Analytical Methods (Finance)

Front 1

Coase Theorem

Back 1

- Theory of the "Firm"
- Firms are founded to:
1) reduce contracting costs (reduces the need for several entities to contract w/ one another when everything’s included in one firm),
2) increase managerial discretion,
3) reduce transaction costs, and
4) eliminate uncertainty

i. Cost savings result from integrating inputs
ii. Beneficial to have managers immediately controlling different sectors (reduces transaction costs result from market transactions (e.g., time lags))
iii. Managers should be able to capitalize quickly on opportunities  deference to managerial discretion

Front 2

Bearle and Means

Back 2

- Management and SH interests may diverge  managers can sometimes have incentives to act in a manner different from SH desire
i. “Separation of Ownership and Control” Problem
ii. Smith’s “invisible hand’ does not necessarily apply
- Tension b/w granting managerial discretion and checking it to avoid abuse at the cost of SHs  the “central issue” in corporate law
i. E.g., Federal Securities Laws tilting power back toward SHs

Front 3

Rule of 72

Back 3

72 divided by the annual i-rate is an accurate estimate of how many years it takes money to double (i.e., increase 100%)

Front 4

Future Value equation

Back 4

FV = PV(1+r)^n

Where (r = interest rate) and (n = number of years)

Front 5

Present Value Equation

Back 5

PV = FV / (1+r)n

Where (r = interest rate) and (n = number of years)

Front 6

FV of an annuity Equation

Back 6

FV annuity = (Cash Payment) x (((1+r)^t) - 1)/r

If I put (Cash Payment) into an account earning (r) for (t) years, I will have exactly (FVAnnuity) in (t) years

Front 7

PV of an annuity equation

Back 7

PV annuity = (cash payment) x (1/r)-(1/(r*((1+r)^t))

If I put in (PVAnnuity) into an account earning (r), I can withdraw exactly (Cash Payment) a year for (t) years

Front 8

Calculating Annuity PV when first payment is received immediately

Back 8

a.Hypo: What’s the PV of 25 yearly payments of $1,000 with Payment #1 occurring immediately?
i. t = 24; add $1,000 to the final PV
b.Hypo: What’s the PV of yearly payments of $1,000 made for the next 25 years, with the first payment occurring immediately?
i. t = 25; add $1,000 to the final PV

Front 9

Calculating Annuity FV when first payment is received immediately

Back 9

a. Hypo: What’s the value, in 2 years, of 3 yearly payments of $1,000 at 5%, with the first payment occurring immediately?
i. t = 3

Front 10

Perpetuity equation

Back 10

Cash Payment = (Present Value)(r)

Front 11

Ways of Selecting Interest Rates (3)

Back 11

1) Current Return on Recipient's
2) Payor's Cost of Borrowing Funds
3) Recipients Costs of Borrowing Funds

Front 12

Current Return on Recipient’s Savings

Back 12

- Way to select interest rate
(how an individual would personally invest)

Benefits: Makes sense when tort victims withdrawing periodic lump sum damage awards

Draw Backs:
1) the recipient’s i-rate on his savings account represents the bank’s risk, therefore it can be significantly lower than the payor’s risk premium
2) IF the award is coming from a source that is a greater risk of not paying in the future than the bank (e.g., a tech company that could well tank in the near future), then this method serves to overvalue future payments

Front 13

Payor’s Cost of Borrowing Funds

Back 13

- Way to select interest rate

How it works:
1) Pegging i-rates to the risk of the entity to be making the payments
- Low rate for payments from the Federal Gov’t
- High for most individuals, business start-ups, etc.
2) Estimate how much a firm has to pay to raise funds in the capital market
3) Greatest analytical purity
4) Applies CAPM

Applications:
1. Most analogous to the approach financial analysts follow
2. Particularly appropriate in something like a breach of contract case (reflects the risk of nonperformance)
3. Particularly appropriate where recipients sell the payor’s obligation in the market (the purchaser will consider this risk in defining the terms of the deal)

Front 14

Recipient’s Costs of Borrowing Funds

Back 14

- Way to select interest rates

ONLY applicable in situations where the payee would need to borrow the money in the interim before a sum is received in the future

Front 15

Risks that cannot be Diversified away

Back 15

risk that is attributable to general market conditions or fluctuations in the general economic system which affect ALL investments (thereby not eliminable by diversification)
- a/k/a “market” or “systemic” risk

Front 16

CAPM Theory (definition)

Back 16

Postulates that, by looking to the manner in which a particular company’s stock has varied in relationship to the general market in the past, analysts can determine how capital markets will value the stock now and in the future

Front 17

CAPM equation

Back 17

Expected Return on a Stock = (Risk-free i-rate) + (β x Market Risk Premium)-

- Creates a line with a y-intercept at the t-bill rate

Front 18

β (from CAPM) (definition)

