Risk Analysis

Risk Assessment Process and Analysis

There is, of course, no return without risk. There is a tendency in investment project modelling to believe that the cash flows from investment models are somehow “real”. The inputs for the model may or may not occur, and, at best, are a considered estimate of what might happen two or more years into a project time span.

Since finance theory teaches that rational people are risk averse, then the next stage of the exercise should be to include in the model techniques for estimating the risk and uncertainty. The model should be tested to see how likely the organisation is to achieve the desired net present value. The upsides may not be a problem, but management needs to assess the possibility of lower than anticipated returns. Again, following theory, if the project earns a lower rate than the cost of capital, then the shareholder value in the company diminishes.

Two types of risk can be identified:

·       Project risk. Which is the variability of the project return.

·   Corporate risk. Since management need to invest in a mixture of projects, which have varying degrees of risk and potential return.

Risk could also be split into two categories:

·       Risk. Which can be described and quantified using some of the techniques in this lesson.

·       Uncertainty. Which can be described as random events.

Sources of risk and uncertainty could include one or more of the following:

·       Commercial and administration.

·       Competitive responses leading to reduced demand.

·       Market shifts, especially with new technology.

·       Financial – liquidity, profitability, and financial structures.

·       Knowledge and information dissemination.

·       Legal issues.

·       Currency issues, both on the supply and sales sides.

·       Partners, suppliers and subcontractors.

·       Political events in home and overseas markets (for instance, Brexit, President Trump impeachment, and so on).

·       Health emergencies (for instance, Covid-19, Ebola, HIV/AIDS).

·       Economic cycles and the effect on demand and prices.

·       Quality issues leading to reduced sales.

·       Resource availability leading to lower production.

·       Technical ability of company.

·       Innovation, copyright and the availability of new technologies.

·       Management competence and drive.

Project risk is related to corporate risk since the latter will change if management invests in risky projects.

Financial Planning and Investments

Many of the financial decisions that individuals have to make in their personal lives - choosing a mortgage, investing in their savings, planning for retirement - require using financial models. In this blog I illustrate additional applications of the time value of money concept and also involve inflation and taxation.

Inflation

Inflation is one of the key factors that has to be incorporated in many models for making personal finance decisions, especially when long-term planning is involved. If you are saving money to buy a car three years from now, inflation may not be an important factor. But if you are 30 now, plan to retire at age 65, and expect to live until you are 90, inflation must be factored into the models you use. For example, it is impossible for any of us to guess how much we will need in nominal Rands per year during retirement - it may be 35 years away! However, we may be able to say more comfortably that we will need in today’s Rands (also called constant Rands or buying power) an amount equal to 80% of our current expenses.

Long-term planning has to be done in one of two ways. We can do the analysis in constant or real Rands, but then we cannot reflect taxes realistically because taxes have to be paid on nominal rand income and investment returns, not on real rand amounts. Alternately, we can do all calculations in nominal Rands but carefully reflect in them the impact of anticipated inflation.

Taxes

We generally have to factor in three types of taxes into our models: income taxes, taxes on dividends (if any), and taxes on capital gains.

Income taxes apply to wages, salaries, and other income, as well as most interest income (except where there may be exemptions, for example on savings or certain bonds). This tax is charged at different rates depending on one’s income level or tax bracket. Unless you want to calculate income taxes in detail by taking into consideration different rates for different tax brackets, you should generally use the marginal tax rate in your models.

Capital gains are defined as the appreciation in the value of an investment asset. One important point to keep in mind is that capital gains taxes have to be paid only when the asset is sold (unless there are applicable exemptions, for example on your primary home); until then no taxes have to be paid, even if the asset’s value keeps growing. When we buy and sell assets over time in tranches, the calculation of the capital gains taxes can get somewhat complicated.

In building models, you have to know whether you are dealing with taxable accounts, tax-deferred accounts, or tax-free accounts. Sometimes you can develop models that will work for both taxable and tax-deferred or even tax-free accounts. For taxable applications, the user has to input the appropriate tax rate, and for tax-deferred and tax-free applications the user will set the tax rates to zero. However, not all models can be built with this flexibility, and you should always document any tax-related limitation a model.

Reinvestment Income

Many stocks pay dividends, and most fixed income investments (for example, bonds) provide ongoing interest income. Unless these investments are in tax-deferred accounts, we have to pay taxes on these returns before reinvesting the funds at rates available at that time. Because the taxes and the reinvestment rates we assume can significantly affect actual returns earned over time, our models should explicitly incorporate them and let the user specify the tax rates as well as reinvestment rates.

