No more capital punishment.

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 long-term capital is in debt and your earnings can't cover the interest charges.

A company's securities have two risks -- a business risk that depends on the nature of the business and a financial risk caused by the use of too much leverage or debt for the company's business risk. Unless a company is very risky, it can stand some debt without adding a significant financial risk. A company with a AA bond rating indicates the use of debt has not been great enough to add a significant financial risk.

To explain cost of capital, we have to start out with a capital structure. The overall cost of capital for our capital structure is a weighted average of the debt and common cost. But that brings us to another important question: What's the common cost? It's the minimum return on market price, as measured by what investors in the market as a whole require from their expectations of dividends plus market appreciation to induce them to provide common-equity capital. Sometimes common cost is defined as an opportunity cost, or the return investor would require compared with what they'd expect to get on other investments, allowing for differences in risk.

Earnings produce dividends and market appreciation, but earnings are not what investors get. They get only the cash from dividends and the cash profit from the market appreciation of their stocks. And it's their expectations of this total return that we need to measure. This is a two-part measurement: one to compensate for the use of the money and the other to compensate for the risk.

You can use various mathematical approaches to determine the common cost, such as the dividend-discount model and capital-asset-pricing model. These are the academic approaches that many in industry and also investment bankers have accepted, with little critical analysis of the possible errors these two method can cause when used for common cost. Both methods assume an efficient stock market.

But ask yourself these questions: Does the stock market take a short-term rathe than a long-term view? Does it go through periods of extreme optimism and pessimism? How rational are different types of investors, including the average individual investor, institutional investor and broker? You'd be hard-pressed after answering those questions to conclude the market is rational. And, if it' true the market's irrational, that raises some troubling questions about using the dividend-discount model and capital-asset-pricing model for common cost.

Electric-utility stocks, circa late 1993, are a good example of how the two methods can produce the wrong answer. At the time, the return on money-market funds became so low investors switched to electric-utility stocks to get more yield, thereby pushing the prices of utility stocks so high that both methods falsely showed their common cost to be only slightly above the long AA bond rate. That's because shareholders weren't looking at long-run growth. This created a problem for utility companies that had to explain these methods when seeking a rate increase in order to provide a fair return to the common shareholders.

There's ample evidence the common cost for a company with AA rated bonds should be about 4 percent above the long AA bond rate. To illustrate this concept, we can use the last 12 months' average AA bond rate to avoid using a spot figure, which varies from day to day. For a company that's added a financial risk with debt rated lower than AA, the spread opens up dramatically as the risk increases, as shown by the rates for different ratings of long industrial bonds for May 31, 1994: AA, 8.09 percent; A, 8.24 percent (a spread of 0.15 percent) and BBB, 8.69 percent (a spread of 0.45 percent). The same applies to the commo cost, only to a greater degree, because equity is in the riskiest position.

IN FOR THE LONG HAUL

Now look at what earning the cost of capital means to shareholder wealth. In th short run, you can do various things to push up current earnings per share, suc as using excess leverage, which would be wrong from the long-run point of view. But investors may welcome it because they can take advantage of such an increas while things are going well for the company. If things turn bad, they have liquidity and can sell. In fact, getting out of a stock at the right time is part of an investment adviser's and investor's job.

On the other hand, a company can't liquidate its shareholders. They'll be hanging around forever. It's this difference that requires you to take a long-run approach, while the shareholders can use the short run. If shareholder were locked in and couldn't sell their stock, they'd have the same view as you do.

We'll use a form of the dividend-discount model solely to show what earnings mean to shareholder wealth in the long-run. With a common cost of 12 percent, investors want that return on the market price they pay. If you earn 12 percent on common book value, the market price and common book value will be equal, provided the figures remain constant. But what about the P/E ratio?

In the long run, your earnings grow from retention and change principally from fluctuations in the rate of return, and, to a lesser extent, from three other factors: repurchase of stock, sale of stock above or below book value while earning the same return on the new capital, and the purchase of a company with different P/E ratio in a stock-for-stock deal.

