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Corporate Finance & Strategy

Lecture 1: Introduction

Outline Lecture

© Prof. dr. J.T.J. Smit

I. Introduction:

‣ Lecturers

‣ Required/Recommended Literature

‣ Exam

‣ Objectives of the Lecture

‣ Course Outline

I. l

II. Overview of Course Topics

‣ Building Blocks

‣ Capita Selecta

2

Lecturers


❖ Drs. Hans Haanappel

Specialization in Corporate Valuation

‣ Email: [email protected]

‣ Visiting hours: Thursday afternoon before lecture on appointment

‣ Location: H14-21

❖ Prof. Dr. Han T.J. Smit

Specialization in Real Options and Games

‣ Location: H14-17

3

Literature


❖ Recommended Literature:

‣ Valuation for Mergers, Buyouts and Restructurings

‣ by E. Arzac (2005) - 281 pages

‣ John Wiley & Sons, ISBN: 0-471-44944-X

❖ Required Literature:

‣ Strategic Investment: Real Options and Games

‣ by Smit and L. Trigeorgis (2004) - 471 pages

‣ Princeton University Press, ISBN: 0691010390

4

Exam


❖ Visiting Hours

‣ Thursday afternoon before the lecture on appointment

‣ Hans Haanappel

❖ Time & Location of Lectures

‣ Time: Thursday from 18:00 - 20:45

❖ Exam and Grade

‣ Closed Book exam with open questions concerning the required

‣ literature and all class room material, including guest speaker’s

‣ lectures.

5

Objectives of the Course


❖ Capita Selecta:

‣ Company Valuation

‣ Debt Capacity and Cost of Capital

‣ Leveraged Buyouts

‣ Mergers & Acquisitions

❖ Building Blocks of Corporate Finance and Strategy:

‣ Market Value

‣ Value Drivers

‣ Strategic Planning

‣ Valuation Methodology

6

Course Outline (1)


Module I: The Building Blocks of Corporate Finance and Strategic Planning

‣ Lecture 2: Corporate Real Options

‣ Required Reading: Chapter 3 (Smit & Trigeorgis)

‣ Lecture 3: Games and Strategic Decisions

❖ Required Reading: Chapter 4 + Chapter 8: section 3 and 4 (Smit & Trigeorgis)

‣ Lecture 1: Corporate Finance and Strategic Planning

❖ Required Reading: Chapter 2 + Chapter 8: section 1 and 2 (Smit & Trigeorgis)

7

Course Outline (2)


Module II: Capita Selecta

‣ Lecture 5: Capital Structure and Cost of Capital

‣ Required Reading: Chapter 3 + 6 (Arzac)

‣ Lecture 6: Introduction to Leveraged Buyouts

❖ Required Reading: Chapter 9 + 13 (Arzac)

❖ Required Reading: Chapter 8 (Smit & Trigeorgis)

‣ Lecture 4: Firm Valuation

‣ Required Reading: Chapter 2 + 4 (Arzac)

8

‣ Lecture 7: Exam Preparation

❖ Required Reading: None

II.

Overview of Course Topics

© Prof. dr. J.T.J. Smit 9

Strategic Investment: Real Options and Games


“I used to think I was indecisive - but now I’m not so sure”

Anonymous

10

Building Blocks:

Corporate Finance & Strategic Planning


Market Value

(Expanded NPV) Value Drivers Strategic Planning Valuation

Methodology

Strategic

Value

Flexibility

Value

Net Present

Value

Strategic

Position

Adaptive

Capability

Competitive

Advantage

Competitive

Strategy

Strategic

Planning of

Growth Options

Project

Appraisal

(CF)

Game Theory

I.O. Economics

Real Options

Valuation

Discounted

Cash Flow

Chapter 1 Chapter 2

Ch. 4

Ch. 3

Chapters. 5-8

11

Market Value:

New Valuation Methods Required


The Rise and Fall of Stock Prices of Amazon.com vs. Barnes & Noble

May 1997:

Barnes & Noble

starts internet

business

May 1999:

