mba 224 power points
TRANSCRIPT
1
Financial Statement Analysis
2
Evaluation of currentand past
financial conditions
• Estimated predictions about• future financial conditions• and performance
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Reasons for Analysis
• Investment decisions*• Credit decisions*• Performance*• Valuation (investment)• Legal liability amount (credit & perf.)• Going concern decisions (credit &
perf.)• Unreasonable returns (performance)
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FSA Steps
• Identify the economic characteristics
• Identify the corporate strategies• Understand the financial
statements• Assess the profitability and risk• Value the particular firm
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Tools for Economic Analysis
• Porter’s Five Forces• Economic Attributes
Framework
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Porter’s Five Forces
• Buyer Power- (price sensitivity)
• Supplier Power• Rivalry among Firms• Threat of New Entrants• Threat of Substitutes
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Economic Attributes Framework• Demand
price sensitivity demand growth cyclical demand seasonal demand
• Supply number of suppliers barriers to entry
• Manufacturing capital intensity process complexity
• Marketing marketing channel--corporate or consumer demand pull or demand creation
• Financing Nature of assets Asset risk Source of cash flow--internal or external
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Strategic Analysis Framework
• Nature of product or service • Degree of Integration• Degree of Geographical
Diversification• Degree of Industry
Diversification
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Financial Statements
• Balance Sheet• Income Statement• Statement of Cash Flows• Footnotes• Auditors Report• Management Discussion and
Analysis
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Income Statement Classification
• Operating income• Other income and expense• Income from continuing
operations• Income, gains & losses from
discontinued operations• Extraordinary gains and losses• Changes in accounting principles
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Comprehensive Income
• Net income plus or minus the changes in shareholders’ equity from other than net income or transactions with owners.
• (we will look at this later)
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Other F/S Considerations
• Quality of Earnings• Statement of Cash Flows• Auditors Report
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Tools of Profit and Risk Analysis
• Common Size Financial Statements
• Percentage Change Statements
• Comparative Analysis• Critical Financial Ratios
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Risks of Comparative Analysis
• Timing• GAAP Application• Degree of Conservatism-
management’s attitude• Size• Geographic Diversification
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Critical Financial Ratios
• Profitability Ratios EPS ROCE
• Risk Ratios Current ratio CFO/Avg. Current Liabilities Debt/Equity
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Valuation
• Price-Earnings Ratio• Market value to Book value
Ratio
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Role of FSA in Capital Markets
• One View: FSA has no impact• The Other View
FSA is a catalyst FSA identifies individual
opportunities Equity markets are not perfectly eff. FSA cleanses F/S biases FSA has unique purpose itself- (go
back to the reasons for analysis)
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Sources of Information
• Annual Report• Form 10-K• Form 10-Q• Form 8-K• Prospectus• Form 20-F (foreign entity 10-K)
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Statement of Cash Flows-chapter 3
• FASB 95--1987• Components
Operating cash: Operations and working capital
Investing cash: Non-current assets and investments
Financing cash: L/T debt, equity and dividends
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Roots = Financing Activities
Trunk & Branches = Investing Activities
Fruit = Operating Activities
Businesses are like Fruit Trees
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Net Income vs. Cash Flow
Indirect Method• Net Income• +/- Non-cash Items• +/- Changes in Operating
Working Capital• = Cash Flow from Operations
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Indirect vs. Direct Method
• FASB prefers the direct method• FASB requires net income to cash
from operations reconciliation• Components:
Cash from customers Cash from dividends Cash from interest income Other operating cash receipts Cash paid to suppliers Cash paid to employees Cash paid for taxes Cash paid for interest Other operating cash payments
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Profitability Analysischapter 4 & 5
• Rate of Return on Assets--ROA Measures success in using assets to
generate earnings (excluding financing)
• Disaggregated ROA ROA = Profit Margin X Asset Turnover Line by line P & L Analysis A/R, Inventory & F/A turnover
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ROA Summary
• Level 1: ROA as a whole• Level 2: Disaggregate ROA• Level 3a: Margin analysis in detail• Level 3b: Disaggregate turnover• Level 4: ROA, margin & turnover
by geographic segment
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ROCE--Return on Common Shareholders’
Equity• Return after O-I-F activities• ROA and ROCE
ROCE > ROA when ROA exceeds the cost of creditor and pref. Shareholder capital
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Disaggregated ROCE
• ROCE = ROA X CEL X CSL• Common Earnings Leverage =
op. Income available to common s/h
• Cap. Structure Leverage = multiplier effect of other capital sources
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Risk Analysis
• Types of risk International Domestic Industry Firm-specific
• Our focus will be on the financial aspects of risk
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Relationship to O-I-F
• S/T liquidity…O…working capital
• L/T liquidity…I…plant capacity• L/T liquidity…F…debt svc.
