AN INTRODUCTION TO ACCOUNTING andMANAGERIAL FINANCE A Merger of Equals
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NEW JERSEY LONDON SINGAPORE BEIJING SHANGHAI HONG KONG TAIPEI CHENNAI World Scientifc Harold Bierman, Jr. Cornell University, USA AN INTRODUCTION TO ACCOUNTING andMANAGERIAL FINANCE A Merger of Equals
Library of Congress Cataloging-in-Publication Data Bierman, Harold.An introduction to accounting and managerial finance : a merger of equals /by Harold Bierman.p. cm.Includes index.ISBN-13: 978-981-4273-82-4 (hardcover)ISBN-10: 981-4273-82-1 (hardcover)1. Corporations--Accounting. 2. Corporations--Finance. I. Title.HF5636.B54 2009657--dc222009034159 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library.For photocopying of material in this volume, please pay a copying fee through the CopyrightClearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission tophotocopy is not required from the publisher.Typeset by Stallion PressEmail: enquiries@stallionpress.com All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means,electronic or mechanical, including photocopying, recording or any information storage and retrievalsystem now known or to be invented, without written permission from the Publisher. Copyright © 2010 by World Scientific Publishing Co. Pte. Ltd. Published by World Scientific Publishing Co. Pte. Ltd.5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HEPrinted in Singapore. Wanda - An Intro to Accounting.pmd3/8/2010, 6:19 PM1
November6,200913:43spi-b8119inx6inb811-fm Preface Introductoryaccountingandfnancehavetraditionallybeentaughtastwoseparatecourses,eventhoughtheimportanceofabasicknowledgeoffnanceinlearningaccountingandaknowledgeofaccountinginlearningfnancehavebeenwidelyacknowledged.Oneimportanthistoricalreasonforhavingtwoseparatecourseswasthat,inthepast,fewprofessorscouldteachbothcourseswell.Thislackofcompetentinstructorshasdisappeared,andtherearenowmanyprofessorswhocanwellintegratethebasicelementsofaccountingandfnance.Accountingisanever-evolvingart.Understandingaccountingisnecessarytounderstandfnancialreportingbybusinessorganizationsandtheusesoffnancialreportsbydecisionmakers,bothinternalmanagersandfnancialanalysts.Thestructureofaccountingisanimportanteducationaltool.Thebasiclogicofthedebit-creditprocessiselegantandlogicallyconsistent.Theuseofdebitsandcreditsemphasizestherelationshipsbetweenaccountsandsimplifestheexplana-tionofawiderangeoffnancialtransactions.Thisbookisalsoanintroductiontocorporatefnancialmanagement,build-ingonthebasiccapitalbudgetingframeworkandthetimevalueofmoney.Theobjectiveistostressthetheoreticalformulationsthataremostusefulinmakingmanagerialfnancialdecisions.Aworkingknowledgeofthetimevalueofmoneyisessentialtohavingacompleteliberaleducation.Theterms netpresentvalue , internalrateofreturn ,and capitalassetpricingmodel aretodaywidelyusedbymanagers.Afewyearsago,thepersonsinimportantmanagerialpositionsmighthavesaidthattheymadethefrm’sbigdecisionsonthebasisoftheirexperience,judgment,andintuition.Now,topmanagersinsistmoreandmoreonhavingfnancialinformationproperlyanalyzedbeforetheyexercisetheirjudgments.Manyofthefnancialmodelsaresimplifcationsoftherealworld.Iftheyweretobeappliedwithoutthought,itislikelythatsomeofthemodelswouldleadtoundesirabledecisions.However,ifusedcorrectly,suchmodelswillgiveinsightsintotheweaknessesofother,moresimplifedanderroneousdecision-makingtech-niques.Thisbookemphasizesthatthecorrectapplicationoffnancialtechniques v
November6,200913:43spi-b8119inx6inb811-fm vi AnIntroductiontoAccountingandManagerialFinance inbusinesssituationsimprovesthelikelihoodofmakinggooddecisions.However,exactanswersandcorrectdecisionsarenotalwaysguaranteedinacomplexanduncertainworld.Thisbookisbasedonanumberoffundamentalprinciples.First,thetimevalueofmoneyisusedasthebasicfoundationforalargeamountoftheanalysis.Second,decisionsareapproachedonanafter-taxbasis.Third,wehaveavoidedrelativelycomplexmodelsthataremoreappropriateforamoreadvancedfnancecourse.Fourth,weemphasizedecisionmaking.Weemphasizethemodelsandmethodsofanalysisthataremostusefulandpracticalratherthandiscussingtheoryfortheory’ssake.Finally,oncethereaderunderstandsthebasicconceptsandmethods,wethinkitisimportanttointroducevariousreal-worldconstraintsandcomplexities.Iacknowledgetheinvaluablecontributionsofmyco-authorsonotherwritingprojects,SySmidt,JerryHass,andBobSwieringa.Whilethesefriendsandcol-leaguescannotbeheldresponsibleforanymistakes(misstatements),theydidhelpcontributesignifcantlytomyunderstandingofthetopicscoveredinthisbook. HaroldBierman,Jr. CornellUniversity
November6,200913:43spi-b8119inx6inb811-fm Contents PrefacevChapter1.Finance,AccountingandCorporateObjectives1Chapter2.TheTimeValueofMoney13Chapter3.AnIntroductiontoFinancialReporting29Chapter4.CapitalBudgeting57Chapter5.TheIncomeStatement85Chapter6.ComparingtheUseofCashFlowsandIncomes101Chapter7.DepreciationExpense111Chapter8.Long-TermLiabilities137Chapter9.Stockholders’Equity151Chapter10.DistributionstoShareholders167Chapter11.CapitalStructure:WeightedAverageCostofCapital(WACC)193Chapter12.BuyversusLease223Chapter13.PreferredStock247 vii
November6,200913:43spi-b8119inx6inb811-fm viii AnIntroductiontoAccountingandManagerialFinance Chapter14.ManagerialPerformance259Chapter15.MergersandAcquisitions:Consolidations289Chapter16.ConvertibleBonds323Chapter17.Inventories343Chapter18.TheCashFlowStatement363Appendices377AbouttheAuthor385Index387
November6,200913:43spi-b8119inx6inb811-ch01 Chapter1 Finance,AccountingandCorporateObjectives CorporateObjectives Themotivationforbuyingthecommonstockofacorporationistheexpectationofmakingalargerrisk-adjustedreturnthancanbeearnedelsewhere.Themanagersofacorporationhavetheresponsibilityofadministeringtheaffairsofthefrminamannerconsistentwiththeexpectationofreturningtheinvestors’originalcapitalplustherequiredreturnontheircapital.Thecommonstockholdersaretheresidualowners,andtheyearnareturnonlyaftertheinvestorsinthemoreseniorsecurities(debtandpreferredstock)havereceivedtheircontractualclaims.Wewillassumethattheobjectiveofthefrmistomaximizeitscommonstockholders’wealthposition.Stockholdersinvestinacorporationwiththeexpectationofmakinganetgainontheirinvestmentconsistentwiththeinvestment’srisk.Themanagersandtheboardofdirectorsofacorporationhavetheresponsibilityofadministeringtheaffairsofthefrminamannerconsistentwiththeinterestsofthestockholders.Thus,oneofmanagement’sprimarygoalsshouldbethemaximizationofstockholders’wealth.Althoughcorporationsmighthaveotherobjectives(suchasfulfllingtheirsocialresponsibilitiesortreatingtheirworkersfairly),wewillfocusourattentiononthemorenarrowcorporategoalofstockholderwealthmaximization.Buteventhisnarrowdefnitionisapttogiverisetomisunderstandingandconfict.Itisverylikelythatsituationswillarisewhereonegroupofstockholderswillpreferonefnancialdecisionwhileanothergroupofstockholderswillpreferanotherdecision.Forexample,imagineasituationwhereabusinessundertakesaninvestmentthatisdeemedtobedesirablebymanagement,buttheimmediateeffectoftheinvestmentwillbetodepressearningsandthecommonstockpricetoday.Inthefuture,themarketmayrealizethattheinvestmentisdesirable,andatthat 1
November6,200913:43spi-b8119inx6inb811-ch01 2 AnIntroductiontoAccountingandManagerialFinance timethestockpricewillrefecttheenhancedvalue.Butthestockholdersexpectingtoselltheirstockinthenearfuturewouldpreferthattheinvestmentberejected,whilestockholdersholdingforthelongrunwouldpreferthattheinvestmentbeundertaken.Astatementsuchas“proftmaximization”doesnotadequatelydescribetheappropriateobjectiveofthefrm,sinceproftsareconventionallycomputedanddonoteffectivelyrefectthecostofthestockholders’capitalthatistiedupintheinvestment.Totalsalesorshareofproductmarketarealsoinadequatenormativedescriptionsofcorporategoals,althoughthesegoalsmayalsoleadtomaximizationoftheshareholders’wealthpositionbytheirpositiveeffectonprofts.Sincethemanagersofacorporationareactingonbehalfofthestockholders,thereisafduciaryrelationshipbetweenthemanagers(andtheboardofdirec-tors)andthestockholders.Thestockholders,thesuppliersoftheriskcapital,haveentrustedapartoftheirwealthpositiontothefrm’smanagement.Thus,thesuccessofthefrmandtheappropriatenessofmanagement’sdecisionsmustbeevaluatedintermsofhowwellthisfduciaryresponsibilityhasbeenmet.Theaccountingreportsmeasure(attheirbest)howwellmanagementismeetingthisgoal. ManagerialFinance Thestudyofmanagerialfnanceisconcernedwiththefnancialdecisionsofafrm(asdistinctfromthestudyofthestructureofmarketsforobtainingcapital).Webreakthefrm’sdecisionsdownintothreebasictypes:1.Investmentdecisionsor,moregenerally,theallocationoffundsamongdifferenttypesofassetsoractivities.2.Theobtainingofcapitalintheappropriatemixtureofdebtandcommonstockorothersecurities.3.Thedividendordistributiondecision(givingoffundsbacktocommonstockinvestorsinreturnfortheuseofthecapital).Weshallfndthatthereareanalyticalmethodsofanalyzingallofthesedeci-sions.Insomecases,wecanreachfairlydefnitejudgmentsastocorrectandincorrectdecisions;inothers,wecanonlyidentifytherelevantquantitativeandqualitativeconsiderations.Businessorganizationsarecontinuallyfacedwiththeproblemofdecidingwhetherthecommitmentsofresources—timeormoney—areworthwhileintermsoftheexpectedbenefts.Ifthebeneftsarelikelytoaccruereasonablysoonaftertheexpenditureismade,andifboththeexpenditureandthebene-ftscanbemeasuredindollars,thesolutiontosuchaproblemisrelativelysimple.
November6,200913:43spi-b8119inx6inb811-ch01 Finance,AccountingandCorporateObjectives 3 Iftheexpectedbeneftsarelikelytoaccrueoverseveralyears,thesolutionismorecomplex.Weshallusetheterm investment torefertocommitmentsofresourcesmadeinthehopeofrealizingbeneftsthatareexpectedtooccuroverareasonablylongperiodoftimeinthefuture.Capitalbudgetingisamany-sidedactivitythatincludessearchingfornewandmoreproftableinvestmentproposals,investigatingengi-neeringandmarketingconsiderationstopredicttheconsequencesofacceptingtheinvestment,andmakingeconomicanalysestodeterminetheproftpotentialofeachinvestmentproposal. TheFinanceManagers Financemanagers(fnancialvice-presidents,controllers,treasurers,etc.)areresponsibleforawiderangeofdecisionsmadeinacorporation.Theaccountsthatappearonabalancesheetcanbeusedtodescribethetasksofafnanceman-ager.Ontheassetside,thereistheadministrationofcurrentassets(managingcash,investinginshort-termsecurities,anddeterminingandadministeringacreditpol-icy)andlong-termassets(i.e.,makingcapitalbudgetingdecisionsthatcommitthecompanytoinvestmentsinlong-livedassets).Shiftingtotheequity(liabilitiesandstockholders’equity)sideofthebalancesheet,thefnancemanagerisresponsibleforofferingadviceastothebestfnancialstructure(determiningtherelativeuseofdebt,preferredstock,orcommonstock)andthecharacteristicsofthefrm’ssecuritiesandthenimplementingthedecisionsthataremade.Decisionsdescribedinthisbookcanberelatedtodecisionsthatinvolveoneormoreoftheaccountsonabalancesheet.Thisbookwilloffersuggestionsonhowtoimprovethelikelihoodofmakingthecorrectdecision,althoughfrequentlyitwillbeseenthatabsolutelycorrectchoicescannotbemade.Tostudyproblemsofamanageablesize,weshallgenerallyassumethataspecifcdecisiondoesnotaffectotherdecisions.Thisnaïveassumptionmaynotbevalidbecauseoftheinterrelationshipsofdecisions,butitdoesenableustogainunderstanding.Afterthisunderstandingisachieved,thecomplexitiescanbeintroduced.Weshalllearntowalkbeforewetrytorun. Time,Risk,andtheRisk-ReturnTrade-off Twoprimaryfactorsthatmakefnanceaninterestingandcomplexsubjectaretheelementsof time and risk .Becausedecisionstodayoftenaffectcashfowformanyfuturetimeperiodsandwearenotcertainastotheoutcomesofouractions,wehavetoformulatedecisionrulesthattakeriskandtimevalueintoconsiderationin
November6,200913:43spi-b8119inx6inb811-ch01 4 AnIntroductiontoAccountingandManagerialFinance asystematicfashion.Thesetwoproblemsareasintellectuallychallengingasanyproblemthatoneislikelytoencounterintheworldofeconomicactivity.Frequently,theexistenceofuncertaintymeansthatthedecisionmakerfacesalternativesthatinvolvetrade-offsoflessreturnandlessriskormorereturnandmorerisk.Alargepartofthestudyoffnancehastodowithlearninghowtoapproachthistypeofrisk-returntrade-offchoice. ThreeBasicGeneralizations Weofferthreegeneralizationsthatareusefulinthetypesoffnancialdecisionsthataretobediscussed.Thefrstgeneralizationisthatinvestorsprefermorereturn(cash)toless,allotherthingsbeingequal.Investorswhothinkthatthereturnsareexcessivelyhighcoulddistributetheexcessinsuchamannerthattheresultswouldmeettheircriterionoffairness.Thesecondgeneralizationisthatinvestorspreferlessrisk(apossibilityofloss)tomoreriskandhavetobepaidtoundertakeriskyendeavors.Thisgeneralizationiscontrarytocommonobservationssuchastheexistenceofracetracksandgamblingcasinos(wherethecustomersofsuchestablishmentsarewillingtopayfortheprivilegeofundertakingriskyinvestments),butthegeneralizationisusefuleveniftherearesomeexceptions.Thethirdgeneralizationisthateveryonepreferscashtobereceivedtodayratherthanforthesameamounttobereceivedinthefuture.Thisonlyrequiresthereasonableassumptionthatthefundsreceivedtodaycanbeinvestedtoearnsomepositivereturn.Sincethisisthesituationintherealworld,thegeneralizationisreasonable.Thesethreegeneralizationsareusedimplicitlyandexplicitlythroughoutthebook. RelevanceofCashFlows Giventheobjectiveofstockholderwealthmaximization,howshouldindividualfnancialdecisionsbeevaluated?Forthepubliclytradedfrm,itisconvenienttoassumethatthemarketvalueofthestockisareasonablemeasureofwealth.Themarket’sassessmentofthefrm’sfutureismanifestintoday’sstockprice,butunfortunatelythisassessmentisnotalwaysaccurate.Fortheprivatelyheldfrm,wherethereisnomarketvalue,thewealthpositionisevenmorediffculttoassess.Theoretically,alternativeactionsshouldbeevaluatedbasedontheextenttowhichtheywillimprovethemarketvalueofthestock,andtheactionleadingtoamaximizationofvalueshouldbechosen.Unfortunately,whilethisevaluation
November6,200913:43spi-b8119inx6inb811-ch01 Finance,AccountingandCorporateObjectives 5 schemeiscorrect,itissometimesnotoperational,forthechainofrelationshipsbetweenadecisionanditsultimateimpactonthevalueofequityislongandcomplicated.Asstatedabove,thedecisiontimehorizonmayaffectthechoiceofdecision.Thereis,however,anapproachthatcanbeusedtoevaluatealldecisions.Thedecisionmakershouldfocusonthecashfowsresultingfromthedecision.Anydecisionthatisexpectedtoaltertheanticipatedcashfowsofthefrmislikelytoalterthevalueofthefrm’scommonstock.Cashisthecommonelementinallfnancialdecisions:investmentsrequireit,creditorsarepaidwithit,andstockholdersexpecttoreceiveitintheformofdividendsorcapitalgains.Thus,mostfnancialdecisionscanbecharacterizedbytheincrementalcashfowsthattheiracceptanceisexpectedtocause. CashFlowsversusEarnings Adecisionmaybecharacterizedbyitseffectonaccountingearningsaswellasbyitsincrementalcashfows.Theearningsandcashfowswouldleadtoconsistentdecisionsifitwerenotforthefactthatearningsareaffectedbymanyaccount-ingconventions,suchasexpenseversuscapitalizationdecisionsandthechoiceofadepreciationmethod.Thus,followingGenerallyAcceptedAccountingPrin-ciples,aninvestmentmightgeneratesubstantialcashfowsinitslateyearsbutadverselyaffectproftsduringtheearlyyearsiftheinitialinvestmentdepreciatesrapidly.Assumingthefrmhassuffcientcashinfowswithwhichtomeetitscashobligations,theinvestmentmaybedesirableregardlessofthelackofshort-runproftability.Ofcourse,long-runproftabilityisanecessarycondition.Ifalltheexpensescannotbecoveredoveralltheyearsofthelifeofthedecision,thentheeffectofthedecisiononthestockholders’wealthpositionwillbenegative.Prof-itabilityisasuffcientconditionforasuccessfuldecisioniftheproftsarecorrectlymeasured.Butthecorrectmeasureofproftsisadiffculttask,andnotalwaysperfectlyexecutedbytheaccountingprofession.Sincecashfowsareeasilymeasured,whenproperlydiscountedfortimeandadjustedforrisktheyareagoodproxyforprofts.Weconsidercashfowstobearelevantmeasureoftheimpactofadecisiononthefrm,andwillusecashfowsastheprimaryinputinthefnancialdecisionstobeanalyzed. AMergerofEquals Intheparlanceoffnance,amergerofequalsoccurswhenamergerisexecutedwiththestockholdersofboththefrmbeingacquiredandthefrmdoingtheacquiring
November6,200913:43spi-b8119inx6inb811-ch01 6 AnIntroductiontoAccountingandManagerialFinance receivingthesamevalueafterthemergerastheydidbeforethemerger.Inthetitleofthisbook,thereferencetoamergerofequalsimpliesthatbothaccountingandknowledgeoffnancecontributetomakinggoodfnancialdecisions.Therefollowsanexampleofamerger-of-equalsvaluecalculation.Example:ParentfrmwantstoacquireTargetfrm. CompanyStockPriceSharesOutstandingMarketCapitalization Parent$50500$25,000Target100404,000 Total$29,000 AssumeParentshareholdersretaintheir500sharesworth$50each.Targetmustreceive N shareswithavaluepershareof P .Target’ssharesmusthaveatotalvalueof$4,000. NP = 4 , 000or P = 4 , 000 N. Inaddition,thetotalvalueofmergedfrmsmustequal$29,000.29 , 000 = P(N + 500 ) or29 , 000 = 4 , 000 N(N + 500 ) 29 , 000 N = 4 , 000 N + 4 , 000 ( 500 ) 25 , 000 N = 4 , 000 ( 500 ) 25 N = 4 ( 500 )N = 4 ( 20 ) = 80and P = $50 . GiveTarget80shares(twoforeachoutstandingshare)withatotalvalueof$4,000.Withanewstockvalueof$50,wehaveforthemergedfrmvalue:50 ( 500 + 80 ) = $29 , 000 . TheCapitalMarket Corporationsatsomestageintheirlifearelikelytogotothecapitalmarkettoobtainfunds.Themarketthatsuppliesfnancialresourcesiscalledthecapitalmarketandit
November6,200913:43spi-b8119inx6inb811-ch01 Finance,AccountingandCorporateObjectives 7 consistsofallsavers(banks,insurancecompanies,pensionfunds,people,etc.).Thecapitalmarketgathersresourcesfromthesaversofsociety(peoplewhoconsumelessthantheyearn)andrationsthesesavingsouttotheorganizationsthathaveaneedfornewcapitalandthatcanpaythepricethatthecapitalmarketdefnesforcapital.Theavailabilityoffunds(thesupply)andthedemandforfundsdeterminethecostoffundstotheorganizationsobtainingnewcapitalandthereturntobeearnedbythesuppliersofcapital.Themeasureofthecostofnewcapitalbecomesveryimportanttoabusinessfrmintheprocessofmakingdecisionsinvolvingtheuseofcapital.Weshallhaveoccasiontousethemarketcostoffunds(theinterestrate)frequentlyinouranalyses,andyoushouldbeawareoftherelevanceofcapitalmarketconsiderationstothedecisionsofthefrm.Actually,thereisnotonemarketcostoffunds;rather,thereisaseriesofdifferentbutrelatedcostsdependingonthespecifctermsonwhichthecapitalisobtainedandtheamountofriskassociatedwiththesecurity.Oneoftheimportantobjectivesofthisbookistodevelopanawarenessofthecostofthedifferentformsofcapital(commonstock,preferredstock,debt,retainedearnings,etc.)andofthefactorsthatdeterminethesecosts.Thisisacomplexmatter,sincethecostofaspecifcformofcapitalforonefrmwilldependonthereturnsinvestorscanobtainfromotherfrms,onthecharacteristicsoftheassetsofthefrmthatisattemptingtoraiseadditionalcapital,andonthecapitalstructureofthefrm.Wecanexpectthatthelargertherisk,thehigherthereturnthatwillbeneededtoattractinvestors. TacticalandStrategicDecisions Investmentdecisionsmaybetacticalorstrategic.Atacticalinvestmentdecisiongenerallyinvolvesarelativelysmallamountoffundsanddoesnotconstituteamajordeparturefromwhatthefrmhasbeendoinginthepast.Theconsiderationofanewmachinetoolbyamotormanufacturingcompanyisatacticaldecision,asisabuy-or-leasedecisionmadebyanoilcompany.Strategicinvestmentdecisionsinvolvelargesumsofmoneyandmayalsoresultinamajordeparturefromwhatthecompanyhasbeendoinginthepast.Strategicdecisionsdirectlyaffectthebasiccourseofthecompany.Acceptanceofastrate-gicinvestmentwillinvolveasignifcantchangeinthecompany’sexpectedproftsandintheriskstowhichtheseproftswillbesubject.Thesechangesarelikelytoleadstockholdersandcreditorstorevisetheirevaluationofthecompany.Ifapri-vatecorporationundertookthedevelopmentofasupersoniccommercialtransport
November6,200913:43spi-b8119inx6inb811-ch01 8 AnIntroductiontoAccountingandManagerialFinance (costingover$20billion),thiswouldbeastrategicdecision.Ifthecompanyfailedinitsattempttodevelopthecommercialplane,theveryexistenceofthecompanywouldbejeopardized.Frequently,strategicdecisionsarebasedonintuitionratherthanondetailedquantitativeanalysis.Theinvestmentstrategyofafrmisastatementoftheformalcriteriaitappliesinsearchingforandevaluatinginvestmentopportunities.Strategicplanningguidesthesearchforprojectsbyidentifyingpromisingproductlinesorgeographicareasinwhichtosearchforgoodinvestmentprojects.Onefrmmayseekopportunitiesforrapidgrowthinemerginghigh-technologybusinesses;anothermayseekoppor-tunitiestobecomethelow-costproducerofcommoditieswithwell-establishedtechnologiesandnounusualmarketproblems;athirdfrmmaylookforopportu-nitiestoexploititsspecialknowledgeofaparticularfamilyofchemicals.Astrategyshouldrefectboththespecialskillandabilitiesofthefrm(itscomparativeadvan-tage)andtheopportunitiesthatareavailableasaresultofdynamicchangesintheworldeconomy.Strategicplanningleadstoachoiceofthe“forest”—tacticalanalysisstudies—andmakesachoicebetweenindividual“trees.”Thetwoactivitiesshouldcomple-mentandreinforceeachother.Projectanalysismayprovideafeedbacklooptoverifytheaccuracyofthestrategicplan.Iftherearegoodopportunitieswherethestrategicplansaystheyshouldbefound,andfewpromisingopportunitiesinlinesofbusinessthatthestrategyidentifesasunattractive,confdenceinthestrategicplanincreases.Alternatively,ifattractiveprojectsarenotfoundwheretheplanhadexpectedthem,orifdesirableprojectsappearinlinesofbusinessthatthestrategicplanhadidentifedasunattractive,areassessmentofboththeprojectstudiesandthestrategicplanmaybeinorder. ScopeofFinancialManagement Manyfnancialdecisionshaveatimedimension:notallrelevanteventsoccurimmediately.AdjustingforthetimingofcashfowsandchoosingbetweencertainalternativecashfowpatternsarediscussedinChapter2. Conclusions Thestudyofaccountingandfnanceshouldbeanexcitingandstimulatingexpe-rience,sinceitisanopportunitytoeliminatealargenumberofcommonmisun-derstandingsandtoaddtoyourownunderstandingoffnancialinstrumentsanddecisions.Youwillbebetterabletomanageyourownpersonalfnancialaffairsaswellastheaffairsofabusinessentity.
November6,200913:43spi-b8119inx6inb811-ch01 Finance,AccountingandCorporateObjectives 9 Thebasicbuildingblocksofthisbookarethreegeneralizationsthatareintroducedinthischapter:1.Investorsprefermoreexpectedreturntoless.2.Investorspreferlessrisktomorerisk.3.Investorspreferanamountofcashtobereceivedearlierthanthesameamounttobereceivedlater.Allmodernfnanceisbuiltonthesegeneralizations.Someinvestorsacceptorseekrisk,buttheynormallydosowiththehopeofsomemonetarygain.Theyexpecttobecompensatedfortherisktheyundertake.Corporations,ormoreexactly,themanagersrunningthecorporations,havemanydifferentgoals.Wehavesimplifedthecomplexsetofobjectivesthatexisttoonebasicobjective,themaximizationofthevalueofthestockhold-ers’ownershiprightsinthefrm.Thoughasimplifcation,itenablesustomakespecifcrecommendationsastohowcorporatefnancialdecisionsshouldbemade.Weshallfndthatwhilesomefnancialdecisionsmaybesolvedexactly,morefrequentlyweshallonlybeabletodefneandanalyzetheproblem.Wemaynotalwaysbeabletoidentifytheoptimumdecisionwithcertainty,butweshallgener-allybeabletodescribesomeerrorsinanalysistoavoid.Inmostcasesincorporatefnance,usefulinsightsforimproveddecisionmakingcanbeobtainedbyapplyingmodernfnancetheoryandusinggoodaccountinginformation. QuestionsandProblems 1.Canafrmhaveincomewithouthavingapositivecashfow?Explain.2.Ifafrmcurrentlyearning$1millioncanincreaseitsaccountingincometo$1.1million(anactionconsistentwithproftmaximization),isthisalwaysadesirablemove?Explain.3.Asalesforceisproudofhavingdoubledsalesinthepastfouryears.Whatquestionsshouldbeaskedbeforepraisingthem?4.Apresidentofanautomobilemanufacturingfrmhastheopportunitytodoublethefrm’sproftsinthenextyear.Toaccomplishthisproftincrease,thequalityoftheproduct(currentlytheprestigecaroftheworldmarket)mustbereduced.Noadditionalinvestmentisrequired.Whatdoyourecommend?5.Namean“economiccost”thatisomittedfromtheaccountingincomestatementsthatshouldbeofinteresttomanagement.6.TheABCCompanycanundertakeaninvestmentthatiseconomicallydesirable.Itwilladverselyaffectcurrentearnings,butinmanagement’sjudgmentwill
November6,200913:43spi-b8119inx6inb811-ch01 10 AnIntroductiontoAccountingandManagerialFinance beneftfutureearnings.Managementfearsthatthestockmarketwillinterpretthedecreaseinearningsasasignofweaknessandthecommonstockpricewillimmediatelygodownasthelowerearningsarereported.Managementplanstodescribethecharacteristicsoftheinvestmentintheannualreportandinmeetingswithsecurityanalysts.Thecompany’sprimarygoalistomaximizethewell-beingofitsstockholders.a.Whatwouldadecreaseinstockpriceasaresultoftheinvestmentimplyaboutthestockmarket?b.Whatdoesthedecreaseinincomeasaresultoftheinvestmentimplyabouttheaccountingmeasures?c.Shouldthecompanyundertaketheinvestment?7.TheABCCompanyhastomakeachoicebetweentwostrategies: Strategy1 :Isexpectedtoresultinamarketpricenowof$100pershareofcommonstockandapriceof$120fveyearsfromnow. Strategy2 :Isexpectedtoresultinamarketpricenowof$80andapriceof$140fveyearsfromnow.Whatdoyourecommend?Assumethatallotherthingsareunaffectedbythedecisionbeingconsidered.8.Ithasbeensaidthatfewstockholderswouldthinkfavorablyofaprojectthatpromiseditsfrstcashfowin100years,nomatterhowlargethisreturn.Commentonthisposition.9.Eachofthefollowingissometimeslistedasareasonableobjectiveforafrm:(a)maximizeproft(accountingincome),(b)maximizesales(orshareofthemarket),(c)maximizethevalueofashareofcommonstock t timeperiodsfromnow,(d)ensurecontinuityofexistence,(e)maximizetherateofgrowth,(f)maximizefuturedividends.Discusseachitemandtheextentofitsrelevancetothemakingofinvestmentdecisions. References Anumberofexcellentintroductoryandintermediatefnancialmanagementtextsareavailabletobeusedinconjunctionwiththisbooktoprovideaparalleldescriptionofmanyofthedecisionswediscussandtofllthereaderinoninstitutionalmaterial.Amongthemarethefollowing:Brealey,R.andS.Myers(2000). PrinciplesofCorporateFinance .NewYork:McGraw-HillBookCompany.
November6,200913:43spi-b8119inx6inb811-ch01 Finance,AccountingandCorporateObjectives 11Copeland,T.E.andJ.F.Weston(2004). FinancialTheoryandCorporatePolicy ,4thEdition.Reading,MA:Addison-WesleyPublishingCompany.VanHorne,J.C.(2001). FinancialManagementandPolicy ,12thEdition.EnglewoodCliffs,NJ:Prentice-Hall,Inc.
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November6,200913:43spi-b8119inx6inb811-ch02 Chapter2 TheTimeValueofMoney TimeDiscounting Oneofthebasicconceptsofbusinesseconomicsandmanagerialdecisionmakingisthatthevalueofanamountofmoneytobereceivedinthefuturedependsonthetimeofreceiptordisbursementofthecash.Adollarreceivedtodayismorevaluablethanadollartobereceivedinthefuture.Theonlyrequirementforthisconcepttobevalidisthattherebeapositiverateofinterestatwhichfundscanbeinvested.Thetimevalueofmoneyaffectsawiderangeofbusinessdecisions,andaknowledgeofhowtoincorporatetimevalueconsiderationssystematicallyintoadecisionisessentialtoanunderstandingoffnance.Thischapterisdevotedtodescribingthemathematicalmodelsofcompoundinterest.Theobjectiveistodevelopskillsinfndingthepresentequivalentofafutureamountandthefutureequivalentofapresentamount. TheInterestRate Adollaravailabletodayismorevaluablethanadollaravailableoneperiodfromnowifdesirableinvestmentopportunitiesexist.Therearetwoprimaryreasonswhyrealinvestmentscangenerateaninterestreturn:1.Sometypesofcapitalincreaseinvaluethroughtimebecauseofchangesinphysicalcharacteristics,forexample,cattle,wine,andtrees.2.Therearemanyworkprocesseswhereroundaboutmethodsofproductionaredesirable,leadingtoincreasedproductivity.Ifyouaregoingtocutdownalargetree,itmaybeworthinvestingsometimetosharpenyouraxe.Asharpaxemayresultinlesstimebeingspentcuttingdowntrees(includingsharpeningtime)thanworkingwithadullaxe.Ifyouaregoingtodigahole,youmightwantto 13
November6,200913:43spi-b8119inx6inb811-ch02 14 AnIntroductiontoAccountingandManagerialFinance buildorbuyashovel,orevenspendthetimetomanufactureabackhoeifitisabighole.Theinvestmentincreasesproductivitysuffcientlycomparedtothealternativemethodsofproductionwithoutcapitalsothatthenewassetcanearnareturnfortheinvestor.Thesecharacteristicsofcapitalleadtoasituationinwhichbusinessentitiescanpayinterestfortheuseofmoney.Ifyouinvest$1inanindustrialfrm,thefrmmaybeabletopayyou$1plusinterestifyourinvestmentenabledthefrmtousesomeroundaboutmethodofproductionortodelaythesaleofanitemwhileitincreasedinvalue. FutureValue Assumethatyouhave$1.00nowandcaninvestittoearn r interest.Afteroneperiod,youwillhavethe$1.00plustheinterestearnedonthe$1.Let FV bethefuturevalueand r betheannualinterestrate.Then, FV = 1 + r. Repeatingtheprocess,attime2youwillhave FV = ( 1 + r) + r( 1 + r) = ( 1 + r) 2 andthefuturevalueof$1.00investedfor n periodsis FV = ( 1 + r) n . If r = 0 . 10and n = 2,wehave FV = ( 1 + r) n = ( $1 . 10 ) 2 = $1 . 21 . Ifinsteadofstartingwith$1westartwithapresentvalue, PV ,of$50,thevalueattime2is FV = PV( 1 + r) n (2.1) FV = 50 ( 1 . 10 ) 2 = $60 . 50 . Witha0.10interestrate,the$50growsto$55attime1.The$55growsto$60.50attime2.Equation(2.1)isthestandardcompoundinterestformula.Theterm ( 1 + r) n iscalledtheaccumulationfactor.Thepowerofcompounding(earninginterestoninterest)isdramatic.Itcanbeillustratedbycomputinghowlongittakestodoublethevalueofaninvestment.Table2.1showstheseperiodsfordifferentvaluesof r .
November6,200913:43spi-b8119inx6inb811-ch02 TheTimeValueofMoney 15 Table2.1. ThePowerofCompounding. InterestRate( r )TimeUntilInitialValueIsDoubled 0.0235.0years0.0514.20.107.30.155.00.203.8 Ausefulruleofthumbinfnanceisthe“double-to-72”rule,whereforwiderangesofinterestrates, r ,theapproximatedoublingtimeis0 . 72 /r .NotehowcloselytheruleapproximatesthevaluesinTable2.1.Witha0.10timevaluefactor,aninvestmentwilldoubleinvalueevery7.3years.Theruleofthumbgives7.2years.Frequently,tomakebusinessdecisions,insteadofcomputingfuturevalueswewillwanttoworkwithpresentvalues. TimeIndifference:PresentValue Today,closeto100percentoflargecorporationsusesomeformofdiscountedcashfow(DCF)techniquesintheircapitalbudgeting(investmentdecisionmaking).ToperformaDCFanalysis,wemustfndthepresentvalueequivalentsoffuturesumsofmoney.Forexample,ifthefrmwillreceive$100oneyearfromnowasaresultofadecision,wewanttofndthepresentvalueequivalentofthe$100.00.Assumingthatthemoneyisworth(canbeborrowedorlentat)0.10peryear,the$100.00isworth$90.91now.Theindifferencecanbeshownbynotingthat$90.91investedtoearn0.10willearn$9.09interestinoneyear;thus,theinvestorstartingwith$90.91willhave$100.00attheendoftheyear.Iftheinvestorcanbothborrowandlendfundsat0.10,theinvestorwouldbeindifferenttoreceiving$100.00attheendoftheyearor$90.91atthebeginningoftheyear.Ifthe0.10interestrateappliesfortwoperiods,theinvestorwouldbeindifferenttoreceiving$82.64todayor$100twoyearsfromtoday.Ifthe$82.64isinvestedtoearn0.10peryear,theinvestorwillhave$90.91afteroneyearand$100attheendoftwoyears.Theunitoftimecanbedifferentfromayear,buttheunitoftimeforwhichtheinterestrateismeasuredmustbethesameastheunitoftimeformeasuringthetimingofthecashfows.Forexample,the0.10usedintheexampleisdefnedastheinterestrateperyearandisappliedtoaperiodofoneyear.
November6,200913:43spi-b8119inx6inb811-ch02 16 AnIntroductiontoAccountingandManagerialFinance Startingwithequation(2.1),wehave FV = PV( 1 + r) n . (2.1)Dividingbothsidesofequation(2.1)by ( 1 + r) n ,weobtain PV = FV ( 1 + r) n . (2.2)Using C n todenotethecashfowattheendofperiod n and r todenotethetimevalueofmoney,wefndthatthepresentvalue, PV ,of C n is PV = C n ( 1 + r) n (2.3)or,equivalently, PV = C n ( 1 + r) n , (2.4)where ( 1 + r) n isthepresentvalueof$1tobereceivedattheendofperiod n whenthetimevalueofmoneyis r .Theterm ( 1 + r) n iscalledthepresentvaluefactor,anditsvalueforvariouscombinationsoftimeperiodsandinterestratesisfoundinTableAoftheAppendixtothebook.Anyhandcalculatorwiththecapabilitytocompute y x canbeusedtocomputepresentvaluefactorsdirectly.If y x isused,then y = 1 + r and x = n .First, y x isfound,andthenthereciprocalistakentodeterminethepresentvaluefactor.Forexample,tofndthepresentvaluefactorfor r = 0 . 10, n = 5usingatypicalcalculator,wewouldplace1.10inthecalculator,pressthe y x button,insert5,pressthe“equals”button,andthenthereciprocaltofnd0.62092. Example2.1 Whatisthepresentvalueof$1.00tobereceivedthreetimeperiodsfromnowifthetimevalueofmoneyis0.10perperiod?InTableAattheendofthebook,the0.10columnandthelineopposite n equalto3gives0.7513.Ifyouinvest$0.7513toearn0.10peryear,afterthreeyearsyouwillhave$1.00.Thus, ( 1 . 10 ) 3 = 0 . 7513.Whatisthepresentvalueof$100.00tobereceivedthreetimeperiodsfromnowifthetimevalueofmoneyis0.10?Since ( 1 . 10 ) 3 = 0 . 7513,thepresent
November6,200913:43spi-b8119inx6inb811-ch02 TheTimeValueofMoney 17 valueof$100is PV = $100 ( 0 . 7513 ) = $75 . 13 . If$75.13isinvestedattime0,thefollowinginterestgrowthtakesplacewitha0.10interestrate. InvestmentatBeginningInvestmentatTimeofPeriodInterestEndofPeriod 0$75.13$7.513$82.643182.6438.26490.907290.9079.091100.000Ifinvestorscanearn0.10perperiodandcanborrowat0.10,thentheyareindifferentto$75.13receivedattime0or$100attime3.Thepresentvalueofaseriesofcashfowsisthesumofthepresentvaluesofeachofthecomponents. Example2.2 Whatisthepresentvalueoftwocashfows,$100.00and$200.00,tobereceivedattheendofoneandtwoperiodsfromnow,respectively,ifthetimevalueofmoneyis0.10? CashFlowPresentValueFactorsPresentPeriod tX t PVF ( t , 0.10)Value PV 1$1000.9091$90.9122000.8264165.28 Totalpresentvalueusing0.10 = $256.19 PresentValueofanAnnuity Frequently,theevaluationofalternativeswillinvolveaseriesofequalpaymentsspacedequallythroughtime.Suchaseriesiscalledanannuity.Thepresentvalueofanannuityof$1perperiodfor n periodswiththefrstpaymentoneperiodfromnowisthesumofthepresentvaluesofeachdollartobereceived:B (n,r) = 1 ( 1 + r) + 1 ( 1 + r) 2 + 1 ( 1 + r) 3 +···+ 1 ( 1 + r) n , (2.5)whereB (n,r) isthesymbolicrepresentationforanannuityof n periodsandaninterestrateof r (frstcashfowoneperiodfromnow).Itcanbeshown(see
November6,200913:43spi-b8119inx6inb811-ch02 18 AnIntroductiontoAccountingandManagerialFinance Appendix2.1)attheendofthischapterthatB (n,r) = 1 ( 1 + r) n r. (2.6)Equation(2.6)isforanannuityinarrears.AppendixTableBattheendofthebookgivesthepresentvaluesofannuitiesof$1perperiodfordifferentvaluesof r and n .Thepresentvalueofanannuitycanalsobecomputeddirectlyusingmanyhandcalculators,orapersonalcomputer.If C dollarsarereceivedeachperiodinsteadof$1,wecanmultiplyequa-tion(2.6)by C toobtainthepresentvalueof C dollarsperperiod.Thatis,foranannuityfor C dollarsperperiod,thepresentvalueis PV = C × B (n,r). (2.7) Example2.3 TheABCCompanyistoreceive$1aperiodforthreeperiods,thefrstpaymenttobereceivedoneperiodfromnow.Thetimevaluefactoris0.10.Computethepresentvalueoftheannuity.Therearethreeequivalentsolutions:a.FromAppendixTableB,B ( 3 , 0 . 10 ) = 2 . 4869 . b.Usingequation(2.6)andAppendixTableA,B ( 3 , 0 . 10 ) = 1 ( 1 + r) n r = 1 0 . 7513 0 . 10 = 0 . 2487 0 . 10 = 2 . 487 . c.Addingthefrstthreeentriesinthe0.10columninAppendixTableA, ( 1 . 10 ) 1 = 0 . 9091 ( 1 . 10 ) 2 = 0 . 8264 ( 1 . 10 ) 3 = 0 . 7513 B ( 3 , 0 . 10 ) = 2 . 4868 . If,insteadof$1perperiod,theamountis$100.00,thenusingequation(2.7),wewouldmultiply$2.487by$100.00andobtain$248.70.
November6,200913:43spi-b8119inx6inb811-ch02 TheTimeValueofMoney 19 AnAnnuity Whenthefrstpaymentisattime1,wehaveanannuityinarrears(alsocalledanordinaryannuity).Whenthepaymentoccursatthebeginningofeachperiod,wehaveanannuitydue(alsocalledanannuityinadvance).Equation(2.6)givesthepresentvalueofanannuityinarrears:B (n,r) = 1 ( 1 + r) n r. (2.6)Ifwehave (n + 1 ) paymentsof$1eachperiodwiththefrstpaymenttakingplaceimmediately,wewouldmerelyadd$1tothevalueofequation(2.6).Thus,ifB(3,0.10)equals$2.4868,afour-paymentannuitywiththefrstpaymentattime0wouldhaveapresentvalueof$3.4868.An n periodannuitydueisnothingmorethanan (n 1 ) periodannuityinarrearsplustheinitialpayment. PresentValueofaPerpetuity Aperpetuityisanannuitythatgoesonforever(aninfnitesequence).Ifwelet n ofequation(2.6)gotoinfnity,sothattheannuitybecomesaperpetuity,thenthe ( 1 + r) n termgoestozero,andthepresentvalueoftheperpetuityusingequation(2.6)becomesB ( ,r) = 1 r. (2.8)Thus,if r = 0 . 10andtheseriesofcashreceiptsof$1.00perperiodisinfnitelylong,investorswouldpay$10.00fortheinfniteseries.Theywouldnotpay$11.00,sincetheycouldinvestthat$11.00elsewhereandearn$1.10perperiodatthegoingrateofinterest,whichisbetterthan$1.00perperiod.Investorswouldliketoobtaintheinvestmentfor$9.00,butnorationalissuerofthesecuritywouldcommittopay$1.00perperiodinreturnfor$9.00when$10.00couldbeobtainedfromotherlendersforthesamecommitment.Althoughperpetuitiesareseldomapartofreal-lifeproblems,theyareuseful,sincetheyallowustodeterminethevalueofextremecases.Forexample,if r = 0 . 10,wemaynotknowthepresentvalueof$1perperiodfor50timeperiods,butwedoknowthatitisonlyasmallamountlessthan$10sincethepresentvalueofaperpetuityof$1perperiodis$10and50yearsiscloseenoughtobeingaperpetuityforustouse$10asanapproximatepresentvalue:B ( ,r) = 1 r = 1 0 . 10 = $10 .
November6,200913:43spi-b8119inx6inb811-ch02 20 AnIntroductiontoAccountingandManagerialFinance AFlexibleTool Wenowhavethetoolstosolveawiderangeoftimevalueproblemsthathavenotbeendescribed.Whilewecouldintroduceotherformulas,weprefertoadaptthethreebasicformulasthathavebeenintroduced.Forexample,ifa$60-per-yearannuityfor20yearsweretohaveitsfrstpaymentattime10andiftheinterestrateis0.10,thepresentvalueis PV = C B (n,r)( 1 + r) t = 60B ( 20 , 0 . 10 )( 1 . 10 ) 9 = 60 ( 8 . 5136 )( 0 . 4241 ) = $216 . 64 . 9 10 11. . .. . . C B( n , r )60600 Notethatifthefrstannuitypaymentisattime10,weonlyhavetodiscounttheannuityfornineyearstofndthepresentvaluesinceB(10, r )givestheannuitypresentvalueasoftime9andthefrstpaymentattime10.Wewanttodeterminehowmuchwewouldhaveattime29ifwesaved$60peryearfor20years,withthefrstamountsavedstartingattime10.Aboveweobtained$216.64forthepresentvalueof$60peryear.Thefuturevalue(time29)of$216.64isFuturevalue = $216 . 64 ( 1 . 10 ) 29 = $216 . 64 ( 15 . 8631 ) = $3 , 437 . Nowassumethe$60annuitystartingattime10isaperpetuity.Thepresentvalueattime9is$60 / 0 . 10 = $600.Thepresentvalueofthe$600attime0is PV = $600 ( 1 . 10 ) 9 = $600 ( 0 . 4241 ) = $254 . 46 . Anotherapproachtosolvingforthepresentvalueoftheannuityistocomputethepresentvalueofaperpetuityandsubtractthepresentvalueofanine-periodannuity: PV = $600 $60B ( 9 , 0 . 10 ) = $600 $60 ( 5 . 7590 ) = $254 . 46 . Thebasictime-discountingtoolsareveryfexible.
November6,200913:43spi-b8119inx6inb811-ch02 TheTimeValueofMoney 21 AnnualEquivalentAmounts Inmanysituationswewanttodeterminetheannualequivalentofagivensum.Forexample,whatistheannualequivalentover20yearsof$100,000receivedtodayifthetimevalueofmoneyis10percent?Solveequation(2.7)fortheannualcashfow: C = PV B (n,r). (2.9)Thatis,tofndtheannualequivalent, C ,ofapresentsum, PV ,thatsumisdividedbytheannuityfactor,B (n,r) ,where r isthetimevalueofmoneyand n isthenumberofyearsoverwhichtheannualequivalentistobedetermined.Calculationsofthistypeareparticularlyusefulinthemanagementoffnancialinstitutionssuchasinsurancecompaniesorbanks,wherecustomersmakeperiodicpaymentsoveranextendedtimeperiodinreturnforalump-sumimmediateloan. Example2.4 TheABCCompanywishestoborrow$10,000fromtheCityBank,repayableinthreeannualinstallments(thefrstonedueoneyearfromnow).Ifthebankcharges0.10interest,whatwillbetheannualpayments?Fromequation(2.9), C = $10 , 000 B ( 3 , 0 . 10 ) = $10 , 000 2 . 4869 = $4 , 021andtheloanamortizationscheduleis (2)(3)(1)BeginningInterest(4) ( 5 ) = ( 2 ) + ( 3 ) ( 4 ) TimeBalance0.10of(2)PaymentEndingBalance 0$10,000$1,000$4,021$6,97916,9796984,0213,65623,6563664,0210Theloanamortizationschedulestartswiththeinitialamountowed.Column3showstheinterestontheamountowedatthebeginningoftheperiod(column2).Column4isthepaymenttopaythedebtandcolumn5showstheendingdebt
November6,200913:43spi-b8119inx6inb811-ch02 22 AnIntroductiontoAccountingandManagerialFinance balance.Theendingdebtbalanceisequaltothebeginningdebtbalanceplustheperiod’sinterestlessthedebtpayment.Theprocessisrepeatedforthelifeofthedebt.Ifthepresentvalueofthedebtpaymentsisequaltotheinitialbeginningbalance(asitwillbeusingtheeffectivecostofdebttocomputethepresentvalue),theendingbalanceafterthelastdebtpaymentwillbeequaltozero. Conclusions Mostinvestmentanalysesperformedbyacompanyaremadeonthebasisofannualcashfows.Finerdivisionsoftimeareusuallyunwarrantedinlightoftheapprox-imatenatureofthecashfowestimates.Somefrmsusepresentvaluetablesthatassumethecashfowsaredistributedevenlyovertheyearoroccuratthemidpointoftheyearinquestionratherthanattheendoftheyear,asdothepresentvaluetablesattheendofthisbook.Suchrefnementsaddlittletothesubstanceofdis-countedcashfowanalysisandarenotlikelytoaltermateriallyanyinvestmentdecisionobtainedfromusingthe“end-of-year”assumption.Mostfnancialdecisionmakingcanbereducedtoevaluatingincrementaloralternativecashfows.Therearethreestepsintheanalysis.First,therelevantincrementalcashfowsmustbeestimated.Second,theremustbesomemeansofdealingwithuncertaintyifthecashfowsareuncertain.Third,theremustbesomewaytotakeintoconsiderationthetimevalueofmoney.Thematerialinthischapterisessentialfordealingwiththetimevalueofmoneytodeterminethepresentandfuturevaluesofsumsofmoneytobereceivedorpaidatvarioustimes. ReviewProblems ReviewProblem2.1 Exactly15yearsfromnow,Joneswillstartreceivingapensionof$20,000ayear.Thepaymentswillcontinueforever.Howmuchisthepensionworthnow,assumingthattheappropriatediscountrateis0.10peryear? SolutiontoReviewProblem2.1 120,0000.10 × 20,000 20,000 0 . . . 14 15 16 Thepresentvalueattime14is$200,000.
November6,200913:43spi-b8119inx6inb811-ch02 TheTimeValueofMoney 23 Thepresentvalueattime0is$200 , 000 ( 1 . 10 ) 14 = $200 , 000 ( 0 . 26333 ) = $52 , 666 . ReviewProblem2.2 (a)Twelverentalpaymentsof$1,000willbepaidmonthlyattheendofeachmonth.Themonthlyinterestrateis0.01.Whatisthepresentvalueofthepayments?(b)Ifthepaymentsareatthebeginningofeachmonth,whatisthepresentvalue? SolutiontoReviewProblem2.2 (a)$1 , 000B ( 12 , 0 . 01 ) = $1 , 000 ( 11 . 2551 ) = $11 , 255.(b)$1 , 000 [ B ( 11 , 0 . 01 ) + 1 ]= $1 , 000 ( 10 . 3676 + 1 ) = $11 , 368or$11 , 255 ( 1 . 01 ) = $11 , 368. QuestionsandProblems 1.Assumea0.05-per-yeartimevalueofmoney.Computethevalueof$100(a)received1yearfromnow;(b)receivedimmediately;(c)receivedattheendof5years;(d)receivedatthebeginningofthesixthyear;(e)receivedattheendof50years;(f)receivedattheendof50years,butwithaninterestrateof0.10.2.Assumethattheinterestrateis0.10.Computethepresentvalueof$1peryearforfouryears(frstpaymentoneyearfromnow)usingthreedifferentmethods(AppendixTableA,AppendixTableB,andanequation).3.Assumea0.05timevalueofmoney.Computethevalueofthefollowingseriesofpaymentsof$100ayearreceivedfor(a)fveyears,thefrstpaymentreceivedoneyearfromnow;(b)fouryears,thefrstoffvepaymentsreceivedimme-diately;(c)tenyears,thefrstpaymentreceivedoneyearfromnow;(d)nineyears,thefrstoftenpaymentsreceivedimmediately.4.Assumea0.05timevalueofmoney.Thesumof$100receivedimmediatelyisequivalenttowhatquantityreceivedin10equalannualpayments,thefrsttobereceivedoneyearfromnow?Whatwouldbetheannualamountifthefrstof10paymentswerereceivedimmediately?5.Assumea0.05timevalueofmoney.Wehaveadebttopayandaregivenachoiceofpaying$1,000noworsomeamount X fveyearsfromnow.Whatisthemaximumamountthat X canbeforustobewillingtodeferpaymentforfveyears?
November6,200913:43spi-b8119inx6inb811-ch02 24 AnIntroductiontoAccountingandManagerialFinance 6.Wecanmakeanimmediatepaymentnowof$10,000orpayequalamountsof R forthenextfveyears(frstpaymentdueoneyearfromnow).Withatimevalueofmoneyof0.05,whatisthemaximumvalueof R thatwewouldbewillingtoaccept?7.Iftheinterestratepermonthis0.05,compoundedquarterly,whatistheannualequivalentrate?8.Ifafrmborrowed$100,000foroneyearandpaidback$9,455.96permonth,whatisthecostofthedebt?9.Afrmcansave$10,000peryearfor15years.Ifthetimevalueofmoneyis0.10,howmuchbetteroffwillthefrmbeafterthe15yearsifitaccomplishesthesaving?10.Ifthetimevalueofmoneyis0.10,howmuchdoyouhavetosaveperyearfor20yearstohave$50,000peryearforperpetuity?Assumethatthefrstdepositisimmediateandthatthefrstpaymentwillbeatthebeginningofthetwenty-frstyear.11.If$100earns0.08peryear,howmuchwilltheinvestorhaveattheendof10years?Whatisthepresentvalueof$100duein10yearsifmoneyisworth0.08?12.Whatisthepresentvalueof$20peryearforperpetuityifmoneyisworth0.10?13.RefertoProblem12.Ifthefrstpaymentistobereceivedin11years,whatistheseriesofpaymentsworthtoday?14.Youaretheloanoffcerofabank.TheABCCompanywantstoborrow$100,000andrepayitwithfourequalannualpayments(frstpaymentdueoneyearfromnow).YoudecidethattheABCCompanyshouldpay0.10peryearontheloan.a.Whatistheannualpayment?b.Completethefollowingdebtamortizationtable: AmountOwedAmountOwedPeriod(beginningofyear)InterestPrincipal(endofyear) 1$100,000234
November6,200913:43spi-b8119inx6inb811-ch02 TheTimeValueofMoney 25 c.Whatwouldbetheannualpaymentifthefrstoffourequalpaymentsisdueimmediately?15.a.Iftheinterestratepermonthis0.02,compoundedmonthly,whatistheannualeffectiveequivalentrate?b.Howmuchdoyouhavetosaveperyearfor20yearsinordertohave$50,000peryearforperpetuity? r = 0 . 10.Thefrst$50,000paymentwillbereceivedattime21.c.If$100willgrowinto$120inoneyear,whatisthecontinuousrateofgrowth?16.Assumea0.10interestrate.Howmuchisaperpetuityof$1,000peryearworth?17.Assumea0.10interestrate(youcanborrowandlendatthatrate).Specifywhichyouwouldprefer:a.$10,000incashor$1,000peryearforperpetuity(frstpaymentreceivedattheendofthefrstperiod).b.$10,000incashor$1,100peryearforperpetuity(frstpaymentreceivedattheendofthefrstperiod).c.$10,000incashor$900peryearforperpetuity(frstpaymentreceivedatthebeginningofthefrstperiod).18.a.Whatwouldbetheannualpaymentsonan8%perannuminstallmentloanof$1,000fromacreditunionwithrepaymentoverthreeyears?b.Writeouttheamortizationschedulefortheloan.c.Nowsupposethatthepaymentsaretobemadeonasemiannualbasis;whatwouldthesemiannualpaymentsbe?Assumethe0.08isanominalrate.d.Isthetotalpaidincase(c)lessormorethanintheformercase?Why?19.a.Howmuchdoyouhavetosaveperyear(attheendofeachyear)for40yearsinordertohave$10,000peryearforperpetuity,frstreceiptstartinginyear41?Use0.10asthetimevaluefactor.b.Iftheinterestratebeingearnedis0.04perquarter,compoundedquarterly,whatistheannualequivalentrate?20.a.Wecanmakeanimmediatepaymentnowof$10,000orpayequalamountsof R forthenextfouryears(frstpaymentdueoneyearfromnow).Withatimevalueofmoneyof0.10,whatisthemaximumvalueofpaymentthatwewouldbewillingtomake?b.Nowassumethatthefrstofthe fve paymentsis immediate .Whatisthemaximumvalueofpaymentwewouldbewillingtomake?21.TheXYZCompanyhasborrowed$100,000.Paymentswillbemadeoverafour-yearperiod(frstpaymentattheendofthefrstyear).Thebankchargesinterestof0.20peryear.
November6,200913:43spi-b8119inx6inb811-ch02 26 AnIntroductiontoAccountingandManagerialFinance a.Theannualpaymentwillbe .b.Thedebtamortizationscheduleis: AmountOwed(BeginningofPeriod)InterestPrincipal 1.$100,0002.3.4.c.Iftherearefvepaymentswiththefrstpaymentmadeatthemomentofborrowing,theannualpaymentwillbe .22.TheXYZCompanyhasborrowed$40,000.Equalpaymentswillbemadeoverathree-yearperiod(frstpaymentattheendofthefrstyear).Thebankchargesinterestof0.15peryear.a.Theannualpaymentwillbe .b.Thedebtamortizationscheduleis: AmountOwed(BeginningofPeriod)InterestPrincipal 1.$40,0002.3.4.c.Iftherearefourpaymentswiththefrstpaymentmadeatthemomentofborrowing,theannualpaymentwillbe . Appendix2.1:TheDerivationofanAnnuityFormula Let r = thetimevalueofmoneyperperiod n = thenumberoftimeperiodsB (n,r) = thepresentvalueofanannuityfor n periods ,r interestrate , withthefrstpaymentoneyearfromtimezero.Inthefollowingtable,eachentryincolumn(1)givesthepresentvalueof$1receivedattheendoftheperiodindicatedinthecolumnheaded“Time”.ThesumoftheitemsinthiscolumnisB (n,r) .Eachentryincolumn(2)ofthistablegivestheiteminthatrowofcolumn1multipliedby ( 1 + r) .Thesumoftheitemsinthiscolumnis ( 1 + r) B (n,r) .Notethat ( 1 + r) 0 = 1andthatallexcepttwoofthe
November6,200913:43spi-b8119inx6inb811-ch02 TheTimeValueofMoney 27 amountsareinbothcolumns.TakingthedifferencebetweenthesumofthetwocolumnsandsolvingforB (n,r) givestheformulawewishtoderive. Time(1)(2) 1 ( 1 + r) 1 ( 1 + r) 0 2 ( 1 + r) 2 ( 1 + r) 1 3 ( 1 + r) 3 ( 1 + r) 2 ········· n 1 ( 1 + r) n + 1 ( 1 + r) n + 2 n( 1 + r) n ( 1 + r) n + 1 B (n,r)( 1 + r) B (n,r) Column(2)minuscolumn(1)yields ( 1 + r) B (n,r) B (n,r) = 1 ( 1 + r) n . Simplifyingtheleft-handside, r B (n,r) = 1 ( 1 + r) n and,dividingby r ,B (n,r) = 1 ( 1 + r) n r. AppendixTableBofthisbookgivesthevaluesofB (n,r) ,thepresentvalueofanannuityof$1perperiod.Iftheannuityisfor$ R ,wemultiplythevalueobtainedfromthetableby R .If n isverylarge(let n approachinfnity),wehavethepresentvalueforaperpetuityof$1perperiod:B ( ,r) = 1 r.
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November6,200913:43spi-b8119inx6inb811-ch03 Chapter3 AnIntroductiontoFinancialReporting Accountingisaformalsystemofrecordkeepingandreportingthatshouldbedesignedtobeusefulinmakingeconomicdecisionsforabusinessorganization.Anindividualcouldoperateasmallbusinesswithaminimumofrecordkeeping.Theinformationrequiredtooperatethebusinesscanbeobservedandrecalledasneeded.Formalrecordswouldimprovethequalityoftheinformationavailabletotheowner,buttheownermaybeabletomakereasonablygooddecisionsonthebasisoflesspreciseinformation.Withincreasesinthesizeandcomplexityofabusinessorganization,theneedfororganizedquantitativeinformationalsoincreases.Themanagerofalargebusi-nessorganizationwithfar-fungplants,adiversifedproductline,andthousandsofemployeescannotdependonfrsthandobservationinmanagingtheorganization’saffairs.Adequaterecordsmustbekept.Theserecordshelpmanagersatvariouslevelsandlocationstomakeandevaluatedecisionsthatmeettheorganization’spolicyobjectives.Inmostlargebusinessorganizations,ownershipandmanagementfunctionsareseparated.Thisseparationmakesitnecessaryforthemanagerstocommuni-catetheeconomicprogressoftheorganizationtoitsowners.Forexample,althoughtheshareholdersaretheownersofacorporation,theydonotknowhowwellthecorporationisperformingunlessmanagementprovidesinformationtothem.Theresponsibilityofreportingtheresultsofmanagement’sadministrationoftheorga-nization’sresourcestotheownersisreferredtoasthe stewardshipfunctionofaccounting .Asecondimportantfunctionofaccountingistopresentusefulinformationformakingmanagerialdecisions.Accountingreportsshouldrefecttheeffectivenessandeffciencywithwhichtheresourceshavebeenusedbythefrm.Theyshouldalsorefecthowwellthecomplexobjectivesofanorganizationaremet.Onegoalofabusinessorganizationistousetheresourcesproftablyintheinterestsofits 29
November6,200913:43spi-b8119inx6inb811-ch03 30 AnIntroductiontoAccountingandManagerialFinance owners.Accountinginformationiswidelyusedbyinvestorstodeterminethemeritsofinvestmentopportunities.Insummary,accountingisconcernedwithpresentinginformationusefulformakingmanagerialandinvestmentdecisions.Accountinginformationcanhelpmanagersmakedecisionsabouttheday-to-dayoperationsofthecompany.Accountinginformationcanalsohelpkeepinvestorsinformedaboutabusinessorganization’sfnancialprogress. FinancialStatements Onefocusofaccountingison fnancialinformation thatismeasuredindollarsorothercurrencyunits.Accountingcannotprovidealltheinformationthatisrequiredorusefulforeverydecision.However,itcanprovideaprofleoftwobasicfnancialaspectsordimensionsofabusinessorganization: Financialposition :thecurrentfnancialstrengthoftheorganizationataparticularpointintimeasindicatedbytheresourcesitownsandtheobligationsitowes; Operatingresults :theresultsofanorganization’soperations—whetheritearnedorlostresourcesfromoperations—overaspecifcperiodoftime.Theseresultsarepresentedinformaldocumentscalled fnancialstatements .Thefnancialstatementthatprovidesinformationaboutabusinessorganization’sfnancialpositioniscalleda balancesheet .Theprimaryfnancialstatementthatprovidesinformationaboutabusinessorganization’soperatingresultsiscalledan incomestatement . UsesofFinancialStatements Knowingaboutthefnancialpositionofabusinessorganizationandtheresultsofitsoperationscanbeimportanttoawiderangeofinterestedparties. Man-agers arelikelytomakeday-to-dayoperatingdecisionsaffectingtheorganization.Theymustknowtheimpactoftheirdecisionsontheorganization’sfnancialwell-being. Taxingauthorities needtoknowwhetherincome-basedtaxesareproperlycalculated.Inlargecorporations,the shareholders ,whoaretheownersofthecorpora-tion,aredependentonpublishedfnancialstatementstoprovidetheinformationtheyrequirefordecisions.Shareholdersmayelectaboardofdirectors,whichisresponsibleforguidingthemanagementofacorporation.However,theprin-cipaldecisionsmadebyshareholdersarewhethertoholdtheirstock,sellit,or
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 31 purchaseadditionalshares.Itisimportantforfnancialstatementstoprovidetheinformationalrequirementsofshareholdersandotherpurchasersofsecurities. Creditors areotherindividualsororganizationstowhomabusinessorga-nizationowesmoney.Creditorsarealsointerestedinthefnancialpositionandoperatingresultsofabusinessorganization.Directlenders,suchasbanks,caninsistonreceivingwhateverfnancialinformationtheyrequiretosupporttheirdecisions.However,largecorporationsdomuchoftheirborrowingthroughtheissuanceoffnancialsecuritiessoldtothepublic.Purchasersofthesesecuritiesaredependentonfnancialstatementstoprovidetheinformationtheyrequirefortheirdecisions. AccountingProfessions A privateaccountant maybeemployedbytheorganizationtopreparetherecordsandreports.A publicaccountant isanindependentprofessionalengagedbyanorganizationtoverifytheaccuracyandacceptabilityoftheorganization’sreports.Independentprofessionalaccountantswhohavebeencertifedtopracticebytheirstatesareknownas CertifedPublicAccountants(CPAs) .Theusesofaccountinginformationgobeyondbusinessenterprises.Accoun-tantsareusefulinprovidingfnancialinformationaboutgovernments,hospitals,schools,churches,etc.Virtuallyanykindoforganizationthatengagesineconomicactivitymaintainsaccountingrecordsandprovidesaccountingreports. TheDisciplineofAccounting Accounting isatermusedtodescribeawiderangeoftechniquesandfeldsofstudy.Wewillbroadlydefneitas theidentifying,measuring,recording,andcom-municatingoffnancialinformationassociatedwitheconomicevents .Thetasksofaccountantscoverdiverseareas,suchasmeasuringeconomicchangesandcon-ditions,recordingfnancialtransactions,reportingtheresultsoffnancialtransac-tions,preparingreportsforgovernmentagencies(includingtheincometaxreturn),andestablishingsystemsforrecordkeepingandreporting.Manyofthethingsthataccountantsdoaredictatedbytherulesofgovernment.Anexampleispreparingincometaxreturns.However,accountantsprimarilypresentinformationforusebydecisionmakers. TheAccountingProcess Accountantsobserveorareinformedofsome economicevent .Anexamplewouldbethepurchaseofequipment.Accountantsthendetermineiftheeventqualifesfor
November6,200913:43spi-b8119inx6inb811-ch03 32 AnIntroductiontoAccountingandManagerialFinance accountingtreatment .Ifitdoesqualify,theymustmeasuretheeconomicchangesthattookplace.Then,an accountingentry thatupdatesthesetofrecordstorefectthiseventiscomposed.Oncethenewinformationisreported,itmaybethebasisforadecisionthatsetsoffanewsetofeconomicchanges.Accountantsmustknowwhatinformationdecisionmakersneed.Also,theymustbeabletomeasuretheeventsandtheireffectsontheeconomicpositionoftheorganization.Theserequirementsimplythataccountantsmustbeknowledgeableinfnanceandmanagerialeconomics.Inaddition,theaccountingreportsbecomethebasisfordecisionsandjudgmentsofindividualsandgroups. FinancialandManagerialAccounting Theterms fnancialaccounting and managerialaccounting refectdifferentusesofaccountinginformation. Financialaccounting pertainstothefnancialstatementspreparedforandusedbyindividualsinternalorexternaltothebusinessorgani-zation.Theseindividualsmaynotbeactivelyengagedinorresponsiblefortheday-to-dayoperationsoftheorganization,buttheydohaveaninterestinknow-ingaboutitseconomicprogress. Managerialaccounting pertainstothefnancialstatementsthatareusedbymanagementformakingeconomicdecisionswithinthebusinessorganization.Basically,thisbookisconcernedwithfnancialaccountingandfnancialdeci-sionmaking. IncomeTaxesandFinancialAccounting Thetaxationofincomebythefederalgovernmentandvariousstategovernmentshashadanimpactontherecord-keepingprocess.Taxesarebasedonafgurethatisdefnedtobetaxableincome.Therulesandregulationspertainingtotax-ableincomearenotnecessarilydesignedtorefecttheeconomicprogressofabusinessorganization,buttorefectthepublicpolicyobjectivesofCongressandothergovernmentalbodies.Asaresult,therearemanyinstancesinwhichtheincometaxtreatmentofaneventortransactiondiffersfromitsfnancialaccountingtreatment.Managementstrategymusttakeintoaccountthetaxconsequencesofanydeci-sion.Someaccountantsbelievethatfnancialaccountingproceduresshouldbeforcedtocoincidewiththeincometaxrequirements.Butthereisnoreasontobelievethatthetreatmentprescribedbyincometaxrequirementswouldbethesameasthetreatmentsuggestedbyadesiretomeasureandrecordeconomiceventsinareasonablemanner.
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 33 BusinessOrganizations Amongbusinessorganizations,therearethreebasicformsoforganization:the individualproprietorship ,the partnership ,andthe corporation .Mostsmallretailestablishments,farms,andprofessionalpractices(suchaslaw,medicine,andaccounting)areorganizedasindividualproprietorshipsorpartnerships.Thedis-tinctionbetweenapartnershipandanindividualproprietorshipisbasedonthenumberofindividualsinvolvedintheownershipoftheorganization.An individ-ualproprietorship hasonlyoneowner,whereasa partnership hasmorethanoneowner.Intermsofeconomicimportance,the corporation istheprimaryformofbusi-nessorganization.Theadvantagesofthecorporateformincludelimitedliabilityforthestockholders,continuityofexistence,andrelativeeaseofraisinglargesumsofmoneyandtransferringownershiprights.Asaresult,practicallyalllargebusinessesareorganizedascorporations.Thisbookwillfocusontheaccountingproblemsofcorporations,butvirtuallyalloftheaccountingprinciplesapplicabletocorporationsalsoapplytoothertypesofbusinessorganizations.Thespecializeddetailsofaccountingforproprietorshipsandpartnershipsareoutsidethescopeofthisbook. Assets,Liabilities,andStockEquities Thefnancialpositionofacorporationcanbedescribedatanypointintimeintermsoftheamountofresourcesitownsandtheclaimsorinterestsofvariouspartiesinthoseresources.Theresourcesownedbyacompanyarecalled assets ,andtheinterestsofvariousclaimantsintheassetsarecalled liabilitiesandstockequities . TheAccountingEquation Thetotalofresources(assets)ownedbyacorporationmustalwaysbeequaltothesourcesofthoseresources.Wecanalsostatethatthetotalsourcesofassets(equities)mustbeequaltothetotalassets.Therelationshipofassetsandsourcesmaybeexpressedintheformofanequation:Assets = Liabilities + Stockholders’Equity . (3.1)Thebalancesheetofacorporationshowsmeasuresoftheassetsofthecorpo-ration,thedebtsowed,andtheinterestsoftheowners.Theinterestsofowners,
November6,200913:43spi-b8119inx6inb811-ch03 34 AnIntroductiontoAccountingandManagerialFinance termed stockholders’equity ,togetherwiththedebtsowed( liabilities )constitutethetotalassetsourcesofthecorporation.Theinterestsoftheowners(stockholders’equity)mayalsobedescribedasbeingequaltothedifferencebetweenthetotalassetsandthetotalliabilities.Thismannerofviewingthebasiccomponentsofthebalancesheetresultsintheequation:Assets Liabilities = Stockholders’Equity . (3.2)Theserelationshipsare,infact,identities—thatis,theequalitiesholdforallvaluesofassetsandequitiesforallcorporationsatalltimes.Wehave,therefore,onebasicaccountingidentity(oraccountingequation)andtwovariationsofit:Assets = Liabilities + Stockholders’Equity(3.1)Assets Liabilities = Stockholders’Equity.(3.2)Eachchangeintotalassetsmustbeaccompaniedbyanequalchangeinthesources.Forexample,ifthestockholdersofacorporationinvest$8,000,thetotalassetsofthecorporationareincreasedby$8,000,asaretheclaimsofthestock-holders.Ifacorporationborrows$3,000fromafnancialinstitution,thetotalassetswouldbeincreasedby$3,000.Thesourceoftheassetisthefnancialinstitutionfromwhomtheamountwasborrowed.Wecouldalsosaythattherightsofthisfnancialinstitutionrepresenta$3,000liability.Assetsareincreasedby$3,000,andliabilitiesareincreasedbythesameamount.Thisequalityofassetsandsourcescanneverbeupset,exceptbymakinganerror. FormoftheBalanceSheet Thebalancesheetreportsthedollaramountsofassetsandequitiesofthecorpo-rationasrecordedintheaccountingrecords.Thereareseveralvariationsintheformofthebalancesheet,butitismostoftenpresentedasabalancedarray,withassetsontheleftsideandsourcesontheright.Thisisaconventionthathasbeenadoptedbyaccountantstofacilitateunderstanding.Insomecountries,theorderofpresentationisreversedwithnolossofinformation. Example Acorporationhascashof$5,000,ownsmerchandisethatcost$6,000,andowes$3,000.Thestockholdersoriginallyinvested$8,000inthecorporation.Thebalance
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 35 sheetinitssimplestformwouldappearasfollows: CompanyXBalanceSheetasofDecember31,20XX AssetsLiabilitiesandStockholders’Equity Cash$5,000Liabilities$3,000Merchandise6,000 Stockholders’Equity8,000 TotalAssets$11,000 TotalEquities$11,000 Thebalancesheethasaheadingcontainingthreeitems:thenameofthecom-pany,thenameofthereport,andthedateforwhichthisstatementisapplicable.Notethatthisstatementis“asofDecember31,20XX.”Thestatementisforaparticularmomentintime,namelythecloseofbusinessonthedateindicated.Abalancesheetmaybepreparedasofanydate,sospecifyingthedateisimportant.Noticethatthebodyofthestatementhastwomainsections,theAssetsandtheLiabilitiesandStockholdersEquity.Becausethetotalassetsmustequalthetotalsources,thestockholders’equityvalueof$8,000couldhavebeencomputedbysubtractingthetotalliabilitiesfromthetotalassets:$11 , 000 $3 , 000 = $8 , 000.However,inactualaccountingpractice,thestockholders’equityisnotcomputedinthismannerbutratherisobtaineddirectlyfromtheaccountingrecords,aswillbeseeninalatersection.Theequalitydefnitionactsasacheckratherthanasameansofobtainingtheamountofstockholderequity. AccountingforAssets Theterm asset mayhavedifferingconnotationsdependingonwhetheritisbeingusedbyaneconomistoranaccountant.Wewilldefnethetermasusedinaccountingpracticeasfollows: Assetsaretheresourcesofabusinessorganizationthatwereacquiredinamarkettransactionandthatwillprovidefutureeconomicbeneftstotheorganization. Examplesofaccountingassetsare: Nonphysicalresources :cash,marketablesecurities,accountsreceivable. Physicalresources :land,buildings,equipment,merchandise. Intangibleresources :patents,goodwill,copyrights,trademarks. Costfactorsapplicabletofutureperiods :rentandinsurancepremiumspaidinadvanceforthefollowingyear. EconomicandAccountingAssets Itisimportanttounderstandthedistinctionbetweenassetsthatarerecordedandthosethatarenot.Thedefnitionofassetsaboverefectstwocriteria:they(1)were
November6,200913:43spi-b8119inx6inb811-ch03 36 AnIntroductiontoAccountingandManagerialFinance acquiredinamarkettransaction,and(2)willprovidefutureeconomicbeneftstothecorporation.Accountantstypicallyrelyheavilyonaclearlydefnedmarkettransactionasthebasisforrecordingassets.Themarketpricerefectedinatransactionbetweentwoindependentpartiesprovidesobjectiveevidenceofthecostofassetsacquiredorthemarketvalueofassetssold.Itisusefulforaccountantstorelyonobjectiveevidenceofeconomicvalueotherthanalong-agoactualmarkettransaction.Inthepast,accountantshavechosentorelyonactualmarkettransactions.Thisreliancetendedtobringaboutuniformityinhowassetsarerecorded,butresultedinlessusefulinformationinthosesituationswhereapurchasecostmaybearlittlerelationtotheeconomicvalueoftheassetacquired.Forexample,thecostsofdrillinganoilwellarenotrelatedtothevalueofthewellasmeasuredbytheamountofoilinit.Recordingthecostsofdrillingthewellislessusefulthanrecordingtheeconomicvalueoftheoil.Similarly,thecostofManhattanmayhavebeen$24,butitscurrenteconomicvaluefarexceeds$24.Requiringactualmarkettransactionsalsoresultsinsomeassetsnotbeingrecorded.Itemssuchascopyrightsandtrademarksareusuallyrecordedasassetsonlyiftheyhavebeenpurchasedbyacorporationforaspecifcprice.Whensuchitemshavebeencreatedorinventedbythecorporation,theywerehistoricallynotrecordedasassets,regardlessoftheireconomicvaluetothecorporation.Simi-larly,high-qualityemployeesofacorporationmayhavealargeeconomicvalue,butaccountantstypicallydonotrecordsuchavalue.Forexample,accountantsforaprofessionalfootballteammightrecordthemultimillion-dollarcostofastarquarterbackobtainedfromanotherteamasanasset,butanequallyfnequarterbackobtainedwithoutexplicitcost(exceptforayear’swages)fromacollegecampuswouldnotappearintheaccountingrecordsasanasset.Economicassetsprovidefutureeconomicbeneftstothecorporation.Allaccountingassetsareeconomicassets,butnotalleconomicassetsareaccount-ingassets.Accountingassetsareasubsetofeconomicassets.Unlessanitemhasfutureeconomicbeneftstothecorporation,itisnotaneconomicassetandthusnotanaccountingasset.Anitem(e.g.,anemployee)canhavefutureeconomicbeneftstothecorporationandthereforebeaneconomicasset,butitisnotrecordedasanaccountingassetifitwasnotacquiredinamarkettransaction.Atthetimeanassetisacquired,anattemptwillbemadetorecorditseconomicvalueasrefectedbytheamountactuallypaidfortheasset.However,thisamountmaynotadequatelymeasuretheasset’seconomicvaluetothepurchaserbutrathertheminimumvalue,andthisfactmustbekeptinmindwhenmakingdecisionsusingrecordedamounts.Withthepassageoftime,thereislittlechancethatthe
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 37 amountpaidtoacquireanassetwillbeanexactestimateofitseconomicvalue,andsotheaccountantmustconsiderusingfairvalue. FinancialAccountingStandardsNo.157 ThisstandardisdatedSeptember2006andistitled“FairValueMeasurements.”Itisanextensivestudyoffairvalueanditsuses.“Thisstatementdefnesfairvalue,establishesaframeworkformeasuringfairvalue,andexpandsdisclosuresaboutfairvaluemeasurements”(paragraph1).Itrecognizesthatthereare“practicabilityexceptionstofairvaluemeasure-ments…”(paragraph2b).Butfairvalue,ingeneral,isthebasicmethodofmea-suringassetsandliabilities.Thedefnitionoffairvalueis:“Fairvalueisthepricethatwouldbereceivedtosellanassetorpaidtotransferaliabilityinanorderlytransactionbetweenmarketparticipantsatthemeasurementdate”(paragraph5).The Standard aspublishedbytheFASBis145pageslongplusafve-pagesummary.Itisanimportantaccountingdocumentsinceitdefnestheuseoffairvalueasthebasisofaccountingmeasurementsreplacingthenearlyuniversalcost-basedaccountingrule. CurrentandNoncurrentAssets Theassetsectionofthebalancesheetisnormallydividedintotwobasiccompo-nents: currentassets and noncurrentassets . Currentassets arecashandthoseotherassetsthatwillnormallybeconvertedintocashwithinaperiodofoneyear(oroneoperatingcycle,ifitislongerthanayear). Noncurrentassets arethoseassetsthatarenotlikelytobeconvertedintocashinthenormaloperatingcycle.Currentassetsincludeitemssuchascashonhandorinthebank;amountsduefromcustomers(accountsreceivable);materials,supplies,orgoodsonhand(inventories);readilymarketablesecuritiesthatareexpectedtobesoldwithinoneyear;andadvancepaymentsforinsurance,rent,andthelike(prepaiditems).Thelistingofprepaiditemsasacurrentassetisjustifediftheadvancepaymentwillbeusedduringthenextoperatingperiod.Iftheprepaymentisforaperiodlongerthanayear,onlytheportionapplicabletothenextyearwouldbeincludedasacurrentasset.Whenitemsareprepaid,theyreducetheoutlayofcashthatmightotherwiseberequiredinfutureyears.Noncurrentassetsarealsoreferredtoas fxedassets or long-livedassets .Thiscategoryincludessuchitemsasland,buildings,andequipment.Theseitemsarenormallyexpectedtolastmorethanoneyearandcannotbesold(convertedintocash)withoutdisruptingthenormalbusinessoperations.
November6,200913:43spi-b8119inx6inb811-ch03 38 AnIntroductiontoAccountingandManagerialFinance Thedistinctionbetweencurrentandnoncurrentassetsismadeonthebasisofintentionornormalexpectationratherthantheabilitytoconverttocash.Thus,inventoriesofmaterialsareclassifedascurrentbecausetheywouldnormallybedisposedofwithinoneyear.Abuildingthatmightbedisposedofisjustaseasilytreatedasnoncurrentifitwouldnotbesoldwithinayearofanormalbusinesscycle.Identicalassetsmaybeclassifeddifferentlywhenitisclearthattheyarebeingheldfordifferentpurposes.Automobilesusedinabusinessthatareexpectedtobeusedforseveralyearswouldbeclassifedasanoncurrentasset.Similarautomobilesheldforsalebyadealerormanufacturerwouldbeconsideredcurrentassets(inventories).Marketablesecuritiesaresecuritiesheldfortemporarypurposesforwhichthereisareadymarket.Theseareconsideredtobeacurrentasset,asitisnormallyexpectedthattheywillbesoldwithinoneyear.Ifsimilarsecuritieswerebeingheldforcontrolpurposesandthereforenotlikelytobesold,theywouldbereferredtoasinvestmentsandclassifedasanoncurrentasset.Anassetheldasanoncurrentinvestmentbecomesacurrentmarketablesecuritywhenthecorporationintendstodisposeofitsholdinginthenextyear.Inconsistenciesoccasionallyariseintheclassifcationbetweencurrentandnoncurrentassets.Forexample,buildingsandequipmentarenotusuallyreclas-sifedevenwhenitbecomesclearthattheywillbedisposedofwithinayear.Slow-movinginventoryitemsarenotreclassifedasnoncurrentevenwhenitislikelytotakemorethanayeartodisposeofthem.Theseinconsistencieshaveonedesirableeffectinthattheygivestabilitytotheclassifcationprocedure.Itwouldbetroublesomeifassetswerecontinuallyreclassifedaccordingtochangesinthestatedintentionsofmanagement. TangibleandIntangibleAssets Adistinctionisoftenmadebetween tangible and intangible assets.Thisdistinc-tionisbasedontheusualphysicalcharacteristicsoftheitems.Buildings,equip-ment,andmerchandiseareconsideredtobe tangibleassets becausetheseitemshavephysicalsubstance.Patents,trademarks,andcopyrightsareconsideredtobe intangibleassets becausetheydonotpossessphysicalsubstance(theymayberepresentedbypiecesofpaper). AccountingforLiabilitiesandStockEquity Thesourcessectionofthebalancesheethastwomainsectionsandseveralsubsections.Thebasicdivisionisbetween liabilities and stockholders’equity .
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 39 Liabilities aretheobligationsoftheorganization.Thetermsoftheseobligationsaregenerallyfxedbylegalcontractandhavedefniteduedates. Stockholders’equity referstotheownershipinterestinacorporation.Theamountofthestock-holders’interestsisnotfxedbycontract,anddoesnothaveduedates.Theliabilitysectioncanbefurtherdividedonthebasisofduedatesbetween currentliabilities and noncurrentliabilities .Thedistinctionisessentiallythesameasthatappliedtoassets: currentliabilities arethoseobligationsthataretobepaidwithinoneyear,whereas noncurrent(orlong-term)liabilities arethosecomingdueinmorethanoneyear.Thisdistinctionisimportant,becausethesolvencyofanorganizationrestsonitsabilitytomeetpaymentobligationswhendue.Currentliabilitiesusuallyincludeamountsowedtotradecreditors(accountspayable),workers(wagespayable),government(taxespayable),investors(interestordividendspayable),andcustomers(advancesfromcustomers).Alloftheseitemsarecurrentliabilitiesiftheyareduewithinayear(orwithintheoperatingcycleoftheorganization).Noncurrentliabilitiesoftenincludebonds,mortgages,andnotes.Ifpartoftheseitemsisduewithin12months,thatamountshouldbeclassifedasacurrentliability.Itistheduedate,notthetitle,thatdetermineswhetheranobligationisclassifedascurrentornoncurrent.Insomecases,theexactamounttobepaidisnotknown.Forexample,acorporationcanestimateitsincometaxliabilityandshowitassuchonabal-ancesheet,eventhoughtheamountisnotcertainandwillnotbecertainuntildetailedcomputationsaremade(andreviewedbytheInternalRevenueSer-vice).Althoughtheamountmustbeestimated,anobligationtopayonorbeforeaspecifcdateexists,andtheexpectedliabilityshouldberecognizedbytheaccountant.Thestockholders’equitysectionofthebalancesheetmaybedividedintotheamountoriginallypaidtoacorporationbystockholders,oftenreferredtoas com-monstock or capitalreceivedfromstockholders ,andtheamountretainedfrompastearnings,oftenreferredtoas retainedearnings .Therearealsoseveralvariationsoftitlesanddifferentclassifcationsthatareusedinpractice.Thesewillbediscussedinlaterchapters.Thecommonstockholdersaretheresidualowners.Theeconomicvalueoftheseinterestsvaries,dependingonthefortunesofthecorporation.Theearningsofthecorporationaccruetothisownershipgroup,but,unlikedebt-likeobligations,thecorporationisnotconsideredinsolventifitfailstomakepaymentstotheseinvestors.Anownershipinterestofsometypeandamountmustexistaslongasthecorporationexists.Ifthecorporationisliquidated,thestockholdersareentitledto
November6,200913:43spi-b8119inx6inb811-ch03 40 AnIntroductiontoAccountingandManagerialFinance theresourcesremainingafterallotherclaimshavebeensatisfed.Theiramountmaybemoreorlessthantheaccountingmeasuresoftheseinterests.Theearningsofthecorporationmaybeeitherretainedbythecorporationordistributedtostockholders.Thesedistributionsnormallytaketheformofcashpay-mentsthatarecalled dividends or sharerepurchases .Barringcomplexities,theretainedearningsbalanceisequaltothesumofthepastearningsofthecorporationreducedbyanydistributionstoshareholdersthathavebeenmade.Anegativebal-anceinretainedearningsisreferredtoasa defcit .Thisoccurswhenthecorporationsustainscumulativelossesinitsoperationsorhasmadelargercashdistributionsthanithasearned.Theclassifcationofaccountsisbasedonthelegalnatureoftheitemandnotonthenatureoftheindividualsholdingtheclaim.Thus,ifadividendofadefniteamounthasbeendeclaredpayableasofadefnitedate,theobligationtopaythedividendisaliabilityofthecorporation.Eventhoughthesumispayableonlytostockholders,itwouldbeconsideredaliabilityofthecorporationandnotapartofstockholders’equity. SampleBalanceSheet Thefrstbalancesheetillustratedbelowisnotcompleteinalldetails,butitdoesshowabasicarrangement.Moredetailedbalancesheetsarefoundinpractice,butthebasicformatisnotchanged.Notethatthecurrentassetsarelistedinorderofliquidity,orhowclosetheyaretobeingcash.Themostliquidassetsarelistedfrst.Thefxedassetsarelistedwiththelongest-livedassetspresentedfrst.Thatis,landisfollowedbybuildingsandequipment.Thereisnoorderspecifedforcurrentliabilities.Inpreparingabalancesheet,thearrangementoftheitemsandtheappearanceofthestatementareimportant.Thereaderwillexpecttofnditemsinspecifclocations.Thepersonpreparingthereportshouldeitherconformtocurrentpracticeorwarnthereaderofdifferencesinpresentation.Thebalancesheetmaybepreparedin verticalform asshownhere,withassetsontopandequitiesonthebottom,oritispreparedasa balancedarray ,withassetsontheleftandliabilitiesandstockholders’equitiesontheright.Eitherformisacceptable,aswellasseveralothervariationsofthesebasicarrangements.Forexample,anothermethodofpresentationisthe stepformat ,inwhichcurrentliabilitiesaresubtractedfromcurrentassetbalancestoobtainnetcurrentassets.Thisformhastheadvantageofhighlightingtherelationshipofthecurrentassetstothecurrentliabilitiesandofshowingthedifferencebetweenthetwo.Ithasthedisadvantageofnotexplicitlyshowingthetotalassetsortotalliabilities.
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 41 Thesetotalscanbederivedfromthebalancesheetregardlessoftheformat,buttheyaremorediffculttofndwhenthesteppresentationisused.Anexampleofabalancesheetusingthisformatisalsoshownbelow. SampleCompanyBalanceSheetasofDecember31,20XXAssetsCurrentAssets CashonHand$2,000CashinBank30,000MarketableSecurities8,000AccountsReceivable60,000Inventories50,000PrepaidExpenses2,000 TotalCurrentAssets $152,000 Long-LivedAssets Land$15,000Buildings53,000Equipment60,000 TotalLong-LivedAssets 128,000 TotalAssets $280,000 LiabilitiesandStockholders’EquityCurrentLiabilities AccountsPayable$30,000TaxesPayable70,000 TotalCurrentLiabilities $100,000 Long-TermLiabilities BondsPayable80,000 TotalLiabilities $180,000 Stockholders’Equity CommonStock$90,000RetainedEarnings10,000 TotalStockholders’Equity 100,000 TotalLiabilitiesandStockholders’Equity $280,000
November6,200913:43spi-b8119inx6inb811-ch03 42 AnIntroductiontoAccountingandManagerialFinance SampleCompanyBalanceSheetasofDecember31,20XXCurrentAssets CashonHand$2,000CashinBank30,000MarketableSecurities8,000AccountsReceivable60,000Inventories50,000PrepaidExpenses2,000 $152,000 Deduct:CurrentLiabilities AccountsPayable$30,000TaxesPayable70,000 $100,000 NetCurrentAssets $52,000 NoncurrentAssets Land$15,000Buildings53,000Equipment60,000 TotalAssetslessCurrentLiabilities $180,000 Deduct:Long-TermDebt BondsPayable$80,000 NetAssets $100,000 Ownership CommonStock$90,000RetainedEarnings10,000 $100,000 ManagerialUsesoftheBalanceSheet Theprimaryfunctionofabalancesheetistoindicatethefnancialpositionofanorganization.Thestatementmayprovideusefulinformationindeterminingthedegreeoffnancialrisk.Forexample,abankconsideringashort-termloantoacorporationwouldwanttoknowthefnancialpositionofthebusinessorganizationasofthedateoftheloan(orasclosetothatdateaspossible).Itsprimaryinternal
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 43 useisasameansofmeasuringthesoundnessofthefnancialpositionoftheorganization.Bylookingatanorganization’sbalancesheetsforsuccessiveperiods,managerscanobservechangesinspecifcitems.Ifthedirectionandamountofthechangeareundesirable,managersmaybeabletotakeactiontocorrectthesituation.Forexample,anincreaseinaccountsreceivable(theamountsowedbythecustomerstothecompany)mayindicateineffciencyintheoperationofthecollectiondepart-ment.Althoughindividualitemssuchasaccountsreceivablewillbethesubjectofseparatereports,itishelpfultohaveallassetsdisplayedinonereportsothatthevariousitemsmaybereadilycomparedwitheachother.Balancesheetspreparedformanagementshouldbedesignedespeciallyfortherequirementsoftheexecutiveswhoareusingthem.Executiveshavenoneedforstatementsshowingpennies;infact,verylargeorganizationsroundoffbalancestothenearesthundredthousandormilliondollars.Reportsmayalsobesimplifedbycombiningsimilaritems.Thus,thesingletitlePrepaidExpensesmayincludeprepaidrent,insurance,andtaxes.Theaimofthesesimplifcationsistosavetimewhenexecutivesreviewthestatementandavoidoverwhelmingthemwithtooextensiveanarrayofnumbers.Inusingabalancesheetformanagerialpurposes,itisimportanttokeepinmindthatthisstatementisnotpreparedprimarilyfortheuseofmanagers.Traditionalfnancialstatementsintendedtoservethepublicatlargemaynotbeoptimalformanagerialdecisionmaking.Thismeansthataconventionalbalancesheetmayhavetobeadjustedormodifedtoincreaseitshelpfulnesstomanagementforusebyafnancialanalyst(orapotentialinvestor). NatureofAccounts Aseparate account ismaintainedforeachiteminthebalancesheet.Transactionsmayberecordedbyenteringtheamountbywhicheachitemisaffectedintotherespectiveaccount. T-Accounts The T-account ,namedforitsshape,isaconvenientwayofrepresentinganaccountonapieceofpaper.TheT,withtheaccountnameenteredatthetop,permitstransactioninformationtobeenteredoneithersideoftheverticalline.Torecordtransactions,wemustbeabletorecordadditionstoaswellassubtractionsfromaccounts.ThisiseasilyhandledinT-accountsbydesignatingthatadditionsaretoberecordedononesideoftheverticallineandsubtractionsontheother.
November6,200913:43spi-b8119inx6inb811-ch03 44 AnIntroductiontoAccountingandManagerialFinance Byconvention,assetsareincreasedbyentriesontheleftsideoftheaccountandaredecreasedbyentriesontherightsideoftheaccount.Entriestoliabilityandstockholders’equityaccountsarehandledinthereversemanner.Theyareincreasedbyentriesontherightsideandaredecreasedbyentriesontheleftside.Theserulesmaybesummarizedasfollows:Assetsareincreasedbyentriesontheleftside.Assetsaredecreasedbyentriesontherightside.LiabilitiesandStockholders’Equityareincreasedbyentriesontherightside.LiabilitiesandStockholders’Equityaredecreasedbyentriesontheleftside. Any Asset Account Any Liabilityor Stockholders’ Equity Account IncreasesDecreasesDecreasesIncreases Allonehastorememberisthatincreasesforassetsarereportedontheleftsideoftheaccountandaretheoppositeofincreasesforliabilitiesandstockholders’equities,andthatdecreasesforanyaccountaretheoppositeofincreasesforthataccount.Theprocessofrecordingtransactionsconsistsofdeterminingwhataccountsareaffected,whethertheyareassetorliabilityandequityaccounts,andwhethertheyaretobeincreasedordecreased.Withthisinformation,anytransactioncanberecorded. Example Toillustratetheuseofaccounts,wewillrecordatransaction.Supposethatstockholdersinvest$10,000incashtoorganizeacorporation.TheCashaccountincreasesby$10,000andtheCommonStockaccountincreasesbythesameamount.Torecordtheincreaseincash,wecandrawaT-accountwiththeheadingCashandwrite10,000ontheleftsideoftheaccount: Cash 10,000 Thisentryof$10,000ontheleftsideoftheaccountisinterpretedasindicatingthattheamountofcashhasincreasedby$10,000.Thus,theinformationispreservedandcanbeusedtoprepareabalancesheetatalatertime.Wecannevermakeanentrytooneaccountwithoutalsomakinganentrytoatleastoneotheraccount.Thereceiptofcashresultedinacorrespondingincreasein
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 45 commonstock.Therefore,anentrymustbemadetotheaccount,CommonStock,toindicateanincreaseof$10,000.Followingtheconventionusedforcash,itmightseemlogicaltorecordtheincreaseincommonstockbywritingtheamountontheleftsideoftheT-account.Thiswouldbethecaseiftheruleweretorecordallincreasesontheleftside.However,theincreasesinequityaccountsarerecordedbyentriestothe right side.Thus,theincreaseincommonstockwouldberecordedbywriting$10,000ontherightsideofanaccountwiththeheadingCommonStock: Common Stock 10,000 DebitsandCredits Itisawkwardtospeakofentries“totheleftsideofanaccount”andentries“totherightsideofanaccount.”Thisdiffcultyiseliminatedbytheuseofspecializedterminology.Thus,insteadofentriestotheleftsideofanaccount,theaccountantspeaksof debits (abbreviatedDr.);insteadofentriestotherightsideofanaccount,theaccountantspeaksof credits (abbreviatedCr.).Thesearetheprimarydefnitionsofdebitsandcredits.Oneislikelytorunintoconfusionattemptingtoinferanyothermeaningfortheseterms.Themostusefuldefnitionisthat adebitisanentrytotheleftsideofanaccount. Itfollowsthat acreditisanentrytotherightsideofanaccount .Ithasbeenshownpreviouslythatanentrytotheleftsideofanassetaccountincreasesthataccount.Ifanassetaccountisincreasedbydebits,itmustbedecreasedbytheoppositeentry—credits.Liabilityorstockholders’equityaccountshavetheoppositecharacteristicsofassetaccounts.Therefore,theyareincreasedbycreditsanddecreasedbydebits. Any Asset Account Any Liabilityor Stockholders’ Equity Account Debit (increase) Credit(decrease)Debit(decrease) Credit(increase) Theterm charge isoftenusedinterchangeablywithdebit.Achargetoanaccountisadebit. KeyingTransactions Whenseveraltransactionsareinvolved,itisconvenienttoplaceanumberiden-tifyingeachtransactionintheT-accountnearthedollaramount.Thisprocedure
November6,200913:43spi-b8119inx6inb811-ch03 46 AnIntroductiontoAccountingandManagerialFinance iscalled keying thetransaction.Keyingfacilitatescross-referencesandaidsincheckingtherecordingprocess.Transactionsshouldalwaysbekeyed. Example Wewillnowcontinuetheillustration.Determinetheaccountsaffectedbyeachtransaction,whethertheyareassetsorequities,andwhethertheyareincreasedordecreased.Thisdetermineswhethertheentriesaretobemadeontheleftorrightsideoftheaccounts.Foreachtransaction,theleft-sideentries(debits)mustbeequaltotheright-sideentries(credits).Transactions:1.Stockholdersinvest$10,000incash(increaseanasset;increaseanequity).2.Thecompanybuys$5,000ofmerchandiseonaccount(increaseanasset;increasealiability).3.Attheendoftheyearthecompanybuysabuildingfor$20,000,pays$4,000cash,andissues$16,000ofbonds(increaseanasset;decreaseanotherasset;increasealiability).4.Themerchandise(seeTransaction2)ispaidfor(decreaseanasset;decreasealiability). Cash Common Stock (1) 10,000 (3) 4,000(4) 5,000(1) 10,000 Merchandise Accounts Payable (2) 5,000 (4) 5,000(2) 5,000 Building Bonds Payable (3) 20,000 (3) 16,000 EqualityofEntries Noticethatitis not necessarilythecasethatthenumberofincreaseswillequalthenumberofdecreasesforanytransaction.Itispossibletohavevalidentrieswithtwoincreases(e.g.,increaseanasset,increaseastockholder’sequity)ortwodecreases(decreaseanasset,decreasealiability)aswellasentrieswithequalincreasesanddecreases(increaseanasset,decreaseanotherasset).Relatingincreasestodecreasesisnotausefulcheck.Theequalityofleft-sideandright-side(debitandcredit)entriesisanimportantcontroldevice.
