Corporate Financial Analysis (Capstone) Final Exam Notes5 Steps of Financial Statement Analysis Identify economic characteristics of an industry Examine the industrys market conditions, trends, performance of companies in the industry, profitability, potential growth for the future Conduct comparative ratio analysis for firms in the industry, by comparing the firms ratios to an industry benchmark or to other similar firms, by creating common size financial statements (everything is comparable as theyre all represented as a %) Analyse industry characteristics value chain analysis, porters 5 forces and economic attributes. 5 Forces (SERBS): Threat of Substitutes, Threat of New Entrants, Rivalry amongst Existing Firms, Buyer/Supplier Power (Switching Costs / Distribution Channels) Economic Attributes: Supply/Demand of Products, Economic Cycle (Fluctuation of Sales), Competitiveness, Barriers to Entry, Capital/Labour Intensive Identify strategies that a firm pursues Nature of product or service --> analyse customers perception of the company (high-end or low-end company), volume of sales, branding strategies, competitive advantage/unique selling points, customer base, target market how does the customer perceive the companys products (is it high quality?) Degree of integration with value chains Degree of geographical or industry diversification Assess the quality of financial statements Use of different accounting frameworks & principles across different firms may cause inconsistencies when comparing financial statements between firmsE.g. different inventory costing methods (LIFO, FIFO, Avg. Cost), Purchase Accounting, Lease Accounting and Revenue Recognition (Accrual v. Cash Basis) The balance sheet reflects historical values, not market values Difficult to assess the value of intangible assets --> estimates may not be accurate Does not account for off-balance sheet assets (contingent assets and liabilities) Does not provide information about the quantitative aspects of a business; such as changes in staff or management, agreements with suppliers, does not tell anything about daily operations or the companys future plans, projects or future prospects Analyse future profitability and risk Current ratio = Current assets / Current liabilities Measures the companys ability to pay short term obligations Debt / Equity ratio = Total Debt / Total EquityMeasures the companys financial leverage, and level of D&E to fund the business Inventory Turnover = Total COGS / Average InventoryWhere Average Inventory = (Inventory @ start of year + Inventory @ end of year) / 2Measures the number of times inventory is sold over a yearFor example: For the financial year ended 2015, Company A had annual COGS of $150m, with an average inventory of $25m. Inventory Turnover = 6 times Days Sales Inventory Turnover = 365 / Inventory Turnover ratioMeasures the number of days it takes for a company to sell its stock/inventoryFor example: 365 / 6 = 60.83 days to sell one FULL round of inventory Accounts Receivables Turnover = Total credit sales / Average Accounts ReceivableWhere Average A/R = (Accounts Receivable @ start of year + Accounts Receivable @ end of year) / 2Measures the number of times receivables are collected over a year. The ratio is intended to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner. A high turnover ratio indicates a combination of a conservative credit policy and an aggressive collections department, as well as a number of high-quality customers. A low turnover ratio represents an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital. Average Collection Period = 365 days / Receivables Turnover ratio Days sales outstanding = Accounts receivables / Total credit sales X 365(Days sales outstanding = Average Collection Period --> represents how long (in days) it takes for a business to collect its average receivables) Accounts Payable Turnover = Total Purchases /Average Accounts Payable(Measures how long it takes for a business to pay it accounts payables)Where Purchases = Cost of Goods Sold + Ending Inventory Beginning InventoryWhere Average Accounts Payable = (Accounts Payable @ start of year + Accounts Payable @ end of year) / 2 Days Payable Outstanding (DPO) = 365 / Accounts payable turnover ratio Profit Margin = Net Income / Sales ROA = Net Income / Total Assets ROE = Net Income / Total Equity Price Earnings Ratio (P/E) = Price per share / Earnings per shareMeasures how much investors are willing to pay for every $1 of earnings Earnings per share = Net Income / No. of Ordinary Shares Dividend Yield (%) = Dividends per share / Market Price per share Value the firm Ball & Brown (1968): if earnings increases, then stock returns > market average returns

