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Hong Kong University of Science & Technology

Department of Finance FINA 5140: Advanced Topics in Financial Management


L1: Fridays 19:00 22:20, Cliftons Limited1 L2: Saturdays 9:00 12:20, HKUST, LTH

Fall 2013
Instructor: Prof. Tim Adam (tadam@mit.edu) Room: TBA Teaching assistant: Pak To Chan, Plato (platocpt@ust.hk) Room: TBA Course Objective This course exposes you to two major areas in corporate finance: conflicts of interests between the various stakeholders of a corporation and information asymmetries between insiders and outsiders. Both aspects have profound effects on a firms optimal financial strategies, such as capital structure, payout policy and fund raising. We will also explore how corporate governance mechanisms can be used to align conflicts of interest between managers and shareholders. At the end of the course we will discuss the difficulties in financing very large projects, which require billions of dollars. Prerequisites FINA 5120 Students should be familiar with the material in Chapters 1-15 of Berk and DeMarzo, Corporate Finance, 2nd edition Grading The final grade will be calculated as follows: Four case reports 40%, final exam 60%.

Level 5, Hutchison House, 10 Harcourt Road, Central 1

Course textbook Berk and DeMarzo, Corporate Finance, 2nd edition, 2007, Pearson Education (BDM) Alternative textbook: Grinblatt and Titman, Financial Markets and Corporate Strategy, 2nd edition, 2004, Irwin/McGraw-Hill (GT)

Course Outline
Date Sep. 6/7 Sep. 13/14 Sep. 13/14 Sep. 20/21 Sep. 20/21 Sep. 27/28 Room 2464 Sep. 27/28 Room 2464 Oct. 4/5 Oct. 4/5 Oct. 11/12 Oct. 11/12 Oct. 18/19 Oct. 27 14-17:00 Topic Review of DCF valuations APV, WACC, CCF, FE Agency costs of debt: The debt holder equity holder conflict Agency costs of equity: The principal agent problem Case: Kennecott Copper Corp. How to control managers: Corporate governance & executive compensation Case: Bankruptcy and Restructuring at Marvel Entertainment Group Capital structure and non-financial stakeholders Case: Stone Container Corp. (A) The effects of information asymmetries on capital structure Raising funds - Project finance Raising funds - IPO Netscapes Initial Public Offering Case: Iridium LLC Final exam (both sections) 23.2-23.4 3.4-3.9 16.8-16.9 & 17 19 16.1-16.4 17 29 18.5 BDM chapters 18 16.5 16.6-16.7 GT chapters 13 16 18.1-18.4

Reading Assignments (per Week) 1 DCF Valuation BDM 18 GT 13 Note on Adjusted Present Value, HBS Note 9-293-092 Valuing Companies in Corporate Restructurings, HBS Note 9201-073 Agency costs of debt: The debt holder equity holder conflict BDM 16.5 GT 16 o Optional: Miller, M. (1991) Leverage, Journal of Finance, 46, 479-88, Nobel Prize Lecture Agency costs of equity: The principal agent problem BDM 16.6 - 16.7 GT 18.1 - 18.4 Myers (2001) Capital Structure, Journal of Economic Perspectives o Optional: Wheres all the fun gone? The Economist, March 18th, 2004. o Optional: Kke (1999) New Evidence on Ownership Structures in Germany Kennecott Copper Corp., HBS Case 9-278-143 Corporate governance & executive compensation BDM 29 GT 18.5 Bargain bosses - American chief executives are not overpaid The Economist, Sep 8th 2012. o Optional: Optional: Edmans and Gabaix (2009), Is CEO Pay Really Efficient? European Financial Management 15, 486496 Bankruptcy and Restructuring at Marvel Entertainment Group, HBS Case 9-298-059 Capital structure and non-financial stakeholders BDM 16.1-16.4 GT 17 o Optional: Jensen, Michael (1986) Agency Costs of Free Cash Flow, Corporate Finance and Takeovers, American Economic Review, 76, 323-29

