AN INTRODUCTION TO
ACCOUNTING and
MANAGERIAL 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 and
MANAGERIAL 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 2009
657--dc22
2009034159
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Wanda - An Intro to Accounting.pmd3/8/2010, 6:19 PM1
November6,200913:43spi-b8119inx6inb811-fm
Preface
Introductoryaccountingandfnancehavetraditionallybeentaughtastwoseparate
courses,eventhoughtheimportanceofabasicknowledgeoffnanceinlearning
accountingandaknowledgeofaccountinginlearningfnancehavebeenwidely
acknowledged.Oneimportanthistoricalreasonforhavingtwoseparatecourses
wasthat,inthepast,fewprofessorscouldteachbothcourseswell.Thislackof
competentinstructorshasdisappeared,andtherearenowmanyprofessorswho
canwellintegratethebasicelementsofaccountingandfnance.
Accountingisanever-evolvingart.Understandingaccountingisnecessaryto
understandfnancialreportingbybusinessorganizationsandtheusesoffnancial
reportsbydecisionmakers,bothinternalmanagersandfnancialanalysts.
Thestructureofaccountingisanimportanteducationaltool.Thebasiclogicof
thedebit-creditprocessiselegantandlogicallyconsistent.Theuseofdebitsand
creditsemphasizestherelationshipsbetweenaccountsandsimplifestheexplana-
tionofawiderangeoffnancialtransactions.
Thisbookisalsoanintroductiontocorporatefnancialmanagement,build-
ingonthebasiccapitalbudgetingframeworkandthetimevalueofmoney.The
objectiveistostressthetheoreticalformulationsthataremostusefulinmaking
managerialfnancialdecisions.Aworkingknowledgeofthetimevalueofmoney
isessentialtohavingacompleteliberaleducation.
Theterms
netpresentvalue
,
internalrateofreturn
,and
capitalassetpricing
model
aretodaywidelyusedbymanagers.Afewyearsago,thepersonsinimportant
managerialpositionsmighthavesaidthattheymadethefrm’sbigdecisionsonthe
basisoftheirexperience,judgment,andintuition.Now,topmanagersinsistmore
andmoreonhavingfnancialinformationproperlyanalyzedbeforetheyexercise
theirjudgments.
Manyofthefnancialmodelsaresimplifcationsoftherealworld.Iftheywere
tobeappliedwithoutthought,itislikelythatsomeofthemodelswouldleadto
undesirabledecisions.However,ifusedcorrectly,suchmodelswillgiveinsights
intotheweaknessesofother,moresimplifedanderroneousdecision-makingtech-
niques.Thisbookemphasizesthatthecorrectapplicationoffnancialtechniques
v
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vi
AnIntroductiontoAccountingandManagerialFinance
inbusinesssituationsimprovesthelikelihoodofmakinggooddecisions.However,
exactanswersandcorrectdecisionsarenotalwaysguaranteedinacomplexand
uncertainworld.
Thisbookisbasedonanumberoffundamentalprinciples.First,thetimevalue
ofmoneyisusedasthebasicfoundationforalargeamountoftheanalysis.Second,
decisionsareapproachedonanafter-taxbasis.Third,wehaveavoidedrelatively
complexmodelsthataremoreappropriateforamoreadvancedfnancecourse.
Fourth,weemphasizedecisionmaking.Weemphasizethemodelsandmethodsof
analysisthataremostusefulandpracticalratherthandiscussingtheoryfortheory’s
sake.Finally,oncethereaderunderstandsthebasicconceptsandmethods,wethink
itisimportanttointroducevariousreal-worldconstraintsandcomplexities.
Iacknowledgetheinvaluablecontributionsofmyco-authorsonotherwriting
projects,SySmidt,JerryHass,andBobSwieringa.Whilethesefriendsandcol-
leaguescannotbeheldresponsibleforanymistakes(misstatements),theydidhelp
contributesignifcantlytomyunderstandingofthetopicscoveredinthisbook.
HaroldBierman,Jr.
CornellUniversity
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Contents
Prefacev
Chapter1.Finance,AccountingandCorporateObjectives1
Chapter2.TheTimeValueofMoney13
Chapter3.AnIntroductiontoFinancialReporting29
Chapter4.CapitalBudgeting57
Chapter5.TheIncomeStatement85
Chapter6.ComparingtheUseofCashFlowsandIncomes101
Chapter7.DepreciationExpense111
Chapter8.Long-TermLiabilities137
Chapter9.Stockholders’Equity151
Chapter10.DistributionstoShareholders167
Chapter11.CapitalStructure:WeightedAverageCostofCapital
(WACC)193
Chapter12.BuyversusLease223
Chapter13.PreferredStock247
vii
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viii
AnIntroductiontoAccountingandManagerialFinance
Chapter14.ManagerialPerformance259
Chapter15.MergersandAcquisitions:Consolidations289
Chapter16.ConvertibleBonds323
Chapter17.Inventories343
Chapter18.TheCashFlowStatement363
Appendices377
AbouttheAuthor385
Index387
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Chapter1
Finance,Accountingand
CorporateObjectives
CorporateObjectives
Themotivationforbuyingthecommonstockofacorporationistheexpectationof
makingalargerrisk-adjustedreturnthancanbeearnedelsewhere.Themanagers
ofacorporationhavetheresponsibilityofadministeringtheaffairsofthefrmina
mannerconsistentwiththeexpectationofreturningtheinvestors’originalcapital
plustherequiredreturnontheircapital.Thecommonstockholdersaretheresidual
owners,andtheyearnareturnonlyaftertheinvestorsinthemoreseniorsecurities
(debtandpreferredstock)havereceivedtheircontractualclaims.Wewillassume
thattheobjectiveofthefrmistomaximizeitscommonstockholders’wealth
position.
Stockholdersinvestinacorporationwiththeexpectationofmakinganetgainon
theirinvestmentconsistentwiththeinvestment’srisk.Themanagersandtheboard
ofdirectorsofacorporationhavetheresponsibilityofadministeringtheaffairsof
thefrminamannerconsistentwiththeinterestsofthestockholders.Thus,oneof
management’sprimarygoalsshouldbethemaximizationofstockholders’wealth.
Althoughcorporationsmighthaveotherobjectives(suchasfulfllingtheirsocial
responsibilitiesortreatingtheirworkersfairly),wewillfocusourattentiononthe
morenarrowcorporategoalofstockholderwealthmaximization.
Buteventhisnarrowdefnitionisapttogiverisetomisunderstandingand
confict.Itisverylikelythatsituationswillarisewhereonegroupofstockholders
willpreferonefnancialdecisionwhileanothergroupofstockholderswillprefer
anotherdecision.Forexample,imagineasituationwhereabusinessundertakesan
investmentthatisdeemedtobedesirablebymanagement,buttheimmediateeffect
oftheinvestmentwillbetodepressearningsandthecommonstockpricetoday.
Inthefuture,themarketmayrealizethattheinvestmentisdesirable,andatthat
1
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2
AnIntroductiontoAccountingandManagerialFinance
timethestockpricewillrefecttheenhancedvalue.Butthestockholdersexpecting
toselltheirstockinthenearfuturewouldpreferthattheinvestmentberejected,
whilestockholdersholdingforthelongrunwouldpreferthattheinvestmentbe
undertaken.
Astatementsuchas“proftmaximization”doesnotadequatelydescribethe
appropriateobjectiveofthefrm,sinceproftsareconventionallycomputedand
donoteffectivelyrefectthecostofthestockholders’capitalthatistiedupinthe
investment.Totalsalesorshareofproductmarketarealsoinadequatenormative
descriptionsofcorporategoals,althoughthesegoalsmayalsoleadtomaximization
oftheshareholders’wealthpositionbytheirpositiveeffectonprofts.
Sincethemanagersofacorporationareactingonbehalfofthestockholders,
thereisafduciaryrelationshipbetweenthemanagers(andtheboardofdirec-
tors)andthestockholders.Thestockholders,thesuppliersoftheriskcapital,have
entrustedapartoftheirwealthpositiontothefrm’smanagement.Thus,thesuccess
ofthefrmandtheappropriatenessofmanagement’sdecisionsmustbeevaluated
intermsofhowwellthisfduciaryresponsibilityhasbeenmet.Theaccounting
reportsmeasure(attheirbest)howwellmanagementismeetingthisgoal.
ManagerialFinance
Thestudyofmanagerialfnanceisconcernedwiththefnancialdecisionsofafrm
(asdistinctfromthestudyofthestructureofmarketsforobtainingcapital).We
breakthefrm’sdecisionsdownintothreebasictypes:
1.Investmentdecisionsor,moregenerally,theallocationoffundsamongdifferent
typesofassetsoractivities.
2.Theobtainingofcapitalintheappropriatemixtureofdebtandcommonstock
orothersecurities.
3.Thedividendordistributiondecision(givingoffundsbacktocommonstock
investorsinreturnfortheuseofthecapital).
Weshallfndthatthereareanalyticalmethodsofanalyzingallofthesedeci-
sions.Insomecases,wecanreachfairlydefnitejudgmentsastocorrectand
incorrectdecisions;inothers,wecanonlyidentifytherelevantquantitativeand
qualitativeconsiderations.
Businessorganizationsarecontinuallyfacedwiththeproblemofdeciding
whetherthecommitmentsofresources—timeormoney—areworthwhilein
termsoftheexpectedbenefts.Ifthebeneftsarelikelytoaccruereasonably
soonaftertheexpenditureismade,andifboththeexpenditureandthebene-
ftscanbemeasuredindollars,thesolutiontosuchaproblemisrelativelysimple.
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Finance,AccountingandCorporateObjectives
3
Iftheexpectedbeneftsarelikelytoaccrueoverseveralyears,thesolutionismore
complex.
Weshallusetheterm
investment
torefertocommitmentsofresourcesmade
inthehopeofrealizingbeneftsthatareexpectedtooccuroverareasonablylong
periodoftimeinthefuture.Capitalbudgetingisamany-sidedactivitythatincludes
searchingfornewandmoreproftableinvestmentproposals,investigatingengi-
neeringandmarketingconsiderationstopredicttheconsequencesofacceptingthe
investment,andmakingeconomicanalysestodeterminetheproftpotentialofeach
investmentproposal.
TheFinanceManagers
Financemanagers(fnancialvice-presidents,controllers,treasurers,etc.)are
responsibleforawiderangeofdecisionsmadeinacorporation.Theaccounts
thatappearonabalancesheetcanbeusedtodescribethetasksofafnanceman-
ager.Ontheassetside,thereistheadministrationofcurrentassets(managingcash,
investinginshort-termsecurities,anddeterminingandadministeringacreditpol-
icy)andlong-termassets(i.e.,makingcapitalbudgetingdecisionsthatcommitthe
companytoinvestmentsinlong-livedassets).Shiftingtotheequity(liabilitiesand
stockholders’equity)sideofthebalancesheet,thefnancemanagerisresponsible
forofferingadviceastothebestfnancialstructure(determiningtherelativeuse
ofdebt,preferredstock,orcommonstock)andthecharacteristicsofthefrm’s
securitiesandthenimplementingthedecisionsthataremade.
Decisionsdescribedinthisbookcanberelatedtodecisionsthatinvolveone
ormoreoftheaccountsonabalancesheet.Thisbookwilloffersuggestionson
howtoimprovethelikelihoodofmakingthecorrectdecision,althoughfrequently
itwillbeseenthatabsolutelycorrectchoicescannotbemade.
Tostudyproblemsofamanageablesize,weshallgenerallyassumethata
specifcdecisiondoesnotaffectotherdecisions.Thisnaïveassumptionmaynot
bevalidbecauseoftheinterrelationshipsofdecisions,butitdoesenableusto
gainunderstanding.Afterthisunderstandingisachieved,thecomplexitiescanbe
introduced.Weshalllearntowalkbeforewetrytorun.
Time,Risk,andtheRisk-ReturnTrade-off
Twoprimaryfactorsthatmakefnanceaninterestingandcomplexsubjectarethe
elementsof
time
and
risk
.Becausedecisionstodayoftenaffectcashfowformany
futuretimeperiodsandwearenotcertainastotheoutcomesofouractions,we
havetoformulatedecisionrulesthattakeriskandtimevalueintoconsiderationin
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4
AnIntroductiontoAccountingandManagerialFinance
asystematicfashion.Thesetwoproblemsareasintellectuallychallengingasany
problemthatoneislikelytoencounterintheworldofeconomicactivity.
Frequently,theexistenceofuncertaintymeansthatthedecisionmakerfaces
alternativesthatinvolvetrade-offsoflessreturnandlessriskormorereturnand
morerisk.Alargepartofthestudyoffnancehastodowithlearninghowto
approachthistypeofrisk-returntrade-offchoice.
ThreeBasicGeneralizations
Weofferthreegeneralizationsthatareusefulinthetypesoffnancialdecisions
thataretobediscussed.Thefrstgeneralizationisthatinvestorsprefermorereturn
(cash)toless,allotherthingsbeingequal.Investorswhothinkthatthereturnsare
excessivelyhighcoulddistributetheexcessinsuchamannerthattheresultswould
meettheircriterionoffairness.
Thesecondgeneralizationisthatinvestorspreferlessrisk(apossibilityofloss)
tomoreriskandhavetobepaidtoundertakeriskyendeavors.Thisgeneralizationis
contrarytocommonobservationssuchastheexistenceofracetracksandgambling
casinos(wherethecustomersofsuchestablishmentsarewillingtopayforthe
privilegeofundertakingriskyinvestments),butthegeneralizationisusefulevenif
therearesomeexceptions.
Thethirdgeneralizationisthateveryonepreferscashtobereceivedtoday
ratherthanforthesameamounttobereceivedinthefuture.Thisonlyrequiresthe
reasonableassumptionthatthefundsreceivedtodaycanbeinvestedtoearnsome
positivereturn.Sincethisisthesituationintherealworld,thegeneralizationis
reasonable.
Thesethreegeneralizationsareusedimplicitlyandexplicitlythroughout
thebook.
RelevanceofCashFlows
Giventheobjectiveofstockholderwealthmaximization,howshouldindividual
fnancialdecisionsbeevaluated?Forthepubliclytradedfrm,itisconvenientto
assumethatthemarketvalueofthestockisareasonablemeasureofwealth.The
market’sassessmentofthefrm’sfutureismanifestintoday’sstockprice,but
unfortunatelythisassessmentisnotalwaysaccurate.Fortheprivatelyheldfrm,
wherethereisnomarketvalue,thewealthpositionisevenmorediffculttoassess.
Theoretically,alternativeactionsshouldbeevaluatedbasedontheextentto
whichtheywillimprovethemarketvalueofthestock,andtheactionleadingto
amaximizationofvalueshouldbechosen.Unfortunately,whilethisevaluation
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Finance,AccountingandCorporateObjectives
5
schemeiscorrect,itissometimesnotoperational,forthechainofrelationships
betweenadecisionanditsultimateimpactonthevalueofequityislongand
complicated.Asstatedabove,thedecisiontimehorizonmayaffectthechoiceof
decision.
Thereis,however,anapproachthatcanbeusedtoevaluatealldecisions.
Thedecisionmakershouldfocusonthecashfowsresultingfromthedecision.
Anydecisionthatisexpectedtoaltertheanticipatedcashfowsofthefrmis
likelytoalterthevalueofthefrm’scommonstock.Cashisthecommonelement
inallfnancialdecisions:investmentsrequireit,creditorsarepaidwithit,and
stockholdersexpecttoreceiveitintheformofdividendsorcapitalgains.Thus,
mostfnancialdecisionscanbecharacterizedbytheincrementalcashfowsthat
theiracceptanceisexpectedtocause.
CashFlowsversusEarnings
Adecisionmaybecharacterizedbyitseffectonaccountingearningsaswellasby
itsincrementalcashfows.Theearningsandcashfowswouldleadtoconsistent
decisionsifitwerenotforthefactthatearningsareaffectedbymanyaccount-
ingconventions,suchasexpenseversuscapitalizationdecisionsandthechoice
ofadepreciationmethod.Thus,followingGenerallyAcceptedAccountingPrin-
ciples,aninvestmentmightgeneratesubstantialcashfowsinitslateyearsbut
adverselyaffectproftsduringtheearlyyearsiftheinitialinvestmentdepreciates
rapidly.Assumingthefrmhassuffcientcashinfowswithwhichtomeetitscash
obligations,theinvestmentmaybedesirableregardlessofthelackofshort-run
proftability.Ofcourse,long-runproftabilityisanecessarycondition.Ifallthe
expensescannotbecoveredoveralltheyearsofthelifeofthedecision,thenthe
effectofthedecisiononthestockholders’wealthpositionwillbenegative.Prof-
itabilityisasuffcientconditionforasuccessfuldecisioniftheproftsarecorrectly
measured.Butthecorrectmeasureofproftsisadiffculttask,andnotalways
perfectlyexecutedbytheaccountingprofession.
Sincecashfowsareeasilymeasured,whenproperlydiscountedfortimeand
adjustedforrisktheyareagoodproxyforprofts.Weconsidercashfowstobea
relevantmeasureoftheimpactofadecisiononthefrm,andwillusecashfows
astheprimaryinputinthefnancialdecisionstobeanalyzed.
AMergerofEquals
Intheparlanceoffnance,amergerofequalsoccurswhenamergerisexecutedwith
thestockholdersofboththefrmbeingacquiredandthefrmdoingtheacquiring
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6
AnIntroductiontoAccountingandManagerialFinance
receivingthesamevalueafterthemergerastheydidbeforethemerger.Inthetitle
ofthisbook,thereferencetoamergerofequalsimpliesthatbothaccountingand
knowledgeoffnancecontributetomakinggoodfnancialdecisions.
Therefollowsanexampleofamerger-of-equalsvaluecalculation.
Example:ParentfrmwantstoacquireTargetfrm.
CompanyStockPriceSharesOutstanding
Market
Capitalization
Parent$50500$25,000
Target100404,000
Total$29,000
AssumeParentshareholdersretaintheir500sharesworth$50each.Target
mustreceive
N
shareswithavaluepershareof
P
.Target’ssharesmusthaveatotal
valueof$4,000.
NP
=
4
,
000or
P
=
4
,
000
N
.
Inaddition,thetotalvalueofmergedfrmsmustequal$29,000.
29
,
000
=
P(N
+
500
)
or
29
,
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
Corporationsatsomestageintheirlifearelikelytogotothecapitalmarkettoobtain
funds.Themarketthatsuppliesfnancialresourcesiscalledthecapitalmarketandit
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Finance,AccountingandCorporateObjectives
7
consistsofallsavers(banks,insurancecompanies,pensionfunds,people,etc.).The
capitalmarketgathersresourcesfromthesaversofsociety(peoplewhoconsume
lessthantheyearn)andrationsthesesavingsouttotheorganizationsthathavea
needfornewcapitalandthatcanpaythepricethatthecapitalmarketdefnesfor
capital.
Theavailabilityoffunds(thesupply)andthedemandforfundsdeterminethe
costoffundstotheorganizationsobtainingnewcapitalandthereturntobeearned
bythesuppliersofcapital.Themeasureofthecostofnewcapitalbecomesvery
importanttoabusinessfrmintheprocessofmakingdecisionsinvolvingtheuse
ofcapital.Weshallhaveoccasiontousethemarketcostoffunds(theinterestrate)
frequentlyinouranalyses,andyoushouldbeawareoftherelevanceofcapital
marketconsiderationstothedecisionsofthefrm.
Actually,thereisnotonemarketcostoffunds;rather,thereisaseriesof
differentbutrelatedcostsdependingonthespecifctermsonwhichthecapitalis
obtainedandtheamountofriskassociatedwiththesecurity.Oneoftheimportant
objectivesofthisbookistodevelopanawarenessofthecostofthedifferentforms
ofcapital(commonstock,preferredstock,debt,retainedearnings,etc.)andof
thefactorsthatdeterminethesecosts.Thisisacomplexmatter,sincethecostof
aspecifcformofcapitalforonefrmwilldependonthereturnsinvestorscan
obtainfromotherfrms,onthecharacteristicsoftheassetsofthefrmthatis
attemptingtoraiseadditionalcapital,andonthecapitalstructureofthefrm.We
canexpectthatthelargertherisk,thehigherthereturnthatwillbeneededtoattract
investors.
TacticalandStrategicDecisions
Investmentdecisionsmaybetacticalorstrategic.Atacticalinvestmentdecision
generallyinvolvesarelativelysmallamountoffundsanddoesnotconstitutea
majordeparturefromwhatthefrmhasbeendoinginthepast.Theconsideration
ofanewmachinetoolbyamotormanufacturingcompanyisatacticaldecision,
asisabuy-or-leasedecisionmadebyanoilcompany.
Strategicinvestmentdecisionsinvolvelargesumsofmoneyandmayalsoresult
inamajordeparturefromwhatthecompanyhasbeendoinginthepast.Strategic
decisionsdirectlyaffectthebasiccourseofthecompany.Acceptanceofastrate-
gicinvestmentwillinvolveasignifcantchangeinthecompany’sexpectedprofts
andintheriskstowhichtheseproftswillbesubject.Thesechangesarelikelyto
leadstockholdersandcreditorstorevisetheirevaluationofthecompany.Ifapri-
vatecorporationundertookthedevelopmentofasupersoniccommercialtransport
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AnIntroductiontoAccountingandManagerialFinance
(costingover$20billion),thiswouldbeastrategicdecision.Ifthecompanyfailed
initsattempttodevelopthecommercialplane,theveryexistenceofthecompany
wouldbejeopardized.Frequently,strategicdecisionsarebasedonintuitionrather
thanondetailedquantitativeanalysis.
Theinvestmentstrategyofafrmisastatementoftheformalcriteriaitapplies
insearchingforandevaluatinginvestmentopportunities.Strategicplanningguides
thesearchforprojectsbyidentifyingpromisingproductlinesorgeographicareasin
whichtosearchforgoodinvestmentprojects.Onefrmmayseekopportunitiesfor
rapidgrowthinemerginghigh-technologybusinesses;anothermayseekoppor-
tunitiestobecomethelow-costproducerofcommoditieswithwell-established
technologiesandnounusualmarketproblems;athirdfrmmaylookforopportu-
nitiestoexploititsspecialknowledgeofaparticularfamilyofchemicals.Astrategy
shouldrefectboththespecialskillandabilitiesofthefrm(itscomparativeadvan-
tage)andtheopportunitiesthatareavailableasaresultofdynamicchangesinthe
worldeconomy.
Strategicplanningleadstoachoiceofthe“forest”—tacticalanalysisstudies—
andmakesachoicebetweenindividual“trees.”Thetwoactivitiesshouldcomple-
mentandreinforceeachother.Projectanalysismayprovideafeedbackloopto
verifytheaccuracyofthestrategicplan.Iftherearegoodopportunitieswherethe
strategicplansaystheyshouldbefound,andfewpromisingopportunitiesinlines
ofbusinessthatthestrategyidentifesasunattractive,confdenceinthestrategic
planincreases.Alternatively,ifattractiveprojectsarenotfoundwheretheplanhad
expectedthem,orifdesirableprojectsappearinlinesofbusinessthatthestrategic
planhadidentifedasunattractive,areassessmentofboththeprojectstudiesand
thestrategicplanmaybeinorder.
ScopeofFinancialManagement
Manyfnancialdecisionshaveatimedimension:notallrelevanteventsoccur
immediately.Adjustingforthetimingofcashfowsandchoosingbetweencertain
alternativecashfowpatternsarediscussedinChapter2.
Conclusions
Thestudyofaccountingandfnanceshouldbeanexcitingandstimulatingexpe-
rience,sinceitisanopportunitytoeliminatealargenumberofcommonmisun-
derstandingsandtoaddtoyourownunderstandingoffnancialinstrumentsand
decisions.Youwillbebetterabletomanageyourownpersonalfnancialaffairsas
wellastheaffairsofabusinessentity.
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Finance,AccountingandCorporateObjectives
9
Thebasicbuildingblocksofthisbookarethreegeneralizationsthatare
introducedinthischapter:
1.Investorsprefermoreexpectedreturntoless.
2.Investorspreferlessrisktomorerisk.
3.Investorspreferanamountofcashtobereceivedearlierthanthesameamount
tobereceivedlater.
Allmodernfnanceisbuiltonthesegeneralizations.Someinvestorsacceptor
seekrisk,buttheynormallydosowiththehopeofsomemonetarygain.They
expecttobecompensatedfortherisktheyundertake.
Corporations,ormoreexactly,themanagersrunningthecorporations,have
manydifferentgoals.Wehavesimplifedthecomplexsetofobjectivesthat
existtoonebasicobjective,themaximizationofthevalueofthestockhold-
ers’ownershiprightsinthefrm.Thoughasimplifcation,itenablesusto
makespecifcrecommendationsastohowcorporatefnancialdecisionsshould
bemade.
Weshallfndthatwhilesomefnancialdecisionsmaybesolvedexactly,more
frequentlyweshallonlybeabletodefneandanalyzetheproblem.Wemaynot
alwaysbeabletoidentifytheoptimumdecisionwithcertainty,butweshallgener-
allybeabletodescribesomeerrorsinanalysistoavoid.Inmostcasesincorporate
fnance,usefulinsightsforimproveddecisionmakingcanbeobtainedbyapplying
modernfnancetheoryandusinggoodaccountinginformation.
QuestionsandProblems
1.Canafrmhaveincomewithouthavingapositivecashfow?Explain.
2.Ifafrmcurrentlyearning$1millioncanincreaseitsaccountingincometo
$1.1million(anactionconsistentwithproftmaximization),isthisalwaysa
desirablemove?Explain.
3.Asalesforceisproudofhavingdoubledsalesinthepastfouryears.What
questionsshouldbeaskedbeforepraisingthem?
4.Apresidentofanautomobilemanufacturingfrmhastheopportunitytodouble
thefrm’sproftsinthenextyear.Toaccomplishthisproftincrease,thequality
oftheproduct(currentlytheprestigecaroftheworldmarket)mustbereduced.
Noadditionalinvestmentisrequired.Whatdoyourecommend?
5.Namean“economiccost”thatisomittedfromtheaccountingincomestatements
thatshouldbeofinteresttomanagement.
6.TheABCCompanycanundertakeaninvestmentthatiseconomicallydesirable.
Itwilladverselyaffectcurrentearnings,butinmanagement’sjudgmentwill
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AnIntroductiontoAccountingandManagerialFinance
beneftfutureearnings.Managementfearsthatthestockmarketwillinterpret
thedecreaseinearningsasasignofweaknessandthecommonstockpricewill
immediatelygodownasthelowerearningsarereported.Managementplans
todescribethecharacteristicsoftheinvestmentintheannualreportandin
meetingswithsecurityanalysts.Thecompany’sprimarygoalistomaximize
thewell-beingofitsstockholders.
a.Whatwouldadecreaseinstockpriceasaresultoftheinvestmentimply
aboutthestockmarket?
b.Whatdoesthedecreaseinincomeasaresultoftheinvestmentimplyabout
theaccountingmeasures?
c.Shouldthecompanyundertaketheinvestment?
7.TheABCCompanyhastomakeachoicebetweentwostrategies:
Strategy1
:Isexpectedtoresultinamarketpricenowof$100pershareof
commonstockandapriceof$120fveyearsfromnow.
Strategy2
:Isexpectedtoresultinamarketpricenowof$80andapriceof
$140fveyearsfromnow.
Whatdoyourecommend?Assumethatallotherthingsareunaffectedbythe
decisionbeingconsidered.
8.Ithasbeensaidthatfewstockholderswouldthinkfavorablyofaprojectthat
promiseditsfrstcashfowin100years,nomatterhowlargethisreturn.
Commentonthisposition.
9.Eachofthefollowingissometimeslistedasareasonableobjectiveforafrm:
(a)maximizeproft(accountingincome),(b)maximizesales(orshareofthe
market),(c)maximizethevalueofashareofcommonstock
t
timeperiods
fromnow,(d)ensurecontinuityofexistence,(e)maximizetherateofgrowth,
(f)maximizefuturedividends.Discusseachitemandtheextentofitsrelevance
tothemakingofinvestmentdecisions.
References
Anumberofexcellentintroductoryandintermediatefnancialmanagementtextsare
availabletobeusedinconjunctionwiththisbooktoprovideaparalleldescriptionofmany
ofthedecisionswediscussandtofllthereaderinoninstitutionalmaterial.Amongthem
arethefollowing:
Brealey,R.andS.Myers(2000).
PrinciplesofCorporateFinance
.NewYork:McGraw-Hill
BookCompany.
November6,200913:43spi-b8119inx6inb811-ch01
Finance,AccountingandCorporateObjectives
11
Copeland,T.E.andJ.F.Weston(2004).
FinancialTheoryandCorporatePolicy
,4thEdition.
Reading,MA:Addison-WesleyPublishingCompany.
VanHorne,J.C.(2001).
FinancialManagementandPolicy
,12thEdition.EnglewoodCliffs,
NJ:Prentice-Hall,Inc.
This page intentionally left blankThis page intentionally left blank
November6,200913:43spi-b8119inx6inb811-ch02
Chapter2
TheTimeValueofMoney
TimeDiscounting
Oneofthebasicconceptsofbusinesseconomicsandmanagerialdecisionmaking
isthatthevalueofanamountofmoneytobereceivedinthefuturedependson
thetimeofreceiptordisbursementofthecash.Adollarreceivedtodayismore
valuablethanadollartobereceivedinthefuture.Theonlyrequirementforthis
concepttobevalidisthattherebeapositiverateofinterestatwhichfundscanbe
invested.
Thetimevalueofmoneyaffectsawiderangeofbusinessdecisions,anda
knowledgeofhowtoincorporatetimevalueconsiderationssystematicallyinto
adecisionisessentialtoanunderstandingoffnance.Thischapterisdevoted
todescribingthemathematicalmodelsofcompoundinterest.Theobjectiveisto
developskillsinfndingthepresentequivalentofafutureamountandthefuture
equivalentofapresentamount.
TheInterestRate
Adollaravailabletodayismorevaluablethanadollaravailableoneperiodfrom
nowifdesirableinvestmentopportunitiesexist.Therearetwoprimaryreasonswhy
realinvestmentscangenerateaninterestreturn:
1.Sometypesofcapitalincreaseinvaluethroughtimebecauseofchangesin
physicalcharacteristics,forexample,cattle,wine,andtrees.
2.Therearemanyworkprocesseswhereroundaboutmethodsofproductionare
desirable,leadingtoincreasedproductivity.Ifyouaregoingtocutdownalarge
tree,itmaybeworthinvestingsometimetosharpenyouraxe.Asharpaxemay
resultinlesstimebeingspentcuttingdowntrees(includingsharpeningtime)
thanworkingwithadullaxe.Ifyouaregoingtodigahole,youmightwantto
13
November6,200913:43spi-b8119inx6inb811-ch02
14
AnIntroductiontoAccountingandManagerialFinance
buildorbuyashovel,orevenspendthetimetomanufactureabackhoeifitis
abighole.Theinvestmentincreasesproductivitysuffcientlycomparedtothe
alternativemethodsofproductionwithoutcapitalsothatthenewassetcanearn
areturnfortheinvestor.
Thesecharacteristicsofcapitalleadtoasituationinwhichbusinessentities
canpayinterestfortheuseofmoney.Ifyouinvest$1inanindustrialfrm,the
frmmaybeabletopayyou$1plusinterestifyourinvestmentenabledthefrmto
usesomeroundaboutmethodofproductionortodelaythesaleofanitemwhileit
increasedinvalue.
FutureValue
Assumethatyouhave$1.00nowandcaninvestittoearn
r
interest.Afterone
period,youwillhavethe$1.00plustheinterestearnedonthe$1.Let
FV
bethe
futurevalueand
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,thevalue
attime2is
FV
=
PV(
1
+
r)
n
(2.1)
FV
=
50
(
1
.
10
)
2
=
$60
.
50
.
Witha0.10interestrate,the$50growsto$55attime1.The$55growsto$60.50at
time2.Equation(2.1)isthestandardcompoundinterestformula.Theterm
(
1
+
r)
n
iscalledtheaccumulationfactor.
Thepowerofcompounding(earninginterestoninterest)isdramatic.Itcanbe
illustratedbycomputinghowlongittakestodoublethevalueofaninvestment.
Table2.1showstheseperiodsfordifferentvaluesof
r
.
November6,200913:43spi-b8119inx6inb811-ch02
TheTimeValueofMoney
15
Table2.1.
ThePowerofCompounding.
InterestRate(
r
)TimeUntilInitialValueIsDoubled
0.0235.0years
0.0514.2
0.107.3
0.155.0
0.203.8
Ausefulruleofthumbinfnanceisthe“double-to-72”rule,whereforwide
rangesofinterestrates,
r
,theapproximatedoublingtimeis0
.
72
/r
.Notehow
closelytheruleapproximatesthevaluesinTable2.1.Witha0.10timevalue
factor,aninvestmentwilldoubleinvalueevery7.3years.Theruleofthumbgives
7.2years.
Frequently,tomakebusinessdecisions,insteadofcomputingfuturevalueswe
willwanttoworkwithpresentvalues.
TimeIndifference:PresentValue
Today,closeto100percentoflargecorporationsusesomeformofdiscountedcash
fow(DCF)techniquesintheircapitalbudgeting(investmentdecisionmaking).To
performaDCFanalysis,wemustfndthepresentvalueequivalentsoffuturesums
ofmoney.Forexample,ifthefrmwillreceive$100oneyearfromnowasaresult
ofadecision,wewanttofndthepresentvalueequivalentofthe$100.00.Assuming
thatthemoneyisworth(canbeborrowedorlentat)0.10peryear,the$100.00is
worth$90.91now.Theindifferencecanbeshownbynotingthat$90.91invested
toearn0.10willearn$9.09interestinoneyear;thus,theinvestorstartingwith
$90.91willhave$100.00attheendoftheyear.Iftheinvestorcanbothborrow
andlendfundsat0.10,theinvestorwouldbeindifferenttoreceiving$100.00at
theendoftheyearor$90.91atthebeginningoftheyear.
Ifthe0.10interestrateappliesfortwoperiods,theinvestorwouldbeindifferent
toreceiving$82.64todayor$100twoyearsfromtoday.Ifthe$82.64isinvested
toearn0.10peryear,theinvestorwillhave$90.91afteroneyearand$100atthe
endoftwoyears.
Theunitoftimecanbedifferentfromayear,buttheunitoftimeforwhichthe
interestrateismeasuredmustbethesameastheunitoftimeformeasuringthe
timingofthecashfows.Forexample,the0.10usedintheexampleisdefnedas
theinterestrateperyearandisappliedtoaperiodofoneyear.
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
todenotethetime
valueofmoney,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
when
thetimevalueofmoneyis
r
.Theterm
(
1
+
r)
−
n
iscalledthepresentvaluefactor,
anditsvalueforvariouscombinationsoftimeperiodsandinterestratesisfound
inTableAoftheAppendixtothebook.Anyhandcalculatorwiththecapability
tocompute
y
x
canbeusedtocomputepresentvaluefactorsdirectly.If
y
x
isused,
then
y
=
1
+
r
and
x
=
n
.First,
y
x
isfound,andthenthereciprocalistakento
determinethepresentvaluefactor.Forexample,tofndthepresentvaluefactorfor
r
=
0
.
10,
n
=
5usingatypicalcalculator,wewouldplace1.10inthecalculator,
pressthe
y
x
button,insert5,pressthe“equals”button,andthenthereciprocalto
fnd0.62092.
Example2.1
Whatisthepresentvalueof$1.00tobereceivedthreetimeperiodsfromnowif
thetimevalueofmoneyis0.10perperiod?
InTableAattheendofthebook,the0.10columnandthelineopposite
n
equal
to3gives0.7513.Ifyouinvest$0.7513toearn0.10peryear,afterthreeyearsyou
willhave$1.00.Thus,
(
1
.
10
)
−
3
=
0
.
7513.
Whatisthepresentvalueof$100.00tobereceivedthreetimeperiodsfrom
nowifthetimevalueofmoneyis0.10?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,thefollowinginterestgrowthtakesplacewitha
0.10interestrate.
InvestmentatBeginningInvestmentat
TimeofPeriodInterestEndofPeriod
0$75.13$7.513$82.643
182.6438.26490.907
290.9079.091100.000
Ifinvestorscanearn0.10perperiodandcanborrowat0.10,thentheyare
indifferentto$75.13receivedattime0or$100attime3.
Thepresentvalueofaseriesofcashfowsisthesumofthepresentvaluesof
eachofthecomponents.
Example2.2
Whatisthepresentvalueoftwocashfows,$100.00and$200.00,tobereceivedat
theendofoneandtwoperiodsfromnow,respectively,ifthetimevalueofmoney
is0.10?
CashFlowPresentValueFactorsPresent
Period
tX
t
PVF
(
t
,
0.10)Value
PV
1$1000.9091$90.91
22000.8264165.28
Totalpresentvalueusing0.10
=
$256.19
PresentValueofanAnnuity
Frequently,theevaluationofalternativeswillinvolveaseriesofequalpayments
spacedequallythroughtime.Suchaseriesiscalledanannuity.Thepresentvalue
ofanannuityof$1perperiodfor
n
periodswiththefrstpaymentoneperiodfrom
nowisthesumofthepresentvaluesofeachdollartobereceived:
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
periodsandan
interestrateof
r
(frstcashfowoneperiodfromnow).Itcanbeshown(see
November6,200913:43spi-b8119inx6inb811-ch02
18
AnIntroductiontoAccountingandManagerialFinance
Appendix2.1)attheendofthischapterthat
B
(n,r)
=
1
−
(
1
+
r)
−
n
r
.
(2.6)
Equation(2.6)isforanannuityinarrears.AppendixTableBattheendofthe
bookgivesthepresentvaluesofannuitiesof$1perperiodfordifferentvaluesof
r
and
n
.Thepresentvalueofanannuitycanalsobecomputeddirectlyusingmany
handcalculators,orapersonalcomputer.
If
C
dollarsarereceivedeachperiodinsteadof$1,wecanmultiplyequa-
tion(2.6)by
C
toobtainthepresentvalueof
C
dollarsperperiod.Thatis,foran
annuityfor
C
dollarsperperiod,thepresentvalueis
PV
=
C
×
B
(n,r).
(2.7)
Example2.3
TheABCCompanyistoreceive$1aperiodforthreeperiods,thefrstpayment
tobereceivedoneperiodfromnow.Thetimevaluefactoris0.10.Computethe
presentvalueoftheannuity.
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(alsocalledan
ordinaryannuity).Whenthepaymentoccursatthebeginningofeachperiod,we
haveanannuitydue(alsocalledanannuityinadvance).Equation(2.6)givesthe
presentvalueofanannuityinarrears:
B
(n,r)
=
1
−
(
1
+
r)
−
n
r
.
(2.6)
Ifwehave
(n
+
1
)
paymentsof$1eachperiodwiththefrstpaymenttaking
placeimmediately,wewouldmerelyadd$1tothevalueofequation(2.6).Thus,
ifB(3,0.10)equals$2.4868,afour-paymentannuitywiththefrstpaymentat
time0wouldhaveapresentvalueof$3.4868.An
n
periodannuitydueisnothing
morethanan
(n
−
1
)
periodannuityinarrearsplustheinitialpayment.
PresentValueofaPerpetuity
Aperpetuityisanannuitythatgoesonforever(aninfnitesequence).Ifwelet
n
ofequation(2.6)gotoinfnity,sothattheannuitybecomesaperpetuity,then
the
(
1
+
r)
−
n
termgoestozero,andthepresentvalueoftheperpetuityusing
equation(2.6)becomes
B
(
∞
,r)
=
1
r
.
(2.8)
Thus,if
r
=
0
.
10andtheseriesofcashreceiptsof$1.00perperiodisinfnitely
long,investorswouldpay$10.00fortheinfniteseries.Theywouldnotpay$11.00,
sincetheycouldinvestthat$11.00elsewhereandearn$1.10perperiodatthegoing
rateofinterest,whichisbetterthan$1.00perperiod.Investorswouldliketoobtain
theinvestmentfor$9.00,butnorationalissuerofthesecuritywouldcommitto
pay$1.00perperiodinreturnfor$9.00when$10.00couldbeobtainedfromother
lendersforthesamecommitment.
Althoughperpetuitiesareseldomapartofreal-lifeproblems,theyareuseful,
sincetheyallowustodeterminethevalueofextremecases.Forexample,if
r
=
0
.
10,wemaynotknowthepresentvalueof$1perperiodfor50timeperiods,but
wedoknowthatitisonlyasmallamountlessthan$10sincethepresentvalue
ofaperpetuityof$1perperiodis$10and50yearsiscloseenoughtobeinga
perpetuityforustouse$10asanapproximatepresentvalue:
B
(
∞
,r)
=
1
r
=
1
0
.
10
=
$10
.
November6,200913:43spi-b8119inx6inb811-ch02
20
AnIntroductiontoAccountingandManagerialFinance
AFlexibleTool
Wenowhavethetoolstosolveawiderangeoftimevalueproblemsthathavenot
beendescribed.Whilewecouldintroduceotherformulas,weprefertoadaptthe
threebasicformulasthathavebeenintroduced.
Forexample,ifa$60-per-yearannuityfor20yearsweretohaveitsfrstpayment
attime10andiftheinterestrateis0.10,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
)
6060
0
Notethatifthefrstannuitypaymentisattime10,weonlyhavetodiscountthe
annuityfornineyearstofndthepresentvaluesinceB(10,
r
)givestheannuity
presentvalueasoftime9andthefrstpaymentattime10.
Wewanttodeterminehowmuchwewouldhaveattime29ifwesaved$60
peryearfor20years,withthefrstamountsavedstartingattime10.Abovewe
obtained$216.64forthepresentvalueof$60peryear.Thefuturevalue(time29)
of$216.64is
Futurevalue
=
$216
.
64
(
1
.
10
)
29
=
$216
.
64
(
15
.
8631
)
=
$3
,
437
.
Nowassumethe$60annuitystartingattime10isaperpetuity.Thepresent
valueattime9is$60
/
0
.
10
=
$600.Thepresentvalueofthe$600attime0is
PV
=
$600
(
1
.
10
)
−
9
=
$600
(
0
.
4241
)
=
$254
.
46
.
Anotherapproachtosolvingforthepresentvalueoftheannuityistocompute
thepresentvalueofaperpetuityandsubtractthepresentvalueofanine-period
annuity:
PV
=
$600
−
$60B
(
9
,
0
.
10
)
=
$600
−
$60
(
5
.
7590
)
=
$254
.
46
.
Thebasictime-discountingtoolsareveryfexible.
November6,200913:43spi-b8119inx6inb811-ch02
TheTimeValueofMoney
21
AnnualEquivalentAmounts
Inmanysituationswewanttodeterminetheannualequivalentofagivensum.For
example,whatistheannualequivalentover20yearsof$100,000receivedtoday
ifthetimevalueofmoneyis10percent?
Solveequation(2.7)fortheannualcashfow:
C
=
PV
B
(n,r)
.
(2.9)
Thatis,tofndtheannualequivalent,
C
,ofapresentsum,
PV
,thatsumis
dividedbytheannuityfactor,B
(n,r)
,where
r
isthetimevalueofmoneyand
n
is
thenumberofyearsoverwhichtheannualequivalentistobedetermined.
Calculationsofthistypeareparticularlyusefulinthemanagementoffnancial
institutionssuchasinsurancecompaniesorbanks,wherecustomersmakeperiodic
paymentsoveranextendedtimeperiodinreturnforalump-sumimmediateloan.
Example2.4
TheABCCompanywishestoborrow$10,000fromtheCityBank,repayablein
threeannualinstallments(thefrstonedueoneyearfromnow).Ifthebankcharges
0.10interest,whatwillbetheannualpayments?
Fromequation(2.9),
C
=
$10
,
000
B
(
3
,
0
.
10
)
=
$10
,
000
2
.
4869
=
$4
,
021
andtheloanamortizationscheduleis
(2)(3)
(1)BeginningInterest(4)
(
5
)
=
(
2
)
+
(
3
)
−
(
4
)
TimeBalance0.10of(2)PaymentEndingBalance
0$10,000$1,000$4,021$6,979
16,9796984,0213,656
23,6563664,0210
Theloanamortizationschedulestartswiththeinitialamountowed.Column3
showstheinterestontheamountowedatthebeginningoftheperiod(column2).
Column4isthepaymenttopaythedebtandcolumn5showstheendingdebt
November6,200913:43spi-b8119inx6inb811-ch02
22
AnIntroductiontoAccountingandManagerialFinance
balance.Theendingdebtbalanceisequaltothebeginningdebtbalanceplusthe
period’sinterestlessthedebtpayment.
Theprocessisrepeatedforthelifeofthedebt.Ifthepresentvalueofthedebt
paymentsisequaltotheinitialbeginningbalance(asitwillbeusingtheeffective
costofdebttocomputethepresentvalue),theendingbalanceafterthelastdebt
paymentwillbeequaltozero.
Conclusions
Mostinvestmentanalysesperformedbyacompanyaremadeonthebasisofannual
cashfows.Finerdivisionsoftimeareusuallyunwarrantedinlightoftheapprox-
imatenatureofthecashfowestimates.Somefrmsusepresentvaluetablesthat
assumethecashfowsaredistributedevenlyovertheyearoroccuratthemidpoint
oftheyearinquestionratherthanattheendoftheyear,asdothepresentvalue
tablesattheendofthisbook.Suchrefnementsaddlittletothesubstanceofdis-
countedcashfowanalysisandarenotlikelytoaltermateriallyanyinvestment
decisionobtainedfromusingthe“end-of-year”assumption.
Mostfnancialdecisionmakingcanbereducedtoevaluatingincrementalor
alternativecashfows.Therearethreestepsintheanalysis.First,therelevant
incrementalcashfowsmustbeestimated.Second,theremustbesomemeansof
dealingwithuncertaintyifthecashfowsareuncertain.Third,theremustbesome
waytotakeintoconsiderationthetimevalueofmoney.Thematerialinthischapter
isessentialfordealingwiththetimevalueofmoneytodeterminethepresentand
futurevaluesofsumsofmoneytobereceivedorpaidatvarioustimes.
ReviewProblems
ReviewProblem2.1
Exactly15yearsfromnow,Joneswillstartreceivingapensionof$20,000ayear.
Thepaymentswillcontinueforever.Howmuchisthepensionworthnow,assuming
thattheappropriatediscountrateis0.10peryear?
SolutiontoReviewProblem2.1
1
20,000
0.10
×
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$1,000willbepaidmonthlyattheendofeach
month.Themonthlyinterestrateis0.01.Whatisthepresentvalueofthe
payments?
(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
,
368
or$11
,
255
(
1
.
01
)
=
$11
,
368.
QuestionsandProblems
1.Assumea0.05-per-yeartimevalueofmoney.Computethevalueof$100
(a)received1yearfromnow;(b)receivedimmediately;(c)receivedattheend
of5years;(d)receivedatthebeginningofthesixthyear;(e)receivedattheend
of50years;(f)receivedattheendof50years,butwithaninterestrateof0.10.
2.Assumethattheinterestrateis0.10.Computethepresentvalueof$1peryear
forfouryears(frstpaymentoneyearfromnow)usingthreedifferentmethods
(AppendixTableA,AppendixTableB,andanequation).
3.Assumea0.05timevalueofmoney.Computethevalueofthefollowingseries
ofpaymentsof$100ayearreceivedfor(a)fveyears,thefrstpaymentreceived
oneyearfromnow;(b)fouryears,thefrstoffvepaymentsreceivedimme-
diately;(c)tenyears,thefrstpaymentreceivedoneyearfromnow;(d)nine
years,thefrstoftenpaymentsreceivedimmediately.
4.Assumea0.05timevalueofmoney.Thesumof$100receivedimmediately
isequivalenttowhatquantityreceivedin10equalannualpayments,thefrst
tobereceivedoneyearfromnow?Whatwouldbetheannualamountifthe
frstof10paymentswerereceivedimmediately?
5.Assumea0.05timevalueofmoney.Wehaveadebttopayandaregivena
choiceofpaying$1,000noworsomeamount
X
fveyearsfromnow.Whatis
themaximumamountthat
X
canbeforustobewillingtodeferpaymentfor
fveyears?
November6,200913:43spi-b8119inx6inb811-ch02
24
AnIntroductiontoAccountingandManagerialFinance
6.Wecanmakeanimmediatepaymentnowof$10,000orpayequalamountsof
R
forthenextfveyears(frstpaymentdueoneyearfromnow).Withatime
valueofmoneyof0.05,whatisthemaximumvalueof
R
thatwewouldbe
willingtoaccept?
7.Iftheinterestratepermonthis0.05,compoundedquarterly,whatistheannual
equivalentrate?
8.Ifafrmborrowed$100,000foroneyearandpaidback$9,455.96permonth,
whatisthecostofthedebt?
9.Afrmcansave$10,000peryearfor15years.Ifthetimevalueofmoneyis
0.10,howmuchbetteroffwillthefrmbeafterthe15yearsifitaccomplishes
thesaving?
10.Ifthetimevalueofmoneyis0.10,howmuchdoyouhavetosaveperyear
for20yearstohave$50,000peryearforperpetuity?Assumethatthefrst
depositisimmediateandthatthefrstpaymentwillbeatthebeginningofthe
twenty-frstyear.
11.If$100earns0.08peryear,howmuchwilltheinvestorhaveattheendof10
years?Whatisthepresentvalueof$100duein10yearsifmoneyisworth0.08?
12.Whatisthepresentvalueof$20peryearforperpetuityifmoneyisworth0.10?
13.RefertoProblem12.Ifthefrstpaymentistobereceivedin11years,whatis
theseriesofpaymentsworthtoday?
14.Youaretheloanoffcerofabank.TheABCCompanywantstoborrow
$100,000andrepayitwithfourequalannualpayments(frstpaymentdue
oneyearfromnow).YoudecidethattheABCCompanyshouldpay0.10per
yearontheloan.
a.Whatistheannualpayment?
b.Completethefollowingdebtamortizationtable:
AmountOwedAmountOwed
Period(beginningofyear)InterestPrincipal(endofyear)
1$100,000
2
3
4
November6,200913:43spi-b8119inx6inb811-ch02
TheTimeValueofMoney
25
c.Whatwouldbetheannualpaymentifthefrstoffourequalpaymentsis
dueimmediately?
15.a.Iftheinterestratepermonthis0.02,compoundedmonthly,whatisthe
annualeffectiveequivalentrate?
b.Howmuchdoyouhavetosaveperyearfor20yearsinordertohave
$50,000peryearforperpetuity?
r
=
0
.
10.Thefrst$50,000paymentwill
bereceivedattime21.
c.If$100willgrowinto$120inoneyear,whatisthecontinuousrateof
growth?
16.Assumea0.10interestrate.Howmuchisaperpetuityof$1,000peryearworth?
17.Assumea0.10interestrate(youcanborrowandlendatthatrate).Specify
whichyouwouldprefer:
a.$10,000incashor$1,000peryearforperpetuity(frstpaymentreceived
attheendofthefrstperiod).
b.$10,000incashor$1,100peryearforperpetuity(frstpaymentreceived
attheendofthefrstperiod).
c.$10,000incashor$900peryearforperpetuity(frstpaymentreceivedat
thebeginningofthefrstperiod).
18.a.Whatwouldbetheannualpaymentsonan8%perannuminstallmentloan
of$1,000fromacreditunionwithrepaymentoverthreeyears?
b.Writeouttheamortizationschedulefortheloan.
c.Nowsupposethatthepaymentsaretobemadeonasemiannualbasis;what
wouldthesemiannualpaymentsbe?Assumethe0.08isanominalrate.
d.Isthetotalpaidincase(c)lessormorethanintheformercase?Why?
19.a.Howmuchdoyouhavetosaveperyear(attheendofeachyear)for40
yearsinordertohave$10,000peryearforperpetuity,frstreceiptstarting
inyear41?Use0.10asthetimevaluefactor.
b.Iftheinterestratebeingearnedis0.04perquarter,compoundedquarterly,
whatistheannualequivalentrate?
20.a.Wecanmakeanimmediatepaymentnowof$10,000orpayequalamounts
of
R
forthenextfouryears(frstpaymentdueoneyearfromnow).Witha
timevalueofmoneyof0.10,whatisthemaximumvalueofpaymentthat
wewouldbewillingtomake?
b.Nowassumethatthefrstofthe
fve
paymentsis
immediate
.Whatisthe
maximumvalueofpaymentwewouldbewillingtomake?
21.TheXYZCompanyhasborrowed$100,000.Paymentswillbemadeovera
four-yearperiod(frstpaymentattheendofthefrstyear).Thebankcharges
interestof0.20peryear.
November6,200913:43spi-b8119inx6inb811-ch02
26
AnIntroductiontoAccountingandManagerialFinance
a.Theannualpaymentwillbe
.
b.Thedebtamortizationscheduleis:
AmountOwed
(BeginningofPeriod)InterestPrincipal
1.$100,000
2.
3.
4.
c.Iftherearefvepaymentswiththefrstpaymentmadeatthemomentof
borrowing,theannualpaymentwillbe
.
22.TheXYZCompanyhasborrowed$40,000.Equalpaymentswillbemadeover
athree-yearperiod(frstpaymentattheendofthefrstyear).Thebankcharges
interestof0.15peryear.
a.Theannualpaymentwillbe
.
b.Thedebtamortizationscheduleis:
AmountOwed
(BeginningofPeriod)InterestPrincipal
1.$40,000
2.
3.
4.
c.Iftherearefourpaymentswiththefrstpaymentmadeatthemomentof
borrowing,theannualpaymentwillbe
.
Appendix2.1:TheDerivationofanAnnuityFormula
Let
r
=
thetimevalueofmoneyperperiod
n
=
thenumberoftimeperiods
B
(n,r)
=
thepresentvalueofanannuityfor
n
periods
,r
interestrate
,
withthefrstpaymentoneyearfromtimezero.
Inthefollowingtable,eachentryincolumn(1)givesthepresentvalueof$1
receivedattheendoftheperiodindicatedinthecolumnheaded“Time”.Thesum
oftheitemsinthiscolumnisB
(n,r)
.Eachentryincolumn(2)ofthistablegives
theiteminthatrowofcolumn1multipliedby
(
1
+
r)
.Thesumoftheitemsin
thiscolumnis
(
1
+
r)
B
(n,r)
.Notethat
(
1
+
r)
0
=
1andthatallexcepttwoofthe
November6,200913:43spi-b8119inx6inb811-ch02
TheTimeValueofMoney
27
amountsareinbothcolumns.Takingthedifferencebetweenthesumofthetwo
columnsandsolvingforB
(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)
,thepresentvalueof
anannuityof$1perperiod.Iftheannuityisfor$
R
,wemultiplythevalueobtained
fromthetableby
R
.
If
n
isverylarge(let
n
approachinfnity),wehavethepresentvaluefora
perpetuityof$1perperiod:
B
(
∞
,r)
=
1
r
.
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November6,200913:43spi-b8119inx6inb811-ch03
Chapter3
AnIntroductiontoFinancialReporting
Accountingisaformalsystemofrecordkeepingandreportingthatshouldbe
designedtobeusefulinmakingeconomicdecisionsforabusinessorganization.
Anindividualcouldoperateasmallbusinesswithaminimumofrecordkeeping.
Theinformationrequiredtooperatethebusinesscanbeobservedandrecalledas
needed.Formalrecordswouldimprovethequalityoftheinformationavailableto
theowner,buttheownermaybeabletomakereasonablygooddecisionsonthe
basisoflesspreciseinformation.
Withincreasesinthesizeandcomplexityofabusinessorganization,theneed
fororganizedquantitativeinformationalsoincreases.Themanagerofalargebusi-
nessorganizationwithfar-fungplants,adiversifedproductline,andthousandsof
employeescannotdependonfrsthandobservationinmanagingtheorganization’s
affairs.Adequaterecordsmustbekept.Theserecordshelpmanagersatvarious
levelsandlocationstomakeandevaluatedecisionsthatmeettheorganization’s
policyobjectives.
Inmostlargebusinessorganizations,ownershipandmanagementfunctions
areseparated.Thisseparationmakesitnecessaryforthemanagerstocommuni-
catetheeconomicprogressoftheorganizationtoitsowners.Forexample,although
theshareholdersaretheownersofacorporation,theydonotknowhowwellthe
corporationisperformingunlessmanagementprovidesinformationtothem.The
responsibilityofreportingtheresultsofmanagement’sadministrationoftheorga-
nization’sresourcestotheownersisreferredtoasthe
stewardshipfunctionof
accounting
.
Asecondimportantfunctionofaccountingistopresentusefulinformationfor
makingmanagerialdecisions.Accountingreportsshouldrefecttheeffectiveness
andeffciencywithwhichtheresourceshavebeenusedbythefrm.Theyshould
alsorefecthowwellthecomplexobjectivesofanorganizationaremet.Onegoal
ofabusinessorganizationistousetheresourcesproftablyintheinterestsofits
29
November6,200913:43spi-b8119inx6inb811-ch03
30
AnIntroductiontoAccountingandManagerialFinance
owners.Accountinginformationiswidelyusedbyinvestorstodeterminethemerits
ofinvestmentopportunities.
Insummary,accountingisconcernedwithpresentinginformationuseful
formakingmanagerialandinvestmentdecisions.Accountinginformationcan
helpmanagersmakedecisionsabouttheday-to-dayoperationsofthecompany.
Accountinginformationcanalsohelpkeepinvestorsinformedaboutabusiness
organization’sfnancialprogress.
FinancialStatements
Onefocusofaccountingison
fnancialinformation
thatismeasuredindollarsor
othercurrencyunits.Accountingcannotprovidealltheinformationthatisrequired
orusefulforeverydecision.However,itcanprovideaprofleoftwobasicfnancial
aspectsordimensionsofabusinessorganization:
Financialposition
:thecurrentfnancialstrengthoftheorganizationataparticular
pointintimeasindicatedbytheresourcesitownsandtheobligationsitowes;
Operatingresults
:theresultsofanorganization’soperations—whetheritearned
orlostresourcesfromoperations—overaspecifcperiodoftime.
Theseresultsarepresentedinformaldocumentscalled
fnancialstatements
.
Thefnancialstatementthatprovidesinformationaboutabusinessorganization’s
fnancialpositioniscalleda
balancesheet
.Theprimaryfnancialstatementthat
providesinformationaboutabusinessorganization’soperatingresultsiscalledan
incomestatement
.
UsesofFinancialStatements
Knowingaboutthefnancialpositionofabusinessorganizationandtheresults
ofitsoperationscanbeimportanttoawiderangeofinterestedparties.
Man-
agers
arelikelytomakeday-to-dayoperatingdecisionsaffectingtheorganization.
Theymustknowtheimpactoftheirdecisionsontheorganization’sfnancialwell-
being.
Taxingauthorities
needtoknowwhetherincome-basedtaxesareproperly
calculated.
Inlargecorporations,the
shareholders
,whoaretheownersofthecorpora-
tion,aredependentonpublishedfnancialstatementstoprovidetheinformation
theyrequirefordecisions.Shareholdersmayelectaboardofdirectors,which
isresponsibleforguidingthemanagementofacorporation.However,theprin-
cipaldecisionsmadebyshareholdersarewhethertoholdtheirstock,sellit,or
November6,200913:43spi-b8119inx6inb811-ch03
AnIntroductiontoFinancialReporting
31
purchaseadditionalshares.Itisimportantforfnancialstatementstoprovidethe
informationalrequirementsofshareholdersandotherpurchasersofsecurities.
Creditors
areotherindividualsororganizationstowhomabusinessorga-
nizationowesmoney.Creditorsarealsointerestedinthefnancialpositionand
operatingresultsofabusinessorganization.Directlenders,suchasbanks,can
insistonreceivingwhateverfnancialinformationtheyrequiretosupporttheir
decisions.However,largecorporationsdomuchoftheirborrowingthroughthe
issuanceoffnancialsecuritiessoldtothepublic.Purchasersofthesesecuritiesare
dependentonfnancialstatementstoprovidetheinformationtheyrequirefortheir
decisions.
AccountingProfessions
A
privateaccountant
maybeemployedbytheorganizationtopreparetherecords
andreports.A
publicaccountant
isanindependentprofessionalengagedbyan
organizationtoverifytheaccuracyandacceptabilityoftheorganization’sreports.
Independentprofessionalaccountantswhohavebeencertifedtopracticebytheir
statesareknownas
CertifedPublicAccountants(CPAs)
.
Theusesofaccountinginformationgobeyondbusinessenterprises.Accoun-
tantsareusefulinprovidingfnancialinformationaboutgovernments,hospitals,
schools,churches,etc.Virtuallyanykindoforganizationthatengagesineconomic
activitymaintainsaccountingrecordsandprovidesaccountingreports.
TheDisciplineofAccounting
Accounting
isatermusedtodescribeawiderangeoftechniquesandfeldsof
study.Wewillbroadlydefneitas
theidentifying,measuring,recording,andcom-
municatingoffnancialinformationassociatedwitheconomicevents
.Thetasks
ofaccountantscoverdiverseareas,suchasmeasuringeconomicchangesandcon-
ditions,recordingfnancialtransactions,reportingtheresultsoffnancialtransac-
tions,preparingreportsforgovernmentagencies(includingtheincometaxreturn),
andestablishingsystemsforrecordkeepingandreporting.Manyofthethingsthat
accountantsdoaredictatedbytherulesofgovernment.Anexampleispreparing
incometaxreturns.However,accountantsprimarilypresentinformationforuseby
decisionmakers.
TheAccountingProcess
Accountantsobserveorareinformedofsome
economicevent
.Anexamplewould
bethepurchaseofequipment.Accountantsthendetermineiftheeventqualifesfor
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32
AnIntroductiontoAccountingandManagerialFinance
accountingtreatment
.Ifitdoesqualify,theymustmeasuretheeconomicchanges
thattookplace.Then,an
accountingentry
thatupdatesthesetofrecordstorefect
thiseventiscomposed.Oncethenewinformationisreported,itmaybethebasis
foradecisionthatsetsoffanewsetofeconomicchanges.
Accountantsmustknowwhatinformationdecisionmakersneed.Also,they
mustbeabletomeasuretheeventsandtheireffectsontheeconomicpositionofthe
organization.Theserequirementsimplythataccountantsmustbeknowledgeable
infnanceandmanagerialeconomics.Inaddition,theaccountingreportsbecome
thebasisfordecisionsandjudgmentsofindividualsandgroups.
FinancialandManagerialAccounting
Theterms
fnancialaccounting
and
managerialaccounting
refectdifferentusesof
accountinginformation.
Financialaccounting
pertainstothefnancialstatements
preparedforandusedbyindividualsinternalorexternaltothebusinessorgani-
zation.Theseindividualsmaynotbeactivelyengagedinorresponsibleforthe
day-to-dayoperationsoftheorganization,buttheydohaveaninterestinknow-
ingaboutitseconomicprogress.
Managerialaccounting
pertainstothefnancial
statementsthatareusedbymanagementformakingeconomicdecisionswithin
thebusinessorganization.
Basically,thisbookisconcernedwithfnancialaccountingandfnancialdeci-
sionmaking.
IncomeTaxesandFinancialAccounting
Thetaxationofincomebythefederalgovernmentandvariousstategovernments
hashadanimpactontherecord-keepingprocess.Taxesarebasedonafgure
thatisdefnedtobetaxableincome.Therulesandregulationspertainingtotax-
ableincomearenotnecessarilydesignedtorefecttheeconomicprogressofa
businessorganization,buttorefectthepublicpolicyobjectivesofCongressand
othergovernmentalbodies.Asaresult,therearemanyinstancesinwhichthe
incometaxtreatmentofaneventortransactiondiffersfromitsfnancialaccounting
treatment.
Managementstrategymusttakeintoaccountthetaxconsequencesofanydeci-
sion.Someaccountantsbelievethatfnancialaccountingproceduresshouldbe
forcedtocoincidewiththeincometaxrequirements.Butthereisnoreasonto
believethatthetreatmentprescribedbyincometaxrequirementswouldbethe
sameasthetreatmentsuggestedbyadesiretomeasureandrecordeconomic
eventsinareasonablemanner.
November6,200913:43spi-b8119inx6inb811-ch03
AnIntroductiontoFinancialReporting
33
BusinessOrganizations
Amongbusinessorganizations,therearethreebasicformsoforganization:the
individualproprietorship
,the
partnership
,andthe
corporation
.Mostsmallretail
establishments,farms,andprofessionalpractices(suchaslaw,medicine,and
accounting)areorganizedasindividualproprietorshipsorpartnerships.Thedis-
tinctionbetweenapartnershipandanindividualproprietorshipisbasedonthe
numberofindividualsinvolvedintheownershipoftheorganization.An
individ-
ualproprietorship
hasonlyoneowner,whereasa
partnership
hasmorethanone
owner.
Intermsofeconomicimportance,the
corporation
istheprimaryformofbusi-
nessorganization.Theadvantagesofthecorporateformincludelimitedliability
forthestockholders,continuityofexistence,andrelativeeaseofraisinglarge
sumsofmoneyandtransferringownershiprights.Asaresult,practicallyalllarge
businessesareorganizedascorporations.Thisbookwillfocusontheaccounting
problemsofcorporations,butvirtuallyalloftheaccountingprinciplesapplicable
tocorporationsalsoapplytoothertypesofbusinessorganizations.Thespecialized
detailsofaccountingforproprietorshipsandpartnershipsareoutsidethescopeof
thisbook.
Assets,Liabilities,andStockEquities
Thefnancialpositionofacorporationcanbedescribedatanypointintimein
termsoftheamountofresourcesitownsandtheclaimsorinterestsofvarious
partiesinthoseresources.Theresourcesownedbyacompanyarecalled
assets
,
andtheinterestsofvariousclaimantsintheassetsarecalled
liabilitiesandstock
equities
.
TheAccountingEquation
Thetotalofresources(assets)ownedbyacorporationmustalwaysbeequalto
thesourcesofthoseresources.Wecanalsostatethatthetotalsourcesofassets
(equities)mustbeequaltothetotalassets.Therelationshipofassetsandsources
maybeexpressedintheformofanequation:
Assets
=
Liabilities
+
Stockholders’Equity
.
(3.1)
Thebalancesheetofacorporationshowsmeasuresoftheassetsofthecorpo-
ration,thedebtsowed,andtheinterestsoftheowners.Theinterestsofowners,
November6,200913:43spi-b8119inx6inb811-ch03
34
AnIntroductiontoAccountingandManagerialFinance
termed
stockholders’equity
,togetherwiththedebtsowed(
liabilities
)constitute
thetotalassetsourcesofthecorporation.
Theinterestsoftheowners(stockholders’equity)mayalsobedescribedas
beingequaltothedifferencebetweenthetotalassetsandthetotalliabilities.
Thismannerofviewingthebasiccomponentsofthebalancesheetresultsinthe
equation:
Assets
−
Liabilities
=
Stockholders’Equity
.
(3.2)
Theserelationshipsare,infact,identities—thatis,theequalitiesholdforall
valuesofassetsandequitiesforallcorporationsatalltimes.Wehave,therefore,
onebasicaccountingidentity(oraccountingequation)andtwovariationsofit:
Assets
=
Liabilities
+
Stockholders’Equity(3.1)
Assets
−
Liabilities
=
Stockholders’Equity.(3.2)
Eachchangeintotalassetsmustbeaccompaniedbyanequalchangeinthe
sources.Forexample,ifthestockholdersofacorporationinvest$8,000,thetotal
assetsofthecorporationareincreasedby$8,000,asaretheclaimsofthestock-
holders.Ifacorporationborrows$3,000fromafnancialinstitution,thetotalassets
wouldbeincreasedby$3,000.Thesourceoftheassetisthefnancialinstitution
fromwhomtheamountwasborrowed.Wecouldalsosaythattherightsofthis
fnancialinstitutionrepresenta$3,000liability.Assetsareincreasedby$3,000,and
liabilitiesareincreasedbythesameamount.Thisequalityofassetsandsources
canneverbeupset,exceptbymakinganerror.
FormoftheBalanceSheet
Thebalancesheetreportsthedollaramountsofassetsandequitiesofthecorpo-
rationasrecordedintheaccountingrecords.Thereareseveralvariationsinthe
formofthebalancesheet,butitismostoftenpresentedasabalancedarray,with
assetsontheleftsideandsourcesontheright.Thisisaconventionthathasbeen
adoptedbyaccountantstofacilitateunderstanding.Insomecountries,theorderof
presentationisreversedwithnolossofinformation.
Example
Acorporationhascashof$5,000,ownsmerchandisethatcost$6,000,andowes
$3,000.Thestockholdersoriginallyinvested$8,000inthecorporation.Thebalance
November6,200913:43spi-b8119inx6inb811-ch03
AnIntroductiontoFinancialReporting
35
sheetinitssimplestformwouldappearasfollows:
CompanyX
BalanceSheetasofDecember31,20XX
AssetsLiabilitiesandStockholders’Equity
Cash$5,000Liabilities$3,000
Merchandise6,000
Stockholders’Equity8,000
TotalAssets$11,000
TotalEquities$11,000
Thebalancesheethasaheadingcontainingthreeitems:thenameofthecom-
pany,thenameofthereport,andthedateforwhichthisstatementisapplicable.
Notethatthisstatementis“asofDecember31,20XX.”Thestatementisfora
particularmomentintime,namelythecloseofbusinessonthedateindicated.A
balancesheetmaybepreparedasofanydate,sospecifyingthedateisimportant.
Noticethatthebodyofthestatementhastwomainsections,theAssetsandthe
LiabilitiesandStockholdersEquity.Becausethetotalassetsmustequalthetotal
sources,thestockholders’equityvalueof$8,000couldhavebeencomputedby
subtractingthetotalliabilitiesfromthetotalassets:$11
,
000
−
$3
,
000
=
$8
,
000.
However,inactualaccountingpractice,thestockholders’equityisnotcomputed
inthismannerbutratherisobtaineddirectlyfromtheaccountingrecords,aswill
beseeninalatersection.Theequalitydefnitionactsasacheckratherthanasa
meansofobtainingtheamountofstockholderequity.
AccountingforAssets
Theterm
asset
mayhavedifferingconnotationsdependingonwhetheritisbeing
usedbyaneconomistoranaccountant.Wewilldefnethetermasusedinaccounting
practiceasfollows:
Assetsaretheresourcesofabusinessorganizationthatwere
acquiredinamarkettransactionandthatwillprovidefutureeconomicbeneftsto
theorganization.
Examplesofaccountingassetsare:
Nonphysicalresources
:cash,marketablesecurities,accountsreceivable.
Physicalresources
:land,buildings,equipment,merchandise.
Intangibleresources
:patents,goodwill,copyrights,trademarks.
Costfactorsapplicabletofutureperiods
:rentandinsurancepremiumspaidin
advanceforthefollowingyear.
EconomicandAccountingAssets
Itisimportanttounderstandthedistinctionbetweenassetsthatarerecordedand
thosethatarenot.Thedefnitionofassetsaboverefectstwocriteria:they(1)were
November6,200913:43spi-b8119inx6inb811-ch03
36
AnIntroductiontoAccountingandManagerialFinance
acquiredinamarkettransaction,and(2)willprovidefutureeconomicbeneftsto
thecorporation.
Accountantstypicallyrelyheavilyonaclearlydefnedmarkettransactionas
thebasisforrecordingassets.Themarketpricerefectedinatransactionbetween
twoindependentpartiesprovidesobjectiveevidenceofthecostofassetsacquired
orthemarketvalueofassetssold.
Itisusefulforaccountantstorelyonobjectiveevidenceofeconomicvalueother
thanalong-agoactualmarkettransaction.Inthepast,accountantshavechosento
relyonactualmarkettransactions.Thisreliancetendedtobringaboutuniformityin
howassetsarerecorded,butresultedinlessusefulinformationinthosesituations
whereapurchasecostmaybearlittlerelationtotheeconomicvalueoftheasset
acquired.Forexample,thecostsofdrillinganoilwellarenotrelatedtothevalue
ofthewellasmeasuredbytheamountofoilinit.Recordingthecostsofdrilling
thewellislessusefulthanrecordingtheeconomicvalueoftheoil.Similarly,
thecostofManhattanmayhavebeen$24,butitscurrenteconomicvaluefar
exceeds$24.
Requiringactualmarkettransactionsalsoresultsinsomeassetsnotbeing
recorded.Itemssuchascopyrightsandtrademarksareusuallyrecordedasassets
onlyiftheyhavebeenpurchasedbyacorporationforaspecifcprice.Whensuch
itemshavebeencreatedorinventedbythecorporation,theywerehistoricallynot
recordedasassets,regardlessoftheireconomicvaluetothecorporation.Simi-
larly,high-qualityemployeesofacorporationmayhavealargeeconomicvalue,
butaccountantstypicallydonotrecordsuchavalue.Forexample,accountants
foraprofessionalfootballteammightrecordthemultimillion-dollarcostofastar
quarterbackobtainedfromanotherteamasanasset,butanequallyfnequarterback
obtainedwithoutexplicitcost(exceptforayear’swages)fromacollegecampus
wouldnotappearintheaccountingrecordsasanasset.
Economicassetsprovidefutureeconomicbeneftstothecorporation.All
accountingassetsareeconomicassets,butnotalleconomicassetsareaccount-
ingassets.Accountingassetsareasubsetofeconomicassets.Unlessanitemhas
futureeconomicbeneftstothecorporation,itisnotaneconomicassetandthusnot
anaccountingasset.Anitem(e.g.,anemployee)canhavefutureeconomicbenefts
tothecorporationandthereforebeaneconomicasset,butitisnotrecordedasan
accountingassetifitwasnotacquiredinamarkettransaction.
Atthetimeanassetisacquired,anattemptwillbemadetorecorditseconomic
valueasrefectedbytheamountactuallypaidfortheasset.However,thisamount
maynotadequatelymeasuretheasset’seconomicvaluetothepurchaserbutrather
theminimumvalue,andthisfactmustbekeptinmindwhenmakingdecisions
usingrecordedamounts.Withthepassageoftime,thereislittlechancethatthe
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amountpaidtoacquireanassetwillbeanexactestimateofitseconomicvalue,
andsotheaccountantmustconsiderusingfairvalue.
FinancialAccountingStandardsNo.157
ThisstandardisdatedSeptember2006andistitled“FairValueMeasurements.”It
isanextensivestudyoffairvalueanditsuses.“Thisstatementdefnesfairvalue,
establishesaframeworkformeasuringfairvalue,andexpandsdisclosuresabout
fairvaluemeasurements”(paragraph1).
Itrecognizesthatthereare“practicabilityexceptionstofairvaluemeasure-
ments…”(paragraph2b).Butfairvalue,ingeneral,isthebasicmethodofmea-
suringassetsandliabilities.Thedefnitionoffairvalueis:“Fairvalueistheprice
thatwouldbereceivedtosellanassetorpaidtotransferaliabilityinanorderly
transactionbetweenmarketparticipantsatthemeasurementdate”(paragraph5).
The
Standard
aspublishedbytheFASBis145pageslongplusafve-page
summary.Itisanimportantaccountingdocumentsinceitdefnestheuseoffair
valueasthebasisofaccountingmeasurementsreplacingthenearlyuniversalcost-
basedaccountingrule.
CurrentandNoncurrentAssets
Theassetsectionofthebalancesheetisnormallydividedintotwobasiccompo-
nents:
currentassets
and
noncurrentassets
.
Currentassets
arecashandthose
otherassetsthatwillnormallybeconvertedintocashwithinaperiodofone
year(oroneoperatingcycle,ifitislongerthanayear).
Noncurrentassets
are
thoseassetsthatarenotlikelytobeconvertedintocashinthenormaloperating
cycle.
Currentassetsincludeitemssuchascashonhandorinthebank;amounts
duefromcustomers(accountsreceivable);materials,supplies,orgoodsonhand
(inventories);readilymarketablesecuritiesthatareexpectedtobesoldwithinone
year;andadvancepaymentsforinsurance,rent,andthelike(prepaiditems).
Thelistingofprepaiditemsasacurrentassetisjustifediftheadvancepayment
willbeusedduringthenextoperatingperiod.Iftheprepaymentisforaperiod
longerthanayear,onlytheportionapplicabletothenextyearwouldbeincluded
asacurrentasset.Whenitemsareprepaid,theyreducetheoutlayofcashthatmight
otherwiseberequiredinfutureyears.
Noncurrentassetsarealsoreferredtoas
fxedassets
or
long-livedassets
.This
categoryincludessuchitemsasland,buildings,andequipment.Theseitemsare
normallyexpectedtolastmorethanoneyearandcannotbesold(convertedinto
cash)withoutdisruptingthenormalbusinessoperations.
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Thedistinctionbetweencurrentandnoncurrentassetsismadeonthebasisof
intentionornormalexpectationratherthantheabilitytoconverttocash.Thus,
inventoriesofmaterialsareclassifedascurrentbecausetheywouldnormallybe
disposedofwithinoneyear.Abuildingthatmightbedisposedofisjustaseasily
treatedasnoncurrentifitwouldnotbesoldwithinayearofanormalbusiness
cycle.
Identicalassetsmaybeclassifeddifferentlywhenitisclearthattheyare
beingheldfordifferentpurposes.Automobilesusedinabusinessthatareexpected
tobeusedforseveralyearswouldbeclassifedasanoncurrentasset.Similar
automobilesheldforsalebyadealerormanufacturerwouldbeconsideredcurrent
assets(inventories).
Marketablesecuritiesaresecuritiesheldfortemporarypurposesforwhich
thereisareadymarket.Theseareconsideredtobeacurrentasset,asitisnormally
expectedthattheywillbesoldwithinoneyear.Ifsimilarsecuritieswerebeingheld
forcontrolpurposesandthereforenotlikelytobesold,theywouldbereferredto
asinvestmentsandclassifedasanoncurrentasset.Anassetheldasanoncurrent
investmentbecomesacurrentmarketablesecuritywhenthecorporationintendsto
disposeofitsholdinginthenextyear.
Inconsistenciesoccasionallyariseintheclassifcationbetweencurrentand
noncurrentassets.Forexample,buildingsandequipmentarenotusuallyreclas-
sifedevenwhenitbecomesclearthattheywillbedisposedofwithinayear.
Slow-movinginventoryitemsarenotreclassifedasnoncurrentevenwhenitis
likelytotakemorethanayeartodisposeofthem.Theseinconsistencieshaveone
desirableeffectinthattheygivestabilitytotheclassifcationprocedure.Itwould
betroublesomeifassetswerecontinuallyreclassifedaccordingtochangesinthe
statedintentionsofmanagement.
TangibleandIntangibleAssets
Adistinctionisoftenmadebetween
tangible
and
intangible
assets.Thisdistinc-
tionisbasedontheusualphysicalcharacteristicsoftheitems.Buildings,equip-
ment,andmerchandiseareconsideredtobe
tangibleassets
becausetheseitems
havephysicalsubstance.Patents,trademarks,andcopyrightsareconsideredtobe
intangibleassets
becausetheydonotpossessphysicalsubstance(theymaybe
representedbypiecesofpaper).
AccountingforLiabilitiesandStockEquity
Thesourcessectionofthebalancesheethastwomainsectionsandseveral
subsections.Thebasicdivisionisbetween
liabilities
and
stockholders’equity
.
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Liabilities
aretheobligationsoftheorganization.Thetermsoftheseobligations
aregenerallyfxedbylegalcontractandhavedefniteduedates.
Stockholders’
equity
referstotheownershipinterestinacorporation.Theamountofthestock-
holders’interestsisnotfxedbycontract,anddoesnothaveduedates.
Theliabilitysectioncanbefurtherdividedonthebasisofduedatesbetween
currentliabilities
and
noncurrentliabilities
.Thedistinctionisessentiallythesame
asthatappliedtoassets:
currentliabilities
arethoseobligationsthataretobepaid
withinoneyear,whereas
noncurrent(orlong-term)liabilities
arethosecoming
dueinmorethanoneyear.Thisdistinctionisimportant,becausethesolvencyof
anorganizationrestsonitsabilitytomeetpaymentobligationswhendue.
Currentliabilitiesusuallyincludeamountsowedtotradecreditors(accounts
payable),workers(wagespayable),government(taxespayable),investors(interest
ordividendspayable),andcustomers(advancesfromcustomers).Alloftheseitems
arecurrentliabilitiesiftheyareduewithinayear(orwithintheoperatingcycleof
theorganization).
Noncurrentliabilitiesoftenincludebonds,mortgages,andnotes.Ifpartof
theseitemsisduewithin12months,thatamountshouldbeclassifedasacurrent
liability.Itistheduedate,notthetitle,thatdetermineswhetheranobligationis
classifedascurrentornoncurrent.
Insomecases,theexactamounttobepaidisnotknown.Forexample,a
corporationcanestimateitsincometaxliabilityandshowitassuchonabal-
ancesheet,eventhoughtheamountisnotcertainandwillnotbecertainuntil
detailedcomputationsaremade(andreviewedbytheInternalRevenueSer-
vice).Althoughtheamountmustbeestimated,anobligationtopayonorbefore
aspecifcdateexists,andtheexpectedliabilityshouldberecognizedbythe
accountant.
Thestockholders’equitysectionofthebalancesheetmaybedividedintothe
amountoriginallypaidtoacorporationbystockholders,oftenreferredtoas
com-
monstock
or
capitalreceivedfromstockholders
,andtheamountretainedfrompast
earnings,oftenreferredtoas
retainedearnings
.Therearealsoseveralvariationsof
titlesanddifferentclassifcationsthatareusedinpractice.Thesewillbediscussed
inlaterchapters.
Thecommonstockholdersaretheresidualowners.Theeconomicvalueof
theseinterestsvaries,dependingonthefortunesofthecorporation.Theearnings
ofthecorporationaccruetothisownershipgroup,but,unlikedebt-likeobligations,
thecorporationisnotconsideredinsolventifitfailstomakepaymentstothese
investors.
Anownershipinterestofsometypeandamountmustexistaslongasthe
corporationexists.Ifthecorporationisliquidated,thestockholdersareentitledto
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AnIntroductiontoAccountingandManagerialFinance
theresourcesremainingafterallotherclaimshavebeensatisfed.Theiramount
maybemoreorlessthantheaccountingmeasuresoftheseinterests.
Theearningsofthecorporationmaybeeitherretainedbythecorporationor
distributedtostockholders.Thesedistributionsnormallytaketheformofcashpay-
mentsthatarecalled
dividends
or
sharerepurchases
.Barringcomplexities,the
retainedearningsbalanceisequaltothesumofthepastearningsofthecorporation
reducedbyanydistributionstoshareholdersthathavebeenmade.Anegativebal-
anceinretainedearningsisreferredtoasa
defcit
.Thisoccurswhenthecorporation
sustainscumulativelossesinitsoperationsorhasmadelargercashdistributions
thanithasearned.
Theclassifcationofaccountsisbasedonthelegalnatureoftheitemandnot
onthenatureoftheindividualsholdingtheclaim.Thus,ifadividendofadefnite
amounthasbeendeclaredpayableasofadefnitedate,theobligationtopaythe
dividendisaliabilityofthecorporation.Eventhoughthesumispayableonlyto
stockholders,itwouldbeconsideredaliabilityofthecorporationandnotapartof
stockholders’equity.
SampleBalanceSheet
Thefrstbalancesheetillustratedbelowisnotcompleteinalldetails,butitdoes
showabasicarrangement.Moredetailedbalancesheetsarefoundinpractice,but
thebasicformatisnotchanged.
Notethatthecurrentassetsarelistedinorderofliquidity,orhowclosethey
aretobeingcash.Themostliquidassetsarelistedfrst.Thefxedassetsarelisted
withthelongest-livedassetspresentedfrst.Thatis,landisfollowedbybuildings
andequipment.Thereisnoorderspecifedforcurrentliabilities.Inpreparinga
balancesheet,thearrangementoftheitemsandtheappearanceofthestatement
areimportant.Thereaderwillexpecttofnditemsinspecifclocations.Theperson
preparingthereportshouldeitherconformtocurrentpracticeorwarnthereader
ofdifferencesinpresentation.
Thebalancesheetmaybepreparedin
verticalform
asshownhere,withassets
ontopandequitiesonthebottom,oritispreparedasa
balancedarray
,with
assetsontheleftandliabilitiesandstockholders’equitiesontheright.Eitherform
isacceptable,aswellasseveralothervariationsofthesebasicarrangements.
Forexample,anothermethodofpresentationisthe
stepformat
,inwhich
currentliabilitiesaresubtractedfromcurrentassetbalancestoobtainnetcurrent
assets.Thisformhastheadvantageofhighlightingtherelationshipofthecurrent
assetstothecurrentliabilitiesandofshowingthedifferencebetweenthetwo.It
hasthedisadvantageofnotexplicitlyshowingthetotalassetsortotalliabilities.
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Thesetotalscanbederivedfromthebalancesheetregardlessoftheformat,but
theyaremorediffculttofndwhenthesteppresentationisused.Anexampleofa
balancesheetusingthisformatisalsoshownbelow.
SampleCompany
BalanceSheetasofDecember31,20XX
Assets
CurrentAssets
CashonHand$2,000
CashinBank30,000
MarketableSecurities8,000
AccountsReceivable60,000
Inventories50,000
PrepaidExpenses2,000
TotalCurrentAssets
$152,000
Long-LivedAssets
Land$15,000
Buildings53,000
Equipment60,000
TotalLong-LivedAssets
128,000
TotalAssets
$280,000
LiabilitiesandStockholders’Equity
CurrentLiabilities
AccountsPayable$30,000
TaxesPayable70,000
TotalCurrentLiabilities
$100,000
Long-TermLiabilities
BondsPayable80,000
TotalLiabilities
$180,000
Stockholders’Equity
CommonStock$90,000
RetainedEarnings10,000
TotalStockholders’Equity
100,000
TotalLiabilitiesandStockholders’Equity
$280,000
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SampleCompany
BalanceSheetasofDecember31,20XX
CurrentAssets
CashonHand$2,000
CashinBank30,000
MarketableSecurities8,000
AccountsReceivable60,000
Inventories50,000
PrepaidExpenses2,000
$152,000
Deduct:CurrentLiabilities
AccountsPayable$30,000
TaxesPayable70,000
$100,000
NetCurrentAssets
$52,000
NoncurrentAssets
Land$15,000
Buildings53,000
Equipment60,000
TotalAssetslessCurrentLiabilities
$180,000
Deduct:Long-TermDebt
BondsPayable$80,000
NetAssets
$100,000
Ownership
CommonStock$90,000
RetainedEarnings10,000
$100,000
ManagerialUsesoftheBalanceSheet
Theprimaryfunctionofabalancesheetistoindicatethefnancialpositionofan
organization.Thestatementmayprovideusefulinformationindeterminingthe
degreeoffnancialrisk.Forexample,abankconsideringashort-termloantoa
corporationwouldwanttoknowthefnancialpositionofthebusinessorganization
asofthedateoftheloan(orasclosetothatdateaspossible).Itsprimaryinternal
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43
useisasameansofmeasuringthesoundnessofthefnancialpositionofthe
organization.
Bylookingatanorganization’sbalancesheetsforsuccessiveperiods,managers
canobservechangesinspecifcitems.Ifthedirectionandamountofthechange
areundesirable,managersmaybeabletotakeactiontocorrectthesituation.For
example,anincreaseinaccountsreceivable(theamountsowedbythecustomers
tothecompany)mayindicateineffciencyintheoperationofthecollectiondepart-
ment.Althoughindividualitemssuchasaccountsreceivablewillbethesubjectof
separatereports,itishelpfultohaveallassetsdisplayedinonereportsothatthe
variousitemsmaybereadilycomparedwitheachother.
Balancesheetspreparedformanagementshouldbedesignedespeciallyforthe
requirementsoftheexecutiveswhoareusingthem.Executiveshavenoneedfor
statementsshowingpennies;infact,verylargeorganizationsroundoffbalances
tothenearesthundredthousandormilliondollars.Reportsmayalsobesimplifed
bycombiningsimilaritems.Thus,thesingletitlePrepaidExpensesmayinclude
prepaidrent,insurance,andtaxes.Theaimofthesesimplifcationsistosavetime
whenexecutivesreviewthestatementandavoidoverwhelmingthemwithtoo
extensiveanarrayofnumbers.
Inusingabalancesheetformanagerialpurposes,itisimportanttokeepinmind
thatthisstatementisnotpreparedprimarilyfortheuseofmanagers.Traditional
fnancialstatementsintendedtoservethepublicatlargemaynotbeoptimalfor
managerialdecisionmaking.Thismeansthataconventionalbalancesheetmay
havetobeadjustedormodifedtoincreaseitshelpfulnesstomanagementforuse
byafnancialanalyst(orapotentialinvestor).
NatureofAccounts
Aseparate
account
ismaintainedforeachiteminthebalancesheet.Transactions
mayberecordedbyenteringtheamountbywhicheachitemisaffectedintothe
respectiveaccount.
T-Accounts
The
T-account
,namedforitsshape,isaconvenientwayofrepresentinganaccount
onapieceofpaper.TheT,withtheaccountnameenteredatthetop,permits
transactioninformationtobeenteredoneithersideoftheverticalline.Torecord
transactions,wemustbeabletorecordadditionstoaswellassubtractionsfrom
accounts.ThisiseasilyhandledinT-accountsbydesignatingthatadditionsareto
berecordedononesideoftheverticallineandsubtractionsontheother.
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AnIntroductiontoAccountingandManagerialFinance
Byconvention,assetsareincreasedbyentriesontheleftsideoftheaccount
andaredecreasedbyentriesontherightsideoftheaccount.Entriestoliability
andstockholders’equityaccountsarehandledinthereversemanner.Theyare
increasedbyentriesontherightsideandaredecreasedbyentriesontheleftside.
Theserulesmaybesummarizedasfollows:
Assetsareincreasedbyentriesontheleftside.
Assetsaredecreasedbyentriesontherightside.
LiabilitiesandStockholders’Equityareincreasedbyentriesontherightside.
LiabilitiesandStockholders’Equityaredecreasedbyentriesontheleftside.
Any Asset Account
Any Liabilityor Stockholders’
Equity Account
IncreasesDecreasesDecreasesIncreases
Allonehastorememberisthatincreasesforassetsarereportedontheleftside
oftheaccountandaretheoppositeofincreasesforliabilitiesandstockholders’
equities,andthatdecreasesforanyaccountaretheoppositeofincreasesforthat
account.
Theprocessofrecordingtransactionsconsistsofdeterminingwhataccounts
areaffected,whethertheyareassetorliabilityandequityaccounts,andwhether
theyaretobeincreasedordecreased.Withthisinformation,anytransactioncan
berecorded.
Example
Toillustratetheuseofaccounts,wewillrecordatransaction.Supposethat
stockholdersinvest$10,000incashtoorganizeacorporation.TheCashaccount
increasesby$10,000andtheCommonStockaccountincreasesbythesame
amount.
Torecordtheincreaseincash,wecandrawaT-accountwiththeheadingCash
andwrite10,000ontheleftsideoftheaccount:
Cash
10,000
Thisentryof$10,000ontheleftsideoftheaccountisinterpretedasindicating
thattheamountofcashhasincreasedby$10,000.Thus,theinformationispreserved
andcanbeusedtoprepareabalancesheetatalatertime.
Wecannevermakeanentrytooneaccountwithoutalsomakinganentrytoat
leastoneotheraccount.Thereceiptofcashresultedinacorrespondingincreasein
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45
commonstock.Therefore,anentrymustbemadetotheaccount,CommonStock,
toindicateanincreaseof$10,000.
Followingtheconventionusedforcash,itmightseemlogicaltorecordthe
increaseincommonstockbywritingtheamountontheleftsideoftheT-account.
Thiswouldbethecaseiftheruleweretorecordallincreasesontheleftside.
However,theincreasesinequityaccountsarerecordedbyentriestothe
right
side.
Thus,theincreaseincommonstockwouldberecordedbywriting$10,000onthe
rightsideofanaccountwiththeheadingCommonStock:
Common Stock
10,000
DebitsandCredits
Itisawkwardtospeakofentries“totheleftsideofanaccount”andentries“to
therightsideofanaccount.”Thisdiffcultyiseliminatedbytheuseofspecialized
terminology.Thus,insteadofentriestotheleftsideofanaccount,theaccountant
speaksof
debits
(abbreviatedDr.);insteadofentriestotherightsideofanaccount,
theaccountantspeaksof
credits
(abbreviatedCr.).Thesearetheprimarydefnitions
ofdebitsandcredits.Oneislikelytorunintoconfusionattemptingtoinferany
othermeaningfortheseterms.Themostusefuldefnitionisthat
adebitisanentry
totheleftsideofanaccount.
Itfollowsthat
acreditisanentrytotherightsideof
anaccount
.
Ithasbeenshownpreviouslythatanentrytotheleftsideofanassetaccount
increasesthataccount.Ifanassetaccountisincreasedbydebits,itmustbe
decreasedbytheoppositeentry—credits.Liabilityorstockholders’equity
accountshavetheoppositecharacteristicsofassetaccounts.Therefore,theyare
increasedbycreditsanddecreasedbydebits.
Any Asset Account
Any Liabilityor Stockholders’
Equity Account
Debit
(increase)
Credit
(decrease)
Debit
(decrease)
Credit
(increase)
Theterm
charge
isoftenusedinterchangeablywithdebit.Achargetoan
accountisadebit.
KeyingTransactions
Whenseveraltransactionsareinvolved,itisconvenienttoplaceanumberiden-
tifyingeachtransactionintheT-accountnearthedollaramount.Thisprocedure
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AnIntroductiontoAccountingandManagerialFinance
iscalled
keying
thetransaction.Keyingfacilitatescross-referencesandaidsin
checkingtherecordingprocess.Transactionsshouldalwaysbekeyed.
Example
Wewillnowcontinuetheillustration.Determinetheaccountsaffectedbyeach
transaction,whethertheyareassetsorequities,andwhethertheyareincreasedor
decreased.Thisdetermineswhethertheentriesaretobemadeontheleftorright
sideoftheaccounts.Foreachtransaction,theleft-sideentries(debits)mustbe
equaltotheright-sideentries(credits).
Transactions:
1.Stockholdersinvest$10,000incash(increaseanasset;increaseanequity).
2.Thecompanybuys$5,000ofmerchandiseonaccount(increaseanasset;
increasealiability).
3.Attheendoftheyearthecompanybuysabuildingfor$20,000,pays$4,000
cash,andissues$16,000ofbonds(increaseanasset;decreaseanotherasset;
increasealiability).
4.Themerchandise(seeTransaction2)ispaidfor(decreaseanasset;decreasea
liability).
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
necessarilythecasethatthenumberofincreaseswillequalthe
numberofdecreasesforanytransaction.Itispossibletohavevalidentrieswithtwo
increases(e.g.,increaseanasset,increaseastockholder’sequity)ortwodecreases
(decreaseanasset,decreasealiability)aswellasentrieswithequalincreases
anddecreases(increaseanasset,decreaseanotherasset).Relatingincreasesto
decreasesisnotausefulcheck.Theequalityofleft-sideandright-side(debitand
credit)entriesisanimportantcontroldevice.
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RecordingAccountingTransactions
Inanyaccountingentry,thedebitsmustequalthecredits.Thisissynonymouswith
thestatementthatentriestotheleftsideofaccountsmustequalentriestotheright
sideofaccounts.Entriesmaytakemanyforms,forthereisavarietyoftransactions
thatmayberecordedwithdebitsandcredits.
Itisnotpossibletobecorrectandmakeanentrythatincreasesoneassetand
alsoincreasesanotherasset(twodebitsandnocredits).Norisitpossibletobe
correctandmakeanentrythatincreasesliabilitiesandstockholders’equitybut
doesnotaffectanotheraccount(twocreditsandnodebits).
Theprocedurefordecidingontheentriestobemadeinrecordingafnancial
transactionconsistsofthethreestepssuggestedbythefollowingthreesetsof
questions:
1.Whataccountsareaffected?Whatwasgivenorreceivedinthetransaction?
2.Whataccountsshouldbedebitedorcredited?
3.Whatamountsshouldbedebitedandcredited?
Assumethat$500ofaccountspayablearepaid.Whataccountsareaffected?
CashandAccountsPayablearethetwoaccountsaffected.Whataccountsshouldbe
debitedorcredited?Whichaccountsareincreasedordecreasedbythetransaction?
CashisdecreasedandAccountsPayableisdecreased.Todecreaseanasset,itis
necessarytocreditit;andtodecreasealiability,itisnecessarytodebitit.What
amountsshouldbedebitedandcredited?Bothaccountsaredecreasedby$500.
ThistransactionisrecordedbydebitingAccountsPayablefor$500andcrediting
Cashfor$500.Thistypeofsystematicanalysisisusefulinrecordingtransactions.
AccountBalances
Formanypurposes,itisnecessarytodeterminethebalanceinanaccount.This
isaccomplishedbyaddingthedebits,addingthecredits,anddeterminingthe
differencebetweenthetwosums.
Anaccountissaidtohavea
debitbalance
ifthesumofthedebitentriestothat
accountexceedsthesumofthecreditentries.Conversely,anaccounthasa
credit
balance
ifthesumofthecreditentriesexceedsthesumofthedebitentries.Inthe
exampleillustratedearlierinthischapter,thecashaccountappearedasfollows:
Cash
(1) 10,000 (3) 4,000
(4) 5,000
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Thedebitstotal$10,000andthecreditstotal$9,000;thedebitsexceedthe
creditsby$1,000.
