ICP Islamic Finance - "Conventional" Analysis

This morning we had a working session for our ICP - Islamic Finance with some lawyers, a corporate banker and professors. The two teams presented their analysis of the conventional financing structure of the primary security instruments used to finnace our projects. Under this conventional analysis, we looked at the costs of capital and the associated terms related to these types of paper with the intent of understanding the requirements need to make them Sharia compliant.

We also had great explanation from a senior lawyer regarding the structuring and "asset-based" (versus "asset-backed") nature of nominating (rather than selling) assets under a Special Purpose Vehicle (SPV) in order to comply with the necessary requirements of Islamic finance. We had considered the capital gains implications of a sale leaseback transaction, as well as understood how an asset and capital intense infrastucture project would look similar under an adjusted EV to EBITDAR metric regardless of the off-balance sheet financing that may potentially be required.

We have a solid understanding of the work requirements due before our next meeting in early January (before I fly off for London). We also had an opportunity to fire questions back at the professionals in the room in terms to learn what were the appropriate resources for generating comparables for analysis and benchmarking of our theoretical capital structures based on similar Sharia compliant instruments and current market conditions.

Some of the best advice we got:

• Understand the difference between "asset backed" versus "asset based" and how that affects your ability to issue Sharia compliant instruments
• Be aware of tax implications of capital gains/losses in a sale leaseback transaction
• Like any financial security, understand the key characteristics of seniority and expected return for a sukuk issuance and understand market appetite for these structured products

What Makes Rotman Different? A foray into the world of Business Design

In anticipation of our trip to LBS, Geoff and I have been asking ourselves: “What makes Rotman different?” In discussing this idea, one of the key points at the top of the list was business design. This week, I’ve had the pleasure of attending various events over at Design works where members of a university in Singapore are undergoing certification for Business Design.

On Tuesday, Geoff and I attended a working session with Anita McGahan discussing the evolution of demographics across different geographies and the implications for the future of the health care industry around the globe. With our guests present, we learned a great deal about the specific differences in the Singaporean culture and life style and were impressed by the innovation produced by their ambitious programs.


This exercise was particularly enlightening for me, not only because of my previous work as a Wireless Consultant for RIM in the healthcare communication and process optimization space, but also to learn more about the business design process.

Today, I also attended a talk given by my class mate and president of the Business Design club, Jason Huang, at Design Works for our Singaporean guests. He gave a very inspiring speech about the current state of business design at Rotman as well as a road map to the initiatives he and his team are putting into place to further develop the program at Rotman at the academic and extra-curricular levels. I am particularly impressed by his attitude, aiming to be the top club at Rotman. I think he also has demonstrated that he has the will and ability to execute on these new initiatives, launching business design more prominently into the spotlight.

He also had a great point about case competitions where “the idea isn’t just to try to do well, but more importantly to learn” a sentiment which I would like to echo and I think reflects my personal motivation for participating in various case competitions, including those not necessarily related to my chosen profession.

What is Business Design @ Rotman? Find out for yourself by watching the YouTube video below:

End of Classes, Start of Exams

Last week marked the end of classes for second years and many of us had our first exams today (with the exception of the options class which had their exams last week due to a scheduling conflict with the professor).

Some of my classmates have been thoughful enough to remind me that this is my "last class at Rotman" or my "last exam week at Rotman" as I'll be leaving for exchange in Jan for London Business School. It has started to become more real for me as I think I have found some good accommodation (deposit to be sent tomorrow).

I just wrote the exam for Business Analysis and Valuation tonight (a four hour exam... Yikes!) This week I also have Financial Management on Wednesday evening, Corporate Finance on Thursday and Mergers & Acquisitions on Friday. Thank goodness my ICP in Islamic Finance doesn't have an exam, although it does have work that will stretch over the holidays.

I'm looking forward to the upcoming break, MBA games in Jan and flying out for exchange!

DCF

With summer recruiting coming up for first years in the next few months and with many of our second year finance courses requiring us to do some form of valuation (Corp Fin, Financial Management, Mergers and Acquisitions, Business Analysis and Valuation etc.), I thought it might be useful to post an "academic" quality discounted cash flow model as a reference.

There are some basic comments in the cells which explain some of the assumptions.

Discounted Cash Flow Model

Discounted Cash Flow Guide

For a more advanced version of forecasting (including working capital schedule and depreciation schedule), check out my Chapters LBO model.

Mergers and Acquisitions – Final Project Surprise

Wednesday morning was the presentation date for our final project in M&A. The Wednesday morning class was given the acquirer of Bombardier and told to pitch an appropriate target for the deal. My team had worked very hard to put together a robust deck for our pitch.

While we were told that there would be two “industry judges” coming to judge our presentations, I was quite pleasantly surprised to see two senior Scotia Capital bankers whom I worked with over the summer (one from M&A and one who covered industrials).

It was fantastic to see them again and our class certainly benefited from their comments. Having worked with these two senior bankers at Scotia, I appreciated their comments and learned a great deal from the high caliber of their questions and the responses of my classmates.

Multi-Factor Models – Applying the Lessons Learned from the Numbers

In Finance 1 last year, we were introduced to the idea of multi-factor models (MFM) originally explained by Fama and French as an alternative to the traditional Capital Asset Pricing Model (CAPM) for assessing systematic risk. Additional factors include small versus big (SML) and value versus growth (HML).

In our Business Analysis and Valuation class, we discussed a merger case in which a large company acquired a smaller company. We talked about what would be the best way to approximate beta. The method I used (which was the best method I could conceive, I’d be happy to hear criticism or suggestions otherwise) was to weight the betas by market cap and take an average.

However, there was some discussion about the fact that one entity was much smaller than the other. While we were having a conversation of what that would actually mean, I would suggest a mathematical method for expressing the quantitative effect of size, using FF’s MFM.

1. 1. Express both company’s re as a three factor MFM
   Re1 – RFR = beta1 (Rm – RFR) + betas1 (SMB) + betav1 (HML)
   Re2 – RFR = beta2 (Rm – RFR) + betas2 (SMB) + betav2 (HML)
2. Take the larger company’s size beta and apply it to the smaller entity
   betasnew = betas2
3. Recalculate re for both entities
   Re1new – RFR = beta1 (Rm – RFR) + betasnew (SMB) + betav1 (HML)
   Re2new – RFR = beta2 (Rm – RFR) + betasnew (SMB) + betav2 (HML)
4. Take a weighted average (by market cap) as the expected return of the combined entity

By taking the larger company’s size beta for both, what you are saying is that you expect the smaller company to have the size “characteristics” of the larger entity. I might even be more appropriate to add the size factors (Would that be appropriate? As the MFM is a linear regression, is it appropriate to add these factors?) and use that for new return on equity for each entity as it relates to the combined entity.

betasnew = betas1 + betas2

While there are some significant assumptions which are required for this to work, it is the best solution I can conjure based on information given. I would really appreciate any additional ideas for creating a more robust model.

Abnormal Earnings Method – Not Entirely Useless

When we were introduced to the Abnormal Earnings method in Business Analysis and Valuation, I was decomposing the math formula which constructs the value of the equity. As far as I was concerned, it didn’t really tell us anything we didn’t already know through a equity based discounted cash flow (FCFE discounted at re).

However, there was an interesting scenario in which this method actually told us something unique. First the formula:

Market Value = Book Value + (NI1 – re*BV)/re + (NI2 – re*BV)/re^2 + …

Nix is Net Income in year x

BV is book value

While in theory, this formula should return a similar value to an equity based DCF, one unique value is that the valuation is relative to book value, rather than strictly looking at only cash flows. Essentially, what it is saying is, the company is worth it’s book value, PLUS it’s “abnormal earnings” where abnormal earnings are the earnings you get in excess of what you would expect (re).

So in looking at a company that is trading below book value, I used to think that it meant that the market did not believe in the company’s management to perform (the company was burning cash). But it doesn’t just have to be that the company is on a “crash” course. It could also just be that the company is not performing as “expected” that is to say there net income is not necessarily negative, but simply less than what is expected.

MBA Games - Rotman Team Kick off

Rotman is putting together a team for this year’s MBA games, hosted by Schulich from Jan 7th to 10th. I saw how much fun they had last year that I missed because I was on the study tour and wanted to make it a priority to participate if possible this year (postponing my flight out to London).

