Ohh the CFA…

I found out late yesterday that I will be a recipient of the 2014 CFA scholarship, allowing me to pursue the charter. With this said, I will be adding a new topic area within my writings—my CFA journey. Some of these writings might be as simple as discussing the processes I am conducting to register, prepare and take the exam. Other writings might include a discussion and analysis of a particular topic; doing this will allow me to solidify my knowledge of this particular subject in turn helping me to be better prepared for exam day. I hope you enjoy.

With the above said, I will be quickly discussing my first CFA issue—the passport ID. Due to heightened identification verification processes required by the CFA Institute, all test takers must have an international travel ID prior to registering for the exam. This cannot be a passport card, it must be a passport book. I personally have had no prior reason to secure a passport, therefore I found myself spending the first half of today researching the process for obtaining a passport. I have submitted my application and according to the travel.state.gov site, they currently have an approximate four week turnaround. With the holidays, I do not expect to receive it any time before the New Year. Luckily, even if I do not receive my passport until mid-January, I will have enough time to register for the level one exam and order my study materials and still allow adequate preparation time. I guess lesson learned for today was to not procrastinate. If I would have waited a few weeks or more before looking into the exam registration process, I might have found myself tight on time for preparation.

Stay tuned for future CFA related posts. 

Goodbye Mouse, Hello Keyboard

This post is for all the Excel nerds out there; hope you enjoy.

Since the second semester of my undergraduate program, I have been a huge fan of Microsoft’s Excel. I enjoyed creating spreadsheets to track my grades and I even got really creative and made my own GPA calculator. At the time, I felt like I knew a lot about Excel; boy was I wrong.

Fast-forward a couple of years and I now in my graduate program. A lot has changed during this time, one thing being my knowledge of Excel. Through my undergraduate program I used Excel almost daily for class projects or to track something in my personal life. This left me with a great understanding of the program and some of its capabilities. However, I still had much more to learn.

Once of my goals for the first part of my graduate program was to teach myself advanced financial modeling on Excel. I have completed FactSet’s DealMaven financial modeling course and am in the early stages of working through Breaking into Wall Street’s modeling course. One common these to these programs is the reference to keyboard shortcuts, which makes sense to increase productivity. However, one comment really stood out—it was said that you should attempt to avoid using the mouse as much as possible.

This, at first, seemed near impossible; yet I still attempted it. After a few weeks of working through modeling, I find myself being able to complete more and more tasks without the need for a mouse. And let me tell you, this has drastically increased my productivity within Excel. It is amazing how much faster you can work through the creation of a model once you know the key strokes to complete common tasks.

One really great Excel add-in that helped not only increase my productivity, but also made it easy to reduce use of the mouse was Macabacus. At the time of this post, I have only used the free version add-in and it is truly amazing. They provide intuitive short-cut keys to complete common modeling tasks such as changing formatting, font floor cycle and increase/decrease decimal places. Another great feature is their advanced formula audit tools. If you have ever build or worked with an in-depth Excel model you know how important it can be to audit your formulas—Macabacus makes this daunting task seem a little bit easier.

Long story short, this add-in is amazing and well worth checking out if you are an avid Excel user. Here is the link to their site with the free download; did I mention they offer some great free models? Enjoy. 

Book Review: The Buy Side

Title: The Buy Side: A Wall Street Trader's Tale of Spectacular Excess

Author: Turney Duff

Publication Date: 06/04/2013

Author's Site            Amazon

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Sex, drugs, money and a hedge fund trader; Turney Duff’s memoir of his Wall Street career takes the reader through his unorthodox start on Wall Street, rise to fame and personal battles that came with the job that ultimately lead to his demise.

Duff begins his novel by describing the events that lead him from growing up in Kennebuck, Maine pursuing a career in journalism after graduating from Ohio University to living in New York City looking for any work possible. Through a connection fostered by his uncle, Duff is able to land a job at Morgan Stanley and begins to learn the ropes of Wall Street.

Through a combination of perseverance and sheer luck, Duff lands a place as a trader for Raj Rajaratnam’s massive hedge fund, Galleon Group. After some time at the fund, he is given the opportunity to conduct proprietary trading for the fund, and starts to see a different side of the Wall Street Culture.

As a buy side trader, expense accounts run deep and Duff finds himself being wine and dinned on a regular basis. This continues when Duff leaves Galleon to become trade for Argus Partners. However, while at Argus, he is encouraged to make stronger connects with sell-siders and begins to enjoy more of the perks being offered. His business dinners transform from a glass of wine over a streak dinner to an eight ball of coke and non-stop shots of tequila, and no party would be complete without hookers—lots of them.

Soon Duff finds himself enjoying this lifestyle a little too much. He comes to this realization after meeting the mother of his future child, Jenn. After learning he has a daughter on the way, Duff attempts to settle down and tells Jenn that he will stop using coke and drinking as much. However, Duff finds it much harder to do than he expects.