rqmts
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S/T Liquidity
• Current ratio• Quick ratio• Ops. Cash flow to C/L• W/C Activity ratios:
A/R turnover Inventory turnover A/P turnover
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L/T Liquidity
• L/T Debt Ratio• Debt/Equity Ratio• Liabilities/Assets Ratio• Interest coverage…fixed
charges coverage• OCF to Total Liabilities• OCF to Capital Expenditures
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Comparative Analyses
• Time series analysis (same company) Changes in customers, product or
geography Major M&A activity Accounting changes
• Cross-sectional analysis (industry) Industry definitions Metric calculations
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Industry Ratio Sources
• Robt. Morris Associates, Annual Statement Studies
• Dun & Bradstreet, Industry Norms and Key Financial Ratios
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Stickney’s Comparability Risks…in
additon to WFO’s• Earnings not reflective of
actual economic value added• F/S restatement• F/S classification• Time variations in excess of 3
mos.• Global accounting factors
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Quality of Earnings Issues-
Chapter 6 • Non-recurring items…
sustainability• Earnings measurement• Earnings management
• Essentially we are trying to determine if what is reported is going to recur in the future.
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Sustainability Issues
• Discontinued operations• Extraordinary gains and losses• Changes in accounting principles• Impairment of long-lived assets• Restructuring charges• Changes in estimates• Peripheral gains and losses• Mgt. analysis including the MD&A
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Restructuring Difficulties
• Conservative vs. aggressive accounting practices
• Periodic charges vs. one time event
• “Taking a bath”
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Analyst’s Role
• Is restructuring adequate• Wall street point of view• Significant judgement required
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Earnings Management• Reasons it occurs:
Incentive compensation factor Job security Smoothing reduces erratic performance
which lowers perceived risk Gov’t anti-trust avoidance
• Reasons against: Can’t do it forever Capital market penalties for excess
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Methods of Management
• GAAP choices• Management judgement and
estimates• Timing of transactions
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Restated F/S
• Discontinued operations• Pooling of interests-(new
guidelines)• Accounting principle changes
• Big issue here is the difficulty of calculating prior years’ impact if information is not presented.
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Global Considerations
• Use SEC Form 20-F Discloses equity and net income
reconciliation between local GAAP and US GAAP
• Evaluate environmental, customs and strategic implications as well as GAAP
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Chp. 6 Examples
• Ex. #1: Halliburton-discontinued segment• Ex. #2: Fountain Pwerboats – extraordinary item• Ex. #3: Tenneco Automotive – changes in acctg. Princ. • Ex. #4: Brunswick- effect of actg. Changes• Ex. #5: Ford-cumulative effect acctg changes• Ex. #6: PepsiCo-other comprehensive loss• Ex. #7: Cisco-other items • Ex. #8: PepsiCo-asset impairment• Ex. #9: JDS Uniphase- asset impairment• Ex. #10: JDS Uniphase -restructuring• Ex. #11: Brunswick-unusual charges• Ex. #12: PepsiCo-merger related costs
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Chp. 6 Examples, cont.• Ex. #13: DriveTime-change in actg estimate• Ex. #14: Hersey-change in actg estimate• Ex. #15: Delta Air Lines- other gains and losses• Ex. #16: PepsiCo-other gains and losses• Ex. #17: PepsiCo-other gains and losses• Ex. #18: General Mills –restated statements• Ex. #19: Account classification differences• Ex. #20: Ericsson-worldwide reporting
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Extended Profitability-(use for chapter 4 & 5)
• ROA=PM x AT• ROA increases as Risk
increases• ROA increases as OL increases• Sales cyclicality increases risk• Offset with higher AT• ROA varies with life cycle
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Economic Aspects
• Monopoly…high PM; low AT• Pure Competition…low PM;
high AT• Oligopoly…mixture of the two
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ROCE Considerations• ROCE tends to follow ROA• Two theories
Random walk…high stays high; low stays low
Equilibrium…revision to average ROCE
• Penman’s findings Random walk valid 1-6years Equilibrium thereafter takes hold
• Capital structure not changed for ROCE improvement
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Extended Risk
• Financial Distress Credit risk Bankruptcy risk
• Financial Distress Spectrum Payment omission Default Bankruptcy Liquidation
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Credit Risk C’s
• Circumstances• Cash flows (Capability to repay)• Collateral• Capacity for debt• Contingencies• Character of management• Conditions
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Bankruptcy
• Process Chapter XI…liquidation Chapter VII…reorganization
• Predictive Models Beaver…univariate
Net income before amort. etc./total liab.
