Six Sigma

Six Sigma

There are those who will tell you that Six Sigma is radical and new. The fact is that Six Sigma (done properly) is a recognisable evolution of TQM. De Mast (2006) sees it as an on-going phase in the evolution of methods and approaches for quality and efficiency improvement. Six Sigma can be seen as the accumulation of principles and practices developed in management statistics and quality engineering, all of which matured significantly over the course of the Twentieth Century.
The Six Sigma approach was first developed in the late 1980s within a mass manufacturing environment in Motorola (Harry, 1998) as they struggled to meet demanding quality targets on complex manufactured products; and become widely known when GE adopted it in the mid-90s (Folaron and Morgan, 2003; Thawani, 2004) when, arguably, it evolved from being a  process  improvement  methodology  to  a  broader,  companywide  philosophy.  Both  companies  still  consider  Six  Sigma as the basis for their on-going strategic improvement approach. Since the 1980s Six Sigma has become one of the most popular improvement initiatives; widely implemented around the world in a wide range of sectors (by companies such as Boeing, DuPont, Toshiba, Seagate, Allied Signal, Kodak, Honeywell, Texas Instruments, Sony, Bombardier, Lockheed Martin) that all declared considerable financial savings (Harry, 1998; Antony and Banuelas, 2001; Kwak and Anbari, 2006).
Other benefits claimed for Six Sigma include increased stock price, improved processes and products quality, shorter cycle times, improved design and increased customer satisfaction (Lee, 2002; McAdam et al, 2005). Six Sigma has undergone a considerable evolution since the early manifestations (Folaron and Morgan, 2003; Abramowich, 2005). Initially it was a quality measurement approach based on statistical principles. Then it transformed to a disciplined processes improvement technique (based on reducing variation within the system with the help of a number of statistical tools).  For  example,  Snee  (1999)  defined  Six  Sigma  as  an  ‘approach  that  seeks  to  find  and  eliminate  causes  of  mistakes or  defects  in  business  processes  by  focusing  on  outputs  that  are  critical  importance  to  customers’.  The  definition  given in 1999 by Harry and Schroeder (1999) also defines Six Sigma as ‘a disciplined method of using extremely rigorous data gathering and statistical analysis to pinpoint sources of errors and ways of eliminating them’. In  its  current  incarnation  it  is  commonly  presented  as  ‘a  breakthrough  strategy’  and  even  holistic  quality  philosophy (Pande,  2002;  Eckes,  2001).  It  is  now  generally  accepted  that  Six  Sigma  is  applicable  to  various  environments  such  as service, transactions or software industry regardless the size of the business (Pande, 2002; Lee, 2002) and being adapted Six Sigma may lead to nearly perfect products and services. Moreover, Six Sigma is widening its areas of application very rapidly and there are examples of applying Six Sigma to predicting the probability of a company bankruptcy (Neagu and Hoerl, 2005) or finding opportunities for growth (Abramowich, 2005).
In  the  past  five  years,  hundreds  of  organizations  have  indicated  their  interest  in  making  Six  Sigma  their  management philosophy  of  choice.  While  many  of  the  businesses  attempting  to  implement  Six  Sigma   are  well  intentioned  and  want to implement  Six Sigma  properly just as General Electric did, there are also those impatient executives who now look on Six Sigma  in the same way as they look on downsizing. This quick-fix approach to  Six Sigma  is a sure path to the same short-term results that prevent long-term profitability.It  is  worth  noting  that  the  evolution  of  Six  Sigma  is  continuing  with,  for  example,  the  integration  of  Lean  Principles, development of a product/service variant (Design for Six Sigma) amongst others (De Mast, 2006). 

Mean Variance Efficiency

The Role of Mean-Variance Efficiency

We began the Chapter with an idealized picture of investors (including management) who are rational and risk-averse and formally analyses one course of action in relation to another. What concerns them is not only profitability but also the likelihood of it arising; a risk-return  trade-off with which they feel comfortable and that may also be unique.

Thus, in a sophisticated mixed market economy where ownership is divorced from control, it follows that the
objective of strategic financial management should be to implement optimum investment-financing decisions using risk-adjusted wealth maximizing criteria, which satisfy a multiplicity of shareholders (who may already hold a diverse portfolio of investments) by placing them all in an equal, optimum financial position.

No easy task!

