Business strategy for lawyers Chapter 4 Corporate finance

Business strategy & finance Business managers compete in three markets • Market for corporate control – Maintaining their position in the firm • Product markets – Maximizing the firm’s profits • Capital markets – Raising money for the firm from investors 2 © Amitai Aviram. All rights reserved. Addressed in BA 2

Business strategy & finance Business managers compete in three markets • Market for corporate control – Maintaining their position in the firm • Product markets – Maximizing the firm’s profits • Capital markets – Raising money for the firm from investors 3 © Amitai Aviram. All rights reserved. Addressed throughout this course

Business strategy & finance Business managers compete in three markets • Market for corporate control – Maintaining their position in the firm • Product markets – Maximizing the firm’s profits • Capital markets – Raising money for the firm from investors 4 © Amitai Aviram. All rights reserved. Topic of this section

Corporate finance Overview of Chapter 4 a) Capital markets b) Valuation c) Financial engineering

Capital markets Thinking of finance as a product • The product: return on an investment – Ownership in a business (equity) – Lending money to a business/government (debt) – Ownership of a physical asset (gold, oil, art) • Basis of competition (what makes a product good? ) – – Return on equity (Ro. E) [equity – the money you put at risk] Risk Price (fees) Convenience • Ease of access • Personal treatment • Access to investment research / explanations for novices 6 © Amitai Aviram. All rights reserved.

Capital markets Types of risk • Operational risk – Risk that business activities fail • Leverage risk – Financing business with debt increases risk of the equity investment – We will see an example later in this section, in Calvin’s hypo • Liquidity risk – Harder to sell illiquid assets (quick sale causes big loss) – But illiquid markets likely have lower market efficiency • Concentration risk – Too many investors employing the same strategy (enter/exit at same time) – Strategy’s popularity gives false sense of lower liquidity risk • Transparency risk – Difficulty to understand/valuate complex financial products – Results in inaccurate valuations 7 © Amitai Aviram. All rights reserved.

Capital markets Efficient Capital Markets Hypothesis • Competing assumptions (called forms/levels of market efficiency) 8 Random prices Weak-form efficiency Semi-strong form efficiency Strong-form efficiency Prices reflect no information Prices reflect previous price info Prices reflect all public info Prices reflect all info © Amitai Aviram. All rights reserved.

Capital markets Investing to match the market • Jane expects the S&P 500 (an index of 500 publicly-traded companies) to rise 5% in the coming year • Is there a way that she can invest her money so that she makes exactly the same return as the S&P 500 – If the market is weak-form efficient? – Semi-strong form efficient? – Strong-form efficient? • To facilitate this kind of investing, there are special type of mutual funds called index funds – Index funds try to match the market index, not beat it – They do not pick the best stocks, but invest in all of them – Very low fees: <0. 1% 9 © Amitai Aviram. All rights reserved.

Capital markets Investing to match the market • Calvin likes to live on the edge. He wants to invest so that he makes ten times what the S&P 500 does. I. e. : – If S&P 500 goes up 5%, Calvin profits 50% – If S&P 500 goes down 5%, Calvin loses 50% • He borrows $100 from a bank; buys units in an S&P 500 index fund – For simplicity, assume 0% interest • Bank holds as collateral: – The index fund units – $10 of Calvin’s own money (margin) 10 © Amitai Aviram. All rights reserved.

Capital markets Investing to match the market • If S&P 500 went up by 5% – Calvin sells units for $105 – Pays back $100 for loan – Profit: $5 off of a $10 investment → 50% • If S&P 500 went down by 5% – – Calvin sells units for $95 Owes bank $100 for loan Bank keeps $95 proceeds + $5 out of the margin Profit: -$5 off of a $10 investment → -50% • How much does this arrangement cost? • Will it work in efficient capital markets? 11 © Amitai Aviram. All rights reserved.

Capital markets Thinking of finance as a product • Because investing to earn market’s Ro. E is “produced” differently than investing to beat the market, we should treat them as different markets, or at least different segments of market • Competition for providing market Ro. E – Entry problem: anyone can make investments with same return (risk-adjusted) as market as a whole – Result: Low “price” (fees) (~0. 1% per year on index mutual fund) – Fees cap supplier’s overhead (0. 1% is not enough to attract talent) • Competition for providing above-market Ro. E – ECMH: because everyone is trying to beat the market, any info that affects price of investment will immediately be incorporated into the price – So, challenge is to overcome ECMH & earn above-market Ro. E – To explore how, consider first some financial terminology… 12 © Amitai Aviram. All rights reserved.

