Comment by MuffinFlavored | Hacker News Reader

Comment by MuffinFlavored | Hacker News Reader

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> Losing money now to make money in the future isn't sexy anymore. So you have to fire people until you make money now.

I am familiar with this concept but I'm curious if you could teach me more on the specifics. I think what you are referring to is basically "cost of capital analysis".

If the companies weren't hiring/paying payroll with debt at 0.5%, why does the fact matter that debt would now hypothetically cost them 5% come into play? Are they up against the fact that their projects (after payroll and all expenses) need to return more than the risk free rate (4-5%)? Why would that matter? Are tech projects really that unprofitable? I figured most projects at tech companies are easily 20%+ in terms of margin.

> For companies like FAANG - which are ridiculously profitable - it's still the same.

Would you go as far as to say Microsoft laying off 10,000 and Amazing laying off 18,000 people had next to nothing to do with the federal funds rate then?

I am just learning about too, but I think the explanation goes something like this: Because the risk-free rate of return is now much higher, the net present value of the estimated future cash returns from that investment has gone down. Another way to look at it, earning a dollar today is now worth much more than earning a dollar in five years.

Just how much has it increased? If we use the 3-month Treasury bill rate as the risk-free return, it has gone from 0.05% to 4.64%. A dollar in five years used to be worth (1 / 1.0005^5) and now it is only worth (1 / 1.0464^5). That's a drop of 25%, definitely significant enough to make some speculative and longer-term investments no longer pencil out.

> Because the risk-free rate of return is now much higher, the net present value of the estimated future cash returns from that investment has gone down.

When the risk free rate was 0.25%, the net present value of estimated future cash returns was X

Now, the risk free rate (2 year) is 4.50%. A different of 4.25%, therefore the net present value of estimate future cash returns is whatever X was, but 4.25% worse

For a company like Microsoft, how does that translate to layoffs? If their project was profitable to the tune of 10% margins and the risk free rate makes it only 5%, why are they getting rid of the entire project?

Or, did they have projects that had 5% net margin, and now the projects are breakeven, so they get rid of them? That would mean the people who got laid off at Microsoft were almost unanimously working on projects that were only netting Microsoft 5% net margin? I thought tech had better margins than that?

> If their project was profitable to the tune of 10% margins and the risk free rate makes it only 5%

The 5% needs to be weighed against the cost of capital, not just the absolute return from the company's perspective. A 5% return sounds fine but if the market is now pricing equities for a 7% return then a company is lighting money on fire by making that 5% investment (because they can return the cash to shareholders who can invest in other businesses at 7%).

I don't understand.

Let's say it was hypothetically like this.

Microsoft

2019

Cost of capital: 0.25% (should be irrelevant because they had billions in cash on hand but let's assume they refuse to use it for whatever reason and instead went to banks to get loans to pay for employees working on projects)

They work on a project, it returns 20% gross. 20% - cost of capital = ROI of 19.75%

2022

Cost of capital: 4.50%

Project returns 20% gross still, but now the net ROI is 15.5%

Why would you lay off employees who could bring you 15.5% (average project profitability assumption?) in favor of instead parking your cash for the risk free rate of 4.5%?

In that hypothetical I do not think they would necessarily do layoffs. The more likely scenario would be:

2019 Cost of capital: 7%, gross return 10% for 3% excess return

2022 Cost of capital: 12%, gross return 10% for -2% excess return

In which case that project would get cut and layoffs would occur.

Another way you can think about this: imagine you have a portfolio that makes 10% every year and risk free rate is zero. If you reinvest your returns (ie compound returns), in 10 years time you'll have made 160% of your original investment vs. 0% if you kept your money in a risk free portfolio.

But now let's say that risk free rates are 5%, which means that your portfolio has to compete with a net positive value asset that is essentially free of risk and in the same 10 year horizon will make you 60%, so your excess profits are now "only" 100%, which is a significant reduction from the original value proposition.

Thus, for the same risk profile, investment firms have to become much more restrictive in what they put in their portfolio. An entire class of investments (e.g. companies who are not expected to ever make money but have hype) has become basically a negative value proposition.

The Fed's dot plot shows they plan on lowering interest rates within the next 24 months.

How can Microsoft (big tech company) not have faith that their highly paid engineers + managers can't build amazing products efficiently (aka not costing too much) to the point where they can outcompete the risk free rate which is temporarily ~5% and headed back down to 2-3% within the next 2-3 years most likely?

Sure, but 24 months is six quarters of potentially lower returns and share price. Execs are bonused on share price appreciation so the layoffs make sense to them.

Ostensibly, company valuation should be reflective of the sum of its future cash flows discounted back to today, with the discount rate being the risk free rate + risk premium (simplifying). If the risk free rate increases, the discount rate increases, if the discount rate increases, future cash flows become meaningfully less valuable than current cash flows. Which means that at the margin, management teams are incentivized to produce higher near term cash flows at the expensive of future ones, one way of doing that is reducing costs…

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