(Half) DONE!

Well, no one said it would be easy. In fact, I'm quite sure everyone was saying it would be really hard. But we finished the operations exam (and by extention first year of our MBA program).

I think everyone generally agrees that Operations Management is the toughest course. And although I'm told engineers are supposed to have an advantage over our classmates when it comes to this course, I think my advantage may have left me when I wasn't looking.

Anyways, the class is heading to a variety of events tonight to celebrate, so I'll probably keep this short. Everyone's energy level has kicked up a notch as people are excited to move on. Some summer jobs are starting straight away on Monday May 3rd. A bunch of us are going on study tours (Latin America study tour flies out tonight and I'm told India study tour flies out this afternoon).

I'm excited to be going on the tour and will certainly keep a better blog post pace than recently.

Flirting with 0.5 MBA

We have entered exams week for Q4, the final quarter of our first year MBA program. We've started it off today with Managerial Accounting. Tomorrow, we have Global Managerial Perspective (GMP) and Friday will be Operations Management.

The other two courses, Business Ethics and Integrative Thinking Practicum (ITP) have major team assignments due, but most teams have finished this work well in advance of exams in order to focus their energies.

I've just moved to my new place closer to work downtown for the summer. I'm subletting from a friend who will be gone. I must say, it feels much more human to have moved out of my notorious "haunted house" in Chinatown near Spadina and College. In all fairness, a good friend of mine gave me some advice for first year: "You'll be at school most of the time until late anyways, so just get a place nearby so you can rest your head at night" and he was absolutely right. As much money as I would have saved staying at home, it was certainly worth the marginal cost to live close to school.

Allowance for Doubtful Collection

In continuing with the thoughts on revenue from last week, I thought it might be worthwhile to look to look at allowance for doubtful collection of funds. Generally, there are two methods which are used: % of receivables and the aging method.

The first method, % of receivables is quite simple and self explanatory. There is a predetermined percentage of receivables (calculated based on historic numbers) which is expected to default.

So assume that this is 1.85%. If the firm's gross revenue is $1M (and all credit sales), then the expected bad debt associated with those revenues is $18.5k. The net value of receivables is $1M - $18.5k or $981.5k.

The aging method is more sophisticated and provides a better picture, however, it requires a great deal more work.

For example: Assume the following definitions:
Normal - Receivables is between 0 and 60 days old (99% chance of collection)
Distressed – Receivables is between 60 to 90 days old (95% chance of collection)
In Default – Receivables over 90 days old (50% chance of collection)

Now assume that of that $1M, there is:
$900k of Normal AR
$90k of Distressed AR
$10k of In Default AR

The expected value of those receivables would be:
Normal – $900k x 99% = $891k
Distressed – $90k x 95% = $85.5k
In Default – $10k x 50% = $5k
Total value = $981.5k

I’ve chosen very particular numbers to get the same result as above, but this also proves a point. If the structure of your debts is predictable enough (or with little variation), a percentage of receivables method is essentially a sort of weighted average of probable defaults.

Winding Down, Gearing Up

While the MBA program is a very packed two years, it does seem to go by very fast. Already, we are almost halfway done (will be as of the end of next week). Yesterday, the GBC class reps had our last meeting of the year. In the last week, positions for various clubs have been announced and people are finding out in which capacity they will be assisting clubs. People have also started volunteering to prepare for the Orientation Camp 2010 for the incoming class (I've applied to participate in that also).

Unlike undergrad which (in engineering) we used to describe as "the worst four or best seven" years of your life, the MBA program is only two years which poses significant challenges when it comes to clubs. There is a very strong "in and out" mentality which is purely a function of the nature of the program when it comes to clubs relative to our undergraduate experience. However, many of the students have strong experiences in extracurriculars and work having passed through the recruitment and admissions process, so they are ready to be thrown right in and get right to it.

Already, there is some talk about some of the new initatives that will be undertaken next year and it will be exciting to see what results they produce. For the incoming class, I suspect that their experience will be improved from ours (which was improved from previous).

More than Mechanics

Many people are still job hunting (with some positive results being announced recently) and I've been collecting their experiences with the recruitment process.

One thing that is common with the successful candidates seems to be that they all have some form of edge and advantage to distinguish themselves from others. While it might be ironic to try to find a common thread which runs between a group in which individuals try to distinguish themselves, I think one of the common themes is the idea that there is more to finance than mechanics.

I can also appreciate that it is VERY easy to focus on the science, mechanics, valuation techniques etc. After all, that is the focus of this blog (generally speaking). However, as some of my colleagues in industry have mentioned: "Understanding the mechanics is table stakes. You can't play the game if you don't know the rules. But you can't succeed if you don't know how to build relationships."

So while having the technical skill is sufficient to do the job at a junior level, if you can't build relationships (leading to driving deals) you can't become a senior manager in finance (or anything really). And if you don't at least exhibit the potential to become a senior manager, you probably won't be given the opportunity to be a junior (after all, what's the point of hiring someone who doesn't have potential to excel?). Even the best Equity Research Analysts (considered one of the most quant jobs) are great at selling ideas. After all, who cares if you're analysis is perfect if you can't convince someone to look at it?

