book preview: the timeless essence of financial science
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Chapter summaries and preview pages of book based on a breakthrough research that busts several misconceptions and flaws deeply embedded in corporate finance, that contribute to financial crises.TRANSCRIPT
The
Timeless
Essence of
Financial
Science
Rajesh D. Mudholkar, B.Com., ACMA
First Edition
First published: December 2013
CreateSpace Independent Publishing Platform
©Copyright 2013
Rajesh D. Mudholkar, Author.
All rights reserved
ISBN: 978-1494799519
This work is dedicated to my late father
who stood as a living example of tenacity,
optimism and mercifulness towards
human fallibility even while enforcing
discipline. He inspired me to aim high,
pursue dreams with passion, and instilled
the values of spiritedly overcoming any
adversities that may come along.
Acknowledgements
This book draws upon more than three decades of my professional
and personal experiences, reflections and insights, gained through
several years of working in leading multinational corporations as well
as teaching corporate finance, quantitative analysis and business
research at post graduate business management programs, after
acquiring the CMA degree from my alma mater, the Institute of Cost
Accountants of India.
Words seem inadequate to convey my gratitude to God, whose divine
benevolence has been the driving force behind this accomplishment.
The blessings of my ancestors and elder kin have contributed in
abundance. Lipika my wife has been the biggest source of inspiration,
as well as my staunch critic, lending her linguistic and editing skills to
articulate ideas with lucidity. Her unflinching faith in me and her
tenacity have also been instrumental in helping me surmount the
trauma of a malignant tumor and accelerate the creation of this book.
The eagerness of a child excited about seeing a book authored by her
father - something that I saw in my daughter Raashi - kept my
motivation high without a pause.
I am deeply grateful to all the doctors whose skills and care gave me a
second life, as well as my friends, well wishers, acquaintances and
colleagues who motivated me during those traumatic days. I consider
every single person with whom I have interacted during the creation of
this work for various purposes - be it discussing a technical point,
seeking advice, or simply bouncing off ideas - as a valuable contributor
towards honing its ultimate result. I wish to sincerely thank each one
of them.
Rajesh D. Mudholkar, Author
Disclaimer
Utmost care has been taken to ensure factual accuracy of data used
and/or presented in this book. Errors and omissions if any, that might
have crept in despite rigorous efforts, are purely accidental and
unintentional. The sources from where such data are obtained have
been mentioned either in the bibliography or in-text as appropriate.
The analyses and arguments presented here, are only an objective
evaluation of various financial theories, practices and concepts
prevalent worldwide, from a professional viewpoint with due respects
to their learned authors, originators or creators. There is no intention
to offend any of them, whether living or dead. Where copyrighted
content is used as reference to explain a point, the copyright owners
have been duly cited. This book is intended to be purely an analytical
treatise, based on the author’s own work and ideas, and not to be
construed as professional advice.
Rajesh D. Mudholkar, Author.
Contents Preface i 1. Introduction 1 2. One Decade, Three Crises! 9 3. The Hypotheses 23 4. Anatomy of a Crisis 41 5. A Fatal Communication Error? 59 6. The Role of ‘Beta’ in Corporate Finance 91 7. Breaking The CAPM Mystery 127 8. From Portfolio Theory to CAPM: A Heuristic Slip? 227 9. Models Deceive, Cash Flows Don’t 249 10. WACC violates the WYDIWYP principle 269 11. If Archimedes Was an Economist! 313 12. Value Centric Capital Budgeting 357 13. A Word on Pay Back Methods 383 14. Measuring Value 395 15. Financial Decision Making Standards 445 Bibliography 457
i
Preface
The biggest irony of economic science lies in its fundamental
assumption. The premise of ‘rational humans’ that economics says we
are, tends to portray the psychological trait as instinctively natural, just
as instinctive it is for fish to swim or birds to fly. We have been
conditioned to believe that evolution, as explained by the scientific
theories of Charles Darwin (1809 - 1882), has transformed us from
mere ‘animal’ to ‘thinking animal’. Yet, the truth cannot be more
vividly described than by the following words of Albert Einstein (1879
- 1955). “Any man, who reads too much and uses his own brain too
little, falls into lazy habits of thinking.”
