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and development or to tap into different markets.

Let's consider a specific example with the recent long-lived accounts for Texas
Instruments:


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What immediately stands out is that equity investments dropped from $800 million
to $265 million in 2003. This should encourage us to examine the footnotes to
understand why.

The footnotes in the same annual report include the following:

During the third and fourth quarters of 2003, TI sold its remaining 57 million shares
of Micron common stock, which were received in connection with TI's sale of its
memory business unit to Micron in 1998. TI recognized pretax gains of $203 million
from these sales, which were recorded in other income (expense) net¦.The
combined effect of the after-tax gains and the tax benefit was an increase of $355
million to TI's 2003 net income.

We learn two things from this footnote: 1) TI sold its significant stake in Micron, and
2) that sale created a one-time (nonrecurring) boost in current profits of $355
million.

Goodwill
Goodwill is created when one company (the "buyer") purchases another company
(the "target"). At the time of purchase, all of the assets and liabilities of the target
company are re-appraised to their estimated fair value. This includes even intangible
assets that were not formerly carried on the target's balance sheet, such as
trademarks, licenses, in-process research & development, and maybe even key
relationships. Basically, accountants try to estimate the value of the entire target
company, including both tangible and intangible assets. If the buyer happens to pay
more than this amount, every extra dollar falls into goodwill. Goodwill is a catch-all
account, because there is nowhere else to put it. From the accountant's perspective,
it is the amount the buyer "overpays" for the target.




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To illustrate, we show a target company below that carries $100 of assets when it is
purchased. The assets are marked-to-market (that is, appraised to their fair market
value) and they include $40 in intangibles. Further, the target has $20 in liabilities,
so the equity is worth $80 ($100 “ $20). But the buyer pays $110, which results in a
purchase premium of $30. Since we do not know where to assign this excess, a
goodwill account of $30 is created. The bottom exhibit shows the target company's
accounts, but they will be consolidated into the buyer's accounts so that the buyer
carries the goodwill.




At one time, goodwill was amortized like depreciation. But as of 2002, goodwill
amortization is no longer permitted. Now, companies must perform an annual test of
their goodwill. If the test reveals that the acquisition's value has decreased, then the
company must impair, or write-down, the value of the goodwill. This will create an
expense (which is often buried in a one-time restructuring cost) and an equivalent
decrease in the goodwill account.

The idea behind this change was the assumption that goodwill--being an unidentified
(unassigned) intangible--does not necessarily depreciate automatically like plants or
machinery. This is arguably an improvement in accounting methods, because we can
watch for goodwill impairments, which are sometimes significant red flags. Because
the value of the acquisition is typically based on a discounted cash flow analysis, the
company is basically telling you "we took another look at the projections for the
acquired business, and they are not as good as we thought last year."




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Consider Novell's latest balance sheet:




We see that intangible assets decreased from $36.351 million to $10.8 million.
Because purchases and dispositions impact the accounts, it is not enough to check
increases or decreases. For example, Novell's goodwill increased, but that could be
due to a purchase. Similarly, it is possible that the decrease in intangible assets
could be the result of a disposition, but this is unlikely as it is difficult to sell an
intangible by itself.

A careful look at the footnote explains that most of this intangible asset decline was
due to impairment. That is, a previously acquired technology has not generated the
revenues that were originally expected:

During the third quarter of fiscal 2003, we determined that impairment indicators
existed related to the developed technology and trade names we acquired from
SilverStream as a result of unexpected revenue declines and the evident failure to
achieve revenue growth targets for the exteNd products. Based on an independent
valuation of these assets, we recorded a $23.6 million charge to cost of revenue to
write down these assets to estimated fair value, which was determined by the net
present value of future estimated revenue streams attributed to these assets.

Summary
You have to be careful when you examine the long-lived assets. It is hard to make
isolated judgments about the quality of investments solely by looking at measures
such as R&D as a percentage or capital expenditures as a percentage of sales. Even
useful ratios such as ROE and ROA are highly dependent on the particular accounting
methods employed. For example, both of these ratios count assets at book value, so
they depend on the depreciation method.

You can, however, look for trends and clues such as the following:

• The method of depreciation and the pattern of investment - Is the company
maintaining investment(s)? If investments are declining and assets are aging,
are profits distorted?




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• The specific nature and performance of investments - Have investment sales
created one-time gains?

• Goodwill impairments - Has goodwill been impaired, and what is the business
implication going forward?



