Accounting: Consolidated financial statements and goodwill calculations

In mergers and acquisitions, most of the time the acquirer will be paying economic benefits exceeding the value of the identifiable assets or fair value of the acquiree. In order to ensure the accounting numbers remain balanced, the amount of economic benefits - such as cash - used in the acquisition of control must be equal to the new amount of assets capitalized in the parent company's SOFP.

Because the amount paid is higher than the recognisable assets, due to some unquantifiable future economic benefits, this capitalization of economic benefits is recorded as goodwill, as intangible assets.

In our examples we will be looking at the acquisition of the same subsidiary in different situations.

Statement of financial position - Subsidiary

Noncurrent assets
Property, plant and equipment     200

Current assets
Working capital                            50

Total assets                                   250


Total liabilities                             (100)
Net assets                                     150

Consisting of:
Paid up share capital (100 shares)  100
Retained earnings                           50
Shareholder equity                          150




In our different scenarios, the parent company would have varying financial positions in the beginning. However, we will keep the FP of our subsidiary constant throughout the varying scenarios for easier comparability.

Case 1. 
- Full acquisition (100% control)
- No goodwill arising from transaction
- Date of acquisition is date of SOFP. No post-acquisition adjustments required for consolidation.


Statement of financial position - Parent (non-consolidated)

Noncurrent assets
Property, plant and equipment     1000
Investment in subsidiary              150

Current assets
Working capital                            200

Total assets                                   1350


Total liabilities                             (350)
Net assets                                     1000

Consisting of:
Paid up share capital                    500
Retained earnings                        500
Shareholder equity                       1000


Statement of financial position - Parent (consolidated)

Noncurrent assets
Property, plant and equipment     1200           (1000+200)
Goodwill                                      0

Current assets
Working capital                            250             (200+50)
Total assets                                   1450

Total liabilities                             450              (350+100)
Net assets                                   1000

Consisting of:
Paid up share capital                    500
Retained earnings                        500
Shareholder equity                       1000

Calculation/proof of zero goodwill
Consideration transferred       150
Less: Net assets acquired       (150)
Goodwill                                  0


Case 2. 
- Full acquisition (100% control)
- Goodwill arising from transaction
- Date of acquisition is date of SOFP. No post-acquisition adjustments required for consolidation.

In this case, the only change is the increment of investment in subsidiary from case 1, ceteris paribus. This would also mean that the parent company in case 2 have a higher amount of assets as compared to case 1, represented by a increase in retained earnings in the equity.

Statement of financial position - Parent (non-consolidated)

Noncurrent assets
Property, plant and equipment     1000
Investment in subsidiary              260

Current assets
Working capital                            200

Total assets                                   1460


Total liabilities                             (350)
Net assets                                     1110

Consisting of:
Paid up share capital                    500
Retained earnings                        610
Shareholder equity                       1110


Statement of financial position - Parent (consolidated)

Noncurrent assets
Property, plant and equipment     1200           (1000+200)
Goodwill                                      110

Current assets
Working capital                            250             (200+50)
Total assets                                   1560

Total liabilities                             450              (350+100)
Net assets                                     1110

Consisting of:
Paid up share capital                    500
Retained earnings                        610
Shareholder equity                       1110

Calculation/proof of goodwill
Consideration transferred     260
Less: Net assets acquired     (150)
Goodwill                               110




Case 3. 
- Partial acquisition (80% control)
- No goodwill arising from transaction
- Date of acquisition is date of SOFP. No post-acquisition adjustments required for consolidation.

In this case, the acquirer pays a lesser amount for investment in subsidiary compared to case 1. This would be portrayed as the parent company having lesser assets, in the form of lesser retained earnings. Ceteris paribus. 

Note: Total equity will be used from now on in place of  as shareholder equity. It has the same meaning.


Statement of financial position - Parent (non-consolidated)

Noncurrent assets
Property, plant and equipment     1000
Investment in subsidiary              120

Current assets
Working capital                            200

Total assets                                   1320


Total liabilities                             (350)
Net assets                                      970

Consisting of:
Paid up share capital                    500
Retained earnings                        470
Total equity                                  970


Statement of financial position - Parent (consolidated)

Noncurrent assets
Property, plant and equipment     1200           (1000+200)
Goodwill                                      0

Current assets
Working capital                            250             (200+50)
Total assets                                   1450

Total liabilities                             450              (350+100)
Net assets                                     1000

