An acquisition cost, also referred to as the cost of acquisition, is the total cost that a company recognizes on its books for property or equipment after adjusting for discounts, incentives, closing costs and other necessary expenditures, but before sales taxes. An acquisition cost may also entail the amount needed to take over another firm or purchase an existing business unit from another company. Additionally, an acquisition cost can describe the costs incurred by a business in relation to the efforts involved in acquiring a new customer.
Key Takeaways
Acquisition cost refers to an amount paid for fixed assets, for expenses related to the acquisition of a new customer, or for the takeover of a competitor.
It is useful in identifying the full cost of fixed assets because it includes items such as legal fees and commissions and removes discounts and closing costs.
Acquisition costs are also useful to determine the full expense incurred in enticing new customers, and it can be used to compare to the revenue new customers generate.
Understanding Acquisition Costs
Acquisition costs provide a reflection of the true amount paid for fixed assets before sales tax is applied, for expenses related to the acquisition of a new customer, or for the takeover of other firms. Acquisition costs are useful because they recognize a more realistic cost on a company’s financial statements than using other measures. For instance, the acquisition cost of property, plant, and equipment (PP&E) recognizes any discounts or additional costs that the company will experience and is often referred to as the original book value of the asset in question.
Acquisition Costs for Fixed Assets
Besides the price paid for the asset itself, additional costs may also be considered part of acquisition when these costs are directly tied to the acquisition process. For example, if the asset in question requires legal assistance to complete the transaction, legal and regulatory fees are also included. Commissions associated with the purchase may also be included, such as those paid to a real estate agent when dealing with a property transaction, to a staffing company for placing an employee, to a marketing firm for acquiring customers, or to an investment bank for brokering a merger.
With regard to manufacturing or production equipment, any costs associated with bringing the equipment to an operational state may also be included in the cost of acquisition. This includes the cost of shipping & receiving, general installation, mounting, and calibration.
Acquisition Costs for Customers
Customer acquisition costs are those funds that are used to introduce new customers to the company’s products and services in hopes of acquiring the customer’s business. The customer acquisition cost is calculated by dividing total acquisition costs by total new customers over a set period.
Understanding customer acquisition costs is helpful in planning future capital allocations for marketing budgets and sales discounts. Costs traditionally associated with customer acquisition include marketing and advertising, incentives and discounts, the staff associated with those business areas, and other sales staff or contracts with external advertising firms. Incentives may be expressed in various formats, such as buy-one-get-one-free deals, receiving another product free with purchase, upgraded service at no additional cost to the customer, gift cards, or bill credits.
One business sector with a high occurrence of promotions directed at new customers is the wireless and cellular industry. Wireless companies often extend deals to new customers such as increased data packages, additional family phone lines for free, and discounts on the newest cellular phones. The purpose of these offerings is to entice customers to choose their business over their competitors.
An advanced internal rating-based (AIRB) approach to credit risk measurement is a method that requests that all risk components be calculated internally within a financial institution. Advanced internal rating-based (AIRB) can help an institution reduce its capital requirements and credit risk.
In addition to the basic internal rating-based (IRB) approach estimations, the advanced approach assesses the risk of default using loss given default (LGD), exposure at default (EAD), and the probability of default (PD). These three elements help determine the risk-weighted asset (RWA) that is calculated on a percentage basis for the total required capital.”
Key Takeaways
An advanced internal rating-based (AIRB) system is a way of accurately measuring a financial firm’s risk factors.
In particular, AIRB is an internal estimate of credit risk exposure based on isolating specific risk exposures such as defaults in its loan portfolio.
Using AIRB, a bank can streamline its capital requirements by isolating the specific risk factors that are most serious and downplaying others.
Understanding Advanced Internal Rating-Based Systems
Implementing the AIRB approach is one step in the process of becoming a Basel II-compliant institution. However, an institution may implement the AIRB approach only if they comply with certain supervisory standards outlined in the Basel II accord.
Basel II is a set of international banking regulations, issued by the Basel Committee on Bank Supervision in July 2006, which expand upon those outlined in Basel I. These regulations provided uniform rules and guidelines to level the international banking field. Basel II expanded the rules for minimum capital requirements established under Basel I, provided a framework for regulatory review, and set disclosure requirements for assessment of capital adequacy. Basel II also incorporates credit risk of institutional assets.
