Pricing of Weather Derivatives Using Monte Carlo Simulations

Derivatives are financial products whose values are determined by the current price of the underlying asset or portfolio. Weather derivatives are a particular class of financial instruments that individuals or companies can use in support of risk management in relation to unpredictable or adverse weather conditions. While some may see them as an exciting innovation, there is considerable debate about the future of weather derivatives and their suitability to specific situations. The main argument against them is that they are too complex and difficult to understand for the average person. Notably, the valuation of weather derivatives is not trivial as it often requires the modeling of an index whose forecast value can change drastically over the next few hours or days. We note that,

There is no standard model for valuing weather derivatives similar to the Black–Scholes formula for pricing European style equity option and similar derivatives. That is because the underlying asset of the weather derivative is non-tradeable which violates a number of key assumptions of the BS Model. Typically weather derivatives are priced in a number of ways…

[Index modelling] approach requires building a model of the underlying index, i.e. the one upon which the derivative value is determined (for example monthly/seasonal cumulative heating degree days). The simplest way to model the index is just to model the distribution of historical index outcomes. We can adopt parametric or non-parametric distributions. For monthly cooling and heating degree days, assuming a normal distribution is usually warranted. The predictive power of such a model is rather limited. A better result can be obtained by modelling the index generating process on a finer scale. In the case of temperature contracts, a model of the daily average (or min and max) temperature time series can be built. The daily temperature (or rain, snow, wind, etc.) model can be built using common statistical time series models (i.e. ARMA or Fourier transform in the frequency domain) purely based only on the features displayed in the historical time series of the index. A more sophisticated approach is to incorporate some physical intuition/relationships into our statistical models based on spatial and temporal correlation between weather occurring in various parts of the ocean-atmosphere system around the world (for example, we can incorporate the effects of El Niño on temperatures and rainfall). Read more

Despite these difficulties, efforts are being made to price weather derivatives accurately. A recent paper [1] presents a valuation method for pricing an exotic wind power option using Monte Carlo simulations.

Wind power generators face risks derived from fluctuations in market prices and variability in power production, generated by their high dependence on wind speed. These risks could be hedged using weather financial instruments. In this research, we design and price an up-and-in European wind put barrier option using Monte Carlo simulation. Under the existence of a structured weather market, wind producers may purchase an up-and-in European wind barrier put option to hedge wind fluctuations, allowing them to recover their investments and maximise their profits. We use a wind speed index as the underlying index of the barrier option, which captures risk from wind power generation and the Autoregressive Fractionally Integrated Moving Average (ARFIMA) to model the wind speed. This methodology is applied in the Colombian context, an electricity market affected by the El Niño phenomenon. We find that when the El Niño phenomenon occurs, there are incentives for wind generators to sell their energy to the system because their costs, including the put option price, are lower than the power prices. This research aims at encouraging policymakers and governments to promote renewable energy sources and a financial market to trade options to reduce uncertainty in the electrical system due to climate phenomena.

References

[1] Y.E. Rodríguez, M.A. Pérez-Uribe, J. Contreras, Wind Put Barrier Options Pricing Based on the Nordix Index, Energies 2021, 14, 1177.

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How to Determine Implied Dividend Yield-Derivative Valuation in Excel

Dividend yield is an input into the option valuation model that often receives little attention from the practitioners. This is probably because the majority of companies do not pay dividends. And for those that pay, an inaccuracy in the estimation of the dividend yield often has a small impact on the fair value of the financial instrument, especially if the tenor of the instrument is short.

However, under some circumstances, dividend can become an important input in the valuation model, and an inaccurate estimation can lead to a severe financial loss. This is what happened with a French bank during the pandemic,

The bank also lost about 100 million euros on dividend futures for the quarter, the people said. The losses had surged at one point to about 300 million euros before improving, according to the people. Dividend futures are derivatives that investors use to speculate on the payouts that companies make to shareholders. They have tumbled to historic lows in recent weeks as some of the world’s biggest corporations shred their awards in response to the coronavirus and, in some industries, pressure from regulators. Read more

In this post, we discuss ways to determine the dividend yield accurately. In the option pricing model, the most accurate dividend yield is the implied one that can be calculated from

1. Dividend futures,
2. Traded single stock futures, or
3. Traded options.

We’re not going to discuss dividend futures here as they are over-the-counter instruments and not traded frequently. Single stock futures, on the other hand, have been traded more frequently than dividend futures, but they are illiquid and the number of available single stock futures is still small.

This leaves us with the last choice, i.e. using traded options to determine the implied dividend yield. Specifically, if the options are of European-style exercise, then we can use the put-call parity to create a synthetic single stock future, i.e.

where C(K,t) is the call price at time t,

            P(K,t) denotes the put price,

            K is the strike price,

           S is the stock price,

           r is the risk-free rate,

          T is the time to maturity, and

          q is the continuous dividend yield.

Note that equation (1) is model-free, and the implied dividend yield can be extracted easily by using it.  This method has been implemented in an Excel spreadsheet.

As an example, we are going to calculate the implied dividend for Microsoft (MSFT) as of Feb-26-2021. The picture bellows shows the price of the 6-month call option with a strike price of $240. The price of the put option, as well as the risk-free rate, are provided in the Excel spreadsheet.

The picture below shows the calculated implied dividend yield from MSFT traded option prices. We obtain an implied dividend yield of 0.72%.

Note that in the above example, for illustration purposes we assumed that the options are European style, but in fact they are American style, as is the case for most equity options. This means that the put-call parity no longer holds, and we cannot use eq (1) to calculate the implied dividend yield.

Fortunately, there is a viable solution. Reference [1] presents a method that generalizes the put-call parity for the case of American options. Essentially, the author introduces a so-called early exercise premium into equation (1), thus allowing the generalized put-call parity relationship continues to be used in the calculation of the implied dividend yield.

A novel element in this methodology is that it clears the hurdle of dealing with the early exercise premium that is not present in index options but is an element of value in American style options of US stocks. The Cox, Ross and Rubinstein (1979) binomial tree takes account of this premium and the tree is constructed simultaneously for a pair of put and call options with otherwise equal characteristics by guessing the same values for implied dividends and implied volatilities for the put and call pricing models. Analyzing dividends from stock options thus implied reveals their predictive power and adds to the understanding of cross-sectional stock returns.

 

Click on the link below to download the Excel spreadsheet.

References

[1] J, Kragt, Option Implied Dividends, https://ssrn.com/abstract=2980275

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Buy-Side vs Sell-Side Analysts

Financial analysts study various companies to identify ones from which investors can benefit. Among these, there are two types of analysts. These include buy-side and sell-side analysis. Both of these are different in various aspects.

Who are Buy-Side Analysts?

Buy-side analysts are institutional investors who collect money from investors and invest it across various asset classes. They use different investing strategies to do so. A buy-side analyst seeks to determine whether an investment will be profitable and will fit the investment strategy. Once they do so, they can make recommendations to the investors for their funds.

Buy-side analysts work to provide benefits to the funds that pay them. Therefore, they limit their recommendations to only the fund. For buy-side analysts, identifying the right investments is crucial for long-term success. It is because investors measure their performance based on whether the recommendations they make are profitable.

Buy-side entities include hedge funds, asset management, institutional investors, private equity, ETFs, etc. The job of these institutions is to identify profitable investments for investors. For that, they identify relevant investments and gather information about them. Similarly, they use several models and techniques to gauge performance.

Buy-side analysts also interact with sell-side analysts. They use reports generated by sell-side analysts to carry out further analysis of their own. While sell-side analysts will make their information available to the public, buy-side analysts don't. Similarly, buy-side analysts provide a more detailed analysis of the financial information for a specific purpose.

Buy-side analysts involve analysts that require higher knowledge and skills than sell-side analysts. It is because they perform more technical analysis and provide better services to clients. However, that also means that they may come with higher costs to investors compared to other options.

Who are Sell-Side Analysts?

Sell-side analysts primarily provide unbiased recommendations based on the research they conduct on securities. They usually do so by following a list of companies within the same industry. It is different from buy-side analysts who follow stocks across various industries. Then they provide regular research reports to their clients.

