Applied FDM (Capstone) PDF

Applied FDM (Capstone) Week 1: Risk Overview: 1. Superannuation 2. Risky investments (frontier and emerging economies) 3. Investments by an Insurance Company Reading SUMMARY: Superannuation: The things Millennials and Gen Z need to watch (AFR) Fees: 1. Low Fees are Crucial: Funds wi...

Applied FDM (Capstone) Week 1: Risk Overview: 1. Superannuation 2. Risky investments (frontier and emerging economies) 3. Investments by an Insurance Company Reading SUMMARY: Superannuation: The things Millennials and Gen Z need to watch (AFR) Fees: 1. Low Fees are Crucial: Funds with fees around 1% are preferable, as high fees (2%) can reduce returns by 27%. - Long-term Impact: Lower fees can save hundreds of thousands of dollars by retirement. - Fee Awareness: Understand different fees (administration, investment management, performance) and monitor annual statements. Asset Allocation: - Growth Assets: Allocate 70-90% to growth assets (shares, property) for higher returns and to handle market volatility. - Fund Strategies: Be aware of how funds manage unlisted assets and ensure balanced exposure to avoid overconcentration in one asset class. - Adjustment by Age: Funds often adjust asset exposure based on age, offering younger members more growth assets. - Monitoring these aspects can significantly improve superannuation outcomes for younger generations.2 Reading SUMMARY: Young workers missing higher super returns by taking the default option (AFR) - Missed Opportunities: Millions of young Australians miss out on higher superannuation returns by sticking to low-risk MySuper accounts. - Innova Analysis: More than 5.2 million young Australians are affected, potentially losing hundreds of thousands of dollars over the long term. - Performance Data: All-equities portfolios significantly outperform typical MySuper balanced funds.  - Risk Tolerance: Younger Australians can afford to take on more risk due to a longer investment horizon, allowing recovery from market dips. Productivity Commission: Investing in underperforming MySuper products can result in being 36% worse off by retirement. - Asset Allocation: MySuper typically has a 70:30 growth-defensive split; higher-growth options like equities may yield better returns. - Property vs. Equities: Younger investors might benefit more from equities due to high property costs. - Financial Advice: Younger Australians would benefit from affordable and scalable financial advice to optimize superannuation investments. - Comparison Tools: Use tools like the ATO’s YourSuper comparison tool to evaluate and improve super fund performance. 1. SUPERANNUATION - 1992: the Australian government introduced compulsory superannuation - The initial contribution rate was 3% - Today is 10.5% - Super guarantee Superannuation fund: types and average returns. Sharpe ratio: - If the standard deviation of a stock declines, then the sharpe ratio will decrease.  - Any sharpe ratio above 1 is GOOD Information needed for superannuation: How to make a decision! ★ Time horizon: ★ Risk tolerance: a person may be risk-loving or very risk-intolerant, this could influence comfort level with different types of funds. ★ Dependent and/or spouse Example: Information on Client. Assume a female is 30 and wants to retire when she is 65. - Her income = $80k, assume super guarantee is 11.5% for 35 years. - Assume taxes are 15% when contribution is made. How much will she have under the scheme 2. RISKY INVESTMENTS Least developed countries (LDCs) 1. Poverty 2. Human resource weakness – nutrition, education, health 3. Economic vulnerability – agricultural instability, unstable export production Frontier vs Emerging economies. What are some examples? Frontier: Frontier markets are less advanced economies in the developing world. They are less established than emerging markets. Many frontier markets do not have developed stock markets, and while they are smaller, less accessible, and riskier than emerging markets, they are still considered viable investments. Examples are Jordan, Kenya, and Kazakhstan, Vietnam - One or more characteristic could be: politically manipulated market, weak legal system and low per capita income/poor GDP Emerging: These countries do not currently have the economic strength of countries like the U.S. or Japan but are in the process of becoming developed economy. Some examples of emerging market economies are India, Mexico, Russia, Pakistan, and Saudi Arabia. - In the process of becoming developed, more expensive base for operations Example: You’re working with a team, the emerging and frontier investment team, which is part of a very large pension fund. You have just received an increased allocation fund that you need to deploy. You have to look at investments in new countries. What are the benefits and risks of investing in companies in these economies? Emerging: Diversified portfolio, high economic growth, rising middle class (opportunity for growth) Frontier: Exponential growth economies, high risk, early entry advantage, untapped market, improving infrastructure Benefits overall: cheap, low valuations Risks overall: highly volatile, illiquid, lack of transparency, currency fluctuations, High potential rewards - Ethics - Sustainability - Long term commitment Example from 1980’s aluminum manufacturing in Venezuela - Cheap power made it possible to manufacturer at low cost - The country was willing to undertake joint ventures with foreign companies to build smelters - Many foreign investments have been expropriated with investors losing everything Research and Discuss whether you would invest in the following 3 companies. Lithium Mining Corporation, Bolivia. Investment 2: 20% of world's lithium reserves Benefits: highly sought after commodity, demand for electric vehicles Risks: supplies are isolated and hard to extract, advancements in technologies, government wants to add value, not just extract and sale, 2019 canceled joint venture with a german company. 3. INSURANCE SCENARIO - You are the risk mitigation officer at a life insurance company. - The analytics department has proposed changes to premiums and a complete hiatus on new life insurance offerings for males in one postcode. - Analytics has identified males of one ethnic background as being predominant in that postcode with a higher likelihood of all-cause mortality. - They propose eliminating life insurance offerings for all males in that postcode. YOUR TASK 1. Identify and evaluate the risks of this proposal. 2. Make a recommendation. Proposal to Insurance Board Risk Committee Part B) Negative Interest rates: Cash deposits at banks incur a charge for money to be safely held in the bank - Typically, during a deflationary period Usually negative at a central bank, designed May weaken currency and assist a country’s economy with cheaper goods for export May encourage investment since it is a cheap source of financing to encourage banks to lend money more easily so not held at the bank Which countries have experienced negative interest rates? - How did the cheap cost of borrowing affect the quality of investments? - What is the current interest rate environment? Proposal to insurance Board risk Committee Scenario: ★ You are the risk mitigation officer at a life insurance company ★ The analytics department has proposed changes to premiums and a complete hiatus on new life insurance offerings for males in one postcode ★ Analytics has identified males of one background being predominant in that postcode with a higher likelihood of all cause mortality ★ They propose eliminating life insurance offerings RISK: - Ethical issues when propagating ethnic profiling - Perception of discrimination - Fail to include or fail to raise premiums could lose $$ Negative Interest rates.. Is it possible? → in relation to the central bank Interest rate made up of: - Cash rate (RBA central bank rate) - risk free rate - Liquidity premium: - Risk premium Countries that have experienced negative IR: ★ Japan, Sweden, Switzerland, Denmark, Euro Negative IR: ★ Cash deposits at bank may incur a charge for $ to be held safely in the bank ★ During a deflationary period ★ Usually negative at central bank, designed to encourage banks to lend money more easily so not held at the bank ★ Lack of transparency. Winners and losers of negative IR Personal Economy Lower cost of borrowing, cheaper loans Currency depreciates (exports cheaper, imports expensive) No return for investors Stimulate economy Decline in value of real savings Investment desirable Asset prices could rise due to cheaper borrowing Creates instability in the banking industry, savers don’t save Scenario: You are a risk officer at P&C insurance company. Effective asset-liability management requires matching of risk exposure around maturities and duration so that cash flows can be met. During the course of the day, colleagues come to your office with the following questions. 1. How will negative IR affect immunization of cash flows - Immunisation: risk mitigation that matches the duration of assets and liabilities in order to minimise the impact of interest rates on net worth over time. - What we are measuring: Duration around a bond → greater the term, the greater the duration risk. Since duration measures the sensitivity of a bond's price to changes in interest rates, when rates are negative, small changes can have larger proportional effects - Reinvestment risk: When interest rates are negative, reinvesting cash flows (coupon payments, maturing bonds) becomes less attractive. 2. Why do our assets backing the liabilities have a shorter duration than the liabilities - In a low or negative interest rate environment, holding shorter-duration assets allows for more frequent reinvestment opportunities. This can be advantageous if interest rates are expected to rise in the future, as it provides the chance to reinvest at higher yields. 