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b. If sales were to increase by 50 percent to $90 million, new fixed assets would need to be
added. The ratio of assets to sales when the company is operating at 100 percent of ca-
pacity (from part a) is $50 million/$75 million = 2/3. Therefore, to support sales of $90
million, the company needs at least $90 million — 2/3 = $60 million of fixed assets. This
calls for a $10 million investment in additional fixed assets.

4 a. This question is answered by the planning model. Given assumptions for asset growth,
the model will show the need for external financing, and this value can be compared to
the firm™s plans for such financing.
b. Such a relationship may be assumed and built into the model. However, the model does
not help to determine whether it is a reasonable assumption.
c. Financial models do not shed light on the best capital structure. They can tell us only
whether contemplated financing decisions are consistent with asset growth.

5 a. If the payout ratio were reduced to 25 percent, the maximum growth rate assuming no
external financing would be .75 — 16 percent — .6 = 7.2 percent.
b. If the firm also can issue enough debt to maintain its equity-to-asset ratio unchanged, the
sustainable growth rate will be .75 — 16 percent = 12 percent.
Appendix A

The Balance Sheet
Book Values and Market Values

The Income Statement
Profits versus Cash Flow

The Statement of Cash
Accounting for Differences
Corporate Tax
Personal Tax


A meeting of a corporation™s directors.
Most large businesses are organized as corporations. Corporations are owned by stockholders,
who vote in a board of directors. The directors appoint the corporation™s top executives and
approve major financial decisions.
Comstock, Inc.

large corporation is a team effort. All the players”the shareholders,

A lenders, directors, management, and employees”have a stake in the
company™s success and all therefore need to monitor its progress. For this
reason the company prepares regular financial accounts and arranges for an
independent firm of auditors to certify that these accounts present a “true and fair
Until the mid-nineteenth century most businesses were owner-managed and seldom re-
quired outside capital beyond personal loans to the proprietor. When businesses were
small and there were few outside stakeholders in the firm, accounting could be less for-
mal. But with the industrial revolution and the creation of large railroad and canal com-
panies, the shareholders and bankers demanded information that would help them gauge
a firm™s financial strength. That was when the accounting profession began to come of age.
We don™t want to discuss the details of accounting practice. But because we will be
referring to financial statements throughout this book, it may be useful to review briefly
their main features. In this material we introduce the major financial statements, the
balance sheet, the income statement, and the statement of cash flow. We discuss the im-
portant differences between income and cash flow and between book values and mar-
ket values. We also discuss the federal tax system.
After studying this material you should be able to
Interpret the information contained in the balance sheet, income statement, and
statement of cash flows.
Distinguish between market and book value.
Explain why income differs from cash flow.
Understand the essential features of the taxation of corporate and personal income.

The Balance Sheet
We will look first at the balance sheet, which presents a snapshot of the firm™s assets
BALANCE SHEET and the source of the money that was used to buy those assets. The assets are listed on
Financial statement that the left-hand side of the balance sheet. Some assets can be turned more easily into cash
shows the value of the firm™s than others; these are known as liquid assets. The accountant puts the most liquid assets
assets and liabilities at a at the top of the list and works down to the least liquid.
particular time. Look, for example, at the left-hand column of Table A.1, the balance sheet for Pep-
siCo, Inc., at the end of 1998. You can see that Pepsi had $311 + $83 = $394 million of
cash and marketable securities. In addition it had sold goods worth $2,453 million but
had not yet received payment. These payments are due soon and therefore the balance
sheet shows the unpaid bills or accounts receivable (or simply receivables) as an asset.
The next asset consists of inventories. These may be (1) raw materials and ingredients
that the firm bought from suppliers, (2) work in process, and (3) finished products wait-
ing to be shipped from the warehouse. Of course there are always some items that don™t