Similar to buy-side analysts, sell-side analysts also create models to forecast a company's financial results. Unlike buy-side analysts, however, they don't conduct the research at a high level. For sell-side analysts, the research reports and forecasts are the primary output. They also provide price targets and recommendations on how they estimate a stock will perform.

The reports that sell-side analysts provide are available to the public. Therefore, anyone can use them according to their needs, which also includes buy-side analysts. However, they must create value for the services they provide for them to be successful. Usually, they do so by providing clients with comprehensive and detailed reports. Similarly, it may involve answering clients face-to-face.

Sell-side analysts primarily include investment banking. However, it may also consist of commercial banks, stockbrokers, and market makers. These entities provide all the services mentioned above while also facilitating buying and selling of securities between investors. Essentially, the job of sell-side investors is to convince clients or act like marketers.

Conclusion

There are various types of financial analysts in the market that may provide recommendations to investors. Buy-side analysts include entities that provide detailed analysis and recommendations to clients. They must make the right recommendations to stay successful. Sell-side analysts also make recommendations. However, these are not as detailed and are publicly available.

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How Leveraged Buyout Works

What is a Leveraged Buyout?

A leveraged buyout represents a strategy that companies use to acquire other companies using debt as the primary source of finance. Leveraged buyouts may also include using the acquired company's assets as collateral to finance the transaction. Sometimes, however, companies may also use their own assets to obtain the debt for leveraged buyouts.

Leveraged buyouts can be a hit or a miss for companies. Usually, it involves undertaking a significant amount of risk to finance these buyouts. Similarly, the acquiring company relies on the acquired company’s performance to repay the loan. Therefore, any problems within this plan can cause issues for the acquiring company.

How do Leveraged Buyouts work?

Leverage buyouts start when a company wants to buy out another company. As with any other transactions, they will need to finance the acquisitions. With leveraged buyouts, these funds come through debt rather than the acquiring company's equity. Therefore, companies may use a significant amount of debt to finance the transaction.

Usually, leveraged buyouts involve a 90% ratio of debt while the rest comes from the acquiring company's equity. The acquiring company may issue bonds to acquire this debt. Due to the risk involved, however, the bond will be high-return rather than investment-grade. Leveraged buyouts usually include using aggressive tactics to acquire another company.

Leveraged buyouts can occur through a company's current management or employees. Similarly, private equity firms may also participate in it. There may be several reasons for leveraged buyouts. These may include transferring private property, taking a public company private, or spinning-off a portion of an existing company and sell it. Similarly, companies may use leveraged buyouts to acquire a competitor and improve underperforming companies.

Which companies are more prone to Leveraged Buyouts?

Some companies are more prone to leveraged buyouts compared to others. These include companies that are in a mature industry. Similarly, companies that have stable and predictable earnings are better candidates for this purpose. It is because the acquiring company takes high risks on the acquisition. Therefore, having stability can help in repaying debts later.

Similarly, companies with a strong team of personnel and involved in cost-cutting measures are prime candidates for leveraged buyouts. Acquiring companies also prefer target companies that have a clean balance sheet with minimal debt. Some other factors may also play a role in deciding whether companies will choose a target company for leveraged buyouts.

What are the advantages of Leveraged Buyouts?

Leveraged buyouts are advantageous to the acquiring companies. Through leverage, companies can finance acquisitions without having the equity necessary to do so. It also provides them with an opportunity to earn a higher return on investment. For some companies, acquiring underperforming companies and turning around can also yield significant returns.

Leveraged buyouts can also be advantageous for sellers. The primary advantage is that sellers can dispose of their companies during their peak performance periods. This way, they can earn the maximum amount of money. Similarly, companies that are on the verge of failure or in a bad market position can also benefit from leveraged buyouts.

Conclusion

A leveraged buyout is the process of financing acquisitions primarily through debt. For the acquiring companies, it presents a significant amount of risk that they undertake to acquire finance. Leveraged buyouts can happen for several reasons. These can have various advantages for both the buyer and the seller, as mentioned above.

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What Does A Chief Financial Officer Do

What is a Chief Financial Officer?

A Chief Financial Officer (CFO) is a senior executive in companies, responsible for overlooking financial matters. In any company, a CFO is the highest rank figure in finance. Usually, CFOs are professionals with an understanding of financial matters and who can resolve any related issues. They also handle strategic-level financial decisions while delegating smaller tasks to others within the finance department.

Chief Financial Officers usually include highly-qualified individuals who understand various aspects of finances. For example, they may include Master of Business Administration graduates or members of professional accounting bodies, such as CPA, CFA, Chartered Accountants, etc. Chief Financial Officers are also a director on the board of directors.

CFOs usually report to Chief Executive Officers and the board of directors only. However, this is only one of the duties they perform. Apart from this, CFOs are also responsible for many other finance-related tasks in a company.

What does a Chief Financial Officer do?

The duties and responsibilities of a CFO in a company will differ according to the company’s requirements. Similarly, they may undertake some tasks while delegating others to junior-level staff. However, a typical Chief Financial Officer’s duties include the following.

Financial Reporting

Reporting is the most crucial responsibility that CFOs perform. As mentioned, they are responsible for reporting performance to the CEO and board of directors. However, that is not all they do in this process. Chief Financial Officers are also responsible for preparing financial reports to report various aspects of a company. Almost every stakeholder a company has will be interested in the financial aspects reported in these statements.

Financial Management

CFOs are also responsible for managing the overall finances of a company. These may include overlooking its capital structure and how it obtains finances. Similarly, it includes managing its liquidity through working capital and cash management. In this role, CFOs are also responsible for overlooking the decision-making process related to new investments and projects.

Strategic Decision-Making

Being on the highest level of a company’s finance structure, CFOs are also responsible for strategic decision-making. Although most decisions go through the CEO, CFOs still play a significant role in them. Similarly, they influence the future direction that companies take with their finances. CFOs are also responsible for aligning a company’s finances with its strategies and facilitating growth.

Risk Management

CFOs are also responsible for risk management within a company. Each company will have its own risks due to its nature. These risks come with significant damages that can impact a company's business and its finances. Identifying and reacting to these risks is crucial for any company. The CFO assumes the responsibility for identifying these risks and mitigating them promptly.

Legal and Regulatory Compliance

Every company has to comply with various rules and regulations. If they fail to do so, they may face penalties and legal action. The CFO is responsible for identifying all applicable regulations and ensuring compliance. Similarly, CFOs are also responsible for compliance with all financial and tax rules relevant to the company.

Financial Advisory

A company's CEO is responsible for shaping the direction for the future. Due to this, they may make various decisions that they think will lead to long-term success. During this process, the CFO also plays a significant role. CFOs advise CEOs on how their plans can affect a company's finances. Likewise, the CFO is responsible for handling the finances for ensuring the strategies succeed.

Conclusion

Chief Financial Officers are the ultimate finance authority figure in a company. These are individuals who have a high level of financial knowledge and skills. CFOs are responsible for overlooking a company's finances. Due to this, they may have various duties, as mentioned above.

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What Is Operational Risk Management

Companies need to face various types of risks during their operations. Most of these risks accompany adverse implications for a company and cause damage to its operations. Therefore, identifying and dealing with these risks promptly is crucial for a company's success. These risks may come in various forms and from different sources. Among these, one of the most prevalent risks is operational risk. Before understanding operational risk management, it is crucial to look at operational risks.

What is Operational Risk?

Operational risks represent all uncertainties and hazards that companies face during their daily activities. These are uncertainties that come from within a company rather than outside of it. Since operational risks relate to a company’s operations, they might be different for each type of company or industry. Operational risks don’t necessarily need to result in losses. However, they can impact a company’s operations.

Operational risk relates to the decisions that companies make and the procedures and processes in place. There are various sources from where these risks may come. For example, operational risks can come from product failure, health and safety issues, interruptions in processes, errors or omissions, litigation, etc. Identifying and managing operational risks is crucial for companies.

What is Operational Risk Management?

Operational risk management is a technique that companies use to manage their risks. These include processes and strategies that they put in place to identify and mitigate those risks. Operational risk management comes due to operational risks, such as internal processes failure, human errors, or external events.

