THE COMPLETE BOOK OF EQUITIES

Trading, Investing, Analysis and Arbitrage

2012 by Steven I. Dym
My motivation for writing this book is simple. Ive taught thousands of market
practitioners from investors and trades to compliance officers and computer
professionals over the past decades, and I know what they need to know. To my
knowledge, most books on the stock market spend most of their time on what market
practitioners do NOT need to know, and precious little on what they must know in order
to get their job done (and does it well). Therefore, I decided to write this book.
Practitioners need to know what stocks are and how they relate to the company whose
name is on the certificate. They have to understand investment management styles and
techniques. They must become familiar with the dynamics of long and short positions,
including financing and collateral. Theyve got to become knowledgeable of the
principal equity derivatives and, crucially, how they are employed. They need to learn
the reasons and the mechanics of relative value trading, with and without derivatives.
They need to be exposed to what is known today as equity alternatives. Finally, they
have to gain a working knowledge of how the macro-economy influences and interacts
with the stock market. They do NOT need to know exactly how to calculate the value
of a stock or a company. They do NOT need to be taught formulas for pricing
derivatives. And they do NOT need to learn any proofs of a capital asset pricing or
related model.
Similar to my first book, this volume is a cross between a textbook and a book on market
practice. That is, it goes carefully through fundamental principles and is full of real
market applications. It is written intuitively without sacrificing rigor. What does it offer
that others dont? Well, besides the previous two sentences, no other book, to my
knowledge, begins at the true beginning. Its truly soup to nuts. Part One provides
the necessary accounting basics without taking an accounting course! And the book
builds logically from there. Theres a self-contained chapter on understanding the
economy (any economy not just the US), which then is employed in making investing
decisions. Can you find this anyplace else? Topics that are treated (correctly) no place
else are found here, for example, how to short stocks, margin calls, equity-linked notes,
effect of the economy on stocks prices. And certainly not in one place! So many terms
and market jargon are explained its almost an encyclopedia, but written in an easy
going language. Theres even a chapter on mergers & acquisitions without having to
buy a separate book! I think theres a gaping hole on bookshelves today, which calls for a
book of this sort. I myself searched for such a book when teaching at business schools
and when giving seminars to market participants, with no success.
Note: This book may be tilted a bit more toward a textbook than my first one. Indeed,
since I am just beginning the writing, I can tilt in the direction and to the degree
recommended by the publishers marketing experts. To this end, I can append review
questions at the end of each chapter to make it more textbook-like and student-friendly.

Youll notice below I havent flushed out many of the chapters. And some of the Parts
may become chapters, and some chapters may be combined. The part on Derivatives
may be divided into two. And the ordering may well change. Its all fluid.
PART ONE
UNDERSTANDING A COMPANY: ACCOUNTING AND FINANCIAL STATEMENT
ANALYSIS IN ONE SITTING
0

Basics: Stocks and Shareholders

Common stock; residuals; cash flow waterfall; preferred shares; lenders and
other outsiders; role of government

Income Statements, Balance Sheets and Financial Ratios

Revenue and costs; profit; taxes; dividends and retained earnings; EBIT &
EBITDA; losses; inventory; ROE; Dupont analysis

II

Advanced: Mergers, Buy-outs, Spin-offs and Carve-outs

Acquirer & target; hedge fund mark-to-market; goodwill; share buy-backs;
leveraged buy-outs

PART TWO
STOCK PRICES AND VALUES
III

Book Value vs. Market Value

III

Dividend Discount Models; Growth & ROC: Enterprise Value

IV

Equity Price Multiples and Price Dynamics

Beta and Measures of Risk

VI

Stock Indices

PART THREE
INVESTMENT MANAGEMENT

VII

Portfolio Management Styles

Growth vs. value; momentum; small, mid & large capitalization, quantities
strategies

VIII

Performance Measurement

IX

Passive Management & Indexing

PART FOUR
HOW THE ECONOMY AFFECTS STOCK PRICES
X

How the Economy Works in One Chapter

Business cycles and the stock market; the Federal Reserve and financial markets;
effects of inflation

XI

How the Stock Market Reacts to the Economys Dynamics

PART FIVE
TRADING DYNAMICS
XII

Rate of Return Calculations; Leverage and Financing

XIIII Margin and Margin Calls

XIV

Shorting Stocks; Securities Lending by Investors

PART SIX
EQUITY DERIVATIVES
XV

Stock Index Futures

Intro to forwards and futures contracts; index futures; hedging, speculating &
leverage; adjusting beta; slippage

XVI

Total Return Swaps

Equity swaps: single name, basket and index-linked; enhanced passive investing;
portable alpha

XVII Index-linked Notes

Plain and funky alternatives
XVIII Exchange Traded Funds
Structure and dynamics of ETFs; leveraged and inverse ETFs
XIX

Options
Option contract; plain vanilla puts & calls; payoffs and combos; options
employed to synthesize, to hedge, to create income; all the Greeks

XX

Exotic Options and Structured Products

Binary and barrier options; managing equity portfolios with options; next
generation options; yield enhancement and principal protected notes

XXI

Convertible Bonds
Structure and attraction of convertibles; understanding the options; reverse
convertibles

PART SEVEN
HEDGE FUNDS AND RELATIVE VALUE TRADING
XXII Hedge Fund Structure and Operations
XXIII Arbitrage and Relative Value Trades
Pair trades; index trades; statistical arbitrage; event driven trading; cash-futures
basis; stripped convertibles
PART EIGHT
INTERNATIONAL INVESTING
XXIV Foreign Exchange and Exchange rates
What determines exchange rates; Effects of currency movements on stock
portfolios; emerging markets

XXV Multi-national Enterprises

PART NINE
MERGERS & ACQUISITIONS
XXVI

What M&A is All About

Motivation for mergers; types of mergers; control premium; financing

XXVII

Implications for Investors

PART TEN
EQUITY ALTERNATIVES
XXVIII

Private Equity
Types of PE investments; venture capital; exit strategies; capital calls and
J curve

XXIX

Leveraged Buy-outs
Motivation; importance of financing; claw-back arrangements

XXX

Real Estate Investment Trusts

Nature of REITs; favorable tax treatment; attraction to investors

UNIT ONE
UNDERSTANDING A COMPANY:
ACCOUNTING AND FINANCIAL STATEMENT ANALYSIS IN ONE SITTING
This unit provides the basics for you to get started in understanding what equities and
equity investing are all about. The first chapter provides you with definitions. But thats
not all. It gives you the proper intuition for the equity holders share in a companys cash
flow.

The second chapter contains a terse introduction to all the accounting concepts youll
need to understand and invest in stocks. It is brief, to the point and absolutely crucial. If
you have an accounting background, you can skip the basics, but make sure you
understand all the ratios discussed. Anyway, you might want to read the chapter quickly
in order to appreciate the perspective of an investor compared to that of an accountant.
While not fundamental to understanding the basics of equities, the final chapter of this
group belongs here because it applies the basic balance sheet ideas to situations that are
not plain vanilla. Mergers, buyouts, etc. are interesting applications and extensions of
what youll learn in the second chapter, they are important in their own right, and youll
probably need to return to this chapter when these situations are introduced later on in the
book. The chapter also discusses the crucial idea of marking-to-market in the context
of a hedge fund purchasing stock.
CHAPTER ONE
BASICS: STOCKS AND SHAREHOLDERS
Buying a share of stock makes you an owner of the company whose name is on the stock
certificate. As an owner, youre entitled to your share of the profits. Youre also
typically entitled to vote at shareholders meetings, choose who will manage the company
and have a say in other corporate matters. But our concern here is with the money, or
cash flow aspects of being a shareholder. So, what are profits?
Profits, Revenue and Costs
Profits are whats left over from selling the items produced (or services provided) after
everyone else involved in the items production has been paid. Figure O-1 sketches a
companys cash flow. Although a very simplified picture of a companys money
dynamics, the figure is quite enlightening. It is not an exhaustive listing of the elements
involved, but is enough to illustrate the principle concepts. Lets take it step-by-step.
FIGURE O-1
Revenue: price per unit x units sold
Less costs:
Variable
labor
materials
energy

Fixed

rent
administrative
equipment depreciation
debt service
--------------------------------------------------Equals profits

Less taxes
____________________________________
Equals NET PROFITS
A companys revenue equals the product of the price it receives for each item it sells, and
the number of units sold. We use the word units as opposed to quantity so that it can
apply to a company providing services as well as to one producing or selling goods.
Goods by nature can be systematically measured: number of shirts, grams of sunflower
seeds. Some services can be counted; e.g., number of patients seen, number of
subscribers. Others are measured by hours of service; e.g., car mechanics, accountants.
And still others employ metrics unique to their businesses.
It is clear that an increase in price will raise revenue unless the units sold fall
proportionately more in response to the price increase. This sensitivity of demand to
price is known as product elasticity. The more elastic the demand for the product, the
greater the decline in sales for any price increase, or jump in sales for any price decrease.
Many products exhibit relative inelasticity in the short run. Gasoline is a prominent
example. While an increase in pump process does reduce demand, the reduction is
relatively small so that the total revenue is higher after the price increase. Over time,
though, consumers react by driving less or more efficiently and firms search for fuel
substitutes. Hence, elasticity tends to increase over time, especially in response to a
major price change.
Costs are classified as variable or fixed. This is a reasonable distinction, as will become
clear. Variable costs are those inputs to the creation of the firms goods or services that
vary with the amount produced. They dont need to vary perfectly. More production
requires moir labor, although existing labor can, of course, work harder (or longer).
Materials are also known as intermediate goods. Why? Because an input to one firm is
often the output of another. A towel manufacturer requires cloth; the department store
needs the towels. Service providers also use materials. Think of the serum inside a
doctors vaccine, an output of a drug manufacturer. Unlike labor, material use correlates
much more strongly with units produced. Energy can go either way. The electricity
running the lights are the same regardless of the traffic in the store or visitors to the
office. On the other hand, gasoline for a taxi clearly depends on the miles driven for a
customer.
Fixed costs, by definition, do not vary with the companys output. Rent is the obvious
example. Administrative costs refer mostly to employees not directly involved in
producing the companys goods or services. Often referred to as overhead expenses,
accounting, legal, human resources, computer support come to mind. Sometimes these
tasks are contracted tom outside suppliers. Either way, they are not a function of the units
produced or sold.