Last year’s team was the first time Rotman had competed in six years I’m told and was put together last minute. However, building on last year’s interest, the efforts and energy of our current organizing executive was quite obvious as they were eager to bring us all into the fold to compete and have fun at the games.

To our competitor colleagues at other MBA schools: “See you at the games!”

Write-Up of Intangible Assets

In M&A, acquiring a company requires you to pay a control premium above the current market price to capture a majority of the shares outstanding needed to own the company. Usually, a company’s equity trades at values above book value (the idea that the sum is greater than the parts) and that there is value creation.

So in an acquisition scenario, there are a few considerations. Firstly, the market price is above the book value. Secondly, the purchase price is above the market value. The cumulative amount by which the purchase price is above the book value is referred to as “excess”. This excess is usually allocated in two ways: Good will and Write-up of Intangible Assets.

Purchase Price > Market Price > Book Value

Purchase Price = Book Value + Excess

Excess = Goodwill + Write-up of Intangible Assets

Intangible assets would normally be amortized, but in this scenario they do not provide a tax shield. This makes sense because if you could amortize them you would essentially be double counting your DA expense (or depending on what type of asset it is, such as Intellectual Property, your R&D expense). Also, if you could count this as an expense, this would provide a tax shield against your acquisition premium and promote higher premiums.

Another consideration is the effect on asset based leverage ratios depending on where you allocated the write-ups in value. One note was that in companies which depend heavily on leverage (and where asset based ratios can significantly affect ratings and therefore borrowing rates), there is a tendency to try to write up assets rather than allocate the excess to goodwill (also for “optics” reasons).

Aside: Any buyer that is offering an acquisition price below the current market price should seriously reconsider their position. Although we've seen this unique situation with the recent Potash deal, there are some obvious problems with offering a purchase price below the market price.

Financial Executives International – 5th Best in Class Competition

On Saturday, a Rotman team composed of myself, Shree, Fei and Matt Literovich competed in the Financial Executives International 5th annual Best in Class Competition. The case company was HudBay Minerals. Unfortunately, we placed second, behind Alberta School of Business.

The competition was intense, as many of the teams worked late into the night on Friday to put together our decks and get a few rehearsals in before scrambling to get a few hours of shut eye. The next morning, our names were drawn for presentation order and we found ourselves in the seventh spot.

Matt Literovich was phenomenal understanding potential legal issues related to mining and commanded the attention of the room when he spoke of precedent case law.

Fei gave a detailed account of all the organizational issues we could expect as HudBay Minerals grew and followed our acquisition strategy.

And Shree’s knowledge of mining and dissection of potential target companies gave us an exceptionally high level of credibility.

All three were exceptionally strong in both the presentation and the question and answer period and this short description does not do justice to the quality of our presentation.

While we were very disappointed that we didn’t take the top spot, the event itself was challenging and very entertaining. Judges from the competition included top executives from HudBay Minerals, USGold, OTPP, Mercator, a justice and many other top professionals. Definitely a great experience, I would recommend any MBA student to attend this competition.

Competitions Week – RMA Case Comp

Last week was very heavy for case competitions and presentations (hence the lack of posts).

On Wednesday, we had the Rotman Marketing Case competition. The case was based on the Pan America (Pan Am) games, where we were asked to create a strategy for how to engage university students to participate in the Toronto 2015 games.

One key insight from our team was that the university students of 2015 are currently high school students, so we took a two pronged approach:

1. Engage high school students now and use their 40 hours of volunteering to instill a culture associated with sport based mentorship.
2. Create the university infrastructure that would allow these students to be received into such post-secondary institutions.

We proposed that as the system developed, this program could follow PanAm games host cities and was modeled similar to "Right to Play" and eventually leverage the Olympics brand to become international and increase the sense of legacy of the games beyond just physical infrastructure.

While we didn’t place in the competition, it was interesting to see what other teams pitched as it was a fairly open ended question and there were plenty of unique solutions proposed by the other groups.

Islamic Finance - International Consulting Project

A new initative at Rotman (although you wouldn't know it as it has simply exploded this year) is the International Consulting Project. Laura Wood, Director of International Programs, has started a new research type project that engages students to work with professors on international topics. Some countries involved are the G20, Middle East, Israel, Africa and potentially others.

I myself am participating in the Islamic Finance ICP with Walid Hejazi, the professor who leads the Middle East study tour.

Yesterday, we were invited to attend the kick off event for the Islamic Finance EMBA course which will be offered in Jan 2011. The keynote speaker was David Dodge, Senior Advisor, Bennett Jones and former Governor of the Bank of Canada. He spoke about the growing interest in Islamic finance and how there it is common for people to see Shariah compliant instruments as simply "no interest" and how this superficial understanding does not encompass the fundamental rational for the structure of these products.

I am looking forward to working with my four other colleagues on this research project to look at Islamic financial instruments.

Legacy REIT

In our corporate finance class today, we were responsible for presenting our valuation of the Legacy REIT IPO. We used a variety of different valuation methods and multiples to provide a range of potential valuations before recommending a price of $10.50.

My team was fantastic to work with. As we are also responsible for the RioCan valuation next week, we opted to split the group work down the middle and sort out our presentation. My team mates produced a robust DCF model which had it's assumptions firmly grounded in the economic realities of the industry. When it came to question and answers, my team mates were resilient in answering questions about reconciling the various valuation methods to resolve model tensions (the DCF says we should price higher, but yield analysis shows that we aren't generating a high enough yield to attract potential investors relative to other REITs).

In the end, it took all the strength I could muster to stop grinning like a Cheshire Cat as my team mates hammered back answers to questions by pulling up pre-emptive appendix slides and presenting a well founded case for our valuation.

As an interesting note, our professor had worked on this deal and mentioned that they had priced the deal at $10 (and that apparently, for mathematical simplicity, these units are generally priced at $10 and that the sources of funds are changed through the number of units issued - like bonds at $1000 or preferreds at $25).

Retail Experts Speaker Series - Jurgen Schreiber, President and CEO, Shoppers Drug Mart

Rotman hosted another speaker series session today from the Retail Experts Speaker Series @ Rotman and the guest was Jurgen Schreiber, President and CEO, Shoppers Drug Mart Corporation. And he spoke on "How and Why Shoppers Drug Mart is Transforming its Stores to One-Stop Shopping”.



After noting that this talk was organized before the change in pharma regulations, he began with a quick history of Shoppers and the development of its stores, noting that the first Shoppers store originally had a variety of products.

He offered a breakdown of Shoppers value proposition on five key elements:

1. Dominate on Convenience


2. Differentiate on Service


3. Differentiate on Products


4. Differentiate on Experiences


5. Compete on Price

Why? Simple answer: Because the customer is ready for it. Real answer: “Our gut told us to do so – to create something really unique and different” & “We have the capital resources and financial strength.”

Mr. Schreiber went on to discuss mega-trends that he perceived as being crucial to the long term success of Shopper’s including: Health, Convenience, Age Complexity, Gender Complexity, Individualism, Sensory, Comfort, Connectivity and how it was necessary to understand and embraces these factors, use them in combination to differentiate and innovate in a scalable way. He also reflected on the changes in demographics in the Canadian market place such as more singles, no or less children, smaller households, aging population and multiple income couples.

Jurgen defined a modern one-stop shopping experience as needed to focus on location and opening hours, store experience, clear assortment, in-store convenience, service, product, loyalty programs and loyalty specific products, to create a “Have it all drug store”. He emphasized how it was also necessary to avoid small and mega store formats, traditional assortments, all services, and all profit pricing. He spoke about how there is a concept of “My store”: my SDM (Shoppers Drug Mart), My SDM Associate and Team, My Optimum, as part of My Neighbourhood.

There was one odd little insight in Shoppers product mix. They don’t sell fresh food, but they make an exception for fresh bread, a noteworthy exception pointed out by Jurgen. He mentioned that, in testing, customers perceive this product has being an exception as to what types of products are expected at Shoppers.

