Islamic Wealth Management MIBF – 4 th Semester Non-Banker Mujeeb BeigÂ

1. Islamic Wealth Management MIBF – 4th SemesterNon-Banker Mujeeb Beig 

2. There are several problems with using P/E analysis: • Earnings are historical cost accounting numbers and may be of differing quality. • Business cycles may affect P/E ratios. Currently reported earnings may be quite different from your expectations of earnings in the future (E1). • Also, like the infinite growth model, when k < g, the model cannot be used. Explain the components of an investor’s required rate of return (i.e., the real risk-free rate, the expected rate of inflation, and a risk premium) and discuss the risk factors to be assessed in determining a country risk premium for use in estimating the required return for foreign securities. As we have discussed, the required rate of return on equity, k, is influenced by: • The real risk-free rate (RFRreal), which is determined by the supply and demand for capital in the country. The real risk-free rate is the rate investors would require if there were absolutely no risk or inflation. 2

3. • An inflation premium (IP), which investors require to compensate for their expected loss of purchasing power. • A risk premium (RP) to compensate investors for the uncertainty of returns expected from an investment. Since different investments have different patterns of return and different guarantees, risk premiums can differ substantially. k = required rate of return = (1 + RFRreal)(1 + IP)(1 + RP) – 1 k = required rate of return (approximate) ≈ RFRreal + IP + RP The real risk-free rate and the inflation premium together comprise the nominal risk-free rate, RFRnominal. That is: RFRnominal = (1 + RFRreal)(1 + IP) – 1 This may be approximated as: RFRnominal = RFRreal + IP Professor’s Note: A real rate is a rate that does not include inflation, while a nominal rate does. If a rate is not specified as being a real rate on the exam, it is safe for you to assume that it is a nominal rate.

4. The risk premium, RP, is a premium demanded for internal and external risk factors. Internal risk factors are diversifiable and include business risk, financial risk, liquidity risk, exchange-rate risk, and country risk. External risk factors, known as market risk factors, are macroeconomic in nature and are nondiversifiable. Example: Computing the nominal risk-free rate Calculate the nominal risk-free rate if the real risk-free rate is 4 percent and the expected inflation rate is 3 percent. Answer: RFRnominal = (1.04)(1.03) – 1 = 1.0712 – 1 = 7.12% Alternatively, the nominal rate is frequently approximated by summing the real rate and expected inflation: RFRnominal = 4% + 3% = 7%

5. The required rate of return on any investment is a combination of the nominal risk-free rate plus a risk premium. For equity investments, the risk premium can be determined by reference to a risk premium curve or by using the capital asset pricing model: k = RFRnominal + RP Using the capital asset pricing model (CAPM), we have: k = RFR +  [E(Rmkt) – RFR] Professor’s Note: Notice here that RFR is a nominal rate. Estimating the Required Return for Foreign Securities Security valuation models and their variables are essentially the same all over the world. However, there are significant differences in the determination of these variables. To estimate the required rate of return for foreign securities, we can calculate the real risk-free rate, adjust it for the expected inflation rate, then determine the risk premium.

6. The country risk premium is estimated with consideration of five types of risk that will differ substantially from country to country. • Business risk represents the variability of a country’s economic activity, along with the degree of operating leverage for firms within the country. • Financial risk will be different in countries throughout the world. • Liquidity risk is often found in countries with small or inactive capital markets. • Exchange rate risk, the uncertainty in exchange rates, must always be taken into account when considering foreign investments. • Country risk arises from unexpected economic and political events. Estimate the implied dividend growth rate, given the components of the required return on equity and incorporating the earnings retention rate and current stock price. Assuming past investments are stable and dividends are calculated to allow for maintenance of past earnings power, the firm’s earnings growth rate, g, can be defined as the firm’s earnings plowback or retention rate (RR) times the return on the equity (ROE) portion of new investments.

