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How wealthy are you?

Surprisingly, it’s time (not money) that will gauge how much you need to be financially free

Brace yourselves. I’m starting off with a question that could very well make your palms sweat and pulse race: If you (or you and your partner/spouse) stopped working today, how long could you survive financially?

If your answer is less than a month, sadly you’re not alone. According to a 2017 GOBankingRates survey, more than half of Americans (57 percent) have less than $1,000 in their savings accounts. And even worse, 39 percent have no savings at all. Now that’s a number that makes my palms sweat.

I’m sure you can see why I asked this critical question—it’s one that most people will never stop to calculate. Perhaps that’s because they feel invincible. Or maybe because it’s just too darn scary.

This is why, when the unexpected happens—like a job layoff, an illness, an accident or a divorce—so many people are not financially prepared. Unfortunately, it’s precisely at the time of the unexpected event that most people, for the first time, experience the reality of where they are and how long they can survive financially. And that’s the exact moment where you will be faced with the cold hard truth of your situation.

What Do Need to Live On, Anyways?

For most people, calculating what they want and need means thinking in terms of money. For instance, “I need $1 million to live on for the rest of my life.” And even when you talk with financial planners, they will mention your nest egg, and discuss how much money you should set aside for retirement.

However, there is a far better way to answer the question. Instead of measuring your wealth in terms of money, it makes more sense to measure your wealth in terms of time. And that, ladies, is what I call the Wealth Number.

When it comes to discovering your Wealth Number, there are two important parts to the question: “If you (or you and your partner/spouse) stopped working today, how long could you survive financially?” Let’s break them down:

  1. If you stopped working today…
    That means there are no more paychecks coming your way. Something has happened and you can no longer work for a business or job. Therefore no income is coming in from those sources.
  2. How long could you survive financially?
    We’re talking about survival at your current standard of living—not if you downsized your house, sold your car and rode the bus, stopped eating out, and gave up your manicures. With your current level of expenses in mind, how long would your money last?

Defining Terms

Let’s get clear on some basic definitions to make sure we’re on the same page. When it comes to calculating your Wealth Number, your money consists of your savings, CDs, retirement accounts, liquid stocks (stocks you could sell today), physical gold and silver you have in your possession—basically anything that can be converted into cash today. It does not include selling your jewelry, your furniture, or your second car, for example, because that would lower your current standard of living. It does include cash flow from dividends, rental real estate, and other investments that produce income without your effort.

Perhaps you’ve done this calculation for yourself before. Well, I encourage you to do it again now. Why? Your finances are dynamic; they are constantly changing. You may come up with a similar answer as the last time you completed this exercise, or you may be surprised by your new outcome.

Do the Math

It’s all too easy to lie to yourself (or incorrectly guesstimate) about how much you actually spend on monthly expenses. So be sure to include all your expenses because you want to expand your financial means to meet the lifestyle to which you aspire, not live below your means.

Use this equation:

Your wealth number = Your available money / Your monthly expenses

Once you put these numbers into a spreadsheet and divide how much money you have available by your monthly expenses, you end up with your wealth number. What does that mean?

Your wealth number is measured in time—in this case, in months. So if your wealth number is 24, that equates to 24 months. If your number is 6, that equates to 6 months. And what does that mean? Your wealth number is the number of months you could survive if you (or both you and your partner) stopped working today.

So, what’s your number? Less than you thought? Hint: It’s rarely more than people think.

Welcome to Reality

For most, the outcome of this calculation is sobering. It brings you and your money face to face, which can be uncomfortable. But it is the most realistic and telling demonstration of exactly where you stand today financially.

For many people, their number is 3 or less. That means they could only survive without paychecks for three months or less. That means they are pretty much living paycheck to paycheck. And in some cases, people actually have a negative number, which means they are spending more every month than they are bringing in.

It really doesn’t matter what your number is. Your number is simply your number. You don’t need to make it right or wrong or continually stress over it. It is what it is. Period. Now you know something that most people will never take the time to figure out. And most importantly, now that you know, you can take action and change it if you choose.