He closed by speaking about the Optimum program. A classmate I was watching the presentation with on the third floor commented that Optimum was a program that was the first of its kind. Unlike popular third party programs, or other loyalty programs, Optimum induces customers to return to the shop to pick up additional items. As an example, this is in contrast to a gas station loyalty program which just causes you to return to the same gas station to purchase something in which you have a relatively inelastic demand – gasoline and convenience goods during travel – selecting between vendors versus marginal purchases though increasing basket size and return visits – two of the key value drivers of Dilip Soman’s customer value framework.

Financial Management Presentation

Yesterday, my team had our presentation for Financial Management with Asher Drory, a professor notorious for not pulling any punches and generally holding all Rotman students to a very high standard. We didn't want to disappoint.

Our case was on securitization as a form of financing. The company was a collections company which bought bad loans for pennies on the dollar and made a profit by collecting on them. However, they were being squeezed on the margins due to banks beginning to charge more for the bad debts as well as the quality and collectability of the debts shrinking.

The company was also looking to grow, and had been previously financing its growth through the securitization of it's uncollected loans (in this specialized financial industry, loans are a form of inventory, rather than as a liability in a traditional company). However, the conditions of the security were almost exactly the same as debt (monthly interest payments and principal flowthrough).

Therefore, in order to properly understand the risk exposure in the company, rather than have the financing sit off the balance sheet, we made adjustments to show what the balance sheet would look like if they were financed with traditional debt (which is not an unreasonable assumption, given the type of business risk that they are exposed to through this financing is not dissimilar). The end result is that suddenly all their solvency ratios and coverage ratios are totally out of whack. Whereas before their company had reasonable ratios (debt to equity of about 0.8x), their ratios were now about 4 to 5x.

Financial Executives International Competition

On Wednesday we had Rotman’s internal competition for the Financial Executives International competition. I was part of a team of four, including Irina, Shree and Matt Literovich. The case was on Tiffany’s expansion into Japan and how they wanted to protect themselves from exchange risk. All the teams did a comprehensive analysis on the potential hedging options and the exposure. It was very humbling to see the caliber of work produced by our classmates in such a short period of time.

It was great to work with my team mates and our discussion on the financial strategy was highly enlightening. In the end, we looked at a variety of strategies including forward contracts, put options and collars.

Yesterday, we found out that we were selected to represent Rotman at the national competition which will be hosted by Ryerson on November 12th. Unfortunately, Irina will be unable to attend, but Fei has gratiously joined our team.

We are all excited at the opportunity to represent our classmates and showcase Rotman talent as well as meet MBAs from all across Canada at the "Best-in-class" competition.

Levering and Unlevering Beta - Mechanics of the Model

It occurs to me that I didn't really describe the formula for levering and unlevering Beta and why it works. Let's have a closer look:

First think of any given industry. There are some major assumptions required to get levering and unlevering beta to work. For instance, a dollar invested in an industry will give a constant return proportional to it's risk (beta). This is one of the fundamental assumptions in CAPM.

Levering beta is the idea that I can amplify the result of a deal by using debt. Let's look at an example:

I'm in an industry that has a beta of 1.2

ERP is 5%

RFR is 4%

ke = RFR + beta * ERP = 4% + (1.2) 5%

= 10%

So if I invest a dollar, I can expect to get a return of 10%.

However, I can use leverage (borrow money) so that I want to experience an amplified result:

I'll invest 1 dollar, but allow borrow another dollar to invest with. So I have two dollars in play, but only one of those is mine. My return? Well, assuming you can borrow at RFR (a huge assumption), you'll gain another 10% on that additional dollar, but have to pay 4% (RFR) so you'll gain another 6% on top of your original 10% for a total of 16%. You've doubled your systematic risk by having two dollars in play. Let's check with CAPM:

Beta = 2*1.2 (twice as much exposure)

ke = RFR + beta * ERP

= 4% + 2.4 * (5%) = 16%

This makes sense. For every additional dollar you borrow at RFR and invest in the industry, you will make the spread between their returns (or the beta * ERP).

So if you borrow D, dollars (D in this case stands for Debt), versus E dollars of your own money (Equity), and because CAPM is a linear function, you can expect:

• Your exposure will be based off of D+E dollars (total capital in the game - systematic risk, exposure)
• But off a base of E dollars invested (the money you have invested yourself, or Equity)

So if an industry has a beta of Ba, and you use leverage D on your initial investment E, you can expect your new beta of Be, to be:

Be = Ba * (E+D)/E

Note, however, that (E+D)/E = 1 + (D/E)

Look familiar? It's the levering formula:

Be = Ba * (1 + D/E)

But there is still one piece missing. The (1-t) portion of the formula is to simply account for the fact that debt that you borrow provides a tax shield, so the final version of the formula replaces D with (1-t)*D to get:

Be = Ba * (1 + (1-t)*D/E)

Hope this decomposition helps. I noticed this relationship is very prevalent in financial calculations as Anita McGahan clarified in one of her lectures on Starbucks in first year when talking about Operating Strategy versus Financial Strategy in the Dupont Decomposition. This was something I had also wondered about previously.

Accounting – The Story Behind the Numbers

It seems like the major topic for this week has been related to working capital. In our financial management course, however, there was a great example case where simply knowing the numbers is not enough.

Simplified Case Info (expressed in thousands):

Revenue = 17805
AR = 6000
Average Day’s Receivable in the industry = 59 days

Analysis:

Company’s Average Day’s Receivable = 123 days

Proposed financing solution: Collect on AR to reduce Day’s Receivable to industry average of 59 days.

If Days Receivable = 59 days, implied new AR is 2878. The change in AR would be 6000 – 2878 or 3122.

So looking at this *mathematical* solution, it seems as if the company can get a free 3 million dollars just by tightening its AR, right? Well as it turns out probably not. The reason?

Most companies define default as non-payment of debts of 90 days or more. Previously, we’ve talked about how debts decay in value as they are outstanding for longer and longer (probability of collection and bad debt expense). If you look at this number, essentially what it is saying that the many of your accounts are in default with an average age of 120 days!

Sometimes you can’t just assume you can make operational changes to reflect a reality that you want. The truth of the matter is that those funds are probably lost. The firm probably won’t collect those accounts and will incur a significant bad debt expense.

In reading more of the case, it also mentioned that the company had a “no returns” policy with its distribution channel partners. Looking at this number not only meant that they probably weren’t going to collect, but that their distributors were telling them that they didn’t want to do business with them any more (affecting their potential future revenue growth). Not only will they not be able to pull 3 million dollars out of working capital, there are some critical red flags appearing about their ability to continue as an ongoing concern.

Unlevered Beta

A quick recap:
Beta of a company is determined by a statistical regression of returns of a given security against returns of the market.

As a result, "beta" usually refers to a company's equity beta or observable beta. Using CAPM, we can calculate the expected cost of equity (ke) using:

ke = RFR + beta * ERP

Where ERP is Equity Risk Premium

So what is unlevered beta and why is it important?

Well, recall from CAPM that you can change a company's capital structure in order to add leverage to increase beta and thereby increase expected return of equity (with a company's cost of equity being the investors return on equity).

Unlevered beta tells you how much a company's industry is expected to return, regardless of the leverage employed by looking at the systematic risk of an industry regardless of the financing decisions. Theoretically, the unlevered beta should be constant across companies in an industry.

Why is this important? Here is one example. You are trying to determine the cost of equity (so you can determine WACC for DCF) of a new company in an industry. However, because it is a new company, there is no previous history in terms of what they can be expected to return relative to the market. So it is impossible to calculate its equity beta. So what can you do?

You can look at a variety of other companies in the space, unlever all their betas to get asset betas and average them (as they should be theoretically the same, but will most likely differ slightly) and then relever it to the new company’s capital structure to approximate its expected equity beta. Armed with its equity beta, you can calculate its cost of equity using CAPM.

While this is how it would work in theory, there are some major problems with this model, the most obvious being:

• How do you do “comps”? How do you define “a variety of companies in the space”, especially if few or none of the companies are exactly the same?
• CAPM has its own issues which make it a less than perfect model
• As a new company, they will probably not behave in the same manner as more mature companies in the space.

Here is an example:

There are four companies with different betas and leverage levels. By unlevering all the equity betas, you can have various approximations for what the asset beta should be. An average of all four gives you a decent approximation for the beta of the industry.


