Finance&Accounting Uniseminar112

Theory
Finance & Accounting

Academic Year 2012/2013, Block 1
Theory
Uniseminar - Firtance & Accounting
Theory
The Theory
Script summarizes
understandable
examples.
way. Concepts
lt is structured
the most important

important,
the whole theory
parts
are explained
according
of the course
with the help
and
of demonstrative
to the seven weeks of the course and is one of
of your exam preparation.
it is even more crucial to understand
in order to be able to calculate
in a simple
and understand
Although
practice
the basic concepts

all different
is very
of the course
kinds of exercises
and
exam questions.
Table of Contents
Finance
1 Capital Matkets - Risk & Return
2 Capital Structure
11
3 PayoutPolicy
24
4 Capital Budgeting and Valuation
34
5 Options
41
Accounting
57
1 Organizations
57
2 Financial Statements
61
3 Transaction Analysis
67
71
4 Accrual Accounting
5 Short- TermjTrading
Investments
73
6 Receivables
75
7 Inventory & Cost of Goods Sold
81
8 Plant Assets and Intangibles
88
9 Current Liabilities
92
10 The Cash Flow Statement
97
11 Financial Statement Analysis
103
Uniseminar
Theory - Finance
- Finance & Accounting
Finance
1
Capital Markets - Risk & Return
The fundamental principle regarding investments
of any kind (stocks, bonds,
options, etc.) is that investors are risk averse and thus demand a risk premium for
bearing risk. Consequently, the basic capital market model (CAPM) establishes a
positive relationship
between
risk and return.
As the risk increases,
the
associated premium that investors demand increases, wh ich in turn raises the
required return on the investment.
1.1
Risk- Commonvs. Independent Risk
In order to und erstand how the risk of an individual security differs from the risk
of a portfolio composed of different securities, one needs to understand that there

are two types of risk:
Common risk: risk that is perfectly correlated (such as an earthquake

affecting all houses in an entire city at the same time)
Independent risks: risks that do not share correlation (such as the risk of
burglalY affecting one house without affecting alJ other houses at the same
time)
Diversiftcation entails the averaging out of independent risks in a large portfolio

and will be defined more extensively below when applied to securities.
Over a given time period, the risk of holding a stock is that the dividends plus the
final stock price will be higher or lower than expected, wh ich makes the realized
return risky. Stock prices fluctuate due to two types of risk:
firm-speclftc risk - risk due to firm-specific news. Risk that does not affect
the whole market, but only one firm or a small number of firms. lt is also
called idiosyncratic, unsystematic, unique or diversifiable risk
syst:ematic risk - risk due to market-wide news. Risk that affects all
companies to so me degree. It is also called undiversifiable or market-risk
1
Uniseminar
Theory - Finance
As the names already suggest, firm-specific risk can be diversified away in a

(Iarge) portfolio. Contrary systematic risk can not be diversified in a portfolio,
because it affects all firms that are publicly traded. Whereas investors are not
compensated
for holding firm-specific risk, they expect a rislk:premium for
holding systematic risk. The risk premium is also known as the excess return,
which can be defined as the difference between the average return for the
investment and the average return for Treasury bills, a risk-free in~estment.
Diverslfication - refers to the reduction of firm-specific risk. It is achieved

by investing in a variety of assets with different characteristics. The lower_
the correlation
between
the assets the higher is the diversification
potential (exception: correlation of 1 -7 no diversification at all!). The

example below illustrates the effect that diversification has .on firm specific
(unsystematic) risk:
Example:
There are two companies. (1) a car producer (e.g. VW) whos return (revenue)
and consequently its share prke
(hjgher steel prkes
wjJJgo down if the prices for steel increase
= hjgher producUon
costs).
(2) a steel producer (e.g. AcelorMHtal), who 5 return (and share prke)
wjJJ
increase as the prke for steel increases (Le. AcelorMkral returns are negaUvely
correlated with VWs returns).
Now thjnk about what happens ifyou invested an equal amount of money in both
companies and the price for steel increases: The share prke of VW will decreasce
due to high er production costs. However, the decrease in VWS share prke will be
offset by the increase in the pr/ce of AcelorMittal
As a result, a portfolio
containing both firms wjJJeffecUvely reduce the firm spedfic risk that is related
to an increase in the price of steel
A portfolio that contains only systematic risk (where all unsystematic
risk is
diversified) is called an efficient portfolio. A natural candidate for an efficient

portfolio is the market portfolio, which is a portfolio of all stocks and securities
2
Uniseminar
Theory - Finance
traded in the capital markets. The systematic risk of a portfolio can be measured
by its beta, which is the expected percent change in the excess return of a security
for a 1% change in the excess of the market portfolio.
1.2
HistoricalReturnsofStocks and Bonds
The expectl!d, or mean, return is the return we expect to earn on average:
E[R]
= LR PR
Of all possible returns, the realized return is the return that actually occurs over a
time period and consists of both dividend yield and capital gain rate:
R t+l =
DiVt+1 +Pt+1
Pt
DiVt+1
Pt+1-Pt
Pt
Pt
1 =--+--
The average annual return of an investment during aperiod is simply the average
ofthe realized returns for each year:
1.3
R = "iLt=lRt
MeasuringRisk
As mentioned, a stockjportfolio
.'
(unsystematic)
contains two kinds of risk (1) diversifiable
risk and (2) undiversifiable
(systematic) risk. The total risk is
measured by the standard deviation while the systematic risk is measured by a

securities' beta.
1.3.1 Variance I Standard Deviation (Volatility)

ForStDcks
Variance and standard deviation both measure the variability of the returns. The
variance is calculated as the expected squared deviation from the mean (squared
because both negative and positive deviations need to be accounted for). The
standard deviation simply is the square root of the variance and is also referred
Theory - Finance
Uniseminar
to as a stocks' volatility. It serves as a measure for the total risk (systematic and
unsystematic risk) of a security.
Variance (ofthe return distributiollt):
Standard Deviation (Volatility) (ohhe return distribution):
SD(R)
= ,)Var(R)
Variance (ofthe empirical distribution ofrealized returns):
In addition to the formerly provided definitions of risk, one can also use past
returns to predict the future. However, when doing so, the average return is just
an estimate of the true expected return and is therefore subject to estimation
error. The estimation error is measured by its standard error, which is the
standard deviation of the estimated value of the mean of the actual distribution
around its true value:
Standard Error
sv
.,fN
where SO is the standard deviation of the estimate of the average return and N
the number of observation.
iS.
For Portfolios:
By holding portfolios of stocks, firm-specific risk can be diversified and therefore
total risk can be reduced. Thus, when combining multiple securities into one
portfolio, the portfolios variance (and standard deviation) does not only depend
on the standard deviations of the individual securities, but also needs to account
4
Uniseminar
Theory - Finance
for the degree of co-variation
(measured
by the covariance)
between
the
securities' returns. Therefore, the covariance has to be taken into consideration

when calculating a portfolios variance and standard deviation.
Covariance:
Cov(R.
(T
t'
R.)
J
hlstorlcal
= number
_1
T-1
I(R.- t.t
R)1 * (R.J,t - R)
J
ofreturn observations, R = return,
R = expected return)
While the covariance is the product of the expected deviation of two returns from
their means its value does not tell us anything about the exact relationship
between the two securities. A covariance of +10 for Nokia stock might mean the
same as the covariance of + 100 for Google stocks. In order to express it in more
meaningful terms, a new measure
- the correlation
. is introduced.
The
correlation can be seen as the "standardized covariance" and is measured on a

scale from -1 to
+ 1. At the bottom end of the spectrum returns are perfectly
negatively correlated and always move oppositely, whereas at the upper end of
the spectrum returns are perfectly correlated and always move together. When
there is perfect correlation, it is not possible to diversify. Perfect negative
correlation on the other hand, theoretically makes it possible to hold a portfolio
that bears no risk. At a correlation of 0, returns are uncorrelated and there is no

tendency for returns to move together. Independent risks are uncorrelated. The
correlation is calculated by dividing the covariance by each components' standard
deviation:
Correlation:
Corr(R1,Rj)
Cov(Ri,R j)
--+
SD(Ri)*SD(Rj)
Cov(R1,Rj)
Theory - Finance
Uniseminar
As discussed above the variance and standard
deviation of a portfolio are
dependent on the covariance of its individual securities. Therefore, the variance

and standard can be expressed as folIows:
Variance:
(Xj= weight, amount of j held in the portiolio)
Standard Deviation (Volatility):
SD(Rp)
= .JVar(R) = LXj
Each security contributes
*SD(R;)
* Corr(Ri,Rp)
to the volatility of the portfolio according to its
volatility, scaled by its correlation with the portfolio.
1.4
CAPM- The capital priqng model
The CAPMenables us to calculate the expected return of a security, given its beta.
Assuming that capital markets are efficient, the expected return on a security
reflects the cost of capital, which is the minimum return investors require to
compensate them for the systematic risk of that security. Thus, a firm's cost of
capital is the expected return that its investors could earn on other securitiee
with the same risk and maturity. All this can be summarized
equation for the expecb!d return.
The CAPMHquation (costofcapital):
rE = expected return
rf = risk free interest rate
6
by the CAPM
Uniseminar
Theory - Finance
= Beta with Market
rMkt = Return on Market

(rMkt- rr) = Market risk premium
Three main assumptions underlie the CAPM:
1. Investors can buy and seil all securities at competitive market prices (without
incurring taxes or transaction costs) and can borrow and lend at the risk-free
interest rate.
2. Investors hold efficient portfolios of traded securities - portfolios that yield
the maximum expected return for a given level ofvolatility'
3. Investors have homogeneous expectations regarding volatilities, correlations,
and expected returns of securities.
1.4.1 The CapitalMarket Line

The capital market line (CML), wh ich is the tangent line from the risk-free
investment through the market portfolio, represents the highest expected return
available for any level of volatility. By definition, all efficient portfolios are
combinations of the risk-free investment and the tangent portfolio (portfolio with
highest Sharpe ratio) independent of theinvestor's
taste for risk and therefore all
investors should choose a portfolio on the CMLby holding some combination of

the risk-free security and the market portfolio. The Market PortfOlio is the
"hypothetical" portfolio that contains all assets that are traded on all exchanges of
the world. By including all assets it yields the highest degree of diversification
achievable.
Uniseminar
Theory - Finance
- FiIiance & Accounting
Capital
Market
Line
'Slope: Sharpe Ratio
Efficlent
fi'(m~ier
15%
Min. Variance
__WExxon
\:vv~~
):lf'fL<~; '
5%
volatilityduej
Volatilitydue to
diversifyable risk
to undiver.i
sifya~[erisk :
~-~ ;~-d
!-~
"'-)~~-
. ,
20%
10%
40%'
30%
Standard deviation (0)
Exhibit :L.2.1: Capital Marlret Line
The CAPM assumes an efficient market portfolio, which means ,that the market
portfolio does not contain any firm-specific risk. Since inv,estors are only
compensated for systematic risk in terms of risk premia (because firm-specific
risk is diversified away), the appropriate
measure
of risk to determine
security's risk premium is its beta. The beta is a measure of sensitivity of an

asset' s returns to market returns.
Beta
. = SD(Ri)*Corr(Ri,RMkt)
[
SD(RMkt)
Co'o(Ri,RMkt)
Var(RMkt)
The slope of the CMLis the Sharpe Ratio which is a measure of a securities excess
return per unit of risk (reward-to-variahility
ratio). Consequently, it serves as a
good measure to compare different investment opportunities.
Sharpe Ratio
R. - rf
Sharpe Ratioi = -,-tri
Uniseminar
Theory - Finance
1.4.2 The security market line

The security market line (SML) shows the required return for each security as a function
of its beta with the market. The security market Hne relates a securities expected return
to its beta. If all securities are correctly priced they He exactly on the security market Hne
(as depicted in Exhibit 1.2.2.1).
'Slope: Risk Premium
15%
~"-seCUrity
q;, IBM
Market
/'"
Market
10%
Une
NOK/
portfolio,,/r
------ -----------------------~'.APl'lle
/EdlSon
5%
I
I
!
[
0.2
0.6
1.0
1.4
1.8
2.2
Beta (13)
Beta ofNokia
Exhibit 1.2.2.1: Security Market Llne

If securities
are mispriced they do not He on the security market Hne. Securi ti es that
yield a lower (higher)

overpriced
(underpriced)
return than predicted
by the CAPM equation
and have a negative (positive)
are said to be
alpha. This is ilIustrated
in
Exhibit 1.2.2.2.
Overpriced security: given the securities level of risk, it provides a lower return
than it should according to the CAPM equation
Underpriced security: given the securities level of risk, it provides a lower return
than it should according to the CAPM equation
.
.
U.msemrnar
- F.ll)ance &A ccountrng
1
Theory - Finance
i
Security has a positive

alpha: it is underpriced.
Given its Risk () it
provides less return than
expected by SML
I
SML
Security has a negative

alpha: it is overpriced. Given
its Risk () it provides less
return than expectediby SML
0.2
0.6
LO
1.4
1.8
Beta (Il)
Hxhibit;1.2.2.2: Mispriced Securities
10
2.2
Uniseminar
Theory - Finance
CapitalStructure
The capital structure is the relative proportion of debt and equity that make up a
firms total capital. The most common choices are financing through either equity
alone or through a combination of debt and equity. Leverage (=debt) generally
increases the risk of equity even when there is no risk that the firm will default.
As a result, investors require a higher rate of return. This is based on the fact that
shareholders
only have a residual claim on a firm's assets: debt holders are
always served first (seniority of debt) and shareholder get what is left over.
Equity in a firm with no debt is called unlevered equity and represents the
value ofthe unlevered firm (Vu)'
Equity in a firm that also has debt outstanding is called levered equity. The
firm value is called levered value (V L)'
Why does leverage increase the risk of equity even ifthere is no risk of default?
In case that there is no default, all cash-flows from new projects will go first to
debt holders in order to meet the required interest payments. After that the
remaining cash flows are distributed to shareholders. If there are high interest
payments, shareholder
might receive less than they would otherwise, increase
the risk of receiving the full benefits of new investments! Therefore, shareholders
demand a higher return for giving some portion of their cash flows to debt
holders. This means that a levered firm has a higher cost of equity (i.e. the return
wh ich equity holders demand, raises the cost of funding).
2.1
Modigliani-Miller
Modigliani and Miller introduced the concept of perfect capital markets, which are
a simplification of the real world in order to build models that explain the
mechanisms of financial markets.
11
Uniseminar - Finance & Accounting
Theory - Finance
I
2.1.1 Modigliani-Miller (withouttaxes)

I
I
Assumptions:
,
,
'
No taxes, transaction cost '01' issuance cost (for new debt/ e~uity)
I
Trade securities at compe~il:ivemarket prices = to present ~alue of future

I
cash flows
Firm's financing decisionJ do not change the cash flows generated by its
investments, nor do they Jeveal new information about the!TI
MM Proposition I: In a perfect capital market, the total value of ~ firm is equal to

the market value of the total cash flows generated by its assets arid is not affected
by its choice of capital structure.
VL = Vu
Homemade leverage serves as perfect substitute

individuals can either duplicate'
01'
for the Jse

of leverage:
I
undo the effects of corporat~ leverage. Thus,
given the leverage choice of the firm, investors can modify the leverage of their
own portfolio, by either (i) borr6wing and adding more leverage,:or (H) by buying
I
bonds and reducing leverage.
Example 1: Investors preferrin~lt~vered equitycan buy stocks onimargin (borrow

money to buy stocks). By doing so the investor adds /everage to 4,iSown portio/io,.,
Example 2: Investors preierring un/evered equity can buy both the debt an~
equity ofthe firm. By doing so the investor owns both the equity and debt (he is
his own fender), efiminating /everage irom his own portio/io.
In the MMworld, a leveraged recapitalization does not affect the share price of the
firm, since it is a zero-NPV transaction. A leveraged recapitalization is conducted
when a firm uses borrowed funds to pay a large special dividend or repurchase a
significant amount of its outstanding shares.
12
Uniseminar
Theory - Finance
MM Proposition 11:The cost of capital of levered equity is equal to the cost of

capital of unlevered equity plus a premium that is proportional
to the market
value debt-equity ratio.
CostofCapital ofLevered Equity: (withouttaxes)
ru = risk without leverage

!!. (ru - rD) = additional risk due to leverage
E
As explained above, the cost of equity rises with leverage
(as ~
1') since equity
becomes riskier. Recall that debt (0) is usually seen as net debt, which is its debt
less its holdings of excess cash or short-term
investment. Cash is in essence
negative debt.
Unlevered Cost of Capital (pretax WACC):
That is, with perfect capital markets, a firm's WACCis independent of its capital
structure and is equal to its equity cast of capital if it is unlevered, wh ich matches
the cast of capital of its assets.
Levered and Unlevered Betas:
E = u
+ Ei (u
- D)
Recall that the unlevered beta measures the market risk of the firm's underlying
assets, and thus can be used to assess the cast of capital for comparable
investments. When a firm changes its capital structure
without changing its

13
I
i
Theory - Finance
investment, the unlevered beta :will remain unaltered, whereasl the equity beta
I
will change to reflect to reflect ~e effect of the capital structure ort its risk.
Capital structure fallacies:

EPS fallacy: Even in a world of perfect capital markets, increasing leverage can
increase a firm's earnings per share. However, even though it might appear
that this makes shareholder~ better off, this is not true. The reason that the
I
'
increase in EPS does not iaffect the stock price is that I these financial.'
transaction
have an NPV of zero and moreover, the risk of earnings has

I
changed. Therefore EPS is ah unreliable measure across firm with different

I
'
capital structures.'
'
Dilution fallacy: dilution means that if the firm issues new khares, the cash
flows generated by the firm must be divided among a larger number of shares,
thereby reducing the value jOf each individual share. However, (in the MM
world!) this argument igno~es the fact that the cash raisedi by issuing new
shares will increase the firm's assets. In general, as long as th~ new shares are
i
sold at a fair price, no gain o~ loss to the shareholders occurs due to the equity
issuance.
2.1.2 Modigliani-Miller (with taxes)
Assumptions:;
Corporations are taxed Oli earnings (at Tc), after interest dn debt has been
,
paid
There are no transactionscosts
or issuance costs
Individuals and,corporations borrow at the same rate
In the presence of taxation, debt provides an advantage due to the interest tax
shield. It emerges from the fact,. that interest expense (in te rest payments on
leverage) are tax deductible, that is, on the income statement they are deducted
14
Uniseminar
Theory - Finance
before tax is applied (EBIT - I
EBT; EBT - T
Net Income)l. This effect is
called the int:eresttax shield of debt. Since the company can shield some of its cash
flows from tax, debt ultimately increases firm value by the amount of the present
value of the interest tax shield.
If debt is riskless, the applicable interest rate is the risk free interest rate (rf)' If
debt is not riskless, the respective bond yield (rD) is the interest rate that must be
applied. If debt is permanent, it can be valued as perpetuity. If it is not permanent
it has to be discounted every period separately.
Tax shield (assuming permanent debt)
If debt is riskless: Interest tax shield = D

~ and the PV(interest
* rf * Tc
tax shield) if it is a perpetuity
If debt is not riskless: interest tax shield = D

~
and the PV(interest
tax shield)if
D*Tf*TC
TI
=D
* TC
* rD * TC
it is a perpetuity
= D*TD*TC
TI
When debt is riskless, the return to bondholders has to be the same as for a risk
free investment, Le. the risk free rate. If the debt is not riskless, debt holders
demand a premium and the rate of return is rD which is higher than
rf'
MM Proposition I (tax): The total value of the levered firm exceeds the value of
the firm without leverage due to the present value of the tax savings from debt.
VL = Vu + interest tax shield = Vu + TC * D
(irdebt ispermanent)
MMProposition 11(tax): The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is proportional
to the market
value debt-equity ratio.
For a detailed explanation
also see Chapter 4.1: Calculation of Free Cash Flows
15
Theory - Finance
Cost of Capital of Levered Equity(with taxes)
The cost oi equity rises with leverage, because the risk to equity rises with
feverage. However it rises by fels compared to the no tax scenario due to the tax
advantage oi debt!
2.2
'
PersonalTaxes
The value of a firm is equal to the amount of money the firm can raise by iSSUinge
securities. The amount of money an investor will pay for a security ultimately
depends on the benefits (cash fliJws) the investor will receive, after all taxes have
been paid. Just like corporate ta~es, personal taxes reduce the casr flows received
by investors. Although, debt sh1ol.lldincrease firm value, taxes Imay reduce the
:
effect. By accounting for the dilferent rates of taxation the folJowing equation
i
shows the effective tax advantage of debt to all investors:
i
I
Effective Tax Advantage of Debt: !

T*
(l-T;)-(l-Te)(l-Tc)
= 1_ !.l-Te)(l-Tc)
1-Tl
1-Ti
Ti
= tax on interest payments
Te
= tax on equity incorrle
,
I
Tc =
corporate ta rate
(1 -
Ta = Cash flow
(1-
Te)(l
TJ
I
!
!
deHt holder receive
= Cash flow share holders receive
Implications of the effective tu: advantage of debt

The effective tax advantage of debt shows that every 1 received by debt holders
after tax, costs equity holders (1 - T*). Furthermore,
hold:
16
the following conditions
Uniseminar
Theory - Finance
if
Ti
Te -->
T*
if
Ti
>
Te -->
T*
< TC
if
Ti
<
Te -->
T*
>
TC -->
-->
TC -->
VL
> Vu
if
Ti
VL
> Vu
is suf ficiently
high it can be that VL < Vu
The calculation of the levered firm value has to be adjusted for the effective tax
advantage of debt. Therefore in case of permanent debt
Tc
is replaced with
T*
and
therefore it holds that:
2.3
VL = Vu
+ T* * D
WeightedAverage CostofCapital [WACC]
In order to calculate the present
(project), its capital structure

rates are applied to debt
(rD)
value of the cash f10ws of a levered firm
composition matters, because different interest
and equity
(rE)'
As a consequence, the cost of capital
of the firm's assets can be calculated by computing the weighted average cost of
capital (WACC)applicable to a firm's debt and equity portion:
E
E+D rE
+ E+D rD
Pre- Tax WACC: rWACC =
Tax-adjusted WACC: rWACC = ....E-rE

E+D
+ --E.rD * (1 E+D
Tc)
Because the value of a firm (project) is the present value of its future cash f1ows,
discounted at the respective cost of capital, the WACC is extremely important
when it comes to the value a company (project): the lower the WACC(=discount
rate), the higher is the present value of future cash f10ws and hence the higher is
the firm (project) value. Finding the lowest WACCyields the optimal capital
structure.
17
Uniseminar - Fi~ance & Accounting
Theory - Finance
I
40%-
40%
I
_
.~
,;
Co
.1
20%
o
u
.;
10%
c-"""'"
.;
,.;
,-
,;
CostofEquily(r,l,;
,- ,-
20%
,-
,- ,-
Due to interest
tax
.;
.. ,
10%_
WACCwith taxes
---------_
>
...
CostofDebt(rol
11
I Debt-to-Value
,-
.; ,-
Pre-tax WACC(rWACC=rU=r
Al
0%
,;
30%
CostofEquily (rEl,;
....'"
.8Vl
,;
30%
100%
50%
0%
Ratio (D/(D+I22]
i
BxbIblt 2.3.1 eomparlson
_"
50~
I Debt-to-Value R~tio (D/(D+E)) I
ofWACC w1th and w1thout taxes
Cost offtnancia1 Distress. and Bankruptcy
2.4
Debt has the highest seniority In a firm's capital structure. Although, there are
different kinds of debt instrum~nts with different seniorities, anl debt claims are
superior to any equity claim.lf aifirm fails to meet the required iJterest payments
or principal payments, the fi~ is in default! Furthermore,
it 'is distinguished
between a firm facing bankruptcy and financial distress:
Financial Distress
Financial distress refers to a situation where a company Has difficulties
iue
paying off its financial obligations. It can lead to bankruptcy.

i
Indirect costs offinancia1 dIstress: Loss of customers, loss of suppliers, loss

of employees, loss of receivables, fire sale of assets, delayed liabilities, cost
to creditors
Direct costs of financial distress (in case of bankruptcy): filing fees, experts,
accounting fees, lawyer jlegal fees
18
Uniseminar
Theory"
Finance
Note that a decline in value can also be caused by economic distress. ECODomfC
dJstress occurs when a firm experience a significant decline in the value oi a firm
assets, wh eth er or not it experience financial distress due to leverage.
Bankruptcy
A firm is said to be bankrupt when a firm is unable to repay its outstanding

debt obligations. In perfect capital markets bankruptcy simply shifts the
ownership of the firm from equity to debt holders!
Chapter 7 liquidation - a trustee oversees the liquidation of a firm's assets.

The proceeds are used to pay the firms outstanding obligations
Chapter 11 reorganization - the firm is protected from any legal filings and
the existing management has the opportunity to work out a reorganization
plan
When a financially distressed firm is successful at reorganizing outside of

bankruptcy;
it is called workout
Consequently,
the direct
costs of
bankruptcy should not substantially exceed the cost of workout
A prepackaged bankruptcy is a bankruptcy in which a firm will firstdevelop

a reorganization with the agreement of its main creditors, and then file for
chapter 11 to implement the plan (and pressure any creditors who attempt
to hold out for better term). With aprepack,
the firm emerges from
bankruptcy quickly and with minimal direct costs.
2.4.1 Trade-offTheory
The trade-off theory weights the benefits of debt such as shielding cash flows
from taxes, against the costs of debt financing such as costs associated with
financial distress. IncIuding the costs and benefits of debt in the equation of the
levered firm value, this leads to the equation depicted below.
VL = Vu + PV(interest
tax shield) - PV(Financial Distress Costs)
The present value of financial distress costs is determined by three factors:

19
Uniseminar
Theory - Finance
- Fibance & Accounting

I
the probability of financial distress (increases with volatillty of cash flows

and with liabilities as percentage of assets)
the magnitude of the costJ after a firm is in distress
the appropriate discount Jate for the distress costs
Due to the risk of financial distr~ssed, there is an optimal level of leverage where
the potential cost of financial distress are smallest compared tp the advantage
that sterns from the interest tax shield. With no cost of finani:ial distress, the
theoretical value that maximizes the advantage of leverage ~ould be where
interest expense equals EBIT. (In real life most shareholder wold not be happye
I
about such a capital structure, <:lS no money would be left over to be distributed
i
(e.g. in form of dividends) to shareholders).
However, under trade-off theory
firms should increase their leveJage until the optimal level of debt, D*,where VL is
1
maximized while accounting far financial distress costs. At this point, the tax
1
savings resulting from increasing leverage are just offset by the increased
probability of incurring the costs of financiaI distress.
2.4.1 Agency Com

An extension of the trade-off theory includes agency cost into t!he calculation of
the levered firm value. Agency (:ost are costs that arise due to t):1emanagers not
behaving in the best interest
10f
a company's stakeholder
(='equity and debt
holder). We now adjust the formula for the value of the firms to include the costs_
and benefits ofthe incentives th!at leverage provides:
VL
Vu + PV(interest
tax shield) - PVUinancial
.,
distress cast)
- PV(agency cost of debt) + PV(agency benefit of debt)
Hxamples of Agency cost arising from mismanagement

Over--investment Problem (Asset Substitution): When a firm faces financial
distress, shareholders
20
can gain by making sufficiently risky investments,
Uniseminar
Theory - Finance
even if they have negative NPVs Ce.g.projects with a high probability of

default and a very low probability of an extraordinary gain).
Under-Investment Problem (Debt Overhang): When a firm faces financial

distress, shareholders
may choose not to finance new positive NPV
projects Ce.g.when the companies value is already below the value of its
debt obligations, most of the benefits of a new positive NPV project will go
to the debt holders), because some of the gains from investment will
accrue to debtholders.
The debt overhang can be approximated
by the following rule: equity
holders will benefit from new investment only if:
where fis an investment with similar risk to the rest. This rule implies that
the project's profitability index N PV / I must exceed a cutoff equal to the
relative riskiness ofthe firm's debt CDD)/CEE).
Management entrenchment theory - managers choose a capital structure
to
prevent the disciplining effect of leverage. The higher the leverage, the less
money managers can waste on inefficient projects as they need to generate
positive cash flows to meet interest payments and to repay the principle.
Agency Beneftts of Leverage
Concentration of ownership allows original owners of the firm to maintain

their equity stake, where major shareholders
have a strong interest in
what's doing what is best for the firm.
Reduction ofwasteful investments is also achieved by leverage. According

to the free cash flow hypothesis, wasteful spending is most likely to occur
when firms have high levels of cash flow in excess of what is needed to
make all positive-NPV
investments
and payments
to shareholders.
Leverage increases firm value, because it commits the firm to make future
21
Uniseminar - Fi~ance & Accounting
Theory - Finance
interest
payments,
management.
thereby
I
reducing
excess cash flow and wasteful
Managers also display greater commitment to pursue strategies with

i
greater vigor or become 'a fiercer competitor under substantial leverage,
I
because it cannot risk the possibility of bankruptcy.
'
2.4.2 The Optimal Debt Level

Having either
I
tao little or Itoo much leverage
has with; the

i
disadvantages:
Too Little Leverage
I,
Too Much Leverage
Lost Tax Benefits
Excess Interest
Excessive Perks
Financial Distress Costs
fOllowing
Wasteful Investment
Excessive Risk Taking
Empire Building
Under-investment
Note that the optimal capital str,ucture choice also varies with the characteristics
I
of the firm: e.g. R&D intensive firms typically maintain low debt levels, whereas
low-growth mature firm often fall into the high-debt category.
I
2.4.3 Asymmetrie information
In the event that parties
have different
information,
therel is asymmetrie
information. For example, if mapagers have superior information in comparison.

to outside investors with regard to the firm's future cash flo~s. In order to.
convince markets that claims in self-interest are credible, they must be supported
by actions that would be too costly to take if the claims were untrue (credibility
principle). Leverage provides a credible signal of good information to investors,

which leads to the following theory:
Signaling theOlY of debt - the use of leverage as a way to signal good

information about the future prospect of a company to repay the debt in
the future
22
Uniseminar
Theory - Finance
Equity issuance is less credible and is subject to adverse selection:
Adverse selection - the idea that when buyers and seilers have different
information, the average quality of assets in the market will differ from the
quality overall.
Adverse selection has a number of implications for equity issuance:
The stock price declines on the announcement of an equity issuance
The stock price tends to rise prior to the announcement of an equity issue
Firms tend to issue equity when information asymmetries are minimized,

such as immediately after earnings announcement
As can be observed,
asymmetrie
information
has implications
for capital
structure, which is reflected in the pecking order hypothesis, wh ich stipulates that
managers will prefer to fund investments by first using retained earnings, then
debt and equity only as a last resort.
Another implication is that besides the general preference, managers choice of

financing will also depend
underpriced
on whether
they believe the firm is currently
or overpriced by investors, a phenomenon also known as market
timing.
23
Theory - Finance
PayoutPolicy
The decision of a firm, how free cash-flows are paid out to its investors is called
payout policy As depicted in; the figure below, a firm has Ifour options to
1
distribute cash: (1) retain the 1ash, using it to undertake new investments and
thereby increasing the future grbwth potential and thus future cash flows.
I
'
i Free
Cash Flow
investin
New Projects
inltroease
I
uash
Reiserves
Repurchase
Shares
Pay
Dividends
I
.
(2) Retain cash and increase cash reserves which might be important if the firm
has a large amount of short term liabilities

operations
running
(e.g. grocery stores
01'
needs a lot bf
cash to keep
I
need lots of chan~e money).
(3)
Repurchase shares thereby chartging the capital structure of the company. This is
especially favorable if the cOp1pany thinks that their shares are currently
I
undervalued! (4) Paya dividend I to investors thereby increasing investors
Return
.
on Equity (RDE).
24
Uniseminar
3.1
Theory - Finance
Dividends (No taxes)
A company's board determines the amount of the firm's dividend. Below you find
the official procedure for dividend payments.
dedaratioll date - the date on which the board authorizesjdeclares
the
dividend
ex-dlyJdend date - buyers of stock on or after this date do not receive the
dividends (two before the record date)
recorddate-
shareholders recorded on this date receive the dividend
payabJe date - the date when the dividend is actually paid out to the
shareholders
+ In a perfect
capital market, when a dividend is paid, the share price drops by
the amount of the dividend when the stock begins to trade ex-dividend (Just
before the stock is traded "cum-dividend" - with the dividend)
3.2
Sharerepurchases (no taxes)
The firm uses cash to buy shares of its own outstanding stock. In a perfect capital
markets, an open-market share repurchase has no effect on the stock price, and the stock is the same as the cum-dividend price if a dividend were paid instead.
Open Market Repurchase - A firm announces its intention to buy its own shares in
the open market and then proceeds to do so over time like any other investor.
The time interval is not specified and the firm has no obligation to repurchase the
amount it originally stated.
Tender offer . A firm repurchases shares through a tender offer, offering to buy
shares at a prescpecified price during a short time period (usually 20 days). The
price is usually set at a substantial premium to the current market price. If not
enough shareholders are willing to tender their shares, the offer will be canceled.
A related method is the Dutch auction share repurchase, in wh ich the firm lists
different prices at which it is prepared to buy shares, and shareholders
in turn
25
Theory - Finance
Uniseminar
- Fi~ance & Accounting

I
indicate how many shares they a:re willing to seil at each price. Th1efirm then pays
the lowest price at which it can
JUY back its desired

I
number of shlres.
'
Targeted Repurchases - A firm dJectly purchase shares from a major shareholder.