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 47 RecordingAccountingTransactions Inanyaccountingentry,thedebitsmustequalthecredits.Thisissynonymouswiththestatementthatentriestotheleftsideofaccountsmustequalentriestotherightsideofaccounts.Entriesmaytakemanyforms,forthereisavarietyoftransactionsthatmayberecordedwithdebitsandcredits.Itisnotpossibletobecorrectandmakeanentrythatincreasesoneassetandalsoincreasesanotherasset(twodebitsandnocredits).Norisitpossibletobecorrectandmakeanentrythatincreasesliabilitiesandstockholders’equitybutdoesnotaffectanotheraccount(twocreditsandnodebits).Theprocedurefordecidingontheentriestobemadeinrecordingafnancialtransactionconsistsofthethreestepssuggestedbythefollowingthreesetsofquestions:1.Whataccountsareaffected?Whatwasgivenorreceivedinthetransaction?2.Whataccountsshouldbedebitedorcredited?3.Whatamountsshouldbedebitedandcredited?Assumethat$500ofaccountspayablearepaid.Whataccountsareaffected?CashandAccountsPayablearethetwoaccountsaffected.Whataccountsshouldbedebitedorcredited?Whichaccountsareincreasedordecreasedbythetransaction?CashisdecreasedandAccountsPayableisdecreased.Todecreaseanasset,itisnecessarytocreditit;andtodecreasealiability,itisnecessarytodebitit.Whatamountsshouldbedebitedandcredited?Bothaccountsaredecreasedby$500.ThistransactionisrecordedbydebitingAccountsPayablefor$500andcreditingCashfor$500.Thistypeofsystematicanalysisisusefulinrecordingtransactions. AccountBalances Formanypurposes,itisnecessarytodeterminethebalanceinanaccount.Thisisaccomplishedbyaddingthedebits,addingthecredits,anddeterminingthedifferencebetweenthetwosums.Anaccountissaidtohavea debitbalance ifthesumofthedebitentriestothataccountexceedsthesumofthecreditentries.Conversely,anaccounthasa creditbalance ifthesumofthecreditentriesexceedsthesumofthedebitentries.Intheexampleillustratedearlierinthischapter,thecashaccountappearedasfollows: Cash (1) 10,000 (3) 4,000 (4) 5,000
November6,200913:43spi-b8119inx6inb811-ch03 48 AnIntroductiontoAccountingandManagerialFinance Thedebitstotal$10,000andthecreditstotal$9,000;thedebitsexceedthecreditsby$1,000.Assetaccountsnormallyhavedebitbalancesinasmuchastheseaccountsareincreasedbydebiting.Anassetaccountwithacreditbalanceisnolongeranasset.Forexample,supposetheAccountsReceivableaccounthadacreditbalance.Thiswouldindicatethatthecompanyowedmoneytoitscustomers,andthusitisproperlyclassifedasaliability.Liabilityandstockholders’equityaccountsnormallyhavecreditbalancesbecausetheseaccountsareincreasedbycrediting.Itisnotpossibletotellwhetheranaccountisanassetorastockholder’sequitybymerelyobservingitsbalance.Forexample,accountswithcreditbalancesmayrepresentdeductionsfromassetsratherthanstockholders’equities.Accountswithdebitbalancesmayrepresentdeductionsfromliabilitiesratherthanassets.Thefactthattotaldebitswereequaltototalcreditsintheillustrationsisnotduemerelytochanceortothecontrivednatureoftheexamples.Thisequalitymustalwaysexistiftherecordingprocessistobecarriedoutcorrectly.Wheneverthetotaldebitsarenotequaltototalcredits,itiscertainthatanerrorhasbeenmade.Testingtheequalityofthedebitandcreditentriesservesasaconvenientdevicetodetectmistakes.Althoughtheinequalityofdebitsandcreditsalwayssignalsthepresenceofanerror,theequalityofdebitsandcreditsdoesnotassuretheaccuracyoftherecords.Therangeoferrorsthatmightbedisclosedbytheequalitytestisquitebroad.However,itdisclosesneithertheomissionofanentrynoranentrytothewrongaccount.Itisimpossibletoconceiveofatransactionwherebyanassetwouldbeincreasedandaliabilitydecreasedwithnootherchanges.Anytimethatdebitsdonotequalcredits,itfollowsthatanerrorhasbeenmade.Thechoicetoincreasestockholders’equityaccountswithcreditsgiventhatassetaccountsareincreasedwithdebitswasnotanarbitrarywhim.Theconventionwasadoptedtoresultintheequalityofdebitsandcreditsforeachtransaction,adesirablecontrolfeature. JournalEntries UptothispointwehavemadeentriesinT-accounts,whichareveryuse-fulforlearninghowtorecordaccountingentries.Inconcept,theT-accountisrelatedtoanimportantcomponentoftherecordingsystemusedinaccountingpractice—theledger.The ledger isacollectionofaccountsthatisusedtosum-marizetheresultsoftransactionssothatthebalanceofeachaccountmaybereadilydetermined.
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 49 Whenmanytransactionsareinvolved,itmightbecomerathercumbersometorecordeachofthemdirectlyintheledger.Theledgerwouldsoonbecomeclutteredwithnumerousentries,anditwouldbediffculttotracetheeffectsofindividualtransactionsevenwhentheledgerentriesarekeyed.Asamatterofconvenience,itisoftendesirabletorecordtransactionsin journalentryform .Inthisform,thetitlesofaccountstobedebitedorcreditedarelistedalongwiththeamountsinvolved.Theaccountstobedebitedarelistedfrst.Theaccountstobecreditedarelistednextandaredistinguishedbyindenting.Anexplanationmaybeaddedwhereitisdesirable.Inmostcases,thejournalentriescontainthesameinformationaswouldhavebeenpresentedifthetransactionshadbeenrecordedinT-accountform.Ifthe journalentryform isusedratherthanT-accountstorecordtransactions,wewouldhavethefollowingformat: Dr.Cr. Cash.............................................1,000,000Commonstock..................................1,000,000Torecordtheissuanceof$1,000,000ofcommonstock.Building..........................................500,000Cash...........................................500,000Torecordthepurchaseofabuildingfor$500,000cash.The journalentryformat isalsorelatedtoarecordingprocedureusedinpractice.A journal ,or bookoforiginalentry ,isusedtorecordtransactionsinchronologicalorder.Entriesarenormallyrecordedfrstinajournalandthentransferredtotheledger. Summary Wehavedefnedtheequation:Assets = Liabilities + Stockholders’Equity.Thisequalityalwaysholds.Theformalexpansionofthisequalityleadstotheimportantfnancialstatement,thebalancesheet.Theprimaryfunctionoffnancialaccountingistoreporttheresultsofoper-ationsandthefnancialpositionoftheenterprise.Thesereportsareimportanttomanagementandotherusersofthestatements,sincetheyrefecttheresultsofpastdecisionsandtheexecutionofthesedecisions.Also,managementknowsthatthepresentdecisionswillbesimilarlyevaluated.However,whenmanagersmakedecisions,theygenerallysupplementconventionalfnancialstatementswith
November6,200913:43spi-b8119inx6inb811-ch03 50 AnIntroductiontoAccountingandManagerialFinance informationpreparedespeciallyforthedecisionsbeingmade.Thus,theprimaryaccountingconcernofthisbookisfnancialreportingofascore-keepingnature.Knowingwhereyouare(thebalancesheet)andhowyougotthere(theincomestatement)isimportanttodecisionmakers.Accountsareusedtorecordincreasesanddecreasesinassets,liabilities,andstockholders’equity.Assetsareincreasedbyentriestotheleft-handsideofT-accounts(debits)andaredecreasedbyentriestotheright-handsideofT-accounts(credits).Liabilitiesandstockholders’equityaredecreasedbyentriestotheleft-handsideofT-accounts(debits)andareincreasedbyentriestotheright-handsideofT-accounts(credits).Theaccountingconventionofincreasingassetaccountswithdebitsandincreas-ingliabilityorequityaccountswithcreditsprovidesasysteminwhich,foreachentry,thedebitsmustequalthecredits.Thus,forthetotalofallentries,thesumofthedebitsmustequalthesumofthecredits.Itisnotimportantthatwedefnedadebittoincreaseassets;wecouldjustasreasonablyhavedefneditasadecrease.Itisimportantthat,havingdefnedadebitasanincreaseinanassetaccount,adebitshouldhavetheoppositeeffectonaliabil-ityorstockholders’equityaccount.Thechangesinassetsmustequalthechangesinsourcesofassets.Also,thedebitsmustequalthecreditsforeachtransaction. ReviewProblems ReviewProblem3.1 ThefollowingfactsapplytotheABCCompanyintheyear20XX.1.Stockholdersinvest$1,000,000.2.Thecompanybuyslandfor$20,000andabuildingfor$380,000incash.3.Thecompanyborrows$100,000fromthebank.Thefve-yearnotebears14percentinterestperyear.4.Thecompanypurchases$300,000ofmerchandise,paysfor$200,000ofit,andrefectstheremainderasanaccountpayable.5.Salesof$800,000aremadeonaccount,andthereis$50,000ofmerchandiseremainingattheendoftheyear.Wagesandotherexpensesfortheyearare$370,000.Interestof$3,000ispaidonthebankdebt.Theincomeis$177,000.6.Dividendsof$100,000arepaidtostockholders.7.Accountsreceivablehasanendingbalanceof$500,000.SetupT-accountsandrecordtheabovetransactions.Keyallentries.PrepareabalancesheetasofDecember31,20XX,thatrefectstheforegoingtransactions.
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 51 SolutiontoReviewProblem3.1 Cash Common Stock (1) 1,000,000 (2) 20,000 1,000,000 (1) 1,000,000 (3) 100,000 (2) 380,000 1,000,000 1,000,000 (7) 300,000 (4) 200,000 1,000,000 (5) 373,000 (6) 100,000 327,000 1,400,000 1,400,000 327,000 Merchandise Retained Earnings (4) 300,000 (5) 250,000 (6) 100,000 (5) 177,000 50,000 77,000 300,000 300,000 177,000 177,000 50,000 77,000 LandAccounts Payable 2(2)0,000 20,000 100,000 (4) 100,000 20,000 200,000 100,000 100,000 20,000 100,000 BuildingNotes Payable (2) 380,000 380,000 100,000 (3) 100,000 380,000 380,000 100,000 100,000 380,000 100,000 Accounts Receivable (5) 800,000 (7) 300,000 500,000 800,000 800,000 500,000 TheABCCompanyBalanceSheetasofDecember31,20XX AssetsLiabilitiesandStockholders’EquityCurrentAssetsCurrentLiabilities Cash$327,000AccountsPayable$100,000AccountsReceivable500,000Merchandise50,000 Long-TermLiabilities NotesPayable100,000 TotalCurrentAssets$877,000TotalLiabilities$200,000 Long-LivedAssetsStockholders’Equity Land20,000CommonStock1,000,000Building380,000 RetainedEarnings77,000 TotalAssets $1,277,000 TotalLiabilitiesandStockholders’Equity $1,277,000
November6,200913:43spi-b8119inx6inb811-ch03 52 AnIntroductiontoAccountingandManagerialFinance QuestionsandProblems 1.Defnetheterm accounting .Whataresomeofthetasksthataccountantsperform?2.Shouldfnancialaccountingprinciplesbebaseduponincometaxregulations?3.Whatformofbusinessorganizationwouldyouexpectthefollowingindustriestotake?Why?a.Steelindustry.b.Law.c.Retailing.d.Farming.4.Whataretwoprincipalfnancialstatements?Whatisthefunctionofeach?5.TheXYZCompanyhaslistedononeofitsfnancialreports(balancesheet),“Buildings,$451,000.”Describetheusefulnessofthismeasurefordecisionmaking.6.Accountingisonetypeofinformationsystem.Nameseveralothersystemssupplyinginformationtobusinessmanagers.Nameseveralothersourcesoffnancialinformationavailabletoinvestors.7.Comparetheneedforfnancialinformationofabankloanoffcer,aninvestorincommonstock,andthefnancialanalystofaninsurancecompanyinvestinginlong-termcorporatedebt.8.Itissometimesstatedthattheassetsideofabalancesheetshouldincludetherightsinproperty,bothtangibleandintangible,ofabusinessenterprise.Acceptingthisstatement,discusswhetherthefollowingitemsshouldbeincludedamongtheassets:a.Investmentingovernmentbonds.b.Investmentincorporatebonds.c.Prepaidexpenses.d.Costsofdrillingforoil(assumingoilwasfound).e.Advertisingcostsconnectedwithanewproduct(notyetofferedforsale).f.Costsoforganizinganewcorporation.g.Costsconnectedwithissuingbonds.h.Costsofinstallingapieceofequipment.i.Costsofdrillingforoil(assumingoilwasnotfound).9.IndicatewhichofthefollowingitemsmightbeexpectedtobefoundonabalancesheetpreparedinaccordancewithGenerallyAcceptedAccountingPrinciples(thebasicframeworkofaccounting):a.Thevalueofthemanagerialorganization,whichhadbeendevelopedthroughtheyears.
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 53 b.Thecostincurredinorganizingthefrm.c.Thevalueofoil,whichhadbeendiscoveredunderacorporateparkinglot(therearenodrillingcosts).d.Thevalueofthegoodwillofcustomerstowardthefrm(thegoodwillhadbeenbuiltupthroughtheyearsbygoodservice).e.Theexcessofthepricepaidforanenterprisethathadbeenpurchasedoverthevalueofthetangibleassetsacquired(considertangibleassetstorefertothevalueofinventories,plant,andequipment).10.Amajorstockholderofacorporationisconcernedaboutthemanagementofherfrm,sincethecompanyhaslandwithavalueof$8,000,000beingusedforparkinglots.Thecontrollerisawareofthe“stewardshipfunction”ofaccountingandcheckstheinvoices.Hefndsthatthecostofthelandwas$400,000andtherewasnopossibilityofdishonesty.Thecontrollerreportsthisfndingbacktothestockholder.Commentontheinformationpresentedtothestockholder.11.Ithasbeensuggestedbyreputableeconomiststhatfrmsshouldbeallowedfortaxpurposestoconsiderthecostofequipmentasareductionofincomeatthetimeofacquisition,sincetheequipmentwaspaidforatthattime(otherreasonsarealsooffered).Iftheaboveproposalweretobeaccepted,doyouthinkthisprocedureshouldbefollowedforfnancialreportingpurposes?Explain.12.Assumethereisanunknown“true”value.Considertwomeasurementpro-cedures.Oneprocedure(A)willprovideameasurethatislessthanthetruevalue,andallmeasurerswillpresentthesamemeasure.Thesecondprocedure(B)willprovide,onaverage,ameasureequaltothetrueamount,butitcanbeeitherlargerorsmalleronarandombasis.Whichmeasurementproceduredoyouprefer,assumingyourdecisionwillbebasedontheinformationobtained?13.Assumethatinthehiringprocessafrmspends$4,000peruniversitygraduatethatithires.Shouldthefrmconsidertheentire$4,000tobeanexpenseintheperiodinwhichthepersonishiredorshouldportionsofitbeconsideredanexpenseeachyearforthedurationofemployment?14.Adividendof$10,000willdecrease ifithasbeenpaid.15.DeterminetheaccountingincomeofacompanyforwhichthefollowinginformationisavailableforthemonthofJune:DividendsPaidtoStockholders$10,000EmployeeSalariesforJune30,000InterestPaidonBankLoanforJune5,000JuneRentPaidtoLandlord25,000SalestoCustomersinJune80,000
November6,200913:43spi-b8119inx6inb811-ch03 54 AnIntroductiontoAccountingandManagerialFinance 16.Theassetsofacorporationtotal$10,000;theliabilities,$4,000.Theclaimsoftheownersare .17.TheAesopCompanyhastotalassetsof$1,000,000andtotalliabilitiesof$600,000.Thecommonstockholdershaveexplicitlyinvested$100,000inthefrm.Sinceorganization,thefrmhaspaidcashdividendsof$800,000.a.Whathavethetotalearningsbeensinceorganization?b.Ifthestockholdershadexplicitlyinvested$700,000butifallotherfactswereunchanged,whatwouldbethetotalearningssinceorganization?18.Fromthefollowinginformation,presentedasofDecember31,20XX,prepareabalancesheetfortheArleyCorporationingoodform.Liabilities$8,000Cash4,000Materials2,000Buildings7,000Owners’Equities?19.Fromthefollowinginformation,obtainedasofDecember31,20XX,prepareabalancesheetfortheAdamsCorporationingoodform.AccountsPayable$12,000Land$25,000DividendsPayable5,000Equipment75,000Cash45,000AccountsReceivable15,000MarketableSecurities10,000InterestPayable2,000Investments40,000Merchandise25,000BondsPayable100,000Supplies2,000CommonStock150,000Buildings100,000RetainedEarnings?20.Fromthefollowinginformation,obtainedasofDecember31,20XX,prepareabalancesheetfortheAdlerCorporationingoodform.AccountsPayable$10,000Land$10,000DividendsPayable4,000Equipment60,000Cash20,000AccountsReceivable15,000MarketableSecurities10,000InterestPayable1,000Investments40,000Merchandise18,000BondsPayable50,000Supplies2,000CommonStock100,000Buildings50,000RetainedEarnings?
November6,200913:43spi-b8119inx6inb811-ch03 AnIntroductiontoFinancialReporting 55 21.Certainaccountsareincreasedbyentriestotheleftsideoftheaccount,othersbyentriestotherightsideoftheaccount.Foreachofthefollowingitems,indicatewhethertheamountshouldbeenteredontherightorleftsideoftheaccount. IncreaseCashIncreaseWagesPayableDecreaseBondsPayableIncreaseRetainedEarningsDecreaseCashIncreaseCommonStock 22.Foreachofthefollowingtransactions,indicatethetwo(ormore)accountsthatareaffectedandhowtheyareaffected(increaseordecrease).Indicatewhethertheaccountsaredebitedorcredited.a.Cashisinvestedbythestockholders.b.Merchandiseispurchasedonaccount.c.Themerchandiseispaidfor.d.Insuranceispurchasedandpaidfor.e.Merchandiseissoldonaccount.f.Dividendsarepaidtothestockholders.23.Foreachofthefollowingtransactions,indicatewhataccountsarelikelytobeaffectedandwhethertheaccountsarelikelytobedebitedorcredited.a.Moneyisreceivedfromstockholders.b.Merchandiseispurchasedonaccount.c.Abuildingispurchased.Paymentismadebycashandbytakingoutamortgage.d.Apieceofequipmentissoldforcash.24.a.SetupT-accountsandrecordthefollowingtransactionsoftheBarkerCor-porationforthemonthofMarch.(1)Stockholdersinvest$100,000.(2)Thecompanybuys$19,000ofmerchandiseonaccount.(3)Thecompanypays$11,000oftheamountowedforthemerchandise.(4)Oneyear’srentispaid,$4,800.TherentappliestotheyearbeginningMarch1.(5)SalesforMarch,thefrstmonthofoperations,total$13,300.Allsalesareforcash.Themerchandisesoldcosts$7,900.Salariespaidincashtoemployeesduringthemonthare$1,000,andthecompanyowesanadditional$300ofwagesasoftheendofthemonth.
November6,200913:43spi-b8119inx6inb811-ch03 56 AnIntroductiontoAccountingandManagerialFinance (6)Dividendsof$500arepaidtostockholders.b.PrepareabalancesheetasofMarch31,20XX.25.a.SetupT-accountsandrecordthefollowingtransactions;keyallentries.(1)Stockholdersinvest$100,000.(2)Thecompanybuys$12,000ofmerchandiseonaccount.(3)Thecompanybuysabuilding,paying$2,000cashandassuminga$28,000mortgagefortheremainderofthepurchasepriceof$30,000.(4)Themerchandise(seeTransaction2)ispaidfor.(5)Salesof$9,000aremade.Ofthesesales,$7,000areforcashandtheremainderonaccount.Thecostofthemerchandisesoldis$6,000.Wagesearnedandpaidduringthisperiodtotal$1,200.(6)Anamountof$800ispaidtothemortgagee.Ofthisamount,$560isinterestandtheremainderrepresentsareductionoftheprincipalbalance.(7)Dividendsof$400arepaidtostockholders.b.PrepareabalancesheetasofDecember31,20XX,givingeffecttoalltheforegoingtransactions.
November6,200913:43spi-b8119inx6inb811-ch04 Chapter4 CapitalBudgeting Acapitalbudgetingdecisionischaracterizedbycostsandbenefts(cashfows)thatarespreadoutoverseveraltimeperiods.Thisleadstoarequirementthatthetimevalueofmoneybeconsideredinordertoevaluatethealternativescorrectly.Althoughinactualpracticewemustconsiderriskaswellastimevalue,inthischapterwerestrictthediscussiontosituationsinwhichthecostsandbenefts(intermsofcash)areknownwithcertainty.Therearesuffcientdiffcultiesinjusttakingthetimevalueofmoneyintoconsiderationwithoutalsoincorporatingriskfactors.Moreover,whenthecashfowsarefnallyallowedtobeuncertain,weshallsuggesttheuseofaprocedurethatisbasedontheinitialrecommendationsmadewiththecertaintyassumption,sonothingislostbymakingtheinitialassumptionofcertainty.Inthischapter,weshalldescribefourofthemorecommonlyusedproceduresformakingcapitalbudgetingdecisions.Weshallnotattempttodescribeallthevariationsthatarepossibleoralltheproceduresusedthatarefaulty.Ifyouunder-standthebasicelementsofacorrectprocedure,youwillbeabletodistinguishbetweencorrectandincorrectprocedures.Thetwobasiccorrectcapitalbudgetingtechniquespresentedinthischapterareapplicabletoawiderangeofdecisionsfoundthroughouttheeconomybothintheproftandnot-for-proftsectors. RateofDiscount Weshallusetheterm timevalueofmoney todescribethediscountrate.Onepossibilityistousetherateofinterestassociatedwithdefault-freesecurities.Thisratedoesnotincludeanadjustmentfortheriskofdefault;thusrisk,ifpresent,wouldbehandledseparatelyfromthetimediscounting.Insomesituations,itisconvenienttousethefrm’sborrowingrate(themarginalcostofborrowingfunds).Theobjectiveofthediscountingprocessistotakethetimevalueofmoneyintoconsideration.Wewanttofndthepresentequivalentoffuturesums,neglecting 57
November6,200913:43spi-b8119inx6inb811-ch04 58 AnIntroductiontoAccountingandManagerialFinance riskconsiderations.Later,weshallintroduceseveraltechniquestoadjustfortheriskoftheinvestment.Althoughthefrm’sweightedaveragecostofcapitalisanimportantconceptthatshouldbeunderstoodbyallmanagersandisusefulindecidingonthefnancingmix,wedonotadvocateitsgeneraluseinevaluatingallinvestments. ClassifcationofCashFlows Weshalldefneconventionalinvestmentsasthosehavingoneormoreperiodsofoutlaysfollowedbyoneormoreperiodsofcashproceeds.Borrowingmoneyisakindof“negativeinvestment”or“loantypeofcashfow”inwhichoneormoreperiodsofcashproceedsarefollowedbyoneormoreperiodsinwhichtherearecashoutlays.Loan-typeinvestmentshavepositivecashfows(cashinfows)followedbyperiodsofnegativecashfows(cashoutlays).Therearealsononconventionalinvestments,orinvestmentsthathaveoneormoreperiodsofoutlaysinterspersedwithperiodsofproceeds.Withnonconventionalinvestments,thereismorethanonesignchangeinthesequenceofthecashfow.Withaconventionalinvestmentorloan,thereisonesignchange.Thepossibilitiesmaybeillustratedasfollows: SignofFlowforPeriod 0123 Conventionalinvestment −+++ Loantypeoffows +−−− Nonconventionalinvestment −++− Nonconventionalinvestment +−−+ DependentandIndependentInvestments Inevaluatingtheinvestmentproposalspresentedtomanagement,itisimportanttobeawareofthepossibleinterrelationshipsbetweenpairsofinvestmentproposals.Agiveninvestmentproposalmaybeeconomicallyindependentof,ordependenton,anotherinvestmentproposal.Aninvestmentproposalissaidtobe economicallyindependent ofasecondinvestmentifthecashfows(orthecostsandbenefts)expectedfromthefrstinvestmentarethesameregardlessofwhetherthesecondinvestmentisacceptedorrejected.Ifthecashfowsassociatedwiththefrstinvest-mentareaffectedbythedecisiontoacceptorrejectthesecondinvestment,thefrstinvestmentissaidtobe economicallydependent onthesecond.Itshouldbeclear
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 59 thatwhenoneinvestmentisdependentonanother,someattentionmustbegiventothequestionofwhetherdecisionsaboutthefrstinvestmentcanorshouldbemadeseparatelyfromdecisionsaboutthesecond. EconomicallyIndependentInvestments InorderforinvestmentAtobeeconomicallyindependentofinvestmentB,twoconditionsmustbesatisfed.First,itmustbetechnicallypossibletoundertakeinvestmentAwhetherornotinvestmentBisaccepted.Forexample,itis not possibletobuildaschoolandashoppingcenteronthesamesite;therefore,theproposaltobuildtheoneisnotindependentofaproposaltobuildtheother.Second,thenetbeneftstobeexpectedfromthefrstinvestmentmustnotbeaffectedbytheacceptanceorrejectionofthesecond.IftheestimatesofthecashoutlaysandthecashinfowsforinvestmentAarenotthesamewhenBiseitheracceptedorrejected,thetwoinvestmentsarenotindependent.Thus,itistechnicallypossibletobuildatollbridgeandoperateaferryacrossadjacentpointsonariver,butthetwoinvestmentsarenotindependentbecausetheproceedsfromonewillbeaffectedbytheexistenceoftheother.Thetwoinvestmentswouldnotbeeconomicallyindependentinthesenseofwhichweareusingtheterm,evenifthetraffcacrosstheriveratthispointweresuffcienttoproftablyoperateboththebridgeandtheferry.Sometimestwoinvestmentscannotbothbeacceptedbecausethefrmdoesnothaveenoughcashtofnanceboth.Thissituationcouldoccuriftheamountofcashavailableforinvestmentswerestrictlylimitedbymanagementratherthanbythecapitalmarket,orifincrementsoffundsobtainedfromthecapitalmarketcostmorethanpreviousincrements.Insuchasituation,theacceptanceofoneinvestmentmaycausetherejectionoftheother.Butwewillnotconsiderthetwoinvestmentstobeeconomicallydependent.Toclassifythistypeofinvestmentasdependentwouldmakeallinvestmentsforsuchafrmdependent,andthisisnotausefuldefnitionforourpurposes. EconomicallyDependentInvestments Thedependencyrelationshipcanbeclassifedfurther.Ifadecisiontoundertakethesecondinvestmentwillincreasethebeneftsexpectedfromthefrst(ordecreasethecostsofundertakingthefrstwithoutchangingthebenefts),thesecondinvest-mentissaidtobea complement ofthefrst.Ifthedecisiontoundertakethesec-ondinvestmentwilldecreasethebeneftsexpectedfromthefrst(orincreasethecostsofundertakingthefrstwithoutchangingthebenefts),thesecondissaidtobea substitute forthefrst.Intheextremecasewherethepotentialbenefts
November6,200913:43spi-b8119inx6inb811-ch04 60 AnIntroductiontoAccountingandManagerialFinance PrerequisiteIndependentMutuallyexclusive StrongcomplementWeak complementWeak substituteStrong substitute Fig.4.1. InvestmentRelationships. tobederivedfromthefrstinvestmentwillcompletelydisappearifthesecondinvestmentisaccepted,orwhereitistechnicallyimpossibletoundertakethefrstwhenthesecondhasbeenaccepted,thetwoinvestmentsaresaidtobe mutuallyexclusive .Itmaybehelpfultothinkofthepossiblerelationshipsbetweeninvestmentsasbeingarrayedalongalinesegment(seeFig.4.1).Attheextremeleft,investmentAisaprerequisitetoinvestmentB.Inthecenteroftheline,investmentAisindependentofinvestmentB.Attheextremeright-handendoftheline,investmentAismutuallyexclusivewithrespecttoinvestmentB.Aswemovetotherightfromtheleft-handsideoftheline,wehavevaryingdegreesofcomplementariness,decreasingtotheright.Similarly,theright-handsideofthelinerepresentsvaryingdegreesofsubstitutability,increasingtotheright. StatisticalDependence Itispossiblefortwoormoreinvestmentstobeeconomicallyindependentbutstatisticallydependent.Statisticaldependenceissaidtobepresentifthecashfowsfromtwoormoreinvestmentswouldbeaffectedbysomeexternaleventorhappeningwhoseoccurrenceisuncertain.Forexample,afrmcouldproducehigh-pricedyachtsandexpensivecars.Theinvestmentdecisionsaffectingthesetwoproductlinesareeconomicallyindependent.However,thefortunesofbothactivitiesarecloselyassociatedwithhighbusinessactivityandalargeamountofdiscretionaryincomeforthe“rich”people.Thisstatisticaldependencemayaffecttheriskofinvestmentsintheseproductlines,becausetheswingsofproftabilityofafrmwiththesetwoproductlineswillbewiderthanthoseofafrmwithtwoproductlineshavinglessstatisticaldependence. MeasuresofInvestmentWorth Inthischapter,weintroducefourmethodsofevaluatingtheworthofinvestmentsthatareincommonuseorhavebeenfrequentlyrecommendedasbeingdesirable.Ifwetakeagroupofinvestmentproposalsandrankthembyeachofthesemethods,we
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 61 shallfndthateachmethodwillfrequentlygiveadifferentrankingtothesamesetofinvestmentproposals.Infact,itcanbesaidthatthedifferentmeasureswillonlyaccidentallygiveidenticalrankingstoasetofinvestmentproposals.Althoughweshallnotbeabletorankeconomicallyindependentinvestmentsinausefulmanner,weshallnormallybeabletomakedecisionswithoutsuchrankings.Variousexecutivesfacedwiththesamesetofinvestmentpossibilities,butusingdifferentmeasuresofinvestmentworth,willtendtomakedissimilarinvestmentdecisions.Clearly,allthemeasuresthatwillbedescribedherecannotbeequallyvalid.Weshallattempttodeterminewhichofthemeasureshavesomelegitimatereasonforuseandtoisolatethecircumstancesunderwhichtheywilltendtogivesatisfactoryresults.Incurrentbusinesspractice,eachofthemethodsselectedhasitsadvocates,andfrequentlytheyareusedincombinationwitheachother.Becauseinvestmentproposalsarerarelyacceptedbytopmanagementsolelyonthebasisofsuchanal-yses,itmaybearguedthatthechoiceofmethodisoflittlesignifcancebecausetheinvestmentdecisionislikelytobeinfuencedbymanydifferentfactors.Insofarastheexecutivesmakingthefnaldecisionareawareoftherisksinvolved,areintimatelyfamiliarwiththeproposals,knowthepossibletechnicaloroperatingproblemsthatmaybeencountered,andrealizethepotentialerosionofearningsresultingfromcompetitiveactionorchangingtechnology,thiscriticismmayverywellbevalid.Inmostlargeorganizations,however,itisimpossibleforthetopmanagementoffcials,whomustfnallyapproveordisapproveinvestmentpropos-als,tobeintimatelyfamiliarwiththedetailsofeachandeveryproposalpresentedtothem.Totheextentthatthisintimateknowledgeisimpossibleorimpractical,theseexecutivesmustrelyupontheeconomicevaluationspreparedbytheirsub-ordinates.Tomakereasonablechoicesinweighingalternativeinvestments,itisincreasinglynecessarythatvariousproposalsbeevaluatedasnearlyaspossibleonsomeuniform,comparablebasis.Insuchcircumstances,althoughthemeasureofeconomicworthofaninvestmentshouldneverbethesolefactorconsideredinmakingafnaldecision,itshouldplayanimportantpartintheevaluationoftheinvestmentsunderconsiderationbythefrm.Thefactthatvariousmeasuresgivedifferentrankingsandindicatedifferentaccept-or-rejectdecisionstoidenticalsetsofinvestmentproposalsisamatterofconcern.Substantialimprovementsineffciencyandincomemayresultifmoreade-quatemeasurescanbediscoveredandwidelyadopted.Anysuchprogressrequiresfrstamoregeneralagreementaboutthedesirablecharacteristicstobepossessedbyagoodindexoftheeconomicworthofaninvestment.Weassumethattheobjectiveistomaximizethewell-beingofthecommonstockholders.
November6,200913:43spi-b8119inx6inb811-ch04 62 AnIntroductiontoAccountingandManagerialFinance IncrementalCashFlow Investmentsshouldbeanalyzedusingafter-taxincrementalcashfows.Althoughweshallinitiallyassumezerotaxessothatwecanconcentrateonthetechniqueofanalysis,itshouldberememberedthattheonlyrelevantcashfowsofaperiodareafteralltaxeffectshavebeentakenintoaccount.Thedefnitionofincrementalcashfowsisrelativelystraightforward:ifthetransactionchangesthebankaccountorcashbalance,thereisacashfow.Thisdefnitionincludesopportunitycosts(thevalueofalternativeuses).Forexample,ifawarehouseisusedforanewproductandthealternativeistorentthespace,thelostrentalsshouldbecountedasanopportunitycostincomputingtheincrementalcashfows.Itisgenerallyadvisabletoexcludefnancialtypesofcashfowsfromtheinvest-mentanalysis.Onecommonerrorincashfowcalculationsistoincludeinterestpaymentsondebtinthecashfowsandthenapplythetime-discountingformulas.Thisresultsindouble-countingthetimevalueofmoney.Thetimediscountingtakesinterestintoconsideration.Itisnotcorrecttoalsodeducttheinterestexpenseofaninvestmentincomputingcashfows. SpecialAssumptions Thecomputationsofthischaptermakeseveralassumptionsthatareconvenient,butarenotessential.Theysimplifytheanalysis.Theassumptionsare:1.Capitalcanbeborrowedandlentatthesamerate.2.Thecashinfowsandoutfowsoccuratthebeginningorendofeachperiodratherthancontinuouslyduringtheperiods.3.Thecashfowsarecertain,andnoriskadjustmentisnecessary.Inaddition,inchoosingthemethodsofanalysisandimplementation,itisassumedthattheobjectiveistomaximizethewell-beingofstockholders,andmorewealthisbetterthanless. TheElementsofaCashFlowProjection Toarriveatthesetofprojectedincrementalcashfowsusedinevaluatinganyinvestment,itisusuallynecessarytoprojecttheimpactoftheinvestmentontherev-enuesandexpensesofthecompany.Someinvestmentswillaffectonlytheexpensecomponents(i.e.,cost-savinginvestments),whereasotherswillaffectrevenuesaswellascosts.Projectinghowvariousexpenseandrevenueitemswillbeaffected
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 63 iftheinvestmentisundertakenisnotaneasytask,forincrementalimpactsareoftendiffculttoassess.Insomecases,suchastheimpactofanewproductonthesalesofanexistingproductthatisconsideredasubstitute,theproblemistheuncertainextentoftheerosion.Inothercases,suchaswithoverheaditems(e.g.,accountingservices,plantsecurity,aregionalwarehousesystem),theproblemarisesbecausethereisnotawell-defnedcashfowrelationshipbetweentheincre-mentalactioncontemplatedandthesecosts.Noexactsolutionexiststotheseknottyproblems.Aninvestmentinplantorequipmenttoproduceanewproductwillprobablyalsorequireaninvestmentincurrentassetslesscurrentliabilities(workingcapital).Theremaybeanincreaseinrawmaterial,work-in-process,andfnishedgoodsinventories.Also,iftherearesalesoncreditratherthancash,accountsreceivablewillincrease;thatis,salespertheincomestatementwillbecollectedwithalag,andtherewillbeanincreaseinaccountsreceivable.Finally,notallpayableswillbepaidimmediately,andthislagwillmanifestitselfinanincreaseincurrentliabilities(reducingtheneedforotherfnancing).Thus,aworkingcapitalinvestment(anegativecashfowandaneedforcapital)usuallyaccompaniesthedirectinvestmentinplantandequipment.Onecanassumethattheworkingcapitalinvestmentisfullyturnedintocashatthehypothesizedendoftheproject.Thatis,itisassumedthatinventoriesaredepleted,receivablesarecollected,andpayablesarepaid.Hence,overthelifeoftheproject,thesumoftheworkingcapitalchangesshouldbezeroifthisassumptionisaccepted.However,thecommitmentofresourcestoworkingcapitalhasacost(thetimevalueofmoney)evenifthoseresourcesareultimatelyfreed. TwoDiscountedCashFlowMethods Weshallfrstintroducethetwoprimarydiscountedcashfowinvestmentevaluationprocedures,netpresentvalue(NPV)andinternalrateofreturn(IRR).Afterabriefdiscussionofthesetwomeasuresofinvestmentworth,weshalldescribeaseriesoffourhypotheticalinvestments.Thefourhypotheticalinvestmentshavebeendesignedsuchthatfortwoselectedpairsitispossibletodecidethatoneinvestmentisclearlypreferabletotheother.Ifameasureofinvestmentworthindicatesthatoneinvestmentisbetterwhentheotherinvestmentisactuallybetter,thenclearlythereisadangerinusingthatmeasure.Weshallfndthatsomemeasurescaneasilybeeliminatedasgeneraldecisionrulesbecauseinsomesituationstheygiveobviouswronganswerswhereasanothermeasuregivesthe“right”answer.Weshallconcludethatthenetpresentvaluemethodisbetterthantheotherpossiblemethods.
November6,200913:43spi-b8119inx6inb811-ch04 64 AnIntroductiontoAccountingandManagerialFinance NetPresentValue Weoffertwoproposedmeasuresofinvestmentworththatasagroupcouldbecalledthediscountedcashfow,orDCF,measures.Beforeproceedingtoanalyzethem,itisdesirabletoexplainagaintheconceptofthepresentvalueofafuturesumbecauseinonewayoranotherthisconceptisutilizedinboththesemeasures.Thepresentvalueof$100payableintwoyearscanbedefnedasthatquantityofmoneynecessarytoinvesttodayatcompoundinterestinordertohave$100intwoyears.Therateofinterestatwhichthemoneywillgrowandthefrequencyatwhichitwillbecompoundedwilldeterminethepresentvalue.Weshallassumethatinterestiscompoundedannually.Themannerinwhicharateofinterestischosenwillbediscussedlater.Forthepresent,assumethatwearegivena0.10annualrateofinterest.Letusexaminehowthepresentvalueofafuturesumcanbecomputedbyusingthatrateofinterest.Supposethataninvestmentpromisestoreturnatotalof$100attheendoftwoyears.Because$1.00investedtodayat10percentcompoundedannuallywouldgrowto$1.21intwoyears,wecanfndthepresentvalueat10percentof$100intwoyearsbydividing$100by1.21orbymultiplyingbythepresentvaluefactor,0.8264.Thisgivesapresentvalueof$82.64.Therefore,asumof$82.64thatearns10percentinterestcompoundedannuallywillbeworth$100attheendoftwoyears.Byrepeatedapplicationsofthismethod,wecanconvertanyseriesofcurrentorfuturecashpayments(oroutlays)intoanequivalentpresentvalue.Becausetables,handcalculators,andcomputersareavailablethatgivetheappropriateconversionfactorsforvariousratesofinterest,thecalculationsinvolvedarerelativelysimple.Thenetpresentvaluemethodisadirectapplicationofthepresentvalueconcept.Itscomputationrequiresthefollowingsteps:(1)chooseanappropriaterateofdiscount,(2)computethepresentvalueofthecashproceedsexpectedfromtheinvestment,(3)computethepresentvalueofthecashoutlaysrequiredbytheinvestment,and(4)addthepresentvalueequivalentstoobtaintheinvestment’snetpresentvalue.Thesumofthepresentvalueoftheproceedsminusthepresentvalueoftheoutlaysisthenetpresentvalueoftheinvestment.Therecommendedaccept-or-rejectcriterionistoacceptallindependentinvestmentswhosenetpresentvalueisgreaterthanorequaltozero,andtorejectallinvestmentswhosenetpresentvalueislessthanzero. Withzerotaxes,thenetpresentvalueofaninvestmentmaybedescribedasthemaximumamountafrmcouldpayfortheopportunityofmakingtheinvestmentwithoutbeingfnanciallyworseoff .Withsuchapayment,theinvestorwouldbeindifferenttoundertakingornotundertakingtheinvestment.Becauseusuallyno
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 65 suchpaymentmustbemade,theexpectednetpresentvalueisanunrealizedcapitalgainfromtheinvestment,overandabovethecostoftheinvestmentusedinthecalculation.Thecapitalgainwillberealizediftheexpectedcashproceedsmateri-alize.Assumeaninvestmentthatcosts$10,000andreturns$12,100ayearlater.Iftherateofdiscountis10percent,acompanycouldmakeamaximumimmediateoutlayof$11,000intheexpectationofreceivingthe$12,100ayearlater.Ifitcanreceivethe$12,100withanactualoutlayofonly$10,000,thenetpresentvalueoftheinvestmentwouldbe$1,000.The$1,000representsthedifferencebetweentheactualoutlayof$10,000andthepresentvalueoftheproceeds$11,000.Thecom-panywouldhavebeenwillingtospendamaximumof$11,000toreceive$12,100ayearlater.Thefollowingexampleillustratesthebasiccomputationsfordiscountingcashfows,thatis,adjustingfuturecashfowsforthetimevalueofmoney,usingthenetpresentvaluemethod.Assumethatthereisaninvestmentopportunitywiththefollowingcashfows: Period 012 Cashfow $12,337$10,000$5,000 Wewantfrsttocomputethenetpresentvalueofthisinvestmentusing0.10asthediscountrate.TableAintheAppendixofthebookgivesthepresentvalueof$1due n periodsfromnow.Thepresentvalueof$1due0periodsfromnowdiscountedatanyinterestrateis1.000.$1due1periodfromnowdiscountedat0.10is0.9091.$1due2periodsfromnowdiscountedat0.10is0.8264.Thenetpresentvalueoftheinvestmentisthealgebraicsumofthethreepresentvaluesofthecashfows: (1)(2)(3)PeriodCashFlowPresentValueFactorPresentValue(col.1 × col.2) 0 $12,3371.0000 $12,3371$10,0000.9091$9,09125,0000.82644,132 Netpresentvalue=$886
November6,200913:43spi-b8119inx6inb811-ch04 66 AnIntroductiontoAccountingandManagerialFinance Thenetpresentvalueispositive,indicatingthattheinvestmentisacceptable.Anyinvestmentwithanetpresentvalueequaltoorgreaterthanzeroisacceptableusingthissinglecriterion.Sincethenetpresentvalueis$886,thefrmcouldpayanamountof$886inexcessofthecostof$12,337andstillbreakeveneconomicallybyundertakingtheinvestment.Thenetpresentvaluecalculationisareliablemethodforevaluatinginvestments. InternalRateofReturn Manydifferenttermsareusedtodefnetheinternalrateofreturnconcept.Amongthesetermsareyield,interestrateofreturn,rateofreturn,returnoninvestment,presentvaluereturnoninvestment,discountedcashfow,investor’smethod,time-adjustedrateofreturn,andmarginaleffciencyofcapital.Inthisbook,IRRandinternalrateofreturnareusedinterchangeably.Theinternalrateofreturnmethodutilizespresentvalueconcepts.Thepro-cedureistofndarateofdiscountthatwillmakethepresentvalueofthecashproceedsexpectedfromaninvestmentequaltothepresentvalueofthecashout-laysrequiredbytheinvestment.Sucharateofdiscountmaybefoundbytrialanderror.Forexample,withaconventionalinvestment,ifweknowthecashproceedsandthecashoutlaysineachfutureyear,wecanstartwithanyrateofdiscountandfndforthatratethepresentvalueofthecashproceedsandthepresentvalueoftheoutlays.Ifthenetpresentvalueofthecashfowsispositive,thenusingsomehigherrateofdiscountwouldmakethemequal.Byaprocessoftrialanderror,thecorrectapproximaterateofdiscountcanbedetermined.Thisrateofdiscountisreferredtoastheinternalrateofreturnoftheinvestment,oritsIRR.TheIRRmethodiscommonlyusedinsecuritymarketsinevaluatingbondsandotherdebtinstruments.Theyieldtomaturityofabondistherateofdis-countthatmakesthepresentvalueofthepaymentspromisedtothebondholderequaltothemarketpriceofthebond.Theyieldtomaturityona$1,000bondhavingacouponrateof10percentwillbeequalto10percentonlyifthecur-rentmarketvalueofthebondis$1,000.Ifthecurrentmarketvalueisgreaterthan$1,000,theIRRtomaturitywillbesomethinglessthanthecouponrate;ifthecurrentmarketvalueislessthan$1,000,theIRRwillbegreaterthanthecouponrate.Theinternalrateofreturnmayalsobedescribedastherateofgrowthofaninvestment.Thisismoreeasilyseenforaninvestmentwithonepresentoutlayandonefuturebeneft.Forexample,assumethataninvestmentwithanoutlayof$1,000todaywillreturn$1,331threeyearsfromnow.
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 67 Thisisa0.10internalrateofreturn,anditisalsoa0.10growthrateperyear: GrowthDividedbyBeginning-of-PeriodBeginning-of-PeriodTimeInvestmentGrowthofPeriodInvestment 0$1,000$100$100/$1,000=0.1011,100110$110/$1,100=0.1021,210121$121/$1,210=0.1031,331— Theinternalrateofreturnofaconventionalinvestmenthasaninterestinginterpretation.Itrepresentsthehighestrateofinterestaninvestorcouldaffordtopay,withoutlosingmoney,ifallthefundstofnancetheinvestmentwereborrowedandtheloan(principalandaccruedinterest)wasrepaidbyapplicationofthecashproceedsfromtheinvestmentastheywereearned.Weshallillustratetheinternalrateofreturncalculationusingtheexampleoftheprevioussectionwheretheinvestmenthadanetpresentvalueof$886using0.10asthediscountrate.Wewanttofndtherateofdiscountthatcausesthesumofthepresentvaluesofthecashfowstobeequaltozero.Assumethatourfrstchoice(anarbitraryguess)is0.10.Intheprecedingsituation,wefoundthatthenetpresentvalueusing0.10isapositive$886.Wewanttochangethediscountratesothatthepresentvalueiszero.Shouldweincreaseordecreasetherateofdiscountforoursecondestimate?Sincethecashfowsareconventional(negativefollowedbypositive),todecreasethepresentvalueofthefuturecashfows,weshouldincreasetherateofdiscount(thuscausingthepresentvalueofthefuturecashfowsthatarepositivetobesmaller).Letustry0.20astherateofdiscount: PeriodCashFlowPresentValueFactorPresentValue 0 $12,3371.0000 $12,3371$10,0000.8333$8,33325,0000.69443,472 Netpresentvalue=$532 Thenetpresentvalueisnegative,indicatingthatthe0.20rateofdiscountistoolarge.Weshalltryavaluebetween0.10and0.20forournextestimate.Assumethat
November6,200913:43spi-b8119inx6inb811-ch04 68 AnIntroductiontoAccountingandManagerialFinance wetry0.16: PeriodCashFlowPresentValueFactorPresentValue 0 $12,3371.0000 $12,3371$10,0000.8621$8,62125,0000.74323,716 Netpresentvalue = $0 Thenetpresentvalueiszerousing0.16astherateofdiscount,whichbydefnitionmeansthat0.16istheinternalrateofreturnoftheinvestment.Althoughtablesgiveonlypresentvaluefactorsforselectinterestrates,calcu-latorsandcomputerscanbeusedforanyinterestrate. NetPresentValueProfle Thenetpresentvalueprofleisoneofthemoreusefuldevicesforsummarizingtheproftabilitycharacteristicsofaninvestment.Onthehorizontalaxis,wemeasuredifferentdiscountrates;andontheverticalaxis,wemeasurethenetpresentvalueoftheinvestment.Thenetpresentvalueoftheinvestmentisplottedforalldiscountratesfromzerotosomereasonablylargerate.Theplotofnetpresentvalueswillcrossthehorizontalaxis(havezeronetpresentvalue)attherateofdiscountthatiscalledtheinternalrateofreturnoftheinvestment.Figure4.2showsthenetpresentvalueproflefortheinvestmentdiscussedintheprevioustwosections.Ifweaddthecashfows,assumingazerorateofdiscount,weobtain $12 , 337 + $10 , 000 + $5 , 000 = $2 , 663 . The$2,663istheintersectionofthegraphwiththe Y -axis.Weknowthatthegraphhasaheightof$886ata0.10rateofdiscountandcrossesthe X -axisat0.16,since0.16istheinternalrateofreturnoftheinvestment.Forinterestratesgreaterthan0.16,thenetpresentvalueisnegative.Notethatforaconventionalinvestment(minuscashfowsfollowedbypositivecashfows),thenetpresentvalueprofleslopesdownwardtotheright.Thenetpresentvalueproflegraphcanbeusedtoestimatetheinternalrateofreturnbyplottingonenegativevalueandonepositivevalueandconnectingthetwopointswithastraightline.Theinterceptwiththe X -axiswillgiveasensibleestimate(nottheexactvalue)oftheinternalrateofreturn.
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 69 2,66388600.100.16 Net present valueNet present value profileInternal rate of returnRate of discount Fig.4.2. NetPresentValueProflefortheInvestment. Weshallnowconsiderfourdifferentinvestmentopportunitiesandwillapplyfourdifferentinvestmentcriteriatotheseinvestments. FourInvestments InTable4.1,fourhypotheticalinvestmentsaredescribedintermsoftheinitialcostofeachandthenetproceedsexpectedduringeachyearoflife.Thesalvagevalueorterminalvalueofeachinvestmentisassumedtobezero.Weshallillustratetherankingthatmaybegiventotheseinvestmentsbyeachmeasureofinvestmentworthunderconsideration.Toavoidcomplexities,wewillassumethattherearezerotaxesandnouncer-tainty.Anevaluationoftheriskoruncertaintyassociatedwithaninvestmentisacrucialpartoftheinvestmentdecisionprocess.Also,allinvestmentsmustbe Table4.1. CashFlowsofHypotheticalInvestments. NetCashProceedsperYear InvestmentInitialCostYear1Year2 A$10,000$10,000B10,00010,000$1,100C10,0003,7627,762D10,0005,7625,762
November6,200913:43spi-b8119inx6inb811-ch04 70 AnIntroductiontoAccountingandManagerialFinance placedonanafter-taxbasis.Theconceptsofriskoruncertaintyandtaxationarecomplex,however,andtheseproblemsareavoidedhere. RankingbyInspection Itispossibleincertainlimitedcasestodeterminebyinspectionwhichoftwoormoreinvestmentsismoredesirable.Twosituationsinwhichthisistruearethefollowing:1.Twoinvestmentshaveidenticalcashfowseachyearthroughthefnalyearoftheshort-livedinvestment,butonecontinuestoearncashproceedsinsubse-quentyears.Theinvestmentwiththelongerlifewouldbemoredesirable.Thus,investmentBisbetterthaninvestmentA,becauseallfactorsareequalexceptthatBcontinuestoearnproceedsafterAhasbeenretired.2.Twoinvestmentshavethesameinitialoutlayandthesameearninglifeandearnthesametotalproceeds.Ifattheendofeveryyear(duringtheirearninglife)thetotalnetproceedsofoneinvestmentareatleastasgreatas,andforatleastoneyeararegreaterthan,thetotalfortheotherinvestment,thenthefrstinvestmentwillalwaysbemoreproftable.Thus,investmentDismoredesirablethaninvestmentC,becauseDearns$2,000moreinyear1thaninvestmentCdoes;investmentCdoesnotearnthis$2,000untilyear2.Theearningof$2,000moreintheearlieryearleadstotheconclusionthatinvestmentDismoredesirablethaninvestmentC. PaybackPeriod Thepaybackperiodisoneofthesimplestandmostfrequentlyusedmethodsofmeasuringtheeconomicvalueofaninvestment.The paybackperiod isdefnedasthelengthoftimerequiredforthestreamofcashproceedsproducedbyaninvestmenttoequaltheoriginalcashoutlayrequiredbytheinvestment.Ifaninvestmentisexpectedtoproduceastreamofcashproceedsthatisconstantfromyeartoyear,thepaybackperiodcanbedeterminedbydividingthetotaloriginalcashoutlaybytheamountoftheannualcashproceedsexpected.Thus,ifaninvestmentrequiredanoriginaloutlayof$300andwasexpectedtopro-duceastreamofcashproceedsof$100ayearforfveyears,thepaybackperiodwouldbe$300dividedby$100,orthreeyears.Ifthestreamofexpectedpro-ceedsisnotconstantfromyeartoyear,thepaybackperiodmustbedeterminedbyaddinguptheproceedsexpectedinsuccessiveyearsuntilthetotalisequaltotheoriginaloutlay.
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 71 Ordinarily,theadministratorsetssomemaximumpaybackperiodandrejectsallinvestmentproposalsforwhichthepaybackperiodisgreaterthanthismaxi-mum.Investigatorshavereportedthatmaximumpaybackperiodsoftwo,three,four,orfveyearsarefrequentlyusedbyindustrialconcerns.Therelativelyshortperiodsmentionedsuggestthatdifferentmaximumpaybackperiodsarerequiredfordifferenttypesofinvestmentsbecausesomekindsofinvestments(construc-tion,forexample)canseldombeexpectedtohaveapaybackperiodasshortasfveyears.Assumethatthepaybackperiodisalsousedtorankinvestmentalternatives,withthosehavingtheshortestpaybackperiodsbeinggiventhehighestranking.TheinvestmentsdescribedinTable4.1arerankedbythismethodinTable4.2.Letuscheckthereasonablenessoftherankinggiventotheinvestmentsbythecashpaybackapproach.InvestmentsAandBarebothrankedas1becausetheybothhaveshorterpaybackperiodsthananyoftheotherinvestments,namely,oneyear.ButinvestmentAearnstotalproceedsof$10,000,andthisamountmerelyequalsthecostoftheinvestment.InvestmentB,whichhasthesamerankasA,willearnnotonly$10,000inthefrstyearbutalso$1,100inthenextyear.Obviously,investmentBissuperiortoA.Anyrankingprocedure,suchasthepaybackperiod,thatfailstodisclosethisfactisdefcient.ConsiderinvestmentsCandDmodifedsoastocost$11,524.Bothwouldbegivenidenticalrankingsbecausebothwouldreturntheiroriginaloutlaybytheendofthesecondyear.Thetwoinvestmentsareinfactsimilar,withthesingleexceptionthatoutofidenticaltotalreturns,moreproceedsarereceivedinthefrstyearandlessinthesecondyearfrominvestmentDthanisthecasewithC.Totheextentthatearningscanbeincreasedbyhaving$2,000availableforreinvestmentoneyearearlier,DissuperiortoinvestmentC,butbothwouldbegiventhesamerankingbythepaybackperiodmeasure.Thus,thecashpaybackperiodmeasurehastwoweaknesses:(1)itfailstogiveanyconsiderationtocashproceedsearnedafterthepaybackdate,and(2)itfails Table4.2. RankingofInvestments. InvestmentPaybackPeriod(years)RankingCalculationsofPayback A1.01B1.01C1.841 + $6 , 238 $7 , 762 = 1 . 803D1.731 + $4 , 238 $5 , 762 = 1 . 736
November6,200913:43spi-b8119inx6inb811-ch04 72 AnIntroductiontoAccountingandManagerialFinance totakeintoaccountthedifferencesinthetimingofproceedsearnedpriortothepaybackdate.Theseweaknessesdisqualifythecashpaybackmeasureasageneralmethodofrankinginvestments.Paybackisusefulasageneralmeasureofrisk(allthingsbeingequal,a2-yearpaybackislessriskythana10-yearpayback). ReturnonInvestment Themethodsdescribedinthissectionarecommonlyreferredtoasrateofreturnanalysisorreturnoninvestment(ROI)analysis.Terminologyisaproblembecauseboththesetermsarealsousedtodescribeotherprocedures.Weshallconsistentlyuseinternalrateofreturnonlywhenwerefertoadiscountedcashfowcalculation,andreturnoninvestmenttorefertoanincomedividedbyinvestmentcalculation.Togetameasureofeffciency,analystsfrequentlyusetheratioofthefrm’sincometothebookvalueofitsassets.Somecompaniesalsousethismeasureasameansofchoosingamongvariousproposedinternalinvestments.Whenthismea-sureisused,theaverageincomeiscomputedafterdepreciation.Ifthedenominatorintheratioisthebookvalueoftheinvestment,thevalueofboththenumeratorandthedenominatorwilldependonthedepreciationmethodused.Analternativeprocedureistodividetheaverageincomebythecostoftheinvestment(theaccrueddepreciationisnotsubtracted).Theratioofincometobookvalueisacommonandusefulmeasureofperfor-mance,butitislessusefulasadeviceforrankinginvestments.Table4.3showsthatthesamerankingofoneisgiventoinvestmentsCandD,althoughDispreferabletoC.Thisprocedurefailstoranktheseinvestmentscorrectlybecauseitdoesnottakeintoconsiderationthetimingoftheproceeds. Table4.3. AverageIncomeonBookValue. AverageIncomeAverageIncomeAverageAverage(proceedslessBookonBookInvestmentProceedsDepreciation a depreciation)Value b Value(%)Ranking A$10,000$10,000$0$5,00004B5,5505,0005505,000113C5,7625,0007625,000151D5,7625,0007625,000151 a Assumingstraight-linedepreciation. b Investmentdividedby2.
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 73 Table4.4. AverageIncomeonCost. AverageAverageIncomeInvestmentCostIncomeonCost(%)Ranking A$10,000$004B10,0005505.53C10,0007627.61D10,0007627.61 Analternativeprocedure(seeTable4.4)istodivideincomebythecostoftheinvestment(accumulateddepreciationnotbeingsubtracted).Forpurposesofmea-suringperformanceandcomputingreturnoninvestment,theuseofundepreciatedcostwillgivelowermeasuresthanwilltheuseofbookvalue.Bothmeasuresillus-tratedfailtotakeintoconsiderationthetimingofcashproceeds.Itisthisfailingthatleadstoincorrectdecisionsfromtheuseofeitherofthetwomethods. DiscountedCashFlowMethods Wehaveconsideredpaybackandreturnoninvestmentasmethodsformeasuringthevalueofaninvestment.PaybackindicatedthatBisasdesirableasA.ROIindicatedthatCistiedwithD.ButBisclearlybetterthanA,andDisbetterthanC.Onthebasisofsuchanexample,wehavebeenabletorejectpaybackandROIasgeneralmethodsofevaluatinginvestments.Thesetwomeasuresfailedtoconsiderthetimingofcashproceedsfromtheinvestments.Thepaybackperiodrepresentsoneextremeinthisregardbecausealltheproceedsreceivedbeforethepaybackperiodarecountedandtreatedasequal,andalltheproceedsreceivedafterthepaybackperiodareignoredcompletely.Withthereturnoninvestment,theproceedswererelatedbysimpleaveragingtechniquestosuchthingsastheoriginalcostoftheinvestmentoritsbookvalue.Neitherofthesemethodssucceededinbringingthetimingofcashproceedsintotheanalysis.Wehaveseenthatthemeasuresofinvestmentworththatwerepreviouslycon-sideredmaygiveobviousincorrectresultsbecausetheyfaileithertoconsidertheentirelifeoftheinvestmentortoadequatelyconsiderthetimingoffuturecashpro-ceeds.Thediscountedcashfowconceptprovidesamethodoftakingintoaccountthetimingofcashproceedsandoutlaysovertheentirelifeoftheinvestment.Wenowreturntothetwomeasuresofinvestmentworthalreadyintroducedthatincorporatepresentvalueconcepts.
November6,200913:43spi-b8119inx6inb811-ch04 74 AnIntroductiontoAccountingandManagerialFinance Table4.5. InternalRateofReturnoftheInvestments. InvestmentIRR(%)Ranking A04B101C9 a 3D101 a Approximatemeasure. InternalRateofReturn InTable4.5,weshowtheinternalrateofreturnforeachoftheinvestmentslistedinTable4.1andtherankingofinvestmentsthatwouldresultifthismethodwereused.Examinetherankingsgivenbythismethodapplicabletoeachpairofinvest-mentsinthislistforwhichwewereearlierabletodeterminethemoredesirableinvestmentofeachpair.WepreviouslycomparedtwopairsofinvestmentsanddecidedthatinvestmentBwaspreferabletoA,andDtoC.Ineachcase,ifpref-erencehadbeendeterminedbyusingtheinternalrateofreturnofaninvestmentmethod,thepairswouldbegiventhecorrectranking.Thisisthefrstmethodthatwehaveusedthatgivesthecorrectrankingsofbothpairs: A,0%C,9%B,10%D,10% NetPresentValue NotetherankingsthatwillbegiventothehypotheticalinvestmentsofTable4.1bythenetpresentvaluemethod,usingtwosampleratesofdiscount.InTable4.6, Table4.6. NetPresentValuesoftheInvestment—RateofDiscountis6Percent. PresentValuePresentValueNetPresentInvestmentofCashFlowofOutlayValueRanking A$9,430$10,000 $5704B10,41310,000 + $4133C10,45710,000 + $4572D10,56410,000 + $5641
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 75 Table4.7. NetPresentValuesoftheInvestment—RateofDiscountis30Percent. PresentValuePresentValueNetPresentInvestmentofProceedsofOutlayValueRanking A$7,692$10,000 $2,3083B8,34310,000 $1,6571C7,48710,000 $2,5134D7,84210,000 $2,1582 wepresenttheresultsofusingthenetpresentvaluemethodanda6percentrateofdiscount.Indiscussingthemeasuresofinvestmentworththatdonotusethediscountedcashfowmethod,wepointedoutthattherelativerankingofcertainpairsofthesefourinvestmentswasobvious.Thatis,itisobviousfromexaminingthecashfowsthatinvestmentBispreferabletoAandthatDispreferabletoC.Ineachcase,thenetpresentvaluemethodusinga6percentrateofdiscountrankstheseinvestmentpairsinthecorrectrelativeorder.InTable4.7,thesameinvestmentsarerankedbythenetpresentvaluemethodusinga30percentrateofdiscountinsteadof6percent.TherelativerankingofinvestmentsCandDdoesnotchangewiththechangeintherateofdiscount.InvestmentC,whichwasrankedsecondwhena6percentrateofdiscountwasused,isrankedfourthwhenthe30percentdiscountrateisused.TherankingofinvestmentDischangedfromfrsttosecondbythechangeintherateofdiscount.Thehigherrateofdiscountresultsintheproceedsofthelateryearsbeingworthlessrelativetotheproceedsoftheearlyyears;thus,therankingofBgoesfrom3to1,butDisstillrankedaheadofC.Evenwitha30percentrateofinterest,thepresentvaluemethodmaintainsthecorrectorderingofeachofthetwopairsofinvestmentsforwhichanobviouspreferencecanbedetermined.Thus,westillfndinvestmentBpreferredtoA,andDpreferredtoC.Wheneveritispossibletodetermineobviouspreferencesbetweenpairsofinvestmentsinthecorrectorder,nomatterwhatrateofdiscountisusedtocomputethepresentvalue,aslongasthesamerateofdiscountisusedtodeterminethepresentvalueofboththeinvestments,therankinggivenbythepresentvaluemethodwillbecorrect. SummaryofRankings Therankingsgivenbyeachmeasureofinvestmentworthforeachofthehypothet-icalinvestmentsdescribedinTable4.1aresummarizedinTable4.8.
November6,200913:43spi-b8119inx6inb811-ch04 76 AnIntroductiontoAccountingandManagerialFinance Table4.8. SummaryofRankings. Investment MeasureofInvestmentWorthABCD Paybackperiod1 a 1 a 43Averageincomeonbookvalueorcost431 a 1 a Internalrateofreturn41 a 31 a NetpresentvalueAt6%4321At30%3142 a Indicatesatiebetweentwoinvestments. ThemoststrikingconclusiontobedrawnfromTable4.8isthetendencyforeachmeasureofinvestmentworthtogiveadifferentrankingtotheidenti-calsetofinvestments.Thisemphasizestheneedtogivecarefulconsiderationtothechoiceofmeasuresusedtoevaluateproposedinvestments.Allfourmeth-odscannotbeequallyvalid.Byconsideringspecifcpairsofinvestments,wehaveshownthatthemeasuresofinvestmentworththatdonotinvolvetheuseofthediscountedcashfowmethodcangiverankingsofinvestmentsthatareobviouslyincorrect.Forthisreason,thesemeasureswillbeexcludedfromfurtherconsideration.Therankingsgiventotheinvestmentsbythenetpresentvaluemeasuresarenotidenticaltothatgivenbytheinternalrateofreturnofaninvestmentmeasure.Neitheroftheserankingscanbeeliminatedasbeingobviouslyincorrect;yet,becausetheyaredifferent,theycouldleadtocontradictoryconclusionsincertainsituations. LimitationofInvestmentRankings Inthischapter,wediscussedtherankingoffourinvestmentsandshowedthat,givenacarefullydefnedsetofinvestments,wecanmakedefnitestatementsabouttherelativedesirabilityoftwoormoreinvestments.Iftheinvestmentsarenotrestrictedtothisset,wewouldfndourabilitytorankinvestmentsverylimited.Weshallnotaimfora“ranking”ofinvestments;instead,weshall:1.Makeaccept-or-rejectdecisionsforinvestmentsthatareindependent(i.e.,ifweundertakeoneinvestment,thecashfowsofundertakingtheotherinvestmentarenotaffected).
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 77 2.Choosethebestofasetofmutuallyexclusiveinvestments(i.e.,ifweundertakeone,eitherwewouldnotwanttoundertaketheotherorwewouldnotbeabletobecauseofthecharacteristicsoftheinvestments).Althoughtheobjectivesaresomewhatmoremodestthantheobjectiveofrankinginvestments,weshallstillencounterdiffculties.Thereisnothinginourrecommendations,however,thatwillprecludeamanagerfromapplyingqualita-tivecriteriatotheinvestmentsbeingconsideredtoobtainaranking.Therank-ingthatissoobtainedislikelytobediffculttodefend.Fortunately,forawiderangeofdecisionsituations,amanagercanmakedecisionswithoutarankingofinvestments. TheRollbackMethod Usingasimplehandcalculator(onewherethereisnopresentvaluebutton),itissometimesconvenienttousearollbackmethodofcalculationtocomputethenetpresentvalueofaninvestment.Oneadvantageofthisprocedureisthatthepresentvaluesatdifferentmomentsintimeareobtained.Considerthefollowinginvestment: TimeCashFlow 0 $7,0001$5,00022,30031,100 Assumethatthediscountrateis0.10.Thefrststepistoplacethecashfowofperiod3($1,100)inthecalculatoranddivideby1.10toobtain$1,000,thevalueattime2.Add$2,300anddividethesumby1.10toobtain$3,000,thevalueattime1.Add$5,000anddivideby1.10toobtain$7,273,thevalueoftime0.Subtract$7,000toobtainthenetpresentvalueof$273. WhereWeAre Therearemanydifferentwaysofevaluatinginvestments.Insomesituations,severalofthemethodswillleadtoidenticaldecisions.Weshallconsistentlyrecommendthenetpresentvaluemethodastheprimarymeansofevaluatinginvestments.
November6,200913:43spi-b8119inx6inb811-ch04 78 AnIntroductiontoAccountingandManagerialFinance Thenetpresentvaluemethodensuresthatfuturecashfowsarebroughtbacktoacommonmomentintimecalled time0 .Foreachfuturecashfow,apresentvalueequivalentisfound.Thesepresentvalueequivalentsaresummedtoobtainanetpresentvalue.Ifthenetpresentvalueispositive,theinvestmentisacceptable.Thetransformationoffuturefowsbacktothepresentisaccomplishedusingthemathematicalrelationship ( 1 + r) n ,whichweshallcallthepresentvaluefactorfor r rateofinterestand n timeperiods.Incasesofuncertainty,additionalcomplexitiesmustbeconsidered,butthebasicframeworkofanalysiswillremainthenetpresentvaluemethod.Today,almostalllargecorporationsuseoneormorediscountedcashfowmethods.NPVandIRRaretwoofthemorewidelyusedmethods.However,ROI(withouttimediscounting)isalsoused,thoughitisnotrecom-mendedinthisbookasamethodofevaluatingprospectiveinvestments.Ithasuseasameansofevaluatingperformanceoncetheinvestmenthasbeenmade,ifitisusedcarefully. Conclusions Aneffectiveunderstandingofpresentvalueconceptsisofgreatassistanceintheunderstandingofawiderangeofareasofbusinessdecisionmaking.Theconceptsareespeciallyimportantinfnancialdecisionmaking,sincemanydecisionsreachedtodayaffectthefrm’scashfowsoverfuturetimeperiods.Itshouldbestressedthatthischapterhasonlydiscussedhowtotakethetimingofthecashfowsintoconsideration.Thislimitationinobjectiveshouldbekeptinmind.Riskandtaxesmuststillbeconsideredbeforethereal-worlddecisionmakerhasatoolthatcanbeeffectivelyapplied.Inaddition,theremaybequali-tativefactorsthatmanagementwantstoconsiderbeforeacceptingorrejectinganinvestment.Itissometimesstatedthatrefnementsincapitalbudgetingtechniquesareawasteofeffortbecausethebasicinformationbeingusedissounreliable.Itisclaimedthattheestimatesofcashproceedsareonlyguessesandthattouseanythingexceptthesimplestcapitalbudgetingproceduresisasfutileasusingcomplicatedformulasorobservationsofpastmarketlevelstodeterminewhichwaythestockmarketisgoingtomovenext.Itistruethatinmanysituationsreliableestimatesofcashproceedsarediffculttomake.Fortunately,therearealargenumberofinvestmentdecisionsinwhichcashproceedscanbepredictedwithafairdegreeofcertainty.Butevenwithanaccurate,reliableestimateofcashproceeds,thewrongdecisionisfrequentlymadebecauseincorrectmethodsareusedinevaluatingthisinformation.
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 79 Whenitisnotpossibletomakeasingleestimateofcashproceedsthatiscertaintooccur,itdoesnotfollowthatincorrectmethodsofanalysisarejustifed.Iftheinvestmentislarge,theuseofacarefulandcomprehensiveanalysisisjustifed,evenifthismeansthattheanalysiswillbemorecomplicatedandcostly.Withsmalltacticalinvestments,somewhatlessinvolvedmethodsmightbeused,butagain,thereisnoneedtouseinferiormethodsthatdecreasethelikelihoodofmakingcorrectinvestmentdecisions.Whenallthecalculationsarecompleted,judgmentalinsightsmaybeincludedintheanalysistodecidewhethertoacceptorrejectaproject. ReviewProblems ReviewProblem4.1 Assumethatafrmhasacostofmoneyof0.15.Itisconsideringaninvestmentwiththefollowingcashfows: TimeCashFlow 0 $27,000,0001 + $12,000,0002 + $11,520,0003 + $15,552,000 Shouldtheinvestmentbeaccepted? SolutiontoReviewProblem4.1 Thenetpresentvalueusing0.15asthediscountrateis: TimeCashFlowPresentValueFactorPresentValue 0 $27,000,0001.15 0 $27,000,0001 + $12,000,0001.15 1 $10,435,0002 + $11,520,0001.15 2 8,711,0003 + $15,552,0001.15 3 10,226,000 Netpresentvalue = $2,372,000 Thenetpresentvalueispositiveandtheinvestmentisacceptable.Theinternalrateofreturnis0.20.
November6,200913:43spi-b8119inx6inb811-ch04 80 AnIntroductiontoAccountingandManagerialFinance QuestionsandProblems 1.Computethenetpresentvalueforeachofthefollowingcashfows.Assumeacostofmoneyof10percent. Period Investment012345 A$(1,000)$100$100$100$100$1,100B(1,000)264264264264264C(1,000)1,611 2.ComputetheinternalrateofreturnforeachofthecashfowsinProblem1.3.ComputethepaybackforeachofthecashfowsinProblem1.Ifthemaximumacceptablepaybackperiodisfouryears,which(ifany)ofthecashfowswouldbeacceptedasadesirableinvestment?4.Assumeacostofmoneyof5percent.ComputethenetpresentvaluesofthecashfowsinProblem1.5.Assumeacostofmoneyof15percent.ComputethenetpresentvaluesofthecashfowsinProblem1.ComparewiththeresultsobtainedfromProblems1and4.6.TheArrowCompanyisconsideringthepurchaseofequipmentthatwillreturncashproceedsasfollows: EndofPeriodProceeds 1$5,00023,00032,00041,0005500 Assumeacostofmoneyof10percent.Whatisthemaximumamountthecompanycouldpayforthemachineandstillbefnanciallynoworseoffthanifitdidnotbuythemachine?
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 81 7.a.Aninvestmentwithaninternalrateofreturnof0.25hasthefollowingcashfows: TimeCashFlow 0C 0 1 + $8,0002 + $10,000 ThevalueofC 0 is .b.Ifthefrmfnancedtheinvestmentin(a)withdebtcosting0.25,thedebtamortizationtable(usingthefundsgeneratedbytheinvestmenttorepaytheloan)wouldbe: TimeAmountOwedInterestPrincipalPayment 012 8.Computethenetpresentvalue(useacostofmoneyof0.15)andtheinternalrateofreturnforeachofthefollowinginvestments: Period Investment012 A$(1,000)$1,322B(1,000)$615615C(1,000)1,150 9.Recomputethenetpresentvaluesusing(a)acostofmoneyof0.20and(b)acostofmoneyof0.05foreachoftheinvestmentsinProblem8.10.Prepareascheduleshowingthat,witharateofgrowthof0.15peryear,$1,000willgrowto$1,322intwoyears.
November6,200913:43spi-b8119inx6inb811-ch04 82 AnIntroductiontoAccountingandManagerialFinance 11.Determinetheinternalrateofreturnofthefollowinginvestment: TimeCashFlow 0 $12,8001 + $8,0002 + $10,000 12.HowmuchcouldyoupayinexcessoftheindicatedcostfortheinvestmentinProblem11ifthecostofmoneywere0.10?13.AssumethatyoucanonlyinvestinoneofthethreeinvestmentsinProblem8.a.Usingtheinternalratesofreturnonthethreeinvestments,whichispreferred?b.Usingthenetpresentvaluemethodandacostofmoneyof0.05,whichispreferred?14.Acompanyusesa10percentdiscountrate.Assumeequalannualcashproceeds.Whatshouldbethemaximumacceptablepaybackperiodforequipmentwhoselifeis5years?Whatarethemaximumacceptablepaybacksforlivesof10,20,and40yearsandinfnitelife?15.Assumethatthediscountrateis5percentandanswerProblem14.16.Assumethat r = 0 . 06.Anewmachinethatcosts$7,000hasequalannualcashproceedsoveritsentirelifeandapaybackperiodof7.0years.Whatistheminimumnumberoffullyearsoflifeitmusthavetobeaccept-able?17.Computetheinternalrateofreturnofthefollowinginvestments: Period Investment0123 A $10,000$4,747$4,747$4,747B $10,00017,280 Comparethetwoinvestments.Whichdoyouprefer?Areyoumakinganyassumptionaboutthereinvest-mentofthecashfows?
November6,200913:43spi-b8119inx6inb811-ch04 CapitalBudgeting 83 18.Determinetheinternalrateofreturnofthefollowinginvestment: PeriodCashFlow 0 $15,0941$10,000210,00031,000 19.TheSuperCompanyusedaROFE(returnonfundsemployed)methodofevaluatinginvestments.Theincomeofeachperiodisdividedbytheaverageassetsusedduringtheperiod.ThisisdoneforeachperiodandthenanaverageROFEiscomputedofalltheROFEs.ThecontrolleroftheSuperCompanydefendstheproceduresinceitisconsistentwiththeperformanceevaluationproceduresthatareusedaftertheinvestmentisacquired.Thecompanyiscurrentlyevaluatingtwoinvestments(AandB). 012 A $20,000 + $11,000 + $12,100B $20,000 + $12,100 + $11,000 AB Year1Year2Year1Year2 Revenue$11,000$12,100$12,100$11,000Depreciation10,00010,00010,00010,000Income$1,000$2,100$2,100$1,000Averageinvestment15,0005,00015,0005,000ROFE0.0670.4200.1400.200AverageROFE0.240.17 Thefrmrequiresa0.20returnforaninvestmenttobeacceptable.ThefrmacquiredinvestmentA.Whichinvestmentismoredesirable?20.TheABCCompanyhasdeterminedthatitscostofmoneyis0.12.However,becauseofaseriesofnecessarynonproductive(notgeneratingcashfows)
November6,200913:43spi-b8119inx6inb811-ch04 84 AnIntroductiontoAccountingandManagerialFinance investments,ithasfoundthatontheaverageadiscretionaryinvestmentmustearn0.15inorderforthefrmtobreakeven.Thefrmhasachancetoundertakeaninvestmentthathasaninternalrateofreturnof0.14andnorisk.Thisinvestmentwillalsonotaffecttheamountofnonproductiveinvestmentsneeded.Shouldtheinvestmentbeaccepted?
November6,200913:43spi-b8119inx6inb811-ch05 Chapter5 TheIncomeStatement Themeasurementofincomeisoneofthemostimportantfunctionsoffnancialaccounting.Investors,managers,bankers,andothersareinterestedinknowinghowwellthecorporationisdoing.Inthischapter,wewilldiscusstheproceduresforrecordingtransactionsforincomedeterminationandthebasicassumptionsrelatingtoincomemeasurement. TheRevenueTransaction Thesaleofgoodsorservicestocustomersiscalleda revenuetransaction .Arevenuetransactionusuallyinvolvesanincreaseinanasset,suchascashoraccountsreceivable,torecognizetheamountreceivedorduefromcustomersbecauseofasaleofgoodsorservices.Stockholdersdonotbenefttothefullextentofthesalesamount.Expensesrelatedtothesalemustberecognizedasreducingoroffsettingtheimpactofrevenuetransactionsonstockholders’equity.Forexample,anexpenseforthecostofthemerchandisedeliveredtocustomersissubtractedfromrevenuetocalculatethenetbenefttostockholders.Toillustratearevenuetransaction,assumethatmerchandisecosting$30,000issoldonacustomer’saccountfor$50,000inJanuary.Alsoassumethatwagesof$5,000wereearnedandpaidtoemployeesduringJanuary.Asaresultofthesetransactions,thefollowingchangeswouldoccurinbalancesheetaccounts.AReceivablesaccountwouldincreaseby$50,000,theamountowedtothecompanybyacustomer.TheCashaccountwoulddecreaseby$5,000,theamountpaidtoemployees.TheMerchandiseaccountwoulddecreaseby$30,000,andtheRetainedEarningsaccountwouldincreaseby$15,000,thenetbenefttostockholdersofthesale.Thetwosidesofthebalancesheetwouldstill 85
November6,200913:43spi-b8119inx6inb811-ch05 86 AnIntroductiontoAccountingandManagerialFinance beinbalance,asmaybeseenfromthefollowingsummaryofchanges: AssetsStockholders’Equities Receivable + $50,000RetainedEarnings + $50,000Merchandise $30,000RetainedEarnings $30,000Cash $5,000 RetainedEarnings $5,000 NetChange + $15,000 NetChange + $15,000 Revenues aremeasuredbythemonetaryvalueoftheassetsreceived(orreduc-tionofliabilities)inreturnforgoodsandservicesthataresold.Thedecreasesintheassetsassociatedwithobtainingtherevenues(e.g.,thecostofthemerchandisesoldandthecostofwagesduringtheperiod)arecalled expenses .Thediffer-encebetweentherevenuesofaperiodandtheexpensesassociatedwithearningthoserevenuesiscalled income iftherevenuesexceedtheexpenses,or loss iftheexpensesexceedtherevenues.Theterms“revenues”and“income”shouldnotbeusedinterchangeably.Iftherearenodistributionsofincometothestockholdersduringaperiod,theRetainedEarningsbalancewillincreasebytheamountoftheincome.Intheforegoingexample,theincomewas$15,000andtheRetainedEarningsbalanceincreasedbythesameamount.Iftherehadbeenalossduringtheperiod(i.e.,expensesexceededrevenues),theRetainedEarningsbalancewouldhavedecreased.AnegativebalanceintheRetainedEarningsaccountiscalleda defcit . AccrualAccounting Inthepreviousexample,areceivablewasrecordedtoshowthatamountswereowedtotheenterpriseforthemerchandisesold.Recordingthisreceivablepermitstherecognitionofrevenueswhentheyhavebeenearned(becausethesaleoccurred),withoutregardtowhethercashpaymentsarereceived.Now,supposethatinthepreviousexamplethewageshadnotactuallybeenpaidtoemployeesinJanuary,eventhoughtheyhadearned$5,000fortheservicestheyperformed.Inthiscase,anexpenseandaliabilitywouldberecordedtoshowthatamountswereowedtotheemployees.Expensesarerecognizedwhentheyhavebeenincurred(becausetheserviceswereperformed),withoutregardtowhenpaymentsaremade.Therecognitionofrevenueswhentheyhavebeenearnedandexpenseswhentheyhavebeenincurredisreferredtoas accrualaccounting .Theuseofaccrualaccountingresultsinrecordingreceivablesandliabilities,withnoimmediateeffectoncash.Theuseofaccrualaccountingcanalsoresultintherecognitionofexpenseswhenassetsexpireorareusedup(orconsumed)duringaperiod.Forexample,if
November6,200913:43spi-b8119inx6inb811-ch05 TheIncomeStatement 87 annualrentof$36,000ispaidonJanuary1,thisamountcouldinitiallyberecordedasanasset,prepaidrent.However,bytheendofJanuary,one-twelfthoftheprepaidrenthasexpired.Asaresult,thePrepaidRentaccountbalanceshouldbecreditedby$3,000andrentexpenseshouldbedebitedby$3,000.Assetswithlongerlivesaretreatedinasimilarmanner.Forexample,ifacompanypurchasesatruckfor$24,000thatisexpectedtobeusedforfveyears,theinitialcostofthetruckwouldberecordedasanasset.Asthetruckisused,however,wemayassumethatone-sixtiethoftheinitialcost,or$400,expireseachmonthandthusbecomesanexpense.Recognitionofthecostsoflong-livedassetsthatexpireinaperiodisreferredtoas depreciationaccounting .Depreciationisanexpensethatreducestheaccountingmeasureoftheassetbeingdepreciatedandreducesincome.Toillustratetherecognitionofexpensesbyaccrualaccounting,letusextendtheprecedingexample.Supposethatinadditiontothefactspresentedpreviously(merchandisecosting$30,000wassoldoncustomeraccountfor$50,000andpay-mentsforwagestotaled$5,000),wearegiventhefollowinginformation.Rentonthestorebuilding,$36,000fortheyear,waspaidonJanuary1.Atruckusedtomakedeliverieshadoriginallycost$24,000andwasexpectedtolastforfveyears.Inadditiontotheworkforwhichtheywerepaid,employeesperformedservicesduringthemonthforwhichtheywillbepaid$2,500nextmonth.Torefectthisinformation,wewoulddecreasetheasset,prepaidrent,by$3,000($36,000/12months);decreasetheasset,deliverytruck,by$400($24,000/60months);andincreasetheliability,wagespayable,by$2,500.Thesechangeswouldbeaccompaniedbyadecreaseinretainedearnings.Thebalancesheetwouldbeaffectedasshowninthefollowingsummaryofchanges: AssetsLiabilitiesandStockholderEquity Receivable + $50,000RetainedEarnings + $50,000Merchandise $30,000RetainedEarnings $30,000Cash $5,000RetainedEarnings $5,000PrepaidRent $3,000RetainedEarnings $3,000DeliveryTruck $400RetainedEarnings $400WagesPayable + $2,500RetainedEarnings $2,500 NetChange + $11,600 NetChange + $11,600 Thenetincomeof$9,100,showninthesummaryincomestatementforJanuary,isequaltothechangeinretainedearningsforthemonth.Thestockholders’interestswereincreasedbythenetdifferencebetweenthesalesrevenuesandtheexpensesrecognizedduringthemonth.
November6,200913:43spi-b8119inx6inb811-ch05 88 AnIntroductiontoAccountingandManagerialFinance RecordingRevenueTransactionsUsingTemporaryAccounts Uptothispoint,therevenuesandexpenseshavebeenrecordedusingonlyassetandequityaccounts.Newaccountsarenowintroducedinwhichtherevenuesandexpensesarerecordedandaccumulatedseparately.Theaccountsarecalled temporary becausetheydonotappearonthebalancesheet.Thus,theymustbeeliminatedwheneverabalancesheetisprepared.Revenueandexpenseaccountscomeintobeingbecauseofpracticalconsider-ations.Imaginethenuisanceifeverytimewerecordedasalewehadtorecordtheexpenseofmakingthatsale.Thediffcultyisavoidedbyusingtemporaryaccountstorecordtherevenuesandexpensesratherthancomputingtheincomeofeachindividualsale.Salesmaybegroupedtogetherandtheresultsoftheoperationsofatimeperiod(month,quarter,year,andsoforth)determined.Inspecialsituationswherethesalesconsistofitemswithalargedollarvalueperunit,theproftoftheindividualsalemaybedetermined,buttheseareexceptionalcases.Expenseaccountsarealsousefulinanalyzingeffciencyandcontrollingcosts.Theyperformthefunctionofaccumulatinginformationabouttheamountofthecoststhathaveexpiredintheproductionoftherevenues.Anexpensemayormaynotbeaccompaniedbyanexpenditureofcash.Thesaleseffortconnectedwithmakingasalebecomesanexpenseeventhoughthesalespersonhasnotyetbeenpaid.Thesameistrueofelectricity,rent,supplies,andothersimilaritems. Example AssumethattheopeningbalancesofthefollowingT-accountsrefectthefnancialpositionoftheSampleCompany(thebalancesareindicatedbychecks ).Thetransactionnumbered(1)recordsthesaleforcashof$100ofmerchandisethatcostthecompany$60.Theonlyotherexpenseistheexpirationof$15ofprepaidrent.Entries(2)and(3)recordtheexpenses.First,thetransactionwillberecordedusingonlyassetandequityaccounts. Cash Common Stock 300 200 (1) 100 Merchandise Retained Earnings 150 (2) 60 (2) 60 295 (3) 15(1) 100 Prepaid Rent 45 (3) 15
November6,200913:43spi-b8119inx6inb811-ch05 TheIncomeStatement 89 Thisisthewayinwhichwehavebeenrecordingrevenuetransactionsuntilnow.EnteringtheamountsofrevenuesandexpensesdirectlyintheRetainedEarningsaccountenablesustodeterminetheamountofstockholders’equityasofanyspecifctime,butitdestroyssomeveryvaluableinformation.Sincewewanttoknowthevariouscomponentsofrevenueandexpenseforeachaccountingperiod,itisimportanttomaintainrecordsoftheseamountsintheaccountingsystem. TemporaryAccounts Thisinformationcanbepreservedduringaspecifcaccountingperiodbysettinguptemporaryaccountstokeeptrackofrevenuesandexpenses.WecanregardthesetemporaryaccountsasbeingatemporarysubdivisionoftheRetainedEarningsaccount.Wewillcreate revenue accountstorecordeachitemofrevenue:sales,interestrevenue,rentrevenue,andsoforth.Asrevenueshavetheeffectofincreas-ingretainedearnings,theseaccountsareincreasedinthesamewayasretainedearnings—theyareincreasedbycredits,andtheyaredecreasedbydebits. Revenue Accounts DecreaseIncrease Similarly,wewillcreate expense accountstorecordeachitemofexpense:wagesexpense,rentexpense,merchandisecostofgoodssold,andsoon.Asexpenseshavetheeffectofdecreasingretainedearnings,theseaccountsareincreasedbydebitsanddecreasedbycredits. Expense Accounts IncreaseDecrease PeriodicAdjustments Inpreviousillustrations,wehavedemonstratedsomeoftheaccountingentriesthatwouldbeusedtoadjusttheaccountsattheendofanaccountingperiod.Forexample,theadjustmentofprepaidrenttorefecttheremainingbalanceattheendoftheyearwasshown.Thisadjustmentnotonlyprovidesfortheproperbalanceintheassetaccount,butalsoresultsinthepropermeasureofrentexpensefortheyear.Similarly,entrieswouldbemadefortheproperstatementoftheassetbalanceofmerchandiseinventoryandalsoforthedeterminationofcostofgoodssold.Theseentries,whicharemadetobringassetandequityaccounts,aswellasrevenueandexpenseaccounts,intoagreementwiththefactsasofthedateofanaccountingreport,arecalledadjustingentries.Attheendofeachaccountingperiod,therewillbesomeaccountsforwhichthebalancesrequireadjustment.Although
November6,200913:43spi-b8119inx6inb811-ch05 90 AnIntroductiontoAccountingandManagerialFinance theremaybenoexplicittransactionatthetime,theaccountantneverthelesswillrecordanentrytoadjusttheaccountstotheirproperbalances,sothatthefnancialstatementspreparedatthattimewillprovideafairpresentation. TheIncomeStatement Theincomestatementshowstheresultsofoperationsforaperiodoftime.Whereasthebalancesheetis“asof”aparticularmoment,theincomestatementis“fortheperiodending.…”Theperiodoftimemaybeayearoranyfractionofayear,butitisaperiodoftimeratherthanamomentintime.Itisessentialthattheincomestatementdisclosetheexactperiodcovered,becausethelengthoftheperiodisabasicelementoftheinterpretationofincome.Forexample,agivenincomeforonemonthwouldhaveafardifferentsignifcancethanthesameincomeforayear.Theincomestatementcomparestherevenuesoftheperiodwiththeexpensesthatwereincurredtogainthoserevenues.Thedifferencebetweentherevenuesandexpensesisgenerallydefnedastheincomefortheperiod:Revenues Expenses = Income . RevenueRecognition Theaccountantdeterminesincomebysubtractingexpensesfromrevenues.Assimpleasthismayseem,therearemanycomplexitiesthatarisewhentryingtoimplementthisconcept.Forexample,therearemanyactivitiesandeventsthatmusttakeplacetogeneraterevenues.Theaccountantadoptstheprocedureofrecognizingrevenuesatthetimeacertain criticalevent takesplace.Butwhicheventisimportantenoughtojustifytherecognitionofrevenue?Dependingonthesituation,thereareseveralacceptablemethodsofrevenuerecognition,butonlythreewillbediscussedhere. Productionbasis —recognizerevenueattimeofproduction. Sales ( oraccrual ) basis —recognizerevenueattimeofsale. Cashreceiptsbasis —recognizerevenueattimecashisreceived. ProductionBasis Productionisthecriticaleventforcompaniesthatproduceorconstructassetsunderlong-termproductionorconstructioncontracts.BoeingAerospacedidnotbuildtheBoeing747and767aircraftstoopenstock.Instead,theseaircraftsarebuilttocustomerspecifcationsunderproductioncontracts.Thesecontractsspecify
November6,200913:43spi-b8119inx6inb811-ch05 TheIncomeStatement 91 whothecustomerisandtheamountsandtimingsofcashfows.Asaresult,thecontractsreducetheuncertaintyofthesaleandcashreceiptsevents.Companiesthatproducetoorderunderproductionorconstructioncontractsoftenattempttospreadprospectiverevenues,relatedcosts,andresultingnetincomeoverthelifeofthecontractinproportiontotheworkaccomplished.Themethodusedtoaccomplishthisspreadingofrevenues,costs,andincomeiscalledthepercentage-of-completionorproductionmethod. SalesBasis Thesales(oraccrual)basisisthemostwidelyusedmethodforrecognizingrev-enues.Revenuesareassumedtobeearnedatthetimethesaleismade,eventhoughthecashmaynothavebeencollectedfromcustomers.Forcompaniesthatproducetoopenstock,thesaleisthecriticaleventforrevenuerecognition.Eventhoughvalueisaddedtogoodsthroughtheproductionprocess,thesecompaniesfacecon-siderableuncertaintyaboutwhothecustomerwillbeandabouttheamountandtimingofthesale.Itisnecessarytohavean arm’slengthtransaction ,inwhichthecustomerislegallyobligatedtopayforthemerchandiseorservice.Suchfactorsasthesigningofasalescontractandthedeliveryoftheproductprovideevidencethatthesalehasbeenmade.Atthetimeofthesale,revenueisrecognizedandtheamountduefromthecustomerisrefectedasanassetsuchasaccountsreceivable.However,someuncertaintystillremainsaboutcashreceipt.Companiesthatusethesalesmethodmustalsobeabletoestimatebaddebtsordoubtfulaccountsatthetimeofthesalesothatthesalesamountsandaccountsreceivablebalancescanbeadjustedtorefecttheexpectedcashreceipts. CashReceiptsBasis Insomecases,thereceiptofcashisconsideredtobethecriticaleventforrevenuerecognition.Therearethreereasonsforusingthecashreceiptsbasis.First,forsometaxpayers,theuseofthecashreceiptbasisisallowableforcomputingtaxableincomeandmayresultinsomepostponementoftaxpayments.Second,whencollectionfromcustomersisregardedasveryuncertain,thecashreceiptsbasismaybethebestindicationofactualrevenues.Finally,thecashreceiptsbasisismoreconservativethanthesalesbasis.Itisimportanttorealizethatwhenthecashreceiptsbasisofrevenuerecognitionisused,theproductmustalsohavebeendeliveredtocustomersbeforerevenueisrecognized.Thus,ifcashisreceivedinadvance(suchaswithmagazinesubscriptions),thereceiptofcashwouldnotbeconsideredsuffcientevidenceforrecognizingrevenue.
November6,200913:43spi-b8119inx6inb811-ch05 92 AnIntroductiontoAccountingandManagerialFinance ExpenseRecognition—TheMatchingConcept Eithertheproduction,sales,orcashreceiptsmethodcanbeusedtoassignrevenuestoperiodsoftime.Expenserecognitioninvolvesassigningormatchingexpensestoperiodsoftime.Someexpensesarecloselyrelatedtotherevenuesassignedtoperiodsoftime.Forexample,thecostsofgoodssoldduringaperiodrefectthecostsofmaterials,labor,andmanufacturingoverheadincurredtoproduceunitsofproductthatweresold.Thesecostsarecalledproductexpenses.Otherexpensesarecloselyrelatedtotheperiodsoftimetowhichrevenuesareassigned.Forexample,costsareincurredtomaintainasalesandmarketingorganization,aresearchanddevelopmentcapability,andageneraladministrativeorganization.Thesecostsarecalledperiodexpenses,becausetheyarecloselyrelatedtotheperiodsduringwhichtheseorganizationsandcapabilitiesexist.Whentorecognizecostsasexpensesisoneofthemostperplexingproblemstheaccountantfaces.Itiseasiertodescribewhatshouldnotbedonethantodescribewhatshouldbedone.Forexample,whetherthecostshavebeenpaidforwithadisbursementofcashhaslittletodowiththedeterminationofwhethertheyshouldberecognizedasexpenses.Thus,theelectricityconsumedinlightingastoreisanexpenseoftheperiodinwhichtheelectricityisused,eventhoughtheelectricbillhasnotyetbeenpaid.Thatis,theelectricityexpenseisaperiodexpense.Iftheelectricityisusedtorunamachineinproducingaproduct,thenthecostoftheelectricitybecomesapartofthecostoftheproductandisnotconsideredanexpenseuntiltheproductissold.Thatis,theelectricitycostisacostofproduct,whichbecomesaproductexpensewhentheproductissold.Laborcostsina manufacturingsituation areconsideredtobeanassetuntiltheproductthatwasproducedissold.Theybecomepartofthecostofinventoryandareonlyregardedaspartofthecostofgoodssoldwhentheproductissold(productexpense).However,laborcostsina merchandisingsituation aregenerallyconsid-eredtobeexpensesatthetimetheyareincurred(periodexpenses),andthestepoffrstrecognizingthesecostsasassetsisbypassed.Thisisnotharmful,becausethelaborcostsofamerchandisingcompanywouldonlyrarelybeconsideredunexpiredattheendoftheperiod.Theguidingruleisthatexpensesshouldbematchedwiththerevenuesthattheyhelptoearnorgenerate.Costsbecomeexpenseswhentheirfutureservicepotentialexpires,andthisnormallyoccursastherevenuesareearned.Forexample,thecostofabuildingischargedtoexpenseoveritsusefullife.Theexpenseassociatedwithallocatingtheoriginalcostofbuildingsandequipmenttotheperiodsinwhichtheyareusediscalleddepreciationexpense.Occasionally,anassetlosesvaluewithouthavingproducedanyrevenue.Exam-plesofthistypeofeventincludethedestructionofabuildingbyfreorthetheftof
November6,200913:43spi-b8119inx6inb811-ch05 TheIncomeStatement 93 cash.Situationsofthisnaturearedescribedas losses .Alossoccurswhenanassetlosesallorpartofitsvaluewithoutprovidingcompensatingeconomicbenefts.Anyinsuranceproceedswouldreducetheamountsoftheselosses.Frequently,theaccountantwillnottakenoteofthefactthatanitemisanassetbeforerecognizingthatitisanexpense.Wheretheassetlosesvalueandbecomesanexpenseinthesameperiodinwhichthecompanyacquiresit,noerrorresultsanditdoessavesomebookkeepingeffort.Inothercases,wherethecostofanitemissmall(suchaspencilsorsmalltools),thecostmaybetreatedasanexpenseeventhoughitdoesnotexpireinthecurrentperiod.Althoughthismaynotseemproperfromatheoreticalviewpoint,thecostsofkeepingdetailedrecordsaboutsmallitemsandamountsmayjustifythistreatment.Thisdeparturerefectsthematerialityassumption.Thereisadifferenceofopinionintheaccountingprofessionastowhetherornotmatchingisavalidconcept.Acceptedornotbytheprofession,itisusefultokeepthematchingobjectiveinmind. RecognitionCriteria Asdescribedpreviously,manyfunctionsmustbeperformedtoearnrevenue.Asalesorderisobtained,theproductismanufacturedandthendeliveredtothecustomer,cashiscollected,andperhapsservicesarerequiredbyguaranteesprovidedforaperiodoftimeafterdeliveryoftheproduct.Withtheneedforfnancialstatementscoveringspecifcperiodsoftime,theaccountantmustmakeassumptionsabouttheexactpointintimeatwhichrevenueistoberecognized.Beforethemanufacturedgoodsaresold,theremaybeagreatdealofuncertaintyabouttheamountofrevenuetobereceivedandexpensestobeincurred.Theneedforobjective,verifableevidenceprevailsatthislevel,andrevenueisnotusuallyrecognizedwhilegoodsarestillbeingmanufactured.Whenthegoodsaredeliveredtocustomers,thereisobjectiveandverifableevidenceoftheamountthatthecustomerhasagreedtopay.Eventhoughthefullamountmightnotultimatelybecollected,accountantsnormallyrecognizerevenueatthispoint.Insomeinstances,accountantsprefertowaituntilthecashproceedsarecollectedbeforerecognizingrevenue.This,however,isgenerallyanoverlyconservativeprocedure.Theaccountantdoesnotusuallyrecognizerevenueuntilitisconsideredtohavebeenrealized.The realizationofrevenue isassumedtotakeplacewhenthereisamarkettransaction,suchasasale,andawell-defnedassetisreceivedinexchangefortheassetorservicethathasbeenprovided.Althoughtheaccountantrequiresrealizationbeforerecognizingrevenue(oragain),thesamerequirementdoes not carryovertolossesorotherdecreasesinvalue.Accountantswillgenerallyrecorda decrease invalueeventhoughamarkettransactionhasnotoccurred,whereasthey
November6,200913:43spi-b8119inx6inb811-ch05 94 AnIntroductiontoAccountingandManagerialFinance wouldnotusethesametypeofevidenceasthebasisforrecordingan increase invalue.Thisprocedureisconsideredtobeconservativeandisviewedasdesirablebymostaccountants,althoughitisinconsistentbecausecomparablegainsarenotrecognized.Regardlessoftheassumptionsorcriteriausedinrecognizingrevenues,expensesshouldberecognizedonacomparablebasis.Therefore,iftheaccountantrecognizesacertainlevelofrevenuesbecauseofarevenuerecognitionassumptionorcriterion,theexpensestobeusedindeterminingincomeshouldbethecoststhatexpiredinearningthoseparticularrevenues.Itwouldbeincorrecttorecognizerevenuesonallgoodsdeliveredtocustomers,butshowasexpensesonlythecostsattributabletogoodsonwhichcollectionshavebeenmade. FormofIncomeStatement Aswiththebalancesheet,thereisnouniformagreementamongaccountantscon-cerningtheformofanincomestatement.Variedformatsareusedinpractice.Aslongasthestatementconveystheessentialinformationinamannerthatallowsthereadertointerpretitwithoutconfusionorambiguity,theformmaybeconsideredacceptable.TheformpresentedinExhibit4.1isasingle-step incomestatement .Therearenoincomesubtotalsabovethenetincomefgure.Someaccountantsprefertotakevarioussubtotals,suchasGrossProft,NetIncomebeforeDepreciation,andNetIncomebeforeTaxes.Theaveragereaderofafnancialreportislikelyto Exhibit4.1. Single-StepIncomeStatement. ABCCompanyIncomeStatementforYearEndingDecember31,19xx RevenueSalesRevenue$19,600InterestRevenue900RentRevenue1,100 $21,600ExpensesCostofGoodsSold$10,000Wages3,000RentExpense1,000Utilities200InterestCharges100IncomeTaxes2,000 16,300 NetIncome$5,300
November6,200913:43spi-b8119inx6inb811-ch05 TheIncomeStatement 95 beconfusedratherthanassistedbythenumeroussubtotals,notknowingwhichincomefgureissignifcant.Thesingle-stepincomestatementhasthevirtueofbeingsimple.Thesingle-stepincomestatementhasincreasedinpopularityinrecentyears,butmanycorporationsprefertousesomevariantofthemulti-stepincomestatement. DiscontinuedOperations Ifamajorportionofacompany’sbusinesshasbeendiscontinued,comparisonsofoperatingresultsamongyearscouldbecomedistorted.Readersoftheincomestatementwhoareinterestedinprojectingtrendsofearningsmightwanttoexcludeincomeattributabletotheseoperations.Yet,theincomestatementmustshowtheactualoperatingresultsfortheyear.Toaccomplishbothofthesepurposes,aseparateitemforincomefromdiscon-tinuedoperationsisincludedinthedeterminationofnetincome.Inthisway,usersoffnancialstatementswhowishtoignoretheresultsofdiscontinuedoperationsmaymaketheirowncalculationsofearningsbyadjustingforthisitem.Incurrentpractice,thespecialtreatmentofdiscontinuedoperationsappliesonlytothedisposalofadivisionorotheroperatingunitwhoseactivitiesrepresentaseparatemajorlineofbusinessorclassofcustomer.Anygainorlossarisingfromthedisposalofsuchanoperatingunitwouldalsobeincludedintheincomefromdiscontinuedoperations. EarningsperShare Thestockholdersofacompanyarelikelytobeveryinterestedintheamountofthecompany’searningspershareofcommonstock.Thisisanindicationofhowtheresultsoftheperiodaffectedtheirinterests,andthisfgureoftenhasadirectbearingonthemarketvalueoftheshares.Althoughtheconceptofearningspershareisrathersimple,therearemanycomplexitiesthatariseinattemptingtomakethecomputationinpractice.Separateearnings-per-sharefguresareshowntoindicatetheeffectsofextraordinaryitemsordiscontinuedoperations.Itemssuchasmergers,issuanceofnewshares,andconvertiblesecuritiesalsomayaffectthecomputation. Summary Althoughwecouldrecordtransactionsusingonlyassetandequityaccounts,theuseofrevenueandexpenseaccountssimplifestherecordingofrevenuetransactions
November6,200913:43spi-b8119inx6inb811-ch05 96 AnIntroductiontoAccountingandManagerialFinance andallowstheaccumulationofmoreinformation.Thesetemporaryaccountsareusedinpractice.Theaccountantdeterminestherevenuesandexpensesoftheperiod.Incomeisdefnedasthedifferencebetweentherevenuesrecognizedduringtheperiodandtheexpensesmatchedagainsttherevenues.Thisisanoperationaldefnitionconsistentwiththewayinwhichtheaccountantmeasuresincome.Theincomestatementreportstheresultsofoperationsforaperiodoftime.Severalmethodscanbeusedtoassignrevenuestoperiodsoftime,andvariousincomestatementformatscanbeusedtocomparetherevenueswiththeexpensesthatwereincurredtogeneratethoserevenues.Netincomeandearningspershareareimportantmeasuresofperformance,butthesemeasurescanbeaffectedbysuchspecialeventsasextraordinaryitemsandthetreatmentofdiscontinuedoperations.Accountingfortheseandotherspecialeventsrequiresjudgment.Usersoffnancialstatementsshouldbeawareofareaswherejudgmententers(orshouldenter),andthusbebetterabletoassessandusetheinformationprovided. QuestionsandProblems 1.Whyarerevenuesincreasedbycreditsandexpensesincreasedbydebits?2.Whenapurchaseismade,wouldyouexpecttheitempurchasedtoberecordedinanassetaccountoranexpensesaccount?Explain.3.Atwhatstepshouldthecostofoilbeconsideredanexpense?a.Oilisordered.b.Theoilisreceived.c.Theoilispaidforbycheck.d.Theoilisburnedinaboilertomakesteamthatisusedtorunageneratorthatproduceselectricitythatpowersamachinethatmanufacturesgadgets.e.Agadgetisshippedtoawholesaler,andthewholesalerisbilled.f.Thecashisreceivedfromthewholesaler.4.Somecostfactorsareconventionallytreatedasexpensesastheyarerequired.Whichofthefollowingitemscouldbeexpensesimmediatelyonacquisi-tionwithoutadverselyaffectingtheinformationprovidedbytheaccountingsystem?a.Salesperson’scommissions.b.Automobileassemblylineworker’swages.c.Costofheatingdepartmentstore.d.Costofheatingfactorybuilding.
