elements Of Finance.netÓ
Shareable Resources for Teaching
& Learning
in the Arts & Sciences, Technology, Engineering, Mathematics, and
Financial Economics and Jurisprudence (aSTEMfej )
Writings by prof-td@elementsOfFinance.net
The elements Of Finance book: http://elementsoffinance.net/elements.pdf
Most recent preview of in-progress Chapter
1.4: http://elementsoffinance.net/palette.pdf
Back history of the preview: http://elementsoffinance.net/support/palette-20261011.pdf
http://elementsoffinance.net/support/palette-20251210.pdf
http://elementsoffinance.net/support/palette-20250213.pdf
http://elementsoffinance.net/support/palette-20230220.pdf
About the baby-boomer
author…
Parents and society taught me the value and
excitement of learning. During 2 years in John Adams Junior High School in historic
downtown Charleston WV, the thrill of diagramming sentences into parts during
English classes coupled with tripartite checks and balances during Civics
classes adding onto beautiful angles of motion during Math classes, that all
put me in the comfort zone for liking learning. Reinforcement came during 2
years at nearly new George Washington High School in the suburban hills south
of downtown Charleston with Biology classes teaching about DNA and textbook imagery
of mitochondria and bacteria through an electron microscope, seminar classes
discussed thoughtful world literature, and a Typing class ignited the cortical
columns of my brain as never has happened before or since, these secondary
school events set a concrete conviction in motion for me to obtain after
graduation as a George Washington Patriot in June 1970 a college degree in Biology (not
pre-medicine) and eventually a doctorate, should circumstances permit.
None before me in family lineage had gone
to college though truthfully very little family history was written and even
less was told to me. Like astronauts, Presidents and great grandparents, the
only time I ever saw a Professor was on TV! El Camino Community College during primary
school years in California and Morris Harvey College in Charleston were the
only colleges that I recall seeing prior to HS graduation. Nonetheless, a dozen
years later and right on time in August 1982 the successful final defense
of my doctoral dissertation at Purdue University in West Lafayette INdy certifies me to “Pile*it*Hip*Deep.
The preceding spring Boston College
Department Head Dr. Jerry Viscione thankfully extended an invitation for me to
join the ranks of about 10 faculty in the Finance Department in Chestnut Hill MAss, just down the Green Line trolley from Fenway Park,
commencing September 1982.
My preconception was that Boston was arguably the metropolis for higher education
in the USA. With gratitude for the goodness that domicile during 4 years in
Tippecanoe County Indiana delivered to me and my spouse, a sharp New Yorker
pointed and direct that has illumined my path since September 1971
during our freshman year at La Universidád Católica
de Puerto Rico, we loaded household property into a 26’ rental box truck and
our 2 preschoolers (Boilermakers before Hoosiers) into our 1978 Honda
Accord. In August 1982 we headed to
Boston to sign a mortgage on our chosen house at an annual percentage rate
(APR) of 17.25%!
My 7-year career with Boston College
was incredible, simply unbelievable, with an ongoing sequence of highly
improbable events that continue to influence me. Discussion below in item #1
begins this side of midway through my BC years with an article about the
linkage between tax policy and the intrinsic value of stock prices.
1. This study, “Tax Policy and
Stock Prices” is co-authored with Dr Patric H. Hendershott, Head of
my dissertation Committee at Purdue University (1978-82; Full Committee: Profs
Gary Schlarbaum, James C. Moore, and Sheng Cheng Hu). This study introduces a
model from my dissertation for intrinsic value in order to measure the
valuation effects from tax law for the real nonfinancial corporate fixed
capital stocks in the USA. Sheer
gratitude flows from me to Prof Hendershott for plotting this study through the
National Bureau of Economic Research (NBER).
http://elementsoffinance.net/support/ntj_tax_policy.pdf
More than forty years ago I presented a
version of the study [1986a Presentation
to the NBER ] at
the NBER Summer Institute Research Series. Distinguished profs seated around
the conference room table included moderator David Bradford (Princeton U),
Martin Feldstein (Harvard U, President and CEO of the NBER), Mervyn King
(London School of Economics), Jonathan Leape (also LSE), Alan Auerbach (HarvardU), Patric Hendershott (Ohio State U, NBER Research
Associate), a few others, each holding a study similar to the NBER working
paper [1986b NBER
WP #2094 ] that
went public about 2 months later. Room discussion by Prof Leape
clarified that the risk premia for tax shields differs from non-tax shields
even though, as is also true and I clarified, the equity financing rate
capitalizes the cash flows to equity at the residual rate. Prof Feldstein saw
the gap between intrinsic value and current replacement cost as problematic.