Depreciation deserves a better explanation. Equipment wears out. However, because the
piece of equipment does not go into the item produced, rather it is employed in the items
production, it cannot be treated like materials. And, since the machines are actually
owned by the company, they cannot be treated like labor. Now, heres the hard part.
Equipment probably does wear out according to the degree it is used, hence according to
the amount of units produced. But that is notoriously difficult to measure. Instead, we
quantify this wearing out as a function of time, and call it depreciation. This will make
more sense in the next chapter, where the interaction between taxes and depreciation
charges take place only with respect to a measure of time.
This actually is a good link to the next fixed cost component debt service. Companies
borrow money. They borrow from banks, and issue bonds to investors. They also
borrow from each other. Suppliers, for example, may allow the firm to pay over a period
of time, known as trade credit. Loans require the payment of interest on a regular
basis, monthly or quarterly, known as servicing the loan. Principal on the loan must be
paid according to a schedule.1 But this is a balance sheet item (see the next chapter) it
is a return of the money, rather than a payment for the use of the money
Another way and a summary - to think of difference is quant vs. time dependent.
Before going on to taxes, it is worthwhile pausing in order to point out the big picture
view of these cost factors. They are all outsiders. The utility supplying electricity,
workers supplying labor, other forms supplying materials, landlord supplying the
building, etc., even lenders supplying loans they are all outsiders relative to the
shareholders, the owners of the firm the insiders. The firm is run by managers for the
benefit of the insiders, period. All else the same, it is the job of management to pay these
outsiders as little as possible unless it compromises their willingness or ability to
produce the firms output of goods or services in order to leave as much over as
possible for the insiders.
Also, diff btwn insiders and outsiders w.r.t bankruptcy obligations to pay; type of
bankruptcy here? Case of loss costs exceed revenue.
Reaching Capacity
Taxes: the Governments Share
Subtracting costs from revenue produces profits. Profits, while technically owned by
shareholders, are not fully available to them. The government takes a piece. Why? As
compensation for the services they indirectly supply to the firm: highways, national
defense, etc. Subtracting taxes leaves after-tax, or net, profits. The government levies
corporate taxes as a percentage of profits. Because the tax code is complicated, we
sometimes distinguish between the marginal and average tax rate. The average tax rate is
simply the total corporate tax bill paid by the company divided by (pre-tax) profits. The
average tax rate is the rate on the next dollar of profits. In this book well simply assume
that the two are the same.

The government takes its share out of the companys profits. The greater the amount of
profit, the more they make. If profits are zero (or negative, when the form incurs a loss),
the government gets nothing. Quite unlike wages, rent or interest or all the other cost
factors. It should be clear, therefore, that the governments relationship to the firm is
more like an insider than an outsider. An implication of this is that, in a sense, the
government is more directly interested in the firms growth than are, for example, its
employees. Indirectly, of course, employees certainly are interested. The better the firm
does, the longer it survives and the greater the likelihood of higher labor compensation in
the future. But if the firm produces more profit during any one period, labor, nor any
other outside supplier to the firm, does not benefit. The government does.
NOPAT
NOPAT is Net Operating Profits After Taxes. Except for the O, we know what this is
already profits after netting out corporate taxes. As such, its an accounting concept.
Inserting the word operating makes it a stock analyst concept. Heres why.
Accountants are concerned with what happened. Perhaps also why it happened. We in
the finance business are concerned with what will happen. The decision whether or not to
purchase a stock rests on the view as to what will happen tomorrow, next week and next
year, not what happened yesterday. When a company announces strong earnings, current
shareholders gain. A buyer of the firms shares based on that earnings report is not
entitled to any of it. On the other hand, although its history, the earnings report may
offer information as to the firms future earnings prospects, which are relevant to the
purchase decision. Of course, if that particular earnings was the result of one-time event,
that is, an event unlikely (or impossible) to be repeated, then it provides no information
for the future. In that case, it might be relevant to an accountant, but to an investor or
investment analyst.
Operating in NOPAT refers to continuing operations. That is, those revenue, hence
profit producing, items which are unlikely to continue are deleted from after-tax profits.
These are known as non-recurring items. It is eminently sensible to subtract them,
since they should not enter the investment decision. Consider a retail establishment
which sells the building housing its store. It is obviously part of the firms revenue, and
the money is owned by the stockholders. But, as it will not be repeated, it is not included
in NOPAT.
Dividends and Retained Earnings
After-tax profits are owned by the shareholders, whether the company puts the money
into an envelope and sends them to shareholders or not. When sent to shareholders, they
are termed distributed corporate profits. The simplest, and most common way to
distribute profits is through dividends, that is, sending each owner of equity a payment
proportional to the number of shares owned. The company can also buy back its shares
in the marketplace, which we will discuss in a later chapter. When sent as dividends,

there can be a tax event for the recipient, the incidence and degree of which depend on
each individual investors position and on the tax regime in place at that time. When
profits are used to repurchase shares, the price per share may rise, precipitating another,
possibly different, tax event.2 .
Profits not sent to shareholders are undistributed corporate profits, more commonly
known as retained earnings. The percentage of profits paid out as dividends is the
dividend pay-out ratio, one minus that being the retention ratio. Firms retain earnings
for a variety of reasons:
1. Dividend smoothing. If the dividend payout ratio were constant, then changes
in any of the factors contributing to net profits would result in changes in
dividends. To reduce this volatility in income to shareholders, firms will keep
some profits during stronger years in order to maintain their dividend payments
in weaker years. The pay-out ratio, you see, moves inversely with a companys
earnings.
2. Liquidity. All enterprises need money on hand. Very simply, suppliers may
require payment before goods are sold, employees need to be paid as their
services are provided but before customers pay their bills. This cash on hand is
part of what is known as working capital. In addition, unforeseen expenses can
crop up, as can unanticipated opportunities. In either case, borrowing from a
bank (and certainly issuing a bond) may not be a practical or timely solution.
Companies maintain bank deposits and, if their liquidity is substantial, may
hold it in interest earning short-term investments, known as money market
securities (for example, Treasury bills or commercial paper).
3. Debt retirement. Bank loans, bonds, trade credit, accounts receivable all need
to be repaid or rolled over (renewed). Repayment can be made at the debts
maturity, in some cases lenders allow for early repayment (a bond call, for
example) or, if tradable securities, the debt instrument can be purchased in the
open market. Funds for repayment can be acquired through selling new equity,
or through retained earnings. In any case, the firms capital structure will be
affected.3
4. Investment. Firms retain earnings for investment purposes. We will discover
in the next chapter that raising capital this way is fundamentally equivalent to
issuing new shares. Investment spending is for the purpose of: expansion,
efficiency and acquisition.
-

Expansionary investment spending adds to the firms capacity to

produce. The firm buys additional equipment, opens new stores,
stocks up on material, etc. in order to sell more stuff. Its scale is
expanded. Profits rise, assuming the increased output can be sold (and
the additions paid for).

Efficiency investment is not meant to produce more, but to produce the

same amount but with less input. Typically this involves purchasing
labor saving equipment.4 When energy prices spike up, companies are
spurred to replace energy inefficient machines, vehicles and processes.
The goal is to reduce costs for the same level of revenue, increasing
profit.
Acquisitions combine two companies. In essence, it is a paper
transaction, with no real consequences by itself. The intention is to
achieve production synergies, reduce costs through redundancies,
take advantage of unused tax credits or a host of other possible
motives, to be discussed in chapter xxx.

Whichever of the above purpose of the investment, the ultimate goal is to

increase future profits. Future profits, in turn, are either paid out as dividends
or retained, again for one of the reasons above. Figure O-2 shows this
diagrammatically.
FIGURE O-2
Diagram of profits divided into dividends and retained earnings, used for investment and
other purposes, and feeding back into profits
Preferred Shares
The stockholders weve been discussing, those investors entitled to the firms net profits,
are known as common shareholders.5 It is important to appreciate the contrast between
these firm owners and lenders to the firm. Bankers, bondholders and other creditors
receive their contractual payments from the companys revenue. Hence, they are paid
prior to common stockholders, who are paid out of profits. More important than the
order of payments, these creditors have a claim on the firm. If not paid, they sue. If the
companys revenue is too low to pay all its outside suppliers, including creditors, they can
theoretically force the firm to sell its assets and honor its obligations to them. If there are
no profits, common stockholders obviously cannot sue. Theyd be suing themselves, as
the owners of the firm!
Preferred stock, also known as preference shares, contain some characteristics of
common and some of debt. Technically, investors in preferred are shareholders in the
company, hence are paid dividends, not interest, out of profits. At the same time, the
amount they receive is not directly tied to the level of the companys profits. Heres how
they work:

The dividend rate on preferred stock is not a function of the level of the firms
profits. Rather, it is typically a fixed rate, based on the face value of the stock.
Although technically a dividend, since the rate is fixed, the prefer reds price will
react to changing interest rates in the marketplace much like bonds. Hence,
preferreds are considered a debt substitute.

The company must pay dividends to the holders of the preferred shares before the
holders of common receive anything. Once the firm makes enough profits to
cover preferred dividends, all the upside goes to the common holders. In other
words, preferred stock does not share in the firms success (above the preferred
dividends).6 From these two perspectives, they are similar to debt.

If the company makes no profits during any particular period, unlike the lenders,
preferred shareholders normally cannot force sales of assets in order to get paid.
In this respect, they are like common stockholders.