But remember, we have not only assumed that investors are rational but that capital markets are also reasonably efficient at processing information. And this greatly simplifies matters for management. Because today’s price is  independent  of yesterday’s price, efficient markets have  no memory  and individual security price movements are  random. Moreover, investors who comprise the market are so large in number that no one individual has a comparative advantage. In the short run, “you win some, you lose some” but long term, investment is a  fair game  for all, what is termed a “martingale”. As a consequence, management can now afford to take a  linear  view of investor behavior (as new information replaces old information) and model its own plans accordingly.

 Like Fisher’s Separation Theorem, the concept of linearity offers management a lifeline because in efficient capital markets, rational investors (including management) can now assess anticipated investment returns (ri) by reference to their probability of occurrence, (pi) using classical statistical theory. What rational market participants require from companies is a diversified investment portfolio that delivers a maximum return at  minimum risk.

What management need to satisfy this objective are investment-financing strategies that maximize corporate wealth, validated by simple  linear  models that statistically quantify the market’s risk-return  trade-off .

If the returns from investments are assumed to be random, it follows that their  expected return (R) is the expected monetary value (EMV) of a symmetrical,  normal  distribution (the familiar “bell shaped curve” sketched overleaf). Risk is defined as the  variance  (or dispersion) of individual returns: the greater the variability, the greater the risk.

Incremental IRR (Internal Rate of Return)

The Incremental IRR

Despite their apparent wealth maximization defects, IRR project rankings that conflict with NPV
can be brought into line by a  supplementary  IRR procedure whereby management: 

Determine the incremental yield (IRR) from an  incremental investment,
which measures marginal profitability by subtracting one project’s cash
inflows and outflows from those of another to create a  sub-project 
(sometimes termed a  ghost or  shadow project).

To prove the point, let us incremental the data from Section 3.1.Two projects that not only
differ with respect to their cash flow patterns ( size  and  timing ) but also their investment cost.

Project  Year 0  Year 1  Year 2  Year 3  Year 4  Year 5  IRR(%) NPV
                                                                                   15%        (10%)  
1 less 2  (35)      (30)     -           20     40   50   11.1

You will recall that IRR maximization favored a higher  percentage return on the smaller more
liquid investment (Project1), whereas NPV maximization focused on higher money profits
overall (Project 2). Now see how the incremental IRR (15%) on the incremental investment
(Project 1 minus Project 2 = £35k) exceeds the discount rate (10%) so Project 1 is accepted.
Moreover, this corresponds to Equation (1) on single project acceptance. The incremental NPV is
positive (£11.1k) because its discount rate r < incremental IRR.

Debt Ratios Caluculation

Debt Ratios         Debt ratios are calculated to assess that how much a firm is using financial leverage for profit maximization with the combination of total assets. These also reflect that how much the firm has the ability to service debt to make the payments required on a scheduled basis over the life of debt. In debt ratios, coverage ratios also measure the bank’s ability to pay certain fixed charges.                                           Total Liabilities Debt Ratio =                                                                  Total Assets   1. Time Interest Earned Ratio         It is also called the Interest Coverage Ratio, measures the firm’s ability to make contractual interest payments. Greater the ratio means that firm is better position to make fulfill its interest obligations.                                                  Earning Before Interest and Taxes  Time interest Earned Ratio  =                                                                                                                  Interest Amount  Earning before income and taxes includes the total interest income and non-interest income, after deducting non-interest expense during the year(s). Interest amount includes interest payments made on deposits (current, saving, fixed) and investments. 2. Fixed Payment Coverage Ratio         The fixed payment coverage ratio was used to measure the firm’s ability to meet all fixed-payment obligations, such as interest and principal, lease payments, and preferred stock dividends.                          Earning before interest and taxes + Lease payments  FPCR        =                                                                                                                  Interest+ Lease Payment+ (Principal) x (1/1-T)          T      = Tax rate applicable to bank income. (1/1-T)      = The term included to adjust the after tax principal amount of borrowing and lease payments back to before tax equivalent.