Eventually, Duff enters himself into rehab and attempts to start clean at a new firm, J.L. Berkowitz. This is short-lived. Soon he will be back to using and hiding it from everyone. He hates himself but can’t seem to stop. This will cost him more than just his buy side ji8ob. His girlfriend and mother of his child, Jenn, leaves him and he finds his two million dollar home nearing foreclosure. With an intervention from a close friend, Duff enters back into rehab.

Duff does an excellent job taking the reader through these events in a way that makes it hard to put the book down. He has opened the door to a Wall Street culture that has remained hidden from Main Street and does so in a way that excites the reader. I would highly recommend this read to anyone interested in a great story of one man’s find of excess on Wall Street. 

Leases and Their Role in Valuation

A lease is a contractual agreement in which one party (the lessor) agrees to allow another party (the lessee) use an asset for a stated period of time. In return, the lessee agrees to make fixed cash payments to the lessor. Since the title does not transfer to the lessee, this is not considered a sale and thus the asset is not recorded on the books of the lessee, rather it stays on the books of the lessor. While this makes sense, there is a problem. Leases are allowing a firm to obtain an asset in return for a future commitment of payments, this is essentially adding an asset to the firm and a corresponding liability. When a firm accounts for this transaction as a lease rather than a sale, it is essentially able to avoid putting the liability on their balance sheet; this is often referred to as “off-balance sheet financing”. This can lead to investors underestimating the liabilities a firm has and therefore poses a risk to the investing community.

Enter capital leases. Under U.S. GAAP, two forms of leasing exist. The first is an operating lease and the second being a capital lease; with the former reflecting the above discussion. Capital leases on the other hand are required to be accounting for in a different manner in which the asset and corresponding liability are reflected on the lessee’s balance sheet. A lease will be classified as a capital lease if it satisfies any one of the following requirements.

1. The life of the lease exceeds 75% of the economic life of the asset.
   (Lease a truck for 9 years that has a useful life of 10 years)
     
2. The present value all future lease commitments is greater than 90% of the current fair market value of the asset.
   (The PV of lease payments is $1,000, when the FMV of the asset is $850)  
   
   
3. The title of the asset transfers from the lessor to the lessee at the conclusion of the lease.
   (After 10 years of leasing a computer, the title of ownership transfers to the lessee) 
         
4. There is bargain purchase price option included in the lease.
   (At the end of a machinery lease, the lessee can purchase the asset for $100, despite the FMV at that time being significantly higher)

In essence, a lease that meets any of the criteria above--while not meeting the legal requirements of a sale--is an economic sale. Since this is the case, the asset being leased is removed from the books of the lessor and placed on the books of the lessee. In addition, the present value of all lease payments are considered a liability on the lessee’s balance sheet and an asset on the lessor’s. This does have a valid reasoning since these type of leases are essentially a form of capital financing and thus should be included in the liabilities section of the balance sheet. Rather than the lessee considering the payment to the lessor an expense, it is now an amortization of the liability with the difference between the payment and the amortized amount classified as interest expense (another indication of debt financing). In addition, the lessee can now depreciate the asset over its useful life.

While much more could be said about capital lease (a possible future topic), I believe from a valuation stand point it is relatively clear as to the treatment. Since they are already classified as assets and a corresponding liability, not too much more needs deep consideration. However, I do not feel the same for operating leases.

If a lease agreement does not meet any of the four criteria outlined above, it will be considered an operating lease. Under this treatment, the lessee does not record the asset nor the corresponding liability. The payments are simply considered lease expense. This is a preference for many firms, as it will give the appearance of a stronger balance sheet (lower debt); thus, it is common for firms to attempt to structure leases in a manner that will allow operating lease treatment under U.S. GAAP. One of the most common assets to be classified as operating leases, while taking on more of an appearance as capital financing, is retail real estate. Since the economic life can be very long for a retail location and the lessor generally has no interest in transferring title at the end of the lease, it is relatively easy to structure a deal in such a way that it will be classified as an operating lease.

With the above said, think about industries such appear retailers and restaurants. In these industries, many operating leases are created for the real estate being used in the ordinary course of business. While these leases are structured in such a way that they are treated as operating leases, they do constitute a large portion of the operating expenses and, in my opinion, represent a form of debt financing. I say this due to the fact that they allow the firm the use of an asset in return for a requirement of a fixed payment; sounds a whole lot like debt financing to me.  

From my perspective, it would be necessary to take the expected future payments of these leases (in many cases this figure can be found on the firm’s 10-K) and discount them to their present value and capitalize them, adding both an asset and liability to the pro-forma statements. The discount factor should be the firm’s pre-tax cost of debt for the firm (pre-tax since the payment being discounted is a pre-tax item). In addition, these payments should no longer be treated as lease expense, but as interest expense. The net effect of this process would be an increase to EBIT, EBITDA, and the weight of debt in the WACC calculation.