There are four principles included in an effective operational risk management framework. These include the following.

• Accept risks when the benefits outweigh the costs.
• Reject unnecessary risks.
• Anticipate and manage risks through planning.
• Make risk decisions promptly at the right level.

For many years, companies ignored operational risks and considered them trivial. These companies believe that operational risks depend on random variables occurring. However, more companies are putting emphasis on an effective operational risk management process. Through this, companies have taken a better view of their operational risks and managed them properly.

Operational risk management starts with understanding a company's nature and the risks associated with it. As mentioned, these risks will differ according to the company's processes and operations. Once companies get an understanding of their operations, they can identify the risks associated with it. Similarly, they can design ways to manage and mitigate them.

What are the benefits of Operational Risk Management?

Operational risk management can have various benefits for companies. Firstly, these improve the reliability of business operations due to fewer failures. It also strengthens the decision-making process where companies face risks. Similarly, it lowers any costs associated with failures, for example, compliance costs.

Operational risk management also reduces the overall impact or damage caused to companies. It improves the effectiveness of risk management operations with companies. It also allows companies to take a proactive approach to manage risks.  It also comes with many other benefits for companies.

Conclusion

Operational risk relates to the issues that companies face during their daily activities. These stem from a company’s operations and can have an adverse impact on the company. Operational risk management is a technique used by companies to manage their risks. It involves identifying risks and managing them and can have many benefits for companies.

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What Is Reputational Risk?

When companies and businesses start operations, they may not be profitable. However, once they develop a customer base and good supplier relationships, they can earn more. These are things that come due to a company's reputation, often termed as goodwill. Developing a good reputation is crucial for a company's success in both the long- and short-term. However, companies may also damage their reputation sometimes.

What is Reputational Risk?

Reputational risk represents the dangers or threats that may damage a company’s goodwill. It comes from both internal and external factors. However, most commonly it stems from within a company and its operations. Companies may, as a result of their actions, create reputational risk. Similarly, a company’s employees may also give rise to reputational risk indirectly. Lastly, any entities that a company deals with can also tangentially affect its reputation.

Reputational risks can create a lot of problems for a company. For example, it may result in a loss of customer base or good supplier relationships. It can also impact a company's revenues and profitability. Reputational risks can come from actions, such as security and safety issues, ethics violations, poor products or services quality, fraudulent activities, and much more.

Regardless of the sources of reputational risk, companies can experience lower profitability. Sometimes, being associated with these activities even if they haven't committed such actions can cause issues.

How does Reputational Risk work?

The main impact of reputational risks on a company is on its goodwill. It is the relations and reputation that a company has accumulated over the past due to its operations. Companies may even have to pay additional money to reduce the impact on their reputation. Usually, companies that participate in activities that others may view as unethical face the highest reputational risk.

However, companies don't need to participate in these activities directly to suffer due to reputational risk. It may also arise due to a company's employees behaving in their own interest or participating in unethical activities. For example, fraud within a company caused by its employees can result in reputational risk.

Similarly, the relationships that companies develop can also bring harm to them. For example, if a company deals with a supplier that participates in unethical or fraudulent activities can also result in reputational risk. Likewise, companies may face this risk from their subsidiaries, joint ventures, and other related entities.

Why is Reputational Risk crucial?

Identifying and mitigating reputational risk is crucial for companies. Usually, companies can use various control measures to manage these risks. Due to the easier availability of information about a company's operations on the internet, reputational risk is more crucial than ever. Sometimes, these can result in instant implications, which may cause a lot of harm.

Companies need to take a proactive approach toward reputational risk. Therefore, they need to identify the risks that can result in damage to their goodwill promptly. It is one of the risks where companies can benefit from preventing rather than controlling them. In case they fail to prevent reputational risk, they can face widespread implications.

Conclusion

Reputational risk is crucial to a company's goodwill, which it develops through years of operations. Reputational risks can come from several sources. These may include a company's operations, its employees, or its associated parties. Companies need to identify these risks promptly and take a proactive approach to prevent them.

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What Is Legal Risk?

Operational risk represents the risk that comes due to uncertainties and hazards in a company's operations. Operational risk is a type of business risk and can impact a company's profits adversely. This risk exists for every business and company. There are various operational risks that companies may face, one of which is a legal risk.

What is Legal Risk?

Legal risk consists of any uncertainties that companies may face due to fraudulent activities. It has various definitions. However, legal risks usually refer to any loss that companies may face due to their activities that may cause issues. For example, companies face legal risk due to defective transactions. Similarly, failing to take appropriate measures to protect its owned assets can cause legal risks.

Legal risks may also refer to any risks that companies face due to changes in the laws. Legal risk is usually associated with operational risks as it may come as a result of fraudulent activity. Therefore, it can impact a company's operations and result in operational losses. Identifying different types of legal and operational risks is crucial for companies. It is because they will need to customize their responses to each risk.

What are the various types of Legal Risk?

Legal risks come from various sources. Usually, it comes as a result of the laws the apply to a company. For example, these may include employment laws, safety laws, tax laws, etc. Therefore, each type of legal risk may have a different impact on a company and its operations. Some of the types of legal risk include the following.

Assets

As mentioned, legal risks stem from a company's failure to protect its assets, whether tangible or intangible. Companies need to identify all their assets to identify and manage any risks associated with them. Once they do so, they can protect the rights and obligations related to all the legal assets owned by them.

Regulations

Regulatory risks refer to any risks that companies face due to changes in regulations. For every company, identifying the applicable rules and complying with them is crucial. Regulatory risk is a type of legal risk and can impact a company's operations. Any changes in the legal implications and regulations can affect a company's operations and are, therefore, a part of legal risks.

Contracts

Contract risk refers to the risks related to the contracts that companies undertake. These arise due to the failure of any of the two parties in an agreement to meet their obligations. Likewise, contract risks lead to legal implications for companies. Since it relates to a company's operations and legal matters, contract risks are a part of legal risks.

Disputes

Working in a business environment gives rise to many duties. Due to these, companies may face various disputes. The risk of facing a legal dispute which also disrupts a company's operations is a part of legal risks. Even those that don't result in legal repercussions can lead to other risks such as reputational risk.

Conclusion

Legal risk refers to the uncertainties that companies face due to legal matters. Usually, it may relate to fraudulent activities within a company. Therefore, these are usually part of operational risks. Legal risks may come from various sources. These include assets, regulations, contracts, and disputes. Identifying the sources of legal risk is crucial in controlling and managing them.

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What Is Regulatory Risk?

There are various risks that surround any company. Some of these may come from external factors, while others may relate to internal operations. For external risks, there are five areas that may affect the risks faced by a company. These include political, economic, social, technological, environmental, and legal matters. Among the risks that come because of political and legal factors is regulatory risk.

What is Regulatory Risk?

Regulatory risk refers to any risk that comes due to changes in regulations or legislation. However, these risks are only worth protecting against if they affect a company or security adversely. Regulatory risks may impact a specific company or an industry as a whole. Following and satisfying all regulations is crucial in business success. Therefore, regulatory risks can result in an adverse change in a company.

Regulatory changes come due to changes in laws or regulations. These changes usually come from a regulatory body. For example, for publicly-listed companies, the regulatory risk may come from changes in the stock market regulations. However, regulations may also relate to the government. Therefore, the policies of the jurisdictions in which a company operates are also relevant to regulatory risk.

How does Regulatory Risk work?

Companies and businesses need to abide by various rules and regulations to operate properly. These rules and regulations exist to direct them on how to function. In some cases, these may also exist to protect a company's stakeholders. For example, stock exchange rules and regulations help provide shareholders with security against fraudulent activities.

For most regulations, not abiding by them is not an option. In case companies do not meet the specific requirements for each regulation, they may face penalties and legal action. Similarly, failing to satisfy them may also come with reputational risks. For example, customers may not be willing to transact with companies that do not follow environmental regulations.

Overall, keeping track of regulations and meeting the requirements is crucial for companies. However, these regulations may also change from time to time. For example, governments may alter their policies, which can result in a change in regulations. Therefore, companies must ensure that they are aware of any regulatory changes that may affect them adversely.