Investment Risk and Return

Investment Risk and Return
Risk means uncertainty. In investment risk, when there is uncertainty attached with the outcomes of investment opportunity. In global markets there are lot of risk attached with the securities that can negatively affect the return of an investment opportunity.
There are basically two types of risks:
1. Systematic Risks    These risks occur inside the organization that can affect the profits of the organization. such as inefficiency of the management, labor unavailability or strikes. We say this risk as controllable because this can be controlled to some extent by the executives.
2. Unsystematic Risks    This type of risk exist outside the organization and are more worse than systematic risks. Such as political factors, competitors strategies, material unavailability, etc. This is also called uncontrollable because it cannot be controlled by the management of the firm.
The return on investment varies from company to company depending upon the nature of organizations and their basic objectives. If the organization is for charitable purposes it will require the non-profit return.
The return may in different forms like increase of sales volume, increase in the firm marketability, increase in customers loyalty. And also return may be positive or negative. This depends upon the risk associated with the investment opportunities.
Risk and return both go side by side in investment opportunities. The most spoken business slogan is "Higher the risk higher the return". Means investing in most risky portfolio (set of diversified investment opportunities) will yield the higher return as compared to the risk free assets. But in portfolio management when we combine different investment opportunities to composite the portfolio and we want higher return with minimum risk. For this purpose we add a risk free asset in our portfolio.

Capital Budgeting

Capital Budgeting
Capital budgeting is the process of evaluating and selecting long-term investments opportunities that are parallel with the firm's objectives. And to fulfill these objectives different investment opportunities are evaluated and then finally one is selected. And, firm generally made capital expenditure in earning assets that could increase their earning capacity.
Following are the key motives for capital expenditures:
1. Expansion    The most common motive is the expansion of firm's operations. And in this firms generally acquire fixed assets because only fixed assets can increase the earning capacity.
2. Replacements    When the machinery of the firm outdates then replacements decisions are made. Replacements are also made when the firm reaches maturity and its growth slows.
3. Renewal    This is the alternative of replacements. This involves rebuilding, overhauling or retrofitting an existing fixed asset. Basis difference is that in replacement we replace the whole asset but in renewal we only replace the a part of asset.
4. Other    If firm make expenditure other that above mentioned that it will fall in this category.
Steps in Capital Budgeting
Different authors present different approaches in capital budgeting process. But the basic logic is same:
1. Screening and Selection of Investments    Among different investment opportunities we generally evaluate and select the investment opportunity by using Capital Budgeting techniques (DCF and Non DCF).
2. Capital Budget Proposal    A budget is proposed in which it is discussed that what will our key expenditure? What will be the total cost of investment? When cash flows will occur?
3. Budget Approval and Authorization    The proposed budget is presented to the top management for approval and top management make authorization and gives the directions that from when these funds will be generated, some time internally and some time externally.
4. Implementation    Following the approval and authorization the expenditures are made and project is implemented.
5. Evaluation and control    Once the project is implemented the results are monitored and matched with the objectives of the firm.

Time Value of Money

Time Value of Money
Financial managers and investors are always confronted with the opportunities to earn positive rates of return on their funds. And we always know that in every single investment opportunity their are always number of cash flows (inflows or outflows). And these cash flows are either same or vary from time to time. We also know that every time there is the uncertainty in the outcomes of returns and inflation is increasing day by day. And it greatly affect the value of money. So, the sensitive financial managers and investors keep close eye on it.
In time value of money we use two inverse concepts:
1. Future Value
2. Present Value
Future value simply means that what will the future value of the present investment opportunity. For example, we keep $1000 in treasury and we forget. After some months when we find it and evaluate its worth we say that this is $1000. But actually when we use time value concept its worth has been decreased because if we had invested that $1000 in any investment opportunity we got some return and obviously, it will  be greater than $1000.
Present value simply means that what is the present value of the future cash flow from an investment opportunity. We generally find the present value of the future cash flow. Because, we know that dollar today is worth more than dollar tomorrow. The logical matter behind the present value is same as behind the future value.
Above mentioned both techniques are used in capital budgeting decisions. In which we evaluate different investment opportunities and made decisions on the basis of present and future values. But one thing should be clear that both present and future value concepts are used in Discounted Cash Flow (DCF) techniques.

DuPont System Of Analysis (EXTENDED)

DuPont System (Extended)

We use extended DuPont system because it provides the additional insights into the effect of financial leverage. The concept and use of the model is the same as the basic DuPont system except for a further breakdown of components.