Advanced Internal Rating-Based Systems and Empirical Models
The AIRB approach allows banks to estimate many internal risk components themselves. While the empirical models among institutions vary, one example is the Jarrow-Turnbull model. Originally developed and published by Robert A. Jarrow (Kamakura Corporation and Cornell University), along with Stuart Turnbull, (University of Houston), the Jarrow-Turnbull model is a “reduced-form” credit model. Reduced form credit models center on describing bankruptcy as a statistical process, in contrast with a microeconomic model of the firm’s capital structure. (The latter process forms the basis of common “structural credit models.”) The Jarrow–Turnbull model employs a random interest rates framework. Financial institutions often work with both structural credit models and Jarrow-Turnbull ones, when determining the risk of default.
Advanced Internal Rating-Based systems also help banks determine loss given default (LGD) and exposure at default (EAD). Loss given default is the amount of money to be lost in the event of a borrower default; while exposure at default (EAD) is the total value a bank is exposed to at the time of said default.
Advanced Internal Rating-Based Systems and Capital Requirements
Set by regulatory agencies, such as the Bank for International Settlements, the Federal Deposit Insurance Corporation, and the Federal Reserve Board, capital requirements set the amount of liquidity is needed to be held for a certain level of assets at many financial institutions. They also ensure that banks and depository institutions have enough capital to both sustain operating losses and honor withdrawals. AIRB can help financial institutions determine these levels.
The Asian financial crisis, also called the “Asian Contagion,” was a sequence of currency devaluations and other events that began in July 1997 and spread across Asia. The crisis started in Thailand when the government ended the local currency’s de facto peg to the U.S. dollar after depleting much of the country’s foreign exchange reserves trying to defend it against months of speculative pressure.
Just weeks after Thailand stopped defending its currency, Malaysia, the Philippines, and Indonesia were also compelled to let their currencies fall as speculative market pressure built. By October, the crisis spread to South Korea, where a balance-of-payments crisis brought the government to the brink of default.
Other economies also came under pressure, but those with solid economic fundamentals and hefty foreign exchange reserves fared much better. Hong Kong fended off several major but unsuccessful speculative attacks on its currency, which is pegged to the U.S. dollar via a currency board system and backed by massive U.S. dollar reserves.
Key Takeaways
The Asian financial crisis started in July 1997, when Thailand stopped defending the baht after months of downward market pressure, causing the currency to fall quickly.
The contagion spread quickly, with currencies across the region falling—some quite catastrophically.
The crisis was rooted in economic growth policies that encouraged investment but also created high levels of debt (and risk) to finance it.
The International Monetary Fund (IMF) bailed out many countries but imposed strict spending restrictions in exchange for the help.
Affected countries have since put in place mechanisms to avoid creating the same scenario in the future.
Impact of the Asian Financial Crisis
As the Thai baht fell, other Asian currencies fell—some precipitously. Across Asia, inflows of capital slowed or reversed.
The Thai baht had been trading at about 26 to the U.S. dollar before the crisis but lost half its value by the end of 1997, falling to 53 to the dollar by January 1998. The South Korean won fell from about 900 to the dollar to 1,695 by the end of 1997. The Indonesian rupiah, which had been trading at around 2,400 to the dollar in June 1997, plummeted to 14,900 by June 1998, less than one-sixth its precrisis level.
Some of the more heavily affected countries fell into severe recession. Indonesia’s gross domestic product (GDP) growth fell from 4.7% in 1997 to -13.1% in 1998. In the Philippines, it slid from 5.2% to -0.5% over the same period. Malaysia’s GDP growth similarly slid from 7.3% in 1997 to -7.4% in 1998, while South Korea’s contracted from 6.2% to -5.1%.
In Indonesia, the ensuing economic crisis led to the collapse of the three-decade-old dictatorship of President Suharto.
The crisis was alleviated by intervention from the International Monetary Fund (IMF) and The World Bank, among others, which poured some $118 billion into Thailand, Indonesia, and South Korea to bail out their economies.