Back 18

- relationship b/w an individual stock’s movements and general market fluctuation
- shorthand for a company’s market risk
1.Popular technique for estimating the non-diversifiable risk (market risk) of individual stocks
2.Measures the stock’s fluctuations (volatility) compared to the market

Front 19

β Numerical meanings (3)

Back 19

1) β = 1.0  Stock has average market risk
2) β > 1.0 --> Stock is more volatile than the market average. Stock tended to go up more in strong markets and go down more in bad markets
3) β < 1.0 --> Stock is less volatile than the market average

Front 20

Efficient Market Hypothesis (types)

Back 20

1) Weak form
2) Semi-strong form
3) Strong form

Front 21

Weak Form

Back 21

Prices reflect all past price information
- Most agree this doesn’t work

Front 22

Semi-Strong Form

Back 22

Prices reflect all past price information and all current public information
- Postulates that the only cause of systematic returns on different investments deals w/ the risk of those firms
- Stock prices reflect anticipation

Counterargument: Bubbles; people aren’t always right; people lose money betting on bubbles

Front 23

Strong Form

Back 23

Prices include past price information, public information, and private (insiders’) information

Counterargument: Insiders make their money precisely b/c information isn’t available publicly

- Never empirically proven

Front 24

Pre-Interest Judgment (definition)

Back 24

Entitles Plaintiffs to the interest on the amount received from when the harm occurred, not just from the time the judgment is entered

Front 25

Arguments in Favor of Granting Pre-Judgment Interest (2)

Back 25

1) Compensatory: Necessary to fully compensate victims (they’re being under-compensated w/o it)
- Absence would prohibit defendants from earning amounts they would’ve received had they been able to invest as intended

2) Deterrence: Entices defendant’s to be efficient and not delay litigation
- BUT, it serves to punish defendants for delays that are not their fault…
- BUT, can encourage plaintiff’s to refuse reasonable settlement opportunities
- However, if D can invest the judgment at interest rates higher than the CT-prescribed pre-judgment rate, the award may not punish defendants as much
- Facilitates settlement

Front 26

Approaches to Pre-litigation Judgment Interest (3)

Back 26

1) Traditional
2) Discretionary Approach
3) Mandatory Prejudgment Interest

Front 27

Traditional Approach to Pre-litigation judgment

Back 27

Pre-judgment interest for liquidated damages
- Some states still ONLY allow for this
- Interest rates prescribed in contracts, as well as specific circumstances prescribed by law (e.g., bonds, defendant’s unnecessary delay at trial, etc.)

Front 28

Discretionary Approach

Back 28

- Federal courts in non-diversity cases allow judicial discretion absent statutory language otherwise (no set i-rate)
- Most states award a considerable amount of judicial discretion as well

Counterargument: Punishes defendant for his right to trial

Front 29

Mandatory Prejudgment Interest

Back 29

- State affixed interest rate (e.g., t-bill or t-bill + 2%)
- Posner: Should reflect the defendant’s availability to return
- Tort reform in several States: awarded in most contexts, but limited to a relatively low rate (lower than the rate at which most would invest)

Front 30

Damage Awards that Receive Prejudgment Interest (3)

Back 30

1) Liquidated Damages
- Most states only allow prejudgment interest for liquidated damages
- Accumulation begins when the complaint is filed, NOT necessarily at the time the harm occurs as it Would prevent defendant from controlling interest accumulation (i.e., efficient disposition of the case would do nothing in such a context)

2) Punitive Damages
- Most states prohibit prejudgment interest here
- Rationale: Interest is intended for compensation; punitive damages do not serve a compensatory function

3) Pain and Suffering Awards
- Theory that juries already award significant awards if the plaintiff has so suffered for awhile, therefore interest wouldn’t serve a compensatory function
- Most states prohibit interest on non-pecuniary damages

Front 31

Discounting Judgments (generally)

Back 31

General Principle of Compensatory Damages: An injured person is entitled to be placed as nearly as possible in the position he would have occupied had it not been for the defendant’s tort

JoShep: Courts typically use the risk-free T-Bill rate when discounting awards, which makes initial awards higher

Rationale: CTs don’t require plaintiffs to invest in risky investments in order to obtain the full amount due to them

Goal: Give the plaintiff a lump-sum amount that he can invest and draw from periodically that, at a certain specified time, will be reduced to 0 (like an annuity)

Front 32

Uncertainties Prevalent When Discounting Judgments (4)

Back 32

1) Inflation
2) Salary/Wage Increases
3) Income Taxes
4) Life Expectancies

Front 33

Inflation (Uncertainties Prevalent When Discounting Judgments)

Back 33

The Fed predicts in 10 years out, but they also readjust those figures every quarter

Front 34

Salary/Wage Increases (Uncertainties Prevalent When Discounting Judgments)

Back 34

Sources of Information:
a. Experts (e.g., economists)
b. Bureau of Labor Statistics
c. The Employer
d. Average past increases

