60 Part 2 Fundamental Concepts in Financial Management
subtract the sum of payables plus accruals from current assets, the difference is
called net working capital. That represents the amount of money that Allied must
obtain from non-free sources to carry its current assets, $800 million in 2008:Net working capital! Current assets # (Payables " Accruals)
! $1,000 # ($60 " $140)! $800- Other sources of funds. Most companies (including Allied)! nance their assets with
a combination of current liabilities, long-term debt, and common equity. Some
companies also use “hybrid” securities such as preferred stock, convertible bonds,
and long-term leases. Preferred stock is a hybrid between common stock and debt,
while convertible bonds are debt securities that give the bondholder an option to
exchange their bonds for shares of common stock. In the event of bankruptcy, debt
is paid off! rst, then preferred stock. Common stock is last, receiving a payment
only when something remains after the debt and preferred stock are paid off.^5 - Depreciation. Most companies prepare two sets of! nancial statements—one is
based on Internal Revenue Service (IRS) rules and is used to calculate taxes;
the other is based on generally accepted accounting principles (GAAP) and is
used for reporting to investors. Firms often use accelerated depreciation for
tax purposes but straight line depreciation for stockholder reporting. Allied
uses accelerated depreciation for both.^6 - Market values versus book values. Companies generally use GAAP to determine
the values reported on their balance sheets. In most cases, these accounting
numbers (or “book values”) are different from what the assets would sell for if
they were put up for sale (or “market values”). For example, Allied purchased
its headquarters in Chicago in 1988. Under GAAP, the company must report the
value of this asset at its historical cost (what it originally paid for the building in
1988) less accumulated depreciation. Given that Chicago real estate prices have
increased over the last 20 years, the market value of the building is higher than
its book value. Other assets’ market values also differ from their book values.
We can also see from Table 3-1 that the book value of Allied’s common equity
at the end of 2008 was $940 million. Because 50 million shares were outstanding,
the book value per share was $940/50! $18.80. However, the market value of
the common stock was $23.06. As is true for most companies in 2008, sharehold-
ers are willing to pay more than book value for Allied’s stock. This occurs in part
because the values of assets have increased due to in" ation and in part because
shareholders expect earnings to grow. Allied, like most other companies, has
learned how to make investments that will increase future pro! ts.
Apple provides an example of the effect of growth on the stock price. When Apple
" rst introduced the iPod and iPhone, its balance sheet didn’t budge; but investors
recognized that these were great products that would lead to higher future pro" ts.
So Apple’s stock quickly rose above its book value—it now (Spring 2008) has a
stock price of $185 versus a $20 book value.Net Working Capital
Current assets minus
accounts payable and
accruals.Net Working Capital
Current assets minus
accounts payable and
accruals.(^5) Other forms of! nancing are discussed in Brigham and Daves, Intermediate Financial Management, 9th edition,
(Mason, OH: Thomson/South-Western, 2007), Chapter 20. In Fundamentals of Financial Management, 12th edition,
readers should refer to Chapter 20.
(^6) Depreciation over an asset’s life is equal to the asset’s cost, but accelerated depreciation results in higher initial
depreciation charges—and thus lower taxable income—than straight line. Due to the time value of money, it is
better to delay taxes; so most companies use accelerated depreciation for tax purposes. Either accelerated or
straight line can be used for stockholder reporting. Allied is a relatively conservative company; hence, it uses
accelerated depreciation for stockholder reporting. Had Allied elected to use straight line for stockholder
reporting, its 2008 depreciation expense would have been $25 million lower, the $1 billion shown for “net plant”
on its balance sheet would have been $25 million higher, and its reported income would also have been higher.
Depreciation is also important in capital budgeting, where we make decisions regarding new investments in
! xed assets. We will have more to say about depreciation in Chapter 12, when we take up capital budgeting.