Lessons in Corporate Finance

Lessons in

Corporate

Finance

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Lessons in

Corporate

Finance

A Case Studies Approach to Financial

Tools, Financial Policies, and Valuation

Paul Asquith

Lawrence A. Weiss

Cover image: © aniaostudio/iStockphoto

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Copyright © 2016 by Paul Asquith and Lawrence A. Weiss. All rights reserved.

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ISBN 978-1-119-20741-2 (Hardcover)

ISBN 978-1-119-20743-6 (ePDF)

ISBN 978-1-119-20742-9 (ePub)

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

To those who taught me.

Paul

For Marilyn, my wife and best friend; Joshua; and Daniel; all of whom

I will love forever.

Larry

vii

Preface xiii

Acknowledgments xv

About the Authors xvii

Chapter 1

Introduction

Two Markets: Product and Capital 2

The Basics: Tools and Techniques 2

A Diagram of Corporate Finance 3

A Brief History of Modern Finance 4

Reading This Book 6

Chapter 2

Determining a Firm’s Financial Health (PIPES-A)

The Conversation with the Banker Is Like a Job Interview 7

Starting with the Product Market Strategy 9

Is PIPES Profitable? 10

Doing the Math 10

Sources and Uses of Funds 12

Ratio Analysis 16

The Cash Cycle 21

Summary 24

Chapter 3

Pro Forma Forecasts (PIPES-B)

First, Let’s Take a Closer Look at Ratio Analysis 27

Pro Forma Forecasts 29

Circular Relationships 36

Back to (Forecasting) the Future 38

Projecting Out to 2014 and 2015 39

Evaluating the Loan 41

Summary 45

Appendix 3A: Accounting Is Not Economic Reality 47

Chapter 4

The Impact of Seasonality on a Firm’s Funding (PIPES-C) 53

Monthly Pro Forma Income Statements 54

Monthly Pro Forma Balance Sheets 56

A Different Picture of the Firm 65

Contents

viii Contents

Summary 70

Appendix 4A: PIPES Monthly Pro Forma Income Statements and

Balance Sheets 2014 71

Appendix 4B: PIPES Monthly Pro Forma Income Statements and

Balance Sheets 2015 74

Chapter 5

Why Financing Matters (Massey Ferguson)

Product Market Position and Strategy 77

Political Risk and Economies of Scale in Production 78

Massey Ferguson 1971–1976 79

Sustainable Growth 81

The Period after 1976 83

Conrad Runs Away 86

The Competitors 87

Back to Massey 90

Massey’s Restructuring 92

Postscript: What Happened to Massey 96

Summary 97

Appendix 5A: Massey Ferguson Financial Statements 99

Chapter 6

An Introduction to Capital Structure Theory

Optimal Capital Structure 104

M&M and Corporate Finance 107

Taxes 112

Costs of Financial Distress 120

The Textbook View of Capital Structure 125

The Cost of Capital 127

Summary 128

Chapter 7

Capital Structure Decisions (Marriott Corporation and Gary Wilson)

Capital Structure 131

The Cost of Capital 138

How Firms Set Capital Structure in Practice 141

Corporate Financial Policies 142

Sustainable Growth and Excess Cash Flow 145

What to Do with Excess Cash? 146

Summary 148

Appendix 7A: Marriott Corporation Income Statements and

Balance Sheets 150

Appendix 7B: Marriott Corporation Selected Ratios 152

Chapter 8

Investment Decisions (Marriott Corporation and Gary Wilson)

What Is the Correct Price? 154

How Should Marriott Buy Its Shares? 154

Contents ix

The Loan Covenants 158

The Impact of the Product Market on Financial Policies 159

The Capital Market Impact and the Future 161

Summary 166

Chapter 9

Financial Policy Decisions (AT&T: Before and after the 1984 Divestiture)

Background on AT&T 172

M&M and the Practice of Corporate Finance 172

Old (Pre-1984) AT&T 174

New (Post-1984) AT&T 189

Summary 202

Appendix 9A: Development of AT&T Pro Formas 1984–1988

(Expected-Case) 203

Chapter 10

The Impact of Operating Strategy on Corporate Finance Policy (MCI)

A Brief Summary 207

A Brief History of MCI 209

Convertible Preferred Stock and Convertible Bonds 215

Interest Rates and Debt Ratios 218

Leases 219

Financing Needs of the New MCI 220

MCI’s Financing Choice 231

MCI Postscript 232

Summary 233

Appendix 10A: Development of MCI’s Pro Formas 1984–1988 235

Chapter 11

Dividend Policy (Apple Inc.)

