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Recommended Reading - Finance


6 Ways companies mismanage risk You have more capital than you think
The New Arsenal of Risk Management Owning the Right Risks
In honour of the Nobel Laureates Merton and Scholes The Venture Capital Revolution

Public vs. Private Equity

You have more capital than you think   

Capital Structure

How Financial Engineering Can Advance Corporate Strategy

Enterprise Risk Management: Theory and Practice

Basle 2 : The route ahead or Cul De Sac

The Summer of '07 and the Shortcomings of Financial Innovation

Regulating risk: A measured response to the banking crisis 

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Public vs Private Equity, by John J. Moon, Journal of Applied Corporate Finance, Summer 2006

This is  a phenomenal article that helps us to understand how private equity actually works as a corporate governance mechanism. Traditionally  private equity has been viewed as “expensive” capital and  public equity as a relatively “cheap” source of funds.. But this logic misses the point. For both private companies considering whether to go public and public companies considering whether to go private there is much more to making sound equity-raising decisions than simply comparing investor returns. Who provides equity capital to a company is as important as how much equity is raised. Moon argues that private equity and public ownership represent very different packages of costs and benefits. Public equity may not turn out to be as cheap as it seems. And, in some cases, the benefits of private equity may prevail. Only by recognizing the costs and benefits of each can companies make the value-maximizing choice.

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The Venture Capital Revolution by Paul Gompers and Josh Lerner, Journal of Economic Perspectives, Spring 2001

Venture capital has emerged as an important source of funding for small firms that would otherwise have problems in accessing capital markets. These firms are subject to various uncertainties and typically operate in fast changing markets with few tangible assets. There are large information gaps between the entrepreneurs involved and the investors. Venture capital as opposed to public equity comes in handy in such situations. This article by two of the leading researchers in the field provides deep insights about the art and science of venture capital.

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Capital Structure by Stewert C Myers, Journal of Economic Perspectives, Spring 2001

In this article, a well known scholar examines the tradeoffs underlying the use of debt and equity. Contrary to what Miller and  Modigliani mentioned, capital structure does matter because of taxes, differences in  information and agency costs. Accordingly,  Myers examines three theories in detail. The trade off theory tries to balance the tax  advantages of debt and the possibility of distress. The pecking order (differences in  information ) theory states that firms will first borrow rather than raise equity when they are short of funds. The free cash flow (agency costs) theory argues that cash flows belong to equity holders. Even dangerously high levels of debt can create value for shareholders if the free cash flows are more than the investment opportunities.

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You have more Capital Than You Think   by Merton, Robert C, Harvard Business Review, November 2005

Thanks to  modern financial markets, managers can ensure that virtually the only risks its shareholders, debt holders, trade creditors, pensioners, and other liability holders must bear are value-adding risks. Those are the risks associated with positive-net-present-value activities in which the company has a comparative advantage. All other risks can be hedged or insured against through the financial markets. In most large companies, equity capital is used to cushion against a great many risks where  the firm does not have a comparative advantage. If it can remove these non-value-adding risks, a company will be able to use its existing equity capital to finance a lot more value-adding assets and activities than competitors. The Nobel prize winner argues that  the potential for creating shareholder value through financial engineering is enormous.

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Enterprise Risk Management: Theory and Practice,  by Brian W. Nocco  and René M. Stulz, Journal of Applied Corporate Finance, Fall 2006

Companies can manage risks in piece meal fashion or they can bring in an integrated approach. Such an approach which takes a view of the risks facing the organization as a whole and comes up with the most effective way of managing risk is called Enterprise Risk Management. ERM creates value at both a “macro” or company-wide level and a “micro” or business- unit level. At the macro level, ERM creates value by enabling senior management to quantify and manage the risk-return trade off that faces the entire firm. This way, ERM helps the firm maintain access to the capital markets and other resources necessary to implement its strategy and business plan. At the micro level, ERM becomes a way of life for managers and employees at all levels of the company.  It makes them think of various projects using a risk- return framework.asel

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Basle 2 : The route ahead or cul de sac by Richard Brealey,  Journal of Applied Corporate Finance, Fall 2006

This article examines some strategic issues pertaining to Basle 2. The new Basle accord is expected to enhance banks’ safety and soundness, strengthen the stability of the financial system as a whole, and improve the financial sector’s ability to serve as a source for sustainable growth for the broader economy. But the record of success of past changes to the regulatory system in reducing bank failures suggests that this may be a somewhat rosy assessment. While an increase in capital requirements may reduce the incidence of bank failure, its efficacy depends on the accuracy and frequency with which bank assets are valued. Brealey argues that the right way  is to move toward an explicit system for regulatory purposes of market-value accounting for bank assets.

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The Summer of '07 And The Shortcomings of Financial Innovation by Joseph R. Mason, Journal of Applied Finance, Spring/Summer 2008

Various  financial innovations developed over the past several decades failed in the summer of 2007, as the sub prime crisis got under way. The $9 trillion of US securitizations that spawned  various instruments including asset-backed securities, mortgage-backed securities,  collateralised debt obligations, asset-backed commercial paper, structured investment vehicles, and credit default swaps  had grown into a monster of an unregulated and conflicted market. The author argues that financial innovations invariably  create conditions of asymmetric information that can lead to financial crises and panics. Also, financial innovations that are not fundamentally diversifying, market completing, or capital deepening will not survive to become mature financial market products. He concludes that finance academics should spend more time focusing on financial efficiencies and less time focusing on Wall Street hype in order to better understand which  financial arrangements are beneficial to savers and borrowers, therefore promoting economic growth.

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Regulating risk: A Measured Response To The Banking Crisis  by David Halliday McIlroy, Journal of Banking Regulation Vol. 9, 4 284–292

 Bank regulation must minimise the adverse consequences of banks taking excessive risks. The author  proposes three reforms: requiring banks to retain a proportion of any loan that they originate, so as to reduce the risks of moral hazard; insisting that the risks involved in the financial products in which banks trade are transparent; and reforming Basel II so that the amounts of regulatory capital that banks are required to hold are less procyclical than is currently the case.

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How Financial Engineering Can Advance Corporate Strategy, by Peter Tufano, Harvard Business Review, Jan/Feb96, 

Inc Financial engineering - the use of derivatives to manage risk and create customized financial instruments - can advance a company's strategic goals. It is true that when traders speculate and their bets backfire, companies lose millions and executives lose their jobs. Managers who seek to avoid disasters certainly must be cautious. But  that does not imply that financial engineering should not be used by nonfinancial companies to advance core business goals. Many  leading organizations have used financial engineering to solve classic and vexing business problems. These are not narrow finance problems but rather broad strategic problems in marketing, production, human resources, investor relations, and strategic restructuring - for which advanced financial techniques have offered new solutions. This article presents five case studies that illustrate innovative applications of financial engineering and offers managers guidance for determining when such techniques are appropriate.

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