Interestingly, the tendency for ‘lazy thinking’ was indeed identified and
explained by the then new school of psychology called ‘behaviorism’
beginning with the earliest contributions by Russian physiologist Ivan
Pavlov (1849 - 1936). Later, John Broadus Watson (1878 - 1958), an
American psychologist, formally established the behavioral school.
Through his research and experiments he demonstrated the behavior
of conditioned response. Nobel Laureate Daniel Kahneman (born
1934), with Amos Tversky and others, established a cognitive basis for
common human errors which arise from heuristics and biases.
Kahneman developed the well known ‘Prospect Theory’. Nobel
Laureate Robert Shiller (born 1946) an economist and author of the
New York Times bestseller ‘Irrational Exuberance’ strengthened the
behavioral finance school, building on the work done by Kahneman.
ii
We know now that the reasons - why psychologists prosper more,
showing people ‘what they are’ and marketers make fortunes from
‘legitimately exploiting behavioral flaws’, than economists who try in
vain to explain ‘what people should be’ - are the same as why investors
read ‘Benjamin Graham’ and ‘Warren Buffet’ but continue to follow
the next door investment advisor, whether qualified or not!
Albert Einstein developed the theory of relativity, a concept that space
and time are relative to the motion of the observer. Our understanding
of ‘value’ cannot be complete if we deter from Einstein’s theory.
Without a well defined benchmark of ‘expectations’ to relate to, it is
impossible to say whether economic benefits ‘delivered’ by a business
enterprise has created ‘value’.
Archimedes is known for his explanation of the principle of the lever.
Although financial economics knows how to benefit by applying
leverage, it has also suffered due to its indiscriminate use.
The era of industrial revolution in the 18th and 19th century also saw the
establishment of the world's first business school ‘ESCP Europe’ in
France in the year 1819, of which the economist Jean-Baptiste Say
(1767 - 1832) best known due to Say’s Law of markets, was the co-
founder. Since then, several advances in the fields of economic science
and business management have been made. The art and science of
financial economics and business management has evolved over time,
enriched both in theory and in practice with several new theories, tools
and techniques. Even though tremendous benefits were derived from
iii
these developments, repeated financial crises and bankruptcies have
engulfed companies and entire nations, causing widespread misery to
their citizens.
Are serious cognitive errors being unwittingly committed? This
question should be of great concern not only for the present, but also
relevant for securing the economic future of mankind. If the flaws that
led to past accidents persist into current and future practice, the odds
in favor of a recurrence of history are stacked quite high.
Despite several years of scientific studies and a number of Nobel
awards honoring significant contributions to economic science, one of
its fields - ‘Asset Pricing’ that has had the most practical impact, still
remains inconclusive. The search for an acceptable asset pricing model
has not ended. This is confirmed by none other than the 2013 Nobel
Laureates in Economic Science - Eugene Fama, Lars Peter Hansen and
Robert Shiller. The conclusions that they reached is clearly expressed
by the Nobel Economic Sciences Prize Committee in their scientific
background note to the 2013 award, which says:
“....we do not yet have complete and generally accepted
explanations for how financial markets function....”
The insights and arguments presented in this book, attempt to unravel
several fallacies practiced in corporate finance, which by virtue of
being interlinked, produce a compounding damage. Although the ideas
and issues discussed herein pertain to what is presumed to be a highly
iv
technical and inveterate field of corporate finance, the presentation has
been guided by a desire to make it comprehensible to all because
financial economics affects all. A common sense approach, liberal use
of diagrams, tables, real-life examples and ample authoritative
references, should enhance the utility of the book.
This book is a sequel to its debut version titled ‘Value Erosion’. It has
been rechristened so as to aptly describe its more comprehensive
coverage, added insights and to highlight that there is nothing ancient
or modern when it comes to human behavior. Wars were fought then
for gaining control over economic resources, and wars are fought now
for the same reason. We cannot get away from the truth that focusing
on war-winning strategies is more rewarding than getting embroiled in
battling multitudes. The timeless relevance of financial science
essentially rooted in traditional economic principles cannot be
forgotten.