Now assume we have a new company in this space that will have a D/E of 50% at the same tax rate. We can use the leverage formula to calculate what the beta equity should be:

Equity Beta = Asset Beta * (1+(1-Tax)*D/E)

In this case, the equity beta would be approximately 1.3, which makes sense as it has a leverage between B and C and therefore should have an equity beta in between.

Excess Cash isn't always just from cash

Putting together the last few posts (House analogy for EV, FCFF and NOWC and N[O]WC as a source of funds), let's look at an example of how they are all interrelated.

Target Company:
Total Assets = $100M
AR = $10M
Inventory = $15M
AP = $10M

Industry Average
Total Assets* = $100M
AR = $5M
Inventory = $10M
AP = $20M

* Total Assets for each company are deliberately the same to make percentage calculations convenient.

Let's also assume that looking only at the company's operations, you are planning on bringing the balance sheet accounts closer in line with industry average. Implicitly, you are improving the company's operations (reducing days receivable, days on hand and increasing days payables).

Therefore:
Change in AR = -5M (cash inflow)
Change in Inventory = -5M (cash inflow)
Change in AP = +10M (cash inflow)

Total cash inflow from Operating Working Capital = +5M +5M + 10M = +20M

This change in accounts reflects a type of excess which can be converted into "excess cash". These changes would be manifested in operations through:

• Collecting on debts sooner, reducing credit terms
• Selling out of inventory without replenishment (reducing inventory size and implicit days on hand)
• Taking longer to pay our suppliers, using more supplier credit
• Essentially, running "leaner"

This excess cash would be captured in a financial DCF model as a change in net operating working capital in the first year of operation and built into the company's EV calculation.

Enterprise Value - House Analogy with Excess Cash

Another common question that comes up is related to enterprise value, particularly as it relates to excess cash. Recall that enterprise value is the value of the entire company and should be capital structure neutral.

EV = Equity + Debt - Excess Cash
or
EV = DCF Value + Excess Cash

The initial reaction is: "Wait, how can that be?" How is it that in one formula excess cash detracts from EV whereas in the other it increases? Does that make sense? In explaining, I find that a house analogy is helpful for understanding how to calculate EV.

Scenario 1:
Imagine Steve ownes a house worth $100k. Over the years, Steve has paid down his mortgage to $50k. Therefore, Steve's house's capital structure is $50k debt and $50k equity.

Dave is interested in buying Steve's house. For simplicity, let's say the house hasn't appreciated in value and is still worth $100k. Dave doesn't care what Steve's mortgage is, how much he's paid down etc. After all, that is Steve's capital structure. Dave is a new home buyer and is starting with a $20k downpayment and $80k mortgage.

The main point is that it doesn't matter who is buying the house (over simplified assumption), the house is worth $100k. It is an attempt to understand an unbiased (unlevered) way of looking at value of the company.

Scenario 2:

Let's assume a few changes:

• The $100k price of the house includes $10k in cash which is sitting on the floor of a room
• The house is being rented out as an investment property for $4k per year forever and the appropriate discount rate is 5%

Using the following formula:

EV = Equity + Debt - Cash = $100k - $10k = $90k

Does this make sense? Dave buys the house with $80k of debt, $20k of equity for a total price of $100k. However, immediately upon buying the house, Dave takes the $10k sitting on the floor and pays down his mortgage. Effectively, Dave has only paid $90k for the house.

Using the alternate formula (using a perpetuity formula for DCF):

EV = DCF Value + Excess Cash = $4,000 / 5% + $10k = $80k + $10k = $90k

That is to say, forgetting the cash, the house is worth $80k only from the income it generates. However, because the cash sitting on the floor is not integral to operating the house, it can be taken out of the house without affecting the income stream.

While it isn't an entire conicidence that the end numbers are the same (I've deliberately selected convenient numbers), it should hopefully demonstrate how excess cash in one formula decreases EV whereas in another in increases EV.

Free Cash Flow to Firm and Net Change in [OPERATING] Working Capital

A few of my classmates have been asking me a very common question so I thought I would post the answer. Particularly because I think it is a fantastic question and is something I’ve wrestled with for sometime.

In Corporate Finance, Financial Management and Mergers & Acquisitions, one of the most important metrics of a company’s performance is it’s free cash flow. Or more specifically, it’s free cash flow to firm (aka. Unlevered free cash flow). This is the cash flow metric that is used to value the entire enterprise. It’s defined as:

FCFF = EBIT (1 – tax) + DA – NWC – Capex

Where:
EBIT is Earnings Before Interest and Tax (otherwise known as operating income)
DA is Depreciation and Amortization (which is actually a place holder for all non-cash expenses, but DA is the largest and most common one)
NWC – Change in net working capital (*NOTE* This is the tricky part that people are asking about)
Capex – Capital Expenditures

So while this formula is not new to most, what I want to focus on is NWC. If you have read my post on the difference between OPERATING working capital and working capital will know what I’m getting at.

First, before we even get to that, I want to emphasize a lesson taught in Anita McGahan’s first year strategy course relating to Dupont analysis (one of my favourite frameworks). Dupont analysis looks at Return on Equity and Anita made a fantastic point about how to look at the formula:

ROE = NI / Equity

ROE = (NI / A) * (A / E)

ROE = ROA * FLA

Where:
ROA is return on assets (Operational Strategy)
FLA is financial leverage (Financial Strategy)

In a discounted cash flow, a company’s value is calculated as it’s enterprise cash flows discounted at the appropriate enterprise cost of capital (it’s weighted average cost of capital).

In other words: In the summation formula, the numerator is operating (FCFF) and the denominator is financial (WACC).

This is another good way to think about the difference between OPERATING working capital (OWC) and working capital (WC) as I explained previously.

While the commonly accepted formula for FCFF is as explained above, anyone who has done a proper financial model is quick to learn that it isn’t change in net working capital which is important, but rather change in OPERATING net working capital (excluding financing items such as cash and short term debt).

FCFF = EBIT (1 – tax) + DA – NOWC - Capex

But the next logical question is what is the difference between something like short term debt (a quantifiable liability) and accounts payable (also a quantifiable liability which is equally a debt of sorts – a debt to a supplier). The answer? Interest.

The reason why something would be considered OPERATING working capital (or particularly an operating current liability) versus a normal working capital (or current liability) is that a financial current liability *bears interest* whereas an operating liability does not.

This raises the next interesting question: How do you treat pension liabilities? As you may recall, I mentioned previously how the CFA treat’s pensions as if they are interest bearing liabilities (or specifically, debts of the company owed to it’s workers which is expected to grow at the company’s cost of debt). This is a perfect example of a judgment call. Some of the top equity research analysts will consider pensions to be part of operating a business (not included in enterprise value as a financial consideration) whereas others will consider pensions to be a type of financing (don’t take my word for it, check out the research reports of companies with sizable pensions and see how different analysts treat different companies). Some will consider current pension obligations as debt (as it has to be financed to be paid out) whereas others will treat the entire long and short term obligation as debt.

Study Tour Applications - Latin America Study Tour Series

Applications for study tour have been submitted for January tours and students are getting emails for interviews over the next period. It seems like there are a lot of keen students who are interested in participating and it looks like there will be some strong candidates representing Rotman in the Middle East and China study tours.

Anticipating the release of applications for the May international study tours for Latin America, I've cleaned up my Latin America Study Tour Series and posted a link in the navigation bar for your reading pleasure.

Unconventional Sources of Funds

A topic I've noticed has appeared in a corporate finance as well as financial modeling cases. Whereas people often think of raising funds in traditional methods such as raising debt and equity, I don’t think people pay enough attention to potential changes in free cash flow, particularly change in net working capital.

For instance, in corporate finance, we were discussing the acquisition of a private company and what considerations should be taken into consideration when acquiring the company. Besides the obvious item’s we’d learned so far, it was also useful to see what would happen to the company if it’s operations were structure in a manner similar to its public counterparts. That is to say, express AR as a percentage of total assets (as well as all assets and liabilities) and look at the change in cash flow that results from the aggregate change in each account when bringing the private company to the industry average. The result can provide a considerable cash flow in or out of the company. While this principle can be generally applied, this is easy to understand using working capital as an example. This is because that unlike capex, change in net working capital can possibly supply cash flow into the company if it was previously poorly managed financially or if new management can improve the cash conversion cycle.