Assetaccountsnormallyhavedebitbalancesinasmuchastheseaccountsare
increasedbydebiting.Anassetaccountwithacreditbalanceisnolongeran
asset.Forexample,supposetheAccountsReceivableaccounthadacreditbalance.
Thiswouldindicatethatthecompanyowedmoneytoitscustomers,andthus
itisproperlyclassifedasaliability.Liabilityandstockholders’equityaccounts
normallyhavecreditbalancesbecausetheseaccountsareincreasedbycrediting.
Itisnotpossibletotellwhetheranaccountisanassetorastockholder’sequity
bymerelyobservingitsbalance.Forexample,accountswithcreditbalancesmay
representdeductionsfromassetsratherthanstockholders’equities.Accountswith
debitbalancesmayrepresentdeductionsfromliabilitiesratherthanassets.
Thefactthattotaldebitswereequaltototalcreditsintheillustrationsisnot
duemerelytochanceortothecontrivednatureoftheexamples.Thisequalitymust
alwaysexistiftherecordingprocessistobecarriedoutcorrectly.Wheneverthe
totaldebitsarenotequaltototalcredits,itiscertainthatanerrorhasbeenmade.
Testingtheequalityofthedebitandcreditentriesservesasaconvenientdeviceto
detectmistakes.
Althoughtheinequalityofdebitsandcreditsalwayssignalsthepresenceofan
error,theequalityofdebitsandcreditsdoesnotassuretheaccuracyoftherecords.
Therangeoferrorsthatmightbedisclosedbytheequalitytestisquitebroad.
However,itdisclosesneithertheomissionofanentrynoranentrytothewrong
account.
Itisimpossibletoconceiveofatransactionwherebyanassetwouldbeincreased
andaliabilitydecreasedwithnootherchanges.Anytimethatdebitsdonotequal
credits,itfollowsthatanerrorhasbeenmade.
Thechoicetoincreasestockholders’equityaccountswithcreditsgiventhat
assetaccountsareincreasedwithdebitswasnotanarbitrarywhim.Theconvention
wasadoptedtoresultintheequalityofdebitsandcreditsforeachtransaction,a
desirablecontrolfeature.
JournalEntries
UptothispointwehavemadeentriesinT-accounts,whichareveryuse-
fulforlearninghowtorecordaccountingentries.Inconcept,theT-accountis
relatedtoanimportantcomponentoftherecordingsystemusedinaccounting
practice—theledger.The
ledger
isacollectionofaccountsthatisusedtosum-
marizetheresultsoftransactionssothatthebalanceofeachaccountmaybereadily
determined.
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Whenmanytransactionsareinvolved,itmightbecomerathercumbersometo
recordeachofthemdirectlyintheledger.Theledgerwouldsoonbecomecluttered
withnumerousentries,anditwouldbediffculttotracetheeffectsofindividual
transactionsevenwhentheledgerentriesarekeyed.
Asamatterofconvenience,itisoftendesirabletorecordtransactionsin
journal
entryform
.Inthisform,thetitlesofaccountstobedebitedorcreditedarelisted
alongwiththeamountsinvolved.Theaccountstobedebitedarelistedfrst.The
accountstobecreditedarelistednextandaredistinguishedbyindenting.An
explanationmaybeaddedwhereitisdesirable.
Inmostcases,thejournalentriescontainthesameinformationaswouldhave
beenpresentedifthetransactionshadbeenrecordedinT-accountform.Ifthe
journalentryform
isusedratherthanT-accountstorecordtransactions,wewould
havethefollowingformat:
Dr.Cr.
Cash.............................................1,000,000
Commonstock..................................1,000,000
Torecordtheissuanceof$1,000,000ofcommonstock.
Building..........................................500,000
Cash...........................................500,000
Torecordthepurchaseofabuildingfor$500,000cash.
The
journalentryformat
isalsorelatedtoarecordingprocedureusedin
practice.A
journal
,or
bookoforiginalentry
,isusedtorecordtransactions
inchronologicalorder.Entriesarenormallyrecordedfrstinajournalandthen
transferredtotheledger.
Summary
Wehavedefnedtheequation:
Assets
=
Liabilities
+
Stockholders’Equity.
Thisequalityalwaysholds.Theformalexpansionofthisequalityleadstothe
importantfnancialstatement,thebalancesheet.
Theprimaryfunctionoffnancialaccountingistoreporttheresultsofoper-
ationsandthefnancialpositionoftheenterprise.Thesereportsareimportant
tomanagementandotherusersofthestatements,sincetheyrefecttheresults
ofpastdecisionsandtheexecutionofthesedecisions.Also,managementknows
thatthepresentdecisionswillbesimilarlyevaluated.However,whenmanagers
makedecisions,theygenerallysupplementconventionalfnancialstatementswith
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AnIntroductiontoAccountingandManagerialFinance
informationpreparedespeciallyforthedecisionsbeingmade.Thus,theprimary
accountingconcernofthisbookisfnancialreportingofascore-keepingnature.
Knowingwhereyouare(thebalancesheet)andhowyougotthere(theincome
statement)isimportanttodecisionmakers.
Accountsareusedtorecordincreasesanddecreasesinassets,liabilities,and
stockholders’equity.Assetsareincreasedbyentriestotheleft-handsideofT-
accounts(debits)andaredecreasedbyentriestotheright-handsideofT-accounts
(credits).Liabilitiesandstockholders’equityaredecreasedbyentriestotheleft-
handsideofT-accounts(debits)andareincreasedbyentriestotheright-handside
ofT-accounts(credits).
Theaccountingconventionofincreasingassetaccountswithdebitsandincreas-
ingliabilityorequityaccountswithcreditsprovidesasysteminwhich,foreach
entry,thedebitsmustequalthecredits.Thus,forthetotalofallentries,thesumof
thedebitsmustequalthesumofthecredits.
Itisnotimportantthatwedefnedadebittoincreaseassets;wecouldjustas
reasonablyhavedefneditasadecrease.Itisimportantthat,havingdefnedadebit
asanincreaseinanassetaccount,adebitshouldhavetheoppositeeffectonaliabil-
ityorstockholders’equityaccount.Thechangesinassetsmustequalthechanges
insourcesofassets.Also,thedebitsmustequalthecreditsforeachtransaction.
ReviewProblems
ReviewProblem3.1
ThefollowingfactsapplytotheABCCompanyintheyear20XX.
1.Stockholdersinvest$1,000,000.
2.Thecompanybuyslandfor$20,000andabuildingfor$380,000incash.
3.Thecompanyborrows$100,000fromthebank.Thefve-yearnotebears14
percentinterestperyear.
4.Thecompanypurchases$300,000ofmerchandise,paysfor$200,000ofit,and
refectstheremainderasanaccountpayable.
5.Salesof$800,000aremadeonaccount,andthereis$50,000ofmerchandise
remainingattheendoftheyear.Wagesandotherexpensesfortheyearare
$370,000.Interestof$3,000ispaidonthebankdebt.Theincomeis$177,000.
6.Dividendsof$100,000arepaidtostockholders.
7.Accountsreceivablehasanendingbalanceof$500,000.
SetupT-accountsandrecordtheabovetransactions.Keyallentries.Preparea
balancesheetasofDecember31,20XX,thatrefectstheforegoingtransactions.
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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
TheABCCompany
BalanceSheetasofDecember31,20XX
AssetsLiabilitiesandStockholders’Equity
CurrentAssetsCurrentLiabilities
Cash$327,000AccountsPayable$100,000
AccountsReceivable500,000
Merchandise50,000
Long-TermLiabilities
NotesPayable100,000
TotalCurrentAssets$877,000TotalLiabilities$200,000
Long-LivedAssetsStockholders’Equity
Land20,000CommonStock1,000,000
Building380,000
RetainedEarnings77,000
TotalAssets
$1,277,000
TotalLiabilitiesand
Stockholders’Equity
$1,277,000
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AnIntroductiontoAccountingandManagerialFinance
QuestionsandProblems
1.Defnetheterm
accounting
.Whataresomeofthetasksthataccountants
perform?
2.Shouldfnancialaccountingprinciplesbebaseduponincometaxregulations?
3.Whatformofbusinessorganizationwouldyouexpectthefollowingindustries
totake?Why?
a.Steelindustry.
b.Law.
c.Retailing.
d.Farming.
4.Whataretwoprincipalfnancialstatements?Whatisthefunctionofeach?
5.TheXYZCompanyhaslistedononeofitsfnancialreports(balancesheet),
“Buildings,$451,000.”Describetheusefulnessofthismeasurefordecision
making.
6.Accountingisonetypeofinformationsystem.Nameseveralothersystems
supplyinginformationtobusinessmanagers.Nameseveralothersourcesof
fnancialinformationavailabletoinvestors.
7.Comparetheneedforfnancialinformationofabankloanoffcer,aninvestor
incommonstock,andthefnancialanalystofaninsurancecompanyinvesting
inlong-termcorporatedebt.
8.Itissometimesstatedthattheassetsideofabalancesheetshouldinclude
therightsinproperty,bothtangibleandintangible,ofabusinessenterprise.
Acceptingthisstatement,discusswhetherthefollowingitemsshouldbe
includedamongtheassets:
a.Investmentingovernmentbonds.
b.Investmentincorporatebonds.
c.Prepaidexpenses.
d.Costsofdrillingforoil(assumingoilwasfound).
e.Advertisingcostsconnectedwithanewproduct(notyetofferedforsale).
f.Costsoforganizinganewcorporation.
g.Costsconnectedwithissuingbonds.
h.Costsofinstallingapieceofequipment.
i.Costsofdrillingforoil(assumingoilwasnotfound).
9.Indicatewhichofthefollowingitemsmightbeexpectedtobefoundona
balancesheetpreparedinaccordancewithGenerallyAcceptedAccounting
Principles(thebasicframeworkofaccounting):
a.Thevalueofthemanagerialorganization,whichhadbeendeveloped
throughtheyears.
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AnIntroductiontoFinancialReporting
53
b.Thecostincurredinorganizingthefrm.
c.Thevalueofoil,whichhadbeendiscoveredunderacorporateparkinglot
(therearenodrillingcosts).
d.Thevalueofthegoodwillofcustomerstowardthefrm(thegoodwillhad
beenbuiltupthroughtheyearsbygoodservice).
e.Theexcessofthepricepaidforanenterprisethathadbeenpurchasedover
thevalueofthetangibleassetsacquired(considertangibleassetstorefer
tothevalueofinventories,plant,andequipment).
10.Amajorstockholderofacorporationisconcernedaboutthemanagement
ofherfrm,sincethecompanyhaslandwithavalueof$8,000,000being
usedforparkinglots.Thecontrollerisawareofthe“stewardshipfunction”
ofaccountingandcheckstheinvoices.Hefndsthatthecostofthelandwas
$400,000andtherewasnopossibilityofdishonesty.Thecontrollerreports
thisfndingbacktothestockholder.
Commentontheinformationpresentedtothestockholder.
11.Ithasbeensuggestedbyreputableeconomiststhatfrmsshouldbeallowed
fortaxpurposestoconsiderthecostofequipmentasareductionofincome
atthetimeofacquisition,sincetheequipmentwaspaidforatthattime(other
reasonsarealsooffered).
Iftheaboveproposalweretobeaccepted,doyouthinkthisprocedureshould
befollowedforfnancialreportingpurposes?Explain.
12.Assumethereisanunknown“true”value.Considertwomeasurementpro-
cedures.Oneprocedure(A)willprovideameasurethatislessthanthetrue
value,andallmeasurerswillpresentthesamemeasure.Thesecondprocedure
(B)willprovide,onaverage,ameasureequaltothetrueamount,butitcanbe
eitherlargerorsmalleronarandombasis.Whichmeasurementproceduredo
youprefer,assumingyourdecisionwillbebasedontheinformationobtained?
13.Assumethatinthehiringprocessafrmspends$4,000peruniversitygraduate
thatithires.Shouldthefrmconsidertheentire$4,000tobeanexpenseinthe
periodinwhichthepersonishiredorshouldportionsofitbeconsideredan
expenseeachyearforthedurationofemployment?
14.Adividendof$10,000willdecrease
ifithasbeenpaid.
15.Determinetheaccountingincomeofacompanyforwhichthefollowing
informationisavailableforthemonthofJune:
DividendsPaidtoStockholders$10,000
EmployeeSalariesforJune30,000
InterestPaidonBankLoanforJune5,000
JuneRentPaidtoLandlord25,000
SalestoCustomersinJune80,000
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AnIntroductiontoAccountingandManagerialFinance
16.Theassetsofacorporationtotal$10,000;theliabilities,$4,000.Theclaimsof
theownersare
.
17.TheAesopCompanyhastotalassetsof$1,000,000andtotalliabilitiesof
$600,000.Thecommonstockholdershaveexplicitlyinvested$100,000inthe
frm.Sinceorganization,thefrmhaspaidcashdividendsof$800,000.
a.Whathavethetotalearningsbeensinceorganization?
b.Ifthestockholdershadexplicitlyinvested$700,000butifallotherfacts
wereunchanged,whatwouldbethetotalearningssinceorganization?
18.Fromthefollowinginformation,presentedasofDecember31,20XX,prepare
abalancesheetfortheArleyCorporationingoodform.
Liabilities$8,000
Cash4,000
Materials2,000
Buildings7,000
Owners’Equities?
19.Fromthefollowinginformation,obtainedasofDecember31,20XX,prepare
abalancesheetfortheAdamsCorporationingoodform.
AccountsPayable$12,000Land$25,000
DividendsPayable5,000Equipment75,000
Cash45,000AccountsReceivable15,000
MarketableSecurities10,000InterestPayable2,000
Investments40,000Merchandise25,000
BondsPayable100,000Supplies2,000
CommonStock150,000Buildings100,000
RetainedEarnings?
20.Fromthefollowinginformation,obtainedasofDecember31,20XX,prepare
abalancesheetfortheAdlerCorporationingoodform.
AccountsPayable$10,000Land$10,000
DividendsPayable4,000Equipment60,000
Cash20,000AccountsReceivable15,000
MarketableSecurities10,000InterestPayable1,000
Investments40,000Merchandise18,000
BondsPayable50,000Supplies2,000
CommonStock100,000Buildings50,000
RetainedEarnings?
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AnIntroductiontoFinancialReporting
55
21.Certainaccountsareincreasedbyentriestotheleftsideoftheaccount,others
byentriestotherightsideoftheaccount.Foreachofthefollowingitems,
indicatewhethertheamountshouldbeenteredontherightorleftsideofthe
account.
IncreaseCash
IncreaseWagesPayable
DecreaseBondsPayable
IncreaseRetainedEarnings
DecreaseCash
IncreaseCommonStock
22.Foreachofthefollowingtransactions,indicatethetwo(ormore)accountsthat
areaffectedandhowtheyareaffected(increaseordecrease).Indicatewhether
theaccountsaredebitedorcredited.
a.Cashisinvestedbythestockholders.
b.Merchandiseispurchasedonaccount.
c.Themerchandiseispaidfor.
d.Insuranceispurchasedandpaidfor.
e.Merchandiseissoldonaccount.
f.Dividendsarepaidtothestockholders.
23.Foreachofthefollowingtransactions,indicatewhataccountsarelikelytobe
affectedandwhethertheaccountsarelikelytobedebitedorcredited.
a.Moneyisreceivedfromstockholders.
b.Merchandiseispurchasedonaccount.
c.Abuildingispurchased.Paymentismadebycashandbytakingouta
mortgage.
d.Apieceofequipmentissoldforcash.
24.a.SetupT-accountsandrecordthefollowingtransactionsoftheBarkerCor-
porationforthemonthofMarch.
(1)Stockholdersinvest$100,000.
(2)Thecompanybuys$19,000ofmerchandiseonaccount.
(3)Thecompanypays$11,000oftheamountowedforthemerchandise.
(4)Oneyear’srentispaid,$4,800.Therentappliestotheyearbeginning
March1.
(5)SalesforMarch,thefrstmonthofoperations,total$13,300.Allsales
areforcash.Themerchandisesoldcosts$7,900.Salariespaidincash
toemployeesduringthemonthare$1,000,andthecompanyowesan
additional$300ofwagesasoftheendofthemonth.
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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,$7,000areforcashandthe
remainderonaccount.Thecostofthemerchandisesoldis$6,000.
Wagesearnedandpaidduringthisperiodtotal$1,200.
(6)Anamountof$800ispaidtothemortgagee.Ofthisamount,$560
isinterestandtheremainderrepresentsareductionoftheprincipal
balance.
(7)Dividendsof$400arepaidtostockholders.
b.PrepareabalancesheetasofDecember31,20XX,givingeffecttoallthe
foregoingtransactions.
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Chapter4
CapitalBudgeting
Acapitalbudgetingdecisionischaracterizedbycostsandbenefts(cashfows)
thatarespreadoutoverseveraltimeperiods.Thisleadstoarequirementthatthe
timevalueofmoneybeconsideredinordertoevaluatethealternativescorrectly.
Althoughinactualpracticewemustconsiderriskaswellastimevalue,inthis
chapterwerestrictthediscussiontosituationsinwhichthecostsandbenefts(in
termsofcash)areknownwithcertainty.Therearesuffcientdiffcultiesinjust
takingthetimevalueofmoneyintoconsiderationwithoutalsoincorporatingrisk
factors.Moreover,whenthecashfowsarefnallyallowedtobeuncertain,weshall
suggesttheuseofaprocedurethatisbasedontheinitialrecommendationsmade
withthecertaintyassumption,sonothingislostbymakingtheinitialassumption
ofcertainty.
Inthischapter,weshalldescribefourofthemorecommonlyusedprocedures
formakingcapitalbudgetingdecisions.Weshallnotattempttodescribeallthe
variationsthatarepossibleoralltheproceduresusedthatarefaulty.Ifyouunder-
standthebasicelementsofacorrectprocedure,youwillbeabletodistinguish
betweencorrectandincorrectprocedures.Thetwobasiccorrectcapitalbudgeting
techniquespresentedinthischapterareapplicabletoawiderangeofdecisions
foundthroughouttheeconomybothintheproftandnot-for-proftsectors.
RateofDiscount
Weshallusetheterm
timevalueofmoney
todescribethediscountrate.One
possibilityistousetherateofinterestassociatedwithdefault-freesecurities.This
ratedoesnotincludeanadjustmentfortheriskofdefault;thusrisk,ifpresent,
wouldbehandledseparatelyfromthetimediscounting.Insomesituations,itis
convenienttousethefrm’sborrowingrate(themarginalcostofborrowingfunds).
Theobjectiveofthediscountingprocessistotakethetimevalueofmoneyinto
consideration.Wewanttofndthepresentequivalentoffuturesums,neglecting
57
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AnIntroductiontoAccountingandManagerialFinance
riskconsiderations.Later,weshallintroduceseveraltechniquestoadjustforthe
riskoftheinvestment.
Althoughthefrm’sweightedaveragecostofcapitalisanimportantconcept
thatshouldbeunderstoodbyallmanagersandisusefulindecidingonthefnancing
mix,wedonotadvocateitsgeneraluseinevaluatingallinvestments.
ClassifcationofCashFlows
Weshalldefneconventionalinvestmentsasthosehavingoneormoreperiodsof
outlaysfollowedbyoneormoreperiodsofcashproceeds.Borrowingmoneyisa
kindof“negativeinvestment”or“loantypeofcashfow”inwhichoneormore
periodsofcashproceedsarefollowedbyoneormoreperiodsinwhichtherearecash
outlays.Loan-typeinvestmentshavepositivecashfows(cashinfows)followed
byperiodsofnegativecashfows(cashoutlays).Therearealsononconventional
investments,orinvestmentsthathaveoneormoreperiodsofoutlaysinterspersed
withperiodsofproceeds.Withnonconventionalinvestments,thereismorethan
onesignchangeinthesequenceofthecashfow.Withaconventionalinvestment
orloan,thereisonesignchange.Thepossibilitiesmaybeillustratedasfollows:
SignofFlowforPeriod
0123
Conventionalinvestment
−+++
Loantypeoffows
+−−−
Nonconventionalinvestment
−++−
Nonconventionalinvestment
+−−+
DependentandIndependentInvestments
Inevaluatingtheinvestmentproposalspresentedtomanagement,itisimportantto
beawareofthepossibleinterrelationshipsbetweenpairsofinvestmentproposals.
Agiveninvestmentproposalmaybeeconomicallyindependentof,ordependent
on,anotherinvestmentproposal.Aninvestmentproposalissaidtobe
economically
independent
ofasecondinvestmentifthecashfows(orthecostsandbenefts)
expectedfromthefrstinvestmentarethesameregardlessofwhetherthesecond
investmentisacceptedorrejected.Ifthecashfowsassociatedwiththefrstinvest-
mentareaffectedbythedecisiontoacceptorrejectthesecondinvestment,thefrst
investmentissaidtobe
economicallydependent
onthesecond.Itshouldbeclear
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CapitalBudgeting
59
thatwhenoneinvestmentisdependentonanother,someattentionmustbegiven
tothequestionofwhetherdecisionsaboutthefrstinvestmentcanorshouldbe
madeseparatelyfromdecisionsaboutthesecond.
EconomicallyIndependentInvestments
InorderforinvestmentAtobeeconomicallyindependentofinvestmentB,two
conditionsmustbesatisfed.First,itmustbetechnicallypossibletoundertake
investmentAwhetherornotinvestmentBisaccepted.Forexample,itis
not
possibletobuildaschoolandashoppingcenteronthesamesite;therefore,the
proposaltobuildtheoneisnotindependentofaproposaltobuildtheother.Second,
thenetbeneftstobeexpectedfromthefrstinvestmentmustnotbeaffectedby
theacceptanceorrejectionofthesecond.Iftheestimatesofthecashoutlaysand
thecashinfowsforinvestmentAarenotthesamewhenBiseitheracceptedor
rejected,thetwoinvestmentsarenotindependent.Thus,itistechnicallypossibleto
buildatollbridgeandoperateaferryacrossadjacentpointsonariver,butthetwo
investmentsarenotindependentbecausetheproceedsfromonewillbeaffected
bytheexistenceoftheother.Thetwoinvestmentswouldnotbeeconomically
independentinthesenseofwhichweareusingtheterm,evenifthetraffcacrossthe
riveratthispointweresuffcienttoproftablyoperateboththebridgeandtheferry.
Sometimestwoinvestmentscannotbothbeacceptedbecausethefrmdoes
nothaveenoughcashtofnanceboth.Thissituationcouldoccuriftheamount
ofcashavailableforinvestmentswerestrictlylimitedbymanagementratherthan
bythecapitalmarket,orifincrementsoffundsobtainedfromthecapitalmarket
costmorethanpreviousincrements.Insuchasituation,theacceptanceofone
investmentmaycausetherejectionoftheother.Butwewillnotconsiderthetwo
investmentstobeeconomicallydependent.Toclassifythistypeofinvestmentas
dependentwouldmakeallinvestmentsforsuchafrmdependent,andthisisnota
usefuldefnitionforourpurposes.
EconomicallyDependentInvestments
Thedependencyrelationshipcanbeclassifedfurther.Ifadecisiontoundertake
thesecondinvestmentwillincreasethebeneftsexpectedfromthefrst(ordecrease
thecostsofundertakingthefrstwithoutchangingthebenefts),thesecondinvest-
mentissaidtobea
complement
ofthefrst.Ifthedecisiontoundertakethesec-
ondinvestmentwilldecreasethebeneftsexpectedfromthefrst(orincreasethe
costsofundertakingthefrstwithoutchangingthebenefts),thesecondissaid
tobea
substitute
forthefrst.Intheextremecasewherethepotentialbenefts
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AnIntroductiontoAccountingandManagerialFinance
PrerequisiteIndependentMutuallyexclusive
Strong
complement
Weak
complement
Weak
substitute
Strong
substitute
Fig.4.1.
InvestmentRelationships.
tobederivedfromthefrstinvestmentwillcompletelydisappearifthesecond
investmentisaccepted,orwhereitistechnicallyimpossibletoundertakethefrst
whenthesecondhasbeenaccepted,thetwoinvestmentsaresaidtobe
mutually
exclusive
.
Itmaybehelpfultothinkofthepossiblerelationshipsbetweeninvestmentsas
beingarrayedalongalinesegment(seeFig.4.1).Attheextremeleft,investment
AisaprerequisitetoinvestmentB.Inthecenteroftheline,investmentAis
independentofinvestmentB.Attheextremeright-handendoftheline,investment
AismutuallyexclusivewithrespecttoinvestmentB.Aswemovetotheright
fromtheleft-handsideoftheline,wehavevaryingdegreesofcomplementariness,
decreasingtotheright.Similarly,theright-handsideofthelinerepresentsvarying
degreesofsubstitutability,increasingtotheright.
StatisticalDependence
Itispossiblefortwoormoreinvestmentstobeeconomicallyindependentbut
statisticallydependent.Statisticaldependenceissaidtobepresentifthecash
fowsfromtwoormoreinvestmentswouldbeaffectedbysomeexternalevent
orhappeningwhoseoccurrenceisuncertain.Forexample,afrmcouldproduce
high-pricedyachtsandexpensivecars.Theinvestmentdecisionsaffectingthese
twoproductlinesareeconomicallyindependent.However,thefortunesofboth
activitiesarecloselyassociatedwithhighbusinessactivityandalargeamountof
discretionaryincomeforthe“rich”people.Thisstatisticaldependencemayaffect
theriskofinvestmentsintheseproductlines,becausetheswingsofproftability
ofafrmwiththesetwoproductlineswillbewiderthanthoseofafrmwithtwo
productlineshavinglessstatisticaldependence.
MeasuresofInvestmentWorth
Inthischapter,weintroducefourmethodsofevaluatingtheworthofinvestments
thatareincommonuseorhavebeenfrequentlyrecommendedasbeingdesirable.If
wetakeagroupofinvestmentproposalsandrankthembyeachofthesemethods,we
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CapitalBudgeting
61
shallfndthateachmethodwillfrequentlygiveadifferentrankingtothesameset
ofinvestmentproposals.Infact,itcanbesaidthatthedifferentmeasureswillonly
accidentallygiveidenticalrankingstoasetofinvestmentproposals.Althoughwe
shallnotbeabletorankeconomicallyindependentinvestmentsinausefulmanner,
weshallnormallybeabletomakedecisionswithoutsuchrankings.
Variousexecutivesfacedwiththesamesetofinvestmentpossibilities,butusing
differentmeasuresofinvestmentworth,willtendtomakedissimilarinvestment
decisions.Clearly,allthemeasuresthatwillbedescribedherecannotbeequally
valid.Weshallattempttodeterminewhichofthemeasureshavesomelegitimate
reasonforuseandtoisolatethecircumstancesunderwhichtheywilltendtogive
satisfactoryresults.
Incurrentbusinesspractice,eachofthemethodsselectedhasitsadvocates,
andfrequentlytheyareusedincombinationwitheachother.Becauseinvestment
proposalsarerarelyacceptedbytopmanagementsolelyonthebasisofsuchanal-
yses,itmaybearguedthatthechoiceofmethodisoflittlesignifcancebecause
theinvestmentdecisionislikelytobeinfuencedbymanydifferentfactors.Insofar
astheexecutivesmakingthefnaldecisionareawareoftherisksinvolved,are
intimatelyfamiliarwiththeproposals,knowthepossibletechnicaloroperating
problemsthatmaybeencountered,andrealizethepotentialerosionofearnings
resultingfromcompetitiveactionorchangingtechnology,thiscriticismmayvery
wellbevalid.Inmostlargeorganizations,however,itisimpossibleforthetop
managementoffcials,whomustfnallyapproveordisapproveinvestmentpropos-
als,tobeintimatelyfamiliarwiththedetailsofeachandeveryproposalpresented
tothem.Totheextentthatthisintimateknowledgeisimpossibleorimpractical,
theseexecutivesmustrelyupontheeconomicevaluationspreparedbytheirsub-
ordinates.Tomakereasonablechoicesinweighingalternativeinvestments,itis
increasinglynecessarythatvariousproposalsbeevaluatedasnearlyaspossible
onsomeuniform,comparablebasis.Insuchcircumstances,althoughthemeasure
ofeconomicworthofaninvestmentshouldneverbethesolefactorconsideredin
makingafnaldecision,itshouldplayanimportantpartintheevaluationofthe
investmentsunderconsiderationbythefrm.
Thefactthatvariousmeasuresgivedifferentrankingsandindicatedifferent
accept-or-rejectdecisionstoidenticalsetsofinvestmentproposalsisamatterof
concern.Substantialimprovementsineffciencyandincomemayresultifmoreade-
quatemeasurescanbediscoveredandwidelyadopted.Anysuchprogressrequires
frstamoregeneralagreementaboutthedesirablecharacteristicstobepossessed
byagoodindexoftheeconomicworthofaninvestment.Weassumethatthe
objectiveistomaximizethewell-beingofthecommonstockholders.
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AnIntroductiontoAccountingandManagerialFinance
IncrementalCashFlow
Investmentsshouldbeanalyzedusingafter-taxincrementalcashfows.Although
weshallinitiallyassumezerotaxessothatwecanconcentrateonthetechniqueof
analysis,itshouldberememberedthattheonlyrelevantcashfowsofaperiodare
afteralltaxeffectshavebeentakenintoaccount.
Thedefnitionofincrementalcashfowsisrelativelystraightforward:ifthe
transactionchangesthebankaccountorcashbalance,thereisacashfow.This
defnitionincludesopportunitycosts(thevalueofalternativeuses).Forexample,
ifawarehouseisusedforanewproductandthealternativeistorentthespace,the
lostrentalsshouldbecountedasanopportunitycostincomputingtheincremental
cashfows.
Itisgenerallyadvisabletoexcludefnancialtypesofcashfowsfromtheinvest-
mentanalysis.Onecommonerrorincashfowcalculationsistoincludeinterest
paymentsondebtinthecashfowsandthenapplythetime-discountingformulas.
Thisresultsindouble-countingthetimevalueofmoney.Thetimediscounting
takesinterestintoconsideration.Itisnotcorrecttoalsodeducttheinterestexpense
ofaninvestmentincomputingcashfows.
SpecialAssumptions
Thecomputationsofthischaptermakeseveralassumptionsthatareconvenient,
butarenotessential.Theysimplifytheanalysis.Theassumptionsare:
1.Capitalcanbeborrowedandlentatthesamerate.
2.Thecashinfowsandoutfowsoccuratthebeginningorendofeachperiod
ratherthancontinuouslyduringtheperiods.
3.Thecashfowsarecertain,andnoriskadjustmentisnecessary.
Inaddition,inchoosingthemethodsofanalysisandimplementation,itis
assumedthattheobjectiveistomaximizethewell-beingofstockholders,and
morewealthisbetterthanless.
TheElementsofaCashFlowProjection
Toarriveatthesetofprojectedincrementalcashfowsusedinevaluatingany
investment,itisusuallynecessarytoprojecttheimpactoftheinvestmentontherev-
enuesandexpensesofthecompany.Someinvestmentswillaffectonlytheexpense
components(i.e.,cost-savinginvestments),whereasotherswillaffectrevenuesas
wellascosts.Projectinghowvariousexpenseandrevenueitemswillbeaffected
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iftheinvestmentisundertakenisnotaneasytask,forincrementalimpactsare
oftendiffculttoassess.Insomecases,suchastheimpactofanewproducton
thesalesofanexistingproductthatisconsideredasubstitute,theproblemisthe
uncertainextentoftheerosion.Inothercases,suchaswithoverheaditems(e.g.,
accountingservices,plantsecurity,aregionalwarehousesystem),theproblem
arisesbecausethereisnotawell-defnedcashfowrelationshipbetweentheincre-
mentalactioncontemplatedandthesecosts.Noexactsolutionexiststotheseknotty
problems.
Aninvestmentinplantorequipmenttoproduceanewproductwillprobably
alsorequireaninvestmentincurrentassetslesscurrentliabilities(workingcapital).
Theremaybeanincreaseinrawmaterial,work-in-process,andfnishedgoods
inventories.Also,iftherearesalesoncreditratherthancash,accountsreceivable
willincrease;thatis,salespertheincomestatementwillbecollectedwithalag,and
therewillbeanincreaseinaccountsreceivable.Finally,notallpayableswillbepaid
immediately,andthislagwillmanifestitselfinanincreaseincurrentliabilities
(reducingtheneedforotherfnancing).Thus,aworkingcapitalinvestment(a
negativecashfowandaneedforcapital)usuallyaccompaniesthedirectinvestment
inplantandequipment.
Onecanassumethattheworkingcapitalinvestmentisfullyturnedintocash
atthehypothesizedendoftheproject.Thatis,itisassumedthatinventoriesare
depleted,receivablesarecollected,andpayablesarepaid.Hence,overthelifeofthe
project,thesumoftheworkingcapitalchangesshouldbezeroifthisassumption
isaccepted.However,thecommitmentofresourcestoworkingcapitalhasacost
(thetimevalueofmoney)evenifthoseresourcesareultimatelyfreed.
TwoDiscountedCashFlowMethods
Weshallfrstintroducethetwoprimarydiscountedcashfowinvestmentevaluation
procedures,netpresentvalue(NPV)andinternalrateofreturn(IRR).Afterabrief
discussionofthesetwomeasuresofinvestmentworth,weshalldescribeaseries
offourhypotheticalinvestments.Thefourhypotheticalinvestmentshavebeen
designedsuchthatfortwoselectedpairsitispossibletodecidethatoneinvestment
isclearlypreferabletotheother.Ifameasureofinvestmentworthindicatesthat
oneinvestmentisbetterwhentheotherinvestmentisactuallybetter,thenclearly
thereisadangerinusingthatmeasure.Weshallfndthatsomemeasurescan
easilybeeliminatedasgeneraldecisionrulesbecauseinsomesituationstheygive
obviouswronganswerswhereasanothermeasuregivesthe“right”answer.We
shallconcludethatthenetpresentvaluemethodisbetterthantheotherpossible
methods.
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NetPresentValue
Weoffertwoproposedmeasuresofinvestmentworththatasagroupcouldbe
calledthediscountedcashfow,orDCF,measures.Beforeproceedingtoanalyze
them,itisdesirabletoexplainagaintheconceptofthepresentvalueofafuture
sumbecauseinonewayoranotherthisconceptisutilizedinboththesemeasures.
Thepresentvalueof$100payableintwoyearscanbedefnedasthatquantity
ofmoneynecessarytoinvesttodayatcompoundinterestinordertohave$100in
twoyears.Therateofinterestatwhichthemoneywillgrowandthefrequencyat
whichitwillbecompoundedwilldeterminethepresentvalue.Weshallassume
thatinterestiscompoundedannually.Themannerinwhicharateofinterestis
chosenwillbediscussedlater.Forthepresent,assumethatwearegivena0.10
annualrateofinterest.Letusexaminehowthepresentvalueofafuturesumcan
becomputedbyusingthatrateofinterest.
Supposethataninvestmentpromisestoreturnatotalof$100attheendoftwo
years.Because$1.00investedtodayat10percentcompoundedannuallywould
growto$1.21intwoyears,wecanfndthepresentvalueat10percentof$100in
twoyearsbydividing$100by1.21orbymultiplyingbythepresentvaluefactor,
0.8264.Thisgivesapresentvalueof$82.64.Therefore,asumof$82.64thatearns
10percentinterestcompoundedannuallywillbeworth$100attheendoftwoyears.
Byrepeatedapplicationsofthismethod,wecanconvertanyseriesofcurrentor
futurecashpayments(oroutlays)intoanequivalentpresentvalue.Becausetables,
handcalculators,andcomputersareavailablethatgivetheappropriateconversion
factorsforvariousratesofinterest,thecalculationsinvolvedarerelativelysimple.
Thenetpresentvaluemethodisadirectapplicationofthepresentvalueconcept.
Itscomputationrequiresthefollowingsteps:(1)chooseanappropriaterateof
discount,(2)computethepresentvalueofthecashproceedsexpectedfromthe
investment,(3)computethepresentvalueofthecashoutlaysrequiredbythe
investment,and(4)addthepresentvalueequivalentstoobtaintheinvestment’snet
presentvalue.
Thesumofthepresentvalueoftheproceedsminusthepresentvalueofthe
outlaysisthenetpresentvalueoftheinvestment.Therecommendedaccept-or-
rejectcriterionistoacceptallindependentinvestmentswhosenetpresentvalueis
greaterthanorequaltozero,andtorejectallinvestmentswhosenetpresentvalue
islessthanzero.
Withzerotaxes,thenetpresentvalueofaninvestmentmaybedescribedasthe
maximumamountafrmcouldpayfortheopportunityofmakingtheinvestment
withoutbeingfnanciallyworseoff
.Withsuchapayment,theinvestorwouldbe
indifferenttoundertakingornotundertakingtheinvestment.Becauseusuallyno
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suchpaymentmustbemade,theexpectednetpresentvalueisanunrealizedcapital
gainfromtheinvestment,overandabovethecostoftheinvestmentusedinthe
calculation.Thecapitalgainwillberealizediftheexpectedcashproceedsmateri-
alize.Assumeaninvestmentthatcosts$10,000andreturns$12,100ayearlater.If
therateofdiscountis10percent,acompanycouldmakeamaximumimmediate
outlayof$11,000intheexpectationofreceivingthe$12,100ayearlater.Ifitcan
receivethe$12,100withanactualoutlayofonly$10,000,thenetpresentvalueof
theinvestmentwouldbe$1,000.The$1,000representsthedifferencebetweenthe
actualoutlayof$10,000andthepresentvalueoftheproceeds$11,000.Thecom-
panywouldhavebeenwillingtospendamaximumof$11,000toreceive$12,100
ayearlater.
Thefollowingexampleillustratesthebasiccomputationsfordiscountingcash
fows,thatis,adjustingfuturecashfowsforthetimevalueofmoney,usingthe
netpresentvaluemethod.
Assumethatthereisaninvestmentopportunitywiththefollowingcashfows:
Period
012
Cashfow
−
$12,337$10,000$5,000
Wewantfrsttocomputethenetpresentvalueofthisinvestmentusing0.10as
thediscountrate.TableAintheAppendixofthebookgivesthepresentvalueof
$1due
n
periodsfromnow.Thepresentvalueof
$1due0periodsfromnowdiscountedatanyinterestrateis1.000.
$1due1periodfromnowdiscountedat0.10is0.9091.
$1due2periodsfromnowdiscountedat0.10is0.8264.
Thenetpresentvalueoftheinvestmentisthealgebraicsumofthethreepresent
valuesofthecashfows:
(1)(2)(3)
PeriodCashFlowPresentValueFactorPresentValue
(col.1
×
col.2)
0
−
$12,3371.0000
−
$12,337
1$10,0000.9091$9,091
25,0000.82644,132
Netpresentvalue=$886
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AnIntroductiontoAccountingandManagerialFinance
Thenetpresentvalueispositive,indicatingthattheinvestmentisacceptable.
Anyinvestmentwithanetpresentvalueequaltoorgreaterthanzeroisacceptable
usingthissinglecriterion.Sincethenetpresentvalueis$886,thefrmcouldpayan
amountof$886inexcessofthecostof$12,337andstillbreakeveneconomicallyby
undertakingtheinvestment.Thenetpresentvaluecalculationisareliablemethod
forevaluatinginvestments.
InternalRateofReturn
Manydifferenttermsareusedtodefnetheinternalrateofreturnconcept.Among
thesetermsareyield,interestrateofreturn,rateofreturn,returnoninvestment,
presentvaluereturnoninvestment,discountedcashfow,investor’smethod,time-
adjustedrateofreturn,andmarginaleffciencyofcapital.Inthisbook,IRRand
internalrateofreturnareusedinterchangeably.
Theinternalrateofreturnmethodutilizespresentvalueconcepts.Thepro-
cedureistofndarateofdiscountthatwillmakethepresentvalueofthecash
proceedsexpectedfromaninvestmentequaltothepresentvalueofthecashout-
laysrequiredbytheinvestment.Sucharateofdiscountmaybefoundbytrial
anderror.Forexample,withaconventionalinvestment,ifweknowthecash
proceedsandthecashoutlaysineachfutureyear,wecanstartwithanyrate
ofdiscountandfndforthatratethepresentvalueofthecashproceedsandthe
presentvalueoftheoutlays.Ifthenetpresentvalueofthecashfowsispositive,
thenusingsomehigherrateofdiscountwouldmakethemequal.Byaprocessof
trialanderror,thecorrectapproximaterateofdiscountcanbedetermined.This
rateofdiscountisreferredtoastheinternalrateofreturnoftheinvestment,or
itsIRR.
TheIRRmethodiscommonlyusedinsecuritymarketsinevaluatingbonds
andotherdebtinstruments.Theyieldtomaturityofabondistherateofdis-
countthatmakesthepresentvalueofthepaymentspromisedtothebondholder
equaltothemarketpriceofthebond.Theyieldtomaturityona$1,000bond
havingacouponrateof10percentwillbeequalto10percentonlyifthecur-
rentmarketvalueofthebondis$1,000.Ifthecurrentmarketvalueisgreater
than$1,000,theIRRtomaturitywillbesomethinglessthanthecouponrate;
ifthecurrentmarketvalueislessthan$1,000,theIRRwillbegreaterthanthe
couponrate.
Theinternalrateofreturnmayalsobedescribedastherateofgrowthofan
investment.Thisismoreeasilyseenforaninvestmentwithonepresentoutlay
andonefuturebeneft.Forexample,assumethataninvestmentwithanoutlayof
$1,000todaywillreturn$1,331threeyearsfromnow.
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Thisisa0.10internalrateofreturn,anditisalsoa0.10growthrateperyear:
GrowthDividedby
Beginning-of-PeriodBeginning-of-Period
TimeInvestmentGrowthofPeriodInvestment
0$1,000$100$100/$1,000=0.10
11,100110$110/$1,100=0.10
21,210121$121/$1,210=0.10
31,331—
Theinternalrateofreturnofaconventionalinvestmenthasaninteresting
interpretation.Itrepresentsthehighestrateofinterestaninvestorcouldaffordto
pay,withoutlosingmoney,ifallthefundstofnancetheinvestmentwereborrowed
andtheloan(principalandaccruedinterest)wasrepaidbyapplicationofthecash
proceedsfromtheinvestmentastheywereearned.
Weshallillustratetheinternalrateofreturncalculationusingtheexampleof
theprevioussectionwheretheinvestmenthadanetpresentvalueof$886using
0.10asthediscountrate.
Wewanttofndtherateofdiscountthatcausesthesumofthepresentvalues
ofthecashfowstobeequaltozero.Assumethatourfrstchoice(anarbitrary
guess)is0.10.Intheprecedingsituation,wefoundthatthenetpresentvalueusing
0.10isapositive$886.Wewanttochangethediscountratesothatthepresent
valueiszero.Shouldweincreaseordecreasetherateofdiscountforoursecond
estimate?Sincethecashfowsareconventional(negativefollowedbypositive),to
decreasethepresentvalueofthefuturecashfows,weshouldincreasetherateof
discount(thuscausingthepresentvalueofthefuturecashfowsthatarepositive
tobesmaller).
Letustry0.20astherateofdiscount:
PeriodCashFlowPresentValueFactorPresentValue
0
−
$12,3371.0000
−
$12,337
1$10,0000.8333$8,333
25,0000.69443,472
Netpresentvalue=$532
Thenetpresentvalueisnegative,indicatingthatthe0.20rateofdiscountistoo
large.Weshalltryavaluebetween0.10and0.20forournextestimate.Assumethat
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AnIntroductiontoAccountingandManagerialFinance
wetry0.16:
PeriodCashFlowPresentValueFactorPresentValue
0
−
$12,3371.0000
−
$12,337
1$10,0000.8621$8,621
25,0000.74323,716
Netpresentvalue
=
$0
Thenetpresentvalueiszerousing0.16astherateofdiscount,whichbydefnition
meansthat0.16istheinternalrateofreturnoftheinvestment.
Althoughtablesgiveonlypresentvaluefactorsforselectinterestrates,calcu-
latorsandcomputerscanbeusedforanyinterestrate.
NetPresentValueProfle
Thenetpresentvalueprofleisoneofthemoreusefuldevicesforsummarizingthe
proftabilitycharacteristicsofaninvestment.Onthehorizontalaxis,wemeasure
differentdiscountrates;andontheverticalaxis,wemeasurethenetpresentvalue
oftheinvestment.Thenetpresentvalueoftheinvestmentisplottedforalldiscount
ratesfromzerotosomereasonablylargerate.Theplotofnetpresentvalueswill
crossthehorizontalaxis(havezeronetpresentvalue)attherateofdiscountthat
iscalledtheinternalrateofreturnoftheinvestment.
Figure4.2showsthenetpresentvalueproflefortheinvestmentdiscussed
intheprevioustwosections.Ifweaddthecashfows,assumingazerorateof
discount,weobtain
−
$12
,
337
+
$10
,
000
+
$5
,
000
=
$2
,
663
.
The$2,663istheintersectionofthegraphwiththe
Y
-axis.Weknowthatthegraph
hasaheightof$886ata0.10rateofdiscountandcrossesthe
X
-axisat0.16,since
0.16istheinternalrateofreturnoftheinvestment.Forinterestratesgreaterthan
0.16,thenetpresentvalueisnegative.
Notethatforaconventionalinvestment(minuscashfowsfollowedbypositive
cashfows),thenetpresentvalueprofleslopesdownwardtotheright.
Thenetpresentvalueproflegraphcanbeusedtoestimatetheinternalrateof
returnbyplottingonenegativevalueandonepositivevalueandconnectingthe
twopointswithastraightline.Theinterceptwiththe
X
-axiswillgiveasensible
estimate(nottheexactvalue)oftheinternalrateofreturn.
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2,663
886
00.100.16
Net present value
Net present value profile
Internal rate of return
Rate of discount
Fig.4.2.
NetPresentValueProflefortheInvestment.
Weshallnowconsiderfourdifferentinvestmentopportunitiesandwillapply
fourdifferentinvestmentcriteriatotheseinvestments.
FourInvestments
InTable4.1,fourhypotheticalinvestmentsaredescribedintermsoftheinitialcost
ofeachandthenetproceedsexpectedduringeachyearoflife.Thesalvagevalue
orterminalvalueofeachinvestmentisassumedtobezero.Weshallillustratethe
rankingthatmaybegiventotheseinvestmentsbyeachmeasureofinvestment
worthunderconsideration.
Toavoidcomplexities,wewillassumethattherearezerotaxesandnouncer-
tainty.Anevaluationoftheriskoruncertaintyassociatedwithaninvestmentis
acrucialpartoftheinvestmentdecisionprocess.Also,allinvestmentsmustbe
Table4.1.
CashFlowsofHypotheticalInvestments.
NetCashProceedsperYear
InvestmentInitialCostYear1Year2
A$10,000$10,000
B10,00010,000$1,100
C10,0003,7627,762
D10,0005,7625,762
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AnIntroductiontoAccountingandManagerialFinance
placedonanafter-taxbasis.Theconceptsofriskoruncertaintyandtaxationare
complex,however,andtheseproblemsareavoidedhere.
RankingbyInspection
Itispossibleincertainlimitedcasestodeterminebyinspectionwhichoftwoor
moreinvestmentsismoredesirable.Twosituationsinwhichthisistruearethe
following:
1.Twoinvestmentshaveidenticalcashfowseachyearthroughthefnalyearof
theshort-livedinvestment,butonecontinuestoearncashproceedsinsubse-
quentyears.Theinvestmentwiththelongerlifewouldbemoredesirable.Thus,
investmentBisbetterthaninvestmentA,becauseallfactorsareequalexcept
thatBcontinuestoearnproceedsafterAhasbeenretired.
2.Twoinvestmentshavethesameinitialoutlayandthesameearninglifeand
earnthesametotalproceeds.Ifattheendofeveryyear(duringtheirearning
life)thetotalnetproceedsofoneinvestmentareatleastasgreatas,andforat
leastoneyeararegreaterthan,thetotalfortheotherinvestment,thenthefrst
investmentwillalwaysbemoreproftable.Thus,investmentDismoredesirable
thaninvestmentC,becauseDearns$2,000moreinyear1thaninvestment
Cdoes;investmentCdoesnotearnthis$2,000untilyear2.Theearningof
$2,000moreintheearlieryearleadstotheconclusionthatinvestmentDis
moredesirablethaninvestmentC.
PaybackPeriod
Thepaybackperiodisoneofthesimplestandmostfrequentlyusedmethodsof
measuringtheeconomicvalueofaninvestment.The
paybackperiod
isdefned
asthelengthoftimerequiredforthestreamofcashproceedsproducedbyan
investmenttoequaltheoriginalcashoutlayrequiredbytheinvestment.Ifan
investmentisexpectedtoproduceastreamofcashproceedsthatisconstant
fromyeartoyear,thepaybackperiodcanbedeterminedbydividingthetotal
originalcashoutlaybytheamountoftheannualcashproceedsexpected.Thus,
ifaninvestmentrequiredanoriginaloutlayof$300andwasexpectedtopro-
duceastreamofcashproceedsof$100ayearforfveyears,thepaybackperiod
wouldbe$300dividedby$100,orthreeyears.Ifthestreamofexpectedpro-
ceedsisnotconstantfromyeartoyear,thepaybackperiodmustbedeterminedby
addinguptheproceedsexpectedinsuccessiveyearsuntilthetotalisequaltothe
originaloutlay.
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Ordinarily,theadministratorsetssomemaximumpaybackperiodandrejects
allinvestmentproposalsforwhichthepaybackperiodisgreaterthanthismaxi-
mum.Investigatorshavereportedthatmaximumpaybackperiodsoftwo,three,
four,orfveyearsarefrequentlyusedbyindustrialconcerns.Therelativelyshort
periodsmentionedsuggestthatdifferentmaximumpaybackperiodsarerequired
fordifferenttypesofinvestmentsbecausesomekindsofinvestments(construc-
tion,forexample)canseldombeexpectedtohaveapaybackperiodasshortas
fveyears.
Assumethatthepaybackperiodisalsousedtorankinvestmentalternatives,
withthosehavingtheshortestpaybackperiodsbeinggiventhehighestranking.
TheinvestmentsdescribedinTable4.1arerankedbythismethodinTable4.2.
Letuscheckthereasonablenessoftherankinggiventotheinvestmentsbythe
cashpaybackapproach.InvestmentsAandBarebothrankedas1becausethey
bothhaveshorterpaybackperiodsthananyoftheotherinvestments,namely,one
year.ButinvestmentAearnstotalproceedsof$10,000,andthisamountmerely
equalsthecostoftheinvestment.InvestmentB,whichhasthesamerankasA,will
earnnotonly$10,000inthefrstyearbutalso$1,100inthenextyear.Obviously,
investmentBissuperiortoA.Anyrankingprocedure,suchasthepaybackperiod,
thatfailstodisclosethisfactisdefcient.
ConsiderinvestmentsCandDmodifedsoastocost$11,524.Bothwould
begivenidenticalrankingsbecausebothwouldreturntheiroriginaloutlaybythe
endofthesecondyear.Thetwoinvestmentsareinfactsimilar,withthesingle
exceptionthatoutofidenticaltotalreturns,moreproceedsarereceivedinthefrst
yearandlessinthesecondyearfrominvestmentDthanisthecasewithC.Tothe
extentthatearningscanbeincreasedbyhaving$2,000availableforreinvestment
oneyearearlier,DissuperiortoinvestmentC,butbothwouldbegiventhesame
rankingbythepaybackperiodmeasure.
Thus,thecashpaybackperiodmeasurehastwoweaknesses:(1)itfailstogive
anyconsiderationtocashproceedsearnedafterthepaybackdate,and(2)itfails
Table4.2.
RankingofInvestments.
InvestmentPaybackPeriod(years)RankingCalculationsofPayback
A1.01
B1.01
C1.841
+
$6
,
238
$7
,
762
=
1
.
803
D1.731
+
$4
,
238
$5
,
762
=
1
.
736
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AnIntroductiontoAccountingandManagerialFinance
totakeintoaccountthedifferencesinthetimingofproceedsearnedpriortothe
paybackdate.Theseweaknessesdisqualifythecashpaybackmeasureasageneral
methodofrankinginvestments.Paybackisusefulasageneralmeasureofrisk(all
thingsbeingequal,a2-yearpaybackislessriskythana10-yearpayback).
ReturnonInvestment
Themethodsdescribedinthissectionarecommonlyreferredtoasrateofreturn
analysisorreturnoninvestment(ROI)analysis.Terminologyisaproblembecause
boththesetermsarealsousedtodescribeotherprocedures.Weshallconsistently
useinternalrateofreturnonlywhenwerefertoadiscountedcashfowcalculation,
andreturnoninvestmenttorefertoanincomedividedbyinvestmentcalculation.
Togetameasureofeffciency,analystsfrequentlyusetheratioofthefrm’s
incometothebookvalueofitsassets.Somecompaniesalsousethismeasureasa
meansofchoosingamongvariousproposedinternalinvestments.Whenthismea-
sureisused,theaverageincomeiscomputedafterdepreciation.Ifthedenominator
intheratioisthebookvalueoftheinvestment,thevalueofboththenumerator
andthedenominatorwilldependonthedepreciationmethodused.Analternative
procedureistodividetheaverageincomebythecostoftheinvestment(theaccrued
depreciationisnotsubtracted).
Theratioofincometobookvalueisacommonandusefulmeasureofperfor-
mance,butitislessusefulasadeviceforrankinginvestments.Table4.3showsthat
thesamerankingofoneisgiventoinvestmentsCandD,althoughDispreferable
toC.Thisprocedurefailstoranktheseinvestmentscorrectlybecauseitdoesnot
takeintoconsiderationthetimingoftheproceeds.
Table4.3.
AverageIncomeonBookValue.
Average
IncomeAverageIncome
AverageAverage(proceedslessBookonBook
InvestmentProceedsDepreciation
a
depreciation)Value
b
Value(%)Ranking
A$10,000$10,000$0$5,00004
B5,5505,0005505,000113
C5,7625,0007625,000151
D5,7625,0007625,000151
a
Assumingstraight-linedepreciation.
b
Investmentdividedby2.
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Table4.4.
AverageIncomeonCost.
AverageAverageIncome
InvestmentCostIncomeonCost(%)Ranking
A$10,000$004
B10,0005505.53
C10,0007627.61
D10,0007627.61
Analternativeprocedure(seeTable4.4)istodivideincomebythecostofthe
investment(accumulateddepreciationnotbeingsubtracted).Forpurposesofmea-
suringperformanceandcomputingreturnoninvestment,theuseofundepreciated
costwillgivelowermeasuresthanwilltheuseofbookvalue.Bothmeasuresillus-
tratedfailtotakeintoconsiderationthetimingofcashproceeds.Itisthisfailing
thatleadstoincorrectdecisionsfromtheuseofeitherofthetwomethods.
DiscountedCashFlowMethods
Wehaveconsideredpaybackandreturnoninvestmentasmethodsformeasuring
thevalueofaninvestment.PaybackindicatedthatBisasdesirableasA.ROI
indicatedthatCistiedwithD.ButBisclearlybetterthanA,andDisbetterthan
C.Onthebasisofsuchanexample,wehavebeenabletorejectpaybackandROI
asgeneralmethodsofevaluatinginvestments.
Thesetwomeasuresfailedtoconsiderthetimingofcashproceedsfromthe
investments.Thepaybackperiodrepresentsoneextremeinthisregardbecauseall
theproceedsreceivedbeforethepaybackperiodarecountedandtreatedasequal,
andalltheproceedsreceivedafterthepaybackperiodareignoredcompletely.
Withthereturnoninvestment,theproceedswererelatedbysimpleaveraging
techniquestosuchthingsastheoriginalcostoftheinvestmentoritsbookvalue.
Neitherofthesemethodssucceededinbringingthetimingofcashproceedsintothe
analysis.
Wehaveseenthatthemeasuresofinvestmentworththatwerepreviouslycon-
sideredmaygiveobviousincorrectresultsbecausetheyfaileithertoconsiderthe
entirelifeoftheinvestmentortoadequatelyconsiderthetimingoffuturecashpro-
ceeds.Thediscountedcashfowconceptprovidesamethodoftakingintoaccount
thetimingofcashproceedsandoutlaysovertheentirelifeoftheinvestment.
Wenowreturntothetwomeasuresofinvestmentworthalreadyintroducedthat
incorporatepresentvalueconcepts.
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AnIntroductiontoAccountingandManagerialFinance
Table4.5.
InternalRateofReturnoftheInvestments.
InvestmentIRR(%)Ranking
A04
B101
C9
a
3
D101
a
Approximatemeasure.
InternalRateofReturn
InTable4.5,weshowtheinternalrateofreturnforeachoftheinvestmentslistedin
Table4.1andtherankingofinvestmentsthatwouldresultifthismethodwereused.
Examinetherankingsgivenbythismethodapplicabletoeachpairofinvest-
mentsinthislistforwhichwewereearlierabletodeterminethemoredesirable
investmentofeachpair.Wepreviouslycomparedtwopairsofinvestmentsand
decidedthatinvestmentBwaspreferabletoA,andDtoC.Ineachcase,ifpref-
erencehadbeendeterminedbyusingtheinternalrateofreturnofaninvestment
method,thepairswouldbegiventhecorrectranking.Thisisthefrstmethodthat
wehaveusedthatgivesthecorrectrankingsofbothpairs:
A,0%C,9%
B,10%D,10%
NetPresentValue
NotetherankingsthatwillbegiventothehypotheticalinvestmentsofTable4.1
bythenetpresentvaluemethod,usingtwosampleratesofdiscount.InTable4.6,
Table4.6.
NetPresentValuesoftheInvestment—RateofDiscountis6Percent.
PresentValuePresentValueNetPresent
InvestmentofCashFlowofOutlayValueRanking
A$9,430$10,000
−
$5704
B10,41310,000
+
$4133
C10,45710,000
+
$4572
D10,56410,000
+
$5641
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Table4.7.
NetPresentValuesoftheInvestment—RateofDiscountis30Percent.
PresentValuePresentValueNetPresent
InvestmentofProceedsofOutlayValueRanking
A$7,692$10,000
−
$2,3083
B8,34310,000
−
$1,6571
C7,48710,000
−
$2,5134
D7,84210,000
−
$2,1582
wepresenttheresultsofusingthenetpresentvaluemethodanda6percentrate
ofdiscount.
Indiscussingthemeasuresofinvestmentworththatdonotusethediscounted
cashfowmethod,wepointedoutthattherelativerankingofcertainpairsofthese
fourinvestmentswasobvious.Thatis,itisobviousfromexaminingthecashfows
thatinvestmentBispreferabletoAandthatDispreferabletoC.Ineachcase,the
netpresentvaluemethodusinga6percentrateofdiscountrankstheseinvestment
pairsinthecorrectrelativeorder.
InTable4.7,thesameinvestmentsarerankedbythenetpresentvaluemethod
usinga30percentrateofdiscountinsteadof6percent.Therelativerankingof
investmentsCandDdoesnotchangewiththechangeintherateofdiscount.
InvestmentC,whichwasrankedsecondwhena6percentrateofdiscountwas
used,isrankedfourthwhenthe30percentdiscountrateisused.Therankingof
investmentDischangedfromfrsttosecondbythechangeintherateofdiscount.
Thehigherrateofdiscountresultsintheproceedsofthelateryearsbeingworth
lessrelativetotheproceedsoftheearlyyears;thus,therankingofBgoesfrom3
to1,butDisstillrankedaheadofC.
Evenwitha30percentrateofinterest,thepresentvaluemethodmaintains
thecorrectorderingofeachofthetwopairsofinvestmentsforwhichanobvious
preferencecanbedetermined.Thus,westillfndinvestmentBpreferredtoA,
andDpreferredtoC.Wheneveritispossibletodetermineobviouspreferences
betweenpairsofinvestmentsinthecorrectorder,nomatterwhatrateofdiscount
isusedtocomputethepresentvalue,aslongasthesamerateofdiscountisused
todeterminethepresentvalueofboththeinvestments,therankinggivenbythe
presentvaluemethodwillbecorrect.
SummaryofRankings
Therankingsgivenbyeachmeasureofinvestmentworthforeachofthehypothet-
icalinvestmentsdescribedinTable4.1aresummarizedinTable4.8.
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AnIntroductiontoAccountingandManagerialFinance
Table4.8.
SummaryofRankings.
Investment
MeasureofInvestmentWorthABCD
Paybackperiod1
a
1
a
43
Averageincomeonbookvalueorcost431
a
1
a
Internalrateofreturn41
a
31
a
Netpresentvalue
At6%4321
At30%3142
a
Indicatesatiebetweentwoinvestments.
ThemoststrikingconclusiontobedrawnfromTable4.8isthetendency
foreachmeasureofinvestmentworthtogiveadifferentrankingtotheidenti-
calsetofinvestments.Thisemphasizestheneedtogivecarefulconsiderationto
thechoiceofmeasuresusedtoevaluateproposedinvestments.Allfourmeth-
odscannotbeequallyvalid.Byconsideringspecifcpairsofinvestments,we
haveshownthatthemeasuresofinvestmentworththatdonotinvolvetheuse
ofthediscountedcashfowmethodcangiverankingsofinvestmentsthatare
obviouslyincorrect.Forthisreason,thesemeasureswillbeexcludedfromfurther
consideration.
Therankingsgiventotheinvestmentsbythenetpresentvaluemeasuresare
notidenticaltothatgivenbytheinternalrateofreturnofaninvestmentmeasure.
Neitheroftheserankingscanbeeliminatedasbeingobviouslyincorrect;yet,
becausetheyaredifferent,theycouldleadtocontradictoryconclusionsincertain
situations.
LimitationofInvestmentRankings
Inthischapter,wediscussedtherankingoffourinvestmentsandshowedthat,given
acarefullydefnedsetofinvestments,wecanmakedefnitestatementsaboutthe
relativedesirabilityoftwoormoreinvestments.Iftheinvestmentsarenotrestricted
tothisset,wewouldfndourabilitytorankinvestmentsverylimited.
Weshallnotaimfora“ranking”ofinvestments;instead,weshall:
1.Makeaccept-or-rejectdecisionsforinvestmentsthatareindependent(i.e.,ifwe
undertakeoneinvestment,thecashfowsofundertakingtheotherinvestment
arenotaffected).
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2.Choosethebestofasetofmutuallyexclusiveinvestments(i.e.,ifweundertake
one,eitherwewouldnotwanttoundertaketheotherorwewouldnotbeable
tobecauseofthecharacteristicsoftheinvestments).
Althoughtheobjectivesaresomewhatmoremodestthantheobjectiveof
rankinginvestments,weshallstillencounterdiffculties.Thereisnothinginour
recommendations,however,thatwillprecludeamanagerfromapplyingqualita-
tivecriteriatotheinvestmentsbeingconsideredtoobtainaranking.Therank-
ingthatissoobtainedislikelytobediffculttodefend.Fortunately,forawide
rangeofdecisionsituations,amanagercanmakedecisionswithoutarankingof
investments.
TheRollbackMethod
Usingasimplehandcalculator(onewherethereisnopresentvaluebutton),it
issometimesconvenienttousearollbackmethodofcalculationtocomputethe
netpresentvalueofaninvestment.Oneadvantageofthisprocedureisthatthe
presentvaluesatdifferentmomentsintimeareobtained.Considerthefollowing
investment:
TimeCashFlow
0
−
$7,000
1$5,000
22,300
31,100
Assumethatthediscountrateis0.10.
Thefrststepistoplacethecashfowofperiod3($1,100)inthecalculator
anddivideby1.10toobtain$1,000,thevalueattime2.Add$2,300anddivide
thesumby1.10toobtain$3,000,thevalueattime1.Add$5,000anddivideby
1.10toobtain$7,273,thevalueoftime0.Subtract$7,000toobtainthenetpresent
valueof$273.
WhereWeAre
Therearemanydifferentwaysofevaluatinginvestments.Insomesituations,several
ofthemethodswillleadtoidenticaldecisions.Weshallconsistentlyrecommend
thenetpresentvaluemethodastheprimarymeansofevaluatinginvestments.
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AnIntroductiontoAccountingandManagerialFinance
Thenetpresentvaluemethodensuresthatfuturecashfowsarebroughtback
toacommonmomentintimecalled
time0
.Foreachfuturecashfow,apresent
valueequivalentisfound.Thesepresentvalueequivalentsaresummedtoobtaina
netpresentvalue.Ifthenetpresentvalueispositive,theinvestmentisacceptable.
Thetransformationoffuturefowsbacktothepresentisaccomplishedusing
themathematicalrelationship
(
1
+
r)
−
n
,whichweshallcallthepresentvalue
factorfor
r
rateofinterestand
n
timeperiods.
Incasesofuncertainty,additionalcomplexitiesmustbeconsidered,butthe
basicframeworkofanalysiswillremainthenetpresentvaluemethod.
Today,almostalllargecorporationsuseoneormorediscountedcashfow
methods.NPVandIRRaretwoofthemorewidelyusedmethods.
However,ROI(withouttimediscounting)isalsoused,thoughitisnotrecom-
mendedinthisbookasamethodofevaluatingprospectiveinvestments.Ithasuse
asameansofevaluatingperformanceoncetheinvestmenthasbeenmade,ifitis
usedcarefully.
Conclusions
Aneffectiveunderstandingofpresentvalueconceptsisofgreatassistanceinthe
understandingofawiderangeofareasofbusinessdecisionmaking.Theconcepts
areespeciallyimportantinfnancialdecisionmaking,sincemanydecisionsreached
todayaffectthefrm’scashfowsoverfuturetimeperiods.
Itshouldbestressedthatthischapterhasonlydiscussedhowtotakethetiming
ofthecashfowsintoconsideration.Thislimitationinobjectiveshouldbekept
inmind.Riskandtaxesmuststillbeconsideredbeforethereal-worlddecision
makerhasatoolthatcanbeeffectivelyapplied.Inaddition,theremaybequali-
tativefactorsthatmanagementwantstoconsiderbeforeacceptingorrejectingan
investment.
Itissometimesstatedthatrefnementsincapitalbudgetingtechniquesare
awasteofeffortbecausethebasicinformationbeingusedissounreliable.Itis
claimedthattheestimatesofcashproceedsareonlyguessesandthattouseanything
exceptthesimplestcapitalbudgetingproceduresisasfutileasusingcomplicated
formulasorobservationsofpastmarketlevelstodeterminewhichwaythestock
marketisgoingtomovenext.
Itistruethatinmanysituationsreliableestimatesofcashproceedsarediffcult
tomake.Fortunately,therearealargenumberofinvestmentdecisionsinwhich
cashproceedscanbepredictedwithafairdegreeofcertainty.Butevenwithan
accurate,reliableestimateofcashproceeds,thewrongdecisionisfrequentlymade
becauseincorrectmethodsareusedinevaluatingthisinformation.
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Whenitisnotpossibletomakeasingleestimateofcashproceedsthatiscertain
tooccur,itdoesnotfollowthatincorrectmethodsofanalysisarejustifed.Ifthe
investmentislarge,theuseofacarefulandcomprehensiveanalysisisjustifed,
evenifthismeansthattheanalysiswillbemorecomplicatedandcostly.Withsmall
tacticalinvestments,somewhatlessinvolvedmethodsmightbeused,butagain,
thereisnoneedtouseinferiormethodsthatdecreasethelikelihoodofmaking
correctinvestmentdecisions.
Whenallthecalculationsarecompleted,judgmentalinsightsmaybeincluded
intheanalysistodecidewhethertoacceptorrejectaproject.
ReviewProblems
ReviewProblem4.1
Assumethatafrmhasacostofmoneyof0.15.Itisconsideringaninvestment
withthefollowingcashfows:
TimeCashFlow
0
−
$27,000,000
1
+
$12,000,000
2
+
$11,520,000
3
+
$15,552,000
Shouldtheinvestmentbeaccepted?
SolutiontoReviewProblem4.1
Thenetpresentvalueusing0.15asthediscountrateis:
TimeCashFlowPresentValueFactorPresentValue
0
−
$27,000,0001.15
−
0
−
$27,000,000
1
+
$12,000,0001.15
−
1
$10,435,000
2
+
$11,520,0001.15
−
2
8,711,000
3
+
$15,552,0001.15
−
3
10,226,000
Netpresentvalue
=
$2,372,000
Thenetpresentvalueispositiveandtheinvestmentisacceptable.Theinternal
rateofreturnis0.20.
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AnIntroductiontoAccountingandManagerialFinance
QuestionsandProblems
1.Computethenetpresentvalueforeachofthefollowingcashfows.Assumea
costofmoneyof10percent.
Period
Investment012345
A$(1,000)$100$100$100$100$1,100
B(1,000)264264264264264
C(1,000)1,611
2.Computetheinternalrateofreturnforeachofthecashfowsin
Problem1.
3.ComputethepaybackforeachofthecashfowsinProblem1.Ifthemaximum
acceptablepaybackperiodisfouryears,which(ifany)ofthecashfowswould
beacceptedasadesirableinvestment?
4.Assumeacostofmoneyof5percent.Computethenetpresentvaluesofthe
cashfowsinProblem1.
5.Assumeacostofmoneyof15percent.Computethenetpresentvaluesofthe
cashfowsinProblem1.ComparewiththeresultsobtainedfromProblems1
and4.
6.TheArrowCompanyisconsideringthepurchaseofequipmentthatwillreturn
cashproceedsasfollows:
EndofPeriodProceeds
1$5,000
23,000
32,000
41,000
5500
Assumeacostofmoneyof10percent.
Whatisthemaximumamountthecompanycouldpayforthemachineand
stillbefnanciallynoworseoffthanifitdidnotbuythemachine?
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81
7.a.Aninvestmentwithaninternalrateofreturnof0.25hasthefollowingcash
fows:
TimeCashFlow
0C
0
1
+
$8,000
2
+
$10,000
ThevalueofC
0
is
.
b.Ifthefrmfnancedtheinvestmentin(a)withdebtcosting0.25,thedebt
amortizationtable(usingthefundsgeneratedbytheinvestmenttorepay
theloan)wouldbe:
TimeAmountOwedInterestPrincipalPayment
0
1
2
8.Computethenetpresentvalue(useacostofmoneyof0.15)andtheinternal
rateofreturnforeachofthefollowinginvestments:
Period
Investment012
A$(1,000)$1,322
B(1,000)$615615
C(1,000)1,150
9.Recomputethenetpresentvaluesusing(a)acostofmoneyof0.20and(b)a
costofmoneyof0.05foreachoftheinvestmentsinProblem8.
10.Prepareascheduleshowingthat,witharateofgrowthof0.15peryear,$1,000
willgrowto$1,322intwoyears.
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AnIntroductiontoAccountingandManagerialFinance
11.Determinetheinternalrateofreturnofthefollowinginvestment:
TimeCashFlow
0
−
$12,800
1
+
$8,000
2
+
$10,000
12.Howmuchcouldyoupayinexcessoftheindicatedcostfortheinvestmentin
Problem11ifthecostofmoneywere0.10?
13.AssumethatyoucanonlyinvestinoneofthethreeinvestmentsinProblem8.
a.Usingtheinternalratesofreturnonthethreeinvestments,whichis
preferred?
b.Usingthenetpresentvaluemethodandacostofmoneyof0.05,whichis
preferred?
14.Acompanyusesa10percentdiscountrate.Assumeequalannualcash
proceeds.
Whatshouldbethemaximumacceptablepaybackperiodforequipment
whoselifeis5years?Whatarethemaximumacceptablepaybacksforlives
of10,20,and40yearsandinfnitelife?
15.Assumethatthediscountrateis5percentandanswerProblem14.
16.Assumethat
r
=
0
.
06.Anewmachinethatcosts$7,000hasequalannualcash
proceedsoveritsentirelifeandapaybackperiodof7.0years.
Whatistheminimumnumberoffullyearsoflifeitmusthavetobeaccept-
able?
17.Computetheinternalrateofreturnofthefollowinginvestments:
Period
Investment0123
A
−
$10,000$4,747$4,747$4,747
B
−
$10,00017,280
Comparethetwoinvestments.
Whichdoyouprefer?Areyoumakinganyassumptionaboutthereinvest-
mentofthecashfows?
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83
18.Determinetheinternalrateofreturnofthefollowinginvestment:
PeriodCashFlow
0
−
$15,094
1$10,000
210,000
31,000
19.TheSuperCompanyusedaROFE(returnonfundsemployed)methodof
evaluatinginvestments.Theincomeofeachperiodisdividedbytheaverage
assetsusedduringtheperiod.Thisisdoneforeachperiodandthenanaverage
ROFEiscomputedofalltheROFEs.
ThecontrolleroftheSuperCompanydefendstheproceduresinceitis
consistentwiththeperformanceevaluationproceduresthatareusedafterthe
investmentisacquired.
Thecompanyiscurrentlyevaluatingtwoinvestments(AandB).
012
A
−
$20,000
+
$11,000
+
$12,100
B
−
$20,000
+
$12,100
+
$11,000
AB
Year1Year2Year1Year2
Revenue$11,000$12,100$12,100$11,000
Depreciation10,00010,00010,00010,000
Income$1,000$2,100$2,100$1,000
Averageinvestment15,0005,00015,0005,000
ROFE0.0670.4200.1400.200
AverageROFE0.240.17
Thefrmrequiresa0.20returnforaninvestmenttobeacceptable.Thefrm
acquiredinvestmentA.
Whichinvestmentismoredesirable?
20.TheABCCompanyhasdeterminedthatitscostofmoneyis0.12.However,
becauseofaseriesofnecessarynonproductive(notgeneratingcashfows)
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AnIntroductiontoAccountingandManagerialFinance
investments,ithasfoundthatontheaverageadiscretionaryinvestmentmust
earn0.15inorderforthefrmtobreakeven.
Thefrmhasachancetoundertakeaninvestmentthathasaninternalrate
ofreturnof0.14andnorisk.Thisinvestmentwillalsonotaffecttheamount
ofnonproductiveinvestmentsneeded.
Shouldtheinvestmentbeaccepted?
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Chapter5
TheIncomeStatement
Themeasurementofincomeisoneofthemostimportantfunctionsoffnancial
accounting.Investors,managers,bankers,andothersareinterestedinknowinghow
wellthecorporationisdoing.Inthischapter,wewilldiscusstheproceduresfor
recordingtransactionsforincomedeterminationandthebasicassumptionsrelating
toincomemeasurement.
TheRevenueTransaction
Thesaleofgoodsorservicestocustomersiscalleda
revenuetransaction
.A
revenuetransactionusuallyinvolvesanincreaseinanasset,suchascashoraccounts
receivable,torecognizetheamountreceivedorduefromcustomersbecauseofa
saleofgoodsorservices.
Stockholdersdonotbenefttothefullextentofthesalesamount.Expenses
relatedtothesalemustberecognizedasreducingoroffsettingtheimpactofrevenue
transactionsonstockholders’equity.Forexample,anexpenseforthecostofthe
merchandisedeliveredtocustomersissubtractedfromrevenuetocalculatethenet
benefttostockholders.
Toillustratearevenuetransaction,assumethatmerchandisecosting$30,000
issoldonacustomer’saccountfor$50,000inJanuary.Alsoassumethatwagesof
$5,000wereearnedandpaidtoemployeesduringJanuary.
Asaresultofthesetransactions,thefollowingchangeswouldoccurinbalance
sheetaccounts.AReceivablesaccountwouldincreaseby$50,000,theamount
owedtothecompanybyacustomer.TheCashaccountwoulddecreaseby$5,000,
theamountpaidtoemployees.TheMerchandiseaccountwoulddecreaseby
$30,000,andtheRetainedEarningsaccountwouldincreaseby$15,000,thenet
benefttostockholdersofthesale.Thetwosidesofthebalancesheetwouldstill
85
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AnIntroductiontoAccountingandManagerialFinance
beinbalance,asmaybeseenfromthefollowingsummaryofchanges:
AssetsStockholders’Equities
Receivable
+
$50,000RetainedEarnings
+
$50,000
Merchandise
−
$30,000RetainedEarnings
−
$30,000
Cash
−
$5,000
RetainedEarnings
−
$5,000
NetChange
+
$15,000
NetChange
+
$15,000
Revenues
aremeasuredbythemonetaryvalueoftheassetsreceived(orreduc-
tionofliabilities)inreturnforgoodsandservicesthataresold.Thedecreasesin
theassetsassociatedwithobtainingtherevenues(e.g.,thecostofthemerchandise
soldandthecostofwagesduringtheperiod)arecalled
expenses
.Thediffer-
encebetweentherevenuesofaperiodandtheexpensesassociatedwithearning
thoserevenuesiscalled
income
iftherevenuesexceedtheexpenses,or
loss
ifthe
expensesexceedtherevenues.Theterms“revenues”and“income”shouldnotbe
usedinterchangeably.
Iftherearenodistributionsofincometothestockholdersduringaperiod,
theRetainedEarningsbalancewillincreasebytheamountoftheincome.In
theforegoingexample,theincomewas$15,000andtheRetainedEarnings
balanceincreasedbythesameamount.Iftherehadbeenalossduringtheperiod
(i.e.,expensesexceededrevenues),theRetainedEarningsbalancewouldhave
decreased.AnegativebalanceintheRetainedEarningsaccountiscalleda
defcit
.
AccrualAccounting
Inthepreviousexample,areceivablewasrecordedtoshowthatamountswereowed
totheenterpriseforthemerchandisesold.Recordingthisreceivablepermitsthe
recognitionofrevenueswhentheyhavebeenearned(becausethesaleoccurred),
withoutregardtowhethercashpaymentsarereceived.
Now,supposethatinthepreviousexamplethewageshadnotactuallybeen
paidtoemployeesinJanuary,eventhoughtheyhadearned$5,000fortheservices
theyperformed.Inthiscase,anexpenseandaliabilitywouldberecordedtoshow
thatamountswereowedtotheemployees.Expensesarerecognizedwhenthey
havebeenincurred(becausetheserviceswereperformed),withoutregardtowhen
paymentsaremade.
Therecognitionofrevenueswhentheyhavebeenearnedandexpenseswhen
theyhavebeenincurredisreferredtoas
accrualaccounting
.Theuseofaccrual
accountingresultsinrecordingreceivablesandliabilities,withnoimmediateeffect
oncash.
Theuseofaccrualaccountingcanalsoresultintherecognitionofexpenses
whenassetsexpireorareusedup(orconsumed)duringaperiod.Forexample,if
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TheIncomeStatement
87
annualrentof$36,000ispaidonJanuary1,thisamountcouldinitiallyberecorded
asanasset,prepaidrent.However,bytheendofJanuary,one-twelfthoftheprepaid
renthasexpired.Asaresult,thePrepaidRentaccountbalanceshouldbecredited
by$3,000andrentexpenseshouldbedebitedby$3,000.
Assetswithlongerlivesaretreatedinasimilarmanner.Forexample,ifa
companypurchasesatruckfor$24,000thatisexpectedtobeusedforfveyears,
theinitialcostofthetruckwouldberecordedasanasset.Asthetruckisused,
however,wemayassumethatone-sixtiethoftheinitialcost,or$400,expireseach
monthandthusbecomesanexpense.Recognitionofthecostsoflong-livedassets
thatexpireinaperiodisreferredtoas
depreciationaccounting
.Depreciationis
anexpensethatreducestheaccountingmeasureoftheassetbeingdepreciatedand
reducesincome.
Toillustratetherecognitionofexpensesbyaccrualaccounting,letusextend
theprecedingexample.Supposethatinadditiontothefactspresentedpreviously
(merchandisecosting$30,000wassoldoncustomeraccountfor$50,000andpay-
mentsforwagestotaled$5,000),wearegiventhefollowinginformation.Renton
thestorebuilding,$36,000fortheyear,waspaidonJanuary1.Atruckusedto
makedeliverieshadoriginallycost$24,000andwasexpectedtolastforfveyears.
Inadditiontotheworkforwhichtheywerepaid,employeesperformedservices
duringthemonthforwhichtheywillbepaid$2,500nextmonth.
Torefectthisinformation,wewoulddecreasetheasset,prepaidrent,by
$3,000($36,000/12months);decreasetheasset,deliverytruck,by$400($24,000/
60months);andincreasetheliability,wagespayable,by$2,500.Thesechanges
wouldbeaccompaniedbyadecreaseinretainedearnings.Thebalancesheetwould
beaffectedasshowninthefollowingsummaryofchanges:
AssetsLiabilitiesandStockholderEquity
Receivable
+
$50,000RetainedEarnings
+
$50,000
Merchandise
−
$30,000RetainedEarnings
−
$30,000
Cash
−
$5,000RetainedEarnings
−
$5,000
PrepaidRent
−
$3,000RetainedEarnings
−
$3,000
DeliveryTruck
−
$400RetainedEarnings
−
$400
WagesPayable
+
$2,500
RetainedEarnings
−
$2,500
NetChange
+
$11,600
NetChange
+
$11,600
Thenetincomeof$9,100,showninthesummaryincomestatementforJanuary,
isequaltothechangeinretainedearningsforthemonth.Thestockholders’interests
wereincreasedbythenetdifferencebetweenthesalesrevenuesandtheexpenses
recognizedduringthemonth.
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AnIntroductiontoAccountingandManagerialFinance
RecordingRevenueTransactionsUsingTemporaryAccounts
Uptothispoint,therevenuesandexpenseshavebeenrecordedusingonlyasset
andequityaccounts.Newaccountsarenowintroducedinwhichtherevenues
andexpensesarerecordedandaccumulatedseparately.Theaccountsarecalled
temporary
becausetheydonotappearonthebalancesheet.Thus,theymustbe
eliminatedwheneverabalancesheetisprepared.
Revenueandexpenseaccountscomeintobeingbecauseofpracticalconsider-
ations.Imaginethenuisanceifeverytimewerecordedasalewehadtorecordthe
expenseofmakingthatsale.Thediffcultyisavoidedbyusingtemporaryaccounts
torecordtherevenuesandexpensesratherthancomputingtheincomeofeach
individualsale.Salesmaybegroupedtogetherandtheresultsoftheoperationsof
atimeperiod(month,quarter,year,andsoforth)determined.Inspecialsituations
wherethesalesconsistofitemswithalargedollarvalueperunit,theproftofthe
individualsalemaybedetermined,buttheseareexceptionalcases.
Expenseaccountsarealsousefulinanalyzingeffciencyandcontrollingcosts.
Theyperformthefunctionofaccumulatinginformationabouttheamountofthe
coststhathaveexpiredintheproductionoftherevenues.Anexpensemayormay
notbeaccompaniedbyanexpenditureofcash.Thesaleseffortconnectedwith
makingasalebecomesanexpenseeventhoughthesalespersonhasnotyetbeen
paid.Thesameistrueofelectricity,rent,supplies,andothersimilaritems.
Example
AssumethattheopeningbalancesofthefollowingT-accountsrefectthefnancial
positionoftheSampleCompany(thebalancesareindicatedbychecks
√
).The
transactionnumbered(1)recordsthesaleforcashof$100ofmerchandisethat
costthecompany$60.Theonlyotherexpenseistheexpirationof$15ofprepaid
rent.Entries(2)and(3)recordtheexpenses.First,thetransactionwillberecorded
usingonlyassetandequityaccounts.
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
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89
Thisisthewayinwhichwehavebeenrecordingrevenuetransactionsuntilnow.
EnteringtheamountsofrevenuesandexpensesdirectlyintheRetainedEarnings
accountenablesustodeterminetheamountofstockholders’equityasofany
specifctime,butitdestroyssomeveryvaluableinformation.Sincewewantto
knowthevariouscomponentsofrevenueandexpenseforeachaccountingperiod,
itisimportanttomaintainrecordsoftheseamountsintheaccountingsystem.
TemporaryAccounts
Thisinformationcanbepreservedduringaspecifcaccountingperiodbysettingup
temporaryaccountstokeeptrackofrevenuesandexpenses.Wecanregardthese
temporaryaccountsasbeingatemporarysubdivisionoftheRetainedEarnings
account.Wewillcreate
revenue
accountstorecordeachitemofrevenue:sales,
interestrevenue,rentrevenue,andsoforth.Asrevenueshavetheeffectofincreas-
ingretainedearnings,theseaccountsareincreasedinthesamewayasretained
earnings—theyareincreasedbycredits,andtheyaredecreasedbydebits.
Revenue Accounts
DecreaseIncrease
Similarly,wewillcreate
expense
accountstorecordeachitemofexpense:
wagesexpense,rentexpense,merchandisecostofgoodssold,andsoon.As
expenseshavetheeffectofdecreasingretainedearnings,theseaccountsare
increasedbydebitsanddecreasedbycredits.
Expense Accounts
IncreaseDecrease
PeriodicAdjustments
Inpreviousillustrations,wehavedemonstratedsomeoftheaccountingentries
thatwouldbeusedtoadjusttheaccountsattheendofanaccountingperiod.For
example,theadjustmentofprepaidrenttorefecttheremainingbalanceattheend
oftheyearwasshown.Thisadjustmentnotonlyprovidesfortheproperbalance
intheassetaccount,butalsoresultsinthepropermeasureofrentexpenseforthe
year.Similarly,entrieswouldbemadefortheproperstatementoftheassetbalance
ofmerchandiseinventoryandalsoforthedeterminationofcostofgoodssold.
Theseentries,whicharemadetobringassetandequityaccounts,aswellas
revenueandexpenseaccounts,intoagreementwiththefactsasofthedateofan
accountingreport,arecalledadjustingentries.Attheendofeachaccountingperiod,
therewillbesomeaccountsforwhichthebalancesrequireadjustment.Although
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theremaybenoexplicittransactionatthetime,theaccountantneverthelesswill
recordanentrytoadjusttheaccountstotheirproperbalances,sothatthefnancial
statementspreparedatthattimewillprovideafairpresentation.
TheIncomeStatement
Theincomestatementshowstheresultsofoperationsforaperiodoftime.Whereas
thebalancesheetis“asof”aparticularmoment,theincomestatementis“forthe
periodending.…”Theperiodoftimemaybeayearoranyfractionofayear,
butitisaperiodoftimeratherthanamomentintime.Itisessentialthattheincome
statementdisclosetheexactperiodcovered,becausethelengthoftheperiodisa
basicelementoftheinterpretationofincome.Forexample,agivenincomeforone
monthwouldhaveafardifferentsignifcancethanthesameincomeforayear.
Theincomestatementcomparestherevenuesoftheperiodwiththeexpenses
thatwereincurredtogainthoserevenues.Thedifferencebetweentherevenuesand
expensesisgenerallydefnedastheincomefortheperiod:
Revenues
−
Expenses
=
Income
.
RevenueRecognition
Theaccountantdeterminesincomebysubtractingexpensesfromrevenues.As
simpleasthismayseem,therearemanycomplexitiesthatarisewhentryingto
implementthisconcept.Forexample,therearemanyactivitiesandeventsthat
musttakeplacetogeneraterevenues.Theaccountantadoptstheprocedureof
recognizingrevenuesatthetimeacertain
criticalevent
takesplace.Butwhich
eventisimportantenoughtojustifytherecognitionofrevenue?Dependingonthe
situation,thereareseveralacceptablemethodsofrevenuerecognition,butonly
threewillbediscussedhere.
Productionbasis
—recognizerevenueattimeofproduction.
Sales
(
oraccrual
)
basis
—recognizerevenueattimeofsale.
Cashreceiptsbasis
—recognizerevenueattimecashisreceived.
ProductionBasis
Productionisthecriticaleventforcompaniesthatproduceorconstructassets
underlong-termproductionorconstructioncontracts.BoeingAerospacedidnot
buildtheBoeing747and767aircraftstoopenstock.Instead,theseaircraftsare
builttocustomerspecifcationsunderproductioncontracts.Thesecontractsspecify
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whothecustomerisandtheamountsandtimingsofcashfows.Asaresult,the
contractsreducetheuncertaintyofthesaleandcashreceiptsevents.Companies
thatproducetoorderunderproductionorconstructioncontractsoftenattempt
tospreadprospectiverevenues,relatedcosts,andresultingnetincomeoverthe
lifeofthecontractinproportiontotheworkaccomplished.Themethodusedto
accomplishthisspreadingofrevenues,costs,andincomeiscalledthepercentage-
of-completionorproductionmethod.
SalesBasis
Thesales(oraccrual)basisisthemostwidelyusedmethodforrecognizingrev-
enues.Revenuesareassumedtobeearnedatthetimethesaleismade,eventhough
thecashmaynothavebeencollectedfromcustomers.Forcompaniesthatproduce
toopenstock,thesaleisthecriticaleventforrevenuerecognition.Eventhough
valueisaddedtogoodsthroughtheproductionprocess,thesecompaniesfacecon-
siderableuncertaintyaboutwhothecustomerwillbeandabouttheamountand
timingofthesale.Itisnecessarytohavean
arm’slengthtransaction
,inwhichthe
customerislegallyobligatedtopayforthemerchandiseorservice.Suchfactors
asthesigningofasalescontractandthedeliveryoftheproductprovideevidence
thatthesalehasbeenmade.Atthetimeofthesale,revenueisrecognizedandthe
amountduefromthecustomerisrefectedasanassetsuchasaccountsreceivable.
However,someuncertaintystillremainsaboutcashreceipt.Companiesthat
usethesalesmethodmustalsobeabletoestimatebaddebtsordoubtfulaccounts
atthetimeofthesalesothatthesalesamountsandaccountsreceivablebalances
canbeadjustedtorefecttheexpectedcashreceipts.
CashReceiptsBasis
Insomecases,thereceiptofcashisconsideredtobethecriticaleventforrevenue
recognition.Therearethreereasonsforusingthecashreceiptsbasis.First,forsome
taxpayers,theuseofthecashreceiptbasisisallowableforcomputingtaxable
incomeandmayresultinsomepostponementoftaxpayments.Second,when
collectionfromcustomersisregardedasveryuncertain,thecashreceiptsbasis
maybethebestindicationofactualrevenues.Finally,thecashreceiptsbasisis
moreconservativethanthesalesbasis.Itisimportanttorealizethatwhenthe
cashreceiptsbasisofrevenuerecognitionisused,theproductmustalsohavebeen
deliveredtocustomersbeforerevenueisrecognized.Thus,ifcashisreceivedin
advance(suchaswithmagazinesubscriptions),thereceiptofcashwouldnotbe
consideredsuffcientevidenceforrecognizingrevenue.
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ExpenseRecognition—TheMatchingConcept
Eithertheproduction,sales,orcashreceiptsmethodcanbeusedtoassignrevenues
toperiodsoftime.Expenserecognitioninvolvesassigningormatchingexpenses
toperiodsoftime.Someexpensesarecloselyrelatedtotherevenuesassignedto
periodsoftime.Forexample,thecostsofgoodssoldduringaperiodrefectthe
costsofmaterials,labor,andmanufacturingoverheadincurredtoproduceunitsof
productthatweresold.Thesecostsarecalledproductexpenses.Otherexpensesare
closelyrelatedtotheperiodsoftimetowhichrevenuesareassigned.Forexample,
costsareincurredtomaintainasalesandmarketingorganization,aresearchand
developmentcapability,andageneraladministrativeorganization.Thesecostsare
calledperiodexpenses,becausetheyarecloselyrelatedtotheperiodsduringwhich
theseorganizationsandcapabilitiesexist.
Whentorecognizecostsasexpensesisoneofthemostperplexingproblemsthe
accountantfaces.Itiseasiertodescribewhatshouldnotbedonethantodescribe
whatshouldbedone.Forexample,whetherthecostshavebeenpaidforwitha
disbursementofcashhaslittletodowiththedeterminationofwhethertheyshould
berecognizedasexpenses.Thus,theelectricityconsumedinlightingastoreis
anexpenseoftheperiodinwhichtheelectricityisused,eventhoughtheelectric
billhasnotyetbeenpaid.Thatis,theelectricityexpenseisaperiodexpense.If
theelectricityisusedtorunamachineinproducingaproduct,thenthecostof
theelectricitybecomesapartofthecostoftheproductandisnotconsideredan
expenseuntiltheproductissold.Thatis,theelectricitycostisacostofproduct,
whichbecomesaproductexpensewhentheproductissold.
Laborcostsina
manufacturingsituation
areconsideredtobeanassetuntilthe
productthatwasproducedissold.Theybecomepartofthecostofinventoryand
areonlyregardedaspartofthecostofgoodssoldwhentheproductissold(product
expense).However,laborcostsina
merchandisingsituation
aregenerallyconsid-
eredtobeexpensesatthetimetheyareincurred(periodexpenses),andthestepof
frstrecognizingthesecostsasassetsisbypassed.Thisisnotharmful,becausethe
laborcostsofamerchandisingcompanywouldonlyrarelybeconsideredunexpired
attheendoftheperiod.
Theguidingruleisthatexpensesshouldbematchedwiththerevenuesthatthey
helptoearnorgenerate.Costsbecomeexpenseswhentheirfutureservicepotential
expires,andthisnormallyoccursastherevenuesareearned.Forexample,thecost
ofabuildingischargedtoexpenseoveritsusefullife.Theexpenseassociatedwith
allocatingtheoriginalcostofbuildingsandequipmenttotheperiodsinwhichthey
areusediscalleddepreciationexpense.
Occasionally,anassetlosesvaluewithouthavingproducedanyrevenue.Exam-
plesofthistypeofeventincludethedestructionofabuildingbyfreorthetheftof
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cash.Situationsofthisnaturearedescribedas
losses
.Alossoccurswhenanasset
losesallorpartofitsvaluewithoutprovidingcompensatingeconomicbenefts.
Anyinsuranceproceedswouldreducetheamountsoftheselosses.
Frequently,theaccountantwillnottakenoteofthefactthatanitemisanasset
beforerecognizingthatitisanexpense.Wheretheassetlosesvalueandbecomes
anexpenseinthesameperiodinwhichthecompanyacquiresit,noerrorresults
anditdoessavesomebookkeepingeffort.Inothercases,wherethecostofanitem
issmall(suchaspencilsorsmalltools),thecostmaybetreatedasanexpense
eventhoughitdoesnotexpireinthecurrentperiod.Althoughthismaynotseem
properfromatheoreticalviewpoint,thecostsofkeepingdetailedrecordsabout
smallitemsandamountsmayjustifythistreatment.Thisdeparturerefectsthe
materialityassumption.
Thereisadifferenceofopinionintheaccountingprofessionastowhetheror
notmatchingisavalidconcept.Acceptedornotbytheprofession,itisusefulto
keepthematchingobjectiveinmind.
RecognitionCriteria
Asdescribedpreviously,manyfunctionsmustbeperformedtoearnrevenue.Asales
orderisobtained,theproductismanufacturedandthendeliveredtothecustomer,
cashiscollected,andperhapsservicesarerequiredbyguaranteesprovidedfora
periodoftimeafterdeliveryoftheproduct.Withtheneedforfnancialstatements
coveringspecifcperiodsoftime,theaccountantmustmakeassumptionsaboutthe
exactpointintimeatwhichrevenueistoberecognized.Beforethemanufactured
goodsaresold,theremaybeagreatdealofuncertaintyabouttheamountofrevenue
tobereceivedandexpensestobeincurred.Theneedforobjective,verifable
evidenceprevailsatthislevel,andrevenueisnotusuallyrecognizedwhilegoods
arestillbeingmanufactured.Whenthegoodsaredeliveredtocustomers,thereis
objectiveandverifableevidenceoftheamountthatthecustomerhasagreedto
pay.Eventhoughthefullamountmightnotultimatelybecollected,accountants
normallyrecognizerevenueatthispoint.Insomeinstances,accountantsprefer
towaituntilthecashproceedsarecollectedbeforerecognizingrevenue.This,
however,isgenerallyanoverlyconservativeprocedure.
Theaccountantdoesnotusuallyrecognizerevenueuntilitisconsideredtohave
beenrealized.The
realizationofrevenue
isassumedtotakeplacewhenthereisa
markettransaction,suchasasale,andawell-defnedassetisreceivedinexchange
fortheassetorservicethathasbeenprovided.Althoughtheaccountantrequires
realizationbeforerecognizingrevenue(oragain),thesamerequirementdoes
not
carryovertolossesorotherdecreasesinvalue.Accountantswillgenerallyrecorda
decrease
invalueeventhoughamarkettransactionhasnotoccurred,whereasthey
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AnIntroductiontoAccountingandManagerialFinance
wouldnotusethesametypeofevidenceasthebasisforrecordingan
increase
in
value.Thisprocedureisconsideredtobeconservativeandisviewedasdesirable
bymostaccountants,althoughitisinconsistentbecausecomparablegainsarenot
recognized.
Regardlessoftheassumptionsorcriteriausedinrecognizingrevenues,
expensesshouldberecognizedonacomparablebasis.Therefore,iftheaccountant
recognizesacertainlevelofrevenuesbecauseofarevenuerecognitionassumption
orcriterion,theexpensestobeusedindeterminingincomeshouldbethecosts
thatexpiredinearningthoseparticularrevenues.Itwouldbeincorrecttorecognize
revenuesonallgoodsdeliveredtocustomers,butshowasexpensesonlythecosts
attributabletogoodsonwhichcollectionshavebeenmade.
