CFA Level 3 Essentials

Private Wealth Management
need for cash reserve is liquidity requirement
if you are drawing from salary for expenses, there is no liquidity requirement. If you have a shortfall between salary and expenses, the difference will be made up by your return. That is a liquidity requirement.

In required return calculation, retirement income (pension income) taxed as ordinary income required return = cash needed / total investable assets
**Cash reserve is not part of cash needed

When answers reasons on IPS risk tolerance, look at the time horizon

Life insurance needs:
- high human capital - higher life insurance need
- less financial capital - higher life insurance need (financial wealth can be viewed as a substitute for life insurance)
- wage correlated to risky assets, the human capital value down -> less need for insurance

Payout of annuity
- payouts (income yields) higher when expected remaining longevity is shorter
- same age male and female, female have smaller payout bcoz of longer life expectancy than male
- 10 year period certain will reduce the payout
- 10 year period certain, small impact for 60 year old, big impact for 90 year old
- insurance company invest in bonds, when current yield on bonds are low, payout rates will be low.

variable annuity has less certainly about CFs bcoz they are linked to the performance of the underlying investment.

return objective is a sentence, eg: Return objective is to earn a rate of return enough to maintain the real value of assets and to support 25% of annual univ operating expenses
required return is calculation, eg: 5% + 4% + 0.55% = 9,55%

bounded rationality (satisficing) - meet the criteria specified but not necessarily optimal
prospect theory- loss averse
expected utility theory- risk averse

Friedman Savage utility function (risk evaluation is reference dependent)

- depending on wealth level and circumstances of decision maker

four axioms of utility theory: completeness, transitivity, independence, continuity

behavioral portfolio theory
investors construct portfolio in layers, portfolio may not be mean variance efficient.

goal based planning in concentrated position
personal risk bucket - protect from poverty
market risk bucket - maintain current standard of living
aspirational risk bucket - increase wealth substantial
* this goal three buckets do not take into account correlation among investments

personal risk bucket + market risk bucket = primary capital
aspirational risk bucket = surplus capital

mental accounting bias: ppl treat one sum of money differently from another sum, depends on which mental account money is assigned to
- cause placement of investment in different "buckets" w/o regard of correlation among the assets

Emotional Bias:
- Loss aversion bias: people tend to avoid losses, rather than achieving gains, risk seeking in losses, risk averse in gains
- overconfidence: people overestimate their knowledge and abilities
- self control bias: people fail to pursue long term goals because of lack of self discipline
- endowment bias: people value an asset more when they hold rights to it
- regret aversion bias: people tend to avoid making decisions, out of fear decision turn out poorly
- status quo bias: do nothing instead of doing something

Fixed Income
classic crossover trade where highest speculative grade bond (Ba1/BB+) are likely to benefit from an upgrade as economy strengthen

for an upward sloping yield curve, the immunization rate of return < ytm because of lower reinvestment return
1 yr spot rate 3%           
2 yr spot rate 5%           
50*1.03 + 50 = 101.50
(1101.50/1000)^(1/2) -1 = 4.9524%

Bonds:
Pure Indexing: full replication
enhanced indexing: match primary risk factors, match duration
enhanced indexing: minor risk factor mismatches, match duration
active management: larger risk factor mismatches, adjust duration slightly away from index's duration
full blown active management: mismatch on duration , and sector weight

primary risk factors: changes in interest rate, twist in yield curve, changes in spread

typical bond index is quite illiquid, pure bond indexing is much less common than pure equity indexing

The PV of the liability varies with interest rates, but the value when it is due, is fixed

The portfolio duration is weighted average of the duration of the bonds in the portfolio.

                                      Asset only       Liability relative
liability exposure           none                 term structure, inflation, growth
risk free investment       cash                 liability mimicking asset
low risk investment     low correlation    high correlation
                                      with assets       with liability

Investing in liability mimicking assets portfolio would not provide expected return greater than liability needs.
The challenge is to find most efficient way to allocate more to higher return assets while minimise risk versus liability
- hedge the liability using derivatives to mimic the market exposures of liability, use derivatives to hedge require less capital than cash investment. It frees up capital for higher return assets
- use the remaining capital for high return investment, using asset only approach

Immunization is a strategy used to minimise interest rate risk
classical immunization: process of structuring a bond portfolio that balances any change in value of portfolio with the return from reinvestment of coupon and principal through the investment period
1. bond portfolio duration = liability duration
2. PV of bond portfolio = PV of liability
Assumption: changes in yield curve are parallel, no default risk bcoz only investing in investment graded bonds

for multiple liability immunization
besides 1 and 2, add 3
3. distribution of durations of portfolio assets must have wider range than distribution of liabilities

In immunization plan, liabilities should be discounted using IRR of immunized portfolio.

Corp bond will not have lower cost of immunization bcoz corp bonds have default risk while immunization assumes no default risk. Use corp bond, raise the cost of immunization.

Also, corp bond is less liquid than T-bond, increase the cost of immunization .

cash flow matching require conservative rate of return assumption for ST cash, cash balance may be substantial. Funds from ash flow matching portfolio must be available when and before each liability is due, bcoz of difficulty in matching.

any portfolio consists of zero coupon bonds that mature at investment horizon has zero immunization risk
if CFs are concentrated aroidn horizon, reinvesmtnet risk and immunization risk are lower
if CFs are dispersed aroidn horizon, reinvesmtnet risk and immunization risk are higher

contingent immunization
- safety net value, cushion spread:  PV(assets) - PV(liabilities) is positive, can do contingent immunization with entire portfolio
- initial safety margin: PV(assets) - PV(liabilities) discounted on immunization rate

putable bonds offer a lower coupon than option free bonds given that  they provide a long option to bondholders. So they are not as sensitive to interest rates and when interest rate ↓, they offer less price appreciation. So putables do poorly when yields drop.

spread duration : % change in bond price for 1% change in its spread over treasure of same maturity,  for risky bonds, measure price changes when nominal spread changes

key rate duration: % change in bond price for 1% change in its ytm over treasure of given maturity, measure price changes when given par rate changes (and all other par rate remain unchanged)

Capital Market Expectation

High frequency data , suffers from asynchronism , or lack of sync –> lower correlation. For example, daily stock movement will have lower correlation than monthly stock movement.

