Financial Management, 15.

414

Prof. Jonathan Lewellen

MOT Program, Summer 2003

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Preliminaries Reading
x x x

Brealey and Myers, Principles of Corporate Finance Class notes Reading packet + handouts

Web pages

x x

Course server
Data: wrds.wharton.upenn.edu

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Preliminaries Teaching assistant

x

Recitations: Monday, Wednesday

Grades
x x x

Assignments (45%) and final exam (40%)

Class participation (15%)
Addl practice problems on syllabus (not graded)

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Today
Introduction Overview of the course

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Introduction
Corporate finance
x

Investment policy How the firm spends its money (real and financial assets) Financing and payout policy How the firm obtains funds (debt, equity, ) and dispurses of excess cash

x

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Balance sheet view of the firm

Assets Liabilities and Equity

Current Liabilities Current Assets

Long-Term Debt Fixed Assets

1. Tangible fixed assets 2. Intangible fixed assets

Shareholders Equity

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Introduction
But we also need to understand
x

Capital markets How securities (stocks, bonds, options, ) are traded Pricing Risk and return Market efficiency International markets

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Financial markets

Firms Curr assets Fixed assets Debt

Financial Markets

Individuals Equity Financial Intermediaries

Government

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Size and stock returns

1.40

Avg returns (% monthly)

1.20

1.00

0.80

0.60

0.40 Small 2 3 4 5 6 7 8 9 Big

Firms sorted by market value (deciles)

MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Accruals and stock returns

1.20

Avg returns (% monthly)

1.00

0.80

0.60

0.40

0.20 Low 2 3 4 5 6 7 8 9 High

Firms sorted by last year's operating accruals (deciles)

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Introduction Finance is really about value

x x x

Firms
Projects and real investments
Securities

Central question
How can we create value through investment and financing decisions?

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Merck
Medco acquisition (1993) Strategic considerations Positioning Does the acquisition generate competitive advantages? Sustainability Are the competitive advantages sustainable through time? Financial considerations
Investment
Does the acquisition generate value for Merck?
Financing
What is the best way to finance it?

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Types of questions

Investment decisions At the end of 2001, GM had $18.6 billion in cash. Should it invest in new projects or return the cash to shareholders? If it decides to return the cash, should it declare a dividend or repurchase stock? If it decides to invest, what is the most valuable investment? What are the risks?

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

General Dynamics
1980s were generally good
x x x

Strong sales growth ($4.7 billion to $10.2 billion)

Reasonable profitability
R&D and capital investment

Beginning of 1990

x x x

End of the Cold War

Likely decline in defense spending
Strategy??

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

General Dynamics

$ 1.0
0.8 0.6

R&D + CapExp
0.4 0.2 0.0

Net Inc

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

-0.2 -0.4 -0.6

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Value of $100 invested Jan. 80

$500

$400

Market

$300

$200

GD
$100

$0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

General Dynamics Investment, 1980 1990 R&D + capital expenditures If invested at 10% Ending market value Value destroyed $3.7 billion $5.5 billion $1.0 billion $4.5 billion

Earnings in 1990 = $578 million

Investment in 1990 = $711 million

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

General Dynamics
1991 1993 William Anders, CEO Divestitures and layoffs Sales, $10.2 to $3.2 billion Employees, 54,050 to 26,800 (cont. operations) Investment cuts
R&D, $390 to $33 million
Cap exp, $321 to $14 million
Cash payouts $3.4 billion to shareholders

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

GD: 1987 1997

$ 1.0

R&D + CapExp
0.8 0.6 0.4 0.2 0.0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

-0.2 -0.4 -0.6

Net Inc

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Value of $100 invested Jan. 91

$700 $600 $500 $400 $300 $200 $100

GD

Market
$0 1987 1988 1989 1990 1991 1992 1993 1994

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Types of questions
Financing decisions In 1998, IBM announced that it would repurchase $2.5 billion in stock. Its price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response? Your firm needs to raise capital to finance growth. Should you issue debt or equity or obtain a bank loan? How will the stock market react to your decision? If you choose debt, should the bonds be convertible? callable? Long or short maturity? If you choose equity, what are the trade-offs between common and preferred stock?

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Types of questions
Financial markets In the 5 years from Jan. 1995 to Dec. 1999, the U.S. stock market increased in value by 227%. DY on the S&P 500 dropped from 2.90% to 1.17%, and the P/E ratio increased from 14.9 to 32.4. Why? What does this tell us about future returns? How should it affect our financing and investment decisions? From 1946 1999, small firms returned 17.8% and large firms returned 12.8%. From 1963 1999, stocks with low B/M ratios returned 13.8% and those with high B/M ratios returned 19.6%. What explains the differences? How can we measure a stocks risk? What does this mean for financing and investment decisions?

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

S&P 500 dividend yield, 1871 1999

14% 12% 10% 8% 6% 4% 2% 0% 1871

1887

1903

1919

1935

1951

1967

1983

1999

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

S&P price-earnings ratio, 1871 1999

35

28

21

14

0 1871

1887

1903

1919

1935

1951

1967

1983

1999

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

The course
Broad and fairly quick survey Managerial focus (general managers) Empirically-oriented

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

Outline Part1. Valuation Basic principles Capital budgeting and real options Firm valuation Part 2. Risk and return
Diversification
Measuring risk: CAPM and APT
Estimating discount rates
Market efficiency
Part 3. Financing and dividend policy
Debt vs. equity Dividends and stock repurchases

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MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 1

A few powerful themes

i. Value maximization

ii. Cash flows iii. Risk, return, and diversification iv. Market efficiency v. Information asymmetries and signaling

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