Front 35

Income Taxes (Uncertainties Prevalent When Discounting Judgments)

Back 35

- Majority Js: Don’t consider taxes at all for future wages, but do for past wage awards
- Minority Js: Flexible rule allowing that taxes can be fairly-easily estimated
- USSC: Consider income taxes and taxes on interest

Front 36

Life Expectancies (Uncertainties Prevalent When Discounting Judgments)

Back 36

– look at the Life and Work Expectancy Tables

Front 37

Approaches to Discounting Judgments (3)

Back 37

1) Feldman Approach (Partial Offset Method)
2) Culver Approach
3) Alaska Rule (Total Offset Method)

Front 38

Tort Damage Types (4)

Back 38

1) Punitive Damages
2) Pain and Suffering
3) Death Damages
4) Hedonic Damages

Front 39

Punitive Damages (purpose)

Back 39

- Primary purpose is deterrence and punishment, NOT compensation
- Another purpose may be to penalize a party not only for the times he’s caught, but for the times he avoids getting caught (i.e., offsetting the likelihood someone will not be brought to justice)

Front 40

Punitive Damages (Problems)

Back 40

Arbitrary and undisciplined awards

Front 41

Punitive Damages (reforms)

Back 41

- 41 states have CAPPED punitive damage awards
- Suggestions to improve the administration of punitive damage awards, thereby rendering caps potentially unnecessary:
1.Removing discretion from juries and giving it to judges
2. Require judges to compare awards to past awards in similar situations
3. Develop a schedule for punitive damages

Front 42

Pain and Suffering Damages (Goals)

Back 42

Compensation and Deterrence

Front 43

Pain and Suffering Damages (Uses)

Back 43

1) physical pain,
2) mental anguish (including fear, anxiety, and embarrassment),
3) inconvenience (loss of bodily function),
4) loss of pleasure and enjoyment of life,
5)altered personality,
etc.

Front 44

Pain and Suffering (Amounts Minority)

Back 44

Juries told to award the fair amount of compensation that would reasonably compensate plaintiff for his pain and suffering on a daily basis

Front 45

Pain and Suffering (Amounts Majority)

Back 45

Minority language + an equation (e.g., this person is expected to live 18 more years, etc.)

Per diem argument: determining a compensatory amount that compensates plaintiff for each day, multiplied by the number of days expected to remain in plaintiff’s life

Front 46

Pain and Suffering (reform suggestions) (2)

Back 46

1) Schedule or guidelines
2) Caps on damages

Front 47

Argument for Pain and Suffering Caps (3)

Back 47

1) Pain and suffering damages increase the costs from everyone in society
i. Manufacturers pass the cost on to consumers in the form of higher Pain and Sufferingprices
ii. Comparable to compulsory insurance
2) If you don’t insure yourself against pain and suffering, you shouldn’t be reimbursed for it
3) Predictable pain and suffering awards are necessary for companies to be able to calculate risks in cost benefit analyses (which facilitates to settlement)

Front 48

Argument against Pain and Suffering Caps

Back 48

Because certain groups (e.g., those typically unemployed: women, minorities, the old and the young) have the majority of their damage awards in the form of non-economic awards, their damages are lowered more than those typically employed

Front 49

Survival Statutes

Back 49

the actions of a deceased survive with dependents of his estate
- Include costs incurred by the deceased (medical expenses, pain and suffering before death, earnings lost b/w injury and death, and punitive damages)

Front 50

Death Damages

Back 50

- Generally include lost earnings
- Can also include
1) value of life damages,
2) non-economic damages to dependents for loss of consortium and mental anguish, etc.

Front 51

Death Damages (types) (3)

Back 51

1.Workers: Income minus taxes and consumption (often done by statute)

2. Individuals With No Income:
- Non-economic damages (loss of consortium, etc.)
- Contribution of services for economic value (new trend)
i. E.g,. Value of replacement services: nanny, cook, etc.

3. Children: lost financial contributions by children to parents
- Most states offset economic damages from this contribution by the money saved through not contributing toward that child’s education
- Also consider the parent’s age, i.e. how long they would’ve been received contributions from the child
i. ALSO considered with the child’s age; i.e., if the child is 17, he wouldn’t be relying on parental contribution for much longer

Front 52

Loss of Consortium Damages

Back 52

– traditionally only for spouses (loss of enjoyment of the marriage relationship)
- NOW, children can recover from the death of a child, and vice versa
- For a child, this is where a lot of the damages would be
- New trend: people in committed relationships (e.g., homosexual couples)

Front 53

Hedonic Damages (definition)

Back 53

The value of pleasure, satisfaction, and utility that humans derive from life
i. Represents that people can suffer from more than mere lost earnings

Front 54

Hedonic Damages (Rationale)

Back 54

- deterrence
- Also a rationale of valuing life as much as possible, but this is clearly secondary to deterrence. I.e., if one has to may more money, they will have less incentive to act