Session 36: Closing Thoughts

In this, the final session of a 36 session corporate finance class, I'd like to wrap up the process by again reviewing some of the key principles and themes that drive corporate finance. And perhaps draw some lessons that we can use if we're in the practice of corporate finance evaluation. So we're 35 sessions into a 36 session class, which brings us to the very last session. In this last session, I'd like to draw your attention to some big picture issues, as well as a reminder of hopefully the points we've tried to make through all 35 sessions. So this is going to be my wrap-up session. And in a wrap-up session, you have to pull pieces together. So let me start off with four very simple points that I hope I've made in the process of looking at real companies. The first is, the world we have to operate in, there are very few facts and lots of opinions. Even the numbers we take as facts, like the risk-free rate, as you have seen, might not be facts. What's the risk-free rate in Indonesian rupiah? Your estimate might be better than mine. So there are very few facts. And with accounting and marketing numbers, all bets are off. With accounting numbers, because the numbers you get are a function of what the accountants do, the judgments they make. And with the market, because the numbers keep changing on you. So the first point is, remember that when you look at real companies, there are lots of estimates, lots of opinions you've got to deal with. The second is, the real world is a messy place. Messy place in what sense? The numbers can be all over the place. New information keeps coming in. Companies can go through facelifts. Bad things can happen to companies. Good things can happen to companies. They're going to create more work for you when they do happen. But there's nothing you can do about it. Third, we've talked about a lot of models, about using models and equations. The key thing to remember is, the models are your tools. Use them well, but if they don't work for you, abandon them. Models don't compute values. You do. Ultimately, you have to take responsibility for what comes out of these models. Finally, change is the only constant in corporate finance. So when you're done with an analysis, you're never quite done, because the world keeps changing around you. So be ready for change. I think it makes corporate finance exciting, but it does make it frustrating. So with that set up, let me talk about a few points we've emphasized through these sessions that I think are worth carrying through into the rest of corporate finance. The first is, remember about all those different interest groups that make up a modern corporation. You've got managers. You've got inside stockholders. You've got outside stockholders. You've got employees. You've got the government step in. You've got society. And they all have very different interests at play, and they all try to get their interest into your decision-making process. That's what makes running a modern corporation so messy. So while it might be easy in the utopian world to tell managers to maximize stock prices, we have to recognize that with all these conflicts of interest, managers will get pulled in different directions. Put differently, when you see a company make a decision, don't always try to analyze through the lens of rational stockholder wealth maximization. There might be a far simpler and ego-driven rationale for why companies do what they do. Second, we talk a lot about risk, but the key lesson I hope you take away from this is when you look at a company, you shouldn't be looking at all of the risk in the company. You should be looking at the risk in this company through the eyes of the marginal investor in the company. Remember the marginal investor? That investor owns a lot of stock and trades that stock. That investor is probably not you. It's probably some institutional investor. So when you think about risk, think about what risk would that investor see in the company, because that is the risk you should be building into your hurdle rates, your cost of equity and your cost of capital. Third, we talked a lot about converting that risk measure into a cost of equity. Without going through the details, there are three key inputs, right? There's a risk-free rate that's driven by what currency you choose to do the assessment in, and that risk-free rate is going to be driven by the expected inflation and the expected real interest rate in that currency. There's a beta. But the best way to think about a beta is it's a relative risk measure. And rather than think of it coming from a regression, think about the fundamentals that drive betas. What kind of business are you in? The more discretionary your product or service, the higher your beta. What kind of cost structure do you have? The more fixed cost you have, the higher the beta. How much have you borrowed? You can try to estimate a beta from a regression, but to me, that's a dangerous road to take. Instead, we looked at the business you're in, a sector average beta, or you might come up with another creative way of measuring relative risk. That cost of equity, of course, goes into a cost of capital. The big item there is the cost of debt. The cost of debt is the rate at which you can borrow money long-term today. So to get it, you've got to build up to it by taking the risk-free rate and adding a default spread. And that default spread, you can estimate either because you have an actual rating for the company, or if you don't have that, try to get a synthetic rating. Do not use the book interest rate as your cost of debt. So cost of capital, the weights have to be market value weights. Again, getting a market value of equity might be easy for a publicly traded company, but try to estimate a market value of debt as well. Now, the reason we do a return on capital or a cost of capital and a cost of equity is it gives us a framework for assessing the quality of your existing investments. So to measure the quality of your investments from an equity perspective, you can take the net income and divide by the book equity, in which case you get a return on equity. You can compare that return on equity to the cost of equity and look at the spread. You can even multiply that spread by the book equity to get an equity