FormofIncomeStatement
Aswiththebalancesheet,thereisnouniformagreementamongaccountantscon-
cerningtheformofanincomestatement.Variedformatsareusedinpractice.As
longasthestatementconveystheessentialinformationinamannerthatallowsthe
readertointerpretitwithoutconfusionorambiguity,theformmaybeconsidered
acceptable.
TheformpresentedinExhibit4.1isasingle-step
incomestatement
.There
arenoincomesubtotalsabovethenetincomefgure.Someaccountantsprefer
totakevarioussubtotals,suchasGrossProft,NetIncomebeforeDepreciation,
andNetIncomebeforeTaxes.Theaveragereaderofafnancialreportislikelyto
Exhibit4.1.
Single-StepIncomeStatement.
ABCCompany
IncomeStatementforYearEndingDecember31,19xx
Revenue
SalesRevenue$19,600
InterestRevenue900
RentRevenue1,100
$21,600
Expenses
CostofGoodsSold$10,000
Wages3,000
RentExpense1,000
Utilities200
InterestCharges100
IncomeTaxes2,000
16,300
NetIncome$5,300
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beconfusedratherthanassistedbythenumeroussubtotals,notknowingwhich
incomefgureissignifcant.Thesingle-stepincomestatementhasthevirtueof
beingsimple.
Thesingle-stepincomestatementhasincreasedinpopularityinrecentyears,
butmanycorporationsprefertousesomevariantofthemulti-stepincome
statement.
DiscontinuedOperations
Ifamajorportionofacompany’sbusinesshasbeendiscontinued,comparisons
ofoperatingresultsamongyearscouldbecomedistorted.Readersoftheincome
statementwhoareinterestedinprojectingtrendsofearningsmightwanttoexclude
incomeattributabletotheseoperations.Yet,theincomestatementmustshowthe
actualoperatingresultsfortheyear.
Toaccomplishbothofthesepurposes,aseparateitemforincomefromdiscon-
tinuedoperationsisincludedinthedeterminationofnetincome.Inthisway,users
offnancialstatementswhowishtoignoretheresultsofdiscontinuedoperations
maymaketheirowncalculationsofearningsbyadjustingforthisitem.
Incurrentpractice,thespecialtreatmentofdiscontinuedoperationsapplies
onlytothedisposalofadivisionorotheroperatingunitwhoseactivitiesrepresent
aseparatemajorlineofbusinessorclassofcustomer.Anygainorlossarisingfrom
thedisposalofsuchanoperatingunitwouldalsobeincludedintheincomefrom
discontinuedoperations.
EarningsperShare
Thestockholdersofacompanyarelikelytobeveryinterestedintheamountof
thecompany’searningspershareofcommonstock.Thisisanindicationofhow
theresultsoftheperiodaffectedtheirinterests,andthisfgureoftenhasadirect
bearingonthemarketvalueoftheshares.
Althoughtheconceptofearningspershareisrathersimple,therearemany
complexitiesthatariseinattemptingtomakethecomputationinpractice.Separate
earnings-per-sharefguresareshowntoindicatetheeffectsofextraordinaryitems
ordiscontinuedoperations.Itemssuchasmergers,issuanceofnewshares,and
convertiblesecuritiesalsomayaffectthecomputation.
Summary
Althoughwecouldrecordtransactionsusingonlyassetandequityaccounts,theuse
ofrevenueandexpenseaccountssimplifestherecordingofrevenuetransactions
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AnIntroductiontoAccountingandManagerialFinance
andallowstheaccumulationofmoreinformation.Thesetemporaryaccountsare
usedinpractice.
Theaccountantdeterminestherevenuesandexpensesoftheperiod.Income
isdefnedasthedifferencebetweentherevenuesrecognizedduringtheperiod
andtheexpensesmatchedagainsttherevenues.Thisisanoperationaldefnition
consistentwiththewayinwhichtheaccountantmeasuresincome.
Theincomestatementreportstheresultsofoperationsforaperiodoftime.
Severalmethodscanbeusedtoassignrevenuestoperiodsoftime,andvarious
incomestatementformatscanbeusedtocomparetherevenueswiththeexpenses
thatwereincurredtogeneratethoserevenues.
Netincomeandearningspershareareimportantmeasuresofperformance,but
thesemeasurescanbeaffectedbysuchspecialeventsasextraordinaryitemsand
thetreatmentofdiscontinuedoperations.Accountingfortheseandotherspecial
eventsrequiresjudgment.Usersoffnancialstatementsshouldbeawareofareas
wherejudgmententers(orshouldenter),andthusbebetterabletoassessanduse
theinformationprovided.
QuestionsandProblems
1.Whyarerevenuesincreasedbycreditsandexpensesincreasedbydebits?
2.Whenapurchaseismade,wouldyouexpecttheitempurchasedtoberecorded
inanassetaccountoranexpensesaccount?Explain.
3.Atwhatstepshouldthecostofoilbeconsideredanexpense?
a.Oilisordered.
b.Theoilisreceived.
c.Theoilispaidforbycheck.
d.Theoilisburnedinaboilertomakesteamthatisusedtorunagenerator
thatproduceselectricitythatpowersamachinethatmanufacturesgadgets.
e.Agadgetisshippedtoawholesaler,andthewholesalerisbilled.
f.Thecashisreceivedfromthewholesaler.
4.Somecostfactorsareconventionallytreatedasexpensesastheyarerequired.
Whichofthefollowingitemscouldbeexpensesimmediatelyonacquisi-
tionwithoutadverselyaffectingtheinformationprovidedbytheaccounting
system?
a.Salesperson’scommissions.
b.Automobileassemblylineworker’swages.
c.Costofheatingdepartmentstore.
d.Costofheatingfactorybuilding.
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5.Foreachofthefollowingevents,indicatewhethertheitemwouldqualifyas
anextraordinaryiteminthedeterminationofincomeasappliedincurrent
practice.
a.Amajorcompanyplantisdestroyedbyanunexpectedearthquake.
b.Companycitrusgrovesarecompletelydestroyedbyfrost.Afrostofthis
magnitudeoccursaboutonceinfveyears.
c.Salesofthecompany’sproducthavebeenreducedbecauseoftheintroduc-
tionofasuperiorproductbyacompetitor.
d.Thecompanysellslandthatitheldformanyyears,recognizingalargegain.
Thecompanyisinthemanufacturingbusiness,andthiswasthecompany’s
onlyinvestmentinland.
e.Thecompany’scurrentincometaxesarereducedbecauseofthecarryfor-
wardoflossesfrompreviousyears.
6.Aconstructionfrmhasacontracttobuildanoffcebuildingthatisexpected
totakethreeyearstocomplete.Woulditbedesirablefortheconstruction
frmtowaituntilthebuildingiscompletedbeforerecognizinganyrev-
enue?Whatothermethodsofrevenuerecognitionmightbeappropriateinthis
case?
7.Foreachaccountthatfollows,(a)listitsnormalbalance(debitorcredit);
(b)identifyitasabalancesheetortemporaryaccount;and(c)classifyitas
acurrentasset,noncurrentasset,currentliability,long-termliability,owners’
equity,revenue,orexpenseaccount.
AccountsPayable
BondsPayable(duein20years)
Buildings
Cash
CommonStock
CostofGoodsSold
HeatandPower
Labor
MerchandiseInventory
PrepaidRent
Rent
RetainedEarnings
Sales
TaxesPayable
WagesPayable
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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,recordtheentriesnecessarytoadjustthe
accountsattheendoftheyear.UseT-accounts.
a.Wagesof$700havenotyetbeenrecorded.Thisisforlaborservices
performedduringthelastthreedaysoftheyear,forwhichpaymentwillbe
madeonthefrstpaydayofnextyear.
b.ThePrepaidInsuranceaccounthasabalanceof$800.Ananalysisofthe
insurancecontractsindicatesthattheamountofpremiumsapplicableto
futureyearsis$500asofDecember31.
c.Sixmonths’intereston$100,000of14percentbondsoutstanding(aliabil-
ity)hasnotyetbeenrecognized.
d.Sixmonths’interestof$80,000ongovernmentsecuritiesheldasaninvest-
menthasnotyetbeenrecognized.
e.ThePrepaidRentaccounthasabalanceof$1,000beforemakingadjust-
ingentries.Analysisindicatesthatrentof$200isowedasofthedateof
closing.
11.Foreachofthefollowingsituations,recordtheentriesnecessarytoadjustthe
accountsattheendoftheyear.UseT-accounts.
a.Wagesof$1,100havenotyetbeenrecorded.Thisisforlaborservices
performedduringthelastthreedaysoftheyear,forwhichpaymentwillbe
madeonthefrstpaydayofnextyear.
b.ThePrepaidInsuranceaccounthasabalanceof$1,200.Ananalysisofthe
insurancecontractsindicatesthattheamountofpremiumsapplicableto
futureyearsis$750asofDecember31.
c.Sixmonths’intereston$200,000of12percentbondsoutstanding(aliabil-
ity)hasnotyetbeenrecognized.
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d.Sixmonths’interestof$8,000ongovernmentsecuritiesheldasaninvest-
menthasnotyetbeenrecognized.
e.ThePrepaidRentaccounthasabalanceof$1,500beforemakingadjust-
ingentries.Analysisindicatesthatrentof$300isowedasofthedateof
closing.
12.Recordthefollowingtransactionsfortheyear20x1,usingT-accounts(open
anyaccountsyoumayneed).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.Therentforthe
year20x1was$4,000.
h.AsofDecember31,20x1,thecompanyoweditsemployeeswagestotaling
$5,000.Duringtheyear,employeeswerepaid$70,000.
i.SuppliesonhandasofDecember31,20x1,were$900.
Theaccountbalancesbeforethetransactionswereasfollows:
December31,20x0
DebitsCredits
Cash$90,000
AccountsReceivable59,500
Merchandise60,000
Supplies1,500
Rent(Prepaid)4,000
WagesExpense—
CostofGoodsSold—
SuppliesExpense—
RentExpense—
AccountsPayable$16,000
WagesPayable24,000
Sales—
CommonStock100,000
RetainedEarnings
75,000
$215,000
$215,000
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AnIntroductiontoAccountingandManagerialFinance
13.TheaccountantoftheBurtCompanymakesuseofexpenseandrevenue
accounts.Allsalesareforcash.
a.Stockholdersinvest$100,000onJanuary1,20xx.
b.Rentof$4,800ispaid.Thisisrentfora12-monthperiodbeginning
February1.
c.Merchandisethatcost$25,000ispurchasedonaccount.
d.Suppliesarepurchasedfor$6,000cashonFebruary1.
e.TheBurtCompanystartsoperationsonFebruary1.Salesforthefrstweek
are$5,000.
RecordtheforegoingtransactionsusingT-accounts.
14.ThefollowingtransactionsaffectingtheCurtisCorporationtookplaceinthe
year20xx.
a.OnJanuary1,20xx,stockholderspaid$100,000tothecorporationfor
10,000sharesofcommonstock.
b.Thefollowingitemswerepurchasedonaccount:
Merchandise$85,000
Supplies6,000
c.Anamountof$6,500waspaidtothelandlord.Thisincludedrentof$500
forJanuaryofthenextyear.
d.Salesof$117,000weremade.
CashSales$57,000
SalesonAccount60,000
e.Collectionofaccountsreceivablewas$47,000.
f.Paymentofaccountspayablewas$82,000.
g.Wagespaidduringtheyearwere$25,000.WagespayableasofDecember31
were$500.
h.Insurancepremiumspaidduringtheyearwere$3,000.Prepaidinsurance
asofDecember31was$1,800.
i.Suppliesusedduringtheperiodwere$4,200.
j.ThemerchandiseinventoryasofDecember31was$15,000.
k.BondswereissuedonJuly1.Theparvalueofthebondsis$50,000,and
thisamountwasreceivedfromtheinvestors.Thebondshavea7percent
rateofinterest.
l.Incometaxesfortheyearare$1,837.Noincometaxeswerepaidinthe
currentyear.
Recordtheforegoingtransactions,includingadjustingentries,inT-accounts.
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Chapter6
ComparingtheUseofCashFlows
andIncomes
Chapter4stressedtheusefulnessofcashfowsinevaluatingandvaluinginvestment
alternatives.Chapter5explainedthecalculationofthecorporateincomemeasure.
Somestudentsofbusinesswillarguetherelativemeritsofthetwomeasures.The
positionputforthinthisbookisthattheyarebothusefulmeasures.Itisimportant
tounderstandhowtocorrectlyusebothmeasures.
TheUseofCashFlows
Wewilluseasimpleexampletoillustratetheuseofcashfowstovalueaninvest-
ment.Assumeanalternativehasthefollowingcashfows:
TimeCashFlows
1$1,300
21,200
31,100
Theappropriatediscountrateis0.10.Thepresentvalue(PV)oftheinvestment’s
beneftsattimezerois$3,000.
PV
=
1
,
300
1
.
10
+
1
,
200
(
1
.
10
)
2
+
1
,
100
(
1
.
10
)
3
=
$3
,
000
.
Thecalculationissimpletomakeandtounderstand.
UseofEarnings
Assumethereisa$3,000investmentwiththeabovesetofcashfowsforthree
years.Theprojectedincomestatementsforthethreeyearsoftheinvestment’s
101
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AnIntroductiontoAccountingandManagerialFinance
lifeare:
Year1Year2Year3
Revenue$1,300$1,200$1,100
DepreciationExpense1,000
1,000
1,000
NetIncome$300
$200
$100
Tousetheincomemeasuresforvaluation,therehastobeacapitalchargefor
thestockequitycapitalbeingused.Assumethereisa0.10annualcapitalcharge.
Wehaveforeachyear:
Year1Year2Year3
AmountofCapital
1
$3,000$2,000$1,000
AnnualCapitalCharge0.10
0.10
0.10
CapitalChargeforYear$300
$200
$100
Wethendeductthecapitalchargefortheyearfromthenetincometoobtain
theeconomicincome.
Year1Year2Year3
NetIncome$300$200$100
CapitalCharge300
200
100
EconomicIncome$0
$0
$0
Thepresentvalueoftheeconomicincomes(zero)isaddedtothebookvalue
toobtaintheasset’svalueof$3,000.Thisisthesamevalueasweobtainedusing
thecashfowmeasures.
Weneedtomaketheexamplesomewhatmorecomplextoillustratethemore
completecalculations.
TheUseofCashFlows:AMoreComplexExample
Nowassumethesamesetofcashfows,butthediscountrateis0.05.Comput-
ingthepresentvalueofcashfows,weobtain(V
i
istheinvestment’svalueat
1
Reducedeachyearbytheamountofdepreciationexpense.
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ComparingtheUseofCashFlowsandIncomes
103
time
i
):
Time
0123
CashFlow$1,300$1,200$1,100
V
0
$3,276.75
V
1
2,140.59
V
2
1,047.62
V
3
0
Thepresentvalueofthethreecashfowsattimezeroisnow$3,276.752using
0.05asthediscountrate(thepresentvaluewas$3,000using0.10asthediscount
rate).
Assumetheresalevalueattime3is$576.75withapresentvalueof$498.218.
Thepresentvalueoftheasset’scashfowsincludingtheresalevalueof$498.218is:
PVofCashFlows
=
3
,
276
.
752
+
498
.
218
=
$3
,
774
.
970
.
UseofEarnings:AMoreComplexExample
Wewillnowassumetheassetcostof$3,276.75,buttheannualdepreciationexpense
isagain$1,000.Attheendofyear3,theasset’sbookvalueis$276.75andthe
resalevalueis$576.75(resalevalueminusbookvalueis$300).
Theincomestatementsforthethreeyearsare:
Year1Year2Year3
Revenue$1,300$1,200$1,100
DepreciationExpense1,000
1,000
1,000
NetIncome$300$200$100
CapitalCharge
∗
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.Thepresentvalueof
theresalevalueminusbookvalueattime3is$300
(
1
.
05
)
−
3
=
$259
.
151.The
valueoftheassetis:
ValueofAsset
=
3
,
276
.
75
+
239
.
068
+
259
.
151
=
$3
,
774
.
97
,
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104
AnIntroductiontoAccountingandManagerialFinance
where
$3,276.75isthebookvalueoftheasset
$239.068isthepresentvalueoftheeconomicincomes
$259.151isthepresentvalueofthe$576.75resalevalueminusthe$276.75
remainingbookvalue.
Usingtheincomesratherthanthecashfows,weobtainexactlythesamevalue
fortheassetifweusetheeconomicincomesandadjustfortheinitialbookvalue,
resalevalueandendingbookvalue.
ValueofAsset
=
InitialBookValue
+
PresentValueofEconomicIncomes
+
PresentValueofResaleValue
−
PresentValueofRemainingBookValue
.
Thisrelationshipisnotonlycomplex,butitislikelyalsotobemisleadingto
acasualreader.Itlookslikethevalueoftheassetisafunctionofthebookvalue,
butitisnot.
ChangingtheBookValue
Nowassumethatinsteadof$3,276.75,thebookvalueis$4,276.75andtheremain-
ingbookvalueattime3is$1,276.75.
Thepresentvalueofthecashfowsisnotchangedfrom$3,774.97sincethe
cashfowassumptionsarenotchanged.However,manyofthecalculationsusing
earningsarenowchanged.Thenewcalculationsofeconomicincomesare:
Year1Year2Year3
Revenue$1,300$1,200$1,100
DepreciationExpense1,000
1,000
1,000
NetIncome$300$200$100
CapitalCharge
0.05(4,276.75)213.838
0.05(3,276.75)163.838
0.05(2,276.75)
113.838
EconomicIncome$86.162$36.162
−
$13
.
838
PVofEconomicIncomes=$102.91
PVofResaleValue=(1.05)
−
3
(576.75)=$498.22
PVofBookValueatTime3=(1.05)
−
3
(1,276.75)=$1,102.90
PVofAsset=4,276.75+102.91+498.22–1,102.90
=$3,774.98.
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ComparingtheUseofCashFlowsandIncomes
105
Asidefromaroundingerror,thepresentvalueoftheassetusingearningsis
unchangedfromwhentheinitialbookvaluewas$3,276.75insteadof$4,276.75.
Thefollowingconclusionsareimportant.Theasset’svalueisnotaffectedby:
a.theinitialbookvalue
b.thedepreciationmethodbeingused.
Thevalueisaffectedbythecashfowsandtheirtiming.Itisalsoaffectedbythe
resalevalueandtheeconomicincomesandtheirtiming(andthisisaffectedbythe
timingofthecashfows).
Whilethebookvalueandtheaccountingdepreciationmethoddonotaffectthe
assetvalue,theydoinfuenceimportantmeasuresusedbymanagementandthus
shouldnotbeconsideredcompletelyirrelevant.
TheBookValueWashesOut
Weneedtoillustratewhytheamountofbookvaluedoesnotaffecttheasset’s
value.Letuscontinuetheexamplewheretheinitialbookvalueis$4,276.75.
Wehave:
InitialBookValue=$4,276.75
PVofDepreciationExpenses
1,000B(3,0.05)
−
$2,723.25
PVofCapitalCharges
−
$450.58
PV
$213
.
838$203
.
655
163
.
838148
.
606
113
.
83898.338
$450
.
58
EndingBookValue1,276.75withPVof
−
$1,102.91
Subtotal
−
$4,276.74
Net$0.01
The$4,276.75initialcostisaddedtodeterminethevalue;butthepresent
valueofdepreciationexpenses,interest,andendingbookvalueareallsubtracted,
andtheirpresentvalueisequaltotheinitialbookvalue.Iftheinitialbookvalue
changes,enoughoftheothermeasureschangeandtheequalityismaintained.If
themethodofcalculatingdepreciationexpenseischanged,thecapitalchargesand
theendingbookvalueareallchangedand(ifnomistakesaremade)theequality
ismaintained.
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AnIntroductiontoAccountingandManagerialFinance
Thisanalysisshouldagreewithyourintuitionthatiftheactualreceiptand
disbursementofcashfowsarenotchanged,thevalueoftheassetisnotchanged
byachangeintheaccountingmethod.
RevenueRecognitionandFinance
Mr.Alex(afctitiousname)wasintheprocessofsellinghisbusiness(afrmselling
computersoftwareandservicingthesoftware).Heandthebuyershadagreedonthe
pricewhenthepublicaccountingfrm(whichhadauditedthecorporationforten
years)decidedthatanerrorhadbeenmadeintheauditsoftherevenuerecognition
methodused.Thefrmhadrecognized60%ofthefrstyear’srevenueatthesigning
ofthecontract,30%onreceiptofthefrstcashreceipts,and10%onreceiptofthe
remainderofthefrstyear’sreceipts.Theaccountantsthought60%wastoolarge.
Mr.Alexdidnotquestionthemeritsoftheproposedrevenuescheduleandthe
recomputationofthemonthlyandyearlyincomes.Hedid,however,pointoutto
thebuyersthattheyhadvaluedthefrmusingthehistoricalcashfownumbers,
andthesenumberswerenotchangedbytheproposedaccountingchanges.
Thetimingofforecastedcashfowsmightbechangedbecauseofthecalculation
methodbeingused,butlogicallyforecastedcashcollectionshouldnotbeaffected
bythemethod(ordetails)ofrevenuerecognitionusedbytheaccountants.
Withthesaleofapubliccorporation,themarketpriceofthefrm’sstock
couldbeaffectedbytherevenuerecognition(andtheperiodicearnings)andour
conclusioncouldbedifferentthanwiththesaleofaprivatefrm.
Conclusions
Thebasicmethodofvaluationadvocatedinthisbookisthediscountedcashfow
(DCF)method,butothermethodsareusedinpractice.Thischaptershowsthatthe
useofaccountingearningscangiveexactlythesamevalueastheDCFmethod,
buttheaccountingearningshavetobeadjustedforacapitalchargetoarriveat
economicincome.
Thereareseveralmethodsofvaluationusedwhichrecognizethediffcultyof
forecastingthefutureandusesimplifedcalculations.Forexample,thefollowing
methodsarewidelyused:
a.Priceearningsmultiple—EarningstimesanassumedP/Emultiple.
b.EBITmultiple—Earningsbeforeinterestandtaxes(EBIT)timesanassumed
EBITmultiple(smallerthantheP/Emultiple).
c.EBITDAmultiple—Earningsbeforeinterest,taxes,depreciationandamorti-
zation(EBITDA)timesanEBITDAmultiple(smallerthantheEBITmultiple).
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ComparingtheUseofCashFlowsandIncomes
107
QuestionsandProblems
1.Assumeaninvestmentof$4,000hasthefollowingprojectedincomestatements.
Therearezerotaxes.Thecostofequityis0.10.
1
2
3
4
Revenue$1,800$1,600$1,400$1,200
Depreciation1,000
1,000
1,000
1,000
Income$800$600$400$200
a.ComputetheNPVusingthecashfows.
b.Computetheeconomicincomesofeachyear.
ComputetheNPVusingeconomicincomes.
c.Compuetheinvestment’sinternalrateofreturn.
2.(continue1)Assumethedepreciationscheduleis:
Year
Depreciation
1$1,600
21,200
3800
4400
Computetheeconomicincomesofeachyearandtheinvestment’sNPVusing
theeconomicincomes.
3.(continue1)Insteadofaninvestmentof$4,000,assumethebookvalueis$9,000
andtheterminalvalueattime4is$1,756.92.
a.ComputetheNPVusingthecashfows.
b.Computetheeconomicincomesofeachyear.
c.ComputetheNPVusingeconomicincomesandotherrelevantinformation.
4.Assumeanassetwithabookvalueof$4,000hasthefollowingprojectedincome
statements.Therearezerotaxes.Thecostofequityis0.10.Theexpectedresidual
valueattime3is$1,331.
123
Revenue(Cash)$1,600$1,400$1,200
Depreciation1,0001,0001,000
Income$600$400$200
a.ComputethePVusingthecashfows.
b.Computetheeconomicincomesofeachyear.
c.ComputethePVusingeconomicincomes.
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108
AnIntroductiontoAccountingandManagerialFinance
5.(continue4)Assumetheinitialbookvalueis$8,000.Allotherfactsarethe
same.
a.ComputethePVusingthecashfows.
b.ComputethePVusingeconomicincomes.
6.Assumeafrmwithabookvalueof$8,000hasthefollowingcashfows:
Time
CashFlows
1$1,200
21,440
31,728
Theinvestmenthasa0.20internalrateofreturn.Therearezerotaxesandthe
frmusesstraight-linedepreciationof$1,000peryear.Attheendofyear3,the
valueofthefrmisexpectedtobe$11,979.
TheCFOthinks0.10isthecorrectrisk-adjusteddiscountrateforthe
investment.
a.Computeeconomicincomeofeachyear.
YearCashFlow
Depreciation
Expense
CapitalCost
(Interest)
Economic
Income
1$1,200$1,000
21,4401,000
31,7281,000
b.Computethefrm’spresentvalueusing0.10andthefrm’scashfows.
c.Computethefrm’spresentvalueusing0.10andtheeconomicincomesand
anyotherrelevantinformation.
d.Areyouranswerstoparts(b)and(c)likelytobecorrect?Why?
7.Assumea$3,000investmenthasthefollowingcashfows:
Time
CashFlows
1$1,200
21,440
31,728
Theinvestmenthasa0.20internalrateofreturn.Therearezerotaxesandthe
frmusesstraight-linedepreciation.
TheCFOthinks0.10isthecorrectrisk-adjusteddiscountrateforthe
investment.
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ComparingtheUseofCashFlowsandIncomes
109
a.Computeeconomicincomeofeachyear.
YearCashFlow
Depreciation
Expense
CapitalCost
(Interest)
Economic
Income
1$1,200$1,000
21,4401,000
31,7281,000
b.Computetheinvestment’snetpresentvalueusing0.10andthecashfows.
c.Computetheinvestment’snetpresentvalueusing0.10andtheeconomic
incomes.
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November6,200913:44spi-b8119inx6inb811-ch07
Chapter7
DepreciationExpense
Thematchingofcostsandrevenuesindeterminingincomerequiresasystemfor
assigningthecostofassetswithterminablelivestospecifctimeperiods.Build-
ingsandequipmentare
depreciated
,naturalresourcesare
depleted
,andpatents
andleaseholdsare
amortized
overtheirusefullives.Thecreditsfordepreciation,
depletion,andamortizationareusuallymadetocontraassetaccounts,reducing
thenetbookvalueoftherelatedassets.
Depreciationaccounting
maybedefnedasasystematicprocedureforallo-
catingthecostofalong-livedassetoveritsusefullife.Thedepreciationexpense
isthecostofusinganasset,anditisassignedaseitheracostofproductionoran
expenseofearningtherevenuesoftheperiod.
Asanalternative,wecoulddefnedepreciationasthedecreaseintheeconomic
valueofalong-livedasset.Inpractice,however,depreciationhaslittlerelationship
withthemeasurementofthechangeineconomicvalue.Thedepreciationcostis
computedfortheperiodbasedontheoriginalcostoftheasset,andthedecreasein
theeconomicvalueofanassetisnotconsideredinthedepreciationcalculations
madebytheaccountant.
Anessentialfeatureoftheaccountingmeasurementofincomeisthatadeduc-
tionfromrevenueismadefortheexpenseofusingthelong-livedassets.Amore
precisemeasurementofincomecouldbemadeifwewaiteduntilthelong-lived
assetswereretired(wecouldthendeterminemoreexactlythetotalexpenseoftheir
utilization).Becauseoftheneedforperiodicreportsofacompany’sprogress,how-
ever,estimatesmustbemadeoftheexpenseofusinglong-livedassetsduringrela-
tivelyshortperiodsoftime—hence,thenecessityforestimatingthedepreciation
expense.
Theinitialcostofanasset,minustheportionofthiscostthathasbeenpre-
viouslychargedtodepreciation,iscalledthe
bookvalue
oftheasset.Itshould
111
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112
AnIntroductiontoAccountingandManagerialFinance
berememberedthatdepreciationaccountinginpracticeisaprocedureforcost
allocationandnotaprocessofvaluation.Thebookvalueofanassetisnotneces-
sarilyareasonableestimateofitseconomicvalue.Itcannotbeusedasthebasis
fordecisionswithoutadjustmentintoavaluemeasure.
ElementsofDepreciationComputation
Thedeterminationofthedepreciationexpenseofaperioddependsonthreebasic
elements.Theseare:
1.Thedepreciationbase:thecostlessresidualvalueofthelong-livedasset;
2.Theusefullifeoftheasset;and
3.Thesystematicprocedurechosenforallocatingthecostovertheasset’slife.
DepreciationBase
Thecosttobeallocatedovertheperiodofuseisknownasthe
depreciationbase
.
Thisconsistsoftheinitialpurchasecostoftheassetminusanysalvagevalue
expectedatthetimeofretirementplustheanticipatedcostsofremovingtheasset
whenitisretired(wewillassumetheremovalisnotdiscretionary).
Thecostofusinganassetduringitslifeisreducedbyanysalvagevalue
recoverableattheendoftheperiodandisincreasedbycostsofremoval.These
elementsofthedepreciationbaseareoftenextremelydiffculttomeasure.When
itisanticipatedthatasubstantialresidualvaluewillberecovered,anestimateof
thisvalueshouldbeincludedinthedeterminationofthedepreciationbase.
Example
Establishthebasesforthecomputationofdepreciation,giventhefollowingfacts:
a.Abuildingispurchasedforanimmediatepaymentof$10,000.Theforecasted
salvageis$500,andtheforecastedremovalcostis$200.
Answerto(a)
CostofBuilding$10,000
Salvage$500
RemovalCost200
NetSalvage300
BaseforDepreciationComputation$9,700
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DepreciationExpense
113
b.Equipmentispurchasedfor$9,000.Theforecastedsalvageis$400,andthe
forecastedremovalcostis$600.
Answerto(b)
CostofEquipment$9,000
RemovalCost$600
Salvage400
NetRemovalCost200
BaseforDepreciationComputation$9,200
Inexample(b),thedepreciationbaseisgreaterthanthecostoftheasset.Thisis
notallowedfortaxpurposes.Itisreasonablethatthelogicofthesituationleadsto
adepreciablebaseof$9,200,inasmuchasthiswillspreadallthecosts,including
theremovalcosts,overtheperiodsinwhichtherevenuesareearned.Itisequally
reasonablefortheInternalRevenueServicetosuggestthatthedepreciablebase
cannotexceedthecostoftheasset.
UsefulLife
The
usefullife
ofafxedassetisafunctionnotonlyofthephysicalwearand
exhaustiontowhichtheassetissubjected,butalsooftechnologicalchange
andinnovation.Thus,aparticularmachinemightbeexpectedtolastforten
yearsonthebasisofphysicalendurancealone,butthedevelopmentofnew
andbettermachinesmightreduceourexpectationofitseconomicusefulnessto
fouryears.
Bothobsolescenceandphysicalendurancemustbeconsideredinestimating
usefullife.Ingeneral,theusefullifetobeusedfordepreciationpurposeswill
betheshorterofthelivesestimatedonthetwobases.Anassetthatisphysically
exhaustedcanbeexpectedtobereplaced,eventhoughitisnotyetobsolete.On
theotherhand,anassetthatisobsoleteshouldalsobereplacedeventhoughitis
notphysicallywornout.
ProceduresforComputingDepreciation
Theobjectiveofdepreciationaccountingistoassigntoexpensesystematicallythe
costofalong-livedassetovertheasset’susefullife.Thereare,however,many
proceduresforaccomplishingthistask.Althoughtherearenumerousdepreciation
proceduresusedinpractice,ourdiscussionwillbelimitedtoproceduresthatare
mostwidelyused.
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114
AnIntroductiontoAccountingandManagerialFinance
Straight-LineDepreciation
Whenusingthe
straight-lineprocedure
forcomputingdepreciation,theannual
depreciationchargeisobtainedbydividingthedepreciationbasebythenumber
ofyearsofusefullifeforecasted.
Example:
Amachineispurchasedfor$10,000.Theforecastedsalvageis$456,andthe
forecastedremovalcostis$200.Theexpectedusefullifeofthemachineisfour
years.Computetheannualdepreciationchargeusingthestraight-lineprocedure.
(Thesefgureswillalsobeusedforothermethodsdiscussedinthischapter.)
AnnualDepreciation
=
(
InitialCost
−
Salvage
+
RemovalCost
)
UsefulLife
=
$10
,
000
−
$456
+
$200
4
=
$9
,
744
4
=
$2
,
436
.
(7.1)
Usingthestraight-lineprocedureforthefour-yearperiodproducesthe
followingresults:
BookValueDepreciationTotalAccumulatedBookValue
YearBeginningofYearChargeDepreciationEndofYear
1$10,000$2,436$2,436$7,564
27,5642,4364,8725,128
35,1282,4367,3082,692
42,6922,4369,744256
Notethatthedepreciationchargeisthesameeveryyear,andthebookvalue(initial
costminusaccumulateddepreciation)attheendofyear4isequaltotheanticipated
salvagelessremovalcost.
Themainadvantagesofthestraight-lineprocedureareitssimplicityandthefact
thatrevenuesofsuccessiveyearsarechargedwithequalamountsofdepreciation.
Themaindisadvantageisthat,giventheassumptionsofconstantrevenueand
constantmaintenancecosts,thereturnoninvestmentoftheasset(incomedivided
bytheinvestment)willincreaseastheassetbecomesolderandthenetbookvalue
decreases.
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DepreciationExpense
115
Thebasicsimplicityofthestraight-lineprocedurehascausedittobethemost
widelyuseddepreciationprocedureforaccountingpurposes.
DecreasingCharge(AcceleratedDepreciation)Methods
The
decreasingcharge
or
acceleratedmethods
ofcomputingdepreciationhave
becomepopularbecausethetaxlawallowstheiruse.Afrmwillgenerallybeneft
bytakingasmuchdepreciationfortaxpurposesaspossibleintheearlyyearsof
theasset’slife.Themethodofaccountingfortaxpurposeshasatendencyalsoto
infuencethefnancialaccounting,althoughthereisnorequirementthatthesame
depreciationproceduresmustbeusedforbothpurposes.
Bydefnition,withadecreasingchargemethodofaccruingdepreciation,the
depreciationinthebeginningyearsisgreaterthanthedepreciationinthelater
years.Overthelifespanofanasset,thetotaldepreciationchargesshouldbe
approximatelyequalregardlessoftheprocedureused.
Whenweconsiderthecomputationofdepreciationforpurposesofdetermining
taxableincome,thetimingofthedepreciationchargesbecomesimportantfromthe
pointofviewofconservingcash.Ifweassumethepresenttaxrateswillcontinue
ordeclineinthefuture,afrmwillwanttodeductdepreciationasearlyaspossible
toreduceitscurrenttaxpayments.Thus,theacceleratedmethodsofdepreciation
havebecomeverypopularfortaxpurposes.
DecliningBalanceProcedure
The
decliningbalanceprocedure
involvestheapplicationofaconstantdeprecia-
tionratetothedecreasingbookvalueoftheasset.Withthestraight-lineprocedure,
aconstantratewasappliedtoaconstantdepreciationbase.Withthedeclining
balancemethod,theuseofbookvalueinsteadoftheconstantbaseresultsin
diminishingchargesoverthelifespanoftheasset.
Conventionally,salvagevalueandremovalcostsarebothignoredunderthe
decliningbalanceprocedure.Itisimpossibletoreducethebookvaluetozeroby
continuallyapplyingaconstantratetothebookvalue.Theresidualvalueremaining
aftertheapplicationofthisprocedurethroughoutanasset’slifemightbeconsidered
tobeanapproximationofsalvage.Althoughthetwofguresarenotlikelytobe
thesame,theymightbecloseenoughforpracticalpurposes.
Withthedecliningbalanceprocedureanydepreciationratecouldconceivably
beused,buttherateisgenerallyexpressedasafunctionofthestraight-linerate.If
arateequaltotwicethestraight-linerateisused,themethodiscalledthe
double
decliningbalancemethod
ofdepreciation.
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116
AnIntroductiontoAccountingandManagerialFinance
Example:
Assumingthesamefguresasthoseusedtoillustratethestraight-lineprocedure,
computedepreciationonadecliningbalancebasisusingarateequaltotwicethe
straight-linerate.Thestraight-linedepreciationratewas25percent,andtwicethis
rateis50percent.Therateistobeappliedtothebookvalueatthebeginningof
eachyear.Depreciationforeachofthefouryearswillbeasfollows:
BookValueBookValue
BeginningRateDepreciationTotalAccumulatedEndof
YearofYear(%)ChargeDepreciationYear
1$10,00050$5,000$5,000$5,000
25,000502,5007,5002,500
32,500501,2508,7501,250
41,250506259,375625
Notethatthebookvalueremainingattheendofyear4is$625,whichissomewhat
higherthantheexpectednetsalvagevalue.Thetotaldepreciationchargesforthe
four-yearperiodwere$9,375,whichislessthantheamountaccruedbyusingthe
straight-lineprocedure($9,744).
TheInternalRevenueCodeallowsafrmtoswitchfromdecliningbalanceto
straight-linedepreciationduringthelifeofanasset.Inthiscase,thestraight-line
depreciationisobtainedbydividingtheremainingamounttobedepreciatedby
theremaininglife.Thetotalamountofdepreciationcannotexceedthecostlessthe
expectedsalvage.Intheexamplesjustcited,attheendofthethirdyearthecompany
couldswitchtothestraight-lineprocedureandcharge$994todepreciationinthe
fourthyear(bookvalueof$1,250lessthe$256salvageequals$994).Becausea
frmdesirestochargeasmuchtoexpensefortaxpurposesasitislegallyallowedto
charge,theswitchtothestraight-linemethodmaybedesirablefromaneconomic
standpoint(thatis,itmaydelaythepaymentofincometaxesuntilsubsequent
periods).Thepresenttaxcodeallowstheignoringofsalvagevalueiftheexpected
salvageislessthan10percentofcost.
Sum-of-the-Years’DigitsProcedure
The
sum-of-the-years’digitsprocedure
isadeviceforobtainingapatternof
depreciationthatstartsouthighanddecreasesovertheyears.
Essentially,thisprocedureusesaconstantdepreciationbase—thesameas
thestraight-linebase—butappliesaconstantlyreducingratetoittoobtaina
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DepreciationExpense
117
decreasingcharge.Therateisdeterminedbyafractionhavingasitsdenominator
thesumofthedigitsfromonethroughtheusefullife,inyears.Thenumerators
aretheindividualyearnumbersindescendingordereachyear(equivalently,the
numberofyearsofliferemainingatthebeginningoftheyear).
Example:
Wewillusetheinformationfromthepreviousexample,wheretheusefullifewas
fouryears.Thedenominatorofeachyear’sratewillbethesumofthedigitsfrom
1through4:
1
2
3
4
Sumofdigits=10
Thenumeratorsforthedepreciationratewillbethenumbersindescendingorder:
4,3,2,1.Thus,therateforthefrstyearwillbe4/10,thesecondyear3/10,and
soforth.Usingthedepreciationbaseof$9,744(initialcostminussalvageplus
removalcost),thefollowingdepreciationchargesareobtained:
BookValueTotalBook
BeginningDepreciationDepreciationAccumulatedValueEnd
YearofYearBaseRateChargeDepreciationofYear
1$10,000.00$9,7444/10$3,897.60$3,897.60$6,102.40
26,102.409,7443/102,923.206,820.803,179.20
33,179.209,7442/101,948.808,769.601,230.40
41,230.409,7441/10974.409,744.00256.00
Overthefour-yearlife,thetotaldepreciationchargesandtheendingbookvalue
balanceareidenticalwiththestraight-lineprocedure.Itisthepatternofcharges
overtheyearsthatdistinguishesthetwomethods.Thesum-of-the-years’digits
methodresultsinsubstantiallyhigherchargesintheearlyyears,whichareoffset
bylowerchargesinlateryears.
Theuseofoneofthedecreasingchargeproceduresmaybejustifedlogically
foraccountingandmanagerialpurposesiftheproductiveoutputoftheassetbeing
analyzedisexpectedtodiminishrapidlywithage.Iftheservicesprovidedbya
machinewillbesignifcantlygreaterinthefrstyearoflifethaninthelateryears,
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AnIntroductiontoAccountingandManagerialFinance
itisreasonabletochargemoreofthedepreciationcosttotheearlieryears.Also,as
machinesgrowoldertheymayrequiremoremaintenance,sotheuseofdecreasing
chargemethodsmightresultintotalcosts(includingmaintenance)thatareabout
equalineachperiod.
AcceleratedCostRecoverySystem(ACRS)
In1981ataxactwaspassedthatintroducedthe
AcceleratedCostRecovery
System(ACRS)
.Thedetailsoftheactwerechangedbythe1982,1984,and1986
taxacts.WhileACRSsurvivedthesereforms,itislikelytobemodifedinthe
future.
ACRSchangedandincreasedthealternativesavailabletocorporations.Ittends
tobeamoregenerousmethodofwritingoffanassetthanthepreviouslyapproved
accelerateddepreciationmethods.Newassetswereoriginallyplacedintofve
classes:
Class
3-yearclass:Tangiblepropertywithalifeofnomorethanfouryears(includes
tools,researchanddevelopmentequipment,lighttrucksand
autos).
5-yearclass:Practicallyallmachineryandequipment,aswellaspublicutility
propertywithlivesbetween4.5and18years.
10-yearclass:Selectedequipmentandpublicutilitypropertywithlivesbetween
18.5and25years.
15-yearclass:Publicutilitypropertywithlivesgreaterthan25years.
Realestate:18yearsusing200percentdecliningbalance(forlow-income
housing)or175percentdecliningbalancewithaswitchto
straight-line(forotherrealestate).
The1986actaddedotherclasses.Corporationsmustuseaclassifcationscheme
forthedeterminationoftheasset’sdepreciationexpense,unlessstraight-linedepre-
ciationisusedforallassetsacquiredintheyearforthegivenclass.Realestate
exceptionsarealsopossible.
DepreciationandActivity
Uptothispoint,procedureshavebeenconsideredbywhichcostsareallocatedas
afunctionoftime.Therearesometypesoffxedassetswhoselivesaremorea
functionofactivity(use)thanoftime.Anexampleofafxedassetofthistypeisan
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DepreciationExpense
119
airplaneengine.Thelifeoftheenginemaywellbeafunctionoffighthoursrather
thanage.Therateofobsolescenceaswellasthephysicaldeteriorationtendsto
determinewhetherthedepreciationaccrualshouldbebasedonactivityortime.
Example
a.Anairplaneenginethatcost$5,000hasalifeof10,000hoursoffyingtime.
Whatisthefrstyear’sdepreciation,iftheplaneisfownatotalof2,000hours?
Answer:
Therateofdepreciationis$0.50perhouroffyingtime.Thedepreciation
expensefor2,000hourswouldbe$1,000.
b.Iftheenginewerefownonly500hours,andiftheexpectedusefullifewereonly
fveyears(becauseoftechnologicalchange),whatwouldbethedepreciation
chargefortheyear?
Answer:
Onanactivitybasisthedepreciationwouldbe
$0
.
50
×
500
=
$250
,
buttheusefullifeoftheassetisonlyfveyears;thus,theminimumdepreciation
onastraight-linebasiswouldbe
$5
,
000
5
=
$1
,
000
.
Thedepreciationcostfortheyearshouldbe$1,000.Ifthereisreasontosuspect
theusageoftheengineinthenextfouryearstobemorethan2,000hoursper
year,theremaybejustifcationforconsideringthedepreciationofthefrstyear
tobe$250(or$0.50perhour).
UnitsofProductionProcedure
The
unitsofproductionprocedure
alsoassumesthatdepreciationisafunction
ofuseoractivity.Thelifeoftheassetismeasuredintermsofitsexpectedunitsof
outputortheexpectednumberofserviceormachinehoursavailable.
Example
Assumethatthemachinepurchasedfor$10,000thathasaforecastedsalvagevalue
of$456andaforecastedremovalcostof$200isexpectedtohaveaproductivelife
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AnIntroductiontoAccountingandManagerialFinance
of4,060units.Thedepreciationrateperunitiscalculatedasfollows:
DepreciationRateperUnit
=
(
InitialCost
−
Salvage
+
RemovalCost
)
ExpectedTotalUnits
=
$10
,
000
−
$456
+
$200
4
,
060
=
$2
.
40
.
(7.2)
If985unitsareproducedinthefrstyear,1,060unitsareproducedinthesecond
year,1,115unitsareproducedinthethirdyear,and900unitsareproducedinthe
fourthyear,depreciationforeachofthefouryearswillbeasfollowsusingthe
unitsofproductionprocedure:
DepreciationTotalAccumulatedBookValue
YearUnitsRateChargeDepreciationatEnd
1985$2.40$2,364$2,364$7,636
21,0602.402,5444,9085,092
31,1152.402,6767,5842,416
49002.402,1609,744256
AccountingEntries
Theaccountsinvolvedinrecognizingdepreciationarefrequentlymisunderstood.
Inordertounderstandtheentriesthatareconventionallymade,itisusefultoreview
theirpurpose.Theaccountantisattemptingtoallocatethecostofanassetoverits
usefullifeandtomeasurethecostofusingtheassetineachaccountingperiod.
Thebasicjournalentrytorecorddepreciationincreasesacostorexpenseaccount
(bydebitingit)anddecreasesanassetaccount(oracontraaccountbycreditingit).
Example
AbuildingispurchasedonJanuary1for$10,000.Ithasanexpectedusefullifeof
tenyears.Salvagevalueisexpectedtoequalremovalcost.Assumethatdepreciation
iscalculatedbythestraight-lineprocedure.
Jan.1Building
..............................
10,000
Cash
..............................
10,000
Torecordthepurchaseofthebuilding.
Dec.31DepreciationExpense
..................
1,000
Building
...........................
1,000
Torecordthedepreciationcostfortheyearandthedecreasein
theBuildingaccount.
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121
Theentriesgivenrepresentasoundaccountingtreatmentofdepreciation,but
notethattheBuildingaccountwillhaveabalanceof$9,000afterthe$1,000
hasbeencreditedtotheBuildingaccount.Theoriginalcostofthefxedassetis
nolongerequaltothebalanceoftheBuildingaccount.Thisproceduremakesit
morediffculttoobtainabitofrelevantinformation.Areaderoffnancialreports
maywanttoknowhowmuchwaspaidfortheassetsandtowhatextentthey
havebeendepreciated.Thisinformationcannotbereadilyobtainediftheformer
procedureisfollowed.Inpractice,theaccountantdoesnotcredittheBuilding
accountdirectly,aswasdoneintheexample,butrathercreditsacontraaccountto
theBuildingaccount(anaccountthatisasubtractionfromtheBuildingaccount).
Thiscontraaccounthasvarioustitles.AmongthemostwidelyusedareAllowance
forDepreciationandAccumulatedDepreciation.TheentrymadeonDecember31
toaccruethedepreciationcostandthedecreaseintheBuildingaccountwould
thenbe
DepreciationExpense
..............................
1,000
Building,AccumulatedDepreciation
............
1,000
Thisisthegenerallyacceptedentryforrecognizingdepreciation.Thecredit
isnotmadedirectlytothefxedassetaccount,buttoacontraassetaccount.The
balanceinthiscontraaccount,nomatterwhatitstitle,is
asubtractionfromthe
fxedassetaccount
.
DepreciationandCashFlow
Theaccountingdepreciationexpenseentrydoesnotaffectthecashfowofabusi-
nessorganization,butthedepreciationexpensefortaxesdoesaffectcashfow.
Assumeasituationinwhichthefollowingfactsapply—cashsalestotal$100,
accountingandtaxdepreciationexpenseis$20,andthetaxrateis0.40.
Thefrststepistocomputethetaxableincome.
CashSales$100
DepreciationExpense20
TaxableIncome$80
Giventaxableincomeof$80andataxrateof0.40,theincometaxprovision
is0
.
40
(
$80
)
=
$32.Theincomestatementfortheperiodis
CashSales$100
DepreciationExpense$20
TaxExpense32
52
Income$48
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AnIntroductiontoAccountingandManagerialFinance
Theenterprise’sincomeis$48.However,itscashfowfromoperationsis$68.
CashSales$100
TaxExpense32
CashFlowfromOperations$68
Theenterprise’scashfowfromoperationscanalsobeobtainedbyaddingthe
depreciationexpensebacktoincome:
Income
+
DepreciationExpense
=
$48
+
$20
=
$68
.
(7.3)
Bydeductingdepreciationexpenseof$20fromthecashsales,theenterprise
saved$8oftaxes.Ingeneral,thetaxsavingsfromdepreciationexpenseisequal
tothetaxratetimesthedepreciationexpenseallowedfortaxes:
TaxRate
×
DepreciationExpense
=
0
.
40
×
$20
=
$8
.
(7.4)
Equivalently,wecanstatethatthecashfoweffectofdeductingdepreciation
expenseof$20istoincreasetheafter-taxcashfowsby0
.
40
(
$20
)
=
$8.Notethat
wemultiplythetaxdepreciationbythetaxratetoobtainthecashfowincrease.
Each$1ofdepreciationexpensereducestaxableincomeby$1andsaves$0.40
oftaxes.
InterpretationofGainorLoss
Thegainorlossrecognizedatthetimeofretirementofalong-livedassetwill
dependonthreefactors:thebookvalueattimeofretirement,theproceedsof
salvageorsale,andthecostsofremoval.Thesefactorscanrarelybeknownwith
certaintyatthetimeofacquiringanasset,sotherewillinvariablybegainsor
lossesonretirement.Incurrentpractice,thegainorlossonretirementisregarded
asaffectingcurrentincome.
Theamountsoftheretirementgainsorlossesareaffectedbythechoiceof
themethodofdepreciation.Asshownintheprecedingsection,thereareseveral
acceptableproceduresfordeterminingthedepreciationcharges.Theuseofdiffer-
entprocedureswillresultindifferingbookvaluesatretirementandthusaffectthe
gainorlossrecognized.
Example
Toillustratethispoint,consideramachinethatcost$10,000andisbeingdepreci-
atedonthebasisofafour-yearusefullifewithnoremovalcostorsalvagevalue
expected.Attheendofthethirdyearofuse,themachineisretiredwithnetsalvage
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123
valueof$1,000.Computetheamountofgainorlossthatwouldberecognized
assumingthattheassetisbeingdepreciatedbyuseofstraight-linedepreciation.
Solution
Usingstraight-linedepreciation,thedepreciationdeductionis$2,500peryear.The
accumulateddepreciationattheendofyear3wouldbe$7,500.Bookvalueatthe
endofyear3wouldbe
AssetCost$10,000
Less:
AccumulatedDepreciation7,500
BookValue$2,500
CalculationofLoss:
BookValue$2,500
NetSalvage1,000
LossonRetirement$1,500
RecordingofNaturalResources
Considerthedrillingofanoilwellandtheaccountingforeventsthattakeplace.
Isthecostoftheoilthatisfoundthecostofthesuccessfulwellsorthecost
ofdrilling
all
thewells,dryandsuccessful?Ifthelatter,overwhattimeframe
andcoveringwhatgeographicalarea?Iscostrelevantatall,orwouldtheusers
offnancialstatementsratherbeinformedofthevalueoftheresourcesthatthe
companyowns?
Thesequestionshavebeenponderedbyaccountantsformanyyears.The
“successfulefforts”methodofreportingforoilexplorationactivitieshasbecome
acceptedpracticebymanyaccountants.Thismeansthatthecostoftheoilownedby
anoilcompanywillrefectthecostoffndingtheoil.Therecordedcostincludesthe
costofnearbydrywells,butnotthecostofdrywellsthataretotallyunconnected
withtheareaswheretheoilwasfound.
DepletionofNaturalResources
Thepreviousdiscussiondealtwiththeproblemsofallocatingthecostofassets
whoselivesextendoverseveralaccountingperiods.Thelivesoftheseassetswere
determinedbyeitherphysicaldeteriorationorobsolescence,andthecostsofusing
theassetswerechargedeithertoproductioncostorimmediatelytoexpense.
Incertainextractiveindustries—coalmining,petroleumproduction,orerefn-
ing,andsoforth—ananalogousproblemexists.Ordinarilyasinglesumispaidto
acquireaquantityofnaturalresources,buttheprocessofextractingtheseresources
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AnIntroductiontoAccountingandManagerialFinance
willextendovermanyaccountingperiods.Theproblemofallocatingthecostof
suchitemstoproductionisanalogoustotheproblemofdepreciation,exceptthat
inthiscasetheassetbecomesphysicallyembodiedintheproductbeingmanufac-
tured.Theprocedureforallocatingsuchcostsiscalled
depletionaccounting
.
Theusefullifeofanaturalresourcedependsonthephysicalquantityofthe
resourceandtherateofusage.Everytonofcoalorironoreextractedfromamine
resultsinonelesstonremaininginthemine.Thus,insteadofyearsormachine
hours,depletionaccountingassignscostsbasedonphysicalquantitiesofproduct
thatareexpectedtobeextracted.
Theprecisequantityofaresourcestillinthegroundmaybeverydiffcult
toevaluate.However,geologistsandotherknowledgeablepersonsmaybecalled
upontotakesamplesandestimatethequantitiesofmineralsorotherresources
existinginaparticularoperation.Oncesuchanestimateisavailable,thedeple-
tioncalculationsaremadeinafashionsimilartodepreciation.Althoughpro-
ceduresinvolvingdecreasingchargescouldbeused,thedepletionprocedures
aregenerallybasedonastraight-lineassumptionaboutthephysicalquantities.
Thedepletioncostofayearwilldependuponthequantitiesextractedinthat
period.Partofthecostwillbeassignedtoinventoryandparttotheexpenseofthe
period.
Theaccountingentriesfordepletionaresimilartothoseusedinaccounting
fordepreciableassets,althoughusuallythelong-livedassetaccountiscredited
directlyratherthanreducedthroughuseofacontraassetaccount.
IntangibleAssets
Intangibleassetsareitemsthatthefrmpurchasedbutthatlackphysicalsub-
stance.Theirvaluetothefrmisoftendependentonotherbusinessfactorsand
issubjecttoconsiderableuncertainty.Inmanyinstances,suchassetshavevalue
onlyinthecontextofaparticularbusinessandthereforecannotbetransferredto
anotherorganization.Becauseoftheuncertaintysurroundingthevalueofthese
items,theyarefrequentlyrecognizedatonlyanominalamountinthefnancial
statementsorexpensedattimeofacquisition.Yetintangibles
could
representa
signifcantamountoftheeconomicresourcesofacompany.Assetsclassifedas
intangiblebyaccountantsincludepatents,trademarks,copyrights,goodwill,and
organizationcosts.
Intangibleresourcesmaybepurchasedfromothersordevelopedinternallyby
acompany.Althoughpurchasedintangiblesaregenerallyrecordedasassets,self-
developedintangiblesarenot.Thus,apatentpurchasedfromanothercompany
wouldbeshownatitscostasanassetonthebalancesheet,whereasasimilar
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125
patentdevelopedthroughthecompany’sownresearchanddevelopmentefforts
wouldnot.
Becausepurchasedintangiblesareincludedasassetswhilenonpurchasedintan-
giblesusuallyarenot,adoublestandardforassetrecognitionexists,making
comparisonsamongfrmsdiffcult.Suppose,forexample,thatCompanyAhas
developedapatentasaresultofitsownresearchefforts.Thepatentwouldnot
beshownasanassetintheaccountingstatementsofCompanyA.However,if
CompanyAweretosellthepatenttoCompanyBfor$100,000cash,Company
Bwouldrecognizethepatentinitiallyatitscosttothatcompany,$100,000.Even
thoughthepatentremainsunchanged,itstransferfromtheoriginalownertoanew
ownerforanobjectivelydeterminablepricegivesrisetotherecognitionofanasset
thathadnotbeenrecognizedbeforebytheoriginatingfrm.
ResearchandDevelopmentCosts
Thecostsofresearchanddevelopmentpresentadiffcultproblemfortheaccoun-
tant.Inthepast,thesecostswerefrequentlycapitalizedandregardedasan
intangibleasset.Butbecausethereisanuncertainrelationshipbetweenresearch
spendingandsubsequentbenefts,theFinancialAccountingStandardsBoard
(FASB)inFinancialAccountingStandard2decidedthatallresearchanddevelop-
mentcostsshouldbeexpensed.Thus,accountantsmustnowchargeallresearch
coststocurrentexpenses.Itshouldberealized,however,thatresearchcostsare
usuallyincurredwiththeexpectationofbeneftingfutureperiodsratherthanthe
presentperiod.Theoretically,suchcostsareassets,eveniftheyareexpensedfor
purposesofconformingtothereportingrequirementsoftheFASB.
Thecostdeferralconceptemphasizesincomedeterminationandisdirectly
relatedtotheaccepteddefnitionofaccountingincome.Thedeterminationof
accountingincomeisbasedontheprocessofmatchingcostswiththerevenuesto
whichtheyrelate.Whencoststhatareexpectedtobeneftrevenuesoffutureperi-
odsareincurred,theymaybedeferreduntilthetimewhentheymaybe“matched”
withtherelatedrevenuestodetermineincome.Theassetclassifcationofthebal-
ancesheetmaybeviewedfollowingthistheoryasincludingcostsawaitingfnal
dispositionthroughperiodicchargesagainstrevenues.
Twocorporationsmaybeidenticalinallrespects,andthenoneofthetwo
maydeclareandpaya$10,000,000dividendtoitsstockholderswhiletheother
spends$10,000,000onresearch.Thebalancesheetsofthesetwocorporations
afterthesetransactionswouldbeexactlythesame.Intheyearofthetransac-
tions,thesecondfrmwouldreportlowerincome,sincetheresearchexpenditure
istreatedasanexpenseoftheperiod.Actually,thesecondfrmhasaccumulated
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AnIntroductiontoAccountingandManagerialFinance
knowledgeasaresultofitsexpenditureof$10,000,000,butthisknowledgewould
notberecognizedasanassetaccordingtocurrentgenerallyacceptedaccounting
practice.
AmortizationofIntangibles
Thecostsofintangiblesthathavebeenrecognizedasassetsshouldbeallocatedto
incomeovertheirestimatedusefullives.Thisprocessisanalogoustodepreciation
oftangibleassets,butitisusuallyreferredtoas
amortization
whenusedwith
intangibles.
Determiningtheusefullifeofanintangibleassetisextremelydiffcult.There
isnophysicalwearandexhaustiontoconsider,onlyobsolescenceordeclinein
economicvalue.
Manyintangibleshaveamaximumlifeprescribedbylaw.Apatent,forexample,
isgrantedforaperiodof17yearsandmaynotberenewed.Copyrightsareissued
foraperiodof28yearswiththepossibilityofrenewalforanother28-yearperiod
atexpiration,givingatotalof56years.Fromaneconomicstandpoint,however,
itisrarethatanintangibleassetwouldmaintainitsfullvalueduringtheentire
periodofitslegalexistence.Forexample,apatentmaybemadeobsoletebyanew
developmentthatsupersedesit.Acopyrightedworkmaynotprovideanyrevenues
afterthefrstfewyearsofitsexistence.Forthesereasons,theusefullifeofan
intangibleassetshouldberegardedastheshorterofthelegaloreconomiclife.
Someintangibleswithindeterminatelives,suchasgoodwill,wereonce
regardedashavingperpetuallivesandthuswerenotamortized.Incurrentpractice,
however,allnewlyacquiredintangiblesareregardedashavinga
maximum
useful
lifeof40years,andtheymustbeamortizedoverthatorashorterperiod.
Oncetheamortizationperiodhasbeenestablished,thecostofanintangible
assetmaybeamortizedoverthisperiodbyanyreasonablesystematicmethod,
althoughthestraight-linemethodtendstobeusedmostoftenincurrentpractice.
Unlikethesituationindepreciationoftangibleassets,thereisnosalvagevalueor
removalcosttoconsider.Themainassetaccountisusuallycrediteddirectlyrather
thancreditingacontraaccount.ThedebitistoanAmortizationExpenseaccount.
GoodwillandOrganizationCosts
Goodwill
maybedefnedasthepresentvalueoffutureearningsinexcessof
whatmightnormallybeexpectedtobeearnedontheidentifableassetsusedin
theenterprise.Thus,goodwillarisesbecauseoftheexpectationofexceptional
earnings.Therearemanyreasonswhyacompanymighthaveearningsthatare
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127
higherthancouldnormallybeexpected.Amongthesereasonsareanestablished
reputation,customeracceptance,auniqueproductorprocessleadingtoamonop-
olisticposition,andastutemanagement.
Ifgoodwillarisesbecauseofthepresenceofexceptionalearnings,doesthat
meanthattheaccountantshouldrecordgoodwillwheneverearningsareexpected
inexcessofnormal?Inpractice,theaccountantrecordsgoodwillonlywhenitis
purchased.Thisisusuallyinterpretedtomeanthepurchaseofonebusinessentity
byanotherbusinessentity.Thus,ifFirmApurchasesFirmBfor$1,000,000,and
thevalueoftheidentifableassetslessliabilitiesofFirmBisonly$750,000,then
FirmAhaspaid$250,000forsomethingofanintangiblenature.Theaccountant
callsthissomething
goodwill
.
Shouldgoodwillberecordedwhenpurchased,andshoulditthenbeamortized?
Purchasedgoodwillrefectstheexpectationoffutureearnings,wheretheexpecta-
tionisverifedbyawillingnessofthepurchasertopayforthesefutureearnings.
Thegoodwillisamortizediftherecenteventsindicatethatthegoodwillhaslost
value.
Themaintenanceofgoodwillusuallydependsonthecontinuanceofexpen-
dituresforitemssuchasadvertisingandpublicrelations.Thecessationofsuch
spendingcouldcausethelifeofgoodwilltobecometerminable.Goodwillisalso
oftencloselyattachedtoacompanyandmightnotbeeasilytransferredtoanother
frm.Anyconditionsthatmightlimitthelifeofacompanycouldalsolimitthelife
ofitsgoodwill.
Theproblemofvaluinganentireindustrialorganizationisusuallytoocomplex
topermitthisvaluationtobethebasisofrecordingincomeandfnancialposition.
Goodwillisnotrecordedunlessitisexplicitlypurchased.
Whentheaccountantrecordsasassetsthoseitemsthathavenosalevalue(in
theterminologyoftheeconomist,theiropportunitycostiszero),thenthebalance
sheetdoesnotpresenttheliquidationvalueofthebusinessentity.Thestatement
doespresentapictureofthefnancialpositionassumingthefrmcontinuesasa
goingconcern.
DeferredBenefts
ConventionaldepreciationaccountingcombinedwiththeusesofROIisatits
worstwhenthebeneftsproducedbytheassetareexpectedtoincreasethrough
timeorwhenthebeneftsareconstant.Theearlyyearsaregreatlypenalizedby
conventionalaccounting,withthemanagershavinganincentivetoavoidsuch
investmentssothattheirperformanceevaluationsdonotsuffer.
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AnIntroductiontoAccountingandManagerialFinance
Forexample,assumeaninvestmentcosting$3,000isexpectedtohavethe
followingbeneftstream:
PeriodCashFlow
1$1,100
21,210
31,331
Thefrm’scostofmoneyis0.10andisequaltotheinvestment’sdiscountedcash
fowinternalrateofreturn.Theresultsusingconventionalaccountingandstraight-
linedepreciationwillbe(assumingtheactualbeneftsareequaltotheexpected):
PeriodRevenuesDepreciationIncomeBookValueROI
1$1,100$1,000$100$3,0000.03
21,2101,0002102,0000.105
31,3311,0003311,0000.331
Thefrstyear’soperationsarenotacceptablegiventhe0.10costofmoney.
Defningdepreciationexpensetobethedecreaseinvalueoftheasset,the
resultswouldbe:
PeriodCashFlowDepreciationIncomeBookValueROI
1$1,100$800$300$3,0000.10
21,2109902202,2000.10
31,3311,2101211,2100.10
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
.
Thedistortioncausedbyconventionaldepreciationaccountingcanbeincreased
byassumingno(orverylow)beneftsuntilperiod3.Theoperatingresultsofthe
earlyyearswouldappeartobeevenworsethanintheexample.
Theseconddepreciationmethodillustratedcanbecalledeconomicdeprecia-
tionorpresentvaluedepreciation.Itisnotgenerallyacceptedaccountingpractice.
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129
CashFlowReturnonInvestment
Recognizingtheinadequaciesofconventionaldepreciationaccounting,someman-
agershaveattemptedtosolvetheproblemsbyusingcashfowreturnoninvestment.
Sincecashfowsareusedtoevaluatetheinvestment,whynotusethemtoevaluate
theinvestment’sperformance?
Defnethecashfowreturnoninvestmenttobe:
Cashfow
Investment
.
Thecomputationseemstobeappealingbecausedepreciationisnotcomputed,
butunfortunately,thecomputationmerelymakesabadanalysisworse.Usingthe
followingexamplewheretheinvestmenthasa0.10internalrateofreturn,we
obtain:
PeriodCashFlowBookValueCashFlow(ROI)
1$1,300$3,0000.433
21,2002,0000.600
31,1001,0001.100
Somefrmshaveactuallytriedtousethehistoricalmeasuresasrequiredreturns
foradditionalinvestments.Youshouldnotethatforaninvestmentyielding0.10
overitslife,thecashfowROIsforthethreeyearsare0.43,0.60,and1.10.The
measuregreatlyoverstatestheROItheassetisactuallyearning.
Anotherdiffcultyofthemeasureisthatitwilltendtobiasmanagementin
favorofcapital-intensivemethodsofproduction,becausecapitalcostisomitted
fromthenumeratoroftheperformancemeasure.
ItisbettertousetheconventionalROIwithincome(afterdepreciation)inthe
numeratorthantousethecashfowROI,whichisextremelydiffculttointerpret
andhasnotheoreticalfoundation.Theuseofthemeasureillustratedabovewill
getmanagementintooneormoreinterpretivediffculties.
ASolution
Onesolutionwouldbefortheaccountingprofessiontoencourageawiderange
ofdepreciationmethods,ifthesemethodsarejustifedbytheeconomiccharac-
teristicsoftheinvestment.Currently,toorapidwrite-off(R&D,training,plant
andequipment)leadsto(1)badmeasuresofperformanceand(2)non-optimal
decisions.
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AnIntroductiontoAccountingandManagerialFinance
Summary
Thischapterhasbeenconcernedwiththeinitialrecordingandallocationofthe
costsoflong-livedassets—depreciation,depletion,andamortization—overthe
assets’usefullives.Therearemanydifferentmethodsforassigningthecostofa
long-livedassettoeachtimeperiod.Themostcommonlyusedaccountingmethod
isstraight-linedepreciation.Itiseasytocomputeandwell-defned.Theselectionof
thedepreciationprocedurecangreatlyinfuencethereportedincomeandfnancial
positionofacompany.Adistinctionmustbemadebetweentheaccountingdepre-
ciationexpense,whichhasnoeffectonacompany’scashfow,andtaxdepreciation
expenseorcostrecovery,whichdoesaffectcashfow.
Thenecessityofmakingassumptionsinaccountingpracticeisdramatized
intheareaofrecordinglong-livedassets.Thecostoftheseassetsissometimes
diffculttomeasureand,evenifmeasuredinareasonablemanner,afterseveral
yearsthecostislikelytobeapoorestimatorofthevalueoftheasset.Although
partofthediffcultiesarisebecauseofarbitraryaccountingpractices,themajor
problemistheattemptbytheaccountanttorecordeventswhenthefullimpactof
theseeventswillnotbeknownuntilsomefuturetime.Forexample,thevalueof
researchisuncertainuntilmanyyearsaftertheaccountant’sreportispublished.
Thesameistrueofthelifeofatangiblelong-livedasset.Perfectaccuracyrelative
tovalueshouldnotbeexpectedinaccountingforlong-livedassets.
ReviewProblems
ReviewProblem7.1
TheHubbardCompanyownsamachinethatwaspurchasedonJanuary1,2xx1,at
acostof$10,000.Themachinehasbeendepreciatedonastraight-linebasiswitha
usefullifeofsixyearsandexpectedsalvagevalueof$1,000.OnJanuary1,2xx5,
themachineistradedinforanewmachinewithalistpriceof$20,000.
Thecompanyreceivesatrade-inallowancefortheoldmachineof$1,200,
whichisestimatedtobeitsfairmarketvalueatthattime.Thenewmachinehasan
expectedusefullifeoftenyearswithnosalvagevalueandwillbedepreciatedby
usingthestraight-linemethod.
Assumingtheuseoffederalincometaxprocedures,preparejournalentriesto
recordtheexchangeofmachinesonJanuary1,2xx5.Prepareajournalentryto
recorddepreciationofthenewmachineonDecember31,2xx5.
SolutiontoReviewProblem7.1
Withfederalincometaxprocedure,nogainorlossisrecognizedontheexchange.
However,thisaffectsthecostbasisofthenewmachine.
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DepreciationExpense
131
TheJanuary1,2xx5entrywouldbe:
Machine
.......................................
21,300
OldMachine—AccumulatedDepreciation
.........
7,500
OldMachine
.................................
10,000
Cash
.......................................
18,800
Torecordtrade-inofmachinefornewmachine.
Sincethecostrecognizedis$21,300,theannualdepreciationchargeswouldbe:
$21
,
300
10
=
$2
,
130
.
TheDecember31,2xx5entrywouldbe:
DepreciationExpense
.................................
2,130
NewMachine—AccumulatedDepreciation
.........
2,130
QuestionsandProblems
1.Inthecourseofobtaininganewmachineforitsfactory,acompanyincurred
thefollowingcosts.Whichcostswouldproperlybeincludableinthecostof
themachine?
a.Thenetinvoicecostofthemachine.
b.Adiscountlostwhentheinvoiceforthemachinewasnotpaidontime.
c.Costofremovinganoldmachinetomakeroomforthenewmachine(the
oldmachinehadbeenretiredayearagoandwouldhavebeenremovedin
anyevent).
d.Transportationcostsofthenewmachine.
e.Installationcostsofthenewmachine.
f.Costsofrepairingthenewmachine:aworkmandroppedthemachineduring
installationandextensiverepairswerenecessarybeforethemachinecould
beused.
2.Depreciationaccountinginvolvestheuseofestimates.Atthetimeanasset
isretiredorsold,however,manyofthefactorsaffectingtheannualcostof
usingtheassetbecomeknown.Foreachofthefollowingerrorsinestimation,
indicatewhethertheaccountingentriesatthetimeofretirementwouldshow
againorloss:
a.Estimatedusefullifeshorterthanactual.
b.Estimatedsalvagevaluehigherthanactual.
c.Estimatedremovalcostslowerthanactual.
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AnIntroductiontoAccountingandManagerialFinance
d.Estimatedusefullifelongerthanactual.
e.Estimatedsalvagevaluelowerthanactual.
3.Whatisthe“bookvalue”ofadepreciableasset?Isthisareasonableestimate
ofmarketvalue?
4.Financialanalystsfrequentlyadddepreciationchargestoreportedincometo
obtainafgurethattheyrefertoas
cashfow
.Thisfgureissometimesusedas
asubstituteforreportedincomeinevaluatingsecurities.Isthisareasonable
indicatorofthefowofcashthroughafrm?Isitanimprovementoverreported
incomeformeasuringperformance?
5.ThepresidentoftheFederalCompanywassomewhatconfusedbyaccounting
terminology.Herecentlyreadinafnancialjournalthatcompanieswerefnanc-
ingtheircapitalexpendituresbyusingdepreciationallowancesandretained
earnings.Aninspectionofthemostrecentbalancesheetrevealedthatdepreci-
ationallowanceswere$20,000,000andretainedearningswere$40,000,000.
Thisinformationaddedtohisconfusion,forhistreasurerhadrecentlyinformed
himofthedesirabilityofpostponingcapitalexpendituresbecauseofalackof
cash.
Prepareabriefreportthatwillclarifytheterminology.Explainwhyfnancial
analystsoftenspeakofcapitalexpendituresbeingfnancedfromdepreciation
allowances.Aretheycorrect?
6.Accountantsusuallyinsistonusingobjectiveverifableevidencetosupport
fguresreportedinthefnancialstatements.Whatelementsofsubjectivityenter
intothedeterminationofdepreciationforaccountingreports?
7.TheABCCoalCompanyhastwoaccountingproblems:
a.Thecompanyisabouttodevelopastripminingfeld.Itisestimatedthat
atthecompletionoftheminingoperationintenyears,itwillcostthefrm
$10,000,000toplacethelandbackintoanacceptableconditiontoconform
withstatelegislation.Howshouldthecompanytreatthecostofreplacing
theland?
b.Thecompanyhasinstalledanelectroniccomputerthathasanestimated
usefullifeofsixyears.Itisestimatedthatitwouldcost$200,000toremove
thecomputerwhenitistobereplaced.Howshouldthecompanytreatthe
costofremovingthecomputer?
8.TheBarnesCompanypurchasedequipmentcosting$200,000onJanuary1,
19x1.Theequipmenthasanexpectedusefullifeoffveyearsandaforecast
netsalvagevalueatretirementof$20,000.Prepareascheduleofdepreciation
fortheyears19x1–19x5,showingforeachyear(1)thebookvalueofthe
equipmentatthebeginningoftheyear,(2)thedepreciationchargeforthe
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133
year,(3)theaccumulateddepreciationattheendoftheyear,and(4)thebook
valueoftheequipmentattheendoftheyear.Prepareaseparateschedulefor
eachofthefollowingmethods:
a.Straight-line.
b.Decliningbalanceattwicethestraight-linerate.
c.Sum-of-the-years’digits.
9.TheCarlsonCoalCompanypurchasedminingpropertyfor$10,600,000in
cash.Itwasestimatedthatthepropertycontained400,000tonsofrecoverable
coalandthatthelandwouldhaveavalueof$400,000afterthecoalhad
beenextracted.Duringthefrstyearofoperations,65,000tonsofcoalwere
recovered,ofwhich50,000tonsweresold.Preparejournalentriestorecord
thepurchaseofthepropertyandtorecognizethecostofcoalextractedand
soldduringtheyear.
10.TheCollierCoalCompanypurchasedminingpropertyfor$6,400,000incash.
Itwasestimatedthatthepropertycontained300,000tonsofrecoverablecoal
andthatthelandwouldhaveavalueof$400,000afterthecoalhadbeen
extracted.Duringthefrstyearofoperations,35,000tonsofcoalwererecov-
ered,ofwhich25,000tonsweresold.Prepareentriestorecordthepurchase
ofthepropertyandtorecognizethecostofcoalextractedandsoldduringthe
year.
11.TheHaberCompanypurchasedlandinArizonaonwhichuraniumhadbeen
discovered.Thecostofthelandwas$1,000,000.Additionalcostsnecessary
topreparethelandforminingoperationswere$200,000.Itisestimatedthat
5,000,000tonsoforecontaininguraniumwillbeextractedbeforethemineis
fullyminedout.Duringthefrstperiodofminingoperations,500,000tonsof
uranium-bearingoreweredugandshippedtotherefnery.Thecostofgetting
theoreoutofthegroundandintorailroadcarswas$930,000.
Recordthetransactions.
12.TheHayesCorporationacquiredatacostof$25,000,000theassets
andnameofanothercorporationwhichitintendstooperateasadivi-
sion.Thebalancesheetoftheacquiredcorporationshowedthefollowing
assets:
CashandOtherLiquidAssets$3,000,000
Inventories5,000,000
PlantandEquipment16,000,000
Land1,000,000
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AnIntroductiontoAccountingandManagerialFinance
Anappraisalmadebyanindependentappraisalcompanylistedthecurrent
valuesoftheassetsasfollows:
CashandOtherLiquidAssets$3,500,000
Inventories4,700,000
PlantandEquipment12,000,000
Land2,500,000
a.Atwhatvaluesshouldthenewlyacquiredassetsberecorded?
b.Iftheappraisalvalueoftheplantandequipmenthadbeen$20,000,000
insteadof$12,000,000,atwhatvalueswouldyourecordtheassets?
13.Equipmentwaspurchasedfor$60,000withanexpectedusefullifeoffour
years.Thecompanyusesthesum-of-the-years’digitsmethodofdepreciation
andexpectssalvagevaluetoequaltheremovalcostattheendofthefourth
year.Attheendofthethirdyear,newequipmentispurchasedtoreplacethe
presentequipment.Theoldequipmentissoldfor$15,000,andremovalcosts
are$3,000.
Preparetheentriestorecordtheretirementoftheoldequipment.
14.TheHarknessCompanytradedinacarforanewmodel.Theoldcarcost$3,500
andwas90percentdepreciated.Thelistpriceofthenewcarwas$4,500,but
theKeenCarAgencyofferedtoallow$1,200ontheoldcar.TheHarkness
Companyhadtriedtoselltheoldcar,andthebestcashpricetheyhadbeen
offeredwas$475.TheKeenCarAgencyofferedtopay$475cashfortheold
cariftheHarknessCompanydidnotwanttotradeitin.
a.Makethejournalentriestorecordthetrade-infromthepointofviewofthe
HarknessCompany.
b.Makethejournalentriestorecordthetrade-infromthepointofviewofthe
KeenCarAgency.
15.TheHardyCompanyceasedoperationsinitsIllinoisplantonJuly1.OnAugust
1,itwasdecidedtodismantletheequipmentandselltheplant.Thecostof
dismantlingtheequipmentwas$7,000.Theequipmentwassoldasscrap,and
second-handequipmentwassoldfor$20,000.Theplantwassoldfor$120,000,
andtherewereexpensesof$6,000connectedwiththesale.Depreciationwas
lastaccruedontheplantandequipmentonthepreviousDecember31.The
January1balancesintheplantandequipmentaccountsoftheIllinoisplant
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DepreciationExpense
135
wereasfollows:
Plant$2,000,000
Plant,AccumulatedDepreciation1,550,000
Equipment400,000
Equipment,AccumulatedDepreciation320,000
Thebuildingdepreciationwas$4,000permonth,andtheequipmentdepre-
ciationwas$3,000permonth.
Preparejournalentriestorecordthedepreciationfortheperiodandalsothe
retirementoftheplantandequipmentoftheIllinoisplant.
16.Assumeaninvestmentof$4,000hasthefollowingprojectedincomestate-
ments.Therearezerotaxes.Thecostofequityis0.10.
1234
Revenue$1,800$1,600$1,400$1,200
Depreciation1,000
1,000
1,000
1,000
Income$800$600$400$200
a.ComputetheNPVusingthecashfows.
b.Computetheeconomicincomesofeachyear(subtractaninterestcoston
thecapitalused).
ComputetheNPVusingeconomicincome.
Computetheinvestment’sinternalrateofreturn.
c.Nowassumethedepreciationscheduleis:
YearDepreciation
1$1,600
21,200
3800
4400
ComputetheeconomicincomesofeachyearandtheNPVusingeconomic
income.
d.Whatisthepresentvaluedepreciationofeachyearif0.10isusedasthe
discountrateand$4,830isusedasthedepreciationbase?
e.Usingtheanswerto(d),computetheincomesandROEofeachyear.
f.Whatisthepresentvaluedepreciationofeachyearif0.20isusedasthe
discountrateand$4,000isusedasthedepreciationbase?
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AnIntroductiontoAccountingandManagerialFinance
g.Usingtheanswerto(f),computetheincomeandROEofeachyear.
h.(continuea)Insteadofaninvestmentof$4,000,assumethebookvalueis
$9,000andtheterminalvalueattime4is$1,756.92.
ComputetheNPVusingthecashfows.
Computetheeconomicincomesofeachyear.
ComputetheNPVusingeconomicincomesandotherrelevantinformation.
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Chapter8
Long-TermLiabilities
A
conventionalbond
isapromisetopayafxedamount(theprincipal)atthe
endofacertainnumberofperiodsandanotheradditionalamounteachperiodas
interest.Theamounttobepaidattheendofthelastperiodisalsoreferredtoas
the
maturityamount
or
facevalue
.Theamountofeachequalperiodicinterest
paymentmaybestatedasadollaramount.Inthelattercase,thestatedpercentage
isreferredtoasthe
contractualrate
.Thistypeofconventionalbondsecurityis
sometimescalledaballoonpaymentdebt.
Intermsofcompoundintereststructure,abondmaybeviewedasacombination
oftwocomponents:(1)thestreamofinterestpayments,whichmayberegardedas
anannuity;and(2)theamount,whichisalumpsumtobereceivedafteranumber
ofperiodsatthematurityofthebond.Thepresentvalueofaballoonpayment
isthepresentvaluesofthetwocomponentsaddedtogethertoobtainthepresent
valueofthebond.
Example
Computethepresentvalueofabondwhosefacevalueis$1,000.00,dueinfour
years,withannualinterestpaymentsof$120each.Moneyisworth12percent
annually.
Answer:
First,thepresentvalueofthematurityamountisdetermined.Thepresentvalueof
$1dueinfourperiodsat12percentinterestis0.6355.Therefore,thepresentvalue
of$1,000.000is
$1
,
000
.
000
×
0
.
6355
=
$635
.
50
.
Thepresentvalueoftheinterestpaymentsisequaltothepresentvalueofanannuity
of$1perperiodforfourperiods(at12percent,thisis3.037).Therefore,thepresent
137
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AnIntroductiontoAccountingandManagerialFinance
valueof$120.00perperiodis
$120
×
3
.
037
=
$364
.
Addingthetwopresentvalues,weobtainthepresentvalueofthebond:
Presentvalueofmaturityamount$636
Presentvalueofinterestpayments364
Presentvalueofbond$1,000
Severalfactorsintheexamplegivenshouldbeobserved.Notethatthecon-
tractualrate(interestpaymentsasapercentageofmaturityamount)isequalto
12percent.The
effective
or
marketrate
ofinterestisalso12percent.Ifthetwo
ratesareequal,thepresentvalueofthebondisidenticalwiththematurityamount.
Theequalitywillalwaysholdwhenevertheeffectiveinterestrateisequaltothe
contractualrate.
Itislikelythattheeffectiveinterestrateofabondwillnotbeexactlyequal
tothecontractualrate.Themarketratefuctuatesfromdaytoday,dependingon
variouseconomicforces.
Thepriceofthebondcanbesetatalevelthatwillallowthepurchasertoearn
theeffectiverateontheinvestment.Thatis,thepriceofthebondwillbeequalto
thepresentvalue,nottothematurityamount.
Ifthecontractualrateislessthanthemarketrate,thebondwillsellinthemarket
forlessthanitsfacevalue(i.e.,itwillsellata
discount
).Ifthecontractualrateis
abovethemarketrate,thebondwillsellformorethanitsfacevalue(i.e.,itwill
sellata
premium
).Theexactpriceisdeterminedbypresentvaluecalculations.
Example
Assumethatthe$1,000bondwithalifeoffouryearspaying$120interestperyear
wasissuedataneffectiverateof10percent.Determinethepriceatwhichitwould
beissued.
Thepresentvalueof$1forfourperiodsat10percentis0.6830.Therefore,the
presentvalueofthematurityamountof$1,000is
$1
,
000
.
000
×
0
.
6830
=
$683
.
00
.
Thepresentvalueof$1perperiodforfourperiodsis3.1699.Therefore,thepresent
valueofthestreamofinterestpaymentsof$120is
$120
×
3
.
1699
=
$380
.
39
.
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Long-TermLiabilities
139
Thepriceatwhichthebondwouldbepricediscalculatedasfollows:
Presentvalueofmaturityamount$683.00
Presentvalueofinterestpayments380.39
Presentvalueofbond$1,063.39
Becausethecontractualrateof12percentishigherthantheeffectiverateof
10percent,thebondwillsellatapremium.Theamountofthepremiumisthe
differencebetweenthepresentvalueandthefacevalueofthebond.
Presentvalueofbond$1,063.39
Facevalueofbond1,000.00
Premium$63.39
Example
Assumethatthe12-percent$1,000bonddescribedinthepreviousexamplewas
issuedataneffectiverateof15percent.Determinethepriceatwhichitwouldbe
issued.
Thepresentvalueof$1forfourperiodsat15percentis0.5718.Therefore,the
presentvalueofthematurityamountof$1,000is
$1
,
000
.
000
×
0
.
5718
=
$571
.
80
.
Thepresentvalueof$1perperiodforfourperiodsat15percentis2.8550.There-
fore,thepresentvalueofthestreamoffourinterestpaymentsof$120is
$120
×
2
.
8550
=
$342
.
60
.
Thepriceofthebondis:
Presentvalueofmaturityamount$571.80
Presentvalueofinterestpayments342.60
Presentvalueofbond$914.40
Becausethecontractualrateof12percentislowerthantheeffectiverateof
15percent,thebondwouldsellatadiscount.Theamountofthediscountisthe
differencebetweenthefacevalueandthepresentvalueofthebond.
Facevalueofbond$1,000.00
Presentvalueofbond914.40
Discount$85.60
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AnIntroductiontoAccountingandManagerialFinance
Inthecalculationsjustgiven,theeffectiveratewasconsistentlyusedtocompute
presentvalues.Thecontractualrateisnotusedtodiscountfortime,althoughit
isusedtodeterminetheamountofinterestpayments.Thebondconsideredinthe
calculationscitedaboveisdescribedasa“$1,000.00,12-percentbondwithfour-
yearmaturity.”Insuchcases,itisimportanttorememberthatthecontractualrateis
usefulonlyfordeterminingtheamountoftheinterestpayments(e.g.,$1
,
000
.
00
×
12percent
=
$120
.
00).Itisnotusedasarateinthepresentvaluecalculations.
Therateusedtocomputethepresentvaluesistheeffectiveinterestrate.
TheSemiannualInterestComplexity
Long-termbondsfrequentlywillpayinterestsemiannually.Thisgivesrisetoconfu-
sionastowhatannualreturnisearnedorwhatthecostistotheissuingcorporation.
Thereturnfromlong-termbondsisusuallyexpressedinnominalratesofone
year,eventhoughinterestispaidsemiannually.Forexample,a$1,000par(face
value)bondpaying$45interesteverysixmonthswithacontractualinterestrate
of0.09wouldhaveaneffectiveinterestrateof
r
=
1
+
0
.
09
2
2
−
1
=
0
.
092025
orjustover0.0920ifitissoldatfacevalue.
Assumethatyoucanearn0.092025onreinvestedfundsandthatyouaregiven
thechoicebetweena0.09$1,000bond(interestpaidsemiannually)ora$1,000
bondpaying0.092025.Withthislatterbond,youwillhave$1,092.025attime1.
Withthe0.09bond,youwillagainhave$1,092.025:
1
/
2
(
$90
)(
1
.
092025
)
1
/
2
=
$47
.
025
attime1
=
1
,
045
.
000
Presentvalue
=
$1
,
092
.
025
Thebondwitha0.09contractualinterestrateactuallyearnsmorethan0.09ifthe
interestisreceivedeverysixmonths.
Assumeathirdbondthatpaysinterestannuallyattherateof0.09sothatatthe
endoftheyeartheinvestorwouldhave$1,090.Thisisinferiortotheconventional
0.09bondthatpaysinteresteverysixmonths.
Ifa0.0930-yearbondwithsemiannualinterestpaymentsisissuedatpar,
itisconventionalpracticetodescribetheyieldtomaturityasbeing0.09.With
semiannualinterestpayments,itwouldbemoreaccuratetosaythattheyieldto
maturityis0.092025.Bondyieldtablesthatareusedtovaluebondswouldindicate
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Long-TermLiabilities
141
thattheyieldtomaturityis0.09.Youhavetorememberthatthiscontractualrateis
anominalrateandthattheeffectiverateis0.092025peryearor0.045compounded
everysixmonths.
Witha30-yearbond,wecoulduse60timeperiodsanda0.045interestrateto
computethepresentvalue:
$1,000(1.045)
−
60
=
$1,000(0.07129)
=
$71.29
$45B(60,0.045)
=
$45(20.638022)
=
928.71
Presentvalue
=
$1,000.00
Ifweuse0.092025,wehavetouse30timeperiodsandannualinterestcosts
of$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
=
$1,000.00
Notethatthemarketinterestrate,thenumberoftimeperiods,andtheannual
interestpaymentsallhavetobeconsistentmeasuresthatapplytothesameunit
oftime.
AZero-CouponBond
Somebondsonlypayinterestatthematurityofthebond.Thesearecalledzero-
couponbondsormoneymultipliernotes.Theyarealsocalledoriginalissue
discount(OID)notes.
Thevaluationofazero-couponbondislesscomplexthanisthatofaconven-
tionalbond.Ifthematurityamountofthebondis$1,000duein30yearsandifthe
bondistoyield0.10annually,thepresentvalueofthebondis
PV
=
$1
,
000
(
1
.
10
)
−
30
=
$57
.
31
.
A$1,000bond(zerocoupon)maturingin30yearsandyielding0.10willonly
cost$57.31attime0.Youcanseewhythename“moneymultiplier”isanapt
description.
Ifthecompanygoesbankruptinyear29,theinvestorwillnotearn0.10.
Example
Assumeaten-yearbondandtheeffectivemarketinterestrateis0.14.
$1
,
000
.
00
×
0
.
26974
=
$269
.
74
.
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AnIntroductiontoAccountingandManagerialFinance
Theissuanceofa$1,000bondwouldberecordedwiththefollowingentry:
Cash.................................269.74
BondsPayable....................269.74
Anequivalententrywouldbe
Cash.................................269.74
BondDiscount........................630.26
BondsPayable....................1,000.00
Theinterestforthefrstyearis14percentof$269.74,or$37.76.Theentryif
thebonddiscounthadnotbeenseparatelyrecordedwouldbe
InterestExpense.......................37.76
BondsPayable....................37.76
Theentryifthediscounthadbeenseparatelyrecordedwouldbe
InterestExpense.......................37.76
BondDiscount...................37.76
Bothentriesincreasetheliabilityby$37.76.Theinterestforthesecondyearwill
be14percentof$307.50,or$43.05.Thisprocessisrepeatedeachyearuntil
maturity.Atmaturity,therecognizedliabilityshouldbeequaltothematurity
amount.
ReducingtheBondLiability
Whenabondispaidatmaturity,theliabilityisdebitedforthefaceamount.With
asystematicamortizationofpremiumoraccumulationofdiscount,thebondlia-
bilitywillbeshownatitsfaceamountatmaturity.Theentrytorecordtheretire-
mentatmaturityofa$1,000-face-valuebondbyapaymentofcashwouldbeas
follows:
BondsPayable..............................1,000
Cash..................................1,000
Torecordretirementof$1,000bondatmaturity.
Corporationssometimesfnditdesirabletopaydebtpriortomaturity.Ifinterest
rateshavefallensincetheoriginalissue,forexample,itmaybeadvantageous
to“call”theoutstandingbondsatasetpriceandissuenewbondsatthelower
rate.Thisisfacilitatedifthebondagreementallowsthecorporationtocallthe
bonds—thatis,requirestheinvestorstoturnthemintothecorporationatafxed
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Long-TermLiabilities
143
price—andmanybondagreementsdohavethisfeature.Corporationscanalso
purchasetheirbondsontheopenmarketwheninterestratesfall,butsincethebond
pricewillhaverisen,thesamepotentialforgaindoesnotexistaswhenthebonds
arecallable.
Ifabondisretiredpriortomaturity,itisunlikelythattheamountpaidoutby
thecorporationwillequalthecurrent“bookvalue”ofthebond.Theamortization
ofpremiumordiscountiscalculatedontheassumptionthatthebondwillbe
outstandinguntilmaturity.Butfuctuationsininterestrateswillcausethemarket
priceofthebondstochangeovertheyears,althoughthesepricechangesarenot
normallyrecognizedintheaccounts.
Whenabondretirespriortomaturityatapricethatis
higher
thantherecorded
bookvalue,a
loss
wouldberecognizedbythecorporation.Ifthepriceis
lower
thantherecordedbookvalue,a
gain
wouldberecognized.Inaccordancewith
currentpractice,thesegainsorlosseswouldbeshownontheincomestatementbut
classifedasanextraordinaryitem.Thus,thegainorlosswillaffectnetincome,
althoughitwillbeseparatelyidentifed.
Theclassifcationofgainsorlossesfromearlyextinguishmentofdebtas
extraordinaryitemsseemstobeadeparturefromtherulethatitemsmustbe
unusualinnatureandnotlikelytorecurtoqualifyasextraordinary.Theclassif-
cationofthegainsasextraordinaryisrequiredtoreducethepossibleconfusion
causedbyreportinggainsfromdebtretirementasordinaryincome.Intimesofris-
inginterestrates,somecorporationswouldfnditpossibletorefnancetheirdebt
at
higher
interestratesandyetreportthegainasordinaryincomeintheirfnancial
statements.
TheBondRefundingDecision
Assumethereare$10,000,000(facevalue)of0.12bondsoutstandingwith20years
ofliferemaining.Thebondsarecallableat$1,050perbondor$10,500,000intotal.
Theincrementalcostsofrefundingare$2,000,000.
Now,20-yearbondscanbeissuedtoyield0.08.Assumezerocorporatetaxes.
AnEasyIncorrectSolution
Thecorporationcouldissue$10,000,000of0.08bondsandsave$400,000of
interesteachyear.
NPV
=
400
,
000
(
20
,j)
−
2
,
000
,
000
.
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AnIntroductiontoAccountingandManagerialFinance
Thisseemstobeatypeofinvestmentdecision.Thefrmuses0.20toevaluate
investments.Assume
j
equals0.20intheaboveequation.
NPV
=
400
,
000
(
4
.
86958
)
−
2
,
000
,
000
=
1
,
948
,
000
−
2
,
000
,
000
=−
$52
,
000
.
Refundingisnotdesirablebasedonthiscalculation.
Theissuethatneedstoberesolvediswhetherthe0.20shouldbeusedasthe
discountrateorwhetherthenewborrowingrateof0.08shouldbeused.
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“AnEasy
CorrectSolution”.
Theanalysisshouldbeonanafter-taxbasis,butthetaxconsiderationsintroduce
nospecialanalyticalcomplexities.
AMoreComplexCalculation
Thepresentvalueofthe0.12outstandingdebtusinga0.08discountrateis:
1,200,000B(20,0.08)
=
$11,782,000
10,000,000(1.08)
−
20
=
2,145,000
PV$13,927,000
Assume$13,927,000ofnew0.08debtisissued(thesamepresentvalueasthe
outstandingdebt).Aftercallingthedebtandpayingalltherefundingexpenses,
wehave:
CashFlowsIn$13,927,000
PayOldDebt$10,000,000
RefundingExpenses2,000,000
12,000,000
NPV$1,927,000
TheNPVisagainequaltotheNPVusing“AnEasyCorrectSolution”.
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Long-TermLiabilities
145
Conclusion
Thetimevalueofmoneyisrelevanttotheunderstandingandtherecordingof
fnancialtransactions.Thetimingofthecollectionorpaymentisimportantaswell
asthedollaramountinvolvedinatransaction.Therearefewfnancialtransactions
thatdonotdependinsomemanneronanapplicationofthefundamentalsof
compoundinterest.
Thevalueofabondisequaltothesumof(1)thepresentvalueoftheprincipal
atmaturityand(2)thepresentvalueoftheseriesofinterestpayments.Witha
normalballoonpaymentbond(e.g.,interestpaymentseachyearandtheprincipal
atmaturity),thebondwillsellatfacevalue(par)ifthemarketinterestrateis
equaltothecontractualrateofthebond.Thebondwillsellatadiscountifthe
marketinterestrateismorethanthecontractualrate.Theinterestexpenseeach
periodisequaltothepresentvalueofthebondatthebeginningoftheperiodtimes
themarketrateofinterestusedtocomputethepresentvalue.Semiannualinterest
paymentsintroduceacomputationalcomplexity.
Leasesthatareessentiallypurchasesofpropertyarecalledcapitalleases.The
accountingtreatmentforcapitalleasesistorecordtheacquisitionofalong-lived
assetandtheissuanceofalong-termliabilityatthepresentvalueofthelease
payments.Thelong-livedassetisdepreciatedoramortizedovertime,andinterest
expenseisrecognizedonthelong-termliability.Allotherleasesarecalledoperating
leases.Theaccountingtreatmentforoperatingleasesistorecordtheleasepayments
asperiodicrentexpense.
ReviewProblems
ReviewProblem8.1
a.Whatisthepresentvalueof$1,000dueintenyears,discountedat14percent?
b.Whatisthepresentvalueof$140peryearforaperiodoftenyearsiftherate
ofinterestusedtodiscountthepaymentsbacktothepresentis14percent?
c.Whatisthesumofthetwoamountsobtainedinparts(a)and(b)?
d.Atwhatpricewoulda14-percent,$1,000,ten-yearbondsellifitistoyield14
percent?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
.
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AnIntroductiontoAccountingandManagerialFinance
c.$269
.
74
+
$730
.
26
=
$1
,
000.
d.$1,000(seepart(c)).
ReviewProblem8.2
Ifthebondofthepreviousproblempaid10percentinterestperyear($100),at
whatpricewoulditsell?
a.Recorditsissuance(useaDiscountaccount).
b.Recordthefrstyear’sinterest.
SolutiontoReviewProblem8.2
$1
,
000
×
0
.
26974
=
$269
.
74
$100
×
5
.
21614
=
521
.
61
Price(value)ofbond$791
.