The main purpose of this book is to resolve the world’s most dreaded,
painful and chronic illness - ‘Financial Crisis’. As if a failure to prevent
one was not tragic enough, the shocking truth this research reveals is
that the methods already followed in financial practice actually
contribute to the crippling disaster. This book should be valuable to
mainly those involved in strategic business and economic decision
making. It should also be an insightful resource for those youth
pursuing business management careers, who aspire to be world class
business leaders, as also ordinary investors whose wealth is actually at
stake.
v
If these goals are achieved, it would be worth the effort. Readers’
comments, suggestions and even criticism will only help in making the
journey towards improvement as meaningful as it has been in the
making of this edition.
Rajesh D. Mudholkar, Author
December, 2013.
vi
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IInnttrroodduuccttiioonn
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Chapter Summary
The 2008 financial crisis, that destroyed US$ 29.7 trillion in
shareholder wealth worldwide in a single year, is evidence that
something is fundamentally wrong with financial practices,
which tremendous developments in financial economics,
managerial know how and regulatory checks and balances
since the industrial revolution, have not been able to resolve.
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“JPMorgan Acts to Buy Ailing Bear Stearns at Huge Discount”
The New York Times, March 16, 2008(1)
“Lehman Files for Bankruptcy; Merrill Is Sold”
The New York Times, September 14, 2008(2)
he word ‘discount’ sounds as tantalizing to a bargain hunter as it
spells doom for the hapless owner in distress. For Bear Stearns
selling at merely $2 a share, a whopping 93 percent discount to the
closing price on New York Stock Exchange barely two days ago,
‘discount’ was an understatement. Business, as the saying goes, is
indeed a zero sum game. While for the top brass at J P Morgan, this
once-in-a-lifetime bargain might have been good reason to cheer, the
sentiment pervading the precincts of all the ‘white-shoe’ firms in
distress, suddenly confronting calamity, couldn’t have been gloomier.
If Bear Stearns was an Easter gift for J P Morgan, Santa came calling
for Bank of America in the form of the $100-billion-a-year-ago Merrill
Lynch, offered at half the price.
T
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2
OOnnee DDeeccaaddee,,
TThhrreeee CCrriisseess!!
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Chapter Summary
The 2008 financial crisis was not an exception. If the Asian
financial crisis in the late 1990s that cost the IMF nearly
US$40 billion and the Euro Zone crisis in 2011 that put a
bailout burden of €484 billion on many countries, are
accounted for, it’s a massive score of economic damage in a
relatively short span of barely a decade and half. This is reason
enough to suspect the presence of hidden cognitive flaws in
understanding financial markets. Obviously, no acceptable
asset pricing model can possibly be developed if the behavior of
financial markets - what a good model is expected to represent
- is not well understood in the first place! Based on the research
by the 2013 Nobel Laureates, the Economic Sciences Prize
Committee confirms that we still do not have complete
understanding of financial markets and that lack of a reliable
asset pricing model causes mispricing of assets and contributes
to financial crisis.
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“Experience is not what happens to you; it's what you do with
what happens to you.” - Aldous Huxley
he financial crisis of 2008 was not the only one of its kind this
generation had witnessed. Little more than a decade ago,
another major disaster, the Asian financial crisis, had put the whole
region in distress. Originating in Thailand, it had radiated across all
ASEAN countries causing widespread loss of demand and confidence.
In part driven by real estate, Thailand’s burden of foreign debt
rendered it effectively bankrupt even before the collapse of its currency.
Foreign debt to GDP ratios spiked from 100% to 167% in 1993–96,
breaking beyond 180% during the worst of the crisis in major ASEAN
countries. The IMF had to initiate a nearly $40 billion program to
stabilize the currencies of South Korea, Thailand, and Indonesia, the
economies particularly impaired by the crisis. The effects lingered
through 1998, when the Philippines growth plummeted to virtually
zero. (Source: Wikipedia (1))
T
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3
TThhee HHyyppootthheesseess
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Chapter Summary Given the backdrop of three major globally impacting crises in
recent history, despite several man-years of research and
development in financial management, there is an urgent need
to go beyond and question the very fundamentals based on
which various financial theories and practices have been
developed. The root cause must be identified and corrected. The
broad hypothesis which needs examination is - whether sound
economic principles have been adhered to or violated in
corporate finance practice? Unscientific practices directly create
financial stress, and in publicly owned business enterprise, this
radiates into banking systems and eventually into the broader
economies in which these entities operate, causing widespread
misery like the kind history has already witnessed.