Long-Term Liabilities

Long-term liabilities are company obligations that extend beyond the current year, or
alternately, beyond the current operating cycle. Most commonly, these include long-
term debt such as company-issued bonds. Here we look at how debt compares to
equity as a part of a company's capital structure, and how to examine the way in
which a company uses debt.

The following long-term liabilities are typically found on the balance sheet:




You can see that we describe long-term liabilities as either operating or financing.
Operating liabilities are obligations created in the course of ordinary business
operations, but they are not created by the company raising cash from investors.
Financing liabilities are debt instruments that are the result of the company raising
cash. In other words, the company--often in a prior period--issued debt in exchange
for cash and must repay the principal plus interest.

Operating and financing liabilities are similar in that they both will require future
cash outlays by the company. It is useful to keep them separate in your mind,
however, because financing liabilities are triggered by a company's deliberate



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funding decisions, and therefore will often offer clues about a company's future
prospects.

Debt is Cheaper than Equity--to a Point
Capital structure refers to the relative proportions of a company's different funding
sources, which include debt, equity, and hybrid instruments such as convertible
bonds (discussed below). A simple measure of capital structure is the ratio of long-
term debt to total capital.

Because the cost of equity is not explicitly displayed on the income statement--
whereas the cost of debt (interest expense) is itemized--it is easy to forget that debt
is a cheaper source of funding for the company than equity. Debt is cheaper for two
reasons. First, because debtors have a prior claim if the company goes bankrupt,
debt is safer than equity and therefore warrants investors a lower return; for the
company, this translates into an interest rate that is lower than the expected total
shareholder return (TSR) on equity. Second, interest paid is tax deductible to the
company; and a lower tax bill effectively creates cash.

To illustrate this idea, let's consider a company that generates $200 of earnings
before interest and taxes (EBIT). If the company carries no debt, owes tax at a rate
of 50%, and has issued 100 common shares, the company will produce earnings per
share (EPS) of $1.00 (see left-hand column below).




Say on the right-hand side we perform a simple debt-for-equity swap. In other
words, say we introduce modest leverage into the capital structure, increasing the
debt-to-total capital ratio from 0 to 0.2. In order to do this, we must have the


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company issue (borrow) $200 of debt and use the cash to repurchase 20 shares
($200/$10 per share = 20 shares). What changes for shareholders? The number of
shares drops to 80 and now the company must pay interest annually ($20 per year if
10% is charged on the borrowed $200). Here is the point of the illustration: after-tax
earnings decrease, but so does the number of shares. Our debt-for-equity swap
actually causes EPS to increase!

What Is the Optimal Capital Structure?
The example above shows why some debt is often better than no debt--in technical
terms, it lowers the weighted average cost of capital. Of course, at some point,
additional debt becomes too risky. The optimal capital structure--that is, the ideal
ratio of long-term debt to total capital--is hard to estimate. It depends on at least
two factors, but keep in mind that the following are general principles:

• First, optimal capital structure varies by industry, mainly because some
industries are more asset-intensive than others. In very general terms, the
greater the investment in fixed assets (plant, property, & equipment), the
greater the average use of debt. This is because banks prefer to make loans
against fixed assets rather than intangibles. Industries that require a great
deal of plant investment, such as telecommunications, generally utilize more
long-term debt.

• Second, capital structure tends to track with the company's growth cycle.
Rapidly growing startups and early stage companies, for instance, often favor
equity over debt because their shareholders will forgo dividend payments--as
these companies are growth stocks--in favor of future price returns. High-
growth companies do not need to give these shareholders "cash today",
whereas lenders would expect semi-annual or quarterly interest payments.




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Examining Long-Term Liability
Below, we look at some important areas investors should focus on when analyzing a
company's long-term liability accounts.

Ask Why the Company Issued New Debt
When a company issues new long-term debt, it's important for investors to
understand the reason. Companies should give explanations of new debt's specific
purpose rather than vague boilerplate such as "it will be used to fund general
business needs." The most common purposes of new debt include the following:

1. To fund growth: The cash raised by the debt issuance is used for specific
investment(s)--this is normally a good sign.

2. To refinance "old" debt: Old debt is retired and new debt is issued,
presumably at a lower interest rate--this is also a good sign, but it often
changes the company's interest rate exposure.

3. To change the capital structure: Cash raised by the debt issuance is used to
repurchase stock, issue a dividend, or buyout a big equity investor--
depending on the specifics, this may be a positive indicator.

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