Capital markets Beta • In finance theory, the correlation between an investment & the market is known as Beta (β) • β=1: Investment acts exactly same as the market – E. g. , an index fund aims to have β=1 • β=10: Investment rises & falls 10 times as much as the market – E. g. , Calvin’s investment • β=0: Investment is not correlated with the market at all – E. g. , lottery ticket • β=-1: Investment acts exactly opposite of the market – E. g. , selling short S&P index fund units 13 © Amitai Aviram. All rights reserved.

Capital markets Beta return • The beta return means the portion of the return that is explained by what the market as a whole did, adjusted for investment’s risk – I. e. , the return that is cheap to create • Example: if the S&P 500 went up 5%, then – the “beta return” for an investment with β=1 is 5% • This is cheap to create, as Jane did – the “beta return” for an investment with β=10 is 50% • This is cheap to create, as Calvin did 14 © Amitai Aviram. All rights reserved.

Capital markets Alpha & investment performance • The portion of the return that is not explained by the market is called Alpha (α) (sometimes called “abnormal return”) • This is the part of the return that requires expertise to create Beta Alpha • A money manager earned a return of 20%. What is her α if – – the portfolio’s beta is 1? – the portfolio’s beta is 10? • Based on her performance, does she deserve a higher fee than what an index fund charges? 15 © Amitai Aviram. All rights reserved.

Capital markets Alpha & investment performance • To know Alpha, you need to know β (the risk of the investment) – Infer β from past behavior • • But investments may act differently in the future Also, new investments have no past record track – Calculate β for the past year & pay at end of year • A single year may not be representative – Calculate β for the past 10 years & pay then • • 16 But no money manager will wait that long to be paid And few investors will invest for that long © Amitai Aviram. All rights reserved.

Capital markets Creating alpha • How do you earn an abnormal return (α)? – Creating a β return is easy & inexpensive • How do you create a Beta return? – But this means that it’s not enough money for an expert money manager – To justify high fees, a money manager needs to create an alpha return • 17 Three ways to create alpha… © Amitai Aviram. All rights reserved.

Capital markets Creating alpha 1. Entrepreneurship • Control the enterprise & make it work better. E. g. – – Venture capitalism: take an inventor & idea and turn into professionally run business Shareholder activism: buy unpopular (cheap) company, replace its management with one that the market trusts more, sell when prices rise Why aren’t profits competed away? • – Requires continuous, active involvement • – 18 Limits manager to a small number of ventures Requires new ideas © Amitai Aviram. All rights reserved.

Capital markets Creating alpha 2. Valuation • Identify underpriced investments & invest in them • Requires market efficiency < strong – – Less liquid markets (few buyers/sellers); or Faster trading technology than rivals Also requires better valuation skills than rivals • – – Nonpublic information (w/o it, mkt eff must be <semi-strong) Better analysis skills Why aren’t profits competed away? • – Scale of investment Requires significant investment in collecting/analyzing info Time scope of investment (Harder to exit an illiquid investment) • – 19 © Amitai Aviram. All rights reserved.

Capital markets Creating alpha 3. Financial engineering • Improve efficiency of firm’s use of capital; or • Create new financial products appealing to investors – Example: Mutual funds. Before mutual funds, middle class investors were unable to diversify, and so bore a higher risk • Why aren’t profits competed away? • – Requires constant innovation • – 20 Investors pay in fees some of the costs the funds save them Once a new idea becomes known, others copy it Requires expertise & marketing ability © Amitai Aviram. All rights reserved.

Capital markets Creating alpha: entrepreneurship • Making the business more profitable – This is

Capital markets Creating alpha: valuation • Works only in less efficient markets, and only

Capital markets Creating alpha: financial engineering • Improve efficiency of firm’s use of capital – Creating new financial products is beyond scope of this course 23 © Amitai Aviram. All rights reserved.