If the firm cannot meet its obligations to creditors, and its assets are sold in
bankruptcy, outside creditors are paid first. But, if there is anything left over,
preferred shareholders claims are honored before common stockholders get
anything. Preferred shareholders, therefore, have priority when the firm is
alive (producing profits, from which preferreds are paid first) and when it is
dead (bankrupt, and assets are liquidated).7

Preferreds, in short, are a hybrid instrument. Indeed, a number of new security types
that Wall Street has created in recent years are labeled hybrids for the same reason: they
have some debt and some equity characteristics.8 From another perspective, preferred
shares lie between debt and common equity in the firms capital structure. They are more
risky than lending to the company, but less risky than buying its common stock. Hence,
preferred should pay investors somewhere between the two. And indeed they do. The
dividend rate on a companys preferred shares exceeds the interest rate on its bonds. But
the yield built in to the price of the firms common shares (we will see precisely what
this term means when we examine the determinants of a stocks price in chapter xxx) is
greater than that of the preferred.
One more thing about preferreds, and that concerns taxes. Go back to Figure 0-1. Notice
that interest on debt (included in debt service) precedes taxes. Interest payments, in other
words, are deducted from revenue in calculating the companys tax obligations. Now
look at Figure 0-2. Dividend payments to preferred shareholders are made after taxes
they are not deducted. This leads to an important conclusion: a dollar of interest
payments costs the company that is, the common stockholders less than a dollar of
preferred payments. Heres an easy example in Figure 0-3.
Figure 0-3
After-Tax Cost of Preferred Dividends vs. Bond Interest
Bond financing
earnings before interest: $1,000
interest: 200
earnings net of interest: 800
tax (40%): 320
400

Preferred financing
earnings before interest: $1,000
interest: 0
earnings net of interest: 1,000
tax (40%):

net profits after taxes: 480

preferred dividends: 0
payments to common stockholders: 480

net profits after taxes: 600

preferred dividends: 200
payments to common stockholders: 400

In the example, the company can raise the same amount of funds either by borrowing via
a bond sale (left side) or by issuing preferred shares (right side). To make the comparison
meaningful, the example assumes that the dividend payment on the preferred shares
equals the interest payment on the bonds. In the bond example, notice that tax is paid on
the firms earnings after the interest is deducted. Only the after-tax interest payment
(60% of $200, or $120) is subtracted from what the common shareholders receive.
Preferred dividends, on the other hand, are not deducted. Hence, the full dividend ($200,
or an extra $80) is subtracted from what the common stockholders are entitled to. In
other words:
From the companys perspective, the cost of interest on debt can only be compared to
dividends on preferred stock on an after-tax basis.
Preferred Types
Preferred stock comes in many shapes and forms. Lets look at a few which are
representative of the major types in todays market.

Cumulative

If you think about it, youll readily see that preferred shareholders are not in a good
position vis-a-vis common. Suppose the companys revenue this year is just enough to
pay all its costs (including interest), but no more. Shareholders preferred and common
receive nothing (as does the government). But since all contractual obligations have
been met, the company can live another day. It does, and next year profits are wonderful.
Preferred holders get no more than their fixed dividend, while the common guys partake
of the sizable profits. Lets build a stronger case. Look carefully at Figure 0-2. Assume
that the firm did produce profits this year. The firms managers representing the
common shareholders decide to plow all that money back into the company, as we
discussed above. Unless stipulated otherwise in the agreement between the two classes
of shareholders, this action leaves zero dividends for both of them. Next year, this
reinvestment proved successful, and profits grow nicely. Who gains? Not the preferred
holders; their dividends are fixed. Only the common stock owners. To address this
negative which preferred stock investors should recognize and, therefore, demand a
higher dividend rate preferred stock can be made cumulative. That is, should a
preferred dividend be missed during any payment period, then next period the firm
cannot make dividend payments to common shareholders until that years dividend is
paid to preferred holders plus the missed dividend of the year before.9
In some, non-payment gives holders right to force liquidation of company.

Adjustable Rate

Also known as money market preferred, this type of preferred stock pays a nonconstant dividend rate. The rate does not change with the companys fortunes (which
would bring it a step closer to common). Rather, every quarter the dividend rate is set to
follow a specific short term interest rate. For example, it might pay the three-month
Treasury bill rate. Or, the federal funds rate plus ten basis points,10 or three quarters of
LIBOR.11 Because of this regular adjustment feature, this type of preferred behaves
similarly to a fixed instrument of very short maturity even though, of course, the
preferred is not set to mature. Its counterpart in the bond market is a floating rate note
(FRN), a long term bond whose coupon is adjusts regularly to prevailing interest rates.
Hence, the price of adjustable rate preferred stock, like an FRN, is sensitive to the
fortunes of the company (dividends are paid out of profits) but is relatively immune to
interest rate volatility.

Trust Preferred

This is a rather complicated innovation, but important. It is important because it

introduced a new structure into the market, one that today finds expression in many other
contexts. Lets first understand the why, and then the how. Interest payments on bonds
are tax deductible. But bonds are risky means of raising capital by the firm, as nonpayment of interest constitutes default with all the attendant implications. Preferred stock
dividends do not present this risk, but their payments are not deductible. A security
whose payments are tax deductible but do not present onerous default implications would
be ideal. Thats the motivation behind trust preferred. Now heres the how.
The company establishes a Trust. A Trust is a legal entity which exists for the benefit of
another entity. Youll see that, in our context, the Trust is set up to pass through
payments. If the Trust pays out nearly of all its earnings, it is not taxed.12 The company
issues a long term bond to the Trust, and pays the Trust coupons, or interest. Interest is
tax deductible. Where does the Trust get the money to pay for the bond? It issues
preferred stock to investors Trust Preferred. Voila! But the key is this: The dividends
that the Trust pays to the holders of its preferred shares are covered by the coupons it
earns on the bond. If the company cannot meet its interest payments to the Trust, the
Trust will not pay dividends to the preferred stockholders, which does not constitute
default! In short, investors buy preferred stock from the Trust, but the money ultimately
goes to the company. The company has its tax deductibility, but without imposing default
risk.13

Convertible

All the above are variations on the basic theme of preferred stock: technically equity,
though no participation in the firms profit upside, hence behaves like debt. Convertible
preferred is not a variation it is a fundamentally different instrument. The entire point
of the structure is to allow the holder to benefit should the firms fortunes improve and be
reflected in a higher stock price. We have a chapter devoted to this asset class, but here

are the basic ideas. An investor in a share of convertible preferred has preferred stock in
the company, with an added benefit: he/she can change the preferred into common. Not
by selling the preferred and using the money to purchase common; that can be done with
any preferred. Rather, the holder can present the preferred to the company and receive
common in a fixed ratio. For example, one share of preferred for .3 shares of common.
It is this fixed ratio that is the key. Why? Because if the common stock rises in price so
that .3 shares of common is worth more than one preferred, the holder will convert. If the
price is below, he/she will keep the preferred. As such, convertible preferred allows the
holder to participate in the upside of the company, but is cushioned on the downside by
the preferreds value. Clearly, a share of convertible preferred is superior to a share of
otherwise similar non-convertible preferred the investor only converts when its to
his/her advantage. As compensation, convertible preferred will be priced in the market to
provide a lower dividend yield than its non-convertible counterpart.
The key to convertible preferred is its participation in the firms appreciation. An
alternative, but less frequently employed, structure is participating preferred stock.
Unlike a convertible, whose participation in the companys upside is through its
transformation into common stock, participating preferred remains preferred. Instead,
should common stockholders receive a dividend in excess of a predetermines side, the
participating preferred holder receive an extra dividend as well. Presumably, the
common stocks increased dividend is due to the firms good performance, hence the
participation. Additionally, should the company be sold, participating preferred holders
receive a percentage of the companys appreciated value.14
mention dividend yield dividend divided by market price (when comparing to bond)
Preferred div paid quarterly
The Waterfall
The cash flows of a company are said to be like a waterfall. Sounds funny, but it happens
to be a great comparison (metaphor?). Look at my rendering of a water fall in Figure 0-4,
and think about rain. As rain accumulates on the mountaintop, it starts to travel down
until it reaches the first cliff. If there is enough rain, it accumulates and then falls down
to the next cliff. It continues this way, cliff after cliff, until it reaches the bottom where, if
there is enough rain, a pool forms. As it rains more and more, none of the water on any
of the cliffs get any bigger each has maximum height the water can reach. Not so the
pool at the bottom. The more rain, the larger the pool. Although it receives only the
residual it gathers water only after all the cliffs above it are filled to capacity it is the
only one that has no limit to the size it can reach.
So, too, a companys cash flow. The company produces and sells, creating revenue.
From revenue, costs need to be met wages, intermediate inputs, etc. After these
suppliers are paid, creditors are satisfied. Only after the firm has serviced its debt are the
shareholders paid. First, preferred dividends. Anything left over goes to common. Every
one of the rungs above common has a maximum payment. As revenue grows, these

claimants do not receive anymore. Although the common stockholders sit all the way at
the bottom they are entitled only to residuals, if any exist their compensation is the
only one that, theoretically, can grow with no upper bound.
Figure 0-4
The Cash Flow Waterfall
Revenue
Labor, Material, Energy
Interest
Taxes
Preferred Dividends
Common Residuals
Two qualifications to this waterfall analogy and then were done. First, although
preferred sits on a cliff above common, it is unlike the cliffs above. Preferred is an equity
claim on the cash flows, whereas creditors, labor, input suppliers etc. have contractual,
payment claims, with different implications for missed payments and default, as
explained earlier. Second, notice the governments position in the waterfall. Taxes are
paid prior to preferred dividends, yet they act like a drainpipe, forming their own pool.
The higher the firms profits, the more the government receives there is no maximum.
Among all the claimants to the firms cash flows, the government is most like the
common stockholders. Clearly, they have a lot to gain from the firms success. It is not,
at least theoretically, an adversarial relationship.
1. Loans are totally paid off on their maturity date. Most bank loans (and some
bonds) amortize, that is, they call for partial payment of principal before
maturity according to a specific schedule. In some cases, firms can pay off
their borrowing ahead of time, known as calling the loan or bond.
2. Another distribution avenue is via something known as return of capital. A
set of requirements need to be met in order for the distribution to qualify as a
return of capital. If qualifying, the tax is generally zero.
3. These actions affect the firms leverage ratio, to be discussed in the next
chapter, as well as throughout the book.
4. From a macro-economic perspective, this is where increased productivity
comes from.