Key Ratios Profitability ratios (Profitability = Net Income) Profit Margin = Net income / Net sales Measures the % amount a business (actually) earns/gets to keep after generating sales and accounting for its expenses. Gross Margin = Gross Profit / Sales or Sales COGS / SalesMeasures the amount used to cover costs/expenses Operating Margin = Operating Profit / SalesMeasures the % of money left over after accounting for expenses (except taxes) EBIT Margin = EBIT / SalesMeasures profitability before interest expense financing and taxes Asset utilisation or efficiency ratios (ROA/ROE) Asset turnover ratio = Sales Revenue / Total assets OR Net Sales / Total assetsMeasures how well a company utilises assets to generate sales revenue Inventory turnover ratio = COGS / Average Inventory Receivables turnover ratio = Total credit sales / Average Accounts Receivables Days Sales Outstanding = Accounts Receivables / Net Income x 365 If there is an increase in Days in Payables, this is an increase to cash flow (means you have a longer time to pay off your accounts payables). If there is an increase in Days in Inventory or Accounts Receivable, this is a decrease to cash flow (means it takes you longer to sell off inventory and takes you longer to collect accounts receivables).

Capitalisation or financial leverage ratios Equity Multiplier = Total Assets / Total EquityMeasures the amount of a firms assets that are funded by its shareholders. The equity multiplier shows a companys total assets per dollar of shareholders equity.For example: an equity multiplier of 3, means that for every $1 of shareholder equity, total assets are worth $3 --> so that means that equity = $1, debt = $2. Current Ratio: Current Assets / Current LiabilitiesCurrent Assets = Cash, marketable securities, inventory, receivables Acid test ratio = Current assets Inventories / Current liabilities = cash + marketable securities+ receivables / current liabilities Debt service ratios or debt coverage ratios (loan protection): how many times can we cover the interest payments with earnings? EBIT coverage = EBIT / interest expense Cash flow coverage = EBIT + Depreciation / interest expense Debt service ratio = EBIT / interest expense + [principal payments / (1 tax rate)] Dividend Payout Ratio (DPO) = Dividends Paid / Net Income Earnings Retention = (Net Income Dividends Paid) / Net Income; OR (1 DPO) Sustainable growth rates: the maximum rate a company can grow by using internally generated funds (by only using retained earnings) Formula: Return on Equity x Retention Ratio = ROE x (1 DPO) For example: if ROE = 6%, and the DPO = 30%; then SGR = 4.2% Capital market ratios (Per share basis) Price Earnings Ratio (P/E) = Price per share / Earnings per share Earnings per share = Net Income / No. of Ordinary Shares Dividend Yield (%) = Dividends per share / Market Price per share Market to book value = Market price per share / Book value per share Economic Value Added: a measure of a companys financial performance based on residual wealth --> calculates whether a company has been profitable by determining whether the profit generated exceeds the companys cost of capital (WACC). EVA = Net Operating Profit After Tax (Capital Invested x WACC); OR = Invested Capital x (Return Earned Required Rate of Return to Investors)

Framework for Analysis Industry analysis, firms strategies, quality of financial statements, ratios, future profitability and risk, valuation of firm.

Week 2 Tutorial Question1. What reasons do managers have to maximise reported earnings? To indicate to investors and shareholders that the company is doing well; hence the share price of the company will increase In order to borrow or raise more money (capital), reported earnings may need to be maximised in order to increase the share price. To not breach debt covenants with creditors such as banks as this will cause significant financial pressure in penalties such as having to fully repay the debt. To meet analyst forecasts or beat them as to maintain or cause upward pressure on the firm's share price. If a company wanted to become a public company and be listed, then reported earnings would be maximised in order to maximise the best issue price for shares.

What reasons do managers have to minimise reported earnings? If there is political pressure for pay rises or less government support then reported earnings may be minimised by managers. By having high profit in one year, and low profit in another, it indicates to investors that the company is very volatile --> this means the companys share price will also be very volatile as well! So it comes down to the issue of earnings management; you need to smooth the companys earnings over time so that it indicates the company is stable! Minimise tax --> lower profits, less tax goes to the government To minimise requests to provide dividends and retain cash for growth opportunities.

