Principles of Finance: Unit 8, Mitigating Risk

Stressed companies seek to reduce risk. What are some ways risk - especially in mergers or changed capital structures like taking on tons of debt - can be mitigated... without having to do a deal with The Devil.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:25

while it reduced the price five percent of the engines and pre-sold a forward

00:29

ten years worth of jet engines to Boeing or whoever well the result was a great [jet engine with 5% off tag]

00:34

partnership that took all of the exogenous stress out of the very

00:38

difficult task of building jet engines let alone building jet engines when the [man building jet engine]

00:43

seller didn't know whether or not there'd be any buyers of the engines by

00:47

the time they were finished years later but in this Blade Runner nano drone LBO

00:52

well you have a consumer item with fickle consumers in a highly volatile [toddler screaming]

00:56

non must-have area like you think about must-have products like milk and clean

01:02

water and heat and you rationalize Netflix but that might not fly with [woman watching netflix]

01:06

partners reviewing your case well nano drones are not must-haves

01:10

neither are blade runner's so if the whole world stopped buying them well not [man sleeping]

01:15

much would change so what can you do to mitigate company risk here is there an

01:20

advance ten years or even three years forward buyer in the GE Boeing vein who

01:25

could pre buy and say a million units so that they had them for ten years well it

01:30

would guarantee at least locking in most of your production costs and leave

01:34

upside to the base case set of free cash flow numbers what deal with the devil

01:38

are you going to do with an advanced pre-sale like this like what terms would [woman sitting beside man with horns in fire]

01:43

you have to give while having never done one before in your vast 27 years of life

01:48

even the voice in your head is queasy thinking about that notion but hey you

01:52

say it's worth exploring anyway so through your partner's rolodex system a

01:56

big part of your value-add as a private equity shop you get to the buyer at

02:00

Walmart she knows your product and well it isn't even yours yet but if it were [woman answers phone]

02:05

you posit how might Walmart think about pre purchasing for ten years forward and

02:11

yeah it's a combination of laughter and [woman laughing on phone]

02:13

wonderings that somehow reality TV is taping the phone call so you hang up

02:18

with Walmart after she does there's no tenure advance by risk

02:22

mitigating partner in that form in the future of be rnd ain't gonna happen but

02:26

you know that's Walmart kind of oldie worldly debt but what about Amazon yeah

02:31

well that call goes a bit differently Amazon actually thinks drones are a [woman gasps on phone call]

02:34

great seller and that they'll be around for a long time Amazon actually uses

02:38

drones to deliver their crap all over the world so they really know the

02:42

industry and the technology and they actually really like your idea and you

02:46

get excited and then Amazon asks if you could make them a million units and your [woman bouncing in excitement]

02:51

head is almost ready to explode and then Amazon finishes the sentence for five

02:55

hundred dollars or less each so the earth stops again you look at BR n DS

03:00

various unit pricing lines and quickly realize that at five hundred dollars a

03:04

unit well the company would make about ten dollars per unit and have to sell

03:08

like super quadrillion of them just to equal the amount you were making by

03:13

selling them on your own off your own website so without making eye contact

03:16

you stare at the ground and slowly back out of the Amazon room in Seattle and [woman walks away]

03:21

fly home more questions you mumble other than pre-selling what else could you do

03:26

here to mitigate risk well what about OMA or original equipment manufacturing

03:32

drones to be private labeled for Apple and low margin a la Amazon you mumble

03:38

correctly at $500 a unit this whole deal isn't worth doing and they'll

03:42

cannibalize most or all of the $2000 sales you rely on for profits to drive [drone appears in amazon search bar]

03:48

the business forward is there an overseas player to pre-buy

03:52

like to co market / share marketing costs you know the way movies and

03:57

McDonald's or coke team-up mmm well no nothing obvious Europe they're not that

04:02

crazy about drones we are here well you spend a [drones exploding]