35
Cash....................................791.35
BondDiscount...........................208.65
BondsPayable......................1,000.00
Theinterestexpenseforthefrstyearis:
$791.35
×
0.14
InterestExpense$110.79
InterestExpense.........................110.79
InterestPayable.....................100.00
BondDiscount......................10.79
Thenewliabilityafterinterestisaccruedis:
$791.35
+10.79
$802.14
or
$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,indicatewhetherthebondswouldbesold
atthefaceamount,atapremium,oratadiscount:
a.A$1,000bondwith20-yearmaturity.Interestcouponsattached,eachin
theamountof$120,arepayableannually.Themarketrateofinterestis14
percent,compoundedannually.
b.A$1,000bondwithten-yearmaturity.Interestcouponsattached,eachin
theamountof$140,arepayableat12-monthintervals.Themarketrateof
interestis14percent,compoundedannually.
c.A$1,000bonddueinfveyears.Interestcouponsattached,eachinthe
amountof$150,arepayableannually.Themarketrateofinterestis14
percent,compoundedannually.
2.Considertheformula
PV
=
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”.Whatisthepresentvalueof
aperpetuityof$1perperiodif
r
is10percent?
3.a.Whatisthepresentvalueof$1,000dueintenyears?Usea6percentrate
ofinterest.
b.Whatisthepresentvalueof$70peryearforaperiodoftenyears?Usea
6percentrateofinterest.
c.Whatisthesumoftheamountsobtainedinparts(a)and(b)?
d.Atwhatpricewilla7-percent,$1,000,ten-yearbondsellifitistoyield6
percent?
e.RecordtheissuanceofsuchabondonJanuary1andthepaymentofthe
frstyear’sinterestonDecember31.
4.Determinetheamountyouwouldbewillingtopayfora$1,000,6-percent,
20-yearbond.Youdesireayieldof8.16percentperyear(4percentcom-
poundedeverysixmonths).Interestistobepaidtwiceayear.
5.Assumethatyoucanborrowandlendmoneyat10percentinterestperyear
andthatsecuritiesyieldingthisreturncanbeobtainedwithanymaturity.You
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AnIntroductiontoAccountingandManagerialFinance
aregiventhefollowingchoice:
a.$1,000tobereceivedannually,frstpaymenttobereceivedoneperiodfrom
now.Thepaymentswillcontinueforever.
b.$11,000tobereceivedimmediately.
Assumingyoucanobtaineitheralternative(a)or(b),whichwouldyouchoose?
6.Determinethepresentvalueofafve-year,$1,000,6-percentbondthatsoldfor
ayieldof7percent(theeffectiveinterestrate).Interestispaidannually.Prepare
abondamortizationschedule.Preparetheentriestorecordtheliabilityofthe
bondissued,theinterestchargeseachyear,andthepaymentoftheprincipal.
Period
Valueof
Bond
Beginning
ofPeriod
Interest
Expense
forPeriod
Interest
Payable
Amount
Subtracted
from
Discountor
Premium
ValueofBond
EndofPeriod
1
2
3
4
5
7.Determinethepresentvalueofafve-year,$1,000,7-percentbondthatsoldfor
ayieldof6percent(theeffectiveinterestrate).Interestispaidannually.Prepare
abondamortizationschedule.Preparetheentriestorecordtheliabilityofthe
bondissued,theinterestchargeseachyear,andthepaymentoftheprincipal.
Period
Valueof
Bond
Beginning
ofPeriod
Interest
Expense
forPeriod
Interest
Payable
Amount
Subtracted
from
Discountor
Premium
ValueofBond
EndofPeriod
1
2
3
4
5
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Long-TermLiabilities
149
8.Determinethepresentvalueofafve-year,$1,000,5-percentbondthatsoldfor
ayieldof6percent(theeffectiveinterestrate).Interestispaidannually.Prepare
abondamortizationschedule.Preparetheentriestorecordtheliabilityofthe
bondissued,theinterestchargeseachyear,andthepaymentoftheprincipal.
Period
Valueof
Bond
Beginning
ofPeriod
Interest
Expense
forPeriod
Interest
Payable
Amount
Subtracted
from
Discountor
Premium
ValueofBond
EndofPeriod
1
2
3
4
5
9.If$1isdepositedonJanuary1,howmuchmoneywillhaveaccumulatedat
theendofoneyearif:
a.Thebankcomputesinterestannually,usinganinterestrateof6percent?
b.Thebankcomputesinteresteverysixmonths,usinganinterestrateof3
percenteverysixmonths?
c.Whatisthecompoundeffectiveannualrateofinterestforthesituation
describedinpart(b)?
10.TheMarshallCompanyauthorizedabondissueoften$1,000,7-percent,
20-yearbonds.
a.RecordtheissuanceofthebondsonJanuary1,2xx3,soastoyield6.09
percentannually(3percentcompoundedtwiceayear).
b.RecordtheaccrualofinterestonJune30,2xx3,andthepaymentofinterest
onJuly1.
c.RecordtheaccrualofinterestonDecember31.
d.Whatwillbethebondliabilityaftertenyears?
11.TheFenwickCompanyauthorizedabondissueoften$1,000,6-percent,
20-yearbonds.Theselow-interestbondswillsellatadiscount.
a.RecordtheissuanceofthebondsonJanuary1,2xx3,soastoyield8.16
percentannually(4percentcompoundedeverysixmonths).
b.RecordtheaccrualofinterestonJune30,2xx3,andthepaymentofinterest
onJuly1.
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AnIntroductiontoAccountingandManagerialFinance
c.RecordtheaccrualofinterestonDecember31.
d.Whatwillbethetotalbondliabilityaftertenyears?
12.Determinetheamountyouwouldbewillingtopayfora$1,000,8-percent,
20-yearbond.Youdesireayieldof10.25percentperyear(5percentcom-
poundedevery6months).Interestistobepaidtwiceayear.
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Chapter9
Stockholders’Equity
Thedivergencebetweenaccountingandfnanceiswellillustratedbythestock-
holders’equityaccountsofapubliclytradedcorporation.Theaccountantrelieson
thehistoryofstockequitytransactionsandfnancereliesonmarkettransactions
forstockvalueestimates.Formostmanagerialdecisions,onlythemarketvalue
measuresarerelevant.Thetraditionalaccountingmeasuresarerelativelyirrelevant
asidefromlegalaspects.
Woulditbeusefuliftheaccountantweretousethemarketvaluestoadjust
thereportedamountsofstockholders’equity?Remember,wearedealingwitha
double-entryaccountingsystem.Ifthemarketvalueofthestockequityisusedas
thebasisoftheaccounting,anotheraccount(probablyanassetaccount)wouldalso
havetobeadjusted.Butthemarketisusingtheaccountingmeasurestovaluethe
commonstock.Iftheaccountingmeasuresarebasedonthemarketmeasuresofthe
stock,thenthemarkethaslostausefultoolforestimatingvalue.Sowehavetolive
withthefactthattheaccountingmeasuresofstockholders’equitywilldifferfrom
themarketvalue,andthisdifferenceisessentialtothedeterminationofmarket
value.Thismeansthatadecisionmakermustdeterminewhethertheaccounting
measuresorthemarketvalueofthestockismoreuseful.Formostpurposes,the
marketvaluewillbemostuseful.Insomesituations,thedecisionmakerwillwant
toignorethemarketvalueandusetheunderlyingaccountingmeasurestoestimate
thevalueofthestockwithoutinitialreferencetothemarketvalue(alaterreference
islikelytobeappropriate).
Commonstockpurchasersmaybeinterestedinthesplitbetweenpermanent
legalcapitalandretainedearnings,sincethedividendsmayberestrictedbythe
amountofretainedearnings.However,foracommonstockpurchaserlookingto
thelongrun,theallocationamongthedifferentstockequityaccountsmaybeof
lessimportance.Long-termrestrictionsonthepaymentofdividendsmaybeof
interest,buttheserestrictionsarenotalwaysrecordedintheaccounts.
151
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ClassifcationofStockholders’Equity
Theaccountantmayclassifythestockholders’equitysectioninvariousways.The
selectionoftheclassifcationthatismostusefulwilldependontheinterestsofthe
usersofthefnancialstatements.Classifcationsaredesignedtoaccomplishthe
followingpurposes:
1.Distinguishamongequitiesofvariousclassesofstockholders;
2.Distinguishbetweenparvalueofstockandamountspaidinexcessof,orbelow,
par(alegalrequirement);
3.Distinguishsharesissuedandoutstandingfromthosethathavebeenreacquired
bythecorporation;
4.Distinguishbetweencapitalarisingfromoriginalcontributionsofstockholders
andthatgeneratedthroughtheretentionofearnings;and
5.Distinguishbetweenretainedearningsavailablefordistributiontostockholders
andretainedearningsrestrictedforvariousreasons.
ParValue
Commonstockmaybeissuedwithparorwithstatedvalues.Theseamountsmay
havecertainlimitedlegalsignifcance,butarenotusuallyofimportancetobuyers
ofcommonstock.Whenacommonstockhasaparvalue,itisgenerallydefnedby
thelegalrequirementsofthevariousstates.Theparvalueisoftenthebasisoftaxing
theissuanceandexchangeofstock.Theaccountingentriestorecordtheissuance
ofcommonstockaremorelikelytobedictatedbythelegalrequirementsthanby
accountingtheory.Thus,insteadofusingoneaccounttorecordthecontribution
ofstockholders,wemightusetwoaccounts:onetorecordtheparorstatedvalue,
andtheothertorecordthedifferencebetweenissuepriceandparorstatedvalue
ofthestock.
Thedesignationofparvalueusuallyhaslittleeconomicsignifcance,butmerely
refectsthelegalrequirements.
Inthepast,theissuanceofstockforlessthanitsparvalueresultedinan
obligationforthestockholdertopaytothecorporationtheamountofthe“discount”
intheeventofcorporateinsolvency.Theuseof“nopar”stockand“lowpar”(such
as$1.00pershare)hasminimizedtheimportanceofthisaspect,andstockisnow
notissuedatadiscount.
Ifparvalueistobeshownseparatelyinthebalancesheet,thepositivedif-
ferencebetweenparandtheamountactuallypaidisshownthroughtheuseof
adjunctaccounts.Theadditionalamountisshowninanadjunctaccountreferred
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Stockholders’Equity
153
toeitherasAdditionalPaid-inCapital,AmountPaidinExcessofPar,orsimply
Premium.
IssuanceofCommonStock
Theissuanceofcommonstockisusuallyprecededbythesubscriptionofthe
stockbytheprospectivestockholders.Thistransactionmayberecorded,butthe
corporationgenerallywaitsuntilthecashisactuallyreceivedbeforerecording
entriesrelativetotheissuanceofthestock.
Whenparvaluesareinvolved,theentriestorecordtheissuancewouldbe
adaptedtorefecttheparvalueandtheamountofpremiumordiscount.Theissuance
ofnoparstockdoesnotrequirethisdistinction.
Example
Recordthejournalentriesforthefollowingsituation.
Onethousandsharesofcommonstock,par$10,areissuedfor$11pershare.
Cash............................................11,000
CommonStock,Par..........................10,000
CommonStock,AmountPaidinExcessofPar..1,000
Iftheissuepriceis$9pershare,theentryis:
Cash............................................9,000
CommonStock,Discount.........................1,000
CommonStock,Par..........................10,000
IssueofStockforAssets
Stockmaybeissuedforassetsotherthancash,suchasland,buildings,andpatents.
Theentryrecordingthestockholders’contributiontothecorporationisbasedon
arealisticvaluationoftheassetscontributed.Ifthestockissuedhasanactive
market,recentpricesofthestockmightbeusedtoestimatethevalueoftheentire
transaction.Ifnomarketexistsforthestock,thentheassetsreceivedshouldbe
appraised.Theamountreceivedforthestockshouldbeassumedtoequalthecurrent
valueoftheassetsreceivedatthetimeofthetransaction.
Forexample,assumethattheRCorporationissues10,000sharesofitscommon
stock,$1parvalue,inexchangeforabuildingandland.Thereisnoactivemarket
forthestock,butindependentappraisershiredbythecompanyplaceavalueof
$50,000onthebuildingand$20,000ontheland.Thetransactionwouldberecorded
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AnIntroductiontoAccountingandManagerialFinance
asfollows:
Building.........................................50,000
Land............................................20,000
CommonStock—Par.......................10,000
CommonStock—AmountPaidinExcessofPar60,000
Torecordtheissuanceofstockinexchangeforbuildingandland.
TreasuryStock
Whenacorporationrepurchasesitsownpreviouslyissuedstock,theacquired
sharesarereferredtoas
treasurystock
.Thetransactionmayberecordedinthe
followingmanner:
TreasuryStock...................................10,000
Cash.......................................10,000
Torecordthepurchaseof500sharesofcommonstockfor$10,000.
TheTreasuryStockaccountisthenpresentedinthebalancesheetasasub-
tractionfromthetotaloftheotherstockequityaccounts.AlthoughtheTreasury
Stockaccountwillhaveadebitbalance,acorporation’sownsharescannotlogi-
callyberegardedasanasset.Whenacompanypurchasesitsownstock,itis,from
aneconomicpointofview,retiringthatstock.Fromalegalpointofview,ashare
ofstockonceissuedmayhavedifferentcharacteristicsfromashareofstocknot
previouslyissued.Forexample,treasurystockmaybeissuedatapricelessthan
parwithoutthepurchaserbeingassessableforthedifferencebetweenparandthe
purchaseprice.Assumethatthestockintheexampleisreissuedfor$15,000.
Cash............................................15,000
TreasuryStock..............................10,000
CommonStock,AmountPaidinExcessofPar..5,000
Nogainorlossshouldberecognizedbyacorporationbecauseoftransactions
initsownstock.
Itcanbeincorrectlyarguedthatacompanythatpays$10,000forsharesofstock
andthenreissuesthesharesfor$15,000hasmadeaproftof$5,000.Ifitwerestock
ofanothercompanythatwasbeingboughtandsold,againwouldberecognized.
However,whenthecompanyhasacquireditsownstockfromitsstockholdersand
reissuesthestocktootherstockholders,nogainorlossisrecorded.
Thisisconsistentwiththeentityconcept.Wedistinguishrevenuetransactions
fromcapitaltransactions.
Revenuetransactions
arethosecarriedonwithinthe
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Stockholders’Equity
155
scopeofthepurposeforwhichthebusinessunitwasorganized—producing,sell-
ing,servicing,andsoforth.Gainsandlossesarerecognizedonsuchtransactions.
Capitaltransactions
aretransactionsinvolvingtheraisingofcapital—issuance
andretirementofownershipequity.Nogainsorlossesarerecognizedonsuch
transactions.
RetainedEarnings
Historically,accountantshaveattemptedtodistinguishbetweenthecapitalexplic-
itlycontributedbystockholders(wheretherehasbeenanissueofstock)andcapital
generatedfromretainedearnings(capitalthatdoesnotrequireanexplicitdecision
bytheindividualstockholders).Thisdistinctionservesseveralpurposes.Itindi-
catestosomeextentthepastproftabilityofthecorporation,althoughthisindica-
tionmaybedistortedbycashdividends,stockdividends,reorganizations,secret
reserves,disclosedreserves,andmergers.Thesecondpurposebehindthedistinc-
tionissomewhateasiertoaccomplish.Itisthefulfllmentoflegalrequirements
fortheseparationofcontributedcapitalandretainedearnings.Themainfunctions
ofthislatterrequirementaretosafeguardtherightsofthecreditorsandtoprevent
thedeclarationofdividendswhenthepaymentwouldendangertheabilityofthe
creditorstocollectionamountsduethem.Wewanttoknowtheamountofretained
earningsinordertodetermineifadividendcanbedeclaredlegally.
RetainedEarnings—Restrictions
Whenretainedearningsarelegallyrestricted,thisfactcanbeindicatedinfootnotes
orthroughtheuseofseparateaccountsidentifyingtherestrictions.Restrictions
mayoccurthroughtheprovisionsofbondindentures,cumulativepreferredstock
inarrearswithrespecttodividends,legalrequirementsregardingtheacquisition
oftreasurystock,andsoforth.Insuchcases,stockholdersmightwishtoknowthe
extenttowhichretainedearningsareavailablefordividends.
Suppose,forexample,thatacompanyhasretainedearningstotaling$100,000,
butprovisionsofabondindenturerequirethatdividendsmaybepaidonlytothe
extentthatretainedearningsexceed$90,000.Thisinformationmaybeindicated
inthebalancesheetthroughtheuseofseparatelydesignatedaccountstoshowthe
componentsofretainedearnings:
RetainedEarnings—RestrictedDuetoBondIndenture$90,000
RetainedEarnings—Unrestricted10,000
TotalRetainedEarnings$100,000
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TheUseofReserves
Occasionally,corporationsshowbalancesontheequitysideofthebalancesheet
thathavetheterm“reserve”intheirtitle.Usuallythesearecomponentsofretained
earningsthathavebeenseparatelyidentifed.Amongtitlesthathavebeenusedfor
suchitemsare:
ReserveforContingencies
ReserveforSelf-Insurance
ReserveforForeignOperations
ReserveforPossiblePriceDeclineofInventory
ReserveforUncollectibles
Thedesignationofsuch“reserves”hassometimesbeenusedtoconcealinfor-
mationfromstockholders.Assumeacompanyaddstosuchareserveduringa
proftableyearbyincludinganexpenseintheincomestatement,andthenavoids
showinganexpenseinsomesubsequentyearbydebitingthereserveaccountrather
thantheexpense.Thiswouldenablethecorporationtosmoothitsreportedincome
overtheyears.Theaccountingprofessionhastriedtoeliminatethispracticeand
hasbeensuccessfulingreatlyreducingtheextentofitsuse.
Formanyyears,accountantswererelativelylaxintheuseofthe“Reserve
forContingencies”accountestablishedbychargingexpenseaccountsforpossible
adverseevents.In1975,theFASBpublishedStatementofAccountingStandards
No.5,“AccountingforContingencies”,whichlimitstheuseofprovisionsfor
contingencies.
Anestimatedlossfromalosscontingencyshallbeestablishedbyachargeto
incomeonlyif
both
thefollowingconditionsaresatisfed:
a.Ithastobeprobablethatthelosscontingencywilloccur(theword“probable”
isusedinamannerthatimpliesaveryhighprobability).
b.Theamountofthelosscanbereasonablyestimated.
Forahundredyears,academicaccountantshavewarnedagainsttheuseof
reserveaccountingtomanipulateearnings.Supposethisyear’searningsare“too
high”.Theaccountantcandebitanexpenseaccountandcreditareserveaccount.
Thisyear’searningsarereduced.Assumethenextyear’searningsaretoolow.
Theaccountantcanthendebitthereserveaccountandcreditacashorliability
account(thus,theexpenseisnotincreased).Theaboveentriesmaybejustifedor
theymaybeattemptstostabilizeearnings.Inthe2006Enrontrial,JeffSkilling
wasaccusedofusingreservestoachievethetargetedearningsmeasures.Butthe
establishmentofareserveforestimateduncollectableaccountscanbeeithera
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Stockholders’Equity
157
reasonableattempttorecognizethatnotallthereceivableswillbecollectedoran
efforttostabilizetheearningsstreamthroughmanipulativeaccounting.Thefrst
explanationislegitimate.Theattempttostabilizeearningsisbadaccountingand
likelytobeacrime.
RetainedEarningsandCash
Thepresenceofretainedearningsdoesnotmeanthatthereisanequalamountof
cashontheassetsideofthebalancesheet.Retainedearningsrepresentaportion
ofthestockholders’shareinthetotalassets.Theremayormaynotbecash.The
retainedearningscannotbeidentifedwithaspecifcassetorgroupofassets.
Example
ABZCompany
BalanceSheetasofDecember31,20xx
Cash$10,000CommonStock$6,000
RetainedEarnings4,000
$10,000
$10,000
Intheforegoingbalancesheet,thecashisactuallygreaterthantheretainedearnings.
Ifthecompanythenbuys$10,000offxedassets,thebalancesheetbecomes:
ABZCompany
BalanceSheetasofDecember31,20xx
Cash—CommonStock$6,000
FixedAssets$10,000
RetainedEarnings4,000
$10,000
$10,000
Theretainedearningsareunchanged,buttheyare$4,000greaterthanthecash
balance,whichisnowzero.
Itissometimeserroneouslystatedthatdividendsare“paidoutofretained
earnings”.Thedeclarationofadividendservestoreducethebalanceofretained
earnings,andinmanycasestheamountofdividendsthatmaylegallybedeclared
islimitedbythebalanceofretainedearnings.Inthefnalanalysis,however,acash
dividendmustbepaidoutofcash,regardlessofthebalanceintheRetainedEarnings
account.Inasmuchasthepresenceofretainedearningsdoesnotnecessarilycoin-
cidewiththeholdingofcashbythecorporation,theamountofretainedearnings
isnotnecessarilyanindicationofthecorporation’sabilitytopaycashdividends.
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AnIntroductiontoAccountingandManagerialFinance
Stockholders’EquitySectionoftheBalanceSheet
Thestockholders’equitysectionofthebalancesheetgenerallyconsistsofthree
parts:thecapitalcontributedbythepreferredstockholders,theexplicitcontribu-
tionsofthecommonstockholders,and,fnally,theretainedearnings.Anycontraor
adjunctaccountsshouldbeplacedimmediatelyundertheprimaryaccountthatthey
adjust.Forexample,treasurystockshouldbeshownasasubtractionimmediately
belowasubtotalofthecommonstockholders’equity.
Thefollowingillustratesanumberoftypicalitemsastheymightbefoundin
thestockholders’equitysectionofabalancesheet.
Stockholders’Equity
PreferredStock,1,000SharesofPar$50
StockOutstanding
$50,000
CommonStock,10,000SharesofPar$10
StockIssued
$100,000
CommonStock,AmountPaidinExcess
ofPar
7,000
$107,000
RetainedEarnings45,000
$152,000
Less:TreasuryStock,1,000Shares(atcost)12,000
140,000
TotalStockholders’Equity$190,000
Fromacommonshareholders’perspective,the$190,000isarelevantmeasure
ofthestockholders’equityasmeasuredbytheaccountants.Theobservedstock
pricemultipliedbythenumberofoutstandingsharesgivesanalternativemeasure.
CostofCommonStock
Thecostofcommonstockequitycannotbeexplicitlyandaccuratelymeasured,
sincetheactualreturntostockholdersdependsnotonlyontheforecastofthe
earningsofthefrm,theinvestment,anddividenddecisionsthataremadebythe
frm,butalsoontheinterpretationbythestockmarketoftheseeventsanddecisions.
Indiscussingthecostofequitycapital,youshouldrealizethatthistopicis
themirrorimageofthedecisiontoinvestincommonstock.Thetheoryofstock
valuationisacrucialelementofthedeterminationofthecostofequitycapital.
AStockValuationModel
Thereareseveraldefnitionsofthecostofequitycapital.Thestandardacademic
defnitionisthatthecostofequitycapitalistherateofdiscountthatequatesthe
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159
presentvalueofallfutureexpecteddividendspersharetothepresentpriceofthe
commonstock.Itisthereturnoninvestmentrequiredbyinvestorssothattheyare
willingtoinvestinthecommonstock.
Letusfrstdefnethecostofequitycapital,
k
e
,astherateofinterestorreturn
thatinvestorsrequiretobuythecommonstock.Mathematically,thecostofequity
istheinterestratethatequatesthenextdividend,
D
1
,andtheexpectedpriceofthe
stockatthetime,
P
1
,backtothepriceofasharetoday,
P
,ifthenextdividendis
paidoneperiodinthefuture.Wethenhave
P
=
D
1
+
P
1
1
+
k
e
=
D
1
1
+
k
e
+
P
1
1
+
k
e
.
(9.1)
Thepricetodayisequaltothepresentvalueofthenextperiod’sdividendplusthe
nextperiod’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.Itstates
thatthecurrentmarketvalueofashareofcommonstockisequaltothepresent
valueofallfuturedividends,discountedatthecostofequitycapital.Thecostof
equitycapitalisthatrateofreturnthestockmarketexpectstoreceiveinorderto
compensateitfortheuseoffundsandtheriskassociatedwiththefuturedividend
stream.Equation(9.4)isthesimplestgeneralformulationforthevaluationof
commonstock.Itassumesthat
k
e
canbeusedasthecostofequitycapitalforall
years.
Althoughequation(9.4)couldbesolvedbytrialanderrorforanysetof
D
t
’s,
thereare“standard”growthpatternsofthedividendstream.Wepresentamodel
inthenextsectiontoillustratethismethodology.
Notethatthefuturestockprices(capitalgains)arenotdirectlyinequation(9.4),
butratherthefuturedividendsaresubstitutedforthesestockprices.
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AnIntroductiontoAccountingandManagerialFinance
AClosed-FormStockPriceModel
Oneofthesimplestassumptionsthatcanbemadeaboutexpecteddividendbehavior
isthatdividendsareexpectedtogrowataconstantratethroughtimesothat
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.Thisisaperpetualgrowthmodel
wheredividendgrowthisconstanteachperiod.
Solvingequation(9.5)forthecostofequitycapital,wefnd
k
e
=
D
1
P
+
g
(9.6)
andthisisawidelyacceptedtheoreticalmeasureof
k
e
,thecostofstockequity
capital.
Example
Acommonstockisexpectedtopaya$1-per-sharedividendattheendoftheyear.
Thestockholderswantareturnof15percentandexpectdividendstogrowatarate
of14percentperperiod.
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.
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Stockholders’Equity
161
Byobservingthecurrentannualdividend($1)andthecurrentprice(say,$25)
andusinganestimateof
g
(say,10percent),wecouldthenestimate
k
e
using
equation(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(or
zero)dividendsand,nevertheless,thecurrentmarketpricemaybeverylarge.The
currenthighprice,however,isonlyjustifedinarationalmarketbytheexpectation
ofhighfuturedividends(orotherformsofcashfowfromthefrmtoinvestors).
Thesummationofthepresentvalueoffuturedividendsdoesnotrequirethatthe
near-termdividendsbelarge.However,ifthereareseveralyearsofzerodividends
and/orchanginggrowthratesthroughtime,thenthemathematicalformulationof
P
doesnotreducetoanexpressionassimpleas
P
=
D
1
/(k
e
−
g)
.
Whatwouldbethevalueofastockthatpromisednevertopaycashtoits
investors(includingaliquidationdividendpayoffarisingfromsellingthefrm)?
Thevalueoftheseshareswouldbezero.Therehastobetheprospectofdividends
(defnedtobeanycashdistributionfromthefrmtoitsinvestors)forstocktohave
apositivevalue.
Theconstantgrowthratedividendvaluationmodelassumesthatthedividend
(
D
1
)
isexpectedtogrowataconstantrate
g
forever.Itmaybemorerealistic
toassumethatspecialinvestmentopportunitiesallowingahighgrowthrateare
availablenotinperpetuity,butonlyoversomefniteintervaloftime,
T
,andafter
timethegrowthratewillbesmaller.
Conclusion
Thischapterhasfocusedonwaysinwhichthestockholders’equitysectionof
afrm’sbalancesheetmaybeclassifedtoprovideadditionalinformation.The
informationsuppliedbythisclassifcationincludes(1)theseparationofequitiesof
variousclassesofstockholders;(2)theseparaterecognitionofamountscontributed
thataremoreorlessthanparvalue;(3)thedistinctionbetweencapitalinitially
contributedtostockholdersandcapitalgeneratedthroughretentionofearnings;
and(4)thedivisionofretainedearningswhendividendrestrictionsareinvolved.
Theseparationofvariouscommonstockequityaccountsmaybeoflim-
itedvaluetousersoffnancialstatements.Exceptforthesatisfactionoflegal
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AnIntroductiontoAccountingandManagerialFinance
requirements,theclassifcationofaccountsinthecommonstockholders’equity
sectionisoflittlebenefttolong-terminvestors.Futuredividendsarelikelyto
dependontheresultsoffutureoperationsandtheasset-debtstructure,noton
pastretainedearnings.Yet,theseclassifcationsarecommonlyrefectedinfnan-
cialstatements,andunderstandingtheirmeaningshouldfacilitatetheanalysisof
fnancialdata.
QuestionsandProblems
1.Whatisthesignifcanceofthe“parvalue”ofcommonstock?Isitabargain
topurchase“$100parvalue”stockforonly$80?
2.Distinguishbetween“stockdividends”and“dividendsonstock”.Distinguish
betweena“stockdividend”anda“stocksplit”.
3.Explainwhyitispossibleforacorporationtohaveretainedearningsofseveral
milliondollarswhilenotbeingabletoexpandplantfacilitiesbyonemillion
dollarswithoutraisingadditionalcapital.
4.ThebalancesheetoftheDupyCorporationshowsaRetainedEarningsbalance
of$3,500,000.Ananalysisoftheaccountrevealedthefollowing:
AnalysisofRetainedEarnings
Arisingfrompastearnings$2,500,000
Donationoflandbythecity600,000
Amountpaidinexcessofparvalueofpreferredstock100,000
Gainonsaleoftreasurystock180,000
Amountpaidinexcessofparvalueofcommonstock120,000
$3,500,000
CommentontheamountshownasRetainedEarnings.
5.Ifyoufounda“ReserveforRetirementAllowances”(foremployees)onthe
equitysideofabalancesheet,whatwouldyouthinkwasthenatureofthe
account?
6.ThebalancesheetoftheAeronauticalCorporationatDecember31,20x1,
showedthefollowingstockholders’equity:
6percentPreferredStock(parvalue$100per
share;authorized30,000shares;issuedand
outstanding15,000shares)
$1,500,000
CommonStock(parvalue$10pershare;
authorized500,000shares;issuedand
outstanding200,000shares)
2,000,000
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Stockholders’Equity
163
AdditionalPaid-inCapital:
OnPreferredStock$60,000
OnCommonStock2,000,000
2,060,000
TotalPaid-inCapital$5,560,000
RetainedEarnings2,800,000
TotalStockholders’Equity$8,360,000
Makegeneraljournalentriesforthefollowingtransactionsoccurringduring
20x2:
a.Tenthousandsharesofcommonstockwereissuedforcashat$35pershare.
b.Thequarterlydividendonthepreferredstockwasdeclaredbutnotpaid.
c.Aeronauticalacquired8,000sharesofitsowncommonstockat$32per
share.
d.Adividendof$1pershareonthecommonstockwasdeclaredbutnotpaid.
e.Threethousandsharesofthecommonstockheldinthetreasurywerereis-
suedat$35pershare.
7.MoranEnergyInc.isarapidlygrowingdomesticenergycompany,withopera-
tionsinoilandgasexplorationandproductionaswellasonshoreandoffshore
contractdrilling.Moran’sstockholders’equitysectionappearedasfollowson
December31,20x0:
Stockholders’Equity
CommonStock,$0.25parvalue,30,000,000
sharesauthorized,2,500,000shares
outstandingatDecember31,20x0
$625,000
CapitalinExcessofParValue20,239,000
RetainedEarnings15,549,000
$36,413,000
Givethejournalentriestorecordthefollowingevents.Assumethattheevents
tookplaceintheorderpresented.Pleaseshowallcalculations.
a.Thecompanydeclaredandissueda10-percentcommonstockdividend.
Themarketpricewas$34.30pershareofcommonstock.
b.Thecompanyissued17,000sharesofcommonstockat$8.06persharefor
theexerciseofcommonstockoptions.
c.$19,443,000principalamountofconvertibledebentureswereconverted
into955,000sharesofcommonstock.
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AnIntroductiontoAccountingandManagerialFinance
d.Thecompanysold880,000sharesofcommonstocktothepublicfor
$24,883,000.
e.Thecompanyissuedacommonstocksplitintheformofa100-percent
stockdividend.Themarketvaluewas$38.50pershare.The$0.25par
valuewasretained.
f.Theboardofdirectorsapprovedarestrictedstockplanwherebyshares
werereservedforissuancetocertainoffcersandkeyemployees.Restricted
planexpenseof$121,980waschargedtoIncomeandcreditedtoUnissued
RestrictedStock.
g.Thecompanyearnedanincomeof$12,187,000in20x1anddeclareddiv-
idendsof$580,000in20x1.
8.Assumethatgrowthisexpectedtocontinueforperpetuityandthat
P
=
D
1
/(k
e
−
g)
canbeusedforvaluationpurposes.Theinitialdividendis$1
andthecostofequityis0.20.
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$80anditsdividendforthenextyearisexpected
tobe$4.Theexpectedperpetualgrowthrateis0.10andthecostofequityis
0.15.
a.Whatwillbetheexpecteddividendafteroneyearhaspassed?
b.Whatwillbethepriceafteroneyear?
c.Whatisthepercentageincreaseinstockprice?
11.CompanyAhasadividendof$2.10andearningsof$3.00.Thestockisselling
at$210.Investorswanta0.15return.Dividendsandearningsareexpectedto
growat0.14peryear.
a.Prepareatableshowingtheexpecteddividendsandstockpricesforthe
nextfveyears.
b.Evaluatethefactsofthisproblemandtheresultingtableifearningsare
expectedtoremainconstant.
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Stockholders’Equity
165
Appendix9.1:DerivationofStockPriceModelwithConstant
GrowthRate
Wewanttoshowthat
P
=
D
1
k
e
−
g
.
Attime
t
,
D
t
=
D
1
(
1
+
g)
t
−
1
.Ifthecurrentmarketpriceisdefnedasthe
presentvalueofthefutureexpecteddividends,
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.cashdividends
b.repurchaseofitssharesbyacorporation.
Theaccountingentryfora$1,000cashdividenddeclarationandpaymentis:
Stockholders’Equity.....................1,000
Cash....................................1,000
Theaccountingentryfora$1,000stockpurchase(thefrm’sownshares)bya
corporationis:
Stockholders’Equity.....................1,000
Cash...................................1,000
Thetwobasicentriesarethesame.Whilethedetailedentrieswilldiffer,infact,
dividendsandastockrepurchaseofanequalamounthavethesamebasicfnancial
consequencestothecorporation.Bothtransactionsreducestockequityandboth
reducethecashaccount.Manyofthedifferentinterpretationsofthesetransactions
oneencountersinnewsandmagazinearticlesaremerelyimaginativefction.
SincetheStockholders’Equityaccountissubdividedinpractice,therewillbe
differencesinthedetailsoftheaccountingrecordings,butthebasicnatureofthe
accountingentriesisthesameforbothtransactions.
AccountingforDividends:TheDetails
Whenadividendisdeclared,atemporaryaccount,Dividends,isdebitedandalia-
bilityaccount,DividendsPayable,iscreditedtorefecttheamountduetothestock-
holders.ThedebittotheDividendsaccountultimatelyreducesRetainedEarnings.
167
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168
AnIntroductiontoAccountingandManagerialFinance
Whendividendsonstockaredeclaredbutnotyetpaid,theamountofthe
declarationbecomesaliabilityofthecorporation.Bytheentityassumption,the
corporationisconsideredtobeadistincteconomicunit,separatefromitsowners.
Theearningsofthecorporationaccrueforthebeneftofstockholdersandthusserve
toincreasethestockholders’equity.However,whenthecorporation’sdirectors
decidetodistributeaportionoralloftheearningsasadividend,theamountofthe
dividendbecomesaliabilityofthecorporation.Thestockholdersarecreditorsof
thecorporationuntiltheactualpaymentismade.
Theentrytobemadeatthetimeofdeclarationcanbe:
Dividends.........................................1,000
DividendsPayable.............................1,000
Torecordthedeclarationofadividend;thedebitreducesretainedearnings.
Whenthecashdisbursementtakesplace,thefollowingentryismade:
DividendsPayable..................................1,000
Cash..........................................1,000
Torecordthepaymentofthedividend.
TheDividendsaccountisthenclosedattheendoftheaccountingperiodto
RetainedEarnings:
RetainedEarnings...................................1,000
Dividends.....................................1,000
Toclosethedividendsaccount.
Theaboveentriescanbesimplifedto:
RetainedEarnings...................................1,000
Cash..........................................1,000
or
Stockholders’Equity................................1,000
Cash..........................................1,000
StockDividends
Stockdividendsarenotdividendsinarealsense.Withastockdividend,thecor-
porationdistributesadditionalsharesofitscommonstockonaproratabasisto
existingshareholders.Astockdividendincreasesthenumberofsharesoutstanding,
butleavestheassetsofthecorporationunchanged(exceptfortransactioncosts).
Theamountofacashdividendisusuallyexpressed(intheUnitedStates)interms
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DistributionstoShareholders
169
ofdollarsandcentspershare.Theamountofastockdividendisusuallyexpressed
asapercentageoraratio.Witha4-percentstockdividend,theholderof100shares
ofstockreceivesanadditional4sharesofstock.
Thestockdividend,fromaneconomicstandpoint,isactuallyastocksplit.
Thus,a100-percentstockdividendanda2-for-1stocksplitareequivalent
asfarasshareholdersareconcerned.Whenastockdividendisdeclaredand
becomeseffective,thenewpriceofthesharesrefectstheadditionalsharesout-
standing.Theactualpercentagedeclinedependsontheamountofthestock
dividend.
Whena10-percentstockdividendispaid,allthingsbeingequal,thenewprice
persharewillbe1/1.1oftheoldprice.Forexample,ifsharesweresellingfor
$100beforethedividend,eachsharewouldtendtosellforabout$90.91after
the10-percentstockdividend.Iftherewere
N
sharesoutstandingbeforethestock
dividend,therewouldbe1.1
N
sharesafterthe10-percentstockdividend.Thetotal
valueofthestockequitywouldbe$100
N
beforeand$90.91
(
1
.
1
N)
=
$100
N
after.
Thetotalvalueisunchanged.
Asanadditionalexplanationastowhyastockdividendisnotcomparabletoa
cashdividend,imaginethefollowingsituation.Youaresittinginarestaurantand
havejustorderedapieceofcherrypie.Whenitarrives,itlookssogoodthatyou
tellthewaitressthatyouwanttwopieces.Shepicksuptheplatewiththepieceof
cherrypieonit,cutsthepieceofpieintotwo,andhandsbothpiecesbacktoyou.
Theoriginalpieceofpieontheplatecorrespondstoyourinterestinthecompany
(yourshareofthetotalpie)beforethestockdividend.Thetwopiecesonyourplate
afterthewaitresshascuttheoriginalpieceinhalfindicateshowyourownership
interestwouldchangeaftera100-percentstockdividend.
Aninvestorholding10sharesworth$100eachwouldhaveatotalinvestment
of$1,000beforethestockdividend.Afterthestockdividend,theinvestorwould
own11sharesandthestockwouldhaveavalueof$90.91pershare.Again,the
valueofthetotalinvestmentis$1,000.Logically,stockdividendsshouldnotbe
taxedasincome,andtheyarenot.
Therearetwoapparentreasonswhycorporationsusestockdividends.If,inthe
opinionoftheboardofdirectors,thepriceofthestockistoohighanditisthought
thatthehighpriceislimitingtheextentofdistributionofthestock(alower-priced
stockwouldhaveabroadermarket),astockdividendmaybeusedtoreducethe
priceofthestock.Thelargernumberofsharesoutstandingwillreducetheprice
pershare.Itmayincreasethenumberofpersonslikelytobuythestock.
Stockdividendsarealsousedtosubstituteforcashdividends.Whenacor-
porationisshortofcashbecauseofeitherexpansionofoperationsorunsatis-
factoryresultsofoperations,astockdividendmayactasapacifertouninformed
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170
AnIntroductiontoAccountingandManagerialFinance
stockholdersuntilcashdividendsmaybeincreasedorresumed.Retainingearnings
andconservingcashmaybereasonableobjectives.
Astockdividendcanberecordedtoconformtolegalrequirementsbydebiting
RetainedEarningsandcreditingCommonStockaccounts.Thereisaproblemin
decidingtheamountofretainedearningsthatshouldbetransferredtotheCommon
Stockaccounts.Thegeneralpracticeistousethemarketvalueofthestockissuedon
thedateofdeclaration.Thus,astockdividendof1,000sharesof$100-par-value
commonstockthathasamarketpriceof$150persharemightberecordedas
follows:
RetainedEarnings....................................150,000
CommonStock—Par............................100,000
CommonStock—AmountPaidinExcessofPar...50,000
Torecordstockdividendof1,000shares.
StockSplit
Astocksplitisalsousedtoreducethepriceofcommonstock.Witha
stock
split
,theshareholdersaregivenamultipleofthenumberofsharestheypresently
hold.Thereisnoeconomicdifferencebetweenastocksplitandastockdividend,
althoughthereisanaccountingdifference.Asdescribedabove,astockdividendis
accompaniedbyatransferofaportionofretainedearningstotheCommonStock
accounts.
Sometimes,companiesissueastocksplitbutretaintheoldparvalue.Anentry
isrequiredforastocksplitiftheparvalueofthecommonstockisnotchanged.
Forexample,assumeacompanyissuedatwo-for-onestocksplitbutassumethat
itretainedthe$100parvalue.Thefollowingentrywouldbemadetorecordthis
stocksplit:
CapitalStock—AmountPaidinExcessofPar......1,000,000
CommonStock—Par.......................1,000,000
Torecordissuanceof10,000sharesof$100-par-value
commonstockforatwo-for-onestocksplit.
Thisentrywouldnotaffectthetotalinvestedequitycapital,butitwouldchange
theamountsreportedascommonstockatparandascommonstockatamounts
paidinexcessofpar.
Insomecases,alargeincreaseinthenumberofsharesmaybeaccomplished
byastockdividend.Alargestockdividendhasthesameeffectonmarketpriceas
astocksplit,andastockdividendisverysimilartoastocksplitinwhichtheold
parvalueisretained.
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171
Howstockdividendsandstocksplitsarestructuredanddescribedcanaffect
whetherparvaluesormarketvaluesareusedandwhetheramountsaretransferred
fromRetainedEarningsorCommonStockaccounts.Sinceamountstransferred
fromRetainedEarningscouldeffectivelylimittheamountofretainedearningsthat
maybedistributedascashdividends,theseissuesmaybeofsomeimportancefrom
alegalviewpoint.Fromafnancialanalysisviewpoint,theseaccountingentriesare
irrelevant.
DividendsandStockValue
Withnoincometaxesandwithotherwell-defnedassumptions(suchasperfect
knowledgeandcertainty),adollarretainedisequalinvaluetoadollardistributed;
thus,dividendpolicyisnotarelevantfactorindeterminingthevalueofacorpora-
tion.However,whentaxesareallowedintheanalysis,dividendpolicyaffectsthe
valueofthestockholders’equity.Inpractice,corporationsappeartobeinfuenced
insettingdividendpolicybyadesiretohavearelativelystabledividend.
Acommonstockdividendisadistributionofaportionoftheassetsofacor-
porationtoitscommonstockshareholders.Theamountreceivedbyeachinvestor
isproportionaltothenumberofsharesheldbytheinvestor.Inmostcases,cash
isdistributed.Whenacorporationpaysadividend,itsassetsarereducedbythe
amountofthedividend.Inpubliclytradedstock,thepricepersharedeclinesbya
fractionoftheamountofthedividendonthedaythatthestockgoes“ex-dividend”.
Apersonwhobuysthestockonoraftertheex-dividenddatewillnotreceivethe
dividend.Becauseofotherfactorsaffectingthestockprice,aswellastaxconsid-
erations,thedeclineinthesharepricewillnotbeexactlyequaltotheamountof
dividendpaid.Thechangewillbeapercentageofthatamount.
DividendPolicy
Acorporationisnotlegallyobligatedtodeclareadividendofanyspecifcamount.A
frm’sboardofdirectorsmakesaspecifcdecisioneverytimeadividendisdeclared.
Oncetheboarddeclaresadividend,thecorporationislegallyobligatedtomake
thepayments.Therefore,adividendshouldnotbedeclaredunlessacorporationis
inafnancialpositiontomakethepayment.
Theexpectationofreceivingdividends(broadlydefnedasanydistributionof
value)ultimatelydeterminesthemarketvalueofthecommonstock.Bydeclaring
adividend,theboardofdirectorsisnotonlyturningoversomeoftheassets
ofthecorporationtoitsstockholders,butalsoinfuencingtheexpectationsthat
stockholdershaveaboutthefuturedividendstheycanexpectfromthecorporation.
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AnIntroductiontoAccountingandManagerialFinance
Ifexpectationsareaffected,thedividenddecisionandtheunderlyingdividend
policywillhaveanimpactonthevaluethatthemarketplacesonthecommon
stockofthecorporation.
Manyfnancialexpertsbelievethatahighlystabledividendisadvantageoustoa
company.Themostcommonreasonstatedforthisbeliefisthatmanystockholders
preferasteadyincomefromtheirinvestments.Thereisatleastoneotherimportant
reasonforthinkingthatahighlyvariabledividendratemaynotbeinthebest
interestofacompany.Inthelongrun,thevalueofashareofstocktendstobe
determinedbythediscountedvalueoftheexpecteddividends.Insofarasthisisthe
case,awidelyfuctuatingdividendratewilltendtomakeitdiffcultforcurrentor
prospectivestockholderstodeterminethevalueofthestocktothem;asaresult,
thestockislikelytosellatalowerpricecomparedtostockspayingthesameor
anincreasingaveragedividendthroughtime,althoughthepaymentsaremadeata
steadyrate.
FactorsAffectingInvestorReactiontoDividends
Traditionalconceptsaboutthedistinctionbetweenincomeandcapital,someof
whichhavebeenembodiedintolawsthatcontrolthebehaviorofcertainfnancial
institutions,areimportantconsiderationsinunderstandinghowtheseinvestors
reacttocorporatedividenddecisionsandpolicies.
Themoresophisticatedthinkingaboutfnancialmatterstendstoemphasizethe
totalreturnreceivedfromanasset,andtoignoredistinctionsbetweencapitalgains
andotherformsofincomeexceptfortheireffectontaxes.
Thetotalreturnapproachtreatsthemarketvalueofthesecuritiesheldand
dividendsreceivedasonepoolthatcanbedividedupateachdecisionpointinto
consumptionandfurtherinvestment.Thefactthatsomeoftheliquidassetsavailable
havecomefromdividendsandothersfromachangeinthevalueoftheinvestment
isofsecondaryimportance.
Therearemanyinvestorswhoapproachthesesameeventswithadifferentpoint
ofview.Forsomeinvestors,thereisanimportantdistinctionbetweenincomeand
capitalgains.Incomemaybetypicallydefnedasdividendsandinterest.Investors
whothinkinthesetermsareoftenquitecomfortableinconsumingpartorallof
theirdividendorinterest“income”,butareuncomfortableabouthavingtodispose
ofsomeoftheirsecuritiesinordertopayforlivingexpenses.
Thedistinctionbetweendividendsandcapitalgainsisalsoreinforcedbytax
lawsthatdefnethereceiptofdividendsorinterestasataxableevent.Bycontrast,
changesinthevalueofcommonstockarenottaxableeventsunless,anduntil,the
securitiesareactuallysold.
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DistributionstoShareholders
173
Onefurtherinstitutionalfactorthatshouldbementionedinconnectionwithdiv-
idendsistheso-calledtrustlegallist.Banks,insurancecompanies,otherfnancial
institutions,andindividualtrusteesoftenmanagesubstantialsumsforthebeneft
ofothers.Overtheyears,manystateshavepassedlawsdesignedtoensurethatthe
benefciariesoftheseassetsdonotincurlossesbecausetrusteeshavepurchased
excessivelyriskyinvestmentsforthetrust.Variouscontrolshavebeendesigned
toaccomplishthisend.Oneistorestrictthekindsofassetsthatareeligiblefor
considerationasinvestmentsbyaparticularkindoftrusteeorfnancialinstitution.
Suchalistofeligibleassetsiscalledatrustlegallist.Thelawsdonotspecifythe
particularsecuritiesthatareeligibleforinclusiononthelegallist,butratherthe
characteristicsthatasecuritymustpossessinordertobeeligible.Astateoffcial
isresponsiblefordeterminingwhichsecuritieshavethenecessarycharacteristics.
Tobeeligibleforinclusiononalegallist,acommonstockmayneedtohave
paiddividendswithoutinterruptionforagivenlengthoftime.Aconsequenceof
thisprocedureisthatifacompanyfailstopaydividendsinonequarter,itmay
substantiallyreducethepopulationofinvestorswhoareeligibletobuyorholdits
commonstock.
CorporateDividendPractice
Oneconsiderationisthedesiretohavearelativelystabledividend;thesecondis
thedesiretopayout,inthelongrun,agivenfractionofearnings.Thisfraction
isusuallyreferredtoasthepayouttarget.Theseobjectivesmaybeconficting.
Earningstendtofuctuatesubstantiallyfromyeartoyear.Ifacorporationroutinely
paidoutagivenfractionofthoseearningsasdividends,thenthedividenditself
wouldtendtofuctuatedrasticallyfromyeartoyearorquartertoquarter.These
fuctuationswouldconfictwiththeobjectiveofmaintainingastabledividend
policy.Ontheotherhand,ifthedividendisaconstantamount,thenitwillbea
fuctuatingproportionofearnings.
Assumethatacorporationstartswithadividendtarget.Ifearningsarestable,
thenthedividendisunlikelytobechanged.However,ifearningsareincreasing,
then,withaconstantdividend,thepayoutratiowillgraduallydecrease.Ifthe
increaseinearningsisexpectedtobetemporary,forexample,asaresultofsome
extraordinaryeventorunusuallygoodbusinessconditions,thenitisunlikelythat
thecompanywillchangeitsdividend.However,ifmanagementbelievesthatearn-
ingsarelikelytobemaintainedattheirnewlevelortoincreaseevenfarther,thenit
islikelythatthedividendwillbeincreased.Theincreasewillbeinthedirectionof
approachingtheamountthattheboardofdirectorshassetasatargetpayoutratio.
Companiesvarythepayoutratiotheyselect,andthespeedwithwhichtheyadjust
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AnIntroductiontoAccountingandManagerialFinance
thedividendofaperiodtochangesinearnings;however,theytendtoadheretoa
targetpayoutratio.Overlongperiodsoftime,thispolicytendstoresultinadivi-
dendpayoutthatisapproximatelyequaltothepayouttarget,butdividendstendto
bemorestablefromyeartoyearthanearnings.Anotherimportantconsequenceof
thisprocessisthatdividenddecisionstendtoprovideinformationtostockholders
aboutmanagement’sforecastsoffutureearnings.Thiswillbeconsideredinalater
section.
Assumethatafrmhasalargeamountofdesirableinvestmentsandthatthese
investmentsrequiremorefundsthanareavailableinternallyafterdividendcom-
mitmentshavebeenmet.Insuchcircumstances,oneortwomajoralternatives
mustbechosenifthealternativeofchangingthedividendpolicyisthoughttobe
unavailable.Thecompanymusteitherforgosomeproftableinvestmentsorseek
additionalfunds.Ontheotherhand,ifthepayoutratioissettoolow,relativetothe
levelofearningsandthequantityofproftableinvestmentsavailabletoit,thecom-
panymayeitherfnditselfaccumulatinganunwarrantedamountofliquidassetsor
betemptedtoacceptinvestmentsthatarenottrulyconsistentwiththeobjectiveof
maximizingtheeconomicwell-beingofthestockholders.Acompanythatconsis-
tentlyfollowseitherofthesepoliciesislikelytobecomeatargetforatakeoverbid,
sinceitsstockwillbedepressedcomparedtoitspotentialvalue.Thedisadvantages
oftoolowadividendpayout,relativetotheproftableinvestmentsavailabletothe
company,aremoreseriousfromthepointofviewoftheshareholdersifthefunds
arebeingreinvestedatlessthancompetitiverates.
TheSettingofDividendPolicy
Dividendpolicyislikelytobesetintheformofagoalratherthanarigidrule,even
thoughadefnitepolicyhastheadvantageofprovidingtheinvestor,orpotential
investor,aclearbasisforchoice.Investorsknowingthedividendpolicyofthe
alternativecompaniescanchoosethetypeofcompanythatbestftstheirindividual
investmentgoals.Thisisdesirable,becausestockholdersdifferintheextentto
whichtheypreferdividendsratherthanopportunitiesforcapitalappreciation.One
mustrememberthat,whileonegroupmightwellprefercapitalgains,asecond
groupofzero-taxinvestorsmayprimarilybeinterestedindividends.Thissecond
groupofinvestorsincludesuniversities,foundations,andprivatepensionfunds,
allofwhichaccruenospecialtaxadvantagesfromcapitalgainsasdistinctfrom
dividends.
Sometimesacompanywilldistinguishbetweena“regular”dividendandan
“extra”dividend.Althoughthisdistinctiondoesnothaveanycashfowsignifcance,
November6,200913:44spi-b8119inx6inb811-ch10
DistributionstoShareholders
175
itisanimportantmeansbywhichthedirectorscansignaltheirintentionsto
stockholders.Bylabelingpartofadividendpaymentasan“extra”,thedirec-
torsareindicatingthattheydonotnecessarilyexpecttocontinuethosepay-
mentsinfutureyears.Bydeclaringtheremainderofthedividendpaymentas
aregularpayment,thedirectorsindicateanintentiontomaintainthisdividend
fortheforeseeablefuture.Extrastendtooccurinthefourthquarterofagood
earningsyear.
DividendChangesandEarningsForecasts
Whenadividendincreaseislogicalforacompany,givenitsearningsandits
traditionalpayouttarget,thenthemerefactthatanincreasehasnotbeendeclared
maysometimesbeinterpretedasevidencethatmanagementdoesnotexpectthe
currentlevelofearningstobemaintained.Ontheotherhand,ifadividendincrease
takesplaceatatimewhenitisnotexpectedonthebasisofthecompany’shistorical
behavior,thefnancialcommunitymayinterpretthisasevidencethatmanagement
ismorebullishaboutfutureprospectsforthecompanythanhadpreviouslybeen
expected.
DividendPolicy,InvestmentPolicy,andFinancingPolicy
Thedividendpolicyofafrmcannotbeconsideredinisolationfromitsotherfnan-
cialpolicies.Inparticular,dividendpolicyisintimatelyconnectedwithinvestment
policyandfnancingpolicy.Whenafrmchangesitsdividendamount,itmay,at
thesametime,havetochangeoneormoreoftheseotherpolicies.
Inanyparticularyear,itwouldbesurprisingiftheamountofcashgenerated
internallyandthescheduleofavailableinvestmentopportunitieswereexactlyas
anticipated.Thus,sometemporaryadjustmentsareneeded.Thefrmcanadjust
eitheritsdividendpolicy,itsfnancingpolicy,oritsinvestmentpolicy.Itwilltry
tomaketheadjustmentsthatareleastcostlytoitslong-termobjectives.
Exceptasalastresort,afrmwillnotreduceawell-establisheddividendamount
asameansofcopingwithatemporaryshortageofcash.Ontheotherhand,aone-
timespecialdividendmightbeusedtocopewithatemporarysurplusoffundsif
adividendincreasecouldbelabeledasan“extra”.
Forindustrialfrms,changesintheamountofinvestmentsarethemostcommon
methodofadjustment.Insomecases,thiscanbedoneatrelativelylowcostby
delayingthestartofnewlong-terminvestmentprojects.Anotheralternativeisto
temporarilyincreaseordecreaseworkingcapital.
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AnIntroductiontoAccountingandManagerialFinance
IrrelevanceofDividendPolicy
Dividendpolicyisnotrelevantindeterminingthevalueofafrmifsomewell-
defnedconditionsaremet.Theconditionsare:
1.Perfectcapitalmarkets(includingrationalinvestors,perfectinformationavail-
abletoall,certainty).
2.Notransactioncosts.
3.Nopersonaltaxes.
4.Theinvestmentpolicyofthefrmisset.Theamountinvestedisnotdetermined
bythedividendpolicy,butratherbythecostofequitycapital.
Laterweshallconsidertheconsequencesofrelaxingsomeoftheseassump-
tions.First,weexaminetheimpactofdividendpolicyonvaluationassumingthat
theseconditionshold.Let
S
t
denotethemarketvalueofthecommonstock(after
theinvestment)attime
t
,
k
e
denotethecostofequitycapital,
C
denoteactualcash
generatedinternallyoverthenextperiod,and
Q
denotetheamountoffnancing
requiredtomeetcashneedsfortheinvestmentprogram.If
Q
islargerthan
C
and
nodividendsarepaid,
Q
−
C
willhavetoberaisedbyanewequityissue.The
currentmarketvalueofthecommonstockwillbe
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
)
to
bethepresentvalueofthenewcapitalthatwillhavetobesuppliedbythecommon
stockholdersasagroup.Itisinconsequentialwhetherexistingornewequityholders
provide
(Q
−
C)
offnancing.
Nowconsidertheimpactofacashdividendof
D
paidoneperiodfromnowto
theexistingstockholders;if
D
ispaid,
Q
−
C
+
D
willhavetoberaisedbyanew
issueofcommonstockinordertoundertakethedesiredinvestments.
IncomeTaxesandDividendPolicy
Theincometaxesofstockholdersshouldaffectthedividendpolicyofafrm.To
helpyouunderstandthesetaximplications,weshallfrstexaminetheimportance
oftaxdeferralandthenshowtheimpactofhavingtwodifferenttaxrates,onefor
ordinaryincomeandoneforcapitalgains.
Rationalstockholdersshouldvalueastockbasedontheafter-taxreturnsthey
expecttoreceivefromowningit.Thetaxstatusofthereturndependsonthe
forminwhichitisreceived.Forahigh-taxstockholder,themarginaltaxrate
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DistributionstoShareholders
177
onsuchincomecanbehighwhenbothstateandfederalincometaxesarecon-
sidered.High-taxindividualsarethebenefcialownersofalargefractionofall
stockoutstanding,butthestockmaybeownedindirectlythroughmutualfundsor
trusts.
Thereturnsreceivedbypensionfundsandbyothernontaxableentitiesarenot
subjecttoeitherordinaryincomeorcapitalgainstaxes.Paymentsmadebythe
pensionfundstopensionersmaybetaxabletothepensioner,buttheamountofthe
taxonthedistributionwillnotdependonwhetherthepensionfundreceivedits
returnintheformofdividendsorcapitalgains.Thus,managersofpensionfunds
canandshouldvaluestocksbasedonthebefore-taxreturnstheyexpecttoreceive
fromthem.
TheprovisionsoftheU.S.taxcodetendtoleadtohigh-taxindividualsprefer-
ringstockswhosereturnsareintheformofcapitalgains,amongothersecurities
withsimilarrisksandcharacteristics.Also,bycomparativeadvantage,pension
fundholdersshouldfndthattheycandobetterbyholdingstockswhosereturns
areintheformofdividends.Thereissomeevidencethatthisoccursinpractice.
TaxDeferralAdvantage
Considertheeffectonthestockholders’wealthattheendofoneperiodifacompany,
insteadofpaying
D
dollarsofdividends,retainsandreinvests
D
toearnareturn
of
r
aftercorporatetaxesandthenpaysacashdividendof
D(
1
+
r)
attime1.This
policywillbecomparedtoapolicyofpayingadividendof
D
tothestockholders,
havingittaxedatarateof
t
p
,andthenhavingthestockholdersinvest
D(
1
−
t
p
)
toearnataxablereturnof
r
foroneperiodoranafter-taxreturnof
r
p
inasecond
company.Afteroneperiodofreinvesting
D
andearning
r
aswellasacashdividend,
thestockholderswillhave
D(
1
+
r)(
1
−
t
p
)
.Withacashdividendof
D
andthen
investingtoearn
r
p
on
(
1
−
t)D
,thestockholderswillhaveafteroneperiod
(
1
−
t)D(
1
+
r
p
).
Theadvantageofretentionandtaxdeferralforoneperiodthenadividend
comparedtoanimmediatedividendis:
Retentionadvantage
=
(
1
−
t)D(r
−
r
p
).
Since
r
islargerthan
r
p
(
r
p
isafterinvestortax),theadvantageisinfavorof
theretentionanddeferraloftax.Aslongas
r
isgreaterthan
r
p
,theadvantagewill
beinfavorofretention.
Atypicalcorporationisfacedwiththefactthatithasstockholderswithvastly
differenttaxrates.Bothpensionfunds(withzerotaxrates)andhigh-taxinvestors
November6,200913:44spi-b8119inx6inb811-ch10
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AnIntroductiontoAccountingandManagerialFinance
willownthecommonstockofthesamecorporation.Thismakesitimpossibleto
determinetheonetaxratevalueforthecommonstockholdersforaspecifcfrm.
Nevertheless,wecandeterminethegainorlosstoaninvestorofdifferentdividend
policiesusingthemodelsofthischapter.
CapitalGainsandTaxDeferralAdvantages
Weshallnowassumenotonlythepossibilityoftaxdeferral,butalsoacapitalgains
taxrateof
t
g
,where
t
g
<t
p
.If
D
dollarsareretainedpershareinsteadofbeing
paidasadividendandarereinvestedtoearn
r
afteroneperiod,thevalueofashare
willincreaseby
D(
1
+
r)
.Also,itisassumedthatthisgainistaxedatarateof
t
g
(implyingasaleofthestock)attheendoftheoneperiod.Afteroneperiodwith
reinvestmentbythecorporationearning
r
,thestockholderhas
D(
1
+
r)(
1
−
t
g
)
afterthecapitalgainstax.Afteroneperiodwithanimmediatecashdividendand
thenreinvestmenttoearn
r
p
,thestockholderwillhave
D(
1
−
t
p
)(
1
+
r
p
).
Theadvantageofretentiontaxedatacapitalgainsratecomparedtodividendstaxed
atordinaryincomeratesisnow:
Deferralandcapitalgainsadvantage
=
D(
1
+
r)(
1
−
t
g
)
−
D(
1
+
r
p
)(
1
−
t
p
).
Example
Letuscomputethedeferraladvantageofacorporationreinvesting$100forone
yeartoearn0.10comparedtopayingadividendof$10.Thestockholderscan
earn0.08onexternalinvestmentsanddonotneedcurrentfunds.Assumethatthe
personalmarginaltaxrateonordinaryincomeis0.30.Theadvantageofretaining
foroneperiod,comparedtoanimmediatedividend,is:
Retentionadvantage
=
(
1
−
t)D(r
−
r
p
)
=
(
1
−
0
.
30
)
100
(
0
.
10
−
0
.
08
)
=
$1
.
40
.
Theretentionalternativeyields$7.00tothestockholdersattheendoftheyear
comparedto$5.60ifthedividendispaid.
Ifcapitalgainsaretaxedat0.20andiftheretentionof
D
leadstoacapitalgain
of
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
,
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DistributionstoShareholders
179
withtheretentionalternativeyielding$88tothestockholdersattheendoftheyear
comparedto$75.60ifthedividendispaid.
CostofRetainedEarningsandNewCapital
Becauseoftaxes,thecostofretainedearningsislessthanthecostofnewequity
capital.Thecostofretainedearningsisthereturnthatretainedearningswould
havetoearnonreinvestmentinorderforstockholderstobeindifferentbetween
theimmediatereceiptofthefundsasadividendandtheirretention.Weassume
zerotransactioncosts.
Tocalculatethecostofretainedearnings,weexaminethechangeinstock-
holders’wealthundertheassumptionthatifreinvestmenttakesplaceatanafter-
corporate-taxreturnof
r
leadingtoavalueof
(
1
+
r)
,theentireproceedstothe
investorarethentaxedasordinaryincome.Theafter-taxchangeinstockholders’
wealthafteronetimeperiodwillbe
(
1
+
r)(
1
−
t
p
)
perdollarofreinvestedfunds.
Ifthedividendpaymentweretotakeplaceimmediatelyand,afterpayment
ofordinaryincometaxesonitatrate
t
p
,theresidualfundswerereinvestedin
anothersecurityofequivalentriskearning
r
p
afterpersonaltax,thenetchangein
stockholders’wealthperdollarofdividendpaidis
(
1
−
t
p
)(
1
+
r
p
),
where
r
p
istheafter-investor-taxreturnontheinvestedfunds.
Defnethecostofretainedearnings,
r
,tobetherateofreturnthatthefrm
mustearnonreinvestedfundsforstockholderindifferencebetweenadividendand
retention.Letusequatetheafter-taxchangeinstockholderwealthperdollarof
fundsunderthetwoalternatives:
(
1
+
r)(
1
−
t
p
)
=
(
1
−
t
p
)(
1
+
r
p
).
Solvingfor
r
,wefndthat
r
=
r
p
.Itcanbeshownthatthisresultisindependent
ofthenumberoftimeperiods.Ifthefrmcanearnthesamereturnasstockholders
canearnaftertaxwiththesamerisk,stockholderswouldbeindifferentbetween
havingthefrmpayadividendandreinvestthefunds—thisisthedefnitionof
thecostofretainedearnings.
Ifnewcapitalisbeingobtained,theinvestorhasachoicebetweenhaving
$1inhandorinvestinginafrmthatwillearn
r
andpay
r
dividendswithan
after-taxpresentvalueof
r(
1
−
t
p
)
r
p
.Equatingthetwoalternativesandsolvingfor
r
,
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AnIntroductiontoAccountingandManagerialFinance
wenowhave
1
=
r(
1
−
t
p
)
r
p
r
=
r
p
1
−
t
p
.
Withretainedearnings,thecostofstockholders’equitycapitalwas
r
p
.Withnew
capitalbeingobtained,thecostofstockholders’equityhasnowincreasedto
r
p
1
−
t
p
.
Havingestablishedthefactthatthecostofstockholders’equitydependson
whetherthefrmisretainingearnings,
r
=
r
p
,orobtainingnewcapital,
r
=
r
p
(
1
−
t
p
)
,
wecouldnextintroducecapitalgainstaxesandthedecisionbytheinvestortohold
orsell.Thesefactorswillalsoaffectthecostofequitycapital.Thus,thecostof
equitycapital,ratherthanbeingoneeasilydeterminablenumber,isafunctionof
thetaxlawandthedecisionsofinvestors.
Thesolutionofferedaboveisanapproximatesolutionsincecorporationswill
typicallypaydividendsandretainearningssimultaneously.Morecomplexmodels
wouldhavetobeusedtoobtainmeasuresapplicabletospecifcsituations.However,
theaboveequationdoesillustratethefactthatthecostofstockholders’equityfunds
dependsonthesourceofthecapitalaswellasonthedividendpolicyofthefrm.
Dividends:TheClienteleEffect
Theorysaysthatzero-taxinvestorswillpreferhigh-dividend-yieldstocks,whereas
thehigh-taxinvestorswillpreferhigh-growthstocks.Thisimpliesthatdividend
policywillaffectthetypesofinvestors(theclientele)whowillownacom-
pany’sstock.
ReasonsforDividends
Thereareseveralgoodreasonsforafrmtopaydividends.Someofthesehave
beenillustratedinthemodelsoftheprecedingsections.Thesereasonsinclude:
1.Thefrmgeneratesmorecashinternallythancanbeproftablyreinvested.
2.Dividendsprovidestable“income”toinvestors(theycanplanassumingthe
dividendswillbepaid).
3.TheInternalRevenueServicepenalizesunnecessarilyretainedearnings.
4.Transactioncostsassociatedwithaninvestorsellingstockmakedividendsless
costlyiftheinvestorneedscashincome.
5.Changesindividendshaveinformationforinvestors.
6.Legallists(eligiblesecuritiesfortrusts)requirearecordofdividendpayments.
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7.Someinvestorspayzerotaxes,andthereisnotaxadvantageindeferredincome
taxestothisgroup.
8.Ifafrmiscurrentlypayingadividend,itisdiffculttostopwithouthurting
somestockholders.
9.Nonpaymentofdividendsmayencourage“raiders”.
10.Amarketthatheavilydiscountstheriskyfuture(refectingahighdegreeof
uncertainty)willvaluecurrentdividendpaymentsmorethanfuturedividend
payments.
Theprimaryargumentsagainstdividendsarethatretainedearningssavefota-
tioncostscomparedtoanewissue,andthatthepaymentofadividendcausesthe
stockholdertobetaxedatordinaryratesontheamountofcashreceived.Since
someinvestorsprefertodefertaxes,onewaytodosoistohavethefrmretain
andreinvestearnings.Furthermore,theremaybeataxadvantageintakingcapital
gainsratherthandividendincome.
Inadditiontocashdividends,therearealso:
1.Stockdividends(moresharesareissuedtoeachshareholderinproportionto
holdings).
2.Repurchasesofstock(acashdistributiontoaself-selectedgroupofstock-
holders).
3.Liquidatingdividends(thismayincludeareturnofcapital).
Stockdividendsarenotactuallydividends;rather,theyrepresentachangeinthe
descriptionoftheownership(achangeinthenumberofshares).Therepurchaseof
stockbyacorporationdiffersfromacashdividendintermsofthetaxconsequences
andinthatthecashisnotdistributedequallytoallstockholders(itonlygoesto
thosestockholderswhoselltheirstock).
RepurchaseofShares
Inthepasttwodecades,majorU.S.corporationshaveincreasinglyrepurchased
signifcantamountsoftheirowncommonshares.Thereasonsforthisdevelopment
anditsimplicationsforthetheoryofsharevaluationandpublicpolicy,however,
havebeensubjecttonumerous,andoftenconficting,interpretations.Thischapter
presentsananalysisoftheeconomicsofsharerepurchasing,whichleadstosome
fairlydefniteconclusionsconcerningthequestionsofsharevaluation.
Therepurchaseofsharesisnotlegalunderallcodesoflaw;butinthecountries
whereitislegal,itopensupavarietyofopportunitiesforgainsforthestock-
holders.Inmanysituations,themotivationwillbeperfectlylegitimate(adesireto
shrinkthesizeofthefrm,withdesirableconsequencesastowhoreceivesthecash
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AnIntroductiontoAccountingandManagerialFinance
distribution),butitisalsopossibleforonegrouptousethisdevicetotakeadvan-
tageofinformationthatisnotavailabletotheremainderoftheinvestingpublic.
Therepurchaseofsharesisnotuncommonand,barringchangesinlegislation,is
likelytoaccelerateinthefuture.
Duringthepast20years,corporationshaveacquiredsignifcantamountsof
theirownsharesofcommonstock.Therepurchaseofcommonstockhasbeensaid
tohavebeenmotivatedbymanyfactors.Amongtheseare:
1.Repurchasedstockisusedbythecorporationforsuchreasonsasmergersand
acquisitionsoffrms,stockoptionsandstockpurchaseplans,andsoon.
2.Stockrepurchaseisaformofinvestment.
3.Repurchasingstockincreasestheamountoffnancialleverageemployedby
thefrm.
4.Stockrepurchaseisaformofdividend,and,asaformofdividendpayment,
stockrepurchasehasfavorabletaxconsequencescomparedwithordinary
dividends.
5.Stockrepurchasecanleadtoachangeinownershipproportions(maintenance
ofcontrolbeingtheobjective).
6.Bytakingadvantageofspecialinformation,stockrepurchasecanimprovethe
wealthpositionofcertainstockholders.
7.Stockrepurchaseisamethodofshrinkingthesizeofthefrm(aformof
liquidatingdividend).
8.Repurchasingstockcomparedtoacashdividendmayimprovefnancialmea-
suressuchasearningspershareand,consequently,thepriceofthestock.
9.Differentexpectationsheldbythefrmandthemarketcanlead,throughrepur-
chase,toimprovingthewealthpositionofcertainstockholders.
10.Stockrepurchasewillincreasestockpricethroughtime.
Weshallconsidereachofthesereasonsseparately,eventhoughseveralofthem
areinterrelated.
RepurchaseofStockforUsebytheCorporation
Corporationsusesharesoftheirownstockforseveralpurposes,includingthe
acquisitionofothercorporations.However,thisisnotacompleteexplanationasto
whyacorporationreacquiresitsownshares,sinceacorporationisgenerallyable
toissuenewsharesforthetypesofpurposesforwhichthesharesareacquired.
Theremaybevalidreasonswhyacorporationdoesnotwanttoissueadditional
shares,hencereacquiringsharesforreissue.Butitistheseotherreasonsthatare
relevant,notthefactthatthesharesaregoingtobeusedbythecorporation.
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StockRepurchaseasanInvestment
Acorporationcannot“invest”initsownshares.Withnormalinvestments,cashis
convertedintoworkingassets.Proftableinvestmentsincreasethesizeofthefrm,
andwhiletheymaybeaccompaniedbyincreasesinthedebtorequityaccounts,
theyareneveraccompaniedbydecreasesintheseaccounts.However,ifafrm
repurchasesitsownshares,thereisdisinvestmentbythecorporation.Withthe
frm’sacquisitionofitsownshares,theassetsdecreaseascashisused,andthe
stockholders’equityalsodecreases.Thecorporateentitydoesnotmakeaninvest-
mentwhensharesareacquired.
Itispossibleforonegroupofstockholderstobeneftandonegrouptobe
harmedbytherepurchaseofshares.Thegroupnotsellingmayincreasethesizeof
itsinvestmentinthefrmcomparedtotheinvestmentofthesellinggroup,butthisis
notthesameassayingthatthefrmisinvesting.Theterm
invest
mustbereservedfor
situationswherethefrmisactuallycommittingresourcestoproductiveactivities
ratherthanasituationwherethefrmisbecomingsmallerastheresultofanaction.
Thefactthattheprocessofstockrepurchaseisnot“investing”doesnotmean
thattheutilizationoffundstopurchase(retire)outstandingstockmaynotbethe
bestuseofthefundsfromtheviewpointofsomeorallofthestockholders.
IncreasesinFinancialLeverage
Therepurchaseofshareswillleadtoanincreaseintheratioofdebttototalstock-
holders’equityemployedandwillthusincreasetheamountoffnancialleverage.
However,thiscannotbethesoleexplanationofthestockrepurchaseprocess,since
acashdividendofthesameamountwouldhaveanidenticalleverageeffect.The
explanationmustbefoundelsewhere.
AFormofDividend
Stockrepurchaseisaspecialtypeofdividend.Iftherewerenoseparatetaxtreat-
mentsbetweenordinaryincomeandcapitalgains,andifaproportionatenumber
oftheshareswereacquiredfromallstockholders,theeconomiceffectswouldbe
almostidenticalforstockrepurchaseasforacashdividend(thenumberofshares
outstandingwouldchange,butthiswouldbetheonlydifference).
Ifthestockisnotacquiredproportionatelyfromallinvestors,stockrepurchase
isaspecialtypeofdividend,sinceitgoesonlytothestockholderswhoprefer
cashcomparedtoincreasedownership.Thosestockholderspreferringtoincrease
theirinvestmentcomparedtoreceivingcashdonotsell.Theself-selectivityofthe
processisanadvantageforthestockholdersasagroup.
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Theforegoingconclusionassumeszerotaxes.Oncetaxesareconsidered,stock
repurchaseisadvantageous.Thetaxsavingstostockholdersofastockrepurchase
comparedtoacashdividendmaybesizable.Supposeaninvestorownsandsells
stockfor$1,200withataxbaseof$1,000.Themarginaltaxrateforordinaryincome
is35percentandforcapitalgains,15percent.Witha$1,200cashdividend,the
stockholderwouldnetout$780(thetaxwouldbe$420).Withthe$1,200disbursed
intheformofastockrepurchase,thestockholderwouldnetout$1,170(thetax
wouldbe$30onacapitalgainof$200).
Theadvantageofrepurchaseoverordinarydividenddistributionispresentfor
tworeasons.Firstisthedifferencebetweenthetwotaxrates.Thesecondreason:
withtherepurchaseplan,partofthepaymentisconsideredarepaymentofprin-
cipaltaxpurposesandsoisnottaxedatall.Althoughsystematicrepurchaseover
timewouldeventuallydrivethecostbaseclosetozero,thepresentvaluemethod-
ologyweighstheearlytaxsavingshigh,andsothedifferencebetweensystematic
repurchaseandordinarydividendisstillconsequentialwhenbothcapitalgains
andordinaryincomearetaxedatthesamerate.Ifbothpersonalandcorporatetax
rateswerezero,eithermethodofincomedistributionwouldleadtothesameintrin-
sicvalue.Theintroductionoftaxconsiderations,however,canaffectthevalueof
different“packages”.
Taxlawscanprovidepowerfulincentivesforfrmswithliquidassetsavailable
fordistributiontopurchasesharesratherthanpaylargerdividends.Manypersons
willprefercapitalgainstoordinaryincomeifthemarginalrateoftaxationon
ordinaryincomeislargewhiletherateonlong-termcapitalgainsissmall.
Giventheseincentivesforreturningcashtostockholdersbyrepurchasing
shares,arelevantquestionwouldseemtobe:Whydofrmseverpaydividends?
Animportantreasonisthattherearesignifcantinvestorswhopayzerotaxes.The
secondexplanationisrelatedtotheattitudeoftheInternalRevenueServicetoward
sharerepurchasing.ThecurrentInternalRevenueCodeclearlyseekstoprohibit
frmsfromdisguisingdividendsintheformofsharerepurchases.Proportional
repurchasesfromallshareholders,forexample,aretreatedthesameasdividends
fortaxpurposes.
Control
Itisnotclearthatrepurchasingwillfacilitatetheretentionofcontrol.Forinstance,
iftwocompetinggroupseachowned40percentofthestockbeforetherepurchase,
theymightwellown40percentafterthecompanyacquires10percentoftheshares.
However,ifoneofthecompetinggroupsweretosellitsstocktothecorporation,
thiswouldalterthesituation.But,ingeneral,stockrepurchaseisnotaneffective
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185
meansofbeatingoffaraiderunlessthestockisactuallypurchasedfromtheraider,
fromthosestockholdersmostlikelytoselltotheraider,orfromthosestockholders
mostlikelytosupporttheraiderratherthantheincumbentgroup.Infact,the
decreaseinthenumberofthesharesoutstandingmightmakeiteasierforthe
raidertonegotiatewiththeremainingstockholders.Thus,thecontrolfactorisnot
likelytobesignifcantwithalargecorporation,unlessthefrmcanidentifythose
partieslikelytosell.However,debtissuancecombinedwithstockrepurchasecan
discouragearaider.Forexample,acompany,byborrowinguptoitsdebtcapacity
andacquiringitsownshareswiththeproceeds,coulddiscouragearaiderwhowas
relyingonthefrm’sdebtcapacitytoincreasevalue.
SpecialInformation
Ifonegroupofstockholdershasspecialoptimisticinformation(say,theyareclosely
associatedwithmanagement),thenthisgroupcouldhavethecorporationbuy
stockattheexpenseofthegroupthatdidnothavetheinformationandwould,
consequently,bewillingtosellatalowprice.Usingspecialinformationinthis
mannerwouldseemtobe,atbest,unethical,andislikelytobeillegal.Ifstockis
tobeacquired,thisinformationshouldbemadeknowntothestockholdersaswell
asthereasonswhythestockistobeacquired.Onegroupofstockholdersshould
notbefreetotakeadvantageofanotherlesswell-informedgroup.
ShrinkingtheSizeoftheFirm
Iftheobjectiveistoshrinkthesizeofthefrm,thetax-effectrationaleforusing
stockrepurchasecomparedtocashdividendsholds.Althoughshrinkagecanbe
accomplishedbyacashdividend,stockrepurchaseleadstopartofthereturnbeing
treatedasatax-freereturnofcapitalandtheresidualgainistaxedatacapitalgain
rateratherthanordinaryincometaxrates.
ImprovingFinancialMeasures
Theeffectofstockrepurchaseonfnancialmeasuresandthestockpriceisevidently
ofinteresttothestockholders.Weshallattempttodeterminetheconditionsunder
whichchangesinthemeasurestakeplaceandhowthestockpriceisaffected.
1.
Bookvalue
:Ifthemarketpricepaidforthecommonstockislessthanthe
currentbookvalue,thebookvaluepersharewillincreasefortheremaining
shares.However,ifthemarketpriceismorethanthebookvalue,thebook
valuewilldecrease.Itwouldbesurprisingifsuchchangesinbookvalueare
suffcientjustifcationforacquiringshares.
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AnIntroductiontoAccountingandManagerialFinance
2.
Earningspershareandmarketpriceofstock
:Earningspersharewillchange
ifthefrmreacquiressharesratherthanpaysacashdividend.Since
D
isgoing
tobedistributedwitheitheradividendorsharerepurchase,thefrm’sfuture
earningstreamisunaffectedbutearningspersharewillbehigheriftherepur-
chasestrategyisfollowed.Althoughtheearningspersharewillbehigherunder
repurchase,fewershareswillbeoutstanding,andonewouldexpectthetotal
valueofthecommonstocktobethesameundereitherstrategy.Ifthevalue
ofthefrmandtheearningsarebothunaffected,thenthefrm’sprice/earnings
multipleisunaffected.Applyingthesameprice/earningsmultipletothehigher
earningspershare,however,leadstoahighermarketpricepershare.
Itisworthwhiletocommentonthetax-relatedrationaleforrepurchase.
AlthoughtheInternalRevenueServicedoesnotallowthedistributiontobetreated
asacapitalgainifthefrmrepurchasesstockprorata(sothatownershippropor-
tionsdonotchange),itdoesevidentlyallowlessstructuredformsofrepurchase
(e.g.,openmarketpurchasesortendering)tobetreatedasacapitalgain.
Thereisalsoanotherfactorthatmayinfuencethemethodofdistributingcash.
Supposeyouarethemanagerofafrm,andyouhaveastockoptiontobuythestock
at$15withthecurrentmarketpricebeing$12(thisistheexpectedpricebeforethe
cashdistribution).Ifa$2cashdividendispaid,itcanbeexpectedthatthepriceof
thestockwillfalltoabout$10(theEPSis$1andtheprice/earningsmultipleis10).
Ifsharesofthestockareacquired,thenumberofshareswilldecreaseandthestock
pricewillbelargerthan$10.Aseriesofstockrepurchaseswilltendtodrivetheprice
ofthecommonstockupwardcomparedtothepricewithacashdividendandmake
iteasierforthestockoptiontobeexercisedunderfavorablecircumstances.Thus,
stockrepurchaseisalogicalstrategyforfrmswhosepoliciesareadministered
bymanagersholdingstockoptions.Retainingearningsratherthanpayingcash
dividendsisstillanotherdesirablestrategytendingtoincreasethepriceofashare
ofstockhigherthanitwouldbeifthecashweredistributedasacashdividend.
DifferentExpectations
Asituationmayariseinwhichthemarketassessesthevalueofthestockdifferently
frommanagement’sassessmentbecauseofdifferentexpectations.Ifmanagement
thinksthatthestockisunderpriced,repurchasingofthestockwillbeneftthose
whocontinuetoholdthestockifmanagement’sassessmentisprovedcorrect.
Ifmanagementiscorrect,thefrmcanrepurchasestockatanypricelessthan
whatitbelievestobetheintrinsicvaluewithoutharmingthefnancialpositionof
thosewhodonotsell.Ifmanagementisincorrect(overlyoptimistic),theextent
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187
towhichthestockholderswhodonotsellareharmedisdeterminedbythespread
betweentherepurchasepriceandthemarketprice.
AFlexibleDividend
Oneadvantageofstockrepurchaseinlieuofcashdividendsisthatinvestorswho
donotwanttoconverttheirinvestmentsintocashdonotselltheirstockbackto
thecorporation.Bynotselling,theyavoidrealizationofthecapitalgainandthey
donothaveanytaxationontheincrementtothevalueoftheirwealth(theyalso
avoidpossibletransactioncosts).
Theinvestorswhowanttoreceivecashsellaportionoftheirholdings,and
eventhoughtheypaytaxontheirgains,thistaxisapttobelessthanifthe
cashdistributionweretaxedasordinaryincome.Byusingstockrepurchaseas
themeansofthecashdistribution,thecompanytendstodirectthecashtothose
investorswhowantthecashandbypasstheinvestorswhodonotneedcashatthe
presenttime.
TheStockPriceEffectofShareRepurchase
Assumeacorporationwith
N
sharesoutstandingbuys
p
ofitsstockeachyear.The
immediatestockpriceeffectiszero,butafteroneyeartherewillbe
(
1
−
p)N
shares
outstandingratherthan
N
andthestockpricewillbehigherwithsharerepurchase
thanwithoutit.
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
.
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AnIntroductiontoAccountingandManagerialFinance
Thegrowthrateinstockpriceis:
G
=
p
1
−
p
=
0
.
05
0
.
95
=
0
.
0526
.
Aftertenyearsthestockpricewouldbe(withnootherchanges):
P
10
=
20
(
1
.
0526
)
10
=
$33
.
39
.
Tothispoint,itwasassumedthatthefrmhadzerorealgrowth.Nowassume
therealgrowthis
g
pershare.Thegrowthrateofthestockpricewith
p
shares
purchasedeachyearis:
G
=
g
+
p
1
−
p
.
Theserelationshipsareimportanttomanagerspossessingstockoptionswith
givenexerciseprices.
Conclusion
Twopublicpolicyquestionsconcerningcorporatesharerepurchasingareapparent.
First,shouldfrmsbeallowedtobuybacktheirownshares,and,ifso,shouldthey
berequiredtogivestockholdersadvancenoticeoftheirintentions?
Repurchasingsharescanhaveasignifcantimpactontheafter-taxreturnsof
stockholders.Shouldtheformofthefrm’sdistribution,ratherthanitssubstance,
infuencetheamountoftaxespaidbystockholders?Itseemsclearthatasmore
andmorefrmsbecomeawareoftheadvantagesofrepurchasingsharescompared
withpayingdividends,thisissueisincreasinglyrelevant.
Shouldcorporationsthatdecidetorepurchasesharesberequiredtonotify
stockholdersoftheirintention?Thevalueofthefrm’sstockisafunctionofthe
formofitscashdistributions.Thus,itseemsreasonablethatshareholdersshould
beadvisedofacompany’sdistributionpolicyandofchangesinthatpolicy.A
corporationthathasrepurchasedshareswithoutgivingitsstockholdersadvance
noticewouldbeimplicitlyplacingthoseinvestorswhoselltheirshareswithout
thisinformationatadisadvantage.
Corporationshaveofferedmanyreasonsforacquiringtheirowncommonstock.
Inthischapter,welistedanumberofreasonsandthenproceededtoexamine
eachofthosereasonsinturn.Twofactorsareofprimeimportance:taxeffects
andexpectationaldifferencesbetweenthemarketandmanagement.Theother
explanationsofferedforrepurchasearerelativelyweak.
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189
Itisveryeasyforasituationtodevelopwhereonegroupofstockholders
beneftsattheexpenseofanothergroup;thus,astockrepurchaseprogrammustbe
administeredwithcareiftheattainmentofapositionwhereallstockholdersare
treatedfairlyisdesired.
Underveryspecialconditions,whicharenotlikelytoholdintherealworld,
themarketvalueofafrm’sstockisindependentofitsdividendpolicy.Withmore
realisticassumptions,differentfrmsmightwishtoadoptdifferentdividendpolicies
dependingontheeconomicandbehavioralcharacteristicsoftheirstockholders.
QuestionsandProblems
1.AssumethattheABCCompanyisearning$2currently,ispayingan$0.80
dividend,andwillcontinuetohavea40-percentdividendpayoutpolicyinthe
future.Allreinvestedfundswillearn0.08.Thestockholdersrequirea0.10
returnontheirinvestmentandarenottaxed.
a.Whatisthevalueofashareofcommonstock?
b.Whatwouldthevaluebeiftheoptimaldividendstrategywasfollowedand
a$2dividendcouldbemaintained?
c.Ifreinvestedfundscouldearn0.15,whatwouldbethevalueofashareof
commonstockwiththe40-percentpayoutpolicy?
d.Whatwouldyouexpecttohappento
r
ifmorefundswerereinvested?
2.Ona“perdollarofpotentialdividendperperiod”basis,calculatetheadvantage
of(a)deferringoneperiodand(b)deferringoneperiodandtaxingatcapital
gainratherthanordinaryrateiftheyieldonreinvestedfundsis20percent,the
personaltaxrateonordinaryincomeis60percent,andthecapitalgainstax
rateis25percent.
3.Supposethatyoudidnotknowthetaxsituationoftheholdersofyourcommon
stock,butwereabletoascertainthattheaveragepersonaltaxratewasabout
40percent.Assumethatthecostofequityforcomparablecommonstocksis
0.12
(k
e
=
0
.
12
)
.
Whatcouldyouconcludetobethecostofretainedearnings?
4.Indiscussingapolicyofissuingannualstockdividends,acorporatepublic
utilitymanagerstated:
“Thestockdividendplanhasdoneagoodjobforus,helpingtofnanceour
expansion,eliminatingpublicofferingsofourcommonstock,andenablingus
toretireourpreferredstock.Italsomadedebtfnancingunnecessary.”
Evaluatethemanager’sstatements.
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AnIntroductiontoAccountingandManagerialFinance
5.TheABCCompanycouldpayoutallofitsearningsasdividends;however,
itwantstochoosebetweenapolicyofpayingoutdividendsastheincomeis
earned(nowandforthenextthreeyears)oralternativelyreinvestingallofits
earningsandpayingonedividendthreeyearsfromnow.Withnoadditional
retainedearnings,thefrmcanmaintainadividendof$100pershare.
Stockholderscanearn0.10byinvestinganydividendsreceived.These
earningsaresubjecttotax.
Assumethatcapitalgainsandordinaryincomearebothtaxedatarateof0.6.
a.ABChasmanyone-periodinvestmentsthatyield0.08.Shouldthefrm
investorpayacurrentdividend?Findthefuturevalueofstockholders’
wealththreeyearsfromnow.
b.Howlowayieldcananinvestmenthaveandstillbeacceptabletothefrm?
c.Assumethefrmhasinvestmentsyielding0.10.Whatistheimprovementin
valuearisingfromretainingforoneyearcomparedwitha$100dividend?
6.Ithasbeenarguedthatitmakesnodifferencewhetherafrmpaysdividends
orretainstheearnings,sincethevaluetothestockholdersisthesameforboth.
Forexample,assuminga0.4taxrateandanabilitytofndastockthatis
growingatabefore-taxrateof0.10,if$100ispaidasadividend,theinvestor
willhaveafteroneperiod
$100
(
0
.
6
)(
1
.
10
)
=
$66
.
Ifthefundsareretainedandinvestedinternallytoearn0.10,andthenpaidas
adividendafteroneperiod,theinvestorwillagainhave
$100
(
1
.
10
)(
0
.
6
)
=
$66
.
Commentontheillustration.
7.TheTaxCourtdecidedseveralyearsagothatincreasesinthevalueof
endowmentpoliciesundercertaincircumstancesareincome.Thecourtdrewa
distinctionbetweenendowmentpoliciesandotherassetssuchasstockwhose
appreciationrefectspricechangesovertime.Thegaininvalueofanendow-
mentpolicyresultsfromtheannualadditiontotheinvestmentfundofthe
earningsontheinvestments,andthegainisnotdirectlyrelatedtoprice
changes.
Commentonthedistinction.
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191
8.TheBigOilCompany’streasurerexplainedhiscompany’sdividendpolicy(a
lowdividendcomparedtoearnings)bystatingthat“thestockholdersdidnoth-
ingtoearnthemoney”andthat“ifthestockholdersdidnotlikethepresent
policy,theycouldsellthestock.”
Discussthestatements.
9.Apublicutilityannouncedanewplanwherebythefullamountofearnings
wouldbepaidtothestockholders,thecurrentcashdividendpersharewouldbe
keptconstant,andtheremainderofthedividendwouldbeintheformofastock
dividend.Thispolicywouldenablethefrmto“retainandreinvestinthebusi-
nessahigherpercentageofourearningsthanwewouldretainunderourpast
dividendpolicyandhelpustofnanceourexpansionprogramandcutdown,
ifnoteliminate,theneedforperiodicofferingsofadditionalcommonstock.”
Evaluatethepolicy.
10.JaneDoe(zerotax)expectsABCCompanytobeginpayingdividendson
anannualbasisattheendoftwoyears.Sheexpectsthefrstannualdivi-
dendtobeonedollarandfurtherexpectsdividendstogrowcontinuouslyat
arateof4percentthereafter.Whatisthemaximumpriceshewouldbewill-
ingtopayforthestocktodayifshewantstoearnatleast12percentonher
investment?
11.a.Ifaninvestorcanearn0.08byinvestingintax-exemptbonds,acor-
porationinvestingincomparableriskinvestmentswouldhavetoearn
whatminimumreturn(s)aftercorporatetaxtojustifyretention?Assume
thattheinvestorisina0.55taxbracketforordinaryincomeandthat
allincomefromthecorporationwillbereceivedintheformofcash
dividends.
b.Ifnewcapitalisraisedandiftheinvestmentbankertakes0.10oftheprice
paidbytheinvestors,theinvestmentmadebythecorporationmustearn
___________aftercorporatetax.
12.CompanyXYZhasfounditselfwith$5millionofunneededcash,andthe
frm’spresidenthasindicatedthathewillsuggesttheboardofdirectorsdeclare
an“extra”dividendof$5pershareonthemillionsharesoutstanding.Thecur-
rentstockpriceis$45pershareandcurrentannualearningsareabout$8per
share(excludinginterestincomeonthe$5millionheldcurrentlyintheform
ofacertifcateofdeposit).
Themarketpriceof$45appearstobecomprisedofabasicP/Eratioof5on
thecurrentearningsplustheanticipatedextra$5milliontorepurchasestock.
Thefrm’sinvestmentbankerindicatesthatapurchasepriceof$50pershare
onatenderofferwouldbesuffcienttoattract100,000sharesforrepurchase.
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AnIntroductiontoAccountingandManagerialFinance
AssumethattheP/Eratiothatwouldbeadoptedbythemarketafterthe
reacquisitionisagain5.
Assumeazero-tax,zero-transaction-costworld
.
a.Whichofthetwoplans(stockacquisitionordividends)shouldthestock-
holdersprefer?Why?
b.Ifyou,thecorporatepresident,heldstockoptions,whichofthetwoplans
wouldyouprefer?Why?
13.TheABCCompanyhasearned$10.Itisthinkingofpayingacashdividend
of$10pershare.Itsstockholderswouldbetaxedata0.55rateonordinary
incomeand0.20oncapitalgains.Thestockholderscanearna0.05returnafter
taxperyear.
Thealternativetothecashdividendistoretainfor10years,andthenpaya
cashdividend.Thefrmcanreinvestfor10yearsandearn0.12peryearafter
corporatetaxes.
a.Howmuchwillaninvestorhaveafter10yearswithacashdividendnow?
b.Howmuchwillaninvestorhaveafter10yearsifthefrstdividendisat
time10?
c.Howmuchwillaninvestorhaveafter10yearsifthefrstdividendisat
time10andiftheinvestorsellsbeforethestockgoesex-dividend(i.e.,the
dividendgoestothebuyerofthestock)?Assumethatadollarofretained
earningsresultsinadollarofstockpriceincrease.
d.Assumethatthecorporatetaxrateis0.46.Ifthecapitalhadbeenclassifed
asdebtandifthe$18.52ofbefore-taxincomewerepaidasinterest,how
muchwouldtheinvestorhaveafter10years?
14.Investorscanearn0.12afterpersonaltax(e.g.,investingintax-exemptbonds).
Theirmarginaltaxrateonordinaryincomeis0.55.
a.Whatreturn(aftercorporatetax)doesacorporationhavetoearnsothat
theinvestorsareindifferenttoreceivingacashdividendnowandacash
dividendattime1?
b.Answer(a)ifthedeferreddividendwillbedeferredandwillbepaid10
yearshence.
c.Ifthecorporationwantstoinvestnewcapitalobtainedfromtheinvestors,
ithastoearnatleast____________.Assumethatadividendwillbepaid
attime1.
November6,200913:44spi-b8119inx6inb811-ch11
Chapter11
CapitalStructure:WeightedAverage
CostofCapital(WACC)
Capitalstructureisnotanimportantconsiderationformanagementunlesstaxes
andbankruptcycostsareconsidered.Thevalueofthefrmwouldnotbeaffected
bydebtleverageiftherewerenotaxesandnotransactioncosts.
Whencapitalbudgetingwithtimediscountingwasfrstintroducedinbusiness
fnanceliteratureintheearly1950s,thecommonrecommendationwasthatan
investmentwasacceptableiftheproposal’snetpresentvaluewaspositiveusing
thefrm’sweightedaveragecostofcapital(WACC)asthediscountrate(orequiva-
lently,iftheinvestment’sinternalrateofreturnwasgreaterthanthefrm’sweighted
averagecostofcapital).Eventoday,morebusinessfrmsareusingthefrm’s
weightedaveragecostofcapitalasthehurdleratethananyothercapitalbudgeting
decisionrequiredreturn.Thisutilizationmakesthefrm’scostofcapitalcalculation
ofgreatimportance.AlthoughIdonotendorsethegeneraluseofthefrm’scost
ofcapitalinthecapitalbudgetingprocessasasinglehurdlerate,itneverthelessis
used;andweshouldcomputeitinareasonablemanner.
Thereisalsothequestionofhowthefrm’svalueisaffectedbythefnancial
mixdecision.Fouralternativetheoriesdeserveconsideration:
1.Thevalueofafrm,andtheconsequentwealthpositionofthestockholders,is
notaffectedbythetypeoffnancing.
2.Thereisanoptimumcapitalstructure,andtheutilizationofthisstructurewill
maximizethevalueofthefrm.
3.Giventhepresentcorporatetaxlaws,afrmshoulduseasmuchdebtaspossible
tomaximizeitsvalueandthewealthpositionofitsstockholders.
4.Giventhepresenceofpersonaltaxesaswellascorporatetaxes,commonstock
mayhavetaxadvantagescomparedtodebtbymeansoftaxdeferralaswellas
preferentialtreatmentofcapitalgains.