Regime change results from monetary policy changes ot fiscal policy changes. Time period bias is the data is chosen to reflect a specific time. time period may not reflect the regime change.

low correlation reduce overall risk of the portfolio , but will not produce higher expected returns

Monte Carlo Simulation

advantage:

provide a distribution of probability of outcomes, than a point estimate

capture multi point effect of tax changes

disadvantage:

relies on historical data

does not incorporate changes of future financial environment

Fed model: 

Set LT treasure yield = S&P forward earnings yield

If LT treasure yield < S&P forward earnings yield  -> US stocks are undervalued

It ignores inflation and earnings growth

it can be applied to non-US equity market

it compare real earnings to nominal T-bond yield

It assume ROE =  treasure bond yield

Yardeni Model:

Set justified forward earnings yield = S&P forward earnings yield

(justified forward earnings yield)  E1/P0 = Yb - d*LTEG

it use corp bond yield, capture default risk premium, not the equity risk premium

CAPE:

use 10 year moving average P/E, uses 10 year moving average to control business cycle effects on earnings

CAPE = S&P index / real earnings

currency risk:

unhedged return = foreign bond return in local currency + currency return

hedged return = foreign bond return in local currency + f

                       forward discount/premium: f = (F - S) / S = id - if

hedged return = id + (rl - if)

ex-post risk is a biased measure of ex-ante performance

ex-post: use historical returns to predict the future risk

ex-ante: measurement before risk has occurred

(if historical prices reflected risk premium for event that did not occur, may overestimate ex-ante return)

resampled efficient frontier

- generate more stable portfolio

- generate more diversified portfolio

Black Litterman approach

- incorporate investor's views on the asset weights

- generate more diversified portfolio

PPP : exchange rate and inflation
current FX rate : THB/GBP = 51.482   annual inflation for next 5 year:Thailand 3.4% UK 1.9%

[1 +  ((1.034)^5-1) - ((1.019)^5 -1)] * 51.482 =

** need to be compounded by 5 years

It covers long term cuurency forecast.

IRP : exchnage rate and intrest rate

 (1 + id) = (S / F) * (1 + if) 

it says that when interest rates are higher, its currency depreciates. for long term forecast

Relative economic strength:

An exchange rate forecasting approach that suggests that strong pace of economic growth in a country creates attractive investment opportunities, increasing the demand for the country’s currency and causing it to appreciate. It focus on inverstment flow. It may cover shorter period of currency movement forecast. 

Tobin's q =  MV of companies / replacement value of assets

Equity q = MV of equity/ (MV assets - MV liabilities)

if q < 1, stock is undervalued

Asset Allocation

duration of foreign bond

 adjusted duration = country beta * country duration (don't use correlation here)

 Δprice = adjusted duration * Δyield

contribution to portfolio duration = %weight in portfolio * adjusted duration

new equity                                       current portfolio

sharpe ratio = rp - rf/σf =0.42       sharpe ratio = rp - rf/σf = 0.44

current portfolio correlation with new equity  p*0.44

if  0.42 >  p*044

if greater, should add new equity to portfolio

(favors low correlations)

return of domestic currency 

  Rdc = (1 + Rfc)(1 + Rfx) -1 standard deviation of domestic currency 

 σdc^2 = σfc^2 + σfx^2 + 2 σfcσfx p(fc, fx)

Derivatives

long position in backwardation  - positive roll yield

short position in backwardation  - negative roll yield

long position in contango  - negative roll yield

short position in contango  - positive roll yield

ETF vs futures:
futures are leveraged, and limited lifespan

overall delta of portfolio -> delta is additive

convert a floating rate loan to a fixed rate loan (using pay fixed, receive floating swap)
- increase the market value risk because duration of borrower position goes up, so interest rate sensitivity goes up. When interest rate down , firm is negatively affected.
- but reduce cash flow risk

futures overlay strategy not same as cash market strategy
- futures are on underlying of broad market index, cash market index is not the same as underlying of futures contract. So cash market portfolio could contain non systematic risk.
- equity do not always respond in the precise manner predicted by betas

min variance hedge ratio , h = p(DC,FX)* stddev(DC)/stddev (FX)

repo rate
lowest ------------------------------------------------------------------------------- highest
physical delivery, wire transfer of title, custodial account, no delivery

the more difficult it is to obtain the securities, the lower the repo rate.

roll yield = change in futures price - change in spot price

duration of fixed/floating swap
floating rate = half of its repricing freq
fixed rate = 0.75 of n (maturity)

Put structure do offer some protection if the issuer has an unexpected credit event, such as when put structure is triggered by a credit event --> binary credit put

to gain exposure to an asset class in advance of the cash receipt (pre-investing), take long position in futures on the asset class, no need to invest notional amount by the risk free rate

collar is a cost efficient hedging strategy, hedge downside risk with long put option, offset the cost with short call.

forward conversion with options is a monetization strategy, for concentration position. The goal is borrow against the hedged position and invest the proceeds in a diversified portfolio. It buys put option and short call option at the same strike price, same maturity date, creating a riskless position.

delta hedge
 Nc/Ns = - 1/delta
transaction    dealer's position      hedging transaction
sell puts        long exposure          sell underlying
sell calls       short exposure         buy underlying


Alternative Investments
vintage year bias means over or under weighting in specific vintages. In good years, PE firm shows good return than bad year. So choosing a specific vintage year would create bias.

In hedge fund industry, survivorship bias and backfill bias, the returns are overstated.

Equity
Equitising a market neutral long short portfolio:
client gives you notional to invest you long undervalued stocks, get an alpha. you short overvalued stocks, get another alpha. short the stocks  raises some cash, which you buy equity future and invest in treasuries.

Pairs trading is a market neutral trading strategy that matches long position with short position in a pair of highly correlated instruments.

Equitising Cash:
if you want $100 of stock exposure, buy $100 of stocks, or buy $100 of futures, you still have ($100 - margin required) of cash to earn interest payment (similar to earning a risk free bond)
long stock = long futures + long risk free bonds

CAL, CML difference
all the points on the CAL are combinations of risk free rate and portfolio of risky assets
all the points on the CML are combinations of risk free rate and market portfolio 

market portfolio is the same for everyone
risky portfolio is different for everyone


pooled account (lowest transaction cost), ETF, mutual fund

historical correlation underestimate the volatility of assets class during market crisis contagion

short extension investment style: long positions of 100% + X % , short positions of X %

market neutral funds -> appropriate benchmark is risk free rate, bcoz zero beta, zero systematic risk

indexed portfolios:
full replication: lower tracking risk, automatic rebalancing, high transaction cost
stratified sampling: lower cost to construct, assume return of stocks that are selected are uncorrelated
optimization: accounts for correlation between selected stocks, require continual rebalancing

semiactive management (enhanced indexing):
two forms, derivative based strategy and stock based strategy
stock based strategy: decisions regarding stock holdings are made relative to benchmark weight. If manager has no opinion on the stock, he will hold it in his portfolio at benchmark weight. If negative opinion, underweight it relative to the benchmark weight.If positive opinion, overweight it relative to the benchmark weight.

derivative based strategy: equitise cash portfolio, and alter the duration of the cash.  Use fixed income portfolio and equity exposure through futures market.

