Making Money in Corporate Finance: Basic Principles

James S. AngFlorida State University

For Presentation at Xiamen University, May 2009

Finance is about making money from money. Firms could derive Profits from

real assets and profits from financial assets or both.

The Sources of Profitable Opportunities: 1. Use information outsiders do not

have on real assets. 2. Exploit disagreements among

outsiders – different expectations. 3. Exploit other parties’ Mistakes 4. Cheating: manipulation and fraud. The means to extract profit is through

the method of arbitrage, and the vehicle is the corporation.

Understanding and harvesting NPV I shall start with the most basic: NPV

analysis Example: PV of inflows is $120mm, or a future value

of $150mm. PV of all costs is $100mm, or a future

value of $120mm. NPV = 120 – 100 = 20mm. NFV = 150 – 120 = 30mm.

But think of yourself as an entrepreneur. This means that an entrepreneur

needs to: Raise $100mm of OPM (other

people’s money), a combination of debt and equity, and when discounted at the cost of capital, should yield $100mm in PV or 120 in FV.

Pocket the $20mm in NPV.

There are two ways: The entrepreneur may sell (give up

the right to) all future cash flow of (FV=150mm) for (PV=120mm). Since it only takes 100mm to invest in the project, the entrepreneur can pocket the difference: 120-100 = 20.

Examples are developers pre-sell housing units, businessmen sell ownership to firms, etc.,

2: OPM The second way is realize that the

entrepreneur has a claim on 150-120 = 30 in the future after the OPM are paid (= 120mm). This means that the entrepreneur owns (30/ 150)= 20% of the firm’s cash flows, and can therefore issue 80% of the firm’s stocks for 100mm to finance the project, and own 20% without putting up own money.

Alternatively, the entrepreneur may use the equivalent of 20% ownership as the firm’s equity and borrow debt (use leverage) to be supported by the cash flows to the other 80%.

Examples include IPO, or earnouts.

NPV To summarize, receiving 20mm now, or hold

20% cost free represents arbitrage profit to the entrepreneur.

The entrepreneur takes a long position on the asset (The asset generates high cash flows due to patent protection, sole ownership of a land to develop properties, right to exclude other users, or political influence, etc.) And issue debt and equity to others (short).

The really interesting question how the entrepreneur can extract the arbitrage profit?

The essence of arbitrage Smart bets have these

characteristics: No cost, or Commit no own funds

(OPM). No risk, or position is a perfect

hedge (perfect or near perfect correlation in returns)

No loss, or position generates either profit or breakeven.

Effective arbitrage requires a set of simultaneous transactions: Buy (Long) undervalued securities and sell

(short) overvalued, but highly correlated securities.

The important point is that a short position is needed.

Sell short means a two parts transactions: a) Sell a security one does not own, b) Buy back the same security later to close out the position.

It is equivalent to: a) Take money now, b) Return them later.

But, selling short is difficult for investors.

An implication Stock market may persist to be

inefficient if there are ‘limits’ to arbitrage, especially in the ability to short.

Limits to arbitrage: Search for stock lenders may be costly and time consuming. Stocks on loan are subject to recall risk. Additional collateral needs be posted. Security lending market may be illiquid. Execution risks, or lack of close substitutes. Counter party risk. Synchronization risks. Noise trader risk. Transaction costs. Holding costs. Liquidation costs and premature liquidation risks. Fundamental risk. Wealth constraint, if fund flow depends on short-term

performance.

Question: If investors could not profit, who could? The answer is the corporation.

They are better in exploiting mispricing in the market/ arbitrage opportunity than individual investors.

This is the main idea underlying my talk today:

Corporations have more arbitrage opportunities

The following is a list of assets investors normally may not be able to acquire:

Assets that have to purchased in bulk, not fractional ownership/ shares: buildings factory, etc.,

Assets that are not publicly traded: privately held companies, subsidiaries of other corporations, state owned companies, cooperatives, and mutual organizations.

Assets that require active management and ownership rights: restructuring (layoff, asset sales, change top management), breaking up (corporate fission), bundling (corporate fusion), realize synergy (information technology, production skills, human capital, cheap capital), positive NPV, improve governance, etc.,

Real assets that require change in ownership to change market expectations.

Assets that require large information costs, which corporations, as bulk buyer, can better afford and can also perform due diligence investigations.

Examples of Corporate Arbitrage A. Long undervalued asset and short undervalued securities. Mergers and acquisitions: Acquire undervalued target (long ) with own stocks (short) in a stock

for stock exchange. Leverage buyout Take private a public firm (buy/long all stocks) and issue highly

levered debt (short). Corporate fission (breakup deals) Acquire a firm (long) and sell pieces or restructure as several separate

legal entities to sell securities (short), as in spin off and split up. Corporate fusion (bundling of assets) Acquire several assets to form a single corporation and sell securities

based on the now more valuable combined firm (short). IPO and SEO Sell over priced stocks as IPO in hot markets (short) and invest the

proceeds (long).

