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Robert Kiyosaki - Rich Dad, Poor Dad

How to make money books by Kiyosaki occupy 2 places in the top 10 of the NY Times best-seller list. To invest freely and grow rapidly, being able to take advantage and use the money earned with safety and convenience, start a business, and deal with taxes and reporting.

It would be wiser moving forward to look at tax rates and benefits of expensing as a limited liability company, using smart contracts that execute automatically. Use local banking and pay taxes with good accounting, also allows other businesses to value our company based on multiple years of growth and earnings (and that isn’t possible without correct tracking).


Rich Dad, Poor Dad

Financial Management

The stockholders who own a corporation want its managers to maximize its overall value and the current price of its shares. The stockholders can all agree on the goal of value maximization, so long as financial markets give them the flexibility to manage their own savings and investment plans. Of course, the objective of wealth maximization does not justify unethical behavior.

Investment decisions force a trade-off. The firm can either invest cash or return it to shareholders, for example, as an extra dividend. When the firm invests cash rather than paying it out, shareholders forgo the opportunity to invest it for themselves in financial markets. The return that they are giving up is therefore called the opportunity cost of capital. If the firm's investments can earn a return higher than the opportunity cost of capital, shareholders cheer and stock price increases. If the firm invests at a return lower than the opportunity cost of capital, shareholders boo and stock price falls.

Managers may consider their own personal interests, which creates a potential conflict of interest with outside shareholders. This conflict is called a principal-agent problem. Any loss of value that results is called an agency cost. Corporate governance helps to align managers' and shareholders' interests, so that managers pay close attention to the value of the firm. For example, managers are appointed by, and sometimes fired by, the board of directors, who are supposed to represent shareholders. The managers are spurred on by incentive schemes, such as grants of stock options, which pay off big only if the stock price increases. If the company performs poorly, it is more likely to be taken over, ushering in a new management team.

Present Value

Firms can best help their shareholders by accepting all projects that are worth more than they cost. In other words, they need to seek out projects with positive net present values. Net present value is present value plus any immediate cash flow. The discount rate is determined by rates of return prevailing in capital markets. If the future cash flow is absolutely safe, then the discount rate is the interest rate on safe securities such as U.S. government debt. If the future cash flow is uncertain, then the expected cash flow should be discounted at the expected rate of return offered by equivalent-risk securities.

Cash flows are discounted for two simple reasons: because a dollar today is worth more than a dollar tomorrow and a safe dollar is worth more than a risky one. Financial markets, including the bond and stock markets, are the markets where safe and risky future cash flows are traded and valued. That is why we look to rates of return prevailing in the financial markets to determine how much to discount for time and risk. By calculating the present value of an asset, we are estimating how much people will pay for it if they have the alternative of investing in the capital markets.

Valuing Bonds

Bonds are simply long-term loans. If you own a bond, you are entitled to a regular interest (or coupon) payment and at maturity you get back the bond’s face value (or principal). The value of any bond is equal to its cash payments discounted at the spot rates of interest. Spot interest rates are most conveniently calculated from the prices of strips, which are bonds that make a single payment of face value at maturity, with zero coupons along the way. The price of a strip maturing in a future date t reveals the discount factor and spot rate for cash flows at that date. All other safe cash payments on that date are valued at that same spot rate.

Investors and financial managers use the yield to maturity on a bond to summarize its prospective return. The yield to maturity discounts all cash payments at the same rate, even if spot rates differ. Notice that the yield to maturity for a bond can’t be calculated until you know the bond’s price or present value. A bond’s maturity tells you the date of its final payment, but it is also useful to know the average time to each payment. This is called the bond’s duration. Duration is important because there is a direct relationship between the duration of a bond and the exposure of its price to changes in interest rates. A change in interest rates has a greater effect on the price of long-duration bonds.

The term structure of interest rates is upward-sloping more often than not. This means that long-term spot rates are higher than short-term spot rates. But it does not mean that investing long is more profitable than investing short. The expectations theory of the term structure tells us that bonds are priced so that an investor who holds a succession of short bonds can expect the same return as another investor who holds a long bond. The expectations theory predicts an upward-sloping term structure only when future short-term interest rates are expected to rise.

The expectations theory cannot be a complete explanation of term structure if investors are worried about risk. Long bonds may be a safe haven for investors with long-term fixed liabilities. But other investors may not like the extra volatility of long-term bonds or may be concerned that a sudden burst of inflation may largely wipe out the real value of these bonds. These investors will be prepared to hold long-term bonds only if they offer the compensation of a higher rate of interest. Bonds promise fixed nominal cash payments, but the real interest rate that they provide depends on inflation. The best-known theory about the effect of inflation on interest rates was suggested by Irving Fisher. He argued that the nominal, or money, rate of interest is equal to the required real rate plus the expected rate of inflation.

Stock Valuation

The value of a stock is equal to the stream of cash payments discounted at the rate of return that investors expect to receive on other securities with equivalent risks. Common stocks do not have a fixed maturity; their cash payments consist of an indefinite stream of dividends. This is a condition of market equilibrium. If it did not hold, the share would be overpriced or underpriced, and investors would rush to sell or buy it. The flood of sellers or buyers over time forces the price to adjust so that the fundamental valuation holds.