3. How can we increase the return on assets when there are negative interest rates - Extend duration to capture higher yields in the long term. - Diversify into Alternative Assets (Credit spread) - International diversification - Increase the risk: Look for investments with a higher risk and return  Week 2: Interest Rates 1. Residential mortgages and bonds (W02 H04) 2. Immunisation (W02 H05) 3. Measuring portfolio returns (W02 H06) 1. Residential Mortgages and Bonds: WHAT FACTORS ARE IMPORTANT TO A LENDER IN A MORTGAGE DECISION? ★ Character: reliability ★ Collateral: 20% deposit for a mortgage ★ credit rating/history ★ income ★ assets ★ work history ★ income/loan ratio ★ amount borrowed ★ type of loan WHAT AFFECTS BOND PRICES? Lecture question: You recently bought a house at an auction where you had a pre-approval for a mortgage in advance that allowed you to borrow 700k at 7.14% variable but are now looking for a better rate. You and your partner have an appointment in 15 mins with a mortgage broker to discuss different options. a) Variable basic 6.49% b) Fixed one year 6.59%  c) Fixed 5 year 6.69% d) Variable with offset and redraw 7.14% e) Fixed 2 year 6.84% Factors that matter 1. Offset account 2. Redraw facility 3. Interest only 4. Interest rate 5. Expectation of what future rates will be 6. Future income 7. Lock in rates. HOUSING MARKET DURING COVID 19: ways it shaped the market 1. Aus home values rose to 25% 2. First homebuyer activity spiked 3. Rent rose 11.8% to record highs 4. Housing debt levels hit record highs 5. Premium of house prices hit record highs 6. Rise of the regions Factors that impact lenders: → income, credit history, borrowing capacity, assets, deposit amount (20%) 2. Immunisation. WHAT IS THE DIFFERENCE BETWEEN IMMUNISATION AND HEDGING?? - Hedging uses financial instruments or strategies to offset the risk of any adverse price movements - Immunisation is to ensure that no changes can occur. Immunisation examples 1. Banks net worth 2. Pension funds have the obligation of payments after a number of years. Two main immunisation strategies: 1. Cash flow matching: zero coupon bond with same maturity 2. Duration matching: assets and liabilities “Risks Facing Today's Bond Investors” Chapter notes. - Asset diversification does not = risk diversification → no assets are completely devoid of risk, even treasury bonds. Lecture Questions: 1. How do the risks affect bond prices? Risks depend on many factors including: 1. Economic climate 2. Financial conditions 3. Types of strategies used to invest Risks to all bonds: - Market or interest rate risk: risk associated with market fluctuations. A risk that interest rates will rise → higher IR = lower priced bonds (inverse relationship) → Affects all investors selling a bond before it’s maturity → price sensitivity to changes in IR (modified duration) increases with maturity length - Reinvestment risk: risk that the bonds cash flows will be reinvested at a falling interest rate → only affects coupon bonds → higher for higher coupon and longer maturity bonds - Event risk: specific to the bond issuer → unexpected events that cause the bond to fall in price. - Liquidity risk: Immunisation and liquidity driven investment. → Inverse relationship between IR risk and reinvestment risk. a) Interest rate risk (price risk) → risk that IR will rise b) Reinvestment risk → risk that IR will fall These two risks offset each other and can be used to build an immunisation portfolio Immunisation an appropriate portfolio strategy when an investor needs to fund a future liability. Example: Employer with a single employee who is to retire in 12 years and to whom they have promised 2.5 mill upon retirement RISKS: you need to have enough money to pay the obligation in 12 years → how much do I have to invest today to have 2.5 mill in 12 years. → cannot invest in bond because it doesn’t exist (no zero coupon bond in the market) Alternatively, build a portfolio of two coupon bonds such that: 1. The PV of the portfolio is exactly = to the PV of obligation today. Obligation: 2.5 mill Duration: 12 years Bond: 20 yrs/30 yrs Both are par bonds (coupon interest and IR are the same) Annual IR of 7% p.a Semi Annual coupon  ★ The present value of the obligation must = portfolio value of the two coupon bonds ★ The duration of the bond portfolio must = the duration of the obligation (liability) 2. How does this impact immunisation? → Bond immunisation is like a shield for bond investors, helping them manage risks. It protects their investment from changes in interest rates that can affect how much their bonds are worth. → Immunization is a risk-mitigation strategy that matches asset and liability duration so portfolio values are protected against interest rate changes. Immunisation can be accomplished by cash flow matching, duration matching, convexity matching, and trading forwards, futures, and options on bonds. Hedging examples: - Currency Swaps: hedge exchange swap - Commodity swaps or futures: farmers can lock the price they will receive. Main difference between futures and swaps - Swaps can be customised - Futures are trading. - Fuel swaps or options: airlines hedging against higher fuel prices Swap is a fixed or variable loan. Option: the right but not the obligation to pay or sell. → Two types: call and put Call: buy (close to b) Put: Sell (close to s) Long vs short Long call: Basic call option, right to buy Short call: obligation to sell.  3. Measuring portfolio returns WHAT RATIOS CAN BE USED TO MEASURE PERFORMANCE? Conventional Methods 1. Benchmark comparison 2. Style comparison Risk adjusted methods 1. Sharpe Ratio: measures the performance of an investment compared to a risk free asset, after adjusting for its risk. 2 is a good ratio, ratio of 3 and above is great (high returns but low levels of risk). → LOW sharpe ratio (1 and below): driven by poor decisions, investor vias, → 0 Sharpe ratio: means that return = rf rate which is NOT good. → how to improve sharpe ratio: → adjusts for the standard deviation 2. Treynor Measure: excess return generated for each 1 unit of risk in that portfolio. → adjusted for systematic risk and uses portfolio beta. → limitations: based on previous performance → 0.5 and 0.25 doesn’t mean 2x as good, doesn’t show the range of the improvement → it just shows which ratio is better than the other. 3. Jensen's Alpha: measures an investment's abnormal or excess returns compared to its estimated returns. → can be positive or negative: negative = worse than expected and positive = better than expected → need to calculate beta, which may need to be an estimate 4. Information Ratio: compared to the benchmark return. → Assessing the skill of the fund manager/ asset team → ability to generate excess returns relative to the benchmark. Issuing portfolio returns: Putting it into action: 1. Underlying stock selection relative to market. Micro cap, ethical companies 2. Past numbers do not indicate the future 3. Requirement to hold a portion $$ in particular asset class 4. Mandate and company insight.  Week 3: Buy vs Rent and Structural Changes 1. Individual Buy vs Rent Decision 2. Buy vs Lease an Asset 3. Real Options 1. Individual Buy vs Rent Decision What factors affect the buy versus rent decision? - Financial considerations: set up costs, interest rates, stamp duty, ongoing costs - How much does it cost rent vs buying - Security of tenure: is it big enough, and long term? Buy Rent Pros ★ Stability ★ Free up savings ★ Value Increase ★ Flexibility ★ Using equity ★ Diversification Cons ★ Interest payments ★ May be more expensive in the long ★ Opportunity costs run ★ Ownership costs: ★ No forced savings maintenance, rates, taxes, insurance eetc Consider whether it is better to rent an apartment versus buying?’ FOUR KEY BEHAVIOURAL BIAS: 1. SELF DECEPTION: don’t see flaws, underestimate mistakes, ignore any key info that is coming out: e.g spending during a time of high inflation → limit what you know and want to learn. 2. HEURISTIC SIMPLIFICATION: rule of thumb, mental shortcut, immediate, automated rules e.g ‘housing prices will come back up’ 3. SOCIAL INFLUENCE: external influences e.g peers, family, work colleagues leading to poor influences 4. EMOTION: stability, security and status: being ‘like everyone else’ can lead to making a poor financial decision! Others include ‘present day bias’: Spending today rather than delaying. Behavioural biases and the ‘BUY VS RENT’ decision. 1. Overconfidence: is a tendency to hold a false and misleading assessment of our skills, intellect and/or talent → Most common is in less experienced investors, assumption that we know more insight to the investment than anyone else, leading to a ‘confident’ decision that is wrong. → effect: individuals who recently sold their property for a large profit compared with the purchase price, and likely to overpay for their next property 2. Anchoring: tendency to rely on initial information to ‘anchor’ subsequent judgments and interpretations → set the starting price point in a negotiation (recent transactions, historical price increases, prices in your local market) → fix: acknowledge it, access independent research resources. 3. Framing effect: our choices are influenced by the way they are framed through wording, settings and situations → effect: focusing on what the seller wants to show → fix: ignore glamorous descriptions Example: 4. Loss aversion: for individuals the pain of losing in psychologically twice as powerful as the pleasure of gaining → effect: reluctance to realise losses → fix: review with independent sources, think of things as total net worth Two types of decisions 1. 98% of decision making: fast thinking, unconscious, intuition, process info quickly, large capacity 2. 