1. The document provides an overview of finance concepts from the perspective of John Becker, including the goal of finance, key tools and methods, and criticisms of the field.
2. The goal of finance is described as balancing value and risk. Value refers to expected future cash flows while risk is the possible deviation from those expected cash flows. Financial tools help evaluate investments and determine if the expected return justifies the risk.
3. Discounted cash flow analysis is identified as the most important tool as it allows present valuation of future cash flows. The weighted average cost of capital is also discussed as a method to determine an appropriate discount rate based on the costs of equity and debt.
4. Criticisms of
1. 1 | P a g e
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
No mom, Finance does not mean “money”…
2. 2 | P a g e
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.
Section 1: What is the goal of Finance?
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3. 3 | P a g e
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
Section 2: How do we accomplish this goal?
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4. 4 | P a g e
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:
If you determine that the risk of this
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.
Discounted Present value= Future value/ (1+interest) years invested
Project:the projectwill gainyou2
milliondollars5yearsfrom now,but
will costyou1 milliondollarstoday.Is
it worththe investment?
2 million / (1+.08) ^5 = $1,361,166.39
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5. 5 | P a g e
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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6. 6 | P a g e
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
Cost of Equity (Ke) = Rf + Beta (Rm-Rf)
Where Rf = risk free rate and Rm-Rf = market risk premium
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7. 7 | P a g e
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)
Back to Table of Contents
Ke = .02 + (.7422(.05)) = .05711
≈ .7 * .05711 + .3 * (1-.4)
≈ .21997 or 22% Weighted
average cost of debt (which is
abnormally large)
8. 8 | P a g e
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 toestimate
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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9. 9 | P a g e
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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10. 10 | P a g e
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 economicvalue 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
Section 3: The faults and prospects of finance looking forward?
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11. 11 | P a g e
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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12. 12 | P a g e
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.
Section 4: Final thoughts and conclusion
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13. 13 | P a g e
Sources used for research:
http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch4.pdf (Damodaranon
finance)
https://www.youtube.com/watch?v=tsZRndV5lIc(TrilliondollarbetLTCM)
http://merage.uci.edu/~jorion/oc/case.html (OrangeCounty)
https://en.wikipedia.org/wiki/Efficient_frontier
Dr. Brian Korb
ProfessorCarl Larsson
Investopedia(forcertainformulareference)
http://ttv.mit.edu/videos/11921-mfin-faculty-speaker---andrew-loR
JeremyGrantham(GMO article)
https://www.youtube.com/watch?v=WjCgtmNibeI (essence of finance byprof.Sweet)
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