Session Long Project 12DCP - 073

Corporate Finance
The document contains solutions for the 9 questions given as part of the session long project. Nikhil Saxena 1/26/2013

Session Long Project -12DCP - 073

Assignment 1 Do you think finance departments are the best place to train future CEOs? The decision that a CFO can become a CEO depends on certain conditions that consider the CFOs past experience and the companys vision, ultimate ly comparing the strengths and weaknesses of candidates from a financial background. Over the last 3 decades, the CFOs role has changed greatly. The reputation of CFOs as technical accountants focused on excel sheets and cloistered from an organizations core operations has slowly evolved. In fact, they are now required to have knowledge in a number of fields that have a direct nexus with a firms business For example, the CFO must have

substantial knowledge of various regulations such as those set by SEBI, in order to execute and comply with corporate governance legislations, as well as have knowledge of inventory, procurement, marketing and operations to make sure the companys financial cycle is managed efficiently.

When a CFO might be suitable for the CEO position? While there are no fixed criteria when a CFO will be suitable for the job of a CEO, there are a few circumstances that favor this switch (CFO to CEO) When companys strategic priorities are focused on finance-related issues The CFO has a versatile portfolio of management experiences to draw upon as CEO. Depending on the industry: Deregulated industries Those industries where there is minimal government interference, usually enacted to create more competition within the industry. Desperate companies Companies that are financially desperate. Complex companies with many moving financial parts

The CFO might be best suited to work as a CEO in companies that involve complex financial decision-making. However, they may not be best for organizations with simplistic financial structure.

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Why a CFO might not be the right person to be CEO? There is still a belief among some corporate insiders that CFOs lack the ability to think strategically about key operational questions outside of finance. For example, while discussing about some key issues like creative solutions and marketing strategies, adding or discontinuing product lines, acquisitions, CFOs wont be involved in the discussion. The role of CFO in some companies might not be tractable to making the switch. While CFOs have evolved professionally from being just technical accountants, there still might be scope for additional growth in understanding a companys full business range in order to become the main authority to groom the next generation of corporate leaders.

Recently, there has been a growing trend of CFOs becoming CEOs: Indra Nooyi of PepsiCo, James Bell at Boeing and James Ziemer at Harley Davidsons, Jose Luis Duran of Carrefour. The failures: As per Lawrena Colombo, partner with PWC, when a company CEO retired in PricewaterhouseCoopers, the organization sought a CFO to take his place. He was a well regarded CFO with real credibility among key shareholders and the board of directors. His style as a leader was well-established and comfortable.

While his efforts were rewarded by increased stock value in the marketplace, he elected not to take on some of the agenda items the retiring CEO had left unfinished. Instead, he led the organization, protecting the brand, assets and market share, but not pushing demonstrable leaps forward.

Three years into his tenure, the stock valuation plummeted and the unaddressed issues became labeled by some observers as a failure of the CEO to lead.

Another CFO who went into the top spot looked for ways to cut costs in order to improve margins and show strong performance to the board. He did it poorly, demoralized the sales organization, and ultimately experienced a mass exodus of key sales people. After the board fired the CEO, it took several years for the company to build back its reputation with its customers.

Session Long Project -12DCP - 073

Conclusion: To an extent it can be said that the finance departments are the best place to train future CEOs, but, in my opinion, merely restricting the CEO into finance departments would not help him or her know all remaining departments of the organization properly. That's why, a CEO is supposed to be well acquainted with all departments of the organization or company - finance, HR, public relations, customer service, sales, marketing etc. Also, it depends a lot on a person-to-person basis. Some people are born leaders and it depends how the person in question adapts to the new position and whether he/she is able to take a broader perspective of the organization or not.

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Assignment 2

Company Chosen: GlaxoSmithKline plc

About GSK: GlaxoSmithKline plc (GSK) is a British MNC pharmaceutical, biologics, vaccines and consumer healthcare company headquartered in London, UK. It is the world's fourth-largest pharmaceutical company measured by 2009 prescription drug sales (after Pfizer, Novartis, and Sanofi).

