Financial Management – Bonds, Financial Markets, and Right-Sizing

Bonds

How Bonds Provide Financing

How do bonds provide financing to corporations for their capital projects?

Bonds can be issued whenever the corporation recognizes a need to raise additional capital. Bonds allow the corporation to raise capital in amounts that match the estimated capital required to complete a given project, as well as control the length of time until maturity. Bonds allow corporations to finance projects without selling additional equity because the debt does not create ownership interest. Bonds have a tax advantage, because the bond is considered a cost of business and therefore interest payments are tax deductible. Capital projects that offer significant assets as collateral make bonds more attractive to creditors. [Ross, 2004, page 164]

Key Differences between Bonds and Stocks

What are the key differences between using bonds to finance capital projects and issuing stock for that purpose?

Bond interest payments are pre-tax, whereas dividends to stockholders are not tax deductible. On the other hand, equity does not need to be repaid and the corporation does not need to pay interest or dividends. Because bondholders can legally claim assets to cover nonpayment, bonds have the risk to the corporation of forcing liquidation of assets, or even bankruptcy. Stockholders, on the other hand, as owners of the corporation and cannot liquidate the company to cover stock loss. One key difference is that bonds allow the corporation to raise a known amount of capital, while stock offerings raise a non-specific, although significant one-time amount of cash. Bond offerings can be tailored to match a certain cash requirement, and can be issued for any reason, whereas stocks cannot be reissued.

Bond Valuation

The value of a bond is dependent, primarily, on two factors. Name and explain those two factors.

The value of a bond is dependent on the value of its cash flow in terms of: 1) the Present Value of the Coupon Payments (the annuity present value), plus 2) The Present Value of the Par Value (time value of money of the bond’s price). [McCracken, Dec. 2005]

The present value of the Coupon changes according to the current interest rate because the coupon payment is fixed to the rate stated at time of bond issuance. When the current interest rate rises above the bond’s coupon rate, the present value of the Coupon Payment falls, concurrently when the interest rate falls lower than the Coupon rate, the value of the bond’s Coupon Payment rises. The length of payments remaining before maturity is also a factor as it represents a greater or lesser portion of the value equation.

A bond’s Par Value (face value) is also measured in terms of its present value, which again is affected by the interest rate.

The current value of a bond (present value) therefore, is always measured against the going (current) interest rate. If the bond pays higher interest than the going rate, the price of the bond will be greater than the par value, or lower if the bond pays a lower interest rate than the current interest rate.

Bonds contrasted to Stocks

Compare and contrast the characteristics of stocks and bonds.

Bond Characteristics	Stock Characteristics
Value rises and falls depending on interest rates	Value rises and falls depending on the value that the stock trades at on any given day
Interest payments are tax deductible by the corporation	Dividends are not tax deductible
Equity is not lost through issuance	Stock issuance is based on transference of equity
Unpaid debt is a liability	Loss of stock value creates no liability
Can be issued at any time for any reason	Can only be issued once
Creditors have no voting power	Equity owners can control the company via voting power

Using Commercial Paper

What is commercial paper and when is it typically used by a corporation?

Commercial paper refers to a short-term note (short maturity of a duration not to exceed 270 days), issued directly to the creditor. Commercial paper with a maturity less than 270 days (nine months) does not need to be registered with the Securities and Exchange Commission (SEC). Corporations issue commercial paper because they can do so at an interest rate that is less than the rate on a traditional bank loan [Ross, 2004, page 491] and is usually offered at a discount (a rate lower than par value). Banks and finance companies use commercial paper as well. The note is typically unsecured, so their use is usually restricted to institutions with very high credit ratings. [Ross, 2004, page 513]

Commercial paper is used to finance deficit cash positions when demand for current assets is high, especially during peak seasonal demand or due to other demand cycle periods, or for financing accounts receivable.

The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement. [Investopedia, 2005, search term “commercial paper”]

Financial markets

Purpose of Financial Markets

What are financial markets and what is their purpose in our economy?

