Investment Science Published
The text, Investment Science, is the most
visible outreach of our program and has received excellent reviews.
For example, there are outstanding reviews at Amazon.com which
continues to be a popular source for the book. The text is crrently
being used for the first time in its published form in several
universities. At Stanford there are nearly 250 students taking the
course this quarter.
Order Investment Science from Amazon.com Here
The course, Investment Science for Industry,
has been evolving at a rapid pace in response to the thoughtful
feedback from participants. This year the course will relate the
modern concepts of finance more directly to conventional methods of
accounting procedures used in most firms. We will not compromise on
theory, but instead reformulate the theory so that it is more
accessible, more intuitive, and more in line with conventional
approaches. Hence, the new approach will show how to modify
existing methods (primarily discounting methods) so that they are
in line with modern financial concepts and more truly reflect the
economic consequences of actions.
Investment Science for Industry was taught in
Taiwan, hosted by Yuan-Ze Institute, last September. There were 30
participants in a beautiful setting on the top floor of the Far
Eastern International Center in Taipei. The participants were from
investment banks, consulting organizations, high-tech industry, and
large conventional industries. The participants and instructors had
very fruitful interchanges of ideas and shared some excellent
cuisine. We also had the opportunity to meet with several of
Taiwan's business leaders and were heartened by their enthusiastic
reaction to investment science.
April and November
Investment Science for Industry will be
offered at Stanford April 30-May1, 1998 and November 12-13,
Projects with industry sponsorship
which are underway include:
CHEVRON has sponsored research on real options and
commodity price cycles which is being carried out primarily by
Marius Holtan in his role as a post-doctoral fellow. We have found
that the issue of commodity price cycels is a concern of major
industries. Our approach is not to predict the exact price pattern
(which is probably impossible) but to understand its statistical
character and translate this into appropriate strategy (for plant
construction, commodity purchase, contract design, hedging, or
acquisition) using investment science methods. Superior strategies
can lead to substantial company value.
NATIONAL SEMICONDUCTOR is working with us on the
development of superior methods for analysis of mergers and
acquisitions using investment science methods.
We have worked with Hewlett-Packard on a number of
innovative projects, including design of commodity contracts,
supplier policies, and general business strategy.
ENRON has sponsored general research, which this
year focused on evaluation of foreign investments subject to
specific country risk as well as other technological and market
risks. This research has been carried out by Kian Esteghamat.
Current Graduate Research
Student research is devoted mainly to
evaluation of projects and development of project portfolio design.
The work on evaluation focuses on how to account for uncertainty
that is partially related to market variables and partially to
private uncertainty unique to that project. In the past, we have
developed methods for determining the value of such projects from a
market perspective -- that is, how much such a project should be
worth in an open market -- which is consistent with the viewpoint
of methods that attempt to generalize Net Present Value. Currently,
we are developing methods that determine the value of projects,
taking into account the fact that the project is in a particular
firm, not in the market by itself.
The work on project portfolio design goes to
the heart of company strategy. Every company must manage its
portfolio of business units, R&D projects, new business
initiatives, and acquisitions. The rewards for proper management
can be substantial. However, such management requires a clear
understanding of business uncertainties and how they interact. We
have new methods for clarifying the possibilities and for
determining suitable actions.
Discount at the Risk-Free Rate?
In conversations with business people and
participants in the short course, we teach that the cash flows of
small risky projects should be discounted at the risk-free rate
provided that the risk is private risk, not related to market
variables. For example, if the cash flow is dependent only on
whether a certain technlogy, currently in development, will work as
planned, the uncertainty can be considered as a private risk. Or as
another example, if the cash flow depends only on the amount of oil
at a specific site, the uncertainty is again private risk. Of
course, most projects have both market and private risk, but still,
the portion of the cash flow due to private risk should be
discounted at the risk-free rate -- that is what we teach.
This simple rule seems to trouble many people
as being non-intuitive -- for after all, the project is resky and
some account should be made of that risk, it seems.
So, here is a question we hear frequently (and
Question: Why should our
company discount private risk at the risk-free rate?
There are two views: the outside view (by
your stockholders) and the inside view (by management's
THE OUTSIDE VIEW (STOCKHOLDERS)
Each part of your
company's portfolio is a portion of the outside investor's
portfolio. Outsiders value risk-free investments at the risk-free
rate. Also the stock in your company is a very small part of the
average outsider's portfolio. When you take on a private risk
investment, it combines with all the other private risk investments
in the world, and through diversification, each outside investor
will obtain very close to the average value of these risky cash
flows; the private risks "'average out" for them and the result is
essentially risk-free. hence, investors will value our private
risks according to their averages, and treat them as essentially
risk free. You should too, if you are concerned with the market
value of a project.
THE INSIDE VIEW
Your company is striving
for growth and value. It has many high-potential opportunities, and
for this reason it borrows money -- to fund additional
opportunities. But the list of viable opportunities is limited, and
borrowing increases overall volatility; as a consequence your
company decides on a best level of debt. It decided (assuming that
managment is rational) that the current debt-equity ratio
represents a good tradeoff between borrowing risk-free and
investing in additional typically risky projects. Hence, risk-free
components of a new project should be regarded as part of the
trade-off and measured just like debt is measured: at the risk-free
rate. (Of course, your company pays a premium over the risk-free
rate for its debt; but ignore that for this discusssion. It does
not materially change the answer.)
If a portion of a
project has private risk, that is somewhat different than being
risk-free. If the project is a small one, then -- just like outside
investors -- managment should lump all the internal private risks
together and determine that, as a group, they are essentialy
risk-free. Hence, for small projects, private risk should be
discounted at the risk-free rate.
Discount at a Higher Rate?
If the project is not small, the uncertainty
associated with private risk is definitely important to the future
of the company. In general, the impact of such rusk is related to
the magnitude of the risk compared to the asset base of the
company. However, the true value of such a risk is not accurately
measured by imposing a higher discount rate. This is easy to see,
because, for example, tow cash flows of $1 million that have
separate private risks are more desirable together (because of
diversification) than one cash flow of $2 million with comparable
risk. Discounting would treat the two cases equally, adding up the
cash flows without accounting for diversification. In a proper
valuation, each private risk must be accounted for separately. This
can be done with a software program and the result related to the
growth potential of the firm. But the best way to treat large
projects is to consider them together and determine the best mix
for company growth and value as part of a strategic plan.
Discounting is, in every case, useful only as a beginning measure,
and primarily for small projects.