5. In a sense, common stockholders are like the commoner in the old British
class system the lowest rung of society. Preferred shareholders, in this
comparison, are like the nobles, who received preferential treatment.
6. Although the varieties of preferred dividends discussed below are not all fixed,
they are all equivalent with respect to this notion of not sharing in the forms
upside.
7. Anticipating what we will learn in the next chapter, another way to say this is
that preferreds have priority to common in the companys income statement
and in its balance sheet.
8. Convertible bonds are not new. But, as we will see in chapter xxx, they belong
in the hybrid class as well.
9. Cumulate preferred typically cumulate for a number of years. Thus, if the
second years dividend is missed as well, then both years dividends need to
be made up before common holders receive any payment. There is a limit,
however, on the number of years that cumulate. Further, in some cases, the
missed dividends accumulate with interest, at a rate stated on the preferred.
10. The federal funds rate is the interest rate on reserves banks borrow from each
other, to be explained in the chapter on the macro-economy. A basis point is
one hundredth of a percent.
11. LIBOR is the London Inter-Bank Offered Rate, a short term interest rate. For
U.S. stocks, it would be the dollar LIBOR rate. See chapter xxx where
LIBOR is a parameter in equity-linked swaps.
12. Well see this in the context of Real Estate Investment Trusts in chapter xxx.
13. This is a somewhat simplified explanation of Trust Preferred stock, but it gets
at the essentials. Be aware that the I.R.S. limits the amount of Trust Preferred
a company can issue, and imposes stiff requirements on the parameters of the
structure. Further, the rating agencies (Moodys, S&P, Fitch) have their own
rules for determining the degree of leverage the bond presents.
14. Private equity investors in the preferred stock of start-up firms (venture
capital) are often compensated in this manner.

CHAPTER II
INCOME STATEMENTS, BALANCE SHEETS AND FINANCIAL RATIOS

This is not a chapter on accounting. Rather, its purpose is to teach you the crucial terms
of the trade in a quantitative, yet intuitive, manner so that you: a) can be conversant with
and appreciate the financial industrys approach to analyzing a company and its stock;
and b) acquire tools that will be necessary for many topics to follow. Well take a
company and watch it grow. In so doing we can introduce concepts intuitively along the
stages of the companys development. Keep in mind: were learning accounting to
become investors, not accountants.
Starting Balance Sheet
So you want to start a shoe company? You need leather, rubber and other materials; you
need equipment; you need a place to manufacture; and you need workers. Youll rent a
facility rather than buy. You dont buy employees, of course; rather, youll pay them for
their work. But you do need some money to start the operation in order to pay for the
material and equipment. You figure you need $100,000. You have $20,000 of your own
money, family and friends have agreed to invest (not lend) another $20,000, and a shrewd
business person youve met is willing to put up $10,000. These are all the owners of the
company the investors, or the equity holders. $50,000, therefore, constitutes the equity
of your company. What about the other $50,000? You need to borrow it. The lenders are
the creditors they are not owners. Your local bank lends you $30,000, and you issue a
$20,000 bond.1 Well get to the interest rate on these loans later. The bank lender and
bond holders differ as to the priority of their claims on your company, that is, who gets
paid first. You have assigned the equipment as collateral for their loans. Hence, they are
secured, so that if you cant pay, they get to grab the collateral. The bank loan is said to
be senior to the bond in its claim on your company. The bond is subordinate in its claim.
All these monies appear on the liability side of the balance sheet in Figure 1-1. The
liability side of the balance sheet contains the sources of funds. In a minute youll see
that the asset side of the balance sheet houses the destinations of those funds. Liabilities
are what you owe, assets are what you own.2

Assets
50,000
40,000
10,000
_______
100,000

Figure 1-1
Initial Balance Sheet
Liabilities

Equipment
Material
Cash

Equity
Bank Loan
Bond

50,000
30,000
20,000
_______
100,000

You take $50,000 of the money you have to spend and purchase shoe-making equipment.
You use $40,000 to buy all the material that go into making the shoes. And you keep
$10,000 in your new companys checking account, which well refer to as cash since,
technically, its not invested in anything. (Why keep cash? One simple reason is that
there is a time lag between paying for labor and material, for example, and receiving
payment for the shoes.) This is all your company owns at this time. Hence, they are
shown as assets on the balance sheet. Notice how the two sides of the sheet balance.
This is a seemingly simple idea, yet not a trivial one. Funds that come in to the company
must end up somewhere in the company. Heres a crucial extension: Since the two values
must always equal each other, a change in one of the values must be equal to a change in
the other. In other words:
A change in the value of assets must be mirrored by a change in the value
of liabilities and vice-versa.
Lets now take a look at a particular financial ratio. Well be examining many ratios in
this book, some measuring a companys risk, others reflecting what investors think about
the firms future prospects, still others relating to the return from holding the companys
stock, and more. Our first ratio is exclusive to the balance sheet, so that even at this early
point in our analysis we have all the information we need. A companys leverage ratio
equals the ratio of the value of its assets to its equity. Your companys leverage is
100,000/50,000 or 2:1. Why? Because you built a company holding $100,000 worth of
assets with only $50,000 of your (and other investors, or co-owners) money. You
levered each dollar of equity 2 times. An alternative measure of leverage looks at how
much money you borrowed relative to how much you put in of owners money. That
measure, known as the debt-to-equity ratio, in our case is exactly 1. Well return to the
leverage ratio later on.
Example assumed no preferred shares.
Income and Profit Statement
Youre ready to go. You manufacture 1,250 pairs of shoes during your first year of
operation. Assume for now that every pair manufactured is sold. Lets see where profit
the owners earnings comes from. Remember, were not becoming accountants. Lets
not lose sight of our goal to understand the path of profit generation by a company in
order to get a sense of the companys value, and from there to valuing its stock. To that
end well take some liberties that an accountant would rant and rave over. Figure 1-2
creates a simplified income statement for your shoe company along the lines of the cash
flow dynamics sketched in Figure 0-1 of the previous chapter.
Figure 1-2
Initial Income Statement
Revenue: 65 x 1,250 =

81,250

Variable costs
Labor: 30 x 1,250 = 37,500
Material: 10 x 1,250 = 12,500
Electricity: 2 x 1,250 = 2,500

Total variable costs

52,500
Fixed costs
Loan interest: .06 x 30,000 = 1,800
Bond interest: .08 x 20,000 = 1,600
Total debt service
3,400
Rent
18,000

Total fixed costs

21,400
-------------------------------------------Profits
7,350
Your company produces only one type of shoe, and sells each pair for $65. Well assume
the following costs:
labor per pair, $30
material per pair, $10
electricity per pair, $2.
Note that this simple cost structure assumes no scale effects. That is, the variable
inputs rise one-for-one with the output.3 Scale will come with the fixed inputs, or costs,
as well soon see.
Your bank charges 6% interest on its loan. The bond, being subordinate to the bank loan
as explained earlier, is more risky. Hence, bondholders demand a higher interest rate,
8%. Your debt service cost is, therefore, 6%x$30,000 + 8%x$20,000 = $3,400 per year.
Your other fixed cost is rent, say $18,000 annually. Well ignore administrative costs,
and get to depreciation later.
During your first year of operation you produce and sell 1,250 pairs of shoes. Hence
your revenue is price x quantity = 65x1,250 = $81,2500. Your variable costs equal
(30+10+2)x1,250 = $52,500. Your fixed costs total 3,400+18,000 = $21,400. This gives
you a profit of 81,250 52,500 21,400 = $7,350, laid out in Figure 1-2.
Book Value and Returns to Shareholders
Up to now weve described the company through its balance sheet, and its operations
through its income statement. Now its time to look at the company as an investment,
that is, through the eyes of its owners (and potential owners). Lets go back to the
companys formation. The amount of money the owners put into the company is
$50,000. This is the book value of your company, so known because it appears on the

balance sheet, which is one page, or sheet, in a book to which pages balance sheets
are added each year).
To evidence ownership you print certificates, otherwise known as shares, and distribute
them to the owners. We could choose any number to start with, so lets go with 1,000
shares. Since the total amount of money the owners put in is $50,000, the initial book
value per share is 50,000/1,000 = $50. Therefore, each owner receives 1 share for every
$50 of equity capital invested.
Now lets return to the companys earnings for the year, from the owners perspective.
The company made $7,350 for the year. With 1,000 shares outstanding, profits per share
equals 7,350/1,000 or $7.35. Lets summarize what we have so far in Figure 1-3, which
uses the profits results of Figure 1-2, the book value (equity) of Figure 1-1 and the 1,000
shares assumed to have been issued.
Figure 1-3
Initial Company Results
Book value:
50,000
Profits:
7,350
Shares:
1,000
Book value/share: 50
Profits/share:
7.35
Were ready for one of the most important measures well be talking about in this entire
book: Return on Equity, or ROE. A companys return on equity means the following:
The amount of profits the company is producing, or returning, to its owners
Alternatively, ROE represents:
The amount of profits that have been produced relative to the money that
the owners have put into the company.
Looking at the alternative definition, it is clear that ROE is measured as a ratio dollar of
profits per dollar of equity investment. Hence:
ROE = profits / book value of equity
For our shoe company this year, ROE is 7350/50000 = 14.70%.
ROE is an example of a financial ratio. Book value per share and profits per share are,
technically, ratios as well. But, as constructed, they do not provide any more information
than the dollar amount of book value and profits do.4 ROE provides new info. By
relating the income statement to the balance sheet how much profits has this company

produced relative to the money that the owners have invested ROE reports the
companys success as an investment by the owners. Its a crucial concept, which is why
investors and analysts expend great effort in getting inside the ratio. Thats what we do
next.
Dupont Analysis.
Return on equity equity here meaning the companys book value can be decomposed
as follows:
ROE = profits / revenue x

revenue / assets x assets / equity

This is known as a Dupont analysis. It tells us that ROE is the product of hence,
stems from three ratios:

Profits / revenue. Known as the profit margin, this ratio measures

how much of what is sold actually flows to the bottom line.

Revenue / assets. This is the asset turnover or turnover ratio,

and is a member of a class of ratios known as activity. It
measures how intensively the firms resources its assets are
being put to use.

Assets / equity. This is the firms leverage ratio, as defined earlier.