Altman’s Z…see pages 631-633 Multivariate
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Multivariate Criticisms
• Relevant ratios might be missing• Subjective evaluation• Model based on available info; lack of
info might bias model• MDA assumes normal distribution of
ratios• MDA requires similar relationship of
variables for bankrupt and non-bankrupt firms
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Other Issues in Bankruptcy Models
• Population does not include equal # of bankrupt and non-bank. Firms
• Excludes size and industry factors
• Accrual vs. cash flow variables• Models remain unchanged over
time
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General Summary of Factors• Investment Factors
Liquidity lowers risk AT lowers risk
• Financing Factors Lower debt levels lowers risk S/T debt increases risk over L/T debt
• Operating Factors Profitability lowers risk Operational consistency lowers risk Small size, rapid growth and audit exceptions
increase risk
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Market Risk• Drivers
Political Personnel Product
• Market risk drives market return• CAPM measures market risk
Market risk beta is driven by… Operating leverage Financial leverage Sales variability
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Pro-forma Financials-Chapter 10
• Sales revenue (revenue growth)• Operating expenses• Asset requirements (asset
turnover)• Debt and equity requirements• Cost of financing-(interest etc.)• Statement of cash flows• Balance sheet
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Pro Forma ApproachesExhibit 10.1
• Follow the 6 step plan page 742• FSAP has a Forecast pro forma
template• % analysis can be used to
project income statement and balance sheet
• Individual items Turnover ratios as a benchmark
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Key Assumptions and Caveats
• Annual revenue growth rate• Expense relationships• Levels of investment
Working capital Fixed Assets
• Financing mix• 4-5 year range• Consistency• GIGO (garbage in garbage out)
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Pro-forma Methodology
• Chapter 10 provides you with a format for building the excel worksheet and integrating it with the FSAP template
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Rev. Recognition OptionsChapter 7
• Period of production• Completion of production• Time of sale• During collection period• Upon cash receipt
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Earnings Management
• Increases as cash flow period grows
• Increases as options for estimation grows
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Criteria for Recognition
• Work is completed• Measurable amount• Costs are identifiable• Collection is reasonably
assured
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Earnings Sustainability Risk
• Uncollectible A/R• High volume of returned goods• Unrecorded warranties
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L/T Contractors
• Multiple accounting periods• Price established in advance of
work• Periodic payments• Percentage of completion
IRS approach
• Completed contract
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Criteria for Exp. Recognition
• Matched with revenue• Consumption of service or
benefit
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Rev. Recog. When Cash is Uncertain
• Installment method• Cost-recovery-first method
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Disclosure
• Accounting policies footnote
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Inventory Cost Flow Assumptions
• Weighted average• FIFO-first in; first out• LIFO-last in; first out
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LIFO Liquidation
• Sales greater than production• Cash flow increases due to
reduced purchases• Cash flow decreases due to
higher income taxes
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LIFO Characteristics
• Rapid price increases• Provides better income
smoothing in light of inventory change variability
• Tax savings• Industry specific• Larger firm size
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Other LIFO Factors
• GAAP disclosure: LIFO reserve• Stock reaction is inconclusive
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Analytical Considerations
• Cost flow assumption• Price variation & inventory
turnover• LIFO liquidation impact• Inventory obsolescence• Inventory financing
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LIFO - FIFO Adj.
