7 Pillars of Financial Literacy, Explained (Part 2)

In Part 1, I delved deeper into the first four "pillars" of financial literacy. In this post, we'll take a look at the remaining three pillars and see how they fit the "bigger picture."

5. Managing debt

A lot of people think that "debt is bad," but it isn't--at least not necessarily. Debt is an essential feature of the economy and society-at-large because it serves as a bridge between those who have excess funds and those who need funds. If people and institutions can't lend to or borrow from each other, then excess capital will remain idle and unproductive, economic opportunities will be unexploited, and personal needs unmet.

Debt is "bad" only if: 1) a substantial portion of the borrower's earnings go to interest and principal repayments; and/or 2) the borrower cannot afford to significantly reduce the principal balance of the debt in the foreseeable future. When one or both of these situations arise, the borrower is left with limited spending power for a considerable amount of time, or even indefinitely.

There are several ways of avoiding this "debt trap." First, remember that borrowing only makes sense for certain purchases or situations: a house, a vehicle, and some consumer durables (such as a personal computer, some appliances) if you can justify the purchase and if you can afford the payments; and emergencies. Borrowing for investments is okay only if you can earn returns that sufficiently cover interest, after considering the riskiness of the investment. Needless to say, it's a bad idea to borrow for things that you don't really need, or things that don't "last" (e.g., weddings, trips, parties). Second, if you're going to borrow, look for the lowest interest rates that you can get (for which you need to understand how concepts like add-on interest and simple vs. compound interest work) and avoid very high interest rates, such as what you get if you don't pay your credit card bill in full every month (more than 50% per year effective interest) or if you borrow from loan sharks (anywhere from 5% to 20% add on interest per month). Finally, if you're going to borrow, apart from the interest rate, ask for a quotation of required monthly payments and make sure that these are sufficiently covered by your income less essential expenses.

6. Investing

Once your "expensive" debt has been paid off and you're amply protected by insurance and cash (see Pillar #4 in Part 1), you can start setting aside capital for investment. Investing involves spending money now for the possibility of receiving more money in the future (which is what sets it apart from "saving," where you just get the same nominal amount in the future). Please note that I said that there's only a possibility of earning from an investment--"returns" are never certain, no matter what anyone says. In fact, for a lot of investment instruments there's also a chance that you'll lose a portion of your investment. The possibility that you'll earn less than what you expect or even lose some amount is called investment risk.

Investments may be broadly classified as "passive" or "active." Passive investments mostly just require capital, in exchange for periodic income (such as dividends or interest) and/or capital appreciation. Some examples of passive investments include financial instruments (stocks, bonds, mutual funds, UITFs), real estate, and speculative instruments like currencies and precious metals. Active investments such as business ventures require time as well as capital from the investor; as one of the founders of the business, the investor needs to spend some time in planning, forming, and establishing the venture, and often also in running/managing the business. Entrepreneurial ventures are covered in greater detail in the next item.

In evaluating investments, an investor needs to consider several factors which we label here as "SHORE": Scrutiny – Do you understand the mechanics of the investment? Are the company and business model sound?; Horizon – Can you afford the lockup period of the investment?; Objective – Does the investment fit your financial goal?; Risk – Are you aware of and can afford to take the risks involved?; Experience – Can you take advantage of any existing experience with this type of investment?

7. Starting and running a business

Starting a business does not just go from a great idea straight to the SEC for business registration. Some questions need to be asked first: What's your business model? How will your business make money?; Who are your customers?; What are the risks involved?; What's your exit strategy?; Are the expected profits worth the capital required and risks involved? Once you have figured out the (best effort) answers to these questions, you organize your ideas into a "business plan."

The next step is to figure out how to finance the venture. Can you cover the required capital on your own, or do you look for partners? Is it a good idea to borrow? If yes, from whom?

Finally, being an entrepreneur involves not just shelling out investment capital, but also making important business decisions. For this, a certain degree of understanding of business processes and activities is necessary. The entrepreneur must try to familiarize his or her self with the following "functional areas" of business: Finance - raising capital for projects; Accounting - keeping track of the business's finances; Operations - managing production and/or processes; Marketing - selling the firm's products/services; and Strategy -  making long-term business decisions.

There you have it: the Seven Pillars of Financial Literacy. I hope you'll find these past three posts helpful in charting your way through the deep and wide, sometimes muddy but always enlightening, realm of financial literacy. As always, comments and feedback are most welcome. Enjoy the rest of the week and have a great weekend!

Learn How to Build a Startup

If you enjoyed the Introduction to Statistics class from Udacity and if you're thinking of founding your own business, you might want to check out this next course about building a startup. The class will be facilitated by noted educator and entrepreneur Steve Blank. In the course, you will learn "the key steps of the Customer Development process: how to identify and engage the first customers for your product, and how to gather, evaluate and use their feedback to make your product, marketing and business model far stronger." Based on the syllabus, the course will cover key aspects of operations management (product design and development, supply chain management), marketing (market segmentation, marketing strategy), and business strategy. The best part is that you don't have to have any prior knowledge about these topics, although "passion, tenacity, and a willingness to work hard are essential."

The course starts on September 14. See you in class!

Four Types of Industry Structure

If you're an aspiring business person, the level of competition is one of the most important things that you should look at in choosing a business or market since more intense competition among players in an industry typically results in lower profit margins; the reason why astute business persons like MVP aggressively seek dominant market positions and less competition is to be able to have greater control over pricing and profits. 

Industry or market structure is primarily defined by the number of competing firms or sellers, and to a lesser degree, the types of products offered by the firms. In this post, I will discuss four main types of market structure; hopefully, this post will be able to help you better evaluate businesses that you are thinking of pursuing in the future.

Number of firms	Type of product
	Identical products	Differentiated products
One firm	Monopoly	-
Few firms	Oligopoly
Many firms	Perfect competition	Monopolistic competition

1. Perfect competition

A perfectly competitive market has the following characteristics:

• There are many buyers and sellers (i.e., firms) in the market
• The goods offered by the various sellers are largely the same
• Firms can freely enter or exit the market

Because of these characteristics, the actions of any one buyer or seller in the market would have very little impact on the market price and firms just take price as given. Also, in perfectly competitive markets prices and margins tend to be low since, in theory, the only way for a seller to attract more buyers and generate more sales is to reduce prices (particularly if there's no effective way of using marketing strategies to differentiate the product).

2. Monopoly

A firm is considered a monopoly if

• It is the sole seller of its product
• Its product does not have close substitutes

The fundamental cause of a monopoly is barriers to entry. Barriers to entry have three primary sources:

• Ownership of a key resource. Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.
• The government gives a single firm the exclusive right to produce some good (or render a service). Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.
• Costs of production make a single producer more efficient than a large number of producers. An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output.

The most important advantage of being a monopolist is that it can set prices without regard to how other firms respond. Thus, while a perfectly competitive firm is a price taker, a monopoly firm is a price maker. 

