A personal summary of Finance as described and argued by John Becker

Table of contents: (All hyperlinks)

Section 1 What is the goal of Finance?

Sweet’s view Personal view

Section 2 How do we accomplish this goal?

Value Vs. Risk and how they balance Tools of finance and their implementation Value process and how discount rates are calculated Examples of why these tools are necessary

Section 3 The faults and prospects of finance looking forward

Grantham My thoughts on Grantham Lo My thoughts on Lo

Section 4 Final thoughts and conclusions

Do I believe that Finance as a field can fulfill the goals presented in this paper? Sources of research

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No mom, Finance does not mean “money”…

Sweet’s view: Professor Sweet has a ton of knowledge and experience in the field and theory of Finance. He told me that his view on the goal of finance is to Increase expected value, reduce expected risk or some combination of the two; it is a constant balancing act. In his opinion you accomplish this by using financial information, financial tools (that will be showcased later in this paper), models (also will be demonstrated), demographics, and tons of worldly or local news. You use these resources to try to implement the best solution you can to an enterprise problem. When Professor Sweet talks about the balancing of Value and Risk he defines Value as Expected future cash flows and Risk as possible deviations from these expected cash flows. In finance he states “you want to be paid to take on extra risk. If you are not being paid to take on extra risk you do not take that risk, and if you are being paid too much for the risk you’re taking then you take as much as you can get.”

Personal view: I have no objections to what Professor Sweet has to offer on his idea of what the goal of finance is. I agree with many if not all of the statements that he makes regarding balancing risk and value, using information, tools, and models to help you make these decisions. I also have no objections of his idea of being compensated for risk, and knowing when to be risk averse. I would however like to take a moment to tell you what I believe the goal of finance to me is in the essence of Application. I think that finance is a wonderful tool that can be used to determine a good decision from a bad one in many more ways than just wise investments. I like to think of finance as a way of making sure you are never getting undercompensated, and never making decisions before critically thinking. Finance has a lot to teach and offer a student other than just how to turn value in my opinion.

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Section 1: What is the goal of Finance?

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Value vs. Risk and how they balance:

Value to me is understood as return on investment or return on future cash flows. As in if I give 5 dollars to a friend and tell him that I would like 6 dollars in return tomorrow, the one dollar difference is a cash flow I expect that will increase my value.

Risk on the other hand is the possibility that I will miss the mark on the expected return or “deviate from expected return” on the capital that I invested. So using the same example above, if I think that my friend will not pay me back the 5 dollars, or the six I was asking for (more on that in a second) I’m taking on a risk that I will not receive the expected cash flow.

The Risk and Value of an investment balance each other. When I loaned the 5 dollars to my friend for a day you notice how I did not ask him to pay me back 5 dollars, but instead required 6. Why is this? Well when I decided to take on the risk of him not returning me that future cash flow I wanted to be compensated for that risk, so I increased my value. So the relationship can be roughly deduced as Risk and Value are positively correlated.

This correlation of risk and return is not something new, Harry Markowitz in the 50’s developed a visual representation of the relationship of Risk and value with his model The Efficient Frontier.

This model tells us that as Value (Y axis) becomes greater, the Risk (X axis) also increases. If you think about it, it is fairly intuitive right? The riskier something is, the more you want to be compensated. But this is not all this model tells us, it also theorizes that investments cannot fall far from the curve of this relationship. If you have an investment that has low risk the demand of that investment will rise, causing price to rise, decreasing your value. Alternatively if you have a high risk investment no one will invest in it unless the price is low so they can increase their value.

The curve of the efficient frontier creates Two zones; above the curve, and below the curve.

Above the curve you have high value with low risk, so this is known as an impossible or highly improbable zone because the efficiency of markets, if an investment is found in this zone everyone will want that investment, causing demand

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Section 2: How do we accomplish this goal?

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to rise, increasing price, and ultimately lowering value.

Below the curve you have a situation where the risk is high, but value is low, meaning there are alternative investments that will give you more value for the same risk out in the market so no one will want to stay in this zone. Demand will drop for that investment, causing price to lower, thus increasing value.

So as you can see no matter what the situation all of the investments in the market naturally pull towards the curve of the efficient frontier.

