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are concerned with the market value of their shares; market value, not book value, is the
price at which they can sell their shares. Managers who wish to keep their shareholders
happy will focus on market values.
We will often find it useful to think about the firm in terms of a market-value bal-
ance sheet. Like a conventional balance sheet, a market-value balance sheet lists the
firm™s assets, but it records each asset at its current market value rather than at histori-
cal cost less depreciation. Similarly, each liability is shown at its market value.

The difference between the market values of assets and liabilities is the
market value of the shareholders™ equity claim. The stock price is simply the
market value of shareholders™ equity divided by the number of outstanding

Market- versus Book-Value Balance Sheets
Jupiter has developed a revolutionary auto production process that enables it to produce
cars 20 percent more efficiently than any rival. It has invested $10 billion in producing
its new plant. To finance the investment, Jupiter borrowed $4 billion and raised the re-
maining funds by selling new shares of stock in the firm. There are currently 100 mil-
lion shares of stock outstanding. Investors are very excited about Jupiter™s prospects.
They believe that the flow of profits from the new plant justifies a stock price of $75.
If these are Jupiter™s only assets, the book-value balance sheet immediately after it
has made the investment is as follows:
(Figures in billions of dollars)
Liabilities and
Assets Shareholders™ Equity
Auto plant $10 Debt $4
Shareholders™ equity 6

Investors are placing a market value on Jupiter™s equity of $7.5 billion ($75 per share
times 100 million shares). We assume that the debt outstanding is worth $4 billion.3
Therefore, if you owned all Jupiter™s shares and all its debt, the value of your investment
would be 7.5 + 4 = $11.5 billion. In this case you would own the company lock, stock,
and barrel and would be entitled to all its cash flows. Because you can buy the entire
company for $11.5 billion, the total value of Jupiter™s assets must also be $11.5 billion.
In other words, the market value of the assets must be equal to the market value of the
liabilities plus the market value of the shareholders™ equity.
We can now draw up the market-value balance sheet as follows:
(Figures in billions of dollars)
Liabilities and
Assets Shareholders™ Equity
Auto plant $11.5 Debt $4
Shareholders™ equity 7.5

3 Jupiter has borrowed $4 billion to finance its investment, but if the interest rate has changed in the mean-
time, the debt could be worth more or less than $4 billion.
Accounting and Finance 117

Notice that the market value of Jupiter™s plant is $1.5 billion more than the plant cost
to build. The difference is due to the superior profits that investors expect the plant to
earn. Thus in contrast to the balance sheet shown in the company™s books, the market-
value balance sheet is forward-looking. It depends on the benefits that investors expect
the assets to provide.

Is it surprising that market value exceeds book value? It shouldn™t be. Firms find it
attractive to raise money to invest in various projects because they believe the projects
will be worth more than they cost. Otherwise, why bother? You will usually find that
shares of stock sell for more than the value shown in the company™s books.

a. What would be Jupiter™s price per share if the auto plant had a market value of $14
Self-Test 2
b. How would you reassess the value of the auto plant if the value of outstanding stock
were $8 billion?

The Income Statement
If Pepsi™s balance sheet resembles a snapshot of the firm at a particular time, its income
Financial statement that statement is like a video. It shows how profitable the firm has been during the past
shows the revenues, year.
expenses, and net income of Look at the summary income statement in Table A.2. You can see that during 1998
a firm over a period of time. Pepsi sold goods worth $22,348 million and that the total expenses of producing and
selling goods was ($9,330 + $291 + $8,912) = $18,533 million. The largest expense
item, amounting to $9,330 million, consisted of the raw materials, labor, and so on, that
were needed to produce the goods. Almost all the remaining expenses were administra-
tive expenses such as head office costs, advertising, and distribution.

(Figures in millions of dollars)
Net sales $22,348
Cost of goods sold 9,330
Other expenses 291
Selling, general, and administrative expenses 8,912
Depreciation 1,234
Earnings before interest and taxes (EBIT) 2,581
Net interest expense 321
Taxable income 2,260
Taxes 270
Net income 1,990
Allocation of net income
Addition to retained earnings 1,233
Dividends 757

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

In addition to these out-of-pocket expenses, Pepsi also made a deduction for the
value of the plant and equipment used up in producing the goods. In 1998 this charge
for depreciation was $1,234 million. Thus Pepsi™s total earnings before interest and
taxes (EBIT) were
EBIT = total revenues “ costs “ depreciation
= 22,348 “ 18,533 “ 1,234
= $2,581 million
The remainder of the income statement shows where these earnings went. As we saw
earlier, Pepsi has partly financed its investment in plant and equipment by borrowing.
In 1998 it paid $321 million of interest on this borrowing. A further slice of the profit
went to the government in the form of taxes. This amounted in 1998 to $270 million.
The $1,990 million that was left over after paying interest and taxes belonged to the
shareholders. Of this sum Pepsi paid out $757 million in dividends and reinvested the
remaining $1,233 million in the business. Presumably, these reinvested funds made the
company more valuable.

