Questions, Comments MBA 673: Fall 2013 Prof. PV Viswanath Questions from Nov. 5 How about for non-oligopolistic industries? I presume youre asking if we need to worry about competitive strategy in nonoligopolistic industries. The answer is that it is much less important in such industries. By this I mean that you dont have to worry about how other firms are going to react to what you do; of course, you still have to take correct decisions. Considering that towards the end of class, you said that advertising is short-term, would a more levered firm increase advertising or aim for lower levels of advertising? I cant tell you for sure that _all_ advertising has only short-run effects. What I said was that that article, The Journal of Industrial Economics, Vol. 42, No. 3 (Sep., 1994), pp. 263-276 by Elisabeth M. Landes and Andrew M. Rosenfield said that empirically advertising effects seemed to be short-lived. The Grullon et al. article suggested that the reason for their finding that levered firms had less advertising was that advertising was long-lived and levered firms would not be able to benefit from long-lived assets. If Landes and Rosenfield are
right, then the Grullon et al. reasoning is wrong. But, either way, Grullon et al. did find that levered firms had less advertising. Questions from Nov. 5 What is the effect of advertising on debt? How does the debt level affect a firms hiring? In class, we spoke mainly about the effect of debt on advertising. As far as the reverse effect is concerned, firms that have more advertising assets, tend to finance them with equity rather than debt because advertising assets lose a lot of their value in bankruptcy. I would think that firms that are over-leveraged would have more difficulty hiring good people because employees would not want to end up in firms that go belly-up and lose their human capital. How to make a Nash equilibrium model to make more aggressive decisions in financial aspect?
Please ask again more clearly, next time, or email me directly. Questions from Nov. 5 The optimal capital structure is that with the lowest WACC, but you told us that higher debt could increase the value of a firm. So whats the best proportion of debt to total assets? The statement that the best capital structure is the one with the lowest WACC is still true. If there are advantages to debt (or equity) that will be reflected in the expected cost of debt (or equity). When we compute weighted-average-cost-of-capital, we need to use not the promised return on debt, or the dividend rate but the expected cost of debt and the expected cost of equity (where expected is the same as average). On slide 10, it says: the greater a firms leverage, the greater its incentive to produce at a higher level of output. This goes contrary to our earlier conclusion that firms with higher leverage would reduce product quality to get more short-term profit. First of all, you can have several things occurring simultaneously. Here we are not talking about the net effect, just the separate effect of different factors. In the case of your issue, though, reducing product quality says nothing about product quantity any way..
Questions from Nov. 5 Whats the difference between game theory and Nash equilibrium? Game theory is a branch of science, where you examine what happens when there are several agents and the agents react to each others actions. In order to come to any conclusions regarding the likely outcome of such strategic behavior, you have to make assumptions. In this case, we assume that each player knows the equilibrium strategies of the other players; a Nash equilibrium refers to the outcome of a game where no player has an incentive to unilaterally deviate from his or her chosen strategy. How can firms maintain a competitive advantage in the long run? And keep barriers to entry in the long run? Not easy! A firm has to be constantly better and constantly trying to improve, assuming that it cannot collude or act illegally. This is why capitalism is often said to lead to the best outcomes. But, of course, capitalism doesnt mean no collusion, or illegality or inequality Questions from Oct. 22
Why is a leveraged firm less likely to liquidate? Equity holders of a levered firm are like holders of a call option; just as holders of a call option can buy the underlying stock for the fixed exercise price, independent of the value of the stock, similarly, equityholders can get rights to the cashflows of the entire firm simply by paying off the face value of the debt. Hence equity is like a call option written on the assets of the firm with the face value of debt as the strike price. | And just as the value of a call option is increasing in the uncertainty of the underlying stock price, similarly, the value of the levered equity is increasing in the volatility of the rate of return on the assets of the firm. When volatility increases, the downside potential increases, but since equity holders can simply walk away from the firm due to limited liability; hence its only the upside potential that matters. I still dont understand why leveraged firms are less risky to liquidate. Leveraged firms are less likely to liquidate, all other things being the same; not less risky. Questions from Oct. 22 A firm with less debt may be willing to maintain high employment,