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“What good is it to run when you are on the wrong road?”-
German proverb
very realm of scientific activity has its own set of clear, well
established principles. When these are meticulously followed,
accurate and reliable results are produced. Conversely, when
subjectivity enters the process, the ensuing result turns out to be a
poor compromise - unverifiable, highly dependent on individual
judgment and therefore lacking ‘quality assurance’. Unchecked
financial crises worsening into corporate bankruptcies, not only cause
erosion of shareholder value, but also radiate into the broader banking
systems and the entire economy. Increasing incidences of non-
performing assets and the associated agony of inevitable debt
restructurings(1)(2) and in extreme cases downgraded sovereign ratings,
are a only the tremors of poor financial decisions which lie at the
epicenter.
E
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Chapter Summary
Data from recent as well as distant history and research shows
that financial markets are driven by behavioral anomalies,
resulting in bubbles and crashes. More than the obvious need
to understand the underlying reasons behind irrational
‘euphoria’ and ‘panic’ frequently occurring in financial
markets, and presumably, public companies being portrayed as
victims thereof, a relevant and perhaps more important
question that deserves examination is - whether financial
practices followed by the affected companies, unwittingly,
actually contribute to the damage to themselves and
consequently the broader economy?
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“The grand aim of all science is to cover the greatest number of
empirical facts by logical deduction from the smallest number of
hypotheses or axioms” - Albert Einstein
he search for explanations why financial assets are mispriced - a
major cause of financial crises - must begin with an incisive
diagnosis of its symptoms. Fundamental questions raised in the
preceding chapter, were analyzed using a wide spectrum of data
collated from diverse sources. These include but not limited to,
statistical data obtained from the World Bank database, index statistics
mostly from the web sites of stock exchanges or from public sources
like yahoo finance, financial data from company websites or financial
portals, extracts from media reports of national and international
repute and extracts from research findings of reputed business
consulting firms like Accenture as well as those published in Harvard
Business Review. Literature on corporate finance from internationally
recognized publishers, as well as reliable sources of general
information such as Wikipedia was used as reference material.
T
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CCoommmmuunniiccaattiioonn
EErrrroorr??
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Chapter Summary
Investors rely on signals given out by company actions, while
companies make inferences about investor expectations based
on interpretation of market behavior - visible through
dynamically changing market price of the companies’ stocks.
What sets the ball rolling first? Obviously, company
managements, in their role as shareholders’ agents, must
necessarily understand shareholder expectations correctly in
order to fulfill them well. Only when they do this, will there be
perfect harmony between shareholder expectations and company
actions. Various theories have been developed over time to
explain market behavior - both from rational as well as
behavioral perspectives. Yet, as the 2013 Nobel Economic
Sciences Prize Committee confirms, understanding asset prices
is still incomplete. Poor understanding contributes to wrong
decisions, eventually leading to financial crisis.
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“It is not that pearls fetch a high price because men have dived
for them; but on the contrary, men dive for them because they
fetch a high price”(13) – Richard Whately
he relationship between ‘reward’ and ‘risk’ conveyed by the
above statement made by the 19th century economist, captures
the very essence of entrepreneurship. It explains a fundamental
economic reality that reward for entrepreneurship must be determined
by the underlying value. So how do we understand the risk return
relationship that forms the foundation of financial science? Even
before we explore the rational vs. non-rational dimensions of equity
price behavior, and attempt to explain it with a reliable model, we must
understand what financial assets are and what financial markets
represent.
We live in a world where economic resources are unequally distributed,
while a wide range of resources are required to fulfill even ordinary
human needs. For example we all need food but everyone does not
T
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6
TThhee RRoollee ooff BBeettaa
iinn CCoorrppoorraattee
FFiinnaannccee
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Chapter Summary
Among several financial models used in corporate finance
practice, the Capital Asset Pricing Model (CAPM) earns
prominence because of it being an estimator of expected equity
returns, a key element of information required for enhancing
shareholder wealth. The model uses the term ‘beta’ to explain
systematic risk of the market portfolio and its constituents.
