Last WE we had capstone, a class aimed to help us reflect on what we learned so far and where we want to go to... Well, this post is not dedicated to Capstone. However, during capstone, one evening, a group of us went to the theater, the one on 210 Shaftbury, to see the music hall "Haispray", the story of wannabe in the 60-70s in Baltimore, with a happy ending. It was a pleasant 2h40mns.
Today in World Economy we talked about Oil. What i take out from the long discussion about past, current and possible future events is one simple thing: an other way, beyond the supply and demand curves, to look at oil price: The Hotelling model.
In brief, it is a model that is applicable to commodities that are in finite supply. One can define P(T) as the price at time T at which we run out of oil. P(T) being such that the demand at that price at that time in 0. Then, as we do often in Finance, we can assess the price at period T-1 via interest rate, and this down to now. This approach can easily be extended to include cost of extraction. The result is an upward sloping curve of the oil price versus time. Although, one cannot really extract T and P(T) this representation is an interesting way to evaluate the impact of some events on the price of oil, without relying soly on the demand and supply theory. For instance:
1. If new oil reserves are found, T increases, P(T) stays the same, thus Pnow decreases.
2. If interest rate rise, the slope of the curve stippen and Pnow decreases.
3. If substitutes are found P(T) decreases, and so does Pnow.
One of the topic we discussed today in world economy was Japan. What i take out is the following: Japan experienced a bubble and an unusually long recession.
The bubble may have come from policies that were influenced by the US to enable them to depreciate their currency. Several hypothesis were mentionned to explain why the following recession was/is so long:
* Bad policy making: indeed, apparenetly the BoJ reduced interest rate too slowly (you can assess that by applying the Fed's Taylor rule to the Japanese economy), and also the japanese governement used too strong fiscal policies (raising taxes) at early signs of recovery, hitting back down the growth.
* The decrease of interest rate, was intended to help in a credit crunch period to facilitate investment. However, a side effect, was that interest rates reached 0%. As such Zombie companies existed in Japan, that is to say, companies that should not exist but can remain because of free financing.
* Another point about interest rate and investment was that, Japan was also experiencing deflation, and as such the real interest rate was positive and may be was to high to foster the new investments required. (real = nominal - inflation expectation).
* Finally, and that is a point of debate, TFP is claimed to have declined affecting GDP growth. Such hypothesis does not necessit a credit crunch hypothesis.
Today in "World Economy" we discussed both the EU and the EMU, as well as the USA. What i take out of the discussion is about the sub-prime crisis and how it results in a credit crunch.
The reasons behind the sub-prime crisis have been heavily discussed in many media. So, what i took out from the class, is how this little incident propagated to the entire financial industry resulting into a lack of availablility of credit.
First, it is interesting to realized that in heavily leveraged financial institution, if one wants to keep leverage constant, a change in asset price (loans) results in massive sale (if fall of value) or massive purchase (if increase of value) of loans, which actually means a downward sloping supply curve of asset.
Then, if one consider a very basic model where a leveraged financial institution has some losses and also wants to decrease its leverage (which is what happens in times of crisis) the aggregate asset contraction is tremendous.
Using numbers, if one were to consider a 200B$ credit loss (from loans and morgage backed securities) for leveraged FI, the resulting contraction can easily be around 10% of the total asset value.
Considering that such total asset value is about 23T$, a 200B$ crisis, results in contraction sucking out about 2T$ of liquity off the market, hence a credit crunch.
This past week was entirely dedicated to a single topic: financing the entrepreneurial business. This course was very pragmatic, full of cases always focused on understanding a specific point. In particular what i take out is:
* The VC method to value a start-up (post-money, and pre-money).
* The concept of ratchet to increase the equity stake of the entrepreneur and keep him motivated.
* The various financing instruments: beyond the different types of debt (senior, mezzanine) that we already covered in corporate finance, we discussed a few on the equity side. From ordinary shares to preferred share with tailored rights (redemption, dividends) and loan stock.