November6,200913:43spi-b8119inx6inb811-ch05 TheIncomeStatement 97 5.Foreachofthefollowingevents,indicatewhethertheitemwouldqualifyasanextraordinaryiteminthedeterminationofincomeasappliedincurrentpractice.a.Amajorcompanyplantisdestroyedbyanunexpectedearthquake.b.Companycitrusgrovesarecompletelydestroyedbyfrost.Afrostofthismagnitudeoccursaboutonceinfveyears.c.Salesofthecompany’sproducthavebeenreducedbecauseoftheintroduc-tionofasuperiorproductbyacompetitor.d.Thecompanysellslandthatitheldformanyyears,recognizingalargegain.Thecompanyisinthemanufacturingbusiness,andthiswasthecompany’sonlyinvestmentinland.e.Thecompany’scurrentincometaxesarereducedbecauseofthecarryfor-wardoflossesfrompreviousyears.6.Aconstructionfrmhasacontracttobuildanoffcebuildingthatisexpectedtotakethreeyearstocomplete.Woulditbedesirablefortheconstructionfrmtowaituntilthebuildingiscompletedbeforerecognizinganyrev-enue?Whatothermethodsofrevenuerecognitionmightbeappropriateinthiscase?7.Foreachaccountthatfollows,(a)listitsnormalbalance(debitorcredit);(b)identifyitasabalancesheetortemporaryaccount;and(c)classifyitasacurrentasset,noncurrentasset,currentliability,long-termliability,owners’equity,revenue,orexpenseaccount.AccountsPayableBondsPayable(duein20years)BuildingsCashCommonStockCostofGoodsSoldHeatandPowerLaborMerchandiseInventoryPrepaidRentRentRetainedEarningsSalesTaxesPayableWagesPayable
November6,200913:43spi-b8119inx6inb811-ch05 98 AnIntroductiontoAccountingandManagerialFinance 8.Recordthefollowingtransactions,usingT-accounts.Usetemporaryaccounts.Whenisthemerchandiserecognizedasanexpense?a.Merchandisecosting$23,000ispurchasedonaccount.b.Merchandisethatcost$1,900issoldfor$4,700cash.c.Oftheamountowedtotradecreditors,$17,000ispaid.9.Recordthefollowingtransactions,usingT-accounts.Usetemporaryaccounts.Whenisthemerchandiserecognizedasanexpense?a.Merchandisecosting$19,000ispurchasedonaccount.b.Merchandisethatcost$2,100issoldfor$4,500cash.c.Oftheamountowedtotradecreditors,$12,000ispaid.10.Foreachofthefollowingsituations,recordtheentriesnecessarytoadjusttheaccountsattheendoftheyear.UseT-accounts.a.Wagesof$700havenotyetbeenrecorded.Thisisforlaborservicesperformedduringthelastthreedaysoftheyear,forwhichpaymentwillbemadeonthefrstpaydayofnextyear.b.ThePrepaidInsuranceaccounthasabalanceof$800.Ananalysisoftheinsurancecontractsindicatesthattheamountofpremiumsapplicabletofutureyearsis$500asofDecember31.c.Sixmonths’intereston$100,000of14percentbondsoutstanding(aliabil-ity)hasnotyetbeenrecognized.d.Sixmonths’interestof$80,000ongovernmentsecuritiesheldasaninvest-menthasnotyetbeenrecognized.e.ThePrepaidRentaccounthasabalanceof$1,000beforemakingadjust-ingentries.Analysisindicatesthatrentof$200isowedasofthedateofclosing.11.Foreachofthefollowingsituations,recordtheentriesnecessarytoadjusttheaccountsattheendoftheyear.UseT-accounts.a.Wagesof$1,100havenotyetbeenrecorded.Thisisforlaborservicesperformedduringthelastthreedaysoftheyear,forwhichpaymentwillbemadeonthefrstpaydayofnextyear.b.ThePrepaidInsuranceaccounthasabalanceof$1,200.Ananalysisoftheinsurancecontractsindicatesthattheamountofpremiumsapplicabletofutureyearsis$750asofDecember31.c.Sixmonths’intereston$200,000of12percentbondsoutstanding(aliabil-ity)hasnotyetbeenrecognized.
November6,200913:43spi-b8119inx6inb811-ch05 TheIncomeStatement 99 d.Sixmonths’interestof$8,000ongovernmentsecuritiesheldasaninvest-menthasnotyetbeenrecognized.e.ThePrepaidRentaccounthasabalanceof$1,500beforemakingadjust-ingentries.Analysisindicatesthatrentof$300isowedasofthedateofclosing.12.Recordthefollowingtransactionsfortheyear20x1,usingT-accounts(openanyaccountsyoumayneed).TheBurnsideCompanyusestheperiodicinven-toryprocedure.a.Salesof$150,000weremade,ofwhich$90,000weremadeonaccount.b.Collectionsduringtheperiodfromcustomerswere$95,000.c.Merchandisepurchasedonaccountduringtheperiodwas$80,000.d.ThemerchandiseinventoryonDecember31,20x1,was$45,000.e.Paymentstotradecreditorsformerchandiseandsuppliespurchasedwere$85,000.f.Suppliespurchasedonaccountduringtheperiodwere$5,500.g.OnDecember15,20x1,therentfor20x2waspaid,$5,000.Therentfortheyear20x1was$4,000.h.AsofDecember31,20x1,thecompanyoweditsemployeeswagestotaling$5,000.Duringtheyear,employeeswerepaid$70,000.i.SuppliesonhandasofDecember31,20x1,were$900.Theaccountbalancesbeforethetransactionswereasfollows: December31,20x0DebitsCredits Cash$90,000AccountsReceivable59,500Merchandise60,000Supplies1,500Rent(Prepaid)4,000WagesExpense—CostofGoodsSold—SuppliesExpense—RentExpense—AccountsPayable$16,000WagesPayable24,000Sales—CommonStock100,000RetainedEarnings 75,000 $215,000 $215,000
November6,200913:43spi-b8119inx6inb811-ch05 100 AnIntroductiontoAccountingandManagerialFinance 13.TheaccountantoftheBurtCompanymakesuseofexpenseandrevenueaccounts.Allsalesareforcash.a.Stockholdersinvest$100,000onJanuary1,20xx.b.Rentof$4,800ispaid.Thisisrentfora12-monthperiodbeginningFebruary1.c.Merchandisethatcost$25,000ispurchasedonaccount.d.Suppliesarepurchasedfor$6,000cashonFebruary1.e.TheBurtCompanystartsoperationsonFebruary1.Salesforthefrstweekare$5,000.RecordtheforegoingtransactionsusingT-accounts.14.ThefollowingtransactionsaffectingtheCurtisCorporationtookplaceintheyear20xx.a.OnJanuary1,20xx,stockholderspaid$100,000tothecorporationfor10,000sharesofcommonstock.b.Thefollowingitemswerepurchasedonaccount:Merchandise$85,000Supplies6,000c.Anamountof$6,500waspaidtothelandlord.Thisincludedrentof$500forJanuaryofthenextyear.d.Salesof$117,000weremade.CashSales$57,000SalesonAccount60,000e.Collectionofaccountsreceivablewas$47,000.f.Paymentofaccountspayablewas$82,000.g.Wagespaidduringtheyearwere$25,000.WagespayableasofDecember31were$500.h.Insurancepremiumspaidduringtheyearwere$3,000.PrepaidinsuranceasofDecember31was$1,800.i.Suppliesusedduringtheperiodwere$4,200.j.ThemerchandiseinventoryasofDecember31was$15,000.k.BondswereissuedonJuly1.Theparvalueofthebondsis$50,000,andthisamountwasreceivedfromtheinvestors.Thebondshavea7percentrateofinterest.l.Incometaxesfortheyearare$1,837.Noincometaxeswerepaidinthecurrentyear.Recordtheforegoingtransactions,includingadjustingentries,inT-accounts.
November6,200913:43spi-b8119inx6inb811-ch06 Chapter6 ComparingtheUseofCashFlowsandIncomes Chapter4stressedtheusefulnessofcashfowsinevaluatingandvaluinginvestmentalternatives.Chapter5explainedthecalculationofthecorporateincomemeasure.Somestudentsofbusinesswillarguetherelativemeritsofthetwomeasures.Thepositionputforthinthisbookisthattheyarebothusefulmeasures.Itisimportanttounderstandhowtocorrectlyusebothmeasures. TheUseofCashFlows Wewilluseasimpleexampletoillustratetheuseofcashfowstovalueaninvest-ment.Assumeanalternativehasthefollowingcashfows: TimeCashFlows 1$1,30021,20031,100 Theappropriatediscountrateis0.10.Thepresentvalue(PV)oftheinvestment’sbeneftsattimezerois$3,000.PV = 1 , 300 1 . 10 + 1 , 200 ( 1 . 10 ) 2 + 1 , 100 ( 1 . 10 ) 3 = $3 , 000 . Thecalculationissimpletomakeandtounderstand. UseofEarnings Assumethereisa$3,000investmentwiththeabovesetofcashfowsforthreeyears.Theprojectedincomestatementsforthethreeyearsoftheinvestment’s 101
November6,200913:43spi-b8119inx6inb811-ch06 102 AnIntroductiontoAccountingandManagerialFinance lifeare: Year1Year2Year3 Revenue$1,300$1,200$1,100DepreciationExpense1,000 1,000 1,000 NetIncome$300 $200 $100 Tousetheincomemeasuresforvaluation,therehastobeacapitalchargeforthestockequitycapitalbeingused.Assumethereisa0.10annualcapitalcharge.Wehaveforeachyear: Year1Year2Year3 AmountofCapital 1 $3,000$2,000$1,000AnnualCapitalCharge0.10 0.10 0.10 CapitalChargeforYear$300 $200 $100 Wethendeductthecapitalchargefortheyearfromthenetincometoobtaintheeconomicincome. Year1Year2Year3 NetIncome$300$200$100CapitalCharge300 200 100 EconomicIncome$0 $0 $0 Thepresentvalueoftheeconomicincomes(zero)isaddedtothebookvaluetoobtaintheasset’svalueof$3,000.Thisisthesamevalueasweobtainedusingthecashfowmeasures.Weneedtomaketheexamplesomewhatmorecomplextoillustratethemorecompletecalculations. TheUseofCashFlows:AMoreComplexExample Nowassumethesamesetofcashfows,butthediscountrateis0.05.Comput-ingthepresentvalueofcashfows,weobtain(V i istheinvestment’svalueat 1 Reducedeachyearbytheamountofdepreciationexpense.
November6,200913:43spi-b8119inx6inb811-ch06 ComparingtheUseofCashFlowsandIncomes 103 time i ): Time 0123 CashFlow$1,300$1,200$1,100V 0 $3,276.75V 1 2,140.59V 2 1,047.62V 3 0 Thepresentvalueofthethreecashfowsattimezeroisnow$3,276.752using0.05asthediscountrate(thepresentvaluewas$3,000using0.10asthediscountrate).Assumetheresalevalueattime3is$576.75withapresentvalueof$498.218.Thepresentvalueoftheasset’scashfowsincludingtheresalevalueof$498.218is:PVofCashFlows = 3 , 276 . 752 + 498 . 218 = $3 , 774 . 970 . UseofEarnings:AMoreComplexExample Wewillnowassumetheassetcostof$3,276.75,buttheannualdepreciationexpenseisagain$1,000.Attheendofyear3,theasset’sbookvalueis$276.75andtheresalevalueis$576.75(resalevalueminusbookvalueis$300).Theincomestatementsforthethreeyearsare: Year1Year2Year3 Revenue$1,300$1,200$1,100DepreciationExpense1,000 1,000 1,000 NetIncome$300$200$100CapitalCharge 163.838 113.838 63.838 EconomicIncome$136.162 $86.162 $36.162 CapitalCharges: ( 0 . 05 )( 3 , 276 . 75 ) = $163 . 838foryear1 ( 0 . 05 )( 2 , 276 . 75 ) = $113 . 838foryear2 ( 0 . 05 )( 1 , 276 . 75 ) = $63 . 838foryear3 . Thepresentvalueoftheeconomicincomesis$239.068.Thepresentvalueoftheresalevalueminusbookvalueattime3is$300 ( 1 . 05 ) 3 = $259 . 151.Thevalueoftheassetis:ValueofAsset = 3 , 276 . 75 + 239 . 068 + 259 . 151 = $3 , 774 . 97 ,
November6,200913:43spi-b8119inx6inb811-ch06 104 AnIntroductiontoAccountingandManagerialFinance where$3,276.75isthebookvalueoftheasset$239.068isthepresentvalueoftheeconomicincomes$259.151isthepresentvalueofthe$576.75resalevalueminusthe$276.75remainingbookvalue.Usingtheincomesratherthanthecashfows,weobtainexactlythesamevaluefortheassetifweusetheeconomicincomesandadjustfortheinitialbookvalue,resalevalueandendingbookvalue.ValueofAsset = InitialBookValue + PresentValueofEconomicIncomes + PresentValueofResaleValue PresentValueofRemainingBookValue . Thisrelationshipisnotonlycomplex,butitislikelyalsotobemisleadingtoacasualreader.Itlookslikethevalueoftheassetisafunctionofthebookvalue,butitisnot. ChangingtheBookValue Nowassumethatinsteadof$3,276.75,thebookvalueis$4,276.75andtheremain-ingbookvalueattime3is$1,276.75.Thepresentvalueofthecashfowsisnotchangedfrom$3,774.97sincethecashfowassumptionsarenotchanged.However,manyofthecalculationsusingearningsarenowchanged.Thenewcalculationsofeconomicincomesare: Year1Year2Year3 Revenue$1,300$1,200$1,100DepreciationExpense1,000 1,000 1,000 NetIncome$300$200$100CapitalCharge0.05(4,276.75)213.8380.05(3,276.75)163.8380.05(2,276.75) 113.838 EconomicIncome$86.162$36.162 $13 . 838PVofEconomicIncomes=$102.91PVofResaleValue=(1.05) 3 (576.75)=$498.22PVofBookValueatTime3=(1.05) 3 (1,276.75)=$1,102.90PVofAsset=4,276.75+102.91+498.22–1,102.90=$3,774.98.
November6,200913:43spi-b8119inx6inb811-ch06 ComparingtheUseofCashFlowsandIncomes 105 Asidefromaroundingerror,thepresentvalueoftheassetusingearningsisunchangedfromwhentheinitialbookvaluewas$3,276.75insteadof$4,276.75.Thefollowingconclusionsareimportant.Theasset’svalueisnotaffectedby:a.theinitialbookvalueb.thedepreciationmethodbeingused.Thevalueisaffectedbythecashfowsandtheirtiming.Itisalsoaffectedbytheresalevalueandtheeconomicincomesandtheirtiming(andthisisaffectedbythetimingofthecashfows).Whilethebookvalueandtheaccountingdepreciationmethoddonotaffecttheassetvalue,theydoinfuenceimportantmeasuresusedbymanagementandthusshouldnotbeconsideredcompletelyirrelevant. TheBookValueWashesOut Weneedtoillustratewhytheamountofbookvaluedoesnotaffecttheasset’svalue.Letuscontinuetheexamplewheretheinitialbookvalueis$4,276.75.Wehave:InitialBookValue=$4,276.75 PVofDepreciationExpenses1,000B(3,0.05) $2,723.25PVofCapitalCharges $450.58PV $213 . 838$203 . 655163 . 838148 . 606113 . 83898.338 $450 . 58EndingBookValue1,276.75withPVof $1,102.91 Subtotal $4,276.74 Net$0.01The$4,276.75initialcostisaddedtodeterminethevalue;butthepresentvalueofdepreciationexpenses,interest,andendingbookvalueareallsubtracted,andtheirpresentvalueisequaltotheinitialbookvalue.Iftheinitialbookvaluechanges,enoughoftheothermeasureschangeandtheequalityismaintained.Ifthemethodofcalculatingdepreciationexpenseischanged,thecapitalchargesandtheendingbookvalueareallchangedand(ifnomistakesaremade)theequalityismaintained.
November6,200913:43spi-b8119inx6inb811-ch06 106 AnIntroductiontoAccountingandManagerialFinance Thisanalysisshouldagreewithyourintuitionthatiftheactualreceiptanddisbursementofcashfowsarenotchanged,thevalueoftheassetisnotchangedbyachangeintheaccountingmethod. RevenueRecognitionandFinance Mr.Alex(afctitiousname)wasintheprocessofsellinghisbusiness(afrmsellingcomputersoftwareandservicingthesoftware).Heandthebuyershadagreedonthepricewhenthepublicaccountingfrm(whichhadauditedthecorporationfortenyears)decidedthatanerrorhadbeenmadeintheauditsoftherevenuerecognitionmethodused.Thefrmhadrecognized60%ofthefrstyear’srevenueatthesigningofthecontract,30%onreceiptofthefrstcashreceipts,and10%onreceiptoftheremainderofthefrstyear’sreceipts.Theaccountantsthought60%wastoolarge.Mr.Alexdidnotquestionthemeritsoftheproposedrevenuescheduleandtherecomputationofthemonthlyandyearlyincomes.Hedid,however,pointouttothebuyersthattheyhadvaluedthefrmusingthehistoricalcashfownumbers,andthesenumberswerenotchangedbytheproposedaccountingchanges.Thetimingofforecastedcashfowsmightbechangedbecauseofthecalculationmethodbeingused,butlogicallyforecastedcashcollectionshouldnotbeaffectedbythemethod(ordetails)ofrevenuerecognitionusedbytheaccountants.Withthesaleofapubliccorporation,themarketpriceofthefrm’sstockcouldbeaffectedbytherevenuerecognition(andtheperiodicearnings)andourconclusioncouldbedifferentthanwiththesaleofaprivatefrm. Conclusions Thebasicmethodofvaluationadvocatedinthisbookisthediscountedcashfow(DCF)method,butothermethodsareusedinpractice.ThischaptershowsthattheuseofaccountingearningscangiveexactlythesamevalueastheDCFmethod,buttheaccountingearningshavetobeadjustedforacapitalchargetoarriveateconomicincome.Thereareseveralmethodsofvaluationusedwhichrecognizethediffcultyofforecastingthefutureandusesimplifedcalculations.Forexample,thefollowingmethodsarewidelyused:a.Priceearningsmultiple—EarningstimesanassumedP/Emultiple.b.EBITmultiple—Earningsbeforeinterestandtaxes(EBIT)timesanassumedEBITmultiple(smallerthantheP/Emultiple).c.EBITDAmultiple—Earningsbeforeinterest,taxes,depreciationandamorti-zation(EBITDA)timesanEBITDAmultiple(smallerthantheEBITmultiple).
November6,200913:43spi-b8119inx6inb811-ch06 ComparingtheUseofCashFlowsandIncomes 107 QuestionsandProblems 1.Assumeaninvestmentof$4,000hasthefollowingprojectedincomestatements.Therearezerotaxes.Thecostofequityis0.10. 1 2 3 4 Revenue$1,800$1,600$1,400$1,200Depreciation1,000 1,000 1,000 1,000 Income$800$600$400$200a.ComputetheNPVusingthecashfows.b.Computetheeconomicincomesofeachyear.ComputetheNPVusingeconomicincomes.c.Compuetheinvestment’sinternalrateofreturn.2.(continue1)Assumethedepreciationscheduleis: Year Depreciation 1$1,60021,20038004400 Computetheeconomicincomesofeachyearandtheinvestment’sNPVusingtheeconomicincomes.3.(continue1)Insteadofaninvestmentof$4,000,assumethebookvalueis$9,000andtheterminalvalueattime4is$1,756.92.a.ComputetheNPVusingthecashfows.b.Computetheeconomicincomesofeachyear.c.ComputetheNPVusingeconomicincomesandotherrelevantinformation.4.Assumeanassetwithabookvalueof$4,000hasthefollowingprojectedincomestatements.Therearezerotaxes.Thecostofequityis0.10.Theexpectedresidualvalueattime3is$1,331. 123 Revenue(Cash)$1,600$1,400$1,200Depreciation1,0001,0001,000 Income$600$400$200 a.ComputethePVusingthecashfows.b.Computetheeconomicincomesofeachyear.c.ComputethePVusingeconomicincomes.
November6,200913:43spi-b8119inx6inb811-ch06 108 AnIntroductiontoAccountingandManagerialFinance 5.(continue4)Assumetheinitialbookvalueis$8,000.Allotherfactsarethesame.a.ComputethePVusingthecashfows.b.ComputethePVusingeconomicincomes.6.Assumeafrmwithabookvalueof$8,000hasthefollowingcashfows: Time CashFlows 1$1,20021,44031,728 Theinvestmenthasa0.20internalrateofreturn.Therearezerotaxesandthefrmusesstraight-linedepreciationof$1,000peryear.Attheendofyear3,thevalueofthefrmisexpectedtobe$11,979.TheCFOthinks0.10isthecorrectrisk-adjusteddiscountratefortheinvestment.a.Computeeconomicincomeofeachyear. YearCashFlowDepreciationExpenseCapitalCost(Interest)EconomicIncome 1$1,200$1,00021,4401,00031,7281,000 b.Computethefrm’spresentvalueusing0.10andthefrm’scashfows.c.Computethefrm’spresentvalueusing0.10andtheeconomicincomesandanyotherrelevantinformation.d.Areyouranswerstoparts(b)and(c)likelytobecorrect?Why?7.Assumea$3,000investmenthasthefollowingcashfows: Time CashFlows 1$1,20021,44031,728 Theinvestmenthasa0.20internalrateofreturn.Therearezerotaxesandthefrmusesstraight-linedepreciation.TheCFOthinks0.10isthecorrectrisk-adjusteddiscountratefortheinvestment.
November6,200913:43spi-b8119inx6inb811-ch06 ComparingtheUseofCashFlowsandIncomes 109 a.Computeeconomicincomeofeachyear. YearCashFlowDepreciationExpenseCapitalCost(Interest)EconomicIncome 1$1,200$1,00021,4401,00031,7281,000 b.Computetheinvestment’snetpresentvalueusing0.10andthecashfows.c.Computetheinvestment’snetpresentvalueusing0.10andtheeconomicincomes.
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November6,200913:44spi-b8119inx6inb811-ch07 Chapter7 DepreciationExpense Thematchingofcostsandrevenuesindeterminingincomerequiresasystemforassigningthecostofassetswithterminablelivestospecifctimeperiods.Build-ingsandequipmentare depreciated ,naturalresourcesare depleted ,andpatentsandleaseholdsare amortized overtheirusefullives.Thecreditsfordepreciation,depletion,andamortizationareusuallymadetocontraassetaccounts,reducingthenetbookvalueoftherelatedassets. Depreciationaccounting maybedefnedasasystematicprocedureforallo-catingthecostofalong-livedassetoveritsusefullife.Thedepreciationexpenseisthecostofusinganasset,anditisassignedaseitheracostofproductionoranexpenseofearningtherevenuesoftheperiod.Asanalternative,wecoulddefnedepreciationasthedecreaseintheeconomicvalueofalong-livedasset.Inpractice,however,depreciationhaslittlerelationshipwiththemeasurementofthechangeineconomicvalue.Thedepreciationcostiscomputedfortheperiodbasedontheoriginalcostoftheasset,andthedecreaseintheeconomicvalueofanassetisnotconsideredinthedepreciationcalculationsmadebytheaccountant.Anessentialfeatureoftheaccountingmeasurementofincomeisthatadeduc-tionfromrevenueismadefortheexpenseofusingthelong-livedassets.Amoreprecisemeasurementofincomecouldbemadeifwewaiteduntilthelong-livedassetswereretired(wecouldthendeterminemoreexactlythetotalexpenseoftheirutilization).Becauseoftheneedforperiodicreportsofacompany’sprogress,how-ever,estimatesmustbemadeoftheexpenseofusinglong-livedassetsduringrela-tivelyshortperiodsoftime—hence,thenecessityforestimatingthedepreciationexpense.Theinitialcostofanasset,minustheportionofthiscostthathasbeenpre-viouslychargedtodepreciation,iscalledthe bookvalue oftheasset.Itshould 111
November6,200913:44spi-b8119inx6inb811-ch07 112 AnIntroductiontoAccountingandManagerialFinance berememberedthatdepreciationaccountinginpracticeisaprocedureforcostallocationandnotaprocessofvaluation.Thebookvalueofanassetisnotneces-sarilyareasonableestimateofitseconomicvalue.Itcannotbeusedasthebasisfordecisionswithoutadjustmentintoavaluemeasure. ElementsofDepreciationComputation Thedeterminationofthedepreciationexpenseofaperioddependsonthreebasicelements.Theseare:1.Thedepreciationbase:thecostlessresidualvalueofthelong-livedasset;2.Theusefullifeoftheasset;and3.Thesystematicprocedurechosenforallocatingthecostovertheasset’slife. DepreciationBase Thecosttobeallocatedovertheperiodofuseisknownasthe depreciationbase .Thisconsistsoftheinitialpurchasecostoftheassetminusanysalvagevalueexpectedatthetimeofretirementplustheanticipatedcostsofremovingtheassetwhenitisretired(wewillassumetheremovalisnotdiscretionary).Thecostofusinganassetduringitslifeisreducedbyanysalvagevaluerecoverableattheendoftheperiodandisincreasedbycostsofremoval.Theseelementsofthedepreciationbaseareoftenextremelydiffculttomeasure.Whenitisanticipatedthatasubstantialresidualvaluewillberecovered,anestimateofthisvalueshouldbeincludedinthedeterminationofthedepreciationbase. Example Establishthebasesforthecomputationofdepreciation,giventhefollowingfacts:a.Abuildingispurchasedforanimmediatepaymentof$10,000.Theforecastedsalvageis$500,andtheforecastedremovalcostis$200. Answerto(a) CostofBuilding$10,000Salvage$500RemovalCost200 NetSalvage300 BaseforDepreciationComputation$9,700
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 113 b.Equipmentispurchasedfor$9,000.Theforecastedsalvageis$400,andtheforecastedremovalcostis$600. Answerto(b) CostofEquipment$9,000RemovalCost$600Salvage400 NetRemovalCost200 BaseforDepreciationComputation$9,200 Inexample(b),thedepreciationbaseisgreaterthanthecostoftheasset.Thisisnotallowedfortaxpurposes.Itisreasonablethatthelogicofthesituationleadstoadepreciablebaseof$9,200,inasmuchasthiswillspreadallthecosts,includingtheremovalcosts,overtheperiodsinwhichtherevenuesareearned.ItisequallyreasonablefortheInternalRevenueServicetosuggestthatthedepreciablebasecannotexceedthecostoftheasset. UsefulLife The usefullife ofafxedassetisafunctionnotonlyofthephysicalwearandexhaustiontowhichtheassetissubjected,butalsooftechnologicalchangeandinnovation.Thus,aparticularmachinemightbeexpectedtolastfortenyearsonthebasisofphysicalendurancealone,butthedevelopmentofnewandbettermachinesmightreduceourexpectationofitseconomicusefulnesstofouryears.Bothobsolescenceandphysicalendurancemustbeconsideredinestimatingusefullife.Ingeneral,theusefullifetobeusedfordepreciationpurposeswillbetheshorterofthelivesestimatedonthetwobases.Anassetthatisphysicallyexhaustedcanbeexpectedtobereplaced,eventhoughitisnotyetobsolete.Ontheotherhand,anassetthatisobsoleteshouldalsobereplacedeventhoughitisnotphysicallywornout. ProceduresforComputingDepreciation Theobjectiveofdepreciationaccountingistoassigntoexpensesystematicallythecostofalong-livedassetovertheasset’susefullife.Thereare,however,manyproceduresforaccomplishingthistask.Althoughtherearenumerousdepreciationproceduresusedinpractice,ourdiscussionwillbelimitedtoproceduresthataremostwidelyused.
November6,200913:44spi-b8119inx6inb811-ch07 114 AnIntroductiontoAccountingandManagerialFinance Straight-LineDepreciation Whenusingthe straight-lineprocedure forcomputingdepreciation,theannualdepreciationchargeisobtainedbydividingthedepreciationbasebythenumberofyearsofusefullifeforecasted. Example: Amachineispurchasedfor$10,000.Theforecastedsalvageis$456,andtheforecastedremovalcostis$200.Theexpectedusefullifeofthemachineisfouryears.Computetheannualdepreciationchargeusingthestraight-lineprocedure.(Thesefgureswillalsobeusedforothermethodsdiscussedinthischapter.)AnnualDepreciation = ( InitialCost Salvage + RemovalCost ) UsefulLife = $10 , 000 $456 + $200 4 = $9 , 744 4 = $2 , 436 . (7.1)Usingthestraight-lineprocedureforthefour-yearperiodproducesthefollowingresults: BookValueDepreciationTotalAccumulatedBookValueYearBeginningofYearChargeDepreciationEndofYear 1$10,000$2,436$2,436$7,56427,5642,4364,8725,12835,1282,4367,3082,69242,6922,4369,744256 Notethatthedepreciationchargeisthesameeveryyear,andthebookvalue(initialcostminusaccumulateddepreciation)attheendofyear4isequaltotheanticipatedsalvagelessremovalcost.Themainadvantagesofthestraight-lineprocedureareitssimplicityandthefactthatrevenuesofsuccessiveyearsarechargedwithequalamountsofdepreciation.Themaindisadvantageisthat,giventheassumptionsofconstantrevenueandconstantmaintenancecosts,thereturnoninvestmentoftheasset(incomedividedbytheinvestment)willincreaseastheassetbecomesolderandthenetbookvaluedecreases.
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 115 Thebasicsimplicityofthestraight-lineprocedurehascausedittobethemostwidelyuseddepreciationprocedureforaccountingpurposes. DecreasingCharge(AcceleratedDepreciation)Methods The decreasingcharge or acceleratedmethods ofcomputingdepreciationhavebecomepopularbecausethetaxlawallowstheiruse.Afrmwillgenerallybeneftbytakingasmuchdepreciationfortaxpurposesaspossibleintheearlyyearsoftheasset’slife.Themethodofaccountingfortaxpurposeshasatendencyalsotoinfuencethefnancialaccounting,althoughthereisnorequirementthatthesamedepreciationproceduresmustbeusedforbothpurposes.Bydefnition,withadecreasingchargemethodofaccruingdepreciation,thedepreciationinthebeginningyearsisgreaterthanthedepreciationinthelateryears.Overthelifespanofanasset,thetotaldepreciationchargesshouldbeapproximatelyequalregardlessoftheprocedureused.Whenweconsiderthecomputationofdepreciationforpurposesofdeterminingtaxableincome,thetimingofthedepreciationchargesbecomesimportantfromthepointofviewofconservingcash.Ifweassumethepresenttaxrateswillcontinueordeclineinthefuture,afrmwillwanttodeductdepreciationasearlyaspossibletoreduceitscurrenttaxpayments.Thus,theacceleratedmethodsofdepreciationhavebecomeverypopularfortaxpurposes. DecliningBalanceProcedure The decliningbalanceprocedure involvestheapplicationofaconstantdeprecia-tionratetothedecreasingbookvalueoftheasset.Withthestraight-lineprocedure,aconstantratewasappliedtoaconstantdepreciationbase.Withthedecliningbalancemethod,theuseofbookvalueinsteadoftheconstantbaseresultsindiminishingchargesoverthelifespanoftheasset.Conventionally,salvagevalueandremovalcostsarebothignoredunderthedecliningbalanceprocedure.Itisimpossibletoreducethebookvaluetozerobycontinuallyapplyingaconstantratetothebookvalue.Theresidualvalueremainingaftertheapplicationofthisprocedurethroughoutanasset’slifemightbeconsideredtobeanapproximationofsalvage.Althoughthetwofguresarenotlikelytobethesame,theymightbecloseenoughforpracticalpurposes.Withthedecliningbalanceprocedureanydepreciationratecouldconceivablybeused,buttherateisgenerallyexpressedasafunctionofthestraight-linerate.Ifarateequaltotwicethestraight-linerateisused,themethodiscalledthe doubledecliningbalancemethod ofdepreciation.
November6,200913:44spi-b8119inx6inb811-ch07 116 AnIntroductiontoAccountingandManagerialFinance Example: Assumingthesamefguresasthoseusedtoillustratethestraight-lineprocedure,computedepreciationonadecliningbalancebasisusingarateequaltotwicethestraight-linerate.Thestraight-linedepreciationratewas25percent,andtwicethisrateis50percent.Therateistobeappliedtothebookvalueatthebeginningofeachyear.Depreciationforeachofthefouryearswillbeasfollows: BookValueBookValueBeginningRateDepreciationTotalAccumulatedEndofYearofYear(%)ChargeDepreciationYear 1$10,00050$5,000$5,000$5,00025,000502,5007,5002,50032,500501,2508,7501,25041,250506259,375625 Notethatthebookvalueremainingattheendofyear4is$625,whichissomewhathigherthantheexpectednetsalvagevalue.Thetotaldepreciationchargesforthefour-yearperiodwere$9,375,whichislessthantheamountaccruedbyusingthestraight-lineprocedure($9,744).TheInternalRevenueCodeallowsafrmtoswitchfromdecliningbalancetostraight-linedepreciationduringthelifeofanasset.Inthiscase,thestraight-linedepreciationisobtainedbydividingtheremainingamounttobedepreciatedbytheremaininglife.Thetotalamountofdepreciationcannotexceedthecostlesstheexpectedsalvage.Intheexamplesjustcited,attheendofthethirdyearthecompanycouldswitchtothestraight-lineprocedureandcharge$994todepreciationinthefourthyear(bookvalueof$1,250lessthe$256salvageequals$994).Becauseafrmdesirestochargeasmuchtoexpensefortaxpurposesasitislegallyallowedtocharge,theswitchtothestraight-linemethodmaybedesirablefromaneconomicstandpoint(thatis,itmaydelaythepaymentofincometaxesuntilsubsequentperiods).Thepresenttaxcodeallowstheignoringofsalvagevalueiftheexpectedsalvageislessthan10percentofcost. Sum-of-the-Years’DigitsProcedure The sum-of-the-years’digitsprocedure isadeviceforobtainingapatternofdepreciationthatstartsouthighanddecreasesovertheyears.Essentially,thisprocedureusesaconstantdepreciationbase—thesameasthestraight-linebase—butappliesaconstantlyreducingratetoittoobtaina
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 117 decreasingcharge.Therateisdeterminedbyafractionhavingasitsdenominatorthesumofthedigitsfromonethroughtheusefullife,inyears.Thenumeratorsaretheindividualyearnumbersindescendingordereachyear(equivalently,thenumberofyearsofliferemainingatthebeginningoftheyear). Example: Wewillusetheinformationfromthepreviousexample,wheretheusefullifewasfouryears.Thedenominatorofeachyear’sratewillbethesumofthedigitsfrom1through4:1234 Sumofdigits=10Thenumeratorsforthedepreciationratewillbethenumbersindescendingorder:4,3,2,1.Thus,therateforthefrstyearwillbe4/10,thesecondyear3/10,andsoforth.Usingthedepreciationbaseof$9,744(initialcostminussalvageplusremovalcost),thefollowingdepreciationchargesareobtained: BookValueTotalBookBeginningDepreciationDepreciationAccumulatedValueEndYearofYearBaseRateChargeDepreciationofYear 1$10,000.00$9,7444/10$3,897.60$3,897.60$6,102.4026,102.409,7443/102,923.206,820.803,179.2033,179.209,7442/101,948.808,769.601,230.4041,230.409,7441/10974.409,744.00256.00 Overthefour-yearlife,thetotaldepreciationchargesandtheendingbookvaluebalanceareidenticalwiththestraight-lineprocedure.Itisthepatternofchargesovertheyearsthatdistinguishesthetwomethods.Thesum-of-the-years’digitsmethodresultsinsubstantiallyhigherchargesintheearlyyears,whichareoffsetbylowerchargesinlateryears.Theuseofoneofthedecreasingchargeproceduresmaybejustifedlogicallyforaccountingandmanagerialpurposesiftheproductiveoutputoftheassetbeinganalyzedisexpectedtodiminishrapidlywithage.Iftheservicesprovidedbyamachinewillbesignifcantlygreaterinthefrstyearoflifethaninthelateryears,
November6,200913:44spi-b8119inx6inb811-ch07 118 AnIntroductiontoAccountingandManagerialFinance itisreasonabletochargemoreofthedepreciationcosttotheearlieryears.Also,asmachinesgrowoldertheymayrequiremoremaintenance,sotheuseofdecreasingchargemethodsmightresultintotalcosts(includingmaintenance)thatareaboutequalineachperiod. AcceleratedCostRecoverySystem(ACRS) In1981ataxactwaspassedthatintroducedthe AcceleratedCostRecoverySystem(ACRS) .Thedetailsoftheactwerechangedbythe1982,1984,and1986taxacts.WhileACRSsurvivedthesereforms,itislikelytobemodifedinthefuture.ACRSchangedandincreasedthealternativesavailabletocorporations.Ittendstobeamoregenerousmethodofwritingoffanassetthanthepreviouslyapprovedaccelerateddepreciationmethods.Newassetswereoriginallyplacedintofveclasses: Class 3-yearclass:Tangiblepropertywithalifeofnomorethanfouryears(includestools,researchanddevelopmentequipment,lighttrucksandautos).5-yearclass:Practicallyallmachineryandequipment,aswellaspublicutilitypropertywithlivesbetween4.5and18years.10-yearclass:Selectedequipmentandpublicutilitypropertywithlivesbetween18.5and25years.15-yearclass:Publicutilitypropertywithlivesgreaterthan25years.Realestate:18yearsusing200percentdecliningbalance(forlow-incomehousing)or175percentdecliningbalancewithaswitchtostraight-line(forotherrealestate). The1986actaddedotherclasses.Corporationsmustuseaclassifcationschemeforthedeterminationoftheasset’sdepreciationexpense,unlessstraight-linedepre-ciationisusedforallassetsacquiredintheyearforthegivenclass.Realestateexceptionsarealsopossible. DepreciationandActivity Uptothispoint,procedureshavebeenconsideredbywhichcostsareallocatedasafunctionoftime.Therearesometypesoffxedassetswhoselivesaremoreafunctionofactivity(use)thanoftime.Anexampleofafxedassetofthistypeisan
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 119 airplaneengine.Thelifeoftheenginemaywellbeafunctionoffighthoursratherthanage.Therateofobsolescenceaswellasthephysicaldeteriorationtendstodeterminewhetherthedepreciationaccrualshouldbebasedonactivityortime. Example a.Anairplaneenginethatcost$5,000hasalifeof10,000hoursoffyingtime.Whatisthefrstyear’sdepreciation,iftheplaneisfownatotalof2,000hours?Answer:Therateofdepreciationis$0.50perhouroffyingtime.Thedepreciationexpensefor2,000hourswouldbe$1,000.b.Iftheenginewerefownonly500hours,andiftheexpectedusefullifewereonlyfveyears(becauseoftechnologicalchange),whatwouldbethedepreciationchargefortheyear?Answer:Onanactivitybasisthedepreciationwouldbe$0 . 50 × 500 = $250 , buttheusefullifeoftheassetisonlyfveyears;thus,theminimumdepreciationonastraight-linebasiswouldbe$5 , 000 5 = $1 , 000 . Thedepreciationcostfortheyearshouldbe$1,000.Ifthereisreasontosuspecttheusageoftheengineinthenextfouryearstobemorethan2,000hoursperyear,theremaybejustifcationforconsideringthedepreciationofthefrstyeartobe$250(or$0.50perhour). UnitsofProductionProcedure The unitsofproductionprocedure alsoassumesthatdepreciationisafunctionofuseoractivity.Thelifeoftheassetismeasuredintermsofitsexpectedunitsofoutputortheexpectednumberofserviceormachinehoursavailable. Example Assumethatthemachinepurchasedfor$10,000thathasaforecastedsalvagevalueof$456andaforecastedremovalcostof$200isexpectedtohaveaproductivelife
November6,200913:44spi-b8119inx6inb811-ch07 120 AnIntroductiontoAccountingandManagerialFinance of4,060units.Thedepreciationrateperunitiscalculatedasfollows:DepreciationRateperUnit = ( InitialCost Salvage + RemovalCost ) ExpectedTotalUnits = $10 , 000 $456 + $200 4 , 060 = $2 . 40 . (7.2)If985unitsareproducedinthefrstyear,1,060unitsareproducedinthesecondyear,1,115unitsareproducedinthethirdyear,and900unitsareproducedinthefourthyear,depreciationforeachofthefouryearswillbeasfollowsusingtheunitsofproductionprocedure: DepreciationTotalAccumulatedBookValueYearUnitsRateChargeDepreciationatEnd 1985$2.40$2,364$2,364$7,63621,0602.402,5444,9085,09231,1152.402,6767,5842,41649002.402,1609,744256 AccountingEntries Theaccountsinvolvedinrecognizingdepreciationarefrequentlymisunderstood.Inordertounderstandtheentriesthatareconventionallymade,itisusefultoreviewtheirpurpose.Theaccountantisattemptingtoallocatethecostofanassetoveritsusefullifeandtomeasurethecostofusingtheassetineachaccountingperiod.Thebasicjournalentrytorecorddepreciationincreasesacostorexpenseaccount(bydebitingit)anddecreasesanassetaccount(oracontraaccountbycreditingit). Example AbuildingispurchasedonJanuary1for$10,000.Ithasanexpectedusefullifeoftenyears.Salvagevalueisexpectedtoequalremovalcost.Assumethatdepreciationiscalculatedbythestraight-lineprocedure.Jan.1Building .............................. 10,000Cash .............................. 10,000Torecordthepurchaseofthebuilding.Dec.31DepreciationExpense .................. 1,000Building ........................... 1,000TorecordthedepreciationcostfortheyearandthedecreaseintheBuildingaccount.
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 121 Theentriesgivenrepresentasoundaccountingtreatmentofdepreciation,butnotethattheBuildingaccountwillhaveabalanceof$9,000afterthe$1,000hasbeencreditedtotheBuildingaccount.TheoriginalcostofthefxedassetisnolongerequaltothebalanceoftheBuildingaccount.Thisproceduremakesitmorediffculttoobtainabitofrelevantinformation.Areaderoffnancialreportsmaywanttoknowhowmuchwaspaidfortheassetsandtowhatextenttheyhavebeendepreciated.Thisinformationcannotbereadilyobtainediftheformerprocedureisfollowed.Inpractice,theaccountantdoesnotcredittheBuildingaccountdirectly,aswasdoneintheexample,butrathercreditsacontraaccounttotheBuildingaccount(anaccountthatisasubtractionfromtheBuildingaccount).Thiscontraaccounthasvarioustitles.AmongthemostwidelyusedareAllowanceforDepreciationandAccumulatedDepreciation.TheentrymadeonDecember31toaccruethedepreciationcostandthedecreaseintheBuildingaccountwouldthenbeDepreciationExpense .............................. 1,000Building,AccumulatedDepreciation ............ 1,000Thisisthegenerallyacceptedentryforrecognizingdepreciation.Thecreditisnotmadedirectlytothefxedassetaccount,buttoacontraassetaccount.Thebalanceinthiscontraaccount,nomatterwhatitstitle,is asubtractionfromthefxedassetaccount . DepreciationandCashFlow Theaccountingdepreciationexpenseentrydoesnotaffectthecashfowofabusi-nessorganization,butthedepreciationexpensefortaxesdoesaffectcashfow.Assumeasituationinwhichthefollowingfactsapply—cashsalestotal$100,accountingandtaxdepreciationexpenseis$20,andthetaxrateis0.40.Thefrststepistocomputethetaxableincome.CashSales$100DepreciationExpense20 TaxableIncome$80 Giventaxableincomeof$80andataxrateof0.40,theincometaxprovisionis0 . 40 ( $80 ) = $32.TheincomestatementfortheperiodisCashSales$100DepreciationExpense$20TaxExpense32 52 Income$48
November6,200913:44spi-b8119inx6inb811-ch07 122 AnIntroductiontoAccountingandManagerialFinance Theenterprise’sincomeis$48.However,itscashfowfromoperationsis$68.CashSales$100TaxExpense32 CashFlowfromOperations$68 Theenterprise’scashfowfromoperationscanalsobeobtainedbyaddingthedepreciationexpensebacktoincome:Income + DepreciationExpense = $48 + $20 = $68 . (7.3)Bydeductingdepreciationexpenseof$20fromthecashsales,theenterprisesaved$8oftaxes.Ingeneral,thetaxsavingsfromdepreciationexpenseisequaltothetaxratetimesthedepreciationexpenseallowedfortaxes:TaxRate × DepreciationExpense = 0 . 40 × $20 = $8 . (7.4)Equivalently,wecanstatethatthecashfoweffectofdeductingdepreciationexpenseof$20istoincreasetheafter-taxcashfowsby0 . 40 ( $20 ) = $8.Notethatwemultiplythetaxdepreciationbythetaxratetoobtainthecashfowincrease.Each$1ofdepreciationexpensereducestaxableincomeby$1andsaves$0.40oftaxes. InterpretationofGainorLoss Thegainorlossrecognizedatthetimeofretirementofalong-livedassetwilldependonthreefactors:thebookvalueattimeofretirement,theproceedsofsalvageorsale,andthecostsofremoval.Thesefactorscanrarelybeknownwithcertaintyatthetimeofacquiringanasset,sotherewillinvariablybegainsorlossesonretirement.Incurrentpractice,thegainorlossonretirementisregardedasaffectingcurrentincome.Theamountsoftheretirementgainsorlossesareaffectedbythechoiceofthemethodofdepreciation.Asshownintheprecedingsection,thereareseveralacceptableproceduresfordeterminingthedepreciationcharges.Theuseofdiffer-entprocedureswillresultindifferingbookvaluesatretirementandthusaffectthegainorlossrecognized. Example Toillustratethispoint,consideramachinethatcost$10,000andisbeingdepreci-atedonthebasisofafour-yearusefullifewithnoremovalcostorsalvagevalueexpected.Attheendofthethirdyearofuse,themachineisretiredwithnetsalvage
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 123 valueof$1,000.Computetheamountofgainorlossthatwouldberecognizedassumingthattheassetisbeingdepreciatedbyuseofstraight-linedepreciation. Solution Usingstraight-linedepreciation,thedepreciationdeductionis$2,500peryear.Theaccumulateddepreciationattheendofyear3wouldbe$7,500.Bookvalueattheendofyear3wouldbeAssetCost$10,000 Less: AccumulatedDepreciation7,500 BookValue$2,500 CalculationofLoss: BookValue$2,500NetSalvage1,000 LossonRetirement$1,500 RecordingofNaturalResources Considerthedrillingofanoilwellandtheaccountingforeventsthattakeplace.Isthecostoftheoilthatisfoundthecostofthesuccessfulwellsorthecostofdrilling all thewells,dryandsuccessful?Ifthelatter,overwhattimeframeandcoveringwhatgeographicalarea?Iscostrelevantatall,orwouldtheusersoffnancialstatementsratherbeinformedofthevalueoftheresourcesthatthecompanyowns?Thesequestionshavebeenponderedbyaccountantsformanyyears.The“successfulefforts”methodofreportingforoilexplorationactivitieshasbecomeacceptedpracticebymanyaccountants.Thismeansthatthecostoftheoilownedbyanoilcompanywillrefectthecostoffndingtheoil.Therecordedcostincludesthecostofnearbydrywells,butnotthecostofdrywellsthataretotallyunconnectedwiththeareaswheretheoilwasfound. DepletionofNaturalResources Thepreviousdiscussiondealtwiththeproblemsofallocatingthecostofassetswhoselivesextendoverseveralaccountingperiods.Thelivesoftheseassetsweredeterminedbyeitherphysicaldeteriorationorobsolescence,andthecostsofusingtheassetswerechargedeithertoproductioncostorimmediatelytoexpense.Incertainextractiveindustries—coalmining,petroleumproduction,orerefn-ing,andsoforth—ananalogousproblemexists.Ordinarilyasinglesumispaidtoacquireaquantityofnaturalresources,buttheprocessofextractingtheseresources
November6,200913:44spi-b8119inx6inb811-ch07 124 AnIntroductiontoAccountingandManagerialFinance willextendovermanyaccountingperiods.Theproblemofallocatingthecostofsuchitemstoproductionisanalogoustotheproblemofdepreciation,exceptthatinthiscasetheassetbecomesphysicallyembodiedintheproductbeingmanufac-tured.Theprocedureforallocatingsuchcostsiscalled depletionaccounting .Theusefullifeofanaturalresourcedependsonthephysicalquantityoftheresourceandtherateofusage.Everytonofcoalorironoreextractedfromamineresultsinonelesstonremaininginthemine.Thus,insteadofyearsormachinehours,depletionaccountingassignscostsbasedonphysicalquantitiesofproductthatareexpectedtobeextracted.Theprecisequantityofaresourcestillinthegroundmaybeverydiffculttoevaluate.However,geologistsandotherknowledgeablepersonsmaybecalledupontotakesamplesandestimatethequantitiesofmineralsorotherresourcesexistinginaparticularoperation.Oncesuchanestimateisavailable,thedeple-tioncalculationsaremadeinafashionsimilartodepreciation.Althoughpro-ceduresinvolvingdecreasingchargescouldbeused,thedepletionproceduresaregenerallybasedonastraight-lineassumptionaboutthephysicalquantities.Thedepletioncostofayearwilldependuponthequantitiesextractedinthatperiod.Partofthecostwillbeassignedtoinventoryandparttotheexpenseoftheperiod.Theaccountingentriesfordepletionaresimilartothoseusedinaccountingfordepreciableassets,althoughusuallythelong-livedassetaccountiscrediteddirectlyratherthanreducedthroughuseofacontraassetaccount. IntangibleAssets Intangibleassetsareitemsthatthefrmpurchasedbutthatlackphysicalsub-stance.Theirvaluetothefrmisoftendependentonotherbusinessfactorsandissubjecttoconsiderableuncertainty.Inmanyinstances,suchassetshavevalueonlyinthecontextofaparticularbusinessandthereforecannotbetransferredtoanotherorganization.Becauseoftheuncertaintysurroundingthevalueoftheseitems,theyarefrequentlyrecognizedatonlyanominalamountinthefnancialstatementsorexpensedattimeofacquisition.Yetintangibles could representasignifcantamountoftheeconomicresourcesofacompany.Assetsclassifedasintangiblebyaccountantsincludepatents,trademarks,copyrights,goodwill,andorganizationcosts.Intangibleresourcesmaybepurchasedfromothersordevelopedinternallybyacompany.Althoughpurchasedintangiblesaregenerallyrecordedasassets,self-developedintangiblesarenot.Thus,apatentpurchasedfromanothercompanywouldbeshownatitscostasanassetonthebalancesheet,whereasasimilar
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 125 patentdevelopedthroughthecompany’sownresearchanddevelopmenteffortswouldnot.Becausepurchasedintangiblesareincludedasassetswhilenonpurchasedintan-giblesusuallyarenot,adoublestandardforassetrecognitionexists,makingcomparisonsamongfrmsdiffcult.Suppose,forexample,thatCompanyAhasdevelopedapatentasaresultofitsownresearchefforts.ThepatentwouldnotbeshownasanassetintheaccountingstatementsofCompanyA.However,ifCompanyAweretosellthepatenttoCompanyBfor$100,000cash,CompanyBwouldrecognizethepatentinitiallyatitscosttothatcompany,$100,000.Eventhoughthepatentremainsunchanged,itstransferfromtheoriginalownertoanewownerforanobjectivelydeterminablepricegivesrisetotherecognitionofanassetthathadnotbeenrecognizedbeforebytheoriginatingfrm. ResearchandDevelopmentCosts Thecostsofresearchanddevelopmentpresentadiffcultproblemfortheaccoun-tant.Inthepast,thesecostswerefrequentlycapitalizedandregardedasanintangibleasset.Butbecausethereisanuncertainrelationshipbetweenresearchspendingandsubsequentbenefts,theFinancialAccountingStandardsBoard(FASB)inFinancialAccountingStandard2decidedthatallresearchanddevelop-mentcostsshouldbeexpensed.Thus,accountantsmustnowchargeallresearchcoststocurrentexpenses.Itshouldberealized,however,thatresearchcostsareusuallyincurredwiththeexpectationofbeneftingfutureperiodsratherthanthepresentperiod.Theoretically,suchcostsareassets,eveniftheyareexpensedforpurposesofconformingtothereportingrequirementsoftheFASB.Thecostdeferralconceptemphasizesincomedeterminationandisdirectlyrelatedtotheaccepteddefnitionofaccountingincome.Thedeterminationofaccountingincomeisbasedontheprocessofmatchingcostswiththerevenuestowhichtheyrelate.Whencoststhatareexpectedtobeneftrevenuesoffutureperi-odsareincurred,theymaybedeferreduntilthetimewhentheymaybe“matched”withtherelatedrevenuestodetermineincome.Theassetclassifcationofthebal-ancesheetmaybeviewedfollowingthistheoryasincludingcostsawaitingfnaldispositionthroughperiodicchargesagainstrevenues.Twocorporationsmaybeidenticalinallrespects,andthenoneofthetwomaydeclareandpaya$10,000,000dividendtoitsstockholderswhiletheotherspends$10,000,000onresearch.Thebalancesheetsofthesetwocorporationsafterthesetransactionswouldbeexactlythesame.Intheyearofthetransac-tions,thesecondfrmwouldreportlowerincome,sincetheresearchexpenditureistreatedasanexpenseoftheperiod.Actually,thesecondfrmhasaccumulated
November6,200913:44spi-b8119inx6inb811-ch07 126 AnIntroductiontoAccountingandManagerialFinance knowledgeasaresultofitsexpenditureof$10,000,000,butthisknowledgewouldnotberecognizedasanassetaccordingtocurrentgenerallyacceptedaccountingpractice. AmortizationofIntangibles Thecostsofintangiblesthathavebeenrecognizedasassetsshouldbeallocatedtoincomeovertheirestimatedusefullives.Thisprocessisanalogoustodepreciationoftangibleassets,butitisusuallyreferredtoas amortization whenusedwithintangibles.Determiningtheusefullifeofanintangibleassetisextremelydiffcult.Thereisnophysicalwearandexhaustiontoconsider,onlyobsolescenceordeclineineconomicvalue.Manyintangibleshaveamaximumlifeprescribedbylaw.Apatent,forexample,isgrantedforaperiodof17yearsandmaynotberenewed.Copyrightsareissuedforaperiodof28yearswiththepossibilityofrenewalforanother28-yearperiodatexpiration,givingatotalof56years.Fromaneconomicstandpoint,however,itisrarethatanintangibleassetwouldmaintainitsfullvalueduringtheentireperiodofitslegalexistence.Forexample,apatentmaybemadeobsoletebyanewdevelopmentthatsupersedesit.Acopyrightedworkmaynotprovideanyrevenuesafterthefrstfewyearsofitsexistence.Forthesereasons,theusefullifeofanintangibleassetshouldberegardedastheshorterofthelegaloreconomiclife.Someintangibleswithindeterminatelives,suchasgoodwill,wereonceregardedashavingperpetuallivesandthuswerenotamortized.Incurrentpractice,however,allnewlyacquiredintangiblesareregardedashavinga maximum usefullifeof40years,andtheymustbeamortizedoverthatorashorterperiod.Oncetheamortizationperiodhasbeenestablished,thecostofanintangibleassetmaybeamortizedoverthisperiodbyanyreasonablesystematicmethod,althoughthestraight-linemethodtendstobeusedmostoftenincurrentpractice.Unlikethesituationindepreciationoftangibleassets,thereisnosalvagevalueorremovalcosttoconsider.Themainassetaccountisusuallycrediteddirectlyratherthancreditingacontraaccount.ThedebitistoanAmortizationExpenseaccount. GoodwillandOrganizationCosts Goodwill maybedefnedasthepresentvalueoffutureearningsinexcessofwhatmightnormallybeexpectedtobeearnedontheidentifableassetsusedintheenterprise.Thus,goodwillarisesbecauseoftheexpectationofexceptionalearnings.Therearemanyreasonswhyacompanymighthaveearningsthatare
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 127 higherthancouldnormallybeexpected.Amongthesereasonsareanestablishedreputation,customeracceptance,auniqueproductorprocessleadingtoamonop-olisticposition,andastutemanagement.Ifgoodwillarisesbecauseofthepresenceofexceptionalearnings,doesthatmeanthattheaccountantshouldrecordgoodwillwheneverearningsareexpectedinexcessofnormal?Inpractice,theaccountantrecordsgoodwillonlywhenitispurchased.Thisisusuallyinterpretedtomeanthepurchaseofonebusinessentitybyanotherbusinessentity.Thus,ifFirmApurchasesFirmBfor$1,000,000,andthevalueoftheidentifableassetslessliabilitiesofFirmBisonly$750,000,thenFirmAhaspaid$250,000forsomethingofanintangiblenature.Theaccountantcallsthissomething goodwill .Shouldgoodwillberecordedwhenpurchased,andshoulditthenbeamortized?Purchasedgoodwillrefectstheexpectationoffutureearnings,wheretheexpecta-tionisverifedbyawillingnessofthepurchasertopayforthesefutureearnings.Thegoodwillisamortizediftherecenteventsindicatethatthegoodwillhaslostvalue.Themaintenanceofgoodwillusuallydependsonthecontinuanceofexpen-dituresforitemssuchasadvertisingandpublicrelations.Thecessationofsuchspendingcouldcausethelifeofgoodwilltobecometerminable.Goodwillisalsooftencloselyattachedtoacompanyandmightnotbeeasilytransferredtoanotherfrm.Anyconditionsthatmightlimitthelifeofacompanycouldalsolimitthelifeofitsgoodwill.Theproblemofvaluinganentireindustrialorganizationisusuallytoocomplextopermitthisvaluationtobethebasisofrecordingincomeandfnancialposition.Goodwillisnotrecordedunlessitisexplicitlypurchased.Whentheaccountantrecordsasassetsthoseitemsthathavenosalevalue(intheterminologyoftheeconomist,theiropportunitycostiszero),thenthebalancesheetdoesnotpresenttheliquidationvalueofthebusinessentity.Thestatementdoespresentapictureofthefnancialpositionassumingthefrmcontinuesasagoingconcern. DeferredBenefts ConventionaldepreciationaccountingcombinedwiththeusesofROIisatitsworstwhenthebeneftsproducedbytheassetareexpectedtoincreasethroughtimeorwhenthebeneftsareconstant.Theearlyyearsaregreatlypenalizedbyconventionalaccounting,withthemanagershavinganincentivetoavoidsuchinvestmentssothattheirperformanceevaluationsdonotsuffer.
November6,200913:44spi-b8119inx6inb811-ch07 128 AnIntroductiontoAccountingandManagerialFinance Forexample,assumeaninvestmentcosting$3,000isexpectedtohavethefollowingbeneftstream: PeriodCashFlow 1$1,10021,21031,331 Thefrm’scostofmoneyis0.10andisequaltotheinvestment’sdiscountedcashfowinternalrateofreturn.Theresultsusingconventionalaccountingandstraight-linedepreciationwillbe(assumingtheactualbeneftsareequaltotheexpected): PeriodRevenuesDepreciationIncomeBookValueROI 1$1,100$1,000$100$3,0000.0321,2101,0002102,0000.10531,3311,0003311,0000.331 Thefrstyear’soperationsarenotacceptablegiventhe0.10costofmoney.Defningdepreciationexpensetobethedecreaseinvalueoftheasset,theresultswouldbe: PeriodCashFlowDepreciationIncomeBookValueROI 1$1,100$800$300$3,0000.1021,2109902202,2000.1031,3311,2101211,2100.10 Thedepreciationcalculationsare: V 0 = $3 , 000valueattime0 d 1 = 3 , 000 2 , 200 = $800depreciationofperiod1 V 1 = $2 , 200valueattime1 d 2 = 2 , 200 1 , 210 = $990depreciationofperiod2 V 2 = $1 , 210valueattime2 d 3 = 1 , 210 0 = $1 , 210depreciationofperiod3 . Thedistortioncausedbyconventionaldepreciationaccountingcanbeincreasedbyassumingno(orverylow)beneftsuntilperiod3.Theoperatingresultsoftheearlyyearswouldappeartobeevenworsethanintheexample.Theseconddepreciationmethodillustratedcanbecalledeconomicdeprecia-tionorpresentvaluedepreciation.Itisnotgenerallyacceptedaccountingpractice.
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 129 CashFlowReturnonInvestment Recognizingtheinadequaciesofconventionaldepreciationaccounting,someman-agershaveattemptedtosolvetheproblemsbyusingcashfowreturnoninvestment.Sincecashfowsareusedtoevaluatetheinvestment,whynotusethemtoevaluatetheinvestment’sperformance?Defnethecashfowreturnoninvestmenttobe:Cashfow Investment . Thecomputationseemstobeappealingbecausedepreciationisnotcomputed,butunfortunately,thecomputationmerelymakesabadanalysisworse.Usingthefollowingexamplewheretheinvestmenthasa0.10internalrateofreturn,weobtain: PeriodCashFlowBookValueCashFlow(ROI) 1$1,300$3,0000.43321,2002,0000.60031,1001,0001.100 Somefrmshaveactuallytriedtousethehistoricalmeasuresasrequiredreturnsforadditionalinvestments.Youshouldnotethatforaninvestmentyielding0.10overitslife,thecashfowROIsforthethreeyearsare0.43,0.60,and1.10.ThemeasuregreatlyoverstatestheROItheassetisactuallyearning.Anotherdiffcultyofthemeasureisthatitwilltendtobiasmanagementinfavorofcapital-intensivemethodsofproduction,becausecapitalcostisomittedfromthenumeratoroftheperformancemeasure.ItisbettertousetheconventionalROIwithincome(afterdepreciation)inthenumeratorthantousethecashfowROI,whichisextremelydiffculttointerpretandhasnotheoreticalfoundation.Theuseofthemeasureillustratedabovewillgetmanagementintooneormoreinterpretivediffculties. ASolution Onesolutionwouldbefortheaccountingprofessiontoencourageawiderangeofdepreciationmethods,ifthesemethodsarejustifedbytheeconomiccharac-teristicsoftheinvestment.Currently,toorapidwrite-off(R&D,training,plantandequipment)leadsto(1)badmeasuresofperformanceand(2)non-optimaldecisions.
November6,200913:44spi-b8119inx6inb811-ch07 130 AnIntroductiontoAccountingandManagerialFinance Summary Thischapterhasbeenconcernedwiththeinitialrecordingandallocationofthecostsoflong-livedassets—depreciation,depletion,andamortization—overtheassets’usefullives.Therearemanydifferentmethodsforassigningthecostofalong-livedassettoeachtimeperiod.Themostcommonlyusedaccountingmethodisstraight-linedepreciation.Itiseasytocomputeandwell-defned.Theselectionofthedepreciationprocedurecangreatlyinfuencethereportedincomeandfnancialpositionofacompany.Adistinctionmustbemadebetweentheaccountingdepre-ciationexpense,whichhasnoeffectonacompany’scashfow,andtaxdepreciationexpenseorcostrecovery,whichdoesaffectcashfow.Thenecessityofmakingassumptionsinaccountingpracticeisdramatizedintheareaofrecordinglong-livedassets.Thecostoftheseassetsissometimesdiffculttomeasureand,evenifmeasuredinareasonablemanner,afterseveralyearsthecostislikelytobeapoorestimatorofthevalueoftheasset.Althoughpartofthediffcultiesarisebecauseofarbitraryaccountingpractices,themajorproblemistheattemptbytheaccountanttorecordeventswhenthefullimpactoftheseeventswillnotbeknownuntilsomefuturetime.Forexample,thevalueofresearchisuncertainuntilmanyyearsaftertheaccountant’sreportispublished.Thesameistrueofthelifeofatangiblelong-livedasset.Perfectaccuracyrelativetovalueshouldnotbeexpectedinaccountingforlong-livedassets. ReviewProblems ReviewProblem7.1 TheHubbardCompanyownsamachinethatwaspurchasedonJanuary1,2xx1,atacostof$10,000.Themachinehasbeendepreciatedonastraight-linebasiswithausefullifeofsixyearsandexpectedsalvagevalueof$1,000.OnJanuary1,2xx5,themachineistradedinforanewmachinewithalistpriceof$20,000.Thecompanyreceivesatrade-inallowancefortheoldmachineof$1,200,whichisestimatedtobeitsfairmarketvalueatthattime.Thenewmachinehasanexpectedusefullifeoftenyearswithnosalvagevalueandwillbedepreciatedbyusingthestraight-linemethod.Assumingtheuseoffederalincometaxprocedures,preparejournalentriestorecordtheexchangeofmachinesonJanuary1,2xx5.PrepareajournalentrytorecorddepreciationofthenewmachineonDecember31,2xx5. SolutiontoReviewProblem7.1 Withfederalincometaxprocedure,nogainorlossisrecognizedontheexchange.However,thisaffectsthecostbasisofthenewmachine.
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 131 TheJanuary1,2xx5entrywouldbe:Machine ....................................... 21,300OldMachine—AccumulatedDepreciation ......... 7,500OldMachine ................................. 10,000Cash ....................................... 18,800Torecordtrade-inofmachinefornewmachine.Sincethecostrecognizedis$21,300,theannualdepreciationchargeswouldbe:$21 , 300 10 = $2 , 130 . TheDecember31,2xx5entrywouldbe:DepreciationExpense ................................. 2,130NewMachine—AccumulatedDepreciation ......... 2,130 QuestionsandProblems 1.Inthecourseofobtaininganewmachineforitsfactory,acompanyincurredthefollowingcosts.Whichcostswouldproperlybeincludableinthecostofthemachine?a.Thenetinvoicecostofthemachine.b.Adiscountlostwhentheinvoiceforthemachinewasnotpaidontime.c.Costofremovinganoldmachinetomakeroomforthenewmachine(theoldmachinehadbeenretiredayearagoandwouldhavebeenremovedinanyevent).d.Transportationcostsofthenewmachine.e.Installationcostsofthenewmachine.f.Costsofrepairingthenewmachine:aworkmandroppedthemachineduringinstallationandextensiverepairswerenecessarybeforethemachinecouldbeused.2.Depreciationaccountinginvolvestheuseofestimates.Atthetimeanassetisretiredorsold,however,manyofthefactorsaffectingtheannualcostofusingtheassetbecomeknown.Foreachofthefollowingerrorsinestimation,indicatewhethertheaccountingentriesatthetimeofretirementwouldshowagainorloss:a.Estimatedusefullifeshorterthanactual.b.Estimatedsalvagevaluehigherthanactual.c.Estimatedremovalcostslowerthanactual.
November6,200913:44spi-b8119inx6inb811-ch07 132 AnIntroductiontoAccountingandManagerialFinance d.Estimatedusefullifelongerthanactual.e.Estimatedsalvagevaluelowerthanactual.3.Whatisthe“bookvalue”ofadepreciableasset?Isthisareasonableestimateofmarketvalue?4.Financialanalystsfrequentlyadddepreciationchargestoreportedincometoobtainafgurethattheyrefertoas cashfow .Thisfgureissometimesusedasasubstituteforreportedincomeinevaluatingsecurities.Isthisareasonableindicatorofthefowofcashthroughafrm?Isitanimprovementoverreportedincomeformeasuringperformance?5.ThepresidentoftheFederalCompanywassomewhatconfusedbyaccountingterminology.Herecentlyreadinafnancialjournalthatcompanieswerefnanc-ingtheircapitalexpendituresbyusingdepreciationallowancesandretainedearnings.Aninspectionofthemostrecentbalancesheetrevealedthatdepreci-ationallowanceswere$20,000,000andretainedearningswere$40,000,000.Thisinformationaddedtohisconfusion,forhistreasurerhadrecentlyinformedhimofthedesirabilityofpostponingcapitalexpendituresbecauseofalackofcash.Prepareabriefreportthatwillclarifytheterminology.Explainwhyfnancialanalystsoftenspeakofcapitalexpendituresbeingfnancedfromdepreciationallowances.Aretheycorrect?6.Accountantsusuallyinsistonusingobjectiveverifableevidencetosupportfguresreportedinthefnancialstatements.Whatelementsofsubjectivityenterintothedeterminationofdepreciationforaccountingreports?7.TheABCCoalCompanyhastwoaccountingproblems:a.Thecompanyisabouttodevelopastripminingfeld.Itisestimatedthatatthecompletionoftheminingoperationintenyears,itwillcostthefrm$10,000,000toplacethelandbackintoanacceptableconditiontoconformwithstatelegislation.Howshouldthecompanytreatthecostofreplacingtheland?b.Thecompanyhasinstalledanelectroniccomputerthathasanestimatedusefullifeofsixyears.Itisestimatedthatitwouldcost$200,000toremovethecomputerwhenitistobereplaced.Howshouldthecompanytreatthecostofremovingthecomputer?8.TheBarnesCompanypurchasedequipmentcosting$200,000onJanuary1,19x1.Theequipmenthasanexpectedusefullifeoffveyearsandaforecastnetsalvagevalueatretirementof$20,000.Prepareascheduleofdepreciationfortheyears19x1–19x5,showingforeachyear(1)thebookvalueoftheequipmentatthebeginningoftheyear,(2)thedepreciationchargeforthe
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 133 year,(3)theaccumulateddepreciationattheendoftheyear,and(4)thebookvalueoftheequipmentattheendoftheyear.Prepareaseparatescheduleforeachofthefollowingmethods:a.Straight-line.b.Decliningbalanceattwicethestraight-linerate.c.Sum-of-the-years’digits.9.TheCarlsonCoalCompanypurchasedminingpropertyfor$10,600,000incash.Itwasestimatedthatthepropertycontained400,000tonsofrecoverablecoalandthatthelandwouldhaveavalueof$400,000afterthecoalhadbeenextracted.Duringthefrstyearofoperations,65,000tonsofcoalwererecovered,ofwhich50,000tonsweresold.Preparejournalentriestorecordthepurchaseofthepropertyandtorecognizethecostofcoalextractedandsoldduringtheyear.10.TheCollierCoalCompanypurchasedminingpropertyfor$6,400,000incash.Itwasestimatedthatthepropertycontained300,000tonsofrecoverablecoalandthatthelandwouldhaveavalueof$400,000afterthecoalhadbeenextracted.Duringthefrstyearofoperations,35,000tonsofcoalwererecov-ered,ofwhich25,000tonsweresold.Prepareentriestorecordthepurchaseofthepropertyandtorecognizethecostofcoalextractedandsoldduringtheyear.11.TheHaberCompanypurchasedlandinArizonaonwhichuraniumhadbeendiscovered.Thecostofthelandwas$1,000,000.Additionalcostsnecessarytopreparethelandforminingoperationswere$200,000.Itisestimatedthat5,000,000tonsoforecontaininguraniumwillbeextractedbeforethemineisfullyminedout.Duringthefrstperiodofminingoperations,500,000tonsofuranium-bearingoreweredugandshippedtotherefnery.Thecostofgettingtheoreoutofthegroundandintorailroadcarswas$930,000.Recordthetransactions.12.TheHayesCorporationacquiredatacostof$25,000,000theassetsandnameofanothercorporationwhichitintendstooperateasadivi-sion.Thebalancesheetoftheacquiredcorporationshowedthefollowingassets:CashandOtherLiquidAssets$3,000,000Inventories5,000,000PlantandEquipment16,000,000Land1,000,000
November6,200913:44spi-b8119inx6inb811-ch07 134 AnIntroductiontoAccountingandManagerialFinance Anappraisalmadebyanindependentappraisalcompanylistedthecurrentvaluesoftheassetsasfollows:CashandOtherLiquidAssets$3,500,000Inventories4,700,000PlantandEquipment12,000,000Land2,500,000a.Atwhatvaluesshouldthenewlyacquiredassetsberecorded?b.Iftheappraisalvalueoftheplantandequipmenthadbeen$20,000,000insteadof$12,000,000,atwhatvalueswouldyourecordtheassets?13.Equipmentwaspurchasedfor$60,000withanexpectedusefullifeoffouryears.Thecompanyusesthesum-of-the-years’digitsmethodofdepreciationandexpectssalvagevaluetoequaltheremovalcostattheendofthefourthyear.Attheendofthethirdyear,newequipmentispurchasedtoreplacethepresentequipment.Theoldequipmentissoldfor$15,000,andremovalcostsare$3,000.Preparetheentriestorecordtheretirementoftheoldequipment.14.TheHarknessCompanytradedinacarforanewmodel.Theoldcarcost$3,500andwas90percentdepreciated.Thelistpriceofthenewcarwas$4,500,buttheKeenCarAgencyofferedtoallow$1,200ontheoldcar.TheHarknessCompanyhadtriedtoselltheoldcar,andthebestcashpricetheyhadbeenofferedwas$475.TheKeenCarAgencyofferedtopay$475cashfortheoldcariftheHarknessCompanydidnotwanttotradeitin.a.Makethejournalentriestorecordthetrade-infromthepointofviewoftheHarknessCompany.b.Makethejournalentriestorecordthetrade-infromthepointofviewoftheKeenCarAgency.15.TheHardyCompanyceasedoperationsinitsIllinoisplantonJuly1.OnAugust1,itwasdecidedtodismantletheequipmentandselltheplant.Thecostofdismantlingtheequipmentwas$7,000.Theequipmentwassoldasscrap,andsecond-handequipmentwassoldfor$20,000.Theplantwassoldfor$120,000,andtherewereexpensesof$6,000connectedwiththesale.DepreciationwaslastaccruedontheplantandequipmentonthepreviousDecember31.TheJanuary1balancesintheplantandequipmentaccountsoftheIllinoisplant
November6,200913:44spi-b8119inx6inb811-ch07 DepreciationExpense 135 wereasfollows:Plant$2,000,000Plant,AccumulatedDepreciation1,550,000Equipment400,000Equipment,AccumulatedDepreciation320,000Thebuildingdepreciationwas$4,000permonth,andtheequipmentdepre-ciationwas$3,000permonth.PreparejournalentriestorecordthedepreciationfortheperiodandalsotheretirementoftheplantandequipmentoftheIllinoisplant.16.Assumeaninvestmentof$4,000hasthefollowingprojectedincomestate-ments.Therearezerotaxes.Thecostofequityis0.10.1234 Revenue$1,800$1,600$1,400$1,200Depreciation1,000 1,000 1,000 1,000 Income$800$600$400$200a.ComputetheNPVusingthecashfows.b.Computetheeconomicincomesofeachyear(subtractaninterestcostonthecapitalused).ComputetheNPVusingeconomicincome.Computetheinvestment’sinternalrateofreturn.c.Nowassumethedepreciationscheduleis:YearDepreciation 1$1,60021,20038004400ComputetheeconomicincomesofeachyearandtheNPVusingeconomicincome.d.Whatisthepresentvaluedepreciationofeachyearif0.10isusedasthediscountrateand$4,830isusedasthedepreciationbase?e.Usingtheanswerto(d),computetheincomesandROEofeachyear.f.Whatisthepresentvaluedepreciationofeachyearif0.20isusedasthediscountrateand$4,000isusedasthedepreciationbase?
November6,200913:44spi-b8119inx6inb811-ch07 136 AnIntroductiontoAccountingandManagerialFinance g.Usingtheanswerto(f),computetheincomeandROEofeachyear.h.(continuea)Insteadofaninvestmentof$4,000,assumethebookvalueis$9,000andtheterminalvalueattime4is$1,756.92.ComputetheNPVusingthecashfows.Computetheeconomicincomesofeachyear.ComputetheNPVusingeconomicincomesandotherrelevantinformation.
November6,200913:44spi-b8119inx6inb811-ch08 Chapter8 Long-TermLiabilities A conventionalbond isapromisetopayafxedamount(theprincipal)attheendofacertainnumberofperiodsandanotheradditionalamounteachperiodasinterest.Theamounttobepaidattheendofthelastperiodisalsoreferredtoasthe maturityamount or facevalue .Theamountofeachequalperiodicinterestpaymentmaybestatedasadollaramount.Inthelattercase,thestatedpercentageisreferredtoasthe contractualrate .Thistypeofconventionalbondsecurityissometimescalledaballoonpaymentdebt.Intermsofcompoundintereststructure,abondmaybeviewedasacombinationoftwocomponents:(1)thestreamofinterestpayments,whichmayberegardedasanannuity;and(2)theamount,whichisalumpsumtobereceivedafteranumberofperiodsatthematurityofthebond.Thepresentvalueofaballoonpaymentisthepresentvaluesofthetwocomponentsaddedtogethertoobtainthepresentvalueofthebond. Example Computethepresentvalueofabondwhosefacevalueis$1,000.00,dueinfouryears,withannualinterestpaymentsof$120each.Moneyisworth12percentannually.Answer:First,thepresentvalueofthematurityamountisdetermined.Thepresentvalueof$1dueinfourperiodsat12percentinterestis0.6355.Therefore,thepresentvalueof$1,000.000is$1 , 000 . 000 × 0 . 6355 = $635 . 50 . Thepresentvalueoftheinterestpaymentsisequaltothepresentvalueofanannuityof$1perperiodforfourperiods(at12percent,thisis3.037).Therefore,thepresent 137
November6,200913:44spi-b8119inx6inb811-ch08 138 AnIntroductiontoAccountingandManagerialFinance valueof$120.00perperiodis$120 × 3 . 037 = $364 . Addingthetwopresentvalues,weobtainthepresentvalueofthebond:Presentvalueofmaturityamount$636Presentvalueofinterestpayments364 Presentvalueofbond$1,000Severalfactorsintheexamplegivenshouldbeobserved.Notethatthecon-tractualrate(interestpaymentsasapercentageofmaturityamount)isequalto12percent.The effective or marketrate ofinterestisalso12percent.Ifthetworatesareequal,thepresentvalueofthebondisidenticalwiththematurityamount.Theequalitywillalwaysholdwhenevertheeffectiveinterestrateisequaltothecontractualrate.Itislikelythattheeffectiveinterestrateofabondwillnotbeexactlyequaltothecontractualrate.Themarketratefuctuatesfromdaytoday,dependingonvariouseconomicforces.Thepriceofthebondcanbesetatalevelthatwillallowthepurchasertoearntheeffectiverateontheinvestment.Thatis,thepriceofthebondwillbeequaltothepresentvalue,nottothematurityamount.Ifthecontractualrateislessthanthemarketrate,thebondwillsellinthemarketforlessthanitsfacevalue(i.e.,itwillsellata discount ).Ifthecontractualrateisabovethemarketrate,thebondwillsellformorethanitsfacevalue(i.e.,itwillsellata premium ).Theexactpriceisdeterminedbypresentvaluecalculations. Example Assumethatthe$1,000bondwithalifeoffouryearspaying$120interestperyearwasissuedataneffectiverateof10percent.Determinethepriceatwhichitwouldbeissued.Thepresentvalueof$1forfourperiodsat10percentis0.6830.Therefore,thepresentvalueofthematurityamountof$1,000is$1 , 000 . 000 × 0 . 6830 = $683 . 00 . Thepresentvalueof$1perperiodforfourperiodsis3.1699.Therefore,thepresentvalueofthestreamofinterestpaymentsof$120is$120 × 3 . 1699 = $380 . 39 .
November6,200913:44spi-b8119inx6inb811-ch08 Long-TermLiabilities 139 Thepriceatwhichthebondwouldbepricediscalculatedasfollows:Presentvalueofmaturityamount$683.00Presentvalueofinterestpayments380.39 Presentvalueofbond$1,063.39Becausethecontractualrateof12percentishigherthantheeffectiverateof10percent,thebondwillsellatapremium.Theamountofthepremiumisthedifferencebetweenthepresentvalueandthefacevalueofthebond.Presentvalueofbond$1,063.39Facevalueofbond1,000.00 Premium$63.39 Example Assumethatthe12-percent$1,000bonddescribedinthepreviousexamplewasissuedataneffectiverateof15percent.Determinethepriceatwhichitwouldbeissued.Thepresentvalueof$1forfourperiodsat15percentis0.5718.Therefore,thepresentvalueofthematurityamountof$1,000is$1 , 000 . 000 × 0 . 5718 = $571 . 80 . Thepresentvalueof$1perperiodforfourperiodsat15percentis2.8550.There-fore,thepresentvalueofthestreamoffourinterestpaymentsof$120is$120 × 2 . 8550 = $342 . 60 . Thepriceofthebondis:Presentvalueofmaturityamount$571.80Presentvalueofinterestpayments342.60 Presentvalueofbond$914.40Becausethecontractualrateof12percentislowerthantheeffectiverateof15percent,thebondwouldsellatadiscount.Theamountofthediscountisthedifferencebetweenthefacevalueandthepresentvalueofthebond.Facevalueofbond$1,000.00Presentvalueofbond914.40 Discount$85.60
November6,200913:44spi-b8119inx6inb811-ch08 140 AnIntroductiontoAccountingandManagerialFinance Inthecalculationsjustgiven,theeffectiveratewasconsistentlyusedtocomputepresentvalues.Thecontractualrateisnotusedtodiscountfortime,althoughitisusedtodeterminetheamountofinterestpayments.Thebondconsideredinthecalculationscitedaboveisdescribedasa“$1,000.00,12-percentbondwithfour-yearmaturity.”Insuchcases,itisimportanttorememberthatthecontractualrateisusefulonlyfordeterminingtheamountoftheinterestpayments(e.g.,$1 , 000 . 00 × 12percent = $120 . 00).Itisnotusedasarateinthepresentvaluecalculations.Therateusedtocomputethepresentvaluesistheeffectiveinterestrate. TheSemiannualInterestComplexity Long-termbondsfrequentlywillpayinterestsemiannually.Thisgivesrisetoconfu-sionastowhatannualreturnisearnedorwhatthecostistotheissuingcorporation.Thereturnfromlong-termbondsisusuallyexpressedinnominalratesofoneyear,eventhoughinterestispaidsemiannually.Forexample,a$1,000par(facevalue)bondpaying$45interesteverysixmonthswithacontractualinterestrateof0.09wouldhaveaneffectiveinterestrateof r = 1 + 0 . 09 2 2 1 = 0 . 092025orjustover0.0920ifitissoldatfacevalue.Assumethatyoucanearn0.092025onreinvestedfundsandthatyouaregiventhechoicebetweena0.09$1,000bond(interestpaidsemiannually)ora$1,000bondpaying0.092025.Withthislatterbond,youwillhave$1,092.025attime1.Withthe0.09bond,youwillagainhave$1,092.025: 1 / 2 ( $90 )( 1 . 092025 ) 1 / 2 = $47 . 025attime1 = 1 , 045 . 000 Presentvalue = $1 , 092 . 025Thebondwitha0.09contractualinterestrateactuallyearnsmorethan0.09iftheinterestisreceivedeverysixmonths.Assumeathirdbondthatpaysinterestannuallyattherateof0.09sothatattheendoftheyeartheinvestorwouldhave$1,090.Thisisinferiortotheconventional0.09bondthatpaysinteresteverysixmonths.Ifa0.0930-yearbondwithsemiannualinterestpaymentsisissuedatpar,itisconventionalpracticetodescribetheyieldtomaturityasbeing0.09.Withsemiannualinterestpayments,itwouldbemoreaccuratetosaythattheyieldtomaturityis0.092025.Bondyieldtablesthatareusedtovaluebondswouldindicate
November6,200913:44spi-b8119inx6inb811-ch08 Long-TermLiabilities 141 thattheyieldtomaturityis0.09.Youhavetorememberthatthiscontractualrateisanominalrateandthattheeffectiverateis0.092025peryearor0.045compoundedeverysixmonths.Witha30-yearbond,wecoulduse60timeperiodsanda0.045interestratetocomputethepresentvalue:$1,000(1.045) 60 = $1,000(0.07129) = $71.29$45B(60,0.045) = $45(20.638022) = 928.71 Presentvalue = $1,000.00Ifweuse0.092025,wehavetouse30timeperiodsandannualinterestcostsof$45 ( 1 . 092025 ) 1 / 2 + $45 . 00 = $92 . 025.$1,000(1.092025) 30 = $1,000(0.07129) = $71.29$92.025B(30,0.092025) = $92.025(10.091942) = 928.71 Presentvalue = $1,000.00Notethatthemarketinterestrate,thenumberoftimeperiods,andtheannualinterestpaymentsallhavetobeconsistentmeasuresthatapplytothesameunitoftime. AZero-CouponBond Somebondsonlypayinterestatthematurityofthebond.Thesearecalledzero-couponbondsormoneymultipliernotes.Theyarealsocalledoriginalissuediscount(OID)notes.Thevaluationofazero-couponbondislesscomplexthanisthatofaconven-tionalbond.Ifthematurityamountofthebondis$1,000duein30yearsandifthebondistoyield0.10annually,thepresentvalueofthebondisPV = $1 , 000 ( 1 . 10 ) 30 = $57 . 31 . A$1,000bond(zerocoupon)maturingin30yearsandyielding0.10willonlycost$57.31attime0.Youcanseewhythename“moneymultiplier”isanaptdescription.Ifthecompanygoesbankruptinyear29,theinvestorwillnotearn0.10. Example Assumeaten-yearbondandtheeffectivemarketinterestrateis0.14.$1 , 000 . 00 × 0 . 26974 = $269 . 74 .
November6,200913:44spi-b8119inx6inb811-ch08 142 AnIntroductiontoAccountingandManagerialFinance Theissuanceofa$1,000bondwouldberecordedwiththefollowingentry:Cash.................................269.74BondsPayable....................269.74AnequivalententrywouldbeCash.................................269.74BondDiscount........................630.26BondsPayable....................1,000.00Theinterestforthefrstyearis14percentof$269.74,or$37.76.TheentryifthebonddiscounthadnotbeenseparatelyrecordedwouldbeInterestExpense.......................37.76BondsPayable....................37.76TheentryifthediscounthadbeenseparatelyrecordedwouldbeInterestExpense.......................37.76BondDiscount...................37.76Bothentriesincreasetheliabilityby$37.76.Theinterestforthesecondyearwillbe14percentof$307.50,or$43.05.Thisprocessisrepeatedeachyearuntilmaturity.Atmaturity,therecognizedliabilityshouldbeequaltothematurityamount. ReducingtheBondLiability Whenabondispaidatmaturity,theliabilityisdebitedforthefaceamount.Withasystematicamortizationofpremiumoraccumulationofdiscount,thebondlia-bilitywillbeshownatitsfaceamountatmaturity.Theentrytorecordtheretire-mentatmaturityofa$1,000-face-valuebondbyapaymentofcashwouldbeasfollows:BondsPayable..............................1,000Cash..................................1,000Torecordretirementof$1,000bondatmaturity.Corporationssometimesfnditdesirabletopaydebtpriortomaturity.Ifinterestrateshavefallensincetheoriginalissue,forexample,itmaybeadvantageousto“call”theoutstandingbondsatasetpriceandissuenewbondsatthelowerrate.Thisisfacilitatedifthebondagreementallowsthecorporationtocallthebonds—thatis,requirestheinvestorstoturnthemintothecorporationatafxed
November6,200913:44spi-b8119inx6inb811-ch08 Long-TermLiabilities 143 price—andmanybondagreementsdohavethisfeature.Corporationscanalsopurchasetheirbondsontheopenmarketwheninterestratesfall,butsincethebondpricewillhaverisen,thesamepotentialforgaindoesnotexistaswhenthebondsarecallable.Ifabondisretiredpriortomaturity,itisunlikelythattheamountpaidoutbythecorporationwillequalthecurrent“bookvalue”ofthebond.Theamortizationofpremiumordiscountiscalculatedontheassumptionthatthebondwillbeoutstandinguntilmaturity.Butfuctuationsininterestrateswillcausethemarketpriceofthebondstochangeovertheyears,althoughthesepricechangesarenotnormallyrecognizedintheaccounts.Whenabondretirespriortomaturityatapricethatis higher thantherecordedbookvalue,a loss wouldberecognizedbythecorporation.Ifthepriceis lower thantherecordedbookvalue,a gain wouldberecognized.Inaccordancewithcurrentpractice,thesegainsorlosseswouldbeshownontheincomestatementbutclassifedasanextraordinaryitem.Thus,thegainorlosswillaffectnetincome,althoughitwillbeseparatelyidentifed.Theclassifcationofgainsorlossesfromearlyextinguishmentofdebtasextraordinaryitemsseemstobeadeparturefromtherulethatitemsmustbeunusualinnatureandnotlikelytorecurtoqualifyasextraordinary.Theclassif-cationofthegainsasextraordinaryisrequiredtoreducethepossibleconfusioncausedbyreportinggainsfromdebtretirementasordinaryincome.Intimesofris-inginterestrates,somecorporationswouldfnditpossibletorefnancetheirdebtat higher interestratesandyetreportthegainasordinaryincomeintheirfnancialstatements. TheBondRefundingDecision Assumethereare$10,000,000(facevalue)of0.12bondsoutstandingwith20yearsofliferemaining.Thebondsarecallableat$1,050perbondor$10,500,000intotal.Theincrementalcostsofrefundingare$2,000,000.Now,20-yearbondscanbeissuedtoyield0.08.Assumezerocorporatetaxes. AnEasyIncorrectSolution Thecorporationcouldissue$10,000,000of0.08bondsandsave$400,000ofinteresteachyear.NPV = 400 , 000 ( 20 ,j) 2 , 000 , 000 .
November6,200913:44spi-b8119inx6inb811-ch08 144 AnIntroductiontoAccountingandManagerialFinance Thisseemstobeatypeofinvestmentdecision.Thefrmuses0.20toevaluateinvestments.Assume j equals0.20intheaboveequation.NPV = 400 , 000 ( 4 . 86958 ) 2 , 000 , 000 = 1 , 948 , 000 2 , 000 , 000 =− $52 , 000 . Refundingisnotdesirablebasedonthiscalculation.Theissuethatneedstoberesolvediswhetherthe0.20shouldbeusedasthediscountrateorwhetherthenewborrowingrateof0.08shouldbeused. AnEasyCorrectSolution WeshallnowcomputetheNPVusingthenew0.08borrowingrate.NPV = 400 , 000 ( 20 , 0 . 08 ) 2 , 000 , 000 = 400 , 000 ( 9 . 81815 ) 2 , 000 , 000 = 3 , 927 , 000 2 , 000 , 000 = $1 , 927 , 000 . NowrefundingofthebondshasapositiveNPV.Thenetcashfowispositiveandequaltotheamountobtainedusing“AnEasyCorrectSolution”.Theanalysisshouldbeonanafter-taxbasis,butthetaxconsiderationsintroducenospecialanalyticalcomplexities. AMoreComplexCalculation Thepresentvalueofthe0.12outstandingdebtusinga0.08discountrateis:1,200,000B(20,0.08) = $11,782,00010,000,000(1.08) 20 = 2,145,000 PV$13,927,000 Assume$13,927,000ofnew0.08debtisissued(thesamepresentvalueastheoutstandingdebt).Aftercallingthedebtandpayingalltherefundingexpenses,wehave:CashFlowsIn$13,927,000PayOldDebt$10,000,000RefundingExpenses2,000,000 12,000,000 NPV$1,927,000 TheNPVisagainequaltotheNPVusing“AnEasyCorrectSolution”.
November6,200913:44spi-b8119inx6inb811-ch08 Long-TermLiabilities 145 Conclusion Thetimevalueofmoneyisrelevanttotheunderstandingandtherecordingoffnancialtransactions.Thetimingofthecollectionorpaymentisimportantaswellasthedollaramountinvolvedinatransaction.Therearefewfnancialtransactionsthatdonotdependinsomemanneronanapplicationofthefundamentalsofcompoundinterest.Thevalueofabondisequaltothesumof(1)thepresentvalueoftheprincipalatmaturityand(2)thepresentvalueoftheseriesofinterestpayments.Withanormalballoonpaymentbond(e.g.,interestpaymentseachyearandtheprincipalatmaturity),thebondwillsellatfacevalue(par)ifthemarketinterestrateisequaltothecontractualrateofthebond.Thebondwillsellatadiscountifthemarketinterestrateismorethanthecontractualrate.Theinterestexpenseeachperiodisequaltothepresentvalueofthebondatthebeginningoftheperiodtimesthemarketrateofinterestusedtocomputethepresentvalue.Semiannualinterestpaymentsintroduceacomputationalcomplexity.Leasesthatareessentiallypurchasesofpropertyarecalledcapitalleases.Theaccountingtreatmentforcapitalleasesistorecordtheacquisitionofalong-livedassetandtheissuanceofalong-termliabilityatthepresentvalueoftheleasepayments.Thelong-livedassetisdepreciatedoramortizedovertime,andinterestexpenseisrecognizedonthelong-termliability.Allotherleasesarecalledoperatingleases.Theaccountingtreatmentforoperatingleasesistorecordtheleasepaymentsasperiodicrentexpense. ReviewProblems ReviewProblem8.1 a.Whatisthepresentvalueof$1,000dueintenyears,discountedat14percent?b.Whatisthepresentvalueof$140peryearforaperiodoftenyearsiftherateofinterestusedtodiscountthepaymentsbacktothepresentis14percent?c.Whatisthesumofthetwoamountsobtainedinparts(a)and(b)?d.Atwhatpricewoulda14-percent,$1,000,ten-yearbondsellifitistoyield14percent?Assumeannualinterestpayments. SolutiontoReviewProblem8.1 a. ( 1 . 14 ) 10 = 0 . 26974;therefore,$1 , 000 × 0 . 269174 = $269 . 74.b.Since 1 ( 1 . 14 ) 10 0 . 14 = 1 0 . 26974 0 . 14 = 5 . 21614 , $140 × 5 . 21614 = $730 . 26 .
November6,200913:44spi-b8119inx6inb811-ch08 146 AnIntroductiontoAccountingandManagerialFinance c.$269 . 74 + $730 . 26 = $1 , 000.d.$1,000(seepart(c)). ReviewProblem8.2 Ifthebondofthepreviousproblempaid10percentinterestperyear($100),atwhatpricewoulditsell?a.Recorditsissuance(useaDiscountaccount).b.Recordthefrstyear’sinterest. SolutiontoReviewProblem8.2 $1 , 000 × 0 . 26974 = $269 . 74$100 × 5 . 21614 = 521 . 61 Price(value)ofbond$791 . 35Cash....................................791.35BondDiscount...........................208.65BondsPayable......................1,000.00Theinterestexpenseforthefrstyearis:$791.35 × 0.14 InterestExpense$110.79InterestExpense.........................110.79InterestPayable.....................100.00BondDiscount......................10.79Thenewliabilityafterinterestisaccruedis:$791.35+10.79 $802.14or$1 , 000 ( 1 . 14 ) 9 = $307 . 50$100 ( 4 . 9464 ) = 494 . 64 $802 . 14 where4.9464isthepresentvalueofanannuityfornineyearsdiscountedat0.14.