A financial market is a virtual place “for raising capital, transferring of risk (in the derivatives markets); and promoting international trade (in the currency markets). Financial markets are used to match those who want capital (borrowers) to those who have it (lenders). Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends.” [Wikipedia, 2005, search terms “financial markets”]

Broadly, there are two major markets, one for government securities and another for corporate securities. The financial markets can be divided into subtypes:

• Capital markets
• Bond markets
• Commodity markets
• Money markets
• Derivatives markets
• Futures markets
• Insurance markets
• Foreign exchange markets

Role of Exchanges

What is the role of exchanges within the financial markets? Within the futures markets?

An exchange is: "a market in which securities, commodities, options, or futures are traded." [Investopedia, 2005, search term “exchange”] The primary function of an exchange is to connect buyers and sellers and provide liquidity to shareholders, and some protections (through the enforcement of rules and by providing oversight) to investors. An exchange tracks the flow of orders and the flow of pricing and trading actions, and provides real-time reporting.

The role of the exchange in the futures market is to provide structure to trading of futures contracts which is extremely liquid, risky, and complex.

Physical exchanges are under threat from electronic-only exchanges that eliminate human intermediaries and are more efficient and cost-effective.

Roles of Cash and Futures Market

The cash market and the futures market serve different purposes for investors. How do their roles differ?

The cash market allows investors to purchase an actual physical commodity, or stock, while the futures market allows investors to purchase or create a (futures) contract. A futures contract is a type of derivative instrument used by two parties to agree to buy or sell a stock or physical commodity in the future for a particular price. In essence, the buyer is agreeing to buy something, for a set price, that a seller has not yet produced. Buyers and sellers in the futures market do so to hedge risk or to speculate, as compared to buyers and sellers in the cash market, who do so to exchange physical property or stocks.

The futures market is primarily used by hedgers and speculators. The futures market for hedgers provides a way to manage price risks. A hedger buys or sells in the futures market to secure the future price of a commodity, either to be sold at a later date in the cash market, or for some other use. This helps the hedger protect against unanticipated price increases. While hedgers want to minimize their risk no matter what they're investing in, speculators want to increase their risk and therefore maximize their profits. Because of the unknown nature future events, the futures market is extremely liquid, risky, and complex.

Effects of Chairman’s Comments

What is the effect of a speech by Alan Greenspan, Chair of the Federal Reserve, on the financial markets?

Allan Greenspan, an accomplished saxophone player who once attended Juilliard, and who believes in the gold standard and yet also supports Any Rand's philosophy of unfettered capitalism, has articulated a purview of monetary policy strongly linked to fiscal and political matters traditionally left to lawmakers, in his often sited testimony before Congress. [Wikipedia, 2005, search terms “Greenspan”] His comments are followed closely by market makers and investors/traders, who struggle to interpret his somewhat rambling missives to find clues into the future movements of interest rates and the general health of the economy. Recently, Greenspan’s comments have helped cool what he calls “irrational exuberance” which refers to unsustainable bubbles leading to short-term boom-bust cycles that seem to be common in today’s markets.

Impact of E-Commerce and Electronic Trading

Electronic trading in the financial markets has captivated public interest. What do you think the impact of e-commerce and electronic trading will be in the future on our financial markets?

Figure 1 show where we have been and where we are headed, relative to the acceleration of knowledge and technology. [Stephen Gall, 2006]

Figure 1: What lies beyond the Information Age?

Age	Dates	Length	Description
Scientific	1490 - 1770	380 years	The age of scientific discovery
Industrial	1770 – 1950	180 years	The industrial revolution
Information	1950 – 2020	70 years	Information is added to products; globalization begins, Web 1.0 – 3.0 (semantics integration begins via metadata)
Symbiosis	2020 – 2050	30 years	The semantic Web, linguistic user interface, distributed networks, the internet becomes the datasphere, birth of AO (Autonomous Observer – an overreaching AI integrated into the internet/datasphere)
Autonomy	2050 – 2065	15 years	AO’s extensive reach, intelligent agents, software that can self-construct internal modifications
Convergence	2065 - 2073	8 years	General systems intelligence. Human-machine convergence
Transvergence	2073 – 2077	4 years	Things are getting weird! Expanded human/machine intelligence
Singularity	2078 – ?	Unknown	Unknown; possibly cumulating in a second big-bang, where super-intelligence explodes out into the universe at the speed of light.