7. g = (RR)(ROE) Note that if RR is the earnings retention rate, (1 – RR) must be the firm’s dividend payout rate. Professor’s Note: Recall that we used the DuPont method to decompose ROE into its component parts: net profit margin × asset turnover × financial leverage = ROE. You can use these components, along with the retention rate, to calculate ROE × RR = g, the implied (sustainable) growth rate. Let’s work through an example to illustrate why g equals RR × ROE for a stable but expanding company. Example: Sustainable growth Assume ROE is constant and that new funds come solely from earnings retention. Calculate the firm’s growth rate, given that the firm earns 10 percent on equity of $100 per share and pays out 40 percent of earnings in dividends.

8. Answer: Period 1 per share earnings = EPS1 = ROE × Equity per share = (0.10)($100) = $10 per share Period 1 dividend per share = D1 = payout × EPS1 = (0.40)($10) = $4.00 per share Period 1 retained earnings = RR1 × EPS1 = ($10)(1 – 0.4) = $6.00 per share so, Period 2 earnings per share = (0.10)($100) +(0.10)($6) = $10.60 per share Period 2 dividend per share = D2 = (0.40)($10.60) = $4.24 per share Analysis of growth: Earnings growth = (EPS1 – EPS2) / EPS1 = ($10.60 – $10) / $10 = 6% Dividend growth = ($4.24 – $4) / $4 = 6% Analysis of stock price: assume k = 10% Price at the beginning of period 1 = D1/(k – gc) = $4.00/(0.10–0.06) =$100 Price at the beginning of period 2 = D2/(k – gc) = $4.24/(0.10–0.06)= $106

9. The stock’s price will grow at a 6 percent rate, just as earnings and dividends will. growth = gc = (ROE) (Retention rate) = (0.1)(1 – 0.4) = 6% The growth rate here, gc = ROE × RR, is called the internal or sustainable growth rate—the rate of growth sustainable without resorting to external sources of capital (relying on retained earnings only). So, what we know about dividend growth can be summarized as follows: • If a firm’s profit margin increases, ROE will increase. • If ROE increases, g, which is (ROE)(RR), will increase. • If g increases, the difference between k and g will decrease. • If k – g decreases, the price of the stock will increase. Describe a process for developing estimated inputs to be used in the DDM, including the required rate of return and expected growth rate of dividends. As we have indicated, the DDM holds that the value of a share of stock is the present value of its cash flows.

10. Thus, the DDM requires the following three inputs: • An estimate of the stock’s future cash flows, which are dividends and future price. • A dividend growth rate, g. • A discount rate, which is the appropriate required return on equity, k. Once the present value of the asset has been estimated, compare it to the current market price. Example: Application of DDM Assume you are analyzing the XYZ company. Its current stock price is $18.00. After reviewing XYZ’s financial data, you find that last year’s earnings were $2.00 per share. The firm’s ROE is 10 percent, and you expect it to stay that way for the foreseeable future. The firm has a stable dividend payout policy of 40 percent. The current nominal risk-free rate is 7 percent, the expected market return is 12 percent, and XYZ’s beta is 1.2. Calculate the value of XYZ and indicate whether this stock is a “buy” based on your estimate.

11. Answer: Step 1: Determine the required rate of return: k = 0.07 + 1.2(0.12 – 0.07) = 13% Step 2: Determine the growth rate: Step 2a: RR = (1 – dividend payout) = 1 – 0.4 = 0.6 Step 2b: g = (RR)(ROE) = (0.6)(0.10) = 0.06 or 6% Step 3: Determine last year’s dividend: D0 = E0(dividend payout ratio) = $2(0.4) = $0.80 Step 4: Determine next year’s dividend: D1 = D0(1 + gc) = $0.80(1 + 0.06) = $0.85 Step 5: Estimate the value: V0 = D1/(k – gc) = $0.85/(0.13 – 0.06) = $12.14 Professor’s Note: Rounding differences may occur, not unlike those you might encounter on the exam. Step 6: Compare the stock’s value to its current market price: $12.14 vs. $18.00

