2.9. Equity (1) – accounting for common and preferred stock

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Do curso por Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

3 classificações

Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

3 classificações

Curso 3 de 5 em Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

Na lição

Operational Assets. Depreciation. Short-Term Investments. Long-Term Liabilities. Shareholders’ Equity. Some Tax Issues

Week 2 is devoted to long-term assets and liabilities. We start with operational assets and see the role of depreciation and amortization in financial accounting and compare it to the way depreciation is used in valuation of investment projects. Then we discuss how financial investments in securities – stocks and bonds – are treated in accounting dependent upon goals and time horizon of holding and/or issuing of these securities. You will see how financial concepts (present values) are used in accounting for bond premium/discount amortization. Finally, an overview of the accounting approach to taxes is provided. On an example, you will study the core idea of deferred taxes.

2.1. Operational assets – types and accounting approach13:17

2.2. Depreciation11:14

2.3. Depreciation tax shield8:53

2.4. Intangible assets – accounting and amortization7:22

2.5. Short-term investments in bonds10:19

2.6. Short-term investments in stocks12:33

2.7. Bonds (1) – parameters and accounting approach10:31

2.8. Bonds (2) – amortization of premium/discount13:34

2.9. Equity (1) – accounting for common and preferred stock11:37

2.10. Equity (2) – treasury stock and stock dividends12:15

2.11. Accounting for taxes – an overview9:11

2.12. Deferred taxes – an example8:32

Conheça os instrutores

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

In what follows, we will study this case two with all parameters constant.

And although there will be quite a few numbers here on this flip chart,

the result will be quite trivial and the actual value of this exercise is

to see how we can generalize that to study more interesting cases.

Well, the setup is like this.

We assume the following parameters of the company,

the market cap rate of 20 percent,

this is the rate at which we discount.

Then some parameters of the company,

earnings per share at year one is expected to be $15,

then payout rate is 60 percent.

Therefore, from this multiplied,

we can see that dividend one is expected to be $9.

Then clearly plowback, which is in this case,

one minus this, is 40 percent.

The only thing that is missing is return on equity,

on book equity in this case,

which is 30 percent.

And if this is the case,

these are all the numbers that for our company.

But this is just an example.

Now from that, we can find G,

because G is plowback times ROE,

which is 12 percent in this case.

And we can use Gordon's formula,

we can say that P sub-zero,

because this is clearly constant growth is $9 divided by 0.20

minus 0.12, which is $112.50.

And just to observe that,

we'll find that the P of no growth,

that will be what?

EPS1 divided by 0.20,

which is in this case,

$15, 0.20, which is $75.

Now from this, we can conclude that output here, that PVGO,

Present Value of Growth Opportunities,

is the difference of these, which is $37.50.

Now in the next list,

I will show exactly how,

well, we found everything.

But what I will do, I will not stop here,

I will start to go deeper in how these mechanics actually yields this result.

So we will follow through the investments year after year,

and we will see that each investment contributes to this growth.

Again, this is easier written than said,

so we will see the chart like this.

So these are years one, two,

three, four, five, six.

Well, I could stop earlier,

but that makes it more understandable.

So this is the result of previous investment.

This is EPS1 $15, $15, $15 forever.

Now, let's analyze, in detail,

investment at year one.

So we reinvest 40 percent or minus $6,

and this $6 brings us 30 percent.

This is return on equity,

so this is 1.8.

So here, we have 1.8,

1.8 and so forth.

Now let's stop for a moment here.

If there were no investment,

there'll be nothing on this flip chart anymore.

So we would take $15,

we would have divided that by 0.2,

and then we would have received $75, the no growth case.

So the top line in this as you'll see triangle table,

is no growth case.

Now see what happens as a result of investment at year two.

Now the key story is here we had $15.

Now by year two, we have grown to this combination.

So now we have 16.8,

so we take 40 percent of that and we get minus 6.72 this is investment.

Well, all these numbers here,

they grow at the rate of 12 percent, which is constant.

So this 6.72 produces us 30 percent in perpetuity,

which is 2.02, 2.02,

and that goes forever.

Now you don't have to be a real wiz to realize that here,

we are minus 7.53,

and the amount is 2.26.

Here, it will be minus 8.43.

And then the year five,

it will be 2.53.

And then finally, here,

it will be minus 9.44.

I will stop here because that now is clear.

So we've created this triangle table,

and see what is the bottom line.

So we see that here,

this is the amount of cash that shareholders can pocket.

This is actually dividend.

So this is 9 here, it's 10.8 here,

it's 11.29 here, 12.64,

and all that grows.

Again, here it grows at 12 percent.

So, let's see exactly the NPV of these investments.

Here I put in blue to be consistent, I'll put that.

So we invest minus 6,

and then plus, we get 1.8 in perpetuity.

So we divide by 0.2,

and that gives us exactly three.

Now here, the same exercise.

Minus 6.72, plus 2.02 divided by 0.2,

and that gives you 3.36.

Well, clearly, again, here,

growth is at 12 percent,

and so on and so forth.

And if we then took this three,

and that is also a constant growth,

then we can see that PVGO will be

three divided by 0.8.

This is the difference between 20 percent and 12 percent,

and that will be exactly 37.5.

This result we've had before.

Now you can ask a question,

why the hell did we study all that with these numbers?

Now see what happens.

The trivial result that we've had before,

we got that because we put all these parameters of reinvestment constant.

But let's take a look at this table.

Let's say that at year three,

we decided to change plowback.

Then in this case,

all these numbers would be different and the corresponding PV would be different.

So what we see here is that for some finite period of time,

we can make whatever investments we would like,

and then we can calculate the contribution of these investments to

the final PVGO with the use of the corresponding horizontal line in this table.

From some further point until infinity,

we must make some assumptions about constant parameters,

and then we'll get to something like this.

So basically, this approach although is funny because

this is sort of a table that doesn't seem to be very serious,

but that really allows you to go deeper in the idea of growth.

You can see that lines may be

different and they could contribute differently, but they all do.

And by the same token with this table,

you can easily study cases of borrowing.

Let's say if in this year you borrowed,

then you can invest much more and the contribution of that would be higher.

Then the old, when we have to take into account the interest you're paying on

that and the repayment of the loan at the point when it occurs.

So this funny example shows to you how you can actually pinpoint

growth for growth rates that are not always equal.

This was for equal for the whole period of time.

But like I said, for a finite time period, you can play with them.

This is a very powerful tool.

And often times, this representation happens to be

much clearer than the one if I used only formulas here.

Again, I was giving assignments to my students for many years,

and one year I realized that talking about this triangle table results in

a much better rate of solutions in their assignments.

So we are almost done.

And in the next,

the final episode of the second week,

we will put everything together.

We will briefly analyze what we've succeeded in so far and where we would go from.

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