Consisting of:
Paid up share capital                    500
Retained earnings                        470
Noncontrolling interests              30
Total equity                                  1000

Calculation/proof of zero goodwill
Consideration transferred                              120             (for 80/100 shares of subsidiary)
Less: Net assets acquired     80% x (150)     (120)
Goodwill                                                          0

Noncontrolling interest = 20% (not acquired) x net assets = 30 (by net assets method)



Case 4a
- Partial acquisition (80% control)
- Goodwill arising from transaction by net asset method.
- Date of acquisition is date of SOFP. No post-acquisition adjustments required for consolidation.
- NCI is based on residual net asset value of un-acquired assets. (IFRS 3)

In this case, the acquirer pays a HIGHER amount for investment in subsidiary compared to case 3 to result in goodwill. This would be portrayed as the parent company having more assets, in the form of more retained earnings. Ceteris paribus. 


Statement of financial position - Parent (non-consolidated)

Noncurrent assets
Property, plant and equipment     1000
Investment in subsidiary              180

Current assets
Working capital                            200

Total assets                                   1380


Total liabilities                             (350)
Net assets                                      1030

Consisting of:
Paid up share capital                    500
Retained earnings                        530
Shareholder equity                       1030


Statement of financial position - Parent (consolidated)

Noncurrent assets
Property, plant and equipment     1200           (1000+200)
Goodwill                                      60

Current assets
Working capital                            250             (200+50)
Total assets                                   1510

Total liabilities                             450              (350+100)
Net assets                                     1060

Consisting of:
Paid up share capital                    500
Retained earnings                        530
Noncontrolling interests              30
Total equity                                  1060

Calculation/proof of goodwill
Consideration transferred                              180             (for 80/100 shares of subsidiary)
Noncontrolling interest                                  30*
Less: Net assets                                             (150)*
Goodwill                                                          60

*This is equivalent to case 3's %control x net assets calculations.
Noncontrolling interest = 20% (not acquired) x net assets = 30 (by net assets method)

Case 4b
- Partial acquisition (80% control)
- Goodwill arising from transaction by fair value method.
- Date of acquisition is date of SOFP. No post-acquisition adjustments required for consolidation.
- NCI is based on fair value, which is given or calculated, of un-acquired assets. If not given, automatically assume net asset value method. (IFRS 3)

In this case, the acquirer pays a HIGHER amount for investment in subsidiary compared to case 3 to result in goodwill. This would be portrayed as the parent company having more assets, in the form of more retained earnings. Ceteris paribus. 


Statement of financial position - Parent (non-consolidated)

Noncurrent assets
Property, plant and equipment     1000
Investment in subsidiary              180

Current assets
Working capital                            200

Total assets                                   1380


Total liabilities                             (350)
Net assets                                      1030

Consisting of:
Paid up share capital                    500
Retained earnings                        530
Shareholder equity                       1030


Statement of financial position - Parent (consolidated)

Noncurrent assets
Property, plant and equipment     1200           (1000+200)
Goodwill                                       80

Current assets
Working capital                            250             (200+50)
Total assets                                   1530

Total liabilities                             450              (350+100)
Net assets                                     1080

Consisting of:
Paid up share capital                    500
Retained earnings                        530
Noncontrolling interests              50*
Total equity                                  1080

Calculation/proof of goodwill
Consideration transferred                              180             (for 80/100 shares of subsidiary)
Noncontrolling interest                                  50
Less: Net assets                                             (150)
Goodwill                                                        80

*Given, does not arise from any calculations nor balancing figure consolidation related. (important)



Case 6. 
- Partial acquisition (80% control)
- 'Negative' goodwill arising from transaction, bargain purchase.
- NCI is calculated using residual net asset value
- Date of acquisition is date of SOFP. No post-acquisition adjustments required for consolidation.


Statement of financial position - Parent (non-consolidated)

Noncurrent assets
Property, plant and equipment     1000
Investment in subsidiary              100

Current assets
Working capital                            200

Total assets                                   1300


Total liabilities                             (350)
Net assets                                      950

Consisting of:
Paid up share capital                    500
Retained earnings                        450
Total equity                                  950


Statement of financial position - Parent (consolidated)

Noncurrent assets
Property, plant and equipment     1200           (1000+200)
Goodwill                                      0

Current assets
Working capital                            250             (200+50)
Total assets                                   1450

Total liabilities                             450              (350+100)
Net assets                                     1000

Consisting of:
Paid up share capital                    500
Retained earnings                        450 + 20**
Noncontrolling interests              30          
Total equity                                  1000

Calculation/proof of goodwill
Consideration transferred                              100          (for 80/100 shares of subsidiary)
Noncontrolling interest                                   30
Less: Net assets                                            (150)
Goodwill                                                        (20)

**Negative goodwill is recognised as a gain in profit and loss statement for that FY, resulting in increased retained earnings. There is NO negative goodwill in SOFPs.