The factors maximizing shareholder wealth are the spread you earn over the common cost, the amount of capital you put to work at that spread and the duration of the first two factors. When you earn below the cost of capital -- that is, when you earn below the common cost and continue to expand -- each dollar of new capital you put to work will be worth less in the marketplace, so you're actually destroying your own capital. This is why it's so important for financial executives to understand cost of capital.

Foreign investments may have significant additional risks that you have to allo for to earn the cost of capital, including operating, economic, political and exchange. And, of course, these risks vary widely from country to country. For example, when the common cost in this country for a well-capitalized large company might be 12 percent, and the company obtains a return of 16 percent in foreign country, you may think it's helping to maximize shareholder wealth. Not so if the added risk in the foreign country increases the common cost to 16 percent.

The common cost in various countries is primarily a matter of judgment, but if you can't assess the risks, don't send shareholder' capital abroad. It's questionable whether many companies measure common cost correctly when they mak overseas investments. One company handled this problem by developing a matrix showing the various risks and assigning rates to each risk in the different countries in which it operates.

You should establish a profit goal as a spread over the common cost based on your competitive edge and historical results, as well as those of your competitors, properly adjusted and compared with the common cost. However, if you're in a very competitive industry and can't develop a competitive edge, recognize that you'll do well to earn the common cost. There's nothing wrong with earning only the common cost, but it simply preserves capital, not maximizes it.

WHERE TO PUT IT

Allocating capital involves project-profitability analysis and acquisition pricing, and the big question to ask about the acquisition price is the percent the terminal value represents of the whole price. In most situations, unless th acquisition is a cash cow, the terminal value may represent about 70 percent of the total price. This is one place where you can make a very large error.

Terminal values throughout the 1980s were based on a multiple of earnings befor interest and after taxes, reflecting what similar stocks in the market sold for or an EBIAT (earnings before interest and after taxes) multiple of what other companies paid for similar acquisitions. This doesn't address the question of what you can do with the acquisition after the initial five-year forecast. You should establish the terminal value based on the investment return it might ear above the common cost and the growth prospects for the future after the five-year forecast. You could easily develop an EBIAT multiple with such terms.

Once you make an acquisition, you should monitor it on the basis of its price. If you buy the acquisition with stock, the purchase appears on your books at book value, so you should gauge it based on the stock price used to buy it, because you could have sold stock for cash and put it into an investment. Then you'd at least expect to earn the cost of capital on that cash investment. In other words, the fact that you pay for it with stock shouldn't change the capital used as a base for monetary results.

Your directors should insist on such monitoring, because many bank acquisitions have been made based on what they did for earnings per share, without paying sufficient attention to return on investment. Companies can increase their short-run earnings per share in various ways that are incorrect in the long-run You must concentrate on return on investment when managing capital.

Since we've been using common book value, among other measures, to show how everything ties together to maximize shareholder wealth, you may be wondering about the concepts of added economic value, which emphasizes cash flow, and added market value. Added economic value compares operating cash flow with the cost of capital for the amount of capital used to determine profit. To illustrate this idea, we'll use the same capital structure as before, with $100 of capital broken down into $30 of debt and $70 of common stock.

First, determine the amount of operating cash flow. Suppose you have operating income of $18.30. (The operating income is after depreciation but before other non-cash items and other possible adjustments. If you use total cash flow, you're including return of capital and return on capital, so you have to use a terminal value and calculate an internal rate of return.) Subtract your taxes a the full effective tax rate, with no reduction because of interest -- $6.22. This is your EBIAT number, which gives you an operating cash flow of $12.08.

Next, determine your cost of capital before interest and after taxes. Calculate the cost-of-capital rate after taxes as follows. Multiply the debt, which is 30 percent of the capital, by the 8 percent interest, and then multiply that figur by 66 percent (this assumes a 34 percent tax rate). The result is 1.58 percent. Then take the common stock, which in this example is 70 percent of the capital, and multiply by a 12 percent common-cost rate after taxes, for a product of 8.4 percent. This gives you a cost-of-capital rate of 9.98 percent (1.58 percent plus 8.40 percent).