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Stone Container Corp. (A), HBS Case 9-297-047 Effects of information asymmetries on capital structure and payout policy BDM 16.8-16.9 & 17 GT 19 o Optional: Bagwell, Laurie Simon and John Shoven (1989) Cash Distributions to Shareholders, Journal of Economic Perspectives, pp. 129-140 o Optional: Brav, Graham, Harvey, and Michaely (2005) Payout policy in the 21st century, Journal of Financial Economics, 483527 Project finance Brealey, R.A., I.A. Cooper, and M.A. Habib (199?), Using Project Finance to Fund Infrastructure Investments, Journal of Applied Corporate Finance, 25-38 IPO BDM 23.2-23.4 GT 3.4-3.9 Netscapes Initial Public Offering, HBS Case 9-296-088 o Optional: Brau and Fawcett (2006), Initial Public Offerings: An Analysis of Theory and Practice, Journal of Finance 61, 399435. Iridium LLC, HBS Case 9-200-039

Case Teams All seminar participants should form teams consisting of 5 members. Students who are not part of a complete team by the end of the first day of class will be allocated randomly to other incomplete teams. Each team needs to submit four case reports: Kennecott, Marvel, Stone, and Iridium. Both a hardcopy of your report and a computer file containing the report are due at the beginning of the class the case is scheduled for discussion. Students attending the Saturday session must submit the computer file by Friday 10 pm at the latest. The computer file that contains the report should be sent as an e-mail attachment. Since we discuss the case solutions in class, late reports cannot be accepted. Case reports that include plagiarism will earn a zero grade.

The workload should be shared equally among all members of a team. If you experience any free-rider problems you should inform me as soon as possible. I will handle any complaints absolutely confidentially. At the end of the course there will be a confidential peer evaluation, which may affect your overall grade.

Case reports The purpose of the cases is to apply the financial concepts covered during the lectures. You need not explain these concepts in your case reports, but can assume that the reader is familiar with the relevant theory. Case reports consist of answers to the case questions. Good case reports are concise, brief, and to the point. The maximum number of pages for a case report is 6-8 pages, using a 12-point font. Make sure you adequately address all case questions. If the strategy options given are insufficient in your opinion then feel free to consider additional options. Support any claims you make by references to the information given in a case, graphs, or figures. Good case reports do not contain vague statements or guesses. It is possible that the information in a case does not provide enough information to make a clear judgment. In this case you should say so rather than make a guess. Any spreadsheet printouts provided should be self-contained, i.e., one should be able to understand the information given in a table without relying on the main text of the analysis. Tables should include all your assumptions as well as the formulas that are not immediately transparent. You should start working on a case report as soon as possible. The assigned cases are challenging, and you are unlikely to grasp the main ideas/problems within a few days. Furthermore, the discussion of the case questions within your team is crucial to understanding and solving a case. Therefore, it is not advisable to assign different questions to different team members, but to work on all questions together.

Case questions Kennecott Copper Corp. 1. Analyze the economic rationale of the Carborundum acquisition. Under what conditions would an acquisition be expected to add to shareholder value in general? Do any of these reasons apply to the Carborundum acquisition? 2. Kennecotts management team determined, based on Exhibit 7, that the value of Carborundum to Kennecott would be about $70$85 per share (page 7). Critically evaluate the methodology used to determine this value. 3. Use the information given in Exhibit 7 to determine the value of Carborundum to Kennecott using the Flow-to-Equity Method. Assume a market risk premium of 8.3%. 4. Why is management pursuing the acquisition? As an outside director of the board, how would you argue and vote on the resolution to tender for Carborundum? 5. Review management's decisions over the 10 years covered by the case, including the acquisition of Peabody, its divestiture, the proposed use of the proceeds of the Peabody sale and the selection of Carborundum as an acquisition target. What were the motivations underlying these decisions? Were they in the best interest of shareholders? 6. Optional: Critically evaluate the actions and recommendations by Kennecott's financial advisors (Morgan Stanley and First Boston) and its legal advisors (Sullivan and Cromwell).