I
~ In perfect capital market~, investors are indifferent between the firm
distributing funds via dividends or share repurchases. By reinvesting dividends
or selling shares, they can replicate either payout method on theil: own.
26
Uniseminar
Theory - Finance
Let' s assume that a Scandiriavian mobile company, Scodia, trades at $44 a share.
Furthermore,
following last year's
outstanding
performance
the manager
decide whether to either pay a dividend of $4 or to repurchase

shareholder
has to
shares. The average
holds 4000 shares of Scodia.
Payout PoJicy Irrelevance
- Is there a difference
between
paying a dividend and
repurchasing shares?
Share price drops by 4 at the
no change in share price because no
announcement
dividend is paid and no taxes are assumed
ofthe dividend
4000 x 44 = 176,000
4000 x 40 = 160,000
4000 x 4 =
16.000
176,000
AW: if the shareholder
does not tender his shares in a repurchase,
his portfolio value
does not change. In both cases the portfolio vaIue is 176,000.

Investor Preference - which method is preferred by investors?
If a dividend were paid but an investor does not want to receive a dividend, he can use
the 16,000 to buy 400 (16,000/40=400)
new shares, holding 4400 shares in total
(scenario A).
If shares are repurchased
but an investor wants to receive a dividend, he can create a
homemade dividend of 16,000 by selling 363.64 or 367 shares (16,000/44=363.64)

(scenario B) leaving 4400-367 = 3633 shares outstanding.
4400 x 40 = 176,000
Seil:
367 x 44 =
16,148
Keep: 3633 x 44 = 159,852
176,000
AW: Absent taxes and transaction
costs, investors are indifferent between the payout
policy of the firm because they can generate the desired cash flows on their own!
27
Uniseminar
Theory - Finance
'*
i
The example above highlig4ts the irrelevance of a firm's payout policy in

;
perfeet capital markets (no tax~s (I), no transaction costs). This has also been
summarized by Modigliani and Mil/er:
MM Dividend Irrelevance - In berfect capital markets, holding the investment
i
policy of a firm fixed, the firm's. choice of dividend policy is irrelevant and does
not affect the initial share price.
to_
Regardless of the amount of cash on hand, under the assumption of perfect

capital markets, a firm can pay a smaller dividend (and use the r~maining cash
I
repurchase shares) or a larger dividend (by selling equity to raise cash) without
I
affecting the share price.
The bird in the band hypothesiS states that firms choosing to pay higher current
dividends will enjoy higher stJCk prices, because shareholder~ prefer current
dividends to future one (with t~e same present value), though according to MM,
the dividend choice should not ~atter under perfect capital markets.
3.4
Payout Policy under Taxe.-s
3.3.1 Tax Disadvantage of Dividehds

I
When a firm pays a dividend, ~hareholders are taxed according to the dividend
tax rate. When shareholders
s~ll their shares (e.g. during a s~are repurchase)
I"
they are subj~ct to capital gdins tax on the profit (loss) tJey make. ThusA
introducing tax in the world ofi perfect capital markets will cHange the payout
policy decision of firms, as the payout policy is no longer irrelevant!
computing the. effective dividend
1JlX
By
rate you can measure the tax disadvantage of
paying a dividend instead of choosing a payout method where the capital gains
tax applies (e.g. repurchasing
shares). Putting it another way, the effective
dividend tax rate measures the additional tax paid by an investor per dollar of
after-tax capital gains income that is instead received as a dividend. Though
dividends have been historicallY taxed at a lower rate than capital gains, firms
28
Theory - Finance

continue
to issue dividends
dMdend puzzle).
despite
their tax disadvantage
Note that the rates have been equalized
(also known
as the
in the USA since 2003.
Hffectivedividend tu rate
Td
= dividend tax rate
TB =
capital gains tax rate
If dividends
are taxed at a higher
prefer share repurchases
rate than capital gains, shareholders
will
to dividends.
Calculate the effective dividend tax rate for an investor (a) ifTd = 30% and TB = 20%
and (b) ifTd = 10% and TB = 15%. Should the company pay a dividend
01'
repurchase
shares to maximize the cash that is distributed to its shareholders?

a) With Td = 30% and TB = 20% the effective dividend tax rate is:
Td
Td - TB 0,30 - 0,20
= --= ---= 12.5%
1- TB
1- 0,20
AW: The positive effective dividend tax rate indicates a significant disadvantage
of dividends compared to capital gains. Each 1 of dividends is worth only (10.125=0.875) 0.875 in capital gains.
b) With Td = 10% and TB = 15% the effective dividend tax rate is:
Td
Td - Tg 0,10 - 0,15
= 1 _ T = 1 _ 0,15 = -5.88%
g
AW: The negative effective dividend tax rate implies that dividends are at an
advantage compared to capital gains. Each 1 of dividends is worth (1-(0.0588)=1.0588) 1.0588 in capital gains.
29
Uniseminar
Theory - Finance
3.3.2 Tax Cliente1es

The rates differ across investors/or
a variety of reasons: income l~vel, investment
horizon, tax jurisdiction, type of investor or investment account.

!
Investors also have different preferences

preferences
regarding the payout policy. These
create clientele ~e(:ts, in which the dividend poliey of a firm is
optimized for the tax preference! of its investor clientele.
Individual investDrs - tax disadvantage

repurchases
for dividend~; prefer
sharee
Institutions, pension fundS -- no tax preference;

!
Corporations - tax advantage for dividends

In addition there is a theoretical effect called dividend-captute theory, which
I
states that in absence of transaction costs, investors can trade shares at the time
of the dividend so that non-taxed investors receive the divid,end. The theory
implies that there should be a -high trading volume (buy and ~ell transactions)
around the ex-dividend day: before the ex-dividend day, high-tax investors will
seIl their shares and low-tax in~estors will buy. After the ex-dividend day these
investors will reverse their positions, thereby taking advantage of their tax
I
brackets.
3.3.3 Cash Retention

If a company retains cash it h~s two options: (1) either invest the cash in new
projects or (2) increase its cash reserves. However, retaining cash can also
increase taxes and create potential agency problems. Absent taxes a firm should
be indifferent between paying out or retaining cash. However, given taxes it can
be costly for a firm to retain excess cash. In the following the no tax scenario and
the tax scenario will be elaborated in more detail:
30
Uniseminar
Theory - Finance
a) Scenario:wJtbmlt taxation
If a company has already invested in all positive NPV projects it cannot generate
superior return on investment than shareholders couId create on their own. Since
in perfeet capital markets buying and selling securities is a zero-NPV transaction,
shareholders
can achieve exactly the same return-on-investment
as the firm
could realize. Therefore, the firm should be indifferent between retaining or

paying out excess cash. This finding is summarized by Modigliani and Miller.
~ MM Payout Irrelevance - In perfeet capitaI markets, if a firm invests excess

cash flows in financiaI securities, the firm's choice of payout versus retention is
irrelevant and does not affect the initial vaIue of the firm.
b) Scenario with taxation

In the presence of taxes, the firm has to pay tax on the interest it receives from its
cash reserves. Furthermore, interest income to the company is also subject to
capital gains tax on the investor level, thus retained cash is taxed twice (once on
the corporate, and once on the investor level). The equation beIow provides you
with a measure of the effective tax disadvantage of retaining cash:
Effective tax disadvantage of retaining cash:
T*
.
retam
= 1_ (l-Tc)(l-Tg)
(i-Ti)
TC
= corporate tax rate
Tg
= capital gains tax rate
Ti
investors individual tax
(1- Tc)(l-
Tg)
= the cash Oows (taxed twice) that Investors would
receive if cash were retained

(1 -
Ti) =
the cash Oow investors would recelve when cash is paid out and
invested by each investor Individually
31
Uniseminar
Theory - Finance
- Fij1ance & Accounting
A firm must balance the tax costs and agency costs of holdin'g cash with the
I
potential benefits of not having to raise external funds in t~e future and of
I
avoiding possible financial distress costs.
3.5
Signaling
The situation in which managert have better information about the prospects of a
company than its investors is referred
informationalasymmetry
to as asymmetrie iIlformation. This
can b~ retlected in the payout policy of a firm and thusa
affects the value of a companyl The dividend signaling hypothesis summarizes.

thisview.
I
;
Dividend signaling hypothesis -ls the idea that dividend changes .retlect managers
views about a firm's future LrningS
prospect. A decrease dn dividends
is
perceived as a bad signal beca~se the firms operations are unli:kely to generate
sufficient cash to meet future e~penses. An increase in dividends !is perceived as a
positive signal, as it retlects thefirm's ability to generate more dash
in the future
,
(it is interpreted
as a long-term commitment as dividends ar~ rarely cut back
after an increase!). Keep the following in mind:
Stock price reactions are disproportional to dividend changes: they are

larger for dividend cuts t~an for dividend increases
Dividends are a weaker signal than debt: debt has strict im'plications (such
as the probability ofban~ruptcy)
..,
An increase in dividends inay also imply lack of investment opportunities

(therefore it can also be accompanied by a decrease in stock prices (highly
unlikely!, but still possible))
Due to the signaling effect of dividends, firms are reluctant to cut dividends and
furthermore adjust their dividends relatively infrequentJy to maintain a constant
32
Uniseminar
Theory - Finance
dividend policy. The practice of keeping dividends relatively constant is referred

toas~~dendmnoodUng.
3.6
Stock dividends, Splits,and Spin-offs
A stock dividend refers to receiving dividends in the form of stock: a 10% stock
dividend means that each shareholder
receives 1 share for every 10 shares
already owned. Stock dividends of 50% or higher are gene rally referred to as
stock splits. Although stock dividendsjsplits
do not change the value, there is still
a valid reason to engage in stock splits: by splitting the stock, the share price is
kept in a price range where it is still attractive to sm all investors. Areverse split is
the reduction of shares outstanding and serves to increase the price when the
share price is in a range that seems to low. Lastly, rather than paying dividends or
its own stock a firm can also distribute shares of a subsidiary in a transaction
referred to as a spin-off.
33
Uniseminar
Theory - Finance
- FiJance & Accounting
Capital Budgeting and Valuation
Company jinvestment
valuation; lies at the heart of corporatej finance and is
widely applied in Investment Banking.

The value of a company jin~estment
can be
,
I
,
'
defined as the present value of all future cash flows. Because we are interested in
the present value, an appropriat~ discount rate needs to be determined.
In this chapter three different valuation procedures will be discussed:
The Weighted Average Cost ofCapital Method
[WACO]
The Adjusted Present Value Method
[APV] :
The Flow to Equity Methold
[FTE]
It represents
the risk compenlation
that stake holders (both, equity and debt
holders) demand for holding securities of the company. The th~ee methods will
be elaborated in the next sections.
34
Uniseminar
4.1
Theory - Finance
Calculations of Free Cash flows [pCP& FCFH]
In order to und erstand the income statement items each of the three valuation
methods is based on, it is essential to understand
how the different free cash
flows are computed.
Sales
Sales
-CDGS
- COGS
Gross Profit
Gross Profit
-SG&A
-SG&A
- other expenses
- other expenses
EBITDA
EBITDA
- Depreciation
-Depreciation
- Amortization
- Amortization
EBfT
(earnings before interest and Tax)
EBfT
(earnings before interest and
Tax)
+ Depreciation
+ Depreciation
- Capital
- Capital
Expenditure
- Change in Net Working
Capital
Expenditure
- Change in Net Working
Capital
The free cash flow tu the firm [FCF] takes all payments (cash flows) to all
stakeholders
(debt and equity holders)
into account. As a result, interest

35
Uniseminar
Theory - Finance
- Firtance & Accounting
payments are not deducted from EBIT,because interest payments are cash tlows
that go to a company's debt holders. Depreciation is added back because it is not
a real cash expense2 The change in NWCrefers to the change between short term
assets and Iiabilities (NWC=current assets - current Iiabilities). It shows how
much money the company has for its operation in the short term~ If the change in
NWCis positive, the amount is subtracted from EBI/net income, a'nd vice versa.
The free cash flow to equity [ptFE] only takes payments (cash tlows) to equity
holders into account Therefore, interest is deducted from the EBIT as interese
payments are made before shareholders
net
borrowings
are
added
are served. Furthermre, increases in
back, since
this
represents
additional
cash
shareholders can use to pay as dividends or invest in projects. It is simply new

debt that is taken on by the company which can be used for any purpose (if you
I
take out a loan you can decide: wh at to do with the money so it represents
an
increase in the amount you can spend).
4.2
The Weighted Average Cost ofCapital (WACC) Method
The WACCmethod determines the firm value to all stakeholders (equity and debt
holders) of a company. The app,ropriate cash tlows to use are the Free Cash Flow
to the Firm (FCF or FeFF) and the discount rate applicable is the WACC.
Procedure:
Step 1- Compute the free cash tlow (FCF) of the company /investtnent
Step 2 - Compute the weighted average cost of capital,
E
E+D
rWACC = -rE
D
E+D
+-rD
.
(1.
tc
rWACC:
E = market value of equity
When machinery is bought this is recarded as "Capital Expenditure" on the balance sheet.
Depreciation only serves as the function to spread the cast of such an investment over its useful
life. That is, when the machinery is bought, cash actually goes out of the company' s pocket. but
the depreciation deductions happen only on paper!
2
36
Uniseminar
Theory - Finance
D = market
value of debt
rE = equity
cost of capital
rv = debt cost of capital

TC
= corporate
tax rate
Step 3 - Compute the present
value of the future
cash
flows of the
company jinvestment:
v:L
FCF1
o = -l+-r-w-Ac-C
+
__ F_CF~2_
(l+rwAcc)2
__F_CF_3_
+ (l+rwAcc)3
+
.
__FC_F~N_
+ (l+rwAcc)N
FCF = Free Cash Flow
Step 4 - Compute the NPVof the company jinvestment:

NPV = FCFo
4.2
+ VL
The Adjusted Present Value Method
The adjusted present value (APV) method is a valuation method in which the
levered Value v of an investment is determined by first calculating the unlevered
L
value
VU
and then adding the value of the interest tax shield and deducting any
costs that arise from other market imperfections.
Procedure:
Step 1- If not given, calculate the unlevered cost of capital,ru:
(= Pre-tax WACC)
Step 2 - Determine the investment's value without leverage (Vu) by discounting

its free cash flows at the unlevered cost of capital, ru:
37
Uniseminar
Theory - Finance
- FiiJance & Accounting
Step 3 . Determine the present v~lue of the interest tax shield.

I
a) Determine the expected inter~st tax shield: given the expectedldebt D on date t,
,
the interest tax shield on date t-if1 is:
interest
tax shield[t+1J
b) Determine the present value
Dt
* TC * rD
bf the interest
tax shield, by discounting at ru (if a
constant debt-equity ratio is maintained):
P V( taxs h.le ld)
Dt * TC * rv
DltH]
* TC * rv
=---+~~--+
1+ru
(1+rU)2
D[t+NJ * TC *tv
...
+~--(1+ru)N :
Step 4 - Add the unlevered vaL~ (Vu) to the present value of the interest tax
I
shield to determine the value ofithe investmentwith
,
leverage (V~):
APV =
VL =
VU
+ PV(interest
tax shleld) - PV(Financial
distress, agency cast, ... )
Step 5 - Determine the NPVof the company jinvestment:
38
NPV = FCFo + APV
Uniseminar
4.3
Theory - Finance
The Flow-to-BquityMethod
The flow-to equity (FTE) method considers the free cash flow that is only
available to equity holders. Hence it takes into account all payments to and from
debt holders, such as interest expense or increases in net borrowing (= taking on
new debt). The cash flows to equity holders are then discounted using the ~
cost of capital.
Procedure:
Step 1- Determine the free cash flow to equity of the investment:
FCFE = FCF - [(1 -
TC)
* (Interest
Step 2 - Determine the equity cost of capital,
Payments)]
+ (Net
Borrowing)
rE'
Step 3 - Compute the equity value, E, by discounting the free cash flow to equity
using the equity cost of capital,
4.4
rE:
MisceUaneousvaluationissues
This section provides some other issues, which may be encountered in valuation.
4.4.1
Project-Based Costs of Capital
In the event that a project is very different from the rest of the firm,
ru can be
calculated by looking at the unlevered cost of capital for firms with similar
business risks. If the leverage ratio also differs from the firm's overallleverage
ratio, the equity cost of capital must be adapted:
39
I
I
I
Uniseminar - FiAance & Accounting

,
Theory - Finance
Hereafter, the
short-cutto
rWACC
can be calcJlated in the standard way. There is however a

!
calculate the projec~-based
rWACC:
4.4.2 APVwith Other Leverage ~(lllicies
A firm could also decide to keep lits interest payments to a target traction of its
FCFin order to maintain constarttinterestcoverage ratio.
I
Assume kis the incremental int~rest payments as a target fraction of the FCF,the
levered valuewithaconstantint!i!tes1:coverage
ratio is calculated by adding the
PV(interest tax shield) to the levered value:
PV(Interest
VL
= VU +
Tck
Tax Shield)=
Tck * VU
(11 -I- Tck) * VU

I
I
40
* PV(FCF)
= Tck
* VU
Uniseminar
Theory - Finance
Options
5.1
Optioncontracts
Options are derivatives that derive their value from some underlying security. To
be specific, a financial option contract gives the owner the right (but not the
obligation!) to purchase or seil an asset at a fixed price at some future date. There
are a number of different components characteristics of an option contract:
Type of option [American/European,
Call/Put)
Position in an option contract (short/long)

Exercise/strike price
Options are used for two purposes: hedging (reducing risk) or speculating
(placing a bet on the direction in which investors believe the market will move).
5.1.1 Type of option

It is distinguished between American and European options:
European options - can be exercised onIy at maturity

American option - can be exercised at any date up to maturity
Furthermore there are two types of options:
caIl option - gives the owner the right to buy the asset
put option - gives the owner the right to seil the asset
The market price of an option is also called to option premium.
5.1.2 Longfshortposition
Furthermore it is distinguished between a long and a short position:
Long position - the buyer of an option (call or put) is in the long position
and has the right. but not the obligation. to exercise the option and
consequently and buy/sell the asset
41
Uniseminar
Theory - Finance

I
Short position - the writer (seiler) of an option (Call/Put~ is in the short

position. He has the obligJtion to sell/buy the asset, in case~the buyer of the
I
option
exercises.
The short position's loss is the IJng positions gain and vice versa.
5.1.3 Option exercise

Maturity/Expiration date - is the date up to which the holder 9f an option can
exercise the option.
~
I
i
Strike/exercise price (K) - is defined in the option contract ami represents the
'
price at which, upon exercise, th1eholder of the option can buy /sell the asset.
5.1.4 Option payoff

A call option gives the right to :buy the underlying for a pre-defined price (the
strike price). It folIows, that if the market price (S) of the underlying is higher
than the strike price it is profitable to exercise the option (the option is said to be
in-the-money). The holder can buy the asset at the lower strike; price and seil it
;
immediately at the higher market price.

,
If the market price is below th~ strike price, the option holder qoes not exercise
and the option expires worthles~ (option is said to be out-of-the-money).
If the strike price equals the mlrket price, the options holder
eioes
thee
not gain but
should still exercise the oPtioJ in order to own the underlying (otherwise
option expires and he is left with nothing). The option is then said to be at-the-
money.
Because a call option is only exercised when the strike price is equal to or is less
than the market price of the underlying, the payoff of a call option can be written
as:
Call option: max(O,S - K)

if K< S ~ call option is in-the-money
42
Uniseminar
Theory - Finance
if K = S ~ call option is at-the-money

if K> S ~ call option is out-of-the-money
A put option gives the right to seil the underlying for a pre-defined price (the
strike price). By the same reasoning as above, it is only worth exercising a put
option if the strike price is above the market price of the underlying, that is, the
security can be sold for more than it currently costs. Therefore the payoff of a put
option can be written as:
Put option: max(O, K - S)
if K > S ~ call option is in-the-money

if K = S ~ call option is at-the-money
if K < S ~ call option is out-of-the-money
5.2
Payoffstruetures
The kink of the graphs below always represents the strike price
00. Because
an
initial premium must be paid to buy an option, the option payoffs can also be
negative. Furthermore, the short position in an option is justthe mirror image of
the long position (as the long positions gain is the short positions loss and vice
versa).
Lang Call
ShartCall
Lang Put
ShartPut
Payoff
K
Option
Premium
As you can see, the short position in an option is always the mirror image of the
long position. Because you have to pay something for receiving a long position in
an option (the option premium), both the long call and long put option graphs
43
I
,
U' nIsemmar
Theory - Finance
F,Imance
&A ccountmg
'
!
i
show negative payoffs if the oJtion is not exercised (negative~initial
price of
option). For the short position i~ the option contracts, the payoff is only positive
!
if the option is not exercised. Fuhhermore, options should always be exercised if

the stock price equals the strike price. Although the initial I?ayoff might be
negative if it is dose to the strike price (for long calls and put$) it will be less
negative than if the option would expire worthless.
Again, to
summarize:
An option is in-the-money
if the payoff from exercising an oPtione
immediately is positive.
An option is at-the-money if the strike price equals the stoc~ price.
An option is out-of-the-money if the payoff from exerdsing the option

immediately is negative.
44
Uniseminar
5.3
Theory - Finance
Optionstrategies
5.3.1 Straddle
A straddle refers to a combination of a long position in a put and a call with the
same strike price and expiration date. It provides a positive payoff as long as the
stock price does not equal the strike price. After deducting the cost of the options,
the profit is negative for stock prices dose to the strike price and positive
elsewhere. Generally it is used for speculative purposes Iike betting on stock price
movements in any direction (+/ -).
Profit/Lass
Lang Call
lang Put
....~
\
S"k
tn e
\ Price ...
....................
'i.
Stock Price
at Expiration
5.3.2 Strangle
A strangle is a combination of a long position in a put and a call with different
strike prices and same expiration date (where Kp < Kc). When the stock price is
between the two strike prices, there is a negative profit. Everywhere else it is
positive. Generally it is used to bet on large stock price movements in any
direction (+/-).
Profit/Lass
Lang Call
Lang Put
I\-
11
...
\
\
K,
K,
:
\
.... X_._.:..
- -
"
StockPrice
at Expir::ltion
45
Uniseminar
Theory - Finance
5.3.3 Cosdess Collar

A cosdess coUar is a combination of a long position in a put and short position in a
I
call option (where Kp < Kc). The .cost of the put option is covered Py the price that
is recovered in the sale of the daJl. The benefit to the hedge is that it locks in a
double-digit rate of return, if prices fall at the cost of capitalizatioh and the rate of
I
return if prices rise. It is a tool that is essentially used in risk management to fix
I
the price of an asset in a given range (between the two different strike prices).
Profit/Lass
Short (all
lang Put
Payoff
,\1
'J\
A"
.~\
~: ~
:.i<;... "....
"1
" '\
AI<;" ",
I"
- - - - -'-:.,
_.t ..
C::::"
'....
Stock Price
at Expiration
.' ..'<l
\I
5.4
Put-CallParity
The put-call parity describes th~ relationship between the value of a stock (S), a
bond PV(K), a call (C) and a put (I') option as folIows:
S+P=PV(K)+C
From this it folIows:
c = P +S
C =P
+S -
PV(K)
for a non-dividend paying stock
PV(K) - PV'(Div)
for a dividend paying stock
The reasoning that underlies the Put-Call parity is that the portfolio of a stock and
a put option should yield the same payoff as a portfolio of a bond and a call
option.
46
Uniseminar
Theory - Finance
The figure below illustrates this:

Call
Put+ Stock
+ Bond
;~
.....
Put
Option
Call
OPtio.~,/
Payoff
......
Bond
.'.'
,
5.4.1Intrlnsic & Time value

Intrinsie value is the value of an option if it would be exercised immediately.
Based on the Put-Call parity, call/put options can be decomposed into intrinsic
and time value. To do so PV(K) needs to be rewritten
as K-dis(K) which is
equivalent of saying that the present value of the strike price is equal to the strike
price minus some amount X (= dis(K)). The example below illustrates this:
PV(K)
= 2..=
l+rt
1000
1.05
952.38 or PV(K)
K - dis(K)
1000 - 47.62
952.38.
From this it follows that the intrinsic value and the time value of an option can be
written as:
Call option:
C =
"--,-J
S- K
Intrinsic Value
~+
dis(K)
+P
Time Value
As lang as the interest rate remains positive PV(K) can never be negative.
Therefore, European (and) call options on non-dividend paying stocks always
47
Theory- Finance
Uniseminar- Fin,ance& Accounting

,
have a positive time value. Ther~fi1re, they cannot seil for less th~n their intrinsic
,
'
value
Put option: P =
K-S
L-.,--J
c." disSK) + S
I
TimeValue
lntrinsic Value
Because PV(K) has a negative c~elfjcient, the time value on European put options
can be negative if the option is suffJciently deep in-the-money
I
iln that case the
European put options will seil fdrless than its intrinsic value.
Does it ever make sense to exen:!ise a put option early?

!
YES!- But this holds only for American put options if they are sufficiently deep in
I
the money (European options dnnot be exercised early!)

!
5.4.2 Arbitrage Bounds on Option l?rices
An American option cannot be worth less than its European counterpart
(as
American options can be exetcised at any point in time up to rhaturity)
An American option cannot be

worth less than its intrinsic value
(as it can be
,
I
exercised at any point in tim~)
An American option with a later exercise date cannot be wqrth less than an
otherwise identical America~noption with an earlier exercis~ date (does not
hold for European options, European options with longer m1turity can trade
at a lower price)
A Put option cannot be worth more than its strike price (right to seil: if stock
price drops to 0 the max value of the option is K-S= K-O=K)
A call option cannot be worth more than the stock itself (right to buy: the
maximum payoff of a call option is S-K, therefore
S represents
the upper
boundary to the option payoff)
An American call on a non-dividend paying stock has the same price as its
European counterpart
48
Uniseminar
Theory - Finance
An American call on a djvjdend payjng stock can be worth than an otherwise

identical European option if PV(Div) is large enough, wh ich means the time of
a European call can be negative whereas it cannot for the American call.
An American put option can be worth more than an otherwise
identical
European option if the put option is sufficiently deep in-the-money, which

means that the discount on the bond value will be large relative to the value of
the call and the time value of the European put option will be negative
5.4.3 Options and Corporate Finance

Equity as a call option:
Equity can be represented
as a call
option with a strike price equal to

Firm assets
the value of debt outstanding. If the

firm's vaIue does not exceed the
value of debt, the firm must declare
bankruptcy
receive
value
and
nothing.
is larger
equity
holders
However, if the
than
the
debt
outstanding, the equity holders get
..
....
.
,,
....."
.-
.,.-
..-
.- .-
.- .-
.-
Firm asset value
what is left after the debt has been

paid.
Debt as an option portfolio:

The debt holders can be seen as owning the firm and having sold a call option
with a strike price equal to the required debt payment. If the value of the firm
exceeds the required debt payment, the call will be exercised and debt holders
will receive the strike price. If the value does not exceed the required debt
payment, the call will not be exercised and the debt holders are entitled to the
firm's assets.
49
I
I
I
,
Uniseminar - Fihance & Accounting
Theory - Finance
Corporate debt can also be seen: as a

portfolio of risk-free debt minus a
short position in a put option on the
Firm assets
firm's assets with a strike price

I
equal to the required debt payment.

If the assets are worth less than the
required
debt payment,
Rbk-free bond
",,"
""1"
,; ~ '
/"
,,
Less: caU
optin
the debt
holder will receive just the assl:1~;.If

the
firm
portfolio
value
holder
is
greater,! the
Firm assel value
will receive' the
required debt payment.

I
A credit default swap is when a puyer pays a premium to the seiler and receives a
payment to make up for the 'lass if the underlying bond defaults. It can be
represented by adding a long put option to risky debt, which i~ essence creates
risk-free debt.
50
Uniseminar
S.S
Theory - Finance
OptionPricing
5.5.1 Binomial Pricing Model

The price of an option depends on the fact if the stock will go up or down in the
next period. From the stock price movements the price of an option can be
calculated. The figure below depicts the basic steps for call and put options. Cu
(Pu) and Cd (Pd) stand for the value of a call (put) option if the price goes up or
down, respectively.
Put Option
Call Option
Cu max(S-K,O)
Pu max(K-S,O)
Co max(S-K,O)
PD max(K-S,O)
Option Price (tor call and tor put optiollll):
B = Cd-Sd!J.
l+Tf
Option price (e or P) = Sb.
+B
You own a European caff option witb strike price (K) oi32! Tbe current stock price oitbe
underlying is 30. During tbe next pe/iod, tbe stock price can eitber go up or down by 5.
Tbe risk free interest rate (rr) is 5%. Wbat is tbe vafue oi tbe option today?
/35
Cu max(35-32, 0) = 3
~25
CD max(25-32, 0)= -7 = 0
30
c = SIJ.+ B
= 30
* 0.3 -7.143
= 1.86
-7 This example is a simplification. Usually there are more than two possible and more than
one period.
51
Uniseminar
Theory - Finance
- Finimce & Accounting
5.5.2 Black-Scholes Model

I
The Black-Scholes Model is an alt~rnative model that can be used
fO
.
price optIOns
on non-dividend paying stocks. IIt

is derived from the Binomial I option pricing
,
model and requires five input vaiiables:
(1) S = current tock prick
i
(2) T = number o[ years
(3) K = exercise price
(4) rf = the risk [ree intbrst rate (to compute PV(K))

(5)
Cf
= annual volatility!
I
The price of a call options is com~llted as folIows:

1
C =S
* N(d1)
d = In[SjPV(K)]
u*..fi'
PV(K)
* f(dz)
* N(dz)
B = -PV(K)
1
+ u*..fi'
z
The Price of a put option is comJuted as folIows:
PV(K)
* [1- N(dz)]!-
S * [1- N(d1)]
41 Ll = -[1-
N(d1)];
B = PV(K)
* [1 - N(dz)]1
The advantage of the Black-Scholes Option Pricing Model is that the only variable
input is the volatility. All other variables are known. Therefore, it is easy to
implement and much quicker than the procedure of the Binomial Option Pricing
Model.
3
4
From the Binomial Option Pricing Model it is known that C = S

From the Binomial Option Pricing Model it is known that P = S
52
* /1 + B
* /1 + B
Uniseminar
Theory - Finance
5.5.3 Risk-Neutral Probabilities

The Binomial Option Pricing Model just randomly assumed what the stock price
will be in the future, without assessing the probability that the stock price will
have the predicted value. If he probability of each possible future stock price
were known, one could simply discount it at the appropriate
cost of capitaI.
However, it is extremely difficult to calculate the cost of capital of an option. The
risk-neutral probabilities provide an easy approach how this problem can be

circumvented: assuming that all market participants are risk neutral, all financial
assets should have the same cost of capital, namely, the risk free interest rate. The
value of an option can then be calculated by computing its expected payoff using
the risk-neutral
probability and discount the expected payoff at the risk-free
interest rate.
The probability of that the stock price will go up in the next period is:
The value of e.g. a call option is the computed as folIows:

(1) compute the value of all end nodes (Cu, Cd)
(2) calculate p, the probability that the stock price goes up
(3) calculate (1 - p), the probability that the stock price goes down
(4) multiply each call options end node value with the respective probability.
Note: as you move along the branches (more than one period) you have to
multiply the probabilities
witch each other. The figure below illustrates the
procedure:
53
Uniseminar
Theory - Finance
- Fihance & Accounting
Option Price= Cl x 0.4 x 0.4
Su
SDU
or UD
SDD,
Option Price= 2 x C2 x 0.4 x !0.6
Option Price = C3 x 0.6 X 0.61
-7 Option Price att=O:

(Cl X 0.4 x 0.4+ 2 x C2 x 0.4 x 0.6 + C3 x 0.6 x 0.6) /
(i +rf)A2
-(1+rrJ"2 because oftwo time peIiods

- Calculation of Cl, C2 and C3 the same wayas with the binomial
optinon model: C = max (S-I(, 0)
Note: Risk neutral probabilities
are also called state-conungent prices, state

!
prices, or martingale prices!
5.5.4 Risk and Return of an Option

To measure the risk of an option we must compute the option be~a:
511
option
= 511+B * s
511
511+B
* Il
where,
is the stock's beta and
t1 = N(d1)
B = -PV(K)
is the bond's beta
* N(dz)
The beta of a call option, on a stock with a positive beta, always exceeds the beta
of a stock. The beta of a put call option, on a stock with a positive beta, is always
negative.
54
Uniseminar
Theory - Finance
The expression ~
sa+B
is also known as the option's leverage ratio and it is the ratio
of the amount of money in the stock position in the replicating portfolio relative
to the value of the replicating portfolio (or the option price).
5.5.3 Real Options

A real option is the right to make a particular business decision. There are many
types of real options, but the following four are quite typical:
The option to delay an investment opportunity: the decision to wait often
involves a trade-offbetween
costs such as the competition catching up and the
benefit ofremaining flexible and waiting for more information.

Growth options: the option to invest in the future and expand
Abandonment options the option to disinvest in the future
Replacement options: the option to for instance replace an older technology
bya newer technology without adopting the new technology at the moment
55
Theory - Finance
56
!
Uniseminar - Fi&ance & Accounting
Theory - Accounting
Uniseminar
Accounting
1
Organizations and Conceptual Framework
1.1
Forms of Organizations
There are different types of organizations, wh ich differ in several characteristics

as ownership, accounting, etc. The most common forms are:
(Sole)
proprietorship
- is a small business owned and managed by one
person. The owner is personally liable for the business and its operations. If the
business is unable to repay its debt he will have to draw on his personal
resources to cover the debt obligation of the business.
Partnership
- is a business that is owned and managed by more than one
person. Every partner is only liable for his own actions, however the partners are
together fully liable for the whole business. The partnership is ended if one of the
partners leaves the contractual agreement (withdrawal or death).
Limited
Partnership
- is a form of business with two different kinds of
owners: the general partners and the limited partners. General partners
the business and are fully liable. Limited partners
their liability is limited to their investment.
contractual
agreement
run
cannot run the business and
If a limited partner
leaves the
this has no effect on the existence of the business.
However, upon a withdrawal of a general partner the partnership is dissolved.

