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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
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
❖ 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)
© Prof. dr. J.T.J. Smit
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)
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
“I used to think I was indecisive - but now I’m not so sure”
Anonymous
10
Building Blocks:
Corporate Finance & Strategic Planning
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
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?
© Prof. dr. J.T.J. Smit
1) Company Valuation
2) Debt Capacity & Cost of Capital
3) Leveraged Buyouts
4) Mergers & Acquisitions
17
1: Company Valuation
© Prof. dr. J.T.J. Smit
❖ 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
1: Company Valuation
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit 20
2: Capital Structure and Cost of Capital
© Prof. dr. J.T.J. Smit
❖ 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
3: Company Valuation
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
❖ Summary of the lectures
❖ Focus points for the exam
❖ Typical exam questions
❖ Question & Answers
❖ Concluding remarks
27
Strategic Management:
Competitive Advantage and Value Creation
© Prof. dr. J.T.J. Smit
“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
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
Building Blocks: Overview
Strategic
Value
Strategic
Position
I.O. Econ.
RBV
Rivalry
30
Strategic Management:
Central Trade-off
© Prof. dr. J.T.J. Smit
Flexibility Commitment
31
Value Drivers and Strategic Planning
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit 34
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
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:
Strategic Conflict and Game Theory
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:
Strategic Conflict and Game Theory
© Prof. dr. J.T.J. Smit 37
❖ 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
© Prof. dr. J.T.J. Smit 38
Internal Approach: Resource Based View
© Prof. dr. J.T.J. Smit
“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
© Prof. dr. J.T.J. Smit 40
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)
© Prof. dr. J.T.J. Smit 41
Financial Markets Assign a Value To Growth
© Prof. dr. J.T.J. Smit
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?
© Prof. dr. J.T.J. Smit
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?
© Prof. dr. J.T.J. Smit
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)
© Prof. dr. J.T.J. Smit
How sophisticated might one think?
45
Portfolio Planning of Growth Opportunities
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
❖ 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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
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
© Prof. dr. J.T.J. Smit
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:
© Prof. dr. J.T.J. Smit 51