Marvel Entertainment Group 1. Why did Marvel file for Chapter 11? Were the problems caused by bad luck, bad strategy (flawed business model), or bad execution? 2. Evaluate the proposed restructuring plan (the one proposed in Jan. 1997). What are the details of the plan? Will the plan solve Marvels problems? 3. How much is Marvels equity worth (in $/share) under the proposed restructuring plan, assuming it acquires Toy Biz as planned? Why is it sensible to use the CCF method here? (Assume a long-term market risk premium of 7.5%.) Consider performing a sensitivity analysis of your assumptions. 4. How does your valuation compare with Perelmans investment at $0.85/share and the current market value of Marvel? What is your

assessment of Perelmans financial projections and liquidation assumptions? Why is Perelman interested in making an equity investment in Marvel? 5. As a public debt holder, would you vote for or against the proposed restructuring plan? Why, or why not? How would you expect Carl Icahn and the other secured and unsecured creditors of Marvel to vote? Hint: What options do public debt holders have, and how much would they gain under each alternative? 6. Optional: Why did the price of Marvels zero-coupon bonds drop on Tuesday, November 12, 1996? Why did portfolio managers at Fidelity and Putnam sell their bonds on Friday, November 8, 1996? Did they break any rules/laws?

Stone Container 1. What was the basis of Stone Containers successful growth during its first fifty years? What was the product market strategy? What was its financial strategy? How did Roger Stones management of the company compare to that of his predecessors? 2. How sensitive are Stone Containers earnings to the paper and linerboard pricing cycle? Estimate the effect on earnings and cash flows of a $50 per ton industry-wide increase in prices. What if there were a $100 per ton industry-wide increase? In each case, assume Stone Containers sales volume approximates its1992 production level of 7.5 million tones per year -- while costs remain the same. Also assume a 35% tax rate. 3. What would be the effect under both these pricing scenarios if production and sales volume increased to full capacity of 8.3 million tons per year? For simplicity, assume costs per ton remain constant. 4. What should be Stone Containers long-term financial strategy? What capital structure do you recommend? 5. What should Stone Container do now? Develop a financial plan. Hints: What are Stones financing needs for 1993? How should these needs be met, i.e., how much debt should be issued, if any? How much equity should be issued, if any? You do not necessarily have to restrict yourself to the five financing alternatives described at the end of the case.

Iridium LLC 1. Assuming the market was rational at the time (i.e. market prices reflect fundamental values), how much was Iridium worth on a per share basis at the end of 1998 according to the projections in Exhibit 5? What are the important determinants of value? How confident are you in your answer? (Please assume the long-term market risk premium equals 7.5%) 2. What caused Iridium to fail: was it a bad strategy, bad execution, or bad luck? Was Iridiums financial structure to blame for its ultimate failure? Why, or why not? 3. With regard to Iridiums financial strategy, did it have the wrong target capital structure, issue the wrong kinds of capital, or issue capital in the wrong sequence? Which capital structure theory justifies its target debt-to-total book capitalization ratio of 60%? 4. Why did Motorola finance Iridium with project debt instead of corporate debt? 5. What lessons regarding the financing of large, Greenfield projects do you draw from this case study?

Peer Evaluation
Your Name: Session: Friday / Saturday Team No:

This evaluation is confidential. Your personal response will not be made available to the other group members or other members of the class. In the table below, rate each group member - including yourself - about his/her contribution to the two case reports that you submitted, using the following scale. 4 Excellent Contributor - The person significantly contributed to our case discussions. Without this person, the quality of the final case reports would have been considerably diminished. Good Contributor - The person contributed to our case discussions. Without this person, the quality of the final case reports would have been diminished. Marginal Contributor - The person barely contributed to our case discussions. Without this person, the quality of the final case reports would have been about the same. Unsatisfactory Contributor - The person failed to contribute in any meaningful way to our case discussions. Other members of the group had to do more because of this person's performance. Without this person, the quality of the final case reports may actually have been improved. Don't Know - I don't have enough information about the person's performance to assess his/her contribution reliably. Report I Report II Report III Report IV Overall

DK

Member Name (include yourself!)

Please provide any additional comments on the back of this form. In particular, explain any significant differences in the overall contributions of your team members.