Accounting and Finance 113

(Figures in millions of dollars)
Assets 1998 1997 Liabilities and Shareholders™ Equity 1998 1997
Current assets Current liabilities
Cash and equivalents 311 1,928 Debt due for repayment 3,921 0
Marketable securities 83 955 Accounts payable 3,870 3,617
Receivables 2,453 2,150 Other current liabilities 123 640
Inventories 1,016 732 Total current liabilities 7,914 4,257
Other current assets 499 486 Long-term debt 4,028 4,946
Total current assets 4,362 6,251 Other long-term liabilities 4,317 3,962
Fixed assets Total liabilities 16,259 13,165
Property, plant, and equipment 13,110 11,294 Shareholders™ equity
Less accumulated depreciation 5,792 5,033 Common stock and other paid-in capital 1,195 1,343
Net fixed assets 7,318 6,261 Retained earnings 5,206 5,593
Intangible assets 8,996 5,855 Total shareholders™ equity 6,401 6,936
Other assets 1,984 1,734 Total liabilities and shareholders™ equity 22,660 20,101
Total assets 22,660 20,101

Note: Columns may not add because of rounding.
Source: PepsiCo, Inc., Annual Report, 1998.

fit into neat categories. So the current assets category includes a fourth entry, other cur-
rent assets.
Up to this point all the assets in Pepsi™s balance sheet are likely to be used or turned
into cash in the near future. They are therefore described as current assets. The next
group of assets in the balance sheet is known as fixed assets such as buildings, equip-
ment, and vehicles.
The balance sheet shows that the gross value of Pepsi™s fixed assets is $13,110 million.
This is what the assets originally cost. But they are unlikely to be worth that now. For ex-
ample, suppose the company bought a delivery van 2 years ago; that van may be worth
far less now than Pepsi paid for it. It might in principle be possible for the accountant to
estimate separately the value today of the van, but this would be costly and somewhat sub-
jective. Accountants rely instead on rules of thumb to estimate the depreciation in the
value of assets and with rare exceptions they stick to these rules. For example, in the case
of that delivery van the accountant may deduct a third of the original cost each year to re-
flect its declining value. So if Pepsi bought the van 2 years ago for $15,000, the balance
sheet would show that accumulated depreciation is 2 — $5,000 = $10,000. Net of depre-
ciation the value is only $5,000. Table A.1 shows that Pepsi™s total accumulated depreci-
ation on fixed assets is $5,792 million. So while the assets cost $13,110 million, their net
value in the accounts is only $13,110 “ $5,792 = $7,318 million.
The fixed assets in Pepsi™s balance sheet are all tangible assets. But Pepsi also has
valuable intangible assets, such as its brand name, skilled management, and a well-
trained labor force. Accountants are generally reluctant to record these intangible assets
in the balance sheet unless they can be readily identified and valued.
There is, however, one important exception. When Pepsi has acquired other busi-
nesses in the past, it has paid more for their assets than the value shown in the firms™
accounts. This difference is shown in Pepsi™s balance sheet as “goodwill.” The greater
part of the intangible assets on Pepsi™s balance sheet consists of goodwill.1
1 Each year Pepsi writes off a small proportion of goodwill against its profits.

Current assets Current liabilities
Cash & securities Payables
Receivables Short-term debt
+ = +
Fixed assets Long-term liabilities
Tangible assets +
Intangible assets Shareholders™ equity

Now look at the right-hand portion of Pepsi™s balance sheet, which shows where the
money to buy the assets came from. The accountant starts by looking at the company™s
liabilities”that is, the money owed by the company. First come those liabilities that are
likely to be paid off most rapidly. For example, Pepsi has borrowed $3,921 million, due
to be repaid shortly. It also owes its suppliers $3,870 million for goods that have been
delivered but not yet paid for. These unpaid bills are shown as accounts payable (or
payables). Both the borrowings and the payables are debts that Pepsi must repay within
the year. They are therefore classified as current liabilities.
Pepsi™s current assets total $4,362 million; its current liabilities amount to $7,914
million. Therefore the difference between the value of Pepsi™s current assets and its cur-
rent liabilities is $4,362 “ $7,914 = “$3,552 million. This figure is known as Pepsi™s net
current assets or net working capital. It roughly measures the company™s potential
reservoir of cash. Unlike Pepsi, most companies maintain positive net working capital.
Below the current liabilities Pepsi™s accountants have listed the firm™s long-term lia-
bilities”that is, debts that come due after the end of a year. You can see that banks and
other investors have made long-term loans to Pepsi of $4,028 million.
Pepsi™s liabilities are financial obligations to various parties. For example, when
Pepsi buys goods from its suppliers, it has a liability to pay for them; when it borrows
from the bank, it has a liability to repay the loan. Thus the suppliers and the bank have
first claim on the firm™s assets. What is left over after the liabilities have been paid off
belongs to the shareholders. This figure is known as the shareholders™ equity. For Pepsi
the total value of shareholders™ equity amounts to $6,401 million. A small part of this
sum ($1,195 million) has resulted from the sale of shares to investors. The remainder
($5,206 million) has come from earnings that Pepsi has retained and invested on share-
holders™ behalf.
Figure A.1 shows how the separate items in the balance sheet link together. There are
two classes of assets”current assets, which will soon be used or turned into cash, and
long-term or “fixed” assets, which may be either tangible or intangible. There are also
two classes of liability”current liabilities, which are due for payment shortly, and long-
term liabilities. The difference between the assets and the liabilities represents the
amount of the shareholders™ equity.