3. Monopolistic competition 

Monopolistic competition is a market structure where many firms are selling products that are similar but not identical. A monopolistically competitive firm’s products may be differentiated due to factors like geography (when consumers prefer stores that are convenient to reach) or the idiosyncratic preferences of buyers (that is, if tastes differ markedly from one person to the next). These slight differences enable firms to charge higher prices and still attract buyers. This opportunity to profit in the short run encourages new firms to enter monopolistically competitive markets, which may eventually lower profits and move the industry closer to perfect competition.
4. Oligopoly 
An oligopoly market is characterized by few sellers offering similar or identical products. While it's possible for competition to be intense even when there are only a few or a couple of players, which places the industry closer to perfect competition (think the local telco industry prior to PLDT's acquisition of Digitel), sometimes firms realize that it's in their best interest to cooperate, and even collude when the law explicitly requires them to compete. When sellers in an oligopoly act in concert, the market becomes a quasi-monopoly since firms are able to set higher prices for greater profitability.

So, given these types of industry structure, as a prospective (or already practicing) entrepreneur these are some things that you have to keep in mind:

• Choose monopolistic or oligopolistic businesses for greater profitability. You do not have to have MVP's resources to achieve this--just remember Porter's Five Forces and choose industries with high barriers to entry (for other entrants) and a low threat of substitute. 
• While it's easier said than done, the best way to achieve monopoly profits is to innovate and create a business that can't easily be emulated. While intellectual property laws in the Philippines may still be limited (or maybe just the enforcement of these laws?), still always try to use them to protect your business.
• Or if you're already in a particularly competitive industry, try to differentiate your product and not just compete based on price. Enter unexplored geographic markets or be a niche player and change the product enough to suit particular tastes.
• If you think it's easy to copy your business but no one is doing it yet, you can enjoy "first mover" advantages and command higher margins for a while. But be ready for an exit strategy and execute this as soon as the market becomes saturated (innovating/improving your product may be considered one such strategy)
• Avoid perfectly competitive markets at all costs! Ask yourself this question: Why would a customer buy this product from me? If the only answer you can think of is "because my price is lower," then in all probability you'll just be wasting your capital, effort, and time if you start this business.

Capital Budgeting Part 3: The Payback Period Rule

PERSONAL FINANCE 101

In Part 2, I discussed the net present value (NPV) rule for capital budgeting. While this method is the most fundamentally sound and most widely used capital budgeting decision criteria available, there's another rule that smaller businesses favor more because it's simpler to use and understand: the payback period rule.

The concept is probably not new to you, although like some people I know you might have mistakenly referred to it as "return on investment," which is a different thing altogether. The payback period rule asks a simple question: how soon will you be able to recover your investment? If the answer is "soon enough," then invest in the project or buy the asset in question; if not, then don't.

For example, if you estimate that a particular project, which costs 4 million pesos, will generate after-tax cash flows of 1 million per year in the next five years, then its payback period--the number of years it will take to recover your initial investment--is four years. That in itself does not lead to a decision; you would have to ask yourself whether, for whatever reason, that payback period is acceptable to you.

It's easy to see why small businesses and many individuals prefer using this method over the NPV rule. First, it's easier to use since there is no need to estimate the cost of capital (the discount rate used to get the present value of cash flows) and it involves infinitely less complicated computations. And second, it just seems to make sense that the shorter the payback period, the more "liquid"--and thus more attractive--the project is.

Unfortunately, like my favorite toy line there's more than meets the eye to the payback period rule--there is a reason why bigger and more sophisticated financial managers use NPV instead. First, unlike NPV, the payback period rule does not consider the riskiness of cash flows and the time value of money. Second, the payback period rule ignores cash flows beyond the payback period (such as the last million in year five of the example). These limitations are crucial because they could lead to the acceptance of negative-NPV or value-losing projects, and vice versa.

Therefore, despite its simplicity, the payback period rule should not be used as a stand-alone capital budgeting criteria. At most, use this method only to roughly gauge the attractiveness of investment prospects, before the cost of capital can be estimated and used for NPV analysis.

Mailbag Cleanup: Business Registration, Bond Yields, and Risk and Return

DEAR INVESTOR JUAN

I've been very busy these past few weeks preparing for a conference (which I'll hopefully have time to talk about in the near future) that I've barely had time to meet my monthly post quota and no opportunity to respond to emails from readers. I'll try to make up for this temporary dereliction of duty by answering some of these neglected emails in this post.

***

Dear Investor Juan,

I enjoy your blog; it's very interesting and helpful for someone like me who wants to have a financial knowledge.

I would like to ask, do I need to register (I know somehow I need to) a business that operates on the Internet? I'm located abroad, my server is here but the domain I'm using is for Philippines because that is my target market. I talked to someone about it, he said I need to, because its a business. But I don't know where to register it: here or Philippines?

Thank you and more power to your blog.

Anonymous


Dear Anonymous,

Thanks for liking the blog, and sorry for the late reply.

Are you already operating? And do you actually need/use an office for operations, where you are and/or in the Philippines? If you don't, I don't think there's any need to register at this point, especially if you have been able to manage without it. The primary benefit of being a registered entity is that it improves your credibility (by being able to issue receipts, for example) and let's you enter above-board transactions (like getting a business loan). While you may be able to run your business without being registered at this point, you definitely have to do it eventually as your business becomes bigger--both where you are and in the Philippines.

***

Dear Investor Juan,

Would like to thank you for your consistent updating and dedication to your blog. I've only started reading your blog for the past month, and I've already learned a lot from it. I have a follow-up question regarding your post on bonds.

Does it imply that as long as we get the bond with the highest yield in the market, would that mean we're getting the best value? Since my understanding of yield is, if you hold this bond until maturity, then you would earn this percentage per year.

Thanks!

Regards,
Bash


Dear Bash,


Sorry for the late reply.

You're right, you would earn the coupon every period as long as you own the bond. The problem is if interest rates go up and make coupons on newly-issued bonds higher than what you receive; missing out on the opportunity to earn higher coupons when interest rates go up is what makes your bond "lose" value. So if you buy a high-yield bond--that is, when interest rates are very high--the price of your bond will only go down if interest rates go even higher; if you have reason to believe that this is unlikely, then yes, buying bonds when yields are high (or bond prices are low) would be a good strategy.

***

Dear Investor Juan,

I currently have an extra 100k and I want to use it for investment but I don't know where to start. I'm looking at investing it with BPI and ask them which fund is currently producing higher returns. Do you have any suggestions?

Thanks.

Jon


Dear Jon,

Sorry for the late reply.

Historically, equity funds (i.e., UITFs and mutual funds) generate higher returns than bond or money market funds, but also involve a higher likelihood of losing principal. So in choosing an investment, you might also want to consider the risk of losing money apart from the potential of earning high returns.