12. Do not buy and possibly sell this stock short. • If estimated value > market price → buy • If estimated value < market price → don’t buy • Key Concepts • 1. The top-down approach to security valuation has three steps: • • Forecast the influence of the general economy on the securities markets. • • Analyze the prospects for the various industries under your economic forecast. • • Analyze the individual firms in the industries under your economic forecast. • 2. The returns from any investment can be measured as price change (capital gain/loss), cash income (i.e., interest, dividends, rental income, etc.), earnings, or a variety of cash flow measures for equities. • 3. The preferred stock valuation model:

13. 4. The calculation of the value of common stock can take different forms: • • One period stock valuation model: • • A multiple-year holding period: • • Infinite period model: • 5. For a firm with supernormal growth (g1) over n periods followed by a constant growth rate of dividends forever (g2) can be valued as: • where: D1 = D0 (1 + g1) … Dn = D0 (1 + g1)n and Dn + 1 = Dn (1 + g2)

14. 6. By dividing both sides of the infinite period DDM by E1, it can used as an earnings multiplier model: 7. The relationship between the nominal risk-free rate, the real risk-free rate, and the expected rate of inflation is: nominal risk-free rate = (1 + real risk-free rate)(1 + expected inflation) – 1. 8. The firm’s internal or sustainable growth rate, g, is equal to ROE × RR. RR is the firm’s retention rate, so (1 – RR) is the firm’s dividend payout rate.

15. INTRODUCTION TO PRICE MULTIPLES Discuss the rationales for the use of price to earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash flow (P/CF) in equity valuation and discuss the possible drawbacks to the use of each price multiple. Calculate and interpret P/E, P/BV, P/S, and P/CF. Professor’s Note: This review is organized according to the types of price multiples. The LOS are addressed within each category. Rationales for using price-to-earnings (P/E) ratios in valuation: • Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value. • The P/E ratio is popular in the investment community. • Empirical research shows that P/E differences are significantly related to long-run average stock returns.

16. The drawbacks of using the P/E ratio are: • Earnings can be negative, which produces a useless P/E ratio. • The volatile, transitory portion of earnings makes the interpretation of P/E difficult for analysts. • Management discretion within allowed accounting practices can distort reported earnings and thereby lessen the comparability of P/E ratios across firms. We can define two versions of the P/E ratio: trailing and leading P/E. The difference between the two is how earnings (the denominator) are calculated. Trailing P/E ratios use earnings over the most recent 12 months in the denominator. The leading P/E ratio (also known as forward or prospective P/E) uses “next year’s expected earnings,” which is defined as either expected earnings per share (EPS) for the next four quarters or expected EPS for the next fiscal year.

17. Professor’s Note: The trailing P/E is what we see published in much of the popular financial press. The leading P/E, P0/E1, is the one we calculated from the DDM. Example: Calculating a P/E ratio Byron Investments, Inc., reported EUR32 million in earnings during fiscal year 2003. An analyst forecasts an EPS over the next 12 months of EUR1.00. Byron has 40 million shares outstanding at a market price of EUR18.00 per share. Calculate Byron’s trailing and leading P/E ratios. Answer:

18. Advantages of using the price-to-book ratio (P/BV) include: • Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a P/BV can typically be used when P/E cannot. • Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile. • Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include finance, investment, insurance, and banking firms. • P/BV can be useful in valuing companies that are expected to go out of business. • Empirical research shows that P/BV ratios help explain differences in long-run average returns. Disadvantages of using P/BV include: • P/BV ratios do not recognize the value of nonphysical assets such as human capital.

19. • P/BV ratios can be misleading when there are significant differences in the asset intensity of production methods among the firms under consideration. • Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/BV ratios across firms and countries. For example, research and development costs (R&D) are expensed in the U.S., which can understate investment and overstate income over time. • Inflation and technological change can cause the book and market value of assets to differ significantly, so book value is not an accurate measure of the value of the shareholders’ investment. This makes it more difficult to compare P/BV ratios across firms. The price-to-book ratio is defined as: where: book value of equity = common shareholders' equity = (total assets – total liabilities) – preferred stock

