Scotia in Dubai

Today, Scotia Mocatta gained approval to operate it's own branch in Dubai to provide gold and price hedging services.

This will certainly be an interesting story to follow both for the implications of gold and the region.

The price of gold seems to be particularly noteworthy, having dropped to below 1100 yesterday for the first time in a while.

Dubai Stock Exchanges Merge

Dubai Financial Market announced today that they will be merging with Nasdaq Dubai for $121M. Also, the troubles with their debt might not yet be over as Dubai World may have to continue to restructure their debt.

There are certainly many interesting events in the area with a lot of activity in this market. It will certainly be worth while to see how the restructuring in the market will manifest and effect other markets around the world.

24h Strategy Case Comp

Yesterday at Rotman we had the 24 hour case competition (mandatory as part of our Strategy Class with Anita McGahan, shown above) with all the first year MBAs.

There were 49 teams of 5 or 6 students each in 7 rooms (7 teams per presentation room competiting against each other in the first round). We were assigned teams and asked to work on and present the case in 24 hours with newly assigned teams (not our teams from Q1-Q2).

I got assigned to a great team: Francois, James P., Miranda and Selina and we managed to place third in the competition overall!

Q2 - Done and Done

One way or another, we are done the dreaded Q2. Tonight, we are heading down to Grace O'Malleys and partying with the second years and others. It promises to be a good night. A good good night.

Mechanics of Retirement Planning

A question I posed to some of my classmates who wanted to practice DCF or time value of money questions:

John is 20 years old and is making $100k annually. He plans on retiring at 65 and will require 70% of his current annual income every year thereafter. The general life expectancy is 'til 85. And he can earn 8% on any money he invests.

How much does John need to save per year in order to retire at 65 according to plan?

[Solution]
You would break this question into two parts.

Part I: Nest Egg - Understanding the PV of the money he needs in retirement (aka how much he needs to have saved by 65)
Using a financial calculator:
PV = ?

FV = 0 (Doesn't plan on giving any inheritance when he dies)
PMT = 70,000 (70% of 100k)
P/Y = 1 (1 period per year, NOT semi-annual)
I/Y = 8
N = 20 (Retires and lives for 20 years, 85 - 65)
PV = 687,270.32 (How much his nest egg should be at 65)

Part II: How much he needs to invest every year
PMT = ?

FV = PV @ 65 = 687,270.32 (How much his nest egg should be at 65)
P/Y = 1
I/Y = 8
N = 45 (Works for 45 years, 65 - 20)
PV = 0 (Starts with nothing)
PMT = 1,778.16

John needs to save 1,778.16 per year. Now most people will say: "That seems really low"

That's true, but look at the scenario: John is saving for 45 years and spending for 20 years. For all of those 65 years, John is earning 8% on every dollar he's invested (aka he's not using). This returns to our original point when it comes to personal finance: "You can buy stocks. You can buy bonds. You can even buy good advice. But the one thing you can't buy is time."

Inventory Turnover - An Alternative

I was thinking about Inventory Turnover (and other similar accounts and operating / activity ratios) when I noticed what I thought were some assumptions that were made that might not be appropriate for all business types.

Recall: The formula for Inventory Turnover is: COGS / Average Inventory

For intance, if you look at an annual report this is what you see regarding inventory:
You get only two numbers regarding the ending balance last year (beginning balance this year) and the ending balance this year. The assumption is that the inventory gradually increased from it's last year's value to this year's value. So we take the value of the area under the graph to produce an average Inventory (Area divided by time).
Rather than calculate the area under the graph of an awkward trapezoid, an easy way to do this is to approximate the volume by taking the average of the two points and taking the area of the resulting rectangle (assuming the line above is straight, this is an exact approximation).
However, while this assumption might be a good approximation for most businesses, this inventory model isn't appropriate for many other types of businesses. Which kinds? I would argue businesses where design is important the inventory takes a much different shape (as shown below):Which types of business might exhibit this behaviour? I would suggest two candidates would be clothing stores or automotive dealers. Why? Because they often shift their inventory for new models every year. Their inventory levels will spike starting at the beginning of the year and then towards the end they will sell out all their inventory to reduce carrying costs and get rid of "old" inventory which will be harder to sell (or sell at a discount etc).

The point I'm trying to make is that if you use the previous (generally accepted) model, you will be underestimating your inventory turnover model because your ending reported inventory is not an accurate reflection of your "average" inventory carried throughout the year.

In the same way some people might cheat a stock price by invoking a "window dressing" price (deliberately bidding up the last trade of the day to inflate the close, I think that if you aren't aware of how the inventory moves throughout the year, you might be in danger of accepting a "window dressing" inventory value.

ICUP

I know it's the eve of the finance exam and most people are expecting me to do finance posts. I'm sure I'll oblige later. But first, I need to make a comment regarding exams and people going to the washroom. What is it about exams where people suddenly have weak bladders? During exams, whether they be MBA or CFA, there are always people getting up to go the washroom.

During today's MCV exam, at the 45 minute mark when people were officially allowed to use the rest room facilities, a few hands immediately went up to use the facilities. I have to admit I do find it mildly hilarious. I don't think I've ever used the facilities during an exam. I think it's a bit creepy and childish to have to be escorted by an exam proctor.

Country Risk Premium

Previously, I was talking about the risks associated with bonds and how yield prices are constructed based on different types of risk.


I wanted to take a moment to have a peek at bonds. First is the US 10 year bond which is a proxy for the Risk Free Rate (RFR). Next, I wanted to look at the equivalent instruments available in different countries and their respective yields. If I'm not mistaken, the difference in yield prices should be accounted for by country risk only (having your bond issued by one country versus another). This should in theory account for both foreign exchange risk as well as sovereign risk.


Let's have a look:

Bond yields source: Bloomberg

A few interesting notes: While the US bond is considered risk free, there are some countries which have yields which are lower (Canada, Germany, Swedish, Swiss, and Japan). Other countries with bond yields at a premium include: Italian, Spanish and Australian. French and Dutch seem to be about par.

Annuity Formula - How it Works

One formula I wanted to have a look at (just in time for both the accounting exam tomorrow and the finance exam on Friday) the annuity formula. While the math looks rather convoluted, I wanted to strip it down to it's parts to understand how (and why) it works.

First let's look at a few things. Assume that you've already explained how a perpetuity formula works (without growth), you know that the value of a perpetuity is:

(Assume it goes forever beyond period 7).

PV = CF / r

Where:

• PV is the present value
• CF is the cash flow per period
• r is the rate per period

The next question I would propose is this, what is the value of the perpetuity in period n at time 0? Well, it would be:

Well it would be the same as the PV's value at time n, discounted back to 0. Since the cash flows at time n would look the same as now, the PV at time n should be the same as the PV now.

PV @ n = PV / (1+r)^n

= CF / [r x (1+r)^n]

Now the last question, what is th value (both of the cash flows and the PV) of the perpetuity now minus the perpetuity at time n? Well, if you draw a diagram, the answer is an annuity from 0 to n. And the math shows the same:
(Note this graph is merely the first graph minus the second graph in the same way the math is the first PV minus the second.)

PV - PV @ n = PV - PV / (1+r)^n
= PV (1 - 1/(1+r)^n)
= CF (1 - 1/(1+r)^n) / r

This is the annuity formula for a cash flow CF, to period n at discount rate r, which is much easier than doing a DCF for each of the cash flows (imagine doing a DCF for 30 even cash flows mechanically).

This is a slight variation on the question that Kent Womack presented to us at our review session in the ROM and also highlights how the formula for annuities is constructed.

Venture Capital - Burn Rate

In preparing for our accounting exam (final exams for this quarter start next week with the rest of the university), I wanted to have a quick look at burn rate. One of the concepts taught in our class is cash flows of companies in different stages. An idea I wanted to look into a bit deeper was the idea of cash flows for start up companies.

Cash flow is the primary metric of financial health. For a start up company, there is a lot of money going out the door, but often little money coming in. Revenues are low or non-existant, R&D (and expenses in general) can often be high, and working capital and CAPEX are growing.

Although I've seen different "interpretations" of burn rate it is essentially an FCF which is negative. An operational definition is how much cash is going out the door excluding what is being replaced through financing activities (CFF). I would say that CFO less CAPEX is generally a good proxy of where burn rate is. The assumption is that other sources of cash flows (selling assets, raising cash through financing etc) are not guaranteed and also not sustainable.

