Questions, Comments

1. Questions, Comments MBA 648: Spring 2014 Prof. PV Viswanath

2. Questions from Feb. 11 • I am still having a little trouble connecting some of the ratios to one another (especially those using equity) • I don’t understand your question. • Being able to use the appropriate ratio • Read the text and ask me again with more specific questions • Do I need to know the accounting formulas? • Yes; you need to know how the numbers are to be computed. But once you understand what their function is, it will easier to remember them. • You mentioned Warren Buffet’s investment technique, I’d like you to elaborate • The key element of Warren Buffet’s investment style was to invest for the long run. Even though at a particular point in time, a well-run company might not be a good investment value, that’s only if you’re planning to hold it for the short run. If you’re planning to hold it over a long-period of time, then the initial price is less important, especially if it’s difficult to know if the company is over- or under-valued. • How and when do we use these theories and formulas in the real business? • All these formulas are used by actual analysts. The four categories indicate how the ratios are used – to estimate short-term liquidity (if the firm has sufficient liquid assets to meet short-term payment needs), long-term profitability (if the firm is making profitable), efficiency of asset use (if firm assets are being used efficiently) and financial leverage (if the firm is in danger of going bankrupt).

3. Questions from Feb. 11 • Still confused on some materials regarding calculations of determinants of growth • The internal rate of growth is how fast the firm can grow without additional external resources; it is equal to Retention Ratio x ROA.The sustainable growth rate is higher and assumes that leverage levels can be maintained, i.e. as the firm retains earnings and increases equity, it can obtain a corresponding amount of additional debt to keep the leverage ratio constant; this rate is equal to the Retention Ratio x ROE. • Difference between balance sheet & income statement • The income statement is a record of the activities of the firm over a period of time, usually a year; the balance sheet is a snapshot of the assets/liabilities of the firm at appoint in time. • The cash flow coverage and times interest earned • Times interest earned is EBIT/Interest. Since Interest expense has to be paid out of EBIT, the ratio indicates the size of the cushion. For example, if the ratio is < 1, the firm is clearly in trouble! • Why does depreciation added back change EBIT into cash flows? • Because to compute EBIT, we subtract out depreciation, which is not a cashflow. So if we were computing the cash profitability of the firm, we would not have subtracted out depreciation. Adding back depreciation undoes this action. • Why is Dupont Analysis is so important? • We’ll do that today. Dupont Analysis helps the firm strategize.

4. Questions from Feb. 18 • All the questions were about valuation and arbitrage, which we are going to redo on Feb. 25!

5. Questions from Feb. 25 • How do we factor frictions and risk into valuation?Ans: We will not be dealing with this in MBA 648, but essentially the existence of frictions will mean that the price that we might be willing to pay for a financial or real asset might be different from the price that we would be willing to sell it at. Hence we would no longer have a unique price for an asset. • What is arbitrage?Ans: Arbitrage simply is buying an asset at a lower price and selling it at a higher price to take advantage of simultaneous price discrepancies. More generally, it means that if a portfolio of assets is selling for more than the sum of the prices of its components, then an arbitrageur would buy the components to synthetically create the portfolio and then sell the portfolio at the higher price. Similarly, if the portfolio is selling for a lower price, the arbitrageur would buy the portfolio, split it into its constituents and sell the parts at a higher total price to make a profit. • When do we use EAR and when do we use APR?Ans: There is no real reason to use APR; however, for legal and historical reasons, people use APR. In these cases, we have to know how to deal with the APR rate and how to convert it into the equivalent EAR, which is the effective annual return the investor would get if the underlying interest rate applied to the entire year.

6. Questions from March 25th • When you say comparable, do you mean comparable duration? • Please be clear when you ask a question; I have no idea what the context to this question is, so I can’t answer it.. • Differences in terms of premium and discount rates • If the question is about yields on premium bonds and yields on discount bonds, then here’s what you need to know. One, yields on premium bonds and yields on discount bonds should be comparable (although sometimes for tax reasons, there are small differences). That is from the market point of view. However, if yields are similar, then the only way that one bond can sell for more than a second bond is if its coupon rate is greater. Consequently, when coupons for premium bonds are greater than coupon rates for discount bonds. Also, the yield will be exactly equal to the coupon rate for a par bond.As a result, premium bonds will have coupon rates higher than their yields; and discount bonds will have coupon rates lower than their yields.

7. Questions from March 25th • How do you find the yield of a bond? • You have to do it by trial-and-error. Use the correct bond-pricing equation, plug in a trial rate, look at the implied price; since bond price and yield move in opposite directions, if the implied price is greater than the actual price, now try a higher yield; if the implied price is lower than the actual price, now try a lower yield; continue until the implied price is equal to the actual price. This is your correct bond yield. Alternatively, use a financial calculator. • Why are the yields of long term bonds less volatile than those of short term bonds? • The yield on a long-term bond is a kind of average of the current short-term rate and our estimates of future short-term rates. We have much less information about the long term; furthermore, any new economic information is likely to change our estimates of the distant future by very little, if at all. Hence our estimates of the future short-term rates are not very volatile. Consequently, the yield on a long-term bond (i.e. the long-term rate) is less volatile than the current short-term rate (or the yield on a short-term bond).

8. Questions from March 25th • Why would one buy a bond from an issuer that will certainly default? • One wouldn’t buy a bond that would default and pay out nothing! However, a bond may be expected to default with a very high degree of probability, but if it will pay out something on default, investors would be willing to pay something for such a bond. In class, I gave the example of a bond that had some probability of total default and some probability of paying off in part or in full. • Still don’t fully grasp coupon/interest rate differences • A coupon rate simply defines the cashflows on the bond. Thus, a 10% coupon rate with semi-annual payments implies a semi-annual payment of $50 (assuming a face value of $1000). This has nothing to do with the price, and normally would not change over the life of a bond. • Given the cashflows on a bond, demand and supply would determine the price of the bond; the market price in turn implies a particular yield on the bond, which is sometimes called an interest rate, particular if the bond is a Treasury bond.