The Theory of Dividend Policy 239

Empirical Evidence 243

Apple Inc. and the Decision on Whether to Pay Dividends 246

What Did Apple Do? 258

Summary 258

Chapter 12

A Continuation of Capital Structure Theory

The Tax Shield of Debt 262

The Costs of Financial Distress 263

Transaction Costs, Asymmetric Information, and Agency Costs 265

Asymmetric Information and Firm Financing 268

Agency Costs: Manager Behavior and Capital Structure 274

Leverage and Agency Conflicts between Equity

and Debt Holders 277

The Amount of Financing Required 281

Summary: An Integrated Approach 284

x Contents

Chapter 13

The Time Value of Money: Discounting and Net Present Values

The Time Value of Money 287

Net Present Value (NPV) 292

Payback 298

Projects with Unequal Lives 299

Perpetuities 301

Summary 302

Chapter 14

Valuation and Cash Flows (Sungreen A)

Investment Decisions 303

How to Value a Project 304

The Weighted Average Cost of Capital (WACC) 315

Terminal Values 316

Summary 318

Chapter 15

Valuation (Sungreen B)

Sungreen’s Projected Cash Flows 319

The Weighted Average Cost of Capital (WACC) 320

Twin Firms 325

The Cost of Equity 328

The Cost of Debt 330

The Final Valuation 332

Strategic Analysis 333

Summary 334

Chapter 16

Valuation Nuances

Cash Flow Nuances 337

Cost of Capital Nuances 339

Nuances on Calculating the Cost of Equity: Levering and

Unlevering Beta 344

Separating Cash Flows and Terminal Values 348

Nuances of Terminal Value Methods 349

Other Valuation Techniques: DCF Variations 355

Real Options (aka Strategic Choices) 358

Summary 360

Chapter 17

Leveraged Buyouts and Private Equity Financing (Congoleum)

Congoleum: A Short History 363

Leading Up to the LBO: What Makes a Firm a Good LBO Target? 364

Details of the Deal 367

Postscript: What Happened to LBOs? 381

Summary 382

Contents xi

Appendix 17A: Congoleum’s Pro Formas with and without the LBO 385

Appendix 17B: Highlights of the Lazard Fairness Opinion 391

Chapter 18

Mergers and Acquisitions: Strategic Issues (The Dollar Stores)

The Three Main Competitors 393

Recent History 394

Shopping a Firm/Finding a Buyer 397

Summary 400

Chapter 19

Valuing an Acquisition: Free Cash Flows to the Firm (The Dollar Stores)

The Bid for Family Dollar 401

Free Cash Flows to the Firm 403

Estimating the Cost of Capital 411

Discounted Cash Flows 415

Terminal Values 416

The Three Pieces 418

Summary 419

Appendix 19A: Family Dollar Pro Forma Financial Statements

with Authors’ Constant Debt Ratio 420

Chapter 20

Understanding Free Cash Flows (The Dollar Stores)

Comparing the Free-Cash-Flows Formulas 423

Back to Discount Rates 425

On to Free Cash Flows to Equity 427

Discounting the Free Cash Flows to Equity 430

Summary 431

Appendix 20A: Family Dollar Pro Forma Free Cash Flows to

Equity with Constant Debt Ratio 432

Chapter 21

Mergers and Acquisitions: Execution (The Dollar Stores)

The Time Line 433

Managerial Discretion 436

Activist Shareholders 438

The Federal Trade Commission (FTC) 440

Shareholder Lawsuits 441

The Vote 442

Summary 443

Appendix 21.A: Key Events in the Bidding for Family Dollar

during 2014 and 2015 444

Chapter 22

Review

Chapters 2–4: Cash Flow Management—Financial Tools 446

Chapters 5–12: Financing Decisions and Financial Policies 446

xii Contents

Chapters 13–21: Valuation 450

Tools and Concepts Discussed in This Book 453

Finance as Art, Not Science 454

Bottom Lines 454

An Intelligent Approach to Finance 455

Keeping Current 456

Larry’s Last (Really a True) Story 457

Paul’s Theory of Pies 457

Rules to Live By 458

Glossary 461

Index 469

xiii

On Tuesday, March 24, 2015, the share price of Google rose 2%, a roughly $8 bil￾lion increase in the value of the firm’s equity. Was the large increase in Google’s

equity value because the firm’s profits were up? No. Was the positive stock price

reaction due to some good news about a new Google product? No. The reaction

was due to Google’s announcement that it was hiring Ruth Porat as its new chief

financial officer (CFO). Why would the hiring of a new CFO cause Google’s stock

price to jump? According to the Wall Street Journal, Wall Street hoped the new CFO

would bring “fiscal control at a company long known for its free spending ways.”1

Lessons in Corporate Finance is about the principal decisions in corporate

finance (in other words, the decisions of CFOs like Google’s Ruth Porat). These deci￾sions focus on: how to decide in which projects the firm should invest, how to finance

those investments, and how to manage the firm’s cash flows. This is an applied book

that will use real‐world examples to introduce the financial tools needed to make

value‐enhancing business decisions.

The book is designed to explain the how and why of corporate finance. While it

is primarily aimed at finance professionals, it is also ideal for nonfinancial managers

who have to deal with financial professionals. The book provides a detailed view of

the inner functioning of corporate finance for anyone with an interest in understand￾ing finance and what financial professionals do. The book would fit well in a second

course in finance, as supplemental readings to an executive education course, or as a

self‐study book on corporate finance (e.g., those studying for the CFA or similar cer￾tifications). The authors believe that any business professional, even someone with a

degree in finance, will find the book to be a valuable review.

While the book can be read without extensive knowledge of accounting or

finance, the book is written for those with at least a basic knowledge of accounting

and finance terminology.

Preface 

1 See Rolfe Winkler, Justin Baer, and Vipal Monga, “Google Turns to Wall Street for New

Finance Chief,” Wall Street Journal, March 24, 2015, www.wsj.com/articles/google‐turns‐to‐

wall‐street‐for‐new‐finance‐chief‐1427217571 10/21/2015.