2% of decisions: require a lot of attention and effort, complex analysis. 2. Buy vs Lease an Asset LEASING: - Leasing in a financing decision, can be done either short or long term - lessee - use of equipment - Lessor - owner - Operating lease is usually short term and can be cancellable → appears on the balance sheet, - Finance lease is typically long term and non-cancellable. Term is for a period which is the major part of the life of the asset How the leases standard impacts company balance sheets | EY - Australia NOTES from article: ★ IFRS 16 Impact: The IFRS 16 standard requires most leases to be recognized on balance sheets, affecting companies in sectors like air travel, retail, and transport, leading to an average 14% increase in total assets. ★ Transparency: Enhanced transparency and comparability in financial statements by reducing off-balance-sheet leases. ★ Management Commentary: Affected companies provided detailed disclosures and adjusted performance measures like EBITDA. ★ Debt Reclassification: Lease liabilities are now included in net debt, affecting debt reporting. Accounting rules changed in 2019 - AASB16 Leases - Previously operating leases were not required to be capitalised - Lease versus buy decisions therefore had very different balance sheet implications - This could affect investors perception of the company - Today the balance sheet appearance is the same regardless of buying versus leasing - The main difference between leasing and buying is no longer the financial statement presentation but the tax effect. If the leasing is cheaper then it may be offset by tax savings from expedited depreciation when you purchase - Depreciation is included in the income statement - Previously: EBITA is lower, Who uses financial ratios? - Investors and analysts - Management - Creditors - Debt holders - Employees - Rating agencies, regulators ^^ the change in Accounting rules completely changes the ratios. What ratios that are affected when you buy/rent an asset. ★ 1st, what accounts are affected? Asset value goes up, debt levels go up, deferred tax may be affected ★ ROE ★ Debt/Equity ★ Debt/EBITDA, EBITDA/interest ★ Taxes payable/deferred taxes EXAMPLE: Should you lease or buy an aircraft?? You are managing the fleet of aircraft at Norwegian Airlines. You have the option to buy: - 5 new Boeing 737-800 aircraft – cost $106 million each and expected to last 30 years. - If you were to lease the same aircraft, it would be half the cost over the 10 years. What should you be concerned about in deciding whether to lease or buy? - What is the aircraft value of the 10 years vs 30 yrs - Depreciation and tax effects - On cost, changes in the price - Flexibility - Impact on cash flow - Tax implications - New technology that reduces the cost of flying - Availability of aircraft - leading vs waiting to buy - Environmental concerns How common is leasing in the airline industry? - What types of leases are there? Dry leasing: the lease of an aircraft without any crewmembers. Wet leasing: one airline (the lessor) provides an aircraft, complete crew, maintenance, and insurance (ACMI) to another airline or other type of business acting as a broker of air travel (the lessee), which pays by hours operated. Damp leasing: is defined as a wet-leased aircraft that includes a cockpit crew but not cabin attendants. THE IMPACT COVID HAD ON AIRCRAFTS: - Airlines - Crew - Leasing companies - Aircraft manufacturers - Engine makers - Cargo - Government support Changes in the industry post covid: - Airlines making record revenues, modest profits. - Cost of decarbonisation - ‘Revenge’ travel - Business travel - ‘Bleisure; - Demand growth differing by regions - Threats to aviation safety - Aircraft shortages ADVANTAGES of leasing ADVANTAGE of buying - Cash retentions - Buying direct results in lower cost per - Greater agility (seasonal changes, exploit aircraft gap in the market - No regular lease payment - Allows to expand without huge capital - Can use aircraft expenditure - Reduction in uncertainty 3. Real options Oil Field Expansion An oil company in Canada has to decide on investing in a new oil field in Alberta that has about 2 billion barrels. The initial investment required would be $150 million. If the costs of production are US$50 per barrel (variable cost) and the current oil price per barrel (West Texas Crude Oil) is $58 per barrel, should the investment go forward? → How would you use a real options framework to answer the question? How do you use real options to value? ★ Value of the oil field is a function of the price of oil minus production costs ★ Price of oil is highly volatile and not easy to predict ★ Make assumptions on the distribution of the price ★ Use past price to estimate future price What factors will change the price of oil? 1. Factors that may result in higher prices → Supply decreases, Demand increases 2. Factors that may result in lower prices →Supply increases, Demand decreases Flexibility becomes more value is the standard NPV is close to 0 - Breaking even → see whether the project is worth to take on  Week 4: ETHICS 1. Wells Fargo Scandal - Intense pressure to cross sell products - Workers created fake accounts or set up accounts that people did not want - Who do you think is to blame for the Wells Fargo fake account scandal? Who is to blame? - Senior leaders: set the targets, and benefited through bonuses - Managers: wanted teams to sell products a day, with very high products. - Lower level workers: threats to lose job, Share price rose 67% - 5300 lower levels workers were fired, over 2m fake accounts created What are Executive Pay Clawbacks? → Return part of salary or bonuses if materially inaccurate financial information or misconduct → 2016 Wells fargo paid $3b fine to regulators, → Customer fees were reimbursed to $2.6million → CEO had to return $41 million → head of banking had to return $19 million EXECUTIVE PAY IN AUS: Recent Executive pay clawback - AUG 23’, ARPA finalised new requirement for authorised deposit taking institutions (ADI’s) Insurers and super entities to publicly disclose info on aspects of remuneration - ARPA will need to annually publish info on their remuneration frameworks, design, governance and outcomes - Variable remuneration must be adjusted, potentially to nil, for adverse risk and conduct outcomes, based on clearly defined risk criteria Qantas bored failed to challenge joyce command and control What is the role of the Board of Directors? ★ strategic direction ★ monitoring the company ★ acting for shareholders ★ reviewing internal compliance /reporting ★ appointing executives, deciding on executive compensation ★ approving budgets Dollarmites - Financial literacy program or child-target marketing scheme - Commonwealth BANK paid schools $200 a year to participate - Staff gamed system - Programme cancelled in 2021 2. Ford Pinto Case Background: Oil crisis, higher cost of petrol ★ Competitive pressure from smaller and more fuel efficient European and Japanese cards ★ Auto-imposed limits: Car should not exceed 2k in cost, 2k pounds in weight. ★ Inception to production: 25 months, Industry average is 43 months → didn’t allow enough time in production → didn’t want other companies taking market share Crash testing showed that - It would cost $11 per vehicle to fix → under the strict budget restrictions, even this cost seemed large - Ford had earlier based on campaign on safety which had already failed - 8/11 crash tested resulted in catastrophic situations - Safety doesn’t sell!!  - Fuel tank put at the back, susceptible to rear-end collision fires - Ford did a cost/benefit analysis: a) New design cost $137 million b) Old design cost of deaths/injuries $49.5 million - The profit mindset resulted in Ford using the National Highway Traffic Safety administration (NHTSA) value of a human life to be $200,000 What is the financial value of a human life? 200k (1970’s) Fixing the issue: Savings: ★ 180 burn deaths, 180 serious burn injuries, 2100 burned vehicles ★ UNIT COST: 200k per death, 67k per injury, 700 per vehicle ★ Total cost: $49.5 million Costs: ★ Sales: 11 million cards, 1.5 million light trucks ★ Unit cost: $11 per car, $11 per truck ★ Total cost: $137 million Ford Pinto legal: GrimShaw v. Ford - Jury awarded the Gray family 560k and Grimshaw $2.5mill in damages Did Ford have a wider social or moral obligation to fix the design? Was this negligence? GM Cobalt ignition switch → failure to open airbags and impacted steering wheel ‘05: GM reject a proposal to fix problem because it was too $$ and takes too long - December ‘05: GM sends dealers a bullet stating the defect occurs when key chains are too heavy - July '05: First death attributed ‘08: government bails GM motors out ‘09: GM files for bankruptcy ‘14 Jan: New CEO → first female ‘14 Feb: officially recalls vehicles ‘14 March: Expected to spend $300 mill in expenses in the quarter to cover the costs of repairing vehicles. ‘15: $4.1 billion in repair costs, victim compensation and other expenses → shareholders bear the cost!! Ford pinto case summary: Issue: Debate on using cost-benefit analysis in cases where design defects can cause death or serious harm, like the Ford Pinto. Ford's Decision: Chose not to upgrade Pinto's fuel system, despite knowing it could save lives, as the cost ($11 per car) was deemed higher than the societal benefit. Legal and Ethical Analysis: Ford followed a legally accepted risk/benefit analysis, but the ethics of valuing human life in monetary terms are questioned. Court Cases: Grimshaw v. Ford resulted in significant compensatory and punitive damages against Ford. Another case led to Ford being prosecuted for criminal recklessness. Arguments Against: Criticisms include ethical concerns, inability to quantify human life, negative publicity, and inadequate consideration of all consequences. Arguments