Archivos por Mes: octubre 2018

What is the SG&A?

SG&A («Selling, General and Administration expenses»)

Costs can be classified under 3 categories:

  • If they depend on the production/units sold, these costs are considered as variable. IN the case they do not depend on the production output or units sold, they are called fixed costs. SG&A expenses are fixed costs from an operational point of view that comprises selling expenses (i.e. marketing budget, commissions of the sales team), general expenses (i.e. utilities, insurance premiums), and administration (i.e. salaries not related to manufacturing, social security of the salaries paid, external service providers).
  • If they are directly related to the production/manufacturing process (direct costs). For example, the salary of the operator at a manufacturing site would be considered as direct cost but the salary of the CEO would be considered as indirect. Electricity cost of the manufacturing machinery would be consider as direct cost but the electricity cost of the headquarters would be indirect cost.
  •  A mix of variable/fixed costs and direct/indirect costs, obtaining a classification of: direct variable costs (raw materials of a product), direct fixed costs (salaries of the operators), indirect variable costs (sales team commissions  per unit sold), indirect fixed costs (salaries of management staff excluding the operations management).

When we discuss about SG&A, this item of the Profit and Loss Account («P&L») is considered as an indirect cost (not related to production) and usually of fixed cost nature and recurring basis (they happen every month of company operations). The mot common items under the SG&A are (values excluding VAT):

  1. Wages and salaries paid to employees (excluding salaries of the operators or any other manufacturing business function. Let’s imagine the company has 10 employees that earn €2,000 gross monthly salary and get x14 payments. The yearly wages and salaries would be: 14*€2,000*10 employees= €240,000.
  2. Social security paid by the company. In Spain this tax is around 30% of the gross yearly salary. This tax rate depends on the country and is used to finance the welfare system (pension, unemployment, etc). In this case, the yearly expense would be 30%*€240,000=€72,000.
  3. Rentals paid by the company for any type of building, office rental, etc. Let’s assume a yearly expense of €18,000.
  4. Facilities: Electricity, telephone, water, utilities, etc. Les assume a yearly expense of €10,000.
  5. Insurance premiums paid. There are many types of business insurances, but most companies have a comprehensive business insurance. Let’s assume a yearly expense of €3,000.
  6. Software licenses. Under this category falls all the software licenses used by the company from 3rd party vendors, such as Windows licenses, SAP, Oracle, CS Project, etc. Please note that the software developed by the company would not be considered as a software licenses expense but a capex investment (it is not considered as an expense but a non-current intangible asset which is accounted in the P&L with the Depreciation and Amortization.Let’s assume a yearly expense of €7,000.
  7. External Service Providers («ESP»). Expenses for any service outsourced to a third party such as legal advisory, tax services, consulting services, maintenance, IT support, etc. In this category outsources services of marketing and transportation nature are not included as they are accounted in the «Marketing budget» and «Distribution and Transportation» accounts. Let’s assume €50,000.
  8. Distribution and transportation expenses, such as petrol spent in the delivery of a product or service. This item is of variable nature but can be calculated on a yearly fixed basis. Outsources services for delivery services such as UPS, FedeX, Amazon Logistics is considered here too. Let’s assume a delivery expense of €5 per product sold and the number of products sold in the fiscal year is 10,000 units. The total yearly expense would be €50,000.
  9. Marketing budget. Any expense of marketing and promotion nature, including services outsource from 3rd party vendors (TV commercials, international fairs, customers discounts and rappels, radio commercial, public relations and brand image campaigns, online marketing and promotion, market research reports and surveys, etc). Let’s assume a yearly expense of €43,000.
  10. Taxes and fees paid by the company excluding corporate taxes (i.e. local taxes paid to city council). Let’s assume a yearly expense of €5,000.
  11. Other SG&A. A buffer for SG&A expenses of different nature. We are estimating other SG&A on a monthly basis of €1,000 (€12,000 on a yearly basis).

Taking into account all of these items the yearly SG&A expense would be €460,000. As it can be seen, excluding the delivery expenses, the SG&A expense is fixed and indirect, as it does not depend if the number of units of the product or service is 1 or 1 million, that is why SG&A is considered as a fixed cost of operational nature (related to the business and main activity of the company).