193
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AnIntroductiontoAccountingandManagerialFinance
Inthischapter,weexamineandevaluateeachofthesetheoriesandtherolethe
frm’sweightedaveragecostofcapitalplays.Thekeysymbolstobeusedare:
k
0
=
theweightedaverageafter-taxcostofcapital
k
i
=
thebefore-taxaveragecostofdebt[
k
i
(
1
−
t)
istheafter-taxcost
ofdebt]
k
e
=
theafter-taxaveragecostofequitycapital
B
=
themarketvalueofthedebtinthecapitalstructure
S
=
themarketvalueofthestockequityinthecapitalstructure
V
=
thetotalmarketvalueofthefrm[
V
U
isthevalueofanunlevered
frm;
V
L
isthevalueofaleveredfrm(with
B
ofnewdebt)]
t
=
thecorporatetaxrate.
Defnition
Theweightedaveragecostofcapital(
k
0
orWACC)isdefnedasthesumofthe
weightedcostsofdebt
(k
i
)
andequitycapital
(k
e
)
,wheretheweightsaretherelative
importanceofeachcapitaltypeinthefrm’scapitalstructureandthe
k
i
and
k
e
costs
aretheexpectedaveragereturnsrequiredbyinvestorsasaninducementtocommit
funds.Forsimplicity,weconsideronlyoneclassofdebtandcommonstock.
Multipleclassesofdebtandpreferredstockcouldbeincludedwithoutalteringthe
logic,butthenotationbecomesdiffculttohandle.
Themarketvalueofthefrmisthesumofthemarketvaluesoftheoutstanding
debtandequity.
V
=
B
+
S.
(11.1)
Themeasuresofrelativeimportanceofdebtandequityinthecapitalstructureare
theratios
B
V
and
S
V
,respectively.Ifweusethesemeasuresasweights,theafter-tax
WACCisdefnedtobe
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,bythepercentagesof
debtandcommonstockcapitalbeingusedtoobtainaweightedaveragecostof
capital.
TheWACCofafrmcanbeinterpretedasbeingthecostofbothcurrent
capitalandanadditionaldollarofnewcapitaliftheexistingcapitalstructureis
maintained.
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CapitalStructure:WeightedAverageCostofCapital(WACC)
195
Example11.1
Supposethatthemarketvalueofacompany’scommonstockisestimatedat$42
million.Themarketvalueofitsinterest-bearingdebtisestimatedat$28million,and
theaveragebefore-taxyieldonthedebtis10percentperyear,whichisequivalent
onanafter-taxbasisto6percentperyear(equalto10percenttimes0.60,assuming
a40-percenttaxrate).
Assumethatthecompanyjustdescribediscurrentlypayingadividendof$8
peryearandthatthestockissellingatapriceof$100.Therateofgrowthofthe
dividendisprojectedtobe12percentperyear.Oneestimateofthecostofthe
commonstockequityis
k
e
=
D
P
+
g
=
$8
$100
+
0
.
12
=
0
.
08
+
0
.
12
=
0
.
20
,
or20%
.
(11.3)
Theweightedaveragecostofcapitalforthecompanyasawholeisestimatedin
Table11.1.
The0.20(onstock)and0.10(ondebt)arethereturnsthatwouldberequiredifa
mixtureofadditionaldebtandcommonstockweretobeissued.Theword
average
thatisusedintheterm
weightedaveragecostofcapital
referstotheaverageofthe
differenttypesofcapitalbeingused.Fordecisions,wewantaweightedaverage
ofmarginalcostsfordebtandstock.Insituationswheretheissuanceofthedebt
andcommonstockwillnotchangethefrm’scapitalstructure,themarginalcosts
mayequaltheaveragecosts.
Shareholdersareexposedtotheriskofbankruptcyassoonasdebtinsomeform
isintroduced.Equityholdersmaylosetheirownershipinterestinacompanythat
Table11.1.
EstimateoftheCostofCapital.
ProportionofAfter-Tax
CapitalSourceTotalCapitalAfter-TaxCostWeightedCost
Commonstock0.600.200.120
Debt,interestbearing0.400.060.024
Weightedaveragecostofcapital
=
0.144
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AnIntroductiontoAccountingandManagerialFinance
mayagainbecomeaproftableoperation.Withawell-managedproftablecom-
panyinasafeindustry,theintroductionofasmallamountofnonequitycapitalwill
presumablyincreasetherisksofbankruptcybyonlyasmallamount.Inpractice,
thelegalpossibilityofbankruptcyisnearlyalwayspresent,becauseacompany
willalwayshavesomedebtoutstanding.Astheamountofdebtrises,therisksof
bankruptcybecomegreater.Everydollarofdebtincreasesrisk.Theamountofthe
increasedependsupontheamountofdebtandtheactivitiesinwhichacompany
isengaged.
Oneadvantageofdebtcapitalcomesfromthefnancialleverageitprovides
fortheremainingequitycapital.However,increasesinthedebt/equityratiowill
increasetheyear-to-yearvariabilityofearningspersharecomparedtotheuseof
commonstockcapital.Takenbyitself,thisislikelytodecreasethepricepershare
thatinvestorsarewillingtopay.However,theissuanceofdebtwillalsotendto
increasetheexpectedearningspershare,andthishopefullywillcounterbalance
theincreasedrisk.
Anotherimportantadvantageofdebtisthatinterestexpenseisdeductibleby
thecorporationforpurposesofcomputingtaxableincome,whereasdividendson
commonstockarenotdeductible.Withcorporatetaxratesatapproximately0.35,
thereisanincentiveforfrmstousedebtasamajorcomponentoftheircapital
structure.
Itisimpossibletogiveanysimplerulesfordeterminingtheoptimumcapital
structureforaparticularfrm.Theoretically,theoptimumstructureisreachedwhen
anychangeinthedebt/equityratiowillresultinadecreaseinthepricepershare
ofthecommonstock.Unfortunately,wedonotknowhowmuchdebtisthecorrect
amountofdebt.Optimumcapitalstructureisa“judgmentcall”.
TheWeights
Weweightthecostofeachtypeofcapitalbythepercentagethatthetypeofcapital
istothetotalcapital.Thereisadifferenceofopinionastowhetherbookvaluesor
marketvaluesofcapitalshouldbeused.Thoseofanacademicbenttendtoprefer
theuseofmarketvalues.Thelogicisthattheweightsshouldrefecttheeconomic
importanceofthecapital,andnotthehistoricalamountsofdebtandcommonstock
asrecordedbytheaccountants.Somepractitionersfavorthebookvalues,since
theyareobjectiveandtendtobeusedbyothermanagers(e.g.,bankersandbond
analysts).
Sincetheissueisunresolved,areasonablepositionforananalystistomake
calculationsusingbothmarketandbookvaluesandlettheuseroftheinformation
decidewhichcalculationismoreuseful.Ifonlyonecalculationisbeingmade,we
wouldprefertheuseofmarketvalue.
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CapitalStructure:WeightedAverageCostofCapital(WACC)
197
AccumulatedDepreciationIsNotCapital
Theaccountingprocessincludesentriestoexpenseaccountsthatresultincredit
entriestoaccumulateddepreciationandtaxdeferralaccounts.Sincetheseentries
canaffectthecalculationofcashfowfromoperations,itiseasytoslipintothe
errorthataccumulateddepreciationandtaxdeferralaccountsgiverisetocapital.
Example11.2
Assumethatafrmhasthefollowingbalancesheet:
Plant$1,000CommonStock$1,000
Duringthenextperiod,salesare$200anddepreciationexpenseis$200.The
incomeiszero.Thebalancesheetafterthesetransactionswerecordedis:
Cash$200
Plant$1,000
Less:accumulateddepreciation200
800
Commonstock$1,000
$1,000
Notethatthecapitalconsistsof$1,000commonstock.The$200ofaccumu-
lateddepreciationisnotcapital.Wecouldrevisethebalancesheetandnotchange
theconclusionthatthecapitalisnotaffectedbytheaccumulateddepreciation.
Cash$200Accumulateddepreciation$200
Plant1,000
Commonstock1,000
$1,200$1,200
Thelocationoftheaccumulateddepreciationaccountonthebalancesheetdoes
notchangetheconclusionthatitisproperlyconsideredtobeasubtractionfrom
theplantassetaccount.
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.Assumingthatinvestorsdemandmore
returniftheirinvestmentissubjecttogreaterrisk,weconcludethat
k
i
willincrease
asmoredebtissubstitutedforequitybecausethepaymentstreamtodebtholders
November6,200913:44spi-b8119inx6inb811-ch11
198
AnIntroductiontoAccountingandManagerialFinance
becomesmorerisky.Thesamelogicleadstotheconclusionthat
k
e
willalso
increaseasdebtissubstitutedforequity,sincethedividendstreamaccruingto
equitybecomesmoreriskyasdebtobligationsincreaseinsizerelativetotheamount
ofequity.Furthermore,ifinvestorsareadversetoriskforanygivendegreeof
fnancialleverage,
k
i
islessthan
k
e
sincedebtholders(aspriorclaimers)aresubject
tolessriskthanareequityholders.Finally,as
B
V
approaches1,
k
i
approachesthecost
ofequityforzeroleverage.Thisistrue,sincethemostriskypositionadebtholder
couldbeinisequivalenttothatofanequityholderofanall-equity-fnancedfrm.
As
B
V
approaches1,debtholdersinfactbecomeimplicitequityholders.Figure11.1
depictsthisassumedbehaviorof
k
i
and
k
e
.
Theshapeofthe
k
0
curvewilldependontheshapesofthe
k
i
and
k
e
curves.
Thetraditionalorclassicalpositionassumesthat
k
i
and
k
e
areshapedsuchthat
theresultant
k
0
curveisU-orsaucer-shaped,implyingthatthereexistsaunique
minimumcostofcapitalstructure,asdepictedinFigure11.2.Startingfromthe
observationthatmostfrmsinanygivenindustry(frmswithroughlythesame
degreeofbusinessrisk)tendtohaveroughlythesamecapitalstructure,thetra-
ditionalistmightarguethat
k
e
risessignifcantlywithincreasedleveragewhile
k
i
beginstorisesignifcantlyonlyafterasignifcantdegreeofleverage.Theweighted
averagecostofcapitalinitiallyfallsastheleverageisincreased,sincetherisein
k
e
ismorethanoffsetbytheutilizationofcheaperdebt.Atsomepoint,however,the
WACCbeginstoriseas
k
i
risesmorerapidlyinresponsetotheincreasedleverage.
Itisassumedthatthereiseitherasinglevalueorarangeofvaluesof
B
V
that
Percent
e
0
kk
=
0
k
e
k
i
k
B
L
V
=
1
0
k
Fig.11.1.
AConstantWeightedAverageCostofCapital.
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CapitalStructure:WeightedAverageCostofCapital(WACC)
199
Percent
e
k
0
k
i
k
L
= 1
Fig.11.2.
TheClassicalViewofanOptimumCapitalStructure.
minimizes
k
0
.Itshouldberememberedthatweareinitiallyconsideringazero-tax
situationandonepointofview.
Acomprehensivetheoryfor
k
0
wasformulatedbyModiglianiandMiller(here-
afterM&M)intheirfamous1958
AmericanEconomicReview
article.
1
Witha
well-formulatedsetofassumptions,includingnocorporatetaxes,
k
0
isaconstant,
independentofcapitalstructure,anditfollowsthatanycapitalstructureisequally
desirable.Aconstant
k
0
isillustratedinFigure11.1.
TheM&Mpositionisbasedonthesetofassumptionsthat(1)marketsare
perfect,(2)transactioncostsarenegligible,(3)marketbehaviorisrational,and
(4)taxesarezero.Withtheseassumptions,allcapitalstructuresareequally
desirable.
Whencorporatetaxes(butnopersonaltaxesandnobankruptcycosts)are
considered,itcanbearguedthat
k
0
isamonotonicallydecreasingfunctionof
B
V
,
implyingthattheminimumcostofcapitalstructureconsistsofnearly100percent
tax-shieldingdebtfnancingandaminimumofequityfnancing.
NoTaxes
LetusconsidertheM&Margumentsfortheno-corporate-taxcase.Theperfect
marketassumptionimpliesthatwithzerotaxes,twonongrowthfrms,whichpay
1
F.ModiglianiandM.H.Miller,“CostofCapital,CorporationFinanceandtheTheoryof
Investments,”
AmericanEconomicReview
,June1958,pp.261–297.
November6,200913:44spi-b8119inx6inb811-ch11
200
AnIntroductiontoAccountingandManagerialFinance
0.15
0.10
0.05
0
0
1
B
S
e
B
k
0.10 + 0.05
S
=
k
0
= 0.10
k
i
= 0.05
Fig.11.3.
CostsofCapital.
allnetincomeasdividendsandareidenticalineveryrespectexceptforcapital
structure,shouldhavethesamemarketvalue.Themarket,asawhole,ispurchasing
thesamefuturestreamofnetoperatingincome(EBIT)fromboth.HowthatEBIT
streamisdividedintointerestanddividendpaymentsisinconsequentialinaperfect
market,andthetotalvalueofthefrmwillnotbeaffectedbythefrm’scapital
structure.Twoidenticalcommodities(inthiscase,thefuturenetoperatingincome
streams)cannotsellfortwodifferentprices(marketvalues).Thelawofoneprice
isassumedtohold.Ifavaluedisparityexists,thearbitrageprocesswillremove
it.Thus,withzerotaxes,thevalueofthefrm
(V)
isindependentoftheamountof
debt,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.Giventhe
M&Massumptions,
k
0
isaconstant.
Example11.3
Assumethat
k
0
=
0
.
10and
k
i
=
0
.
05andthatthesevaluesarenotafunctionof
theamountofleverage.Thevalueofthefrmis$10,000,000andthefrmcurrently
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CapitalStructure:WeightedAverageCostofCapital(WACC)
201
has$2,000,000ofdebtand$8,000,000ofstock.Rearrangingequation(11.2)to
solvefor
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
fordifferentdegreesofleverageareplottedinFigure11.3
from
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,sincewewouldnot
expect
k
i
tobeaconstantwithrespecttochangesin
B/S
.
AConstantWACC
Letusassumethatasubstitutionofdebtforequitywillincreasethecostofbothdebt
andcommonstock.Canthesubstitutionbeacceptable?Surprisingly,theanswer
isyes.Evenifbothcostsgoup,thesubstitutionofthelower-costdebtcancause
theaveragecostofcapitaltostayconstant.
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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,sotheincreasein
theleverageincreasesbothcosts.ButtheWACCisunchanged.TheWACCis
again0.15:
k
0
=
(
0
.
1167
)
2
3
+
0
.
2167
1
3
=
1
3
(
0
.
2333
+
0
.
2167
)
=
1
3
(
0
.
45
)
=
0
.
15
.
Justbecausedebtcostslessthancommonstockdoesnotmeanthatsubstituting
debtforcommonstockwillreducetheaveragecostofcapital.Thisisasurprising
andveryimportantobservation.
BuyingaCombinationofStocksandBonds
toDelevertheFirm:NoTaxes
Wecandeleverthefrmtoazero-debtlevel.Thatis,aninvestmentintheabove
highlyleveredfrmcanbemadeequivalenttoaninvestmentinthecommonstock
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CapitalStructure:WeightedAverageCostofCapital(WACC)
203
ofazero-debtfrm.Thereturnoninvestmentof
pV
forazero-debtfrmwiththe
sameoperatingcharacteristicsis
pX
ifthefrmearns
X
.
Withaleveredfrm,wehave:
AmountofCapitalEarnings
BI
SX
−
I
X
Iftheinvestorbuys
p
ofboth
B
and
S
(averticalslice),wehave:
AmountofInvestmentEarnings
pBpI
pSpX
−
pI
p(B
+
S)pX
Thus,theinvestoralwaysearns
pX
withtheleveredfrm—thesameincome
aswiththeunleveredfrm.
Thereturnsfromtheinvestmentinboththedebtandcommonstockofthe
leveredfrmintheappropriateproportionswillalwaysbeidenticallyequaltothe
returnfromtheinvestmentinthecommonstockofthezero-debtfrm,assuming
thattheoperatingresultsofthetwofrmsareidentical.
LeveringaFirm
Theprevioussectionshowedhowafrmcanbedeleveredbytheinvestorbuying
stocksandbondsofthesamefrm.Afrmwithtoolittleleveragecanalsobe
leveredbytheuseofpersonalborrowing.Investorssubstitutetheirownborrowing
capacityforthatofthefrmtoattaintheamountoftotalleveragethatisdesired.
Athirdpossiblewayofchangingtheamountofleverageofafrmistopurchase
acombinationoffrms(onefrmwithtoolowandonefrmwithtoohighleverage)
toobtainamixtureofinvestmentthatisequivalenttoamedium-leveredfrm.Thus,
ifthestockofthemedium-leveredfrmispricedhighcomparedtotheothertwo
frms,amixtureoftheunderpricedsecuritiescanbepurchasedatalowercostto
obtainaninvestmentequivalenttothemedium-leveredfrm.Theonlylimitationof
thisprocedureisthediffcultyoffndingfrmsthatdifferonlybycapitalstructure.
Inpractice,amixtureoftheextremefrms(veryhighorverylowfnancialleverage)
willnotexactlyduplicatethemediumfrm.
Before-andAfter-TaxCosts
Wewanttoillustratethebefore-andafter-taxcoststotheissuerofdebt,preferred
stock,andcommonstock.
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AnIntroductiontoAccountingandManagerialFinance
Example11.5
Letusassumethatthecorporatetaxrateis0.35,andthatinvestorsrequirethe
followingreturns:
0.10withdebt
0.078withpreferredstock
0.1040withcommonstock
Rememberthatpreferredstockdividendsoffernotaxshieldtothecorporate
issuer.
Thefollowingtableshowsthebefore-taxcostsandtheafter-taxcostsofthe
threedifferenttypesofcapital:
ReturnsBefore-TaxCostsTaxTaxSavingsAfter-TaxCost
Debt0.100.100.0350.065
Preferredstock0.0780.120.0420.078
Commonstock0.1040.160.0560.104
Assumethatthefrmisfnancedwith0.4debt,0.1preferredstock,and0.5common
stock.Thebefore-andafter-taxcostsofcapitalare:
Before-taxWACC
=
0
.
4
(
0
.
10
)
+
0
.
1
(
0
.
12
)
+
0
.
5
(
0
.
16
)
=
0
.
132
After-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
.
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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
isgivento
shareholders.
AmountofCapital
ReturnonCapital
BI
S(X
−
I)(
1
−
t)
Butassumeaninvestorbuysallthestockand
(
1
−
t)
ofthedebtandearns
(
1
−
t)I
onthedebt.
AmountofInvestmentReturnonInvestment
(
1
−
t)B(
1
−
t)I
S(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,thenwemustturnto
institutionalreasons.Oneimportantreasonisthetaxlaw.Asecondreasonfor
capitalstructurebeingimportantisthecostofbankruptcy.
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AnIntroductiontoAccountingandManagerialFinance
Bankruptcyhascostsarisingfromthecourt’sadministrationofthecorpora-
tion’saffairsaswellasthecostsarisingfromothercompaniesbeingreluctantto
offercredit.Bankruptcyhascoststhatarenotbuiltintothebasicmodelsillustrated
inthischapter.
ValuingaFirm:CapitalStructureandCorporateTaxes
Letusdefne
X
tobeequaltoEBIT.Thenwehave:
(X
−
k
i
B)(
1
−
t)
=
theafter-taxreturntostockholders(assumethatitis
allpaidasdividendstostockholders)
k
i
B
=
theinterestpaidtodebtholders.
Thetotalcashfowsaccruingtocapitalsupplierswillbethesumofthedividends
plusinterestpayments:
(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
)
hascashfowseachperiodthatarelargerthanthose
oftheunleveredfrm
(B
=
0
)
by
k
i
Bt
.Leveragecreatesanannualcorporatetax
savingof
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
,then
MaximumDebt
=
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)
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207
Thus,withcorporatetaxesincludedintheanalysisbutwithoutconsideringpersonal
taxes,thevalueofthezero-growthfrmismaximizedbyutilizingasmuchdebtas
islegallypermissible.
Analternativeapproachtoequation(11.8)wouldbetostatethatthevalueof
thefrmisequaltothediscountedvalueoftheexpectedcashfowsaccruingtothe
capitalsuppliers,wherethediscountrateusedistheborrowingrate,
k
i
,andriskis
accountedforbyadollarriskadjustmentfactor,
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
,maximumdebtshouldbeissuedtomaximize
thevalueofthefrm.However,thedeterminationofthevalueof
R
wouldnotbe
aneasy,well-defnedexercise.
PersonalTaxes
Theconclusionthattheoptimalcapitalstructuredecisionisforthecorporation
toissueasmuchdebtasispermissiblemaybemodifedwhenweallowthefrm
toretainearningsandtoincludepersonaltaxconsiderationsinexaminingthe
wealthpositionofstockholders.ThispositionwasstronglyarguedbyM.H.Miller
in1977.
2
Assumethattheprimaryobjectiveofacorporationistomaximizethewealth
positionofitsstockholders.Dividendsreceivedbyshareholdersaretaxedasordi-
naryincome.Ifthefrmretainstheearningsinsteadofpayingthemasimmediate
dividendsandthenreinveststheearningstoearnacompetitivereturn,payment
ofpersonaltaxesonthedividendisdeferred(sotheentireearningsratherthan
theafter-taxdividendarereinvested).Furthermore,whentheshareholderswishto
obtaincash,theycansellstockandpaythecapitalgainstaxonthepresentvalueof
thereinvestmentasviewedbythemarketratherthanhavingdividendstaxedimme-
diatelyatordinaryincomerates.Thus,personaltaxconsiderationsforstockholders
inhightaxbracketsexertsomepressureforacorporationtouseretainedearnings
tofnancegrowth.
2
M.H.Miller,“DebtandTaxes,”
JournalofFinance
,May1977,pp.261–276.
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AnIntroductiontoAccountingandManagerialFinance
Withfniteinvestmentpossibilitiesandpersonaltaximplicationsconsidered,
stockholderswithhighpersonaltaxratesmightbebetteroffhavingthefrmuse
retainedearningsratherthandebttofnanceinvestmentopportunities.
3
Whilethe
debtfnancingwouldsavecorporatetaxes,thepersonaltaxsavingsfromtheuse
ofretainedearningsmightbegreaterthanthecorporatetaxsavingsresultingfrom
theuseofdebt.
Ifthedebtholdersandequityholdersareidenticalgroups,taxavoidanceby
labeling“dividends”as“interest”canbeintheowners’bestinterest.Althoughthere
arenotexactrules,beyondsomeill-defneddegreeofleverage,interestpayments
maybetreatedasdividendsbytheInternalRevenueServiceandtheirdeductibility
fortaxpurposesdisallowed.
Theoptimalfnancialstructuredependsinpartonthetaxcircumstancesofthe
shareholdersandthedividendpolicyofthefrm,andinpartonthecorporatetax
savingassociatedwithdebtfnancing.Nosinglestrategyisoptimalforallfrms.
A“zero-tax-investor”-orientedfrmmightpayoutalargefractionofitsincomeas
dividendsandemployahighdegreeoffnancialleverage(anypublicutility?)to
meetitscapitalneeds,whereasa“growth”frmmightplowmostofitsearnings
backandmaintainalowdegreeoffnancialleverage.
TheCapitalCostofRisk
Asriskisincreased,thecostofcapitalcanbeexpectedtoincrease.Anextensively
usedmethodofadjustingthecostofcapitalforriskistousethecapitalassetpricing
model(CAPM).TheCAPMmakesuseofthepricesthatthemarketissettingfor
return-risktrade-offsratherthanusingsubjectivemeasuresofattitudestoward
risk(suchastheriskpreferencesofspecifcinvestors).Thecapitalassetpricing
modelisamajorcontributiontomodernbusinessfnancetheoryandpractice.
TounderstandtheCAPManditslimitations,itisnecessarytounderstandthe
assumptionsonwhichthemodelisbased.Itisasingle-periodmodelwithno
assumptionsbeingmadeabouttheinteractionofreturnandriskthroughtime.It
isassumedthattheinvestorisonlyinterestedintheexpectedreturnandstandard
3
The“accumulatedearningstax”isintendedtokeepfrmsfromretainingearningsexpressly
toavoiddividendpayments.Tobeexemptfromthisoneroustax,theretainedearningsmust
beusedtofnanceactive(plantandequipment,workingcapital)investmentsratherthan
passive(marketablesecurities,realestate)investments.Thisprovisionofthetaxcodehas
beenadministeredinaninconsistentmanner,soitisnotalwayspossibletocomputethe
effectsofcorporateinvestmentdecisionsontheaccumulatedearningstax.
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CapitalStructure:WeightedAverageCostofCapital(WACC)
209
deviation(orvariance)oftheinvestmentportfolio’soutcomes.Thisisatheoretical
defciency.Forsomeprobabilitydistributions,thisignoresotherinformationthat
aninvestormightconsidertoberelevant.
Itisassumedthatallinvestorsmustbepersuadedtotakemoreriskbythe
prospectofahigherexpectedreturn(theyarerisk-averse).Theactionsofaninvestor
donotaffectprice.Theinvestorsare“pricetakers”.Theinvestorscaninvestatthe
default-freerate
(r
f
)
,andgenerallyweassumethattheycanborrowatthesame
ratebutthisassumptioniseasilydropped.Investorscansellsecuritiestheydonot
own;thatis,theycanborrowsecuritiestosellthem(thisiscalledashortsale).All
investorsthinkthesameabouttheexpectedreturnandvarianceofallsecurities
(theyhavehomogeneousexpectations),andtheyareallperfectlydiversifed.
Thequantityofsecuritiestobepurchasedisfxedanddivisible(securitiesof
anydollaramountcanbepurchased).Therearenotransactioncostsandtaxes.
Manyoftheseassumptionscouldbedropped,andamodelverymuchlikethe
conventionalCAPMwouldbederived.Oneimportantfunctionservedbythisset
ofassumptionsisasimplifcationofthemodelsothatwearenotdistractedby
unnecessarycomplexity.
TheExpectedReturn
Assumethataninvestorownsthemarketportfolio.Inequilibrium,ifweaddavery
smallamountofanewsecurity
i
,theexpectedreturn-risktrade-offthatresults
fromtheinclusionof
i
mustequalthemarket’scurrenttrade-offrate.Forthisto
happen,itcanbeshownthatitisnecessarythatsecurity
i
’sexpectedreturnbe
equalto
¯
r
i
=
r
f
+
(
¯
r
m
−
r
f
)β
i
,
where
¯
r
i
=
theequilibriumexpectedreturnofsecurity
i
r
f
=
thereturnfromtherisk-freeasset
¯
r
m
=
theexpectedreturnfrominvestinginthemarket
β
i
=
thebetaofsecurity
i
,where
β
i
=
cov
(r
i
,r
m
)/σ
2
m
andisthemeasureof
marketrisk.
Theterm
(
¯
r
m
−
r
f
)β
i
istheadjustmenttotherisk-free
r
f
fortheriskofsecurity
i
.
Thebetameasurestheamountofsystematicrisk,thatis,theriskarisingbecause
offuctuationsinthemarketreturn.Thereisnoadjustmentforriskspecifctothe
frm(unsystematicrisk)intheCAPM,sinceitisassumedthattheunsystematic
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210
AnIntroductiontoAccountingandManagerialFinance
riskgoestozerogiventheverylargenumberofinvestments(theunsystematic
componentsareindependent).
Thebetaofasecuritymeasureshowthesecurity’sreturniscorrelatedwiththe
market’sreturn;thus,itisameasureofthesecurity’ssystematicrisk.
SystematicandUnsystematicReturns
Itisconventionaltheorytoseparateriskintotwocomponents.Onecomponentis
systematicrisk,ormarketriskthatrepresentsthechangeinvalueresultingfrom
marketvaluechanges.Systematicriskcanbesomewhatreducedbythechoice
ofsecurities(low-betasecurities).Butreducingsystematicriskinthiswaymay
increasetotalrisk,sincetheinvestor’sportfoliowillnotbeperfectlydiversifed.
Thisgivesrisetothesecondtypeofrisk.Thisisresidualorunsystematicrisk.
Thisriskisspecifctothecompany(orasset)andisindependentofwhathap-
penstotheothersecurities.Iftheinvestor’sportfolioconsistsofaverylarge
numberofsecuritieswithnosecuritybeingalargepercentageoftheportfolio,
thenthisunsystematicriskcanbemadetoapproachzerobyastrategyofperfect
diversifcation.
Withaportfolioof10securities,90percentoftheunsystematicriskiselim-
inated.Withaportfolioof100securities,99percentoftheunsystematicriskis
eliminated.Thesystematicriskremains.
TheCAPMneglectsrelevantfactorsthatareactuallyconsideredbyinvestors.
Forexample,thecommonstockofelectricutilitiesbuildingnuclear-generating
plantscouldhaveanegativeimpactbecausetheCAPMdoesnottakeintocon-
siderationthespecifcriskofbuildingnuclear-generatingplants,butthemarketis
likelytoconsiderthisriskevenifitisnon-systematicrisk.
Totheextentthatsecuritypricesaredeterminedbytheactivitiesoftheinvestors
whocandiversifytheirportfoliosatlowcost,thepricesofsecuritieswillbeset
insuchawaythatdifferentialsinexpectedratesofreturnwillrefectprimarily
differencesintheamountofsystematicrisktowhichthesecuritiesareexposed.
Whileamiddlemanagermightfndtheriskofaspecifcassettobeofinterest,
thetopmanagementofafrmwillwanttoknowtheeffectoftheassetonthe
overallriskofthefrm.Attheinvestorlevel,investorsshouldbemoreinterested
intheeffectofthespecifcassetontheriskinessoftheirportfoliosthantherisk
ofaspecifcasset.Managersarelikelytobeinterestedintheeffectofthespecifc
assetontheriskoftheircareers.
Wefnditusefultobreakdownriskintotwocomponents:(1)riskthatcan
beeliminatedbydiversifcation,whichistermedunsystematicrisk;and(2)risk
thatisstillpresentwhenallunsystematicriskhasbeeneliminated,whichistermed
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211
systematicrisk.Thelatterrefectshowtheinvestmentsintheportfolioarecorrelated
withthemarket.Onlysystematicriskisrelevantforaperfectlydiversifedinvestor.
Thebetaofasecuritymeasuresitssystematicrisk.Thisistheriskassociated
withchangesinthemarket’sexcessreturn.
Unsystematicriskcanbediversifedaway.Iftheportfolioconsistsofavery
largenumberofsecuritiesandnosecuritybeingalargeproportionoftheportfolio,
theunsystematicriskoftheportfoliowillapproachzero.Itdoesnottakemany
securitiesfortheunsystematicriskoftheportfoliotoapproachzero.
Abetacoeffcientofunityindicatesthatasecurityhasthesameamountof
systematicriskasthemarketportfolio.Abetacoeffcientgreater(less)thanunity
indicatesthatthesecurityisriskier(safer)thanthemarketportfolio.Betasbased
onactualdataarepreparedbyMerrillLynch,WellsFargoBank,andtheValueLine
investorserviceaswellasothers.Thesearecalledhistoricalbetas.Fundamental
betaswouldbe
ex-ante
estimatesbasedonthecapitalstructureandoperating
characteristicsofthefrm.
Oneimportantfactorshouldbekeptinmind.Weareinterestedinwhatreturn
themarketexpectstoearnforagivenamountofrisk.Todeterminethis,weneed
toknowthereturnthatisexpectedtobeearnedinthemarket
(
¯
r
m
)
aswellashow
theriskofaspecifcsecuritycomparestotheriskofthemarket.Themodelneeds
expectationsinordertobeusedcorrectly.Allweshallhavearedatabasedonpast
eventsthatweshallusetoestimatethevariablesthatweneed.Forexample,one
problemisthatthebetawillchangethroughtime.Also,thevalueof
r
f
willdepend
onthematurityofthegovernmentsecuritythatisused.Itisnoteasytousethe
CAPMinanexactmanner.
UseoftheCAPM
EventhoughtheassumptionsonwhichtheCAPMisbasedlimitthegeneralityof
themodel,itisstillwidelyused.Amongtheusesare:
1.Toestimatethecostofequitycapitalusing
¯
r
i
=
r
f
+
(
¯
r
m
−
r
f
)β
i
.
Theseestimatesmaybeusedasthebasistodeterminetherequiredreturntobe
earnedbyafrm’sasset.
2.Toevaluatesecurities—iftheexpectedreturnislargerthan
¯
r
i
=
r
f
+
(
¯
r
m
−
r
f
)β
i
,
thesecurityisa“bargain”.
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AnIntroductiontoAccountingandManagerialFinance
IfasecurityhasalargerexpectedreturnthanthereturnindicatedbytheCAPM,
allinvestors(withhomogeneousexpectations)willbuyituntilitsexpectedreturn
isloweredtobeequalto
¯
r
i
=
r
f
+
(
¯
r
m
−
r
f
)β
i
.
Inlikemanner,ifasecurity
i
isexpectedtoearnlessthan
r
f
+
(
¯
r
m
−
r
f
)β
i
,
noonewillbuy(somewillsellitshort),itspricewilldecrease,anditsexpected
returnwillincrease.
Allsecuritiesarecontainedinthemarketportfolioinproportiontotheirmarket
value.Thebetaofthemarketportfoliois1.
Industrytendstousea“costofcapital”ora“hurdlerate”toimplementthe
discountedcashfowcapitalbudgetingtechniques.Bothofthesemeasuresare
“averages”refectingaveragerisksandaveragetimevalueconditions,andcannot
besensiblyappliedtounique“marginal”situations.Thereisnoreasontothinkthat
theweightedaveragecostofcapitalcanbeinsertedinacompoundinterestformula
andthenbeappliedtoanyseriesoffuturecashfowstoobtainausefulmeasure
ofnetpresentvaluethattakesboththetimevalueandriskoftheinvestmentinto
consideration.
Thecapitalassetpricingmodeloffershopeforaccomplishingasystematic
calculationofrisk-adjustedpresentvalue.Themeasurerefectstheinvestor’salter-
nativeinvestmentreturn-risktrade-offopportunitiesinthesamewayastherateof
interestonagovernmentbondrefectsinvestmentopportunitieswhenthereisno
defaultrisk.Evenwherethereisareluctancetoacceptimmediatelythespecifc
calculationsofthetypeillustratedinthischapter,therewillbeachangeintheway
thatmanagementwilllookatalternatives.
Oneimportantlimitationofthecapitalassetpricingmodelforcorporatedeci-
sionmakingshouldbekeptinmind.Themodelassumesthattheinvestorsare
widelydiversifed,and,equallyimportant,itassumesthatthemanagersofthefrm
arewillingtomakeinvestmentdecisionswiththeobjectiveofmaximizingthe
well-beingofthistypeofinvestor.Thismeansthatunsystematicrisk(forwhich
theinvestoriswelldiversifed)maybeignoredintheevaluationofinvestments.
Itiswellknownthatobjectivesoffrmsandmanagersaremultidimensionaland
thattherewillbeareluctancetoignoreriskbecauseitdoesnotaffectthewell-
diversifedinvestor.Theso-called“unsystematic”riskisnotsomethingthatislikely
tobeignoredbyamanagementthatincludesamongitsobjectivesthecontinuity
ofexistenceofthefrm.
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CapitalStructure:WeightedAverageCostofCapital(WACC)
213
Themodelswehaveusedherearesomewhatsimplifed.Investorsaremuch
morecomplexintheirbehaviorandmarketsarelessthanperfect.Nevertheless,
theconclusionsreachedarerelevantandwillbethefoundationforagreatdealof
thefnancialinvestmentmodelsofthefuture.Investmentdecisionmakingunder
uncertaintyisnotaneasytask,butuncertaintyisacharacteristicoftheworldand
theproblemmustbefaced.
Conclusion
Oneamountofdebtleverageispreferredtoanotherifmovingtothatleverage
willimprovethestockholders’wealthposition.Buttodeterminethedegreeof
fnancialleveragethatleadstoaweightedaveragecostofcapitalthatmaximizes
stockholders’wealthisnoeasytask.
Althoughthetraditional(orclassical)positionstatesthatajudiciousamount
ofdebtistobeemployed,theModiglianiandMiller1958paperstatesthat,with
well-defnedassumptions,anydegreeoffnancialleverageisequallydesirable
(withnocorporatetaxes).
4
Whencorporatetaxesareconsidered,itcanbeargued
thatthetheoreticalminimumcostofcapitalstructureisvirtuallyalldebt.
Caremustbeusedintakingsidesonthiscontroversy.Thetraditionalistsargue
theirpositionbynotingthatfrmsadoptcapitalstructuressubstantiallylessthan100
percentdebtandsubstantiallymorethan0percentdebt.TheModiglianiandMiller
zero-taxargumentforavaluethatisindependentofcapitalstructure,ontheother
hand,isclearlyspelledoutintermsoftheirassumptionsandmodels.Whilethelat-
terarecorrectgiventheirassumptions,theirassumptionsareworthreconsidering.
Theextenttowhich(1)marketsareimperfectand(2)equitysuppliersdiscrimi-
natebetweendividendsandcapitalgains(treateddifferentlyfortaxpurposes),and
(3)thefactthattherearebothcorporateandpersonaltaxes,makesitdiffcultto
makethedefnitiveexactstatementsastotheexactoptimumcapitalstructure.Most
important,thereisgeneralagreementthatthedifferenttaxtreatmentsawardedto
interestandstockholder’searningsaffecttherelativedesirabilityofdebtandstock.
Iftherewerenopersonaltaxes,theuseofdebtinthecapitalstructureofa
corporationwouldenableafrmtoreduceitscostofraisingcapitalsincethe
interestpaymentsaredeductibleforcorporatetaxpurposes.Thedesirabilityof
debtcomparedtocommonstockisdramatizedwhenthedebtispurchasedby
thecommonstockholders,sinceinthissituationthereisnoincreaseintherisk
4
F.ModiglianiandM.H.Miller,“CostofCapital,CorporationFinanceandtheTheoryof
Investments,”
AmericanEconomicReview
,June1958,pp.261–297.
November6,200913:44spi-b8119inx6inb811-ch11
214
AnIntroductiontoAccountingandManagerialFinance
totheinvestors.Onecouldbeledtotheconclusionthatafrmshouldissueas
muchdebtaspossible,withzero-taxstockholderspurchasingthedebtifthey
fearanexcessiveincreaseinriskarisingfromthehighlyleveredcapitalstructure.
However,theInternalRevenueServicemightlimittheamountofthistypeofdebt
thatacorporationmayissuesincetoomuchdebtmayresultinthecashdistribution
beingrelabeledasdividends.
Theadditionofdebt,evenwherethedebtisarelativelycheapsourceofcap-
italbecauseofthetaxstructure,doesaddrisktothestockholdersifthedebtis
soldtononstockholders.Ifthereisnotaxableincome,thefullcostoftheinterest
fallsonthecorporationandultimatelyonthestockholders.Thus,wecanconclude
thatthepresenttaxstructureoffersstrongincentivestoissuedebt,butthatthere
arefrequentlyforces(theriskofbankruptcyandtheconventionsoftheinvest-
mentbankingcommunity)thatrestrainthecorporationconsideringtheissuance
ofunusuallylargeamountsofdebtcomparedtocommonstock.
Businessmanagersquiteproperlywanttoknowhowdifferentcapitalstructures
affectthecostofobtainingcapital.Theywanttoreducethecostofusingthefrm’s
presentcapitalortoreducethecosttothefrmofobtainingnewcapital.
Althoughmanagersmayalsowanttousetheweightedaveragecostofcapital
asthediscountrate(thehurdlerate)inevaluatingallinvestments,wearenot
enthusiasticaboutthisusage.Iftheriskoftheassetisdifferentfromtheriskof
thefrm’sotherassets,orifthetimingofthecashfowsisdifferent,usingtheone
risk-adjusteddiscountrate(thefrm’sweightedaveragecostofcapital)toevaluate
alltheinvestmentsisnotlikelytoleadtocorrectdecisions.
ReviewProblems
ReviewProblem11.1
(a)Thecorporatetaxrateis0.35.Completethefollowingtable.
RequiredBefore-TaxAfter-Tax
ReturnsCostsTaxTaxSavingsCost
Debt0.12
Preferredstock0.11
Commonstock0.14
(b)Theafter-taxweightedaveragecostofcapital(0.45debt,0.15preferredstock,
0.40commonstock)is
WACC
=
November6,200913:44spi-b8119inx6inb811-ch11
CapitalStructure:WeightedAverageCostofCapital(WACC)
215
(c)Aninvestorbuyingaverticalsliceofthefrmwillearnhowlargeareturnif
therequiredreturnsareearned?
SolutiontoReviewProblem11.1
(a)Thecorporatetaxrateis0.35.
RequiredBefore-TaxAfter-Tax
ReturnsCostsTaxTaxSavingsCost
Debt0.120.120.0420.078
Preferredstock0.110.16920.05920.1100
Commonstock0.140.21540.07540.1400
(b)Theafter-taxweightedaveragecostofcapital(0.45debt,0.15preferredstock,
0.40commonstock)is
WACC
=
0
.
45
(
0
.
078
)
+
0
.
15
(
0
.
11
)
+
0
.
40
(
0
.
14
)
=
0
.
1075
.
(c)Aninvestorbuyingaverticalsliceofthefrmwillearnareturnof0.1265if
therequiredreturnsareearned.
r
=
0
.
45
(
0
.
12
)
+
0
.
15
(
0
.
11
)
+
0
.
40
(
0
.
14
)
=
0
.
1265
.
QuestionsandProblems
1.Assumea0.35taxrate.Topay0.10toinvestors,acompanymustearnwhat
return(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-tax
WACCofthefrmis____________________.
November6,200913:44spi-b8119inx6inb811-ch11
216
AnIntroductiontoAccountingandManagerialFinance
b.Azero-taxinvestorholdingtheproportionofsecuritiesgivenin(a)would
earn____________________.
3.Assumethatafrmhasearned$100ofbefore-taxincome.Thecorporatetax
rateis35percent.
a.Ifthesecurityusedtofnancetheinvestmentis$1,000of10percent
debt,thefrmholdingthedebt(supplyingthedebtcapital)willhave
_______________aftertax.
b.Ifthesecurityusedtofnancetheinvestmentis$1,000ofcommonstock
andiftheentireafter-taxamountofincomeispaidasadividend,thezero-
taxinvestorholdingthecommonstockwillhave_______________after
tax.
4.Assumethatacompanyborrowsatacostof0.14.Itstaxrateis0.35.Whatis
theminimumafter-taxcostofcapitalforacertaincashfowif:
a.100percentdebtisused?
b.100percentcommonstockisused(assumethatthestockholderswillaccept
a0.14return)?
5.Assumethatthereturnontax-exemptsecuritiesis0.09andthat
t
p
=
0
.
3,
t
g
=
0
.
20,and
t
c
=
0
.
35,where
t
g
istherateoncapitalgains,
t
c
isthe
corporatetaxrate,and
t
p
isthepersonaltaxrateondividendsandinterest.
Equilibriumconditionsexist.
a.Thereturntoinvestorsontaxablebonds(withequalrisk)raisedasnew
capitalcanbeexpectedtobe____________________.
b.Thereturntoinvestorsoncommonstock(allcapitalgains)raisedasnew
capitalcanbeexpectedtobe____________________.
6.ThetaxratefortheGasCorporationis0.35.Thefollowingtablehasbeen
preparedforthepresidentofthefrm.
Before-TaxCostAfter-TaxCostCapitalStructure
Bonds0.100.0650.4
Preferredstock0.200.13000.1
Commonstock0.23080.150.5
a.Computetheweightedaverageafter-taxcostofcapitalofthefrm,withthe
givencapitalstructure.
b.Computethereturnbeforetaxforaninvestorwhosplitstheinvestmentin
thecompanyinthesameproportionasthesourcesofcapital.
November6,200913:44spi-b8119inx6inb811-ch11
CapitalStructure:WeightedAverageCostofCapital(WACC)
217
c.If$1,000ofeachtypeofcapitalwereraised,thecapitalwouldhavetoearn
beforetax:
Bonds$______________________
Preferredstock______________________
Commonstock______________________
7.Foracompanywithzerodebt,thecostofthefrstdollarofdebtis0.10,and
thecostofcommonstockis0.18(thesearereturnsrequiredbyinvestors).We
havedeterminedthatthecostofdebtis
k
i
=
0
.
10
+
0
.
08
B
V
andthattherearenotaxesandnobankruptcycosts.Thecapitalmarketis
rationalandwellinformed.
a.Whatistheweightedaveragecostofcapital?
b.Shouldthenextissueofthecompanybecommonstockordebtifthe
objectiveistominimizethecostofthecapital?
c.Whatwillbethecostofequityifthecapitalstructurehasequalamountsof
debtandequity?
8.ThefollowingfactsapplytotheXYZCompany:
Bondscanbeissuedtoyield0.10.
Preferredstockcanbeissuedtoyield0.08.
Commonstockcanbeissuedwithanexpectedyieldtostockholdersof
0.18.
Thetaxratesare0.4forallsectionsofthisproblem.
a.Computethebefore-taxcashfowsthathavetobeearnedtocompensate
investorsfor$1,000ofcapital:
(1)Debt.(2)Preferredstock.(3)Commonstock.
b.ComputetheWACC(after-tax)ifthecapitalstructureis0.5debt,0.1
preferredstock,and0.4commonstock.
c.Computetheweightedaveragereturnforaninvestorwhoinvestsinthe
sameproportion(fordifferentsecurities)asthecapitalstructure.
9.AssumetheM&Mzero-taxmodel,where
k
0
=
0
.
14and
k
i
=
0
.
10forall
capitalstructures(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,whatisthepersonaltaxrateofthe
marginalinvestor?
b.Aninvestorintaxexemptsinthe58-percenttaxbracketwouldearnthe
equivalentofwhatbefore-taxreturn?
c.If$10billionoftax-exemptsecuritiesareissued,theannualinterestsavings
totheissuingauthoritiesare_______________.
11.
0
a
c
b
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$4
millionofequity.Youhave$2milliontoinvestinthefrm.Therearezero
taxes.
Howwouldyouinvestsothatyourinvestmentisequivalenttoinvestingin
anidenticalfrmwith100percentcommonstock?
13.Afrmisbeingorganizedthatrequiresaninitialinvestmentof$20million.You
have$200,000andwillbuy0.01ofthecommonstockifthefrmis100percent
fnancedwithcommonstock.Theuseof$8millionof10-percentpreferred
stockand$12millionofcommonstockisbeingconsidered.
November6,200913:44spi-b8119inx6inb811-ch11
CapitalStructure:WeightedAverageCostofCapital(WACC)
219
a.Ifthiscapitalstructureischosen,whatinvestmentstrategyshouldyou
choosetohavethesameidenticaloutcomesasinvestinginthecommon
stockatthe100-percentcommonstock-fnancedfrm?
b.Ifthefrmearns$900,000,whatwillyouearnifthecommonstockfnancing
ischosen?Whatwillyouearnifthepreferredstockfnancingischosenand
youinvestasdescribedin(a)?
14.Encircleonenumeralforthecorrectstatement.
a.Ifwithasubstitutionofdebtforcommonstockthecostsofbothcommon
stockanddebtincrease,thentheWACCwill
(1)Increase.
(2)Decrease.
(3)Staythesame.
(4)Increase,decrease,orstaythesame.
b.Ifdebtissubstitutedforcommonstock,onewouldlogicallyexpectthecost
ofstockequityto
(1)Increase.
(2)Decrease.
(3)Staythesame.
(4)Increase,decrease,orstaythesame.
c.Intheabsenceofbankruptcycostsandcorporatetaxes,afrmwithmore
debtthanthemarketthinksisrationalwillsell
(1)Atthesamevalueasanidenticalfrmproperlyfnanced(asviewedby
themarket).
(2)Atlessthanafrmproperlyfnanced.
(3)Atmorethanafrmproperlyfnanced.
(4)Atthesamevalue,orlessthan,ormorethan,dependingonriskpref-
erences.
15.Assumethatforapublicutilitythefollowingfactsandestimatesapplyand
areaccepted:
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
.
6and
hasmadethefollowingcalculationforWACC:
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(theyarethesame
frmexceptforcapitalstructure).Otherfactsare:
MarketValues
FirmXFirmY
Debt$0$75,000,000
Commonstock110,000,00025,000,000
Thecostofthedebtis0.10.
a.Assumethatyouaregoingtoinvest$1,000,000inoneofthefrms.What
wouldbeyourinvestmentplanifyouwantyourstrategytodominatethe
alternativeofinvestingintheequityoftheotherfrm?
b.Explainwhyyourplanisdesirable.
17.TheplanningteamoftheABCInsuranceCompanyistryingtoorganizethe
capitalstructureofanacquisition.Bothfrmsarepayingincometaxes.You
aregiventhechoiceoftwocapitalstructures:
StructureStructure
10%Debt60%
10%Preferredstock60%
Commonstock40%40%
ABCwillown0.40ofallsecurities.
Whichcapitalstructureshouldthefrmprefer?Explain.
18.TheABCInsuranceCo.followsapolicyofbuyingthesamepercentageof
commonstockasdebt.Thatis,ifitbuys0.20ofacompany’sdebt,itwillbuy
0.20ofthecompany’scommonstock.
November6,200913:44spi-b8119inx6inb811-ch11
CapitalStructure:WeightedAverageCostofCapital(WACC)
221
TheMetroInsuranceCo.willonlybuycommonstockincompaniesthat
havezerolong-termdebt.Allthecompaniesbeinginvestedinhavethesame
operatingrisk.
Assumethattherearezerotaxes.
Whichinsurancecompanyhasamoreriskyinvestmentstrategy?Explain.
19.Assumethatacompanyborrowsatacostof0.09.Itstaxrateis0.35.Whatis
theminimumcostofcapitalforacertaincashfowif:
a.100-percentdebtisused?
b.100-percentcommonstockisused(assumetheinvestorsaccepta0.09
return)?
20.a.TheABCCompanyhasasimplecapitalstructure.Managementwantsto
substitute$100millionof0.12debtforcommonstock.Whateffectwillthe
changehaveonthevalueofthefrmtoazero-taxinvestor?Thecorporate
taxrateis0.35.
b.TheXYZCompanyisthinkingofacquiringafrmthatisearningbefore-
tax$100,000ayear.XYZ’sborrowingrateis0.10,anditstaxrateis0.46.
Thus,itsafter-taxborrowingrateis0.65.Theinvestmentinthefrmwillbe
fnancedwithsuffcientdebttocausetheamountofincometaxespaidto
bezeroonthisinvestment.WhatisthemaximumamountthatXYZcould
affordtopayforthefrm?
21.ThetaxrateforTheIthacaCorporationis0.4.Thefollowingtablehasbeen
preparedforthepresidentofthefrm.
Before-TaxCostAfter-TaxCost
Bonds0.100.06
Preferredstock0.120.072
Commonstock0.200.12
Onlybondinterestisdeductibleforincometaxes.Thefrmhasacapitalstruc-
tureof0.4debt,0.1preferredstock,and0.5commonstock.Assumethatthe
U.S.InternalRevenueCodeapplies.
a.Computetheweightedaveragecostofcapitalofthefrm,withthegiven
capitalstructure.
b.Computethebefore-taxreturnforaninvestorwhosplitsherinvestmentin
thecompanyinthesameproportionasthesourcesofcapital.
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November6,200913:44spi-b8119inx6inb811-ch12
Chapter12
BuyversusLease
Leasingisoneofthemostpopularmeansbywhichcorporationsfnanceassets.
Younameit,youcanleaseit—atomicfuelfornuclearpowerplants,hospital
equipment,truckfeets,helicoptersand747s—thelistislong.Thetotalvalueof
leasedassetshasbeengrowingatarateofmorethan10percentperyear.
Therehavebeenfundamentalmisunderstandingsabouttherelativemeritsof
buyingversusleasing.Forexample,considerthefollowingissue.Ifonewere
indifferenttobuyingandleasingwithoutconsideringtaxes,wouldtheaddition
oftaxconsiderationsdrivethedecisioninthedirectionofleasing?Ifyousaid
“yes”withoutqualifcations,youhavesomethingtolearn.Theaboveimproper
leasingversusbuyinganalysiswithtaxconsiderationsincludedhasprobablybeen
somewhatresponsibleforthetremendouspopularityofleasing.
Theconfusionregardingtheleasedecisionisnothelpedbythefactthat
thetaxlawskeepchangingdramatically.Notonlyisitnecessarytobefamil-
iarwiththespecifcsofthecurrenttaxacts,butitisalsonecessarytobefamiliar
withtheTreasuryDepartmentregulationsthatinterpretthetaxlawspassedby
Congress.
Therearetwoveryimportantcharacteristicsofleasesthatshouldbecarefully
distinguishedandunderstood.Themoreimportantisthewayinwhichaleasewill
affectthefrm’staxsituation.Thesecondisthewayinwhichaleasewillaffectthe
accountingreports.Therearefewfnancialdecisionsaffectedbytheaccounting
rulesasmuchastheleasingdecision.
FAS13:AccountingforLeases
Companiesoftenrentpropertyunderlong-termleaseagreementsthatrequirefxed
rentalpaymentstobemadebythe
lessee
(useroftheproperty)tothe
lessor
(owner
oftheproperty)forthedurationofthelease.Leasingisfrequentlyviewedasan
223
November6,200913:44spi-b8119inx6inb811-ch12
224
AnIntroductiontoAccountingandManagerialFinance
alternativetopurchasingthepropertyandmaybeanattractivemeansoffnancing
neededfacilities.Becausetheobligationforrentalpaymentscouldbesubstantial,
theireffectshouldbedisclosedinthefnancialstatements.Onewayofaccom-
plishingthisistorecordthepresentvalueofrequiredleasepaymentsasaliability.
Acorrespondingassetwouldthenberecognizedtoindicatethevalueoftheleased
propertytobeutilizedinthecompany’soperations.Asecondmethodwouldbe
todisclosethetermsofthelease(cashoutlaysthatwillberequired),butnotto
capitalizetheassetortheliability.
Theproblemofthedisclosureofleasesinthefnancialstatementiscomplicated
bythevaryingtermsandobjectivesoftheleaseagreements.Atoneextreme,the
lesseemaybeviewedassimplyusingaserviceforashortperiodoftimeand
payingrentfortheperiodofuse.Rentinganautomobileforaweekendwould
ftthisdescription.Attheotherextreme,thelesseemaybeviewedasactually
acquiringanownershipinterestinalong-termasset,despitethefactthatlegaltitle
mayremainwiththelessor.Leasinganautomobileforfouryearswithmonthly
paymentsthatarecomparabletofnancingtermsforapurchasemightftthis
description.
Incurrentpractice,twotypesofleasesaredistinguishedfromthelessee’s
pointofview.Leasesthatessentiallymayberegardedaspurchasesarecalled
capitalleases
andareaccountedforasanacquisitionofalong-termassetwith
correspondingrecognitionofthepaymentobligationasaliability.Allotherleases
arecalled
operatingleases
andaretreatedastheutilizationofservices,withrental
paymentsrecognizedascurrentexpensesastheycomedue.Theaccountingfor
leaseshasbeendefnedbyFinancialAccountingStandardsBoardStatementNo.13
andthesupplementarystatementsissuedtoexplainFASB(FinancialAccounting
StandardsBoard)No.13.
Thereareseveralcriteriathatmaybeusedtodeterminewhetheraleasequalifes
forclassifcationasacapitallease.Amongtheseareprovisionsforthetransfer
ofownershipofthepropertytothelesseeduringtheleaseterm,provisionsfor
purchaseofthepropertybythelesseeatabargainprice,aleasetermthatisequal
toorgreaterthan75percentoftheusefullifeoftheproperty,orthepresentvalueof
minimumleasepaymentsbeingequaltoorgreaterthan90percentofthefairvalue
ofthepropertyatthebeginningoftheleaseterm.
1
Ifaleasemeets
anyoneofthese
criteria
,itisclassifedasacapitallease.Otherwise,itisregardedasanoperating
lease.
1
Thisisasimplifedexplanation.Formoredetailsconcerningthespecifcrequirements,
seeFinancialAccountingStandardsBoard,StatementofFinancialAccountingStandards
No.13,
AccountingforLeases
(Stamford,CT:FASB,1976).
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
225
Withacapitallease,thelesseemustshow:
a.Theinitialpresentvalueoftheleasepaymentsasanasset(theassetistobe
depreciatedthroughtimeinthesamemannerasanyotherdepreciableasset).
b.Theinitialpresentvalueoftheleasepaymentsasaliability,tobereduced
throughtimeusingpresentvalueprinciples.
c.Thefutureminimumleasepaymentsforeachofthenextfveyearsandintotal
forthelifeofthelease.Thistotalamountisreducedbytheimputedinterest
payments,toobtainthepresentvalueofthelease.
Withoperatingleases(leasesnotqualifyingascapitalleases),thelesseemust
showthefutureminimumleasepaymentsforfveyearsandthetotalminimum
leasepaymentsforthelivesofalltheoperatingleases.Operatingleasesarenot
shownonthebalancesheetexceptinfootnotes.Thelessee’sborrowingratewill
beusedincalculatingpresentvalues.
ExampleofAccountingforLeases
AssumethatonJanuary1,20x1,ElcoCorporationrentsequipmentfromOrco
Corporationunderaten-yearleasecallingforrentalpaymentsof$10,000atthe
endofeachofthetenyears.Attheendoftheleaseperiod,Elcomaypurchasethe
equipmentfor$1.Theequipmenthasanexpectedusefullifeoftenyearsandhas
afairvaluenowof$61,500.Elcopaysinterestof10percentperyeartoborrow
money.
Thismaybeviewedasacapitalleasebecausethetermoftheleaseextends
beyond75percentoftheusefullifeoftheequipment.(Itwouldalsoqualifyon
othergrounds.)UsingAppendixTableB,wefndthatthepresentvalueof$1per
periodfortenperiodsat10percentis6.1446.Therefore,thepresentvalueoftheten
paymentsis
$10
,
000
×
6
.
1446
=
$61
,
446
.
Theassetandtheleaseobligationmayberecordedasfollows:
LeasedEquipment
....................................
61
,
446
LiabilityforLeasedEquipment
..................
61
,
446
Theliabilityshouldbeshownatitspresentvalue,andafnancingchargeshould
berecordedeachyear,basedontheassumedrateofinterestandthebalanceofthe
November6,200913:44spi-b8119inx6inb811-ch12
226
AnIntroductiontoAccountingandManagerialFinance
obligationfortheyear.AbalancesheetonJanuary1,20x1,wouldshowanasset,
LeasedEquipment$61
,
446
andaliability,
CapitalLeaseObligation$61
,
446
.
Afootnotewouldshowthefollowinginformation:
MinimumleasepaymentsforyearendingDecember31
20x1$10,000
20x210,000
20x310,000
20x410,000
20x510,000
LaterYears50,000
TotalMinimumLeasePayments$100,000
Less
:AmountRepresentingInterest38,554
PresentValueofNetMinimumLeasePayments$61,446
Theasset,LeasedEquipment,mustbedepreciatedintheusualmanner.Letus
assumethefrmusesstraight-linedepreciationandthattheequipmenthasanesti-
matedlifeoftenyears.ThefollowingentrywouldbemadeonDecember31,20x1:
DepreciationCost
.......................................
6
,
145
LeasedEquipment:AccumulatedDepreciation
......
6
,
145
Itisalsonecessarytorecordtheinterestcostoftheliabilityandthepaymentof
the$10,000leaseoutlay.Forexample,thepresentvalueoftheobligationatthe
beginningofyear20x1was$61,446.Atthe10-percentrate,theamountofinterest
toberecognizedfortheyearwouldbe
$61
,
446
×
0
.
10
=
$6
,
145
.
Torecordtheinterest,theprincipalpayment,andthecashoutlay,wehave:
InterestExpense
··
....................................
6
,
145
LiabilityforLeasedEquipment
........................
3
,
855
Cash
..........................................
10
,
000
Attheendofyear1,theliabilityaccountwouldhaveabalanceof$57,591.
Itshouldbenotedthatthisisequaltothepresentvalueofthenineremaining
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
227
Exhibit12.1.
AmortizationTableforLeaseLiability.
Period
Lease
Payment
Interest
Expense
Liability
Reduction
NetValueof
LeaseObligation
$61,446.00
1$10,000$6,144.60$3,855.4057,590.60
210,0005,759.064,240.9453,349.66
310,0005,334.974,665.0348,684.63
410,0004,868.465,131.5443,553.09
510,0004,355.315,644.6937,908.40
610,0003,790.846,209.1631,699.24
710,0003,169.926,830.0824,869.16
810,0002,486.927,513.0817,356.08
910,0001,735.618,264.399,091.68
1010,000909.179,090.830.85
leasepaymentsdiscountedat10percentperyear.Attheendofyear10,whenthe
fnalpaymentismade,theliabilityaccountwouldbereducedtoazerobalance.
Exhibit12.1presentsanamortizationtablefortheleaseliability.Also,theasset
accountforLeasedEquipmentwouldhaveazeronetbalance,asitisbeingdepre-
ciatedoveraten-yearperiod.Theleasingarrangementistreatedasanimplicit
purchaseofequipment.
Iftheleasedescribedintheaboveexampledid
not
qualifyasacapitallease,it
wouldberegardedasanoperatinglease.Inthiscase,noassetorliabilitywouldbe
recognized.Instead,eachyearthecompanywouldrecognizea$10,000expense,
theamountoftheleasepayment.
Itshouldbenotedthatiftheleaseistreatedasacapitallease,theexpenseof
thefrsttime-periodisnotequaltothe$10,000cashoutlay.Thetotalexpenseis:
DepreciationCost$6,145
Interest6,145
TotalExpense$12,290
Whilethe$6,145ofdepreciationwillstayconstant,theinterestwillbereduced
throughtime,astheliabilityisbeingreduced.Theuseofdifferentdepreciation
methodswouldproducedifferentresults.
Therecognitionofcapitalleasesasaliabilityinthefnancialstatementsisa
relativelyrecentdevelopmentinaccountingpractice.Atonetime,itwaswidely
believedthatleaseobligationsweredifferentfromotherformsofdebtanddidnot
November6,200913:44spi-b8119inx6inb811-ch12
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AnIntroductiontoAccountingandManagerialFinance
needtobereportedonthebalancesheet.Thisledtosomecompaniespreferringto
leaseratherthanpurchasetheirplantandequipmentinordertoreducetheamount
ofdebtappearingontheirbalancesheets.Thispractice,whichcametobeknown
as“off-balance-sheetfnancing,”hasbeenrestrictedbyFAS13.
LessorsandLessees
Anybusinessentitycanbealessee.Abigleasingcategoryistransportation
equipment—oiltankers,railroadrollingstock,airplanes,trucks,andautos.Other
majorgroupsofassetsthatareleasedarecomputersandotherdataprocessing
devices,copiers,andspecializedmachinery.
Lessorsarefrequentlyfnancialinstitutionswithlargecashfows(i.e.,theinsur-
ancecompanies,banks,andfnanceandinvestmentcompanieswithlargetaxable
incomes“requiring”taxsheltering).Theseinstitutionshaveastrongincentive
tobuyequipmentandthenleaseittoequipmentuserswhocannottakeadvan-
tageofsuchtaxbeneftsasaccelerateddepreciationbecausetheydonothave
taxableincome.Insomecases,theplantorequipmentpurchasedbythelessoris
fnancedbyloansmadetothelessor,therebycreatingasituationknownasleveraged
leasing.
Asecondtypeoflessoristhemanufacturer-lessor.Thesecompaniesuseleases
andrentalagreementsaskeytoolsinthemarketingoftheirproducts,enabling
themtoattractcustomerswhomightnotbeabletofnanceanoutrightpurchase.
TheProsandConsofLeasing
Table12.1showsinsummaryformmanyoftheargumentsofferedinfavorofand
againstleasing.Itcanbeseenthatfrequentlya“pro”argumentiscanceledbya
“con”argument,leavingthedecisionmakertoevaluatesubjectivelyhowthefactor
istobebroughtintothedecision.
Wewillconsiderthecashfowsassociatedwiththetwoalternatives(buyand
lease)underwell-defnedconditions.Wewillcompareleasingwithconventional
debtaccompanyingthebuyalternative.
Figure12.1showsthebasicbuyversusleaseanalysis.First,itmustbedecided
whetherornottheinvestmentisacceptable.Second,theannualcostofbuyingthe
assetwithborrowedfundsmustbecomparedwiththeannualcostofleasing.Ifthe
costofbuyandborrowislessthanthecostofleasing,thenthethirdandfnalstep
istoconsiderwhetheritisdesirabletofnancetheinvestmentwithdebtorwitha
mixtureofdebtandstockequity.
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
229
Table12.2.
TenProsandConsofLeasing.
ProCon
1.Itis100percentdebtfnancing.1.Aleasemayprecludeotherdebt
fnancingifitisafrmobligationtopay.
2.Withashort-termlease,thereislessrisk
ofbeing“stuck”withabadassetifthe
usefullifeislessthanexpected;thereis
noargumentaboutlifewithIRS.
2.Noresidualvalueiflifeislongerthan
expected.
3.Theshort-termleasegivesfexibility.3.Leasetermsmaybeadjustedupwardat
theendofthelease.
4.Maintenancemaybecheaperthanif
youdidityourself.
4.Thesamemaintenancecontractcan
probablybepurchasedifyoubuy.
5.Anoperatingleaseisoff-balance-sheet
fnancing.
5.Manyexpertsreconstructfnancial
statementstoincludeoperatingleases.
6.Withalease,itiseasiertojustify
investments(higherreturnon
investmentsincethereiszeroorasmall
investment).
6.Itdoesnotfoolasmanyasitusedto.
Theleaseshouldbecapitalized.
7.Aleaseiseasyandquicktoobtain.7.Notalways.Someleasearrangements
areverycomplex.
8.Higherbookincomeisgeneratedin
earlyyears.
8.Thisisaresultofaccounting
convention;also,laterincomeswill
beless.
9.Lowerpropertytaxesarepaid.9.Propertytaxesarelikelytobebuiltinto
leasepayments.
10.Therearetaxsavings.10.Therearetaxdissavings.
Cost of buy-borrow
Buy-Borrow
Accept
Investment
Lease
Acquire
Investment? Cost of leasing
Reject
investment
End
Fig.12.1.
Buy-BorrowversusLease:Lessee.
November6,200913:44spi-b8119inx6inb811-ch12
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AnIntroductiontoAccountingandManagerialFinance
ThreeBasicProblems
Therearethreebasicproblemsinanalyzingbuyversusleasedecisions.Oneis
thedefnitionofthecashfowstobeused.Thesecondisthechoiceoftherateof
discount.Thethirdproblemistomatchtheappropriaterateofdiscountwiththe
choiceofcashfow.
Forsimplicity’ssake,weshallrecommendtheuseofafter-taxcashfows.For
purposesofsimplifcation,azerotaxratewillinitiallybeusedsothatthebefore-tax
andafter-taxcashfowsareidenticalforthefrstexample.
Amajorproblemwiththecashfowcalculationistheinclusionorexclusionof
thedebtcomponentoftheleasefows.Theobjectiveistomaketheleaseanalysis
comparableintermsofdebtcharacteristicswiththebuyanalysis.Generally,this
meansextractingdebt-equivalenttaxdeductionelementsoftheleasecashfows.
Therearethreebasicoptionsfromwhichtherateofdiscountcanbechosen:
1.Theafter-taxborrowingrate,
2.Thebefore-taxborrowingrate,or
3.Sometypeofrisk-adjustedratesuchastheweightedaveragecostofcapital.
Ifweassumethattherearefourpossiblesetsofcashfows(thereare,inreality,
more)andthreepossiblediscountrates(again,thereare,inreality,more),thenthere
aretwelvedifferentwaysofcombiningthetwoelements.Ifwethenrecognizethe
possibilityofusingdifferentratesofdiscounttodiscountdifferenttypesofcash
fowsforeitherthebuyortheleasecomponent,wecanreadilyseewhytherehas
notbeenagreementonthemethodofanalyzingbuyversusleasedecisions.
Itisnecessarytocomparethecashfowsandthepresentvalueofonealternative
(buy)withtheotheralternative(lease).Ratherthanreviewingthebasictheoryand
practiceofcapitalbudgeting,weshalljumpintothemiddleofthatdiscussionand
concludethatoneshouldusethenetpresentvaluemethodsinceitisatleastas
goodasanyothermethodand,formanypurposes,better.
SeparatingFinancingandInvestment
Itisnecessarytoevaluatethefnancialaspectofleasingandtoseparatethefnancing
andinvestmentelements.Weshallassumethatwearediscussingaleasethat
ishighlysimilartoapurchasewiththeborrowingofthepurchaseprice.The
leasecontractbeingconsideredhasallthecharacteristicsofalong-termlegaldebt
obligation.Thelesseemustpaythespecifedsumtothelessoratthespecifedtimes
ofpaymentorsufferlegalconsequences.Aleasethatcanbebrokenbythelessee
withoutsubstantialpenaltyisnotthetypeofleasebeingdiscussedinthissection.
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
231
Inthesituationbeinganalyzed,committingone’scompanytoasetoflease
paymentsisequivalenttocommittingthecompanytoasetofcomparabledebtser-
vicepayments.Anyknowledgeablefnancialanalystwouldimmediatelycapitalize
fnancialleaseseveniftheyweretechnicallyoperatingleases.Forexample,ifitis
disclosedthatagivencompanyisobligedtopay,say,$36,829peryearforthree
yearstoaleasingfrm,thepresentvalueofthoseleaseobligationsattheexisting
opportunitycostofdebt,say,10percent,wouldbe
$36
,
829
×
B
(
3
,
0
.
10
)
=
$36
,
829
×
2
.
4869
=
$91
,
590
.
Theanalystwouldmodifytheexistingbalancesheetdatabyadding$91,590worth
oflease-equivalentassetstothefrmand$91,590worthofdebt-equivalentliabil-
ities.Therelevantcomparisonfordecisionpurposesisbuyandborrowversus
lease.
TheProblemEvenwithaZero-TaxSituation
Weshalltrytoisolatethebasiccomponentsofthebuyversusleasedecision.
Considerthefollowingsetofsituations:
Example12.1:Buy-BorrowversusLease
TheAssumptions
1.Notaxconsiderations.
2.Nouncertaintyregardingcashfows.
3.Theinvestmenthasnosalvagevalue.
TheProblem
Theeconomiclifeoftheequipmentisthreeyears.Youhavealreadydecidedto
proceedwiththeproject,buttheproblemiswhethertobuythemachineatacost
of$90,000orleaseitfromthemanufactureratanannualleasefeeof$36,829for
threeyears.Theleaseis“net,net”,meaningthatyouprovideallthemaintenance
andinsurance.
TheAnalysis
Acalltothelocalbankerrevealsthatthebankiswillingtolendyourfrmthe
$90,000ataninterestrateof10percent.This,thebanklendingoffcerinforms
November6,200913:44spi-b8119inx6inb811-ch12
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AnIntroductiontoAccountingandManagerialFinance
you,willrequireannualpaymentsof$36,190.Thebankcreditoffcerdidthe
followingcalculationstoobtaintheannualpayments.Let
R
betheannualpayment;
then,
R
×
B
(
3
,
0
.
10
)
=
$90
,
000or
R
=
$90
,
000
2
.
4869
=
$36
,
190
.
TheDecision
Sincebuy-borrowischeaperthanleaseby$639peryearforthethreeyears,you
arrangefortheloanandpurchasetheequipment.Thefrmwouldratherpay$36,190
tothebankthan$36,829tothelessor.Itcanbeshownthattheleasehasanimplicit
costof11percent.
Giventhesefacts,weseethatbuy-borrowispreferredtoleaseifitisalready
decidedthatweneedtheequipment.Thus,ourdecisionatthesecondnodeof
thedecisiontreedepictedinFigure12.2istobuy-borrow.Nowconsiderthefrst
decision—theacquisitiondecision.
Example12.2:AcquiretheNewEquipment?
TheProblem
Theincrementalcashfowsassociatedwithanequipmentacquisitionwouldbe
$38,000peryear(estimatedannualrevenuefromsaleofproductlesscostofpro-
ductionexcludingequipmentcost).Theequipmentcosts$90,000.
$36,190 Annual cash outlay
of debt payment
Buy-Borrow
Yes
Lease
Acquire
Equipment? $36,829 Annual cost
No
End
Fig.12.2.
Buy-BorrowversusLease:Lessee.
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
233
TheAnalysis
Thefrmnormallyusestheweightedaveragecostofcapital(WACC)asits“hurdle
rate”ininvestmentanalysis.TheWACCisestimatedtobe14percent.
Methodof
FinancingCost
WeightedinCapital
StructureWeightedCost
Debt0.100.50.05
Equity0.180.50.09
0.14=WACC
Ifweuse14percentasthediscountrate,thenetpresentvalueanalysisforacquiring
theequipmentis:
TimeCashFlowPresentValueFactor@14%PresentValue@14%
0
−
$90,0001.0000
−
$90
,
000
1–3$38,0002.3216$88
,
221
Netpresentvalue@14%
=−
$1
,
779
ThenetpresentvalueofacquiringtheequipmentisnegativeusingtheWACCas
adiscountrate.But,ifweleasetheequipment,thenetpresentvalueisclearly
positiveatanydiscountratesinceleasingprovidesanexpectednetbeneftof
$38,000
−
$36,829
=
$1,171peryear.
Using14percent,thesebeneftshaveanetpresentvalueof$2,719.
TheDecision
Thisanalysiswouldseemtoindicatethatthefrmshouldrejectthebuyalternative,
butthatleasingisacceptable(leasinghasapositivenetpresentvaluewithany
positiverateofdiscount).ButExample12.1alreadyshowedthatiftheequipment
isacceptable,thefrmshouldbuy-borrow,notlease!
TheProperComparison
TheanalysisinExample12.2leadingtotheacceptanceofleasingandtherejection
ofthebuyalternativeisfaulty.Wecannotlogicallycompare“buy”and“lease”;
rather,wecompare“buy-borrow”and“lease”orcompare“buy”withaleasealter-
nativethatisplacedonabasisthatiscomparableto“buy”.Theleasealternative
November6,200913:44spi-b8119inx6inb811-ch12
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AnIntroductiontoAccountingandManagerialFinance
implicitlyincludesdebtfnancingfows,whilethe“buy”alternativehasnosuch
fows.Acomparisonofthenetpresentvaluesasstructuredaboveislikelytobe
faulty.
ALeaseIsaDebt
Assumeaninvestmentanalysisthatusescashfowswithdebtfowssubtracted
fromthebasicinvestmentfows(stockequityfowsarebeingused).Anycon-
ventionalinvestmentwithaninternalrateofreturngreaterthanthecostofdebt
canbemadetoappearbetter(agreaternetpresentvalue)byincludingthedebt
fowsintheanalysisorbyincreasingthedebtusedtofnancetheinvestment
andfocusingonthenetpresentvalueoftheresidualcashfows.Sinceleasepay-
mentsareeffectivelydebtservice,itisimportantthatcomparabilitybeestab-
lishedbetweentheleaseandbuyalternativesinacquisitionanalysis.Thereare
essentiallythreemethodsofneutralizingthefnancialdifferencesbetweenthetwo
alternatives.
Thefrstmethodwouldbetorecognizetheleasepaymentsasdebtserviceand
discountthesepaymentsatthecostofdebt,therebycomparingthecostofbuying
withdebtagainstacquiringwithlease.Intheillustration,thedebtequivalentof
leasing(thepresentvalueoftheleasepaymentsat10percent)is
$36
,
829
×
B
(
3
,
0
.
10
)
=
$36
,
829
×
2
.
4869
=
$91
,
590
.
Iffundsareborrowedandtheequipmentispurchased,thepresentvalueofthedebt
serviceandfowsis$90,000,andsobuy-borrowispreferredtoleasingthatcosts
$91,590.
Thesecondmethodofcomparingbuy-borrowandleaseistoincludethedebt
fowsinthebuyanalysis.Thenetdebtfowsofbuyingare$38
,
000
−
$36
,
190
=
$1
,
810peryear.Thenetbeneftsfromleasingare$1,171peryear,whichisless
thanthebuy-borrownetbeneftsof$1,810.
Thethirdmethodiscomparabletothesecond.Wecontendthatthedecisiontree
approachofFigure12.1isanappropriateapproach.Ifacquisitionisdesirableand
leasingisanalternative,wecancomparetheannualequivalentcostsoffnancing
theacquisitionbydebtandbyleasing.Sincethebeneftstreamofcashfowsfrom
acquisitionisthesameundereitheracquisitionstrategy,thedifferentialcashfows
betweenbuy-borrowandleasearisesolelyfromthedifferencesinthecontractual
obligationofthetwoalternatives.Debtfnancingcosts$36,190,andtheleasecosts
$36,829;therefore,buy-borrowismoredesirablethanleasing.
Thesethreeprocedurestelluswhattodoifwehavedecidedtoacceptthe
equipment.Theydonottelluswhetherornottheequipmentisdesirable.Withno
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
235
uncertainty,theinvestmentisdesirable.Withuncertainty,bothbuyingandleasing
maynotbeacceptable.Thedecisiondependsontheanalysisoftheproject’srisk.
TheEffectofTaxes
Letusassumethattheequipmentacquisitionisdeemeddesirableandthatthe
methodofacquisitionistheonlyquestion.Taxesexertsubstantialinfuenceand
mustbeconsidered.Withrespecttoincometaxes,thetotalleasepaymentsare
tax-deductible,whereasdepreciationandinterestpaymentsondebtaredeductible
underthebuy-borrowalternative.
Howdothesetaxfactorsaffectthedecision?Letusproceedwithourprevious
illustration.Nowassumethatthelessorofferstoleaseat$36,190peryear,the
sameasthedebtservicepaymentstothebankifthe$90,000wereborrowed.This
wouldresultinindifferenceiftherewerezerotaxes.Dotaxesforcetheanalysis
towardleaseorbuy-borrowinthiscase?
Supposethatthetaxrateis40percent.Ifthe$90,000isborrowed,thedebt
repaymentschedulewouldbe:
Period
AmountOwed
Beginningof
PeriodInterestat10%
Principal
PaymentTotalPayment
1$90
,
000$9
,
000$27
,
190$36
,
190
262
,
8106
,
28029
,
91036
,
190
332
,
9003
,
290
32
,
900
36
,
190
$18
,
570$90
,
000$108
,
570
Ifstraight-linedepreciationisusedbythefrmfortaxes,thetotaltaxdeductions
resultingfrombuy-borrowandleasingwouldbe:
PeriodInterest
Straight-Line
Depreciation
Buy-Borrow
TotalTax
Deductions
LeaseTax
Deductions
1$9
,
000$30
,
000$39
,
000$36
,
190
26
,
28030
,
00036
,
28036
,
190
33
,
290
30
,
000
33
,
290
36
,
190
$18
,
570$90
,
000$108
,
570$108
,
570
Thetaxdeductioneachyearwithleasingis$36,190or$108,570forthree
years.Thesumsofthedeductionsarisingfrombothbuy-borrowandleasingare
November6,200913:44spi-b8119inx6inb811-ch12
236
AnIntroductiontoAccountingandManagerialFinance
$108,570,butthetimingofthecashfowsclearlyfavorthebuy-borrowalternative,
evenifstraight-linedepreciationexpenseisusedfortaxesratherthanaccelerated
depreciation.
Notethatifthefrmusedaccelerateddepreciation,asitnormallywouldfor
taxpurposes,thebuy-borrowalternativewouldbeevenmorepreferable.Totaltax
deductionswouldagainbethesame,butthetimingwouldbeevenmorefavorablein
theearlyyearstobuy-borrow.Inthissituationwheretherewasinitiallyindifference
andzerotaxes,theinclusionoftaxesmovedthedecisiontowardbuy-borrow.
AMethodofSolution
Ifweusestraight-linetaxdepreciationandtheafter-taxborrowingrateof0.06,the
netcostofbuy-borrowis
$90
,
000
−
0
.
4
(
$30
,
000
)
2
.
673
=
$90
,
000
−
$32
,
076
=
$57
,
924
.
The$32,076isthepresentvalueofthetaxsavingsresultingfromtheuseof
straight-linetaxdepreciation.
Let
r
=
theafter-taxborrowingrate
t
c
=
thecorporatetaxrate
L
=
theannualleasepayment
B(
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-taxborrowing
rateisbeingusedasthediscountrate.
Thiscalculationisareasonablesolutiontotheproblemofdeterminingwhether
leasingorbuyingwithborrowingismoredesirable.Thisveryeasymethodof
solutionispossible,sincethefrmiswillingtousetheafter-taxborrowingrate
todiscountallthecashfows.Ifanyotherdiscountrateisused,wemustusea
morecomplexmethodofsolution.Theuseoftheafter-taxborrowingratehasthe
advantageofcausingtheafter-taxpresentvalueofthedebtfowsassociatedwith
borrowingtobeequaltozero.Thismakesthebuy-borrowandtheleasecalculations
equivalent.
Youshouldnotbelulledintothebeliefthatifthereisnodifferencebetween
buy-borrowandleaseonabefore-taxbasis,theafter-taxanalysiswillalways
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
237
demonstratethatbuy-borrowislesscostly.Supposethatthelessorofferedthe
equipmentat$32,901peryear,withpaymentdueatthebeginningoftheyear
ratherthanattheend.Thepresentvalueoftheleasepaymentsatthebefore-tax
costofdebtisagain$90,000,
$32
,
901
+
$32
,
901
×
B
(
2
,
0
.
10
)
=
$90
,
000
,
whichisthesameasthepresentvalueofthedebtservicecashfows,andthereis
before-taxindifference.Butthepresentvalueoftheafter-taxcashfowsofleasing
discountedattheafter-taxcostofdebt,
(
1
−
0
.
4
)(
$32
,
901
)
[
1
+
B
(
2
,
0
.
06
)
]=
$55
,
933
,
isinthiscaselessthanthepresentvalueoftheafter-taxcashfowsfrombuy-
borrowwithstraight-linedepreciation($57,924).Leasingisnowlesscostlythan
buy-borrowing.Changingthetimingoftheleasepaymentsandthetaxdeductions
affectstherelativedesirabilityofbuy-borrowandlease,eventhoughthebefore-tax
presentvaluesarenotchanged.
Therearenoeasilyappliedconsistentlycorrectrulesofthumbinbuyversus
leaseanalysis—acompleteafter-taxdiscountedcashfowanalysisisthesafest
wayofmakingthedecision.
Risk-AdjustedDiscountRate
Weshallnowassumethatmanagementiswillingtodiscountdebtfowsusing
theborrowingrate,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,butwehavetobreakthat
downinto“interest”and“depreciation”.Forleasing,the“depreciation”equivalent
isequaltothe“principal”portionoftheleasepayment.
Usingthebefore-taxborrowingrateof0.10,weobtainapresentvalue(debt
equivalent)ofleasepaymentsof
$36
,
190B
(
3
,
0
.
10
)
=
$36
,
190
(
2
.
4869
)
=
$90
,
000
.
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AnIntroductiontoAccountingandManagerialFinance
Theimplicitdebtamortizationschedulefortheleaseis:
PeriodBeginningLiabilityInterest(0.10)PrincipalPayment
1$90
,
000$9
,
000$27
,
190
262
,
8106
,
28029
,
910
332
,
9003
,
29032
,
900
$90
,
000
Thetaxsavingsassociatedwiththeinvestment-likeaspectsoftheleaseare:
Period
Lease
OutlayInterest
“Depreciation”
orPrincipal
Tax
Rate0.4
CashFlow
(taxsavings)
PresetValueof
TaxSavings
(
j
=
0
.
20)
1$36
,
190$9
,
000$27
,
1900.4$10
,
876$9
,
063
236
,
1906
,
28029
,
9100.411
,
9648
,
308
336
,
1903
,
29032
,
9000.413
,
1607
,
616
$90
,
000
$36
,
000
$24
,
987
Forthebuyalternativeusingstraight-linedepreciation,wehave:
PeriodBuy
CashFlow
(taxsavings)
PresentValueof
TaxSavings
(
j
=
0
.
20)
1$30
,
000
×
0
.
4
=
$12
,
000$10
,
000
230
,
000
×
0
.
4
=
12
,
0008
,
333
330
,
000
×
0
.
4
=
12
,
000
6
,
944
$36
,
000$25
,
277
Thedepreciationtaxsavingsofbuyarelargerthanthedepreciation-equivalent
taxsavingsofleasing.Sinceallotherthingsareequal,buyisbetterthanleasing.
Thesedepreciationtaxsavingsaretheonlycashfowsforbothalternativesthat
arenotdebttypesoffows,anditcanbearguedthatonlythesefowsandnotthe
fnancing-typefowsshouldbediscountedatarisk-adjustedrate.
Inspectionofthetaxsavingnumbersrevealsthatatanypositiverateofinterest,
thebuystream(evenwithzeroresidualvalue)istobepreferredtotheleasing
stream.Adecreaseintheleasepaymentsfrom$36,190isnecessarytoincreasethe
relativedesirabilityofleasecomparedtobuy-borrow.Using
j
=
0
.
20,theafter-tax
presentvaluecostofbuyingis$90
,
000
−
$25
,
277
=
$64
,
723.
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
239
Ifwehadincorrectlyused
j
=
0
.
20todiscountalltheafter-taxcashfowsof
leasing,wewouldhave
(
1
−
t
c
)L
B
(
3
,
0
.
20
)
=
(
1
−
0
.
4
)
$36
,
190
(
2
.
1065
)
=
$45
,
741
.
Thiscalculationindicatesthatleasinghasasmallernetcostthandoesbuying.It
isanincorrectcalculationbecauseitimplicitlyincludesthedebtcomponentinthe
leasecashfowsthatarebeingdiscountedat0.20.Ifweincludedthedebtfowsin
thebuyanalysisanddiscountedat0.20,thenetcostwouldbe$45,451.Thecost
isreduced,since0.10debtisbeingdiscountedat0.20.
DebtCalculationsUsing0.20
PeriodInterest
(1
−
0
.
4)
Interest
Principal
Payment
After-Tax
CashFlows
PresentValue
Using0.20
1$9,000$5
,
400$27
,
190$32
,
590$27
,
158
26,2803
,
76829
,
91033
,
67823
,
388
33,2901
,
97432
,
90034
,
87420
,
182
Presentvalueofoutlays
=
$70
,
728
Netpresentvalueofdebt
=
$90
,
000
−
$70
,
728
=
$19
,
272
.
Netcostofbuying
=
$64
,
723
−
$19
,
272
=
$45
,
451
or
Netcostofbuying
=
$70
,
728
−
$25
,
277
=
$45
,
451
,
where$70,728isthepresentvalueofthedebtoutlays,andthe$25,277isthe
presentvalueofthetaxsavingsfromdepreciation.
ResidualValue
Assumethat0.06isthecorrectinterestrateandthatthesamefactsapplyasearlier
whentheleasepaymentsare$35,555peryear,exceptthattheexpectedresidual
valueis$1,070ifthefrmbuys.Thepresentvalueofdepreciationtaxsavings
$32,076plusthepresentvalueofresidualvalue($898)is$32,974forbuy-borrow
using0.06.Thisisequaltothepresentvalueofthetaxshieldofthenoninterest
portionoftheleasepayments($31,396)plusthe$1,578ofsavingsbecausethe
presentvalueofbefore-taxleasepayments($88,422)islessthanthepresentvalue
November6,200913:44spi-b8119inx6inb811-ch12
240
AnIntroductiontoAccountingandManagerialFinance
ofdebtfowsofbuying($90,000).Figure12.3showsthatiftheappropriatediscount
rateisgreaterthan0.06,leasingismoredesirablethanbuy-borrow.
InsteadofplottingthepresentvalueofthenondebtfowsasinFigure12.3,we
couldplotthenetcostofthetwoalternativesasinFigure12.4.
Withazerorateofdiscount,thenetcostofbuyingis
$90
,
000
−
0
.
4
(
$90
,
000
)
−
$1
,
070
=
$52
,
930
Present value of savings,
Non-debt flows
Net present value
0.4(90,000) + 1,070 = 37,070
0.4(88,422) + 1,578 = 36,947
Buy-borrow
Leasing
$32,974
Rate of discount 0.06
0
Fig.12.3.
BuyversusLeasewith$1,070ofResidualValue(PresentValueofSavings).
Net cost
Cost of buying
0
0.06Rate of discount
57,026
52,930
53,053
Cost of leasing
Cost 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)
=
$88,422
PVoftaxsavings
=
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,thereisno
difference.
TheIssues
Wehaveillustratedaprocedurethatallowstheuseofanyrateofdiscountforcom-
putingthepresentvalueofthetaxsavingsfromdepreciation(orthedepreciation
equivalentofleasing)andthepresentvalueoftheresidualvalue.
Someanalystswillwanttodiscountdepreciationtaxsavingsusingarisk-
freeratesincethesecashfowsarenearlycertain.Otherswillprefertheafter-
taxborrowingratesinceitavoidscertaintypesoferrorandisconsistentwith
theopportunitycostofnewdebtcapital.Finally,somewillprefertoincludean
adjustmentforriskincomputingthepresentvalueofdepreciationtaxsavingsand
residualvalue(orforoneofthem).
Ifaninterestratelargerthantheafter-taxborrowingrateisused,caremust
betakentoplacethebuy-borrowanalysisonacomparablebasistothelease
analysis.Theleaseanalysistendstoincludedebtfows;andifahighinterestrate
isused,thiscreatesabiasforleasing.Thesolutionrecommendedistocomputea
debtequivalentofleasingandanalyzeseparatelytheinvestmentcharacteristicsof
leasingsothatleasingandbuyingarecomparable.
ThreeDecisions
Firmshavethreedecisionstomakebeforeanassetcanbeleased.First,the
frmhastodecidewhetherornottheprojectisworthwhile.Second,adecision
November6,200913:44spi-b8119inx6inb811-ch12
242
AnIntroductiontoAccountingandManagerialFinance
hastobemadewhetherthefnancingshouldbedonewithstraightdebtor
withleasing.Third,thefrmmustconsiderusingequityratherthanleasing
ordebt.Wearenotconcernedwiththesequenceinwhichthedecisionsare
madeaslongasitisrecognizedthattherearethreedecisions.Forexample,
itmightbedecidedthat,iftheprojectweretobeaccepted,buyingwouldbe
moredesirablethanleasing,butitstillwouldnotbedesirabletoacquirethe
project.
Thefnancingcaninfuencewhetherornottheprojectisdesirable.Forexample,
abuyanalysismightleadtoarejectanalysis,butsincetheleasetermsareso
favorable,leasingmightcausetheprojecttobeacceptable.Acceptabilityimplies
thattheassetpassessometypeofriskandpresentvalueanalysis.
Ifitisdecidedthatstraightdebtratherthanleasingisdesirable,itisstillpossible
thatthefrmwilldecidetousecommonstockorsomeothertypeoffnancing.The
buyversusleasedecisionshouldbemadecomparingtheleasecontractwithstraight
debtfnancingsothatthetwoalternativesareascomparableaswecanmakethem.
Butafterthatdecisionismade,itmaystillbecorrectforthefrmtorejectdebtin
favorofsomeothertypeoffnancing.
Conclusion
Leasingisanimportantfnancingmethod.Forfrmswithoutaccesstodebtmoney,
itmaybetheonlywayofacquiringassets.Butformanypotentiallessees,the
optiontobuyisavailable,and,withreadyaccesstothedebt-capitalmarket,themost
relevantdecisionistocomparebuy-borrowandleasesinceleasecommitmentsmay
be,ineffect,debt-typeobligations.Furthermore,infocusingontheincremental
cashfowsofbuy-borrowandlease,theuseoftheafter-taxborrowingrateenables
ustochoosetheformofthedebt.Theuseofaconventionalinvestmenthurdlerate
(
j
)orWACCtodiscounttotalleasefowswiththeformula
(
1
−
t
c
)L
B
(n,j)
is
inerror.
Manyfrmshavemadethewrongfnancingdecisionbynotfollowingthese
principles.Comparingbuy(withoutincludingdebtfows)withleasefowsusinga
highdiscountrateandcashfowsof
(
1
−
t
c
)L
createsaninherentbiastowardthe
leasingalternative,andwesuspectthatthephenomenalgrowthrateinleasingis,
inpart,theresultoffaultyanalysis.
Therearenoeasyrulesofthumbtohelpdecidewhichalternativeispreferable
evenwhentheintangiblesareignored.Calculatingandcomparingtheafter-tax
cashfowsofthetwoalternativesandcomputingthepresentvalueswillprovidea
guidelinewithrespecttothesefactorsifthecorrectdiscountrateandcorrectcash
fowsareemployed.
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
243
ReviewProblems
ReviewProblem12.1
AssumethattheACorporationcanobtaina10-yearnoncancellableleaseof
$12,500peryearforanassetthatitwants.Theleasepaymentisdueattheendof
eachyear.Theassetwillhavezerovalueattheendof10years.
Theassetwouldcost$70,000ifpurchased.Itwillearngrosscashfowsof
$13,500peryear.
Corporatetaxesare0.35.Theassetftsinthe5-yearAcceleratedCostRecovery
System(ACRS)classlife.
Thecorporationcanborrowmoneyrepayableinequalinstallmentsatanafter-
taxcostof0.07.Ithasaweightedaveragecostofcapitalof0.15.
Assumethatthefrmhasdecidedtoacquiretheasset.Assumethatthefrmis
willingtousetheafter-taxborrowingrate.
Thenettaxcostofbuyingis__________.
Thenettaxcostofleasingis__________.
PresentValueofDepreciationof$1,000,000ofAssetsUnderACRS
(allthetablevalueshaveadecimalinfrontofthefrstdigit)
ClassLife
DiscountRate3Years5Years10Years15Years
01979156969618949194928486
02959001940615902132864282
03939507912912858479806496
04920645886436817933754358
05902386861118780223707203
06884707836893745105664453
07867582813701712360625607
08850988791487681788590226
09834904770198653211557930
10819309749784626466528385
11804183730201601407501299
12789507711404577900476415
13775263693353555825453508
14761435676010535071432377
15748007659340515539412848
16734962643309497136394764
18709968613040463395362398
20686343584973433263334347
November6,200913:44spi-b8119inx6inb811-ch12
244
AnIntroductiontoAccountingandManagerialFinance
SolutiontoReviewProblem12.1
Netcostofbuying
=
$70
,
000
−
0
.
35
(
$70
,
000
)(
0
.
813701
)
=
70
,
000
−
19
,
936
=
$50
,
064
Netcostofleasing
=
$12
,
500
(
1
−
0
.
35
)
B
(
10
,
0
.
07
)
=
$57
,
067
.
QuestionsandProblems
1.Assumezerotaxes.Equipmentcanbeleasedat$10,000peryear(frstpayment
oneyearhence)fortenyearsorpurchasedatacostof$64,177.Thecompany
hasaweightedaveragecostofcapitalof15percent.Abankhasindicatedthat
itwouldbewillingtomaketheloanof$64,177atacostof10percent.
Shouldthecompanybuyorlease?Therearenouncertainties.Theequipment
willbeusedfortenyears.Thereiszerosalvagevalue.
2.(continue1)Ifthebankwaswillingtolendfundsat9percent,shouldthe
companybuyorlease?
3.(continue2)Ifthecompanypays$64,177fortheequipment,itwillsave
$10,000ayearonleasepaymentsfortenyears.
Whatinternalrateofreturnwillitearnonits“investment”?
4.(continue1)Nowassumeamarginaltaxrateof0.4.Assumethatthefunds
canbeobtainedfor0.10atabank.Thecompanyusessum-of-the-years’digits
depreciationfortaxes.
Shouldthefrmbuyorlease?(Assumethatthepresentvalueofthedepreci-
ationdeductionsis0.79997perdollarofdepreciableassetsusing0.06asthe
discountrate.)
5.(continue1)Nowassumeamarginaltaxrateof0.4andthataloancanbe
obtainedfromthebankatacostof9percent.
Shouldthefrmbuyorlease?Using0.054,thepresentvalueofdepreciation
is0.811.Use0.054asthediscountrate.
6.(continue5)Assumethattheleasepaymentsof$10,000startimmediatelyand
thattheyarepaidattheendofeachyear.Thereare10payments.
Computethepresentvalueofleasing;comparethepresentvaluewiththat
obtainedforproblem5.
7.Assumethatthereisa0.4marginaltaxrate.Anassetwithalifeofthree
yearscanbeboughtfor$25,313orleasedfor$10,000peryear.Fundscanbe
borrowedatacostof0.09(paymentsof$10,000peryear).
November6,200913:44spi-b8119inx6inb811-ch12
BuyversusLease
245
a.Whatisthepresentvalueofthedebt(theliability)ifthefundsareborrowed
atacostof9percent?Assumethatthepaymentstothebankare$10,000
peryear.
b.Whatisthepresentvalueoftheleasepaymentsof$10,000(theliability)?
8.(continue5)
a.Includetheborrowingcashfowsinthebuyanalysis.Assumeequalpay-
mentsofdebt.Howdoesthischangethenetcost?
b.Assumethatthenetcostofbuyingwascomputedusingthecostofcapital
of15percent.Nowincludetheborrowingcashfows.Howwillthischange
thenetcostofbuying(youdonothavetocomputethepresentvalue)?
