Finance 2 Review
Section C, 2010
1
Review Materials
 Case
and class notes
 Review problems (weekly)
 Quizzes (each module)
 Module Overviews (each module)
 Practice Exam (Nova Chemical)
 These slides
2
Three Pillars of Fin 2
 Technical
proficiency
 Technical judgment
 Managerial judgment
3
Three Pillars of Fin 2

Technical proficiency
– Ability to correctly apply finance tools, formulas, concepts, e.g.,
» What is Free Cash Flow?
» What is CAPM rate of return given Rf, Beta, MRP?
– Review problems, quizzes

Technical judgment
– Ability to decide on inputs or ranges for technical analysis, e.g.,
» What is a reasonable LT growth rate?
» What how did MRP change during financial crisis?

– Needs supporting reasons and evidence
Managerial judgment
– Ability to decide what a manager should do, e.g.,
» High cost financing from Warren Buffett? (Fin 2, Day 1)
» Hostile tender offer for Genentech, at what price? (Fin 2, Day 27)
– No right answer, careful reasoning, weighing of pros and cons
4
Technical Proficiency
Correctly construct models and apply
analytic tools and concepts, given
appropriate inputs
5
7
Technical Proficiency—Valuation
You should be able to …
 Forecast
Income Statement, Balance Sheet
and Free Cash Flow outcomes based on
assumed operating ratios
 Calculate discount rates (and know when to
use each one)
– CAPM: Rf, Re, Ra, Rd, WACC
– Yield (or promised rate)
8
Technical Proficiency—Valuation
You should be able to …
 Calculate
(and interpret) risk parameters
– Beta of equity, Beta of assets, Beta of debt,
– Volatility
 Calculate
Enterprise, Equity and Per Share
Values
– Using WACC or APV methods, as appropriate
 Value
Interest Tax Shields
 Value Synergies
9
Technical Proficiency—Financial
Policy — You should …
 Know
the rules of priority for debt
– Tranches: senior, junior
– Secured vs. unsecured
– Rules of bankruptcy
 Know
the mechanics of dividend payments
and stock repurchases
– Announcement, ex-date, payment date
10
Technical Proficiency—Financial
Policy—You should …

Be able to assess the capital structure and liquidity
of a company
– Relative to competitors
– Relative to potential shocks, e.g.,
» increase in price of gold
– Relevant measures are
» D/V [how much of enterprise market value is pledged to debt]
» Interest coverage, eg, EBIT/Int
» Cash/ST Financing [can company withstand a bank run?]
11
Derivatives—You should know how
to …
Short sell stock
 Estimate the expected payoff from buying
insurance
 Analyze the payoff functions of

– Forward sales and purchases
– Simple options (puts and calls)
– Complex/composite options
» Spread collars
» Local collars

Calculate exposure to margin calls
12
Derivatives—You should know how
to …

Calculate the value of
– Forwards
– Options (simple puts and calls)
– Composite positions
»
»
»
»
»
Floor
Cap
Spread collar
Local collar
Cash + collar
13
Technical Proficiency—M&A—
You should know how to …

Calculate properties of a stock-for-stock exchange
– Exchange ratio
» Zero premium
» Non-dilutive (to each side)
–
–
–
–
–
% Ownership (both sides)
Acquisition Premium
Wealth Transfer
Downside Protection
Deal NPV
14
Technical Judgment
Make and support reasoned technical
assumptions when faced with an
ambiguous environment
15
Technical Judgment—
Law of One Price
 Modigliani-Miller
capital structure
irrelevance
 M-M dividend irrelevance
 Replication of option payoffs via
dynamically updated portfolio
 Covered interest parity
When must these LOOP relationships hold true?
16
When do the LOOP relationships
hold?
 In
a “perfect” market
– No taxes
– No transaction costs
– No asymmetric information
 In
imperfect markets, get deviations from
LOOP  arbitrage opportunities for traders
– As long as LOOP is eventually restored
17
Technical Judgment—
Valuation
 Selection
of comparable companies
 Selection of future operating ratios
– Revenue growth, cost, asset efficiency
 Tax
rates
– Tax payer or not? (MCI)
– Tax holiday (Geita mine in Ashanti)
18
Technical Judgment—
Negotiation

Reservation prices
– Can be based on public information
– May change based on confidential, i.e. asymmetric
information

ZOPA “Zone of positive agreement”
– Range of values (or exchange ratios) between the
buyer’s and seller’s reservation prices
– Deals should fall within the ZOPA unless one or the
other side (or both) receives new information
19
Technical Judgment—
Market Responses/Announcement Effects
New information causes a reassessment of value
 Market prices change as a result
 Announcement effects are large for

– New issues of equity (signals)
– Mergers (synergies)
– Anything reflecting on creditworthiness

Market is always second-guessing managers… get
used to it!
20
Technical Judgment—
Fiduciary Responsibilities

Who has them?
– Officers, director and controlling shareholders

What is required of fiduciaries?
– Duties of care, loyalty, and transparency (LCA)
– Act in the best long-run interest of “corporation”
– If corporation will cease to exist in the short run,
maximize value of shares
» Revlon duties apply to cash acquisitions only
21
Managerial Judgment
Use technical proficiency and
technical judgment to design an
integrated set of actions to address the
problem at hand
22
Managerial Judgment—
Financial Policy

How much debt can a company carry?
– Short run? Long run?
When should a company issue equity (or not)?
 How should it finance a project or an acquisition?
 When should a company

– Pay regular dividends
– Pay a special dividend
– Repurchase shares
23
Managerial Judgment—
Value Creation


What is the value (NPV) of a capital project (like Ashanti’s
Geita mine)?
What is the value of an enterprise
– To a buyer in an auction (Berkshire-Carters)
– To the seller in an auction (Burger King A)

Does the combination of A and B create value? How?
(Cost savings, cross-selling, market power)
–
–
–
–
–
–
JPMC-Bear Stearns
BNY-Mellon
PepsiCo-Quaker
Wine Country combinations
Roche-Genentech
MCI with Verizon or Qwest
24
Managerial Judgment—
Risk Management

What risks should I insure (pay to avoid)
– Systematic to me, unsystematic to others, eg, rainfall in India

What risks should I hedge (via derivatives)
– Can be cheaper than purchasing insurance
– Introduces new risks, ie, basis risk and margin calls

What controls should I place on my traders/risk managers?
– OSG currency hedging policy
– Ashanti hedgebook became a profit center and then blew up
25
Managerial Judgment—
Negotiations

In a two-way negotiation, what is my bargaining
power?
– Which end of the ZOPA should I aim for?
» BNY vs. Mellon –will BNY really walk from the deal?
» PepsiCo Round 1 vs. Round 2
» Roche-Genentech pre and post tender offer

What tactics will I use?
– Headline vs. intrinsic value?
– First vs. final offer?
– Can I use price protection (floors, caps, collars) to make
the deal more attractive to my counterparty?
26
Managerial Judgment—
Philosophy

In a three-way negotiation, am I willing to be the party
“left out”?
– Short-term Pstk increase vs. long-term performance (Wine Country)

When should I walk away from the table?
– BNY, PepsiCo, Roche

When should I come back?
– PepsiCo, Roche

Should I bailout a failing company?
– JP Morgan-Bear Stearns

Should I use high-cost emergency financing to survive and
live to play another day?
– Williams/Buffett loan
27
Managerial Judgment—
Core Beliefs

Does my firm have a mission different from or in
addition to shareholder value maximization?
– Congressional Oversight Panel — mission to represent
the US public
– BASIX — mission to bring capital markets to rural
India
28