Letters

Direct or Indirect—CAPM or WACC?

“Taking the Temperature of Health Care Valuations” (JofA, Oct.01, page 79) indicates the capital asset pricing model (CAPM) was used to derive the discount rate, which resulted in an “enterprise value” that included both the value of equity capital and debt capital. I believe this is incorrect.

The purpose of the appraisal in the article evidently is to estimate the company’s equity value at the appraisal date. Equity can be valued under the income approach either directly or indirectly. When the indirect approach is used, the value of invested capital (equity and interest-bearing debt) is computed, and then the value of the interest-bearing debt is subtracted to arrive at the equity value.

The income stream used in the direct method is after subtracting interest expense. The income stream for the indirect approach is before subtracting interest expense because interest expense is the return to the debt holders rather than the equity holders. In the indirect approach, the income stream includes the return for both the debt holders and equity shareholders.

The methodology used in the article is CAPM. By applying the CAPM, an appraiser will arrive at a discount rate for equity, which should be used in the direct approach to valuation.

The article appears to apply this rate to the cash flow after interest expense has been subtracted (the direct approach) to derive “enterprise value.” Then, the value of interest-bearing debt is subtracted to arrive at the value of stockholder’s equity. This is incorrect since the discount rate and the cash flow stream being discounted apparently arrive directly at the value of equity.

The article should have derived the discount rate by use of the weighted average cost of capital (WACC) if the indirect method was to be used, and the income stream should have been before interest expense was subtracted. The WACC is the cost of equity capital times its market weighting plus the cost of debt capital times its market weighting.

For example, if debt and equity are weighted 50% each and the cost of debt is 10% and the cost of equity is 24.8% and long-term growth is 3%, then the WACC is 17.4% (the discount rate) and the capitalization rate is 14.4% (the discount rate minus growth).

The article apparently uses a capitalization rate that directly values equity capital and then incorrectly treats this value as though it was total invested capital (stockholder’s equity plus interest-bearing debt). By subtracting the interest-bearing debt from the initial amount, the value of a stockholder’s equity is understated.

James W. Kukull, CPA, ASA
Kirkland, Washington

Relief for Those Who Don’t Need It

Et tu? I expect it from politicians, but not from tax people.

I read “Making Sense of the New Tax Legislation” (JofA, Sep.01, page 22). This is not marriage penalty relief—it’s a break for all married people, including those who already had a significant break over single people.

Married couples with only one of the persons working, or where one had only a small amount of income, never had a penalty. It was the unmarried couple that had the penalty. With the new law, this penalty has increased.

I am married, by the way, and my wife works.

Jay Aronowitz, CPA
Manalapan, New Jersey

Keep an Eye on Concepts Statements

“Future Cash Flow Measurements” (JofA, Oct.01, page 57) provides an excellent summary of the detailed guidance provided by FASB Concepts Statement no. 7, Using Cash Flow Information and Present Value in Accounting Measurements. However, JofA readers should be aware this statement could have a distinctive impact on the continuing development of U.S. GAAP.

The FASB series of concepts statements forms what is usually referred to as the “conceptual framework.” As most CPAs know, this body of objectives of financial reporting, qualitative characteristics of accounting information, definitions of elements of financial statements and criteria for recognizing and measuring those elements does not affect the practice of accounting directly—that is, it is not part of GAAP. The purpose of the conceptual framework is to set forth principles on which financial accounting and reporting standards are based.

Nevertheless, Concepts Statement no. 7 is important for practitioners for at least two reasons:

It is the first change in the conceptual framework since 1985. (As most auditors would attest, a change in something that rarely, if ever, changes is usually worthy of special examination.)

The focus of Statement no. 7 is measurement. Unlike Concepts Statement no. 5, which simply notes that multiple attributes are measured in accounting, Statement no. 7 provides very specific guidance regarding fair value measurement of both assets and liabilities.

Much ado about nothing? I think not. In contrast to the case of comprehensive income, included in the conceptual framework in 1980 but not part of GAAP until 1997, FASB has already used Concepts Statement no. 7 principles in two exposure drafts—one on impairment or disposal of long-lived assets and the other exposure draft on obligations associated with the retirement of long-lived assets.

I believe CPAs should prepare themselves for extensive involvement with fair values and that we should find a place on our radar screens for FASB concepts statements—they may become a much more important part of keeping up with the current trends in accounting and financial reporting.

John P. McAllister, CPA
Chairman and professor of accounting
Coles College of Business
Kennesaw State University
Atlanta