New Year’s Resolution to Save More? Here’s Some Motivation…

Here is a thought exercise -- think about what you spend money on and if there is a way to cut back on individually small expenditures. Suppose that you routinely order an extra drink or two at a coffee shop or bar. And let's say you're able to pinpoint a few other items to save on, and can spend an average of $15 less per day.

Saving an extra $15 per day, and investing this amount at the end of each year, can boost your finances considerably more than you’d expect.  With inevitable fiscal pressures threatening the viability of Social Security, Medicare, and pension systems, you would be very wise to do this if at all possible.

If you’re 25 now, let’s consider the extra money you’ll have at age 65.  Assuming 6.5% investment returns and a 2.5% inflation rate, saving an extra $15 per day will generate extra pre-tax savings of… $1,433,208!

Note:  Your contributions will need to keep up with inflation, which should rise at a similar rate to your income.  In this scenario, you would save $15.38/day next year, $15.76/day in 2015, etc.

You may be wondering how $15/day could generate so much additional wealth for you.  Perhaps you’re in a position to save an extra $5, $10, or $25/day rather than $15.  If we modify the rates for inflation and investment returns, how would that impact the savings calculation?  What if you want to save money for a 5- or 10-year goal, rather than 40?

If you want the answers to any of these questions, e-mail me at krkreflections@gmail.com and I will send you a very user-friendly Excel spreadsheet where you can obtain these findings instantly.

Excise Tax on Medical Devices

The Patient Protection and Affordable Care Act, more commonly referred to as Obamacare, will have far-reaching consequences in the health care industry. (See the first paragraph of this previous post for my take on how congressional bills are named.)

Without getting into the political, moral, and religious implications of the legislation, it is important to consider the economic impact.  Let’s look at one single provision of the ~400,000 word statute.  To raise tax revenue, a 2.3% excise tax on the sales of medical devices went into effect on January 1, 2013.  At first glance, this figure may not seem especially high, but this tax is on sales, not profits.

Traditional corporate taxes are paid on profits, so if a company sells $10 million of furniture, and incurs $9 million of expenses, its pre-tax profit is $1 million.  The federal corporate tax rate of 35% is applied to this figure, so $350,000 goes to the federal government and $650,000 is kept by the company.  A start-up company is likely to lose money for years, and it pays no federal tax because it is unprofitable.

The Obamacare tax on medical device companies, which manufacture a wide array of products, behaves differently.  Start-up companies now have to pay taxes despite being unprofitable, which is devastating from a cash flow perspective and could threaten their viability.  The 2.3% tax on top-line revenues has a huge effect on the profitability of mature companies as well.  These calculations below illustrate comparing 2012 vs. 2013 for three hypothetical companies with pre-tax profit margins of 20%, 5%, and -10% (start-up):

Pre-Tax Profit Margin = Pre-Tax Profit / Gross Revenue
Net Income is based on 35% corporate tax rate

20% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$800		$800
Pre-Tax Profit	$200		$177
Net Income (Profit)	$130		$115
Net Income fell by 11.5%

5% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$950		$950
Pre-Tax Profit	$50		$27
Net Income (Profit)	$33		$18
Net Income fell by 46.0%

10% Pre-Tax Loss for Start-up Company
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$1,100		$1,100
Pre-Tax Profit	-$100		-$123
Net Income (Profit)	-$65		-$80

Net income fell by $15, but actual cash loss was $23 because losses for a start-up can only be offset by future gains

These results are staggering, because a 2.3% tax may not register as being huge, but it is extremely problematic for the industry.  Profitability falls by 11.5% for a firm with a pre-tax profit margin of 20%, and 46.0% for a firm with a pre-tax profit margin of 5%.  Start-up companies looking to create innovative products that could help save or improve our lives now face a huge additional financial burden that could threaten their existence and cause a slowdown in entrepreneurial capital flowing into the industry.

At a time where tens of millions of baby boomers are requiring more health care services, it is instructive that many medical device manufacturers have resorted to layoffs over the past two years to cut costs in response to this excise tax.  The companies will also have no choice but to pass on costs to hospitals, physicians, and consumers, thereby increasing, rather than decreasing, the cost of health care.  This illustrates yet another example of government policy producing unintended economic consequences.