- tangency portfolio

corner portfolio with the highest Sharpe ratio

- to find the optimal leverage, combine corner portfolio closest to tangency portfolio, and borrow at risk free, to select a portfolio on the CAL

mismatch in character occurs when gain/losses in concentrated position and offsetting gain/loss in hedge are subject to different tax treatments

  put option - capital gains tax

  stock options - ordinary income tax

Performance Measurement and Trading

Appropriate benchmark help identify whether skill or luck achieve excess return, but they do not reduce the active risk exposures.

Benchmark attributes past performance to security selection or industry bets.

benchmark need not be widely available, eg. custom benchmark

performance attribution is about account performance relative to specific benchmark, not managers past performance.

performance appraisal is about the quality of the account's relative performance , it is investment skill or luck.

total value added return by fund manager (micro attribution)
= weighted average of manager return - weighted average of benchmark return - trading cost

Incremental return of total fund = (total fund value - beginning value - net contribution) / beginning value

macro attributions inputs
- policy allocation ot normal weightings
- benchmark portfolio returns
- fund returns

macro attributions
A : A cash attribution
R - risk free return
A - Asset category return          -- passive indexing return
B - benchmark return                -- style return
I - investment management return    -- active return
A - Allocation effect
transaction cost components
explicit cost: commission
implicit cost: bid-ask spread, market impact cost, missed trade opportunity cost, delay cost

bid-ask spread narrowing -> more liquidity, cost of trading is lower, lower volatility, low risk

return based analysis 
- can be executed quickly, bcoz it is regression
- based on historical data
- use to see overall portfolio behavior
- mutually exclusive, collectively exhaustive, represent distinct sources of risk
- use Shapre style analysis as optimization procedure , portfolio weights must be non negative and sum to one.

holding based analysis 
- can detect style drift quickly bcoz it use recent data
- based on current snapshot of the portfolio
- P/E, dividend yield, EPS growth rate

buy and hold: the investors risk tolerance is positively related to stock market returns -> stock market ↑ , investor's risk tolerance ↑

constant mix: constant risk tolerance , investor desires to hold stocks at all levels of wealth

rebalancing and corridor width
factor                                          corridor width
high transaction cost                     wider
high risk tolerance                         wider
high correlation with portfolio        wider
high volatility of assets                 narrower

Trading tactics
Liquidity at any cost: information motivated traders, timely execution
Cost are not important: market orders, mask trading intention since all market orders lookalike, for small trades and more liquid stocks
Need trustworthy agent: larger order on thinly traded stocks
Advertise to draw liquidity: IPO, secondary offerings, public display the trading interest in advance of the actual order
Low cost whatever the liquidity: limit order

Risk Management
tail VaR: VaR plus the expected loss in excess of VaR
cash flow at risk : CFAR measures the risk to company's cash flow, it is the min cash flow loss that are expected with a given probability over a specified time period
incremental VaR: how adding an asset will affect the overall VaR

methods of estimating VaR
- analytical or variance covariance method: simple, but have normality assumption, not suitable for portfolio that have fat tails, or containing options
- historical method: being non-parametric (no probability distribution assumption), reply on past data
- Monte Carlo method: can use any distribution, generate random outcome given an probability distribution

market risk: left tail risk, risk that value of an asset will go down
credit risk: right tail risk, risk that value of contract increases and counterparty does not pay

GIPS
firm description is required in disclosure
use trade date accounting  (after 1 Jan 2005)
use accrual accounting for fixed income securities
if firm does not use leverage in composite, no disclosure of the use of leverage is needed
annualised three year ex-post std dev of monthly return must be presented for both composite and benchmark (after 1 Jan 2011)
composite description is required in disclosure, such as composite creation date
internal dispersion is required in disclosure
the fee schedule is required in disclosure
currency used to express performance is required in disclosure
the number of accounts in the composite need not be disclosed in advertisement
carve-out must include their own cash balance (after 1 Jan 2010), so cash allocation policy is not needed and would be GIPS compliant (after 1 Jan 2010)
if minimum asset level is set, it must be followed consistently
actual, discretionary, non-fee-paying may be included in at least one composite.
actual, discretionary, fee-paying must be included in at least one composite.
must not link perf of simulated or model potfolios with actual perf
custodial fee is not considered direct trading expenses
portfolio valuations at least monthly (after 1 Jan 2001)
real estate portfolio accounting at least quarterly 
real estate portfolio external valuation at least yearly (after 1 Jan 2012)

Marketing and Behavioral Economics

Consumer Behavior
use theories to understand, explain, predict and change the Consumer Behavior
- consumer consume (consumer behavior)
- customer buy (customer behavior)

consumer behavior and advertising , how to link together?
- largely a matter of motivation
- what and how to say things that interest them

needs: hunger state of feeling deprivation, shaped by culture and individual
wants: noodles. sushi, rice

marketing myopia
- forgetting customers needs, focusing only on wants
- product differentiation to a point that it is overdone
- forgetting customers needs

different benefits for diff wants and needs, differentiate and target different segments

Motivation and Culture
two motivation types:
utilitarian - functional
hedonistic - fun, pleasure

approach or avoidance motivation
- problem solving or avoidance of problem

evolutionary psychology
- human do not like being oppressed, rebel instinct
- humans seek status instinctively
- conformity consumption - fitting in
- opposition consumption - standing out, rebel cool

Consumption and signals
- clean cut (Ralph Lauren) or rebellious (Diesel)
- hanky code , ppl create their meaning

public consumption : conspicuous consumption - want to be seen
private consumption : cheaper brands

Adding structure to unstructured problems
- structured: routine and repetitive
- unstructured: non routine, rely on experience, intuition, judgement, eg. choosing strategy to remain competitive in changing market
- semi-structured: combination of the above two,  eg. choosing a new univ

theories and past research help structure an unstructured problem into semi structure problem

constructs - prefer intangible variables
price, age - tangibles
IQ, personality, religiosity, happiness - intangibles

factor analysis - data reduction to identify a small number of factors that explain most of the variance that is observed in variables

Marketing Research
the planning, collection, analysis of data relevant to marketing decision making, and communication of the results of analysis to the management (the client)

use market research before advertising campaign, reduce risk. save money

1st step - identify the problem
2nd step - identify the variables
- eg. what factors are involved when choosing a bank
3rd step - clarify the questions
4th step build the constructs and scales

qualitative - understanding, tell you why, such as focus group
quantitative - measurement, tell you what but not why, such as descriptive research

descriptive research doesn't tell why, only tell what, it is very weak

Attitudes and Behavior
- do attitudes have to be based on experience
no, you can form attitudes without ever using a product

attitudes comes first, long lasting behavior second
attitudes drives behavior

Double jeopardy
- similar to halo effect
- ppl are using a brand with high market share, so end up with more ppl talking about a brand they use themselves
- big brands get good scores
- small brands will not, except from those who use the brands

Puffery
- express subject views, no reasonable person would take it seriously
- a brand calling itself the best or the finest, might not be true

