The

Timeless

Essence of

Financial

Science

Rajesh D. Mudholkar, B.Com., ACMA

First Edition

First published: December 2013

CreateSpace Independent Publishing Platform

©Copyright 2013

Rajesh D. Mudholkar, Author.

All rights reserved

ISBN: 978-1494799519

This work is dedicated to my late father

who stood as a living example of tenacity,

optimism and mercifulness towards

human fallibility even while enforcing

discipline. He inspired me to aim high,

pursue dreams with passion, and instilled

the values of spiritedly overcoming any

adversities that may come along.

Acknowledgements

This book draws upon more than three decades of my professional

and personal experiences, reflections and insights, gained through

several years of working in leading multinational corporations as well

as teaching corporate finance, quantitative analysis and business

research at post graduate business management programs, after

acquiring the CMA degree from my alma mater, the Institute of Cost

Accountants of India.

Words seem inadequate to convey my gratitude to God, whose divine

benevolence has been the driving force behind this accomplishment.

The blessings of my ancestors and elder kin have contributed in

abundance. Lipika my wife has been the biggest source of inspiration,

as well as my staunch critic, lending her linguistic and editing skills to

articulate ideas with lucidity. Her unflinching faith in me and her

tenacity have also been instrumental in helping me surmount the

trauma of a malignant tumor and accelerate the creation of this book.

The eagerness of a child excited about seeing a book authored by her

father - something that I saw in my daughter Raashi - kept my

motivation high without a pause.

I am deeply grateful to all the doctors whose skills and care gave me a

second life, as well as my friends, well wishers, acquaintances and

colleagues who motivated me during those traumatic days. I consider

every single person with whom I have interacted during the creation of

this work for various purposes - be it discussing a technical point,

seeking advice, or simply bouncing off ideas - as a valuable contributor

towards honing its ultimate result. I wish to sincerely thank each one

of them.

Rajesh D. Mudholkar, Author

Disclaimer

Utmost care has been taken to ensure factual accuracy of data used

and/or presented in this book. Errors and omissions if any, that might

have crept in despite rigorous efforts, are purely accidental and

unintentional. The sources from where such data are obtained have

been mentioned either in the bibliography or in-text as appropriate.

The analyses and arguments presented here, are only an objective

evaluation of various financial theories, practices and concepts

prevalent worldwide, from a professional viewpoint with due respects

to their learned authors, originators or creators. There is no intention

to offend any of them, whether living or dead. Where copyrighted

content is used as reference to explain a point, the copyright owners

have been duly cited. This book is intended to be purely an analytical

treatise, based on the author’s own work and ideas, and not to be

construed as professional advice.

Rajesh D. Mudholkar, Author.

Contents Preface i 1. Introduction 1 2. One Decade, Three Crises! 9 3. The Hypotheses 23 4. Anatomy of a Crisis 41 5. A Fatal Communication Error? 59 6. The Role of ‘Beta’ in Corporate Finance 91 7. Breaking The CAPM Mystery 127 8. From Portfolio Theory to CAPM: A Heuristic Slip? 227 9. Models Deceive, Cash Flows Don’t 249 10. WACC violates the WYDIWYP principle 269 11. If Archimedes Was an Economist! 313 12. Value Centric Capital Budgeting 357 13. A Word on Pay Back Methods 383 14. Measuring Value 395 15. Financial Decision Making Standards 445 Bibliography 457

i

Preface

The biggest irony of economic science lies in its fundamental

assumption. The premise of ‘rational humans’ that economics says we

are, tends to portray the psychological trait as instinctively natural, just

as instinctive it is for fish to swim or birds to fly. We have been

conditioned to believe that evolution, as explained by the scientific

theories of Charles Darwin (1809 - 1882), has transformed us from

mere ‘animal’ to ‘thinking animal’. Yet, the truth cannot be more

vividly described than by the following words of Albert Einstein (1879

- 1955). “Any man, who reads too much and uses his own brain too

little, falls into lazy habits of thinking.”

Interestingly, the tendency for ‘lazy thinking’ was indeed identified and

explained by the then new school of psychology called ‘behaviorism’

beginning with the earliest contributions by Russian physiologist Ivan

Pavlov (1849 - 1936). Later, John Broadus Watson (1878 - 1958), an

American psychologist, formally established the behavioral school.

