Financial issues » Finance

Simultaneous Death

admin — Mon, 13 Jul 2009 18:50:49 +0000

The will may provide that testator’s spouse shall be presumed to have survived the testator if both should die in a common disaster under circumstances that make it uncertain who died first. If the will does not contain such a simultaneous death clause, Oklahoma’s statute (Title 58, Oklahoma Statutes Annotated, Section 1001) directs that in event of such common disaster causing the simultaneous death of both husband and wife, it shall be ruled by the court that neither spouse shall have survived the other. The estate of each then would pass to his or her respective heirs or in accordance with their respective wills. The statute would disqualify the marital deduction savings on federal estate taxes if this provision is not included.

(In)Efﬁcient Markets

admin — Sat, 27 Jun 2009 13:02:35 +0000

As we know from earlier posts, economic theory approaches the issue of exchange rates by trying to ﬁnd a theoretical equilibrium level, against which one can measure over- or undervaluation relative to the actual exchange rate. Such theory relies on a number of important premises with regard to the information that might affect exchange rates:
Exchange rates reﬂect all available knowledge at any one time
There is perfect knowledge dispersal (such that no-one has an advantage)
While it is debatable whether or not these exist in other ﬁnancial markets, we do know that these are not the reality in the currency market. Many people think of the currency or FX market as the “perfect market”, being that in which knowledge dispersal is optimum and which responds with perfect efﬁciency to stimulus. This simply isn’t the case. Information is not perfect and some market participants can indeed gain a knowledge advantage over their counterparts. Why is this so?
The sheer weight of information affecting exchange rates at any one time is so huge that all currency market practitioners cannot possibly absorb all of it all of the time.
Knowledge dispersal is not perfect and some do have an advantage over others. Such advantages may include knowledge about speciﬁc ﬂows that may occur, a bank’s own “order book” and ﬁnally the ability to do larger currency market transactions than other market participants.
If knowledge is power, then such power in the currency market is not distributed equally. This is no accident. Indeed, it is the very intention of normal and healthy competition to try to gain advantage over other market participants. While news information has never been as freely available as now, at some point that very availability swamps the ability of the users of such information to absorb it all. To some, we appear closer to a state of perfect knowledge than we have ever been, yet I would liken this to the speed of transportation. In 1900, the average speed of the leading mode of transportation in the city of London (the horse) was 11 miles an hour. In 2000, the average speed of the now leading mode of transportation (the turbo fuel-injected car) was . . . 11 miles an hour. Progress begets more progress until you progress so far that you go nowhere. The more information that is available to us, the less we actually have the time (or the willingness) to read. If the good news is that we are closer to perfect knowledge than we have ever been, then the bad news is that we are never likely to get there!
Information costs money to deliver and therefore there is not “perfect” information delivery because not everyone gets it, either at all or at the same time. Even if it were free, “information overload” still means that not everyone reads and uses it at the same time. If you don’t believe me, just think of your e-mail inbox! In sum, there is neither perfect information nor perfect information dispersal — and there never will be. In response, an economist might argue that we have “good” information, if not perfect information. It would be tough to argue with this, but then “good” is not “perfect” and “perfect” is a necessary aspect of the equilibrium concept. Furthermore, this supposed equilibrium level is rarely ever reached. Real life is surely a constant state of ﬂux and imbalance, so why should ﬁnancial markets be any different? In turn, if one assumes that the economic fundamentals that can affect exchange rates are themselves in a constant state of ﬂux, one must equally assume that the equilibrium itself is in a constant state of ﬂux — which to an extent calls into question the idea of it being an “equilibrium” in the ﬁrst place. In truth, it is a signpost on a road. It points you in the right direction, but it gives you no idea of when you will get there or where you might have to turn off along the way.

