1. Overview of Accounting Part 2 Click here for Streaming Audio To Accompany Presentation (optional) Click here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

2. EGR 403 - Cal Poly Pomona - SV22 EGR 403 - The Big Picture Framework: Accounting & Breakeven Analysis “Time-value of money” concepts - Ch. 3, 4 Analysis methods –Ch. 5 - Present Worth –Ch. 6 - Annual Worth –Ch. 7, 8 - Rate of Return (incremental analysis) –Ch. 9 - Benefit Cost Ratio & other techniques Refining the analysis –Ch. 10, 11 - Depreciation & Taxes –Ch. 12 - Replacement Analysis

3. EGR 403 - Cal Poly Pomona - SV23 Financial Statements Balance Sheet (General Accounting) –Snap shot of what the company owns and how much they owe. Discloses information to investors. Income Statement (Cost Accounting) –Shows profit for the period based on Generally Accepted Accounting Practices (GAAP) Cash Flow Statement (Sources & Uses of Funds) –Shows the actual need for cash over time so that the company can manage their cash properly The first two statements will be discussed

4. EGR 403 - Cal Poly Pomona - SV24 The Balance Sheet The balance sheet is a picture of the financial health of a corporation at a point in time It is based on the accounting equation: Assets = Liabilities + Equity or Corporate Value = Value owed + Value owned

5. EGR 403 - Cal Poly Pomona - SV25 Assets Assets are traditionally shown on the left side of the balance sheet Asset are “what the company owns”: –Current Assets: Cash, Short-Term Investments, Accounts Receivable, Inventory, and Prepaid Expenses –Property, Plant & Equipment –Long-Term Investments –Intangible Assets (goodwill) –Other Assets (patents, copyrights, etc.)

6. EGR 403 - Cal Poly Pomona - SV26 Liabilities Liabilities are amounts owned to third parties. Two types of liabilities –Current (bills): Accounts Payable, Accrued Liabilities, Notes Payable –Long-Term (loans, bonds): Long-Term Notes Payable, Mortgages Payable, Long-Term Accrued Liabilities

7. EGR 403 - Cal Poly Pomona - SV27 Equity Equity is sometimes called “Owner’s Equity” or “Shareholder’s Equity” Equity is a valuation of what has been invested and reinvested. It is a total of: –Common Stock –Additional Paid-In Capital –Retained Earnings (from P&L)

8. EGR 403 - Cal Poly Pomona - SV28 Balance Sheet (Left Side Total = Right Side Total) Assets Current Assets –Cash –Inventory –Accounts Receivable Long Term –Equipment –Building and Land –Goodwill Liabilities Current Liabilities –Accounts Payable –Line of Credit Long Term Debt –Mortgages –Bonds Equity Stock Retained Earnings

9. EGR 403 - Cal Poly Pomona - SV29 Balance Sheet Uses The balance sheet reveals to managers, owners, and potential investors the financial health of the company. Each industry has a different blend of assets, liabilities, and equity that typify a successful company. Ratios are used to analyze the balance sheet (e.g., Acid Test = Current Assets/Current Liabilities, Debt/Equity Ratio, etc.)

10. EGR 403 - Cal Poly Pomona - SV210 Inventories Inventory refers to the raw materials, work-in- process, and finished goods that are owned by the company. Inventory represents capital that is tied up. Until the product is sold it is not an expense...it is still an asset. High inventory costs can hurt your profitability. Much emphasis is placed on business today on meeting customer needs with minimal inventory.

11. EGR 403 - Cal Poly Pomona - SV211 Bonds Sold to raise money. Also popular with utilities, state, and local governments. Bonds are rated based on the financial stability of the company, city, or state. The higher the rating, the less the risk of losing your investment. Bonds have a “Face Value” of $1000, but are bought and sold at market value. The market value determines the true interest rate on the bond.

12. EGR 403 - Cal Poly Pomona - SV212 Bonds (Cont’d) Face value: $1,000 Stated interest rate: 10% Term: 5 Years Date sold: April 1, Year 1 Interest payment dates: April 1 & October 1 Market value: What the bond is actually selling for in the bond market

13. EGR 403 - Cal Poly Pomona - SV213 Bonds (Cont’d) The relationship between the stated interest rate for a bond issue and the market interest rate (effective interest rate) determines whether the bonds will sell for: –a discount: sells for < $1000 (stated interest rate < market interest rate) –face value: sells for $1000 (stated interest rate = market interest rate) –a premium: sells for > $1000 (stated interest rate > market interest rate)

14. EGR 403 - Cal Poly Pomona - SV214 Common Stock Shares of ownership are sold to provide capital to finance the beginning or expansion of a corporation. These shares are called “common stock.” Owners of common stock usually receive dividends from profits four times a year (quarterly dividends). An “IPO” is the Initial Public Offering of common stock to make ownership available to the public. The New York Stock Exchange (NYSE), Amex, and NASDAQ are places where many common stocks are then sold or “traded” by shareholders.

15. EGR 403 - Cal Poly Pomona - SV215 Common Stock Common stockholders have the right to: Share in the residual assets of a corporation when it is liquidated Share proportionately in common stock dividends Maintain their fractional ownership interest (the “preemptive right”) Vote on key matters facing the corporation Participate in annual stock holder meeting (if any)

16. EGR 403 - Cal Poly Pomona - SV216 Preferred Stock Preferred stockholders generally have the right to: Receive an annual dividend before common stockholders are paid a dividend Receive the liquidation value of their stock (upon the termination of a corporation) before common stockholders receive any distribution

17. EGR 403 - Cal Poly Pomona - SV217 Investing in Stocks and Bonds Stock is usually traded in blocks of 100 shares. Profit is made two ways: –Dividends - distributions of quarterly profits –Appreciation - selling the stock for more than you paid for it Bonds are purchased at market value. Profit is made two ways: –Dividends at rate & schedule stated on the bond –Sold for market value or held until maturity for $1000 face value

18. EGR 403 - Cal Poly Pomona - SV218 Investment Considerations The stock and bond markets often vary in opposite directions. Many investors diversify their “portfolios” as a hedge against different economic situations (e.g., inflation, recession). If a company grows in size, so does the value of the common stock and the size of the dividends. Length of ownership affects tax treatment. Generally less risk in bonds. If a company is liquidated, bond holders are paid off ahead of common stockholders.