Controversy: On 2 July 2012, GSK pleaded guilty to criminal charges and agreed to a $3 billion settlement of the largest health-care fraud case in the U.S. and the largest payment by a drug company. The settlement is related to the company's illegal promotion of prescription drugs, its failure to report safety data, bribing doctors, and promoting medicines for uses for which they were not licensed. The government investigation of GSK was launched largely on the basis of information provided by four whistleblowers. GSK settled the whistleblowers lawsuits for a total of $1.017 billion out of the $3 billion settlement, the largest civil False Claims Act settlement to date, eclipsing Pfizer's 2009 $2 billion payment.

As part of the settlement, GSK has entered into a Corporate Integrity Agreement (CIA) with the US Government. Part of the CIA covers obligations that GSK has agreed to as it pertains to the manufacturing facilities in its former Ciadra PR plant. GSK will also enter a five-year Corporate Integrity Agreement, brokered with the Department of Health and Human Services Office of Inspector General that mandates changes in sales force compensation.

The Future: With respect to the accounting of the settlement of the lawsuit and its effect GSKs total earnings Andrew Witty, CEO (GSK) says: The net effect of these movements on total earnings is expected to be neutral.

Session Long Project -12DCP - 073

In a single leap, GSK has attempted to gather and quantify its various legal trials into an orderly ruck to deal with and neutralize. This effort goes a long way in limiting the collateral damage. This also serves to limit the unknown cost of all the separate litigation that is covered by this settlement. Combined and coupled with its reliable dividend yield (4.8%) and promising pipeline of products makes it a must have share in the long run. The future of GSK looks exceptionally promising. That is exactly why it is important to prevent a legal loophole from appearing that would have the past mistakes of GSK dent the future of GSK for decades to come. Based on this strategic move, this settlement has already been taken care of into the valuation of the company and should have very little effect on the companys future total earnings.

Financial Highlights from the past year: Year 2011 Year 2010 Year 2009

Fiscal Year Fiscal Year Ends: Most Recent Quarter (mrq): Profitability Profit Margin (ttm): Operating Margin (ttm): Management Effectiveness Return on Assets (ttm): Return on Equity (ttm): Income Statement 10.97% 68.01% 18.61% 27.01% Dec 31 Sep 30, 2012

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Revenue (ttm): Revenue Per Share (ttm): Qtrly Revenue Growth (yoy): Gross Profit (ttm): EBITDA (ttm)6: Net Income Avl to Common (ttm): Diluted EPS (ttm): Qtrly Earnings Growth (yoy): Balance Sheet Total Cash (mrq): Total Cash Per Share (mrq): Total Debt (mrq): Total Debt/Equity (mrq): Current Ratio (mrq): Book Value Per Share (mrq): Cash Flow Statement Operating Cash Flow (ttm): Levered Free Cash Flow (ttm):

42.77B 17.31 -8.10% 31.17B 13.17B 7.96B 3.17 -18.60%

5.81B 2.39 28.10B 248.79 0.97 4.11

7.41B 5.06B

One-Year HPR: -0.40% Most recent price of share: $44.83

Top Management at GSK: CEO Sir Andrew Witty Senior VP, Governance, Ethics and Assurance Simon Bicknell CFO Simon Dingemans

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President, North America Pharmaceuticals Deirdre Connelly President, Global Manufacturing & Supply - Roger Connor President, Pharmaceuticals R&D Patrick Vallance

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Assignment 3

Agency problem is likely to be intense when there is individual ownership. This is because an individual owner might not be able to exercise that much influence and control, as a group of owners might. An individual owner is limited in his ability to gather information on what is going on within the company. On the other hand, a group of owners can brain storm and make better decisions about the corporate goals. The high percentage of group ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. Additionally, institutional owners have extensive experience with handling their resources in monitoring managers performances. They will be better able to bring in these experiences to monitor the managers performances of the other organizations as well.

Because of the above mentioned reasons, there is a tendency of agency problems being less severe in Germany and Japan than USA. However, with trends growing towards institutional ownership in USA as well, agency problems will tend to decline there as well.

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Assignment 4: Executive Compensation

The debate on Executive compensation is based on principal-agent theory. Conflicts of interest and moral hazard issues that arise when a principal hires an agent to perform specific duties that are in the best interest of the principal but may be costly, or not in the best interests of the agent. The principal-agent problem develops when a principal creates an environment in which an agent has incentives to align its interests with those of the principal, typically through incentives. Principals create incentives for the agent to act as the principal wants because the principal faces information asymmetry and risk with regards to whether the agent has effectively completed a contract.