Companies usually have a risk management department that overlooks all these matters. This department follows all regulatory changes and ensures proper regulatory compliance. Similarly, the internal audit department may also track regulations and ensure the management complies with them. Although regulatory risks are not as common as others, they are still crucial and can impact a company's operations.

Where does Regulatory Risk exist?

Regulatory risks relate to changes in regulations that impact business activities. Usually, these risks are common for companies that follow a high number of regulations. For example, the regulatory risk may exist in the stock market due to the stock market regulations. Similarly, it is common for financial institutions to deal with these risks more than others.

Regulatory risks can come from various sources. For example, changes in tax policy reforms each year can bring about regulatory risks with them. Similarly, changes in laws such as minimum wage laws can impact a business.

Conclusion

Regulatory risk is the risk that changes in regulations may adversely impact a company’s operations. For every company, identifying and complying with all regulations is crucial. However, these regulations may change with time and accompany adverse impacts. Regulatory risk is most common for companies that operate in a highly-regulated environment.

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Audit Committee Role in Corporate Governance

What is Corporate Governance?

Corporate governance represents a system of rules, practices, and processes which dictate how companies should operate. Technically, corporate governance can be defined as "the system by which companies are directed and controlled in the interests of shareholders and other stakeholders”. The control and direction may come from within the company or from outside.

Corporate governance provides a framework for achieving a company’s objectives. The purpose of corporate governance is to define a system that promotes transparency within a company. Similarly, it exists to provide security for a company's shareholders. Corporate governance became relevant due to various high-profile company failures in the past.

Corporate governance also defines various committees that companies must have. One of these includes the audit committee that is essential for all companies.

What is the Audit Committee?

The audit committee is a committee that exists on a company's board of directors. It consists of independent non-executive directors. The primary function of the committee in a company is to provide evidence of increased accountability to shareholders. This committee is in charge of overseeing financial reporting and related disclosures.

For most publicly-traded companies, having an audit committee is mandatory. For private companies, the audit committee must have at least one non-executive director. Public companies must have at least three independent non-executive directors. In either case, at least one director on the committee must have recent financial experience or qualify as a financial expert.

The audit committee also coordinates with a company's auditors. Overall, the committee must include only independent directors. In case any of the non-executive directors on the committee cannot demonstrate independence, they cannot stay on it. The role of the audit committee in corporate governance is crucial for companies.

What is the role of the Audit Committee in Corporate Governance?

The audit committee in a company usually overlooks the financial matters. It includes any issues related to financial statements and auditing. During this, the audit committee plays a significant role in a company's corporate governance.  Some of the primary functions that the audit committee performs in corporate governance include the following.

The audit committee in a company evaluates critical issues and judgments that a company's management makes during financial reporting. It also reviews the effects of any accounting policies on a company's financial statements.

The audit committee also ascertains that the company has appropriate policies and processes to identify or prevent fraud. Some regulations may require the audit committee to oversee the internal auditing function in a company.

The committee also appoints, oversees, and compensates the independent auditor for a company. Overall, it acts as a liaison between a company's management and independent auditors. They also meet with both parties to discuss the audited financial statements. The committee also reviews non-financial information to ensure it relates to financial reports.

Most companies also have a risk committee that overlooks a company's risk management process. In its absence, the audit committee also assumes the responsibility for risk management. Therefore, in some companies, it may be the audit and risk committee.

Overall, the audit committee overlooks and controls a company's financial matters. Apart from the above roles, the audit committee can also look at compliance and regulation matters. Similarly, the audit committee may also perform several other finance-related duties in a company.

Conclusion

Corporate governance is a system of management through which companies are directed and controlled. Audit committees play a significant role in corporate governance. Usually, a company’s audit committee overlooks financial and audit matters. Similarly, it may also handle risk and compliance issues. Having an audit committee is mandatory for publicly-listed companies.

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Corporation Advantages and Disadvantages

There are various business structures around the world. The most basic types are sole proprietorships and partnerships. However, these come with a limited number of owners and capital. Due to these restrictions, some businesses may take the form of corporations. Corporations fix some problems with basic business structures. However, they may also come with some other limitations.

What are Corporations?

Corporations are one of the most advanced business structures. These represent separate legal entities from their owners. Similarly, corporations can theoretically have unlimited owners, known as shareholders. Unlike other business structures, shareholders can transfer their ownership by selling and buying stocks. However, the corporation’s activities don’t get affected by the transfers of ownership.

Corporations often have to abide by several regulations, such as stock market regulations. These regulations exist to keep both the corporation and its investors safe. In most countries, corporations can also take several forms, for example, C Corporations or S Corporations. Each structure can have its advantages and disadvantages.

What are the advantages of Corporations?

Corporations have various advantages compared to other business structures. These include the following.

Limited liability

One of the most prominent advantages of corporations is that it limits the liability of owners or shareholders. Since corporations are separate legal entities, owners don't have to suffer from their corporation's liabilities. It means that the personal assets of the owners are safe from obligations. The same is does not apply to other business structures.

Unlimited capital

As mentioned, corporations can have unlimited owners in theory. Therefore, they can also get endless capital theoretically. There are some restrictions to the capital that corporations raise. However, corporations don't have to suffer due to limited capital as with other structures.

Perpetual existence

With sole proprietorships, the business only exists until the owner is alive. Similarly, partnerships can have a limited existence until a partner leaves or joins. However, corporations have perpetual existence. These businesses don't get affected when shareholders buy or sell their stock. Therefore, corporations have a longer lifetime than other business structures.

Ownership transfer

As mentioned, shareholders can buy and sell a corporation’s stocks at any time. Therefore, the process of ownership transfer is more straightforward compared to other business structures. Shareholders can also get control of a corporation by owning more than 50% of the stock.

What are the disadvantages of Corporations?

Despite the advantages, corporations can have many disadvantages as well. These include the following.

Agency problems

Corporations separate shareholders from the management. It can create various agency problems between both parties. When a company's management starts to act in their own interest, agency problems can arise. For other structures, similar issues may not exist. However, with corporations, agency problems are always an issue.

More regulations

Corporations have various regulations to which they must comply. It creates an administrative burden for the corporation and its management. Similarly, it results in more paperwork and, sometimes, the regulations may be considered excessive. Setting up corporations also requires going through a complex process.

Double taxation

Shareholders in corporations have to suffer due to double taxation. First, the corporation has to pay taxes on its earnings. When it distributes its profits to shareholders through dividends, shareholders have to pay tax on it again. Similarly, they have to pay tax on capital gains when disposing of their shares. It can be a disadvantage for many shareholders.

Conclusion

Corporations are separate legal entities that can have unlimited owners. Shareholders can sell and purchase a corporation’s stocks at any time and gain ownership. Being complex structures and separate entities, corporations can have many advantages. However, they can also come with certain disadvantages.

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Partnerships Advantages and Disadvantages

Most businesses start as sole proprietorships. However, once they face limitations, such as capital or expertise limitations, they may convert into partnerships. Partnerships are one of the oldest business structures. They have several advantages and disadvantages. However, it is crucial to understand what these are first.

What are Partnerships?

Partnerships are businesses where two or more owners combine their resources to operate. These owners may come together for a specific, shared purpose. Usually, they combine their assets, expertise, and skills to benefit from the business mutually. Partnerships have evolved significantly from the past. Now, there are various types of structures within this business structure as well.

Most partnerships operate through a partnership agreement or contract. This contract specifies various aspects of the business. It also mentions each partner and how much capital they invested in the partnership. When a partner joins or leaves the business, the partnership agreement gets renewed to include new terms.

What are the advantages of Partnerships?

Partnerships have many advantages for the owners compared to other business structures. These include the following.

More capital

Since partnerships involve more than one individual, these businesses don't have to suffer capital limitations. They can get funds from all involved partners. In case the existing partners cannot pay for additional finance, the business structure allows the inclusion of new partners. This way, partnerships don't run out of capital.

