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Pablo Fernandez, Ten badly explained topics in most Corporate Finance Books 2015

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Pablo Fernandez. Professor of Finance. IESE Business School

Camino del Cerro del Aguila 3. 28023 Madrid, Spain

e-mail: fernandezpa@iese.edu

Previous versions: 2013, 2014.

This chapter addresses ten corporate finance topics that are not well treated (or not treated at all) in many

Corporate Finance Books. The topics are:

1. Where does the WACC equation come from?

2. The WACC is not a cost

3. The WACC equation when the value of debt is not equal to its nominal value

4. The term equity premium is used to designate four different concepts

5. Textbooks differ a lot on their recommendations regarding the equity premium

6. Which Equity Premium do professors, analysts and practitioners use?

7. Calculated (historical) betas change dramatically from one day to the next

8. Why do many professors still use calculated (historical) betas in class?

9. EVA does not measure Shareholder value creation

10. The relationship between the WACC and the value of the tax shields (VTS)

Exhibit 1. Calculating the WACC

Exhibit 2. 72 comments from readers

Tables and figures are available in excel format with all calculations in:

http://web.iese.edu/PabloFernandez/Book_VaCS/valuation%20CaCS.html

The WACC is just the rate at which the Free Cash Flows (FCF) must be discounted to obtain the

same result as the valuation using Equity Cash Flows.

There are two basic methods for valuing companies by discounted cash flows:

Method 1. Using the expected equity cash flow (ECF) and the required return to equity (Ke).

Equation [1] indicates that the value of the equity (E) is the present value of the expected equity

cash flows (ECF) discounted at the required return to equity (Ke).

[1] E0 = PV0 [Ket; ECFt]

Equation [2] indicates that the value of the debt (D) is the present value of the expected debt

cash flows (CFd) discounted at the required return to debt (Kd).

[2] D0 = PV0 [Kdt; CFdt]

I am very grateful to the professionals and professors that sent comments about this chapter. Special thanks go

to Marian Moszoro, Rob Szold, Ron Leonard, Troy Lynch, Don Chance, Arnold Glen, Axel Finsterbusch, Orest

Monokandilos, Roby Roediyanto, Tylor Claggett and Jacques Tierny.

1

CH3- 1

Pablo Fernandez

IESE Business School, University of Navarra

The free cash flow is the hypothetical equity cash flow when the company has no debt. The

expression that relates the FCF (Free Cash Flow) with the ECF is:

[3] ECFt = FCFt + Dt - It (1 - T)

Dt is the increase in debt, and It is the interest paid by the company. CFdt = It - Dt

T is the effective tax rate applied to interest.

Method 2. Using the free cash flow and the WACC (weighted average cost of capital).

Equation [4] indicates that the value of the debt (D) plus that of the shareholders equity (E) is

the present value of the expected free cash flows (FCF) that the company will generate, discounted at

the weighted average cost of capital (WACC):

[4] E0 + D0 = PV0 [WACCt ; FCFt]

The WACC is the rate at which the FCF must be discounted so that equation [4] gives the same

result as that given by the sum of [1] and [2]. By doing so (see exhibit 1), the expression of the WACC

(Weighted Average Cost of Capital) is given by [5]:

E Ke D t -1Kd t (1 - T)

WACC t t -1 t

[5]

E t -1 D t -1

Et-1 + Dt-1 are not market values nor book values: in actual fact, Et-1 and Dt-1 are the values

obtained when the valuation is performed using formulae [1], [2] or [4].2

This is explained in chapter 8 WACC: Definition, Misconceptions and Errors, downloadable in

http://ssrn.com/abstract=1620871. Also in chapter 6 Valuing Companies by Cash Flow Discounting: Ten Methods

and Nine Theories, downloadable in http://ssrn.com/abstract=256987

2. The WACC is not a cost

Just by looking at equation [5], it is clear that the WACC is neither a cost nor a required return.

The WACC is a weighted average of two very different magnitudes:

a cost: the cost of debt (Kd), and

a required return: the required return to equity (Ke). Although Ke is often called cost of equity,

there is a big difference between a cost and a required return.

Then, the WACC is neither a cost nor a required return, but a weighted average of a cost and a

required return.

To refer to the WACC as the cost of capital may be misleading because it is not a cost.

3. The WACC equation when the value of debt is not equal to its nominal value

When the required return to debt (Kd) is different from the cost of the debt (r), the value of

debt (D) is not equal to its nominal value (N).

The interest paid in period t is: It = Nt-1 rt .

E Ke + D Kd - N r T

The expression of the WACC in this case is:

[5*] WACC =

E + D

The increase in debt in period t is: Nt = Nt - Nt-1 .

The debt cash flow in period t is: CFdt = It - Nt = Nt-1 rt - (Nt - Nt-1 ).

This is explained in chapter 6 Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories,

downloadable in http://ssrn.com/abstract=256987

2 Consequently, the valuation is an iterative process: the free cash flows are discounted at the WACC to

calculate the companys value (D+E) but, in order to obtain the WACC, we need to know the companys value

(D+E).

CH3- 2

Pablo Fernandez

IESE Business School, University of Navarra

The equity premium (also called market risk premium, equity risk premium, market premium

and risk premium), is one of the most important and discussed, but elusive parameters in finance.

