ShmoopTube

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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to get pretty aggressive lead appreciative of the costs of that

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

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

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

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

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million dollars or three point eight mil a year

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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by 100 gets you eight hundred thousand batteries

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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to move off their butts on the couches to fly them

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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property patents knowledge systems etc of your company a European partner

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

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

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

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

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

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

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

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

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

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

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partnership as is because your operations are starting to generate

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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you now have serious market Fiat or power and are thinking

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

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partners there and sell direct to consumers yeah

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

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or at least playing with their drums

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