In our financial management case example, this principle was more pronounced as the history of a company’s operations for four years worth of balance sheet items was produced. Activity / operating ratios were heavily underperforming, particularly in prepaid expenses (compared against revenue as an appropriate base) as well as accounts payable (days payable).

While an “unconventional” method of financing, this was one of the lessons from Bombril on the Latin America study tour, where Gustavo Ramos, the CEO, a former Rotman Commerce undergrad and Columbia MBA, told us about how he turned the company around when it was in financial distress. One of the methods he used to “finance” the company was to stretch the cash conversion cycle: negotiating with suppliers to get more favourable terms, being more aggressive in collecting on accounts receivable, managing inventory (reducing days on hand) etc.

While strategies such as stretching the payables is considered to be a last resort for companies in “survival mode”, it can also be used to trim a type of operational fat and is directly related to the calculation of excess cash (and also excess working capital) as you structure your balance sheet accounts with optimal weightings.

Any non-income generating assets that can be sold for excess cash without affecting the underlying FCF can create additional value for the company. Clearly, this unlocks value in the company not captured in at DCF, but does not make the DCF any less sustainable (valid).

Rotman International Fair

Yesterday was Rotman's International Fair in the Fleck Atrium. The Global Business Association (GBA) hosted tables with food from around the world and there were table set up with various international opportunities.

I was present at the international study tours table and was happy to answer questions from students about what the study tours were like, how the application process works, etc. I think that with the future growth and development plans of Rotman and the $200 million expansion project of the school, international programs will be at the forefront of further developing the Rotman brand. I believe these programs will be of paramount importance to attracting talented candidates to attend the school from different parts of the world.

It is my hope that students will be interested in applying for these once in a lifetime opportunities to extend their learning beyond the classroom (such as in the Middle East study tour and our trip to the Central Bank of the UAE and asking them about their policies) or how our visit to Embraer on the Latin America tour was directly related to our Global Managerial Perspectives (GMP) final exam of an aircraft manufacturer outsourcing parts and its exposure to foreign currencies etc.

Pop Quiz

What is the value of a zero coupon bond with no maturity?

Back in the Mix

Today marked my first official day back at school with my Corporate Finance class. I've essentially sorted out what project groups I'll be working on this term and have the opportunity to work with people I haven't worked with before (all with reputations for being smart and hardworking). It also occurs to me that there is also a notable bias towards JD/MBA teammates.

The school is abuzz with info sessions and recruiting events every day it seems as my classmates are constantly appearing in business formal wear and putting their best foot forward for potential employeers. People are taking the opportunity to really investigate what career they want to build and what direction they want to take.

There are also first year students who are now in the same place we were last year and some of my classmates have admitted that it is a bit "different" to suddenly be the senior students giving advice on the MBA program to a group of bright motivated students.

2nd Year Case Comp - My Turn

Last year, I went to the 2nd Year Management Consulting Association (MCA) Case Comp as an observer to see the upper year students duke it out. Just like last year, there were a few first year students who came to observe. This year, I put together a team to give it a try. While we didn't place, the experience was well worthwhile. It certainly served as a good primer to get back into "the right frame of mind" for school.

I'm incredibly impressed with the quality of the presentations. One of my buddies came out with a truly unique solution to the problem presented and had an equally incredibly pitch to sell the idea.

One interesting lesson was why companies focus on top line revenue at the expense of bottom line income. While a short term focused company will need to produce results in the form of profits, a firm with a more long term outlook will often focus on top line revenue as a metric reflecting product and volume growth (with operational margins improving over time and producing future profits).

The first place team was a group of part time students, and I'm starting to notice a trend when it comes to part time students and their performance in case comps.

Orientation Camp

Yesterday marked the end of Orientation Camp for the incoming students. Unfortunately, the weather was not ideal, but that didn't dampen their spirits or enthusiasm. During our costume parties, I was glad to see several group costumes as well as some well thought out and executed individual costumes.

Roger Martin also gave a good talk on what makes Rotman different and how integrative thinking is essential from creating good MBA graduates who have something extra. He explained how he envisioned for us to become good users and creators of models and that this will help us in our future careers.

The incoming class was eager and very inquisitive into the nature of the MBA program. They took advantage of the team activities to work with each other and get to know each other before school started. I think we have a great incoming class and I’m looking forward to watching their development over the school year.

It was very obvious from beginning to end how much work the orientation committee had put into organizing the event by the quality of the opportunities for students to interact and the relationships built at this formative stage of the MBA program.

Negotiations

Classes have started a bit early for me as I've started taking negotiations this week (I had repeatedly missed this class for study tours). I've been taking this class since Sunday with the incoming Morning MBA class (apparently this is their first class that they take with FIT).

It's a fantastic class, showing you the mechanics of negotiation with the opportunity to practice your skills with your fellow classmates. A large component is experiential so I don't that it is easy to transpose the nuances onto a blog post. However, I have been told (and can understand why) this class is popular with students.

Most people would probably initially think that a negotiations course will help people "get a bigger slice", but that is too narrow a perspective. It focuses on tactics and strategies for how to enlarge the pie, how to ensure that the counter party feels like they have been dealt with fairly (even deals in which you concede a great deal of value is no guarantee that your counterparty will be entirely happy with the deal and can affect your relationship and future ability to negotiate).

London Business School - Electives

So I heard back a few weeks ago from London Business School about all the course electives I applied for and I'm happy to say that I got them all. This means that the course I put at the top of my list will also be the last class I end my MBA program on: Service Management Field Trip (aka LBS Greek Study Tour). I've read a few great reviews of this course from other blogs (as well as for the other courses I've choosen) and I'm very happy with the results.

I've just finished my last day at Scotia on Friday and I'm catching up with friends and family before starting my negotiations course in a week's time (you know, that course I kept missing because I kept going on study tours?) I'm taking it with the incoming Morning MBA class so it will be fun to meet them.

Orientation camp is the following week and that looks to be good times. The costume theme this year is super heros and I think I have an awesome idea. I might post a pic after camp is over.

I've got a lot of stuff I need to catch up on, but will start picking up regular posting again soon enough.

Flight of Fancy: What If...? A Market for Bid Points

One common theme I've heard is that MBA's are often upset when they don't get all the elective courses that they want. While I certainly can't complain, it brings up an interesting question: "What if someone like me was able to sell their bid points? What would I get for them? And how would you value them?"

For example, my course choices weren’t very restrictive, I got 500 points to bid on four courses, most of which I could have gotten with a zero bid. Whereas, Mr(s). Ambitious was trying to take TMP and Value Investing while going on Exchange (physically impossible, Value Investing is a year long course and Exchange means you are physically gone). If there existed a mechanism (and therefore a market) for me to transfer my points for a price, what would I get for them? What should they be worth? Clearly, there is currently some "market inefficiency" as we are both unsatisfied: Mr(s). Ambitious because they didn't get all the courses they wanted [net deficiency] and me because I didn't realize the full value of my bid points because I had more than I could use - [net surplus].

Well let’s make some assumptions:

• Rotman tuition is C$35k per year (let’s not include first year as it’s common, or you can adjust the value of points accordingly if you feel second year courses are more / less important)
• You take 10 elective courses in your second year
• You are given 1000 points with which to bid

A “book value” of the points would simply be C$35k / 1000 points or about $35 per point.

But keep in mind that when something is inherently useful, especially in a scenario where a few points margin can mean the difference between getting the course you really want versus having to settle for a less popular course, there can potentially be bidding wars from “oversubscription” (points trade at a multiple above their book value) especially if they were in limited supply.

While people are paying C$70+k to go to school, for a marginal $35 x 100 points (a rough approximation of the average points allocated per student / course) or $3500 you can get any course you want (including the highly coveted TMP and Value Investing – which includes a trip to visit Warren Buffet – one of the reasons why this course is so wildly popular).

If you could some how do it, you could see how much additional probability you have of getting into the classes you wanted and put a dollar value on how badly you wanted to be in that class (regression analysis), you can determine a price you’d be willing to pay to attend that class. For example: Would there be a correlation between the number of points you consumed to get into classes of your choice against your overall earning power once out of university (thinking along the lines of DCF to value bid points like common shares).