Increased expertise and accountability

Usually, each partner brings some expertise to a partnership. It allows partnerships to benefit from their skills and knowledge to grow the business. Similarly, each partner is responsible for a specific part of the business, which allows for better control and accountability.

Fewer legal obligations

While partnerships have more legal obligations compared to sole proprietorships, they are still lower than corporations. Therefore, there is lesser administration involved in these businesses, which also results in lesser paperwork. Similar, partnerships don't have to abide by strict market regulations, which is not true for some corporations.

Better decision-making

Partnerships allow partners from different backgrounds to come together. As mentioned, each partner brings expertise to the business. It further allows for better decision-making. Since each partner can contribute and increase the decision-making quality, partnerships are better than sole proprietorships.

What are the disadvantages of partnerships?

Partnerships also have some disadvantages, which include the following.

More disputes

Not every partner in a partnership will agree to the course of the business it takes. Therefore, it may create more disputes among the partners. These can even result in slower business processes and decision-making. It also creates a “blame game” culture within the business.

Lower profits

Partnerships involved sharing profits between partners. Therefore, it results in lower income for each partner than if they were in a sole proprietorship. The profit-sharing ratio is a part of the partnership agreement. Sometimes, partners may also disagree with their share of the profits, which can create further disputes.

Unlimited liability

Most partnerships come with unlimited liability for the partners. In case the business dissolves or legal disputes, they have to repay debts from their personal assets. Although each partner's liability is limited to their profit-sharing percentage, they still have to pay more than they have invested in the business.

Conclusion

Partnerships are business structures where two or more individuals form a business. Usually, there is a partnerships agreement that defines the terms of the partnership between both partners. Partnerships have various advantages for the partners involved but may also come with some disadvantages.

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Sole Proprietorship Advantages and Disadvantages

Businesses can come in various forms and sizes. For example, these may include sole proprietorships, partnerships, corporations, and many more. There are even more classifications in each type. However, the most basic form is still a sole proprietorship. Sole proprietorships have existed from the beginning of time. These businesses have various advantages and disadvantages as well.

What is a Sole Proprietorship?

A sole proprietorship is a primary business structure where one person controls and handles all matters. This person is the owner of the sole proprietorship. Similarly, there are no other partners involved in this type of business structure. It makes sole proprietorships much more straightforward. However, that does not imply that this business structure is better than the rest.

In a sole proprietorship, the owner has the responsibility of handling all business-related matters. Usually, there is no legal distinction between the owner and the business. However, this business structure can provide the base for more complex business structures in the future.

What are the advantages of Sole Proprietorships?

There are various advantages of the sole proprietorship business structure compared to others. These include the following.

Straightforward to set up

Sole proprietorships are straightforward to set up. Compared to business structures, these businesses don’t require owners to satisfy the same complex requirements. In most countries, sole proprietors don’t need to register their business to get started either.

Lower fees

Due to how easy they are to set up, sole proprietorships also have lower setup fees requirements for the owners. They can also use this money to boost their business instead. Sole proprietors can save a substantial amount of money from the lesser fees they have to pay. Given that they have a limited amount of capital, this can be a significant advantage for them.

Less paperwork

In most countries, sole proprietorships don't have to meet the same rules and regulatory requirements as other business structures. Therefore, these businesses have to handle less paperwork, which can also save on administrative costs. It can further allow sole proprietors to focus on more important matters for their business.

More control

Sole proprietors have more control and decision-making power in their business. Compared to other business structures, sole proprietorships allow the owner to be the only authority. It can also save a significant amount of time that other business structures waste in decision-making.

What are the disadvantages of Sole Proprietorships?

Sole proprietorships can also be disadvantageous in various cases. These include the following.

Limited capital

Since sole proprietorships have one owner only, they can raise a limited amount of capital. This limitation can restrict these businesses from expanding or in other primary business activities. These businesses also can't raise finance from other sources due to various restrictions.

Unlimited liability

Sole proprietorships come with unlimited liability for the owner. Since the business owner and the business are legally the same in this structure, the sole proprietor faces unlimited personal liability. If it fails to meet its financial obligations, the owner will have to compensate creditors from their personal assets.

Limited scope

Sole proprietorships have limited scope. These businesses can’t expand to other locations due to various limitations. The owner can’t control the business properly after a certain point, which can limit it. Similarly, there is little or no growth for employees, which results in high employee turnover in this structure.

Conclusion

Sole proprietorships are businesses that have a single owner. Similarly, it is a primary business structure that is different from almost every other structure. There are many advantages of sole proprietorship businesses. However, they also come with various disadvantages.

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What is a Dividend Reinvestment Plan

What is a Dividend Reinvestment Plan?

A dividend reinvestment plan (DRIP) represents a plan that companies offer to shareholders. Through this plan, shareholders can automatically reinvest their cash dividends in additional shares of the company on the dividend payment date. It may also refer to other programs set up by a brokerage or investment company. Dividend reinvestment plans are usually commission-free and may come with discounts.

Usually, shareholders have to opt into the dividend reinvestment plan that a company offers. With this plan, investors can reinvest their income into new shares issued by a company. However, the investor can also opt out of it if they want to receive their cash dividends. DRIPs are beneficial for both investors and companies.

How do Dividend Reinvestment Plans work?

Usually, shareholders receive dividends through a check or a direct deposit into their bank account. However, with dividend reinvestment plans, they get the option to reinvest the amount that they can receive. The shareholder does not reinvest their income into shares from the market. Instead, they buy newly issued shares directly from the company.

Usually, DRIPs are commission-free or may come with a minimal fee for the investor. They also offer a significant discount to the current share price that shareholders can get. However, the issuing company may some limits, for example, a minimum reinvestment amount. Some companies may also extend their dividend reinvestment plans to new investors.

For the company, dividend reinvestment plans present a way to obtain capital without any additional requirements. The company also has more control over the process and can start or stop it at any time.

What are the advantages of Dividend Reinvestment Plans?

Dividend reinvestment plans are beneficial to both the shareholder and the issuing company. These plans allow shareholders to reinvest their dividends without having to pay additional commission or brokerage fees. Similarly, they can buy shares for much cheaper than they would get from the market. It involves lower costs for the company, as it doesn't have to pay market or issuance fees.

DRIPs may also come with an option to purchase fractional shares. Therefore, shareholders can benefit even if they don’t meet the requirements to get a full share. They also get a compounding effect on their investments each time they reinvest into a company’s shares. For companies, DRIPs are an inexpensive and straightforward way to raise additional capital.

What are the disadvantages of Dividend Reinvestment Plans?

Although dividend reinvestment plans come with the option to purchase fractional shares, these are no marketable. For short-term investors, dividend reinvestment plans do not present a real value. Therefore, these plans may not suit them. Similarly, shares purchased through DRIPs are not as liquid as those acquired through the market.

Companies may also charge higher prices for their shares with these plans. Therefore, investors may not have any control over the purchase prices that they pay. However, these instances are rare for most companies. Dividend reinvestment plans also cause a dilution of shares in a company. Similarly, shareholders who don't participate in it may end up losing a portion of their ownership.

Conclusion

Dividend reinvestment plans allow shareholders to reinvest their cash dividends in a company’s stock. Usually, they get to invest in newly issued shares at a discount with nominal or no extra charges. These plans are beneficial for both companies and shareholders due to the low cost to both parties. However, they may also come with some disadvantages.

Originally Published Here: What is a Dividend Reinvestment Plan

How Are Ordinary Dividends Taxed

What are Ordinary Dividends?

Ordinary dividends represent the distribution of a company's profits to its shareholders after an accounting period. For shareholders, dividends are one of the two primary returns they get on their investment. There are other types of dividends as well, such as special dividends. However, ordinary dividends are more common. Shareholders can expect ordinary dividends after regular intervals based on a company's history.

For the IRS, dividends may fall into either qualified or non-qualified dividends. The classification is crucial to determine the tax that shareholders have to pay on their income. It is because the taxation procedure for each type of dividend will differ. Therefore, it is crucial to understand what qualified and non-qualified ordinary dividends are.

What are Qualified and Non-qualified Dividends?

Qualified ordinary dividends represent dividends that meet some criteria specified by the IRS. Any distribution of profits from companies that meets the following criteria will be considered qualified dividends.

