Volume 35 CONTENTS Fall 2009
H. Kent Baker, Prakesh Deo and TarunMukherjee
Much debate exists about the effectiveness of Economic Value Added (EVA). We evaluate 11 common concerns about EVA and conclude that the major concerns are that EVA (1) is distorted by the depreciation method, (2) might require complex adjustments; (3) is a short-term measure; (4) is an absolute measure; and (5) has a low correlation with the stock price. Proponents argue that some concerns would be eliminated by focusing on Market Value Added (MVA). Yet, there is no clear evidence to indicate that MVA is strongly correlated to either EVA or the stock price. If MVA is equal to EVA as some researchers suggest, EVA may not be a new paradigm for measuring financial performance. For those companies that adopt EVA despite its limitations, we offer several recommendations for using EVA more effectively.
Error in MIRR Estimate Using the Texas Instrument BAII Plus Professional
The Texas Instruments® BAII Plus Professional calculator yields two inconsistent MIRR estimates for unconventional cash flows depending on the sequence of its estimate. If NPV has been estimated first, then the MIRR estimate is correct. However, if the NPV has not been estimated first, the MIRR output from the calculator is erroneous and inconsistent with its correct estimate. Since the BAII Plus Professional is widely adopted by many instructors and students alike, and since the nature of the problem is partially camouflaged if the NPV had been estimated first before the MIRR estimate, it seems aptly to disclose the problem to the finance educators’ community.
Do Clickers 'Click' in the Finance Classroom
Kam C. Chan and Jean C. Snavely
A relatively recent innovation in interactive classroom hardware is student response systems or clickers. Clickers are wireless response keypads that allow students to spontaneously reveal personal answer choices to objective problem sets in the classroom. The keypads transmit individual student responses via radio frequency to the response system’s computer-interfaced receiver. The system software then processes, records, reports, and instantly graphically displays the percentage input for each answer. Individual responses are available through saved clicker reports and are not displayed to the class allowing anonymity for individual students. Clickers, in principal, may be beneficial to students because students are able to quickly and effectively interact in the classroom and to be engaged in the learning process. In addition, clickers should benefit instructors by providing timely feedback on material covered in clicker exercises. Instructors can then adjust classroom coverage with the objective of improved student performance.
Free Cash Flow, the Cash Flow Identity, and the Accounting Statement of Cash Flows
J. William Petty and John T. Rose
This study highlights the relationship between the two major tools of cash flow analysis, namely, free cash flow within the cash flow identity and the accounting statement of cash flows. After reviewing current textbook pedagogy for introducing the concept of a firm’s cash flow, we derive the accounting statement of cash flows from the cash flow identity (in which a firm’s free cash flow equals its cash flow to investors). Using a numeric example, we also compare the information generated by the two analytical tools, noting both the difference in focus between the tools as well as the differences in construction. Finally, we encourage textbook authors to give greater attention to the linkage between free cash flow within the cash flow identity and the accounting statement of cash flows, as well as the importance of free cash flow for financial management.
Portfolios and Regressions
This study examines the relationship between portfolios and regressions, which is desirable for educational, mathematical, and theoretical reasons. Educationally, understanding this relationship simplifies the teaching and learning of both procedures. Mathematically, portfolio optimization and regression systems are abstractly, algebraically, topologically, and structurally equivalent. One is obtained from the other as if modeling clay, without tears or discontinuities, and what one learns in one system can be applied to the other. We show portfolios and regressions are equivalent at a theoretical level as well. In the economic-financial context, this theoretical equivalence means that mean-variance, efficient portfolios are in fact optimal predictors, which is necessary for arbitrage-based investment valuation and for the study of arbitrage-based market adjustment. We use linear algebra and study the characteristics of Lagrange methods to make our point. We also provide specialized procedures to facilitate portfolio optimizations.
A Cross-Disciplinary Approach to Teaching Financial Analysis and Corporate Global Diversification Strategy
Kevin Wynne, Ellen Weisbord and Douglas Leary
This paper contributes to the academic literature by outlining an innovative approach to teaching global diversification strategy within a financial analysis framework. The majority of the information in this article can be replicated for use in an academic environment. The project described combines financial analysis, management strategy, database applications, and practical business applications. Close proximity to Wall Street, access to senior level executives, and streaming media technology all contribute to program success.
Kartono Liano and Alexandre Sanchini
This paper introduces a new performance measure by adjusting the return of a portfolio to match the return of the market portfolio. The risk is recalculated and is called the return-adjusted risk, RAR. The RAR is compared to the risk of the market portfolio. Since the portfolio has the same return as the market, the portfolio has outperformed (underperformed) the market if the RAR of the portfolio is lower (higher) than the risk of the market. The RAR is easy to calculate and the interpretation is straight forward. Consequently, the return-adjusted risk is a simple alternative to the traditional performance measures.
Anatomy of an Unusual Merger: ABE (2006)
Chun-Keung Hoi, Ashok Robin and Daniel Tessoni
Firm values tend to be related to the pattern of ownership, reflected Ashwin Rao, an analyst with a large investment bank. In his MBA days, Ashwin, or Ash as he was known to his colleagues, had come across academic studies showing an inverted-U relationship between the ownership of insiders and firm value. [See for example Morck, Shleifer and Vishny, 1988.] A certain degree of ownership aligned insiders’ interests with external shareholder interests, but too much ownership tended to make the same insiders entrenched and potentially at odds with external shareholders. Like most academic works, these results were based on statistical tests on large samples of firms, so they may not be reflective of the firm he was interested in, World Fabric Corporation (WFC).
Financial Management Decision-Making at a Community Bank: A Case Study
John S. Walker and Henry F. Check, Jr.
The effective use of financial leverage is fundamental to sound financial management, and no industry exemplifies leverage’s importance more than banking. Commercial banks typically have returns on assets (ROA) in the range of one to two percent and sometimes less, and they use equity multipliers of five to 20 times to leverage that modest return into returns on equity (ROE) of around 15 percent. But suppose a bank is over-leveraged or under-leveraged? How does that affect the stockholders’ rate of return? What can a bank do to adjust its leverage position? This case study examines two banks with leverage positions that are polar extremes. The effect on the banks’ fundamentals is examined and corrective measures are proposed.
Hedonic Price Estimation for Residential Property: Gulf Coast Properties, Inc.
Jeffrey R. Donaldson and Speros Margetis
This case offers the opportunity to discuss multivariate regression analysis used in developing pricing models in the real estate market. Several issues in multivariate regression arise when applied to assets such as real estate. The following exercise includes the application of a hedonic regression model and consequences of multicollinearity and heteroscedasticity in the model. Factors that are important in determining the value of a house are analyzed to determine the appropriate valuation model.