid on nominal income and debt repayments are usually not indexed. Is your business sensitive to changes in inflation?

What regulations are in place to monitor the board of directors?

In the United States Or Australia, the board of directors has a clear fiduciary duty to protect the interests of the shareholders. Most other countries give some weight to the interests of other stakeholders in the firm, such as the employees. In Australia, it's clearly stated in sections such as 181&183 of the Corporations Act.

What are some monitors of a corporate board?

Includes security analysts, lenders, the SEC (or the ASIC in Australia), and employees. Securities analysts produce independent valuations of the firms they cover so that they can make buy and sell recommendations to clients. Lenders carefully monitor firms to which they are exposed as creditors. Employees of the firm are most likely to detect outright fraud because of their inside knowledge. The SEC in USA or ASIC in Australia protects the investing public against fraud and stock price manipulation.

What are the types of directors?

Inside Directors - Members of a board of directors who are employees, former employees, or family members of employees Gray Directors - Members of a board of directors who are not as directly connected to the firm as insiders are, but who have existing or potential business relationships with the firm Outside (Independent) Directors - Any member of a board of directors other than an inside or gray director

What is the moral hazard with the separation of ownership and control?

Insufficient effort Extravagant investments Entrenchment strategies Self-dealing

What are the 3 major decisions of a corporation

Investment decisions - Purchase of real assets Financing decisions - Sale of financial assets Payout policy - Dividend versus capital gain

What is a capital budget

List the projects and investments that a firm plans to undertake in the coming year. Capital budgeting process: analyze alternative projects and investments by examining the consequence of the project on firm's value. Common procedure: analyze the effect on firm cash flow and NPV of those cash flows. Capital budget is a list of investment projects under consideration by a firm. Cash flow estimates for projects are uncertain and the above methods provide ways to handle uncertainty. Generally more than one cash-flow estimate is generated for a project by changing the assumptions about the economy, the market, technology, costs, etc.

What tools ensure Management Pays Attention to the Value of the Firm

Manager's actions subject to the scrutiny of board of directors Shirkers are likely to find they are ousted by more energetic managers Financial incentives provided, such as stock options

What is management entrenchment?

Managerial entrenchment can be defined as an action, such as investing corporate funds, that is made by a manager in order to boost his or her perceived value as an employee, rather than to benefit the company financially or otherwise. Managerial entrenchment occurs when managers gain so much power that they are able to use the firm to further their own interests rather than the interests of shareholders Large investors have become increasingly interested in measuring the balance of power between shareholders and managers in a firm. The Investor Responsibility Research Center (IRRC) has collected information on 24 different characteristics that can entrench managers. The data is limited to U.S firms. However, those measures provide a good standard for other markets.

When are agency costs incurred?

Managers do not attempt to maximize firm value Shareholders incur costs to monitor managers and constrain their actions

What are the different objectives for ownership vs management?

Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders

What is the threat of takeover?

Many of the provisions listed in the IRRC index concern protection from takeovers. One motivation for a takeover can be to replace poorly performing management. An active takeover market is part of the system through which the threat of dismissal is maintained.

What are the ways to takeover?

Mergers Acquisitions (Assets or Shares) Proxy Fights Buyouts Corporate restructuring

What are some compensation policies?

Monetary incentives: Stock and Options Pay and Performance Sensitivity Backdating

What is controlling owners and pyramids?

Much of the focus in the United States is on the agency conflict between shareholders and managers. In many other countries, the central conflict is between what are called "controlling shareholders" and "minority shareholders." In these firms, there is usually little conflict between the controlling family and the management (it is often made up of family members). Instead, the conflict arises between the minority shareholders (those without the controlling block) and the controlling shareholders.

If you calculate a discount rate before interest can you value a firm?

No - this can be used to value equity

What is board independence? i.e. what is the role of independent directors?

On a board composed of insider, gray, and independent directors, the role of the independent director is really that of a watchdog. But, Insufficient incentives. Insufficient attention. Avoidance of conflict Captured Describes a board of directors whose monitoring duties have been compromised by connections or perceived loyalties to management

What is the option to abandon

Option to abandon provides the firm with ability to sell or terminate a project if the project turns out to be a loss maker. This will minimize the losses for the firm.

What is sensitivity analysis?

Sensitivity analysis shows how the project NPV is affected by changes in variables like sales, costs, etc. In this analysis only one variable is changed at a time. These are easy to carry out on a spreadsheet program.

What types of capital budget analysis are there?

Sensitivity: Analyzes effects of changes in sales, costs, etc., on project Scenario: Project analysis given particular combination of assumptions Simulation: Estimates probabilities of different outcomes Break Even: Level of sales (or other variable) at which project breaks even

What are possible shareholder actions?

Shareholder Voice Shareholder Approval

What is shareholder approval?

Shareholders must approve many major actions taken by the board. For example, target shareholders must approve merger agreements.