9.Whatfactorsmightmakealessor’sexpectedcostofacquiringanddisposing
ofequipmentlessthanthelessee’sexpectedcost?
10.Whyareleasingcompanies(lessors)sohighlylevered?
11.Considerthefollowinginvestment:
CashFlowsatTime
012InternalRateofReturn
−
$1,000$576$57610%
Ifdebtcanbeobtainedatacostof5percent,determinethenetpresentvalue
oftheequitycashfowsdiscountedat15percentif:
a.Nodebtisusedtofnancetheinvestment.
b.$500ofdebtisusedtofnancetheinvestment.
c.$900ofdebtisusedtofnancetheinvestment.
d.Repeatthecalculationsusing5percentasthediscountrate.
12.Supposethat$100,000isborrowedat8percentandistoberepaidinthree
equalannualinstallments.Prepareadebtamortizationtableandshowthat
thenetpresentvalueoftheafter-taxcashfowsofthedebtiszerousingthe
after-taxcostofdebtasthediscountrate.Thetaxrateis40percent.
13.MBIhasofferedtosellorleasecomputingequipmenttoCornellUniversity
thathasanexpectedlifeofthreeyears.Ifpurchased,theinitialcostwouldbe
$2million.Ifleased,theannualleasepaymentswouldbe$800,000peryear.
Cornellcanborrowmoneyatabout7percentonitsendowmentandpaysno
taxes.Ignoringsalvagevalue,whatshouldCornelldo?
November6,200913:44spi-b8119inx6inb811-ch12
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November6,200913:44spi-b8119inx6inb811-ch13
Chapter13
PreferredStock
PreferredStock:AHybrid
Preferredstockisasecuritythat,similartodebt,promisesawell-defned(specifed)
butnotnecessarilyconstantcontractualcashfow(dividend)totheholdersofthe
security.Unlikedebt,itdoesnotcausethefrmtobesubjecttobankruptcyifthe
dividendsarenotpaid.Theterm
preferredstock
impliesthatthissecurityisina
morefavorablepositionthanthecommonstock.Thisconclusionisnotlikelytobe
validforanindividualinvestorpayingtaxesatahighrateondividends.Acorporate
investormightlikepreferredstockbecauseofa70%“dividend-receiveddeduction”
(intheUnitedStates,normallyonly0.30ofthedividendincomereceivedbya
corporationissubjecttotax).
Thecorporatetaxsavingsassociatedwithinterestondebtmakeitdiffcult
forpreferredstocktocompetewithdebtinthenonregulatedsectorofcorporate
activity.Also,thecapitalgainsandtaxdeferredpossibilitiesforindividualinvestors
ofcommonstockgivecommonstocktaxadvantagesoverpreferredstockwitha
contractualdividendandlittlechanceofcapitalgains.
Preferredstockhashistoricallybeenimportanttoregulatedpublicutilities,
anditislikelytobeapproximately10percentofatypicalpublicutility’scapital
structure.
Preferredstockisahybridformofcapital,possessingamixtureofdebtand
commonstockcharacteristics.Liketheinterestondebt,itsdividendsmaybefxed
overtime.However,“participating”preferredstocksharesincomewithcommon
stockaccordingtosomeprearrangedformula,andotherpreferredstockmaypay
adividendthatislinkedtosomeindependentmeasuresuchastheyieldongov-
ernmentbonds.Likecommonstock,preferredstockisgenerallytreatedasequity
capitalforcorporatetaxpurposes,soitsdividendsarepaidfromcorporateearnings
thathavebeentaxed.Preferredstockgenerallyhasaperpetuallife,althoughitmay
haveafnitelife,anditmayhaveacallpricespecifedandevenasinkingfund
247
November6,200913:44spi-b8119inx6inb811-ch13
248
AnIntroductiontoAccountingandManagerialFinance
wherestockistoberepurchasedbythefrmintheopenmarket.Itisimportantto
theissuingfrmandtotheinvestorthatnonpaymentofthepreferredstockdividend
doesnottriggerbankruptcy.Normally,commonstockdividendscannotbepaid
untilallpastduepreferreddividendshavebeenpaidorthepreferredstockholders
havebeencompensatedbysomeothermeans.Preferredstockdividendshaveto
beapprovedbytheboardofdirectorsbeforetheybecomealegalliabilityofthe
corporation.Preferredstockgenerallydoesnothavevotingrights,butifapreferred
stockdividendispassedover,thepreferredstockholderssometimeshavetheright
toselectoneormoremembersoftheboardofdirectors.
Althoughthedividendsonsomepreferredstockareallowedasataxdeduc-
tion,currentlyintheUnitedStatesdividendsofpreferredstockarenotnormally
deductiblefortaxesbyacorporation(unliketheinterestpaymentofdebt).This
tendstolimittheuseofpreferredstockbycorporations.However,insomeparts
oftheworld,preferredstockdividendsaretreatedinthesamemannerfortaxes
asinterest;thus,inthosepartsoftheworld,thisdrawbackwouldnotapply.Itis
logicaltohavesecuritiesthatbridgethegapbetweendebt,wherefailuretopay
interestresultsinbankruptcy,andcommonstock,wherethereisnostatedcom-
mitmenttopaydividends.Fromtheinvestors’viewpoint,comparedtocommon
stock,preferredstockreducessomewhattheamountofuncertaintyassociatedwith
futuredividendpayments.
AccountingforPreferredStock
Thepreferredstockisclassifedinthestockholders’equitysectionofthebalance
sheet,althoughitshouldbeseparatedfromthecommonstockequity.Thepreferred
stockwillgenerallyhaveaparvaluethatwilldeterminethecredittothepreferred
stockaccount.Iftheamountcontributedbythepreferredstockholdersisgreater
orlessthanpar,thedifferenceshouldberecordedinacontraaccountoradjunct
account.
Example
Recordthejournalentriesforthefollowingsituations:
a.Onethousandsharesof5percent,cumulativepreferredstock,par$100,are
issuedfor$100pershare.
Cash.........................................100,000
PreferredStock...........................100,000
November6,200913:44spi-b8119inx6inb811-ch13
PreferredStock
249
b.Assumetheabovestockisissuedat$110ashare.
Cash.............................................110,000
PreferredStock...............................100,000
PreferredStock:AmountPaidinExcessofPar...10,000
ThePreferredStock,AmountPaidinExcessofParaccountisanadjunct
accounttoPreferredStock;inthebalancesheet,itshouldbeaddedtoPreferred
Stock.
Someaccountantshavearguedthatsuchamountsshouldbeaddedtothe
commonstockholders’equitybecause,intheeventofliquidation,thepreferred
stockholderswouldreceiveonlytheparamountoftheirshares.Thisargument
iscontrarytothebasicassumptionsofagoingconcern.Theaccountsshould
showtheamountsinitiallypaidbythevariousclassesofshareholdersrather
thanliquidationvalues.
c.Assumetheabovestockisissuedfor$92pershare.
Cash.............................................92,000
PreferredStock,Discount..........................8,000
PreferredStock...............................100,000
Thediscountaccountisacontraaccount(asubtraction)toPreferredStock;in
thebalancesheet,itshouldbesubtractedfromPreferredStock.
d.Adividendof$5pershareisdeclaredonthepreferredstock.
PreferredStockDividends..........................5,000
DividendsPayable............................5,000
Iftheinterestonbondsisnotpaid,thebondholdershavelegalrecourseandcan
causethecorporationtobedeclaredinsolvent.Whendividendsonpreferredstock
arenotpaid,however,thepreferredstockholdershavenosuchrecoursebecause
thecorporationisnotlegallyrequiredtopaydividendsonpreferredstock.
Ahistoryoffailuretopaydividendswillaffectthecorporation’sabilityto
raisecapitalthroughissuingpreferredstockinthefuture.Itcouldevenresult
inthepreferredshareholdersreceivingrightstoelectmembersoftheboardof
directors.Sincethereisnolegalliability,theaccountantmakesnoentryatthetime
apreferredstockdividendispassedover.Thisisconsistentwiththeassumption
thattheaccountingisbeingdoneforthecorporateentityratherthanforaparticular
groupofshareholders.However,thepreferredstockarrearageisofinteresttoall
stockholders,andtheamountofarrearageshouldbedisclosedonthebalancesheet
November6,200913:44spi-b8119inx6inb811-ch13
250
AnIntroductiontoAccountingandManagerialFinance
eitherinafootnoteorbytheseparationandidentifcationofpartoftheretained
earnings.
MeasuringtheCostofPreferredStock
Thecostofpreferredstockisdefnedasthediscountratethatequatesthefuture
expectedpreferreddividends(andcallpriceifcallable)tothepresentmarketprice.
Let
P
denotethecurrentpriceofashareofpreferredstock,
D
theannualconstant
dividendpayment,and
k
p
thereturnrequiredbyinvestorsorcostofthepreferred
stock.Thecurrentpriceofashare,ifnoncallable,maybedefnedintermsof
D
and
k
p
.Thedividendisassumedtobeaperpetuitywithfrstpaymentoneyear
fromnow:
P
=
D
k
p
.
(13.1)
Solvingfor
k
p
,weobtain
k
p
=
D
P
(13.2)
undertheassumptionthattheissuingfrmexpectstopaythedividendforperpetuity.
So,thecurrentcostofnoncallablepreferredstocktotheissuingcorporationisthe
stock’sdividendyield.
Ifinterestratesandstockyieldsshouldfallaftersellinganewissueandthe
issueisnotcallable,theissuingfrmisstuckwithperpetualfnancingatahigh
cost.Forexample,iftheinterestrateona$100preferredstockwere10percentat
timeofissue(a$10peryearcashdividend)andifthemarketnowrequiresa0.08
return,thestockwouldhavetoberepurchasedintheopenmarketfor
P
=
10
0
.
08
=
$125
ifthefrmwishedtoretiretheobligation.If,ontheotherhand,acallprovision
werespecifedat,say,$110,thefrmcouldcallthe$10obligationperannumfor
$110andreplaceitwitha$110parvalue,8-percentissuepayingonly$8.80per
annumandissuedatpar.Thecompanyreplacesasecuritypromisingtopay$10.00
ayearwithasecuritypaying$8.80ayear.Thisisasavingof$1.20peryear.The
$110issuepriceofthe8-percentpreferredstockisenoughtoretirethecurrently
outstandingpreferredstock.
Iftherewerenocallprovisionandthecompanypaid$125toretireashare,
thenewsecurityissuedat$125withaparvalueof$125andpaying0.08would
haveanannualdividendof$10andthecompany’sfnancialpositionwouldnot
improve.
November6,200913:44spi-b8119inx6inb811-ch13
PreferredStock
251
Investorspreferthepreferredstocktobenoncallablesothatifinterestratesfall,
thestock’svaluegoesup.Thus,investorswillrequireahigheryieldonthecallable
preferredstockissuethanonthenoncallableissue.Forexample,ifanoncallable
issueissellingfor10percent,anotherwisecomparablecallableissuewouldhave
topromisetopaysomewhatmorethan10percentiftheinvestoristopaythesame
priceforbothissues.
Intheexample,ifthe10-percentpreferredstockwerenoncallableandifthe
fallininterestratesto0.08occurredinthefrstyear,theinvestorwhosellswould
receive$10ofdividendsand$25ofcapitalgainsforatotalreturnoninvestment
of35percent.Withthepreferredstockcallableat$110,therewouldbeonly$10
ofcapitalgainsandthereturnoninvestmentwouldbe20percent.
Example13.1
XYZCorporationhasdecidedtoissuepreferredstock.Thepreferredstockwill
carrya$10dividendandwillbesoldfor$105withacallpriceof$110.The
frmexpectslowerinterestrates(say,8percent)inapproximatelytwoyearsand
thereforeexpectstocalltheissueattime2.Wecansolvebytrialanderrorforthe
costofthispreferredstockissueorequivalentlythereturnearnedbytheinvestor:
$105
=
2
t
=
1
$10
(
1
+
k
p
)
t
+
$110
(
1
+
k
p
)
2
.
Inthiscase,
k
p
isapproximately12percentwhiletheone-perioddividendyield
of
10
105
isapproximately9.5percent.Thecallprovisionseemstomakethecostof
thepreferredstockgreaterthanthedividendyield,butthisismisleading.Assume
thatwithoutacallprovisionaftertwoyearsthestockpricegoesupto$125.The
two-periodeconomiccostis
$105
=
2
t
=
1
$10
(
1
+
k
p
)
t
+
$125
(
1
+
k
p
)
2
.
Solvingfor
k
p
(bytrialanderror),wefndthatwithoutacallprovision
k
p
isnow
18.25percent.Inthisexample,thecallprovisionreducesthecostofthepreferred
stockiftheissuepriceof$105isassumedtobeindependentofthecallprovision.
FactorsAffectingtheCostofPreferredStock
Preferredstockissimilartodebt,andthefactorsaffectingthecostofdebtarealso
importanthere.Thereis,however,oneadditionalfactorthathastobediscussed:the
November6,200913:44spi-b8119inx6inb811-ch13
252
AnIntroductiontoAccountingandManagerialFinance
dividend-receiveddeduction.Ifacorporationpurchasesequitycapital(preferred
orcommonstock)ofanothercorporation,andifitownslessthan20percentof
thevotingstock,70percentofthedividendsitreceivesonthatstockisnontaxable
incomeforthereceivingcorporation.Ontheotherhand,allinterestthecorporation
receivesontaxabledebtsecuritiesheldistaxable.Insurancecompaniesinparticular
fndthatthedividend-receiveddeduction,plustherelativepredictabilityofthe
dividendfow,makespreferredstockadesirableformofinvestment.
Notasriskyascommonstockandofferingahighafter-taxyieldontheinvest-
ment,asubstantialamountofpreferredstockisheldbyinsurancecompanies.In
fact,thedemandforpreferredstockbythesecompaniesissogreatthatthebefore-
taxyieldonpreferredstockissometimeslessthanthebefore-taxyieldonthedebt
ofthesameissuingfrm,despitethefactthatthepreferredstockisobviouslymore
riskyinsofarasthedebthasfrstclaimtoearningsandpriorclaimonassetsincase
ofliquidation.
Toexplainwhypreferredstockmayyieldlessthandebt,letusexaminethe
after-taxyieldofdebt.Theeffectiveafter-taxyieldondebtofacorporationbeing
taxedatarateof
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-taxyieldon
thepreferredstockwouldbegreaterthanthatonthedebtsince
(
1
−
t
c
)
isless
than
(
1
−
0
.
30
t
c
)
.Forexample,if
t
c
=
0
.
35and$100ofinterestisreceived,the
investingcorporationnets$65aftertax.If$100ofdividendsarereceived,thetax
is$10.50andthecorporationnets$89.50.
Ifthepreferredstockisonlyslightlymoreriskythanthedebt,thenitcould
yieldlessthandebtbeforetaxandstillreturnenoughinexcessoftheyieldondebt
aftertaxtocompensateacorporateinvestorfortheadditionalrisk.
MergersandAcquisitions
Preferredstockhasfrequentlybeenissuedinconnectionwithmergersandacqui-
sitions.Oftenthepreferredstockisissuedwithaconversionfeature,sointhelong
runthereisaprobabilityitwillbecomecommonstockcapital.Preferredstock
allowstheacquiredfrm’sownersapriorclaimrelativetocommonstockandrea-
sonablydefnitedividendswhilesimultaneouslygivingtheacquiringfrmaform
ofleveragewithoutstrappingitwiththerigidobligationsofdebt.
Thisprovidesajustifcationforthefactthatsomefrmsdoissuepreferredstock.
However,onapureexplicitcostcomparisonwithdebt,preferredstocktendstobe
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253
inferior(haveahigherafter-taxcost).Afrmnotmakingsuffcienttaxableincome
tousethetaxshieldofthedebtmayhaveincentivetousepreferredstock,aswill
afrmclosetoitsdebtcapacity.
Variable-RatePreferredStock
Sometreasurersofcorporationswouldliketoinvestinpreferredstockhaving
before-taxyieldsaboutthesameas(orsomewhatlessthan)short-termdebtif
someoftheriskofpreferredstockcanberemoved.
Oneriskthatinvestorswouldliketoseeremovedistheriskthatthepriceof
preferredstockwillfallbecausethemarket’srequiredreturnhasgoneup.
Variable-ratepreferredstocksisonemethodofinsuringthatthestockpricewill
notfall.Ratherthanpayingafxeddividend,thistypeofsecuritypaysadividend
thatisafxedfractionofthehighestofasmanyasthreegovernmentbondyields
(e.g.,theT-billrate,theU.S.Treasury10-yearconstantmaturityrate,andtheU.S.
Treasury20-yearconstantmaturityrate).Theadvantageofavariable-ratepreferred
stockisthatitsmarketpriceshouldalwaysbeclosetoitsfacevalue.Ifthepay-
mentriskdoesnotchange,itwilldifferonlybecausethelinkagetotheU.S.Trea-
surysecuritiesdoesnotperfectlyrefectthemarket’srequiredreturnonpreferred
stock.
Toprotecttheissuingfrmagainstverylargecashoutlaycommitments,amaxi-
mumdividendrateisestablished.Toprotecttheinvestoragainstverylowdividends,
aminimumdividendrateisestablished.Whilenotnecessarytothebasicconcept
ofthesecurity,theseprovisionsaregenerallypresent,butthelevelsofmaximum
andminimumvarygreatly.Also,thedifferentialbetweenthemaximumofthe
threeU.S.Treasuryreturnsandthepreferredstockdividendalsodiffersfromissue
toissue.Thesefactorsaresetbymarketconditions(supplyanddemand)forthis
particulartypeofsecurity.
PreferredStockversusCommonStock
Theprimaryadvantagetoaninvestorofholdingpreferredstockcomparedwith
commonstockisthatthepreferredstockreturnissomewhatmorepredictable
(morecertain).Theissuingcompanywillgenerallymakearealefforttotryto
avoiddefaultingonthepreferredstockdividend.Sincethereturntopreferred
stockisreasonablywelldefnedandsincethepreferredstockholdersprecedethe
commonstockholders(thepreferreddividendsarepaidbeforethecommondiv-
idends),preferredstockisapopulartypeofsecurityforexecutingmergersand
acquisitions.
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AnIntroductiontoAccountingandManagerialFinance
Fromthepointofviewofanissuingcorporation’scommonstockholders,
preferredstockofferstheopportunitytointroduceaformofleverage(thepre-
ferredstockholdersgenerallyhaveamaximumdividendreturn)thatcouldbeneft
thecommonstockholdersifthecorporationdoesverywellinthefuture.Thepre-
ferredstockholdersdonotnormallyparticipateinanybonanzathatmightoccur
sincetheirdividendrateiseitherfxedor,ifvariable,generallyhasasetmaximum.
Itiswrongtoassumethatpreferredstockfllsauniquedemandforaninvest-
mentsecurityinthemarketthatothersecuritiescannotfll.Dividendsfromcommon
stockareaseligibleforthedividend-receiveddeductionavailabletocorporate
investorsaspreferredstock.Second,aportfolioofafrm’sdebtandcommon
stockcanbeconstructedtohaveareturnthatbehavescloselytothereturnon
preferredstock.Althoughpreferredstockmayappeartoacorporateissuertobe
moredesirablethancommonstockbecauseofitsfnancialleveragecharacteris-
tics,thisadvantageislikelytobeillusory.Withthepresenttaxlaw,preferred
stockhasnospecialattributesforwhichaneffcientmarketwouldbewilling
topayapremium;thus,itscostisnotlikelytobecheaperthanotherformsof
fnancing.
Ifthetypesofrisksassociatedwithaninvestmentincommonstockandpre-
ferredstockpurchasedindividually(notamixture)arewhatthemarketdesiresand
iftherisksandreturnscouldnotbeexactlyduplicatedinanyotherway,thenit
wouldbepossibleforafrmwithpreferredstockoutstandingtosellatapremium.
Asatheoreticalaswellasapracticalmatter,itisunlikelythattheinvestorsneedthe
preferredstocktoaccomplishtheirinvestmentobjectives.Ifanexplanationisto
befoundfortheissuanceofpreferredstock,itislikelytobefoundininstitutional
considerations.
Theissuingcorporationdoesnothaveataxshieldwitheitherpreferredstock
orcommonstock,sothereisnoadvantageforthecorporationissuingpreferred
stocktobefoundinthetaxlaws.Thecommonstockcangiverisetoretained
earnings(deferringtaxestotheinvestor)andtheprospectofcapitalgainsfrom
theseretainedearnings.Thepreferredstockdoesnotofferthesepossibilities;thus,
itisatadisadvantage.Forzero-taxinvestors,neitherpreferredstocknorcommon
stockhasanyspecifcadvantagefortheinvestor.Debtislikelytobemoredesirable
thaneithersecuritybecauseofthetaxshieldprovidedtotheissuerbytheinterest
expense.
Witharegulatedpublicutility,preferredstockofferstheinvestorsomeprotec-
tionagainstarbitraryactionsbytheregulatorycommissioninregardtothereturn
tobeallowedoncommonstockequity.Thepreferredstockdividendiscontrac-
tual,whereasthecommonstockdividendisacombinedresultofthejudgments
andactionsoftheregulatorycommissionandthecorporation’sboardofdirectors.
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255
Inthecaseofzero-taxinvestors,itwouldbediffculttoarguethatpreferredstock
isinferiortocommonstock.Wecouldstillarguethatpreferredstockisinferior
todebt.
ConvertibleExchangeablePreferredStock
Letusassumethatacorporationisoperatingatalevelthatleadstozerotaxes.There
arenocurrenttaxbeneftsassociatedwiththeissuanceofdebt.Ifexchangeable
(intodebtattheoptionoftheissuingfrm)preferredstockcanbeissuedatalower
before-taxyieldthandebt,itwillhavealowercostthandebt.
Butwhatifthecorporationstartsearningsuffcientincometostartpaying
taxes?Thecorporationwouldthenprefertohaveoutstandingdebtratherthan
preferredstock.The“exchangeable”featureofthesecurityallowsthecorporation
toforcetheinvestorstoacceptdebtforthepreferredstock.Ifboththepreferred
stockanddebtcost0.15beforetax,witha0.35taxrate,theafter-taxcostofdebt
becomes0.0975.Thisisasignifcantsavingcomparedwiththe0.15costofthe
preferredstock.
Thecorporateinvestorthatpurchasedthepreferredstockwithits70percent
dividend-receiveddeductionwillnotbepleasedwiththeforcedexchangeintoa
debenture.Thecorporateinvestorcansell,convertintocommonstock,ormerely
accepttheexchange.Theinterestrateonthebondislikelytobeatleastaslarge
asthepreferredstockdividend,andwillbesomewhatsafer.Zero-taxedinvestors,
suchaspensionfunds,arelikelytofndthedebenturesofmorevaluethanwilla
corporationtaxedatamarginalrateof0.35.
Thefactthatthesecurityisexchangeableattheoptionoftheissuingcorporation
reducestheexpectedoverallcosttothatcorporation,butitdoesdecreasethe
attractivenessofthesecuritytothenormallytaxedcorporateinvestor.
Theindividualinvestororthezero-taxedinstitutionalinvestorwouldwelcome
theexchange,sincethebondinterestissaferthanthepreferredstockdividend.
Theinvestorcannotinitiatetheexchangeandthushastowaituntilthecorporate
issuerfndsitadvantageoustoforcetheexchange.
Theconversionfeatureisvaluabletotheinvestorsincetheinvestorcanconvert
intocommonstockatanytime.Ifthepreferredstock’sconversionvalueis$1,900
atthetimeofmaturity,andthecashvalueifredeemedis$1,000,thevalueofthe
conversionrightatthattimewillhaveavalueofapproximately$900.Iftheissuing
corporationcancallthebondpriortomaturity,thevalueoftheconversionfeature
maybecutoffbeforeitreaches$900,butitislikelytohavesomepositivevalue.
Theinvestorisnotlikelytooptforconversionpriortocallormaturityunless
thecommonstockdividendexceedsthepreferredstockdividendorthedebenture
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AnIntroductiontoAccountingandManagerialFinance
interest(therelativesafetytothedebentureinterestandprincipalshouldalso
beconsidered),andeventhentherearestrongreasons(riskavoidance)fornot
converting.Thecorporationislikelytocalltheconvertiblesecurityifitcancall
andiftheconversionvalueexceedsthecallprice.
Thecorporationcanmovethesecurityfrombeingpreferredstocktobeinga
debenture(desirableifthecorporationchangesfromhavingzerotaxableincome
toneedingtaxdeductions).Itcanalsocallthesecurityiftheconversionvalueis
largerthanthecallpriceandchangethesecurityintocommonstock.
Theconvertibleexchangeablepreferredstockisasensiblesecurity,andwe
wouldexpectthecorporateandpersonaltaxlawsaswrittentoencourageavari-
etyofsecurities.Aslongasthetaxlawdistinguishesbetweensecuritiesthatare
essentiallythesame,wecanexpectcorporatefnancialoffcerstotrytoexploit
thisfact.
PrivateEquity
Privateequityfrmsfnditconvenienttousepreferredstocktoincreasethereturn
earnedonthecommonstockofaninvestment.
Assumethatwithaninvestmentof$1,000,000(commonstock)aprivateequity
frmwillearn$1,200,000attime1.A20%returnisnotadequateandithasreached
itsdebtcapacity.However,itcanissue$500,000ofpreferredstockpaying0.10.
Theprojectedcashfowsare:
01IRR
BasicInvestment
−
$1,000,000
+
$1,200,0000.20
PreferredStock
+
$500,000
−
$550,000
0.10
CommonStock
−
$500,000
+
$650,0000.30
Withtheuseofthepreferredstock,theexpectedreturnoncommonstockis
increasedfrom0.20to0.30.
If0.30isnotasuffcientlyhighreturn,alargeramountofpreferredstockcould
beconsidered.
PreferredStockasanInvestment
Corporationshavethedividend-receiveddeductionasanincentiveforthemto
investinpreferredstock.Individualsandzero-taxedinvestorsdonothavethat
incentive,andnormallytendtonotholdstraightpreferredstockintheirportfolios.
Straightdebtwithitstaxdeductibilityforinterestatthecorporateissuerlevelis
November6,200913:44spi-b8119inx6inb811-ch13
PreferredStock
257
apttobelowercosttotheissuingcorporationandshouldhaveabetterrisk-return
relationshipforthenoncorporateinvestorthanpreferredstock.
Unlessthetaxlawsarechanged,preferredstocktendstobedominatedforthe
noncorporateinvestorbystraightdebtandbycommonstock.Achangeinthetax
lawscouldchangethisconclusion.
Conclusion
Itisnotatallobviousthatafrm’scommonstockholdersbeneftfromtheissuance
ofpreferredstockoverotherfnancialinstruments,iftheissuingfrmispaying
incometaxes.Likedebt,preferredstockprovidesleveragethatislikelytoincrease
therateofreturnoncommonstockinvestmentaswellasincreasetheriskiness
ofthatreturn.Butbecausedebtalsoprovidesleverageatalowerafter-taxcost,
unlessthefrmdoesnotwishtoruntheriskassociatedwithdebt,hasreached
itsinstitutionallyacceptabledebtceiling,ordoesnothavetaxableincome,the
stockholderswouldbebetteroffwiththeissuanceofdebttoachievefnancial
leverage,assumingthefrmdoeshavedebtcapacity.
Taxconsiderationsplayanimportantroleinthefnancingdecision.Sinceall
earningsbeforeinterestandtaxesareavailabletopayinterestondebt,andtaxes
mustbepaidpriortopayinganyincomeoutaspreferreddividends,thetaxsavings
fromdebtcanbeusedtoretirethedebt,whilealower-yieldingpreferredstock’s
dividendcancontinueasaclaimperpetually.Thus,inasensefromalong-run
perspective,preferredstockismorerisky.
Ifdebtcapacityisavailable,debthastaxadvantagescomparedtopreferred
stock.Ifthefrmdoesnotwishtoissuedebt(orcannotissuedebtbecauseof
institutionalbarriersorrestrictivecovenantsinitsexistingdebtinstruments),then
thechoiceofwhethertoissuepreferredstockorcommonstockisrelevantandthe
risksandreturnsofeachalternativemustbeweighed.
QuestionsandProblems
Forallproblems,assumethereisa70percentdividend-receiveddeductionfora
corporateinvestor(30percentofthedividendistaxed).Thecorporatetaxrateis
40percent.
1.Assumethatthereisacorporateinvestorwantingtoinvest$10millioninyour
frm.Debtorpreferredstockcanbeissuedatacostof0.10.Thefrmneeds$10
millionofcapital.Assumea0.4corporatetaxrate.
a.Onastraightcashfowbasis,shouldafrmissuedebtorpreferred
stock?
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AnIntroductiontoAccountingandManagerialFinance
b.If$1millionofearningsbeforeinterestandtaxes(EBIT)isavailable,on
acashfowbasis,aretheinvestingfrmsbetteroffwithdebtorpreferred
stock?
c.Whatamountdoesthefrmhavetoearntopay$1millionofinterest?To
pay$1millionofpreferredstockdividends?
d.Whatisthebefore-taxpercentagecostof0.10debt?Of0.10preferredstock?
e.Whatistheafter-taxcostofeach?
f.Whatdoesaninvestmenthavetoearn
aftertax
tobefnancedbydebt?By
preferredstock?Assumeabreak-evenobjectiveforthefrm.
2.Howmuchdoesacorporateinvestornetout(aftertax)from$100ofinterest?
From$100ofpreferredstockdividends?
3.Whataretheriskstoacorporateinvestorbuyingpreferredstock?
4.Ifcallablepreferredstockisissuedatapriceof$100andpromisestopay$9
perannum,whatisthecost(asapercentage)oftheissueaftertaxtotheissuing
frmifthecallprovisionisexpectedtobeexercisedtwoyearsfromnowata
priceof$105?
5.Acorporationhasearned$100(beforetax)andispayingtheafter-taxresidual
toitsstockholders.Assume
k
i
=
k
p
=
0
.
10
.
Thetaxrateonallsecuritiesis0.4,butthereisa0.70dividend-receiveddeduc-
tionforcorporationsinvestinginstock.
Toacorporatestockholder,whatistheafter-taxdollarreturnifthesecurity
isadebt?Apreferredstock?Acommonstock?
6.Assumea0.4taxrate.Topay0.10,acompanymustearnwhatpercentagereturn
(beforetax)ifthesecurityis:
a.Debt?
b.Preferredstock?
c.Commonstock?
7.Describetheeconomicconsequencesofacorporationissuing0.08debtto
fnanceaninvestmentof$1millionin0.08preferredstock.Thecorporatetax
rateis0.4.
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Chapter14
ManagerialPerformance
Thischapterwillevaluatedifferentquantitativefnancialmeasuresofperformance
includingreturnoninvestmentandeconomicincome.Theargumentsofthischap-
terareapplicabletoentirefrms,self-containedoperatingcomponentsofafrm,or
componentsthatarenotself-containedbutinwhichthereisareasonabletransfer
pricingprocedure.Tocomputeanyquantitativeperformancemeasurementofan
operatingunit,itisnecessarytoarriveatreasonableincomeandinvestmentmea-
suresfortheunit.Thereareafewshortcutsinundertakinganintelligentanalysisof
fnancialstatements.Aknowledgeofaccountingtheoryandpracticeisdesirableto
ensureasoundinterpretation.Equallyimportantisthefactthattheanalysisshould
bedetailedandvaried.
Therearevarioustoolsofanalysisthatarehelpfulwhenusedintelligently.
Butnotoolofanalysisisbetterthantheinformationonwhichitisbased.This
isnotanareainwhichonewillfndexactanswers;often,theanalysiswillraise
additionalquestions.Also,itshouldbenotedthatfnancialanalysisbasedonpub-
lishedaccountingdatatendstobeashort-runanalysis.Thelong-runwell-being
ofthefrmisrelatedtofutureconditions,competitiveenvironment,technology,
andotheritemsthattheaccountantdoesnotmeasure(suchasthecaliberofthe
youngerexecutivesofthefrm).Thefnancialanalysisdiscussedinthischapteris
ahistoricalapproachbasedonpastevents,notforecastsofthefuture.Accountants
followwell-defnedrulesofthegame(whichwehavecalled“GenerallyAccepted
AccountingPrinciples”)inpreparingpublishedfnancialstatements.Theserules
andthecontextsinwhichtheyaresetmustfrstbeunderstoodifaccountingreports
aretobeproperlyused.
Oneofthemostimportantandmostdiffculttasksofanadministratoristo
measuretheperformanceofsubordinates.Sometimesameasureisusefulforone
purpose,butnotforanother.Thefactthatagolfdrivewent250yardsisusefulin
judgingtheforcewithwhichtheballwashit,butknowledgeofthetotaldistance
coveredisnotusefulinjudgingwhetherthedrivewasgoodorbad.Weneed
259
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260
AnIntroductiontoAccountingandManagerialFinance
informationrelatingtothelocationanddistanceoftheholebeforewecanmake
thattypeofdecision.
Howdowemeasuretheperformanceofamemberofmanagement?Thefrst
stepistoestablishobjectives.Thesecondstepistoseehowwelltheseobjectivesare
met.Weshallassumethataprimeobjectiveofthefrmistomaximizeprofts;from
theaccountant’spointofview,thisisanimportantconsideration.Otherobjectives
suchasmaintainingcontinuityofexistencewillnotbeconsidered.
Theextentofsuccessinattainingobjectivesmaybeassessedquantitatively
orqualitatively.Thequalitativecriterionwillincludethingssuchasrelationswith
superiorsandsubordinates,trainingofsubordinates,professionalattainments,civic
activities,andabilitytogetthingsdone.Thequalitativefactorsarerelevantin
judgingperformance,butaremoretheprovinceoftheindustrialpsychologistthan
oftheaccountantorthefnancialmanager.
PerformanceMeasurementandManagerialCompensation
Measuringmanagerialperformanceforpraiseorcompensationdeterminationisa
diffculttask.Anymeasureusedissubjecttovalidobjections.Itisdesirablethat
therebecongruencebetweenthefrm’sgoalsandthemeasuresthatareused.One
cannotexpectmanagerstoconsciouslytakeactionsthataredesirableforthefrm
ifthoseactionswilladverselyaffecttheircareerpathorcompensation.
Myrecommendationistouseseveralmeasures.Sinceallmeasureswillbe
subjecttosomesortofgamingbymanagement,theuseofseveralgoodmeasures
reducesthelikelihoodthatmanagerswillconsciouslymakeundesirabledecisions.
Wewillreviewfourbasicmeasuresthatcanbeused:
1.Accountingmeasures(e.g.,incomereturnoninvestment,economicincome,
etc.).
2.Marketmeasures(thereturnearnedonaninvestmentinthecompany’scommon
stock).
3.Non-accountingbutquantitativemeasures(e.g.,customerandemployeesatis-
faction).
4.Qualitativemeasures(subjectiveevaluations).
AccountingMeasures
Theaccountingmeasureswewillconsiderare:
1.Salesrevenue.
2.Operatingmargins:percentagesordollaramounts.
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261
3.Income.
4.Returnoninvestmentorreturnonequityorreturnonassets.
5.Economicincome(residualincomeoreconomicvalueadded).
6.Earningspershare(foraperiodofyears).
Salesrevenueisanattractiveaccountingmeasuresincetherearerelativelyfew
argumentsastothemagnitude.Addmeasuresoftheshareofmarketandgrowthin
sales,andonecanbecomeenthusiasticabouttheusefulnessofthesalesmeasures.
Butweshouldalsoconsiderproftability.
Theoperatingmarginisapopularproftabilitymeasure:subtractfromsales
revenuethedirectcostsofgeneratingtherevenue.Forexample,theoperating
marginofaretailstoreissalesminusthecostofthemerchandisesold.Witha
manufacturer,thedefnitionoftheexpensestobesubtractedtocomputethemargin
isnotasexactasforaretailer.
Ifsalesare$100andthecostofgoodssoldis$60,theoperatingmargincanbe
expressedasadollaramount,$40,orasapercentage,40%.Operatingmarginsasa
controlmechanismareveryuseful.Ifoperatingmarginsaremaintained,itislikely
thatapositivebottomline(income)willresult.Ontheotherhand,manyexpenses
(includingcapitalcosts)areomittedfromthecalculation.Thus,theoperating
margincanonlybeoneofseveralmeasuresthatareused.
IncomeisrevenueminusexpensesasdefnedbyGenerallyAcceptedAccount-
ingPrinciples.Unliketheoperatingmargin,itincludesthefxedexpensesaswell
asthevariableexpenses.
Theprimaryareawheretheincomemeasureisdefcientistheexpenseofthe
equitycapitalused.Theimplicitcostoftheequitycapitalusedisnormallynot
deductedincomputingtheincome.
Itisessentialthatthecostsofthecapitalusedaffecttheperformancemeasures.
Thetwocommonmeasuresarereturnoninvestmentinsomeformandeconomic
income.Economicincomedeservestobeusedmoreextensively(itsuseisgrowing
rapidly).
ReturnonInvestment(ROI)
Advocatingtheuseof
returnoninvestment
(ROI)impliesthatitisabettermea-
sureofperformancethanisobtainedfromusingjusttheincomeoftheoperat-
ingunit.Whilethisisnormallythesituation,notallsubsidiaryoperatingunits
shouldbejudgedusingROI,andROIshouldalwaysbeonlyoneofseveralmea-
sures.Formanyoperatingunits,marketingeffortsarenotautonomous,anditis
moreappropriatetousecostminimizationratherthanproftmaximization(orits
near-equivalent,maximizationofROI,subjecttoconstraints).
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AnIntroductiontoAccountingandManagerialFinance
ItshouldberealizedthatROIisnotnecessarilythebestmeasureofperfor-
mance,butthatROIcanbeausefulmeasure.ConsiderwhatagoodROImeasure
canaccomplish.Wehavefrstameasureofincome;butbeforeconcludingthatthe
incomelevelissatisfactory,werelatetheincometotheamountofassetsusedto
earntheincome.While$1millionofearningsmaybetermedtobeverygood,if
youaretoldthattheoperatingunitused$100millionofcapitaltoearnthe$1mil-
lion,yourconclusionmightwellshiftfromgoodtobad.Toevaluateperformance,
itisnecessarytoconsidertheamountofassetsusedinearningtheincome.Thus,
theuseofROIhasadvantagesovertheuseofincomeonly.
InsteadofROI,somefrmsusethe
returnonequity
(ROE).Whilethetwo
measureshavecomparableuses,theROEmeasurehasseverallimitations:
a.Itisaffectedbycapitalstructure(whichmaynotbecontrollablebytheman-
agementbeingmeasured).
b.Itadverselyaffectscertaintypesofdecisions(investmentanddivestment)
becauseitisapercentage.
c.Equityinvestmentcreatesbiasesunlesstheanalystdistinguishesbetweeninvest-
mentsintheequityofasubsidiaryandinvestmentsinrealassets.
Thesecondlimitation(b)appliesequallytoROIasitdoestoROE.Other
termscommonlyusedinsteadofROIare
returnonnetassetsemployed
(RONAE),
returnonfundsemployed
(ROFE),
returnoncapitalapplied
(ROCA),and
return
onassets
(ROA).
ComponentsofROI
Forsomepurposes,itisusefultobreakROIintotwocomponents(thisissometimes
referredtoastheDuPontformulation):
ROI
=
Income
Assets
=
Income
Sales
×
Sales
Assets
,
whereincomeismeasuredafterinterestandtaxes.
Thetermsales/assetsmeasuresthedegreeofassetutilization.Theterm
income/salesmeasuresproftability.Theproductofthetwotermsgivesthereturn
oninvestment.
TheprimarycontributionofROI(orROE)isthatmanagementisheldresponsi-
bleforthecapitalused.However,returnoninvestmentmaybeusedinasomewhat
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ManagerialPerformance
263
fawedmanner(mayadverselyaffectcertaintypesofinvestmentorassetretention
decisions).
ValuationofAssets
Importantvaluationproblemsariseintheareasofintangibles,inventories,invest-
ments,andfxedassets.Theseproblemsmustberecognizedbytheanalystinusing
accountingdata.
Theproblemofvaluingintangiblesmaybeavoidediftheanalystsubtractsthem
fromtheassettotal(intangiblesmaybeconsideredaresidual,valuedbyearning
powerinexcessofwhatwouldnormallybeexpectedfromthetangibleassets).
Thisproceduresubstitutestheproblemofvaluationofthecorporateentityforthe
problemofspecifcassetvaluation.Itisdiffculttomeasureeitherthecostofthe
intangiblesortheirvalue.
Theanalysthasseveralchoicesinthevaluationoffxedassets,includingfnding
thecurrentmarketvaluesoftheseassetsordeterminingtheiroriginalorreplace-
mentcostsandtheextenttowhichtheirusefulliveshaveexpired.Themeasures
maydiffergreatly.Usuallytheanalystwillacceptthereported(book)amounts,
althoughtheinformationgivenonthebalancesheetmayhavenorelationshipto
thecurrentmarketvaluesortotheoriginalcostortothecurrentreplacementcosts
oftheseassets.
Thesecommentsabouttheassetmeasuresonthebalancesheetmayseemtobe
indirectcriticismsofcurrentfnancialreportingpractices.Theaccountingprofes-
sion,theFASB,andtheSEChaveimprovedaccountingandreportingpractices,
butfnancialstatementspreparedtoservetheusesofmanyvariedgroupscannot
alwaysprovidetheinformationrequiredforparticulardecisionsofaspecialized
nature.Therecommendeduseoffairvaluehasreducedthepastcriticismsofthe
useofhistoricalcostmeasures.
TheIncomeStatement
Itmaybereassuringtoreadthatashareofstockearnedexactly$3.12forthe
year.Thisisapositiveandclear-cutstatement,althoughitmaybemisleading.The
measurementoftheincomeofanenterpriseforashortperiodoftimeisadiffcult
process.Theshorterthetimeperiod,themorediffcultthemeasurement.
Oneofthemaindiffcultiesistheinclusionorexclusionofitemsthatare
essentiallyadjustmentsofprioryears’incomesandnotrevenuesofthisperiodor
expensesofgainingtherevenuesofthisperiod.Theinclusionofanitemofthis
nature,whenlarge,candistortthemeasurementoftheperiod’soperatingincome
oranestimateofthenextperiod’sincome.
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AnIntroductiontoAccountingandManagerialFinance
ROIandInvestmentDecisionMaking
TheuseofROItoevaluateperformancecanaffectinvestmentdecisionsbecause
themanagerknowsthatafteracceptinganinvestmentitsoperationswillaffect
theperformancemeasurement.Thisleadstoanincentiveforthedivisional(or
othersubcomponent)managertorejectinvestmentsthatyieldalowerreturnon
investmentthanisbeingearnedonthecurrentlyownedassets,eventhoughthe
incrementalinvestmentsareattractiveforthefrm.
Topmanagementshouldbeconcernednotonlywiththereturnoninvestment
oftheassetsbeingused,butalsowiththegrowthinassetsandincome.
Growth
as
wellasreturnoninvestmentisimportant.Astaticdivisionearninga30-percent
ROImaywellbeevaluatedasbeingbadlymanaged,whereasitmaybeconcluded
thatadivisionthatisgrowingandearning15percentiswellmanaged.
Theinvestmentdecisionproblemresultingfromadesiretomaintainahigh
ROIhighlightsthenecessityofnotrelyingononeperformancemeasure(ROIor
somethingelse),butratherbringinginsuffcientmeasurestorestraintheimpulse
ofpersonstryingtocircumventthecontrol-evaluationsystem.AnydefenseofROI
shouldbebasedonadesiretouseitasonemethodofevaluatingtheperformance
ofinvestments,notsothatitmaybeusedtoevaluatethedesirabilityofunder-
takinginvestments.ROIisnotanacceptablemethodofevaluatingprospective
investments.
TheCaseoftheResourceBeneftingtheFuture
Measuresofperformanceusedinanincorrectmannerwilltendtoleadtoincorrect
conclusions.Thereisanecessitytoimprovethemeasuresandtousethemintelli-
gently.Considerthecaseofadivisionmanagerofatimbercompanywhohasthe
opportunitytoinvestin500,000acresofprimetimberland.Thecatchisthatthe
treesonthelandareallseedlingsandtheywillnotmaturefor30years.Itisagreed
bytheplanninggroupthatthelandisagoodinvestment.However,themanager’s
performanceismeasuredusingreturnoninvestment.Themanagerknowsthatthe
landwillincreasethedenominator(investment)now,butitwillbe30yearsbefore
thenumerator(income)isalsoincreased.Sincethedivisionmanageronlyhasfve
yearstogobeforeretirement,theinvestmentinlandisrejected.
Thiscasehasareasonablesolution.Thelandshouldbeexcludedfromthe
investmentbaseinmeasuringperformanceunlessthevalueincrementisallowed
toaffecttheincome.Unlesssomethinglikethisisdone,therewillbeadistortionin
theinvestmentperformanceanalysis,andthusdistortionintheinvestmentdecision-
makingcriteriaapplied.
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Nowconsideraplantbeingbuiltwithexcesscapacitytoservicetheexpected
demandofyear2030.Isthenormalperformancemeasurementschemecapable
oftakingthissituationintoconsideration?Probablyitisnot.GenerallyAccepted
AccountingPrinciplesdonotdoagoodjobofassigningexpensesthroughtime.
TheComputationofIncomeandROI
Itiswidelyknownthatstraight-linedepreciationoraccelerateddepreciation,
exceptinverywell-defnedandspecifcsituations,willdistortmeasuresofROI.
Also,theROIthatresultsforeachyearwilldifferfromtheinternalrateof
returncomputedatthetimeofacquisition,evenwhentheexpectedresultsare
realized.
Defnetheoreticaldepreciation(thisisnottheaccountingdepreciation)tobe
the
decreaseinvalueoftheinvestmentduringthetimeperiod
.Althoughthedefnition
becomesmorecomplexifthereareadditionalinvestmentsmadeduringtheperiod,
thetheorycanbeusedtocomputetheincomethatisusedintheROIcalculations.
Thefollowingexampleisusedasavehicletoshowthatreturnoninvestment,when
properlycalculated,givesusefulperformancemeasurementinformation.
Assumethenetcashfows(andnetrevenues)associatedwithaninvestment
costing$3,000attimezeroare:
TimeCashFlow
1$1,300
21,200
31,100
Thefrmusesstraight-linedepreciationandhasatimevalueofmoneyof10percent.
Thisinvestmenthasayield(internalrateofreturn)of10percent.Therearezero
taxes.
Exhibit14.1showstheincomeandinvestmentsforeachofthethreeyearsof
use.Thefactthateachyearhasidenticalreturnsoninvestmentequaltotheinternal
rateofreturnoftheinvestmentseemstobeacoincidence.However,ifweinspect
Exhibit14.2,whichshowsthepresentvalueoftheinvestmentatthreemoments
intime(
V
i
isthevalueattime
i
),weseethatineachperiodthedecreaseinvalue
is$1,000(thevalueof
V
3
iszero),andthatinthisveryspecialsituationtheuseof
straight-linedepreciationiscorrect(ifthecashfowsaredifferent,thedepreciation
schedulewouldbedifferent).Thepresentvalueattime0is$3,000;attime1,
$2,000;andattime2,$1,000.
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AnIntroductiontoAccountingandManagerialFinance
Exhibit14.1.
EqualROIs.
CashFlowsInvestmentattheROIIncome
orNetBeginningofDividedby
YearRevenuesDepreciationIncomethePeriodInvestment
1$1,300$1,000$300$3,0000.10
21,2001,0002002,0000.10
31,1001,0001001,0000.10
Exhibit14.2.
ThePresentValues.
Period1Period2Period3
PresentTime0PresentTime1PresentTime2
ValuePresentValuePresentValuePresent
TimeFlowsFactorsValuesFactorsValuesFactorsValue
1$1,3000.9091$1,182
21,2000.82649920.9091$1,091
31,1000.7513826
0.8264909
0.9091$1,000
V
0
=
$3
,
000
V
1
=
$2
,
000
V
2
=
$1
,
000
Defnedepreciationexpensetobethechangeineconomicvalue.Theprocedure
workswithanysetofcashfows.ThereneednotbedistortioninROIbecauseof
themethodofdepreciation.Inthissimplifedexample,theinternalrateofreturnon
theinvestmentisequaltothefrm’stimevalueofmoney,andthecashfowsofeach
periodequalthenetrevenues.Differentassumptionswouldaddtothecomplexity
ofthecalculations,butthesecomplicationscanbesolved.
TheEconomicIncomeMethod
Somemanagerscallthismethodthe
residualincomemethod
andotherscallit
economicvalueadded
orEVA.Themaincharacteristicofthemethodisthatinterest
onequityisdeductedfromincometoobtainthenetincome.Thisprocedureisvery
usefulifweproperlydefneincomeandinvestment,ifthecorrectinterestrateis
used,andifinterestisappropriatelyassignedtotimeperiods.Unfortunately,the
aboverequirementsmaynotbefulflledinamannerthatwillgivetheoretically
sound(anduseful)resultsifoneusesconventionalaccountinginasituationwhere
thebeneftsareincreasingthroughtime.Usingthepreviousexample,weillustrate
anapplicationoftheeconomicincomemethod.
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Defneeconomicincomeasnetrevenuelessacapitalconsumptionexpense
(depreciation)andtheinterestcostoftheinvestment.ContinuingtheROIexample,
theexpectedeconomicincomesforthethreeyearsare:
Year1Year2Year3
Revenues$1,300
$1,200
$1,100
Depreciation$1,000$1,000$1,000
InterestCost300
200
100
EconomicIncome$0$0$0
Notethatiftheinternalrateofreturnisusedastheinterestrate(thebasis
ofcomputingtheinterestcost),theeconomicincomesareequaltozero.Zero
economicincomeisnotabadresult,sinceinvestorsearntheasset’sinternalrate
ofreturnwhichisabovethefrm’srequiredreturn.
Whentheactualrevenueofyear1is$1,500(beatingthe$1,300expected
revenue),therewillbe$200ofeconomicincome.
Nowassumetheinternalrateofreturnis0.20butthefrmusesa0.10capital
costtocomputetheeconomicincomes.Therevenuesarenow$1,600,$1,400,
and$1,200foryears1,2,and3,respectively.Theassetagaincosts$3,000.The
expectedeconomicincomesarenow:
Year1Year2Year3
Revenues$1,600
$1,400
$1,200
Depreciation$1,000$1,000$1,000
InterestCost300
200
100
EconomicIncome$300$200$100
Thenetpresentvalue(NPV)oftheeconomicincomesis
NPV
=
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“economicvalue
added.”Thisisunfortunatesincetheeconomicvalueaddedbytheinvestment
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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,theeconomicvalue
addedattime1is$351.31,notthe$300ofeconomicincomecomputedabove.
Themeasurethatisbeingcomputedisanincomemeasure,notavalueoravalue
changemeasure.
ComparingROIandEconomicIncome
EconomicincomeoffersseveralsignifcantadvantagesoverROIasaperformance
measure.First,andmostimportantly,theuseofROImightdiscouragedivision
managersfromacceptinginvestmentsthatofferreturnsthatarelargerthanthe
frm’srequiredrisk-adjustedreturns,butthatarelessthantheROIthedivisionis
currentlyearning.Ifthenewinvestmentisaccepted,thedivision’sROIwillbe
decreased.
Forexample,supposeadivisionisnowearning$30million(aperpetuity)on
aninvestmentof$100million.Then,
ROI
=
$30
,
000
,
000
$100
,
000
,
000
=
0
.
30
.
Thedivisioncaninvestanadditional$50millionandearn0.15ROIor$7.5million
peryear(aperpetuity)onthisnewinvestment.Thefrm’srequiredreturnforthis
investmentis0.10;thus,theinvestmentiseconomicallydesirable.Shouldthe
divisionacceptthenewinvestment?Ifitisaccepted,thedivision’sROIisreduced
from0.30to
ROI
=
$37
,
500
,
000
$150
,
000
,
000
=
0
.
25
.
Basedontheadverseeffectonthedivision’sROI,amanagermightrejectthis
economicallydesirableinvestment.Thisproblemdoesnotariseifeconomicincome
isused.Theeconomicincomebeforethenewinvestmentis
InitialEconomicIncome
=
$30
,
000
,
000
−
$10
,
000
,
000
=
$20
,
000
,
000
.
Notethatthe$15,000,000interestcostiscomputedonthe$50millionofnew
investmentplusthe$100millioninitialinvestment,notjusttheportionfnanced
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bydebt.Aftertheinvestment,theeconomicincomeincreasesfrom$20,000,000to
NewEconomicIncome
=
$37
,
500
,
000
−
$15
,
000
,
000
=
$22
,
500
,
000
.
Basedoneconomicincome,thereisanincentiveforthedivisionmanagertoaccept
thedesirableinvestmentandincreasetheeconomicincomeby$2,500,000.
ThesecondproblemwithROIisrelatedtothefrst.ROIgivesfaultyevaluations
ofrelativedivisionperformance.Considertwodivisions,onewithaROIof0.30
andthesecondwithaROIof0.25.Whichofthetwodivisionmanagersisdoingthe
betterjob?Above,weshowedthatacceptingtheeconomicallydesirableinvestment
reducesthedivision’sROIfrom0.30to0.25.Thedivisionearning0.25isbeing
managedbetterthanthedivisionthatearns0.30andthatrejectsgoodinvestments.
Usingeconomicincometomeasureperformancesolvesthisproblemthatexists
withROI.
Thethirdadvantageofeconomicincomeisthatitallowsmorefexibility.For
example,ifshort-terminterestratesare0.20andlong-termratesare0.12(the
patternof1980),the0.20interestratecouldbeusedforworkingcapitalitemsin
computingeconomicincome.Theabilitytousedifferentinterestratesfordifferent
assetsintroducesafexibilitythatROIlacks.
SummaryofComplexities
Thecomplexitiesofapplyingeconomicincometoperformancemeasuresorcom-
pensationare:
1.Themethodofcalculatingdepreciationexpense.
2.Thechoiceofthecapitalcost(interestrate).
3.Thechangingvalueofassets(e.g.,infationortechnologicalchange).
4.Risk.
5.Non-controllablefactorsaffectingthemeasure.
SummaryofEconomicIncomeAdvantages
Economicincomeoffersthreeprimaryadvantages:
1.Anyinvestmentwithapositivenetpresentvalueoraninternalrateofreturn
largerthanthefrm’srequiredreturnwillhavepositiveeconomicincomes.
2.Theuseofeconomicincomewilltendtonotadverselyaffectinvestmentor
divestmentdecisions.
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AnIntroductiontoAccountingandManagerialFinance
3.Withtheuseofeconomicincome,managementischargedforthecapitalituses;
thus,managementhasadirectincentivetousecapitaleconomically.
Economicincomeisaverysensiblemeasure.
MarketMeasures
Thestockholdersarethefrm’sresidualownersandtheyareinterestedinthe
stock’stotalreturn.HowwelldidtheCEOperform?Whatwasthestockholders’
totalreturn?
Thestock’sreturndoesnotalwaystracktheCEO’sperformance,especially
intheshortrun.Acompanymaydowellbutthestockmightgodown(e.g.,with
aninterestrateincrease).Nevertheless,tyingaCEO’scompensationtothestock’s
marketperformanceissensible(aslongasitisnottheonlybasisofcompensation
calculation).
Thereareseveralcomparisonsthatcanbemade.Thefrm’sperformancecanbe
comparedtoadefnedtargetreturn,thereturnearnedbythemarket,orthereturns
earnedbyasetofcomparablefrms.
Inadditiontorelatingcompensationtothecurrentyear’sperformance,itis
reasonabletorewardtoday’smanagersinthefutureforperformanceforthenext
tenyears.Itisdesirabletogivetoday’smanagersanincentivetomakedecisions
withaconcernforthefuture.
EarningsPerShare
Theearningspershareofcommonstockiswidelyusedininvestmentanalysis.It
maybehelpfulinevaluatingtheinvestmentworthofashareofstock,anditmay
alsoprovideanindicationofmanagerialperformance.
Basically,earningspershareistheratiooftheearningsavailabletocommon
stockholdersdividedbytheaveragenumberofcommonsharesoutstanding.
EarningsperShare
=
EarningsAvailabletoCommonShareholders
AverageSharesOutstanding
.
Manycompanieshaverelativelycomplexcapitalstructures,anditisnotunusualfor
thesecompaniestopresentseveralearningspershareintheirincomestatements.
Therearemanycomplexitiesthatcanariseinthecomputationofearningsper
share,mostofwhicharebeyondthescopeofthisbook.However,wewillconsider
somebasicfeaturesoftheearningspersharecalculationthatapplytomostcases.
Earningsavailabletocommonstockholdersgenerallyconsistofthenetincome
fortheperiodlessanydividendsoraccumulationsattributabletopreferred
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stockholders.Whenthereareextraordinaryitems,earningspershareshouldbe
calculatedonthebasisofincomebeforeextraordinaryitems,aswellasnetincome.
Thus,twoearningspersharefgureswouldbeshown.
Thenumberofsharesoutstandingmayvaryduringaperiodbecauseofbusiness
combinations,acquisitionsoftreasurystock,publicissuancesofstock,andsoforth.
Insuchcases,thecalculationofearningspershareisbasedonaweightedaverage
ofsharesoutstandingduringtheperiod.Thus,ifacompanyhad1,000,000shares
outstandingforfourmonthsduringtheyear,and2,000,000sharesoutstanding
duringeightmonths,theweightedaveragewouldbe1,666,667shares.
Companieswithcomplexcapitalstructuresgenerallyreporttwosetsofearn-
ingspersharefgures:primaryearningspershare,andfullydilutedearningsper
share.Bothofthesesetsoffguresmeasuretheearningspersharethatwouldhave
beendeterminedifcertainsecuritieshadbeenconvertedandoptionshadbeen
exercisedduringtheperiod.Thedistinctionbetweenthetwosetsoffguresliesin
theassumptionsaboutwhichsecuritiesshouldbetreatedasthoughtheyhadbeen
convertedintocommonstock.
BookValuePerShare
Thebookvaluepershareistheamounteachsharewouldreceiveifthecompany
wereliquidatedonthebasisofthehistoricalaccountingamountsreportedonthe
balancesheet.
BookValueperShare
=
Shareholders’Equity
SharesOutstanding
=
$5
,
080
166
.
4
=
$30
.
53
.
Wehaveusedtheaveragenumbersofsharesoutstanding.Theend-of-periodnum-
berofsharescouldjustaslogicallybeused.
Thebookvaluepersharecalculationisstraightforwardifthecompanydoes
nothavedifferentclassesofstock.Thecalculationbecomesmorecomplexwhen
differentclassesofstockexist,becausestockholders’equityitemshavetobeallo-
catedamongthedifferentclassesofstockandtheamountallocatedtoeachclassis
thendividedbythenumberofsharesoutstanding.Withregardtothefactthatthe
balancesheetvaluationsdonotrefectorapproximatefairmarketvalues,thebook
valuepersharefgureisnotlikelytobeveryusefulormeaningfulfordecision
making.
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TimesInterestEarned
Theholdersofdebtareconcernedaboutthesecurityoftheirinvestment.Thetimes
interestearnedratiofocusesonthesafetyorcoverageofperiodicinterestpayments.
TimesInterestEarned
=
OperatingIncome
InterestExpense
.
Lookingatoneyear’sfgurescanbemisleading.Long-termcreditorswishto
haveinterestexpensecoveredthroughoutthedebtperiod.Acompany’soperating
incomemaydifferquitedramaticallyfromitscashfowsfromoperations.Revenues
andexpensesmaydifferfromcashreceiptsanddisbursements.
Debt-EquityRatio
Thedebt-equityratiogivesanindicationofanenterprise’sabilitytosustainlosses
withoutjeopardizingtheinterestsofcreditors.Thisratioisbasedonlyoninfor-
mationprovidedinthebalancesheet.Althoughstockholders’equityservesasa
buffertoprotectthecreditors’interests,itshouldbekeptinmindthattheearning
prospectsoftheenterprisearealsorelevantinjudgingafrm’sabilitytosurvive
thelongrun.Thedebt-equityratioisonlyoneofseveralfactorstobetakeninto
consideration.
Therearenumerouswaysinwhichthedebt-equityratiomaybeexpressed.Four
widelyusedandciteddefnitionswillbepresentedhere.Thesedefnitionscanbe
usedtoexpressthebalancebetweendebtandequity,whichtogetherconstitutethe
resourcesofanenterprise.Thesedefnitionscanalsobeusedtoexpresstherelative
riskfromrelyingondebtorequity.
Onedefnitionofthedebt-equityratioistheratiooftotaldebttostockholders’
equity.
Debt-EquityRatio
=
TotalDebt
Stockholders’Equity
.
Aseconddefnitionofthisratiofocusesonanarrowerdefnitionofdebtthat
includesonlylong-termdebt.Thisdefnitionexcludesshort-termdebtaswellas
otherdebtthatwillnotbepaidaccordingtoafxedpaymentschedule.
Debt-EquityRatio
=
Long-TermDebt
Stockholders’Equity
.
Athirddefnitionofthedebt-equityratiofocusesontherelationshipbetween
totaldebtandtotalinvestment(e.g.,totaldebtplusstockholders’equity).Thisratio
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essentiallyprovidesthepercentageoftotalinvestmentcomposedoftotaldebt.
Debt-EquityRatio
=
TotalDebt
TotalDebtandStockholders’Equity
.
Afourthandfnaldefnitionofthedebt-equityratiofocusesontherelationship
oflong-termdebttototalinvestment.
Debt-EquityRatio
=
Long-TermDebt
TotalDebtandStockholders’Equity
.
Thesefourdefnitionsofthedebt-equityratiofocusonhowwellthecreditors
areprotected.
LimitationsofRatioAnalysis
Althoughtheuseofratioscanprovehelpfulinanalyzingfnancialdata,thereare
somepitfalls.Thefrstthingtokeepinmindisthatratiosbasedonaccounting
recordswillinheritmanyofthedefcienciesoftheaccountingdata.Forexample,
ratiosthatincorporatelong-livedassetsintheircalculationswillbeaffectedby
theconventionofrecordingassetsatcostratherthancurrentvalueandbythe
alternativesavailableforrecordingdepreciation.Thus,twocompaniesmaybe
virtuallyidentical,buttheuseofstraight-linedepreciationbyoneandaccelerated
depreciationbytheotherwillresultindifferenceswhensuchthingsasthereturn
onassetsorthebookvaluepersharearecomputed.Thiscouldbeovercomeby
makingsuitableadjustmentsinthedatatoplaceallfrmsonacomparablebasis,
buttheanalystusuallylackssuffcientdatafordoingthis.
Anotherdangertobealertforisthearithmeticeffectofcertaintypesoftrans-
actionsontheratios.Forexample,thequickratioissupposedtoprovideanindi-
cationofthecompany’sabilitytomeetitscurrentobligationswhendue.Suppose
acompanyhascashof$40million,accountspayableof$30million,andnoother
currentassetsorliabilities.Thecurrentratioandquickratiowouldbothbe1.33
to1.Nowsupposethatthecompanyused$20milliontopayalikeamountof
accountspayable.Thistransactionshouldhavenospecialsignifcance,asboth
theveryliquidassetsandthecurrentliabilitieswouldbereducedbythesame
amount—to$20millionand$10million,respectively.Theimpactonthequick
ratioissignifcant.Thisratiowouldnowbe2to1.
Ratiosaremostmeaningfulwhenviewedincomparisonwiththoseofother
frmsofasimilarnatureandwhenthetrendofaperiodofyearsisestablished.
BusinessservicessuchasDun&BradstreetandRobertMorrisAssociatescompile
listsofimportantratiosformanyindustries,andthesemaybeusedincomparing
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AnIntroductiontoAccountingandManagerialFinance
theratiosofaparticularcompanytothoseofitsindustry.Onewouldexpect,for
example,thatafrminthemeat-packingindustrywouldhaveasmallerincomeasa
percentageofsalesthanfrmsinthepharmaceuticalindustry.Comparingtheoper-
atingratiosofameat-packingfrmwiththoseofothermeat-packingfrmswould
givemoremeaningfulresultsthancomparisonswithaveragesforallmanufacturing
industries.
EffcientMarketsandAccounting
Inthepast,accountingtheory(andthechoiceamongaccountingalternatives)has
beendoneonan
apriori
basis.Thisbookwaswritteninthatspirit.Forexample,we
frstassumeitisdesirabletomatchrevenuesandtheexpensesassociatedwiththose
revenues.Theaccountingentriesthatareappropriateforrecordingdepreciable
assetsstemfromthatassumption.Inrecentyears,anotherschoolofthoughthas
arisenwhichsuggeststhatweshouldconsidertheexistingevidenceastohow
thefnancialmarketsactuallyusetheaccountinginformationpresented.Oneof
themajortheoriesthatformsthebasisofthisnewschoolistheeffcientmarket
hypothesis.
Theextremepositionofthosewhoadvocatetheeffcientmarkethypothesis
claimsthatallthemarketrequiresisbasicfnancialinformation.Wecanexpect
themarkettodigestthatinformationwiththeresultthatthemarketpricewillfully
refectthebasicinformation,eveniftheaccountingpracticeisnotconsistentwith
thebestaccountingtheory.Thus,variationsinaccountingpracticewillnotaffect
themarketpriceofafrm’scommonstock,aslongasthebasicdataaredisclosed.
Theeffcientmarkethypothesiscomesinseveralforms.Weshallconsideronly
three:theweak,thesemi-strong,andthestrongforms.
TheWeakForm
Theeffcientmarkettheorieshadtheirorigininresearchthattendedtoprovethat
stockmarketpriceswerearandomwalk.Accordingtotheweakformoftheeffcient
markethypothesis,topredicttomorrow’spriceofashareofcommonstockweneed
onlytoday’sprice.Yesterday’sprice(thepasthistoryofthestock)orthevolume
ofsharestradedtellonenothingabouttomorrow’sprice.Theexpectedvalueof
tomorrow’spriceistoday’sprice(assumingashorttimehorizon).Ifvalid,this
stateoftheworldeliminatesawiderangeofsecurityanalysesthatlookatpatterns
ofstockpricechanges.
Theimplicationsforaccountingpracticeofthe“weakform”centeronthe
accountingforsecuritiesthathaveawidemarket.Ifstockpricesfollowarandom
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walk,andiftheexpectedvalueoftomorrow’spriceistoday’sprice,thenthe
accountanthasajustifcationforshowingsuchsecuritiesatmarketvalue.
TheSemi-StrongForm
Thesemi-strongformoftheeffcientmarkethypothesisstatesthatthemarket
incorporatesalltheknowninformationaboutastock,thecurrentpricerefectsthis
information,andthisinformationisincorporatedinthepriceveryrapidly.Thus,
aninvestorcannotusetheknownpublicinformationtomakeamore-than-normal
return.
Letusassumethattwootherwiseidenticalfrmsarepresentingincomestate-
ments,butthatonefrmusesthestraight-linemethodindepreciatingitsequipment
whiletheotherfrmusesthedoubledecliningbalancemethod.Thedifferences
inaccountingarefullyexplainedwithsupportingschedulesintheirrespective
reports.Theeffcientmarkethypothesis,giventheassumptions,suggeststhatboth
commonstockswouldsellforexactlythesameprice.Themarketwouldadjust
fortheaccountingpractices,soonlytherealdifferenceswouldremain.Inthis
case,therearenorealdifferences;thus,thestockpricesofthetwofrmswouldbe
identical.
Apersonwhobelievesinthesemi-strongformoftheeffcientmarketwould
arguethatmoreattentionshouldbedirectedtowardobtainingcompletenessof
disclosureandimprovingthetimingoftheannouncementscontaininginforma-
tionratherthantowardtheformofthepresentation.Apersonwhodoubtedthat
themarketwasperfectlyeffcientinthesemi-strongformmightagreewiththe
importanceofcompletenessofinformationdisclosureandtheimportanceoftim-
ing,butheorshewouldstillarguethattheformofpresentationmadeadifference
toenoughinvestorssothattheaccountingproblemswerestillarelevantareaand
theimprovementofaccountingpracticeswasavalidendeavor.Inaddition,since
theprocessingofinformationhasacost,theaccountanthasanobligationtorefne
theinformationandpresentitinasgoodformasisfeasiblesothatinformation
processingcostscanbereduced.
Whileonemightnotagreecompletelywiththesemi-strongformoftheeff-
cientmarkethypothesis,itwouldbeincorrecttoarguethatthemarketisperfectly
fooledbydifferencesinaccountingpracticesandmakesnoadjustmentforsuch
differences.IfonefrmisusingFIFO(frst-in,frst-out)andasecondfrmisusing
LIFO(last-in,frst-out),themarketislikelytobemakingsometypeofadjustment
forthefactthattwodifferentaccountingassumptionsarebeingused.
Wewouldexpectthemarkettomakereasonablygoodadjustmentswhere
thesupplementalinformationisclearlypresented,butinsomecases,wherethe
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AnIntroductiontoAccountingandManagerialFinance
informationisnotclearorisnotpubliclyavailable,theadjustmentsmaynotbeas
effective.Thisbringsustothestrongformoftheeffcientmarkethypothesis.
TheStrongForm
Thestrongformsaysthatonecannotmakeabnormalproftswitheitherpublicly
heldinformationornonpublicinformation.Thus,insiderscannotmakeabnormal
proftiftheytradeusingthatinformation.Itisdiffculttotestthestrongform(itis
againstthelawforinsiderstotradeusingprivilegedinformation;therefore,obtain-
inginformationaboutthetradingofinsidersisextremelydiffcult).Theauthor
wouldguessthatifonehadgoodinsideinformation,onecouldmakeabnormal
profts.However,thereisatendencyforapersonwhoistooclosetoasituation
tonotappraiseitobjectively;thus,thestrongformmighthavesomevalidity.Itis
possiblethatinsidersdonotdoaswellasanenviousoutsidermightthink.
Ifwebelievethatthestrongformdoesnotholdandthatinsidersdohave
anedgeintrading,thenthisconclusionaffectsthemannerinwhichconfdential
accountinginformationishandled.Forexample,wewouldnotwanttheemployees
ofanindependentcertifedpublicaccountingfrmtoownortradeinthestockof
acompanythefrmisauditing.Thesameconclusionholdsfortheexecutives
ofanindustrialfrm.Ifcommonstockistobeheldbytheexecutives,thestock
shouldbeheldwithotherinvestmentsinablindtrustsothatthetimingofbuy
andselldecisionscannotbetheresultofinformationthatisavailableonlytoa
few.Thus,thestrongformisimportanttoaccountinginanegativesense.Sincewe
tendtorejectthestrongform,wethinktheinformationpossessedbyinsidersis
important,andrulesshouldbeestablishedthatpreventindividualsfromexploiting
thatinformation.
Implications
Thedevelopmentoftheeffcientmarkethypothesishasimplicationsforthedevel-
opmentofaccountingtheoryandpractice.Itisimportantforaccountantstorealize
thattherearemanyintelligentanalystsinterpretingthedataand,aslongassuf-
fcientlyaccurateinformationispresented,theanalystislikelytoworkaround
differencesintheexactformofabalancesheetorincomestatement.Forexample,
accountingpracticemightinsistontheuseoffairvalueforpresentingmarketable
securities,butthisshouldnotprecludethepresentationofothermarketvalues
suchasbidandofferpricesinafootnote.Thereareseveralpossiblewaysinwhich
securitiesmaybepresentedinabalancesheet.Itispossiblethat
apriori
reasoning
maybeabletosuggestthatonemethodisbetterthananothermethod,andamore
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reasonablepresentationmightresultinadecreaseininformationprocessingcosts
fortheanalysts.
Non-AccountingQuantitativeMeasures
Giventhegenerallyacceptedcriticismsofaccounting(e.g.,itiscost-based),most
analystsofbusinessaffairssearchforotherquantitativemeasurestocomplement
(orreplace)theaccountingmeasures.Thesemeasuresinclude:
1.Marketpenetration.
2.Customersatisfaction.
3.Employeesatisfactionandturnover.
4.Unitssold.
5.Diversitymeasures.
6.Qualitycontrolmeasures(percentageofdefectives).
Ifreliableusefulmeasurescanbeobtained,thenthenon-accountingquantita-
tivemeasurescantaketheirplacewiththeaccountingmeasures.Inmanysituations,
theywillbemoreimportantthantheaccountingmeasuressincetheygiveahintof
theleveloffutureincomes.
QualitativeMeasures
Therearemanyqualitativeaspectsthatenterintoanevaluation.Forexample,a
managermightbereliableandeasytoworkwith.Amanagermighthavelaid
thefoundationforfuturegrowthbyhiringoutstandingmanagersandresearchers.
Doesthemanagergenerateenthusiasmandcreativity?Hasthemanagerenhanced
thefrm’sreputationamongcustomersandsuppliers?Therearemanywaysin
whichthemanagercanenhancethefrm’sfutureproftabilityandvaluebyactions
thatdonotleadtocurrentproftability.Toevaluateamanager’sperformance,itis
necessarytoconsiderthesefactors.
Inaddition,frmscanhavegoalsotherthanameasurableeffectonproftability.
Thismightinvolvethelocalsocietyorsocietyinabroadersense(e.g.,protecting
theenvironmentbeyondthelegalrequirements).
Intangiblesarefactorsnoteasilymeasured,buttheycanbeimportanttothe
long-runsuccessofacorporation.
ManagerialCompensation
Thebasisofcompensationshouldbeboththeoperatingresultsofthemanager’s
specifcunitandtheresultsofthefrm.Themanagershouldhavejointloyalties.
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Thebasisofcompensationshouldincludequantitativeobjectivemeasures,
butnottotheexclusionofqualitativemeasures.Theexistenceofthequalitative
considerationsreducesthetendencyofmanagerstogamethesystem.
Tosomeextent,someofthecompensationshouldbedeferredandbetiedtothe
frm’sfutureperformance.Wewantmanagerstomakedecisionsfromalong-run
perspective.Thebasisofcompensationshouldbebothaccountingmeasuresand
marketmeasures.Thereturnearnedbytheshareholdersshouldaffectthecompen-
sationofthemanagers.
AgencyTheoryAppliedtoCorporateManagement
andPerformanceMeasurement
Problemsofagencyarisewhenaprincipalemploysanagenttoperformatask,
andtheinterestsoftheprincipalandtheagentarenotidentical.Thecorporate
formisfertilesoilforagencyproblemstotakeroot.Considertherelationships
betweenshareholders(theprincipal)andmanagement(theagent).Formanyrea-
sonsincludingtheincreaseinpower,managementmightwantthefrmtogrow
whiletheshareholderswouldbebetteroffwithasmallfrmandalargecashdis-
tribution.Itisnecessaryforthecompensationmethodtobeeffcientintermsof
eliminatingthepossibilityofamanagementtoundertakeknowinglyundesirable
investmentsfromtheviewpointofshareholders.
Therecanalsobeagencyproblemswithdifferentlevelsofemployees.Consider
theCEOandtradersofabank.Theyareallemployees.Theyallwanttoincrease
thebank’sprofts.Butthetradersmighthavebonusarrangementsthatencourage
themtotakeexcessiverisksfromtheCEO’sperspectiveinordertoearnalarge
bonus.Thisstrategymightbegoodforthetraders,butbadfortheexpectedprofts
ofthebank.Atraderwhowinsbecomesrich.Atraderwholosesgetsanidentical
jobwiththebankacrossthestreet.
Anothertypeofagencyproblemariseswhenonegroupisinapositionto
takeadvantageofasecondgroup.Letusconsiderafrmfnancedby$9million
of0.08debtand$500,000ofcommonstock.Therearezerotaxes.Withoutany
newinvestments,thereiscertaintyofthefrmearning$800,000(beforeinterest)
andbeingabletopaythe$720,000interestonthedebt.Thestockholderswould
earn$80,000peryear.Thefrmisconsideringa$1millioninvestmentfnanced
by0.08debt.Withthisinvestment,thereis0.5probabilitythatnodebtinterest
willbepaid.Theinitialdebtholdersdonotwantthe$1millionofnewdebttobe
issued.
Obviously,theinitialdebtholderswillattempttostructuretheirindenturesso
thattheylimittheabilityofthestockholderstochangethenatureofthebusinessin
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amannerthatadverselyaffectsthepositionofthedebtholders.Thisisavariation
ofanagencyproblem.
Agencycostsconsistofseveraltypes.Oneisthetransactioncost.Buyersof
debthavetohirealawyerthatprotectsthedebtbuyers’interests.Corporationshire
consultantstoestablishsystemssothatthetradersofderivativescannotbankrupt
thefrm.Thesearetransactioncostsoragencycosts.Anothertypeofagencycost
arisesbecauseofthenecessitytorewardtheagentinamannerthatmakesthe
agent’sinterestscongruentwiththeprincipal’sinterests.
Non-ControllableFactors
Anoilcompanyexecutive’sfrmislosing$500millionperyear.TheCEOisin
dangerofbeingfred.Thenoilpricesdoubleandthefrmmakes$800million.It
isthesamemanagermanaginginthesameway,buttheeconomicenvironment
haschanged.Obviously,someattemptcouldbemadetoseparateoutthefactors
thatareandarenotcontrollablebythemanager.Butthisisdiffcult,andisaptto
introducesubjectivemeasuresintotheevaluation.
Thisproblemisanexampleofthequalitativeaspectsofperformanceevaluation.
ANon-ZeroNetPresentValue
Thebasicexampleusedinthischaptersetsthenetpresentvalueoftheinvestment
equaltozero,thatis,theinternalrateofreturnoftheinvestmentisequaltothetime
valuefactorforthefrm.Obviously,thiswillonlyrarelybethecase.Weexpectmost
investmentstohaveexpectedreturnsinexcessoftheirrequiredreturn.Forexample,
letusassumethatthethree-yearinvestmentcosts$2,760insteadof$3,000.Thenet
presentvalueoftheinvestmentatthetimeofacquisitionis$240,anditsinternal
rateofreturnis0.15.Thereareseveralpossiblepathswecantake.Twomethods
willbedescribed.Themoststraightforwardwouldbetouse0.15astherateof
discounttocomputethedepreciationexpensesandreturnsoninvestment.
Using0.15astherateofdiscount,weobtain:
PeriodRevenuesDepreciationIncomeInvestmentROI
1$1,300$844$416$2,7600.15
21,2009192811,8760.15
31,1009571439570.15
Theprimarydiffcultywiththissolutionisthatthetimevalueofmoneyis
defnedtobe0.10,not0.15.Thus,thevaluesoftheinvestmentateachtimeperiod
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aregreaterthanthoseshownabove.Asecondsolutionistoimmediatelyadjustthe
valueoftheinvestmentto$3,000,thepresentvalueofthebenefts,despitethefact
thattheinvestmentcostisonly$2,760.Thisprocedurewouldnotbeacceptable
forconventionalfnancialaccountingpurposesbecauseoftheimplicitthreatof
manipulation,butitwouldbeacceptableforinternalmanagerialpurposes.Itisa
veryappealingprocedurebecauseitisrelativelysimpleandyetiscorrectfromthe
standpointofaccountsrefectingvalues.
IncentiveConsideration
Theuseofbookvaluebasedoncosttomeasuretheinvestment(thedenominator
intheROIcalculationandthebasisoftheinterestcostintheeconomicincome
calculation)oreventheuseofestimatesofprice-level-adjustedcostissubjectto
severecriticism.Thereisnoreasonwhyasystembasedonvaluesestimatedby
managementcannotbeusedforinternalpurposesinsteadofcost-basedconven-
tionalaccounting.Herewehaveanopportunitytoapplyingenuitytobypassavalid
objectionbymanagerstocost-basedaccounting.
Ratherthanaskinganaccountantoranotherstaffpersontosupplythenumber
onwhichthemanagersaretobejudged,letusaskthemanagerstosupplythe
valueestimate.Theprocedurewouldbesimple.Takeasetofeligiblemanagers
andaskthemto“bid”periodicallyfortheassetstheywanttomanageandforwhich
achangeinmanagementisappropriate.Themanagerwhosebidisacceptedtakes
theasset,andthebidbecomestheaccountingbaseforperformanceevaluation.If
themanagerbidstoohigh,thatmanagergetstheassetbutwillfndithardtomeet
thereturnoninvestmentandeconomicincomerequirements.Ifthemanagerbids
toolow,acompetingmanagerwillwin,oralternativelythe“board”mayreject
thebidandaskforrevisedbids.Thereisonemajordiffcultywiththisprocedure.
Managerscanrigthetimeshapeofprojectedearningssothatearlytargetscanbe
easilyattainable.Thistendencywouldhavetobecontrolledbythetopmanagers
awardingthebid.Largedeferredbeneftswouldhavetobediscounted.
Theproposedprocedurewouldhavemanyadvantages.Itwouldestablishan
investmentbasewhosemeasureisacceptabletoboththeoperatingmanagerand
thetoplevelofmanagement(theformersetsthevalue,thelattermustacceptit).
Theaccountantservestheveryimportantandproperfunctionofsupplyingrelevant
informationthatisusedbythemanagersinmakingtheirrespectivejudgmentsand
bids.TheROIandeconomicincomemeasuresareimprovedbecausetheinvest-
mentbaseisappropriatetothespecifcinvestmentandmanagerbeingevaluated
ratherthanbeingtheresultofaseriesofhistoricalaccidents(suchastheyearof
purchaseandthemethodofdepreciation).Mostimportant,itrequiresmanagersto
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set,describe,andquantifytheirplansfortheutilizationoftheassets.Itwouldtie
togetherplanning,decisionmaking,andcontrol.
DeferredBenefts
ConventionaldepreciationaccountingcombinedwiththeusesofROIisatits
worstwhenthebeneftsproducedbytheassetareexpectedtoincreasethrough
timeorwhenthebeneftsaredeferred.Theearlyyearsaregreatlypenalizedby
conventionalaccounting,withthemanagershavinganincentivetoavoidsuch
investmentssothattheirperformanceevaluationsdonotsuffer.
Forexample,assumeaninvestmentcosting$3,000isexpectedtohavethe
followingbeneftstream:
PeriodBenefts
1$1,100
21,210
31,331
Thefrm’scostofmoneyis0.10andisequaltotheinvestment’sdiscounted
cashfowinternalrateofreturn.Theresultsusingconventionalaccountingand
straight-linedepreciationwillbe(assumingtheactualbeneftsareequaltothe
expected):
PeriodRevenuesDepreciationIncomeInvestmentROI
1$1,100$1,000$100$3,0000.03
21,2101,0002102,0000.105
31,3311,0003311,0000.331
Thefrstyear’soperationsarenotacceptable.
Defningdepreciationexpensetobethedecreaseinvalueoftheasset,the
resultswouldbe:
PeriodRevenueDepreciationIncomeBookandValueInvestmentROI
1$1,100$800$300$3,0000.10
21,2109902202,2000.10
31,3311,2101211,2100.10
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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.
Thedistortioncausedbyconventionalaccountingcanbeincreasedbyassuming
no(orverylow)beneftsuntilperiod3.Theoperatingresultsoftheearlyyears
wouldappeartobeevenworsethanintheexample.
CashFlowReturnonInvestment
Recognizingtheinadequaciesofconventionaldepreciationaccounting,someman-
agershaveattemptedtosolvetheproblemsbyusingcashfowreturnoninvestment.
Sincecashfowsareusedtoevaluatetheinvestment,whynotusethemtoevaluate
theinvestment’sperformance?
Defnethecashfowreturnoninvestmenttobe:
CashFlowReturnonInvestment
=
Cashfow
Investment
.
Thecomputationseemstobeappealingbecausedepreciationisnotcomputed,
butunfortunately,thecomputationmerelymakesabadanalysisworse.Usingthe
previousexamplewheretheinvestmenthasa0.10internalrateofreturn,wewould
obtain:
PeriodCashFlowInvestmentCashFlowROI(CashFlow/Investment)
1$1,300$3,0000.433
21,2002,0000.600
31,1001,0001.100
Somefrmshaveactuallytriedtousethehistoricalmeasuresasrequiredreturns
foradditionalinvestments.Youshouldnotethatforaninvestmentyielding0.10
overitslife,thecashfowROIsforthethreeyearsare0.43,0.60,and1.10.The
measuregreatlyoverstatestheROItheassetisactuallyearning.
Anotherdiffcultyofthemeasureisthatitwilltendtobiasmanagementin
favorofcapital-intensivemethodsofproduction,becausecapitalcostisomitted
fromthenumeratoroftheperformancemeasure.
ItisbettertousetheconventionalROIwithincome(afterdepreciation)inthe
numeratorthantousethecashfowROI,whichisextremelydiffculttointerpret
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andhasnotheoreticalfoundation.Theuseofthemeasureillustratedabovewill
getmanagementintooneormoreinterpretivediffculties.Therearealternative
methodsofusingcashfowreturnoninvestmentthatareimprovementsoverthe
methodillustrated.
PlanningImplications
Thefactthattheremaybeaconfictbetweentheinvestmentcriteriausedandthe
performancemeasuresmeansthatcorporateplanningmusttakeintoconsideration
thefactthatalldesirableinvestments(fromthecorporatestandpoint)maynotbe
submittedupward.Itwouldbena˙ıvetoexpectadivisionmanagertorecommend
aplantwith60percentexcesscapacitywheretheanalysisofmutuallyexclusive
investmentsindicatesthatthisisthebestalternative,iftheperformancemeasures
foraperiodoffveyearswillbeadverselyaffectedbythechoice.Rather,the
divisionmanagerislikelytoburythistypeofalternativesothattheboardof
directorsisnotconfusedbythenumberofalternativesandthis“undesirable”
alternativespecifcally.
Themanagershaveasimilartypeofconfictwhentheyevaluatemajorinvest-
mentsthatsatisfynormalinvestmentcriteria,buthaveadverseeffectsontheROIs
andearningspershareofthenextfewyearsbecauseofconventionalaccounting.
Theplannerrejectinginvestmentswithpositivenetpresentvaluesmaygain
short-runbenefts(nondepressedearnings),butwillhavealong-runcostinthat
futureearningswillbedepressedcomparedtowhattheycouldhavebeen.
Onealternativeistousetherecommendedinvestmentcriteriaandhopetomod-
ifytheaccountingconventionsthatcausethedistortions.Failingthat,management
canalternativelyattempttoexplainthecharacteristicsoftheinvestment(andthe
deferredbenefts)totheinvestingcommunity.
Thebestsolutionwouldbefortheaccountingprofessiontoencourageawide
rangeofdepreciationmethods,ifthesemethodsarejustifedbytheeconomic
characteristicsoftheinvestment.Currently,toorapidwrite-off(R&D,training,
plantandequipment)leadsto(1)badmeasuresofperformanceand(2)non-optimal
decisions.
Conclusion
Annualorquarterlyaccountingproftscanbeapoormeasureofwhathasbeen
accomplishedduringanyrelativelyshortperiodoftime.Also,itisoftendiffcult
toassignresponsibilityforadeviationfromtheproftobjective.Manyeconomic
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eventswithlong-runimplicationsarenotrecordedbytheaccountant.Oneshould
notuseanyperformancemeasurewithoutconsideringthosefactorsnotnormally
appearinginthemanagementinformationsystem.
Insomecases,theROIoreconomicincomeshouldnotbeusedforoperating
unitsbecauseitistoodiffculttomeasureeithertheincomeortheinvestment.
Normally,themeasureofROIcanbeusedtogainanimpressionofmanage-
rialperformance,buttheuseofROIshouldalwaysbesupplementedbyeco-
nomicincomemeasures.Thisisnecessaryifthetopmanagementofafrmis
attemptingtomeasuretheeffectivenessoftheutilizationofassetscontrolledby
personsatdifferentlevelsofthefrm.Theeconomicincomeisaveryuseful
meansofaccomplishingthis,ifeffortsaremadetomeasureincomeandinvest-
mentinausefulway.Economicincomecombinedwitheconomicdepreciation
isverygood.Performancemeasurescanbemadeascomplexorsimplifedas
youwish.
Inconclusion,tomeasureperformanceyou
can
useROI(neverbyitself),but
economicincomeisstronglyrecommended.Tomakeinvestmentdecisions,you
cannot
useROIeffectively.
Althoughperformancemeasurementisadiffculttaskwhenexactreliablemea-
suresofincomeandinvestmentarenotfeasible,itisnecessarythatallmanagers
evaluatepersonsforwhomtheyareresponsible.Asguidesandindicators,ROIand
economicincomehavetheiruses.
QuestionsandProblems
1.AsoftheendofDecember,thecurrentliabilitiesoftheLargeSteelCompany
are$800millionanditsliquidassetsare$600million.Thefundsgenerated
byoperationsinthepastyearwere$1billion,anditisexpectedthatthisrate
willcontinueinthefuture.
Howmanydaysoffundsgenerationwouldbeneededtopaytheamountof
currentliabilitiesinexcessofliquidassets?
2.(continue1)TheLargeSteelCompanyalsohas$1billionoflong-termdebt
inadditiontothe$800millionofcurrentliabilities.
Howmanydaysoffundsgenerationwouldbeneededtopaytheamountof
totalliabilitiesinexcessofliquidassets?
3.TheLargeSteelCompanyhas$1.5billionofcurrentassets,$0.8billionof
currentliabilities,and$1billionoflong-termdebt.Itgenerates$1billionof
fundsperyear.
Computesomemeaningfulmeasuresrelatingassets,debt,andfunds
generation.
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4.ThefollowinginformationappliestotheABCCompanyforthecomingyear:
Earningsbeforeinterestandtaxes$3,000,000
Interest300,000
Principalrepayment1,200,000
Depreciation(fortaxesandaccounting)800,000
Taxrate0.40
Whatbefore-taxcashfowhastobeearnedtomeetthedebtrequirementsin
thecomingyear?
5.Doestheuseofinventorynecessarilyaffecttheamountofcashthatisheldby
acorporation?
6.WhyisEBITgenerallyusedintheinterestcoverageratioratherthanincome
aftertaxes?
7.Abankloanoffcerisconsideringlending$2millionona60-daynotetoa
corporation.
Whatquantitativemeasuresshouldtheloanoffcercompute?Iftheloanis
for20years,howshouldtheanalysisdiffer?
8.ThefollowingfactsapplytotwocompaniesfortheyearendingDecember31
ofthesameyear:
CompanyACompanyB
Income$10,000,000$10,000,000
Fundsfow16,000,00016,000,000
Interestpayments4,000,0003,000,000
Nolong-termdebt(principal)paymentsaredueforeitherfrmfor10years.
Beforeevaluatingtheliquidityofthetwofrms,whatadditionalinformation
wouldyoudesire?
9.Thebasicdefensiveinterval(BDI)isdefnedas:
BDI
=
totaldefensiveassets
forecasteddailyoperatingexpenditures
.
Thedefensiveassetsincludethoseassetsthatcanreadilybeturnedintocash
(liquidassets)suchascash,marketablesecurities,andaccountsreceivable.
EvaluatetheusefulnessoftheBDI.
10.Ananalystwantsacashfowcoverageratiopreparedfromthepointofview
ofthecommonstockholdersofafrm.Thefrmhasalong-termdebtand
preferredstockoutstanding.
Prepareausefulratiofortheanalyst.
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11.Toearn$78aftertax,howmuchhastobeearnedbeforetax?Thetaxrate
is0.4.
12.Thedepreciationexpensefortaxesis$80andthedebtprincipalpayment
is$110.
Withataxrateof0.4,whatdothebefore-taxearningshavetobeinorder
tohavesuffcientcashtopaythedebtprincipal?
13.Doesahighcurrentratioindicateawell-managedcompany?
14.Whatwouldbetheeffectontheall-assetearningrateintheyearinwhich
equipmentisacquiredofusingsum-of-the-years’digitsratherthanastraight-
linedepreciationprocedure?
15.Aleadingcompanyinthepaperindustryincludedthefollowinginformation
inanannualreport:
“Timberlandsarecarriedat$1percordofestimatedstandingsoftwoodon
November30,1904,plussubsequentpurchaseacquisitionsatcost,lessdeple-
tionbasedontimbercut.Thecarryingvaluesoftimberlandsdonotrefect
regrowthinareaswhichhavebeencutorcurrentmarketvaluesforstumpage
whicharebelievedtobesubstantiallyhigherthancarryingvalues.”
Commentontheprocedurefollowed.
16.Assumeyouwerethinkingofinvesting$1,000,000inacommonstock.Ifyou
weregiventoday’sstockprice,wouldyoupayanythingtofndoutyesterday’s
price?Explain.
17.(continue16)Wouldyoupayanythingfortheentirepasthistoryofstockprices
ofthatstock?
18.Assumeyoubelieve100percentinthesemi-strongformoftheeffcientmarket
hypothesis.InJune,youareconsideringinvesting$1,000,000inthecommon
stockofafrmwhosefscalyearendsDecember31andwhoseannualreport
cameoutinMarch.Wouldyoulookatthelastyear’sannualreport?Explain.
19.Assumeyoubelieve100percentinthestrongformoftheeffcientmarket
hypothesis.Afriendisworkingintheaccountingdepartmentofalargepublicly
tradedfrm.Heinadvertentlydisclosesthequarter’sincome,whichisvery
differentfromtheforecastedincome.Ignoringlegalandmoralissues,would
youtrade?Explain.
20.Shouldapublicaccountingfrmallowitsemployeestoholdstockinpublicly
ownedfrmsthatarebeingauditedbythefrm?
21.“Thecompany’sstockhasreachedanewhigh,thereforeyoushouldsell.”
Evaluatethisadvice.
22.“Thecompany’sstockhasreachedanewlow,thereforeyoushouldbuy.”
Evaluatethisadvice.
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23.“Wecannotrecordtheinvestmentinstockatitsmarketvalue,sinceweknow
thatvalueofthestockwillchangeinthefuture.”Evaluatethisstatement.
24.Therehavebeenmanycaseswherethemarkethasseemedtobefooledbybad
accounting.Somecompanieswhosestockshadsoldathighpricesarenowin
bankruptcy.Dotheseexamples“prove”thatthemarketisnoteffcient?
25.Abusinesscasestatesthatthestockofthecompanybeingstudieddropped
froma20x1peakof$31ashareto$10bymid-20x2.Itthenstates,“Inthelight
ofthisdevelopmentthemanagementhadruledoutanewissueofcommon
stockasasourceoffnancingcapitalexpendituressolongasthepriceofthe
company’scommonstockremaineddepressed.”
Doyouagreewiththeposition?
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Chapter15
MergersandAcquisitions:Consolidations
Twofrmsmayjointogether(amerger)toformanewjointfrm,oronefrmmay
acquireallthecommonstockofanotherfrm(anacquisition).Theconsequences
ofbothrestructuringsarethesame.Almostallfrmsareeitheractivelyengaged
inmergeractivityorworriedaboutbeingacquired.Thus,thetopicisimportantto
management.
Mergersandacquisitionsoccurformanydifferentreasons,rangingfromthe
desireforriskreductiontothenecessityofdoingsomethingwithextracashcur-
rentlyheldforwhichthefrmhasnootherspecialplans.Considerthefollowing
fouracquisitionsofoilcompanies:
1.Socal(nowChevron)acquiredGulfOilforUS$13.2billionin1984.
2.TexacoacquiredGettyOilforUS$10.2billionin1984.
3.DuPontacquiredConocoforUS$7.4billionin1981.
4.U.S.SteelacquiredMarathonOilforUS$6.5billionin1981.
Allfouracquisitionsoccurredbecausethemanagementoftheacquiringfrm
thoughtthattheoilreserveswereundervaluedbythemarket.SocalandTexaco
wereseekingadditionaloilreserves.DuPontandU.S.Steelwerediversifyingout
oftheirbasicindustriesbecausetheysawrelativelylowproftsandhighrisksin
thoseindustries(chemicalsandsteel).Thediversifcationeffortswerenoteffective.
ReasonsforMergers
ObtainingResources
Manyspecifcreasonsaregivenformergersandacquisitions.Forexample,ifa
frmwantstostartanewtypeofactivity,anacquisitionofafrmmaybequicker
thandoingitfromscratch.Anotherreasonformergersisthatretentionofearnings
289
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AnIntroductiontoAccountingandManagerialFinance
savesinvestortaxes;thus,itisasensiblestrategycomparedtoacashdividendand
maybethebestinternaluseofresourcesfromtheviewpointofstockholders.
Therearemanyreasonsformergersandacquisitions.Amongthemare:
1.Synergy(realandimaginary),theprocesswherebyitishopedthat2plus2
equals5,butsometimesitequals3.
2.Financialconsiderations(includingtaxeffects).
3.Bargainpricesandavailabilityofcapital.
4.Psychologicalreasons(empirebuildingbymanagersandraiders).
5.TheP/Eeffect.
6.Thereductionofrisk(diversifcation).
Oneofthemoreimportantreasonsforamergeristhatitwillleadtothe
acquisitionofresourcessuchas:
1.Managementtalent.
2.Markets.
3.Products.
4.Cashordebtcapacity.
5.Plantandequipment(replacementcostislessthantheprice).
6.Rawmaterial.
7.Patents.
8.Know-how(processesorthemanagementteam).