Noncontrolling interest = 20% (not acquired) x net assets = 30 (by net assets method)

Behavioral economics - Millennials

Yes that's me. That's most of us. We're the Millennials.

 Before I proceed into my discussion, the case in point:
https://www.cnbc.com/2017/06/30/heres-how-millennials-spend-their-money-compared-to-their-parents.html

Young adults nowadays are spending much much more than our parents' generation, or the older people. This article discusses the reasons why (in my opinion, of course), its repercussions and advantages.

Areas marked with ***** might require some understanding on fundamental economics/finance to grasp.

The why

1. Gaps in daily necessity and needs are constantly being filled and patched up.

This is one of the reason I got to writing this article. The line between needs and wants are being blurred as companies and kickstarters constantly innovate new products to improve our standards of living. I am actually spending more money than I would have if technology or creativity isn't this advanced, but wait, I am happy to do so. Imagine this, 10 years ago, I would buy a phone because you can say I need the phone. That might be considered a want for many, but ok just stay with me for this one. 

I would buy the phone, I will use the phone, that's it. As a matter of fact that is exactly what happened for me 10 years ago, in secondary school. Fast forward to the present, I bought my most recent phone, a samsung s7, a few months back. Since then I've spent money on a couple of tempered glass screen guards, cases, additional charging cables, multi-usb charging ports, bluetooth earpieces, earpieces, that ring thingy where you stick to the back of your phone, wifi-extenders, etc. These purchases would not appear without the purchase of the smartphone. 

However, am I complaining? nope. I would definitely say I need those cables simply because my old ones aren't working. I need the multi-usb charger because I need to charge my bluetooth headphones, my ipad, and my phone at the same time. I need that ring-thingy because I do not want my phone drop kicking my face every time I use it before bed. Thing is, these needs arose because of my smartphone purchase, which is a need. 

Just to clarify, I am not against the improvement of technology, I would definitely chose spending on all these instead of going back to using a non-smart phone and not doing these purchases. I am just saying technology is making us spend more because now we can. Because of technology, we are allowed to increase our standards of living by spending more. 10 years ago, you couldn't attain the standards of living now no matter how much you spend.

Technology aside, I recently purchased some NATO watch straps (the cloth ones) for my watch because I do not like the weight and feel of the original metal bracelet. 10 years ago, the only choice for me were to suck it up or to not wear the watch entirely. This money would not be spent. However, I am happy and my standards of living have increased because of this purchase. 

I am sure many of you see new kickstarter projects appearing all the time - New bag for cameramans! New activewear for the sport enthusiast! New pants for hikers! 

These increased spending would not be possible at all 10 years ago, and we're all the happier for its existence.So by now I am sure you get my point. Technology and innovation allows us to spend more, and so we shall. 

******

This means that as innovation opens up increased marginal benefits, and we will always base our purchases such that marginal benefit > marginal cost, so too shall marginal cost increase. 

******

2. It is getting easier and easier to spend money.

Remember the days when you forgot to bring cash out, and nobody would lend you money? In secondary school, I starved. Now?

http://www.channelnewsasia.com/news/singapore/posb-launches-digital-watch-that-teaches-students-to-manage-9127520

With the plethora of payment methods such as visa paywave, credit cards, debit cards, paypal, paying with your phone to PAYING WITH A WATCH. Money flow is much more fluid compared to the years back. This would simply allow us to be trigger happy with our spending as rational decisions are less likely to be made when liquidity is so easily available. 

I am definitely a 'victim'(can't think of another word atm) of this. I have never been happier for the advent of online shopping. In many cases, online shopping is actually much more convenient and cheaper than actually going out to a store to buy it. It is also for this exact reason I am spending more than I would be if online shopping didn't existed. 

So recently I ordered a laptop from amazon for about ~$900sgd net because that model wasn't available in Singapore. If this hasn't existed, I would probably either (a) not buy the laptop or (b) settle for a costlier version that meets my criteria, but either option I would be worse off. Bear in mind the importance of the term worse off. Worse off does not simply imply spending more. I would be worse off if I do not buy the laptop from amazon because I actually need/want it, and that inconvenience in my life would cost more than the $900sgd.