And also imagine if this market had a “market maker”. For example, the PSO will (create and) sell you points for a certain value (either regulated and pre-determined or floating with the market). Students could liquidate their points at market value and get money back or buy points of the market to be more competitive for course selection and the school could potentially get revenue from selling points.

And since you have a market with underlying assets, imagine if you created financial instruments for those assets (shorts, puts, and calls for bid points, futures).

And imagine if other schools had market systems (I’m told that bidding systems are not uncommon at other MBA schools), you could trade between these. Or even other programs!

Of course, these points would inherently have an “expiry” as to their value (you wouldn’t want to be holding (take delivery of) 5000 MIT Engineering points if you were going to Stanford Law School).

There are some interesting implications. For instance, a new ranking system for schools where the relative value of a course is determined by the market value (determined by students taking courses there) in real time with comparisons to year over year values. Example: Would an engineering calculus class go for more at Waterloo or Toronto? Could you couple this with flexibility between schools (accreditation programs) which allow students to take equivalent courses at other schools and what do you get?

It would be a more sophisticated and real-time version of tuition regulated by the market. Taken to the extreme, here is another idea: drop the original tuition completely and have students buy bid points for classes. And then what if you were able to connect this market to actual financial markets? An S&P Index of Undergraduate studies to benchmark the valuation of your individual class’ performance.

Another thought: If the value of courses in a particular faculty started to "overheat" would that be a leading indicator of oversupply of labour in a particular industry in 4 years time?

Bidding Strategy - The Mechanics

So I've been lucky enough to receive all the classes I want in all the sections I want and it turns out that LBS doesn't use a "bidding" system per say (classes awarded based on listed "preference" - an ordinal system).

A few people were asking about how my bidding formula works and while it's hardly perfect, I figured I'd put up some of the details just for laughs (or a least as building blocks for someone who plans on taking this model to the next level). It uses only public information available to all students at the time of bidding.

In this model, each course bid is determined by three factors. The first is the inital base and most people will choose one of two initial bases: Last year's minimum bid or last year's median bid (depending on how competitive the class is).

After determining the appropriate bases for your five courses, the remaining points (“the Remainder”) can be divided amongst your courses to make your bids more competitive. But like all dilemmas in bidding, you want to assign just enough points so that you get the courses you want, but not so much that you jeopardize your chances of getting the other courses. So how do you do it?

I propose that the two major factors you should look at are what I call:

1. The Ballot factor (anticipated) (x% of the Remainder, or “X-Factor”)
2. The Historic factor (backward-looking) ([100% - x%] of the Remainder, or the “Y-Factor”)

Where x% is the weight of value of your Ballot factor versus your Historical factor (In other words: how much you believe your Ballot Factor represents real bidding behaviour versus historical).

Ballot Factor:

This factor accounts for the number of people who say they will take the course. A few notes:

• People don’t always bid for the courses they ballot for
• Use the numbers as guidance to see if the course is oversubscribed
• Calculate the expected utilization capacity = total number of students balloting for any course in that section / total class capacity
• Square the utilization capacity to create an “intensity factor”
• Total all the factors and express each factor as a percentage of the total
• Multiply the percentages by the X-Factor
• The result is each individual courses’ Ballot Factor offset

Example:

• 2 classes have a capacity of 40 people each
• You have 200 points allocated to Ballot Factor
• 20 people bid on Class A (fairly certain everyone who bids will get in… There is even a chance that a 0 point bid could win) has utilization 50% and Ballot “intensity factor” of .25
• Class B has 60 bidders has utilization 150% (red flag: guarantee that not everyone will get in) and it’s “intensity factor” is 2.25.
• Class A’s weight is .25/(.25+2.25) = 10%
• Class B’s weight is 2.25 /(.25+2.25) = 90%
• Class A’s Ballot factor offset is 10% * 200 points = 20 points (a non-zero bid with decent margin, you'll probably get in)
• Class B’s Ballot factor offset is 90% * 200 points = 180 points (a strong bid, considering an average of 100)

This model tries to account for the fact that only very high bids will win the competative class, but you also don't want to low ball Class A incase a few stray bids appear from people who take the class last minute (obviously, the less people who originally bid on the class, the less you have to worry about dark horse bidders).

Note that it is 9x because at least 20 people are guaranteed to not get in the class. Classes that are oversubscribed will have intensity factors much higher than 1 with much heavier weights and undersubscribed much lower than 1 with much lower weights. This accounts for the premium on variation and intensity due to the number of bids in a competitive environment. Note that in this pure form, this is a best effort bidding mechanism with the scaling of points to consume all remaining points.

Historical Factor:

Another way to try to guess what the bidding will look like is to use the historical bidding as guidance for the variation of bids (were the bids tight or across a broad range?) One indicator of that is the minimum and median bid. If you make some HUGE assumptions, you can use these two points to create a normal curve with standard deviations. Since the mechanics of this are taught in stats in first quarter, I won’t bore my readers with a poor facsimile of Prof. Krass’ lecture.

Even if you don’t technically know the actual distribution of the curve, you can also use Chebyshev's inequality to position yourself within a certain percentile (also looking at the expected capacity utilization of the class based on your previous calculations). How? Here’s a hint (shown above): the bidding percentiles (% of students bidding that are not successful being admitted into the class) should be the same as the bid oversubscription capacity (again, huge assumptions) to provide the number of standard deviations. Combine this fact with the distance from the median to the minimum should provide a clue as to size of a standard deviation. Note that using this method, you may not (probably won't) have enough points to guarantee getting into the courses you want (unless like me, you probably have a surplus of points or are taking unpopular courses), but it is probably one of the best mechanical methods for balancing aggresive bidding with conserving points as well as building a view for what the bidding landscape looks like. In practical terms, at this point you can use a best effort model similar to the one shown above using the Y-Factor.

Also, I’ve deliberately left out methodology for mechanically scaling up courses based on your individual preferences (ie rating courses from 1 to 10 and incorporating that into your bidding strategy). Also, there are huge economic implications for bidding strategy considering that the involved parties do communicate with each other and affect the bidding levels of courses (ie Friends talk to each other about how they plan to bid). Signalling, game theory and strategy all come into play.

While not perfect, this model will give you some perspective into what a reasonable, very mechanically inclined bid would be. Admittedly, while I built this model, I did do some “emotional” adjustments to my bids (there was one course where I wanted to work with my friends on their team, so I wanted to be CERTAIN that I got the course). Like anything done on a computer, it’s just a tool.

Disclaimer: Like anything on this blog, this model does not guarantee any degree of success. This post is intended as a conversation / pensive reflection piece only. It is possible for you to use this model and not get ANY courses you want. For instance, it is physically impossible to get both Top Management Perspective AND Value Investing because both courses usually require exceptionally high bids. Note that by definition, there will be some people who don't get the courses they want. The more you want to be certain that you are in one course, the less certain that you will be in another (almost like the Heisenberg uncertainty principle). For better or worse, it is a zero-sum game.

Also, more importantly, I've been told that it's all a wash and at the end of the day, after the drop and add periods are over, most people get the courses they want anyways.

Round 1 Bidding Results

Round 1 bidding has ended, and I got every course I wanted in all the sections I wanted. This should come as no huge surprise. I only had to take 4 courses, had a full 500 points and selected courses that weren't very popular / had low bid requirements. I also changed my bid. Rather than bid on Options, I decided to do Case Analysis and Presentation, an intensive course, with a team I think is mostly JD/MBAs who wanted a finance person on their team so I happily joined. I'm hoping that I can overload to take Options as well.

I've heard others were not so lucky. Quite a few people I know (a small non-scientific sample) did not get the courses they wanted or had to get slotted into a different section. I'm guessing this is because they bid for highly competitive courses which cost something absurd like Top Management Perspective (TMP, for 452 min to 548 median) or Value Investing (between 340 min and 360 median). This is in the context of being allocated an initial 100 points per course and with some courses going for 0.

