Trujillo Corporate Finance Fall 2010
LIntroduction: 7 points from class:
1. Nature, scope, and limitations of this course
a. Look at the syllabus, model exams, ask questions, course does not include a lot of law. Reading finance and stuff that you are radically unfamiliar with.
b. Assuming no prior knowledge, no ideas such as a utility curve.
c. An attempt to teach what a lawyer needs to know about finance and this course is intended to be a basic primer. Basic ideas about finance. No spreadsheets, but will be describing what an attorney should know.
d. A lot of theory: Accounting is the language of business, finance is the theory.
e. No Mergers and Acquisitions
f. Basic Valuation-primer about what lawyers need to know
g. Bond lawyering- lawyering a debt instrument
2. 3 tensions/themes in the materials
a. This is a course about being a business lawyer-what does a lawyer need to know about finance and economics? From a lawyer’s point of view.
b. Continua- Business people—-[business world]—–Business lawyer; a good lawyer knows how to think like a business person. Business Law—there are litigators and transactional lawyers (this is about transactional lawyers). Transactional lawyers always think about enforcement.
c. Quantitative numbers—Cruncher—-[numbers]—Recognition (understanding assumptions)
3. Introduction to the materials & problem method
a. Does not provide much interpretation or explanation—for example—what is the cap M? Have a calculator with you. Purpose of this class is to tell the story that the numbers present. Look at quantitative representation and make determinations about them.
4. On call system: forced participation
a. You get notice and get respect for your time. Divide class into groups. Group 1-will is graded based on participation. Plus-is doing extraordinary job. Minus-be unprepared and to be on call and not show up.
5. Exam
a. Look at the past exam located on ereserve
6. Quick Look through the syllabus.
7. Get volunteers
PART I: VALUATION AND LAW
A. Elements of Valuation
1. Time value of money (discounting future returns to present value).
a) Discounting and Compounding (CB 1-6, 38-45)
b) Discounting and Capital Budgeting (CB 45-47 skim)
c) The composition of Returns (47-58 skim)
Value Lecture from Class:
Value (create maintain and preserve the value)
Two ideas within value: 1) Protection of value (defend ideas, products, the company)
2) Creation of value (knowing the intersection of law and economics to generate worth)
What do business lawyers do?
1. Curt Vonngate-Mainstream type of view: “an alert lawyer will get ahead by looking to situation where large amounts of money are about to change hands in the business world” and “if the receiver of the money is stupid/ignorant they may part with half of the wealth to the lawyer.”
2. Clients view: Basically a transacting entity-“will I be able to avoid certain costs be saved from the lawyer” the lawyer will make these costs cheaper in order to cover the costs of the business enterprise.
3. Inside view: We lawyers think that we assist in the ordering of private transactions. 1) Public order-how to limit exposure to and costs of complying with state impose regulations. Examples: contract law, corporate law, bankruptcy law, securities law, tax law, employment, antitrust, environmental law, intellectual properties law, and communications law. Transaction Cost Engineer-stuff that you know and bring to the table and be a master of something technical. 2) We help order private transactions to avoid public costs in order to make more money; like a hybrid; inside the business instinct in the creation of value-General idea is we anticipate circumstances (financial, economic, and social) and provide them in the deal.
Transaction
How does the firm raise money to finance its transactions? Players in this process are 2) some financial advisor (JP Morgan)(advise financially) and 3) the law firm (provide legal advice and work with financial advisor) and 1) the firm itself (decision maker).
What is the process? What drama is played out in the raising of money?
1. Deals take two basic forms-Supplemental finance (put gas into a car) 1) basic finance-go to the bank and borrow money. Go outside the firm and bring money inside the firm [zone between where the bonds live] and structural finance (rebuild the car) an example of this is 2) mergers/takeovers and the next would be a 3) spinoff, 4) acquisitions 5) joint ventures (binding through a contract), and 6) offers.
2. Bonds-Highly structured IOU or loan. Forces the borrower to have limitations which they have to comply with. Is both supplemental and structural.
Supplemental
1) Basic Financing
FINANCE DEALS
Bond
Structural
2) Mergers 3) Spinoffs
3) Acquisitions 4) Joint Venture
4) Offerings
Concerns for Accountants-valuable stuff that is not very tangible.
Why Does Value Matter? Why-because managers make decisions based on it. Should be invest in product A or not? Spinoff a division? Make these decisions by assigning a value. Value is the basic lexicon of business. Value is tough to measure and represent in consistent and helpful ways.
Time value of money-Birthplace of finance, only 150-200 years old. Time confers a property upon money that has to measured and accounted for. In order to have a good theory of value we need a theory that takes account of prominent reality. Time has properties that are relevant. “People who don’t understand the time/value of money get rich off those that do not.” We are not talking about inflation. This is about OPPORTUNITY. Time + Dollar drives up the utility.
Understanding first generation finance-the value of a dollar appreciates over time. The value upon money that must be regulated and measured. What do we do as actors moving in commerce and realization of value.