CURRENCIES ARE DIFFERENT

admin — Sat, 27 Jun 2009 12:02:20 +0000

The ﬁrst thing to say about the currency market is that it possesses and obeys a different set of dynamics to other ﬁnancial markets. Unlike in the case of equity or ﬁxed income markets, the vast majority of currency market practitioners are speculators of one sort or another. Global merchandise trade going through the currency market makes up around 1–2% of total volume. Let’s say we more than double that to allow for foreign direct investment, making a volume contribution of around 5%. Asset market volumes have risen sharply over the past 20 years as barriers to capital have fallen. Having made up only a small proportion of currency market volume before the end of the Bretton Woods exchange rate system, they probably now make up as much as 35% of total currency market volume on a daily basis. That still leaves 60% of daily currency market volume, which has to ascribe to “speculation”. Granted, these are very rough, back-of-the-envelope ﬁgures, but they give a good idea of the proportions that are involved. Given this, is it any wonder that many of the traditional exchange rate models that are based on the current account and therefore on trade ﬂows are poor predictors of exchange rates over the short term?! Equally, this gives some clue as to why the portfolio balance approach to exchange rates also achieves unsatisfactory results.

Terms of Trade

admin — Thu, 25 Jun 2009 21:35:01 +0000

Another important aspect of the external balance approach to exchange rate determination is the so-called “terms of trade”, which is the relationship between a country’s export and import prices. A country’s terms of trade can be an important determinant of its long-term equilibrium real exchange rate. We ﬁnd this particularly the case for countries that are major commodity exporters and therefore whose economies are particularly sensitive to swings in commodity prices. An improvement in a country’s terms of trade, that is a rise in its export prices relative to import prices, should lead to a rise in the real exchange rate equilibrium value. Rising export prices should be reﬂective of rising global demand for that country’s exports, both on an absolute basis and relative to domestic demand levels. Consequently, one should assume that an improvement in the terms of trade should lead to an improvement in the current account balance, which in turn requires a real exchange rate appreciation to restore equilibrium. Equally, a deterioration in the terms of trade leads to a current account deterioration, which requires a real exchange rate depreciation to restore equilibrium. For the sake of clarity, we can express this transmission mechanism using the following simple diagram:
Change in terms of trade -> Change in current account balance -> Real exchange rate change to restore equilibrium
Taking oil as an example, the terms of trade concept is an important determinant of the long term real exchange rate equilibrium value for the countries of the Gulf, Mexico, Venezuela, Colombia, Nigeria, Indonesia, Russia, the UK and Norway. Note that these are just the exporters. The terms of trade concept also works for the importers as well, which is why when the international price of oil experiences a signiﬁcant uptrend, this causes a terms of trade deterioration for the major oil importers, leading to current account balance deterioration. All else being equal, this should require a real exchange rate depreciation to restore equilibrium.