Suppose that Pepsi borrows $500 million by issuing new long-term bonds. It places
Self-Test 1
$100 million of the proceeds in the bank and uses $400 million to buy new machinery.
What items of the balance sheet would change? Would shareholders™ equity change?
Accounting and Finance 115

Throughout this material we will frequently make a distinction between the book val-
ues of the assets shown in the balance sheet and their market values.
Items in the balance sheet are valued according to generally accepted accounting
principles, commonly called GAAP. These state that assets must be shown in the bal-
ance sheet at their historical cost adjusted for depreciation. These book values are
therefore “backward-looking” measures of value. They are based on the past cost of the
asset, not its current market price or value to the firm. For example, suppose that a
Procedures for preparing
printing press cost McGraw-Hill $1 million 2 years ago, but that in today™s market such
financial statements.
presses sell for $1.3 million. The book value of the press would be less than its market
value and the balance sheet would understate the value of McGraw-Hill™s assets.
Net worth
Or consider a specialized plant that Intel develops for producing special-purpose
of the firm according to the
computer chips at a cost of $100 million. The book value of the plant is $100 million
balance sheet.
less depreciation. But suppose that shortly after the plant is constructed, a new chip
makes the existing one obsolete. The market value of Intel™s new plant could fall by 50
percent. In this case market value would be less than book value.
The difference between book value and market value is greater for some assets than
for others. It is zero in the case of cash but potentially very large for fixed assets where
the accountant starts with the initial cost of the fixed assets and then depreciates that
figure according to a prespecified schedule. The purpose of depreciation is to allocate
the original cost of the asset over its life, and the rules governing the depreciation of
asset values do not reflect actual loss of market value. As a result, the book value of
fixed assets often is much higher than the market value, but often it is less.
The same goes for the right-hand side of the balance sheet. In the case of liabilities
the accountant simply records the amount of money that you have promised to pay. For
short-term liabilities this figure is generally close to the market value of that promise.
For example, if you owe the bank $1 million tomorrow, the accounts show a book lia-
bility of $1 million. As long as you are not bankrupt, that $1 million is also roughly the
value to the bank of your promise. But now suppose that $1 million is not due to be re-
paid for several years. The accounts still show a liability of $1 million, but how much
your debt is worth depends on what happens to interest rates. If interest rates rise after
you have issued the debt, lenders may not be prepared to pay as much as $1 million for
your debt; if interest rates fall, they may be prepared to pay more than $1 million.2 Thus
the market value of a long-term liability may be higher or lower than the book value.

To summarize, the market values of neither assets nor liabilities will
generally equal their book values. Book values are based on historical or
original values. Market values measure current values of assets and liabilities.

The difference between book value and market value is likely to be greatest for
shareholders™ equity. The book value of equity measures the cash that shareholders have
contributed in the past plus the cash that the company has retained and reinvested in the
business on their behalf. But this often bears little resemblance to the total market value
that investors place on the shares.
If the market price of the firm™s shares falls through the floor, don™t try telling the
shareholders that the book value is satisfactory”they won™t want to hear. Shareholders

2 We will show you how changing interest rates affect the market value of debt.


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