Performing Industry Analysis with Porter's Five Forces

According to business strategy expert Michael Porter, "the essence of formulating competitive strategy is relating a company to its environment." The state of competition in an industry depends on five basic competitive "forces": the threat of new entrants, bargaining power of suppliers, bargaining power of buyers, threat of substitute products or services, and rivalry among existing firms. The goal of competitive strategy for a business unit is to find a position in the industry where the company can best defend itself against these competitive forces or can influence these forces in its favor. Porter's "Five Forces" framework is also widely used in evaluating the attractiveness or suitability of an industry for investment or entry, or the competitive standing of a particular player within an industry.

Threat of new entrants

New entrants inject substantial resources and bring new capacity to an industry, thus increasing competition and placing additional pressure on profitability among all players. The threat posed by new entrants primarily depends on the barriers to entry that are present: the higher the barriers to entry, the lower the threat from new entrants. Major barriers to entry include economies of scale, product differentiation (brand identification and customer loyalties), capital requirements, switching costs, access to distribution channels, and cost disadvantages independent of scale (proprietary product technology, favorable access to raw materials, favorable locations, government subsidies, learning or experience curve, etc.), and government policy. Also, if existing competitors respond forcefully to make the entrant’s stay an unpleasant one, the entry may well be deterred: specifically, the threat of entry into an industry can be eliminated if incumbent firms price products and services low enough

Bargaining power of suppliers

Suppliers can exert bargaining power over participants in an industry by threatening to raise prices or reduce the quality of purchased goods and services.

A supplier group is powerful if: it is dominated by a few companies; it is not obliged to contend with other substitute products for sale to the industry; the industry is not an important customer of the supplier group; the suppliers’ product is an important input to the buyer’s business; the supplier group’s products are differentiated or it has built up switching costs; and finally, the supplier group poses a credible threat of forward integration.

A firm can improve its situation through strategies such as enhancing its threat of backward integration or eliminating switching costs.

Bargaining power of buyers

Buyers compete with the industry by forcing down prices, bargaining for higher quality or more services, and playing competitors against each other--all at the expense of industry profitability.

A buyer group is powerful if: it is concentrated or purchases large volumes relative to seller sales; the product it purchases from the industry represents a significant fraction of the buyer’s costs or purchases; the products it purchases from the industry are standard or undifferentiated; it faces few switching costs; it earns low profits, and hence is highly price sensitive and less loyal to a firm; the buyers pose a credible threat of backward integration and can therefore demand bargaining concessions; the industry’s product is unimportant to the quality of the buyer’s products or services; the buyer is well informed; and lastly, the buyer can influence other buyer’s purchasing decisions.

A company can improve its strategic posture by finding buyers who posses the least power to influence their profitability adversely.

Threat of substitute products or services

Substitutes limit the potential returns of an industry by placing a ceiling on the prices firms in the industry can profitable charge. Substitutes not only limit profits in normal times but these can also reduce the rewards an industry can reap in boom times.

Identifying substitute products is a matter of searching for other products that can perform the same function as the product of the industry. Substitute products that deserve the most attention are those that are subject to trends improving their price-performance tradeoff with the industry’s product, or are produced by industries earning higher profits.


Rivalry among existing competitors

Rivalry among existing competitors takes the familiar form of "jockeying for position" or performing actions that aim to improve a player's competitive position in the industry--using tactics like price competition, advertising battles, product introductions, and increased customer service and warranties. This occurs because one or more competitors feel the pressure or see the opportunity to improve its position in the industry. Intense rivalry may result from numerous or equally balanced competitors, slow industry growth, high fixed or storage costs, lack of differentiation or switching costs, over capacity in the industry, and the diversity of competition. As such, the intensity of rivalry in industries are often described using industry classifications that range from "monopoly" (one player = no rivalry) to "perfect competition" (many players = intense rivalry).

10 Commandments of the Gokongweis

Ten "secrets" that enabled the Gokongwei business conglomerate to successfully transition from a closely-held family enterprise to a large and diversified publicly-listed corporation, as related by JG Summit President Lance Gokongwei in a recently-held forum at the Ateneo de Manila University.

1. No in-laws

During his father’s generation, Lance's aunts (married to his dad’s brothers) and his mother were involved in the business, but the elder Gokongwei soon discovered that this was not always ideal.

“There were situations where some of the marriages did not work. Loyalties change. Sometimes relationships between the different in-laws from the second generation become strained. Feelings get hurt. It is tricky deciding which in-law is more deserving, which is smarter, which would do a better job.”

2. No moonlighting

If one is working for JG Summit, one can only own passive assets that do not require their attention such as property, shares, bonds and the like.

“If you work for the company, you must be either fully in the business or completely out. In running the business, you must be actively involved, with full-time commitment and focus.”

3. No conflict of interest

As a family member, one cannot set up a business involved in supplying or transacting with the JG Group of Companies.

“Around 20 years ago, my family learned this lesson. In one of the family manufacturing companies we acquired, one sibling was involved in an outside business supplying the company. Another was involved in a business that sold the final product for commission, and another was involved in a business that sold the scrap. As each party was concerned with his own interests, nobody was thinking of the interest of the family business.”

4. No work, no pay from the company

“The family member must work to receive a salary. There should be no fake pay. You must have a real, full-time position in the company. In my family, we do not receive allowances after graduating from college. If as a parent you want to give your child money from your own salary or dividends, that’s your prerogative. But the family is not going to pay for this.”

5. Personal assets should be kept separate from company assets

Personal expenses should be paid from one’s own pocket--including personal travels via the family-controlled Cebu Pacific and personal hotel stay at the family-owned RLC hotels, and even shopping at the Robinsons retail stores.

6. Pay must be based on contribution to the business

In order for the family member to live and think independently, the family business must pay the right salary for the right job, but the pay must be adequate enough so that the family member will not be dependent on the parents for support.

“The amount you will receive is based on merit and not who you are in the family totem pole.”

7. Being family is no guarantee of employment

“There comes a time when there is not enough jobs for everyone in the family. Oftentimes, professionals may even be better in running the day to day operations.”

8. Avoiding working directly under one’s parents, specifically at the start of a career

“When I first started, I did not report to my father. I worked for my uncle and another manager. If you are too close to the person, you usually won’t get good feedback. The parent might spoil the child or he may be too harsh. There is also danger of bringing issues and arguments home.”

9. Give the next generation wings 

Also part of this rule is “have a fixed retirement age” for the business.

“I have seen many families where the patriarch passed on the responsibilities to the next generation successfully and some passed it on too late.”

10. There can only be one boss

This rule is related to succession. The role of the family and owners is to prepare a board to appoint a successor.

“You must establish a process to appoint the leaders. My dad and his brothers established a clear process on who can decide who the next leaders will be. They created an outside board whose role is to appoint and fire the CEO. This is critical so that a business can smoothly pass on from generation to generation, and achieve longevity.”

via PhilStar

MVP's Philippine "Silicon Valley"

IN THE NEWS from PhilStar.com

Manuel V. Pangilinan yesterday launched a multimillion-dollar program that seeks to emulate the Silicon Valley technological entrepreneurship incubator model. IdeaSpace Foundation Inc. is a non-profit foundation established exclusively to implement the program. The foundation is supported by the following companies: First Pacific, Metro Pacific Investments Corp., (MPIC), MPIC hospital group, Philippine Long Distance Telephone Co. (PLDT), Meralco, Smart Communications, Digitel, Sun Cellular, SPI Global, ePLDT, Indofood, Philex Mining, Maynilad, MediaQuest, and TV5.

