Summaries of the five articles

By

Muhammad Ishaq(233-FMS/MSFIN/S13)

MUHAMMAD ILYAS (240-FMS/MSFIN/S13)

A summary of the research paper “Corporate finance and governance in emerging
market”

1: Introduction:

In this paper the author describe that how institutional forces affect the financial and governance
policies and decision in the emerging market. Most of the researches related to finance have been
conducted in developed economies but in the past twenty years the interest of the researchers in
the emerging markets has been growing.

The author pointed out that how firm performance and behavior can be affected by law and
enforcement. The major institutional forces that can influence the firm decision and policies are
state ownership and privatization, the interference of government and development of financial
sector.

2: institution and emerging market firm behavior:

The first institutional factor that can influence the firm’s financial decision and policies is
government quality. By government quality we mean that up to what extent the decisions of the
government officials and politician can be beneficial for public and wither these decisions are
socially acceptable or not and what will be the policies of business organization under low and
high quality government. The other important factor that can affect the firm’s organizational
structure and policies is state ownership. The restriction of the government on the transferring of
ownership of share holders can affect the productivity as well as the performance of the firms.
The performance of the emergence market is not good in the development of financial market. In
many emerging market there is no rules for bankruptcy law as a result the right of the investors is
not protected and the cost of capital is rising very high. The firm usually gets external financial
resources by developing relationship with great officers and bankers.

3: Empirical evidence:

The author stated that how ownership structure is changing with different government regulation.
In the emergent market the ownership is either in the hand of family or government agency. The
ownership structure increase the control of owner over firm by transferring the wealth of
minority share holders but by doing this the cost of transferring wealth will increase. The
question arise that what the owner gain by increasing their ownership if is costly? Therefore we
cannot say that transferring wealth is the reason of ownership in the emerging market. Some time
firms are enforced by the government to unify their stocks which decrease the ownership and
voting power of the owner, so the owner increase their share holding in order their voting power.
The author has given the example of china where the firms are in the control of government.
These firms have direct contact with political beurocrates which makes it more concentrated in
term of ownership. The extent of privatization is another issue that affects the performance and
policies of the firms. The method of privatization and their outcomes depend on the institutional
factors. In those countries where the influence of government is on the private firms, these firms
are considered to be partially privatized. Privatization is minimum in those countries where the
government control is maximum and the ownership level of the government is high. Institutional
factor is also play a vital role in firm investment decision. The sensitivity to new opportunities of
the companies controlled by the government is less than the firms controlled by the private
ownership. So the performance of the companies are affected that is in the control of
government. Most of the previous studies find out that the banking system in the emerging
economies is very weak and there is constrains for the banks to lends money because of the
government interference. In case of state ownership if the government make constrains on
manager compensation, it will decrease the performance of managers and as a result they will be
less productive. In emerging markets the financial records of firms are not transparent because of
the different institutional factors including weak property rights protection, complex
organizational structure and so on.

4: Research agenda:

Emergent market provide a lot of space for the researchers to do research and at the same time it
is more rewarding because this market provide the opportunity for the researchers to discover
new theories due to deference in firm’s level.

As we have studied that government influenced the firm performance, so it is important for the
researcher to do more researches in this area like the analysis of political system, how politician
is selected into power, and the detection and punishment of miss conduct. In future the
researcher would do researches the why these network organization are formed, how financing
and investment decision

In emerging market all the companies are connected with one another through some formal and
informal connection. Some companies formed informal relationship like because of the blood
relations of their owners, marriages, college ties, job relationship. In future the researcher would
do researches the why these network organization are formed, how financing and investment
decision are made by these organization, which is the proper way to govern these organization
and how these organization evolve over the time.

In emerging market most of the private firms are under the control of family ownership, so the
researcher should focus to find out why there is a difference in family ownership and control in
emerging market, what is the contribution of these families to their firms and how family
ownership and management are related to firm growth and investment.
Finance theory and financial strategy

Introduction:

In this article the author says that finance theory had a limited impact on strategic planning. Both
strategic planning and finance theory should be reconciled. Strategic planning includes the
allocation of resources to a line of business. Although finance theory had progressed but still its
impact on strategic planning is not significant. The author explains the gap between finance
theory and strategic planning. This gap may be attributed to 1) language and cultural differences
(2) misuse of discounted cash flows (3) even if discounted cash flows are properly may fail.