November6,200913:44spi-b8119inx6inb811-ch08 Long-TermLiabilities 147 QuestionsandProblems 1.Ineachofthefollowingsituations,indicatewhetherthebondswouldbesoldatthefaceamount,atapremium,oratadiscount:a.A$1,000bondwith20-yearmaturity.Interestcouponsattached,eachintheamountof$120,arepayableannually.Themarketrateofinterestis14percent,compoundedannually.b.A$1,000bondwithten-yearmaturity.Interestcouponsattached,eachintheamountof$140,arepayableat12-monthintervals.Themarketrateofinterestis14percent,compoundedannually.c.A$1,000bonddueinfveyears.Interestcouponsattached,eachintheamountof$150,arepayableannually.Themarketrateofinterestis14percent,compoundedannually.2.ConsidertheformulaPV = 1 ( 1 + r) n r, whichgivesthepresentvalueofanannuityof$1perperiodfor n periods.a.Whatisthevalueof ( 1 + r) n forverylargevaluesof n ?b.WhatisthevalueofPVforverylargevaluesof n ?c.If n isinfnitelylarge,wehavea“perpetuity”.Whatisthepresentvalueofaperpetuityof$1perperiodif r is10percent?3.a.Whatisthepresentvalueof$1,000dueintenyears?Usea6percentrateofinterest.b.Whatisthepresentvalueof$70peryearforaperiodoftenyears?Usea6percentrateofinterest.c.Whatisthesumoftheamountsobtainedinparts(a)and(b)?d.Atwhatpricewilla7-percent,$1,000,ten-yearbondsellifitistoyield6percent?e.RecordtheissuanceofsuchabondonJanuary1andthepaymentofthefrstyear’sinterestonDecember31.4.Determinetheamountyouwouldbewillingtopayfora$1,000,6-percent,20-yearbond.Youdesireayieldof8.16percentperyear(4percentcom-poundedeverysixmonths).Interestistobepaidtwiceayear.5.Assumethatyoucanborrowandlendmoneyat10percentinterestperyearandthatsecuritiesyieldingthisreturncanbeobtainedwithanymaturity.You
November6,200913:44spi-b8119inx6inb811-ch08 148 AnIntroductiontoAccountingandManagerialFinance aregiventhefollowingchoice:a.$1,000tobereceivedannually,frstpaymenttobereceivedoneperiodfromnow.Thepaymentswillcontinueforever.b.$11,000tobereceivedimmediately.Assumingyoucanobtaineitheralternative(a)or(b),whichwouldyouchoose?6.Determinethepresentvalueofafve-year,$1,000,6-percentbondthatsoldforayieldof7percent(theeffectiveinterestrate).Interestispaidannually.Prepareabondamortizationschedule.Preparetheentriestorecordtheliabilityofthebondissued,theinterestchargeseachyear,andthepaymentoftheprincipal. PeriodValueofBondBeginningofPeriodInterestExpenseforPeriodInterestPayableAmountSubtractedfromDiscountorPremiumValueofBondEndofPeriod 12345 7.Determinethepresentvalueofafve-year,$1,000,7-percentbondthatsoldforayieldof6percent(theeffectiveinterestrate).Interestispaidannually.Prepareabondamortizationschedule.Preparetheentriestorecordtheliabilityofthebondissued,theinterestchargeseachyear,andthepaymentoftheprincipal. PeriodValueofBondBeginningofPeriodInterestExpenseforPeriodInterestPayableAmountSubtractedfromDiscountorPremiumValueofBondEndofPeriod 12345
November6,200913:44spi-b8119inx6inb811-ch08 Long-TermLiabilities 149 8.Determinethepresentvalueofafve-year,$1,000,5-percentbondthatsoldforayieldof6percent(theeffectiveinterestrate).Interestispaidannually.Prepareabondamortizationschedule.Preparetheentriestorecordtheliabilityofthebondissued,theinterestchargeseachyear,andthepaymentoftheprincipal. PeriodValueofBondBeginningofPeriodInterestExpenseforPeriodInterestPayableAmountSubtractedfromDiscountorPremiumValueofBondEndofPeriod 12345 9.If$1isdepositedonJanuary1,howmuchmoneywillhaveaccumulatedattheendofoneyearif:a.Thebankcomputesinterestannually,usinganinterestrateof6percent?b.Thebankcomputesinteresteverysixmonths,usinganinterestrateof3percenteverysixmonths?c.Whatisthecompoundeffectiveannualrateofinterestforthesituationdescribedinpart(b)?10.TheMarshallCompanyauthorizedabondissueoften$1,000,7-percent,20-yearbonds.a.RecordtheissuanceofthebondsonJanuary1,2xx3,soastoyield6.09percentannually(3percentcompoundedtwiceayear).b.RecordtheaccrualofinterestonJune30,2xx3,andthepaymentofinterestonJuly1.c.RecordtheaccrualofinterestonDecember31.d.Whatwillbethebondliabilityaftertenyears?11.TheFenwickCompanyauthorizedabondissueoften$1,000,6-percent,20-yearbonds.Theselow-interestbondswillsellatadiscount.a.RecordtheissuanceofthebondsonJanuary1,2xx3,soastoyield8.16percentannually(4percentcompoundedeverysixmonths).b.RecordtheaccrualofinterestonJune30,2xx3,andthepaymentofinterestonJuly1.
November6,200913:44spi-b8119inx6inb811-ch08 150 AnIntroductiontoAccountingandManagerialFinance c.RecordtheaccrualofinterestonDecember31.d.Whatwillbethetotalbondliabilityaftertenyears?12.Determinetheamountyouwouldbewillingtopayfora$1,000,8-percent,20-yearbond.Youdesireayieldof10.25percentperyear(5percentcom-poundedevery6months).Interestistobepaidtwiceayear.
November6,200913:44spi-b8119inx6inb811-ch09 Chapter9 Stockholders’Equity Thedivergencebetweenaccountingandfnanceiswellillustratedbythestock-holders’equityaccountsofapubliclytradedcorporation.Theaccountantreliesonthehistoryofstockequitytransactionsandfnancereliesonmarkettransactionsforstockvalueestimates.Formostmanagerialdecisions,onlythemarketvaluemeasuresarerelevant.Thetraditionalaccountingmeasuresarerelativelyirrelevantasidefromlegalaspects.Woulditbeusefuliftheaccountantweretousethemarketvaluestoadjustthereportedamountsofstockholders’equity?Remember,wearedealingwithadouble-entryaccountingsystem.Ifthemarketvalueofthestockequityisusedasthebasisoftheaccounting,anotheraccount(probablyanassetaccount)wouldalsohavetobeadjusted.Butthemarketisusingtheaccountingmeasurestovaluethecommonstock.Iftheaccountingmeasuresarebasedonthemarketmeasuresofthestock,thenthemarkethaslostausefultoolforestimatingvalue.Sowehavetolivewiththefactthattheaccountingmeasuresofstockholders’equitywilldifferfromthemarketvalue,andthisdifferenceisessentialtothedeterminationofmarketvalue.Thismeansthatadecisionmakermustdeterminewhethertheaccountingmeasuresorthemarketvalueofthestockismoreuseful.Formostpurposes,themarketvaluewillbemostuseful.Insomesituations,thedecisionmakerwillwanttoignorethemarketvalueandusetheunderlyingaccountingmeasurestoestimatethevalueofthestockwithoutinitialreferencetothemarketvalue(alaterreferenceislikelytobeappropriate).Commonstockpurchasersmaybeinterestedinthesplitbetweenpermanentlegalcapitalandretainedearnings,sincethedividendsmayberestrictedbytheamountofretainedearnings.However,foracommonstockpurchaserlookingtothelongrun,theallocationamongthedifferentstockequityaccountsmaybeoflessimportance.Long-termrestrictionsonthepaymentofdividendsmaybeofinterest,buttheserestrictionsarenotalwaysrecordedintheaccounts. 151
November6,200913:44spi-b8119inx6inb811-ch09 152 AnIntroductiontoAccountingandManagerialFinance ClassifcationofStockholders’Equity Theaccountantmayclassifythestockholders’equitysectioninvariousways.Theselectionoftheclassifcationthatismostusefulwilldependontheinterestsoftheusersofthefnancialstatements.Classifcationsaredesignedtoaccomplishthefollowingpurposes:1.Distinguishamongequitiesofvariousclassesofstockholders;2.Distinguishbetweenparvalueofstockandamountspaidinexcessof,orbelow,par(alegalrequirement);3.Distinguishsharesissuedandoutstandingfromthosethathavebeenreacquiredbythecorporation;4.Distinguishbetweencapitalarisingfromoriginalcontributionsofstockholdersandthatgeneratedthroughtheretentionofearnings;and5.Distinguishbetweenretainedearningsavailablefordistributiontostockholdersandretainedearningsrestrictedforvariousreasons. ParValue Commonstockmaybeissuedwithparorwithstatedvalues.Theseamountsmayhavecertainlimitedlegalsignifcance,butarenotusuallyofimportancetobuyersofcommonstock.Whenacommonstockhasaparvalue,itisgenerallydefnedbythelegalrequirementsofthevariousstates.Theparvalueisoftenthebasisoftaxingtheissuanceandexchangeofstock.Theaccountingentriestorecordtheissuanceofcommonstockaremorelikelytobedictatedbythelegalrequirementsthanbyaccountingtheory.Thus,insteadofusingoneaccounttorecordthecontributionofstockholders,wemightusetwoaccounts:onetorecordtheparorstatedvalue,andtheothertorecordthedifferencebetweenissuepriceandparorstatedvalueofthestock.Thedesignationofparvalueusuallyhaslittleeconomicsignifcance,butmerelyrefectsthelegalrequirements.Inthepast,theissuanceofstockforlessthanitsparvalueresultedinanobligationforthestockholdertopaytothecorporationtheamountofthe“discount”intheeventofcorporateinsolvency.Theuseof“nopar”stockand“lowpar”(suchas$1.00pershare)hasminimizedtheimportanceofthisaspect,andstockisnownotissuedatadiscount.Ifparvalueistobeshownseparatelyinthebalancesheet,thepositivedif-ferencebetweenparandtheamountactuallypaidisshownthroughtheuseofadjunctaccounts.Theadditionalamountisshowninanadjunctaccountreferred
November6,200913:44spi-b8119inx6inb811-ch09 Stockholders’Equity 153 toeitherasAdditionalPaid-inCapital,AmountPaidinExcessofPar,orsimplyPremium. IssuanceofCommonStock Theissuanceofcommonstockisusuallyprecededbythesubscriptionofthestockbytheprospectivestockholders.Thistransactionmayberecorded,butthecorporationgenerallywaitsuntilthecashisactuallyreceivedbeforerecordingentriesrelativetotheissuanceofthestock.Whenparvaluesareinvolved,theentriestorecordtheissuancewouldbeadaptedtorefecttheparvalueandtheamountofpremiumordiscount.Theissuanceofnoparstockdoesnotrequirethisdistinction. Example Recordthejournalentriesforthefollowingsituation.Onethousandsharesofcommonstock,par$10,areissuedfor$11pershare.Cash............................................11,000CommonStock,Par..........................10,000CommonStock,AmountPaidinExcessofPar..1,000Iftheissuepriceis$9pershare,theentryis:Cash............................................9,000CommonStock,Discount.........................1,000CommonStock,Par..........................10,000 IssueofStockforAssets Stockmaybeissuedforassetsotherthancash,suchasland,buildings,andpatents.Theentryrecordingthestockholders’contributiontothecorporationisbasedonarealisticvaluationoftheassetscontributed.Ifthestockissuedhasanactivemarket,recentpricesofthestockmightbeusedtoestimatethevalueoftheentiretransaction.Ifnomarketexistsforthestock,thentheassetsreceivedshouldbeappraised.Theamountreceivedforthestockshouldbeassumedtoequalthecurrentvalueoftheassetsreceivedatthetimeofthetransaction.Forexample,assumethattheRCorporationissues10,000sharesofitscommonstock,$1parvalue,inexchangeforabuildingandland.Thereisnoactivemarketforthestock,butindependentappraisershiredbythecompanyplaceavalueof$50,000onthebuildingand$20,000ontheland.Thetransactionwouldberecorded
November6,200913:44spi-b8119inx6inb811-ch09 154 AnIntroductiontoAccountingandManagerialFinance asfollows:Building.........................................50,000Land............................................20,000CommonStock—Par.......................10,000CommonStock—AmountPaidinExcessofPar60,000Torecordtheissuanceofstockinexchangeforbuildingandland. TreasuryStock Whenacorporationrepurchasesitsownpreviouslyissuedstock,theacquiredsharesarereferredtoas treasurystock .Thetransactionmayberecordedinthefollowingmanner:TreasuryStock...................................10,000Cash.......................................10,000Torecordthepurchaseof500sharesofcommonstockfor$10,000.TheTreasuryStockaccountisthenpresentedinthebalancesheetasasub-tractionfromthetotaloftheotherstockequityaccounts.AlthoughtheTreasuryStockaccountwillhaveadebitbalance,acorporation’sownsharescannotlogi-callyberegardedasanasset.Whenacompanypurchasesitsownstock,itis,fromaneconomicpointofview,retiringthatstock.Fromalegalpointofview,ashareofstockonceissuedmayhavedifferentcharacteristicsfromashareofstocknotpreviouslyissued.Forexample,treasurystockmaybeissuedatapricelessthanparwithoutthepurchaserbeingassessableforthedifferencebetweenparandthepurchaseprice.Assumethatthestockintheexampleisreissuedfor$15,000.Cash............................................15,000TreasuryStock..............................10,000CommonStock,AmountPaidinExcessofPar..5,000Nogainorlossshouldberecognizedbyacorporationbecauseoftransactionsinitsownstock.Itcanbeincorrectlyarguedthatacompanythatpays$10,000forsharesofstockandthenreissuesthesharesfor$15,000hasmadeaproftof$5,000.Ifitwerestockofanothercompanythatwasbeingboughtandsold,againwouldberecognized.However,whenthecompanyhasacquireditsownstockfromitsstockholdersandreissuesthestocktootherstockholders,nogainorlossisrecorded.Thisisconsistentwiththeentityconcept.Wedistinguishrevenuetransactionsfromcapitaltransactions. Revenuetransactions arethosecarriedonwithinthe
November6,200913:44spi-b8119inx6inb811-ch09 Stockholders’Equity 155 scopeofthepurposeforwhichthebusinessunitwasorganized—producing,sell-ing,servicing,andsoforth.Gainsandlossesarerecognizedonsuchtransactions. Capitaltransactions aretransactionsinvolvingtheraisingofcapital—issuanceandretirementofownershipequity.Nogainsorlossesarerecognizedonsuchtransactions. RetainedEarnings Historically,accountantshaveattemptedtodistinguishbetweenthecapitalexplic-itlycontributedbystockholders(wheretherehasbeenanissueofstock)andcapitalgeneratedfromretainedearnings(capitalthatdoesnotrequireanexplicitdecisionbytheindividualstockholders).Thisdistinctionservesseveralpurposes.Itindi-catestosomeextentthepastproftabilityofthecorporation,althoughthisindica-tionmaybedistortedbycashdividends,stockdividends,reorganizations,secretreserves,disclosedreserves,andmergers.Thesecondpurposebehindthedistinc-tionissomewhateasiertoaccomplish.Itisthefulfllmentoflegalrequirementsfortheseparationofcontributedcapitalandretainedearnings.Themainfunctionsofthislatterrequirementaretosafeguardtherightsofthecreditorsandtopreventthedeclarationofdividendswhenthepaymentwouldendangertheabilityofthecreditorstocollectionamountsduethem.Wewanttoknowtheamountofretainedearningsinordertodetermineifadividendcanbedeclaredlegally. RetainedEarnings—Restrictions Whenretainedearningsarelegallyrestricted,thisfactcanbeindicatedinfootnotesorthroughtheuseofseparateaccountsidentifyingtherestrictions.Restrictionsmayoccurthroughtheprovisionsofbondindentures,cumulativepreferredstockinarrearswithrespecttodividends,legalrequirementsregardingtheacquisitionoftreasurystock,andsoforth.Insuchcases,stockholdersmightwishtoknowtheextenttowhichretainedearningsareavailablefordividends.Suppose,forexample,thatacompanyhasretainedearningstotaling$100,000,butprovisionsofabondindenturerequirethatdividendsmaybepaidonlytotheextentthatretainedearningsexceed$90,000.Thisinformationmaybeindicatedinthebalancesheetthroughtheuseofseparatelydesignatedaccountstoshowthecomponentsofretainedearnings:RetainedEarnings—RestrictedDuetoBondIndenture$90,000RetainedEarnings—Unrestricted10,000 TotalRetainedEarnings$100,000
November6,200913:44spi-b8119inx6inb811-ch09 156 AnIntroductiontoAccountingandManagerialFinance TheUseofReserves Occasionally,corporationsshowbalancesontheequitysideofthebalancesheetthathavetheterm“reserve”intheirtitle.Usuallythesearecomponentsofretainedearningsthathavebeenseparatelyidentifed.Amongtitlesthathavebeenusedforsuchitemsare: ReserveforContingenciesReserveforSelf-InsuranceReserveforForeignOperationsReserveforPossiblePriceDeclineofInventoryReserveforUncollectibles Thedesignationofsuch“reserves”hassometimesbeenusedtoconcealinfor-mationfromstockholders.Assumeacompanyaddstosuchareserveduringaproftableyearbyincludinganexpenseintheincomestatement,andthenavoidsshowinganexpenseinsomesubsequentyearbydebitingthereserveaccountratherthantheexpense.Thiswouldenablethecorporationtosmoothitsreportedincomeovertheyears.Theaccountingprofessionhastriedtoeliminatethispracticeandhasbeensuccessfulingreatlyreducingtheextentofitsuse.Formanyyears,accountantswererelativelylaxintheuseofthe“ReserveforContingencies”accountestablishedbychargingexpenseaccountsforpossibleadverseevents.In1975,theFASBpublishedStatementofAccountingStandardsNo.5,“AccountingforContingencies”,whichlimitstheuseofprovisionsforcontingencies.Anestimatedlossfromalosscontingencyshallbeestablishedbyachargetoincomeonlyif both thefollowingconditionsaresatisfed:a.Ithastobeprobablethatthelosscontingencywilloccur(theword“probable”isusedinamannerthatimpliesaveryhighprobability).b.Theamountofthelosscanbereasonablyestimated.Forahundredyears,academicaccountantshavewarnedagainsttheuseofreserveaccountingtomanipulateearnings.Supposethisyear’searningsare“toohigh”.Theaccountantcandebitanexpenseaccountandcreditareserveaccount.Thisyear’searningsarereduced.Assumethenextyear’searningsaretoolow.Theaccountantcanthendebitthereserveaccountandcreditacashorliabilityaccount(thus,theexpenseisnotincreased).Theaboveentriesmaybejustifedortheymaybeattemptstostabilizeearnings.Inthe2006Enrontrial,JeffSkillingwasaccusedofusingreservestoachievethetargetedearningsmeasures.Buttheestablishmentofareserveforestimateduncollectableaccountscanbeeithera
November6,200913:44spi-b8119inx6inb811-ch09 Stockholders’Equity 157 reasonableattempttorecognizethatnotallthereceivableswillbecollectedoranefforttostabilizetheearningsstreamthroughmanipulativeaccounting.Thefrstexplanationislegitimate.Theattempttostabilizeearningsisbadaccountingandlikelytobeacrime. RetainedEarningsandCash Thepresenceofretainedearningsdoesnotmeanthatthereisanequalamountofcashontheassetsideofthebalancesheet.Retainedearningsrepresentaportionofthestockholders’shareinthetotalassets.Theremayormaynotbecash.Theretainedearningscannotbeidentifedwithaspecifcassetorgroupofassets. Example ABZCompanyBalanceSheetasofDecember31,20xx Cash$10,000CommonStock$6,000 RetainedEarnings4,000 $10,000 $10,000 Intheforegoingbalancesheet,thecashisactuallygreaterthantheretainedearnings.Ifthecompanythenbuys$10,000offxedassets,thebalancesheetbecomes: ABZCompanyBalanceSheetasofDecember31,20xx Cash—CommonStock$6,000FixedAssets$10,000 RetainedEarnings4,000 $10,000 $10,000 Theretainedearningsareunchanged,buttheyare$4,000greaterthanthecashbalance,whichisnowzero.Itissometimeserroneouslystatedthatdividendsare“paidoutofretainedearnings”.Thedeclarationofadividendservestoreducethebalanceofretainedearnings,andinmanycasestheamountofdividendsthatmaylegallybedeclaredislimitedbythebalanceofretainedearnings.Inthefnalanalysis,however,acashdividendmustbepaidoutofcash,regardlessofthebalanceintheRetainedEarningsaccount.Inasmuchasthepresenceofretainedearningsdoesnotnecessarilycoin-cidewiththeholdingofcashbythecorporation,theamountofretainedearningsisnotnecessarilyanindicationofthecorporation’sabilitytopaycashdividends.
November6,200913:44spi-b8119inx6inb811-ch09 158 AnIntroductiontoAccountingandManagerialFinance Stockholders’EquitySectionoftheBalanceSheet Thestockholders’equitysectionofthebalancesheetgenerallyconsistsofthreeparts:thecapitalcontributedbythepreferredstockholders,theexplicitcontribu-tionsofthecommonstockholders,and,fnally,theretainedearnings.Anycontraoradjunctaccountsshouldbeplacedimmediatelyundertheprimaryaccountthattheyadjust.Forexample,treasurystockshouldbeshownasasubtractionimmediatelybelowasubtotalofthecommonstockholders’equity.Thefollowingillustratesanumberoftypicalitemsastheymightbefoundinthestockholders’equitysectionofabalancesheet. Stockholders’Equity PreferredStock,1,000SharesofPar$50StockOutstanding$50,000CommonStock,10,000SharesofPar$10StockIssued$100,000CommonStock,AmountPaidinExcessofPar7,000 $107,000RetainedEarnings45,000 $152,000Less:TreasuryStock,1,000Shares(atcost)12,000 140,000 TotalStockholders’Equity$190,000 Fromacommonshareholders’perspective,the$190,000isarelevantmeasureofthestockholders’equityasmeasuredbytheaccountants.Theobservedstockpricemultipliedbythenumberofoutstandingsharesgivesanalternativemeasure. CostofCommonStock Thecostofcommonstockequitycannotbeexplicitlyandaccuratelymeasured,sincetheactualreturntostockholdersdependsnotonlyontheforecastoftheearningsofthefrm,theinvestment,anddividenddecisionsthataremadebythefrm,butalsoontheinterpretationbythestockmarketoftheseeventsanddecisions.Indiscussingthecostofequitycapital,youshouldrealizethatthistopicisthemirrorimageofthedecisiontoinvestincommonstock.Thetheoryofstockvaluationisacrucialelementofthedeterminationofthecostofequitycapital. AStockValuationModel Thereareseveraldefnitionsofthecostofequitycapital.Thestandardacademicdefnitionisthatthecostofequitycapitalistherateofdiscountthatequatesthe
November6,200913:44spi-b8119inx6inb811-ch09 Stockholders’Equity 159 presentvalueofallfutureexpecteddividendspersharetothepresentpriceofthecommonstock.Itisthereturnoninvestmentrequiredbyinvestorssothattheyarewillingtoinvestinthecommonstock.Letusfrstdefnethecostofequitycapital, k e ,astherateofinterestorreturnthatinvestorsrequiretobuythecommonstock.Mathematically,thecostofequityistheinterestratethatequatesthenextdividend, D 1 ,andtheexpectedpriceofthestockatthetime, P 1 ,backtothepriceofasharetoday, P ,ifthenextdividendispaidoneperiodinthefuture.Wethenhave P = D 1 + P 1 1 + k e = D 1 1 + k e + P 1 1 + k e . (9.1)Thepricetodayisequaltothepresentvalueofthenextperiod’sdividendplusthenextperiod’sprice.Bythesamedefnition,thestockpriceattime1is P 1 = D 2 + P 2 1 + k e (9.2)sothat,substitutingequation(9.2)intoequation(9.1),wefnd P = D 1 1 + k e + D 2 ( 1 + k e ) 2 + P 2 ( 1 + k e ) 2 . (9.3)Continuingthissubstitutionprocess,weobtain P = t = 1 D t ( 1 + k e ) t . (9.4)Equation(9.4)isabasicdividendvaluationmodelforcommonstock.Itstatesthatthecurrentmarketvalueofashareofcommonstockisequaltothepresentvalueofallfuturedividends,discountedatthecostofequitycapital.Thecostofequitycapitalisthatrateofreturnthestockmarketexpectstoreceiveinordertocompensateitfortheuseoffundsandtheriskassociatedwiththefuturedividendstream.Equation(9.4)isthesimplestgeneralformulationforthevaluationofcommonstock.Itassumesthat k e canbeusedasthecostofequitycapitalforallyears.Althoughequation(9.4)couldbesolvedbytrialanderrorforanysetof D t ’s,thereare“standard”growthpatternsofthedividendstream.Wepresentamodelinthenextsectiontoillustratethismethodology.Notethatthefuturestockprices(capitalgains)arenotdirectlyinequation(9.4),butratherthefuturedividendsaresubstitutedforthesestockprices.
November6,200913:44spi-b8119inx6inb811-ch09 160 AnIntroductiontoAccountingandManagerialFinance AClosed-FormStockPriceModel Oneofthesimplestassumptionsthatcanbemadeaboutexpecteddividendbehavioristhatdividendsareexpectedtogrowataconstantratethroughtimesothat D t = D 1 ( 1 + g) t 1 .Ifdividendsgrowatarate g inperpetuityand g<k e ,then(asshowninAppendix9.1)wecanobtain P = D 1 k e g, (9.5)where D 1 isthenextperiod’sdividendamount.Thisisaperpetualgrowthmodelwheredividendgrowthisconstanteachperiod.Solvingequation(9.5)forthecostofequitycapital,wefnd k e = D 1 P + g (9.6)andthisisawidelyacceptedtheoreticalmeasureof k e ,thecostofstockequitycapital. Example Acommonstockisexpectedtopaya$1-per-sharedividendattheendoftheyear.Thestockholderswantareturnof15percentandexpectdividendstogrowatarateof14percentperperiod. D 1 = $1peryear(thenextdividend) g = 0 . 14 , growthrateindividends k e = 0.15,costofstockequitycapital(thereturnrequiredbystockholders)Usingequation(9.5),wefndthatthevaluepershareis P = D 1 k e g = $1 0 . 15 0 . 14 = $100 . If g weretochangefrom14to10percent,thevalueofasharewouldchangeto P = D 1 k e g = $1 0 . 15 0 . 10 = $1 0 . 05 = $20 . Notethatachangeinstockprice, P ,mightbecausedbyachangein D 1 , g ,or k e .Adecreasein P doesnotnecessarilymeanthat k e hasincreased.
November6,200913:44spi-b8119inx6inb811-ch09 Stockholders’Equity 161 Byobservingthecurrentannualdividend($1)andthecurrentprice(say,$25)andusinganestimateof g (say,10percent),wecouldthenestimate k e usingequation(9.6): k e = D 1 P + g = $1 25 + 0 . 10 = 0 . 04 + 0 . 10 = 14% . (9.7)Onemightarguethatinvestorsbuypriceappreciation,notfuturedividends.Formanystocks,investorsmayexpectthefrst n periodstohaveverysmall(orzero)dividendsand,nevertheless,thecurrentmarketpricemaybeverylarge.Thecurrenthighprice,however,isonlyjustifedinarationalmarketbytheexpectationofhighfuturedividends(orotherformsofcashfowfromthefrmtoinvestors).Thesummationofthepresentvalueoffuturedividendsdoesnotrequirethatthenear-termdividendsbelarge.However,ifthereareseveralyearsofzerodividendsand/orchanginggrowthratesthroughtime,thenthemathematicalformulationof P doesnotreducetoanexpressionassimpleas P = D 1 /(k e g) .Whatwouldbethevalueofastockthatpromisednevertopaycashtoitsinvestors(includingaliquidationdividendpayoffarisingfromsellingthefrm)?Thevalueoftheseshareswouldbezero.Therehastobetheprospectofdividends(defnedtobeanycashdistributionfromthefrmtoitsinvestors)forstocktohaveapositivevalue.Theconstantgrowthratedividendvaluationmodelassumesthatthedividend( D 1 ) isexpectedtogrowataconstantrate g forever.Itmaybemorerealistictoassumethatspecialinvestmentopportunitiesallowingahighgrowthrateareavailablenotinperpetuity,butonlyoversomefniteintervaloftime, T ,andaftertimethegrowthratewillbesmaller. Conclusion Thischapterhasfocusedonwaysinwhichthestockholders’equitysectionofafrm’sbalancesheetmaybeclassifedtoprovideadditionalinformation.Theinformationsuppliedbythisclassifcationincludes(1)theseparationofequitiesofvariousclassesofstockholders;(2)theseparaterecognitionofamountscontributedthataremoreorlessthanparvalue;(3)thedistinctionbetweencapitalinitiallycontributedtostockholdersandcapitalgeneratedthroughretentionofearnings;and(4)thedivisionofretainedearningswhendividendrestrictionsareinvolved.Theseparationofvariouscommonstockequityaccountsmaybeoflim-itedvaluetousersoffnancialstatements.Exceptforthesatisfactionoflegal
November6,200913:44spi-b8119inx6inb811-ch09 162 AnIntroductiontoAccountingandManagerialFinance requirements,theclassifcationofaccountsinthecommonstockholders’equitysectionisoflittlebenefttolong-terminvestors.Futuredividendsarelikelytodependontheresultsoffutureoperationsandtheasset-debtstructure,notonpastretainedearnings.Yet,theseclassifcationsarecommonlyrefectedinfnan-cialstatements,andunderstandingtheirmeaningshouldfacilitatetheanalysisoffnancialdata. QuestionsandProblems 1.Whatisthesignifcanceofthe“parvalue”ofcommonstock?Isitabargaintopurchase“$100parvalue”stockforonly$80?2.Distinguishbetween“stockdividends”and“dividendsonstock”.Distinguishbetweena“stockdividend”anda“stocksplit”.3.Explainwhyitispossibleforacorporationtohaveretainedearningsofseveralmilliondollarswhilenotbeingabletoexpandplantfacilitiesbyonemilliondollarswithoutraisingadditionalcapital.4.ThebalancesheetoftheDupyCorporationshowsaRetainedEarningsbalanceof$3,500,000.Ananalysisoftheaccountrevealedthefollowing: AnalysisofRetainedEarnings Arisingfrompastearnings$2,500,000Donationoflandbythecity600,000Amountpaidinexcessofparvalueofpreferredstock100,000Gainonsaleoftreasurystock180,000Amountpaidinexcessofparvalueofcommonstock120,000 $3,500,000 CommentontheamountshownasRetainedEarnings.5.Ifyoufounda“ReserveforRetirementAllowances”(foremployees)ontheequitysideofabalancesheet,whatwouldyouthinkwasthenatureoftheaccount?6.ThebalancesheetoftheAeronauticalCorporationatDecember31,20x1,showedthefollowingstockholders’equity:6percentPreferredStock(parvalue$100pershare;authorized30,000shares;issuedandoutstanding15,000shares)$1,500,000CommonStock(parvalue$10pershare;authorized500,000shares;issuedandoutstanding200,000shares)2,000,000
November6,200913:44spi-b8119inx6inb811-ch09 Stockholders’Equity 163 AdditionalPaid-inCapital:OnPreferredStock$60,000OnCommonStock2,000,000 2,060,000 TotalPaid-inCapital$5,560,000RetainedEarnings2,800,000 TotalStockholders’Equity$8,360,000Makegeneraljournalentriesforthefollowingtransactionsoccurringduring20x2:a.Tenthousandsharesofcommonstockwereissuedforcashat$35pershare.b.Thequarterlydividendonthepreferredstockwasdeclaredbutnotpaid.c.Aeronauticalacquired8,000sharesofitsowncommonstockat$32pershare.d.Adividendof$1pershareonthecommonstockwasdeclaredbutnotpaid.e.Threethousandsharesofthecommonstockheldinthetreasurywerereis-suedat$35pershare.7.MoranEnergyInc.isarapidlygrowingdomesticenergycompany,withopera-tionsinoilandgasexplorationandproductionaswellasonshoreandoffshorecontractdrilling.Moran’sstockholders’equitysectionappearedasfollowsonDecember31,20x0: Stockholders’Equity CommonStock,$0.25parvalue,30,000,000sharesauthorized,2,500,000sharesoutstandingatDecember31,20x0$625,000CapitalinExcessofParValue20,239,000RetainedEarnings15,549,000 $36,413,000 Givethejournalentriestorecordthefollowingevents.Assumethattheeventstookplaceintheorderpresented.Pleaseshowallcalculations.a.Thecompanydeclaredandissueda10-percentcommonstockdividend.Themarketpricewas$34.30pershareofcommonstock.b.Thecompanyissued17,000sharesofcommonstockat$8.06persharefortheexerciseofcommonstockoptions.c.$19,443,000principalamountofconvertibledebentureswereconvertedinto955,000sharesofcommonstock.
November6,200913:44spi-b8119inx6inb811-ch09 164 AnIntroductiontoAccountingandManagerialFinance d.Thecompanysold880,000sharesofcommonstocktothepublicfor$24,883,000.e.Thecompanyissuedacommonstocksplitintheformofa100-percentstockdividend.Themarketvaluewas$38.50pershare.The$0.25parvaluewasretained.f.Theboardofdirectorsapprovedarestrictedstockplanwherebyshareswerereservedforissuancetocertainoffcersandkeyemployees.Restrictedplanexpenseof$121,980waschargedtoIncomeandcreditedtoUnissuedRestrictedStock.g.Thecompanyearnedanincomeof$12,187,000in20x1anddeclareddiv-idendsof$580,000in20x1.8.Assumethatgrowthisexpectedtocontinueforperpetuityandthat P = D 1 /(k e g) canbeusedforvaluationpurposes.Theinitialdividendis$1andthecostofequityis0.20.a.Whatis P if g = 0 . 19?b.Whatis P if g = 0 . 10?c.Whatis P if g = 0?d.Whatis P if g =− 0 . 05?9.Acompany’sstockissellingat$50anditsdividendis$4.a.Whatis k e if g = 0 . 10?b.Whatis k e if g = 0?c.Whatis k e if g =− 0 . 05?10.Acompany’sstockissellingat$80anditsdividendforthenextyearisexpectedtobe$4.Theexpectedperpetualgrowthrateis0.10andthecostofequityis0.15.a.Whatwillbetheexpecteddividendafteroneyearhaspassed?b.Whatwillbethepriceafteroneyear?c.Whatisthepercentageincreaseinstockprice?11.CompanyAhasadividendof$2.10andearningsof$3.00.Thestockissellingat$210.Investorswanta0.15return.Dividendsandearningsareexpectedtogrowat0.14peryear.a.Prepareatableshowingtheexpecteddividendsandstockpricesforthenextfveyears.b.Evaluatethefactsofthisproblemandtheresultingtableifearningsareexpectedtoremainconstant.
November6,200913:44spi-b8119inx6inb811-ch09 Stockholders’Equity 165 Appendix9.1:DerivationofStockPriceModelwithConstantGrowthRate Wewanttoshowthat P = D 1 k e g. Attime t , D t = D 1 ( 1 + g) t 1 .Ifthecurrentmarketpriceisdefnedasthepresentvalueofthefutureexpecteddividends, P = t = 1 D t ( 1 + k e ) t = D 1 1 + k e 1 + 1 + g 1 + k e + 1 + g 1 + k e 2 +··· . If k e >g , P = D 1 1 + k e 1 1 1 + g 1 + k e = D 1 k e g.
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November6,200913:44spi-b8119inx6inb811-ch10 Chapter10 DistributionstoShareholders Thetwomajorformsofcashdistributionstoshareholdersare:a.cashdividendsb.repurchaseofitssharesbyacorporation.Theaccountingentryfora$1,000cashdividenddeclarationandpaymentis:Stockholders’Equity.....................1,000Cash....................................1,000Theaccountingentryfora$1,000stockpurchase(thefrm’sownshares)byacorporationis:Stockholders’Equity.....................1,000Cash...................................1,000Thetwobasicentriesarethesame.Whilethedetailedentrieswilldiffer,infact,dividendsandastockrepurchaseofanequalamounthavethesamebasicfnancialconsequencestothecorporation.Bothtransactionsreducestockequityandbothreducethecashaccount.Manyofthedifferentinterpretationsofthesetransactionsoneencountersinnewsandmagazinearticlesaremerelyimaginativefction.SincetheStockholders’Equityaccountissubdividedinpractice,therewillbedifferencesinthedetailsoftheaccountingrecordings,butthebasicnatureoftheaccountingentriesisthesameforbothtransactions. AccountingforDividends:TheDetails Whenadividendisdeclared,atemporaryaccount,Dividends,isdebitedandalia-bilityaccount,DividendsPayable,iscreditedtorefecttheamountduetothestock-holders.ThedebittotheDividendsaccountultimatelyreducesRetainedEarnings. 167
November6,200913:44spi-b8119inx6inb811-ch10 168 AnIntroductiontoAccountingandManagerialFinance Whendividendsonstockaredeclaredbutnotyetpaid,theamountofthedeclarationbecomesaliabilityofthecorporation.Bytheentityassumption,thecorporationisconsideredtobeadistincteconomicunit,separatefromitsowners.Theearningsofthecorporationaccrueforthebeneftofstockholdersandthusservetoincreasethestockholders’equity.However,whenthecorporation’sdirectorsdecidetodistributeaportionoralloftheearningsasadividend,theamountofthedividendbecomesaliabilityofthecorporation.Thestockholdersarecreditorsofthecorporationuntiltheactualpaymentismade.Theentrytobemadeatthetimeofdeclarationcanbe:Dividends.........................................1,000DividendsPayable.............................1,000Torecordthedeclarationofadividend;thedebitreducesretainedearnings.Whenthecashdisbursementtakesplace,thefollowingentryismade:DividendsPayable..................................1,000Cash..........................................1,000Torecordthepaymentofthedividend.TheDividendsaccountisthenclosedattheendoftheaccountingperiodtoRetainedEarnings:RetainedEarnings...................................1,000Dividends.....................................1,000Toclosethedividendsaccount.Theaboveentriescanbesimplifedto:RetainedEarnings...................................1,000Cash..........................................1,000orStockholders’Equity................................1,000Cash..........................................1,000 StockDividends Stockdividendsarenotdividendsinarealsense.Withastockdividend,thecor-porationdistributesadditionalsharesofitscommonstockonaproratabasistoexistingshareholders.Astockdividendincreasesthenumberofsharesoutstanding,butleavestheassetsofthecorporationunchanged(exceptfortransactioncosts).Theamountofacashdividendisusuallyexpressed(intheUnitedStates)interms
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 169 ofdollarsandcentspershare.Theamountofastockdividendisusuallyexpressedasapercentageoraratio.Witha4-percentstockdividend,theholderof100sharesofstockreceivesanadditional4sharesofstock.Thestockdividend,fromaneconomicstandpoint,isactuallyastocksplit.Thus,a100-percentstockdividendanda2-for-1stocksplitareequivalentasfarasshareholdersareconcerned.Whenastockdividendisdeclaredandbecomeseffective,thenewpriceofthesharesrefectstheadditionalsharesout-standing.Theactualpercentagedeclinedependsontheamountofthestockdividend.Whena10-percentstockdividendispaid,allthingsbeingequal,thenewpricepersharewillbe1/1.1oftheoldprice.Forexample,ifsharesweresellingfor$100beforethedividend,eachsharewouldtendtosellforabout$90.91afterthe10-percentstockdividend.Iftherewere N sharesoutstandingbeforethestockdividend,therewouldbe1.1 N sharesafterthe10-percentstockdividend.Thetotalvalueofthestockequitywouldbe$100 N beforeand$90.91 ( 1 . 1 N) = $100 N after.Thetotalvalueisunchanged.Asanadditionalexplanationastowhyastockdividendisnotcomparabletoacashdividend,imaginethefollowingsituation.Youaresittinginarestaurantandhavejustorderedapieceofcherrypie.Whenitarrives,itlookssogoodthatyoutellthewaitressthatyouwanttwopieces.Shepicksuptheplatewiththepieceofcherrypieonit,cutsthepieceofpieintotwo,andhandsbothpiecesbacktoyou.Theoriginalpieceofpieontheplatecorrespondstoyourinterestinthecompany(yourshareofthetotalpie)beforethestockdividend.Thetwopiecesonyourplateafterthewaitresshascuttheoriginalpieceinhalfindicateshowyourownershipinterestwouldchangeaftera100-percentstockdividend.Aninvestorholding10sharesworth$100eachwouldhaveatotalinvestmentof$1,000beforethestockdividend.Afterthestockdividend,theinvestorwouldown11sharesandthestockwouldhaveavalueof$90.91pershare.Again,thevalueofthetotalinvestmentis$1,000.Logically,stockdividendsshouldnotbetaxedasincome,andtheyarenot.Therearetwoapparentreasonswhycorporationsusestockdividends.If,intheopinionoftheboardofdirectors,thepriceofthestockistoohighanditisthoughtthatthehighpriceislimitingtheextentofdistributionofthestock(alower-pricedstockwouldhaveabroadermarket),astockdividendmaybeusedtoreducethepriceofthestock.Thelargernumberofsharesoutstandingwillreducethepricepershare.Itmayincreasethenumberofpersonslikelytobuythestock.Stockdividendsarealsousedtosubstituteforcashdividends.Whenacor-porationisshortofcashbecauseofeitherexpansionofoperationsorunsatis-factoryresultsofoperations,astockdividendmayactasapacifertouninformed
November6,200913:44spi-b8119inx6inb811-ch10 170 AnIntroductiontoAccountingandManagerialFinance stockholdersuntilcashdividendsmaybeincreasedorresumed.Retainingearningsandconservingcashmaybereasonableobjectives.AstockdividendcanberecordedtoconformtolegalrequirementsbydebitingRetainedEarningsandcreditingCommonStockaccounts.ThereisaproblemindecidingtheamountofretainedearningsthatshouldbetransferredtotheCommonStockaccounts.Thegeneralpracticeistousethemarketvalueofthestockissuedonthedateofdeclaration.Thus,astockdividendof1,000sharesof$100-par-valuecommonstockthathasamarketpriceof$150persharemightberecordedasfollows:RetainedEarnings....................................150,000CommonStock—Par............................100,000CommonStock—AmountPaidinExcessofPar...50,000Torecordstockdividendof1,000shares. StockSplit Astocksplitisalsousedtoreducethepriceofcommonstock.Witha stocksplit ,theshareholdersaregivenamultipleofthenumberofsharestheypresentlyhold.Thereisnoeconomicdifferencebetweenastocksplitandastockdividend,althoughthereisanaccountingdifference.Asdescribedabove,astockdividendisaccompaniedbyatransferofaportionofretainedearningstotheCommonStockaccounts.Sometimes,companiesissueastocksplitbutretaintheoldparvalue.Anentryisrequiredforastocksplitiftheparvalueofthecommonstockisnotchanged.Forexample,assumeacompanyissuedatwo-for-onestocksplitbutassumethatitretainedthe$100parvalue.Thefollowingentrywouldbemadetorecordthisstocksplit:CapitalStock—AmountPaidinExcessofPar......1,000,000CommonStock—Par.......................1,000,000Torecordissuanceof10,000sharesof$100-par-valuecommonstockforatwo-for-onestocksplit.Thisentrywouldnotaffectthetotalinvestedequitycapital,butitwouldchangetheamountsreportedascommonstockatparandascommonstockatamountspaidinexcessofpar.Insomecases,alargeincreaseinthenumberofsharesmaybeaccomplishedbyastockdividend.Alargestockdividendhasthesameeffectonmarketpriceasastocksplit,andastockdividendisverysimilartoastocksplitinwhichtheoldparvalueisretained.
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 171 HowstockdividendsandstocksplitsarestructuredanddescribedcanaffectwhetherparvaluesormarketvaluesareusedandwhetheramountsaretransferredfromRetainedEarningsorCommonStockaccounts.SinceamountstransferredfromRetainedEarningscouldeffectivelylimittheamountofretainedearningsthatmaybedistributedascashdividends,theseissuesmaybeofsomeimportancefromalegalviewpoint.Fromafnancialanalysisviewpoint,theseaccountingentriesareirrelevant. DividendsandStockValue Withnoincometaxesandwithotherwell-defnedassumptions(suchasperfectknowledgeandcertainty),adollarretainedisequalinvaluetoadollardistributed;thus,dividendpolicyisnotarelevantfactorindeterminingthevalueofacorpora-tion.However,whentaxesareallowedintheanalysis,dividendpolicyaffectsthevalueofthestockholders’equity.Inpractice,corporationsappeartobeinfuencedinsettingdividendpolicybyadesiretohavearelativelystabledividend.Acommonstockdividendisadistributionofaportionoftheassetsofacor-porationtoitscommonstockshareholders.Theamountreceivedbyeachinvestorisproportionaltothenumberofsharesheldbytheinvestor.Inmostcases,cashisdistributed.Whenacorporationpaysadividend,itsassetsarereducedbytheamountofthedividend.Inpubliclytradedstock,thepricepersharedeclinesbyafractionoftheamountofthedividendonthedaythatthestockgoes“ex-dividend”.Apersonwhobuysthestockonoraftertheex-dividenddatewillnotreceivethedividend.Becauseofotherfactorsaffectingthestockprice,aswellastaxconsid-erations,thedeclineinthesharepricewillnotbeexactlyequaltotheamountofdividendpaid.Thechangewillbeapercentageofthatamount. DividendPolicy Acorporationisnotlegallyobligatedtodeclareadividendofanyspecifcamount.Afrm’sboardofdirectorsmakesaspecifcdecisioneverytimeadividendisdeclared.Oncetheboarddeclaresadividend,thecorporationislegallyobligatedtomakethepayments.Therefore,adividendshouldnotbedeclaredunlessacorporationisinafnancialpositiontomakethepayment.Theexpectationofreceivingdividends(broadlydefnedasanydistributionofvalue)ultimatelydeterminesthemarketvalueofthecommonstock.Bydeclaringadividend,theboardofdirectorsisnotonlyturningoversomeoftheassetsofthecorporationtoitsstockholders,butalsoinfuencingtheexpectationsthatstockholdershaveaboutthefuturedividendstheycanexpectfromthecorporation.
November6,200913:44spi-b8119inx6inb811-ch10 172 AnIntroductiontoAccountingandManagerialFinance Ifexpectationsareaffected,thedividenddecisionandtheunderlyingdividendpolicywillhaveanimpactonthevaluethatthemarketplacesonthecommonstockofthecorporation.Manyfnancialexpertsbelievethatahighlystabledividendisadvantageoustoacompany.Themostcommonreasonstatedforthisbeliefisthatmanystockholderspreferasteadyincomefromtheirinvestments.Thereisatleastoneotherimportantreasonforthinkingthatahighlyvariabledividendratemaynotbeinthebestinterestofacompany.Inthelongrun,thevalueofashareofstocktendstobedeterminedbythediscountedvalueoftheexpecteddividends.Insofarasthisisthecase,awidelyfuctuatingdividendratewilltendtomakeitdiffcultforcurrentorprospectivestockholderstodeterminethevalueofthestocktothem;asaresult,thestockislikelytosellatalowerpricecomparedtostockspayingthesameoranincreasingaveragedividendthroughtime,althoughthepaymentsaremadeatasteadyrate. FactorsAffectingInvestorReactiontoDividends Traditionalconceptsaboutthedistinctionbetweenincomeandcapital,someofwhichhavebeenembodiedintolawsthatcontrolthebehaviorofcertainfnancialinstitutions,areimportantconsiderationsinunderstandinghowtheseinvestorsreacttocorporatedividenddecisionsandpolicies.Themoresophisticatedthinkingaboutfnancialmatterstendstoemphasizethetotalreturnreceivedfromanasset,andtoignoredistinctionsbetweencapitalgainsandotherformsofincomeexceptfortheireffectontaxes.Thetotalreturnapproachtreatsthemarketvalueofthesecuritiesheldanddividendsreceivedasonepoolthatcanbedividedupateachdecisionpointintoconsumptionandfurtherinvestment.Thefactthatsomeoftheliquidassetsavailablehavecomefromdividendsandothersfromachangeinthevalueoftheinvestmentisofsecondaryimportance.Therearemanyinvestorswhoapproachthesesameeventswithadifferentpointofview.Forsomeinvestors,thereisanimportantdistinctionbetweenincomeandcapitalgains.Incomemaybetypicallydefnedasdividendsandinterest.Investorswhothinkinthesetermsareoftenquitecomfortableinconsumingpartoralloftheirdividendorinterest“income”,butareuncomfortableabouthavingtodisposeofsomeoftheirsecuritiesinordertopayforlivingexpenses.Thedistinctionbetweendividendsandcapitalgainsisalsoreinforcedbytaxlawsthatdefnethereceiptofdividendsorinterestasataxableevent.Bycontrast,changesinthevalueofcommonstockarenottaxableeventsunless,anduntil,thesecuritiesareactuallysold.
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 173 Onefurtherinstitutionalfactorthatshouldbementionedinconnectionwithdiv-idendsistheso-calledtrustlegallist.Banks,insurancecompanies,otherfnancialinstitutions,andindividualtrusteesoftenmanagesubstantialsumsforthebeneftofothers.Overtheyears,manystateshavepassedlawsdesignedtoensurethatthebenefciariesoftheseassetsdonotincurlossesbecausetrusteeshavepurchasedexcessivelyriskyinvestmentsforthetrust.Variouscontrolshavebeendesignedtoaccomplishthisend.Oneistorestrictthekindsofassetsthatareeligibleforconsiderationasinvestmentsbyaparticularkindoftrusteeorfnancialinstitution.Suchalistofeligibleassetsiscalledatrustlegallist.Thelawsdonotspecifytheparticularsecuritiesthatareeligibleforinclusiononthelegallist,butratherthecharacteristicsthatasecuritymustpossessinordertobeeligible.Astateoffcialisresponsiblefordeterminingwhichsecuritieshavethenecessarycharacteristics.Tobeeligibleforinclusiononalegallist,acommonstockmayneedtohavepaiddividendswithoutinterruptionforagivenlengthoftime.Aconsequenceofthisprocedureisthatifacompanyfailstopaydividendsinonequarter,itmaysubstantiallyreducethepopulationofinvestorswhoareeligibletobuyorholditscommonstock. CorporateDividendPractice Oneconsiderationisthedesiretohavearelativelystabledividend;thesecondisthedesiretopayout,inthelongrun,agivenfractionofearnings.Thisfractionisusuallyreferredtoasthepayouttarget.Theseobjectivesmaybeconficting.Earningstendtofuctuatesubstantiallyfromyeartoyear.Ifacorporationroutinelypaidoutagivenfractionofthoseearningsasdividends,thenthedividenditselfwouldtendtofuctuatedrasticallyfromyeartoyearorquartertoquarter.Thesefuctuationswouldconfictwiththeobjectiveofmaintainingastabledividendpolicy.Ontheotherhand,ifthedividendisaconstantamount,thenitwillbeafuctuatingproportionofearnings.Assumethatacorporationstartswithadividendtarget.Ifearningsarestable,thenthedividendisunlikelytobechanged.However,ifearningsareincreasing,then,withaconstantdividend,thepayoutratiowillgraduallydecrease.Iftheincreaseinearningsisexpectedtobetemporary,forexample,asaresultofsomeextraordinaryeventorunusuallygoodbusinessconditions,thenitisunlikelythatthecompanywillchangeitsdividend.However,ifmanagementbelievesthatearn-ingsarelikelytobemaintainedattheirnewlevelortoincreaseevenfarther,thenitislikelythatthedividendwillbeincreased.Theincreasewillbeinthedirectionofapproachingtheamountthattheboardofdirectorshassetasatargetpayoutratio.Companiesvarythepayoutratiotheyselect,andthespeedwithwhichtheyadjust
November6,200913:44spi-b8119inx6inb811-ch10 174 AnIntroductiontoAccountingandManagerialFinance thedividendofaperiodtochangesinearnings;however,theytendtoadheretoatargetpayoutratio.Overlongperiodsoftime,thispolicytendstoresultinadivi-dendpayoutthatisapproximatelyequaltothepayouttarget,butdividendstendtobemorestablefromyeartoyearthanearnings.Anotherimportantconsequenceofthisprocessisthatdividenddecisionstendtoprovideinformationtostockholdersaboutmanagement’sforecastsoffutureearnings.Thiswillbeconsideredinalatersection.Assumethatafrmhasalargeamountofdesirableinvestmentsandthattheseinvestmentsrequiremorefundsthanareavailableinternallyafterdividendcom-mitmentshavebeenmet.Insuchcircumstances,oneortwomajoralternativesmustbechosenifthealternativeofchangingthedividendpolicyisthoughttobeunavailable.Thecompanymusteitherforgosomeproftableinvestmentsorseekadditionalfunds.Ontheotherhand,ifthepayoutratioissettoolow,relativetothelevelofearningsandthequantityofproftableinvestmentsavailabletoit,thecom-panymayeitherfnditselfaccumulatinganunwarrantedamountofliquidassetsorbetemptedtoacceptinvestmentsthatarenottrulyconsistentwiththeobjectiveofmaximizingtheeconomicwell-beingofthestockholders.Acompanythatconsis-tentlyfollowseitherofthesepoliciesislikelytobecomeatargetforatakeoverbid,sinceitsstockwillbedepressedcomparedtoitspotentialvalue.Thedisadvantagesoftoolowadividendpayout,relativetotheproftableinvestmentsavailabletothecompany,aremoreseriousfromthepointofviewoftheshareholdersifthefundsarebeingreinvestedatlessthancompetitiverates. TheSettingofDividendPolicy Dividendpolicyislikelytobesetintheformofagoalratherthanarigidrule,eventhoughadefnitepolicyhastheadvantageofprovidingtheinvestor,orpotentialinvestor,aclearbasisforchoice.Investorsknowingthedividendpolicyofthealternativecompaniescanchoosethetypeofcompanythatbestftstheirindividualinvestmentgoals.Thisisdesirable,becausestockholdersdifferintheextenttowhichtheypreferdividendsratherthanopportunitiesforcapitalappreciation.Onemustrememberthat,whileonegroupmightwellprefercapitalgains,asecondgroupofzero-taxinvestorsmayprimarilybeinterestedindividends.Thissecondgroupofinvestorsincludesuniversities,foundations,andprivatepensionfunds,allofwhichaccruenospecialtaxadvantagesfromcapitalgainsasdistinctfromdividends.Sometimesacompanywilldistinguishbetweena“regular”dividendandan“extra”dividend.Althoughthisdistinctiondoesnothaveanycashfowsignifcance,
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 175 itisanimportantmeansbywhichthedirectorscansignaltheirintentionstostockholders.Bylabelingpartofadividendpaymentasan“extra”,thedirec-torsareindicatingthattheydonotnecessarilyexpecttocontinuethosepay-mentsinfutureyears.Bydeclaringtheremainderofthedividendpaymentasaregularpayment,thedirectorsindicateanintentiontomaintainthisdividendfortheforeseeablefuture.Extrastendtooccurinthefourthquarterofagoodearningsyear. DividendChangesandEarningsForecasts Whenadividendincreaseislogicalforacompany,givenitsearningsanditstraditionalpayouttarget,thenthemerefactthatanincreasehasnotbeendeclaredmaysometimesbeinterpretedasevidencethatmanagementdoesnotexpectthecurrentlevelofearningstobemaintained.Ontheotherhand,ifadividendincreasetakesplaceatatimewhenitisnotexpectedonthebasisofthecompany’shistoricalbehavior,thefnancialcommunitymayinterpretthisasevidencethatmanagementismorebullishaboutfutureprospectsforthecompanythanhadpreviouslybeenexpected. DividendPolicy,InvestmentPolicy,andFinancingPolicy Thedividendpolicyofafrmcannotbeconsideredinisolationfromitsotherfnan-cialpolicies.Inparticular,dividendpolicyisintimatelyconnectedwithinvestmentpolicyandfnancingpolicy.Whenafrmchangesitsdividendamount,itmay,atthesametime,havetochangeoneormoreoftheseotherpolicies.Inanyparticularyear,itwouldbesurprisingiftheamountofcashgeneratedinternallyandthescheduleofavailableinvestmentopportunitieswereexactlyasanticipated.Thus,sometemporaryadjustmentsareneeded.Thefrmcanadjusteitheritsdividendpolicy,itsfnancingpolicy,oritsinvestmentpolicy.Itwilltrytomaketheadjustmentsthatareleastcostlytoitslong-termobjectives.Exceptasalastresort,afrmwillnotreduceawell-establisheddividendamountasameansofcopingwithatemporaryshortageofcash.Ontheotherhand,aone-timespecialdividendmightbeusedtocopewithatemporarysurplusoffundsifadividendincreasecouldbelabeledasan“extra”.Forindustrialfrms,changesintheamountofinvestmentsarethemostcommonmethodofadjustment.Insomecases,thiscanbedoneatrelativelylowcostbydelayingthestartofnewlong-terminvestmentprojects.Anotheralternativeistotemporarilyincreaseordecreaseworkingcapital.
November6,200913:44spi-b8119inx6inb811-ch10 176 AnIntroductiontoAccountingandManagerialFinance IrrelevanceofDividendPolicy Dividendpolicyisnotrelevantindeterminingthevalueofafrmifsomewell-defnedconditionsaremet.Theconditionsare:1.Perfectcapitalmarkets(includingrationalinvestors,perfectinformationavail-abletoall,certainty).2.Notransactioncosts.3.Nopersonaltaxes.4.Theinvestmentpolicyofthefrmisset.Theamountinvestedisnotdeterminedbythedividendpolicy,butratherbythecostofequitycapital.Laterweshallconsidertheconsequencesofrelaxingsomeoftheseassump-tions.First,weexaminetheimpactofdividendpolicyonvaluationassumingthattheseconditionshold.Let S t denotethemarketvalueofthecommonstock(aftertheinvestment)attime t , k e denotethecostofequitycapital, C denoteactualcashgeneratedinternallyoverthenextperiod,and Q denotetheamountoffnancingrequiredtomeetcashneedsfortheinvestmentprogram.If Q islargerthan C andnodividendsarepaid, Q C willhavetoberaisedbyanewequityissue.Thecurrentmarketvalueofthecommonstockwillbe S 0 = S 1 ( 1 + k e ) (Q C) ( 1 + k e ) = S 1 Q + C ( 1 + k e ), wheretheterm S 1 /( 1 + k e ) isthepresentvalueofnextperiod’smarketvalueand (Q C)/( 1 + k e ) istheamountofnewequityfunds.Weinterpret (Q C)/( 1 + k e ) tobethepresentvalueofthenewcapitalthatwillhavetobesuppliedbythecommonstockholdersasagroup.Itisinconsequentialwhetherexistingornewequityholdersprovide (Q C) offnancing.Nowconsidertheimpactofacashdividendof D paidoneperiodfromnowtotheexistingstockholders;if D ispaid, Q C + D willhavetoberaisedbyanewissueofcommonstockinordertoundertakethedesiredinvestments. IncomeTaxesandDividendPolicy Theincometaxesofstockholdersshouldaffectthedividendpolicyofafrm.Tohelpyouunderstandthesetaximplications,weshallfrstexaminetheimportanceoftaxdeferralandthenshowtheimpactofhavingtwodifferenttaxrates,oneforordinaryincomeandoneforcapitalgains.Rationalstockholdersshouldvalueastockbasedontheafter-taxreturnstheyexpecttoreceivefromowningit.Thetaxstatusofthereturndependsontheforminwhichitisreceived.Forahigh-taxstockholder,themarginaltaxrate
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 177 onsuchincomecanbehighwhenbothstateandfederalincometaxesarecon-sidered.High-taxindividualsarethebenefcialownersofalargefractionofallstockoutstanding,butthestockmaybeownedindirectlythroughmutualfundsortrusts.Thereturnsreceivedbypensionfundsandbyothernontaxableentitiesarenotsubjecttoeitherordinaryincomeorcapitalgainstaxes.Paymentsmadebythepensionfundstopensionersmaybetaxabletothepensioner,buttheamountofthetaxonthedistributionwillnotdependonwhetherthepensionfundreceiveditsreturnintheformofdividendsorcapitalgains.Thus,managersofpensionfundscanandshouldvaluestocksbasedonthebefore-taxreturnstheyexpecttoreceivefromthem.TheprovisionsoftheU.S.taxcodetendtoleadtohigh-taxindividualsprefer-ringstockswhosereturnsareintheformofcapitalgains,amongothersecuritieswithsimilarrisksandcharacteristics.Also,bycomparativeadvantage,pensionfundholdersshouldfndthattheycandobetterbyholdingstockswhosereturnsareintheformofdividends.Thereissomeevidencethatthisoccursinpractice. TaxDeferralAdvantage Considertheeffectonthestockholders’wealthattheendofoneperiodifacompany,insteadofpaying D dollarsofdividends,retainsandreinvests D toearnareturnof r aftercorporatetaxesandthenpaysacashdividendof D( 1 + r) attime1.Thispolicywillbecomparedtoapolicyofpayingadividendof D tothestockholders,havingittaxedatarateof t p ,andthenhavingthestockholdersinvest D( 1 t p ) toearnataxablereturnof r foroneperiodoranafter-taxreturnof r p inasecondcompany.Afteroneperiodofreinvesting D andearning r aswellasacashdividend,thestockholderswillhave D( 1 + r)( 1 t p ) .Withacashdividendof D andtheninvestingtoearn r p on ( 1 t)D ,thestockholderswillhaveafteroneperiod ( 1 t)D( 1 + r p ). Theadvantageofretentionandtaxdeferralforoneperiodthenadividendcomparedtoanimmediatedividendis:Retentionadvantage = ( 1 t)D(r r p ). Since r islargerthan r p ( r p isafterinvestortax),theadvantageisinfavoroftheretentionanddeferraloftax.Aslongas r isgreaterthan r p ,theadvantagewillbeinfavorofretention.Atypicalcorporationisfacedwiththefactthatithasstockholderswithvastlydifferenttaxrates.Bothpensionfunds(withzerotaxrates)andhigh-taxinvestors
November6,200913:44spi-b8119inx6inb811-ch10 178 AnIntroductiontoAccountingandManagerialFinance willownthecommonstockofthesamecorporation.Thismakesitimpossibletodeterminetheonetaxratevalueforthecommonstockholdersforaspecifcfrm.Nevertheless,wecandeterminethegainorlosstoaninvestorofdifferentdividendpoliciesusingthemodelsofthischapter. CapitalGainsandTaxDeferralAdvantages Weshallnowassumenotonlythepossibilityoftaxdeferral,butalsoacapitalgainstaxrateof t g ,where t g <t p .If D dollarsareretainedpershareinsteadofbeingpaidasadividendandarereinvestedtoearn r afteroneperiod,thevalueofasharewillincreaseby D( 1 + r) .Also,itisassumedthatthisgainistaxedatarateof t g (implyingasaleofthestock)attheendoftheoneperiod.Afteroneperiodwithreinvestmentbythecorporationearning r ,thestockholderhas D( 1 + r)( 1 t g ) afterthecapitalgainstax.Afteroneperiodwithanimmediatecashdividendandthenreinvestmenttoearn r p ,thestockholderwillhave D( 1 t p )( 1 + r p ). Theadvantageofretentiontaxedatacapitalgainsratecomparedtodividendstaxedatordinaryincomeratesisnow:Deferralandcapitalgainsadvantage = D( 1 + r)( 1 t g ) D( 1 + r p )( 1 t p ). Example Letuscomputethedeferraladvantageofacorporationreinvesting$100foroneyeartoearn0.10comparedtopayingadividendof$10.Thestockholderscanearn0.08onexternalinvestmentsanddonotneedcurrentfunds.Assumethatthepersonalmarginaltaxrateonordinaryincomeis0.30.Theadvantageofretainingforoneperiod,comparedtoanimmediatedividend,is:Retentionadvantage = ( 1 t)D(r r p ) = ( 1 0 . 30 ) 100 ( 0 . 10 0 . 08 ) = $1 . 40 . Theretentionalternativeyields$7.00tothestockholdersattheendoftheyearcomparedto$5.60ifthedividendispaid.Ifcapitalgainsaretaxedat0.20andiftheretentionof D leadstoacapitalgainof D( 1 + r) ,wewouldhaveanadvantageofretainingforoneperiodas:Retentionadvantage = D( 1 + r)( 1 t g ) D( 1 + r p )( 1 t p ) = 100 ( 1 . 10 )( 1 0 . 20 ) 100 ( 1 . 08 )( 1 0 . 30 ) = 88 75 . 60 = $12 . 40 ,
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 179 withtheretentionalternativeyielding$88tothestockholdersattheendoftheyearcomparedto$75.60ifthedividendispaid. CostofRetainedEarningsandNewCapital Becauseoftaxes,thecostofretainedearningsislessthanthecostofnewequitycapital.Thecostofretainedearningsisthereturnthatretainedearningswouldhavetoearnonreinvestmentinorderforstockholderstobeindifferentbetweentheimmediatereceiptofthefundsasadividendandtheirretention.Weassumezerotransactioncosts.Tocalculatethecostofretainedearnings,weexaminethechangeinstock-holders’wealthundertheassumptionthatifreinvestmenttakesplaceatanafter-corporate-taxreturnof r leadingtoavalueof ( 1 + r) ,theentireproceedstotheinvestorarethentaxedasordinaryincome.Theafter-taxchangeinstockholders’wealthafteronetimeperiodwillbe ( 1 + r)( 1 t p ) perdollarofreinvestedfunds.Ifthedividendpaymentweretotakeplaceimmediatelyand,afterpaymentofordinaryincometaxesonitatrate t p ,theresidualfundswerereinvestedinanothersecurityofequivalentriskearning r p afterpersonaltax,thenetchangeinstockholders’wealthperdollarofdividendpaidis ( 1 t p )( 1 + r p ), where r p istheafter-investor-taxreturnontheinvestedfunds.Defnethecostofretainedearnings, r ,tobetherateofreturnthatthefrmmustearnonreinvestedfundsforstockholderindifferencebetweenadividendandretention.Letusequatetheafter-taxchangeinstockholderwealthperdollaroffundsunderthetwoalternatives: ( 1 + r)( 1 t p ) = ( 1 t p )( 1 + r p ). Solvingfor r ,wefndthat r = r p .Itcanbeshownthatthisresultisindependentofthenumberoftimeperiods.Ifthefrmcanearnthesamereturnasstockholderscanearnaftertaxwiththesamerisk,stockholderswouldbeindifferentbetweenhavingthefrmpayadividendandreinvestthefunds—thisisthedefnitionofthecostofretainedearnings.Ifnewcapitalisbeingobtained,theinvestorhasachoicebetweenhaving$1inhandorinvestinginafrmthatwillearn r andpay r dividendswithanafter-taxpresentvalueof r( 1 t p ) r p .Equatingthetwoalternativesandsolvingfor r ,
November6,200913:44spi-b8119inx6inb811-ch10 180 AnIntroductiontoAccountingandManagerialFinance wenowhave1 = r( 1 t p ) r p r = r p 1 t p . Withretainedearnings,thecostofstockholders’equitycapitalwas r p .Withnewcapitalbeingobtained,thecostofstockholders’equityhasnowincreasedto r p 1 t p .Havingestablishedthefactthatthecostofstockholders’equitydependsonwhetherthefrmisretainingearnings, r = r p ,orobtainingnewcapital, r = r p ( 1 t p ) ,wecouldnextintroducecapitalgainstaxesandthedecisionbytheinvestortoholdorsell.Thesefactorswillalsoaffectthecostofequitycapital.Thus,thecostofequitycapital,ratherthanbeingoneeasilydeterminablenumber,isafunctionofthetaxlawandthedecisionsofinvestors.Thesolutionofferedaboveisanapproximatesolutionsincecorporationswilltypicallypaydividendsandretainearningssimultaneously.Morecomplexmodelswouldhavetobeusedtoobtainmeasuresapplicabletospecifcsituations.However,theaboveequationdoesillustratethefactthatthecostofstockholders’equityfundsdependsonthesourceofthecapitalaswellasonthedividendpolicyofthefrm. Dividends:TheClienteleEffect Theorysaysthatzero-taxinvestorswillpreferhigh-dividend-yieldstocks,whereasthehigh-taxinvestorswillpreferhigh-growthstocks.Thisimpliesthatdividendpolicywillaffectthetypesofinvestors(theclientele)whowillownacom-pany’sstock. ReasonsforDividends Thereareseveralgoodreasonsforafrmtopaydividends.Someofthesehavebeenillustratedinthemodelsoftheprecedingsections.Thesereasonsinclude:1.Thefrmgeneratesmorecashinternallythancanbeproftablyreinvested.2.Dividendsprovidestable“income”toinvestors(theycanplanassumingthedividendswillbepaid).3.TheInternalRevenueServicepenalizesunnecessarilyretainedearnings.4.Transactioncostsassociatedwithaninvestorsellingstockmakedividendslesscostlyiftheinvestorneedscashincome.5.Changesindividendshaveinformationforinvestors.6.Legallists(eligiblesecuritiesfortrusts)requirearecordofdividendpayments.
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 181 7.Someinvestorspayzerotaxes,andthereisnotaxadvantageindeferredincometaxestothisgroup.8.Ifafrmiscurrentlypayingadividend,itisdiffculttostopwithouthurtingsomestockholders.9.Nonpaymentofdividendsmayencourage“raiders”.10.Amarketthatheavilydiscountstheriskyfuture(refectingahighdegreeofuncertainty)willvaluecurrentdividendpaymentsmorethanfuturedividendpayments.Theprimaryargumentsagainstdividendsarethatretainedearningssavefota-tioncostscomparedtoanewissue,andthatthepaymentofadividendcausesthestockholdertobetaxedatordinaryratesontheamountofcashreceived.Sincesomeinvestorsprefertodefertaxes,onewaytodosoistohavethefrmretainandreinvestearnings.Furthermore,theremaybeataxadvantageintakingcapitalgainsratherthandividendincome.Inadditiontocashdividends,therearealso:1.Stockdividends(moresharesareissuedtoeachshareholderinproportiontoholdings).2.Repurchasesofstock(acashdistributiontoaself-selectedgroupofstock-holders).3.Liquidatingdividends(thismayincludeareturnofcapital).Stockdividendsarenotactuallydividends;rather,theyrepresentachangeinthedescriptionoftheownership(achangeinthenumberofshares).Therepurchaseofstockbyacorporationdiffersfromacashdividendintermsofthetaxconsequencesandinthatthecashisnotdistributedequallytoallstockholders(itonlygoestothosestockholderswhoselltheirstock). RepurchaseofShares Inthepasttwodecades,majorU.S.corporationshaveincreasinglyrepurchasedsignifcantamountsoftheirowncommonshares.Thereasonsforthisdevelopmentanditsimplicationsforthetheoryofsharevaluationandpublicpolicy,however,havebeensubjecttonumerous,andoftenconficting,interpretations.Thischapterpresentsananalysisoftheeconomicsofsharerepurchasing,whichleadstosomefairlydefniteconclusionsconcerningthequestionsofsharevaluation.Therepurchaseofsharesisnotlegalunderallcodesoflaw;butinthecountrieswhereitislegal,itopensupavarietyofopportunitiesforgainsforthestock-holders.Inmanysituations,themotivationwillbeperfectlylegitimate(adesiretoshrinkthesizeofthefrm,withdesirableconsequencesastowhoreceivesthecash
November6,200913:44spi-b8119inx6inb811-ch10 182 AnIntroductiontoAccountingandManagerialFinance distribution),butitisalsopossibleforonegrouptousethisdevicetotakeadvan-tageofinformationthatisnotavailabletotheremainderoftheinvestingpublic.Therepurchaseofsharesisnotuncommonand,barringchangesinlegislation,islikelytoaccelerateinthefuture.Duringthepast20years,corporationshaveacquiredsignifcantamountsoftheirownsharesofcommonstock.Therepurchaseofcommonstockhasbeensaidtohavebeenmotivatedbymanyfactors.Amongtheseare:1.Repurchasedstockisusedbythecorporationforsuchreasonsasmergersandacquisitionsoffrms,stockoptionsandstockpurchaseplans,andsoon.2.Stockrepurchaseisaformofinvestment.3.Repurchasingstockincreasestheamountoffnancialleverageemployedbythefrm.4.Stockrepurchaseisaformofdividend,and,asaformofdividendpayment,stockrepurchasehasfavorabletaxconsequencescomparedwithordinarydividends.5.Stockrepurchasecanleadtoachangeinownershipproportions(maintenanceofcontrolbeingtheobjective).6.Bytakingadvantageofspecialinformation,stockrepurchasecanimprovethewealthpositionofcertainstockholders.7.Stockrepurchaseisamethodofshrinkingthesizeofthefrm(aformofliquidatingdividend).8.Repurchasingstockcomparedtoacashdividendmayimprovefnancialmea-suressuchasearningspershareand,consequently,thepriceofthestock.9.Differentexpectationsheldbythefrmandthemarketcanlead,throughrepur-chase,toimprovingthewealthpositionofcertainstockholders.10.Stockrepurchasewillincreasestockpricethroughtime.Weshallconsidereachofthesereasonsseparately,eventhoughseveralofthemareinterrelated. RepurchaseofStockforUsebytheCorporation Corporationsusesharesoftheirownstockforseveralpurposes,includingtheacquisitionofothercorporations.However,thisisnotacompleteexplanationastowhyacorporationreacquiresitsownshares,sinceacorporationisgenerallyabletoissuenewsharesforthetypesofpurposesforwhichthesharesareacquired.Theremaybevalidreasonswhyacorporationdoesnotwanttoissueadditionalshares,hencereacquiringsharesforreissue.Butitistheseotherreasonsthatarerelevant,notthefactthatthesharesaregoingtobeusedbythecorporation.
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 183 StockRepurchaseasanInvestment Acorporationcannot“invest”initsownshares.Withnormalinvestments,cashisconvertedintoworkingassets.Proftableinvestmentsincreasethesizeofthefrm,andwhiletheymaybeaccompaniedbyincreasesinthedebtorequityaccounts,theyareneveraccompaniedbydecreasesintheseaccounts.However,ifafrmrepurchasesitsownshares,thereisdisinvestmentbythecorporation.Withthefrm’sacquisitionofitsownshares,theassetsdecreaseascashisused,andthestockholders’equityalsodecreases.Thecorporateentitydoesnotmakeaninvest-mentwhensharesareacquired.Itispossibleforonegroupofstockholderstobeneftandonegrouptobeharmedbytherepurchaseofshares.Thegroupnotsellingmayincreasethesizeofitsinvestmentinthefrmcomparedtotheinvestmentofthesellinggroup,butthisisnotthesameassayingthatthefrmisinvesting.Theterm invest mustbereservedforsituationswherethefrmisactuallycommittingresourcestoproductiveactivitiesratherthanasituationwherethefrmisbecomingsmallerastheresultofanaction.Thefactthattheprocessofstockrepurchaseisnot“investing”doesnotmeanthattheutilizationoffundstopurchase(retire)outstandingstockmaynotbethebestuseofthefundsfromtheviewpointofsomeorallofthestockholders. IncreasesinFinancialLeverage Therepurchaseofshareswillleadtoanincreaseintheratioofdebttototalstock-holders’equityemployedandwillthusincreasetheamountoffnancialleverage.However,thiscannotbethesoleexplanationofthestockrepurchaseprocess,sinceacashdividendofthesameamountwouldhaveanidenticalleverageeffect.Theexplanationmustbefoundelsewhere. AFormofDividend Stockrepurchaseisaspecialtypeofdividend.Iftherewerenoseparatetaxtreat-mentsbetweenordinaryincomeandcapitalgains,andifaproportionatenumberoftheshareswereacquiredfromallstockholders,theeconomiceffectswouldbealmostidenticalforstockrepurchaseasforacashdividend(thenumberofsharesoutstandingwouldchange,butthiswouldbetheonlydifference).Ifthestockisnotacquiredproportionatelyfromallinvestors,stockrepurchaseisaspecialtypeofdividend,sinceitgoesonlytothestockholderswhoprefercashcomparedtoincreasedownership.Thosestockholderspreferringtoincreasetheirinvestmentcomparedtoreceivingcashdonotsell.Theself-selectivityoftheprocessisanadvantageforthestockholdersasagroup.
November6,200913:44spi-b8119inx6inb811-ch10 184 AnIntroductiontoAccountingandManagerialFinance Theforegoingconclusionassumeszerotaxes.Oncetaxesareconsidered,stockrepurchaseisadvantageous.Thetaxsavingstostockholdersofastockrepurchasecomparedtoacashdividendmaybesizable.Supposeaninvestorownsandsellsstockfor$1,200withataxbaseof$1,000.Themarginaltaxrateforordinaryincomeis35percentandforcapitalgains,15percent.Witha$1,200cashdividend,thestockholderwouldnetout$780(thetaxwouldbe$420).Withthe$1,200disbursedintheformofastockrepurchase,thestockholderwouldnetout$1,170(thetaxwouldbe$30onacapitalgainof$200).Theadvantageofrepurchaseoverordinarydividenddistributionispresentfortworeasons.Firstisthedifferencebetweenthetwotaxrates.Thesecondreason:withtherepurchaseplan,partofthepaymentisconsideredarepaymentofprin-cipaltaxpurposesandsoisnottaxedatall.Althoughsystematicrepurchaseovertimewouldeventuallydrivethecostbaseclosetozero,thepresentvaluemethod-ologyweighstheearlytaxsavingshigh,andsothedifferencebetweensystematicrepurchaseandordinarydividendisstillconsequentialwhenbothcapitalgainsandordinaryincomearetaxedatthesamerate.Ifbothpersonalandcorporatetaxrateswerezero,eithermethodofincomedistributionwouldleadtothesameintrin-sicvalue.Theintroductionoftaxconsiderations,however,canaffectthevalueofdifferent“packages”.Taxlawscanprovidepowerfulincentivesforfrmswithliquidassetsavailablefordistributiontopurchasesharesratherthanpaylargerdividends.Manypersonswillprefercapitalgainstoordinaryincomeifthemarginalrateoftaxationonordinaryincomeislargewhiletherateonlong-termcapitalgainsissmall.Giventheseincentivesforreturningcashtostockholdersbyrepurchasingshares,arelevantquestionwouldseemtobe:Whydofrmseverpaydividends?Animportantreasonisthattherearesignifcantinvestorswhopayzerotaxes.ThesecondexplanationisrelatedtotheattitudeoftheInternalRevenueServicetowardsharerepurchasing.ThecurrentInternalRevenueCodeclearlyseekstoprohibitfrmsfromdisguisingdividendsintheformofsharerepurchases.Proportionalrepurchasesfromallshareholders,forexample,aretreatedthesameasdividendsfortaxpurposes. Control Itisnotclearthatrepurchasingwillfacilitatetheretentionofcontrol.Forinstance,iftwocompetinggroupseachowned40percentofthestockbeforetherepurchase,theymightwellown40percentafterthecompanyacquires10percentoftheshares.However,ifoneofthecompetinggroupsweretosellitsstocktothecorporation,thiswouldalterthesituation.But,ingeneral,stockrepurchaseisnotaneffective
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 185 meansofbeatingoffaraiderunlessthestockisactuallypurchasedfromtheraider,fromthosestockholdersmostlikelytoselltotheraider,orfromthosestockholdersmostlikelytosupporttheraiderratherthantheincumbentgroup.Infact,thedecreaseinthenumberofthesharesoutstandingmightmakeiteasierfortheraidertonegotiatewiththeremainingstockholders.Thus,thecontrolfactorisnotlikelytobesignifcantwithalargecorporation,unlessthefrmcanidentifythosepartieslikelytosell.However,debtissuancecombinedwithstockrepurchasecandiscouragearaider.Forexample,acompany,byborrowinguptoitsdebtcapacityandacquiringitsownshareswiththeproceeds,coulddiscouragearaiderwhowasrelyingonthefrm’sdebtcapacitytoincreasevalue. SpecialInformation Ifonegroupofstockholdershasspecialoptimisticinformation(say,theyarecloselyassociatedwithmanagement),thenthisgroupcouldhavethecorporationbuystockattheexpenseofthegroupthatdidnothavetheinformationandwould,consequently,bewillingtosellatalowprice.Usingspecialinformationinthismannerwouldseemtobe,atbest,unethical,andislikelytobeillegal.Ifstockistobeacquired,thisinformationshouldbemadeknowntothestockholdersaswellasthereasonswhythestockistobeacquired.Onegroupofstockholdersshouldnotbefreetotakeadvantageofanotherlesswell-informedgroup. ShrinkingtheSizeoftheFirm Iftheobjectiveistoshrinkthesizeofthefrm,thetax-effectrationaleforusingstockrepurchasecomparedtocashdividendsholds.Althoughshrinkagecanbeaccomplishedbyacashdividend,stockrepurchaseleadstopartofthereturnbeingtreatedasatax-freereturnofcapitalandtheresidualgainistaxedatacapitalgainrateratherthanordinaryincometaxrates. ImprovingFinancialMeasures Theeffectofstockrepurchaseonfnancialmeasuresandthestockpriceisevidentlyofinteresttothestockholders.Weshallattempttodeterminetheconditionsunderwhichchangesinthemeasurestakeplaceandhowthestockpriceisaffected.1. Bookvalue :Ifthemarketpricepaidforthecommonstockislessthanthecurrentbookvalue,thebookvaluepersharewillincreasefortheremainingshares.However,ifthemarketpriceismorethanthebookvalue,thebookvaluewilldecrease.Itwouldbesurprisingifsuchchangesinbookvaluearesuffcientjustifcationforacquiringshares.
November6,200913:44spi-b8119inx6inb811-ch10 186 AnIntroductiontoAccountingandManagerialFinance 2. Earningspershareandmarketpriceofstock :Earningspersharewillchangeifthefrmreacquiressharesratherthanpaysacashdividend.Since D isgoingtobedistributedwitheitheradividendorsharerepurchase,thefrm’sfutureearningstreamisunaffectedbutearningspersharewillbehigheriftherepur-chasestrategyisfollowed.Althoughtheearningspersharewillbehigherunderrepurchase,fewershareswillbeoutstanding,andonewouldexpectthetotalvalueofthecommonstocktobethesameundereitherstrategy.Ifthevalueofthefrmandtheearningsarebothunaffected,thenthefrm’sprice/earningsmultipleisunaffected.Applyingthesameprice/earningsmultipletothehigherearningspershare,however,leadstoahighermarketpricepershare.Itisworthwhiletocommentonthetax-relatedrationaleforrepurchase.AlthoughtheInternalRevenueServicedoesnotallowthedistributiontobetreatedasacapitalgainifthefrmrepurchasesstockprorata(sothatownershippropor-tionsdonotchange),itdoesevidentlyallowlessstructuredformsofrepurchase(e.g.,openmarketpurchasesortendering)tobetreatedasacapitalgain.Thereisalsoanotherfactorthatmayinfuencethemethodofdistributingcash.Supposeyouarethemanagerofafrm,andyouhaveastockoptiontobuythestockat$15withthecurrentmarketpricebeing$12(thisistheexpectedpricebeforethecashdistribution).Ifa$2cashdividendispaid,itcanbeexpectedthatthepriceofthestockwillfalltoabout$10(theEPSis$1andtheprice/earningsmultipleis10).Ifsharesofthestockareacquired,thenumberofshareswilldecreaseandthestockpricewillbelargerthan$10.Aseriesofstockrepurchaseswilltendtodrivethepriceofthecommonstockupwardcomparedtothepricewithacashdividendandmakeiteasierforthestockoptiontobeexercisedunderfavorablecircumstances.Thus,stockrepurchaseisalogicalstrategyforfrmswhosepoliciesareadministeredbymanagersholdingstockoptions.Retainingearningsratherthanpayingcashdividendsisstillanotherdesirablestrategytendingtoincreasethepriceofashareofstockhigherthanitwouldbeifthecashweredistributedasacashdividend. DifferentExpectations Asituationmayariseinwhichthemarketassessesthevalueofthestockdifferentlyfrommanagement’sassessmentbecauseofdifferentexpectations.Ifmanagementthinksthatthestockisunderpriced,repurchasingofthestockwillbeneftthosewhocontinuetoholdthestockifmanagement’sassessmentisprovedcorrect.Ifmanagementiscorrect,thefrmcanrepurchasestockatanypricelessthanwhatitbelievestobetheintrinsicvaluewithoutharmingthefnancialpositionofthosewhodonotsell.Ifmanagementisincorrect(overlyoptimistic),theextent
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 187 towhichthestockholderswhodonotsellareharmedisdeterminedbythespreadbetweentherepurchasepriceandthemarketprice. AFlexibleDividend Oneadvantageofstockrepurchaseinlieuofcashdividendsisthatinvestorswhodonotwanttoconverttheirinvestmentsintocashdonotselltheirstockbacktothecorporation.Bynotselling,theyavoidrealizationofthecapitalgainandtheydonothaveanytaxationontheincrementtothevalueoftheirwealth(theyalsoavoidpossibletransactioncosts).Theinvestorswhowanttoreceivecashsellaportionoftheirholdings,andeventhoughtheypaytaxontheirgains,thistaxisapttobelessthanifthecashdistributionweretaxedasordinaryincome.Byusingstockrepurchaseasthemeansofthecashdistribution,thecompanytendstodirectthecashtothoseinvestorswhowantthecashandbypasstheinvestorswhodonotneedcashatthepresenttime. TheStockPriceEffectofShareRepurchase Assumeacorporationwith N sharesoutstandingbuys p ofitsstockeachyear.Theimmediatestockpriceeffectiszero,butafteroneyeartherewillbe ( 1 p)N sharesoutstandingratherthan N andthestockpricewillbehigherwithsharerepurchasethanwithoutit. Example Assumeafrmhas100,000sharesoutstandingwithamarketcapitalizationof$2,000,000.Themarketpriceofashareis$20.Thecompanybuys5,000shares (p = 0 . 05 ) atacostof$100,000.Thenewstockpriceis:Price = 2 , 000 , 000 100 , 000 95 , 000 = $20 . Thestockpriceisnotchanged.Assumethefrmvalueafteroneyearisagain$2,000,000.Thenewvaluepershareis:Price = 2 , 000 , 000 95 , 000 = $21 . 05 .
November6,200913:44spi-b8119inx6inb811-ch10 188 AnIntroductiontoAccountingandManagerialFinance Thegrowthrateinstockpriceis: G = p 1 p = 0 . 05 0 . 95 = 0 . 0526 . Aftertenyearsthestockpricewouldbe(withnootherchanges): P 10 = 20 ( 1 . 0526 ) 10 = $33 . 39 . Tothispoint,itwasassumedthatthefrmhadzerorealgrowth.Nowassumetherealgrowthis g pershare.Thegrowthrateofthestockpricewith p sharespurchasedeachyearis: G = g + p 1 p. Theserelationshipsareimportanttomanagerspossessingstockoptionswithgivenexerciseprices. Conclusion Twopublicpolicyquestionsconcerningcorporatesharerepurchasingareapparent.First,shouldfrmsbeallowedtobuybacktheirownshares,and,ifso,shouldtheyberequiredtogivestockholdersadvancenoticeoftheirintentions?Repurchasingsharescanhaveasignifcantimpactontheafter-taxreturnsofstockholders.Shouldtheformofthefrm’sdistribution,ratherthanitssubstance,infuencetheamountoftaxespaidbystockholders?Itseemsclearthatasmoreandmorefrmsbecomeawareoftheadvantagesofrepurchasingsharescomparedwithpayingdividends,thisissueisincreasinglyrelevant.Shouldcorporationsthatdecidetorepurchasesharesberequiredtonotifystockholdersoftheirintention?Thevalueofthefrm’sstockisafunctionoftheformofitscashdistributions.Thus,itseemsreasonablethatshareholdersshouldbeadvisedofacompany’sdistributionpolicyandofchangesinthatpolicy.Acorporationthathasrepurchasedshareswithoutgivingitsstockholdersadvancenoticewouldbeimplicitlyplacingthoseinvestorswhoselltheirshareswithoutthisinformationatadisadvantage.Corporationshaveofferedmanyreasonsforacquiringtheirowncommonstock.Inthischapter,welistedanumberofreasonsandthenproceededtoexamineeachofthosereasonsinturn.Twofactorsareofprimeimportance:taxeffectsandexpectationaldifferencesbetweenthemarketandmanagement.Theotherexplanationsofferedforrepurchasearerelativelyweak.
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 189 Itisveryeasyforasituationtodevelopwhereonegroupofstockholdersbeneftsattheexpenseofanothergroup;thus,astockrepurchaseprogrammustbeadministeredwithcareiftheattainmentofapositionwhereallstockholdersaretreatedfairlyisdesired.Underveryspecialconditions,whicharenotlikelytoholdintherealworld,themarketvalueofafrm’sstockisindependentofitsdividendpolicy.Withmorerealisticassumptions,differentfrmsmightwishtoadoptdifferentdividendpoliciesdependingontheeconomicandbehavioralcharacteristicsoftheirstockholders. QuestionsandProblems 1.AssumethattheABCCompanyisearning$2currently,ispayingan$0.80dividend,andwillcontinuetohavea40-percentdividendpayoutpolicyinthefuture.Allreinvestedfundswillearn0.08.Thestockholdersrequirea0.10returnontheirinvestmentandarenottaxed.a.Whatisthevalueofashareofcommonstock?b.Whatwouldthevaluebeiftheoptimaldividendstrategywasfollowedanda$2dividendcouldbemaintained?c.Ifreinvestedfundscouldearn0.15,whatwouldbethevalueofashareofcommonstockwiththe40-percentpayoutpolicy?d.Whatwouldyouexpecttohappento r ifmorefundswerereinvested?2.Ona“perdollarofpotentialdividendperperiod”basis,calculatetheadvantageof(a)deferringoneperiodand(b)deferringoneperiodandtaxingatcapitalgainratherthanordinaryrateiftheyieldonreinvestedfundsis20percent,thepersonaltaxrateonordinaryincomeis60percent,andthecapitalgainstaxrateis25percent.3.Supposethatyoudidnotknowthetaxsituationoftheholdersofyourcommonstock,butwereabletoascertainthattheaveragepersonaltaxratewasabout40percent.Assumethatthecostofequityforcomparablecommonstocksis0.12 (k e = 0 . 12 ) .Whatcouldyouconcludetobethecostofretainedearnings?4.Indiscussingapolicyofissuingannualstockdividends,acorporatepublicutilitymanagerstated:“Thestockdividendplanhasdoneagoodjobforus,helpingtofnanceourexpansion,eliminatingpublicofferingsofourcommonstock,andenablingustoretireourpreferredstock.Italsomadedebtfnancingunnecessary.”Evaluatethemanager’sstatements.
November6,200913:44spi-b8119inx6inb811-ch10 190 AnIntroductiontoAccountingandManagerialFinance 5.TheABCCompanycouldpayoutallofitsearningsasdividends;however,itwantstochoosebetweenapolicyofpayingoutdividendsastheincomeisearned(nowandforthenextthreeyears)oralternativelyreinvestingallofitsearningsandpayingonedividendthreeyearsfromnow.Withnoadditionalretainedearnings,thefrmcanmaintainadividendof$100pershare.Stockholderscanearn0.10byinvestinganydividendsreceived.Theseearningsaresubjecttotax.Assumethatcapitalgainsandordinaryincomearebothtaxedatarateof0.6.a.ABChasmanyone-periodinvestmentsthatyield0.08.Shouldthefrminvestorpayacurrentdividend?Findthefuturevalueofstockholders’wealththreeyearsfromnow.b.Howlowayieldcananinvestmenthaveandstillbeacceptabletothefrm?c.Assumethefrmhasinvestmentsyielding0.10.Whatistheimprovementinvaluearisingfromretainingforoneyearcomparedwitha$100dividend?6.Ithasbeenarguedthatitmakesnodifferencewhetherafrmpaysdividendsorretainstheearnings,sincethevaluetothestockholdersisthesameforboth.Forexample,assuminga0.4taxrateandanabilitytofndastockthatisgrowingatabefore-taxrateof0.10,if$100ispaidasadividend,theinvestorwillhaveafteroneperiod$100 ( 0 . 6 )( 1 . 10 ) = $66 . Ifthefundsareretainedandinvestedinternallytoearn0.10,andthenpaidasadividendafteroneperiod,theinvestorwillagainhave$100 ( 1 . 10 )( 0 . 6 ) = $66 . Commentontheillustration.7.TheTaxCourtdecidedseveralyearsagothatincreasesinthevalueofendowmentpoliciesundercertaincircumstancesareincome.Thecourtdrewadistinctionbetweenendowmentpoliciesandotherassetssuchasstockwhoseappreciationrefectspricechangesovertime.Thegaininvalueofanendow-mentpolicyresultsfromtheannualadditiontotheinvestmentfundoftheearningsontheinvestments,andthegainisnotdirectlyrelatedtopricechanges.Commentonthedistinction.
November6,200913:44spi-b8119inx6inb811-ch10 DistributionstoShareholders 191 8.TheBigOilCompany’streasurerexplainedhiscompany’sdividendpolicy(alowdividendcomparedtoearnings)bystatingthat“thestockholdersdidnoth-ingtoearnthemoney”andthat“ifthestockholdersdidnotlikethepresentpolicy,theycouldsellthestock.”Discussthestatements.9.Apublicutilityannouncedanewplanwherebythefullamountofearningswouldbepaidtothestockholders,thecurrentcashdividendpersharewouldbekeptconstant,andtheremainderofthedividendwouldbeintheformofastockdividend.Thispolicywouldenablethefrmto“retainandreinvestinthebusi-nessahigherpercentageofourearningsthanwewouldretainunderourpastdividendpolicyandhelpustofnanceourexpansionprogramandcutdown,ifnoteliminate,theneedforperiodicofferingsofadditionalcommonstock.”Evaluatethepolicy.10.JaneDoe(zerotax)expectsABCCompanytobeginpayingdividendsonanannualbasisattheendoftwoyears.Sheexpectsthefrstannualdivi-dendtobeonedollarandfurtherexpectsdividendstogrowcontinuouslyatarateof4percentthereafter.Whatisthemaximumpriceshewouldbewill-ingtopayforthestocktodayifshewantstoearnatleast12percentonherinvestment?11.a.Ifaninvestorcanearn0.08byinvestingintax-exemptbonds,acor-porationinvestingincomparableriskinvestmentswouldhavetoearnwhatminimumreturn(s)aftercorporatetaxtojustifyretention?Assumethattheinvestorisina0.55taxbracketforordinaryincomeandthatallincomefromthecorporationwillbereceivedintheformofcashdividends.b.Ifnewcapitalisraisedandiftheinvestmentbankertakes0.10ofthepricepaidbytheinvestors,theinvestmentmadebythecorporationmustearn___________aftercorporatetax.12.CompanyXYZhasfounditselfwith$5millionofunneededcash,andthefrm’spresidenthasindicatedthathewillsuggesttheboardofdirectorsdeclarean“extra”dividendof$5pershareonthemillionsharesoutstanding.Thecur-rentstockpriceis$45pershareandcurrentannualearningsareabout$8pershare(excludinginterestincomeonthe$5millionheldcurrentlyintheformofacertifcateofdeposit).Themarketpriceof$45appearstobecomprisedofabasicP/Eratioof5onthecurrentearningsplustheanticipatedextra$5milliontorepurchasestock.Thefrm’sinvestmentbankerindicatesthatapurchasepriceof$50pershareonatenderofferwouldbesuffcienttoattract100,000sharesforrepurchase.
November6,200913:44spi-b8119inx6inb811-ch10 192 AnIntroductiontoAccountingandManagerialFinance AssumethattheP/Eratiothatwouldbeadoptedbythemarketafterthereacquisitionisagain5. Assumeazero-tax,zero-transaction-costworld .a.Whichofthetwoplans(stockacquisitionordividends)shouldthestock-holdersprefer?Why?b.Ifyou,thecorporatepresident,heldstockoptions,whichofthetwoplanswouldyouprefer?Why?13.TheABCCompanyhasearned$10.Itisthinkingofpayingacashdividendof$10pershare.Itsstockholderswouldbetaxedata0.55rateonordinaryincomeand0.20oncapitalgains.Thestockholderscanearna0.05returnaftertaxperyear.Thealternativetothecashdividendistoretainfor10years,andthenpayacashdividend.Thefrmcanreinvestfor10yearsandearn0.12peryearaftercorporatetaxes.a.Howmuchwillaninvestorhaveafter10yearswithacashdividendnow?b.Howmuchwillaninvestorhaveafter10yearsifthefrstdividendisattime10?c.Howmuchwillaninvestorhaveafter10yearsifthefrstdividendisattime10andiftheinvestorsellsbeforethestockgoesex-dividend(i.e.,thedividendgoestothebuyerofthestock)?Assumethatadollarofretainedearningsresultsinadollarofstockpriceincrease.d.Assumethatthecorporatetaxrateis0.46.Ifthecapitalhadbeenclassifedasdebtandifthe$18.52ofbefore-taxincomewerepaidasinterest,howmuchwouldtheinvestorhaveafter10years?14.Investorscanearn0.12afterpersonaltax(e.g.,investingintax-exemptbonds).Theirmarginaltaxrateonordinaryincomeis0.55.a.Whatreturn(aftercorporatetax)doesacorporationhavetoearnsothattheinvestorsareindifferenttoreceivingacashdividendnowandacashdividendattime1?b.Answer(a)ifthedeferreddividendwillbedeferredandwillbepaid10yearshence.c.Ifthecorporationwantstoinvestnewcapitalobtainedfromtheinvestors,ithastoearnatleast____________.Assumethatadividendwillbepaidattime1.
