Category Archives: Markets (Stocks, Bonds, Currencies, etc.)

Comprehensive Financial Analysis

In this post several calculations and analysis will be examined.  Specifically, the Weighted Cost of Capital (WACC) will be calculated and considerations of capital budgeting analysis.   Ford’s financials will be examined in finding the most effective budget analysis.   National trends toward capital risks will also be discussed in reference to the Ford’s WACC.   Lastly the capital requirements of Ford will discussed.

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the “Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments” (Brealey, Myers, & Marcus, 2007, p. 327). The calculation of the WACC takes into account the firm’s capital structure as well as the amount of return required from shareholders for debt and for equity or any other class of security that is part of a company’s capital structure. The cost of capital is the weighted average of the required returns and the WACC uses the same calculations but accounts for the tax discount on interest paid for debt. In order to calculate the WACC the company must first calculate the expected rate of return based on the level of risk that an investor is taking on.

The required rate of return on common stock can be calculated using the capital asset pricing model (CAPM) which measures the rate of return required by investors based on risk as well as current market expected return on risk-free assets. The WACC is used to determine the necessary cash flows that an investment must produce in order to generate enough income to give investors a fair return on their investment. Ford Motor Company has a complex capital structure involving outstanding debts as well as equity, preferred stock and other classes of security. In order to measure the WACC the CAPM model is used to derive a beta for debt and equity and from there the WACC can be calculated.

Effectiveness

WACC is an excellent tool to evaluate a project. However, using this method for Ford Motor Company can provide both positive analysis and problems. First of all, as mentioned WACC is helpful in deciding if a project offers a return that shareholders find acceptable. Obviously, Ford needs to evaluate individual projects to see if the project matches up with Ford’s goals. However, applying WACC to a whole company can be difficult. For one, the process gets much more complicated. As mentioned earlier WACC calculated required rate of return for each class of security and debt. For example, Ford has long term debt, minority interest, redeemable preferred stock, non-redeemable preferred stock, common stock, and treasury stock just to name a few (MSN money, n.d.). Each one of these debts or equity is a portion of WACC. Inherently, more variables makes calculation more difficult.

Another point is that changing capital structure of the company will change WACC. Many companies change capital structure and Ford may possibly do so as well. Logically, this means one needs to readjust the WACC whenever capital structure changes. The problem is forecasting the outcome of changing capital structure is difficult. One reason for example, is when a company decides to take on more debt this most likely means shareholders will ask for higher returns. In this case, calculating Ford’s WACC if it decides to take on more debt will prove hard. Plus, not only will the required return on equity increase, but most likely debt will as well. The reason is creditors will ask for a higher return since the company is more leveraged. In this instance WACC debt and equity required return needs to be increased (Brealey, Myers, & Marcus, 2007).

Using WACC on Ford is both complicated and may not yield accurate results. Since, Ford has a variety of debt and equity the rate of return for each needs to be figured. Plus, WACC readjustment would be done every time the capital structure is modified. However, WACC is a way for Ford to benchmark and is a tool for Ford to use in financial analysis.

WACC Calculation

The calculation of WACC for Ford is based on the 2008 Form 10-k (2008) filed with the SEC. Debt rates were calculated using interest expense as a percentage of total debt value. For equity, shares from the financial statements were used, but matched to market value based on the current share price as quoted at $7.75 (Yahoo Finance, 2009). Convertible preferred stock values were also included in the calculation of WACC. The expected equity returns were calculated using the CAPM with a risk-free rate of 4.5% and an assumed market risk premium of 4%, for a total expected return of 8.5%.

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Figure 1. WACC Calculation

 The calculated WACC is 5.43% given the stated assumptions. This may be used as a discount factor for internal analysis of new investments, given that it represents the average cost of raising capital for a new project. The expected return rate of the project must cover this weighted average return value with margin above it so that a profit may be made. A project with a return value less than WACC will not yield returns after accounting for cost of capital. This is therefore a hurdle rate and not a target return, as ideally the firm will produce returns in excess of the cost of capital.

It must be noted that Ford is showing a rising value of equity. Over the last year, the stock price has risen over three times from $2 to over $7 (Yahoo Finance, 2009). A forward looking calculation of WACC could take this into consideration. This would increase the proportion of monies calculated for equity in a future WACC calculation, which would increase the cost of capital as equity does not receive the benefits of the tax shelter that debt carries. However, as funds for a project may be required today rather than a year later, the current WACC would be used as a it represents the cost of raising funds at that point in time.