but it still may not be able to hire more people. Maybe the HR strategy has more to do with company style; for example, if its a government company , it wont lay off employees, right? We still havent seen the effect of leverage on advertising. Of course, HR strategy depends on many things, including company style and culture; here we are focusing on leverage and HR policy. Go to http:// webpage.pace.edu/pviswanath/class/mba673/notes/capstruc_competitiven ess.html#adv for a note on leverage and advertising. If we can have more real world examples to prove the knowledge we learn, it will be more interesting. I will try; however, I do give you citations of papers that have looked at data from firms to validate their hypotheses. Questions from Oct. 15
We know that the covenants are there to prevent debtholders rights. Are there any cases where covenants dont work for debtbholders? How do firms determine what is the right amount of debt to keep in order to finance future projects? Debtholders can put in whatever covenants they want, as long as the firm agrees to those covenants. Of course, if there are a lot of covenants, the firm might demand a lower interest rate. However, if the debtholders ask for a certain covenant, presumably thats good from them. Debtholders could make a mistake, of course. They might think ex ante that a covenant preventing the issue of debt with equal seniority is good and then realize that it keeps the firm from making new investments. Firms need to make forecasts of future capex needs and the state of the market at that future time. This needs to be considered in the context of lost investment opportunities today, since the money is being kept idle or, at the most, invested in short-term assets. In the myopia problem or the debt-overhang problem, when the firm issues new junior debt, the lender asks for higher interest rates. Is this true in the real world? Yes, junior debt is paid after other senior claimants are paid. Hence there are more
states of the world where junior debt will be paid in full or in part. As a result, junior debtdholders ask for a higher interest rate so that in good states they will get enough to compensate them for losses in bad states. Questions from Oct. 15 How could a firm solve the credit rationing problem? We saw how it might resolve the debt overhang problem, but what about the credit rationing problem? If there is some way that the firm could credibly commit to choosing the less risky projects, then the credit rationing problem could be avoided. However, this could be expensive in terms of auditor monitoring or providing informational access potentially to competitors. When interest rates rise, are firms more willing to take risky investments? Firms may not want to dispossess bondholders in order to destroy their reputation in the bond market. For example, Argentina is having much more difficulty attracting bondholders after its bond default. But, yes, the attractiveness of bondholder dispossession goes up when interest rates go up. Intuitively, if you have to pay somebody a high price for the use of his money, you would want to make sure you have a good chance at really high asset returns to make up for the high cost of the money. And, since you wont get anything in bad states, you want
to make up for it in good states. But generally, if you want very good asset returns in good states, you will also have to take very low returns in bad states, i.e. very volatile returns. Questions from Oct. 15 It seems like a lot of this simply depends on having the right profit margins from potential projects and interest rates. Some of the interest rates used dont seem realistic, where bondholders arent even getting a full expected rate of return using risk-free interest rates. As I explained several weeks ago, the conclusions dont depend on the specific numbers. The numerical examples are simply to give you a better feel for whats happening and to show that the claimed outcomes could occur. Whats important is the intuition and if that makes sense. And, if it does, then the examples could be replicated with different interest rates etc. In our examples, risk attitudes are completely irrelevant, thats why we use risk-free rates. If you had a valid objection to the intuition behind a particular example, where your objection was of the form but if the bondholders were risk-averse, then this situation would not occur, then there would be a problem. But, as it is, if you wanted to make the examples more realistic, they would become more complex, but not necessarily more convincing. What we are trying with our examples is simply to show the possibility of certain situations and outcomes e.g. if the firm is levered, its going to take more risky projects; if the firm is levered, its going to reject some otherwise desirable projects etc.
There is empirical evidence for most of these phenomena, as well. For example, when savings and loans were deregulated in the 1980s, they took on a lot of risky projects banks/savings and loans, of course, are by definition highly levered. Questions from Oct. 15 How can we use what we learned in class today (credit rationing, debt overhang) to analyze the real world problems? For one thing, we can understand why firms would keep idle cash on hand. For another, we can understand why bondholders in certain situations might insert covenants in bond indentures, and not in others. We can also understand why firms might use more expensive bank credit instead of issuing public debt its a lot easier to renegotiate terms with a bank: there is only one party to deal with, and one doesnt have to make a lot of information private.
