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Principles of Finance: Unit 7, Hedging Your Bets 6 Views


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Hedging your bets, à la Shmoop.

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English Language

Transcript

00:00

principles of finance a la shmoop hedging your bets all right people the

00:06

epic continues you're in the CEQ B seat you know chief executive quarterback [businessman smiles]

00:12

you're jonesing to buy that new battery upgrade element to your drone

00:16

manufacturing plant you've tweaked its size and shape and scope so that its

00:20

total cost is down to quote just unquote 50 million boxer but the markets [man shows picture of 'gold viagra'

00:25

perceive you as risky they just don't buy into the notion that toy drones are

00:30

forever Barbie and Ken or risk or battleship or whatever other kind of a

00:34

toy that's here to stay forever ish so after trying to negotiate with banks and [two people talking with briefcases]

00:39

bankers while the best debt rate you can get is 10% which would mean you'd need

00:43

to pay five million bucks a year just in interest to rent that money and in

00:48

reality the bankers would want you to pay back the principal along the way so

00:52

that your actual payments in cash will be meaningfully more than the five

00:55

million bucks in interest more like you know seven eight nine million is a year

01:00

in total payments so you ugh loudly but then the banker trying to sell you the

01:04

ten percent debt package whispers loudly in your ear interest payments are taxed [man whispers into businessman's ear]

01:10

and he goes on to say that since you pay 33% tax the real cost of that debt isn't

01:16

n percent it's more like a little under seven percent super cheap if you use the

01:21

money wisely so the real rant on the money isn't five

01:24

mil year it's three point five mil taxes or tax adjustments as one point five

01:30

million bucks will be coming out of your taxable profits there's also the ability

01:34

to get pretty aggressive lead appreciative of the costs of that

01:39

Factory which well you figure in as well meaning you can depreciate the cost of

01:43

that factory even more and maybe save even more dough on your taxes well

01:47

straight-line say ten-year exit at scrap value of twelve million dollars would

01:53

mean that the factory depreciates on your books at a total of thirty eight

01:56

million dollars or three point eight mil a year

01:58

yeah battery factories run out of juice about as fast as batteries but that 3.8 [battery fuel monitor running low]

02:03

million would also come against taxes of the tune of about thirty three percent [white board with numbers]

02:06

so roughly a million dollars in change of taxes would have been forgiven as

02:11

well as part of all this all this is great as long as you have

02:15

taxable profits but for now business is rosy so you just assume you will have [drone product on shelf]

02:20

those profits for the foreseeable future you really want this fancy-schmancy [money raining down]

02:24

battery upgrade to your drone you have almost half a million drones out there

02:28

and you bet 30% of the existing owners and 150,000 of them would buy an

02:32

additional drone if they could fly it for an hour before recharging instead of

02:36

the current 15 minutes of real air time you could also charge more for the

02:39

drones like I don't know an extra 200 bucks you guess at very high [large price tag on drones in store]

02:43

contribution margin but in order to make that happen well you have to build your

02:47

own 50 million dollar battery plant nobody else will sell you batteries of [large price tag on battery plant]

02:50

the type you want at the scale you want in the timeframe you want with the

02:54

delivery certification and legal and regulatory hurdles met at the price you

02:58

want so you have to build your own which means that you'll need to weigh the cost

03:02

of debt against the cost of the new plant and all that it brings both risk

03:05

and reward batteries need to be made and sold to break-even you do some [production line of 'gold viagra']

03:10

break-even math and think about the internal rate of return you're applying [white board with numbers]

03:13

to that 50 million bucks you're hoping to be able to borrow and spin you're

03:17

spending five million bucks a year to rent capital to buy this manufacturing

03:20

plant and likely suffering another two million in change in actual depreciation

03:24

meaning the plant will be getting less valuable each year and new plants they

03:28

don't get more valuable as they go usually so that's 7 million a year for a

03:32

while to foot the bill to this plant all right the big Matthew question can you

03:36

gain enough in profits and growth from that spend to warrant spending it well

03:41

you've noted that you have 500,000 drones already sold in total in the

03:44

history of your company into the marketplace and you think 30% will

03:47

upgrade batteries and for now you ignore the overall quote lifts unquote that the [drone hovering]

