Giant Cheerio

"Oh my god. Brian, there's a message in my alphabits. It says 'oooooo'." ~ Peter
"Peter, those are Cheerios." ~ Brian, Family Guy

Miranda's team was in the General Mills competition and she mentioned an idea that was critisized as a "Giant Cheerio".

One of her team mates decided to carry the joke a little further. It was delicious.

It was by far the most clever and delicious thing I've ever seen anyone make out of anything ever.

Integrative Thinking Practium - Agent Based Modeling

At the beginning of the course I was a bit confused. At first I thought I didn't really understand what was happening. And then our class today started by describing a model of sand falling on a table. I was further confused as to how this was in any way related to business.

With a few changes in our frame of mind, "sand falling on a table" became a metaphor (or analogy?) for customer arrivals at a business. Pile height became analogous to company capacity constraints and pile location became geographic properties of companies.

Suddenly, we actually had a working model for the growth of an industry into equilibrium which encompassed such ideas as customer movement from one business to another. With a few more tweaks, the model was even able to show the decline of an industry (and death of underperforming companies).

I think my favourite part of this class was that it showed us in a very intuitive way how the models of our business work in more practical sense which are based in math, but don't require formulas.

I do apologize for my explanation as I don't feel it truly does justice to the class, but it encorporated topics we had learned in economics, operations management, managerial accounting, strategy I and II (Prof Ryall even made references to Anita McGahan's research).

Gravity as a Analogy to Globalization

Our professor just used one of the most clever analogies for international trade I've ever seen. It's surprising how much the physics of gravity can model relationships involving size and proximity.

The formula for the physics of gravity is:

Force = Gravitational Constant x Mass 1 x Mass 2 / Distance ^ 2

In this analogy:

• Force -> Strength of trade relationship
• Gravitational Constant -> Trade coefficient <-- trade barriers / regulations / tarrifs?
• Mass 1 -> Size (GDP as proxy?) of country 1
• Mass 2 -> Size (GDP as proxy?) of country 2
• Distance -> Distance

Our professor, Blum, took it a step further and did a logarithmic deconstructed the formula to further show how changing different values of each variable (pulling different strings) results in intuitive changes in the relationship. For example: Decreasing distance between countries increases. He even quotes his research (2004). This is his criticism of the idea that the world is truly "flat".

Imagine the game theory implications also. If you could use this relationship to predict how countries would trade and grow, you could build a model with multiple components (countries) to see how they'd develop.

So... It turns out that when Roger Martin tells us that Rotman has a world class research faculty which impacts the material we learn in our classes, he certainly wasn't lying.

Non-Leveraged Accretive Mezzanine Financing

I was looking over my CFA Level II materials for corporate finance this weekend when I looked at the CFA's definition of different types of risk. For instance:

Sales (Business / Industry risk)
- Operating Expenses (Operating Leverage)
- Interest Expense (Financial Leverage)
_____________
Cash flow

The definition of any type of leverage (operational or financial) is increasing your fixed cost component but reducing your variable component.

It got me thinking, is it possible to have an instrument which doesn't increase leverage and solvency ratios, but also provides accretion for common equity holders? For instance, if you want to deleverage, the general strategy is to purchase debt with equity (which results in dilution because cost of equity is higher than cost of debt due to risk concerns etc). I don't know if this is possible, but I asked myself about a preferred share with very particular characteristics.

Fixed income instruments (coupon paying bonds, dividend paying preferred shares) increase the fixed payments required which technically increase leverage.

Accretive
Is it possible to have a preferred share that, rather than paying a fixed predetermined dividend (similar to dividend yield based on price), that pays a percentage of net income (similar to a stated dividend payout ratio). Because it is more senior than common equity, the cost of this capital would be less than the cost of equity (accretive if used in a refinancing / capital restructuring).