2. a) During a time of inflation, would a manager prefer to use FIFO or LIFO?During inflation, prices are increasing therefore FIFO would give a HIGHER profit figure as the COGS wouldve been purchased at a lower price. Conversely, LIFO would give a LOWER profit figure as the COGS wouldve been purchased at a higher (and more recent) price.Note: An increase in COGS may mean the business has increased sales (and increased revenues), increases in inflation, or there are higher commodity input costs (higher inventory costs)

3. Identify industries that should typically have high leverage (stable companies) and those industries that should typically have low leverage (volatile companies).High leverage: low margin high turnover industries like grocery stores/supermarkets + popular restaurants, and stable industries like utilities such as electricity/gas/water companies, airports, hospitals, manufacturing companies and phone companies. Financial companies typically have huge amounts of leverage they would not make a respectable profit otherwise since margins are so low. Low leverage: high value added companies that are not stable like service companies such as lawyers/investment bankers, technology/software developers, mining companies

4. Explain why firms have different P/E ratios.P/E ratios indicate growth in earnings. The numerator (price) is based on expected future earnings whereas the denominator is current earnings. If future earnings are expected to be higher than current earnings (that is, growth in earnings is expected), the P/E will be high. If future earnings are expected to be lower, the P/E ratio will be low. So differences in P/E ratios are determined by differences in growth in future earnings from the current level of earnings.

Cash Flow Analysis Young companies with profitable investment opportunities do not pay out cash and rarely repurchase stock. Growth companies finance investments as much as they can with internally generated cash flow. Retaining cash avoids cost of issuing securities and minimizes shareholders taxes. Young companies and growth companies typically experience high levels of risk in relation to cash flows, as they usually incur negative income (and negative cash flows) cash flows only start to become positive once they enter the maturity phase. As firms mature, growth opportunities gradually fade away and surplus cash accumulates. Investors press for payout because they worry that managers will overinvest if there is too much idle cash is lying around. A firm with surplus cash will probably start by repurchasing shares, which is more flexible than dividends. By repurchasing shares, the number of shares in the market decrease and the value (price) per share increases. Once a company announces a regular cash dividend, investors expect the dividends to continue unless the company encounters serious financial trouble. As firm ages, more and more payout are called for. The payout may come as higher dividends or larger repurchases. Free cash flow: operating cash flow capital expenditures Where operating cash flow = net income + noncash expenses + changes in working capital Jensens (1986) agency costs of free cash flow: firms will too much free cash flow will have high agency costs; managers will tend to overspend money and will make decisions that are not in the best interests of shareholders.

Cash flow Statement Cash from operating activities focuses on the cash inflows and outflows from a company's main business activities such as collecting cash from customers against the sale of goods and services rendered, buying and selling inventory, cash paid to employees and other expenses. Cash from investing activities focuses on the cash inflows and outflows from a companys investing activities such as the purchase and sale of fixed assets (machinery, land, buildings), purchase and sale of stocks/bonds, lending of money and collection of loans Cash flows from financing activities focuses on the cash inflows and outflows from a companys financing activities such as the sale and repurchasing of shares (IPO), issuance and repayment of debt and the payment of dividends.

Start UpGrowthMaturityDecline

Cash flows from operationsNegativePositivePositivePositive

Cash flows from investingNegativeNegativeNegativePositive

Cash flows from financingPositivePositiveNegativeNegative

Negative investing means the firm is spending extra money (internal cash flows) to undertake projects, acquire more assets --> it is not borrowing the money to fund these investments. Negative financing means the firm is spending extra money (internal cash flows) to pay off loans, buy-back shares and pay out dividends. Operating cycle the length of time from the manufacture to the sale of a good Examples of industries with long operating cycles: chemical refining, construction of apartments, development of land, manufacturers of airplanes, aerospace, automobiles, electronics, pharmaceutical companies Examples of industries with short operating cycles: restaurants, grocery stores/supermarkets, food or drink-related industries Operating cash flow ratio = cash flow from operations / current liabilities(Measures how well current liabilities are covered by the cash flows generated from a companys operations) Income statement = accrual basis of accounting, records revenues and expenses when they are incurred, and not when cash is received. Net income Net cash flow. The income statement takes into account both cash and non-cash cash flows (e.g. depreciation), whilst the cash flow statement only takes into account actual changes in cash flow (more accurate).

5. Calculate cash payments to suppliers. A retailer reports the following: Cost of goods sold = $24,165 Inventories beg = $4,584 Inventories end = $5,982 Accounts payable beg = $2,212 Accounts payable end = $2,687Calculate the amount of cash paid to its suppliers.