Here’s what is going to happen. As the information age winds-down we are already seeing and experiencing the effects of online trading. It’s easy to envision all financial markets moving online by 2015 and certainly by 2020. Google has recently announced the ‘google’ as a form of currency. It is likely that new financial instruments and currencies such as the google will continue to gain momentum and become quite acceptable and even targeted toward certain financial markets and situations. Under normal circumstances this shift would cause a chaotic trading environment, however, thanks to ever more sophisticated software these instruments will be quite stable. The shock will be to traditional investors who are not willing to learn and accept new forms of trading. They may find themselves victim of future shock, just as the majority of people are missing major technology shifts and trends today, technology integration into the financial markets will only accelerate. Finance managers who understand these instruments and trading methodologies will be well rewarded.

The next shock to the financial markets that will happen early in the age of Symbiosis is the rise of robot software programs designed for analyzing markets and even performing trades based on triggers. These programs will be orders-of-magnitude in their complexity and ability to analyze a trade when compared to the simplistic trading bots we see today; they will have (be integrated with) extensive knowledge bases combined with thousands of business rules, allowing them to interpret data and events in almost real time and will be able to not only advise on financial decisions but make them! Their ability to trade will eclipse that of their human counterparts. Human traders will accuse these programs of being unfair, as they find themselves competing with software programs, not other humans, in the financial markets trading arena. Your Bot (robot) may become your best friend!

By 2030, I see two possible paths based on competing trends; basically we will start gaining control of global events and systems, or we will start to lose control due to chaotic events on a global scale (war, disease, global warming, etc.). Right now it’s a very close call; I am not an optimist, but I do think that we might be passing a threshold that will allow us to gain control. And we will figure out that we gain even more control by turning the management of major systems, including financial systems, over to an artificial intelligence system called the Autonomous Observer (AO). By the age of Autonomy, AO will have well over a billion rules in its primary database, and sub-systems may allow it to access a trillion rules (many of these rules will be machine created). It’s likely that AO will manage and modify a global financial system based on rules and regulations that allow the seamless flow of money between and among people and organizations.
Beyond the age of Symbiosis, financial markets, systems, and monetization methodologies as we know it today will cease to exist. We will be in a new economic era. And we’ll still have 30 or more years to go before the singularity!

Right Sizing

Definition of Right Sizing

We often hear the term ‘downsizing’ in corporate finance. This term has a negative connotation since we have come to associate it with layoffs, lower wages, and other seemingly negative effects. What is the definition of ‘right-sizing’ and what is its ultimate goal?

The US financial system was built upon an ever modernizing industrial base. But in 2000 that base began to seriously erode due to competition from low cost providers, especially in Asia. The concept of downsizing and right-sizing arose out of the first shock-waves in the West due to the forces of globalization. In response, corporations began to rethink their human resources requirements in relation to the issues of outsourcing and overseas production operations. I have spent the last 10 years of my career as a business process analyst and systems engineer, helping companies figure-out what they can downsize, outsource, offshore, or automate, and I fear a second wave of right-sizing just over the horizon; just as we saw in the manufacturing sector, I believe that many types of knowledge-related jobs are, or will soon be at risk; to be sent to low wage but highly-capable providers due to advances in communication technologies. Many jobs are going to be automated also. In this light, I believe that the term right-sizing is a moving target; one that is accelerating.

Actually, the value proposition of the corporation entity itself is being redefined. Here’s what right-sizing means for corporations:

• Becoming global in scope relative to markets and suppliers
• Becoming managerially optimized by focusing on business processes not people
• Becoming optimally resourced (use of human resources) per the mix of specialists and generalists
• Becoming as automated as is cost effective

As business models churn due to a variety of forces, especially technology, the need to even have employees at all is in question. I envision corporate entities in the near future with very few actual employees; choosing instead to outsource to specialists. This market shift is happening today, as many corporations use temporary help and consultants who can provide specific, targeted services to better ensure a project’s success. The individual nature of work is changing; the ultimate right-size is when you work for yourself, and that may be the true definition and ultimate goal of right-sizing.