For: Economic efficiency, risk/benefit analysis as a standard practice, and the necessity to compare all factors in a common measure. Value on Human Life: 3 main ways 1. Human capital or the pecuniary loss rule → earning capacity average work life expectancy, income at time of death 2. Hedonic damages compensate for non economic loss → pain and suffering preceding death, loss of companionship 3. Value of Statistical Life (VSL) - How much society is willing to pay to reduce the risk of death. - AUS 4.1million Should we assign monetary value to human life? - 9/11 compensation fund → Kenneth Fienburg - Voluntary program. Very easy for victims to be compensated without suing. Congress authorised unlimited funds. - Airlines would not contribute $$ 3. Theranos, Whistleblowing, Madoff Ponzi Scheme, Worldcom 1. Theranos: Revolutionise healthcare by making blood testing cheaper and more convenient → How did Elizabeth Holmes become so successful? - Inspiration leadership/incredible enthusiasm  - Dictatorship culture - Faking results/using old technology - Big name endorsements - Great mission/vision → Notable cause → Why did so many people believe her story? Ethics framework Setting the ethical tone (leadership) → Planning the elements (system) → Managing the system (Evaluate, report, commit, reinforce, guide, actions) 2. Whistleblowing: Whistleblowing is the voluntary release of non-public information, as a moral protest, by a member or former member of an organisation outside the normal channels of communication - Employees could also contact regulators - Who “blew the whistle” on Theranos?: Tyler Shulza, raised concerns and used an alise to inform NY public health about the manipulation of test results 3. Whistleblowing & other companies Bernie Madoff Ponzi Scheme: - What was it?: Ponzi scheme, funnels of money from top that allows payment at the bottom, Madoff created a fund that was outperforming the market. - Madoff had high profile investors, only able to get back 2 mill - How did he get caught? → whistleblowing Harry Markopoloos told the SEC about Madoff, however it took 7 years before the case was realised. Worldcom Purchase businesses, write down actual assets, differences between purchase price and assets is purchased GOODWILL - Purchased goodwill is tested for impairment over 10 yrs - Purchase company for 200 mill, assets worth 100 mil, goodwill 100mil - Capex/Opex → Capital expenditure (Balance sheet asset), Operational expense (cost incurred) - World COM was finding expenses that could be classified as decreasing expenses and maximising assets → increase profit margin - Reversal of a expense provision Why was whistleblowing difficult at WorldCom? 1. External auditors ‘in bed’ with the company through consulting contracts 2. Management and employee bonuses tied to company performance 3. Retailiation?  - the role of the auditor - auditor versus consultant - culture of executive remuneration and bonuses Reading:” Keep Track Of The Theranos Scandal With This Detailed Timeline” 2003: Elizabeth Holmes, at 19, founded Theranos, aiming to revolutionise blood testing with just a few drops of blood. 2004-2007: Theranos raises significant funding, reaching a $197 million valuation by 2007. 2010-2014: Theranos raises $45 million and achieves a valuation exceeding $9 billion by 2014, attracting high-profile investors and media attention. 2015: Scrutiny begins; Theranos's technology is criticised by the medical community, and a damning report by The Wall Street Journal exposes the company's fraudulent practices. 2016-2017: Regulatory and legal actions escalate, with Walgreens suspending tests, CMS finding safety violations, and Theranos settling with CMS and investors. 2018: The SEC charges Holmes and Balwani with massive fraud, and both are indicted on multiple counts of fraud and conspiracy. Theranos shuts down in September. 2019: HBO releases a documentary on Theranos, and the Justice Department reviews millions of documents for potential further charges. Week 5: Agency costs AGENCY COST: Someone is working as an agent for someone else (principal). The agent may have different information and/or different motivations/ interest WHAT ARE SOME EXAMPLES OF PRINCIPALS AND AGENTS? REMUNERATION DESIGN You’ve just been offered a job at XYZ Startup and they are giving you 3 options: →1. Straight salary $80K per year →2. Salary + options $50K per year and 5K options (worth $5K now but increase in value if the stock price rises) →3. Salary + restricted stock $50K per year + $40K in stock (can’t touch for 3 years) What would you choose and why? AGENCY COSTS IN A BUSINESS DIRECT AND INDIRECT AGENCY COSTS IN A BUSINESS 1. Direct costs - Expenditures that benefit management at the expense of shareholders - Monitoring expense to ensure agent working for the shareholders 2. Indirect costs - Opportunities that might be too risky for individual managers WHY IS DEBT CONSIDERED AN AGENCY COST? IS DEBT A SIGNAL OF A FIRM’S STRENGTH? Review signalling models before class: - How is debt considered a signal of a firm’s strength? IS THE WELLS FARGO SCANDAL A RESULT OF PRINCIPAL – AGENT DIFFERENCES? - Were there conflicts of interest and/or informational asymmetry? - What were the agency costs? WORLDCOM SCANDAL - Where were the conflicts of interest and the information asymmetry (and resultant agency costs) in this scandal? DIVIDENDS AND SIGNALLING WHERE DID DIVIDENDS ORIGINATE? - United East India Company (VOC) ★ Transformational company – before VOC each ship was a limited partnership and would dissolve after returning from one trip but this was very inefficient ★ Introduced limited liability ★ First company to issue shares that were tradeable on a stock exchange ★ Paid dividends each year reflecting earnings that year:  ★ Some of the dividends were paid in kind (spices), rather than in money, ★ Dividends varied widely ★ Low interest rates ★ Paid high dividends, sometimes funded by borrowing WHY WOULD COMPANIES PAY DIVIDENDS NOW? - The alternative to dividends: repurchasing shares/share buybacks - Taxes deferred until sell shares – can create your own income via selling some shares - Dividends result in tax now AND can be double taxation - Why pay dividends? Share buybacks are more tax efficient but share buybacks increase the - stock price without organic growth and this could affect expectations Classical tax system vs Dividend imputation and franking in Australia Distribute by share buyback instead? DIVIDEND POLICY THEORIES Dividend irrelevance hypothesis (Miller and Modigliani) M&M (1961) demonstrated that under certain assumptions about perfect capital markets, dividend policy would be irrelevant Bird-In-The-Hand High Dividends Increase Stock Value Investors prefer the “bird in the hand” of cash dividends rather than the “two in the bush” of future capital gains Tax-Effect Low Dividends Increase Stock Value Assumption - dividends are taxed at higher rates than capital gains - dividends are taxed immediately, while taxes on capital gains are deferred until the stock is actually sold Clientele effects Choices of individual investors might be influenced by certain market imperfections Transaction costs and differential tax rates to prefer different mixes of capital gains and dividends. Signalling (Information content of Dividends)  There is asymmetric information between managers and shareholders Dividends contain information about the firm’s current and future cash flows Poor-quality firms cannot mimic by sending a false signal Agency costs hypotheses There are conflicts of interest between managers and shareholders Dividend payments reduce the discretionary funds available to managers Dividends might serve to align the interests of managers and shareholders HOW DOES AUSTRALIA CORRECT THE TAX ISSUE? The issue: double taxation Some of the tax paid by a company can be attributed to the shareholders via a tax credit Taxpayers pay only the difference between the corporate tax rate and the marginal rate This can reduce the tax disadvantage of distributing dividends to shareholders FULLY FRANKED DIVIDEND EXAMPLE Investor receives a $70 fully franked dividend (including a $30 franking credit) Investor declares $100 If the investor’s tax bracket is: 20%, then they will get a $10 refund 30%, then no refund or additional tax 40%, then they will have to pay an additional $10  Week 6: Capital Structure and Financing 1. Restructuring after a shock 2. Ipo vs Selling 3. Financing Alternatives 1. Restructuring after a shock: Demand shock reduces demand for goods and moves lower on the supply curve - What are some examples of demand-side shocks? Note demand shocks can be in both directions! Examples of demand side shocks: Negative: - Economic downturn in trading - Unexpected tax increases - Cuts to welfare or other benefits - Financial cirisis, causing bank lending - Rise in unemployment Positive - Post War Aus - Consumer staples increase (e.g toilet paper) Post war economic boom demand shock: 1. Economic markets booming - top export crop in AUs 2. Export income rose dramatically - transferred to domestic demand shock 3. Removal of controls over prices, wages and rationing from the war, post immigration. Supply shock affects short-run supply and can affect long-run productive potential Note supply shocks can be both directions! Negative: - Natural disasters - Political termoil - Trade embargoes Positive: - Technology advances e.g fords assembly line Venetian Arsenal - the original assembly line: - Ships moved down a canal where they were fitted with parts - By 1500, largest industrial complex in the world - At its peak, the Venetians launched two new ships per day. Fords Assembly line positive supply shock: - A moving assembly line allowed individual workers to specialise - Huge increase in productivity - Reduced car cost and boom in