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2020 | OriginalPaper | Buchkapitel

2. Statics. The Law of Conservation

verfasst von : Carlo Alberto Magni

Erschienen in: Investment Decisions and the Logic of Valuation

Verlag: Springer International Publishing

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Abstract

We investigate the statics of an economic system. We introduce the Law of Conservation, according to which each of the basic elements of an economic system (capital, income, cash flow, income rate) is subjected to opposite forces that balance. We classify the capital as operating capital, non-operating capital, debt capital, and equity capital; the income as operating income, non-operating income, interest, and net income; the cash flow as cash flow from operations, cash flow from non-operating assets, cash flow to debt, and cash flow to equity. We distinguish borrowing from debtholders (increasing the amount of the firm’s loans, bonds, etc.) and borrowing from the project (subtracting resources from customers and suppliers).

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Vorheriges Kapitel Dynamics. The Law of Motion

Nächstes Kapitel Financial Statements

Strictly speaking, non-operating assets do not coincide with liquid assets. For example, the firm may own some real estate assets for investment (not operational) purposes. The real asset is, from the point of view of the firm, a non-operating asset although it is less liquid than cash or marketable securities (it does not have a high degree of liquidity). For simplicity, we will make use of the terms ‘liquid assets’ and ‘non-operating assets’ as synonyms, with the understanding that any income related to non-operating assets must be added to the interest income of liquid assets (e.g., see rental income in HomeNet project in Chap. 12).

If an account form is used, replace “lower” with “right” and “upper” with “left”.

This capital quantifies the operating assets, resources that are associated with transactions with customers and suppliers, as well as with workers and employees involved in the business and with the government for tax payments.

These liquid assets correspond to transactions made in financial markets. Other non-operating assets may include real estate assets, rental property, vacant land, etc.

The debt has to do with financial transactions with the creditors.

Equity has to do with economic transactions with the firm’s equityholders.

In accounting and finance, investments are called “assets” and financings are called “liabilities” (debt) and “net worth” (equity). Hence, the balancing identity may also be written as

$$\begin{aligned} \text {Assets} = \text {Liabilities} + \text {Net Worth}. \end{aligned}$$

Strictly speaking, the expression “liabilities” might be used as a synecdoche, that is, including equity, because both debtholders and equityholders are, financially speaking, in a lending position; in particular, equityholders have indeed a legal claim on equity (albeit residual), so the firm is liable to pay the residual capital to equityholders when the asset (project, firm) is liquidated.

It is worth pointing out that, if $F_t^l<0$ (i.e., $F^o_t>F^e_t+F^d_t$), then an amount smaller than the CFO is distributed to capital providers and an additional investment in financial activities occurs. In this case, the CFL represents retained or undistributed cash, which flows in the liquid assets (see Sect. 4.10). Conversely, if $F_t^l>0$ (i.e., $F^o_t<F^e_t+F^d_t$), an amount greater than CFO is distributed to debtholders and equityholders.

Splitting hairs, the rate $i_t$ is a return on capital (ROC) and $i^{\text {inv}}_t$ is a return on investments/assets (ROI/ROA). Given the law of conservation (2.15), ROC and ROI/ROA are equal. However, the ROC/ROI/ROA is, at the same time, a cost of financing (from the point of view of the firm): $i_t{=}i^{\text {fin}}_t$. Unfortunately, no particular expression or acronym is used in finance for this financing rate.

See also Sect. 1.3 on the sign of cash flows, incomes, capital amounts, and income rates.

The choice between an account form representation or a report form representation is only a matter of taste. However, we will often use a report form representation, and we will build a technique of analysis grounded on it.

As for EngPro, it is a levered firm/project (see Sect. 2.2 on the notion of levered/unlevered project).

See, for example, also Berk and DeMarzo (2014, p. 40 and p. 410).

The convention of netting liquid assets out of debt is analogous to the convention of netting accounts payable out of accounts receivable to give rise to the notion of net operating working capital (see also Sect. 3 and Table 3.11).

Proof is straightforward by using the law of conservation.

See Sect. 3.1 for details.

See treatment of NOWC in Sect. 3.2 and definition of cash cycle in Sect. 3.2.4. See also Sect. 2.3.

A further framing may get rid of negative numbers by placing investments and financings on the same side:

https://static-content.springer.com/image/chp%3A10.1007%2F978-3-030-27662-1_2/MediaObjects/434345_1_En_2_Equ28_HTML.png

(2.29)

We will keep the convention according to which the symbol $C^{\text {inv}}_t$ denotes the sum of operating and non-operating assets, whatever the sign. Accordingly, we will keep the symbol $C^{\text {fin}}_t$ to denote the sum of equity and debt, regardless of the sign.

More precisely, the firm will distribute to equityholders an amount of money which will be smaller by $|F^e_t|$ than the amount that would be distributed if the project were rejected (however, if the latter is nonnegative and smaller than $|F^e_t|$, then equityholders will indeed make actual payments to the firm).

Titel: Statics. The Law of Conservation
verfasst von: Carlo Alberto Magni
Verlag: Springer International Publishing
Buch: Investment Decisions and the Logic of Valuation
Print ISBN: 978-3-030-26775-9

Electronic ISBN: 978-3-030-27662-1

Copyright-Jahr: 2020
DOI: https://doi.org/10.1007/978-3-030-27662-1_2