The most important tool of finance:

Professor Sweet argues that the most important tool of finance is the discounted cash flow (DCF) model that is used in almost every application of finance. I agree that DCF models are of the utmost importance, but why is this model so important? Well in short my opinion on the matter is that without discounted cash flows you are stuck in the past. You cannot forecast any financial decisions with ought DCF’s.

The world does not think in Future dollars. If you go up to someone and ask them how much their car cost them, they are not going to say “it cost me 5 thousand bucks in 2045 dollars.” They will tell you what they bought it for in today’s dollar value.

This means that if we want to relate the value of future financial decisions to what is going on in the world today, we

need to discount those values (future cash flows) for the horizon of that investment.

Corporate finance in my opinion showcases how powerful a discounted cash flow can be. Let’s say your boss comes to you with a project:

I f y o u d e t e r m i n e t h a t t h e r

investment is roughly 8%, meaning that you require 8% return on your invested capital because of risk you’re taking with the investments, what is it worth today?

Well if you use the formula for discounting cash flows;

You can plug in your values and

determine that the present value of project A is;

Now you can go to your boss and

tell him if you decide to proceed with the project you should be paying 1 million dollars to make 1.361 million dollars, thus making $361,000 profit. Figuring this out was all thanks to discounting cash flows. By discounting the future value by the amount of risk we believe we have assumed we can now determine if an investment is going to add value or not, which leads me to the next topic of discussion the Value creation Process.

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Discounted Present value = Future value / (1+interest) years invested

Project: the project will gain you 2 million dollars 5 years from now, but will cost you 1 million dollars today. Is it worth the investment?

2 million / (1+.08) ^5 = $1,361,166.39

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The Value Creation Process:

The value creation process is a five step process that you go through when determining what the value is of a financial decision, or to value a firm. It is only five steps so it would seem simple, but this is in my opinion probably the most difficult thing to get right in financial analysis.

Step one in the Value creation process is to project future cash flows by looking at things like company growth, past performance, or even the performance of comparable companies.

Dr. Damodaran talks in one of his papers written for NYU that forecasting cash flows is harder than just looking at past free cash flows and adjusting for a growth rate. He talks about how there are tons of factors you should look at to make proper models such as, magnitude of growth, competitive advantages, length of extraordinary growth, and a very important concept of choosing the right period of estimation. The period of estimation should not be a period which cannot be logically attributed to the period you are trying to forecast for. (You cannot choose to start a historical analysis in a period of a recession if you are not currently in a recession and vice versa.)

Dr. Damodaran goes as far as to state in his article that “he found little evidence that firms that grew fast in one period continued to grow fast in the next period.” Meaning you should never just assume that because a company had good growth in the last period that they will have similar growth in this period, especially if

you’re considering earnings growth. This number is subject to a lot of change and would be better replaced by revenue growth, because it is a much more predictable number.

After you have forecasted these cash flows to the best of your ability however you then must discount these cash flows by a rate called the Discount Rate which we talked about earlier to account for assumed risk.

If you thought getting an accurate account of forecasted cash flows was difficult, predicting an accurate discount rate is even harder, because so much information and consideration must be factored into this rate. Does the company you are looking to invest in seem to be doing well financially? Does the market as a whole seem like it is stable or sustainable? WILL A TORNADO CRUSH THE BUILDING WHERE YOUR COMPANY HAS ITS HEADQUARTERS? It may seem crazy to consider the fact that something uncontrollable could happen to your investment, but you need to consider that and more when you are deciding what sort of risk you are taking on by investing in a certain security.

In this paper I am going to discuss how to calculate the discount rate using Weighted Average Cost of Capital (WACC). The WACC looks at the cost of Equity for a company and the Cost of Debt.

Cost of Equity: The cost of equity is in theory what it will cost a company to keep a stable share price. The formula used by many to calculate this is CAP-M or

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Capital Asset Pricing Model.

The Risk free rate (Rf) is the return you could get if you invested in a zero risk investment (usually just the interest rate on a US Treasury bill or bond.)

Beta is a measure of how the company moves in relation to the market. A beta of greater than one for instance would mean that when the market moves any direction the company should move even more in the same direction. If the beta is less than one, it means the company does not get affected by the market movements as much, so if the market moves 1% the company should in theory move less than 1% in that direction.