So take a look at your finances. If you are unhappy, or even upset and sad, about that number in front of you—good. That just means it’s time to take some action. Consider enrolling in a free education workshop to learn how to build streams of long-term cash flow, or explore some free tools to help increase your financial intelligence. It’s never too late to start making some changes that will enhance your future.

Reference: Robert Kiyosaki

p.s. Will do an islamic version of this soon. when i got the time insyaAlah. Too busy with effective project management these few days.

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How cryptocurrency can help startups get investment capital

When I was raising investment for my startup, a venture capitalist said to me, “Ashwini, I think you’re going to raise a few million dollars.And your company — it’s going to sell for 50 to 70 million. You’re going to be really excited. Your early investors are going to be really excited. And I’m going to be really upset. So I’m not going to invest in this deal.”

I remember just being dumbstruck. Who would be unhappy with putting four or five million dollars into a company and having it sell for 50 to 70 million?

I was a first-time founder. I didn’t have a wealthy network of individuals to turn to for investment, so I went to venture capitalists the most common form of investor in a technology company. But I’d never taken the time to understand what was motivating that VC to invest.

I believe we’re living in a golden era of entrepreneurship. There is more opportunity to build companies than ever before. But the financial systems designed to fund that innovation, venture capital, they haven’t evolved in the past 20 to 30 years. Venture capital was designed to pour large sums of money into a small number of companies that can sell for over a billion dollars. It was not designed to sprinkle capital across many companies that have the potential to succeed but for less, like my own. That limits the number of ideas that get funded, the number of companies that are created and who can actually receive that funding to grow.

And I think it inspires a tough question: What’s our goal with entrepreneurship? If our goal is to create a tiny number of billion-dollar companies, let’s stick with venture capital, it’s working. But if our goal is to inspire innovation and empower more people to build companies of all sizes, we need a new way to fund those ideas. We need a more flexible system that doesn’t squeeze entrepreneurs and investors into one rigid financial outcome. We need to democratize access to capital.

In the summer of 2017, I went out to San Francisco, to join a tech accelerator with 30 other companies. The accelerator was supposed to teach us how to raise venture capital. But when I got out there, the startup community was buzzing about ICOs, or Initial Coin Offerings. For the first time, ICOs had raised more money for young startups than venture capital had.

It was the first week of the program. Tequila Friday. And the founders couldn’t stop talking. “I’m going to raise an ICO.” “I’m going to raise an ICO.” Until one guy goes, “How cool if we did this all together? We should do an ICO that combines the value of all of our companies and raise money as a group.” At that point, I had to ask the obvious question, “Guys, what’s an ICO?”

ICOs were a way for young companies to raise money by issuing a digital currency tied to the value and services that the company provides. The currency acts similar to shares in a company, like on the public stock market, increasing in value as it’s traded online.Most important, ICOs expanded the investor pool, from a few hundred venture capital firms to millions of everyday people, excited to invest. This market represented more money. It represented more investors. Which meant a greater likelihood to get funded. I was sold.

The idea, though, of doing it together still seemed a little crazy. Startups compete with each other for investment, it takes hundreds of meetings to get a check. That I would spend my precious 15 minutes in front of an investor talking not just about my own company, but all the companies in the batch, was unprecedented. But the idea caught on. And we decided to cooperate, rather than compete. Every company put 10 percent of their equity into a communal pool that we then split into tradable cryptocurrency that investors could buy and sell. Six months and four law firms later —

in January 2018, we launched the very first ICO that represented the value of nearly 30 companies and an entirely new way to raise capital. We got a lot of press. My favorite headline about us read, “VCs, read this and weep.”

Our fund was naturally more diverse. Twenty percent of the founders were women. Fifty percent were international. The investors were more excited, too. They had a chance to get better returns, because we took out the middleman fees of venture capital. And they could take their money and reinvest it, potentially funding more new ideas faster.