November6,200913:44spi-b8119inx6inb811-ch11 Chapter11 CapitalStructure:WeightedAverageCostofCapital(WACC) Capitalstructureisnotanimportantconsiderationformanagementunlesstaxesandbankruptcycostsareconsidered.Thevalueofthefrmwouldnotbeaffectedbydebtleverageiftherewerenotaxesandnotransactioncosts.Whencapitalbudgetingwithtimediscountingwasfrstintroducedinbusinessfnanceliteratureintheearly1950s,thecommonrecommendationwasthataninvestmentwasacceptableiftheproposal’snetpresentvaluewaspositiveusingthefrm’sweightedaveragecostofcapital(WACC)asthediscountrate(orequiva-lently,iftheinvestment’sinternalrateofreturnwasgreaterthanthefrm’sweightedaveragecostofcapital).Eventoday,morebusinessfrmsareusingthefrm’sweightedaveragecostofcapitalasthehurdleratethananyothercapitalbudgetingdecisionrequiredreturn.Thisutilizationmakesthefrm’scostofcapitalcalculationofgreatimportance.AlthoughIdonotendorsethegeneraluseofthefrm’scostofcapitalinthecapitalbudgetingprocessasasinglehurdlerate,itneverthelessisused;andweshouldcomputeitinareasonablemanner.Thereisalsothequestionofhowthefrm’svalueisaffectedbythefnancialmixdecision.Fouralternativetheoriesdeserveconsideration:1.Thevalueofafrm,andtheconsequentwealthpositionofthestockholders,isnotaffectedbythetypeoffnancing.2.Thereisanoptimumcapitalstructure,andtheutilizationofthisstructurewillmaximizethevalueofthefrm.3.Giventhepresentcorporatetaxlaws,afrmshoulduseasmuchdebtaspossibletomaximizeitsvalueandthewealthpositionofitsstockholders.4.Giventhepresenceofpersonaltaxesaswellascorporatetaxes,commonstockmayhavetaxadvantagescomparedtodebtbymeansoftaxdeferralaswellaspreferentialtreatmentofcapitalgains. 193
November6,200913:44spi-b8119inx6inb811-ch11 194 AnIntroductiontoAccountingandManagerialFinance Inthischapter,weexamineandevaluateeachofthesetheoriesandtherolethefrm’sweightedaveragecostofcapitalplays.Thekeysymbolstobeusedare: k 0 = theweightedaverageafter-taxcostofcapital k i = thebefore-taxaveragecostofdebt[ k i ( 1 t) istheafter-taxcostofdebt] k e = theafter-taxaveragecostofequitycapital B = themarketvalueofthedebtinthecapitalstructure S = themarketvalueofthestockequityinthecapitalstructure V = thetotalmarketvalueofthefrm[ V U isthevalueofanunleveredfrm; V L isthevalueofaleveredfrm(with B ofnewdebt)] t = thecorporatetaxrate. Defnition Theweightedaveragecostofcapital( k 0 orWACC)isdefnedasthesumoftheweightedcostsofdebt (k i ) andequitycapital (k e ) ,wheretheweightsaretherelativeimportanceofeachcapitaltypeinthefrm’scapitalstructureandthe k i and k e costsaretheexpectedaveragereturnsrequiredbyinvestorsasaninducementtocommitfunds.Forsimplicity,weconsideronlyoneclassofdebtandcommonstock.Multipleclassesofdebtandpreferredstockcouldbeincludedwithoutalteringthelogic,butthenotationbecomesdiffculttohandle.Themarketvalueofthefrmisthesumofthemarketvaluesoftheoutstandingdebtandequity. V = B + S. (11.1)Themeasuresofrelativeimportanceofdebtandequityinthecapitalstructurearetheratios B V and S V ,respectively.Ifweusethesemeasuresasweights,theafter-taxWACCisdefnedtobe k 0 = k i ( 1 t)B V + k e S V. (11.2)Inequation(11.2),wehave k i ( 1 t) ,theafter-taxcostofborrowing,and k e ,thecostofcommonstockcapital,weighted,respectively,bythepercentagesofdebtandcommonstockcapitalbeingusedtoobtainaweightedaveragecostofcapital.TheWACCofafrmcanbeinterpretedasbeingthecostofbothcurrentcapitalandanadditionaldollarofnewcapitaliftheexistingcapitalstructureismaintained.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 195 Example11.1 Supposethatthemarketvalueofacompany’scommonstockisestimatedat$42million.Themarketvalueofitsinterest-bearingdebtisestimatedat$28million,andtheaveragebefore-taxyieldonthedebtis10percentperyear,whichisequivalentonanafter-taxbasisto6percentperyear(equalto10percenttimes0.60,assuminga40-percenttaxrate).Assumethatthecompanyjustdescribediscurrentlypayingadividendof$8peryearandthatthestockissellingatapriceof$100.Therateofgrowthofthedividendisprojectedtobe12percentperyear.Oneestimateofthecostofthecommonstockequityis k e = D P + g = $8 $100 + 0 . 12 = 0 . 08 + 0 . 12 = 0 . 20 , or20% . (11.3)TheweightedaveragecostofcapitalforthecompanyasawholeisestimatedinTable11.1.The0.20(onstock)and0.10(ondebt)arethereturnsthatwouldberequiredifamixtureofadditionaldebtandcommonstockweretobeissued.Theword average thatisusedintheterm weightedaveragecostofcapital referstotheaverageofthedifferenttypesofcapitalbeingused.Fordecisions,wewantaweightedaverageofmarginalcostsfordebtandstock.Insituationswheretheissuanceofthedebtandcommonstockwillnotchangethefrm’scapitalstructure,themarginalcostsmayequaltheaveragecosts.Shareholdersareexposedtotheriskofbankruptcyassoonasdebtinsomeformisintroduced.Equityholdersmaylosetheirownershipinterestinacompanythat Table11.1. EstimateoftheCostofCapital. ProportionofAfter-TaxCapitalSourceTotalCapitalAfter-TaxCostWeightedCost Commonstock0.600.200.120Debt,interestbearing0.400.060.024 Weightedaveragecostofcapital = 0.144
November6,200913:44spi-b8119inx6inb811-ch11 196 AnIntroductiontoAccountingandManagerialFinance mayagainbecomeaproftableoperation.Withawell-managedproftablecom-panyinasafeindustry,theintroductionofasmallamountofnonequitycapitalwillpresumablyincreasetherisksofbankruptcybyonlyasmallamount.Inpractice,thelegalpossibilityofbankruptcyisnearlyalwayspresent,becauseacompanywillalwayshavesomedebtoutstanding.Astheamountofdebtrises,therisksofbankruptcybecomegreater.Everydollarofdebtincreasesrisk.Theamountoftheincreasedependsupontheamountofdebtandtheactivitiesinwhichacompanyisengaged.Oneadvantageofdebtcapitalcomesfromthefnancialleverageitprovidesfortheremainingequitycapital.However,increasesinthedebt/equityratiowillincreasetheyear-to-yearvariabilityofearningspersharecomparedtotheuseofcommonstockcapital.Takenbyitself,thisislikelytodecreasethepricepersharethatinvestorsarewillingtopay.However,theissuanceofdebtwillalsotendtoincreasetheexpectedearningspershare,andthishopefullywillcounterbalancetheincreasedrisk.Anotherimportantadvantageofdebtisthatinterestexpenseisdeductiblebythecorporationforpurposesofcomputingtaxableincome,whereasdividendsoncommonstockarenotdeductible.Withcorporatetaxratesatapproximately0.35,thereisanincentiveforfrmstousedebtasamajorcomponentoftheircapitalstructure.Itisimpossibletogiveanysimplerulesfordeterminingtheoptimumcapitalstructureforaparticularfrm.Theoretically,theoptimumstructureisreachedwhenanychangeinthedebt/equityratiowillresultinadecreaseinthepricepershareofthecommonstock.Unfortunately,wedonotknowhowmuchdebtisthecorrectamountofdebt.Optimumcapitalstructureisa“judgmentcall”. TheWeights Weweightthecostofeachtypeofcapitalbythepercentagethatthetypeofcapitalistothetotalcapital.Thereisadifferenceofopinionastowhetherbookvaluesormarketvaluesofcapitalshouldbeused.Thoseofanacademicbenttendtoprefertheuseofmarketvalues.Thelogicisthattheweightsshouldrefecttheeconomicimportanceofthecapital,andnotthehistoricalamountsofdebtandcommonstockasrecordedbytheaccountants.Somepractitionersfavorthebookvalues,sincetheyareobjectiveandtendtobeusedbyothermanagers(e.g.,bankersandbondanalysts).Sincetheissueisunresolved,areasonablepositionforananalystistomakecalculationsusingbothmarketandbookvaluesandlettheuseroftheinformationdecidewhichcalculationismoreuseful.Ifonlyonecalculationisbeingmade,wewouldprefertheuseofmarketvalue.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 197 AccumulatedDepreciationIsNotCapital Theaccountingprocessincludesentriestoexpenseaccountsthatresultincreditentriestoaccumulateddepreciationandtaxdeferralaccounts.Sincetheseentriescanaffectthecalculationofcashfowfromoperations,itiseasytoslipintotheerrorthataccumulateddepreciationandtaxdeferralaccountsgiverisetocapital. Example11.2 Assumethatafrmhasthefollowingbalancesheet: Plant$1,000CommonStock$1,000 Duringthenextperiod,salesare$200anddepreciationexpenseis$200.Theincomeiszero.Thebalancesheetafterthesetransactionswerecordedis: Cash$200Plant$1,000Less:accumulateddepreciation200 800 Commonstock$1,000$1,000 Notethatthecapitalconsistsof$1,000commonstock.The$200ofaccumu-lateddepreciationisnotcapital.Wecouldrevisethebalancesheetandnotchangetheconclusionthatthecapitalisnotaffectedbytheaccumulateddepreciation. Cash$200Accumulateddepreciation$200Plant1,000 Commonstock1,000 $1,200$1,200 Thelocationoftheaccumulateddepreciationaccountonthebalancesheetdoesnotchangetheconclusionthatitisproperlyconsideredtobeasubtractionfromtheplantassetaccount. ExistenceofaUniqueOptimalFinancialStructure Whathappenstothevalueof k 0 iftheamountoffnancialleveragechanges? k 0 = k i ( 1 t)B V + k e S V. (11.2)Letusconsiderhowthetwocostcomponentsofthecostofcapital, k i and k e ,reacttoanincreaseinfnancialleverage.Assumingthatinvestorsdemandmorereturniftheirinvestmentissubjecttogreaterrisk,weconcludethat k i willincreaseasmoredebtissubstitutedforequitybecausethepaymentstreamtodebtholders
November6,200913:44spi-b8119inx6inb811-ch11 198 AnIntroductiontoAccountingandManagerialFinance becomesmorerisky.Thesamelogicleadstotheconclusionthat k e willalsoincreaseasdebtissubstitutedforequity,sincethedividendstreamaccruingtoequitybecomesmoreriskyasdebtobligationsincreaseinsizerelativetotheamountofequity.Furthermore,ifinvestorsareadversetoriskforanygivendegreeoffnancialleverage, k i islessthan k e sincedebtholders(aspriorclaimers)aresubjecttolessriskthanareequityholders.Finally,as B V approaches1, k i approachesthecostofequityforzeroleverage.Thisistrue,sincethemostriskypositionadebtholdercouldbeinisequivalenttothatofanequityholderofanall-equity-fnancedfrm.As B V approaches1,debtholdersinfactbecomeimplicitequityholders.Figure11.1depictsthisassumedbehaviorof k i and k e .Theshapeofthe k 0 curvewilldependontheshapesofthe k i and k e curves.Thetraditionalorclassicalpositionassumesthat k i and k e areshapedsuchthattheresultant k 0 curveisU-orsaucer-shaped,implyingthatthereexistsauniqueminimumcostofcapitalstructure,asdepictedinFigure11.2.Startingfromtheobservationthatmostfrmsinanygivenindustry(frmswithroughlythesamedegreeofbusinessrisk)tendtohaveroughlythesamecapitalstructure,thetra-ditionalistmightarguethat k e risessignifcantlywithincreasedleveragewhile k i beginstorisesignifcantlyonlyafterasignifcantdegreeofleverage.Theweightedaveragecostofcapitalinitiallyfallsastheleverageisincreased,sincetherisein k e ismorethanoffsetbytheutilizationofcheaperdebt.Atsomepoint,however,theWACCbeginstoriseas k i risesmorerapidlyinresponsetotheincreasedleverage.Itisassumedthatthereiseitherasinglevalueorarangeofvaluesof B V that Percent e 0 kk = 0 k e k i k BLV = 1 0 k Fig.11.1. AConstantWeightedAverageCostofCapital.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 199 Percent e k 0 k i k L = 1 Fig.11.2. TheClassicalViewofanOptimumCapitalStructure. minimizes k 0 .Itshouldberememberedthatweareinitiallyconsideringazero-taxsituationandonepointofview.Acomprehensivetheoryfor k 0 wasformulatedbyModiglianiandMiller(here-afterM&M)intheirfamous1958 AmericanEconomicReview article. 1 Withawell-formulatedsetofassumptions,includingnocorporatetaxes, k 0 isaconstant,independentofcapitalstructure,anditfollowsthatanycapitalstructureisequallydesirable.Aconstant k 0 isillustratedinFigure11.1.TheM&Mpositionisbasedonthesetofassumptionsthat(1)marketsareperfect,(2)transactioncostsarenegligible,(3)marketbehaviorisrational,and(4)taxesarezero.Withtheseassumptions,allcapitalstructuresareequallydesirable.Whencorporatetaxes(butnopersonaltaxesandnobankruptcycosts)areconsidered,itcanbearguedthat k 0 isamonotonicallydecreasingfunctionof B V ,implyingthattheminimumcostofcapitalstructureconsistsofnearly100percenttax-shieldingdebtfnancingandaminimumofequityfnancing. NoTaxes LetusconsidertheM&Margumentsfortheno-corporate-taxcase.Theperfectmarketassumptionimpliesthatwithzerotaxes,twonongrowthfrms,whichpay 1 F.ModiglianiandM.H.Miller,“CostofCapital,CorporationFinanceandtheTheoryofInvestments,” AmericanEconomicReview ,June1958,pp.261–297.
November6,200913:44spi-b8119inx6inb811-ch11 200 AnIntroductiontoAccountingandManagerialFinance 0.150.100.05001 BS e Bk 0.10 + 0.05 S = k 0 = 0.10 k i = 0.05 Fig.11.3. CostsofCapital. allnetincomeasdividendsandareidenticalineveryrespectexceptforcapitalstructure,shouldhavethesamemarketvalue.Themarket,asawhole,ispurchasingthesamefuturestreamofnetoperatingincome(EBIT)fromboth.HowthatEBITstreamisdividedintointerestanddividendpaymentsisinconsequentialinaperfectmarket,andthetotalvalueofthefrmwillnotbeaffectedbythefrm’scapitalstructure.Twoidenticalcommodities(inthiscase,thefuturenetoperatingincomestreams)cannotsellfortwodifferentprices(marketvalues).Thelawofonepriceisassumedtohold.Ifavaluedisparityexists,thearbitrageprocesswillremoveit.Thus,withzerotaxes,thevalueofthefrm (V) isindependentoftheamountofdebt,andwecanwrite V = EBIT k 0 , (11.4)whereEBITisaperpetualearningsstream(earningsbeforeinterestandtaxes).Solvingfor k 0 , k 0 = EBIT V. (11.5)Giventheassumptions,anyamountofleverageisequallydesirable.Thezero-taxM&MpositionisdepictedinFigures11.1and11.3.GiventheM&Massumptions, k 0 isaconstant. Example11.3 Assumethat k 0 = 0 . 10and k i = 0 . 05andthatthesevaluesarenotafunctionoftheamountofleverage.Thevalueofthefrmis$10,000,000andthefrmcurrently
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 201 has$2,000,000ofdebtand$8,000,000ofstock.Rearrangingequation(11.2)tosolvefor k e ,thecostofequitycapitalimpliedbythesefactsis k e = k 0 + (k 0 k i ) B S = 0 . 10 + ( 0 . 10 0 . 05 )B S = 0 . 10 + 0 . 05 B S. (11.6)Since B = $2 , 000 , 000and S = $8 , 000 , 000,then k e = 0 . 10 + 0 . 05 2 8 = 0 . 10 + 0 . 0125 = 0 . 1125 . (11.6)ThevalueoftheWACC (k 0 ) is0.10(with t = 0): k 0 = k i B V + k e S V = 0 . 05 ( 0 . 2 ) + 0 . 1125 ( 0 . 8 ) = 0 . 01 + 0 . 09 = 0 . 10 . (11.2)Thevaluesof k i and k e fordifferentdegreesofleverageareplottedinFigure11.3from B/S = 0to B/S = 1.Inthiscase, k e riseslinearlywithrespectto B/S .Ifthefrmsubstituted$6,000,000ofdebtfor$6,000,000ofstockwith k i unchanged,wewouldhave k e = 0 . 10 + ( 0 . 05 ) $8 , 000 , 000 $2 , 000 , 000 = 0 . 30 . (11.6)While k e increaseswithincreaseindebt,thevalueof k 0 remains0.10: k 0 = 2 10 ( 0 . 30 ) + 8 10 ( 0 . 05 ) = 0 . 10 . (11.2)Otherfunctionalformsfor k i leadtodifferentfunctionalformsfor k e .Normally,weexpectthe k e tobeeverywhereincreasingbutnotlinear,sincewewouldnotexpect k i tobeaconstantwithrespecttochangesin B/S . AConstantWACC Letusassumethatasubstitutionofdebtforequitywillincreasethecostofbothdebtandcommonstock.Canthesubstitutionbeacceptable?Surprisingly,theanswerisyes.Evenifbothcostsgoup,thesubstitutionofthelower-costdebtcancausetheaveragecostofcapitaltostayconstant.
November6,200913:44spi-b8119inx6inb811-ch11 202 AnIntroductiontoAccountingandManagerialFinance Example11.4 Assumethat k i = 0 . 05 + 0 . 10 B V andthat k e = 0 . 15 + ( 0 . 15 k i )B S. Assumethatthefrmhas B = S sothat B/S = 1, B/V = 1 / 2, k i = 0 . 10,and k e = 0 . 20.Then, k 0 = 0 . 15: k 0 = 0 . 10 1 2 + 0 . 20 1 2 = 0 . 15 . Nowassumethat B/V = 2 3 , S/V = 1 3 ,and B/S = 2: k i = 0 . 05 + 0 . 10 B V = 0 . 05 + 0 . 10 2 3 = 0 . 1167 k e = 0 . 15 + ( 0 . 15 k i )B S = 0 . 15 + ( 0 . 15 0 . 1167 ) 2 = 0 . 2167 . Thevalueof k i was0.10,andthevalueof k e was0.20,sotheincreaseintheleverageincreasesbothcosts.ButtheWACCisunchanged.TheWACCisagain0.15: k 0 = ( 0 . 1167 ) 2 3 + 0 . 2167 1 3 = 1 3 ( 0 . 2333 + 0 . 2167 ) = 1 3 ( 0 . 45 ) = 0 . 15 . Justbecausedebtcostslessthancommonstockdoesnotmeanthatsubstitutingdebtforcommonstockwillreducetheaveragecostofcapital.Thisisasurprisingandveryimportantobservation. BuyingaCombinationofStocksandBondstoDelevertheFirm:NoTaxes Wecandeleverthefrmtoazero-debtlevel.Thatis,aninvestmentintheabovehighlyleveredfrmcanbemadeequivalenttoaninvestmentinthecommonstock
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 203 ofazero-debtfrm.Thereturnoninvestmentof pV forazero-debtfrmwiththesameoperatingcharacteristicsis pX ifthefrmearns X .Withaleveredfrm,wehave: AmountofCapitalEarnings BISX I X Iftheinvestorbuys p ofboth B and S (averticalslice),wehave: AmountofInvestmentEarnings pBpIpSpX pI p(B + S)pX Thus,theinvestoralwaysearns pX withtheleveredfrm—thesameincomeaswiththeunleveredfrm.Thereturnsfromtheinvestmentinboththedebtandcommonstockoftheleveredfrmintheappropriateproportionswillalwaysbeidenticallyequaltothereturnfromtheinvestmentinthecommonstockofthezero-debtfrm,assumingthattheoperatingresultsofthetwofrmsareidentical. LeveringaFirm Theprevioussectionshowedhowafrmcanbedeleveredbytheinvestorbuyingstocksandbondsofthesamefrm.Afrmwithtoolittleleveragecanalsobeleveredbytheuseofpersonalborrowing.Investorssubstitutetheirownborrowingcapacityforthatofthefrmtoattaintheamountoftotalleveragethatisdesired.Athirdpossiblewayofchangingtheamountofleverageofafrmistopurchaseacombinationoffrms(onefrmwithtoolowandonefrmwithtoohighleverage)toobtainamixtureofinvestmentthatisequivalenttoamedium-leveredfrm.Thus,ifthestockofthemedium-leveredfrmispricedhighcomparedtotheothertwofrms,amixtureoftheunderpricedsecuritiescanbepurchasedatalowercosttoobtainaninvestmentequivalenttothemedium-leveredfrm.Theonlylimitationofthisprocedureisthediffcultyoffndingfrmsthatdifferonlybycapitalstructure.Inpractice,amixtureoftheextremefrms(veryhighorverylowfnancialleverage)willnotexactlyduplicatethemediumfrm. Before-andAfter-TaxCosts Wewanttoillustratethebefore-andafter-taxcoststotheissuerofdebt,preferredstock,andcommonstock.
November6,200913:44spi-b8119inx6inb811-ch11 204 AnIntroductiontoAccountingandManagerialFinance Example11.5 Letusassumethatthecorporatetaxrateis0.35,andthatinvestorsrequirethefollowingreturns: 0.10withdebt0.078withpreferredstock0.1040withcommonstock Rememberthatpreferredstockdividendsoffernotaxshieldtothecorporateissuer.Thefollowingtableshowsthebefore-taxcostsandtheafter-taxcostsofthethreedifferenttypesofcapital: ReturnsBefore-TaxCostsTaxTaxSavingsAfter-TaxCost Debt0.100.100.0350.065Preferredstock0.0780.120.0420.078Commonstock0.1040.160.0560.104 Assumethatthefrmisfnancedwith0.4debt,0.1preferredstock,and0.5commonstock.Thebefore-andafter-taxcostsofcapitalare:Before-taxWACC = 0 . 4 ( 0 . 10 ) + 0 . 1 ( 0 . 12 ) + 0 . 5 ( 0 . 16 ) = 0 . 132After-taxWACC = 0 . 4 ( 0 . 065 ) + 0 . 1 ( 0 . 078 ) + 0 . 5 ( 0 . 104 ) = 0 . 0758 . Topaypreferredstockholders0.078,thefrmmustearn ( 1 0 . 35 )k p = 0 . 078 k p = 0 . 12 . Forcommonstockholderstoearn0.104,thefrmmustearn ( 1 0 . 35 )k e = 0 . 104 k e = 0 . 16 . Aninvestorwhobuysaverticalsliceofthefrm’ssecuritieswouldearn:Returntoinvestor = 0 . 4 ( 0 . 10 ) + 0 . 1 ( 0 . 078 ) + 0 . 5 ( 0 . 104 ) = 0 . 142 .
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 205 FirmValuewithTaxes Assumeacorporatetaxrateof t .Withnodebt,wehave: AmountofCapital After-TaxReturnonCapital I = 0 X( 1 t) V U X( 1 t) Thefrmvalue (V U ) isthepresentvalueof X( 1 t) or V U .Nowassumetheissuanceof B debtpaying I interestandthe B isgiventoshareholders. AmountofCapital ReturnonCapital BIS(X I)( 1 t) Butassumeaninvestorbuysallthestockand ( 1 t) ofthedebtandearns ( 1 t)I onthedebt. AmountofInvestmentReturnonInvestment ( 1 t)B( 1 t)IS(X I)( 1 t) Sum S + ( 1 t)BX( 1 t) Abovewefoundthat X( 1 t) ofbeneftswithzerodebthadavalueof V U ,so V U = S + ( 1 t)B or S + B = V U + tB. But S + B = V L where V L isthevalueoftheleveragedfrm,so V L = V U + tB. (11.7)If B ofdebtissubstitutedfor S ofstock,thevalueofthefrmincreasesby tB andthenewvalueofthefrmis V L = V U + tB. (11.7)Intheabsenceoftaxes,capitalstructuredoesnotaffectthevalueofafrm.Ifwearetoarguethatcapitalstructuremakesadifference,thenwemustturntoinstitutionalreasons.Oneimportantreasonisthetaxlaw.Asecondreasonforcapitalstructurebeingimportantisthecostofbankruptcy.
November6,200913:44spi-b8119inx6inb811-ch11 206 AnIntroductiontoAccountingandManagerialFinance Bankruptcyhascostsarisingfromthecourt’sadministrationofthecorpora-tion’saffairsaswellasthecostsarisingfromothercompaniesbeingreluctanttooffercredit.Bankruptcyhascoststhatarenotbuiltintothebasicmodelsillustratedinthischapter. ValuingaFirm:CapitalStructureandCorporateTaxes Letusdefne X tobeequaltoEBIT.Thenwehave: (X k i B)( 1 t) = theafter-taxreturntostockholders(assumethatitisallpaidasdividendstostockholders) k i B = theinterestpaidtodebtholders. Thetotalcashfowsaccruingtocapitalsupplierswillbethesumofthedividendsplusinterestpayments: (X k i B)( 1 t) + k i B. Thissumcanbewrittenas X( 1 t) + (k i B)t. Thereturntostockholderswithzerodebtis X( 1 t). Thus,aleveredfrm (B> 0 ) hascashfowseachperiodthatarelargerthanthoseoftheunleveredfrm (B = 0 ) by k i Bt .Leveragecreatesanannualcorporatetaxsavingof k i Bt .Letusdefnethepresentvalueofthecashfowsofanunleveredfrmtobe V U andequaltothepresentvalueof X( 1 t) perperiod.Thevalueoftheleveredfrm V L hasbeenshownabovetobe V L = V U + Bt. (11.7)Ifatheoreticalmaximumamountofdebtisusedsothat B equals V L ,thenMaximumDebt = V U 1 t. (11.8)Ifwithacorporatetaxrateof0.35anunleveredfrmhadavalueof$65,000,000,then,withmaximumdebt,thevalueoftheleveredfrmwouldbe V L = $65 , 000 , 000 1 0 . 35 = $100 , 000 , 000 . (11.8)
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 207 Thus,withcorporatetaxesincludedintheanalysisbutwithoutconsideringpersonaltaxes,thevalueofthezero-growthfrmismaximizedbyutilizingasmuchdebtasislegallypermissible.Analternativeapproachtoequation(11.8)wouldbetostatethatthevalueofthefrmisequaltothediscountedvalueoftheexpectedcashfowsaccruingtothecapitalsuppliers,wherethediscountrateusedistheborrowingrate, k i ,andriskisaccountedforbyadollarriskadjustmentfactor, R .Then,fortheunleveredfrm,thevalueis V U = X( 1 t) k i R. (11.9)Ifdebtisissuedtotheexistingstockholders,nochangeinthedollarriskcompen-sationwilloccur,andtheexpectedcashfowswillbe V L = X( 1 t) + k i Bt k i R = V U + Bt R. (11.10)If R isnotaffectedbythevalueof B ,maximumdebtshouldbeissuedtomaximizethevalueofthefrm.However,thedeterminationofthevalueof R wouldnotbeaneasy,well-defnedexercise. PersonalTaxes Theconclusionthattheoptimalcapitalstructuredecisionisforthecorporationtoissueasmuchdebtasispermissiblemaybemodifedwhenweallowthefrmtoretainearningsandtoincludepersonaltaxconsiderationsinexaminingthewealthpositionofstockholders.ThispositionwasstronglyarguedbyM.H.Millerin1977. 2 Assumethattheprimaryobjectiveofacorporationistomaximizethewealthpositionofitsstockholders.Dividendsreceivedbyshareholdersaretaxedasordi-naryincome.Ifthefrmretainstheearningsinsteadofpayingthemasimmediatedividendsandthenreinveststheearningstoearnacompetitivereturn,paymentofpersonaltaxesonthedividendisdeferred(sotheentireearningsratherthantheafter-taxdividendarereinvested).Furthermore,whentheshareholderswishtoobtaincash,theycansellstockandpaythecapitalgainstaxonthepresentvalueofthereinvestmentasviewedbythemarketratherthanhavingdividendstaxedimme-diatelyatordinaryincomerates.Thus,personaltaxconsiderationsforstockholdersinhightaxbracketsexertsomepressureforacorporationtouseretainedearningstofnancegrowth. 2 M.H.Miller,“DebtandTaxes,” JournalofFinance ,May1977,pp.261–276.
November6,200913:44spi-b8119inx6inb811-ch11 208 AnIntroductiontoAccountingandManagerialFinance Withfniteinvestmentpossibilitiesandpersonaltaximplicationsconsidered,stockholderswithhighpersonaltaxratesmightbebetteroffhavingthefrmuseretainedearningsratherthandebttofnanceinvestmentopportunities. 3 Whilethedebtfnancingwouldsavecorporatetaxes,thepersonaltaxsavingsfromtheuseofretainedearningsmightbegreaterthanthecorporatetaxsavingsresultingfromtheuseofdebt.Ifthedebtholdersandequityholdersareidenticalgroups,taxavoidancebylabeling“dividends”as“interest”canbeintheowners’bestinterest.Althoughtherearenotexactrules,beyondsomeill-defneddegreeofleverage,interestpaymentsmaybetreatedasdividendsbytheInternalRevenueServiceandtheirdeductibilityfortaxpurposesdisallowed.Theoptimalfnancialstructuredependsinpartonthetaxcircumstancesoftheshareholdersandthedividendpolicyofthefrm,andinpartonthecorporatetaxsavingassociatedwithdebtfnancing.Nosinglestrategyisoptimalforallfrms.A“zero-tax-investor”-orientedfrmmightpayoutalargefractionofitsincomeasdividendsandemployahighdegreeoffnancialleverage(anypublicutility?)tomeetitscapitalneeds,whereasa“growth”frmmightplowmostofitsearningsbackandmaintainalowdegreeoffnancialleverage. TheCapitalCostofRisk Asriskisincreased,thecostofcapitalcanbeexpectedtoincrease.Anextensivelyusedmethodofadjustingthecostofcapitalforriskistousethecapitalassetpricingmodel(CAPM).TheCAPMmakesuseofthepricesthatthemarketissettingforreturn-risktrade-offsratherthanusingsubjectivemeasuresofattitudestowardrisk(suchastheriskpreferencesofspecifcinvestors).Thecapitalassetpricingmodelisamajorcontributiontomodernbusinessfnancetheoryandpractice.TounderstandtheCAPManditslimitations,itisnecessarytounderstandtheassumptionsonwhichthemodelisbased.Itisasingle-periodmodelwithnoassumptionsbeingmadeabouttheinteractionofreturnandriskthroughtime.Itisassumedthattheinvestorisonlyinterestedintheexpectedreturnandstandard 3 The“accumulatedearningstax”isintendedtokeepfrmsfromretainingearningsexpresslytoavoiddividendpayments.Tobeexemptfromthisoneroustax,theretainedearningsmustbeusedtofnanceactive(plantandequipment,workingcapital)investmentsratherthanpassive(marketablesecurities,realestate)investments.Thisprovisionofthetaxcodehasbeenadministeredinaninconsistentmanner,soitisnotalwayspossibletocomputetheeffectsofcorporateinvestmentdecisionsontheaccumulatedearningstax.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 209 deviation(orvariance)oftheinvestmentportfolio’soutcomes.Thisisatheoreticaldefciency.Forsomeprobabilitydistributions,thisignoresotherinformationthataninvestormightconsidertoberelevant.Itisassumedthatallinvestorsmustbepersuadedtotakemoreriskbytheprospectofahigherexpectedreturn(theyarerisk-averse).Theactionsofaninvestordonotaffectprice.Theinvestorsare“pricetakers”.Theinvestorscaninvestatthedefault-freerate (r f ) ,andgenerallyweassumethattheycanborrowatthesameratebutthisassumptioniseasilydropped.Investorscansellsecuritiestheydonotown;thatis,theycanborrowsecuritiestosellthem(thisiscalledashortsale).Allinvestorsthinkthesameabouttheexpectedreturnandvarianceofallsecurities(theyhavehomogeneousexpectations),andtheyareallperfectlydiversifed.Thequantityofsecuritiestobepurchasedisfxedanddivisible(securitiesofanydollaramountcanbepurchased).Therearenotransactioncostsandtaxes.Manyoftheseassumptionscouldbedropped,andamodelverymuchliketheconventionalCAPMwouldbederived.Oneimportantfunctionservedbythissetofassumptionsisasimplifcationofthemodelsothatwearenotdistractedbyunnecessarycomplexity. TheExpectedReturn Assumethataninvestorownsthemarketportfolio.Inequilibrium,ifweaddaverysmallamountofanewsecurity i ,theexpectedreturn-risktrade-offthatresultsfromtheinclusionof i mustequalthemarket’scurrenttrade-offrate.Forthistohappen,itcanbeshownthatitisnecessarythatsecurity i ’sexpectedreturnbeequalto ¯ r i = r f + ( ¯ r m r f i , where ¯ r i = theequilibriumexpectedreturnofsecurity ir f = thereturnfromtherisk-freeasset ¯ r m = theexpectedreturnfrominvestinginthemarket β i = thebetaofsecurity i ,where β i = cov (r i ,r m )/σ 2 m andisthemeasureofmarketrisk.Theterm ( ¯ r m r f i istheadjustmenttotherisk-free r f fortheriskofsecurity i .Thebetameasurestheamountofsystematicrisk,thatis,theriskarisingbecauseoffuctuationsinthemarketreturn.Thereisnoadjustmentforriskspecifctothefrm(unsystematicrisk)intheCAPM,sinceitisassumedthattheunsystematic
November6,200913:44spi-b8119inx6inb811-ch11 210 AnIntroductiontoAccountingandManagerialFinance riskgoestozerogiventheverylargenumberofinvestments(theunsystematiccomponentsareindependent).Thebetaofasecuritymeasureshowthesecurity’sreturniscorrelatedwiththemarket’sreturn;thus,itisameasureofthesecurity’ssystematicrisk. SystematicandUnsystematicReturns Itisconventionaltheorytoseparateriskintotwocomponents.Onecomponentissystematicrisk,ormarketriskthatrepresentsthechangeinvalueresultingfrommarketvaluechanges.Systematicriskcanbesomewhatreducedbythechoiceofsecurities(low-betasecurities).Butreducingsystematicriskinthiswaymayincreasetotalrisk,sincetheinvestor’sportfoliowillnotbeperfectlydiversifed.Thisgivesrisetothesecondtypeofrisk.Thisisresidualorunsystematicrisk.Thisriskisspecifctothecompany(orasset)andisindependentofwhathap-penstotheothersecurities.Iftheinvestor’sportfolioconsistsofaverylargenumberofsecuritieswithnosecuritybeingalargepercentageoftheportfolio,thenthisunsystematicriskcanbemadetoapproachzerobyastrategyofperfectdiversifcation.Withaportfolioof10securities,90percentoftheunsystematicriskiselim-inated.Withaportfolioof100securities,99percentoftheunsystematicriskiseliminated.Thesystematicriskremains.TheCAPMneglectsrelevantfactorsthatareactuallyconsideredbyinvestors.Forexample,thecommonstockofelectricutilitiesbuildingnuclear-generatingplantscouldhaveanegativeimpactbecausetheCAPMdoesnottakeintocon-siderationthespecifcriskofbuildingnuclear-generatingplants,butthemarketislikelytoconsiderthisriskevenifitisnon-systematicrisk.Totheextentthatsecuritypricesaredeterminedbytheactivitiesoftheinvestorswhocandiversifytheirportfoliosatlowcost,thepricesofsecuritieswillbesetinsuchawaythatdifferentialsinexpectedratesofreturnwillrefectprimarilydifferencesintheamountofsystematicrisktowhichthesecuritiesareexposed.Whileamiddlemanagermightfndtheriskofaspecifcassettobeofinterest,thetopmanagementofafrmwillwanttoknowtheeffectoftheassetontheoverallriskofthefrm.Attheinvestorlevel,investorsshouldbemoreinterestedintheeffectofthespecifcassetontheriskinessoftheirportfoliosthantheriskofaspecifcasset.Managersarelikelytobeinterestedintheeffectofthespecifcassetontheriskoftheircareers.Wefnditusefultobreakdownriskintotwocomponents:(1)riskthatcanbeeliminatedbydiversifcation,whichistermedunsystematicrisk;and(2)riskthatisstillpresentwhenallunsystematicriskhasbeeneliminated,whichistermed
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 211 systematicrisk.Thelatterrefectshowtheinvestmentsintheportfolioarecorrelatedwiththemarket.Onlysystematicriskisrelevantforaperfectlydiversifedinvestor.Thebetaofasecuritymeasuresitssystematicrisk.Thisistheriskassociatedwithchangesinthemarket’sexcessreturn.Unsystematicriskcanbediversifedaway.Iftheportfolioconsistsofaverylargenumberofsecuritiesandnosecuritybeingalargeproportionoftheportfolio,theunsystematicriskoftheportfoliowillapproachzero.Itdoesnottakemanysecuritiesfortheunsystematicriskoftheportfoliotoapproachzero.Abetacoeffcientofunityindicatesthatasecurityhasthesameamountofsystematicriskasthemarketportfolio.Abetacoeffcientgreater(less)thanunityindicatesthatthesecurityisriskier(safer)thanthemarketportfolio.BetasbasedonactualdataarepreparedbyMerrillLynch,WellsFargoBank,andtheValueLineinvestorserviceaswellasothers.Thesearecalledhistoricalbetas.Fundamentalbetaswouldbe ex-ante estimatesbasedonthecapitalstructureandoperatingcharacteristicsofthefrm.Oneimportantfactorshouldbekeptinmind.Weareinterestedinwhatreturnthemarketexpectstoearnforagivenamountofrisk.Todeterminethis,weneedtoknowthereturnthatisexpectedtobeearnedinthemarket ( ¯ r m ) aswellashowtheriskofaspecifcsecuritycomparestotheriskofthemarket.Themodelneedsexpectationsinordertobeusedcorrectly.Allweshallhavearedatabasedonpasteventsthatweshallusetoestimatethevariablesthatweneed.Forexample,oneproblemisthatthebetawillchangethroughtime.Also,thevalueof r f willdependonthematurityofthegovernmentsecuritythatisused.ItisnoteasytousetheCAPMinanexactmanner. UseoftheCAPM EventhoughtheassumptionsonwhichtheCAPMisbasedlimitthegeneralityofthemodel,itisstillwidelyused.Amongtheusesare:1.Toestimatethecostofequitycapitalusing ¯ r i = r f + ( ¯ r m r f i . Theseestimatesmaybeusedasthebasistodeterminetherequiredreturntobeearnedbyafrm’sasset.2.Toevaluatesecurities—iftheexpectedreturnislargerthan ¯ r i = r f + ( ¯ r m r f i , thesecurityisa“bargain”.
November6,200913:44spi-b8119inx6inb811-ch11 212 AnIntroductiontoAccountingandManagerialFinance IfasecurityhasalargerexpectedreturnthanthereturnindicatedbytheCAPM,allinvestors(withhomogeneousexpectations)willbuyituntilitsexpectedreturnisloweredtobeequalto ¯ r i = r f + ( ¯ r m r f i . Inlikemanner,ifasecurity i isexpectedtoearnlessthan r f + ( ¯ r m r f i , noonewillbuy(somewillsellitshort),itspricewilldecrease,anditsexpectedreturnwillincrease.Allsecuritiesarecontainedinthemarketportfolioinproportiontotheirmarketvalue.Thebetaofthemarketportfoliois1.Industrytendstousea“costofcapital”ora“hurdlerate”toimplementthediscountedcashfowcapitalbudgetingtechniques.Bothofthesemeasuresare“averages”refectingaveragerisksandaveragetimevalueconditions,andcannotbesensiblyappliedtounique“marginal”situations.Thereisnoreasontothinkthattheweightedaveragecostofcapitalcanbeinsertedinacompoundinterestformulaandthenbeappliedtoanyseriesoffuturecashfowstoobtainausefulmeasureofnetpresentvaluethattakesboththetimevalueandriskoftheinvestmentintoconsideration.Thecapitalassetpricingmodeloffershopeforaccomplishingasystematiccalculationofrisk-adjustedpresentvalue.Themeasurerefectstheinvestor’salter-nativeinvestmentreturn-risktrade-offopportunitiesinthesamewayastherateofinterestonagovernmentbondrefectsinvestmentopportunitieswhenthereisnodefaultrisk.Evenwherethereisareluctancetoacceptimmediatelythespecifccalculationsofthetypeillustratedinthischapter,therewillbeachangeinthewaythatmanagementwilllookatalternatives.Oneimportantlimitationofthecapitalassetpricingmodelforcorporatedeci-sionmakingshouldbekeptinmind.Themodelassumesthattheinvestorsarewidelydiversifed,and,equallyimportant,itassumesthatthemanagersofthefrmarewillingtomakeinvestmentdecisionswiththeobjectiveofmaximizingthewell-beingofthistypeofinvestor.Thismeansthatunsystematicrisk(forwhichtheinvestoriswelldiversifed)maybeignoredintheevaluationofinvestments.Itiswellknownthatobjectivesoffrmsandmanagersaremultidimensionalandthattherewillbeareluctancetoignoreriskbecauseitdoesnotaffectthewell-diversifedinvestor.Theso-called“unsystematic”riskisnotsomethingthatislikelytobeignoredbyamanagementthatincludesamongitsobjectivesthecontinuityofexistenceofthefrm.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 213 Themodelswehaveusedherearesomewhatsimplifed.Investorsaremuchmorecomplexintheirbehaviorandmarketsarelessthanperfect.Nevertheless,theconclusionsreachedarerelevantandwillbethefoundationforagreatdealofthefnancialinvestmentmodelsofthefuture.Investmentdecisionmakingunderuncertaintyisnotaneasytask,butuncertaintyisacharacteristicoftheworldandtheproblemmustbefaced. Conclusion Oneamountofdebtleverageispreferredtoanotherifmovingtothatleveragewillimprovethestockholders’wealthposition.Buttodeterminethedegreeoffnancialleveragethatleadstoaweightedaveragecostofcapitalthatmaximizesstockholders’wealthisnoeasytask.Althoughthetraditional(orclassical)positionstatesthatajudiciousamountofdebtistobeemployed,theModiglianiandMiller1958paperstatesthat,withwell-defnedassumptions,anydegreeoffnancialleverageisequallydesirable(withnocorporatetaxes). 4 Whencorporatetaxesareconsidered,itcanbearguedthatthetheoreticalminimumcostofcapitalstructureisvirtuallyalldebt.Caremustbeusedintakingsidesonthiscontroversy.Thetraditionalistsarguetheirpositionbynotingthatfrmsadoptcapitalstructuressubstantiallylessthan100percentdebtandsubstantiallymorethan0percentdebt.TheModiglianiandMillerzero-taxargumentforavaluethatisindependentofcapitalstructure,ontheotherhand,isclearlyspelledoutintermsoftheirassumptionsandmodels.Whilethelat-terarecorrectgiventheirassumptions,theirassumptionsareworthreconsidering.Theextenttowhich(1)marketsareimperfectand(2)equitysuppliersdiscrimi-natebetweendividendsandcapitalgains(treateddifferentlyfortaxpurposes),and(3)thefactthattherearebothcorporateandpersonaltaxes,makesitdiffculttomakethedefnitiveexactstatementsastotheexactoptimumcapitalstructure.Mostimportant,thereisgeneralagreementthatthedifferenttaxtreatmentsawardedtointerestandstockholder’searningsaffecttherelativedesirabilityofdebtandstock.Iftherewerenopersonaltaxes,theuseofdebtinthecapitalstructureofacorporationwouldenableafrmtoreduceitscostofraisingcapitalsincetheinterestpaymentsaredeductibleforcorporatetaxpurposes.Thedesirabilityofdebtcomparedtocommonstockisdramatizedwhenthedebtispurchasedbythecommonstockholders,sinceinthissituationthereisnoincreaseintherisk 4 F.ModiglianiandM.H.Miller,“CostofCapital,CorporationFinanceandtheTheoryofInvestments,” AmericanEconomicReview ,June1958,pp.261–297.
November6,200913:44spi-b8119inx6inb811-ch11 214 AnIntroductiontoAccountingandManagerialFinance totheinvestors.Onecouldbeledtotheconclusionthatafrmshouldissueasmuchdebtaspossible,withzero-taxstockholderspurchasingthedebtiftheyfearanexcessiveincreaseinriskarisingfromthehighlyleveredcapitalstructure.However,theInternalRevenueServicemightlimittheamountofthistypeofdebtthatacorporationmayissuesincetoomuchdebtmayresultinthecashdistributionbeingrelabeledasdividends.Theadditionofdebt,evenwherethedebtisarelativelycheapsourceofcap-italbecauseofthetaxstructure,doesaddrisktothestockholdersifthedebtissoldtononstockholders.Ifthereisnotaxableincome,thefullcostoftheinterestfallsonthecorporationandultimatelyonthestockholders.Thus,wecanconcludethatthepresenttaxstructureoffersstrongincentivestoissuedebt,butthattherearefrequentlyforces(theriskofbankruptcyandtheconventionsoftheinvest-mentbankingcommunity)thatrestrainthecorporationconsideringtheissuanceofunusuallylargeamountsofdebtcomparedtocommonstock.Businessmanagersquiteproperlywanttoknowhowdifferentcapitalstructuresaffectthecostofobtainingcapital.Theywanttoreducethecostofusingthefrm’spresentcapitalortoreducethecosttothefrmofobtainingnewcapital.Althoughmanagersmayalsowanttousetheweightedaveragecostofcapitalasthediscountrate(thehurdlerate)inevaluatingallinvestments,wearenotenthusiasticaboutthisusage.Iftheriskoftheassetisdifferentfromtheriskofthefrm’sotherassets,orifthetimingofthecashfowsisdifferent,usingtheonerisk-adjusteddiscountrate(thefrm’sweightedaveragecostofcapital)toevaluatealltheinvestmentsisnotlikelytoleadtocorrectdecisions. ReviewProblems ReviewProblem11.1 (a)Thecorporatetaxrateis0.35.Completethefollowingtable. RequiredBefore-TaxAfter-TaxReturnsCostsTaxTaxSavingsCost Debt0.12Preferredstock0.11Commonstock0.14 (b)Theafter-taxweightedaveragecostofcapital(0.45debt,0.15preferredstock,0.40commonstock)isWACC =
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 215 (c)Aninvestorbuyingaverticalsliceofthefrmwillearnhowlargeareturniftherequiredreturnsareearned? SolutiontoReviewProblem11.1 (a)Thecorporatetaxrateis0.35. RequiredBefore-TaxAfter-TaxReturnsCostsTaxTaxSavingsCost Debt0.120.120.0420.078Preferredstock0.110.16920.05920.1100Commonstock0.140.21540.07540.1400 (b)Theafter-taxweightedaveragecostofcapital(0.45debt,0.15preferredstock,0.40commonstock)isWACC = 0 . 45 ( 0 . 078 ) + 0 . 15 ( 0 . 11 ) + 0 . 40 ( 0 . 14 ) = 0 . 1075 . (c)Aninvestorbuyingaverticalsliceofthefrmwillearnareturnof0.1265iftherequiredreturnsareearned. r = 0 . 45 ( 0 . 12 ) + 0 . 15 ( 0 . 11 ) + 0 . 40 ( 0 . 14 ) = 0 . 1265 . QuestionsandProblems 1.Assumea0.35taxrate.Topay0.10toinvestors,acompanymustearnwhatreturn(beforetax)ifthesecurityis:a.Debt?b.Preferredstock?c.Commonstock?Whatafter-taxinternalrateofreturnmustaninvestmentearnforacor-porationtosupplysuffcientcashfowstopayabefore-tax(personal)0.10to:d.Debtholders?e.Preferredstockholders?f.Commonstockholders?2.(continue1)a.Assuming0.5commonstock,0.4debt,and0.1preferredstock,theafter-taxWACCofthefrmis____________________.
November6,200913:44spi-b8119inx6inb811-ch11 216 AnIntroductiontoAccountingandManagerialFinance b.Azero-taxinvestorholdingtheproportionofsecuritiesgivenin(a)wouldearn____________________.3.Assumethatafrmhasearned$100ofbefore-taxincome.Thecorporatetaxrateis35percent.a.Ifthesecurityusedtofnancetheinvestmentis$1,000of10percentdebt,thefrmholdingthedebt(supplyingthedebtcapital)willhave_______________aftertax.b.Ifthesecurityusedtofnancetheinvestmentis$1,000ofcommonstockandiftheentireafter-taxamountofincomeispaidasadividend,thezero-taxinvestorholdingthecommonstockwillhave_______________aftertax.4.Assumethatacompanyborrowsatacostof0.14.Itstaxrateis0.35.Whatistheminimumafter-taxcostofcapitalforacertaincashfowif:a.100percentdebtisused?b.100percentcommonstockisused(assumethatthestockholderswillaccepta0.14return)?5.Assumethatthereturnontax-exemptsecuritiesis0.09andthat t p = 0 . 3, t g = 0 . 20,and t c = 0 . 35,where t g istherateoncapitalgains, t c isthecorporatetaxrate,and t p isthepersonaltaxrateondividendsandinterest.Equilibriumconditionsexist.a.Thereturntoinvestorsontaxablebonds(withequalrisk)raisedasnewcapitalcanbeexpectedtobe____________________.b.Thereturntoinvestorsoncommonstock(allcapitalgains)raisedasnewcapitalcanbeexpectedtobe____________________.6.ThetaxratefortheGasCorporationis0.35.Thefollowingtablehasbeenpreparedforthepresidentofthefrm. Before-TaxCostAfter-TaxCostCapitalStructure Bonds0.100.0650.4Preferredstock0.200.13000.1Commonstock0.23080.150.5 a.Computetheweightedaverageafter-taxcostofcapitalofthefrm,withthegivencapitalstructure.b.Computethereturnbeforetaxforaninvestorwhosplitstheinvestmentinthecompanyinthesameproportionasthesourcesofcapital.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 217 c.If$1,000ofeachtypeofcapitalwereraised,thecapitalwouldhavetoearnbeforetax: Bonds$______________________Preferredstock______________________Commonstock______________________ 7.Foracompanywithzerodebt,thecostofthefrstdollarofdebtis0.10,andthecostofcommonstockis0.18(thesearereturnsrequiredbyinvestors).Wehavedeterminedthatthecostofdebtis k i = 0 . 10 + 0 . 08 B V andthattherearenotaxesandnobankruptcycosts.Thecapitalmarketisrationalandwellinformed.a.Whatistheweightedaveragecostofcapital?b.Shouldthenextissueofthecompanybecommonstockordebtiftheobjectiveistominimizethecostofthecapital?c.Whatwillbethecostofequityifthecapitalstructurehasequalamountsofdebtandequity?8.ThefollowingfactsapplytotheXYZCompany:Bondscanbeissuedtoyield0.10.Preferredstockcanbeissuedtoyield0.08.Commonstockcanbeissuedwithanexpectedyieldtostockholdersof0.18.Thetaxratesare0.4forallsectionsofthisproblem.a.Computethebefore-taxcashfowsthathavetobeearnedtocompensateinvestorsfor$1,000ofcapital:(1)Debt.(2)Preferredstock.(3)Commonstock.b.ComputetheWACC(after-tax)ifthecapitalstructureis0.5debt,0.1preferredstock,and0.4commonstock.c.Computetheweightedaveragereturnforaninvestorwhoinvestsinthesameproportion(fordifferentsecurities)asthecapitalstructure.9.AssumetheM&Mzero-taxmodel,where k 0 = 0 . 14and k i = 0 . 10forallcapitalstructures(both k 0 and k i areconstants).a.Givetheequationfor k e .b.Whatisthevalueof k e if B = $4millionand S = $8million?
November6,200913:44spi-b8119inx6inb811-ch11 218 AnIntroductiontoAccountingandManagerialFinance 10.Assumethattax-exemptbondsarebeingissuedatacostof0.12andrisk-equivalenttaxablesat0.18.a.Consistentwiththeabovereturns,whatisthepersonaltaxrateofthemarginalinvestor?b.Aninvestorintaxexemptsinthe58-percenttaxbracketwouldearntheequivalentofwhatbefore-taxreturn?c.If$10billionoftax-exemptsecuritiesareissued,theannualinterestsavingstotheissuingauthoritiesare_______________.11. 0 a cb Cost = B 1 V k i Assumethatthe k i curveiscorrectlydrawn.Commentonthefollowingstate-mentsorcompletethem.(Therearezerotaxes.)a.The k e curvemaybebelowthe k i curveatsomepoint.b.Theweightedaveragecostofcapitalisapproximatelyequalto_______________.c.Iftheshapeofthe k 0 curveisahorizontalstraightline,thenlogicallythe k e curvewillhavea_______________slope.d.Ifthe k e curvehasapositiveslope,thenthe k 0 curvemustalsoslopeupward.12.Afrmhas$10millionofassetstobefnancedwith$6milliondebtand$4millionofequity.Youhave$2milliontoinvestinthefrm.Therearezerotaxes.Howwouldyouinvestsothatyourinvestmentisequivalenttoinvestinginanidenticalfrmwith100percentcommonstock?13.Afrmisbeingorganizedthatrequiresaninitialinvestmentof$20million.Youhave$200,000andwillbuy0.01ofthecommonstockifthefrmis100percentfnancedwithcommonstock.Theuseof$8millionof10-percentpreferredstockand$12millionofcommonstockisbeingconsidered.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 219 a.Ifthiscapitalstructureischosen,whatinvestmentstrategyshouldyouchoosetohavethesameidenticaloutcomesasinvestinginthecommonstockatthe100-percentcommonstock-fnancedfrm?b.Ifthefrmearns$900,000,whatwillyouearnifthecommonstockfnancingischosen?Whatwillyouearnifthepreferredstockfnancingischosenandyouinvestasdescribedin(a)?14.Encircleonenumeralforthecorrectstatement.a.Ifwithasubstitutionofdebtforcommonstockthecostsofbothcommonstockanddebtincrease,thentheWACCwill(1)Increase.(2)Decrease.(3)Staythesame.(4)Increase,decrease,orstaythesame.b.Ifdebtissubstitutedforcommonstock,onewouldlogicallyexpectthecostofstockequityto(1)Increase.(2)Decrease.(3)Staythesame.(4)Increase,decrease,orstaythesame.c.Intheabsenceofbankruptcycostsandcorporatetaxes,afrmwithmoredebtthanthemarketthinksisrationalwillsell(1)Atthesamevalueasanidenticalfrmproperlyfnanced(asviewedbythemarket).(2)Atlessthanafrmproperlyfnanced.(3)Atmorethanafrmproperlyfnanced.(4)Atthesamevalue,orlessthan,ormorethan,dependingonriskpref-erences.15.Assumethatforapublicutilitythefollowingfactsandestimatesapplyandareaccepted: k i = 0 . 10 k e = 0 . 15 B V = 0 . 2 t = 0 . 46 .
November6,200913:44spi-b8119inx6inb811-ch11 220 AnIntroductiontoAccountingandManagerialFinance Theratecommissionthinksthatthecapitalstructureshouldbe B V = 0 . 6andhasmadethefollowingcalculationforWACC: k 0 = ( 1 0 . 46 ) 0 . 10 ( 0 . 6 ) + 0 . 15 ( 0 . 4 ) = ( 0 . 054 )( 0 . 6 ) + 0 . 06 = 0 . 0324 + 0 . 06 = 0 . 0924 . Briefyevaluatethecalculation.16.TheearningsoffrmsXandYareidenticallydistributed(theyarethesamefrmexceptforcapitalstructure).Otherfactsare: MarketValues FirmXFirmY Debt$0$75,000,000Commonstock110,000,00025,000,000 Thecostofthedebtis0.10.a.Assumethatyouaregoingtoinvest$1,000,000inoneofthefrms.Whatwouldbeyourinvestmentplanifyouwantyourstrategytodominatethealternativeofinvestingintheequityoftheotherfrm?b.Explainwhyyourplanisdesirable.17.TheplanningteamoftheABCInsuranceCompanyistryingtoorganizethecapitalstructureofanacquisition.Bothfrmsarepayingincometaxes.Youaregiventhechoiceoftwocapitalstructures: StructureStructure 10%Debt60%10%Preferredstock60%Commonstock40%40% ABCwillown0.40ofallsecurities.Whichcapitalstructureshouldthefrmprefer?Explain.18.TheABCInsuranceCo.followsapolicyofbuyingthesamepercentageofcommonstockasdebt.Thatis,ifitbuys0.20ofacompany’sdebt,itwillbuy0.20ofthecompany’scommonstock.
November6,200913:44spi-b8119inx6inb811-ch11 CapitalStructure:WeightedAverageCostofCapital(WACC) 221 TheMetroInsuranceCo.willonlybuycommonstockincompaniesthathavezerolong-termdebt.Allthecompaniesbeinginvestedinhavethesameoperatingrisk.Assumethattherearezerotaxes.Whichinsurancecompanyhasamoreriskyinvestmentstrategy?Explain.19.Assumethatacompanyborrowsatacostof0.09.Itstaxrateis0.35.Whatistheminimumcostofcapitalforacertaincashfowif:a.100-percentdebtisused?b.100-percentcommonstockisused(assumetheinvestorsaccepta0.09return)?20.a.TheABCCompanyhasasimplecapitalstructure.Managementwantstosubstitute$100millionof0.12debtforcommonstock.Whateffectwillthechangehaveonthevalueofthefrmtoazero-taxinvestor?Thecorporatetaxrateis0.35.b.TheXYZCompanyisthinkingofacquiringafrmthatisearningbefore-tax$100,000ayear.XYZ’sborrowingrateis0.10,anditstaxrateis0.46.Thus,itsafter-taxborrowingrateis0.65.Theinvestmentinthefrmwillbefnancedwithsuffcientdebttocausetheamountofincometaxespaidtobezeroonthisinvestment.WhatisthemaximumamountthatXYZcouldaffordtopayforthefrm?21.ThetaxrateforTheIthacaCorporationis0.4.Thefollowingtablehasbeenpreparedforthepresidentofthefrm. Before-TaxCostAfter-TaxCost Bonds0.100.06Preferredstock0.120.072Commonstock0.200.12 Onlybondinterestisdeductibleforincometaxes.Thefrmhasacapitalstruc-tureof0.4debt,0.1preferredstock,and0.5commonstock.AssumethattheU.S.InternalRevenueCodeapplies.a.Computetheweightedaveragecostofcapitalofthefrm,withthegivencapitalstructure.b.Computethebefore-taxreturnforaninvestorwhosplitsherinvestmentinthecompanyinthesameproportionasthesourcesofcapital.
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November6,200913:44spi-b8119inx6inb811-ch12 Chapter12 BuyversusLease Leasingisoneofthemostpopularmeansbywhichcorporationsfnanceassets.Younameit,youcanleaseit—atomicfuelfornuclearpowerplants,hospitalequipment,truckfeets,helicoptersand747s—thelistislong.Thetotalvalueofleasedassetshasbeengrowingatarateofmorethan10percentperyear.Therehavebeenfundamentalmisunderstandingsabouttherelativemeritsofbuyingversusleasing.Forexample,considerthefollowingissue.Ifonewereindifferenttobuyingandleasingwithoutconsideringtaxes,wouldtheadditionoftaxconsiderationsdrivethedecisioninthedirectionofleasing?Ifyousaid“yes”withoutqualifcations,youhavesomethingtolearn.Theaboveimproperleasingversusbuyinganalysiswithtaxconsiderationsincludedhasprobablybeensomewhatresponsibleforthetremendouspopularityofleasing.Theconfusionregardingtheleasedecisionisnothelpedbythefactthatthetaxlawskeepchangingdramatically.Notonlyisitnecessarytobefamil-iarwiththespecifcsofthecurrenttaxacts,butitisalsonecessarytobefamiliarwiththeTreasuryDepartmentregulationsthatinterpretthetaxlawspassedbyCongress.Therearetwoveryimportantcharacteristicsofleasesthatshouldbecarefullydistinguishedandunderstood.Themoreimportantisthewayinwhichaleasewillaffectthefrm’staxsituation.Thesecondisthewayinwhichaleasewillaffecttheaccountingreports.Therearefewfnancialdecisionsaffectedbytheaccountingrulesasmuchastheleasingdecision. FAS13:AccountingforLeases Companiesoftenrentpropertyunderlong-termleaseagreementsthatrequirefxedrentalpaymentstobemadebythe lessee (useroftheproperty)tothe lessor (owneroftheproperty)forthedurationofthelease.Leasingisfrequentlyviewedasan 223
November6,200913:44spi-b8119inx6inb811-ch12 224 AnIntroductiontoAccountingandManagerialFinance alternativetopurchasingthepropertyandmaybeanattractivemeansoffnancingneededfacilities.Becausetheobligationforrentalpaymentscouldbesubstantial,theireffectshouldbedisclosedinthefnancialstatements.Onewayofaccom-plishingthisistorecordthepresentvalueofrequiredleasepaymentsasaliability.Acorrespondingassetwouldthenberecognizedtoindicatethevalueoftheleasedpropertytobeutilizedinthecompany’soperations.Asecondmethodwouldbetodisclosethetermsofthelease(cashoutlaysthatwillberequired),butnottocapitalizetheassetortheliability.Theproblemofthedisclosureofleasesinthefnancialstatementiscomplicatedbythevaryingtermsandobjectivesoftheleaseagreements.Atoneextreme,thelesseemaybeviewedassimplyusingaserviceforashortperiodoftimeandpayingrentfortheperiodofuse.Rentinganautomobileforaweekendwouldftthisdescription.Attheotherextreme,thelesseemaybeviewedasactuallyacquiringanownershipinterestinalong-termasset,despitethefactthatlegaltitlemayremainwiththelessor.Leasinganautomobileforfouryearswithmonthlypaymentsthatarecomparabletofnancingtermsforapurchasemightftthisdescription.Incurrentpractice,twotypesofleasesaredistinguishedfromthelessee’spointofview.Leasesthatessentiallymayberegardedaspurchasesarecalled capitalleases andareaccountedforasanacquisitionofalong-termassetwithcorrespondingrecognitionofthepaymentobligationasaliability.Allotherleasesarecalled operatingleases andaretreatedastheutilizationofservices,withrentalpaymentsrecognizedascurrentexpensesastheycomedue.TheaccountingforleaseshasbeendefnedbyFinancialAccountingStandardsBoardStatementNo.13andthesupplementarystatementsissuedtoexplainFASB(FinancialAccountingStandardsBoard)No.13.Thereareseveralcriteriathatmaybeusedtodeterminewhetheraleasequalifesforclassifcationasacapitallease.Amongtheseareprovisionsforthetransferofownershipofthepropertytothelesseeduringtheleaseterm,provisionsforpurchaseofthepropertybythelesseeatabargainprice,aleasetermthatisequaltoorgreaterthan75percentoftheusefullifeoftheproperty,orthepresentvalueofminimumleasepaymentsbeingequaltoorgreaterthan90percentofthefairvalueofthepropertyatthebeginningoftheleaseterm. 1 Ifaleasemeets anyoneofthesecriteria ,itisclassifedasacapitallease.Otherwise,itisregardedasanoperatinglease. 1 Thisisasimplifedexplanation.Formoredetailsconcerningthespecifcrequirements,seeFinancialAccountingStandardsBoard,StatementofFinancialAccountingStandardsNo.13, AccountingforLeases (Stamford,CT:FASB,1976).
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 225 Withacapitallease,thelesseemustshow:a.Theinitialpresentvalueoftheleasepaymentsasanasset(theassetistobedepreciatedthroughtimeinthesamemannerasanyotherdepreciableasset).b.Theinitialpresentvalueoftheleasepaymentsasaliability,tobereducedthroughtimeusingpresentvalueprinciples.c.Thefutureminimumleasepaymentsforeachofthenextfveyearsandintotalforthelifeofthelease.Thistotalamountisreducedbytheimputedinterestpayments,toobtainthepresentvalueofthelease.Withoperatingleases(leasesnotqualifyingascapitalleases),thelesseemustshowthefutureminimumleasepaymentsforfveyearsandthetotalminimumleasepaymentsforthelivesofalltheoperatingleases.Operatingleasesarenotshownonthebalancesheetexceptinfootnotes.Thelessee’sborrowingratewillbeusedincalculatingpresentvalues. ExampleofAccountingforLeases AssumethatonJanuary1,20x1,ElcoCorporationrentsequipmentfromOrcoCorporationunderaten-yearleasecallingforrentalpaymentsof$10,000attheendofeachofthetenyears.Attheendoftheleaseperiod,Elcomaypurchasetheequipmentfor$1.Theequipmenthasanexpectedusefullifeoftenyearsandhasafairvaluenowof$61,500.Elcopaysinterestof10percentperyeartoborrowmoney.Thismaybeviewedasacapitalleasebecausethetermoftheleaseextendsbeyond75percentoftheusefullifeoftheequipment.(Itwouldalsoqualifyonothergrounds.)UsingAppendixTableB,wefndthatthepresentvalueof$1perperiodfortenperiodsat10percentis6.1446.Therefore,thepresentvalueofthetenpaymentsis$10 , 000 × 6 . 1446 = $61 , 446 . Theassetandtheleaseobligationmayberecordedasfollows:LeasedEquipment .................................... 61 , 446LiabilityforLeasedEquipment .................. 61 , 446Theliabilityshouldbeshownatitspresentvalue,andafnancingchargeshouldberecordedeachyear,basedontheassumedrateofinterestandthebalanceofthe
November6,200913:44spi-b8119inx6inb811-ch12 226 AnIntroductiontoAccountingandManagerialFinance obligationfortheyear.AbalancesheetonJanuary1,20x1,wouldshowanasset,LeasedEquipment$61 , 446andaliability,CapitalLeaseObligation$61 , 446 . Afootnotewouldshowthefollowinginformation: MinimumleasepaymentsforyearendingDecember3120x1$10,00020x210,00020x310,00020x410,00020x510,000LaterYears50,000 TotalMinimumLeasePayments$100,000 Less :AmountRepresentingInterest38,554 PresentValueofNetMinimumLeasePayments$61,446 Theasset,LeasedEquipment,mustbedepreciatedintheusualmanner.Letusassumethefrmusesstraight-linedepreciationandthattheequipmenthasanesti-matedlifeoftenyears.ThefollowingentrywouldbemadeonDecember31,20x1:DepreciationCost ....................................... 6 , 145LeasedEquipment:AccumulatedDepreciation ...... 6 , 145Itisalsonecessarytorecordtheinterestcostoftheliabilityandthepaymentofthe$10,000leaseoutlay.Forexample,thepresentvalueoftheobligationatthebeginningofyear20x1was$61,446.Atthe10-percentrate,theamountofinteresttoberecognizedfortheyearwouldbe$61 , 446 × 0 . 10 = $6 , 145 . Torecordtheinterest,theprincipalpayment,andthecashoutlay,wehave:InterestExpense ·· .................................... 6 , 145LiabilityforLeasedEquipment ........................ 3 , 855Cash .......................................... 10 , 000Attheendofyear1,theliabilityaccountwouldhaveabalanceof$57,591.Itshouldbenotedthatthisisequaltothepresentvalueofthenineremaining
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 227 Exhibit12.1. AmortizationTableforLeaseLiability. PeriodLeasePaymentInterestExpenseLiabilityReductionNetValueofLeaseObligation $61,446.001$10,000$6,144.60$3,855.4057,590.60210,0005,759.064,240.9453,349.66310,0005,334.974,665.0348,684.63410,0004,868.465,131.5443,553.09510,0004,355.315,644.6937,908.40610,0003,790.846,209.1631,699.24710,0003,169.926,830.0824,869.16810,0002,486.927,513.0817,356.08910,0001,735.618,264.399,091.681010,000909.179,090.830.85 leasepaymentsdiscountedat10percentperyear.Attheendofyear10,whenthefnalpaymentismade,theliabilityaccountwouldbereducedtoazerobalance.Exhibit12.1presentsanamortizationtablefortheleaseliability.Also,theassetaccountforLeasedEquipmentwouldhaveazeronetbalance,asitisbeingdepre-ciatedoveraten-yearperiod.Theleasingarrangementistreatedasanimplicitpurchaseofequipment.Iftheleasedescribedintheaboveexampledid not qualifyasacapitallease,itwouldberegardedasanoperatinglease.Inthiscase,noassetorliabilitywouldberecognized.Instead,eachyearthecompanywouldrecognizea$10,000expense,theamountoftheleasepayment.Itshouldbenotedthatiftheleaseistreatedasacapitallease,theexpenseofthefrsttime-periodisnotequaltothe$10,000cashoutlay.Thetotalexpenseis: DepreciationCost$6,145Interest6,145 TotalExpense$12,290 Whilethe$6,145ofdepreciationwillstayconstant,theinterestwillbereducedthroughtime,astheliabilityisbeingreduced.Theuseofdifferentdepreciationmethodswouldproducedifferentresults.Therecognitionofcapitalleasesasaliabilityinthefnancialstatementsisarelativelyrecentdevelopmentinaccountingpractice.Atonetime,itwaswidelybelievedthatleaseobligationsweredifferentfromotherformsofdebtanddidnot
November6,200913:44spi-b8119inx6inb811-ch12 228 AnIntroductiontoAccountingandManagerialFinance needtobereportedonthebalancesheet.Thisledtosomecompaniespreferringtoleaseratherthanpurchasetheirplantandequipmentinordertoreducetheamountofdebtappearingontheirbalancesheets.Thispractice,whichcametobeknownas“off-balance-sheetfnancing,”hasbeenrestrictedbyFAS13. LessorsandLessees Anybusinessentitycanbealessee.Abigleasingcategoryistransportationequipment—oiltankers,railroadrollingstock,airplanes,trucks,andautos.Othermajorgroupsofassetsthatareleasedarecomputersandotherdataprocessingdevices,copiers,andspecializedmachinery.Lessorsarefrequentlyfnancialinstitutionswithlargecashfows(i.e.,theinsur-ancecompanies,banks,andfnanceandinvestmentcompanieswithlargetaxableincomes“requiring”taxsheltering).Theseinstitutionshaveastrongincentivetobuyequipmentandthenleaseittoequipmentuserswhocannottakeadvan-tageofsuchtaxbeneftsasaccelerateddepreciationbecausetheydonothavetaxableincome.Insomecases,theplantorequipmentpurchasedbythelessorisfnancedbyloansmadetothelessor,therebycreatingasituationknownasleveragedleasing.Asecondtypeoflessoristhemanufacturer-lessor.Thesecompaniesuseleasesandrentalagreementsaskeytoolsinthemarketingoftheirproducts,enablingthemtoattractcustomerswhomightnotbeabletofnanceanoutrightpurchase. TheProsandConsofLeasing Table12.1showsinsummaryformmanyoftheargumentsofferedinfavorofandagainstleasing.Itcanbeseenthatfrequentlya“pro”argumentiscanceledbya“con”argument,leavingthedecisionmakertoevaluatesubjectivelyhowthefactoristobebroughtintothedecision.Wewillconsiderthecashfowsassociatedwiththetwoalternatives(buyandlease)underwell-defnedconditions.Wewillcompareleasingwithconventionaldebtaccompanyingthebuyalternative.Figure12.1showsthebasicbuyversusleaseanalysis.First,itmustbedecidedwhetherornottheinvestmentisacceptable.Second,theannualcostofbuyingtheassetwithborrowedfundsmustbecomparedwiththeannualcostofleasing.Ifthecostofbuyandborrowislessthanthecostofleasing,thenthethirdandfnalstepistoconsiderwhetheritisdesirabletofnancetheinvestmentwithdebtorwithamixtureofdebtandstockequity.
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 229 Table12.2. TenProsandConsofLeasing. ProCon 1.Itis100percentdebtfnancing.1.Aleasemayprecludeotherdebtfnancingifitisafrmobligationtopay.2.Withashort-termlease,thereislessriskofbeing“stuck”withabadassetiftheusefullifeislessthanexpected;thereisnoargumentaboutlifewithIRS.2.Noresidualvalueiflifeislongerthanexpected.3.Theshort-termleasegivesfexibility.3.Leasetermsmaybeadjustedupwardattheendofthelease.4.Maintenancemaybecheaperthanifyoudidityourself.4.Thesamemaintenancecontractcanprobablybepurchasedifyoubuy.5.Anoperatingleaseisoff-balance-sheetfnancing.5.Manyexpertsreconstructfnancialstatementstoincludeoperatingleases.6.Withalease,itiseasiertojustifyinvestments(higherreturnoninvestmentsincethereiszeroorasmallinvestment).6.Itdoesnotfoolasmanyasitusedto.Theleaseshouldbecapitalized.7.Aleaseiseasyandquicktoobtain.7.Notalways.Someleasearrangementsareverycomplex.8.Higherbookincomeisgeneratedinearlyyears.8.Thisisaresultofaccountingconvention;also,laterincomeswillbeless.9.Lowerpropertytaxesarepaid.9.Propertytaxesarelikelytobebuiltintoleasepayments.10.Therearetaxsavings.10.Therearetaxdissavings. Cost of buy-borrow Buy-BorrowAccept InvestmentLeaseAcquireInvestment? Cost of leasing Reject investmentEnd Fig.12.1. Buy-BorrowversusLease:Lessee.
November6,200913:44spi-b8119inx6inb811-ch12 230 AnIntroductiontoAccountingandManagerialFinance ThreeBasicProblems Therearethreebasicproblemsinanalyzingbuyversusleasedecisions.Oneisthedefnitionofthecashfowstobeused.Thesecondisthechoiceoftherateofdiscount.Thethirdproblemistomatchtheappropriaterateofdiscountwiththechoiceofcashfow.Forsimplicity’ssake,weshallrecommendtheuseofafter-taxcashfows.Forpurposesofsimplifcation,azerotaxratewillinitiallybeusedsothatthebefore-taxandafter-taxcashfowsareidenticalforthefrstexample.Amajorproblemwiththecashfowcalculationistheinclusionorexclusionofthedebtcomponentoftheleasefows.Theobjectiveistomaketheleaseanalysiscomparableintermsofdebtcharacteristicswiththebuyanalysis.Generally,thismeansextractingdebt-equivalenttaxdeductionelementsoftheleasecashfows.Therearethreebasicoptionsfromwhichtherateofdiscountcanbechosen:1.Theafter-taxborrowingrate,2.Thebefore-taxborrowingrate,or3.Sometypeofrisk-adjustedratesuchastheweightedaveragecostofcapital.Ifweassumethattherearefourpossiblesetsofcashfows(thereare,inreality,more)andthreepossiblediscountrates(again,thereare,inreality,more),thentherearetwelvedifferentwaysofcombiningthetwoelements.Ifwethenrecognizethepossibilityofusingdifferentratesofdiscounttodiscountdifferenttypesofcashfowsforeitherthebuyortheleasecomponent,wecanreadilyseewhytherehasnotbeenagreementonthemethodofanalyzingbuyversusleasedecisions.Itisnecessarytocomparethecashfowsandthepresentvalueofonealternative(buy)withtheotheralternative(lease).Ratherthanreviewingthebasictheoryandpracticeofcapitalbudgeting,weshalljumpintothemiddleofthatdiscussionandconcludethatoneshouldusethenetpresentvaluemethodsinceitisatleastasgoodasanyothermethodand,formanypurposes,better. SeparatingFinancingandInvestment Itisnecessarytoevaluatethefnancialaspectofleasingandtoseparatethefnancingandinvestmentelements.Weshallassumethatwearediscussingaleasethatishighlysimilartoapurchasewiththeborrowingofthepurchaseprice.Theleasecontractbeingconsideredhasallthecharacteristicsofalong-termlegaldebtobligation.Thelesseemustpaythespecifedsumtothelessoratthespecifedtimesofpaymentorsufferlegalconsequences.Aleasethatcanbebrokenbythelesseewithoutsubstantialpenaltyisnotthetypeofleasebeingdiscussedinthissection.
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 231 Inthesituationbeinganalyzed,committingone’scompanytoasetofleasepaymentsisequivalenttocommittingthecompanytoasetofcomparabledebtser-vicepayments.Anyknowledgeablefnancialanalystwouldimmediatelycapitalizefnancialleaseseveniftheyweretechnicallyoperatingleases.Forexample,ifitisdisclosedthatagivencompanyisobligedtopay,say,$36,829peryearforthreeyearstoaleasingfrm,thepresentvalueofthoseleaseobligationsattheexistingopportunitycostofdebt,say,10percent,wouldbe$36 , 829 × B ( 3 , 0 . 10 ) = $36 , 829 × 2 . 4869 = $91 , 590 . Theanalystwouldmodifytheexistingbalancesheetdatabyadding$91,590worthoflease-equivalentassetstothefrmand$91,590worthofdebt-equivalentliabil-ities.Therelevantcomparisonfordecisionpurposesisbuyandborrowversuslease. TheProblemEvenwithaZero-TaxSituation Weshalltrytoisolatethebasiccomponentsofthebuyversusleasedecision.Considerthefollowingsetofsituations: Example12.1:Buy-BorrowversusLease TheAssumptions 1.Notaxconsiderations.2.Nouncertaintyregardingcashfows.3.Theinvestmenthasnosalvagevalue. TheProblem Theeconomiclifeoftheequipmentisthreeyears.Youhavealreadydecidedtoproceedwiththeproject,buttheproblemiswhethertobuythemachineatacostof$90,000orleaseitfromthemanufactureratanannualleasefeeof$36,829forthreeyears.Theleaseis“net,net”,meaningthatyouprovideallthemaintenanceandinsurance. TheAnalysis Acalltothelocalbankerrevealsthatthebankiswillingtolendyourfrmthe$90,000ataninterestrateof10percent.This,thebanklendingoffcerinforms
November6,200913:44spi-b8119inx6inb811-ch12 232 AnIntroductiontoAccountingandManagerialFinance you,willrequireannualpaymentsof$36,190.Thebankcreditoffcerdidthefollowingcalculationstoobtaintheannualpayments.Let R betheannualpayment;then, R × B ( 3 , 0 . 10 ) = $90 , 000or R = $90 , 000 2 . 4869 = $36 , 190 . TheDecision Sincebuy-borrowischeaperthanleaseby$639peryearforthethreeyears,youarrangefortheloanandpurchasetheequipment.Thefrmwouldratherpay$36,190tothebankthan$36,829tothelessor.Itcanbeshownthattheleasehasanimplicitcostof11percent.Giventhesefacts,weseethatbuy-borrowispreferredtoleaseifitisalreadydecidedthatweneedtheequipment.Thus,ourdecisionatthesecondnodeofthedecisiontreedepictedinFigure12.2istobuy-borrow.Nowconsiderthefrstdecision—theacquisitiondecision. Example12.2:AcquiretheNewEquipment? TheProblem Theincrementalcashfowsassociatedwithanequipmentacquisitionwouldbe$38,000peryear(estimatedannualrevenuefromsaleofproductlesscostofpro-ductionexcludingequipmentcost).Theequipmentcosts$90,000. $36,190 Annual cash outlayof debt payment Buy-Borrow YesLeaseAcquireEquipment? $36,829 Annual cost No End Fig.12.2. Buy-BorrowversusLease:Lessee.
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 233 TheAnalysis Thefrmnormallyusestheweightedaveragecostofcapital(WACC)asits“hurdlerate”ininvestmentanalysis.TheWACCisestimatedtobe14percent. MethodofFinancingCostWeightedinCapitalStructureWeightedCost Debt0.100.50.05Equity0.180.50.09 0.14=WACC Ifweuse14percentasthediscountrate,thenetpresentvalueanalysisforacquiringtheequipmentis: TimeCashFlowPresentValueFactor@14%PresentValue@14% 0 $90,0001.0000 $90 , 0001–3$38,0002.3216$88 , 221 Netpresentvalue@14% =− $1 , 779 ThenetpresentvalueofacquiringtheequipmentisnegativeusingtheWACCasadiscountrate.But,ifweleasetheequipment,thenetpresentvalueisclearlypositiveatanydiscountratesinceleasingprovidesanexpectednetbeneftof$38,000 $36,829 = $1,171peryear.Using14percent,thesebeneftshaveanetpresentvalueof$2,719. TheDecision Thisanalysiswouldseemtoindicatethatthefrmshouldrejectthebuyalternative,butthatleasingisacceptable(leasinghasapositivenetpresentvaluewithanypositiverateofdiscount).ButExample12.1alreadyshowedthatiftheequipmentisacceptable,thefrmshouldbuy-borrow,notlease! TheProperComparison TheanalysisinExample12.2leadingtotheacceptanceofleasingandtherejectionofthebuyalternativeisfaulty.Wecannotlogicallycompare“buy”and“lease”;rather,wecompare“buy-borrow”and“lease”orcompare“buy”withaleasealter-nativethatisplacedonabasisthatiscomparableto“buy”.Theleasealternative
November6,200913:44spi-b8119inx6inb811-ch12 234 AnIntroductiontoAccountingandManagerialFinance implicitlyincludesdebtfnancingfows,whilethe“buy”alternativehasnosuchfows.Acomparisonofthenetpresentvaluesasstructuredaboveislikelytobefaulty. ALeaseIsaDebt Assumeaninvestmentanalysisthatusescashfowswithdebtfowssubtractedfromthebasicinvestmentfows(stockequityfowsarebeingused).Anycon-ventionalinvestmentwithaninternalrateofreturngreaterthanthecostofdebtcanbemadetoappearbetter(agreaternetpresentvalue)byincludingthedebtfowsintheanalysisorbyincreasingthedebtusedtofnancetheinvestmentandfocusingonthenetpresentvalueoftheresidualcashfows.Sinceleasepay-mentsareeffectivelydebtservice,itisimportantthatcomparabilitybeestab-lishedbetweentheleaseandbuyalternativesinacquisitionanalysis.Thereareessentiallythreemethodsofneutralizingthefnancialdifferencesbetweenthetwoalternatives.Thefrstmethodwouldbetorecognizetheleasepaymentsasdebtserviceanddiscountthesepaymentsatthecostofdebt,therebycomparingthecostofbuyingwithdebtagainstacquiringwithlease.Intheillustration,thedebtequivalentofleasing(thepresentvalueoftheleasepaymentsat10percent)is$36 , 829 × B ( 3 , 0 . 10 ) = $36 , 829 × 2 . 4869 = $91 , 590 . Iffundsareborrowedandtheequipmentispurchased,thepresentvalueofthedebtserviceandfowsis$90,000,andsobuy-borrowispreferredtoleasingthatcosts$91,590.Thesecondmethodofcomparingbuy-borrowandleaseistoincludethedebtfowsinthebuyanalysis.Thenetdebtfowsofbuyingare$38 , 000 $36 , 190 = $1 , 810peryear.Thenetbeneftsfromleasingare$1,171peryear,whichislessthanthebuy-borrownetbeneftsof$1,810.Thethirdmethodiscomparabletothesecond.WecontendthatthedecisiontreeapproachofFigure12.1isanappropriateapproach.Ifacquisitionisdesirableandleasingisanalternative,wecancomparetheannualequivalentcostsoffnancingtheacquisitionbydebtandbyleasing.Sincethebeneftstreamofcashfowsfromacquisitionisthesameundereitheracquisitionstrategy,thedifferentialcashfowsbetweenbuy-borrowandleasearisesolelyfromthedifferencesinthecontractualobligationofthetwoalternatives.Debtfnancingcosts$36,190,andtheleasecosts$36,829;therefore,buy-borrowismoredesirablethanleasing.Thesethreeprocedurestelluswhattodoifwehavedecidedtoaccepttheequipment.Theydonottelluswhetherornottheequipmentisdesirable.Withno
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 235 uncertainty,theinvestmentisdesirable.Withuncertainty,bothbuyingandleasingmaynotbeacceptable.Thedecisiondependsontheanalysisoftheproject’srisk. TheEffectofTaxes Letusassumethattheequipmentacquisitionisdeemeddesirableandthatthemethodofacquisitionistheonlyquestion.Taxesexertsubstantialinfuenceandmustbeconsidered.Withrespecttoincometaxes,thetotalleasepaymentsaretax-deductible,whereasdepreciationandinterestpaymentsondebtaredeductibleunderthebuy-borrowalternative.Howdothesetaxfactorsaffectthedecision?Letusproceedwithourpreviousillustration.Nowassumethatthelessorofferstoleaseat$36,190peryear,thesameasthedebtservicepaymentstothebankifthe$90,000wereborrowed.Thiswouldresultinindifferenceiftherewerezerotaxes.Dotaxesforcetheanalysistowardleaseorbuy-borrowinthiscase?Supposethatthetaxrateis40percent.Ifthe$90,000isborrowed,thedebtrepaymentschedulewouldbe: PeriodAmountOwedBeginningofPeriodInterestat10%PrincipalPaymentTotalPayment 1$90 , 000$9 , 000$27 , 190$36 , 190262 , 8106 , 28029 , 91036 , 190332 , 9003 , 290 32 , 900 36 , 190 $18 , 570$90 , 000$108 , 570 Ifstraight-linedepreciationisusedbythefrmfortaxes,thetotaltaxdeductionsresultingfrombuy-borrowandleasingwouldbe: PeriodInterestStraight-LineDepreciationBuy-BorrowTotalTaxDeductionsLeaseTaxDeductions 1$9 , 000$30 , 000$39 , 000$36 , 19026 , 28030 , 00036 , 28036 , 19033 , 290 30 , 000 33 , 290 36 , 190 $18 , 570$90 , 000$108 , 570$108 , 570 Thetaxdeductioneachyearwithleasingis$36,190or$108,570forthreeyears.Thesumsofthedeductionsarisingfrombothbuy-borrowandleasingare
November6,200913:44spi-b8119inx6inb811-ch12 236 AnIntroductiontoAccountingandManagerialFinance $108,570,butthetimingofthecashfowsclearlyfavorthebuy-borrowalternative,evenifstraight-linedepreciationexpenseisusedfortaxesratherthanaccelerateddepreciation.Notethatifthefrmusedaccelerateddepreciation,asitnormallywouldfortaxpurposes,thebuy-borrowalternativewouldbeevenmorepreferable.Totaltaxdeductionswouldagainbethesame,butthetimingwouldbeevenmorefavorableintheearlyyearstobuy-borrow.Inthissituationwheretherewasinitiallyindifferenceandzerotaxes,theinclusionoftaxesmovedthedecisiontowardbuy-borrow. AMethodofSolution Ifweusestraight-linetaxdepreciationandtheafter-taxborrowingrateof0.06,thenetcostofbuy-borrowis$90 , 000 0 . 4 ( $30 , 000 ) 2 . 673 = $90 , 000 $32 , 076 = $57 , 924 . The$32,076isthepresentvalueofthetaxsavingsresultingfromtheuseofstraight-linetaxdepreciation.Let r = theafter-taxborrowingrate t c = thecorporatetaxrate L = theannualleasepaymentB( n,r ) = thepresentvalueofanannuityfor n periodsdiscountedat r interestrate.Theafter-taxpresentvaluecostofleasingis ( 1 t c )L B (n,r) = $36 , 190 ( 1 0 . 4 ) B ( 3 , 0 . 06 ) = $58 , 042 . Buyhasasmallerafter-taxpresentvaluecostthandoesleasing.Wecanuse(1 t c ) L B( n,r )tocomputethepresentvalueofleasing,sincetheafter-taxborrowingrateisbeingusedasthediscountrate.Thiscalculationisareasonablesolutiontotheproblemofdeterminingwhetherleasingorbuyingwithborrowingismoredesirable.Thisveryeasymethodofsolutionispossible,sincethefrmiswillingtousetheafter-taxborrowingratetodiscountallthecashfows.Ifanyotherdiscountrateisused,wemustuseamorecomplexmethodofsolution.Theuseoftheafter-taxborrowingratehastheadvantageofcausingtheafter-taxpresentvalueofthedebtfowsassociatedwithborrowingtobeequaltozero.Thismakesthebuy-borrowandtheleasecalculationsequivalent.Youshouldnotbelulledintothebeliefthatifthereisnodifferencebetweenbuy-borrowandleaseonabefore-taxbasis,theafter-taxanalysiswillalways
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 237 demonstratethatbuy-borrowislesscostly.Supposethatthelessorofferedtheequipmentat$32,901peryear,withpaymentdueatthebeginningoftheyearratherthanattheend.Thepresentvalueoftheleasepaymentsatthebefore-taxcostofdebtisagain$90,000,$32 , 901 + $32 , 901 × B ( 2 , 0 . 10 ) = $90 , 000 , whichisthesameasthepresentvalueofthedebtservicecashfows,andthereisbefore-taxindifference.Butthepresentvalueoftheafter-taxcashfowsofleasingdiscountedattheafter-taxcostofdebt, ( 1 0 . 4 )( $32 , 901 ) [ 1 + B ( 2 , 0 . 06 ) ]= $55 , 933 , isinthiscaselessthanthepresentvalueoftheafter-taxcashfowsfrombuy-borrowwithstraight-linedepreciation($57,924).Leasingisnowlesscostlythanbuy-borrowing.Changingthetimingoftheleasepaymentsandthetaxdeductionsaffectstherelativedesirabilityofbuy-borrowandlease,eventhoughthebefore-taxpresentvaluesarenotchanged.Therearenoeasilyappliedconsistentlycorrectrulesofthumbinbuyversusleaseanalysis—acompleteafter-taxdiscountedcashfowanalysisisthesafestwayofmakingthedecision. Risk-AdjustedDiscountRate Weshallnowassumethatmanagementiswillingtodiscountdebtfowsusingtheborrowingrate,butwantstousea“risk-adjustedrate”forothercashfows.These“other”cashfowsinclude(1)depreciationtaxsavings(ortheequivalent)and(2)residualvalue. Example12.3 Assumethatboththeleasepaymentsanddebtpaymentswithbuy-borroware$36,190.Thefrmevaluatesinvestmentsusingarisk-adjustedrate (j) of0.20.Thetotalannualtaxdeductionwithleasingis$36,190,butwehavetobreakthatdowninto“interest”and“depreciation”.Forleasing,the“depreciation”equivalentisequaltothe“principal”portionoftheleasepayment.Usingthebefore-taxborrowingrateof0.10,weobtainapresentvalue(debtequivalent)ofleasepaymentsof$36 , 190B ( 3 , 0 . 10 ) = $36 , 190 ( 2 . 4869 ) = $90 , 000 .
November6,200913:44spi-b8119inx6inb811-ch12 238 AnIntroductiontoAccountingandManagerialFinance Theimplicitdebtamortizationschedulefortheleaseis: PeriodBeginningLiabilityInterest(0.10)PrincipalPayment 1$90 , 000$9 , 000$27 , 190262 , 8106 , 28029 , 910332 , 9003 , 29032 , 900 $90 , 000 Thetaxsavingsassociatedwiththeinvestment-likeaspectsoftheleaseare: PeriodLeaseOutlayInterest“Depreciation”orPrincipalTaxRate0.4CashFlow(taxsavings)PresetValueofTaxSavings( j = 0 . 20) 1$36 , 190$9 , 000$27 , 1900.4$10 , 876$9 , 063236 , 1906 , 28029 , 9100.411 , 9648 , 308336 , 1903 , 29032 , 9000.413 , 1607 , 616 $90 , 000 $36 , 000 $24 , 987 Forthebuyalternativeusingstraight-linedepreciation,wehave: PeriodBuyCashFlow(taxsavings)PresentValueofTaxSavings( j = 0 . 20) 1$30 , 000 × 0 . 4 = $12 , 000$10 , 000230 , 000 × 0 . 4 = 12 , 0008 , 333330 , 000 × 0 . 4 = 12 , 000 6 , 944 $36 , 000$25 , 277 Thedepreciationtaxsavingsofbuyarelargerthanthedepreciation-equivalenttaxsavingsofleasing.Sinceallotherthingsareequal,buyisbetterthanleasing.Thesedepreciationtaxsavingsaretheonlycashfowsforbothalternativesthatarenotdebttypesoffows,anditcanbearguedthatonlythesefowsandnotthefnancing-typefowsshouldbediscountedatarisk-adjustedrate.Inspectionofthetaxsavingnumbersrevealsthatatanypositiverateofinterest,thebuystream(evenwithzeroresidualvalue)istobepreferredtotheleasingstream.Adecreaseintheleasepaymentsfrom$36,190isnecessarytoincreasetherelativedesirabilityofleasecomparedtobuy-borrow.Using j = 0 . 20,theafter-taxpresentvaluecostofbuyingis$90 , 000 $25 , 277 = $64 , 723.
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 239 Ifwehadincorrectlyused j = 0 . 20todiscountalltheafter-taxcashfowsofleasing,wewouldhave ( 1 t c )L B ( 3 , 0 . 20 ) = ( 1 0 . 4 ) $36 , 190 ( 2 . 1065 ) = $45 , 741 . Thiscalculationindicatesthatleasinghasasmallernetcostthandoesbuying.Itisanincorrectcalculationbecauseitimplicitlyincludesthedebtcomponentintheleasecashfowsthatarebeingdiscountedat0.20.Ifweincludedthedebtfowsinthebuyanalysisanddiscountedat0.20,thenetcostwouldbe$45,451.Thecostisreduced,since0.10debtisbeingdiscountedat0.20. DebtCalculationsUsing0.20 PeriodInterest(1 0 . 4)InterestPrincipalPaymentAfter-TaxCashFlowsPresentValueUsing0.20 1$9,000$5 , 400$27 , 190$32 , 590$27 , 15826,2803 , 76829 , 91033 , 67823 , 38833,2901 , 97432 , 90034 , 87420 , 182 Presentvalueofoutlays = $70 , 728 Netpresentvalueofdebt = $90 , 000 $70 , 728 = $19 , 272 . Netcostofbuying = $64 , 723 $19 , 272 = $45 , 451orNetcostofbuying = $70 , 728 $25 , 277 = $45 , 451 , where$70,728isthepresentvalueofthedebtoutlays,andthe$25,277isthepresentvalueofthetaxsavingsfromdepreciation. ResidualValue Assumethat0.06isthecorrectinterestrateandthatthesamefactsapplyasearlierwhentheleasepaymentsare$35,555peryear,exceptthattheexpectedresidualvalueis$1,070ifthefrmbuys.Thepresentvalueofdepreciationtaxsavings$32,076plusthepresentvalueofresidualvalue($898)is$32,974forbuy-borrowusing0.06.Thisisequaltothepresentvalueofthetaxshieldofthenoninterestportionoftheleasepayments($31,396)plusthe$1,578ofsavingsbecausethepresentvalueofbefore-taxleasepayments($88,422)islessthanthepresentvalue
November6,200913:44spi-b8119inx6inb811-ch12 240 AnIntroductiontoAccountingandManagerialFinance ofdebtfowsofbuying($90,000).Figure12.3showsthatiftheappropriatediscountrateisgreaterthan0.06,leasingismoredesirablethanbuy-borrow.InsteadofplottingthepresentvalueofthenondebtfowsasinFigure12.3,wecouldplotthenetcostofthetwoalternativesasinFigure12.4.Withazerorateofdiscount,thenetcostofbuyingis$90 , 000 0 . 4 ( $90 , 000 ) $1 , 070 = $52 , 930 Present value of savings, Non-debt flows Net present value0.4(90,000) + 1,070 = 37,070 0.4(88,422) + 1,578 = 36,947 Buy-borrowLeasing$32,974Rate of discount 0.060 Fig.12.3. BuyversusLeasewith$1,070ofResidualValue(PresentValueofSavings). Net costCost of buying 00.06Rate of discount 57,026 52,93053,053Cost of leasingCost of leasing Cost of buying Fig.12.4. NetCosts(Residualvalue = $1 , 070).
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 241 andthenetcostofleasingis$88 , 422 0 . 4 ( $88 , 422 ) = $53 , 053 . Ifweuse0.06todiscountthetaxsavings,thenetcostofleasingis: PVoflease(beforetax) = $88,422PVoftaxsavings = 31,396 Netcostofleasing = $57,026 Thenetcostofbuyingwithresidualvalueof$1,070isalso$57,026using0.06:$90 , 000 $32 , 076 $898 = $57 , 026 . Withalowerinterestratethan0.06,buy-borrowismoredesirablethanleasing;andwithahigherinterestrate,leasingwins(hasalowercost).At0.06,thereisnodifference. TheIssues Wehaveillustratedaprocedurethatallowstheuseofanyrateofdiscountforcom-putingthepresentvalueofthetaxsavingsfromdepreciation(orthedepreciationequivalentofleasing)andthepresentvalueoftheresidualvalue.Someanalystswillwanttodiscountdepreciationtaxsavingsusingarisk-freeratesincethesecashfowsarenearlycertain.Otherswillprefertheafter-taxborrowingratesinceitavoidscertaintypesoferrorandisconsistentwiththeopportunitycostofnewdebtcapital.Finally,somewillprefertoincludeanadjustmentforriskincomputingthepresentvalueofdepreciationtaxsavingsandresidualvalue(orforoneofthem).Ifaninterestratelargerthantheafter-taxborrowingrateisused,caremustbetakentoplacethebuy-borrowanalysisonacomparablebasistotheleaseanalysis.Theleaseanalysistendstoincludedebtfows;andifahighinterestrateisused,thiscreatesabiasforleasing.Thesolutionrecommendedistocomputeadebtequivalentofleasingandanalyzeseparatelytheinvestmentcharacteristicsofleasingsothatleasingandbuyingarecomparable. ThreeDecisions Firmshavethreedecisionstomakebeforeanassetcanbeleased.First,thefrmhastodecidewhetherornottheprojectisworthwhile.Second,adecision
November6,200913:44spi-b8119inx6inb811-ch12 242 AnIntroductiontoAccountingandManagerialFinance hastobemadewhetherthefnancingshouldbedonewithstraightdebtorwithleasing.Third,thefrmmustconsiderusingequityratherthanleasingordebt.Wearenotconcernedwiththesequenceinwhichthedecisionsaremadeaslongasitisrecognizedthattherearethreedecisions.Forexample,itmightbedecidedthat,iftheprojectweretobeaccepted,buyingwouldbemoredesirablethanleasing,butitstillwouldnotbedesirabletoacquiretheproject.Thefnancingcaninfuencewhetherornottheprojectisdesirable.Forexample,abuyanalysismightleadtoarejectanalysis,butsincetheleasetermsaresofavorable,leasingmightcausetheprojecttobeacceptable.Acceptabilityimpliesthattheassetpassessometypeofriskandpresentvalueanalysis.Ifitisdecidedthatstraightdebtratherthanleasingisdesirable,itisstillpossiblethatthefrmwilldecidetousecommonstockorsomeothertypeoffnancing.Thebuyversusleasedecisionshouldbemadecomparingtheleasecontractwithstraightdebtfnancingsothatthetwoalternativesareascomparableaswecanmakethem.Butafterthatdecisionismade,itmaystillbecorrectforthefrmtorejectdebtinfavorofsomeothertypeoffnancing. Conclusion Leasingisanimportantfnancingmethod.Forfrmswithoutaccesstodebtmoney,itmaybetheonlywayofacquiringassets.Butformanypotentiallessees,theoptiontobuyisavailable,and,withreadyaccesstothedebt-capitalmarket,themostrelevantdecisionistocomparebuy-borrowandleasesinceleasecommitmentsmaybe,ineffect,debt-typeobligations.Furthermore,infocusingontheincrementalcashfowsofbuy-borrowandlease,theuseoftheafter-taxborrowingrateenablesustochoosetheformofthedebt.Theuseofaconventionalinvestmenthurdlerate( j )orWACCtodiscounttotalleasefowswiththeformula ( 1 t c )L B (n,j) isinerror.Manyfrmshavemadethewrongfnancingdecisionbynotfollowingtheseprinciples.Comparingbuy(withoutincludingdebtfows)withleasefowsusingahighdiscountrateandcashfowsof ( 1 t c )L createsaninherentbiastowardtheleasingalternative,andwesuspectthatthephenomenalgrowthrateinleasingis,inpart,theresultoffaultyanalysis.Therearenoeasyrulesofthumbtohelpdecidewhichalternativeispreferableevenwhentheintangiblesareignored.Calculatingandcomparingtheafter-taxcashfowsofthetwoalternativesandcomputingthepresentvalueswillprovideaguidelinewithrespecttothesefactorsifthecorrectdiscountrateandcorrectcashfowsareemployed.
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 243 ReviewProblems ReviewProblem12.1 AssumethattheACorporationcanobtaina10-yearnoncancellableleaseof$12,500peryearforanassetthatitwants.Theleasepaymentisdueattheendofeachyear.Theassetwillhavezerovalueattheendof10years.Theassetwouldcost$70,000ifpurchased.Itwillearngrosscashfowsof$13,500peryear.Corporatetaxesare0.35.Theassetftsinthe5-yearAcceleratedCostRecoverySystem(ACRS)classlife.Thecorporationcanborrowmoneyrepayableinequalinstallmentsatanafter-taxcostof0.07.Ithasaweightedaveragecostofcapitalof0.15.Assumethatthefrmhasdecidedtoacquiretheasset.Assumethatthefrmiswillingtousetheafter-taxborrowingrate.Thenettaxcostofbuyingis__________.Thenettaxcostofleasingis__________. PresentValueofDepreciationof$1,000,000ofAssetsUnderACRS (allthetablevalueshaveadecimalinfrontofthefrstdigit) ClassLife DiscountRate3Years5Years10Years15Years 019791569696189491949284860295900194061590213286428203939507912912858479806496049206458864368179337543580590238686111878022370720306884707836893745105664453078675828137017123606256070885098879148768178859022609834904770198653211557930108193097497846264665283851180418373020160140750129912789507711404577900476415137752636933535558254535081476143567601053507143237715748007659340515539412848167349626433094971363947641870996861304046339536239820686343584973433263334347
November6,200913:44spi-b8119inx6inb811-ch12 244 AnIntroductiontoAccountingandManagerialFinance SolutiontoReviewProblem12.1 Netcostofbuying = $70 , 000 0 . 35 ( $70 , 000 )( 0 . 813701 ) = 70 , 000 19 , 936 = $50 , 064Netcostofleasing = $12 , 500 ( 1 0 . 35 ) B ( 10 , 0 . 07 ) = $57 , 067 . QuestionsandProblems 1.Assumezerotaxes.Equipmentcanbeleasedat$10,000peryear(frstpaymentoneyearhence)fortenyearsorpurchasedatacostof$64,177.Thecompanyhasaweightedaveragecostofcapitalof15percent.Abankhasindicatedthatitwouldbewillingtomaketheloanof$64,177atacostof10percent.Shouldthecompanybuyorlease?Therearenouncertainties.Theequipmentwillbeusedfortenyears.Thereiszerosalvagevalue.2.(continue1)Ifthebankwaswillingtolendfundsat9percent,shouldthecompanybuyorlease?3.(continue2)Ifthecompanypays$64,177fortheequipment,itwillsave$10,000ayearonleasepaymentsfortenyears.Whatinternalrateofreturnwillitearnonits“investment”?4.(continue1)Nowassumeamarginaltaxrateof0.4.Assumethatthefundscanbeobtainedfor0.10atabank.Thecompanyusessum-of-the-years’digitsdepreciationfortaxes.Shouldthefrmbuyorlease?(Assumethatthepresentvalueofthedepreci-ationdeductionsis0.79997perdollarofdepreciableassetsusing0.06asthediscountrate.)5.(continue1)Nowassumeamarginaltaxrateof0.4andthataloancanbeobtainedfromthebankatacostof9percent.Shouldthefrmbuyorlease?Using0.054,thepresentvalueofdepreciationis0.811.Use0.054asthediscountrate.6.(continue5)Assumethattheleasepaymentsof$10,000startimmediatelyandthattheyarepaidattheendofeachyear.Thereare10payments.Computethepresentvalueofleasing;comparethepresentvaluewiththatobtainedforproblem5.7.Assumethatthereisa0.4marginaltaxrate.Anassetwithalifeofthreeyearscanbeboughtfor$25,313orleasedfor$10,000peryear.Fundscanbeborrowedatacostof0.09(paymentsof$10,000peryear).
