Tag Archives: Finance

09Jan/12

What is net working capital?

Put simply, net working capital is your current assets minus your current liabilities.  So, what are current assets and what are current liabilities?  Your current assets are anything that you would expect to be convertible into cash within one operating cycle.  This means that they are cash, inventory, securities, prepaid expenses (like insurance or rent), accounts receivable, etc.  Your current liabilities are your debts and obligations that are due within one operating cycle.  This could be short-term notes, part of long-term notes, income tax, accounts payable, etc.

This means that your net working capital is what money you have left after you pay your bills.

19Dec/11

What is a bond spread?

A bond spread is the difference between the yields of two bonds with different credit ratings.  The differing ratings are usually because of different levels of risk involved with the bonds.  Mathematically, you can calculate the spread by subtracting the interest rate of one bond from the interest rate of the other.  For example, if the current yield on a bond that Microsoft is offering is 6.1% and a federal bond has a current yield of 5.9%, the two bonds would have a .2% spread.

So, how can you use this information as an investor?  If you look at the spread over time, you should be able to find abnormalities in the spread.  These abnormalities could be buying or selling opportunities.

05Dec/11

How long have we had a national debt?

US Gov Debt Projection (Year 2000)I recently listened to a rather interesting  episode of the NPR podcast, Planet Money.  Through a Freedom of Information Act request, NPR received a report from 2000 entitled Life After Debt.  At the time, it was estimated that with the current budgetary surpluses, the US federal government would have the national deficit paid off in the year 2012.  The report was not originally released and since then, we have developed a record deficit.  This change of course was partially because of two simultaneous wars and partially because of high tax cuts and stimulus spending.  The podcast primarily asked why things changed so dramatically since 2000.

The podcast is worth listening to but, I found myself asking another question: “How long have we had a national debt?”  There has been a lot of talk about management of the national debt but how long have we had it?  Have we always had it.  I found a governmental source that shows historical outstanding national debt figures going back to the fiscal year starting on January 1, 1791.  For some context, the first fiscal year for the US Government started January 1, 1789 and George Washington gave the first State of the Union Address on January 9, 1790.

In 1791, the national debt was $75,463,476.52 (source).  The GDP is 1791 was $204,000,000 (source).  This means that in 1791, the national debt was 37% of GDP.  Another way of looking at it is that (based upon a population of 4,048,000 (source)) the the debt was $18.64.  In an attempt to compare see the changes in the nation debt over time, I looked up the same information (using the same sources) for the years 1891, 1991, and 2010.  You can see the results below.

US National Debt 1791, 1891, 1991, and 2010

So, there appears to be a very jump in the national debt, when you look at the numbers in this admittedly narrow way.  More to the original question, we have had the national debt since the dawn of the nation.  I think that it is an excellent goal to eliminate the national debt.  I am just not sure that it will be possible in our current economic climate.  The republicans insist that revenue can not be increased and the democrats insist that expenses can not be decreased.  Maybe by 2091, we will have a new party that knows better. 🙂

14Nov/11

What is a High Ratio Mortgage?

Today’s business term is “high ratio mortgage”.  A high ratio mortgage is a mortgage of over 80% of the value of the property being mortgaged.  Put in other words, it is when the borrower is putting down 20% or less, as a down payment.  Often, the borrower is going to have difficulty getting such a loan without having Private Mortgage Insurance (PMI).  PMI allows the borrower to buy a property with as little as a 3%-5% down payment (source).  The amount that the borrower has to pay per month for PMI is dependent on the how much is left on the mortgage.

07Nov/11

What is the difference between a real interest rate and a nominal interest rate?

In our current economic conditions, it is important to understand interest rates.  If you do not understand what the actual cost of borrowing of lending money is, you could be cheating yourself out of profits.  Let’s start by defining nominal interest rates.  The nominal interest rate is the market interest rate before an adjustment for inflation.  Based upon that, you could probably guess what the real interest rate would be.  The real interest rate is the nominal interest rate minus the rate of inflation.  The rate of inflation that you use could be the current rate or your expectation of what the rate will be in the future.  The nominal rate is what you will see when you look at your bank’s website.

Currently, my bank is quoting 3.89% for a 12-year fixed-rate home loan.  According to inflationdata.com, the inflation rate in August 2011 (most recent available data) was 3.77%.  This means that the 12 loan has a nominal interest rate of 3.89% and a real interest rate of 0.12%.  So, if you take out this loan, you it will cost you 0.12%.  As of writing this, the rate on a 6 month CD is 0.23%.  If you convert that to a real interest rate, using the same 3.77% inflation rate, you are paying 3.54% for the privilege of having the bank hold your money.

Next time you are planning out your next investment, take a moment to think about what the real interest rate is.

31Oct/11

What is the London Interbank Offer Rate (LIBOR)?