Part of the confusion arises from the fact that the term equity premium is used to designate

four different concepts:

1. Historical equity premium (HEP): historical differential return of the stock market over treasuries.

2. Expected equity premium (EEP): expected differential return of the stock market over treasuries.

3. Required equity premium (REP): incremental return of a diversified portfolio (the market) over the

risk-free rate required by an investor. It is used for calculating the required return to equity.

4. Implied equity premium (IEP): the required equity premium that arises from assuming that the

market price is correct.

The equity premium designates four different concepts: Historical Equity Premium (HEP);

Expected Equity Premium (EEP); Required Equity Premium (REP); and Implied Equity Premium

(IEP). Although the HEP is equal for all investors, the REP, the EEP and the IEP are different for

different investors.

There is a kind of schizophrenic approach to valuation: while all authors admit different

expectations of equity cash flows, most authors look for a unique discount rate. It seems as if the

expectations of equity cash flows are formed in a democratic regime, while the discount rate is

determined in a dictatorship.

A unique IEP requires assuming homogeneous expectations for the expected growth (g), but

we show that there are several pairs (IEP, g) that satisfy current prices. We claim that different

investors have different REPs and that it is impossible to determine the REP for the market as a whole,

because it does not exist.

Chapter 13 shows that 129 out of 150 books identify Expected and Required equity premium

and 82 identify Expected and Historical equity premium. This is also explained in chapter 12 Equity

Premium: Historical, Expected, Required and Implied, downloadable in http://ssrn.com/abstract=933070

5. Textbooks differ a lot on their recommendations regarding the equity premium

Chapter 15 (The Equity Premium in 150 Textbooks3) reviews 150 textbooks on corporate

finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland,

Merton, Ross, Bruner, Bodie, Penman, Arzac, Damodaran and shows that their recommendations

regarding the equity premium range from 3% to 10%, and that 51 books use different equity premia in

different pages. Figure 1 contains the evolution of the Required Equity Premium (REP) used or

recommended by 150 books, and helps to explain the confusion that many students and practitioners

have about the equity premium. The average is 6.5%.

Figure 1. Evolution of the Required Equity Premium (REP) used or recommended in 150 finance and valuation textbooks

10%

9%

8%

7%

6%

5%

4%

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

3%

CH3- 3

Pablo Fernandez

IESE Business School, University of Navarra

Figure 2. Moving average (last 5 years) of the REP used or recommended in 150 finance and valuation textbooks

9%

8%

7%

6%

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

5%

Figure 2 shows that the 5-year moving average has declined from 8.4% in 1990 to 5.7% in

2008 and 2009.

For example, Brealey and Myers considered until 1996 that REP = EEP = arithmetic HEP over T-Bills

according to Ibbotson: 8.3% in 1984 and 8.4% in 1988, 1991 and 1996. But in 2000 and 2003, they stated that

Brealey and Myers have no official position on the exact market risk premium, but we believe a range of 6 to 8.5% is

reasonable for the United States. In 2005, they increased that range to 5 to 8 percent.

Copeland et al. (1990 and 1995), authors of the McKinsey book on valuation, advised using a REP =

geometric HEP versus Government T-Bonds, which were 6% and 5.5% respectively. However, in 2000 and

2005 they changed criteria and advised using the arithmetic4 HEP of 2-year returns versus Government T-Bonds

reduced by a survivorship bias. In 2000 they recommended 4.5-5% and in 2005 they used a REP of 4.8%

because we believe that the market risk premium as of year-end 2003 was just under 5%.

A survey5 shows that the average Market Risk Premium (MRP) used in 2011 by professors for

the USA (5.7%) is higher than the one used by analysts (5.0%) and companies (5.6%). The standard

deviation of the MRP used in 2011 by analysts (1.1%) is lower than the ones of companies (2.0%) and

professors (1.6%).

Figure 3 shows the dispersion of the MRP used

Figure 3. Market Risk Premium for the USA used in 2011

Although in the 2nd edition they stated (page 268) we use a geometric average of rates of return because arithmetic

averages are biased by the measurement period.

5 US Market Risk Premium Used in 2011: A Survey, downloadable in: http://ssrn.com/abstract=1805852. Also:

4

Market Risk Premium Used in 56 Countries in 2011: A Survey with 6,014 Answers, downloadable in:

http://ssrn.com/abstract=1822182

CH3- 4

Pablo Fernandez

IESE Business School, University of Navarra

7. Calculated (historical) betas change dramatically from one day to the next

Figure 4 shows the historical betas of AT&T, Boeing and Coca-Cola in the two-month period

of December 2001 and January 2002 with respect to the S&P 500. It may be seen that the beta of

AT&T varies from 0.32 (January 14, 2002) to 1.02 (December 27, 2001), the beta of Boeing varies

from 0.57 (January 30, 2002) to 1.22 (January 20, 2002), and the beta of Coca-Cola varies from 0.55

(December 28, 2001) to 1.11 (January 15, 2002). A closer look at the data shows that the beta of

AT&T is higher than the beta of Boeing 32% of the days, and is higher than the beta of Coca-Cola

50% of the days. The beta of Boeing is higher than the beta of Coca-Cola 76% of the days. AT&T has

the maximum beta (of the three companies) 29% of the days and the minimum beta 47% of the days.

Boeing has the maximum beta (of the three companies) 58% of the days and the minimum beta 15% of

the days. Coca-Cola has the maximum beta (of the three companies) 13% of the days and the

minimum beta 38% of the days.

Figure 4. Historical betas of AT&T, Boeing and Coca-Cola.