Why Finance and Accounting Think Diﬀerently

admin — Sun, 14 Jun 2009 18:56:37 +0000

Both accountants and ﬁnanciers are interested in ﬁrm value. But the principal diﬀerence between them is that the accountants try to approximate changes in the current value of the ﬁrm, while the latter try to understand the exact timing of hard cash inﬂows and outﬂows over the entire future. The former want to learn about earnings, the latter want to learn about cash ﬂows.
The main diﬀerence between these two concepts of income and cash ﬂows are accruals: economic transactions that have delayed cash implications. For example, if I owe your ﬁrm $10,000
and have committed to paying you tomorrow, the accountant would record your current ﬁrm value to be $10,000 (perhaps time- and credit-risk adjusted). In contrast, the ﬁnancier would consider this to be a zero cash-ﬂow—until tomorrow, when the payment actually occurs. The contrast is that the accountant wants the ﬁnancial statements to be a good representation of the economic value of the ﬁrm today (i.e., you already own the payment commitment), instead of a representation of the exact timing of inﬂows and outﬂows. The ﬁnancier needs the timing of cash ﬂows for the NPV analysis instead.
Accruals can be classiﬁed into long-term accruals and short-term accruals. The primary long-term accrual is depreciation, which is the allocation of the cost of an asset over a period of time. For example, when a ﬁnancier purchases a maintenance-free machine, he sees a machine that costs a lot of cash today, and produces cash ﬂows in the future. If the machine needs to be replaced every 20 years, then the ﬁnancier sees a sharp spike in cash outﬂows every 20 years, followed by no further expenditures (but hopefully many cash inﬂows).
The accountant, however, sees the machine as an asset that uses up a fraction of its value each year. So, an accountant would try to determine an amount by which the machine deteriorates in each year, and would only consider this prorated deterioration to be the annual outﬂow (called an expense). The purchase of a $1 million machine would therefore not be an earnings reduction of $1 million in the ﬁrst year, followed by $0 in the remaining 19 years. Instead, it would be an expense of $50,000 in each of 20 years. (This is a very common method of depreciation and is called straight-line depreciation.)
To complicate matters further, accountants often use diﬀerent standardized depreciation schedules over which particular assets are depreciated. These are called impairment rules, and you already know the straight-line rule. Houses, for example, are commonly depreciated straight-line over 30 years—often regardless of whether the house is constructed of wood or brick. The predetermined value schedule is usually not accurate: For example, if investors have recently developed a taste for old buildings, it could be that a building’s value has doubled since its construction, even though the ﬁnancial statements might record this building to be worth nothing. (Even this is oversimpliﬁed. On occasion, accountants invoke procedures that allow them to reduce the value of an asset midway through its accounting life—but more often downward than upward.) Another common impairment rule is accelerated depreciation, which is especially important in a tax context. (But we are straying too far.)
If the machine happens to continue working after 20 years, the ﬁnancials which have just treated the machine as a $50,000 expense in Year 20 will now treat it as a $0 expense in Year 21. It remains worth $0 because it cannot depreciate any further—it has already been fully depreciated. The ﬁnancier sees no diﬀerence between Year 20 and Year 21, just as long as the machine continues to work.
Short-term accruals come in a variety of guises. To a ﬁnancier, what matters is the timing of cash coming in and cash going out. A sale for credit is not cash until the company has collected the cash. To the accountant, if the ﬁrm sells $100 worth of goods on credit, the $100 is booked as revenue (which ﬂows immediately into net income), even though no money has yet arrived. In the accounting view, the sale has been made. To reﬂect the delay in payment, accountants increase the accounts receivables by $100. (Sometimes, ﬁrms simultaneously establish an allowance for estimated non-payments [bad debts].)
Another short-term accrual is corporate income tax, which a ﬁnancier considers to be an outﬂow only when it has to be paid—at least not until (the corporate equivalent of) April 15 of the following year. However, on the income statement, when a ﬁrm in the 40% corporate tax bracket makes $100 in proﬁts, the income statement immediately subtracts the corporate income tax of $40 (which will eventually have to be paid on the $100 in proﬁts) and therefore records net income of only $60. To reﬂect the fact that the full $100 cash is still around, $40 is recorded as tax payables.
In sum, for a ﬁnancier, the machine costs a lot of cash today (so it is an immediate negative), theaccounts receivables are not yet cash inﬂows (so they are not yet positives), and the corporate income tax is not yet a cash outﬂow (so it is not yet a negative). For an accountant, the machine costs a prorated amount over a period of years, the accounts receivables are immediate positive earnings, and the corporate income tax is an immediate cost. There is deﬁnite sense in the approaches of both accounting and ﬁnance: the accounting approach is better in giving a snapshot impression of the ﬁrm’s value; the ﬁnance approach is better in measuring the timing of the cash inﬂows and cash outﬂows for valuation purposes. Note that valuation leans much more heavily on the assumption that all future cash ﬂows are fully considered. Today’s cash ﬂows alone would not usually make for a good snapshot of the ﬁrm’s situation.