Beta can be calculated by taking a period of closing prices of an index that represents most of the stock market (such as the S&P 500) and then taking the closing stock prices of the company being measured for the same time period and placing all of their returns in Excel and doing some simple formulation.

If you compare the covariance of the returns of your stock to the covariance of returns of the S&P and then divide them by the Variance of the S&P returns you will get your beta. You can also use a slope function by setting the return values of your stock as the Y axis and the S&P stocks as the X axis. This can be graphed to give a visual representation.

For Example here I compare CST (Cornerstore stock to the S&P 500 to get a beta of .7422)

Market risk premium is a much harder figure to get exactly right so I decided it might be worthwhile to go get some extra insight into what professionals and scholars thought of calculating this number.

Dr. Brian R. Korb a PhD, CFA, CFP professor of finance at the University of Texas at San Antonio talked with me about how to calculate Market return which is a large component of Market risk premium, and he told me that his preferred method of calculation is the historical method, and he stated that it is very important that when you look back at historical market return you should make sure the period you use to find the average return is as perfect as you can be. As I stated earlier in this paper you do not want to compare

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Cost of Equity (Ke) = Rf + Beta (Rm-Rf)

Where Rf = risk free rate and Rm-Rf = market risk premium

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figures during a recession to figures in economic growth.

I also talked to Professor Carl Larsson, a Doctoral student at the University of Texas at San Antonio who teaches a corporate finance class. He stated that when you are calculating market return it is fine to use historical return and made a lot of similar statements that Dr. Korb did, however he wanted to add that when you do get the assumed return, the accuracy of the rate is important, but will never be perfect, so you should run a sensitivity analysis to make sure that a good return benefits outweigh bad return losses.

Both of them made very good points, but both of them seemed to make a point that looking at historical market returns is a good way to estimate what the future market return will be for an investment. So for example purposes we will go with the historical method (sorry professor I know the world is moving away for the historical method.)

So to calculate the market risk premium you would look at what the return on the market has been for a period that you think would mirror the horizon of your investment so let’s say you determine it is 7%. After you get the return of the market you need to subtract what the risk free rate of return is (let’s say 2%) so your market risk premium is 5%.

Now that you have done all this work to find your Beta and Market risk premium you can calculate your Cost of Equity. With a beta of .7422, a Risk Free rate of 2% and a market risk premium of 5% you can plug the formula and get:

Your cost of equity is .028765 or 2.88%

Cost of Debt: now that you have cost of equity you need to calculate the cost of debt to get your WACC to apply as a discount rate for a project or investment.

Cost of debt is a whole lot more straightforward and simple to calculate for many firms than Cost of Equity. To calculate cost of debt you look at recent debt or Debt like issuances that the company has made and look at the interest rate they put on that debt. So if a company issues a bond at 5% the cost of that debt before taxes is 5%.

After you get the before tax cost of debt you need to get the after tax cost of debt by multiplying the before tax by (1-Tax rate) you need to use the after tax cost of debt because taxes are payed before debt holders are.

Now that you have the cost of equity and the cost of debt you can multiply each number by its corresponding weight of the company’s capital structure. A simple hypothetical example could be a company has assets funded by 70% debt and 30% equity. That would mean (assuming a 40% tax rate) that their WACC is ≈ .3 * .05711 + .7 * (1-.4)

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Ke = .02 + (.7422(.05)) = .05711

≈ .7 * .05711 + .3 * (1-.4)

≈ .21997 or 22% Weighted average cost of debt (which is abnormally large)

Now that we have a discount rate to apply to future cash flows we can discount any future cash flows using the discount rate and the horizon of the investment and get the net present value of those cash flows, which we then call our Intrinsic Value.

The Intrinsic value is our estimation of the worth of future cash flows, however we are not the only ones trying to estimate the future worth of cash flows so people that are out in the market buying and selling the security or whatever investment we are trying to make. These purchases and sales set a Current Market Price that we can use to compare to our assumed intrinsic value.

Once we compare our intrinsic value to the Market price of the investment we can then see if we believe we can make any value out of this investment. If our intrinsic value is higher than what the market is selling it at, we see a good deal to be made and will buy it hoping that the market will adjust for the lack of cost and the price will go up letting us pocket the difference. And alternatively if the Market says it is more expensive than our intrinsic value, we think the market will correct and price will fall, so we will either not buy the investment or if it is stocks we can even short it.

