elements Of Finance.netÓ
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Writings by prof-td@elementsOfFinance.net
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1.4: http://elementsoffinance.net/palette.pdf
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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 and
eventually a doctorate, should circumstances permit.
None before known to me in family
lineage had gone to college though I know relatively little of maternal or
paternal grandparents. Like astronauts and Presidents, 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. 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 that I can “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
and August 1982 we headed to Boston to sign a mortgage on our chosen
house at a rate 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 with a presentation by me discussing 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 Hendershott, Head of my
dissertation Committee at Purdue University (1978-82; other Committee members:
Profs Gary Schlarbaum, James Moore, and Sheng Cheng Hu). This study introduces a
model 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
Forty years ago a
version of the study was presented by me [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
labels the “fundamental value of capital” for the same “intrinsic value” object
that my current writing uses.
2. 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!
3. This study tests whether actual stock prices map
to 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 Tuscaloosa at the Department
of Economics, Finance, & Legal Studies.
4. 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, 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.
http://elementsoffinance.net/support/jpm_asset_valuation.pdf
This invited presentation (1991.1017) 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).
5. 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.
6. 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
.
7. 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.
8. 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
9. 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.
10.
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.
11.
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.
12. 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.
13. 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.
14.
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
15.
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
16.
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.
17.
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
18. 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
19.
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
[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.
[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," Bostonn College SOM
Working Paper 86-90 (October 1986).
bcwp86-10-19860115.pdf
bcwp84-35-19840915.pdf
[1987a] Downs, Thomas W and Patric H.
Hendershott; “Tax Policy and
Stock Prices”;
National Tax Journal vol 40 (2), June 1987, pp 183-190.
[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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