Firms and Markets

• F650 is an introductory course in corporate finance. The questions you’ll be able to

answer when we’re done are:
• What is this project/company worth? What can we do to increase that?
• How should we finance the necessary assets?

• There is some (…) math involved but you will expected to apply what you learn in
realistic situations (spreadsheets and case studies).
• Assessment involves: 7 weekly assignments (1-2 tough questions each) = 14%; 2 groups
case studies = 2x25%; final exam (individual case study) = 36%
• Don’t let your group’s strength become a crutch - be sure to develop the analytical skills
you’ll need to tackle a finance case yourself!
• There are optional weekly tutorials held to go over some of the recommended problems
from the text and TA is able to provide more support by email.
The Case Method
• The use of cases in both interviews and education is predicated on the idea that
people benefit from unpacking their thinking and methodically tackling problems.
• The real objective is to see what your thinking process is.
• The end result is less important than the journey

• Applying methodical analysis to complex problems can help structure the task at
hand, enabling a faster turnover and a more comprehensive analysis.

• One of the important aspects of the method is for people to actively discuss ideas
about approaches and to describe the logic that underlay their decision making.
• The purpose of the case approach is not to teach you the answer to a very specific question
but to develop your judgement and give you some scaffolding for how to approach future
challenges.
The Purpose of Case Studies

• Good cases have multiple challenges and considerations. Their objectives are two-fold:
1. Teach you a specific lesson (or two, or three…)
2. Teach you how to manage complexity

Managing complexity boils down to discarding irrelevant information.

• In basic education (like the homework), you get problems and the inputs necessary to
generate the correct output.
• In a case study, you face challenges which can be addressed using some (or all) of the
materials in the package provided. There is usually excess information on purpose to force
you to sort based on what you need.
• In real management, you don’t even get that. There may or may not be “supporting facts” to
work with (and those could be incomplete, or wrong).
Action Plans
• Analysis without follow up action isn’t very valuable to a client (or anyone else).
• In a case interview, your action plan details how you would tackle the problem
• Academically, it focuses on “what can go wrong” with execution
• In practice, the action plan needs costing as well as realistic goals short-term, intermediate, and
long-term objectives

• A timeline is usually important, as is a breakdown of which order steps should be

performed in (to control risk, gather more information, etc)
• You should develop metrics for success and set appropriate benchmarks
• Consider what risk factors might complicate implementation and develop a communication plan
to reduce resistance to necessary changes.
Presentation
• There are no “live” presentations in this course but I DO have expectations about
what your case write-ups will look like.

• REQUIRED: title page, table of contents, executive summary, consistent format,

lack of spelling and grammatical errors, exhibits appear in the order they are
referenced, no superfluous exhibits.

• NICE: colour, some graphs or tables embedded (less than ½ page), a narrative
flow that reads like one person wrote it

• LENGTH AND SPACING: limit to 10 pages (~4000 words) of text

Structure of the Course
• Roughly speaking, I’ve broken the course into four unequal units:
• Project Valuation: capital budgeting, risk control, working capital management
• Cost of Capital: portfolios, CAPM, risk-based pricing, WACC
• Capital Structure: corporate leverage, bankruptcy, dividend policy, raising capital
• Firm Valuation: valuation methods, mergers, corporate governance

• The first case is due at the end of May (31), the second at the end of June (26)

• The textbook will take you further than this course does – I recommend that
students focused in finance read the “uncovered” chapters when you get the
chance as they will prepare you for more advanced studies.
What You Need to Do to Succeed
1. Get your textbooks RIGHT NOW (during the break) and be sure to read it
• Its quite good IMO. Pearson MyLab might be useful but its NOT required
2. Get the case pack(s) from HBS:
1. Group cases: https://hbsp.harvard.edu/import/1054324
2. Final Exam: https://hbsp.harvard.edu/import/1054326
3. Come to class – This supplements self-study, it does not replace it.
4. Practice the end of chapter problems – They will help you build basic skills
• I recommended some but do as many as you feel you need to (solution files are posted).
• Be sure to note which topics are and aren’t covered in the course
5. Complete the weekly homework problem - Review the solutions
6. Meet with your group every week to work on the cases.
• Whether to split it up, talk about progress, assemble components, etc
Unit 1: Project Evaluation

• Over the next two weeks we will be focused on understanding the mechanics of
capital budgeting (aka, which projects should you invest in). This involves:
• Learning about the tools used to assess them when resources are limited (today)
• Identifying relevant cash flows and modelling decision points (Wednesday)
• Building cash budgets and learning to manage short-term resources (next Monday)
• Understanding the risks a project faces and how to control them (next Wednesday)

• The primary tool used for valuing large scale projects is the same as used for
valuing whole companies. You will need to learn how to use the basic kit first so
that you can apply it later to help diagnose and remedy firm level challenges.
What Makes a Good Decision Criteria?
• In order to ensure we are creating value when we allocate resources to a project,
we need a set of tools to help us vet competing proposals.