Today, we are going to be looking into the world of international finance.  The London Interbank Offer Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market (source).  The LIBOR is fixed on a daily basis by the British Bankers’ Association.  The BBA polls the contributing banks on a daily basis.  The BBA website states that “every contributor bank is asked to base their bbalibor submissions on the following question; ‘At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?'”  The BBA then bases the set of rates on the submissions from the banks.  Submissions are not based upon actual transactions due to the fact that transactions “in a reasonable market size” do not necessarily happen every day.

So, the LIBOR is a guide to what banks should expect to pay, in order to borrow funds “in a reasonable market size” in the London interbank market.  So, how does this effect me?  According to the BBA website, the LIBOR is the primary benchmark for short term interest rates globally. It is used as a barometer to measure strain in money markets and often as a gauge of the market’s expectation of future central bank interest rates.  According to the third edition of Corporate Finance: Core Principles & Applications, the LIBOR is a cornerstone in the pricing of money market issues and other short-term debt issues by both governments and corporate borrowers.

17Oct/11

What are Modigliani and Miller Proposition I and Proposition II?

A business can have a number of different possible capital structures.  A firm’s capital structure is defined as “mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity.(source)”  In the paper “The Cost of Capital, Corporation Finance and the Theory of Investment”, Franco Modigliani and Merton Miller stated that if you consider two firms which are identical except for their financial structures, with one firm being unlevered and the other being levered, the two firms would have the same value (V_u = V_l).  According to the third edition of Corporate Finance: Core Principles & Applications, this means that a firm cannot change the total value of its outstanding securities by changing the proportions of its capital structure, or in other words, no capital structure is any better or worse than any other capital structure for the firm’s stockholders.  This is known as MM Proposition I.  The assumptions that they make, in order to come to their conclusion are that individuals can borrow as cheaply as corporations and that there are no transaction costs.  It also discards the effect of taxes.

If you are like me, you might be asking yourself, at this point, what about the effect of risk?  A levered company, by default is more risky than an unlevered company.  In MM Proposition II, Modigliani and Miller argue that the risk to equity holders increases with leverage.  In MM Proposition II, we are still ignoring taxes.  Remember when we looked at the Weighted Average Cost of Capital, last week?  Well, we are going to use it again.

We defined WACC=(E/V)*R_e+(D/V)*R_d*(1-T_c).  This week, we are ignoring (1-T_c).  In order to determine the cost of equity (R_e), we use the formula:

R_e = R_0 + (R_0 - R_d)*(D/E)

Where:
R_E = Cost of equity
R_0 = Cost of capital for an all-equity firm
R_d = Cost of debt
D = Value of the firm’s debt or bonds
E = Value of the firm’s stock or equity

According to the third edition of Corporate Finance: Core Principles & Applications, the cost of equity capital R_E, will be positively related to the firm’s debt-equity ratio and the firm’s WACC will be invariant tot he firm’s debt-equity ratio.

Using the cost of equity number, in a number of simulations can help a company determine the effects of taking on additional debt capital.

As a quick programming note, before I end this post,  I have turned on comments on the blog.  If you would like to be part of a discussion surrounding these posts, feel free.  I would love to hear your thoughts.

10Oct/11

What is the Weighted Average Cost of Capital?

We are a few weeks into the series of finance-related posts.  I figured I would explain this series a little before we go into today’s topic.  I am currently working on an Masters of Business Administration at Cardinal Stritch University, in Glendale, WI.  As I go through my homework, I often find that the textbook is not the best in the world and I have to pull concepts from a number of source.  With this content, I try to develop a reasonable narrative that pulls things together.  When I blog a topic like today’s topic, it’s my highly public way of doing that.  I hope it helps someone else out there.

Today, we’re going to talk a little about the Weighted Average Cost of Capital (WACC).  According to the third edition of Corporate Finance: Core Principles & Applications, “the WACC is the minimum return a company needs to satisfy all of its investors, including stockholders, bondholders, and preferred stockholders.”  According to investopedia, “all else being equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.”

So, essentially the WACC is the amount of profit that the firm has to earn, in order to satisfy all of its obligations and if the firm starts to look like a worse investment, they will need to earn more profit.  The formula for the WACC (according to investopedia) is:

WACC = (E/V)*R_e+(D/V)*R_d*(1-T_c)

Where:
R_E = cost of equity
R_d = cost of debt
E = the market value of the firm’s equity
D = the market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percent of financing that is debt
T_c = the corporate tax rate

So, let’s look at a small example problem.  Let’s say that a firm has a cost of debt of 5.2% and a cost of equity of 9.1%.  Let’s also say that the corporate tax rate is 39% and the firm’s debt-equity ratio is 0.6.  How would you figure out the firm’s WACC?

