A Financial Bedtime Story for Arya

[Credit: JB Curish, Draft 1.1 – 12/5/07]

Note: This was done as a fun exercise. The original story is written by Prof. J B
Curish. I replaced the name in the story with ‘Arya’

Once upon a time it became clear to young girl, Arya, that the amount (more is better
than less) and timing (sooner is better than later) of financial cash flows was an important
issue. To handle this, Arya learned how to appropriately discount cash flows when given
specific cash flows and interest rates. She also learned about some useful tools such as
annuities and perpetuities.

After gaining comfort with these early concepts, Arya applied her newfound
understanding of the time value of money to making smart capital investment decisions
when cash flows and interest rates were explicitly given. Further, she learned about a
couple of techniques often used to evaluate capital investment decisions – NPV and IRR.

Upon comprehending time value of money, perpetuities, annuities, NPV, and IRR, Arya
was pleased to apply that knowledge to valuing some specific financial assets – stocks
and bonds.

All of this was pretty exciting to Arya, but like many young children she had some
questions. In particular she wondered where some of the information came from –
especially the interest rates that were used to undertake discounting of cash flows. To a
lesser degree, Arya was also wondering about where some of the cash flows themselves
came from.

Arya asked her father the interest rate question. Her father realized it was now time to
have a difficult, long, yet important, father to daughter discussion. Arya’s father said to
understand where interest rates for discounting come from you first must understand an
important aspect of risky assets - the logical tradeoff between risk and return. Hence,
Arya learned about the return and risk of assets and how to measure them.

Next, Arya was told she had to understand that you can put together assets (build
portfolios) and calculate the return and risk of those portfolios. Her father also told Arya
about and showed her the potential magic of diversification that can come about when
building portfolios of assets. This was Arya’s first experience with the concept of risk
management. Arya found the portfolio building to be fun and she played with numbers
and graphs in Excel for many hours.

However, Arya still did not see how the portfolio discussion explained to her where
interest rates for discounting came from. Her father told Arya that the next step on the
journey to answer that had to do with a very, most likely overly, simple logical and
mathematical concept – the CAPM. Arya’s father said that investors wishing to earn
cash flows from an investment in a risky asset logically expect to receive a return in
excess of the return for a non-risky asset. The amount of extra return beyond the non-
risky asset is dependent upon two things: (1) the general performance of all risky assets
in the market over the non-risky asset and (2) the specific performance of the specific
risky asset relative to the general performance of all risky assets in the market – this
relationship has a special name called Beta. Arya agreed that made sense. She then
understood that one place where interest rates used for discounting came from was the
CAPM. In particular, if Arya knew the return for the non-risky asset, the expected excess
return of risky assets over the non-risky asset, and the specific Beta, an interest rate for
the purpose of discounting could take life.

Arya’s father pointed out that the CAPM was a good start to understanding the mystery
of discounting, but she also noted that there may be different sources of funds. For
example, one basic source is equity and another is debt. If a firm has capital from both
equity and debt, the CAPM could be used to determine two different interest rates.
Arya’s father went on to point out that the average interest rate could be calculated by
doing a weighted average of the individual rates for equity and debt. This weighted
average number is called the WACC. Arya’s father also pointed out that to be more
realistic, an adjustment has to be made on the debt interest rate to take into account taxes.

Arya was beginning to fall asleep by this time and asked her father to speed the story up a
bit. Arya’s father said he was almost done for now. One additional concern is that a
firm’s capital structure (its mix of equity and debt) may have an impact on the interest
rate used for discounting. To deal with this it is necessary at times to unlever and relever
Betas when doing work. Arya’s father told Arya he would read to him at a different time
a Harvard case titled “Financial Leverage, The Capital Asset Pricing Model, and The
Cost of Equity Capital” that would help clarify the concept.

Arya now understood where interest rates used for discounting came from. But she was
still wondering about the cash flows. Her father said cash flows are the result of business
activity (both real and expected); and, if Arya needed to know more about those she had
better also ask her accounting, data analysis, economics, and management professors.

The key point of all this, Arya’s father said, is that cash flows and financial analysis are a
bit mysterious at times – much like life itself. The formulas and other tools used to
undertake financial analysis are very specific. Unfortunately, the ambiguity of the real
world can make you wonder what to do; and, therefore make you afraid to do anything.

Success will come to you not from learning the formulas and tools, but from
understanding why and how they can be useful in an applied setting. Whether you grow
up to be a person who undertakes high level financial analysis or whether you grow up to
be a person who has to understand the high level financial analysis of others, you will
succeed only if you do the following: (1) remember the basics of financial thought and
analysis, (2) have an intuitive understanding of those basics, and (3) use your financial
and analytical skills to do the right thing.