* How these various instruments truly affect the future payment at exit for the different parties.
The past class on M&A and Co., we talked about financial distress. In short:
* Signs of financial distress are when cash and other liquid assets are insufficient to meet current debt obligation. Violation of covenants can also be early signs of distress.
* We talked about the problem of debt overhang. That is to say, that when good project are not taken because of conflicts between equity and debt holders. In short, near financial distress shareholders are reluctant to fund good projects because much of the gains go to the creditors. We also discuss the major difference between countries to solve try to solve these problems (Chapter 11 and 7 in the US, and UK legislation).
* We also talked about how to value equity in the case of distress. In particular we diwscussed the Merton's model: evaluate EV, and then option pricing (Black-Scholes) to value equity. E=Cbs(EV, Net Debt, T, Rf, sigma). EV can come from CCF or liquidation value, net debt is from the books. Then D= EV - E of course.
* Finally, we also touched upon assessing the probability of default. In particular we were introduced to the KMV model.
One of the recent topic we discussed in finance was Leverage Buy-Outs. This discussion was illustrated with the Yell case, which also enabled us to touch upon the International CAPM.
International CAPM: in the case of integrated countries one can use the Beta-E against world index (MSCI) and then unlever to get the Beta-A. Then, depending on the reference country one wants to use, we simply use the CAPM with that Beta-A with the Rf of the local currency.
LBO: well, in the case of an LBO, the most appropriate valuation method is CCF (capital Cash Flow), which is no other that APV with a discount rate that is the return on asset. Basically, CCF = FCF - Interest. When constructing the model, one may also want to include principal repayment so that appropriate gearing is exhibited upon exit. Note that depending on the plan, one can use 100% cash sweep for repayment or just a portion of the CCF. The rest is factored in as ECF (equity free cash flow).
This past WE we started the new finance class dedicated to Mergers, MBOs, LBOs, and corporate reorganization. This course covers lots of examples through cases whose theoritical aspects are presented first. We also discuss the many aspects of deals, but focus most on the financial views. In particular this past class, i take away the following:
* Synergies valuation from the market: S = CARa x Va + CARb x Vb, where CAR is the cumulative abnormal return, CAR = R - (alpha+beta x Rm). Also Va and Vb are the values pre-event and S is evaluated in an event window [-10 ; +10] days around the event, and alpha and beta are extracted from an estimation window, [-120 ; -20] before the announcement. Note that if there is uncertainty about the deal this S is a weighted value of the real synergies with p, probability of success.
* An offer can be composed of cash and share exchange. In that case, the value of the offer is: c + (x/(Na+x.Nb)).(Va + Vb + S - Nb.c); where c is the cash offer from A to B, x, the exchange ratio of shares, Na and Nb the number of existing shares, Va and Vb the value of A and B pre-announcement, and S the synergies.
* Collar: we can also imagine some contractual arrangement in the case of share exchange, with floor and ceiling. In such cases, we can value the offer using option valuations (Black-Scholes) as the deal is a combination of long shares, long puts and short calls.
* Earn-outs: provide payment to the target 2 to 5 years after the deal depending on performance.
When it comes to outsourcing it is important to first understand the difference between a core process and a critical process. A Core process is one that generates a competitive advantage, those should not be outsourced.
The motivation for outsourcing include: efficiency (lower costs), effectiveness (access to better technology, continuous improvement), and flexibility (convert fixed costs into variable costs).
Overall, it make sense to outsource a non-core process when the market cost associated to it, which is the sum of the production cost (from the market) + the transaction costs, is lower than the cost of in-house production.
Usually, it is helpful to think of transaction costs from 3 perspectives: interaction costs, contracting costs, and transition costs.
Also, it is important to understand the difference between off-shoring and outsourcing. Off-shoring relies on the move of a process to a different location, while outsourcing represents moving an activity outside the scope of the company.
We have seen previously that M&A is one form of expansion/diversification. The steps in an acquisition process can be summarized as follow:
This being said we can mention 4 comments made about M&A:
