Discussion

Reviewing at this point what has been done, we see that annual revenue requirements were established for a given plant. An expense was deferred in the third year of operation, and paid in the sixth year. This deferred expense resulted in an excess in earnings over the base requirements, which was used in two ways: 1. to decrease the amount of external financing from the sale of stocks and bonds equally, in which case the average rate of return on the deferred expense was (R¿tib); 2. to decrease the amount of external financing from the sale of stocks only, in which case the average rate of return on the deferred expense was R or our average cost of money. Why the discrepancy in our average rate of return? In case 1, referring to Table X, we see that our debt ratio has not remained constant at 50% but has decreased to 48.5% ($776,000 bonds)/(1,600,000 total capital). This decrease in debt ratio resulted from a portion of surplus being used to decrease the need for external financing through bonds and this is the fallacy. From gross income, we are obligated to pay the interest on our bonds, and any excess or deficiency in earnings accrues to the stockholders. The portion of these earnings not paid out as dividends remains in the company as earned surplus and as the property of the stockholders. Being a part of equity, this surplus must earn 9% just as the common stock must earn 9%.