Valuation Piemonte v. New Boston Garden Corp. [Mass. 1979] • Court needs to determine value of Boston Garden Arena Corp. (“Garden Arena”) – Boston Bruins & Boston Braves hockey franchises – Boston Garden Sports Arena (sports/entertainment facility) – Operator of food & beverage concession @ Arena • Lower court judge uses “Delaware block approach” 25 © Amitai Aviram. All rights reserved.

Valuation Market value • Variation 1: Share price – Only works for a public company – Doesn’t work for valuation of a segment of a company • Garden Arena is a public company – Between 1968 -1972, shares traded between $20. 50 & $29 – Last sale prior to merger was for $26. 50 • Why isn’t this the end of the valuation process? – Any reason market value won’t be the correct valuation? 26 © Amitai Aviram. All rights reserved.

Valuation Market value • Variation 2: Trading comps – Comparison to other publicly traded companies • Example: Suppose that Garden Arena is not publicly traded, but Acme (which also owns a hockey franchise & sports arena) is publicly traded – Suppose Acme’s market value is $100 M – Pick a relevant criteria to compare Acme to Garden Arena (earnings, assets, number of season ticket holders, etc. ) – Suppose that Acme has twice the earnings of Garden Arena – Garden Arena’s valuation would therefore be $50 M • Weaknesses of this method? 27 © Amitai Aviram. All rights reserved.

Valuation Market value • Variation 3: Deal comps – Comparison to other company acquisitions • Example: Suppose that no hockey teams are publicly traded, but Acme (which also owns a hockey franchise & sports arena) was recently acquired for $100 M – Pick a relevant criteria to compare Acme to Garden Arena (earnings, assets, number of season ticket holders, etc. ) – Suppose that Acme has twice the earnings of Garden Arena – Garden Arena’s valuation would therefore be $50 M • Weaknesses of this method? 28 © Amitai Aviram. All rights reserved.

Valuation Earnings vs. cashflow • Cashflow: cash or assets that can readily be turned into cash (e. g. , money in the firm’s bank account, liquid securities) that firm receives during specified period, less cash or equivalents that firm pays during same period • Earnings: revenues - expenses, based on accounting rules • Why do cashflow & earnings differ? – Revenues are recorded when a sale is made (not when money is paid) • E. g. , A delivers widget to B, who will pay $100 next year; $100 revenue is recorded now – Expenses recorded are those incurred in generating the revenues that were recorded for that time period • E. g. , This year A produced two widgets @ total cost of $120, but only one widget was sold; A records expenses of $60 • So, cashflow was -$120, but A recorded earnings of $60 29 © Amitai Aviram. All rights reserved.

Valuation Earnings vs. cashflow • Why do cashflow & earnings differ? (continued) – The cost of assets used long-term (capital assets) is not recorded as an expense; instead, it is depreciated over its lifetime • Example: A buys widget-producing machine for $10, 000 in cash. The machine is expected to have a lifespan of 10 years • Each year, a depreciation expense of $1, 000 ($10 K/10 years) is recorded; after the 10 th year, the machine is fully depreciated and no more depreciations are recorded • Cashflow: -$10 K in first year, no changes in later years unless new machine is needed • Earnings: -$1 K/year for 10 years • Cashflow fails to capture aspects of the “living business”, but earnings are easier for managers to manipulate – E. g. , decide machine’s life span is 5 yrs. or 20 yrs. to double or halve the depreciation expense 30 © Amitai Aviram. All rights reserved.

Valuation Earnings / cashflow (comps) • Variation 1: Earnings multiplier – 2 steps – Determine appropriate price/earnings (P/E) ratio (multiplier) – Value = Multiplier x company’s average earnings in past 5 yrs. • Multiplier – Judge decides appropriate multiplier is 10 – Comparison to other firms (publicly traded or acquired) • Earnings – Earnings should exclude extraordinary gains/losses – Judge includes payments from expansion teams • Weaknesses of this method? – Cashflow multiplier valuation done in same way 31 © Amitai Aviram. All rights reserved.

Valuation Earnings / cashflow (DCF) • Variation 2: Discounted cash flow (DCF) – Not in Piemonte case – Predict future net cash flows (inflows - outflows) • Considers cashflow, not earnings • Predicting future figures avoids bias of misrepresentative past earnings, but future estimates may be speculative – Determine appropriate discount rate • I. e. , money’s loss of value over time – Discount future earnings by discount rate & add them up 32 © Amitai Aviram. All rights reserved.