The next important measure of financial health is the actual cash and equivalents account. Between the two values, burn rate and cash, you can approximate how long the company will survive without additional financing activities (cash / burn rate per quarter = approximate longevity in quarters).

The goal, of course, is the hockey stick shaped recovery: eventually investing enough to develop a revolutionary product or service that causes revenue and profits to go through the roof (and provided dramatic long term IRR).

Enterprise Value - Cash, how much is too much?

One interesting note made by our professor, Heather Ann Irwin, was for calculating EV.

I've learned the two basic ways to calculate EV (again in theory they should work out to be the same):

EV = EBITDA x Multiple
or
EV = Market Capitalization + Net Debt

Where
Market Capitalization = Share Price x # of Shares
Net Debt = Long Term Debt + Short Term Debt - Cash and Equivalents

I've been told there are more sophisticated versions of EV which include:
+ Preferred Shares
+ Minority Interest

And that the reason we use EV is to look a the company's value assessed under a capital structure neutral scenario (because the capital structure will change when you acquire it).

What I wanted to focus on is the Net Debt component, specifically cash and equivalents. Heather Ann Irwin mentioned a version of the formula which uses "excess cash" instead of cash. I had an idea what she meant but I asked her to clarify. She confirmed my perspective of her idea:

You subtract cash from net debt (and from EV) because cash has a special relationship as a highly liquid asset, so it is often seen as different from other working capital accounts (such as AR, Inv or Prepaid Exp). However, a company still requires some cash to run. The assumption of removing cash from net debt implies that you are acquiring the company for it's "raw" value. Leaving the cash in the company's EV is like buying cash with cash.

However, Heather Ann Irwin proposed that instead of "cash and equivalents" we should use "excess cash". This subtle difference is rather interesting. Yes, cash has a special relationship and is therefore different than other current accounts and working capital, however, you still need SOME cash in order to operate and maintain liquidity. But you don't want ALL the cash (you don't want to have to raise more funds than you need or else you risk screwing up your WACC when you try to raise too much funds). So rather than cutting out all the cash (or none at all) she is suggesting that you remove the excess cash, cash that is not necessary.

In other works, there is some cash which should be treated like working capital because it is actively employed in keeping the company running. The other "cash and equivalents" which are relatively stagnant should be excluded from the EV calculation. When I asked her what constitutes "excess cash" and how would you determine it, she had a great answer: Look at the liquidity ratios and do comps analysis. I'd have to think that it would also be prudent to look at the cash cycle.

I guess this is one of those subtle points that would probably come up in the negotiation of an M&A deal if someone was thinking of acquiring a company. It would probably come up as a point of discussion in terms of the strategic nature of the acquisition and the target capital structure after the deal was done.

Terminal Valuations - Theory and Practice

Yesterday, we had another Capital Markets Technical Prep session. We were looking at valuation methods including DCF, multiples, book value and precedent transactions.

In DCF, we talked about how to value a company's terminal value and discussed how in theory the values should be the same. This a concept I talked about at the Analyst Exchange when I was giving my lecture on geometric series (the math behind DCF's perpetuity formula). In the video, I briefly mentioned how our Hedge Fund Manager commented how it was a coincidence that the numbers were so similar. In theory, as our professor, Heather Ann Irwin mentioned, they should be the same and I just wanted to have a quick look at what the implication is.

There are two methods for valuing a companies terminal value are using a perpetuity method and EBITDA multiples.

The first method, the Terminal Value calculation using a perpetuity formula is: TV = FCF / (WACC - g).

The second method, the TV using EBITDA multiples is: TV = EBITDA x Multiple.

However, if in theory, they are supposed to be the same:

FCF / (WACC - g) = EBITDA x Multiple

I wanted to express the multiple in terms of the perpetuity formula so I rearranged the equation to get:

Multiple = (FCF/EBITDA) / (WACC - G)

This is exactly the point I was trying to make in my lecture in New York when I said that the two formulas and methods were related (except I forgot to highlight the "correction factor" between FCF and EBITDA which is essentially the same as a cash flow to operating profit margin - a factor which adjusts for the difference between FCF and EBITDA - just because EBITDA is often a proxy for FCF doesn't mean it's exact).

Another way of looking at this is as a mathematical proof for why comps valuation works. From an Integrative Thinking perspective, it is essentially looking at two different models for valuation which are looking at the same object and producing different results. Even though in theory both models look at the identical object, they will produce different values, yet I think this is a good integrative solution for understanding what is salient and causal in both models (and how they are related despite their differences).

In this way, if you could have perfect information, assuming that other analysts did comprehensive DCF, you could take a similar company and use the comps multiples to value that company.

Revisiting History - "Pricing the upside derivative"

Our finance professor, Kent Womack, was just describing the model for pricing derivatives and it is almost exactly what I suggested the best method for pricing options would be based on my intuition in January (and was the topic of my Peter Godsoe Scholarship Award in Financial Engineering). He even asked the same questions I was looking into when I was studying for the CFA exam regarding the profit profiles for different put options and call options and why you would enter into different positions.

In his slide, he even mentions the idea of the distribution of stock prices influencing the expected outcome. I think the only difference in our models is that he used a distribution called Geometric Brownian Motion. It's similar to my normal distribution assumption, however, it accounts for an upward drift (which I didn't account for). However, I wonder if it can be approximated with a shifted normal distribution (mean greater than zero).

Also, to actually determine his option price prof. Womack used simulations whereas my model was based more on mathematical calculations. I'm sure both methods to determine the price are acceptable as it's more the model for describing the final underlying price that is more important.

Another improvement from his model is the inclusion of the time value of money as he discounts the future gains back to the present value.

Bova @ the ROM

Due to construction, renovation and expansion at Rotman being disruptive, we've moved our classes to the Royal Ontario Museum theater.

Our accounting professor, Francesco Bova, had the honour of being the first prof to teach us in the ROM. He gave us a warm morning welcome (shown above). It was another rare class where all four sections were together.

At the end of class, Francesco thanked the PSO and the class reps: Myself, Amit, Thi and Katie. Anita McGahan had also done the same in our last Strategy class. What classy profs.

Kingsford Charcoal Case

For our Managing Customer Value class, myself and Jasmine were warm called to do a presentation on the brand of Kingsford Charcoal case and present an overview of the situation. Vincent and Yijun provided an analysis of the price strategy analysis. Finally Harsh and Kim represented agency 1 and Irina, Mainak and Gang presented as agency 2.

Our professor asked us (Jasmine and I) to ask questions of the two agency groups which was a bit of a unique experience. I drew on the classes' conversation to try to ask intellegent questions to understand how they were positioning Kingsford charcoal relative to it's competitors, what their vision was for differentiating our product and how they planned to build an advertising strategy to drive consumer behaviour.

Harsh and Kim had picked mediums which we thought were in line with the BBQ experience. Agency two, with Irina, Mainak and Gang, showed that they understood Kingsford's position as a market leader and planned to exploit it by emphasizing the advantages of charcoal. However, we felt that their advertising strategy wasn't as focused.

In the end, we had to choose which group we prefered and we went with Agency 1 (Harsh and Kim).

It was an intersting exercise as Jasmine and I had to have a discussion outside of the class while the class came up with it's own selection. I'm told they came up with the same decision, albeit possibly based on different criteria.

Dubai World in Trouble

I've had this article (or variants) sent to me from many different people who are concerned / aware of what is happening in Dubai.

We had just done our Dubai presentation on market entry (our project was done on Sugar Mountain and their positioning with international infrastructure to source confectionaries from around the world) and were looking at different possible locations.

We had discovered Dubai World in our research and commented on how monsterously large it was. It actually dwarfs other famous projects from the same real estate development company, Nakheel, such as the famous World project, which creates small artificial islands on the coast in the shape of the earth.

An interesting point, the financing involve is actually islamicly based, as the bonds are sukuks. But there are interesting implications when it involves default and unwinding financial positions which have islamic components. It will be an interesting lesson in understanding not only islamic financial instruments, but also a pragmatic lesson in how distressed islamic investment instruments.

I wonder how liquidation would work. One of the general tenants (as I understand it) of islamic finance is that there are not many recourses for default, however, bonds do have an equity component so I wonder if the bonds will just naturally "convert" if the bond (sukuk) holders do not agree to delaying / suspending payments.

Strategy with Anita McGahan, Fleck Atrium Part II

In another rare treat, Anita ran another tutorial based on our most recent quiz in the Atrium earlier today (around lunch time). She discussed the answers and rational for the quiz questions as well as what she was looking for in good responses.

This time the tutorial was only for two of the four sections at Rotman. The other two courses are having their tutorial now.