IdeaSpace will act as an incubator and accelerator program to support technology entrepreneurs in the Philippines and for the global market through partnerships between the MVP Group of Companies and global IT companies. The seed fund being invested will be augmented with parallel activities for mentorship, resources and support. The program goes beyond “angel investing” and provides incubation and acceleration with access to a wide group of companies to share and learn experiences, fast access to be defined market runway and opportunities to be connected to potential investors.

This is another laudable initiative of MVP that is aligned with national development efforts. What strikes me as odd, though, is that there is no mention of any partnership with the academe in the press release. The role of the universities in the technology-based business incubator model is crucial as they supply the researchers, engineers, and scientists that are necessary in making the model work. We see this role exemplified by the relationship between Stanford and Silicon Valley, between Harvard and MIT and business accelerators in the Massachusetts area, and locally between the University of the Philippines and the Ayala Technopark. I would have expected the program to involve Ateneo de Manila University, at least, given MVP's close ties with the institution, but as far as I know no such involvement exists.

5 Reasons Why You Should Not Quit Your Day Job to Start Your Own Business

Many of us believe that entrepreneurship--founding and running our own businesses--is the one true path to riches and the good life. Perhaps inspired by stories of legendary, self-made businessmen, old and new--from how John Gokongwei restored his family's fortune to how Injap Sia built a giant-killing fast food restaurant brand from scratch--we dream and daydream of retiring early and enjoying the rest of our lives living off the fruits of our own business ventures. Anecdotal statistics like how one out of every ten new businesses fail within a year of founding do not deter us, maybe because the promised rewards of success greatly outweigh the possibility of failure.

Contrary to popular notion, however, there are valid reasons to not get out of the rat race. A lot of us downplay the benefits of a thriving, stable, and adequately-paying career, especially given the amount of effort and hard work that is often necessary to maintain it; in wanting to become entrepreneurs we do not realize that we would have to give up this valuable asset for a risky undertaking, a trade off that unfortunately does not make sense for everyone. In this post, I present a few points that will hopefully paint a more realistic picture of entrepreneurship in our minds and help us better decide if a shift from being "someone's employee" to being "our own boss" is really the best way to go.

1. Sometimes the "politics" that you run into as a business person is even worse than the typical "office politics." If as an employee you're tired all the difficulties with interacting with your superiors and coworkers, as a business owner it's highly likely that you'll experience much of the same problems--if not more--with your partners, suppliers, customers, and your own employees.

2. Your business would be much more vulnerable to economic shocks than a stable career. If the economy turns sour, as in a recession or financial crisis, an employee might lose his or her job, but a business person often stands to lose everything. Arguably, it would be easier for an employee to find a new job or source of income than for an entrepreneur to recover a lost business (which does not in any way mean the that the unemployment woes in the US and parts of Europe are trivial).

3. Not everyone will find it easy to sell something. Running your own business involves selling substantially more stuff than what a regular person normally could (or would). Unfortunately, generating revenues on such a scale takes a lot more that most of us can give. Before you even think of founding your own enterprise, try selling something--anything--to someone first and see how well it suits you.

4. Anyone who tells you that money is not an issue in founding a business is delusional. Unless you can come up with a Silicon Valley-level business concept to attract venture capital or angel investor funding, your idea won't go anywhere if you can't fund your idea yourself. And no potential partner would be willing to be a part of your venture if you can't even shoulder a portion of the risk by investing your own money. Unfortunately, it would take many of us quite a number of years of working and saving before we raise enough funds for a decent business.

5. As an employee, you're expected to be very good at one specific task and work from 9 to 5; as an entrepreneur you need to do EVERYTHING on your own 24/7. If you think you'll have more free time and a balanced life if you run your own business, you're fooling yourself. Whatever dreams of early retirement and "living the life" you may have would require a lot of effort and hard work first. In other words, if you're predisposed to laziness and half-assed work, entrepreneurship is not for you.

via The New York Times

Why It Does Not Pay to Work for (or Be) an Asshole Boss

I'm sure a lot of us have this notion that being an ass and financial success go hand in hand. I personally know at least a couple of highly accomplished executives and business persons who get away with "conduct unbecoming of a gentleman" either because people believe that bad behavior is a key ingredient of success, or that successful people are simply entitled to occasional bouts of temper tantrums and acts of boorishness. Regardless of how the misguided majority regard the behavior of "bad bosses," I have always had this firm belief that there is rarely a valid excuse for shouting at or humiliating a subordinate or employee. So I guess this recent study which shows how the bad behavior of bosses negatively impact the lives of all involved just proves my point.

The study specifically demonstrates that YES, the more negatively bosses acted towards their employees, the less happy these employees were. Also, when bosses were controlling rather than encouraging, employee well-being was low. On the other hand, the overall well-being of employees was better when they felt that their autonomy was encouraged. In summary, we can tell from these results that employee happiness and well-being are significantly affected by the management style of the boss, and that this places an additional toll on the already limited monetary and non-monetary benefits that the typical rank and file gets from the job.

Overall these findings may not be very surprising, but that does not make them any less important. If you're an employee who works for an asshole boss, you now have scientifically-backed reasons to look for another job soon. If you're the asshole boss, do you really think whatever satisfaction you get from being an ass is worth the cost to your employees and organization?

via The Atlantic

Break Even Analysis: The Easiest Way to Know if Your Business Model Makes Financial Sense

PERSONAL FINANCE 101

Kat and I recently started working on (what could turn out to be a big) project, and I volunteered to be responsible for the financial stuff. Between this project and my regular dissertation work (for which a conference paper is due at the end of the month), I realize that I will have even less time for Investor Juan and my other "less noble" pursuits (think what you will). So this month at least, I'll try to hit as many birds as I can with the few stones that I have. I worked on our project's break even analysis earlier this morning, so it made sense to to make that the topic of this post.

What is break even analysis?

Break even analysis, if done right, should be able to tell you if your business concept has a good chance of making money. As the name suggests, it shows how much sales you need to generate to break even: if you are confident that your business can easily and consistently beat break even sales, then you're on your way to riches; if, on the other hand, you think only a miracle could make you beat your break even point, then it makes no sense to proceed with the business.

However, since break even analysis only determines the profitability of your planned business and does not consider the investment (in real estate, machinery, or vehicles, for example) that your business would require, your financial analysis should not end there. To determine if your business can actually create additional wealth or value for your investment, then you would have to use your break even analysis results with capital budgeting procedures like net present value analysis and others that I'll discuss in future posts. Still, break even analysis is the most practical starting point of every financial analysis for a business venture.