Structuring Portfolios

For long-term investment success, it is essential that an investor creates and maintains a properly structured portfolio. A portfolio is generally structured at three levels.

First, the investor has to choose the broad asset classes (for example, stocks, bonds, etc.) in which to invest and decide how much of the portfolio to invest in each asset class. That is generally called the portfolio’s asset allocation. Studies have shown that a portfolio’s asset allocation has the largest impact on its long-term return.

Second, the investor has to choose within each asset class the categories of securities in which to invest. For stocks, the categories may be large-cap stocks, small-cap value stocks, and so on. For bonds, these may be short-term bonds, long-term bonds, foreign bonds, and so on. The investor must then decide what percentage of his allocation to each asset class he wants to allocate to each category within that class.

Third, within each category of securities the investor has to choose specific securities and mutual funds and decide how much to invest in each of them. To make this decision, the investor will probably start with a select list of stocks of funds in each category and then do an allocation among them.

Although both financial theory and analysis of historical data provide some guideline for portfolio structuring, there is quite a bit of leeway in choosing the allocation at each level. There is no perfect answer, and even for the same person the “right” portfolio will change over the years as family circumstances change (for example, children finish college, the person approaches retirement, and so forth). Although most people think they should adjust their portfolios at least periodically in response to changing market outlook, market history shows that no one can reliably predict what the market will do in the future and which stocks will do better than others over the years. Contrary to what most people believe, then, the structure and holdings of a portfolio should not be influenced much by anyone’s views on the market outlook.

A Step-By-Step Guide to Analysing Capital Expenditures

You’ve been talking with your boss about buying a new piece of equipment for the plant, or maybe mounting a new marketing campaign. He ends the meeting abruptly. “Sounds good”, he says. “Write me up a proposal with the ROI and have it on my desk by Monday”.

Don’t panic, here’s a step-by-step guide to preparing your proposal.

A.     Remember that ROI means “return on investment” – just another way of saying, “Prepare an analysis of this capital expenditure”. The boss wants to know whether the investment is worth it, and he wants calculations to back it up.

B.     Collect all the data you can about the cost of the investment. In the case of a new machine, total costs would include the purchase price, shipping costs, installation, factory downtime (while installation occurs), debugging, and so on. Where you must make estimates, note that fact. Treat the total as your initial cash outlay. You will also need to determine the machine’s useful life, not an easy task (but part of the art I enjoy so much!) You might talk to the manufacturer and to others who have purchased the equipment to help you answer the question.

C.     Determine the benefits of the new investment, in terms of what it will save the company or what it will help the company to earn. A calculation for a new machine should include any cost savings from greater output speed, less rework, a reduction in the number of people required to operate the equipment, increased sales because customers are happier, and so on. The tricky part here is that you need to figure out how all these factors translate into an estimate of cash flow. Don’t be afraid to ask for help from your finance department – they are trained in this kind of thing and should be willing to help.

D.    Find out the company’s hurdle rate (remember, this is the interest rate you will use to discount the future cash flows) for this kind of investment. Calculate the net present value of the project using this hurdle rate.

E.     Calculate payback and internal rate of return as well. You’ll probably get questions about what they are from your boss, so you need to have the answers ready.

F.     Write up the proposal. Keep it brief. Describe the project, outline the costs and benefits (both financial and otherwise), and describe the risks. Discuss how it fits with the company’s strategy or competitive situation. Then give your recommendations. Include your NPV, payback, and IRR calculation in case there are questions about how you arrived at your results.

Managers sometimes go overboard in writing up capital expenditure proposals. It’s probably human nature: we all like new things, and it’s usually pretty easy to make the numbers turn out so that the investment looks good. But I advise conservatism and caution. Explain exactly where you think the estimates are good and where you think they may be shaky. Do a sensitivity analysis, and show (if you can) that the estimate makes sense even if cash flows don’t materialise at quite the level you hope. A conservative proposal is one that is likely to be funded – and one that is likely to add the most to the company’s value in the long run.

Reading an Income Statement

Before you even start contemplating the numbers, you need some context for understanding the document.

The Label

Does it say “income statement” at the top? It may not. It may instead say “profit and loss statement” or “P&L statement”, “operating statement” or “statement of operations”, “statement of earnings” or “earnings statement”. Often the word consolidated is in front of these phrases. With all these terms for the same thing, one might get the idea that our friends in finance and accounting don’t want us to know what is going on. Or, maybe they just take it for granted that everybody knows that all the different terms mean the same thing. However, that may be, in this course I will always use the term income statement.