The concepts of finance i-e capital investment decisions are relevant to strategic planning. The
present value, of investment that a firm does in a project can be calculated by net present value.
The author further argues that firm can be thought of group of small projects. The firm invests in
these small projects and their present value is calculated through net present value. The present
values obtained for these small projects can be added to get the value of the firm. However
discounted cash flows may also be used an alternative method for obtaining present values. DCF
should also be used for calculating firm value. Both tangible and intangible assets and growth
opportunities are the part of the business. Stock of the company exhibits growth as well as
intangible assets. They can also be valued through capital budgeting.

A firm with different risks has different cost of capital. Firms of same risks are classified into
same class and thus same rate of return is assumed for the whole class. The emphasis in finance
theory is on fundamentals. Consider a project of positive NPV, the theory would ask for carrying
out the project but this can cause a decline in stock’s value. The investors look at the declining
value of the share and not blindly accept the end results.

Gap between finance theory and strategic planning:

The purpose of capital budgeting is to carry out project which values more than its cost. It is
basically bottom up approach. Investment is the allocation of capital to a line of business. The
investment must earn more than the allocated capital otherwise it would be wasting of capital.
Although this have a direct application in strategic planning. Yet most of the strategic planner
does not use these tools in their decision. For example negative NPV project but still considered
by strategic planner for strategic reasons. One of the gap between the two is that in many cases
strategic analysis considers variables that according to finance theory are irrelevant. For example
if a project does increases the value of the firm then according to finance theory looking at book
value of share is irrelevant but strategic planner do take into account this issue.

The conflict between the finance theory and strategic planning is that financial analysis increases
current earnings at the cost of long run values, however this is not a drawback of finance theory
rather is the habits of financial analysts. Moreover quantitative analyses are short sighted and the
difficulties the industries are facing are due to DCF and DCF is being misused.

Two cultures and one problem:

Both finance theory and strategic planning can be thought of as two cultures facing the same
problem. The difference of approach and language makes the two apart. This gap can be
removed through enhanced communication. The problems that discounted cash flows may face
are (1) chance of random error (2) firms need to make themselves safe from error that dominates
projects choice.(3) managers uses NPV as check. It means that they do not blindly take decision
rather they do consider NPV. They do not accept NPV(positive, naegative) until and unless they
cannot explain the reasons. It means that the difference between the two is more than just two
cultures and one problem. This is why it is difficult to reconcile both.

Misuse of finance theory:

The gap between strategic planning and finance theory is due to misuse of the tools of finance
theory. Those who uses these tools commits misuse. Some strategic analysis do not use financial
tools due to their short sighted results. However the story is not so actually the tools are being
misused. The errors made in applying DCF are

1) Ranking on IRR:
Internal rate of return (IRR) for smaller projects is high and that of large projects is low.
So even though if a project has a positive NPV but it comes down the order due to low
IRR. Thus it is not an appropriate technique.
2) Inconsistent treatment of inflation:
Most of the firms uses inconsistent inflation rate, they use high discount rate and don’t
adjust inflation which makes long lived projects less worthy.
3) Unrealistic high rate:
Some time firm sets unrealistic high rates for even though if inflation is adjusted. The
reason for this might be that strategic planner may not be well aware of the of how to use
capital markets data.
Bridging the gap:
The gap between finance theory and strategic planning can be bridged by use of the
various finance theory tools in balance with strategic planning.
 Summary of the paper “Revealing money’s time value”

Valuation is a very important technique to measure the real value of any assets and any project
that is employed by a business organization. The main purpose of this paper is to give
information to the students about the valuation concepts and the practical application of time
value of money. This

Valuation techniques have always been a great challenge for the student to understands, so the
author has giventhree exercises which show the importance of the valuation concepts and their
application. The first exercise the shows the importance and use of valuation in the capital
market. The second exercise is about the proper presentation of valuation concept that will help
the students how to discover the relationships between cash flows, interest rates, and investment
values and the third exercise is about the practical application of these techniques.