Having said that, a question asked by JD is a common question by people looking to enter the industry. How does my background fit when transitioning to a job (particularly finance)? In JD's case, with a background in sales in marketing (and any job in general) I'd focus on your ability to sell an idea. Don't worry about demonstrating your technical prowless.

While you need to strike a balance beween showing interest and going overboard, you can't expect to be able to answer EVERY technical question that comes up. As keen and diligent as you are, the person interviewing you has already passed the vigorous recruitment filtering process and is now doing this as their livelihood and is guaranteed 100% to know this more than you and drill you until you get to a place where you simply don't have the answer. It's more important to show interest, that you've taken the steps to learn as much as is reasonably possible and that you have the potential to excel.

Valuing Commodities Companies - Looking at P/NAV

Recently, I've been trying to learn more about commodities companies building on what we've learned in class as well as discussions with colleagues. Especially as Canada is a strong resource based economy (with a currency heavily influenced by the price of oil, I'm told), it is important to understand how these companies are valued.

Shree was previously very kind to explain why commodities companies provide leveraged exposure to the underlying commodity. In fact, I'm told that this is the reason why companies trade a P/NAV multiples greater than 1.

When I inquired as to what exactly Net Asset Value (NAV) was composed of, I was told that it is essentially the Asset Value (value of the commodity "in the ground") netted by the cost it took to get that asset out of the ground. So if you had to take a snap shot of what that company was worth, you'd intuitively assume that the value of the company was it's NAV.

However, as Shree demonstrated, the markets are always moving and the price of the commodity which the company bases its value on will change. This produces option like behaviour in the price of the company. While not a perfect explaination, I was told to think of it this way:

The value of the company is related to it's NAV PLUS a premium associated with the volatility of the commodity and the probability that the price of that commodity will increase. This is analogous to Intrinsic Value (NAV) + Time Value of a call option.

Obviously, there are a host of complicated relationships related to volatility, future price expectations, supply and demand, hedging and speculation which make this basic generalization a little too simple. However, I think it serves as a good starting point for how to think about and model the price.

This is similar to what we learned in Finance II when our professor explained the example of land that contained 1M barrles of oil which could be extracted at a price of $70 per barrel when the market price of oil was $60 per barrel. While a naive NPV calculation at today's rates would imply a negative NPV, the potential for the price of oil to top $70 provides real value to the land.

Another Look at Synergies

In thinking about OWC and also M&A recently, I was thinking about other possible forms of synergies rather than the two most obvious ones: revenue growth and cost reduction.

While not exactly the same as cost reduction, there are potentially certain economies of scale which can be achieved through reducing OWC requirements. Firstly, when looking at PV of CFs related to synergies, recall that FCFF (UFCF) is defined as:

FCFF = NI + Dep - Δ WC - Capex + Int (1 - t)

Increasing sales and decreasing costs will certainly affect NI, but I also thought that there was the possibility of also being more operationally efficient (reducing size of distribution networks, inventory holding requirements and demand / capacity mismatches due to manufacturing variations resulting in either lost sales etc). Most of these topics are the same topics ones we discuss in our Strategy and Operations Management courses and would affect all the activity ratios.

While probably not the most significant category of possible synergies, when dealing in deals worth millions or billions, I'm sure such attention to detail would probably result in noteworthy potential value creation opportunities. Also, this could be another potential reason why Stragetic buyers will probably command a higher premium than Financial buyers.

Another potential example I was thinking about was the idea of writing up intangible assets (which was the cause of my deal being dilutive). The value creation in this case, however, would be more for the target companies current share holders rather than the acquirers (and also be reflected in the division of synergies between the two groups through the premium).

The idea is that the target companies share holders gain value throught the premium which is the excess over fair market value. This excess is divided into write up of intangible assets and good will. While the acquirer "loses" some of the value through good will, it can reclaim some of the value of the write up of intangible assets through the tax shield provided by amortizing this value.

Again, while not as large an effect as the original two primary methods, I'm sure the attention to this detail will yield some additional value creation (and at least value retention for the acquirer) associated with an M&A deal. At the very least, the target shareholders can gain and the acquirers can give up less of their synergies.

Understanding Aggressive Revenue Recognition

While we normally look at items higher up on the I/S as being of higher quality (less prone to manipulation), there are still some issues which may cause analysts to take a closer look at some of the top line items. For instance, revenue is not immune to manipulation.

For example, a company that is looking to boost it's top line revenue might be more inclined to aggressively (through a variety of mechanisms) recognize revenue. However, with accrual accounting, there are many potential ways to detect some red flags with regards to changes in current practices by looking at the numbers.

First, let's decompose what revenue is actually composed of. Revenue is composed of two types of sales, cash sales and credit sales. Or expressed as:

Revenue = Cash Sales Collected + Δ A/R

Even if all sales contain some component of credit, the conversion implications as it relates to collecting debts will have a noticable effect on various ratios.