** marketing can be very good at stimulating wants and needs, but nobody can force you to buy anything

Loyalty and Brand Repertoires
- loyalty means a person chooses a brand due to preference
- timeframe very likely to affect loyalty patterns
- more time, less likely to appear loyal
- using share of category requirements (SCR), how many times you buy the category per year
- proportional loyalty - SCR

Dirichlet model
- assume normal distribution, random (stochastic) purchasing
implications of it
- brand loyalty is mostly divided, almost all customers buy more than one brand over time period
- buyers of my brand also buy other brands
- individuals have brand repertoires -> multi brand royal
- should try to reach more consumers so that a larger group of people us buying your brand, some of the time
- do not aim for 100% loyalty
- big brands likely to be consumed publicly, while cheaper brands consumed privately

Branding
- familiarity and trust make it easier for consumers to buy, reduce effort in decision making
- serves as a bridge, help connect people
- a strong brand moves product away from commodity status

product differentiation or salient point
- no fixed answer
- most ads are using salient points
- product differentiation can be boring because it focus on facts

after learning about brand repertoires, it seems that ads should mainly be about getting ppl to know a brand and use it (at least once in a while)
- brand does not have to be seen as the best, but only as good enough - satisficing
- survival of the fit enough, not of the fittest

the more you see an ads, the more effective it is ? Not true
- if ad doesn't work in the short term, will it magically start working in the long term?
- must have short term impact to have any long term effect

break thru the clutter
- to find a way to reach consumers in spite of the many ads they are exposed to
- use creativity

however, dangers of creativity
- ppl don't understand
- may offend ppl
- ppl don't link to or remember the brand
- different reactions to ads because values may differ, sense of humor can differ

world of mouth can be tiring if repeat many times, such as on social media

Product and price
core product: core benefits, eg. same functionalities, watches, cameras, shampoo
actual product: combine to deliver core product benefits, eg. private label or manufacturer bands
augmented product: additional services or benefits

**successful new products are kept away from the formal system. Why?
ans: company is rigid and slow , difficult to break out of the system
dont judge new product using old criteria

Marketing Management 
- five different concepts
1. production - believe that consumers want products that are available and affordable.
mgt shd focus on improving production efficiency
2. product - believe that consumers want products that offers most quality, features, performance. mgt shd focus on continuous product improvements
3. selling - believe that people won't buy enough unless promotion is done
4. marketing - believe that consumer needs and wants must be understood and satisfied
5. social marketing - questions the marketing concept is adequate due to the number of problems in the world

McDonalds - selling , faster , std product
BurgerKing - marketing, slower, customised product

Promotion and advertising
- if you have a discount, give a reason
- advertising, for LT, build up the brand
- promotion, for ST, if brand is strong, promotion can be effective

cognitive dissonance, buyer's remorse
- anxiety or regret that lingers on after a difficult decision
esp if it is tough choice, many close alternatives, expensive, or leads to long term commitment

advertising type
- primary demand stimulation, for entire product category, eg. milk, egg
- selective stimulation, promote particular brand

Marketing funnel
- awareness
- interest
- evaluation
- commitment
- referral

if awareness high, interest low, what to do?
ans: change benefits or communications

if awareness high, interest high, trial low , what to do?
ans: free sample, distribution

if awareness high, interest high, trial high , what to do?
ans: more market research, maybe it is not good value for money

buyer decision process
- need recognition
- info search
- evaluation of alternative
- purchase decision
- post purchase behavior

adoption process
- action
- desire
- interest
- awareness

STP marketing
- segmentation
according to demographics or psychographics
- targeting
target specific segment
- positioning
where the product's position is in the consumers' mind

beware:
- different benefits for diff wants and needs, differentiate and target diff segments
- create choice confusion, variety seeking
- danger to label ppl when they don't want to be reminded of

better:
- understand ppl and position product to reach a wider group
- better than segment the market and find loyal customers

CPN stock analysis

Central Pattana (CPN) operates in retail property for rent, which comprises of large-scale shopping complexes and other supportive businesses. Its portfolio comprises of shopping centers, offices, hotels, residential buildings and recreational parks. In addition, the company invests in retail growth property fund and acts as a property manager of the fund.

Let's look at the price ratios. Its YTD P/E ratio is 27.31, compared to sector average of 17.04. Its YTD P/B ratio is 4.85, compared  to sector average of 1.72. Its dividend yield is 1.48, compared  to sector average of 1.23.

P/B ratio

P/E ratio

Looking at financial ratios. The changes over the three year period are minor.

Ratios	2016	2015	2014
Current Ratio (X)	0.45	0.47	0.5
ROE (%)	18.87	18.12	18.93
ROA (%)	11.24	10.37	11.39
D/E (X)	0.99	1.22	1.15
Total Asset Turnover (X)	0.29	0.28	0.3
Gross Profit Margin (%)	49.19	47.97	47.93
EBIT Margin (%)	38.74	37.4	38.29
Net Profit Margin (%)	30.7	29.6	29.5

The stock price has moved up over the past three months, from around 55 to 70. The stock looks overvalued in June 2017

Airweave financial analysis

Airweave financial analysis

Financial analysis outline

• Introduction
• Capital Structure
• Financial Statement Background
• Trend Analysis
• Cross Sectional Analysis
• Financial Instrument risk information
• Conclusion
• Recommendation
• Bibliography

Introduction

This article is about the financial analysis of Airweave. Airweave has been selling their core product, mattress pad since 2007. We examine the capital structure of Airweave using Modigliani-Miller theory. We analyse the financial trend of Airweave. We analyse and compare the financial statement of Airweave with other companies in the industry group. The financial instrument risk information will be discussed. Financial instruments are the borrowings and equity that Airweave uses to manage its financing. A conclusion will be made based on the analysis. Lastly, a few recommendations that may be useful for Airweave to manage its financial risks, will be discussed.

Capital Structure

We can use financial theory to explain the optimal debt ratio.

The Modigliani-Miller theorem with taxes, proposition one says that the value of levered firm is equal to the value of the unlevered firm, plus the tax multiplied by debt taken. Since debt borrowings are tax deductible, there are advantages of taking up debt. Leverage adds value to a levered company.

V_L = V_U + T*D ----- 1.1

where

V_L is the value of levered company

V_U is the value of unlevered company

D is the amount of debt taken

T is tax rate

The formula above says when we add debt to a company, the value of the company increases.

The Modigliani-Miller theorem with taxes, proposition two states that the cost of equity rises with leverage.

r_E = r₀ + D/E(r₀-r_d)(1-T) ----- 1.2

where

r₀ is the cost of equity without leverage

T is tax rate

r_d is the cost of debt

The formula says when we use more debt to replace equity, the WACC drops and there is an optimal capital structure.