It should be noted that the SG&A expenses that happen in t=0 are called start-up expenses, they can be categorized in one of the 10 categories defined and these expenses are non-recurring as the only happen in t=0, but are included in the first fiscal year of company operations.

It should be highlighted that SG&A is updated on a yearly basis by inflation forecast when a P&L and SG&A projection of a financial plan is undertaken (for those items that makes sense to be updated by inflation). Historical inflation can vary among countries, but for developed economies the inflation average value range 2%-3% on a yearly basis. Please refer to «HCPI» (Harmonised Consumer Price Index) from Eurostat, International Monetary Fund (IMF), European Central Bank (ECB) or Instituto Nacional de Estadística (INE, Spain).

What is the CAPEX or investment plan in non-current assets

WHAT IS THE INVESTMENT PLAN OF A COMPANY=CAPEX

It is defined as the cash flow allocated for the investment plan, known as “CAPEX” (Capital Expenditures). The assets of a company can be categorized as current assets (less than 1 year) and non-current assets (more than 1 year).

The cash flow that the company invest in non-current assets is the CAPEX, and by definition, the non-current assets are those assets that will be held more than a year in the company (usually the operating cycle in accounting is defined as short-term, less than a year). Non-current assets are considered the fixed infrastructure of the company, and without them, it would not be possible to manufacture and sell the products or services of the company. The CAPEX is very important as somehow establishes the foundations for building manufacturing capacity for the future, that will allow to increase sales.

The non-current assets «NCA» can be classified as: (I) Tangible (land, vehicles, furniture, buildings, computers, machinery, etc); (II) Intangible (trademarks, goodwill, patents, software developed by a company); (III) Long-term financial assets (financial products owned by the company, with the idea to remain these assets in the company for the long run, such as shares of another company).

Imagine that company “A” has an investment plan, CAPEX, of €50 millions to build a hotel resort in Aruba or an IT company that invest $200 millions in the 4G internet infrastructure.

There are different types of CAPEX, mainly:

  1. Replacement CAPEX: Cash invested in NCA to maintain the current production level.
  2. Growth CAPEX: Cash invested in NCA to expand the current production level.
  3. Efficiency CAPEX: Cash invested in NCA to increase the efficiency of the current NCA.
  4. Socially Responsible CAPEX: Cash invested in the environment (i.e. reduce the environmental impact of a mining facility).

The non-current assets loss value every year, and this loss of value is accounted by the Depreciation and Amortization, quoted as «D&A». There are different types of D&A, but the most common one is the linear D&A, where the NCA loss value at the same pace every year. It is key to understand that CAPEX means there is a cash-outlay (money goes out of the company to purchase the non-current assets) but the D&A does not mean a cash-outlay. The D&A is an accounting item from the Profit and Loss Account (P&L) that accounts for an expense and decreases the Earning Before Taxes (EBT), decreasing the tax bill of a company.

The D&A is calculated as follows: [Gross Book Value – Residual Value of the Asset at the end of the life span] / Expected lifespan. The NCAs usually have a Residual Value of zero at the end of the lifespan.

When discussing about non-current assets, we must define:

  1. Gross Book Value («GBV»): It includes all the cost items from purchasing of the asset to have it fully operational. For example, imagine Apple is purchasing a automatic insertion robot for $10 millions in Japan, the transportation costs to Europe are $10,000, import duties $1 million and installation cost of the robot in the factory $990,000. The gross book value of the non-current asset would be $12 millions and the CAPEX amount $12 millions too.
  2. If the expected life of the robot is 10 years with a residual value of zero at the end of the lifespan, the yearly D&A would be $12 millions/10 years= $1.2 millions per year.

Once we know de GBV and the D&A, we must build the amortization table of the non-current assets that have the following items:

  • Gross Book Value, GBV.
  • Yearly Depreciation and Amortization, D&A. It is the value that is accounted in the Profit and Loss Account of the company.
  • Accumulated D&A. It is the accumulated life of the non-current asset. Please note that this amount is not saved as cash-flow anywhere in the company.
  • Net Book Value, NBV. It is defined as the accounting value of the non-current asset that is recorded in the balance sheet of the company.