After finishing amidst salutations, Prof Feldstein asked for me to meet in a
few days with capital stock specialist Charles Hulten (U Maryland) for
discussion. After exiting alone from the conference room to the hallway the
next presenters, Lawrence Summers (Harvard U) and David Cutler (MIT) were going
in. That gave me opportunity to offer Prof Summers thanks for the fantastic
discussions on economic income in Feldstein and Summers [1979a] that
were pivotal for me developing a dissertation proposal. The encounter also gave
opportunity for me to confess some confusion following his Q-trajectories [1981a]
to their point!
Two months after the presentation my home
phone rang about 8:30am. Though answering the phone with a poopy baby diaper
in-hand before heading to my Boston College office, I hear “Hello, this is
Fischer Black,” then Managing Director at Saloman Brothers and forevermore the
MIT prof that laid a firm foundation for standardized derivative security
markets. The 45-minute phone conversation about intrinsic value remains a
cherished & inspirational event in my half century with universities of
higher learning. “Tax Policy and Stock Prices” was published in 1987 by editor
Daniel Holland (Massachusetts Institute of Technology) in the National Tax
Journal. The publication uses the label “fundamental value” for the same
“intrinsic value” object that my current writing uses.
2.
This 1991 study explains that the three standard financial accounting valuation
methods for fixed asset stocks extend like a telescope through different
information sets. The historical
replacement cost method measures historical investment flows net of accumulated
depreciation. The current replacement
cost method extends the measurements to account for incremental information on
cumulative class specific price inflation.
The intrinsic value method in this article accounts for general
inflation, taxes, capital accumulation histories, and capacity depreciation
schedules and compares them to actual seasoned asset prices.
http://elementsoffinance.net/support/jar_fundamental_value.pdf
Thanks
to co-author Keith Shriver for questioning how my intrinsic value computations
might compare to his dataset with actual used fixed corporate asset prices. On
May 8, 1991, I presented our findings in the “Accounting and Taxation”
conference at the University of Chicago Graduate School of Business hosted by
the Institute for Professional Accounting [ JARconference.pdf ].
Actual used corporate fixed asset prices track intrinsic valuations better than
historical cost or current cost valuations. A happy learning moment for me occurred
when discussant prof Ralph Sansing (Yale) having said that the intrinsic
valuation method “lacks a decision making context”
received a reply from Editor Katherine Schipper (UChicago) that the method is
immune to this criticism because the intrinsic value specification “has a
dimension of timelessness.” That dimension of timelessness forms the concrete
bond between the number and the real underlier! An uncertain learning moment
for me occurred when audience member Richard Leftwich (UChicago) sought
clarification for the effects on intrinsic value of asset specific price
inflation versus class or general inflation. I knew not the answer but only its
glitter. Firstly, measuring intrinsic value for similar underliers in a class
or portfolio is valid as real unsystematic risk vibrates randomly. Secondly,
capital market equilibrium with shortfall constraints hold true at every moment
through 2 orthogonal coincident concrete underliers: (a) Consumer theory of
utility specifications by Chipman and Moore [1983] that in the absence of
identical wants and needs by households (homothetic preferences), Domestic
Tranquility for polymorphic “do your own thing” households begins at home and
accumulates into the wealth of a nation, and (b) Producer theory of value
specifications from Dale Jorgenson [1983] that measure flow of funds matrices,
capacity utilization rates, and gross profit margins that accumulate into the
wealth of the nation.
