Monday, September 17, 2018

Volkswagen's Option To Abandon

Volkswagen recently announced that it would discontinue production of the iconic Beetle, which was first manufactured in the 1930s. The Beetle was produced until 1978, when Volkswagen first dropped the car from production in Germany. The car was reintroduced in 1997. With sales of only 60,000 cars per year, evidently the NPV of continuing to produce Beetles was negative. Remember, the option to abandon exists with any project, although as the previous reintroduction of the Beetle shows, the abandonment need not always be permanent.

Wednesday, September 5, 2018

Activist Bondholders

Because bondholders have a fixed claim on assets and no vote in company operations, they tend to be passive investors in companies. However, a new type of investor, the net-short bondholder, has become more prevalent. A net-short bondholder will buy a bond and at the same time take a larger short position in the same company's bonds. A short position benefits when the asset value decreases. Thus, the investor will lose in the long position but gain a larger amount in the short position. The investor will then implement a claim if the company violates any covenant. For example, Aurelius Capital Management took a net-short position in Windstream's corporate debt and then claimed a violation of a covenant two years prior. Windstream had even undertaken actions to satisfy bondholders that held the bonds when the violation occurred. In short, companies now must be even more careful when writing covenants for bonds. 

Tuesday, August 28, 2018

Moody's Fined

Moody's Investors Services, the well-known bond rating agency, was fined $16.5 million for failing to ensure the accuracy of its statistical models. The SEC accused the company of failures on more than 650 mortgage backed securities. Moody's assigned ratings on several bonds that were inconsistent with ratings for similar bonds and did not establish a rigorous control process for bond data entry, resulting in incorrect data entry. This resulted in bonds being given incorrect ratings.

Thursday, February 8, 2018

Lower Taxes, NPV, and Company Value

A major benefit of the Tax Cuts and Jobs Act of 2017 is that it reduces taxes paid, which increases operating cash flow. Increased cash flow can increase the NPV of a project, even turning a negative NPV to a positive NPV, and increase the overall value of a company. Since the value of a project or the value of a company are both based on the present value of future cash flows, this result is fairly obvious. As a recent article points out, what is less obvious is that the reduced tax rate will also increase the required return on a project or a company. Since the cost of debt that is important for either valuation is the aftertax cost of debt, a reduced tax rate actually makes the cost of capital higher, all else the same. So, in discounting higher future cash flows with a higher cost of capital, the present value will not increase as much as you might think at first glance.