Examples of corporate arbitrage B. Short overvalued assets and long

undervalued securities Repurchase stocks

Sell overvalued asset/ subsidiaries (short) to

buyback stocks (long). Debt refunding

Retire high interest cost existing debt (long) and replace with lower interest cost debt (short).

The Sources of Arbitrage Opportunities: The market/ investors make

mistakes: mispricing. Other companies make mistakes. Your company help the market

makes mistakes. - manipulating information and

expectations to committing fraud.

Where do profitable opportunities in corporate finance come from

1. Smart money taking from dumb money.

Based on their source, these opportunities, many are results of mistakes by others, may be classified as originated from:

A. Markets/ Investors. B. Managers of other firms. C. Government.

More on profitable opportunities 2. Helping hand. Or, finance in steroids, it gives the firm short term

boost, but may result in long term harm. In the meantime, there are telltale signs, and would not pass closer examination.

A. Catering (also knows as following fads and fashion, pseudo market timing, herding, etc., )

Examples: 1. Increase or initiate dividends when dividend

paying stocks are selling at a premium. 2. Corporate name change. Add dot com when in

fashion, and remove dot com after bursting of dot com bubble.

3. Buy or sell assets base don prevailing trend; Increase investment when regarded as a growth stock.

Manipulate market expectations Earnings smoothing (to give

semblance of consistent growth) and manipulation.

Fraud. Keep up the appearance.

Examples of helping hand: When to boost earnings: Before IPO, SEO, mergers to be financed with own

stocks and prior to debt renewal, extension and refinancing.

2. When to depress earnings: Repurchase stocks, and management lead LBO. 3. Take value destroying actions to keep up

appearance. Suppose the market overprices your stock, implying it

expects your company to deliver higher growth than you are capable of.

The strategy is to: a) Issue stocks at inflated price, and to keep up the appearance of growth, would invest in inferior or value destroying projects (NPV<).

Opportunities as mistakes made by the market : Irrational 1. Investors following simple heuristics as portfolio strategy, such as market to book, EPS, buy winners (momentum investing), buy losers, etc., 2. Herding, 3. Responding to noise, including rumors. Rational 1. Following price trend leading to bubble, in a ‘If you can’t

beat them, join them’ and “ I am smarter than the rest and know when to bail out” strategy.

Given bad information by the companies

Opportunities from or mistakes made by the government. Tax arbitrage: Buy (long) low taxed assets, e.g.,

tax law passed to give tax credit for new investments, and short (borrow) liabilities with tax deductible interest.

Buy tax free bonds, financed with tax deductible debt.

Acquire companies with large tax loss carry forward..

Mistakes made by managers A. Behavioral 1. Over optimism, e.g., illusion of control. 2. Overconfident, e.g., attribution bias. 3. Limited capacity to process information, e.g., bounded rationality, representativeness, availability, narrow

focusing, B. Agency 1. Poor governance. 2. Unnecessary diversification, done on

behalf of less diversified managers

Misplaced trust in market efficiency.

When the securities of the firm are over priced, cost of capital may appear ‘too low’ to the insiders/ managers, and the company may be induced to accept too many inferior projects (NPV<0). Thus, we have a situation in which over optimism by the market leads managers to act as if they, too, are over optimistic.

The opposite is also true. Too pessimistic market results in low security prices. Raise the perceived cost of capital, and too few investments may be undertaken. I.e., some NPV>0 may be foregone.

mistakes Sentiments of the stock market, whether too

optimistic or pessimistic, may affect managers’ actions in the same direction, i.e, sentiments are contagious.

Unwittingly, the investment behavior of the of corporations caters to please the market.

What a long term value maximizing firm can do?

-It may not rely on short term market prices to calculate capital costs.

- When market prices are too high (or too low), risk premium may appear too low (too high), and even beta may appear too low (high).

To Summarize Idea #1: All profits, other than that are

needed to compensate for risk taking, may be formulated as a result of an arbitrage.

Idea #2: Capital market may remain inefficient because of limits to arbitrage by investors.

Idea #3: Corporations are better in exploiting mispricing in the market/ arbitrage opportunity than individual investors.

ideas Idea #4: Making money in corporate

finance means knowing how to let other people take risks, as in OPM, and risk management strategies.

Idea #5: Arbitrage opportunities arise from action taken to correct mistakes by others.

Idea #6: There are long term versus short term arbitrage profits; those involving attempts to change market expectations or to follow the market could only produce short term gains.