Next week, due to construction in extending the Rotman facilities, we've been told that some of our classes will be in the Royal Ontario Museum (ROM). That plans to be exciting, not only to also be in a large class with all our 265 classmates, but also to be in such an interesting "class room". I hope we don't have to pay additional "admission".

Companies Investing in Securities

Our professor, Francesco Bova, has the honour / misfortune of having us for our Friday afternoon Financial Accounting class. It's usually a good time (yes, you read that correctly).

Just now, he was asking us what types of securities would be considered as being classed as "held to maturity". He jokingly hinted that the only securities with maturities are bonds. The best question of the day:

"Does a zero coupon bond have a maturity?"

Semper Fidelis

Once a few years ago, I was having dinner with a friend. This person was certainly very successful in a traditional way and we were having a conversation about the plants around his house as a metaphor for life.

He was talking to the head house keeper about the upkeep of the house. She explained to him how she had been singing to the plants and how she felt that was encouraging them to grow. He took exception: "Why are you singing to the plants? Things grow better under pressure! You shouldn't be singing to them, you should be yelling at them!"

He chuckled as he related the story, and reflected on how history tests and challenges us and how the people who have tasted the peaks of success in life first drank deep from the cup of failure in the depths of despair. Success too easily won, he argued, no matter how tremendous, is not a path to sustained growth. The irony is that success often invokes a sense of accomplishment and complacency although the drive that accompanies true success is never really satisfied.

This is certainly true for those of us who chose to do an MBA at Rotman. We are being put through the wringer now. But most of us know that if things go the way we want, this is just the beginning. Should we be so lucky to achieve the goals we are aiming for, life will only become more challenging, more difficult and more rewarding.

There are many people here who are exceptionally bright and hard working. Everyone is being put under pressure. Everyone is being "rattled" as we are being pushed to our limits to see how far we can go. But I'm very impressed with the resilience and strength of my classmates. Clearly, they are made of strong yet malleable stuff. You can tell that in 10 years time (if not sooner) they will be rock stars and will look back and smile at "the good ol' days at Rotman".

Dany Shehab Wins Spelling Bee

On Tuesday evening, Rotman hosted its annual Spelling Bee in the Atrium where students, faculty and staff were challenged to spell different words in front of their friends and colleagues.

Section 2's very own Dany Shehab rocked the Rotman world with his stunning win at the Rotman Spelling Bee with a word I will not attempt to reproduce here.

Roger Martin Launches New Book

Roger Martin launched his new book on earlier this week in the Atrium at Rotman. "The Design of Business: Why Design Thinking is the Next Competitive Advantage".

Although many companies strive to be innovative, very few often are. Roger Martin offers an interesting explaination in that companies focus on analytical thinking at expense of design thinking. His book investigates the topic further and promises to be an interesting read.

Islamic Finance

Additionally in this Middle East International Study Tour class, we had professor Mohammad Fadel come in and describe the details, mechanics and rational of Islamic Finance.

While most people are familiar with Islamic Finance as simply "not charging interest" there are many more details which make up the rich tapestry of Islamic Finance.


The first note is that conformity with Islamic finance is voluntary. I think this might have been a point many members of my class (myself chief among them) got hung up on. Especially when we asked questions about how this law affected goodwill for M&A, sale of IP or brand equity or options or sale of receivables.


Some of the key takeaways for understanding Islamic Finance include:

• a strong association with tangible assets
• a general prohibition against floating or uncapped risk elements
• an emphasis on partnership, ownership and charity

There are certainly going to be more study before I can even begin to understand the find details, but this is certainly an interesting consideration for global finance.

Level 5 Marketing with Peter Drumond

In our Middle East International Study Tour class, Peter Drummond from Level 5 came in to discuss how marketing affects strategy, which is particularly cructial to how we will conduct our market entry strategy projects for bringing companies into the Middle East.

I was fortunate enough to ask him a question relating to how to focus our approach in bringing our company into Dubai. He focused on the emotional aspects of our company's product, which was particularly relevent and discussed Cirque de Soleil (our second choice) as an example.

He talked about Second Cup, and how the core value of similar companies was items such as "sensory experiences", "another place" (similar to what we discussed in the SBUX case). An interesting point was that each of these points never used the word "coffee" in them. And building from this base, there was some importance of understanding his framework of table stakes, key drivers, limitations of operations and hidden value.

With his background, he emphasized the value of intangible assets and how the emotional connections that individuals have can drive additional value add beyond standard economic value creation (the lesson we are learning in Managing Customer Value this term).

Strategy in The Atrium

We have a strategy quiz coming up on Thursday and our professor decided to book out the atrium yesterday evening in order to accommodate all four sections at once. This was probably one of the best lectures we've had in a while if only for the fact that this was the one time all 270 students were able to be in the "same" class.

As with all Atrium speakers, there were some curious on lookers and some students were observing from the second floor and balcony areas.

Anita went through all of the key take aways from each of the cases we've studied so far and reiterated how we are to look at and apply framework to have a better understanding of how strategy affects the profitability of a company.

It's too bad we can't have all our classes like this.

Lunch With Chad

If being outbid was a down point today, then lunch with Chad was certainly a good up point. We eventually decided to forego sushi and head out for lunch at Noodle Bowl on Bloor a little past Spadina.

We had a great chat about what it's like to be in the MBA, what we want to do in the summer and when we are finished here. It was good to see a class mate outside of the class as too often we have hectic whirlwind lives bound within the Rotman bubble.

It seems like this is the first week this quarter has been "reasonable" meaning a hectic pace rather than earlier this quarter (only two or three weeks ago) which have been progressing at break neck speed. We were promised by our second year peers that quarter 2 would probably be the toughest and we are certainly seeing that now.

In the spirit of keeping interesting content coming, I'll be thinking about other great questions to post and see what answers I get. Stay tuned!

United Way Auction - Outbidding Maddness

The Outreach club at Rotman was running an auction to sell items in order to raise funds for the United Way. There were certainly interesting items being auctioned, most of which were meals with professors or second year students, gift sets or even a name card decorating session.

I had put together a small syndicate of bidders to bid on the Capital Markets night out with a fairly healthy max bid. Just before 1 pm, it was pure chaos as there were groups of students sitting out in the atrium trying to outbid each other by different increments for different items. Unfortunately, we got booted below our maximum bid at $1450 because I lost my wifi connection.



However, I'm really impressed with the group of students that I came to bid with. Although everyone was commenting that it "wasn't really worth it", the eventual selling price was only at about a 45% premium over the projected cost and it is for charity and a good cause. Who ever won certainly deserves rock star status.

No one really knows who won yet, but everyone is poking around trying to find out who it is.

An Evening of Hope for Ghana

Saturday certainly wasn't over after RFA's Super Saturday. My good friend, Rich Wiltshire, who had previously worked in Ghana, was organizing a charity event to raise money for this worthy cause. He raise his goal of $5000 for SMIDO which will be used to "improve their training center and give the people in the Suame Magazine community a little bost to have a better life."

It was an interesting evening as I met some people I haven't seen in a while (as far back as our CFES days when Rich and I were organizing Congress events for the Canadian Federation of Engineering Students in Toronto). Ironically, many of them have gone on to do their MBA at Rotman (myself included of course).

It was my conversation with Rich in Malaysia which helped me make the decision to come back to Canada to do my MBA at Rotman. He is certainly one of the ambassadors I was previously referring to. He was on exchange at National University of Singapore (NUS) and he was travelling around and visited me in Kota Kinabalu, Sabah. We climbed Mt. Kinabalu, visited Jalan Gaya and took the whirlwind tour (he was only there for a few days). I remember our conversation sitting in one of the few Starbucks in the city, located at Times Square mall when we were chatting about our futures and where we saw ourselves going.

Later, he would talk to me about his time spent in Ghana and how he was going there to work to do international / business development work. In looking at his photos, I have to admit there were some striking similarities in the context he was working in compared to Kota Kinabalu despite the geographic distance.

Currently, Rich and Fayaz Manji (my official Rotman GBC buddy) are currently trying to build a stronger program to entice Rotman MBAs to do development work in Ghana. If you are interested you should certainly get in contact with them and look into it.

RFA Super Saturday

This past saturday was Rotman's Finance Super Saturday. We had a host of speakers from all the major banks talk about some of the different flavours of finance including investment banking, equity research and sales and trading.

There were a series of live interviews with Joe, Katie and Carl. They were asked questions ranging from "Why investment banking?" to "How would you value a mining company?" with live realtime critiquing on how to best craft our answers to deliver maximum impact in a short amount of time.