However, on the purely monetary spending side, this $900 would probably not be spent assuming I go with option (a) if online shopping wasn't a thing. I spent $900 more because of the availability of spending, and I am happy to do so. 

Online trading. I will not go into too much details but basically the purchase of stocks, bonds and financial assets are also increasingly becoming easier due to the advancement of technology. 

*****

Inexplicit social costs such as travelling, hassle of payments would contribute to an increased marginal cost and thus for the exact same product (marginal benefit), the lack of liquidity could push MC > MB, stopping the transaction altogether.

Also, given MV = PY, the increasing availability of payment methods would increase V and thus P/Y

*****

3. Social-media induced advertisement/pressure.

There's this buffet that I would definitely not have eaten because I simply do not know about it, but because I browse instagram, I did, and it was definitely worth the money. I am better off after spending this money on the buffet. So to reiterate my point, I'm not complaining about increased spending. However, fact is I did spend more because of the creation of instagram. That is just an example, with the smart-ads nowadays, I am sure the browsing of any social media would cause me to spend more money in areas that I am interested in (mostly food, but yeah).

Similarly, seeing your friend post about a new purchase or recommendation would tempt a fair amount of viewers to do so as well, and I am sure they are happy to do so. Remember, we're all increasingly spending more at our own discretion, nobody is holding us at gunpoint or hitting us with hyperinflation. That brings us to the next point.

Pressure. Well personally I am not really subject to it as I couldn't care less about what people have that I don't just for the sake of having it. However, it is undeniable that some of us have to buy branded goods because their friends are posting it on instagram. This would cause a propagation of purchases as a girl buying a Chanel bag would prompt a few others to similarly purchase a branded bag to 'save face'. Similarly, guys are into sneakers or some streetwear rubbish (sue me) and one or few purchase would propagate many more. 

All of these increased spending basically stems from the increased exposure to the daily lives of one another, by social media.

So by now some of you might be thinking, 

What does these have to do with anything?

By now we have fairly established that people nowadays ARE spending more money, and why. This increased velocity of money flow and increased standards of living would basically mean that everyone is better off because of technology. Simply because the people buying smartphones have to buy other necessary accessories for it, more jobs can be created for these producers. Because more people are buying sneakers, more jobs can be created for those companies. 

To put it in a bigger picture, because of increased spending habits, generally people would be receiving increased salaries, and then they too would spend on attaining a better living standard. These increased spending would benefit the economy as a whole, and the way we can benefit from it is to definitely take part in this boom. That's where investing comes in. While it is said there is a 'right' time to buy stocks, when they're the lowest, when market crashes etc, to be honest I feel that the right time is now. Due to the inevitable progress of technology, the economy in turn shall progress as well. Market noise aside, if one looks forward far enough, they shouldn't be clouded by the smoke and fear of market swings, but instead understand that macroeconomically, the earlier you invest, the better. The event of market crash is always unpredictable, and a year you hold your cash uninvested, it is a year lost in opportunity costs.

This is also another reason why I believe investing for the long term is still full of steam. Major corporations would benefit NOT because they invents a new product or comes up with a technological breakthrough, but because of the increased spending and flow of money would undoubtedly have a portion of them flowing to these companies. 

Putting it in another perspective, we can see that different companies are like different tributaries (these are the smaller rivers that branch off a larger river stream), where blue chips (large cap companies) are the bigger ones and developing or new companies are the smaller ones. What is happening now is that the entire start of the river has increased flow of water. While some empty ground could turn into a new stream (kickstarters/new technology/new products companies), and some smaller stream could potentially turn into a large one (medium sized/developing companies), fact is the large streams in the first place would definitely receive the increased water flow, albeit not relatively proportionally larger versus the smaller ones. I am still extremely adherent to my views that one shouldn't invest in a volatile company/industry/financial asset, but still, those are my views. For the better or worse, I am very risk averse.

Thanks for reading!

Cryptocurrencies, an analysis

Disclaimer: Admittedly, I am biased against cryptocurrencies, but I'll try to make this article as fair as possible. Just a reminder though.

Stories of people earning a windfall from the speculation of cryptocurrencies are not uncommon nowadays. Recently, stories such as these(link) '

If You Bought $5 of Bitcoin 7 Years Ago, You’d Be $4.4 Million Richer'

are appearing all over the place. This creates a snowball effect that attracts more investors and attention to themselves, causing a self-fulfilling prophecy of value appreciation. However, as history has proven itself time and time again, there is nothing that can rise in value that drastically without an actual product or object backing it up. I'll get to that later.