As a result of the the crisis, affected countries restructured their economies, generally because the IMF required reform as a condition of help. The specific policy changes were different in each country but generally involved strengthening weak financial systems, lowering debt levels, raising interest rates to stabilize currencies, and cutting government spending.
The crisis also serves as a valuable case study for economists to understand how interwoven markets affect one another, especially as it relates to currency trading and national accounts management.
Causes of the Asian Financial Crisis
The crisis was rooted in several threads of industrial, financial, and monetary government policies and the investment trends that they created. Once the crisis began, markets reacted strongly, and one currency after another came under pressure. Some of the macroeconomic problems included current account deficits, high levels of foreign debt, climbing budget deficits, excessive bank lending, poor debt-service ratios, and imbalanced capital inflows and outflows.
Many of these problems were the result of policies to promote export-led economic growth in the years leading up to the crisis. Governments worked closely with manufacturers to support exports, including providing subsidies to favored businesses, more favorable financing, and a currency peg to the U.S. dollar to ensure an exchange rate favorable to exporters.
While this did support exports, it also created risk. Explicit and implicit government guarantees to bail out domestic industries and banks meant investors often did not assess the profitability of an investment but instead looked to its political support. Investment policies also created cozy relationships among local conglomerates, financial institutions, and the regulators who oversaw their industries. Large volumes of foreign money flowed in, often with little attention to potential risks. These factors all contributed to a massive moral hazard in Asian economies, encouraging major investment in marginal and potentially unsound projects.
As the crisis spread, it became clear that the impressive economic growth rates in these countries were concealing serious vulnerabilities. In particular, domestic credit had expanded rapidly for years, often poorly supervised, creating significant leverage along with loans extended to dubious projects. Rapidly rising real estate values (often fueled by easy access to credit) contributed to the problem, along with rising current account deficits and a buildup in external debt. Heavy foreign borrowing, often at short maturities, also exposed corporations and banks to significant exchange rate and funding risks—risks that had been masked by long-standing currency pegs. When the pegs fell apart, companies that owed money in foreign currencies suddenly owed a lot more in local currency terms, forcing many into insolvency.
Many Asian economies had also slid into current account deficits. If a country has a current account surplus, that means it is essentially a net lender to the rest of the world. If the current account balance is negative, then the country is a net borrower from the rest of the world. Current account deficits had grown on the back of heavy government spending (much of it directed to supporting continued export growth).
Response to the Asian Financial Crisis
The IMF intervened to stem the crisis with loans to stabilize the affected economies. The IMF and others lent roughly $118 billion in short-term loans to Thailand, Indonesia, and South Korea. The bailouts came with conditions, though: Governments had to raise taxes, cut spending, and eliminate many subsidies. By 1999, many of the affected countries began to show signs of recovery.
Other financial institutions also intervened. For example, in December 1997, the U.S. Federal Reserve Bank brokered a deal under which U.S. banks owed money by South Korean companies on short-term loans voluntarily agreed to roll them over into medium-term loans.
Lessons from the Asian Financial Crisis
Many of the lessons of the Asian financial crisis remain relevant today. First, beware of asset bubbles, as they have a habit of bursting. Another is that governments need to control spending and pursue prudent economic development policies.
How do government spending and monetary policy affect a currency’s value?
When governments spend, implement policies that keep taxes low, subsidize the price of staple goods, or use other methods that effectively put more money in people’s pockets, consumers have more money to spend. As most economies rely at least partly on imports for many goods and services, this increased spending creates demand for foreign currency (usually U.S. dollars), as importers have to sell local currency and buy foreign currency to pay for imports.
Demand for foreign currency (and selling of local currency to buy it) increases exponentially when those policies also promote heavy investment in infrastructure, new businesses, and other economic projects. As more local currency is offered for sale on foreign exchange markets, its value goes down, unless there is a corresponding demand to buy it (say, by exporters selling foreign currency that they earn from exports).
Why do governments keep exchange rates high?