Incidentally, if you see “balance sheet” or “statement of cash flows” at the top, you have the wrong document. The label pretty much has to include one of the above phrase I just mentioned.

What It’s Measuring

Is this income statement for an entire company? Is it for a division or a business unit? Is it for a region? Larger companies typically produce income statements for various parts of the business as well as for the whole organisation. H. Thomas Johnson and Robert Kaplan, in their classic book Relevance Lost, tell how General Motors developed the divisional system – with income statements for each division – in the first half of the twentieth century. We can be glad it did. Creating income statements for smaller business units has provided managers in large corporations with enormous insights into their financial performance.

Once you have identified the relevant entity, you need to check the time period. An income statement, like a report card in school, is always for a span of time: a month, quarter, or year, or maybe year-to-date. Some companies produce income statements for a time span as short as a week. Incidentally, the figures on large companies’ income statements are usually rounded off, and the last zeros are left off. So, look for a little note at the top: “in millions” (add six zeros to the numbers) or “in thousands” (add three zeros). This may sound like common sense, and indeed it is. But I have found that seemingly trivial details such as this are often overlooked by financial newcomers.

“Actual” versus “Pro-Forma”

Most income statements are “actual”, and if there’s no other label, you can assume that is what you’re looking at. They show what “actually” happened to revenues, costs, and profits during that time period according to the rules of accounting. (I put “actually” in quotes to remind you that any income statement has those built-in estimates, assumptions, and biases, which I will discuss in more detail later in this part of the course).

Then there are what’s known as pro forma income statements. Sometimes pro forma means that the income statement is a projection. If you are drawing up a plan for a new business, for instance, you might write down a projected income statement for the first year or two – in other words, what you hope and expect will happen in terms of sales and costs. That projection is called a pro forma. But pro forma can also mean an income statement that excludes any unusual or one-time charges. Say a company has to take a big write-off in a particular year, resulting in a loss on the bottom line. (More on write-offs later in this part). Along with its actual income statement, it might prepare one that shows what would have happened without the write-off.

Be careful of this kind of pro forma! Its ostensible purpose is to let you compare last year (where there was no write-off) with this year (if there hadn’t been that ugly write-off). But there is often a subliminal message, something along the lines of, “Hey, things aren’t really as bad as they look – we just lost money because of that write-off”. Of course, the write-off really did happen, and the company really did lose money. Most of the time, you want to look at the actuals as well as the pro-formas, and if you have to choose just one, the actuals are probably the better bet. Cynics sometimes describe pro-formas as income statements with all the bad stuff taken out, which is how it sometimes appears.

The Big Numbers

No matter whose income statement you’re looking at, there will be three main categories. One is sales, which may be called revenue (it’s the same thing). Sales or revenue is always at the top. When people refer to “top-line growth”, that’s what they mean: sales growth. Costs and expenses are in the middle, and profit is at the bottom. (If the income statement you’re looking at is for a non-profit, “profit” may be called “surplus/deficit” or “net revenue”). There are subsets of profit that may be listed as you go along, too – gross profit, for example. I’ll explain all of these in a later lesson.

You can usually tell what’s important to a company by looking at the biggest numbers relative to sales. For example, the sales line is usually followed by “cost of goods sold”, or COGS. In a service business the line is often “cost of services”, or COS. If that line is a large fraction of sales, you can bet that management in that company watches COGS or COS very closely. In your own company, you will want to know exactly what is included in line items that are relevant to your job. If you’re a sales manager, for instance, you’ll need to find out exactly what goes into the line labelled “selling expense”. As we’ll see, accountants have some discretion as to how they categorise various expenses.

By the way: unless you’re a financial professional, you can usually ignore items like “consolidated, liquidating securitisation entities”. Most line with labels like that aren’t material to the bottom line anyway. And if they are, they ought to be explained in the notes.

Reading a Balance Sheet

First, however, find a sample balance sheet, either your own company’s or one in an annual report (or just look at the sample below). Since the balance sheet shows the company’s financial situation at a given point in time, there should be a specific date at the top. It’s usually the end of a month, quarter, year, or fiscal year. When you’re looking at financial statements together, you typically want to see an income statement for a month, quarter, or year, along with the balance sheet for the end of the period reported. Unlike income statements, balance sheets are almost always for an entire organisation. Sometimes a large corporation creates subsidiary balance sheets for its operating divisions, but it rarely does so for a single facility. As we’ll see, accounting professionals have to do some estimating on the balance sheet, just the way they do with the income statement. Remember the delivery business? The way we depreciate the truck affects not only the income statement but also the value of assets shown on the balance sheet. It turns out that the assumptions and biases in the income statement flow into the balance sheet one way or another.