For our shoe company:

.1470 = 7350 / 81250 x 81250 / 100000 x 100000 / 50000 = .0905 x .8125 x 2
The company achieved its 14.7% return on equity through a combination of a 9.05%
profits margin on its sales, turning over 81.25% of its assets during the year and
leveraging its equity two-to-one. To understand what this means, we need to either
compare these numbers to those of another company, or to move ahead to next year and
explore how they change. Some industries operate with a high degree of turnover. Think
of food stores. They can get away with a low profit margin, and still produce decent
ROE. Other firms jewelry, for example need significantly higher profit margins to
compensate for low turnover. Leverage, by contrast, is not a market phenomenon, as the
first two ratios are, but a corporate phenomenon. That is, it is decoded upon by the
owners via the financial mangers of the company. Well visit this in the next section.
What should be clear at this point is that an increase in any of the three ratios, assuming
the other two ratios are unchanged and this is a VERY big assumption increase the
firms profits, hence its return on shareholders equity.
Next Year: A Jump in Sales

Lets assume that all your companys profits from its first year of operations are
distributed to the owners. The balance sheet, therefore, is unaltered. Its now next year.
Suppose you sell 10% more shoes 1,375 pairs at the same price of $65/pair. Lets
look at the new income statement, recognizing that variable costs have risen
proportionately and fixed costs are, well, fixed.5
Figure 1-4
Second Income Statement
Revenue: 65 x 1,375 =

89,375

Variable costs
Labor: 30 x 1,375 = 41,250
Material: 10 x 1,375 = 13,750
Electricity: 2 x 1,375 = 2,750

Total variable costs

57,750
Fixed costs
Loan interest: .06 x 30,000 = 1,800
Bond interest: .08 x 20,000 = 1,600
Total debt service
3,400
Rent
18,000

Total fixed costs

21,400
-------------------------------------------Profits
10,225
Profits have increased from $7,350 to $10,225, or 39%. A ten percent sales increase has
brought about a nearly forty percent increase in profits! Why? Fixed costs. Heres how
to think about it. Each shoe manufactured and sold produces a $23 profit - $65 less the
total $43 of variable costs. Thats where the $2,875 in greater profits comes from (125
more shoes x $23). But although each additional shoe needs additional labor, material
and energy, it does not require additional machinery or building facilities (or borrowing).
The company has, in other words, levered its fixed costs.
Heres where the Dupont breakdown is really valuable. Return on equity is now
10,225/50,000 = 20.45% (again, 39% higher than the year before):
.2045 = 10225 / 89375 x 89375 / 100000 x 100000 / 50000 = .1144 x .8934 x 2
The firms profit margin has gone up from 9.04% to 11.44%. This is another
manifestation of the leveraging of its fixed costs.6 And the turnover ratio has improved
from 81.25% to 89.34%, a reflection of the increase in volume. The leverage ratio is, of
course, unaltered because, at this point, the balance sheet has not been changed. With
1,000 shares outstanding, profits-per-share equal $10.225.

Dividends and Retained Earnings

At this point the company has $10,225 in its pocket, so to speak. What does it do with
the money? Here we turn from the operations managers to the companys financial
managers. The former make production and other real decisions for example, style
and number of shoes to produce, marketing and advertising, hiring and laying off
employees. The latter are charged with financial decision making, or what to do with the
money generated by operations and, as we will see later, how to get more money should
the company need it.
How the $10,225 your company earned is disposed of is independent of the fact that this
is the companys earnings this year. Keeping this firmly in mind will help you avoid
some common confusion. Suppose you (acting as the financial manager) decide to send
$2,225 of earnings to shareholders. These are termed dividends or, more formally,
distributed corporate profits. Since there are 1,000 shares, dividends per share equal
$2.225.
What about the rest of the money? The $8,000 by definition is retained. Formally,
these are undistributed corporate profits.
Corporate profits are either distributed to owners as dividends or undistributed
and kept in the firm as retained eanings.7
Your company has to do something with the money retained. It might keep it as cash, in
a bank account. It might stock up on material for future shoe production. Or, it might
buy equipment. In any of these cases, you see, the asset side of the balance sheet grows.8
Well, then, its got to show up on the liability side as well. You havent borrowed any
more funds. So, it must show up as an increase in the equity portion! So heres a crucial
result:
Retained earnings increase a companys equity.
This actually makes quite a lot of sense. After all, what is equity? The funds that owners
have put into the firm. Well, retained earnings are money that belongs to the owners
remember, this money is part of the companys profits. Instead of accepting it as
dividends which would be taking money out of the company the owners have, in
effect, put the money back in. They have, in other words, purchased additional equity.
Figure 1-5 shows your companys new balance sheet, where we have assumed that the
retained earnings have been kept in the firms bank account.

Assets

Figure 1-5
Second Balance Sheet
Liabilities

50,000 Equipment
40,000 Material
8,000 + 10,000 Cash
_______
108,000

Equity
Bank Loan
Bond

50,000 + 8,000
30,000
20,000
_______
108,000

One last, but important, idea before graduating to the next topic. Earlier we defined a
firms book value as all the funds invested by the owners. In our example, the original
equity investments totaled $50,000. Now that $8,000 in earnings have been retained,
your companys new book value equals $58,000. Book value per share has
concomitantly risen from 50 to 58. We conclude that retained earnings constitute an
additional equity investment by existing owners. In short:
Change in Book Value = Retained Earnings = Profits Dividends 8
This relationship is almost definitional. Its very important, and will come up in much of
what follows in this chapter.
Introducing Taxes and Depreciation
Okay, we need to give the government its share, as we learned in the previous chapter.
There are many forms of taxes personal, sales, real estate, social security but well
stick to only one here, that is, corporate taxes. The U.S. government taxes the profits of
corporations. Its a complicated formula. As this is not a book on taxes, well make a
simplifying assumption in order to get at the main ideas. Well assume a simple corporate
tax regime a flat tax. That is, unlike individual income taxes, there is no increase in
the tax rate based on profits brackets and there are no exemptions.9
Lets work with a 40% tax rate. Returning to the situation in Figure 1-4, the government
gets .4x10,225 = 4,090 of your companys profits. You, therefore, keep $6,135 in aftertax, or net, profits. After-tax profits per share equal $6.135, and after-tax ROE, using the
book value from Figure 1-3, is 6,135/50,000 = 12.27%.
Straightforward, no? It gets a little messier when we introduce depreciation, which well
do now, and then see what the result is for the balance sheet.
Equipment wears out. If it is not replaced, at some point you wont be able to make your
shoes. Theoretically, wear and tear is a function of degree of use the more shoes
produced, the more the machinery is used, hence used up. Unlike material, which is used
up and replaced continuously as the shoes are manufactured, equipment is typically
replaced as an entire unit, not a little bit for every shoe. Maintenance, repairs and parts
replacement, however, are typically performed periodically. But there is no simple, direct
association between permanent destruction and the quantity of production. Therefore, the
convention is to recognize wear and tear on a calendar basis. This is known as
depreciation. Just like rent and debt service, depreciation charges on the income

statement are calculated per unit time, as opposed to per unit quantity, which is the case
for labor and materials. This makes depreciation a fixed, rather than a variable cost.
Lets suppose your shoe making equipment depreciates at the rate of 10% per year. We
cant really say that this is in fact, true - we dont observe the machinery shrinking! But
we need to make some accounting assumption (and the government will need to approve
this assumption because, as we will see, taxation of profits depends on it). Figure 1-6
revises the income statement to reflect this cost. After taxes, profits equal $3,135.
Figure 1-6
Revised Income Statement
Revenue: 65 x 1,375 =
Variable costs
Labor: 30 x 1,375 =
Material: 10 x 1,375 =
Electricity: 2 x 1,375 =
Total variable costs

89,375
41,250
13,750
2,750

57,750

Fixed costs
Rent

18,000
Depreciation: .10 x 50,000 5,000
Loan interest: .06 x 30,000 =
1,800
Bond interest: .08 x 20,000 =
1,600
Total debt service
3,400

Total fixed costs

26,400
-------------------------------------------Profits
5,225
Taxes: .4 x 5,225 =
2,090
______________________________
Net Profits After Taxes
3,135
Now lets assume that you actually spend $5,000 this year to replace the worn out shoe
making machinery. Then the equipment entry on the balance sheet (Figure 1-5) remains
$50,000, because its back to where it was prior to its use throughout the year. Thats
where the money went. You see, its just like the material in the income statement and on
the balance sheet it was used up during production, then replaced. $5,000 is subtracted
from income, because it costs money to replace depreciated equipment.
Suppose you dont fix up the machinery. Its still doing its job adequately, and you dont
feel like spending the money. Regardless of whether funds are spent on replacing worn
out equipment, depreciation is subtracted from revenue to arrive at profit. Why?

Because depreciating equipment is a cost of production. Producing shoes requires, or

costs, labor, materials, etc. and wearing out of machinery. The income statement,
therefore, remains as Figure 1-6. Lets also assume that you pay out the $5,225 in
dividends. But hold on - whered the $5,000 go? Since you didnt actually spend the
money, its got to be someplace. Look at the new balance sheet in Figure 1-7.
Figure 1-7
Second Balance Sheet with Depreciation
Assets
Liabilities
50,000 5,000 Equipment
40,000 Material
18,000 + 5,000 Cash
_______
108,000

Equity
Bank Loan
Bond

58,000
30,000
20,000
_______
108,000

This might be counter-intuitive, so think about it by going through these logical steps:
1. We learned that the change in book value equals retained earnings. The entire
profit was paid in dividends to shareholders, hence no retained earnings. No
retained earnings, no change in equity or book value.
2. Since you didnt borrow any more money either, the liability side of the
balance sheet is unchanged.
3. If the liability side is unchanged, so must be the asset side.
4. The equipment is worth less it depreciated by $5,000. But the total value of
your assets (by the previous step) is unchanged. Theres got to be a plus
$5,000 there someplace to keep the total at $108,000. Thats the $5,000 cash
the money deducted from revenue that you didnt use to fix up your
equipment.
In short, the $5,000 out of your revenue of $89,375 that should have gone into replacing
worn out equipment went to cash. But its still a cost of production, whether you pay it in
cash or not.
What if you decide to take that $5,000 and, rather than keeping it in the company, send it
to investors as dividends, on top of the $3,135 in net profit you send them? Remember:
Change in book value = Retained earnings = Profits Dividends. In this case Retained
Earnings = 3,135 8,225 = 5,000. Hence, the book value falls by $5,000 and so, too,
the liability side of the balance sheet. Of course, the asset side must as well. How so?
Equipment has depreciated by the $5,000 and the extra cash has left the firm.
One important idea to take away from all this is that depreciation is not a cash expense.
It is deducted from revenue in order to calculate profit (known also as accounting

profits), but it is not necessarily spent. You, as the owner/manager of the firm, can
choose to spend it and replace the worn out value of the equipment. Or, use the money
elsewhere pay dividends, keep as cash, buy materials, etc. but you must recognize the
depreciated value of the equipment. This idea that deprecation is a cost of production yet
not a cash one has major implications. One involves taxes, another relates to default risk.
Well discuss taxes now and get to default in the next section.
Taxation of corporate profits is based on accounting profits. This means that, regardless
of whether the company chooses to replace worn out equipment, the tax rate is applied to
profits after depreciation is deducted. Go back to the above examples. Your shoe
making equipment depreciated by $5,000. In the first case you actually spent the $5,000
on replacement parts. In the second case you kept the money in the company as cash. In
either case, because wear and tear is a cost of production, the government allows you
deduct the $5,000 from revenue in order to calculate profits upon which the tax is based.10
Lets examine this idea under a different scenario, which will introduce the next concept.
Suppose you dont pay out the $3,135 in dividends. Then, from the fundamental
equation, retained earnings increase by that amount. Say you hold it as cash (in a bank
account). Book value rises by $3,135, reflecting the same increase in equity on the
liability side of the balance sheet. On the asset side, cash rise by that amount as well.
Notice: these changes occur regardless of whether you decide to replace the depreciated
equipment or not! The fundamental equation is independent of your replacement
decision. But heres the difference. If you spend the $5,000 on replacing depreciated
equipment, you have only $3,135 more in cash. If you dont spend it, you have $8,135
more in cash (and $5,000 less in the value of your equipment). Now youre ready for the
next section.
Default Risk and Coverage Ratio
In simple terms, a company which cannot make good on its obligations is in default.
Your shoe company owes $3,400 in interest to its lenders. If you dont pay, they can
conceivably take your company and sell the assets in order to be paid what theyre owed.
Lets read from top down (the down arrows) in Figure 1-8 an abridged version of your
income statement in Figure 1-6 to see how much money the company has available to
service its debt.
Figure 1-8
Income Statement / Coverage Analysis