Answer:Purchases = (Cost of goods sold + Inventory at end of period - Inventory at beg. of period) = 24,165 + 5,982 4,584 = 25,563 (amount paid in $$)

Accounts payable = (Inventory purchases + accounts payable at beg. accounts payable at end) = 25,563 + 2,212 - 2,687 = $25,088 cash paid to suppliers

Reliability of Accounting Information Accounting quality is defined as the precision with which financial reporting informs equity investors about future cash flows of a firm. Financial statements only reflect the financials for the current period according to accounting rules (involves estimates); it does not show anything about economic effects, future profitability and risk of the firm. A companys management is responsible for the fair presentation of financial statements in accordance with GAAP principles that portray the companys performance and position (financials) to all end-users of financial statements. There are a few qualities and characteristics that make financial statements reliable for decision making: Relevance: the financial information is viewed to be relevant if it makes a difference to the decisions made by stakeholders and helps users to assess past performance and predict future performance. Timeliness: this means the financial statements are able to provide end-users with the relevant information before it loses its value. Online financial reports, together with analyst reports and news articles, enables end-users to keep up to date with the companys news and progress. Reliability: financial information is reliable when investors and creditors consider the information to reflect current economic conditions or events. Reliability is a measure of the integrity and objectivity of financial reports. Financial statements are now required to reflect the fair value of a companys assets and liabilities. Verifiability: the extent that different individuals are able to obtain the same result or same value when calculating the companys financials. Representational faithfulness: the degree to which the companys financials reflect actual events that have occurred to the company. Neutrality: the companys financial statements should be free from biasedness, and should be consistently prepared by using standardized and uniform accounting principles to calculate financial values. Transparency: high-quality financial statements must be transparent in the sense that it provides the complete reporting and disclosure of notes.

Earnings Management Defined as the use of management choice and judgement in the reporting process to mask the underlying economic performance of a firm. It includes any judgement employed by management that results in lower economic information content of the financial report and provides a skewed basis for making decisions. Reasons why managers manage earnings include: Influence manager compensation (stock options and bonuses) Job security Adhering to debt covenant policies Influence short-term stock price Maintain smooth earnings (prevents volatility in company performance and share price) to avoid industry specific actions.

Backdating Options Options backdatingoccurs when companies grant options to their executives that correspond to a day where there was a significantly lower share price. This is illegal, because the company has manipulated the date of the option granted to the executive, and chosen a day (in the past) where the strike price would be significantly lower, to enable the executives to make more profit. For example, suppose that it is August 16, 2014, and the closing share price of XYZ Corp. is $45. On June 1, 2014, XYZ Corp.'s stock price was at a six-month low of $25. Technically, any options granted today (August 16) should bear a strike price of $45. In a backdated situation, however, the options would be granted today (August 16), but their listed day of granting would be June 1 in order to give the options a lower strike price. Options backdating defeats the purpose of linking an executive's compensation to the company's performance, because the bearer of the options will already have experienced a gain.

Big Bath Accounting Big bath accounting is an earnings management technique where publicly traded corporations write-off or write-down certain assets from their balance sheets in a single year. The write-off removes or reduces the asset from the financial books and results in lower net income for that year. The objective is to make poor results look even worse in a single year, so that future years will show increased net income. This technique is often employed in a year when sales are down from other external factors and the company would report a loss in any event. For example, inventory valued on the books at $100 per item is written down to $50 per item resulting in a net loss of $50 per item in the current year. Note there is no cash impact to this write-down. When that same inventory is sold in later years for $75 per item, the company reports an income of $25 per item in the future period. This process takes an inventory loss and turns it into a profit. Corporations will often wait until a bad year to employ this technique to clean up the balance sheet.

Seven Financial Shenanigans Recording revenue before it has been earned Recording bogus revenue --> income (bottom line) revenue (top line) Boosting income with one-off gains Shifting current expenses to a later or earlier period (capitalising expenses over multiple years, changing accounting techniques to shift expenses to another period, failing to write down or write off impaired assets, understating bad debts and loan losses) Failing to record or improperly reduce liabilities Shifting current revenue to a later period (holding back revenue for future years) Shifting future expenses to the current period

