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Sense and nonsense in modern corporate f inance

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  • 1.sense andnonsensein moderncorporate finance

2. Thought # 1: A lot of what youve beentaught is wrong 3. Example # 1:The Notion ofRisk inAcademic Corporate Finance 4. William Sharpe,Noble Laureate 5. High degree of variability means high risk 6. Low degree of variability means low risk 7. Inference: Treasury bonds are risk-free securitiesbecause they have zero variability of return. 8. Treasurybonds arerisk free Hmmm 9. We define risk, using dictionary terms, as the possibility of loss orinjury.The real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) willover his prospective holding period, give him at least as much purchasingpower as he had to begin with, plus a modest rate of interest on that initialstake. 10. Investing is often described asthe process of laying out money now intheexpectation of receivingmore money inthe future.At Berkshire we take a more demanding approach, dening investing as thetransfer to others of purchasing power now with the reasoned expectationof receiving more purchasing power after taxes have been paid onnominal gains in the future. More succinctly, investing is forgoingconsumption now in order to have the ability to consume more at a laterdate.From 2011 Letter. 11. If you forego tenhamburgers to purchase aninvestment; 12. receive dividends which, after tax, buytwo hamburgers;and receive, upon sale ofyour holdings, after-tax proceeds that will buy eight hamburgers, 13. then youhave had no real income from yourinvestment, no matter how muchitappreciatedin dollars. 14. You may feelricher, 15. but you wonteatricher. 16. Bonds promotedas offering risk-free returns arenow priced to deliver return- free risk.From 2011 Lettercommenting onthe prevailing almost zerointerest rates on treasury bonds. 17. Example # 2:The Relationship between Riskand Return in Academic CorporateFinance 18. Academic FinancesDefinition of RiskTwo components: Systematic andUnsystematic risk 19. Investors will not get paid to assume unsystematic risk because thatcomponent of total risk can be diversied away. 20. Investors will get paid onlyfor takingsystematic risk, a proxyof which isbeta.Academics...like to dene investment risk differently, averring that it isthe relative volatility of a stock or portfolio of stocks - that is, their volatilityas compared to that of a large universe of stocks. 21. High RiskHigh Return Low Risk Low ReturnStocks with high beta are riskier than stockswith lower betas but are expected to deliverhigher returns.HmmmmmStocks with high beta are riskier than stocks with lower betas but areexpected to deliver higher returns. 22. Do?Do stocks with large betas outperform stocks with low betas?Ans: No 23. Do =?Do stocks with identical beta produce same returns?Ans: No 24. a proxy Is? forAns: NoVolatility is not the same as risk. 25. Beta does not capture risk 26. How does He think of Risk?Though this risk cannot be calculated with engineering precision, it can insome cases be judged with a degree of accuracy that is usefulThe primary factors bearing upon this evaluation are: 27. A. Thecertainty withwhich thelong-term economiccharacteristics of the business can be evaluated 28. B. Thecertainty with whichmanagement can beevaluated, both as to its ability torealize thefull potentialof the business and to wisely employ itscash flows 29. C. Thecertainty with whichmanagementcan be countedon to channelthe rewardsfrom thebusiness to the shareholdersrather than to itself. 30. D. Thepurchase price of thebusiness 31. E. The levelsof taxation and inflation that will beexperienced andthat will determine thedegree by whichan investors purchasing-power return is reduced fromhis grossreturn. 32. The Trouble with his definition of risk? You cannot objectively measure it!Is that a problem? 33. Falseprecision istotally crazy... Itonlyhappens topeople with high IQs.The desire to be PRECISE makes people do some incredibly FOOLISH things. 34. Its better tobe approximately right than tobe precisely wrong - JohnMaynard keynesThe desire to be PRECISE makes people do some incredibly FOOLISH things. 35. Noteverythingthat countscan be counted,and noteverythingthat can be counted, counts. -Einstein 36. Buffetton RISKExtract from 2011 Annual Report of Berkshire HathawayThe Basic Choices for Investors and the One We Strongly PreferInvesting is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, deninginvesting as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power after taxes have been paid on nominal gains in the future.More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.From our denition there ows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used inmeasuring risk) but rather by the probability the reasoned probability of that investment causing its owner a loss of purchasing-power over his contemplated holding period.Assets can uctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, anon-uctuating asset can be laden with risk.Investment possibilities are both many and varied. There are three major categories, however, and its important to understand the characteristics of each. So lets survey the eld. Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments arethought of as safe. In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. 37. Buffett on RISKBerkshire Hathaways AGM for 1993: Comments on RiskShareholder: There appears to be inconsistencies between your view of risk and the conventional view.Derivatives are dangerous. And yet you feel comfortable playing derivatives through Salomon.Betting on hurricanes is dangerous. And yet you feel comfortable playing with hurricanes through insurance companies. So it appears that you have some view of risk thats inconsistent with whatwould appear on the face of it to be conventional view of risk.Buffett: We do dene risk as the possibility of harm or injury. Therefore, we think its inextricably would up in our time horizon for holding an asset. If you intend to buy XYZ Corporation at 11:30 thismorning and sell it out before the close today, thats a very risky transaction in our view -because we think that 50% of the time, youre going to suffer some harm or injury. On the other hand, given asufciently long time horizon . . .For example, we believe that the risk of buying something like Coca Cola at the price we paid a few years ago is close to nil -given our prospective holding period. But if you asked me to assess therisk of buying Coca-Cola this morning and selling it tomorrow morning, Id say that thats a very risky transaction.As I pointed out in the annual report, it became very fashionable in the academic world -and it spilled over into the nancial markets -to dene risk in terms of volatility of which beta is a measure. Butthat is no measure of risk to us.The risk in terms of our super-cat business is not that we lose money in any given year. We know were going to lose money in some given day. Thats for certain. And were extremely likely to losemoney in some years. But our time horizon in writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon ofinvestment, we think that it is not a risky business.And its a whole lot less risky than writing something that is much more predictable. Its interesting to us that using conventional measures of risk, something whose return varies from year-to-yearbetween +20% and +80% is riskier than something that returns 5% a year every year. We think the nancial world has gone haywire in terms of how they measure risk. 38. Buffett on RISKBerkshire Hathaways AGM for 1993: Comments on RiskShareholder: Wall Street often evaluates the riskiness of a particular security by the volatility of its quarterly or annual results -and likewise, measures money managers riskiness bytheir volatility. I know you guys dont agree with that approach. Could you give us some detail about how you measure risk?Buffett: We regard volatility as a measure of risk to by nuts. And the reason its used is because the people that are teaching want to talk about risk -and the truth is that they dont knowhow to measure it in business. Part of our course on how to value a business would also be on how risky the business is. And we think about that in terms of every business we buy.Risk with us relates to several possibilities. One is the risk of permanent capital loss. And the other risk is that theres just an inadequate return on the kind of capital weput in.However, it doesnt relate to volatility at all. For example, our SeesCandy business will lose money-and it depends on when Easter falls -in two quarters each year. So it has this hugevolatility of earnings within the year. Yet its one of the least risky businesses I know. You can nd all kinds of wonderful businesses that have great volatility in results. But that doesntmake them bad businesses.Similarly, you can nd some terrible businesses with very low volatility. For example, take a business that did nothing. Its results wouldnt vary from quarter to quarter. So it just doesntmake any sense to equate volatility with risk.ENDNotice he talks about two types of risks: Risk of permanent loss of capital and Opportunity loss. 39. Buffetton RISKBerkshire Hathaways AGM for 1994: Comments on RiskBuffett: We do dene risk as the possibility o

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