“DISCOUNTING FUTURE RETURNS TO PRESENT VALUE”
When we talk about the time value of money or value of money we are talking about the value of money to someone. It is not a purely objective exercise. The value of money into a subjective value. Introducing into valuation the subject of introduction of subjects (levels of learning).
Management decisions are made by quantitatively comparing alternative worlds. The difference between action A and non A. What the manager will measures that cannot be compared. What is a quantitative comparison-the ideal for the manager to get predictions that are so good or transparent.
Every term on the board has weight to it in DFRPV: Discount-time value of money, opportunity costs (realization that you could always be doing something else with the money or the time capital budgeting; Part of the calculation is to give some sort of measurement or representation that you could be doing something else with the money) (Kid in the candy store-when you do x, y will evaporate)(if I get the snickers I cannot get the M & Ms). Returns-composition of returns (accounting) Buffet, the second idea here is representation (statistics), Value-gets us to risk (how do we measure this or understand this). How do we do this so that our client profits.
Valuing the Firm and its Securities:
Introduction
Many of the most interesting legal issues in the field of corporate finance in some sense require an answer to the question of how much the firm and its securities are worth.
1. Valuation and the objective of the firm:
Valuation and value maximization are of central importance to those who manage a corporation’s business and finances.
Ordinary equity investors expect management to enhance their economic welfare through stock ownership.
To the equity investor, the objective of the firm can be stated easily: it is to maximize the firm’s value to its stockholders, subject to whatever constraints may be imposed externally.
When we speak of “maximizing the value of the corporation” or “shareholder value” what is the relevant measure of the worth? Should we focus on the firm’s after-tax profits? Or should we look at earnings per share, or dividends or rate of return on equity, or growth prospects, to name a few of the better known standards?
For at least three reasons it appears that none of these measures is sufficiently comprehensive and unambiguous to serve our purpose.
1. First, when we assert that the firm should “maximize profits” there remains the question whether we mean current or future profits.
2. Once we focus on future profits we must recognize that the future is uncertain.
Taken by itself, therefore, the familiar profit-maximizing standard leaves open important questions about timing and risk.
3. Third, comes the question as to how the term “profit” is to be defined-the familiar profit-maximizing standard lacks a cle
t value NPV approach to capital budgeting, the decision entails (a) estimating the returns that can be expected to be realized from the investment over time, and (b) discounting those projected returns to present value.
NPV=Discounted sum of expected inflows minus cost
Managers wanting to maximize the value of the enterprise should accept all investment projects having a positive NPV because the effect of such acceptance is to replace cash assets with tangible, producing assets of greater worth.
2. The Internal Rate of Return Method:
There is an alternative formulation, usually referred to as the internal-rate-of-return (IRR) method of project evaluation, which also involves discounting.
The NPV and IRR methods differ in some respects. The principal difference involves the implied rate of return on invested capital.
Conflicting signals can result if the choice is between two mutually exclusive projects, one of which involves a larger investment but a small rate of return than the other, or a project whose cash flows over time vary between positive and negative.
3. The Payback Method:
Another commonly used method of project evaluation—the payback method is usually through to be inadequate because it fails to take account of timing and ignores the need to discount all expected flows.
Under the payback method, an investment is deemed acceptable if within a certain maximum period of time arbitrarily set by management the expected cash inflows produced by the investment equal the original cash outlay which the investment requires.
EXPECTED RETURNS:
The mechanics of discounting describe the formal framework of valuation theory. To fill that framework with substantive content, we need to determine (1) the quantity and duration of the stream of expected returns to be discounted and (2) the discount rate.
With respect to the determination of the amount to be discounted—vairously referred to as inflows, income, profits, earnings, returns, or yield—two general questions can be raised. First, what is (or ought to be) meant by the terms returns in the context of investment valuation? Second, is it appropriate to utilize a single-valued estimate of expected returns, or should the investor or appraiser somehow attempt to take account of the full range of possible outcomes, insofar as they can be foreseen?
Warren Buffett, The Essays of Warren Buffet: Lessons for Corporate America
Many businesses acquisitions require major purchase price accounting adjustments, as prescribed by generally accepted accounting principles (GAAP). The GAAP figures, of course, are the ones used in our consolidated financial statements. However, in Warren’s view GAAP figures are not necessarily the most useful ones for investors or managers.
Buffet contrasts the use of GAAP principles to his acquisition of Scott Fetzer. He notes that under GAAP, differences such as premiums or discounts—must be accounted for by “purchase price adjustments.” In Fetzer’s case, he paid 315 million for net assets that were carried on its books at 172.4 million. So they paid a premium of 146.2 million.
The first step in accounting for any premium paid is to adjust the carrying value of current assets to current values. In practice, this requirement usually does not affect receivables, which are routinely carried at current value, but often affects inventories. So when making the first accounting move, Buffet used 37.3 million of 142.6 to increase the carrying value of the inventory.
Assuming any premium is left after current assets are adjusted; the next step is to adjust fixed assets to current value. In our case, this adjustment also required a few accounting acrobatics relocating to deferred taxes.
