Non Performance Risk- Warranty vs Guaranty

– The concept of Warranty and Guarantee covers for Non Performance Risk.

– The term Guarantee is coined by people for convenience.

– It is left to the contracting parties to define what they mean by “Warranty” and “Guaranty”.

– In lending agreements, collateral is a borrower’s pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as protection for a lender against a borrower’s default – that is, any borrower failing to pay the principal and interest under the terms of a loan obligation.

– Terms and Stipulations are the one and the same things.

– Essence of any contract are warranties and conditions.

– Any breach in warranties means the right to claim damages.

– Any breach in conditions leads to cancellation of the contract (+ damages)

[This blog is captured from “Managing Commercial contracts” class notes (by Prof S. Shankar . Some information referred from Wikipedia/other listed sites.]

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Nominal and Real Cost of Capital

Cost of Capital or Discounting factor can also be termed as Weighted Average Cost of Capital (WACC)

WACC(nominal) is defined as

Cost of Capital = 
             [CoE * (Equity/Total_Capital)] +
                   [CoD * (Debt/Total_Capital) * (1-Tax_Rate)]
             OR
             [CoE*((Proportionate of Equity in Total Capital)/Total_Capital)]
                + [CoD * ((Proportionate of Debt in Total Capital) /Total_Capital)
                                                                   * (1-Tax_Rate)]
where
# CoE is Cost of Capital and CoD is Cost of Debt

If there is inflation, then WACC(real) is defined as

WACC(real) = {[WACC(nominal)/(1+inflation_rate)]-1}

Cost of Capital or Discounting Factor

‘Cost of Capital’ or Discounting Factor

There are two kinds of capital, one is loan/debt and other is equity.
How do we get discounting factor OR ‘Cost of Capital’? Here cost of debt can be known from the banks, but the cost of equity depends on the risk involved in the business. As cost of equity is not straight forward, we have to identify a mechanism to find out the cost of equity capital. Minimum cost of equity capital would be bank lending rate/government bond return (risk free rate).

Cost of Debt Capital = (Government Bond Return) + (Risk Premium for Lending)
Cost of Equity Capital = (Government Bond Return) + (Risk Premium for Investing)

Note: Government bond returns can be looked at rbi.org. Today’s  rate is 8%.

In general
Cost of Capital = (Risk Free Rate) + (Risk Premium) = RF + RP
where
# Risk Premium is a function of lending/investment instrument. For lending
      instrument RP is lower and for investment instrument RP will be higher.
# RP also depends on the risk involved in the business.

Let’s take an example (explained in our classroom):
Assume Jet Airline and Tata Power Utility companies are planning to  raise money through their bonds along with the equity investors and if investor X is planning to invest money in these companies then

Airline Power Utility
Bond 8% + ? 8% + ?
Equity 8% + ? 8% + ?

Say, investor X is interested in all the cases then, since Airline industry is more riskier than power utility business let’s assume, in Airline Bond X is expecting 4% more and in Power Utility Bond X is expecting 3% (which is nothing but risk premium on debt instrument) more than government risk free bond (i.e, 8%)

Airline Power Utility
Bond 8% + 4% 8% + 3%
Equity 8% + ? 8% + ?

Now calculate how much more X should demand on equity investment? which is nothing but risk premium on investment. How do we determine this? using Capital Asset Pricing Model CAPM, using CAPM we can calculate cost of capital.

Cost of Capital = RF* + Beta(RM-RF)
where
# RF* is the government's bond risk free rate that is taken today
  (at which point X is investing).
# Beta is a constant factor
# RM is Stock Market Return (RM) Rate
# RF is risk free rate
# (RM-RF) is historical average (not the current one)

How to find RF*? Go to http://www.rbi.org.in  On the front page itself, you will see Market Trends.  You can also use Deposit Rate or policy rates.  Place your cursor and you will find the rates.  This link also gives you good amount of information:  Database of Indian Economy RBI site has huge data and you need to patiently go through to extract the information.

RM-RF has to be sourced from two different sources.

How to find RM? RM is available in this link:  Database of Indian Economy.  You need to select:   Home + Statistics + Financial Market + Equity and Corporate Debt Market + YEARLY.

How to find RF? RF is from RBI website. Normally, it is recommended that we use about 60 years average period risk premium.  We don’t have that much of history in India and what we have is at best 30 years data.

How to get beta? You can get beta from http://www.capitaline.com but this one will work only in IIMB.  Google search will be helpful. See this one: http://in.reuters.com/finance/stocks/overview?symbol=JET.NS It looks http://in.reuters.com is useful.

What is Stock Index? It is a bench mark to invest money on safer side with minimum risk (like mutual funds). S&P is one such standard. How do we measure individual stock risk? Instead of trying to measure individual stock risk, we measure it relative to the stock index.

What does beta indicates? Beta for Jet Airways from Nifty is 1.27, which means that on a day when market raises 1% – expected returns of Jet Airways becomes 1.27% and vice versa applies when market declines.
Beta for Tata Power is 0.94

Note: If beta >1; it is more risky. If beta<1 is considered good.