November6,200913:44spi-b8119inx6inb811-ch12 BuyversusLease 245 a.Whatisthepresentvalueofthedebt(theliability)ifthefundsareborrowedatacostof9percent?Assumethatthepaymentstothebankare$10,000peryear.b.Whatisthepresentvalueoftheleasepaymentsof$10,000(theliability)?8.(continue5)a.Includetheborrowingcashfowsinthebuyanalysis.Assumeequalpay-mentsofdebt.Howdoesthischangethenetcost?b.Assumethatthenetcostofbuyingwascomputedusingthecostofcapitalof15percent.Nowincludetheborrowingcashfows.Howwillthischangethenetcostofbuying(youdonothavetocomputethepresentvalue)?9.Whatfactorsmightmakealessor’sexpectedcostofacquiringanddisposingofequipmentlessthanthelessee’sexpectedcost?10.Whyareleasingcompanies(lessors)sohighlylevered?11.Considerthefollowinginvestment: CashFlowsatTime 012InternalRateofReturn $1,000$576$57610% Ifdebtcanbeobtainedatacostof5percent,determinethenetpresentvalueoftheequitycashfowsdiscountedat15percentif:a.Nodebtisusedtofnancetheinvestment.b.$500ofdebtisusedtofnancetheinvestment.c.$900ofdebtisusedtofnancetheinvestment.d.Repeatthecalculationsusing5percentasthediscountrate.12.Supposethat$100,000isborrowedat8percentandistoberepaidinthreeequalannualinstallments.Prepareadebtamortizationtableandshowthatthenetpresentvalueoftheafter-taxcashfowsofthedebtiszerousingtheafter-taxcostofdebtasthediscountrate.Thetaxrateis40percent.13.MBIhasofferedtosellorleasecomputingequipmenttoCornellUniversitythathasanexpectedlifeofthreeyears.Ifpurchased,theinitialcostwouldbe$2million.Ifleased,theannualleasepaymentswouldbe$800,000peryear.Cornellcanborrowmoneyatabout7percentonitsendowmentandpaysnotaxes.Ignoringsalvagevalue,whatshouldCornelldo?
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November6,200913:44spi-b8119inx6inb811-ch13 Chapter13 PreferredStock PreferredStock:AHybrid Preferredstockisasecuritythat,similartodebt,promisesawell-defned(specifed)butnotnecessarilyconstantcontractualcashfow(dividend)totheholdersofthesecurity.Unlikedebt,itdoesnotcausethefrmtobesubjecttobankruptcyifthedividendsarenotpaid.Theterm preferredstock impliesthatthissecurityisinamorefavorablepositionthanthecommonstock.Thisconclusionisnotlikelytobevalidforanindividualinvestorpayingtaxesatahighrateondividends.Acorporateinvestormightlikepreferredstockbecauseofa70%“dividend-receiveddeduction”(intheUnitedStates,normallyonly0.30ofthedividendincomereceivedbyacorporationissubjecttotax).Thecorporatetaxsavingsassociatedwithinterestondebtmakeitdiffcultforpreferredstocktocompetewithdebtinthenonregulatedsectorofcorporateactivity.Also,thecapitalgainsandtaxdeferredpossibilitiesforindividualinvestorsofcommonstockgivecommonstocktaxadvantagesoverpreferredstockwithacontractualdividendandlittlechanceofcapitalgains.Preferredstockhashistoricallybeenimportanttoregulatedpublicutilities,anditislikelytobeapproximately10percentofatypicalpublicutility’scapitalstructure.Preferredstockisahybridformofcapital,possessingamixtureofdebtandcommonstockcharacteristics.Liketheinterestondebt,itsdividendsmaybefxedovertime.However,“participating”preferredstocksharesincomewithcommonstockaccordingtosomeprearrangedformula,andotherpreferredstockmaypayadividendthatislinkedtosomeindependentmeasuresuchastheyieldongov-ernmentbonds.Likecommonstock,preferredstockisgenerallytreatedasequitycapitalforcorporatetaxpurposes,soitsdividendsarepaidfromcorporateearningsthathavebeentaxed.Preferredstockgenerallyhasaperpetuallife,althoughitmayhaveafnitelife,anditmayhaveacallpricespecifedandevenasinkingfund 247
November6,200913:44spi-b8119inx6inb811-ch13 248 AnIntroductiontoAccountingandManagerialFinance wherestockistoberepurchasedbythefrmintheopenmarket.Itisimportanttotheissuingfrmandtotheinvestorthatnonpaymentofthepreferredstockdividenddoesnottriggerbankruptcy.Normally,commonstockdividendscannotbepaiduntilallpastduepreferreddividendshavebeenpaidorthepreferredstockholdershavebeencompensatedbysomeothermeans.Preferredstockdividendshavetobeapprovedbytheboardofdirectorsbeforetheybecomealegalliabilityofthecorporation.Preferredstockgenerallydoesnothavevotingrights,butifapreferredstockdividendispassedover,thepreferredstockholderssometimeshavetherighttoselectoneormoremembersoftheboardofdirectors.Althoughthedividendsonsomepreferredstockareallowedasataxdeduc-tion,currentlyintheUnitedStatesdividendsofpreferredstockarenotnormallydeductiblefortaxesbyacorporation(unliketheinterestpaymentofdebt).Thistendstolimittheuseofpreferredstockbycorporations.However,insomepartsoftheworld,preferredstockdividendsaretreatedinthesamemannerfortaxesasinterest;thus,inthosepartsoftheworld,thisdrawbackwouldnotapply.Itislogicaltohavesecuritiesthatbridgethegapbetweendebt,wherefailuretopayinterestresultsinbankruptcy,andcommonstock,wherethereisnostatedcom-mitmenttopaydividends.Fromtheinvestors’viewpoint,comparedtocommonstock,preferredstockreducessomewhattheamountofuncertaintyassociatedwithfuturedividendpayments. AccountingforPreferredStock Thepreferredstockisclassifedinthestockholders’equitysectionofthebalancesheet,althoughitshouldbeseparatedfromthecommonstockequity.Thepreferredstockwillgenerallyhaveaparvaluethatwilldeterminethecredittothepreferredstockaccount.Iftheamountcontributedbythepreferredstockholdersisgreaterorlessthanpar,thedifferenceshouldberecordedinacontraaccountoradjunctaccount. Example Recordthejournalentriesforthefollowingsituations:a.Onethousandsharesof5percent,cumulativepreferredstock,par$100,areissuedfor$100pershare.Cash.........................................100,000PreferredStock...........................100,000
November6,200913:44spi-b8119inx6inb811-ch13 PreferredStock 249 b.Assumetheabovestockisissuedat$110ashare.Cash.............................................110,000PreferredStock...............................100,000PreferredStock:AmountPaidinExcessofPar...10,000ThePreferredStock,AmountPaidinExcessofParaccountisanadjunctaccounttoPreferredStock;inthebalancesheet,itshouldbeaddedtoPreferredStock.Someaccountantshavearguedthatsuchamountsshouldbeaddedtothecommonstockholders’equitybecause,intheeventofliquidation,thepreferredstockholderswouldreceiveonlytheparamountoftheirshares.Thisargumentiscontrarytothebasicassumptionsofagoingconcern.Theaccountsshouldshowtheamountsinitiallypaidbythevariousclassesofshareholdersratherthanliquidationvalues.c.Assumetheabovestockisissuedfor$92pershare.Cash.............................................92,000PreferredStock,Discount..........................8,000PreferredStock...............................100,000Thediscountaccountisacontraaccount(asubtraction)toPreferredStock;inthebalancesheet,itshouldbesubtractedfromPreferredStock.d.Adividendof$5pershareisdeclaredonthepreferredstock.PreferredStockDividends..........................5,000DividendsPayable............................5,000Iftheinterestonbondsisnotpaid,thebondholdershavelegalrecourseandcancausethecorporationtobedeclaredinsolvent.Whendividendsonpreferredstockarenotpaid,however,thepreferredstockholdershavenosuchrecoursebecausethecorporationisnotlegallyrequiredtopaydividendsonpreferredstock.Ahistoryoffailuretopaydividendswillaffectthecorporation’sabilitytoraisecapitalthroughissuingpreferredstockinthefuture.Itcouldevenresultinthepreferredshareholdersreceivingrightstoelectmembersoftheboardofdirectors.Sincethereisnolegalliability,theaccountantmakesnoentryatthetimeapreferredstockdividendispassedover.Thisisconsistentwiththeassumptionthattheaccountingisbeingdoneforthecorporateentityratherthanforaparticulargroupofshareholders.However,thepreferredstockarrearageisofinteresttoallstockholders,andtheamountofarrearageshouldbedisclosedonthebalancesheet
November6,200913:44spi-b8119inx6inb811-ch13 250 AnIntroductiontoAccountingandManagerialFinance eitherinafootnoteorbytheseparationandidentifcationofpartoftheretainedearnings. MeasuringtheCostofPreferredStock Thecostofpreferredstockisdefnedasthediscountratethatequatesthefutureexpectedpreferreddividends(andcallpriceifcallable)tothepresentmarketprice.Let P denotethecurrentpriceofashareofpreferredstock, D theannualconstantdividendpayment,and k p thereturnrequiredbyinvestorsorcostofthepreferredstock.Thecurrentpriceofashare,ifnoncallable,maybedefnedintermsof D and k p .Thedividendisassumedtobeaperpetuitywithfrstpaymentoneyearfromnow: P = D k p . (13.1)Solvingfor k p ,weobtain k p = D P (13.2)undertheassumptionthattheissuingfrmexpectstopaythedividendforperpetuity.So,thecurrentcostofnoncallablepreferredstocktotheissuingcorporationisthestock’sdividendyield.Ifinterestratesandstockyieldsshouldfallaftersellinganewissueandtheissueisnotcallable,theissuingfrmisstuckwithperpetualfnancingatahighcost.Forexample,iftheinterestrateona$100preferredstockwere10percentattimeofissue(a$10peryearcashdividend)andifthemarketnowrequiresa0.08return,thestockwouldhavetoberepurchasedintheopenmarketfor P = 10 0 . 08 = $125ifthefrmwishedtoretiretheobligation.If,ontheotherhand,acallprovisionwerespecifedat,say,$110,thefrmcouldcallthe$10obligationperannumfor$110andreplaceitwitha$110parvalue,8-percentissuepayingonly$8.80perannumandissuedatpar.Thecompanyreplacesasecuritypromisingtopay$10.00ayearwithasecuritypaying$8.80ayear.Thisisasavingof$1.20peryear.The$110issuepriceofthe8-percentpreferredstockisenoughtoretirethecurrentlyoutstandingpreferredstock.Iftherewerenocallprovisionandthecompanypaid$125toretireashare,thenewsecurityissuedat$125withaparvalueof$125andpaying0.08wouldhaveanannualdividendof$10andthecompany’sfnancialpositionwouldnotimprove.
November6,200913:44spi-b8119inx6inb811-ch13 PreferredStock 251 Investorspreferthepreferredstocktobenoncallablesothatifinterestratesfall,thestock’svaluegoesup.Thus,investorswillrequireahigheryieldonthecallablepreferredstockissuethanonthenoncallableissue.Forexample,ifanoncallableissueissellingfor10percent,anotherwisecomparablecallableissuewouldhavetopromisetopaysomewhatmorethan10percentiftheinvestoristopaythesamepriceforbothissues.Intheexample,ifthe10-percentpreferredstockwerenoncallableandifthefallininterestratesto0.08occurredinthefrstyear,theinvestorwhosellswouldreceive$10ofdividendsand$25ofcapitalgainsforatotalreturnoninvestmentof35percent.Withthepreferredstockcallableat$110,therewouldbeonly$10ofcapitalgainsandthereturnoninvestmentwouldbe20percent. Example13.1 XYZCorporationhasdecidedtoissuepreferredstock.Thepreferredstockwillcarrya$10dividendandwillbesoldfor$105withacallpriceof$110.Thefrmexpectslowerinterestrates(say,8percent)inapproximatelytwoyearsandthereforeexpectstocalltheissueattime2.Wecansolvebytrialanderrorforthecostofthispreferredstockissueorequivalentlythereturnearnedbytheinvestor:$105 = 2 t = 1 $10 ( 1 + k p ) t + $110 ( 1 + k p ) 2 . Inthiscase, k p isapproximately12percentwhiletheone-perioddividendyieldof 10 105 isapproximately9.5percent.Thecallprovisionseemstomakethecostofthepreferredstockgreaterthanthedividendyield,butthisismisleading.Assumethatwithoutacallprovisionaftertwoyearsthestockpricegoesupto$125.Thetwo-periodeconomiccostis$105 = 2 t = 1 $10 ( 1 + k p ) t + $125 ( 1 + k p ) 2 . Solvingfor k p (bytrialanderror),wefndthatwithoutacallprovision k p isnow18.25percent.Inthisexample,thecallprovisionreducesthecostofthepreferredstockiftheissuepriceof$105isassumedtobeindependentofthecallprovision. FactorsAffectingtheCostofPreferredStock Preferredstockissimilartodebt,andthefactorsaffectingthecostofdebtarealsoimportanthere.Thereis,however,oneadditionalfactorthathastobediscussed:the
November6,200913:44spi-b8119inx6inb811-ch13 252 AnIntroductiontoAccountingandManagerialFinance dividend-receiveddeduction.Ifacorporationpurchasesequitycapital(preferredorcommonstock)ofanothercorporation,andifitownslessthan20percentofthevotingstock,70percentofthedividendsitreceivesonthatstockisnontaxableincomeforthereceivingcorporation.Ontheotherhand,allinterestthecorporationreceivesontaxabledebtsecuritiesheldistaxable.Insurancecompaniesinparticularfndthatthedividend-receiveddeduction,plustherelativepredictabilityofthedividendfow,makespreferredstockadesirableformofinvestment.Notasriskyascommonstockandofferingahighafter-taxyieldontheinvest-ment,asubstantialamountofpreferredstockisheldbyinsurancecompanies.Infact,thedemandforpreferredstockbythesecompaniesissogreatthatthebefore-taxyieldonpreferredstockissometimeslessthanthebefore-taxyieldonthedebtofthesameissuingfrm,despitethefactthatthepreferredstockisobviouslymoreriskyinsofarasthedebthasfrstclaimtoearningsandpriorclaimonassetsincaseofliquidation.Toexplainwhypreferredstockmayyieldlessthandebt,letusexaminetheafter-taxyieldofdebt.Theeffectiveafter-taxyieldondebtofacorporationbeingtaxedatarateof t c is ( 1 t c )k i .Theafter-taxcostofpreferredstockis (k p 0 . 30 k p t c ) = k p ( 1 0 . 30 t c ) (13.3)ifthepreferredstockyields k p beforetaxtotheholder.Ifbothdebtandpre-ferredstocksecuritiesyieldedthesamebefore-taxreturn,theafter-taxyieldonthepreferredstockwouldbegreaterthanthatonthedebtsince ( 1 t c ) islessthan ( 1 0 . 30 t c ) .Forexample,if t c = 0 . 35and$100ofinterestisreceived,theinvestingcorporationnets$65aftertax.If$100ofdividendsarereceived,thetaxis$10.50andthecorporationnets$89.50.Ifthepreferredstockisonlyslightlymoreriskythanthedebt,thenitcouldyieldlessthandebtbeforetaxandstillreturnenoughinexcessoftheyieldondebtaftertaxtocompensateacorporateinvestorfortheadditionalrisk. MergersandAcquisitions Preferredstockhasfrequentlybeenissuedinconnectionwithmergersandacqui-sitions.Oftenthepreferredstockisissuedwithaconversionfeature,sointhelongrunthereisaprobabilityitwillbecomecommonstockcapital.Preferredstockallowstheacquiredfrm’sownersapriorclaimrelativetocommonstockandrea-sonablydefnitedividendswhilesimultaneouslygivingtheacquiringfrmaformofleveragewithoutstrappingitwiththerigidobligationsofdebt.Thisprovidesajustifcationforthefactthatsomefrmsdoissuepreferredstock.However,onapureexplicitcostcomparisonwithdebt,preferredstocktendstobe
November6,200913:44spi-b8119inx6inb811-ch13 PreferredStock 253 inferior(haveahigherafter-taxcost).Afrmnotmakingsuffcienttaxableincometousethetaxshieldofthedebtmayhaveincentivetousepreferredstock,aswillafrmclosetoitsdebtcapacity. Variable-RatePreferredStock Sometreasurersofcorporationswouldliketoinvestinpreferredstockhavingbefore-taxyieldsaboutthesameas(orsomewhatlessthan)short-termdebtifsomeoftheriskofpreferredstockcanberemoved.Oneriskthatinvestorswouldliketoseeremovedistheriskthatthepriceofpreferredstockwillfallbecausethemarket’srequiredreturnhasgoneup.Variable-ratepreferredstocksisonemethodofinsuringthatthestockpricewillnotfall.Ratherthanpayingafxeddividend,thistypeofsecuritypaysadividendthatisafxedfractionofthehighestofasmanyasthreegovernmentbondyields(e.g.,theT-billrate,theU.S.Treasury10-yearconstantmaturityrate,andtheU.S.Treasury20-yearconstantmaturityrate).Theadvantageofavariable-ratepreferredstockisthatitsmarketpriceshouldalwaysbeclosetoitsfacevalue.Ifthepay-mentriskdoesnotchange,itwilldifferonlybecausethelinkagetotheU.S.Trea-surysecuritiesdoesnotperfectlyrefectthemarket’srequiredreturnonpreferredstock.Toprotecttheissuingfrmagainstverylargecashoutlaycommitments,amaxi-mumdividendrateisestablished.Toprotecttheinvestoragainstverylowdividends,aminimumdividendrateisestablished.Whilenotnecessarytothebasicconceptofthesecurity,theseprovisionsaregenerallypresent,butthelevelsofmaximumandminimumvarygreatly.Also,thedifferentialbetweenthemaximumofthethreeU.S.Treasuryreturnsandthepreferredstockdividendalsodiffersfromissuetoissue.Thesefactorsaresetbymarketconditions(supplyanddemand)forthisparticulartypeofsecurity. PreferredStockversusCommonStock Theprimaryadvantagetoaninvestorofholdingpreferredstockcomparedwithcommonstockisthatthepreferredstockreturnissomewhatmorepredictable(morecertain).Theissuingcompanywillgenerallymakearealefforttotrytoavoiddefaultingonthepreferredstockdividend.Sincethereturntopreferredstockisreasonablywelldefnedandsincethepreferredstockholdersprecedethecommonstockholders(thepreferreddividendsarepaidbeforethecommondiv-idends),preferredstockisapopulartypeofsecurityforexecutingmergersandacquisitions.
November6,200913:44spi-b8119inx6inb811-ch13 254 AnIntroductiontoAccountingandManagerialFinance Fromthepointofviewofanissuingcorporation’scommonstockholders,preferredstockofferstheopportunitytointroduceaformofleverage(thepre-ferredstockholdersgenerallyhaveamaximumdividendreturn)thatcouldbeneftthecommonstockholdersifthecorporationdoesverywellinthefuture.Thepre-ferredstockholdersdonotnormallyparticipateinanybonanzathatmightoccursincetheirdividendrateiseitherfxedor,ifvariable,generallyhasasetmaximum.Itiswrongtoassumethatpreferredstockfllsauniquedemandforaninvest-mentsecurityinthemarketthatothersecuritiescannotfll.Dividendsfromcommonstockareaseligibleforthedividend-receiveddeductionavailabletocorporateinvestorsaspreferredstock.Second,aportfolioofafrm’sdebtandcommonstockcanbeconstructedtohaveareturnthatbehavescloselytothereturnonpreferredstock.Althoughpreferredstockmayappeartoacorporateissuertobemoredesirablethancommonstockbecauseofitsfnancialleveragecharacteris-tics,thisadvantageislikelytobeillusory.Withthepresenttaxlaw,preferredstockhasnospecialattributesforwhichaneffcientmarketwouldbewillingtopayapremium;thus,itscostisnotlikelytobecheaperthanotherformsoffnancing.Ifthetypesofrisksassociatedwithaninvestmentincommonstockandpre-ferredstockpurchasedindividually(notamixture)arewhatthemarketdesiresandiftherisksandreturnscouldnotbeexactlyduplicatedinanyotherway,thenitwouldbepossibleforafrmwithpreferredstockoutstandingtosellatapremium.Asatheoreticalaswellasapracticalmatter,itisunlikelythattheinvestorsneedthepreferredstocktoaccomplishtheirinvestmentobjectives.Ifanexplanationistobefoundfortheissuanceofpreferredstock,itislikelytobefoundininstitutionalconsiderations.Theissuingcorporationdoesnothaveataxshieldwitheitherpreferredstockorcommonstock,sothereisnoadvantageforthecorporationissuingpreferredstocktobefoundinthetaxlaws.Thecommonstockcangiverisetoretainedearnings(deferringtaxestotheinvestor)andtheprospectofcapitalgainsfromtheseretainedearnings.Thepreferredstockdoesnotofferthesepossibilities;thus,itisatadisadvantage.Forzero-taxinvestors,neitherpreferredstocknorcommonstockhasanyspecifcadvantagefortheinvestor.Debtislikelytobemoredesirablethaneithersecuritybecauseofthetaxshieldprovidedtotheissuerbytheinterestexpense.Witharegulatedpublicutility,preferredstockofferstheinvestorsomeprotec-tionagainstarbitraryactionsbytheregulatorycommissioninregardtothereturntobeallowedoncommonstockequity.Thepreferredstockdividendiscontrac-tual,whereasthecommonstockdividendisacombinedresultofthejudgmentsandactionsoftheregulatorycommissionandthecorporation’sboardofdirectors.
November6,200913:44spi-b8119inx6inb811-ch13 PreferredStock 255 Inthecaseofzero-taxinvestors,itwouldbediffculttoarguethatpreferredstockisinferiortocommonstock.Wecouldstillarguethatpreferredstockisinferiortodebt. ConvertibleExchangeablePreferredStock Letusassumethatacorporationisoperatingatalevelthatleadstozerotaxes.Therearenocurrenttaxbeneftsassociatedwiththeissuanceofdebt.Ifexchangeable(intodebtattheoptionoftheissuingfrm)preferredstockcanbeissuedatalowerbefore-taxyieldthandebt,itwillhavealowercostthandebt.Butwhatifthecorporationstartsearningsuffcientincometostartpayingtaxes?Thecorporationwouldthenprefertohaveoutstandingdebtratherthanpreferredstock.The“exchangeable”featureofthesecurityallowsthecorporationtoforcetheinvestorstoacceptdebtforthepreferredstock.Ifboththepreferredstockanddebtcost0.15beforetax,witha0.35taxrate,theafter-taxcostofdebtbecomes0.0975.Thisisasignifcantsavingcomparedwiththe0.15costofthepreferredstock.Thecorporateinvestorthatpurchasedthepreferredstockwithits70percentdividend-receiveddeductionwillnotbepleasedwiththeforcedexchangeintoadebenture.Thecorporateinvestorcansell,convertintocommonstock,ormerelyaccepttheexchange.Theinterestrateonthebondislikelytobeatleastaslargeasthepreferredstockdividend,andwillbesomewhatsafer.Zero-taxedinvestors,suchaspensionfunds,arelikelytofndthedebenturesofmorevaluethanwillacorporationtaxedatamarginalrateof0.35.Thefactthatthesecurityisexchangeableattheoptionoftheissuingcorporationreducestheexpectedoverallcosttothatcorporation,butitdoesdecreasetheattractivenessofthesecuritytothenormallytaxedcorporateinvestor.Theindividualinvestororthezero-taxedinstitutionalinvestorwouldwelcometheexchange,sincethebondinterestissaferthanthepreferredstockdividend.Theinvestorcannotinitiatetheexchangeandthushastowaituntilthecorporateissuerfndsitadvantageoustoforcetheexchange.Theconversionfeatureisvaluabletotheinvestorsincetheinvestorcanconvertintocommonstockatanytime.Ifthepreferredstock’sconversionvalueis$1,900atthetimeofmaturity,andthecashvalueifredeemedis$1,000,thevalueoftheconversionrightatthattimewillhaveavalueofapproximately$900.Iftheissuingcorporationcancallthebondpriortomaturity,thevalueoftheconversionfeaturemaybecutoffbeforeitreaches$900,butitislikelytohavesomepositivevalue.Theinvestorisnotlikelytooptforconversionpriortocallormaturityunlessthecommonstockdividendexceedsthepreferredstockdividendorthedebenture
November6,200913:44spi-b8119inx6inb811-ch13 256 AnIntroductiontoAccountingandManagerialFinance interest(therelativesafetytothedebentureinterestandprincipalshouldalsobeconsidered),andeventhentherearestrongreasons(riskavoidance)fornotconverting.Thecorporationislikelytocalltheconvertiblesecurityifitcancallandiftheconversionvalueexceedsthecallprice.Thecorporationcanmovethesecurityfrombeingpreferredstocktobeingadebenture(desirableifthecorporationchangesfromhavingzerotaxableincometoneedingtaxdeductions).Itcanalsocallthesecurityiftheconversionvalueislargerthanthecallpriceandchangethesecurityintocommonstock.Theconvertibleexchangeablepreferredstockisasensiblesecurity,andwewouldexpectthecorporateandpersonaltaxlawsaswrittentoencourageavari-etyofsecurities.Aslongasthetaxlawdistinguishesbetweensecuritiesthatareessentiallythesame,wecanexpectcorporatefnancialoffcerstotrytoexploitthisfact. PrivateEquity Privateequityfrmsfnditconvenienttousepreferredstocktoincreasethereturnearnedonthecommonstockofaninvestment.Assumethatwithaninvestmentof$1,000,000(commonstock)aprivateequityfrmwillearn$1,200,000attime1.A20%returnisnotadequateandithasreacheditsdebtcapacity.However,itcanissue$500,000ofpreferredstockpaying0.10.Theprojectedcashfowsare: 01IRR BasicInvestment $1,000,000 + $1,200,0000.20PreferredStock + $500,000 $550,000 0.10 CommonStock $500,000 + $650,0000.30Withtheuseofthepreferredstock,theexpectedreturnoncommonstockisincreasedfrom0.20to0.30.If0.30isnotasuffcientlyhighreturn,alargeramountofpreferredstockcouldbeconsidered. PreferredStockasanInvestment Corporationshavethedividend-receiveddeductionasanincentiveforthemtoinvestinpreferredstock.Individualsandzero-taxedinvestorsdonothavethatincentive,andnormallytendtonotholdstraightpreferredstockintheirportfolios.Straightdebtwithitstaxdeductibilityforinterestatthecorporateissuerlevelis
November6,200913:44spi-b8119inx6inb811-ch13 PreferredStock 257 apttobelowercosttotheissuingcorporationandshouldhaveabetterrisk-returnrelationshipforthenoncorporateinvestorthanpreferredstock.Unlessthetaxlawsarechanged,preferredstocktendstobedominatedforthenoncorporateinvestorbystraightdebtandbycommonstock.Achangeinthetaxlawscouldchangethisconclusion. Conclusion Itisnotatallobviousthatafrm’scommonstockholdersbeneftfromtheissuanceofpreferredstockoverotherfnancialinstruments,iftheissuingfrmispayingincometaxes.Likedebt,preferredstockprovidesleveragethatislikelytoincreasetherateofreturnoncommonstockinvestmentaswellasincreasetheriskinessofthatreturn.Butbecausedebtalsoprovidesleverageatalowerafter-taxcost,unlessthefrmdoesnotwishtoruntheriskassociatedwithdebt,hasreacheditsinstitutionallyacceptabledebtceiling,ordoesnothavetaxableincome,thestockholderswouldbebetteroffwiththeissuanceofdebttoachievefnancialleverage,assumingthefrmdoeshavedebtcapacity.Taxconsiderationsplayanimportantroleinthefnancingdecision.Sinceallearningsbeforeinterestandtaxesareavailabletopayinterestondebt,andtaxesmustbepaidpriortopayinganyincomeoutaspreferreddividends,thetaxsavingsfromdebtcanbeusedtoretirethedebt,whilealower-yieldingpreferredstock’sdividendcancontinueasaclaimperpetually.Thus,inasensefromalong-runperspective,preferredstockismorerisky.Ifdebtcapacityisavailable,debthastaxadvantagescomparedtopreferredstock.Ifthefrmdoesnotwishtoissuedebt(orcannotissuedebtbecauseofinstitutionalbarriersorrestrictivecovenantsinitsexistingdebtinstruments),thenthechoiceofwhethertoissuepreferredstockorcommonstockisrelevantandtherisksandreturnsofeachalternativemustbeweighed. QuestionsandProblems Forallproblems,assumethereisa70percentdividend-receiveddeductionforacorporateinvestor(30percentofthedividendistaxed).Thecorporatetaxrateis40percent.1.Assumethatthereisacorporateinvestorwantingtoinvest$10millioninyourfrm.Debtorpreferredstockcanbeissuedatacostof0.10.Thefrmneeds$10millionofcapital.Assumea0.4corporatetaxrate.a.Onastraightcashfowbasis,shouldafrmissuedebtorpreferredstock?
November6,200913:44spi-b8119inx6inb811-ch13 258 AnIntroductiontoAccountingandManagerialFinance b.If$1millionofearningsbeforeinterestandtaxes(EBIT)isavailable,onacashfowbasis,aretheinvestingfrmsbetteroffwithdebtorpreferredstock?c.Whatamountdoesthefrmhavetoearntopay$1millionofinterest?Topay$1millionofpreferredstockdividends?d.Whatisthebefore-taxpercentagecostof0.10debt?Of0.10preferredstock?e.Whatistheafter-taxcostofeach?f.Whatdoesaninvestmenthavetoearn aftertax tobefnancedbydebt?Bypreferredstock?Assumeabreak-evenobjectiveforthefrm.2.Howmuchdoesacorporateinvestornetout(aftertax)from$100ofinterest?From$100ofpreferredstockdividends?3.Whataretheriskstoacorporateinvestorbuyingpreferredstock?4.Ifcallablepreferredstockisissuedatapriceof$100andpromisestopay$9perannum,whatisthecost(asapercentage)oftheissueaftertaxtotheissuingfrmifthecallprovisionisexpectedtobeexercisedtwoyearsfromnowatapriceof$105?5.Acorporationhasearned$100(beforetax)andispayingtheafter-taxresidualtoitsstockholders.Assume k i = k p = 0 . 10 . Thetaxrateonallsecuritiesis0.4,butthereisa0.70dividend-receiveddeduc-tionforcorporationsinvestinginstock.Toacorporatestockholder,whatistheafter-taxdollarreturnifthesecurityisadebt?Apreferredstock?Acommonstock?6.Assumea0.4taxrate.Topay0.10,acompanymustearnwhatpercentagereturn(beforetax)ifthesecurityis:a.Debt?b.Preferredstock?c.Commonstock?7.Describetheeconomicconsequencesofacorporationissuing0.08debttofnanceaninvestmentof$1millionin0.08preferredstock.Thecorporatetaxrateis0.4.
November6,200913:44spi-b8119inx6inb811-ch14 Chapter14 ManagerialPerformance Thischapterwillevaluatedifferentquantitativefnancialmeasuresofperformanceincludingreturnoninvestmentandeconomicincome.Theargumentsofthischap-terareapplicabletoentirefrms,self-containedoperatingcomponentsofafrm,orcomponentsthatarenotself-containedbutinwhichthereisareasonabletransferpricingprocedure.Tocomputeanyquantitativeperformancemeasurementofanoperatingunit,itisnecessarytoarriveatreasonableincomeandinvestmentmea-suresfortheunit.Thereareafewshortcutsinundertakinganintelligentanalysisoffnancialstatements.Aknowledgeofaccountingtheoryandpracticeisdesirabletoensureasoundinterpretation.Equallyimportantisthefactthattheanalysisshouldbedetailedandvaried.Therearevarioustoolsofanalysisthatarehelpfulwhenusedintelligently.Butnotoolofanalysisisbetterthantheinformationonwhichitisbased.Thisisnotanareainwhichonewillfndexactanswers;often,theanalysiswillraiseadditionalquestions.Also,itshouldbenotedthatfnancialanalysisbasedonpub-lishedaccountingdatatendstobeashort-runanalysis.Thelong-runwell-beingofthefrmisrelatedtofutureconditions,competitiveenvironment,technology,andotheritemsthattheaccountantdoesnotmeasure(suchasthecaliberoftheyoungerexecutivesofthefrm).Thefnancialanalysisdiscussedinthischapterisahistoricalapproachbasedonpastevents,notforecastsofthefuture.Accountantsfollowwell-defnedrulesofthegame(whichwehavecalled“GenerallyAcceptedAccountingPrinciples”)inpreparingpublishedfnancialstatements.Theserulesandthecontextsinwhichtheyaresetmustfrstbeunderstoodifaccountingreportsaretobeproperlyused.Oneofthemostimportantandmostdiffculttasksofanadministratoristomeasuretheperformanceofsubordinates.Sometimesameasureisusefulforonepurpose,butnotforanother.Thefactthatagolfdrivewent250yardsisusefulinjudgingtheforcewithwhichtheballwashit,butknowledgeofthetotaldistancecoveredisnotusefulinjudgingwhetherthedrivewasgoodorbad.Weneed 259
November6,200913:44spi-b8119inx6inb811-ch14 260 AnIntroductiontoAccountingandManagerialFinance informationrelatingtothelocationanddistanceoftheholebeforewecanmakethattypeofdecision.Howdowemeasuretheperformanceofamemberofmanagement?Thefrststepistoestablishobjectives.Thesecondstepistoseehowwelltheseobjectivesaremet.Weshallassumethataprimeobjectiveofthefrmistomaximizeprofts;fromtheaccountant’spointofview,thisisanimportantconsideration.Otherobjectivessuchasmaintainingcontinuityofexistencewillnotbeconsidered.Theextentofsuccessinattainingobjectivesmaybeassessedquantitativelyorqualitatively.Thequalitativecriterionwillincludethingssuchasrelationswithsuperiorsandsubordinates,trainingofsubordinates,professionalattainments,civicactivities,andabilitytogetthingsdone.Thequalitativefactorsarerelevantinjudgingperformance,butaremoretheprovinceoftheindustrialpsychologistthanoftheaccountantorthefnancialmanager. PerformanceMeasurementandManagerialCompensation Measuringmanagerialperformanceforpraiseorcompensationdeterminationisadiffculttask.Anymeasureusedissubjecttovalidobjections.Itisdesirablethattherebecongruencebetweenthefrm’sgoalsandthemeasuresthatareused.Onecannotexpectmanagerstoconsciouslytakeactionsthataredesirableforthefrmifthoseactionswilladverselyaffecttheircareerpathorcompensation.Myrecommendationistouseseveralmeasures.Sinceallmeasureswillbesubjecttosomesortofgamingbymanagement,theuseofseveralgoodmeasuresreducesthelikelihoodthatmanagerswillconsciouslymakeundesirabledecisions.Wewillreviewfourbasicmeasuresthatcanbeused:1.Accountingmeasures(e.g.,incomereturnoninvestment,economicincome,etc.).2.Marketmeasures(thereturnearnedonaninvestmentinthecompany’scommonstock).3.Non-accountingbutquantitativemeasures(e.g.,customerandemployeesatis-faction).4.Qualitativemeasures(subjectiveevaluations). AccountingMeasures Theaccountingmeasureswewillconsiderare:1.Salesrevenue.2.Operatingmargins:percentagesordollaramounts.
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 261 3.Income.4.Returnoninvestmentorreturnonequityorreturnonassets.5.Economicincome(residualincomeoreconomicvalueadded).6.Earningspershare(foraperiodofyears).Salesrevenueisanattractiveaccountingmeasuresincetherearerelativelyfewargumentsastothemagnitude.Addmeasuresoftheshareofmarketandgrowthinsales,andonecanbecomeenthusiasticabouttheusefulnessofthesalesmeasures.Butweshouldalsoconsiderproftability.Theoperatingmarginisapopularproftabilitymeasure:subtractfromsalesrevenuethedirectcostsofgeneratingtherevenue.Forexample,theoperatingmarginofaretailstoreissalesminusthecostofthemerchandisesold.Withamanufacturer,thedefnitionoftheexpensestobesubtractedtocomputethemarginisnotasexactasforaretailer.Ifsalesare$100andthecostofgoodssoldis$60,theoperatingmargincanbeexpressedasadollaramount,$40,orasapercentage,40%.Operatingmarginsasacontrolmechanismareveryuseful.Ifoperatingmarginsaremaintained,itislikelythatapositivebottomline(income)willresult.Ontheotherhand,manyexpenses(includingcapitalcosts)areomittedfromthecalculation.Thus,theoperatingmargincanonlybeoneofseveralmeasuresthatareused.IncomeisrevenueminusexpensesasdefnedbyGenerallyAcceptedAccount-ingPrinciples.Unliketheoperatingmargin,itincludesthefxedexpensesaswellasthevariableexpenses.Theprimaryareawheretheincomemeasureisdefcientistheexpenseoftheequitycapitalused.Theimplicitcostoftheequitycapitalusedisnormallynotdeductedincomputingtheincome.Itisessentialthatthecostsofthecapitalusedaffecttheperformancemeasures.Thetwocommonmeasuresarereturnoninvestmentinsomeformandeconomicincome.Economicincomedeservestobeusedmoreextensively(itsuseisgrowingrapidly). ReturnonInvestment(ROI) Advocatingtheuseof returnoninvestment (ROI)impliesthatitisabettermea-sureofperformancethanisobtainedfromusingjusttheincomeoftheoperat-ingunit.Whilethisisnormallythesituation,notallsubsidiaryoperatingunitsshouldbejudgedusingROI,andROIshouldalwaysbeonlyoneofseveralmea-sures.Formanyoperatingunits,marketingeffortsarenotautonomous,anditismoreappropriatetousecostminimizationratherthanproftmaximization(oritsnear-equivalent,maximizationofROI,subjecttoconstraints).
November6,200913:44spi-b8119inx6inb811-ch14 262 AnIntroductiontoAccountingandManagerialFinance ItshouldberealizedthatROIisnotnecessarilythebestmeasureofperfor-mance,butthatROIcanbeausefulmeasure.ConsiderwhatagoodROImeasurecanaccomplish.Wehavefrstameasureofincome;butbeforeconcludingthattheincomelevelissatisfactory,werelatetheincometotheamountofassetsusedtoearntheincome.While$1millionofearningsmaybetermedtobeverygood,ifyouaretoldthattheoperatingunitused$100millionofcapitaltoearnthe$1mil-lion,yourconclusionmightwellshiftfromgoodtobad.Toevaluateperformance,itisnecessarytoconsidertheamountofassetsusedinearningtheincome.Thus,theuseofROIhasadvantagesovertheuseofincomeonly.InsteadofROI,somefrmsusethe returnonequity (ROE).Whilethetwomeasureshavecomparableuses,theROEmeasurehasseverallimitations:a.Itisaffectedbycapitalstructure(whichmaynotbecontrollablebytheman-agementbeingmeasured).b.Itadverselyaffectscertaintypesofdecisions(investmentanddivestment)becauseitisapercentage.c.Equityinvestmentcreatesbiasesunlesstheanalystdistinguishesbetweeninvest-mentsintheequityofasubsidiaryandinvestmentsinrealassets.Thesecondlimitation(b)appliesequallytoROIasitdoestoROE.OthertermscommonlyusedinsteadofROIare returnonnetassetsemployed (RONAE), returnonfundsemployed (ROFE), returnoncapitalapplied (ROCA),and returnonassets (ROA). ComponentsofROI Forsomepurposes,itisusefultobreakROIintotwocomponents(thisissometimesreferredtoastheDuPontformulation):ROI = Income Assets = Income Sales × Sales Assets , whereincomeismeasuredafterinterestandtaxes.Thetermsales/assetsmeasuresthedegreeofassetutilization.Thetermincome/salesmeasuresproftability.Theproductofthetwotermsgivesthereturnoninvestment.TheprimarycontributionofROI(orROE)isthatmanagementisheldresponsi-bleforthecapitalused.However,returnoninvestmentmaybeusedinasomewhat
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 263 fawedmanner(mayadverselyaffectcertaintypesofinvestmentorassetretentiondecisions). ValuationofAssets Importantvaluationproblemsariseintheareasofintangibles,inventories,invest-ments,andfxedassets.Theseproblemsmustberecognizedbytheanalystinusingaccountingdata.Theproblemofvaluingintangiblesmaybeavoidediftheanalystsubtractsthemfromtheassettotal(intangiblesmaybeconsideredaresidual,valuedbyearningpowerinexcessofwhatwouldnormallybeexpectedfromthetangibleassets).Thisproceduresubstitutestheproblemofvaluationofthecorporateentityfortheproblemofspecifcassetvaluation.Itisdiffculttomeasureeitherthecostoftheintangiblesortheirvalue.Theanalysthasseveralchoicesinthevaluationoffxedassets,includingfndingthecurrentmarketvaluesoftheseassetsordeterminingtheiroriginalorreplace-mentcostsandtheextenttowhichtheirusefulliveshaveexpired.Themeasuresmaydiffergreatly.Usuallytheanalystwillacceptthereported(book)amounts,althoughtheinformationgivenonthebalancesheetmayhavenorelationshiptothecurrentmarketvaluesortotheoriginalcostortothecurrentreplacementcostsoftheseassets.Thesecommentsabouttheassetmeasuresonthebalancesheetmayseemtobeindirectcriticismsofcurrentfnancialreportingpractices.Theaccountingprofes-sion,theFASB,andtheSEChaveimprovedaccountingandreportingpractices,butfnancialstatementspreparedtoservetheusesofmanyvariedgroupscannotalwaysprovidetheinformationrequiredforparticulardecisionsofaspecializednature.Therecommendeduseoffairvaluehasreducedthepastcriticismsoftheuseofhistoricalcostmeasures. TheIncomeStatement Itmaybereassuringtoreadthatashareofstockearnedexactly$3.12fortheyear.Thisisapositiveandclear-cutstatement,althoughitmaybemisleading.Themeasurementoftheincomeofanenterpriseforashortperiodoftimeisadiffcultprocess.Theshorterthetimeperiod,themorediffcultthemeasurement.Oneofthemaindiffcultiesistheinclusionorexclusionofitemsthatareessentiallyadjustmentsofprioryears’incomesandnotrevenuesofthisperiodorexpensesofgainingtherevenuesofthisperiod.Theinclusionofanitemofthisnature,whenlarge,candistortthemeasurementoftheperiod’soperatingincomeoranestimateofthenextperiod’sincome.
November6,200913:44spi-b8119inx6inb811-ch14 264 AnIntroductiontoAccountingandManagerialFinance ROIandInvestmentDecisionMaking TheuseofROItoevaluateperformancecanaffectinvestmentdecisionsbecausethemanagerknowsthatafteracceptinganinvestmentitsoperationswillaffecttheperformancemeasurement.Thisleadstoanincentiveforthedivisional(orothersubcomponent)managertorejectinvestmentsthatyieldalowerreturnoninvestmentthanisbeingearnedonthecurrentlyownedassets,eventhoughtheincrementalinvestmentsareattractiveforthefrm.Topmanagementshouldbeconcernednotonlywiththereturnoninvestmentoftheassetsbeingused,butalsowiththegrowthinassetsandincome. Growth aswellasreturnoninvestmentisimportant.Astaticdivisionearninga30-percentROImaywellbeevaluatedasbeingbadlymanaged,whereasitmaybeconcludedthatadivisionthatisgrowingandearning15percentiswellmanaged.TheinvestmentdecisionproblemresultingfromadesiretomaintainahighROIhighlightsthenecessityofnotrelyingononeperformancemeasure(ROIorsomethingelse),butratherbringinginsuffcientmeasurestorestraintheimpulseofpersonstryingtocircumventthecontrol-evaluationsystem.AnydefenseofROIshouldbebasedonadesiretouseitasonemethodofevaluatingtheperformanceofinvestments,notsothatitmaybeusedtoevaluatethedesirabilityofunder-takinginvestments.ROIisnotanacceptablemethodofevaluatingprospectiveinvestments. TheCaseoftheResourceBeneftingtheFuture Measuresofperformanceusedinanincorrectmannerwilltendtoleadtoincorrectconclusions.Thereisanecessitytoimprovethemeasuresandtousethemintelli-gently.Considerthecaseofadivisionmanagerofatimbercompanywhohastheopportunitytoinvestin500,000acresofprimetimberland.Thecatchisthatthetreesonthelandareallseedlingsandtheywillnotmaturefor30years.Itisagreedbytheplanninggroupthatthelandisagoodinvestment.However,themanager’sperformanceismeasuredusingreturnoninvestment.Themanagerknowsthatthelandwillincreasethedenominator(investment)now,butitwillbe30yearsbeforethenumerator(income)isalsoincreased.Sincethedivisionmanageronlyhasfveyearstogobeforeretirement,theinvestmentinlandisrejected.Thiscasehasareasonablesolution.Thelandshouldbeexcludedfromtheinvestmentbaseinmeasuringperformanceunlessthevalueincrementisallowedtoaffecttheincome.Unlesssomethinglikethisisdone,therewillbeadistortionintheinvestmentperformanceanalysis,andthusdistortionintheinvestmentdecision-makingcriteriaapplied.
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 265 Nowconsideraplantbeingbuiltwithexcesscapacitytoservicetheexpecteddemandofyear2030.Isthenormalperformancemeasurementschemecapableoftakingthissituationintoconsideration?Probablyitisnot.GenerallyAcceptedAccountingPrinciplesdonotdoagoodjobofassigningexpensesthroughtime. TheComputationofIncomeandROI Itiswidelyknownthatstraight-linedepreciationoraccelerateddepreciation,exceptinverywell-defnedandspecifcsituations,willdistortmeasuresofROI.Also,theROIthatresultsforeachyearwilldifferfromtheinternalrateofreturncomputedatthetimeofacquisition,evenwhentheexpectedresultsarerealized.Defnetheoreticaldepreciation(thisisnottheaccountingdepreciation)tobe thedecreaseinvalueoftheinvestmentduringthetimeperiod .Althoughthedefnitionbecomesmorecomplexifthereareadditionalinvestmentsmadeduringtheperiod,thetheorycanbeusedtocomputetheincomethatisusedintheROIcalculations.Thefollowingexampleisusedasavehicletoshowthatreturnoninvestment,whenproperlycalculated,givesusefulperformancemeasurementinformation.Assumethenetcashfows(andnetrevenues)associatedwithaninvestmentcosting$3,000attimezeroare: TimeCashFlow 1$1,30021,20031,100 Thefrmusesstraight-linedepreciationandhasatimevalueofmoneyof10percent.Thisinvestmenthasayield(internalrateofreturn)of10percent.Therearezerotaxes.Exhibit14.1showstheincomeandinvestmentsforeachofthethreeyearsofuse.Thefactthateachyearhasidenticalreturnsoninvestmentequaltotheinternalrateofreturnoftheinvestmentseemstobeacoincidence.However,ifweinspectExhibit14.2,whichshowsthepresentvalueoftheinvestmentatthreemomentsintime( V i isthevalueattime i ),weseethatineachperiodthedecreaseinvalueis$1,000(thevalueof V 3 iszero),andthatinthisveryspecialsituationtheuseofstraight-linedepreciationiscorrect(ifthecashfowsaredifferent,thedepreciationschedulewouldbedifferent).Thepresentvalueattime0is$3,000;attime1,$2,000;andattime2,$1,000.
November6,200913:44spi-b8119inx6inb811-ch14 266 AnIntroductiontoAccountingandManagerialFinance Exhibit14.1. EqualROIs. CashFlowsInvestmentattheROIIncomeorNetBeginningofDividedbyYearRevenuesDepreciationIncomethePeriodInvestment 1$1,300$1,000$300$3,0000.1021,2001,0002002,0000.1031,1001,0001001,0000.10 Exhibit14.2. ThePresentValues. Period1Period2Period3PresentTime0PresentTime1PresentTime2ValuePresentValuePresentValuePresentTimeFlowsFactorsValuesFactorsValuesFactorsValue 1$1,3000.9091$1,18221,2000.82649920.9091$1,09131,1000.7513826 0.8264909 0.9091$1,000 V 0 = $3 , 000 V 1 = $2 , 000 V 2 = $1 , 000 Defnedepreciationexpensetobethechangeineconomicvalue.Theprocedureworkswithanysetofcashfows.ThereneednotbedistortioninROIbecauseofthemethodofdepreciation.Inthissimplifedexample,theinternalrateofreturnontheinvestmentisequaltothefrm’stimevalueofmoney,andthecashfowsofeachperiodequalthenetrevenues.Differentassumptionswouldaddtothecomplexityofthecalculations,butthesecomplicationscanbesolved. TheEconomicIncomeMethod Somemanagerscallthismethodthe residualincomemethod andotherscallit economicvalueadded orEVA.Themaincharacteristicofthemethodisthatinterestonequityisdeductedfromincometoobtainthenetincome.Thisprocedureisveryusefulifweproperlydefneincomeandinvestment,ifthecorrectinterestrateisused,andifinterestisappropriatelyassignedtotimeperiods.Unfortunately,theaboverequirementsmaynotbefulflledinamannerthatwillgivetheoreticallysound(anduseful)resultsifoneusesconventionalaccountinginasituationwherethebeneftsareincreasingthroughtime.Usingthepreviousexample,weillustrateanapplicationoftheeconomicincomemethod.
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 267 Defneeconomicincomeasnetrevenuelessacapitalconsumptionexpense(depreciation)andtheinterestcostoftheinvestment.ContinuingtheROIexample,theexpectedeconomicincomesforthethreeyearsare: Year1Year2Year3 Revenues$1,300 $1,200 $1,100 Depreciation$1,000$1,000$1,000InterestCost300 200 100 EconomicIncome$0$0$0 Notethatiftheinternalrateofreturnisusedastheinterestrate(thebasisofcomputingtheinterestcost),theeconomicincomesareequaltozero.Zeroeconomicincomeisnotabadresult,sinceinvestorsearntheasset’sinternalrateofreturnwhichisabovethefrm’srequiredreturn.Whentheactualrevenueofyear1is$1,500(beatingthe$1,300expectedrevenue),therewillbe$200ofeconomicincome.Nowassumetheinternalrateofreturnis0.20butthefrmusesa0.10capitalcosttocomputetheeconomicincomes.Therevenuesarenow$1,600,$1,400,and$1,200foryears1,2,and3,respectively.Theassetagaincosts$3,000.Theexpectedeconomicincomesarenow: Year1Year2Year3 Revenues$1,600 $1,400 $1,200 Depreciation$1,000$1,000$1,000InterestCost300 200 100 EconomicIncome$300$200$100 Thenetpresentvalue(NPV)oftheeconomicincomesisNPV = 300 1 . 1 1 + 200 1 . 1 2 + 100 1 . 1 3 = $513 . 15 . This$513.15isalsoequaltotheNPVofthecashfows:NPV = 1 , 600 1 . 1 1 + 1 , 400 1 . 1 2 + 1 , 200 1 . 1 3 3 , 000 = $513 . 15 . Thepresentvalueoftheeconomicincomemeasuresistiedto(andconsistentwith)theNPVmeasuresusedtoevaluatetheinvestment.Someconsultantscallthiseconomicincomecalculation“economicvalueadded.”Thisisunfortunatesincetheeconomicvalueaddedbytheinvestment
November6,200913:44spi-b8119inx6inb811-ch14 268 AnIntroductiontoAccountingandManagerialFinance is$513.15attimezero.Theoperationsinthefrstyear(withrevenuesof$1,600)resultinthefollowingvalueattime1:Valueattime1 = 1 , 400 1 . 1 1 + 1 , 200 1 . 1 2 + 1 , 600 = $3 , 864 . 46 . Sincethetimezerovalueoftheinvestmentis$3,513.15,theeconomicvalueaddedattime1is$351.31,notthe$300ofeconomicincomecomputedabove.Themeasurethatisbeingcomputedisanincomemeasure,notavalueoravaluechangemeasure. ComparingROIandEconomicIncome EconomicincomeoffersseveralsignifcantadvantagesoverROIasaperformancemeasure.First,andmostimportantly,theuseofROImightdiscouragedivisionmanagersfromacceptinginvestmentsthatofferreturnsthatarelargerthanthefrm’srequiredrisk-adjustedreturns,butthatarelessthantheROIthedivisioniscurrentlyearning.Ifthenewinvestmentisaccepted,thedivision’sROIwillbedecreased.Forexample,supposeadivisionisnowearning$30million(aperpetuity)onaninvestmentof$100million.Then,ROI = $30 , 000 , 000 $100 , 000 , 000 = 0 . 30 . Thedivisioncaninvestanadditional$50millionandearn0.15ROIor$7.5millionperyear(aperpetuity)onthisnewinvestment.Thefrm’srequiredreturnforthisinvestmentis0.10;thus,theinvestmentiseconomicallydesirable.Shouldthedivisionacceptthenewinvestment?Ifitisaccepted,thedivision’sROIisreducedfrom0.30toROI = $37 , 500 , 000 $150 , 000 , 000 = 0 . 25 . Basedontheadverseeffectonthedivision’sROI,amanagermightrejectthiseconomicallydesirableinvestment.Thisproblemdoesnotariseifeconomicincomeisused.TheeconomicincomebeforethenewinvestmentisInitialEconomicIncome = $30 , 000 , 000 $10 , 000 , 000 = $20 , 000 , 000 . Notethatthe$15,000,000interestcostiscomputedonthe$50millionofnewinvestmentplusthe$100millioninitialinvestment,notjusttheportionfnanced
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 269 bydebt.Aftertheinvestment,theeconomicincomeincreasesfrom$20,000,000toNewEconomicIncome = $37 , 500 , 000 $15 , 000 , 000 = $22 , 500 , 000 . Basedoneconomicincome,thereisanincentiveforthedivisionmanagertoacceptthedesirableinvestmentandincreasetheeconomicincomeby$2,500,000.ThesecondproblemwithROIisrelatedtothefrst.ROIgivesfaultyevaluationsofrelativedivisionperformance.Considertwodivisions,onewithaROIof0.30andthesecondwithaROIof0.25.Whichofthetwodivisionmanagersisdoingthebetterjob?Above,weshowedthatacceptingtheeconomicallydesirableinvestmentreducesthedivision’sROIfrom0.30to0.25.Thedivisionearning0.25isbeingmanagedbetterthanthedivisionthatearns0.30andthatrejectsgoodinvestments.UsingeconomicincometomeasureperformancesolvesthisproblemthatexistswithROI.Thethirdadvantageofeconomicincomeisthatitallowsmorefexibility.Forexample,ifshort-terminterestratesare0.20andlong-termratesare0.12(thepatternof1980),the0.20interestratecouldbeusedforworkingcapitalitemsincomputingeconomicincome.TheabilitytousedifferentinterestratesfordifferentassetsintroducesafexibilitythatROIlacks. SummaryofComplexities Thecomplexitiesofapplyingeconomicincometoperformancemeasuresorcom-pensationare:1.Themethodofcalculatingdepreciationexpense.2.Thechoiceofthecapitalcost(interestrate).3.Thechangingvalueofassets(e.g.,infationortechnologicalchange).4.Risk.5.Non-controllablefactorsaffectingthemeasure. SummaryofEconomicIncomeAdvantages Economicincomeoffersthreeprimaryadvantages:1.Anyinvestmentwithapositivenetpresentvalueoraninternalrateofreturnlargerthanthefrm’srequiredreturnwillhavepositiveeconomicincomes.2.Theuseofeconomicincomewilltendtonotadverselyaffectinvestmentordivestmentdecisions.
November6,200913:44spi-b8119inx6inb811-ch14 270 AnIntroductiontoAccountingandManagerialFinance 3.Withtheuseofeconomicincome,managementischargedforthecapitalituses;thus,managementhasadirectincentivetousecapitaleconomically.Economicincomeisaverysensiblemeasure. MarketMeasures Thestockholdersarethefrm’sresidualownersandtheyareinterestedinthestock’stotalreturn.HowwelldidtheCEOperform?Whatwasthestockholders’totalreturn?Thestock’sreturndoesnotalwaystracktheCEO’sperformance,especiallyintheshortrun.Acompanymaydowellbutthestockmightgodown(e.g.,withaninterestrateincrease).Nevertheless,tyingaCEO’scompensationtothestock’smarketperformanceissensible(aslongasitisnottheonlybasisofcompensationcalculation).Thereareseveralcomparisonsthatcanbemade.Thefrm’sperformancecanbecomparedtoadefnedtargetreturn,thereturnearnedbythemarket,orthereturnsearnedbyasetofcomparablefrms.Inadditiontorelatingcompensationtothecurrentyear’sperformance,itisreasonabletorewardtoday’smanagersinthefutureforperformanceforthenexttenyears.Itisdesirabletogivetoday’smanagersanincentivetomakedecisionswithaconcernforthefuture. EarningsPerShare Theearningspershareofcommonstockiswidelyusedininvestmentanalysis.Itmaybehelpfulinevaluatingtheinvestmentworthofashareofstock,anditmayalsoprovideanindicationofmanagerialperformance.Basically,earningspershareistheratiooftheearningsavailabletocommonstockholdersdividedbytheaveragenumberofcommonsharesoutstanding.EarningsperShare = EarningsAvailabletoCommonShareholders AverageSharesOutstanding . Manycompanieshaverelativelycomplexcapitalstructures,anditisnotunusualforthesecompaniestopresentseveralearningspershareintheirincomestatements.Therearemanycomplexitiesthatcanariseinthecomputationofearningspershare,mostofwhicharebeyondthescopeofthisbook.However,wewillconsidersomebasicfeaturesoftheearningspersharecalculationthatapplytomostcases.Earningsavailabletocommonstockholdersgenerallyconsistofthenetincomefortheperiodlessanydividendsoraccumulationsattributabletopreferred
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 271 stockholders.Whenthereareextraordinaryitems,earningspershareshouldbecalculatedonthebasisofincomebeforeextraordinaryitems,aswellasnetincome.Thus,twoearningspersharefgureswouldbeshown.Thenumberofsharesoutstandingmayvaryduringaperiodbecauseofbusinesscombinations,acquisitionsoftreasurystock,publicissuancesofstock,andsoforth.Insuchcases,thecalculationofearningspershareisbasedonaweightedaverageofsharesoutstandingduringtheperiod.Thus,ifacompanyhad1,000,000sharesoutstandingforfourmonthsduringtheyear,and2,000,000sharesoutstandingduringeightmonths,theweightedaveragewouldbe1,666,667shares.Companieswithcomplexcapitalstructuresgenerallyreporttwosetsofearn-ingspersharefgures:primaryearningspershare,andfullydilutedearningspershare.Bothofthesesetsoffguresmeasuretheearningspersharethatwouldhavebeendeterminedifcertainsecuritieshadbeenconvertedandoptionshadbeenexercisedduringtheperiod.Thedistinctionbetweenthetwosetsoffguresliesintheassumptionsaboutwhichsecuritiesshouldbetreatedasthoughtheyhadbeenconvertedintocommonstock. BookValuePerShare Thebookvaluepershareistheamounteachsharewouldreceiveifthecompanywereliquidatedonthebasisofthehistoricalaccountingamountsreportedonthebalancesheet.BookValueperShare = Shareholders’Equity SharesOutstanding = $5 , 080 166 . 4 = $30 . 53 . Wehaveusedtheaveragenumbersofsharesoutstanding.Theend-of-periodnum-berofsharescouldjustaslogicallybeused.Thebookvaluepersharecalculationisstraightforwardifthecompanydoesnothavedifferentclassesofstock.Thecalculationbecomesmorecomplexwhendifferentclassesofstockexist,becausestockholders’equityitemshavetobeallo-catedamongthedifferentclassesofstockandtheamountallocatedtoeachclassisthendividedbythenumberofsharesoutstanding.Withregardtothefactthatthebalancesheetvaluationsdonotrefectorapproximatefairmarketvalues,thebookvaluepersharefgureisnotlikelytobeveryusefulormeaningfulfordecisionmaking.
November6,200913:44spi-b8119inx6inb811-ch14 272 AnIntroductiontoAccountingandManagerialFinance TimesInterestEarned Theholdersofdebtareconcernedaboutthesecurityoftheirinvestment.Thetimesinterestearnedratiofocusesonthesafetyorcoverageofperiodicinterestpayments.TimesInterestEarned = OperatingIncome InterestExpense . Lookingatoneyear’sfgurescanbemisleading.Long-termcreditorswishtohaveinterestexpensecoveredthroughoutthedebtperiod.Acompany’soperatingincomemaydifferquitedramaticallyfromitscashfowsfromoperations.Revenuesandexpensesmaydifferfromcashreceiptsanddisbursements. Debt-EquityRatio Thedebt-equityratiogivesanindicationofanenterprise’sabilitytosustainlosseswithoutjeopardizingtheinterestsofcreditors.Thisratioisbasedonlyoninfor-mationprovidedinthebalancesheet.Althoughstockholders’equityservesasabuffertoprotectthecreditors’interests,itshouldbekeptinmindthattheearningprospectsoftheenterprisearealsorelevantinjudgingafrm’sabilitytosurvivethelongrun.Thedebt-equityratioisonlyoneofseveralfactorstobetakenintoconsideration.Therearenumerouswaysinwhichthedebt-equityratiomaybeexpressed.Fourwidelyusedandciteddefnitionswillbepresentedhere.Thesedefnitionscanbeusedtoexpressthebalancebetweendebtandequity,whichtogetherconstitutetheresourcesofanenterprise.Thesedefnitionscanalsobeusedtoexpresstherelativeriskfromrelyingondebtorequity.Onedefnitionofthedebt-equityratioistheratiooftotaldebttostockholders’equity.Debt-EquityRatio = TotalDebt Stockholders’Equity . Aseconddefnitionofthisratiofocusesonanarrowerdefnitionofdebtthatincludesonlylong-termdebt.Thisdefnitionexcludesshort-termdebtaswellasotherdebtthatwillnotbepaidaccordingtoafxedpaymentschedule.Debt-EquityRatio = Long-TermDebt Stockholders’Equity . Athirddefnitionofthedebt-equityratiofocusesontherelationshipbetweentotaldebtandtotalinvestment(e.g.,totaldebtplusstockholders’equity).Thisratio
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 273 essentiallyprovidesthepercentageoftotalinvestmentcomposedoftotaldebt.Debt-EquityRatio = TotalDebt TotalDebtandStockholders’Equity . Afourthandfnaldefnitionofthedebt-equityratiofocusesontherelationshipoflong-termdebttototalinvestment.Debt-EquityRatio = Long-TermDebt TotalDebtandStockholders’Equity . Thesefourdefnitionsofthedebt-equityratiofocusonhowwellthecreditorsareprotected. LimitationsofRatioAnalysis Althoughtheuseofratioscanprovehelpfulinanalyzingfnancialdata,therearesomepitfalls.Thefrstthingtokeepinmindisthatratiosbasedonaccountingrecordswillinheritmanyofthedefcienciesoftheaccountingdata.Forexample,ratiosthatincorporatelong-livedassetsintheircalculationswillbeaffectedbytheconventionofrecordingassetsatcostratherthancurrentvalueandbythealternativesavailableforrecordingdepreciation.Thus,twocompaniesmaybevirtuallyidentical,buttheuseofstraight-linedepreciationbyoneandaccelerateddepreciationbytheotherwillresultindifferenceswhensuchthingsasthereturnonassetsorthebookvaluepersharearecomputed.Thiscouldbeovercomebymakingsuitableadjustmentsinthedatatoplaceallfrmsonacomparablebasis,buttheanalystusuallylackssuffcientdatafordoingthis.Anotherdangertobealertforisthearithmeticeffectofcertaintypesoftrans-actionsontheratios.Forexample,thequickratioissupposedtoprovideanindi-cationofthecompany’sabilitytomeetitscurrentobligationswhendue.Supposeacompanyhascashof$40million,accountspayableof$30million,andnoothercurrentassetsorliabilities.Thecurrentratioandquickratiowouldbothbe1.33to1.Nowsupposethatthecompanyused$20milliontopayalikeamountofaccountspayable.Thistransactionshouldhavenospecialsignifcance,asboththeveryliquidassetsandthecurrentliabilitieswouldbereducedbythesameamount—to$20millionand$10million,respectively.Theimpactonthequickratioissignifcant.Thisratiowouldnowbe2to1.Ratiosaremostmeaningfulwhenviewedincomparisonwiththoseofotherfrmsofasimilarnatureandwhenthetrendofaperiodofyearsisestablished.BusinessservicessuchasDun&BradstreetandRobertMorrisAssociatescompilelistsofimportantratiosformanyindustries,andthesemaybeusedincomparing
November6,200913:44spi-b8119inx6inb811-ch14 274 AnIntroductiontoAccountingandManagerialFinance theratiosofaparticularcompanytothoseofitsindustry.Onewouldexpect,forexample,thatafrminthemeat-packingindustrywouldhaveasmallerincomeasapercentageofsalesthanfrmsinthepharmaceuticalindustry.Comparingtheoper-atingratiosofameat-packingfrmwiththoseofothermeat-packingfrmswouldgivemoremeaningfulresultsthancomparisonswithaveragesforallmanufacturingindustries. EffcientMarketsandAccounting Inthepast,accountingtheory(andthechoiceamongaccountingalternatives)hasbeendoneonan apriori basis.Thisbookwaswritteninthatspirit.Forexample,wefrstassumeitisdesirabletomatchrevenuesandtheexpensesassociatedwiththoserevenues.Theaccountingentriesthatareappropriateforrecordingdepreciableassetsstemfromthatassumption.Inrecentyears,anotherschoolofthoughthasarisenwhichsuggeststhatweshouldconsidertheexistingevidenceastohowthefnancialmarketsactuallyusetheaccountinginformationpresented.Oneofthemajortheoriesthatformsthebasisofthisnewschoolistheeffcientmarkethypothesis.Theextremepositionofthosewhoadvocatetheeffcientmarkethypothesisclaimsthatallthemarketrequiresisbasicfnancialinformation.Wecanexpectthemarkettodigestthatinformationwiththeresultthatthemarketpricewillfullyrefectthebasicinformation,eveniftheaccountingpracticeisnotconsistentwiththebestaccountingtheory.Thus,variationsinaccountingpracticewillnotaffectthemarketpriceofafrm’scommonstock,aslongasthebasicdataaredisclosed.Theeffcientmarkethypothesiscomesinseveralforms.Weshallconsideronlythree:theweak,thesemi-strong,andthestrongforms. TheWeakForm Theeffcientmarkettheorieshadtheirorigininresearchthattendedtoprovethatstockmarketpriceswerearandomwalk.Accordingtotheweakformoftheeffcientmarkethypothesis,topredicttomorrow’spriceofashareofcommonstockweneedonlytoday’sprice.Yesterday’sprice(thepasthistoryofthestock)orthevolumeofsharestradedtellonenothingabouttomorrow’sprice.Theexpectedvalueoftomorrow’spriceistoday’sprice(assumingashorttimehorizon).Ifvalid,thisstateoftheworldeliminatesawiderangeofsecurityanalysesthatlookatpatternsofstockpricechanges.Theimplicationsforaccountingpracticeofthe“weakform”centerontheaccountingforsecuritiesthathaveawidemarket.Ifstockpricesfollowarandom
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 275 walk,andiftheexpectedvalueoftomorrow’spriceistoday’sprice,thentheaccountanthasajustifcationforshowingsuchsecuritiesatmarketvalue. TheSemi-StrongForm Thesemi-strongformoftheeffcientmarkethypothesisstatesthatthemarketincorporatesalltheknowninformationaboutastock,thecurrentpricerefectsthisinformation,andthisinformationisincorporatedinthepriceveryrapidly.Thus,aninvestorcannotusetheknownpublicinformationtomakeamore-than-normalreturn.Letusassumethattwootherwiseidenticalfrmsarepresentingincomestate-ments,butthatonefrmusesthestraight-linemethodindepreciatingitsequipmentwhiletheotherfrmusesthedoubledecliningbalancemethod.Thedifferencesinaccountingarefullyexplainedwithsupportingschedulesintheirrespectivereports.Theeffcientmarkethypothesis,giventheassumptions,suggeststhatbothcommonstockswouldsellforexactlythesameprice.Themarketwouldadjustfortheaccountingpractices,soonlytherealdifferenceswouldremain.Inthiscase,therearenorealdifferences;thus,thestockpricesofthetwofrmswouldbeidentical.Apersonwhobelievesinthesemi-strongformoftheeffcientmarketwouldarguethatmoreattentionshouldbedirectedtowardobtainingcompletenessofdisclosureandimprovingthetimingoftheannouncementscontaininginforma-tionratherthantowardtheformofthepresentation.Apersonwhodoubtedthatthemarketwasperfectlyeffcientinthesemi-strongformmightagreewiththeimportanceofcompletenessofinformationdisclosureandtheimportanceoftim-ing,butheorshewouldstillarguethattheformofpresentationmadeadifferencetoenoughinvestorssothattheaccountingproblemswerestillarelevantareaandtheimprovementofaccountingpracticeswasavalidendeavor.Inaddition,sincetheprocessingofinformationhasacost,theaccountanthasanobligationtorefnetheinformationandpresentitinasgoodformasisfeasiblesothatinformationprocessingcostscanbereduced.Whileonemightnotagreecompletelywiththesemi-strongformoftheeff-cientmarkethypothesis,itwouldbeincorrecttoarguethatthemarketisperfectlyfooledbydifferencesinaccountingpracticesandmakesnoadjustmentforsuchdifferences.IfonefrmisusingFIFO(frst-in,frst-out)andasecondfrmisusingLIFO(last-in,frst-out),themarketislikelytobemakingsometypeofadjustmentforthefactthattwodifferentaccountingassumptionsarebeingused.Wewouldexpectthemarkettomakereasonablygoodadjustmentswherethesupplementalinformationisclearlypresented,butinsomecases,wherethe
November6,200913:44spi-b8119inx6inb811-ch14 276 AnIntroductiontoAccountingandManagerialFinance informationisnotclearorisnotpubliclyavailable,theadjustmentsmaynotbeaseffective.Thisbringsustothestrongformoftheeffcientmarkethypothesis. TheStrongForm Thestrongformsaysthatonecannotmakeabnormalproftswitheitherpubliclyheldinformationornonpublicinformation.Thus,insiderscannotmakeabnormalproftiftheytradeusingthatinformation.Itisdiffculttotestthestrongform(itisagainstthelawforinsiderstotradeusingprivilegedinformation;therefore,obtain-inginformationaboutthetradingofinsidersisextremelydiffcult).Theauthorwouldguessthatifonehadgoodinsideinformation,onecouldmakeabnormalprofts.However,thereisatendencyforapersonwhoistooclosetoasituationtonotappraiseitobjectively;thus,thestrongformmighthavesomevalidity.Itispossiblethatinsidersdonotdoaswellasanenviousoutsidermightthink.Ifwebelievethatthestrongformdoesnotholdandthatinsidersdohaveanedgeintrading,thenthisconclusionaffectsthemannerinwhichconfdentialaccountinginformationishandled.Forexample,wewouldnotwanttheemployeesofanindependentcertifedpublicaccountingfrmtoownortradeinthestockofacompanythefrmisauditing.Thesameconclusionholdsfortheexecutivesofanindustrialfrm.Ifcommonstockistobeheldbytheexecutives,thestockshouldbeheldwithotherinvestmentsinablindtrustsothatthetimingofbuyandselldecisionscannotbetheresultofinformationthatisavailableonlytoafew.Thus,thestrongformisimportanttoaccountinginanegativesense.Sincewetendtorejectthestrongform,wethinktheinformationpossessedbyinsidersisimportant,andrulesshouldbeestablishedthatpreventindividualsfromexploitingthatinformation. Implications Thedevelopmentoftheeffcientmarkethypothesishasimplicationsforthedevel-opmentofaccountingtheoryandpractice.Itisimportantforaccountantstorealizethattherearemanyintelligentanalystsinterpretingthedataand,aslongassuf-fcientlyaccurateinformationispresented,theanalystislikelytoworkarounddifferencesintheexactformofabalancesheetorincomestatement.Forexample,accountingpracticemightinsistontheuseoffairvalueforpresentingmarketablesecurities,butthisshouldnotprecludethepresentationofothermarketvaluessuchasbidandofferpricesinafootnote.Thereareseveralpossiblewaysinwhichsecuritiesmaybepresentedinabalancesheet.Itispossiblethat apriori reasoningmaybeabletosuggestthatonemethodisbetterthananothermethod,andamore
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 277 reasonablepresentationmightresultinadecreaseininformationprocessingcostsfortheanalysts. Non-AccountingQuantitativeMeasures Giventhegenerallyacceptedcriticismsofaccounting(e.g.,itiscost-based),mostanalystsofbusinessaffairssearchforotherquantitativemeasurestocomplement(orreplace)theaccountingmeasures.Thesemeasuresinclude:1.Marketpenetration.2.Customersatisfaction.3.Employeesatisfactionandturnover.4.Unitssold.5.Diversitymeasures.6.Qualitycontrolmeasures(percentageofdefectives).Ifreliableusefulmeasurescanbeobtained,thenthenon-accountingquantita-tivemeasurescantaketheirplacewiththeaccountingmeasures.Inmanysituations,theywillbemoreimportantthantheaccountingmeasuressincetheygiveahintoftheleveloffutureincomes. QualitativeMeasures Therearemanyqualitativeaspectsthatenterintoanevaluation.Forexample,amanagermightbereliableandeasytoworkwith.Amanagermighthavelaidthefoundationforfuturegrowthbyhiringoutstandingmanagersandresearchers.Doesthemanagergenerateenthusiasmandcreativity?Hasthemanagerenhancedthefrm’sreputationamongcustomersandsuppliers?Therearemanywaysinwhichthemanagercanenhancethefrm’sfutureproftabilityandvaluebyactionsthatdonotleadtocurrentproftability.Toevaluateamanager’sperformance,itisnecessarytoconsiderthesefactors.Inaddition,frmscanhavegoalsotherthanameasurableeffectonproftability.Thismightinvolvethelocalsocietyorsocietyinabroadersense(e.g.,protectingtheenvironmentbeyondthelegalrequirements).Intangiblesarefactorsnoteasilymeasured,buttheycanbeimportanttothelong-runsuccessofacorporation. ManagerialCompensation Thebasisofcompensationshouldbeboththeoperatingresultsofthemanager’sspecifcunitandtheresultsofthefrm.Themanagershouldhavejointloyalties.
November6,200913:44spi-b8119inx6inb811-ch14 278 AnIntroductiontoAccountingandManagerialFinance Thebasisofcompensationshouldincludequantitativeobjectivemeasures,butnottotheexclusionofqualitativemeasures.Theexistenceofthequalitativeconsiderationsreducesthetendencyofmanagerstogamethesystem.Tosomeextent,someofthecompensationshouldbedeferredandbetiedtothefrm’sfutureperformance.Wewantmanagerstomakedecisionsfromalong-runperspective.Thebasisofcompensationshouldbebothaccountingmeasuresandmarketmeasures.Thereturnearnedbytheshareholdersshouldaffectthecompen-sationofthemanagers. AgencyTheoryAppliedtoCorporateManagementandPerformanceMeasurement Problemsofagencyarisewhenaprincipalemploysanagenttoperformatask,andtheinterestsoftheprincipalandtheagentarenotidentical.Thecorporateformisfertilesoilforagencyproblemstotakeroot.Considertherelationshipsbetweenshareholders(theprincipal)andmanagement(theagent).Formanyrea-sonsincludingtheincreaseinpower,managementmightwantthefrmtogrowwhiletheshareholderswouldbebetteroffwithasmallfrmandalargecashdis-tribution.Itisnecessaryforthecompensationmethodtobeeffcientintermsofeliminatingthepossibilityofamanagementtoundertakeknowinglyundesirableinvestmentsfromtheviewpointofshareholders.Therecanalsobeagencyproblemswithdifferentlevelsofemployees.ConsidertheCEOandtradersofabank.Theyareallemployees.Theyallwanttoincreasethebank’sprofts.ButthetradersmighthavebonusarrangementsthatencouragethemtotakeexcessiverisksfromtheCEO’sperspectiveinordertoearnalargebonus.Thisstrategymightbegoodforthetraders,butbadfortheexpectedproftsofthebank.Atraderwhowinsbecomesrich.Atraderwholosesgetsanidenticaljobwiththebankacrossthestreet.Anothertypeofagencyproblemariseswhenonegroupisinapositiontotakeadvantageofasecondgroup.Letusconsiderafrmfnancedby$9millionof0.08debtand$500,000ofcommonstock.Therearezerotaxes.Withoutanynewinvestments,thereiscertaintyofthefrmearning$800,000(beforeinterest)andbeingabletopaythe$720,000interestonthedebt.Thestockholderswouldearn$80,000peryear.Thefrmisconsideringa$1millioninvestmentfnancedby0.08debt.Withthisinvestment,thereis0.5probabilitythatnodebtinterestwillbepaid.Theinitialdebtholdersdonotwantthe$1millionofnewdebttobeissued.Obviously,theinitialdebtholderswillattempttostructuretheirindenturessothattheylimittheabilityofthestockholderstochangethenatureofthebusinessin
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 279 amannerthatadverselyaffectsthepositionofthedebtholders.Thisisavariationofanagencyproblem.Agencycostsconsistofseveraltypes.Oneisthetransactioncost.Buyersofdebthavetohirealawyerthatprotectsthedebtbuyers’interests.Corporationshireconsultantstoestablishsystemssothatthetradersofderivativescannotbankruptthefrm.Thesearetransactioncostsoragencycosts.Anothertypeofagencycostarisesbecauseofthenecessitytorewardtheagentinamannerthatmakestheagent’sinterestscongruentwiththeprincipal’sinterests. Non-ControllableFactors Anoilcompanyexecutive’sfrmislosing$500millionperyear.TheCEOisindangerofbeingfred.Thenoilpricesdoubleandthefrmmakes$800million.Itisthesamemanagermanaginginthesameway,buttheeconomicenvironmenthaschanged.Obviously,someattemptcouldbemadetoseparateoutthefactorsthatareandarenotcontrollablebythemanager.Butthisisdiffcult,andisapttointroducesubjectivemeasuresintotheevaluation.Thisproblemisanexampleofthequalitativeaspectsofperformanceevaluation. ANon-ZeroNetPresentValue Thebasicexampleusedinthischaptersetsthenetpresentvalueoftheinvestmentequaltozero,thatis,theinternalrateofreturnoftheinvestmentisequaltothetimevaluefactorforthefrm.Obviously,thiswillonlyrarelybethecase.Weexpectmostinvestmentstohaveexpectedreturnsinexcessoftheirrequiredreturn.Forexample,letusassumethatthethree-yearinvestmentcosts$2,760insteadof$3,000.Thenetpresentvalueoftheinvestmentatthetimeofacquisitionis$240,anditsinternalrateofreturnis0.15.Thereareseveralpossiblepathswecantake.Twomethodswillbedescribed.Themoststraightforwardwouldbetouse0.15astherateofdiscounttocomputethedepreciationexpensesandreturnsoninvestment.Using0.15astherateofdiscount,weobtain: PeriodRevenuesDepreciationIncomeInvestmentROI 1$1,300$844$416$2,7600.1521,2009192811,8760.1531,1009571439570.15 Theprimarydiffcultywiththissolutionisthatthetimevalueofmoneyisdefnedtobe0.10,not0.15.Thus,thevaluesoftheinvestmentateachtimeperiod
November6,200913:44spi-b8119inx6inb811-ch14 280 AnIntroductiontoAccountingandManagerialFinance aregreaterthanthoseshownabove.Asecondsolutionistoimmediatelyadjustthevalueoftheinvestmentto$3,000,thepresentvalueofthebenefts,despitethefactthattheinvestmentcostisonly$2,760.Thisprocedurewouldnotbeacceptableforconventionalfnancialaccountingpurposesbecauseoftheimplicitthreatofmanipulation,butitwouldbeacceptableforinternalmanagerialpurposes.Itisaveryappealingprocedurebecauseitisrelativelysimpleandyetiscorrectfromthestandpointofaccountsrefectingvalues. IncentiveConsideration Theuseofbookvaluebasedoncosttomeasuretheinvestment(thedenominatorintheROIcalculationandthebasisoftheinterestcostintheeconomicincomecalculation)oreventheuseofestimatesofprice-level-adjustedcostissubjecttoseverecriticism.Thereisnoreasonwhyasystembasedonvaluesestimatedbymanagementcannotbeusedforinternalpurposesinsteadofcost-basedconven-tionalaccounting.Herewehaveanopportunitytoapplyingenuitytobypassavalidobjectionbymanagerstocost-basedaccounting.Ratherthanaskinganaccountantoranotherstaffpersontosupplythenumberonwhichthemanagersaretobejudged,letusaskthemanagerstosupplythevalueestimate.Theprocedurewouldbesimple.Takeasetofeligiblemanagersandaskthemto“bid”periodicallyfortheassetstheywanttomanageandforwhichachangeinmanagementisappropriate.Themanagerwhosebidisacceptedtakestheasset,andthebidbecomestheaccountingbaseforperformanceevaluation.Ifthemanagerbidstoohigh,thatmanagergetstheassetbutwillfndithardtomeetthereturnoninvestmentandeconomicincomerequirements.Ifthemanagerbidstoolow,acompetingmanagerwillwin,oralternativelythe“board”mayrejectthebidandaskforrevisedbids.Thereisonemajordiffcultywiththisprocedure.Managerscanrigthetimeshapeofprojectedearningssothatearlytargetscanbeeasilyattainable.Thistendencywouldhavetobecontrolledbythetopmanagersawardingthebid.Largedeferredbeneftswouldhavetobediscounted.Theproposedprocedurewouldhavemanyadvantages.Itwouldestablishaninvestmentbasewhosemeasureisacceptabletoboththeoperatingmanagerandthetoplevelofmanagement(theformersetsthevalue,thelattermustacceptit).Theaccountantservestheveryimportantandproperfunctionofsupplyingrelevantinformationthatisusedbythemanagersinmakingtheirrespectivejudgmentsandbids.TheROIandeconomicincomemeasuresareimprovedbecausetheinvest-mentbaseisappropriatetothespecifcinvestmentandmanagerbeingevaluatedratherthanbeingtheresultofaseriesofhistoricalaccidents(suchastheyearofpurchaseandthemethodofdepreciation).Mostimportant,itrequiresmanagersto
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 281 set,describe,andquantifytheirplansfortheutilizationoftheassets.Itwouldtietogetherplanning,decisionmaking,andcontrol. DeferredBenefts ConventionaldepreciationaccountingcombinedwiththeusesofROIisatitsworstwhenthebeneftsproducedbytheassetareexpectedtoincreasethroughtimeorwhenthebeneftsaredeferred.Theearlyyearsaregreatlypenalizedbyconventionalaccounting,withthemanagershavinganincentivetoavoidsuchinvestmentssothattheirperformanceevaluationsdonotsuffer.Forexample,assumeaninvestmentcosting$3,000isexpectedtohavethefollowingbeneftstream: PeriodBenefts 1$1,10021,21031,331 Thefrm’scostofmoneyis0.10andisequaltotheinvestment’sdiscountedcashfowinternalrateofreturn.Theresultsusingconventionalaccountingandstraight-linedepreciationwillbe(assumingtheactualbeneftsareequaltotheexpected): PeriodRevenuesDepreciationIncomeInvestmentROI 1$1,100$1,000$100$3,0000.0321,2101,0002102,0000.10531,3311,0003311,0000.331 Thefrstyear’soperationsarenotacceptable.Defningdepreciationexpensetobethedecreaseinvalueoftheasset,theresultswouldbe: PeriodRevenueDepreciationIncomeBookandValueInvestmentROI 1$1,100$800$300$3,0000.1021,2109902202,2000.1031,3311,2101211,2100.10
November6,200913:44spi-b8119inx6inb811-ch14 282 AnIntroductiontoAccountingandManagerialFinance Thevalue( V i )anddepreciation( d i )calculationsare: V 0 = $3 , 000attime0 d 1 = $3 , 000 $2 , 200 = $800inperiod1 V 1 = $2 , 200attime1 d 2 = $2 , 200 $1 , 210 = $990inperiod2 V 2 = $1 , 210attime2 d 3 = $1 , 210 $0 = $1 , 210inperiod3.Thedistortioncausedbyconventionalaccountingcanbeincreasedbyassumingno(orverylow)beneftsuntilperiod3.Theoperatingresultsoftheearlyyearswouldappeartobeevenworsethanintheexample. CashFlowReturnonInvestment Recognizingtheinadequaciesofconventionaldepreciationaccounting,someman-agershaveattemptedtosolvetheproblemsbyusingcashfowreturnoninvestment.Sincecashfowsareusedtoevaluatetheinvestment,whynotusethemtoevaluatetheinvestment’sperformance?Defnethecashfowreturnoninvestmenttobe:CashFlowReturnonInvestment = Cashfow Investment . Thecomputationseemstobeappealingbecausedepreciationisnotcomputed,butunfortunately,thecomputationmerelymakesabadanalysisworse.Usingthepreviousexamplewheretheinvestmenthasa0.10internalrateofreturn,wewouldobtain: PeriodCashFlowInvestmentCashFlowROI(CashFlow/Investment) 1$1,300$3,0000.43321,2002,0000.60031,1001,0001.100 Somefrmshaveactuallytriedtousethehistoricalmeasuresasrequiredreturnsforadditionalinvestments.Youshouldnotethatforaninvestmentyielding0.10overitslife,thecashfowROIsforthethreeyearsare0.43,0.60,and1.10.ThemeasuregreatlyoverstatestheROItheassetisactuallyearning.Anotherdiffcultyofthemeasureisthatitwilltendtobiasmanagementinfavorofcapital-intensivemethodsofproduction,becausecapitalcostisomittedfromthenumeratoroftheperformancemeasure.ItisbettertousetheconventionalROIwithincome(afterdepreciation)inthenumeratorthantousethecashfowROI,whichisextremelydiffculttointerpret
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 283 andhasnotheoreticalfoundation.Theuseofthemeasureillustratedabovewillgetmanagementintooneormoreinterpretivediffculties.Therearealternativemethodsofusingcashfowreturnoninvestmentthatareimprovementsoverthemethodillustrated. PlanningImplications Thefactthattheremaybeaconfictbetweentheinvestmentcriteriausedandtheperformancemeasuresmeansthatcorporateplanningmusttakeintoconsiderationthefactthatalldesirableinvestments(fromthecorporatestandpoint)maynotbesubmittedupward.Itwouldbena˙ıvetoexpectadivisionmanagertorecommendaplantwith60percentexcesscapacitywheretheanalysisofmutuallyexclusiveinvestmentsindicatesthatthisisthebestalternative,iftheperformancemeasuresforaperiodoffveyearswillbeadverselyaffectedbythechoice.Rather,thedivisionmanagerislikelytoburythistypeofalternativesothattheboardofdirectorsisnotconfusedbythenumberofalternativesandthis“undesirable”alternativespecifcally.Themanagershaveasimilartypeofconfictwhentheyevaluatemajorinvest-mentsthatsatisfynormalinvestmentcriteria,buthaveadverseeffectsontheROIsandearningspershareofthenextfewyearsbecauseofconventionalaccounting.Theplannerrejectinginvestmentswithpositivenetpresentvaluesmaygainshort-runbenefts(nondepressedearnings),butwillhavealong-runcostinthatfutureearningswillbedepressedcomparedtowhattheycouldhavebeen.Onealternativeistousetherecommendedinvestmentcriteriaandhopetomod-ifytheaccountingconventionsthatcausethedistortions.Failingthat,managementcanalternativelyattempttoexplainthecharacteristicsoftheinvestment(andthedeferredbenefts)totheinvestingcommunity.Thebestsolutionwouldbefortheaccountingprofessiontoencourageawiderangeofdepreciationmethods,ifthesemethodsarejustifedbytheeconomiccharacteristicsoftheinvestment.Currently,toorapidwrite-off(R&D,training,plantandequipment)leadsto(1)badmeasuresofperformanceand(2)non-optimaldecisions. Conclusion Annualorquarterlyaccountingproftscanbeapoormeasureofwhathasbeenaccomplishedduringanyrelativelyshortperiodoftime.Also,itisoftendiffculttoassignresponsibilityforadeviationfromtheproftobjective.Manyeconomic
November6,200913:44spi-b8119inx6inb811-ch14 284 AnIntroductiontoAccountingandManagerialFinance eventswithlong-runimplicationsarenotrecordedbytheaccountant.Oneshouldnotuseanyperformancemeasurewithoutconsideringthosefactorsnotnormallyappearinginthemanagementinformationsystem.Insomecases,theROIoreconomicincomeshouldnotbeusedforoperatingunitsbecauseitistoodiffculttomeasureeithertheincomeortheinvestment.Normally,themeasureofROIcanbeusedtogainanimpressionofmanage-rialperformance,buttheuseofROIshouldalwaysbesupplementedbyeco-nomicincomemeasures.Thisisnecessaryifthetopmanagementofafrmisattemptingtomeasuretheeffectivenessoftheutilizationofassetscontrolledbypersonsatdifferentlevelsofthefrm.Theeconomicincomeisaveryusefulmeansofaccomplishingthis,ifeffortsaremadetomeasureincomeandinvest-mentinausefulway.Economicincomecombinedwitheconomicdepreciationisverygood.Performancemeasurescanbemadeascomplexorsimplifedasyouwish.Inconclusion,tomeasureperformanceyou can useROI(neverbyitself),buteconomicincomeisstronglyrecommended.Tomakeinvestmentdecisions,you cannot useROIeffectively.Althoughperformancemeasurementisadiffculttaskwhenexactreliablemea-suresofincomeandinvestmentarenotfeasible,itisnecessarythatallmanagersevaluatepersonsforwhomtheyareresponsible.Asguidesandindicators,ROIandeconomicincomehavetheiruses. QuestionsandProblems 1.AsoftheendofDecember,thecurrentliabilitiesoftheLargeSteelCompanyare$800millionanditsliquidassetsare$600million.Thefundsgeneratedbyoperationsinthepastyearwere$1billion,anditisexpectedthatthisratewillcontinueinthefuture.Howmanydaysoffundsgenerationwouldbeneededtopaytheamountofcurrentliabilitiesinexcessofliquidassets?2.(continue1)TheLargeSteelCompanyalsohas$1billionoflong-termdebtinadditiontothe$800millionofcurrentliabilities.Howmanydaysoffundsgenerationwouldbeneededtopaytheamountoftotalliabilitiesinexcessofliquidassets?3.TheLargeSteelCompanyhas$1.5billionofcurrentassets,$0.8billionofcurrentliabilities,and$1billionoflong-termdebt.Itgenerates$1billionoffundsperyear.Computesomemeaningfulmeasuresrelatingassets,debt,andfundsgeneration.
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 285 4.ThefollowinginformationappliestotheABCCompanyforthecomingyear: Earningsbeforeinterestandtaxes$3,000,000Interest300,000Principalrepayment1,200,000Depreciation(fortaxesandaccounting)800,000Taxrate0.40 Whatbefore-taxcashfowhastobeearnedtomeetthedebtrequirementsinthecomingyear?5.Doestheuseofinventorynecessarilyaffecttheamountofcashthatisheldbyacorporation?6.WhyisEBITgenerallyusedintheinterestcoverageratioratherthanincomeaftertaxes?7.Abankloanoffcerisconsideringlending$2millionona60-daynotetoacorporation.Whatquantitativemeasuresshouldtheloanoffcercompute?Iftheloanisfor20years,howshouldtheanalysisdiffer?8.ThefollowingfactsapplytotwocompaniesfortheyearendingDecember31ofthesameyear: CompanyACompanyB Income$10,000,000$10,000,000Fundsfow16,000,00016,000,000Interestpayments4,000,0003,000,000 Nolong-termdebt(principal)paymentsaredueforeitherfrmfor10years.Beforeevaluatingtheliquidityofthetwofrms,whatadditionalinformationwouldyoudesire?9.Thebasicdefensiveinterval(BDI)isdefnedas:BDI = totaldefensiveassets forecasteddailyoperatingexpenditures . Thedefensiveassetsincludethoseassetsthatcanreadilybeturnedintocash(liquidassets)suchascash,marketablesecurities,andaccountsreceivable.EvaluatetheusefulnessoftheBDI.10.Ananalystwantsacashfowcoverageratiopreparedfromthepointofviewofthecommonstockholdersofafrm.Thefrmhasalong-termdebtandpreferredstockoutstanding.Prepareausefulratiofortheanalyst.
November6,200913:44spi-b8119inx6inb811-ch14 286 AnIntroductiontoAccountingandManagerialFinance 11.Toearn$78aftertax,howmuchhastobeearnedbeforetax?Thetaxrateis0.4.12.Thedepreciationexpensefortaxesis$80andthedebtprincipalpaymentis$110.Withataxrateof0.4,whatdothebefore-taxearningshavetobeinordertohavesuffcientcashtopaythedebtprincipal?13.Doesahighcurrentratioindicateawell-managedcompany?14.Whatwouldbetheeffectontheall-assetearningrateintheyearinwhichequipmentisacquiredofusingsum-of-the-years’digitsratherthanastraight-linedepreciationprocedure?15.Aleadingcompanyinthepaperindustryincludedthefollowinginformationinanannualreport:“Timberlandsarecarriedat$1percordofestimatedstandingsoftwoodonNovember30,1904,plussubsequentpurchaseacquisitionsatcost,lessdeple-tionbasedontimbercut.Thecarryingvaluesoftimberlandsdonotrefectregrowthinareaswhichhavebeencutorcurrentmarketvaluesforstumpagewhicharebelievedtobesubstantiallyhigherthancarryingvalues.”Commentontheprocedurefollowed.16.Assumeyouwerethinkingofinvesting$1,000,000inacommonstock.Ifyouweregiventoday’sstockprice,wouldyoupayanythingtofndoutyesterday’sprice?Explain.17.(continue16)Wouldyoupayanythingfortheentirepasthistoryofstockpricesofthatstock?18.Assumeyoubelieve100percentinthesemi-strongformoftheeffcientmarkethypothesis.InJune,youareconsideringinvesting$1,000,000inthecommonstockofafrmwhosefscalyearendsDecember31andwhoseannualreportcameoutinMarch.Wouldyoulookatthelastyear’sannualreport?Explain.19.Assumeyoubelieve100percentinthestrongformoftheeffcientmarkethypothesis.Afriendisworkingintheaccountingdepartmentofalargepubliclytradedfrm.Heinadvertentlydisclosesthequarter’sincome,whichisverydifferentfromtheforecastedincome.Ignoringlegalandmoralissues,wouldyoutrade?Explain.20.Shouldapublicaccountingfrmallowitsemployeestoholdstockinpubliclyownedfrmsthatarebeingauditedbythefrm?21.“Thecompany’sstockhasreachedanewhigh,thereforeyoushouldsell.”Evaluatethisadvice.22.“Thecompany’sstockhasreachedanewlow,thereforeyoushouldbuy.”Evaluatethisadvice.
November6,200913:44spi-b8119inx6inb811-ch14 ManagerialPerformance 287 23.“Wecannotrecordtheinvestmentinstockatitsmarketvalue,sinceweknowthatvalueofthestockwillchangeinthefuture.”Evaluatethisstatement.24.Therehavebeenmanycaseswherethemarkethasseemedtobefooledbybadaccounting.Somecompanieswhosestockshadsoldathighpricesarenowinbankruptcy.Dotheseexamples“prove”thatthemarketisnoteffcient?25.Abusinesscasestatesthatthestockofthecompanybeingstudieddroppedfroma20x1peakof$31ashareto$10bymid-20x2.Itthenstates,“Inthelightofthisdevelopmentthemanagementhadruledoutanewissueofcommonstockasasourceoffnancingcapitalexpendituressolongasthepriceofthecompany’scommonstockremaineddepressed.”Doyouagreewiththeposition?
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November6,200913:44spi-b8119inx6inb811-ch15 Chapter15 MergersandAcquisitions:Consolidations Twofrmsmayjointogether(amerger)toformanewjointfrm,oronefrmmayacquireallthecommonstockofanotherfrm(anacquisition).Theconsequencesofbothrestructuringsarethesame.Almostallfrmsareeitheractivelyengagedinmergeractivityorworriedaboutbeingacquired.Thus,thetopicisimportanttomanagement.Mergersandacquisitionsoccurformanydifferentreasons,rangingfromthedesireforriskreductiontothenecessityofdoingsomethingwithextracashcur-rentlyheldforwhichthefrmhasnootherspecialplans.Considerthefollowingfouracquisitionsofoilcompanies:1.Socal(nowChevron)acquiredGulfOilforUS$13.2billionin1984.2.TexacoacquiredGettyOilforUS$10.2billionin1984.3.DuPontacquiredConocoforUS$7.4billionin1981.4.U.S.SteelacquiredMarathonOilforUS$6.5billionin1981.Allfouracquisitionsoccurredbecausethemanagementoftheacquiringfrmthoughtthattheoilreserveswereundervaluedbythemarket.SocalandTexacowereseekingadditionaloilreserves.DuPontandU.S.Steelwerediversifyingoutoftheirbasicindustriesbecausetheysawrelativelylowproftsandhighrisksinthoseindustries(chemicalsandsteel).Thediversifcationeffortswerenoteffective. ReasonsforMergers ObtainingResources Manyspecifcreasonsaregivenformergersandacquisitions.Forexample,ifafrmwantstostartanewtypeofactivity,anacquisitionofafrmmaybequickerthandoingitfromscratch.Anotherreasonformergersisthatretentionofearnings 289
November6,200913:44spi-b8119inx6inb811-ch15 290 AnIntroductiontoAccountingandManagerialFinance savesinvestortaxes;thus,itisasensiblestrategycomparedtoacashdividendandmaybethebestinternaluseofresourcesfromtheviewpointofstockholders.Therearemanyreasonsformergersandacquisitions.Amongthemare:1.Synergy(realandimaginary),theprocesswherebyitishopedthat2plus2equals5,butsometimesitequals3.2.Financialconsiderations(includingtaxeffects).3.Bargainpricesandavailabilityofcapital.4.Psychologicalreasons(empirebuildingbymanagersandraiders).5.TheP/Eeffect.6.Thereductionofrisk(diversifcation).Oneofthemoreimportantreasonsforamergeristhatitwillleadtotheacquisitionofresourcessuchas:1.Managementtalent.2.Markets.3.Products.4.Cashordebtcapacity.5.Plantandequipment(replacementcostislessthantheprice).6.Rawmaterial.7.Patents.8.Know-how(processesorthemanagementteam). Diversifcation Anotherreasonformergersandacquisitionsisdiversifcation(riskreduction).Riskdiversifcationisadiffcultobjectivetoevaluate.Individualinvestorscandiversifyforthemselves.Acorporationdoesnothavetodiversifyforitsinvestors.Mergersandacquisitionsaregenerallyassumedtoreduceriskfortheacquiringfrm,butthisisnotnecessarilyso.Iftheriskoftheacquiredfrmissuffcientlylarge,ittendstocontaminatethefnancialpositionofthefrmacquiringit.Payingtoomuchforanacquisitioncanalsoadverselyaffecttheacquirer’srisk.Despitethis,certaintypesofmergerstendtoreducerisk.Assumetwofrmshaveoperationsthatareperfectlyindependentofeachother,bothinaneconomicandstatisticalsense.Inthissituation,investorswhokeeptheirinvestmentsizethesameinamergerwillreducetheirrisk.Weareassumingthatthefailureofonefrmwillnotcauseafailureofthesecondfrm,andthatoperationsarenotaffectedbythemerger.Forexample,sayonegroupofinvestorsownsafrmwherethereisa0.5probabilityofsuccessand0.5probabilityoffailure.Ifthatfrmis
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 291 mergedwithasecondfrmwiththesameprobabilitiesofsuccessandfailurebutwhoseoperationsareindependent,andiftheoriginalinvestorsnowown50percentofthemergedfrms,therewouldonlybea0.25probabilityofbothportionsofthemergedfrmfailing.Hence,inthiscase,riskhasbeenreduced(theexpectedreturnmaybeunchanged).Forsimplicity’ssake,wegenerallyassumethegoalofafrmisproftmaximiza-tion(inpresentvalueterms)inordertomaximizethewell-beingofthecommonstockholders.Weshouldperiodicallyquestionthisassumption,sincecorporationsarealsoinexistencetoserveothergroups,forexample,management.Whenafrmdiversifesbymergingwithoracquiringafrminanotherindustry,whobenefts?Letusconsiderthepositionoftheshareholderand,forpurposesoffocusingondiversifcation,letusassumezeroinvestortaxrates.Theobjectiveofdiversifcationisriskreduction.Theadvicenottoputallone’seggsinonebasketisgoodadviceiftheobjectiveistoavoidafeast-or-faminesituation.Theindividualshareholdercandiversifyeasilybybuyingstocksindifferentfrmsindifferentindustriesorbyinvestinginmutualfunds.Thestockholderofacompanydoesnotneedthecompanytoincurcoststoachievediversifcation.Ifdiversifcationcangenerallybeeffcientlyachievedbyinvestors,thenwhydofrmsdiversify?Naturally,therearemanyinvestorswhoarenotwelldiversifedandwouldlikethecorporationtodiversifyontheirbehalf.Moreimportantly,managementhasitsmajorassetinvestedinthefrm,andthisassetisdiffculttodiversify.Themajorassetsofmanagersaretheircareers.Ifacompanygoesbankruptorentersaperiodoffnancialdiffculty,themiddle-agedmanagerpaysaheavyprice.Hence,itisreasonableforsuchamanagertoseekahigherlevelofsecuritybytryingtostabilizetheincomeofthecorporation. Synergy Apopularreasonofferedformergersisthatthetwofrmsjoinedtogetherwillbemorevaluablethanthesumofthevaluesofthetwoindependentfrms.Therewillbesynergy.Synergyisaprocesswherebywhen1and1areadded,morethan2isobtained.Twofrmsjoinedtogethermaybeworthmorethantheyareworthindividually.Thereareseveralreasonswhyamergerofthetwofrmsmayresultintotalproftslargerthanthesumofthetwoindividualprofts.Twofrmsmaybemorevaluableafteramergerthanasseparateentitiesbecause:1.Onefrmmaybebadlymanagedandtheotherfrmmayhavemanagerialtalent.2.Onefrmmayhaveassets(e.g.,plantorliquidassets)thatcanbeeffectivelyusedbytheotherfrm,orintangibleassetssuchastechnological,marketing,orproductionknow-how.