What is a private corporation

Shares are held closely by a small group of investors, and shares are not publicly traded. e.g. Dell

Define a Partnership

Similar to a sole proprietorship, but with more than one owner All partners are personally liable for all of the firm's debts. Two types of owners (general partners and limited partners)

What is simulation analysis

Simulation analysis is useful for the estimation of the probabilities of different possible NPV outcomes.

What is temporary abandonment?

Sometimes companies face complex options that may allow them to abandon the project temporarily and resume when the conditions improve There is usually a cost associated with mothballing and reactivating

What are the 4 steps of a monte carlo simulation?

Step 1: Model Project - set up the basic equations and interrelated variables Step 2: Specify Probabilities - set up forecast errors Step 3: Simulate Cash Flows - generate a sample of random cash flows Step 4: Calculate Present Value - calculate expected cash flows based on the random values, use it to calculate present value

What are the monetary incentives for management?

Stock and Options Managers' pay can be linked to the performance of a firm in many ways. Many companies have adopted compensation policies that include grants of stock or stock options to executives. The use of stock and option grants in the 1990s has lead to a substantial increase in management compensation. However, this has had some negative consequences. For example, often options are granted "at the money," meaning that the exercise price is equal to the current stock price. Managers therefore have an incentive to manipulate the release of financial forecasts so that bad news comes out before options are granted (to drive the exercise price down) and good news comes out after options are granted. Recent research has found evidence suggesting that many executives have engaged in backdating their option grants.

What is the difference in information for ownership vs management?

Stock prices and returns Issues of shares and other securities Dividends Financing

What are the takeover regulations like?

Takeover activity is highly regulated. Acquirers must satisfy the requirements of. Corporations law (ASIC - Takeovers Panel). Trade practice act. Foreign investment review board. Special Provisions - banking and media ASX listing rules. Your text outlines the takeover legislation. Regulatory involvement: ACCC, FIRB, ASIC, Takeovers panel, International regulatory approval Australian Competition Tribunal

What is a takeover?

Takeovers are frequently reported in the financial press, particularly in a prosperous economic climate. A takeover is defined as the situation where an acquiring company achieves control of the target company. If successful, the acquirer takes control of the assets of the target. A takeover can in theory be viewed as an investment in assets, not unlike a capital budgeting investment. This suggests that a takeover will only proceed if it is a positive NPV project for the acquirer. However, in practice, it can be difficult to estimate the NPV of a takeover. a situation where an acquiring (bidder) firm achieves control of a target company. The process could be viewed as an investment in assets not unlike a capital budgeting investment. Takeovers are controversial and there has been heated public debate about them.

What is flexible production

Textile firms investing in computer-controlled knitting machines, which allow production to shift from product to product, or from design to design as demand. Combustion Turbine generating plants are designed to be turned on or off on short notice, unlike the coal plants and nuclear plants that are efficient only if operated on "based load" for long period.

What is the stakeholder model?

The explicit consideration most countries (other than the United States) give to other stakeholders besides equity holders, in particular, rank-and-file employees

How can real options help create value?

The firm must continually re-evaluate its investment opportunities, including the options to delay or abandon projects, as well as to create or grow them.

How do we value shares?

The future cash flows are dividends For going concern dividends go to infinity Method used depends on pattern of CFs Simplify: Perpetuity Constant growth Standard model

What is backdating?

The practice of choosing the grant date of a stock option retroactively, so that the date of the grant would coincide with a date when the stock price was lower than its price at the time the grant was actually awarded By backdating the option in this way, the executive receives a stock option that is already in-the-money.

What is a real option compared to a financial option?

The right to make a particular business decision, such as a capital investment A key distinction between real options and financial options is that real options, and the underlying assets on which they are based, are often not traded in competitive markets.

What is insider trading?

Two types: Legal insider trading: Managers trade stocks of their companies Not on material information. Illegal insider trading: Occurs when any person makes a trade based on privileged information. Some examples of insider information include knowledge of an upcoming merger announcement, earnings release, or change in payout policy. The penalties for violating insider trading laws include jail time, fines, and civil penalties.

What is a timing option

Timing options provide the firm with the ability to postpone or pre-pone a project.

What is corporate regulation?

US. The Sarbanes-Oxley Act (SOX) The overall intent of SOX was to improve the accuracy of information given to both boards and to shareholders. The Cadbury Commission: The U.K. government commissioned Sir Adrian Cadbury to form a committee to develop a code of best practices in corporate governance

Why is the standard model for valuing shares good?

Very commonly during the business cycle you find that a firm grows at different rates. Typically a new firm will grow rapidly in its early years then level out to some lower growth rate - so we might observe several periods of different growth. Break the series into components.

How is an investment valued?

When you purchase an asset or security you are paying a price today for a series of future cash flows. Given time value of money then it makes sense to value the security as the present value of all future cash flows. The discount rate used should reflect the risk involved - higher the risk the higher the rate.

What are dual class shares?

When one class of a firm's shares has superior voting rights over the other class One way for families to gain control over firms even when they do not own more than half the shares is to issue dual class shares. For example, a class B share might have ten votes for every one vote of a class A share. Controlling shareholders will hold all or most of the shares with superior voting rights and issue the inferior voting class to the public.