Balance sheets come in two typical formats. The traditional model shows assets on the left-hand side of the page and liabilities and owners’ equity on the right side, with liabilities at the top. The less traditional format puts assets on top, liabilities in the middle, and owners’ equity on the bottom. Whatever the format, the “balance” remains the same: assets must equal liabilities plus owners’ equity. (In the non-profit world, owners’ equity is sometimes called “net assets”). Often a balance sheet shows comparative figures for, say, 31 December of the most recent year and 31 December of the previous year. Check the column headings to see what points in time are being compared.

As with income statements, some organisations have unusual line items on their balance sheets that you may not find discussed in this course. Remember, many of these items may be clarified in the footnotes. In fact, balance sheets are notorious for their footnotes. Ford Motor Company’s 2004 annual report contained a whopping thirty pages of notes, many of them pertaining to the balance sheet. Indeed, companies often include a standard disclaimer in the notes making the very point about the art of finance that I am making in this course. Ford, for instance, says:

Use of Estimate

The financial statements are prepared in conformity with generally accepted accounting principles in the United States. Management is required to make estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those assumptions. Estimates and assumptions are periodically reviewed, and the effects of any material revisions are reflected in the financial statements in the period that they are determined to be necessary.

The Benefits of Financial Literacy

But it isn’t just a matter of scoring well on a test; financial literacy brings with it a host of benefits. Here’s a short list of the advantages you’ll gain.

Increased Ability to Intelligently Evaluate Your Organisation

Do you really know if your organisation has enough cash to make salary and wage payments? Do you know how profitable the products or services you work on really are? When it comes to capital expenditure proposals, is the return on investment analysis based on solid data? And is it even the right measure to base your decision on? And, by the way, how is it even calculated? Boost your financial intelligence, and you’ll gain more insight into questions like these. Or maybe you’ve had nightmares in which you worked or were on the board of Enron, or South African Airways, or maybe Steinhoff. Many of the people there, including board members, had no idea of their companies’ precarious situations.

Suppose, for instance, you worked at the big telecoms company WorldCom (later known as MCI) during the late 1990’s. WorldCom’s strategy was to grow through acquisition (that is, buying other companies). Trouble was, the company wasn’t generating enough cash for the acquisitions it wanted to make. So, it used shares as its currency, and paid for the companies it bought partly with WorldCom shares. That meant it had to keep its share price high; otherwise, the acquisitions would be too expensive. It also meant keeping profits high, so that Wall Street (the main financial district in the US) would give it a high valuation. WorldCom paid for the acquisitions through borrowing. A company doing a lot of borrowing has to keep its profits up; otherwise, the banks will stop lending it money. So, on two fronts WorldCom was under severe pressure to report high profits. Add to that the fact that top management are rewarded mainly for delivering on the corporate strategy.

That, of course, was the source of the fraud that was ultimately uncovered. The company artificially boosted profits “with a variety of accounting tricks, including understating expenses and treating operating costs as capital expenditures”, as BusinessWeek summarised the US Justice Department’s indictment. When everyone learned that WorldCom wasn’t as profitable as it had claimed, the house of cards came tumbling down. But even if there hadn’t been fraud, WorldCom’s ability to generate cash was out of step with its growth-by-acquisitions strategy. It could live on borrowing and stock for a while, but not forever.

Or look at Tyco International. For all the news stories about Dennis Kozlowski’s (former CEO of Tyco, who was later convicted in 2005 of crimes related to his receipt of $81 million in unauthorised payments, and so on) elaborate birthday party and zillion-dollar umbrella stand, there is another story that wasn’t widely reported. During the 1990’s, Tyco also was a big buyer of companies. In fact, it acquired some six hundred companies in just two years, or more than one every working day. With all those acquisitions, the goodwill[1] number on Tyco’s balance sheet[2] grew to the point where bankers began to get nervous. Bankers and investors don’t like to see too much goodwill on a balance sheet; they prefer assets that you can touch (and in a pinch, sell off). So, when word spread that there might be some accounting irregularities at Tyco, they effectively shut off Tyco off from further acquisitions.

Now, I’m not arguing that every financially intelligent manager would have been able to spot WorldCom’s or Tyco’s or Steinhoff’s precarious situations. Plenty of seemingly savvy Wall Street or JSE types were fooled by the three companies. Still, a little more knowledge will give you the tools to watch trends at your organisation and understand more of the stories behind the numbers. While you might not have all of the answers, you should know what questions to ask when you don’t. It’s always worth your while to assess your company’s performance and prospects. You’ll learn to gauge how it’s doing and to figure out how you can best support those goals and be successful yourself.