Other great questions included: "What types of valuation methods are there?" "Which ones will produce the highest value?" etc.

It's great to see the connections that Rotman has in industry as current alumni were telling us about their roles and offered us insight into how to best compose our application materials and prepare for interviews.

ROA as a Proxy for WACC

I was thinking about the previous brilliant question asked at the Rotman Stock Pitch and I wanted to extend the idea a bit further. While I know there are some obvious short comings in the analysis (and idea of proxies) I would like to make the following proposal:

ROA is a proxy for WACC

Most people know that ROA has to be greater than WACC in order to be profitable. Also, the accounting in the proof highlights an idea I've been struggling with:

A as a proxy for D + E VERSUS L + E

First WACC is calculated as:

WACC = ke (E / (D+E)) + kd (1-t) (D / (D+E))

= [ke * E + kd (1-t) * D] / (D+E)

And ROA is defined as:

ROA = [NI + Int Exp (1-t)] / A

However, recall that ROE is a proxy for ke so:

WACC = [ROE * E + kd (1-t) *D] / (D + E)

Note that ROE * E = NI and
kd * D = Int Exp

Therefore (with some assumptions and proxies):

WACC = NI + Int Exp (1-t) / (D+E)

So we can see that WACC is strikingly similar to ROA. What's the difference? This is the original problem I was having before.

The difference between WACC and ROA is that WACC has a denominator of (D+E) whereas ROA has a denominator of A.

What's the difference? A is L + E, not technically D+E. So what's the difference between Liabilities (L) and Debt (D)?

Debt is technically only Long term debt + Short Term debt (and perhaps minus cash, depending on the financial model?)

L is ALL the liabilities, including Current Liabilities (CL) and "Other long term liabilities".

Periods and Terminal Values

If you look at financial models that people have put together, Terminal Value usually accounts for a monstrous portion of Price (above 50%).

I wanted to ask myself:

[Question] How far into the future do I have to model into the future to make sure that TV is less than x% of the price?

TV is calculated as
CF (1+g)^n / (r-g)
And the PV of TV is TV / (1+r)^n

x% of the price is calculated as
x% * CF (1+g) / (r-g)

So if I want the TV to represent x% of the total price:
TV = x% * PV

Simplifying we get:
x% = (1+g)^n / [(1+r)^n*(1+g)]
x% (1+g) = [(1+g)/(1+r)]^n

Solving for n:
n = ln [x%/(1+g)] / ln [(1+g)/(1+r)]

While hardly a clean solution, this formula can be used to find out how far you need to model in order to have TV represent a given percentage of your price.

For instance, let's say growth of 2% and discount at 8% (standard "long term" numbers), and you want TV to represent 50%, then n should be about 12.5 periods.

Or:
Percent PV @ 2%
40% 16.4 periods
50% 12.5 periods
60% 9.3 periods
70% 6.6 periods
80% 4.3 periods

Dogdeball in the Atrium

Shown here: Jeff McCabe against the world!

Also: Prof. Kent Womack is a dodgeball champ!
Sent from my BlackBerry device on the Rogers Wireless Network

Predicting Venture Cost of Capital with Failure Rate (or Visa Versa)

I just did a little more math and came up with an amazing (in my opinion) result.

Question: Can I use the failure rate to determine an appropriate cost of capital (or visa versa)?

Imagine our previous company, but let's simplify it:

Cash Flow: $10 (it doesn't matter - We'll see why shortly)
Regular discount rate: 8%
Venture discount rate: 20%
Failure Rate: ???

Let's look at a given cash flow in period (n) in isolation:

Well using Method 1 - Venture capital discounting @ 20%:
PV1 = $10 * (1 + g)^n / (1 + 20%)^n

Using Method 2 - Regular equity discounting @ 8%, but undetermined failure rate:
PV2 = $10 * (1 + g)^n * (1 - f)^n / (1 + 8%)^n

Note that PV1 = PV2 according to the law of one price.

Also note: for any given period, you can cancel the effect of:

• period because the failure and discount rate affect the PV in the same way,
• the value of the actual cash flow doesn't matter, and
• the growth factor

All of these factors cancel out algebraically.

So we now know that:
1 / (1.20) = (1 - f) / (1.08)

Solving for f = 10%

[Solution]

So we can see that there is a general relationship:

• ke, "normal" cost of equity
• kv, cost of venture capital
• f, failure rate

(1 + ke) / (1 + kv) = (1 - f)
f = 1 - [(1 + ke) / (1 + kv)]
f = (kv - ke) / (1 + kv)

Similarly:

kv = (ke + f) / (1 - f)

Why does Venture Capital Require High Returns?

Intuitively, we can understand how venture capital requires high discount rates because of the high potential of failure of ventures and speculative projects. However, I wanted to see if it was possible to build a model to describe and bridge the gap between "traditional" valuation modeling and modeling for venture capital firms. What do I mean? I wanted to price a theoretical company using two methods:

1. A traditional venture capital method which accounts for failure in the high discount rate.
2. A variation of a standard method which uses a lower discount rate, but uses probability to account for failure in the cash flow itself.

Company Details (Assumptions):

Next Year's Cash Flow per stock: $10
Super Normal Growth for 3 years: 15%
Perpetual Growth: 2%

Note - Raw Cash Flow Would be:

Year 1 2 3 4 5 (2% - Growth)

Raw Projected Cash Flows $10.00 $11.50 $13.23 $15.21 $15.51

Method 1: Typical Venture Capital Model

Use a high discount rate to account for the failure rate, but assume project will work.
Venture cost of capital (ke) = 20%

Using DCF, the value of the stock is:

Year 1 2 3 4 TV Price

Raw Projected Cash Flows $10.00 $11.50 $13.23 $15.21 $5.07
Method 1 (PV) $8.33 $7.99 $7.65 $7.33 $2.44 $33.75**

Method 2: New model using standard discount rates, but also accounting for possibility of failure (not collect cash flow).

Failure rate: 55% every year
Typical discount rate (ke): 8% (exclude effects of leverage - assume venure can't raise debt)

Year 1 2 3 4 TV Price

Method 2 (Undiscounted)* $10.00 $5.18 $2.68 $1.39 $23.56
Method 2 (PV) $9.26 $4.44 $2.13 $1.02 $17.32 $34.16**

* Cash flow in this method is calculated as Raw cash flow * (1 - Failure Rate)^(Years in Operation - 1) - Note this assumes the company's first year is guaranteed (Big assumption)

** The price is about the same (same ballpark) using both methods, which makes sense with the law of one price.

The difference between the two methods is that Method 1 accounts for the chance of failure in the high discount rate, but Method 2 accounts for the chance of failure as a probability of receiving the cash flow. The same concept would apply with junk / high yield bonds.

The point I'm trying to investigate is the idea that there is an intrinsic relationship (possibly even isomorphic in the same way Womack called Price isomorphic to yield with bonds) between a high required rate of return and high failure rate.

Winner: Chad - Perpetuity Formulas

Congrats to the winner: Chad!

The answer to last night's question is: Infinite

If you calculated the value using the Gordon Growth model (or cash flow perpetuity model), you would get -20.11 (which is what Darshan got).

[Solution - Finance Answer]
If your cash flows grow faster than you discount, each cash flow continues to contribute more and more in terms of present value when calculating the price. With a perpetuity, you are adding an infinite number of values which don't converge.

The perpetuity formula is calculated by using a geometric series of cash flows which include the growth rate and discount rate.

[Solution - Calculus Answer]
Another way to look at this question is what happens when the cost of capital (k) is equal to the growth rate (g). If you use Gordon's Growth model, you get a divide by zero. Or if you look at values of g which are trivially smaller than k, you get astronomical prices (if k = 8% and g = 7.99999%). If you take values of k and g such that g incrementally approaches k in the manner shown above, you can see the astronomical effect it has on the stock price.

If you graph price as a function of g (holding k constant), you can see that there is some crazy behaviour when g is close to k (take the limit as g approaches k).

[Why this question is tricky]
Most people could understand that the numbers didn't look right, but let's look at why.
k is usually pegged at about 8% to reflect the opportunity cost of capital (traditionally it is pegged at historical year-over-year returns in the stock market).

g is usually pegged at inflation or GDP growth and is realistcally 2% (for those of us doing Womack's homework yesterday, he had us do a sensitivity test with ranges between 1 to 4%). Even if a company has phenominal growth, you have to remember that a perpetuity formula is the company's performance ever after. And over time, everyone starts to look "the same". Basic economic theory says that over time overly profitable industries will have entry and become more competitive and you have to consider this when doing a terminal value calculation.