Betas calculated during the two-month period of December 2001 and January 2002 with respect to the S&P 500. Each day,

betas are calculated using 5 years of monthly data, i.e. on December 18, 2001, the beta is calculated by running a regression

of the 60 monthly returns of the company on the 60 monthly returns of the S&P 500. The returns of each month are

calculated on the 18th of the month:

monthly return of December18, 2001 =

1,4

AT&T

1

total return November18, 2001

Boeing

Coca Cola

1,2

1,0

0,8

0,6

0,4

0,2

01/12/01

11/12/01

21/12/01

31/12/01

10/01/02

20/01/02

30/01/02

This is explained in chapter 15 Are Calculated Betas Worth for Anything?, downloadable in

http://ssrn.com/abstract=504565

The article provides additional information about the 62 calculated betas of 3,813 companies

with respect to the S&P 500 in the two -month period of December 2001 and January 2002:

2,927 companies (77%) had, in the sample period, a maximum beta more than two times

bigger than their minimum beta.

Only 2,780 companies (73%) had positive betas on the 62 consecutive days.

52% of companies in the S&P 500 had a maximum beta more than two times bigger than their

minimum beta.

The median of the difference between the maximum and the minimum of the 62 betas

calculated for each company was 0.88 for the 3,813 companies in our full sample, 0.63 for the 450

companies in the S&P 500,

CH3- 5

Pablo Fernandez

IESE Business School, University of Navarra

Looking at industry betas, 25% of the industries had a maximum beta more than two times

bigger than their minimum beta.

It seems that it can be an enormous error to use the historical beta as a proxy for the expected

beta. First, because it is almost impossible to calculate a meaningful beta because historical betas

change dramatically from one day to the next; second, because very often we cannot say with a

relevant statistical confidence that the beta of one company is smaller or bigger than the beta of

another; third, because historical betas do not make much sense in many cases: high-risk companies

very often have smaller historical betas than low-risk companies; and fourth, because historical betas

depend very much on which index we use to calculate them.

A survey6 done in 2009 reports 2,510 answers from professors from 65 countries and 934

institutions. 1,791 respondents use betas, but 107 of them do not justify the betas they use.

97.3% of the professors that justify the betas use regressions, webs, databases, textbooks or

papers (the paper specifies which ones), although many of them state that calculated betas are poorly

measured and have many problems.

Only 0.9% of the professors justify the beta using exclusively personal judgement (named

qualitative, common sense, intuitive, and logical magnitude betas by different professors).

All professors admit that different investors may have different expected cash flows, but many

of us affirm that the required return should be equal for everybody: That is a kind of schizophrenic

approach to valuation. Most professors teach that the expected cash flows should be computed using

common sense and good judgement about the company, its industry, the national economies

However, many professors teach a formula to calculate the discount rate (instead of using again

common sense).

The paper includes interesting comments such as:

I justify the betas by computing them and proving that they are right. References are also made to financial

webs.

I always emphasize that beta calculations have to be taken with some leeway.

I use betas but I use all metrics that are available.

I do not have much confidence in beta but we dont seem to have any easy substitute.

It is poorly measured, but no substitution so far.

I justify the betas if the published betas are "abnormal" (i.e., negative when you would expect it to be positive)

The model has received a Nobel Prize in Economics and while not perfect is used extensively in practice.

If you dont use betas, how do you adjust for risk? Almost every practitioner book uses betas such as the

McKinsey publications.

I use whatever is suggested in the teaching note.

Beta is a simple method and it is used in the "real world." It is really not so helpful, although easy to use.

I use beta in my valuations. In consulting, it is essential to fully support your estimates.

Referees want to see them as the underlying model. I need a model anyway, and these are the safe bets that

referees will not challenge.

Students tend so see CAPM as just one recipe from a cooking book.

I do not use betas except for teaching purposes. I researched the predictability for stock returns. I found worse

out of sample predictive power for future returns using betas than when the market average return is used.

We justify use of betas through underlying theory and students get convinced. I found that students are quite

excited about betas.

CH3- 6

Pablo Fernandez

IESE Business School, University of Navarra

EVA (economic value added) is the term used8 to define:

EVAt = NOPATt - (Dt-1 + Ebvt-1)WACC

EVA is simply the NOPAT less the firms book value (Dt-1 + Ebvt-1) multiplied by the average

cost of capital (WACC). NOPAT (net operating profit after taxes) is the profit of the unlevered (debtfree) firm. Sometimes, it is also called EBIAT (earnings before interest and after tax)9.

Stern Stewart & Cos advertising contained such eye-catching statements as the following:

- EVA is the measure that correctly takes into account value creation or destruction in a company.

- EVA is a measure of the true financial performance of a company.

- There is evidence that increasing EVA is the key for increasing the companys value creation.

- more EVA always is unambiguously better for shareholders.

- managing for higher EVA is, by definition, managing for a higher stock price.

- EVA is the performance measure most directly linked to the creation of shareholder wealth over time.

A firms value and the increase in the firms value over a certain period are basically

determined by the changes in expectations regarding the growth of the firms cash flows and also by

the changes in the firms risk, which lead to changes in the discount rate. However, accounting only

reflects the firms history. Both the items of the income statement, which explain what has happened

during a certain year, and those of the balance sheet, which reflect the state of a firms assets and

liabilities at a certain point in time, are historic data. Consequently, it is impossible for accountingbased measures, such as EVA, to measure value creation.

