ACC2231 - Departmental Accounts (Revision)

Assalamualaikum,

As requested by you, kindly download the attachment for our discussion later in class.

Exercise 3 - FA2 - Departmental Accounts - Knowledge Factory

Also need your views on each of the departments...

ACC2232 - Equivalent Units, Joint Products and By-Products

Equivalent units of production

March 29, 2013

Equivalent units of production is a term applied to the work-in-process inventory at the end of an accounting period. It is the number of completed units of an item that a company could theoretically have produced, given the amount of direct materials, direct labor, and manufacturing overhead costs incurred during that period for the items not yet completed. In short, if 100 units are in process but you have only expended 40% of the processing costs on them, then you are considered to have 40 equivalent units of production.

Equivalent units is a cost accounting concept that is used in process costing for cost calculations. It has no relevance from an operational perspective, nor is it useful for any other type of cost derivation other than process costing.

Equivalent units of production are usually stated separately for direct materials and all other manufacturing expenses, because direct materials are typically added at the beginning of the production process, while all other costs are incurred as the materials gradually work their way through the production process. Thus, the equivalent units for direct materials are generally higher than for other manufacturing expenses.

When you assign a cost to equivalent units of production, you typically assign either the weighted average cost of the beginning inventory plus new purchases to the direct materials, or the cost of the oldest inventory in stock (known as the first in, first out, or FIFO, method). The simpler of the two methods is the weighted average method. The FIFO method is more accurate, but the additional calculations do not represent a good cost-benefit trade off. Only consider using the FIFO method when costs vary substantially from period to period, so that management can see the trends in costs.

Example of Equivalent Units of Production

ABC International has a manufacturing line that produces large amounts of green widgets. At the end of the most recent accounting period, ABC had 1,000 green widgets still under construction. The manufacturing process for a green widget requires that all materials be sent to the shop floor at the start of the process, and then a variety of processing steps are added before the widgets are considered complete.  At the end of the period, ABC had incurred 35% of the labor and manufacturing overhead costs required to complete the 1,000 green widgets. Consequently, there were 1,000 equivalent units for materials and 350 equivalent units for direct labor and manufacturing overhead.

 - from https://www.accountingtools.com

Joint products

May 09, 2017

Joint products are multiple products generated by a single production process at the same time. These products incur undifferentiated joint costs until a split-off point, after which each product incurs separate processing. Prior to the split-off point, costs can only be allocated to the joint products.

 - from https://www.accountingtools.com

By-product costing and joint product costing

May 14, 2017

A joint cost is a cost that benefits more than one product, while a by-product is a product that is a minor result of a production process and which has minor sales.

Joint costing or by-product costing are used when a business has a production process from which final products are split off during a later stage of production. The point at which the business can determine the final product is called the split-off point. There may even be several split-off points; at each one, another product can be clearly identified, and is physically split away from the production process, possibly to be further refined into a finished product. If the company has incurred any manufacturing costs prior to the split-off point, it must designate a method for allocating these costs to the final products. If the entity incurs any costs after the split-off point, the costs are likely associated with a specific product, and so can be more readily assigned to them.

Besides the split-off point, there may also be one or more by-products. Given the immateriality of by-product revenues and costs, byproduct accounting tends to be a minor issue.

If a company incurs costs prior to a split-off point, it must allocate them to products, under the dictates of both generally accepted accounting principles and international financial reporting standards.  If you were not to allocate these costs to products, then you would have to treat them as period costs, and would charge them to expense in the current period. This may be an incorrect treatment of the cost if the associated products were not sold until some time in the future, since you would be charging a portion of the product cost to expense before realizing the offsetting sale transaction.

Allocating joint costs does not help management, since the resulting information is based on essentially arbitrary allocations. Consequently, the best allocation method does not have to be especially accurate, but it should be easy to calculate, and be readily defensible if it is reviewed by an auditor.

How to Allocate Joint Costs

There are two common methods for allocating joint costs. One approach allocates costs based on the sales value of the resulting products, while the other is based on the estimated final gross margins of the resulting products. The calculation methods are as follows:

• Allocate based on sales value. Add up all production costs through the split-off point, then determine the sales value of all joint products as of the same split-off point, and then assign the costs based on the sales values. If there are any by-products, do not allocate any costs to them; instead, charge the proceeds from their sale against the cost of goods sold. This is the simpler of the two methods.
• Allocate based on gross margin. Add up the cost of all processing costs that each joint product incurs after the split-off point, and subtract this amount from the total revenue that each product will eventually earn. This approach requires additional cost accumulation work, but may be the only viable alternative if it is not possible to determine the sale price of each product as of the split-off point (as was the case with the preceding calculation method).