Financial Statements

admin — Mon, 08 Jun 2009 18:55:52 +0000

We already know that the value of our ﬁrm is determined by its underlying projects. We already know that these projects have cash ﬂows that we use in our NPV analyses. So, why should you bother with learning about what companies say in their ﬁnancials? A rose is a rose is a rose, isn’t it? The projects and thus the ﬁrm have the same value no matter what we report.
Yes and no. There are many good reasons why you should understand ﬁnancial statements:
1. If you want to have an intelligent conversation with someone else about corporations, you must understand the language of accounting. In particular, you must understand what earnings are—and what they are not.
2. Subsidiaries and corporations report ﬁnancial statements, designed by accountants for accountants. They rarely report the exact cash ﬂows and cash ﬂow projections that you need for PV discounting. How can you make good decisions which projects to take if you cannot understand most of the information that you will ever have at your disposal?
3. It may be all the information you will ever get. If you want to get a glimpse of the operation of a publicly traded corporation, or understand its economics better, then you must be able to read what the company is willing to tell you. If you want to acquire it, the corporate ﬁnancials may be your primary source of information.
4. The IRS levies corporate income tax. This tax is computed from a tax-speciﬁc variant of the corporate income statement, which relies on the same accounting logic as the published ﬁnancials. (The reported and tax statements are not the same!) Because income taxes are deﬁnite costs, you must be able to understand and construct ﬁnancial statements that properly subtract taxes from the cash ﬂows projected from projects when you want to compute NPV. And, if you do become a tax guru, you may even learn how to structure projects to minimize the tax obligations.
5. Many contracts are written on the basis of ﬁnancials. For example, a bond covenant may require the company to maintain a price-earnings ratio above 10. So, even if a change in accounting rules should not matter theoretically, such contracts can create an inﬂuence of the reported ﬁnancials on your projects’ cash ﬂows.
6. There is no doubt that managers care about their ﬁnancial statements. Managerial compensation is often linked to the numbers reported in the ﬁnancial statements. Moreover, managers can also engage in many maneuvers to legally manipulate their earnings. For example, ﬁrms can often increase their reported earnings by changing their depreciation policies (explained below). Companies are also known to actively and expensively lobby the accounting standards boards. For example, in December 2004, the accounting standards board ﬁnally adopted a mandatory rule that companies will have to value employee stock options when they grant them. Until 2004, ﬁrms’ ﬁnancial statements could treat these option grants as if they were free. This rule was adopted despite extremely vigorous opposition by corporate lobbies, which was aimed at the accounting standards board and
Congress. The reason is that although this new rule does not ask ﬁrms to change projects, it will drastically reduce the reported net income (earnings) especially of technology ﬁrms. But why would companies care about this? After all, investors can already determine that many high-tech ﬁrms (including the likes of Microsoft a few years ago) may have never had positive earnings if they had had to properly account for the value of all the stock options that they have given. This is a big question. Some behavioral ﬁnance researchers believe that the ﬁnancial markets value companies as if they do not fully understand corporate ﬁnancials. That is, not only do they share the common belief that ﬁrms manage their earnings, but they also believe that the market fails to see through even mechanical accounting computations. Naturally, the presumption that the ﬁnancial markets cannot understand accounting is a very controversial hypothesis—and, if true, this can lead to all sorts of troublesome consequences.
For example, if the market cannot understand ﬁnancials, then managers can legally manipulate their share prices. A ﬁrm would especially beneﬁt from a higher share price when it wants to sell more of its shares to the public. In this case, managers could and should maneuver their ﬁnancials to increase their earnings just before the equity issue. There is good evidence that ﬁrms do this—and also that the ﬁnancial markets are regularly disappointed by these ﬁrms’ performances years after their equity issues.
Even more troublesome, there is also evidence that managers do not take some positive NPV projects, if these projects harm their earnings. Does this sound far-fetched? In fact, in a survey of 401 senior ﬁnancial executives Graham, Harvey, and Rajgopal found that 55% would delay starting a project and 80% would defer maintenance and research spending in order to meet earnings targets. Starting projects and doing maintenance and R&D are presumably the right kind of (positive NPV) projects, so not taking them decreases the underlying real value of the ﬁrm—even though it may increase the ﬁnancial image the ﬁrm projects.