IPO BN.com

carve out

0

20

40

60

80

100

120

jan-96 okt-96 jul-97 apr-98 jan-99 okt-99 jul-00 apr-01 jan-02

amazon

bn.com

barnes&noble

12

Market Value:

PV of Growth Options Embedded in Stock Prices


Industry Average Volatility (Market and Firm-specific Uncertainty)

and Proportion of PVGO to Price for a Number of representative Industries (as of 06/30/98)

13

Value Drivers and Strategic Planning


Paradigm Unit of Analysis Focal Concern

EXTERNAL

1: Industry and Competitive

Analysis

2: Strategic conflict/game

Theory

Industry (Firm/Products)

Firms/products

Structural conditions and

competitor positioning

Strategic interaction

INTERNAL

3: Resource-Based View

4: Dynamic Capabilities

Internal

Capabilities/Resources

Process/Positions/Paths

Asset Accumulation

Asset Accumulation,

replicability

LINKAGE 5: Real Options and Games Above/Under Uncertainty

Adjusting decisions in a

dynamic and competitive

environment

External and Internal Views of the Firm and Approaches to Strategy

14

Valuation Methodologies:

A Taxonomy of Common Corporate Real Options


❖ Growth: The option to grow when an initial investment is made and a strategic

position is acquired (e.g. the option embedded in a brand-name to launch new

products under the same brand)

❖ Operating: The option to abandon, to temporarily shut down, contract and

expand capacity, to switch input and/or output factors, which hedges the

downside risk of an investment or captures some upside potential (e.g. the

option to shut down production if price drops below variable costs)

❖ Timing: The option to delay an investment until more market information

becomes known (e.g. when to start with the exploration of an oilfield)

15

Valuation Methodologies:

Game Theory Competitive Bidding


1) Public announcement of merger negotiations of Ahrend and Samas

2) Hostile take-over bid by Buhrmann on Samas and Ahrend

3) HAL enters in bidding contest for Ahrend

4) Buhrmann withdraws offer on Ahrend and focusses on office supplies division from Samas

5) Ahrend is taken private

Value of

Synergistic

opportunities

1

2

3 4 5

10

11

12

13

14

15

16

17

18

19

20

jul-00 aug-00 sep-00 okt-00 nov-00 dec-00 jan-01

samas

ahrend

Acquisition

Premium

Buyer

Value

16

Capita Selecta:

Where Can the Valuation Methodology be Applied?


1) Company Valuation

2) Debt Capacity & Cost of Capital

3) Leveraged Buyouts

4) Mergers & Acquisitions

17

1: Company Valuation


❖ Company Valuation using multiples:

‣ Overview of different multiples

‣ Understanding the fundamentals behind multiples

❖ Company Valuation using Real Option Theory

‣ Valuation of distressed firms

❖ Company Valuation using the traditional DCF-framework:

‣ Estimating and forecasting free cash flow

‣ Valuation according to the “ WACC-approach”

‣ Valuation according to the “ Adjusted Present Value approach”

18



DCF Valuation Framework:

The economic value of the firm equals the present value of the expected cash flows,

discounted with the appropriate CoC

“Cash Flow is the pulse - the vital sign of life in a company”

Jack Welch, CEO of General Electric

19

1: Company Valuation Valuation range: 200-325 Mn Euro


2: Capital Structure and Cost of Capital


❖ How do firms determine the optimal debt level in practice?

‣ A Theoretical model that minimizes the WACC

‣ Target setting based on rating-target

‣ Target setting based on net debt/EBITDA-target

‣ Maximum debt capacity in downward cash flow-scenario

❖ Theoretical considerations

‣ Modigliani & Miller

‣ Bankruptcy Costs

‣ Agency Costs

‣ Etcetera..

21



❖ Different types of financing in a leveraged buyout:

‣ Senior A/B/C

‣ Mezzanine

‣ Preferred Equity

‣ Loan Stock

❖ IRR equity holders and mezzanine providers

❖ What is a typical buyout structure?