Limited Liability
Company (LLC) - is a form of business that is exclusively
owned and managed by limited partners. The business, not the owners, is liable
for the company's debts (no personalIiability!).
Corporation
- is a legally defined, artificial being that is separate from its
owners. The distinguishing characteristic
is the separation
of ownership and
contro!. Because of that, the owners of a corporation (shareholders)
are not liable
for the corporation's debts and vice versa. The liability of the corporation is born
by the
management.
The percentage
of ownership
in a corporation
decomposed into shares of stock and the owners of a corporation
is
are called
shareholders or equity holders. They are entitled to dividend payments.

57
Uniseminar-
Theory - Accounting
Firjance & Accounting
1.2 Accounting
I
I
Accounting
is the language
the stakeholders
documenting
processes
of business
of a business.
information
by wh ich information
It is the process
(about
these data into reports
the
is communicated
of identifying,
operations
measuring
of a business).
and communicates
financial
to
and
Accounting
information
in the
form of financial statements.

All companies
(small or large) tise accounting
methods.
It enabl~s a company
check whether
all operations
are running
inefficiencies,
and thus providek
Furthermore,
accounting
most cases companies

business.
Therefore
Management
need money
information
for
Management
Accounting
company
Accounting
management
example
is n?t
to run, expand
to the outside
IFRS (International
and
imProvements.e
o~ maintain
which in turn require
In
their
some security
and
There are two types of AccQunting:
for
processes.
example
regulated
for
by any
- cre~tes financial
Financial Accounting
the
(Generally
It creates
higher-(evel
higher
statements,
stakeholders,
underlies
who
certain
Financial
financial
managers.
au!thority,
Le. any
accounting.
in ord1er to report
do not take
regulations,
Reporting
part
the
and rules, as
Standards)
or
fo_
in the
GAAP
Accepted Accountin& Principles).
(Finance
Accounting
58
in order
- lis about internal

levels,
efficiency
firm performance
treated
different
for possible
can choose on its own how to organize their management
Financial
In this
processes.
helps to d1etect errors
an image to the outside ,stakeholders.
they need i1vestors,
Accounting
as intended,
insights
communicates
insight into the company's
to
and
&) Accounting
it's procedures,
in the Accounting
course
since
we
will
Management
1.2 course in your first year.
only
talk
about
Accounting
was
Financial
al ready
Uniseminar
1.3
Theory - Accounting
The Conceptual Framework
The conceptual
assumptions
framework
represents
guiding the presentation
the basic objective,

and preparation
principle
of general
and
purpose
financial statements. The following figure represents the conceptual framework

of accounting:
The qualitative characteristics

einformation
of accounting describe attributes that make the
provided in the financial statements useful to users:

Understandability:
accounting
information
(and vocabulary)
must be
sufficiently transparent so that it makes sense to users of the information.

Reliability:
in general, informationis
reliable if it is complete, free from
material error or bias, prudent, and can be expected to faithfully represent the
economic substance of the underlying event or transaction.
Relevance:
information
must be capable of making a difference to the
decision maker, having predictive or feedback value.
59
Uniseminar-
Theory - Accounting
Comparability:
it is important
that
the
basis
of pteparation
and
presentation remains compa~able over time. It does not mean uniformity, nor
continuing to use the same :accounting principles when more relevant and
reliable alternatives exist, however it must be comparable.
With regards to the assumptions of financial reporting, there are ~o:
i
Accrual basis: transaction$ and other events are recognizedlwhen they

occur and not when cash is re'ceived or paid.
Going concern: we assumelthat the entity will continue to operate long

I
enough to use existing assets fr its intended purposes, which means that it
does not have the intention nor need to liquidate or curtail materially the scale
of operations.
The elements of financial statements

on which statements are build
are:
I
I
.
'
Assets are economic resourJes controlled by the entity which are expected to
produce future economic beJefits to the entity.
I
Liabilities
are present obligations ofthe entity wh ich are expected to result
in an outflow of economic benefits from the entity.
Equity is the residual interest in the entity's assets after ded~cting the
liabilities and are a shareholder's residual claim to the assets.
Income is increases in economic benefits during an accountirlg period

resulting in an increase in eqhity other than those related to transactions with
I
shareholders.
o Revenue arises from ordinary course ofbusiness
o Gains may or may not arise from ordinary course ofb~siness
Expenses
decreases in economic benefits during an accountihg period
resulting in an increase in equity other than those related to transactions with

shareholders.
o Expenses arises from ordinary course of business
o Losses may or may not:arise from ordinary course ofbusiness
60
Uniseminar
Theory - Accounting
Financial Statements
Financial Accounting provides information for people outside of a firm. The

information is conveyed in form of financial statements,
which are business
documents that companies use to represent their finances to the public. There are
four important financial statement documents wh ich will be addressed in the
following:
(1)
Statement of Comprehensive Income (Income Statement)
(2)
Statement of Changes in Equity
(3)
Statement of Financial Position (Balance Sheet)
(4)
Statement of Cash Flows
These
statements
communicated
are
the
effective
to stakeholders.
means
Furthermore,
with
which
international
such as IFRS make it possible to draw international
information
standardized
comparisons
is
rules
between
different companies based on these documents.
2.1
Income statement (Statement of Comprehensive Income)
The income statementreports
revenues or expenses for the period and measures
the operating performance of a business. The bottom line is the net profit/loss or
"Net Income". It teils how well a company performed during the period, that is,
whether its operations have been profitable or not.
2.2
Net Income
Total Revenues and Gains - Total Expenses and Losses
The statement of Changes in Equity
The statement
of changes
in equity
provides
a reconciliation
of the
movement of equity items during a financial period. It basically shows how a

company used its net income. The most important items are shareholder equity
at the start of the period, net income, (share issuance, share cancellation,)
dividends paid and ending shareholder equity:
61
Uniseminar-
Theory - Accounting
Fin~nce & Accounting
Beginning equ,ity
,
+ Net
income (-Net lass)
- Dividends ~
= Ending
equi'ty
a.
Sometimes companies will alsoi~;sue or buy back shares in th~ir Statement of

Equity, where issuing shares has a positive influence and buyin~ back shares
negative influence on ending equity. The fact that income iqcreases equity,whereas expenses decrease equity, is usually shown as an incr~ase to retained
earnings for net income or a decrease to net earnings for net loss: '
Beginning balance of retained earnings

dividends for the period
2.3
=: ending balance
i
Balance Sheet (Stateklent
The balance
+ net income (<:ir- net loss) of retained earnihgs
of financial position~
I
sheet shows the financial position of a company at a specific point
I
'
'
of time. It reports 3 items: assets" Iiabilities and stockholders' e4uity (or simply
equity). Assets are recorded at the left hand side of the balance Isheet (or at the
top) and Liabilities plus Shareholder's equity are reported on thJ right hand side
,
th_
(or at the bottom). The balanc~ sheet gives investors an idea of how much has
been invested in the company, ihat the company owns and what it owes. As
name already implies, the two ]sides of the balance sheet have to balance out,
which is referred to as the accounting
equation.
The rationale behind this is
that the company has to pay fr all assets it owns by either borrowing money
from creditors (liabilities) or to raise money from shareholders (equity).
62
___
i_
Theory - Accounting
Uniseminar
The Accounting
Equation - Assets
Liabilities
+ Owners' Equity
Equity
Assets
Liabilities
Assets
- are any economic resources
of a company Ce.g. cash, inventory,
equipment, land) that provide a future benefit to the company.
Current assets
- are short-term
They are representative
assets that are due within one year.
for the liquidity of a company. Current asset
accounts are: Cash, Short-term investments, Accounts receivable, Notes

receivable, Merchandise lnventory, Prepaid Expense.
Non-current
assets
- all assets with a longer lifetime than one year. E.g.
Property, Plant and Equipment, Intarigibles and Investments.
Liabilities
- are a company's legal debts or obligations to outsiders that arise
from its business operations Ce.g.debt, notes payable).
Current liabilities
- are short-term liabilities that are due within one
year. Examples are: Accounts payable, Income taxes payable, Short-term

borrowing, Salaries and wages payable.
Non-current
liabilities:
All liabilities with a maturity of longer than
one year.
Shareholders'
equity
(capital)
- represents shareholders' ownership of the
business's assets. Its' two main components are paid-in capital and retained
earnings.
63
Uniseminar-
Theory - Accounting
2.4
Statement
The statement
Fi~ance & Accounting
of Cash Ffows
of cash flows measures cash receipts and cash payments. The
I
activities
of a company's
opJrations
are subdivided
into three
!
categories
according to which the respective cash flows are calculated:

(1)
Operating activities
(2)
Investing
activities
- records the sale of goods or servires to customers

~ records
investments
in non-current
assets
(purchases) and
sales of non-current
machinery)
(3)
Financing
~
activities
assets
(buildirlgs,
I
(Le. cash flows related to debt and equity
holders). It records the i~suance of stock, dividend pay1ents
as weil as
in bo~rowing (taking on/ paying off nJw debt.)
I
shows the effect that the :accounts
of the
The cash flow statement therefore
,
!
balance sheet and the income stktement have on the "cash and cash equivalents"
I
item on the balance sheet. The hottom line of the cash flow statement, the "net
I
cash flow", represents the increqse/decrease

one period to the next.
64
- states all cash flows related to tne

financing of a
I
company's capital structure
increases/decreases
equipment,
in "cash and cash equivalents" from
Theory - Accounting
2.5
Relationship
between
It is of great importance
statements.
accounting
that you understand
Understanding
procedures
the processes
between
the financial
this will give you a general understanding
of the
and make other things way easier:
Revenue
- Cast of Goods Sold
Grass profit
- Selling, Administrative
& General (Rent, Salaries)
EBITDA
- Depreciation
- Amortization
EBIT
- interest expense
Pretax Income
-Tax
100,000
25,000
75,000
30,000
Current assets
Cash & Cash equivalents
Accounts Receivable
lnventories
Total current assets
Non-current Assets
Property, Plant, Equip.
- Ace. Depreciation
Total Non-current Assets
Total Assets
Netlncome
Liabilities
Current Liabilities
Aeeounts payable
Short term borrowing
Total current Liabilities
8,000
2,000
10,000
Non-current Liabilities
Long-term Debt (rD=l 0%)
Other L- T Liabilities
Total Non-current
Liabilities
Net Cash by Operating
Net Cash by Investing
Net Cash by Financing
Net Cash Flow
Cash balance beginning
Cash balance end of the
Activ.
Activ.
Activ.
year
year
Shareholders'
Share capital
Retained Earnings
Total Sh. Equity
Total Liabilities and

Shareholders' Equity
E ui
70,000 .
65
Uniseminar-
Theory - Accounting
The net income from the Income Statement enters th~ Statement
i
Changes in Equity. It increases
equity balance at the end of the
year.
,
I
of
f) The ending equity on the statement of Changes in Equity enters the balance
sheet und er Total Shareho:Jders equity, wh ich is equal to die share capital
and retained earnings.
The Cash Flow Statemen~ shows the actual changes in <;ash that occur
during a year. The Net Cash Flow is the cash amount by which last year's
cash balance (20XX) is: increased
to yield this year's
cash balance
(20XX+1). This year's en1ing cash balance enters the balance sheet undere
the name Cash (and cash equivalents).

I
The Accounting Equation: :,set = Liabilities + Shareholder:'s Equity!
i
G Accumulated depreciation!expense of 50,000/10(years)
== 5,000.
When the company make~ an investment and buys e.g. m'achinery this is
recorded in the Cash Flow Statement (Investing Activiti~s). However, in
order to provide a more a~curate figure (that the machine \s used for more
than the year it was bought in, let's say 10 years) only part of the cost of
the machine is sUbtracte9 as an expense for the next 10 y~ars: the annual
depreciation amount. If thietotal cost of the machine were subtracted in the
I
year it is bought, the net income on the income statement would be
i
I
understated in that year <'mdoverstated in the remaining years where the
I
i_
machine operates. Therefore depreciation is only a theon!tical expense on

paper but it is NOT a cash:expense!
o A company
has to pay ~nterest on its debt (e.g. a bank loan). This
recorded on the Income Statement:

interest expense
66
D * cast o{ debt (rD)
= 50,000 * 10% =
5,000
Uniseminar
Theory - Accounting
Transaction Analysis
3.1
The Account
An account
is the record of all the changes in a particular asset, liability, or
shareholders' equity during aperiod. For all three categories; there are a number
of items, which you will gene rally encounter for most firms:
Assets:
cash, accounts receivable, notes receivables, inventory, prepaid
expenses, land, buildings, and equipment, furniture and fixtures
Liabilities:
accounts payable, notes payable, accrued liabilities
Shareholders'
equity:
share
capital, retained
earnings,
dividends,
revenues and expenses
3.2
The double entry system and T-Accounts
IFRS as requires double entry accounting. This means that every transaction is
recorded twice: For each transaction there must be one debit and one credit entry
so that the total amounts of debits and credits are balanced out.
Principle
of duality - every economic event (e.g.) transaction has two aspects:
giving something for receiving something. In terms of accounting this means that
each credit entry must have a complementary debit entry and vice versa.
Therefore
represented
each transaction
affects at least two accounts.
Accounts
are
in the form of the letter T (t-account). The left side is called the
debit side and the right side is called the credit side. Thus, the t-account helps
to keep track of all transactions
and enables management to draw inferences
about the company's operations. Such a T-account is presented below:
Account
Debit
Credit
As already stated above, every business transaction involves both adebit and a
credit
However debiting and crediting has different
effects depending
on
67
Uniseminar-
Theory - Accounting
I
I
Firjance & Accounting
whether an asset or a liabilitY/equity account is affected. The figure below

!
summarizes the debit and credit system for the balance sheet.
Assets
Deblt(+)
Credit(-)
Liabilities
Deblt:(-)
Credit(+)
Shareholder' s Equity
I
I
Credit(+)
Deblt(-)
~
3.3
Journal Entries
The journal is a chronological,record
of transactions.
The jOur~aliZing process
consists ofthree steps:

(1)
Specify each account affected and classify each account by type (asset,
liability etc.)
.
(2)
Determine whether each Jccount is increased or decreasedi
(3)
Record the transaction, ihc:lUdinga brief explanation. First the debit and
!
then the credit transaction is recorded!
A company is taking a bank loan oi 50, 000. How does the resp:ective
journal entry look like?
68
Theory - Accounting
3.4
Ledger
The ledger is a grouping

have
opening
accounts).
(permanent
with their balances.
accounts)
and others
Make sure that you know the difference
Permanent
balance
balances
of all the t-accounts,
Accounts
- are accounts
(e.g. Cash, inventory,
Temporary
Accounts
income statement
accounts
that
between
have
Some accounts
do not (temporary
these accounts.
adebit
or credit
opening
etc.)
- are accounts
are temporary
that are closed

accounts
after
every period.
(e.g. all expenses
All
or revenue
accounts).
Below the cash t-account is shown. The col1ection of many t-accounts is cal1ed Ledger.
Therefore, the example below is NOT a ledger but only an example of what one TAccount in a ledger might look like. Furthermore,
remember
that cash is an asset
account tiJat increases when it is debited.
Cash sales
100,000
Rent Expense
10,000
101,500
Salary Expense
20,000
Depreciation expense
5,000
Interest Expense
5,000
Dividend
5,500
Other expenses
41.500
86,500
Ending balance
15,000
69
Uniseminar- Finance & Accounting
Theory - Accounting
Note: You should practice the recording of transactions
a lot. There \Ire always exam
questions concerning these entries. Go therefore through the tasks o~ the course and
try to do the tasks on your own a~ain and don't just read the solutiohs. Furthermore
I
we have supported
you with additional
exercises
(-7 Practice
Part) that allow
deepening your knowledge in a practical way.
By listing
shareholders'
all accounts
their
balances
equity - one can show whether
listing of accounts
70
with
is also knownlas
- assets
first, then
liabilities
and
total debits equals total credit. This
a trial balance.
Theory - Accounting
Uniseminar
Accrual Accounting
Accounting can be either based on the accrual basis or the cash basis. IFRS
requires accrual accounting.
Accrual accounting
. this system records the impact of a business transaction
as it occurs, irrespective if cash is receivedjpaid or not.

Cash basis accounting
. this system only records cash transactions. that is, it
only records a transaction if cash is actually receivedjpaid.
If a company would
buy new equipment this month but pay it next month, cash basis accounting
would record this transaction in the month when the payment is made.
-+
compared to accrual accounting, cash basis accounting fails to relate efforts
and accomplishments
within the same time period, since expenses and revenues
are not matchedl This violates the very basic principles IFRS requires.
To use aecrual aeeounting. we need to understand
a few more concepts and
principles. They are listed below:

Time-Period
regular
Concept - it ensures that aecounting information is reported at
intervals. An entity needs to present
a complete
set of financial
statements at least annually according to IFRS.

Revenue
Recognition
Principle
. the basis for reeording revenues. It states
that revenues have to be recorded in the period they are earned.

Matching
Principle
. the basis for recording expenses. It states that expenses
(resourees consumed) associated with earning revenue have to be recorded in

the period when the revenue is earned.
4.1
Updating
accounts
At the end of aperiod.
all accounts need to be adjusted. in order to display
aeeurate information to the stoekholders. There are three basic categories of

accounting adjustments:
71
Uniseminar-
Theory - Accounting
Deferrals
(future)
Firlance & Accounting
- adjustments for an item that the business paid or received
cash in advance
Accruals (past) - the opposite of a deferral. An expense or revenue is recorded
before paying cash.
Depreciation
- the allocation; of an asset expense over the u~eful life of this

I
asset.
'
Examples: Prepaid Expenses. Depreciation of Plant Assets. Ad:rued Expenses,

I
Accrued Revenue, Unearned Re"1enue
Acc. payable
(Li)
The adjusted
trial balance
- first lists all accounts and their respective
balances, then lists adjustments that have occurred during aperiod

lists the adjusted trial balance.
72
and finally
Uniseminar
Theory - Accounting
Short-Term Investments
The purpose of owning a trading

investments
in marketable
securities,
securities,
also known as short-term
(such as stocks or bonds) is to hold
it for a short time and then seIl it for more than its cost There are 2 ways to
account for gainsjlosses in these investments.
Unrealized
Gains and Losses
- Trading securities are reported
on the
balance sheet at their current market value, because this is the amount the
investor can receive by seIling the investment now. Because this gain (loss) is
only on paper but could be realized immediately by seIling the investment, it is
caIled "unrealized gain (loss)".
Realized
Gains and Losses
- A realized gain or loss occurs whenever the
investor seIls an investment
Account for the following short-term investment
in Nokia Corporation:
(1) 1000 shares of Nokia are bought at lOjshare.

ljshare.
(2) A cash dividend is received of
(3) The stock price increases to 12jshare.
(4) The investment
is sold at
12jshare.
73
Theory - Accounting
Uniseminar- Fin'ance & Accounting
Short-term Investments (Ai)
Unrealized Gain' on Investment (Ei)
P4
Cash (Ai)
Gain on saJe of s.-i. Investments
Short- Term investment
74
2,000
2,000
12,000
Uniseminar
Theory - Accounting
Receivables
It is very common for companies that some orders are not paid immediately but
will be paid within one year. In order to account for these short-term claims on
outsiders, companies set up special accounts, the so-called accounts receivable,
which represent monetary claims against others. These accounts are on the asset
side of the balance sheet as they represent a future benefit for the company. The
two major types of receivables are:
Accounts
Receivable
Notes Receivable
6.1
[AR] - amounts collectible from customers
- more formal contracts than AR;written pro mise to pay
Accounting for Uncollectible
Receivables
If a company seIls a product or service on credit (on account), an account

receivable for this transaction is created. Unfortunately, it sometimes happens
that a customer who bought a good/service on credit defaults and is hence unable
to make the payment. In order to account for such an event to happen, companies
are required
to set up an Allowance
for
Uncollectible
Account.
This
account serves the purpose to account for the probability that a customer to
whom a sale on credit was made, might default on his payment. Thus, the
Allowance for Uncollectible Account serves as a capital buffer in case a customer
will default.
Once a customer
actually defaults, an uncollectible-account
doubtful-account
expense
or bad-debt
expense
expense,
is accounted for.
There are two methods to account for uncollectible account expenses:

(1)
Allowance
Method
Based
on
the
company's
past-collection
experience. an estimate of the total amount that seems unlikely to be collected is

made. A popular
method
for estimated
uncollectibles
is called aging-of-
receivables.
75
Uniseminar-
Theory - Accounting
Aging-of.Reeeivables
customer's
amount
. The aging-of-receivables
,
outstanding
by investigating
method! looks at each
receivahl.es individually. It determines

how long the individual's
outstanding and assigns a probabnity accordingly.
[t
the allowance
receiva~les
have been
is a balance sheet approach,
because it focuses on accounts receivable.

NOTE:
Using the aging-of-receivables
method, you first calculate the "new"
ending balance of the allowancJ account. From this you can det~rmine what the
!
respective uncollectible accountiexpense is:

I
Uneolleetible
aeeount'expense:
Uncollectible Account E~pense =

i
Ending Balance of Allowance
(number determined
by method]
- beginning balance of 'allowance
(given from previ0j-Ls period]
The ending balance of the "Allowance for Uncollectible Accounts" (Allowance

account] represents a capital buHer the company preserves in order to mitigate
the negative effect of defaulting customers on its liquidity. The; capital buffer is
the ending balance of the allowknce account. The Uncollectible ~ccount Expense
is the money the company h~s to put aside to build up thiis capital buffer.
Therefore, if the Allowance accollnt has a positive opening balance (i.e. there is
still some capital buffer from the last period that was not used up), the
:
Uncollectible Account Expense iNil\be less than the ending bala~ce. If there is no
I
opening balance, the two amourits will be the same!

(2)
Direct
Write-Off
Meth.od . The direct write-off method does
noe
predict any allowances 'fr Ilncollectible accounts. The company waits

until a specific customer's receivable proves uncollectible and then the
accountof the customer . is simply written off.
[t
is considered defective,
because it fails to take into account the possibility of impairment
of
receivables at balance sheet date. As a result, receivables are always

reported at their fUIIamollnt, which is more than the business expects to
collect.
76
Uniseminar
Theory - Accounting
You were asked by your manager to set up an aJIowance account for your company.
The Table below depicts the outstanding accounts receivables of your customers.
1,000
2,000
500
300
Estimated % of
3%
2%
1%
default
Furthermore,
your current allowance account shows the following entries:
Opening
50
Balance
In period P2 one ofyour customers. Mr. Z defaults.
How da the respective journal entries look like? What are the most important steps
you have to consider?
Step 1: Check the current Allowance Account for its opening balance
Opening
Balance
77
Theory - Accounting
Step 2: Calculate the ending balance of the Allowance Account using the aging-ofreceivables method
1,000
2,000
X
y
500
300
Total
2,000
1,500
300
1%
2%
Estimated %
30
20
Allowance for
Uncollectible
Accounts
-+
The ending balance of aJJowance account should be

I
20
+ 30 + 9 = 59 [This
is NOT the UncoJJectible
Account Expense!}
Step 3: Based on the ending balahce calculated in step 2, the "Uncollectible Account
Expense" is calculated. Thi:s is the amount the company puts a~ide to build up a
capital buffer for the case that one of the customers
defal;llts. Because the
estimated percentages
(1(0, 2%, 3%) imply how large the capital buffer needs
to be (=59), this is the ENDINGBALANCEofthe allowance account.

When the allowance
account
has an opening
balance,
the "Uncollectible
Account Expense" can be calculated as the difference between the opening and
ending balance. That is, it represents
the amount the company has to put aside,
in order to have a sufficient capital buffer.
Note: Although the allowance
account is on the asset side, it is a contra account (it increases with credit and
decreases with debit)!
78
Theory. Accounting
Pl
Uneolleetible Aeeount Expense (CEi /E!)

Allowance for Uncollectible
(=50-59)
Accounts
(CAi/At)
Step 4: Onee the customer defaults, the balance of the allowance account is reduced
by the fuilloss that results from the default (debit). Furthermore,
account
(Accounts Receivable)
is credited
the reference
to refleet the redueed
value of
receivables that will be eolleeted from customers.
pz
300
Allowanee for Uneollectible Aecounts

(CAt/Ai)
300
Aecounts Receivable (Al.)
6.2
Accounting
for Notes Receivables
Notes receivables
can be either
latter
as long-term
are known
following example illustrates

lmagine
receivables
assets
or long-term
with a term
assets,
beyond
where
the
one year. The
how to account for notes receivables:
lohn Stone, the debtor,
the creditor
current
borrowed,
$3,000 from Bank of America,
and it is a three month note receivable
with an interest
being
of 8%. What
79
Theory - Accounting
do they respective bank entries look like at the start, after two months and at the
end?
Step 1: Making the loan
Pl
Note Receivable -
J. Stone
(At)
3,000
3,000
Cash (M)
Step 2: Accounting
P2
for revenue
Interest Receivable
-t J. Stone
increases
(Ai)
40
Interest revenue (Ei)
Step 3: Collecting
P2
80
40
the ndte
Cash (Ai)
3060
Note Receivable (M)
3000
Interest Receivable
40
Interest Revenue;
20
Uniseminar
Theory - Accounting
Inventory & Cost of Goods Sold
7.1
Inventory Costing Methods
Inventory can be defined as all goods that are completed but not sold yet. In
general, inventory. stocks are very essential to keep a business
operations
running. If a company does not have sufficient inventory it might fail to meet
short term needs of c1ients (such as new unexpected orders). If the inventory
stock is too large, the company incurs high storage costs. Thus, inventory
management
is an important aspect of today's higher management positions.
Because it provides the company with a future benefit (= revenue if inventory is

sold), inventory is Iisted on the asset side (current assets) ofthe balance sheet.
But how do we account for the cost of production of the goods that are stored as
inventory? Usually, if a good is produced
directly
attributable
to the production
Goods Sold and subtracted
and sold, the costs
that are
of the good are called Cost of
from the revenue on the income statement. The
matching principle dictates that expenses are matched with revenues once they
are realized.
Cost of Goods
Sold
[COGS] - costs that are direct!y attributable
to the
production of a good or service. It is recorded as an expense and subtracted from

the revenue on the income statement.
As a mobile phone producer Scandia needs to buy new supplies in order to

manufacture its products, in period 1it buys supplies worth SOO.In period 2 it uses
all supplies to manufacture products and seil the products worth 800. How do the
journal entries look like (assuming no beginning and no ending inventory)?
81
Uniseminar-Finance& Accounting
Theory- Accounting
P2
Cash or Accounts Receivable (Ai)
800
Sales Revenue (Ei)
800
500
COGS (E!)
Inventory (A!)
500
As the example above highlights, the profit of the company depends on the COGS
and how these are estimated.Assuming
that a company has inventory (e.g.
supplies) of different periods, which it bought at different prices, the COGSfigure

will vary according to which prices will be used for its calculation.
r
r
There are two main types of inventory accounting systems:
The periodic inventory system is used for inexpensive goods, does not keep a
running record of all goods bought, sold and on hand and the inventory is
counted at least once a year ..
The perpetual inventory system is used for all types of goods, keeps a running
record of all goods bought, solid and on hand and the inventory is counted at
least once a year.
There are four different methods to account for the cost of inventory in order to
determine the appropriate COGS:
(1)
Specific Unit Cost Method
(2)
Weighted Average Costing lVIethod
(3)
First In First Out Method [FIFO]
(4)
Lastln First Out Method [UFO]
82
Theory-Accounting
Uniseminar- Finance& Accounting
The accounting method selected for inventory costing affects the profits to be
reported and the amount of income tax to be paid. Thus, just by choosing among
different methods, management
Therefore, dose attention
is able to generate
different profit figures.
must be paid to wh ich inventory cost accounting
method is to be used. However, IFRS requires consistencyin
the costing method
used and further requires companies to provide dear explanations if the costing
method is changed. The four costing methods are explained in more detail below:
(1)
Specific
Unit Cost - calculates inventory cost at the specific cost of the
particular unit. It is used in business es that deal with unique inventory

items (automobiles, jewelry, real estate etc.).
(2)
(Weighted)
Average
Costing Method - This method calculates COGS
by simply taking the average cost of inventory during aperiod .

Average Costper Unit =
CostofGoodsavailable
Numher
units
available
caGS = Number of units sold * Average cost per unit
Ending Inventory
number of units on hand
Beginning
balance
10 units
Purchase 1
25 units
Purchase 2
25
10
* average cost per unit
100
= 300
units @ 14 = 350
Total = 750
@
12
Average cost:
10*10+25*12+25*14
~ COGS(40 units
Ending
Balance
20 units
(OT
750 -
12,5
10+25+25
12,5)
500
= 250
500 = 250)
12,5
83
Theory - Accounting
(3)
First
In First
assumed
Out [FIFO] - Under
the
that the goods thaI: were produced
FIFO methd
it is always
first, are also ~he first ones to
be sold.
Beginning
balance
noo
10 units @ 10 =
10 units @ 10=
100
25 units @ 12 =
300
Purchase 1
25 units @ 12 = 000
Purchase 2
25 units @ 14 = !~350
Total:i 050
Ending
Balance
(4)
5 units @14i=
470
COGS
20 units @ 14:::!:G80
(ar 750 - 470 = ,280)
Last In First Out [L1FO] - is the opposite

assurnes
70
that the goods produced
This method
of the FIFO method.
It
last are always the first ones to be sold.
is not allowed under IFRS.
Beginning
balance
10 units @ 10 = 100
Purchase 1
25 units @ 12
300
15 units @ 12 =
180
Purchase 2
25 units @ 14 == 350
25 units @ 14 =
35.
53
Total == 750
I
Ending
Balance
10 units @ 10
+ 10 units
@ 12 = 220
(ar 750 - 530 = ~~220)
84
COGS
Uniseminar
Theory - Accounting
7.2 FIFO and LIFO in Practice

What is the impact of increasing
or decreasing unit costs for the FIFO and LIFO
respectively? As the figure below ilIustrates, increasing costs (prices) result in

lower
COGS under
FIFO and higher
COGS under
LIFO. Thus, with
increasing prices the FIFO method will provide a higher profit figure (due to
lower COGS),while the LIFO method would result in high er COGS~ lower profit
~ lower tax payments! For this reason LIFO is not allowed under IFRS (since
prices generally increase over time ~ inflation!).
With decreasing costs the FIFO method yields higher COGSand the LIFO yields
lower COGS.Thus, the FIFO (LIFO) yields higher (lower) COGS.
FIFa
LIFO
A) Increasing Cast
B) Decreasing Cast
Exhibit 7.2.1: FiFa and LiFa cast structures far increasingjdecreasing prices
LIFO Liquidation
- occurs when inventory levels fall below the levels of the
previous year. If the quantities fall below the level of the previous year the
company has to use (even) older inventory prices to compute COGS.Assuming
that due to inflation, prices usually increase, older and consequently lower costs
are shifted into the COGS calculation, which results in high er net income and
higher tax payments. As a result, managers try to avoid LIFOliquidation.
85
I
I
I
Uniseminar-Finimce& Accounting
Theory- Accounting
Lower of cost and net realizable
value rule - requires that inventory is
reported at the lower value of either (i) the market value or (ii) ~he current cost
;
of replacement.
Once you hav~ determined
the cost, the inv~ntory must be
compared to its NRV.The net realizable
value (NRV) is the estimated selling
price in the ordinary course of business less the estimated cos~ of completion
and the estimated cost necessa,ry to make the sale. Building on the example
above, the write down for the three different methods if the price would drop to
9 per unit would be:
All three methods
of the previous example yielded an ending inventory

I
value of 20
units. Assuming that the unit market price drops to 9, how do we hatre to account for
I
the decrease in unit cost? According to the lower of cost and net realizable value rule,
the value ofthe ending inventory is: 20 units
* 9
-Current
maket value
Write-down
UFO
FIFO
Weigtited Average
Ending Inventory
= 180
250
280
220
-180
-180
-180
70
100
40
Journal Entry:
70
Inventory (At)
7.3
Additional
inventory
Cost-of-Goods-Sold-Model
40
100
70
COGS(Et)
100
40
Issues
- Assuring that a company always has sufficient
inventory to meet its client's orders is fundamental to the success of a company.