It is simple to verify this statement in quantitative terms: one has only to analyze the

relationship between the shareholder value creation, or the shareholder value added, and the EVA and

cash value added.

Using EVA, MVA, NOPAT and WACC data provided by Stern Stewart for 582 companies, it

is easy to calculate the 10-year correlation between the increase in the MVA (Market Value Added)

each year and each year's EVA, NOPAT and WACC:

- For 210 companies (out of the 582) the correlation with the EVA was negative!

- The average correlation between the increase in the MVA and EVA, NOPAT and WACC was 16%,

21% and -21.4%.

- The average correlation between the increase in the MVA and the increases of EVA, NOPAT and

WACC was 18%, 22.5% and -4.1%.

10. The relationship between the WACC and the value of the tax shields (VTS) 10

The correct calculation of the WACC rests on a correct valuation of the tax shields. The value of

tax shields depends on the debt policy of the company.

The equation that relates the WACC and the VTS (the Value of Tax Shields) for a

perpetuity (being g the growth rate) is:

VTS g VTS

WACC = Ku1

E D E+D

D

Ku Kd(1 T) VTS Ku g

E

E

Ku is the required return to equity in the debt-free company (also called the required return to assets)

T is the effective tax rate applied to earnings. D is the value of the debt and E is the value of the equity.

7 This is explained in Chapter 35 EVA and Cash Value Added Do Not Measure Shareholder Value Creation,

http://ssrn.com/abstract=270799

8 According to Stern Stewart & Cos definition (page 192 of their book The Quest for Value. The EVA Management Guide)

9 NOPAT is also called NOPLAT (Net Operating Profit Less Adjusted Taxes).

10 This is explained in A General Formula for the WACC: A Correction, http://ssrn.com/abstract=949464

CH3- 7

Pablo Fernandez

IESE Business School, University of Navarra

The intertemporal form of equations [1], [2] and [4] is:

[2i] Dt+1 = Dt (1+Kdt+1) - CFdt+1

[1i] Et+1 = Et (1+Ket+1) - ECFt+1

[4i] [Et+1 + Dt+1] = [Et + Dt] (1+WACCt+1) - FCFt+1

The sum of [1i] and [2i] must be equal to [4i]:

[Et + Dt] + Et Ket+1 + Dt Kdt+1 - [ECFt+1 + CFdt+1] = [Et + Dt] (1+WACCt+1) - FCFt+1

As CFdt+1 = Dt Kdt+1 - [Dt+1 - Dt] and ECFt+1 = FCFt+1 + [Dt+1 - Dt] - Dt Kdt+1 (1-T)

and

[ECFt+1 + CFdt+1] = FCFt+1 + Dt Kdt+1 -- Dt Kdt+1 (1-T)

[Et + Dt] + Et Ket+1 + Dt Kdt+1 (1-T)] - FCFt+1 = [Et + Dt] (1+WACCt+1) - FCFt+1

[Et + Dt] WACCt+1 = Et Ket+1 + Dt Kdt+1 (1-T).

Et Dt

T is the effective tax rate applied to interest in equation [3]. Et + Dt are not market values nor book values: in

actual fact, Et and Dt are the values obtained when the valuation is performed using formulae [1], [2] or [4].

1. While I continue to work as a security analyst and capital markets consulting, I have been doing some tutoring and

teaching. I have been surprised at the rigid and somewhat superficial treatment of WACC, beta and equity premium. I

think even undergraduates could understand your presentation since it is so concise and straightforward.

2. Most students I have run across do not really understand what the risk free asset really is.

3. Your discussions are insightful and most appropriate. I especially like your discussion of how we teach betas and the

growing difference between teaching and practicing.

4. I cannot agree more with regard to the WACC. WACC is not a cost but a weighted average rate.

5. I came across an interesting topic at a real-estate valuation conference recently. Practitioners and educators teaching

real-estate topics tend to have a confused idea about what real estate capitalization rates (cap rates) really are. I

understand that until recently, the concept of the cap rate was taught as being equivalent to a discount rate. Now people

realize that the cap rate is simply the inverse of the valuation multiple. But even professional appraisers trained according

to the earlier methodology remain confused about it.

6. The thing that is really badly explained is that the efficient market hypothesis does not hold in general and thus the

CAPM is not valid.

7. If the efficient market hypothesis does not hold, then the price and the value of a share are not the same. As a

professional investor I exploit this difference.

8. I actually require my students to calculate a value, with risk measure, and find the probability that the equity is over - or

underpriced.

9. The use of beta's, CAPM etc only has value in the very short term (High frequency trading etc.). These people work with

computer algorithms and exploit deviations from their idea of the efficient market to make small profits. These are not

investors but (day or shorter) traders that provide market liquidity. The same can be said about traders in derivatives

(even if they claim to be hedge funds, they speculate / gamble with hedging instruments and do not hedge to remove the

risk for a constant return). These people in effect make profit out of the random walk of equity prices in the short term.

10. The "cost of debt" to consider in WACC is always the expected return, to be weighted according to the market value. The

use of nominal figure is a (widely used) professional practice. I suggest you to strike out in the paper the best condition to

follow this professional approach

11. I'm convincing that the "equity risk premium" is no more mean-reverting. That's why the four different concepts are

dirverting more and more along with the textbook (and professor's) recommendations

12. I do fully agree with you about EVA!

13. Why not making a video-paper to explain the points? It could be put on EDU-YouTube (or open a video section inside

SSRN)

14. Our firm does a large amount of valuation work, mostly for early stage, venture-backed, high-tech private companies. So

our discount rates are pretty large. We might use WACC on occasion but then we add "specific risk" to increase it for

most of the firms we value. Valuation has a reasonable amount of "art" to it. Clearly not a formulaic "science".

