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Principles of Finance Videos 166 videos

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Principles of Finance: Unit 4, Capital Efficiency Tradeoffs: Where Do I Spend My Cash? 4 Views


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Description:

You've got a tractor-stamping factory. Where and how do you spend your cash? We'll cover capital efficiency, and how you shouldn't blow it all at the track.

Language:
English Language

Transcript

00:00

Principles of finance, a la shmoop. Capital efficiency trade-offs: where and

00:06

how do I spend my cash? All right well let's take a look at a gnarly tractor

00:12

smelting example case study today you stamp out about ten tractors a week in [Man presenting]

00:16

Bessie your 38 year old factory and plant

00:20

she's stalwart wide hip and sturdy she did you proud and well now she's falling

00:26

apart it's a miracle she lasted this long

00:28

she was only warrantied for 20 years so 38 is like 2x and you've already

00:33

depreciated away all of her costs so your tractor company appears to be very

00:38

profitable from an earnings basis in fact it looks like this contribution

00:43

margin is how much profit the unit generates for its n plus 1 unit in this [Contribution margin definition appears]

00:49

case that $50,000 tractor sells that retail to dealers for 80 grand

00:54

and yes the factory then you'd say whole sales it to those dealers for 50 grand

00:58

alright well the cost of the metal assembly electronics treads engine and

01:01

so on is 40 grand so the extra n plus oneth tractor generates $10,000 in

01:07

contributed profits well the company's summary income statement for last year [Income statement appears]

01:12

looks like this so this is a nice little company great tractors independent

01:16

Heartland America but weirdly there's nothing in the DNA line like if the

01:21

company had bought a plant some years ago shouldn't there be a plug to

01:24

depreciate it well yes but their CFO didn't take this

01:28

course had she she would have put in a line

01:31

called sinking fund or something similar so it was budgeted on the line such that [Wood burning in the fire]

01:36

when old Bessie finally died and was resting comfortably stuffed by the

01:41

tractor dermist sitting by the fireplace she'd have a replacement the

01:45

company shows kind of "false" profits here right if a new

01:49

basic plan cost twenty million dollars and Bessie is fully depreciated 20 years

01:53

ago well for the last 18 years we probably should have been socking away a [People working in a factory]

01:57

few nuts to fund the build of a new plant and we should have deducted a bit

02:01

more than a million bucks a year to fund that it would have come right off our

02:05

taxes but we didn't do that we took the excess free cash and stupidly

02:10

distributed as dividends to the laborer owners why did we do that well they wanted to [Man carrying sacks of cash]

02:16

get paid understandably unfortunately in the process they robbed the company of

02:20

cash resources to build a new plant now that this one was well pretty much done [Explosion occurs]

02:25

how could this have happened well the people in charge of dividend

02:28

distribution were the highly tenured laborers those who had been at the plant

02:33

over 25 years they were a year or two from retirement by the time Bessie was

02:38

going to die so why would they worry about long-term planning take the money

02:43

and run right well that's why you have diversified boards and it's a big issue

02:47

when it comes to capital expenditures if you don't have a range of voices [Men discussing matters in a meeting]

02:51

speaking up for those who will be at the company 20 years later while you end up

02:55

anemic at best luckily despite the short-sighted financial management of

02:59

capital tread on me has had a great reputation as a builder of high-end

03:03

tractors and banks are happy to have the conversation about giving them a loan

03:07

for a new factory well the basic new one will cost 20 mil but allow the company

03:11

to make the same 300 tractors now for 30 thousand bucks each instead of 40

03:16

thousand there that they've been making them for before and guess what the new

03:20

factory replaces one-third of the laborers with robots [Factory robot machine working]

03:24

surprise surprise maybe that's why the old guys took the money and ran instead

03:28

of spending the plant capital on robots and while the new plant is just

03:32

generally more efficient with inventory assembly tracking metrics and so on so

03:36

on this new plant factory will hold all of the other variables to be the same

03:40

and instead of making 10 grand a unit of 300 in a year 300 produced in a year

03:45

they'll make 20,000 in pre-tax profit or contribution per unit that's double so [Pre-tax profit highlighted]

03:50

pre-tax profit is going to be 6 million bucks give or take remember that times

03:54

interest covered ratio thing we covered before well shoot were 3x and change

04:00

here the factory is 20 million dollars divided operating income of 6 million

04:03

and you get to 20 over 6 about 3.3 X well it's pretty easy and easy to get to [Person holding Basic factory build folder]

04:08

a YES on the basic factory build in 3 years and change the factory is fully

04:13

paid off the conservative founder of tread on me would rest easy

04:17

but the young whippersnappers angry about how the old guys left them are

04:21

more greedy than fearful they haven't lived

04:24

through many bad economies and they seek risk they're ready to do the fancy [Robots working on tractors]