Let’s build the amortization table for the example explained above:

AMORTIZATION TABLE OF THE NON-CURRENT ASSET: AUTOMATIC INSERTION A/I ROBOT

Capex and the amortization table of non-current assets

The % remaining life of the NCA is a key metric, as it is not the same to buy a company where its NCAs are fairly new (value close to 80-90%) or quite old (% remaining life 10%). Imagine a company that is bought by an investor group that pays $1,000 millions and assets with a 100% remaining life (lifespan 10 years) and GBV of $200 millions, or the same transaction, where the company pays $1,000 millions but with a 10% remaining life. This would mean that the buyer should invest another extra cash of $180 millions to renew the non-current assets of the company.

Please note that all the non-current assets have a expected lifespan and D&A, except the «land», that has a D&A value of zero, and therefore the GBV=NBV.

The expected lifespan of the non-current assets can be calculated using the Tax Authorities Tables of each country or the expected life defined by the Accounting standards.

If we define the Tax Authorities Tables, the lifespan of the assets must meet the following 2 criteria:

  1. The total number of years chosen as lifespan should not be higher than the lifespan defined in the table.
  2. The yearly D&A expressed as %, cannot be greater that the value defined in the table.
  3. If the selected lifespan meet both criteria 1+2, the expected lifespan can be chosen.

USEFUL LIFESPAN OF NON-CURRENT ASSETS ACCORDING TO THE SPANISH TAX AUTHORITIES

Let’s imagine we are developing a patent (intangible non-current asset) and we decide to use a 5 years lifespan for this NCA. If the lifespan is 5 years, the D&A would be 100%/5=20%. This D&A value of 20% is not allowed by the table, as the maximum value must not be greater than 10%. The 5 years lifespan is allowed, as it is less than 20 years. However, as both criteria must be met, the 5 years expected life cannot be selected.

If we try with 10 years as expected lifespan, this value provides a 10 years lifespan (less than 20 years) and a yearly D&A of 100%/10=10%, that is at the maximum allowed value. In this case, a 10 years lifespan for the NCA can be used as we meet both criteria.

Cost of equity (Ke): CAPM and the capital asset pricing model

CAPM: CALCULATION OF THE COST OF EQUITY («Ke») OR THE MINIMUM YEARLY RETURN IN PERCENTAGE REQUIRED BY AN INVESTOR IN A PROJECT, USING THE CAPITAL ASSET PRICING MODEL

Let’s assume that we are a group of entrepreneurs that are founding a start-up project in Spain.

The entrepreneurs want to enter as shareholders of the company, entrepreneurship or business project. The total funding required by this project in t=0 is called TOTAL FUNDING NEEDS OF THE PROJECT,  and the funding will be secured by banking debt («D%») with an annual cost of interests Kd = 5% and by the contribution made by the founding partners = «equity owners» = «shareholders». As the banking debt, the shareholders will also demand a minimum yearly profit for their investment, that is called «Ke» or cost of equity, being the CAPM model used to calculate its value.

1. How an investor who enters a business project earns money:

Just as the bank requires a 5% annual return (Kd) + the return of the principal amount borrowed; we, as shareholders, will demand a minimum annual return for the money we invest in this project, that is called «Ke: Cost of equity». This profitability must be paid by the project with the cash flows it generates in two ways:

1) Payment of dividends from the profits generated by the company / project each year. The metric that defines the percentage of net profit that goes to pay dividends is called «Pay-Out».

2) Increase in the value of the company (share price increase). Depending on the valuation method, the share price can be calculated as: a) net equity of the company on the balance sheet, b) intrinsic value of the company, c) market value (share price in the market). The value of the company will depend on the valuation method. If we invest in a company €10,000 for a 10% of the shares, and now these shares have a price in the market of €100,000, our profitability should be calculated taking into account the dividends received during the time we held the shares + value of the 10% shares, calculating the profitability received as investors (cash-flow invested at t0 = € 10,000 versus cash-flows received over the investment time horizon consisting of dividends and a final value of € 100,000). The calculation of the profit should be undertaken using investment appraisal techniques such as Net Present Value («NPV»), Internal Rate of Return («IRR») and Payback period («PB»).

To calculate the minimum annual return that we will demand as shareholders, and which we will call «Ke»,  the CAPM model will be used («Capital Asset Pricing Model»). It seems obvious that if the project does not provide at least a return equal to or greater than Ke, it will not be profitable for the shareholders.

In general terms, and depending on the type of entrepreneurship project (=risk), the Ke internationally moves in the range between 15% and 40%, with an average value of  25% circa, although this metric must to be supported with a relevant report/research, and will depend on the risk of the investment project.