Variable and fixed costs

Break even analysis is based on how the costs of operating a business behave differently. One set of costs or expenses--variable costs--rise and fall with revenues or sales. Some common examples of variable costs are the cost of raw materials for manufacturing and the cost of merchandise for retail or merchandising firms. Expenses that stay the same regardless of sales (only to a certain degree, which I'll get back to later) are referred to as fixed costs: examples include rent, (usually) wages, and overhead expenses.

A simple example to see how it works

Say, you're thinking of investing in a sandwich cart business. Your only product is ham and cheese sandwich, which consists of bread, ham, cheese, and mayonnaise; you estimate that these materials cost around 20 pesos per sandwich. You've found a suitable location for your business, for which the lessor asks 5,000 pesos per month. Finally, you figure that you would have two get two personnel--one to man the cash register and one to prepare the sandwiches--and you would have to pay each 7,000 pesos per month. If you plan to sell each sandwich for 30 pesos, how many sandwiches would you have to sell to break even? How much would you have to sell to break even?

Break even analysis is based on the simplest business formula there is: PROFIT = SALES - EXPENSES. To perform break even analysis, we just have to break these terms down into their respective components:

PROFIT = SALES - EXPENSES

PROFIT = SPU*Q - (VC + FC)

where SPU = selling price per unit, Q = quantity sold, VC =  variable costs, and FC = fixed costs. Going further

PROFIT = SPU*Q - (VC + FC)

PROFIT = SPU*Q - VCU*Q - FC

PROFIT = (SPU - VCU)*Q - FC

Where VCU = variable cost per unit. Remember, since VC rises and falls with Q, then VCU = VC/Q should be constant regardless of sales.

By definition, break even is the level of sales at which profit is zero. So at break even,

PROFIT = 0 = (SPU - VCU)*Q - FC

(SPU - VCU)*Q = FC

Q = FC/(SPU - VCU) = BEQ

Where BEQ = break even quantity. The break even point in pesos is just BEQ*SPU. SPU - VCU is referred to as the contribution margin per unit or CMU. It's the amount that each unit sold contributes to the recovery of fixed costs.

Now, back to your sandwich business. The first thing we have to do is identify which are variable and which are fixed costs. Based on how we defined these earlier, I hope that it's (even a bit) clear that the cost of bread, ham, cheese, and mayo represents variable costs and that rent and wages comprise fixed costs. [Speaking of which, one wise economist once mentioned that in the long run (or in continuously increasing sales quantities), all costs are variable: this means that some costs are only fixed at a certain level of sales called the relevant range. For example, as your business grows and you sell more sandwiches, you may eventually realize that two personnel are not enough to manage the demand at that branch and that you would have to hire another one. Soon, you may even decide to expand and open another branch and pay for another location. In both these instances, sales will have grown enough to drive "fixed" costs such as wages and rent past their relative ranges and become somewhat variable. But I digress...]

VCU = 20

FC = 5,000 + 2*7,000 = 19,000

SPU = 30

So now we have everything we need to proceed with our analysis.

BEQ = 19,000/(30 - 20) = 1,900 sandwiches per month
Break even point in pesos = 1,900*30 = 57,000 pesos per month

Based on the analysis, you would need to sell at least 1,900 ham and cheese sandwiches or generate sales of 57,000 pesos to break even. That's around 64 sandwiches or 1,920 pesos of sales per day. The next question that you need to answer is: do you have what it takes to break even?

If at first pass your think your break even point is too high, there are still a few things you can do to get better results. Try increasing the selling price, but not too much that it will result in significantly less demand (an estimate for the price elasticity of demand for your core product or service would be helpful, but that's another story altogether). Or try looking for cheaper supplies or a less expensive place to bring down your fixed costs. Tweaking your model is okay as long as you remain realistic.

Well, that's it. Now to go back to my other pursuits. ;)

7 Entrepreneurship Lessons from "Dilbert" Creator Scott Adams

You've seen his comics grace more than a few of my posts; we all know how, through Dilbert, he is able to show the sarcastic and idiotic -- but always funny -- sides of business and finance. However, from his recent article on The Wall Street Journal, we see that Scott Adams is so much more than the puns and wisecracks that he is well known for: his rigorous training in entrepreneurship and business management in college and graduate school, plus the fact that he has been able to find creative ways to practice what he has been taught even at a young age, makes Mr. Adams a very credible source of lessons about learning and doing business.

1. Combine skills

'The first thing you should learn in a course on entrepreneurship is how to make yourself valuable. It's unlikely that any average student can develop a world-class skill in one particular area. But it's easy to learn how to do several different things fairly well. I succeeded as a cartoonist with negligible art talent, some basic writing skills, an ordinary sense of humor and a bit of experience in the business world. The "Dilbert" comic is a combination of all four skills. The world has plenty of better artists, smarter writers, funnier humorists and more experienced business people. The rare part is that each of those modest skills is collected in one person. That's how value is created.'

2. Fail forward

'If you're taking risks, and you probably should, you can find yourself failing 90% of the time. The trick is to get paid while you're doing the failing and to use the experience to gain skills that will be useful later. I failed at my first career in banking. I failed at my second career with the phone company. But you'd be surprised at how many of the skills I learned in those careers can be applied to almost any field, including cartooning. Students should be taught that failure is a process, not an obstacle.'

3. Find the action

'In my senior year of college I asked my adviser how I should pursue my goal of being a banker. He told me to figure out where the most innovation in banking was happening and to move there. And so I did. Banking didn't work out for me, but the advice still holds: Move to where the action is. Distance is your enemy.'

4. Attract luck

'You can't manage luck directly, but you can manage your career in a way that makes it easier for luck to find you. To succeed, first you must do something. And if that doesn't work, which can be 90% of the time, do something else. Luck finds the doers. Readers of [The Wall Street Journal] will find this point obvious. It's not obvious to a teenager.'

5. Conquer fear 

'I took classes in public speaking in college and a few more during my corporate days. That training was marginally useful for learning how to mask nervousness in public. Then I took the Dale Carnegie course. It was life-changing. The Dale Carnegie method ignores speaking technique entirely and trains you instead to enjoy the experience of speaking to a crowd. Once you become relaxed in front of people, technique comes automatically. Over the years, I've given speeches to hundreds of audiences and enjoyed every minute on stage. But this isn't a plug for Dale Carnegie. The point is that people can be trained to replace fear and shyness with enthusiasm. Every entrepreneur can use that skill.'

6. Write simply 

'I took a two-day class in business writing that taught me how to write direct sentences and to avoid extra words. Simplicity makes ideas powerful. Want examples? Read anything by Steve Jobs or Warren Buffett.'

7. Learn persuasion 

'Students of entrepreneurship should learn the art of persuasion in all its forms, including psychology, sales, marketing, negotiating, statistics and even design. Usually those skills are sprinkled across several disciplines. For entrepreneurs, it makes sense to teach them as a package.'