supply What economic shocks occurred with Covid-19? Was it a demand shock or supply shock? - SUPPLY: shock - shut down sectors of the economy, supply chains affected - DEMAND: shock - populations in social distancing, quarantinem, unemployment. - Interest rates: historical low - Oil prices - demand or supply shock. What has happened since: Current economic and social environment - Inflation - Higher IR - Geopolitical tensions and crises - Supply chain issues - US Elections in NOV - Chinas economy, J - Cyber attacks - Deglobalisation - AI - Climate risks Implications on FDM: 1. Flexibility (Capital structure) 2. Significant variance within indiustries → M & A 3. Acceleration of trends 4. Speed of investment decicions - NPV and invesntment 5. ADa  2. IPO versus Selling Do you remember the IPO process? Who has the risk when the company is selling its shares? What do you need to do to IPO? What are the changes to mandatory reporting after the IPO? Process: - Dutch were known to have conducted the first IP - IPO’s have the upward trends and downward trends in issuance - Tech boom, during dot.com vs downward decline - Recent is the tred of co-called ‘Unicorns’ (Start up companies) - What are the steps to IPO - Moving from private or Unlisted Public Company to… a listed public company Why do go through IPO: - Raise capital!! - New shareholders come with new insights - Attract more borrowing - Attract better employees.. Who has the risk when the company is selling it’s shares? - Investment bankers take a cut, and usually take the risk of selling the shares to the public (underwrite) → underwriting the issue: if the book is not filled when selling, the Investment bank will BUY the leftover STOCK (insurance policy) Internal and external factors infleunce a company to IPO: ★ State of the market: hot market? Appetite for risk? ★ Sufficiently used private finance? Do they need more capital ? ★ When the founders want to cash out, but will they be able to? ★ When the venture capitals apply pressure to realise a return ★ Should you IPO or stay private/sell the company? IPO - cash injection, reputation/perception, right of passage, expensive, subject to public perception Staying private - fewer investors/less pressure, IPO failure risk, don’t have to conform, limited liquidity for investors. What happens to IPO Market - Worst performers: ADore Beauty, Zebit, YouFoodz, Victor. Wework See Canvas for wework article links Search for the 2019 wework prospectus at the SEC archives What happened with the IPO in 2019? What role did SoftBank play? Article summary: “SoBank to Boost Stake in WeWork in Deal That Cuts Most Ties With Neumann” ★ SoftBank takes 80% stake in WeWork, valuing it at $8 billion. ★ Co-founder Adam Neumann exits with a $1.7 billion payout. ★ SoftBank invests an additional $6.5 billion to stabilize WeWork. ★ WeWork plans major layoffs and asset sales to cut costs. ★ Early investors see losses; some like Benchmark Capital gain significantly. And this article “WeWork boss steps down with IPO in crisis” ★ WeWork's valuation plummets from $47 billion to $10 billion. ★ CEO Adam Neumann steps down amid governance and financial concerns. ★ Neumann's controversial behavior and business dealings under scrutiny. ★ WeWork's IPO delayed, company faces significant financial losses and potential layoffs. The IPO revealed many govcernment issues. 3. Financing Alternatives What is finance: Discipline that deals with decisions concerning how money is raised and used by businesses, governments and individuals. What is traditional financing? Short term, medium term and long term financing Alternative financing? Faster? Easier? Riskier? Technology removes intermediary? → What are some examples? Bear Bar Case 5 Lockout resulted in a loss of all inventory, equipment and furniture New location but needed a capital investment - $500 up front gets you one drink per week for the rest of your life - Crowdfunded capital investment - Is this a NPV positive investment for the consumer? - Is this a NPV positive source of financing for the Bear Bar?  Week 7: Start up’s W07 H19 FINANCING TRADEOFFS AND NEEDS WHAT IS A STARTUP? A startup is a company that's in the initial stages of business. - Growth focused, revenue focused SME: - More typical business, not as risky, not as innovative - May have different attitudes towards financing and risk tolerance - Be perceived differently by financiers WHAT IS FINANCE FOR BUSINESSES LONG TERM SOURCE: Share capital, retained earnings, venture capital, mortgages, long term bank loans/leasing MEDIUM TERM SOURCE: bank loan, leasing, vendor finance, government grant SHORT TERM SOURCE: bank overdraft, trade creditors, factoring ALTERNATIVE FINANCING: - Microfinancing - direct investment - Government grant/tax initiatives - Crowdfunding - Angel investors - Boost strapping - Initial coin offerings - Spac - Accelerator/incubators - FFF’s - Family, friends and fouls. - Strategic partners MICROFINANCE: Peer to peer lending → higher returns by linking to individuals who may not normally have access to financing. CROWDFUNDING: raises money from the crowd, reduces risk because finance is tied to the demand. SPAC: ‘blank check companies’ - A company with no commercial operations - Formly strict to raising capital through an IPO - For the purpose of acquiring an existing company - Have been around for decades. BOOTSTRAPPING: using own personal funds without relying on external forces ANGEL INVESTOR: An angel investor is a wealthy individual who provides capital to startups or early-stage companies in exchange for equity (ownership shares) in the business. VENTURE CAPITAL: Venture capital (VC) is a form of private equity financing that is provided by venture capital firms or funds to startups and early-stage companies that have high growth potential. Super Frisbie case study: Potential issues Financial Risk: Uncertainty in revenue and high costs, especially with the potential loss of exclusive rights if the sport doesn’t grow quickly. Legal Concerns: Incidents like the child being hit by a Frisbie pose legal and safety risks. Scalability: Expanding to other cities is labor-intensive and may stretch resources. Market Demand: Uncertain if there's enough interest to sustain the business long-term, especially with competition from established sports. Revenue Viability: Current revenue model may not cover costs, particularly with expansion. Marketing Needs: Significant investment in marketing may be needed to grow participation. Work-Life Balance: Expansion could heavily impact Lisa’s time and personal life. WHAT IS A STARTUP? IS A STARTUP THE SAME AS A SMALL BUSINESS? WHERE DO THEY GET THEIR FINANCING? W07 H20 STRUCTURING FINANCE Australian Venture Capital Industry - Largest Venture Capital fund is Blackbird, then Square Peg and Telstra Venture capital fund structure It all starts with the General Partners (GPs) and Limited Partners (LPs). - GPs and LPs are at the core of every venture capital firm and act as the two primary types of investors. - GPs identify potential investment opportunities, conduct due diligence, and decide which startups or companies to invest in. - GPs often take an active role in the management and strategy of the portfolio companies. WHERE DO YOU GET FINANCING? Several different criteria can help us place financing into categories - Time: short, medium and long term - Ownership: how much control can you give away? - GovernanceL: Internal vs external WHAT MATTERS TO AN ENTREPRENEUR? No one wants to give up equity, but there are substantial risks of debt What are the tradeoffs? - COST VS BENEFIT BENEFIT EQUITY = long term, BENEFIT DEBT = variable term, regain control, lower cost (tax deductible), COST OF EQUITY = higher cost → loss of control COST OF DEBT = Risk of bankruptcy HOW DO YOU OPTIMISE CAPITAL STRUCTURE? What are the main and secondary drivers for an entrepreneur? Main drivers: - Cost vs risk? - Survival at any cost? Secondary drivers: - Timing of cash flows - Tax issues require profits - Agency costs: how much funding can be provided, and what will it be used for? How does this differ with a more established business? OTHER CONSIDERATIONS FOR ENTREPRENEUR? Lack of diversification - Interdependence between investment and financing decisions Exit? - Timing of VC fund exit strategy - IPO/trade sale/MBO? Expansion/later stage funding sources - Public equity markets - seasoned offerings (post-ipo) - Commercial banks/debt markets Role of entrepreneur - How does the entrepreneur feel about the business WHICH OFFER WOULD YOU TAKE AND WHY? W07 H21 DECISIONS FROM A VC PERSPECTIVE Industries that attract the most venture capitaL - IT - Software (30%) - Medical devices and equipment (7%) - BIotech (17%) - Media and entertainment (10%) What do venture capitals care about? - Everything specified in a term sheet KEY ITEMS: - Valuation/amount invested/ % stake/ anti dillutive provisions - Voting rights - Liquidation procedure - Investor commitment and corporate governance What to worry about? - Departure of a founder - When to exit? The ultimate term sheet guide Different type of shares 1. B class share: is created with which holders have less voting rights than A class shareholders (original shares). 