Sadly, the connection between Gross
National Product measurements and Domestic Tranquility is nil to none and
lately negative. During the 3rd quarter of 2026 announcement came that
a first time home buyer in the USA average age is 40!
At that middle age many households with children already may be contemplating
graduation or wedding gifts for their teenagers! Hardly the ideal life cycle
stage for becoming a first-time home buyer, for finally acquiring ownership of an
estate! No worries, some say, since an irreversible decline in the cohort of living
18 year-olds in the USA also is underway. Without
importing people into the USA the number of teenagers
is destined to decline for the next half century. Domestic youngsters could
breed like bunnies, good or bad bunny and poor or rich bunny, it doesn’t
matter. It takes 18 years to make an 18-year old
human, 36 years to make a run of 2. The end of children in communities
throughout the USA is an acute predictable behavioral response when the cry of
Domestic Tranquility for households falls on the deaf ears of a federal government
immune to the original checks and balances that the US Constitution ordains.
3. This 1988 study tests whether actual stock
returns for an industry in response to tax policy changes map to changes in
intrinsic value.
http://elementsoffinance.net/support/aer_stock_prices.pdf
A
fundamental finding is that the responsiveness of balance sheet intrinsic value
to a change in the financial cost of capital may be positive or negative and
depends on a ratio of percentage changes, that is an interest elasticity
(“duration”) of the return streams for marginal investments relative to that
for total assets. When the ratio of elasticities exceeds unity, a plausible
scenario in some scenarios, then intrinsic value rises with a rising cost of
capital and falls with a falling cost of capital. An increase in the cost of
capital is commonly thought to unidirectionally depress intrinsic value –
wrong! Thanks to Boston College co-author colleague Hassan Tehranian that while
comparing the excess stock return numbers from his FORTRAN program with my
predicted changes of intrinsic value for 3 industries selected a priori stated
“but how did you know” – priceless. Besides lucky stats, I am even more
grateful to HT for the introduction outside my BC office door to Professor
Billy Helms visiting momentarily from the University of Alabama who,
unbeknownst at the time, would very soon offer guidance and growth
opportunities for my family and me in sweet home Alabama at the Department of
Economics, Finance, & Legal Studies in Tuscaloosa.
4. This 1991 study models and measures industry level
intrinsic values, an approach that focuses on the asset side of the balance
sheet. The ratio of industry market
capitalization to intrinsic value, labeled the overvalue ratio in the study but
more accurately labeled an overprice ratio, leverages rates of return
independently of required risk premia for liability side commitments. Namely,
for a $1 change in intrinsic value the resultant shareholder rate of return is
smaller for an overpriced industry (or company) and bigger for an underpriced company
irrespective of risk factors or preferences. It’s mechanical.
http://elementsoffinance.net/support/jpm_asset_valuation.pdf
This invited presentation [ JPMpresentation1991.pdf ] of an article from the
Journal of Portfolio Management (Editor Frank Fabozzi) at the Institutional
Investor Institute Quantitative Research Roundtable, an annual gathering of
securities market specialists October 17, 1991. During the 75
minute opening session at 8:30am Dr. Martin Leibowitz, then at
TIAA-CREF, presented “Asset allocation under shortfall constraints.” Seated
beside him for lunch, I was grateful for opportunity to praise his book Investing (1992) for its enduring
lessons, especially the “riding the yield curve” and the “barbell” investment
strategies, that I used in class and for analysis. Prof Ken French (Dartmouth) presented
the Fama-French (1991) seminal work on Book-to-Market ratios and multi-factor
risk models. I briefly conjectured to Prof French that the explanatory power of
the Book-to-Market ratio (=Stockholders’ equity divided by market cap) likely
has little to do with being a risk factor and more with being mechanically
connected by concrete numeracy to the Overprice ratio (=market cap divided by
intrinsic value). Eventual findings by me in 2001 and 2002 in items #8 and #9 support
the conjecture.