15. I like your comment that WACC is a combination of cost and expected return but everyone calls it "cost of capital" --which

it clearly is not. Like most of finance (and the medical and legal fraternities) the language is often used to obscure the

meaning than to clarify it.

CH3- 8

Pablo Fernandez

IESE Business School, University of Navarra

16. The variability of beta is pretty funny to me because I have raised this issue at several classes I took years ago with the

American Society of Appraisers. The valuation experts who do private company valuations assume beta's that are for

"comparable public companies" which is a bit vague.

17. What about alpha?

18. I have wondered why the valuation experts don't take price volatility into account as well. A company that has high

volatility should have a lower value than the same business with low volatility. But volatility does not get factored into the

analysis either for related transaction comparable data or in the public comparable companies that are selected as

surrogates for the Price to earnings ratio or Price to Sales ratio for the private company. If the price is "bouncing around"

for the public comparable companies it certainly should be factored into the valuation analysis as compared to a set of

public comparable that have very little price volatility.

19. The whole valuation exercise is a bit amateurish in one sense and it's an art. But I guess it's better than just guessing at

a value without doing any thinking or analysis.

20. I agree with all the 10 common mistakes and wonder whether it is possible to estimate the amount of damage that was

and is created by applying theory in a badly understood manner.

21. I like the most your point on EVA!

22. I have worked with various valuation systems through the time (40 years) and time learned me not to hold on stringently

to the company specific WACC. There were periods that companies used the system i.c. a lot of debt in order to reach a

low number for the company. However, actuality came along with higher interest rates or otherwise higher banking rules

and these were often very negative for the valuation. M&A drove the deals, but could not hold on.

23. Why regulators and banks all inclined to use VAR as risk measurement tools despite the fact that they all know that their

relevant risks are skewed.

24. A very good and useful chapter, noting in particular the background on the very practical illustration of the wide range of

ERPs used and the volatility of Bs and that you linked well equity and debt and debt components of WACC.

25. Perhaps some comments on leveraging and unleveraging practices for Betas and on what best to use for a Beta might

be added, but it is a good and useful paper. Time permitting I will read carefully and comment more thoughtfully

26. Why didnt you add or discuss conditional vs. unconditional ERP

27. I think you article is great! It reinforces my belief that we need a better framework for valuation, measurement, and

corporate planning. I think Beta makes no sense in the real world look at my companys beta as an example. Also our

measures of risk do not really reflect risk. No one is worried about upside performance but it is treated as just as evil as

the downside.

28. I enjoyed your work on 10 badly explained topics in corporate finance books. Heres my list of six. While your comments

are more on the financing side, mine are more on the investment side.

a. Net working capital additions in capital budgeting: Most textbooks say that the (typical) increase in NWC is because

additional working capital is necessary to support new capital investment. That is not the reason. The reason is that the

cash flow estimates start with sales and costs from pro forma income statements. These figures are not cash-adjusted.

The change in NWC makes this adjustment.

b. Profitability Index: First off, it is not an index of profitability. It is an index of present value added relative to initial cost.

But there are further problems that are never identified in textbooks. For one, they do not tell you how to calculate it if

the project is not a standard project in which there is an initial outlay followed by a series of cash flows. Some projects

have the major outlays later, not up front (leading to another pet peeve of mine). When the problems of using PI are

identified, the main one seems to be the multi-period issue, where capital is rationed over several periods. That

problem pales in comparison to the fact that if you rank projects by PI and select from largest PI to smallest, you will

not necessarily get the optimal combination of projects. You can only be assured of doing so if the projects selected

expend the entire budget.

c. Capital budgeting: I do not even like the term capital budgeting. A budget is a plan implying a limit. To use the

expression capital budgeting is, in my mind, synonymous with capital rationing. Yet, we use capital budgeting as a

general expression for capital investment. I believe we use the term because somewhere in the early days of finance

theory, someone gave it this name and tradition is hard to break.

d. Net present value: I certainly agree with the concept, which I teach my MBAs as the value of money in minus the value

of money out. To call it net present value, and in particular, to define it as the present value of the cash flows minus

the initial outlay, creates the general impression that all projects have an initial outlay. Many projects get money in first

and pay out later. Some have payouts spread out. Some projects are simply cost generators, whereby you choose the

one with the higher, albeit negative, NPV. I reluctantly use the term NPV because everyone else uses it, but like

capital budgeting, it is a bit of an archaic term that we ought to but cannot get rid of.

e. Purchasing power parity: One need only check the Big Mac Index or do a little foreign travel to see how absurd this is

empirically, but it is not even sound theoretically. What a Spaniard will pay for something is not necessarily what an

American will pay. Because its in the book, I have to present this and tell them it is nonsense.

f. Number of stocks to diversify: A wrote a paper on this recently in Financial Review. This point is widely misunderstood.

The equation that shows how variance declines by the average covariance is wrong because it assumes that average

covariance and variance are constant across the universe and the stocks chosen. That is only true for large samples.