Financing Your Business Part 2: Debt

DEAR INVESTOR JUAN

Perhaps the most important reason why you, as a business owner, would want to (partly) finance a venture with debt is that you want to maintain majority or sole ownership and control of the business, which may be significantly diluted if you instead use additional equity financing, as was discussed in Part 1. Also, as I already mentioned in that post, while the business entity would have to be formed first (and in many cases, be in operation for a number of years) before a business loan gets approved, the entrepreneur can always use personal debt to supplement the initial equity raised.

Having said that, here are the most common sources of debt financing for budding entrepreneurs.

1. Credit card debt. Yes, I'm not joking: you can use your credit card to finance some of your business's capital needs. Not only that, it can be your cheapest source of financing if you play your cards right. Remember, you only get charged if you don't pay the entire balance on or before the due date; so the key is to use your credit card to buy some of your business needs, like say, your monthly inventory if you're running a sari-sari store, and pay the entire balance on the due date. Doing this is like getting a one-month loan at zero interest rate every month; as a deal, nothing can be sweeter.

Of course, paying beyond the due date comes at a terribly high price: credit card financial charges in the Philippines run at around 3.5% per month, or 42% per year (annual percentage rate or APR). So don't even bother using your card if you know you won't be able to wipe out the balance every month.

2. Cooperative/payday loans. If you're currently working, ask your more seasoned officemates the going rate for payday loans or for loans offered by your office credit cooperative, and you'll hear that it's anywhere from 1 to 5% per month (by the way, this is add-on interest, which is applied differently than the monthly compounded interest rate of credit cards); while not as high as the infamous "five-six" rates offered by loan sharks, 5% per month is still quite expensive. Still, you might find these loans useful because they are readily available and the application is usually hassle-free.

3. Loans from government offices (SSS, GSIS, Pag-ibig). Not a lot of people know this, but you can actually use all of those deductions you see on your paychecks to your benefit as early as two years after the start of your employment. For example, you can get a two-year, 24,000 peso loan from SSS at only 10% per year. Also, apart from housing loans (best rates in town if you're going to borrow 1 million pesos or less, by the way), Pag-ibig also offers multi-purpose loans and calamity loans to its members. Far from being worthless, these government agencies can boost your debt capacity and strengthen the capital base of your business.

4. Bank loan (personal). Sometimes banks offer really low interest rates for personal loans, like less than 1% per month, add-on, with borrowed amounts that can range from 10,000 to 500,000 pesos. The problem is, the application period may take some time, and there's no certainty that your application will get approved (I know a couple of people who have already been turned down even if they're capable of paying back the loans).

5. Bank loan (business). If your business is already up and running, and you need additional financing for expansion purposes, for example, you can get either a line of credit or a business loan from a bank. With a line of credit, an amount you apply for will be made available to you for a specified period of time; when you need the money, you can borrow or draw funds from this line at a predetermined interest rate, and you don't have to submit an application every time you borrow. SME business loans, like the ones offered by BPI and DBP, generally requires collateral.

In getting a bank loan for your business, it would help immensely if you already have a long and meaningful relationship with the bank, even just by maintaining a considerable deposit balance. With this kind of relationship with your bank, there's a higher chance of getting your loans approved, getting lower interest rates, and even securing a business loan for your new business.

6. SME business loans from other financial institutions. Like the ones offered by Small Business Corporation (SBC) and SSS. SBC even offers debt financing for startups, so just make sure that you have a sound business model and a well-prepared business plan for your new business. You can probably even get lower rates from these institutions than what most banks provide.

To end, just remember two important things before you borrow money for your business. One, by borrowing, you will be committing your business to a fairly large business expense (interest plus principal repayments), so make sure that you can generate enough cash flow (not profits, mind you) to meet these future needs, or your business falls to ruin. Two, even if you organize your business as a corporation or a limited liability company (each of which provides owners with limited liability for business debt, meaning creditors can only run after the assets of the business), almost all commercial lenders will require you, as the owner of a new or small business, to personally guarantee the loan with your personal assets through what is called a surety, a guarantee which essentially wipes out your limited liability. In other words, before you borrow any amount for your business, be ready to lose your shirt (and maybe your underwear too) if you're unable to repay your debt.

Financing Your Business Part 1: Equity

DEAR INVESTOR JUAN

Dear Investor Juan,

Many aspiring entrepreneurs fail to put their business ideas into reality because there's almost no way for them to access external financing, like through banks, for example. Most financial institutions have very strict requirements: banks, for example, require at least three years of operations; and even if the individual has real property that may be used as collateral for a business loan, it does not guarantee approval.

Based on my research and personal experience, banks charge an annual interest rate of 14 to 17%. Individual lenders (loan sharks), on the other hand, charge as much as 8% a month, which is equivalent to 96% annual interest. I guess this is the reality in the Philippines, where wealth distribution and access to capital are dismal.

What's the best way to finance a business startup? I fear that my personal funds won't be enough for the business that I have in mind, so I may have to turn to other sources.

Thanks!

Anonymous


Dear Anonymous,

Raising the necessary capital is the second most important challenge would-be entrepreneurs would have to face in founding a new business (coming up with a sound business model, of course, should be the most important concern for entrepreneurs, but that's a matter for another post). In forming your business, you would need to have enough cash for machinery and equipment, the purchase or lease of real property for your office and/or production facilities, investment in raw materials or merchandise, buffer or contingency funds, and registration costs, among others. And even if you're able to successfully form your business, eventually you'll need to expand, and your profits may not be enough to finance this growth.

Entrepreneurs turn to two main financing sources at the onset of the business: equity and debt (which are both considered external sources; internal financing comes from the business's earnings). Equity represents ownership in a business, and the consequent claims of owners on the earnings and assets of the firm; in other words, equity is money that comes from the owners and investors of a business. Debt is debt, money that comes with an obligation to repay the borrowed amount, plus interest, in future periods. Naturally, startups would have to turn to equity financing first as the business entity would have to first exist before it can borrow money, although entrepreneurs can also avail of personal loans to finance their businesses (something that will be discussed in Part 2).

Here are some obvious and not-so-obvious sources of equity financing.

1. Your own money. As an entrepreneur, staking some of your own money is something you cannot avoid (although in some cases, certain skills and non-economic assets can buy you a stake in a business as an industrial partner); in any case, risking your own money shows other potential investors and creditors that you are confident of the soundness and prospects of your business, so it becomes easier to convince them to take the plunge with you. But since most of the time you what you have won't be enough for your business (like in your case), you have to turn to other sources like...

2. Your family and friends. If you can't convince the people closest to you that you have a winning formula, how can you convince anyone else? But even if you are able to wow your family and friends with your business plan, unless you come from a clan of hacienderos or politicians, available funds will still most probably be limited. Also, before you ask your loved ones to be your business partners, remember that money can fray even the strongest ties, so try your best to convince everyone that it's not personal, just business.

3. Angel investors. These are individuals who have excess capital earmarked for investment in new new and existing firms. Since these investors are presumably very wealthy, they are likely to have more available capital than your family and friends.