Through his research and experiments he demonstrated the behavior

of conditioned response. Nobel Laureate Daniel Kahneman (born

1934), with Amos Tversky and others, established a cognitive basis for

common human errors which arise from heuristics and biases.

Kahneman developed the well known ‘Prospect Theory’. Nobel

Laureate Robert Shiller (born 1946) an economist and author of the

New York Times bestseller ‘Irrational Exuberance’ strengthened the

behavioral finance school, building on the work done by Kahneman.

ii

We know now that the reasons - why psychologists prosper more,

showing people ‘what they are’ and marketers make fortunes from

‘legitimately exploiting behavioral flaws’, than economists who try in

vain to explain ‘what people should be’ - are the same as why investors

read ‘Benjamin Graham’ and ‘Warren Buffet’ but continue to follow

the next door investment advisor, whether qualified or not!

Albert Einstein developed the theory of relativity, a concept that space

and time are relative to the motion of the observer. Our understanding

of ‘value’ cannot be complete if we deter from Einstein’s theory.

Without a well defined benchmark of ‘expectations’ to relate to, it is

impossible to say whether economic benefits ‘delivered’ by a business

enterprise has created ‘value’.

Archimedes is known for his explanation of the principle of the lever.

Although financial economics knows how to benefit by applying

leverage, it has also suffered due to its indiscriminate use.

The era of industrial revolution in the 18th and 19th century also saw the

establishment of the world's first business school ‘ESCP Europe’ in

France in the year 1819, of which the economist Jean-Baptiste Say

(1767 - 1832) best known due to Say’s Law of markets, was the co-

founder. Since then, several advances in the fields of economic science

and business management have been made. The art and science of

financial economics and business management has evolved over time,

enriched both in theory and in practice with several new theories, tools

and techniques. Even though tremendous benefits were derived from

iii

these developments, repeated financial crises and bankruptcies have

engulfed companies and entire nations, causing widespread misery to

their citizens.

Are serious cognitive errors being unwittingly committed? This

question should be of great concern not only for the present, but also

relevant for securing the economic future of mankind. If the flaws that

led to past accidents persist into current and future practice, the odds

in favor of a recurrence of history are stacked quite high.

Despite several years of scientific studies and a number of Nobel

awards honoring significant contributions to economic science, one of

its fields - ‘Asset Pricing’ that has had the most practical impact, still

remains inconclusive. The search for an acceptable asset pricing model

has not ended. This is confirmed by none other than the 2013 Nobel

Laureates in Economic Science - Eugene Fama, Lars Peter Hansen and

Robert Shiller. The conclusions that they reached is clearly expressed

by the Nobel Economic Sciences Prize Committee in their scientific

background note to the 2013 award, which says:

“....we do not yet have complete and generally accepted

explanations for how financial markets function....”

The insights and arguments presented in this book, attempt to unravel

several fallacies practiced in corporate finance, which by virtue of

being interlinked, produce a compounding damage. Although the ideas

and issues discussed herein pertain to what is presumed to be a highly

iv

technical and inveterate field of corporate finance, the presentation has

been guided by a desire to make it comprehensible to all because

financial economics affects all. A common sense approach, liberal use

of diagrams, tables, real-life examples and ample authoritative

references, should enhance the utility of the book.

This book is a sequel to its debut version titled ‘Value Erosion’. It has

been rechristened so as to aptly describe its more comprehensive

coverage, added insights and to highlight that there is nothing ancient

or modern when it comes to human behavior. Wars were fought then

for gaining control over economic resources, and wars are fought now

for the same reason. We cannot get away from the truth that focusing

on war-winning strategies is more rewarding than getting embroiled in

battling multitudes. The timeless relevance of financial science

essentially rooted in traditional economic principles cannot be

forgotten.

The main purpose of this book is to resolve the world’s most dreaded,

painful and chronic illness - ‘Financial Crisis’. As if a failure to prevent

one was not tragic enough, the shocking truth this research reveals is

that the methods already followed in financial practice actually

contribute to the crippling disaster. This book should be valuable to

mainly those involved in strategic business and economic decision

making. It should also be an insightful resource for those youth

pursuing business management careers, who aspire to be world class

business leaders, as also ordinary investors whose wealth is actually at

stake.

v

If these goals are achieved, it would be worth the effort. Readers’

comments, suggestions and even criticism will only help in making the

journey towards improvement as meaningful as it has been in the

making of this edition.

