Joe Steinbring

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.

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.

Today, I am going to try to define a suspense account.  A suspense account is an account in the general ledger used to temporarily carry receipts, disbursements, or discrepancies until it can be analyzed and classified.  The suspense account allows you to record a payment when you don’t know what the payment is meant for.  An example would be if you receive a payment from a client but the invoice is missing from the envelope.  Using a suspense account is preferable to not recording a payment but you need to address it and move the money elsewhere as soon as possible.

In these modern times of electronic trading and credit default swaps, it sometimes feels hard for the average person to figure out where the economy is going.  There are a number of economic indicators that the average person can try to wrap their head around, such as international trade and construction spending.  Well, in Alan Greenspan‘s book “The Age of Turbulence”, he talks about a slightly unconventional indicator: The Men’s Underwear Index. Greenspan says that men tend not to replace their underpants when they have a forward impression that trouble is coming. His reasoning is that the sales of such a necessity fluctuate the least among all apparels, so even the slightest change in numbers can be revealing. So, how accurate is the Men’s Underwear Index (MUI)?  I went looking for a publicly traded men’s underwear company and the only one that I could come up with was Hanes.  My thought was that stock price should indicate sales success.  Below is a comparison of Hanesbrands Inc. vs the S&P 500 vs the Dow Jones. They appear to be follow similar patterns but I’m not sure if this particular chart shows that Hanes is predicting a move in the market.  It looks more like it is moving with the market.  How about if we look at their 2011 sales figures.  In early Q1 2011, net sales went up 12%.  In Q2 2011, net sales went up 14%.  How does that compare to unemployment levels?  If you look at the below chart, it looks like unemployment has plateaued, but only after sharply increasing. I get the impression that the Men’s Underwear Index might be an indicator of the consumer’s confidence in the economy but it isn’t a very good one.  Maybe economists should stick with something else. :)

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.” 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.

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: [pmath size=10]E(R) = R_f + beta * (E(R_m) – R_f)[/pmath] Where: [pmath size=10]E(R)[/pmath] is the Expect Return on a Security [pmath size=10]R_f[/pmath] is the Risk-free rate [pmath size=10]beta[/pmath] is the Beta of the security [pmath size=10]E(R_m)[/pmath] 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 [pmath size=10]beta[/pmath] of the security is 1.2, and the expected market return on the market is 11%, then stock should return 13%.

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 [pmath size=10]R_s = R_f + beta*(R_m – R_f)[/pmath]

Where [pmath size=10]R_f[/pmath] is the risk-free rate, [pmath size=10]R_m – R_f[/pmath] is the market risk premium, and [pmath size=10]beta[/pmath] 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:  [pmath size=10]R_s = 0% + (1.2*7%) = 8.4%[/pmath]

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

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 ([pmath size=10]sigma[/pmath]) 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.

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:

[pmath size=10]WACC = (E/V)*R_e+(D/V)*R_d*(1-T_c)[/pmath]

Where: [pmath size=10]R_E[/pmath] = cost of equity [pmath size=10]R_d[/pmath] = cost of debt [pmath size=10]E[/pmath] = the market value of the firm’s equity [pmath size=10]D[/pmath] = the market value of the firm’s debt [pmath size=10]V = E + D[/pmath] [pmath size=10]E/V[/pmath] = percentage of financing that is equity [pmath size=10]D/V[/pmath] = percent of financing that is debt [pmath size=10]T_c[/pmath] = 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 [pmath size=10]5.2/(5.2+10)=0.342105[/pmath].  The equity-value ratio would then be [pmath size=10]10/(5.2+10)=0.657895[/pmath].

[pmath size=10].657895 * 9.1% + .342105 * 5.2% * (1 – 39%) = 0.07072 = 7.072%[/pmath]

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. :)

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 ([pmath size=10]V_u = V_l[/pmath]).  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 [pmath size=10]WACC=(E/V)*R_e+(D/V)*R_d*(1-T_c)[/pmath].  This week, we are ignoring [pmath size=10](1-T_c)[/pmath].  In order to determine the cost of equity ([pmath size=10]R_e[/pmath]), we use the formula:

[pmath size=10]R_e = R_0 + (R_0 – R_d)*(D/E)[/pmath]

Where: [pmath size=10]R_E[/pmath] = Cost of equity [pmath size=10]R_0[/pmath] = Cost of capital for an all-equity firm [pmath size=10]R_d[/pmath] = Cost of debt [pmath size=10]D[/pmath] = Value of the firm’s debt or bonds [pmath size=10]E[/pmath] = Value of the firm’s stock or equity

According to the third edition of Corporate Finance: Core Principles & Applications, the cost of equity capital [pmath size=10]R_E[/pmath], 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.

