Sunday, January 18, 2009

Corporate Finance - post crisis

I just finished teaching my first corporate finance class in the post-crisis period (to an executive MBA class). Having taught this class for close to 25 years now, I was wondering how I would bring in the events of the last few months into the sessions and be able to draw out the implications for businesses. I must confess that it was a lot less trying than I thought it would be.

In broad terms, these are the corporate finance implications that I see for the near future and the long term:
a. In investment analysis: I see a shift away from expected value and base case valuations that have dominated financial analysis for the last few decades to more probabilistic approaches. Since both the data and the tools (Crystal Ball, @Risk etc.) are accessible and available now to most of us, I think this shift is long overdue.

b. In risk and hurdle rates: For the near term, I see a move towards higher risk premiums for both equity and debt, reflecting recent history and changes in risk aversion. In the long term, I think that we have to become more dynamic in our assesments of risk parameters and premiums, since the assumption that these numbers don't change much has clearly been shaken. Put another way, we have to accept the fact that risk premiums can change quickly even in developed markets and even more so in emerging markets.

c. In capital strucure: If debt represents a trade off between tax benefits on one side and expected bankruptcy costs on the other, the last few months have clearly tilted the scales away from the use of debt. The probability of distress and the cost of distress have both increased, particularly so for large companies where the notion that capital markets would provide needed funds is no longer universally accepted. I expect to see debt ratios decrease as companies retool and a less cavalier use of short term financing to fund long term assets.

d. In dividend policy: In the short term, companies will value liquidity and cash balances will go up. In the long term, the events of the last few months will make companies even more wary about instituting and increasing dividends (because of the instability and unpredictability of earnings) and I would not be surprised to see even more of a shift towards flexible cash return policies (stock buybacks).

I feel more confortable now, going into the new semester. I don't have all of the answers but I feel that I have a framework for approaching the questions. The 450 students in my class will put me to the test and I am looking forward to it. You will have a ring side seat.

14 comments:

Manish said...
This comment has been removed by the author.
gopi kumar v said...

Sir,
As per the final point ie dividend policy of companies you expect companies to retain cash in the short term for liquidity reasons. But in the aftermath of the Stayam saga in India, do you expect companies especially software companies to pay higher dividends to instill confidence in their cash balances and corporate governance practises.

Теймураз Теймуразович Вашакмадзе said...

If companies would decrease debt ratios and risk premiums would increase it means that there will be decline in capitalization?

evileconboy said...

Probabilistic approaches are all well and good, but to what end? How do you calibrate the a level of tolerance?

In CAPM, we already have the risk premium assumption to cover market risk (which is historical) and which should already cover the standard deviation which a probabilistic model would test.

So what are we adding really with a probabilistic model? 2 years ago, X% deviation was acceptable, but now much less is acceptable. How do we tell the two apart?

Sanjiv Barve said...

Sharp increase in Equity risk premium and default spread means increase in Cost of Equity as well as debt and finally Cost of Capital. Economic slow down means direct adverse impact on cash flows and profits. Companies earning positive EVA will suddenly become negative EVA businesses; although their competence, capabilities and character mostly has remained in tact. IS EVA as a performance measure or value enhancement tool or Residual Income Valuation relevant in this situation? Or should we consider EVA as a product of bygone era of economic prosperity?

Sam said...

Very useful materials and information about Corporate Finance. Great topic for writing Finance research papers in college.

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