Variations in returns between stocks constituting the market
portfolio are directly correlated with the ‘beta’ values of those
stocks relative to the beta of the market portfolio which is
considered as 1. A stock’s ‘beta’ reflects its relative sensitivity
to systematic risk which the portfolio as a whole is exposed to,
and could be positive, negative or zero. While making capital
investment decisions, it is important to apply the correct ‘beta’.
Yet, what corporate finance theory prescribes conflicts with
rational economic principles, and leads to faulty project
selection decisions, consequently hurting shareholder value.
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“Risk comes from not knowing what you're doing”- Warren
Buffett
hat exactly is ‘beta’, how important it is and how does it
affect financial decisions? The capital asset pricing model
(CAPM) was developed as a financial tool to determine an appropriate
risk adjusted rate of return of an asset, based on that asset’s marginal
contribution to the risk of a well-diversified portfolio. The model takes
into account three influencing factors. First, the expected return of a
risk-free asset; second, the expected return of the market portfolio; and
third, the asset's relative sensitivity to the risk of the portfolio as a
whole, represented by ‘beta (β)’. The model was introduced by Jack
Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and
Jan Mossin (1966) independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory. William
Sharpe and Harry Markowitz jointly received the Nobel Memorial
W
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TThhee CCAAPPMM
MMyysstteerryy
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Chapter Summary
The widely used Capital Asset Pricing Model (CAPM)
developed in the mid 1960s, began to show anomalies when
thousands of studies failed to establish the validity of the model.
While explanations and alternatives were proposed, they were
subsequently rejected. As on date no acceptable asset pricing
model exists, a fact confirmed by the 2013 Nobel Economic
Sciences Prize Committee, based on the research contributions
by Nobel Laureates Fama, Hansen and Shiller. All studies
made and explanations provided so far addressed a common
question - ‘What else can explain asset prices besides ‘beta’,
the lone determinant variable used in the model’ - resulting in
one or more ‘fillers’ that attempted to plug the gap in vain, and
some even proclaiming the irrelevance of ‘beta’. The real flaw in
the model lies not in the inadequacy of ‘beta’ per se but in the
faulty representation of ‘riskless return’ and ‘risk premium’,
and an erroneous application of ‘beta’ - a measure of relative
risk - to ‘market risk premium’ which is not the correct
measure of market risk at all.
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“An error does not become truth by reason of multiplied
propagation, nor does truth become error because nobody sees
it”- Mahatma Gandhi
s already explained, the capital asset pricing model (CAPM) is
widely used for pricing of financial assets. ‘Cost of equity’, i.e.
the rate of return expected by a typical equity investor is estimated by
the model. Consequently, this expected rate is used to determine the
discounted present value of an asset’s estimated future returns. Returns
from risky assets such as business enterprises usually vary, and thus
owning such assets involves the risk of earning lower than expected
returns or even loss of capital. For this reason, stock prices of these
assets naturally fluctuate. Conventional thinking has been that variation
in stock prices reflects dynamically changing return expectations
directly proportional to expected risk, in the sense that higher returns
are expected for compensating higher risk. The CAPM attempts to
capture this risk adjusted cost of equity. On the premise that rational
investors hold typical well diversified portfolios such as the market
A
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Chapter Summary
The previous chapter analysed the CAPM from economic and
statistical perspectives. How does the model measure against its
parent theory, Harry Markowitz’s ‘Theory of Portfolio
Choice’, based on which it was built? The ‘Theory of Portfolio
Choice’ or simply ‘Portfolio Theory’ explains how an optimum
portfolio can be constructed that maximizes average returns for
a given degree of risk or minimizes risk for a given average
return. Thus, the theory converges all variables that affect the
choice of a portfolio into two dimensions - ‘expected portfolio
returns’ and ‘portfolio variance’ - also called the ‘mean-
variance’ paradigm. The CAPM used this idea to estimate
expected return of the optimum equity portfolio and its
constituent stocks. However, while the ‘mean returns’
dimension is correctly represented in the CAPM, the model
expresses ‘variance’ only in relative terms in the form of ‘beta’,
which is insufficient to completely understand risk of the
portfolio or its constituent stocks.