Rajesh D. Mudholkar, Author

December, 2013.

vi

- 1 -

1

IInnttrroodduuccttiioonn

- 2 -

- 3 -

Chapter Summary

The 2008 financial crisis, that destroyed US$ 29.7 trillion in

shareholder wealth worldwide in a single year, is evidence that

something is fundamentally wrong with financial practices,

which tremendous developments in financial economics,

managerial know how and regulatory checks and balances

since the industrial revolution, have not been able to resolve.

- 4 -

- 5 -

“JPMorgan Acts to Buy Ailing Bear Stearns at Huge Discount”

The New York Times, March 16, 2008(1)

“Lehman Files for Bankruptcy; Merrill Is Sold”

The New York Times, September 14, 2008(2)

he word ‘discount’ sounds as tantalizing to a bargain hunter as it

spells doom for the hapless owner in distress. For Bear Stearns

selling at merely $2 a share, a whopping 93 percent discount to the

closing price on New York Stock Exchange barely two days ago,

‘discount’ was an understatement. Business, as the saying goes, is

indeed a zero sum game. While for the top brass at J P Morgan, this

once-in-a-lifetime bargain might have been good reason to cheer, the

sentiment pervading the precincts of all the ‘white-shoe’ firms in

distress, suddenly confronting calamity, couldn’t have been gloomier.

If Bear Stearns was an Easter gift for J P Morgan, Santa came calling

for Bank of America in the form of the $100-billion-a-year-ago Merrill

Lynch, offered at half the price.

T

- 9 -

2

OOnnee DDeeccaaddee,,

TThhrreeee CCrriisseess!!

- 10 -

- 11 -

Chapter Summary

The 2008 financial crisis was not an exception. If the Asian

financial crisis in the late 1990s that cost the IMF nearly

US$40 billion and the Euro Zone crisis in 2011 that put a

bailout burden of €484 billion on many countries, are

accounted for, it’s a massive score of economic damage in a

relatively short span of barely a decade and half. This is reason

enough to suspect the presence of hidden cognitive flaws in

understanding financial markets. Obviously, no acceptable

asset pricing model can possibly be developed if the behavior of

financial markets - what a good model is expected to represent

- is not well understood in the first place! Based on the research

by the 2013 Nobel Laureates, the Economic Sciences Prize

Committee confirms that we still do not have complete

understanding of financial markets and that lack of a reliable

asset pricing model causes mispricing of assets and contributes

to financial crisis.

- 12 -

- 13 -

“Experience is not what happens to you; it's what you do with

what happens to you.” - Aldous Huxley

he financial crisis of 2008 was not the only one of its kind this

generation had witnessed. Little more than a decade ago,

another major disaster, the Asian financial crisis, had put the whole

region in distress. Originating in Thailand, it had radiated across all

ASEAN countries causing widespread loss of demand and confidence.

In part driven by real estate, Thailand’s burden of foreign debt

rendered it effectively bankrupt even before the collapse of its currency.

Foreign debt to GDP ratios spiked from 100% to 167% in 1993–96,

breaking beyond 180% during the worst of the crisis in major ASEAN

countries. The IMF had to initiate a nearly $40 billion program to

stabilize the currencies of South Korea, Thailand, and Indonesia, the

economies particularly impaired by the crisis. The effects lingered

through 1998, when the Philippines growth plummeted to virtually

zero. (Source: Wikipedia (1))

T

- 23 -

3

TThhee HHyyppootthheesseess

- 24 -

- 25 -

Chapter Summary Given the backdrop of three major globally impacting crises in

recent history, despite several man-years of research and

development in financial management, there is an urgent need

to go beyond and question the very fundamentals based on

which various financial theories and practices have been

developed. The root cause must be identified and corrected. The

broad hypothesis which needs examination is - whether sound

economic principles have been adhered to or violated in

corporate finance practice? Unscientific practices directly create

financial stress, and in publicly owned business enterprise, this

radiates into banking systems and eventually into the broader

economies in which these entities operate, causing widespread

misery like the kind history has already witnessed.