I believe this creates a virtuous cycle of capital that allows many more entrepreneurs to succeed. Because access to capital is access to opportunity. And we have only just begun to imagine what democratizing access to capital will do. I would have never thought that my own search for funding would lead me to this stage, having helped nearly 30 companies get investment.

Imagine if other entrepreneurs tried to invent new ways to access capital rather than following the traditional route. It would change what gets built, who builds it and the long-term impact on the economy. And I believe that’s way more exciting than just trying to invest in the next billion-dollar startup.

 

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Designing My Very Own Financial Road-map

First, I would need to carefully consider these 3 things:

  1. What is my financial goals?
  2. When do I plan to achieve these goals?
  3. How do I plan to do it?
  4. What is my current wealth level? (Will elaborate further in future post)

In order to better understand this idea, we need an example, and some sets of assumptions. Here is the assumptions:

  • Like any road-maps, there’s a end of the line, in this case, the end of the line is the end of my life, since we can’t predict the future, just assume it is around 75 years old.
  • Current age of 19 years old (the younger you start, the better)
Age Financial Goals (FG) FG value
19 (current age)
25 Getting married RM 25,000.00
30 Buy a car RM 30,000.00
35 Buy a house RM 100,000.00
40 Children education fund RM 60,000.00
55 (retirement) Retired RM 1,000,000.00
75 Preparation for death ?

19 Y.O to 25 Y.O (Preparing to get married)

[6 years timeline]

You estimate for the marriage ceremony cost to be around RM 25,000.00

(1) You could save the needed money using the normal practice (the hard way)

RM 25, 000 / (12*6) = RM 347.23 per month for every month for 6 years , minimum to get RM 25,000.00

(2) You could try to find an investment instrument which yield at least 10% per annum (p.a)

Note: Initially, I plan to share the formula to calculate these, but then, nobody got time for manual calculation nowadays. I suggest you to download any financial calculator apps to calculate the compounded amount for you. Easier and much more accurate.

In order to get a minimum of RM 25,000.00 in 6 years, you would need to save a minimum of RM 255 per month for 6 years.

Monthly deposit : RM 255 per month for 6 years.

Annual return : 10% p.a

Investment period : 6 years or 72 months

Total money + profit earned after 6 years:  RM 25, 226.87

Further saving on monthly saving commitment of RM 92.23 ( RM 347.23 – RM 255)

So, using this kind of investment instrument, you end up saving more money with less. Well, the question is, what investment instrument would allow you to earn 10% p.a.

Honestly, I don’t know yet. Maybe I would have the answer if and when I decided to give unit trust consulting a try. Until then, do the research yourself.

(3) If the option is only find an investment instrument which yield at least 6% per annum (p.a)

Monthly deposit : RM 255 per month for 6 years.

Annual return : 6% p.a

Investment period : 6 years or 72 months

Total money + profit earned after 6 years:  RM 22, 144.43

Further saving on monthly saving commitment of RM 92.23 ( RM 347.23 – RM 255)

You might not get the RM 25K, but it will be close.

For Malaysia, I would suggest to maximize their ASB 1 & ASB 2. It secure and low risk.

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40 Y.O to 55 Y.O (Retirement – RM 1,000,000.00)

[15 years timeline]

(1) You could save the needed money using the normal practice (the hard way)

RM 1,000, 000.00 / (12*15) = RM 5,555.56 per month for every month for 15 years , minimum to get RM 1,000,000.00 for retirement.

(2) You could try to find an investment instrument which yield at least 10% per annum (p.a)

In order to get a minimum of RM 1,000,000.00 in 15 years, you would need to save a minimum of RM 2,400.00  per month for 15 years.

Monthly deposit : RM 2, 400.00 per month for 15 years.

Annual return : 10% p.a

Investment period : 15 years or 180 months

Total money + profit earned after 15 years:  RM 1, 003,018.24 (RM 432,000.00 Principal + RM 571,018.24 profit).

Using this kind of instrument, you would have an excess of RM 3,155.56 to use for further investment or for fun, or better yet, for charity.