The most obvious among these is the Days Sales Outstanding (DSO) ratio:

DSO = (A/R) / Averages Sales per day = 365 * (A/R) / Sales

This is a familiar activity / operating ratio, because it is used to forcast A/R levels in the OWC schedule in a financial model and is the most obvious place to look to see if the active practices of the company have changed. It also plays a huge role in the Cash Conversion and Operating cycles.

Another interesting note is that with a constant of 365, this ratio tells the EXACT same story as the ratio (A/R) / Sales which offeres some insight into your company's policy with regards to percentage of credit extended per sale.

An alternative method is the portion of aggregated accrual attributed to revenue recognition method which is calculated as (A/R) / Δ in Net Operating Assets (or NOA).

However, note that the major components of NOA are Inventory and A/R (related to OWC which is similar but also includes A/P, prepaid expenses and other current / operating liabilities). Notice that when financial modeling, these items are modeled against ratios which incorporate I/S items such as Revenue, COGS, Operating expenses etc. Note that in turn, these items (COGS, Operating Expenses etc.) are usually modeled as a constant percentage of Revenue.

The end result? It doesn't matter which of the two ratios you use, they should both tell you the same story. If a company starts taking more aggressive revenue recognition through extending credit (and possibly risking having customers default on purchases), both of these ratios will increase as A/R as a % of sales increases faster than sales.

Defined Pension / Benefit Obligations

One of the interesting topics in the CFA Level II material is the mechanics for Defined Pension / Benefit Obligations. Previously, in the Rotman Finance I exam / CFA Level I material, I posted an example of the basic mechanics of how a pension plan would be valued (how much would be the PV of future benefit cash flows based on life expectancy and % of salary expectations and what rate of saving would be required to save the required FV to generate those future CF's).

However, if you notice, the "mechanics" of a pension plan are suspiciously similar to that of a bond. And that should come as no surprise. In the retirement or payout phase of retirement, it is as if the retiree is cashing out a fixed income investment (getting regular payments over time) or similar to amortizing a bond liability for the pension plan. However, when they are still "young and saving money" the pension plan is receiving regular payments overtime. The because the payments are regular and defined, they have all the characteristics of a bond.

This metaphor extends even further when you think about what the worker is doing. First a few contrasting scenarios:

Scenario 1: The worker makes a salary of $100k per year.

Scenario 2: The worker makes a salary of $70k per year, but has a defined benefit plan where the company contributes $30k per year into it.

In both of these scenarios the worker (assuming fair treatment) is being given the same value through salary (note also, the I/S in both scenarios reflects a $100k expense with regards to this worker... the only difference is that the $30k would be recognized as deferred wages or change in pension benefit non-cash expense on the CF/S).

However, let's take a closer look at that $30k. What is another way of looking at this? Well, another perspective is to say that the worker is deferring $30k of salary in the hope of future gain as realized through the defined pension benefit. In essence, the worker is loaning money to the company. Assuming that the DPO/DBO is as risk free as the company can guarantee (it is a contractual obligation) in terms of seniority of capital, this money actually ranks as quite senior (priority claim). This is a topic of particular interest with the recent financial crisis, especially as it related to Chrysler and it's recent financial trouble and relationship with the UAW / CAW.

This answers the next question: What is the appropriate discount rate for these funds? Well if you assume this obligation to be one of the most senior forms of claims against the company, it should have the most risk free rate the company can afford which is usually the same rating as it's highest quality bond.

This also raises an interesting point, if you were a lender or potential acquirer (through M&A or LBO) and you were analyzing a company with a defined benefit plan, would you consider the liability similar to debt? While it is not strictly a form of debt in the same way as a revolving credit facility, debenture, high yield bond, PIK or other, it noticably has many of the same characteristics (and is often modeled as a bond liability).

Non-Cash Expenses

A friend was asking me some questions about financial statements and modeling companies and it brought up an interesting question. What exactly are non-cash expenses? For example, when we calculate FCFF we normally just focus on depreciation, although technically depreciation is just a component of the broader category of non-cash expenses. The next most obvious non-cash related expense is deferred taxes.

This got me thinking about what else is included:

• employee stock compensation (appearing on the I/S as operating expenses in SG&A)
• deferred wages (possibly relating to a pension plan obligation or company matching scheme, also appearing in SG&A)
• restructuring charges
• impairment of good will
• amortization of intangible assets
• non-controlling interest

These are normally the cash flow items that appear right in the "adjustment for non-cash expenses" (or similarly named category in CFO) with depreciation and deferred taxs after NI but before operating working capital.

When we were doing financial modeling in NYC, this was the most common question people where people were confused and were asking each other as it related to what exactly was going on in the statement. Other items, like OWC, CFI or CFF were normally pretty straight forward.

With the CFA level II material, at least it is going over some of the more common items in detail which really helps when reviewing and reading F/S. It provides a bit of clarity as to exactly what is happening in the income statement and the real cash effects it is having on the operation of the company.