In order to assure that the right quantity of inventory is bought the COGSModel
can be employed:
86
Uniseminar
Theory - Accounting
Grass profit method
. The gross profit method is used in order to estimate
the value of goods, in order to determine the ending inventory.
Beginning
COGS
+ Ending
lnventory
lnventory
+ Purehases
Goods available
Goods available
- Beginning
- COGS
Purehases
inventory
Ending Inventory
87
Uniseminar-
Theory - Accounting
PPE and Intangibles
PPE (Property,
Plant and Equipment),
sometimes called fixed assets, are

I
non-current assets or long-Iivediassets that are tangible. Intangible
assets
are
identifiable non-monetary assets without physical substance. Acqounting for PPE

and intangibles has its own terminology, which is provided in the following table:
Asset Account (Balance Sheet~
Related Expense Account (Income

statement)
Depreciation
Buildings,Machinery,and
Equipment
Intangibles
Intangibles with indefinite useful

Jives
8.1
Depreciation
None
Assets
I
Depreciation
ae
- the systematic allocation 01' the cost 01' tangible Ilong-Iived assets
over their useful life (length ~f service expected from using the asset). It is
example 01' the matching principl,~! Depreciation is not a process! 01' valuation and
it also does not mean setting aside cash to replace assets as they wear out.
When a company buys new machinery for its production (or other plant assets)
this is initially recorded as a capital expenditure in the period the purehase is
made. However, the machinery usually has duration 01' longer than one time
period. Furthermore, assets wear out and lose value over time. Since plant assets
are reported on the balance sheet at book value, they need to be depreciated
the asset's cost are allocated to the expenses over its life. In order to calculate the
88
Uniseminar
Theory - Accounting
book value of an asset (that is the current value of the asset), we need to subtract
the depreciation that has accumulated so far (accumulated depreciation)
from
the original cost. In addition to this, most assets have whatis called a residual
value
(or salvagejscratch
value), which is the value the respective asset can be
sold for once it is fully depreciated (=at the end of its useful Iife). The residual
value must be considered when calculating the periodical depreciation expense.
Book Value:
Carrying amount of an item PPE = Cost - Aceumulated
8.2
Depreciation
Depreciation
Methods
There are three widely used depreciation methods:

Straight-line
depreciation
amount of depreciation
[SL] - The straight-line method assigns an equal
to each period an asset is used. Depreciable cost is
divided by usefullife in years to determine the annual depreciation expense.
SL Depreciation
Units-of-production
er year = Cost
of asset-Residual
Value
Usefullife
[in years]
[UP] - The units-of-production
method assigns a fixed
amount of depreciation to each unit of output produced by the asset. This perunit depreciation expense is then multiplied by the number of units produced
each period to compute depreciation.
UP Depreciation [per unit
Depreciation per year
Double-declining-balance
0f
output] =
Cost-Residual
Value
Usefullife
[in units of production)
Depreciation per unit
- The double-declining
* Units produced
balance method is an
accelerated depreciation method. It writes off a larger amount of the asset's cost
near the start of its useful life. In order to determine the depreciation expense,
first the DDB rate is computed. Then the DDB rate is multiplied with the book
value of the asset (cost-accumulated depreciation). Because the residual value is
not incorporated in the depreciation expense, special attention must be paid to
the last year' s depreciation amount: it is the asset' s residual value!
89
Uniseminar-
Theory - Accounting
Fin,ance & Accounting

I
DDB depreciation rate = Usefullife
Depreciation
8.3
= DDB rat~
I in
years
]*2
* (cost - accunlulated depreciation)
Further Issues
FuHy Depreciated
Assets
- A
fully depreciated asset is one that
has reached
,
,
the end of its estimated useful 'life. The equipment's book value is zero. This
however, does not mean that the asset is worthless - the company is not required
to report a fully depreciated asset on its financial statements anyrrore.

Depletion
[Accounting for Nathral Resources] - Depletion is that portion of the
cost of a natural resource that: is used up in a particular peribd. Depletion is

I
computed in the same way as units-of-production depreciation.
Measurement
subsequent
tb
initial recognition
- En entity elects one out
of two measurement models forleach dass of the property:

!
Cost model:
an item of PPE shall be carried at its cost, less any
accumulated depreciation amd any accumulated impairment losses.
Revaluation
model: ah item of PPE whose fair value dan be measured

I
reliably shall be carried at a revalued amount, being its :fair value at the
I
date of revaluation less I any subsequent
accumulated depreciation
and
subsequent accumulated impairment losses.
8.4
Intangible Assets
Intangible
Assets
- Intangible Assets are long-Iived assets With no physical
form. Because many intangible assets do not meet certain recognition criteria
they are not recorded in company's financial statements.
Intangible assets fall into 2 cate~ories:
(1)
Intangibles with finite Iive~,(Patents, Copyrights etc.) [Amortization]
(2)
Intangibles with indefinite Iives (Franchises

[Impairment]
90
and Licenses, Goodwill)
Uniseminar
Theory - Accounting
In order to aeeount for the loss in value of intangible assets, they are amortized.
Amortization
works Iike depreciation and is usually eomputed on a straight-
line basis. Only intangible assets with a Iimited/finite useful Iife are amortized.
Intangibles with indefinite Iives are not amortized. Still the value of intangible
assets is eheeked every year. In ease there is an increase/decrease
of value this
change ofvalue is written down in the books - called Impairment.
91
Uniseminar-
Theory - Accounting
Liabilities
9.1
Current Liabilities
Current liabilities are liabilities due within 1 year or within the cotnpany's normal
i
operating cycle if longer than a year. They represent claims the dompany has on
outsiders. Current liabilities can fuebroadly put into two categories:
I
(1)
Current
liabilities
of I known
amounts
- for exarnple:
accounts
Ofe
payable, short-term notes payable, sales tax payable, accrued expenses, payroll
i
liabilities, unearned revenues, cvrrent portion of long-term debt (the portion

long-term debt that is due this y~ar)
i
(2)
Current liabilities
thit
must be estimated
- it is probable that it
occurs and it can be reasonably ~stimated (e.g. Warranty).

I
In the following you will find an, example of how to account for warranty. Please
note that you only account for wkl'ranty provided by your company and only your
company. If a producer goes bankrupt who provided warranty bn his products,
I
your company does not have ~o take the responsibility. In this case you will
encounter what is called a contirtgent liability.
I
Contingent
Liabilities
- is not an actual liability but a note, disclosure. It is

I
reasonable that a loss occurs put it cannot be exactly estimated. An example

would be a producer
that currently
faces financial distres~ and might go
bankrupt. Lawsuits that arise from the wrongdoing of your company are anothee
example. Formally, IAS37 states:a contingent liability arises when:
There is a possible obligation to be confirmed by a future event that is
outside the control oftheentity;
or
A present obligation may, but probably will not, requil'e an outflow of

resources; or
A sufficiently reliable estimate of the amount of the present obligation
cannot be made
92
Theory - Accounting

It is important
to remember
is unlikely to occur. lnstead,
that there is no need to report a contingent

one must wait for new information
loss that
is available to up
the situation.
Assume that Company XYZseils products and also gives a one year warranty
products. The warranty
expense is estimated to be 10% of sales. For the first period
sales of 5000 were made. Ouring the second period, the actual replacement
on these
cast of
defective items amounted to 200. The opening balance of the "Provision for Warranty"
account is 200.
Hint: accounting for warranty works exactly the same as accounting for an allowance!
Step 1: Check the current Allowance Account for its opening balance
Opening
Balance
Step 2: Account for the warranty provision. Oue to the opening balance of 200 in the
provision for warranty
account and the newly estimated
"Provision for warranty"
of
500 the warranty expense to account for is: 300.
P1
Warranty Expense (E!)
300
Provision for Warranty

or estimated
Warranty payable (Li)
300
93
Uniseminar-Finance& Accounting
Theory- Accounting
Step 3: Account for the refund of returned products that were sold under warranty
Provision ofWarranty: (U)
P2
200
Inventory (A!)
(or Cash (A!) if th~ customer is entitled to
I
a cash refund)
Long-Term Liabiliti~s
i
9.2.1 Bonds
9.2
Bonds payable
are groups ofi notes payable issued to multiple lenders, called
bondholders. Corporations use these vehicles to borrow larger amounts. Issuing

!
bonds typically requires

underwriter
the: services
of a securities
firm to act as the
of the bond issue. who buys the bonds from the i~suing company.
resells them to its clients and earns a commission on the sale.

There are multiple types of b9nds: (i)term
whereas
serial
bonds
mature
Furthermore. one could discriJinate

unsecured bonds (debentures;).
bonds
in instalments
mature at the same time

over aperiod
of time.
between secured (or mortgage) bonds and
where the former give the bon~holder the righ_
to take specified assets of the i~suers if the company defaults and the latter does
not. Some bonds are callable. :meaning that the issuers may caU (pay off) those
bonds at a prearranged price whenever the issuer chooses.
In addition to this there are also convertible
bonds (and notes).
which are
bonds that can be converted ioto the issuing company's share capital. These
bonds combine the safety of (i) assured receipt of interest and principal on bonds
with (ii) the opportunity for &ains on the shares. This conversion feature may
convince investors to accept a lower interest rate.
94
Uniseminar
Theory - Accounting
9.2.2 Financing Operations

There
are
three
ways
to
finance
operations
which
have
their
own
(dis)advantages:
Financed by retained earnings means that there is no need for

extern al financing and there is low risk to the company
Issuing shares creates no Iiabilities and interest expense and hence less
risky to the issuing corporation. However, it is more costly.
Issuing bonds or notes payable does not dilute control of the

corporation and often results in high er EPS. However,it does increase the
risk ofthe company.
9.2.3 Non-current
Liabilities:
Leases and Pensions
Alease is arental agreement in which the tenant (Iessee) agrees to make rent
payments to the property owner (Iessor) in exchange for the use of the asset and
falls under non-current Iiabilities The lessee can use the needed assets without
make the up-front payment of purchasing the assets. There are two types of
leases: operating and capital leases. An operating lease is basically arental
agreement between the lessor and lessee, where the lessee has the right to use
the asset, but has no continuing rights to the asset. The lessor retains the risks
and rewards of owning the leased asset To account for an operating lease, the
eIessee
debits rent expense and credits cash for the amount of the payment. A
capital lease is a lease agreement in which the lessee assumes, in substance, the
risk and rewards of the asset ownership. The original entry is adebit
to lease
assets and lease Iiability. Afterwards, it is depreciated in accordance with the

usual depreciation
policy. When lease payments are made, the lessee debits
interest expense, and the remaining outstanding balance reduces lease Iiability:
With regard to pensions, there are two schemes for post-retirement
obligations:
defined contribution and defined benefits. In the former, employers contribute a

95
Uniseminar-
Theory - Accounting

I
fixed amount of money to an em~lOyee'S pension funds. Onee the eontribution is

made, the employer's obligation ends. In the Iatter, the empIoyee is promised
some post-retirement
benefits,lusually
referred
eompany reeords pensions and retirement-benefit

I
work for the eompany on an ongoing basis.
96
to as pensi~ns.
Here, the
expenses Jhile
employees
Uniseminar
10
Theory - Accounting
The Cash Flow Statement
The Cash Flow Statement (CFS) or statement
of cash flows shows the cash
flows to and from a company and relates these cash flows with their underlying
causes (operations of the company). That is, the CFS shows where cash came
from and how it was spent. As a result, the CFSserves the purpose to
(1)
predict future cash flows based on the past history of cash flows
(2)
evaluate
management's
decisions
by reporting how mangers utilized
the cash
(3)
show the relationship
of net income
to cash flows
. a high net
income usually increases the cash holdings of a company. If this is not the
case the CFS teils why.
10.1 Operating, Investing,
and Financing Activities
On the CFScash flows are sorted into three categories:

(1)
Cash flows
from operating
activities
- operating activities create
revenues, expenses, gains, and losses. While the Income Statement records
these cash flows on an accrual basis (match expenses with revenues) the
CFS reports them on an operating basis (as they occur!). There are two
methods that can be used in order to compute the operating cash flow: the
direct and indirect method which will be discussed in the next section.
These cash flows relate to current assets and current liabilities.
(2)
Cash flows from investing
activities
. show the increasejdecrease
in long-term assets such as machinery, land, buildings, and equipment.

Here "Capital Expenditures" are recorded, that is, the initial cost paid for
new plant assets. Investing cash flows relate to non-current assets.
97
Uniseminar-
Theory - Accounting
(3)
Cash flows from financing
activities
- show cash flows from and to
investors such as dividend payments, new stock issues, !lew debt issues
and interest payments. These cash flows relate to non-c~rrent liabilities
and owners equity. Cash' outflows are subtracted
added.
98
and cash inflows are
Uniseminar
Theory - Accounting
10.2 Preparing
As pointed
the CFS - Direct and Indirect method
out above, there are two different
flow from operating
activities.
However,
methods
despite
to compute
their different
the net cash
approaches,
they
yield the same net cash flow!
Indirect
Method
subtracts
expenses.
operating
activities.
Cash Flows
Activities
- starts
out with the net income
It reconciles
from
from Operating
net income
and adds
to net
cash
revenues
provided
and
by
Explanation:
Net Incame
+ Depreciatian
~ Depreciation is no cash expense. The

initial cast is recordedas investing cash
flow
+ Lass on sale af lang- term assets
~ Gain/loss on sale of non-current assets is

an investing cash flaw and already recorded
for under investing activities
- Gain on sale af lang- term assets

- Increases in current assets
(other than cash)
+ Decreases in current assets
~ if a current asset increases (decreases)

cash decreases (increases) e.g. purchase of
a machine decreases the cash balance
(other than cash)
+ Increases in current liabilities

- Decreases in current liabilities
~ if a liability increases (decreases) cash

increases (decreases), e.g. a Iiability is paid
off decreases the cash balance
= Net cash provided tram operating
activities
99
Uniseminar- Finilnce & Accounting
Theory - Accounting
Direct Method - reports

activities.
rather
lt provides
all cash receipts and cash payments ifrom operating

I
clearer information
about the sources and uses of cash
than the accounts
while cash payments

it provides
clearer
companies
use
method.
(as wi~h the indirect
are subtracted.
information
it, because
The statement
method).
It is the method
a'bout the sources

it ~equires
more
advocated
computations
Cash flows from Operating Activities

I
Receipts
+Collections from customers
+Interest received on notes receivable
+Dividends received on stock investments
+ Total cash receipts
Payments
I
- to employees
- for interestl
- for income tax
i
- Total cash payments
= Net cash provided by operating

activities
thhn
all togethet
folIows:
100
~y lAS7, because
and uses of cash. However,
of cash flow from operations
- to supplier~
Cash recieipts are added
the
should
few
indirect
look as
Theory - Accounting

Another
direct
way how to construct

method
interrelationship
is iIlustrated
between
the cash flow statement

in the
income
following
statement
table.
accounts
or t-accounts
This
table
for the
shows
the
and the corresponding
balance sheet accounts:
From Customers
Sales Revenue
+ Decrease
in Accounts Receivable
- Increase in Accounts Receivable

Ofinterest
Interest Revenue
+ Decrease
in Interest Receivable
- Increase in Interest Receivable
To suppliers
Cost of Goods Sold
+ Increase
in Interest Receivable
- Decrease in Interest Receivable
+ Increase
in Accounts Payable
- Decrease in Accounts Payable

Operating Expense
+ Increase
in Prepaids
- Decrease in Prepaids
+ Increase
in Accrued Liabilities
- Decrease in Accrued Liabilities
To employees
Salary Expense
+ Decrease
in Salary Payable
- Increase in Salary Payable

For interest
Interest Expense
+ Decrease
in Interest Payable
- Increase in Interest Payable

For income tax
Income Tax Expense
+ Decrease
in Income Tax Payable
- Increase in Income Tax Payable
101
Theory - Accounting
10.3 Preparing the CFS - ~inancing
Cash flow from Investing Activities
Sales of non-current
(e.g. machinery)
assets
and Investing Activities
Explanations:
Cash inflow from sale of assets raises cash on hands ofexisting
shareholders
.
->
Cash outflow from purchases of

assets - cash is paid to qutsiders,
decreasing cash balance
- Purchases oflong term assets
->
- Loans to others
-> Cash outflow - cash holdings of the

I
company are reduced when lend to
third parties
+ Collections
ofnotes receivable
-> Cash inflows - outstahding debt

collected raises cash on!hands of
investors
Net cash flow provided by inresting

activities
Cash flow from Financing Actvities
+ Issuance
+ Sale of treasury
shares
- Purchase oftreasury
+ Increase
-> Cash inflow from sto:ck sales to

investors - increases cash on hand of
existing Shareholders
of shares
shares
Borrowing (issuance of
bonds)
- Payment of notes/bonds
payable
- Payment of dividends
Net Cash flow from Financing

Activities
102
-> Cash inflow from the sale of stock

that is in inventory (was purchased
back originally)
-> Cash inflow from th~ sale of stock
that is in inventory (was purchased
back originally)
.
Cash inflows - if the ~ompany takes

on more debt, this reptesents more
cash it has to fund its operations
->
Cash outflow - outstanding debt is

repaid
->
Dividend payments decrease the

cash that is available to the company to
fund its operations
->
Uniseminar
11
Theory - Accounting
Financial Statement Analysis
When comparing different companies, you usually look at more than one year of
data. For a point in time analysis, one year of data is fine, but it teils you nothing
about the past performance and if the company is currently on an upswing or
downswing. Therefore, to carry out a detailed financial statement analysis you
need at least two years of data. Usually, analysts look at a three to five year time
span.
There are three different types of analysis that can be performed.
(1)
Horizontal
analysis
(2)
Vertical analysis
(3)
Benchmarking
11.1 Types of Analysis

Horizontal
analysis
(trend analysis)
- In the horizontal analysis, the study
of percentage changes from year to year, time-trends in financial statement items

are analyzed. In order to investigate the change over different time periods,
independent of the size of different cash f1ows, all numbers should be expressed
as percentage changes from one year to the next:
Amount
Percentage Change = -----Base year
Trend percentages
f change
amount
are a form of horizontal analysis and indicate the direction
a business is taking:
Trendo/o
Vertical
= Any year $
Base year $
analysis
are expressed
(component
analysis)
as percentages
ta same
- all financial statement items

base measure
(for the income
statement the base measure would be sales revenue, for the balance sheet total
assets / total Iiabilities). The purpose is, to detect if there have been any relative
103
Uniseminar-
Theory - Accounting
changes over time (e.g. if COGSjRevenue would decrease this means that working
efficiency improved).
. I
I'
V ertlca
ana YSIS
Benchmarking
Ol
'0
Each income statement

Total revenue
item
- refers to the comparison of financial statement
items to
external benchmarks such as market means or median values.

I
When comparing one company tO another, financial statement can be modified to

report only percentages. When ,compared side-by-side, such fin~ncial statemene
are called common-size
the comparison
statements.
A common-size financialstatement
of different companies, because all amounts
are stated
aids
in
percentages, thus expressing thb financial results of each comp~rative company

in term of a common denominator.
Hence, currency and sizei differences are
eliminated by common-size comiparison.
11.2 Ratios
As just stated above, it is important to scale all items when comparing companies
of different sizes. In order to compare two or more companies With each other, it
I
is important to account for the: scale of the different itemsjaCC(,lUntsof intt;rest.

Therefore, it is very helpful to express the number in percentag~s (=ratios). This
enables comparisons of companies with different sizes.
11.2.1 Measuring the ability to pay current liabilities

(Net)
Working
capital
[NWC] - Expresses the operating liquidity of a
company. In general it is beneficial for a company to maximize interest free

current liabilities (borrowing money without paying any interest) and minimize
interest
free current
assets
(=lending
money without
receiving
interest
payments). However, if the company runs into financial difficulties its current
assets are the easiest one to be sold to generate cash. In general, the larger the
NWC,the better the ability to pay debts.
104
Uniseminar
Theory - Accounting
(Net) Working Capital = Current Assets - Current Liabilities
Current
ratio
- Measures the ability to pay current liabilities with current
assets. NWC can be 1000, but if current liabilities amount to 100,000 there is
almost no capital buffer. Thus, in order to account for the scale the current ratio
expresses current assets as a percentage of current liabilities. The norm for the
current ratio depends on the industry, however in most industries the norm is
around 1.5.
Current Ratio
Acid-Test
Current Assets
Current Liabilities
ratio - Shows the ability to pay all current liabilities if they come due
immediately. As such, it only considers the most liquid current assets and uses a
narrower base of liquidity than the current ratio. An acid test of 0.9 - 1.00 is
acceptable in most industries.
Acid- Test (Quick) Ratio =
Cash+Short-term
investments+Net
Curreltt
11.2.2 Measuring
Inventory
Ability
Turnover
to Seil Inventory
Current Receivables
Liabilities
and Collect Receivables
- Indicates the ability of selling inventory and measures
the number of times a company seils its average inventory during a year. It
indicates how efficiently management
is utilizing its inventory. A high ratio
indicates that a company is doing weil. A low ratio indicates that a company has
problems in selling its products. However, a too high a high value can mean that
the business does not keep enough inventory at hand. Hence, one should strive
for the most profitable, not necessarily the highest rate.
Inventory
Turnover
caGS
= ... -----------
Average lnventory
Inventory turnover can be expressed in the number of days by dividing 365 days
by the inventory turnover ratio, also known as the inventory
resident
period.
105
Uniseminar-
Theory - Accounting
Accounts
Receivable
Turnover
. Shows the ability to collect

cash from
I
credit customers. The higher the~ratio, the better because the shorter is the time
that customers are provided withinterest
free loans (there is no interest paid on
accounts receivable!).
Accounts Receivable Tutnover
Days' Sales in Receivables-
Average
Net Sales'
Net Accounts
'S I
. R
. bl
ay s a es m ecewa es
Accounts
Payable
Shows how many days the c~mpany takes to
collect its receivables (also known as the receivables

D
,
Receivable
Turnover
Average
collectio:n period).
Net Accounts Receivable

One Day's Sales
- Shows the ability to pay its suppliers cash
from credit customers. The low,er the ratio, the better because the longer is the
time that customers can use the credit terms by its creditors and ;receive interestfree loans (there is no interest p~id on accounts receivable!).
Accounts Payable Turnover
Cash Conversion
Average
COGS
Net Accounts
Payable
Cyde - IfJ.e put the three ratios (inventory resident period,
receivables collection period and payable collection period) together, we can

i
speculate how long it takes for a business to seil its inventory, liollect payments,
and less the time it takes to m~ke its own payments to suppliers. A shorter Cycl_
is better than a longer cycle.
Cash Conversion Cycle =
Days sales outstanding
+ Days of supply in inventory-
Days in accounts payable
sales = Sales less any deduction of returns, allowances for damaged or missing goods and any
discounts allowed
1 Net
106
Uniseminar
Theory - Accounting
Also described as:
Cash Conversion Cycle =

Receivables collection period
+ lnventory resident period -
Payable collection period
11.2.3 Measuring
Ability to Pay Debts
Debt ratio - Shows how much of its assets the company has financed with debt
Depending on the industry this ratio can vary a lot. While the pharmaceutical
industry has very low debt ratios (as it is dependent on the generation of new
patents which are difficult to predict in advance), the utilities industry has very
high debt ratios (revenue is very predictable and it has a lot of assets that can be
used as collateral).
Debt Ratio
Total
Uabilities
Total
Times-Interest-Earned
Assets
Ratio - Measures how many times operating income
can cover the interest expenses. It is an indicator of a company's liquidity. This is

also commonly known as the interest-coverage ratio.
Times-interest-earned
11.2.4 Measuring
ratio = Income
trom
Interest
Operations
Expense
Profitability
Rate of Return on Sales (Net Profit Margin) - Shows the percentage of

each sales dollar earned as net income. It shows how efficient a company is
operating.
Rate of Return on Sales
Net In co me
Net Soles
107
Uniseminar-
Theory - Accounting
Rate of Return on Total Assets
- Indicates how profitably
<;1.
company uses
its assets.
Rate
0f
Return on Total Assets = Net
11lcome+Interest
ExpellS~
Average Total Assets
Rate of return on ordinary 'slilareholders'
equity
[also ~OE
Return
on Equity] - Shows how much1money is earned with the money invested by the
shareholders.
N et 11lcome- Pre f erred
Ra t e 0f Re t urn on 0 r d.mary Sh are h 0 ld er ' s E qw 'ty --
Dividends
Average Ordinary
Share holders'
Earnings
Equity
per Share [EPS] of Ordinary Shares - Gives the amount of net

I
income earned for each share of'the company's common stock outstanding.
.
Net Income-Preferred
Dividends
Weighted-Average
Number of
Ordinary Shares Outstanding
EPS of Ordmary Shares:=
11.2.5 Analyzing
Price/Earnings
Stock Investments
I
Ratio - It shows how much an investors is willing to pay for
each unit of earnings.

.
E
.
R'
Market
Pnce- armngs- atlO = '
Dividend
Price per Share of Share

Earnings per Share
Capitat
Yield - Shows the percentage of a stock's market value returned as
dividends to stockholders each period.

"d
DlVI
108
en
d Y' ld
le
Divid~nd
per share
= -----~-----------Market
(ordinary
P:rice per share
(ordinary
or preferred)
or pre{erred)
Uniseminar
Book
Theory - Accounting
Value
per
Share
of Ordinary
Share
- Indicates the recorded
accounting amount for each ordinary share outstanding.
Book Value
0[
Ordinary Share = Total
Shareholder's
Number
11.2.6 Other Issues in Financial
Statement
measure whether
performance.
operations
Equity
Shares Outstanding
Analysis
Managers of leading companies also use economic

evaluate operating
Equity-Pre[erred
o[ Ordinary
value
added
EVA combines accounting
have increase shareholder
(EVA) to
and finance to
wealth and can be
calculated as folIows:
EVA = Net income
+ Interest expense - Capital charge
, where the capital charge is defined as:
+ Current maturities o[ lang term debt + Lang - term debt + Shareholders' equity) *
Capital charge = (Notes payable
Cast o[ capital
The cost of capital is a weighted average of the returns demanded by company's
shareholders and lenders depending on the company's risk, whereas the rest can
be retrieved in the financial statements.
Before rounding up this financial accounting script, we would like to point out six
red flags in financial
statement
analysis, wh ich may mean that a company
is very risky:
Earnings problems (e.g.low or decreased income)
Decreased cash flow (e.g. consistently lower cash flows than income)
Too much debt (e.g. higher debt ratio than industry average)
Inability to collect receivables (e.g. growing receivables resident period

compared to industry average)
Build-up of inventories (e.g. slowdown of inventory turnover)
Trends of sales, inventory and receivables (e.g. incoherent movements in

these items)
109
Theory - Accounting
110
Uniseminar-
Practice Exercises

Uniseminar
Practice
Practice Exercises
This part contains practice exercises to each week and therefore to each chapter
of the theory script By this, you can deepen your theoretical knowledge with
practical exercises and you can! go through the exercises of these topics again.
which you have not understoo~ so weil until now. Although you may thinkthat
you already have done enough lexercises during the weeks, the'se exercises are
tailored specifically to your neeGs and try to teach you the most important topics
ofthe exam in a practical manner.

I
Table of Contents
Finance
Exercises
Solutions
16
Accounting
43
Exercises
43
Solutions
56
Uniseminar
Practice - Finance
Finance - Exercises
1
This topic deals with the basic principle of capital markets: the risk-return
relationship of securities. The two most important aspects are the CAPM model
and the Security Market Line (SML).
Exercise
1.1
The table below shows the quarterly stock prices of Apple, lnc. (AAPL) and
Microsoft, lnc. (MSFT) during June and July 2011 (Weekly data, closing prices).
Based on these data, calculate
a)
24. Jun. 11 317
1272
01. Ju\. 11
328
1268
08. Ju\. 11
343
1340
15. Ju\. 11
356
1343
the mean weekly return for the two stocks and the market (round to three
digits)
b)
the variance for the two stocks and the market (round to six digits)
c)
the standard deviation for the two stocks and the market (round to four
digits)
Furthermore, calculate AAPL's

d)
correlation
assuming that the covariance of AAPL with the market is
0.000184 and (round to three digits)

e)
beta
t)
sharpe ratio (assume a risk free rate of 2.5%)

1
Uniseminar
Practice - Finance
Exercise
a)
1.2.
- Fiilance & Accounting
Explain the difference bJtvveen the Security Market LinJ (SML) and the
Capital Market Line (CMd). In this regard. elaborate on t~e different axes
~~
b)
Explain where the market portfolio is positioned on each lihe.
c)
Regarding the CAPMmodel
i. What is the efficient frontier?

I
ii. Explain
the
difference
i between
Total
risk,
systen1atic
risk,
and
unsystematic risk. How cln

I you measure each risk type? ...,
iii. What is the CAPM equation? In this regard, explain wh~t kind of return
I,
relationship is represent~d by this equation? What is meaJt by market risk

I
d)
premium? How does it differ from an individual's risk premium?

I
I
Regarding the SML
i
i. What does "alpha" mea~ and when is a security over- pr undervalued?
Explain the phenomenon
bf mispricing
I
from a risk-return Jerspective.

I
ii. What does a securities beia imply?
Exercise
1.3
Assurne that in 2007 the rate of return on short-term
goverhment securities
(perceived to be risk-free) was about 4.5%. Suppose the expectbd rate of return
required by the market for a portfolio with abeta of 1 is 11%. kccording to the
CAPM:
a)
What is the expected ratk of return on the market portfblio? What is the
market risk premium?
b)
What is the risk premium for a security with a beta of 0.8 and 1.2?
c)
The rate of return on Skodia's was 16% in the first quarter of 2007 and
currently Skodia has a beta of 1.5. According to the CAPM,is the stock overor undervalued? Is the alpha positive or negative? Does it lie above or
Uniseminar
Practice - Finance
below the SML (=Security Market Line)? Would you recommend to

investors buying this stock?
d)
What is the rate of return on a stock with a beta of O?
e)
Suppose you consider buying a share of Monosoft's stock at $40. The stock
is expected to pay a $2 dividend next year and you expected to seil the
stock at $41. The stock's beta has been estimated at 0.5. Is the stock overvalued or undervalued?
Uniseminar - FiAance & Accounting
Practice - Finance
Capital Structure,
Modigliani
and Miller
i
:
This chapter deals with the optimal capital structure decision fdr a firm. Taking
on leverage increases the risk Jf the company, but it also has the advantage of
I
shielding interest payments frorAtax.

I
Exercise
2.1
Correct the statements below.

a)
In perfect capital markets, the total value of a firm is/is not equal to
thee
market value of the total! cash flows generated by its ass~ts and is/is not
affected by its choice of capital structure
b)
In perfect capital markets, homemade leverage is/is not la good example

that a firm's choice of capital structure does not affect its oterall value.
c)
Assuming perfect capital barkets, which of the following s~atements about

perfect capital markets i~ wrong?
..
secuntIes
.. pnces,
I.
(")11
at competltlve
(i) all market partici1pants can trade

th ere are no taxes or transactIOn
i.
costs,
(iii) a firm's financing de~ision can alter the cash flows generated by its
I
investments, (iv) all market participants can borrow and lend at the risk
free rate.
d)
When a company repuichases
its shares in the open market this is
always/sometimes/neve1referred
e)
to as leveraged recapitalization.
In perfect capital marke~, an increase in a firms leverage I(everything else

constant) increases/decr~ases/does
not change its cost of ievered equity.
f)
In perfect capital markets', the cost of equity equals/does not

equal the cost
:
;
of unlevered equity only when a firm does not have any leverage.
g)
Which of the following does not belong to direct cast of bankruptcy?
(i)
fees to lawyers, (ii) fire sale of assets, (iii) auction fees, (iv) fees to
investment bankers (for restructuring purposes).
h)
When a firm faces financial distress it may /may not file for chapter 7 or 11
of the V.S.bankruptcy code. Chapter 7 reorganizationjJiquidation
appointing a trustee/a new
CEO
involves
to oversee the reorganization/liquidation
Uniseminar
Practice - Finance
of a firm's assets. Chapter 11 liquidation/reorganization

restructuring/liquidation
of a
allows for a
firm"s asset and enabJes/does not enabJe a
firm to keep its operations running.

i)
Due to the high costs associated with financial distress, firm"s facing
financial distress can/cannot directly negotiate with their creditors and
thus avoid the high costs of filing for bankruptcy; this is called a workout.
j)
Another approach that minimizes the directjindirect costs associated with

bankruptcy is called prepackaged bankruptcy. In this process a firm facing
bankruptcy, first develops a reorganization
plan to which all creditors
agree and then files for Chapter 7/11 ofthe 0.5. Bankruptcy Act.
k)
Is the following statement false or true? Tradeoff theory states that the
value of a levered firm can be explained by adding the sum of its present
values of its interest tax shield and its agency benefits of debt to the
unlevered value and by subtracting agency costs and financial distress
costs.
Exercise
a)
2.2
Assurne the company Micromini Inc. has a debt-to-equity ratio of 40%, its
cost of equity is 14% and its cost of debt equals 10%. What is the
company"s unlevered cost of capital?
b)
Now consider another company: Bertelsbrecht Ine. It has a cost of debt of

8% and its unlevered cost-of-capital is equal to 12%. Furthermore, it faces
a corporate tax rate 35% and has the same capital structure
debt-to-equity ratio) as Micromini. Calculate the company"s
c)
Calculate the
rWACC
(that is same
rWACC'
of a company that has 300 million of debt with a cost of
debt of 11%, 500 million in equity on wh ich a cost of equity of 15% is

charged and that is subject to corporate taxation at 40%.
Uniseminar
Practice - Finance
- Fihance & Accounting

!
Exercise
2.3
i
Imagine the company HTCMoblie. It has 50 million shares outsbnding
with an
average share price of 10. FurJhermore, it currently has debt oJtstanding worth
400 million. HTCMobile has to pky 6% interest on its debt.
a)
Assume that HTCMobile:s unlevered
cost of capital is! equal to 14%.
Calculate HTCMobile's co~t of equity.