If youre evaluating a bond issue, as an investor, you know what to be on the lookout for, to see if the promised interest rate makes sense and compensates you for possible negative outcomes. And well see other implications in the next set of slides. Is the percentage of the two projects (risky and not so risky) always 80% and not 20%? Not sure what the question is; can you repeat your question with more information? Seems like a question about the facts on a slide just ask it directly in class! Questions from Oct. 8 Just for stating my point. Maybe existing debtholders only focus on cashflow, not investment. So they want debt issuers to issue new debt to pay them back. How to make decisions on long-term and short-term investments.
There is only one rule NPV. If capital markets are relatively efficient, there is no need to consider separate decision rules for long-term and short-term investments. Are covenants always respected? What if they are not? What if new debt is raised anyway? Apparently, this is a further comment to my answer to a question from last class. I am not sure what this comment means. But I think its not productive to conduct a conversation in this manner. One question, yes; but if you have comments on my answer to your question, its probably better to do this face-to-face (but it doesnt have to be in class make an appointment to see me in my office). Covenants are part of the contract; so if a covenant is not respected, thats a contract violation and the bondholder can take the firm to court. How does the negative pledge clause work? A negative pledge clause is a provision in a bond contract that prevents the borrower from raising any new debt that might reduce the security of the current lender. For example, issuing debt that is senior to the current debt. Questions from October 8
Equityholders dont make decisions; managers do. Would they still invest in risky projects, when there is a chance of losing their job? Youre absolutely right. This is what is known as the agency problem between managers and shareholders. In order to ensure that managers act in the shareholders best interests, they are often given stock options. As we saw on Oct. 8, the value of options are increasing in the volatility of the underlying asset. So this makes the manager want to take greater risk. However, it must be acknowledged that this could lead to criminal activities on the part of the manager, as well, as might have happened in the Enron case. Is there any case where the managers interests are aligned with the bondholders interests? Yes, we have already seen that increasing risk is beneficial to the equityholders; decreasing risk, to the bondholders. And since managers have a lot invested in the firm (in terms of their human capital), they tend to not take as much risk as the shareholders would like them to.. Questions from Oct. 8 When thinking of debt, should equityholders take the interest rate into consideration?
More about options and futures would be interesting. Yes, of course. In our examples, I have assumed that the interest rate is determined by competition in the marketplace. There is more to say about this, but these issues are discussed in more detail in FIN 652. Unfortunately, we dont have time to discuss this in our class. No doubt! But thats another course! Is myopia always bad for business? Picking a short-term project when a long-term project has greater value is, of course, bad. However, if the short-term project has greater value, then it should be chosen. Normally, the word myopia would not be used in such a context. So myopia doesnt just mean picking a short-term project; it means picking a short-term project when it is suboptimal. Questions from Oct. 8 On slide twelve, how did you compute the value of the new debt? Why do you use the computation (1700/2700)(2500) and (1700/2700)(800)?
Are you saying that bondholders have the advantage in the short-term and equity holders have the advantage in the long-term , but equity holders are greedy and mess things up by desiring profits in the short term as well? This is a case, where it would have been much better for you to ask the question in class! I hope I am not so threatening that you feel you cant ask me such questions! The answer to this question is that since the new debt has equal seniority with the existing debt, they will both be paid pro-rata. No! I assume that all economic actors are interested in maximizing their own well-being both equity holders and bondholders. However equity holders have decision-making power in the firm, while bondholders can only choose whether or not to buy bonds, and once they have bought the bonds, they dont have much input into the firms decisions. In general, since we assume relatively efficient capital markets, there is no conflict between long-term objectives and short-term objectives for individuals (be they bondholders, managers or shareholders). I did not understand the debt and equity portion of class. Oops! What didnt you understand? Please be more specific.
Comments from October 8 I cant read your handwriting. The class went by sooner than usual, for some reason. That is amazing! I thought some of you might have been bored! Can you go slower with examples? I think the problem might be that I use cursive, because today I tried hard to write clearly. Please ask me to read out from the blackboard, if you cant read anything. I tried to go as slow as necessary. If you need more clarification, you should ask me in class to explain again. It would be pointless for me to explain things over and over again without knowing if it was helping anybody! But if I am requested to do so, I have no objection to going slower, explaining something over again etc. I liked the Commons example you gave in class, it really helped us to see the
relationship of the class material to real life examples. There is actually a lot of history behind this; for more information, go to http://en.wikipedia.org/wiki/Enclosure Questions from Oct. 1 I am still vague about what we use alternate decomposition for I am looking to find out what happens in case of bankruptcy/liquidation. Alternate decomposition is used for exactly the same sorts of things as standard Dupont decomposition. The only difference is that it is more precise, since we are not mixing up financial assets/liabilities with operating assets/liabilities and financing income/expenses with operating income/expenses. Essentially, the firm is sold intact or its assets are sold to pay off bondholders. Alternatively, the firms debt is exchanged for stock and the previous stock (generally) declared worthless. But who gets how much thats usually the difficult stuff. (Take a look at http://en.wikipedia.org/wiki/Chapter_11,_Title_11,_ United_States_Code.)