For the optimal capital structure, we can refer to the table below. Firstly, we follow the Modigliani-Miller theory, and say that if the company takes on debt beyond the optimal level, the company will have greater default risk, so its cost of equity goes up, and its cost of debt also goes up. From the table, we find out that the lowest weighted average cost of capital (WACC) happens when D/E is equal to one.

To calculate WACC, we use the WACC formula as shown below:

WACC = Re*E/(D+E) + Rd*(1-T)*D/(D+E) ----- 1.3

According to the table below, the optimal D/E ratio for lowest WACC is when debt is roughly equal to equity.

Table 1: Optimal D/E ratio for lowest WACC

D/(D+E)	Re	Rd	After-tax Cost of Debt	WACC
0	10.50%	8%	4.80%	10.50%
10%	11%	8.50%	5.10%	10.41%
20%	11.60%	9.00%	5.40%	10.36%
30%	12.30%	9.00%	5.40%	10.23%
40%	13.10%	9.50%	5.70%	10.14%
50%	14%	10.50%	6.30%	10.15%
60%	15%	12%	7.20%	10.32%
70%	16.10%	13.50%	8.10%	10.50%

In 2016, the Airweave ratio of total liabilities to total equity is roughly one, which mean D/E is equal to one. So Airweave is close to its optimal capital structure.

For long term, and short term borrowing, the Japanese long term interest rate is at historic low at the moment. There is a risk of interest rate goes up in the next five years during to possible monetary tightening policy of the Bank of Japan. Therefore, Airweave takes advantage of the low interest rate situation by borrowing long term, and locking in lower rates.

Financial Statement Background

From the income statement below, the cost of goods sold is around 50% of its revenue in 2015, and 40% of its revenue in 2016, due to improving economies of scale. The selling and administrative expenses is slowly increasing due to company expansion. For income tax expenses, the corporate tax rate is about 40% in Japan from 2014 to 2016. Airweave pays 10% of its long term borrowing as the finance cost. The depreciation expenses is calculated from the balance sheet.

Items	Yearly/2016	Yearly/2015	Yearly/2014
	(31/12/2016)	(31/12/2015)	(31/12/2014)
	million yen	million yen	million yen
Income Statement
TOTAL REVENUES	14000	12000	9500
COST OF GOODS SOLD	5500	6000	4500
SELLING AND ADMINISTRATIVE EXPENSES	2200	1610	1250
DEPRECIATION EXPENSES	200	200	200
OTHER EXPENSES	90	90	90
TOTAL EXPENSES	7990	7900	6040
PROFIT (LOSS) BEFORE FINANCE COSTS AND INCOME TAX EXPENSES	6010	4100	3460
FINANCE COSTS	323	233	114
INCOME TAX EXPENSES	2275	1547	1338
NET PROFIT (LOSS)	3412	2320	2008
Other Comprehensive Income Statement
NET PROFIT (LOSS)	3412	2320	2008
EXCHANGE DIFFERENCES ON TRANSLATING FOREIGN OPERATIONS	192	76	-38
TOTAL OTHER COMPREHENSIVE INCOME	3604	2396	1970
DIVIDENDS	200	200	200

From the balance sheet below, the cash and cash equivalent number in 2015 and 2016 are calculated from cash flow statement. The property, plant and equipment, it is increasing because of Airweave company expansion. Similarly, the long term borrowings are increasing because Airweave borrows capital for expansion.

We can see that the ordinary shares and paid up capital are constant. The retained earnings keeps increasing from 2014 to 2016 because of strong financial performance of Airweave. As a result, the total equity of the company increase by 44% from 2014 to 2015, and 47% from 2015 to 2016.

Items	Yearly/2016	Yearly/2015	Yearly/2014
	(31/12/2016)	(31/12/2015)	(31/12/2014)
	million yen	million yen	million yen
CASH AND CASH EQUIVALENTS	4327	3924	2110
ACCOUNTS RECEIVABLE	3942	3117	2783
INVENTORIES	3433	4389	3468
PREPAID EXPENSES	458	453	367
SHORT TERM INVESTMENTS	434	636	424
OTHER CURRENT ASSETS	624	765	536
TOTAL CURRENT ASSETS	13218	13284	9688
INVESTMENT PROPERTIES	1921	1821	1221
PROPERTY, PLANT AND EQUIPMENTS	6023	3951	1832
Less: Accumulated Depreciation	600	400	200
INTANGIBLE ASSETS	167	167	167
Less: Accumulated Amortization	29	23	17
DEFERRED TAX ASSETS	428	453	367
OTHER NON-CURRENT ASSETS	87	52	13
TOTAL NON-CURRENT ASSETS	9255	6867	3817
TOTAL ASSETS	22473	20151	13505
BANK OVERDRAFTS	300	200	100
ACCOUNTS PAYABLE	1121	2122	1343
CURRENT PORTION OF LONG-TERM LIABILITIES	230	230	230
ACCRUED EXPENSE	1522	2122	1733
OTHER CURRENT LIABILITIES	553	213	121
TOTAL CURRENT LIABILITIES	3726	4887	3527
LONG-TERM BORROWINGS FROM FINANCIAL INSTITUTIONS	3233	2333	1135
LIABILITIES FOR EMPLOYEE RETIREMENT BENEFITS	524	477	165
OTHER NON-CURRENT LIABILITIES	746	453	233
TOTAL NON-CURRENT LIABILITIES	8229	8150	5060
TOTAL LIABILITIES	11955	13037	8587
ORDINARY SHARES	4499	4499	4499
ISSUED AND FULLY PAID-UP SHARE CAPITAL	240	240	240
RETAINED EARNINGS	5460	2248	128
CURRENCY TRANSLATION CHANGES	319	127	51
TOTAL EQUITY	10518	7114	4918

From the cash flow statement below, for the cash from operating activities, the net profits numbers are calculated from income statement. The changes in account receivable, inventories, prepaid expenses, short term investments, other current assets, account payable, accrued expenses, other current liabilities, non current liabilities are from balance sheet.

For the cash from investing activities, the changes in investment properties, property plant and equipments are calculated from balance sheet. For the cash from financing activities, the changes in long term borrowings and retirement benefits are calculated from balance sheet.