Angel investors will likely just be interested in businesses that they are familiar with and industries with which they have extensive experience. Also, with their extensive experience, they can provide helpful advice and connections to you and your business.

I don't know any angel investor personally, but I'm sure we all know the type. The best example I can think of is the character "S.R. Hadden" of Hadden Industries in the 1997 film Contact starring Jodie Foster (it's a great film, you should see it).

4. Venture capitalists. These are organizations whose business it is to invest in startups; by investing early in a business's life, venture capital firms or VCs bet that phenomenal growth will follow if the business becomes successful. Like in the U.S. where the VC industry is much more developed, in the Philippines local VCs are also partial towards businesses that have a high-technology base, so if your just thinking of a kariton food business, forget it. But if you do get VC funding, you get to benefit from value-added services like management and technical assistance, strategic guidance, and network of contacts.

There are active VCs operating in the Philippines: perhaps the most notable of these are Narra Venture Capital and ICCP Venture Partners. For smaller scale businesses, there's the Small Business Corporation, a government-owned and -controlled entity that provided financing (both equity and debt) to small and medium businesses.

If you're considering approaching an angel investor or venture capitalist for additional financing, the most important issue you need to think of is having to give up partial control of your business to strangers. If you want to maintain absolute control, or at least keep it within your circle, you might want to just borrow your capital shortfall, which is something we'll discuss in Part 2.

10 Reasons Why Small Businesses Fail

IN THE NEWS from The New York Times

There's this myth that the one thing successful "technopreneurs" in Silicon Valley have in common is that they all have failed at least once. If it's true, then it's reason to rejoice for someone like me who has already tasted bitter failure in founding and running a business; at least, I already have that one little detail taken care of in my quest for billions. If not, then let's all try our darndest to benefit from the mistakes of those who have come before us and avoid needing to learn this most expensive lesson first-hand.

1. The math just doesn’t work. There is not enough demand for the product or service at a price that will produce a profit for the company. Diligent market research is key in avoiding this mistake.

2. Owners who cannot get out of their own way. They may be stubborn, risk averse, conflict averse -- meaning they need to be liked by everyone. They may be perfectionist, greedy, self-righteous, paranoid, indignant or insecure. The biggest problem may have is yourself.

3. Out-of-control growth. This one might be the saddest of all reasons for failure -- a successful business that is ruined by over-expansion. This would include moving into markets that are not as profitable, experiencing growing pains that damage the business, or borrowing too much money in an attempt to keep growth at a particular rate. Sometimes less is more.

4. Poor accounting. You cannot be in control of a business if you don’t know what is going on. With bad numbers, or no numbers, a company is flying blind. If you have no idea how accounting works, learn it (you can start with this post and this post), or get a partner who is familiar with it; you can't rely on your external accountant to do the important things like financial planning for you.

5. Lack of a cash cushion. If we have learned anything from the financial crisis two years ago, it’s that business is cyclical and that bad things can and will happen over time -- the loss of an important customer or critical employee, the arrival of a new competitor, the filing of a lawsuit. These things can all stress the finances of a company. If that company is already out of cash (and borrowing potential), it may not be able to recover.

6. Operational mediocrity. No business owner will describe his or her operation as mediocre, but we can’t all be above average. Repeat and referral business is critical for most businesses, as is some degree of marketing (depending on the business).

7. Operational inefficiencies. Paying too much for rent, labor, and materials (something I have unfortunately learned the hard and expensive way). Now more than ever, the lean companies are at an advantage. Not having the tenacity or stomach to negotiate terms that are reflective of today’s economy may leave a company uncompetitive.

8. Dysfunctional management. Lack of focus, vision, planning, standards and everything else that goes into good management. Throw fighting partners or unhappy relatives into the mix and you have a disaster.

9. The lack of a succession plan. We’re talking nepotism, power struggles, significant players being replaced by people who are in over their heads -- all reasons many family businesses do not make it to the next generation.

10. A declining market. Book stores, music stores, printing businesses and many others are dealing with changes in technology, consumer demand, and competition that will most probably render them obsolete in the next few years. In short: don't enter a dying industry.

Capital Budgeting Part 2: The Net Present Value Rule

PERSONAL FINANCE 101

In Part 1, we talked about a situation where you, as the owner of Cheeky Chicken, are thinking of buying a new chicken deep fryer worth 4 million pesos and is expected to bring in additional profits of 1 million pesos per year; "additional" means if you already earn 2 million pesos with your existing set up, you expect to earn a total of 3 million pesos per year with the new machine. In making capital budgeting decisions, you should not focus on your total earnings (3 million), but rather on the additional or incremental cash flows you expect the investment to generate.

To better visualize the situation, let's summarize the cash flows into a table. The negative 4,000,000 cash flow just means that it is a cash outflow and Year 0 means today or now.

As we explained briefly in Part 1, we can't just add the future cash inflows and compare the sum to the required investment because of time value of money: we have to convert all the cash flows to a common time reference, given the rate of return of a comparable alternative investment, before we can compare the costs of the investment (cash outflows) to its benefits (cash inflows). And the easiest way to do this would be to determine how each cash flow is worth today by getting its present value.

For example, if you can earn 5% per year on an alternative investment, compounded annually, how much would you need now to have 1 million pesos by the end of the year? If you answer 952,381 pesos, you're right; you get that by dividing the future value, which is 1,000,000, by 1 plus the rate of return, or 1.05. So, we say that 952,381 is the present value of the 1,000,000 cash flow in Year 1; alternatively, we can say that we need to invest 952,381 today at 5% per year to have 1,000,000 by the end of the year.

How about the present value of 1,000,000 in Year 2? The 1,000,ooo in Year 3? As many of you might have already figured out, we can get the present value (PV) of any future amount (FV) in period t, given a rate of return r, with the following equation:

Which gives us present values of 907,029 and 863,838 to the cash flows in Years 2 and 3, respectively.

If you're allergic to this kind of math (who isn't, right?), then there's always Excel.

Notice that farther away in the future a cash flow is, the lower its present value; this is just consistent with our definition of time value of money, that earlier cash flows are more valuable than later cash flows.

Finally, to be able to decide whether it's a good idea to buy that new fryer or not, just add the present values of all the cash flows and get the net present value or NPV of the investment.

A positive NPV means the benefits of an investment outweigh the costs, considering time value of money, so you should accept or go through with the investment; a negative NPV means you will be better off investing in the alternative investment instead. In our Cheeky Chicken example, since the deep-fryer has an NPV of positive 329,477 pesos, then it makes good economic sense to pursue the venture; buying the machine would provide an additional value of 329,477 pesos, on top of 5% per year which is some sort of benchmark return.

As fundamentally sound as the NPV rule is, it's not fool proof. Basically, it depends on two very important inputs:

1. The future incremental cash flows the investment or project is expected to generate.
2. The rate of return of a comparable, alternative investment.