• The dividend must be from an American company or a qualifying foreign company.
• The dividend must not be listed as an unqualified dividend with the IRS, under IRS publication 550.
• Shareholders must have held it for at least 60 days for common stock, 90 days for preferred stock, and 60 days for dividend-paying mutual funds.

Qualified dividends get their name because these qualify for long-term capital gains tax rates. Any distribution of profits that does not meet the above criteria will be considered non-qualified. An ordinary dividend is not a part of the qualified dividend. Therefore, taxation procedures for both will differ.

How are Qualified Dividends taxed?

Once shareholders can differentiate between the classification of their dividends, they can also determine their taxation treatment. For qualified dividends, investors have to pay tax at 0%, 15%, and 20% depending on their long-term gains tax bracket.  There are some specified rules for each tax percentage. For the 0% tax rate, shareholders can qualify if:

• Their income is less than $40,000, and they are single.
• Their income is less than $80,000, and they are married and file a joint return with their spouse.
• Their income is less than $53,600, and they qualify as head of household.

Shareholders have to pay a 15% tax on their qualified dividend if they exceed the above limit up to:

• $441,449 for single individuals.
• $496,599 for a married couple
• $469,049 for the head of households.

Shareholders who exceed the above limits must pay taxes at 20%. For other types of dividends, shareholders have to pay the same rates as their other income.

How Are Ordinary Dividends Taxed?

The taxation on ordinary dividends depends on the tax bracket in which shareholders are. The IRS provides these tax brackets for income tax each year. Since ordinary dividends qualify in these brackets, shareholders must pay taxes by adding these dividends to their total income. The taxes that they must pay include 10%, 12%, 22%, 24%, 32%, 35% and 37%.

Therefore, shareholders may have to pay at least 10% and at most 37% tax on their ordinary dividends. However, the high rate is for the highest tax bracket. The IRS has several limits for shareholders to qualify in each category. These brackets differ for single individuals, married couples, and heads of households similar to qualified dividends.

Conclusion

Ordinary dividends include any income from the distribution of a company’s profits that shareholders get. Shareholders must differentiate between qualified and non-qualified dividends. Qualified dividends have specific tax rules and are taxed based on the long-term gains tax bracket. For ordinary dividends, shareholders have to pay tax according to their income tax bracket.

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Real Options vs Financial Options

Options are financial instruments that derive their value from underlying securities such as stocks, bonds, etc. These are common in options contracts which offer buyers the opportunity to buy or sell the underlying asset in the future. However, it does not oblige them to do so. Instead, they get the right to the purchase or sale of the underlying asset.

Options come in different forms. The classification depends on several factors. For example, call options allow holders to buy the underlying asset while a put option lets them sell it. Similarly, options may come as real and financial options. Both of these are different. Therefore, it is crucial to understand the differences between them.

What are Real Options?

Real options are mostly applicable to company management. These give a company's management the right to undertake a business opportunity or investment at a specific time. Real options get their name from the fact that they involve tangible assets instead of financial instruments. Usually, most options in the market involve an underlying financial instrument. Real options don't and are, therefore, rare.

For companies, real options are crucial for long-term success. These options provide companies with the opportunity to choose the right business opportunity. Through this, they can increase profitability and growth. With real options, a company's management has the choice to make a decision. Similarly, they get the right to reject or abandon a decision, which can be crucial sometimes.

Real options can provide a company's management with several types of decisions. These include options to expand, abandon, wait, contract or switch. Since it depends on decision-making, real options get their value from relevant techniques, for example, Net Present Value. The price or value of a real option may depend on the type of decision it contains.

Overall, real options relate to decisions and do not have underlying financial assets. These apply to the management of a company or business.

What are Financial Options?

Financial options are derivatives contracts that get their value from an underlying financial instrument. It may include stocks, bonds, or even an interest rate. Instead of relating to decision-making, financial options provide holders with the opportunity to buy or sell the underlying financial instrument. These options also come with a time and price specification.

There are two types of financial options that are common in the market. These include call and put options. As mentioned, call options give holders the right to buy the financial instrument at a specified price at a specified future date. Put options, on the other hand, come with the right to sell the underlying financial instrument.

Financial options are prevalent on the stock exchange. However, they may also come over-the-counter. Holders can use financial options to hedge against risks or increase their future gains. Unlike real options, financial options don't get their value from capital budgeting techniques. Instead, they consider several variables.

Overall, financial options are derivatives that involve an underlying financial instrument. These do not apply to the decision-making process, unlike real options.

Conclusion

Options are financial instruments that derive their value from underlying securities. There are various types of options that may exist. Real options include derivatives that get their value from future decisions. These give the holder the right to make a decision in the future. Financial options are derivatives that get their value from underlying financial instruments, such as stocks or bonds.

Originally Published Here: Real Options vs Financial Options

Depreciation Methods in Accounting

Assets are resources that companies own or control and result in future economic inflows. These are expenses that companies and businesses must bear for long-term success. Unlike other expenses, companies cannot charge an asset's total cost to a single accounting period. It is because the matching principle in accounting requires entities to match their expenses with the revenues they help generate.

Therefore, companies use depreciation to spread an asset’s cost over various accounting periods. There are several depreciation methods in accounting. However, it is crucial to understand what depreciation is first.

What is Depreciation?

Depreciation is a systematic process that companies use to spread an asset's cost over various accounting periods. Companies use depreciation to allocate an asset's cost to the period in which it helps generate revenues. The concept of depreciation applies to every asset owned by companies that has a finite life. It includes property, plant, and equipment but usually excludes land.

Depreciation helps companies calculate their net income in each accounting period. If a company charges an asset's total cost to a single period, it will distort the true view of its profitability. Therefore, it must allocate it over several accounting periods.

What are the various Depreciation methods in accounting?

There are several methods for depreciating assets that companies may use. These include the straight-line, declining (or reducing) balance, sum-of-the-years' digits, and units of production methods. Each of these produces varying results for depreciation. Therefore, it is crucial to understand what each of these is.

Straight Line Depreciation

The straight-line method of depreciation is the most straightforward way to calculate depreciation. For this method, companies need to establish a useful life for an asset. It also considers the asset's salvage value at the end of its life. Once companies measure both of these, they can calculate the straight-line depreciation using the formula below.

Depreciation = (Asset’s Cost - Asset’s Salvage Value) / Asset’s Useful Life

Depreciation calculated using the straight-line method will always result in the same depreciation over several periods.

Declining Balance Depreciation

The declining balance method of depreciation is a type of accelerated depreciation. With this method, companies must establish a percentage to use for depreciation. Unlike the straight-line method, this method results in higher depreciation in an asset's initial years. Companies use this method for assets that have more utility in earlier years.

There are several advantages of using this method over others. Companies may also use the double-declining depreciation method, which accelerates depreciation even further.

Sum-Of-The-Years’ Digits Depreciation

The sum-of-the-years’ digits depreciation method is another accelerated depreciation method. It produces higher depreciation than the straight-line method but lower than the declining balance method. With this approach, companies apportion an asset’s depreciation based on the year of its useful life. They use the sum of these years to apportion the depreciation.

The SYD method is more appropriate for assets with higher utility in the initial years.

Units of Production Depreciation

The units of production depreciation method allocates an asset's cost based on the number of units it produces. Instead of establishing a useful life for it, companies determine the expected number of units an asset will produce. Then, they calculate the depreciation based on the actual production units. With this method, companies experience higher depreciation during high production periods.

This method of depreciation is useful for manufacturing companies.

Conclusion

Depreciation is a technique that companies use to allocate an asset's cost over several periods. There are various depreciation methods in accounting. These include straight-line, declining balance, sum-of-the-years' digits, and units of production methods.

 

Article Source Here: Depreciation Methods in Accounting

Formula for Profitability Index

What is the Profitability Index?

Profitability Index (PI) is a measure of the ratio between the discounted cash flows and the initial investments for a given project. Another name for the profitability index is the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR). Profitability index is prevalent in capital budgeting. Companies use it to measure an investment's potential profitability.