Combining the Operating profit margin and total asset turnover;

  EBIT                  Net Sales                       EBIT

                X                              =                     

Net Sales           Total Assets                 Total Assets

To consider the negative effect of financial leverage, we deduct the interest expense;

  EBIT                           Interest                      EBT

                        _                              =                     

Total Assets               Total Assets               Total Assets

To find the positive effect of financial leverage, we will get;

   EBT                             Total Assets             EBT

                        X                              =                     

Total Assets               Common Equity           Common Equity

Finally to reach on ROE, we multiply the tax retention rate;

   EBT                                Income Tax              EBT

                       X   1-                        =                      

Common equity               EBT                       Common Equity

 

In summary, we use the following five components in extended DuPont system of analysis;

  EBIT       

1.                             =      Operating profit margin

T. Revenue        

 

T. Revenue

2.                            =      Total asset turnover

Total Assets

 

  Interest  

3.                            =      Interest expense rate

Total Assets

 

Total Assets

4.                            =      Financial leverage multiplier

Common Equity       

income Tax       

5.     1-                             =      Tax retention rate

            EBT      

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Diversification of Portfolio

Diversification

Before discussing diversification, we should first understand the correlation between the different investment opportunities.
Correlation is the statistical measure of the relationship between any two series of numbers. The two series moving parallel in same direction will be positively correlated. And if two series are moving in opposite directions they will be negatively correlated.

We know that the returns of a portfolio can be maximized by diversifying the risk. And diversification totally depends upon the correlation of assets. In diversifying the portfolio for the purpose of reducing risk, correlation is best measure of risk attached with the proposed portfolio. Before making the portfolio, one must understand that the securities selected should be negatively correlated. Because the negative correlation means high diversification of portfolio and high diversification means more certainty of positive return from the portfolio.

Some assets are uncorrelated means there is no correlation between their returns. Combining uncorrelated assets can reduce risk but not so effectively than combining pure negatively correlated assets.
Correlation, Diversification, Risk and Return
In general, the lower the correlation between assets return, the greater the potential diversification of risk. How much the risk of portfolio can be minimized depends upon the degree of correlation between the assets returns.
There are three types of combinations:
Positively correlated    In which degree of correlation is greater than zero means low diversification so, risk will greater and return will uncertain.
Uncorrelated    In which degree of correlation is approximately equals to zero means total diversification so risk will smaller and return will certain.
Negatively Correlated    In which degree of correlation is less than zero means pure diversification so risk will eliminated and returns will higher.

Diversification of Portfolio

Diversification

Before discussing diversification, we should first understand the correlation between the different investment opportunities.
Correlation is the statistical measure of the relationship between any two series of numbers. The two series moving parallel in same direction will be positively correlated. And if two series are moving in opposite directions they will be negatively correlated.

We know that the returns of a portfolio can be maximized by diversifying the risk. And diversification totally depends upon the correlation of assets. In diversifying the portfolio for the purpose of reducing risk, correlation is best measure of risk attached with the proposed portfolio. Before making the portfolio, one must understand that the securities selected should be negatively correlated. Because the negative correlation means high diversification of portfolio and high diversification means more certainty of positive return from the portfolio.

Some assets are uncorrelated means there is no correlation between their returns. Combining uncorrelated assets can reduce risk but not so effectively than combining pure negatively correlated assets.
Correlation, Diversification, Risk and Return
In general, the lower the correlation between assets return, the greater the potential diversification of risk. How much the risk of portfolio can be minimized depends upon the degree of correlation between the assets returns.
There are three types of combinations:
Positively correlated    In which degree of correlation is greater than zero means low diversification so, risk will greater and return will uncertain.
Uncorrelated    In which degree of correlation is approximately equals to zero means total diversification so risk will smaller and return will certain.
Negatively Correlated    In which degree of correlation is less than zero means pure diversification so risk will eliminated and returns will higher.

The Active Strategy

Portfolio Management Strategy
3. The Active Strategy
Most of the techniques discussed in this text involve an active approach to investing. In the area of common stocks, the use of valuation models to value and select stocks indicates that investors are analyzing and valuing stocks in an attempt to improve their performance relative to some benchmark such as a market index. They assume or expect the benefits to be greater than the costs.

Pursuit of an active strategy assumes that investors possess some advantage relative to other market participants. Such advantages could include superior analytical or judgment skills, superior information, or the ability or willingness to do what other investors, particularly institutions, are unable to do. For example, many large institutional investors cannot lake positions in very small companies, leaving this field for individual Furthermore, individuals' are not required to own diversified portfolios and are not prohibited from short sales or margin trading as are some institutions.

Most investors still favor an active approach to common stock selection and management despite the accumulating evidence from efficient market studies and the published performance results of institutional investors. The reason for this is obvious that the potential rewards are very large, and many investors feel confident that they can achieve such awards even if other investors cannot.