- 26 -

- 27 -

“What good is it to run when you are on the wrong road?”-

German proverb

very realm of scientific activity has its own set of clear, well

established principles. When these are meticulously followed,

accurate and reliable results are produced. Conversely, when

subjectivity enters the process, the ensuing result turns out to be a

poor compromise - unverifiable, highly dependent on individual

judgment and therefore lacking ‘quality assurance’. Unchecked

financial crises worsening into corporate bankruptcies, not only cause

erosion of shareholder value, but also radiate into the broader banking

systems and the entire economy. Increasing incidences of non-

performing assets and the associated agony of inevitable debt

restructurings(1)(2) and in extreme cases downgraded sovereign ratings,

are a only the tremors of poor financial decisions which lie at the

epicenter.

E

- 41 -

4

AAnnaattoommyy ooff

aa CCrriissiiss

- 42 -

- 43 -

Chapter Summary

Data from recent as well as distant history and research shows

that financial markets are driven by behavioral anomalies,

resulting in bubbles and crashes. More than the obvious need

to understand the underlying reasons behind irrational

‘euphoria’ and ‘panic’ frequently occurring in financial

markets, and presumably, public companies being portrayed as

victims thereof, a relevant and perhaps more important

question that deserves examination is - whether financial

practices followed by the affected companies, unwittingly,

actually contribute to the damage to themselves and

consequently the broader economy?

- 44 -

- 45 -

“The grand aim of all science is to cover the greatest number of

empirical facts by logical deduction from the smallest number of

hypotheses or axioms” - Albert Einstein

he search for explanations why financial assets are mispriced - a

major cause of financial crises - must begin with an incisive

diagnosis of its symptoms. Fundamental questions raised in the

preceding chapter, were analyzed using a wide spectrum of data

collated from diverse sources. These include but not limited to,

statistical data obtained from the World Bank database, index statistics

mostly from the web sites of stock exchanges or from public sources

like yahoo finance, financial data from company websites or financial

portals, extracts from media reports of national and international

repute and extracts from research findings of reputed business

consulting firms like Accenture as well as those published in Harvard

Business Review. Literature on corporate finance from internationally

recognized publishers, as well as reliable sources of general

information such as Wikipedia was used as reference material.

T

- 59 -

5

AA FFaattaall

CCoommmmuunniiccaattiioonn

EErrrroorr??

- 60 -

- 61 -

Chapter Summary

Investors rely on signals given out by company actions, while

companies make inferences about investor expectations based

on interpretation of market behavior - visible through

dynamically changing market price of the companies’ stocks.

What sets the ball rolling first? Obviously, company

managements, in their role as shareholders’ agents, must

necessarily understand shareholder expectations correctly in

order to fulfill them well. Only when they do this, will there be

perfect harmony between shareholder expectations and company

actions. Various theories have been developed over time to

explain market behavior - both from rational as well as

behavioral perspectives. Yet, as the 2013 Nobel Economic

Sciences Prize Committee confirms, understanding asset prices

is still incomplete. Poor understanding contributes to wrong

decisions, eventually leading to financial crisis.

- 62 -

- 63 -

“It is not that pearls fetch a high price because men have dived

for them; but on the contrary, men dive for them because they

fetch a high price”(13) – Richard Whately

he relationship between ‘reward’ and ‘risk’ conveyed by the

above statement made by the 19th century economist, captures

the very essence of entrepreneurship. It explains a fundamental

economic reality that reward for entrepreneurship must be determined

by the underlying value. So how do we understand the risk return

relationship that forms the foundation of financial science? Even

before we explore the rational vs. non-rational dimensions of equity

price behavior, and attempt to explain it with a reliable model, we must

understand what financial assets are and what financial markets

represent.

We live in a world where economic resources are unequally distributed,

while a wide range of resources are required to fulfill even ordinary

human needs. For example we all need food but everyone does not

T

- 91 -

6

TThhee RRoollee ooff BBeettaa

iinn CCoorrppoorraattee

FFiinnaannccee

- 92 -

- 93 -

Chapter Summary

Among several financial models used in corporate finance

practice, the Capital Asset Pricing Model (CAPM) earns

prominence because of it being an estimator of expected equity

returns, a key element of information required for enhancing

shareholder wealth. The model uses the term ‘beta’ to explain

systematic risk of the market portfolio and its constituents.

Variations in returns between stocks constituting the market

portfolio are directly correlated with the ‘beta’ values of those

stocks relative to the beta of the market portfolio which is

considered as 1. A stock’s ‘beta’ reflects its relative sensitivity

to systematic risk which the portfolio as a whole is exposed to,

and could be positive, negative or zero. While making capital

investment decisions, it is important to apply the correct ‘beta’.

