What is this project?
This project provides an opportunity to get some hands-on experience applying corporate finance theory and models to real firms. In the process, participants will get a chance to
(a) evaluate the risk profile of a firm, and examine the sources of risk.
(b) analyze its capital structure, and decide whether the firm is under or over leveraged.
(c) examine its dividend policy, and decide whether more or less should be paid in dividends
(d) value the firm
(e) restructure the firm, and revalue it.
How is the project structured?
– This is a group project. Each group must have four individuals in it. The group size should not exceed four.
– Each person in the group will pick a company to analyze. The companies chosen by a group should be from the same industry grouping. This does not imply however that they have to be competitors. For instance, a group can pick a company that manufactures personal computers, a company that produces software and a company that provides computer services as part of the same group.
– Each person will be responsible for doing the entire analysis for the company that he or she has chosen.
– At the end of the process, the group will write one report for all the firms in the group. In this report, the firms will be compared and contrasted and the results will be presented as a whole rather than as four separate parts.
How will the project be graded?
– Each group will receive one grade and every group member will receive the same grade.
– No attempt will be made to allow for intra-group differences in effort.
Who polices the group?
– You do.
Corporate Finance Project: A Help Manual
These are a few questions that you might find useful in doing the project analysis
I. Corporate Governance Analysis
• To understand the relationship between managers and stockholders, try answering the following questions:
1. The Chief Executive Officer
• Who is the CEO of the company? How long has he or she been CEO?
• If it is a family run company, is the CEO part of the family? If not, what career path did the CEO take to get to the top? (Did he come from within the organization or from outside?)
• How much did the CEO make last year? What form did the compensation take? (Break down by salary, bonus and option components)
• How much stock and options in the company does the CEO own?
2. The Board of Directors
• Who is on the board of directors of the company? How long have they served as directors?
• How many of the directors are insider directors? (i.e. employees or managers of the company)
• How many of the directors have other connections to the firm (as suppliers, clients, customers..)?
• How many of the directors are CEOs of other companies?
• Do any of the directors have large stockholdings or represent those who do?
3. Share Voting Structure
• Are there differences in voting rights across shares?
• If so, do incumbent managers own a disproportionate share of the voting shares?
• To understand the relationship between the firm and financial markets, try asking the following questions:
1. Financial Market Concerns
• How many analysts follow the firm?
• How much trading volume is there on this stock?
• To understand the relationship between the firm and society try answering the following questions:
1. Societal Constraints
• Does the firm have a particularly good or bad reputation as a corporate citizen?
• If it does, how has it earned this reputation?
• If the firm has been a recent target of social criticism, how has it responded?
II. Stockholder Analysis
• To understand who the average and marginal investors in the firm are, try answering the following questions:
1. Who holds stock in this company?
• How many stockholders does the company have?
• What percent of the stock is held by institutional investors?
• Does the company have listings in foreign markets? (If you can, estimate the percent of the stock held by non-domestic investors)
2. Insider Holdings
• Who are the insiders in this company? (Besides the managers and directors, anyone with more than 5% is treated as an insider)
• What role do the insiders play in running the company?
• What percent of the stock is held by insiders in the company?
• What percent of the stock is held by employees overall? (Include the holdings by employee pension plans)
• Have insiders been buying or selling stock in this company in the most recent year?
III. Risk and Return
• To understand the risk profile of the company, estimate risk parameters and the hurdle rates for the firm, try answering the following questions:
1. Estimating Historical Risk Parameters (Top Down Betas)
Run a regression of returns on your firm’s stock against returns on a market index, preferably using monthly data and 5 years of observations (or)
If you have access to Bloomberg, go into the beta calculation page and print off the page (after setting return intervals to monthly and using 5 years of data)
• What is the intercept of the regression? What does it tell you about the performance of this company’s stock during the period of the regression?
• What is the slope of the regression?
– What does it tell you about the risk of the stock?
– How precise is this estimate of risk? (Provide a range for the estimate.)
• What portion of this firm’s risk can be attributed to market factors? What portion to firm-specific factors? Why is this important?
• How much of the risk for this firm is due to business factors? How much of it is due to financial leverage?
1. Comparing to Sector Betas (Bottom up Betas)
• Break down your firm by business components, and estimate a business beta for each component
• Attach reasonable weights to each component and estimate an unlevered beta for the business.