04:28

factory which will let them stamp out more tractors with more bells and

04:33

whistles albeit in an unproven marketplace which may or may not want

04:36

them fancy right all right well they can count on for now the same numbers is the

04:41

basic factory sales going forward right so the question then is how much could

04:45

we spend on a new factory and still sleep at night well the answer revolves

04:49

around the cost of money and the time required for them to pay back that loan

04:53

if they had to pay everything back in four years well they couldn't afford

04:58

much more than what they're spending in this 20 million dollar version of

05:01

capital for a basic factory in theory after year three if they had paid back

05:05

and say fifteen million dollars in owed just five million at that point well [Interest graphs appear]

05:10

they could refinance and extend the payback terms if they had to but let's

05:13

say the board is worried about a global economic meltdown or the new Google

05:18

driverless tractor so they want read my lips no debt in four years just like the

05:22

bank does well the money costs five percent and it is secured by the entire

05:26

business that is if the company doesn't pay back the loan the company is owned

05:30

by the bank who loaned them the money and the bank is betting that the entire [Man put down gambling chips on roulette table]

05:34

company will be worth more than what they're loaning them the money for so

05:37

let's say the super duper factory is forty million dollars to build well the

05:42

company has six million in operating profits they have to pay back loan in 20

05:45

years so they owe two million in principle each year and they'll pay in

05:50

year one five percent of forty million borrowed or two million in interest the

05:54

interest is deductible the principle is not so together these two elements

05:59

comprise four million dollars in cash costs to the company each year doable

06:02

yes they have six million in profits here plenty of cushion and you can do

06:07

the math that two million dollars goes against taxes so instead of paying a

06:11

third of their operating profits of six million dollars in taxes or two million

06:15

dollars in taxes if taxable income now of six million minus the two million of

06:20

interest costs or taxable income of four million bucks and then a third of that

06:24

is 1.3 million note that is the principle owed declines ie 40 million [Principle owed declining on a graph]

06:29

owed in year one and 38 million million in year two and so on the

06:33

interest cost on that money declines as well by year ten tread on me owes twenty

06:38

million dollars on SuperDuper at five percent or just a million bucks a year

06:43

in interest half of what they started with but as always here at shmoop [Man holding baseball bat]

06:47

central there's a curve ball the economy tanks Google cranks and the next year

06:51

instead of selling three hundred tractors like they had for decades they

06:55

only sell two hundred so the board is thinking woe is me why did we ever

06:59

upgrade Bessie? well for four million dollars we could have fixed her up and

07:04

gone producing three hundred tractors a year for another ten years

07:07

well that math is totally different of course with almost no needs for capital [Wheel of fortune wheel appears and lands on taxes]

07:11

expenditures company finds itself with tons of options and tons of taxes tread

07:15

on me left with bessie continues for a decade or more with $10,000 per tractor

07:20

in pre-tax profit or three million of pre-tax profit and cash builds up ensure

07:24

the company pay a big dividend well only equity holders get dividends and

07:27

only a relative handful of labor owners maybe 10% own equity shares in the

07:32

company the rest just get paid a salary a small bonus if quotas are met and a

07:36

free turkey for christmas well they feel unfairly treated if the company just

07:41

hoards its cash and oh by the way the company just got to tax 33 [Man points to taxes in presentation]

07:45

percent on its profits if it pays a dividend the employees get taxed a

07:48

second time on that dividend fair? doesn't matter it's how the laws are set

07:52

up what else can the company do beyond upping the dividend well it could just

07:56

keep the cash pouring but good rainy day fodder does the board trust that

08:00

management won't spend it stupidly maybe the company could also use the excess [Men sitting in board room]

08:04

cash to buy back its own stock fewer shareholders out there mean the same

08:08

volume of cherry pie is shared with fewer mouths so each eater gets more but

08:12

then the capital that probably should someday be used for a new factory has

08:17

been given over to equity owners who are basically leaving the business that is

08:21

when they sell out their equity stakes and move on they no longer financially [Woman running away from exploding building]

08:24

care whether the business is doing well or not it's likely that some were at

08:28

least partly responsible for the 300 tractors that got sold every year so

08:33

what happens now that those workers are gone? Does the Department of

08:36

Agriculture still buy five tractors a year or do those sales just go away to a

08:41

competitor now hopefully you get the idea here lots of moving [Man discussing companies]

08:44

parts lots of choices with what you do with your free cash as a company and

08:49

factories matter the spiffy new ones don't need humans though so you know

08:53

here's hoping you and the robots get along [Robot working in factory]

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