❖ Determining maximum bidding ranges

22

3: Leveraged Buyouts A Buyout Structure


NEWCO

OPCO

PE House Management

Purchase Price

100%

Ordinary Shares

Ordinary Shares

&

Preferred Equity

Former Equity

and Debt Providers

of OPCO

Mezzanine

Bank Financing

23

4: Mergers and Acquisitions


❖ Deal Rationale

❖ The M&A process

❖ Valuation of a Merger and synergies

❖ Transaction Dynamics

❖ Take over defenses

24

4: Mergers and Acquisitions Valuation of a Merger


Economic gain = VA&B – [VA + VB]

Economic cost = TP – VB

Stand-

alone

Value of

firm A

Value

Value

of

A & B

Expected

Synergies

Stand-

alone

Value of

firm B

Maximum

Premium

Stand-

alone

Value of

firm A

Value

Value

of

A & B

Expected

Synergies

Stand-

alone

Value of

firm B

Maximum

Premium

25

4: Mergers and Acquisitions Transaction Dynamics


Transaction

dynamics

• Number of bidders

• Speed of industry

consolidation

• Number of bid

confrontations

Market dynamics Internal value

creating expectations

• Expected synergies

• Acquisition experience

• Risk attitude of

management

• Experience in post

merger integration

• ...

Purchase

price

Acquisition

premium

26

Conclusion & Exam Preparation


❖ Summary of the lectures

❖ Focus points for the exam

❖ Typical exam questions

❖ Question & Answers

❖ Concluding remarks

27

Strategic Management:

Competitive Advantage and Value Creation


“Instead of breaking that bridge, we should, if possible, provide

another, that he may retire the sooner out of Europe”

Aristides, The Just

Chapter 2 Smit and Trigeorgis

28 28

Outline


❖ Internal and External views of value creation of the Firm

❖ Thought Experiments

❖ Portfolio Approaches

29

Market Value

(Expanded NPV) Value Drivers Valuation

Methodology

Flexibility

Value

Present Value

of Assets

Adaptive

Capability

Competitive

Advantage

Real Options

Games

Valuation

Discounted

Cash Flow


Building Blocks: Overview

Strategic

Value

Strategic

Position

I.O. Econ.

RBV

Rivalry

30

Strategic Management:

Central Trade-off


Flexibility Commitment

31

Value Drivers and Strategic Planning


Paradigm Unit of Analysis Focal Concern

EXTERNAL

1: Industry and Competitive

Analysis

2: Strategic conflict/game

Theory

Industry (Firm/Products)

Firms/products

Structural conditions and

competitor positioning

Strategic interaction

INTERNAL

3: Resource-Based View

4: Dynamic Capabilities

Internal

Capabilities/Resources

Process/Positions/Paths

Asset Accumulation

Asset Accumulation,

replicability

LINKAGE 5: Real Options and Games Above/Under Uncertainty

Adjusting decisions in a

dynamic and competitive

environment

External and Internal Views of the Firm and Approaches to Strategy

32

External Approach:

Porter’s Five Forces Industry Analysis


History: The industry and competitive analysis framework of Michael Porter (1980), the

leading strategy paradigm in the 1980’s, has its roots in industrial organization. The

foundation of Porter’s framework for business strategy is the structure-conduct-

performance paradigm, based on a survey performed by Scherer

33

External Approach:

Porter’s Five Forces Industry Analysis



❖ The Nash Equilibrium, Mixing Moves (mixed equilibrium), Commitments.

❖ Applications: Game theory is unusual in the breadth of its potential

applications. From everyday social interactions and sports to business and

economics, politics, law, diplomacy and war biology evolutionary theory.

❖ History: John von Neumann and Oskar Morgenstern studied "zero-sum"

games where the interests of two players were strictly opposed. John Nash

treated the more general and realistic case of a mixture of common interests

and rivalry and any number of players. Other theorists, most notably Reinhard

Selten and John Harsanyi who shared the 1994 Nobel Memorial Prize with

Nash, studied even more complex games with sequences of moves, and

games where one player has more information than others.

