Bankruptcy

We all usually get a lot of mails (junk ones), not all of them are junk though.
I got a forwarded mail from a friend.... I found it interesting.. so here it is.

If you could read patiently and understand, its a great knowledge !
　
Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.
　
There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.
B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.
* The net asset of the country now = 3 dollars.
　
Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.
*A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
* Thus, the net asset of the country = 4 dollars.
　
A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.
* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.
* The net asset of the country = 5 dollars. A bubble is building up.
　
B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.
* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.
* The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.
　
Everybody has made money and everybody felt happy and prosperous.
　
One day an evil wind blew, and an evil thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more."
　
A also thought the same way.
Nobody wanted to buy land anymore.
* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.
* The net asset of the country = 3 dollars again.
　
So, who has stolen the 3 dollars from the country ? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B's net asset is still 2 dollars, his heart is palpitating.
　
B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.
* A owns the 2 coins, his net asset is 2 dollars.
* B is bankrupt, his net asset is 0 dollar. ( he lost everything )
* C got no choice but end up with a land worth only 1 dollar
* The net asset of the country = 3 dollars.
　
****** End of the story ******
BUT......
There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting -
(1) When a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depend largely on psychology

Where is the money going?

Its Global Liquidity Crisis ! We all have been listening to this for a while now and are adversely affected by this. the global markets are down and money is flowing out of the emerging economies.
I am being asked a very valid question time and again. If money is flowing out of (say) India, it must be going somewhere. For every outflow of money, there must be a corresponding inflow somewhere. But that's not the case. the whole world is facing this liquidity crisis. A gentleman (he invested a lot in the equities and has lost millions due to fall in the market; "the FIs are selling") came up with an answer that the FIs are sitting on cash. OK! lets take this for a while. But are they hold currency notes. Nopes. This money shud then be deposited in the bank accounts. But again this liquidity crisis is most faced by banks. the banks dont have money to lend, the interest rates are shooting up. So is it that the banks are holding money with themselves are not willing to lend. Nopes; not possible.

First let me tell you the cause of liquidity crisis. Liquidity crisis occurs when the borrowers fail to repay. Remember the subprime crisis last year? The banks and other financial institutions lent to low-creditworthy borrowers huge sums of money and they defaulted. It all started from here.

Now let me explain how this non-payment of loan affects liquidity.
Lets go back to the basics of economics that we read in high school. the process of creating money by banks. We read that banks create money using the deposits it gets from the account holders. We know the concept Cash Reserve Ratio [CRR] (known by different but similar names in different countries). Central banks require banks to maintain a minimum percentage of deposit as reserve to meet withdrawal needs. This minimum percentage is called Cash Reserve Ratio. The banks lend the balance of the deposit to borrowers.
I'll explain in detail.
Assume that the CRR is 9% (as was in India about 15 days ago)
Mr. A deposits Rs 100000 into his bank account (Bank A). Based on the liquidity requirement, Bank A is required to hold 9% of 100000 = 9000 and lend the balance Rs 91000.
The bank lends this Rs 91000 to Mr B who deposits this money in say Bank B (even if he uses for any purpose, it ultimately goes to a bank account). Bank B again holds 9% i.e. 8190 and lends the balance (i.e. Rs 82810) to C Ltd and the money goes to Bank C and the process continues.
So we see that Rs 100000 deposited by Mr A in Bank A has already created (or circulated) money worth Rs 100000+91000+82810 = 273810. Mind you, the process continues and there is more money that is generated with this Rs 100000.
Mathematically, Maximum money that is generated with this Rs 100000 given 9% CRR is;
1 / CRR x Initial Money Deposited i.e.
1/0.09 x 100,000 = 1,111,111

Though there were various other related factors, the subprime itself let to writedowns of $501 billion in the US. Assuming a 10% reserve requirement, the banks lost $5010 billion of money creation.
Since there has been huge defaults, the banks are unable to generate money and are thus unable to lend too. Again, the increased demand for loans (and short supply) has led to increase in Interest rates as well.

This is indeed the main reason why the RBI has been trimming the CRR rates (6.5% from 9% in a matter of 10 days).

The policies are being put in place. Lets hope things shape up well !!!
As for the people who are wondering where has the money gone; I hope I have answered to an extent.

Banking Industry - Reasons to smile amidst challenges

The statements issued by the Prime Minister, Finance Minister, RBI Chief and Bank chairmen have at least some truth in it. This is seconded by the recent Crisil report. But again, there are two sides of a coin. The report says that the global crisis is not responsible for the challenges faced by the Indian Banks; but at the same time, there are a lot of internal factors that are responsible for the same.

Contrary to the stance taken by authorities, ratings major Crisil has said domestic, not global factors are responsible for the current challenges facing the banking sector. In a statement issued on Tuesday, the ratings agency has said: “Crisil believes that the Indian banking system is relatively insulated from factors leading to the turmoil in the global banking industry.” The statement goes on to add that the recent tight liquidity in the Indian market is also qualitatively different from the global liquidity crunch, which was caused by a crisis of confidence in banks lending to each other.

Crisil managing director and chief executive officer Roopa Kudva said: “While the main causes of global stress are less relevant here, Indian banks do face increased challenges due to domestic factors.

