CAPITAL BUDGETING BAFI503 PERIOD 3 2011 Instructor: Teaching Assistant: Kai Li Alejandra Medina DL-530 Alejandra.Medina@sauder.ubc.ca kai.li@sauder.ubc.ca Office Hours: Monday/Wednesday 13:00-14:00 Office Hours: by appointment Office: Syllabus Course Objective: The objective of the course is for you to learn the basic financial tools needed to make good business decisions. This course is intended to broaden and deepen your understanding of issues related to valuing long-term investment projects. After reviewing some of the basic concepts from BAFI 500, we will introduce Weighted Average Cost of Capital (WACC) and Adjusted Net Present Value (APV) as alternative methods for evaluating long-term investments. Differences between WACC and APV as well as the strengths and weaknesses of each method will be discussed. The second part of the course focuses on advanced firm and project valuation with applications in the area of leveraged buyouts. Business cases and real world applications are used extensively throughout the course. This course will be useful to students considering careers in corporate finance, investment banking, commercial banking and consulting. Teaching methods: I will present the basic insights of corporate finance theory, but emphasize the application of theory to real business decisions. Each session will involve class discussion. In some instances, discussion will be centered on lectures; in others it will be centered on a business case. Your participation is critical to the success of the course. You are expected to read all cases, come to class, and participate in class discussion. I welcome comments from you to improve the course. Prerequisites: BAFI500 Corporate Finance and BAFI511 Investments. It will also help if you know some basic economics and accounting. Readings/Books: Higgins, Analysis for Financial Management, 2009, 9 th ed., Irvin, McGraw-Hill. Berk, DeMarzo, Stangeland, Corporate Finance, 2010, Canadian Edition, ISBN No. 978-0-321-62599-1, Pearson Canada (recommended). Brealey, Myers, and Allen, Principles of Corporate Finance, 10 th Edition (recommended). HBS cases can be purchased at the following HBS website: http://cb.hbsp.harvard.edu/cb/access/5638011 Case exhibits and additional reading material are posted on Blackboard Vista. Requirements/Grading: Case Write-ups: 40% - Students should form teams of 4 to 5, and hand in a single write-up per team. - Both hardcopy and email-version of the write-ups are due on the day that the case is discussed in the beginning of the class (make copies to refer to during the class). Please hand in the hardcopies in class, and email the same write-ups to Alejandra.Medina@sauder.ubc.ca. 1
- All cases require handing in write-ups. - Grading guidelines are at the end of this syllabus. Class Participation: 10% Final Exam: 50% Team formation: Teams will be 4-5 students each. Teams with members less than four and greater than five are strongly discouraged. Further details: Each group is required to submit ONE two-page memorandum on the cases. The memorandums should be typed. They should be written as if your were presenting it to your business colleagues. The two-page limit is for text only. Please use font 11 or 12. If we cannot read, we cannot grade. You may attach as many numerical calculations as you wish. Memorandums will not be accepted after the class has met. Class attendance and participation in case discussions is critical to the learning process. My teaching assistant is Alejandra Medina. Her main responsibility will be grading case write-ups and answering questions during office hours. Course outline (in brief): subject to adjustments Changes to this calendar will be available on the course webpage. # Date Topic Assignment (date due) 1 Tu, Apr 12 Lecture: Valuation of Free Cash Flows 2 Th, Apr 14 Lecture: WACC and APV 3 Tu, Apr 19 Case: Dixon Corporation Dixon 4 Th, Apr 21 Lecture: Valuing a Company 5 Tu, Apr 26 Case: Eddie Baur (A) Eddie Baur 6 Th, Apr 28 Case: Shenzhen Development Bank Shenzhen Guest Speaker: Mr. David Bell, MD, Jim Pattison Group 7 Tu, May 3 Case: Kohler (A) Kohler 8 Th, May 5 Lecture: Buyout Fund Valuation Methods CCF and ECF 9 Tu, May 10 Guest Speaker: Frederic Bastien, Raymond James 10 Th, May 12 Case: Bidding for Hertz: Leveraged Buyout Hertz 2