!
b)
'
'e
Assuming no tax, if HTCiMobile would issue 300 million in new debt to

repurchase shares, how many shares would it be able to fElpurchase? What
I
I
would be the new share price?
Can you explain the results?1
c)
Assuming a corporate ta* rate of 35%, an equity tax rat~ of 20% and an
income tax rate on inte~est income of 15%, calculate ~e effective tax
I
I
advantage of debt. (round to four digits)
I
d)
Applying the tax rate of
d), what
I
effect would a leveraged recapitalization
with a new debt issue of 300
million (permanent
debt) have on
HTCMobiles share price? What is the new market value ~f its equity after
the recapitalization? Assurne that the debt is risk free and that the risk free
interest rate is 4%. Fur~hermore, use the information las stated in the
introduction text (50 million shares at 10 and cost of debt of 6%).
I
I
I
Uniseminar
Practice - Finance
Payout Policy
In this chapter you explored the effect of dividends on the share price and how
market imperfections can affect the payout policy of a company. The exercises
below will help you to foster your knowledge in this topic.
Exercise
3.1
a)
Name the four different options of a company to distribute cash.
b)
When a company decides to pay dividends to its shareholders,

follow an officialprocedure
it has to
including four different dates. Each date has a
special relevance in the process of paying dividends. Please name all four
dates and their respective implication.
c)
Explain, why in perfect capital markets, investors are indifferent between

receiving a dividend and selling their shares in an open market share
repurchase.
d)
Explain the dividend signaling hypothesis, the clientele effect and the
dividend capture theory.
e)
Is it ever wise to retain cash within your company? Why or why not? What
would be the effective dis/advantage
of retaining cash if the following tax
rates apply: corporate tax rate of 35%, capital gains tax rate of 20% and
individual tax rate of 35%?
Exercise
3.2
The management of the car manufacturer
Wulfswagen has to decide how the
unexpected profit of 40 million of the last quarter can be used most efficiently.
They are very concerned about their shareholders well-being and thus have to
consider if a dividend will be in their interest. Furthermore, except for the one
time profit, Wulfswagen expects to generate 100 million in free cash flow for the
next 5 years and after that (beginning in year 6) 45 million each following year
forever. It is debt free and its unlevered cost of capital is 12%.
I
I
Uniseminar
Practice - Finance
a)
- FiLnce
& Accounting
I
I
With a corporate tax ratelof 35%. a dividend tax rate of 30% and a capital
I
gains tax of 25%. is a divitlend advantageous?

I
b)
A new law has been ratifi~d and put into action. As of now the dividend tax
I
.
rate hasdropped to 20%. How does your result under a) change?
c)
Given the cash flows of Jhe company. calculate Wulfswagen's enterprise

value (excluding the one Lne profit).
d)
shareholder
outstanding?
e)
2dI
would recei~e for one share, assuming
million shares
Would it be best to paYIa one-time special dividend orl to increase the

current dividend level for~ver?
:
If a one-time special divi1end were paid, what would be lhe amount each
Uniseminar
Practice - Finance
Capital budgeting and valuation
Exercise
4.1
In table a) beIow you find the modified financial statements of AppIe Inc. for the
last three years. Furthermore, some balance sheet items have also been reported
in table b) below. For the foIIowing exercise, assume a corporate tax rate of 35%
and a cost of debt of 10%.
- COGS
Gross Profit
-Selling
& Administrative
-R&D Expenses
EBITDA
- Depreciation
65,000
43,000
32,000
32,000
25,500
21,000
33,000
17,500
11,000
2,000
4,000
3,000
5,500
1,500
1,000
25,500
12,000
7,000
3,500
1,000
& Amortization
EBIT
22,000
11,000
7,000
Table a)
Debt Ouststanding
20,000
10,000
Changein NWC
+2,000
-500
Capital Expenditures
7,000
3,000
o
+1500
3,500
Table b)
a)
Calculate the Free Cash Flow to the Firm in 2010
b)
Calculate the Free Cash Flow to Equity in 2009 and the increase in net
borrowing for 2010
I
Uniseminar - Fin1ance & Accounting
Practice - Finance
Assume that the FCF in 2:007 was 6,000. Assuming interest payments of
c)
3,000 and an increase in j1netborrowing of 5,000, what ib the Free Cash

Flow to Equity in 20077
d)
Calculate the interest tax shield for the years 2010, 2009, and 2008
e)
Calculate the cash flow that. is available to all stakeholders ih! 2010
Exercise
4.2
The companyScubaDIVE
ScubaDIVE currently
has the optio~ to invest in a new project "Scoobi".
has 5001 million of equity and 330 million of deb_
outstanding. Furthermore, it holds 30 million in cash and cash equivalents. The

corporate tax rate is 30%. The [cost of debt is 8%, the risk fre~ rate is 3%, the
market risk premium is estimated at 12% and the average industry beta is 1.4.
You as a manager were asked tb linvestigate the different effect 0f the project on
I
stakeholders
and shareholdersl using a WACC analysis. Perfo~m this analysis
based on the financial figures p~ovided in the tables below. Round your result for
the WACCto four digits.
The cash flows of the project are presented in the table below.
I
- COGS
Gross Profit
-Selling
& Administrative
-Operating
20
Expenses
- Depreciation
30
EBIT
+ Depreciation
- Capital Expenditure
- Change in NWC
10
10
10
10
5
0
0
35
Uniseminar
Practice - Finance
Exercise
4.3
Assume that the apparel company V-Star asked you as a consultant to evaluate
their newest project Pants & Shirts using
a)
The Adjusted Present Value method, assuming constant permanent debtto-equity ratio throughout the projects life (5 years). There is a special
fund set up to pay the debt after the project is over, wh ich is unrelated to
the project itself.
b)
The Flow to Equity method
Furthermore, it is known that V-Star has a constant debt-to-value ratio of 50%

and its current cost of debt is 6%. The corporate tax rate is 35%. Additional
research has shown that the current market risk premium is 10%, the risk free
rate is 4% and the beta of comparable apparel companies is 1.6.
-70
45
45
45
45
136.8
108.2
76.1
40.2
68.4
54.1
38.05
20.1
FCF
Levered Valueat
(Rwacc=12%)
Debt Capacity
Interest payments
6%
Note that when using the WACC method,
assumption
the levered
that there is a constant debt-equity
value equals 66.8. Under the
ratio, the WACC, APV and FTE method
should provide us with the same result. Jf the debt-equity
ratio is not assumed to be
constant, the levered values may differ.
11
Uniseminar - Firlance & Accounting
Practice - Finance
Options
Exercise
5.1
I
Answerjcorrectthe statements below:
I
a)
Given that you know the Irisk
free interest rate, the strike price of a call
,
I
option maturing in 2 months and the price of its underlying, you are able to
I
calculate the option premium using Black-Scholes Model.

b)
The Black-Scholes Model generally applies to European/Aberican options

I
on non-dividend
payingstocks.
account for dividend pay\'nents.

.
c)
i.
I
Implied volatility refers t~ the volatility that is implied by tre current price
the option trades for in the open market.
d)
However, it can be eafily adjusted toA
The Put-Call Parity states ~hat a portfolio of a European put-oPtion plus the
underlying stock yields
European call option and
ihe
same payoff as a portfolio .consisting of a
b bond with a face value equal to the strike price
of the option and which hJs the same maturity as the option.
e)
The Put-Call Parity also sfates that the price of a call can be expressed by
the price of a stock plus an otherwise identical put plus thelpresent value of
a bond with a face value' equal to the strike price of the loption and that
. !. .
I
matures at t h e same pom~ In time.
i
f)
An increase in the price df an underlying has a positive/n~gative effect on

the premium of a call opti1onand a positive/negative effect,on the premium
of a put option.
g)
A decrease in the strike price, increases/decreases the premium of a call

option. However, it yiel'ds to a higher/lower premium
regarding
put
options.
h)
Higher levels of volatility have no/a negative/a positive effect on call

premia and a no/a negative/a positive effect on put premia.
i)
The time value of a call option on a dividend paying stock is equal to the
present value of the strike price plus the option premium of an otherwise
12
Practice - Finance
Uniseminar
identical put less the present value of any dividend payments that occur
until the option matures.
j)
The intrinsic value of a put option on a dividend paying stock is equal to the
strike price less the price of the underlying.
k)
A call option ean/eannotbe
worth more than the stock itself.
I)
A put option ean/eannot be worth more than its strike price.
m)
An American option cannot be worth
more/less
than its European
counterpart.
n)
An American option ean/eannotbe worth less than its intrinsic value.
0)
The premium of any call option on a non-dividend paying stock does

not/always/sometimes
p)
The time value of an American put option on a non-dividend paying stock

ean/eannotbe
Exercise
a)
negative when the option is sufficiently deep in-the-money.
5.2
Explain the following option strategies:

i.
b)
exceeds its intrinsic value.
A costless collar
ii.
Astrangle
iii.
Astraddie
iv.
A butterfly spread
Given the price of a call Janll 30.00 and knowing that the underlying stock
price is equal to 25.00, the put-call parity can/cannot be used to estimate
the theoretical price of a Febll put option with the same strike price.
c)
What is the price of a call Augll 20.00 that matures in three months, if the
current stock price of the underlying is 25.00 and an otherwise identical
put trades at 0.60. Assurne the risk free rate to be 5%.
d)
It is mid February 2011 and HSBC's share price is currently 18.00.

Because it is the third Friday of the month, all options bought today exactly
mature in one month. Furthermore, the price of a Mar12 25.00 put option
is 3.50 and the price of a call Mar12 20.00 is 1.50. There is also another
13
I
I
Uniseminar
Practice - Finance
- Fidance & Accounting

I
put option traded with a' strike price of 20.00 which also matures on
March 2012. The premium of this option is 2.50. In addition, the Apr12
call 25.00 trades at 0.50.Given this information,
rate.
e)
estimate
the risk free
Use the information proviCied in the table below to calculate d1 and d2 for
the European call option Jith a maturity of 75 days:
I
S
72
68
5%
0.3
f)
Calculate the price of a: European call and put option using the data
I,.
provided in the table below:

I
Exercise 5.3
rf
5%
(J
0.25
64/365
N(dl)
0.7658
N(d2)
0.7325
e
!
Assume that IBM stock is currehtly trading at 30.00. The stock price will either
j
increase or decrease by 5 during the next two periods. There is a European put
option traded on IBM stock with a strike price of 32.00 and the risk-free rate is
5%. Please estimate the premium of the European put option.
Helpful steps in solving the exercise:
1)
14
Draw the option payoff (tree) diagram
Uniseminar
2)
Estimate the value at the end nodes
3)
Decompose the diagram into sub-branches
4)
Estimate the option value at time t=O
Practice - Finance
15
Uniseminar
Practice - Finance
- Firlance & Accounting

I
Finance - Solutions
1
Solution to Exercise 1.1
I
!
How to calculate the numbers? Example using AAPLstock:
Before calculating the statisticall figures, please keep in mind thJt all figures are
based on return data. Since you were only given stock prices you first need to
compute the respective return Jates
(using AAPL's return from 24th Jun. to 1st_
i
Jul. as an example):
,.,
ReturnMPL= AAPL 24.06-01.07= 328-317

317 = 0.035 ,., 3.50'0
l(
a)
Mean return:
-
R, = -
* :LR1 + R2 + ...+ RN = -1 * (0.035 + 0.046 + 0.038) ,., 4.0%

I
I
i
b)
Variance and Standard De'viation of AAPL:

Var(R)
=-
J
I
* :L(Rr - R32
T-1
= -3 1 * [(0.035 - 0.04)2
-1
I
+ (0.046 - 0.04)2 + (0.038 - 0.04)2]
,., 0.000032
c)
Standard Deviation
SD = -JVar(R)
d)
Correlation between AAPLand the Market:

C orr =
16
= ,.10.000032 '" 0.0057
Cov(Mkt;
stock)
SD(Mkt)*SD(stock)
0.000184 = 0.979
0.0057*0.0332
Uniseminar
e)
Practice - Finance
The beta measures a securities sensitivity to market movements. If the
market moves by one unit, the security will move by "beta" units.
Cov(AAPL;Mkt)
=~
Var(Mkt)
f)
= 0.17
0.000110
Sharpe Ratio:
.
R;-rt
0.04-0.025
2545
= .
Sh arpe R atw = --u; = ---0.0057
Keep in mind that same of the numbers given in this exercise are rounded
numbers. In the exam it is aIways best to onIy round the end resuIts without
intermediate rounding. Furthermore, the covariance given is based on the
following formula:
Cov(R"} R.) =_l_*~(R't-k)(R't-k)

T - 1 ,L,',
,
},
The tabIe beIow shows the resuIts far the exercise.
1272
24. Jun.
317
01.lu!.
328
3.5%
1268
-0.3%
08.lu!.
343
4.6%
1340
5.7%
15.lu!.
356
3.8%
1343
0.2%
Mean Return
Variance
Std. Deviation
Covariance
Correlation
Beta
Sharpe Ratio
4.0%
1.9%
0.000032
0.001099
0.0057
0.0332
0,000184
0,979
0.17
2.545
-0.192
17
Uniseminar
Practice - Finance
I
I

a)
I
The CML depicts the rela~ionship of a securities return aAd its total risk.
I
The x-axis is labeled with
(J
'
(total risk) and the percentage expected return on the
y-axis. The CMLis an upward slJping line that intersects the Y-axis at the return
that is equivalent to the risk free !rate and is tangent to the market portfolio which
lies on the efficient frontier. I~ slope is the Sharpe Ratio and indicates the
I
steepest possible line that can b~eachieved by combining a risk free investment
I
with (a portfolio of) risky securities.

The SMLdepicts the relationshiJ of a securities return and its sYSlematic risk (ite
beta). The x-axis is labeled with

return. The SML diagram shols
Overvalued (undervalued)
I
while the y-axis also showsl the percentage
whether securities are fairl~ priced or not.
'''1''''''
H, b,low (,bov') tb, SML,nd hm
negative (positive) alpha.

I
b)
On the CMLthe market pqrtfolio lies on the efficient frontier. It represents
the portfolio on the efficient frontier that yields the steepest line :(highest Sharpe
ratio) when connected with a, risk free investment. Regardi~g the SML, the
market portfolio lies on the SMLwhere beta equals one.
c)
;
(i) The efficient frontier represients the most efficient (highest return given the
I
level of risk) combination of different assets of a portfolio. It is;the part at an~
I
above the minimum variance p~rtfolio (the point on the frontier with the lowest
standard deviation). All investm'ents along the frontier are efficient, which means
I
that given any level of risk along the efficient frontier, no higher return can be
achieved.
(ii) Total risk can be decomposed
unsystematic
risk. Systematic
into two components:
risk is measured
systematic
by a securities
beta
and
and
represents the t1uctuations in a stock's return due to market-wide t1uctuations.

Total risk is measured by a securities standard deviation and consists out of both
18
Practice - Finance
Uniseminar
systematic and unsystematic risk. Unsystematic risk represents the f1uctuations

in a stock's return due to firm-specific news and is unrelated across stocks (an
efficient portfolio contains only systematic risk).
(Hi) The CAPM equation is as folIows: E[RJ = rf
+ i(RMkt
rf)' It shows a
positive relationship between risk and return, implying that the higher the risk of
a security, the higher its return should be (in order to compensateinvestors
the additional
represented
risk). In the equation
by the term (RMkt
above, the market
risk premium
is
rf) and is the risk compensation for systematic
risk. An individual security's risk premium is represented by the term i(RMkt

rf)'
for
The beta coefficient measures the respective securities risk towards the
market

The CAPM gives us the basic formula to calculate the expected return of a
security, given its beta:
+ i(RMkt
E[RJ = rf
a)
rf)
As given in the exercise, the return for the market portfolio (which has a
beta of 1) is equal to 11%. So 11% is the "rate of return on the market portfolio".
Furthermore, with a risk free rate of 4.5%, the risk premium due to systematic
market risk is:
b)
Unlike the risk premium of the market where beta equals one, the risk
rf)
11% - 4.5%
(RMkt
6.5%
premium of an individual security is dependent on its beta. Following the CAPM

equation provided above, the risk premium for a security with a beta of 0.8 and
1.2 is
i(RMkt
rf)
and i(RMkt
=
-
0.8
rf)
* (0.11 - 0.045) = 0.052 -75.2%

1.2 * (0.11 - 0.045) = 0.078 -77.8%
19
c)
Uniseminar
Practice - Finance
In order to test whether a:stock is over
01'
undervalued, Y9u can calculate
the expected return of this stoc* using the CAPM equation. If th:~ stock is fairly
priced, the real and expected r~turn should be equal. If a sec~rity's expected
return exceeds its real return'lthe
security is underpriced:
it, provides more
return than necessary to compensate for its systematic risk (its b,eta). Vice versa,
a security would be overpricedl if the expected return were le~s than the real
return. Underpriced (overpricedD securities have a positive (neg4tive) alpha and
I
lie above (below) the SML!
In order to caiculate whether skbdia's stock is overjunderpriced,
all you need to
do is to plug in the correct values in the CAPMformula:

!
E(R;)
rf
+ i(RMkt
rf)
4.5% + 1.5 * (11% - 4.5%)

I
14.25%
'
Because Skodia's real rate of return was equal to 16% and 16%' > 14.25% (the
I
expected
return,
given
underpricedjundervalued.
itis
'
systematic
risk),
Skodiil's
stock
is
Therefore, investors should be recommended to
buy the stock. The stock lies abo~e the SMLand has a positive alpfua.
I
I
I
I
d)
A security with a beta of ~ eloes not move in relation with tpe market at all.
Because the securities return is i,rrespective of any market move~ents, the return
is simply the risk free rate. The ~n:swer to the question is thereforlO 4.5%.
I
e)
Although dividends do not belong to this topic, their relevance is only
trivial. All you need to know is that a stock's return is composed of the dividend
payments plus a capital gain (the increase in stock price). As a result, the real
return on Monosoft's stock is:
Capital gain = 41 - 40 = 1
Dividend
--+
20
= 2
Real return
= 1+2
= 7.5%
40
Uniseminar
Practice - Finance
According to the CAPMthe expected return should be:

E[R;] = 4.5%
+ 0.5 * (11% - 4.5%)
= 7.75%
Because the expected rate of return is higher than the real rate of return (7.75%
> 7.5%), Monosoft's stock is currently overvalued. Given its systematic risk, a
return of 7.75% would be expected. However, the stock only yields a real return
of7.5%.
21
Uniseminar
Practice - Finance
Capital Structure,
Modigliani
and Miller

a)
Modigliani and Miller Proposition I: In perfect capital markets, the total
value of a firm is equal to the ma~ket value of the total cash flows generated by its
assets and is not affected by its ~hoice of capital structure.
I
I
b)
In perfect capital markets,: homemade leverage is not a good example that
a firm's choice of capital structurb does not affect its overall value.
c)
(iii) A firm's financing decision cannot alter the cash floWs generated by
I
its investments. Investors can alter their portfolio individually an~dthus replicate
any capital structure choice themselves.
d)
Sometimes.
It is only called leveraged recapitalization if the issuance of
new leverage is used to repurchJse shares. lt can also be financed,j by using excess
I
'
cash of a company's cash reservels.

I
In perfect capital markets,l an increase in a firms leverage (everything else

I
constant) increases its cost ofllevered equity. Leverage increases the riskiness
e)
of a firm's cash flow to its equiJ. holders as they only have a residual claim on
I
firm 's assets (due to the senioritY of debt).
f)
a_
In perfect capital markets, the cost of equity equaIs the cost of unlevered
equity only when the firm does not has any leverage. Because the unlevered cost
of capital is the cost of capital of a hypothetical all equity (completely unlevered)
firm, the unlevered cost of capital has to be the same as the cost of equity of a
completely unlevered firm.
22
Uniseminar
Practice - Finance
g)
Fire sale of assets is an indirect cost of bankruptcy.
h)
When a firm faces financial distress it may file for chapter 7 or 11 of the
U.S. bankruptcy code. Chapter 7 liquidation

oversee the liquidation
for restructuring
involves appointing a trustee
of a firm's assets. Chapter 11 reorganization
of firm's assets and enables
to
allows
a firm to keep its operations
running.
i)
Oue to the high costs associated with financial distress, firm's facing
financial distress can directly negotiate with their creditors and thus avoid the
high costs of filing for bankruptcy; this is called a workout.
j)
Another
bankruptcy
approach
that minimizes
is called prepackaged
the direct
bankruptcy.
costs associated
with
In this process a firm facing
bankruptcy, first develops a reorganization plan to which all creditors agree and
then files for Chapter 11 ofthe U.S.Bankruptcy Act
k)
False.
lt is the present value of agency- and distress costs that is
subtracted, not just the costs themselves!

a)
You were given a debt-to-equity
ratio of 40%.
First, let's clarify the
different nomenclatures of different capital ratios:
!!. = Oebt-to-equity ratio

E
!!. =
C
~D+E = Oebt-to-value
CE =
D+E
ratio
.
= E.qmty-to-va Iue ratIO
23
Uniseminar - Finiance & Accounting
Practice - Finance
This exercise can be solved in two ways:

I
1.
Using the pre-tax WACCforrnula

I
Because you were only given t~e D/E ratio, you need to calculate the D/D+E
ratio. There are two ways to do sb: i) the intuitive way. ii) the rnathernatical way
i)
if . = 0.4 = ~ ~ D = 4
E
10
Thereforethe
2,
D+E
10+4
-=--=-
dnd E = 10
I
10
D+E
10+4
and -=--=
1--=-
I
ii)
Because the following re:Jationship holds between the

D
_E
holds:
(1+%)
D
-
=_D
0.4
1.4
D+E
.E:
and....!!...-ratioe
D+E
Once the debt-to-value and equi~y-to-value ratio have been calcJlated, all values
can be plugged into the Pre-tax rl,qcc forrnula:
Pre-tax
2.
rWACC = D:E
* rE + D:E *
k ~~
* 0.14 + ~* 0.1 =
Using the forrnula for equity-cost-of-capital
rE = ru
+-
(ru - rD) ~
0.14 = ru
+ O.4(ru
0.1286 or 12.86%
i
:
- 0.1) ~ ru = 0.1286 or 12.86%
b)
Because there is no infprrnation given about the cos~ of equity. the.
conventional
rWACC
formula1 ca:nnot be applied. However, becarse information.
about the unlevered cost of capi~ai are provided another formula tan be used:
D
rWACC = ru - D+E
c)
* Tc * rD =
0.12.- -
* 0.35 * 0.08 =
0.112 or 11.2%
With 300 million of debt and 500 million in equity. the company's debt-to-
value and equity-to-value ratio can be computed as illustrated below:
24
Uniseminar
D
300
300+500
-=---=D+E
Practice - Finance
- Finance & Accounting'
and ...!-=~=~
300+500
D+E
Plugging all values into the correct formula for the weighted average cost of
capital yields:
E
* rE + -D+E * rD(l-
rWACC = -D+E
5
= 8 * 0.15
TC)
+ 8 * 0.11 * (1 - 0.4) = 0.1185 or 11.85%

a)
First you need to compute the debt-to-equity ratio: because the company
has SO million shares outstanding at -10 each, the equity capitalization is equal
to -500 million (50mil. x -i0). Therefore, the debt-to-equity ratio is 400/500 =
0.8. The correct formula to calculate the cost of equity is:
rE = ru
b)
+ -DE (ru
- rD) = 0.14
+ 0.8 * (0.14 - 0.06) = 0.204 or 20.4%
The current share price of HTCMobile is -10. Because it is not subject to
any taxes, there is no interest tax shield benefit and the firm value does not
increase due to the issuance of new debt. Thus, by issuing 300 million in new debt
HTCMobile could repurchase: 300/-10=30
million shares, leaving a total of 20
million shares outstanding.

Because of the absence of tax, there is no change in the overall value of the
company. The share price remains at -10 because 300 of equity is replaced with
debt and the number of shares is reduced proportionally.
c)
Applying the correct formula below, the effective tax advantage of debt can
be computed.
T*
= 1-
(1-Te)(1-Tc)
= 1-
1-Ti
d)
(1-0.20)(1-0.35)
= 0.3882 or 38.82%
1-0.15
In order to answer this question correctly, follow the procedure that is
outlined on the next page.

25
Uniseminar - Finknce & Accounting
Practice - Finance
Leveraged Recapitalization
Scenario:
i
company issues new debt (Dnew)
I
to repurchase
shares
Assumingrv stays constant!
Step 1: Calculate the Present Value (PV) of the interest tax shield eint. shield)
rd
cost of debt;
,* = effective
tax
!
a)
b)
Calculate the interest payments (int. pay.): rd * DNew

I
Calculate the tax shield res1iIltingfrom interest payments:
tax shield = int. pay *
c)
,*
Calculate the PV(int. shiel4) by discounting at
r[
(since debt is risk-free)
i
i
'
Step 2: Calculate the new market value of equity [MV(E)] at the a~nouncement of
I
I
the recap. At the announcement.1 the MV(E) increases by the pres'ent value of the
I
'
interest tax shield [PV(int. shieldD]:

I
New MV(E) = MV(E)old + PV(int:.shield)
I
,I
Step 3: Calculate new share price based on new MV(E):
i
.
NewMv(e)
New share pnce = # o[ shares outstandinB
;
I
Step 4: Calculate the number (#) of shares being repurchased:
Shares
rep
new
D
.
New Share prtce
Step 5: Calculate new # of shareS outstanding:

New Shares Outstanding
=#
of shares before recap - # of rep. shares
Step 6: Calculate new MV(E) after the repurchase took place. based on the new
share price and the new number of outstanding shares:
MV(E) after rep. = (new # of shares outstanding)
26
* (new share price)
Uniseminar
Application
Step 1:
Practice - Finance
to Exercise
2.2 d)
PV(interest tax shield)
Dnew
'"rv '"r*
300.0.06.0.3882
0.04
6,9876
0.04
= 174.69
Step 2: New MV(E)

S
~
3 N ews h.arepnce
Step 4: Sharesrep
MV(E)Old
=
+ PV(int.shield)
New MV(E)
-_
# of shares outstandlng
D
300
= New Share
new.
= --13.49
=
pnce
500
674.69 _50
+ 174.69 = 674.69
13.4938 '"
.- 13.49
22.24 "" 22
Step 5: # of shares outstanding = 50 - 22 = 28 [million]

Step 6: MVafter repurchase
= 28 * 13.49 =
377.72
27
Uniseminar
Practice - Finance
Payout Policy

a)
(1) Invest cash in new projects

I
(2) Increase cash reserves !

(3) Repurchase shares
(4) Pay dividends
;
b)
When a company decidesi to pay a dividend, it first has tb authorize the
dividend payment by the board of directors, which is the declara~ion
date.
Once the dividend has been registered, it will be paid to every s~areholder who
holds stocks on the so-called reJord date. Only shareholders \\iho bought their
I
shares at least three days prior to the record date will receive dividend payments
(as it takes three business days tor a share to be registered). ThJrefore, the date
two days prior to the record datJ is called ex-dividend
I
date.
Finally the payable
or distriJjution date is the day on whicH the dividend is

I
distributed to all attributable shareholders.
I
c)
In perfect capital market~, when a dividend is paid, the s~are price drops
I
by the amount of the dividend v:vhenthe stock begins to trade el'-dividend. If no
dividend is paid, but shares are repurchased instead, the sharJ price stays the
I
same (shares outstanding are reOluced, but equity (cash) is also reduced). Thus,
I.,
by selling their shares, shareholders can create a dividend themseJves.
d)
The dividend
I
signaliJ~g
hypothesis
states that when a company
changes its dividend policy this has adverse effect on its share price. Generally an
increase in dividends is perceived as positive signal, as it shows that the company
will be able to meet higher future payments to its shareholders. This can only be
achieved if it generates higher free cash flow in the future. [In very unlikely
situations a dividend increase could also be interpreted as a negative signal if the
company has not enough new investment opportunities]. A dividend cut however
is perceived as negative signal by the market (much worse than an increase of the
28
Uniseminar
same magnitude)
and results
as a signal
the company
operations
that
without
As a result,
increase
the dividend
holding dividends
The c!ientele
according
brackets
Another
constant
is dividend
and
cannot
fund
its
smoothing.
only
the higher
wh ich refers
to
over time.
the fact. that a firm tailors
its dividend
policy
of its investors.
capture theory describes
that absent
paying stocks is highest
with high tax brackets
transaction
around
costs, the
the ex-dividend
seil their shares and investors
with low tax
will buy shares.
the individual
retaining
to retain excess cash within the company,
(like interest)
once on the individual
difficulties
to shareholders.
expression
effect describes
It is never beneficial
retam
financiaI
conceived
level when they are sure that they can maintain
relatively
income it generates
T*
share prices. It is generally
are said to be sticky. that is companiesjmanagers
volume of high-dividend
date. Investors
e)
has
to the tax preferences
The dividend
trading
in decreasing
cutting payments
dividends
level in the future.
Practice - Finance
will be taxed twice, once on the corporate
level. In the case at hand, the corporate
investor's
tax rate
Ti
and
thus
cash is equal to the capital gains tax rate
= 1-
(l-Tc)(l-Tg)
(I-Ti)
1-
because
(1-0.35)(1-0.20)
1-0.35
the
effective
tax rate
Tc
the
and
equals
disadvantage
of
Tg:
0,20 or 20%
29
.
.
UnIsemmar
Practice - Finance
I
&A ccountmg
.
- F'mance

a)
The formula for the effecti~e dividend tax rate is:
- 'd-'g _ 30%-25%
_-.
Td - -- ---
1-25%
l-'g
0067 ar.,o
61701
I
Because the result is positive: (6.7%) this implies that divi~ends are at a
disadvantage compared to capital gains. Each 1 dividends is worth only (1I
0.067=0.933) 93.3 cents in capital gains.
b)
T'
d
= 'r'g = 20%-25%= -d.067 ar - 6.7%

l-'g
1-25%
I
The negative sign now indicates ithat dividends are at an advantage compared to
:
ca~ital gains. Each 1 dividendl is worth (1-[-0.067]=1.067)
~.067 in capital
gams.
c)
The enterprise value (EV)Iconsists of two cash streams. Firh, an annuity of
100 million that lasts far 5 years. Second, a perpetuity of 45 mhlion starting in
year 6. Therefore, the perpetuity!has to be discounted for 6 years.
45
~ * (1 - __ 1_)
+ 012 6 = 3 60.48 + ~ 6= 550.4643 ar 550 :
0.12
(HO.12)5
1.12
I
1.12
1
d)
Because Wulfswagen has 40 million excess cash on hands, a one-time

I
special dividend would amount ~o:
40million
----=
20million
e)
2 d'LVL'd en d per sh are

I
!
Because the dividend is ftmded with an unexpected excess of profit of the

I
last quarter, it is unlikely that the company will generate this cash flow again in
the future. Because the stock price is very sensitive to long-term changes in a
company's dividend policy it is not advised to use the excess cash to raise the
current dividend level forever. lnstead, a one-time special dividend would be
perceived as a bonus of the share holders and might have a positive effect on the
stock price.
30
Uniseminar
Practice Finance
Capital budgeting and valuation

a)
In order to calculate the Free Cash Flow to the Firm (FCF) the unlevered
net income or earnings before interest (EBI) have to be calculated. In the next
step, the respective balance sheet items are added or subtracted from the EBI.
The procedure and solution is presented below:
(= EBlT * (1 -
EBl
Tc))
+ Depreciation
+3,500
-7,000
- Change in NWC
-2,000
8,800
FCF
b)
14,300
Unlike in the previous question, the Free Cash Flow to Equity (FCFE) is
only concerned with payments to equity holders. Consequently, the calculation

starts with net income (not the unlevered net income). Furthermore, increases in
borrowing represent
additional cash on hands of shareholders
and therefore
need to be added in the calculation of FCFE.

The solution is presented in the two tables below. Note that you were only given
the total amount of debt and not the change (increase) in net borrowing. In order
to calculate the change in net borrowing, you have to calculate the yearly change
in debt outstanding as presented in the second table below.
11,000
EBlT
-lnterestexpense
1,000
Pre-tax income
10,000
-lncome
tax
Net lncome
35%
3,500
6,500
31
Uniseminar - Finimce & Accounting
Practice - Finance
+ Depreciation
+1,000
-3,000
-(-500)
- Change in NWC
+ Change
in Net Borrowing
FCFE
15,000
Debt Ouststanding
~ lncrease in Net Borrowing
The Free Cash Flow to Equity i'll 2009 amounts to 15,000. FJrthermore,
:
the
increase in net borrowing in 2010 is equal to 10,OOO.

I
c)
From the FCFthe FCFEcaJ be derived as iIlustrated below:

I
FCFE = FCF - [(1- Tc)

--+ FCF E2007 =
d)
(Interest
6,000 - [(1 - 0.35}
Payments)]
+ (Net
* (3,000)] + 5,000
Borrowing)
= 9,050 or,9.050
The solution is presented in the table below. In the introductory text the
!
cost of debt was given as 10% and the corporate tax rate as
3so/d. Thus, you first
need to compute how much in~erest you have to pay for the o~tstanding debt
I
each year and then apply the corporate tax rate.
Debt
lnterest
expense
10%
Tax shield
= Intererst
32
expense
* Tc
20,000
10,000
2,000
1,000
700
350
o
o
Uniseminar
e)
Practice - Finance
Because you were asked to find the cash that is available to all stakeholders
(equity and debt holders) you have to consider both, net income and interest
payments! The result is presented below:
Net Income = (EBIT - Interest Expense) * (1 - TC)
=
Net IncomeZ010
(22,000 - (20,000
+ interest
* 0,1)) * (1- 0,35) = 13,000
expenseZ010 = 13,000
+ (20,000 * 0,1)
= 15,000
33
Solution
a)
- Finfnce & Accounting
Uniseminar
Practice - Finance
to Exercise
4.2
,
In order to perform a WACC
analysis, the following siteps must be
I
completed:
Step 1: Calculate the Free Cash Flow to the Firm

Step 2: Calculate the debt-to-valu1e ratio (or alternatively the debt-to equity ratio)
Step 3: Calculate the cost of eqUi& using the CAPMmodel.
Step 4: Calculate the
rWACc
Step 5: Discount the FCFat the
r\1i'ACC
The procedure is iIlustrated belo~,

I
Step 1: FCF
- income tax (30%)
* (1-
EBf [= EBfT
Tc)]
+ Depreciation
-Capital
15
15
25
30
+3
4.5
4.5
7,5
-7
10.5
10.5
17,5
21
10
10
10
35
(42)
20.5
20.5
27,5
26
-10
EBfT
Expenditure
- Change in NWC
FCF
Step 2: Debt-to-value ratio
Next, the cash flows need to be discounted at the WACCin order to determine the
i
NPV of the project. For that: purpose
thedebt-to-value
ratio needs to be
estimated. From the introductioh it is known that the company has 500 million in
equity and 330 million in debt plus an additional 30 million in cash and cash
equivalents.
Its
net
debt
can
therefore
be
330 - 30 = 300 million.