Therefore, the best criticism of the problem I've got is that the growth rate is too high. But the reason it's too high is because most people will only use a growth rate of 3% (at most).

Also, note that ke and kd are both less than g so there is no weighting of capital such that WACC is greater than g (no calculation needed to solve this problem).

Chad: Let me know when you want to go eat!

CONTEST: Free Lunch / Dinner at Sushi On Bloor

I was thinking of (deliberately tricky) questions that might get asked in investment banking interviews and I created this one myself:

What is the theoretical value of a company's stock that:

• has earnings of $1.50 per share,
• Dividend payout ratio of 33%,
  
• has a perpetual earnings growth rate of 9%,
  
• Cost of equity of 9%,
  
• After-tax Cost of debt of 5%, and
  
• Financial Leverage of 2.1x

Hint (Question Variant): What would its PE ratio be?

First person who comments on this blog post with the right answer wins a free lunch / dinner at Sushi on Bloor on me. If you are outside of Toronto, we can think of some other prize of approximately equivalent value (let's say $20 CND).

Comment on the blog for your official submission.

Using Proxies: M&A Accretion or Dilution

Another phenomenal question that was asked at the Rotman stock pitch was this:
Company A is trading at a PE of 10.
Company B is trading at a PE of 15.
Company A acquires B using only debt at an after tax rate of 5%.

Is the deal accretive or dilutive?

This was a brilliant question and the trick was this:

PE is calculated as EPS / Price per Share and is a per share approximation of NI / E which is a proxy for cost of capital. This is the same result as when I was wondering about PEG ratios to find an appropriate discount rate for equity.

So using PE, the reciprocal of 15 is 6.67%. If the deal is paid entirely in debt at a kd(1-t) of 5%, then the cost of capital raised is cheaper than the return on capital used (the returns from the investment instrument we are buying outstrip the costs of the investment instrument we use to raise capital). Think of profiting from a financing transaction.

Another way of thinking of it is that (assuming that equity is always more expensive than debt) is that the change to the capital structure in this transaction is that the two entities are being combined and there is more debt being added to the capital strucure (more leverage, ceteris paribus).

In this case, the deal is accretive. This was absolutely a brilliant question.

A variation of this question could have been: "What if only equity was used to raise capital?"

Then the cost of capital for this incremental deal would be the ke of the acquiring company (Company A). The cost of capital would be the inverse of a PE of 10 or 10%. 10% is greater than the 6.67% of Company B and would therefore be dilutive.

Logically, the next question that follows would be: "Why would a company ever do a deal that's dilutive?"

One possible solution is that we're looking at the original formula for PE and PEG, a company that trades at a high PE ratio (keeping most other characteristics constant and assuming perfectly efficient markets) may have some growth build into the price.

For instance, Company B could be a young upstart company with a really strong product with potential for growth, whereas Company A is more mature but with good distribution networks. Company A might acquire Company B to have access to it's high growth product which it can distribute on it's network for high earnings growth (synergies).

In this case, a short term dilutive transaction might lead to much stronger future earnings growth for the combined entity.

2x Gold Exposure Without Leverage?

Today was the first Rotman stock pitch competition where the second year students gave the first years a chance to practice their skills in valuing and pitching companies. It was an interesting experience for all of us and there were many lessons learned.

In talking to other people doing pitches for companies in different industries, there was a lot of learning between groups. I though I would write about some of the more interesting lessons.

This post is focused on gold (or mining exposure to raw materials). Gold and copper have very important attributes and characteristics which are highly correlated to the health and confidence of the economy, especially as it relates to Canada. As a result, most portfolios will have some exposure in these areas depending on the strategy. Gold is often used as a hedge against inflation, but copper is associated as a leading indicator for the health of the economy.

However, in order to make larger hedges in the market based on these commodities, portfolios will utilize instruments which promise 2x exposure to these materials. When I first heard this, I asked, "How is it possible to have 2x exposure without employing some form of leverage?"

As Shree explained to me, this is how it works:
Imagine gold is selling for $1000 per ounce.
Imagine a company can mine gold for $500 per ounce.
It's profit is $500 per ounce (and let's exclude all other costs for now, or assume that the $500 per ounce includes all expenses).

Now imagine gold rises in price to $1100 per ounce.
The company can still mine it for $500 per ounce.
The profit is now $600.

Gold has only gone up 10%, but the companies earnings have gone up 20%! It's a 2x exposure without any leverage.

The Calculus of Duration

We have been discussing bonds and spot rates in finance as a fairly "simple" investment vehicle (no default risk for government bonds and steady and predictable cash flows).

While I had technically learned the math behind bond duration, it was after the homework assignment that we were assigned in finance that I began to get a better understanding of exactly what this means and why it's important.

As I had mentioned before, duration is defined as the percent change in price for a given change in yield. You'll notice that the definition of the formula is strikingly similar to elasticity calculations.

However, rather that jump in at that level, let's talk about it from the first principles of calculus:

P = C + C/(1+y) + C/(1+y)^2 + C/(1+y)^3 + ... + C/(1+y)^n + M/(1+y)^n

Where P is the price of the bond, C is the coupon and y is the YTM and M is the face value. So far nothing new. But the next idea is to take the derivative of the Price, P, with respect to y to understand how the price will be affected for any give change in y. We can re-write the formula as:

P = C + C (1+y)^-1 + C (1+y)^-2 + C (1+y)^-3 + ... + C (1+y)^-n + M (1+y)^-n

dP/dy = - C (1+y)^-2 + -2 C (1+y)^-3 + -3 C (1+y)^-4 + ... + -n C (1+y)^-(n+1) + -n M (1+y)^-(n+1)
= -1/(1+y)[ C (1+y)^-1 + -2 C (1+y)^-2 + -3 C (1+y)^-3 + ... + -n C (1+y)^-n + -n M (1+y)^-n

Recall that dP/dy describes the change in P with respect to y. In order to get percentage change, we divide both sides by P. This gives us the term dP/dy * 1/P which is a precursor to understanding % change in P or modified duration:

dP/dy * (1/P) = (1/P)[ -1/(1+y)][ C (1+y)^-1 + -2 C (1+y)^-2 + -3 C (1+y)^-3 + ... + -n C (1+y)^-n + -n M (1+y)^-n]

There is a special definition for the monstrous summation term above called the Macaulay duration which is defined as:

Macaulay duration = [ C (1+y)^-1 + -2 C (1+y)^-2 + -3 C (1+y)^-3 + ... + -n C (1+y)^-n + -n M (1+y)^-n] / P

Modified Duration = -Maccaulay duration / (1 + y)
= dP/dy * (1/P)

That's a lot of complicated math with calculus. What is the value of this exercise? Well if you can understand how your bond liabilities will move with interest rates, you can construct a portfolio of bonds which can insulate (immunize) you from changes in the price due to changes in the yield even if the bond's structure you are using to immunize is not of the same construction as the original liability buy matching face values and durations.

Therefore any change in the percentage value of your liability will be offset by a similar change in the percentage value of your bond portfolio (a hedging asset).

Capital Markets Technical Prep

"They" have always said that preparing for recruitment is like taking another class. That was certainly the case this morning as the CCC prepared a morning session entitled: "Capital Markets Technical Overview". The session was fully booked and Heather-Anne Irwin was teaching us about how to ramp up our learning for capital markets beyond what we were taught in our classes.

She gave us the opportunity to try to discuss complex finance terms in layman's terms appropriate for a technical interview scenario as well as a quick review of key financial indicators and what the implications were for movement in either direction. It was certainly a good primer for us to go about doing our own homework to learn more and form our own opinions of what's happening in the market.

While we are not officially graded on this course, perhaps our "grade" is the most important grade of all, the stamp of approval in the form of a summer job offer.

Tell Me The Story

In preparing to enter the business world, we were told that it would be a good idea to read the paper daily. We were promised that it would become natural and, even in the extreme, that there are some people that look forward to that morning paper.

As of today, I'm am now in that place. I've been regularly reading the paper to understand the key business stories of the day, but I'm starting to feel a sense of withdrawal since there was no Sunday paper today at Rotman. I actually find myself craving reading tomorrow's paper to see what has been happening in the business world and around the globe. I caught myself browsing through the internet looking for news stories about some of the major companies that have been in the news lately and the latest related developments.