5. This 1993 study reports that market
capitalizations for public utility industries track measurements of underlying
intrinsic values. Current replacement
cost measurements (CC) contain specifiable biases of economic value that depend
on capital accumulation histories, capacity depreciation schedules, tax
depreciation schedules, and cost of capital components. The intrinsic value model provides estimates
that contain incremental information beyond that inherent with the CC
measurements.
http://elementsoffinance.net/support/ntj_utility_valuation.pdf
This
1993 study was awarded the $5,000 prize sponsored by the National Tax
Association and the Public Utility and Railroad Workshop at Wichita State
University for the Distinguished Award in Applied Research.
6. The 1992 study below extends the sample from
item #3 in this list, the AER paper on stock prices and tax policy changes, to 10
industries (2-digit SIC code) rather than the 3 industries (2-digit SIC code)
as in the former study. The time required for collecting the information on
price to book ratios for debt securities compelled settling on 3 heavily
capitalized industries for the AER study. No other industries were examined as
we lacked key data. The additional evidence for all 10 industries shows quite a
bit of noise in the conclusions.
http://elementsoffinance.net/support/tfr_tax_reform.pdf
7.
For a conference on taxation at the American Institute for Economic Research
(AIER) at a manor for overnight attendees in Great Barrington Massachusetts
that included William Vickrey (Columbia U Nobel Laureate a year later) as well
as public finance specialists Richard and Peggy Musgrave, somehow seemingly
like magic an invitation flew my way due to the AER study in item #3.
American
Institute for Economic Research-Conference
The
study documents a decline by 1/3 in the ratio of real price to intrinsic value.
Interestingly, at the subsequent 1993 National Tax Association annual meeting
Prof. Vickrey presented arguments that the federal government was strangling
the real exchange economy through unsound public policy.
8.
This 2001 study supports the 1991 conjecture in item #4 above that the price to
intrinsic value ratio mechanically inflates or deflates shareholder rates of
return. Also, see that penny stocks and extreme outcomes provide evidence for
the share market lottery premium.
http://elementsoffinance.net/support/jpm_lottery.pdf
This
article with then Ph.D. Finance student coauthor Quan Wen at the University of Alabama
shows that 1-in-4 of extreme positive stock returns occur for stocks priced
under $7 a share whereas 1-in-20 occur for medium and higher priced stocks.
Expectations are that rates of returns distribute independently of any specific
share price level. Those investors seeking extreme returns behaviorally respond
to a low stock price by perceiving a chance to own the winning ticket, however
remote, and willingly accept lower than average outcomes. The lottery premium
is larger in up markets than down markets and has become more costly as decades
roll on.
9. In this study, inspired and coauthored with
the then Head of the UA School of Accountancy, Prof Robert Ingram, we replicate
the Fama-French research relating the cross-section of stock returns to firm
size, beta, and total risk. Fama-French find that size relates positively with
average returns, and beta doesn’t, a result we replicate. Extending the
analysis, however, finds that as the extreme 2% of stock returns are censored
with trimmed least squares that the explanatory power of firm size persists
only in flat to falling markets. Systematic risk relates positively in
up-markets and negatively in down-markets, an outcome consistent with the
Sharpe-Lintner-Black capital asset pricing model for beta. We also find that
average returns relate negatively with total risk. The reduction in average
return associated with an increase in total risk presumably reflects the
tradeoff that investors willingly sacrifice for a chance at an extreme albeit
unlikely return.
http://elementsoffinance.net/support/jfr_risk_return.pdf
The
43 associate editors at Journal of Financial Research selected this
article as the Best of the Year and kindly sent us two a $5,000 prize to share.
10. Nearly all studies on fixed asset capital stocks
employ a user cost derived under assumptions inconsistent with the assumptions
used to derive their capital stock estimates. This study examines the
significance of this inconsistency and, more importantly, presents the
intrinsic value model that eliminates it. “Using the User
Cost” appears in
the Journal of Economics and Business [1986c]. The
study presents the model with continuous time math (calculus). Most my other writings
are, like all moments of time, discrete period math.
http://elementsoffinance.net/support/jecb_user_cost.pdf
The user cost accounts for phenomena besides the
financial cost of money such as physical depreciation in productive capacity
and the effects of inflation and taxation. The user cost of capital is akin to
the gross profit margin ratio of financial accounting with a numerator of
EBITDA (earnings before interest, taxes, and depreciation or amortization
charges). Synonyms for “user cost of
capital” include the rental price, shadow price, or time cost of capital. This
study refers to the product of the user cost times the quantity of real capital
as “the NOIs” (net operating income, a synonym for EBITDA).