Recommendations

Recommendations for Ford Company would be to continue to use the WACC as a tool to allow them to assess what projects would add value to its shareholders and company with a high return. If they decide not to use this tool it can in ongoing efforts with future projects they could hurt them in the long term. They must take a risk in creating more capital to gain more cash flow to balance their debt ratio. There is a need to make sure that all of their projects are on point and following their timelines and expense. They must comply with all the necessary steps in obtaining their project goal and staying within budget. The last thing the company and its shareholders would want is that the project costs more than their return. Example: If they chose to develop a new make/model car and is projecting the project to cost $4 million dollars but they end up spending $8 million on project. Then when the cars are released for sale, they only make sold $2.6 million in cars which results to a $6.2 million loss. So they must be careful as to how they determine as to what type of project they decide to implement and try their very best to save money as much as possible but yet be able to seek positive and high returns.

Conclusion

After careful analysis, Ford’s WACC is extremely complicated given the company’s structure and national trends.    Ford has a required rate of returns for each class of security and debt.  For a company such as Ford, this can further complicated the measure.   To further complicate the calculations, many companies have been restructuring their capital in light of recent developments.    The WACC is 5.43% and includes discount rates and internal analysis.   However, the most impressive and shocking thing is the stock’s movement.   In the last year it is has gone from $2 and risen to $7.   This has to be a disturbing because it doesn’t support our analysis.  However, this can be dismissed as fluke in the market, rather than the financials of the company.    Ford should use WACC as a tool to measure its effectiveness of the financials and how to structure its debt and capital.

 

References

Brealey, R.A., Myers, S.C., Marcus, A.J. (2007). Fundamentals of Corporate Finance, 5e. New York: The McGraw-Hill Companies, Inc.

Ford (2008). Form 10k-k, 2008. Retrieved on November 8, 2009 from http://edgar.sec.gov

MSN money. (n.d.). Retrieved November 2, 2009, from http://moneycentral.msn.com/investor/research/welcome.asp

Yahoo Finance (2009). Stock quote for F. Retrieved on November 8, 2009 from http://finance.yahoo.com.

Bill Gross Calls Fed Change To “Benefit Savers And The Economy” – Zero Hedge

Great article by Zero Hedge regarding Bill Gross’s Comments.

After years of ZIRP (and QE), finally it has dawned on the “smartest people in the room” that neither ZIRP nor QE do much, if anything, to boost the economy. In fact, judging by the secular stagnation the world finds itself in primarily as a result of the $200+ trillion in debt that ZIRP (and QE) have unleashed, growth is contracting with every passing year.

As such, some 6 years after this website first claimed just that, the “smartest people in the room”, especially those working for investment banks and large asset managers, have turned the “tinfoil hat” corner and admit it is time to try something different (of course, they already got their bailouts which were possible only thanks to ZIRP and QE) because everything else the Fed has tried has failed.

Today, in what isn’t the first nor the last call to end ZIRP, Janus’ Bill Gross has released his November monthly outlook titled “It’s the Zero Bound Yield Curve, Stupid!” in which he calls for an anti-Operation Twist, or “Operation Switch” whereby the Fed sells its long-dated holdings and buys short-term paper thereby “steepening the yield curve and benefiting savers, liability based businesses, and the economy itself.” He adds: “They should produce a much steeper yield curve and a higher policy rate to allow banks, financially oriented businesses, as well as household savers themselves to increase margins and restore profit and disposable income growth.”

However, even Gross realizes this is futile:

“But they won’t, you know. Yellen and Draghi believe in the Taylor model and the Phillips curve. Gresham’s law will be found in the history books, but his corollary has little chance of making it into future economic textbooks. The result will likely be a continued imbalance between savings and investment, a yield curve too flat to support historic business models, and an anemic 1-2% rate of real economic growth in even the most robust developed countries.”

This will continue until the day which Bank of America’s Michael Hartnett has dubbed the day the market accepts the Fed has succumbed to “policy failure” and it can no longer push on a string.

But the real reason the Fed no longer has the option to push long-term rates higher is far simpler than any macroeconomic textbook argument or debate between very serious people. It’s this.

And that, more than anything, is why the Fed is caught in a trap: even it realizes it desperately needs to raise rates, but doing so may be the catalyst that finally topples the global $200+ trillion house of debt cards.

From Janus Capital

It’s the Zero Bound Yield Curve, Stupid!