Valuation Earnings / cashflow (DCF) • Example (discount rate: 10%) Year Outflow Net cashflow Discount DCF 2000 $50 $250 -$200 1. 00 -$200 2001 $300 $100 $200 0. 90 $180 2002 $350 $300 0. 81 (0. 9 x 0. 9) $243 2003 $400 $50 $350 0. 73 (0. 9 x 0. 9) $255. 50 2004 $450 $400 0. 66 $264 2005 $500 $50 $450 0. 59 $265. 50 2006 $500 $50 $450 0. 53 $238. 50 Total $2, 550 $600 $1, 950 33 Inflow © Amitai Aviram. All rights reserved. $1, 246. 50

Valuation Earnings / cashflow (LBO) • Variation 3: LBO feasibility • Also not in Piemonte case • Example: Valuation of Target Corp. – Assumptions • Target has a stable cashflow of $90 M/yr. • Acquirer corp. can borrow money at 10% interest • Lender insists that Acquirer put in $100 M of its own money; can use borrowed money for the remainder of the acquisition (Why? ) – Acquirer can borrow up to $900 M while paying interest exclusively from Target’s cashflow ($900 M x 10% = $90 M) – Target’s valuation is $1 B ($900 M borrowed + $100 M equity) – In what way does this tell you how much Target is worth? 34 © Amitai Aviram. All rights reserved.

Valuation Asset value • Net asset value: Value of all assets – all debts • Problem: Value of assets based on accounting standards – not necessarily representing the market value of the assets or their value to the business – Example 1: New car purchased for $30 K. Expected life: 10 years • After 1 year, book value is $27 K, but car worth far less • After 10 years, book value is $0, but car is still worth something – Example 2: Law firm leases office space @ fair market value, owns furniture/computers worth $100 K; profit: $2 M/year • Asset value clearly doesn’t represent business value of firm • Accounting concept of goodwill is a crude approximation 35 © Amitai Aviram. All rights reserved.

Valuation Asset value • Example 3: Garden Arena purchased the Arena on May 1973 (½ year before valuation) for $4 M, with $3. 4 M mortgage – If the Arena is worth $4 M, then it would add $600 K to Garden Arena’s net asset value • Prior to purchase, Garden Arena leased the Arena with a fixed maximum rent & an obligation on the lessee to pay only ⅔ of local realestate tax increases • Lease had 13 more years to run; inflation was high & real-estate taxes were rising – Court: “The existence of the lease would tend to depress the purchase price. ” Why? 36 © Amitai Aviram. All rights reserved.

Valuation Weighting of valuations • Last step is to give each valuation method a weight • Judge gives 10% to market value; 50% to asset value – Market unreliable because of low flotation (freely-trading shares) • Less trading means less accurate valuation (inefficient market) • Even acquiring entire flotation wouldn’t give any control in company, so market price discounts benefits to controlling SHs – Earnings value less reliable than asset value because: • “Garden Arena had been largely a family corporation in which earnings were of little significance” – What does that mean? Owners don’t care about making money? • “Garden Arena had approximately $5, 000 in excess liquid assets; and… substantial real estate holding in an excellent location. ” – Why does this make asset value better than earnings value? 37 © Amitai Aviram. All rights reserved.

Valuation Keep a healthy skepticism… • Valuation uses crude approximations to come up with very precise results – Like deciding whether a team has a first down in football 38 © Amitai Aviram. All rights reserved.

Financial engineering Private equity • Private equity firms (“PE”) are businesses that specialize in identifying attractive businesses (often public companies), acquiring control in them, making changes to improve their value, and after a few years sell them & distribute profits to the PE firm’s investors – Unlike other investors, PE emphasizes ability to improve the company, not just spot undervalued companies (i. e. , alpha comes from entrepreneurship, not just beating the capital market) – Some value comes from improved financial engineering – better (or more risky) use of capital 40 © Amitai Aviram. All rights reserved.

