No more capital punishment.

• Author: Childs, John F.
• Position: Managing capital - Includes related article - Treasury Management

To manage capital properly and keep your shareholders happy, train your eye on the right ball and don't put all your faith in new profitability measurements.

Every financial executive knows that maximizing shareholder wealth means managing capital properly. If you goof, you'll face embarrassing write-offs and shareholder losses. But are you sure you're measuring your capital and profitability correctly? The following executives all thought they had it right

* The author of an article on hurdle rates states, "New equity would cost about 12 percent after taxes, based on the reciprocal of a price-earnings ratio of eight."

* An executive at a large company, who's in charge of making capital-investment decisions, says, "There are a number of ways to estimate the cost of equity capital. When a company's shares are publicly traded, the reciprocal of the price-earnings ratio, which usually reflects expectations of future potential, is a useful guide."

* A utility company with a sound capital structure develops some excess cash by investing in short-term certificates of deposit. The CFO appropriately considers using the funds to repurchase company stock. The common cost is 14 percent, and the company's limited to that return because it's a regulated firm Plus, the stock's overpriced and selling at 130 percent of common book value, s the CFO decides against repurchasing, since he'd receive a poor return of only 10.8 percent (14 percent/130 percent). That reasoning is in the right direction But then the CFO decides to use the funds for acquisitions, figuring any return above 10.8 percent is better than the company could make by repurchasing the stock.

The first two examples show a total lack of knowledge of the cost of capital, and the third fails to associate investment returns with the risk of the investment being made. Managing capital correctly means earning at least the common cost and hopefully more, depending on your company's competitive edge. I you've had anything to do with managing capital, you've had at least some experience with cost of capital, acquisition pricing, project-profitability analysis, and the monitoring of company and division performance.

As a financial executive, you've read articles about new measurements like adde market value and added economic value. These articles say if you don't use thes measurements, you're behind the times, because you may be looking at your financial-statement results when you should be looking at security market value and cash flow to assess your profits. But note that companies send out millions of financial statements in their annual reports with an okay from their auditors, and the world hasn't ended yet.

BACK TO BASICS

While cash flow as a measurement definitely has its place, to manage capital an learn how to tie it together to maximize shareholder wealth, you'll do well to start with a simple balance sheet and income statement and assume the figures represent true values. Otherwise, you're liable to make some bad mistakes when using these new concepts.

One of the greatest errors companies commit in handling capital is not understanding the cost of capital. Knowing your cost of capital is fundamental in putting capital to work and monitoring performance, and it would be very simple for management to understand if all capital were in the form of debt, with no common stock. For example, if your long-term capital consists of $30 of debt and $70 of common stock, and we replace that $70 with $70 of subordinated debt at a 12-percent interest rate, then we can calculate the pre-tax cost of total capital this way: $30 of debt at 8 percent is $2.40, and $70 of subordinated debt at 12 percent equals $8.40, for a total cost of $10.80 per each $100 of capital, or 10.8 percent.

If you earn just enough to cover the $10.80, you don't show any profit. On a cash-flow basis, you'd have an excess if you don't have to replace any property or expand, because cash depreciation and retained earnings provide cash. It's not surprising, then, to find that some managements reporting poor earnings emphasize cash flow in managing their capital. All capital, including common equity, has a cost, and if you don't earn enough to cover the common cost, you're losing money for your shareholders the same as if all of your...