Purchasing Power Parity

Another example of exchange rate theory is the Purchasing Power Parity (PPP) condition. This model is similar to IRP in that it assumes that when purchasing commodities across borders that the same real price should be used regardless of currency.

For example.

• A widget costs $150 USD in the US
• The same widget costs £100 in the UK

What is the implicit FX rate between US dollars and pounds?

Well, you should be able to buy the same widget with either $150 USD or £100, so the implicit exchange rate (assuming PPP holds) is:

= $150 / £100

= $1.5 / £

Obviously, there are some HUGE assumptions required for this theory to hold. Minimal or zero transaction costs (including transportation, cross border tarrifs etc). In practice, it is probably more realistic to say that there is a threshold for which arbitrage probably won't happen in PPP because of the real costs incurred to handle transactions.

Also to be more accurate, rather than just use a "widget" it would be more appropriate to use a basket of goods to reflect a more broad use of the currency.

Interest Rate Parity Condition

The Interest Rate Parity condition that is in the CFA and discussed in our Global Managerial Perspective (GMP) class talks about.

Long story short, it says: Regardless of what financial mechanisms are used, two countries which are considered to be default free should generate the same real returns for the same period.

For example:
Today:

• You hold $1 USD
• The FX rate is 100 yen per USD
• The Japanse Bonds are yielding 5%

A year from now:

• FX rate is expected to be 103 yen per USD

What does IRP imply the interest rate on the US bond should be?

This can be graphically represented by:


The blue path shows how $1 USD is convered to Japanese Yen, held in a bond, and converted back at the new exchange rate back into USD. IRP states that whether this route is taken or if the USD is just held in a US bond (Red path) should make no difference. It should result in the same amount otherwise there is an arbitrage opportunity.

This is the solution. Note that the US bond rate is reverse engineered from the information given such that the end result produced in the red path is the same as the blue path.

You also note that there is a relationship which is defined by IRP. That is:

Japanese Bond Rate = US Bond Rate + [Appreciation / Depreciation of Foreign Exchange Rate]

Notice that this framework can have a blank in any one cell which can be derived using algebra if the other cells are filled in.

Recursive Options? Calling a Call

We've been shown how equity near bankruptcy behaves like a call option in our Finance II class. We've also been told in some of our integrative thinking classes to consider the models for employee (CEO) compensation to reduce the principle-agent costs / issues resulting from the relinquishing of control from capital investment.

My question is this. Consider the following scenario:

A company is struggling. It's Enterprize Value is low (less than debt) making equity intrinsic value essential zero (or negative) trading like an option.

In order to turn the company around and restructure, the company fires it's current CEO and recruits a new one. In order to motivate the new CEO to turn the company around, the CEO is offered stock options (we'll assume unrestricted for now).

What scenario have I just decribed? The securities that the CEO is holding are essentially call options on call options. That is to say the CEO's derivative, the call option, has an underlying asset which also behaves as an option (the equity behaves like a call option).

... Now assume that the stock is a mining company (which behaves like an option relative to the underlying commodity).

I wonder how you would even begin to model how much these options are worth? While valuing options itself are already quite tricky using models like Black Sholes Martin, I wonder what model would be appropriate for a derivative with recursive properties.

Also, as a financial derivatives joke, I overheard one unfortunate soul ask this question: "Are management stock options calls or puts?"

Sustainable FCFF (UFCF)

One of the most important measures of value for a company is Sustainable (Terminal) FCFF so I wanted to review some of the ideas which go into calculating it. As the finance saying goes:

"Turnover is vanity,
Earnings is sanity,
but Cash is reality"

Also, because Terminal Value represents somewhere between 70 to 80% of the calculated Enterprise Value in a DCF, the assumptions that go into developing and FCFF have a major impact on the final valuation.

First a recap of what composes FCFF (a slightly more educated view since my first encounter with this measure on the CFA Level I exam):

FCFF = NI + Dep - WCInv - Capex + Int (1-t)

To build up to FCFF, we

1. take NI from the Income Statement
2. add depretiation to get Cash Flow (CF) as a non cash expense (we'll ignore others like change in deferred tax liability for now although for a "sustainable" cash flow they'd net out at 0 anyways)
3. Subtract Working Capital Investment (change in working capital) to get Cash Flow from Operations (CFO)
4. Subtract Capex to get Free Cash Flow (FCF)
5. Finally, since we are looking for cash flows to all stakeholders (including debt holders) we add back the net value of debt after tax to get FCFF

Now let's break down each of these components. First of all, in real terms we'll project zero growth. However, some terms are susceptible to inflation growth (marginal nominal growth).

As a result, even with zero real growth, there will be some marginal incremental growth in WCInv and Capex to reflect this inflation. The best way to model it is as a percentage of sales according to the CFA.