There is an optimal capital structure for a firm. Is there one for an industry? Well, industries dont make decisions, firms (or firm managers) do. But the optimal capital structure of a firm depends often on the nature of its assets and firms in a given industry are often similar in terms of the nature of their assets. So in this sense, yes, there is an optimal capital structure for an industry. Which is why you see variations across industries in terms of average debt ratio. Questions from Oct. 1 How do you calculate borrowing interest taking bankruptcy into consideration? Should we always choose the project with the higher equity value? Should we not be considering cashflows, time values etc? I dont know what this question means. Care to explain? Yes, indeed. If capital markets are perfect and its possible to move cashflows easily over time and place, then market value summarizes the present value of all
cashflows. This is the implicit assumption that we are making most of the time in class. To the extent this is not true, capital structure would probably be even more important and have much more of an impact on other decisions. How do firms assess the value of overlooking equity holders myopia and mitigate risk without the benefit of equity dealings? Not sure what the question is. Please explain. Do you mean how do firms decide whether or not to obtain outside equity considering the fact that this might lead firms to be myopic? If so, then the answer is that they should look at market value if the firm used internally generated capital versus externally generated capital. They should go with whichever generates higher market value. Questions from Oct. 1 In the short-sighted problem, debt holders want to be paid off as soon as possible, but equity holders would also like to choose short-term projects. So is there really a conflict? Think of the prisoners dilemma. (See http:// webpage.pace.edu/pviswanath/research/papers/environment.pdf, e.g p. 3). The conflict here is not between the two parties; rather its between what they would have wanted in the best of all possible worlds versus where theyre stuck now. Heres another example. Lets say youre trying to diet. You have to decide whether to invite your friend over to watch TV with you. You really like the guy, but you know that hes going to bring candy over he does that every time. And if the candys
there in front of you, you are going to eat it! One might say whats the problem? If the guy eats it, clearly s/he wanted it, so theres no conflict. The guy wanted candy and the other guy who brought it over is happy because his gift was appreciated. So everybody is happy! But is everybody happy? No! Everybody would have been happy if the guest had _not_ brought the candy over. Its the same here. There is no conflict, but the ending is not what everybody desired. If the equity holders had chosen the long-term project, firm value would have been higher and there would have been more to share between bondholders and shareholders. You may ask if so, then why dont shareholders choose the long-term project? Thats what I asked you to think about and what we will discuss today. Questions from Oct. 1 How would the view of each side change when presented with more than two options for investing and more than two possible states? You talked about two different ways of doing Dupont analysis the standard one and the alternative one. In a real company case, which technique is better? We use an example with two options and two possible states for convenience. We could make the situation more complex, but we would have similar results. Of course, in some cases making the situation more complex could change the result, but in this case, our
results match our intuition. Do you have any intuition that the outcome/inference would be different with more than two options? Or more than two states? We answered this question, last week. Take a look and if you still dont understand, send me an email. If google said they did not want to do an IPO considering their long-term goals, why did they then go public at that time? They might have needed funding or more likely, they wanted to allow current shareholders (who were employees and managers) a way of selling some of their stock and keeping a more diversified portfolio. Questions from Oct. 1 Why cant we buy low and sell high when we have an efficient markets? Market efficiency means that the price at any point in time is correct given the information available at that time. Buying low and selling high means buying when the price is lower than it should be and then selling later when the price corrects and reflects the information, at which time it will be higher. But if the security is never overvalued or undervalued, this is not possible. When we think of investments, we talk of portfolios. When we borrow