(3) If the option is only find an investment instrument which yield at least 6% per annum (p.a)

Monthly deposit : RM 2,400.00 per month for 15 years.

Annual return : 6% p.a

Investment period : 15 years or 180 months

Total money + profit earned after 15 years:  RM 701,454.73 ( RM 432,000.00 Principal + RM 269,454.73 Profit)

To get to the RM 1,000,000.00 mark, for 6% p.a. you need to save at least RM 3,500.00 per month for 15 years, which will amount to RM 1,022,954.82 (RM 630,000.00 Principal + RM 392,954.82 Profit)

Again for Malaysian, I would suggest to maximize their ASB 1 & ASB 2. It secure and low risk.


Sure, you noticed that, with an investment instrument, you would be able to save more by making sure that your money do the heavy lifting for you. But then, make sure that you save or invest in a legit investment scheme, not some get-rich-quick scheme.

When dealing with investment, I would rather stick to the golden advice I learnt from ‘The Richest Man in Babylon”, That is . . .

“Seek the counsel of knowledgeable experts before you invest. Never put the principal  that you invested in unseemly risk”

So for me, as I mentioned above, the 1/10th of all my earning would go to the safest low risk investment of my preferences, the extra, would go to moderate and high risk investment at a ratio which I predetermined.

And in preparing for death, I would suggest for wakaf and charity money.

So, let’s discuss on how to calculate our wealthiness in the next post (for finance categories that is).

Till then, good day to you all .

And.

Assalamualaikum warahmatullahi wabarakatuh

 

 

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Pendapatan yang berkat

Dalam mengejar harta dunia, kadang-kala kita mungkin terlibat dengan perkara-perkara yang akan menjadikan pendapatan kita tidak diberkati. Rumah besar, kereta cantik, hidup bergaya dan bermewah-mewah seringkali menjadi kayu ukuran kejayaan sesorang. Oleh itu, tidak hairanlah kenapa rasuah masih wujud untuk ‘memudahkan’ urusniaga. Namun begitu, harus di ingat, si pemberi dan penerima akan menerima balasannya, kalau tidak di dunia, di akhirat, atau mungkin kedua-duanya.

police fun funny uniform
Photo by Pixabay on Pexels.com

Saya pernah mendengar satu ceramah, di mana, seorang bekas pegawai beruniform yang telah bersara mengajukan soalan, “Kenapa anak-anak saya tidak menjadi ‘manusia yang berguna’?”. Setelah merenungkan persoalan tersebut, ustaz tersebut bertanya, “adalah Tuan pernah mengambil rahsuah atau ‘wang bawah meja’?” Penanya tersebut mengaku, “Ya, kerana gaji pokoknya terlalu rendah.”. Maka Ustaz tersebut menjawap, bahawasanya, ‘wang bawah meja’ tersebutlah yang telah menghancurkan keluarganya.

Allah SWT berfirman: “Dan janganlah sebahagian kamu memakan harta (orang-orang yang diantara) kamu dengan (jalan) yang tidak betul, dan (janganlah) kamu bawa (urusan harta) itu kepada hakim-hakim dengan maksud kamu hendak memakan sebahagian daripada harta orang (lain) dengan (jalan) dosa, padahal kamu tahu.” (Al-baqarah 2:188)

Terdapat pelbagai cara untuk mendapatkan harta dan anda harus ingat, jangan sesekali menggunakan cara yang tidak dibenarkan dalam Islam ataupun yang tidak bermoral.

“Hai orang-orang yang beriman, janganlah kamu saling memakan harta sesamamu dengan jalan yang batil, kecuali dengan jalan perniagaan yang berlaku suka sama suka di antara kamu. Dan janganlah kamu membunuh dirimu, sesungguhnya Allah adalah Maha Penyayang kepadamu.” (An-Nisa, 4:29)

‘Ayat seribu dinar’ yang sering dipaparkan di kedai-kedai makan dipetik dari Surah At-Thalaq, ayat 2-3.