EVA. Or you can look at everything from the perspective of the entire business. You can take after-tax operating income, divide by invested capital, which is book value of debt, plus book value of equity minus cash. You can compare that to the cost of capital and see if the spread is positive, and then convert that spread into a EVA for the company. Again, this is measuring the quality of past investments, and it's only as good as the accounting numbers that go into the return on equity and return on capital. Then we moved on to debt, and we talked about the trade-off in debt. And that trade-off was driven by the fact that debt provides you with a significant tax advantage. There's an added advantage of sometimes in some companies, debt can make managers more disciplined about the way they pick projects. On the other side of the equation, you have expected bankruptcy cost to factor in. For some companies, those costs can be so large that borrowing even mild amounts of money can tip the scales. You have agency costs, where what's good for equity investors might not be good for lenders. And as a consequence, lenders build in covenants, which are expensive when you go out to borrow money. And the higher this agency costs, the less you should borrow. And every time you borrow money, you do lose some flexibility. That trade-off, we said, is what should determine whether you should be borrowing money or using equity. And in fact, we converted this into a number by using a tool, in this case, the cost of capital. We argued that by changing the mix of debt and equity and looking at what will happen to the cost of capital, we could answer the question of what the right mix of debt and equity is for a company. The key, though, is as your debt ratio changes, you have to change your cost of equity. And we did it by using a levered beta. And as the debt changes, you should be changing your cost of debt. And we did that using a synthetic rating. But we were able to come up with the right mix of debt and equity for a variety of companies, ranging from Disney to a private business. Now, once we got to the optimal, we had to make some decisions. We had to decide first how quickly we wanted to move to the optimal. And that decision was based on the urgency we felt. If you had too little debt, that urgency was driven by the fact that you could potentially become the target of a hostile acquisition. If you're over levered, it was driven by the fact that you could go bankrupt. And once we decided that it wasn't urgent or was urgent, we had a follow-up decision to make. Were we going to change the debt ratio by recapitalizing, which effectively means borrowing money to buy back stock if you're under levered, or issuing equity to pay off debt if you're over levered? Or were we going to get to the optimal debt ratio by using disproportionately large amounts of debt to fund investments if you're under levered, or disproportionately large amounts of equity if you're over levered? As a follow-up to that, and as a final piece to the financing principle, we also looked at the right kind of debt. Without going into the details, remember, your objective when you issue debt is for it to carry the tax benefits of debt. And if you can somehow build in the flexibility that equity has, you have the perfect kind of financing. That was the end game. And the reason we tried so hard to pull that off is it reduces default risk, reduces the cost of debt, and reduces the overall cost of capital. When we got to dividend policy, the key step was assessing how much a company could pay in dividends. To measure potential dividends, we started with net income. We subtracted out every conceivable need, capital expenditures, working capital, debt payments. We did add back any new cash we got from debt issues, and we got the free cash-flowed equity of potential dividends. We said this is what companies can afford to pay. But we also noted that many companies don't pay out what they can, which effectively leads to the building up of cash balances. And we looked at why different companies are treated differently. Some companies can accumulate large cash balances and are left alone. Other companies can accumulate much smaller cash balances, and stockholders want them back. And we said it all revolved around the trust that stockholders have in the managers. And in the final set of sessions, we looked at valuation. And we talked about the two different ways you could approach valuation. We said you could value the equity in a business by taking cash flows to equity, discounting the cost of equity, and arriving at a value of equity. Or we said we could value the operating assets in a business by taking cash flows to firm, pre-debt cash flows, discounting the cost of capital, and getting a value for the operating assets. Of course, there were a bunch of loose ends you had to tie up when you did that, adding back cash, subtracting out debt, dealing with cross-holdings. But eventually, we ended up with a value of equity. We also argued that there are lots of valuation approaches where you value something based on how similar assets are priced. And we call that relative valuation. But those, in a sense, captured the big picture of what we were trying to deliver in this class. So I will end this class with a picture that I started this class with. The big picture of corporate finance. The three big principles that animate corporate finance. The investment principle. Remember that? Invest in projects or assets that earn a return that is greater than a minimum acceptable hurdle rate. We said that hurdle rate should be higher for riskier investment and should reflect where you raise your money. The return should be based on cash flows, should reflect when those cash flows happen, and have all side costs and side benefits built into them. On the financing principle, we said find a mix of debt and equity that minimizes your hurdle rate and maximizes value, and match your debt up to your assets. And on the dividend principle, we said that if you cannot find investments that make your hurdle rate, return the cash back to the owners of the business. It's been a long journey, and I'm glad you've been with me on this journey, and I hope you've enjoyed it. I clearly have, and I hope to see you again. Thank you very much.