FCFF = NI + Dep - WCInv - Capex + Int (1-t)

Another consideration is dividing up capex along two dimensions - 1. Maintenance capex and 2. Investment capex. Maintenance capex is defined as the capex required to maintain your operations. By definition, it is equal to depreciation. Therefore:

FCFF = NI + Dep - WCInv - [Maintenance Capex + Investment Capex] + Int (1-t)

= NI - WCInv - Investment Capex + Int (1-t)

Also, investment capex is related to expanding to new opportunities. However, again, since we are modeling a "sustainable" cash flow rather than a perpetually growing cash flow, investment capex is 0 by definition. This generates a further interesting result:

FCFF = NI - WCInv + Int (1-t)

Next I'd have a look at WCInv. If WCInv is stable, then it should produce a marginal change in the cash flow.

Note also that FCFF = FCFE + Int (1-t) + Net Principle Repayment

This shows that NI is a decent (though not perfect) proxy for sustainable FCFE and that by tacking on the interest net of tax effect, we can arrive at a good proxy for sustainable FCFF.

Choosing Courses

I'll probably be putting up more posts on technical finance concepts for the next little while. As it was when I was thinking of coming to Rotman, I used this blog to flush out and articulate ideas on what interested me. This was supposed to provide me with a voice and a place to review some of the ideas I was thinking about and help me decide (initially) whether I wanted to gun for Management Consulting or Finance.

Currently, we are in the process of picking what courses we want. Looking at the electives that might be offered next year (Balloting or "giving a heads up to the PSO regarding what we *might* take next year for scheduling purposes" was due last week) I'd want to take:

• Corporate Finance
• Financial Management
• M&A
• Options

However, as you can expect, these are some of the heavier finance courses. I was warned by every second year I met that it would be a bad idea to take more than three finance courses together in one term, regardless of how much we keen first years thought we loved finance. Especially any of the first three, which I'm told are the core courses for a "specialization" in Investment Banking.

So I find myself posting outloud again to both prep for the CFA exam as well as put some thoughts into writing for me to review as I select my electives for next year. Technically, with the credits I already have, I could get away with only taking three courses, but it seems like such a waste. A - We paid too much to come here to start taking "spares" and B - the profs are good and the topics are interesting. I guess it's just a matter of balancing workloads.

BATNA and Sharpe Ratios in M&A

While I missed the Negotiations class my classmates took for the Middle East Study tour, I was fortunate enough to have taken a Negotiations class at the Analyst Exchange in NYC where they explained concepts like BATNA (Best Alternative to a Negotiated Agreement) in a simulated negotiation environment.

Also, in ITP, we talked about the model for "rational experimentation", that is to say the formula which describes the logic between probability of successful outcomes versus the risk and initial investment required (looks suspiciously similar to an NPV calculation because it uses the same mathematical components with probability of success superimposed on the cash flow, similar to how the CFA teaches to account for risk).

With my last post on M&A and splitting synergies with the target's share holders, this got me thinking about what would be "rationally" fair in M&A negotiations. I thought about it and decided it might be a good idea to integrate the thoughts from the post below with the idea of a Sharpe Ratio (or more exactly, Roy’s Safety First Criterion – where we use a “minimum return” rather than risk free rate).

S = (E[R] - Rf) / sigma

Where:

• E[R] is the expected return of the project
• Rf is the risk free rate (or in Roy's SFC, minimum return)
• sigma is the standard deviation of the investment

Obviously, there are some of the same undertones that we have learned from CML or CAPM. While I was thinking about Synergies and Premiums analysis of an M&A deal, it struck me that while there is some "risk" in the total Synergies achievable, the Premium is paid in advance and essentially risk free. Immediately, some of the same terminology which was used in the previous post suddenly rung a bell with regards to the Sharpe Ratio (from CFA Level I).

I would propose that the Sharpe ratio calculation can be used in an analogous manner for an M&A deal with synergies. For example:

• Expected Returns --> Synergies
• Risk Free Rate --> Premium
• Sigma --> some sort of volatility related to success of M&A deals to achieve expected returns

In fact, you can take this a step further and get:

• Synergies / EV as a proxy for M&A incremental ROA
• Premium / EV as a proxy for M&A minimum return

S = (Synergies – Premium) / (EV * sigma)

The formula would then calculate something very similar to marginal excess ROA or value creation per unit risk by the deal. Besides helping you understand your BATNA, this metric might also help you select acquisition targets from a financial perspective.

PVs of M&A - Premiums and Synergies Analysis

There was an interesting perspective for Mergers and Acquisitions in the CFA course readings. Rather than look at accretion / dilution, there was the alternate perspective of looking at doing a sort of NPV analysis of M&A and seeing who benefits and what the implications are.

Example: Look at two companies A (Acquirer) and T (Target). The companies are all equity and have 100 shares each. However, A is valued at $1000 and T is valued at $400. Synergies (defined as the PV of all future cashflows) is valued at $200. The premium is $100 and the deal is all cash. What is the value of the combined entity, C?