Companies use the profitability index to compare various projects and show how much value they create for the investment. PI does not work for single projects as it does not give a definitive result. The profitability index isn't only applicable to capital budgeting and companies. It is also common for investors to use PI to quantify the amount of value created for every unit of investment.

What is the formula for Profitability Index?

Companies can calculate the profitability index for a project by calculating the present value of future cash flows for it. They must also determine the initial cost of the project. Once they do so, they can use the following formula for profitability index calculation.

Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project

The decision rule for the profitability index depends on the various projects under consideration. The higher a project’s PI is, the more feasible it is for the company. When comparing, companies must select the project that has the highest profitability index.

Example

A company, Blue Co., is considering investing in one of two given projects. Both projects are for five years. The company uses a 10% discount rate to discount its cash flows.

The first project requires Blue Co. to invest $100,000. The discounted cash flows from the project are as below.

Year	Cash Flows ($)	Discount factor (10%)	Discounted Cash Flows ($)
1	40,000	0.909	36,360
2	35,000	0.826	28,910
3	25,000	0.751	18,775
4	25,000	0.683	17,075
5	20,000	0.621	12,420
Total	145,000		113,540

Therefore, the project’s profitability index will be as follows.

Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project

Profitability Index = $113,540 / $100,000

Profitability index = 1.14

The second project requires an investment of $150,000. The discounted cash flows from the project are as follows.

Year	Cash Flows ($)	Discount factor (10%)	Discounted Cash Flows ($)
1	60,000	0.909	54,540
2	55,000	0.826	45,430
3	50,000	0.751	37,550
4	40,000	0.683	27,320
5	40,000	0.621	24,840
Total	245,000		189,680

Therefore, the profitability index for the second project will be as follows.

Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project

Profitability Index = $189,680 / $150,000

Profitability Index = 1.26

Since the second project has a higher profitability index, it will be more feasible for the company to select it. Therefore, Blue Co. must select the second project.

What is the importance of Profitability Index?

Profitability index is crucial for several reasons. Firstly, it helps in the decision-making process for ranking various investments or projects. Similarly, it focuses on maximizing a company's profits, particularly when it has limited resources. Comparatively, it makes the process of selecting projects with variable investment requirements easier.

Conclusion

Profitability index is a metric used to calculate a project's profitability. It considers a project's discounted cash flows in relation to the initial investment requirement. Profitability index is more effective if used comparatively. It has various applications for companies and focuses on maximizing profitability with limited resources.

Originally Published Here: Formula for Profitability Index

What is the Accounting Rate of Return

What is the Accounting Rate of Return?

The Accounting Rate of Return (ARR) represents the average net income that a company expects to generate from an asset from its capital cost. In other words, it is the return that a company expects on an investment in relation to the initial investment cost. The ARR is often applicable in capital budgeting, where companies need to know the returns they can get on their investments.

While ARR is a decision-making tool for companies, it is not as prevalent in its usages as other techniques such as Net Present Value or Payback Period. Despite that, it is useful in decision-making as it considers accounting profits. It differs in that aspect from other techniques that use cash flows for decision-making instead. Similarly, ARR does not consider the time value of money, unlike other techniques.

What is the Accounting Rate of Return formula?

The ARR formula may differ according to the needs of the company that uses it. Usually, the formula that companies use depends on the information they have available at the time. The basic ARR formula is as follows.

Accounting Rate of Rate = Annual Profit / Initial Investment

Companies may also use the average amount for both parts of the formula. Therefore, companies can also calculate their ARR, using the following formula.

Accounting Rate of Return = Average Net Income / Average Capital Cost

Example

A company, Green Co., is considering investing in a project. The project requires an initial investment of $100,000. Green Co. also forecasts that the project will earn revenues of $200,000 while incurring expenses of $180,000. Therefore, the project's Accounting Rate of Return will be as follows.

Accounting Rate of Rate = Annual Profit / Initial Investment

Accounting Rate of Rate = ($200,000 - $180,000) / $100,000

Accounting Rate of Rate = 0.20 or 20%

What are the advantages of the Accounting Rate of Return?

ARR has several advantages for companies. Firstly, it is simple to use compared to other capital budgeting techniques. It does not consider the time value of money, which means that the calculations are relatively straightforward. Similarly, it also links with other accounting measures, such as Return on Capital Employed, making it easier to understand.

Companies use ARR to compare various projects and the expected returns from those. Therefore, it is crucial in a company's decision-making process. It also considers the accounting returns, making it easier to compare with actual profits from the investment.

What are the disadvantages of the Accounting Rate of Return?

Compared to other capital budgeting techniques, ARR has several limitations. Firstly, it does not consider the time value of money, which is crucial for decision-making. Instead of using cash flows, it uses profits, which are easily manipulatable. It also ignores various other critical factors, such as working capital changes.

The ARR does not calculate the absolute gain on a project. Similarly, it does not provide a definitive investment signal, unlike other techniques such as NPV. Overall, ARR has more disadvantages than benefits.

Conclusion

Accounting Rate of Return is a metric that shows the average returns from a project based on the capital investment requirements. ARR is a common technique used in capital budgeting. Companies can calculate the ARR of a project using different formulas. ARR has some advantages, but it has more disadvantages due to being basic.

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Sunk Cost vs Opportunity Cost

When companies are performing capital budgeting, they must consider various costs related to the projects. Mostly, these include costs directly associated with the project, such as material and labour. However, it may also consist of some other costs, which may not be as clear. These usually include opportunity and sunk costs. There are some differences between both.

What are Sunk Costs?

A sunk cost represents money that a company or business has already spent. While in finance, any cost is relevant, in decision-making sunk costs are irrelevant. It is because it represents money spent that the company cannot recover. Similarly, since the company has already paid for it, it does not alter the decisions that a company makes.

Sunk costs are in the past and vary from future costs. Therefore, they do not contribute to a company's decisions. Companies usually exclude sunk costs from their decision-making due to this reason. Therefore, identifying sunk costs and differentiating them from others is crucial in decision-making. For companies, sunk costs do not represent relevant costs.

For example, a company may have to decide on either using in-house production or outsourcing. If it chooses to use in-house production, it may use its factory building that it has already acquired for $100,000. In that case, the company can make $200,000 from the project. In case it chooses to outsource, it can make a profit of $150,000.

Some may think that the second option provides a better return as the company can make $150,000. On the other hand, they may believe the first decision will only make $100,000. It is because it involves using the $100,000 factory, which reduces the benefits of in-house production. However, the factory cost in that example is a sunk cost.

Therefore, the $200,000 profit that inhouse production brings does not include any other costs. Since the factory cost of $100,000 is irrelevant to the decision, it does not reduce the profit. If the company could recover the $100,000 factory cost with either decision, it would be relevant to the decision-making process.

Overall, sunk costs do not impact the decision-making process. They remain unchanged and do not have any future impact. Therefore, companies ignore sunk costs when measuring their profits from projects or investments.

What are Opportunity Costs?

Unlike sunk costs, opportunity costs are relevant to the decision-making process. Therefore, companies must calculate these and include them when measuring profits from various projects. However, opportunity costs are not actual costs that companies bear. These represent the profits or benefits that companies miss out on when choosing one course over another.

Opportunity costs represent the value that decision-makers lose when choosing between various options. While a single project may have sunk costs, it will never have opportunity costs. It is because the company does not have to choose between two projects. Essentially, whenever companies have to choose between various decisions, they will suffer opportunity costs.

For example, a company may choose to invest in a project that provides $100,000 in profits. However, the company must take the resources out of from an existing project that can profit $20,000 in the future. In this decision, the $20,000 relinquished in choosing the first project represents an opportunity cost.

Conclusion

When making decisions, it is crucial for companies to identify relevant costs. Sometimes, however, these costs may not be as clear, like sunk and opportunity costs. Sunk costs represent any money that a company has already spent in is not recoverable. On the other hand, opportunity costs refer to the profits foregone when choosing between several options.

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Off-Balance Sheet Assets

Companies have several financial statements that report various aspects of their business. Among these, the balance sheet presents the assets and liabilities balances that companies own or owe. However, these do not contain all of those assets or liabilities. It is because some of these items may remain off the balance sheet. Off-balance sheet accounting has long been a debate topic for most experts.