The following are two basic strategies underlying all accounting tricks: To inflate current-period earnings by inflating current-period revenue and gains or by deflating current-period expenses To deflate current-period earnings (and, consequently, inflate future periods' results) by deflating current-period revenue or by inflating current-period expenses Financial shenanigans are often used by fast-growth companies, whose real growth is beginning to decline, basket-case companies that are struggling to survive, newly listed companies, private companies, and companies that have a weak control environment, or are under extreme competitive pressure. Case study: AOL was a media company that spent more capital than it earned. The company excluded current marketing costs in its profit instead of immediately expensing them in the current period. The company shifted the costs onto the balance sheet as an asset (capitalising costs), and expensed them off in future periods. The amortization period of these costs gradually increased from 12 months, to 18 months to 24 months --> way of inflating company earnings for the current period. Capitalising costs An accounting method used to delay the recognition of expenses by recording the expense as a long-term asset. In general, capitalizing expenses is beneficial as companies acquiring new assets with a long-term lifespan can spread out the cost over a specified period of time. Companies take expenses that they incur today and deduct them over the long term without an immediate negative affect against revenues.

Factors that explain differences in ROA between industries Operating leverage fixed costs vs. variable costs A company with higher fixed costs will need to generate high level of sales to cover the fixed costs. Higher risk if there are a lot of fixed costs in the business, as fixed costs may not always be covered. Some industries are more capital intensive than others --> bear more fixed costs. For example, mining, automobile/airline and pharmaceuticals are extremely capital intensive, whilst service companies have more variable costs. Cyclicality of sales This depends on whether the industrys sales are impacted by market (economic) conditions; depends whether the goods are defined as a need or a want, whether the goods are expensive or not, whether the goods are necessary for survival, or they are for entertainment or leisure purposes. Product Life Cycle Four stages: introduction, growth, maturity and decline The shape of ROA in these four stages is like an upside-down parabola ROA is negative in introduction, increasing and positive in growth, flat and positive in maturity and decreasing in decline. ROA indicates how much earnings were generated from invested capital (assets). TATO indicates how efficient the company has used assets to generate sales revenue ROA is specific to many industries. High ROA low TATO Hotels, utilities, oil and gas exploration, communication, health services, entertainment Medium ROA medium TATO Printing, petroleum, airlines, manufacturing, restaurants Low ROA high TATO Retailers, wholesalers, grocery stores ROA (efficiency & profits) = PM (profits) x TATO (efficiency) Profit Margin: net income/sales. Study the components of net income, especially how we derived net income. Examine the expenses of a business as a % of sales; COGS, selling and admin, amortization/depreciation, interest and tax. TATO: sales/total assets. Study the turnover rates for particular assets, such as accounts receivables turnover, inventory turnover, payables turnover. Return on Capital Employed (ROCE) = Profit Margin x Asset Turnover x Equity Multiplier

COGS increase: increase in raw material prices, increase in demand/sales (higher quality), prices lowered to sell inventory more quickly COGS decrease: less sales, resort to lower quality (and cost) materials, buying less

Dividend Discount Model (DDM) v Cash Flow Valuation The main difference between the two models is that the DDM values a company based on the amount of dividends (retained profits) given back to investors whereas the FCF model values a company based on its ability to generate profits (FCF). The DDM is arbitrary, because it only relies on company dividends; however not all companies pay dividends (i.e. young and growth firms). The dividends are also not periodic, the amount of the dividends does not vary with performance --> so it is very difficult to use the DDM to accurately value a firm. A cash flow valuation is more accurate; for example, free cash flow represents the amount that is (potentially) available to be paid out to shareholders (similar to dividends).

Free Cash Flow Valuation To use the FCF method, you will need to forecast expected future FCFs over a horizon period, the expected FCF at the final year of the horizon period (continuing FCF), forecast the terminal (long-run) growth rate and a discount rate (WACC) to discount all FCFs. Net OA Net FL = E PV of net cash flows from operations PV of net cash flows to debt financing (liabilities) = PV of net cash flows to shareholders equity An estimation of the future FCF will depend on an analysis of the industry, maturity of the firm, expected growth (future firm prospects), predictability of the FCF (trends in the past) Continuing Value (Terminal Value) = FCFt+1 / R g ---> discount using t-1 Discounting Value (Calculating PV) = CF / (1+R)t Where: R = appropriate risk-adjusted discount rate, G = projected steady-state growth rate Return on Equity (RE) = Risk free rate + Beta x (Return on Market Risk free rate) --> CAPM