C = A - Outflows + Inflows

Outflows = T + Premium
Inflows = T + Synergies

C = A - (T + Premium) + (T + Synergies) // T's cancel - makes sense, lose T in cash, but gain T in value by way of acquisition

Therefore,
C = A - Premium + Synergies
= $1000 - $100 + 200
= $1100

For the original share holders of A, the new stock price would be:
$1100 / 100 shares or $11, a $1 increase in value!

Note that T shareholders got $500 for their 100 shares or $5 each, also a $1 increase.

This is an interesting result, the actual value of T doesn't really affect the value of A. This alternative focuses more on two of the most important financial points of information on an M&A deal: Premium and Synergies. Because A and T split the synergies evenly through the premium, they both benefit the same. This result holds for any porportion of split between A and T shareholders based on the portion of the Synergies represented by the premium.

Another way of looking at it is this: Synergies are the value created in an M&A deal. The Premium represents what is picked up by the current owners of the target, T, where as what remains (Synergies - Premium) represents the value picked up by the original shareholders of A (the acquirer).

While this is a unique perspective, it also lends itself to another interesting result:

Continuing the example from above, the stock price for A is $10 ($1000 EV / 100 shares) and the acquisition price for T is $5 (($400 + $100) / 100 shares). A plans to acquire T by issuing T's current owners 1 Share of A for every share of T (giving away a "$10" dollar share for two "$5" dollar shares). We get an interesting result. Suddenly, the Value of A is different:

C = A + Outflows - Inflows

HOWEVER:

Outflows = 0
Inflows = T + Synergies = $400 + $200

Suddenly, value of C is $1600. Wow! Seems like we got something for nothing. But wait a second! We need to issue more shares to T's owners. How many? Well:

$500 EV / $10 per share = 50 shares.

So what is the new price per share of A? Well:

$1600 / 150 shares = $10.67 / share

Why is it lower? Where did the creation of value go? Well because A "gave away" some of their share of the synergies by paying T shareholders with PRE-merger valuations of their shares. Essentially, they gave T share holders some of their share of the synergies BEYOND the premium paid upfront in A's stock.

Note that T's former owners are now holding $10.67 for every two shares or $5.33 for each of their T shares or a $1.33 premium per share (@100 shares, thats $133). Notice anything interesting? The total synergies are the same ($67 for A shareholders + $133 for T shareholders = $200 total synergies), but T has taken a bigger slice. In the theoretical space, it is a zero sum game.

Why would A do this? A may not have enough cash on their balance sheet to entirely swallow T (they'd need T's full value in cash). Also, perhaps they are not entirely confident on being able to realize the synergies in the deal and are looking to share the risk with T's shareholders. Giving away stock might also incentivize some of T's current shareholders (aka current management) to stay, align their interests and realize the synergies.

Free Food Day

Today was certainly a good day for free food. We started the day with free breakfast courtesy of the PSO as an "End of Year" social event. The coffee was much appreciated.

Currently, we are in our Operations Management class talking about Caruso's Pizza case and pizza delivery systems. When it was time for our break, our professor ordered pizza for our class. Our classmates are now hoping for a InBev case next to complement our practical "case study method".

Speaking of which, last week we were playing the "Beer Game" developed at Harvard. In the [Root]beer game, a team of four players each manage a part of a supply chain in order to satsify the consumer demand at the end. Players within teams do not communicate and are not identified during the game and the only method of communication is by placing orders.

The point of the game was to demonstrate what happens with a small jot of variation. The players in the supply chain tend to panick and as a result they order much more than demand might justify.

Without having to describe any academic theory beforehand, the professors were able to show the dramatic "Bullwhip" effect that this had on the supply chain at each point. After we had the results, they described how this effect has been replicated over many iterations of this exercise throught their history of running the exercise. It was a truly remarkable exercise that was interactive yet seemed to lead to an inevitable conclusion.

George Soros - Breaking the Bank

We were discussing the notorious story of George Soros' shorting of the UK pound in our GMP class this morning.

The story begins with the UK joining Europe's Exchange Rate Mechanism (ERM), not exactly fixed but had a policy where the currencies were staying within an exchange rate band. This simultaneously existed with a carry trade scenario where the German government was offering a higher interest rate than the British Government so people were borrowing in pounds and lending in DMs.

George Soros foresaw the opportunity where people who were participating in carry trades with the British pound created an opportunity for currency deprectiation. He sold off all his positions and then proceeded to short the position. This aggressive "attack" position resulted in many other fund managers dumping pound denominated assets. On the "Black Wednesday", the Bank of England tried to fight back by raising interest rates up to as high as 15% that day, but it wasn't enough.

Also, this is compounded by the required draw of the UK's foreign reserves (another avenue to defend against currency depretiation) to prop up the currency would have resulted in a significant depletion which would not have benefited nor saved the currency (essentially paying out the speculators).

This reminds me of the scenario I experienced in the finance trading lab where I could see the ask list depleting very quickly (low number of orders). The Interest Rate Parity condition only holds if you have a player who is large enough to hold the position of the currency. In a scenario (often repeated in other markets) where people put a currency (or any financial instrument) under siege, it makes it difficult for players to hold their positions as they take massive losses.