Diversifcation
Anotherreasonformergersandacquisitionsisdiversifcation(riskreduction).Risk
diversifcationisadiffcultobjectivetoevaluate.Individualinvestorscandiversify
forthemselves.Acorporationdoesnothavetodiversifyforitsinvestors.
Mergersandacquisitionsaregenerallyassumedtoreduceriskfortheacquiring
frm,butthisisnotnecessarilyso.Iftheriskoftheacquiredfrmissuffciently
large,ittendstocontaminatethefnancialpositionofthefrmacquiringit.Paying
toomuchforanacquisitioncanalsoadverselyaffecttheacquirer’srisk.
Despitethis,certaintypesofmergerstendtoreducerisk.Assumetwofrms
haveoperationsthatareperfectlyindependentofeachother,bothinaneconomic
andstatisticalsense.Inthissituation,investorswhokeeptheirinvestmentsize
thesameinamergerwillreducetheirrisk.Weareassumingthatthefailureof
onefrmwillnotcauseafailureofthesecondfrm,andthatoperationsarenot
affectedbythemerger.Forexample,sayonegroupofinvestorsownsafrmwhere
thereisa0.5probabilityofsuccessand0.5probabilityoffailure.Ifthatfrmis
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mergedwithasecondfrmwiththesameprobabilitiesofsuccessandfailurebut
whoseoperationsareindependent,andiftheoriginalinvestorsnowown50percent
ofthemergedfrms,therewouldonlybea0.25probabilityofbothportionsofthe
mergedfrmfailing.Hence,inthiscase,riskhasbeenreduced(theexpectedreturn
maybeunchanged).
Forsimplicity’ssake,wegenerallyassumethegoalofafrmisproftmaximiza-
tion(inpresentvalueterms)inordertomaximizethewell-beingofthecommon
stockholders.Weshouldperiodicallyquestionthisassumption,sincecorporations
arealsoinexistencetoserveothergroups,forexample,management.
Whenafrmdiversifesbymergingwithoracquiringafrminanotherindustry,
whobenefts?Letusconsiderthepositionoftheshareholderand,forpurposesof
focusingondiversifcation,letusassumezeroinvestortaxrates.Theobjectiveof
diversifcationisriskreduction.Theadvicenottoputallone’seggsinonebasket
isgoodadviceiftheobjectiveistoavoidafeast-or-faminesituation.
Theindividualshareholdercandiversifyeasilybybuyingstocksindifferent
frmsindifferentindustriesorbyinvestinginmutualfunds.Thestockholderofa
companydoesnotneedthecompanytoincurcoststoachievediversifcation.
Ifdiversifcationcangenerallybeeffcientlyachievedbyinvestors,thenwhy
dofrmsdiversify?Naturally,therearemanyinvestorswhoarenotwelldiversifed
andwouldlikethecorporationtodiversifyontheirbehalf.Moreimportantly,
managementhasitsmajorassetinvestedinthefrm,andthisassetisdiffcult
todiversify.Themajorassetsofmanagersaretheircareers.Ifacompanygoes
bankruptorentersaperiodoffnancialdiffculty,themiddle-agedmanagerpays
aheavyprice.Hence,itisreasonableforsuchamanagertoseekahigherlevelof
securitybytryingtostabilizetheincomeofthecorporation.
Synergy
Apopularreasonofferedformergersisthatthetwofrmsjoinedtogetherwillbe
morevaluablethanthesumofthevaluesofthetwoindependentfrms.Therewill
besynergy.Synergyisaprocesswherebywhen1and1areadded,morethan2
isobtained.Twofrmsjoinedtogethermaybeworthmorethantheyareworth
individually.Thereareseveralreasonswhyamergerofthetwofrmsmayresult
intotalproftslargerthanthesumofthetwoindividualprofts.Twofrmsmaybe
morevaluableafteramergerthanasseparateentitiesbecause:
1.Onefrmmaybebadlymanagedandtheotherfrmmayhavemanagerialtalent.
2.Onefrmmayhaveassets(e.g.,plantorliquidassets)thatcanbeeffectively
usedbytheotherfrm,orintangibleassetssuchastechnological,marketing,or
productionknow-how.
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3.Horizontalintegration—increasesmarkets(andpossiblyreducescompetition).
4.Verticalintegration—increasesoperatingeffcienciesbyintegrationof
production.
5.Jointutilizationofservicefacilities,ororganizationandeliminationofdupli-
cation.
Alloftheformermightleadtooperatingeffciencies(lowercosts).Horizontal
integrationmightalsoleadtodecreasedcompetition,which,althoughnotsocially
desirable,mightwellbewelcomedbymanagement(thistypeofmergerwould
tendtobediscouragedbygovernmentbodies).
Aformofsynergycanbederivedsincethemarketaddsvalueforsize.Afrm
oflargesizetendstobeabletoobtaincapitalatalowercost.Consistentwiththis
ismanagement’shopethatthemarketwillpayahigherP/Eratioforthestockof
alarger,lessriskyfrm.
Proftsmayalsoincreasewhenaresource-poorcompanyacquiresaresource-
richcompanybecausethemarginalvalueofthatresourceisgreaterfortheresource-
poorcompany.Thus,thereareoilcompanieswithwidedistributionnetworks
acquiringfrmswithlargeamountsofoilreservesbutinadequatedistribution
systems.
TaxImplications
Atax-losscompanymightacquireaproftablecompanyinordertouseitstaxloss,
oraproftablefrmmightacquireatax-losscompany.(Totakeadvantageofthe
loss,thelosscompanymustbeoperated;itcannotbeacquiredjustforthetaxloss.)
Thetaxmotivationforamergerissometimesnotapparenttothepublicsince
bothfrmsinvolvedarereportingincomes.Itmustberememberedthatafrmwith
accountingincomemightstillhaveataxloss.
Frequently,acquisitionsofprivatelyownedfrmsoccurbecausetheowners
oftheacquiredfrmwanttopreparetheirestatesfortheinevitablemomentof
death.Thereareadvantagestoanestateinhavingmarketablestockwhosevalue
isrelativelyeasilydetermined,ratherthanhavingpartialownershipinaprivately
ownedcorporation.Inthelattercase,itisnecessarytoestimatethevalueofthefrm,
andthisvaluationprocessisfarfrombeingasobjectiveasastockmarketprice.
Growth
Thequestionmightbeaskedastowhyafrmwouldacquireanotherfrmwhen
theacquiringfrmcouldentertheindustrybydevelopingitsownproductand
productivefacilities.Acquisitionismuchfasterandsometimessaferthan“doing
ityourself.”Managementhasitsownreasonsforwantingrapidgrowth.Growth
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throughmergerandacquisitionmeansmorepowerandprestigeaswellasthe
potentialforhighersalariesandbonuses.
Size
Sizeitselfmaybeoneofthereasonsforamerger(nottheonlyreason,itis
hoped).Sizeisthoughttoreducefnancingcostsandmayofferbargainingpower
innegotiatingwithsuppliers.
Itisalsopossiblethatsomemanagersvaluesizeasrefectingatypeofpersonal
achievement,butthisisnotlikelytobeasignifcantfactorasageneralexplanation
ofmergers.
Anti-RaidingManeuver
Somemergerstakeplaceinordertofghtoffotherraiders.Areluctantbridemight
wellpreferafriendlymarriagetoawhiteknightratherthansuccumbtoaraidby
ablackknight.Managersarepeople,anditisreasonabletoexpectthattheywill
fearnotbeingabletocontinueastheydidinthepast.Theywouldliketochoose
theirnextboss.Thisdesiremaygiverisetoamergerwithafriendlyfrm(awhite
knight),eventhoughthenumberonechoice(iffeasible)wouldbetocontinuewith
unchangedoperations.
DifferentExpectations
Ifthemanagersandownersoftwofrmshavedifferentexpectations,theywill
computedifferentvalues,andthismightcreateasituationwhereanexchangecan
takeplace.
Otherfactorsthatcreatesuchasituationaredifferentperceptionsofthetime
valueofmoney(ordifferentactualtimevalues)anddifferentriskattitudes.Dif-
ferentopinionshelptocreatemergers.
AntitrustConsiderations
TheU.S.JusticeDepartment,theFederalTradeCommission,andtheEuropean
Unionactaswatchdogstopreventmergersthattendtolessencompetitionortend
tocreateamonopoly.Therearesomewhowouldalsolikethemtopreventthe
largestfrmsintheeconomyfromacquiringanysmallerfrmsinanyindustry.
Sinceittendstolessencompetitionorcreateamonopoly,thepreventionofany
mergeroracquisitionwillobviouslybeajudgmentcallifthetwofrmsinvolvedare
inthesameindustry.Well-defneddistinctionsbetweenlegalandillegalmergers
areverydiffculttodefne.Theapplicationoflawsdependstoalargeextentonthe
politicalandphilosophicalleaningsofthepersonsadministeringthelaw.
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Itisreasonabletoexpectthataconglomerateacquisition(unrelatedbusinesses)
willbemorelikelytobeapprovedbytheGovernmentthanwillahorizontal
acquisition(say,adepartmentstorechainacquiresanotherdepartmentstorechain).
Averticalintegration(eitherintegratingbackwardbyacquiringamaterialorparts
supplierorforwardbyacquiringasalesoutlet)willtendtobelessacceptablethan
aconglomerateacquisition,butmoreacceptablethanahorizontalacquisition.
AcquisitionforCash
Afrmfndingitselfwithextracashabovethatrequiredfornormaloperations
essentiallyhasfourchoices:
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,anyoftheabovecanalsobefnancedbyraisingnew
capital.
Wewillconcentrateinthefollowingsectionsonthemergeralternativeusing
eitheraccumulatedcashornewcapital.Theobjectiveisassumedtobetoincrease
value.Thefrststepwillbetodeterminethepremiumthattheacquiringfrmcan
affordtopay.
DeterminingthePremium
Wewanttodeterminehowmuchcashafrmcanofferforanacquisitionwhenas
analternativeitcanpayacashdividendanditsinvestorscanbuysharesofthe
samefrminthecapitalmarket.Wewillassumethattheinvestor’sobjectiveisto
acquirethesharesofcommonstockinthefrmbeingacquired.
Let
P
0
bethecurrentmarketpriceofthefrmtobeacquiredand
x
equalthe
stockpricemultiplier.Theinvestor’staxrateis
t
p
.Thebidpriceisdefnedtobe:
Bidprice
=
xP
0
.
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Assumethatafrmhas
D
availableeitherforreinvestmentorforacashdividend.
Tomaketheinvestorindifferenttoretentionoradividend,wewantthesamenumber
ofsharespurchasedwithretentionaswithdividend(weinitiallyassumethatcapital
gainsanddividendsearnedbyacorporationarenottaxed).
Thesharestobepurchasedbytheinvestorwiththeafter-taxproceedsofacash
dividendof
D
are
N
=
D(
1
−
t
p
)
P
0
,
where
P
0
isthecurrentcommonstockpriceand
t
p
isthetaxontheinvestor’s
ordinaryincome.
Withretentionandabidpriceof
xP
0
,thesharespurchasedbythefrmwith
the
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$40andthatthisisits
value.Let
t
p
=
0
.
6.Tocompareadividendandfrmacquisition,wefrstcompute
thestockpricemultiplierthatresultsinindifference.
x
=
1
1
−
t
p
=
1
0
.
4
=
2
.
5
.
Bidprice
=
xP
0
;
2
.
5
×
$40
=
$100pershare
.
Withadividendof$100,theinvestorsnet$40aftertax.Thecashbuysoneshare
withataxbasisof$40.Withretainedearningsof$100,thefrmcanpay$100
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pershareforoneshare.Thetaxbasisis$0fortheinvestorsand$100forthe
corporation.
Ifthe$100isretainedand$100ispaidbythecorporationforashare,then
onesharecanbepurchased.Ifthe$100ispaidasacashdividend,the$60of
taxispaidandasharecanbepurchasedfor$40.Thecompanycanpay2.5times
thecurrentmarketpriceandleavethetaxableinvestorwiththesamenumberof
sharesofstockoftheacquiredfrmasiftheinvestorhadpurchasedthestock
directly.
Thisanalysisignoresthecapitalgainstaxthatwouldtakeplaceonsaleand
assumesthatthealternativetoretentionbythefrmisacashdividend.
AHoldingCompany
Althoughholdingcompaniesarenotawidelyusedformofbusinessorganization,
itisnotunusualtoseeachainoffrmsowningeachother.
Example15.2
AssumeAownsBwhichownsCwhichownsDwhichownsE.Thecommonstock
ofAis$10,000.Mr.Jonesowns51percentofA’scommonstockfnancedwith
borrowedfunds.
ABCDE
Assets$50,000$500,000$5,000,000$50,000,000$500,000,000
Debt40,000400,0004,000,00040,000,000400,000,000
Commonstock10,000100,0001,000,00010,000,000100,000,000
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.
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ConsolidatedBalanceSheet
Debt$444,440,000
Commonstock,minorityinterest55,550,000
Commonstock10,000
$500,000,000
Thisisanextremecase,sinceallofA’sassetsconsistofstockinB,allofB’sassets
consistofstockinC,etc.
EBITandEBITDA
Twoproftabilitymeasuresnotnormallypresentedbytheaccountantsbutwidely
usedbyfnancepeopleandmanagersareEBIT(earningsbeforeinterestandtaxes)
andEBITDA(earningsbeforeinterest,taxes,depreciationandamortization).Pri-
vateequityfrms,inparticular,usethesemeasuresindeterminingthevalueofa
prospectiveacquisition.
EBITisparticularlyusefulwhenthecapitalstructureoftheacquisitioncan-
didateisfnancedwithdebt,sincetheamountoftaxesisreducedtoclosetozero
andEBITismorerelevantthanafter-taxearnings.
EBITDAisacashfowmeasureofoperations.Ifthecapitalexpenditures
havealreadybeenmade,eliminatingthedepreciationandamortizationdeductions
incomputingthepositivefowsfromoperationsissensible.Ifadditionalcapital
expenditureswillbeneededinthefuture,thenthefnalvaluationshouldrefect
theseasadditionaloutlays.
ValuationforAcquisition
Thefourbasicmethodsofvaluatingafrmforacquisitionare:
1.Present value of cash flow
Present value of earnings
2.Earnings or other flows P/E multiplier or earnings
1
−
b
k g
×
−
Multiplier of EBIT or EBITDA
Book value
3.Assets – liabilities Market values (liquidation value)
Replacement cost
4.Stock price: present and past
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Thecashfowapproachtovaluationtreatsafrmbeingconsideredforacquisition
thesameasanyrealasset.Thecashfowsaretherelevantinput.
Sinceafrmhasanearningshistory,thereisatemptationtousetheearnings
astheinput.Onecancomputethepresentvalueoftheearnings.Ifinterestonall
capitalissubtractedincomputingtheearningsofeachyear,thepresentvalueof
theearningswillbethesameasthenetpresentvalueofthecashfows.
Analternativevaluationapproachusingearningsistomultiplytheearningsby
aprice/earningsmultiplier.Thebasicvaluationmodelis
P
=
D
k
−
g
=
(
1
−
b)E
k
−
g
.
Ifwemultiply
E
(theearningspershare)by
(
1
−
b)
(k
−
g)
,where
1
−
b
=
theretentionrate
k
=
therequiredreturn
g
=
thegrowthrate
,
weobtainthevalueofashare.Thiscanbemadetobeequivalenttocomputing
thenetpresentvalueofthecashfowsandthepresentvalueoftheearnings,ifall
theinputsareconsistent,buttheequivalencyshouldnotbeassumed.Ifwedivide
bothsidesby
E
,wehaveforthe
P
/
E
multiplier
P
E
=
1
−
b
k
−
g
.
Insteadofusingtheincomefows,someanalystsprefertouseotherfowmea-
sures(e.g.,EBITorEBITDA).Insteadofusingfows,onecanalsousetheassets
andtheliabilitiesforvaluation.Theeasymeasurestousearethebookvalues(the
dataarereadilyavailable),buteithermarketvalues(includingliquidationvalues)
orreplacementcostsarelikelytobemoreuseful.Notconsideringthefowsisnot
recommended.
Withtheacquisitionofafrmwhosestockistradedonamarket,thepresent
andpaststockpricesarerelevant.Investorswillconsideranyofferinrelationto
thecurrentstockpriceandarelikelytocompareanyoffertotherecentpastprices
(eventhoughpastpricesarenotrelevantinatheoreticaleconomicsense).
OtherFactorstobeConsidered
Theexistenceofassetsthatcanbesold,ordebtcapacitythatisavailable,will
affectthevalueofanacquisition.Someassetswillnotberecorded(e.g.,recent
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knowledgeacquiredthroughresearch)orwillbestatedonthefnancialstatements
atunderstatedcosts(e.g.,land).
Animportantconsiderationformanagementisananalysisoftheeffectofthe
acquisitionontheriskinessofthefrm.Thiswillbehighonmanagement’slistof
relevantconsiderations.
TheP/ERatio
Wewanttoinvestigatethefnancialeffectsofahigh-P/Eratiofrm(P)acquiringa
low-P/Efrm(S).Table15.1showsthefnancialinformationforthetwofrmsand
fortheircombination.
Example15.3
IfPgives25,000shareshavingamarketpriceof$80pershare(havingatotal
valueof$2,000,000)forS,therewillbe125,000sharesoutstanding.Whatistheir
valueiftheearningspershareis$11.20?
ItisincorrecttoarguethattheP/EofP+SwillbethesameastheP/EofP,
leadingtoapriceof$11
.
20
×
8or$89.60.Thenewprice/earningsratiocanbe
expectedtobeaweightedaverageoftheoldP/Eratios,wheretheweightsare
thetotalearningsofeachofthecompaniesdividedbythetotalearningsofboth
companies.
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$10,000,000
Totalearnings$1,000,000$400,000$1,400,000
Numberofshares100,000100,000125,000
Earningspershare$10$4$11.20
Marketprice$80$20$80
P/Eratio8
×
5
×
7.143
×
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ThisleadstoamarketvalueofashareofP
+
Sequalto7.143($11.20)
=
$80.The
totalmarketvalueis
$80
(
125
,
000
)
=
$10
,
000
,
000
,
whichisequaltothesumofthevaluesoffrmsPplusS.Valueisbeingneither
creatednordestroyedbytheacquisition.
Withnochangeinoperations,expectations,orpayouts,thepost-acquisitionP/E
ratioshouldbeaweightedaverageofthepre-acquisitionP/Es,wheretheweights
aretherelativeamountsofearningsofeachcomponent.
TounderstandbetterthelogicofwhytheP/EoffrmP
+
Sislessthanthat
offrmP,wewilldeterminetheimpliedgrowthratesforPandforS.Table15.2
showsthecurrentdividend,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$2.00
Costofcommonstockequity(
k
e
)0.150.15
Retentionrate(
b
)0.40.5
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Withzerodebt,andareturnoninvestmentof
r
fornewinvestments,then
g
=
rb
0
.
075
=
0
.
4
r
r
=
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
r
r
=
0
.
10
.
FirmShasalowergrowthratethandoesP;wealsoseethatSisexpected
toearnonly0.10onnewinvestments,whereasPisexpectedtoearn0.1875.P’s
higherP/Eratioimpliesthatthemarketismoreoptimisticaboutitsfuturegrowth
andearningsopportunities.
Each
P
/
E
ratioanddividendretentionpercentageimpliesadifferentgrowth
rate(andthusadifferentreturnonnewinvestment).Table15.3givesafewillus-
trativevaluesforaretentionrateof0.6anda0.15costofequitycapital.
Therelationship
g
=
rb
assumesthatthereiszerodebt.Ifwechangedthat
assumption,thegrowthrateformulationwouldbesomewhatmorecomplex.
Table15.3.
ImpliedGrowthRatesandReturns.
P/E
E
P
0
.
60
E
P
g
=
0
.
15
−
0
.
60
E
P
r
=
g
0
.
4
200.050.030.120.30
100.100.060.090.225
50.200.120.030.075
40.250.1500
Note:
b
=
0
.
4
;
k
e
=
0
.
15
;
g
=
k
e
−
(
1
−
b)
E
P
;
g
=
rb
.
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Thus,assumingthatafrmcanbeacquiredforitscurrentmarketvalue,itis
notimportantifthecurrentP/Eofthecandidateforacquisitionisaboveorbelow
theacquirer’sP/E.Itisimportantwhethertheacquisitioncanbeexpectedtoresult
inanincreaseintheacquirer’sP/Easaresultofachangeinoperations(changing
retentionratesordebtutilization),adecreaseinfnancingcosts(
k
i
and
k
e
)
,orreal
synergisticeffectssuchasbetterratesofreturnonreinvestmentordirectreduction
ofcost(highercurrentearnings).Iftheweightedaveragepost-acquisitionP/Eratio
exceedstheweightedaveragepre-acquisitionP/Eratio,orifearningsimprove,the
acquisitionwilltendtobebenefcialtostockholdersofboththeacquiredand
acquiringfrms.
DilutionofEarnings
Assumethatearningspersharearenow$1.20andthattheyaregrowingat5percent
peryear.Iftheacquisitiontakesplace,theearningspersharewillonlybe$0.80,
buttheexpectedgrowthratewillnowbe10percentperyear.Theearningsper
sharearediluted.
Howlongwillittakefortheearningswiththeacquisitiontoequaltheearnings
withouttheacquisition?Letbothsetsofearningsgrowfor
n
yearssothatthetwo
earningsareequal:
(
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
.
Manymanagerswouldstatethat8.716yearsistoolongtowaitforanuncertain
improvementinearningspershareandwouldrejecttheacquisition.
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TheCostofanAcquisition
Ifanacquisitionrequirestheissuanceof1,000,000shares,wherethesharesofthe
acquiringfrmbeforetheacquisitionannouncementweresellingat$80pershare,
thecostoftheacquisitioncanbedefnedtobe
$80
(
1
,
000
,
000
)
=
$80
,
000
,
000
.
Ifthereare3,000,000sharesoutstandingbeforetheacquisition,and4,000,000
sharesafter,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
,
000beforethe
acquisitionand$300,000,000aftertheacquisition,theoriginalstockholderswill
havea$60,000,000improvementintheirwealthposition(beforetax).Thetotal
valueofthefrmaftertheacquisitionisassumedtobe$400,000,000.
Althoughcommonstockisfrequentlyissuedforanacquisition,sincethetrans-
actioncanbenontaxabletotheinvestors,cash,debt,andpreferredstockarealso
used.
Ifinsteadofissuingnewcommonstockshares,intheexample,apurchaseprice
of$80,000,000cashispaidandifthefrm’svalueafteracquisitionis$320,000,000
(equalto$400,000,000minusthe$80,000,000purchaseprice),thenthestock-
holder’spositionwillnowimprovefrom$240,000,000to$320,000,000,foragain
of$80,000,000.
LeveragedBuyouts
Inaleveragedbuyout(LBO),afrmisacquiredbyagroupofinvestors.The
fnancingforthepurchaseischaracterizedbytheuseofalargeamountofdebt.
Therearetwobasictypesofleveragedbuyouts.Onetypeisengineeredbythe
currentmanagementwhosemembersbecomesignifcantstockholdersinthenew
frm.Thesecondtypeisstructuredbyoutsiders,butalmostinvariablytheywill
attempttoretainthemoreimportantmembersofmanagement.
AverylargeLBOofthefrsttypewastheacquisitionofMetromediaBroadcast-
ingCorporationbyagroupcalledJ.W.K.AcquisitionCorporation.Theacquisition
pricewasoverUS$1billion.Infact,MetromediaitselfissuedUS$1.3billionworth
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ofhigh-yieldbondstohelpfnancetheacquisition(thefundswereusedtobuyback
thecompany’scommonstock).Toplacethisamountofdebtinperspective,the
totalrecordedassetsofMetromediawasUS$1.3billion.J.W.K.AcquisitionCor-
porationwascontrolledbythemanagementofMetromedia.
Aslongasbanksandotherinvestorsarewillingtofnanceveryhighlyleveraged
acquisitions,LBOswillprosper.Theyareaveryimportantfnancialdevelopment
oftheendofthe20thandthebeginningofthe21stcenturies.
Greenmail
Historically,acorporation(oracorporatemanagement)fndingthatitwasbeing
pursuedbyanundesirablesuitor(ablackknight)wouldarrangetobuytheshares
heldbytheblackknightatapremiumprice.Theintentionsoftheraidermaybe
perfectlyhonorable,buttheperceptionsofthemanagementmightbedifferent.The
greenmailprocessisnotfairtoallshareholders.Oneselectgroupofinvestorsis
giventheopportunitytosellatapremiumprice.Congresspassedalawthatimposes
ataxpenaltyonanyfrmengagedingreenmailandthiseffectivelystoppedthe
process.Now,thesameoffertobuyhastogotoallshareholders.
GoldenParachutes
Ifthedefensivetacticsofatargetfrmhavenotworked,thenmanagement’sfnal
optionistohaveasafetynet.Acontractualagreementispreparedthatguarantees
amanageragivensumifhisorheremploymentisterminatedbecauseofan
acquisitionormerger(achangeofcontrol).
AccountingIssues
Itisnotunusualforacorporationtoownsharesofcommonstockinoneormore
othercorporations.Thepercentageofownershipmayvaryfromafewshares,repre-
sentingasmallpercentageofownership,to100percentofthesharesoutstanding.
Intheabsenceofanactualmerger,whenthepercentageofownershipislarge,
itisusuallydesirabletotreattheseparatecorporationsasiftheywereasingle
entity,resultinginconsolidatedfnancialstatements.Regardlessoftheextentof
theholdingsinvolved,wemustdeterminethemanneroftreatingintercorporate
investmentsonthebalancesheetandofrecognizingtheincomeattributableto
theseholdings.
AccountingforLong-TermInvestments
Assumethatonecorporationispurchasingsharesofcommonstockinasecond
corporationbutthatthepercentageofownershipisrelativelysmall.Inthissituation,
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itwouldnotbeappropriatetoconsiderthefnancialaffairsofthetwocorporations
asiftheywereonecorporation.
LetusassumethatCorporationAhaspurchasedasmallpercentageofthe
outstandingsharesofCorporationB.IfCorporationAviewsthesesharesasa
temporaryinvestment
,itwouldclassifytheinvestmentasamarketablesecurity(a
currentasset).Ifthesharesarea
long-terminvestment
,however,theaccount-
ingtreatmentissomewhatdifferent.CorporationAowningcommonstockin
Bmay:
a.Maintaintheinvestmentaccountatcost.
b.Adjusttheinvestmentaccountasmarketvaluechanges.
c.Recordtheinvestmentatthelowerofcostormarketvalue.
d.RecordtheinvestmentatcostandadjustforCorporationA’sequityinthesub-
sequentchangesinundistributedearnings(orlosses)ofCorporationB.
Eachoftheseprocedureswillnowbediscussed.
Cost
Theadvantageofusingcostisthatthecostoftheinvestmentmaybedocumented
withwell-defnedobjectiveevidenceandtheuseofcosthereisconsistentwith
thebasisusedtorecordotherlong-livedassets.Thedisadvantageofrecordingthe
investmentatcostisthat,withtime,costbecomesapoorestimatorofvalue.It
isnotsignifcantinformationforAtoindicatethatitpaid$100,000forsharesof
CorporationBstock30yearsago.Thecostislikelytohavelittlerelationshipto
thevalueofthesesharestoday.
HowistheincomeofAaffectedbytheincomeearnedbyB?Theuseofcost
torecordtheassetimpliesthatincomeisrecognizedasthedividendsarereceived
ontheshares.Butdividendsreceivedmaybeapoormeasureoftheeconomicgain
arisingfrompossessinganinvestmentinsecurities.Theproblembecomeseven
moreacutewhenthestockholdingsaresolargethattheinvestingcorporation
caninfuencethedividendpolicyofthecompanywhosestockitholds.Insuch
acase,itwouldbepossibletomanipulatethereportedearningsofCorporation
AbyalteringthedividenddistributionsofCorporationB.Therefore,thisincome
measuringprocedureshouldbeusedonlywhentheinvestorcorporationdoesnot
haveasignifcantinfuenceovertheaffairsofthecompanyinwhichtheinvestment
isheld.
Market
Recordingtheinvestmentatmarketvalueisanimprovementovertheuseofcost.
Themeasureoftheassetrefectswhatthemarketthinkstheinvestmentiscurrently
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AnIntroductiontoAccountingandManagerialFinance
worth.Ithasthecharacteristicofresultinginavaluationthatwillfuctuateasthe
stockmarketfuctuates.However,formanyinvestments,thereisnotaneffective
market.Thisistrueofwhollyownedsubsidiariesorwhereseveralcompaniesjoin
forcestoformasubsidiary.Inthesesituations,marketvaluationcannotbeused.
Nevertheless,insituationswhereawell-defnedmarketpricedoesexist,andwhere
theholdingscanbereadilysoldatthemarketprice(thiswouldnotbethecaseif
holdingswereverylargeorthemarketthin),themarketpriceprovidesthebest
measureofthefairvalueoftheinvestmentformostpurposes.
Ifmarketpricesareusedtorecordthevalueoftheinvestment,thenchanges
inmarketpricesmustberecognizedasaffectingthestockholders’equity.One
possibilityistotreatthechangeasincome(oraloss).Anydividendsreceivedare
recordedasrevenuewiththisprocedure.
Equity
Thefourthprocedure,usuallyreferredtoasthe
equitymethod
,retainsanobjective
basisforrecordingtheinvestment,yetdoesnotadheretooriginalcostasthe
measureoftheinvestment.Afterrecordingtheinvestmentatitsinitialacquisition
cost,adjustmentsaremadetorefecttheproportionateshareoftheearnings(or
losses)ofthecompanywhoseshareshavebeenpurchased.Therecognitionisnot
contingentonthedeclarationofadividend.
Thisprocedureisparticularlyappropriatewhenthepurchasingcorporationhas
controloftheothercorporationandcaninfuencetheamountofdividendspaid.
Theearningsoftheperiodprovideamoreobjectivemeansofdeterminingthe
economicbeneftsthataccruefromtheinvestmentinthissituationthandothe
dividends.
Whenearningsarereportedbythepurchasedcompany,aproportionateshare
oftheearningsisaddedtotheInvestmentaccountandrecognizedasrevenueby
theacquiringcompany.Whendividendsarereceived,theyarenotconsideredto
berevenue.Therevenuehasalreadybeenrecognizedbasedontheequityinthe
earningsofthecompany.Thereceiptofcashisrecordedasanexchangeofassets—
theInvestmentaccountisreducedandCashisincreased—butthereisnoeffect
onincome.
ConsolidatedFinancialStatements
Whenthepercentageofownershipofonecompanyinanotherislarge,itisoften
desirabletoprovidestatementsshowingtheoperatingresultsandfnancialposition
asthoughtheseparatecorporationswerecombinedintoasingleoperatingunit.
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Such
consolidatedfnancialstatements
frequentlyreplacethesingle-company
statementspreparedinthemannerdescribedinthepreviouschaptersofthisbook.
Theconsolidatedstatementsareregardedassoimportantthattheyovershadowthe
fnancialstatementsoftheseparatecorporations,andmanycorporationsprovide
onlytheconsolidatedstatementsintheirannualreports.
Whenonecorporationownsasubstantialproportionofthesharesofanother
corporation,theinvestingcorporationiscalledthe
parentcorporation
.Anycor-
porationsinwhichithassubstantialinvestmentsareknownas
subsidiaries
.In
preparingconsolidatedstatements,theaccountantignoresthelegalfactthatthe
companiesareeachseparateentities.Instead,thecompaniesaretreatedasthough
theywereasingleentityandtheaccountingtreatmentisadjustedaccordingly.
Takingtheeconomicpointofview,itisreasonabletocastasidethelegalfction
ofseparateentitiesandcombinethefnancialaffairsofseveralcorporationswhen
thecorporationsdo,infact,operateasasingleunit.
AccountingAssumptions
Theconsolidatedstatementsarebasedoninformationcontainedintheseparate
companystatements.Adjustmentsarelikelytobenecessaryforpurposesofcon-
solidatingtheaffairsoftheseveralcorporations.Forexample,theinvestmentin
subsidiariesisshownasanassetonthestatementsoftheparentcompany.This
wouldbetrueofanyofthebasicmethodsdescribedinthefrstpartofthischapter.
Whenthecompaniesareconsolidated,theoriginalinvestmentoftheparentandthe
correspondingportionofthestockequityofthesubsidiaryatthetimeofpurchase
mustbeeliminated.Thesetwoitemsareredundantfromtheconsolidatedentity
viewpoint,becausethenetassetsofthesubsidiaries(whichtheInvestmentaccount
represents)willbeincludedintheassetsofthecombinedunit.
Theparentcompany’sshareofstockequityofthesubsidiaryasofthedateof
stockpurchasemustbeeliminatedbecauseitdoesnotrepresentanoutstanding
capitalelementoftheconsolidatedcompany.Fromtheconsolidatedentitypoint
ofview,itisakintotreasurystock.TheInvestmentaccountmustbeeliminated,
becausetheconsolidationprocedureseffectivelychangethepurchaseofcommon
stockintothepurchaseofassetsandtheassumptionofliabilities.Itwouldbedouble
countingtoincludeboththeparentcompany’sinvestmentandthesubsidiary’snet
assetsintheconsolidatedstatement.
Theneedforanotheradjustmentariseswhenthesubsidiarysellsgoodstothe
parent(ortheparenttothesubsidiary).Proftisrecognizedatthetimeofasale
tooutsiders.Fromtheseparatecompanypointofview,theparentcompanyis
anoutsidertothesubsidiaryandviceversa.Inaccountingfortheseparatelegal
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entities,then,itisappropriatetorecognizeproftsonsalestransactionsbetween
thetwocompanies.Whenthetwocompaniesaretreatedasasingleentity,how-
ever,adjustmentsmustbemadeforintercompanysalestransactions.Theyarenow
consideredtobemeretransferswithinthesameorganization,andnoproftisrec-
ognized.Theproftthathasbeenrecognizedintheseparatecompanyaccountsfor
suchtransactionsmustthereforebeeliminatedwhenconsolidatedstatementsare
prepared.
ConsolidatedBalanceSheets
Thepreparationofaconsolidatedbalancesheetrequiresthecombiningofvarious
accountbalancesoftheseparatelegalentities.Beforesuchcombinationscanbe
accomplished,however,certainadjustmentsandeliminationsmustbemadein
thedata.
Althoughwewilldescribetheseadjustmentsintermsofaccountingentries,
itshouldbepointedoutthattheseentriesareforworksheetpurposesonlyand
arenotrecordedinthejournalsofeithercompany.Fromthelegalpointofview,
itistheconsolidatedentitythatisanaccountingfction,amerecreatureofthe
accountantdesignedtoprovideeconomicinformationinarelevantcontext.Thus,
theconsolidatedentitydoesnotexistinastrictlegalsense,althoughitisconvenient
toassumeitsexistenceforthepurposeofprovidinginformation.
Thefrstexamplewillassumethattheparent,CompanyA,haspurchased100
percentofthecommonstockofCompanyB.Forsimplicity’ssake,theamount
paidinthisexamplewillbeequaltothebookvalueofthestock.
Example
CompanyAbuys100percentofthecommonstockofCompanyBfor$10,000.
Immediatelyafterthepurchase,theseparatebalancesheetsofthetwocompanies
appearasfollows:
CompanyA
BalanceSheetasofDecember31,20xx
Assets
LiabilitiesandStockholders’
Equity
InvestmentinCompanyB$10,000Liabilities$15,000
MiscellaneousAssets30,000CommonStock20,000
RetainedEarnings5,000
TotalAssets$40,000
TotalLiabilitiesand
Stockholders’Equity$40,000
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CompanyB
BalanceSheetasofDecember31,20xx
Assets
LiabilitiesandStockholders’
Equity
MiscellaneousAssets$18,000Liabilities$8,000
CommonStock7,000
RetainedEarnings3,000
TotalAssets$18,000
TotalLiabilitiesand
Stockholders’Equity$18,000
Thefrststepinpreparingtheconsolidatedbalancesheetistoorganizethedata
fromtheseparatestatementsinaworksheet.Thisisdoneinthefrsttwocolumns
ofthefollowingworksheet.Wethenproceedwiththenecessaryeliminationsand
adjustments,andaddtheremainingitemstoobtaindatafortheconsolidatedbalance
sheet(theright-handcolumnoftheworksheet).
Eliminations
AccountsCompanyACompanyBDr.Cr.
Consolidated
Balance
Sheet
Miscellaneous
Assets
$30,000$18,000$48,000
Investmentin
Co.B
10,000
(1)
$10,000
$40,000
$18,000
$48,000
Liabilities$15,000$8,000$23,000
Common
Stock
20,0007,000(1)20,000
$7,000
Retained
Earnings
5,000
3,000
(1)
5,000
3,000
$40,000$18,000$10,000$10,000$48,000
TheeliminationentryisacredittotheInvestmentaccountofCompanyAto
eliminatetheinvestmentinCompanyB(butleavingtheassetsofCompanyB)
anddebitstoeliminatethestockequityofCompanyBasofthetimeofpurchase.
Letusassumethattheeliminationentrywasnotmadeandthattheconsolidated
balancesheetwaspreparedbynaivelyaddingtheasset,liability,andstockequity
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accountsofthetwocorporations.
MiscellaneousAssets$48,000
InvestmentinCo.B10,000
$58,000
Liabilities$23,000
CommonStock27,000
RetainedEarnings8,000
$58,000
Theformerstatementshowstotalassetsof$58,000,butthisincludesadouble
countingof$10,000ofB’sassets,becausenotonlyaretherealassetsofCompany
BincludedbutalsotheinvestmentofCompanyAinCompanyB.Thevalueofthe
investmentofAinBisderivedfromtheassetsthatarealreadyincluded;thus,to
includetheinvestmentagainwouldbedoublecounting.Inlikemanner,thestock
equityisoverstatedby$10,000,becausenotonlyaretherightsoftheinvestment
ofAinBincludedbutalsotherightstotheassetsofB,andthisisalsocounting
thesamethingtwice.
Basedonthefguresshowninthelastcolumnoftheworksheet,theconsolidated
balancesheetwouldappearasfollows:
CompanyAandSubsidiary
ConsolidatedBalanceSheetasofDecember31,20x1
Assets
LiabilitiesandStockholders’
Equity
MiscellaneousAssets$48,000Liabilities$23,000
CommonStock20,000
RetainedEarnings5,000
TotalLiabilitiesand
TotalAssets$48,000
Stockholders’Equity$48,000
ComplicationswouldbeintroducedifCompanyApurchased100percentof
thecommonstockatapricedifferentfromthebookvalueofthestockequityof
CompanyB.Forexample,ifCompanyAhadpaid$12,000forstockwithabook
valueof$10,000,thiswouldindicatethatCompanyAthoughttherewas$2,000
ofintangiblevaluessuchasgoodwillorthattheotherassetswereundervalued.If
theformerisassumedtobetrue,theeliminationentrywouldbe:
CommonStock—B.............................7,000
RetainedEarnings—B...........................3,000
Goodwill........................................2,000
InvestmentinCo.B............................12,000
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Again,theinvestmentandthestockequityofCompanyBareeliminated.Inthis
situation,anintangibleassetof$2,000isrecognizedinasmuchasCompanyApaid
$2,000morethanthebookvalueoftheassets.Ifwecantracetheexcessofthe
purchasepricetospecifcassetaccounts,thenthoseassetaccounts,ratherthanthe
Goodwillaccount,shouldbedebited.
InsteadofincreasingspecifcassetaccountsorcreatingaGoodwillaccount,
thedifferencebetweentheamountpaidandthebookvalueofthestockhold-
ers’equityissometimesdebitedtoanaccountcalledExcessofInvestmentCost
overBookValue.Thisaccountisthentreatedasanoncurrentasset.Thedisad-
vantageofthisprocedureisthatitresultsinapoorlydefnedassetitemthatthe
averagereaderoffnancialreportswillhavediffcultyininterpreting.Itisbetter
fortheaccountanttomakethedecisionastowhethertheamountpaidinexcess
ofbookvalueisaresultofundervaluationofspecifcassetsorthepresenceof
goodwill.Ifassetsareunderstated,theyshouldbewrittenuptoarealisticvalue.
Ifthereareintangiblesconnectedwiththeutilizationoftheassets,resultingin
theexpectationofhighfutureearnings,itisreasonabletorecordtheamountas
goodwill.
AssumethatCompanyAhadpaid$8,000forthecommonstock.Thisisan
amountlessthanthebookvalue.Thebookvalueoftheassetsisoverstated,and
thereisatypeofnegativegoodwill.Negativegoodwillindicatesthattheearning
poweroftheassetsisactuallylessthanwemightexpectfromassetsofthisnature
or,equivalently,thattheassetsareoverstated.Theeliminationentrymightbe:
CommonStock—B.............................7,000
RetainedEarnings—B...........................3,000
InvestmentinCo.B............................8,000
ExcessofBookValueoverInvestmentCost.......2,000
ThecredititemExcessofBookValueoverInvestmentCostwouldnotappearon
thebalancesheet.Itshouldbeallocatedamongtheidentifableassets,reducing
assetstotheirvalueatthetimeofacquisition.Asexplainedearlier,itis,ina
sense,negativegoodwill.InsteadofcreditingtheamountExcessofBookValue
overInvestmentCost,wemaycreditthespecifcassetsthatareovervalued.This
isappropriateifweareabletoidentifytheassetsthatareoverstated.Ithasthe
doubleadvantageofbeingmorestraightforward,thuseasiertounderstand,aswell
aspresentingbetterinformationrelativetothevaluationoftheassetsowned.
MinorityInterest
AnothercomplicationariseswhenCompanyApurchaseslessthan100percent
ofthecommonstockoutstanding.Thisgivesrisetoa
minorityinterest
inthe
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AnIntroductiontoAccountingandManagerialFinance
consolidatedcorporation.Ifweassumethesamesituationasthepreviousone,
exceptthatCompanyApurchases80percentofthecommonstockfor$8,000,the
eliminationentrieswouldbe:
CommonStock—B.............................7,000
RetainedEarnings—B...........................3,000
InvestmentinCo.B............................8,000
MinorityInterest...............................2,000
TheminorityinterestwouldappearontheconsolidatedbalancesheetofCom-
panyAbetweentheliabilitiesandthestockholders’equity,oraspartofthestock-
holders’equitysection.Itrepresentstheinterestofoutsidestockholdersofthe
subsidiaryintheassetsoftheconsolidatedcorporation.
Intheexamplecited,ApaidanamountequaltothebookvalueofBtimes
thepercentageofownershipacquiredbyA(thepercentageofownershipbeing
measuredbythefractionofcommonstocksharesitacquired).Letusnowassume
thatApaid$12,000for80percentownershipinB.Therearetwopossiblemethods
oftreatingthissituation.
IfApaid$12,000for80percentoftheownership,thenthevalueoftheentire
stockholders’equitycouldbeinferredtobe$15,000.Let
X
equalthevalueof
B;then,
0
.
8
X
=
$12
,
000
,
X
=
$15
,
000
.
Thebookvalueofthestockholders’equityis$10,000;thus,thereis$5,000of
goodwill(oranyoftheotherpossibleinterpretationspreviouslydescribed).The
followingeliminationentrymightbemade:
CommonStock—B.............................7,000
RetainedEarnings—B...........................3,000
Goodwill........................................5,000
InvestmentinCo.B............................12,000
MinorityInterest...............................3,000
Theminorityinterestisequalto20percentof$15,000,theinferredvalueof
CompanyB.
Theforegoingtreatment,whichassumesitisappropriatetoadjustthetotal
assetsofB,isreasonable.Incurrentpractice,however,accountantsrecognize
goodwillonlytotheextentthatithasbeenpaidfor.Thus,theywouldrecordonly
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313
$4,000ofgoodwill.The$4,000iscomputedasfollows:
InvestmentbyA$12,000
EquityinIdentifableAssetsofB(80%oftotalvalue)8,000
Goodwill$4,000
Inthiscase,thefollowingeliminationentrywouldbemade:
CommonStock—B.............................7,000
RetainedEarnings—B...........................3,000
Goodwill........................................4,000
InvestmentinCo.B............................12,000
MinorityInterest...............................2,000
Theminorityinterestisequalto20percentofthe$10,000bookvalueofthe
stockholders’equityofCompanyB.
Thesecondtreatmentassumesthatitisreasonabletorecordthegoodwillfor
theportionofthefrmpurchasedbytheparent,butitisnotreasonabletorecord
thegoodwilloftheminorityinterest.Thisisconsistentwiththeusualaccounting
conventionofrecordingintangibleassetsonlywhentheyareexplicitlypurchased.
Thevalueofgoodwillrelatingtotheminorityinterestmaybeimputedfromthe
parentcorporation’spurchase,butinasmuchastheminorityshareholdersdidnot
explicitlypayforgoodwill,itisnotrecordedunderthisassumption.
Inthefollowingexample,weshallassumethatApaid$5,600for80percent
ownership.Again,therearetwopossiblemethodsofrecordingthissituation,but
weshallillustrateonlytheprocedurethatassumesitisappropriatetoadjustthe
assetvaluationcompletely.Wefrstfndthevalueofthestockholders’equity.If
80percentisworth$5,600,thentheentirestockholders’equityisworth$7,000
(insteadofthebookvalueof$10,000).Theeliminationentrywouldbe:
CommonStock—B.............................7,000
RetainedEarnings—B...........................3,000
InvestmentinCo.B............................5,600
ExcessofBookValueoverInvestmentCost.......3,000
MinorityInterest...............................1,400
Theminorityinterestisequalto20percentof$7,000,theinferredvalueofthe
stockholders’equityofCompanyB.TheExcessofBookValueoverInvestment
Costwouldbeallocatedtothevariousspecifcassetsandliabilitiesinpreparing
theconsolidatedstatement.ThespecifcassetsofBareassumedtobeoverstated
intheaggregateby$3,000.
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IntercompanyTransactions
Inadditiontotheentrieseliminatingtheinvestmentoftheparentinthesubsidiary
andthestockholders’equityofthesubsidiary,theremaybeintercompanytransac-
tionsthatrequireeliminationentries.Forexample,BmaybeindebttoA.Assume
BowesA$2,000.Theeliminationentrywouldbe:
AccountsPayable—B...........................2,000
AccountsReceivable—A......................2,000
FailuretoeliminatethereceivableonthebooksofAandthepayableonthebooks
ofBwouldbelikeahusbanddeclaringhimselfamillionairebecausehiswifelost
thatsumtohiminaginrummygame.Forintrafamilypurposes,thedatamaybe
ofinterest;butinaconsolidatedstatement,whichtreatsthecombinedoperations
asasingleunit,thereceivableandpayableoffsetoneanother.
IfBdeclaresacashdividend,AandBmightrecordthedeclarationintheir
accounts.Thefollowingeliminationentrywouldberequiredifthedividendhas
beendeclaredandrecordedbybothpartiesbutnotyetpaid(assumethetotal
dividendis$4,000,ofwhich$3,200willgotoA):
DividendsPayable—B...........................3,200
DividendsReceivable—A......................3,200
IfAhassoldaproducttoB,someofwhichisstillinB’sinventory,andthereis
anelementofproftinthepricechargedbyA,itisnecessarytoeliminatetheproft
fromtheinventoryofBandfromtheretainedearningsofA.AssumeAhasmade
aproftof$0.25perdollarofsale,andthatBhasinventorythatwaspurchased
fromAatacostof$4,000.Itisnecessarytomakethefollowingeliminations:
RetainedEarnings—A...........................1,000
Inventory—B.................................1,000
Thisentryeliminatesthe$1,000ofintercompanyproftsfromtheinventoryofB
andtheretainedearningsofA(thedebitcouldbetotheIncomeSummaryofA).
Inthepresenceofa20-percentminorityinterest,someaccountantswould
maketheforegoingentry,butsomewouldeliminateonly80percentoftheproft
intheinventory.Theywouldcontendthatproftisrealizedtotheextentofthe
minorityinterestshare.Theminorityinterestisthusviewedasan“outsider”bythe
company.Otheraccountantsarguethatifthesaleweremadefollowingthesame
proceduresasifthecompanieswereseparateentitiesandnotparentandsubsidiary,
thennoneoftheproftshouldbeeliminated(thiswouldbeconsistentwithalegal
interpretationoftheentity).Incurrentpractice,theentityconceptprevails,which
November6,200913:44spi-b8119inx6inb811-ch15
MergersandAcquisitions:Consolidations
315
suggeststhatalloftheintercompanyproftswouldbeeliminated,regardlessofthe
minorityinterest.
Whenadebtexistsbetweenaparentandsubsidiary,theentireamountof
thedebtiseliminateddespitethepresenceofminorityinterests.Thisshouldbe
interpretedasaruleestablishedforuniformity,becauseotherpossibleprocedures
mightbeequallyacceptablefromatheoreticalpointofview.Forexample,the
eliminationofafractionoftheamount(equaltothefractionofownership)could
bejustifed,becausetheinterestsoftheminoritystockholdersmakethedebtdueto
“outsiders”.Thiswouldnotbethecaseifthesubsidiarywere100percentowned
bytheparent.
Aprevalentassumption,whichsupportstheeliminationoftheentireamount
ofintercompanyprofts,isknownasthe
entitytheoryofconsolidations
.Withthis
assumption,theconsolidatedgroupisregardedasanentity,andtheminorityinter-
estsareconsiderednotas“outsiders”butaspersonswhohavecontributedcapital
tothecompleteenterprise.Thus,theirequityistreatedaspartofthestockhold-
ers’equityintheconsolidatedstatement,andalltransactionswithsubsidiariesare
handledasiftheywereentirelywithinthesingleunitwithno“outside”interests
involved.
ConsolidationinaLaterPeriod
Intheperiodsafterpurchase,thebasiceliminationentryforconsolidationisthe
sameastheonemadeatthetimeofpurchase.Thesignifcanceofthistreatmentis
thattheincomesearnedandretainedsincethepurchaseofstockarenoteliminated.
However,additionaleliminationentriesmaybenecessaryfordebtsowedbyoneof
thecorporationstoanotherorforproperrecognitionofothertransactionssuchas
theearningssinceacquisition.Also,therearecomplexitieswhenoneofthefrms
sellstoanotherfrm.Thesecomplexitiesarebeyondthescopeofthisbook.
TheSpin-off:SplittingtheCorporation
Justasitisdesirableforsomecorporationstomerge,itmaybedesirableforother
frmstodivestaunitorunits.Thereareseveralsituationswheredivestmentmay
logicallybedesirable.Inthefrstplace,theunitmaybemorevaluabletoanother
corporationbecausesynergyofsometypewouldresult.Infact,allthereasonsfor
mergersare,withslightadjustments,reasonsfordivestment.
Thereisanotherbasicreasonfordivestment.Assumeacorporationhasa
majorunitthatisnothealthy.Thefnancialdiffcultyofthemajorunitmayover-
shadowthefactthatotherunitsofthecorporationhaveexcellentprospects.In
November6,200913:44spi-b8119inx6inb811-ch15
316
AnIntroductiontoAccountingandManagerialFinance
suchasituation,bondcovenantsmightpreventthespinningoffofproftable
units,sincetheseunitsareamajorpartofthedebtsecurity.However,there
maybenoreasonwhyasuitablesplitofthedebtcannotbearrangedsothat
thedebtholdersareapproximatelyaswelloff(orbetteroff).Addingwarrantsor
conversionfeaturesisonemethodofaccomplishingtheacceptanceofacorporate
spin-off.
Athirdreasonfordivestmentexistswhenthecentralcoreofthecorporation
addsoverheadcostsbutlittleornovalue.Infact,itcanbethatthelargesizeof
thecorporationreducesmanagerialfexibilityaswellaspreventsidentifcation
byemployeeswiththewell-beingofthecorporation.Smallerorganizationalunits
standingontheirownbottomsmightcollectivelybemorevaluablethananentire
setofunitsoperatingasonecorporation.
Thereareseveraldifferentwaysofsplittingacorporation.Witha
spin-off
,the
shareholdersoftheparentreceivesharesintheunitbeingseparated(thistransaction
tendstobetax-freeandinexpensive).Witha
carve-out
,thesharesareissuedtothe
public(cashisraised).Witha
split-off
,theshareholderschoosetoconvertsomeor
alloftheirsharesintothesharesofthedivestedcorporation(theprocessprotects
theparent’sstockprice).
Conclusion
Theacquisitionofacorporationbyanothercorporationisaninvestmentdeci-
sion.Ifoneisconvincedthatinvestmentsshouldbeevaluatedusingthenet
presentvaluemethod,itwouldbedisconcertingifaninvestmentdecisioninvolv-
ingtheacquisitionofacorporateentitycouldbecorrectlymadeusingasimplistic
devicesuchasconjectingthechangeinthefrm’sP/Eratio.Itisnotclearthat
amanagementisabletoacquireafrmwithalowP/E(suchasafrmwithlow
growthopportunities)andfolditintoafrmwithahighP/Eandobtainaben-
eft,unlessthemarketassumesthatthegrowthratewillchangeunderthenew
management.
Wecanexpectthattheprospectofquickandeasyproftsarisingfromfnancial
wheelinganddealingwillsometimesgiverisetodecisionsmadefromthepoint
ofviewofshort-runconsiderationsratherthanfromthelong-termproftabilityof
thedecision.Wecannotforcemanagementtosetobjectivesofonetypeoranother.
Wecanhopethatabetterunderstandingofthesignifcanceofmergerswilllead
tobetteranalysisonwhichtobasedecisions.Justcombiningtwofrmsdoesnot
automaticallyleadtoanincreaseinvalue.
Mergersandacquisitionswillalwaysbewithusasonewayinwhicha
frmmaygrow(whiletheinvestorsoftheacquiredfrmchangethenatureof
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MergersandAcquisitions:Consolidations
317
theirinvestment).Wemayseethegovernmentdefninglimitationsonsituations
wherefrmsmaymerge,butitwouldbesurprisingtoseelegislationthatdis-
couragedmergersandacquisitionsoffrmsindifferentindustriesfromtaking
place.
Financialplannersmustconsiderthepossibilitiesofmergersandacquisitions
fromtwodifferentperspectives.Oneistheopportunitytoacquirenewfrms,and
theotheristhattheirfrmisapossiblecandidateforsomeoneelsetoacquire.Itis
extremelydiffcultformanagerstoviewamergercompletelyobjectively.Iftheir
frmisacquiringanotherfrm,theprocessislookedatasbeingbenefcialtoall
parties.Iftheirfrmisbeingacquired,theacquiringfrmisa“raider”.
Afrmwithunder-utilizedassetsandlittledebtthatisundertakingless-than-
proftableinvestmentsandhasoutstandinglargeamountsofpreferredstockisa
likelymergercandidate.Theforegoingreasonsmaynotallbevalid,butthesesit-
uationsdotendtoattractmerger-orientedfrms.Thefnancialplannershouldkeep
thisinmind.Hopefully,thedecisionsthataremadewillbeaimedatmaximizing
thewell-beingofthestockholders.
Therearemanymotivationsthatleadtomergersandacquisitions.Thepayment
ofalargepremiumovermarketpricedoesnotnecessarilyindicateanunwise
decisionbytheacquirer.Unfortunately,sometimesmanagementmightnotbeable
torevealallitsreasonsforofferingthelargepremium.Thus,stockholderunrest
canarisewheretherewouldnotbeunrestifallthefactswereknown.Buteven
worse,therecanalsobesituationswheremanagement’sanalysisisfaultyandthe
purchasepriceisexcessive.Timewillrevealwhichisthetruesituation.Looking
back,anyoneofuscanbewiserthanthewisestmanagertryingtomakemerger
decisionsunderconditionsofuncertainty.
ReviewProblems
ReviewProblem15.1
IfthecommonstockholdersofABDCorporationaretaxedat0.52andiftheybuy
XYZstockat$100,howmuchcouldthecorporationABDpayforXYZstockand
havetheinvestorsindifferent?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.Managementwantsto
substitute$100millionof0.12debtforcommonstock.
Whateffectwillthechangehaveonthevalueofthefrmtoazero-tax
investorwhoownsallthestock?Thecorporatetaxrateis0.35.
b.TheXYZCompanyisthinkingofacquiringafrmthatisearningbefore
tax$100,000ayear.TheborrowingrateofXYZis0.10,anditstaxrateis
0.35.Thus,itsafter-taxborrowingrateis0.054.Theinvestmentinthefrm
willbefnancedwithsuffcientdebttocausetheamountofincometaxes
paidtobezeroonthisinvestment.
WhatisthemaximumamountthatXYZcouldaffordtopayfor
thefrm?
2.Thefollowingfactsapplytotwocompanies,AandB,whoseoperationsare
completelyindependent.
AB
P/E205
Earningspershare$1$2
Sharesoutstanding10,000,0001,000,000
AssumethatAacquiresBinexchangefor500,000sharesofcommon
stock.
a.Whatwillbethenewearningspershare(EPS)forA?
b.WhatwouldyouexpectthenewP/EofA(afteracquisition)tobe?Assume
arationalmarket.
c.WhatwillbethetotalmarketvalueofA’scommonstockaftertheacquisi-
tion?Assumearationalmarket.
3.TheABCCompanyisconsideringacquiringtheDoggyCorporation.The
DoggyCorporationisearningbeforeinterestandtaxes$2millionper
yearandexpectstocontinuetoearnthat(forperpetuity),andithas
zerodebt.
TheABCCompanycanborrowatacostof0.10andwouldhaveacapital
structureof100percentdebtfortheDoggyCorporationifitacquiredit.The
corporatetaxrateis0.35.
Consideronlycorporatetaxes.WhatisthepresentvalueoftheDoggy
CorporationtotheABCCompany?Assumethatthefollowingcalculationis
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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.TheEPSofAwill
increaseimmediatelyasaresultoftheacquisition.
b.Continuing(a),theEPSforaperiod10yearsfromnowwillcertainlybe
largerforAasaresultoftheacquisition.
5.TheRSCompanyiscurrentlyearning$10pershareandexpectstogrowata
rateof0.05peryear.IfRSmergeswithTCompany,whichisgrowingat0.14,
theearningswillbereducedto$8pershareandthegrowthratewillbe0.09.
Inhowmanyyearswilltheearningspershareofthemergedfrmsequalthe
earningspershareofRSwithoutthemerger?
6.TheABCCompanyhasthefollowingcapitalstructure:
ProportionCostWeightedCost
Debt0.80.100.080
Commonstock0.20.160.032
0.112
ThecommonstockofacompanywithanidenticaloperatingriskasABC
canbeacquiredfor$1,000,000.Thestockholders’equitycashfowsofthe
acquisitionare:
012
−
$1,000,000$120,000$120,000Thebeneftsareaperpetuity.
Thissecondfrmhas$200,000ofdebt(netofanydisposableassets)paying
0.06($12,000)peryear.Therearezerotaxes.
ShouldtheacquisitionbeacceptediftheABCreturnsestablishtherequired
returns?
7.Distinguishbetweentheinformationsuppliedbyconsolidatedfnancialstate-
mentsandfnancialstatementspreparedforseparatecorporations(withfnan-
ciallinkages).
8.OnJanuary15,20xx,CompanyQpurchasedallthecommonstockofCompany
Yfor$40,000.Atthetimeofpurchase,thebalancesheetsofthetwocompanies
November6,200913:44spi-b8119inx6inb811-ch15
320
AnIntroductiontoAccountingandManagerialFinance
wereasfollows:
CompanyQCompanyY
OtherAssets$65,000$50,000
InvestmentinCompanyY40,000
$105,000
$50,000
Liabilities$30,000$10,000
CommonStock50,00025,000
RetainedEarnings25,000
15,000
$105,000
$50,000
PrepareaconsolidatedbalancesheetasofJanuary15,20xx.
9.OnDecember31,20xx,theOliverCorporationacquired100percentowner-
shipoftheStanleyCorporationbyissuing500,000sharesofcommonstock.
Thetwocompanieswerethenlegallymerged.ThemarketpriceofOliverCor-
porationstockwas$70pershare.Atthetimeofacquisition,thebalancesheets
ofthetwocorporationswereasfollows:
OliverCorporationStanleyCorporation
Assets$200,000,000
$40,000,000
Liabilities$95,000,000$5,000,000
CommonStock75,000,00010,000,000
RetainedEarnings30,000,000
25,000,000
$200,000,000
$40,000,000
a.Preparejournalentriestorecordtheacquisition,assumingtheStanleyCor-
porationceasestoexistasaseparatecorporateentity.
b.ShowthebalancesheetoftheOliverCorporationafterthemerger.
10.CompanyAbuys100percentofCompanyBfor$55,000.
AccountsCompanyACompanyBEliminations
Consolidated
BalanceSheet
OtherAssets$90,000$70,000
Investmentin
Co.B55,000
$145,000
$70,000
Liabilities$25,000$15,000
CommonStock40,00025,000
RetainedEarnings80,000
30,000
$145,000
$70,000
November6,200913:44spi-b8119inx6inb811-ch15
MergersandAcquisitions:Consolidations
321
11.CompanyCbuys100percentofCompanyDfor$130,000.
AccountsCompanyCCompanyDEliminations
Consolidated
BalanceSheet
OtherAssets$65,000$130,000
Investmentin
Co.D130,000
$195,000
$130,000
Liabilities$40,000$20,000
CommonStock65,00030,000
RetainedEarnings90,000
80,000
$195,000
$130,000
12.CompanyEbuys100percentofCompanyFfor$80,000.
AccountsCompanyECompanyFEliminations
Consolidated
BalanceSheet
OtherAssets$110,000$140,000
Investmentin
Co.F80,000
ExcessofBook
Valueover
Investment
$190,000
$140,000
Liabilities$70,000$40,000
CommonStock50,00045,000
RetainedEarnings70,000
55,000
$190,000
$140,000
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November6,200913:44spi-b8119inx6inb811-ch16
Chapter16
ConvertibleBonds
Weshallconsiderinthischapterdebtsecuritiesthatareconvertibleattheoption
oftheownerintoagivennumberofcommonstockshares.Thesesecuritiesdo
notclassifyneatlyasbeingeitherdebtorstockequity,sincetheyarehybrids
containingcharacteristicsofseveraltypesofsecurities.Thesehybridsecurities
tendtobediffculttovalue.Infact,oneoftheadvantagesofthesesecuritiesisthat
thecompanyissuingthemandtheinvestorsconsideringbuyingthemmayhave
differentestimatesofvalue.
Convertiblesecuritiesarepopularamonginvestorswhowantafxed(well-
defned)interestincomebutalsoanupsidepotential.Theconvertiblefeatureopens
upthepossibilityoflargegainsforinvestorsifthestockrapidlyappreciatesin
value.Thereisonlyasmallprobabilityoflargelossesbecauseofthesecurity’s
bondcharacteristics.Thebondfeaturetendstoguaranteeperiodicinterestpay-
mentsandthepaymentofprincipalatthegivenmaturitydate(ifthebondisnot
previouslyretired)ifthestockpricedoesnotincreasesuffcientlytojustifycon-
version.Theseconversionfeaturesarenotwithoutacosttoinvestors;convertible
bondscarryalowerinterestratethandocomparablebondswithouttheconversion
feature.Thisdiscussionofconvertiblesecuritieswillbeintermsofconvertible
bonds,eventhoughmuchofthediscussionalsoappliestoconvertiblepreferred
stock.
Considera$1,000facevalueorparvalue$1,000bondthatisconvertibleinto
20sharesofcommonstock.Theconversionpriceis$50pershare(equaltothe
facevalueof$1,000dividedby20).Ifthecommonstockpricegoesabove$50,
thentheconversionprivilegeisofthevaluetotheinvestorwhohastosell.For
example,ifthecommonstockiscurrentlysellingat$60pershare,theconversion
valueofthebondis$1,200.Themarketpriceofthebondwillbeatleast$1,200.
Theholderofthebondcanrealizeatleast$1,200onthesaleofthebond.Without
theconversionfeatureandwithnochangeininterestrates,aninvestorwouldonly
323
November6,200913:44spi-b8119inx6inb811-ch16
324
AnIntroductiontoAccountingandManagerialFinance
realize$1,000onsale(ifinterestrateshadfallensignifcantly,theinvestormight
beabletorealize$1,200ormore,evenwithouttheconversionfeature).
Apersonbuyingaconvertiblebondisreceivingtherightstofutureinterest
andprincipalpaymentsplustheprivilegeofconvertingtocommonstockifitis
desirable.Ifthepriceofthecommonstockincreasessuffcientlytojustifythe
conversion,thebondholderbeneftsfromtheconversionfeature.Theissuingcor-
porationbeneftsfromtheconversionfeaturebybeingabletoissuedebtwitha
lowerinterestratethanitwouldotherwisehavetopay.Inaddition,atsometimein
thefuturetheremaybeconversionofthedebtintocommonstock,thusdecreasing
theamountofdebtoutstanding,withoutmakingacashoutlayfortheprincipal.
Conversiontermsofabondmaychangethroughtimeeitherbecauseofbuilt-in
conditionsinthebondindentureorbecauseofstockdividendsandstocksplits.
Informedinvestorsinconvertiblebondswillinsistonprotectionagainstdilution
withstockdividendsandsplits.
Theperiodoftimeduringwhichtheconversionfeaturesapplymaynotbethe
sameasthebondmaturity.Itisimportantthatthebondcontractbereadcarefully
byaconservativeinvestorconsideringpurchasesoastoreducethenumberof
unpleasantsurprises.
DescriptionofConvertibleBond
Thefnancialcharacteristicsofaconvertiblebondcanbedescribedinthreedifferent
ways:
1.Itisabondwithacalloptiontoconverttocommonstock.
2.Itisthesumofitsexpectedvalueasdebtplustheexpectedvalueasstock.
3.Itiscommonstockwithdownsideinsuranceifthecommonstockdoesnotgo
upsuffcientlytowarrantconversion.
Letusassumethataveryriskycompanywantstoissuedebt,butitcannot
fndbuyersforitsbondsunlessitpaysmoreinterestthanitcanafford.Adding
aconversionfeaturemayattractinvestors.Forexample,ifthestockpriceis$40,
thebondscanbedefnedtobeconvertibleinto20shares(thereisa25-percent
conversionpremium).
Aconvertiblebondisahybrid.Itisadebt,butifthestockpricegoesupto$60
bymaturity,theinvestorwillhaveavaluableoptionofconvertingitinto20shares
ofcommonstock.Ifthebondisnotcallableforaperiodoftime,theinvestorhas
someprobabilityoflargegains.Ifthestockpricedoesnotgoup,theinvestorhas
thefallbackpositionofreceiving$1,000atmaturity.
November6,200913:44spi-b8119inx6inb811-ch16
ConvertibleBonds
325
Oneoftheimportantadvantagesofconvertiblebondsisthattheyofferinterest-
ingriskpossibilities.Thereisonlyaverysmallprobabilityoflosinglargeamounts,
andthereisaprobabilityoflargegains(ifthecommonstockincreasesinvalue
rapidly).Thereisalsoahighprobabilityofasmallloss.Thereisanopportunity
lossarisingfromacceptinglowerinterestthanwithstraightdebt(thelossoccursif
theconversionfeatureturnsouttohavelittleornovalue).Sinceitisanopportunity
loss,itisimplicitratherthanexplicit(largerinterestpaymentscouldhavebeen
earnedonbondswithouttheconversionfeature);therefore,itisnotapparentto
someinvestors.
Anadvantageofconvertiblebondsforaspeculatoristhatthebondssometimes
haveasmallermarginrequirementthanstock.Thus,theinvestorscanlevertheir
investmentwithmoredollarsinvestedinbondsthantheycaninvestincommon
stock.
ConversionPremiums
BasicRelationships
Wefrstestablishbasicconvertiblebondrelationshipsthatareusefulforanalysis.
Let
B
=
thefacevalueofthedebt;
s
=
thenumberofsharesofcommonstockintowhichabondcanbecon-
verted,i.e.,theconversionratio;
B
0
=
thevaluenowofthesecurityasstraightdebt;
M
0
=
theconvertiblebond’smarketvaluenow;
P
0
=
thecommonstock’smarketvaluenow.
Investorsarefrequentlyinterestedintwomeasures:thepremiumoverbond
valueandtheconversionpremium.Weshallcomputethesemeasuresaspercent-
ages,althoughtheyaresometimespresentedindollaramounts.
Thepremiumoverstraightbondvalueincurredbybuyingtheconvertiblebond
isdefnedas
M
0
−
B
0
B
0
.
(16.1)
Theconversionpremiumisdefnedas
B
−
sP
0
sP
0
.
(16.2)
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326
AnIntroductiontoAccountingandManagerialFinance
Thisgivesthepercentageincreaseincommonstockpricerequiredforthebond(as
commonstock)tobeworthasmuchasthecommonstockthatcouldbepurchased.
Example16.1
An8-percent$1,000bondisconvertibleinto20sharesofcommonstock.Thestock
iscurrentlysellingat$45pershareandthebondissellingat$1,200.Assumethat
thebondasstraightdebtwouldhaveavalueof$800.Thepremiumoverstraight
bondvalueis
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
.
Thebondiscurrentlysellingat50percentoveritsvalueasstraightdebtandhas
an11-percentconversionpremium.
Otherfactorsofinteresttotheinvestorarethecallpremiumandtheperiodofno
call(theissuingfrmcannotcallduringthisperiod).Thehigherthecallpremium
andthelongertheperiodofnocall,themoreprotectiontheinvestorshaveagainst
beingforcedtosellortoconverttheirbondsbeforetheywantto.Duringtheperiod
thattheissuingcorporationcannotcall,theinvestor’spotentialgainsareunlimited.
Iftheissuingcorporationcancall,thepotentialgainislimitedbythelikelihoodof
thefrmcalling.Acalledconvertiblebondcanalwaysbeconvertedwithinagiven
timeperiodintocommonstockifaninvestorsodesires.Onecriterionusedwhen
determiningwhetherornottocallisthedrainoncashresultingfromthedividends
onstockcomparedtothecashdrainoftheinterestpayments.Equallyimportantis
whetherornottheconversionvalueofthebondisabovethecallprice.
IfthecommonstockinExample16.1werepaying$1pershareperyear,
conversionwouldmeancashdividendsof$20peryearcomparedto$52peryear
ofafter-taxinterest(assuminga0.35corporatetaxrate,theafter-taxcostofthe
$80contractualinterestis$52).Letthestockpriceattime
t
be
P
t
.Thecorporation
mightwelldecidethatconversionwasdesirableassoonastheconversionvalue
(
sP
t
)wentabovethecallprice(orenoughabovesothattheinvestorswouldconvert
ratherthantakeadvantageoftheopportunitytoliquidatetheirinvestmentwithout
transactioncostsatthecallprice).Theinvestors,fortheirpart,wouldcompare
$80ofinterestand$20ofcommonstockdividend,thetaxesonthesereturns,and
thesafetygivenbythebondfeaturebythesecurity,andwouldlikelydecideto
November6,200913:44spi-b8119inx6inb811-ch16
ConvertibleBonds
327
postponeconversionuntilthecashdividendwereincreasedortheywereforcedto
convertbythebondsbeingcalled.
ValueofaConvertibleBond
If
P
t
isthestockpriceattime
t
,thepresentvalueofaconvertiblebond,
M
0
,canbe
expressedintermsofthepresentvalueoftheinterestandprincipalorthepresent
valueoftheconversionvalue.If
P
t
nevergoesabovetheconversionprice,the
facevalueofthebondisusedastheestimateoffuturevalue(therewillbeno
conversion)andthebondisvaluedasstraightdebt.If
P
t
goesabovetheconversion
price,wecanassumethatthebondisconvertedattime
t
,where
t
ischosento
maximizethenetpresentvalue.Ifthesecondcalculation(valuewithconversion)
islargerthanthevalueasstraightdebt,theconversionfeaturehassomevalue.
Example16.2
A30-year,0.08bond($1,000facevalue)isconvertibleinto25sharesofcommon
stock.Thepriceofthecommonstockiscurrently$50pershare,andthecommon
stockpriceisexpectedtoincreasesteadilyto$391attheendofyear30(a7-percent
growthrate).Thecommonstockispayinga$2-per-sharedividendthatisexpected
tocontinuefortheentire30years.Theyieldforcomparablebondswithouta
conversionfeatureis0.09.Wewanttodeterminethepresentvalueoftheconvertible
bondifitisconvertedjustbeforematurity.Assumethattheinvestordoesnotpay
taxes.
Thevalueoftheconvertiblebondwithconversionin30yearsusing0.09as
theopportunitycostandthecommonstockpriceof$391pershare(25sharesare
worth$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-year
presentvaluefactors:
$1
,
000
×
0
.
0754
=
$75
.
40
$80
×
10
.
2737
=
821
.
90
$897
.
30
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AnIntroductiontoAccountingandManagerialFinance
Thetotalvalueofthebondisequaltothesumofthestraightbondplusthevalueof
theconversionfeature.Ifthepriceofthebondis$1,558.94,thevaluebeingplaced
ontheconversionprivilegeis
valueofconversionpackage
=
$1
,
558
.
94
−
$897
.
30
=
$661
.
64
onthebasisofconvertingattime30.
TheInvestmentDecision
ComparingConvertiblesandDebt
Howdoesonemakethedecisiontobuyaconvertiblebond?First,weshallcompare
theconvertiblebondtostraightdebt;then,weshallcomparebuyingaconvertible
bondorcommonstockofthesamefrm.
Assumethatstraightdebtispaying
k
i
interestandthattheconvertibledebt
willpay
k
.Assumethatthecallpremiumof
C
willbereceivedattime
n
only
iftheconvertiblebondispurchased.Theincrementalnetpresentvalue(NPV)
ofthecashfowsfrominvestingintheconvertiblebondratherthanthestraight
debtis
NPV
=
[
B
(
k
−
k
i
)
]
B
(
n,k
i
)
+
C
(
1
+
k
i
)
−
n
.
(16.3)
Theinvestorintheconvertiblereceives
(k
−
k
i
)B
lessinterestfor
n
yearsthan
theinvestorinstraightdebt,butdoesreceive
C
(thecallpremium)attime
n
that
thestraightdebtdoesnotpay.
SettingtheNPVequaltozero,wecansolvefor
n
,thenumberofyearsthat
canpasswiththeinvestorearningatleastareturnof
k
i
ifthebondiscalledon
orbefore
n
yearshavepassed.Ifthebondiscalledafter
n
yearshavepassed,and
iftheconversionvalueisnotlargerthanthecallprice,theinvestorwillearnless
than
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).The
convertibleyields0.082andcomparablestraightdebtyields0.10.Theinvestoris
zerotax.
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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,theinvestor
canearnunlimitedreturns(thefrmcannotcall).Inyears2.0to4.25,theinvestor
canearnmorethan
k
i
,butthegainsarelimitedbythefactthatthefrmcancall
anytimeafter2.0years.
Assumingthattheconversionvalueattime4.25islessthanthecallpriceand
thatthefrmwillcallassoonastheconversionvalueequalsthecallprice,the
investorwillearnareturnafteryear4.25thatislessthan
k
i
.Ifthebondisheldto
maturity,withoutcalloraconversiontakingplace,theinvestorwillearn
k
=
0
.
082.
Thisisthecontractualrateontheconvertiblebondoriginallyissuedatpar.
Nowassumethatthefrmcanonlycallafteryear6.Theinvestorcanearn
unlimitedgainsuntilyear6(
n
islessthan6,sotheexactvalueof
n
doesnotaffect
thevalueofthebondtotheinvestor).However,since
n
islessthan6,weknowthat
thestockpricehastogoabovetheconversionpricepriortoyear6ortheinvestor
willearnlessthan
k
i
.
Theprimaryimportanceofthemodel[equation(16.4)]isthatithighlights
theimportanceof
k
,
k
i
,
C
,andtheperiodduringwhichthefrmcannotcall.Also,
becausethelikelihoodofthestockincreasingabovethecallpricebefore
n
timeperi-
odsisofimportance,theconversionpremiumthatissetisofconcerntotheinvestor.
ComparingConvertiblesandCommonStock
Insteadofcomparingtheconvertiblebondandstraightdebt,investorsfrequently
compareinvestingintheconvertibledebtandinvestingincommonstock.Thereare
severalapproaches,butwewillcomparebuyingabondconvertibleinto
s
shares
ofcommonstockorbuying
s
sharesofcommonstock.
Example16.4
k
i
=
0
.
10,
k
=
0
.
09,
s
=
20andtherearenotaxes
B
=
$1
,
000(costofconvertiblebond)
P
0
=
$42,dividend
=
$2pershare
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AnIntroductiontoAccountingandManagerialFinance
Since
s
=
20,assumethattheinvestorbuys20sharesofcommonstock.Twenty
sharesofcommonstockwillcost
$42
×
20
=
$840
.
Thestockwillpaydividendsof
$2
×
20
=
$40peryear
.
Buyingtheconvertiblebondcostsanextra$160:
$1
,
000
−
$840
=
$160
,
andthisbondwillearnanextra$50ofinterestperyearcomparedtothe$40
commonstockdividend:
$90
−
$40
=
$50
.
Thenetpresentvaluefrominvestingintheconvertiblebondratherthanthecommon
stock,assumingtheinterestadvantagelastsforever,is
NPV
=−
$160
+
$50
0
.
10
=
$340
.
Wecandeterminehowlongtheinterestadvantagehastoexistfortheinitial$160
investmenttoberecovered:
−
$160
+
$50B
(
n,
0
.
10
)
=
0
B
(
n,
0
.
10
)
=
3
.
2
n
=
4
.
05years
.
Wecanalsosolvefor
n
moregenerally.Let
C
0
betheadditionaloutlayresulting
frombuyingthebondinsteadofthestock:
−
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
.
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ConvertibleBonds
331
Someinvestorsliketocomputeapaybackperiodfortheextra$160investment:
$160
$50
=
3
.
2years
.
ThismeasureiswidelyusedonWallStreettoevaluatetheinvestmentdesirability
ofaconvertible.
The4.05yearspreviouslydeterminedtakesintoconsiderationthetimevalue
ofmoney.The3.2doesnotconsiderthetimevalueofmoney.
Sofar,wehaveassumedaconstantcommonstockdividend.Ifthedividendis
increasing,thenwedecreasethenetpresentvalueofinvestinginthebondcompared
toinvestinginthecommonstock.
Theadvantageofcomparinganinvestmentintheconvertiblebondandan
investmentinthecommonstockisthatitholdsthecommonstockpriceappreciation
neutral(itispresentwithbothbuyingalternatives)sothatwecanconcentrateon
thecharacteristicsoftheconvertibledebt.
InterestRateandConversionPremium
Thepricethatissetforaconvertiblebondisafunctionoftheinterestrateon
thebondandtheconversionpremium.Thesmallertheconversionpremium,the
smallertheinterestrateontheconvertiblebondhastobe.Conversionpremiums
areusuallybetween20and30percent.
Example16.5
Letusanalyzethefollowingtwoalternativesfora20-yearbond.Thestockprice
isnow$40.
Interest
RateSharesConversionPremium
Conversion
Price
Alternative10.0825
$1
,
000
−
25
$40
25
$40
=
0$40
Alternative20.1020
$1
,
000
−
20
$40
20
$40
=
0
.
25$50
Whichalternativeisbetterfortheissuingfrm?
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AnIntroductiontoAccountingandManagerialFinance
Alternative2hasanextra$20-per-yearinterestona$1,000bond.Butitsaves
fvesharesatthetimeofconversion.Ifthestockpriceis$40orlessandconversion
doesnottakeplace,alternative2leadstoanextra$20-per-year(before-tax)cost
andzerobenefts.Thebondsarenotconvertedwitheitheralternative.Alternative
2isinferiortoalternative1.
Ifthestockpricegoesto
P
n
where
P
n
islargerthan$50,thenalternative2
savesfvesharesworth
P
n
each.Fortheissuingfrm,wehaveaNPVof
NPV
=−
20B
(
n,k
i
)
+
5
(
P
n
)(
1
+
k
i
)
−
n
.
Ifthestockpriceisbetween$40and$50,thenattime
n
alternative1costs
25
P
n
whilealternative2costs$1,000.
TheNPVofalternative2comparedtoalternative1is
NPV
=−
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,wehave
NPV
=−
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
)
=
0
5
P
n
=
$170
0
.
1486
=
$1
,
144
P
n
=
$229
.
Theanalysiscanalsobedonefordifferentvaluesof
n
anddifferentcallstrate-
gies.Anearlierconversionwillincreasetheimportanceoftheextrafveshares.
TheInvestor
Whyshouldaninvestorbuyaconvertiblebond?Weshallassumethattheinvestor
hasalreadydecidedtoinvestinthecommonstockofthecorporation.Weconsider
onlythequestionastowhetherornotthisproposedconvertibledebtisabetter
investmentthanthecommonstock.
Tosimplifytheanalysisforboththeinvestorandtheissuingfrm,wewill
assumethat:
1.Thereiszeroconversionpremium;
2.Theinterestpaymentperperiodwillinitiallybelargerthanthecashdividend
onthecommonstock;
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ConvertibleBonds
333
3.Thereisantidilutionprotection(thenumberofsharesthebondisconvertible
intoisadjustedforstockdividendsandstocksplits).
Assumethattheconvertiblebondisbeingissuedatapriceof$40andthatitis
convertibleintooneshareofcommonstockcurrentlysellingat$40pershare.The
bondpays$4interestperyearandthestockpays$3ofdividendsperyear.Should
theinvestorbuythebondorthestock?Bothinterestanddividendsaretaxedthe
same.
Theconvertiblesecurityjustdescribedisbetterthanthepurchaseofanequiva-
lentnumberofsharesofcommonstockinthesamecompanyforazero-taxinvestor
orforanindividual.Themostsignifcantadvantageoccursbecausethecontractual
interestpaymentislargeraswellassaferthanthecashdividend.Fortheinvestor,
thebonddominatesthecommonstockbecausethereisnopossiblewayinwhichit
canbeinferior.Ifthestockpricegoesupandthecashdividendexceedstheinter-
estbeingpaid,theinvestormightwanttoconvertandthuswillholdthecommon
stock(thesamenumberofshareswillbeheldasifthecommonstockhadbeen
purchasedinitially).Ifthecommonstockpricefallsbelowtheconversionvalue,
thecallpriceandthematurityvaluesupplysomeprotection(theexistenceofa
maturitydateensuresthattheinvestorwillatleastreceivethematurityvalue).But
thisprotectionisanextrabonusgiventhatwehadalreadyestablishedtherelative
meritsofthebondandthecommonstock.
Normally,theinvestorwillconsiderthisvaluetobeamajorreasonforpurchas-
ingthesecurity.Iftheconversionvaluefallsbelowthematurityprice,theinvestor
hasdownsideprotection.
Ifthefrmwantstoavoidtheinterestpaymentsandiftheconversionvalue
exceedsthecallprice,thefrmcancallandforceconversion.However,ifthefrm
wantstoavoidtheinterestpayments,andthecallpriceexceedstheconversion
value,thenacallbythefrmwillrequireacashoutlay.Unfortunately,thesame
factors(unproftableoperations)thatmightcausethefrmtowanttoavoidpaying
theinterestwillalsotendtopreventitfromcallingthebondspriortomaturity,if
callingthebondscausesacashoutlaytotakeplace.
Ifthefrmcanpaytheinterestbecauseofadequatecashfowbutcannotuse
theinteresttaxshieldbecauseoflowtaxableprofts,thefrmmightwishtocallthe
debttoconverttheinterestpaymentintothesmallercashdividend.Aconversion
valuelargerthanthecallpricecombinedwithanexpectationthattheinteresttax
shieldcouldnotbeusedinthefuturewouldsimplifythedecisiontocall.Buteven
withforcedconversion,theinvestorisatleastaswelloffasifthecommonstock
hadbeenpurchasedinitially.
Iftheconversionvalueiscurrentlylargerthanthecallprice,theissuingfrm
mightcallnowifthereisaprobabilityofafuturechangeinthefrm’swell-being
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AnIntroductiontoAccountingandManagerialFinance
andaresultantdecreaseinstockprice,sothatthefrmwouldnotbeabletoforce
conversioninthefuture.
TheIssuingFirm’sPerspective
Thenegativefeaturesoftheconvertiblesecurityfromtheviewpointoftheissuing
frmarethatitpromisestopayinterestperiodicallyandthatthereisanamount
dueatmaturity.Theinterestpaymentiscontractualandthushasmorerisktothe
frmthandocommonstockdividends.Also,iftheinterestpaymentislargerbefore
taxesthanthecommonstockdividend,andifthefrm’staxstatusweretochange
sothatthefrmcouldnotusethetaxshield,thedebtcouldbemorecostly.Ifthe
stockpricedropsbelowthecallprice,acallingofthebondwouldresultinacash
outlay;thus,forcingconversionmightbeimpossibleforafrmwithcashproblems.
Anotherwayofdescribingthisdiffcultyistodefneitintermsofthedownside
protectionbeingofferedtotheinvestors.Althoughthedownsideprotectionisan
advantagetotheconvertiblebondpurchaser,itisadisadvantagetothecommon
stockholders(itincreasestheirrisk).
Theprimaryadvantagefortheissuingfrmofthistypeofconvertiblesecurity
comparedtocommonstockisthetaxdeductibilityoftheinterest.If$100millionof
convertibledebtispaying$10millionofinterestinsteadof$10millionofcommon
stockdividends,thefrmwitha0.35taxratewillsave$3.5millionperyear.Thisis
asignifcantincentiveforusingtheconvertiblesecurityratherthancommonstock.
Butthisadvantageexistsforallsecuritiesclassifedasdebt.
TheIRSwillobjecttodebtthatistoomuchlikecommonstockandwill
attempttoblocktheuseoftheinterestpaymentasataxdeduction.However,any
convertibledebtispartdebtandpartcommonstock,sotheissueisalreadyonthe
table.Theonlyquestionistheextenttowhichthelogicaluseofconvertibledebt
canbeextendedbytheuseofsecuritiesthathavedesirablecharacteristicsfromthe
issuingfrm’sviewpoint.Thebasicfaultisinataxcodethatattemptstodistinguish
inasubstantivemannerbetweenthecashdistributionsofcommonstockanddebt.
Itisnotpossibletodistinguishbetweentheminanexactmannerwithahybrid
security.
Theissuingfrmwillbehappywithitsdecisiontoissuetheconvertibledebt
ratherthancommonstockaslongastheafter-taxcostoftheinterestislessthan
thecashdividendthatwouldhavebeenpaid,andifatthetimeofcallormaturity
theconversionvalueismarginallylargerthanthecallprice.
Supposethatthepriceofthecommonstockfallsandthedebtiscalledwhen
theconversionvalueislessthanthecallpricesothatthefrmhastomakeacash
outlay.Inthatcase,itispossiblethattheissuanceofcommonstockwouldhave
November6,200913:44spi-b8119inx6inb811-ch16
ConvertibleBonds
335
beenbetter.However,ifthetimeofcallisreasonablylongafterthetimeofissue,it
islikelythatthecashsavingsfromtheinteresttaxshieldwillhavealargerpresent
valuethanwillthecostofthecall(thedifferencebetweenthecallpriceandthe
valueoftheequivalentsharesofthecommonstockattimeofcall,whenthecall
priceislargerthantheconversionvalue).
Ifthecallpriceissetrelativelylow,thereislikelytobeaverysmallprobability
thatthefrmwillregrettheissuanceoftheconvertibledebtcomparedtotheissuance
ofanequivalentnumberofcommonstockshares.Theguidelinesestablishedbythe
TreasuryorbyCongressastowhatacceptabledebtis(thus,theinterestpayments
willbetax-deductible)willbecruciallyimportantindetermininghowcloseafrm
canmovetothetheoreticallyoptimumsecurity(averylowcallpriceandasmall
conversionpremiumattimeofissuance).
Animportantargumentagainsttheissuanceofconvertibledebtisthatitdoes
resultinadilutioninthestockholder’sequityposition.Theholderofaconvertible
securitycanshareinthewinningsiftheeventsturnouttobedesirable.Thisis
realdilution.Ifeventsdonotgowell,withtheresultthatthestockpricedoesnot
increase,thenanoverhangofpotentialdilutioniscreated,andthereisstilldebt
outstanding.
Anotherimportantconsiderationisthatfnancialanalyststendtoconsidercon-
vertiblebondsascommonstockequivalentsinevaluatingthecommonstock,and
bondratingagenciestendtoconsiderconvertiblesasdebtinarrivingatbondrat-
ings.Thisislookedatbyfnancialoffcersasadoublepenalty,andisconsidered
asanegativefactorarguingagainsttheissuanceofconvertibledebt.
Taxconsiderationsworkbothforandagainstconvertiblebonds.Thetaxdeduc-
tionofconvertiblebondinterestgivesthebondsanadvantagecomparedtocommon
stock.Butthelowerexplicitinterestcostscomparedtonon-convertibledebtresult
inlowertaxshields;thus,thereislessvalueaddedper$1,000bondasaresultof
usingtheconvertiblebond(whichispartequitycapital).
BondswithWarrants
Awarrantgivestheinvestortherighttobuyashareofstock(orafractionofa
share)atagivenexerciseprice.Theexercisepriceispaidtotheissuingcorporation.
Inadditiontoconvertiblebonds,bondswithdetachablewarrantsarealsousedby
corporations.Theadvantageofthedetachablewarrantisthat,uponexercise,the
investorstillhasabondinvestmentwithitsfxedreturnandthecorporationhas
debtoutstanding.Ifthenumberofsharesofstockassociatedwitheachbondisless
withdetachablewarrantsthanwithaconversionfeature,therewouldtendtobe
lessdilutionofthecurrentstockholders’position.Apossibledrawbackfromthe
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AnIntroductiontoAccountingandManagerialFinance
corporation’spointofviewisthat,aftertheexerciseofthewarrants,thereisstill
debtoutstanding,andthisreducesthedebt-issuingabilityofthefrm(assuming
thatitwantstoissuemoredebt).Tosolvethisobjection,thefacevalueofthebond
maybeacceptedfortheexerciseprice.
Oneadvantageofissuingbondswithwarrantsisthattheissuepriceissplit
betweendebtandstockequity(thevalueofthewarrantisclassifedasstockequity).
Theissuepriceofaconvertiblebondisclassifedasdebt.
Thetwotypesofsecurities(convertiblebondsandbondswithdetachablewar-
rants)areverysimilar,anditisdiffculttodescribesubstantivedifferencesaside
fromdifferencesinaccounting.
Dilution
Dilutionforthepresentshareholderstakesplacewhentheirpercentageofown-
ershipisreducedbytheissuanceofnewsharesornewsecurities.Convertible
securitiesareattractivetoissuers,sincetheconversionfeaturetendstoreducethe
explicitinterestcost.Butaconvertiblesecuritycarrieswithitathreatofdilutionof
thestockholders’equitythatisnotpresentwithstraightdebt.However,thedilution
maybelessthanifcommonstockwereissuedimmediately.Also,thereisalways
thechancethatthebondswillnotbeconverted,andthecorporationwillhaveraised
fundsatalowerexpostcostthanstraightdebt.(Thismeansthatthestockprice
failedtoriseabovetheconversionprice,sostockholdersmaystillbeunhappy.)
Example16.6
Assumethatacorporationisconsideringissuing1millionsharesofcommonstock
atapriceof$40or40,000convertible$1,000bondswitha20-yearmaturity.Each
bondwouldbeconvertibleinto20sharesofcommonstock.Therearecurrently5
millionsharesofcommonstockoutstanding.
Aslongasthereisapositiveconversionpremium(itis25percent),thebonds
willleadtolesspotentialdilutionthanwilltheissuanceofcommonstock.The
purchaserofthebondispayingapriceforthedownsideprotectionofferedbythe
bondfeatures.
Whetherconvertiblebondsorbondswithwarrantsattachedwillleadtomore
dilutionwilldependonthetermsofthespecifcsecurities.Wemightexpectdetach-
ablewarrantstoleadtolessdilution,sincetheinvestorwillhaveadebtsecurityno
matterwhathappenswiththewarrant.Ontheotherhand,thewarrantuponbeing
exercisedwillrequireanadditionalcashinvestment;thus,wecannotguessatthe
potentialadvantage.
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ConvertibleBondsandtheBlack–ScholesModel
Sinceaconvertiblebondisacombinationofaconventionalbondandanoption
toconvertintocommonstock,itfollowsthatmethodsofvaluingoptionsarealso
ofinterestinthevaluationofconvertiblebonds.Animportantstepinconvertible
bondvaluationistheapplicationoftheBlack–Scholesmodeltovaluationofboth
theoptionfeatureandbondfeatureofconvertibledebtasaninvestment.
1
WhyShouldanInvestorConvertVoluntarily?
Ifthecommonstock’scashdividendsbecomelargerthantheinterestpaymentson
thedebt,theinvestorhasadecision.Thechoiceisbetweenmorecashfowwith
thelargerriskassociatedwithcommonstockdividendsandasaferbutsmaller
amountofcash.Iftheinvestorconverts,theinvestorismakinganassumptionthat
theexpectedpresentvalueofcashdividendsislargerthanthepresentvalueofthe
interestpayments.Inaddition,itisexpectedthatthepriceofthecommonstock
willremainsuffcientlyhighsothatonedoesnotloseinthefuturebygivingupthe
safermaturitypaymentofthedebt.Ifalltheseconditionsaresatisfed,theinvestor
hasaconversiondecision,butbecauseoftheriskitisnotobviousthattheinvestor
shouldconvertvoluntarily.Exceptinraresituationswheretherearehigh,relatively
safecashdividends,theinvestorisbetteroffholdingtheconvertiblebondsthan
converting.Theputoptionhasvalue.
Ifthebond’smarketpriceislargerthantheconversionvalue,itisbettertohold
orsellthanitistoconvertvoluntarily.Theinvestorisreluctanttogiveupthecall
option(therighttoconverttocommonstock)ortheputoption(therighttothe
facevalueoftheconvertibledebtatmaturity).
WhyShouldaFirmForceConversion?
Theopportunityforafrmtoforceconversionariseswhentheconversionvalue
ofthebondislargerthanthecallprice.Normally,apricecushionisrequiredto
reducethelikelihoodofthefrmpayingoutcash.Thereareseveralreasonswhya
frmmightwanttoforceitsinvestorstoconvertintocommonstockbycallingthe
1
TheBlack–Scholesmodelisamathematicalmodelforthevaluationofanoption.See
F.BlackandM.Scholes,“TheValuationofOptionContractsandaTestofMarket
Effciency,”
JournalofFinance
,May1972,pp.399–417;F.BlackandM.Scholes,“The
PricingofOptionsandCorporateLiabilities,”
JournalofPoliticalEconomy
,May–June
1973,pp.637–654.
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338
AnIntroductiontoAccountingandManagerialFinance
bond.Itmightbeawaytostrengthenthecapitalstructuresothatnewdebtcanbe
issued.Anotherreasonforthefrmtoforceconversionisthatthecashoutlaysof
outstandingcommonstockarelessthanwithdebt.Forexample,agrowthstock
maybepayingzerodividends;thus,theafter-taxinterestpaymentsaresavedif
conversionisforced.Also,callingthebondsresultsintheeliminationoftheimplicit
putoptionheldbytheinvestors.
Assumea$1,000bondpaying0.10interestisconvertibleinto40sharesof
commonstock.Thecommonstockpaysa$1-per-yeardividendandissellingata
priceof$50.Thecallpriceofthebondis$1,080.Shouldthecompanycall?The
corporatetaxrateis0.35.
Thecompanycancall,sincetheconversionvalue,$50
×
40
=
$2
,
000,is
largerthanthecallprice.Ifthebondsarecalled,therationalinvestorsmustconvert
ratherthanacceptthecallprice.Theconversionvalueislargerthan$1,080.The
bondsconvertedintocommonstockwillrequire$40perbondofcashoutlaysfor
dividends.Thebondsnowrequire$100ofinterestoutlays,whichare$65after
tax.The$40islessthan$65.Theinvestorswillreceive$40ofdividendsinstead
of$100ofinterest;thus,theydonothavetheirpositionimprovedbythecall.The
positionofthepresentstockholdersisimprovedbythecall,sincethefrm’scash
outfowisreduced.Inaddition,thedownsideprotectionofferedbythebond(the
putoptionheldbyinvestors)iseliminated.
Earningspersharewillalsobeaffectedbytheconversion.Interestcostswillbe
reduced,andthenumberofsharesoutstandingwillbeaffected(theexacteffectwill
dependonwhetherwearecomputingearningspersharewithorwithoutdilution
andonthenatureoftheconversionfeature).
Insomesituations,theamountofdebtnotyetconvertedhasbecomeverysmall
andcallingthedebtisareasonablewayofeliminatinganunnecessaryfnancial
complexity.
Thereisasoundfnancialtheorythatconvertiblebondsshouldbecalledas
soonasthemarketpriceofthebondishighenoughabovethecallpriceto
insureconversion.Ifcalledatlowerprices,theremightbecashoutlaysassociated
withtheretirementofthedebt.Justasaninvestorpreferstoholdtheconvert-
iblebondratherthanconvertbecauseofthedownsideprotectionofferedbythe
bond,thecorporationwantstoforceconversionsothatthelegalobligationtopay
interestandprincipalarereplacedbythemorefexiblecommitmentstocommon
stock.
HedgeFunds
Inrecentyears,hedgefundshaveboughtbetween70and80percentofthe
convertiblebondsissued.Thefundsbuytheconvertiblesandsellthestockshort.