Price Formulation for Joint Products and By-Products

The costs allocated to joint products and by-products should have no bearing on the pricing of these products, since the costs have no relationship to the value of the items sold. Prior to the split-off point, all costs incurred are sunk costs, and as such have no bearing on any future decisions – such as the price of a product.

The situation is quite different for any costs incurred from the split-off point onward. Since these costs can be attributed to specific products, you should never set a product price to be at or below the total costs incurred after the split-off point. Otherwise, the company will lose money on every product sold.

If the floor for a product’s price is only the total costs incurred after the split-off point, this brings up the odd scenario of potentially charging prices that are lower than the total cost incurred (including the costs incurred before the split-off point). Clearly, charging such low prices is not a viable alternative over the long term, since a company will continually operate at a loss. This brings up two pricing alternatives:

• Short-term pricing. Over the short term, it may be necessary to allow extremely low product pricing, even near the total of costs incurred after the split-off point, if market prices do not allow pricing to be increased to a long-term sustainable level.
• Long-term pricing. Over the long term, a company must set prices to achieve revenue levels above its total cost of production, or risk bankruptcy.

In short, if a company is unable to set individual product prices sufficiently high to more than offset its production costs, and customers are unwilling to accept higher prices, then it should cancel production – irrespective of how costs are allocated to various joint products and by-products.

The key point to remember about the cost allocations associated with joint products and by-products is that the allocation is simply a formula – it has no bearing on the value of the product to which it assigns a cost. The only reason we use these allocations is to achieve valid cost of goods sold amounts and inventory valuations under the requirements of the various accounting standards.

ACC2232 - Process Costing

Process Costing

Process costing is a costing method used when it is not possible to identify separate units of production, or jobs, usually because of the continuous nature of the production processes involved. Process costing traces and accumulates direct cost, and allocates indirect cost incurred during a manufacturing process.

The following are examples of some of the industries which use process costing:

1. Oil refineries
2. Soap manufacturers
3. Paint manufacturers
4. Sugar manufacturers

Features of Process Costing

The following features distinguish process costing from other costing methods:

a) The continuous nature of production in many processes means that there will usually        be closing work in progress which must be valued. In process costing it is not possible      to build up a cost record of the cost incurred on individual units of output because            production in progress is an indistinguishable homogeneous mass.

b) The output of one process becomes the input of the next,unless it is the final process,        culminating in the finish product.

c) Losses often occur during the process due to spoilage, wastage, evaporation and so on.

d) Output from production may be a single product, but depending on the industry there      may also be by-products and joint products.

Process accounts are used to accumulate the cost incurred during a process. The following four step approach is used to complete the process accounts, minimizing the chances of error:

i. Determine output and losses

ii. Calculate cost per unit of output, losses and work in progress

iii. Calculate total cost of output, losses and work in progress

iv. Complete accounts

Example:

The input to a process is 2,000 units at a cost of $ 9,000. Normal loss is 10%. No opening and closing stocks. Complete the process accounts if output is 1660 units

Solution:

Before solving the example, the following points should be noted.

a. Normal loss is given no share of cost. Therefore, the cost of output will be based on 90% of units completed i.e. 2,000 @ 90% = 1,800

b. Abnormal loss will be given a cost. Abnormal loss=Total loss – Normal loss

Step 1:

Now, to complete the process account the first step is to determine output and losses

Total Input = 2,000

Output = 1,660

Normal Loss = 200

Abnormal Loss = 140

Step 2:

Calculate cost per unit of output and losses

Total Cost Incurred / Expected Output = 9,000 / 1,800 = $5 per unit

Step 3:

Calculate total cost of output and losses

Output = $8,300

Normal Loss = Nil

Abnormal Loss = $700

Step 4:

Process accounts

Particular	Units	Amount ($)	Particular	Units	Amount ($)
Cost Incurred	2,000	9,000	Normal Loss	200	0
Abnormal Loss	140	700
Output	1,660	8,300
2,000	9,000	2,000	9,000

from readyratios.com

Illustration

Neo Pharma process a product through three distinct stages, these production of on process being passed on to the next process and so on to the finished product. Details of the cost incurred in each process are given below.