2. Preferred shares: more senior than regular equity. Preferred shares have more claim to the company’s assets than regular shareholders. In the event of liquidation, this can be of great importance. Capitalisation table example The key terms related to valuation are: Pre-Money Valuation – Valuation of the company before the investment Post-Money Valuation – Valuation of the company after the investment Price per Share – This is calculated by taking the post-money valuation and dividing it by the fully diluted number of shares (see below) Security types - Common Stock  - Preferred Stock - Stock Options - Warrants - Restricted Stock Share counts - Authorised Shares – Before issuing any shares, they need to be authorised by the company’s board. Authorised shares refer to the number of shares that is authorised for current and future issuance - Outstanding Shares – total number of shares that have been issued (thus a subset of authorised shares). It does not include options that have not been granted, nor does it include options that have not been exercised, as the shares are only issued when exercised - Fully Diluted Shares – This is a calculation which models all the granted options, restricted stock, warrants, and the remainder of the option pool itself, into a number of shares that represents a theoretical count, as if all of these outstanding items were granted and exercised. - Pre-money refers to the value of your company excluding the funding that you are raising. - Post-money refers to the value of your company directly after you receive the investment. - Conversion: the right to convert shares of preferred stock into shares of common stock. The rate at which this happens is the conversion rate (e.g. 2:1). - Option pool: A key tool to attract talent in the startup world is by sharing equity with your employees. Investors know this and often ask you to organize a pretty sizeable option pool before their WHAT DO VENTURE CAPITALISTS CARE ABOUT? Everything specified in a term sheet Key items: Financial and Control What to worry about? From either side? - What is pre-money and post-money? Venture capital and investing is all about valuation - Investors prefer a low valuation (maximise ownership) - Founders prefer a high valuation (preserve ownership) Pre money = valuation before investment Post money = valuation after investment → pre-money + money Price per share = post money valuation/ Example: You own 100% of 1mill shares, and a VC wants to invest 250k - If the investment is valued at 1mill pre money Founder = 1mil (80%), investor 250k (20%), total = 1.25 mill - If the investment is valud at 1 mill post money Founder (750k), investor 250k = 1 mill Corporate governance - Who controls company - How is it represented - How does this impact management, founders and investors? Preferred stock issued and participating: - Preferred stock issued and participating - VC are entitled to return of their ,oeny before common shareholders get any EXAMPLE: VC buys 50% of company for 50mill, for a 100mill post-money valuation If that company sells for 75mill , the VC gets more than 50% of the 75% - The VC gets 50mill first, and then 50% of the 25 mill remaining → the total return of 62.5% - The common stockholders split the remaining 12.5 mill Liquidation multiple is 1.25 → they get their money back + 25% before a liquidation event (such as when the company is sold, goes public or declares bankrputct) Specific clauses - conversion “The holders of the series B preferred shares will have the right to convert the shares at any time into a common stock of the company. The initial conversion rate shall be on a 1-1 basis and shall be subject to adjustment and dilution protections. - Who is this good for? The founder or the VC? - Can you negotiate these terms? Preemptive/Pro rata rights - Gives investors the right to buy shares to maintain their level of ownership. - Can dissuade new investors since they are buying a smaller percentage of the company. - If you are investing – you want peremtive - If you are buying - you don’t want preemptive TERMINOLOGY Down Round: A financing round where a company’s valuation is lower than in previous rounds, meaning new investors get shares at a reduced price, which can dilute existing shareholders. Pre-money / Post-money: Pre-money valuation is the company's value before new capital is added. Post-money valuation is the company's value after new capital is added, including the new investment. Optional vs. Mandatory Conversion: Optional conversion allows investors to convert their preferred shares into common shares at their discretion. Mandatory conversion requires investors to convert their preferred shares under specific conditions, like an IPO. Option Pool: A reserved pool of shares set aside by a company for future issuance to employees, consultants, or advisors as stock options. Liquidation Preference: t ensures preferred shareholders get paid before common shareholders in the event of a liquidation, sale, or bankruptcy. Participating Preferred: A type of preferred stock that allows investors to receive their liquidation preference and then share in the remaining proceeds with common shareholders. Dividends: Payments made to shareholders, typically preferred ones, as a return on their investment, which can be cumulative or non-cumulative. Anti-dilution Rights: Provisions that protect investors from dilution by adjusting the conversion ratio if new shares are issued at a lower price than they originally paid. Right of First Refusal / Co-sale: Right of First Refusal (ROFR) gives existing investors the right to purchase shares before the company sells to new investors. Co-sale rights allow minority shareholders to sell their shares alongside majority shareholders during a sale. Single Trigger vs. Double Trigger: Single trigger vesting allows an employee's options to vest upon a single event, like a company sale. Double trigger vesting requires two events, such as a sale and the employee being terminated, for options to vest. Drag-along, Tag-along: Drag-along rights allow majority shareholders to force minority shareholders to join in selling their shares. Tag-along rights allow minority shareholders to join a sale if majority shareholders decide to sell their shares. Redemption Rights: The right for investors to force the company to buy back their shares after a certain period or under specific condition Week 8: Forensic 08 H22 What happened? Financial Forensics: Uses accounting, auditing and investigative skills to analyse a company’s financial statements for possible fraud 5 steps of a bubble:” 1. Displacement 2. Boom 3. Euphoria 4. Profit-Taking/Distress 5. Panic The Fraud Triangle (Context behind why people commit fraud) MOTIVATION 1. External (personal situations) - Greed, Life events, additions 2. Internal - Bonus, unrealistic performance targets, excessive work, analyst/shareholder expectation OPPORTUNITY - Weak internal control, absence of oversight - Complex transactions, significant estimates RATIONALISATION: - Look for justification of behaviour e.g poor job satisfaction, perceived entitlement Know your sources: 1. Mandated disclosure 2. Company press releases 3. Company conference calls 4. Sell side research reports 5. Social media rumours What should you look for? – Revenue too early or bogus revenue or one-time boosts to income – Shifting expenses to a later period – Techniques to hide expenses or losses – Shifting income to a later period or expenses to an earlier period – Shifting financing CF to operating CF – Shifting operating outgoing CF to financing CF – Inflating operating cash flow using acquisitions or disposals – Showcasing misleading metrics / distorting metrics to hide poor performance Is there an error? ▪ What is mark-to-market accounting and how is it related to the downfall of Enrol? Mark to market accounting uses current prices instead of historical - Assets - Projected profit includes ★ It’s easier to manipulate ★ Violates accounting principles - Special purpose entities if profits below projected. ▪ Who is James Chanos and what is short-selling? (OWNER OF ENRON) Runs a hedge fund that focused on securities believed to be overvalued due to 1. Overstated earnings 2. Unstaimable flawed business plan 3. Outright fraud. Is short selling ethical? James has been called names because he is shorting the companies island profiting from their demise and loss by other shareholders? Short selling involves borrowing a security whose price you think is going to fall and then selling it on the open market. - Helps in price discovery and market efficiency GameStop Short Squeeze What Happened?? - In Jan 2021: a short squeeze of American video game retailer GameStop - Initiated by subreddit - Squeeze against institutional investors and hedge funds (Melvin Capital) - Role of social media: Motivation - Who was involved: retailed investors, hedge funds, market makers, brokers, regulators - Who gained? Who Lost? Conflict of interest? Future of short selling: - Retail investors continue to disrupt short sellers by 65% - Despite rising interest rates, short selling activity has dropped Article Summary: Short selling is no easy way to make money (AFR) Role of Short Sellers: Viewed as divisive market participants; praised for market transparency when successful, criticized as manipulative when they fail. Short Selling Explained: Involves borrowing shares to sell and repurchase at a lower price, with asymmetric risk—potential for unlimited loss. Market Impact: Contributes to market liquidity and informed trading, though perceived as high-risk. Challenges: Requires paying borrowing costs and dividends, with positions needing constant adjustments. Regulatory Environment: Mixed views on their role; regulatory bodies are cautious, especially around activist shorting. Persistence in the Market: Despite challenges and risks, short sellers continue to play a significant role in market dynamics W08 H23 What do you do? Ponzi schemes - Charles Ponzi → arbitrage with international reply coupons →but then he got greedy What common characteristics are shared by Ponzi schemes? - Promise of high returns with little risk - Returns regardless of market condition - Investments are not registered - Investment strategies that are complex - Difficult to remove money from the scheme - Appear to be selective about clientele What happens when the Ponzi scheme collapses? Who should be paid