Fundamentally, the valuation of everything in the world depends on demand. That's the rule that underpins the entire economy since the beginning of mankind. Currency or not, a transaction can only occur under the condition of 'coincidence of wants'. Be it trading an apple for an orange, or buying an apple for $1, both parties must be willing to accept what the other party have to offer.

And what exactly does this have to do with cryptocurrencies? The meteoric rise of the valuation of these cryptocurrencies highlights a major flaw/point in our economy - that government-backed currencies are too lawful to be used. Most transactions with cryptocurrencies are used because of its anonymity, you don't have to declare income taxes on bitcoin gains, nobody will know if you wired millions of bitcoin overseas to pay for firearms or drugs, because there is no central bank or regulatory bodies acting upon cryptocurrencies. This mean that while originally the demand stems from these properties, more aboveboard parties such as banks and financial institutions are starting to join in where wall street companies are starting to accept bitcoin transactions because illegal or not, wherever there's profits to be made, people will be there.

However, what puts me off is that because of its growing acceptance, people assume cryptocurrencies are a good investment opportunity or a quick get-rich scheme. It is not, at least not by traditional standards.

For those who studied finance, you would have known the concept of beta, risk-adjusted returns and some, the modern portfolio theory. Basically it means that with increased returns comes increased risk. There's no way around it, at least not over the long run. Markets are increasingly becoming more and more efficient as technology involves, this also means that the appearance of a profitable opportunity appearing would quickly be known by (informational efficiency) and quickly seized by the influx of investors (allocative efficiency) dumping funds into what's hot.

I do not deny the emergence of cryptocurrencies is a lucrative new opportunity opening up. However, temporal opportunities are never a source of long-term investments. I emphasize long-term investments because while personally anything that isn't long term is simply not investments, many do not feel that way.

Traditionally, stocks and bonds have been the key players of anything investment related. While they still do so now, the creation of complex products as the result of financial engineering have brought many new financial instruments into the game - with cryptocurrencies as one of the newer big boys. That aside, the fact that stocks and bonds manage to hold their ground over the centuries are that they are easier to be intrinsically valued. Vanilla bonds pays out a fixed rate annually. Investors knows what are they gonna get, expectations are usually met. Stocks are for people with a riskier appetite, some mature companies rise slowly over the years while paying out dividends, some such as REITs provide more fixed income with lesser growth. Key point is, investors can reasonably expect some returns on their funds.

One simple concept highlighting this is
Total returns = Appreciation in price + Dividend/cash payouts

However, the valuation of stocks and bonds can be said to come from it's expected payouts, as seen in the discounted cash flow (DCF) or dividend discount models. The fact that these models exist, and also they can only be used in is because that a company issuing stock or bonds are expected to continue its business and generate cash for investors.

With the creation of complex derivatives and cryptocurrencies, this is no longer the case. While some derivatives are good, whereby is actually reduces risk, most amplifies them and increases its speculative capabilities. While I do not believe in derivatives as a suitable investment instrument, I do understand its purposes.

First-order derivatives have themselves an underlying traditional asset, meaning that these derivatives are created based on bonds and stocks or debt such as mortgages, such as a collateralized debt obligation (CDO). They still have something that are of intrinsic value in it, although the market valuation and intrinsic value can be very far apart, they do have some worth. Higher-order derivatives are derivatives built upon derivatives, and these can go up so many levels that one don't even know what underlying assets is the original first-order derivative based on. Even worse is that as derivatives stack upon each other, multiple asset classes can be lumped together into one huge mess.

The thing about cryptocurrencies is that THERE IS NO UNDERLYING ASSET. One can tell from simply observing that all cryptocurrencies start from nearly zero value, and as its use gets more widespread, so does its valuation. Obviously something with no underlying asset cannot have a cash payout, bringing us to the fact that

Expected total returns = Appreciation in price

This, if anything, is purely speculative. Speculative activities are NOT investment opportunities. Yes some people earned a million dollar from 10 bucks by buying (i refuse to use the word investing) into cryptocurrencies. Do you know where else you can get these kind of returns? The casino. Secondly, the other guy who probably achieved something like this, and also the creator of this type of business, Charles Ponzi. If you know who that is then you should get what I mean.