Yet, what corporate finance theory prescribes conflicts with

rational economic principles, and leads to faulty project

selection decisions, consequently hurting shareholder value.

- 94 -

- 95 -

“Risk comes from not knowing what you're doing”- Warren

Buffett

hat exactly is ‘beta’, how important it is and how does it

affect financial decisions? The capital asset pricing model

(CAPM) was developed as a financial tool to determine an appropriate

risk adjusted rate of return of an asset, based on that asset’s marginal

contribution to the risk of a well-diversified portfolio. The model takes

into account three influencing factors. First, the expected return of a

risk-free asset; second, the expected return of the market portfolio; and

third, the asset's relative sensitivity to the risk of the portfolio as a

whole, represented by ‘beta (β)’. The model was introduced by Jack

Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and

Jan Mossin (1966) independently, building on the earlier work of Harry

Markowitz on diversification and modern portfolio theory. William

Sharpe and Harry Markowitz jointly received the Nobel Memorial

W

- 127 -

7

BBrreeaakkiinngg

TThhee CCAAPPMM

MMyysstteerryy

- 128 -

- 129 -

Chapter Summary

The widely used Capital Asset Pricing Model (CAPM)

developed in the mid 1960s, began to show anomalies when

thousands of studies failed to establish the validity of the model.

While explanations and alternatives were proposed, they were

subsequently rejected. As on date no acceptable asset pricing

model exists, a fact confirmed by the 2013 Nobel Economic

Sciences Prize Committee, based on the research contributions

by Nobel Laureates Fama, Hansen and Shiller. All studies

made and explanations provided so far addressed a common

question - ‘What else can explain asset prices besides ‘beta’,

the lone determinant variable used in the model’ - resulting in

one or more ‘fillers’ that attempted to plug the gap in vain, and

some even proclaiming the irrelevance of ‘beta’. The real flaw in

the model lies not in the inadequacy of ‘beta’ per se but in the

faulty representation of ‘riskless return’ and ‘risk premium’,

and an erroneous application of ‘beta’ - a measure of relative

risk - to ‘market risk premium’ which is not the correct

measure of market risk at all.

- 130 -

- 131 -

“An error does not become truth by reason of multiplied

propagation, nor does truth become error because nobody sees

it”- Mahatma Gandhi

s already explained, the capital asset pricing model (CAPM) is

widely used for pricing of financial assets. ‘Cost of equity’, i.e.

the rate of return expected by a typical equity investor is estimated by

the model. Consequently, this expected rate is used to determine the

discounted present value of an asset’s estimated future returns. Returns

from risky assets such as business enterprises usually vary, and thus

owning such assets involves the risk of earning lower than expected

returns or even loss of capital. For this reason, stock prices of these

assets naturally fluctuate. Conventional thinking has been that variation

in stock prices reflects dynamically changing return expectations

directly proportional to expected risk, in the sense that higher returns

are expected for compensating higher risk. The CAPM attempts to

capture this risk adjusted cost of equity. On the premise that rational

investors hold typical well diversified portfolios such as the market

A

- 227 -

8

FFrroomm PPoorrttffoolliioo

TThheeoorryy TToo CCAAPPMM::

AA HHeeuurriissttiicc SSlliipp??

- 228 -

- 229 -

Chapter Summary

The previous chapter analysed the CAPM from economic and

statistical perspectives. How does the model measure against its

parent theory, Harry Markowitz’s ‘Theory of Portfolio

Choice’, based on which it was built? The ‘Theory of Portfolio

Choice’ or simply ‘Portfolio Theory’ explains how an optimum

portfolio can be constructed that maximizes average returns for

a given degree of risk or minimizes risk for a given average

return. Thus, the theory converges all variables that affect the

choice of a portfolio into two dimensions - ‘expected portfolio

returns’ and ‘portfolio variance’ - also called the ‘mean-

variance’ paradigm. The CAPM used this idea to estimate

expected return of the optimum equity portfolio and its

constituent stocks. However, while the ‘mean returns’

dimension is correctly represented in the CAPM, the model

expresses ‘variance’ only in relative terms in the form of ‘beta’,

which is insufficient to completely understand risk of the

portfolio or its constituent stocks.