Once you've arrived at that figure, multiply it by the amount of capital employed ($100). This $100 consists of plant, net, plus working capital (curren assets less current liabilities), both of which are bookkeeping figures. This produces the cost-of-capital amount. The amount of capital employed should equa long-term capital or it won't synchronize with the cost-of-capital amount. For example, it's not total assets unless you subtract current liabilities.

Take your original operating cash flow of $12.08 and subtract $9.98, your cost of capital. This gives you an added economic value, or the amount of profit ove the cost of total capital, of $2.10. To understand the significance of this number, it's important to put the result in terms of return on common stock. Th added economic value is the amount earned over the cost of capital, so by dividing the added economic value by the common-stock-invested capital, you get the spread earned over the common cost. In our example, this is 3 percent ($2.10/$70). Adding the 3 percent to the common cost of 12 percent gives a return of 15 percent on common-stock-invested capital.

OLD HAT

One of the much-touted advantages of measuring added economic value is its emphasis on using capital, so management will appreciate that reducing the use of capital increases the return to shareholders. But it hardly seems necessary to use added economic value for that purpose. Actually, this fact is more clearly illustrated by the Du Pont formula -- operating income divided by sales times sales divided by assets employed, equals operating income on assets employed -- and that formula has been around for ages.

And what about added market value? Does it really measure performance? In essence, this measurement compares the total capital put to work with the total market value of the capital. If the market value is greater, management has added to shareholders' wealth. If you've already concluded the stock market is irrational, then you might also conclude that added market value is an irrational measure. Stock prices are based on what investors expect, not what the company will do. If you use added market value as a performance measure, yo have your eye on the wrong ball. You're watching the short-run stock price on the ticker tape instead of sound long-run goals.

Companies may fail to appreciate that too high a stock price in relationship to a company's performance will be bad for investors, because if the stock price i too high to provide a fair return, it will have to come down. Some companies haven't earned the cost of capital for many years. Yet those companies may have an added market value of total capital that's at least equal to the total capital used, because investors live on expectations and can't believe management could continue to produce such poor results. Added market value as a measurement would falsely show the company was preserving capital. At the very least, the measurement in the short run can produce misleading results.

In short, the basic test of whether a company should produce a product in our free-market economy is whether it allocates capital properly to cover all costs including at least a fair return for shareholders. If the return on invested capital doesn't meet all costs, it means consumers are unwilling to pay the price necessary to cover the costs, and that means the shareholders are subsidizing the product. This hurts shareholders and wastes our nation's capital. And although consumers may appear to benefit from lower prices, they'r actually losers, because when the company can't cover all costs, it's misdirecting capital and producing the wrong goods.

For any company, that kind of scenario can only spell disaster, so as a financial executive, make sure you're well-versed in using cost-of-capital measurements so you can keep your management team on the right track. There's some indication that companies' knowledge of the subject is increasing -- and that's for the good of all concerned.

DON'T BLOW YOUR HOUSE DOWN

Managing your capital properly means understanding how your common cost contributes to shareholder wealth. Here are simple examples that illustrate the effects of spread and growth rate. Assume all figures are constant and growth comes from retained earnings. The calculations are based on two formulas using the dividend-discount model: P/E = Payout/Divided Yield, and Market Price/Commo Book Value = P/E x ROE.

For the first three columns, you don't have a spread over the common cost. If, on average, you earn only the common cost, you can huff and puff and grow and grow, but typically, in the long run, the stock will sell at only common book value, and the P/Es will be the reciprocal of the common cost. In columns four and five, you do see a spread over the common cost, and the stocks sell at higher P/Es and over book value. With the increase in growth in column five, th P/E and market-to-book ratios increase significantly.

Returned earned on
common book value                    12%      12%      15%      15%      15%
Common cost                          $12      $12      $15      $12      $12
Spread                               0%       0%       0%       3%       3%
Growth rate from retention           8.0%     9.6%     9.6%     8.0%    10.0%
P/E ratio                            8.3x     8.3x     6.7x    11.7x    16.7x
Market price/Common book value       100%     100%     100%    175%     250%

Mr. Childs is senior vice president of Kidder, Peabody & Co. in New York.