Therefore, the reliability of your NPV calculation is just as good as your estimates of these two inputs, and as they say, garbage in, garbage out. In practice, these two inputs are not easy to estimate accurately; still, you should be able to come up with reasonable assumptions that will make your computations more believable.

Do you think this is too much trouble for a piece of kitchen equipment? Actually, while most books recommend the use of NPV in capital budgeting, most businesses use other, more informal alternative criteria. And that's what we will talk about in Part 3.

Ten Questions For Mark Cuban

We all know him as the hot-headed and very hands-on owner of the Dallas Mavericks. What most of us don't know is that Mark Cuban is a self-made billionaire, being one of the lucky few who were able to ride the dot.com wave and luckier still for being able to cash out just before the bubble burst. Here is the Forbes interview that will teach us a few things about how to build and keep a fortune.

1. What personality trait was the key to your success?

I worked hard and smarter than most people in the businesses I have been in.

2. What financial advice do you have for someone who is newly rich?

Cash is king.

3. How do you choose a money manager or investment advisor?

Someone who I can trust, has an idea every now and then, but most importantly can efficiently research my ideas and make the investments I ask them to make.

4. Talk about the most offbeat advice you followed.

I create offbeat advice; I don't follow it. I rarely take third-party advice on my investments.

5. What do you think are the biggest obstacles to job creation in America?

Complexity. You can't just start a company. You can't just take an idea and run with it, like you used to be able to. You have to have lawyers and accountants to make sure you have lived up to all the local, regional, state and national "administrivia" that is required of you. And once you get started you have to keep up with the administrivia. All of which is a huge inhibitor to business formation and a huge capital drain for any entrepreneur who is starting with sweat equity. The first cities to create friction-free enterprise zones will get a lot of entrepreneurial traction.

To help fix the economy, I would require any public company laying off more than 1,000 employees at a time, or in aggregate for a single year, to put the details up for a shareholder vote.

I'm guessing that most shareholders realize that losing a penny a share or two in earnings is less expensive than the cost to them in taxes to cover the cost of more people joining the ranks of the unemployed.

6. Who is your hero, and why?

My dad. He made me believe in myself.

7. What are the unforeseen downsides to success? 

You become a target for extortionists who are looking for skins on the wall or easy money. I spend far too much time and money crushing all the nuisance suits that are filed. If you try to make me a skin on your wall or an easy payout, I will do everything in my power to bring justice to the situation. No matter how long it takes or how much it costs.

8. What book should every entrepreneur read?

The Fountainhead.

9. You have $100,000--where do you put it?

First I pay off all my credit card debt and evaluate paying off any other debt I have. What I have left I put in the bank.

Then I try to create as much transactional value as possible from that cash. I look at my annual budgets for everything and anything, and I look to see where I can save the most money on those items. Saving 30% to 50% buying in bulk--replenishable items from toothpaste to soup, or whatever I use a lot of--is the best guaranteed return on investment you can get anywhere. Then whatever I have left I keep in the bank and let it earn nothing. Why? Because then its available for when I get a good opportunity.

Every five years or so there is a bubble bursting or amazing deals available because of a change in the economy. Anyone who just kept their cash in the bank rather than in stocks over the past five to 10 years could be buying the home of their dreams for half price in most of the country. They earned good money in half the past 10 years on the cash, and even though they aren't making much now, they have the transactional value available to them. Plus they have cash to invest if the market craters and, most importantly, they sleep great at night. Cash is king--and works far better than Ambien when you want a good night's sleep every night.

10. Name one experience every entrepreneur-to-be must have.

Coming home and having the lights turned off because you couldn't afford to pay the bills. It's incredibly motivating and humbling.

Capital Budgeting Part 1: Making Long-term Investment Decisions for Your Business

PERSONAL FINANCE 101

Capital budgeting is the decision-making process with respect to investments in long-term assets--machinery and equipment, vehicles, and real property--with the purpose of enhancing the value of a business. Some examples of capital budgeting decisions include:

• The development and introduction of a new product to the market
• Replacing an old piece of equipment with a newer model
• Expanding production capacity

These decisions are "long term" since they cannot be "unmade" without incurring significant losses. And since these investments usually entail a huge amount of capital, it pays to know the best way of making such decisions.

The central idea in capital budgeting is to weigh the costs associated with the purchase against the expected benefits. Apart from the actual cost of the asset in question, like, say, an expensive deep fryer for your fried chicken business, other "costs" of the investment include transportation and installation (if they're not yet included in the sticker price of the machine) and investments in materials or inventory needed to make use of the asset (an increase in your inventory of dressed chicken). The benefits of the investment come from the additional cash flows you expect the asset to deliver in the future (maybe you're considering buying the new fryer because it can cook more chicken faster, which you estimate can boost your sales and cash flows significantly). In performing cost-benefit analysis, if the benefits of the asset in question outweigh the costs, then buying it would make economic sense; if it’s the other way around, if costs outweigh the benefits, then you would be better off spending your money on other value-boosting investments.

Unfortunately, of you really want to make the best decision for your business, you will have to complicate things a bit. In a previous post, we talked about time value of money: the idea that receiving money earlier is better, and vice versa. This notion complicates the cost benefit approach we discussed above; since cash received earlier is more valuable that that received at a later date, we can't just add all the future monetary benefits of an investment because they usually occur at different times. Which means, if you expect your new fryer to provide additional cash flows of 1 million pesos per year in the next five years, the benefit of the investment is not 1 million x 5 years = 5 million pesos because, with time value of money, the first million you'll receive is more valuable than the one you'll receive in five years. 

To better understand this concept, let's take a look at a specific example. Say, you're the owner of Cheeky Chicken, and you operate a small chain of fried chicken restaurants in the country. You're thinking of adding new capacity to your restaurants, and you're interested in buying a new deep fryer--the latest model--for 4 million pesos. Based on you rough estimates, the new fryer can bring in additional cash flows of 1 million pesos a year in the next five years, after which the machine will be fully depreciated and useless.

Without time value of money, the decision to buy the machine or not seems very uncomplicated: comparing the machine cost of 4 million pesos to the total benefit worth 5 million pesos clearly shouts buy. But what if you know you that can also invest your 4 million pesos in a fund that pays 5% per year? Now the decision to buy the machine or not is not so simple anymore, since now you have an alternative use for your capital that may provide better benefits. So how can we use this new information to make the right decision?

Those of you who still remember a bit of your high school math may be thinking along these lines: if we invest 4 million pesos at 5% per year, interest compounded annually (meaning interest also earns interest every year), that will give us 4 x (1.05)^5 or around 5.1 million pesos after five years, which is higher than the 5 million peso total benefit provided by the machine, which makes not buying the machine the right decision, right?

Well, almost, but not quite. While we have considered time value of money to evaluate the next best use for our capital (investing in the fund), we failed to use it with the benefits of the machine. Remember: with time value of money, earlier cash flows are worth more than those that come later, so the machine does not really provide a net benefit of 5 million pesos. So how exactly can we do this the right way? Well, you'll have to wait for Part 2 to find out. ;)