5.2% implies 5.2 parts debt for 10 parts equity and because the value is equal to the sum of debt plus the equity, the debt-value ratio is 5.2/(5.2+10)=0.342105.  The equity-value ratio would then be 10/(5.2+10)=0.657895.

.657895 * 9.1% + .342105 * 5.2% * (1 - 39%) = 0.07072 = 7.072%

So, now that we know what the WACC is and how it’s calculated, is there an easy way to find the WACC for a publicly traded company?  Well, for better or worse, there is apparently an app for that. 🙂

03Oct/11

What does it mean for a stock to be normally distributed?

According to investopedia, a normal distribution is “a probability distribution that plots all of its values in a symmetrical fashion and most of the results are situated around the probability’s mean”.  If a firm’s returns are normally distributed, it means that if you create a histogram of a company’s returns, over a larger period of time, the histogram would take a bell shape, centered on the mean return.

If a stock’s return is normally distributed, it means that 68.26% chance that a return will be within one standard deviation (sigma) from the mean.  There is a 95.44% chance that the return will be within two standard deviations from the mean and a 99.74% chance that it will be within three standard deviations from the mean.

26Sep/11

What is the cost of equity?

Two weeks ago, we learned about a company’s beta.  Last week, we used the company’s beta when we learned about the capital asset pricing model.  This week, we are going to take things a little further.  In today’s post, we are going to be talking about the cost of equity.

Investopedia states that “a firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.”  Traditionally, you would calculate the cost of equity using the dividend capitalization model but what if the firm you are studying does not pay dividends?  We can still use our capital asset pricing model to get the cost of capital.

If the firm that you are studying doesn’t offer a dividend, what else will it do with the money?  It will invest it in a project and use the profits for future dividends or future investment in other projects.  If you put yourself in the shoes of the investor, they could invest in something that pays an immediate dividend and reinvest the dividend in something else.  Alternatively, they could invest in something that doesn’t pay an immediate dividend but pays one down the road.  They are going to want to invest in the option that pays the most, though.  This means that the investor will be happy if the new project pays more than a security of comparable risk would pay.

According to the third edition of Corporate Finance: Core Principles & Applications, “the discount rate of a project should be the expected return on a financial asset of comparable risk.”

The Cost of Equity can be estimated as R_s = R_f + beta*(R_m - R_f)

Where R_f is the risk-free rate, R_m - R_f is the market risk premium, and beta is the stock beta.

This assumes that the stock’s beta is the same as the project’s beta and the firm has no debt.  If the assumptions are not true, the above equation would need to be adjusted.

Let’s look at a quick example.  The risk-free rate of return is typically equal to the United States three-month Treasury bill rate.  As of writing this, it is 0%.  Lets say that the firm has a beta of 1.2 and that the new project has the same risk as the rest of the firm.  Lets also say that the market risk premium equals 7%.

The cost of equity would be:  R_s = 0% + (1.2*7%) = 8.4%

According to the third edition of Corporate Finance: Core Principles & Applications, almost three-fourths of U.S. companies use the CAPM in capital budgeting.

19Sep/11

What is the capital asset pricing model?


Last week, we talked about what a company’s beta is.  I figured that this week, we would learn about the Capital Asset Pricing Model (CAPM).  According to Investopedia, the CAPM is “a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.”

According to the third edition of Corporate Finance: Core Principles & Applications, the CAPM “implies that the expected return on a security is linearly to its beta.”

The equation: E(R) = R_f + beta * (E(R_m) - R_f)
Where:
E(R) is the Expect Return on a Security
R_f is the Risk-free rate
beta is the Beta of the security
E(R_m) is the Expected return on market

 

 

In the above graph, the Security Market Line is the depiction of the actual CAPM.  Lets try an example.  If the risk-free rate is 1%, the beta of the security is 1.2, and the expected market return on the market is 11%, then stock should return 13%.

12Sep/11

What is a company’s beta?

This is a topic that I recently dealt with within an assignment for class.  Investopedia defines a company’s beta as “a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.”

Illustration of Beta

According to the third edition of Corporate Finance: Core Principles & Applications, when you graph the return on the particular security on theY axis and the return on the market on the X axis, the slope of the line is the Beta.

A beta of 1.21 would mean that for every 1% that the market moves, the company would move 1.21%.  A high beta  would mean that the company is risky.  If the return on the market goes down at all, the return on the security goes down much faster.

Chances are, you will not find a stock with a negative beta but it would mean that the return goes up when the return on the market goes down.

If the beta is zero, it means that the market has no influence at all on the security.

If a security has a beta of one, it means that the return moves with the fund.  An example could be an index fund.

If the security has a beta greater than one, the security is more volatile than the market.

How do you find a company’s beta?  One way is to go to finance.yahoo.com and look under key statistics.  If you prefer to you Google Finance, the same number is listed at the top of the page, next to the stock quote.