The Ten-Day MBA 4th Ed. Page 18

  Probability Distributions—The graph of all possible outcomes with their respective probabilities of occurring

  Binomial Distributions—Probability distribution with only two possible outcomes

  Normal Distributions—The bell-shaped probability distribution of all possible outcomes

  Standard Deviation (σ)—The measure of the dispersion (width) of the normal distribution

  Mean (µ)—The arithmetic average of all outcomes

  Z Value—A tool to measure probabilities of specific situations on the normal distribution curve

  Cumulative Distribution Function (CDF)—A form of the normal distribution that shows the probability of being less than or equal to all possible outcomes

  Regression—A mathematical method of forecasting using line equations to explain the relationships between multiple variables

  Day 6

  FINANCE

  Finance Topics

  Business Structures

  Beta Risk

  The Efficient Frontier

  Capital Asset Pricing Model

  The Efficient Market Hypothesis

  Investment Valuations

  Discounted Cash Flows

  Dividend Growth Model

  Capital Budgeting

  Capital Structure

  Dividend Policy

  Mergers and Acquisitions

  I want to be an investment banker. If you had 10,000 shares I sell them for you. I make a lot of money. I will like my job very, very much. I will help people. I will be a millionaire. I will have a big house. It will be fun for me.

  —Seven-year-old schoolboy, “What I Want to Be When I Grow Up,”

  (from Michael Lewis’s Liar’s Poker, 1989)

  In the 1980s, finance was the place to be. Even kids dreamed of a life on Wall Street. Machiavellian young MBAs were beside themselves with glee as a Wall Street hired them by the droves, offering them a shot at big bucks trading and deal-making as investment bankers. Unfortunately, the bubble burst in 1987 with the stock market crash, and MBAs were forced to seek less glamorous jobs by joining the financial staffs at banks, corporations, and mutual funds.

  But like the seasons, Wall Street made a comeback in the 1990s, and after the Internet meltdown in 2000, and again after the financial meltdown in 2008. MBAs from the top schools are put on the fast track and are paid significantly more than their non-MBA peers. On Wall Street, MBAs make thousands more per year than non-MBAs in the same job. Moreover, job advancement is often limited to the MBA elite.

  Do not read this chapter in isolation. If finance turns you on, a single-minded focus on this discipline could be hazardous to your business health. Finance is very quantitative, using numbers from the accounting and QA chapters. Finance also plays as much of a role in marketing as marketing does in finance. Marketers are responsible for their financial results. Financiers work hard to market themselves to new clients and to sell new stocks to old ones.

  THE NATURE OF THE FIRM

  Why do businesses exist? In a financier’s eyes, the sole purpose of a firm is to maximize the wealth of its owners. In their pursuit of riches, people can organize their businesses in several ways. There are three basic legal business structures that entities take on in the United States. Each is chosen depending on the complexity of the business, liability preference, and tax considerations of the owners.

  PROPRIETORSHIPS

  A proprietorship, commonly called a sole proprietorship, is a business owned by an individual or husband and wife. The owner reaps all the profits and has unlimited liability for all losses. If things go poorly, the owner’s personal assets can be seized. It’s a simple structure. As with a child’s lemonade stand, no special government registration is required. Earnings are added to the individual’s other income, and taxes are paid on the total income. Because it is not a separate legal entity that can be divided and sold in pieces, it is more difficult for a proprietorship to raise money in the financial markets.

  PARTNERSHIPS

  When several individuals form a business, they often enter into a partnership. As in a proprietorship, each owner’s share of the earnings is included on his or her personal tax returns. Depending on the nature of the business, there are two types of partnerships. In a general partnership, active owners, called general partners, have unlimited liability for all business debts. When the accounting firm of Laventhol & Horwath went into bankruptcy in 1990 because of auditing malpractices, creditors went after the personal assets of the partners to pay off the partnership’s debts.

  In a limited partnership structure, limited partners are shielded to the extent of their investment. The “limited” form is often used in real estate and oil exploration ventures to protect the investing partners that do not participate in management. In the real estate busts of the late 1980s, the early 1990s, and 2008, the limited partners in vacant building projects were able to walk away from their investments with no further liability. On the other hand, the general partners of the same projects were personally on the hook. As in the proprietorship instance, the ability to raise money or to sell partial interests in partnership structures is rather difficult.

  CORPORATIONS

  Corporations, registered with a state, are legal entities that are separate from the individuals who own them. In the eyes of the law, a corporation is treated as an individual who conducts his or her own business independently. The assets and liabilities of the entity are owned by the corporation, not by the owners of the corporation. As with limited partnerships, owners of corporations have limited liability for the obligations of the business. In the case of a bankruptcy, the owners’ personal assets are shielded from creditors.

  A corporation’s ownership is split into shares of stock that investors can purchase and trade in the financial markets such as the New York Stock Exchange (NYSE). Shares can be traded among investors without disrupting the business. When management and the board of directors who represent the owners decide that more money is needed, additional shares can be issued. An investor, whether he takes an active role or chooses to remain passive, is personally shielded from the liabilities of the company.