Eventually, as the story concludes, the epilogue is that the UK bank decided to let go and allow the currency to depreciate. George Soros also made a reported $1B USD.

Exchange Rates - Currencies as Investment Instruments

Oddly, in my Global Managerial Perspective (an international economics course), we were discussing exchange rates and the professor brought up nominal and real exchange rates (nothing new really), but also introduced the idea of using a weighted average of currency exchange rates as a bench mark for appreciation. There are two neat ideas which I took away from this:

The first is that when currencies appreciate relative to one another (on a bi-lateral basis) it is often hard to tell what is happening. For example, the Canadian dollar flirting with parity to the US dollar in the last few years. Is this a result of the US recession and lack of confidence in their dollar? Or the fact that Canadian Exports are in high demand and driving up our dollar value? Or both? In putting together a weighted average of exchange rates against your currency, you can tell on a more clear individual basis if your currency is appreciating against your "basket", a proxy for global currencies and real Purchasing Power Parity growth.

The second idea is that this weighted average looks an awful lot like an index. Much of the language above encompasses the idea that it behaves like a portfolio of financial instruments. Having said that, I recognize that things like CAPM probably wouldn't work (considering that currencies are not return generating instrumentns) so a regression of gains over time from the currency to the "index" would probably be meaningless. In the same way that commodities (although they are assets - items that store value) are not investment assets in the same way other financial instruments are because they don't generate return.

As the CFA material mentions, the only real way to receive gains from non-income generating instruments (commodities and currencies) is to rebalance after a change in price of the underlying asset.

The Marquee Group - Financial Modeling 4 - M&A

On Saturday, there was the fourth and last module available to Rotman students from the Marquee Group's Financial Modeling Series - Mergers and Acquisitons where we did a mini (accretion / dilution) model for M&A.

Rather than just talk about the mechanics of how M&A is done, it was also good to talk about the underlying logic for why these transactional deals are done, what to look for and areas of concern for understanding if a deal is a "success" or not.

While we didn't have time to do a full-blown model, it was a good opportunity to brush up on the basics of putting together a small model to determine what the pro-forma financial statements would look like after the deal was done.

Also, Salim was there.

MBA or CFA? What's the Difference?

I've been asked repeatedly by various people about the difference in value between an MBA and a CFA. First there are some notable differences:

Pro-MBA

• If you decide to do an MBA, go to a top school. While the MBA teaches you very broad range of interesting topics, the value of the MBA program is heavily weighted towards the relationships and network you build.
• There is admissions in an MBA program with standards. You know the people getting in are motivated and ambitious and are probably very good at what they do and looking to take it to the next level. Also, with the Party Model of admissions, you have a diverse range of backgrounds and cultures.
• MBA programs have faculty, admissions, staff and alumni to provide support.
• Recruiters come to MBA programs looking for talent.
• You learn a broad base of business topics, not just those related to the Association of Investment Managment and Research (the old name of the CFA).

Pro-CFA

• There is no "admissions" into a CFA program. People here are motivated, but focused on finance. No need to write essays, cover letters, resumes etc. to apply. While you can just buy your way into writing the Level I exam, you can't advance without doing an enormous amount of work (mid-30%ish pass rate for Level I).
• If you don't go to a top MBA (and you are interested in finance), you might want to do a CFA instead. The CFA program has the benefit of being standardized and recognized around the world. It covers a lot of the same basic technical / quant materials as core courses in most MBA programs.
• If you are working in Toronto, it seems like everyone has one. Apparently, I'm told it also gives you the acumen to speak to buyside clients (or work on the buyside).
• There are local CFA societies where investment professionals meet. However, events are generally not free (sizable ticket costs for luncheons) but still good events.

Con-MBA

• An MBA will cost you about $70 to $80k at a top international school whereas the CFA is $400 for membership and $600 per exam (give or take) for a total of $2200ish (assuming you pass all exams in one go... A bit of a stretch).
• Admissions. Because it's not a light endeavour, you want to get into a top school. And top schools don't make it easy. Candidate profiles and application materials tend to skew higher for top schools.
• It consumes a LOT of time. Full time means you give up 2 years of work experience, pay, advancement, etc. If you do it part time, you give up a lot of "work life balance".

Con-CFA

• To get a proper CFA (the whole designation) it takes at least four years worth of experience [and] having completed the three tests (which will take you one year each assuming you pass each in one go).
• It also consumes a LOT of study time to prep for the exams. Almost like doing an MBA parttime I'm told for those who are doing it while working.
• HIGH failure rate. And most exams are yearly meaning a fail equates to a year delay and another $600 out of pocket.
• ALL self study. While you can take a course with Stalla or Schweser (or PASSMAX which I recommend), you don't really build your network. It's great for building your technical proficiency or signalling to the market (if you don't have any finance on your resume as I didn't when I started), but not as much for extending your contacts.