- 230 -

- 231 -

“No problem can be solved from the same level of consciousness

that created it.” - Albert Einstein

arry Markowitz’s ‘Theory of Portfolio Choice’(1) analyzes how

wealth can be optimally invested in a portfolio of assets that

differ in terms of expected return and risk, so as to achieve maximum

average return for a given degree of risk or minimum risk for a given

average return. William Sharpe applied Markowitz's portfolio theory

and developed the ‘Capital Asset Pricing Model’ (CAPM), which

estimates risk-adjusted expected equity return.(2) The CAPM estimate

of cost of equity serves as a criterion cost for capital budgeting and

asset pricing.

This chapter presents an analytical review of, primarily the ‘Theory of

Portfolio Choice’ and as a consequence, its effect on the ‘Capital Asset

Pricing Model’. The unexplained gap which exists in CAPM, and

H

- 249 -

9

MMooddeellss DDeecceeiivvee,,

CCaasshh FFlloowwss DDoonn’’tt

- 250 -

- 251 -

Chapter Summary

Generally speaking, excessive reliance on models without

questioning their validity, and in particular, focusing on the

average or consolidated picture alone, without evaluating the

inevitable periodic deviations, leads to concealment of inherent

risk. Conventional Discounted Cash Flow (DCF) based

project appraisal methods suffer from the serious limitation of

the latter kind, because typically projects are selected on the

basis of Net Present Value (NPV) or Internal Rate of

Return (IRR) criteria, which essentially tell nothing more than

the average result for the overall project. Financial risk directly

hurts cash flows. Regardless of differences in periodic cash flow

patterns, two projects may produce equal NPV/IRR

outcomes. Since higher adverse deviations imply greater risk,

unless cash flows are measured against an appropriate periodic

benchmark, it would be impossible to say whether such

deviations pose a threat to the project’s targeted returns or only

constitute harmless normal variations.

- 252 -

- 253 -

“I abhor averages. I like the individual case. A man may have six

meals one day and none the next, making an average of three

meals per day, but that is not a good way to live.”- Louis D.

Brandeis

oes inflating the cost of equity with higher beta, serve the

purpose of compensating for risk? Any attempt to manage risk

by the simple act of raising the bar of criterion cost, wouldn’t require

any model at all! All that would need to be done is to raise the bar high

enough. In effect most actual practitioners do exactly that. The

findings of the AFP survey referred to earlier confirms this fact as

quoted below.

“A small majority of organizations use their calculated cost of

capital as the standard hurdle rate for evaluating a project or

investment (53 percent). However, large organizations and those

that are publicly traded are more apt to use a rate above the

calculated cost of capital as their standard hurdle rate than are

small organizations and private ones. Organizations adjust the

D

- 269 -

10

WWAACCCC

VViioollaatteess tthhee

WWYYDDIIWWYYPP

PPrriinncciippllee

- 270 -

- 271 -

Chapter Summary

WYDIWYP is an acronym for What-You-Do-Is-What-

You-Plan. Weighted Average Cost of Capital (WACC)

deviates from this principle. WACC has its roots in the notion

of ‘one-firm-one-value’ introduced in corporate finance by the

Modigliani-Miller duo. Their theories, popularly known as

MM models, posited that value of a firm remains the same

regardless of the composition of its capital structure and

regardless of the distribution or retention of profits. Ever since,

WACC became the standard benchmark for selection of

projects. It gained further endorsement as a benchmark for

measuring enterprise performance with the introduction of

EVA. In reality, WACC becomes irrelevant simply because

cash flows do not occur in the consolidated manner implied by

WACC, but rather in a sequential manner where debt

obligations must be fulfilled first before any residual profits are

available for equity. Thus WACC contributes to liquidity

crisis because it fails to recognize the cash flow effect of debt

obligations during project evaluation. Any shortfall in residual

income hurts equity alone.

- 272 -

- 273 -

“The most dangerous untruths are truths slightly distorted.”

-Georg C. Lichtenberg

ike the CAPM, the concept of Weighted Average Cost of Capital

(WACC) is also widely used globally. As seen below, this too has

been confirmed by the Harvard Business Review article titled “Do You

Know Your Cost of Capital?”(2), already referred to in chapter 6

“...…80% of more than 300 respondents – of which 90% with

over $ 1 billion in revenues – use free-cash-flow projections

discounted by the weighted average of the costs of debt and

equity, to estimate the value of investments.......about 90% of

the respondents use the capital assets pricing model (CAPM),

which quantifies the return required by an investment on the

basis of the associated risk.”