	Process A	Process B	Process C
Raw Material	1000	800	200
Direct Wages	500	600	700
Direct Expenses	150	250	500

The overhead expenses or the period amount to RM 3600 and is to be distributed to the process on the basis of direct wages.

There were no stocks in any of the process either at the beginning or at the close of the period.

Assuming the output was 1000 kilos, show the process cost of A, B and C indicating also the cost per kilo of each element of cost and the output in each process.

If 10% of the output is lost in storage and giving samples, what should be the selling price per unit to make a gross profit of 33.33% on the selling price.

Process A Account 

Debit	Amount	Credit	Amount
Raw Material	1000	Process B Account	2650
Direct wages	500
Direct Expenses	150
Overheads	1000
	2650		2650

Process B Account 

Debit	Amount	Credit	Amount
Process A Account	2650	Process C Account	5500
Raw Material	800
Direct Wages	600
Direct Expenses	250
Overhead	1200
	5500		5500

Process C Account 

Debit	Amount	Credit	Amount
Process B Account	5500	Finished Stock Account	8300
Raw Material	200
Direct Wages	700
Direct Expenses	500
Overhead	1400
	8300		8300

If 10% is lost

Total Output = 900 Kgs

Total Cost = RM 8300

Cost Per Kg = 8300 / 900 = RM9.22

Selling Price to earn 33.33% on Selling price

Cost price = 100 - 33.33 = RM66.67

If cost is RM66.67, sale value = 100

If cost is RM1, sale value = 100 / 66.67

If cost is RM 8300, sale value = 100/66.67 X 8300 = 12449.37

Selling price per unit = 12449.37/900 = RM 13.83

- from http://www.svtuition.org

ACC1231&BUS1233 - SELF LEARNING ACTIVITIES (WEEK 10 - 18 SEP - 22 SEP 2017)

Assalamualaikum, attached is the exercise for you to do this weekend. We shall discuss this further next week. The exercise consists depreciation and accounts receivables. It is a combo!

Here it is....

SELF LEARNING ACTIVITIES – WEEK 10 (18 Sep – 22 Sep)

Required:

1. Download the required document.
2. Print it.
3. Attempt all the questions.
4. Bring them to class for discussion.

Potential marks ♥♥

Partnership Account - Exercise

Assalamualaikum,

I have done my introduction regarding the partnership accounts in class recently. Also, we have done some exercise regarding the profit and loss appropriation account where you able to classify items whether it is an expense or revenue to the partnership. In the end, you managed to get the profit distributed to each partner.

Therefore, before we proceed to the creation of the current account of the partnership, you need to master the profit appropriation account in the first place. Download the exercise, attempt them and we will discuss later in class.

Good luck!

Exercise 2 - FA2 - Partnership - Various Tales

and also take a look at my advertisement...hehe

Need one?

They have to move....

This picture was taken in 2015 in one of the supermarket in Gombak. Somehow it attracted me to snap this picture because the way the notification was made tickles me. Even though we understood the signage /notification telling us where to find these items but i put myself being those items. Just imagine, if I was an onion, you were a potato and some of our friends were the anchovies...then this sign made us sad. We had to leave our current place and move to a new new place, joining the vegetable colonies. See? So, like refugees walking in one line....sad.

Ok, just sharing.

Ok enjoy this...

How Islamic Bank Makes Money

HOW ISLAMIC BANK MAKES MONEY - Hj Razli Ramli (IBFIM)

==============================

Teringat saya pada kunjungan ke luar negara satu masa lalu, ada satu soalan yg straight forward telah disoal kpd saya.

"With no interest charge to your customer, how does your bank make money to survive?"

Jawapan saya:

1. We "buy and sell" with our customer.

Profit created.

2. We "joint venture" together with our customer to venture in projects.

Profit we share.

3. We serve our customer financial needs.

Service fee, we earned.

But when we give "loan" to our customer, we never take more than the principal amount of loan.

Because any extra amount paid from the loan is the interest which is against the law.

Allah knows best.

BUACC3701 - Cost of Capital (cont')

Introduction To Cost Of Capital

By Investopedia

Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.

Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure represents how a firm finances its overall operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt increases. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness. We'll discuss optimal capital structure further in section 14.