Items	Yearly/2016	Yearly/2015	Yearly/2014
	(31/12/2016)	(31/12/2015)	(31/12/2014)
	million yen	million yen	million yen
NET PROFIT	3412	2320	2008
DEPRECIATION	-200	-200	-200
AMORTISATION	-6	-6	-6
CHANGES IN ACCOUNT RECEIVABLE	-825	-334	-321
CHANGES IN INVENTORIES	956	-921	-345
CHANGES IN PREPAID EXPENSES	-5	-86	-50
CHANGES IN SHORT TERM INVESTMENTS	202	-212	45
CHANGES IN OTHER CURRENT ASSETS	141	-229	-100
CHANGES IN ACCOUNT PAYABLE	-1001	779	343
CHANGES IN ACCRUED EXPENSES	-600	389	212
CHANGES IN OTHER CURRENT LIABILITIES	340	92	46
CHANGES IN OTHER NON-CURRENT LIABILITIES	293	220	101
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES	2707	1812	1733
CHANGES IN INVESTMENT PROPERTIES	-100	-600	-100
CHANGES IN PROPERTY, PLANT AND EQUIPMENTS	-2072	-2119	-212
CHANGES IN INTANGIBLE ASSETS	0	0	0
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES	-2172	-2719	-312
CHANGES IN LONG-TERM BORROWINGS FROM FINANCIAL INSTITUTIONS	900	1198	500
CHANGES IN LIABILITIES FOR EMPLOYEE RETIREMENT BENEFITS	47	312	93
DIVIDEND PAID	-200	-200	-200
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES	747	1310	393
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENT	1282	403	1814
CASH AND CASH EQUIVALENTS, BEGINNING BALANCE	4327	3924	2110
CASH AND CASH EQUIVALENTS, ENDING BALANCE	5609	4327	3924

Trend Analysis

We analyse the Airweave financial data from year 2014 to year 2016.

The company has about the same liabilities and equities in 2016 due to increased borrowings from the bank for company expansion. The Account Receivables is slowly increasing, and Property Plant and Equipments (PP&E) increases significantly over the three years due to increase in fixed assets investment.

Table 2: Airweave overall cash flow analysis

Cash flow analysis Unit:Million yen

Item	2016	2015	2014
Net Cash flow from operating activities	2,207	1,812	1,733
Net Cash flow from investing activities	(2,172)	(2,719)	(312)
Net Cash flow from financing activities	747	1,310	393
Net change in cash	1,282	403	1,814

Table 3: Airweave cash flow analysis showing sources and uses of cash

	2016	2015	2014
Revenue	14,000	12,000	9,500
Net Income	3,412	2,320	2,008
Account Receivable	(825)	(334)	(321)
Inventories	956	(921)	(345)
Account Payable	(1,001)	779	1,343
Accrued Expenses	(600)	389	212
Capital Expenditures	(2,072)	(2,119)	(212)
Common Dividends	(200)	(200)	(200)
Long Term Borrowings	900	1198	500

For cash flow from operations, the major source of cash are net income, and increase in Account Payables for year 2014 ad 2015. The major use of cash are Inventories for year 2014 and 2015, Account Receivables from year 2014 to 2016. The Account Payable is a source of cash in 2014 and 2015, and a use of cash in 2016. The Accrued Expenses is a source of cash in 2014 and 2015, and a use of cash in 2016. The cash flow from operations is a positive number and increases from 2014 to 2016.

For cash flow from investing, the major use of cash is purchase of PP&E or capital expenditures. It was used in new shops and capacity expansion. The cash flow from investing is a negative number and highest negative value in 2015.

For cash flow from financing, in 2014 and 2015 and 2016, the major source of cash was an increase in long term borrowings. In all three years, the major use of financing cash flow is the dividends paid. The cash flow from financing is a positive number and has highest positive value in 2015.

In the overall, the net change in cash is positive from 2014 to 2016.

DuPont Analysis

DuPont analysis is useful to measure the financial performance of a company. This analysis method was started by the DuPont Corporation in 1920s. It measures return on assets (ROA) and return on equity (ROE). ROE is the net income as a percentage of total shareholder equity. ROA is the net income as a percentage of total assets. According to DuPont analysis, ROA is broken down into two parts, and ROE is broken down into three parts. The details are shown below.

ROA = NI/Sales * Sales/total Assets

ROE = NI/Sales * Sales/total Assets * Total Assets/Total SH Equity

DuPont Analysis is useful to determine what is driving the company’s financial performance. Profit Margin shows the operation efficient. Asset Turnover shows the asset usage efficiency. The financial leverage shows the degree of leverage of the company.

Table 4: NI/Sales (Profit Margin)

2016	2015	2014
0.2437	0.1933	0.2114

Table 5: Sales/total Assets (Asset Turnover)

2016	2015	2014
0.6229	0.5955	0.7034

Now, we have Profit margin and Asset turnover. We multiply them and obtain the ROA number.

Table 6: ROA calculation

Item	2016	2015	2014
ROA	0.2437*0.6229 =0.1518	0.1933*0.5955 =0.1151	0.2144*0.7034 =0.1508

The Net profit margin is declining from 2014 to 2015, and increases from 2015 to 2016.

The Asset Turnover declines from 2014 to 2015, then increases from 2015 to 2016.

In the overall, ROA declines from 2014 to 2015, and increase from 2015 to 2016. It is a good indicator of company performance.

Table 7: Total Assets/Total SH Equity (Financial Leverage)

2016	2015	2014
2.1367	2.8325	2.7460

Now, we multiply Profit margin, Asset Turnover and financial leverage, we obtain the ROE number.

Table 8: ROE calculation

Item	2016	2015	2014
ROE	0.2437*0.6229*2.137 =0.3244	0.1933*0.5955*2.833 =0.3261	0.2144*0.7034*2.746 =0.4141

The Net profit margin is declining from 2014 to 2015, and increases from 2015 to 2016.

The Asset Turnover declines from 2014 to 2015, then increases from 2015 to 2016.

The equity multiplier increases from 2014 to 2015, then decline in 2016.

In the overall, ROE declines from 2014 to 2016. The decline in 2016 is due to less financial leverage. ROE decline is an indicator that the company is using more equity to generate net income. The more equity comes from increased retained earnings. This is a good sign.

The conclusion of DuPont analysis : Airweave profitability performance is improving from 2014 to 2016. For every Japanese yen that the investors put into AIrweave assets, the return that investors get out of it, is increasing.

Cross Sectional Analysis

Cross sectional analysis is a comparison of company financial performance against industry peers, within the industry group. The purpose is to find out the financial performance of Airweave relative to its industry peers. Airweave is a mattress and mattress pad company. It is not possible to find listed Japanese company that manufactures mattress or mattress pad in the Tokyo Stock Exchange or other stock exchange in Japan. We use Japanese hospital bed manufacturer, Paramount Bed, Dutch mattress and bedroom furniture company, Beter Bed and American bed and mattress company, Sleep Number, as the industry peers. Only one of these companies is located in Japan. The other two companies are not located in Japan but they are mattress company. So we use them for comparison.

Firstly, we will see the fiscal year end of the companies. Their fiscal year end is shown in table below.

Table 9: Fiscal year end of companies

Airweave	Paramount Bed	Sleep Number	Beter Bed
31 December	31 March	31 December	31 December

Next, we find out and compare the financial ratios of the four companies in year 2016. For the easy understanding of the readers, we explain the financial ratios used in the analysis.

