elements Of Finance.netÓ
Shareable Resources for Teaching
& Learning
for Arts & Sciences, Technology, Engineering, Mathematics, and
Financial Economics (aSTEMfe)
Writings by prof-td@elementsOfFinance.net
The elements Of Finance book: http://elementsoffinance.net/elements.pdf
Preview of active project: http://elementsoffinance.net/palette.pdf
1. This study “Tax Policy and
Stock Prices” is
co-authored with Dr Patric Hendershott, Head of my dissertation Committee at
Purdue University (1978-82; other Committee members: Profs Gary Schlarbaum,
James Moore, and (Minister) Hu Sheng Cheng). This study introduces the
intrinsic value model in order to measure the effects from tax law changes nonfinancial
corporate fixed capital stocks in the USA.
http://elementsoffinance.net/support/ntj_tax_policy.pdf
An
early draft of the study was presented by me [1986a Presentation
to the NBER ] at
the National Bureau of Economic Summer Institute Research Series. Distinguished
profs seated around the table included moderator David Bradford (Princeton U),
Martin Feldstein (Harvard U), Mervyn King (London School of Economics),
Jonathan Leape (also LSE), Alan Auerbach (HarvardU),
Pat Hendershott (Ohio State U), a few others, each holding a study similar to
the NBER working paper [1986b NBER
WP #2094 ] that
went public 2 months later. Room discussion by Prof Leape
clarified that the risk premia for tax shields vary and that the cash flows to
equity capitalize at the residual equity financing rate. Prof Feldstein saw the
gap between intrinsic value and current replacement cost as problematic. he
asked for me to meet later with capital stock specialist Charles Hulten (UMaryland) for discussion. Finishing and exiting to the
hallway revealed the next presenters were Lawrence Summers (Harvard U) and
David Cutler (MIT). That gave opportunity for me to offer thanks for the
fantastic discussions on economic income in Feldstein and Summers (1979) that
for me was pivotal developing my dissertation proposal, opportunity to confess
confusion seeing those trajectories in those Q-trajectories (Brookings Papers
on Economic Activity).
Three 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 BC office, I hear “Hello, this is Fischer Black,”
then a Goldman-Sachs VP and forevermore the MIT prof that laid a firm foundation
for standardized option markets. The 45-minute 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 (also at Massachusetts Institute of Technology)
at the National Tax Journal. The text labels the “intrinsic value”
object as the “fundamental value of capital.”
2.
This study “Using the User
Cost” appears in
the Journal of Economics and Business [1986b]. This is my only writing with continuous time
math (calculus).
http://elementsoffinance.net/support/jecb_user_cost.pdf
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. 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 or 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, 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!
1. Read how 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.
2. 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
.
3. 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.
4. See
that a complex modeling and measuring of the intrinsic value for a balance
sheet enables mapping intrinsic value to public policy in general and to tax
policy in particular.
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 comparing the excess
stock return numbers from his FORTRAN program with my predicted changes of
intrinsic value for 3 industries selected a priori while stating “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 Tuscaloosa at the Department of Economics, Finance, & Legal Studies.
6.
Three financial accounting methods for valuing 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.
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. I presented
our findings at the University of Chicago Graduate School of Business annual
conference hosted by the Institute for Professional Accounting. Actual used
corporate fixed asset prices track intrinsic valuations better than historical
cost or current cost measurements. A happy learning moment 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 occurred when
audience member Richard Leftwich (UChicago) requested from me 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 event horizon. The
answer forms the overlapping equatorial meridian between (a) consumer theory of
utility specifications by Chipman and Moore (1983) that in the absence of
polymorphic household wants and needs, domestic tranquility 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, domestic tranquility figures none to nil in Gross
National Product measurements.
7.
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.
8. 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.
9. This 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, dubbed the overvalue ratio in the
study, 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 overvalued industry (or company) and bigger for an undervalued
company irrespective of risk factors or preferences.
http://elementsoffinance.net/support/jpm_asset_valuation.pdf
This invited presentation (2017.1017) of an article
from the Journal of Portfolio Management (Editor Frank Fabozzi) at the
Institutional Investor Institute Quantitative Research Roundtable, a 1-day
annual gathering of securities market specialists. During the 75 minute opening session at 8:30am Dr. Martin Leibowitz,
then at TIAA-CREF, presented “Asset allocation under shortfall constraints.”
grateful 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 cognition. Two profs presented to the
attendees, say 400 diverse workers in finance, already seated for lunch in this
1-day program at the then famous Helmsley Hotel. Prof Ken French (Dartmouth)
was the keynote speaker presenting the Fama-French (1991) seminal work on
Book-to-Market ratios and multi-factor risk models. Then I spoke and sat back down
for lunch beside In a brief back-stage chat after
lunch before attendees went to break-out sessions and speakers skedaddled i conjectured to Ken 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).