Controllable Factors Affecting Cost of Capital

These are the factors affecting cost of capital that the company has control over:

• Capital Structure Policy
  A firm has control over its capital structure, and it targets an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.
• Dividend Policy
  Given that the firm has control over its payout ratio, the breakpoint of the marginal cost of capital schedule can be changed. For example, as the payout ratio of the company increases, the breakpoint between lower-cost internally generated equity and newly issued equity is lowered. (Read How And Why Do Companies Pay Dividends? and Due Diligence On Dividends to learn more.)
• Investment Policy
  It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.

Uncontrollable Factors Affecting the Cost of Capital

These are the factors affecting cost of capital that the company has no control over:

• Level of Interest Rates
  The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital.

Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.

Cost Of Equity

By Investopedia

The cost of equity is the return that stockholders require for their investment in a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. (Learn more about investing in Hate Dealing With Money? Invest Without Stress and Investment Options For Any Income.)

Here's a very simple example: let's say you require a rate of return of 10% on an investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a combination of dividends and share appreciation you require a $1.00 return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70, which, combined with the $0.30 from dividends, gives you your 10% cost of equity.

A company that earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)

Calculating the Cost of Equity

The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost. Unlike debt, which the company must pay in the form of predetermined interest, equity does not have a concrete price that the company must pay, but that doesn't mean no cost of equity exists.

Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders' required rate of return is a cost from the company's perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price that is theoretically satisfactory to investors. (For further reading on share price, see Top 5 Stocks Back From The Dead and The Highest Priced Stocks In America.)

On this basis, the most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed formulaically below:

Re = r_f + (r_m – r_f) * β

Where:

• Re = the required rate of return on equity
• r_f = the risk free rate
• r_m – r_f = the market risk premium
• β = beta coefficient = unsystematic risk

But what does this mean?

• Rf – Risk-free rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury Bills is frequently used as a proxy for the risk-free rate.
• ß – Beta - This measures how much a company's share price reacts against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold-mining company), which means the share price moves in the opposite direction to the broader market. (Learn more in Beta: Know The Risk.)
  For public companies, you can find database services that publish betas. Few services do a better job of estimating betas than BARRA. While you might not be able to afford to subscribe to the beta estimation service, this site describes the process by which they come up with "fundamental" betas. Bloomberg and Ibbotson are other valuable sources of industry betas.
• (Rm – Rf) = Equity Market Risk Premium (EMRP) - The equity market risk premium (EMRP) represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become more risky.
  The EMRP frequently cited is based on the historical average annual excess return obtained from investing in the stock market above the risk-free rate. The average may either be calculated using an arithmetic mean or a geometric mean. The geometric mean provides an annually compounded rate of excess return and will in most cases be lower than the arithmetic mean. Both methods are popular, but the arithmetic average has gained widespread acceptance.

Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease a company's risk profile. Such factors include the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment, and they vary from company to company. (Learn more in The Capital Asset Pricing Model: An Overview.)

Cost of Newly Issued Stock

Cost of newly issued stock (R_c) is the cost of external equity, and it is based on the cost of retained earnings increased for flotation costs (cost of issuing common stock). For a constant-growth company, this can be calculated as follows:

Rc = D1__ + g P0 (1-F)  where: F = the percentage flotation cost, or (current stock price - funds going to company) / current stock price

Example: Cost of Newly Issued Stock
Assume Newco's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. What is Newco's cost of new equity?

Answer: 

R_c = 2 + 0.07 = 0.123, or 12.3%

40(1-0.05)

It is important to note that the cost of newly issued stock is higher than the company's cost of retained earnings. This is due to the flotation costs. (For more on newly issued stock, see Why Investors Can't Get Enough Of Social Media IPOs and 5 Signs That Social Media Is The Next Bubble.)

Weighted Average Cost of Equity

Weighted average cost of equity (WACE) is a way to calculate the cost of a company's equity that gives different weight to different aspects of the equities. Instead of lumping retained earnings, common stock and preferred stock together, WACE provides a more accurate idea of a company's total cost of equity.

Here is an example of how to calculate WACE:

First, calculate the cost of new common stock, the cost of preferred stock and the cost of retained earnings. Let's assume we have already done this and the cost of common stock, preferred stock and retained earnings are 24%, 10% and 20% respectively.

Now, calculate the portion of total equity that is occupied by each form of equity. Again, let's assume this is 50%, 25% and 25%, for common stock, preferred stock and retained earnings, respectively.

Finally, multiply the cost of each form of equity by its respective portion of total equity, and sum of the values to get WACE. Our example results in a WACE of 19.5%.

WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5%

Determining an accurate cost of equity for a firm is integral in order to be able to calculate the firm's cost of capital. In turn, an accurate measure of the cost of capital is essential when a firm is trying to decide if a future project will be profitable or not.

Cost Of Debt And Preferred Stock

By Investopedia

Recall from Section 5 that companies sometimes finance their operations through debt in the form of bonds because bonds provide more flexible borrowing terms than banks. How much do companies pay for this debt?

Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.

Calculating the Cost of Debt

Because companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment.

The after-tax cost of debt can be calculated as follows:

After-tax cost of debt = Rd (1-tc)

Note: Rd represents the cost to issue new debt, not the cost of the firm\'s existing debt.

Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt?

Answer:

R_d (1-t_c) = 7% (1-0.40) = 4.2%

Calculating the Cost of Preferred Stock

As we discussed in section 6 of this walkthrough, preferred stocks straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate.

Cost of preferred stock (R_ps) can be calculated as follows:

Rps = Dps/Pnet where: Dps = preferred dividends Pnet = net issuing price

Example: Cost of Preferred Stock
Assume Newco's preferred stock pays a dividend of $2 per share and sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?

Answer:

R_ps = D_ps/P_net = $2/$100(1-0.04) = 2.1%

For more on this subject, read Prefer Dividends? Why Not Look At Preferred Stock?

Next, we'll take a look at the weighted average cost of capital, a calculation that will put our formulas for both the cost of equity and the cost of debt to work.

Weighted Average Cost Of Capital (WACC)

By Investopedia

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summed:

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. (Learn more in Evaluating A Company's Capital Structure.)

Further Understanding WACC

The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect. WACC, in other words, represents the investor's opportunity cost of taking on the risk of putting money into a company.

To understand WACC, think of a company as a bag of money. The money in the bag comes from two sources: debt and equity. Money from business operations is not a third source because, after paying for debt, any cash left over that is not returned to shareholders in the form of dividends is kept in the bag on behalf of shareholders. If debt holders require a 10% return on their investment and shareholders require a 20% return, then, on average, projects funded by the bag of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC.

If the only money the bag held was $50 from debtholders and $50 from shareholders, and the company invested $100 in a project, to meet expectations the project would have to return $5 a year to debtholders and $10 a year to shareholders. This would require a total return of $15 a year, or a 15% WACC.

WACC: An Investment Tool

Securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a business's net present value. WACC can be used as a hurdle rate against which to assess ROIC performance. It also plays a key role in economic value added (EVA) calculations.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company's return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

WACC serves as a useful reality check for investors. To be blunt, the average investor probably wouldn't go to the trouble of calculating WACC because it is a complicated measure that requires a lot of detailed company information. Nonetheless, it helps investors to know the meaning of WACC when they see it in brokerage analysts' reports.

Be warned: the WACC formula seems easier to calculate than it really is. Just as two people will hardly ever interpret a piece of art the same way, rarely will two people derive the same WACC. And even if two people do reach the same WACC, all the other applied judgments and valuation methods will likely ensure that each has a different opinion regarding the components that comprise the company's value.

BUACC3701 - Shareholder Value and Cost of Equity

First of all, I will focus on the shareholder value topic before I proceed to the cost of equity topic.

What shareholder value is really about?

This blog post is part of the HBR Online Forum The CEO’s Role in Fixing the System.

Most CEOs, as well as some of the other contributors to this forum, appear to have a false sense of what creating shareholder value means. CEOs need to understand the principles of shareholder value and why they are so important in judging difficult trade-offs, learn about the relationship between the financial performance of the company and the company’s stock, and communicate clearly and act appropriately when expectations gaps open.

It is now in vogue to dismiss the idea that creating shareholder value should be a CEO’s guiding objective. Concepts like “societal value,” “shared value,” and “customer capitalism” are offered as desirable and more enlightened substitutes. This is muddled thinking. CEOs who understand the principles of shareholder value and execute effectively will satisfy most, if not all, of the objectives of those who call for a new way of thinking. The problem is that the true definition of creating shareholder value seems to have gotten lost.

A CEO must understand three issues to be effective. First, he or she needs to internalize the true meaning of creating shareholder value. This amounts to a collection of principles that guide strategic, financial, and organizational issues. Second, he or she needs to understand how capital markets work. Finally, he or she must communicate effectively to shareholders, as well as to other stakeholders.