Revenue:

89,375

Variable costs
Rent
Interest on Debt
Depreciation
Taxes:

57,750
18,000
3,400
5,000
2,090

____________________________
Net Profits
3,135
Out of your revenue of $89,375, you must pay your employees, electricity and the other
variable, or direct, costs of making the shoes. You also need to pay the rent. But you do
not need to replace worn out equipment. No one will sue you for holding off on that
expense. (Of course, it may not be a great idea to let the machinery go like that. But its
better than defaulting and losing your company!) As we learned above, depreciation is
not a cash expense. Cash available to pay interest, therefore, equals $13,625.
Lets look at the same thing from bottom up (the up arrows in the figure), the $13,625 in
net profits . Taxes are only paid after interest expense is met. Hence, they should be
added to Profits as a source of funds from which to pay interest. Depreciation is a source
as well. So is, by definition, the money used to pay interest. Therefore, another way to
get at the available cash is by calculating earnings, or net profits, before the deductions
for interest and taxes, or EBITD earnings before (deduction of) interest, taxes and
depreciation. The greater the level of EBITD (in this case 13,625), the greater your
ability to pay interest on debt (in this case 3,400).11 Investors and analysts calculate a
coverage ratio:
coverage ratio = earnings before interest, taxes and depreciation (EBITD) / interest expense
In our example, the coverage ratio equals 4 (13,625/3400), that is, funds generated by the
firm can cover its interest expense four times.
Lets repeat the crucial conclusion of the previous paragraph, but now in terms of the
coverage ratio:
The greater the coverage ratio, the less the risk of the firm not meeting its interest
obligations, hence the lower the risk of default.
Heres an important question: why should we care how high the coverage ratio is? All that
matters is that it equals at least 1, so that you can pay interest on your debt! If its less than 1
youre cooked. And one you hit 1 youre safe and anything above 1 is irrelevant, no?
No. You and your lenders are thinking about the companys future, not only the present. The
ratio may equal 1 this year, so that your interest expense is totally covered. But you cant be
sure about next year. Similarly, a companys value (and that of its equity) reflects prospects
for years to come, as we will see later in this book. Next year, or the year after, revenues can
decline. Fixed costs do not. Furthermore, variable costs, particularly labor, may well decline
less than proportionately. The coverage ratio, therefore, can easily fall. If it falls below 1,
youre in trouble. Hence, the further above 1 the ratio is today, the less likely for it to drop
below 1 in the future. Again we conclude that the greater the ratio, the less the default risk.
Volatility

What if this was a jewelry company, instead of shoes, with the same coverage ratio? If
youre worried about sales of shoes declining, say, because of an economic downturn,
then you certainly should be worried about jewelry sales. Jewelry is a luxury item, hence
is much more sensitive to the overall economys fortunes. An economic downturn
normally depresses jewelry sales far more than shoe sales. A lender would need a larger
cushion a higher coverage ratio to feel as comfortable lending to a jewelry
manufacturer as to your shoe business.12 Another way to say this is, the more volatile a
companys revenue, the greater the risk faced by lenders. We have a very crucial result:
Given equal coverage ratios, more volatile industries present greater risk than industries
facing less volatility.
Its crucial not only because it points out the greater coverage cushion needed for firms
and industries experiencing high volatility, but because it calls attention to the importance
of volatility in determining risk. Well encounter this link between risk and volatility a
lot.
Inventory
Lets return to the beginning situation displayed in Figure 1-4. Well ignore depreciation
and taxes in order to focus on a new concept. Suppose you manufacture 1250 pairs of
shoes, but sell only 1200. The rest enter your inventory of unsold product. How do we
handle this, and what are the implications for the balance sheet?
Heres what we do. Revenue, obviously, is only 65x1,200. When we calculate costs, we
restrict the calculation to the costs of producing only those shoes actually sold. Wait
didnt we spend money producing the 50 unsold pairs? Of course we did well get to
these later.13 Figure 1-9 is an abridged version of Figure 1-4. The variable costs
calculation is cost of goods sold, known as COGS.
Figure 1-9
Income Statement Recognizing Unsold Goods
Revenue: 65 x 1,200 =

78,000

Costs of goods sold: (30+10+2)x1200 =

Interest: .06 x 30,000 + .08 x 20,000 =
Rent

50,400
3,400
18,000

-------------------------------------------Profits

6,200

What about the unsold shoes? Your company owns them theyre on the balance sheet.
But, rather than buying them and entering their value on the balance sheet, as you would

equipment, you made them yourself. It cost you (30+10+2)x50 = 2100 to manufacture
them. So 2100 of your initial cash was spent making these shoes. Its not a loss its an
investment (in inventory)! This is shown in the new balance sheet in Figure 1-10.
Assume the $6200 in profit is paid out entirely in dividends. We know that retained
earnings will, therefore, be unchanged, as will the book value. If so, the assets are
unchanged as well (because you havent added to debt). How, then, did you pay the
$2,100 to make the shoes you didnt sell? You drew down some of the companys cash.
Figure 1-10
Balance Sheet with Inventory Accumulation
Assets
50,000 Equipment
40,000 Material
+ 2,100 Inventory
10,000 2,100 Cash
_______
100,000

Liabilities
Equity
Bank Loan
Bond

50,000
30,000
20,000
_______
100,000

A couple of points before we examine what happens if you sell more shoes than you
produce. Were we to recognize taxes, they would be calculated on the 6,200 profit. The
costs of the unsold shoes are not a deduction theyre an investment. If, however, their
price has to be marked down in order to sell, or if they simply lose value because similar
shoes that are actually sold fetch a lower price, then that decline in price is deducted from
profit (as well as in the balance sheet). Well deal with losses in the last section of this
chapter.
Okay, lets move on to the reverse situation, taking the balance sheet above as the starting
point. As you sold only 1200 pairs last year, you decide to produce that amount this year,
with the 50 pairs in inventory there just in case. Surprisingly, though, your sales revert
back to 1250. How do we handle this? Easy just the opposite of the previous case.
Revenue is 65x1250. COGS is based on the 1250 pairs actually sold. So, do the
calculations as in Figure 1-9, but with 1250 units. Fixed costs are, of course, unchanged,
so that profits equal 7,350. Assuming again no earnings retained, book value is
unchanged. But the balance sheet certainly looks different the inventory is gone. Lets
examine what happened by doing something analysts call follow the cash.
How much cash came in? 65x1250 = 81,250. How much cash went out? Well, you only
paid the variable costs of 42 on 1200 pairs, or 50,400. Including the 21,400 in fixed
costs, 71,800 went out the door. That leaves 81,250 71,800 = 9,450. But there is only
7,350 in profit. Wheres the 2,100? That cash is not profit. Its simply the 50 pairs of

shoes in inventory, valued at a cost of 50x42=2,100, that was liquidated, or turned into
cash. Which, you see, is exactly the opposite of how we treated the previous case.
Looking at Figure 1-10, the new balance sheet removes the inventory and adds back the
2,100 in cash, so that the balance sheet is back to where it was.14
Market Value
Lets return to our company and its analysis before we complicated things with taxes,
depreciation, inventory and the like. Its the end of the second year of operations, and
you or one of your partners the other owners of the shoe company wants to sell some
shares. Book value per share is $58, as above (Figure 1-5). A potential buyer is
examining the company. Shes looking at the first two years of results the income
statements in Figures 1-2 and 1-4 and the returns on equity they generated for the owners.
They look pretty good compared to other investments shes considering. One of the
owners wants to sell some or all of his interest in the company. Based on these past two
years return on equity and, more important, as we will see in later chapters, based on
her assessment of the companys future profit potential and return on equity she offers
$75 per share for the existing owners shares.15 A sale is agreed upon, and the shares are
transferred to the new owner. What matters to us now is this: the transaction has
established a market price for the shares. Even though only some of the shares were sold,
we know that the market as manifested in the most recent transaction of shares in the
company now values each share at $75. The companys book value is $58,000, while
its market value is $75,000 (the number of shares 1,000 has not changed due to the
transaction). The ratio of market value to book value is 75/58 = 1.29. We will see in later
chapters that this is an extremely important ratio for investors. Now, though, well
concentrate on the market value on its own.
Additional Share Issuance
You now want to expand your company. The first two years were good, and you think
you can sell a lot more shoes. Maybe you want to introduce a new style, maybe you just
want to open more locations. Either way, you need more equipment, material, etc. You
issue 1,000 additional shares. Some are sold to existing investors, who are happy with
the performance thus far and wish to invest more, some to new investors who see an
attractive new opportunity. At what price? Not $50/share, the original per share price.
Of course not you have two years of profits and retained earnings to show. Not even at
$58/share. Rather, $75/share, which is the price at which shares changed hands recently
the market price. Your company now has 1,000x$75 = $75,000 in additional equity.
Before you spend the money on expanding your operations, lets take a look at the new
balance sheet, Figure 1-11 (Figure 1-5 with the additional shares issued).
Figure 1-11
Balance Sheet with Additional Share Issuance