• Using the current leverage of the company, estimate a levered beta for each component.
2. Choosing Between Betas
• Which of the betas that you have estimated for the firm (top down or bottom up) would you view as more reliable? Why?
• Using the beta that you have chosen, estimate the expected return on an equity investment in this company to
* a short term investor
* a long term investor
• As a manager in this firm, how would you use this expected return?
3. Estimating Default Risk and Cost of Debt
If your company is rated,
• What is the most recent rating for the firm?
• What is the default spread and interest rate associated with this rating?
• If your company has bonds outstanding, estimate the yield to maturity on a long term bond? Why might this be different from the rate estimated in the last step?
• What is the company’s marginal tax rate?
If your company is not rated,
• Does it have any recent borrowings? If yes, what interest rate did the company pay on these borrowing?
• Can you estimate a synthetic rating? If yes, what interest rate would correspond to this rating?)
4. Estimating Cost of Capital
Weights for Debt and Equity
• What is the market value of equity?
• Estimate a market value for debt. (To do this you might have to collect information on the average maturity of the debt, the interest expenses in the most recent period and the book value of the debt)
• What are the weights of debt and equity?
Cost of Capital
• What is the cost of capital for the firm?
IV. Measuring Investment Returns
To analyze the quality of the firm’s existing projects and get a sense of the quality of future projects, try answering the following questions:
1. Accounting Returns on Projects
• What is the return on equity earned by the firm? Based upon this return, is the firm picking good projects?
• What is the return on capital earned by the firm? Based upon this return, is the firm picking good projects?
• Are there any trends in the accounting returns, and if so, what do they tell you about future projects?
• Do you think the accounting return is a fair measure of the returns that this firm is making on existing projects? If not, how would you modify the return to make it a fairer measure?
2. Economic Value Added
• Compute the book value of equity invested in this company and compute the equity economic value added. What, if anything, does this tell you about this company?
• Compute the book value of capital invested in this company and compute the economic value added. What, if anything, does this tell you about this company?
• Why might a comparison based upon economic value added lead you to different conclusions than one based upon the return differences in the earlier section?
V. Capital Structure Choices
To analyze the existing financial mix of the firm and to assess, from a qualitative trade off between the benefits and the costs of debt, whether the firm has too much or too little debt, try answering the following questions:
To answer these questions, you might want to look at the following
1. Benefits of Debt
• What marginal tax rate does this firm face and how does this measure up to the marginal tax rates of other firms? Are there other tax deductions that this company has (like depreciation) to reduce the tax bite?
• Does this company have high free cash flows (for eg. EBITDA/Firm Value)? Has it taken and does it continue to have good investment projects? How responsive are managers to stockholders? (Will there be an advantage to using debt in this firm as a way of keeping managers in line or do other (cheaper) mechanisms exist?)
3. Costs of Debt
• How high are the current cash flows of the firm (to service the debt) and how stable are these cash flows? (Look at the variability in the operating income over time)
• How easy is it for bondholders to observe what equity investors are doing? Are the assets tangible or intangible? If not, what are the costs in terms of monitoring stockholders or in terms of bond covenants?
How well can this firm forecast its future investment opportunities and needs? How much does it value flexibility?
VI. Optimal Capital Structure
To assess the optimal financing mix of your firm, try the following questions:
1. Cost of Capital Approach
• What is the current cost of capital for the firm?
• What happens to the cost of capital as the debt ratio is changed?
• At what debt ratio is the cost of capital minimized and firm value maximized? (If they are different, explain)
• What will happen to the firm value if the firm moves to its optimal?
• What will happen to the stock price if the firm moves to the optimal, and stockholders are rational?
2. Building Constraints into the Process
• What rating does the company have at the optimal debt ratio? If you were to impose a rating constraint, what would it be? Why? What is the optimal debt ratio with this rating constraint?
• How volatile is the operating income? What is the normalized operating income of this firm and what is the optimal debt ratio of the firm at this level of income?