Firstly, there is the Liquidity ratio. It is a measure of the company’s ability to pay debt obligations.

Current ratio = Current Assets / Current Liabilities

Quick ratio = (Cash and equivalents + Marketable securities + Accounts receivable) / Current Liabilities

Current ratio measures the company’s ability to pay short term and long term debt. Quick ratio is an indicator of company’s short term liquidity.

Secondly, there is Asset Management ratio. It measures company’s ability to use assets to generate sales.

Inventory Turnover = Sales / Average Inventory

Asset Turnover = Sales / Total Assets

Fixed Asset Turnover = Sales / Fixed Assets

Inventory Turnover measures the company’s management of its inventory. Asset Turnover measures the company’s management of its assets. Fixed Asset Turnover measures the company’s management of its fixed assets

Thirdly, there is Debt Management ratio. It measures the company’s resources coming from debt or from equity. It measures the company’s financial leverage.

Debt ratio = Total Debt / Total Assets

Debt/Equity ratio = Total Debt / Total Assets

Debt ratio measures the level of debt of a company. Debt/Equity ratio measures the degree of leverage of a company. It shows how much debt the company use to finance its assets relative to the amount in equity.

Fourthly, there is Profitability ratio. It measures the business profit compared to its expenses and cost.

Gross Margin = Gross Profit / Revenue

Operating Margin = Operating Profit / Revenue

Net Margin = Net Profit / Revenue

ROA = Net Profit / Total Assets

ROE = Net Profit / Total Equity

The gross margin measures the profitability before operating factors is considered. The operating margin measures the profitability after operating efficiency is considered. The net margin measures the profitability after tax and interest payments are calculated. The ROA and ROE are described in details in DuPont analysis section.

Lastly, there is receivable turnover and payable turnover.

receivable turnover = sales/account receivable

payable turnover = sales/account payable

High numbers in receivable turnover means fast cash recovery, fast cash collection time.

Low numbers in payable turnover means company pays suppliers slowly.

Table 10: Cross sectional analysis

Item	Airweave	Paramount	Sleep Number	Beter Bed	Average
Liquidity ratio
Current Ratio (x)	3.55	3.51	0.61	1.50	2.29
Quick Ratio (x)	2.34	2.98	0.14	0.54	1.50
Asset Management Ratio
Inventory Turnover (x)	4.08	10.19	17.48	6.63	9.59
Asset Turnover (x)	0.62	0.59	2.87	2.86	1.74
Fixed Assets Turnover (x)	2.32	2.46	6.29	8.74	4.95
Debt Management Ratio
Debt Ratio(x)	0.53	0.33	0.65	0.46	0.49
Debt/Equity ratio(x)	1.14	0.48	1.85	0.87	1.08
Profitability Ratio
Gross Margin %	60.71	42.64	61.78	57.76	55.72
Operating Margin %	42.93	13.04	5.85	6.34	17.04
Net Profit Margin %	24.37	8.62	3.92	4.63	10.38
ROA %	15.18	5.06	11.25	13.24	11.18
ROE %	32.44	7.49	32.07	24.73	24.18
Receivable and Payable Turnover Ratio
Receivables Turnover(x)	3.55	3.01	66.55	31.59	26.17
Payable Turnover (x)	12.49	5.69	12.44	12.88	10.87

As can be seen from the table above, we compare the liquidity ratio, asset management ratio, debt management ratio and profitability ratio, and receivable payable turnover ratio.

For easy understanding, the above table is plotted in the graphs below.

Figure 1: Liquidity ratio

Figure 2: Asset Management ratio

Figure 3: Debt Management ratio

Figure 4: Profitability ratio

Firstly, the liquidity ratio, Airweave current ratio is above industry average, and the quick ratio is above industry average too. For the liquidity ratio, the higher the number, the better it is. So Airweave is in good position in terms of liquidity ratio.

Secondly, the asset management ratio, Airweave’s Inventory Turnover, Asset Turnover and Fixed Assets Turnover are below industry average. For the asset management ratio, the higher the number, the better it is. The implication is that Airweave is not generating high enough sales from the existing assets and inventories. Airweave is using more assets to generate sales, compared to its industry average. There is room for improvement in asset management for Airweave. Airweave could improve its asset management strategy.

Thirdly, the debt management ratio, Airweave debt ratio and debt/equity ratio are slightly higher than industry average. Airweave is using more borrowings compared to its industry average. However, Airweave is a young and growth company. It is using leverage to grow its business and generate sales. Its debt/equity ratio is close to one, which is the optimal case for capital structure. Therefore, it is acceptable for a company such as Airweave to borrow up to 50% of its assets because it uses the borrowings to maximise the value of the company.

Fourthly, profitability ratio, the Airweave numbers beat the industry average in every cases. For the profitability ratio, the higher the number, the better it is. It shows that Airweave is well managed, with little operating and administration overhead. It could be because Airweave is a small and tightly run company. Airweave has less overhead and it can achieve a high profitability ratio.

Lastly, the receivable and payable turnover ratio is discussed. The receivable ratio measures the efficiency of company collecting credit sales from customers. The ratio is the higher the number, the better it is. Airweave has the lowest receivable turnover ratio. The payable turnover ratio is the ratio that measures the efficiency of company paying credit sales to suppliers. The ratio is the lower the number, the better it is. Airweave has the highest payable turnover ratio. Airweave is collecting receivables too slow and paying payables too fast.

Furthermore, for further understanding of company performance, we calculate the net operating cycle. Net operating cycle shows how many days it takes to create inventory, sell inventory, and collect money from customers. The lower the number, the better is the company performance.

Net operating cycle = No. of Days of Inventory + No. of Days of Receivables - No. of Days of Payables

Table 11: Net operating cycle comparison of the four companies in year 2016

	Airweave	Paramount	Sleep Number	Beter Bed
No. of Days of Inventory	89.46	35.82	20.88	55.05
No. of Days of Receivables	102.82	121.26	5.48	11.55
No. of Days of Payables	29.22	64.15	29.34	28.34
Net Operating Cycle	163.06	92.93	-2.98	38.26

Airweave has the highest Net operating cycle. So it is below the performance of industry peers.

Next, we look at the cash flow of the four companies in year 2016. We will attempt to get a clearer picture of the financial health of the companies from the cash flow analysis.

For USD, we use exchange rate of JPY/USD of 115.

For Euro, we use exchange rate of JPY/EUR of 121.

Table 12: Cash flow comparison of the four companies in year 2016

Unit:Million yen

Item	Airweave	Paramount	Sleep Number	Beter Bed
Net Cash flow from operating activities	2707	9657	17439	4119
Net Cash flow from investing activities	(2172)	(2038)	(4907)	(2391)
Net Cash flow from financing activities	747	(5493)	(13610)	(2178)
Net change in cash	1282	2126	(1078)	(450)

From the table above, we can see that Airweave operating cash flow sizes are smaller than other other three companies. This is expected as Airweave is a smaller company in terms of operation size, and sales. It can be seen that Airweave has a strong positive net change in cash given its smaller net cash flow from operations. Its has an investing cash flow which is almost equal to the cash flow from operations. It is also getting a positive financing cash flows.

