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Market- versus Book-Value Balance Sheets

Jupiter has developed a revolutionary auto production process that enables it to produce cars 20 percent more efficiently than any rival. It has invested $10 billion in producing its new plant. To finance the investment, Jupiter borrowed $4 billion and raised the remaining funds by selling new shares of stock in the firm. There are currently 100 million shares of stock outstanding. Investors are very excited about Jupiter`s prospects. They believe that the flow of profits from the new plant justifies a stock price of $75. If these are Jupiter`s only assets, the book-value balance sheet immediately after it has made the investment is as follows:

Investors are placing a market value on Jupiter`s equity of $7.5 billion ($75 per share times 100 million shares). We assume that the debt outstanding is worth $4 billion.3 Therefore, if you owned all Jupiter`s shares and all its debt, the value of your investment would be 7.5 + 4 = $11.5 billion. In this case you would own the company lock, stock, and barrel and would be entitled to all its cash flows. Because you can buy the entire company for $11.5 billion, the total value of Jupiter`s assets must also be $11.5 billion. In other words, the market value of the assets must be equal to the market value of the liabilities plus the market value of the shareholders` equity. We can now draw up the market-value balance sheet as follows:

Notice that the market value of Jupiter`s plant is $1.5 billion more than the plant cost to build. The difference is due to the superior profits that investors expect the plant to earn. Thus in contrast to the balance sheet shown in the company`s books, the marketvalue balance sheet is forward- looking. It depends on the benefits that investors expect the assets to provide.

The Income Statement

If Pepsi`s balance sheet resembles a snapshot of the firm at a particular time, its income statement is like a video. It shows how profitable the firm has been during the past year.

Look at the summary income statement in Table A.2. You can see that during 1998 Pepsi sold goods worth $22,348 million and that the total expenses of producing and selling goods was ($9,330 + $291 + $8,912) = $18,533 million. The largest expense item, amounting to $9,330 million, consisted of the raw materials, labor, and so on, that were needed to produce the goods. Almost all the remaining expenses were administrative expenses such as head office costs, advertising, and distribution.

In addition to these out-of-pocket expenses, Pepsi also made a deduction for the value of the plant and equipment used up in producing the goods. In 1998 this charge for depreciation was $1,234 million. Thus Pepsi`s total earnings before interest and taxes (EBIT) were

EBIT = total revenues Ј costs Ј depreciation

= 22,348 Ј 18,533 Ј 1,234

= $2,581 million

The remainder of the income statement shows where these earnings went. As we saw earlier, Pepsi has partly financed its investment in plant and equipment by borrowing. In 1998 it paid $321 million of interest on this borrowing. A further slice of the profit went to the government in the form of taxes. This amounted in 1998 to $270 million. The $1,990 million that was left over after paying interest and taxes belonged to the shareholders. Of this sum Pepsi paid out $757 million in dividends and reinvested the remaining $1,233 million in the business. Presumably, these reinvested funds made the company more valuable.

INCOME STATEMENT

Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.