out? Goldsky global Acess Fund - Kenneth Grace, a car dealer who convenienced investors he was a hedge fund genius - Goldsky Fund was registered officially - Grace claimed to operate in US, but was actually resided in Tweed Heads, NSW - The fund was named among asias top hedge funds - 2017: ASIC received tip off, claiming a lack of professional behaviour”  - Jan 2019: SEC obtained judgement against goldsky Asset Management and Kenneth Grace for making misleading statements - ASIC obtained orders placing Golfsky into liquidation and freezing assets Bernie Madoff Ponzi Scheme: - $64 raud discovered 2008 - Evidence of fraud over 17 years Madoff reputation - pioneered electronic trading Returns were high, portfolio appeared to stick to safe investment Scheme claimed to use legitimate option strategies Warning signs: large sums in the bank, auditor was a small firm, Madoff posted statements to clients, consistent returns, whistleblower Markopoulos! Winners and losers - Madoff said he only prevented rich from getting richers - Some investors have been with Madoff since 196-0’s - Losers included individuals, charities, banks, investment funds, pension funds Legal claims - The trustee first tried to recover asset - The accounting of funds stolen in this matter excludes inflation, interest, time invested, and falsely reported balances - The interpretations of the laws do not consider tmv when reimbursing lost funds Payouts - From the trustee - liquidating Madoff securities - From Gov Fund: raised from settlements with JP Morgan Chase and the estate of JP Morgan Chase What happens in a sovereign default? ★ A sovereign default is the failure or refusal of the government of a country ot pay back it’s debt in full - exclusion from the capital markets ★ Debt restructuring: haircut, moratorium ★ Financial rescue accompanied by requirements on country: structural reforms, belt tightening  - What happens when a country defaults on its debt? - Who gets paid? - Who has the power in negotiations What happened in Greece? - Global recession following GFC in 2008, Greece most affected country in EU - AMount of gov. Debt unreported - 2010: Financial rescue by Eu and IMF, emergency loans What happened in Argentina? - 2001 Argentina Default of $100 billion precipitated an economic crisis 2014: Argentina classified at selected default 2016: Argentina report ed it had reached agreemetns to settle outstanding defaulted debt 2019: Government wants to resture 100 billion of debt, proposed restructuring of 65 billion with longer maturity and no repayments. W08 H24 Business failures General Motors 2009 reorganisation - What is Chapter 11 reorganisation and what types of financing are used during a reorganisation? - Who are the interested parties in the reorganisation/default and are there any agency costs/weird incentives? How did they generate money? - Debtor in possession financing in place during reorganisation so that new creditors are projected - Sell off assets - Government guaranteed debt and %50 bill in treasury loans - Reduced workforce ★ Owners - shareholders ★ Management - concentrated human capital ★ Employees – represented by strong unions ★ Creditors - different creditors ★ Government - didn’t want to lose all the jobs Lehman Brothers 2008 collapse - $450 billion owed by the bank but only $65 billion available (14%) - Were they too big to fail? Should they have been bailed out? Views on the case: - Significant proportion of the investment was in housing related assets, making it vulnerable - One measure of this risk taking was with the leverage ratio, which increased  - While generating profits during boom, this position mean that just a 3-4% decline in the value of its assets would eliminate book value of equity - Investment banks such as Lehman were not subject to the same regulations - Claim to pay increased before bankruptcy - Accounting manipulation Virgin Australia ▪ 2019 annual report available online (link on Canvas) ▪ Read through the key developments on page 15 ▪ Cost based initiatives? - fuel ▪ What happened? Immediately moved to voluntary administration when a company can’t pay it’s denbts April 2020: Virgin asked the gov for a $24 billion loan from aus gov → it was rejected Debt settled for a % of face value - different creditors can be treated differently - Virgin was bought for 3 billion, reduced fleet and less routes Week 9: Purchase Should you buy this company? W09 H25 Porter's five forces Type 1 and 2 error Type I – you buy it and it was a mistake Type II – you don’t buy it and it was a mistake Top Down investment analysis approach ★ Macro economic perspective first ★ Industry position/trends ★ Financial statement extracts – what to look for? PE and P/E: Private equity and Price / earnings W09 H26 What is Private Equity? ★ Difference between venture capital vs private equity? ★ How do private equity firms make money? ★ How does a PE firm decide to buy? Is the value correct? W09 H27 How do you value a company using DCF? 1. Expected future free cash flows over the forecast horizon 2. Terminal Value - Liquidation value - Exit: Multiples valuation - Continuing Value: Perpetuity 3. Discount rate to compute the present value of the future cash flows Valuation: 4 key pieces of information 1. Operations of the business 2. Debt financing costs 3. Debt financing benefits 4. Equity financing costs Cash Flows and Valuation Let’s value a craft brewery Is this valuation realistic? How can we assess this? How do you value a company with negative earnings? Is the stock market efficient?  Week 10: Timing is everything W10 H28 RETIREMENT DECISIONS WHEN DO YOU WANT TO RETIRE? 1. AGING POPULATION 3 subsectors: 1. Go GO’s - 65 - 75 yrs old → spending, travelling, volunteering , retired or part time work, 2. Go Slows - over 75, selling big home to down size, simplifying house, 3. No Go’s RETIREMENT IN AUS - Technology: healthcare and wellbeing asseser - Downsizing from 3mill house to 3mill apartment Joe (58) and Mary (53) want to retire… but they have some questions WHEN CAN YOU RETIRE AND HOW MUCH MONEY WILL YOU HAVE? 1. What is their life expectancy JOE: 23ears Mary: 33.34 Years 2. Can they generate 50k after tax? - Apartment generates 25k - Other asset: 1mil super + 500k in cash 3. Should they buy the annuity Yes; if 2% is the appropriate discount rate, if you live longer than life expectancy, if interest rates go down No: if interest rates increase, inflation increases, if you don’t live longer than expected, legacy and estate planning, capital is gone Annuities remove longevity risk: - Lifetime annuity: outlive savings - Pooled amount by life companies - Indexation and CPI - Other alternative: extra’s on the annuity product that provides cash within the first 10 years - SOme products add insurance if you die in the first 10 years or before a certain age, it costs more. Withdraw value, but these diminish very quickly. What happens in a relationship breakdown - She may take the 1m apartment, he keeps the 1m superannuation Age pension eligibility Pension FW: 67 YEARS is the date you can access How much: 1000 per fortnight for single, benefits include reduced health costs, hospital fees, travel expenses etc. - Cut offs: asset test and income test → homeowner? What is your assets and income threshold Annuity calculation: W10 H29 CEO SUCCESSION SUDDEN DEATH OF A CEO - Stock price falls: due to restructuring - Share price may rise: Average CEO tenue: 1990’s 9.5 years 2000’s → 7.6 years 2018 → 5.8 years Why has this decreased: more technology and social media, increases exposure and availability of information, increased transparency, faster need to perform, increased pressure, more vocal investors Potential issues with long CEO tenure - Stagnation and complacency - Diminished accountability - Risk aversion - Talent drain - high executives may leave due to limited advancement opportunities - Succession challenges WHY IS THERE AN INCREASE IN CEO TURNOVER? CEO departures have been rising CEO Turnover Report | Challenger, Gray & Christmas, Inc. BROWN APPAREL CO. Planned vs forced successions - Planned transactions have increased in aus the last 15 years. - Outside vs inside successors (AUS 2012 - 2016). Key Steps to a successful transition: - Identify high potential candidates early in their careers Insiders: progression through position with responsibility for steadily larger and more complex p&L centres - Large corporations: single product → several product lines → business unit → entire division - Small business : manage large projects or small internal organisations Outsiders: the board should be informed drivers of the process, recruiters should be led by the board Brown apparel co. W10 H30 OPPORTUNITIES WHAT HAPPENED AT KODAK? ★ Kodak invented digital photography but failed to embrace it as a disruptive technology. ★ The company continued focusing on film-based business even as digital technology advanced. ★ A 1981 market study predicted digital photography’s potential to disrupt Kodak's core business, giving them a 10-year window to adapt, but they didn’t. ★ Kodak used digital technology to improve film rather than shift its business model, leading to costly failures like the Advantix system. ★ 1986: first megapixel ★ Developed a camera to preview photo, however couldn’t be used to actually take photos (included an extra step) ★ 1986: purchased a drug company ★ Key mistakes included poor leadership choices, such as prioritising traditional film business over digital opportunities. ★ A series of CEOs failed to successfully transition the company to digital, leading to Kodak’s decline and eventual bankruptcy. ★ 2001: film sales dropped ★ 2004: announced it would stop selling traditional film cameras ★ 2012: went bankrupt, emerged 2013 with all shareholders shares cancelled ★ Kodak’s failure illustrates the importance