04:05

mind-numbing set of brain cycles trying to figure out how to answer the oldest

04:09

firm partners question when he undoubtedly will ask about reducing risk

04:13

and you keep mumbling about this problem if you stand in the corner of the giant [woman mumbling in room of people]

04:17

hallways of the San Jose Convention Center which is hosting drone world over

04:22

the phone you chat with your secretary and are overheard to have said I have to

04:26

figure out a big way to cut costs if nothing else and then a man confronts

04:32

you he's smoking a cigarette indoors here as he leans on the no smoking sign [man smokes cigarette]

04:36

I got you he says he nods walk with me and zombie-like you do this is normal

04:41

behavior for geeky convention goers you want cut costs I have way you're in with

04:46

drone maker right and you not yes and he says guidance system I have one just as

04:51

good one fourth price you license big you have big really can I see how it [man discussing guidance system]

04:56

works what do you have he nods over to my booth and way over in the far corner

05:01

there's a tiny booth you don't fear for your physical safety but someone clearly

05:05

did not get the no-smoking memo here as his partners jump back when you approach [men smoking in booth]

05:09

from the clouds they're making well he opens the guts of a guidance system you

05:14

spent enough time with blade runner's guts in this lbo process to know the

05:17

layout your electoral engineering major in college also helped the non bloody [electrical engineering certificate on a wall]

05:22

drone guts you're staring at seemed eerily identical to those of blade

05:27

runners yeah some foreign lettering stamped above them is that Chinese

05:32

Arabic Russian well one of the smoker man's partners asked you about batteries [smoking partners smoking in booth]

05:37

they can make those also at 1/4 the price and as you're taking all this in

05:41

you mumble how's that and you hear the phrase gallium arsenide and there's a [woman mumbles]

05:46

crushing blade that feels like it's coming down on the paper work cycles

05:50

you've put into this LBO these guys clearly steal the electronic

05:55

architecture of guidance systems and make them cheaply overseas with what [person building guidance system]

06:00

looks like prison labor and yeah you note on the little notes scrawled on the

06:04

side of the drone casing saying help get me out of here with GPS coordinates on

06:09

them as well these guys then apparently sell product for less and just in case

06:13

you didn't hear clearly well you asked them to repeat in broken English you

06:17

catch it clearly the second time gallium arsenide

06:19

equals arsenic equals poison that's how they make the baseboards and structured

06:24

semiconductors for the guidance system so cheap

06:28

they itch silicon with arsenic poison and well just dump it in the river and [silicon etching with arsenic]

06:32

as you imagine the three headed children down river in some foreign country [woman appears with three headed baby]

06:37

you've never visited or maybe even ever heard of you hand the guidance guts back

06:42

to the smoker and beat it out of there with a flurry of questions at costing

06:46

you is this gray / black / stolen market a big part of the drone world there in

06:52

the back corner here so it can't be that big can it would be would they sell to [smoke appears from corner of room]

06:57

Amazon on the five hundred dollars a unit deal is there anything I could or

07:00

would do about it if I called the cops what would happen why didn't I go to med [cops talking on the street]

07:05

school well the bottom line is that it sounds like there is simply no real

07:09

ethical way to mitigate risk in this deal so what does that mean to the math

07:13

of the financial engineering bigger discount rate on the discounted cash

07:16

flow model remember that thing that you'll put together for your partners [man discussing cash flow model]

07:20

well the last dying embers of risk mitigation are about just having an exit

07:24

door ie someone to sell the whole company to and this is a very bad

07:28

alternative when you have a lot of debt if things should not go well three years

07:33

in you might still have 750 million dollars of debt in a company whose total

07:37

value declined say 40 percent from the one point three or four billion it

07:42

started at and in that case on a sale of 750 million bucks well the only ones

07:46

made whole are the banks which loaned the lbo the money that equity piece [piggy bank forms back to normal]

07:51

remember the hundred fifty million that you put in and then also the hundred

07:55

fifty million that management put in yeah that'd be worth gonzo zero nuked

08:00

well what do you do then hint it rhymes with driving for shmoo BRR [woman driving car and man in the back appears smoking]