“…Sesiapa yang bertaqwa kepada Allah nescaya akan dibukakan jalan keluar baginya (daripada sebarang masalah) dan akan dikurniakan rezeki daripada sumber yang tidak diduganya …”

Hidup di dunia ini hanyalah sementara yang dapat diibaratkan musafir lalu menuju destinasi abadi. Jadi, sewajar musafir, tepuklah dada anda, dan tanyalah hati, berapa banyakkah harta yang perlu diraih di dunia ini dan bagaimanakah cara anda memperolehnya?

Ibarat permainan ‘Monopoly’, kita seringkali lalai kerana berlumba memusing papan untuk mengumpulkan harta, dan cuba mendapatkan lebih banyak dari pesaing-pesaing yang lain. Namun, jika kita menang, dan permainan tamat, apakah yang terjadi? Semua harta yang telah kita kumpulkan akan di ambil semula, dan dimasukkan kembali ke dalam kotak, yang akan menjadi rebutan pemain-pemain yang akan datang !

Daripada Abu Hurairah r.a., katanya, Rasullullah SAW bersabda:

“… seorang hamba berkata, ‘Hartaku ! Hartaku!’ padahal hartanya yang sesungguhnya tiga macam:

  1. Apa yang dimakannya lalu habis
  2. Apa yang dipakainya lalu lusuh; dan
  3. Apa yang disedekahkannya lalu tersimpan (untuk akhirat). Selain daripada tiga macam itu lenyap atau ditinggalkan bagi orang lain.
*ye, sekarang mungkin analogi permainan ‘Monopoly’ lebih masuk akal.

Dalam perancangan kewangan Islam, konsep terasnya adalah Allah SWT adalah merupakan Pemilik harta yang mutlak dan kita manusia hanyalah merupakan ‘pemegang amanah’, dan para pemegang amanah semuanya akan dipertanggungjawapkan oleh amanah yang dipikulnya. Oleh hal yang demikian, sebagai seorang pemegang amanah, kita tidak boleh membelanjakannya dengan sewenang-wenangnya mahupun terlalu kikir untuk bersedekah. Jangan boros serta jangan kikir.

Dalam usuha kita mencari pendapatan yang barakah ini terpulang pada diri kita sendiri. Allah SWT telah berjanji, setiap makhluk tidah akan hidup melata di bumi ini, melainkan setiap rezekinya telah ditentukan. Kita perlu berikhtiar lalu bertawakkal.

Wallahua’lam.

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What is a theory?

A theory is an explanation, but not just any explanation. A theory asserts that wherever a set of circumstances occur, a predictable similar result will be seen. For example, suppose someone has a theory of speeding which says that whenever a car is driven over the speed limit, the probability of an accident greatly exceeds the probability of an accident for cars driven below the speed limit. In simple language, the theory says speeding drivers are more likely than regular drivers to be victims of road accidents. This is a proper theory, because it applies to any car anywhere there is a speed limit.

Secondly, a proper theory can be tested for its accuracy against the known facts (data). In this case, the facts would be the number of accidents recorded in a particular jurisdiction, the number of cars driving over the limit and also the number under the limit associated with recorded accidents. As a matter of fact, accidents will generally show an association with speeding or they will not. If they do, the theory is supported by the facts. If they do not, the theory is not supported; but it is still a theory just not a correct one.

  1. An explanation
  2. Can be tested against known facts (data)

A theory makes general statements, could either be of cause and effect or of association between two things, and a theory is testable against facts. A theory need not be right every single time, but it does need to be right often enough to be rely on most of the time. It differs from a law which needs be right all of the time, for example, the four laws of thermodynamics; else it is not a law but still a theory.

A law is always right. A theory is usually right

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Understanding Sensitivity analysis

Suppose you expect a new product line to start generating a certain amount of annual profit a year from now. What if some variable in the scenario changed? How would that affect your overall evaluation of the investment opportunity?