November6,200913:44spi-b8119inx6inb811-ch15 292 AnIntroductiontoAccountingandManagerialFinance 3.Horizontalintegration—increasesmarkets(andpossiblyreducescompetition).4.Verticalintegration—increasesoperatingeffcienciesbyintegrationofproduction.5.Jointutilizationofservicefacilities,ororganizationandeliminationofdupli-cation.Alloftheformermightleadtooperatingeffciencies(lowercosts).Horizontalintegrationmightalsoleadtodecreasedcompetition,which,althoughnotsociallydesirable,mightwellbewelcomedbymanagement(thistypeofmergerwouldtendtobediscouragedbygovernmentbodies).Aformofsynergycanbederivedsincethemarketaddsvalueforsize.Afrmoflargesizetendstobeabletoobtaincapitalatalowercost.Consistentwiththisismanagement’shopethatthemarketwillpayahigherP/Eratioforthestockofalarger,lessriskyfrm.Proftsmayalsoincreasewhenaresource-poorcompanyacquiresaresource-richcompanybecausethemarginalvalueofthatresourceisgreaterfortheresource-poorcompany.Thus,thereareoilcompanieswithwidedistributionnetworksacquiringfrmswithlargeamountsofoilreservesbutinadequatedistributionsystems. TaxImplications Atax-losscompanymightacquireaproftablecompanyinordertouseitstaxloss,oraproftablefrmmightacquireatax-losscompany.(Totakeadvantageoftheloss,thelosscompanymustbeoperated;itcannotbeacquiredjustforthetaxloss.)Thetaxmotivationforamergerissometimesnotapparenttothepublicsincebothfrmsinvolvedarereportingincomes.Itmustberememberedthatafrmwithaccountingincomemightstillhaveataxloss.Frequently,acquisitionsofprivatelyownedfrmsoccurbecausetheownersoftheacquiredfrmwanttopreparetheirestatesfortheinevitablemomentofdeath.Thereareadvantagestoanestateinhavingmarketablestockwhosevalueisrelativelyeasilydetermined,ratherthanhavingpartialownershipinaprivatelyownedcorporation.Inthelattercase,itisnecessarytoestimatethevalueofthefrm,andthisvaluationprocessisfarfrombeingasobjectiveasastockmarketprice. Growth Thequestionmightbeaskedastowhyafrmwouldacquireanotherfrmwhentheacquiringfrmcouldentertheindustrybydevelopingitsownproductandproductivefacilities.Acquisitionismuchfasterandsometimessaferthan“doingityourself.”Managementhasitsownreasonsforwantingrapidgrowth.Growth
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 293 throughmergerandacquisitionmeansmorepowerandprestigeaswellasthepotentialforhighersalariesandbonuses. Size Sizeitselfmaybeoneofthereasonsforamerger(nottheonlyreason,itishoped).Sizeisthoughttoreducefnancingcostsandmayofferbargainingpowerinnegotiatingwithsuppliers.Itisalsopossiblethatsomemanagersvaluesizeasrefectingatypeofpersonalachievement,butthisisnotlikelytobeasignifcantfactorasageneralexplanationofmergers. Anti-RaidingManeuver Somemergerstakeplaceinordertofghtoffotherraiders.Areluctantbridemightwellpreferafriendlymarriagetoawhiteknightratherthansuccumbtoaraidbyablackknight.Managersarepeople,anditisreasonabletoexpectthattheywillfearnotbeingabletocontinueastheydidinthepast.Theywouldliketochoosetheirnextboss.Thisdesiremaygiverisetoamergerwithafriendlyfrm(awhiteknight),eventhoughthenumberonechoice(iffeasible)wouldbetocontinuewithunchangedoperations. DifferentExpectations Ifthemanagersandownersoftwofrmshavedifferentexpectations,theywillcomputedifferentvalues,andthismightcreateasituationwhereanexchangecantakeplace.Otherfactorsthatcreatesuchasituationaredifferentperceptionsofthetimevalueofmoney(ordifferentactualtimevalues)anddifferentriskattitudes.Dif-ferentopinionshelptocreatemergers. AntitrustConsiderations TheU.S.JusticeDepartment,theFederalTradeCommission,andtheEuropeanUnionactaswatchdogstopreventmergersthattendtolessencompetitionortendtocreateamonopoly.Therearesomewhowouldalsolikethemtopreventthelargestfrmsintheeconomyfromacquiringanysmallerfrmsinanyindustry.Sinceittendstolessencompetitionorcreateamonopoly,thepreventionofanymergeroracquisitionwillobviouslybeajudgmentcallifthetwofrmsinvolvedareinthesameindustry.Well-defneddistinctionsbetweenlegalandillegalmergersareverydiffculttodefne.Theapplicationoflawsdependstoalargeextentonthepoliticalandphilosophicalleaningsofthepersonsadministeringthelaw.
November6,200913:44spi-b8119inx6inb811-ch15 294 AnIntroductiontoAccountingandManagerialFinance Itisreasonabletoexpectthataconglomerateacquisition(unrelatedbusinesses)willbemorelikelytobeapprovedbytheGovernmentthanwillahorizontalacquisition(say,adepartmentstorechainacquiresanotherdepartmentstorechain).Averticalintegration(eitherintegratingbackwardbyacquiringamaterialorpartssupplierorforwardbyacquiringasalesoutlet)willtendtobelessacceptablethanaconglomerateacquisition,butmoreacceptablethanahorizontalacquisition. AcquisitionforCash Afrmfndingitselfwithextracashabovethatrequiredfornormaloperationsessentiallyhasfourchoices:1.Expand present activities.2.Add new activities.a.“Do-it-yourself”withbasicbuildingblocks.b.Acquireanongoingactivitybythemergerandacquisitionprocess.3.Givetheexcesscashtostockholdersviathefollowingmethods:a.Dividends.b.Othercashdistributions(suchastherepurchaseofsharesbythefrm).4.Retiredebt.Ifthecashisnotavailable,anyoftheabovecanalsobefnancedbyraisingnewcapital.Wewillconcentrateinthefollowingsectionsonthemergeralternativeusingeitheraccumulatedcashornewcapital.Theobjectiveisassumedtobetoincreasevalue.Thefrststepwillbetodeterminethepremiumthattheacquiringfrmcanaffordtopay. DeterminingthePremium Wewanttodeterminehowmuchcashafrmcanofferforanacquisitionwhenasanalternativeitcanpayacashdividendanditsinvestorscanbuysharesofthesamefrminthecapitalmarket.Wewillassumethattheinvestor’sobjectiveistoacquirethesharesofcommonstockinthefrmbeingacquired.Let P 0 bethecurrentmarketpriceofthefrmtobeacquiredand x equalthestockpricemultiplier.Theinvestor’staxrateis t p .Thebidpriceisdefnedtobe:Bidprice = xP 0 .
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 295 Assumethatafrmhas D availableeitherforreinvestmentorforacashdividend.Tomaketheinvestorindifferenttoretentionoradividend,wewantthesamenumberofsharespurchasedwithretentionaswithdividend(weinitiallyassumethatcapitalgainsanddividendsearnedbyacorporationarenottaxed).Thesharestobepurchasedbytheinvestorwiththeafter-taxproceedsofacashdividendof D are N = D( 1 t p ) P 0 , where P 0 isthecurrentcommonstockpriceand t p isthetaxontheinvestor’sordinaryincome.Withretentionandabidpriceof xP 0 ,thesharespurchasedbythefrmwiththe D dollarsare N = D xP 0 . Equatingtheabovetwoequationsyields D( 1 t p ) P 0 = D xP 0 . Solvingfor x ,weobtain ( 1 t p ) = 1 x or x = 1 1 t p . Example15.1 Assumethatthestockbeingacquiredisactuallysellingfor$40andthatthisisitsvalue.Let t p = 0 . 6.Tocompareadividendandfrmacquisition,wefrstcomputethestockpricemultiplierthatresultsinindifference. x = 1 1 t p = 1 0 . 4 = 2 . 5 . Bidprice = xP 0 ; 2 . 5 × $40 = $100pershare . Withadividendof$100,theinvestorsnet$40aftertax.Thecashbuysonesharewithataxbasisof$40.Withretainedearningsof$100,thefrmcanpay$100
November6,200913:44spi-b8119inx6inb811-ch15 296 AnIntroductiontoAccountingandManagerialFinance pershareforoneshare.Thetaxbasisis$0fortheinvestorsand$100forthecorporation.Ifthe$100isretainedand$100ispaidbythecorporationforashare,thenonesharecanbepurchased.Ifthe$100ispaidasacashdividend,the$60oftaxispaidandasharecanbepurchasedfor$40.Thecompanycanpay2.5timesthecurrentmarketpriceandleavethetaxableinvestorwiththesamenumberofsharesofstockoftheacquiredfrmasiftheinvestorhadpurchasedthestockdirectly.Thisanalysisignoresthecapitalgainstaxthatwouldtakeplaceonsaleandassumesthatthealternativetoretentionbythefrmisacashdividend. AHoldingCompany Althoughholdingcompaniesarenotawidelyusedformofbusinessorganization,itisnotunusualtoseeachainoffrmsowningeachother. Example15.2 AssumeAownsBwhichownsCwhichownsDwhichownsE.ThecommonstockofAis$10,000.Mr.Jonesowns51percentofA’scommonstockfnancedwithborrowedfunds. ABCDE Assets$50,000$500,000$5,000,000$50,000,000$500,000,000Debt40,000400,0004,000,00040,000,000400,000,000Commonstock10,000100,0001,000,00010,000,000100,000,000 Nowassumethat:1.Aowns50percentofB’scommonstock.2.Bowns50percentofC’scommonstock.3.Cowns50percentofD’scommonstock.4.Downs50percentofE’scommonstock.Ehas$100,000,000ofcommonstockand$500,000,000ofassets,andJonescon-trolsitallwithaninvestmentof$5,100fnancedwiththebank’smoney.Theconsolidatedbalancesheetshowstheimmenseamountofdebt.
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 297 ConsolidatedBalanceSheet Debt$444,440,000Commonstock,minorityinterest55,550,000Commonstock10,000 $500,000,000 Thisisanextremecase,sinceallofA’sassetsconsistofstockinB,allofB’sassetsconsistofstockinC,etc. EBITandEBITDA TwoproftabilitymeasuresnotnormallypresentedbytheaccountantsbutwidelyusedbyfnancepeopleandmanagersareEBIT(earningsbeforeinterestandtaxes)andEBITDA(earningsbeforeinterest,taxes,depreciationandamortization).Pri-vateequityfrms,inparticular,usethesemeasuresindeterminingthevalueofaprospectiveacquisition.EBITisparticularlyusefulwhenthecapitalstructureoftheacquisitioncan-didateisfnancedwithdebt,sincetheamountoftaxesisreducedtoclosetozeroandEBITismorerelevantthanafter-taxearnings.EBITDAisacashfowmeasureofoperations.Ifthecapitalexpenditureshavealreadybeenmade,eliminatingthedepreciationandamortizationdeductionsincomputingthepositivefowsfromoperationsissensible.Ifadditionalcapitalexpenditureswillbeneededinthefuture,thenthefnalvaluationshouldrefecttheseasadditionaloutlays. ValuationforAcquisition Thefourbasicmethodsofvaluatingafrmforacquisitionare: 1.Present value of cash flow Present value of earnings 2.Earnings or other flows P/E multiplier or earnings 1 bk g × Multiplier of EBIT or EBITDA Book value 3.Assets – liabilities Market values (liquidation value) Replacement cost 4.Stock price: present and past
November6,200913:44spi-b8119inx6inb811-ch15 298 AnIntroductiontoAccountingandManagerialFinance Thecashfowapproachtovaluationtreatsafrmbeingconsideredforacquisitionthesameasanyrealasset.Thecashfowsaretherelevantinput.Sinceafrmhasanearningshistory,thereisatemptationtousetheearningsastheinput.Onecancomputethepresentvalueoftheearnings.Ifinterestonallcapitalissubtractedincomputingtheearningsofeachyear,thepresentvalueoftheearningswillbethesameasthenetpresentvalueofthecashfows.Analternativevaluationapproachusingearningsistomultiplytheearningsbyaprice/earningsmultiplier.Thebasicvaluationmodelis P = D k g = ( 1 b)E k g. Ifwemultiply E (theearningspershare)by ( 1 b) (k g) ,where1 b = theretentionrate k = therequiredreturn g = thegrowthrate , weobtainthevalueofashare.Thiscanbemadetobeequivalenttocomputingthenetpresentvalueofthecashfowsandthepresentvalueoftheearnings,ifalltheinputsareconsistent,buttheequivalencyshouldnotbeassumed.Ifwedividebothsidesby E ,wehaveforthe P / E multiplier P E = 1 b k g. Insteadofusingtheincomefows,someanalystsprefertouseotherfowmea-sures(e.g.,EBITorEBITDA).Insteadofusingfows,onecanalsousetheassetsandtheliabilitiesforvaluation.Theeasymeasurestousearethebookvalues(thedataarereadilyavailable),buteithermarketvalues(includingliquidationvalues)orreplacementcostsarelikelytobemoreuseful.Notconsideringthefowsisnotrecommended.Withtheacquisitionofafrmwhosestockistradedonamarket,thepresentandpaststockpricesarerelevant.Investorswillconsideranyofferinrelationtothecurrentstockpriceandarelikelytocompareanyoffertotherecentpastprices(eventhoughpastpricesarenotrelevantinatheoreticaleconomicsense). OtherFactorstobeConsidered Theexistenceofassetsthatcanbesold,ordebtcapacitythatisavailable,willaffectthevalueofanacquisition.Someassetswillnotberecorded(e.g.,recent
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 299 knowledgeacquiredthroughresearch)orwillbestatedonthefnancialstatementsatunderstatedcosts(e.g.,land).Animportantconsiderationformanagementisananalysisoftheeffectoftheacquisitionontheriskinessofthefrm.Thiswillbehighonmanagement’slistofrelevantconsiderations. TheP/ERatio Wewanttoinvestigatethefnancialeffectsofahigh-P/Eratiofrm(P)acquiringalow-P/Efrm(S).Table15.1showsthefnancialinformationforthetwofrmsandfortheircombination. Example15.3 IfPgives25,000shareshavingamarketpriceof$80pershare(havingatotalvalueof$2,000,000)forS,therewillbe125,000sharesoutstanding.Whatistheirvalueiftheearningspershareis$11.20?ItisincorrecttoarguethattheP/EofP+SwillbethesameastheP/EofP,leadingtoapriceof$11 . 20 × 8or$89.60.Thenewprice/earningsratiocanbeexpectedtobeaweightedaverageoftheoldP/Eratios,wheretheweightsarethetotalearningsofeachofthecompaniesdividedbythetotalearningsofbothcompanies.NewP / E = E P E P + E S ( P/EofP ) + E S E P + E S ( P/EofS ) = $1 , 000 , 000 $1 , 400 , 000 ( 8 ) + $400 , 000 $1 , 400 , 000 ( 5 ) = 5 . 714 + 1 . 429 = 7 . 143 . Table15.1. FinancialInformationforFirmsPandS. TheMergerofPandS PSProForma(P+S) Totalmarketvalue$8,000,000$2,000,000$10,000,000Totalearnings$1,000,000$400,000$1,400,000Numberofshares100,000100,000125,000Earningspershare$10$4$11.20Marketprice$80$20$80P/Eratio8 × 5 × 7.143 ×
November6,200913:44spi-b8119inx6inb811-ch15 300 AnIntroductiontoAccountingandManagerialFinance ThisleadstoamarketvalueofashareofP + Sequalto7.143($11.20) = $80.Thetotalmarketvalueis$80 ( 125 , 000 ) = $10 , 000 , 000 , whichisequaltothesumofthevaluesoffrmsPplusS.Valueisbeingneithercreatednordestroyedbytheacquisition.Withnochangeinoperations,expectations,orpayouts,thepost-acquisitionP/Eratioshouldbeaweightedaverageofthepre-acquisitionP/Es,wheretheweightsaretherelativeamountsofearningsofeachcomponent.TounderstandbetterthelogicofwhytheP/EoffrmP + SislessthanthatoffrmP,wewilldeterminetheimpliedgrowthratesforPandforS.Table15.2showsthecurrentdividend,thecostofequity,andtheretentionrate.Forexample,Pearned$10andpaida$6dividend;therefore,theretentionrateis0.4.Usingtheone-stagegrowthmodel, P = D k e g and,if D = ( 1 b)E ,then P = ( 1 b)E k e g. Solvingthisrelationshipfor g ,weobtaintheimplicitgrowthrate: g = k e ( 1 b)E P. ForfrmP,wehave g = 0 . 15 1 8 ( 1 0 . 4 ) = 0 . 15 0 . 075 = 0 . 075 . Table15.2. AdditionalInformation. PS Currentdividend$6.00$2.00Costofcommonstockequity( k e )0.150.15Retentionrate( b )0.40.5
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 301 Withzerodebt,andareturnoninvestmentof r fornewinvestments,then g = rb 0 . 075 = 0 . 4 rr = 0 . 1875 . ForfrmS,wehavealowerimpliedgrowthrate: g = k e E P( 1 b) = 0 . 15 1 5 ( 1 0 . 5 ) = 0 . 05 . Theimplicitreturnonnewinvestmentsis g = rb 0 . 05 = 0 . 5 rr = 0 . 10 . FirmShasalowergrowthratethandoesP;wealsoseethatSisexpectedtoearnonly0.10onnewinvestments,whereasPisexpectedtoearn0.1875.P’shigherP/Eratioimpliesthatthemarketismoreoptimisticaboutitsfuturegrowthandearningsopportunities.Each P / E ratioanddividendretentionpercentageimpliesadifferentgrowthrate(andthusadifferentreturnonnewinvestment).Table15.3givesafewillus-trativevaluesforaretentionrateof0.6anda0.15costofequitycapital.Therelationship g = rb assumesthatthereiszerodebt.Ifwechangedthatassumption,thegrowthrateformulationwouldbesomewhatmorecomplex. Table15.3. ImpliedGrowthRatesandReturns. P/E E P 0 . 60 E P g = 0 . 15 0 . 60 E P r = g 0 . 4 200.050.030.120.30100.100.060.090.22550.200.120.030.07540.250.1500 Note: b = 0 . 4 ; k e = 0 . 15 ; g = k e ( 1 b) E P ; g = rb .
November6,200913:44spi-b8119inx6inb811-ch15 302 AnIntroductiontoAccountingandManagerialFinance Thus,assumingthatafrmcanbeacquiredforitscurrentmarketvalue,itisnotimportantifthecurrentP/Eofthecandidateforacquisitionisaboveorbelowtheacquirer’sP/E.Itisimportantwhethertheacquisitioncanbeexpectedtoresultinanincreaseintheacquirer’sP/Easaresultofachangeinoperations(changingretentionratesordebtutilization),adecreaseinfnancingcosts( k i and k e ) ,orrealsynergisticeffectssuchasbetterratesofreturnonreinvestmentordirectreductionofcost(highercurrentearnings).Iftheweightedaveragepost-acquisitionP/Eratioexceedstheweightedaveragepre-acquisitionP/Eratio,orifearningsimprove,theacquisitionwilltendtobebenefcialtostockholdersofboththeacquiredandacquiringfrms. DilutionofEarnings Assumethatearningspersharearenow$1.20andthattheyaregrowingat5percentperyear.Iftheacquisitiontakesplace,theearningspersharewillonlybe$0.80,buttheexpectedgrowthratewillnowbe10percentperyear.Theearningspersharearediluted.Howlongwillittakefortheearningswiththeacquisitiontoequaltheearningswithouttheacquisition?Letbothsetsofearningsgrowfor n yearssothatthetwoearningsareequal: ( 1 . 05 ) n 1 . 20 = ( 1 . 10 ) n 0 . 80 1 . 10 1 . 05 n = 1 . 5 n ln ( 1 . 0476 ) = ln1 . 5 n = 0 . 405465 0 . 04652 = 8 . 716years . After8.716yearswithouttheacquisition,theearningswillbe ( 1 . 05 ) 8 . 716 ( $1 . 20 ) = 1 . 53 ( $1 . 20 ) = $1 . 84 . After8.716yearswiththeacquisition,theearningswillbe ( 1 . 10 ) 8 . 716 ( $0 . 80 ) = 2 . 295 ( $0 . 80 ) = $1 . 84 . Manymanagerswouldstatethat8.716yearsistoolongtowaitforanuncertainimprovementinearningspershareandwouldrejecttheacquisition.
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 303 TheCostofanAcquisition Ifanacquisitionrequirestheissuanceof1,000,000shares,wherethesharesoftheacquiringfrmbeforetheacquisitionannouncementweresellingat$80pershare,thecostoftheacquisitioncanbedefnedtobe$80 ( 1 , 000 , 000 ) = $80 , 000 , 000 . Ifthereare3,000,000sharesoutstandingbeforetheacquisition,and4,000,000sharesafter,andifthetotalvalueofthepost-acquisitionfrm’sstockis$400,000,000,wecoulddefnethecosttobe$400 , 000 , 000 × 1 , 000 , 000 4 , 000 , 000 = $100 , 000 , 000 , sinceone-fourthofthesharesarebeinggivenawaytoachievetheacquisition.However,thisisstretchingthedefnitionofcost,sincethefrmwouldnotbeworth$400,000,000withouttheacquisition.Ifthe3,000,000sharesareworth$80 ( 3 , 000 , 000 ) = $240 , 000 , 000beforetheacquisitionand$300,000,000aftertheacquisition,theoriginalstockholderswillhavea$60,000,000improvementintheirwealthposition(beforetax).Thetotalvalueofthefrmaftertheacquisitionisassumedtobe$400,000,000.Althoughcommonstockisfrequentlyissuedforanacquisition,sincethetrans-actioncanbenontaxabletotheinvestors,cash,debt,andpreferredstockarealsoused.Ifinsteadofissuingnewcommonstockshares,intheexample,apurchasepriceof$80,000,000cashispaidandifthefrm’svalueafteracquisitionis$320,000,000(equalto$400,000,000minusthe$80,000,000purchaseprice),thenthestock-holder’spositionwillnowimprovefrom$240,000,000to$320,000,000,foragainof$80,000,000. LeveragedBuyouts Inaleveragedbuyout(LBO),afrmisacquiredbyagroupofinvestors.Thefnancingforthepurchaseischaracterizedbytheuseofalargeamountofdebt.Therearetwobasictypesofleveragedbuyouts.Onetypeisengineeredbythecurrentmanagementwhosemembersbecomesignifcantstockholdersinthenewfrm.Thesecondtypeisstructuredbyoutsiders,butalmostinvariablytheywillattempttoretainthemoreimportantmembersofmanagement.AverylargeLBOofthefrsttypewastheacquisitionofMetromediaBroadcast-ingCorporationbyagroupcalledJ.W.K.AcquisitionCorporation.TheacquisitionpricewasoverUS$1billion.Infact,MetromediaitselfissuedUS$1.3billionworth
November6,200913:44spi-b8119inx6inb811-ch15 304 AnIntroductiontoAccountingandManagerialFinance ofhigh-yieldbondstohelpfnancetheacquisition(thefundswereusedtobuybackthecompany’scommonstock).Toplacethisamountofdebtinperspective,thetotalrecordedassetsofMetromediawasUS$1.3billion.J.W.K.AcquisitionCor-porationwascontrolledbythemanagementofMetromedia.Aslongasbanksandotherinvestorsarewillingtofnanceveryhighlyleveragedacquisitions,LBOswillprosper.Theyareaveryimportantfnancialdevelopmentoftheendofthe20thandthebeginningofthe21stcenturies. Greenmail Historically,acorporation(oracorporatemanagement)fndingthatitwasbeingpursuedbyanundesirablesuitor(ablackknight)wouldarrangetobuythesharesheldbytheblackknightatapremiumprice.Theintentionsoftheraidermaybeperfectlyhonorable,buttheperceptionsofthemanagementmightbedifferent.Thegreenmailprocessisnotfairtoallshareholders.Oneselectgroupofinvestorsisgiventheopportunitytosellatapremiumprice.Congresspassedalawthatimposesataxpenaltyonanyfrmengagedingreenmailandthiseffectivelystoppedtheprocess.Now,thesameoffertobuyhastogotoallshareholders. GoldenParachutes Ifthedefensivetacticsofatargetfrmhavenotworked,thenmanagement’sfnaloptionistohaveasafetynet.Acontractualagreementispreparedthatguaranteesamanageragivensumifhisorheremploymentisterminatedbecauseofanacquisitionormerger(achangeofcontrol). AccountingIssues Itisnotunusualforacorporationtoownsharesofcommonstockinoneormoreothercorporations.Thepercentageofownershipmayvaryfromafewshares,repre-sentingasmallpercentageofownership,to100percentofthesharesoutstanding.Intheabsenceofanactualmerger,whenthepercentageofownershipislarge,itisusuallydesirabletotreattheseparatecorporationsasiftheywereasingleentity,resultinginconsolidatedfnancialstatements.Regardlessoftheextentoftheholdingsinvolved,wemustdeterminethemanneroftreatingintercorporateinvestmentsonthebalancesheetandofrecognizingtheincomeattributabletotheseholdings. AccountingforLong-TermInvestments Assumethatonecorporationispurchasingsharesofcommonstockinasecondcorporationbutthatthepercentageofownershipisrelativelysmall.Inthissituation,
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 305 itwouldnotbeappropriatetoconsiderthefnancialaffairsofthetwocorporationsasiftheywereonecorporation.LetusassumethatCorporationAhaspurchasedasmallpercentageoftheoutstandingsharesofCorporationB.IfCorporationAviewsthesesharesasa temporaryinvestment ,itwouldclassifytheinvestmentasamarketablesecurity(acurrentasset).Ifthesharesarea long-terminvestment ,however,theaccount-ingtreatmentissomewhatdifferent.CorporationAowningcommonstockinBmay:a.Maintaintheinvestmentaccountatcost.b.Adjusttheinvestmentaccountasmarketvaluechanges.c.Recordtheinvestmentatthelowerofcostormarketvalue.d.RecordtheinvestmentatcostandadjustforCorporationA’sequityinthesub-sequentchangesinundistributedearnings(orlosses)ofCorporationB.Eachoftheseprocedureswillnowbediscussed. Cost Theadvantageofusingcostisthatthecostoftheinvestmentmaybedocumentedwithwell-defnedobjectiveevidenceandtheuseofcosthereisconsistentwiththebasisusedtorecordotherlong-livedassets.Thedisadvantageofrecordingtheinvestmentatcostisthat,withtime,costbecomesapoorestimatorofvalue.ItisnotsignifcantinformationforAtoindicatethatitpaid$100,000forsharesofCorporationBstock30yearsago.Thecostislikelytohavelittlerelationshiptothevalueofthesesharestoday.HowistheincomeofAaffectedbytheincomeearnedbyB?Theuseofcosttorecordtheassetimpliesthatincomeisrecognizedasthedividendsarereceivedontheshares.Butdividendsreceivedmaybeapoormeasureoftheeconomicgainarisingfrompossessinganinvestmentinsecurities.Theproblembecomesevenmoreacutewhenthestockholdingsaresolargethattheinvestingcorporationcaninfuencethedividendpolicyofthecompanywhosestockitholds.Insuchacase,itwouldbepossibletomanipulatethereportedearningsofCorporationAbyalteringthedividenddistributionsofCorporationB.Therefore,thisincomemeasuringprocedureshouldbeusedonlywhentheinvestorcorporationdoesnothaveasignifcantinfuenceovertheaffairsofthecompanyinwhichtheinvestmentisheld. Market Recordingtheinvestmentatmarketvalueisanimprovementovertheuseofcost.Themeasureoftheassetrefectswhatthemarketthinkstheinvestmentiscurrently
November6,200913:44spi-b8119inx6inb811-ch15 306 AnIntroductiontoAccountingandManagerialFinance worth.Ithasthecharacteristicofresultinginavaluationthatwillfuctuateasthestockmarketfuctuates.However,formanyinvestments,thereisnotaneffectivemarket.Thisistrueofwhollyownedsubsidiariesorwhereseveralcompaniesjoinforcestoformasubsidiary.Inthesesituations,marketvaluationcannotbeused.Nevertheless,insituationswhereawell-defnedmarketpricedoesexist,andwheretheholdingscanbereadilysoldatthemarketprice(thiswouldnotbethecaseifholdingswereverylargeorthemarketthin),themarketpriceprovidesthebestmeasureofthefairvalueoftheinvestmentformostpurposes.Ifmarketpricesareusedtorecordthevalueoftheinvestment,thenchangesinmarketpricesmustberecognizedasaffectingthestockholders’equity.Onepossibilityistotreatthechangeasincome(oraloss).Anydividendsreceivedarerecordedasrevenuewiththisprocedure. Equity Thefourthprocedure,usuallyreferredtoasthe equitymethod ,retainsanobjectivebasisforrecordingtheinvestment,yetdoesnotadheretooriginalcostasthemeasureoftheinvestment.Afterrecordingtheinvestmentatitsinitialacquisitioncost,adjustmentsaremadetorefecttheproportionateshareoftheearnings(orlosses)ofthecompanywhoseshareshavebeenpurchased.Therecognitionisnotcontingentonthedeclarationofadividend.Thisprocedureisparticularlyappropriatewhenthepurchasingcorporationhascontroloftheothercorporationandcaninfuencetheamountofdividendspaid.Theearningsoftheperiodprovideamoreobjectivemeansofdeterminingtheeconomicbeneftsthataccruefromtheinvestmentinthissituationthandothedividends.Whenearningsarereportedbythepurchasedcompany,aproportionateshareoftheearningsisaddedtotheInvestmentaccountandrecognizedasrevenuebytheacquiringcompany.Whendividendsarereceived,theyarenotconsideredtoberevenue.Therevenuehasalreadybeenrecognizedbasedontheequityintheearningsofthecompany.Thereceiptofcashisrecordedasanexchangeofassets—theInvestmentaccountisreducedandCashisincreased—butthereisnoeffectonincome. ConsolidatedFinancialStatements Whenthepercentageofownershipofonecompanyinanotherislarge,itisoftendesirabletoprovidestatementsshowingtheoperatingresultsandfnancialpositionasthoughtheseparatecorporationswerecombinedintoasingleoperatingunit.
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 307 Such consolidatedfnancialstatements frequentlyreplacethesingle-companystatementspreparedinthemannerdescribedinthepreviouschaptersofthisbook.Theconsolidatedstatementsareregardedassoimportantthattheyovershadowthefnancialstatementsoftheseparatecorporations,andmanycorporationsprovideonlytheconsolidatedstatementsintheirannualreports.Whenonecorporationownsasubstantialproportionofthesharesofanothercorporation,theinvestingcorporationiscalledthe parentcorporation .Anycor-porationsinwhichithassubstantialinvestmentsareknownas subsidiaries .Inpreparingconsolidatedstatements,theaccountantignoresthelegalfactthatthecompaniesareeachseparateentities.Instead,thecompaniesaretreatedasthoughtheywereasingleentityandtheaccountingtreatmentisadjustedaccordingly.Takingtheeconomicpointofview,itisreasonabletocastasidethelegalfctionofseparateentitiesandcombinethefnancialaffairsofseveralcorporationswhenthecorporationsdo,infact,operateasasingleunit. AccountingAssumptions Theconsolidatedstatementsarebasedoninformationcontainedintheseparatecompanystatements.Adjustmentsarelikelytobenecessaryforpurposesofcon-solidatingtheaffairsoftheseveralcorporations.Forexample,theinvestmentinsubsidiariesisshownasanassetonthestatementsoftheparentcompany.Thiswouldbetrueofanyofthebasicmethodsdescribedinthefrstpartofthischapter.Whenthecompaniesareconsolidated,theoriginalinvestmentoftheparentandthecorrespondingportionofthestockequityofthesubsidiaryatthetimeofpurchasemustbeeliminated.Thesetwoitemsareredundantfromtheconsolidatedentityviewpoint,becausethenetassetsofthesubsidiaries(whichtheInvestmentaccountrepresents)willbeincludedintheassetsofthecombinedunit.Theparentcompany’sshareofstockequityofthesubsidiaryasofthedateofstockpurchasemustbeeliminatedbecauseitdoesnotrepresentanoutstandingcapitalelementoftheconsolidatedcompany.Fromtheconsolidatedentitypointofview,itisakintotreasurystock.TheInvestmentaccountmustbeeliminated,becausetheconsolidationprocedureseffectivelychangethepurchaseofcommonstockintothepurchaseofassetsandtheassumptionofliabilities.Itwouldbedoublecountingtoincludeboththeparentcompany’sinvestmentandthesubsidiary’snetassetsintheconsolidatedstatement.Theneedforanotheradjustmentariseswhenthesubsidiarysellsgoodstotheparent(ortheparenttothesubsidiary).Proftisrecognizedatthetimeofasaletooutsiders.Fromtheseparatecompanypointofview,theparentcompanyisanoutsidertothesubsidiaryandviceversa.Inaccountingfortheseparatelegal
November6,200913:44spi-b8119inx6inb811-ch15 308 AnIntroductiontoAccountingandManagerialFinance entities,then,itisappropriatetorecognizeproftsonsalestransactionsbetweenthetwocompanies.Whenthetwocompaniesaretreatedasasingleentity,how-ever,adjustmentsmustbemadeforintercompanysalestransactions.Theyarenowconsideredtobemeretransferswithinthesameorganization,andnoproftisrec-ognized.Theproftthathasbeenrecognizedintheseparatecompanyaccountsforsuchtransactionsmustthereforebeeliminatedwhenconsolidatedstatementsareprepared. ConsolidatedBalanceSheets Thepreparationofaconsolidatedbalancesheetrequiresthecombiningofvariousaccountbalancesoftheseparatelegalentities.Beforesuchcombinationscanbeaccomplished,however,certainadjustmentsandeliminationsmustbemadeinthedata.Althoughwewilldescribetheseadjustmentsintermsofaccountingentries,itshouldbepointedoutthattheseentriesareforworksheetpurposesonlyandarenotrecordedinthejournalsofeithercompany.Fromthelegalpointofview,itistheconsolidatedentitythatisanaccountingfction,amerecreatureoftheaccountantdesignedtoprovideeconomicinformationinarelevantcontext.Thus,theconsolidatedentitydoesnotexistinastrictlegalsense,althoughitisconvenienttoassumeitsexistenceforthepurposeofprovidinginformation.Thefrstexamplewillassumethattheparent,CompanyA,haspurchased100percentofthecommonstockofCompanyB.Forsimplicity’ssake,theamountpaidinthisexamplewillbeequaltothebookvalueofthestock. Example CompanyAbuys100percentofthecommonstockofCompanyBfor$10,000.Immediatelyafterthepurchase,theseparatebalancesheetsofthetwocompaniesappearasfollows: CompanyABalanceSheetasofDecember31,20xx AssetsLiabilitiesandStockholders’Equity InvestmentinCompanyB$10,000Liabilities$15,000MiscellaneousAssets30,000CommonStock20,000 RetainedEarnings5,000 TotalAssets$40,000 TotalLiabilitiesandStockholders’Equity$40,000
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 309 CompanyBBalanceSheetasofDecember31,20xx AssetsLiabilitiesandStockholders’Equity MiscellaneousAssets$18,000Liabilities$8,000CommonStock7,000 RetainedEarnings3,000 TotalAssets$18,000 TotalLiabilitiesandStockholders’Equity$18,000 Thefrststepinpreparingtheconsolidatedbalancesheetistoorganizethedatafromtheseparatestatementsinaworksheet.Thisisdoneinthefrsttwocolumnsofthefollowingworksheet.Wethenproceedwiththenecessaryeliminationsandadjustments,andaddtheremainingitemstoobtaindatafortheconsolidatedbalancesheet(theright-handcolumnoftheworksheet). Eliminations AccountsCompanyACompanyBDr.Cr.ConsolidatedBalanceSheet MiscellaneousAssets$30,000$18,000$48,000InvestmentinCo.B10,000 (1) $10,000$40,000 $18,000 $48,000 Liabilities$15,000$8,000$23,000CommonStock20,0007,000(1)20,000$7,000RetainedEarnings5,000 3,000 (1) 5,000 3,000 $40,000$18,000$10,000$10,000$48,000 TheeliminationentryisacredittotheInvestmentaccountofCompanyAtoeliminatetheinvestmentinCompanyB(butleavingtheassetsofCompanyB)anddebitstoeliminatethestockequityofCompanyBasofthetimeofpurchase.Letusassumethattheeliminationentrywasnotmadeandthattheconsolidatedbalancesheetwaspreparedbynaivelyaddingtheasset,liability,andstockequity
November6,200913:44spi-b8119inx6inb811-ch15 310 AnIntroductiontoAccountingandManagerialFinance accountsofthetwocorporations.MiscellaneousAssets$48,000InvestmentinCo.B10,000 $58,000 Liabilities$23,000CommonStock27,000RetainedEarnings8,000 $58,000 Theformerstatementshowstotalassetsof$58,000,butthisincludesadoublecountingof$10,000ofB’sassets,becausenotonlyaretherealassetsofCompanyBincludedbutalsotheinvestmentofCompanyAinCompanyB.ThevalueoftheinvestmentofAinBisderivedfromtheassetsthatarealreadyincluded;thus,toincludetheinvestmentagainwouldbedoublecounting.Inlikemanner,thestockequityisoverstatedby$10,000,becausenotonlyaretherightsoftheinvestmentofAinBincludedbutalsotherightstotheassetsofB,andthisisalsocountingthesamethingtwice.Basedonthefguresshowninthelastcolumnoftheworksheet,theconsolidatedbalancesheetwouldappearasfollows: CompanyAandSubsidiaryConsolidatedBalanceSheetasofDecember31,20x1 AssetsLiabilitiesandStockholders’Equity MiscellaneousAssets$48,000Liabilities$23,000CommonStock20,000 RetainedEarnings5,000 TotalLiabilitiesandTotalAssets$48,000 Stockholders’Equity$48,000 ComplicationswouldbeintroducedifCompanyApurchased100percentofthecommonstockatapricedifferentfromthebookvalueofthestockequityofCompanyB.Forexample,ifCompanyAhadpaid$12,000forstockwithabookvalueof$10,000,thiswouldindicatethatCompanyAthoughttherewas$2,000ofintangiblevaluessuchasgoodwillorthattheotherassetswereundervalued.Iftheformerisassumedtobetrue,theeliminationentrywouldbe:CommonStock—B.............................7,000RetainedEarnings—B...........................3,000Goodwill........................................2,000InvestmentinCo.B............................12,000
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 311 Again,theinvestmentandthestockequityofCompanyBareeliminated.Inthissituation,anintangibleassetof$2,000isrecognizedinasmuchasCompanyApaid$2,000morethanthebookvalueoftheassets.Ifwecantracetheexcessofthepurchasepricetospecifcassetaccounts,thenthoseassetaccounts,ratherthantheGoodwillaccount,shouldbedebited.InsteadofincreasingspecifcassetaccountsorcreatingaGoodwillaccount,thedifferencebetweentheamountpaidandthebookvalueofthestockhold-ers’equityissometimesdebitedtoanaccountcalledExcessofInvestmentCostoverBookValue.Thisaccountisthentreatedasanoncurrentasset.Thedisad-vantageofthisprocedureisthatitresultsinapoorlydefnedassetitemthattheaveragereaderoffnancialreportswillhavediffcultyininterpreting.Itisbetterfortheaccountanttomakethedecisionastowhethertheamountpaidinexcessofbookvalueisaresultofundervaluationofspecifcassetsorthepresenceofgoodwill.Ifassetsareunderstated,theyshouldbewrittenuptoarealisticvalue.Ifthereareintangiblesconnectedwiththeutilizationoftheassets,resultingintheexpectationofhighfutureearnings,itisreasonabletorecordtheamountasgoodwill.AssumethatCompanyAhadpaid$8,000forthecommonstock.Thisisanamountlessthanthebookvalue.Thebookvalueoftheassetsisoverstated,andthereisatypeofnegativegoodwill.Negativegoodwillindicatesthattheearningpoweroftheassetsisactuallylessthanwemightexpectfromassetsofthisnatureor,equivalently,thattheassetsareoverstated.Theeliminationentrymightbe:CommonStock—B.............................7,000RetainedEarnings—B...........................3,000InvestmentinCo.B............................8,000ExcessofBookValueoverInvestmentCost.......2,000ThecredititemExcessofBookValueoverInvestmentCostwouldnotappearonthebalancesheet.Itshouldbeallocatedamongtheidentifableassets,reducingassetstotheirvalueatthetimeofacquisition.Asexplainedearlier,itis,inasense,negativegoodwill.InsteadofcreditingtheamountExcessofBookValueoverInvestmentCost,wemaycreditthespecifcassetsthatareovervalued.Thisisappropriateifweareabletoidentifytheassetsthatareoverstated.Ithasthedoubleadvantageofbeingmorestraightforward,thuseasiertounderstand,aswellaspresentingbetterinformationrelativetothevaluationoftheassetsowned. MinorityInterest AnothercomplicationariseswhenCompanyApurchaseslessthan100percentofthecommonstockoutstanding.Thisgivesrisetoa minorityinterest inthe
November6,200913:44spi-b8119inx6inb811-ch15 312 AnIntroductiontoAccountingandManagerialFinance consolidatedcorporation.Ifweassumethesamesituationasthepreviousone,exceptthatCompanyApurchases80percentofthecommonstockfor$8,000,theeliminationentrieswouldbe:CommonStock—B.............................7,000RetainedEarnings—B...........................3,000InvestmentinCo.B............................8,000MinorityInterest...............................2,000TheminorityinterestwouldappearontheconsolidatedbalancesheetofCom-panyAbetweentheliabilitiesandthestockholders’equity,oraspartofthestock-holders’equitysection.Itrepresentstheinterestofoutsidestockholdersofthesubsidiaryintheassetsoftheconsolidatedcorporation.Intheexamplecited,ApaidanamountequaltothebookvalueofBtimesthepercentageofownershipacquiredbyA(thepercentageofownershipbeingmeasuredbythefractionofcommonstocksharesitacquired).LetusnowassumethatApaid$12,000for80percentownershipinB.Therearetwopossiblemethodsoftreatingthissituation.IfApaid$12,000for80percentoftheownership,thenthevalueoftheentirestockholders’equitycouldbeinferredtobe$15,000.Let X equalthevalueofB;then,0 . 8 X = $12 , 000 ,X = $15 , 000 . Thebookvalueofthestockholders’equityis$10,000;thus,thereis$5,000ofgoodwill(oranyoftheotherpossibleinterpretationspreviouslydescribed).Thefollowingeliminationentrymightbemade:CommonStock—B.............................7,000RetainedEarnings—B...........................3,000Goodwill........................................5,000InvestmentinCo.B............................12,000MinorityInterest...............................3,000Theminorityinterestisequalto20percentof$15,000,theinferredvalueofCompanyB.Theforegoingtreatment,whichassumesitisappropriatetoadjustthetotalassetsofB,isreasonable.Incurrentpractice,however,accountantsrecognizegoodwillonlytotheextentthatithasbeenpaidfor.Thus,theywouldrecordonly
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 313 $4,000ofgoodwill.The$4,000iscomputedasfollows:InvestmentbyA$12,000EquityinIdentifableAssetsofB(80%oftotalvalue)8,000 Goodwill$4,000 Inthiscase,thefollowingeliminationentrywouldbemade:CommonStock—B.............................7,000RetainedEarnings—B...........................3,000Goodwill........................................4,000InvestmentinCo.B............................12,000MinorityInterest...............................2,000Theminorityinterestisequalto20percentofthe$10,000bookvalueofthestockholders’equityofCompanyB.Thesecondtreatmentassumesthatitisreasonabletorecordthegoodwillfortheportionofthefrmpurchasedbytheparent,butitisnotreasonabletorecordthegoodwilloftheminorityinterest.Thisisconsistentwiththeusualaccountingconventionofrecordingintangibleassetsonlywhentheyareexplicitlypurchased.Thevalueofgoodwillrelatingtotheminorityinterestmaybeimputedfromtheparentcorporation’spurchase,butinasmuchastheminorityshareholdersdidnotexplicitlypayforgoodwill,itisnotrecordedunderthisassumption.Inthefollowingexample,weshallassumethatApaid$5,600for80percentownership.Again,therearetwopossiblemethodsofrecordingthissituation,butweshallillustrateonlytheprocedurethatassumesitisappropriatetoadjusttheassetvaluationcompletely.Wefrstfndthevalueofthestockholders’equity.If80percentisworth$5,600,thentheentirestockholders’equityisworth$7,000(insteadofthebookvalueof$10,000).Theeliminationentrywouldbe:CommonStock—B.............................7,000RetainedEarnings—B...........................3,000InvestmentinCo.B............................5,600ExcessofBookValueoverInvestmentCost.......3,000MinorityInterest...............................1,400Theminorityinterestisequalto20percentof$7,000,theinferredvalueofthestockholders’equityofCompanyB.TheExcessofBookValueoverInvestmentCostwouldbeallocatedtothevariousspecifcassetsandliabilitiesinpreparingtheconsolidatedstatement.ThespecifcassetsofBareassumedtobeoverstatedintheaggregateby$3,000.
November6,200913:44spi-b8119inx6inb811-ch15 314 AnIntroductiontoAccountingandManagerialFinance IntercompanyTransactions Inadditiontotheentrieseliminatingtheinvestmentoftheparentinthesubsidiaryandthestockholders’equityofthesubsidiary,theremaybeintercompanytransac-tionsthatrequireeliminationentries.Forexample,BmaybeindebttoA.AssumeBowesA$2,000.Theeliminationentrywouldbe:AccountsPayable—B...........................2,000AccountsReceivable—A......................2,000FailuretoeliminatethereceivableonthebooksofAandthepayableonthebooksofBwouldbelikeahusbanddeclaringhimselfamillionairebecausehiswifelostthatsumtohiminaginrummygame.Forintrafamilypurposes,thedatamaybeofinterest;butinaconsolidatedstatement,whichtreatsthecombinedoperationsasasingleunit,thereceivableandpayableoffsetoneanother.IfBdeclaresacashdividend,AandBmightrecordthedeclarationintheiraccounts.Thefollowingeliminationentrywouldberequiredifthedividendhasbeendeclaredandrecordedbybothpartiesbutnotyetpaid(assumethetotaldividendis$4,000,ofwhich$3,200willgotoA):DividendsPayable—B...........................3,200DividendsReceivable—A......................3,200IfAhassoldaproducttoB,someofwhichisstillinB’sinventory,andthereisanelementofproftinthepricechargedbyA,itisnecessarytoeliminatetheproftfromtheinventoryofBandfromtheretainedearningsofA.AssumeAhasmadeaproftof$0.25perdollarofsale,andthatBhasinventorythatwaspurchasedfromAatacostof$4,000.Itisnecessarytomakethefollowingeliminations:RetainedEarnings—A...........................1,000Inventory—B.................................1,000Thisentryeliminatesthe$1,000ofintercompanyproftsfromtheinventoryofBandtheretainedearningsofA(thedebitcouldbetotheIncomeSummaryofA).Inthepresenceofa20-percentminorityinterest,someaccountantswouldmaketheforegoingentry,butsomewouldeliminateonly80percentoftheproftintheinventory.Theywouldcontendthatproftisrealizedtotheextentoftheminorityinterestshare.Theminorityinterestisthusviewedasan“outsider”bythecompany.Otheraccountantsarguethatifthesaleweremadefollowingthesameproceduresasifthecompanieswereseparateentitiesandnotparentandsubsidiary,thennoneoftheproftshouldbeeliminated(thiswouldbeconsistentwithalegalinterpretationoftheentity).Incurrentpractice,theentityconceptprevails,which
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 315 suggeststhatalloftheintercompanyproftswouldbeeliminated,regardlessoftheminorityinterest.Whenadebtexistsbetweenaparentandsubsidiary,theentireamountofthedebtiseliminateddespitethepresenceofminorityinterests.Thisshouldbeinterpretedasaruleestablishedforuniformity,becauseotherpossibleproceduresmightbeequallyacceptablefromatheoreticalpointofview.Forexample,theeliminationofafractionoftheamount(equaltothefractionofownership)couldbejustifed,becausetheinterestsoftheminoritystockholdersmakethedebtdueto“outsiders”.Thiswouldnotbethecaseifthesubsidiarywere100percentownedbytheparent.Aprevalentassumption,whichsupportstheeliminationoftheentireamountofintercompanyprofts,isknownasthe entitytheoryofconsolidations .Withthisassumption,theconsolidatedgroupisregardedasanentity,andtheminorityinter-estsareconsiderednotas“outsiders”butaspersonswhohavecontributedcapitaltothecompleteenterprise.Thus,theirequityistreatedaspartofthestockhold-ers’equityintheconsolidatedstatement,andalltransactionswithsubsidiariesarehandledasiftheywereentirelywithinthesingleunitwithno“outside”interestsinvolved. ConsolidationinaLaterPeriod Intheperiodsafterpurchase,thebasiceliminationentryforconsolidationisthesameastheonemadeatthetimeofpurchase.Thesignifcanceofthistreatmentisthattheincomesearnedandretainedsincethepurchaseofstockarenoteliminated.However,additionaleliminationentriesmaybenecessaryfordebtsowedbyoneofthecorporationstoanotherorforproperrecognitionofothertransactionssuchastheearningssinceacquisition.Also,therearecomplexitieswhenoneofthefrmssellstoanotherfrm.Thesecomplexitiesarebeyondthescopeofthisbook. TheSpin-off:SplittingtheCorporation Justasitisdesirableforsomecorporationstomerge,itmaybedesirableforotherfrmstodivestaunitorunits.Thereareseveralsituationswheredivestmentmaylogicallybedesirable.Inthefrstplace,theunitmaybemorevaluabletoanothercorporationbecausesynergyofsometypewouldresult.Infact,allthereasonsformergersare,withslightadjustments,reasonsfordivestment.Thereisanotherbasicreasonfordivestment.Assumeacorporationhasamajorunitthatisnothealthy.Thefnancialdiffcultyofthemajorunitmayover-shadowthefactthatotherunitsofthecorporationhaveexcellentprospects.In
November6,200913:44spi-b8119inx6inb811-ch15 316 AnIntroductiontoAccountingandManagerialFinance suchasituation,bondcovenantsmightpreventthespinningoffofproftableunits,sincetheseunitsareamajorpartofthedebtsecurity.However,theremaybenoreasonwhyasuitablesplitofthedebtcannotbearrangedsothatthedebtholdersareapproximatelyaswelloff(orbetteroff).Addingwarrantsorconversionfeaturesisonemethodofaccomplishingtheacceptanceofacorporatespin-off.Athirdreasonfordivestmentexistswhenthecentralcoreofthecorporationaddsoverheadcostsbutlittleornovalue.Infact,itcanbethatthelargesizeofthecorporationreducesmanagerialfexibilityaswellaspreventsidentifcationbyemployeeswiththewell-beingofthecorporation.Smallerorganizationalunitsstandingontheirownbottomsmightcollectivelybemorevaluablethananentiresetofunitsoperatingasonecorporation.Thereareseveraldifferentwaysofsplittingacorporation.Witha spin-off ,theshareholdersoftheparentreceivesharesintheunitbeingseparated(thistransactiontendstobetax-freeandinexpensive).Witha carve-out ,thesharesareissuedtothepublic(cashisraised).Witha split-off ,theshareholderschoosetoconvertsomeoralloftheirsharesintothesharesofthedivestedcorporation(theprocessprotectstheparent’sstockprice). Conclusion Theacquisitionofacorporationbyanothercorporationisaninvestmentdeci-sion.Ifoneisconvincedthatinvestmentsshouldbeevaluatedusingthenetpresentvaluemethod,itwouldbedisconcertingifaninvestmentdecisioninvolv-ingtheacquisitionofacorporateentitycouldbecorrectlymadeusingasimplisticdevicesuchasconjectingthechangeinthefrm’sP/Eratio.ItisnotclearthatamanagementisabletoacquireafrmwithalowP/E(suchasafrmwithlowgrowthopportunities)andfolditintoafrmwithahighP/Eandobtainaben-eft,unlessthemarketassumesthatthegrowthratewillchangeunderthenewmanagement.Wecanexpectthattheprospectofquickandeasyproftsarisingfromfnancialwheelinganddealingwillsometimesgiverisetodecisionsmadefromthepointofviewofshort-runconsiderationsratherthanfromthelong-termproftabilityofthedecision.Wecannotforcemanagementtosetobjectivesofonetypeoranother.Wecanhopethatabetterunderstandingofthesignifcanceofmergerswillleadtobetteranalysisonwhichtobasedecisions.Justcombiningtwofrmsdoesnotautomaticallyleadtoanincreaseinvalue.Mergersandacquisitionswillalwaysbewithusasonewayinwhichafrmmaygrow(whiletheinvestorsoftheacquiredfrmchangethenatureof
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 317 theirinvestment).Wemayseethegovernmentdefninglimitationsonsituationswherefrmsmaymerge,butitwouldbesurprisingtoseelegislationthatdis-couragedmergersandacquisitionsoffrmsindifferentindustriesfromtakingplace.Financialplannersmustconsiderthepossibilitiesofmergersandacquisitionsfromtwodifferentperspectives.Oneistheopportunitytoacquirenewfrms,andtheotheristhattheirfrmisapossiblecandidateforsomeoneelsetoacquire.Itisextremelydiffcultformanagerstoviewamergercompletelyobjectively.Iftheirfrmisacquiringanotherfrm,theprocessislookedatasbeingbenefcialtoallparties.Iftheirfrmisbeingacquired,theacquiringfrmisa“raider”.Afrmwithunder-utilizedassetsandlittledebtthatisundertakingless-than-proftableinvestmentsandhasoutstandinglargeamountsofpreferredstockisalikelymergercandidate.Theforegoingreasonsmaynotallbevalid,butthesesit-uationsdotendtoattractmerger-orientedfrms.Thefnancialplannershouldkeepthisinmind.Hopefully,thedecisionsthataremadewillbeaimedatmaximizingthewell-beingofthestockholders.Therearemanymotivationsthatleadtomergersandacquisitions.Thepaymentofalargepremiumovermarketpricedoesnotnecessarilyindicateanunwisedecisionbytheacquirer.Unfortunately,sometimesmanagementmightnotbeabletorevealallitsreasonsforofferingthelargepremium.Thus,stockholderunrestcanarisewheretherewouldnotbeunrestifallthefactswereknown.Butevenworse,therecanalsobesituationswheremanagement’sanalysisisfaultyandthepurchasepriceisexcessive.Timewillrevealwhichisthetruesituation.Lookingback,anyoneofuscanbewiserthanthewisestmanagertryingtomakemergerdecisionsunderconditionsofuncertainty. ReviewProblems ReviewProblem15.1 IfthecommonstockholdersofABDCorporationaretaxedat0.52andiftheybuyXYZstockat$100,howmuchcouldthecorporationABDpayforXYZstockandhavetheinvestorsindifferent?Theywillholdandnotsell. SolutiontoReviewProblem15.1 x = 100 1 t p = 100 1 0 . 52 = $208 . 33 .
November6,200913:44spi-b8119inx6inb811-ch15 318 AnIntroductiontoAccountingandManagerialFinance QuestionsandProblems 1.a.TheABCCompanyhasasimplecapitalstructure.Managementwantstosubstitute$100millionof0.12debtforcommonstock.Whateffectwillthechangehaveonthevalueofthefrmtoazero-taxinvestorwhoownsallthestock?Thecorporatetaxrateis0.35.b.TheXYZCompanyisthinkingofacquiringafrmthatisearningbeforetax$100,000ayear.TheborrowingrateofXYZis0.10,anditstaxrateis0.35.Thus,itsafter-taxborrowingrateis0.054.Theinvestmentinthefrmwillbefnancedwithsuffcientdebttocausetheamountofincometaxespaidtobezeroonthisinvestment.WhatisthemaximumamountthatXYZcouldaffordtopayforthefrm?2.Thefollowingfactsapplytotwocompanies,AandB,whoseoperationsarecompletelyindependent. AB P/E205Earningspershare$1$2Sharesoutstanding10,000,0001,000,000 AssumethatAacquiresBinexchangefor500,000sharesofcommonstock.a.Whatwillbethenewearningspershare(EPS)forA?b.WhatwouldyouexpectthenewP/EofA(afteracquisition)tobe?Assumearationalmarket.c.WhatwillbethetotalmarketvalueofA’scommonstockaftertheacquisi-tion?Assumearationalmarket.3.TheABCCompanyisconsideringacquiringtheDoggyCorporation.TheDoggyCorporationisearningbeforeinterestandtaxes$2millionperyearandexpectstocontinuetoearnthat(forperpetuity),andithaszerodebt.TheABCCompanycanborrowatacostof0.10andwouldhaveacapitalstructureof100percentdebtfortheDoggyCorporationifitacquiredit.Thecorporatetaxrateis0.35.Consideronlycorporatetaxes.WhatisthepresentvalueoftheDoggyCorporationtotheABCCompany?Assumethatthefollowingcalculationis
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 319 acceptedfor V U : V U = X( 1 t) 0 . 10 = $1 , 300 , 000 0 . 10 = $13 , 000 , 000 , where0.10istheappropriatediscountfactorforthezero-debtcashfows.4.Answerthefollowingstatementsastrueorfalse.a.FirmAwithahighP/EacquiresFirmBwithalowP/E.TheEPSofAwillincreaseimmediatelyasaresultoftheacquisition.b.Continuing(a),theEPSforaperiod10yearsfromnowwillcertainlybelargerforAasaresultoftheacquisition.5.TheRSCompanyiscurrentlyearning$10pershareandexpectstogrowatarateof0.05peryear.IfRSmergeswithTCompany,whichisgrowingat0.14,theearningswillbereducedto$8pershareandthegrowthratewillbe0.09.InhowmanyyearswilltheearningspershareofthemergedfrmsequaltheearningspershareofRSwithoutthemerger?6.TheABCCompanyhasthefollowingcapitalstructure: ProportionCostWeightedCost Debt0.80.100.080Commonstock0.20.160.032 0.112 ThecommonstockofacompanywithanidenticaloperatingriskasABCcanbeacquiredfor$1,000,000.Thestockholders’equitycashfowsoftheacquisitionare: 012 $1,000,000$120,000$120,000Thebeneftsareaperpetuity. Thissecondfrmhas$200,000ofdebt(netofanydisposableassets)paying0.06($12,000)peryear.Therearezerotaxes.ShouldtheacquisitionbeacceptediftheABCreturnsestablishtherequiredreturns?7.Distinguishbetweentheinformationsuppliedbyconsolidatedfnancialstate-mentsandfnancialstatementspreparedforseparatecorporations(withfnan-ciallinkages).8.OnJanuary15,20xx,CompanyQpurchasedallthecommonstockofCompanyYfor$40,000.Atthetimeofpurchase,thebalancesheetsofthetwocompanies
November6,200913:44spi-b8119inx6inb811-ch15 320 AnIntroductiontoAccountingandManagerialFinance wereasfollows: CompanyQCompanyY OtherAssets$65,000$50,000InvestmentinCompanyY40,000 $105,000 $50,000 Liabilities$30,000$10,000CommonStock50,00025,000RetainedEarnings25,000 15,000 $105,000 $50,000 PrepareaconsolidatedbalancesheetasofJanuary15,20xx.9.OnDecember31,20xx,theOliverCorporationacquired100percentowner-shipoftheStanleyCorporationbyissuing500,000sharesofcommonstock.Thetwocompanieswerethenlegallymerged.ThemarketpriceofOliverCor-porationstockwas$70pershare.Atthetimeofacquisition,thebalancesheetsofthetwocorporationswereasfollows: OliverCorporationStanleyCorporation Assets$200,000,000 $40,000,000 Liabilities$95,000,000$5,000,000CommonStock75,000,00010,000,000RetainedEarnings30,000,000 25,000,000 $200,000,000 $40,000,000 a.Preparejournalentriestorecordtheacquisition,assumingtheStanleyCor-porationceasestoexistasaseparatecorporateentity.b.ShowthebalancesheetoftheOliverCorporationafterthemerger.10.CompanyAbuys100percentofCompanyBfor$55,000. AccountsCompanyACompanyBEliminationsConsolidatedBalanceSheet OtherAssets$90,000$70,000InvestmentinCo.B55,000 $145,000 $70,000 Liabilities$25,000$15,000CommonStock40,00025,000RetainedEarnings80,000 30,000 $145,000 $70,000
November6,200913:44spi-b8119inx6inb811-ch15 MergersandAcquisitions:Consolidations 321 11.CompanyCbuys100percentofCompanyDfor$130,000. AccountsCompanyCCompanyDEliminationsConsolidatedBalanceSheet OtherAssets$65,000$130,000InvestmentinCo.D130,000 $195,000 $130,000 Liabilities$40,000$20,000CommonStock65,00030,000RetainedEarnings90,000 80,000 $195,000 $130,000 12.CompanyEbuys100percentofCompanyFfor$80,000. AccountsCompanyECompanyFEliminationsConsolidatedBalanceSheet OtherAssets$110,000$140,000InvestmentinCo.F80,000ExcessofBookValueoverInvestment $190,000 $140,000 Liabilities$70,000$40,000CommonStock50,00045,000RetainedEarnings70,000 55,000 $190,000 $140,000
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November6,200913:44spi-b8119inx6inb811-ch16 Chapter16 ConvertibleBonds Weshallconsiderinthischapterdebtsecuritiesthatareconvertibleattheoptionoftheownerintoagivennumberofcommonstockshares.Thesesecuritiesdonotclassifyneatlyasbeingeitherdebtorstockequity,sincetheyarehybridscontainingcharacteristicsofseveraltypesofsecurities.Thesehybridsecuritiestendtobediffculttovalue.Infact,oneoftheadvantagesofthesesecuritiesisthatthecompanyissuingthemandtheinvestorsconsideringbuyingthemmayhavedifferentestimatesofvalue.Convertiblesecuritiesarepopularamonginvestorswhowantafxed(well-defned)interestincomebutalsoanupsidepotential.Theconvertiblefeatureopensupthepossibilityoflargegainsforinvestorsifthestockrapidlyappreciatesinvalue.Thereisonlyasmallprobabilityoflargelossesbecauseofthesecurity’sbondcharacteristics.Thebondfeaturetendstoguaranteeperiodicinterestpay-mentsandthepaymentofprincipalatthegivenmaturitydate(ifthebondisnotpreviouslyretired)ifthestockpricedoesnotincreasesuffcientlytojustifycon-version.Theseconversionfeaturesarenotwithoutacosttoinvestors;convertiblebondscarryalowerinterestratethandocomparablebondswithouttheconversionfeature.Thisdiscussionofconvertiblesecuritieswillbeintermsofconvertiblebonds,eventhoughmuchofthediscussionalsoappliestoconvertiblepreferredstock.Considera$1,000facevalueorparvalue$1,000bondthatisconvertibleinto20sharesofcommonstock.Theconversionpriceis$50pershare(equaltothefacevalueof$1,000dividedby20).Ifthecommonstockpricegoesabove$50,thentheconversionprivilegeisofthevaluetotheinvestorwhohastosell.Forexample,ifthecommonstockiscurrentlysellingat$60pershare,theconversionvalueofthebondis$1,200.Themarketpriceofthebondwillbeatleast$1,200.Theholderofthebondcanrealizeatleast$1,200onthesaleofthebond.Withouttheconversionfeatureandwithnochangeininterestrates,aninvestorwouldonly 323
November6,200913:44spi-b8119inx6inb811-ch16 324 AnIntroductiontoAccountingandManagerialFinance realize$1,000onsale(ifinterestrateshadfallensignifcantly,theinvestormightbeabletorealize$1,200ormore,evenwithouttheconversionfeature).Apersonbuyingaconvertiblebondisreceivingtherightstofutureinterestandprincipalpaymentsplustheprivilegeofconvertingtocommonstockifitisdesirable.Ifthepriceofthecommonstockincreasessuffcientlytojustifytheconversion,thebondholderbeneftsfromtheconversionfeature.Theissuingcor-porationbeneftsfromtheconversionfeaturebybeingabletoissuedebtwithalowerinterestratethanitwouldotherwisehavetopay.Inaddition,atsometimeinthefuturetheremaybeconversionofthedebtintocommonstock,thusdecreasingtheamountofdebtoutstanding,withoutmakingacashoutlayfortheprincipal.Conversiontermsofabondmaychangethroughtimeeitherbecauseofbuilt-inconditionsinthebondindentureorbecauseofstockdividendsandstocksplits.Informedinvestorsinconvertiblebondswillinsistonprotectionagainstdilutionwithstockdividendsandsplits.Theperiodoftimeduringwhichtheconversionfeaturesapplymaynotbethesameasthebondmaturity.Itisimportantthatthebondcontractbereadcarefullybyaconservativeinvestorconsideringpurchasesoastoreducethenumberofunpleasantsurprises. DescriptionofConvertibleBond Thefnancialcharacteristicsofaconvertiblebondcanbedescribedinthreedifferentways:1.Itisabondwithacalloptiontoconverttocommonstock.2.Itisthesumofitsexpectedvalueasdebtplustheexpectedvalueasstock.3.Itiscommonstockwithdownsideinsuranceifthecommonstockdoesnotgoupsuffcientlytowarrantconversion.Letusassumethataveryriskycompanywantstoissuedebt,butitcannotfndbuyersforitsbondsunlessitpaysmoreinterestthanitcanafford.Addingaconversionfeaturemayattractinvestors.Forexample,ifthestockpriceis$40,thebondscanbedefnedtobeconvertibleinto20shares(thereisa25-percentconversionpremium).Aconvertiblebondisahybrid.Itisadebt,butifthestockpricegoesupto$60bymaturity,theinvestorwillhaveavaluableoptionofconvertingitinto20sharesofcommonstock.Ifthebondisnotcallableforaperiodoftime,theinvestorhassomeprobabilityoflargegains.Ifthestockpricedoesnotgoup,theinvestorhasthefallbackpositionofreceiving$1,000atmaturity.
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 325 Oneoftheimportantadvantagesofconvertiblebondsisthattheyofferinterest-ingriskpossibilities.Thereisonlyaverysmallprobabilityoflosinglargeamounts,andthereisaprobabilityoflargegains(ifthecommonstockincreasesinvaluerapidly).Thereisalsoahighprobabilityofasmallloss.Thereisanopportunitylossarisingfromacceptinglowerinterestthanwithstraightdebt(thelossoccursiftheconversionfeatureturnsouttohavelittleornovalue).Sinceitisanopportunityloss,itisimplicitratherthanexplicit(largerinterestpaymentscouldhavebeenearnedonbondswithouttheconversionfeature);therefore,itisnotapparenttosomeinvestors.Anadvantageofconvertiblebondsforaspeculatoristhatthebondssometimeshaveasmallermarginrequirementthanstock.Thus,theinvestorscanlevertheirinvestmentwithmoredollarsinvestedinbondsthantheycaninvestincommonstock. ConversionPremiums BasicRelationships Wefrstestablishbasicconvertiblebondrelationshipsthatareusefulforanalysis.Let B = thefacevalueofthedebt; s = thenumberofsharesofcommonstockintowhichabondcanbecon-verted,i.e.,theconversionratio; B 0 = thevaluenowofthesecurityasstraightdebt; M 0 = theconvertiblebond’smarketvaluenow; P 0 = thecommonstock’smarketvaluenow.Investorsarefrequentlyinterestedintwomeasures:thepremiumoverbondvalueandtheconversionpremium.Weshallcomputethesemeasuresaspercent-ages,althoughtheyaresometimespresentedindollaramounts.Thepremiumoverstraightbondvalueincurredbybuyingtheconvertiblebondisdefnedas M 0 B 0 B 0 . (16.1)Theconversionpremiumisdefnedas B sP 0 sP 0 . (16.2)
November6,200913:44spi-b8119inx6inb811-ch16 326 AnIntroductiontoAccountingandManagerialFinance Thisgivesthepercentageincreaseincommonstockpricerequiredforthebond(ascommonstock)tobeworthasmuchasthecommonstockthatcouldbepurchased. Example16.1 An8-percent$1,000bondisconvertibleinto20sharesofcommonstock.Thestockiscurrentlysellingat$45pershareandthebondissellingat$1,200.Assumethatthebondasstraightdebtwouldhaveavalueof$800.Thepremiumoverstraightbondvalueis M 0 B 0 B 0 = $1 , 200 $800 $800 = $400 $800 = 0 . 50 . Theconversionpremiumis B sP 0 sP 0 = $1 , 000 20 ( $45 ) 20 ( $45 ) = $100 $900 = 0 . 11 . Thebondiscurrentlysellingat50percentoveritsvalueasstraightdebtandhasan11-percentconversionpremium.Otherfactorsofinteresttotheinvestorarethecallpremiumandtheperiodofnocall(theissuingfrmcannotcallduringthisperiod).Thehigherthecallpremiumandthelongertheperiodofnocall,themoreprotectiontheinvestorshaveagainstbeingforcedtosellortoconverttheirbondsbeforetheywantto.Duringtheperiodthattheissuingcorporationcannotcall,theinvestor’spotentialgainsareunlimited.Iftheissuingcorporationcancall,thepotentialgainislimitedbythelikelihoodofthefrmcalling.Acalledconvertiblebondcanalwaysbeconvertedwithinagiventimeperiodintocommonstockifaninvestorsodesires.Onecriterionusedwhendeterminingwhetherornottocallisthedrainoncashresultingfromthedividendsonstockcomparedtothecashdrainoftheinterestpayments.Equallyimportantiswhetherornottheconversionvalueofthebondisabovethecallprice.IfthecommonstockinExample16.1werepaying$1pershareperyear,conversionwouldmeancashdividendsof$20peryearcomparedto$52peryearofafter-taxinterest(assuminga0.35corporatetaxrate,theafter-taxcostofthe$80contractualinterestis$52).Letthestockpriceattime t be P t .Thecorporationmightwelldecidethatconversionwasdesirableassoonastheconversionvalue( sP t )wentabovethecallprice(orenoughabovesothattheinvestorswouldconvertratherthantakeadvantageoftheopportunitytoliquidatetheirinvestmentwithouttransactioncostsatthecallprice).Theinvestors,fortheirpart,wouldcompare$80ofinterestand$20ofcommonstockdividend,thetaxesonthesereturns,andthesafetygivenbythebondfeaturebythesecurity,andwouldlikelydecideto
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 327 postponeconversionuntilthecashdividendwereincreasedortheywereforcedtoconvertbythebondsbeingcalled. ValueofaConvertibleBond If P t isthestockpriceattime t ,thepresentvalueofaconvertiblebond, M 0 ,canbeexpressedintermsofthepresentvalueoftheinterestandprincipalorthepresentvalueoftheconversionvalue.If P t nevergoesabovetheconversionprice,thefacevalueofthebondisusedastheestimateoffuturevalue(therewillbenoconversion)andthebondisvaluedasstraightdebt.If P t goesabovetheconversionprice,wecanassumethatthebondisconvertedattime t ,where t ischosentomaximizethenetpresentvalue.Ifthesecondcalculation(valuewithconversion)islargerthanthevalueasstraightdebt,theconversionfeaturehassomevalue. Example16.2 A30-year,0.08bond($1,000facevalue)isconvertibleinto25sharesofcommonstock.Thepriceofthecommonstockiscurrently$50pershare,andthecommonstockpriceisexpectedtoincreasesteadilyto$391attheendofyear30(a7-percentgrowthrate).Thecommonstockispayinga$2-per-sharedividendthatisexpectedtocontinuefortheentire30years.Theyieldforcomparablebondswithoutaconversionfeatureis0.09.Wewanttodeterminethepresentvalueoftheconvertiblebondifitisconvertedjustbeforematurity.Assumethattheinvestordoesnotpaytaxes.Thevalueoftheconvertiblebondwithconversionin30yearsusing0.09astheopportunitycostandthecommonstockpriceof$391pershare(25sharesareworth$9,775)is 30 t = 1 $80 ( 1 . 09 ) t + 25 $391 ( 1 . 09 ) 30 = $80 × 10 . 2737 + $9 , 775 × 0 . 0754 = $821 . 90 + $737 . 07 = $1 , 558 . 94 . Thevalueofthesecurityasastraightbondis$897.30,using0.09and30-yearpresentvaluefactors:$1 , 000 × 0 . 0754 = $75 . 40$80 × 10 . 2737 = 821 . 90 $897 . 30
November6,200913:44spi-b8119inx6inb811-ch16 328 AnIntroductiontoAccountingandManagerialFinance Thetotalvalueofthebondisequaltothesumofthestraightbondplusthevalueoftheconversionfeature.Ifthepriceofthebondis$1,558.94,thevaluebeingplacedontheconversionprivilegeisvalueofconversionpackage = $1 , 558 . 94 $897 . 30 = $661 . 64onthebasisofconvertingattime30. TheInvestmentDecision ComparingConvertiblesandDebt Howdoesonemakethedecisiontobuyaconvertiblebond?First,weshallcomparetheconvertiblebondtostraightdebt;then,weshallcomparebuyingaconvertiblebondorcommonstockofthesamefrm.Assumethatstraightdebtispaying k i interestandthattheconvertibledebtwillpay k .Assumethatthecallpremiumof C willbereceivedattime n onlyiftheconvertiblebondispurchased.Theincrementalnetpresentvalue(NPV)ofthecashfowsfrominvestingintheconvertiblebondratherthanthestraightdebtisNPV = [ B(k k i ) ] B(n,k i ) + C( 1 + k i ) n . (16.3)Theinvestorintheconvertiblereceives (k k i )B lessinterestfor n yearsthantheinvestorinstraightdebt,butdoesreceive C (thecallpremium)attime n thatthestraightdebtdoesnotpay.SettingtheNPVequaltozero,wecansolvefor n ,thenumberofyearsthatcanpasswiththeinvestorearningatleastareturnof k i ifthebondiscalledonorbefore n yearshavepassed.Ifthebondiscalledafter n yearshavepassed,andiftheconversionvalueisnotlargerthanthecallprice,theinvestorwillearnlessthan k i .Solvingfor n ,weobtain n = ln k i C/B(k i k) + 1 ln ( 1 + k i ). (16.4) Example16.3 Assumethataconvertiblebondiscallableatapriceof$1,090( C = $90).Theconvertibleyields0.082andcomparablestraightdebtyields0.10.Theinvestoriszerotax.
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 329 Solvingfor n , n = ln k i C/B(k i k) + 1 ln ( 1 + k i ) (16.4) = ln 0 . 10 × $90 / 0 . 018 ( $1 , 000 ) + 1 ln ( 1 . 10 ) = ln1 . 5 ln1 . 10 = 0 . 40547 0 . 09531 = 4 . 25 . Assumethatthebondiscallableaftertwoyears.Inthefrsttwoyears,theinvestorcanearnunlimitedreturns(thefrmcannotcall).Inyears2.0to4.25,theinvestorcanearnmorethan k i ,butthegainsarelimitedbythefactthatthefrmcancallanytimeafter2.0years.Assumingthattheconversionvalueattime4.25islessthanthecallpriceandthatthefrmwillcallassoonastheconversionvalueequalsthecallprice,theinvestorwillearnareturnafteryear4.25thatislessthan k i .Ifthebondisheldtomaturity,withoutcalloraconversiontakingplace,theinvestorwillearn k = 0 . 082.Thisisthecontractualrateontheconvertiblebondoriginallyissuedatpar.Nowassumethatthefrmcanonlycallafteryear6.Theinvestorcanearnunlimitedgainsuntilyear6( n islessthan6,sotheexactvalueof n doesnotaffectthevalueofthebondtotheinvestor).However,since n islessthan6,weknowthatthestockpricehastogoabovetheconversionpricepriortoyear6ortheinvestorwillearnlessthan k i .Theprimaryimportanceofthemodel[equation(16.4)]isthatithighlightstheimportanceof k , k i , C ,andtheperiodduringwhichthefrmcannotcall.Also,becausethelikelihoodofthestockincreasingabovethecallpricebefore n timeperi-odsisofimportance,theconversionpremiumthatissetisofconcerntotheinvestor. ComparingConvertiblesandCommonStock Insteadofcomparingtheconvertiblebondandstraightdebt,investorsfrequentlycompareinvestingintheconvertibledebtandinvestingincommonstock.Thereareseveralapproaches,butwewillcomparebuyingabondconvertibleinto s sharesofcommonstockorbuying s sharesofcommonstock. Example16.4 k i = 0 . 10, k = 0 . 09, s = 20andtherearenotaxes B = $1 , 000(costofconvertiblebond) P 0 = $42,dividend = $2pershare
November6,200913:44spi-b8119inx6inb811-ch16 330 AnIntroductiontoAccountingandManagerialFinance Since s = 20,assumethattheinvestorbuys20sharesofcommonstock.Twentysharesofcommonstockwillcost$42 × 20 = $840 . Thestockwillpaydividendsof$2 × 20 = $40peryear . Buyingtheconvertiblebondcostsanextra$160:$1 , 000 $840 = $160 , andthisbondwillearnanextra$50ofinterestperyearcomparedtothe$40commonstockdividend:$90 $40 = $50 . Thenetpresentvaluefrominvestingintheconvertiblebondratherthanthecommonstock,assumingtheinterestadvantagelastsforever,isNPV =− $160 + $50 0 . 10 = $340 . Wecandeterminehowlongtheinterestadvantagehastoexistfortheinitial$160investmenttoberecovered: $160 + $50B (n, 0 . 10 ) = 0B (n, 0 . 10 ) = 3 . 2 n = 4 . 05years . Wecanalsosolvefor n moregenerally.Let C 0 betheadditionaloutlayresultingfrombuyingthebondinsteadofthestock: C 0 + ( Int Div ) B (n,k i ) = 0 . Solvingfor n yields n = ln ( Int Div )/( Int Div k i C 0 ) ln ( 1 + k i ). (16.5)Fortheexample,wehave n = ln $50 /( $50 $16 ) ln1 . 10 = 0 . 3857 0 . 0953 = 4 . 05years .
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 331 Someinvestorsliketocomputeapaybackperiodfortheextra$160investment:$160 $50 = 3 . 2years . ThismeasureiswidelyusedonWallStreettoevaluatetheinvestmentdesirabilityofaconvertible.The4.05yearspreviouslydeterminedtakesintoconsiderationthetimevalueofmoney.The3.2doesnotconsiderthetimevalueofmoney.Sofar,wehaveassumedaconstantcommonstockdividend.Ifthedividendisincreasing,thenwedecreasethenetpresentvalueofinvestinginthebondcomparedtoinvestinginthecommonstock.Theadvantageofcomparinganinvestmentintheconvertiblebondandaninvestmentinthecommonstockisthatitholdsthecommonstockpriceappreciationneutral(itispresentwithbothbuyingalternatives)sothatwecanconcentrateonthecharacteristicsoftheconvertibledebt. InterestRateandConversionPremium Thepricethatissetforaconvertiblebondisafunctionoftheinterestrateonthebondandtheconversionpremium.Thesmallertheconversionpremium,thesmallertheinterestrateontheconvertiblebondhastobe.Conversionpremiumsareusuallybetween20and30percent. Example16.5 Letusanalyzethefollowingtwoalternativesfora20-yearbond.Thestockpriceisnow$40. InterestRateSharesConversionPremiumConversionPrice Alternative10.0825$1 , 000 25 $40 25 $40 = 0$40Alternative20.1020$1 , 000 20 $40 20 $40 = 0 . 25$50 Whichalternativeisbetterfortheissuingfrm?
November6,200913:44spi-b8119inx6inb811-ch16 332 AnIntroductiontoAccountingandManagerialFinance Alternative2hasanextra$20-per-yearinterestona$1,000bond.Butitsavesfvesharesatthetimeofconversion.Ifthestockpriceis$40orlessandconversiondoesnottakeplace,alternative2leadstoanextra$20-per-year(before-tax)costandzerobenefts.Thebondsarenotconvertedwitheitheralternative.Alternative2isinferiortoalternative1.Ifthestockpricegoesto P n where P n islargerthan$50,thenalternative2savesfvesharesworth P n each.Fortheissuingfrm,wehaveaNPVofNPV =− 20B (n,k i ) + 5 (P n )( 1 + k i ) n . Ifthestockpriceisbetween$40and$50,thenattime n alternative1costs25 P n whilealternative2costs$1,000.TheNPVofalternative2comparedtoalternative1isNPV =− 20B (n,k i ) + 25 P n $1 , 000 ( 1 + k i ) n . If P n = $40,theNPVisanegative20B( n , k i )andalternative1ispreferred.If P n = $50, n = 20,and k i = 0 . 10,wehaveNPV =− 20 ( 8 . 5136 ) + ( $1 , 250 $1 , 000 )( 0 . 1486 ) =− 170 + 37 =− 133 . Alternative1isbetterthanalternative2.With n = 20, P n hastobeatleastaslargeas$229foralternative2tobebetter:NPV =− 20 ( 8 . 5136 ) + 5 P n ( 0 . 1486 ) = 05 P n = $170 0 . 1486 = $1 , 144 P n = $229 . Theanalysiscanalsobedonefordifferentvaluesof n anddifferentcallstrate-gies.Anearlierconversionwillincreasetheimportanceoftheextrafveshares. TheInvestor Whyshouldaninvestorbuyaconvertiblebond?Weshallassumethattheinvestorhasalreadydecidedtoinvestinthecommonstockofthecorporation.Weconsideronlythequestionastowhetherornotthisproposedconvertibledebtisabetterinvestmentthanthecommonstock.Tosimplifytheanalysisforboththeinvestorandtheissuingfrm,wewillassumethat:1.Thereiszeroconversionpremium;2.Theinterestpaymentperperiodwillinitiallybelargerthanthecashdividendonthecommonstock;
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 333 3.Thereisantidilutionprotection(thenumberofsharesthebondisconvertibleintoisadjustedforstockdividendsandstocksplits).Assumethattheconvertiblebondisbeingissuedatapriceof$40andthatitisconvertibleintooneshareofcommonstockcurrentlysellingat$40pershare.Thebondpays$4interestperyearandthestockpays$3ofdividendsperyear.Shouldtheinvestorbuythebondorthestock?Bothinterestanddividendsaretaxedthesame.Theconvertiblesecurityjustdescribedisbetterthanthepurchaseofanequiva-lentnumberofsharesofcommonstockinthesamecompanyforazero-taxinvestororforanindividual.Themostsignifcantadvantageoccursbecausethecontractualinterestpaymentislargeraswellassaferthanthecashdividend.Fortheinvestor,thebonddominatesthecommonstockbecausethereisnopossiblewayinwhichitcanbeinferior.Ifthestockpricegoesupandthecashdividendexceedstheinter-estbeingpaid,theinvestormightwanttoconvertandthuswillholdthecommonstock(thesamenumberofshareswillbeheldasifthecommonstockhadbeenpurchasedinitially).Ifthecommonstockpricefallsbelowtheconversionvalue,thecallpriceandthematurityvaluesupplysomeprotection(theexistenceofamaturitydateensuresthattheinvestorwillatleastreceivethematurityvalue).Butthisprotectionisanextrabonusgiventhatwehadalreadyestablishedtherelativemeritsofthebondandthecommonstock.Normally,theinvestorwillconsiderthisvaluetobeamajorreasonforpurchas-ingthesecurity.Iftheconversionvaluefallsbelowthematurityprice,theinvestorhasdownsideprotection.Ifthefrmwantstoavoidtheinterestpaymentsandiftheconversionvalueexceedsthecallprice,thefrmcancallandforceconversion.However,ifthefrmwantstoavoidtheinterestpayments,andthecallpriceexceedstheconversionvalue,thenacallbythefrmwillrequireacashoutlay.Unfortunately,thesamefactors(unproftableoperations)thatmightcausethefrmtowanttoavoidpayingtheinterestwillalsotendtopreventitfromcallingthebondspriortomaturity,ifcallingthebondscausesacashoutlaytotakeplace.Ifthefrmcanpaytheinterestbecauseofadequatecashfowbutcannotusetheinteresttaxshieldbecauseoflowtaxableprofts,thefrmmightwishtocallthedebttoconverttheinterestpaymentintothesmallercashdividend.Aconversionvaluelargerthanthecallpricecombinedwithanexpectationthattheinteresttaxshieldcouldnotbeusedinthefuturewouldsimplifythedecisiontocall.Butevenwithforcedconversion,theinvestorisatleastaswelloffasifthecommonstockhadbeenpurchasedinitially.Iftheconversionvalueiscurrentlylargerthanthecallprice,theissuingfrmmightcallnowifthereisaprobabilityofafuturechangeinthefrm’swell-being
November6,200913:44spi-b8119inx6inb811-ch16 334 AnIntroductiontoAccountingandManagerialFinance andaresultantdecreaseinstockprice,sothatthefrmwouldnotbeabletoforceconversioninthefuture. TheIssuingFirm’sPerspective Thenegativefeaturesoftheconvertiblesecurityfromtheviewpointoftheissuingfrmarethatitpromisestopayinterestperiodicallyandthatthereisanamountdueatmaturity.Theinterestpaymentiscontractualandthushasmorerisktothefrmthandocommonstockdividends.Also,iftheinterestpaymentislargerbeforetaxesthanthecommonstockdividend,andifthefrm’staxstatusweretochangesothatthefrmcouldnotusethetaxshield,thedebtcouldbemorecostly.Ifthestockpricedropsbelowthecallprice,acallingofthebondwouldresultinacashoutlay;thus,forcingconversionmightbeimpossibleforafrmwithcashproblems.Anotherwayofdescribingthisdiffcultyistodefneitintermsofthedownsideprotectionbeingofferedtotheinvestors.Althoughthedownsideprotectionisanadvantagetotheconvertiblebondpurchaser,itisadisadvantagetothecommonstockholders(itincreasestheirrisk).Theprimaryadvantagefortheissuingfrmofthistypeofconvertiblesecuritycomparedtocommonstockisthetaxdeductibilityoftheinterest.If$100millionofconvertibledebtispaying$10millionofinterestinsteadof$10millionofcommonstockdividends,thefrmwitha0.35taxratewillsave$3.5millionperyear.Thisisasignifcantincentiveforusingtheconvertiblesecurityratherthancommonstock.Butthisadvantageexistsforallsecuritiesclassifedasdebt.TheIRSwillobjecttodebtthatistoomuchlikecommonstockandwillattempttoblocktheuseoftheinterestpaymentasataxdeduction.However,anyconvertibledebtispartdebtandpartcommonstock,sotheissueisalreadyonthetable.Theonlyquestionistheextenttowhichthelogicaluseofconvertibledebtcanbeextendedbytheuseofsecuritiesthathavedesirablecharacteristicsfromtheissuingfrm’sviewpoint.Thebasicfaultisinataxcodethatattemptstodistinguishinasubstantivemannerbetweenthecashdistributionsofcommonstockanddebt.Itisnotpossibletodistinguishbetweentheminanexactmannerwithahybridsecurity.Theissuingfrmwillbehappywithitsdecisiontoissuetheconvertibledebtratherthancommonstockaslongastheafter-taxcostoftheinterestislessthanthecashdividendthatwouldhavebeenpaid,andifatthetimeofcallormaturitytheconversionvalueismarginallylargerthanthecallprice.Supposethatthepriceofthecommonstockfallsandthedebtiscalledwhentheconversionvalueislessthanthecallpricesothatthefrmhastomakeacashoutlay.Inthatcase,itispossiblethattheissuanceofcommonstockwouldhave
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 335 beenbetter.However,ifthetimeofcallisreasonablylongafterthetimeofissue,itislikelythatthecashsavingsfromtheinteresttaxshieldwillhavealargerpresentvaluethanwillthecostofthecall(thedifferencebetweenthecallpriceandthevalueoftheequivalentsharesofthecommonstockattimeofcall,whenthecallpriceislargerthantheconversionvalue).Ifthecallpriceissetrelativelylow,thereislikelytobeaverysmallprobabilitythatthefrmwillregrettheissuanceoftheconvertibledebtcomparedtotheissuanceofanequivalentnumberofcommonstockshares.TheguidelinesestablishedbytheTreasuryorbyCongressastowhatacceptabledebtis(thus,theinterestpaymentswillbetax-deductible)willbecruciallyimportantindetermininghowcloseafrmcanmovetothetheoreticallyoptimumsecurity(averylowcallpriceandasmallconversionpremiumattimeofissuance).Animportantargumentagainsttheissuanceofconvertibledebtisthatitdoesresultinadilutioninthestockholder’sequityposition.Theholderofaconvertiblesecuritycanshareinthewinningsiftheeventsturnouttobedesirable.Thisisrealdilution.Ifeventsdonotgowell,withtheresultthatthestockpricedoesnotincrease,thenanoverhangofpotentialdilutioniscreated,andthereisstilldebtoutstanding.Anotherimportantconsiderationisthatfnancialanalyststendtoconsidercon-vertiblebondsascommonstockequivalentsinevaluatingthecommonstock,andbondratingagenciestendtoconsiderconvertiblesasdebtinarrivingatbondrat-ings.Thisislookedatbyfnancialoffcersasadoublepenalty,andisconsideredasanegativefactorarguingagainsttheissuanceofconvertibledebt.Taxconsiderationsworkbothforandagainstconvertiblebonds.Thetaxdeduc-tionofconvertiblebondinterestgivesthebondsanadvantagecomparedtocommonstock.Butthelowerexplicitinterestcostscomparedtonon-convertibledebtresultinlowertaxshields;thus,thereislessvalueaddedper$1,000bondasaresultofusingtheconvertiblebond(whichispartequitycapital). BondswithWarrants Awarrantgivestheinvestortherighttobuyashareofstock(orafractionofashare)atagivenexerciseprice.Theexercisepriceispaidtotheissuingcorporation.Inadditiontoconvertiblebonds,bondswithdetachablewarrantsarealsousedbycorporations.Theadvantageofthedetachablewarrantisthat,uponexercise,theinvestorstillhasabondinvestmentwithitsfxedreturnandthecorporationhasdebtoutstanding.Ifthenumberofsharesofstockassociatedwitheachbondislesswithdetachablewarrantsthanwithaconversionfeature,therewouldtendtobelessdilutionofthecurrentstockholders’position.Apossibledrawbackfromthe
November6,200913:44spi-b8119inx6inb811-ch16 336 AnIntroductiontoAccountingandManagerialFinance corporation’spointofviewisthat,aftertheexerciseofthewarrants,thereisstilldebtoutstanding,andthisreducesthedebt-issuingabilityofthefrm(assumingthatitwantstoissuemoredebt).Tosolvethisobjection,thefacevalueofthebondmaybeacceptedfortheexerciseprice.Oneadvantageofissuingbondswithwarrantsisthattheissuepriceissplitbetweendebtandstockequity(thevalueofthewarrantisclassifedasstockequity).Theissuepriceofaconvertiblebondisclassifedasdebt.Thetwotypesofsecurities(convertiblebondsandbondswithdetachablewar-rants)areverysimilar,anditisdiffculttodescribesubstantivedifferencesasidefromdifferencesinaccounting. Dilution Dilutionforthepresentshareholderstakesplacewhentheirpercentageofown-ershipisreducedbytheissuanceofnewsharesornewsecurities.Convertiblesecuritiesareattractivetoissuers,sincetheconversionfeaturetendstoreducetheexplicitinterestcost.Butaconvertiblesecuritycarrieswithitathreatofdilutionofthestockholders’equitythatisnotpresentwithstraightdebt.However,thedilutionmaybelessthanifcommonstockwereissuedimmediately.Also,thereisalwaysthechancethatthebondswillnotbeconverted,andthecorporationwillhaveraisedfundsatalowerexpostcostthanstraightdebt.(Thismeansthatthestockpricefailedtoriseabovetheconversionprice,sostockholdersmaystillbeunhappy.) Example16.6 Assumethatacorporationisconsideringissuing1millionsharesofcommonstockatapriceof$40or40,000convertible$1,000bondswitha20-yearmaturity.Eachbondwouldbeconvertibleinto20sharesofcommonstock.Therearecurrently5millionsharesofcommonstockoutstanding.Aslongasthereisapositiveconversionpremium(itis25percent),thebondswillleadtolesspotentialdilutionthanwilltheissuanceofcommonstock.Thepurchaserofthebondispayingapriceforthedownsideprotectionofferedbythebondfeatures.Whetherconvertiblebondsorbondswithwarrantsattachedwillleadtomoredilutionwilldependonthetermsofthespecifcsecurities.Wemightexpectdetach-ablewarrantstoleadtolessdilution,sincetheinvestorwillhaveadebtsecuritynomatterwhathappenswiththewarrant.Ontheotherhand,thewarrantuponbeingexercisedwillrequireanadditionalcashinvestment;thus,wecannotguessatthepotentialadvantage.
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 337 ConvertibleBondsandtheBlack–ScholesModel Sinceaconvertiblebondisacombinationofaconventionalbondandanoptiontoconvertintocommonstock,itfollowsthatmethodsofvaluingoptionsarealsoofinterestinthevaluationofconvertiblebonds.AnimportantstepinconvertiblebondvaluationistheapplicationoftheBlack–Scholesmodeltovaluationofboththeoptionfeatureandbondfeatureofconvertibledebtasaninvestment. 1 WhyShouldanInvestorConvertVoluntarily? Ifthecommonstock’scashdividendsbecomelargerthantheinterestpaymentsonthedebt,theinvestorhasadecision.Thechoiceisbetweenmorecashfowwiththelargerriskassociatedwithcommonstockdividendsandasaferbutsmalleramountofcash.Iftheinvestorconverts,theinvestorismakinganassumptionthattheexpectedpresentvalueofcashdividendsislargerthanthepresentvalueoftheinterestpayments.Inaddition,itisexpectedthatthepriceofthecommonstockwillremainsuffcientlyhighsothatonedoesnotloseinthefuturebygivingupthesafermaturitypaymentofthedebt.Ifalltheseconditionsaresatisfed,theinvestorhasaconversiondecision,butbecauseoftheriskitisnotobviousthattheinvestorshouldconvertvoluntarily.Exceptinraresituationswheretherearehigh,relativelysafecashdividends,theinvestorisbetteroffholdingtheconvertiblebondsthanconverting.Theputoptionhasvalue.Ifthebond’smarketpriceislargerthantheconversionvalue,itisbettertoholdorsellthanitistoconvertvoluntarily.Theinvestorisreluctanttogiveupthecalloption(therighttoconverttocommonstock)ortheputoption(therighttothefacevalueoftheconvertibledebtatmaturity). WhyShouldaFirmForceConversion? Theopportunityforafrmtoforceconversionariseswhentheconversionvalueofthebondislargerthanthecallprice.Normally,apricecushionisrequiredtoreducethelikelihoodofthefrmpayingoutcash.Thereareseveralreasonswhyafrmmightwanttoforceitsinvestorstoconvertintocommonstockbycallingthe 1 TheBlack–Scholesmodelisamathematicalmodelforthevaluationofanoption.SeeF.BlackandM.Scholes,“TheValuationofOptionContractsandaTestofMarketEffciency,” JournalofFinance ,May1972,pp.399–417;F.BlackandM.Scholes,“ThePricingofOptionsandCorporateLiabilities,” JournalofPoliticalEconomy ,May–June1973,pp.637–654.
November6,200913:44spi-b8119inx6inb811-ch16 338 AnIntroductiontoAccountingandManagerialFinance bond.Itmightbeawaytostrengthenthecapitalstructuresothatnewdebtcanbeissued.Anotherreasonforthefrmtoforceconversionisthatthecashoutlaysofoutstandingcommonstockarelessthanwithdebt.Forexample,agrowthstockmaybepayingzerodividends;thus,theafter-taxinterestpaymentsaresavedifconversionisforced.Also,callingthebondsresultsintheeliminationoftheimplicitputoptionheldbytheinvestors.Assumea$1,000bondpaying0.10interestisconvertibleinto40sharesofcommonstock.Thecommonstockpaysa$1-per-yeardividendandissellingatapriceof$50.Thecallpriceofthebondis$1,080.Shouldthecompanycall?Thecorporatetaxrateis0.35.Thecompanycancall,sincetheconversionvalue,$50 × 40 = $2 , 000,islargerthanthecallprice.Ifthebondsarecalled,therationalinvestorsmustconvertratherthanacceptthecallprice.Theconversionvalueislargerthan$1,080.Thebondsconvertedintocommonstockwillrequire$40perbondofcashoutlaysfordividends.Thebondsnowrequire$100ofinterestoutlays,whichare$65aftertax.The$40islessthan$65.Theinvestorswillreceive$40ofdividendsinsteadof$100ofinterest;thus,theydonothavetheirpositionimprovedbythecall.Thepositionofthepresentstockholdersisimprovedbythecall,sincethefrm’scashoutfowisreduced.Inaddition,thedownsideprotectionofferedbythebond(theputoptionheldbyinvestors)iseliminated.Earningspersharewillalsobeaffectedbytheconversion.Interestcostswillbereduced,andthenumberofsharesoutstandingwillbeaffected(theexacteffectwilldependonwhetherwearecomputingearningspersharewithorwithoutdilutionandonthenatureoftheconversionfeature).Insomesituations,theamountofdebtnotyetconvertedhasbecomeverysmallandcallingthedebtisareasonablewayofeliminatinganunnecessaryfnancialcomplexity.Thereisasoundfnancialtheorythatconvertiblebondsshouldbecalledassoonasthemarketpriceofthebondishighenoughabovethecallpricetoinsureconversion.Ifcalledatlowerprices,theremightbecashoutlaysassociatedwiththeretirementofthedebt.Justasaninvestorpreferstoholdtheconvert-iblebondratherthanconvertbecauseofthedownsideprotectionofferedbythebond,thecorporationwantstoforceconversionsothatthelegalobligationtopayinterestandprincipalarereplacedbythemorefexiblecommitmentstocommonstock. HedgeFunds Inrecentyears,hedgefundshaveboughtbetween70and80percentoftheconvertiblebondsissued.Thefundsbuytheconvertiblesandsellthestockshort.
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 339 Ifthestockpricegoesdown,theywinontheshortsaleanddonotlosemuch(ifanything)ontheconvertiblebonds.Ifthestockpricegoesup,theywinontheconvertiblebutloseontheshortsale.Obviously,theamountsofgainsandlosseswilldependontheexactnatureofthetransactions.Thestrategyhasitsrisks(no“freelunch”). Conclusion Thevalueofwarrants,options,calls,andtheconversionfeatureofconvertiblesecuritiesareallgovernedbythesameeconomicrationale.Iftheycanbeconvertedimmediately,theirminimumvalueascommonstockissetbytheirimmediateconversionvalue.Theiractualvaluewilldependonahostoffactors,amongwhicharethecurrentcommonstockmarketprice,thedistributionoffuturestockprices,thetimevalueofmoney,andtheriskpreferencesofthemarket.Convertiblebondsmaybeanattractiveinvestmentinacommonstockgrowthsituation(thus,tendingtoensureconversion)andasasubstituteforcommonstockwherethereisapossibilityofthegrowthnottakingplace(thus,investorsarewillingtopayforthedownsideprotection).Iftherearenocommonstockgrowthpossibilities,theinvestorwouldpreferstraightdebt.Ifthereiscertaintyofgrowth(noriskoftheconversionfeaturebeingworthless),theinvestorislikelytodobetterinvestinginthecommonstockorwarrantsorcalls.Thus,aconvertiblebondisatypeofsecuritythatfllstheneedsforaninvestorwithariskpreferenceforachanceofalargegainandaverysmallchanceofalargeloss,butwithalargechanceofasmallloss(anopportunitycost). ReviewProblems ReviewProblem16.1 Assumea$1,000,20-yearconvertiblebondthathasacontractualinterestrateof0.10.Straightdebtpays0.12.Thecorporatetaxrateis0.46.Thestockpriceattimeofissueis$20.Thebondiscallableatapriceof$1,100afteroneyear.(a)Iftheconversionpremiumattimeofissueis0.25,theconversionpricepershareis______________.Thebondisconvertibleinto_______________shares.(b)Azero-taxinvestorwillearnmorethan0.12ifthebondiscalledpriorto______________years.(c)Assumethata0.10bondisconvertibleinto25sharesofcommonstockcurrentlysellingat$40pershare.Thestockispayinga$3-per-sharedividend.Thebondisbeingissuedatapriceof$1,000.