  A major drawback of ownership in a corporation is double taxation. The corporation, like an individual, must pay taxes. When the corporation pays its owners a dividend, that dividend is taxable again as income to the individual.

  There are variations to the corporate form. The C Corp., as it is called by accountants and lawyers, works as described above, but there is also a Subchapter S Corp. These corporations have thirty-five or fewer owners. They agree to include the corporation’s earnings in their personal tax returns as in the case of a partnership. In that way, the double-taxation hammer does not fall on the owners, while at the same time the corporation’s limited liability advantage is maintained.

  If you are interested in finance, you can take two different yet interconnected routes. There is the investments area, which is more glamorous, the thing that fortunes, headlines, and stock quotes are made of; and there is financial management, which is the “in the trenches” work that helps companies finance their growth, pay the bills, and make acquisitions. The two areas are interconnected because the performance of a business, for which the finance department is to a large extent responsible, affects its investors’ share of the firm’s profits. Let’s start with the glamour.

  INVESTMENTS

  RISK AND RETURN

  How can I profit by owning a large or small share of a corporation or other business? This investment decision is really a two-pronged question: What is the potential income, and how risky is the venture? The basic concepts of discounted cash flows and probability explained earlier in the QA chapter can be used to answer these valuation questions. Refer to them as you would look up old class notes.

  A basic tenet of finance dictates that the return should be commensurate with the risk. If you know that an investment is a sure thing, then you should expect a lower rate of return in compensation for the lower
risk. Accordingly, certificates of deposit insured by the Federal Deposit Insurance Corporation (FDIC) pay low rates of return. Wildcatting for oil involves a great deal of risk, but it also promises a huge jackpot if a well turns out to be a gusher.

  Types of Risk. If risk applies to a whole class of assets, such as the markets for stocks, bonds, and real estate, it is called systematic risk. For instance, when the public believes that the stock market is a good bet (a so-called bull market), the market as a whole will climb. When the public leaves, the market “lays an egg” or “melts down,” as the headlines read in the crashes of 1929, 1987, 2000, and 2008. Movements in the economy, interest rates, and inflation are systematic factors that affect the entire market. In making any investment, you are exposed to the systematic risk of the market.

  If the risk applies to a particular asset or to a small group of assets, it is called unique or unsystematic. An individual investment performance may be volatile because of specific risks inherent to the investment. If you own shares in Disney, for instance, and Mickey catches a cold, the stock could tumble. That type of risk can largely be compensated for by owning a number of investments. This is called diversification. By holding a broad portfolio of investments, investors can offset losses on some investments with gains on others. Diversification moderates the overall fluctuations of a portfolio.

  BETA: RISK WITHIN A PORTFOLIO OF INVESTMENTS

  The market prices of stocks, IBM for example, fluctuate daily on the stock exchanges of the world. That volatility is equated with risk. A distribution of historical outcomes would show the risk graphically, as was shown for Seattle’s rainfall and for shoe sizes in the QA chapter. To refresh your memory of probability distributions, the mean long-term historical return on common stocks was 12.1 percent with a standard deviation of 21.2 percent. Within one standard deviation, 68 percent of the time the stock market will return between +33.3 percent and −9.1 percent per year.

  In addition to showing on a graph an individual investment’s absolute volatility, financial analysts measure the risk of individual stocks or small groups of stocks by comparing their price movements with the entire market’s movement. That measurement, beta, quantifies the risk of holding that particular investment versus owning a very large portfolio that represents “the market.” An example of such “market” portfolios are the collection of 500 stocks called the Standard & Poor’s 500 (S & P 500) or the 5,000 stocks that are included in the Wilshire 5000. The Nikkei index of 225 stocks represents the Japanese market. The DAX represents the German market and the FTSE reflects the British market.

  A PROBABILITY DISTRIBUTION OF HISTORICAL STOCK RETURNS

  The famous Dow Jones Industrial Average is a diverse collection of thirty of the most stable industrial companies in America (e.g., IBM, 3M, P&G, Coca-Cola, Boeing, and ExxonMobil). The Dow’s thirty “blue-chip” stocks are traded on the NYSE and are not representative of the broader market, even though the press might have you believe that they are.

  If a stock or portfolio moves in tandem with the market, it is said to be perfectly correlated with a beta of 1. Coca-Cola is such a stable company that it moves with the market with a beta of 1. If a stock moves in perfect opposition to the market, it is said to be negatively correlated, or to have a beta of −1.

  There are no such perfectly negatively correlated stocks, but there are some stocks with low betas. Luby’s Cafeterias has a .45 beta. When the market fluctuates down wildly, older people still go to the cafeteria. However, in a big market rally Luby’s is less likely to rise dramatically. Electric utilities also have low betas. Theoretically, a beta of 0 would mean an absence of risk. In that case the investments’ betas would perfectly cancel each other so that there would be no risk regardless of the movement of the market.

  HOW INVESTMENTS WITH DIFFERENT BETAS ACT

  A risky stock, like Alcoa, an aluminum company, has a beta of 1.84. A 1 percent fluctuation in the market would be magnified in a 1.84 percent movement in Alcoa’s price. Moderately risky stocks such as Boeing and Disney have 1.2 betas.