Shorting the stock means we sell someone else’s share of a security and when the price falls we buy it back for them and keep the difference in prices.

Why are these tools and models needed?:

There are a few moments in history that we are going to look at that show us exactly why finance is a study that cannot be accomplished without models and also cannot be accomplished with only models.

The first example was Orange County which was run by Robert Cirton the county treasurer. He had been successful in his investment decisions however he had never learned about financial modeling or the tools and formulas we use every day in finance.

He was very confident in his decisions, and felt that the need of models was not of the utmost importance, but rather the fact that he had been correct in the past was proof enough that he knew what he was doing. While interest rates were low, he kept the bet that they would stay low and so he would invest in medium duration securities for the premium rate of return believing that interest rate risk was nothing to be worried about.

The fed however decided to raise interest rates in February 1994 six consecutive times leading to a fallout of the bond market and a 1.6 billion dollar loss for Robert Citron and Orange county.

This event did a lot to show us that in finance Intuition is good and can be used effectively, but you must use models and tools to see what could happen if the bet you are making on the market is risky or not. Robert ignored risk and got burned for it.

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The next company that demonstrated the exact opposite situation opened that same year under the name of Long Term Capital Management. However the idea behind LTCM started way before then.

Myron Scholes and Fischer Black took the workings of a young French mathematician and noticed that he had begun to work a formula for option pricing. They took this formula and decided that the only piece that was not solvable by quantitative means was Risk.

They worked very hard at it though and figured out that if you took two risky investments of opposite movement and put them together you could eliminate risk and know the price of any option as long as you had the price of the corresponding stock.

They found out however that for it to work they needed to have the price formula update continuously otherwise the changing markets would render the formula useless.

This is when they enlisted the help of Robert Merton who had studied the theory of Continuous Time used in rocket science by a Japanese scholar. Once Merton had mulled over the formula he developed a model that would continuously update just as they had needed it to.

They put the formula to the test in the market and it excelled beyond anything anyone had seen before and became so popular among traders that the Two men Scholes and Merton (Black had passed away by then) won the Nobel Prize.

In 1995 the two men decided that they would take their formula and model and create a company that would be very large scale and make tons of money so they created the giant hedge fund Long Term Capital Management. They made tons of money and were making their clients huge returns above 40-50% a year for 3 years.

Then in 1997 an Asian panic occurred when Thailand had a huge economic hardship, and the Scholes model began to give weird results. It turned out that the model worked great when there was economic prosperity and things were stable, but when large upsets occurred it gave radically poor results.

Finally in its final year in 1998 LTCM met its demise when Russia, one of the largest countries in the world defaulted on bond payments. The model made horrible errors in choice and did not work for the failing market causing LTCM to lose hundreds of millions of dollars a day.

When the company hit the bottom the government had to bail the company out, and we all learned a valuable lesson that even though we saw that relying on solely intuition was a poor decision, relying solely on models and formulas was an equally if not greater mistake.

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Grantham on finance in scope of investing:

Grantham’s has a very upsetting view on finance in my opinion, I’m not saying I don’t agree or disagree with any of his statements because they upset me, but rather that I find it very sad that he has valid positions on financial innovations being bad for the economy. I do not like to think about the fact that the people I talk to day in and day out who study and practice finance could very well fall victim to the faults Grantham points out in his article.

Grantham states that in his opinion the Investment industry is a Zero sum Game, meaning that investors are not adding value to the economy. They are simply moving money from one place to another and then charging a fee for moving the money.

He also states that these agents that move the money around through investing are able to charge this fee and make money for adding no economic value because they are managing someone else’s money and they have more information than the client they are investing for. Since they have this Asymmetric information they can confuse their clients into thinking they are preforming magic when really all they are doing is charging a fee for a service that is in most cases a worse service than just buying an index fund.

He talks about how this is evident when you look at how as finance has grown as a portion of GDP (3% in 1965 to 7.5% in 2010) GDP growth rate has been consistently falling. GDP was growing at a rate of 3.5% a year all the way up to 1965, and then once finance became an industry it fell all the way to 2.5% by the year 2000.