20. We often make adjustments to book value in order to allow the P/BV ratio to more accurately measure the value of the shareholders’ investment and to create more useful comparisons across different stocks. A common adjustment is to use tangible book value, which is equal to book value of equity less intangible assets. Examples of intangible assets include goodwill from acquisitions (which makes sense because it is not really an asset) and a patent (which is more questionable since the asset and patent are separable). Furthermore, balance sheets should be adjusted for significant off-balance-sheet assets and liabilities and for differences between the fair and recorded value of assets and liabilities. Finally, book values often need to be adjusted to ensure comparability. For example, companies using the first in, first out (FIFO) inventory accounting method cannot be accurately compared with peers using the last in, first out (LIFO) method. Thus, book values should be restated on a consistent basis. Example: Calculating a P/BV ratio Based on the information in the table, calculate the current P/BV for Cisco Systems Inc. and Oracle Corp.

21. Figure: Data for Cisco Systems and Oracle Corp. Answer: Cisco Systems Inc.: Oracle Corp.:

22. The rationales for using the P/S ratio include: • P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/BV ratios, which can be negative. • Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions. • P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis. • P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and for start-up companies with no record of earnings. • Like P/E and P/BV ratios, empirical research finds that differences in P/S are significantly related to differences in long-term average stock returns. The disadvantages of using P/S ratios are: • High growth in sales does not necessarily indicate operating profits as measured by earnings and cash flow. • P/S ratios do not capture differences in cost structures across companies.

23. • While less subject to distortion than earnings or cash flows, revenue recognition practices can still distort sales forecasts. For example, analysts should look for company practices that speed up revenue recognition. An example is sales on a bill-and-hold basis, which involves selling products and delivering them at a later date. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio. P/S multiples are computed by dividing a stock’s price per share by sales or revenue per share or by dividing the market value of the firm’s equity by its total sales: Example: Calculating a P/S ratio Based on the information in the table, calculate the current P/S for Cisco Systems Inc. and Oracle Corp.

24. Figure: Data for Cisco Systems and Oracle Corp. Answer: Cisco Systems Inc.: Oracle Corp.:

25. Rationales for using the P/CF ratio include: • Cash flow is harder for managers to manipulate than earnings. • Price to cash flow is more stable than price to earnings. • Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings, which is a problem for P/E. • Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long-run average stock returns. There are two drawbacks to the price to cash flow ratio, both of which are related to the definition of cash flow used. We discuss the specific cash flow definitions next. • Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored. • From a theoretical perspective, free cash flow to equity (FCFE) is probably preferable to cash flow. However, FCFE is more volatile than straight cash flow.

26. Professor’s Note: Free cash flow to equity is the cash flow available to common stockholders after all operating expenses, interest and principal payments, investment in working capital, and investments in fixed assets. Calculating P/CF Ratios. There are at least four definitions of cash flow available for use in calculating the P/CF ratio: earnings-plus-noncash charges (CF), adjusted cash flow (adjusted CFO), free cash flow to equity (FCFE), and earnings before interest, taxes, depreciation, and amortization (EBITDA). Expect to see any one of them on the exam. One commonly used proxy for cash flow is earnings-plus-noncash charges (CF): CF = net income + depreciation + amortization The limitation of this definition, as we mentioned previously, is that it ignores some items that affect cash flow, such as noncash revenue and changes in net working capital.

27. Another proxy for cash flow is cash flow from operations (CFO) from the cash flow statement. The limitation of CFO, however, is that it includes items related to financing and investing activities. Therefore, analysts often adjust CFO by adding back the after-tax interest cost: Adjusted CFO = CFO + [(net cash interest outflow)  (1 – tax rate)] In addition, analysts sometimes further adjust CFO for items that are not expected to persist in the future. Analysts also often use FCFE and EBITDA as proxies for cash flow. As we mentioned above, theory suggests that FCFE is the preferred way to define cash flow, but it is more volatile than straight cash flow. EBITDA is a pretax, pre-interest measure that represents a flow to both equity and debt. Thus it is better suited as an indicator of total company value than just equity value. More on this point is provided in our discussion of the Enterprise Value to EBITDA ratio. Analysts typically use trailing price to cash, which relies on the most recent four quarters of cash flow per share.