Previously as I mentioned, risk and return are correlated, but in most lessons of finance, risk is simply measured as standard deviation, which is the chance of fall in valuation. This means that risk is defined as personally, how much money would an investor stand to lose or make by taking on a certain amount of risk. However, one additional perspective I would like to add into evaluating risk is the ratio of successful investors vs total investors.

Imagine buying a US government bond that pays out 5% annual coupons. Out of 1000 investors, I'm sure all 1000 investors would be getting their 5% at the end of the year. For a corporate junk bond, out of 1000 investors, perhaps only 800 of them would be getting the promised returns while the rest defaults. For the investment in risky growth stocks such as technology, perhaps out of 1000 investors, 100 of them would see considerable returns. For a ponzi scheme such as most MLM nowadays, probably only 10 out of 1000 people in it would be sitting in the green, this is worse because it actually drags more and more victims into it.

In the case of cryptocurrencies I believe it to be no different. The percentage of winning investors are only the ones at the very beginning and that percentage is definitely not large. Yes cryptocurrencies is definitely here to stay, AS A WHOLE. This does not mean that any single cryptocurrencies is a good buy. Do not fall into the fallacy of composition. Stocks have existed for centuries and many have reaped great benefits from it, but I'm sure all of you can tell that this does not mean simply buying any stock is a good idea. Same as cryptocurrencies. That is not to say that one CANNOT make a windfall from buying cryptocurrencies, you can. I am just saying that it won't be a sustainable venture, if you even manage to gain anything from it in the first place.

If anything, cryptocurrencies is the biggest ponzi scheme since the 2008 financial crisis.  
Feel free to quote me on that.

"When you start thinking that you can create something out of nothing, it's very difficult to resist" - Lee Hsien Loong

Finance 101 part 2: Bonds

1. What are bonds and the different types of bonds

As we mentioned, bonds are contractual agreements for borrowing and lending between borrowers and investors. Bonds are a separate funding mechanism an entity can get besides bank loans, although they are contractual as well. For example, a $100 bond paying coupon rate of 5% maturing in 10 years would pay you $5 every year for 10 years, where you then get back your $100.

There are many bodies that can issue bonds, mainly government and private companies. Governments issue bonds when they run out of money. How do they run out of money? Well governments get their revenue mainly from taxes, sometimes in a bad economy such as financial crises, entire economy plunges and that is bad on tax revenue. Sometimes they just want to spend more than they have (such as the USA) be it due to badly planned expansions or too much natural disasters. Road repairs, infrastructure upgrading, military spending, building more lamp posts on the roads, reclaiming land ALL requires money which are funded by the government, so sometimes they just need more money than they got, this is what we call a government deficit.

And so they issue government bonds. Treat this as the government borrowing money from it's citizens to build stuffs for the benefit of the citizens, good right? In Singapore, our government is in a surplus, meaning they are actually earning more than they spend. However, as an avenue for citizens to invest their money in a risk-free asset, they still offer bonds that pays you a coupon yearly, but they are so low that you might as well invest them elsewhere. It makes sense because if they don't really need your money, definitely they are not going to pay high interest for it.

Secondly, here are the people who really needs your money. Corporations. Companies issue bonds as a method to raise funds, with the other being equities, but as we shall see there are a plethora of ways to raise funds. We'll go through that in corporate finance.[xx] Why do they raise funds? Most of the time they are probably planning expansions, acquisitions and sometimes to tide them through a bad year. For example, if Singtel wants to build more telephone lines and radio towers, upgrade computers, implement a 5G network etc. all of these requires money. If they do not have enough liquidity, such as cash in the bank, they would have to borrow the money first and to pay them once these investments pay off. It's another matter if they DON'T pay off, though. Therefore, by terms of 'neediness', we can see that companies need the money more than governments, since their profit is at stake, and so they will be willing to pay more on their bond's interest. As a gauge, if SG government bond is 2%, most companies would probably be at 4-5%.

But what if the government is actually in deficit and really needs your money to pay for the defense in case north korea nukes them? Will their coupon rates be as high as a company's? Most of the time, no. We will now discuss another factor affecting bond yields - credit risk.

Credit risk is the risk that a bond defaults, which means that they are unable to either pay the promised coupon rates and/or the face value at maturity. This is what would happen if a planned expansion for a company turns very very sour. Most companies usually operate on a relatively low debt-equity ratio such that in event of a bad decision making, they wouldn't go bankrupt immediately. The optimization of this would be covered in capital structures.[xx] Other than that, remember that a bond usually lasts a long time, commonly more than 5 years. It is hard to tell what will happen to the company in 5 years time. There could be new technology rendering their product useless, a major embezzlement or fraud (see barings bank) or simply bad economic conditions causing the firm to be unable to pay its debts.