Since the EBIT, EBITDA and WACC all play a very important role in a DCF valuation, this process can be key to an accurate calculation in some cases. Is this always right? As with most valuation topics, there can be a long debate about how valid this theory is. However, I do believe that in certain industries that rely heavily on operating leases, not creating pro-forma financials with these operating leases capitalized will create an error in your final valuation.

As a last note, while I believe this process to be an accurate treatment for many operating leases, in cases where the operating leases do not represent a major portion of the firm’s expenses, I do not believe this process will yield a material difference the final valuation. 

Book Review: The New Financial Deal

Title: The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences

Author: David A. Skeel

Publication Date: 12/07/2010

Publisher's Site            Amazon

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David Skeel’s The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences provided a basic overview of the Dodd-Frank Act that lacked in-depth analysis and rigor. Skeel, a Professor of Corporate Law at Penn with an expertise in Bankruptcy and an extensive Curriculum Vitae promises to disseminate the Wall Street Reform and Consumer Protection Act in a meaningful way while also providing his suggestions to correct major flaws he sees within this piece of legislation. While both of these promises are kept, neither are done so in a manner that yield significant value to the reader.

Skeel begins with his own explanation of government intervention within the financial system ranging from the marriage between Bear Sterns and JP Morgan Chase, to the collapse of Lehman Brothers and the “bailouts” of American International Group (AIG), Chrysler and General Motors. This includes basic explanations of the events that occurred and his opinions on their flaws. A brief outline on the original drafters of the bill, including the involvement from Timothy Geithner, Henry Paulson, Ben Bernanke, and of course Christopher Dodd and Barney Frank, was also included.

After laying out the basic framework for the Dodd-Frank Act, Skeel then proceeds to break down the content into key regulatory reforms enacted under this law. This include the new derivative reforms, capital requirements, Consumer Protection Agency, new resolution tools at the FDIC’s disposal, and international regulations changes. Each of these topics were broken down into bite-sized sections that provide a basic overview of what the law will mean and its implementation.

Skeel also introduces his imaginary example bank referred to as Bank of the World, a massive would-wide financial conglomerate. He uses this example bank through multiple sections to demonstrate how the law would hypothetically impact the firm under a given set of circumstances, particularly the negative impact it may have.

Lastly, Skeel provides two chapters that give his opinion on changes that could be made to the existing law which, he claims, would have a profound impact on undoing a large part of the damage created by Dodd-Frank. This includes changes to treatments of derivatives under the current bankruptcy law and resolution constraints under the FDIC.

While the author did provide a basic overview of the Dodd-Frank Act, he failed to provide any deep explanations that yield useful understanding. This theme was kept constant through the book and was especially prominent in his chapters of proposed changes. I do understand that this piece of legislation is far too large to provide a full detailed explanation; however, I believe that the author failed to provide enough information to educate the reader in a manner that would allow a reasonable understanding of the topic. Through the text, the author makes clear that he believe much of the Dodd-Frank Act is harmful but yet fails give any more than a simple reasoning why. How can one be expected to agree with his point of view without being provided with a strong argument for the case? Being a former student and current professor of law, one would expect this to be common practice. If the author wants his readers to agree with his point-of-view, more emphasis should have been placed on explanations and understanding.

My particular area of concern was his proposed changes. I can confidently say that I do not have enough information to form an opinion on whether or not these changes would have any meaningful impact. The author does a great job at outlining what he proposes as changes, but fails miserably in providing any explanation of why these changes would prove to be positive. He simply provides a short explanation of how his hypothetical bank, Bank of the World, would be impacted differently under his changes versus the current law and how these would be positive. However, I do not believe that providing a simple one situational example can shed any real light on the impact of his proposed changes. I believe the author needs to revise this piece of work and provide a more rigors analysis of how his proposed changes would improve or fix the Dodd-Frank legislation.

On a bright note, I do believe the author used his extensive academic background that focuses on corporate law to provide useful insight into the benefits associated with bankruptcy. A great deal of reference was made to how current bankruptcy law could have resolved with many of the situations that Dodd-Frank is attempting to deal with. The author also indicates that he would like to see changes in the current law that provide preferential treatment to derivatives in bankruptcy proceedings. This was great insight from an individual with great expertise in this field.

In conclusion, David Skeel has created a great framework for what could have been a very informative book. I believe that the author would create a significantly stronger piece of writing by expanding on his current edition. While I do believe that I have gained a better understanding of the Dodd-Frank through reading this text, I would have liked to have gained a better understanding of the true implication of the law. While I am not overall satisfied with this book, due to its relatively short length and semi-useful information, I do recommend it as a read for anyone interested in the Dodd-Frank Act.