John Keynes
writes in The
General Theory of Employment, Interest, and Money [1936a] that “the user cost
constitutes a link between the present and future.” Finance is all about time as
often it’s heard that time is money for the many that put their mind on their
money and their money on their mind!
11. This study is one of just a handful in the
literature that model the economic value of nonfinancial corporate assets to
establish that the well-known Tobin’s Q-ratio (= market cap to current
replacement cost) may systematically and routinely deviate from unity due to
differences in the timing of expected after-tax cash flows. Still, empirical evidence shows little
incremental explanatory power from using tax-adjusted Q-ratios instead of
standard unadjusted Q-ratios.
http://elementsoffinance.net/support/jpub_tax_bias.pdf
12. Learn that the ex ante rate of return required to induce investment
generally equals the risk free rate of return plus a
risk premium whereas the expected rate of return depends on information and information
alone. The expected value of future flows sustains the expected rate of return
in a model of capitalized economic value described centuries ago, never
abandoned, made stronger ever since.
http://elementsoffinance.net/support/average_period_user_cost_and_term_structure.pdf
.
13. Learn that the shape of the intrinsic yield curve
depends on the degree of risk-sharing and risk-aversion between creditors and
shareholders.
http://elementsoffinance.net/support/neoclassical_term_structure.pdf
This
paper introduces diversification benefits from investment as a source of wealth
for the risk premium that sustains the growth of financial markets.
14. This study in The Financial Review [1986d], “The User
Cost and Capital Budgeting”, expounds on the
generalization of cash flow stream shapes from the perspective of the zero net
present value rule for determining the feasible investment set.
http://elementsoffinance.net/support/tfr_capital_budgeting.pdf
15. Learn that the demand price for real capital
embodies expected returns based upon economic information about discounted cash
flows.
http://elementsoffinance.net/support/producer_theory_of_value_and_equilibrium_stock_returns.pdf
When
properly discounted expected cash flows provide an intrinsic value measurement
then market competition assures that required risk premia measurements from the
consumer theory of value vibrate randomly and unpredictably around the
information-based expected returns (Bachelier 1893, 1906 and Paul Samuelson
1965). Burton Malkiel (Princeton U) writes wrongly in A Random Walk Down
Wall Street (1968) that risk and risk alone determines the level of
equilibrium rates of return. Correction:
Risk and risk alone determine the required risk premium added to the risk-free
rate, a societal rate with concrete components independent of preferences. Risk
determines only the required rate of return and not its dual, the expected rate
of return. Information and information alone determines
expected rates of return. With well functioning
markets and wise public policy, competitive rates of returns vibrate randomly
around an idiosyncratic, asset specific intrinsic value.
16.
This study incorporates debt maturity structure into intrinsic value by
focusing on the zero net present value equilibrium condition in the market for
real assets. Market equilibria implies that the net
present value of the marginal investment is independent of the financing method
therefore user costs for alternative debt contracts equilibrate. The user cost
specification therefore implies a determinate relationship between interest
rates on alternative debt contracts.
http://elementsoffinance.net/support/embodied_equity_theory_of_term_structure.pdf
Analysis
of the user cost specification reveals that the equilibrium interest rate is an
increasing function of the debt contract's loan-to-value ratio and debt
duration (its elasticity , average period). The basic
reason why the interest rate increases with average period is this: the equity
financing rate exceeds the interest rate, a
lengthening debt average period reduces to equity the discounted cost of debt
and the financing rate increases to re-establish equilibrium. The “embodied equity”
hypothesis advanced herein joins the expectations hypothesis, the liquidity
preference hypothesis, and the market segmentation hypothesis as fundamental
explanations for the normal upward slope on the yield curve.