November6,200913:44spi-b8119inx6inb811-ch16 340 AnIntroductiontoAccountingandManagerialFinance Wouldyoubuythecommonstockortheconvertiblebond,assumingyou(anindividual)aregoingtobuyoneortheother?Explain. SolutiontoReviewProblem16.1 (a)$20 ( 1 . 25 ) = $25conversionprice.$1 , 000 $25 = 40shares . (b) n = ln Ck i /B(k i k) + 1 ln ( 1 + k i ) = ln $100 ( 0 . 12 )/ $20 + 1 ln1 . 12 = ln1 . 6 ln1 . 12 = 0 . 47 0 . 1133 = 4 . 15years . Thebasicformulationis C( 1 + k i ) n B(k i k) B (n,k i ) = 0 . (c)Buythebond.Itisatleastasgoodasthecommonstockcostingthesameforthesamenumberofshares,plus:(1)$100interest > $75dividendtoday.(2)Downsideprotection.(3)Sameupsidepotential. QuestionsandProblems 1.A$1,000bondcanbeconvertedinto20sharesofcommonstock.Thestockisnowsellingat$36.Whatisthebond’sconversionpremium?2.(continue1)Ifthestockpriceweretoincrease38.9percent,whatwouldbetheconversionvalueofthebond?3.(continue1)Ifthepresentvalueoftheconvertiblebondasstraightdebtis$780,whatisthebond’spremiumonstraightbondvalueifthemarketpriceofthebondis$940?4.a.Assumethata20-yearconvertiblebondispaying0.06interestperyear.Straightdebtisyielding0.10.Whatisthevalueoftheconvertibleasstraightdebt?b.Ifthebondissellingfor$940,whatvalueisthemarketplacingontheconversionfeature?
November6,200913:44spi-b8119inx6inb811-ch16 ConvertibleBonds 341 5.(continue4)Assumethatthebondisexpectedtobecalledafterfveyearsatacallpriceof$1,090.Whatisthenetpresentvalueoftheinvestmentintheconvertiblebondattime0,assumingazero-taxinvestorwhopaid$1,000forthebond?6.(continue4and5)Whatisthenetpresentvalueattime0ifthebondisconvertibleinto20sharesandthestockissellingat$70persharewhenthebondiscalledattime5?7.TheABCDCompanyisissuinga7-percent,20-yearconvertibledebtcallableatapriceof$1,080atanytime.Theconversionpricehasbeensetata30-percentpricepremiumoverthecurrentstockprice.Thebondshavebeenrecommendedtoapensionfundmanager.Theargumenthasbeenmade,“Youwillearnahighreturnsincewecanexpectthestockpricetoeasilydoublewithinthenext10years.”However,itisagreedthatitisunlikelythattheannualrateofgrowthinstockpricewillexceed10percentperyear.Comparable-riskstraightnoncallabledebtisbeingissuedatayieldof11percent.Shouldthebondsbeboughtiftheysellatpar?Explain.8.Azero-taxinvestorisconsideringpurchasingeitherstraightdebtoraconvert-iblebondissuedbyfrmsofidenticalrisk.Thestraightdebthasacouponof0.12andtheconvertibledebt,0.05.Thecallpriceoftheconvertiblebondis$1,140andthebondcanbecalledatoraftertime2.Bothbondscanbeboughtatpar.Theinvestorexpectsthecommonstockpricetoincrease,sothatthestockpriceislargerthantheconversionpriceatandaftertime3,butnotpriortothattime.a.Whichsecurityshouldbepurchased?Why?b.Howlongcanitbe(maximumtime)beforethestockpriceforcesthebondpriceabovethecallprice,iftheinvestoristoearnmorethan0.12?9.TheABCCompanyhasbeengiventwochoicesbyaninvestmentbanker.Oneistoissue5-percentconvertible20-yearbonds($1,000par).Thestockpriceisnow$10pershare,andtheconversionpremiumwouldbe100percent.Theotheralternativewouldbea4-percentinterestrateanda25-percentconversionpremium.Thebondswouldbenoncallable.Thecompanydoesnotpayacashdividendonitsstock,anditdoesnotintendtostartinthenearfuture.Thecompanyhasrecentlyissued20-yearstraightdebtcosting0.10.Thecompanyhasa0.40taxrate.Whichofthetwoalternativesshouldthecompanyprefer?Explain.
November6,200913:44spi-b8119inx6inb811-ch16 342 AnIntroductiontoAccountingandManagerialFinance 10.CompanyFisconsideringthetermsofaconvertiblebondthatitisgoingtoissue.Thefollowingfactsapply: AlternativeInterestConversionPremium 10.080.1520.090.20 Thebondissuesizeis$10million.Thebondswillhaveamaturityof10yearsandwillbenoncallable.Thetaxrateis0.46.Thestockpriceis$50.a.Howmanyshareswouldthebondsbeconvertibleintowiththe0.15pre-mium?b.Howmanyshareswouldthebondsbeconvertiblesintowiththe0.20pre-mium?c.Withthe0.20conversionpremium,thereisanextraafter-taxcostof$________________peryear.d.Whatdoesthepriceofthecommonstockhavetobeattime10foralternative2tobepreferred?Assumethefrmhasanopportunitycostofmoneyof0.10.11.A$1,000convertiblebondistobeissuedwithacallpremiumof$90andacouponof0.12.Straightdebtcouldbeissuedatacostof0.16.Thebondiscallableanytimeafteryear4.Isthisconvertiblebondagoodinvestment,comparedtostraightdebt,ifazero-taxinvestorthinksthatthebondwillbecalledatyear5?Explainwithnumericaljustifcation.12.Assumethatthestockpriceisabovetheconversionprice.Whenshouldaninvestorholdingtheconvertiblebondvoluntarilyconvertintocommonstock?Listthreenecessaryconditions(notnecessarilysuffcientconditions).13.Designaconvertiblebondthatisverymuchlikedebt.14.Designaconvertiblebondthatisverymuchlikecommonstock.
November6,200913:44spi-b8119inx6inb811-ch17 Chapter17 Inventories Attheendofeachperiod,theaccountantallocatesthetotalcostsofopeninginventoryandpurchasesbetweenanexpenseofthecurrentoperatingperiodandcostsoffutureoperatingperiods.Thecostsapplicabletothecurrentperiodarerecognizedascostofgoodssold(anexpense)intheincomestatement,whereasthecostsapplicabletofutureperiodsareplacedintheEndingInventoryassetaccount.Accountantswouldliketoreportrelevantvaluesinthebalancesheet,matchrevenuesandexpensesintheincomestatement,minimizecurrentincometaxobli-gations,andpresentmeasureswithahighdegreeofreliability.Someoftheseobjectivesareinconfictwithoneanother;thus,achoiceastotheaccountingmethodmustbemade. ClassifcationsofInventory Inventories aregoodsthatareheldforsaleintheordinarycourseofbusiness,orgoodsthatwillbeusedorconsumedintheproductionofgoodstobesold.Manufacturingconcernstypicallyhavethreeinventoryaccounts.Costsassignedtogoodsandmaterialsonhandthathavenotyetbeenplacedinproductionarereportedas rawmaterialsinventory ;costsassignedtopartiallycompletedgoodsarereportedas work-in-processinventory ;andcostsassignedtocompletedbutunsoldgoodsarereportedas fnishedgoodsinventory .Inventoriesareoftenthelargestitemamongthecurrentassetsformerchandis-ingandmanufacturingconcerns.Salescanbelostifinventoriesareinadequate,butexcessiveinventoriescanexposeacompanytosignifcantfnancingcostsandpotentiallossesfromspoilageandobsolescence. 343
November6,200913:44spi-b8119inx6inb811-ch17 344 AnIntroductiontoAccountingandManagerialFinance WhatCostsAretoBeInventoried? Thereisnoclear-cutdistinctionbetweencoststhatmayormaynotbeassignedtoinventories.Thereisageneralagreementthatinboundfreightcostsaretobeincluded;andsomeaccountantsarguethatpurchasingcosts,materialshandlingcosts,andstoragecostsarealsoproperlyincludedascostsofinventory.Thecostsarisingfromineffciencyorprolongedstorageoftheitemsininventoryareexpenses.Anotherexampleofacostthatshouldbeexcludedfrominventoryisalostpurchasediscount.Lostdiscountsarenotacostofthepurchasedmaterial.Costsofshippinggoodstocustomersareconsideredtobeexpenses.Fromapracticalpointofview,itisnotunreasonableforamerchandisingfrmtoplaceintotheinventoryaccountonlythenetinvoiceprice,freight,andhandlingcostsofplacingthemerchandiseinitsstorageplace.Othercostswouldnormallybeconsideredexpensesoftheperiod.Thisprocedureexcludesfrominventorythepurchasingdepartmentcosts,accountingdepartmentcosts,andcostsofwarehousingtheinventory,andthesecostsareconsideredtobeexpensesoftheperiodinwhichtheyareincurred.Therecanbetimeswhenitisappropriatetoplacecostsofwarehousinganinventory.Thiswillbethesituationwhenthewarehousingwasexpectedatthetimeofpurchaseandthewarehousingenhancesthevalueoftheproductorenablesthefrmtoreduceorderingcosts.Forexample,storinggrainorotherseasonalcommoditiesfromharvesttimeuntilitissoldinanotherseasonmaynormallybeexpectedtoaddvalue.Wherethewarehousingwasnotplanned(addedvalueislessthancost),addingstoragecoststothecostoftheproductisnotjustifed. CostsofManufacturingFirms Whatcostsmaybeincludedininventoryifthefrmisengagedinamanufacturingprocess?Anarrowdefnitionwouldincludeininventoryonlythedirectvariablecosts(thiswouldusuallyincludeonlydirectmaterialanddirectlabor).Acostis variable ifwhenproductiondoublesinamount,thetotalvariablecostwillalsodouble.Asomewhatbroaderviewpointwouldincludeallothervariablecostscon-nectedwiththemanufacturingprocess(indirectvariablematerials,indirectvariablelabor,andothervariablecostssuchaspowerwouldbeincluded).Thegenerallyacceptedaccountingtreatmentofmanufacturingcostsissomewhatmoreinclusive.Allcostsconnectedwiththemanufacturingprocessmaybeconsideredcostsofinventories.Thisdiffersfromthetwoprecedingalternativesbytheinclusionofsomeorallfxedcostsinthecostsofinventories.Examplesofcoststhatarenot
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 345 includableininventoriesaresellingexpenses,incometaxes,advertisingexpenses,expensesofshippingout,andsalesinvoicepreparation.TheyareclassifedasexpensesandchargedtoIncome.Afrmengagedinamanufacturingprocesswillusuallyhaveseveralaccountsthatarenotrequiredforamerchandisingfrm.Theinventorycostofamanufactur-ingfrmwillusuallybedividedamongrawmaterials,workinprocess,andfnishedgoods.Theproblemofallocatingthefactorycostsamongthesethreecategoriesisbeyondthescopeofthisbook.Oncetheseallocationsaremade,however,theaccountingtreatmentofmanufacturinginventoriesissimilartothatofmerchandiseinventories. CostFlowAssumptions Witheitheramerchandisingoramanufacturingfrm,itisnecessarytomakesomeassumptionsabouttheorderinwhichcostsfowthroughtheaccounts.Itisnecessarytodistinguishbetweenthe fowofthephysicalunits ofinventorythatpassthroughtheplantandareshippedtocustomersandthe fowofaccountingcosts .Thefowofthephysicalunitsmaybetheresultofamaterialshandlingarrangementthatensuresthattheoldestgoodsaresoldorusedfrst.Theaccountingcostsofinventorythatarechargedtoexpensemayormaynotbethecostsoftheoldestgoodsonhand.Thiswoulddependonwhichofseveralaccountingconventionsisadoptedbythecompany.Thefollowingarethefouralternativefowassumptionsmostoftenusedinpractice:1.Theoldestgoodsaresoldorusedfrst—FIFO(frst-in,frst-out).2.Thelastgoodspurchasedaresoldorusedfrst—LIFO(last-in,frst-out).3.Thegoodsareintermingledandgoodsusedareofaveragecostandage—AverageCost.4.Thespecifcunitsusedareidentifed.Inpractice,the physicalfow ofgoodsfrequentlywillnotcorrespondtothemethodchosenbytheaccountanttorecordthe fowofcosts . FlowofCosts:FIFO The FIFO(frst-in,frst-out)procedure ofaccountingforinventorychargesthecostsofthefrstgoodspurchasedtoexpense.Thismeansthatthecostofthegoodsappearingininventorywillbethecostofthegoodsmostrecentlypurchased.
November6,200913:44spi-b8119inx6inb811-ch17 346 AnIntroductiontoAccountingandManagerialFinance Example Beginninginventory:100units@$2 . 00 = $200 . 00 PurchasesduringtheMonth Jan.15200units@$2 . 10 = $420.00Jan.24300units@$2 . 20 = 660.00Jan.30100 units@$2 . 25 = 225.00 600 units$1,305.00 DuringthemonthofJanuary,thecompanysold500units.Computethecostofgoodssoldandendinginventory. CostofGoodsSold: 100units@$2 . 00 = $200.00(beginninginventory)200units@$2 . 10 = 420.00(Jan.15purchase)200 units@$2 . 20 = 440.00 (Jan.24purchase)500 units$1,060.00 EndingInventory: 100units@$2 . 25 = $225.00(Jan.30purchase)100 units@$2 . 20 = 220.00 (Jan.24purchase)200 units$445.00 Theresultsmaybecheckedbyaddingtheinventoryandthecostofgoodssold ( $1 , 060 + $445 = $1 , 505 ) .Thisshouldbeequaltotheopeninginventoryplusthecostofthegoodspurchasedduringtheperiod ( $200 + $1 , 305 = $1 , 505 ) .FIFOresultsinaninventorymeasurethatisreasonable(thegoodshaverecentlybeenpurchased),butthecostofgoodssoldconsists,tosomeextent,ofitemspurchasedinpastperiodsandmightnotrefectcurrentcosts. FlowofCosts:LIFO The LIFO(last-in,frst-out)procedure ofaccountingforinventorychargesthecostofthegoodsmostrecentlypurchasedtoexpense.Thismeansthatthecostofthegoodsappearinginendinginventorywillbethecostoftheoldestgoodspurchased.Thiswillbetheopeninginventoryplusadditions(orlessdeductions)duringtheperiod.Iftherehavebeenchangesinthecostofgoodspurchasedoveraperiodofyears,thisinventoryfgurecanbecomefarremovedfromeithertheactualcostofthegoodsonhandortheircurrentvalue.Thecostofgoodssoldisareasonablemeasureunlessoldinventorywitholdpricesissold(salesdipintoinventory).
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 347 Example AssumethattheSampleCompanyisusingaLIFOprocedure.Computethecostofgoodssoldandtheendinginventory.(SeetheFIFOsection.) CostofGoodsSold: 100units@$2 . 25 = $225.00(Jan.30purchase)300units@$2 . 20 = 660.00(Jan.24purchase)100 units@$2 . 10 = 210.00 (Jan.15purchase)500 units$1,095.00 EndingInventory: 100units@$2 . 00 = $200.00(beginninginventory)100 units@$2 . 10 = 210.00 (Jan.15purchase)200 units$410.00 Theresultsmaybecheckedbyaddingtheendinginventoryandthecostofgoodssold ( $1 , 095 + $410 = $1 , 505 ) .Thisshouldbeequaltotheopeninginventoryplusthecostofthegoodspurchasedduringtheperiod ( $200 + $1 , 305 = $1 , 505 ) .AlthoughLIFOmayseemtoprovideasolutiontotheproblemofchangingprices,itdoeshaveseriouslimitations.Aparticulardisadvantageisthevaluationofendinginventory.Althoughthecostsofmostrecentpurchasesarechargedasexpensesforthedeterminationofgrossmargin,theendinginventoryfguremaybebasedonthelowercostsofpurchasesofpasttimeperiods.Thus,theassetfgureresultingfromtheuseofLIFOisnotlikelytorefectthecurrentvaluesofthegoodsremainingininventory.Byfailingtoadjusttheinventory,LIFOfailstorecognizethegainsandlossesthatmayresultfrompricechanges.Theseeconomicgainsandlossesshouldbetakenintoaccountinevaluatingmanagerialperformance.Evenifthesearebeyondthecontrolofmanagement,theyshouldneverthelessbeseparatelyreportedsothatthenormaloperatingresultsmaybemoreeffectivelyappraised.Iftheseelementsaretosomedegreecontrollablebymanagement,theirdeterminationshouldformpartofthemanagerialreportingprocess.TheFIFOinventoryassumptioncausesthesemarketgainsandlossestobecommingledwiththeresultsofordinaryoperationsinthesinglefgureofgrossmargin.WhenLIFOisused,themarketgainsandlossesareusuallyeliminatedfromgrossmargin,buttheystillarenotseparatelydetermined.IfLIFOisusedtocomputeafrm’sfederalincometaxes,thenintheU.S.thefrmisalsorequiredtouseLIFOforitsfnancialstatements. FlowofCosts:WeightedAverageCost The weightedaveragecostprocedure ofaccountingforinventorychargestoexpenseanaverageofthecostsofthegoodspurchasedduringtheperiodandthe
November6,200913:44spi-b8119inx6inb811-ch17 348 AnIntroductiontoAccountingandManagerialFinance openinginventory.Theendinginventoryfgureisalsobasedonthisaverage.Thisisaweightedaverage.Thefollowingexampleillustratestheapplicationoftheweightedaverageprocedure. Example AssumethattheSampleCompanyisusingaweightedaveragecostprocedure.Computethecostofgoodssoldandtheendinginventory. GoodsAvailable OpeningInventory100@$2 . 00 = $200.00Jan.15thpurchase200@$2 . 10 = 420.00Jan.24thpurchase300@$2 . 20 = 660.00Jan.30thpurchase100 @$2 . 25 = 225.00 700 $1,505.00 WeightedAverageCost = $1 , 505 700 = $2 . 15perunit . CostofGoodsSold = $2 . 15 × 500 = $1,075.00EndingInventory = $2 . 15 × 200 = 430.00 $1,505.00 FlowofCosts:IdentifcationofCostsofSpecifcUnits Insomesituations,accountantswillidentifytheactualcostsofspecifcunits.Inmostcases,thisprocedurewillbetooexpensive;andinsomecases,itwillbeimpossible.Thebeneftsofsuchasystemare,atbest,doubtfulexceptwherehigh-costitemsarebeingsoldandthecostofspecifcitemscanbeeasilytraced.Evenifthecostofeachspecifcunitcouldbeidentifed,itisnotclearthatspecifcidentifcationwouldbeadesirableaccountingprocedure.Itwouldopenthedoortopossiblemanipulationofincomeandthusreducethereliabilityofaccountingdata.Ifthecompanyhadsomereasonforwantingitsincometobehigherorlowerinaparticularperiod,itcouldaccomplishthisgoalbychoosingthespecifcunitstobedelivered. EvaluationofCostFlowAssumptions Thecostfowassumptionusedindetermininginventorycostcanhaveanimpactontheincomereportedbyacompanyinanygivenyear.Thereisagreatdeal
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 349 offexibilitypermittedinthechoiceofmethod,andmanymethodsareusedinpractice.ThecostfowassumptionofFIFOcloselyparallelsthenormalphysicalmove-mentofgoodsthroughthefrm.Also,thebalancesheetinventorybalanceislikelytobefairlyclosetocurrentvalue.WhenLIFOisused,thebalancesheetfguremaybebasedonpricesofgoodsacquiredmanyyearsago,whichoftenmeansthatthebalancesheetbalancesareunrealisticintermsoftoday’sprices.ItisclaimedthattheLIFOprocedurehasadvantagesinregardtoincomedetermination.Ifacompanyistoremaininbusiness,itmustmaintainacertainlevelofinventory.Therefore,whenanitemissold,itmustbereplaced,anditmightbearguedthattheproftonsaleshouldbebasedonthecostofreplacingtheitemratherthanitsoriginalcost.Totheextentthatthecostsofthemostrecentpurchasesrefectcurrentreplacementcosts,LIFOwillprovideameasureofoperatingincomethatembodiesthisviewpoint.LIFO,however,doesfailtorecordmarketgainsandlosses.AmajordrawbackofLIFOisthatwhenthereisadecreaseinthephysicalvolumeofinventorybelowthatofthebeginningoftheaccountingperiod,costschargedtocurrentincomewillincludecostsofearlierpurchases.Thesecostsmightbestatedatpricesthatrepresentveryoldpurchasesandthusnotmeasurecurrentreplacementcosts.Thisdependenceonphysicalinventoryvolumemaypermitsomemanipulationofincomethroughtimingofpurchases.LIFOdoeshaverealadvantagesindecreasingincometaxesintimesofrisingprices.Thisisbecausethemorerecent,higher-pricedpurchasesarechargedasexpensessothatincomeislowerthanitotherwisewouldbe.Ifpricesweretodecline,however,LIFOwouldthenresultinhigherincome(andthushighertaxes)thanFIFO.CurrentU.S.incometaxregulationsrequirethatcompaniesusingLIFOfortaxpurposesmustalsousethisfowassumptionintheiraccountingreports. Cost-or-Market,WhicheverIsLower TheFIFO,LIFO,andweightedaveragecostproceduresareallconcernedwithdeterminingthecostoftheendinginventory.IfFIFOoraveragecostisusedtoimplementcost-or-market,onemustcomparethecost(asdeterminedbyusingoneoftheseprocedures)tothemarketpriceoftheitemandtakethe lower amountforthevaluationoftheinventory.Thisprocedureresultsinaconservativeinventoryfgure,becausetheinventoryis writtendown tomarketbut neverup tomarket.Theincon-sistencymaybeexplainedbytherulethatrecognizeslossesbutdoesnotrecognizegainsuntiltheyarerealized.Onceaninventoryitemiswrittendowntomarket,itis not writtenbackuptocostifthemarketsubsequentlyexceedsinitialcost.
November6,200913:44spi-b8119inx6inb811-ch17 350 AnIntroductiontoAccountingandManagerialFinance Thejournalentrytorecordthewrite-downtomarkettakesvariousforms.Thedebitmaybetocostofgoodssoldortoalossamount.ThecreditmaybetotheInventoryaccountortoacontraassetaccount,AllowanceforMarketValuation,whichissubtractedfromtheInventoryaccountforstatementpurposes.Thecost-or-marketrulehasbeenattackedbyaccountingtheoreticiansonthegroundsthatitisnotconsistent(inventoriesarewrittendowntomarket,butneveruptomarket)andthatitisnotevenconsistentlyconservative(inthenextperiod,theincomemaybehigheriftheinventoriesarewrittendowninthisperiod,andtheinventoryofthisperiodisincludedinthecostofgoodssoldnextperiod).Italsosuffersfromconfusionastowhatismeantby market .Onthepositivesideisthefactthatthewrite-downtomarketisdesirabletopreventthesubsequentyear’searningsfrombeingchargedwithexcessivecostsandtopreventtheinventorypresentationfrombeingoverstatedonthebalancesheet.However,write-upstomarketmightalsobedesirabletobebetterabletojudgemanagerialperformanceinthenextperiodandtopresentmorerealisticinventoryfguresonthebalancesheet.Reliablemarketvaluewouldbepreferabletothelowerofcost-or-marketprocedure.TheInternalRevenueCodedoesforbidtheuseofLIFOcombinedwithcost-or-marketfortaxpurposes. Example Attheendofthecalendaryear,theSampleCompany’srawmaterialinventorysheetshowedthefollowingitems.Using“cost-or-market,whicheverislower,”determinethedollaramountofrawmaterialinventory. CostperMarketPriceLowerofMaterialUnitsUnitperUnitCostMarketCost-or-Market A100$1.00$0.80$100$80$80B2002.002.10400420400C1503.003.00450450450D3002.202.00660 600 600 $1,610$1,550$1,530 Therearetwoacceptableanswers.Cost-or-marketappliedtotheindividualinven-toryitemsprovidesaninventoryfgureof$1,530.Ontheotherhand,applyingthisruletotheinventoryasawhole,thefgureof$1,550isobtained.Determiningthelowerofcost-or-marketbyindividualitemswillalwaysgivethelowerinventoryfgureandisthereforemoreconservative.
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 351 FinancialAccountingStandardsNo.157 FAS157wasissuedinSeptember2006andwaseffectiveforfnancialstatementsissuedforfscalyearsbeginningafterNovember15,2007.ThefairvaluemeasuresofFAS157applytosomeinventorymeasures.Forexample,paragraphA5(C)states:C.Thein-usevaluationpremisemightbeincorporatedinthefairvalueoftheassetthroughthemarketparticipantassumptionsusedtomeasurethefairvalueoftheasset.Forexample,iftheassetiswork-in-processinventorythatisuniqueandmarketparticipantswouldcompletetheinventoryintofnishedgoods,thefairvalueoftheinventorywouldassumethatanyspecializedmachinerynecessarytocompletetheinventoryintofnishedgoodswouldbeavailabletomarketparticipants.ButparagraphC24severelylimitstheapplicationoffairvalueconceptstoinventory:C24.ThisStatementalsodoesnotapplyforthemarketvaluemeasurementthatresultswhenmeasuringinventoriesatthelowerofcostormarketunderARBNo.43,Chapter4,‘InventoryPricing.’ARB43,Chapter4,placesupperandlowerlimitsonthemeasurementthatmaynotresultinafairvaluemeasurement.Thelowerofcostormarketcalculationsasillustratedabovestillapplyratherthanfairvalue.Wecanexpectinventoriestobevaluedatfairvaluetobeconsistentwithotherassetvaluesinthefuture. InventoryandFinance Therearetworelevantfnancialaspectsofinventory.First,theaccountingmeasuresofinventorystocksandfowsaffectboththeincomemeasureandbalancesheet.Second,thelevelofinventoryheldaffectstheamountofcapitalneededaswellastheincomeoftheperiod.Theavailabilityofinventoryaffectsthelikelihoodofmakingasaleaswellasthecostsofcarryinginventory.Thedeterminationoftheoptimumlevelofinventoryunderconditionsofcer-taintyistheresultofbalancingthecostsoforderingwiththecostsofcarryinginventory.Withuncertainty,thefrmalsohastobalancethecostsofhavingtoomuchinventorywiththecostsofhavingtoolittle.Inadequateinventorylevelsleadtodisruptionsinproductionandlostsalesopportunities.Excessiveinventoriestie
November6,200913:44spi-b8119inx6inb811-ch17 352 AnIntroductiontoAccountingandManagerialFinance upcapitalinassetsthatarenotearninganadequatereturn.Excessiveandleftoverinventorycanlosevaluethroughobsolescenceandcauseexcessivestoragecost. InventoryModelsversus“JustinTime” OnemanagerialtechniquethathasbeenexportedfromJapantotheUnitedStatesisthe“justintime”inventorymodel.Ratherthanhavinglargesafetystocks,thenextshipmentarrivesjustasthelastunitisused.Thisreductionininventorylevelsresultsinincreasedprofts.Also,byreducingset-upcosts(includingset-uptime),theordersize(orproductionrun)isfurtherreduced,againresultinginlessinventory.Despitethegreatappealofazero-inventorydecisionmodel,wewilltakethepositionthattheoptimumlevelofinventorywilldependonthefactsandmustbedetermined.A“justintime”inventoryproceduremayberightwheretheinstanta-neoussupplyiscertainorwhenthereiszerocostofbeingshortofinventory.Withotherfacts,a“justintime”policymaynotbeattractive.ImaginefyingacrosstheAtlanticOceaninaBoeing747thathadjustenoughfueltoreachtheothersideoftheoceanifthetailwindisaconstant40milesperhour.Mostofuswouldpreferamarginforerrorarisingfromcarryingextrafuel. AnInventoryModel Althoughinventoriesareheldforspeculation(thepriceisexpectedtoincreaseorastrikeisanticipated),weshallonlyconsiderthesituationwheninventoriesareheldfortransactions(eitherforproductionorforsales).First,weassumethattherateofusage(demand)andallotherfactorsareknownwithcertainty.Theeconomicorderquantity(EOQ)modelisthemostsimpleandmostwidelyusedofalltheformalmathematicalinventorymodels.Itgivesexactanswersthatarecorrectiftheassumptionsarevalid.Let K = theordercost(perorder); r = thecarryingcost(perunitpertimeperiod); D = thetotalexpecteddemand(duringthetimeperiod).Ifwedefne Q tobetheoptimalordersize(theEOQ),thentheaverageinventoryonhandis Q 2 .Totalcarryingcostsfortheperiodcannowbedefnedtobe r Q 2 .Thenumberofordersrequiredis D Q ,and,hence,purchaseordercostsare K D Q .Totalcost, TC ,fortheperiodconsideringholdingandorderingcostsisgivenby TC = r Q 2 + K D Q .
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 353 As Q increases,thecarryingcost, r Q 2 ,increases.Butas Q increases,thecostofordering, K D Q ,decreases.Tominimizethisexpressionrequiresthatitsderivativebetaken,setequaltozero,andsolvedfor Q . 1 Q = 2 KD r 1 / 2 . AssumptionsimplicitintheEOQmodelare:1.Aknown,constantdemandovertheperiodandknowndeliverytimes.2.Nochangeinholdingcostsperunitorordercosts.3.Nochangeinpricesthroughtimeandnoquantitydiscounts.If K (ordercosts)isequaltoorclosetozero,then Q willbeequaltoorclosetozero.Ifset-uporordercostsareverysmall,thentheamountorderedwillbeverysmallandtheresultinginventory,whichis Q/ 2,willbeverysmall.The“justintime”rulewouldbeeffectivewithsmallamountsofinventoryarrivingeachtime. TheValueofInventoryReductions Whatisitworthtoafrmtoreduceitsaverageinventoryby$1million?Theansweris$1millionplusanyreductionsincostssuchasinsurance,storage,taxes,andsoon.Thefnancialincentivetohaveatheoreticallycorrectinventorypolicyislarge. InventoryLevelsandUncertainty Ifwerelaxtheassumptionofcertainty,thenthefrmwillwanttohaveinventorytopreventstockouts. 1 dTC dQ = r 2 DK Q 2 = 0 . Theoptimumordersizeis r 2 = DK Q 2 and rQ 2 = DK Q or Q = 2 KD r 1 / 2 . Thetwocomponentsoftotalcostareequalif Q istheoptimumordersize.
November6,200913:44spi-b8119inx6inb811-ch17 354 AnIntroductiontoAccountingandManagerialFinance Let k u = thecostperunitofnothavingenoughinventory(costofunderage); k 0 = thecostperunitofhavingexcessinventory(costofoverage).Defne p tobetheprobabilitythatthenextunitofinventoryisdemandedand ( 1 p) thatitisnotdemanded.Weassumethatiftheunithasnotbeenordered,itcannotbereorderedwhentheactualdemandisestablished.Wewanttheexpectedcostofunderagetobeequaltotheexpectedcostofoverage: pk u = theexpectedcostofhavingaunitdemandedandnothavingit; ( 1 p)k 0 = theexpectedcostofnothavingaunitdemandedbuthavingitininventory.Atthemargin, pk u = ( 1 p)k 0 . Solvingfor p yields p = k 0 k 0 + k u . Example Assumethat k 0 = $20 k u = $80sinceeachunitcosting$20canbesoldfor$100.Aleftoverunitisworthless.Theprobabilityofdemandis: ProbabilityofDemandBeingatUnitsDemand D ProbabilityLeastasLargeas D 00.101.0010.200.9020.300.7030.200.4040.100.2050.100.1060.000.00
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 355 Solvingfor p ,weobtain p = k 0 k 0 + k u = 20 20 + 80 = 0 . 2 . Thenumberofunitsthatshouldbeobtainedis3or4(thefourthunitdoesnotaddtoproft).Theexpectedproftoforderingthreeorfourunitsis$140: Order4Units UnitsProftsonLeftoverCostofLeftoverDemandedSoldUnitsSoldUnitsUnitsNetProftProbability 00$04$80 $800.101180360$200.20221602401200.30332401202200.2044320003200.1054320003200.10 Expectedproft = $140 Order3Units UnitsProftsonLeftoverCostofLeftoverDemandedSoldUnitsSoldUnitsUnitsNetProftProbability 00$03$60 $600.101180240$400.20221601201400.3033240002400.2043240002400.1053240002400.10 Expectedproft = $140 Theexpectedproftcalculationfororderingtwounitsis$120: Order2Units UnitsProftsonLeftoverCostofLeftoverDemandedSoldUnitsSoldUnitsUnitsNetProftProbability 00$02$40 $400.101180120$600.2022160001600.3032160001600.2042160001600.1052160001600.10 Expectedproft = $120
November6,200913:44spi-b8119inx6inb811-ch17 356 AnIntroductiontoAccountingandManagerialFinance Ifweallowreorderingbutthetimetoreplenishinventoryisnotknown,thentherewillbeneedforsafetystock.Fromafnancepointofview,everydollarthatisreleasedfrominventorysavesadollarofcapital.Unfortunately,wecannotthenconcludethatitisdesirabletoreduceinventory.Managementmustbalancethecostsandbeneftsofinventoryreduction.Carryinginventoryhasacost,butsodoesexcessivereorderingorbeingcaughtshortofinventory.Insomecases,itmightbefeasibletoreducetheorderingcostsorthedowntimeassociatedwithproductionchangeovers.Uncertaintyastotimingofreplacementcanalsobereducedwithgoodmanagement.Thus,theinventorymodelsandthevaluesofthevariablesshouldnotbetakenasgiven,butratherthepossibilityofchangingtheprocesstoimproveeffciencyshouldbeinvestigated. Conclusion Therearemanycomplexproblemsassociatedwithaccountingforinventories.Forexample,indeterminingthecostoftheinventory,weencounterproblemsofdeterminingwhatcostsaretobeincludedininventoryandwhatassumptionsshouldbemadeaboutcostfow(FIFO,LIFO,orweightedaverage).Alowerofcost-or-marketrulemayalsobeused.FIFOassumesthatthemostrecentcostsshouldbeassignedtoinventory;thus,itsuseresultsinrecentcostsbeingrefectedinthebalancesheetandoldercostsbeingrefectedintheincomestatement.LIFOassignsthemostrecentcoststocostofgoodssold;thus,itsuseresultsinrecentcostsbeingrefectedintheincomestatementandoldercostsbeingrefectedinthebalancesheet.Sincethecostsassignedtoinventorymaybeveryold,thebalancesheetvaluationsthatresultfromtheuseofLIFOmaynotbereliableestimatesofcurrentmarketvalue. QuestionsandProblems 1.Whichofthefollowingcostswouldbeproperlyincludableintheinventoryofaretailingfrm?a.Advertisingcosts.b.Grossinvoicecostofmerchandisepurchased(discountwasavailablebutnottaken).c.Grossinvoicecostofmerchandisepurchased(discountwastaken).d.Netinvoicecostofmerchandisepurchased.
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 357 e.Transportationcostapplicabletogoodspurchased.f.Transportationcostapplicabletogoodsdeliveredtocustomers.2.Whichofthefollowingcostswouldbeproperlyincludableintheinventoryofamanufacturingfrm?a.Directlaborcost.b.Salariesofshopforemen.c.Salesrepresentatives’salaries.d.Salaryofvicepresidentinchargeofmanufacturing.e.Depreciationoffactorybuilding.f.Depreciationofsalesoffce.3.Foreachofthefollowingproducts,describethe physicalfow thatonemightnormallyexpecttheproductstofollowthroughafrm.a.Bakeryproducts.b.Nailsinabin.c.Bottledmilk.d.Gasolineinundergroundtanks.e.Coalinapile.f.Wineinavat.4.Discusstheprocedureof“cost-or-market,whicheverislower”inlightofthebasicaccountingassumptionsofconsistency,conservatism,andobjectivity.5.Assumethatacompanymustusethesameinventoryfowassumptionconsis-tentlyfromyeartoyear.Whichfowassumptionwouldgenerallyresultinthehighestreportedincomeduringanextendedperiodofrisingprices?Whichduringanextendedperiodoffallingprices?6.Inanticipationofincreasedsteelprices,theAutoCompanypurchasedafourmonths’supplyofsteel.AsofDecember31,thecostsofcarryingthissteelininventorywere$10,000,000(thesteelhadaninvoicepriceof$200,000,000).ShouldthesteelinventorybeshownontheDecember31statementsat$200,000,000or$210,000,000?7.TheIthacaGasCompanyhasaproblemarisingfromtheseasonalnatureofitsproduct.Peopleusemoregasinthewintertoheattheirhomesandtocook.Thiscreatestheproblemofpeakloads.Theproblemismadeevenmorediffcultbythefactthattherearefveorsixexceptionallycolddayseachwinter,duringwhichtimethedemandforgasincreasestremendously.Ratherthanbuildpipelinesforthepeakloads,thedailyfuctuationsarehandledbytheuseofgastanks.Thepeakloadscreatedbyseasonaldemandshave
November6,200913:44spi-b8119inx6inb811-ch17 358 AnIntroductiontoAccountingandManagerialFinance beensomewhatsolvedbytheuseofundergroundstorage.Gasispumpedundergroundunderpressureduringthesummerandthenusedinthewinter.Ofthe$10,000,000worthofgaspumpedundergroundduringthefrstyearofoperatingtheundergroundstorage,itisestimatedthat$7,000,000willneverberecovered(thisamountofgasisrequiredtobuildupthepressuresothatgasmaybetakenout).Shouldthe$7,000,000betreatedasinventory?Doesamanufacturingfrmhaveasimilarproblem?8.TheRustySteelCompanyshiftedtotheLIFOmethodofaccountingforinven-toryin1929.Atthattime,theinventoryofTypeA-1steelplatewas1,000tons,withacostof$100perton.In1932,thecompanydecidedtocontinueusingLIFO,butitalsoincorpo-ratedthe“cost-or-market,whicheverislower”criterion.CostwascomputedbyusingaLIFOassumptionastofow.Atthattime,theinventoryofTypeA-1steelplatewas$2,000tons,andthemarketvaluewas$40perton(costrangedfrom$50to$100perton).Thefollowingentrywasmadetowritetheinventorydowntomarket:LossonInventoryPriceDecline.................80,000Inventories...............................80,000From1932to2010,inventoriesofTypeA-1steelplateincreasedeachyear,andthemarketvaluewasneverlowerthan$40perton.In2010,thefnishedgoodsinventoryofA-1steelplatedecreasedto500tons.In2010,atonofsteelplateofthistypecost$200pertontoproduce(themarketvaluewasgreaterthan$200).a.Commentonthewrite-downofinventoryin1932andtheprocedureusedsincethen(LIFOpluscost-or-market).b.Howwouldtheincomefor2010beaffectedbythefactthatinventorywasdecreasedbyatleast1,500tons?9.TheD.JonesShipCompanyreceivedanorderonJuly1,2010,tobuilda110,000-tontanker.Thecostsconnectedwithobtainingthesalewere$20,000,andthesewereallincurredin2010.Itisestimatedthatthetankerwilltake24monthstobuild.Howshouldthesellingcostsbetreated?Howshouldthecostsconnectedwithconstructingtheshipbetreated?Whenshouldtherevenuefromthesaleoftheshipberecognized?
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 359 10.Considerthetwofollowingsituationsanddeterminethedispositionofthecostofwarehousing.a.TheABCCompanypurchasedatruckloadofminkcoats.Demandwasnotasstrongasexpectedand,ratherthanselltheleftovercoatsatalargeloss,itwasdecidedtostorethemuntilthenextyear.b.TheXYZLumberCompanyhadtheopportunitytopurchasealargequantityofrarewoodpaneling.Itexpectedtobeabletosellthispanelingoverthenext18months.Thecompanyactuallysolditin12months.11.DuringthemonthofApril,theJansenManufacturingCompany’sRawMate-rialsaccountwasdebitedfor$511,000.Areviewoftheentriestotheaccountdisclosedthecompositionofthedebitstobeasfollows:MaterialsPurchased(grossprice)$450,000Freight-in(includingdemurragechargesof$3,000)15,000ReceivingDepartmentCosts25,000MaterialsHandlingandStorageCosts10,000AllocationofSellingDepartmentCosts5,000ShippingDepartmentCosts6,000 $511,000 ThecompanyfollowsaprocedureofcreditingaPurchaseDiscountRevenueaccountwhenpurchasediscountsaretaken.Termsofpurchaseare2/10, n /30.AnalyzeandadjusttheRawMaterialsaccountasnecessary.12.TheWinchesterStoreshowsthefollowinginformationrelatingtoCommodityA,whichithandles.Inventory,January1:100units@$6.50PurchasesforJanuary:400units@$7.00Inventory,January31:175unitsa.Whatvalueshouldbeassignedtotheendinginventory,assumingtheuseofLIFO?b.WhatisthecostofgoodssoldforJanuary,assumingtheuseofFIFO?c.Whatisthevalueoftheendinginventory,assumingcostisdeterminedonthebasisofaweightedaverageandvaluationisatcost-or-market,whicheverislower?MarketonJanuary31is$6.75.
November6,200913:44spi-b8119inx6inb811-ch17 360 AnIntroductiontoAccountingandManagerialFinance 13.Fromthefollowingdata,determinetheinventoryvaluationbyapplyingtheruleofcost-or-market,whicheverislower. CommodityQuantityUnitCostUnitMarket A100$1.15$1.05B4002.402.75C5004.004.35D7003.453.1014.DuringthemonthofJanuary,theJamesManufacturingCompany’sRawMate-rialsaccountwasdebitedfor$450,000.Areviewoftheentriestotheaccountdisclosedthecompositionofthedebitstobeasfollows:MaterialsPurchased(grossprice)$400,000Freight-in(includingdemurragechargesof$3,000)12,000ReceivingDepartmentCosts20,000MaterialsHandlingandStorageCosts8,000AllocationofSellingDepartmentCosts7,000ShippingDepartmentCosts3,000 $450,000 ThecompanyfollowsaprocedureofcreditingaPurchaseDiscountRevenueaccountwhenpurchasediscountsaretakenorlost.Termsofpurchaseare2/10, n /30.a.AnalyzeandadjusttheRawMaterialsaccountasnecessary.b.Describebriefyageneralrulefordeterminingwhatcostsaretobeconsid-eredasCostofMaterialPurchases.15.TheBlueFrontStoreshowsthefollowinginformationrelatingtoCommodityA,whichithandles.Inventory,January1:100units@$5.00Purchases,January300units@$6.00Inventory,January31:200unitsa.Whatvalueshouldbeassignedtotheendinginventory,assumingtheuseofLIFO?b.WhatisthecostofgoodssoldforJanuary,assumingtheuseofFIFO?c.Whatisthevalueoftheendinginventory,assumingcostisdeterminedonthebasisofaweightedaverageandvaluationisatcost-or-market,whicheverislower?MarketonJanuary31is$5.80.
November6,200913:44spi-b8119inx6inb811-ch17 Inventories 361 16.DuringthemonthofJune,SampleCompanysold350units.Thefollowinginformationisgivenonpurchases.BeginningInventoryJune1100units$1.00$100June10150units1.10165June20200units1.25250June28100units1.40140Computethecostofgoodssoldandendinginventory,using:a.FIFO.b.LIFO.c.AverageCosts.17.TheInfateCompanyhas100unitsofinventorythatcost$5.00perunit.Itsellsthe100unitsfor$7.00perunitandreplacesthematacostof$6.50perunit.a.Determinetheincome,using:i.FIFO.ii.LIFO.b.Determinetheinventory,using:i.FIFO.ii.LIFO.c.Whatdidtheendinginventoryactuallycost?18.(continue17)Assumethemarketvalueattheendoftheperiod(replacementcost)is$8.Howmightyoubringthisinformationintothereporting?
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November6,200913:44spi-b8119inx6inb811-ch18 Chapter18 TheCashFlowStatement FinancialAccountingStandardsStatementNo.95(StatementofCashFlows)datedNovember1987establishesstandardsforcashfowreporting.Itsupersedesstate-mentsdealingwithchangesinfnancialpositionandfundfowstatements.Thebottomlineofthecashfowstatementiseither“Netcashprovidedby(usedin)investingactivitiesofcontinuingoperations”orthecashbalance“Cashandcashequivalentsatendofyear.”Thesecondtermisamoreexacttermsinceitrequiresthatallitemsaffectingthecashbalanceduringtheyearbeincludedinthereport. ThreeMainSections Thethreemainsectionsofthecashfowstatementare:1.Cashfowsfromoperations.2.Cashfowsfrominvestingactivities.3.Cashfowsfromfnancingactivities(includingeffectofexchangeratechangesoncash). CashFlowsfromOperations Thecontinuousprocessofproducingandsellingthecompany’sproductorserviceisoneofthemainsourcesofcashofanenterprise.Thecashfromoperations,however,willonlyrarelybeequaltotheoperatingincome.Theaccrualbasisofaccountinginvolvestherecognition,forincomedeterminationpurposes,ofseveraltypesofeconomiceventsthatdonotinvolvecash.Forexample,someoftheexpensesofaperioddonotusecashduringtheperiod.Frequently,theincomestatementfortheperiodisusedasthestartingpointforderivingthecashfowstatement.Tocomputethenetcashfromoperations,itis 363
November6,200913:44spi-b8119inx6inb811-ch18 364 AnIntroductiontoAccountingandManagerialFinance necessarytoaddbacktooperatingincomethoseexpensesthatdidnotutilizecashandtosubtractthoserevenueorotherincomeitemsthatdidnotgeneratecash.Analternativetreatmentistostartwithrevenuesthatincreasecashandthendeductonlythoseexpensesthatutilizecash.Thedisadvantageofthelatterprocedureisthatitdoesnotmakespecifcreferencetotheincomefgurereportedintheincomestatement.Thetwoproceduresmaybereconciled,however.Thecurrentdiscussionwillbelimitedtotheprocessthatstartswithincome.Themainitemsthatmaynecessitateadjustmentstoincometoobtainthecashfromoperationsare:Depreciationoffxedassets;Depletionofnaturalresources;Amortizationofpatentsandotherintangibles;Lossorgainonsaleorretirementofnoncurrentassets(Thecashorothercurrentassetsreceivedfromthesaleisasourceoffunds,butthisisnotlikelytobeequaltothegainrecognized.Salesofnoncurrentassetsareshownseparatelyinthestatement.);Accumulationofbonddiscountoramortizationofpremium;andExpensesassociatedwithfutureincometaxliabilities. Example Giventhefollowingconventionalstatement,computethecashfromoperations.Sales$50 , 000 Less: Labor,etc.$35 , 000Depreciation12 , 000 TotalExpenses47 , 000 NetIncome$3 , 000 Thecashfromoperationsmaybecomputedbyaddingbacktoincomethoseexpensesthatdidnotusefunds.IncomeReported$3 , 000Addbackexpensesnotusingfunds(depreciation)12 , 000 CashfromOperations$15 , 000 Thisprocedureisverywidelyused.Depreciationmustbeexplicitlyaddedtoobtainthetotalcashfow.Itshouldberecognizedthatdepreciationactuallyhasno
November6,200913:44spi-b8119inx6inb811-ch18 TheCashFlowStatement 365 effectonworkingcapital,butismerelyaddedbacktoincometooffsettheresultoftheaccountingentrythatresultedinitsbeingdeductedfromrevenuetodeterminetheamountofincome.Theaccountingentrytoaccruedepreciationisadebittodepreciationexpenseandacredittothefxedassetaccount(usuallyacontraaccount,suchasAccumu-latedDepreciation,isused).Theassetthathasbeendecreasedisalong-livedasset.Thus,cashandworkingcapitalarenotaffectedbytheaccrualofdepreciation,anddepreciationshouldnotbedeductedfromrevenuesifwearecomputingfundsfromoperations.Ifithasbeensubtracted(i.e.,ifwearestartingfromincomeratherthanfromrevenue),itisnecessarytoaddbacktoincometheamountofdepreciationdeductedfromrevenuetoobtainthecashfromoperations.Leavingoutthetaxconsequences, cashisnotgeneratedbychargingoraccruingdepreciation;itiscreatedbysales .Chargingmoreorlessdepreciationwillhavenoeffectontheamountofworkingcapital.Thedepreciationchargeaffectstheincomeoftheperiod,anditwillaffecttheamountthathastobeaddedbacktoincometocomputethefundsfromoperations.Ifwestartwithincome,depreciationexpenseisaddedbacktoincome,sincedepreciationdoesnotusecash.Ifthetaxconsequencesofdepreciationareconsidered,depreciationmayberegardedashavinganeffectoncash.Theamountofdepreciationchargedfortaxpurposesaffectsthecurrentpaymentortheliabilityrecognizedfortaxes.Thetaxitselfisthecurrentoutlayaffected.Theamountofdepreciationchargedforfnancialaccountingpurposesdoesnotaffectcash.Thedepletionchargestakenbyfrmsinextractiveindustries(mining,oil,andsoforth)shouldbetreatedinamannersimilartothatofdepreciation.Becausethedepletionchargedoesnotresultinadecreaseofcash,itmustbeaddedbacktoincometoobtaincashfromoperations.Ingeneral,theexpensearisingfromtheamortizationofanylong-livedassetmustbeaddedbackwheneverthecashfromoperationsfgureistobederivedfromincome. GainorLossonSaleofNoncurrentAssets Whennoncurrentassetsaresold,thedifferencebetweenthebookbasisfortheasset(costlessdepreciationoramortization)andtheamountreceivedisrecognizedasagainorloss.Suchgainsandlossesareincludedintheincomecalculation,butareoftenstatedseparately.Long-livedassetsthatmaybesoldincludeland,buildings,equipment,andinvestments.Fromtheviewpointofcashchanges,wearenotconcernedwiththeamountofgainorlossrecognized,butratherwiththeamountofcashreceivedinthe
November6,200913:44spi-b8119inx6inb811-ch18 366 AnIntroductiontoAccountingandManagerialFinance transaction.Thesaleofanoncurrentassetisnotconsideredtobeapartofcur-rentoperations,butthecashwouldbeshownasasourceofcash.Therefore,iftheworkingcapitalreceivedisincluded,thelossorgainarisingfromthesaleoftheseassetsmustbeeliminatedincomputingcashfromoperations.Anylossmustbeaddedbacktoincomeifithasbeensubtracted.Anygainrecognizedmustbesubtractedifithasbeenincludedinincome.Includingthegainsandlossesfromthetransactioninadditiontothecashreceivedwouldresultindoublecounting. Example Afxedassetwithabookvalueof$10,000issoldfor$12,000cash.a.Whatisthegainorlossrecognized?b.Whatamountofcashisgeneratedbythetransaction?c.Whatadjustmentmustbemadetotheincomefortheperiodtoobtainthefundsfromoperations? Solution a.Thegainis$2,000.b.Cashof$12,000isgeneratedbythetransaction.c.The$2,000gainmustbesubtractedfromincome(assumingthatithasbeenincludedinotherincome).Nottosubtractthe$2,000wouldmeanthatcashof$14,000wouldbereportedtohavebeengenerated,butonly$12,000ofworkingcapitalwouldactuallyhavebeenreceived(the$14,000isequaltothe$2,000gainplusthe$12,000ofcashreceived). Example Afxedassetwithabookvalueof$10,000issoldfor$8,000cash.a.Whatisthegainorlossrecognized?b.Whatcurrentassetsaregeneratedbythetransaction?c.Whatadjustmentmustbemadetotheincomefortheperiodtoobtainthefundsfromoperations? Solution a.Thelossis$2,000.b.Cashof$8,000isgeneratedbythetransaction.
November6,200913:44spi-b8119inx6inb811-ch18 TheCashFlowStatement 367 c.The$2,000booklossmustbeaddedbacktoincome(assumingthatithadbeensubtractedtoobtaintheincomefgure).Nottoaddbackthe$2,000wouldmeanthatalosswhichdidnotutilizecashwassubtractedincomputingcashfromoperations. BondDiscountorPremium Thenormalentryforrecordinginterestaccruedonabondpayablethathadbeenissuedatadiscountis:InterestExpense............................40BondDiscount.........................2InterestPayable........................38Theexpenseis$40,butthedecreaseinworkingcapital(byanincreaseincurrentliabilities)isonly$38.Whentheinterestispaid,cashisreducedby$38.Thedifferencebetweentheinterestexpenseandthecashoutlayof$2iscausedbythefactthatlong-termliabilitieshavebeenincreasedby$2(thecredittoBondDiscountineffectincreasesthelong-termdebt).Thus,theinterestexpensefortheperiodisnotequaltothedecreaseincash.Theadjustmentthatshouldbemadeistoadd$2backtoincome,if$40ofinterestexpensehasbeensubtractedinobtainingincome.Bondsissuedatapremiumrequireanadjustmentintheoppositedirection.Inthiscase,theamountofcashusedwouldbegreaterthantheexpenserecognized,asindicatedbythenormalaccrualentry:InterestExpense............................45BondPremium.............................5InterestPayable........................50The$5isauseofcash,butonlytheinterestexpenseisdeductedindeterminingincome.Theadditionalcurrentoutlayduetotheamortizationofthepremiumreducescash. CashFlowsfromInvestingActivities Thissectionincludesthecashfromthesaleoflong-livedassetsorthereclassi-fcationofspecialcash“funds”.Thisincludesthesaleofinvestments(butnotmarketablesecuritiesclassifedascurrentassets),land,buildings,andequipment.
November6,200913:44spi-b8119inx6inb811-ch18 368 AnIntroductiontoAccountingandManagerialFinance Cashsetasideforbuildingpurposes,debtretirement,andsoforthissometimesclassifedasacashusage.Whenthefundisliquidated,anyresidualcashmaybeasource.Gainsfromtransactionsinvolvinglong-livedassetsareexcluded,butthecashacquiredinsuchtransactionsisincluded.Cashiscommonlyutilizedtopurchaselong-livedassets(land,buildings,equipment,investments,patents,andsoforth)ortoretirelong-termdebt. CashFlowsfromFinancingActivities Animportantsourceofcashistheissuingofnewsecurities,bothlong-termdebtandstockequity.Thisincludescommonandpreferredstock,bonds,long-termnotes,andwarrants.Dividendspaidonbothcommonandpreferredstockwillappearinthissectionascashoutlays.Purchaseofcompanystockisanothercommonoutlay.Ifthecompanyhascapitalleases,thiswillbeacashoutlayreportedinthissection.Anyinvestmentinfowsorinvestmentoutfowsareincludedinthissection. TransactionsNotAffectingFunds Mostoftheproblemsarisinginthepreparationofstatementsofchangesinfnancialpositionarenotconnectedwiththosetransactionsthataresourcesofcashordistributionsofcash,butaretheresultoftransactionsthatdonotaffectcash.Atransactionofthisnatureistheaccrualofdepreciationanddeple-tion.Appropriationsofretainedearningsarealsoofthisnature.Theestab-lishmentofanaccountsuchasDeferredIncomeTaxesdoesnotinvolvecash;thus,itshouldnotaffectthecashfromoperations(theexpensewillhavetobeaddedbacktoincome).Astockdividend(incontrastwithacashdividend)isanothertransactionthatdoesnotdirectlyaffecttheworkingcapitalpositionofthefrm. ManagerialUses Acashfowstatementisusefulbecauseittellsuswherethecashiscomingfromandwhereitisbeingused.Itis,bynecessity,asummary,butitdoesindicatewhatishappeningtothecashpositionofthefrmandwhyitishappening.Thisisofimportancetomanagementaswellasinvestors.Althoughthestatementasdefnedisuseful,managementneedsadditionalinformation.Explanationsofwhythecashbalancehaschangedaredesirable,
November6,200913:44spi-b8119inx6inb811-ch18 TheCashFlowStatement 369 andforecastsofwhatisgoingtohappentocashinthefutureareoftenessential.Thisinformationisnecessarytoensurethattheproperamountofcashwillbeonhandfortheoperationsoffutureperiods.Asproductivefacilitiesareenlarged,thetreasurerofthecorporationmustensurethatcashisonhandtopayforthecon-structionofthefacilities.Asthefacilitiesareplacedintooperations,newworkersmustbepaid,materialspurchased,andsoforth.Alltheseitemsrequirethatcashbeavailablelongbeforetheproductbeingproducedissold. EBIT(EarningsBeforeInterestandTaxes) TocomputeEBIT,startwiththecorporateincomeandaddbacktheamountsofinterestandtaxes.ThemostcommonwayofusingEBITistomultiplyEBITbyaconstanttoobtainavalueforthecorporation.Financialanalystsuseseveraldifferentfowmeasuresandmultipliers.Themultipliersareappliedtoeitherhistoricalmeasuresorforecastsforthenextperiod.Wewillconsiderthreedifferentmultipliers:a. M 0 —appliedtoafter-taxearnings(E).b. M 1 —appliedtoearningsbeforeinterestandtaxes(EBIT).c. M 2 —appliedtoearningsbeforeinterest,taxes,depreciation,andamortization(EBITDA).Let P bethevaluenowofashareofcommonstock.Then,bydefnitionof M 0 , P = M 0 E or M 0 = P E. If P = D k g ,thenthetheoreticalvalueoftheearningsmultiplieris M 0 = D E(k g) = ( 1 b)E E(k g) = 1 b k g. Assumewewanttodeterminethemultiplier( M 1 ) touseifEBIT(defnedtobe X )isusedratherthanE(after-taxearnings).Again,let P bethevaluenowofashareofcommonstock.Then, P = M 1 ( EBIT ) = D k g = ( 1 b)E k g = ( 1 b)( 1 t)X k g.
November6,200913:44spi-b8119inx6inb811-ch18 370 AnIntroductiontoAccountingandManagerialFinance Solvingfor M 1 ,weget M 1 = ( 1 b)( 1 t) k g since X =EBIT. Example Assumethat X = $100 ,t = 0 . 35 ,b = 0 . 4 ,E = $65 ,D = $39 ,k = 0 . 12 ,g = 0 . 02 , EBITDA = $150 . Then, P = D k g = $39 0 . 12 0 . 02 = $390 . Calculatingthemultipliersfor E and X , M 0 = 1 b k g = 0 . 6 0 . 12 0 . 02 = 6 M 1 = ( 1 b)( 1 t) k g = 0 . 6 ( 0 . 65 ) 0 . 10 = 3 . 9 . Thefrmvalueusing E = $65and M 0 = 6is P = M 0 E = 6 ( 65 ) = $390 . Thefrmvalueusing M 1 = 3 . 9and X = $100is P = M 1 X = 3 . 9 ( 100 ) = $390 . EBITDA(EarningsBeforeInterest,Taxes,Depreciation,andAmortization) Themostpopularvaluationmethodforprivateequityandothercorporateacquisi-tionsistouseEBITDAandaEBITDAvaluationmultiplier( M 2 ) .
November6,200913:44spi-b8119inx6inb811-ch18 TheCashFlowStatement 371 Now P is P = M 2 ( EBITDA ) = ( 1 b)( 1 t)X k g and M 2 = ( 1 b)( 1 t)X (k g)( EBITDA ). AbovewedefneEBITDA = $150,and M 2 is M 2 = ( 1 b)( 1 t)X (k g)( EBITDA ) = ( 0 . 6 )( 0 . 65 ) 100 ( 0 . 12 0 . 02 ) 150 = 39 15 = 2 . 6 .P = 39 15 ( 150 ) = $390or2 . 6 ( 150 ) = $390 . Forallthecalculations,thefrmvalueis$390.Thisoccurssincethevaluesofallthreemultipliersarelinked.Inpractice,themultiplierforEBITDAislikelytobedeterminedbyagroupofwisemen(usingjudgment)ratherthanfnancetheorists,andthethreevaluesarelikelytobedifferentratherthanbeingexactlyequal.Itislikelythatthesemultiplierscannotbeappliedtoadifferentfrmwithadifferentcostofequityandadifferentgrowthrate.Above,themultiplierswerecomputedbasedonspecifcinformation.Otherinformationwillleadtodifferentmultipliers. TheInternationalAccountingSurge Currently,theU.S.accountingstandardsareestablishedbytheFinancialAccount-ingStandardsBoard(FASB)locatedinNorwalk,Connecticut.TheFASBsuppliesverydetailedrulesandguidancefortheaccountingprocessofpubliccorporations.Inthedistantfuture,wecanexpecttherulesandguidanceofferedbytheInternationalAccountingStandardsBoard(IASB)tobegivenmoreorlessequalstanding.TheIASBallowsmorejudgmentthantheFASBinapplyingprinciples.Theobjectivewilllikelybetoprovideinformationusefulformakingeconomicdecisionsnotfollowingasetofbookkeepingrules.Along-termobjectiveistohaveonesetofrulesthroughouttheworldsothatfnancialstatementsoriginatingindifferentcountriesarecomparable.
November6,200913:44spi-b8119inx6inb811-ch18 372 AnIntroductiontoAccountingandManagerialFinance Conclusion Wecanexpecttheuseoffairvalueforbothassetsandliabilitiestoincrease.Thus,theuseofhistoricalcostscanbeexpectedtodecreaseexceptforcashandnearcash.Thougheasy,ruleswillbeincorrectlydiscarded(ifnotalreadydiscarded).Thus,justifyinganaccountingprocessbecauseitisconservativewillnotbe(isnot)accepted.Afaithfulrepresentationofassets,liabilities,andincomewillbemoreimpor-tantthanbeingabletoverifytheexactcorrectnessofthemeasures.Itwillberecognizedthatestimationisanimportantandinescapableelementoftheaccount-ingprocess.Keepinginmindtheabovesetofobjectiveswillhelpyoubeabetteraccountantoruserofaccountinginformation.Wehaveattemptedtoshowthatthereareavarietyofmeasures,someobjectiveandsomehighlysubjective,thatcanbeusedbythedecisionmakersinattemptingtodeterminethevalueofafrm.Thereareexactmethodsofcalculation,buttherearenotexactreliablemeasuresofvalue.Accountinginformationmustbeadjustedforpurposesofdeterminingthevalueofafrm.Theliquidationvalueoftheassetssetsaminimumpriceandvalue,butanyvalueinexcessofthisminimummustfnditsjustifcationinthepresentvalueoftheprojectedcashfowexpectedtobegeneratedinthefuture.Thegoingconcernvalueoftheassets,withtheassetsgainingtheirvaluefromthecashfow,istherelevantfactor.Theprimeadvantagetobegainedbyusingcashfowversusconventionalincomeisthatitistheoreticallycorrectanditdoesnottieustotheresultsofaccountingproceduresthatarenotdesignedforthisspecifctypeofdecision.Ifthedecisionmakerswanttousethecurrentincomeasthebasisformakingtheirinvestmentdecision,careshouldbetakensincethecomputationmaynotbeequivalenttotheuseofcashfows.However,eveniftheydonotusetheincomemeasuredirectly,thedecisionmakerswilluseitindirectlyasthebasisfortheirevaluationoffuturedividends.Thecashfowstatementofchangesinfnancialpositionhasbecomeanimpor-tantandwidelyusedfnancialreport,helpingthereadertounderstandchangesinthecashpositionofthefrm.Althoughreportingwhathappenedisdesirableandnecessary,managementalsowishestoestimatesourcesandusesofcashinplanningforthefuture.Onecanformimpressionsfromthehistoricalrecords,butmanagerialdecisionsmustbebasedonprojections.Weshouldplacethecashfowstatementinproperperspective.Thestatementisnotasubstituteforeithertheincomestatementorthebalancesheet,butisausefulsupplementtothesetworeports.
November6,200913:44spi-b8119inx6inb811-ch18 TheCashFlowStatement 373 QuestionsandProblems 1.“Higherdepreciationaccrualshavereducedtheneedofcorporationstoborrow.”Commentonthisstatement.2.Aleadingbusinessperiodicalstatedthat“thetwoprimarysourcesoffundsforcorporateexpansionareretainedearningsandtheallowancefordepreciation.”Commentonthisstatement.3.Therearetwomajorcategoriesoftransactionsthatdonotaffectthefundsfow,yetmayhaveaprofoundimpactontheoperationsofacompanyandmayevenaffectthecompany’sneedforfnancing.Describethesetwotypesoftransactionsandgiveanexampleofeach.4.TheNo-AshCoalCompanyrecordedthefollowingtransactions.Indicatehoweachwouldbetreatedonastatementofchangesinfnancialposition,assumingthatfundsaredefnedasthecashbalance.Ifthetransactioninvolvesasourceoruseofcash,indicatetheamountthatwouldappearonthestatementasaresultofthetransaction.Eachtransactionmaybeidentifedasoneofthefollowing:a.Asourceofcash.b.Auseofcash.c.Anincomestatementadjustmentthathasnoeffectoncash.d.Atransactionthathasnoeffectoncashbecauseitinvolveschangesonlyinnon-cashitems.e.Atransactionthatrepresentsneitherasourceofcashnoranapplicationofcash.Thetransactionswereasfollows.Thecompany:(1)Paidadividendonpreferredstockpaidincash,$25,000.(2)Purchasedrawmaterialscosting$87,000oncredit.(3)Soldanoldtruckfor$300thatcost$2,000andwas80percentdepreciated.Lossrecognizedonthesaleamountedto$100.(4)Received$280,000inpaymentsonaccountsreceivable.(5)Purchasedanewmachinewithalistpriceof$27,000.Receivedadiscountof10percentforpayingcash.(6)Acquiredanewbuildingwithfairmarketvalueof$200,000byissuing$200,000inlong-termnotestothebuilder.5.Howdoesthepresenceofbondpremiumaffectthecomputationofthecashfromoperations?
November6,200913:44spi-b8119inx6inb811-ch18 374 AnIntroductiontoAccountingandManagerialFinance 6.Explainhowthegainorlossonthesaleoffxedassetsshouldbetreatedincomputingthecashfromoperations.7.ShownarecomparativebalancesheetsandanincomestatementfortheRobertsCompany.PrepareacashfowstatementfortheyearendedDecember31,20X2. TheRobertsCompanyComparativeBalanceSheetsasofDecember3120X220X1 Cash$150 , 000$125 , 000AccountsReceivable197 , 000160 , 000Inventories50 , 00085 , 000MachineryandEquipment75 , 00050 , 000BondsPayable,Discount5 , 250 5 , 500 $477 , 250 $425 , 500 AllowanceforUncollectibles$2 , 000$1 , 000AccumulatedDepreciation10 , 0007 , 000AccountsPayable53 , 00070 , 000BondsPayable100 , 000100 , 000CommonStock 150 , 00050 , 000RetainedEarnings 162 , 250 197 , 500 $477 , 250 $425 , 500 Represents10,000sharesoutstandingonDecember31,20X2,and5,000sharesonDecember31,20X1. A$100,000stockdividendwasissuedin20X2. TheRobertsCompanyIncomeStatementforYearEndedDecember31,20X2 Sales$400 , 000 Less AllowanceforUncollectibles3 , 000 $397 , 000ExpensesCostofGoodsSold$260 , 000OperatingExpenses60 , 000Taxes7 , 000InterestExpense5 , 250 332 , 250 NetIncome$64 , 750
November6,200913:44spi-b8119inx6inb811-ch18 TheCashFlowStatement 375 8.AssumethefollowingfactsapplytoBernakeCorporation( t c = 0 . 35): E = $195 ,X = $390 ,M 0 = 20 , Interest = $90 . a.Whatisthevalueofthecorporationusingearningstostockholders( E )?b.AssumetheEBITmultiplieris10( M 1 =10).Whatisthefrmvalue?c.Assumethatthedepreciationexpenseaccrualis$260andthattheEBITDAmultiplieris6.Whatisthefrmvalue?9.Duringtheyear20X2,theFosterCompanypurchasedbuildingsthatcostatotalof$3,400,000.TheBuildingsaccountandtherelatedAccumulatedDepreciationwereshowninthecomparativebalancesheetsofthecompanyasofDecember31,20X1and20X2,asfollows: 20X220X1 Buildings$5 , 600 , 000$3 , 100 , 000AccumulatedDepreciation2 , 500 , 000 1 , 700 , 000 $3 , 100 , 000$1 , 400 , 000Thecompany’sincomestatementfortheyear20X2includedthefollowingitems:DepreciationofBuildings$1 , 200 , 000GainonSaleofBuildings$600 , 000Determinethecostofthebuildingsthatweresoldduring20X2andthetotalamountreceivedfromthesaleofbuildings.
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November6,200913:44spi-b8119inx6inb811-App Appendices TableA Presentvalue a of$1.00 ( 1 + r) n . n/r 1%2%3%4%5%6%7%8%9%10%11%12%13%14%15% 10.99010.98040.97090.96150.95240.94340.93460.92590.91740.90910.90090.89290.88500.87720.869620.98030.96120.94260.92460.90700.89000.87340.85730.84170.82640.81160.79720.78310.76950.756130.97060.94230.91510.88900.86380.83960.81630.79380.77220.75130.73120.71180.69310.67500.657540.96100.92380.88850.85480.82270.79210.76390.73500.70840.68300.65870.63550.61330.59210.571850.95150.90570.86260.82190.78350.74730.71300.68060.64990.62090.59350.56740.54280.51940.497260.94200.88800.83750.79030.74620.70500.66630.63020.59630.56450.53460.50660.48030.45560.432370.93270.87060.81310.75990.71070.66510.62270.58350.54700.51320.48170.45230.42510.39960.375980.92350.85350.78940.73070.67680.62740.58200.54030.50190.46650.43390.40390.37620.35060.326990.91430.83680.76640.70260.64460.59190.54390.50020.46040.42410.39090.36060.33290.30750.2843100.90530.82030.74410.67560.61390.55840.50830.46320.42240.38550.35220.32200.29460.26970.2472110.89630.80430.72240.64960.58470.52680.47510.42890.38750.35050.31730.28750.26070.23660.2149120.88740.78850.70140.62460.55680.49700.44400.39710.35550.31860.28580.25670.23070.20760.1869130.87870.77300.68100.60060.53030.46880.41500.36770.32620.28970.25750.22920.20420.18210.1625140.87000.75790.66110.57750.50510.44230.38780.34050.29920.26330.23200.20460.18070.15970.1413150.86130.74300.64190.55530.48100.41730.36240.31520.27450.23940.20900.18270.15990.14010.1229 ( Continued ) 377
November6,200913:44spi-b8119inx6inb811-App 378 AnIntroductiontoAccountingandManagerialFinance TableA ( Continued ) n/r 1%2%3%4%5%6%7%8%9%10%11%12%13%14%15% 160.85280.72840.62320.53390.45810.39360.33870.29190.25190.21760.18830.16310.14150.12290.1069170.84440.71420.60500.51340.43630.37140.31660.27030.23110.19780.16960.14560.12520.10780.0929180.83600.70020.58740.49360.41550.35030.29590.25020.21200.17990.15280.13000.11080.09460.0808190.82770.68640.57030.47460.39570.33050.27650.23170.19450.16350.13770.11610.09810.08290.0703200.81950.67300.55370.45640.37690.31180.25840.21450.17840.14860.12400.10370.08680.07280.0611210.81140.65980.53750.43880.35890.29420.24150.19870.16370.13510.11170.09260.07680.06380.0531220.80340.64680.52190.42200.34180.27750.22570.18390.15020.12280.10070.08260.06800.05600.0462230.79540.63420.50670.40570.32560.26180.21090.17030.13780.11170.09070.07380.06010.04910.0402240.78760.62170.49190.39010.31010.24700.19710.15770.12640.10150.08170.06590.05320.04310.0349250.77980.60950.47760.37510.29530.23300.18420.14600.11600.09230.07360.05880.04710.03780.0304260.77200.59760.46370.36070.28120.21980.17220.13520.10640.08390.06630.05250.04170.03310.0264270.76440.58590.45020.34680.26780.20740.16090.12520.09760.07630.05970.04690.03690.02910.0230280.75680.57440.43710.33350.25510.19560.15040.11590.08950.06930.05380.04190.03260.02550.0200290.74930.56310.42430.32070.24290.18460.14060.10730.08220.06300.04850.03740.02890.02240.0174300.74190.55210.41200.30830.23140.17410.13140.09940.07540.05730.04370.03340.02560.01960.0151350.70590.50000.35540.25340.18130.13010.09370.06760.04900.03560.02590.01890.01390.01020.0075400.67170.45290.30660.20830.14200.09720.06680.04600.03180.02210.01540.01070.00750.00530.0037450.63910.41020.26440.17130.11120.07270.04760.03130.02070.01370.00910.00610.00410.00270.0019500.60800.37150.22810.14070.08720.05430.03390.02130.01340.00850.00540.00350.00220.00140.0009 ( Continued )
November6,200913:44spi-b8119inx6inb811-App Appendices 379 TableA ( Continued ) n/r 16%18%20%22%24%26%28%30%32%34%36%38%40%45%50% 10.86210.84750.83330.81970.80650.79370.78130.76920.75760.74630.73530.72460.71430.68970.666720.74320.71820.69440.67190.65040.62990.61040.59170.57390.55690.54070.52510.51020.47560.444430.64070.60860.57870.55070.52450.49990.47680.45520.43480.41560.39750.38050.36440.32800.296340.55230.51580.48230.45140.42300.39680.37250.35010.32940.31020.29230.27570.26030.22620.197550.47610.43710.40190.37000.34110.31490.29100.26930.24950.23150.21490.19980.18590.15600.131760.41040.37040.33490.30330.27510.24990.22740.20720.18900.17270.15800.14480.13280.10760.087870.35380.31390.27910.24860.22180.19830.17760.15940.14320.12890.11620.10490.09490.07420.058580.30500.26600.23260.20380.17890.15740.13880.12260.10850.09620.08540.07600.06780.05120.039090.26300.22550.19380.16700.14430.12490.10840.09430.08220.07180.06280.05510.04840.03530.0260100.22670.19110.16150.13690.11640.09920.08470.07250.06230.05360.04620.03990.03460.02430.0173110.19540.16190.13460.11220.09380.07870.06620.05580.04720.04000.03400.02890.02470.01680.0116120.16850.13720.11220.09200.07570.06250.05170.04290.03570.02980.02500.02100.01760.01160.0077130.14520.11630.09350.07540.06100.04960.04040.03300.02710.02230.01840.01520.01260.00800.0051140.12520.09850.07790.06180.04920.03930.03160.02530.02050.01660.01350.01100.00900.00550.0034150.10790.08350.06490.05070.03970.03120.02470.01950.01550.01240.00990.00800.00640.00380.0023160.09300.07080.05410.04150.03200.02480.01930.01500.01180.00930.00730.00580.00460.00260.0015170.08020.06000.04510.03400.02580.01970.01500.01160.00890.00690.00540.00420.00330.00180.0010180.06910.05080.03760.02790.02080.01560.01180.00890.00680.00520.00390.00300.00230.00120.0007190.05960.04310.03130.02290.01680.01240.00920.00680.00510.00380.00290.00220.00170.00090.0005200.05140.03650.02610.01870.01350.00980.00720.00530.00390.00290.00210.00160.00120.00060.0003 ( Continued )
November6,200913:44spi-b8119inx6inb811-App 380 AnIntroductiontoAccountingandManagerialFinance TableA ( Continued ) n/r 16%18%20%22%24%26%28%30%32%34%36%38%40%45%50% 210.04430.03090.02170.01540.01090.00780.00560.00400.00290.00210.00160.00120.00090.00040.0002220.03820.02620.01810.01260.00880.00620.00440.00310.00220.00160.00120.00080.00060.00030.0001230.03290.02220.01510.01030.00710.00490.00340.00240.00170.00120.00080.00060.00040.00020.0001240.02840.01880.01260.00850.00570.00390.00270.00180.00130.00090.00060.00040.00030.00010.0001250.02450.01600.01050.00690.00460.00310.00210.00140.00100.00070.00050.00030.00020.00010.0000260.02110.01350.00870.00570.00370.00250.00160.00110.00070.00050.00030.00020.00020.0001270.01820.01150.00730.00470.00300.00190.00130.00080.00060.00040.00020.00020.00010.0000280.01570.00970.00610.00380.00240.00150.00100.00060.00040.00030.00020.00010.0001290.01350.00820.00510.00310.00200.00120.00080.00050.00030.00020.00010.00010.0001300.01160.00700.00420.00260.00160.00100.00060.00040.00020.00020.00010.00010.0000350.00550.00300.00170.00090.00050.00030.00020.00010.00010.00000.00000.0000400.00260.00130.00070.00040.00020.00010.00010.00000.0000450.00130.00060.00030.00010.00010.00000.0000500.00060.00030.00010.00000.0000 Note : a r istherateofdiscountand n isthenumberoftimeperiods.
November6,200913:44spi-b8119inx6inb811-App Appendices 381 TableB Presentvalueof$1.00received a perperiod ( 1 ( 1 + r) n )/r . n/r 1%2%3%4%5%6%7%8%9%10%11%12%13%14%15% 10.99010.98040.97090.96150.95240.94340.93460.92590.91740.90910.90090.89290.88500.87720.869621.97041.94161.91351.88611.85941.83341.80801.78331.75911.73551.71251.69011.66811.64671.625732.94102.88392.82862.77512.72322.67302.62432.57712.53132.48692.44372.40182.36122.32162.283243.90203.80773.71713.62993.54593.46513.38723.31213.23973.16993.10243.03732.97452.91372.855054.85344.71354.57974.45184.32954.21244.10023.99273.88973.79083.69593.60483.51723.43313.352265.79555.60145.41725.24215.07574.91734.76654.62294.48594.35534.23054.11143.99753.88873.784576.72826.47206.23036.00205.78645.58245.38935.20645.03304.86844.71224.56384.42264.28834.160487.65177.32557.01976.73276.46326.20985.97135.74665.53485.33495.14614.96764.79884.63894.487398.56608.16227.78616.43537.10786.80176.51526.24695.99525.75905.53705.32825.13174.94644.7716109.47138.98268.53028.11097.72177.36017.02366.71016.41776.14465.88925.65025.42625.21615.01881110.36769.78689.25268.76058.30647.88697.49877.13906.80516.49516.20655.93775.68695.45275.23371211.255110.57539.95409.38518.86328.38387.94277.53617.16076.81376.49246.19445.91765.66035.42061312.133711.348410.63509.98569.39368.85278.35777.90387.48697.10346.74996.42356.12185.84245.58311413.003712.106211.296110.56319.89869.29508.74558.24427.78627.36676.98196.62826.30256.00215.72451513.865012.849311.937911.118410.37979.71229.10798.55958.06077.60617.19096.81096.46246.14225.84741614.717913.577712.561111.652310.837810.10599.44668.85148.31267.82377.37926.97406.60396.26515.95421715.562214.291913.166112.165711.274110.47739.76329.12168.54368.02167.54887.11966.72916.37296.04721816.398314.992013.753512.659311.689610.827610.05919.37198.75568.20147.70167.24976.83996.46746.12801917.226015.678514.323813.133912.085311.158110.33569.60368.95018.36497.83937.36586.93806.55046.19822018.045516.351414.877513.590312.462211.469910.59409.81819.12858.51367.96337.46947.02486.62316.2593 ( Continued )
November6,200913:44spi-b8119inx6inb811-App 382 AnIntroductiontoAccountingandManagerialFinance TableB ( Continued ) n/r 1%2%3%4%5%6%7%8%9%10%11%12%13%14%15% 2118.857017.011215.415014.029212.821111.764110.835510.01689.29228.64878.07517.56207.10156.68706.31252219.660417.658015.936914.451113.163012.041611.061210.20079.44248.77158.17577.64467.16956.74296.35872320.455818.292216.443614.856813.488612.303411.272210.37119.58028.88328.26647.71847.22976.79216.39882421.243418.013916.935515.247013.798612.550411.469310.52889.70668.98478.34817.78437.28296.83516.43382522.023219.523517.413115.622114.093912.783411.653610.67489.82269.07708.42177.84317.33006.87294.46412622.795220.121017.876815.982814.375213.003211.825810.81009.92909.16098.48817.89577.37176.90616.49062723.559620.706918.327016.329614.643013.210511.986710.935210.02669.23728.54787.94267.40866.93526.51352824.316421.281318.764116.663114.898113.406212.137111.051110.11619.30668.60167.98447.44126.96076.53352925.065821.844419.188416.983715.141113.590712.277711.158410.19839.36968.65018.02187.47016.98306.55093025.807722.396519.600417.292015.372413.746812.409011.257810.27379.42698.69388.05527.49577.00276.56603126.542322.937720.000417.588515.592813.929112.531811.394810.34289.47908.73318.08507.51837.01996.57913227.269623.468320.388817.873515.802714.084012.646611.435010.40629.52648.76868.11167.53837.03506.58053327.989723.988620.765818.147616.002514.230212.753811.513910.46449.56948.80058.13547.55607.04826.60053428.702724.498621.131818.411216.192914.368112.854011.586910.51789.60868.82938.15667.57177.05996.60913529.408624.998621.487218.664616.374214.498212.947711.654610.56689.64428.85528.17557.58567.07006.61664032.834727.355523.114819.792817.159115.046313.331711.924610.75749.77918.95118.24387.63447.10506.64184536.094529.490224.518720.720017.774115.455813.605512.108410.88129.86289.00798.28257.66097.12326.65435039.196131.423625.729821.482218.255915.761913.800712.233510.96179.91489.04178.30457.67527.13276.6605 ( Continued )
November6,200913:44spi-b8119inx6inb811-App Appendices 383 TableB ( Continued ) n/r 16%18%20%22%24%26%28%30%32%34%36%38%40%45%50% 10.86210.84750.83330.81970.80650.79370.78130.76920.75760.74630.73530.72460.71430.68970.666721.60521.56561.52781.49151.45681.42351.39161.36091.33151.30321.27601.24971.22451.16531.111132.24592.17432.10652.04221.98131.92341.86841.81611.76631.71881.67351.63021.58891.49331.407442.79822.69012.58872.49362.40432.32022.24102.16622.09572.02901.96581.90601.84921.71951.604953.27433.12722.99062.86362.74542.63512.53202.43562.34522.26042.18072.10582.03521.87551.736663.68473.49763.32553.16693.02052.88502.75942.64272.53422.43312.33882.25062.16801.98311.824474.03863.81153.60463.41553.24233.08332.93702.80212.67752.56202.45502.35552.26282.05731.882984.34364.07763.83723.61933.42123.24073.07582.92472.78602.65822.54042.43152.33062.10851.922094.60654.30304.03103.78633.56553.36573.18423.01902.86812.73002.60332.48662.37902.14381.9480104.83324.49414.19253.92323.68193.46483.26893.09152.93042.78362.64952.52652.41362.16811.9053115.02864.65604.32714.03543.77573.54353.33513.14732.97762.82362.68342.55552.43832.18491.9769125.19714.79324.43924.12743.85143.60593.38683.19033.01332.85342.70842.57642.45592.19651.9845135.34234.90954.53274.20283.91243.65553.42723.22333.04042.87572.72682.59162.46852.20451.9897145.46755.00814.61064.26463.96163.69493.45873.24873.06092.89232.74032.60262.47752.21001.9931155.57555.09164.67554.31524.00133.72613.48343.26823.07642.90472.75022.61062.48392.21381.9954165.66855.16244.72964.35674.03333.75093.50263.28323.08822.91402.75752.61642.48852.21641.9970175.74875.22234.77464.39084.05913.77053.51773.29483.09712.92092.76292.62062.49182.21821.9980185.81785.27324.81224.41874.07993.78613.52943.30373.10392.92602.76682.62362.49412.21951.9986195.87755.31624.84354.44154.09673.79853.53863.31053.10902.92992.76972.62582.49582.22031.9991205.92885.35274.86964.46034.11033.80833.54583.31583.11292.93272.77182.62742.49702.22091.9994 ( Continued )
November6,200913:44spi-b8119inx6inb811-App 384 AnIntroductiontoAccountingandManagerialFinance TableB ( Continued ) n/r 16%18%20%22%24%26%28%30%32%34%36%38%40%45%50% 215.97315.38374.89134.47564.12123.81613.55143.31983.11582.93492.77342.62852.49792.22131.9996226.01135.40994.90944.48824.13003.82233.55583.32303.11802.93652.77462.62942.49852.22161.9997236.04425.43214.92454.49854.13713.82733.55923.32533.11972.93772.77542.63002.49892.22181.9998246.07265.45094.93714.50704.14283.83123.56193.32723.12102.93862.77602.63042.49922.22191.9999256.09715.46694.94764.51394.14743.83423.56403.32863.12202.93922.77652.63072.49942.22201.9999266.11825.48044.95634.51964.15113.83673.56563.32973.12272.93972.77682.63102.49962.22211.9999276.13645.49194.96364.52434.15423.83873.56693.33053.12332.94012.77712.63112.48872.22212.0000286.15205.50164.96974.52814.15663.84023.56793.33123.12372.94042.77732.63132.49982.22222.0000296.16565.50984.97474.53124.15853.84143.56873.33163.12402.94062.77742.63132.49992.22222.0000306.17725.51684.97894.53384.16013.84243.56933.33213.12422.94072.77752.63142.49992.22222.0000316.18725.52274.98244.53594.16143.84323.56973.33243.12442.94082.77762.63152.49992.22222.0000326.19595.52774.98544.53764.16243.84383.57013.33263.12462.94092.77762.63152.49992.22222.0000336.20345.53204.98784.53904.16323.84433.57043.33283.12472.94102.77772.62152.50002.22222.0000346.20985.53564.98984.54024.16393.84473.57063.33293.12482.94102.77772.63152.50002.22222.0000356.21535.53864.99154.54114.16443.84503.57083.33303.12482.94112.77772.62152.50002.22222.0000406.23355.54824.99664.54394.16593.84583.57123.33323.12502.94122.77782.63162.50002.22222.0000456.24215.55234.99864.54494.16643.84603.57143.33333.12502.94122.77782.63162.50002.22222.0000506.24635.55414.99954.54524.16663.84613.57143.33333.12502.94122.77782.63162.50002.22222.0000 Note : a r istherateofdiscountand n isthenumberoftimeperiods.
November6,200913:44spi-b8119inx6inb811-about AbouttheAuthor HaroldBierman,Jr. istheNicholasH.NoyesProfessorofBusinessAdmin-istrationattheJohnsonGraduateSchoolofManagement,CornellUniversity.AgraduateoftheU.S.NavalAcademy,Annapolis,hereceivedhisMBAandhisPh.D.fromtheUniversityofMichigan.ACornellfacultymembersince1956,ProfessorBiermanformerlytaughtatLouisianaStateUniversity,theUniversityofMichigan,andtheUniversityofChicago.HehasalsotaughtatINSEADinFountainebleau,France,andatKULinBelgium,andwasaresearchfellowatCambridgeUniversity(England).HewasarecipientoftheDowJonesAwardfromtheAmericanAssemblyofCollegiateSchoolsofBusinessforhisoutstandingcontributionstocollegiatebusinesseducation.HeservedasafnancialconsultantatPrudentialBacheSecuri-tiesinNewYork.HisindustrialexperienceincludesconsultingforCorningGlassCorporation,EastmanKodak,SunOilCompany,ExxonOilCorporation,IBM,andXeroxCorporation.Hehaswrittennumerousbooks,including TheCapitalBudgetingDecision (withSeymourSmidt), FinancialAccounting,ManagerialAccounting ,and QuantitativeAnalysisforBusinessDecisions ,aswellasmorethan170journalarticles. 385
November6,200913:44spi-b8119inx6inb811-about This page intentionally left blankThis page intentionally left blank
November6,200913:44spi-b8119inx6inb811-Index Index AcceleratedCostRecoverySystem(ACRS),118account,43accountbalances,47accounting,31stewardshipfunctionof,29accountingassumptions,307accountingdepreciationexpense,130accountingentries,120equalityof,46periodicadjustments,89accountingentry,32accountingequation,33accountingidentity,34accountinginformation,30accountingissues,304accountingmeasures,260accountingprocess,31accountingrecords,accuracyof,48accrualaccounting,86accumulateddepreciation,197AccumulatedDepreciationaccount,121accumulatedearningstax,208accumulationfactor,14acquisitionscostof,303forcash,294highlyleveraged,304horizontal,294valuationfor,297agencytheory,278AllowanceforDepreciationaccount,121amortization,126annualequivalentamounts,21annuity,19derivationof,26ordinary,19presentvalueof,17,20,26annuityinarrears,18,19anti-raidingmaneuver,293antidilutionprotection,333antitrustconsiderations,293assetsources,34assets,33,35valuationof,263balancesheet,3,30,34,40–43balancedarray,40verticalform,40387
November6,200913:44spi-b8119inx6inb811-Index 388 AnIntroductiontoAccountingandManagerialFinance balloonpayment,137bankruptcy,costof,205betacoeffcientofunity,211bidprice,295Black-Scholesmodel,337boardofdirectors,1bond,137valueof,145withwarrants,335bonddiscount,367bondliability,142bondpremium,367bondrefundingdecision,143bookvalue,105,111,112,196bookvaluepershare,271buyversuslease,223,230buy-borrowversuslease,231calloption,324callpremium,326capitalcostof,197,212obtainingof,2,179,180capitalassetpricingmodel(CAPM),208–210,212useof,211capitalbudgeting,3,15,57,193capitalcostofrisk,208capitalgains,172andtaxdeferraladvantages,178capitallease,224,225,227capitalleaseobligation,226capitalleases,145capitalmarket,6capitalreceivedfromstockholders,39capitalstructure,193capitaltransactions,155cashdividends,167cashfowprojection,elementsof,62cashfowreturnoninvestment(ROI),129,282cashfowstatement,363,372managerialuses,368cashfows,5,101adjustingforthetimingof,8alternative,22annual,22depreciationand,121fromfnancingactivities,368frominvestingactivities,367fromoperations,363incremental,22,62relevanceof,4useof,101,102versusearnings,5cashtobereceivedearlier,9cashtobereceivedtoday,4CertifedPublicAccountants(CPAs),31Chevron,289combinationofstocksandbonds,202commonstock,3,7,39,152,329costof,158issuanceof,153repurchaseof,167,182commonstockdividend,171commonstockequity,195commonstockequityaccounts,separationof,161commonstockholders,1conglomerateacquisition,294Conoco,289consolidatedbalancesheets,308eliminationsandadjustments,309consolidatedfnancialstatements,306,307consolidation,315entitytheoryof,315contraassetaccounts,111contractualrate,137,140control,184conversionpremium,325,326,331convertiblebond,324,328,329valueof,327convertiblebonds,323,339convertiblesecurities,323corporatedividendpractice,173corporatetaxes,207
November6,200913:44spi-b8119inx6inb811-Index Index 389corporation,33cost,305costfowassumptions,345evaluationof,348cost-or-market,349costs,344creditbalance,47creditpolicy,3creditors,31credits,45,47criticalevent,90currentassets,3,37currentliabilities,39debitbalance,47debits,45,47debt,7,206,207,234,257,328advantageof,196debtleverage,213debt-equityratio,272decliningbalanceprocedure,115decreasingcharge(accelerateddepreciation),115deferredbenefts,127,281defcit,86depletionaccounting,124depletionofnaturalresources,123depreciationandactivity,118andcashfow,121proceduresforcomputing,113depreciationaccounting,87,111depreciationbase,112depreciationexpense,111,112,266differentexpectations,186,293dilution,336directvariablecosts,344discontinuedoperations,95discount,138,139discountedcashfow(DCF),15,63,64,66,73distributiondecision,2distributionstoshareholders,167diversifcation,290dividendchangesandearningsforecasts,175dividenddecision,2dividendpolicy,171,175incometaxesand,176settingof,174dividendvaluationmodel,159dividend-receiveddeduction,247,256dividends,40,157,161,172accountingfor,167andstockvalue,171clienteleeffect,180“extra”,174fexible,187formof,183highlystable,172reasonsfor,180“regular”,174relativelystable,173dividendsonstock,168doubledecliningbalancemethod,115double-entryaccountingsystem,151“double-to-72”rule,15downsideinsurance,324downsideprotection,334DuPontformulation,262DuPont,289earningsdilutionof,302useof,101,103earningspershare,95,261,270,338EBIT,297,369EBITmultiple,106EBITDA,297,370EBITDAmultiple,106economicandaccountingassets,35economicincome,259,261,266–268,284summaryofadvantages,269economicorderquantity(EOQ),352economicvalueadded(EVA),266effectiveormarketrateofinterest,138
November6,200913:44spi-b8119inx6inb811-Index 390 AnIntroductiontoAccountingandManagerialFinance effectiverate,140effcientmarkethypothesis,274implicationsof,276semi-strongform,275strongform,276weakform,274eliminationofduplication,292equity,306equitycapital,costof,158,180equityliabilities,3EuropeanUnion,293expectationaldifferences,188expectedreturn,9,209expenseaccounts,89expenserecognition,92expenses,86,92facevalue,137FederalTradeCommission,293fduciaryrelationship,2fnancemanagers,3fnancialaccounting,32,49fnancialaccountingstandards,351,363FinancialAccountingStandardsBoard(FASB),125,156,224,371fnancialleverage,196,203,206increasesin,183fnancialmeasures,improving,185fnancialposition,30,42,49fnancialreporting,29fnancialstatements,30fnancing,230fnancingpolicy,175fnishedgoods,345frmvaluewithtaxes,205fxedassets,37usefullife,113fowofcostsFIFO,345,356LIFO,346,356specifcunits,348weightedaveragecost,347futurevalue,14GenerallyAcceptedAccountingPrinciples,5,259GettyOil,289goal,1,174goldenparachutes,304goodwill,126,127greenmail,304growth,292growthmodel,300GulfOil,289hedgefunds,338historicalcosts,372holdingcompany,296horizontalintegration,292hurdlerate,212,233,242implicitgrowthrate,300implicitreturnonnewinvestments,301impliedgrowthrate,301incentiveconsideration,280income,86,96,101,261computationof,265measurementof,85incomestatement,30,85,90,263formof,94multi-step,95single-step,94incometaxes,32anddividendpolicy,176individualproprietorship,33intangibleassets,38,124intercompanysalestransactions,308intercompanytransactions,314intercorporateinvestments,304interestpayments,62taxdeductibilityof,334interestrate,323,331interestrateofreturn,66internalrateofreturn(IRR),63,66,74,78InternalRevenueCode,116,350InternalRevenueService,214InternationalAccountingStandardsBoard(IASB),371inventories,343,344
November6,200913:44spi-b8119inx6inb811-Index Index 391inventoryandfnance,351classifcationsof,343investment,1,3,68,230complement,59economicallydependent,59economicallyindependent,59mutuallyexclusive,60,77statisticallydependent,60substitute,59investmentdecision,2,328accept-or-reject,61,76investmentpolicy,175irrelevanceof,176investmentrankings,61byinspection,70limitationof,76investmentrelationships,60investmentworth,measuresof,60investor’smethod,66jointutilization,292journalentries,48journalentryform,49“justintime”inventory,352lease,145,234leaseliability,amortizationtablefor,227leasing,242prosandconsof,228ledger,48lessees,228lessors,228leveragedbuyout(LBO),303liabilities,33,38,39,168loanamortizationschedule,21long-livedassets,37gainorloss,122long-terminvestment,305accountingfor,304long-termliabilities,39,137loss,86managerialaccounting,32managerialcompensation,260,277managerialdecisions,29managerialfnance,2managerialperformance,259MarathonOil,289marginrequirement,325marginaleffciencyofcapital,66market,305marketinterestrate,141marketmeasures,260,270markettransactions,151marketvalue,196,200marketvalueofthestock,4maximizationofvalue,4,9marketablesecurities,38matchingconcept,92matchingofcostsandrevenues,111maturityamount,137,138mergerofequals,5valuecalculation,6mergersandacquisitions,252,289,316,317acquisitionofresources,290obtainingresources,289reasonsfor,289–294minorityinterest,311,313moneymultipliernotes,141netpresentvalue(NPV),63,64,74,77,78non-zero,279no-corporate-taxcase,199non-accountingbutquantitativemeasures,260non-accountingquantitativemeasures,277noncurrentassets,37gainorlossonsaleof,365noncurrentliabilities,39off-balance-sheetfnancing,228operatingleases,145,224,225operatingmargins,260opportunityloss,325optimumcapitalstructure,196,197classicalviewof,199originalissuediscount(OID)notes,141
November6,200913:44spi-b8119inx6inb811-Index 392 AnIntroductiontoAccountingandManagerialFinance P/Eratio,299parvalue,152parentcorporation,307partnership,33paybackperiod,70payouttarget,173performancemeasurement,260periodexpenses,92periodicrentexpense,145perpetuity,19presentvaluefor,27personalborrowing,203personaltaxes,207powerofcompounding,14,15preferredstock,3,7,247accountingfor,248asinvestment,256convertibleexchangeable,255costof,250,251noncallable,251variable-rate,253versuscommonstock,253preferredstockdividends,204premium,138,139determining,294premiumoverbondvalue,325presentvalue,16,78presentvaluereturnoninvestment,66priceearningsmultiple,106pricetakers,209privateaccountant,31privateequity,256processofrecordingtransactions,44proftmaximization,2,291publicaccountant,31publicpolicyquestions,188qualitativemeasures,260,277rateofdiscount,57rateofreturn,66,72ratioanalysis,limitationsof,273rawmaterials,345regulatedpublicutility,254removalcosts,115researchanddevelopmentcosts,125reserves,useof,156residualincome,266residualvalue,239resultsofoperations,49retainedearnings,7,39,155andcash,157costof,179restrictions,155returnonassets(ROA),262returnoncapitalapplied(ROCA),262returnonequity(ROE),262returnonfundsemployed(ROFE),262returnoninvestment(ROI),66,72,78,259,261,268,284andinvestmentdecisionmaking,264componentsof,262computationof,265returnonnetassetsemployed(RONAE),262revenueaccounts,89revenuerecognition,90,106cashreceiptsbasis,90criteria,93productionbasis,90sales(oraccrual)basis,90revenuetransaction,85,154revenues,86,92realizationof,93risk,3,4,9,325risk-adjusteddiscountrate,237risk-returntrade-off,3rollbackmethod,77roundaboutmethodsofproduction,13salesrevenue,260salvagevalue,115saversofsociety,7semiannualinterestcomplexity,140semiannualinterestpayments,145sharerepurchases,40,167stockpriceeffectof,187tax-relatedrationalefor,186shareholders,30
November6,200913:44spi-b8119inx6inb811-Index Index 393shares,167repurchaseof,167,181short-termsecurities,3sizeoffrm,293shrinking,185specialinformation,185spin-off,315,316split-off,316stockdividend,168–170,181stockequities,33stockequitytransactions,historyof,151stockprice,growthratein,188stockpricemodelclosed-form,160derivationof,165stockrepurchase,183asinvestment,183stocksplit,169,170stockvaluationmodel,158stockholderwealthmaximization,1stockholders,2stockholders’equity,3,34,38,39,151,158classifcationof,152costof,180straight-lineprocedure,114strategicplanning,8subsidiaries,307sum-of-the-years’digitsprocedure,116synergy,291systematicreturns,210systematicrisk,211T-account,43tacticalandstrategicdecisions,7tangibleassets,38taxdeferraladvantage,177taxdepreciationexpense,130taxeffects,188taximplications,292taxlaw,205taxableevent,172taxableincome,196taxesabsenceof,205effectof,235temporaryaccounts,89temporaryinvestment,305Texaco,289timediscounting,13,62,193timevalue,3timevalueofmoney,13,22,57time-adjustedrateofreturn,66timesinterestearned,272totalreturnapproach,172transactionsnotaffectingfunds,368treasurystock,154trustlegallist,173U.S.JusticeDepartment,293U.S.Steel,289unitsofproductionprocedure,119unsystematicreturns,210unsystematicrisk,211,212verticalintegration,292weightedaveragecostofcapital(WACC),193–195,233,242after-tax,194constant,198,201workinprocess,345workingcapital,63write-off,283yield,66yieldtomaturity,140zero-couponbond,141