Assets

Liabilities

50,000 Equipment
40,000 Material
18,000 + 75,000 Cash

Equity
Bank Loan
Bond

_______
183,000

58,000 + 75,000
30,000
20,000
_______
183,000

The new book value is $58,000+$75,000 = $133,000. Market value equals 2,000x$75 =
$150,000. Figure 1-12 compares the situations prior to and following the additional
equity issuance, both after your second year of operations. Notice that although the
number of shares have doubled, book value has more than doubled. Why? The original
shares were issued when the company was born, at $1,000/share. Now that the company
has shown its stuff, the market, expecting profits to continue as just experienced, is
valuing it at a higher level, allowing the company to issue shares more expensively. The
new book value per share is the average of the book and market values per share prior to
the issuance of new shares. Looked at another way, the original investors or shareholders
have monetized their shares. Selling new shares has established a market value for all
shares.16
Figure 1-12
Book and Market Values: before and After Additional Share Issuance
Shares
Book Value
Book Value per Share
Market Value
Market Value per Share
Market Value/Book Value

Before
1,000
58,000
58
75,000
75
1.293

After
2,000
133,000
66.5
150,000
75
1.128

Lets look at the key ratio, ROE, now that there is more equity in your firm. As your
company stands now, that is, based on the past years earnings (Figure 1-4), return on
equity is 10,225/133,000 = 7.69%, a far cry from the 20.45% that the second years
results returned to the owners. Similarly, earnings per share equals $5.11, half of what it
was before you doubled the number of shares. This is known as dilution. Following
issuance of new shares, the convention is to take the most recent earnings figures and
perform calculations based on the new book value or number of shares. Why do we look

at the most recent earnings? Its the past isnt the past over! Because thats all we have
to go on. Clearly, the very purpose of issuing additional shares and raising capital is to
increase earnings! So, lets do some forward looking, rather than backward looking,
analysis.
Your company now has $183,000 worth of capital (equity plus debt) to work with,
compared to the $100,000 at the start of the year. Obviously, you didnt issue new shares
(nor did you retain earnings) in order to keep all the proceeds in cash. Lets assume you
purchase additional shoe manufacturing equipment and buy material proportionately, that
is, 83% more of each. Your assets now consist of $91,500 in equipment, $73,200 of
material and $18,300 cash. You also rent more manufacturing space, so your rent rises to
$32,940 from $18,000. Lets assume your expansion works out just as planned you sell
83% more pairs of shoes (1.83x1375), at the original price. Your new income statement
is Figure 1-13 (interest cost is unchanged as you havent incurred any additional debt).
Figure 1-13
Income Statement after Expansion
Revenue: 65 x 2,516 =

163,540

Variable costs: 42 x 2,516 = 105,672

Debt service
3,400
Rent
32,940
-------------------------------------------Profits
21,528
Profits have more than doubled.17 Lets break this down using the Dupont analysis:
ROE =

21,528 / 133,000 = 16.18% =

21,528 / 163,540 x 163,540 / 183,000 x 183,000 / 133,000
profit margin

.1316

turnover
x

.8936

leverage
x

1.376

ROE the year before the expansion before was 20.45% = 1144 x .8934 x 2. Why the
drop? Lets compare components. Profit margin is up somewhat because interest
payments are unchanged. The turnover ratio is intact, reflecting our assumption that sales
expanded concomitantly (83%) with the increase in assets. So what did it? Reduced
leverage. You relied totally on equity to expand your firms operations. By increasing
the equity base, the higher profit is spread over more shareholders. And you did this in
three ways:
1. Retained earnings. The $8,000 is effectively additional equity issuance.

2. New shares. Sure profit has risen, but it has to be shared by more claimants.
3. Each new share added $75 (market value) in equity, not $50 (original book
value). So the sharing of profits on a dollar basis is even more pronounced.
Additional Borrowing
An alternative way to expand your scale of operations is by issuing debt. Rather than sell
new shares, borrow more from banks or sell additional bonds. This would increase
leverage and raise ROE. Or, split the capital raising into debt and equity, keeping the
leverage ratio intact and preventing the decline in ROE. In fact, were we to recognize
taxes, an added benefit is the tax deductibility of interest payments to the debtholders.
So, whats the downside in doing it this way? Greater risk. You cant be sure that youll
sell the extra shoes youre producing, hence there may not be enough money to pay
interest after the variable costs are met. (You dont face this risk shareholders you have
no contractual obligation to pay dividends.) In fact, this very possibility and, as weve
seen above, the more volatile the product the greater the chance of this occurring causes
bond investors to demand higher interest rates than youre paying on the existing debt.
Furthermore, to the extent the existing bank loans and bonds need to be refinanced on
their maturity dates, their interest rates will rise as well.18
Losses
1. Its unrealistic to suppose that a start-up company such as the one weve
concocted will be able to issue a bond in the market. As a theoretical
exercise to teach you principles, well take that liberty.
2. Not exactly, because you dont owe the equity to anybody other than
yourself (and your equity/owner partners).
3. Technically, this would be described as variable costs rising linearly
with production
4. If the number of shares change (which we examine later), then dividing by
the number of shares is necessary.
5. Were implicitly assuming that the companys fixed resources can
accommodate the increase in production; i.e., that it hasnt reached
capacity. We deal with the need to increase capacity later.
6. Profit margin calculated on a variable cost basis, revenue less variable
costs divided by revenue, or (89,37557,750)/89,375 = 35.38%, is the
same as in the first year.

7. Technically, profits can also be distributed to owners via repurchases of

shares and via return of capital. We will come across share repurchases
and share repurchase programs in other contexts in this book. Profits
distribution qualifies as return of capital if stringent requirements are met,
and in that case are not taxed as dividends, which we discuss later in this
chapter.
8. What about using the money to hire employees, you ask? Remember
and this is not completely intuitive, so you need to digest this hiring (and
firing) is part of the production process. It is not a balance sheet issue.
The money to pay for labor (as well as for electricity and for materials
used in shoe production) comes from the sale of the shoes. We already
took care of that. This money is whats left over after that process is
complete, in a sense. Now, because funds spent on labor, materials, etc. is
used before money is received from shoe sales, the financial managers
may decide to keep more in cash. That cash, of course, is on the balance
sheet, as noted earlier in the text.
8. This equality holds only if the firm does not issue new shares. We
examine this possibility toward the end of the chapter.
9. This means the average tax rate is equal to the marginal rate. (There are
no deductions, credits, carry-forwards, etc.)
10. This explains why firms favor accelerated depreciation. Under such a
tax regime, the IRS allows a faster rate of depreciation for example, 20%
per year rather than ten. Whether or not the firm actually replaces what
economically depreciated, the tax bill is reduced (in the earlier years).
11. It is common to see the term EBITDA. A is amortization, a measure
closely related to depreciation and, for similar reason, is added back to
earnings to produce the coverage ratio. As depreciation applies to physical
assets, amortization applies to intangible assets. Examples are patents,
which expire over time, and goodwill, which is a deduction after an
acquisition (see chapter xxx).
12. Of course, the more volatile earnings, the greater upside as well. But
lenders gain no benefit from the companys higher earnings, because
theyll never get more than the coupon or interest (and principal) due
them. So volatility is for the most part a negative for creditors.
13. This actually makes eminent sense. For, if we were to include the cost of
the 50 unsold shoes in the variable cost calculation, but not recognize
them in revenue (because they were not sold), it would imply that they
were sold at a price of 0!

14. It gets a little messy when the price of the shoes rose or fell while they
were held in inventory. This is known as inventory profits (or losses)
and has tax as well as accounting implication which, thankfully, well
ignore, as our purpose is not to become accountants.
15. In assessing what a share is worth, investors also look at the market
value (compared to book) of other firms in the same industry. This is
known as comparables. Its a bit circular, but well examine it in later
chapters.
16. They have monetized their investment in your shoe company established
a market value for their shares but have not realized their profit from the
investment. That occurs only when the shares are sold in the market.
17. Why not 83% more? Because one of the fixed cost factors interest on
debt has not increased.
18. Bank loans and floating rate notes tied to LIBOR will command a wider
spread.

CHAPTER III
MARKING-TO-MARKET, ACQUISITIONS & GOODWILL, AND
SHARE REPURCHASES
Who says finance is boring? The chapters title alone is enough to get your adrenaline
flowing!
Market Value and Book Value of Stocks and of Companies
Towards the end of the previous chapter we spoke a bit about the contrast between the
book value of a company and the market value of the companys equity. They are
typically not the same. Book value equals all the moneys the companys owners have put
into the firm original equity to start the company plus retained earnings (less losses)
plus additional equity sold to investors. Market value represents the number of shares the
company has outstanding multiplied by the (most recent) price per share, hence the price
the company fetches in the marketplace. Alternatively, book value is what the owners
of the company have invested in it in the past to bring it to where it is today. Market
value is what investors are willing to pay for the company based on their expectations of
the future. This led naturally to looking at a new investor purchasing shares of your shoe

company from an existing owner, which established a shares market value. And then we
considered your company selling new shares at that market price.
Lets think about that investor who purchased shares from an existing investor. Well
assume he/shes a speculator-type, in that he/she buys shares in anticipation of near term
price appreciation, as opposed to investing for the dividends, or to participate in your
companys growth. So, for identification purposes, well call him/her a hedge fund
manager, or hedge fund for short. Lets also simplify the financial numbers of your shoe
company and assume the balance sheet is as in Figure 2-1 (000 is omitted from each
number). The $1,000 worth of equipment are your companys sole operating assets
what you use to make your shoes. The leverage ratio, as you see, is 2. The book value,
of course, is 500. Assuming 10 shares (omitting 000) outstanding, book value per share
is 50. Lets assume that shares recently changed hands in the market at 60/share. This
establishes a market value of 10x60=600 for your firm.
Figure 2-1
Shoe Company Balance Sheet
Assets

1,000

Liabilities

Equipment

Equity
Debt

_______
1,000

500
500
_______
1,000

Suppose now the hedge fund buys 1 share. Lets say the hedge fund, for simplicitys
sake, is capitalized similarly, that is, 50% equity & 50% debt. Its balance sheet,
therefore, is in Figure 2-2. Doesnt seem so interesting, does it? Ah, but it is.
Figure 2-2
Hedge Fund Balance Sheet
Assets