Better Understanding of the Bias in the Numbers

What will understanding the bias do for you? One very big thing: it will give you the knowledge and the confidence – the financial intelligence – to challenge the data provided by your finance and accounting department. You will be able to identify the hard data, the assumptions, and the estimates. You will know when your decisions and actions are based on solid ground.

Let’s say you work in operations, and you are proposing the purchase of some new equipment. Your boss says he’ll listen, but he wants you to justify the purchase. That means digging up data from finance, including cash flow analysis for the machine, working capital requirements, and depreciation schedules.  All these numbers – surprise! – are based on assumptions and estimates. If you know what they are, you can examine them to see if they make sense. If they don’t, you can change the assumptions, modify the estimates, and put together an analysis that is more realistic and that (hopefully) supports your proposal. Sibongile, for example, likes to say that she’s a veteran finance professional and could easily come up with an analysis showing how her company should buy her a R30,000 computer. She would assume that she could save an hour a day because of the computer’s features and processing speed; she would calculate the value of an hour per day of her time over a year; and presto, she would show that buying the computer is a no-brainer. A financially intelligent boss, however, would take a look at those assumptions and propose some alternatives, such as that Sibongile might actually lose an hour of work a day because it was now so easy for her to surf the net and be on social media.

It’s amazing, in fact, how easily a financially knowledgeable manager can change the terms of discussion, so that better decisions get made. When he worked for Ford, Khaya had an experience that underlined just that lesson. He and several other finance people were presenting financial results to a senior marketing executive. After they sat down, she looked straight at them and said, “Before I open these finance reports, I need to know… for how long and at what temperature?” Khaya and the others had no idea what she was talking about. Then the light went on and Khaya replied, “Yes, Ma’am, they were in for two hours at 400 degrees”. She said, “Ok, now that I know how long you cooked them, let’s begin”. She was telling the finance people that she knew there were assumptions and estimates in the numbers and that she was going to ask questions. When she asked in the meeting how solid a given number was, the finance people were comfortable explaining where the number came from and the assumptions, if any, they had had to make. The executive could then take the numbers and use them to make decisions she felt comfortable with.

Absent such knowledge, what happens? Simple: the people from accounting and finance control the decisions. I use the word control because when decisions are made based on numbers, and when the numbers are based on accountants’ assumptions and estimates, then the accountants and finance people have effective control (even if they aren’t trying to control anything). That’s why you need to know what questions to ask.

The Ability to Use Numbers and Financial Tools to Make and Analyse Decisions

What is the ROI of that project? Why can’t we spend money when our company is profitable? Why do I have to focus on accounts receivable when I am not in the accounting department? You ask yourself these and other questions every day (or someone else asks them – and assumes you know the answers!) You are expected to use financial knowledge to make decisions, to direct your subordinates, and to plan the future of your department. I will show you how to do this, give you useful examples, and discuss what to do with the results. In the process I will try to use as little financial jargon as possible.

For example, let’s look at why the finance department might tell you not to spend any money, even though the company is profitable. I’ll start with the basic fact that cash and profit are different. I’ll explain later why, but right now let’s just focus on the basics. Profit is based on revenue. Revenue, remember, is recognised when a product or service is delivered, not when the bill is paid. So, the top line of the income statement, the line from which you subtract expenses to determine profit, is often no more than a promise. Customers have not paid yet, so the revenue number does not reflect real money and neither does the profit line at the bottom. If everything goes well, the company will eventually collect its receivables and will have cash corresponding to that profit. In the meantime, it doesn’t.

Now, suppose you’re working for a fast-growing business-services company. The company is selling a lot of services at a good price, so its revenues and profits are high. It is hiring people as fast as it can, and of course it has to pay them as soon as they come on board. But all the profit that these people are earning won’t turn into cash until thirty days or maybe sixty days after it is billed out! That’s one reason why even the CFO of a highly profitable company may sometimes say, don’t spend any money right now because cash is tight.

Although this course focuses on increasing your financial intelligence in business or in a not-for-profit, you can also apply what you’ll learn in your personal life. Consider your decisions to purchase a house, a car, or a boat. The knowledge you’ll gain can apply to those decisions as well. Or consider how you plan for the future and decide how to invest. This course if not about investing, but it is about understanding company financials, which will help you analyse possible investment opportunities.