How to calculate new beta with change in capital structure Levered Beta = Unlevered Betax (1 + ((1 Tax Rate)x (Debt/Equity))) E.g. Current (levered) beta = 0.9, Tax rate = 35%, old D/E = 0.6, risk free rate = 6%, market risk premium = 7%, new D/E = 1.4 Step 1: Calculate your current unlevered beta 0.9 = X * (1 + (0.65) x 0.6) --> X = 0.65 Step 2: Calculate new beta by substituting everything into the formula X = 0.65 * (1 + (0.65) x 1.4) --> X = 1.24 FCF requires more estimations and forecasting --> potential errors! However, it takes into account cash flows, which has more economic meaning than earnings

The amount of residual income earned is seen as a contribution to shareholders equity + firm value because there is an implied assumption that the total amount of earnings are being paid out to the shareholders. With a 100% payout, the book value of equity and required rate of return by shareholders stays the same. If the payout is not 100% of earnings, then the book value of equity will increase each year (due to retained earnings) and the required rate of return will also increase.

Five-Step Summary of Residual Income Model 1. Determine the book value of a firms equity (balance sheet) and project residual income after calculating the return on equity (CAPM equation) --> RI = NI (RE x BV)2. Project long run growth3. Estimate the appropriate discount rate (this depends on the firms capital structure; if the firm is completely funded with equity, then use RE as the discount rate, otherwise if the firm is funded with both debt and equity, use the WACC)4. Add book value of equity to PV, then divide by the number of shares outstanding (SP)5. Examine sensitivity analysis of estimates 5. Income statement and cash flows:EBIT800Interest paid225Profit before tax575Taxes (40%)230Profit after tax345Depreciation200

What is the FCF to shareholders?FCF to shareholders = Profit after tax + Depreciation (non-cash expense) = 345 + 200 = 545 What is the FCF to shareholders and debtholders?FCF to shareholders and debtholders = PAT + Depreciation + After-tax Interest = 545 + 225 (1 - 0.40) = 680 Assuming a risk free rate of 12%, a market risk premium of 8% and a beta of 1.375, what valuation based on FCF to shareholders would you assign based on this information?Required rate of return = 12% + 1.375*8% = 23%Value of firm (based on FCF perpetuity) = 545 / 0.23 = $2,369.57

6. Investors have $200,000 invested in common equity of a company and the required rate of return is 14%. Income for the first four years is expected to be $16,000, $28,000, $30,000 and $32,000. In the fifth and subsequent years the company is expected to earn $37,000 per year (perpetuity). Calculate the value of the company using the residual income approach assuming 100% payout.

Value of company = Book value of Equity + PV of all future residual incomeResidual Income = Net Income (Return on Equity x Book value of Equity)

Residual IncomePresent Value

Year 1: (16,000 28,000) / 1.14-10,526

Year 2: (28,000 28,000) / 1.1420

Year 3: (30,000 28,000) / 1.1431350

Year 4: (32,000 28,000) / 1.1442368

Year 5: (37,000 28,000) / 1.14438,062

Total Value of Company = $200,000 + PVs ($31,254) = $231,254

7. Investors have $200,000 invested in common equity of a company and the required rate of return is 14%. Income for the first four years is expected to be $16,000, $28,000, $30,000 and $32,000. In the fifth and subsequent years the company is expected to earn $37,000 per year (perpetuity). Calculate the value of the company using the residual income approach assuming 50% payout.

With a 50% payout, the company pays out 50% of net income and retains 50% of net income. So the book value of equity will increase by 50% by net income earned every year --> BV1 = BV0 + 0.5NI

YearNet IncomeBook Value of EquityEquity ChargeResidual IncomePV

Year 116,000200,00028,000-12,000-10,526

Year 228,000208,00029,120-1,1200

Year 330,000222,00031,080-1,0801350

Year 432,000237,00033,180-1,1802368

Year 537,000253,00035,42011,28638,062

Total Value of Company = $200,000 + PVs (-$6,134) = $193,866 --> business should not run!

Note: the first book value of equity is $200,000 and not $208,000 because net income is generated at the end of the (financial) year, but equity charge is calculated at the beginning of the year. So the change does not come into effect until the second year.