28. Given one of the four definitions of cash flow, the P/CF ratio is calculated as: where: cash flow = CF, adjusted CFO, FCFE, or EBTIDA Example: Calculating P/CF Data Management Systems, Inc. (DMS) reported net income of USD32 million, depreciation and amortization of USD41 million, net interest expense of USD12 million, and cash flow from operations of USD44 million. The tax rate is 30 percent. Calculate the P/CF ratio using CF and adjusted CFO as proxies for cash flow. DMS has 25 million shares of common stock outstanding, trading at USD47 per share. Answer: CF = USD 32 million + USD 41 million = USD 73 million adjusted CFO = USD 44 million + [(USD 12 million)(1 – 0.30)] = USD 52.4 million

29. market value of equity = 25 million shares USD47 per share = USD1,175 million • KEY CONCEPTS • 1. Advantages of using P/E ratios in valuation are: • • Earnings power is the primary determinant of investment value. • • The P/E ratio is popular in the investment community. • • Empirical research shows that P/E differences are significantly related to long-run average stock returns. • 2. Disadvantages of using P/E ratios in valuation are: • • Earnings can be negative, which produces a useless P/E ratio. • • The volatile, transitory portion of earnings makes the interpretation of P/E ratios difficult for analysts. • • Management discretion within allowed accounting practices can distort reported earnings.

30. 3. The following are advantages of using P/BV: • • Book value is a cumulative amount that is usually positive even when EPS is negative. • • Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile. • • Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets, including finance, investment, insurance, and banking firms. • • P/BV can be useful in valuing companies that are expected to go out of business. • • Empirical research shows that P/BV ratios help explain differences in long-run average returns.

31. • The discounted after-tax cash flow model links the value of a property to an investor’s specific marginal tax rate. The net present value of an investment equals the present value of after-tax cash flows, discounted at the investor’s required rate of return, minus the equity portion of the investment. Only those projects with a positive expected net present value would make financial sense. Professor’s Note: When we are calculating after-tax cash flow, after-tax refers to the investor’s marginal tax rate. Calculate the net operating income (NOI) from a real estate investment. Net operating income (NOI) is defined as the gross operating income less estimated vacancy, collections, and other operating expenses. Example: Real estate net operating income An investor is considering the purchase of a small office building and, as part of his analysis, must calculate the NOI. The information on the building is as follows:

32. Gross potential rental income: $250,000 Estimated vacancy and collection loss rate: 5% Insurance: $10,000 Taxes: $8,000 Utilities: $7,000 Maintenance: $15,000 Answer: NOI = $250,000 – ($250,000 × 0.05) – $10,000 – $8,000 – $7,000 – $15,000 = $197,500 Professor’s Note: Be aware that depreciation and financing costs are not factors in the calculation of NOI. It is assumed that maintenance will keep the property in good condition, and the value of the property is independent of any financing arrangements. Also note that the taxes that are relevant to the calculation of NOI for real estate are property taxes.

33. Calculate the value of a property using the sales comparison and income approaches. The sales comparison approach is based on sales prices of comparable properties. Valuation can then be done relative to a specific similar property or relative to a benchmark such as the mean or median home price in the area. Then additions (e.g., for more square feet) and subtractions (e.g., for poor locations) are made to estimate the value of the subject property. Another approach under the general heading of sales comparison methods (hedonic price estimation) involves regressing the sales prices of properties on the key property characteristics that influence the value of a property. The slope coefficients estimated by the regression can then be used to estimate the value of the subject property. The regression equation is used like any multiple regression model; the values of the independent (right-hand side) variables for the subject property are multiplied by the estimated slope coefficients to estimate its value.