Course Outline Objective: The aim of the course is to study and develop tools to evaluate real investment opportunities, such as building a new plant or acquiring another company. We develop a framework of analysis and confront it to business cases. 1 Lecture: Valuation of Free Cash Flows - BMA, ch. 6: Why NPV Leads to Better Investment Decisions Than Other Criteria - BMA, ch. 7: Making Investment Decisions with the Net Present Value Rule 2 Lecture: WACC and APV - BMA, ch. 10: Capital Budgeting and Risk - BMA, ch. 20: Financing and Valuation - HBS Note on Free Cash Flow Valuation Models - HBS Note on Adjusted Present Value - Booth, Finding Value Where None Exists: Pitfalls in Using Adjusted Present Value - Cooper, Nyborg, Valuing the Debt Tax Shield Background readings: - BMA, ch. 12: Investment, Strategy, and Economic Rents - Higgins, ch. 7: Discounted Cash Flow Techniques - Higgins, ch. 8: Risk Analysis in Investment Decisions 3 Case Study: Dixon Corporation Case Questions Your job is to help Dixon's management decide whether to acquire the Collinsville plant at the proposed price. Some of the managers in charge of the decision are familiar with the simple WACC valuation method (i.e., using a single WACC to discount all cash flows) and so you have been asked to perform the valuation in this way. However, because you are aware of certain pitfalls of this method, you are also performing an APV-based valuation exercise. 1. Estimate the weighted average cost of capital that is appropriate for discounting the Collinsville plant s incremental cash flows. You should estimate and present each component of the WACC separately, explaining briefly but clearly what assumptions you are making for each of them. In the same spirit, estimate the appropriate all-equity cost of capital for the APV-based valuation. 2. Project the incremental cash flows associated with the acquisition of the Collinsville plant without the laminate technology. Use projections from Exhibit 8 through 1984. After 1984 assume: EBIT is flat; capital expenditures are $600,000 per year; and that net working capital increases 8% per year. Assume that the plant is shut down at the end of 1989 and that its salvage value is zero. 3. Estimate the value of the Collinsville plant without the laminate technology using the simple WACC method. 3
4. Project the incremental cash flows associated with the 1980 investment in laminate technology. Using the simple WACC method, estimate the investment s net present value. 5. Compare the WACC-based valuation to the APV-based valuation. Do they differ and how much? If the difference is important, explain why. If the difference is small or zero, explain why. 6. As CEO of Dixon Corporation, would you approve the acquisition of the Collinsville plant at the price and on the terms proposed? Why, or why not? 4 Lecture: Valuing a Company 5 Case Study: Eddie Baur (A) Case Questions 1. What is Eddie Bauer s strategy upon emerging from bankruptcy protection? What are the key success and risk factors associated with this strategy, for both the firm and its industry? 2. Where, if anywhere, in the financial statements are these success and risk factors reflected? Are any adjustments needed to better reflect economic reality? 3. How has Eddie Bauer performed in the past? What key measures can be used to gauge the company s success? 4. What are your expectations of Eddie Bauer s future performance? Please evaluate management s projections. 5. Should Bank of America and J.P. Morgan Chase continue to hold Eddie Bauer stock, or was the time to sell while it was valued at $24 per share? - Higgins, ch. 9: Business Valuation and Corporate Restructuring 6 Case Study: Shenzhen Development Bank Case Questions: 1. What is the business model of a commercial bank? What are the revenue and cost drivers of a bank? What are the key success factors for operating a bank? 2. What are the challenges for SDB? Why did these problems happen to SDB? 3. What are the investment thesis and key risks for Newbridge s investment in SDB? How can Newbridge mitigate these potential risks? 4. How does the valuation of a bank differ from other industries? What are the methods available to value a bank? What are the pros and cons of each method? 5. How to value the SDB stake on sale? Should the value of the minority stake on sale be different from market price? Why? 4