Top Management Perspective is highly coveted (especially by would-be consultants) because there is a lot of meetings with CEOs and other top execs. Value investing is popular because of the annual trip to see Warren Buffet (Caution for anyone interested in this course: The trip could potentially be cancelled at anytime if you notice and read the fine print). Many people I know take Value Investing so that they can "get a photo with Warren that they can use in their promotional material when they start their own hedge funds".

On a modeling note, I'm pretty happy with how my bidding model worked. It predicted that certain courses would be over subscribed and calculated a premium factor for how to bid. For instance, Corp Fin, a normally non-competitive course (three sections of 33 people each), had a minimum bid of 50 (historically 0), meaning that some people were excluded. That means if you mis-read the historic bidding data and thought that you could save some points by bidding 0 (a common strategy for people saving points for TMP and Value Investing) you would have been left out in the cold. I'm thinking of posting my bidding formula later for calculating bid premiums for courses. I'd make some tweaks so that the formulas can be for more general use by students. It benefits everyone if we bid economically rationally.

Electives Bidding Close

Today at 1 pm was the last chance to get your bids in for Round 1 of elective course bidding for next year. I put together a pretty neat spreadsheet (as I'm told MBA students do every year) to mathematically calculate what I should bid based on points available, course competitiveness and my desire to take the course. Results should be released later this week in advance of Round 2 of bidding which happens next week.

Also, I've selected my electives for LBS and have applied to take certain courses. There is a bit more to the process as they want you to have taken Capital Markets before you can select finance courses, but I'll have taken that by the time I get there. Read a few blogs on students going to LBS on exchange from different US schools and their experiences. I must admit, it has shaped my course selection.

Bidding for Electives Begins Today

Bidding for elective courses in second year began today. I'm happy to report that I still have 500 points to bid (the rumor that I lost points for study tours is apparently untrue). However, I only have to take 4 courses this term (maximum and minimum). I'm trying to bundle them together all on Tuesday, Wednesday and Thursday so I can have a four day long weekend every week (and so far it seems possible).

I'm thinking of taking all the core IB courses in one go (so I can concentrate on electives at LBS) including: Corporate Finance, Financial Management, M&A and Options and Derivatives. Considering the sessions (date / time / profs) I want, I will have plenty of points (some courses requiring as few as 0 points).

I just need to confirm my selection with a few friends before placing my bid. Bidding ends one week after the open.

First Year Final Grades Released

Grades from our Q4 classes were released today. While most students felt like this was the toughest batch of courses, I think that the grades panned out as they usually do (some up, some down, class wide aggregate average change of zero). I myself had flat grades (no significant change from previous).

Investment Banking and M&A - Scotia Capital

I returned from the Latin America Study Tour very early this morning. After filling up on Chinese food at lunch and running a few errands throughout the day, I'm finally settled at my new place.

Tomorrow, I'll be starting as a Summer Associate, Investment Banking and M&A at Scotia Capital. I anticipate being very busy and will also not be putting up any posts until I return to school in late August (probably with a post from MBA Orientation Camp).

So far, the CFA / MBA journey has been an exceptionally rewarding one and I am really looking forward to what challenges await in the summer and the opportunities of the coming year.

PREVI

[LAIST Tour Begins, Fazenda Tozan, Churrascaria – Nova Pampa, Port of Santos, Deloitte, Embraer, Natura, Gol de Letra, Bom Bril, Agencia Click, Nextel Institute, May 6, Rio, Rio Weekend, Petrobras, PREVI]

Previ is Latin America’s largest pension fund (34th in the world) and manages funds for Banco de Brasil employees. They have R$142 AuM where the 10 largest pension funds (including themselves) have less than R$300B and the entire industry is estimated at less than R$500B. They have the following allocations:

Fixed Income: 31% (max 100%)
Equities: 63% (max 70%)
Real Estate: 3% (max 8%)
Structured Investments: .54% (max 20%)
Investments Abroad: 0% (max 10%)
Loans to participants: 3% (max 15%)

The interesting story here is that they currently have zero exposure abroad (or 100% domestic exposure). They only recently made a change such that they could invest a maximum of 10% of their assets in foreign countries and will probably be looking in the future to find good investment opportunities abroad.

They currently benchmark against the IPSA (indexed to inflation) and look for a +5.5% spread (usually ending up at a hurdle rate of 12.6%). They currently earn through the common 2/20 model, with a 2% management fee and a 20% performance fee for every dollar earned above the benchmark.

Being a pension fund, they prefer low leverage as there is plenty of volatility in the Brazilian markets. Their high (63%) exposure in equities is a result of their heavy investments in certain Brazilian companies and their lack of asset reallocation (doesn’t make sense at the moment for them to divest from large or controlling positions).

However, their corporate governance focuses on how they manage investment decisions to focus on dividends as a cash flow, investment rates of return and the liquidity of their positions. They also try to make investments in sectors which are a priority for developing Brazil’s industries in general including Structured Investments in Private Equity and Venture Capital as well as infrastructure such as the metro, roads, rail, sea ports and airports.

They even presented a case study on Vale. In 2001 Vale was in rough shape. The company needed a corporate reorganization as the financial performance was weak and less than expectations, they lacked strategic direction and transparency. In a move of shareholder activism Previ (similar to what OTPP did with Petro-Can last summer) shook up the corporate structure and took at 14.4% stake in the company.

Previ focused the restructuring of Vale on different strategic horizons. Horizon 1: lead in iron ore and expand capacity in pellets. Horizon 2: Global prominence in bauxite and alumina, growth though exploration, acquisition and joint venture and develop logistics networks. Horizon 3: Acquire non-ferrous businesses. Since these changes, Vale has traded at a spread over the IBovespa index, earning a return from 2001 of 412.02% beating the index’s performance of 54.91%.

This also brings me to the original point of my interest in the study tour. In the current economic market place, it becomes increasingly difficult to be insulated from the world economy and to be truly domestic. In the Vale example, while Previ doesn’t officially have investments in foreign companies, Vale does, having recently acquired Inco from Canada. Their commoditized products, namely iron ore and nickel, also trade on the international market. So while Previ doesn’t officially have foreign investments, they are not insensitive to the global macroeconomic conditions.

The example I’m always given is a company like IBM, where although they may be a US company, they have clients around the globe so they actually have exposure to international markets.

Petrobras

[LAIST Tour Begins, Fazenda Tozan, Churrascaria – Nova Pampa, Port of Santos, Deloitte, Embraer, Natura, Gol de Letra, Bom Bril, Agencia Click, Nextel Institute, May 6, Rio, Rio Weekend, Petrobras, PREVI]

Petrobras is one of the top oil producer, refiner and associated industries company in the world, headquartered in Rio de Janeiro. They are currently 55% owned by the government (representing 1/3 of the total equity of the company) with the government owning a golden share (similar to Embraer and Vale) which allows the government the first right of refusal on various governance issues. Looking at massive capitalization, Petrobras is considering issuing more of their stock which is currently trading at a PE of 10.5x with an industry benchmark of 10x.

However, with Petrobras in the midst of heavy capitalization which begs the question of whether or not they plan to maintain this government owned model if they decide to continue to raise capital in the public markets. Currently, they command 14.17B boe and their major costs are their appraisal costs in exploration and their production costs split between lifting costs and government costs. The current extraction price of oil is an attractive $24.74 USD with a $9.51 lifting cost and a $15.23 government cost.

Petrobras is currently seeking to drill for oil in more extreme depths than it is currently operating at looking at their Presalt projects (projects similar in nature to Canada’s oil sands in that they are looking at unique locations with which to extract oil). When asked if this will increase their lifting costs, they remarked that they initially expected costs to rise as much as 20%, but have since revised that number to be equal to or less than current costs as a result of the economies of scale through automation.

However, it is not without challenges. The new oil sites will be 300 km out from the coast line where the traditional helicopters used do not have enough range, requiring them to purchase new types of equipment. They will also require hubs as jump points to the new rigs to store inventory, food and maintenance equipment. There are also implications for transport of product back to shore.