CH3- 9

Pablo Fernandez

IESE Business School, University of Navarra

Small sample properties apply for portfolios of the small sizes under consideration (typically less than 30). The

exponentially declining relationship between variance and number of stocks holds only in large samples. We confirmed

this with portfolios chosen by people and using random number generators.

29. Studies such as those by Gary Biddle suggest that accrual is better than both cash flow and EVA measures.

30. Thank you very much for your sense of realism (and your data).

31. I would also consider elaborating on a very common mistake: people tend to only account for risk through WACC, rather

than in cash flows. E.g., for a company that has limited systematic risk, but very uncertain cash flows (lets say oil assets

in Africa), people to use a very high WACC instead of properly risking the expected cash flows. As you understand, this

distorts investment priorities as cash flows further out in time are unfairly worth less. Also, it creates issues when analysts

and investors discuss the case, because investors tend to use their own WACC assessment, and are more interested in

properly understanding the cash flows. My experience is that changes in expected cash flows are what drives share

prices in the end. The key contribution from an analyst is therefore to create a convincing case around the forecasts,

which in turn need to be properly risked.

32. Our primary business is m&a in enterprises with a company size spectrum 10 Mi. to 750 Mi. annual revenue.

Much theory on scientific valuation goes out the window at this level. Price is determined according to current market

multiples, e.g. 6-8 X EBIT (minus liabilities), or 1-1,5 X revenue (minus liabilities), etc.. Beyond that, the (perceived)

strategic logic of the transaction determines whether a price at the top end or bottom end of the scale is paid.

I have expended much effort and many hours arriving at the "correct" valuation (using all those methods common in

DCF), only to have decisions made on what I mention above. So no more.

33. As a Finance student and professor (1966-1980), I was educated and taught using Brigham and Weston and later, Van

Horne.... Many years later, I now have some 25 years as a Corporate Treasurer and CFO to lean on as well.... I offer a

few comments based on that extended experience:

Many years ago, at a Financial Management Association Meeting, I recall a finance official from DuPont advising us that

DuPont had finally committed to using DCF when evaluating Capital Projects(!!). He then added that they were using a

discount rate of twelve percent. (I cannot recall whether he referred to it as a discount rate or a cost of capital. He then

repeated himself (in emphatic terms), that the rate was twelve percent, not 12.0% and certainly not 12.00%! The

wisdom contained in that statement has become more and more evident to me over the years....while academics may

spend much time counting all the intricacies to be addressed when accurately calculating both WACC and MCC for

capital budgeting purposes, I can truly say that I have never seen a project whose ultimate acceptance or rejection was

impacted by .1% (or maybe even .5% ) difference in the discount rate..., and further, the greatest risk in making a wrong

decision lies not in the discount rate, but in the cash flow forecasts. A much greater opportunity for error, and

unfortunately, one that continues to be made as (I would guess) the majority of companies seldom ever make an effort to

effectively audit their decision making process. (I also think that Monte Carlo analysis and/or scenario testing are key

aspects of effective decision-making...but have not seen that effectively used either!)

34. I enjoyed again reading your papers and agree with any of the points the way they are presented, and the

demonstrations.

35. Concerning the WACC, the way it is defined (deduction from market figures at equilibrium), I cannot use it to value

business plans from projects. Therefore, I use cash-flow to economic capital (which is a cash-flow to equity, where the

financial structure is adjusted every year to bear the constant risk I have chosen to remain in; economic capital allocation

is performed on assets or cash-flows, mostly based on distance to default, and excesses/needs of equity are adjusted

from the shareholders pocket). So the debt is served and the variations in equity contribute to the cash-flow to economic

capital

36. Moreover, the WACC cannot be used where there is some risk transfer.

37. Excellent! Some more badly explained concepts are (a) IRR computation involves reinvestment of cashflows this is a

total myth; (b) NPV is a better measure than IRR again, a completely wrong approach. NPV can never be used to

compare options best.

38. I totally agree with your view on EVA. I have difficulty relating EVA directly to value creation. EVA to me is like excess

profit over all costs.

39. Thanks a lot. Very interesting. I am studying the early days of the stock market, a century and a half ago, when things

like WACC had not been thought of yet, but find it fascinating there is so much confusion in the field today.

40. Adding one more badly explain topics: Investment Decision discussion. Professor always explain Investment Decision

based on a premise of future economic conditions so as to produce a scenario NPV and IRR. In fact, the world economy

after the 1998 crisis can no longer be approximated by a scenario. Uncertainty of the world economy and the country in

the period in which the cashflow forecast is made so large to be accommodated in an economic scenario only. It takes

more than one scenario estimates cash flows under a premise of the economic conditions of different.

41. I am working with a Professor of Physics where we look at the corporation as a complex option. We value each

component as a real option. Still we have to use the changes you are suggesting to end up with a more accurate

Valuation.

CH3- 10

Pablo Fernandez

IESE Business School, University of Navarra

42. The area that I struggle with in application and teaching corporate finance is applying a low beta in CAPM which results

in a cost of equity which is less than the current cost of debt for let's say 10 year bonds for companies of similar risk. That

results in a non-sensical answer... and then I revert to using the bond yield premium.

43. Thank you. It helps for my teaching. Your work is very intuitive.

44. I'm hopeful that your work will begin a movement away from some of the complete bs that many finance professors

teach.

45. I agree that these are badly explained topics. I would go quite a bit further. By not acknowledging Benoit Mandelbrots

research on fat tailed distributions with infinite variances, professors fail to question the most basic underlying

assumption of the CAPM mainly that beta exists.