Unintended Effects of Right Sizing

What are some often unintended effects of right sizing a company?

• Cultural shift as employees start to mistrust management (loss of shared values)
• Loss of knowledge assets as employees who perform business processes (held as tribal knowledge) are downsized or leave the company
• Non-optimized restructuring, leading to increased costs
• Reliance on outsourced services that fail to deliver
• Reliance on economic assumptions and drivers that fail to occur
• Failed company initiatives
• Disorganization and paralysis within the management structure including a loss of strategy and vision among senior executives
• Loss of trust in the community and in the customer base
• The organization begins a slow blood-letting as top performers decide to leave the company for other opportunities
• Recovery becomes long and painful; and cumulates with a mass turnover at the executive level

Restructuring to Increase Efficiency and Effectiveness

After sale, how was ABTCo restructured to increase its efficiency and effectiveness?

ABTCo was restructured from a centralized functional organization (whatever that means), to a decentralized divisional management organization (whatever that means). In other words, the new owners cut management staff in a central office and off-loaded management tasks to the divisional managers. They also implemented a new inventory management software system, which probably allowed them to restructure using a decentralized model. On one hand, senior management reduced the work force, cut wages, froze benefits, and reduced inventory. On the other hand, employee incentive programs were implemented that were tied to productivity gains and employee stock options were offered to offset the wage and benefit cuts. Management also looked for new product offerings.

As a side note, I think they stumbled on to the vinyl siding business (discussed below), and that’s why there profits soared. You’ll notice that vinyl siding is their core business today. I don’t think that the management actions, to increase efficiency, would have necessarily saved the company, important as they were.

What Happened to ABT Company?

To whom was ABTCo sold and why? What happened when, a year after sale, the company issued an IPO? Why do you think this happened?

ABTCo was sold to a small group of former industry specialists acting in conjunction with a venture capital firm. This group of industry insiders had a vision of right-sizing based on a dramatic restructuring of the company’s human resources, software systems, and inventory. They recognize that the company was run by inefficient and ineffective management.

What really happened? ABTCo was a vinyl siding manufacturer with a very acceptable siding product in its lineup. However, at the time of sale, the vinyl siding market segment was small but steady. (It was off the radar so to speak). Then, the 800-lb. gorilla, Louisiana-Pacific, was involved in a massive class-action lawsuit when its wood siding products began to fail. (About 5 years after installation, the siding bubbled and began to fall-apart). Suddenly, vinyl siding became very hot. ABTCo was there, and everybody wanted a piece of the vinyl siding market, and the lemmings, I mean investors, rushed-in to buy the stock.

Barriers to Entry

What does the term ‘barriers to entry’ mean in business finance? How does this term apply to ABTCo?

An entry barrier refers to a minimum amount of capital or the ability to obtain a resource that is needed to begin or sustain a project. In business finance it usually refers to cash flow, capitalization, or access to other needed resources such as technical expertise, raw materials, and machinery as well as office or production facilities.

Investopedia defines barriers to entry as: "The existence of high start-up costs or other obstacles that prevent new competitors from easily entering an industry or area of business." [Investopedia, 2005, search term “barriers to entry”] Other barriers to entry include: industry regulation, patents, special or unusual business processes, brand identity, and switching costs for customers.

Conclusions and Summary

Capital markets pay an important role in financing corporate projects. Both the bond and the stock market rely on traditional financial analysis and valuation mechanisms as a basis of pricing. Bonds have traditionally been considered safer than stocks because the future values of cash flows are known and interest rates are the biggest variable. With stock valuations, not only are there more variables, but perceived value also makes it more difficult to accurately value a stock.

There are many new financial instruments for trading, and electronic trading is changing the investment markets. In the future, we are likely to see this trend accelerate.

Bibliography

Ross, Westerfield, Jordan, Essentials of Corporate Finance, 4th edition, McGraw Hill, 2004, ISBN 0-07121507-7

McCracken, Mark, Bond Valuation, Dec. 2005, <http://www.teachmefinance.com/bondvaluation.html>

Investopedia, 2005, <http://www.investopedia.com/>

Wikipedia, 2005, <http://en.wikipedia.org/>

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