This is a quick tip.  Lets say you are working on developing an equation within a cell in Excel and you find yourself wanting to refer back to how you set up another cell.  You can click on the other cell and see the equation but how do you show the value of the cell while it is not selected?  Just hit Ctrl + ` on your keyboard.  To toggle it off, just hit the combination again.  It is as easy as that.

Gimmick factor is high but it just tastes like water. Crazy looking but probably won’t buy it again.

 

Syllabus is over 146 pages long

Not too long ago, I saw a groupon become available for Segway tours of Chicago.  I have always been a little curious about the Segway, so I bought the groupon and talked my sister into coming with me down to Chicago for the tour.  Yes, the primary reason for the trip to Chicago was the tour. We were using the Segway i2.  My first thought, getting on the thing was that it is really hard to steady yourself.  You get more skilled at controlling it, as time goes on but your feet start hurting fast.  You are balancing on it, the entire time you are using it and the constant rocking back and forth works muscles that I just do not have. The Segway is incredibly nimble.  You can turn insanely tight circles with ease.  The speed is limited to 12 mph.  That said, I am not sure I would want to go much faster than that.  It does not do well with potholes, or cracks in the sidewalk, or bumps.  I am sure, over time you would develop more skill at dealing with obstacles but I was having a lot of trouble.  As soon as you hit something, like a shallow hole in the sidewalk, your balance gets slightly thrown off.  If you are not careful, you are going to fall off.  If you are going fast, the likelihood of this seems much greater. The big thing I noticed from on-top of the Segway was the attention you get when you are on-top of a Segway.  I would not necessarily call it positive attention either.  One woman, as I rode past, covered her mouth and said “Oh, my God!”  I quickly asked one couple, as I rode past “How do I look on this thing?”  The man replied “Not good, not good” while the woman simply giggled.  It is not exactly like driving around in a Porsche. So, would I buy one?  Probably not.  It is a $5,000 woman repellent that makes your feet hurt and bucks you off as soon as you come across a crack in the sidewalk.  Would I do the tour again?  Definitely.  The Segway is a fun toy.  I would not want to be zipping around Milwaukee on one but it is kinda fun to play with on occasion. On a final note, I really like how Groupon sells these opportunities to do weird things that you would never think to do on your own.  I am curious to see what comes next.

When a company makes a profit, it is its obligation to return that profit to its shareholders.  In the case of a younger company, the company might want to reinvest its profits back into the firm but that is because it hopes to maximize future returns for the shareholders.  When the company pays part or all of its profits back to its shareholders, it is called a dividend.  The payment does not necessarily need to be from its earnings.  If the company pays its shareholders from capital, it is called a liquidating dividend.  Another option, the company has is to pay a stock dividend.  A stock dividend is when the company pays out shares of stock.  This simply increases the number of shares outstanding, so no cash leaves the firm. So, how does the dividend get paid out, in a world where shares fly from investor to investor continually?  According to the third edition of Corporate Finance: Core Principles & Applications, there are four milestones: the declaration date, the ex-dividend date, the record date, and the payment date.  On the declaration date, the board of directors declares the payment of dividends.  At this point, it sets a record date when you must be on the company’s books as a shareholder to receive the dividend (source).  An important fact at this point is that if the company does not receive notification of purchase until after the record date, the purchaser will not receive the dividend. Once the company sets the record date, the stock exchanges or the National Association of Securities Dealers, Inc. fix the ex-dividend date (source).  The ex-dividend date is normally set for stocks two business days before the record date. If you purchase a stock on its ex-dividend date or after, you will not receive the dividend payment. Instead, the seller gets the dividend. If you purchase before the ex-dividend date, you get the dividend (source). So, how is the stock price affected by the dividend?  Before the ex-dividend date, the value of the stock will increase by the value of the dividend (minus applicable taxes).  After the ex-dividend date, it will fall back to normal levels. As I implied earlier, younger companies tend to not issue dividends, since they are still working on growing.  Mature companies tend to offer dividends more often.  Companies that issue dividends use a dividend policy, that helps it decide when to issue dividends and how large the dividends should be.  You can try to determine facts regarding the company based upon how the company issues dividends but it does not tend to be as relevant as some investors believe.

Microsoft Excel is a powerful tool.  You can use it to track your personal budget, create a shopping list, or build a corporate cash-flow statement.  Sometimes, troubleshooting an Excel file can be difficult, though.  As you can see in examples below, the variables in an equation are represented by grid coordinates consisting of letters and numbers.  This means that you must look at the coordinates and try to figure out what the variable actually represents.  There is a better way.  If you right-click on a cell and click “Define Name”, you can rename the cell.  This means that instead of the cell being named “D2” it can be named “Hourly Wage”.  This will allow you to develop much more “human readable” Excel formulas.