Here, principal is the company owner while agents are the executives (read: CEOs).

CEO compensation should be designed in a way to alleviate this principal-agent problem, which provides both incentives and a monitoring facility to align self-interest of a CEO with that of the companys shareholders.

Now, whether they are appropriately or overly paid depends on whether shareholders have prospered as much as CEOs. Earlier, CEOs were often compensated through cash. But recently, added awareness of the principal-agent problem has slowly shifted compensation schemes toward a greater use of incentives, whereby the CEO would profit whenand hypothetically, only whenshareholders did.

What is unclear, however, is the degree to which rising CEO pay is actually linked to greater firm performance. Empirical evidence regarding executive compensation and firm performance is quite mixed.

Since the board nomination process is typically controlled by the CEO and the CEO has considerable information advantage over the board in terms of the company's performance and his or her role in it, CEOs hold leverage over the boards that set their compensation. This

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leverage persists because board members are generally reluctant to disturb the companys stability and are somewhat incapable to do much, given their limited time commitments as directors.

As a result, company boards cannot negotiate CEO pay equitably. Instead, what happens is a false-negotiation biased towards the CEO by which, CEOs can extract pay that exceeds fair market value.

The design of the compensation process also matters. Boards tend to benchmark pay in terms of what the competition offers. When this happens, boards inevitably approve above-average pay packages because they don't want to send the message that their CEO is average, or worse.

Sometimes, CEOs receive big executive payouts from stock appreciation that stem more from an industry or market-wide surge than from judicious moves by the CEO.

For example, Oil and other energy firms: Rising stock prices in that industry have been due as much to political conflict, natural disasters and even serendipity than to the particular activities or visions of the CEO. Rising energy prices have lifted virtually all stocks in this sector, which creates windfall compensation for CEOs despite the fact that their company's stock performance was not unique within the sector.

Though some studies have found correlations between CEO pay and firm performance (specifically stock prices), there is little evidence that high stock market returns are the direct result of CEO performance (and related CEO pay).

There are plenty of examples of highly paid CEOs running poorly performing companies, as well as modestly paid CEOs at the helm of high-performing companies.

Also, there are plenty of examples of pay-for-performance incentives going haywire, where CEOs either manipulate the books or focus on short-term stock prices to the long-term damage to the company.

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There is a growing trend toward hiring CEOs from outside the firm, rather than the more traditional method of promoting from within. Firms tend to pay more to attract CEOs from outside the firm.

With CEOs having shorter expected tenure, more demands for performance, greater demand for their services and higher personal liability for a firm's financial statements, economic theory suggests that reservation wagesthe level at which a person chooses work over leisurefor CEOs should also be going up.

There appears to be a solid correlation between good governance and shareholder return, though research to date is limited.

In essence, current CEO pay levels, whether deemed too low, too high or just right, haven't happened by chance, but by design. And in the future, better design is likely to come about through better corporate governance. That might or might not lead to changes in CEO pay levels, but it would better ensure that CEO paywhatever its levelis more surely attached to performance.

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Assignment 5: Five Year Chart:

Expectations: The shares have been stagnant over the last year. They trade on just 11 times next year's forecast earnings with an attractive dividend. Investors have begun to understand the fact that this company is undervalued but there should be more to come. The company is about to come up with drugs for cancer and diabetes. It has already submitted its application for the two drugs to FDA. This will be a huge boost to the top-line drugs that GSK produces and shall reflect in the share price. My expectations are that the share price of GSK should rise the next year.

Past Trends: Over the past 1.5 years, the share price has been relatively stable with the price being in the range of $43 - $47. However, before that, in the year 2009, the share price fell steeply due to the lawsuits filed against GSK for its strategy on sales compensation.

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Alternative Investments:

Fixed Bank Deposits Savings Bonds Gold Options Real Estate Commodities (crude oil etc.)

Savings Account Interest Rate in a US Bank (MetLife): 2%

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Assignment 6: Two Companies chosen: GSK and Pfizer

GSK: Book Value per share as at 30th September, 2012: $3.89 Market Price per share: $44.66

Market-to-book ratio = 11.48

Pfizer: Book Value per share as at 30th September, 2012: $10.99 Market Price per share: $26.9

Market-to-book ratio = 2.44

Analysis: Since the company is about to launch 2 new major drugs in the market and the company fundamentals are very strong (proven by their comeback from the lawsuits mire), investors feel that the company is going to be very fruitful in the future. As a result, the demand and hence the share price of GSK is highly values as compared to its book value.