34. The income approach is based on taking the present value of the stream of annual NOI, assuming it is an infinite stream, using the required rate of return or “cap rate” estimated for the property. These approaches are illustrated in the following two examples. Example: Real estate valuation Continuing the previous example, the investor has obtained additional information regarding other recent sales of comparable office buildings in the vicinity. The investor can use the comparable sales information in a hedonic price model to estimate a current appraised value of the property. Assuming a current market cap rate of 10 percent, compute the value of the property using (1) the sales comparison approach and (2) the income approach. Slope Coefficient CharacteristicsUnitsin $ per Unit Proximity to downtown In miles –50,000 Vacancy rate Percentage –35,000 Building size Square feet 40

35. The potential investment is half a mile from downtown, has an estimated vacancy rate of 4 percent, and is 50,000 square feet. Answer 1: Sales comparison approach Using the price model, the estimated appraised value would be: value = (–50,000 × 0.5) + (–35,000 × 0.04) + (40 × 50,000) = $1,973,600 Answer 2: Income approach Using the income approach, the appraised value of the property equals the NOI divided by the market cap rate and can be calculated as: appraisal price = NOI / market cap rate = $197,500 / 0.10 = $1,975,000 Calculate the after-tax cash flows, net present value, and yield of a real estate investment. Example: Computing after-tax cash flows, NPV, and yield for real estate Continuing the previous example, assume the investor purchases the building for $1,850,000, putting down 20 percent cash and financing

36. the remainder with a long-term mortgage at a rate of 10 percent. The annual payments on the mortgage are $156,997, and the interest portion is fully deductible for income tax purposes. The investor’s marginal income tax rate is 28 percent. Depreciation per year, using the straight-line method, is estimated to be $45,000 per year. Calculate the after-tax cash flows, net present value, and the yield of the investment. Answer: After-tax cash flow: The first year’s interest payment of $148,000 is calculated as the amount borrowed ($1,480,000) times the interest rate of the loan. After-tax net income (NOI less depreciation, less interest, net of taxes) is ($197,500 – 45,000 – 148,000) × (1 – 0.28) = $3,240. After-tax cash flow can be determined by adding depreciation back to and subtracting the principal component of the mortgage payment from the after-tax net income number. For this investment, the year 1 after-tax cash flow is $3,240 + $45,000 – $8,997 = $39,243.

37. Net present value: Three years forward, the investor plans to sell the building for $1,950,000. The remaining mortgage balance at payoff is $1,450,000. Assume that the cost of equity is 10% and the net cash flows for the investment are as follows: Year 1: $39,243 Year 2: $38,991 Year 3: $538,721 (year of sale, net of mortgage payoff, no capital gains tax) The present value of the cash flows is: ($39,243 / 1.10) + ($38,991 / 1.102) + ($538,721 / 1.103) = $472,649 The NPV is the present value of the cash flows minus the initial investment: $472,649 – $370,000 = $102,649 Yield: In summary, the cash flows of the investment are: Year 0 –$370,000 = CF0 Year 1 $39,243 = CF01

38. Year 2 $38,991 = CF02 Year 3 $538,721 = CF03 CPT → IRR = 20.18% WARM-UP: VENTURE CAPITAL Venture capital investments are private, non-exchange traded equity investments in a business venture. Investments are usually made through limited partnerships, with investors anticipating relatively high returns in exchange for the illiquidity and high-risk profile of a venture capital investment. Investments may be made at any point of the business cycle of the company, from the initial planning stages of a new venture to an established firm ready to go public. Explain the various stages in venture capital investing. The stages of venture capital investing, which overlap somewhat, are as follows: • Seed stage. Investors are providing capital in the earliest stage of the business and may help fund research and development of product ideas.

39. • Early stage. Early stage financing includes: •  Start-up financing, which typically refers to capital used to complete product development and fund initial markets. •  First stage financing, which refers to the funding of the transition to commercial production and sales of the product. • • Formative stage. Broad category which encompasses the seed stage and early stage. • • Later stage. Marketable goods are in production and sales efforts are underway, but the company is still privately held. Within the later stage period, second-stage investing describes investments in a company that is producing and selling a product but is not yet generating income. Third-stage financing would fund a major expansion of the company. Mezzanine or bridge financing would enable a company to take the steps necessary to go public. • Broad terms, such as “expansion stage financing,” are used to describe the second and third stage, while the term “balanced stage” covers all stages, from seed through later stage.