As a result the debt-to-value
34
ratio is equal to ~500+300 = 0.375.
calculated
as:
Uniseminar
Practice - Finance
Its equity-to-value
ratio therefore is: 1 - 0.375
0.625
Step 3: Cost of equity
+ (Rmkt
rE = rf
rf)
~ rE =
3% + 1.4 * (12%) = 0.198
or
19.8%
Step 4: rWACC
E
rWACC = -rE
E+D
* (1- tJ
+ -rE+D
D
0.625
* 0.198 + 0.375 * 0.08 * (1- 0.30)
= 0.14475 or 14.48%
Step 5: Discount the FCFto determine the projects NPV

NPV
-42 +~+~+~+_2_6_=
1.14482
1.1448
1.14483
1.14484
2502
'
As the caIcuIation above shows, the project generates a positive NPV of 25.02
million to aII stakeholders. ScubaDiVE shouId therefore definiteIy invest in
project Scoobi.
Solution
a)
to Exercise
4.3
In order to appIy the APV method, first the unIevered-cost-of-capitaI
needs
to be determined:
+ (RMkt
rE = rf
ru
- rf)
= E+D rE + E+D rD
= 0,04
ru
+ 1.6 * 0,10 = 0,20 or
20%
0.5 * 0,20 + 0,5 * 0,06 = 0.13 or 13%
In the next step, the unIevered vaIue is determined by discounting the FCF at the
unIevered cost-of-capitaI:
35
Uniseminar
Practice - Finance
Next the present

canstant
value of the interest
debt-equity
ratio capacity
the interest
tax shield is:
PV(interest
tax shield)
tax shield needs to be caJ'culated. With a
of 30 million each year, the present
* :c' rD
l+ru
Dt-1
- Finimce & Accounting
+ D[t] *Tc
* rD
O+ru)2
value of
+ ...+ D[t+NJ
*Tc rrD
(l+ru)N;;l
'
Recall the table in the exercise an1d now fill it in accordingly:
FCF
-70
45
45
145
45
Levered Value at
(Rwacc=12%)
1136.8
108.2
76.1
40.2
68.4
54.1
38.05
20.1
4.10
3.24
f.28
1.21
1.44
1.14
0.80
0.42
Debt Capacity
Interest payments
6%
Interest tax shield (*35%)
PV (tax shield)
1.44
1.13
1.14
1.132
+ ~~ +
1.133
Finally the levered value can be LIculated

the present
VL = VU
value of the interest
txI
+ PV(interest tax shield)

I
0.42
1.134
2 97
as the sum of the unle"ered
value plus
shield:
= 63.85
+ 2.97
= 66.82
I
i
b)
equity.
The FCFE method

The
after
(1- Tc) e. g.4.1
tax
requireb
interest!
a different
expense
caIculation
is computed
for the free cash flow to

as:
.
int~rest expense *
* (1-
0.35) = ~.67. The change in net borrowing

I
change from year n+1 - year n (e.g. 54.1 - 68.4 = -14.3)
-70
FCF
- after tax interest expense
+ Change
FCFE
36
in Net Borrowing
45
45
is just
the
45
45
-2.67
-2.11
-1.48
-0.78
68.41
-14.32
-16.04
-17.95
-20.10
-1.59
28.00
26.85
25.56
24.12
Uniseminar
Practice - Finance
Next, the FCFE has to be discounted at the cost of equity which was estimated
under a) to be 20%. Consequently, the value of the project can be calculated as:
vL = -1.59 + 28.00 + 26.8 5 + 25.536 + 24.1.2 = 66.82

1.2
1.2 2
1.2
Notice that under a constant

same levered
constant,
1.2
DIE ratio: WACC, APV and FTE give the
value! But also keep in mind that if the DIE ratio is not
this does not have to hold!
37
Uniseminar
Practice - Finance
- Fin~nce & Accounting

I
I
Options
I
I
I
a)
False, you also need to kndw the volatility
b)
Usually applies to European options. It is true that it can easily be adjusted
for dividends, in case of a call option Sneeds to be replaced by SX
IS -
PV(Div)
In case of a put option Sneeds to'be replaced by SX = S + PV(Div)

:
I
c)
True, the implied vOlatili1 is derived by inverting the Black~Scholes Model
:;;n
e)
~:::<v'd
opt;onp"m;.
False. Less the present value of a bond with same maturity and a face value
I
equal to the strike price of the option. C = P
+S-
PV (K)
f)
Positive effect on call, negJtive effect on put
g)
Increases the premium of call, lower premium regarding ~ut options
h)
Higher levels of volatility Jave a positive effect on both, call 'and put premia
i)
Correct: Call option:
1
I
C:J
S- K
! I"--.~
'-
+ dis(K) + P -
Idtrinsic VaIue
j)
True, Put option:
P =
r-y---l
K- S
intrinsic VaIue
Time VaIue
- dis(K)
'-
PV(Div)
y-
+ C + PV(Di;v)
...
TimeVaIue
1/
I
k)
Cannot
I)
Cannot
m)
Less: the option to exercis1eat any time must be valuable
n)
Cannot
0)
Always
p)
Can, if the present value of the strike price is sufficiently la~ge.
38
Uniseminar
Practice - Finance

a)
(i) A costless
collar involves buying a put and selling a call with the same
maturity but different strike prices. The put option's strike price has to be smaller
than the call option's strike price.
(ii) Astrangle
involves buying a put and a call with different strike prices,
where the strike price of the put is less than the strike price of the call. The
maturity ofboth options has to be the same.
(iii) AstraddIe
involves buying a put and a call with the same strike price and
maturity.
(iv) A butterfly
spread involves buying two calls with different strike prices
and selling two calls with the same strike price, where the strike prices of the
written calls lie in-between the strike prices of the long-positions:
KLong!
call
b)
<
< KLong2
call
Kshort
calls
The correct answer is "can". Both options have the same maturity and
strike price. Furthermore, also the price of the underlying is known.
c)
From the put-call parity it follows that:
S + P = PV(K)
d)
+C ~
25
20
+ 0.60 = --:;j12
+C ~
1.05
C = 5.84
By rearranging the put call parity you can solve for the risk free rate.
However, in order to apply the put call parity please note, that both options need
to have the same maturity and the same strike price. As a result, only the call
Mar12 20.00
2.00 and the put Mar12 20.00
1.50 can be used to estimate
the risk free rate:

S
+ P = PV(K) + C
~ 18
20
+ 2.50 _ 1.50
= (1
S+P=--N+CK
(1+rt)
+ rf)
K
--=
s+p-c
l+rf
)N
rf = 0.0526 or 5.26%
39
,
Uniseminar
Practice - Finance
e)
Step 1: Calculate the presei1t value ofthe strike price
PV(K) =
68
[1.05]'(75/365)
- Fin~nce & Accounting
I
:
= 67.32
Step 2: calculate d1 and d2:

d = In[S/PV(K)
1 + ".,ff =
".,ff
72]
(75
In[67.32
-i+ ~.3'~36s = 0.56

I
2
0.3.~
365
d2 = d1
7s-
er * ...ff = 0.56 - 0.3 * ! :-
, .365
= 0.43
f)
C = S * N(d1)
P = PV(K)
= 46.60
40
PV(K)
* [1-
* N(d2)
N(d2)]
* [1- 0.7325]
= SO
* 0.7658 - 46.60 * 0.7325

I
S * [1- N(d1)]
* [1 -0.7658]
I
= 0.76
= 4.16
Uniseminar
Practice - Finance

It is very helpful to first draw the tree diagram, illustrating the payoff structure of
the put option. By looking at the diagram below, the option value at the respective
end nodes can be computed easily: The value of a put option is: max(K - S; 0),
where K is the strike price (32.00) and S is the respective stock price. The
formula indicates that the option value is the larger of K - S or O. Thus, if the
option is out-of-the money it expires worthless and takes a value ofzero.
Pu max(K-S; 0)=max(32-40;
0) = 0
PMmax(K-S; 0)=max(32-30;
0) = 2
PDmax(K-S; 0)=max(32-20;
0) = 8
Once the option values at the different end-nodes have been determined, the
option value at time t=O (at the present) can be estimated by following the fourstep procedure outlined below. Note, that the tree is decomposed into its subbranches in order to make it easier to solve for the option value.
41
-----
---------~--------------.,...----------....,
i
Uniseminar
Practice - Finance
Pu max(K-$; 0)=max(32-40;
I
0) = 0
B -I
PMmax(K-$; 0)=max(32-30;
- Finknce & Accounting
0)
,= 2
PM-Sd!J. -
= SIJ.
+B
762
2-30'(-0,2)
l+r[
1.05,
35
* (-0.2) + 7.62
= 0.62
PMmax(K-$; 0)=max(32-30;
~) = 2
= Pd-Sd!J. =
PDmax(K-$; 0)=max(32-20;
0) = 8
= SIJ.
/35
B
p
~25
-+ The option
42
25
Po= 5.48
premium at t
* (-1) + 30.48
= 0,62-5,48,=
35-25
I
-0.49
= Pd-Sd!J. = 5.48-25'(-0.49)
= SIJ.
+B
= 2.21
0 is 2.21!
30.48
5.48
Hr[
30
1.05[
+B
IJ.= Pu-Pd
Su-Sd
Pu= 0,62
12-20'(;-1)
l+r[
16.78
1.05
=
30
* f-0.49) + 16.78
Uniseminar
Practice - Accounting
Accounting - Exercises
This practice part has the purpose to foster your knowledge in Accounting. At the
example of a fictive company you will be asked to perform a number
of
accounting
to
tasks, ranging from journal
entries
and posting of ledgers
allowance methods and depreciation techniques. The exercises do not exactly

take the form of exam questions as they will be quite complex. However, the
different steps you have to perform to answer the questions are very dose to the
type of questions you will encounter during your exam.
Note: Regarding journal entries, an A, CA,E, CE and L stands for an asset, contra
asset, equity, contra equity, and a liability account, respectively.
Furthermore,
Shareholder's
equity is simply referred to as equity (E). When
preparing journal entries, revenues and expenses are both categorized as equity.
Accounting
Exercise
a) Complete the following table regarding the different forms of organizations.

Fill in all blank cells (note: also one organizational form is missing!)
Proprietorship
Partnership
Limited-liability
partnership
Corporation
43
Uniseminar
- Fin;ance & Accounting
b) What is the difference between financial and management accdunting?

c) Name the four different finam:ial statements and their purposes.
d) Write down the accounting equation and explain its purpose. In this regard,
also explain how the debit jnd credit system works. Furth1ermore explain
what a journal entry is?
e) Explain how the different firtancial statements are related with each other.
I
What specific items are intersonnected?
44
Uniseminar
Exercise
Complete the financial statements below. Hint: Start with the Income Statement
(hint: you will need some Balance Sheet items to complete this statement).
Uniseminar
Journal.entries
Exercise
Imagine that Rachelle and her Mo best friends Christian and Dirk are opening a
brand new coffee corner next to their university: the "Drop By". Prepare the
journal entries and account for t~e following transactions:
a) On 01.01.2012 each of the three

entrepreneurs
I
i
!
the "Drop By"-shop.
provides 3,dOO
in capital to
I
b) On 10.01.2012 dishes are puri:hased on account at a cost of 2!500. The dishes
have to be paid by the end of hext month. Furthermore, supplies (coffee be ans,
flavors, etc.) are bought and ~aid totaling 2,000.

c) On 15.01.2012 the rental c+tract
is finally signed and renf is prepaid for
three months in advance. Theimonthly re nt expense is 550 pJr month.

d) On 20.01.2012 interest rates; are still very favorable and therefore the three
entrepreneurs
decide to takel a three-year bank loan of 30,0~0 at an inte rest
rate of 6% p.a. starting on ls~ February 2012. Interest is paid ronthly and the
principal is only repaid in the[last month of maturity.
e) On 25.01.2012 further equipinent is bought on account for 3;500. It has to be

paid within one month time. I
f) On 28.01.2012 cash sales of 4,000 are made. Furthermore, sales on account

add up to 1,200.
46
.-----------
--
--------
Uniseminar
Accruals, Deferrals & Receivables
This exercise builds on the previous exercise and you may require so me
information from the exercise 3 in order to successfully complete this exercise.
Exercise
4.1
Prepare the journal entries and account for the following transactions:
a) On 05.02.2012 additional 5,000 of new inventory is purchased.
b) On 10.02.2012 receivables are collected totaling 1,200.
c) Light and heat expense for this month are 400 but do not have to be paid
before the end of the next month.
d) On 15.02.2012 sales on account are made totaling 700
e) On 20.02.2012 total cash sales amount to 4,000
f) On 25.02.2012 interest expense on the bank loan has to be paid. In addition
the purehases on account ofthe previous period have to be paid.
g) Additionally, Dirk contracted one employee to handle the shop sales during
February. On 28.02.2012 the employee is paid a salary of 800.
h) Perform the adjusting entry for the rent that was prepaid for February.
i) On 25.03.2012 the Drop By shop receives 2,300 in advance for a big order to
be delivered in April. Please also prepare the April accounting entry for this
order. In addition receivables worth 700 are collected on 18.03.2012.
Exercise
4.2
Draw the ledger for all transactions of exercise 3 and 4. You can treat inventory
and supplies as one account: "inventory jsupplies".
47
Uniseminar
Short-Term and Trad.ing Investments

!
Exercise
Prepare the journal entries and account for the following transactIons:
I
'
a) Since February the economy 'is
recovering
and
there
was
a
surge
in the stock
I
I
market. As a result, Rachel {.yho is responsible for the financing decides to

invest 5,000 in "Volkswag~n" shares (100 shares @ 50)1 on 05.03.2012.
.
I
Two weeks later VW pays a dIvidend and the Drop By shop receives 175.
I
I
b) Account for the change in value given that the share price rises to 55
20.03.2012. Furthermore, R1chel decides to seil part of the investment
28.03.2012 she seils 50 shar~s at aprice of 56 per share.
one
On
c) On 30.03.2012 VW's share price drops to 54. For the accounting purpose the
"market-value method" has t~ be used!
48
Uniseminar
Allowances
Exercise
a)
In April, Rachel, Christian, and Dirk check their receivables outstanding
records. The table below contains information about the balances due from their
customers. Moreover, Dirk knows from another coffee shop owner that Mr. Z
experiences financial difficulties. However he did not default yet. Please set up the
allowance accounts for the Drop By shop for the current period Pi and answer
the following questions using the aging-of-receivables method: (i) What is the
ending balance of the allowance account? (ii) Calculate the Uncollectible Account
Expense. Furthermore, prepare the journal entry.
1,000
500
250
200
Estimated % of default
1%
3%
2%
Furthermore, the current allowance account shows the following balance:
Opening
Balance
b)
10
In period P2 Mr. Z defaults on his payments. (i) Name all accounts that will
be affected by the default and (ii) draw the journal entries.
49
Uniseminar- Fimince& Accounting
Practice- Accounting
Inventory
Exercise
The coffee shop buys different flavors to mix its farnaus coffee drinks ranging
,
from "Heavenly Nuts" to "HelJ'sIDark Roasted". Over the last three months the
prices for bestseller coffee "HelJ'~ Dark Roasted" varied quite a ldt. Due to a very
hot and dry summer that was especially devastating for the southern hemisphere,
the prices for coffee beans indreased constantly. Now Rachel: would like to
I
'
calculate the grass profit, the cost of goods sold (COGS) and the value of the
I"
i shows the different amount olfflavor and the.

ending inventory. The table bel~w
respective price over the last thr~e months.
10 units
25 units
25 units
February purchase
March purchase
April purchase
12
14
Sale price per unit
16
20
I .
a) Name the different inventoJy casting methods and explain Which one/ones
would be appropriate in the fase at hand.
th_
b) Apply all inventory casting ~ethods (except the specific unitl cast method) to
calculate the grass margin, the cast of goods sold (COGS) and the value of
ending inventory.
c) Explain under which conditions the FIFO and UFO method is preferred,
assuming that Rachel wants ~oshow high profit figures.
d) At the end of the month the rnarket price of the inventory drops to 8. Please
account for the write down.
50
Uniseminar
Depreciation
Exercise
a) Due to their enormous success, the entrepreneurs
decide to buy a new high-
end coffee machine in early May 2012. The cost ofthe machine is 13,000 and
its expected usefullife is estimated to be 4 years. Based on their research, Dirk
expects to seil the machine after 4 years at 1,000. Calculate the monthly
depreciation
amount using the straight-li ne depreciation
and the yearly
depreciation using the double-declining balance method.

b) Apply the units-of-production
method assuming that over the usefullife of the
machine it is expected to make about 100,000 coffees. Furthermore, the three

entrepreneurs
expect to seil 20,000 coffees in the first, 25,000 coffees in the
second 30,000 in the third and 25,000 in the fourth year.

c) Account for the purchase of the machine and the depreciation amount in May
2012 using straight-line depreciation Qournal entry).
d) Assume that after 2 years there is a new machine available and the "Drop By"
owners decide to replace the current machine. For depreciation purpose the
straight line method is applied and the new machine costs 15,000. The old
machine can be sold for 4,000.
e) Christian who is in charge of managing the business decides to register a
patent for the procedure of mixing the "Hell's Dark Roasted". He estimates the
value of the patent to be 35,000.
Ci)
How do you (in general) account for intangibles such as the patent
above? Are there different c1assifications for intangible assets?
Cii)
How would you account for the patent created by the "Drop By"shop?
f) What does the term depletion mean? Assume Royal Dutch Shell Corporation
bought an oil excavation certificate for 200,OOO.It was estimated that the oil
field contains about 20,000 barrels of oil. If 5,000 barrels are extracted what is
the depletion entry?
51
Uniseminar
Warranty
Exercise
Rachel, Dirk and Christian starte1
1:0
seil cups ofthe already famoJs "Drop By".On
these cups they provide a one y~ar warranty. The warranty expense is estimated
I
to be 8%. During the first year' of operations (2012) the "Drop By" sold cups
worth 18,000. Assume that the!actual replacement of defective i1temsin january
I
I
2013 added up to 1,000. Plea$e prepare the journal entries fr the warranty
iSe
provision. Assume that defecti~e items are replaced with new! items from the
inventory stock. The opening balance of the "Provision for Warranty" account
I
'
zero!
52
Uniseminar
10
Preparing Financial Statements
Exercise
10
a) Explain the purpose ofthe Trial Balance.

b) Name the two different Cash Flow Statement approaches and explain them.
c) Explain the purpose ofvertical and horizontal analysis. What is the purpose of
the two analysis techniques? In this regard explain the term "common sizing"
and why it is relevant.
53
11
Financial Analysis
Exercise
11
Note that the statements have blen somewhat altered comparedlto the previous
statements in order to obtain )more
common debt versus equity relationship.
The post that have been altered 4ave been underlined to avoid coJfusion.
I
Revenue
- Cost of Goods Sold
Gross profit
& General (Rent,Salaries)
EBITDA
- Depreciation
- Amortization
EBIT
- interest expense
Pretax Income
-Tax
Net Income
100,000
I
2~,OOO
75,000
30,000
Current assets
Cash& Cashequivalents
Accounts Receivable I
Inventories
Total
4 5,000
:5,000
0
40,000
15,000
current
assetsl
35,000
~OOO
2q,OOO
Non-current Assets
Property, Plant,Equip:
-Ace. Depreciation I
90,000
5,000
85,000
Total Non-current
Assets
140,000
Total Assets
Liabilities
Current Liabilities
Accounts payabIe
Short term borrowing,1
Total current
Liabilities
- Dividends
Non-current Liabilities
Ending eguity
Lang-term Debt (rD=l,O%)

Other L-T LiabiIities
Total Non-current
Liabilities
Net Cash by Operating Activ.

fO,OOO
Net Cash by Investing Activ.
~;,OOO
Net Cash by Financing Activ._,_
0
Net Cash Flow
Cash balance beginning year
Cash balance end of the year
1'5,000
__ 25000
40000
Shareholders'
Share capital
Retained Earnings
Total Sh. Equity
Total Liabilities
and
Shareholders'
Equity
54
8,000
2,000
10,000
50,00
3,000
53,000
E ui
61.000
16,000
77,000
140,000
Uniseminar
Given the financial statements on the previous page, perform the foIIowing tasks:
a) Calculate the Grass Margin?
b) Calculate the Net Profit Margin?
c) Calculate Inventory Turnover, assuming that the inventory on the Balance
Sheet corresponds to the average inventory du ring the year.
d) Calculate the "Current Ratio"
e) Calculate the "Acid-Test-Ratio". Can you explain the difference to the "Current
Ratio"?
f) Calculate the debt to equity ratio.
g) Calculate "Return-on-Equity" (ROE)
h) Calculate "Return-on-Assets"
(ROA) (=Return
on total assets)
under the
assumption that the beginning balance of total assets is 130,000.
55
Uniseminar
Accounting
1

I
- Solutio,US
!
Accounting
Solution to Exercise 1
a)
Fuilliability:
O~ner jmanager
fu'ny liable for his
aqtions
i
Partnership
More thim one

person
Owners are also the

managers
Fuilliability:
Every partner is
liJble for his own
actions
Limited-liability
Partnership
General iPartners
& Limited Partners
General Partner(s)
run(s) the business
General partners
take responsibility
fdr the company's
adtions (personally
li~ble)
Llmited partners'
li;Ibility is limited by
t~eir investment
I
Corporation
b)
Sharehdlders
Management such as
CEO, CFO, COO etc.
(distinct and
separate from
owners)
L\ability lies within

the management
The corporation
itself is a legally
d~fined, artificial
b~ing separate from
i~s owners!
i
Management accounting; is not regulated and is only' concerned with
internal processes. Financial 4ccounting is regulated (IFRS) on anational
or
international basis and communicates financial information to the public.

c)
1. Statement
of Comprehensive
Income
(Income
Statement)
lists all revenues and expenses during an accounting period. The bottom line is
the net income/profit
56
a company generates during a fiscal year. It helps to
Uniseminar
identify costs related with the production
and sale of products
or services,
thereby measuring the operating performance of a company.

2. Statement
of Changes
in Equity
- provides a reconciliation
of the
movement of equity items during a financial period. It provides the following

items: affected share
issuance, share cancellation,
net income (loss), and
dividends paid.
3. Statement
of Financial
Position
(Balance
Sheet)-
assets, liabilities and equities. While assets represent
shows a company's
future benefits to the
company, liabilities represent claims against the company and equity refers to
shareholder's
ownership in a company as weil as the profit that is retained each
year (retained
earnings). Furthermore,
assets and liabilities are categorized
according to their duration as either short term (current) or long-term (longterm). Thus, the balance sheet shows the financial position of a company at a
specific point in time.
4. Statement
of Cash Flows - measures the real cash flows that are cash
receipts and payments. It differentiates the cash flows (CF) in three categories: (i)
CF from Operating Activities; (ii) CF from Investing Activities; and (iii) CF from
Financing Activities.
d) Below the asset equation and the respective debit/ credit system is illustrated:
Assets
1r ~
Deblt(+)
Credlt(-)
Liabilities
Deblt(-)
Credlt(+)
it
Shareholder' s Equity
Deblt(-)
Credlt(+)
it
A journal entry is the chronological record of an entity's transactions. Generally

each transaction involves two steps: adebit and a credit. Putting it another way,
each economic transaction involves giving something for receiving something.
57
Uniseminar
e)
In short:
Income Statement -7 Statement o'fChanges in Equity [net income]

Statement of Changes in Equity
1Balance Sheet [ending equity]
Cash Flow Statement -7 Balance Sheet [ending cash balance]
Balance Sheet -7 Income stateme1nt [depreciation, interest payme~ts]
i
Explanations:
Income Statement:
the Net In~ome is added to the beginning balance of equity
on the Statement of changes in e9uity.

Statement
other
of Changes in Equity: After adding net income anr accounting for
subtractions
.
(dividends)
share
repurchases)
the closing balance
of
statement of changes in equity rbpresents the ending equity of t* company. The

amount of ending equity goes to1the Balance Sheet under the name shareholder's
equity and it is composed of reta!ined earnings and share capitaI.
Cash Flow Statement:
The b61tom line of this statement, "cash balance at the
end ofthe year", is entered into ~he Balance Sheetunder the namle "cash and cash
equivalents". Cash balance at the end of the year is constructed b'y adding the net
cash flow to the cash balance at ~he beginning of the year.
Balance
sheet:
It shows the amount of accumulated depteciation that is

I
subtracted from revenues on the Income Statement. It also show~ the amount of
company's leverage. By multiplying the interest rate with the anJount of debt, the
,
associated interest payments can be caIculated, which are also deducted from
revenues on the income statement.
58
Uniseminar
Financial
Solution
- Finance & Accaunting
Statements
to Exercise
Detailed explanations
for the ealculations
are printed
on the next page.
2011
2012
Revenue
- Cost of Goods Sold
Grass profit
& General
100,000
25,000
75,000
30,000
EBITDA
- Depreciation
- Amortization
EBIT
- lnterest expense
45000
5000
Pretax Income
-Tax
NetIncome
35,000
15,000
20,000
Beginning
equity
+ Net lncame
- Dividends
Ending equity
Net Cash by Operating Act

Net Cash by lnvesting Acti
Net Cash by Financing Act
Net Cash Flow
Cash beginning year
Cash end year
Assets
Current assets
Cash & Cash equivalents
Accounts Receivable
In ventories
Total current assets
0
40,000
5,000
2,500
20000
-5,500
17,000
10,000
5,000
0
15,000
25000
400001
140,000
5,000
110,000
I
I
25,000
12,000
8,000
45,000
55,000
Non-current Assets
Property, Plant, Equip.
- Ace. Depreciatian
Total Non-current Assets
Total Assets
Liabilities
Current Liabilities
Accounts payable
Short- Term borrowing
Total current Liabilities
Long- Term Liabilities
Lang-term Debt
(rD=10%)
Other L- T Liabilities
Total Non-current
Liabilities
170,000
65000
8,000
2,000
10,000
5,000
1,000
6,000
50,000
55,000
3,000
53,000
1,500
56,500
Shareholders' E ui
Share capital
Retained Earnings
Total Sh. Equity
Total Liabilities
and
Shareholders'
Equity
1,000
1,500
2,500
70,000
65,000
59
Uniseminar
Income Statement
EBfTDA = Gross Profit - Selling,:Administrative & General
= 75,000 - 30,000 = 45,000
i,
Depreciation
-+
from Balance Sbeet: Start with calculating Total Long-Term
Assets from the previous year by subtracting the accumulated depreciation from
Property Plant and Equipment: 3!0,000 - 10,000 = 20,000.
Because no other Non-Current tssets
than PPE (=Property,
Pl~nt, EquiPment)e
exist, the 20,000 long-term assets in 2011 are the starting amount for PPE in
2012. Knowing that PPE in 201iz is 20,000 and that total Non-Chrrent Assets in
I
2012 are 15,000 implies a depreciation amount of 5,000 (20,000 - 15,000 =
I
I
5,000)
I
EBfT = EBITDA- Depreciation
fnterest
1- Amortization
= 45,000 - 5,OQO= 40,000
Expense -+ From the B~lance Sheet (Liabilities). The company has Long-
Term Debt of 50,000 at an interest rate (rD) of 10%. Conseque~tly, the interest
expense ean be ealeulated as follbws 50,000
I
Pretax income = EBfT - interest
* 10% = 5,000 in interest payments

I
I
= 40,000 - 5,000 = 35,000
'
Net fncome = EBfT - fnterest: expense - Tax = 40,000 - 5,000 - 15,000 =
20,000
Statement
oe
Changes in Equm
Ending Equity
= Beginning
17,000 = 2,500
+ 20,000
60
Equity
[[rom
+ Net
income - Dividends
,[ncome statement]
- 5,500
Uniseminar
Cash Flow Statement

Net Cash Flow =
+ CF from Investing Activities
CF from Operating Activities
+ CF from
=
Financing Activities
10,000 + 5,000 + 0
15,000
Cash Balance at the end of the year
= Cash Balance at the Beginning
+ Net Cash Flow
of the Year
= 40,000
25,000 + 15,000
Balance Sheet
Cash and Cash Equivalents
-4
from the cash flow statement
The "Cash balance at
the end of the year" shows the ending balance of cash Hence, this is equal to the
amount of "Cash and Cash Equivalents" in 2011.
Inventories
Can be calculated by looking at the total amount of "Current
-4
Assets". The total sum of all current assets equals 55,000. lnventory is simply the
difference
between
= 45,000).
(40,000+5,000
Accumulated
total current
assets
and cash
+ accounts receivable
Therefore inventory is 55,000 - 45,000
Depreciation
-4
has already
been explained
= 10,000.
in the "lncome
Statement" section above.

eTatal
Assets
-4
simply add up "Lang-term Assets" and "Short-term Assets":
55,000+ 15,000 = 70,000

Retained Earnings
-4
"Shareholder's
given on the Statement
Equity" is equal to "Ending Equity", which is
of Changes in Equity. In order to calculate retained
earnings, one must subtract "Share Capital" from "Ending Equity" = 17,000 1,000 = 16,000
Finally, check that the two sides of the balance sheet, assets and Iiabilities and
shareholder's equity balance out. Both sum up to 70,000.
61
Uniseminar
Journal entries
Below you find the journal entries for the respective transactions: :
i
a)
b)
c)
d)
e)
62
Uniseminar
f)
Remember that safes revenue is booked according to the revenue

principfe. Once the receivabfes are collected, cash increases and
accounts receivabfe decrease.
63
Accruals, Deferrals & Receivables

a)
b)
c)
d)
e)
64
Uniseminar

!
Uniseminar
f)
Feb 25
Cash (A.!-)
Interest Expense (CEi jE.!.)
150
(30,OOO*(6%/12)]
Accounts Payable (U)
6,000
g)
h)
i)
65
Uniseminar
Solution to Exercise
4 ....')
Debit
9,000
30,000
4,000
Debit
4,500
1,200
13,0:00
4,000
3,000
3,~00
5,qOO
I
35,600
Total: 49,700
2,300
Credit
5,200
700
4,000
2,300
12,200
Total: 49,700
66
Short-Term and Trading Investments
Solution Exercise 5
a)
b)
Mar 28
2,800
Cash (Ai)
Gain on sale of investment
[Realized Gain] (Ei)
Short-term Investment
300
(AI.)
2500
67
Uniseminar

I
c)
Mar 30
Unrealized loss bn
investment (Et),
Short-term!investment
68
100
(At)
100
Allowances
a)
(i) The calculation
the aging-of-receivables
for the ending balance

method is illustrated
of the Allowance
Account using
below
500
1,000
250
200
Estimated %
Allowance for
Uncollectible
Accounts
Therefore
10
200
1%
2%
3%
10
15
the ending balance of the allowance
+ 15 + 6
account should be:
= 31.
(H) Because the "Allowance

10, but according
adjusting
750
1,000
Total
for Doubtful Receivables"
to the aging of receivables
entry is needed.
"bad debt expense",
This is known
The T-account
method
account shows a balance of

the balance should be 31, an
as "Uncollectible
Account
Expense"
or
is listed below:
Beginning Balance
Adjustment
Ending Balance
The adjusting
entry
is depicted
account is a contra account
below. Please keep in mind that the allowance
(it increases
with debit and decreases
with credit):
69
Uniseminar

I
,
b)
(i) Given the default of ~r. Z in period P2 the affected ~ccounts are the
"Accounts Receivable" account, the "Uncollectible Account Expenlse" account ande

the "Allowance for Doubtful Receivables" [Allowance] account.
I
The "Allowance" account neeqs to be debited by the default ;amount and the
Account
Receivable
needs to!be credited
to show that the money will not be
collected anymore. Because in {his particular case the default a:mount is higher
I
than the initial allowance account, a new allowance amount has t6 be expensed to
!
bring the allowance account back to its desired level (othervyise it would be
I
negative: 31- 200 = -169).
'
In order to bring the "Allowanc~" account back to its desired level, first the new
ending balance of the "Allowance" account needs to be calcula'ted. Second. the
appropriate
amount in order Ito restore the allowance balan!ce, is expensed,

!
crediting
the "UncollectiMe
Account
account is credited (contra-acc?unt)

level.
Expense".
Third, the Allowance
thereby restoring the balance to its desired
(H) In order to write off uncollectible accounts, the Uncollectibie Account has to
!
be written off. The journal entry. is illustrated beIow.

i
70
Uniseminar
(Note: only the write off is iIlustrated above. In order to restore the balance of the
Allowance account you simply follow the procedure
outlined
above. The
allowance for uncollectible account shows a negative balance of [31 - 200 =

-169. The new ending balance should be 25 (0.01 %*1000+0.02%*750).
Thus 25
- (- 169) = 194 need to be expensed.)
71
Inventory
a)
The four different
inventry-costing
I'
Mefhod,
Method, (2) Average Costing

in-First-Out
(3) First-in-First-Out
is not appropriate
inventory
like luxury articles. TJe remaining
However,
the UFO is not allowed
leaves
FIFO
entrepreneurs'
Methqd, and (4) Last-
Method.
The specific unit cost method
This
are: (1) SP:ecific Unit Cost
methods
and
the
preference
three methods
(only under
Average
for 1igher
used.
since it is onlYI used to unique
certain
Costing
all se'em appropriate.
conditions)
Method.
profit figures
'
IFRS'e
under
Depending
on
the
or lower ta~es both can be
'
I
I
b) The different
(1)
methods
are ill~strated
below:
Average Costing M~thod
Beginning
balance
Purchase 1
Purchase 2
10 units
12 ~ 120
25 units
14 h 350
25 units
16 = 400
Average cost:
10*12+25*14+25*16
14,50
10+25+25
Total , 870
....COGS (40 units
Ending
Balance
(20 units
14,50) ~ 290
(or 870 - 580 d G90)

Gross
profit
72
40*20 - 580 = 220
14,~)
58~
Uniseminar - Finance
(2)
&
[FIFO]
First In First Out
Beginning
balance
10 units @ 12
10 units @ 12
Purchase 1
25 units
25 units @ 14
Purchase 2
25 units
e
Ending
Balance
= 120
@ 14 = 350
@ 16 = 400
Total = 870
Grass profit
(3)
....COGS
120
350
80
550
= 320
550 = 320)
- 550 = 250
40*20
Last In First Out
[LIFO]
Beginning
balance
10 units @ 12
Purchase 1
25 units @ 14
Purchase 2
25 units
Ending
Balance
5 units @ 16
=
=
=
20 units @ 16
(ar 870 -
Accounting
= 120
= 350
@ 16 = 400
Total = 870
15 units @ 14
25 units @ 16
....COGS
=
=
210
400
610
10 units @12
+ 10 units
= 260
= 260)
610 = 190
@ 14
(ar 870 - 610
Grass profit
40*20 -
73
Uniseminar

I
c)
Given that the prices for coffee beans are constantly risin,g, the preferred
method would be FIFO as it shdws the lowest COGSfigure and thus the highest
profit. The reasoning is depictedlin the figure below:
FIFa
LIFO
,
I
Increasing
Cost
Decreasing Cost
d)
To account for changes ih the value of inventory, the lower

I
net realizable
of cost or
value rule has to be applied.