L

- 313 -

11

IIff AArrcchhiimmeeddeess

WWaass aann

EEccoonnoommiisstt

- 314 -

- 315 -

Chapter Summary

Typically Debt/Equity ratio is used as a measure of financial

leverage. For this reason it is also known as ‘Leverage Ratio’.

In the computation of ‘Cost of Equity’, where ‘beta’ is applied

as a measure of relative systematic risk, the ‘beta’ value is

typically calibrated to incorporate appropriate degree of leverage

induced risk. Debt/Equity ratio is used in this computation

as the determinant variable so that the resultant ‘beta’ value

moves in direct correlation with Debt/Equity ratio, other

things being constant. In reality, real risk of leverage comes not

from the proportion of debt in total capital but from the

proportion of cost of debt in total operating profits. What

matters to equity value is the quantum of operating profits and

its sharing between debt and equity rather than Debt/Equity

ratio per se. Therefore, adjusting ‘beta’ based on Debt/Equity

ratio produces a misleading estimate of leveraged cost of equity

and consequently hurts shareholder value.

- 316 -

- 317 -

“Give me a place to stand on, and I will move the earth”

- Archimedes (1)

hese were the words of the Greek mathematician, physicist,

engineer, inventor, and astronomer, whose explanation of the

principle of the lever, counts among his several scientific contributions.

Leverage did shake up the world, not once but several times over!

Little would Archimedes have thought that one of the shake ups would

also originate from his own country! Expanding credit and earning

discredit for the Euro Zone debt crisis, the Greek economy still

struggles to find a place to stand.

The word ‘lever’ originated from the French lever, ‘to raise’. A lever

amplifies an input force to produce a stronger – thus leveraged -

output force. In finance, it comes with a condition attached – ‘only if it

is applied in favourable conditions’. If only Archimedes was also an

T

- 357 -

12

VVaalluuee CCeennttrriicc

CCaappiittaall BBuuddggeettiinngg

- 358 -

- 359 -

Chapter Summary

Conventional Discounted Cash Flow (DCF) methods used in

capital budgeting determines Net Present Value (NPV) by

consolidating cash inflows and outflows discounted at the

WACC rate. Even where Internal Rate of Return (IRR)

method is used, WACC forms the criterion cost. These

methods suffer from several limitations that actually contribute

to liquidity crisis and erosion of shareholder value. One,

WACC is derived from a faulty CAPM, second WACC

itself is irrelevant for any cash flow evaluation, and third, the

consolidated NPV or IRR provides no information about

whether or not periodic cash flow deviations are harmless or

threatening. Thus the current capital budgeting methods are

misaligned with economic reality, conceal cash flow risks and

therefore contribute to financial crisis. A revised method

eliminates these flaws and highlights probable cash flow

deviations during the planning stage itself, so that unforeseen,

harmful cash flow disruptions are avoided.

- 360 -

- 361 -

“Someone's sitting in the shade today because someone planted

a tree a long time ago.” - Warren Buffett

n Chinese philosophy(2) the yin and yang concept recognizes the

co-existence of mutually complementing states that define each

other. Can we comprehend static without understanding dynamic, light

without darkness, order without chaos, inside without outside etc? Sir

Isaac Newton, the 17th century English physicist and a key figure in the

scientific revolution, explained the first law of motion as “when viewed

in an inertial reference frame, an object either is at rest or moves at a

constant velocity, unless acted upon by an external force”. Can we

define motion without defining rest or vice versa? If all human beings

were perfectly rational and devoid of emotions, like the fictional

character called Mr. Spock in the popular ‘Star Trek’ series, would

stock prices have behaved differently? The behavioral school of

economic thought tells us that that we are predominantly non-rational.

Yet, economic science has empirical evidence that in the long term we

I

- 383 -

13

AA WWoorrdd oonn

PPaayy BBaacckk MMeetthhooddss

- 384 -

- 385 -

Chapter Summary

While Discounted Cash Flow (DCF) remains the most widely

used method for capital budgeting worldwide, one or the other

variants of non-discounted methods are also used even by large

organizations. When the limitations of currently practiced

DCF methods already threaten shareholder value, they affect

non-DCF methods such as Pay Back Period (PBP) as well,

besides already known drawbacks of such methods.