We've also be given our companies for the RFA stock pitch competition and my partner and I have reviewed our company and although it presents its unique challenges it is also paired with unique and highly profitable earnings growth opportunities (a healthy CAGR), we believe we have a compelling story for a long position.

This bring me to my point. Most people who know me know that I am comfortable with numbers (a quant by nature and training). But doing the CFA and MBA has reminded me (or rather, highlighted in my personality) that I want to know the story behind the numbers. In reading the paper and analyzing the company we were assigned for the competition, I've found that I really enjoy the discussion that follows thoughtful analysis.

Porter's Five Forces and Basic Economic Theory

In our strategy class last week, we were discussing Porter's Five Forces by extending the idea beyond just a static analysis of the industry as is, but looking at the trends in movement for each of the five forces.

I suspected that there would be a pattern that industries with forces which have a rating of "low" would naturally have a trend of "increasing" whereas forces with "high" ratings would have trends of "decreasing" assuming efficient markets. While not a perfectly isomorphic, I would expect this relationship to at least have a high correlation coefficient in terms of regression if you had to build a model for prediction.

When it comes to Buyer or Supplier Power (a recursive framework which can be applied forwards or backwards with regards to vertical integration / value add or creation), I've always enjoyed using elasticity as a measure of bargaining power. However, in economics, there is the axiom that over time there is more "flexibility" for substitution which I would suggest directly results in increased elasticity.

In the same way that a buyer might not have flexibility or bargaining power in the short term, the natural inclination would be for substitutes to enter into an industry with low price elasticity in order to capture producer surplus (in the case of inelastic demand).

In more pragmatic terms, while it might be academically sound (and necessary) to look at historic values to understand how we got to where we are, it doesn't really become as useful (and it is hardly sufficient) until we understand not only our position, but where we are going.

GBC Leadership Conference

Yesterday was the GBC's inaugural NSITE Leadership conference, hosting such fantastic speakers as Michael Lee Chin, Don Morrison from RIM (my old boss), Robert Deluce from Porter Airlines and a host of other tremendous speakers. Topics ranged from entrepreneurship to social responsibility.

Each speaker had their own individual flair and unique experiences for how they got to be where they are now. They talked about the challenges they faced, the frameworks they relied on and how there is a constant struggle against complacency caused by success.

The event was hosted at the Hyatt on King in Downtown Toronto as the event was too large for our Fleck Atrium. I believe that there were over 300 people in attendance.

Many of the students had a great time and several members of our class were excited and already planning ideas for how they could build on the work done by this year's founding team.

Rotman Ambassador - Recruitment Info Session

Today, I was asked to be one of two students acting as Rotman Ambassadors at an evening info session for about 50 prospective students. Jeff Trapp was giving a presentation and the recruitment team asked me to represent first year students.

It was interesting as we were doing the info session in my classroom, and the notes from our earlier lecture on bonds in finance were still on the board. There were some good questions asked by applicants about what to look for in MBA programs, what life is like at Rotman, and how to put together applications.

It was great to pitch the benefits of the Rotman program to a very intelligent crowd and I would hope that my comments have driven them to take a closer look to see if Rotman is a fit for them.

Spot Rates and Bonds - Supply and Demand of Investment Vehicles

We were discussing Treasury strips for CI (Coupon Interest) and NP (Note Principle) bonds. We discussed ideas such as reconstituting bonds, arbitrage opportunities and pricing.

I had wondered before if when investment vehicles get "abstracted" (either with a derivative, in some form of aggregation etc), if it was possible to get supply and demand curves which differ from the original underlying asset.

Prof. Womack showed us the example of two otherwise identical treasury strips, both maturing in 2 years with the same $100 Face Value, but trading at nearly the same (but marginally different) prices. One was a CI strip with the ask yield at 5.78% with an ask price at $89/08 and the other was an NP strip with an ask yield at 5.79% with an ask price of $89/07.

Although these two investment vehicles have identical risk profiles, payment schedules etc. (for all intents and purposes, they are identical) they are trading at different prices. Prof. Womack described the different as being differences in supply and demand for investors who are interested in reconstituting bonds (for example). However, at the same time, since they are so related, they should trade at near identical values.

Financial Accounting II - Understanding the Story Behind Accounts

In our Financial Accounting class today (we have a new professor, Francesco Bova) and although Franco Wong (no relation) was a great professor, the material in Financial Accounting II is more "practical" building on the foundations in Fin Acc I (where we were learning mechanics of accounting).

We began by discussing cash cycle as composed of days [inventory, receivables, payables]. However, Francesco posed an interesting question: "Is it possible to have a negative cash conversion cycle?" (in the same way I had asked Prof. Franco Wong if it is possible to have a negative LIFO reserve). The answer is 'yes', but with special conditions:

Recall:

Cash Conversion Cycle = Days Inventory + Days Receivables - Days Payables

So for Cash Conversion Cycle to be negative:

• Days Inventory should be smaller
• Days Receivables should be smaller
• Days Payable should be higher

When is this the case? Look at Dell computers:

• JIT Inventory - Extremely low Days Inventory (inventory only used as needed / ordered)
• Visa and cash payments - Extremely low Days Receivable (is paid fairly immediately to Dell. It's A/R for Visa)
• Days Payable - Standard terms to suppliers

Because of these unique relationships, (which also exists in construction where revenue and cash is often recognised earlier and then placed in a treasury bond to gain interest) and is known as stretching payables. This is the act of investing cash which is dormant in a negative cash conversion cycle to make some interest income.

Finance - TVM

So we had our first finance class today where we covered the idea of TVM, PV, FV, NPV and discounting. This is the foundation of all finance concepts and, as our Professor Kent Womack described, aims to answer the question of: "How much is this worth?"

Our class is mildly disadvantaged because of this week because of the GBC Leadership conference happening on Friday which has compressed the week such that we have a finance assignment due less than 24 hours between classes. There are also group presentations every day on market updates and I feel bad for the group that has to present tomorrow: they have less than 24 hours to do their homework (allocated 2-3 hours) plus their presentation (also allocated another 2-3ish hours). It would be nice if they could eat, sleep and (more importantly) do work for other courses.

Our homework assignment is related to bond pricing and although a "different" concept for many people, it is still fairly heavily quant, requires Excel or a financial calculator and our tutorial session will be after the assignment is due, therefore a few of us will be sticking around after classes in the evening so that we can bounce ideas off each other to make sure our numbers add up the way they are supposed to.

Fundamentals of Strategic Management - SBUX

Today we hit Q2 running and had a new class, Fundamentals of Strategic Management with Anita McGahan. Her reputation certainly proceeds her, as she has been described as a protegé of Micheal Porter. You can tell with in minutes of meeting her that she's intense. Many students are intimidated by her, but in our class she was absolutely brilliant. Even some students who weren't considering consulting before are certainly considering it now.

She dived right into describing ROA and benchmarking companies versus the industries they were in versus the economy at large.She showed how a company might "out perform" the general economy, but still be "under performing" their industry. This is an idea which I had recently discussed as an extension of Nick Kerhoulas' idea for CEO compensation, but using derivatives (long / short positions) to mathematically come to the same result for bonuses (compensate CEOs and other top managers based on alpha less beta).

Also, I've previously mentioned that DuPont Analysis is one of my favourite financial frameworks because it is intuitive and Anita cut into it in more detail, specifying (as I had previously) that:

ROE = ROA x FLA

But she emphasized that FLA is a financial strategy whereas ROA is an operational strategy (I got called on this question when I was describing it in my post, but obviously Prof. McGahan described it much better. I made the mistake of saying that Total Asset Turnover, TAT, was "how much you could sell". Anita described it better as "Operational Strategy"). She even confirmed my hunch that FLA = 1 + D/E.

Also, her description of Porter's Five Force's was brilliantly (no surprise) insightful as she explained how three of the forces:

1. Buyer Power
2. Supplier Power
3. Threat of Substitution

were all measures of Value Creation (what value can be yielded by this industry - directly related to Industry Structure in the previous graphic and more specifically by the graphic below).(Also note the graphic immediately above can be recursively applied to describe an entire Value Added chain)

However, the last two of Porter's Five Forces:

1. Rivalry
2. Threat of Entry

were directly related to Value Capture (or more generically, Competitive Position as described in the first graphic above).

When it came to applying the material to the Starbucks case, she used the framework to describe where the most interesting stories were in the case, used math to describe the costs of achieving SBUX's growth goals and showed that against the balance sheet that additional fund raising was necessary to fuel growth. She dipped briefly into finance to describe EPS dilution caused by the payback periods required to cover store openings.

