Applied Finance – Course Outline & Project Guidelines

Applied Finance
Grading System
The final marks would be divided into following 3 parts;
1. Project – 30
2. Exam – 70
Group Formulation
 There will be 4 to 7 individual members in a group.
 Every members of the group will have to take one company each.
 Once the group is formed, it can not be changed in future, so make sure you are in a right team
and with right people.
 There will be a group co-coordinator in every class.
 You can submit your group member’s name to your respective class coordinators as per schedule.

Course Outline and Project Description

I. Stockholder Analysis

II. Risk and Return

III. Measuring Investment Returns

IV. Capital Structure Choices

V. Optimal Capital Structure

VI. Mechanics of Moving to the Optimal

VII. Dividend Policy

VIII. A Framework for Analyzing Dividends

IX. Valuation

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Applied Finance – Course Outline & Project Guidelines

Material Submission

Project Time Frame

End of Class You should be done with
2 Picked the firms for the project; Get data;
3 Stockholder Analysis
4 Risk and Return
6 Measuring Investment Returns
8 Capital structure Choices
9 Optimal Capital Structure
10 Mechanics of Moving to the Optimal
11 Dividend Policy
12 Valuations

Project Due Submission on Last day of the session.

General Information
Contact Details

E-Mail - alok.kuma@gmail.com

Readings

 A. Damodaran’s website. - http://pages.stern.nyu.edu/~adamodar/

 Applied Corporate Finance – A user’s Manual by A. Damodaran

 Principle of Corporate Finance by Brealey and Myers

 Financial Management Policy by Van Horne

 Intermediate Financial Management by Brigham and Gapenski

Anyone other books or website you feel should be included in our reading list, you are
most welcome.

Corporate Finance Project: A Help Manual

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Applied Finance – Course Outline & Project Guidelines

These are a few of the questions that you might find useful in doing the
project analysis
I. Corporate Governance Analysis

• To understand the relationship between managers and stockholders, try answering the following
questions:

1. The Chief Executive Officer

o Who is the CEO of the company? How long has he or she been CEO?
o If it is a family run company, is the CEO part of the family? If not, what career path did the
CEO take to get to the top? (Did he come from within the organization or from outside?)
o How much did the CEO make last year? What form did the compensation take? (Break down
by salary, bonus and option components)
o How much stock and options in the company does the CEO own?
2. The Board of Directors
o Who is on the board of directors of the company? How long have they served as directors?
o How many of the directors are insider directors? (i.e. employees or managers of the company)
o How many of the directors have other connections to the firm (as suppliers, clients,
customers..)?
o How many of the directors are CEOs of other companies?
o Do any of the directors have large stockholdings or represent those who do?
3. Share Voting Structure
o Are there differences in voting rights across shares?
o If so, do incumbent managers own a disproportionate share of the voting shares?

• To understand the relationship between the firm and financial markets, try asking the following
questions:

1. Financial Market Concerns

o How many analysts follow the firm?
o How much trading volume is there on this stock?

• To understand the relationship between the firm and society try answering the following questions:

1. Societal Constraints
o Does the firm have a particularly good or bad reputation as a corporate citizen?
o If it does, how has it earned this reputation?
o If the firm has been a recent target of social criticism, how has it responded?
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II. Stockholder Analysis

• To understand who the average and marginal investors in the firm are, try answering the following
questions:

1. Who holds stock in this company?

o How many stockholders does the company have?
o What percent of the stock is held by institutional investors?
o Does the company have listings in foreign markets? (If you can, estimate the percent of the
stock held by non-domestic investors)
2. Insider Holdings
o Who are the insiders in this company? (Besides the managers and directors, anyone with more
than 5% is treated as an insider)
o What role do the insiders play in running the company?
o What percent of the stock is held by insiders in the company?
o What percent of the stock is held by employees overall? (Include the holdings by employee
pension plans)
o Have insiders been buying or selling stock in this company in the most recent year?

III. Risk and Return

• To understand the risk profile of the company, estimate risk parameters and the hurdle rates for the
firm, try answering the following questions:

1. Estimating Historical Risk Parameters (Top Down Betas)

Run a regression of returns on your firm's stock against returns on a market index, preferably using monthly
data and 5 years of observations (or)

• What is the intercept of the regression? What does it tell you about the performance of this company's
stock during the period of the regression?
• What is the slope of the regression?
o What does it tell you about the risk of the stock?
o How precise is this estimate of risk? (Provide a range for the estimate.)
• What portion of this firm's risk can be attributed to market factors? What portion to firm-specific
factors? Why is this important?
• How much of the ìriskî for this firm is due to business factors? How much of it is due to financial
leverage?