8. What does the decision to begin paying dividends signal? It can be viewed as a (positive) signal that the firm is not wasting money on unproductive projects, or a (negative) signal there are no attractive projects to invest in. A dividend payout may signal to investors that the firm rather pays out dividends to shareholders rather than wasting on perquisites or empire building (agency costs).

9. A firm has shareholders equity on the balance sheet with a book value of $100 at the end of year t-1. Suppose that during year t, the firm earns net income of $50, pays dividends to shareholders of $25, issues new stock to raise $10 of capital, and uses $5 to repurchase common shares. What is the all-inclusive dividends in year t?BVt = BVt-1 + NIt - Dt = 100 + 50 25 + 10 5 = 130Dt = NIt + BVt-1 - BVt = 50 + 100 130 = 20

4. The following capital structure is in place: LTD 10% coupon $20 millionPref stock 4% dividend$5 millionCommon equity $15 millionDebt yields 8%, tax rate 35%, beta 0.9, RF=6% Market risk premium 9%Calculate the weighted average cost of capital.After tax cost of debt: 8% x (1-0.35) = 5.2%Cost of equity: 6% + 0.9 x 9% = 14.1%Debt: 50% x 5.2% = 2.6%Preferred Stock: 12.5% x 4.0% = 0.5%Common equity: 37.5% x 14.1% = 5.29%WACC = 8.39%

Market Valuation MethodsValue to Book Ratio VB = value of equity to book value of equity = 1 + PV of abnormal returns (or Residual ROCE) x cumulative BV growth Example: if a company earns a 15% rate of return for 3 years, has a cost of capital of 10% and the companys book value of equity increases by 15% every year for the 3 year period, calculate the VB ratio. Year 1 BV = 1.0, Year 2 BV = 1.152, Year 3 BV = 1.153 Multiply individual BV by Residual ROCE (0.05) Discount individual values back to PV by using a 10% required rate of return. VB ratio = 1 + PV = 1.14265

Market to Book Ratio M/B = market value of equity to book value of equity. Price to book value tells whether investors in general value the company above, at or below the face value of the company's assets as they appear in its financial reports. M/B of company (total value) = current market capitalisation / total shareholders equity M/B of company (per share) = market price per share / book value per share Penmann: M/B should be 1 when market expects company to earn required rate of return (no residual income)

10. In what industries do you expect the M/B ratio to be close to 1? In what industries do you expect the M/B ratio to be high? Be prepared to provide a reason for your answers.Low (close to 1): Banks, insurance, and finance companies, since their assets are recorded at market value or recorded close to fair value.

High (above 1): Industries with investments in R&D like pharmaceuticals, chemical companies or mining companies. Also industries with human capital such as service or knowledge firms such as Google or high-tech companies.

Price to Earnings Ratio Perpetual Growth It is calculated as current period share price divided by reported earnings per share for the most recent year or four quarters (trailing 12 months) It reflects the markets optimism concerning a companys growth prospects. If a company has a P/E ratio higher than the market or industry average, then the market has high expectations of the company in the future. P/E ratios can be used to project firm value from permanent earnings perpetuity! P0 = E1/R or P/E = 1/R Example: A company is expected to generate $700 of earnings at a 14% return on equity. Therefore, the market value of the firm = 700/0.14 = $5,000 Adjusting for P/E ratio with Perpetual Growth --> P/E = 1/R-G You could also find the P/E multiple by using the second equation. Example: companys earnings are expected to grow 5% perpetually and required rate of return is 15%. Find the P/E multiple. P/E = 1/R-G = 1/0.15-0.05 = 1/0.1 = 10 General rule: companies that are low growth and low risk have low P/E ratios. Companies that are high growth and high risk have high P/E ratios. Companies that are able to generate profits (ROCE exceeds required rate of return) and are able to sustain profits will have a high P/E ratio

Price-Earnings Growth Approach (PEG) Short term Growth PEG ratio (short term growth) is calculated as the P/E ratio divided by the expected short-term earnings growth rate (expressed in percent) PEG = P/E ratio / growth rate A PEG value 1.0 means the market price reflects expected earnings growth A PEG value > 1 means a companys share price is overpriced (bad investment) A PEG value < 1 means a companys share price is undervalued (good investment) Note: always invest in the company with a PEG value less than 1.