I have been increasingly suspicious since late 2011 that Sir Thomas Gresham (1519-1579) may be the modern John Maynard Keynes. I said as much in a Financial Times op-ed when I wrote in December of that year, that the famous “Gresham’s Law” needs a corollary. Not only does “bad money drive out good money” but “cheap money” may do harm as well. Just as Newtonian physics breaks down, and Einsteinian theories prevail at the speed of light, so too might easy money, which has invariably led to stronger economic recoveries, now fail to stimulate growth close to the zero bound.

Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset prices up and purchases outward on the risk spectrum as investors seek to maintain higher returns. Today, near zero policy rates and in some cases negative sovereign yields have succeeded in driving asset markets higher and keeping real developed economies afloat. But now, after nearly six years of such policies producing only anemic real and nominal GDP growth, and – importantly – declining corporate profit growth as shown in Chart 1, it is appropriate to question not only the effectiveness of these historical conceptual models, but entertain the increasing probability that they may, counterintuitively, be hazardous to an economy’s health.

The proposed Gresham’s corollary is not just another name for “pushing on a string” or a “liquidity trap”. Both of these concepts depend significantly on the perception of increasing risk in credit markets which in turn reduce the incentive for lenders to expand credit. But rates at the zero bound do much the same thing. Zero-bound money – quality aside – lowers incentives to expand loans and create credit growth. Will Rogers once humorously said in the Depression that he was more concerned about the return of his money than the return on his money. His simple expression was another way of saying that from a system wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may break down. If at the same time, and over a several year timeframe, bond investors become increasingly convinced that policy rates will remain close to 0% for an “extended period of time”, then yield curves flatten; 5, 10, and 30 year bonds move lower in yield, which at first blush would seem to be positive for economic expansion (reducing mortgage rates and such). It would seem that lower borrowing costs in historical logic should cause companies and households to borrow and spend more. The post-Lehman experience, as well as the lost decades of Japan, however, show that they may not, if these longer term yields are close to the zero bound.

Chart 1: U.S. Corp Profit Growth (1993-2015)

Chart 1: U.S. Corp Profit Growth (1993-2015)

In the case of low yielding sovereign, as well as corporate AAA and AA rated bonds, this new Gresham’s corollary is certainly counterintuitive. If a government or a too big to fail government bank can borrow near 0%, then theoretically it should have no problem making a profit or increasing real economic growth. What is more important, however, is the flatness of the yield curve and its effect on lending across all credit markets. Capitalism would not work well if Fed Funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30- year corporates did as well. Investors would have no incentive to invest long term. What central bank historical models fail to recognize is that over the past 25 years, capitalism has increasingly morphed into a finance dominated as opposed to a goods and service producing system.

It is not only excessive debt levels, insolvency and liquidity trap considerations, then, that delever both financial and real economic growth, it is the zero-bound nominal policy rate, the assumption that it will stay there for “an extended period of time” and the resultant flatness of yield curves which may be culpable. As a result, in the case of banks, their “Nims” or net interest margins are narrowed as Chart 1 suggests. It stands to reason that when bank/finance profit margins resulting from maturity extension are squeezed (curve flattening) then overall corporate profits are squeezed as well.

This new Gresham’s corollary applies to other finance based business models as well. If long term liability based pension funds and insurance companies cannot earn an acceptable “spread” from maturity extension – and in the case of zero based policy rates – cannot therefore earn an acceptable return on their investments to cover future liabilities, then capitalism stalls or goes in reverse. Profit growth or profits themselves come down and economic growth resembles the anemic experience of Japan; pension funds begin to cut benefit payments as recently threatened in Puerto Rico and Illinois, reducing disposable personal income. Even unions are not exempt, as preliminary threats to cut benefits by 50% by the Teamsters show. Corporate profits may be further reduced as an increasing number of companies using defined benefit plans are forced to increase contributions to wobbly and underfunded balance sheets. Individual households must also save more and consume less if the return on their savings is reduced by a flatter yield curve.

My primary thesis, supported by the above examples, remains that capitalism does not function well, and profit growth is stunted, if short term and long term yields near the zero bound are low and the yield curve inappropriately flat. Chart 2, which graphically displays yield curve flattening cycles over the past 20 years, shows a remarkable one to two year leading correlation

Chart 2: U.S. Yield Curve (1993-2015)

Chart 2: U.S. Yield Curve (1993-2015)

to increasing/decreasing rates of profit growth seen in Chart 1, even when the flattening results from lower long term yields as opposed to central bank tightening as in 1993-1997. When our modern financial system can no longer find profitable outlets for the credit it creates, it has a tendency to slow and begin to inhibit economic and profit growth in the overall economy. With a near zero interest rate policy, central banks zero out the cost of time, bidding up existing asset prices, but failing to create sufficient new assets in the real economy.