Exercise no 1:

In the first exercise shows that how these techniques of time value were used in the history. A
video that shows the role of moody’s in history, that how time value of money were used in bond
and stock. The objective of this exercise is that to show the importance of time value of money
calculations in the history. The first section and the last section focus on the importance of
mathematics in the time value of money and the importance of bond financing. This article has
given some solutions to the students to reach the results from the video.

Exercise no 2:

The basic objective of this exercise is to highlights bonds financing concepts with the help of
discovery learning approach. This exercise focuses on the bond valuation and interest rate and
also shows the relationship between interest rate and present value. The exercise consists of
different steps in which the students are given to calculate bond values.

1: In the first step the students uses interests’ rates to calculate the inverse relations between
bond values and interest rate. They calculates the bond value under three condition, bonds value
face value, essence at less than face value and issue at premium. Students are given different
interest rates to calculate the present value of bonds.
2: In the next step the student relate the purchase price of the investment with present value
calculated in the first step. After calculating the present value of the future cash flow it is
compared with purchase price.

3: In those exercise the students have to find out the different value of interest earnings from
different bonds cash flows. Beside these calculations the students have to find that the
investment value adjusts to face value over the duration of bond.

4: In this step the concept of face value and stated interest rate are introduced to the students
which are used to calculate bond’s cash flow. After those different concepts like par, premium
and discount are introduced and also the inverse relationship between bond’s purchase price and
interest rate is calculated.

Exercise no 03:

This exercise is based on the idea of time value of money, and to make the students understand
the planning for early retirement. The objective of this task is to enhance the understandings of
students regarding time value of money by providing such questions that valuates different types
of assets like retirement fund or saving funds. The author says that such kind of practice will be
worthy for both professional and students because the concepts are demonstrated in a very
efficient manner. Secondly such kinds of tasks encourage the students of accounting to use the
learned concepts actively. In this exercise the already learned concepts are further strengthened
and integrated.

Conclusion:

In the end the author have a bird eye view on the techniques that have been discussed in the
paper and which can have an impact in practical world on time value of money. There are three
such techniques. The first on which inspired the scholars for valuation is the importance of
mathematics. The second one helps teacher in delivering valuation concepts. The last one is
helpful in the understandings of TVM.
Explaining International Equity Valuation Ratios: The Role of Commodity Price
Inflation and Relative Asset Volatilities:
In this paper the author describes the factors that influence stock valuation in
international markets. Earlier research conducted has found that variables long bond rate,
stock and bond volatilities have been influential in the U.S but not in other countries.
Studies conducted in other markets shows that input rates and consumer inflation are
influential in other markets. There exist a strong correlation between stock return and
bond return before first half of the 20th century and during first half of the 20th century
there were found no relation between the two. So Asness suggested that there are some
other variables that need to be identified which can explain this phenomenon. In first half
of 20th century stocks were considered more riskier than bond by the investors. Thus
returns on stocks were greater than bonds. It indicates that risk may also be considered as
factor explaining their relationship. The author argues that as the century progressed, the
volatility of stock were less than that of the bond. Thus bonds were then considered more
risky and investors demands greater return for bonds than the stock.
Some researchers argue that inflation is also an important factor in valuation. They are of
the view that rising inflation will lead to real equity return. One of the problem investors
facing across the globe is that the results found for stock valuation is only applicable to
U.S because of the availability of the data and due to U.S economy. Now the question is
that whether these results apply to other markets or not, however the researcher’s are of
the view that it is not applicable to others market.
Data and methodology:
The sample of this study consists of eight equity market indexes. The length of the time
for which data is collected is forty three years. The variables studied are CPI/PPI, CRB,
bond values, dividend and earnings yield. Nominal bond yield used is of long term bond.
Correlation and regression analysis are used for the analysis of the data.
Relation between bond’s yield and equity valuation:
The relation between stock and bond were examined through correlation. The results
suggested that bond yield have positive correlation with both dividend and earnings yield.
The results also indicated that there exists correlation between them in international
market as well as in U.S. Even though inflation was different across countries but still
similar findings were reported in other markets as well.
Stock valuation and inflation:
First the author studies the relationship between inflation and nominal dividend yield and
earnings yield. The study reported that this relation is weaker in U.S and strong in United
Kingdom. It was negative for Switzerland however these differing results may be due to
low inflation and variable payout ratio.
The author also studied the relationship between earning yield, nominal bond yield and
PPI/CPI, stick and bond volatilities. The results of the study showed that earnings yield
was positively correlated to stock volatility and ratio of stock-bond volatility and was
negatively correlated to bond yield. Similar results were obtained the variables PPI and
CPI only in France and Canada and not in other countries.
Conclusion:
The aim of this paper was to determine different valuation techniques. Past research
conducted in U.S market shows that investors used long term interest rate for stock
market valuation. This paper examines that whether the response of the investor was U.S
specific, by studying other international markets as well. The results indicated a strong
correlation between stock and bond in all markets. The author argues that the ratio of
CPI/PPI can explain significant part of the variation in the stock yields. This ratio is
positively correlated with earnings yields. To cut long story short it has been said that in
stocks valuation consumer inflation and relative rates of input are important factors.
Discussion of ‘‘on the relation between expected returns and implied cost of capital’’