03:51

better product will have on your brand and future sales and it gets worth

03:55

something you don't know what well that's something not mathematically

03:58

calculable so it just means and well more people will know and like and

04:02

respect your brand so you put a pin on that extra thingy now so you have [drone on pedestal with worshippers]

04:06

150,000 units you think you'll sell for an upgrade fee of 200 bucks a hundred of

04:11

which is pure free cash profit for you that's 150 thousand times a hundred

04:16

bucks or fifteen million dollars hmm so that's great in year one just that lift

04:21

pays back a big part of the loan but what about subsequent years and sales

04:25

will there be demand for the better batteries going forward well if there

04:29

isn't then the factory was a crazy lavish expense and a 50 million dollar [bags on money]

04:33

loan may be paid down in two years to say 40 million but that's a big debt

04:38

load on a small company and I have to service if it's not producing real [unhappy businessman holding bags of money]

04:41

tangible cash-on-cash value if the batteries contribute a hundred bucks in

04:45

cash value to the company for each one sold well then to pay back the 50

04:49

million plus say an accrued amount of debt on it of another 30 million or so

04:54

well that'd be a total cost for the factory of some 80 million dollars that

04:58

could cost of the factory plus the cost of renting the money to pay for the

05:01

factory well at a hundred bucks a battery that's a lot of batteries to be

05:04

sold just to break even or pay for the factory that's 80 million bucks divided

05:08

by 100 gets you eight hundred thousand batteries

05:11

lots of drone sales needed to cover that but it's not a crazy number actually

05:14

you've sold 500,000 units already in a few years since you've been in business

05:18

and you know there are a lot of geeks on this planet and you also note that

05:22

there's a whole new market you think opens up when there are more batteries ['viagra gold' on production line in factory]

05:26

cheaper better faster you know that are out there in the market so you think the

05:29

new battery will help you sell an additional 200,000 units and put you a

05:34

full notch ahead of the competition well at this point the factory seems like a

05:38

solid idea well worth the risk maybe even a no-brainer but there are big [man opens up empty head]

05:42

risks here you know brainers if you will a few examples of things that haunt you [man catches brain in hands]

05:47

you've pegged the cost of the data seven percent but that assumes that the

05:50

company continues to be profitable what if it's not it has a bad product run and [money vanishes]

05:54

instead of making a gajillion dollars it loses money well the debt still has to

05:59

be paid and if there are no profits from which to deduct interest well then the

06:03

cost of the debt goes back to the full 10% so this extra cost adds to the

06:08

pressure in needing to sell more units you mentally commit to allocate big pay

06:12

downs of that debt in the first few years such that you swear to your board [man arrives to board meeting]

06:15

with hand on chest that the 50 mil will become 35 mil by the end of the second

06:20

year after you've borrowed it and then you'll pay down five mil a year quote no

06:23

matter what unquote so that after five years a total principal remaining on the

06:27

debt will be something like 20 million dollars which should be a pretty easily

06:30

digestible loan at that point well what if there are lawsuits maybe the battery

06:34

comes from Samsung and explodes in the air what ['gold viagra' explodes in woman's face]

06:37

and what if people simply fall out of love with drones and now want SHM owns a [drone hovering]

06:42

virtual reality version of the physical drones you sell only people don't have [people on couch with VR head gear]

06:46

to move off their butts on the couches to fly them

06:49

well you rationalize that the entity that got you here was the physical drone

06:53

you built and that investors in you believe that there will be a healthy

06:57

demand for drones for a very long time so your job in this seat as CQB isn't to

07:02

be a mutual fund manager for your investors it's to produce drones that

07:06

sell at a good margin in good volume you're got one stock bat all on your own

07:11

yeah you still remain worried and think about ways to hedge your risks

07:14

well fiduciary you want to mitigate some of them anyway well one way would be to

07:18

form a partnership with a distributor in Europe unfortunately all the proper [world map]