60 Value of shoe
company shares
_______
60

Liabilities

Equity 30
Debt 30
_______
60

What does your shoe company own? $1,000 worth of equipment. It owes $500. So, its
worth (in book terms) the difference, $500. Now think about the hedge fund. It owns
10% of your company (1 of 10 shares) 10% of $500 is $50. It owes $30. Should it not
be worth $50? But, in fact, its balance sheet shows its worth $60 $30 = $30!
This is where the rubber meets the road, so to speak, in equities. Its another aspect of
the difference between book value and market value. On a company basis, the difference
between its assets and liabilities equals $500, with a tenth of that being $50. But the
hedge fund did not purchase a tenth of the companys assets-less-liabilities a tenth of its
book value. It didnt buy a piece of the shoe making equipment. Rather, it made its
purchase in the stock market, hence paid one tenth of the shoe companys market value.
In short, the hedge fund, as an investor, not a shoe maker, owns one tenth of the shoe
makers market value, and thats whats on its books.
Marking-to-Market
Return to the shoe manufacturer for a moment. Shoe making equipment can go up and
down in value, like any other good or service. But it doesnt matter to your business,
does it? Youre not planning to sell the equipment; youre using it. The only change in
value that concerns you is its physical depreciation.1 On the other hand, the hedge funds
assets (as those of any investment manager, for that matter) are meant to go up and down,
to be sold and bought. Indeed, that was our original assumption about the speculative
nature of the hedge fund manager.
So, heres the implication of all this. If the price of your shoe making machinery rises or
falls, we wont change its entry in your coronarys balance sheet. The equipment is
carried on your books at its cost price (net of any depreciation that is not replaced). By
contrast, should the assets on the balance sheet of the hedge fund appreciate or
depreciate, we definitely will change their entries. Why? Because the hedge fund is
looking to make a living based on these asset price changes. Your shoe company is
looking to make a living by using the equipment, not buying and selling them. Stock
prices, therefore, are carried on the books of a hedge fund at their market value. When
their market price changes, it is shown as such on the balance sheet. This is known as
marking positions to market, or, mark-to-market for short.2
Acquisition
Good news! A big company Shoe Corporation of America (SCA) wants to buy yours.
Youve done well, people seem to like your quirky shoe, and SCA thinks it would be an
attractive addition to its lineup. Whatever. Lets say that SCA simply enters the stock
market and purchases all ten shares of your company at the market price of 60/share.3
Figure 2-3 displays SCAs balance sheet before the acquisition. It is a much bigger
company than yours, in terms of assets or book value. To make things clear and simple,
all its assets equipment, materials and inventory, buildings (it owns its own building,
unlike your rinky-dink company which has to rent!) are grouped together in one entry.

Figure 2-3
SCA Balance Sheet
Assets

5,000 Operating Assets

Liabilities

Equity
Debt

_______
5,000

3,000
2,000
_______
5,000

Where does SCA get the money to pay for all your companys shares? According to the
balance sheet, it has no cash (or money market investments) on hand. So, it issues new
shares with a total value of $300 and borrows the other $300. Now heres the difference
between the hedge fund buying shares in your company and SCA buying your whole
company. SCA cant just show the $600 asset (10 shares, $60 each) on its balance sheet
along with the associated liabilities. No, sir! It must consolidate its original balance sheet
with yours. SCA is now responsible for the $500 in debt your shoe company incurred.
Hence, its a liability on SCAs new, consolidated balance sheet. And on the asset side,
SCA shows all your shoe companys assets, which it now owns. Plus and this is crucial
- the extra $100 due to the excess of $10/share in market value over book value must be
on the asset side as well. No different from the hedge fund buying shares in your
company as we showed above. Anyway, this is how the consolidated balance sheet
balances!
Figure 2-4
Consolidated SCA Balance Sheet, Post-Merger
Assets

5,000 Operating Assets

1,100 Acquired Shoe Comp.
1,000 acquired assets
100 goodwill
_______
6,100

Liabilities

Equity
Debt
(Assumed) Debt

3,000 + 300
2,000 + 300
500
_______
6,100

Figure 2-4 presents SCAs new balance sheet. Look first at the liabilities. 300 has been
added to SCAs equity. Equity holders of your shoe company have been bought out, so
their shares are gone. Only SCA shares exist. Indeed, your original company and SCA

are now one. Hence, SCA owes 2,000 to its original debtholders, 300 to the new lenders
plus 500 of the debt owed to your shoe company creditors.
Now examine carefully the asset side. The 5,000 value of SCAs original assets, of
course, remain. In addition, SCA paid 1,100 for your shoe company. Hows that? It
bought all the equity in your company for 600 (by issuing 300 in new equity and
borrowing 300) and took on 500 of your companys debt. That is, it paid 1,100 for your
companys assets. Thing is, your companys assets were only worth 1,000 look at
figure 2-1. So, we show this by separating the 1,000 in to the original (book) value of the
assets and something that goes by the name of goodwill. Goodwill in this case equal
to 100 represents the excess of the price paid by the acquiring company for the acquired
entitys assets over the assets book value.
Truth is, since SCA paid 1,100 for the shoe manufacturer, thats what the assets are worth.
Still, separating out the goodwill makes the payment explicit. Furthermore, precisely
because SCA paid 1,100 and not 1,000 does the IRS permit the entire 1,100 to be
depreciated over time and thus deducted for purposes of tax liability. The yearly
deduction of the 100 goodwill is known as amortization, and may follow a different
schedule from standard depreciation.4,5
Share Repurchase
Instead of buying your shoe company, suppose SCA decides to purchase some of its
shares in the open market. Return to the companys original balance sheet in Figure 2-1.
Assume that out of the $5,000 in assets, $1,000 is cash. It uses the cash to purchase its
shares from existing holders. The number of shares it succeeds in purchasing depends on
the market price per share, but that is not relevant at this point. What is relevant is this:
SCA has transformed $1,000 of cash on its balance sheet into equity temporarily. Why
temporarily, you ask? Why is this not the same as SCA buying shares of your shoe
company, assuming SCA made the purchase with shares? Because these are its own
shares, stupid. It makes no sense to have $1,000 worth of shares on both the asset and
liability side! Instead, the $1,000 in cash is removed from assets and the corresponding
$1,000 is erased from equity, hence from book value, on the liability side.6
One more thing. When SCA held the cash prior to its share repurchase, existing
shareholders were the owners of the physical (operating) assets plus the cash. Paying out
the cash as dividends pro-rata to all shareholders just changes the location of the cash, so
to speak, from the companys bank to each shareholders bank. The book value per
share, therefore, falls by the dividend per share. The sum of the new price per share and
the dividend payment per share equals the original (book) price per share. Instead, SCA
chose to use the cash to buy back shares. Those shareholders who sell, therefore, should
receive the current price per share. Those retaining shares, not having received
dividends, own shares at the same price.7

This analysis ignores the effect of taxes. If the share buyback does not affect price per
share, there should theoretically be no tax consequence. Payment of dividends, on the
other hand, triggers a tax event.
Spin-Off
Lets change the story once again. Of the $5,000 in assets held by SCA in Figure 2-1,
4,000 is its shoe-making and related equipment and material. The remaining $1,000,
rather than held in cash as in the previous section, are real assets dedicated to producing
shoe polish. SCA management wants to separate the two businesses so that managers
with the relevant expertise can work to their comparative advantage. One way to
accomplish this is through a spin-off.
On a fundamental level, a spin-off is not so different from a cash dividend payment.
With the latter, the company sends cash from its balance to shareholders (the owners of
the cash). With the former, the company sends physical assets from its balance sheet (in
the form of pieces of paper evidencing ownership in those assets) to shareholders (the
owners of the physical assets). Suppose SCA spins off SPC Shoe Polish Company in
this manner. An investor owning, say, 5% of the common stock of SCA now owns 5% of
SPC stock with a book value of 5%x1,000=20. $1,000 leaves SCAs assets, a
corresponding amount is deduced from equity on its liability side, and SPC is capitalized
with $1,000 of equity.8 SCA may alternatively decide to assign some of its debt to SPC.
Say half of SPCs capitalization is debt. Of course, debtholders would need to accept that
SPC owes them money in place of SCA. Assuming so, each SCA shareholders
ownership of SPC stock is still in proportion to his/her ownership interest in SCA, but the
book value is reduced by half.9

1. And, possibly, the change in price of replacement parts.

2. There is another reason hedge funds mark to market. The hedge fund
managers compensation from investors (the owners of the equity on the
funds balance sheet) is largely based on changes in the market price of the
stocks sold from (realized) or remaining on (unrealized) the balance
sheet.
3. They probably would have to pay more than 60 per share. Why? Not every
one of your companys owners was willing to part with his/her shares when
the hedge fund paid 60 earlier. Typically, SCA would have negotiate directly
with you or other big shots (the financial managers) in your company and
come to an agreement as to a fair price. Then you would recommend the
transaction to the shareholders. These merger dynamics are not the topic of
this chapter, so we simply proceed with the texts assumptions that the shares
are purchased in the open market, which serve our present purposes well.

4. Goodwill is an example of an intangible asset, in contrast to, for example,

tangible equipment.
5. Note well: The physical cost of the machinery is 1,000. Hence, the cost of
replacement the true total depreciation is 1,000, not 1,100. Therefore,
although the machinery depreciation and the goodwill amortization are both
deducted for the purpose of tax calculations, the net profit after taxes
(NOPAT) of chapter 1, should add back the yearly amortization.
6. Were SCA to finance its share repurchase via additional borrowing rather than
use it cash the shares would nevertheless be extinguished and book value
reduced just the same. The firms assets would be larger and its leverage ratio
greater than the situation in the text.
7. Theres actually a sleight-of-hand here. The analysis is only perfectly correct
if the market price per share equals book value per share. If not that is, the
ratio of market to book value exceeds 1, as in the example in the previous
sections then proving this indifference result is more complex.
8. This simplified example assumes this transaction between SCA and SPC is
done on a pure book value basis.
9. SCA could have elected to carve-out rather than spin-off. In a carve-out, the
parent company sells some assets usually in the form of a newly created
company or subsidiary company to investors. Shares are sold in the open
market. Or, the assets (or the subsidiary) are sold to another company (or a
private equity firm). Because the sale is at market value, there may be a tax
event due to the profit earned by SCA on the sale.