Financial engineering Private equity • Process – PE firm owned by highly respected financial experts – PE firm opens a fund; solicits investors • Investors invest in fund • Fund has limited lifespan; withdrawal rights restricted • Fund managed by PE firm; draws fees – Fund uses money to buy control in several businesses • Makes changes to business to increase value – Fund sells improved business – When time is up, fund dissolves & distributes profits 41 © Amitai Aviram. All rights reserved.

Financial engineering Posen, If Private equity sized up your business • According to Posen, 5 ways PE increases firm’s value – – – 42 Reduce idle cash Financial engineering Optimize capital structure Entrepre. Improve business plan; monitor performance better neurship Better incentives for management Reducing agency problem Better board member selection © Amitai Aviram. All rights reserved.

Financial engineering Reducing idle cash • Ro. E = return (i. e. , profit) / amount investor puts at risk • Ro. E can be increased by either: – Increasing Return on Assets (Ro. A) • Managing the business better (entrepreneurship) – Reducing the amount of equity (investor’s money at risk) • Reducing idle cash • Optimizing capital structure (leveraging) 43 © Amitai Aviram. All rights reserved.

Financial engineering Reducing idle cash • Return tends to be correlated with risk – If investment is more risky, investors demand higher return – What’s likely to be more risky: the company’s main business, or money the company has in the bank? • If investor wants a safe investment (with a low return), she doesn’t need the company to make it – Why pay executives’ salaries, office space, etc. , just to earn interest on bank account? • So why do companies keep spare cash? 44 © Amitai Aviram. All rights reserved.

Financial engineering Reducing idle cash • Spare cash levels offer a trade-off: – Spare cash reduces Ro. E – But higher chance to survive financial difficulties & exploit business opportunities • Management has incentive to keep a lot of cash – Gives them more flexibility to manage the company – Executive compensation tied to size of company – If company fails, they lose their jobs; on the other hand, management doesn’t directly benefit from higher Ro. E • So, high cash levels may signal an agency problem • But, it also may be a prudent thing for firm to do 45 © Amitai Aviram. All rights reserved.

Financial engineering Optimizing capital structure • Even when the firm has no spare cash, it can reduce the amount of capital invested by borrowing money and returning it to investors – Dividends – Repurchasing shares 46 © Amitai Aviram. All rights reserved.

Financial engineering Optimizing capital structure • Example: Acme has $10 M of assets; earns a profit of $1 M/year (Ro. A = 10% [$1 M/$10 M]) • Originally, Acme has no debt (all equity) – Ro. E=10% [$1 M/$10 M] • Acme borrows $8 M from bank @ 5% (paying $250 K/yr), offering its assets as collateral – Acme then gives its SHs a $8 M dividend (equity is now $2 M) • Or, Acme purchases $8 M of its shares (again, equity=$2 M) – Acme now has a profit of $750 K – Ro. E=37. 5% [$750 K/$2 M] 47 © Amitai Aviram. All rights reserved.

Financial engineering Optimizing capital structure • Modigliani & Miller: Capital structure shouldn’t matter if: – – Capital markets are efficient No information asymmetry between firm, SHs & lenders No bias caused by tax laws No bias caused by bankruptcy laws • Why wouldn’t capital structure matter? – Because firms that have less capital and more debt are riskier, so lenders would charge higher interest rate from firm, reducing profits and therefore Ro. E 48 © Amitai Aviram. All rights reserved.

Financial engineering Optimizing capital structure • So why does capital structure matter? 1. Mispriced capital: capital markets are not always efficient and information asymmetries exist – When credit is underpriced, firm benefits from higher leverage 2. Tax laws – Interest is deducted from profits; dividends are not 3. Bankruptcy costs 4. Restricting free cash flow to control agents – 49 Interest reduces free cash flow, limiting managers’ ability to engage in wasteful expenditures (managers must return to capital markets to raise more money) © Amitai Aviram. All rights reserved.

Corporate finance Alpha & market efficiency • Entrepreneurship – Only works in less efficient product markets • Otherwise, competition erodes profits • Valuation – Only works in less efficient equity markets • Otherwise, ECMH suggests you can’t make abnormal profits • Financial engineering – Only works in less efficient debt markets • Otherwise, Modigliani & Miller suggest financial structure doesn’t matter 50 © Amitai Aviram. All rights reserved.