Governments, especially in developing economies, seek to manage exchange rates to balance their ability to pay debts denominated in foreign currencies. Because investors generally prefer instruments denominated in more stable currencies, governments in developing economies often raise funds by issuing bonds denominated in U.S. dollars, Japanese yen, or euros.
However, if the value of the domestic currency falls vs. the currency in which its debt is denominated, that effectively increases the debt, as more local currency is needed to pay it. So, when the Thai baht lost half of its value in 1997, that meant local borrowers needed twice as many baht to pay debts denominated in U.S. dollars. As many developing countries also rely on imports, a higher-valued local currency also makes those imports cheaper in local currency terms.
Why do governments keep exchange rates low?
Conversely, governments may seek to keep their exchange rates low to increase the competitiveness of exports.
In the 1980s, following years of complaints from U.S. companies about competition from cheap Japanese imports, the U.S. government convinced Japan to allow its currency to appreciate as part of the Plaza Accord. The currency’s value climbed from 250 yen to one U.S. dollar in early 1985 to less than 130 yen by 1990. The U.S. trade deficit with Japan fell from $55 billion in 1986 to $41 billion in 1990.
The Bottom Line
In 1997, decades of economic policy planning that featured close relationships among government policy planners, regulators, the industries they regulated, and financial institutions came to a head when markets began putting downward pressure on Asian currencies. The most vulnerable were those countries with high levels of debt and insufficient financing to pay it.
The IMF stepped in to bail out the most affected economies, but it imposed strict conditions in exchange for the help. Some measures included requiring governments to cut spending, raise taxes, eliminate subsidies, and restructure their financial systems.
The crisis also serves as a case study in asset bubbles and how quickly panic selling can trigger contagion that central bankers cannot control.
A 12B-1 plan is a plan structured by mutual fund companies for the distribution of funds through intermediaries. 12B-1 plans provide mapping for the partnerships between distributors and intermediaries who help to ensure the sale of a fund. Sales commission schedules and 12B-1 distribution expenses are the primary components driving a 12B-1 plan.
Understanding the 12B-1 Plan
12B-1 plans facilitate the partnerships between distributors and intermediaries offering mutual fund shares. 12B-1 plans are primarily focused on open-end mutual funds, which have multiple class structures for sales charges and distribution expenses. Mutual fund companies consider two types of 12B-1 charges in their 12B-1 plans, sales commissions, and 12B-1 expenses.
Sales Commissions
Sales commission schedules are structured to provide compensation to intermediaries for transacting mutual funds. These partnerships can help to increase demand for funds by being marketed from a full-service broker-dealer who facilitates the transaction for a sales load fee. These fees are paid to the broker and are not associated with annual fund operating expenses.
Sales loads are structured to vary across share classes. Share classes can include front-end, back-end, and level-load sales charges. These sales charges are associated with individual retail share classes which typically include Class A, B, and C shares.
12B-1 Expenses
12B-1 expenses paid from the mutual fund to distributors and intermediaries are also a key part of a 12B-1 plan. To market and distribute open-end mutual fund shares, mutual fund companies work with distributors to get their funds listed with discount brokerages and financial advisor platforms. Distributors help fund companies partner with the full-service brokers that transact their funds at the agreed-upon sales load schedule.
Mutual fund companies will pay 12B-1 fees from a mutual fund to compensate distributors. In some cases, funds may also be structured with a low-level load that is paid to financial advisors annually during the course of an investor’s holding period.
Financial industry legislation typically restricts 12B-1 fees to 1% of the current value of the investment on an annual basis, but fees generally fall somewhere between 0.25% and 1%. In most cases, fund companies will have higher 12B-1 fees on share classes paying a lower sales charge, and lower 12B-1 fees on share classes with higher sales charges. This helps to balance out the compensation paid to intermediary brokers while also providing for payment to distribution partners.
Disclosure
Mutual fund companies are required to provide full disclosure on their sales load schedules and 12B-1 annual fund expenses in the fund’s prospectus. The prospectus is one aspect of documentation required for the mutual fund’s registration and is also the key offering document providing information on the fund for investors. 12B-1 plans and any changes to their expense structuring must be approved by the fund’s board of directors and amended in its prospectus filed with the Securities and Exchange Commission.
