THE THREE FINANCIAL REPORTS OR statements required under accounting rules are the balance sheet, the income statement, and the statement of cash flows. These rules are established by the Financial Accounting Standards Board (FASB), a self-regulating organization managed by the accounting profession, with oversight by the Public Company Accounting Oversight Board (PCAOB) for companies traded on stock exchanges (“public companies”). FASB oversees GAAP (generally accepted accounting principles), which provides accounting standards that are considered as the foundation of financial reporting.
Public companies are required to publish annual reports containing an explanation of the past year's activities, nonconfidential plans for the future, and financial reports including an opinion letter by external auditors as to their accuracy. In addition, they must file detailed financial analyses with the primary regulatory agency, the Securities and Exchange Commission (SEC). The annual version of this report is called a 10-K; quarterly reports are known as 10-Qs. Most public companies provide them on their websites.
Several issues relate to the entire balance sheet:
As we discussed in Chapter 1, working capital involves current assets and current liabilities. In this section we define noncurrent entries on the balance sheet. The fixed asset that is presented in Exhibit 1.1 (i.e., assets with lives of more than one year) is plant and equipment, calculated at cost less depreciation. The concept of “net” refers to the accounting convention of writing off a portion of the cost of a fixed asset over the estimated life of the asset. In making this calculation, various methods are permitted as selected by management.
These methods are collectively known as depreciation, and the choice is usually made for tax reasons. The total original cost of the plant and equipment was $85 million. If the life of these assets was estimated to be five years, the company would be allowed to expense $17 million each year ($85 million divided by 5 years). Accelerated depreciation methods are also permitted.
There are various conventions used to write down the value of fixed assets. If a company acquires such intangible property as patents, copyrights, or licenses, these assets are subject to amortization, which is treated in the same way as depreciated property. If it owns natural assets such as oil or gas reserves, coal, or other minerals, this property would be subject to a similar treatment known as depletion. Land is presumed to exist forever and is not depreciated or depleted.
The two long-term liabilities will be due in periods beyond one year, and include bonds payable and mortgage payable. Bonds payable is debt held by outside investors; mortgage payable is a loan taken to acquire real property (land and buildings).
Net worth is what the company is worth after liabilities are subtracted from assets. The two accounts in net worth are defined as follows:
Cost of capital is the calculation of the cost to finance a business based on several factors:
Exhibit A.1 shows a company that has a 10 percent cost of capital. This is the assumption used throughout this book. However, each business would have to do this calculation based on its own unique situation.
Percentage of Balance Sheet |
Pre-Tax Cost | After-Tax Cost | Weighted Cost | |
Debt | 40 % | 7½% interest yield | 5%* | .02 |
Equity | 60 % | 4 % dividend yield + 9½ % growth yield |
13½ % | .08 |
Total Financial Structure |
100 % | .10 or 10.0 % |
*Calculated as 7½% times (1 − corporate tax rate)
= 7½% times the assumed tax rate of 34% = 5%
EXHIBIT A.1 Calculating the Cost of Capital
Any investment above this cost should be considered, assuming it is consistent with the company's long-term strategy. Any investment returning less than this cost should be rejected as it would negatively affect owners' equity and impair shareholder value. Calculations of returns are a concern of capital budgeting, which includes such techniques as net present value (NPV) and internal rate of return (IRR).
An alternative method for the cost of equity capital is the capital asset pricing model (CAPM). The idea of the CAPM is that the relationship between the expected return and beta can be quantified. In this method, the risk-free return (the rate on U.S. Treasury Bills) is added to the beta (βe) for the company multiplied by the risk premium required by the market for that class of securities. The concepts of beta and risk premium effectively require that the equity be a publicly traded security. The equation that determines this result is as follows:
Expected return of a stock (based on CAPM) = Risk-free return + β of the stock × Market's expected return – Risk-free return (on a short-term U.S. Treasury security)
or
Re = Rf + [βe × (Rm − Rf)]
CAPM shows that the expected return of a stock (or other asset) depends on the risk-free return that is available to investors, the reward for bearing systematic risk, and the amount of systematic risk.
For a discussion of these concepts, the interested reader should consult any standard finance text.