I
Because the value of the inventbry for each purchase lies above 112, the drop in
I
market value implies that the inventory has to be written down, Le. adjusted for
the decrease in value. The table Ibelow ilIustrates the procedure
The market price drops to

--> 20 units * 8 = 160
8. FlIrthermore,
Weighted
-Current maket value
Average
FIFO
UFO
260
3?0
----=1QQ
----=1QQ
130
Write-down
'
20 llnits are in the e'nding inventory
290
Ending Inventory
----=1QQ
100
160
Journal Entry:
130
COGS CE!)
Inventory
74
CA!)
100
160
130
160
100
Uniseminar
Depreciation
Exercise
a)
The straight-line
depreciation
method: The salvage value is given as
1,000. Consequently, the yearly depreciation amount can be calculated as:

SL Depreciation per year = Cast
of asset-Residual
Value
Usefullife
[in years]
~ monthly depreciation
The double-dec1ining
13.000-1.000
= 3,000
= 3,000
= 250
12
balance method yields:
DDB depreciation rate per year
Usefullife
in years
Depreciation
year 2
Depreciation
year 3
0.5
Depreciation
year 4
1,625 - 1,000 = 625
* 3,250
* 2 = ~4 * 2 = 0.5 ~ 50%
= 1,625
Note: With the DDB method, the salvage value is not subtracted when calculating
the yearly depreciation amount. But, the value of the asset cannot fall below
1,000 (its salvage value). Therefore, the depreciation amount in year 4 is only
625 instead of 812.5 (= 0.5
b)
Unit of production
* 1625).
method:
The salvage value is given as 1,000.
Consequently, the unit depreciation amount can be computed as folIows:

UP Depreciation
Cast-Residual
Value
Usefullife
[in units of production]
Depreciation
year 2
0.12
* 25,000
= 3,000
Depreciation
year 3
0,12
* 30.000
= 3,600
Depreciation
year 4
0.12
* 25.000
= 3,000
13,000-1,000
= 0.12
100,000
75
I
c)
d)
The book value of the machine at the end of the second ye~r using straight
line is 13,000 - (2
* 3,000)
,
= 7,000
I
and the sale price is only 4,OOO. This
implies a loss of 3,OOO. FurtI1ermore, the accumulated depreciation

,
account
needs to be closed, implying a d~bit of 6,OOO (the actual amount of accumulated
F' Debit because it is a contra as~et account!). As
depreciation at the end of year
you can see below, the assets an~I shareholders' equity decrease oy 3,OOO due to
the impairment loss on the sale bf the machine.
I
May
Accumulated ~epreciation
(CAtI At)
6,000
Cash (Ai)
4,000
Impairment lo,ss on sale of machine

(Et)
3,000
Property, ~lant & Equipment (At)
13,000
Note: we didnot define the jOi;Jrnalentry for the new machine, but clearly this
,
will involve a credit to cash of lS,OOO and adebit to equipment of lS, 000 (or
for instance adebit to equipment oflS,OOO and a credit to accounts payable of
lS,OOO ifthe equipment is bought on credit).
76
Uniseminar
e)
(i) In general you only account for patents that meet the following three
criteria: controlIed by the enterprise,
provides a probable
future economic
benefit, and is reliably measurable. If a patent is acquired and there exists a

market price, this intangible asset is amortized over its jurisdictional valid life.
In addition, accounting for intangibles is differentiated between intangibles with
finite and indefinite
lives. The former
are amortized
(which works like
depreciation and is usually done on a straight-line basis), whereas the latter are
impaired annually for any loss in value if it occurs.
(H) You do not account for the patent that was created by the "Drop by"-shop. It
does not meet the measurement
(controlIed
measurable)
by the enterprise,
criteria of the three necessary conditions

probable
future economic benefit, reIiably
because no market price exists for the patent As a result it is not
listed on the balance sheet.

f)
Depletion is used to account for natural resources. Given the initial cost of
the certificate of 200,000 and an estimated 20,000 barrels of oil, the depletion
rate per barrel is 10 (200,000/20,000).
5,000 barrels is: 5,000 * 10
Consequently the depletion expense for
50,000. The corresponding
depletion journal
entry is:
77
Uniseminar
Warranty
Please
note
accounting
that
accounting
for allowance.
for Uncollectible"
"Uncollectible
Just t~e names
account
the opening balance of this account

the ending balance of the "Provision
Given l8,OOO
provision
of sold
should be 8%
equivalent
cups, ~he estimated
* l8,OqO
'
Because
account
as
expense"
balance
The
the ending
in thiS particular
account.
ending
way
E~pense".
only yields
is zero, the "warranty

for Warranty"
same
for Warranty"
(8%)
account!
the
differ. ~he "Allowance
to the "Warranty
of replacement
for W~rranty"
exactly
of the accounts
percentage
of the "Provision
works
is notv called "Provision
Account Expense"!is
Again, the estimated

balance
f9r warranty
casee
is the same as
the warranty
= l,440.
Note: understand that the T-acdount tor the Provision tor Warranty will look as
[olJows:
78
Uniseminar
10
Preparing Financial Statements
Solution
a)
to Exercise
The trial
10
balance
- is a list of all ledgers with all its balances. By
summarizing all accounts management can investigate whether total debits equal
total credits.
Indirect
b)
Method - starts out with the net income and adds revenues and
subtracts expenses.
Direct Method - reports all cash receipts and cash payments from operating
activities. It provides c1earer information about the sources and uses of cash
rather than the accounts (as with the indirect method). Cash receipts are added
while cash payments are subtracted.
c)
Horizontal
analysis
(trend analysis)
- In the horizontal analysis, the
study of percentage changes from year to year, time-trends in financial statement

items are analyzed. In order to investigate the change over different time periods,
independent of the size of different cash flows, all numbers should be expressed
as percentage changes from one year to the next:
Percentage Change
Amount of change
= ------
Base year amount
A useful form of horizontal analysis is trend percentages,
which indicates the
direction a business is taking:
Trend (%) =
Vertical
analysis
are expressed
Any year $.
Base year $
(component
as percentages
analysis)
- all financial statement items
to some base measure
(for the income
statement the base measure would be sales revenue, for the balance sheet total
assets / totalliabilities).
The purpose is, to detect if there have been any relative
79
Uniseminar

I
changes over time (e.g. if COGSjRevenue would decrease this meahs that working
efficiency improved).
. I
I'
(1)
V ertzca ana YS1S lO
Each in co me statement
= .
Total revenue
item
When comparing one company to another, financial statement can be modified to

report only percentages. When liompared side-by-side, such financial statement
are called common-size
statements.
A common-size financial statement aids
the comparison
of different c~mpanies, because all amounts
are stated in
percentages, thus expressing th~ financial results of each compa,rative companye

in term of a common denomina~or. Hence, currency
are eliminated
by common-size
I
80
comparison.
and siz1e differences
Uniseminar
11
Financial Analysis
a)
GM'
ross
ar!Jln =
.
Gross Profit
Revenue
.
b)
Net profIt Mar!Jln
c)
Inventory
d)
Current Ratio
e)
Acid- Test Ratio
Net Ineome
or
=,
20,000
= --Net Soles
turnover
075
75,000
100,000
= --
100,000
7501
70
0,2 or 20%
COGS
= -----= --25,000
=
Average Inventory
10,000
Current Assets
Current
55,000
10,000
Liabilities
= Cash+Short-term
40,000+5,000
2,5x
55
'
investment+Net
Current Reeeivables
Current Liabilities
4,5.
10,000
The Acid-Test ratio is lower because lnventories are not taken into consideration.
This measure only accounts for the most liquid assets. In a crisis situation
inventory may have to be sold at reduced prices and it may take some time to seil
the inventory stock. Therefore, inventory is not taken into consideration.
f)
Debt-to-Equity Ratio
= Total
Liabilities
Total Equity
63,000
77,000
0,818 or 81,8%.
Please note that a lot of times only interest bearing long term liabilities are
counted as debt! In this case, the equation would be as folIows:
Debt-to-Equity Ratio
g)
h)
RO E =
= Interest
Net ineome-preferred
average ordinary
ROA
= Net ineome+lnterest
Bearing Debt Liabilities

Total Equity
dividends
shareholder's
expense
Average totalassets
equity
50,000
77,000'
20,000-0
(62500+77000)/2'
20,000+5,000
(13000+14000)/2
0 65 or 65%
= 0 287 or 28 7%
,
0,185 or 18,5%.
You have to add interest expense because it is a cash flow that goes to the debt
holder of a company. Because total assets also include liabilities, this cash flow
must be accounted for!
81
82
Uniseminar
Exams
Uniseminar
Exams
Exams
You should start early with the calculation of exams, because you need to get a
general feeling of how the exams are buHt up. You will soon discover how the
exams are constructed and that there are general tendencies, wh ich repeat from
exam to exam. In this part you will find old exams of the Maastricht University, as
weil as two practice exams constructed by Uniseminar. During the seminar you
will then receive a third practice exam.
Table of Contents
Praetiee
Exam 1 (ine!. solutions)
Praetiee
Exam 2 (ine!. solutions)
25
Old Exams
09/10 Resit
08/09 First Sit
Trial Exam
39
Uniseminar
Practice Exam 1
Practice
Exam 1
Finance
1.
Bondholders are always served before shareholders are served. Therefore,

shareholders are said to have a residual claim on the assets of a company.
2.
For a levered company 100%
debt financing), the cost-of-debt is always
sm aller than the weighted average cost of capital and the cost-of-equity is
always larger than the weighted average cost of capital.
[Question 3 & 4]
Assume that the risk free rate in 2011 is 5% and the return on SchnitzelStock's
share is 15.5%. Furthermore, the variance of the stock during 2011 has been
calculated as 0.2345. The covariance with the market is 0.00323 and the markets
standard deviation during 2011 was 11.55%.
3.
The Sharpe Ratio of SchnitzelStock is larger than 1.75.
4.
The correlation of SchnitzelStock with the market is smaller than 0.5.
5.
In the world of Modigliani and Miller absent taxes, dividends do determine

share prices but a firm' s choice of dividend policy does not.
6.
Assume that WirelessCab Inc. has a cost-of-equity of 12%, a cost-of-debt of

5%, and a debt-to-value ratio of 30%. Given that it is subject to a 35%
corporate tax rate, its unlevered cost of equity must be smaller than 11%.
Practice Exam 1
7.
Tradeofftheory
Uniseminar
predicts that the value of a levered firm can be expressed as
the sum of its unlevered value, the value of the interest tax shield less any
cost of financial distress.
[Questions 8 & 9]
Assurne that the company McBurger has a beta of 1.2 and the risk premium of the
market is 4% and the risk free interest rate is 3%. Furthermore, it currently has a
debt-to-equity ratio of 40%. McBurger's cost-of-debt of 6% and a corporate tax
rate of 35%.
8.
Given the information above, McBurger's cost of equity is equal to 7.8%.
9.
Given the information above McBurger's weighted average cost of capital is
larger than 7.00%.
10. Given that a firm faces financial distress, it may not choose to invest in
positive NPV projects because most of the benefits will go to debt holders.
This problem is referred to as the underinvestment
problem.
11. Assurne that in 2011 the company WatchTube lnc. faced a corporate tax rate.
of 38%, and tax on interest income and capital gains tax were 20% and.
22%, respectively. As a result, the effective tax advantage of debt is equal to
39.55%
12. By minimizing the WACCone can determine the optimal capital structure
for a company.
Uniseminar
Practice Exam 1
13. In a world of Modigliani and Miller with corporate
tax a firm's WACC
decreases as the debt-to-value ratio increases.
14. All investors who hold shares on the ex-dividend date are entitled to receive
the dividend payment that was declared in the preceding declaration date.
15. In an open market repurchase
a firm exactly states how many shares it
intends to buy back. As so on as the number is announced the firm has to

purchase
back the declared
number
of stocks, since otherwise
non-
tendering shareholders would be harmed.
16. Management entrenchment
theory states that managers' tend to take on
excessive leverage to fund operations that benefit themselves but not the
company.
17. In a world of Modigliani and Miller without taxes, a firm that lowers its
dividend for one period does not risk that its share price will drop.
18. The free cash flow hypothesis predicts that if managers have excess cash on
hand they tend to waste it for their own benefit. As a result, dividend
payments for instance, are highly valued by shareholders
as it re duces
excess cash management can waste.
19. The free cash flow to equity can be calculated by taking the free cash flow to
the firm and subtracting
after tax interest
expense
and adding net
borrowing.
Practice Exam 1
Uniseminar
20. A short position in a call option gives the holder the right but not the
obligation to seil a contractually fixed number of shares at maturity.
21. The payoff from a put option is the greater of zero or K - S where K is the
strike price and S the price of the underlying.
22. Assuming perfect capital markets, retaining cash is never a good idea.
23. The c1ientele effect implies that absent transaction
costs there is a high
trading volume around the ex-dividend date because low tax investors buy
and high tax investors seil their shares.
24. Given a tax on dividends of 20% and a tax on capital gains of 26% results in
an effective disadvantage dividends over share repurchases of more than
7.9%.
[Questions 25 - 27]
The stock of BetaGamma Investments Inc. is currently traded at 30 and has a
volatility of 25%. There is a European call and a European put option trading on
this stock with a strike price of 28 and 29, respectively. The put option_
currently trades at 3.50 For both options the time to maturity is one year .
Additionally it is known that the current risk free rate is 3% and the market risk
premium is 5%.
25. Given the information provided above, the Put-Call parity can be used to
calculate the price of the European call option.
Unis emin ar - Finance & Accounting
Practice Exam 1
26. Using the Black and Scholes Model, N(dl) can be computed as 0.5192
27. Using the Black and Scholes Model, N(d2) can be computed as 0.3461
28. On a stock that currently trades for 40 with a European put option is
traded with a strike price of 41 and a maturity of 60 days. Assume that
N(dl) is 0.3837 and N(d2) is 0.3607. Given a risk free rate of 3%, the price
of a European put option can be calculated as 1,20.
29. Given the price of a European call and a European put option with the same
exercise price and maturity, the risk free rate can be estimated.
30. Risk neutral probabilities imply that all financial assets should have the
same cost of capitaI.
31. The value of call Mar16 25.00 has to be greater than the call Apr16 20.00.
32. The stock price of Texano lnc. is currently 30. Analysts expect the stock
price to increase or decrease with an equal probability by 10% over the next
period. The risk free rate is 5%. Using the Binomial Option Pricing Model,
the price of a European call option with a strike price of 27 is 2.14.
33. AStraddie refers to buying a put and a call option on the same stock with
the same maturity dates and the same strike price.
34. The Weighted Average method is the easiest to implement even when the
firm does not maintain a constant debt-to-equity ratio.
Practice Exam 1
Uniseminar
35. Free cash flow is computed as Net Income plus Depreciation less Capital
Expenditures less any increases in Net Working Capital.
36. The Flow to Equity method is especially preferred by shareholders,
as it
shows best the advantage ofthe interest tax shield. As a result, shareholders
are better able to determine the optimal level ofleverage.
37. Dividend smoothing means that management tries to avoid any changes in a
firm's dividend payout because investors
react very sensitive to the.
information conveyed by changes in dividends.
38. A spin-off is a combination of writing two call options with different strike
prices.
[Question 39 & 40]

Sunrise Systems Inc. expects to generate free cash flow next year of 10 million
growing constantly at a rate of 4% thereafter.
Furthermore
it is subject to
corporate taxation of 40%, has a cost-of-debt of 6% and an equity cost-of-capital

of11%.
39. Given the information provided above and assuming a debt-to-equity ratioe
of 40%, Sunrise Systems Inc. vaIue as an all equity firm is larger than 180
million.
40. Assuming a constant debt of 60 million, the interest tax shield is equal to 24
million.
Uniseminar
Practice Exam 1
Accounting
41. In a corporation the managers are also the owners of the company and are
Iiable for the company's actions. This is also called "separation of ownership
and control".
42. The accounting

accounting
entry
equation
is the foundation
bookkeeping
system.
of the standard
It states
that
Assets
doubleminus
Stockholders' Equity is equal to Liabilities.
43. On March 15th a company purchases inventory, which has to be paid by the
end of next month. The journal entries to record for the purchase and
payment (in the next month) are adebit to Inventory, a credit to Accounts
Payable, adebit to Cash, and a credit to Accounts payable.
[Questions 44 & 45]

On March 29th a company signs a renting contract and prepays re nt for the next
5 months totaling 2,000. Rent is always paid on the 5th each month.
44. On April 5th the adjusting journal entry is adebit
to the Rent Expense
account and a credit to the Prepaid Rent account. The Cash account is not
affected.
45. On May 6th the balance ofthe Prepaid Rent account is 1,ZOO.
[Questions 46 - 48]
A company (i) issues 1,000 shares at a share price of 12, (H) pays interest on a
bank loan of 20,000 at an interest rate of 6% p.a., (Hi) collects 5,300 in cash
7
Uniseminar
Practice Exam 1
from a customer, (iv) delivers products that it was paid for l,250 the month
before, and (v) accounts for the decrease in the share price from 15 to 13 of its
500 share investment in XYZCompany.
46. As a result of the transactions above, Cash increases by 19,450.
47. As a result ofthe transactions above Assets increase by 10,900 and Equity
increase by 12,150.
48. Accumulated Depreciation is the contra account to Property Plant and

Equipment and the Allowance for Uncollectible accounts is the contra
account to Accounts Receivable. Both increases (decreases) with a credit
(debit) balance.
49. Expenditures that improve the status of a machine but do not extend its
usefullife are called Capital Expenditures.
50. (i)
Depreciation is not a cash expense.
(H) Only fixed assets or plant assets are depreciated.

(Hi) Short-term assets are depleted
All three statements above are correct.
51. The double declining-balance depreciation rate per year is computed as two
times the straight-line
declining book value.
depreciation
rate
multiplied
with the asset's
Uniseminar
Practice Exam 1
52. The cost-of-goods-sold model adds purchases to beginning inventory and

subtracts ending inventory to yield COGS.
53. An accrual is the opposite of a deferraI. An example for an accrual is

unearned service revenue.
54. The consistency principle assures that companies do not simply switch their
accounting methods such as LiFo or FiFo inventory costing.
55. A pharmaceutical company developed a new drug against breast cancer for
which it also holds the patent, wh ich lasts for 10 years. Therefore, using
straight-line depreciation the depreciation rate should be 0.1 [or 10%].
[Question 56
&
57]
A machine was purchased for 10,000 and its life is estimated to last for 5 years.
The salvage value is estimated to be 900.
56. Using the double-declining-balance
method, the depreciation
expense in
year 5 is 777.6.
57. According to straight-li ne depreciation, the straight-line depreciation rate

per year is 0.2 and the book value at the end ofyear 3 is 4,000.
58. The journal entry to record an uncollectible-account
expense using the
direct write-off method is to credit accounts receivable and to debit

Uncollectible-Account Expense.
Practice Exam 1
59. Common
percentages
Uniseminar
sizing
refers
to
expressing
Le. income statement
financial
statement
items
as
items are measured as percentage of
revenues and balance sheet items are measured as percentages
of total
liabilities.
60. Depreciation is a good example for the matching principle.

[Question 61 & 62]
Sales for the Drop By shop in 2011 accounted for 40,000 and the estimatede
warranty
expense is 5% of sales. Additional!y, the opening balance of the
"Provision for Warranty" account is 100.
61. Given the information above, the journal entry to account for the warranty
expense would record adebit of 2,000 (to the Warranty Expense account)
62. Assuming that defective items added up to 1,000 the respective journal
entry
to account
reimbursement)
for the replacement
is adebit
of defective
items
(no cash
to the Provision for Warranty account and a
credit to the inventory account.
63. Assuming decreasing prices, LiFo method yields the higher Cost of Goods
Sold and LiFo yields higher ending inventory. Therefore, from a tax savina
perspective LiFo is preferred.
64. An unrealized gain is a form of accrual.
65. If a trading investment, which decreases in value over the year is sold, this
decreases net income.
10
Uniseminar
Practice Exam 1
66. The Uncollectible Account Expense is also called Bad Debt Expense or
Undetermined Account Expense
67. Goodwill is the only intangible asset that is recorded on the balance sheet.
[Question 68 - 71]
See the financial statement information below:
Assets
Cash & equivalents
Inventory
Accounts receivable
Property,
Plant
Equipment
Trading investment
4,000
2,500
1,000
3,000
500
Liabilities
Bank loan (@ 5% p.a.)
Accounts Payable
Income tax Payable
5,000
2,500
1,500
Shareholder" s Equity
Retained earnings
Paid-in Capital
1,500
500
68. The Acid-Test ratio for the financial statements above is larger than 1.38
69. Net Working Capital can be computed as:

current assets - current liabilities and in the example above it is equal to
5,500.
70. Assuming a tax rate of 30% and an EBIT of 5,000, net in come can be
calculated as 3,325.
11
Uniseminar
Practice Exam 1
71. Assuming a Net Income of 3,000, Return on Assets (ROA) is larger than
28%
72. Prepaying rent decreases Assets by the amount of rent prepaid.
73. Inventory turnover
is caIculated by dividing "Cost of Goods Sold" by
"Average Inventory".
74. Dividend payments decrease retained earnings while Net Income increases
retained earnings.
75. Salaries payable, wages payable, interest payable and income tax payable
are aII examples of accrued expenses.
76. Inventory errors do not balance out over time. Rather they add up and
result in wrang financial statements
[Questions 77 & 78]

DataPro Inc. purchased inventory at the foIIowing prices:
March: 10 units
10
April: 10 units
11
May:
5 units 12
77. Assuming that 15 products were sold, applying the FiFo method would yield
an ending balance of the inventory account of 115
12
Uniseminar
Practice Exam 1
78. Assuming that 20 products were sold, LiFo would give COGSof 225.
79. LiFo liquidation means that managers have to dig into older layers of
inventory cost because the inventory quantities fall below the levels of the
previous period.
80. Management accounting is very essential as it communicates important

internal information to the public.
13
Uniseminar
Practice Exam 1
Practice
Exam 1 - Solutions
Finance
1.
True: Due to the seniority of debt shareholders rank lower in the hierarchy.
2.
True: Because the company is levered its cost-of-equity cannot be equal to

the WACC (which it would be, given that the company is unlevered).
Furthermore, because less than 100% debt financing is assumed, the costof-debt is always lower than the WACC (given 100% leverage the cost-of-e
debt = WACC).
3.
True: Sharpe Ratw
Ri-rf
= --
Ui
15.5%-5%
0.2345
4.
False: Corr =
5.
True: a dividend of 3 resultsin
Cov(Mkt;stock)
SD(Mkt)-SD(stock)
""
1.91
0.00323
0.23452_0.1155
""
0.51
a drop in the share price of 3 while a
dividend of 2 results in a drop of 2. Therefore, the amount that is

distributed per dividend does affect the share price. However, whether a
firm repurchases shares or pays a dividend does not affect the share price.
Thus, the payout policy is irrelevant.
6.
True
When ........ = 0.3 =
D+E
rE
D
= ru + -(ru
E
2. = _3_
10
- rE)(1 -
ru = 0.1109 [or 11.09%]
14
7+3
->
. = ~
E
TC) ->
12%
= ru + - * (ru
3
- 0.05)
* 0.35
Uniseminar
7.
Practice Exam 1
False: it is the sum of the unlevered value and the present value of the
interest tax shieid iess the present value of any cost of financial distress.
8.
True: re = rf
+ * (Rmkt
9.
False:
= --
10
rWACC
4+10
7.8%
rf) = 0.03
+ 1.2 * 0.04
+ -* 6% * (14+10
= 0.078 or 7.8%
35%) = 6.69%
10. True.
11.
True: [(1-
0.38)(1 - 0.22)] /(1 - 0.20) = 0.3955 [39.55%]
12. True.
13. True: because the present value ofthe interest tax shield is accounted for.
14. False. On or after the ex-dividend date shareholders
are not entitled to
receive the dividend.
15. False. The firm has no obligation to buy back the number of stock it
originally stated.
16. False: Management entrenchment = minimizing leverage to avoid the

disciplining effect of debt.
17. False: negative effect of dividend cuts. The share price will drop.
15
Uniseminar
Practice Exam 1
18. True.
19. True:
FCFE = FCF - [(1- Tc)
* (Interest
Payments)]
+ (Net
Borrowing)
20. False: a short position has the obligation, not the right.
21. True: value ofput = max(K - S, 0)
22. True: by retaining cash this cash is taxed twice (once on the corporate level
for interest income and once on the investor level).
23. False: The correct theory is the dividend-capture theory.
td-tg
20%-26%
24 . True: -= --1-tg
1-26%
h
= -0.081 ....advantage of dividends over repurc ases
25. False: Put-Callparity is not applicable since the strike prices differ.
26.
. d _
rue.
In[SfPV(K)
a.,ff
1 -
1 + ,,,,ff
2
27. False, the correct value is 0.2692 (when d1 is rounded to 4 digits)
28. False: PV(K) = 41/[1.03"(60/365)]

....P
16
PV(K)
* [1-
N(dJ]
= 40.80
- S
* [1 -
N(d1)]
1.43
Uniseminar
29.
Practice Exam 1
True, From the put call parity. Solve the equation
for rf (-7 Present
value of
strike price)
30.
True.
31.
False: They have to have the same strike prices. Otherwise
no comparison
is
possible.
32.
True: delta = 0.5 and B2 = ~ -+ C = 2.14
33.
False: Different strike prices
34.
False: The APe method
is preferred
when
there
is no constant
debt-to-
equity ratio.
netincome
is used (EBfT
35.
False: The unlevered
36.
False: the APV method shows the advantage
37.
True.
38.
False: a spin-off refers to the distribution
(1- Tc))
of the interest
tax shield.
of shares of a subsidiary
by the
parent.
39 . True: Pre tax rWAcc =
67
700
""
9.57% -+ V U =
10
-9.-S7-oA-o--4-% =
179.48
'f t h e pre-
(1
17
Uniseminar
Practice Exam 1
tax fwaccis not founded!).
40. False: 60
18
* 0.06 * 0.4 = 1.44 [million]
Uniseminar
Practice Exam 1
Accounting
41. False: owners are NOT liable for a company's actions, but ONLYthe
management (separation of ownership and control)
42. True:
Assets
Liabilities
+ Stockohlders'
Equity
Assets - St. Equity =
Liabilities
43. False: debit to Inventory, credit to Accounts Payable & debit to Accounts
Payable, credit to Cash
lnventory (Ai)
Accounts Payable (Li)
xxx
xxx
xxx
xxx
44. True: the cash account is only affected when the rent is initially prepaid.
45. True: 2,000 was prepaid and 2 months' rent is subtracted: 2,000 - 800 =
1,200
[Questions 46 - 48]
Cash (Ai)
Paid in Capital (Ei)
12,000
Interest expense (EL) [20,000*(6%/12)]

Cash (AL)
100
12,000
100
19
Uniseminar
Practice Exam 1
Cash(Ai)
Accounts Receivable (A~)
5,300
Unearned Revenue (U)

Service Revenue (Ei)
1,250
Unrealized loss on Investment (E~)

Short Term investments (A~)
1,000
5,300
1,250
1,000
46. False: cash increases by 17,200 (12,000-100+5300)
47.
True:
Assets
= 12000-100+5300-5300-1000
= 10,900
Equity
= 12000-100+1250-1000 = 12,150
48. True: Accumulated depreciation is the contra account to Property, Plant and
Equipment and the allowance for uncollectible account is the contra account
to
49. False: Only expenses that extend the usefullife of an asset are called Capital
Expenditure
50. False: The last statement is incorrect. Only natural resources (wh ich are
also long-term assets) are depleted.
51. True: ---*
usetullite
2 *book value
52. True: Beginning inventory
20
+ Purehases - Ending inventory
coes
Uniseminar
Practice Exam 1
53. False: it is correct that accruals are the opposite of deferrals. But unearned
service revenue is a deferral not an accrual
54. True: Businesses are required to use the same accounting methods over
time
55. False. First, intangible assets are AMORTIZEDnot depreciated. Therefore

the amortization rate should be 0.1. Second, patents that are created by a
company itself cannot be accounted for as no market value exists.
[Question 56 & 57]

56. False. The correct amount is 396. The DDBrate is':5 * 2 = 0.4
Yearly
Accumulated
Book
Depreciation
Depreciation
value
Year 1
4,000
4,000
6,000
Year 2
2,400
6,400
3,600
Year 3
1,440
7,840
2,160
Year 4
864
8,740
1,296
Year 5
396 [1296-900]
9,100
900
57. False: the depreciation rate is correct. The book value should be 4,540.
1. The straight-li ne depreciation rate is .:5 = 0.2
2. The yearly depreciation amount is
10.000-900
5
1,820
3. At the end ofthe third year the book value is: 10,000 - (3 * 1,820)
= 4,540
21
Uniseminar
Practice Exam 1
58. True.
59. False: balance sheet items are measured relative to total assets (not
liabilities)
60. True: Matching principle = the consumption of resources to earn a revenue

have to be recognized in the period the revenue is earned.
[Questions 61 & 62]

61. False: 2,OOO is the ending balance of the Provision for Warranty account.
The Warranty expense is = ending balance - opening balance = 1,900
62. True.
63. False. FiFo results in high er COGS-7less profit-7higher tax savings-7 Fifo
preferred
64. True.
65. True. Cash is only reduced
66. False. Undetermined is incorrect.
67.
False. (e.g.) Acquired patents are accounted for as weil
68.
False: it is exactly 1.375
22
<
1.38 -7 (4,000+ 1,000+500)
/ (2,500+ 1,500) =
Uniseminar
Practice Exam 1
1.375
69. False: it is equalto 4,000 (4,000+2,500+1,000+500-2,500-1,500)
70. True: Net income

= (EBIT- interest expense)*(1-tax)= (5,000 -[5,000*0.05])*0.7 = 3,325
71. True: (net income + interest expense) / total assets =

(3,000+5,000*0.05)/11,000 = 0.2955
72. False. Asset increase and decrease by the same amount so they do not
change overall (Cash!.and PrePaid Renti)
73. True
74. True
75. True
76. False: Inventory errors balance out over 2 consecutive periods
[Questions 77 & 78]

77. True: 5*12+5*11 = 115
78. False: 5*12+ 10*11+5*10 = 220
23
Practice Exam 1
Uniseminar
79. True
80. False: Financial accounting communicates information to the public.
24
Uniseminar
- Finance
Practice
Practice
& Accounting
Exam 2
Exam 2
Finance
[Question 1 & 2]
There are two stocks in the market, stock X and stock Y.The price of stock Xtoday
is 100. The price of stock X next year will be 80 if the economy is in a
recession, 110 if the economy is normal, and 140 if the economy is expanding.
The probabilities belonging with those scenarios are 0.1, 0.8, and 0.1 respectively.
Stock Y and X do no pay dividends. More information is given in the table.
Expected return on stock Y
9%
Correlation
0.7
of stock X a nd the market

of stock Y and the market
COITel;atiolnof stock X and Y
1.
0.3
0.6
The expected return of a portfolio consisting of 60 % of stock X and 40 %

of stock Y is 10.2 %.
2.
The standard deviation of a portfolio consisting of 70% of stock X and 30%

of stock Y is lower than 15%
[Question 3 - 4]
Suppose the market risk premium is 9% and the risk free rate is 4%. Furthermore
the expected return of Deanna Fashion Ltd. Is 16% and the beta of Bulldog Ud. Is
0.7.
3.
The beta for Deanna Fashion Ud. equals 1 1/3.
25
Practice Exam 2
Uniseminar
4.
Bulldog Ltd. has an expected return of 10.3%.
5.
The Security Market Une presents the relationship between Beta and the
expected return ofboth single securities and portfolios.
6.
The Capital Market Une describes the relationship between a portfolio's

expected return and its Beta.
7.
The risk of an individual asset can be measured by the variance or standard
deviation ofits returns.
8.
The correlation coefficient between two stocks is 1 if those stocks show a

return higher (lower) than average at the same time.
9.
The market portfolio contains both risky and riskless assets.
10.
Unsystematic risk is the risk that cannot be diversified away.
11.
A stock whose expected return lies above the security market line is
overvalued.
12.
The higher the risk free rate, the lower the slope of the capital market line.
[Question 13 & 14]