2. CAPM model (Capital Asset Pricing Model)

Before commenting on this model, it must be said that the CAPM model has many detractors for its limitations, although it is widely taught in Corporate Finance subjects.

The CAPM model conceptually establishes that an investor will demand a higher profitability if the risk the project bears is greater. Therefore a project with more risk should provide a higher return to an investor. The investor will demand for each element of perceived risk, a return or profit (risk premium = profitability). It is important to note that although we speak of «risk premium» in the following formula, what we are adding is profitability in %, and not risks (the risks are measured as standard deviations!). Therefore, we will identify risks, then we will quote that risk in terms of profitability («risk premium»), and the formula will be as follows:

Ke = Risk premium 1 + Risk premium 2 + … + Risk premium «n».

But before adding risk premiums, we must ask ourselves: is there an investment that does not bear any risk at all? The answer is simple, NO, but in finance the 10-year bond of a government is considered as the risk free investment.

Let’s now imagine that we have the option to invest our money in a risk-free project (option A) or investing the money in this start-up project that we’ve been offered and bears more risk (option B). It seems logical to think that we will demand as shareholders more profitability to our money in that project that bears more risk and less to what we consider as «investment without risk» (in the case of existing such investment). We will see below, that we will assume that there is a risk-free investment, and therefore, the Ke formula will remain as:

Ke = Profitability risk-free investment + Risk premium 1 + Risk premium 2 + … + Risk premium «n».

3. Risk-free return or risk free investment («Rf»)

In general terms, there is not an asset without 100% no risk, but in finance, the risk free investment or «Rf» is considered to be the profitability offered by the 10-year bond of a country (certain countries only). The reason for taking the 10-year bond is because this instrument has high liquidity (we can buy-sell at any time that financial asset in the financial market) and it is considered a risk-free investment  due to the payment capacity of selected countries (although we know that countries also go bankrupt).

Thus, if we are Americans, we will consider the risk-free investment as the 10-year Americans bond («Rf10a_U»), if we are Spaniards, the Spanish 10-year bond («Rf10_ESP») and if we are Germans, the 10-year German bond («Rf10_GE»). Analyzing this data on May 28, 2016, the annual coupon (= annual interest that the US, Spanish or German state would pay to investors for a 10 year-bond would be as follows):

• Rf10a_US: 1.818%
• Rf10_ESP: 1.476%
• Rf10_GE: 0.143%

From this data, it is observed that Spain as a state, gets funding from the investors in a 10-year horizon with an annual cost of 1.476% while Germany does it at 0.143%. As it can be seen, Spain bears a 1.33% (1.476% -0.143%) higher funding costs than Germany, and the reason is investors perceive more risk in lending money to Spain as a country than to Germany (mainly related to stability of public finances, country global competitiveness, labour market, unemployment rates, and probability to payback the amount borrowed).

The 1.33% spread (=133 basis points) is known as «Country Risk Premium», defined as the additional/excess of profitability over the 10-year German Bond demanded by investors from the Spanish government in order to get funding and due to Spain’s country’s intrinsic risks. Here we see again that at higher risk, the investor demands greater profitability. In our specific case, when investing in Spain, our risk-free return will be the 10-year Spanish bond, Rf = 1.476%.

The value of the risk premium is very important, because if Spain has €1 trillion of public debt at an average annual rate of 3% and has annual debt maturities of €250,000 millions this fiscal year, an increase in the country risk premium from 1.33% to 8%, it would imply that Spain in order to raise public debt funding in the stock markets, it should pay an annual return or coupon to its bonds of 0.143% + 8% = 8.143%, and should refinance the total debt maturities of €250,000 millions at a yield/cost of 8.143% rather than 3%; having to assume the Spanish finances an annual interest cost of 8.143% * 250,000 million = €20,358 millions (only because of the increase in risk perceived by investors), and if we assume that the other €750,000 millions remain at 3% level (3% * €750,000 millions = €22,500 millions). So the total annual cost of the Spanish debt would be €42,858 millions, which makes it a situation very difficult to maintain from a long-term perspective and solvency of the Spanish finances that could lead to the country’s bankruptcy.

4. Rate of returns for perceived risk.

Now, we will have to identify the risks that affect the business. The risks impacting  a project can be of different nature, among others:

(1) Risks due to the nature of the company / industry in which it is developed (IT, food and beverage, banking, construction, etc.).