The ratio EPS is the capitalized value of the earnings per share that the firm generates. A growth stock is one for which earnings growth is large relative to the capitalized value of EPS. Most growth stocks are found in rapidly expanding firms, but expansion alone does not create a high value. What matters is the profitability of the new investments.

The same formulas used to value common shares can also be used to value entire businesses. In that case, you discount not dividends per share but the entire free cash flow generated. Usually a two-stage discounted cash flows model is deployed. Free cash flows are forecasted out to a horizon and discounted to present value. Then a horizon value is forecasted, discounted, and added to the value of the free cash flows. In valuing a business, forecasting reasonable horizon values is particularly difficult. The usual assumption is moderate long-run growth after the horizon, which allows use of the growing-perpetuity formula at the horizon. Horizon values can also be calculated by assuming “normal” price–earnings or market-to-book ratios at the horizon date.

Investment Criteria

Some firms look at the book rate of return on the project. In this case the company decides which cash payments are capital expenditures and picks the appropriate rate to depreciate these expenditures. It then calculates the ratio of book income to the book value of the investment. Few companies nowadays base their investment decision simply on the net present vale (NPV) rate of return, but shareholders pay attention to book measures of firm profitability and some managers therefore look with a jaundiced eye on projects that would damage the company's book rate of return.

Some companies use the payback method to make investment decisions. In other words, they accept only those projects that recover their initial investment within some specified period. Payback is an ad hoc rule. It ignores the timing of cash flows within the payback period, and it ignores subsequent cash flows entirely. However, this takes no account of the opportunity cost of capital.

The internal rate of return (IRR) is defined as the rate of discount at which a project would have zero net present value (NPV). The IRR rule states that companies should accept any investment offering an IRR in excess of the opportunity cost of capital. If capital is limited, then the firm should follow a simple rule: Calculate each project's profitability index, which is the project's net present value per dollar of investment. Then pick the projects with the highest profitability indexes until you run out of capital. Unfortunately, this procedure fails when capital is rationed in more than one period or when there are other constraints on project choice.

Investment Decisions

  1. Discount cash flows, not profits.
  2. Remember that depreciation is not a cash flow (though it may affect tax payments).
  3. Concentrate on cash flows after taxes. Stay alert for differences between tax depreciation and depreciation used in reports to shareholders.
  4. Exclude debt interest or the cost of repaying a loan from the project cash flows. This enables you to separate the investment from the financing decision.
  5. Remember the investment in working capital. As sales increase, the firm may need to make additional investments in working capital, and as the project comes to an end, it will recover those investments.
  6. Beware of allocated overhead charges.
  7. Estimate the project's incremental cash flows.
  8. Include all indirect effects of the project, such as its impact on the sales of the firm's other products.
  9. Dismiss sunk costs.
  10. Include opportunity costs, such as the value of land that you would otherwise sell.
  11. Take inflation into account.
  12. If cash flows are forecasted in nominal terms, use a nominal discount rate.
  13. Discount real cash flows.

Investment Risks

Suppose the project has the same market risk as the company's existing assets. In this case, the project cash flows can be discounted at the company cost of capital. The company cost of capital is the rate of return that investors require on a portfolio of all of the company's outstanding debt and equity. It is usually calculated as an after-tax weighted-average cost of capital, that is, as the weighted average of the after-tax cost of debt and the cost of equity.

Managers, therefore, need to understand why a particular project may have above or below-average risk. You can often identify the characteristics of a project even when the beta cannot be estimated directly. For example, you can figure out how much the project's cash flows are affected by the performance of the entire economy.Diversifiable risks do not affect asset betas or the cost of capital, but the possibility of bad outcomes should be incorporated in the cash-flow forecasts. Also be careful not to offset worries about a project's future performance by adding a fudge factor to the discount rate.

Most projects produce cash flows for several years. Firms generally use the same risk-adjusted rate to discount each of these cash flows. When they do this, they are implicitly assuming that cumulative risk increases at a constant rate as you look further into the future. That assumption is usually reasonable. It is precisely true when the project's future beta will be constant, that is, when risk per period is constant.

Project Analysis

Good capital budgeting practice also tries to identify the major uncertainties in project proposals. There are several ways in which companies try to identify and evaluate the threats to a project's success. The first is sensitivity analysis. Here the manager considers in turn each forecast or assumption that drives cash flows and recalculates net present value (NPV) at optimistic and pessimistic values of that variable. Sensitivity analysis often precedes break-even analysis, which identifies break-even values of key variables. Suppose the manager is concerned about a possible shortfall in sales. Then he or she can calculate the sales level at which the project just breaks even.

Scenario analysis looks at a limited number of combinations of variables. In that case, you must build a financial model of the project and specify the probability distribution of each variable that determines cash flow. With these distributions in hand, you can get a better handle on expected cash flows and project risks. You can also experiment to see how the distributions would be affected by altering project scope or the ranges for any of the variables.