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ConvertibleBonds
339
Ifthestockpricegoesdown,theywinontheshortsaleanddonotlosemuch(if
anything)ontheconvertiblebonds.Ifthestockpricegoesup,theywinonthe
convertiblebutloseontheshortsale.Obviously,theamountsofgainsandlosses
willdependontheexactnatureofthetransactions.Thestrategyhasitsrisks(no
“freelunch”).
Conclusion
Thevalueofwarrants,options,calls,andtheconversionfeatureofconvertible
securitiesareallgovernedbythesameeconomicrationale.Iftheycanbeconverted
immediately,theirminimumvalueascommonstockissetbytheirimmediate
conversionvalue.Theiractualvaluewilldependonahostoffactors,amongwhich
arethecurrentcommonstockmarketprice,thedistributionoffuturestockprices,
thetimevalueofmoney,andtheriskpreferencesofthemarket.
Convertiblebondsmaybeanattractiveinvestmentinacommonstockgrowth
situation(thus,tendingtoensureconversion)andasasubstituteforcommonstock
wherethereisapossibilityofthegrowthnottakingplace(thus,investorsare
willingtopayforthedownsideprotection).Iftherearenocommonstockgrowth
possibilities,theinvestorwouldpreferstraightdebt.Ifthereiscertaintyofgrowth
(noriskoftheconversionfeaturebeingworthless),theinvestorislikelytodo
betterinvestinginthecommonstockorwarrantsorcalls.Thus,aconvertiblebond
isatypeofsecuritythatfllstheneedsforaninvestorwithariskpreferencefor
achanceofalargegainandaverysmallchanceofalargeloss,butwithalarge
chanceofasmallloss(anopportunitycost).
ReviewProblems
ReviewProblem16.1
Assumea$1,000,20-yearconvertiblebondthathasacontractualinterestrateof
0.10.Straightdebtpays0.12.Thecorporatetaxrateis0.46.
Thestockpriceattimeofissueis$20.Thebondiscallableatapriceof$1,100
afteroneyear.
(a)Iftheconversionpremiumattimeofissueis0.25,theconversionpricepershare
is______________.Thebondisconvertibleinto_______________shares.
(b)Azero-taxinvestorwillearnmorethan0.12ifthebondiscalledpriorto
______________years.
(c)Assumethata0.10bondisconvertibleinto25sharesofcommonstockcurrently
sellingat$40pershare.Thestockispayinga$3-per-sharedividend.Thebond
isbeingissuedatapriceof$1,000.
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AnIntroductiontoAccountingandManagerialFinance
Wouldyoubuythecommonstockortheconvertiblebond,assumingyou(an
individual)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.Itisatleastasgoodasthecommonstockcostingthesamefor
thesamenumberofshares,plus:
(1)$100interest
>
$75dividendtoday.
(2)Downsideprotection.
(3)Sameupsidepotential.
QuestionsandProblems
1.A$1,000bondcanbeconvertedinto20sharesofcommonstock.Thestock
isnowsellingat$36.
Whatisthebond’sconversionpremium?
2.(continue1)Ifthestockpriceweretoincrease38.9percent,whatwouldbe
theconversionvalueofthebond?
3.(continue1)Ifthepresentvalueoftheconvertiblebondasstraightdebtis
$780,whatisthebond’spremiumonstraightbondvalueifthemarketprice
ofthebondis$940?
4.a.Assumethata20-yearconvertiblebondispaying0.06interestperyear.
Straightdebtisyielding0.10.
Whatisthevalueoftheconvertibleasstraightdebt?
b.Ifthebondissellingfor$940,whatvalueisthemarketplacingonthe
conversionfeature?
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ConvertibleBonds
341
5.(continue4)Assumethatthebondisexpectedtobecalledafterfveyearsat
acallpriceof$1,090.
Whatisthenetpresentvalueoftheinvestmentintheconvertiblebondat
time0,assumingazero-taxinvestorwhopaid$1,000forthebond?
6.(continue4and5)Whatisthenetpresentvalueattime0ifthebondis
convertibleinto20sharesandthestockissellingat$70persharewhenthe
bondiscalledattime5?
7.TheABCDCompanyisissuinga7-percent,20-yearconvertibledebtcallable
atapriceof$1,080atanytime.Theconversionpricehasbeensetata30-
percentpricepremiumoverthecurrentstockprice.Thebondshavebeen
recommendedtoapensionfundmanager.Theargumenthasbeenmade,
“Youwillearnahighreturnsincewecanexpectthestockpricetoeasily
doublewithinthenext10years.”However,itisagreedthatitisunlikely
thattheannualrateofgrowthinstockpricewillexceed10percentper
year.Comparable-riskstraightnoncallabledebtisbeingissuedatayieldof
11percent.
Shouldthebondsbeboughtiftheysellatpar?Explain.
8.Azero-taxinvestorisconsideringpurchasingeitherstraightdebtoraconvert-
iblebondissuedbyfrmsofidenticalrisk.Thestraightdebthasacouponof
0.12andtheconvertibledebt,0.05.Thecallpriceoftheconvertiblebondis
$1,140andthebondcanbecalledatoraftertime2.Bothbondscanbebought
atpar.
Theinvestorexpectsthecommonstockpricetoincrease,sothatthestock
priceislargerthantheconversionpriceatandaftertime3,butnotpriorto
thattime.
a.Whichsecurityshouldbepurchased?Why?
b.Howlongcanitbe(maximumtime)beforethestockpriceforcesthebond
priceabovethecallprice,iftheinvestoristoearnmorethan0.12?
9.TheABCCompanyhasbeengiventwochoicesbyaninvestmentbanker.One
istoissue5-percentconvertible20-yearbonds($1,000par).Thestockprice
isnow$10pershare,andtheconversionpremiumwouldbe100percent.The
otheralternativewouldbea4-percentinterestrateanda25-percentconversion
premium.
Thebondswouldbenoncallable.Thecompanydoesnotpayacashdividend
onitsstock,anditdoesnotintendtostartinthenearfuture.
Thecompanyhasrecentlyissued20-yearstraightdebtcosting0.10.The
companyhasa0.40taxrate.
Whichofthetwoalternativesshouldthecompanyprefer?Explain.
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AnIntroductiontoAccountingandManagerialFinance
10.CompanyFisconsideringthetermsofaconvertiblebondthatitisgoingto
issue.Thefollowingfactsapply:
AlternativeInterestConversionPremium
10.080.15
20.090.20
Thebondissuesizeis$10million.Thebondswillhaveamaturityof10years
andwillbenoncallable.Thetaxrateis0.46.Thestockpriceis$50.
a.Howmanyshareswouldthebondsbeconvertibleintowiththe0.15pre-
mium?
b.Howmanyshareswouldthebondsbeconvertiblesintowiththe0.20pre-
mium?
c.Withthe0.20conversionpremium,thereisanextraafter-taxcostof
$________________peryear.
d.Whatdoesthepriceofthecommonstockhavetobeattime10foralternative
2tobepreferred?Assumethefrmhasanopportunitycostofmoneyof
0.10.
11.A$1,000convertiblebondistobeissuedwithacallpremiumof$90anda
couponof0.12.Straightdebtcouldbeissuedatacostof0.16.Thebondis
callableanytimeafteryear4.
Isthisconvertiblebondagoodinvestment,comparedtostraightdebt,ifa
zero-taxinvestorthinksthatthebondwillbecalledatyear5?Explainwith
numericaljustifcation.
12.Assumethatthestockpriceisabovetheconversionprice.
Whenshouldaninvestorholdingtheconvertiblebondvoluntarilyconvert
intocommonstock?Listthreenecessaryconditions(notnecessarilysuffcient
conditions).
13.Designaconvertiblebondthatisverymuchlikedebt.
14.Designaconvertiblebondthatisverymuchlikecommonstock.
November6,200913:44spi-b8119inx6inb811-ch17
Chapter17
Inventories
Attheendofeachperiod,theaccountantallocatesthetotalcostsofopening
inventoryandpurchasesbetweenanexpenseofthecurrentoperatingperiodand
costsoffutureoperatingperiods.Thecostsapplicabletothecurrentperiodare
recognizedascostofgoodssold(anexpense)intheincomestatement,whereas
thecostsapplicabletofutureperiodsareplacedintheEndingInventoryasset
account.
Accountantswouldliketoreportrelevantvaluesinthebalancesheet,match
revenuesandexpensesintheincomestatement,minimizecurrentincometaxobli-
gations,andpresentmeasureswithahighdegreeofreliability.Someofthese
objectivesareinconfictwithoneanother;thus,achoiceastotheaccounting
methodmustbemade.
ClassifcationsofInventory
Inventories
aregoodsthatareheldforsaleintheordinarycourseofbusiness,
orgoodsthatwillbeusedorconsumedintheproductionofgoodstobesold.
Manufacturingconcernstypicallyhavethreeinventoryaccounts.Costsassigned
togoodsandmaterialsonhandthathavenotyetbeenplacedinproductionare
reportedas
rawmaterialsinventory
;costsassignedtopartiallycompletedgoods
arereportedas
work-in-processinventory
;andcostsassignedtocompletedbut
unsoldgoodsarereportedas
fnishedgoodsinventory
.
Inventoriesareoftenthelargestitemamongthecurrentassetsformerchandis-
ingandmanufacturingconcerns.Salescanbelostifinventoriesareinadequate,
butexcessiveinventoriescanexposeacompanytosignifcantfnancingcostsand
potentiallossesfromspoilageandobsolescence.
343
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AnIntroductiontoAccountingandManagerialFinance
WhatCostsAretoBeInventoried?
Thereisnoclear-cutdistinctionbetweencoststhatmayormaynotbeassigned
toinventories.Thereisageneralagreementthatinboundfreightcostsaretobe
included;andsomeaccountantsarguethatpurchasingcosts,materialshandling
costs,andstoragecostsarealsoproperlyincludedascostsofinventory.The
costsarisingfromineffciencyorprolongedstorageoftheitemsininventoryare
expenses.
Anotherexampleofacostthatshouldbeexcludedfrominventoryisalost
purchasediscount.Lostdiscountsarenotacostofthepurchasedmaterial.Costs
ofshippinggoodstocustomersareconsideredtobeexpenses.
Fromapracticalpointofview,itisnotunreasonableforamerchandising
frmtoplaceintotheinventoryaccountonlythenetinvoiceprice,freight,and
handlingcostsofplacingthemerchandiseinitsstorageplace.Othercostswould
normallybeconsideredexpensesoftheperiod.Thisprocedureexcludesfrom
inventorythepurchasingdepartmentcosts,accountingdepartmentcosts,andcosts
ofwarehousingtheinventory,andthesecostsareconsideredtobeexpensesof
theperiodinwhichtheyareincurred.Therecanbetimeswhenitisappropriate
toplacecostsofwarehousinganinventory.Thiswillbethesituationwhenthe
warehousingwasexpectedatthetimeofpurchaseandthewarehousingenhances
thevalueoftheproductorenablesthefrmtoreduceorderingcosts.Forexample,
storinggrainorotherseasonalcommoditiesfromharvesttimeuntilitissoldin
anotherseasonmaynormallybeexpectedtoaddvalue.Wherethewarehousing
wasnotplanned(addedvalueislessthancost),addingstoragecoststothecostof
theproductisnotjustifed.
CostsofManufacturingFirms
Whatcostsmaybeincludedininventoryifthefrmisengagedinamanufacturing
process?Anarrowdefnitionwouldincludeininventoryonlythedirectvariable
costs(thiswouldusuallyincludeonlydirectmaterialanddirectlabor).Acostis
variable
ifwhenproductiondoublesinamount,thetotalvariablecostwillalso
double.Asomewhatbroaderviewpointwouldincludeallothervariablecostscon-
nectedwiththemanufacturingprocess(indirectvariablematerials,indirectvariable
labor,andothervariablecostssuchaspowerwouldbeincluded).Thegenerally
acceptedaccountingtreatmentofmanufacturingcostsissomewhatmoreinclusive.
Allcostsconnectedwiththemanufacturingprocessmaybeconsideredcostsof
inventories.Thisdiffersfromthetwoprecedingalternativesbytheinclusionof
someorallfxedcostsinthecostsofinventories.Examplesofcoststhatarenot
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Inventories
345
includableininventoriesaresellingexpenses,incometaxes,advertisingexpenses,
expensesofshippingout,andsalesinvoicepreparation.Theyareclassifedas
expensesandchargedtoIncome.
Afrmengagedinamanufacturingprocesswillusuallyhaveseveralaccounts
thatarenotrequiredforamerchandisingfrm.Theinventorycostofamanufactur-
ingfrmwillusuallybedividedamongrawmaterials,workinprocess,andfnished
goods.Theproblemofallocatingthefactorycostsamongthesethreecategories
isbeyondthescopeofthisbook.Oncetheseallocationsaremade,however,the
accountingtreatmentofmanufacturinginventoriesissimilartothatofmerchandise
inventories.
CostFlowAssumptions
Witheitheramerchandisingoramanufacturingfrm,itisnecessarytomake
someassumptionsabouttheorderinwhichcostsfowthroughtheaccounts.It
isnecessarytodistinguishbetweenthe
fowofthephysicalunits
ofinventorythat
passthroughtheplantandareshippedtocustomersandthe
fowofaccountingcosts
.
Thefowofthephysicalunitsmaybetheresultofamaterialshandlingarrangement
thatensuresthattheoldestgoodsaresoldorusedfrst.Theaccountingcostsof
inventorythatarechargedtoexpensemayormaynotbethecostsoftheoldest
goodsonhand.Thiswoulddependonwhichofseveralaccountingconventionsis
adoptedbythecompany.Thefollowingarethefouralternativefowassumptions
mostoftenusedinpractice:
1.Theoldestgoodsaresoldorusedfrst—FIFO(frst-in,frst-out).
2.Thelastgoodspurchasedaresoldorusedfrst—LIFO(last-in,frst-out).
3.Thegoodsareintermingledandgoodsusedareofaveragecostandage—
AverageCost.
4.Thespecifcunitsusedareidentifed.
Inpractice,the
physicalfow
ofgoodsfrequentlywillnotcorrespondtothe
methodchosenbytheaccountanttorecordthe
fowofcosts
.
FlowofCosts:FIFO
The
FIFO(frst-in,frst-out)procedure
ofaccountingforinventorycharges
thecostsofthefrstgoodspurchasedtoexpense.Thismeansthatthecost
ofthegoodsappearingininventorywillbethecostofthegoodsmostrecently
purchased.
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AnIntroductiontoAccountingandManagerialFinance
Example
Beginninginventory:100units@$2
.
00
=
$200
.
00
PurchasesduringtheMonth
Jan.15200units@$2
.
10
=
$420.00
Jan.24300units@$2
.
20
=
660.00
Jan.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
)
.Thisshouldbeequaltotheopeninginventoryplus
thecostofthegoodspurchasedduringtheperiod
(
$200
+
$1
,
305
=
$1
,
505
)
.
FIFOresultsinaninventorymeasurethatisreasonable(thegoodshaverecently
beenpurchased),butthecostofgoodssoldconsists,tosomeextent,ofitems
purchasedinpastperiodsandmightnotrefectcurrentcosts.
FlowofCosts:LIFO
The
LIFO(last-in,frst-out)procedure
ofaccountingforinventorychargesthe
costofthegoodsmostrecentlypurchasedtoexpense.Thismeansthatthecost
ofthegoodsappearinginendinginventorywillbethecostoftheoldestgoods
purchased.Thiswillbetheopeninginventoryplusadditions(orlessdeductions)
duringtheperiod.Iftherehavebeenchangesinthecostofgoodspurchasedover
aperiodofyears,thisinventoryfgurecanbecomefarremovedfromeitherthe
actualcostofthegoodsonhandortheircurrentvalue.Thecostofgoodssoldis
areasonablemeasureunlessoldinventorywitholdpricesissold(salesdipinto
inventory).
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Inventories
347
Example
AssumethattheSampleCompanyisusingaLIFOprocedure.Computethecost
ofgoodssoldandtheendinginventory.(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
Theresultsmaybecheckedbyaddingtheendinginventoryandthecostofgoods
sold
(
$1
,
095
+
$410
=
$1
,
505
)
.Thisshouldbeequaltotheopeninginventory
plusthecostofthegoodspurchasedduringtheperiod
(
$200
+
$1
,
305
=
$1
,
505
)
.
AlthoughLIFOmayseemtoprovideasolutiontotheproblemofchanging
prices,itdoeshaveseriouslimitations.Aparticulardisadvantageisthevaluation
ofendinginventory.Althoughthecostsofmostrecentpurchasesarechargedas
expensesforthedeterminationofgrossmargin,theendinginventoryfguremay
bebasedonthelowercostsofpurchasesofpasttimeperiods.Thus,theassetfgure
resultingfromtheuseofLIFOisnotlikelytorefectthecurrentvaluesofthegoods
remainingininventory.Byfailingtoadjusttheinventory,LIFOfailstorecognize
thegainsandlossesthatmayresultfrompricechanges.Theseeconomicgains
andlossesshouldbetakenintoaccountinevaluatingmanagerialperformance.
Evenifthesearebeyondthecontrolofmanagement,theyshouldneverthelessbe
separatelyreportedsothatthenormaloperatingresultsmaybemoreeffectively
appraised.Iftheseelementsaretosomedegreecontrollablebymanagement,their
determinationshouldformpartofthemanagerialreportingprocess.
TheFIFOinventoryassumptioncausesthesemarketgainsandlossestobe
commingledwiththeresultsofordinaryoperationsinthesinglefgureofgross
margin.WhenLIFOisused,themarketgainsandlossesareusuallyeliminated
fromgrossmargin,buttheystillarenotseparatelydetermined.
IfLIFOisusedtocomputeafrm’sfederalincometaxes,thenintheU.S.the
frmisalsorequiredtouseLIFOforitsfnancialstatements.
FlowofCosts:WeightedAverageCost
The
weightedaveragecostprocedure
ofaccountingforinventorychargesto
expenseanaverageofthecostsofthegoodspurchasedduringtheperiodandthe
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348
AnIntroductiontoAccountingandManagerialFinance
openinginventory.Theendinginventoryfgureisalsobasedonthisaverage.This
isaweightedaverage.Thefollowingexampleillustratestheapplicationofthe
weightedaverageprocedure.
Example
AssumethattheSampleCompanyisusingaweightedaveragecostprocedure.
Computethecostofgoodssoldandtheendinginventory.
GoodsAvailable
OpeningInventory100@$2
.
00
=
$200.00
Jan.15thpurchase200@$2
.
10
=
420.00
Jan.24thpurchase300@$2
.
20
=
660.00
Jan.30thpurchase100
@$2
.
25
=
225.00
700
$1,505.00
WeightedAverageCost
=
$1
,
505
700
=
$2
.
15perunit
.
CostofGoodsSold
=
$2
.
15
×
500
=
$1,075.00
EndingInventory
=
$2
.
15
×
200
=
430.00
$1,505.00
FlowofCosts:IdentifcationofCostsofSpecifcUnits
Insomesituations,accountantswillidentifytheactualcostsofspecifcunits.In
mostcases,thisprocedurewillbetooexpensive;andinsomecases,itwillbe
impossible.Thebeneftsofsuchasystemare,atbest,doubtfulexceptwherehigh-
costitemsarebeingsoldandthecostofspecifcitemscanbeeasilytraced.
Evenifthecostofeachspecifcunitcouldbeidentifed,itisnotclearthat
specifcidentifcationwouldbeadesirableaccountingprocedure.Itwouldopen
thedoortopossiblemanipulationofincomeandthusreducethereliabilityof
accountingdata.Ifthecompanyhadsomereasonforwantingitsincometobe
higherorlowerinaparticularperiod,itcouldaccomplishthisgoalbychoosing
thespecifcunitstobedelivered.
EvaluationofCostFlowAssumptions
Thecostfowassumptionusedindetermininginventorycostcanhaveanimpact
ontheincomereportedbyacompanyinanygivenyear.Thereisagreatdeal
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Inventories
349
offexibilitypermittedinthechoiceofmethod,andmanymethodsareusedin
practice.
ThecostfowassumptionofFIFOcloselyparallelsthenormalphysicalmove-
mentofgoodsthroughthefrm.Also,thebalancesheetinventorybalanceislikely
tobefairlyclosetocurrentvalue.WhenLIFOisused,thebalancesheetfgure
maybebasedonpricesofgoodsacquiredmanyyearsago,whichoftenmeansthat
thebalancesheetbalancesareunrealisticintermsoftoday’sprices.
ItisclaimedthattheLIFOprocedurehasadvantagesinregardtoincome
determination.Ifacompanyistoremaininbusiness,itmustmaintainacertain
levelofinventory.Therefore,whenanitemissold,itmustbereplaced,anditmight
bearguedthattheproftonsaleshouldbebasedonthecostofreplacingtheitem
ratherthanitsoriginalcost.Totheextentthatthecostsofthemostrecentpurchases
refectcurrentreplacementcosts,LIFOwillprovideameasureofoperatingincome
thatembodiesthisviewpoint.LIFO,however,doesfailtorecordmarketgains
andlosses.
AmajordrawbackofLIFOisthatwhenthereisadecreaseinthephysical
volumeofinventorybelowthatofthebeginningoftheaccountingperiod,costs
chargedtocurrentincomewillincludecostsofearlierpurchases.Thesecostsmight
bestatedatpricesthatrepresentveryoldpurchasesandthusnotmeasurecurrent
replacementcosts.Thisdependenceonphysicalinventoryvolumemaypermit
somemanipulationofincomethroughtimingofpurchases.
LIFOdoeshaverealadvantagesindecreasingincometaxesintimesofrising
prices.Thisisbecausethemorerecent,higher-pricedpurchasesarechargedas
expensessothatincomeislowerthanitotherwisewouldbe.Ifpriceswereto
decline,however,LIFOwouldthenresultinhigherincome(andthushighertaxes)
thanFIFO.CurrentU.S.incometaxregulationsrequirethatcompaniesusingLIFO
fortaxpurposesmustalsousethisfowassumptionintheiraccountingreports.
Cost-or-Market,WhicheverIsLower
TheFIFO,LIFO,andweightedaveragecostproceduresareallconcernedwith
determiningthecostoftheendinginventory.IfFIFOoraveragecostisusedto
implementcost-or-market,onemustcomparethecost(asdeterminedbyusingone
oftheseprocedures)tothemarketpriceoftheitemandtakethe
lower
amountforthe
valuationoftheinventory.Thisprocedureresultsinaconservativeinventoryfgure,
becausetheinventoryis
writtendown
tomarketbut
neverup
tomarket.Theincon-
sistencymaybeexplainedbytherulethatrecognizeslossesbutdoesnotrecognize
gainsuntiltheyarerealized.Onceaninventoryitemiswrittendowntomarket,it
is
not
writtenbackuptocostifthemarketsubsequentlyexceedsinitialcost.
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AnIntroductiontoAccountingandManagerialFinance
Thejournalentrytorecordthewrite-downtomarkettakesvariousforms.The
debitmaybetocostofgoodssoldortoalossamount.Thecreditmaybetothe
Inventoryaccountortoacontraassetaccount,AllowanceforMarketValuation,
whichissubtractedfromtheInventoryaccountforstatementpurposes.
Thecost-or-marketrulehasbeenattackedbyaccountingtheoreticiansonthe
groundsthatitisnotconsistent(inventoriesarewrittendowntomarket,butnever
uptomarket)andthatitisnotevenconsistentlyconservative(inthenextperiod,
theincomemaybehigheriftheinventoriesarewrittendowninthisperiod,and
theinventoryofthisperiodisincludedinthecostofgoodssoldnextperiod).It
alsosuffersfromconfusionastowhatismeantby
market
.
Onthepositivesideisthefactthatthewrite-downtomarketisdesirableto
preventthesubsequentyear’searningsfrombeingchargedwithexcessivecostsand
topreventtheinventorypresentationfrombeingoverstatedonthebalancesheet.
However,write-upstomarketmightalsobedesirabletobebetterabletojudge
managerialperformanceinthenextperiodandtopresentmorerealisticinventory
fguresonthebalancesheet.Reliablemarketvaluewouldbepreferabletothelower
ofcost-or-marketprocedure.
TheInternalRevenueCodedoesforbidtheuseofLIFOcombinedwithcost-
or-marketfortaxpurposes.
Example
Attheendofthecalendaryear,theSampleCompany’srawmaterialinventory
sheetshowedthefollowingitems.Using“cost-or-market,whicheverislower,”
determinethedollaramountofrawmaterialinventory.
CostperMarketPriceLowerof
MaterialUnitsUnitperUnitCostMarketCost-or-Market
A100$1.00$0.80$100$80$80
B2002.002.10400420400
C1503.003.00450450450
D3002.202.00660
600
600
$1,610$1,550$1,530
Therearetwoacceptableanswers.Cost-or-marketappliedtotheindividualinven-
toryitemsprovidesaninventoryfgureof$1,530.Ontheotherhand,applyingthis
ruletotheinventoryasawhole,thefgureof$1,550isobtained.Determiningthe
lowerofcost-or-marketbyindividualitemswillalwaysgivethelowerinventory
fgureandisthereforemoreconservative.
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FinancialAccountingStandardsNo.157
FAS157wasissuedinSeptember2006andwaseffectiveforfnancialstatements
issuedforfscalyearsbeginningafterNovember15,2007.Thefairvaluemeasures
ofFAS157applytosomeinventorymeasures.Forexample,paragraphA5(C)
states:
C.Thein-usevaluationpremisemightbeincorporatedinthefairvalueof
theassetthroughthemarketparticipantassumptionsusedtomeasurethefair
valueoftheasset.Forexample,iftheassetiswork-in-processinventorythat
isuniqueandmarketparticipantswouldcompletetheinventoryintofnished
goods,thefairvalueoftheinventorywouldassumethatanyspecialized
machinerynecessarytocompletetheinventoryintofnishedgoodswould
beavailabletomarketparticipants.
ButparagraphC24severelylimitstheapplicationoffairvalueconceptsto
inventory:
C24.ThisStatementalsodoesnotapplyforthemarketvaluemeasurement
thatresultswhenmeasuringinventoriesatthelowerofcostormarketunder
ARBNo.43,Chapter4,‘InventoryPricing.’ARB43,Chapter4,places
upperandlowerlimitsonthemeasurementthatmaynotresultinafairvalue
measurement.
Thelowerofcostormarketcalculationsasillustratedabovestillapplyrather
thanfairvalue.Wecanexpectinventoriestobevaluedatfairvaluetobeconsistent
withotherassetvaluesinthefuture.
InventoryandFinance
Therearetworelevantfnancialaspectsofinventory.First,theaccountingmeasures
ofinventorystocksandfowsaffectboththeincomemeasureandbalancesheet.
Second,thelevelofinventoryheldaffectstheamountofcapitalneededaswell
astheincomeoftheperiod.Theavailabilityofinventoryaffectsthelikelihoodof
makingasaleaswellasthecostsofcarryinginventory.
Thedeterminationoftheoptimumlevelofinventoryunderconditionsofcer-
taintyistheresultofbalancingthecostsoforderingwiththecostsofcarrying
inventory.Withuncertainty,thefrmalsohastobalancethecostsofhavingtoo
muchinventorywiththecostsofhavingtoolittle.Inadequateinventorylevelslead
todisruptionsinproductionandlostsalesopportunities.Excessiveinventoriestie
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AnIntroductiontoAccountingandManagerialFinance
upcapitalinassetsthatarenotearninganadequatereturn.Excessiveandleftover
inventorycanlosevaluethroughobsolescenceandcauseexcessivestoragecost.
InventoryModelsversus“JustinTime”
OnemanagerialtechniquethathasbeenexportedfromJapantotheUnitedStatesis
the“justintime”inventorymodel.Ratherthanhavinglargesafetystocks,thenext
shipmentarrivesjustasthelastunitisused.Thisreductionininventorylevelsresults
inincreasedprofts.Also,byreducingset-upcosts(includingset-uptime),theorder
size(orproductionrun)isfurtherreduced,againresultinginlessinventory.
Despitethegreatappealofazero-inventorydecisionmodel,wewilltakethe
positionthattheoptimumlevelofinventorywilldependonthefactsandmustbe
determined.A“justintime”inventoryproceduremayberightwheretheinstanta-
neoussupplyiscertainorwhenthereiszerocostofbeingshortofinventory.With
otherfacts,a“justintime”policymaynotbeattractive.Imaginefyingacrossthe
AtlanticOceaninaBoeing747thathadjustenoughfueltoreachtheothersideof
theoceanifthetailwindisaconstant40milesperhour.Mostofuswouldprefer
amarginforerrorarisingfromcarryingextrafuel.
AnInventoryModel
Althoughinventoriesareheldforspeculation(thepriceisexpectedtoincreaseor
astrikeisanticipated),weshallonlyconsiderthesituationwheninventoriesare
heldfortransactions(eitherforproductionorforsales).
First,weassumethattherateofusage(demand)andallotherfactorsareknown
withcertainty.
Theeconomicorderquantity(EOQ)modelisthemostsimpleandmostwidely
usedofalltheformalmathematicalinventorymodels.Itgivesexactanswersthat
arecorrectiftheassumptionsarevalid.
Let
K
=
theordercost(perorder);
r
=
thecarryingcost(perunitpertimeperiod);
D
=
thetotalexpecteddemand(duringthetimeperiod).
Ifwedefne
Q
tobetheoptimalordersize(theEOQ),thentheaverageinventory
onhandis
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
.
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353
As
Q
increases,thecarryingcost,
r
Q
2
,increases.Butas
Q
increases,thecost
ofordering,
K
D
Q
,decreases.
Tominimizethisexpressionrequiresthatitsderivativebetaken,setequalto
zero,andsolvedfor
Q
.
1
Q
=
2
KD
r
1
/
2
.
AssumptionsimplicitintheEOQmodelare:
1.Aknown,constantdemandovertheperiodandknowndeliverytimes.
2.Nochangeinholdingcostsperunitorordercosts.
3.Nochangeinpricesthroughtimeandnoquantitydiscounts.
If
K
(ordercosts)isequaltoorclosetozero,then
Q
willbeequaltoorcloseto
zero.Ifset-uporordercostsareverysmall,thentheamountorderedwillbevery
smallandtheresultinginventory,whichis
Q/
2,willbeverysmall.The“justin
time”rulewouldbeeffectivewithsmallamountsofinventoryarrivingeachtime.
TheValueofInventoryReductions
Whatisitworthtoafrmtoreduceitsaverageinventoryby$1million?Theanswer
is$1millionplusanyreductionsincostssuchasinsurance,storage,taxes,andso
on.Thefnancialincentivetohaveatheoreticallycorrectinventorypolicyislarge.
InventoryLevelsandUncertainty
Ifwerelaxtheassumptionofcertainty,thenthefrmwillwanttohaveinventory
topreventstockouts.
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.
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AnIntroductiontoAccountingandManagerialFinance
Let
k
u
=
thecostperunitofnothavingenoughinventory(costofunderage);
k
0
=
thecostperunitofhavingexcessinventory(costofoverage).
Defne
p
tobetheprobabilitythatthenextunitofinventoryisdemandedand
(
1
−
p)
thatitisnotdemanded.Weassumethatiftheunithasnotbeenordered,
itcannotbereorderedwhentheactualdemandisestablished.
Wewanttheexpectedcostofunderagetobeequaltotheexpectedcostof
overage:
pk
u
=
theexpectedcostofhavingaunitdemandedandnothavingit;
(
1
−
p)k
0
=
theexpectedcostofnothavingaunitdemandedbuthaving
itininventory.
Atthemargin,
pk
u
=
(
1
−
p)k
0
.
Solvingfor
p
yields
p
=
k
0
k
0
+
k
u
.
Example
Assumethat
k
0
=
$20
k
u
=
$80
sinceeachunitcosting$20canbesoldfor$100.Aleftoverunitisworthless.
Theprobabilityofdemandis:
ProbabilityofDemandBeingat
UnitsDemand
D
ProbabilityLeastasLargeas
D
00.101.00
10.200.90
20.300.70
30.200.40
40.100.20
50.100.10
60.000.00
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355
Solvingfor
p
,weobtain
p
=
k
0
k
0
+
k
u
=
20
20
+
80
=
0
.
2
.
Thenumberofunitsthatshouldbeobtainedis3or4(thefourthunitdoesnotadd
toproft).Theexpectedproftoforderingthreeorfourunitsis$140:
Order4Units
UnitsProftsonLeftoverCostofLeftover
DemandedSoldUnitsSoldUnitsUnitsNetProftProbability
00$04$80
−
$800.10
1180360$200.20
221602401200.30
332401202200.20
44320003200.10
54320003200.10
Expectedproft
=
$140
Order3Units
UnitsProftsonLeftoverCostofLeftover
DemandedSoldUnitsSoldUnitsUnitsNetProftProbability
00$03$60
−
$600.10
1180240$400.20
221601201400.30
33240002400.20
43240002400.10
53240002400.10
Expectedproft
=
$140
Theexpectedproftcalculationfororderingtwounitsis$120:
Order2Units
UnitsProftsonLeftoverCostofLeftover
DemandedSoldUnitsSoldUnitsUnitsNetProftProbability
00$02$40
−
$400.10
1180120$600.20
22160001600.30
32160001600.20
42160001600.10
52160001600.10
Expectedproft
=
$120
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AnIntroductiontoAccountingandManagerialFinance
Ifweallowreorderingbutthetimetoreplenishinventoryisnotknown,thenthere
willbeneedforsafetystock.
Fromafnancepointofview,everydollarthatisreleasedfrominventorysaves
adollarofcapital.Unfortunately,wecannotthenconcludethatitisdesirableto
reduceinventory.Managementmustbalancethecostsandbeneftsofinventory
reduction.Carryinginventoryhasacost,butsodoesexcessivereorderingorbeing
caughtshortofinventory.
Insomecases,itmightbefeasibletoreducetheorderingcostsorthedowntime
associatedwithproductionchangeovers.Uncertaintyastotimingofreplacement
canalsobereducedwithgoodmanagement.Thus,theinventorymodelsandthe
valuesofthevariablesshouldnotbetakenasgiven,butratherthepossibilityof
changingtheprocesstoimproveeffciencyshouldbeinvestigated.
Conclusion
Therearemanycomplexproblemsassociatedwithaccountingforinventories.
Forexample,indeterminingthecostoftheinventory,weencounterproblems
ofdeterminingwhatcostsaretobeincludedininventoryandwhatassumptions
shouldbemadeaboutcostfow(FIFO,LIFO,orweightedaverage).Alowerof
cost-or-marketrulemayalsobeused.
FIFOassumesthatthemostrecentcostsshouldbeassignedtoinventory;thus,
itsuseresultsinrecentcostsbeingrefectedinthebalancesheetandoldercosts
beingrefectedintheincomestatement.LIFOassignsthemostrecentcoststocost
ofgoodssold;thus,itsuseresultsinrecentcostsbeingrefectedintheincome
statementandoldercostsbeingrefectedinthebalancesheet.Sincethecosts
assignedtoinventorymaybeveryold,thebalancesheetvaluationsthatresult
fromtheuseofLIFOmaynotbereliableestimatesofcurrentmarketvalue.
QuestionsandProblems
1.Whichofthefollowingcostswouldbeproperlyincludableintheinventoryof
aretailingfrm?
a.Advertisingcosts.
b.Grossinvoicecostofmerchandisepurchased(discountwasavailablebut
nottaken).
c.Grossinvoicecostofmerchandisepurchased(discountwastaken).
d.Netinvoicecostofmerchandisepurchased.
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357
e.Transportationcostapplicabletogoodspurchased.
f.Transportationcostapplicabletogoodsdeliveredtocustomers.
2.Whichofthefollowingcostswouldbeproperlyincludableintheinventoryof
amanufacturingfrm?
a.Directlaborcost.
b.Salariesofshopforemen.
c.Salesrepresentatives’salaries.
d.Salaryofvicepresidentinchargeofmanufacturing.
e.Depreciationoffactorybuilding.
f.Depreciationofsalesoffce.
3.Foreachofthefollowingproducts,describethe
physicalfow
thatonemight
normallyexpecttheproductstofollowthroughafrm.
a.Bakeryproducts.
b.Nailsinabin.
c.Bottledmilk.
d.Gasolineinundergroundtanks.
e.Coalinapile.
f.Wineinavat.
4.Discusstheprocedureof“cost-or-market,whicheverislower”inlightofthe
basicaccountingassumptionsofconsistency,conservatism,andobjectivity.
5.Assumethatacompanymustusethesameinventoryfowassumptionconsis-
tentlyfromyeartoyear.Whichfowassumptionwouldgenerallyresultinthe
highestreportedincomeduringanextendedperiodofrisingprices?Which
duringanextendedperiodoffallingprices?
6.Inanticipationofincreasedsteelprices,theAutoCompanypurchasedafour
months’supplyofsteel.AsofDecember31,thecostsofcarryingthissteelin
inventorywere$10,000,000(thesteelhadaninvoicepriceof$200,000,000).
ShouldthesteelinventorybeshownontheDecember31statementsat
$200,000,000or$210,000,000?
7.TheIthacaGasCompanyhasaproblemarisingfromtheseasonalnatureof
itsproduct.Peopleusemoregasinthewintertoheattheirhomesandto
cook.Thiscreatestheproblemofpeakloads.Theproblemismadeevenmore
diffcultbythefactthattherearefveorsixexceptionallycolddayseach
winter,duringwhichtimethedemandforgasincreasestremendously.Rather
thanbuildpipelinesforthepeakloads,thedailyfuctuationsarehandled
bytheuseofgastanks.Thepeakloadscreatedbyseasonaldemandshave
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AnIntroductiontoAccountingandManagerialFinance
beensomewhatsolvedbytheuseofundergroundstorage.Gasispumped
undergroundunderpressureduringthesummerandthenusedinthewinter.
Ofthe$10,000,000worthofgaspumpedundergroundduringthefrstyearof
operatingtheundergroundstorage,itisestimatedthat$7,000,000willnever
berecovered(thisamountofgasisrequiredtobuildupthepressuresothat
gasmaybetakenout).
Shouldthe$7,000,000betreatedasinventory?Doesamanufacturingfrm
haveasimilarproblem?
8.TheRustySteelCompanyshiftedtotheLIFOmethodofaccountingforinven-
toryin1929.Atthattime,theinventoryofTypeA-1steelplatewas1,000tons,
withacostof$100perton.
In1932,thecompanydecidedtocontinueusingLIFO,butitalsoincorpo-
ratedthe“cost-or-market,whicheverislower”criterion.Costwascomputed
byusingaLIFOassumptionastofow.Atthattime,theinventoryofType
A-1steelplatewas$2,000tons,andthemarketvaluewas$40perton(cost
rangedfrom$50to$100perton).Thefollowingentrywasmadetowritethe
inventorydowntomarket:
LossonInventoryPriceDecline.................80,000
Inventories...............................80,000
From1932to2010,inventoriesofTypeA-1steelplateincreasedeachyear,
andthemarketvaluewasneverlowerthan$40perton.In2010,thefnished
goodsinventoryofA-1steelplatedecreasedto500tons.In2010,atonofsteel
plateofthistypecost$200pertontoproduce(themarketvaluewasgreater
than$200).
a.Commentonthewrite-downofinventoryin1932andtheprocedureused
sincethen(LIFOpluscost-or-market).
b.Howwouldtheincomefor2010beaffectedbythefactthatinventorywas
decreasedbyatleast1,500tons?
9.TheD.JonesShipCompanyreceivedanorderonJuly1,2010,tobuilda
110,000-tontanker.Thecostsconnectedwithobtainingthesalewere$20,000,
andthesewereallincurredin2010.Itisestimatedthatthetankerwilltake24
monthstobuild.
Howshouldthesellingcostsbetreated?Howshouldthecostsconnected
withconstructingtheshipbetreated?Whenshouldtherevenuefromthesale
oftheshipberecognized?
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359
10.Considerthetwofollowingsituationsanddeterminethedispositionofthecost
ofwarehousing.
a.TheABCCompanypurchasedatruckloadofminkcoats.Demandwasnot
asstrongasexpectedand,ratherthanselltheleftovercoatsatalargeloss,
itwasdecidedtostorethemuntilthenextyear.
b.TheXYZLumberCompanyhadtheopportunitytopurchasealargequantity
ofrarewoodpaneling.Itexpectedtobeabletosellthispanelingoverthe
next18months.Thecompanyactuallysolditin12months.
11.DuringthemonthofApril,theJansenManufacturingCompany’sRawMate-
rialsaccountwasdebitedfor$511,000.Areviewoftheentriestotheaccount
disclosedthecompositionofthedebitstobeasfollows:
MaterialsPurchased(grossprice)$450,000
Freight-in(includingdemurragechargesof$3,000)15,000
ReceivingDepartmentCosts25,000
MaterialsHandlingandStorageCosts10,000
AllocationofSellingDepartmentCosts5,000
ShippingDepartmentCosts6,000
$511,000
ThecompanyfollowsaprocedureofcreditingaPurchaseDiscountRevenue
accountwhenpurchasediscountsaretaken.Termsofpurchaseare2/10,
n
/30.
AnalyzeandadjusttheRawMaterialsaccountasnecessary.
12.TheWinchesterStoreshowsthefollowinginformationrelatingtoCommodity
A,whichithandles.
Inventory,January1:100units@$6.50
PurchasesforJanuary:400units@$7.00
Inventory,January31:175units
a.Whatvalueshouldbeassignedtotheendinginventory,assumingtheuse
ofLIFO?
b.WhatisthecostofgoodssoldforJanuary,assumingtheuseofFIFO?
c.Whatisthevalueoftheendinginventory,assumingcostisdeterminedonthe
basisofaweightedaverageandvaluationisatcost-or-market,whichever
islower?MarketonJanuary31is$6.75.
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AnIntroductiontoAccountingandManagerialFinance
13.Fromthefollowingdata,determinetheinventoryvaluationbyapplyingthe
ruleofcost-or-market,whicheverislower.
CommodityQuantityUnitCostUnitMarket
A100$1.15$1.05
B4002.402.75
C5004.004.35
D7003.453.10
14.DuringthemonthofJanuary,theJamesManufacturingCompany’sRawMate-
rialsaccountwasdebitedfor$450,000.Areviewoftheentriestotheaccount
disclosedthecompositionofthedebitstobeasfollows:
MaterialsPurchased(grossprice)$400,000
Freight-in(includingdemurragechargesof$3,000)12,000
ReceivingDepartmentCosts20,000
MaterialsHandlingandStorageCosts8,000
AllocationofSellingDepartmentCosts7,000
ShippingDepartmentCosts3,000
$450,000
ThecompanyfollowsaprocedureofcreditingaPurchaseDiscountRevenue
accountwhenpurchasediscountsaretakenorlost.Termsofpurchaseare2/10,
n
/30.
a.AnalyzeandadjusttheRawMaterialsaccountasnecessary.
b.Describebriefyageneralrulefordeterminingwhatcostsaretobeconsid-
eredasCostofMaterialPurchases.
15.TheBlueFrontStoreshowsthefollowinginformationrelatingtoCommodity
A,whichithandles.
Inventory,January1:100units@$5.00
Purchases,January300units@$6.00
Inventory,January31:200units
a.Whatvalueshouldbeassignedtotheendinginventory,assumingtheuse
ofLIFO?
b.WhatisthecostofgoodssoldforJanuary,assumingtheuseofFIFO?
c.Whatisthevalueoftheendinginventory,assumingcostisdeterminedonthe
basisofaweightedaverageandvaluationisatcost-or-market,whichever
islower?MarketonJanuary31is$5.80.
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361
16.DuringthemonthofJune,SampleCompanysold350units.Thefollowing
informationisgivenonpurchases.
BeginningInventoryJune1100units$1.00$100
June10150units1.10165
June20200units1.25250
June28100units1.40140
Computethecostofgoodssoldandendinginventory,using:
a.FIFO.
b.LIFO.
c.AverageCosts.
17.TheInfateCompanyhas100unitsofinventorythatcost$5.00perunit.It
sellsthe100unitsfor$7.00perunitandreplacesthematacostof$6.50per
unit.
a.Determinetheincome,using:
i.FIFO.
ii.LIFO.
b.Determinetheinventory,using:
i.FIFO.
ii.LIFO.
c.Whatdidtheendinginventoryactuallycost?
18.(continue17)Assumethemarketvalueattheendoftheperiod(replacement
cost)is$8.Howmightyoubringthisinformationintothereporting?
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November6,200913:44spi-b8119inx6inb811-ch18
Chapter18
TheCashFlowStatement
FinancialAccountingStandardsStatementNo.95(StatementofCashFlows)dated
November1987establishesstandardsforcashfowreporting.Itsupersedesstate-
mentsdealingwithchangesinfnancialpositionandfundfowstatements.
Thebottomlineofthecashfowstatementiseither“Netcashprovidedby
(usedin)investingactivitiesofcontinuingoperations”orthecashbalance“Cash
andcashequivalentsatendofyear.”Thesecondtermisamoreexacttermsince
itrequiresthatallitemsaffectingthecashbalanceduringtheyearbeincludedin
thereport.
ThreeMainSections
Thethreemainsectionsofthecashfowstatementare:
1.Cashfowsfromoperations.
2.Cashfowsfrominvestingactivities.
3.Cashfowsfromfnancingactivities(includingeffectofexchangeratechanges
oncash).
CashFlowsfromOperations
Thecontinuousprocessofproducingandsellingthecompany’sproductorservice
isoneofthemainsourcesofcashofanenterprise.Thecashfromoperations,
however,willonlyrarelybeequaltotheoperatingincome.Theaccrualbasis
ofaccountinginvolvestherecognition,forincomedeterminationpurposes,of
severaltypesofeconomiceventsthatdonotinvolvecash.Forexample,someof
theexpensesofaperioddonotusecashduringtheperiod.
Frequently,theincomestatementfortheperiodisusedasthestartingpointfor
derivingthecashfowstatement.Tocomputethenetcashfromoperations,itis
363
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AnIntroductiontoAccountingandManagerialFinance
necessarytoaddbacktooperatingincomethoseexpensesthatdidnotutilizecash
andtosubtractthoserevenueorotherincomeitemsthatdidnotgeneratecash.An
alternativetreatmentistostartwithrevenuesthatincreasecashandthendeduct
onlythoseexpensesthatutilizecash.Thedisadvantageofthelatterprocedureis
thatitdoesnotmakespecifcreferencetotheincomefgurereportedintheincome
statement.Thetwoproceduresmaybereconciled,however.Thecurrentdiscussion
willbelimitedtotheprocessthatstartswithincome.
Themainitemsthatmaynecessitateadjustmentstoincometoobtainthecash
fromoperationsare:
Depreciationoffxedassets;
Depletionofnaturalresources;
Amortizationofpatentsandotherintangibles;
Lossorgainonsaleorretirementofnoncurrentassets(Thecashorother
currentassetsreceivedfromthesaleisasourceoffunds,butthisisnot
likelytobeequaltothegainrecognized.Salesofnoncurrentassetsare
shownseparatelyinthestatement.);
Accumulationofbonddiscountoramortizationofpremium;and
Expensesassociatedwithfutureincometaxliabilities.
Example
Giventhefollowingconventionalstatement,computethecashfromoperations.
Sales$50
,
000
Less:
Labor,etc.$35
,
000
Depreciation12
,
000
TotalExpenses47
,
000
NetIncome$3
,
000
Thecashfromoperationsmaybecomputedbyaddingbacktoincomethose
expensesthatdidnotusefunds.
IncomeReported$3
,
000
Addbackexpensesnotusingfunds(depreciation)12
,
000
CashfromOperations$15
,
000
Thisprocedureisverywidelyused.Depreciationmustbeexplicitlyaddedto
obtainthetotalcashfow.Itshouldberecognizedthatdepreciationactuallyhasno
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TheCashFlowStatement
365
effectonworkingcapital,butismerelyaddedbacktoincometooffsettheresultof
theaccountingentrythatresultedinitsbeingdeductedfromrevenuetodetermine
theamountofincome.
Theaccountingentrytoaccruedepreciationisadebittodepreciationexpense
andacredittothefxedassetaccount(usuallyacontraaccount,suchasAccumu-
latedDepreciation,isused).Theassetthathasbeendecreasedisalong-livedasset.
Thus,cashandworkingcapitalarenotaffectedbytheaccrualofdepreciation,and
depreciationshouldnotbedeductedfromrevenuesifwearecomputingfundsfrom
operations.Ifithasbeensubtracted(i.e.,ifwearestartingfromincomeratherthan
fromrevenue),itisnecessarytoaddbacktoincometheamountofdepreciation
deductedfromrevenuetoobtainthecashfromoperations.
Leavingoutthetaxconsequences,
cashisnotgeneratedbychargingor
accruingdepreciation;itiscreatedbysales
.Chargingmoreorlessdepreciation
willhavenoeffectontheamountofworkingcapital.Thedepreciationcharge
affectstheincomeoftheperiod,anditwillaffecttheamountthathastobe
addedbacktoincometocomputethefundsfromoperations.Ifwestartwith
income,depreciationexpenseisaddedbacktoincome,sincedepreciationdoesnot
usecash.
Ifthetaxconsequencesofdepreciationareconsidered,depreciationmaybe
regardedashavinganeffectoncash.Theamountofdepreciationchargedfor
taxpurposesaffectsthecurrentpaymentortheliabilityrecognizedfortaxes.The
taxitselfisthecurrentoutlayaffected.Theamountofdepreciationchargedfor
fnancialaccountingpurposesdoesnotaffectcash.
Thedepletionchargestakenbyfrmsinextractiveindustries(mining,oil,and
soforth)shouldbetreatedinamannersimilartothatofdepreciation.Becausethe
depletionchargedoesnotresultinadecreaseofcash,itmustbeaddedbackto
incometoobtaincashfromoperations.Ingeneral,theexpensearisingfromthe
amortizationofanylong-livedassetmustbeaddedbackwheneverthecashfrom
operationsfgureistobederivedfromincome.
GainorLossonSaleofNoncurrentAssets
Whennoncurrentassetsaresold,thedifferencebetweenthebookbasisfortheasset
(costlessdepreciationoramortization)andtheamountreceivedisrecognizedasa
gainorloss.Suchgainsandlossesareincludedintheincomecalculation,butare
oftenstatedseparately.Long-livedassetsthatmaybesoldincludeland,buildings,
equipment,andinvestments.
Fromtheviewpointofcashchanges,wearenotconcernedwiththeamount
ofgainorlossrecognized,butratherwiththeamountofcashreceivedinthe
November6,200913:44spi-b8119inx6inb811-ch18
366
AnIntroductiontoAccountingandManagerialFinance
transaction.Thesaleofanoncurrentassetisnotconsideredtobeapartofcur-
rentoperations,butthecashwouldbeshownasasourceofcash.Therefore,if
theworkingcapitalreceivedisincluded,thelossorgainarisingfromthesale
oftheseassetsmustbeeliminatedincomputingcashfromoperations.Anyloss
mustbeaddedbacktoincomeifithasbeensubtracted.Anygainrecognized
mustbesubtractedifithasbeenincludedinincome.Includingthegainsand
lossesfromthetransactioninadditiontothecashreceivedwouldresultindouble
counting.
Example
Afxedassetwithabookvalueof$10,000issoldfor$12,000cash.
a.Whatisthegainorlossrecognized?
b.Whatamountofcashisgeneratedbythetransaction?
c.Whatadjustmentmustbemadetotheincomefortheperiodtoobtainthefunds
fromoperations?
Solution
a.Thegainis$2,000.
b.Cashof$12,000isgeneratedbythetransaction.
c.The$2,000gainmustbesubtractedfromincome(assumingthatithasbeen
includedinotherincome).Nottosubtractthe$2,000wouldmeanthatcashof
$14,000wouldbereportedtohavebeengenerated,butonly$12,000ofworking
capitalwouldactuallyhavebeenreceived(the$14,000isequaltothe$2,000
gainplusthe$12,000ofcashreceived).
Example
Afxedassetwithabookvalueof$10,000issoldfor$8,000cash.
a.Whatisthegainorlossrecognized?
b.Whatcurrentassetsaregeneratedbythetransaction?
c.Whatadjustmentmustbemadetotheincomefortheperiodtoobtainthefunds
fromoperations?
Solution
a.Thelossis$2,000.
b.Cashof$8,000isgeneratedbythetransaction.
November6,200913:44spi-b8119inx6inb811-ch18
TheCashFlowStatement
367
c.The$2,000booklossmustbeaddedbacktoincome(assumingthatithadbeen
subtractedtoobtaintheincomefgure).Nottoaddbackthe$2,000wouldmean
thatalosswhichdidnotutilizecashwassubtractedincomputingcashfrom
operations.
BondDiscountorPremium
Thenormalentryforrecordinginterestaccruedonabondpayablethathadbeen
issuedatadiscountis:
InterestExpense............................40
BondDiscount.........................2
InterestPayable........................38
Theexpenseis$40,butthedecreaseinworkingcapital(byanincreaseincurrent
liabilities)isonly$38.Whentheinterestispaid,cashisreducedby$38.The
differencebetweentheinterestexpenseandthecashoutlayof$2iscausedby
thefactthatlong-termliabilitieshavebeenincreasedby$2(thecredittoBond
Discountineffectincreasesthelong-termdebt).Thus,theinterestexpenseforthe
periodisnotequaltothedecreaseincash.
Theadjustmentthatshouldbemadeistoadd$2backtoincome,if$40of
interestexpensehasbeensubtractedinobtainingincome.
Bondsissuedatapremiumrequireanadjustmentintheoppositedirection.In
thiscase,theamountofcashusedwouldbegreaterthantheexpenserecognized,
asindicatedbythenormalaccrualentry:
InterestExpense............................45
BondPremium.............................5
InterestPayable........................50
The$5isauseofcash,butonlytheinterestexpenseisdeductedindetermining
income.Theadditionalcurrentoutlayduetotheamortizationofthepremium
reducescash.
CashFlowsfromInvestingActivities
Thissectionincludesthecashfromthesaleoflong-livedassetsorthereclassi-
fcationofspecialcash“funds”.Thisincludesthesaleofinvestments(butnot
marketablesecuritiesclassifedascurrentassets),land,buildings,andequipment.
November6,200913:44spi-b8119inx6inb811-ch18
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AnIntroductiontoAccountingandManagerialFinance
Cashsetasideforbuildingpurposes,debtretirement,andsoforthissometimes
classifedasacashusage.Whenthefundisliquidated,anyresidualcashmaybe
asource.Gainsfromtransactionsinvolvinglong-livedassetsareexcluded,but
thecashacquiredinsuchtransactionsisincluded.Cashiscommonlyutilizedto
purchaselong-livedassets(land,buildings,equipment,investments,patents,and
soforth)ortoretirelong-termdebt.
CashFlowsfromFinancingActivities
Animportantsourceofcashistheissuingofnewsecurities,bothlong-termdebt
andstockequity.Thisincludescommonandpreferredstock,bonds,long-term
notes,andwarrants.
Dividendspaidonbothcommonandpreferredstockwillappearinthissection
ascashoutlays.Purchaseofcompanystockisanothercommonoutlay.
Ifthecompanyhascapitalleases,thiswillbeacashoutlayreportedin
thissection.Anyinvestmentinfowsorinvestmentoutfowsareincludedinthis
section.
TransactionsNotAffectingFunds
Mostoftheproblemsarisinginthepreparationofstatementsofchangesin
fnancialpositionarenotconnectedwiththosetransactionsthataresources
ofcashordistributionsofcash,butaretheresultoftransactionsthatdonot
affectcash.Atransactionofthisnatureistheaccrualofdepreciationanddeple-
tion.Appropriationsofretainedearningsarealsoofthisnature.Theestab-
lishmentofanaccountsuchasDeferredIncomeTaxesdoesnotinvolvecash;
thus,itshouldnotaffectthecashfromoperations(theexpensewillhavetobe
addedbacktoincome).Astockdividend(incontrastwithacashdividend)is
anothertransactionthatdoesnotdirectlyaffecttheworkingcapitalpositionof
thefrm.
ManagerialUses
Acashfowstatementisusefulbecauseittellsuswherethecashiscomingfrom
andwhereitisbeingused.Itis,bynecessity,asummary,butitdoesindicatewhat
ishappeningtothecashpositionofthefrmandwhyitishappening.Thisisof
importancetomanagementaswellasinvestors.
Althoughthestatementasdefnedisuseful,managementneedsadditional
information.Explanationsofwhythecashbalancehaschangedaredesirable,
November6,200913:44spi-b8119inx6inb811-ch18
TheCashFlowStatement
369
andforecastsofwhatisgoingtohappentocashinthefutureareoftenessential.
Thisinformationisnecessarytoensurethattheproperamountofcashwillbeon
handfortheoperationsoffutureperiods.Asproductivefacilitiesareenlarged,the
treasurerofthecorporationmustensurethatcashisonhandtopayforthecon-
structionofthefacilities.Asthefacilitiesareplacedintooperations,newworkers
mustbepaid,materialspurchased,andsoforth.Alltheseitemsrequirethatcash
beavailablelongbeforetheproductbeingproducedissold.
EBIT(EarningsBeforeInterestandTaxes)
TocomputeEBIT,startwiththecorporateincomeandaddbacktheamountsof
interestandtaxes.
ThemostcommonwayofusingEBITistomultiplyEBITbyaconstantto
obtainavalueforthecorporation.
Financialanalystsuseseveraldifferentfowmeasuresandmultipliers.The
multipliersareappliedtoeitherhistoricalmeasuresorforecastsforthenextperiod.
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(defnedto
be
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
.
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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
)
.
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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.Thisoccurssincethevalues
ofallthreemultipliersarelinked.Inpractice,themultiplierforEBITDAislikely
tobedeterminedbyagroupofwisemen(usingjudgment)ratherthanfnance
theorists,andthethreevaluesarelikelytobedifferentratherthanbeingexactly
equal.
Itislikelythatthesemultiplierscannotbeappliedtoadifferentfrmwitha
differentcostofequityandadifferentgrowthrate.Above,themultiplierswere
computedbasedonspecifcinformation.Otherinformationwillleadtodifferent
multipliers.
TheInternationalAccountingSurge
Currently,theU.S.accountingstandardsareestablishedbytheFinancialAccount-
ingStandardsBoard(FASB)locatedinNorwalk,Connecticut.TheFASBsupplies
verydetailedrulesandguidancefortheaccountingprocessofpubliccorporations.
Inthedistantfuture,wecanexpecttherulesandguidanceofferedbythe
InternationalAccountingStandardsBoard(IASB)tobegivenmoreorless
equalstanding.TheIASBallowsmorejudgmentthantheFASBinapplying
principles.
Theobjectivewilllikelybetoprovideinformationusefulformakingeconomic
decisionsnotfollowingasetofbookkeepingrules.Along-termobjectiveisto
haveonesetofrulesthroughouttheworldsothatfnancialstatementsoriginating
indifferentcountriesarecomparable.
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AnIntroductiontoAccountingandManagerialFinance
Conclusion
Wecanexpecttheuseoffairvalueforbothassetsandliabilitiestoincrease.
Thus,theuseofhistoricalcostscanbeexpectedtodecreaseexceptforcashand
nearcash.
Thougheasy,ruleswillbeincorrectlydiscarded(ifnotalreadydiscarded).
Thus,justifyinganaccountingprocessbecauseitisconservativewillnotbe(is
not)accepted.
Afaithfulrepresentationofassets,liabilities,andincomewillbemoreimpor-
tantthanbeingabletoverifytheexactcorrectnessofthemeasures.Itwillbe
recognizedthatestimationisanimportantandinescapableelementoftheaccount-
ingprocess.
Keepinginmindtheabovesetofobjectiveswillhelpyoubeabetteraccountant
oruserofaccountinginformation.
Wehaveattemptedtoshowthatthereareavarietyofmeasures,someobjective
andsomehighlysubjective,thatcanbeusedbythedecisionmakersinattempting
todeterminethevalueofafrm.Thereareexactmethodsofcalculation,butthere
arenotexactreliablemeasuresofvalue.
Accountinginformationmustbeadjustedforpurposesofdeterminingthevalue
ofafrm.Theliquidationvalueoftheassetssetsaminimumpriceandvalue,
butanyvalueinexcessofthisminimummustfnditsjustifcationinthepresent
valueoftheprojectedcashfowexpectedtobegeneratedinthefuture.Thegoing
concernvalueoftheassets,withtheassetsgainingtheirvaluefromthecashfow,
istherelevantfactor.Theprimeadvantagetobegainedbyusingcashfowversus
conventionalincomeisthatitistheoreticallycorrectanditdoesnottieustothe
resultsofaccountingproceduresthatarenotdesignedforthisspecifctypeof
decision.Ifthedecisionmakerswanttousethecurrentincomeasthebasisfor
makingtheirinvestmentdecision,careshouldbetakensincethecomputationmay
notbeequivalenttotheuseofcashfows.However,eveniftheydonotusethe
incomemeasuredirectly,thedecisionmakerswilluseitindirectlyasthebasisfor
theirevaluationoffuturedividends.
Thecashfowstatementofchangesinfnancialpositionhasbecomeanimpor-
tantandwidelyusedfnancialreport,helpingthereadertounderstandchangesin
thecashpositionofthefrm.Althoughreportingwhathappenedisdesirableand
necessary,managementalsowishestoestimatesourcesandusesofcashinplanning
forthefuture.Onecanformimpressionsfromthehistoricalrecords,butmanagerial
decisionsmustbebasedonprojections.Weshouldplacethecashfowstatementin
properperspective.Thestatementisnotasubstituteforeithertheincomestatement
orthebalancesheet,butisausefulsupplementtothesetworeports.
November6,200913:44spi-b8119inx6inb811-ch18
TheCashFlowStatement
373
QuestionsandProblems
1.“Higherdepreciationaccrualshavereducedtheneedofcorporationstoborrow.”
Commentonthisstatement.
2.Aleadingbusinessperiodicalstatedthat“thetwoprimarysourcesoffundsfor
corporateexpansionareretainedearningsandtheallowancefordepreciation.”
Commentonthisstatement.
3.Therearetwomajorcategoriesoftransactionsthatdonotaffectthefundsfow,
yetmayhaveaprofoundimpactontheoperationsofacompanyandmayeven
affectthecompany’sneedforfnancing.Describethesetwotypesoftransactions
andgiveanexampleofeach.
4.TheNo-AshCoalCompanyrecordedthefollowingtransactions.Indicatehow
eachwouldbetreatedonastatementofchangesinfnancialposition,assuming
thatfundsaredefnedasthecashbalance.Ifthetransactioninvolvesasource
oruseofcash,indicatetheamountthatwouldappearonthestatementas
aresultofthetransaction.Eachtransactionmaybeidentifedasoneofthe
following:
a.Asourceofcash.
b.Auseofcash.
c.Anincomestatementadjustmentthathasnoeffectoncash.
d.Atransactionthathasnoeffectoncashbecauseitinvolveschangesonlyin
non-cashitems.
e.Atransactionthatrepresentsneitherasourceofcashnoranapplicationof
cash.
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.Receivedadiscount
of10percentforpayingcash.
(6)Acquiredanewbuildingwithfairmarketvalueof$200,000byissuing
$200,000inlong-termnotestothebuilder.
5.Howdoesthepresenceofbondpremiumaffectthecomputationofthecash
fromoperations?
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374
AnIntroductiontoAccountingandManagerialFinance
6.Explainhowthegainorlossonthesaleoffxedassetsshouldbetreatedin
computingthecashfromoperations.
7.ShownarecomparativebalancesheetsandanincomestatementfortheRoberts
Company.PrepareacashfowstatementfortheyearendedDecember31,20X2.
TheRobertsCompany
ComparativeBalanceSheetsasofDecember31
20X220X1
Cash$150
,
000$125
,
000
AccountsReceivable197
,
000160
,
000
Inventories50
,
00085
,
000
MachineryandEquipment75
,
00050
,
000
BondsPayable,Discount5
,
250
5
,
500
$477
,
250
$425
,
500
AllowanceforUncollectibles$2
,
000$1
,
000
AccumulatedDepreciation10
,
0007
,
000
AccountsPayable53
,
00070
,
000
BondsPayable100
,
000100
,
000
CommonStock
∗
150
,
00050
,
000
RetainedEarnings
†
162
,
250
197
,
500
$477
,
250
$425
,
500
∗
Represents10,000sharesoutstandingonDecember31,20X2,and5,000shareson
December31,20X1.
†
A$100,000stockdividendwasissuedin20X2.
TheRobertsCompany
IncomeStatementforYearEndedDecember31,20X2
Sales$400
,
000
Less
AllowanceforUncollectibles3
,
000
$397
,
000
Expenses
CostofGoodsSold$260
,
000
OperatingExpenses60
,
000
Taxes7
,
000
InterestExpense5
,
250
332
,
250
NetIncome$64
,
750
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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$260andthattheEBITDA
multiplieris6.Whatisthefrmvalue?
9.Duringtheyear20X2,theFosterCompanypurchasedbuildingsthatcostatotal
of$3,400,000.TheBuildingsaccountandtherelatedAccumulatedDepreciation
wereshowninthecomparativebalancesheetsofthecompanyasofDecember
31,20X1and20X2,asfollows:
20X220X1
Buildings$5
,
600
,
000$3
,
100
,
000
AccumulatedDepreciation2
,
500
,
000
1
,
700
,
000
$3
,
100
,
000$1
,
400
,
000
Thecompany’sincomestatementfortheyear20X2includedthefollowing
items:
DepreciationofBuildings$1
,
200
,
000
GainonSaleofBuildings$600
,
000
Determinethecostofthebuildingsthatweresoldduring20X2andthetotal
amountreceivedfromthesaleofbuildings.
November6,200913:44spi-b8119inx6inb811-ch18
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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%
10.99010.98040.97090.96150.95240.94340.93460.92590.91740.90910.90090.89290.88500.87720.8696
20.98030.96120.94260.92460.90700.89000.87340.85730.84170.82640.81160.79720.78310.76950.7561
30.97060.94230.91510.88900.86380.83960.81630.79380.77220.75130.73120.71180.69310.67500.6575
40.96100.92380.88850.85480.82270.79210.76390.73500.70840.68300.65870.63550.61330.59210.5718
50.95150.90570.86260.82190.78350.74730.71300.68060.64990.62090.59350.56740.54280.51940.4972
60.94200.88800.83750.79030.74620.70500.66630.63020.59630.56450.53460.50660.48030.45560.4323
70.93270.87060.81310.75990.71070.66510.62270.58350.54700.51320.48170.45230.42510.39960.3759
80.92350.85350.78940.73070.67680.62740.58200.54030.50190.46650.43390.40390.37620.35060.3269
90.91430.83680.76640.70260.64460.59190.54390.50020.46040.42410.39090.36060.33290.30750.2843
100.90530.82030.74410.67560.61390.55840.50830.46320.42240.38550.35220.32200.29460.26970.2472
110.89630.80430.72240.64960.58470.52680.47510.42890.38750.35050.31730.28750.26070.23660.2149
120.88740.78850.70140.62460.55680.49700.44400.39710.35550.31860.28580.25670.23070.20760.1869
130.87870.77300.68100.60060.53030.46880.41500.36770.32620.28970.25750.22920.20420.18210.1625
140.87000.75790.66110.57750.50510.44230.38780.34050.29920.26330.23200.20460.18070.15970.1413
150.86130.74300.64190.55530.48100.41730.36240.31520.27450.23940.20900.18270.15990.14010.1229
(
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%
160.85280.72840.62320.53390.45810.39360.33870.29190.25190.21760.18830.16310.14150.12290.1069
170.84440.71420.60500.51340.43630.37140.31660.27030.23110.19780.16960.14560.12520.10780.0929
180.83600.70020.58740.49360.41550.35030.29590.25020.21200.17990.15280.13000.11080.09460.0808
190.82770.68640.57030.47460.39570.33050.27650.23170.19450.16350.13770.11610.09810.08290.0703
200.81950.67300.55370.45640.37690.31180.25840.21450.17840.14860.12400.10370.08680.07280.0611
210.81140.65980.53750.43880.35890.29420.24150.19870.16370.13510.11170.09260.07680.06380.0531
220.80340.64680.52190.42200.34180.27750.22570.18390.15020.12280.10070.08260.06800.05600.0462
230.79540.63420.50670.40570.32560.26180.21090.17030.13780.11170.09070.07380.06010.04910.0402
240.78760.62170.49190.39010.31010.24700.19710.15770.12640.10150.08170.06590.05320.04310.0349
250.77980.60950.47760.37510.29530.23300.18420.14600.11600.09230.07360.05880.04710.03780.0304
260.77200.59760.46370.36070.28120.21980.17220.13520.10640.08390.06630.05250.04170.03310.0264
270.76440.58590.45020.34680.26780.20740.16090.12520.09760.07630.05970.04690.03690.02910.0230
280.75680.57440.43710.33350.25510.19560.15040.11590.08950.06930.05380.04190.03260.02550.0200
290.74930.56310.42430.32070.24290.18460.14060.10730.08220.06300.04850.03740.02890.02240.0174
300.74190.55210.41200.30830.23140.17410.13140.09940.07540.05730.04370.03340.02560.01960.0151
350.70590.50000.35540.25340.18130.13010.09370.06760.04900.03560.02590.01890.01390.01020.0075
400.67170.45290.30660.20830.14200.09720.06680.04600.03180.02210.01540.01070.00750.00530.0037
450.63910.41020.26440.17130.11120.07270.04760.03130.02070.01370.00910.00610.00410.00270.0019
500.60800.37150.22810.14070.08720.05430.03390.02130.01340.00850.00540.00350.00220.00140.0009
(
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%
10.86210.84750.83330.81970.80650.79370.78130.76920.75760.74630.73530.72460.71430.68970.6667
20.74320.71820.69440.67190.65040.62990.61040.59170.57390.55690.54070.52510.51020.47560.4444
30.64070.60860.57870.55070.52450.49990.47680.45520.43480.41560.39750.38050.36440.32800.2963
40.55230.51580.48230.45140.42300.39680.37250.35010.32940.31020.29230.27570.26030.22620.1975
50.47610.43710.40190.37000.34110.31490.29100.26930.24950.23150.21490.19980.18590.15600.1317
60.41040.37040.33490.30330.27510.24990.22740.20720.18900.17270.15800.14480.13280.10760.0878
70.35380.31390.27910.24860.22180.19830.17760.15940.14320.12890.11620.10490.09490.07420.0585
80.30500.26600.23260.20380.17890.15740.13880.12260.10850.09620.08540.07600.06780.05120.0390
90.26300.22550.19380.16700.14430.12490.10840.09430.08220.07180.06280.05510.04840.03530.0260
100.22670.19110.16150.13690.11640.09920.08470.07250.06230.05360.04620.03990.03460.02430.0173
110.19540.16190.13460.11220.09380.07870.06620.05580.04720.04000.03400.02890.02470.01680.0116
120.16850.13720.11220.09200.07570.06250.05170.04290.03570.02980.02500.02100.01760.01160.0077
130.14520.11630.09350.07540.06100.04960.04040.03300.02710.02230.01840.01520.01260.00800.0051
140.12520.09850.07790.06180.04920.03930.03160.02530.02050.01660.01350.01100.00900.00550.0034
150.10790.08350.06490.05070.03970.03120.02470.01950.01550.01240.00990.00800.00640.00380.0023
160.09300.07080.05410.04150.03200.02480.01930.01500.01180.00930.00730.00580.00460.00260.0015
170.08020.06000.04510.03400.02580.01970.01500.01160.00890.00690.00540.00420.00330.00180.0010
180.06910.05080.03760.02790.02080.01560.01180.00890.00680.00520.00390.00300.00230.00120.0007
190.05960.04310.03130.02290.01680.01240.00920.00680.00510.00380.00290.00220.00170.00090.0005
200.05140.03650.02610.01870.01350.00980.00720.00530.00390.00290.00210.00160.00120.00060.0003
(
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%
210.04430.03090.02170.01540.01090.00780.00560.00400.00290.00210.00160.00120.00090.00040.0002
220.03820.02620.01810.01260.00880.00620.00440.00310.00220.00160.00120.00080.00060.00030.0001
230.03290.02220.01510.01030.00710.00490.00340.00240.00170.00120.00080.00060.00040.00020.0001
240.02840.01880.01260.00850.00570.00390.00270.00180.00130.00090.00060.00040.00030.00010.0001
250.02450.01600.01050.00690.00460.00310.00210.00140.00100.00070.00050.00030.00020.00010.0000
260.02110.01350.00870.00570.00370.00250.00160.00110.00070.00050.00030.00020.00020.0001
270.01820.01150.00730.00470.00300.00190.00130.00080.00060.00040.00020.00020.00010.0000
280.01570.00970.00610.00380.00240.00150.00100.00060.00040.00030.00020.00010.0001
290.01350.00820.00510.00310.00200.00120.00080.00050.00030.00020.00010.00010.0001
300.01160.00700.00420.00260.00160.00100.00060.00040.00020.00020.00010.00010.0000
350.00550.00300.00170.00090.00050.00030.00020.00010.00010.00000.00000.0000
400.00260.00130.00070.00040.00020.00010.00010.00000.0000
450.00130.00060.00030.00010.00010.00000.0000
500.00060.00030.00010.00000.0000
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%
10.99010.98040.97090.96150.95240.94340.93460.92590.91740.90910.90090.89290.88500.87720.8696
21.97041.94161.91351.88611.85941.83341.80801.78331.75911.73551.71251.69011.66811.64671.6257
32.94102.88392.82862.77512.72322.67302.62432.57712.53132.48692.44372.40182.36122.32162.2832
43.90203.80773.71713.62993.54593.46513.38723.31213.23973.16993.10243.03732.97452.91372.8550
54.85344.71354.57974.45184.32954.21244.10023.99273.88973.79083.69593.60483.51723.43313.3522
65.79555.60145.41725.24215.07574.91734.76654.62294.48594.35534.23054.11143.99753.88873.7845
76.72826.47206.23036.00205.78645.58245.38935.20645.03304.86844.71224.56384.42264.28834.1604
87.65177.32557.01976.73276.46326.20985.97135.74665.53485.33495.14614.96764.79884.63894.4873
98.56608.16227.78616.43537.10786.80176.51526.24695.99525.75905.53705.32825.13174.94644.7716
109.47138.98268.53028.11097.72177.36017.02366.71016.41776.14465.88925.65025.42625.21615.0188
1110.36769.78689.25268.76058.30647.88697.49877.13906.80516.49516.20655.93775.68695.45275.2337
1211.255110.57539.95409.38518.86328.38387.94277.53617.16076.81376.49246.19445.91765.66035.4206
1312.133711.348410.63509.98569.39368.85278.35777.90387.48697.10346.74996.42356.12185.84245.5831
1413.003712.106211.296110.56319.89869.29508.74558.24427.78627.36676.98196.62826.30256.00215.7245
1513.865012.849311.937911.118410.37979.71229.10798.55958.06077.60617.19096.81096.46246.14225.8474
1614.717913.577712.561111.652310.837810.10599.44668.85148.31267.82377.37926.97406.60396.26515.9542
1715.562214.291913.166112.165711.274110.47739.76329.12168.54368.02167.54887.11966.72916.37296.0472
1816.398314.992013.753512.659311.689610.827610.05919.37198.75568.20147.70167.24976.83996.46746.1280
1917.226015.678514.323813.133912.085311.158110.33569.60368.95018.36497.83937.36586.93806.55046.1982
2018.045516.351414.877513.590312.462211.469910.59409.81819.12858.51367.96337.46947.02486.62316.2593
(
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%
2118.857017.011215.415014.029212.821111.764110.835510.01689.29228.64878.07517.56207.10156.68706.3125
2219.660417.658015.936914.451113.163012.041611.061210.20079.44248.77158.17577.64467.16956.74296.3587
2320.455818.292216.443614.856813.488612.303411.272210.37119.58028.88328.26647.71847.22976.79216.3988
2421.243418.013916.935515.247013.798612.550411.469310.52889.70668.98478.34817.78437.28296.83516.4338
2522.023219.523517.413115.622114.093912.783411.653610.67489.82269.07708.42177.84317.33006.87294.4641
2622.795220.121017.876815.982814.375213.003211.825810.81009.92909.16098.48817.89577.37176.90616.4906
2723.559620.706918.327016.329614.643013.210511.986710.935210.02669.23728.54787.94267.40866.93526.5135
2824.316421.281318.764116.663114.898113.406212.137111.051110.11619.30668.60167.98447.44126.96076.5335
2925.065821.844419.188416.983715.141113.590712.277711.158410.19839.36968.65018.02187.47016.98306.5509
3025.807722.396519.600417.292015.372413.746812.409011.257810.27379.42698.69388.05527.49577.00276.5660
3126.542322.937720.000417.588515.592813.929112.531811.394810.34289.47908.73318.08507.51837.01996.5791
3227.269623.468320.388817.873515.802714.084012.646611.435010.40629.52648.76868.11167.53837.03506.5805
3327.989723.988620.765818.147616.002514.230212.753811.513910.46449.56948.80058.13547.55607.04826.6005
3428.702724.498621.131818.411216.192914.368112.854011.586910.51789.60868.82938.15667.57177.05996.6091
3529.408624.998621.487218.664616.374214.498212.947711.654610.56689.64428.85528.17557.58567.07006.6166
4032.834727.355523.114819.792817.159115.046313.331711.924610.75749.77918.95118.24387.63447.10506.6418
4536.094529.490224.518720.720017.774115.455813.605512.108410.88129.86289.00798.28257.66097.12326.6543
5039.196131.423625.729821.482218.255915.761913.800712.233510.96179.91489.04178.30457.67527.13276.6605
(
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%
10.86210.84750.83330.81970.80650.79370.78130.76920.75760.74630.73530.72460.71430.68970.6667
21.60521.56561.52781.49151.45681.42351.39161.36091.33151.30321.27601.24971.22451.16531.1111
32.24592.17432.10652.04221.98131.92341.86841.81611.76631.71881.67351.63021.58891.49331.4074
42.79822.69012.58872.49362.40432.32022.24102.16622.09572.02901.96581.90601.84921.71951.6049
53.27433.12722.99062.86362.74542.63512.53202.43562.34522.26042.18072.10582.03521.87551.7366
63.68473.49763.32553.16693.02052.88502.75942.64272.53422.43312.33882.25062.16801.98311.8244
74.03863.81153.60463.41553.24233.08332.93702.80212.67752.56202.45502.35552.26282.05731.8829
84.34364.07763.83723.61933.42123.24073.07582.92472.78602.65822.54042.43152.33062.10851.9220
94.60654.30304.03103.78633.56553.36573.18423.01902.86812.73002.60332.48662.37902.14381.9480
104.83324.49414.19253.92323.68193.46483.26893.09152.93042.78362.64952.52652.41362.16811.9053
115.02864.65604.32714.03543.77573.54353.33513.14732.97762.82362.68342.55552.43832.18491.9769
125.19714.79324.43924.12743.85143.60593.38683.19033.01332.85342.70842.57642.45592.19651.9845
135.34234.90954.53274.20283.91243.65553.42723.22333.04042.87572.72682.59162.46852.20451.9897
145.46755.00814.61064.26463.96163.69493.45873.24873.06092.89232.74032.60262.47752.21001.9931
155.57555.09164.67554.31524.00133.72613.48343.26823.07642.90472.75022.61062.48392.21381.9954
165.66855.16244.72964.35674.03333.75093.50263.28323.08822.91402.75752.61642.48852.21641.9970
175.74875.22234.77464.39084.05913.77053.51773.29483.09712.92092.76292.62062.49182.21821.9980
185.81785.27324.81224.41874.07993.78613.52943.30373.10392.92602.76682.62362.49412.21951.9986
195.87755.31624.84354.44154.09673.79853.53863.31053.10902.92992.76972.62582.49582.22031.9991
205.92885.35274.86964.46034.11033.80833.54583.31583.11292.93272.77182.62742.49702.22091.9994
(
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%
215.97315.38374.89134.47564.12123.81613.55143.31983.11582.93492.77342.62852.49792.22131.9996
226.01135.40994.90944.48824.13003.82233.55583.32303.11802.93652.77462.62942.49852.22161.9997
236.04425.43214.92454.49854.13713.82733.55923.32533.11972.93772.77542.63002.49892.22181.9998
246.07265.45094.93714.50704.14283.83123.56193.32723.12102.93862.77602.63042.49922.22191.9999
256.09715.46694.94764.51394.14743.83423.56403.32863.12202.93922.77652.63072.49942.22201.9999
266.11825.48044.95634.51964.15113.83673.56563.32973.12272.93972.77682.63102.49962.22211.9999
276.13645.49194.96364.52434.15423.83873.56693.33053.12332.94012.77712.63112.48872.22212.0000
286.15205.50164.96974.52814.15663.84023.56793.33123.12372.94042.77732.63132.49982.22222.0000
296.16565.50984.97474.53124.15853.84143.56873.33163.12402.94062.77742.63132.49992.22222.0000
306.17725.51684.97894.53384.16013.84243.56933.33213.12422.94072.77752.63142.49992.22222.0000
316.18725.52274.98244.53594.16143.84323.56973.33243.12442.94082.77762.63152.49992.22222.0000
326.19595.52774.98544.53764.16243.84383.57013.33263.12462.94092.77762.63152.49992.22222.0000
336.20345.53204.98784.53904.16323.84433.57043.33283.12472.94102.77772.62152.50002.22222.0000
346.20985.53564.98984.54024.16393.84473.57063.33293.12482.94102.77772.63152.50002.22222.0000
356.21535.53864.99154.54114.16443.84503.57083.33303.12482.94112.77772.62152.50002.22222.0000
406.23355.54824.99664.54394.16593.84583.57123.33323.12502.94122.77782.63162.50002.22222.0000
456.24215.55234.99864.54494.16643.84603.57143.33333.12502.94122.77782.63162.50002.22222.0000
506.24635.55414.99954.54524.16663.84613.57143.33333.12502.94122.77782.63162.50002.22222.0000
Note
:
a
r
istherateofdiscountand
n
isthenumberoftimeperiods.
November6,200913:44spi-b8119inx6inb811-about
AbouttheAuthor
HaroldBierman,Jr.
istheNicholasH.NoyesProfessorofBusinessAdmin-
istrationattheJohnsonGraduateSchoolofManagement,CornellUniversity.
AgraduateoftheU.S.NavalAcademy,Annapolis,hereceivedhisMBAand
hisPh.D.fromtheUniversityofMichigan.
ACornellfacultymembersince1956,ProfessorBiermanformerlytaught
atLouisianaStateUniversity,theUniversityofMichigan,andtheUniversityof
Chicago.HehasalsotaughtatINSEADinFountainebleau,France,andatKULin
Belgium,andwasaresearchfellowatCambridgeUniversity(England).
HewasarecipientoftheDowJonesAwardfromtheAmericanAssembly
ofCollegiateSchoolsofBusinessforhisoutstandingcontributionstocollegiate
businesseducation.HeservedasafnancialconsultantatPrudentialBacheSecuri-
tiesinNewYork.HisindustrialexperienceincludesconsultingforCorningGlass
Corporation,EastmanKodak,SunOilCompany,ExxonOilCorporation,IBM,
andXeroxCorporation.Hehaswrittennumerousbooks,including
TheCapital
BudgetingDecision
(withSeymourSmidt),
FinancialAccounting,Managerial
Accounting
,and
QuantitativeAnalysisforBusinessDecisions
,aswellasmore
than170journalarticles.
385
November6,200913:44spi-b8119inx6inb811-about
This page intentionally left blankThis page intentionally left blank
November6,200913:44spi-b8119inx6inb811-Index
Index
AcceleratedCostRecoverySystem
(ACRS),118
account,43
accountbalances,47
accounting,31
stewardshipfunctionof,29
accountingassumptions,307
accountingdepreciationexpense,130
accountingentries,120
equalityof,46
periodicadjustments,89
accountingentry,32
accountingequation,33
accountingidentity,34
accountinginformation,30
accountingissues,304
accountingmeasures,260
accountingprocess,31
accountingrecords,accuracyof,48
accrualaccounting,86
accumulateddepreciation,197
AccumulatedDepreciationaccount,121
accumulatedearningstax,208
accumulationfactor,14
acquisitions
costof,303
forcash,294
highlyleveraged,304
horizontal,294
valuationfor,297
agencytheory,278
AllowanceforDepreciationaccount,121
amortization,126
annualequivalentamounts,21
annuity,19
derivationof,26
ordinary,19
presentvalueof,17,20,26
annuityinarrears,18,19
anti-raidingmaneuver,293
antidilutionprotection,333
antitrustconsiderations,293
assetsources,34
assets,33,35
valuationof,263
balancesheet,3,30,34,40–43
balancedarray,40
verticalform,40
387
November6,200913:44spi-b8119inx6inb811-Index
388
AnIntroductiontoAccountingandManagerialFinance
balloonpayment,137
bankruptcy,costof,205
betacoeffcientofunity,211
bidprice,295
Black-Scholesmodel,337
boardofdirectors,1
bond,137
valueof,145
withwarrants,335
bonddiscount,367
bondliability,142
bondpremium,367
bondrefundingdecision,143
bookvalue,105,111,112,196
bookvaluepershare,271
buyversuslease,223,230
buy-borrowversuslease,231
calloption,324
callpremium,326
capital
costof,197,212
obtainingof,2,179,180
capitalassetpricingmodel(CAPM),
208–210,212
useof,211
capitalbudgeting,3,15,57,193
capitalcostofrisk,208
capitalgains,172
andtaxdeferraladvantages,178
capitallease,224,225,227
capitalleaseobligation,226
capitalleases,145
capitalmarket,6
capitalreceivedfromstockholders,39
capitalstructure,193
capitaltransactions,155
cashdividends,167
cashfowprojection,elementsof,62
cashfowreturnoninvestment(ROI),129,
282
cashfowstatement,363,372
managerialuses,368
cashfows,5,101
adjustingforthetimingof,8
alternative,22
annual,22
depreciationand,121
fromfnancingactivities,368
frominvestingactivities,367
fromoperations,363
incremental,22,62
relevanceof,4
useof,101,102
versusearnings,5
cashtobereceivedearlier,9
cashtobereceivedtoday,4
CertifedPublicAccountants(CPAs),31
Chevron,289
combinationofstocksandbonds,202
commonstock,3,7,39,152,329
costof,158
issuanceof,153
repurchaseof,167,182
commonstockdividend,171
commonstockequity,195
commonstockequityaccounts,separation
of,161
commonstockholders,1
conglomerateacquisition,294
Conoco,289
consolidatedbalancesheets,308
eliminationsandadjustments,309
consolidatedfnancialstatements,306,307
consolidation,315
entitytheoryof,315
contraassetaccounts,111
contractualrate,137,140
control,184
conversionpremium,325,326,331
convertiblebond,324,328,329
valueof,327
convertiblebonds,323,339
convertiblesecurities,323
corporatedividendpractice,173
corporatetaxes,207
November6,200913:44spi-b8119inx6inb811-Index
Index
389
corporation,33
cost,305
costfowassumptions,345
evaluationof,348
cost-or-market,349
costs,344
creditbalance,47
creditpolicy,3
creditors,31
credits,45,47
criticalevent,90
currentassets,3,37
currentliabilities,39
debitbalance,47
debits,45,47
debt,7,206,207,234,257,328
advantageof,196
debtleverage,213
debt-equityratio,272
decliningbalanceprocedure,115
decreasingcharge(accelerated
depreciation),115
deferredbenefts,127,281
defcit,86
depletionaccounting,124
depletionofnaturalresources,123
depreciation
andactivity,118
andcashfow,121
proceduresforcomputing,113
depreciationaccounting,87,111
depreciationbase,112
depreciationexpense,111,112,266
differentexpectations,186,293
dilution,336
directvariablecosts,344
discontinuedoperations,95
discount,138,139
discountedcashfow(DCF),15,63,64,
66,73
distributiondecision,2
distributionstoshareholders,167
diversifcation,290
dividendchanges
andearningsforecasts,175
dividenddecision,2
dividendpolicy,171,175
incometaxesand,176
settingof,174
dividendvaluationmodel,159
dividend-receiveddeduction,247,256
dividends,40,157,161,172
accountingfor,167
andstockvalue,171
clienteleeffect,180
“extra”,174
fexible,187
formof,183
highlystable,172
reasonsfor,180
“regular”,174
relativelystable,173
dividendsonstock,168
doubledecliningbalancemethod,115
double-entryaccountingsystem,151
“double-to-72”rule,15
downsideinsurance,324
downsideprotection,334
DuPontformulation,262
DuPont,289
earnings
dilutionof,302
useof,101,103
earningspershare,95,261,270,338
EBIT,297,369
EBITmultiple,106
EBITDA,297,370
EBITDAmultiple,106
economicandaccountingassets,35
economicincome,259,261,266–268,284
summaryofadvantages,269
economicorderquantity(EOQ),352
economicvalueadded(EVA),266
effectiveormarketrateofinterest,138
November6,200913:44spi-b8119inx6inb811-Index
390
AnIntroductiontoAccountingandManagerialFinance
effectiverate,140
effcientmarkethypothesis,274
implicationsof,276
semi-strongform,275
strongform,276
weakform,274
eliminationofduplication,292
equity,306
equitycapital,costof,158,180
equityliabilities,3
EuropeanUnion,293
expectationaldifferences,188
expectedreturn,9,209
expenseaccounts,89
expenserecognition,92
expenses,86,92
facevalue,137
FederalTradeCommission,293
fduciaryrelationship,2
fnancemanagers,3
fnancialaccounting,32,49
fnancialaccountingstandards,351,363
FinancialAccountingStandardsBoard
(FASB),125,156,224,371
fnancialleverage,196,203,206
increasesin,183
fnancialmeasures,improving,185
fnancialposition,30,42,49
fnancialreporting,29
fnancialstatements,30
fnancing,230
fnancingpolicy,175
fnishedgoods,345
frmvaluewithtaxes,205
fxedassets,37
usefullife,113
fowofcosts
FIFO,345,356
LIFO,346,356
specifcunits,348
weightedaveragecost,347
futurevalue,14
GenerallyAcceptedAccounting
Principles,5,259
GettyOil,289
goal,1,174
goldenparachutes,304
goodwill,126,127
greenmail,304
growth,292
growthmodel,300
GulfOil,289
hedgefunds,338
historicalcosts,372
holdingcompany,296
horizontalintegration,292
hurdlerate,212,233,242
implicitgrowthrate,300
implicitreturnonnewinvestments,301
impliedgrowthrate,301
incentiveconsideration,280
income,86,96,101,261
computationof,265
measurementof,85
incomestatement,30,85,90,263
formof,94
multi-step,95
single-step,94
incometaxes,32
anddividendpolicy,176
individualproprietorship,33
intangibleassets,38,124
intercompanysalestransactions,308
intercompanytransactions,314
intercorporateinvestments,304
interestpayments,62
taxdeductibilityof,334
interestrate,323,331
interestrateofreturn,66
internalrateofreturn(IRR),63,66,74,78
InternalRevenueCode,116,350
InternalRevenueService,214
InternationalAccountingStandardsBoard
(IASB),371
inventories,343,344
November6,200913:44spi-b8119inx6inb811-Index
Index
391
inventory
andfnance,351
classifcationsof,343
investment,1,3,68,230
complement,59
economicallydependent,59
economicallyindependent,59
mutuallyexclusive,60,77
statisticallydependent,60
substitute,59
investmentdecision,2,328
accept-or-reject,61,76
investmentpolicy,175
irrelevanceof,176
investmentrankings,61
byinspection,70
limitationof,76
investmentrelationships,60
investmentworth,measuresof,60
investor’smethod,66
jointutilization,292
journalentries,48
journalentryform,49
“justintime”inventory,352
lease,145,234
leaseliability,amortizationtablefor,227
leasing,242
prosandconsof,228
ledger,48
lessees,228
lessors,228
leveragedbuyout(LBO),303
liabilities,33,38,39,168
loanamortizationschedule,21
long-livedassets,37
gainorloss,122
long-terminvestment,305
accountingfor,304
long-termliabilities,39,137
loss,86
managerialaccounting,32
managerialcompensation,260,277
managerialdecisions,29
managerialfnance,2
managerialperformance,259
MarathonOil,289
marginrequirement,325
marginaleffciencyofcapital,66
market,305
marketinterestrate,141
marketmeasures,260,270
markettransactions,151
marketvalue,196,200
marketvalueofthestock,4
maximizationofvalue,4,9
marketablesecurities,38
matchingconcept,92
matchingofcostsandrevenues,111
maturityamount,137,138
mergerofequals,5
valuecalculation,6
mergersandacquisitions,252,289,316,
317
acquisitionofresources,290
obtainingresources,289
reasonsfor,289–294
minorityinterest,311,313
moneymultipliernotes,141
netpresentvalue(NPV),63,64,74,77,78
non-zero,279
no-corporate-taxcase,199
non-accountingbutquantitativemeasures,
260
non-accountingquantitativemeasures,277
noncurrentassets,37
gainorlossonsaleof,365
noncurrentliabilities,39
off-balance-sheetfnancing,228
operatingleases,145,224,225
operatingmargins,260
opportunityloss,325
optimumcapitalstructure,196,197
classicalviewof,199
originalissuediscount(OID)notes,141
November6,200913:44spi-b8119inx6inb811-Index
392
AnIntroductiontoAccountingandManagerialFinance
P/Eratio,299
parvalue,152
parentcorporation,307
partnership,33
paybackperiod,70
payouttarget,173
performancemeasurement,260
periodexpenses,92
periodicrentexpense,145
perpetuity,19
presentvaluefor,27
personalborrowing,203
personaltaxes,207
powerofcompounding,14,15
preferredstock,3,7,247
accountingfor,248
asinvestment,256
convertibleexchangeable,255
costof,250,251
noncallable,251
variable-rate,253
versuscommonstock,253
preferredstockdividends,204
premium,138,139
determining,294
premiumoverbondvalue,325
presentvalue,16,78
presentvaluereturnoninvestment,66
priceearningsmultiple,106
pricetakers,209
privateaccountant,31
privateequity,256
processofrecordingtransactions,44
proftmaximization,2,291
publicaccountant,31
publicpolicyquestions,188
qualitativemeasures,260,277
rateofdiscount,57
rateofreturn,66,72
ratioanalysis,limitationsof,273
rawmaterials,345
regulatedpublicutility,254
removalcosts,115
researchanddevelopmentcosts,125
reserves,useof,156
residualincome,266
residualvalue,239
resultsofoperations,49
retainedearnings,7,39,155
andcash,157
costof,179
restrictions,155
returnonassets(ROA),262
returnoncapitalapplied(ROCA),262
returnonequity(ROE),262
returnonfundsemployed(ROFE),262
returnoninvestment(ROI),66,72,78,
259,261,268,284
andinvestmentdecisionmaking,264
componentsof,262
computationof,265
returnonnetassetsemployed(RONAE),
262
revenueaccounts,89
revenuerecognition,90,106
cashreceiptsbasis,90
criteria,93
productionbasis,90
sales(oraccrual)basis,90
revenuetransaction,85,154
revenues,86,92
realizationof,93
risk,3,4,9,325
risk-adjusteddiscountrate,237
risk-returntrade-off,3
rollbackmethod,77
roundaboutmethodsofproduction,13
salesrevenue,260
salvagevalue,115
saversofsociety,7
semiannualinterestcomplexity,140
semiannualinterestpayments,145
sharerepurchases,40,167
stockpriceeffectof,187
tax-relatedrationalefor,186
shareholders,30
November6,200913:44spi-b8119inx6inb811-Index
Index
393
shares,167
repurchaseof,167,181
short-termsecurities,3
sizeoffrm,293
shrinking,185
specialinformation,185
spin-off,315,316
split-off,316
stockdividend,168–170,181
stockequities,33
stockequitytransactions,historyof,151
stockprice,growthratein,188
stockpricemodel
closed-form,160
derivationof,165
stockrepurchase,183
asinvestment,183
stocksplit,169,170
stockvaluationmodel,158
stockholderwealthmaximization,1
stockholders,2
stockholders’equity,3,34,38,39,151,
158
classifcationof,152
costof,180
straight-lineprocedure,114
strategicplanning,8
subsidiaries,307
sum-of-the-years’digitsprocedure,116
synergy,291
systematicreturns,210
systematicrisk,211
T-account,43
tacticalandstrategicdecisions,7
tangibleassets,38
taxdeferraladvantage,177
taxdepreciationexpense,130
taxeffects,188
taximplications,292
taxlaw,205
taxableevent,172
taxableincome,196
taxes
absenceof,205
effectof,235
temporaryaccounts,89
temporaryinvestment,305
Texaco,289
timediscounting,13,62,193
timevalue,3
timevalueofmoney,13,22,57
time-adjustedrateofreturn,66
timesinterestearned,272
totalreturnapproach,172
transactionsnotaffectingfunds,368
treasurystock,154
trustlegallist,173
U.S.JusticeDepartment,293
U.S.Steel,289
unitsofproductionprocedure,119
unsystematicreturns,210
unsystematicrisk,211,212
verticalintegration,292
weightedaveragecostofcapital(WACC),
193–195,233,242
after-tax,194
constant,198,201
workinprocess,345
workingcapital,63
write-off,283
yield,66
yieldtomaturity,140
zero-couponbond,141