Breakeven Point Analysis

The analysis is to find out the minimum number of units required to overcome the variable cost and fixed cost of the company’s operation. A graph illustrating the break even analysis is shown below.

Figure 5: Breakeven analysis

Source: http://www.12manage.com/methods_break-even_point.html

In 2016, the sales is 14000 million yen. The Airweave mattress pad selling price ranges from 50000 yen to 250000 yen. Taking the middle figure of 150000 yen, 14000 million is divided by 150000, the result is 93333 unit sales. Airweave cost of goods sold is 5500 million yen. The 5500 million is divided by by 93333 unit, the result is 58928 yen. This number is the variable cost per unit sold. For the fixed cost, it can be found by adding up the selling and administrative expenses, depreciation expenses, and other expenses. The result is 2490 million yen which is the fixed cost.

To show the calculation:

14000 million / 150000 = 93333 unit (sales)

5500 million / 93333 = 58928 yen (variable cost)

To break even, we can use a formula to calculate. Assuming unit is the number of units to breakeven:

150000 * unit = 2490 million + 58928 * unit

Unit = 27341

Therefore, we can see that 27341 units are needed for the company to break even. The company is selling 93333 units in 2016. It has exceeded the break even point.

Financial instrument risk information

Financial instrument risk is the risk of using the financial instrument in a company’s operation. In Airweave case, it uses long term borrowings, and equity from green tea company to fund its investment. Airweave has roughly one to one of debt to equity ratio in 2016. From the capital structure, Airweave financial instrument (debt, equity) is subject to market risk, such as interest rate risk, currency risk, price risk.

To measure the market risk, we can use Value at risk (VaR) method. Value at risk measures the probability that financial instrument of a firm will lose a certain amount in a given period of time. For example, we can say: with 95% confidence, we expect the investment will not lose $10 million yen over a year.

There are three methods to calculate VaR. There are historical method, variance covariance method, and Monte Carlo method.

The VaR formula is: VaR = R_p - Z * σ_p

Z is the value of test statistics, it can be of 95% or 99% confidence level.

95%: 1.65

99%: 2.33

For the Airweave debt borrowing, Airweave takes up fixed rate borrowings at low interest rates, so there is very little market risk.

For the Airweave equity, it is subject to currency risk. Airweave equity valuation will decline when its domestic currency appreciates.

To show an example of the application of VaR formula: If return of equity is set at 10%, the standard deviation of return is 10%, at 95% confidence level, the VaR is:

VaR = 0.10 - 1.65*0.10 = -0.065

In 2016, the total shareholder equity capital is 10518 million yen. We multiply 0.065 by 10518 million, the result is 683 million. In this example, the minimum equity capital at risk, or losses, would be 683 million, at 95% confidence level.

Conclusion

Airweave is a growth company. Its total revenue is growing. Its retained earnings is increasing in the three year period from 2014 to 2016. Its net cash flows are positive in the three year period from 2014 to 2016. It has a strong balance sheet, such as strong current ratio, quick ratio, reasonable D/E ratio, and high ROE and ROA and high profit margin. All these numbers show that it is in good financial position.

The negative with Airweave is the asset management ratio. Airweave’s asset management ratio is below its peers. Airweave should improve on asset management, in the way that it should use less assets to generate sales. With expected revenue growth in the coming years, Airweave is expected to continue with its strong financial position.

Furthermore, Airweave has the worst net operating cycle. Airweave should improve on this aspect. Airweave can shorten the number of days in inventory, number of days in receivables.

After three years, when Airweave is listed on the Tokyo Stock Exchange, their financial statements will be available for public viewing. It will help to validate our assumptions in the financial statements.

Recommendation

Airweave is preparing to be listed on Tokyo Stock Exchange before the Tokyo Olympics in year 2020. Airweave is aggressively expanding overseas so it is subject to more currency risk. On a sales revenue of 14000 million, if 30% are from overseas, 4200 million is at risk of exchange rate changes.

To reduce finance risk of Airweave, we propose the following strategies as written below. The strategies make use of derivatives, such as as FX futures, FX forward, FX swap, and swaption. The details of the derivatives are described in the points below.

1. Use FX futures contract or FX forward contract to hedge the earnings coming from outside Japan, managing the currency risk. FX future is a publicly traded future contract, it is standardised and free of counterparty risk. Counterparty in this case is the exchange. FX forward is a privately negotiated contract between one company and one financial institution. It can be customised and subject to counterparty risk. Both FX future and FX forward are used to lock in the exchange rate in the future.
2. It can also use FX swap to manage the currency risk. FX swap is a privately negotiated contract between one company and one financial institution, to exchange one currency for another currency.

For item one and two, we can further analyze. Firstly, we see the domestic currency return is made up of:

Rdc = (1+Rfc)(1+Rfx)-1

Where

Rfx = Return of foreign exchange rate

Rfc = Return of foreign currency

And the variance of return σ_dc² = σ_Fc² + σ_FX² + 2 σ_Fcσ_Fx COV(FC, FX)

We can hedge foreign currency return, be it USD or SGD or HKD, and convert them to yen.

For example, we can see from table 12 below about how to make hedging decision.

Table 12: Hedging foreign currency

	Current spot rate	six month forward rate	six month forecast spot rate
JPY/USD	113.4	116.4	112.6

Airweave is long the USD against JPY, and JPY/USD is selling at a forward premium. Moreover, Airweave expects USD to depreciate against the JPY. This is a case of hedging the USD exposure.

To find the optimal the minimum variance hedge ratio, (the optimal hedging ratio) we can use the formula:

Hedge ratio = correlation(FC, FX)*σ_Fc/σ_FX

For example, if the hedge ratio is 2.3, for a USD 1 million exposure, Airweave will need short a JPY/USD forward contract of USD 2.3 million.

3. Manage the interest rate risk, Airweave borrows in fixed interest rate. If interest rate goes down, Airweave will suffer a loss. Airweave can buy a swaption on pay floating, receive fixed swap, Airweave can exercise it if necessary. Swaption is an option to enter into an swap.
4. Implement an action plan to accelerate collecting account receivables from customers, so that it can increase its receivables turnover.
5. Implement an action plan to delay paying payables to suppliers, so that it can reduce its payable turnover.

Bibliography

Academic Paper:

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Textbook:

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Websites:

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[9]      DuPont Analysis Definition, Retrieved April 17, 2017,

http://www.investinganswers.com/financial-dictionary/ratio-analysis/dupont-analysis-3123

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