• When selecting a decision criteria, we have to ask ourselves the following:

• Does the decision rule adjust for the time value of money?
• Does the decision rule adjust for risk?
• Does the decision rule provide information on whether we are creating value for the firm?
Net Present Value
• NPV = the sum of the present value of benefits minus the present value of
costs (or equivalently, the formula below)

• If benefits > cost, NPV will be positive and the project is acceptable (it creates
value-for-risk in excess of the cost)

• If benefits < cost, NPV will be negative and the project is unacceptable because it
destroys the investors wealth.
Net Present Value

• A firm plans to invest $100,000 immediately into a project it expects will yield
cash flows of $22,000 per year for the next 7 years.
• If the company requires a 10% rate of return on this investment, is this project worth it?

• NPV = -$100,000 + PVannuity (CF = $22,000; n=7; k=10%)

• NPV = -$100,000 + ($22,000)*(1 – (1.1)-7)/.1
• NPV = -$100,000 + $107,105
• NPV = $7,105 (do it!)
Net Present Value
• NPV is an absolute measure (expressed in present, risk-adjusted dollars) of the net
incremental benefits the project is forecast to bring to the shareholders.

• In a perfectly efficient market, the total value of the firm should rise by the value
of the NPV if the project is undertaken as investors get the necessary information
to make such forecasts.
Decision Criteria Test - NPV
• Does the NPV rule account for the time value of money? Yes
• Does the NPV rule account for the risk of the cash flows? Yes
• Does the NPV rule provide an indication about the increase in value? Yes

• We will use the NPV rule for our primary decision criteria.
• Be cautious about ascribing high precision to NPV estimates that rely on distant or
uncertain outcomes however.
• Other tools may act as a supplement or second-pass tool when NPVs of mutually exclusive
projects are very close, but NPV will be our workhorse.
Payback Methods
• This is a simple approach to capital budgeting that is designed to tell you how long
it will take to recover the initial investment.

• The basic payback approach ignores risk however, and the basic time value of
money arising from inflation (covered by the discounted payback approach).

• Payback methods (discounted or not) also ignores cash flows after the payback
period, as well as relying on an ad hoc decision criterion.

• The decision rule about how long a project should take to recover its initial cost is
a completely arbitrary choice (which is a problem).
Simple Payback Example
Discounted Payback Example
Profitability Index
• The Profitability Index is traditionally defined as the ratio of the present value of
benefits to costs. PI = PV(in) / PV(out)
• Decisions are simple - we accept projects with a PI over 1.
• The text introduces an alternative definition which we examine shortly (after the break).

• Consider 2 projects with the same NPV ($10)

• One costs $1000 and produces $1010, the other costs $10 and produces $20.
• Use of the profitability index helps to identify which is more valuable per dollar invested.

• This tool is a useful supplement to NPV but its output is intellectually “clumsy”.
• It also doesn’t provide a measure of the amount of value created, only an estimate of the
“rate” at which investment is transformed into outflow (on a present value basis).
Internal Rate of Return
• Finally there is a project’s “internal rate of return”. It is a popular metric in certain
industries (real estate) but it has important weaknesses you should know about.
• Mathematically, it is the discount rate that makes the NPV to equal zero.
• If IRR > the require rate of return (cost of capital) then the project is acceptable.
Decision Criteria Test - IRR
• Does the IRR rule account for the time value of money? Yes
• Does the IRR rule account for the risk of the cash flows? Yes
• Does the IRR rule provide an indication about the increase in value? Yes, but not
how MUCH value.

• Even though IRR is very intuitive as it can provide a simple check against the cost
of capital, we use the NPV rule as our primary decision criteria because there are
no “special cases” where it doesn’t behave (unlike IRR)
• We examine some of the problems with IRR next
IRR and Non-Conventional Cash Flows
• When the cash flows change sign more than once, there is more than one IRR

• When you solve for the IRR, you are solving for the root of an equation. When
you cross the x-axis more than once, there will be more than one return that solves
the equation

• If you have more than one IRR, which one do you use to make your decision?
Non-conventional Cash Flows
• An investment costs $90,000 initially and will generate the following cash flows:
• Year 0: -$90,000 (initial cost)
• Year 1: $132,000
• Year 2: $100,000
• Year 3: -$150,000

• The required return is 15%.