(2) Financial (prices, interest rates, credit default, exchange rates, etc).

(3) Liquidity of the investment (ability to convert into cash the financial assets)-

(4) Environment (country, legal, fiscal, etc).

(5) Others.

The basic CAPM model only quotes the risk-free investment and the specific risks for the type of project/company/sector undertaken. This risk is defined by a numerical constant called BETA (equal or greater than zero), that conceptually means if our company (or project) has the same risk as the comparable equity stockmarket  (beta = 1), higher risk than the equity market (if Beta = 2, we would say that the project has twice the risk of the stockmarket) or lower risk (Beta = 0.5, our company/project has half the risk of the comparable equity market). If we were investing in Spain, the comparable equity market would be IBEX-35, in the United States S&P 500 and in Europe, Eurostoxx 50.

Therefore the intrinsic risk of a project is measured by a number, called Beta, the higher the Beta, the higher the risk, and the higher should be the demanded profit. In general terms, Beta is calculated based on the correlation between the profitability of our company compared to the equity market (in terms of stock prices profit), however, if our project is new, we can not calculate it by this procedure since we do not have quoted prices of our company nor we can calculate price returns (unlike publicly traded companies where on a daily basis we can calculate the price of the shares and the equity index, calculate daily returns to both and therefore calculate a Beta (share, market).

When you do not have price quotes for the start-up, you should look for a betas report by country and sector. It is important to understand very well what Beta is provided by the report , because a Betas report of American automotive companies could not be used for a European automotive companies, nor an automotive beta report made for multinational companies when our company is a SME automotive (the SME-Small, Medium Enterprises have more risk than a multinational because of its size). A source for obtaining the Beta of a company could be the Beta report from professor Aswath Damoradan, professor of finance at Stern University in New York:

• Betas report by sector for US companies.
• Betas report by sector for European companies.

Additionally, Dr. Damoradan publishes reports of all kinds on its website about market risk premiums, interest rates, etc.

The next consideration to make is that if the Beta provided is calculated on a sample of multinational companies or large capitalization companies; we can not use the same Beta report and we will have to increase the Beta to incorporate the risk we have due to the size of our project or company. This is what is known as the «Size Risk Premium» and that in an entrepreneurial project would increase the value of  Damoradan’s Beta between x1 and x4 times (A reasonable value, although it must be justified, could be x2-x3 times , although as I mentioned this will depend on the risk of the project). Therefore, the formula of Beta = Beta Damoradan * Beta size of the company. This calculation therefore would tale into account that our project does not have the same scale than the companies sample analyzed by Damoradan in his Beta report (designed for large size companies).

In our example, if the Beta for the «Advertising» sector is 0.87, and we increase it by the risk premium due to size by 400% (Beta size: x4), the Beta of our project would be: 0.87 * (400%) = x3.48. Note: In our calculations we are not considering leveraged and unlevered Betas (i.e, there are betas per sector depending on whether the company has debt or does not have debt). In this example, we do not enter into these considerations or calculations. But it seems logical that the beta of an advertising company that does not have banking debt is lower than the risk (beta) of an advertising company that has debt (a company with leverage). Betas reports can give us unlevered betas (that is, without a debt structure), where the beta would have to be leveraged based on the specific debt structure of our company. If this consideration and calculation is not made, we will take leveraged betas instead of unlevered betas for having more risk.

Once we know that the risk of our project measured as Beta is x3,48 (=348%)) and  the comparable equity market (Ibex 35 in this case) has a Beta of 1, it seems logical that if we know the profitability that investors demand from the Ibex 35 for the risk of the companies that make up the index (known as «MRP = Market Risk Premium»), we will demand as risk premium for the sector-industry of the project: Beta * MRP = x3.48 * PRM. For the calculation of the MRP of the Ibex 35 we have 3 options:

a. To obtain the expected MRP that as of today for the Ibex 35 (difficult to obtain, but it is the right way). MRP = Expected profitability of the Ibex 35 – Profitability of the Spanish 10-year bond.

b. Calculate the historical MRP of the Ibex 35 in a period of time (easy to obtain, but conceptually incorrect, although widely used in finance). MRP=Historical profitability of the Ibex 35 – Profitability of the Spanish 10-year bond. According to various studies (see Pablo Fernández) and the period considered, the Ibex-35 MRP can range between 3.7% -5.5%. We could take a value of 5%.