External Approach:

Strategic Conflict and Game Theory

35


The Bidding Game:

Competitive forces of shared opportunities make it difficult for the buy-and-build

investor to undertake acquisitions without paying for at least some of the synergies.

Of course, in many if not most cases the players will not be exactly “symmetric”; one

of them will have a stronger market position. Exercising the option to expand, for

instance, is going to be more valuable for a consolidator than for another player

when the consolidated firm is a market leader by virtue of its size, earlier

acquisitions, and complementary assets.

External Approach:


36

❖ Strategy Applications:

‣ Game theory can be used to help analyze which factors affect the trade-

off between cooperation and conflict.

‣ Particularly relevant in stable environments when the strategic

alternatives can be easily ascertained and when competitors are not to

dissimilar, as in the case of Unilever and Procter and Gamble, Coca-Cola

and Pepsi, or Boeing and Airbus

‣ A general criticism is that by trying to rationalize known behavior in a

stylized way, standard game theory models often fail to produce testable

predictions (the insights from the analysis can be self-evident)

External Approach:



❖ History: The ideas, first described in The Theory of the Growth of the Firm by

Edith Penrose (1959), later became more well known as the “resource-based

theory” in articles by Birger Wernerfelt (1984) and others (e.g., Rumelt, 1984;

Teece, 1984, Hamel and Prahalad, 1990).

❖ Each company is characterized by its own collection of resources and

capabilities. It is the exploitation and leveraging and scarcity of firm-specific

resources and capabilities that enable the firm to generate a profit stream in

excess of the opportunity cost of capital.

‣ Resources should be a source of competitive advantage

‣ The Advantage should be sustainable

‣ The value of the resource should be appropriable

Internal Approach: Resource Based View


Internal Approach: Resource Based View


“Dynamic Capabilities”, proposed by Teece, Pisano and Shuen (1997), views competitive advantage

and capabilities to adapt in a changing environment as resting on distinctive processes, shaped by

the firm’s asset position and the evolution paths it has adopted or inherited.

1: Trajectories of asset accumulation

In an analysis of the industry evolution, acquisitions of industry players are no longer viewed as

stand-alone investments, but rather as links in a chain of interrelated investments in which the early

investments are prerequisites to modify the strategic position of the bidder.

2: Position

The strategic position of the firm is partly determined by its specific asset base, as well as its

relationships with other players and its reputation. The acquisition of platform and its built-in assets

shape the firm’s reputation, probable future acquisition opportunities and merger alternatives.

39

Valuation Example: Buy-and-Build Strategy


Financial Markets Assign a Value To Growth

Equity Value = Assets in Place + PVGO

Equity Value : Known from financial markets

Net Assets in Place : Present value of earnings (as an annuity) generated by the assets in place.

We make a calculation of the scenario average of the analyst forecast and

discount rates

PVGO : “Back-solve” for the value of the growth opportunities from the stock price.

(PVGO = EV - assets in place)


Financial Markets Assign a Value To Growth


Firm Price Earnings5.

I/B/E/S Forecasted earnings 2007

Assets in Place PVGO/P

1. Market

Value of Equity (Million US$)

2. Cost of equity (Ke)

3. Net

Earnings 2005

4. I/B/E/S

Forecasted earnings

2006

5. I/B/E/S

Forecasted earnings

2007

6. Various Estimates of Assets in Place

7. Growth

Options to Equity

Current earnings

@ Ke

I/B/E/S earnings @ rf + 4

I/B/E/S earnings

@ Ke

Falconbridge

15,900 8.8 892 1,686 1,136 7,600 12,200 12,000 23 – 52 %

Inco

11,400 8.4 864 1,210 1,311 7,700 9,500 11,300 1 – 32 %

Teck Cominco

14,400 9.3 1,147 1,740 1,593 9,300 13,400 13,400 7 – 36 %

Rio Tinto

92,600 7.2 5,025 6,600 6,100 52,600 64,100 66,800 28 – 43 %

BHP Billiton

141,500 7.2 8,360 9,800 10,900 83,300 92,500 107,300 24 – 41 %

42

Thought Experiment 1:

How sophisticated might one think?