Options to modify projects are known as real options. In this chapter we introduced the main categories of real options: expansion options, abandonment options, timing options, and options providing flexibility in production. Good managers take account of real options when they value a project. One convenient way to summarize real options and their cash-flow consequences is to create a decision tree. You identify the things that could happen to the project and the main counteractions that you might take. Then, working back from the future to the present, you can consider which action you should take in each case.

Behavioral Finance

The efficient-market hypothesis comes in three different flavors. The weak form of the hypothesis states that prices efficiently reflect all the information in the past series of stock prices. In this case it is impossible to earn superior returns simply by looking for patterns in stock prices; in other words, price changes are random. The semistrong form of the hypothesis states that prices reflect all published information. That means it is impossible to make consistently superior returns just by reading the newspaper, looking at the company's annual accounts, and so on. The strong form of the hypothesis states that stock prices effectively impound all available information.

Limits to arbitrage can explain why asset prices may get out of line with fundamental values. Behavioral finance, which relies on psychological evidence to interpret investor behavior, is consistent with many of the deviations from market efficiency. Behavioral finance says that investors are averse to even small losses, especially when recent investment returns have been disappointing. Investors may rely too much on a few recent events in predicting the future. They may be overconfident in their predictions and may be sluggish in reacting to new information.

Corporate Borrowing

The most profitable firms within an industry generally have the most conservative capital structures. Under the trade-off theory, high profitability should mean high debt capacity and a strong tax incentive to use that capacity. Firms use internal financing when available and choose debt over equity when external financing is required. This explains why the less profitable firms in an industry borrow more-not because they have higher target debt ratios but because they need more external financing and because debt is next on the pecking order when internal funds are exhausted.

If investors pay higher taxes on interest income than on equity income (dividends and capital gains), then interest tax shields to the corporation will be partly offset by higher taxes paid by investors. U.S. tax rates on dividends and capital gains have reduced the tax advantage to corporate borrowing. The trade-off theory balances the tax advantages of borrowing against the costs of financial distress. Corporations are supposed to pick a target capital structure that maximizes firm value. Firms with safe, tangible assets and plenty of taxable income to shield ought to have high targets. Unprofitable companies with risky, intangible assets ought to rely more on equity financing.

Managers know more about their firms than outside investors do, and they are reluctant to issue stock when they believe the price is too low. They try to time issues when shares are fairly priced or overpriced. Investors understand this, and interpret a decision to issue shares as bad news. That explains why stock price usually falls when a stock issue is announced. Debt is better than equity when these information problems are important. Optimistic managers will prefer debt to undervalued equity, and pessimistic managers will be pressed to follow suit. The pecking-order theory says that equity will be issued only when debt capacity is running out and financial distress threatens.

Call Options

There are two types of options. An American call is an option to buy an asset at a specified exercise price on or before a specified maturity date. Similarly, an American put is an option to sell the asset at a specified price on or before a specified date. European calls and puts are exactly the same except that they cannot be exercised before the specified maturity date. Calls and puts are the basic building blocks that can be combined to give any pattern of payoffs.

To exercise an option you have to pay the exercise price. Other things being equal, the less you are obliged to pay, the better. Therefore, the value of a call option increases with the ratio of the asset price to the exercise price. You do not have to pay the exercise price until you decide to exercise the option. Therefore, a call option gives you a free loan. The higher the rate of interest and the longer the time to maturity, the more this free loan is worth. So the value of a call option increases with the interest rate and time to maturity.

If the price of the asset falls short of the exercise price, you won't exercise the call option. You will, therefore, lose your investment in the option no matter how far the asset depreciates below the exercise price. On the other hand, the more the price rises above the exercise price, the more profit you will make. Therefore the option holder does not lose from increased volatility if things go wrong, but gains if they go right. The value of an option increases with the variance per period of the stock return multiplied by the number of periods to maturity. Always remember that an option written on a risky (high-variance) asset is worth more than an option on a safe asset. It's easy to forget, because in most other financial contexts increases in risk reduce present value.

Planning

Financial planning is concerned with the management of the firm's short-term, current assets and liabilities. The most important current assets are cash, marketable securities, accounts receivable, and inventory. The most important current liabilities are short-term loans and accounts payable, and the difference between current assets and current liabilities is called working capital.

A firm that issues large amounts of long-term debt or common stock, or that retains a large part of its earnings, may find it has permanent excess cash. However, large cash holdings can lead to complacency. Other firms raise relatively little long-term capital and end up as permanent short-term debtors. Most firms attempt to find a golden mean by financing all fixed assets and part of current assets with equity and long-term debt. Such firms may invest cash surpluses during part of the year and borrow during the rest of the year.

If the forecasted cash balance is insufficient to cover day-to-day operations and to provide a buffer against contingencies, the company will need to find additional finance. The financial manager must explore the consequences of different assumptions about cash requirements, interest rates, sources of finance, and so on. Firms use computerized financial models to help in this process.

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