What is an Off-Balance Sheet?

Off-balance sheet represents items that do not appear on a company’s balance sheet. It may include both assets and liabilities. However, that does not mean that companies don’t own these. Instead, some accounting standard provisions may disallow these companies from reporting them. In some cases, companies may also use it adversely and structure their assets and liabilities to stay off the balance sheet.

Off-balance sheet accounting, while permissible, can also lead to some problems. For a company's stakeholders, off-balance-sheet accounting can cause incorrect decision-making. In some cases, assets and liabilities may miss the definition set by the contextual frameworks. Therefore, companies cannot disclose them. However, some companies may deliberately choose to keep items off-balance sheets to mask their financial health.

What are Off-Balance Sheet Assets?

Off-balance sheet assets are resources that companies may remove from their balance sheet. Despite them not appearing on the balance sheet, it does not imply that companies don't own these assets. Companies may hold these assets, whether tangible or intangible, but not report them on their balance sheet. Some companies may use it to their advantage and remove any assets that may have an adverse effect on their balance sheets.

According to the contextual framework, assets are resources that companies own or control and result in future economic inflows. Any item that does not meet the definition cannot be a part of the balance sheet. There are some items that may not meet this definition. Therefore, it may give rise to off-balance-sheet assets that companies do not report.

As mentioned, however, some companies may use it to benefit or mask their accounts. They may structure their assets, so they don't meet the definition and stay off their balance sheet. Inherently, off-balance sheet items are not deceptive in nature. However, companies may use them with the wrong intent, making them a problem for their stakeholders.

An example of a company using off-balance-sheet assets is Enron. The company worked on assets and immediately claimed the projected profits from it. If the actual profits were lower than anticipated, it would remove the asset from the balance sheet.

What are the types of Off-Balance Sheet Assets?

There are various types of off-balance sheet assets that companies may keep away from their balance sheet. These include the following.

Accounts Receivables

With accounts receivable balances, companies have the option to outsource their collection using a factoring company. Once they do so, they can remove the accounts receivable balance from their balance sheet. This way, they can outsource their default risk while also keeping the asset off their balance sheet.

Operating leases

Operating leases come with an underlying asset that companies can use. However, their accounting treatment may require companies not to report the leased asset and the associated liability. In that case, companies only report the rent payments while keeping the asset away from the balance sheet.

Conclusion

Off-balance sheet items include any assets or liabilities that do not appear on a company's balance sheet. Off-balance assets are resources that a company may own but not report on its balance sheet. While the requirement to avoid including them may come to accounting standards, some companies may also use it adversely.

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Off-Balance Sheet Liabilities

What is an Off-Balance Sheet?

Off-balance sheet items include assets or liabilities that do not appear on a company’s balance sheet. However, that does not mean that these items may not exist. These are the actual assets and liabilities that companies own. However, there are some technical aspects that prevent them from appearing on the balance sheet.

Off-balance sheet accounting has long been a critical point for experts. Most accounting standards have introduced provisions that prevent such accounting. Sometimes, however, off-balance sheet accounting may be necessary to meet the fundamental definition of elements. For example, operating leases in the previous accounting standards were off-balance sheet items. The latest accounting standards change that.

What are Off-Balance Sheet Liabilities?

Off-balance sheet liabilities are similar to any off-balance sheet items. These are obligations that companies may owe to other parties. However, accounting standards may not allow them to be a part of the balance sheet. Usually, companies and businesses don't need to perform any accounting treatment for these liabilities or report it in their financial statements.

Usually, off-balance sheet liabilities include items that are not firm obligations. However, companies may need to settle them at a future date. For example, lawsuits may cause off-balance sheet liabilities where the company may need to pay it in the future. However, at the time of the reporting, the liabilities may not have realized.

Despite that, most accounting standards require companies to disclose liabilities that may not appear on the balance sheet. There are various disclosure requirements for each liability that companies must follow. For example, reporting companies must disclose the possibility and nature of the lawsuits that are off-balance sheets. These may also be a part of the contingencies and commitments that companies report.

Some companies may also use off-balance sheet accounting to keep their liabilities away from their financial statements. This kind of accounting is not permissible under most accounting standards. Companies do so to mask the financial position and appear more financially healthy. For some companies, it may be a case of removing any adverse liabilities to appear more liquid.

What are some examples of Off-Balance Sheet Liabilities?

There are various types of off-balance sheet liabilities that companies may have. Some of the most common ones include the following.

Operating leases

For a long time, operating leases have been a part of off-balance sheet liabilities. As mentioned, the latest changes in accounting standards may rectify it but with a limited scope. With operating leases, companies only report the associated rent payments. They do not list the asset or the liability that corresponds to the lease.

Leaseback agreements

As with operating leases, companies do not put leaseback agreements on their balance sheets. These agreements are common where one company sells an asset and leases it back from the buyer. Companies may use it to keep their financial statements clear of any adverse liabilities. Like with operating leases, companies don’t report the asset or liability associated with the agreements. They only record and report the related rent payments.

Conclusion

Off-balance sheet is a term used to describe assets or liabilities that companies have but don’t appear on their balance sheet. Off-balance sheet liabilities are the liabilities that companies may have to settle in the future but don’t report in the financial statements. Despite that, they must disclose it in the notes to the financial statements, as required by accounting standards.

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What is a Special Purpose Entity

A special-purpose entity (SPE) is a subsidiary company created by a parent company to isolate financial risk. This entity is legally separate from the parent company. It aims to absorb risks that the parent company faces. In some cases, SPEs can hold assets if the parent company enters bankruptcy. Another name used for a special-purpose entity is a special-purpose vehicle (SPV).

SPEs have their own assets and liabilities. Similarly, investors can buy their stocks, which are legally separate from the parent company. SPEs may not be a part of the parent company’s financial statements or accounting record. However, there are some specific account criteria that they have to meet first.

How does a Special Purpose Entity work?

SPEs start with a parent company that creates the entity to isolate its assets or liabilities. Some other companies may use these entities to securitize their assets in case of bankruptcy. However, SPEs stay off the parent company’s balance sheet. Usually, companies create these entities when investing in risky projects to protect the parent company from the associated risks.

In case the risks realize, the parent company always stays clear of any consequences. Since most SPEs remain off the balance sheet, the parent company does not suffer due to it. However, there are only particular cases where the use of these entities might be relevant. For example, special-purpose entities may serve as a counterparty for swaps and other similar credit-sensitive derivative instruments.

SPEs may come in different forms, such as corporations, limited partnerships, trusts, etc. It usually depends on the parent company’s preference. However, they may also be helpful in creating joint ventures or performing financial transactions. Similarly, SPEs may come as either on- or off-balance sheet entities.

What are the advantages of a Special Purpose Entity?

SPEs can have various advantages. Firstly, it allows parent companies to isolate the financial risk associated with an investment. The parent company usually doesn't have to disclose these entities on their balance sheets, given they meet some conditions. Therefore, it allows companies to mask investments or projects from competitors or even investors.

SPEs are also helpful in tax saving and planning. Usually, there is not much effort involved in creating these entities, making them easier to set up and use. Overall, SPEs allow parent companies to perform high-risk transactions. In case of failure, however, the parent company does not suffer the consequences.

What are the disadvantages of a Special Purpose Entity?

SPEs have several disadvantages. Parent companies can use these entities to mask information from stakeholders, which is not ethical in some cases. On top of that, they require a significant capital investment. Special-purposes entities may not get the same opportunities and exposure that established parent companies do.

Some regulations may also apply to SPEs, which can cause problems for the parent companies. These may change regularly, which may have an adverse impact on the parent company's financial position. Similarly, some accounting standards may apply to these entities. Therefore, SPEs may not always stay off-balance sheets.

Conclusion

A special-purpose entity is a subsidiary company used to isolate financial risks or securitize assets. SPEs are useful when parent companies make risky investments or face bankruptcy. With these entities, parent companies can mitigate any risks they face. Special-purpose entities can have various advantages but may also come with some disadvantages.

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