It is important to distinguish between Pepsi™s profits and the cash that the company gen-
erates. Here are three reasons why profits and cash are not the same:
1. When Pepsi™s accountants prepare the income statement, they do not simply count
the cash coming in and the cash going out. Instead the accountant starts with the
cash payments but then divides these payments into two groups”current expendi-
tures (such as wages) and capital expenditures (such as the purchase of new ma-
chinery). Current expenditures are deducted from current profits. However, rather
than deducting the cost of machinery in the year it is purchased, the accountant
makes an annual charge for depreciation. Thus the cost of machinery is spread over
its forecast life.
When calculating profits, the accountant does not deduct the expenditure on new
equipment that year, even though cash is paid out. However, the accountant does
deduct depreciation on assets previously purchased, even though no cash is currently
paid out.

To calculate the cash produced by the business it is necessary to add back
the depreciation charge (which is not a cash payment) and to subtract the
expenditure on new capital equipment (which is a cash payment).

2. Consider the following stages in a manufacturing business. In period 1 the firm pro-
duces the goods; it sells them in period 2 for $100; and it gets paid for them in pe-
riod 3. Although the cash does not arrive until period 3, the sale shows up in the in-
come statement for period 2. The figure for accounts receivable in the balance sheet
for period 2 shows that the company™s customers owe an extra $100 in unpaid bills.
Next period, after the customers have paid their bills, the receivables decline by

The cash that the company receives is equal to the sales shown in the
income statement less the increase in unpaid bills:
Accounting and Finance 119

Period: 2 3
Sales 100 0
“ Change in receivables 100 (100)
= Cash received 0 +100

3. The accountant also tries to match the costs of producing the goods with the rev-
enues from the sale. For example, suppose that it costs $60 in period 1 to produce
the goods that are then sold in period 2 for $100. It would be misleading to say that
the business made a loss in period 1 (when it produced the goods) and was very prof-
itable in period 2 (when it sold them). Therefore, to provide a fairer measure of the
firm™s profitability, the income statement will not show the $60 as an expense of pro-
ducing the goods until they are sold in period 2. This practice is known as accrual
accounting. The accountant gathers together all expenses that are associated with a
sale and deducts them from the revenues to calculate profit, even though the ex-
penses may have occurred in an earlier period.
Of course the accountant cannot ignore the fact that the firm spent money on pro-
ducing the goods in period 1. So the expenditure will be shown in period 1 as an in-
vestment in inventories. Subsequently in period 2, when the goods are sold, the in-
ventories would decline again.
In our example, the cash is paid out when the goods are manufactured in period
1 but this expense is not recognized until period 2 when the goods are sold.

The cash outflow is equal to the cost of goods sold, which is shown in the
income statement, plus the change in inventories:

Period: 1 2
Costs of goods sold 0 60
+ Change in inventories 60 (60)
= Cash paid out + 60 0

A firm pays $100 in period 1 to produce some goods. It sells those goods for $150 in
Self-Test 3
period 2 but does not collect payment from its customers until period 3. Calculate the
cash flows to the firm in each period by completing the following table. Do the result-
ing values for net cash flow in each period make sense?
Period: 1 2 3
Change in accounts receivable
Cost of goods sold
Change in inventories
Net cash flow

The Statement of Cash Flows
The firm requires cash when it buys new plant and machinery or when it pays interest
to the bank and dividends to the shareholders. Therefore, the financial manager needs
to keep track of the cash that is coming in and going out.

We have seen that the firm™s cash flow can be quite different from its net income.
These differences can arise for at least two reasons:
1. The income statement does not recognize capital expenditures as expenses in the
year that the capital goods are paid for. Instead, it spreads those expenses over time
in the form of an annual deduction for depreciation.
2. The income statement uses the accrual method of accounting, which means that rev-
enues and expenses are recognized as they are incurred rather than when the cash is
received or paid out.
The statement of cash flows shows the firm™s cash inflows and outflows from op-
FLOWS Financial erations as well as from its investments and financing activities. Table A.3 is the cash-
statement that shows the flow statement for Pepsi. It contains three sections. The first shows the cash flow from
firm™s cash receipts and cash operations. This is the cash generated from Pepsi™s normal business activities. Next
payments over a period of comes the cash that Pepsi has invested in plant and equipment or in the acquisition of
time. new businesses. The final section reports cash flows from financing activities such as
the sale of new debt or stocks. We will look at these sections in turn.
The first section, cash flow from operations, starts with net income but adjusts that
figure for those parts of the income statement that do not involve cash coming in or
going out. Therefore, it adds back the allowance for depreciation because depreciation
is not a cash flow even though it is treated as an expense in the income statement.
Any additions to current assets need to be subtracted from net income, since these
absorb cash but do not show up in the income statement. Conversely, any additions to
current liabilities need to be added to net income because these release cash. For ex-

(Figures in millions of dollars)
Cash provided by operations
Net income $1,990
Noncash expenses
Depreciation expense 1,234
Other noncash expenses 382
Changes in working capital
Decrease (increase) in inventories (284)
Decrease (increase) in accounts receivable (303)
Increase (decrease) in accounts payable 253
Other (60)
Cash provided by operations 3,212
Cash provided (used) by investments
Additions to property, plant, and equipment (1,271)
Acquisitions of subsidiaries (4,520)
Other investments, net 772
Cash provided (used) by investments (5,019)
Cash provided (used) by financing activities
Additions to (reductions in) debt 2,762
Net issues of stock (1,815)
Dividends (757)
Cash provided (used) by financing activities 190
Net increase in cash and marketable securities (1,617)

Note: Numbers may not add because of rounding.
Source: PepsiCo, Inc. Annual Report, 1998.
Accounting and Finance 121


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