Please write down:

a number between 0 and 100 such that your guess will be as close as possible to

2/3 of the average guess.

For example:

Suppose five people enter and their guesses are 50,40,30,20 and 10. Then the

average guess would be 30, two thirds of which is 20, so the person guessing 20

would win.

What would you guess?

43

How Sophisticated might one think?


The Rise and Fall of Stock Prices of Amazon.com vs. Barnes & Noble

May 1997:

Barnes & Noble

starts internet

business

May 1999:

IPO BN.com

carve out

0

20

40

60

80

100

120

jan-96 okt-96 jul-97 apr-98 jan-99 okt-99 jul-00 apr-01 jan-02

amazon

bn.com

barnes&noble

44

“I can calculate the motions of heavenly bodies, but not the

madness of people”

Sir Isaac Newton

(upon losing 20.000 pounds in the South Sea Bubble in 1720)


How sophisticated might one think?

45

Portfolio Planning of Growth Opportunities


❖ Often map businesses according to current profitability (or market share)

and future growth

❖ Often used in conjunction with learning curve and life cycle or industry

evolution

❖ Portfolio planning for business units and acquisitions

46

Portfolio Planning of Growth Opportunities


❖ Expanded (strategic) NPV = Direct NPV + PVGO

❖ Embed a dynamic real-options-based valuation

(current value plus growth option value) within

portfolio management analysis.

47

R&D Project as an Option


Investment Opportunity NPV Metric PVGO Metric Total Value Strategy

Stage I: R&D Investment

Investment -30

Option value of commercialization -37

Stage II: Follow-on commercial project

PV investment - 74

PC of commercialization - 100

-30

100-74 = 26

37

11

+ 7

+ 37

Invest in R&D

to commercialize

Maybe later

0 1 2 3 4 5 6

R&D Commercial Project

48

The Real Options Growth (ROG) Matrix


Region 6: invest never Region 1: invest now

Region 5:

Opportunities with

low profitability and

low growth potential

Region 2:

Profitable projects

with low potential

Region 4:

Opportunities with

commercialization

potential

Region 3:

Profitable projects

with growth potential

Asset Value, V

Exercise price, I

NPV = V - I

Expanded NPV = NPV + PVGO

PVGO

+

-

- +

49

R&D Investment in the Real Options Growth (ROG) Matrix


Region 6:invest never Region 1: invest now

Region 5

Region 2

Region 4

Region 3

NPV = V - PV (I) +

100 -20

Region 6:invest never Region 1: invest now

Region 5:

Probably never

Region 2:

Maybe now

Region 4:

Invest to

commercialize R&D

Maybe later

Region 3:

Invest now to

commercialize

Probably later

NPV = V - PV (I)

PVGO

+

I

Follow on

+ 26 -30

11

37

Compound option at t = 0 Simple option at t = 1

II

Follow on

II

II

Investment Opportunity NPV Metric PVGO Metric Total Value Strategy

Stage I: R&D investment

Exercise price, I0 = 30

Underlying asset value: follow-on option value on

V0) = $100 million

Time to expiration (years), t = 0

Risk free rate, r = 0.08

Stage II: Follow-on commercial project

Exercise price, I1 = 80; PV(80) = 74

Underlying asset: E(V1) = $120 million; PV(120) =

100

Time to expiration, t = 1 year

Uncertainty up = 1.6, down = 0.8

t = 1:

Expected underlying asset value:

E(V1) = $120 million

Value of follow-on project

when nature moves up

Value of follow-on project

when nature moves down

-30

100-74 = 26

180 - 80 = 100

60 - 80 = -20

37

11

0

0

+7

+37

+100

0

Invest Now

Maybe Later

Invest Now

Invest Never

50

❖ Both the resource-based view as well as the industry and competitive analysis

framework can benefit from a closer linkage with quantification tools from

corporate finance.

❖ When there are inter-project and inter-temporal synergies between projects,

careful valuation is paramount. In particular, in volatile and evolving industries,

strategies have to be flexible to enable the firm to adjust to an uncertain and

changing competitive and technological landscape.

Summary:


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