c. Take the average value used by companies in the financial sector for MRP. This value according to a survey conducted by Pablo Fernández in 2011 and for the case of Spain has an average of 5.9% and a median of 5.5%, with a minimum value of 1.5% and a maximum value of 15.5% (on a sample of 900 surveys). If instead of considering Spain, we consider the entire sample of 1,500 surveys made to managers of financial companies, analysts and finance professors of universities at the international level, the most relevant results of the survey are: Large dispersion of responses (teachers use market risk premiums MRP between 3% and 8%, analysts between 2% and 11.9%, and companies between 1.5% and 15%). The average premium used by companies (6.1%) is higher than that used by teachers (5.5%) and that used by analysts (5.6%).

We will take a value of 5.5% as MRP for the Ibex 35. Therefore, and for the case of our project, we will demand a return for the intrinsic risk of the company due to the industry/sector:

(Beta = x3.48): x3.48 * 5, 5% = 19.14%.

5. Minimum annual return required by the shareholder to enter into this investment project.

Once we have calculated the risk free investment yield (10-year Spanish Bond) and the risk premium demanded due to the industry/sector risk of our start-up project, we apply the CAPM formula:

Ke = Rf + PRM = Spanish bond 10 years + risk premium of the company = 1.476% + 19.14% = 20.61%. As shareholders, we will demand a at least an annual return of 20.61%. If the project does not provide us with such minimum profitability, it will not be profitable, and the investment should not be undertaken.

The french amortization method of a banking loan, cost of debt (Kd)

WHAT IS THE FRENCH AMORTIZATION METHOD OF A BANKING LOAN

In the following post it will be explained how to solve a banking loan following the French amortization method that is widely used in the financial industry.

The main characteristic of this methodology is that the installments or payments are always a fixed amount (“C”) comprised of interests (“I”) and amount amortized from the principal or amount borrowed (“K”).

A banking loan amortized by the French method will always have the following 5 columns:

  1. “K”: Outstanding debt or principal amount (money that the company owes).
  2. “C”: Fixed installment, comprised of interest and amount amortized.
  3. “I”: Interests paid in the period and defined by “Kd”.
  4. “A”: Amount amortized or paid back from the principal amount borrowed.
  5. Cash-flow generated by the loan.

The financial condition that must be met in any banking loan is that the present value of the banking debt cash-flows must be equal than the money borrowed in t=0, at the interest rate of the loan, defined as “Kd” or cost of debt. Under this financial equation, the fixed payment or installment formula is as follows, where the incognita “C” must be obtained:

Amount borrowed (K) = Fixed installment (C) * [(1-(1+interest)^(-time)] / interest

It is very important to note, that in the formula, the interest and time must be in the same time units. For example, if the payments are undertaken yearly, the installments “C” are yearly and the interest rate Kd must be a nominal yearly interest. The time period should be years. If the installments are monthly, the interest Kd must be a monthly nominal rate and the time must be in months. For example, if Kd=12% yearly and time t=5 years, but the payments are monthly, the interest rate to be used in the formula is 12%/12 months=1% and the time period=5*12=60 months.

Once the “C” fixed installment is calculated, we must calculate the interests paid in the period “t” (“I”). The outstanding amount or debt at the beginning of the period “t-1” (“D”)*interest yield “Kd” will produce an output of the interests paid in that period “t”. “C”-“I” will allow to calculate the amount amortized “A” in that period of time “t”. Then, the level of outstanding debt in “t” will be level of outstanding debt in “t-1” minus the amount amortized in “t”.

In order to validate that the banking loan has been correctly solved, the sum of all the amounts amortized must be the amount of money borrowed from the bank “K”. Additionally, the level of outstanding debt the last year must be zero. If these two conditions are not met, the banking loan table is wrong, and calculations must be revised.