The Efficient Market Hypothesis Grantham states Is an “unproven assumption” (Grantham), he talks about how if you blindly believe the theory that markets will always correct itself and there is no need to worry, you will be horrible unprepared when the model does fail. He believes that there has to be regulation on the new instruments of finance because capitalism may not always look after itself.

My thoughts on Grantham:

I honestly see the truth in everything that Grantham is saying. There must be regulation on instruments we use to evaluate markets because we see time and time again that markets change and if we are stubborn to prepare for those changes we fail.

I also agree that Asymmetric information and poor incentives in the investing world are there, and are apparent. I don’t however think that they are sustainable.

When I talked with Professor Larsson and Dr. Korb all three of us were in

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Section 3: The faults and prospects of finance looking forward?

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agreement that when there is poor incentive apparent in the market it is naturally weeded out because of how quickly information can spread to tarnish a reputation and make an agent undesirable by clients.

Dr. Lo on the power of finance:

Dr. Lo has a very optimistic view on finance and the power it brings to the table regarding incentivizing people to take action.

Lo believes that everyone should be interested in finance, because it can be so powerful. He uses the Financial crisis of 2008 as an example or a proof of this power in the sense that, the incentives put in place by banks, government agencies, credit agencies and all the other organizations that were making it really easy to get a loan for a house. This caused trillions of dollars to be pumped into the housing market, demonstrating that with the right incentives we can fund enormous projects.

These financial incentives come in the form of securitizations, Mortgage backed securities and other forms of financing that make it easier to allocate resources. It is a good thing to have resources easily transferable Lo states, because innovation needs private investment to make it off the research and development table.

Lo also talks about how easy it is to get things done when proper financial pressure is applied. He gives the example of the DARPA challenge headed by the Department of Defense. This was a challenge posed to a few schools asking

them to find the exact location of 10 weather balloons placed randomly across the United States for the chance to win 40k dollars if they finished in the fastest time.

The team that won the challenge completed it in 9 hours, an astonishing figure considering the size of the United States and the fact that no one person or group of people would be able to travel to each location and report it back in 9 hours.

The way they completed the task was through financial incentive. They promised a piece of the winnings to every person who helped them find them, and got 10,000 people involved with the contest. This demonstrates that will proper incentive finance can be tremendously powerful and can do wonderful things.

One of the wonderful things he talks about financial incentives being able to accomplish is curing cancer, or solving the energy crisis, or even perhaps ending world hunger. He demonstrates that even with the high cost of 500million dollars per development of drugs to cure cancer, and the high fail rate of 95% failure, if we can get enough money pumped into the cause we can fund 40 or more projects all at one time increasing our chance of success and the chance of return on the invested capital.

My thoughts on Lo:

Lo in my opinion is everything I ever wanted to be in becoming a lifelong pursuer of finance. I believe that finance can do tremendous things, inherently some of these things will be bad, but I believe a majority of what finance can provide the

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world is good. What a way to go into work every day right? Today I’m going to go to work and try my hardest to mold and use financial models and innovations to work towards achieving the perfect capital allocation system so that we can solve world issues. I’m sure there are very few people who would not want to go into work believing they were helping work towards such a beautiful goal.

Do I believe that Finance as a field can fulfill the goals presented in this paper?

I absolutely with no hesitation believe that the art of finance is a wonderful thing, and I believe that everything expressed in this paper is more than executable with the right motivation and discipline. The essence of finance in my opinion as I stated in the beginning of this paper is about making rational critical decisions and making sure that to the best of my abilities that I am not being undercompensated.

I believe that through proper compensation and good moral character I and everyone can use finance to help rather than hinder progress on a global scale.

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Section 4: Final thoughts and conclusion

Sources used for research:

http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch4.pdf (Damodaran on finance)https://www.youtube.com/watch?v=tsZRndV5lIc (Trillion dollar bet LTCM)http://merage.uci.edu/~jorion/oc/case.html (Orange County)https://en.wikipedia.org/wiki/Efficient_frontierDr. Brian KorbProfessor Carl LarssonInvestopedia (for certain formula reference)http://ttv.mit.edu/videos/11921-mfin-faculty-speaker---andrew-loRJeremy Grantham (GMO article)https://www.youtube.com/watch?v=WjCgtmNibeI (essence of finance by prof. Sweet)

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