Question

Firm Values. Referring back to the General Motors example used at the beginning of the chapter, note that we suggested that General Motors’ stockholders probably didn’t suffer as a result of the reported loss. What do you think was the basis for our conclusion?

General Motors example:

A WRITE-OFF BY A COMPANY frequently means that the value of the company’s assets has declined. In November 2007, for example, General Motors (GM) announced that it would take a write-off of about $39 billion, meaning that it was reducing net income for the third quarter of the year by that amount. GM took the charge because of deferred tax credits that the company was not going to be able to use. What made GM’s write-off so unusual is that the total value of the company’s stock at the time was slightly less than $20 billion. In other words, the writeoff was about twice the value of the company’s stock! GM’s write-off was a big one, but not a record. Possibly the largest write-offs in history were done by the media company Time Warner, which took a charge of $45.5 billion in the fourth quarter of 2002. This enormous write-off followed an earlier, even larger, charge of $54 billion. So did stockholders in General Motors lose $39 billion because of the loss of the tax credits? The answer is probably not. Understanding why ultimately leads us to the main subject of this chapter: that all important substance known as cash flow.


  

Answer 1

The basis of the conclusion here is bases on two bases – difference between book value and market value on one hand and the difference between accounting income and cash flow on the other hand.

In this case the write down of $39 billion by GM in 2007 was as a result if change in accounting rules. Due to the changes in the accounting rules GM had to write down $39 billion and this led to reduction in book value of some of its assets. However these changes brought about no changes in the market value of GM’s assets as their real worth in the market remained unaffected. It should be noted here that market value of assets depends on two main factors – cash flow and riskiness. Here the write down of $39 billion by GM was merely due to a change in accounting rule and hence the factors of cash flow and riskiness were not affected at all.

As such we can say that GM’s stockholders probably didn’t suffer as a result of the reported loss as it was a notional accounting loss that did not had any impact on the company’s cash flows and hence the market values of its assets.