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“No problem can be solved from the same level of consciousness
that created it.” - Albert Einstein
arry Markowitz’s ‘Theory of Portfolio Choice’(1) analyzes how
wealth can be optimally invested in a portfolio of assets that
differ in terms of expected return and risk, so as to achieve maximum
average return for a given degree of risk or minimum risk for a given
average return. William Sharpe applied Markowitz's portfolio theory
and developed the ‘Capital Asset Pricing Model’ (CAPM), which
estimates risk-adjusted expected equity return.(2) The CAPM estimate
of cost of equity serves as a criterion cost for capital budgeting and
asset pricing.
This chapter presents an analytical review of, primarily the ‘Theory of
Portfolio Choice’ and as a consequence, its effect on the ‘Capital Asset
Pricing Model’. The unexplained gap which exists in CAPM, and
H
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Chapter Summary
Generally speaking, excessive reliance on models without
questioning their validity, and in particular, focusing on the
average or consolidated picture alone, without evaluating the
inevitable periodic deviations, leads to concealment of inherent
risk. Conventional Discounted Cash Flow (DCF) based
project appraisal methods suffer from the serious limitation of
the latter kind, because typically projects are selected on the
basis of Net Present Value (NPV) or Internal Rate of
Return (IRR) criteria, which essentially tell nothing more than
the average result for the overall project. Financial risk directly
hurts cash flows. Regardless of differences in periodic cash flow
patterns, two projects may produce equal NPV/IRR
outcomes. Since higher adverse deviations imply greater risk,
unless cash flows are measured against an appropriate periodic
benchmark, it would be impossible to say whether such
deviations pose a threat to the project’s targeted returns or only
constitute harmless normal variations.
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“I abhor averages. I like the individual case. A man may have six
meals one day and none the next, making an average of three
meals per day, but that is not a good way to live.”- Louis D.
Brandeis
oes inflating the cost of equity with higher beta, serve the
purpose of compensating for risk? Any attempt to manage risk
by the simple act of raising the bar of criterion cost, wouldn’t require
any model at all! All that would need to be done is to raise the bar high
enough. In effect most actual practitioners do exactly that. The
findings of the AFP survey referred to earlier confirms this fact as
quoted below.
“A small majority of organizations use their calculated cost of
capital as the standard hurdle rate for evaluating a project or
investment (53 percent). However, large organizations and those
that are publicly traded are more apt to use a rate above the
calculated cost of capital as their standard hurdle rate than are
small organizations and private ones. Organizations adjust the
D
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PPrriinncciippllee
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Chapter Summary
WYDIWYP is an acronym for What-You-Do-Is-What-
You-Plan. Weighted Average Cost of Capital (WACC)
deviates from this principle. WACC has its roots in the notion
of ‘one-firm-one-value’ introduced in corporate finance by the
Modigliani-Miller duo. Their theories, popularly known as
MM models, posited that value of a firm remains the same
regardless of the composition of its capital structure and
regardless of the distribution or retention of profits. Ever since,
WACC became the standard benchmark for selection of
projects. It gained further endorsement as a benchmark for
measuring enterprise performance with the introduction of
EVA. In reality, WACC becomes irrelevant simply because
cash flows do not occur in the consolidated manner implied by
WACC, but rather in a sequential manner where debt
obligations must be fulfilled first before any residual profits are
available for equity. Thus WACC contributes to liquidity
crisis because it fails to recognize the cash flow effect of debt
obligations during project evaluation. Any shortfall in residual
income hurts equity alone.
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“The most dangerous untruths are truths slightly distorted.”
-Georg C. Lichtenberg
ike the CAPM, the concept of Weighted Average Cost of Capital
(WACC) is also widely used globally. As seen below, this too has
been confirmed by the Harvard Business Review article titled “Do You
Know Your Cost of Capital?”(2), already referred to in chapter 6
“...…80% of more than 300 respondents – of which 90% with
over $ 1 billion in revenues – use free-cash-flow projections
discounted by the weighted average of the costs of debt and
equity, to estimate the value of investments.......about 90% of
the respondents use the capital assets pricing model (CAPM),
which quantifies the return required by an investment on the
basis of the associated risk.”