money, do we also have to consider a portfolio? Is it better to borrow from different lenders or from a single lender? Borrow money can be considered as a negative investment in an asset/security. And, as such, it can be included in a portfolio analysis. Hence, just as it might be useful to consider the correlation between returns on different assets from a portfolio analysis standpoint, similarly, it might be useful to look at the return (i.e. rate of interest) on borrowings (negative assets) with other holdings. If the rate of interest is a floating rate, this could increase or decrease the volatility of the total portfolio. Comments from October 1 Your handwriting is not easy to read. I will try to be clearer. Keep in mind that I usually say aloud what I am writing that should be helpful as well, in deciphering my writing. The class today was great. Now that sort of comment is easy on the ears! Questions from Sept. 24
How Dupont Decomposition can be used to analyze companies How to choose between traditional decomposition and the alternate decomposition when doing Dupont Analysis As we discussed in class. I will put up a couple of the group projects that have done a good job on Blackboard (if they agree). Always use the alternate decomposition, if you have the data available. Since higher financial leverage gives higher ROE, does this mean that the more debt, the better? No, because assets with certain kinds of cashflows are best suited to be financed by debt. For example, assets with relatively stable cashflows, assets that are liquid, assets that are tangible, assets whose uses are relatively clear and stable/fixed. Investors know that one, borrowers are unlikely to suddenly use the assets for risky purposes; two, if borrowers dont pay up, they can seize the assets, sell them and pay themselves off. If companies choose to use debt financing for, say, non-marketable assets like human capital, interest rates will be profitably high. Recall what we saw in
the alternate decomposition, ROE = Operating ROA + Spread x Net Fin Leverage. If Spread is low or negative, its not going to enhance ROE! Questions from Sept. 24 How to use ROE for financial decisions Moving from high ROA to even higher ROE is a question of optimal capital structure. We will talk about that in class, soon. What is all this useful for? I dont see the real world application We have seen how the firms strategy can be inferred from the Dupont decomposition. Similarly, you can do it in reverse. That is, you can look at your current Asset Turnover Ratio and Profit margin and compare them to where you were in prior years; you can also compare your performance to competitors. You can see where you stand with respect to them. If youre in the wrong quadrant, you will see it clearly; you can then take action. Now exactly what action to take, we havent spent much time on. Should a firm go the differentiation route or the cost minimization route? One approach to this is given by the Resource-based view of the firm (see http://en.wikipedia.org/wiki/Resource-based_view and http:// www.istheory.yorku.ca/rbv.htm). Dupont Analysis primarily allows you to diagnose the problem and can, to some extent, help with the solution.
Questions from Sept. 24 Benchmarking Could you provide a numerical example of Dupont Analysis? Yes, we will go over one today. (Its online at http:// webpage.pace.edu/pviswanath/class/mba673/notes/dupont_analysis.html) I would have liked comments on the presentation today to help me with the writeup. Didnt follow what the question is.. I tried to provide comments. I will try harder. In the Dupont Identity, Sales gets canceled out! So whats the significance of increasing sales in Dupont analysis?
Ultimately, it doesnt matter. Its just Profit and how much you invest in assets to generate those profits (leaving capital structure aside for now). However the Dupont identity suggests how to generate those profits. The two elements of the Dupont decomposition to a certain degree break down into operational strategies (when we focus on asset turnover) versus marketing strategies (when we focus on profit margin). Looked at in that manner, the Dupont analysis suggests a certain decentralization which a firm can implement to achieve its objective of high ROA. Suggestions from Sept. 24 Can you present the slides at the beginning of class when we are most alert? I need to go over the material pertaining to the previous class first; then I can move to the new material. Let me see what I can do to keep you most alert. You are assigning a lot of group work in a short time! I think, particularly in this course, group work is rewarding. I will try to continue to keep some time free during class for group work. Questions from Sept. 17
How to define your brand with a volume focus This is an interesting question. In a certain sense, its a self-contradictory proposition, since according to the standard Dupont analysis, you either cultivate a brand focus or a low-cost, volume focus. However, I have put an article called Profit Leveraging on Blackboard. Read this article; we will discuss this in class on September 24 and it will figure on the midterm, as well. When a company decides to manipulate and play around with its financial data to tell a more successful story, how can investors detect this? This is a difficult question. There is an entire field called forensic accounting that deals with this. (See http:// en.wikipedia.org/wiki/Forensic_accountant) The accounting department has an undergraduate course ACC 366 - Forensic Accounting that deals with such questions. Essentially what needs to be done is to locate inconsistencies in the companys accounting story.