Sensitivity analysis enables you to ask just this kind of question. It also helps you see the ramifications of incremental changes in the assumptions that underlie a particular projection. A sensitivity analysis shall determines how different values of an independent variable affect a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that depend on one or more input variables, such as the effect that changes in interest rates (independent variable) has on bond prices (dependent variable).


Example:

Kedai Jam Terlajak Laris (KJTL) is considering investing in a new line of serving carts. Key stakeholders have different assumptions about this investment:

The three different assumptions are

  • Aarif, the vice president of the company’s hanging-racks division, would exercise day-to-day oversight of the new product line. He projects that the new line will generate MYR 60,000 in annual profit for five years.
  • Adi, the company’s CFO, is a bit wary about the investment. That’s because he thinks that Aarif has drastically underestimated the marketing costs necessary to support the new line. He predicts an annual profit stream of MYR 45,000.
  • Luqman, KJTL’s senior vice president for new business development, is optimistic by nature. He’s convinced that the serving carts will practically sell themselves, producing an annual profit stream of MYR 75,000 a year.

KJTL conducts a sensitivity analysis by calculating NPV for the three different profit scenarios:

Yield three different results:

  • NPV for Aarif’s scenario is MYR 2,742.
  • NPV for Adi’s scenario is MYR – 60,443 (a negative NVP).
  • NPV for Luqman’s scenario is MYR 65,927.

If Adi is right, the serving carts won’t be worth the investment, since the NPV for this scenario is significantly negative. But if Aarif or Luqman is right, the investment will be worthwhile marginally so according to Aarif’s profit projections, and very much so according to Luqman’s.

This is where judgment comes into play. If Adi is the best estimator of the three, KJTL’s board of directors might prefer to accept her estimate of the new line’s profit potential. Better still, the company should analyze its marketing costs in greater detail.

Whichever route KJTL takes, the sensitivity analysis will give the board of directors a more nuanced view of the investment and how it would be affected by different assumptions.


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Understanding Break-even analysis

Break-even analysis is a useful tool for evaluating an investment that will enable you to sell something new or sell more of something you already make. It tells you how many units (or how many more) you need to sell in order to pay for the fixed investment in other words, at what point you will break-even.

With that information in hand, you can look at market demand and competitors’ market shares to determine whether it’s realistic to expect to sell that much.

Break-even calculation

Here are the components that go into a breakeven calculation:

  • Unit revenue. The revenue brought in by each unit sold, or the unit selling price.
  • Variable costs. These are expenses that change depending on how many units are produced and sold. Examples include labor, utility costs, and raw materials.
  • Contribution (or “contribution margin”). This is defined as unit revenue minus variable costs per unit. It’s the sum of money available to contribute to paying fixed costs.
  • Fixed costs. These are items such as insurance, management salaries, rent, and product development costs that stay pretty much the same, no matter how many units of a product or service are sold.

Here are the formulas for calculating breakeven:

  1. Contribution margin = Selling price – variable cost per unit
  2. Breakeven volume = Total fixed costs ÷ unit contribution margin

Fixed cost is the cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses that a company must pay independent of any business activity. These costs are one of the main components of the total cost of a good or service. An example of a fixed cost would be a company’s lease on a building. If a company has to pay MYR 15,000 each month to cover the cost of the lease but does not manufacture anything during the month, the lease payment is still due in full.

In economics, a business can achieve economies of scale when it produces enough goods to spread fixed costs. For example, the MYR 200,000 lease spread out over 100,000 widgets means that each widget carries with it MYR 2 in fixed costs. If the company produces 400,000 widgets, the fixed cost per unit drops to MYR 1. Hence, lowering down the cost per unit production of the widgets.

Variable costs on the other hand are dependent on production output. They rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output.

Variable costs can include direct material costs or direct labor costs necessary to complete a certain project. For example, a company may have variable costs associated with the packaging of one of its products. As the company moves more of this product, the costs for packaging will increase. Conversely, when fewer of these products are sold, the costs for packaging will decrease.