Creating Shareholder Value

Critics imply that managing for shareholder value is all about maximizing the short-term stock price. Companies that manage for shareholder value, the thinking goes, do whatever it takes to engineer an ever-higher market price. That is a profound misunderstanding. The premise of shareholder value, properly understood, is that if a company builds value, the stock price will eventually follow. The objective is to build value and then let the price reflect that value.

While some executives allow that they should not manage to increase the short-term stock price, they remain reluctant to embrace the concept of managing for shareholder value. It is worth explaining why this is the right objective, and how other stakeholders — including employees, customers, and suppliers — fit into the picture.

A CEO’s job is about resource allocation with a goal of earning a return in excess of the opportunity cost of capital. This requires difficult trade-offs. The challenge is figuring out how to allocate human and financial capital to its best and highest use for the long term. Value creation, by means of maximizing long-term free cash flow, provides the appropriate approach to judge alternative strategies and subsequent performance.

Here’s where other stakeholders come in. To maximize long-term free cash flow, a company must properly manage its relationships with all of its stakeholders. For instance, companies that charge too much for their goods or services will lose customers to the competition. Companies that charge too little may have happy customers but will be unable to meet their other financial obligations or offer new and improved products and services to customers. So a successful shareholder value-oriented company must find the price that adds value for both customers and shareholders.

Similarly, paying employees too little ensures a substandard workforce in a competitive world. Paying employees too much, as the U.S. auto companies discovered, hampers a company’s ability to remain competitive. The same logic extends to suppliers and the government.

The shareholder value approach acknowledges the tough choices that corporate executives face, and gives them a means to decide between them. But one point should be abundantly clear: A company cannot maximize shareholder value through systematic exploitation of its stakeholders.

Understanding Capital Markets

Almost without fail, individuals who get promoted to the position of CEO have been highly successful in some part of the corporation. They may have effectively run a large division or devised a winning marketing strategy. But the fact is, most CEOs have a poor understanding of how the stock market works. The skills and effort that catapulted them to the top spot typically do not prepare them to deal with markets and investors.

An enlightened CEO learns how the stock market sets prices. The research in this area points to three salient points:

First, the value of the business is the present value of future cash flows. In the very long haul, earnings and cash flow converge. But in the short run, cash flows and earnings can be very different. Notwithstanding a nearly ubiquitous focus on earnings and earnings per share, the informed CEO will focus on long-term cash flow.

Second, the stock market reflects cash flows many years into the future — it is long-term oriented. Let me say that again: No matter what you hear about short-term focused investors, values in the stock market are driven by long-term cash flows. Essentially, investors make short-term bets on long-term outcomes. The way to convince yourself of this is to build a spreadsheet and see for yourself. It is not uncommon for it to take 10 or more years of value-creating cash flows to justify a company’s stock price.

Third, the market pays for value creation. Take M&A as an example. Most deals are additive to earnings but destroy value. But research shows that if the synergies of combining businesses exceed the premium the acquirer pays, the stock of the acquiring company goes up irrespective of the immediate earnings impact — and the reverse is true as well.

CEOs often pay attention to analysts, investment bankers, or the media to try to understand the market. None of these are good sources because they represent a small percentage of the collective information that prices capture. A CEO who doesn’t take the time to understand markets is at risk of being influenced by individuals who have incentives that are not aligned with the goals of the company.

Communication

A company’s stock price conveys useful information about the expectations for future financial performance. Executives can reverse engineer those expectations, generally expressed through value drivers, and compare them to the company’s internal forecasts. (Value drivers include sales growth, operating profit margin, and investment requirements.) Large gaps between what the market believes and what the company believes represent an opportunity for communication or action.

If a company perceives that the market has the expectations wrong, the CEO can discuss the key value drivers of the business with the financial community in order to narrow the gap. If the market doesn’t respond, management can take action to benefit from the value gap. For example, if the shares are undervalued, management can buy back shares. If the shares are overvalued, management can issue them as currency for an acquisition.

There is no reason to scrap the notion of creating shareholder value. If anything, it is more important now than ever. The problem is that the concept is broadly misunderstood. CEOs need to grasp what creating shareholder value is really about and to have the fortitude to implement strategies to create long-term value.

Michael Mauboussin is an investment strategist and an adjunct professor at Columbia Business School. His latest book is The Success Equation.

And..... this is a debate. Something to look on. Watch and I need your views on this.