L
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EEccoonnoommiisstt
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Chapter Summary
Typically Debt/Equity ratio is used as a measure of financial
leverage. For this reason it is also known as ‘Leverage Ratio’.
In the computation of ‘Cost of Equity’, where ‘beta’ is applied
as a measure of relative systematic risk, the ‘beta’ value is
typically calibrated to incorporate appropriate degree of leverage
induced risk. Debt/Equity ratio is used in this computation
as the determinant variable so that the resultant ‘beta’ value
moves in direct correlation with Debt/Equity ratio, other
things being constant. In reality, real risk of leverage comes not
from the proportion of debt in total capital but from the
proportion of cost of debt in total operating profits. What
matters to equity value is the quantum of operating profits and
its sharing between debt and equity rather than Debt/Equity
ratio per se. Therefore, adjusting ‘beta’ based on Debt/Equity
ratio produces a misleading estimate of leveraged cost of equity
and consequently hurts shareholder value.
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“Give me a place to stand on, and I will move the earth”
- Archimedes (1)
hese were the words of the Greek mathematician, physicist,
engineer, inventor, and astronomer, whose explanation of the
principle of the lever, counts among his several scientific contributions.
Leverage did shake up the world, not once but several times over!
Little would Archimedes have thought that one of the shake ups would
also originate from his own country! Expanding credit and earning
discredit for the Euro Zone debt crisis, the Greek economy still
struggles to find a place to stand.
The word ‘lever’ originated from the French lever, ‘to raise’. A lever
amplifies an input force to produce a stronger – thus leveraged -
output force. In finance, it comes with a condition attached – ‘only if it
is applied in favourable conditions’. If only Archimedes was also an
T
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VVaalluuee CCeennttrriicc
CCaappiittaall BBuuddggeettiinngg
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Chapter Summary
Conventional Discounted Cash Flow (DCF) methods used in
capital budgeting determines Net Present Value (NPV) by
consolidating cash inflows and outflows discounted at the
WACC rate. Even where Internal Rate of Return (IRR)
method is used, WACC forms the criterion cost. These
methods suffer from several limitations that actually contribute
to liquidity crisis and erosion of shareholder value. One,
WACC is derived from a faulty CAPM, second WACC
itself is irrelevant for any cash flow evaluation, and third, the
consolidated NPV or IRR provides no information about
whether or not periodic cash flow deviations are harmless or
threatening. Thus the current capital budgeting methods are
misaligned with economic reality, conceal cash flow risks and
therefore contribute to financial crisis. A revised method
eliminates these flaws and highlights probable cash flow
deviations during the planning stage itself, so that unforeseen,
harmful cash flow disruptions are avoided.
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“Someone's sitting in the shade today because someone planted
a tree a long time ago.” - Warren Buffett
n Chinese philosophy(2) the yin and yang concept recognizes the
co-existence of mutually complementing states that define each
other. Can we comprehend static without understanding dynamic, light
without darkness, order without chaos, inside without outside etc? Sir
Isaac Newton, the 17th century English physicist and a key figure in the
scientific revolution, explained the first law of motion as “when viewed
in an inertial reference frame, an object either is at rest or moves at a
constant velocity, unless acted upon by an external force”. Can we
define motion without defining rest or vice versa? If all human beings
were perfectly rational and devoid of emotions, like the fictional
character called Mr. Spock in the popular ‘Star Trek’ series, would
stock prices have behaved differently? The behavioral school of
economic thought tells us that that we are predominantly non-rational.
Yet, economic science has empirical evidence that in the long term we
I
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AA WWoorrdd oonn
PPaayy BBaacckk MMeetthhooddss
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Chapter Summary
While Discounted Cash Flow (DCF) remains the most widely
used method for capital budgeting worldwide, one or the other
variants of non-discounted methods are also used even by large
organizations. When the limitations of currently practiced
DCF methods already threaten shareholder value, they affect
non-DCF methods such as Pay Back Period (PBP) as well,
besides already known drawbacks of such methods.