Global central bank staff models will likely not validate this new Gresham’s corollary. Former Fed chairman Ben Bernanke blamed a mild policy rate increase in the midst of the 1930s for an economic relapse, and a lack of credit expansion for Japan’s lost decades 60 years later. He avoided the potential influence of low yields themselves, claiming then, as now, that green-shoots growth would eventually restore normality to savers. But all central banks should now commonsensically question whether ultra-cheap money continually creates expansions as opposed to reducing profit margins and hindering recovery. Recent experience would confirm the latter thesis.

And if the Fed and other central banks one day understand this, what should they do? They should produce a much steeper yield curve and a higher policy rate to allow banks, financially oriented businesses, as well as household savers themselves to increase margins and restore profit and disposable income growth. How is a steeper yield curve possible however, if at the same time they are raising policy rate targets to more normal levels as I and others have recommended for some time now in the U.S.? Two ways in my view, neither of which would support intermediate/long term bond prices at current levels but which might be beneficial to the longer term real economy.

  1. Central banks could raise their inflation targets. Japan has done so over the past few years, avoided deflation/recession and actually benefited bond and equity markets. Targeting 3% inflation worldwide should raise 10-30 year yields more than short rates resulting in a steeper curve at slightly higher yield levels. San Francisco Fed President John Williams recently brought up the possibility of raising inflation targets in the absence of more stimulative fiscal policy.
  2. I propose an “Operation Switch”. Instead of 2012’s “Operation Twist”, which sold 2-5 year notes and reinvested the proceeds in longer dated Treasuries now resting in their portfolio, the Fed should do just the reverse. After all, the twist did nothing to improve YOY GDP growth – it may in fact have lowered it as the above argument claims – dropping GDP in the 4th quarter of 2013 to .9% YOY following the “Twist” in 2012. The Fed now holds upwards of $2 trillion longer dated Treasuries and mortgages that can be “switched” into 2-5 year paper, steepening the yield curve and benefiting savers, liability based businesses, and the economy itself. But they won’t, you know. Yellen and Draghi believe in the Taylor model and the Phillips curve. Gresham’s law will be found in the history books, but his corollary has little chance of making it into future economic textbooks. The result will likely be a continued imbalance between savings and investment, a yield curve too flat to support historic business models, and an anemic 1-2% rate of real economic growth in even the most robust developed countries.

The Fed, the ECB, the BOJ? Stupid, they are not. But stubborn, and reluctant to adapt to a significantly changed finance based economy over the past 40 years? Most certainly. Central bankers’ failure to recognize the “Shadow Banking” system pre-Lehman proved that, and their fixation on zero bound or in some cases negative yields, with their accompanying low and flat intermediate and long term rates, confirms the same today.

The Right Way to Invest: Our Investment Principles – OppenheimerFunds

This is an excellent example of a marketing and life concept.  Ideas and believes drive your success.  I also enjoyed his point on remaining positive. 

Chief Investment Officer Krishna Memani describes our approach.

Markets may change, but we believe remains constant. We believe success in investing can come by adhering to four simple, but important principles.

  • Make Global Connections
  • Look to the Long Term
  • Take Intelligent Risks
  • Invest with Proven Teams

Fed Would Consider “Negative Interest Rates”

Speaking of Fed rate hikes. Or better yet, the lack of them. So. Do you remember when I told you that in the next recession, that the Fed’s quiver was just about out of arrows, and that the arrows that remained were desperate measures?  You know, like negative deposit rates.  Well, get this. Fed member Dudley decided that now was the time to begin to grease the tracks for negative rates.  Let’s listen in. “Some of the experiences in Europe suggest maybe we can use negative interest rates and the costs aren’t as great as you anticipate. So I would think that in a future episode that the Fed would consider it.”

So, in other words, in the next recession, you can look for negative interest rates. And if that’s the case, then you might as well, begin to get used to it, because the next recession in just around the corner.  I read this weekend that there’s a group of economists that get asked every month by Bloomberg to estimate the likelihood that the U.S. Economy will go into a recession within a year, and for the past year, they’ve put the odds at 10% (so not much chance, eh?) Well, this month the odds rose to 15%… Still no chance, according to these economists that the U.S. will experience a recession in the next year. Apparently, these economists had been standing in line for the grand opening of the new IKEA store here in St. Louis, and missed all the recent data that shows the U.S. economy slowing down again.