- 386 -

- 387 -

“it is better to be vaguely right than exactly wrong” - Carveth

Read

he impropriety and drawbacks of non-DCF methods, which are

mere routes of convenience and lack economic rationale, needs

no explanation. This has been rightly highlighted by the following

comment in the ‘International Good Practice Guidance’ on ‘Project &

Investment Appraisal for Sustainable Value Creation’ issued by IFAC(1)

“Organizations with explicit sustainable value-creating strategies typically

emphasize techniques such as DCF and real options and downplay the role of other

short-term measurement criteria, such as payback and earnings per share (EPS)

growth. Research shows that a significant number of organizations do not prioritize

such techniques when perhaps they should, especially in assessing strategic investment

decisions and taking a long-term view. This applies to smaller organizations where

their use of such techniques is particularly variable as many rely on relatively simple

approaches, such as payback criteria and informal rules of thumb. More

T

- 395 -

14

MMeeaassuurriinngg VVaalluuee

- 396 -

- 397 -

Chapter Summary

‘Value’ in general and ‘Economic Value’ in particular, is

essentially a ‘relative’ rather than an ‘absolute’ concept. Unless

‘expectations’ are well defined, it is impossible to say whether

or not actual performance has added value. Also ‘value’ is

quite different from periodic performance that may inevitably

fluctuate, even though a particular period’s good or bad

performance would undoubtedly affect long term ‘value’.

Different degrees of variation in periodic performance would

have corresponding effects on ‘Economic Value’ but not all

variations may have a material effect. Managerial intervention

must focus only on those effects that matter and not all. The

right way to measure ‘Economic Value’ therefore must

consider both - that ‘value’ is relative to ‘expectations’ and that

it is a long term and cumulative phenomenon - and filter out

insignificant variations in causal factors. ‘Value Creation

Index’ a new metric, achieves these goals which other measures

such as the popular Economic Value Added (EVA) fail to

do.

- 398 -

- 399 -

“Stock market bubbles don't grow out of thin air. They have a

solid basis in reality, but reality as distorted by a misconception.”

- George Soros

apital clings to ‘value’ like iron filings to a magnet and scatters

equally fast when there’s nothing to attract it. The term ‘value’

remains a matter of great discussion among economists. It is linked to

price through the mechanism of exchange between buyers and sellers.

Buyers express the amount of money they are willing to pay for

acquiring assets, whereas sellers, the money they willing to accept to

give up ownership of those assets. Whether a risky asset such as a

publicly owned business enterprise has created value, is ultimately

reflected in the change in its long term price on the stock market.

Prospective owners (buyers) and current owners (sellers) forming the

stock market not only react to actual performance of enterprises, but

also respond to various actions taken by their managements, judging

the effect of managerial actions on future value. After all, investors

C

- 445 -

15

FFiinnaanncciiaall DDeecciissiioonn

MMaakkiinngg SSttaannddaarrddss

- 446 -

- 447 -

Chapter Summary

While significant developments have taken place in financial

‘Accounting’, ‘Auditing’ and ‘Reporting’ standards, the

absence of financial decision making standards is conspicuous.

In the interest of prudent utilization of capital - particularly

when enormous amounts have already been destroyed due to

poor financial management - the importance and urgency of

putting in place robust financial decision making standards

needs no more justification. The world’s first ever standard

issued by International Federation of Accountants (IFAC) as

late as Aug 2013, though a significant step in the right

direction, only consolidates already existing best practices,

therefore continues to carry the flaws present in them. If the

proposals presented in this book are accorded serious thought

by the global community of financial professionals, financial

management has the potential to transform into a true objective

science from the cultivated subjective art that it presently is, so

as to prevent large scale financial crisis like the 2008 case.

- 448 -

- 449 -

“Good order is the foundation of all good things.” – Edmund

Burke

ver time, the accounting profession has continuously evolved to

address the changing needs of stakeholders in public companies,

with better accounting and reporting standards like ‘International

Financial Reporting Standards’ (IFRS)(1). Regulatory bodies like the

Securities and Exchange Board of India (SEBI) lay down several

investor protection guidelines(2). However, till recently no universal

guidelines existed at a global level on similar lines to ensure uniformity

and objectivity in financial decision making. The latest document -

‘International Good Practice Guidance’ on ‘Project and Investment

Appraisal for Sustainable Value Creation’ – published by International

Federation of Accountants (IFAC) in Aug 2013(3), is an effort in this

direction. Although an important step, understandably it disappoints as

an authoritative guide for the reason that it only consolidates best

current practices, given the limitations of what is already explained

O