1. Comparing to Sector Betas (Bottom up Betas)

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o Break down your firm by business components, and estimate a business beta for each
component
o Attach reasonable weights to each component and estimate an unlevered beta for the business.
o Using the current leverage of the company, estimate a levered beta for each component.
2. Choosing Between Betas
o Which of the betas that you have estimated for the firm (top down or bottom up) would you
view as more reliable? Why?
o Using the beta that you have chosen, estimate the expected return on an equity investment in
this company to
 a short term investor
 a long term investor
o As a manager in this firm, how would you use this expected return?
3. Estimating Default Risk and Cost of Debt
o If your company is rated,
 What is the most recent rating for the firm?
 What is the default spread and interest rate associated with this rating?
 If your company has bonds outstanding, estimate the yield to maturity on a long term
bond? Why might this be different from the rate estimated in the last step?
 What is the company's marginal tax rate?
o If your company is not rated,
 Does it have any recent borrowings? If yes, what interest rate did the company pay on
these borrowing?
 Can you estimate a ìsyntheticî rating? If yes, what interest rate would correspond to
this rating?)
4. Estimating Cost of Capital
o Weights for Debt and Equity
 What is the market value of equity?
 Estimate a market value for debt. (To do this you might have to collect information on
the average maturity of the debt, the interest expenses in the most recent period and
the book value of the debt)
 What are the weights of debt and equity?
o Cost of Capital
 What is the cost of capital for the firm?

IV. Measuring Investment Returns

• To analyze the quality of the firm's existing projects and get a sense of the quality of future projects,
try answering the following questions:

1. Accounting Returns on Projects

o What is the return on equity earned by the firm? Based upon this return, is the firm picking
good projects?

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oWhat is the return on capital earned by the firm? Based upon this return, is the firm picking
good projects?
o Are there any trends in the accounting returns, and if so, what do they tell you about future
projects?
o Do you think the accounting return is a fair measure of the returns that this firm is making on
existing projects? If not, how would you modify the return to make it a fairer measure?
2. Economic Value Added
o Compute the book value of equity invested in this company and compute the equity economic
value added. What, if anything, does this tell you about this company?
o Compute the book value of capital invested in this company and compute the economic value
added. What, if anything, does this tell you about this company?
o Why might a comparison based upon economic value added lead you to different conclusions
than one based upon the return differences in the earlier section?

V. Capital Structure Choices

• To analyze the existing financial mix of the firm and to assess, from a qualitative trade off between
the benefits and the costs of debt, whether the firm has too much or too little debt, try answering the
following questions:

To answer these questions, you might want to look at the following

1. Benefits of Debt
o What marginal tax rate does this firm face and how does this measure up to the marginal tax
rates of other firms? Are there other tax deductions that this company has (like depreciation)
to reduce the tax bite?
o Does this company have high free cash flows (for eg. EBITDA/Firm Value)? Has it taken and
does it continue to have good investment projects? How responsive are managers to
stockholders? (Will there be an advantage to using debt in this firm as a way of keeping
managers in line or do other (cheaper) mechanisms exist?)
2. Costs of Debt
o How high are the current cash flows of the firm (to service the debt) and how stable are these
cash flows? (Look at the variability in the operating income over time)
o How easy is it for bondholders to observe what equity investors are doing? Are the assets
tangible or intangible? If not, what are the costs in terms of monitoring stockholders or in
terms of bond covenants?
o How well can this firm forecast its future investment opportunities and needs? How much
does it value flexibility?

VI. Optimal Capital Structure

• To assess the optimal financing mix of your firm, try the following questions:

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1. Cost of Capital Approach

o What is the current cost of capital for the firm?
o What happens to the cost of capital as the debt ratio is changed?
o At what debt ratio is the cost of capital minimized and firm value maximized? (If they are
different, explain)
o What will happen to the firm value if the firm moves to its optimal?
o What will happen to the stock price if the firm moves to the optimal, and stockholders are
rational?
2. Building Constraints into the Process
o What rating does the company have at the optimal debt ratio? If you were to impose a rating
constraint, what would it be? Why? What is the optimal debt ratio with this rating constraint?
o How volatile is the operating income? What is the ìnormalizedî operating income of this firm
and what is the optimal debt ratio of the firm at this level of income?