Semi-variable costs, also called semi-fixed costs, comprise a mixture of fixed and variable components. Costs are fixed for a set level of production or consumption then become variable after that level is exceeded. With semi-variable costs, greater levels of production increase total cost, but if no production occurs, then a fixed cost is still incurred.

The simple example of semi-variable cost is the labor costs. The fixed portion is the wage paid to workers for their regular hours while the variable portion is the overtime pay they receive when they exceed their regular hours.

Pricing?

The next step in break-even analysis is determining what price to charge for your good or service. Let’s look at some of the pricing strategies companies use.

With competition-driven pricing, the seller establishes its prices based on what its competitors charge. Competition-driven pricing focuses on determining a price that will achieve the most profitable market share and does not always mean that the price is identical to the competitions’. Determining how to profitably achieve the greatest market share without incurring excessive costs requires strategic decision making. The seller must focus not only on obtaining the largest market share, but in finding the combination of margin and market share that will be the most profitable in the long run.

Penetration pricing is a marketing strategy firms use to attract customers to a new product or service. This strategy means offering a low price for a new product or service during its debut in order to attract customers away from competitors. The goal of this pricing strategy is to make customers aware of the new product due to its lower price in the marketplace relative to rivals.

When applied correctly, penetration pricing can increase both market share and sales volume. High sales volume may then lead to lower production costs and higher inventory turnover, both of which are positive for any firm with fixed overhead.

The chief disadvantage of penetration pricing is that the increase in sales volume may not lead to a profit if prices are kept too low. As well, if the price is only an introductory campaign, customers may leave the brand once prices begin to rise to levels more in line with competitors’ prices.

Variable cost-plus pricing is a pricing method in which the selling price is established by adding a markup to total variable costs. The expectation is that the markup will contribute to meeting all or a part of fixed costs and generate some level of profit. Variable cost-plus pricing is especially useful in competitive scenarios such as contract bidding, but is not suitable in situations where fixed costs are a major component of total costs.

For example, assume total variable costs for manufacturing one unit of a product are MYR 10 and a markup of 50% is added. The selling price as determined by this variable cost-plus pricing method would be MYR 15. If the contribution to fixed costs per unit is estimated at MYR 4, then profit per unit would be MYR 1.

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Understanding Internal rate of return analysis

Internal rate of return (IRR) is another analytical method that can help you or your organization to decide whether to make a particular investment. IRR is the rate at which the NPV of an investment equals zero. Like NPV, IRR enables you to consider returns on an annual basis and takes into account the time value of money.

Typically, when the IRR is greater than the opportunity cost (the expected return on a comparable investment) of the capital required, the organization should make the investment under consideration.

The IRR calculation is based on the same algebraic formula as the NPV calculation. With the NPV calculation, you know the desired rate of return, and you’re solving the equation for the net present value of the future cash flows. With IRR, the NPV is set at zero, and you solve the equation for the rate of return.

Your spreadsheet program, app, or calculator will perform IRR calculations for you, just as it will for NPV.

What’s a reasonable rate of return for a business to expect on an investment comparable to the one under consideration? Typically, it’s well above what it could get on a “risk-free” investment, such as a Treasury bill or note (which is usually the benchmark value).

In many instances, companies will set a hurdle rate, which is the minimum rate of return that all investments are required to achieve. In such instances, the IRR of the investment under consideration must exceed the hurdle rate before the company will go forward with it.

 

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Understanding Net present value analysis

The conventional way of calculating ROI has some limitations. For one thing, it doesn’t provide an accurate economic picture of the organization. That’s because it ignores the time value of money, that is the notion that any money received now is worth more than it would be worth in the future.

Also, ROI reflects the rate of return over the life of the investment, not the annual rate of return. This is a problem because you can’t analyze it in terms of annual costs and thus easily compare it with other annual returns.

Therefore in order to compensate for these limitations, you can use a method called net present value(NPV) analysis. NPV is more sophisticated because it takes into account the time value of money.