The banking sector faces profitability pressures due to

• higher funding costs,
• mark-to-market requirements on investment portfolios, and
• asset quality pressures due to a slowing economy.”

But the strong capitalisation of Indian banks is a positive feature in the current environment. Problems of global banks arose, mainly due to exposure to subprime mortgage lending and investments in complex collateralised debt obligations whose values have eroded sharply over the past few months. Globally, the crisis of confidence among banks that has also been affected by the freeze in the inter-bank lending market.

Reasons to smile

Indian banks have limited vulnerability. Indian banks’ global exposure is relatively small, with international assets at about 6% of total assets. Even banks with international operations have less than 11% of their total assets outside India.

The reported investment exposure of Indian banks to distressed international financial institutions of about $1 billion is also very small.

The mark-to-market losses on this investment portfolio, will, therefore, have only a limited financial impact.

Indian banks’ dependence on international funding is also low.

The reasons for tight liquidity conditions in the Indian market in recent weeks are quite different from the factors driving the global liquidity crisis. Some reasons include

• large selling by foreign institutional investors (FIIs),
• subsequent Reserve Bank of India (RBI) interventions in the foreign currency market,
• continuing growth in advances,
• earlier increases in cash reserve ratio (CRR) to contain inflation.

RBI’s recent initiatives, including the reduction in CRR by 150 basis points from October 11, 2008, cancellation of two auctions of government securities, and confidence-building communication, have already begun easing liquidity pressures.

Being an optimist citizen and a strong believer in the government policies, I hope things should turn out well and investors should gein confidence in the Indian Banks soon.

EVA revisited

Economic value Added


INTRODUCTION
Economic Value Added™ is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA also is the performance measure most directly linked to the creation of shareholder wealth over time.

EVA = Net operating Profit After tax – (Capital Employed x Cost of Capital)

Net Operating Profit After Tax (NOPAT): A company's potential cash earnings if its capitalization were unleveraged (that is, if it had no debt). NOPAT is frequently used in economic value added (EVA) calculations.
Calculated as:
NOPAT = Operating Income x (1 - Tax Rate)

Put most simply, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk.

Profits the way shareholders count them
The capital charge is the most distinctive and important aspect of EVA. Under conventional accounting, most companies appear profitable but many in fact are not. As Peter Drucker put the matter in a Harvard Business Review article, "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources…Until then it does not create wealth; it destroys it." EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage.
By taking all capital costs into account, including the cost of equity, EVA shows the cash wealth a business has created or destroyed in each reporting period. In other words, EVA is profit the way shareholders define it. If the shareholders expect, say, a 10% return on their investment, they "make money" only to the extent that their share of after-tax operating profits exceeds 10% of equity capital. Everything before that is just building up to the minimum acceptable compensation for investing in a risky enterprise.

Aligning decisions with shareholder wealth
EVA has been developed to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximize the wealth of its shareholders. The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company. This approach has proved effective in virtually all types of organizations, from emerging growth companies to turnarounds. This is because the level of EVA isn't what really matters. Current performance already is reflected in share prices. It is the continuous improvement in EVA that brings continuous increases in shareholder wealth.

A financial measure line managers understand
EVA has the advantage of being conceptually simple and easy to explain to non-financial managers, since it starts with familiar operating profits and simply deducts a charge for the capital invested in the company as a whole, in a business unit, or even in a single plant, office or assembly line. By assessing a charge for using capital, EVA makes managers care about managing assets as well as income, and helps them properly assess the tradeoffs between the two. This broader, more complete view of the economics of a business can make dramatic differences.

Ending the confusion of multiple goals
Most companies use a numbing array of measures to express financial goals and objectives. Strategic plans often are based on growth in revenues or market share. Companies may evaluate individual products or lines of business on the basis of gross margins or cash flow. Business units may be evaluated in terms of return on assets or against a budgeted profit level. Finance departments usually analyze capital investments in terms of net present value, but weigh prospective acquisitions against the likely contribution to earnings growth. And bonuses for line managers and business-unit heads typically are negotiated annually and are based on a profit plan. The result of the inconsistent standards, goals, and terminology usually is incohesive planning, operating strategy, and decision making.

EVA compared with MVA
Unlike Market based measurements like MVA[Market Value Added is the difference between the equity market valuation of a listed company and the sum of the adjusted book value of debt and equity invested in the company. In other words, it is the sum of all capital claims held against the company; the market value of debt and the market value of equity], EVA can be calculated for a divisional (strategic Business Unit) level. Unlike equities measurements, EVA is a flow and can be used for performance evaluation over time.

EVA compared with EBIT and EPS
Unlike accounting profit such as EBIT, PAT and EPS, EVA is economic and is based on the idea that a company must cover both the operating costs and capital costs.

Usage of EVA:
EVA can be used for the following purposes:
Ø Setting organizational goals
Ø Performance measurement
Ø Determing bonuses
Ø Communication with shareholders and investors
Ø Motivation of managers
Ø Capital budgeting
Ø Corporate valuation
Ø Analyzing equity securities.

Source:
http://www.sternstewart.com/evaabout/whatis.php
http://www.valuebasedmanagement.net/methods_eva.html
http://www.12manage.com/methods_eva.html

National Express

Poor management and lack of investment in new technology. Sell.