Even in building a potential solution, she lead the class in a discussion which critiqued possibilities such as franchising: why firms in the industry, the majority framed as operating as a sole proprietorship, would under report earnings and be disinterested in becoming a franchise.

Besides being a very technical and framework heavy course, it was certainly enjoyable. I know it sounds weird, but she kept our class in absolute stitches with her jokes about strategy and doing business (as I type this, I am aware of how awkward this appears).

To put it lightly, this promises to be an interesting class. This felt exactly like a case interview for consulting.

International Study Tour - Latin America

Upon returning from my last exam, I checked my Blackberry and found an email from the PSO relating to the Latin America International Study Tour. It was the same procedure as before: Go to the office of the Director of International Programs, Laura Wood, and see if we were selected for the tour.

Well, I am very excited to say that I've also been selected for the Latin America tour where we will be visiting Brazil and Argentina. I had originally thought that my application for the Middle East tour was weak, and as a result made doubly sure that my application for the Latin America did not have the same weaknesses.

I'd be remiss if I didn't acknowledge the help of Jenny Mila, a fellow student in my class who had lived in Argentina. She was patient enough to answer some of my questions and dispel my ignorance about that part of the world. She was helpful in providing guidance so I could look in the right places to find out more about Argentina.

I am using Rotman for as much travel as possible it seems, with my Middle East tour in January and the Latin America tour (visiting Brazil and Argentina) in May.

The India tour (also happening in May) has also just released it's candidates and I'm happy to say a few of my friends are also going to be going for that tour. We are certainly going to swap photos and stories as we embark on our adventurous excursions.

One Eighth MBA

"One eighth! One eighth!"

That was the chant at the Madison pub at about 2 pm today. The end of Q1 exams marks a major milestone for those of us in the MBA program at Rotman. We finished our first set of courses and have had a true taste of MBA life.

There was a strong sense of camaraderie as everyone was in good spirits and raising a glass to the end of Q1. Tonight promises to have more celebrations. While the future promises more hard work with Q2 classes starting again on Monday, at least for this weekend we have earned our first real free time in a while.

Exams and International Study Tour Class

I feel like I'm finally a real Rotman MBA student. I've finally written two exams and submitted a paper, meaning I've officially completed all the work for three of the five courses this quarter. We have two exams over the next two days: Managing People in Organizations and Financial Accounting.

Yesterday, I spent some time helping a few people understand stats (one person who I helped was beaming when she came out of the stats exam and said: "Everything I answered was what Josh and I did yesterday"). And she is a pretty smart person to begin with, so that felt pretty good. A few of the guys I helped were also giving me high fives with thanks which was also nice.

Almost immediately after my stats exam, I had to go to my first Middle East International Study tour class (2 hours every Wednesday on top of the regular courseload). As my classmates in Section 2 will know very well, I have an urge to speak up in classes. It was a little intimidating to do at first, as there were mostly second years in the room (I found one other first year who is going on the tour) because they have all had one year of classes under their belts already and they are all very sharp (selected based on interest, academics and extracurricular involvement). However, I would like to feel that I made some useful contributions to the discussion regarding an international perspective on emerging markets and would like to think that I also got some acknowledgement on my ideas by the professor.

Next up is the MPO exam and as brilliant as I think I am, I won't be helping anyone on this one (there's no math, people are generally confident with the material and the method of study doesn't really lend itself to tutorials).

You Make Me Stronger

Continuing my post from yesterday, I was very happy with all the requests by my colleagues to review the more difficult example questions provided by our profs. They were very helpful in learning the concepts which will help as the professors from both classes promised to provide "cook book breaking" questions on the exam. I feel that by being challenged by my classmates to do the tougher questions, we were all able to get better at reframing problems in different ways with the economics tools we were taught in our classes. We even earned a reputation as the 'help desk' as people were often coming by to ask questions and people would often stop by to listen to how we'd put together solutions.

Our table in the public common area on the second floor of Rotman just outside the primary study stacks was alive with boisterous laughter (unusual for the generally somber mood of exam studying MBAs) as we discovered the mechanics of a particularly challenging problem.

I'm very proud to be a part of this class. Numerous second year students have come by and commented on our performance as a whole. "When it was exam time in our year, there weren't this many people who stayed as late as your class. Every day, until late at night, all the study desks in the library are full."

Everyone agrees that economics is a very interesting class and the only regret is that we didn't have enough time to study the concepts in more detail.

Anyways, to all of us who are carving out our futures over the next week, best of luck to all of you and remember me when you're famous!

Even In The Most Important Week of Your Life - Never Lose Perspective in MBA Competition

Please forgive me as I take a small tangent from the regular topics I usually cover. To my friends in New York from the summer who know me well, this will be a familiar theme.

This week is the most important week of my life. As Prof. Walid Hejazi was so elequent to describe in his session entitled: The ROI on your MBA investment. He talked about how your trajectory in life and what stream you find yourself on in terms of career paths is the primary determinent on your success in life (success deliberatetly defined in the traditional sense of your professional development).

While this session was several months ago, I'm guessing that it was intended to "assist" the students who were still debating if they should do the MBA at Rotman, I still remember some of his key take aways:

- An MBA is a great equalizer, especially for those of us who aren't the "traditional stereotype" of executive management (the "white male 42-longs" - a reference to suit size).

- It signals to the market that we are looking for more challenges by taking the initative to complete a challenging and competitive program.

Having said all that, this brings me to the coming week. As Prof. Hejazi has stated, the MBA is probably an inflection point for all our respective careers. And the grades we get in the coming week based on our exam performance will help determine where we end up with summer internships which will in turn determine where we end up with full-time jobs (granted, I've been told repeatedly that there are still "opportunities to change your trajectory" in second year, you can put yourself on "the right track" if you can put yourself together now.)

So we (my fellow students and I) are not naive about the importance of grades especially since Q1 and Q2 are what determines how we are perceived by the market for summer internships. Everyone wants to do well, and this has led to some competitive behaviour. And if there's one thing we've learned (especially with the "flexible" grading in some of our classes, which shall remain unnamed) it is that EVERYTHING IS RELATIVE. What does that mean?

Unlike undergrad, where a good raw percentage grade is all you needed to succeed: In graduate studies (or particularly in the MBA), it's all about PERCENTILES rather than PERCENTAGES. It doesn't matter that your score is 90/100. It matters that your score is in the top 90 percentile (that you beat 90% of your classmates). The work is difficult and intellectually challenging. And your classmates are BRILLIANT too. There is a very good chance they will score high also. The prestige of the Rotman brand coupled with the effectiveness of the Rotman recruitment machine will ensure this. I imagine this is true of any top tier MBA program.

This has lead to some interesting behaviour. In reading my blog, many people have asked me for help on particular topics which I am more than happy to give (more on this later). But one thing I've noticed is that EVERYTHING here is competitive (there are even lines for the men's washroom between classes).

I think that the healthy competition keeps us sharp. But there are a *small* group of people (and this is where my closest NYC friends will probably nod their heads in agreement) where some people have lost perspective when it comes to competition.

Yes, our grades are important. Yes, our grades are relative. By rational economic theory, there is no benefit (in fact there is a HUGE cost) for skewing the curve to bias the grades up by helping "weaker" students.

But there is a *small* group of people who unconciously (involuntarily, reflexively... You get the idea) frown when they walk by and see me helping out other students. I can understand their logic. By helping the weaker students out, I'm making it more difficult to get that "A+" by boosting the curve.

I once put as my status update on Twitter and Facebook: "If you have become so competitive that you can't help a colleague out, you are lost". We've often been told that having grades is important. But having grades is of no value if no one can work with you.

Never lose perspective. Grades are important as a proxy for performance. But never forget the reasons for why we strive to achieve more. If you are the type of person who has to build a "economically rational model" to describe the motivation to help your peers, then understand that performance is a poor proxy for usefulness and there are more valuable skills than simply being "brilliant". No one works in isolation. And the network we build here at Rotman is arguably much more important that that B+ we are trying to turn into an A.

Everyone here is going to be successful. And as I wrote in one of my recent applications to yet another competitive Rotman opportunity: I modeled myself against [a recent Rotman alum who is wildly successful] who "when you hear his peers speak about him they have a high respect for him not only because of his individual success but also because he played a role in their success."

... Having said that I will be focusing on my studies as exams are coming up and occupying my thoughts for all of next week.