17. This study analyzes a specification for the
user cost of capital that reveals fundamental implications for interpretation
and measurement of marginal effective income tax rates.
http://elementsoffinance.net/support/marginal_effective_tax_rates.pdf
A
novel and surprising finding is that the marginal effective income tax rate is
invariant to asset characteristics such as service life and capacity
depreciation through equilibration by the user cost of capital that maintains a
zero net present value for marginal investments. Maybe the findings echo Paul Samuelson (1963)
regarding the invariance of asset intrinsic value to the marginal income tax
rate.
18. This paper, coauthored with then
Ph.D. student Cűneyt Demirgűreş,
examines country funds trading on the NYSE or AMEX comprised of common stocks
trading on foreign exchanges. We find
high positive correlation among premiums for country funds and conclude a "foreign-fund
investor sentiment" is systematic to all country funds. Premiums and domestic market indexes
correlate positively for funds investing in developed-economies (which largely concentrate
in the hands of individual investors) and negatively for funds investing in
developing-economies (which primarily are held by institutions). Returns on country funds and domestic indexes
correlate positive irrespective of ownership structure. These results suggest that foreign and
domestic investors use different information in setting asset prices thus
giving support to the investor sentiment hypothesis.
http://elementsoffinance.net/support/investor_sentiment_closed_end_country_funds.pdf
19.
Another nonclassical study that endogenizes debt maturity into the
intrinsic value of a hypothetical balance sheet shows different recognizable
formulations therein for the financial cost of capital.
http://elementsoffinance.net/support/debt_maturity_and_cost_of_capital.pdf
20. The important issue of government tax shields
squeezing out private investment is significant.
http://elementsoffinance.net/support/tfr_tax_shields.pdf
21. My doctoral dissertation from Purdue
University approved December 1982, “The Effects of Inflation and Taxation on
the Value of Capital” is item=8310819 at ProQuest. Therein the differential effect
of LIFO versus FIFO inventory accounting method on intrinsic value is specified
and accounted for though no later manuscripts utilize that particular reality
check! The Full Committee includes Prof Patric Hendershott (Head), eventual
Minister without Portfolio for the Republic of China (Taiwan) Prof Hu Sheng
Cheng, Prof Gary Schlarbaum, and Prof James Moore.
The
Effects of Inflation and Taxation on the Value of Capital
References and Additional Readings
[1989a] Cutler, David M.,
James M. Poterba, and Lawrence H. Summers. “What Moves Stock Prices?” Journal
of Portfolio Management, 1989, vol 15 (3), pp 4-12.
[1987a] Downs, Thomas W and Patric H.
Hendershott; “Tax Policy and
Stock Prices”;
National Tax Journal vol 40 (2), June 1987, pp 183-190.
[1986a] Downs, Thomas W;
Text of the presentation read by me that introduces the intrinsic value model
at the NBER Summer Research Institute, Cambridge MA; 2026.0731
[1986b] Downs, Thomas W and
Hendershott, Patric H; NBER Working Paper #2094 is the presentation paper with
few exceptions.
[1986c] Downs, Thomas W; “Using the User Cost”; Journal of Economics and Business vol 38, pp 297-305; Fall 1986.
[1986d] Downs, Thomas W, “The User Cost
and Capital Budgeting”; The
Financial Review, vol 21 (2), May 1986, pp 277-287.
Downs,
T. and Tehranian, H., "The Differential Impacts of Tax Policy Changes on
Industry Stock Prices," Boston College SOM Working Paper 86-90 (October
1986).
bcwp86-10-19860115.pdf
bcwp84-35-19840915.pdf
[1981a]
Summers, L.H., "Taxation and Corporate Investment: A Q-Theory
Approach,"
Brookings
Papers on Economic Activity
(1981:1) , pp 67-127.
[1979a]
Summers, L.H. and Martin Feldstein; "Inflation and the Taxation of Capital
Income in the Corporate Sector," NBER Working Paper 312 (1979)
[1936a] Keynes, J. M. (1936). The
General Theory of Employment, Interest and Money. London: Macmillan (1936).
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