• Inventory value• Working capital changes• Income statement changes• SCF changes
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Fixed Assets--Key Issues
• B/S Amount• Useful lives• Depreciation method• Recoverability• Maintenance & repair expense• Overall issue: undervaluation
potential
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F/A--Earnings Sustainability
• B/S amount vs. replacement cost
• Choice of depr. Lives (instant profit)
• Choice of depr. method
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Intangibles--General
• Expense cost of development• Recognize as asset purchased
intangibles• Amortize up to 40 years• Caution surrounding “in
process R&D”
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S/W Development Costs
• Expense through “tech. feasibility”
• Capitalize, thereafter• Amortize over useful life
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Goodwill
• Results from acquisitions Treat according to GAAP Eliminate from B/S
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Intangibles--Earnings Sustainability
• Generally expense• The above is a questionable
approach• Needed-ways to value intangibles
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Liability RecognitionChapter 8
• Probable future sacrifice• Little or no discretion to avoid• Event has occurred
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No Liability, If...
• Mutually unexecuted contracts• Certain contingencies
Not probable Not measurable
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Controversial Liability Issues
• Hybrid securities• Sale of A/R w/recourse• Product financing
arrangements• R&D financing arrangements• Take or pay contracts• Derivative instruments
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Liability Valuation
• PV of future cash flows > 1 year
• Cost of future deliverables• Cash advance value
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Leases• Operating lease
Expense
• Capital lease Capitalize w/liability SFAS 13
Title transfer Bargain purchase option 75% of life rule 90% of cost rule
Slightly different tax rules
• May want to restate all as capital
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Retirement Benefits
• Pensions (FASB 87 & 132)• Post-retirement Health
Benefits (FASB 106 & 132)
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pensions
Pension Fund Assets Assets-BOP
+/- Actual Earnings+ Contributions- Payments
= Assets-EOP
Pension Fund Liab.Liab-BOP
+ Incr.- Time+ Incr.- Service+/- Actuarial G & L- Payments= Liab-EOP
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Key Terms
• ABO - amount expected to be paid--current salaries
• PBO - amount expected to be paid--future salaries
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Pension Expense
• Service cost• Interest cost• Actual return on plan assets• Amort. of adoption cost• Amort. of PBO increase/decrease• Amort. of actuarial gains &
losses
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Minimum Liability
• If ABO > FV of Assets, then adjust to Comprehensive Income
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Health Care Benefits
• No minimum liability• Minor measurement
differences• Considers income tax impact• Sensitivity analysis• Note politicization on p. 410
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Analyst’s Role
• Awareness of underfunding• Reasonableness of
assumptions• Actual performance vs.
expected performance
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Income Taxes-FASB 109
• Book income• Permanent differences• Temporary differences
Taxables Deductibles
• Taxable income
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FASB 109-History
• APB 11 - income statement focus
• FASB 109 - B/S focus• FASB 109 - Allows deferred
debits
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Implementation
• Determine differences• Eliminate permanent differences• Classify temporary differences• Assess need for valuation allowance
Taxables > deductibles Negative factors Positive factors “more likely than not…”
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Disclosure
• Income tax expense• Income before taxes• Statutory rate reconciliation• Composition of deferred taxes
and assets
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Deferred Tax Liability
• Is it real?• Consider in terms of a “going
concern”
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Analyst’s Role
• Effective tax rate changes• Changes in valuation
allowance• Tax rate by venue• Normalize rate excluding one
time changes
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Reserves
• Matching principle• Exclude expenses• Defer negative asset
revaluation (ie FASB 115)• Difficult to assess & adjust
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Combination IssuesChapter 9
• Corporate acquisitions• Investments in securities• Foreign currency translation• Segment reporting
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Business Combinations
• Purchase accounting Record at FMV Excess to goodwill
• Pooling Assume assets and liabilities Must meet the 12 criteria for
pooling
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Pooling Criteria• 2 year autonomy• independence• single transaction w/in one year• stock for at least 90% of stock• 2 year moratorium on equity interest changes• no reacquisition of shares for bus. Combos• ratio interests remain unchanged• no change in voting rights• no security issues remain outstanding• no reacquisition of securities• no special funding agreements• no disposal plans
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Investment in Securities
• Under 20%• 20% to 50%• Over 50%
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Under 20%
• Held to maturity• Available for sale…
comprehensive inc.• Trading…income statement• Analyst issues
include or exclude adj. from income
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20% to 50%
• Equity method if influence exists
• Analyst issues relationship between income and
cash submerged assets
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Over 50%
• Consolidation• Might want to consider ROA
after inclusion of unconsolidated subs.