40. Discuss venture capital investment characteristics and the challenges to venture capital valuation and performance measurement. Venture capital investment characteristics (may have some or all of the following): • Illiquidity. Investors’ ability to cash out is dependent upon a successful IPO, which probably will not occur in the short term, if ever. • Long-term investment horizon. Market conditions must be conducive for a public offering, and the company most likely must be at a profitable point in order for investors to recognize returns on their investment. • Difficulty in valuation. Because of the uniqueness of each investment, there are few comparable assets with meaningful trading volume available for market value comparisons. • Limited data. There is not much comparable historical risk and return data, nor is there much information on which to base future cash flows and earnings estimates. There also is insufficient information on what competing ideas or products other entrepreneurs may be developing. • Entrepreneurial/management mismatches. Entrepreneurs with good ideas don’t always necessarily evolve into good managers as their company grows.

41. • Fund manager incentive mistakes. The primary incentive for fund managers must be performance, not size or some other criteria. • Timing in the business cycle. Market conditions are a primary determinant of the timing of market entrance and exit strategies. • Requirement for extensive operations analysis. A successful venture capital manager must act as both a financial and operations advisor to the venture. Valuing and measuring the performance of a venture capital investment is tricky at best, due to the large probability of failure plus the overall uncertainty as to amount and timing of cash flows. The three most important factors that must be assessed are the expected payoff at exit, timing of exit, and the probability of failure. Prior to exit (or failure), evaluation of the venture’s performance must be made, although precise measurement is challenging. Difficulties include deriving accurate valuations, establishing benchmarks, and lacking reliable performance measures.

42. Calculate the net present value (NPV) of a venture capital project, given the project’s possible payoff and conditional failure probabilities. Example: Computing NPV for a venture capital opportunity A venture capital fund manager is considering investing $2,500,000 in a new project that he believes will pay $12,000,000 at the end of five years. The cost of equity for the investor is 15 percent, and the estimated probability of failure is presented in Figure. These are conditional probabilities since they represent the probability of failure in year N, given that the firm has survived to year N. Figure: Estimated Probability of Failure Calculate the NPV of the potential investment.

43. Answer: The probability that the venture survives for five years is calculated as: (1 – 0.20)(1 – 0.20)(1 – 0.17)(1 – 0.15)(1 – 0.15) = 0.3838 = 38.38% Under the original assumptions that the investment pays $12,000,000 at the end of year 5, the NPV of a successful project is –$2,500,000 + ($12,000,000 / 1.155) = $3,466,121. The NPV of the project if it fails is –$2,500,000. The expected NPV of the project is a probability-weighted average of the two possible outcomes: (0.3838 × $3,466,121) + (0.6162 × –$2,500,000) = –$210,203 The fund manager would not invest in the new project due to the negative expected NPV.

44. Discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in terms of objectives, legal structure, and fee structure, and describe the various classifications of hedge funds. Hedge funds today utilize a wide variety of strategies, which may or may not utilize hedging techniques to reduce or eliminate risk. The term “hedge fund” does not begin to describe this broad asset class that has evolved over the past two decades. The common objective of hedge funds is that they strive for absolute returns. That is to say that hedge funds are not constrained by the fact that they must perform relative to some specific benchmark or index and simply seek to maximize returns in all market scenarios. Most hedge funds are in the form of either a limited partnership, a limited liability corporation, or an offshore corporation. In the U.S., limited partnerships that abide by certain guidelines (regarding the maximum allowable number of investors, the “qualifications” of the investors, and the prohibition of advertising) are exempt from most SEC regulations. Because the number of investors is limited, the amount of their individual investments is relatively large, usually $200,000 or more.

45. The manager of the fund receives compensation that is comprised of two components. The base fee is typically around 1 percent of assets, and the manager receives this fee regardless of performance of the hedge fund. The second component, the incentive fee, is paid based on the actual returns of the fund. Some structures allow the manager to participate in all returns, while other structures pay the manager only if performance exceeds a target return, such as the risk-free rate. Classifications of Hedge Funds Hedge funds can usually be classified by investment strategy; however, there is a great deal of overlap among categories. Some hedge fund classifications are: • Long/short funds make up the largest category of hedge funds in terms of asset size. These funds take long and short common stock positions, use leverage, and are invested in markets worldwide. By definition they are not market-neutral but seek to profit from greater returns on the long positions than on the short positions.