The Acumen

I've been exceptionally busy the last few weeks. Even though I've decided to place a moratorium on competitions, I’ve still found myself overwhelmed with the MBA and the CFA Level II material. One thing I’ve been trying to keep track of in my posts is the absolutely brilliant ideas I’m encountering, whether in the Rotman MBA or CFA Level II.

But lately, my ability to post and get work done has drastically dropped off. And I would like to think it’s not because I’ve gotten lazy, but rather because there is so much brilliant and interesting stuff going on that I can’t post it all.

And I think that is exactly the case. Example? ITP, a course that had many of us scratching our heads in the beginning has suddenly burst forth with ‘light bulbs’. For example, not too long ago, I was complaining about how “past performance does [NOT] predict future behaviour” in some cases but not others. For example, individuals (as social science will tell you) are predictable (past performance DOES predict future behavior) but this is not so in finance and capital market instruments (good luck buying a stock based on it’s past behaviour hoping for gains).

And ITP has taken this exact point and, in our latest team assignment, asked us to investigate why this is. How “predictable” individuals (with their behaviour well defined) in a group produce slightly unexpected results. And the effect this has on our perception of what we learn in finance classes as it relates to theoretical concepts (CAPM comes to mind at the top of this list, but is closely accompanied by the idea of bubbles and crashes in the stock market, a very timely topic).

You can imagine that I am very excited. Suddenly, I am being given the vocabulary to describe in practical terms what we’ve been taught in textbooks. One of the reasons why I came to the MBA program was to help me structure my thoughts so that I could package them and deliver them to someone in a more digestible format.

While I was fortunate to have known many brilliant minds at McMaster Engineering, in my work life, I felt like I wanted to further develop my business skills to speak the same language as my colleagues and be able to use descriptors outside of the Engineering dictionary so we could understand each other, work together and accomplish amazing things. It was one of my goals coming into Rotman: I thought I was pretty clever. But I wanted to develop my business acumen.

Electives Fair

Today was a very important day, the day when we learn more about the potential electives we can take next year. While the sessions run by the faculty were informative (Marketing had the best idea of having each prof pitch their own course so that many students could immediately tell if they were "interested") the sessions run by the students were truly insightful from the perspective of people who had taken the courses previously.

I'm pretty sure I know what I'm interested in taking next year with a few adjustments (part of the International Exchange application process is understanding what courses are offered at Rotman versus the partner school and making choices), what I have found interesting is that students have already started looking ahead and forming teams based on group work we are expected to do next year.

Unlike first year where most of our team based experiences are such that our teams are picked out for us, the majority of second year courses allow you to pick your own team mates. Some of us have jokingly said that we shall never meet again (many of my close friends have sworn off finance courses).

GRADitude Campaign Begins

Today marks the launch of the 2010 GRADitude campaign at Rotman. Funds raised by the campaign go back towards funding projects from the school. Money donated goes towards scholarships, travel bursaries for study tours and exchange, special projects by the GBC and a whole host of other initiatives at Rotman.

Personally, I've already benefited a great deal from Rotman. Besides the fact that I'm obviously having a great time here, I've also received a lot of financial support in the form of scholarships and bursaries to fuel my experiences.

While I don't have the financial muscle to donate much (the very reason why I needed the financial support to begin with), this is something that has helped me a lot and if I am lucky enough to "make it big" some day, I'd like to think that I could give back more to the school than my "two mites".

The school has made participating particularly easy, hosting a pair of events with the funds going towards the GRADitude campaign. The first is Lazy Dog Sports night, a fun event with games in the Atrium ($5) and a networking event at the Duke of York ($5 buys you a drink and entry, or you can pay $8 for the pair of events). Donations of $5 or more will receive a tax reciept. While the actual financial contribution of each ticket sale is not exactly earth shattering, what is important is the statement a contribution makes regardless of how small it is. The target goal is only $2000, the cost of putting in a nice foozball table in the new expansion. There is a competition in first year to see which section donates the most by dollar value and a competition for naming rights to the table by the year which has the highest participation rate.

While none of us are exactly matching Joseph Rotman's contribution, those who are donating what little we can are acknowledging the value of what we've been given beyond what's covered in our tuition in the same way that the Rotman MBA experience is more than just classes in finance (not a slight on finance... I love finance).

Something else to think about, giving doesn't have to take a financial form. While financial contributions certainly help, we are in the midst of elections season for various clubs at Rotman. People who don't currently have "excess cash" to contribute are finding other ways to support Rotman by donating their time in organizing clubs and events for next year.

While I'm told that there is no link to Rankings based on alumni donations (something that surprises me quite a bit), I think it would be short sighted to say that it doesn't have an enormously positive impact on the Rotman experience to have the support of current students and alumni. Even staff and faculty give, with participation rates historically as high as in the 60+% range.

And at the end of the day, being the best b-school in Canada didn't just happen. It is a combination of recruiting smart interesting people to share your classes, a world class faculty to research and teach, and administrative staff and alumni to support us.