To analyze whether the firm has too much or too little debt relative to the sector and the market, try the following :
1. Relative Analysis
• Relative to the sector to which this firm belongs, does it have too much or too little in debt? (Do a regression, if necessary)
• Relative to the rest of the firms in the market, does it have too much or too little in debt? (Use the market regression, if necessary)
VII. Mechanics of Moving to the Optimal
To understand whether your firm should move to its optimal gradually or quickly, and whether it should take projects or alter its existing mix, try answering the following questions:
1. The Immediacy Question
• If the firm is under levered, does it have the characteristics of a firm that is a likely takeover target? (Target firms in hostile takeovers tend to be smaller, have poorer project and stock price performance than their peer groups and have lower insider holdings)
• If the firm is over levered, is it in danger of bankruptcy? (Look at the bond rating, if the company is rated. A junk bond rating suggests high bankruptcy risk.)
2. Alter Financing Mix or Take Projects
• What kind of projects does this firm expect to have? Can it expect to make excess returns on these projects? (Past project returns is a reasonable place to start – see the section under investment returns)
• What type of stockholders does this firm have? If cash had to be returned to them, would they prefer dividends or stock buybacks? (Again, look at the past. If the company has paid high dividends historically, it will end up with investors who like dividends)
To analyze what kind of financing the firm should use to move to its optimal, try the following:
1. Financing Type
• How sensitive has this firm’s value been to changes in macro economic variables such as interest rates, currency movements, inflation and the economy?
• How sensitive has this firm’s operating income been to changes in the same variables?
• How sensitive is the sector’s value and operating income to the same variables?
• What do the answers to the last 3 questions tell you about the kind of financing that this firm should use?
VIII. Dividend Policy
To analyze how much the firm has returned to stockholders in the past, and to assess, from a qualitative trade off, whether it should return more or less, try the following:
1. Historical Dividend Policy
• How much has this company paid in dividends over the last few years?
• How much stock has this company bought back over the last few years?
2. Firm Characteristics
• How easily can the firm convey information to financial markets? In other words, how necessary is it for them to use dividend policy as a signal?
• Who is the average stockholder in this firm? Does he or she like dividends or would they prefer stock buybacks?
• How well can this firm forecast its future financing needs? How valuable is preserving flexibility to this firm?
• Are there any significant bond covenants that you know of on the firm’s dividend policy?
• How does this firm compare with other firms in the sector in terms of dividend policy?
IX. A Framework for Analyzing Dividends
To assess how much the firm could have returned to stockholders and whether it should be returning more or less, try the following:
1. Affordable Dividends
• What were the free cash flows to equity that this firm had over the last few years?
• How much cash did the firm actually return to its owners over the last few years?
• What is the current cash balance for this firm?
2. Management Trust
• How well have the managers of the firm picked investments, historically? (Look at the investment return section)
• Is there any reason to believe that future investments of this firm will be different from the historical record?
3. Changing Dividend Policy
• Given the relationship between dividends and free cash flows to equity, and the trust you have in the management of this firm, would you change this firm’s dividend policy?
To measure whether your company is paying too much or too little relative to the sector and the market, try the following:
1. Comparing to Sector and Market
• Relative to the sector to which this firm belongs, does it pay too much or too little in dividends? (Do a regression, if necessary)
• Relative to the rest of the firms in the market, does it pay too much or too little in dividends? (Use the market regression, if necessary)
To pick the right model, estimate inputs and value your firm, try the following:
1. Cash Flow Choice
• How does this company’s dividends compare to its free cash flow to equity?
• How stable is leverage expected to be at this firm?
If leverage is expected to change, use FCFF
If leverage is stable and dividends are equal to FCFE, use Dividends
If leverage is stable and dividends are not equal to FCFE, use FCFE.
If you cannot estimate FCFE or FCFF, use dividends
• How high is inflation in the local currency? (If it is in double digits, you might consider doing a real valuation or a valuation in a different currency)
2. Growth Pattern Choice
• How fast have this company’s earnings grown historically?
• How fast do analysts expect this company’s earnings to grow in the future?
• What do the fundamentals suggest about earnings growth at this company? (How much is being reinvested and at what rate of return?)
• If there is anticipated high growth, what are the barriers to entry that will allow this high growth to continue? For how long?
• What is the value of this firm, based upon a discounted cash flow model?
• How much of this value comes from the expected growth?
• How sensitive is this value to changes in the different assumptions?
4. Value Enhancement
• In what aspect of corporate finance (investment, financing or dividend policy) does this firm lag? (You can build on the intrinsic analysis that you have done so far, or use industry averages)
• If you fixed the problem areas (i.e., take better projects, move to the optimal debt ratio, return more or less cash to owners), what would happen to the value of the equity in this firm?
• What is the value of control in this firm?