Better Career Prospects

A demonstrably better understanding of the numbers can’t hurt your career prospects. Imagine the shock on your boss’s face if you made a case for a raise – and part of your case included a detailed analysis of the company’s financial picture, showing exactly how your unit has contributed. Far-fetched? Not really. The same goes for when you apply for that next job. Hiring experts always job seekers to ask questions of the interviewer – and if you ask financial questions, you’ll show that you understand the financial side of the business. You might also save yourself some pain by analysing the financial position of your next employer, and perhaps finding out that its not such an attractive prospect after all.

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[1] Goodwill comes into play when one company acquires another company. It is the difference between the net assets acquired (that is, the fair market value of the assets less the assumed liabilities) and the amount of money the acquiring company pays for them. For example, if a company’s net assets are valued at R1 million and the acquirer pays R3 million, then goodwill of R2 million goes onto the acquirer’s balance sheet. That R2 million reflects all the value that is not reflected in the bought company’s tangible assets – for example, its name, reputation, customer lists, and so on.

[2] You’ll learn about a balance sheet later, but it is part of the financial statements of a company and reflects the assets, liabilities and owner’s equity at a point in time. The balance sheet is called such because it balances – assets always must equal liabilities plus owner’s equity.

No More Thumb Suck - Estimating the Cost of Capital

The Risk-Free Rate

Most risk and return models in finance start off with an asset that is defined as risk free and use the expected return on that asset as the risk-free rate. The expected returns on risky investments are then measured relative to the risk-free rate. But what makes an asset risk free? And what do we do when we cannot find such an asset? These are the questions we will deal with next.

The Cost of Equity

Firms raise money from both equity investors and lenders to fund investments. Both groups of investors make their investments expecting to make a return. The expected return for equity investors would include a premium for the equity risk in the investment. We label this expected return the cost of equity. In other words, the cost of equity is the rate of return investors require on an equity investment in a firm.

As you may know, the risk and return models need a riskless rate and a risk premium. They also need measures of a firm’s exposure to market risk in the form of betas. These inputs are used to arrive at an expected return on an equity investment:

Expected return = Riskless rate + Beta(Risk premium)

This expected return to equity investors includes compensation for the market risk in the investment and is the cost of equity.

In the Capital Asset Pricing Model (CAPM), the beta of an investment is the risk that the investment adds to a market portfolio. There are three approaches available for estimating these parameters: one is to use historical data on market prices for individual investments; the second is to estimate the betas from the fundamental characteristics of the investment; and the third is to use accounting data. We will look at all three approaches next.

Calculating the Cost of Debt

The cost of debt measures the current cost to the firm of borrowing funds to finance projects. In general terms, it is determined by the following variables:

•   The riskless rate. As the riskless rate increases, the cost of debt for firms will also increase.

•   The default risk (and associated default spread) of the company. As the default risk of a firm increases, the cost of borrowing money will also increase.

•   The tax advantage associated with debt. Since interest is tax deductible, the after-tax cost of debt is a function of the tax rate. The tax benefit that accrues from paying interest makes the after-tax cost of debt lower than the pre-tax cost. Furthermore, this benefit increases as the tax rate increases:

After-tax cost of debt = Pre-tax cost of debt(1 – Tax rate)

Estimating the Default Risk and the Default Spread of a Firm

The simplest scenario for estimating the cost of debt occurs when a firm has long-term bonds outstanding that are widely traded. The market price of the bond in conjunction with its coupon and maturity can serve to compute a yield that is used as the cost of debt. For instance, this approach works for a firm like AT&T that has dozens of outstanding bonds that are liquid and trade frequently.

Many firms have bonds outstanding that do not trade regularly. Since these firms are usually rated, we can estimate their costs of debt by using their ratings and associated default spreads. Thus, Boeing with an AA rating can be expected to have a cost of debt approximately 1.00 percent higher than the Treasury bond rate, since this is the spread typically paid by AA-rated firms.

Some companies choose not to get rated. Many smaller firms and most private businesses fall into this category. While ratings agencies have sprung up in many emerging markets, there are still a number of markets where companies are not rated on the basis of default risk. When there is no rating available to estimate the cost of debt, there are two alternatives:

1.     Recent borrowing history. Many firms that are not rated still borrow money from banks and other financial institutions. By looking at the most recent borrowings made by a firm, we can get a sense of the types of default spreads being charged the firm and use these spreads to come up with a cost of debt.