• To analyze whether the firm has too much or too little debt relative to the sector and the market, try
the following :

1. Relative Analysis
o Relative to the sector to which this firm belongs, does it have too much or too little in debt?
(Do a regression, if necessary)
o Relative to the rest of the firms in the market, does it have too much or too little in debt? (Use
the market regression, if necessary)

VII. Mechanics of Moving to the Optimal

• To understand whether your firm should move to its optimal gradually or quickly, and whether it
should take projects or alter its existing mix, try answering the following questions:

1. The Immediacy Question

o If the firm is under levered, does it have the characteristics of a firm that is a likely takeover
target? (Target firms in hostile takeovers tend to be smaller, have poorer project and stock
price performance than their peer groups and have lower insider holdings)
o If the firm is over levered, is it in danger of bankruptcy? (Look at the bond rating, if the
company is rated. A junk bond rating suggests high bankruptcy risk.)
2. Alter Financing Mix or Take Projects
o What kind of projects does this firm expect to have? Can it expect to make excess returns on
these projects? (Past project returns is a reasonable place to start - see the section under
investment returns)
o What type of stockholders does this firm have? If cash had to be returned to them, would they
prefer dividends or stock buybacks? (Again, look at the past. If the company has paid high
dividends historically, it will end up with investors who like dividends)

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• To analyze what kind of financing the firm should use to move to its optimal, try the following:

1. Financing Type
o How sensitive has this firm's value been to changes in macro economic variables such as
interest rates, currency movements, inflation and the economy?
o How sensitive has this firm's operating income been to changes in the same variables?
o How sensitive is the sector's value and operating income to the same variables?
o What do the answers to the last 3 questions tell you about the kind of financing that this firm
should use?

VIII. Dividend Policy

• To analyze how much the firm has returned to stockholders in the past, and to assess, from a
qualitative trade off, whether it should return more or less, try the following:

1. Historical Dividend Policy

o How much has this company paid in dividends over the last few years?
o How much stock has this company bought back over the last few years?
2. Firm Characteristics
o How easily can the firm convey information to financial markets? In other words, how
necessary is it for them to use dividend policy as a signal?
o Who is the average stockholder in this firm? Does he or she like dividends or would they
prefer stock buybacks?
o How well can this firm forecast its future financing needs? How valuable is preserving
flexibility to this firm?
o Are there any significant bond covenants that you know of on the firm's dividend policy?
o How does this firm compare with other firms in the sector in terms of dividend policy?

IX. A Framework for Analyzing Dividends

• To assess how much the firm could have returned to stockholders and whether it should be returning
more or less, try the following:

1. Affordable Dividends
o What were the free cash flows to equity that this firm had over the last few years?
o How much cash did the firm actually return to its owners over the last few years?
o What is the current cash balance for this firm?
2. Management Trust
o How well have the managers of the firm picked investments, historically? (Look at the
investment return section)

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o Is there any reason to believe that future investments of this firm will be different from the
historical record?
3. Changing Dividend Policy
o Given the relationship between dividends and free cash flows to equity, and the trust you have
in the management of this firm, would you change this firm's dividend policy?

• To measure whether your company is paying too much or too little relative to the sector and the
market, try the following:

1. Comparing to Sector and Market

o Relative to the sector to which this firm belongs, does it pay too much or too little in
dividends? (Do a regression, if necessary)
o Relative to the rest of the firms in the market, does it pay too much or too little in dividends?
(Use the market regression, if necessary)

X. Valuation

• To pick the right model, estimate inputs and value your firm, try the following:

1. Cash Flow Choice

o How does this company's dividends compare to its free cash flow to equity?
o How stable is leverage expected to be at this firm?
If leverage is expected to change, use FCFF
If leverage is stable and dividends are equal to FCFE, use Dividends
If leverage is stable and dividends are not equal to FCFE, use FCFE.
If you cannot estimate FCFE or FCFF, use dividends
o How high is inflation in the local currency? (If it is in double digits, you might consider doing
a real valuation or a valuation in a different currency)
2. Growth Pattern Choice
o How fast have this company's earnings grown historically?
o How fast do analysts expect this company's earnings to grow in the future?
o What do the fundamentals suggest about earnings growth at this company? (How much is
being reinvested and at what rate of return?)
o If there is anticipated high growth, what are the barriers to entry that will allow this high
growth to continue? For how long?
3. Valuation
o What is the value of this firm, based upon a discounted cash flow model?
o How much of this value comes from the expected growth?
o How sensitive is this value to changes in the different assumptions?
4. Value Enhancement

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Applied Finance – Course Outline & Project Guidelines

o In what aspect of corporate finance (investment, financing or dividend policy) does this firm
lag? (You can build on the intrinsic analysis that you have done so far, or use industry
averages)
o If you fixed the problem areas (i.e., take better projects, move to the optimal debt ratio, return
more or less cash to owners), what would happen to the value of the equity in this firm?
o What is the value of control in this firm?

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