There are also new changes expected in the regulatory model they use. Currently, they are using a concession model, but may possibly switch to a production sharing agreement where companies bid and allocate a percentage of the oil profit to the government. The strategy for some of these companies (example those in China) may have a strategic benefit to bid higher (as a strategic buyer versus a financial buyer) in order to gain access to the oil reserves (the story I had come to investigate, the effect of a resource race on international business relationships) producing a sort of vertical integration which would technically remove a double bottom line (an idea thwarted by the financial theory we learned in Finance II but revisited in Managerial Accounting). The current rules for bidding are that at least 30% of the profit must return back to the government, and the government can refuse bids which are not economically viable (allocating too much of the profit to the government and overbidding for the resource) and Petrobras continues to dictate what technology is used in extraction.

Another interesting relationship they have with China is through the Chinese Development Bank where they have procured a $10B loan, $3B of which is executed through a barter system of trading oil for products. However, apparently China’s new policies with trade throughout the world are stepping on a few toes as they are generally changing their strategy such that they don’t want products from the rest of the world, but are continuing to export to partners. However, a company like Brazil (and Canada) wouldn’t be interested in just exporting commodities without developing their own industries which causes some friction in the business relationship.

When asked why they don’t just acquire refineries as part of their strategy, they mentioned that it is really expensive to do, that complex regulations make it difficult and that retrofitting or upgrading their a rig to increase capacity is generally not financially viable.

They prefer to make an entry via a joint venture with partners to explore new reserves in different geographies. Once a discovery is made they also prefer not to be an operator in these locations.
Also, in some countries like Argentina, where the regulations are about to dictate the price of oil, the financial viability of projects in the region become unattractive (a very subtle and modern form of expropriation) and companies in that region are generally looking to divest operations in those markets as capital continues to flee Argentina.

With Brazil having a leading role in the development of bio fuel (Ethanol), Petrobras explained how they could create bio fuel efficiently from sugar cane with an Energy Out / Energy In ratio of 8.3, beating wheat at 1.2, corn at 1.3 to 1.8 and sugar beet at 1.9. They use their Petrobras Research Center, the largest in Latin America, to focus on three development goals: Expand limits (exploration), Enhance Product Mix (new product techniques) and Sustainability (CO2 production, H2O management and energy efficiency). One example of a project they are working on is 2nd generation bio fuels, where they use a special enzyme from biomass byproducts to create more ethanol.

[LAIST] A Weekend in Rio de Janeiro

[LAIST Tour Begins, Fazenda Tozan, Churrascaria – Nova Pampa, Port of Santos, Deloitte, Embraer, Natura, Gol de Letra, Bom Bril, Agencia Click, Nextel Institute, May 6, Rio, Rio Weekend, Petrobras, PREVI]

Saturday in Rio – Christ the Redeemer

We had planned to visit Sugar Loaf Mountain, but the conditions were not appropriate for a visit so we ended up going to Christ the Redeemer. We also picked up some supplies for the soccer match the next day. We also got a chance to check out the local night life.

Flamengo versus Sao Paulo

Our guide took us to a soccer match at Maracana between Flamengo (the soccer club with the second largest fan base, second only to Manchester United). As we were walking to the Metro station, already half a street away from our hotel and decked out in Flamengo gear, we were being heckled by a Sao Paulo fan.

We were certainly sitting in the right section as there was almost as much entertainment behind us as there was on the field. The fans are passionate, cheering through the entire game non-stop and waving their massive flags. While we didn’t understand the Portuguese cheers, we shouted similar phonetic sounds while mimicking the same motions.

While the game ended in a 1:1 tie, it was certainly an experience to be there when the team scored a goal (as well as each time there was a “controversial” call). I can understand why this experience and culture would be described as a “religion” by our guide.

[LAIST] May 7th Visits – Rio de Janeiro

[LAIST Tour Begins, Fazenda Tozan, Churrascaria – Nova Pampa, Port of Santos, Deloitte, Embraer, Natura, Gol de Letra, Bom Bril, Agencia Click, Nextel Institute, May 6, Rio, Rio Weekend, Petrobras, PREVI]

Upon arriving at Rio late at night, we made a quick reconnasance of the area before calling it a night. The next morning, we were up and ready to go to our next set of meetings.

TV Globo

TV Globo is the largest group of media and entertainment companies in Latin America. They are focused on TV and entertainment, print and media and radio; telecommunications and distribution.
Because of their influence on the Brazilian society, they have been playing a unique role as educator. Although Brazil has language unity, there is a great deal of cultural diversity which plays a unique challenge to media broadcasters. In a growing economy, Brazil’s newspaper readership has been growing rather than falling, primarily because of the growing C class (lower middle class).
Brazil is divided into a class system (not well explained if it is a formal or informal class system – need to look into this more) where there are A1, A2, B1, B2, C, D and E rankings.

TV Globo mentioned that infrastructure remains the biggest challenge for Brazil, not just in terms of roads and rail, but rather in education in the form of schools and labs for students to learn.
TV Globo uses their Tela Nouvella’s (sophisticated versions of soap opera’s) to address social change. They often hire sociologists to address social issues that are currently on the minds of Brazilians addressing topics such as racism and . They treat this service as a charitable non-cash forgone revenue expense.

Vale

The next presentation was at Vale (recent acquirer of Inco) the largest producer and has the most reserves of iron ore in the world (2nd largest resource producer in the world). Their business is 35% based in iron ore, demonstrates stable demand and has recently successfully moved from a yearly pricing model to a quarterly pricing model.

We had a talk from a political analyst two was describing the broad range of international investments of Vale in different parts of the world including Asia Pacific, South America and Africa.
In the crisis period, 38% of their revenue was from China, their number one client, who was previously only accounting for 17.4% of their revenue previously (number one position in the past also).

The cycle for mining is usually 3 to 8 years for exploration followed by licensing and 4 to 5 years to open and build the mine and infrastructure required to develop the mine. Their required IRR is 12+% and they have 12 golden shares held by the government (similar to Embraer).
One of their largest challenges is relocating indigenous people, developing infrastructure and developing communities at mine sites. Once a mine’s resources are deleted, there is a large outflow of business which can potentially decimate at geography, so Vale is careful to build a legacy plan and invest in the community remain stable after their exit including schools and diversified industry.

Brookfield Brazil

Next we had a talk from the CEO of Brookfield Brazil, an asset management company with $100B USD AuM and $22B invested capital. They talked about the macro factors affecting investment in Brazil including the allocation of 4% of Brazilian GDP towards social development, allocating resource surpluses towards financial deficits versus social deficits and the challenges of moving from an “artificially fixed exchange rate” to a floating rate.

He also mentioned the rebirth of the consumer class in Brazil, or the so called D and E class to the C class and how Brookfield was capitalizing on commercial real estate development. Their strategy is to invest in tangible assets where there are high barriers to entry, predictable long term cash flows and they prefer to be operators rather than passive investors.

Their IRR is 12% and they tend to focus on quality of investments rather than increased marginal returns. Their strategy allows their mall properties to command the same sales per square foot as comparable US malls. The mall model is different in Brazil than what we are used to in NA. Rather than have high city density where consumers drive to malls or super centers in sub-urban areas, Brazil malls tend to be in the city, with high density, vertical and paid parking (a surprisingly large 12-15% of mall revenue) and demonstrate less dependency on large anchor stores (such as Walmart or Sears). Consumption growth is currently well above the GDP which is having a large effect on the financial and economic strategy of the country.

With their high 16.7% Tier 1 capital ratio in Brazil allowed many Brazilian asset management firms like Brookfield take advantage of depressed prices in the market as a result of the recent financial crisis. They prefer to avoid higher leverage, look for quality of earnings and a high level of liquidity which allowed them to take advantage of special situations.

With the acquisition of many new properties, they have boosted their CAGR to a whooping +119% (keep in mind that this is a result of massive acquisitions and actually investing more of their AuM). When investing, the look for different partners including: Institutional, sovereign, pension, endowment and family funds. We were told they were partnering with 2 Canadian Pension funds, 1 Asian sovereign fund and 2 European family offices. You can probably guess who the Canadian and Asian sovereign funds are.

They prefer partners who have the same market views and investing profiles: long term, stable predictable growth and high cash positions and liquidity (all attractive makings of a proper pension fund investment).

They also have a unique array of investments, including agriculture. They raise cattle as one of their primary investments and follow their operator strategy. What does this mean? They may be one of the few companies where cowboys who work in a company which complies with Sarb-Ox and is audited by Deloitte. The work environment creates a unique culture.