2.     Estimate a synthetic rating. An alternative is to play the role of a ratings agency and assign a rating to a firm based on its financial ratios; this rating is called a synthetic rating. To make this assessment, we begin with rated firms and examine the financial characteristics shared by firms within each ratings class. For instance, the Altman Z score, which is used as a proxy for default risk, is a function of five financial ratios that are weighted to generate a Z score. The ratios used and their relative weights are usually based on empirical evidence on past defaults. The second step is to relate the level of the score to a bond rating.

What is Debt?

The answer to this question may seem obvious since the balance sheet for a firm shows the outstanding liabilities of a firm. There are, however, limitations with using these liabilities as debt in the cost of capital computation. The first is that some of the liabilities on a firm’s balance sheet, such as accounts payable and supplier credit, are not interest-bearing. Consequently, applying an after-tax cost of debt to these items can provide a misleading view of the true cost of capital for a firm. The second is that there are items off the balance sheet that create fixed commitments for the firm and provide the same tax deductions that interest payments on debt do. The most prominent of these off-balance sheet items are operating leases. Consider what an operating lease involves. A retail firm leases a store space for 12 years and enters into a lease agreement with the owner of the space agreeing to pay a fixed amount each year for that period. We do not see much difference between this commitment and borrowing money from a bank and agreeing to pay off the bank loan over 12 years in equal annual instalments.

There are therefore two adjustments we can make when we estimate how much debt a firm has outstanding.

1.     We can consider only interest-bearing debt rather than all liabilities. We would include both short-term and long-term borrowings in debt.

2.     We can also capitalise operating leases and treat them as debt.

Weighted Average Cost of Capital (WACC) or Cost of Capital

Since a firm can raise its money from three sources - equity, debt, and preferred stock - the cost of capital is defined as the weighted average of each of these costs. The cost of equity (k_e) reflects the riskiness of the equity investment in the firm, the after-tax cost of debt (k_d) is a function of the default risk of the firm, and the cost of preferred stock (k_ps) is a function of its intermediate standing in terms of risk between debt and equity. The weights on each of these components should reflect their market value proportions, since these proportions best measure how the existing firm is being financed. Thus, if E, D, and PS are the market values of equity, debt, and preferred stock, respectively, the cost of capital can be written as follows:

Cost of Capital = k_e[E/(D + E + PS)] + k_d[D/(D + E + PS)] + k_ps[PS/(D + E + PS)]

Familiarity and contempt - A tale of the Sheep and the Wolf

Long, long ago animals feared the sheep. With its woolly body, it appeared fearsome. And, of course, the sheep cultivated this image.

Obviously, this kind of image was terribly advantageous.

None of the animals had seen the teeth of the sheep, and the sheep successfully continued to conceal them. Finally, the wolf could not take it any longer, and devised a clever plan. The wolf organised a party for all the animals and served alcohol. The wolf made sure the sheep had had enough to drink, and started telling jokes.

All the animals began laughing, including the sheep. Of course, in laughing the sheep exposed very small teeth that are only suitable for grazing on grass and greenery, and not for biting or fighting fiercely.

The wolf immediately pounced, and from that day no other animal feared the sheep.

The Biblical Israel Question - Concluding Remarks

It is true that God made Abraham a father of many nations (Gen 17:4-6), and indeed he bore more than one son. However, it is also true that the son of the promise was Isaac and the promise was again reconfirmed to Isaac’s son, Jacob (Israel – Gen 32:28).

Therefore, in a strictly literal and legalistic sense, God’s covenant was with the descendants of Israel (Jacob – see above), despite that other nations also came from Abraham. By the way, you may be aware that Arabs claim descent from Ishmael and were/are, therefore, brethren with the descendants of Isaac and Israel, the Israelites.

But Ishmael was born of a mistake, a lack of faith or misunderstanding by Abraham, which is probably why in the end he and his mother got sent away, probably to protect the promised child of Sarah and, more importantly, to protect the promise God had made. Not much significance attaches, also, to the other children that Abraham subsequently had. I should mention, in passing, that God did not abandon Ishmael, as he blessed and protected him (Gen 21:13-20).

It would, therefore, be dishonest of me (indeed, probably of anyone) to hang onto the fact that Abraham was/is a father of many nations and to use that to attempt to deprive Israel/Jews of their special old covenant status as the descendants of Jacob/Israel, the son of the son of the promise. You may notice, as an aside, that Isaac was not the first born son of Abraham and neither was Israel (and by the way, neither was Abel, the brother of Cain); however, God blessed them according to His will and plan as God, regardless of their status in the family hierarchy!

Therefore, the spiritual approach taken by Apostle Paul, which I dealt with in my first ‘paper’, is much richer and it overcomes and trumps the legalistic approach.