TRACKING PIPE TRANSACTIONS

admin — Sun, 24 May 2009 18:55:00 +0000

Regulation FD, which is now known as Reg FD, was enacted in 2000 in order to deal with the issue of selective disclosure of material nonpublic information by public issuers of securities. Reg FD was designed to create a level playing field between institutional and individual market participants. The fair disclosure rules of Reg FD prohibit a company from revealing material nonpublic information to selected investors without disclosing that same material to the public at the same time. While material nonpublic information does not have an exact definition under the regulations, most investment professionals would agree that corporate information can be viewed as material if there exists a substantial possibility that a reasonable investor would consider the information as important in making an investment decision. Information can be viewed as nonpublic if it has not been disseminated in a way that makes it available to all investors at the same time. Thus, a private placement of securities by an issuer in most instances would be a material fact.
Because the fair disclosure regulations would apply to public companies conducting any type of private offering, the information that companies are able to disclose to potential investors during the PIPE marketing process is restricted to publicly available information. However, through the use of confidentiality agreements, potential investors at times expressly agree to keep the information that the issuer is considering an equity offering in confidence until the transaction has been publicly announced or terminated. So a potential investor in a private investment offering for a public company would not be allowed to trade in the issuer’s securities prior to such an announcement or termination of the offering. After a PIPE funding has been agreed to, the public issuer would be required by SEC guidelines and fair disclosure regulations to publicly disclose the transaction. Typically, an issuer would file a current report Form 8-K and issue a press release regarding the funding. It is the Form 8-K filings and press releases that provide a fertile opportunity for micro cap investors to discover potential candidates in the micro cap arena. This is a very useful screening technique when looking at micro cap opportunities.
Private investments in public equities would be considered smart-money transactions. The investment professionals who are in a position to make a large private investment in a public company will typically have extensive industry and investment knowledge and will see there an opportunity that may not be apparent to the broader equity markets. In addition, because these investors may have a limited time frame, particularly in the case of technical investors, it is possible to construct a series of logical assumptions that would lead to an end point or exit strategy for a typical PIPE investor. There are several good venues for obtaining information on PIPES and private equity deals. Of course, the SEC, in its daily filing reports, would allow an investor to download and review all 8-Ks filed by public companies. Although this is a cumbersome process, investors who monitor such activity on a daily basis become fairly efficient at weeding through 8-K filings. However, there are several private databases available via the Internet that provide information about equity private placements. PrivateRaise.com is a web site that compiles statistics about private investments in public equities. The transactions on the web site are contained in a database that includes Rule 144A PIPE transactions, registered direct PIPE transactions, and non–rule 144A transactions. The database also documents the issuance of any equity or equity-linked security of over $1 million in nominal value that has been executed by a public company domiciled in the United States or public foreign-based company that has its primary trading listing or a significant trading presence on any of the U.S. stock markets. Equity and equity-linked security-type structures included in the database are common stock, convertible preferred stock, nonconvertible preferred stock that has warrants attached for common stock, convertible debt and nonconvertible debt with warrants attached for common stock, prepaid warrants, and equity lines of credit. This is a useful resource if you are going to seriously consider a focus on PIPE transactions as part of the micro cap screening process.

Changing or Correcting a Will

admin — Sun, 12 Apr 2009 17:25:35 +0000

A supplement to a will, consisting of revisions, additions, or alterations made after the will has been made, is known as a codicil. The codicil must be executed (signed, witnessed, etc.) in the same manner as the will being amended. Corrections should not be made in a will by erasures, insertions, or cross-outs. All corrections or other changes should be made by codicil and in many cases it may be preferable to execute a new will.
If a new will is made, it should state that all prior wills are revoked. It may also be desirable to physically destroy a previous will to avoid any possible confusion later.