6. Did Newbridge pay the right price for the SDB stake? What is the possible return for Newbridge assuming exit in 2009? 7. Why did the Shenzhen government back out of the deal? What lessons can be learned from Newbridge s setback? 8. Should Newbridge give up the investment? If no, what should Weijian Shan do immediately to save the deal? 9. How will Newbridge turnaround the SDB? Please develop short-term and long-term turnaround plans? - BMA, ch. 34: Governance and Corporate Control Around the World 7 Case Study: Kohler (A) Case questions: 1. What is the total enterprise value of Kohler Co. using a discounted cash flow approach? What is the total enterprise value using a multiples (market value of comparable companies) approach? What is the value of a share held by a minority shareholder in Kohler Co. that is implied by your valuations? 2. What assumptions can you use to arrive approximately at the share price of $55,400 that was estimated by Kohler Co.? Show how these assumptions impact your valuation. 3. What assumptions can you use to arrive approximately at the share price of $273,000 that was estimated by the dissenting shareholders? Show how these assumptions impact your valuation. 4. What is the maximum share price at which Herbert Kohler should be willing to settle with the dissenting shareholders in order to stop the trial on April 11, 2000? Assume that: a. if the trial proceeds, it is expected to last less than a month and to result in one of two possible outcomes in terms of the price per share established in court: the $273,000 being claimed by the plaintiffs, or the $55,400 being defended by Herbert Kohler; b. Kohler estimates the probabilities of these two outcomes at 30% and 70%, respectively. Background readings: - HBS Note on Valuing Control and Liquidity in Family and Closely Held Firms 8 Lecture: Buyout Fund Valuation Methods Capital Cash Flows and Equity Cash Flows - HBS Note on Valuing Capital Cash Flows - HBS Note on Valuing Equity Cash Flows 9 Case Study: Bidding for Hertz Case questions: 5
1. How does the dual-track process used by Ford to initiate consideration of strategic alternatives affect the bidding process for Hertz? 2. In what ways does Hertz conform or not conform to the definition of an ideal LBO target? Do you believe Hertz is an appropriate buyout target? 3. Strategically, what value-creating opportunities can the sponsors exploit in this transaction? 4. How realistic are the key assumptions that underlie the Bidding Group s projections in case Exhibits 8, 9, and 10? Which assumptions are most likely to have the largest impact on returns? 5. What is the value of Hertz using the Equity Cash Flow method of valuation? 6. Based on the base-case estimates in case Exhibits 8, 9, and 10 and your estimate(s) of terminal value if the sponsors put up $2.3 billion in equity, what return can they expect to earn? 7. If Carlyle desires a 20% target return on its equity investment, does your analysis suggest that $2.3 billion is too much to pay, or can it afford to pay more in either case, by how much? 8. What is the market-required rate of return for this investment, and why might this differ from the sponsors target return? - BMA, ch. 33: Corporate Restructuring - Tuck Note on Leveraged Buyouts - Damodaran, The Anatomy of an LBO: Leverage, Control and Value Background readings: - HBS Note on the Private Equity Industry - Kaplan, Private Equity: Past, Present, and Future - Acharya, Franks, Servaes, Private Equity: Boom and Bust? - Cornelius, Langelaar, van Rossum, Big is Better: Growth and Market Structure in Global Buyouts - Wruck, Private Equity, Corporate Governance, and the Reinvention of the Market for Corporate Control - Shivdasani, Zak, The Return of the Recap: Achieving Private Equity Benefits as a Public Company 6
Guidance on Grading Think of yourself as an analyst preparing a memorandum for a senior partner, MD, or associate of a firm. A (85): For a memorandum / writeup that a senior banker/analyst would be happy to take to a client meeting as is, that completely answers the question or questions posed, contains no noticeable errors, and is nicely presented. A (80): For a writeup that covers most of the relevant question and/or has minor errors, and could be presented to a client with only minor modifications. B+ (76): May miss some relevant areas or have some minor mistakes, but these could be fixed with a brief email or short discussion. B and lower (75 and below): If a lengthier conversation would be required to correct mistakes or omissions in the writeup, and to probe what areas the analyst needed reinforcement in to improve the quality of the memorandum A+ (90 and above): If the writeup is so impressive that the senior banker would want to bring the analyst to the meeting to help explain it! 7