of an open, adaptive, and holistic approach to decision-making in the face of disruptive innovations. Disruptive Innovation: innovation that creates a new market and value network and eventually disrupts an existing market and value network, displacing established market-leading firms, product and alliances - An innovation that simplifies and makes more affordable products and services to undesirable or ignored markets. Other companies that failed to innovate: - Blackberry: failed to innovate the keyboard and didn’t do touch screens  - Blockbuster video - Nokia - Xerox - Toysrus - Sony How to get out of status quo - Using finance to recognise and be aware of relative strength of different products/income streams and dependence - Question assumptions underlying cash flows and profits - Investigate rivals/threats/competitors - Invest in r&d - Engage in enterprise wide decisions - Encourage innovation and openness - Consider transformations and experimentation Week 11: Trends Week 11 Hr 31 Energy Trends HOW DO YOU IDENTIFY TRENDS IN DATA? Trend: long term impacts in data → assumptions about the future Seasonality: specific and regular intervals during a course of the year Remainder: random, irregular outliers → flips in the data that don’t make sense, also known as shocks, DO YOU REMEMBER REGRESSIONS? Regression model: Y = a + bX + e A = intercept parameter B = slope X = explanatory variable e E = error variable. Relationship between one or more variables and response of dependent - Impact of two variables, and how the data moves  - Slope of the line represents the relation → coefficient of determination R^2 - The time series shows a trend → visually easy, only shows correlation: Issue: oversimplified and we don’t get the accurate numbers - Omitted variable: may be increasing over time, but something has changed over time too. For example: over time, alcohol content increases and therefore calories increase. BUT data can’t predict shocks: data driven may provide early warnings or may only provide confirmation after the trend IS well underway WHAT FUTURE RISKS AFFECT VALUATION IN THE ENERGY INDUSTRY? - Climate change - Changing industry - Cyber threats to energy grid - Regulatory changes - Geopolitical tensions - Tarifs and trade tensions - Talent gap - Catastrophic events ARE WE USING LESS FOSSIL FUELS? - Fossil fuel trend is slightly down - Renewable sources are increasing over time - Is this enough? Electricity generation notes Australia's electricity generation rose by 1% in 2022-23 to 274 terawatt hours. Fossil fuels accounted for 65%: coal (46%), gas (17%), oil (2%). Renewables reached 35%, with solar (16%), wind (12%), and hydro (6%). This represents a record share for renewables, increasing by 3% from the previous year. Around 20% of electricity came from households and businesses. More details can be found here. Wk 11 Hr 32 Demographics and Industries HOW DO DEMOGRAPHIC TRENDS AFFECT INDUSTRIES ? HOW DO YOU CHARACTERISE AN INDUSTRY? ★ does the industry move with/before/ after opposite to the business cycle ★ Recession proof industries: funeral parlour, children's toys, supermarkets ★ What does the typical balance sheet look like? - Long term assets? - Debt level? HIGH OR low level of debt → depends on credit ratings, - Leases? ★ What does the typical income statement look like? - Profit margin ? - R&D expenses? ★ Other ratios across financial statements - revenue/assets - efficiency measures HOW DO WE CLASSIFY SECTORS: - General sectors, industry groups, industries and sub industries - Industry classifications are open to interpretation Common methods: Porters, Swot, Pest (political, economic, social and technological)  - Adaptive: building products, computers, electrical equipment → unpredictable and cannot be changes - Shaping: unpredictable and you CAN change it - Classical: industry IS predictable, but you can’t change it → automobiles, consumer finance - Visionary: industry is predictable and it can be changed → established industries , can be changed and designed Pharmaceuticals: How is characterised: ★ High profit margin → they are the price makers ★ High R&D → finding new solutions to ★ Number of patents? Expiry date? → ★ How do demographics affect this? → move to lifestyle drugs, as a way to make money, no money in antibiotics Sales opportunities in pharmaceuticals CONSTRUCTION INDUSTRY: ★ Buildings, infrastructure and industrial ★ How do you character this industry? → heavily dependent on economic cycle: materials and labour costs → cyclical with the business cycle → working capital? Cash flow? Debt? →high levels of debt or equity to not go bankrupt!!! How do demographics affect this industry? - More old age care facilities - Smaller homes and apartments - More environmentally conscious construction - Acts supporting industries/ suppliers MATERIALS INDUSTRY: - Raw materials, semiconductors, minerals are examples - How do you characterise the industry? Feeder to other industries (e.g construction) Facing pressure to consider environment Very cyclical and tied to global prices/trade How do demographics affect this industry? - Pricing, differentiation, competition TELECOMMUNICATIONS INDUSTRY: ★ High fixed asset requirement ★ Highly regulated ★ Require a lot of financing but regulated returns CONSUMER DISCRETIONARY INDUSTRY: ★ Clothing, personal products, white goods (recession group and a defensive stock) ★ Highly cyclical with business cycle ★ Profit margins and volume depend on whether luxury or high volume ★ Inventory turnover key to understanding what products are selling/speed ★ Financing and collection efficiency ratios are important: inventory ★ Compare reject shop vs Louis Demographics affect this industry - products dependent on age group - Fashion trends change very fast - Method of purachse shifting/ exteremly competitive with internet selling Population, households and families reading summary: ★ Australia's population has doubled since 1971, reaching 25.4 million in 2021. ★ Most Australians live in capital cities; household sizes are shrinking. ★ Households are increasingly diverse, with more First Nations and immigrant households. ★ The population is aging, with 17% aged 65+. ★ One-person households represent 26% of all households. ★ Family households remain the most common type, though couple-only families are increasing. More details can be found here. AGEING AND INNOVATION article: ★ Ageing populations lead to lower birth rates, shrinking workforces, and reduced innovation. ★ Countries like Italy, Japan, and South Korea face severe demographic decline. ★ The decline in fertility and aging results in economic strain, lower productivity, and fewer technological breakthroughs. ★ Innovation is increasingly incremental, as younger generations, especially in advanced economies, shrink. ★ Government policies like tax incentives and subsidies for children have been introduced in many countries to combat these trends. ★ Solutions for maintaining economic growth amid these shifts remain a major global challenge. SMH article: CHINA ★ China is raising the retirement age for the first time since 1978 to combat labor force decline. ★ Men will now retire at 63 (up from 60), women at 55 (up from 50), and white-collar women at 58 (up from 55). ★ This gradual change will take 15 years to implement and aims to address the challenges of an aging population. ★ The retirement age hike may bring economic benefits but could also increase health issues and social unrest among workers. ★ The move follows China's shrinking population and increasing elderly proportion. Wk 11 HR 33 COVID SHOCK SUSTAINABILITY ★ Definition (world commission): meeting needs without compromising future generations ability to meet their needs → more globally and socially aware that businesses have ★ Sustainable can be with respect to environment, natural resources and financial resources ★ Sustainable economy ★ Sustainable firms: ESG aspects of a firm's operations Pre covid trends: - Environmental awareness - Shifting away from growth focus? Better use of assets through sharing (airbnb, uber) - Technology use - Social issues - Governance COVID impact on sustainability: - Positive or negative? → Victorian economy shut down completely: impacted citerzen wellbeign - Financial impact - economy, companies and individuals - Rapidly moved online into virtual world - Environment - Social issues - Governance HOW DID SPANISH FLU CHANGE SOCIETY? - Many breadwinners killed leaving destitute dependents - Increase in life expectancy (if you survived) - Baby boom: but some cognitative effects - A move towards science and better public health CAN YOU PREDICT THE LONG LASTING EFFECTS OF COVID 19? Online/Virtual catapulted forward/work from home likely to stay as an option The great resignation → quiet quitting Zombie business operating before covid 19 used cheap debt but not sustainable Supply chains move to regionalisation, rather than globalisation Opportunity to rethink whole industries. WHAT OTHER TRENDS HAVE EMERGED? WHAT IMPACT ON INDUSTRIES? - Health care: online consultations, vaccines, elective surgery - Travel: pent up demand, travel more expensive off season → longer term: rethinking reliance in some countries, environmental concerns - Info tech: demand soaring, increased reliance on robots, data/Ai - Real estate: commercial property changes, future need changes, social/work changes, residential value changes → location preferences, shortages, immigration. Jobs of the future: 2030 - Work from home faciliartor - Data detective - Tide water architect - Human machine teaming manager - Workplace environment architect - Fitness commitment counsellor  - Smart home design manaer Fastest growing vs declining: Growing: Ai and ML specialists, sustainable,ity specificalist Declining: bank telling, postal service clerks, cashiers