Governments on the other hand, have a much more steady stream of income from taxes compared to individual corporations. Governments can also control their spending much more ad-hoc than corporations. Lastly, government CAN print money via the central bank to repay their loans. Therefore the credit default risk of government bonds is extremely low, where in the financial world, they are referred to as risk-free assets. We will take a look at why governments do not print money to solve every financial problems we have later on.  [xx]

Given these increased risk from a private company defaulting, an investor would expect a higher return from lending them money. Simply put, risk = return. This would explain why government bonds carry a lesser yield/coupon rate than corporate bonds.

2. Yields of bonds, issuance and secondary market

At the point of bond issuance, the face value (also called par value) is usually fixed at a nice number, say $100. This would allow the coupon rate to be calculated easily and to also facilitate transactions. If a company wants to raise $1million, they would simply issue 10,000 of these $100 bonds. Note that bonds are usually issued via a underwriter who then sells it in smaller chunks in the secondary market. It means that an investment bank will pay the entire $1million themselves less some cut off as commission, and cut them into smaller pieces of $100 or $1000 bonds to sell in the SECONDARY market, because obviously very little investors would have or want to purchase $1million in bonds at one go. Initially, these $100 bonds with a coupon rate of say 5%, would pay you $5 annually till maturity, thus your YIELD TO MATURITY(YTM) is also 5%.

However, after the initial issuance, the demand of a certain bond might increase. It might be due to interest rate falling, so that no other bonds have such a high coupon rate anymore or that the safety rating of that issuer has gone up and thus more investors want to buy those bonds. Remember that the company had already raised the money it needs and is NOT issuing any more bonds, so any increased demand for the bonds would have to be fulfilled by the existing secondary market. Increased demand would bid the price of these bonds up. For example, if you buy the same $5 bond at $110, your yield to maturity would fall to approximately ~4.5%. You cannot simply use the 5/110 as the YTM since maturity affects the YTM, thus approximate.

As an investor, what you should be interested in is the YTM, not coupon rate, although that plays a part too. For example, off the bat a bond paying a coupon rate of 6% would be better than a 5% one, but what if the 6% bond costs $150 and the 5% costs $110, which is the better one now? IMPORTANT: Note that in this example, the 6% bond WILL NOT pay you 6% of $150, but 6% of its par value of $100, which is $6.

3. Bond pricing

Note: This section contains technical information not needed by the average person unless you're a student or worker in the finance industry, or you are very keen in learning, then by all means.

YTM can be defined as the yield you are getting per annum if you hold the bond to maturity, given the price you paid for the bond. Without any calculations, one should intuitively tell that if a bond is purchased at a price HIGHER than the par, also known as a premium, the YTM will be lower than the coupon rate, and vice versa. If you buy a $100 par bond at $150, then definitely your yield will be lesser than the coupon rate % on the bond.

The pricing of a bond is simply the net present value of the future cash flows of the bond, and so we consider the net present value formula:

NPV : CF1/(1+r)^1 + CF2/(1+r)^2 + .... CFN/(1+r)^N

Where (1+r)^N is the discount factor. For more understanding on discount factor, refer to time value of money. [xx]

CF would be respective cash flows.

In the case of bonds, it would look like:

Bond price: Coupon payment 1/(1+YTM)^1 + coupon payment 2/(1+YTM)^2 + .... last coupon payment/(1+YTM)^M + Par value / (1+YTM)^M

Where M is the maturity periods. If a bond pays annual coupons and mature in 10 years, M is 10. If a bond pays semi-annual coupons(2 times a year) and mature in 10 years, M is 20.

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. WIP TBC

Finance 101 Part 1: General concepts

Hello. This is (hopefully) one of the many posts I will start to publish with what I know about finance. My method of learning and storing information is rather erratic and I wish this would help to cement my knowledge better and also help others with similar attributes to pick up what I know. For knowledge is like happiness - the totality only increases when shared.

This list is by no mean bridging and so it is not meant to be learnt in order. You can skip to any points you want/are more interested in but generally I will try to state the simpler ones first.

[xx] markers denote further in-depth topics that are separately discussed, yet to be written.

1 - Asset classes. 
These are broad terms that includes securities that share the similar attributes. Examples are
-Stocks (I will use 'stocks' and 'shares' and 'equities' interchangeably and they mean the same thing unless otherwise stated),
-Bonds,
-Options
-and Cash.