46. In the past, as a practitioner, I have provided input to you regarding MRP, CAPM etc. As an adviser of M&A transactions

which include business valuation, I tend to take a pragmatic, and perhaps less theoretical, approach to such issues. I

particularly agree with your observation that while so much subjectivity is involved in estimating cash flow, we seek one

pure number for the discount rate. I often use a build-up method to develop the discount rate which includes several

risk factors such as customer concentration, product concentration, lack of management depth etc. along with the normal

industry and macro risk factors (I mostly work with midsize private companies so direct market beta is not available in the

first place). Sometimes, the buyer has a hurdle rate regardless of what the theoretical WACC is, and in that case, we

simply calculate how much can he afford to pay (for buy-side advisory) to generate a return (IRR) equaling his hurdle

rate. Of course, cash flow is subject to estimation anyway. We also use scenario analysis to get a range of values; I tried

to use Monte Carlo as well.

47. I worked with Bennett Stewart when I was heading up CSX Corporations corporate finance. I was one of the early users

of EVA framework in the US. So, I do relate to many of the issues you mentioned in the article. I have been a university

professor in the past, and after several years of industry career, started teaching MBAs again.

a. Ive assumed that WACC refers to the weighted average cost of finance capital that is, money for investment and

operational purposes rather than human/intellectual capital or physical capital such as plants and equipment. In my

experience, human and real capital matter more to a firms survival and growth but arent reflected very well in

conventional finance or conventional financial reports.

b. Nobel laureate James Tobin of Yale University reportedly proved that one cannot calculate a realistic value for WACC for

a variety of reasons, notably an enormous amount of unobtainable but necessary data. Part of the problem is that

some finance capital is obtained for specific uses and/or restricted geographically. Its cost potentially is infinite those

constraints are violated. Its cost usually is understated if the constraints are honored. Another issue involves costing

internally generated capital versus new debt/equity.

c. According to Fortune magazine, Stern Stewart advised Robert Allen when Mr. Allen led AT&T to ascertain WACC. Even

AT&T with its large staff of economists couldnt do it. I arranged for the woman in charge of that project to address a

group of business strategists on the subject. She turned out to be an eager young financial clerk! All the in-house

economists and financial experts refused to get involved. [It always struck me as odd that Stern Stewart couldnt or

wasnt retained to find AT&Ts WACC.] Some of AT&Ts economists reportedly cited Tobins work for not getting

involved; others simply balked.

d. Whether WACC is or isnt a cost partly depends on how one defines the terms. If cost is defined as an out-of-pocket

payment, then WACC is an oxymoron, Weighted Average COST of Capital, and need a more appropriate name. If,

however, cost is defined in an economic sense, then WACC unquestionably is a cost.

e. A firm has several values. The ever changing valuation of a publicly traded firm represents its liquidation value rather

than its use or absolute value. Its use value primarily depends on what use(s) the management targets and secondarily

how credible that is to all stakeholders.

Enjoyed the paper and learned from it.

48. One of my pet peeves in academia: Searching for deterministic values rather than understanding theory.

49. You are certainly correct: WACC is neither a required rate of return, nor a payout rate, etc. I would be glad to use your

insights in my future teaching.

50. Your paper did a great job of raising other questions such as the validity of CAPM and Efficient Markets theory,

Economic Value versus Accounting Value, validity of betas, etc all fascinating concepts, but none without flaws!

51. I am finding wacc, eva and beta not useful as a fund manager. Rather, I have a long list of rules of thumb well

established by academics. A few examples: 1) Primary market tends to be overvalued; 2) Avoid crowded trades; 3) Buy

distressed bonds after default did actually occur; 4) Volume and price level tends to be correlated; 5) Discounts of all kind

tend to be pro cyclical.

52. Believe in the Sun, even though it doesn't Shine. Believe in Love, even when it isn't Shown. Believe in God, even when

he doesn't Speak.

53. I have an 11th item that, at least to me, gets thrown around in the financial sector in a very loose way: "alpha".as a

measure of excess return without additional risk.

54. I think your sections on WACC and equity premium are very well done. I'm not sure what to conclude after reading your

section on "betas" other than its hopeless to compute them. Not everything that counts can be counted, and not

everything that can be counted counts. Albert Einstein (18791955)

CH3- 11

Pablo Fernandez

IESE Business School, University of Navarra

55. Your argument about EVA is very well taken, and I appreciate it.

56. I think most texts treat the word "cost" as "opportunity cost" rather than actual cost.

57. The only explanation for why the experts controlling the profession are unwilling to correct their fallacious partial risk

pricing dogma - by not publishing total risk pricing models in the 'top' journals they control - is that they are heavily funded

by the mega traders who profit by trading on total risk while hooking up the vast majority of professionals (indoctrinated

by the experts) to the unstable partial risk pricing dogma.

58. Youre amazing and I truly appreciate your approach to our discipline and dedication to making it better. As a text author

of 40 years I can tell you honestly that your approach is refreshing and that it will make us better.

59. You have identified some very important areas of confusion and even straight disinformation floating about. In particular,

the historical beta method is widely used by corporate finance, valuation consultants and investment banking

professionals with no regard to its validity.