Source:  http://mblb.com/wp-content/uploads/2012/04/Medical-Symbol2.jpg

General Motors and Chrysler

A contributing factor to Barack Obama's defeat of Mitt Romney on November 6, 2012 was a New York Times op-ed authored by Romney on November 18, 2008. General Motors and Chrysler were hemorrhaging money amidst the sharp economic downturn, attributable to both low demand for automobiles and an unsustainably high cost structure. If the automotive manufacturers closed down entirely, many suppliers (primarily located in the Midwest) would have suffered irreparably and be forced to shut down their own operations. Having read Romney's op-ed the morning of publication, his methodical outline of the situation was rooted in a unique perspective – his father actually ran a Detroit car company called American Motors.

http://www.nytimes.com/2008/11/19/opinion/19romney.html

The New York Times editorial staff’s headline associated with Romney’s op-ed, “Let Detroit Go Bankrupt,” ended up resonating very poorly among some of the 2012 electorate because of the negative connotations associated with bankruptcy.  In debates and on the campaign trail (particularly Ohio and Wisconsin), President Obama repeatedly accused Romney of wanting to let Detroit go bankrupt.  This charge was not effectively countered by the Romney campaign, and losing Ohio sealed his fate on Election Day.

In this context, it may be surprising that the actual content of Romney's fateful piece is in fact quite moderate and business oriented, rather than politically oriented. He addressed failures of management, GM and Chrysler's lack of product competitiveness amidst high gasoline prices, and how labor unions had extracted untenable wages, benefits, and pensions during the good industry years of the early 2000s.

Crucially, Romney became the first major public figure to propose a long-term solution other than just throwing money at the problem, and some of his proposals were indeed incorporated by the Obama Administration in early 2009. The government would oversee a pre-packaged bankruptcy process, where the companies could avoid liquidating all their assets, and customer warranty agreements would be protected.

A critical difference emerged, however, between Romney's proposal and what the Obama Administration implemented. The next article below discusses this difference, centered on the companies' creditors. While the bankruptcy process may not seem like an incredibly compelling topic, the consequences of these 2009 actions are far-reaching, and almost certainly affected you as taxpayers or your family members as investors and/or pensioners.

Source: http://kids.britannica.com/comptons/art-54773/Detroit-Michigan

Lending to a Company

In order to finance operations, companies need to obtain cash by either borrowing money (debt) or issuing equity (stock). When most people think of the financial markets, the stock market immediately comes to mind, yet the credit market is much larger. In the stock market, if you purchase five Apple shares at $500/share, you pay $2,500 to own 0.0000005% of the company's market value of $500 billion, hoping the market value will increase over time.

A company's equity represents what is left over after paying all other obligations, and is driven by earnings (profits). Earnings fluctuate, and a struggling company may experience a decline in its stock price. A firm can struggle to the point where its liabilities exceed its assets, such as GM and Chrysler, and the value of its stock becomes worthless ($0/share). Investors in the stock market demand a higher rate of return than investors in the bond market, because it is a riskier investment and they need to be compensated for taking that extra risk.

While this prioritization holds true between debt and equity, debt itself can be divided into different tranches that vary according to risk and return. This diagram depicts different investments that can be made in a given company, and ranks the investment types from lowest risk to highest risk.

Source:  https://www.fiig.com.au/learn/educational-articles/2009/07/10/capital-structure---a-detailed-assessment

Before the Equity investors can be paid $1 in dividends, the company is legally obligated to pay all other investors. The Senior Secured Debt investors may demand a 4% annual return, 5% for Senior (Unsecured) Debt investors, 8% for Subordinated Debt investors, and Equity investors receive whatever is left over. Debt investors receive their principal back with interest, but don't receive any upside – a lender to Apple ten years ago would receive the same amount of money whether Apple's stock was $10/share or $500/share.

Without going into great detail here, the GM and Chrysler bailouts deviated from what always happens when a company files for bankruptcy. The Senior Secured Debt investors consisted of banks, mutual funds, and pension funds. Many of you have investments in corporate debt through mutual funds (401k and brokerage accounts), and you have family members who receive private or public pensions. Many such funds lent money to GM and Chrysler, either directly or in the secondary market, knowing that by law, they would receive top priority on any money that could be recovered from the companies in the event of bankruptcy.

In the 2009 bailout, this fundamental principle was completely revamped. Politically favored groups (i.e., United Auto Workers union) had claims in the Senior Unsecured Debt tranche, which was below the Senior Secured Debt group consisting of the banks and investment funds. Despite having legal priority, the Senior Secured group was substantially pressured and felt, shall we say, obligated to accept far worse terms than what the Senior Unsecured group received. Tens of billions of U.S. taxpayer dollars were also used to indirectly prop up the Senior Unsecured group, and you will be financing the principal and interest on that loss for decades to come.

The managed bankruptcy process provided an opportunity to make Detroit sustainably competitive with other automakers (many of whom have significant operations in the U.S.). Instead, very little was done about its burdensome cost structure. Moreover, arbitrarily overhauling bankruptcy law increases the risk premium required by lenders, so automakers and other industries with similar issues will incur more interest expense in the years ahead. Increased expenses leads to fewer profits, which leads to lower stock prices, which leads to less money for investors and pensioners, and results in fewer jobs in those industries. Time will tell if these issues will (yet again) cause financial hardship for GM and Chrysler.