Questions from Sept. 17 Implications of marketing strategies that are reflected in financial statements how do we pick them up? Dupont Analysis can be used for this. Thus, a firm that has a higher assetturnover than the industry average and a lower profit margin is adopting a low-cost high volume strategy. You may also want to look at http:// webpage.pace.edu/pviswanath/class/mba673/notes/dupont_analysis.html, as well as the slides of Dupont Analysis Application at http:// webpage.pace.edu/pviswanath/class/mba673/notes/dupont_analysis_appli cation.pptx . However, we are also trying to use Dupont Analysis as a guide to better marketing decisions. Different market strategy reflect different in the real market. ??? Not sure what this means.. Questions from Sept. 17
This does not seem like a financial decision to me. Youre absolutely right. The course has two kinds of topics. This first topic that deals with applying financial theory/models to operating decisions. In this case, were using Dupont analysis which financial analysts/accountants employ to throw light on marketing decisions. Another example that I have on the syllabus, but which I dont think I will have time to do is the use of option theory (also developed by financial economists to price option securities) to throw light on operating decisions (called real option theory). The second part of the course deals with the implications of financial decisions (in our case financial leverage and hedging) on operating decisions. Give us more examples of how financial decisions affect a firms operating activities. We will looking at this for the rest of the term; you can go ahead and look at the slides on Capital Structure and on Hedging at http://webpage.pace.edu/pviswanath/class/mba673/classnotes.html What is the most accurate way to conduct an accurate Dupont Analysis?
Dupont Analysis simply makes use of an identity that is developed to provide a model. It can be used for various things to throw light on a firms current marketing strategy, to forecast a future marketing strategy, to plan a firms marketing strategy. Depending on what its to be used for, you would use historical data or forecasted data; youd compare it with other firms, or look at the decomposition over time. Questions from Sept. 17 How can such models be sustained in the long run? Market research how does this play out in the market? Dont understand this question. If you mean, how can a firm maintain a high profit-margin branding strategy, then the answer is that its not easy; the firm has to keep an eye on competitors, be forever vigilant and forever innovative. Not sure what this means.. However, one way to bring in market research is to throw light on price elasticities and demand conditions to see how best to exploit Dupont Model regularities. How does the company maintain a balance between profit margin and asset turnover?
The balance is different for different firms. It depends on the firms resources in terms of human capital and organizational resources, corporate culture etc. Questions from Sept. 17 The exact nature of a companys asset allocation strategy I dont understand the question. Asset allocation in the context of a nonfinancial firm could refer to how the firms financial resources are deployed to purchase different productive assets though the term is rarely used in this sense. How do we use financial leverage in the Dupont formula? Financial leverage simply allows us to convert the ROA formula into an ROE formula. Branding creates intangible assets, which cannot usually be financed by equity, hence a branding approach would, ceteris paribus lead to a lower ROE because of lower financial leverage. Furthermore, branding probably is a riskier strategy. On the other hand, a volume strategy probably attracts lots of competition because its easier to copy and replicate. Questions from Sept. 17
Based on the principle of financial decisions, how to establish a new firm and bring it into the industry successfully? How does the financial industry work? This seems like an extremely broad question and I am not sure it has anything to do with the principle of financial decisions. I am not aware exactly what you mean by this principle. But perhaps I have misunderstood you. Whoops! Wrong class! Unless youre talking about the application of the Dupont formula to financial firms. In that case, the Dupont analysis would apply similarly; we can talk about branding and creating value in the provision of financial services, just as we can create value in the selling of shoes (for example). What is expected next class? This is the sort of question thats better asked directly in class. I didnt catch it until I started looking at your questionnaire on Monday! Hopefully you have talked to the other people in your class and you have figured out the answer!
Suggestions from Sept. 17 Can you have the break in the middle of class? Please give specific examples when explaining things. I will try to do that. Again, I try to do that. Two exceptions one, when I present concepts first and then develop examples; and two, when I forget to do that. The solution in both cases is to ask me in class to provide concrete examples. If I dont give examples, its not because I dont want to. Can you speak more loudly? I will try. Usually I speak loudly, but there could be exceptions.