46. • Market-neutral funds are a type of long/short fund that strives to hedge against general market moves. Managers may try to achieve this through any of several strategies, some involving derivatives. The fund may still have long and short positions, but the positions will offset each other so that the effect is a net zero exposure to the market. • Global macro funds make bets on the direction of a market, currency, interest rate, or some other factor. Global macro funds are typically highly leveraged and rely heavily upon derivatives. • Event-driven funds strive to capitalize on some unique opportunity in the market. This may involve investing in a distressed company or in a potential merger and acquisition situation. Discuss the benefits and drawbacks to fund of funds investing. Fund of funds investing involves creating a fund open to both individuals and institutional investors, which in turn invests in hedge funds.

47. Benefits. Funds of funds enable investors with limited capital to invest in a portfolio of hedge funds. Likewise, investors with more capital can diversify their holdings by investing in several hedge funds via a fund of funds for roughly the same amount required for directly investing in a single hedge fund. Fund of funds investing may grant new investors access to hedge funds that might otherwise be closed to them due to limitations on the number of investors. A fund of funds manager will have the expertise necessary to choose high-quality hedge funds and will also perform the due diligence required by investing in hedge funds. Drawbacks. Fund of funds managers charge a management fee in addition to those fees already charged by the hedge fund manager. Diversification among hedge funds will decrease the investor’s risk but most likely his return as well, from which additional fees must be subtracted. Fund of funds managers may or may not deliver returns superior to what an investor might achieve by selecting her own hedge funds.

48. Discuss the leverage and unique risks of hedge funds. The majority of hedge fund managers utilize some form of leverage in order to enhance returns. Some arbitrage opportunities may have such a small return that leverage is necessary to make the strategy meaningful. However, leveraged positions can sometimes backfire and cause losses to be magnified. Hedge funds typically limit the amount of leverage that can be used, and fund managers are legally required to operate within the limit. One way a hedge fund can increase its leverage is by borrowing through a margin account. Also, a hedge fund manager could borrow external funds to either buy more assets or sell short more than the equity in the fund. A third way is for hedge fund managers to utilize those securities that only require posting margin versus trading in cash securities requiring full payment. Risks associated with hedge funds include: • Illiquidity. Investing in those markets with little liquidity, such as derivatives, decreases a hedge fund’s trading flexibility.

49. • Potential for mispricing. Investments in esoteric securities that trade infrequently may lead to difficulty in determining true current market value. Broker-dealers who are financing such securities tend to be conservative in their valuations, thereby increasing the amount of cash that is required to be posted by the hedge fund. • Counterparty credit risk. A broker-dealer is involved in almost every transaction a hedge fund enters into, thereby creating significant counterparty risk to the hedge fund. • Settlement errors. Hedge funds bear the risk that the counterparty will fail to deliver a security as agreed on settlement day. • Short covering. Short selling is a component of many common hedge fund strategies. Hedge fund managers run the risk that they will have to cover their shorts and repurchase securities at a price higher than where they originally sold. • Margin calls. Margin calls on an already highly leveraged position can result in forced selling of assets, possibly at a loss.

50. Discuss the performance of hedge funds, the biases present in hedge fund performance measurement, and explain the effect of survivorship bias on the reported return and risk measures for a hedge fund data base. There are numerous hedge fund indexes designed to measure historical performance; however, they may not provide much meaningful information on hedge funds as an asset class because each hedge fund’s structure is so unique. Since hedge funds are not legally required to publicly disclose performance, only those hedge funds that elect to disclose performance information are included in the indexes. Some general conclusions regarding hedge funds can be derived. • Hedge funds, as a class, have historically outperformed both U.S. equity and bond market benchmarks (S&P 500 and Lehman Brothers Government/Corporate Bond Index). • Hedge funds have demonstrated a lower risk profile than traditional equity investments as measured by standard deviation.