Airline Power Utility
Bond 8% + 4% 8% + 3%
Equity 8% + (1.27*9%) = 19.43% 8% + (0.94*9%) = 16.46%

Now that we have cost of equity and debt capital, we can calculate the cost of capital.

Let’s say: Jet Airways company Equity of 30% and Debt 70% and Tata Power Utility company Equity of 20% and Debt 80%.

Cost of Capital = [CoE * (Equity/Total_Capital)] +
                        [CoD * (Debt/Total_Capital) * (1-Tax_Rate)]
                OR
                = [CoE*((Proportionate of Equity in Total Capital)/Total_Capital)]
                      + [CoD * ((Proportionate of Debt in Total Capital) /Total_Capital)
                                                                      * (1-Tax_Rate)]
where
# CoE is Cost of Capital and CoD is Cost of Debt

Since interests are exempted from taxes, cost of debt is multiplied by (1-tax_rate)

If we remember in previous cash flow concepts we assumed total projects are equity funded and exempted tax rates and hence we are including the taxes here in cost of debt.

From the above equations it implies that cost of capital reduces with increase in equity which means that we should go more for debt, but going for more debt involves more risk that we are taking. How do we measure the tolerance level of the risk involved in taking debts? Use optimal debt capacity

Optimal Debt Capacity: It depends on
1. Nature of the project: If the risk involved in business(technology products which outdates very soon) is high then take less risk and hence low debt. Look at the explanation from financial accounting.
2. Age of the business.

Uncertainty Costs and problems with NPVs and IRRs

What are Uncertainty Costs? uncertainty in the costs because of the instability in various factors that are considered in the project costs.

How are uncertainty costs addressed in stock markets?
In stock market there is something called ‘Call Option’. Call Option is like while buying the share we can also buy the call option of the share which implies the agreement between the buyer and the seller of the call option that if the share value goes up then buyer will get benefited from the shares, and if the share value goes down then buyer is not going to bear the loss(insulated by the call option provider)

Black Shoe Option pricing Model is one way of coming up with an algorithm to price the call option.

What is the problem with NPV or IRR? Since we assume every future number’s present value, there is some uncertainty involved the evaluation of the project costs. To address this we need to simulate the NPV/IRR for different values of ‘Cost of Uncertainties’, Cash Inflows and Cash Outflows.

Assume we simulate NPVs for thousands of times by taking different uncertainties. And from this we can form rules to find out possibilities of IRR>=15%, then we can take out all the cases in which it is meeting the criteria, etc…

This simulation is also known as Monte Carlo Simulation (MCS).

Working Capital, Cash Inflows and Cash Outflows

Working Capital

It is the minimum amount of money which is required to run the project.

In financial accounting Working Capital is

(Current Assets - Current Liabilities)
# where
# Current Assets includes cash, inventory(which includes raw material, etc)
# and account receivables.

In corporate financing, Working Capital is

[(current asset which is the minimum capital required to run the business
 + account receivables) - (account payables)]

What is Cash Outflow (COF)? it is an expense occured in all the project activities like infrastructure, salaries, land value etc. We should always avoid sunk costs such as R&D costs in cash outflows.

Note: Cash Outflows are always negative numbers.

What is sunk cost and when we should avoid them?
Sunk cost is something which is already spent and cannot be retrieved. We should always avoid sunk costs in the project costs (Cash Outflows) unless there is a value for the sunk cost in the market. For example, land value of project, R&amp;D expense of the project should not be considered in the project costs.

What is Cash Inflow? Cash Inflows can be computed in number of ways:

#1. CI = PBDIT-Tax;

#2. CI = PAT+Interest+Depreciation

Corporate Financing takes Cash Inflows a bit different from financial accounting – The factors we need to consider are:

  • We take depreciation as 0 because there is no actual cash involved in depreciation.
  • We take interest also as 0 just like we have started company with 100% equity. Even if there is actual interest we do not consider the interest.
  • Then we calculate tax separately, at the time of calculating tax, we consider depreciation.

Depreciation and Working Capital
At the start of the company/project we need to have working capital, and at the end of the project/company or after the life of the project we will get back the working capital that we initially started through salvage value of the remaining assets. Salvage value of the asset is 5% of the actual asset value.

Profitability Index and its usage

Profitability Index (PI)

What is Profitability Index? This is one of the index used to evaluate if the project is feasible to execute or not.  This is computed in two different ways

PI = (present value of cash inflow)/( present value of cash outflow)
OR
PI = NPV/COF

Decision Rule: In Method #1 accept the project if PI>1 and Method#2 accept if PI>0.