Time value of money

The time value of money principle states that a dollar you receive five years from now is worth less than a dollar you receive today. The reason: even assuming no inflation or risk, the dollar you get today can be invested somewhere. Assuming a positive return on that investment, that means you’d be able to earn more than a dollar by the fifth year.

When you’re evaluating a potential investment, you need to analyze the income you expect that investment to provide at some point in the future (n). But to do that, you have to express future dollars in terms of current dollars.

Net present value (NPV) and internal rate of return (IRR) calculations help you do that.

These analytical methods are fairly complicated. But most calculators, apps, and spreadsheet programs can make these computations for you easily.

Discount future income

To reflect the time value of money, you have to discount future cash so it’s expressed accurately in today’s dollars. Simply put, a $100 savings today will not be $100 savings five years from now.

NPV calculation

While you can use a calculator or app to calculate NPV, you need to supply the values. An NPV calculation determines the net present value of a series of cash flows according to the following algebraic formula:

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In this formula:

  • Each CF is a future cash flow, so CF1 = cash flow in the first year
  • n is the number of years over which the cash flow stream is expected to occur
  • i is the desired rate of return, or the discount rate

The discount rate in the context of financial analysis means the interest rate earned. In the United States, it refers to the rate at which banks can borrow short-term funds from the Federal Reserve Bank, and is used as a conservative proxy for the cost of funds.

In analyzing an investment, the discount rate is any market interest rate for a “riskless” asset, for example, a Treasury bill, note, or bond, whose maturity matches the investment’s time frame. For a shorter-term investment, an organization might use the rate on a Treasury bill (whose term is under one year). For a longer-term investment, it might opt for the rate on a Treasury note or bond, whose terms run 2-10 years. As a rule, the higher the discount rate, the lower the NPV, all else being equal.

Some organizations ignore the market discount rate and stick with a theoretical or historical discount for analyzing potential investments. Others use the weighted average cost of capital which averages the return of a stock, debt, and preferred stock instead. This option is sometimes used by larger organizations that issue stock.

Another option is using the rate of return for alternative investments.

Finally, consider the element of risk. A riskier investment should have a higher discount rate than a safe investment. Similarly, a longer-term investment should use a higher discount rate than a short-term project.

When you supply the values for each future cash flow, the discount rate, and the number of years, your spreadsheet, app, or calculator will do the rest.

If the NPV of an investment is a positive number, and no other investments are under consideration, the company would do well to pursue the investment. If it’s less than zero, the company should reject the investment. If it equals zero, it’s marginal, therefore, a judgment call.

NPV > 1 (GO)

NPV < 1 (NO GO)

NPV = 1 (MARGINAL)

KJTL example

In considering whether to invest in a new line of serving carts, KJTL assumes a discount rate of 6%. (Surveys show that the discount rate used by companies today varies greatly, from 3% to as much as 7%.) Plugging in the additional data for the calculation—the initial costs and expected returns—yields an NPV of $2,742 for the new line. This NPV is positive, so it suggests that the new line could be an attractive investment for KJTL.

But what about KJTL’s other possible investment , the $100,000 production-line robot? At a discount rate of 6%, the NPV for this investment is $483, which is just barely positive.

If KJTL can afford to make only one of these two investments, it should go with the new serving cart line, because the NPV is much greater.

Companies often purposely set the bar to investment high. So, what would happen if you assumed a discount rate of a more conservative 10% instead of 6% for KJTL? (A discount rate of 10% these days is very high, but is used here for the sake of illustration.) The NPV for the serving carts would be MYR –22,553; for the robot, MYR –$12,368. The serving carts were a better investment than the robot at 6%. At 10%, both investments are bad, but the serving carts are worse. This shows just how much the picture changes when a different discount rate is assumed.

INVESTMENT INITIAL COST RETURN DISCOUNT RATE NPV
Serving Carts MYR 250,000 MYR 300,000

(5 YEARS)

6% MYR 2,742
      10% MYR (22,553)
Robot MYR 100,000 MYR 126,000

(7 YEARS)

6% MYR 483
      10% MYR (12,368)