  The behavior of the market is so important because most large investment decisions are made in the context of a large portfolio, or collection of investments. Although the risks of individual investments may be high, the overall risk will be lowered by investing in the right mix of investments to lower the portfolio’s beta. Large mutual funds that own hundreds of investments, such as Fidelity’s Magellan Fund’s $19 billion portfolio, provide this kind of diversification. Hedge funds, on the other hand, are private equity (PE) pools for institutions and wealthy individuals that are able to take on more risk by making big bets on targeted investments. When a multibillion-dollar speculation on the direction of interest rates went bad, costing $4 billion, an ironically named hedge fund, Long-Term Capital Management, went bankrupt in 1998.

  Of course the beta number does not appear from nowhere. Beta is a statistical calculation of a correlation coefficient, the covariance of a stock with the market divided by the variance of the market. Betas can be calculated, but financial analysts will admit that investment information services, such as the Value Line Survey or Reuters, provide the beta coefficients. Calculating beta is tedious, and in true MBA fashion, this book will skip it.

  THE EFFICIENT FRONTIER

  Given all the possible portfolios of assets, theoretically there is a perfect mix of investments at each level of risk. The graphical representation of these theoretical “best” portfolios lies on a line called the efficient frontier. The area below the efficient frontier line encompasses the attainable or feasible portfolio combinations. Theoretically above the frontier are the unattainable returns.

  THE EFFICIENT FRONTIER

  THE CAPITAL ASSET PRICING MODEL FOR STOCKS

  The capital asset pricing model (CAPM) determines the required rate of return of an investment by adding the unsystematic risk and the systematic risk of owning this asset. A simple formula, the CAPM says that the required rate of return is the risk-free rate plus a premium for unsystematic risk. That risk is the beta that you are already familiar with.

  Ke = Rf + (Km − Rf) Beta

  Required Return on an Equity Investment = Risk-Free Rate + (Avg. Market Return Rate − Risk-Free Rate) × Beta

  Suppose you wanted to know in 1992 what IBM should return to be a worthwhile investment. The Value Line Survey told you that IBM had a conservative beta of 1.2. The Wall Street Journal told you that the long-term risk-free U.S. Treasury bond pays a return of 8 percent. This is a far more historical rate than the 4 percent rate prevailing in 2011 that was at forty-year lows. The final CAPM input requires some more homework. A study conducted since 1926 shows that the average return on the Standard & Poor 500 has exceeded the risk-free rate of investing in risk-free U.S. Treasury bonds by 7.4 percent. This is called the market risk premium (MRP). Some currently use a rate of 5 to 6 percent to reflect abnormally lower current interest rates and market returns. With those three CAPM inputs, an investment in IBM should return on average 16.8 percent.

  8% + (7.4%) 1.2 = 16.8%

  Plugging many, many betas into the linear algebraic equation of the CAPM, you can generate a graph. That line is called the security market line (SML). In the IBM example, suppose that the return on IBM is actually 12 percent. That is less than the required rate of return determined by the CAPM. The theory suggests that a rational investor would sell IBM. If the return rate exceeded the required rate as determined by the CAPM, then the market is offering a bargain, and investors should buy the stock. It sounds great, but the CAPM tells the required rate of return, not what an investment will actually return. For that you need tea leaves and a crystal ball.

  THE SECURITY MARKET LINE

  Moreover, the whole CAPM is theoretically under attack. In an article entitled “Bye-Bye Beta” in Forbes, March 1992, David Dreman, a noted investment adviser, reported on new and startling research and pronounced CAPM and beta dead. A study by University of Chicago professors Fama and French
saw no link between risk, as defined by the CAPM, and long-term performance. Because betas are based on historical volatility, betas may have no relevance for future predictions. Betas may have fallen into disrepute, but since there is nothing better, business schools still teach this theory.

  THE EFFICIENT MARKET HYPOTHESIS

  The SML graph suggests that there are bargains in the market. But that begs the question “If the market is efficient, then how can there be bargains?” The efficient market hypothesis (EMH) alleges that to varying degrees the market reflects all current information. Therefore, no one can take advantage of market aberrations to “beat the market.” Investors competing for profits are so numerous that quoted stock prices are exact indicators of value.

  There are three degrees of belief in the efficiency of the market: weak, semistrong, and strong.

  Weak Form of Efficiency. All information that caused past price movements is reflected in the current market price. Believing in the weak form means that no benefit is gained by charting stock price movements using technical analysis as a predictor of the future. However, by doing in-depth fundamental analysis about companies’ operations and profitability, analysts can gain insights that will provide opportunities for big profits.

  Semistrong Form of Efficiency. This camp believes that market prices reflect all publicly known information. Therefore, without insider information, no “abnormal” returns can be gained by poring over financial statements. The Securities and Exchange Commission (SEC) acts as a policeman to try to ensure that investors do not trade based on insider information. Believing in the semistrong form of efficiency means that fundamental analysis, conducted by reading financial statements and all public information, will not result in big gains.