• Should we accept or reject the project?

Problems with the IRR Rule
• Consider projects with the following cash flows:

• Which of these projects have an IRR close to 20%? For which of these projects is
the normal IRR rule valid?
Only Project A (has “conventional” project cash flows)
Other IRR Challenges - Mutually Exclusive Projects
• When two projects are being evaluated on a 13 - 2
FIGURE
“one or the other” basis, a conflict can When such a conflict arises,
emerge between IRR and NPV decision NPV select the project with the
rules. ($) highest NPV given the
• This mostly happens when projects have major 700 appropriate discount rate.
differences in the timing of their cash flows.
500

• To illustrate the problem, consider the NPV

profile of two mutually exclusive projects.
12 15 Discount Rate
• A has “soon dated” cash flows that would resist B A (k) (%)
revaluation as the discount rate increased
• B has with “late dated” cash flows whose value
would erode more quickly under a higher
discount rate.
Other IRR Challenges – Reinvestment, Size, and Risk
• One of the key differences is the assumed reinvestment rate.
• By using the IRR as a discount rate, we assume that cash flows from the project are being
reinvested at the IRR rate, an assumption that needs to be carefully considered.
• By comparison, NPV conservatively assumes they are reinvested at the cost of capital.

• If a project’s size is doubled, its NPV will double. This is not the case with IRR
because IRR measure average return of the investment. Thus, the IRR rule cannot
be used to compare projects of different scales.

• Similarly, the IRR that is attractive for a safe project need not be attractive for a
much riskier project.
Capital Budgeting with Limited Resources
• Under certain circumstances, a firm may limit the amount of capital available for
new investment.

• On the surface this seems economically illogical.

• Why wouldn’t anyone invest in a project that with a greater return than the cost of capital?
• In the long-run, such choices could threaten a firm’s continued existence through the
erosion of its competitive position.

• In practice, there may be a good reason for this:

• The firm may have owners who do not want to raise additional equity fearing it would
dilute their control over the company.
• The firm may have so many great investment projects that they exceed the company’s short-
term managerial capacity to take advantage of them.
Keep Maximizing Value (NPV)
• The best procedure for rationing capital, is to select the combination of projects
that fits under the constraint but provides the highest total NPV.
• Evaluate the NPV of each project and recombine them until you maximize the amount of
time and risk-adjusted value you can create with your resource budget.

• In some cases, the resource constraint isn’t financial capital however.

• If you only have 100,000 square feet to allocate, which projects should it choose?
Project NPV Square feet needed
Project 1 100,000 40,000
Project 2 88,000 30,000
Project 3 80,000 38,000
Project 4 50,000 24,000
Project 5 12,000 1,000
Total 330,000 133,000
Capital Budgeting – Brute Force Approach
• A brute force approach would consider the requirements of every possible
combination, filter out those costing requiring more than 100,000 sq ft, and then
selecting the one which generates the greatest total NPV.
• In this case, projects 1, 2, 4, and 5 use 95,000 square feet and generate $250,000 in NPV.

• While this type of brute force approach (try all the combinations) gets the job
done, its not particularly elegant.
• Also, the number of combinations you have to compare increases wildly as the number of
portfolio choices increase.
Capital Budgeting – Another take on Profitability Index
• Another way to approach budgeting of non-financial capital is to re-visit the
profitability index discussed earlier, but to re-define it as the ratio of value created
per unit of resource invested.

• For instance, ranking these three projects below based on PI rather than NPV helps
to identify the basket of projects which produces the greatest total value.
Profitability Index With a Human Resource Constraint
• Your division has put together a project proposal to develop a new home
networking router. The expected NPV of the project is $17.7 million, but will
require 50 software engineers.
• The firm has a total of 190 engineers available, and the router project must compete with
these other projects for these engineers. Will it make the cut?
Profitability Index With a Human Resource Constraint
Shortcomings of Sorting by Profitability Index
• You should still carefully review the results of sorting projects by a single
resource constraints.
• It also doesn’t work with multiple resource constraints.

• Suppose in the last example we had an additional small project with a NPV of
only $100,000 that required 3 engineers.
• The profitability index in this case is 0.1/3 = 0.03, so this project would appear at the
bottom of the ranking.
• However, 3 of the 190 employees are not being used after the first four projects are
selected so it would make sense to take on this project as well.
CFO Preferences (2020)
• The survey asked CFOs to “check all that apply”. Given a sample of 39 firms, you
will note every CFO who responded indicated they used at least 2 (as many as 6!)
different tools for assessing the merits of a project.
• https://www.emerald.com/insight/content/doi/10.1108/PRR-10-2020-0035/full/pdf