Please find below an example of a banking loan table following the french amortization table and with the following conditions:

  1. “K”=Amount borrowed €7,729,890
  2. Frequency of payments: Semi-annual.
  3. Yearly nominal interest (“Kd”)=5%. Semi-annual nominal interest (5%/2=2,5%)
  4. Time: 3 years (3*2=6 semesters)

The we proceed to solve the problem:

  1. Applying the formula, the semi-annual fixed payments or installments, “C”=€1,403,361
  2. Semi-annual interests paid in the first semester: 2,5%*€7,729,890=€193,247
  3. Amortized amount in the first semester t=1: C-I=€1,403,361-€193,247=€1,210,114
  4. Outstanding debt level (“D”) at the end of the first semester (t=1)=€6,519,776
  5. Please note that the cash-flow calculation analyzes de cash inflows and outlays from the company perspective.
  6. If we repeat this calculation for each semester, we obtain the following table.
  7. Please note that the total amount of payments would be: 6*€1,403,361=€8,420,168 (€7,729,890 amount borrowed+€690,278 interests paid).

A BANKING LOAN TABLE (FRENCH AMORTIZATION METHOD)

French amortization method of solving a banking loan

WACC: Weighted average cost of capital, definition

WHAT IS THE FUNDING MIX OF A PROJECT AND THE WACC (WEIGHTED AVERAGE COST OF CAPITAL)

Once the total funding needs of a start-up project has been calculated, the following step would be to consider the potential funding sources where the funding can be obtained. The two major funding sources of any company/project are mainly:

  1. Equity funding (“E”) or amount of money borrowed from investors/shareholders/equity owners of a project/company.
  2. Banking debt (“D”) or amount of money borrowed from financial institutions or banks.

The funding mix ratio depends on the project risk, credit scoring/rating, country framework and start-up ecosystem for that specific country. For the case of Spain, according to Webcapital (2016), the funding mix ratio for start-up projects in Spain was 86% from shareholders (“E”) and 14% from banking debt (“D”).

It is very important to understand that this funding is not for free, and it has a yearly cost in percentage defined as “Ke” (cost of equity funding) and “Kd” (cost of banking debt funding). The “Ke” depends on the project characteristics and risk profile, and the “Kd” depends on the interest rates yield curve and risk profile of the project too (credit spread). As a general rule we could assume that Ke will be in the range of 15%-40% with an average value of 25%, and the Kd could range from 3%-8% with an average value of 5%. These metrics should be supported by any study/research depending of the project characteristics. The Ke metric usually is calculated using the “CAPM”, Capital Asset Pricing Model.

The Ke is defined as the minimum yearly profit expectations in percentage required by shareholders that invest in a project. If this Ke or minimum profit expectation is not achieved by the project, the shareholder or equity owner will not be satisfied with the project’s profitability according to the project’s risk profile. In the same way, the project should be able to pay back the amount of money borrowed from the bank (principal of the banking loan) and the yearly interest determined by Kd.

Once the funding mix ratio has been defined and the Ke and Kd have been calculated, the cost of the funding mix can be calculated, being defined as the“WACC” or Weighted Average Cost of Capital. This KPI or metric would be defined as the yearly weighted cost in percentage of the funding mix taking into account the Ke and Kd and the ratio %E and %D. The WACC formula is as follows:

WACC=%E*Ke+%D*Kd*(1-corporate taxes)

Let’s imagine a project with the following financing scheme:

  • Equity funding (E: 86%), Baking debt funding (D: 14%).
  • Ke (25%) and Kd (5%).
  • Corporate tax level: 25%.
  • The WACC=86%*25%+14%*5%*(1-25%)=22.03%. For every euro borrowed with the funding mix 86% (E) and 14% (D), and with a cost of funding Ke (25%) and Kd (5%), the weighted cost is €0.05, and the project should generate at least a profit/return of €0.05 to be able to pay back the funding sources and profit expectations, otherwise the project will be unprofitable.

EXAMPLE

In the following link it is explained how to determine the total funding needs of a start-up project. Using the methodology explained there, the entrepreneurs require for their start-up €55,213,500. If the funding mix is 86% equity (E) and 14% financial debt (D), the amount borrowed from the investors will be «E»=86%€55,213,500= €47,483,610 and from banks «D»=14%€55,213,500= €7,729,890.

The E=86%=€47,483,610 should be invested in the project through shares.

The cash-flow generated by the project should be able to payback to the investors (via dividends and share price increase) at least the minimum profit expectations defined by Ke=25%. In addition, the project cash-flow generation should be able to payback the principal of the banking loan («D»=€7,729,890) and the interests («Kd»=5%). In the following link there is an explanation of how a banking loan is solved following a French amortization method.

 

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