Example: You are considering two potential investments in the TV manufacturing industry. PLASMA Corporation has had a 35% annual growth rate and a current price of $28.30. LCD Company has had a 20% annual growth and it has a cheaper price at only $18.87 per share. If last years earnings were 57 cents per share for PLASMA and 38 cents per share for LCD, which company (or companies) if any should you invest in if you rely on the PEG ratio to make the decision? PLASMA: 28.30 / .57 = P/E of 49.65 --> PEG = 49.65/35% = 1.42 LCD: 18.87/.38 = P/E of 49.65 --> PEG = 49.65/20% = 2.48 You should invest in neither, as theyre both overpriced according to the PEG ratio

Price-Earnings to Growth and Dividend Yield PEGY ratio is relevant to stocks that pay a substantial dividend. Variant of PEG ratio but also includes dividend yield in the denominator (%) PEGY ratio = P/E ratio / Growth (%) + Dividends (%) Example: A company has 40% annual growth in net income, an 8% dividend yield and a P/E ratio of 50. The PEGY ratio 50/48% = 1.04

Credit Judgement The credit decision process is quite simple either yes, grant loan or no, do not grant loan Two errors that might arise: Type 1 Error: giving credit to companies that default Type 2 Error: not giving credit to companies that have the ability to pay it back

Credit Suppliers: Commercial Banks e.g. bank loans (private debt) Non-banks and other financial institutions e.g. finance companies, credit unions, insurance companies, investment bankers, venture capital companies, government agencies (private debt) Security Markets e.g. public debt markets; involves a primary market (organisations selling debt to the public directly for example, corporate/government bonds, CDs or securitised loans) and a secondary market (trading of debt securities between investors) Trade Credits e.g. credit obtained from sellers and manufacturers; usually unsecured with for 30-60 days but sometimes secured with a note (depending on value).

Question: Whats the difference between public and private debt?Private debt is owed by individuals and private sector businesses to their lenders. It encompasses informal loans between friends and family, credit card and bank loans, and corporate bonds issued by private companies. There is usually a close relationship between borrowers and lenders. Public debt is accumulated by national, regional or local government bodies or by public sector organisations. Public debt includes government bonds, the sale of which constitutes borrowing from private citizens and businesses, and also sovereign debt, whereby one country borrows money from another. Public debtholders (borrowers) must rely on professional debt analysts to assess credit risk.The 5 Cs of Credit Character: examine borrowers past financial statements and borrowing history Capacity: examine the borrowers capacity to repay credit ratings, debt repayment ratios Capital: examine the firms ability to lend the amount of money would it impact their D/E Collateral: examine the type of collateral/security the borrower is willing to provide Condition: examine the current industry and economy

The Credit Decision Process1. Consider the nature and purpose of the loan What is the loan going to be used for? How long will the loan run for, and how will it be repaid?2. Consider the type of loan and available security Is it short term? E.g. line of credit, working capital loan Is it long term? E.g. term loan or mortgage, lease financing, acquisitions/mergers Is it secured or unsecured/is there a guarantor? Ranking of securities: cash/liquid securities, A/R, inventory, machinery, real estate Lenders prefer more liquid securities than illiquid securities as collateral3. Analyse the borrowers financial strength --> solvency, debt coverage, cash flow ratios! Solvency ratio = After tax net profit + depreciation / total liabilities Debt service ratios or debt coverage ratios (loan protection): how many times can we cover the interest payments with earnings? EBITDA coverage = EBITDA / interest expense Cash flow coverage = EBIT + Depreciation / interest expense

Funds flow coverage ratio = Funds flow coverage = cash flow + interest paid + taxes paid / interest expense Debt service ratio = 4. Utilise forecasts to assess payment prospects Includes preparing forecasting and planning how the loan will be repaid, and creating control mechanisms in case of default5. Assemble the detailed loan structure, including loan covenants

Factors that drive debt ratings What are the key ratios debt rating agencies look at when rating a company? Profitability: return on long term capital Leverage: long term debt to market capitalisation Interest and Cash flow coverage ratios Firm size and sales / Systematic risk Debt rating models: Kaplan-Urwitz & EDF Prediction of bankruptcy (models) and financial distress: Altman and FSI

Altmans Z-score Bankruptcy Model & (Public/Private Companies) Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 For public companies, bankruptcy occurs if the Z-score is