60. Is there a difference between the cost of debt and its required return? I dont think so.

61. Accounting statements do not allow the analyst to measure the economic reality of a company.

62. Thank you for your paper. I read it with interest. It is notable that what you actually find are gaps in the theory.

63. EVA versus MVA. You are quite correct: accounting measures cannot be used to measure value creation; nothing can.

64. Historical betas do mean nothing in Techs (extremely low) as their correlation with the indexes is rather low, while their

risk is high. Indeed the CAPM does not encompass the cost of specific risk and it should, due to the bankruptcy risk. By

introducing other variables like liquidity, size, the APT and Ibbotson have made progress, but full volatility should be

the basis of computation of the cost of capital, as well as the shape of the distribution of potential losses for the equity

claim holder.

65. Interesting the traditional value of a corporation usually comes to play in two ways. A) When it is being bought by others.

B) When shareholders evaluate the purchase price of a stock that is traded on the markets. The third and possibly more

important, valuation analysis, occurs when others look at the company in terms of giving credit or partnering. So in the

first case if you look at the old 1.2 X EBITAS valuation for a entity you come up with a simplified offer the rest is

negotiation or for those participating in the stock market that is mostly gamed now by computer trades and other fast

money schemes the market pundits seem to abound in giving specious opinions. Those are dominated by statistics de

jour and heir analysis is dominated by opinion rather than facts.

See what they said about AAPL before their recent earnings analysis. A famous USA author Mark Twain saw the same

thing over a 100 years ago. He is often quoted in relation to that issue. Mark Twain said There are three kinds of lies:

Lies, Damned Lies, and Statistics. That can certainly be applied to many areas, including the valuation of a company.

Never the less, your analysis is interesting in that it tries to account for variables that are below the radar and put a

numerical valuation to the often nebulous data.

The tax shield is one of the often neglected area that you cover well but possibly more important in this competitive

market are intellectual property and patents valuation.

These are actually now being used as weapons in many technology sectors or in the case of virtually defunct companies

like Kodak used to prolong their value when the base business is long gone. I encourage you to look at the intellectual

property and innovation value as a key indicator of present and future growth.

No matter how well a company is doing now without a future (like many drug companies have proved with lapsed

patents) they are doomed.

66. Your work is very important and interesting to our profession.

67. The WACC is an average of a cost and a required return. That is a subtle but important point for those setting return

targets.

68. An interesting piece. I am glad that you are trying to correct the constant misinformation round the ERP. It is often

referred to as your first and or fourth definitions, but is in reality for an investor only number 3, the required premium to

invest in equities over treasuries. (your next work may be the effect of the sovereign bond crisis on the riskfree rate!)

69. I tend to find more comfort by thinking of WACC as a marginal cost what it costs to raise additional capital averaged

across the different sources of capital.

For bonds - the after-tax cost of raising additional debt. In addition, there are certainly many complications if there's a

need to approximate cost of raising additional debt when it has to do with risk hedges (interest rate swaps and/or credit

default swaps), convertible debt, interest rate caps and floors, foreign currency debt with or without hedges, debt that is

not rated...

70. As far equity risk premiums and historical/implied/expected... betas (and 2/1 ratios between max and min betas for the

same stocks used in various studies) - one should probably give a sizable influence to other factors that may be

overlooked or assumed to stay the same - volatility (including the impact of day-traders and professional speculators),

availability of capital, extreme weather effects, major political changes...

71. Just sharing, related to calculated (historical) betas..., we are currently calculating our own beta for cost-of-equity (or,

more precisely, opportunity cost of capital for equity) by comparing directly the movement of our share with that of the

index at Jakarta Stock Exchange. We are using the changing of our proportion (based on market-cap) to the index as the

cut-off for calculating beta, since our weighting on the index changes quite enough for the last several years.

CH3- 12

Pablo Fernandez

IESE Business School, University of Navarra

I also agree with EVA does not..., since it based on historical accounting and did not account for the risk. The only

acceptable measurement for value should be DCF method based on expected cash-flow discounted at proper

opportunity cost-of-capital.

72. As a quid pro quo, allow me to refer you to an alternative view of EVA, namely Shareholder value debunked in Strategy

& Leadership, January/February 2000. 3 Nobel laureates [Lawrence Klein of the Wharton School, Harry Markowitz of the

Rady School at the University of California and Franco Modigliani of M.I.T. have pointed out different fatal flaws in the

shareholder value doctrine. According to Professor Klein, when Professor Modigliani was teased about supposedly being

the intellectual godfather of the shareholder value paradigm at a Nobel Prize ceremony, he responded by saying, Im

tired of being blamed for such crap. I later met and asked Professor Modigliani if that quotation was correct and, if so,

could I use it. He said: I never said that. Id never say that. I said Shit and I meant it. You may quote me.

Questions

Is the WACC a cost?

What is the WACC?

Is EVA (Economic value added) a good measure of Shareholder value creation? Why?

Which Equity Premium do professors, analysts and practitioners use?

What is the best way of calculating a beta?

How would you calculate the Required Equity Premium (REP) of the whole market?

What is the typical recommendation of textbooks regarding the Equity premium?

What do you think about using a historical beta as a proxy for the expected beta?

Do calculated (historical) betas change much from one day to the next?

Please define:

Equity premium or Market risk premium

Historical equity premium (HEP)

Required equity premium (REP)

Risk-free asset

Expected equity premium (EEP)

Implied equity premium (IEP)

Historical equity premium (HEP). Expected equity premium (EEP). Required equity premium (REP). Implied equity

premium (IEP)

Historical beta. Calculated beta. Expected beta

CH3- 13

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