To conclude. My view, therefore, does not negate nor does it minimise the old covenant. I confirm it. Having done so, however, I argue that that old covenant was superseded by a new covenant, which came/comes about through the birth, death and resurrection of another son of the promise, Jesus. Indeed, one may arguably also trace this promise to Abraham. The Angel told Abraham that, “In your seed all the nations of the earth shall be blessed…” (Gen 22:18). I would posit that this message was/is a foretelling of Christ, through whom (the seed of Abraham) all the nations of the earth shall be/have been blessed.

Further thoughts on the Biblical Israel Question

Paul’s style was very intellectual. The early Christian church had many issues to deal with: debates about its tenets; inconsistency of belief and practice, especially between Jews and Gentiles; cultural practices brought over from Judaism and paganism, etc. In his epistles, addressed to each church and in each focussing on issues plaguing that particular church, Paul set out to address these issues.

So, Paul’s style is to expose these inconsistencies by positing hypotheses and premises, and then proceeding to show how inconsistent with Christ’s teachings such hypotheses and premises are. He poses rhetorical questions and then proceeds to answer them. Key among the issues he dealt with were:

1.     The Jews or Israel being a special people and the old covenant. He starts off by putting that forward as a given, and then proceeds to show that if this were so, it would be a negation of Christ’s teachings and of the whole purpose of Christ coming to earth and dying and being resurrected. He shows that, although the Jews/Israel may have been special, by their rejection of Christ they are rejecting God and, therefore, will not receive salvation. He shows, however, that not all Jews/Israel have rejected Christ, that like he (a Jew) there are some who have accepted Him and will, therefore, receive salvation.

2.     The question of the law of Moses. Early Christians who were also Jews/Israel believed that even under Christianity the law of Moses had to be observed (see also below). Again Paul, as indeed did Peter and the elders after much debate, shows that this is not necessary and would, in fact, be an imposition on the Gentiles because the law of Moses was only given to the Jews/Israel. In fact, the continued insistence on the observance of Mosaic laws, even by Jews/Israel themselves is inconsistent with being a Christian and amounts to a ‘betrayal’ of Christ’s mission on earth.

3.     Salvation by grace because of faith, instead of observance of the law or by works. Christian Jews/Israel continued to regard salvation as coming from observing the law, as opposed to grace by faith in Christ, and they continued to believe in works as they did in Old Testament times when they fell short of the law. Paul, as did the elders, shows that this is incorrect and inconsistent with Christianity.

4.     Circumcision. The belief and insistence of the Christian Jews/Israel that Gentile converts to Christ should be circumcised. Paul shows that this is not necessary and emphasises spirituality, over physical circumcision.

5.     Cultural practices. Jews/Israel and Gentiles brought their past cultural practices into Christianity. Paul shows that “the old has gone, the new has come” and exhorts them to abandon their baggage and create a new Christian culture. They are born again, new creations. However, he also argues that even though there is freedom in Christ, in exercising that freedom they should be sensitive to existing sensibilities, for instance on the issue of food.

In reading Paul’s epistles, therefore, it is important to read the whole letter, but in particular, follow a particular argument or point to its conclusion. Selectively looking at chapters or verses may lead to a wrong and dangerous or fallacious conclusion. For instance, in line with what I have argued above is Paul’s style, the passage you have proposed is only part of the argument, which continues in 10 and concludes only in 11. It is therefore necessary to read 9-11 and not just 9 only. My contention is, therefore, not contradicted.

Regarding John’s Revelations. Revelations as a Book is difficult. There are various interpretations of the symbolism contained in there, whether to see it literally or purely symbolically. My own view is middle of the road. Far from confirming a special status for Jews/Israel, I believe there is an element of symbolism aligned with what I pointed out in point 1. Above, namely that there will be a “remnant” of Jews/Israel that turns to God and are, therefore, saved. The fact that there is a specific number according to the twelve tribes, I believe, is purely symbolic. The notion of the remnant of Jews/Israel appears in various parts of the Old Testament starting with Isaiah, through Jeremiah, Ezekiel, Joel and Zechariah and is also mentioned by Paul in Rom 11:5. It essentially refers to Jews/Israel that gets saved at each stage of their history, in relation to bondage and sin. In Romans Paul puts their salvation as arising from grace, not a special status.

In conclusion, let me also say, though, that the Bible, even in the new testament, clearly states that God is God, He saves whomsoever He chooses. Purely on this basis, and not necessarily a specific special status, if He chooses to save the 144 000 Jews/Israel, who am I to argue with that?