However, we will learn later that different items in the same asset class can behave very differently, even to the extent of having characteristics from multiple asset classes.

Stocks are in its simplest form, rights to part of a company. Assuming a company has 100 shares issued, and you own 1 of them, then you own 1% of the company, simple as that. These holds true for private and public companies. The only difference for public companies is that their shares are PUBLICLY traded and are subject to much more stringent compliance laws and regulations. Private companies (usually identifiable by the 'Pte Ltd' in their names) have no shares available in the public, but among their founders, such as a family, they can internally trade their shares but of course these are much less legally binding.

I will not be covering the public listing of a private company since that is more of an investment bank underwriting topic than finance.

For example, DBS bank now has approximately 2.5 billion shares outstanding. You can also see it as this company is divided into 2.5 billion parts, each share representing a part. If you buy 100 shares of it (~$20 per share as of writing) costing $2000 then you own 100/2.5billion of the company or 0.000004%. Yes $2000 is no small amount, and yes the fraction you would own is also rather negligible. That's how large it is. All stocks work based on this concept, no matter how small you are, where you are (USA/Europe/HK). There are definitely much more sub-classes of stocks such as defensive, aggressive, growth and passive but we will go through that in future topics. [xx]

Bonds are a rather fancy term for a legal loan contract. By contract it means that compared to equities, bonds do have some legally binding function in it. What this means is that if you, the investor, purchases a bond for $100, you are technically LENDING $100 to the bond SELLER. The seller would then be a borrower, or debtor, and the investor the creditor. This part of the article is not meant to discuss laws and thus I won't go into details how are they enforced but just know that the borrower are obligated to repay their debts (unless they pull off a Greece, but that's another story).

As such, borrowers usually pay interest on their loans, say 5% p.a. This would result in the lender getting back $5 every year until a fixed amount of time (the maturity of the bond) where the lender will repay the capital ($100). This percentage of interest is normally called the coupon rate. Our Singaporean government do offer bonds such as these, although corporates issue them as well. An example can be seen here :
http://www.sgs.gov.sg/savingsbonds/Your-SSB/This-months-bond.aspx
Government bond yields are pretty low at ~2% and there is a whole topic regarding bond risks and yield that I will go through in later topics. [xx]

Options are technically a subset of a bunch of securities called derivatives, which are endlessly technical and has too many innovative products in it (read: weird stuffs) but options are the most commonly used. What an option is is a payment that entitles you to something, imagine it as a gym membership, the membership ENTITLES you to use the gym, but you can choose not to.

Most options comes in the form of you paying X amount of money that entitles you to buy a certain share at price Y. Logically, 99% of the time share price will be = Y at the time of option purchase, but what happens is that share price fluctuates, while Y doesn't. 1 Year later, if share price > Y+X, you earn money, but the interesting thing here is that IF share price is lesser than Y, you can simply choose not to use('exercise') the option and let it expire. What you are losing here is then X.

If this concept seems hard to grasp, it kinda is, and there is much more innovative stuffs in options and derivatives, which the average guy has no business dabbling with for their financial safety. Do not mess with options and definitely not derivatives. Avoid them like a plague. Oh yeah, also they are one of the key causes in the global financial crisis of 2008.

Cash is pretty self-explanatory, but just to make things complete - Cash is fiat money that holds transactional value enforced by the governing body that issues the said currency. Fiat money means that the denoted value on the currency is usually much higher than how much that piece of paper/polymer is actually worth. And this value is enforced by governments. So the fed and USA government can exert its laws onto citizens rejecting it, but not USA citizens rejecting Singapore dollars. Likewise, the USA can't do anything if a Singaporean citizen rejects US dollars as payment in Singapore. That's that legal tender written on it means. Didn't know that before about money eh?

2 - Financial markets 
These includes primary markets and secondary markets. The primary market is where any financial asset is first sold/transacted. Examples of these are initial public offerings (IPOs) of shares when a private company goes public and initial issuance of bonds by corporations or governments.

Subsequently, trading among investors always happen in the secondary market. Examples are the stock exchanges such as SGX and NYSE. In between the investor and the secondary market there are usually brokers who does the technical part of actually doing the transactions. Broker services are usually provided by financial institutions such as DBS, OCBC... almost every bank and broker houses such as Phillip capital.

... I will update this list as it goes on on the future, for now we'll proceed to more educational stuffs.