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Tax Consequences
• Under 80%…interest or dividends
• Over 80%…consolidated return
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Foreign Currency Translations
• Functional currency Foreign currency
all-current method income stmt. at the avg. rate B/S at end-of-period rate unrealized translation adj. in comp. income
U.S. currency monetary method avg., end of period and historical rates
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FX-Analyst Issues
• Translation adjustments in income?
• Difficult to interpret due to limited disclosure
• Significant international variance in practice
107
Disaggregation of Info.• Disclosure of segments (mgt. Approach)
operating segments geographic locations major customers
• 10% rule• Elements
operating income sales assets
108
Why Value Via Cash Flow?Chapter 11
• Cash = ultimate value• Cash = common denominator
109
Economists & Cash Flow
• Investors spend cash• Accrual method subject to “acctg.
Tricks• Mgt. can manipulate earnings
110
Valuation: Cash Flow Based
• Periodic cash flows• Residual value• Approximate discount rate
Cost of capital
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Periodic Cash Flows
• Unleveraged Excludes interest, debt & pfd. stock Weighted avg. cost of capital Valuation of assets
• Leveraged Includes interest, debt & pfd. Stock Cost of equity capital Valuation of common shareholder equity
112
Periodic Cash Flows, cont.
• Appropriately reflect inflation Nominal vs. real cash
• Use after tax amounts
113
Residual Value
• Horizon = no growth• (last cash flow) x (1 + growth rate)
(discount rate - growth rate)
• Consider conversion tables (Stickney-p. 766)
114
Cost of Capital• Debt
Market rate (1-tax rate) Leases: use borrowing rate
• Preferred Equity Dividend rate
• Common Equity Risk free rate + ß(Mkt. Rate - RFR) Betas published in S&P’s stock reports
115
Releveraging @ New Capital Structure
• BL0=BU[1+(1-tax rate)(Current Debt)] Current Equity
• Substitute BU with new capital structure
• BL1=BU[1+(1-tax rate)(New Debt)] New Equity
116
CAPM Critique
• Unstable ß’s• Unstable MROR• Size vs. ß’s
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Valuation Techniques
• Equity CFU-[(interest)(1-tax rate)]
Cost of equity capital
• Debt plus equity CFU ÷ Wtd. average cost of capital
• Adjusted present value CFU ÷ Unleveraged cost of equity cap. [interest(tax rate)] ÷ cost of debt cap.
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Unleveraging
• CECU = CECL - [(current debt)(1-tax rate)(CECU-CDC)]current equity
119
Cash Flow Evaluation
• Advantages Economic base Rigorous methodology
• Disadvantages Residual value dominant Time consuming Subjective
120
Price-Earnings RatioChapter 12
• Higher risk -> lower PE• Theoretical model
P/Actual earnings = (1+g)/(r-g)
121
Theoretical Variances: PE
• Earnings persistance Transitory…no change in PE Permanent…change in PE
• Accounting principles Lower earnings…higher PE
122
Trending
• Penman found transitory earnings consistency…that is high PE caused by lower than normal earnings is counterbalanced in the following year.
• 5-7 years reversion to mid-teens growth
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PE Ratio Factors
• Risk (cost of capital)• Growth• Earnings persistence• GAAP
124
PE Analysis Keys
• Use a sustainable growth rate• Doesn’t work when g>r• Doesn’t work when g
approximates r• Test reasonableness with actual
PE• Existence of transitory earnings• Impact of GAAP
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Price to Book Value
• Market rewards growth in excess of cost of capital
• Ultimately reverts to 1.0• Function of
Profitability BV growth
126
P/BV-Theoretical Model
• 1+ [(Expected ROCE-r)(BVt)/(1+r)t] … BV0
127
Theoretical Variances: P/BV
• ROCE errors• Cost of capital errors• Growth rate errors• Transitory earnings• GAAP impact
lower earnings…higher P:BV
128
Trending: P/BV
• ROCE remains consistent and reverts to 1.0 slowly.
129
Cash Flow vs. Earnings
• Long term impact is indifferent• Short term impact: earnings
more indicative• Use multiple approaches