07:23

distributors who sell into geek channels build a vastly inferior competitive [drone with dog head]

07:28

drone it's called the retriever and it's designed specifically to snag soccer

07:32

balls out of rain gutters and like so many things in Europe which are price

07:36

and competition protected well the manufacturers of that drone don't [newspaper article of dog headed drone]

07:40

realize how much better your drone is than theirs they keep pushing you to use

07:45

their facilities they're highly paid union workers they're amazing wireless

07:50

phones and you know that at least a few of them realize that if you start [world map]

07:54

selling your drones into the European market you will destroy their drone

07:58

sales everyone will be out of work and well it will be bad for Europeans so you

08:03

need an outside party to help you sell realizing that the local player with its

08:07

government backing it will try to be protectionist it will tax you to death

08:11

as you sell into the market you know with the import taxes that is so that if

08:16

someone wants your drone they'll be paying $2,000 plus $1,000 in those taxes

08:22

making your drone cost three grand to a consumer in Europe just too expensive to

08:27

really reach a big market you wonder why the US doesn't do the same to the [man walks away from a $3000 drone in store]

08:31

Europeans but you vow to go into politics only after you've retired from [people in white house]

08:35

having a you know real job well one offer you get is to form Bladerunner

08:39

Europe as a new and separate corporation which owns all of the intellectual

08:43

property patents knowledge systems etc of your company a European partner

08:48

offers to fund it by generously put in $50,000,000 to own half the company [investor walks in with a bag on money]

08:53

ah how generous you think they're valuing your business entire volumes in

08:58

Europe at only fifty million dollars and you think that's an extremely high

09:02

capital cost because you estimate that you could be selling half a million

09:06

units a year throughout that territory in a very not distant future at that [map of Europe with increase units sold]

09:11

point it would maithili come to five hundred thousand units times 1,000

09:15

dollars a unit and contribution margin to give you five hundred million dollars

09:19

in gross profits per year and yes that's not like next year but it's not that far [flipping calendar]

09:23

away off either selling half your company for 50 million bucks regardless

09:28

makes no sense at all way too cheap so you just leave your would-be euro [man walks away from European investor]

09:32

partnership as is because your operations are starting to generate

09:35

serious cash everywhere else and you're optimistic that you can just with us [mountains on money on US map]

09:41

business pay off that loan and then some so we've laid the groundwork here roll

09:45

the clock forward three years do that dissolve thingy and Wow nice job you

09:51

have a billion dollars in sales just in the u.s. you have twenty five percent

09:54

net margins which gives you two hundred fifty million dollars in earnings on 19

09:58

million shares outstanding that's 250 million divided by 19 or thirteen

10:02

dollars fifteen cents a share in earnings think about that a moment in

10:06

stunned silence it means that the people who bought your IPO at eighteen dollars [man in money suit]

10:10

and whined when it didn't immediately go to the moon well they paid less than 1.5

10:15

times this set of earnings for the company yes it was earnings four years

10:19

forward from the IPO but just in cash profits the company made back its whole

10:24

market cap at the bottom and now at what you think is still a very low multiple

10:28

of 20 times earnings well you carry a market cap of five billion dollars which

10:33

means that your stock trades at five billion dollars divided by 19 million

10:36

shares or about 263 ish dollars a share and by the way remember that you spent

10:41

twelve million dollars buying back your own stock remember that will that buy

10:45

back now that 12 mil is today worth yes 263 million dollars remember that you

10:51

bought a million shares in you know the dark days are you kicking yourself you

10:55

didn't buy back five times as many shares well maybe you should be anyway [man in money suit holding his own leg]

10:59

you now have serious market Fiat or power and are thinking

11:02

about spending a boatload to build your own website in Europe not have any

11:06

partners there and sell direct to consumers yeah

11:09

viva la drone baby can you hear the people sing [people in French revolution costumes with drones]

11:12

or at least playing with their drums

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