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“it is better to be vaguely right than exactly wrong” - Carveth
Read
he impropriety and drawbacks of non-DCF methods, which are
mere routes of convenience and lack economic rationale, needs
no explanation. This has been rightly highlighted by the following
comment in the ‘International Good Practice Guidance’ on ‘Project &
Investment Appraisal for Sustainable Value Creation’ issued by IFAC(1)
“Organizations with explicit sustainable value-creating strategies typically
emphasize techniques such as DCF and real options and downplay the role of other
short-term measurement criteria, such as payback and earnings per share (EPS)
growth. Research shows that a significant number of organizations do not prioritize
such techniques when perhaps they should, especially in assessing strategic investment
decisions and taking a long-term view. This applies to smaller organizations where
their use of such techniques is particularly variable as many rely on relatively simple
approaches, such as payback criteria and informal rules of thumb. More
T
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MMeeaassuurriinngg VVaalluuee
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Chapter Summary
‘Value’ in general and ‘Economic Value’ in particular, is
essentially a ‘relative’ rather than an ‘absolute’ concept. Unless
‘expectations’ are well defined, it is impossible to say whether
or not actual performance has added value. Also ‘value’ is
quite different from periodic performance that may inevitably
fluctuate, even though a particular period’s good or bad
performance would undoubtedly affect long term ‘value’.
Different degrees of variation in periodic performance would
have corresponding effects on ‘Economic Value’ but not all
variations may have a material effect. Managerial intervention
must focus only on those effects that matter and not all. The
right way to measure ‘Economic Value’ therefore must
consider both - that ‘value’ is relative to ‘expectations’ and that
it is a long term and cumulative phenomenon - and filter out
insignificant variations in causal factors. ‘Value Creation
Index’ a new metric, achieves these goals which other measures
such as the popular Economic Value Added (EVA) fail to
do.
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“Stock market bubbles don't grow out of thin air. They have a
solid basis in reality, but reality as distorted by a misconception.”
- George Soros
apital clings to ‘value’ like iron filings to a magnet and scatters
equally fast when there’s nothing to attract it. The term ‘value’
remains a matter of great discussion among economists. It is linked to
price through the mechanism of exchange between buyers and sellers.
Buyers express the amount of money they are willing to pay for
acquiring assets, whereas sellers, the money they willing to accept to
give up ownership of those assets. Whether a risky asset such as a
publicly owned business enterprise has created value, is ultimately
reflected in the change in its long term price on the stock market.
Prospective owners (buyers) and current owners (sellers) forming the
stock market not only react to actual performance of enterprises, but
also respond to various actions taken by their managements, judging
the effect of managerial actions on future value. After all, investors
C
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MMaakkiinngg SSttaannddaarrddss
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Chapter Summary
While significant developments have taken place in financial
‘Accounting’, ‘Auditing’ and ‘Reporting’ standards, the
absence of financial decision making standards is conspicuous.
In the interest of prudent utilization of capital - particularly
when enormous amounts have already been destroyed due to
poor financial management - the importance and urgency of
putting in place robust financial decision making standards
needs no more justification. The world’s first ever standard
issued by International Federation of Accountants (IFAC) as
late as Aug 2013, though a significant step in the right
direction, only consolidates already existing best practices,
therefore continues to carry the flaws present in them. If the
proposals presented in this book are accorded serious thought
by the global community of financial professionals, financial
management has the potential to transform into a true objective
science from the cultivated subjective art that it presently is, so
as to prevent large scale financial crisis like the 2008 case.
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“Good order is the foundation of all good things.” – Edmund
Burke
ver time, the accounting profession has continuously evolved to
address the changing needs of stakeholders in public companies,
with better accounting and reporting standards like ‘International
Financial Reporting Standards’ (IFRS)(1). Regulatory bodies like the
Securities and Exchange Board of India (SEBI) lay down several
investor protection guidelines(2). However, till recently no universal
guidelines existed at a global level on similar lines to ensure uniformity
and objectivity in financial decision making. The latest document -
‘International Good Practice Guidance’ on ‘Project and Investment
Appraisal for Sustainable Value Creation’ – published by International
Federation of Accountants (IFAC) in Aug 2013(3), is an effort in this
direction. Although an important step, understandably it disappoints as
an authoritative guide for the reason that it only consolidates best
current practices, given the limitations of what is already explained
O