In this paper the author had discussed a paper written on the topic “on relation between expected
returns and implied cost of capital.” The author says that the paper had used a model for
comparing stock’s return with implied cost of capital. Implied cost of capital is the internal rate
of return that makes current price equals to the present value of future cash flows. Researchers
use different methods for the calculation of implied cost of capital which can be future residual
income, dividend or future cash flows. All these methods assume constant discount rate while
calculating present values. This paper highlights the errors that might occur if the assumption of
constant discount rate does not hold.
The paper says that according to model expected return is affected only by beta but implied cost
of capital depends on several factors which are volatility of future cash flows, beta and growth
and leverage. The paper also suggests that systematic biasness may occur in implied cost of
capital. Moreover empirical research suggests that implied cost of capital is lower than expected
return. One of the problems in calculating the implied cost of capital is varying discount rate
which is also well researched area. One situation in which in varying discount rates is important
is that if its determinants are also time varying, only then varying discount rates could be used.
Cost of capital will be on the higher side if problems such as internal control or governance
problems are not corrected but it will be high only for short term and once these problems are
resolved the costs of capital will decrease in long term. So this can be a problem for constant
discount rates models to incorporate such issues.
The model in the paper is trying to use constant rate in situation where the rates are not being
constant across time. Other aspects of the model are rightly specified. The model has used the
following components.
1) Present value of future cash flows is the stock value.
2) The discount rates are assumed as stochastic.
3) Both cash flow and discount rates shocks could be related
4) Growth and leverage ratio is constant over the time.
The author says that the only factor affecting stocks return is beta which is assumed as constant,
however implied cost of capital cannot be calculated correctly because factors such as growth,
leverage and volatility are assumed constant. The model has also assumed the most unrealistic
assumption of constant growth in estimating the implied cost of capital. It is very important in
calculating cost of capital to assume varying growth rates. To make things simple leverage ratio
is assumed to be constant because it can be problematic if considered varying.
According to the author the discount rate estimated through implied cost of capital could be
biased and there are also other factors than beta which had an impact on implied cost of capital.
The results of this paper are consistent with empirical research performed earlier. There is an
empirical evidence of the fact that cost of capital is on average less than the expected returns.
The author argues that the model had assumed stochastic discount rate, however if discount rates
are assumed to have deterministic behavior still there would be problems in the estimation of
cost of capital. There is also a chance of measurement error in calculating implied cost of capital
because while calculating present values the discount rate comes in the denominator. The author
point out that the use of finite horizon could be a problem if residuals income or earnings models
are employed by the researcher.