On the other hand, Pfizer which has a greater Market Capitalization than GSK is seen as a stable company by investors, which has many top products in the market. However, lately there have been no new introductions by the company in the market and hence Pfizer shares trade at a decent level of 2.44 times of their book value.

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Assignment 7:

A) a. A large fire severely damages three major U.S. cities Diversifiable risk. If the portfolio of assets includes companies not located in these cities, then there is no risk to the returns on that portfolio. In short, the affect of this situation depends on the portfolio mix and hence can be avoided. b. A substantial unexpected rise in the price of oil Undiversifiable risk. The effect of this situation depends on the economy and affects all the citizens of that economy. c. A major lawsuit is filed against one large publicly traded corporation Diversifiable risk. Again, it depends whether the shares of this company are included in a person s portfolio or not. The return on a portfolio depends on the inclusion of this companys assets.

B) = 0.55 Since 0 < < 1, the asset moves in the same direction as the market but to a lesser extent. The asset is relatively steady as it does not fluctuate as much as the market does.

b. Rf = 0.045 RM Rf = 0.065 Cost of Equity (RE) = Rf + (RM Rf)* Cost of Equity (RE) = 0.045 + (0.065)*0.55 = 0.08075 = 8.075%

c. (Pfizer) = 0.66 (Mc Donalds) = 0.31

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(of Portfolio) = ( (GSK) + (Pfizer) + (Mc D))/3 = 0.5067

RE (Pfizer) = 4.79%

RE (Mc D) = 6.5% Expected Rate of Return (Portfolio) = (RE (GSK) +RE (Pfizer) + RE (Mc D))/3 = 6.455%

The portfolio can be made more diverse because two of the assets belong to the same industry and if some mandate is released by the Government which works against this industry, then the returns on this portfolio will suffer.

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Assignment 8

Project 1: GlaxoSmithKline Proprietary Knowledge Pool

In 2009, GSK helped to establish an independent knowledge pool where GSK and others could make available patents and knowledge that may stimulate research into treatments for 16 neglected tropical diseases (NTDs). This is now known as the Pool for Open Innovation against Neglected Tropical Diseases (POINT). Since January 2010 it has been independently administered by BIO Ventures for Global Health (BVGH), a non-profit organization that aims to accelerate the development of drugs, vaccines and diagnostics to meet global needs.

Funding: GSK's proprietary adjuvant systems

Project 2 (Current): GSK HPV-021 Trial

Cervical cancer is the second most common cancer among women worldwide. Up to 70% of cervical cancer cases are attributable to human papillomavirus (HPV) genotypes 16 and 18. Two prophylactic HPV vaccines are now available that have high efficacy against incident and persistent HPV-16/18 infections and associated cytological abnormalities. However, HPV vaccines have not yet been tested in Africa. Two sites in Africa, Mwanza in Tanzania and Dakar in Senegal, are participating in a multicentre immunogenicity and safety trial of GSK Biologicals bivalent HPV vaccine in young girls.

Funding Source: GSK Biologicals because Biologicals department at GSK is responsible for projects in these fields.

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Assignment 9

Corporate Events Undertaken

GlaxoSmithKline advances multi-city discussion focused on improving the health of US communities GSK Responds to Hurricane Sandy Relief Needs GlaxoSmithKline honors healthcare nonprofits with $40,000 IMPACT Award Ex-Date for dividend payment of $0.579 13/11/2012 Ex-Date for dividend payment of $0.528 07/08/2012

Announcements:

FDA Approves GlaxoSmithKline's four-strain seasonal influenza vaccine for use in the U.S. - December 17, 2012 GSK receives FDA approval for raxibacumab anti-toxin for the treatment of inhalational anthrax - December 14, 2012 FDA approves new indication for PROMACTA (eltrombopag) - November 19, 2012 Efficacy Shown With GlaxoSmithKline's Phase 3 Malaria Vaccine Candidate, Which Contains Agenus' Qs-21 Stimulon(R) ADJUVANT - November 9, 2012