No Leverage
But the payout would also be variable based on NI meaning that it isn't technically leverage according to the CFA definition (plus it would be classed as equity rather than debt on the books). If earnings are low, the payout is low. If the earnings are high, payout is high. It rises and falls as a variable component rather than a stated fixed component.

The problem with this model of an instrument is that I don't think you could get a "senior" level instrument to payout variable to net income with a cost of capital less than common equity because they technically face the same level of risk (percent of NI).

Also, because earnings can be manipulated, perhaps the payout would work if it was stated as a percentage of EBT or some other higher quality form of earnings? At first I thought EBITDA, but then I realized that doesn't make sense. It would have to be paidout after EBIT (because interest should be a more senior form of financing and paid first). However, EBT is often modeled with a fixed tax rate to go to NI (so a % of EBT is really a % of NI since tax rate is usually constant).

Perhaps it could be payed out as a % of EBITDA which is paid out after interest?

This would justify the instrument being more senior and paying a lower cost of capital.

Q3 Grades

Q3 grades came out today (just in time for the weekend). After this much "official academic" feedback, the world between expectations and reality are starting to collide for most so there were no major surprises.

Personally, my grades are about the same (only a 0.02 change in GPA) and I am happy to say that I did particularly well in the courses where I expect to have my future career.

As I said last quarter, my grades seem to be reaffirming the fact that I'm really enjoying what I'm doing, learning a lot and having a great time.

Why isn't my deal accretive?

I'm building an M&A model for two firms in the same industry and I noticed that the deal I was modeling wasn't accretive. However, the PE for the target was lower (marginally) than the PE of the acquirer and I was using a capitalization structure that was similar for both (both had about the same debt to equity ratios implying similar capital structures). Both also paid about the same interest rate on their debt.

According to simplification and a common interview question, as I mentioned before: buying a high return equity with a low return equity means you should get to "keep the difference". So in this case, when I modeled an acquirer with implied cost of equity lower than the target, I couldn't figure out why my model was telling me the deal was dilutive!

Turns out, I had forgotten about my asset write ups. What I had done was allocated 25% (not sure if this is a reasonable number - I don't have practical experience yet and I also don't have intimate / insider knowledge of the company being modeled) of my good will to writing up intangible assets. What does that mean?

Often a company develops intangible assets (brand value, patents). Companies are generally not allowed to record the value of their own internally developed intangible items on the books (because this would be a very subjective exercise). However, when companies are purchased, the value above book value is recorded as goodwill. Companies can further allocate portions of this good will (not sure the legal or accounting regulations, although I'm sure there are plenty) on the books as intangible assets and amortize them over time.

So what happened in my model? I merged two companies that had similar capital structures and costs of capital (with the target returning *slightly* more), but these synergies were being offset (at least temporarily in the short run) by the increase in D&A expense due to the write up of intangible assets resulting in an apparently dilutive deal.

Note, however, that for an owner with "foresight" (that is to say, not earnings focused), having a higher write up value increases the D&A expense which results in an increase in cash flow (from the tax shield of a non-cash expense) and also reduces debt and interest payments in the long term (model assumes a sweep with a portion of debt financed in a revolver). That is if you can stomach the low to negative earnings results in the short run. The deal would look more dilutive in the short run, but actually be much more accretive in the long run.

GBC Elections for Second Year

The GBC is currently holding elections for all it's Executive Positions. There are some very strong candidates running who are very motivated and excited for the next year.

Because I'll be gone for half the year on exchange, I don't qualify for running for any of the GBC positions nor many of the clubs positions (a sacrifice I knew I'd have to make and acknowledged in my exchange interview).

However, I will still be around and helping students out in my own little way, either if people want help with prepping for jobs or in classes (I'm considering being a Rotman Scholar perhaps). I know that our year has been doing very well both academically and in our career hunts and that is very much a function of the support we received, especially from second year students.

Already, I have a few friends I know are coming to Rotman next year and I hope that my year can be as useful to them as the second years were to us.