10.
This unpublished paper 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.
11. This study, inspired and coauthored
with the then Head of the UA School of Accountancy Robert Ingram replicates 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.
12.
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
13.
This unpublished 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
14.
Learn how market capitalizations for public utility industries relate to
measurements of underlying asset values.
Current replacement cost measurements (CC) of those assets contain
specifiable biases of economic value that depend on capital accumulation
histories, capacity depreciation schedules, tax depreciation schedules, and
cost of capital components. An intrinsic
value model provides estimates that show the bias contains incremental
information beyond that inherent with the CC measurements.
http://elementsoffinance.net/support/ntj_utility_valuation.pdf
This
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
annual Distinguished Award in Applied Research.
15.
Another unpublished 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
16.
My first publication in a journal that has “Finance” in the journal
title is pedagogic, maybe useful for teachers or students alike.
http://elementsoffinance.net/support/tfr_capital_budgeting.pdf
17.
The study below extends the sample from item #4 in this list, the AER
paper on stock prices and tax policy changes tracking intrinsic value, to 10 industries
(2-digit SIC code) rather than the 3 industries (2-digit SIC code) 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 showed quite a bit of
noise in the conclusions which was little disheartening, for sure.
http://elementsoffinance.net/support/tfr_tax_reform.pdf
18.
The important issue of government tax shields squeezing out private
investment is significant.
http://elementsoffinance.net/support/tfr_tax_shields.pdf
20. 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! Committee members included 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
[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.
[1987a] Downs, Thomas W
and Hendershott, Patric H; “Tax Policy and
Stock Prices”; National
Tax Journal vol 40(2), pp 183-190; June 1987.
[1936a] Keynes, J. M. (1936). The
General Theory of Employment, Interest and Money. London: Macmillan (1936).
21.
http://elementsoffinance.net/AlgorithmicDocumentGenerator.pdf
The free add-in below for Microsoft Excel can create a new
algorithmic document in MS Word
useful for nearly any topic or purpose.
Package personalized learning content into algorithmic setups
embodying random redraws of worksheet cells.
Cells might contain a number, word, or an alphanumeric phrase/sentence/paragraph
made from other cells! Endless options
to uniquely redraw algorithmic scenario setups give teachers and students alike
lots of choices.
Click http://elementsoffinance.net/Algogen.xla to download the add-in for Excel.
Better yet, first peruse this documentation below then download the
add-in! http://elementsoffinance.net/AlgorithmicDocumentGenerator.pdf
Installation Instruction #3 in the above pdf describes how to activate two Excel add-ins
– the free Algogen add-in above and the Analysis Tool-Pak add-in from Microsoft. Completing that step (only) empowers Word
& Excel with Algogen wizards that help package your content into
algorithmic scenario setups, a potentially high return on invested time that
enhances teaching and learning effectiveness and efficiency. Find examples, hints, and more in the
documentation. For example, the first
pages present an analysis of student learning outcomes with multiple attempt
algorithmic online quizzes, multiple attempt algorithmic paper exams submitted
in class and/or online. The sample
includes thousands of students with varied teachers and course formats
(traditional, hybrid & online registrants).
All students populated one common undergraduate core course learning
community. All were challenged by the
same set of algorithmic assessments.
All software
resources listed herein are authored by prof-td@elementsOfFinance.net
and are available “as-is” subject to terms in the End User License agreement (EULA).
No liability nor benefit accrues to prof-td or elementsOfFinance.net
LLC by your use of these resources.
No harm is intended, either.
Hopefully you find unbelievably huge reductions in exam preparation time – for me the 18 hours per exam dropped down to
2 hours, a savings that accrued 4 times a semester (more than a complete
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data, and makes a Standings page showing all student scores, publicly viewable
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everyone else, anonymously. With a
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25-question exam with 4 unique versions ready for duplication onto paper for
classroom use. The procedure also
transfers the 25 answers for the 4 exam versions into the gradebook.xlsx ready
for the eventual Algogen click that processes
the scantron data, no matter how large or small the class. One semester more than 1,200 students
populated one common core course learning community with prof-td.
Not
every teacher wants to make easy tests
but
every teacher wants to easily make tests.
Get the free Algogen
app that allows you to select finance scenario setups from documents in an
algorithmic content collection and make countless new versions for purposes
like quizzes, exams, assignments, presentation examples, or for making
algorithmic online practice scenarios or assessments, at http://elementsOfFinance.net/Algogen.zip
Documentation provides installation instructions and
more: http://elementsoffinance.net/AlgorithmicDocumentGenerator.pdf .
Get the free algorithmic content collection written
for the elements Of Finance book at http://elementsoffinance.net/elements.zip