Rotman Awards Ceremony

As I had mentioned before, I have been awarded the Peter Godsoe Scotiabank Entrance Scholarship for Financial Engineering. There was a reception in the Fleck Atrium (open bar and hors d'oeuvres) with a short presentation by the Associate Dean Rick Powers (shown above).

Many of my classmates had won awards also and once again, it was no big surprise who was winning the awards. These were the people who you could tell by their comments in class that they were smart cookies.

There were many second years and students from different programs at Rotman as well as our benefactors and scholarship sponsors.

Finance Industry Day - Group 1's first small victory

First some background:
Because I was very busy yesterday, I didn't get a chance to blog about our little finance prep team. We've split the team into two groups, the "advanced group" (Group 2: people with experience who just want to talk about the markets and current events) and the "beginner group" (Group 1: people with little or no experience).

Yesterday, we also had an intense speaker, CEO of Claymore Investments, Som Seif, give a fantastic talk, describing how correlations between different asset classes are increasing (even between international and geographic regions) because of increased globalization. He also described how asset allocation plays a major role in determining return and managing risk. One of his more poignant points was that weak fund managers who can't justify their performance fees in down markets will be quickly replaced by low cost ETFs (the philosophy that management fees are not necessarily supposed to provide amplification on the upside, but rather a sense of expertise and awareness to protect from the downside).

His talk was fairly technical at points, and I began to wonder about our "Group 1" members in the audience. I asked them after the talk, "Did you feel intimidated? Don't worry, the purpose of the group is that a someday (soon) you can have an intelligent conversation with Som with the same vocabulary and technical proficiency".

For Group 1, I've set a schedule of topics to supplement what we'll be learning in finance class, and began reviewing basics like Time Value of Money (TVM), NPV, IRR etc. It was a whirlwind class, but we took them from zero to being able to have the vocabulary and math to describe when perpetuity formulas fail, to how to select between multiple investment vehicles. We'll even be asking Group 2 members to lecture on topics for the Group 1 team as practice. While I am very happy with the result at the end of yesterday, it is also what happened today which made me smile:

Today was the Rotman Finance Industry day and we had a host of speakers in the afternoon from industry (recruiters and alumni) as well as current students and the CCC. So far there wasn't anything earth shatteringly new (mostly hearing the same message from different people: Finance is hard to get into, this is how you should prepare: read the Vault Guides, read the newspaper, be intense... etc)

My proudest moment was during the presentation from one of the industry speakers when he mentioned that you have to calculate IRR's for different projects as part of your job. Immediately, I saw a few heads turn around and catch eyes with me with a knowing smile on their face. If there was anyone who was living the message of "MBA school is great, but a large component of your success is what you do and who you are" it was those who turned around and knew they were doing the right thing by preparing early. These were the people who, less than 24 hours before, were intimidated by Finance TLAs (Three letter acronyms) were now getting a sense of confidence.

Word has spread also. While Group 2 membership is deliberately limited (not a "snobby thing" but rather a purely logistical issue - I've been helping other people put together their own "Group 2's"), the word has spread and Group 1 has picked up a couple more members.

Again, I don't know if people remember that I had promised in my GBC first year rep speech to help all the Rotman students "reach their maximum potential" and build more equity into the degree (and network) we all paid so much to have the opportunity to earn, but I hope I'm beginning to show active signs outside of the standard "job requirements" that there is a lot I can offer and that we can do together.

International Study Tour - Middle East

I got some good news today from the PSO. I have been selected for the Middle East International Study Tour for course credit with Rotman. I'm very happy with the result. I thought that the interview process was very intense, and as I told my fellow classmates who were applying, I felt like I was competing against a future version of myself (the second years).

The tour promises to be an excellent opportunity for culture exchange as well as to understand global markets. The trip will be preceded by a six week course leading up to the travel itself which will be in the first two weeks of January. This means that I have to have my act together well in advance (because recruitment and interviews will occur immediately).

I am absolutely ecstatic about this and am looking forward to traveling with some very intense students from Rotman. This promises to be an exceptional experience and the preparation begins now.

CEO Compensation - Using Complex Derivatives

In our FIT class, our group presentation project was to look at CEO compensation (with deliberately vague instructions to give the teams flexibility to take the initiative on how to approach the topic: allowing us to think about our thinking). Our group was one of the teams that presented today (and we got generous feedback from our peers), however, it's another group's presentation I wanted to discuss in more detail.

Nick Kerhoulas' team, composed of Amanda, Nik, Mark and Nick K, mentioned in their presentation the unique idea of compensating a CEO with stock options against a benchmark. I thought this was a brilliant (yet generally overlooked) idea and I wanted to explore it further.

First, you will probably notice a trend (and skeptics and critics in the market have always highlighted this) that when a company has done well, it is touted as because of good management (alpha). However, when the company is doing poorly, it is pitched as being because the market (beta) is in recession.

In using Kerhoulas' idea which he presented in class, I think it would be interesting to see if CEO compensation could be restructured to include more complex derivatives rather than just stock options. Although stock options are a form of derivatives, deriving their value based on the underlying stock (in this case the firm's equity), I think Kerhoulas' idea can be adopted with more complex derivatives. My proposal is to use a sort of net neutral strategy similar to the market leader growth strategy I mentioned at the end of this previous post. The assumption here is that you believe your company should outperform competitors.

How would this work? Well rather than compensate your CEO with either pure equity or call options to buy the equity at a given exercise price, the CEO should be compensated with a mix of these options as well as a short position against an industry index. What does this mean?

The short position against the industry index means that if the industry as a whole succeeds because the market rises (beta), the compensation of the CEO goes down (the firm is succeeding because of the industry). However, if the CEO's decision making allows his/her firm to outperform the industry, then (s)he will be compensated based on the performance in excess of what the market is providing (alpha).

Similarly, if a market is in recession (beta), the short position gains value as the market declines, but if the CEO can manage the company to outperform (or 'do less bad' than the market as a whole), (s)he gets compensation accordingly (based on alpha).

How about poorly performing CEOs? If management ability (alpha) ever underperforms the market (beta), the CEO's compensation will always be negative. Now rather than qualitatively make statements against the causes of your firm's performance, you can use the market index as a benchmark to have a context in which to describe management (CEO) performance as suggested by Nick.

I think another interesting result is what happens if this compensation structure is adopted in a system (say, the industry at large) versus in isolation (at one company). I intuitively believe that the game theory grid that would represent this scenario describing a system would resemble the prisoner's dilemma, in that as CEO's are incented to "outperform" the market becomes more competitive and the market index rises (which reduces overall compensation within the system due to all the short positions) because each of its individual components rise. It could even potentially be framed as a zero-sum game (as shown below) if the CEOs are forced to trade stocks with each other to create the required short positions in the market index.

This actually even acts as a natural cap for CEO compensation, but still motivates CEO's to fight over the same pool of compensation. The maximum compensation available will be determined by the increase in the short position of the market (how the market moves as a whole), but CEO's can essentially earn more compensation against their competitors.

Example:
Assume 3 CEO's managing equal companies. Each company's stock is valued at $100.
Market index is composed of one of each stock and the compensation derivative is described as:

• Long three shares of the company's stock
• Short one unit of the market index

Assuming that companies 2 and 3 have stable performance (no change in stock price), but company 1's performs and stock price goes up by $10.

Total compensation would be:

• Long three shares: Increase in value $30
• Short Market: Decrease in value $10
• Total compensation change:+ $20

Now try a new (industry wide / systems based) scenario:

Firm 1's stock: +$50

Firm 2's stock: +$20

Firm 3's stock: -$10

Market index: +$60

CEO 1's compensation: 3*(+$50) - (+$60) = +$90

CEO 2's compensation: 3*(+$20) - (+$60) = $0

CEO 3's compensation: 3*(-$10) - (+$60) = -$30

Note that the sum of the CEO's compensation is $60 (CEO compensation 1 + 2 + 3 which is the Market index). This is because the market index compensates 3 CEO's with 3 shares of each company, and the CEO's each hold three shares of their own company. It's as if each CEO shorts competitors' stocks to the other CEOs respectively. In this way, there is a natural cap on the CEO compensation (which is directly reflected to the value they bring to the market) yet, CEO's are still incented to overperform because they can capture the bonuses of their competitors if they outperform them.

Would this work in practice? Well the only people who would actually adopt this form of compensation are the executives who actually believe they can outperform the market. Once this gains legitimacy as a compensation structure by those who want their performance bonuses to have high credibility, it provides companies with a quantitative answer (and a nearly indisputable answer) to the question: Is your company performing well because of you or the market you are in?