Where do we use PI? If we have limited cash where we have to select a single project and very large number of available options (with high number of projects)

Example:
Select projects subject to COF<=1000

Project    COF      NPV   IRR
     1	   300	    66	  17.2
     2	   200	   -4	  10.7
     3	   250	    43	  16.6
     4	   100	    14	  12.1
     5	   100	    7	  11.8
     6	   350	    63	  18.0
     7	   400      48	  13.5
Cash Available:    $ 1.00
Cost of Capital:     11%

Which of these projects to be selected? Apart from 2nd project other are positive hence eligible, find out values and take the projects in the descending order with sum<=1000

Payback Period and Book Returns

Payback Period (PP)

Period required to get back initial investment (adjusted for time value)
Decision Rule: Consider projects whose payback period is less than or equal to hurdle payback period
Hurdle Payback Period is some standard period defined for PP.

Book Return

It is also called as Accounting Rate of Return. This is defined as

Book Return = (Book Income)/(Book Assets)
or
ARR = (Avg PAT + Interest)/(Avg Book Value)

How is Book Income calculated? is also called as PAT.
How is Avg Book Value calculated? is the average of year after year depreciation of the initial investment.

Note: In practice it is better to avoid this value because it is easy to manipulate this value (one reason can be because of different depreciation methods).

Net Present Value and Internal Rate of Return

Net Present Value (NPV)

It is defined as (Sum of present value of all cash inflows) – (sum of present value of all cash outflows)
Decision Rule:  Accept the project if NPV is >= 0: Accept the project OR project is financially feasible.

Internal Rate of Return(IRR): 

It means the rate at which the Present Value of cash inflow (CIF) is equal to Present Value of cash outflow (COF) or npv=0.
Decision Rule:
  Accept project whose IRR>=Discounting Factor
where,
Discounting Factor = 1/[(1+r)^n]
where,
r is the interest rate/discounting rate and n is the period

Note: We can also define it in terms of future values but in general future values are generally used for savings and present value is used for investments

There is possibility of having two IRR values for same project. How can IRR have two different value? Let’s see the below problem
Question: Initial investment of the project is 100 and cash inflows in first and second years are 40 and 60 respectively. Find if the project is feasible or not?

From the definition of IRR, equate PV of initial investment = PV of cash inflows

100 = 40/(1+r) + 60/(1+r)^2

this would lead to function defined by a quadratic equation and hence with two roots, hence IRR could have more than one value.

In general use NPV for decision making and IRR for communication

Reasons NPV as positive value and IRR as negative could be:

  • adding new project to the existing project
  • if there are any additional cash outflows apart from the initial investment (initial cash outflow) because of which cash inflows are positive and outflows negative could lead to negative IRR.

How do you identify if IRR is negative? In IRR excel function put some positive and negative percentages, it the value remains same then we have only one IRR otherwise there is more than one value for IRR.

A project with positive NPV and negative IRR is generally considered inconsistent.

What does COMBITERMS 2000 mean ?

– COMBITERMS helps us understand who will bear the cost of shipment considering the various stages of shipment.

– COMBITERMS defines the cost sharing terms for a shipment between a buyer and a seller.

– COMBITERMS helps define the Trade terms for the different modes of the transport.

This site defines COMBITERMS 2000 as “Combiterms 2000 is based on Incoterms, a set of regulations containing international trade terms and standardized contract terms about how responsibility and the costs of transporting goods should be divided between buyers and sellers. They are fundamental, especially to international trade transactions, and are in line with the UN Convention on Contracts for the International Sale of Goods.”

Some examples below-

– In sea transport, the Trade term- FAS means Free Alongside Ship. If this is the trade term then Loading at the seller’s premises is the Seller’s responsibility whereas paying Import charges and Unloading at buyer’s premises is Buyer’s responsibility.

– In all modes of transport, the Trade term- DDP means Delivered buyer’s premises Duty Paid, exclusive of. In this trade term, Loading at the seller’s premises is the seller’s responsibility but paying the Import charges is Seller’s responsibility whereas Unloading at buyer’s premises is the Buyer’s responsibility.

– P-56 in the printed material provided in the class defines the COMBITERMS for Sea transport only.

– P-57 in the printed material provided in the class defines the COMBITERMS for all the modes of transport.

[This blog is captured from “Managing Commercial contracts” class notes (by Prof S. Shankar . Some information referred from Wikipedia/other listed sites.]

Functional structure vs. Divisional structure

– Functional structure is considered more efficient because people are organized as per the expertise they bring in. Because of this they could deliver the output more efficiently. For the very same reasons, the Divisional structure is not considered efficient as there tend to be the redundancy of resources.

– In Functional structure, the across-function communication is less so the chances of creating Functional silos is more. Divisional structure on the other hands is more flexible and allows for movement of people. Silos are possible here too.

– Functional structure is less flexible whereas Divisional structure is more flexible.

– The Manager or the superior will be an expert in the functional area so there will be more credibility in relaying the feedback. This leads to something called as a Social Specialization. Since Social specialization is missing in Divisional organization, the feedback mechanism may not be fully trust-worthy.

 [This blog is captured from “Organization Structure and Design” class notes (by Prof Sourav Mukherji . Some information referred from Wikipedia/other listed sites.]

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