Assume a Modigliani and Miller world with corporate taxes. The firm's required
return on levered equity is 12% while its after tax cost of debt equals 8% and its
26
Uniseminar
Practice Exam 2
debt-to equity ratio is equal to 1. Consider the firm's Weighted Average Cost of
Capital (WACC)
13.
For a constant capital structure, the firm's WACC decreases when the
corporate tax rate increases.
14.
The firm's WACCis equal to 10%.
15.
In a world of Modigliani and Miller without corporate taxes, the weighted

average cost of capital (WACC) is increasing with an increase in debt-toequity-ratio because the risk of a levered firm is higher than the risk of an
unlevered firm.
16.
When a company's debt-to-equity ratio is 35% its debt-to-capitaI ratio is

lower than 30%.
[Question 17]
Assume a world of Modigliani and Miller with corporate taxes (Tc), personal taxes
on interest (Tb) and personal taxes on dividends and other equity distributions
(Ts). Imagine that these tax rates are 40%, 55% and 25% respectively.
17.
The value of the levered firm (VL) is equal to the value of the unlevered
firm (Vu)
18.
An increase in personal taxes on interest (Tb) would lead to an decrease in

value ofthe levered firm.
27
Practice Exam 2
[Question 19]
Suppose a Modigliani- Miller world with corporate taxes of 60%, personal taxes
on interest of 30% and personal taxes on dividends and other equity distribution
of10%
19.
When increasing its leverage, a company in such a world increases its

value.
[Question 20 & 21]

Moramax Inc. currently has a debt-to-capital ratio of 80%. Personal taxes are
60% and corporate taxes equal 50%. The unlevered beta equals 0.84.
20.
The levered beta at the current capital structure equals 2.52.
21.
Increasing the leverage for this company will increase its levered beta.
[Question 22]
Paradigm PIc. has a debt-to-capital ratio of 45%. Its pre-tax cost of debt is always
constant at 7% and at a market return of 12%, risk-free rate of 5%, and beta of
1.20, the company has a WACCof 7.81 %. Corporate taxes are 35%.
22.
A debt-to-capital ratio of 55% is preferred to the current debt-to-capital

ratio of 45%.
23.
In Modigliani and Miller's setting of perfect capital markets, firms could use
any combination of debt and equity to finance their investments without

changing the value ofthe firm.
28
Uniseminar
24.
Practice Exam 2
According to the clientele effect, corporations prefer zero or low payout

stocks.
[Question 25 & 26]

Consider a world of Modigliani and miller without taxes.
25.
If a firm lowers its dividend per share at a given date while holding the
dividends per share for each other date constant, the firm's stock price will
fall.
26.
A reduction in dividends through share repurchase neither helps nor hurts

stock holders.
[Question 27]
Flagstaff Enterprises expected to have free cash flow in the coming year of 8
million, and this free cash flow is expected to grow at a rate of 3% per year
thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of
7%, and it is in the 35% corporate tax bracket.
27.
If Flagstaff currently maintains a 0.5 debt to equity ratio, then the value of
Flagstaff as an all equity firm is smaller than 90 million.
[Question 28]
Consider the Adjusted Present Value (APV), Flow to Equity (FTE), and the
Weighted Average Cost of Capital (WACC)approaches that can be used to value a
project.
28.
80th the APV and the WACC approach use unlevered cash flows for the
calculation of a project's net present value.
29
Uniseminar
Practice Exam 2
[Questions 30-31]
Consider the following information. All numbers are in thousands of dollars ($
000).
Pro FOIll1ll !ncomeStalement
forAldaf!nc,
Year2000
Infame Statement
1 Sales
2
3
4
5
6
7
2000.2005
2001
2002
2003
2003
2005
88,358
103,234
119,777
138,149
158,526
(16,000) (18.665)
(18,000) (21,622)
41.000 48.071
(11.250)(145792
(13,500) (13,254)
16,250 20,238
(5,500)
(5.450)
14,788
10,750
(75)
(6.800)
10,675
7,988
(3,736)
(2,796)
6,939
5;193
(21,593)
(25,757)
55,883
(18,582)
(15,485)
21,816
(5,405)
16,411
(6.800)
9,611
(3.364)
6,247
(24,808)
(30,471)
64,498
(23,356)
(16,769)
24,373
(6,865)
17,508
(6,800)
10,708
(3,748)
6,960
(28,333)
(35,834)
73,982
(27.630)
(17,959)
28,393
(7,678)
20,715
(7,820)
12,895
(4,513)
8,382
(32,193)
(41,925)
84,407
(31,705)
(20,608)
32,094
(7,710)
24,383
(8.160)
16,223
(5,678)
10,545
75,000
Cost of Goods Sold

Raw Materials
Direct Labor Costs
Gross Profit
Sales and Marketing
Adnunistrntive
8 EBITDA
9 Depreciation
10EBIT
11 !ntetest Expense (net)
.12 Pretax lncome

13 Income Tax
14 Net In.ome
Year
20tH
incre,'lses in NWC
Ne! BOlT'Owing
2,250
5,000
0
2002
3,000
5.000
0
2003
3,250
20,000
15,000
2004
3.600
15;000
5,000
2005
4,000
8,000
0
30.
The Free Cash Flow to the Firm in 2002 is equal to $ 8,072,000.
31.
The Free Cash Flow to Equity in 2004 is larger than $ 2.5 million.
[Questions 32 & 33]

The current stock price of company ABC is 19.92. A call option that expires in
exactly two months and has an exercise price of 18.25 is selling at 2.55. The
put option with the same exercise price and maturity is selling at 0.65. A call
option with the same maturity and an exercise price of 20 is selling at 0.64.
32.
The price of a put option on stock ABC that matures in three months and
that has an exercise price of 20 can be calculated with the available
information.
30
Uniseminar
33.
Practice Exam 2
According to put-call parity the annual risk-free rate will be larger than
7.0%.
34.
The loss that the seiler of a put option can make is limited loss.
35.
The strike price of an in-the-money call option is always smaller than the
spot price of the underlying asset.
36.
One of the differences of real options analysis over traditional NPV analysis
is that real option analysis takes a real-discount rate into account whereas
NPV analysis uses a nominal weighted
average cost of capital as the
discount rate.
37.
If the strike price of a call option is below the current stock price, the call
option is out-of-the money.
38.
The maximum gain that the writer of a call option can make is equal to the
premium ofthe option, assuming there are not transaction costs.
39.
The value of a put option is higher, the lower the strike price.
40.
Due to arbitrage, a call option cannot be worth more than the underlying
stock itself.
41.
A higher volatility of the underlying stock adversely affects the value of a

put option.
31
Practice Exam 2
42.
Uniseminar
The option writer, who has the short position in the contract, has an
obligation to fulfill the contract.
43.
American options are traded in the United States whereas

options are traded throughout Europe.
32
European
Uniseminar
Practice Exam 2
Accounting
44.
Buying equipment on account will increase an asset and increase a liability.
45.
Borrowing money from a bank will increase an asset and increase

stockholders' equity.
46.
Accounts payable is an asset account.
47.
Adebit entry to an account increases liabilities but not assets.
48.
Liabilities and Revenues should have a credit balance.
49.
Accounts receivable would appear as a current asset on the balance sheet.
SO.
lf a company receives cash in exchange for issuing stock, the journal entry
to record this transaction involves adebit
to assets and a credit to
revenues.
51.
lf a company pays cash for an amount owed to a creditor, the journal entry
to record this transaction involves adebit to liabilities and the credit to
assets.
52.
The recording of the cost of merchandise inventory by a trading company

when the associated revenue is recorded is an application of "matching".
33
Practice Exam 2
[Questions 53 & 54]

A company (i) receives $900 cash from a customer as a payment on account, (ii)
prepays 6 months insurance of $ 600, (iii) purchases
$1,500 inventory on
account, and (iv) performs services that it was prepaid $700 for last month.
53.
As a result ofthese 4 transactions, total assets increase by $1,500.
54.
As a result ofthese 4 transactions, totalliabilities decrease.
[Question 55 & 56]

Consider the following information about Company A at 2008 fiscal year end:
Sales 2008
$200,000
Accounts Receivable (gross)
$19,000
Allowance for Uncollectible Accounts
$500
Aging of receivables schedule

Days outstanding
Amount
Likelihood of uncollectibility
1-30 days
$10,000
5%
30- 60 days
$4,000
10%
60-90 days
$5,000
30%
55.
If 1% of sales is estimated
to be uncollectible,
the difference
in
Uncollectible Account Expense (also called bad debt expense) between the
aging-of receivables method and the percent-of-sales method is $400.
56.
The Allowance of Uncollectible Accounts under

method on the year-end balance sheet is $2,500.
34
the percent-of-sales
Uniseminar
Practice Exam 2
[Questions 57 & 59]

Consider the following information about Company A
57.
If campany A uses FIFa inventory costing, cost of goods sold is $19,200.
58.
If company A uses FIFa inventory casting, net income is higher than if

company A uses LIFO.
59.
If company A uses the average-cost inventory method, ending inventory is

$ 14,000.
[Question 60- 61]

On january
1,2006, Company A purchases
a machine for $10,000 with an
economic life of 5 years and a salvage value of $ 1,000.
60.
If Company A uses the double-declining balance depreciation method, the

depreciation expense in 2010 is $296.
61.
If Company A uses the straight-line depreciation method, the book value on

December 31,2006 would be $ 8,000.
35
Uniseminar
Practice Exam 2
Practice
Exam 2 - Solutions
Finance
1.
False, 9.6%
2.
True
3.
True
4.
True
5.
True
6.
False ~ the SML
7.
True
8.
True
9.
False ~ only risk assets
10.
False ~ can be diversified away
11.
False ~ undervalued
12.
True
13.
True
14.
True
15.
False
16.
True
17.
True
18.
True
19.
True
20.
True
21.
True
22.
False
36
Uniseminar
Practice Exam 2
23.
True
24.
False
25.
True
26.
True
27.
True
28.
False
30.
True
31.
False
32.
False
33.
True
34.
True
35.
True
36.
False
37.
False
38.
True
39.
False
40.
True
41.
False -7 positive effect
42.
True
43.
False -7 both are traded
in Europe and U.S.
37
Practice Exam 2
Accounting
44.
True
45.
False
46.
False
47.
False
48.
False
49.
True
50.
False
51.
True
52.
True
53.
True
54.
False
55.
False
56.
True
57.
False
58.
True
59.
False
60.
True
61.
False
38
Uniseminar
Resit 2009/2010
Finance
[Questions 1-2]
Consider Samsung's Project P which cancerns the development of a new product
wh ich Samsung expects to successfully launch on the market. The expected cash
flow from Project P is $2 million in the first year, which will increase by 5% per
year thereafter. The initial cast to Samsung is $50 million, of which $20 million
will be financed with new debt. Samsung's unlevered cast of capital is I 0%, while
the cast of equity is 15% and the cast of debt is 5%. The tax rate is 35%. Samsung
will maintain a constant debt-equity
ratio for Project P. Samsung uses the
Adjusted Present Value method to value Project P.

1
The size of the tax shield associated with project P da es not affect Project
p's unlevered value.
The pretax cast ofinterest of Project P is Jess than $400,000.
[Question 3]
Suppose Luther Industries is considering divesting one of its product Iines. The
product line is expected to generate free cash flows of $2 million per year,
growing at a rate of 3% per year. Luther has an equity cast of capital of 10%, a
debt cast of capital of 7%, a marginal tax rate of 35%, and a debt-equity ratio of 2.
This product line is of average risk and Luther plans to maintain a constant debtequity ratio.
3
According to the Weighted Average Cast of Capital method,
Luther
Industries must use a weighted average cast of capital of 6.4% to value this
divestiture.
According to the Adjusted Present Value method, when the firm maintains
a target leverage ratio, its future interest tax shields have similar risk to the
project's
cash f1ows, so they should be discounted
at the project's
unlevered cost of capital.

5
The project's free cash f10w to equity shows the expected amount of
additional cash the firm will have available each year to pay dividends or
conduct share repurchases.
[Question 6 - 7]
When estimating
a firm's continuing value, the multiples method and the
discounted cash f10w method can be used. In both methods, there are common
pitfalls which lead an upward bias of the estimated current value of the firm.
6
When estimating a firm's continuing value with the multiples method, a

common pitfall is ignoring investment necessary for growth.
When estimating a firm's continuing value with the discounted cash f10w
method, a common pitfall is using unsustainable ]ong-term growth rates.
The Flow To Equity method can offer an advantage when calculating the
value of equity for the entire firm, if the firm's capital structure is complex
and the market values of other securities in the firm's capital structure are
notknown.
If the financing of the project involves an equity issue and if management

believes that the equity will seil at a price that is less than its true value,
this mispricing is a cost of the project for the existing shareholders.
10
The purpose of valuation using comparables is to provide a benchmark

value rather than a precise estimate of the value.
[Question 11 - 12]
Consider the following information regarding ldeko.
!'.!O Forl1la Income Statement for Idcko, 200S.2010c ..,"",~,_,.,
__
__________
~~2~0_05_._2006
~,[~Z
2008
2009
2010
Incame. Statcl!!,!1J!!.lS.99J!L_.
""_._"_' ,.,....._....~,...".~~~
__
~~~
__
~_ .._ .... _.,.._._
! Salcs
75,000
68,358
}.Q.3.tS2~_l!2.Jn} 138,149 158,526
2 Cosl ofGods Sold
Raw MteiiJs-' -'-(18,665) (21,593) (24,808)
(30,471)
4 Direct Labor Costs
(21,622)
(25.757)
5 Gross Profit
6 Sales and M~;.k.etih-.7 Administrative
"_"C'"~"~~~~
1"
8 EBlTDA
2.. Dep
10 EBlT
11 lntetest ExpenseJI}:.!.L_~
.I.l.Rretax Income
13 Incorne Tax
7,988
(2;796)
5,193
14 Net Income
~).r.2.
Formll Balance Sheel for Ideko, 2~~~:ll1JL_20-0-6-'--20-0-1---20-0-8---20-09'~=_j.ol
~-
.!la.lanc~SlIcet ($000)
AsscH.
I.<=h~i~~ash E~uiv~!.nl;-.
~;[~~~-.-,
.I.\,355
J 3,030
?~~C.~2.t.t!1~_~_&~~yable
...J~d2.3._._14,??-,Lc")?,21g. __._.12,.?~~
.....
~J~~.2.L
3..III\'!111l~.~ies
,.__ ~_,.,~.,_?,-1.~.2.
6.501 ._.:Z&r3.
J!;854 ".,)..Q.240
J J, 784
4 Total Current Assets
30,822
28,288
33,067 __38,388
44,304
50.8n
5 Propeny, Plant, and Equipment
49,500 .._4~,050
48,645 ... ~Z.~I.
69,102
69,392
6 Goodwill
72,332
72,332
72,332
72,332
72,332
72,332
7" TotalAssets
152,654".149,670
154,044-Yn,5o I
i85,738 192597
Uabilities
8 AcCUlltsPayable
4,654
5,532
6,648
7,879
9,110
10,448
9 Debt
100,000 1OO,OOOIl)!Jlll)_<.!_._IJ.~,!!Ql)
__ !.?l),OOL.120,l).llll.LO TotalLiabilities
104-:-654.'j2~2'106,648
122,879 If2J 10 I30,448
~!2_kll0Id!~E9uity
....
UStartingStockholder's EquitX
. 48,000
44,138
47,396
49,621
$6,628
12 Nellncome=::j~193
=.Q~?:47.:-::~~;9.QQ
__ , 8,382
10,545
13 Dividends
(2.000) (9,055)
(2.989) ..., ..'(4Im
(l,375)
(5,024)
14 Capital Contributions
50,000
15 SIgekholdct~.~_<LI!.!.!Y._
..... ._ 48,000
44.138.
47.396
49,621
56,628
62,149
I~J()talpabilities
and Egtlity __
ll~&?J.J49,gZ9 __ 111,.l)1.4 In,501
Jll~,}:?~
..__
.l.~?-.J,?:?.L
7,2g='=~~;1??~':::}:~i5__
cc............
11
..................
.._ . _
__
..
_
_.__
._ ...__
, ...
_
Assuming that ideko has a EBITDAmultiple of 8.5, then the continuation

equity value ofldeko in 20 i 0 is more than $160 million.
12
Assuming that Ideko has a EBITDAmultiple of 9.4, then the continuation

unlevered PJE ratio of Ideko in 20 I 0 is more than 18.0.
13
Systematic risk cannot be eliminated by diversifying your portfolio.
14
The beta of a risk-free portfolio is I.
15
The relationship between a security's return and its beta is called the
security market line.
16
According to the CAPM, the risk premium of a security is equal to the

market risk premium (the amount by wh ich the market's expected return
exceeds the risk-free rate), divided by the amount of market risk present in
the security's returns measured by its beta with the market.
17
Cash distributions to shareholders - for example in the form of dividends must be made before interest payments are made to debtholders.
18
In perfect capital markets without taxes and bankruptcy costs, the cost of
equity is unaffected by the firm's choice ofthe debt-to-value ratio.
[Question 19]
Assume a perfect capital market without any imperfections. A company exhibits
the
following
characteristics:
Its debt-to-equity
ratio
is equal
to
75%.
Furthermore, the firm's cost of debt is 5.25% and the cost of levered equity is
12.75%.
19
The unlevered cost of equity is less than 8.00 %.
20
In a Modigliani-Miller world with perfect capital markets, dividends are

irrelevant.
21
In perfeet capitaI markets, a share repurchase has a no effect on the stock

price. A dividend payout, however, decreases the stock price by exactly the
amount of the dividend in this perfeet market.
[Question 22]
Assume company XZ is a Ieading car manufacturer.
It is operating in aperfect
capital market without taxes and bankruptcy costs. XZ exhibits a debt-to-value
ratio of 33%. The average unIevered beta of the industry is equal to 1.80.
Furthermore, XZ's debt is risk-free.
22
XZhas an equity beta of 2.39.
[Question 23]
Assume a Modigliani-Miller world with taxes but without bankruptcy costs. The
corporate
tax rate
is equal to 35.00%. UM [ne. is a leading
computer
manufacturer and it has a cost of equity of 13.00%. Furthermore, it can borrow at

5.50%. Currently, UM Inc. has an equity-to-capital ratio of 80%.
23
UMlnc. 's weighted average cost of capital is lower than 11.00%.
24
The tradeoff theory states that the value of the levered firm equals the
unlevered value of the firm plus the present value oft he tax savings, plus
the present value of financial distress costs.
25
According to the pecking order hypothesis, management should use debt

financing first to finance investment projects.
[Question 26]
Frank, a wealthy private investor, owns 7.5% of Banana Inc. 's outstanding
shares. Banana Inc. intends to pay out dividends. The company has 56,540,000
shares outstanding and is planning to distribute 98,945,000 to shareholders.

The tax rate on dividends is equal to 45%.
26
The after-tax cash flow to Frank is smaller than 4,240,500.
27
In general, a cut in dividends conveys negative information about the

future prospects of a company, provided that no profitable investment
opportunities are available.
[Question 28]
Assume the following characteristics of company T' and its industry peers, A, B,C.
T exhibits a debt-to-value ratio of 40%. The risk-free interest rate is equal to 4%
and the market return equals 9.5%. Companies A, B, and C have unlevered betas
of 1.15, 1.4, and 1.65, respectively. The corporate tax rate equals to 40% and the
after-tax cost of debt is equal to 5.5%. Assume no further financial distress costs.
28
T's weighted average cost of capital is larger than 12.00%.
[Question 29]
Assume the following characteristics of company Z and its industry peers, E, G, F,
H. Z exhibits an equity-to-value ratio of75%. The risk-free interest rate is equal to
5% and the market return equals I 0.75%. Companies E, G, Fand
H have
unlevered betas of 1.25, 1.40, 1.60 and 1.65, respectively. The corporate tax rate
equals to 30% and the before-tax cost of debt is equal to 7 .5%. Assume no
further financial distress costs.
29
The levered equity beta of Z is equal to 1.48.
[Question 30]
Assume the following characteristics of company X: X has a debt-to-value ratio of
35%. Furthermore, its levered beta is equal to 1.50. The risk-free rate equals to
4% and the market return is 10.45%. The corporate tax rate is 40% and X's cost
of debt is 5% after tax.
30
X's cost oflevered equity is smaller than 15.00%
31
In a Modigliani-Miller world with corporate taxes but without any further

imperfections, the weighted average cost of capital increases with a firm's
leverage.
32
Managers are more Iikely to seil equity when they know that the stock of
their firm is overvalued. As a result, the stock price increases when their
firm announces the issuance of equity.
33
The payout of excess cash can serve as a positive signal to capital markets
because it reduces managers' ability and temptation to waste resources.
American options are traded in the United States whereas
European
options are traded throughout Europe.

35
The option writer, who has the short position in the contract, has an
obligation to fulfill the contract.
36
If the strike price of a call option is below the current stock price, the call
option is out-of-the money.
37
A higher volatility of the underlying stock adversely affects the value of a

put option.
38
The combination of a long put option and a long call option with the same
strike prices and the same expiration date is known as astrangle.
39
A combination of options that pays off when the stock price is dose to the
strike price is called a butterfly spread.
40
The maximum gain that the writer of a call option can make is equal to the
premium ofthe option, assuming there are no transaction costs.
41
lt is possible to show that the put-call parity holds by comparing the payoff
of owning a stock with the payoff of a portfolio consisting of a long call, a
cash investment equal to the present value of the strike price, and a short
put.
42
The value of a put option is higher, the lower the strike price.
43
Due to arbitrage, a call option cannot be worth more than the underlying
stock itself.
[Question 44 - 45]
The current stock price of ABC Ud is 15. In each of the following 2 years, this
stock price can either go up by 2 or go down by 1. The stock pays no dividends.
The one year risk-free interest rate is 5% and will remain constant.
44
Using risk neutral probabilities, the price of a 2-year call option on ABC's
stock with a strike price of14 is sm aller than 2.40.
45
Using the binomial pricing model, the price of a 2-year call option on ABC's
stock with a strike price of14 is larger than 2.65.
46
We only need 4 input parameters to price a call option using the BlackScholes option pricing model: the stock price, the strike price, the risk-free
interest rate and the volati!ity of the stock.
[Question 47 - 49]
Atlantic Oil Corporation has bought the right to drill 100,000 barrels of crude oil
out of the North Sea in the next year. The current oil price is $95 per barrel. The
costs associated with the excavation are $8,450,000.
47
The option 's intrinsic value is $1,050,000.
48
The exercise price of this option is $9,500,000.
49
When the volatiIity is known, this option can be valued using the BlackScholes option pricing model.
50
The Option to wait is most valuable when there is

uncertainty
future.
a great deal of
regarding what the value of the investment will be in the
Accounting
51
All business owners are personally Iiable for the debts oftheir business
52
Net income appears on both the income statement and the statement of
retained earnings
53
The relevant measure of the value of the assets of a company that is going
out of business is the historical cost
54
Stockholders' equity can increase as a result of owner investments
55
Notes payable (due in 60 days) would appear as a current asset on the

balance sheet
56
Double-entry accounting records only those transactions
affecting the
income statement
57
Prepaid expense accounts appear on the balance sheet
[Questions 58 - 59]
Consider the following transactions:
I.
Borrowed cash on a note payable, $80,000
II.
Received cash from a customer as payment on account, $8,000
III.
Received cash for services to be performed in the future, $10,000
IV.
Paid rent in advance for six months, $6,000
58
Whereas transaction I increases total assets, transaction II does not
59
Transaction
III increases both assets and liabilities and transaction
decreases both assets and Iiabilities
IV
60
The payment of an amount owed to a creditor decreases both assets and

liabilities
61
Cash dividends paid to Stockholders will have no effect of Stockholders'

equity
62
The journal entry to record the purchase of inventory on account includes

adebit to Accounts Payable
63
In accounting, the process of posting involves transferring data from the

journal to the ledger
64
The matching
principle
requires
the identificationof
expenses
and
matching them with the cash used to pay them

65
Prepaid expenses are often referred to as "accruals" because the recording

ofthe expense is accrued until after cash is paid
66
An expense incurred in 2008 that is not paid until 2009 should appear on
both the 2008 and 2009 income statement
67
If, on September I, 2008, $6,000 maintenance costs are prepaid for six
months, the balance in the account Prepaid Maintenance Expenses on
December 31,2008 is $4,000
68
The Accumulated Depreciation account is a contra-asset account with a

normal debit balance
69
If on December 31, 2008, salaries owed to employees total $4,150, which

will be paid on january 4, 2009, the adjusting entry prepared on December
31,2008, includes adebit to Salary Expense for $4,150
70
The current
ratio
is computed
by dividing
current
assets
by current
liabilities
71
Trading
investments
are reported
on the balance
sheet
at their
market
value
72
If trading
$80,000
beginning
report
[Question
purchased
in 2008
for $85,000
on December
31, 2008
and
securities
of2009
an unrealized
revealed
the 2009
were
income
valued
sold
statement
at
at the
should
gain of $3,000
receivable
($46,000)
and estimated
Uncollectible
1 - 30 days
$ 40,000
1.5 %
31 - 60 days
$ 10,000
8.0%
61-
$ 6,000
22.0 %
90 days
over 90 days past due are written

for Uncollectible
Using the aging-of-receivables

(bad debt expense)
Under
account
includes
percentage
off. Before the year-end
review, the
Accounts was $520.
method,
the uncollectible-account
expense
for the year should be $3,240
the allowance
for Uncollectible
uncollectible
the following:
Accounts receivable
balance in Allowance
74
then
loss of $5,000 and a realized
review of accounts
percentages
73
for $83,000,
the
were
73]
A year-end
Amounts
investments
method,
the
a credit to Accounts
Accounts
entry
to write
Receivable
off an uncollectible
and adebit
to Allowance
[Question 75]
Company A uses the percentage-of-sales
method
to estimate
uncollectible
accounts. The Allowance for Doubtful Accounts prior to adjustment has a credit
balance of $16,000, net credit sales for the current year amount to $5,000,000
and management estimates that 2% will be uncollectible.
75
After all necessary adjusting entries have been made, the balance in
Allowance for Uncollectible Accounts will be $116,000
[Question 76 - 78]
Consider the following information about company A
Beginning inventory
400 units at $16
Units sold
1,200 units at $45
Purchases
1,600 units at $19
76
If company A uses FIFa inventory costing, cost of goods sold is $19,200
77
If company A uses FIFa inventory costing, net income is higher than if

company A uses UFO
78
If company A uses the average-cost inventory method, ending inventory is

$14,000
79
The choice of inventory costing method does not affect total assets
80
The inventory turnover ratio indicates how rapidly inventory is sold
81
The cost of a plant asset includes all amounts paid to acquire the plant
asset and to get it ready for its intended use
[Question 82 - 84]
On january I, 2007, company A purchases a machine for $2,500,000 with an
estimated usefullife of 20 years and salvage value of $100,000.
82
Under the double-declining balance depreciation
method, the net book
value ofthe machine on December 31, 2009 is less than $1,800,000 -
83
In 2010,depreciation
expense
under
the double-declining
balance
depreciation method is higher than under the straight-line depreciation

method
84
If company A uses the straight-line depreciation method and on I january

20 I 0 seils the machine for $750,000, this results in a lass on the sale of the
machine
85
Land has to be depleted
[Question 86]
On january I, 2007, Company A paid $250,000 for an oil lease that contains an
estimated 20,000 barrels of oil. 5,000 barrels are extracted in 2007 and 6,500
barrels are extracted in 2008.
86
The entry to journalize the depletion expense for 2008 involves a credit to
depIetion expense of $81,250
87
Warranty expense should be recorded
in the period that a defective
product is repaired or replaced

88
A contingent liability is not on the balance sheet
[Question 89]
The beginning balance in the Warranty Payable Caliability) account was $50,000.
Sales were $900,000 and warranty costs were estimated at 7% of sales. During
the year, $55,000 was paid to settle warranty claims.
89
Warranty expense is $113,000 and the ending balance ofWarranty Payable

is $58,000
90
Gains and losses
are considered
extraordinary
if they arise
from
transactions which are unusual or infrequent

91
When the financial statements are in accordance with GAAP,the auditor

issues an qualified opinion
92
Dilution of EPS can occur when convertible preferred stock is converted

into common stock
[Questions 93 - 97]
Consider the following information about Company A:
CompanyA
Cotnparati\'e
balance sbeet
3\ Dceetnber 1008 llntll007
Amounhin
Cash
Accounts reeeivable
InVCnlerles
Prepaid expenses
Equipmenl, net'
100angibleam:ts
2008
1007
38,000
6,000
46,000
44,000
68,000
2,000
180,000
J!l.&QQ
350,000
Tntal assets
28,000
32,000
;2S,OllO
Aecowlts payabk
Accrued Iiabilitics
Incnme tax. payable
anklean"
90,000
62,000
Commen stock
Retained camings
IJJ1.!lUQ
TotlllliablliUes
350,000
and stockholders'
cquity
Company Apaid 40,(}OOlorncw cquipmentduring 200S,
Company A repaid 10,000 on Hs bankloan durinll :1008,
CompanyA
\neome shltement
Yellt ended 31 Oeeember 2008
Salcs revenue
Inventories
DepreCiationexpcnse
Otheroperating. expenses.
Gain on salt ofequipment
IllCome be:fore iilcorne laxes
Ineome lax expense
Netineome
380,000
.170,000
38,000
72,Oao
12,000
112,000
,1.9..QQQ
76,000
93
Cash collections from customers are 336,OOOin 2008
94
Cash payments for inventory are 166,OOO in 2008
95
Cash payments for income taxes are 40,000 in 2008
96
Cash received from the sale of equipment is 20,000 in 2008
62,000
6,000
158,000
l~,OQQ
296,000
18,000
38,000
24,000
100,000
40,000
76,000
296,000
97
On an indirect method cash flow statement, the lZ,OOO gain on the sale of
equipment reported on the income statement should be added back to net
income in computing cash flow from operating activities
98
A direct and indirect method cash flow Statement differs in the way cash
flows from financing and investing activities are presented
99
The payment of a cash dividend is a financing cash flow
100
If a company lends money to another company, this would appear on the

cash flow statement as a negative cash flow from investing activities.
Solutions
1. True
2. False
3. True
4. True
5. True
6. False
7. True
8. True
9. True
10. True
11. False
12. True
13. True
14. False
15. True
16. False
17. False
18. False
19. False
20. True
21. True
22. False
23. False
24. False
25. False
26. True
27. True
28. False
29. True
30. Trlle
31. False
32. False
33. True
34. False
35. Trlle
36. False
37. False
38. False
39. True
40. True
41. True
42. False
43. True
44. True
45. False
46. False
47. True
48. False
49. False
50. True
51. False
52. True
53. False
54. Trlle
55. False
56. False
57. True
58. True
59. False
60. True
61. False
62. False
63. True
64. False
65. Trlle
66. False
67. False
68. False
69. True
70. Trlle
71. True
72. False
73. False
74. True
75. True
76. False
77. Trlle
78. False
79. False
80. True
81. True
82. False
83. True
84. False
85. False
86. False
87. False
88. True
89. False
90. False
91. False
92. True
93. False
94. True
95. False
96. False
97. False
98. False
99. True
100. True
First Sit 2008

Finance
1-3) Consider Samsung's Project P wh ich concerns the development
of a new product
which Samsung expects to successfully launch on the market. The expected cash flow
from Project P is $2 million in the first year, which will increase by 5% per year
thereafter.
The initial cast to Samsung is $50 million, of which $20 million will be
financed with new debt Samsung's unlevered cost of capital is 10%, while the cost of
equity is 15% and the cast of debt is 5%. The tax rate is 35%. Samsung will maintain a
constant
debt-equity
ratio for Project P. Samsung uses the Adjusted Present Value
method.
1) The unlevered Value of Project P is more than $50.0 million.
2) The levered value of Project P will be smaller than the unlevered value of the project
3) Samsung's tax shield for project P is less than $400,000.
4) Deducting costs arising from market imperfections,
calculating the unlevered value of
the project, and calculating the after-tax weighted average cost of capital are all steps
that are necessary in the Adjusted Present Value method.
5) Determining the equity cast of capital, computing the equity value by discounting the
free cash flow to equity using the equity cost of capital, determining the free cash flow to
equity of the investment, and determining
the before-tax cost of capital are all steps in
the flow to equity method.
6) In the APV method, when debt levels are set according to a fixed schedule, we
discount the predetermined
tax shields using the debt cast of capitaJ.
8) The cash multiple method of firm valuation does not take into account the time
horizon of investment
risk. Therefore it is only useful in comparing deals with similar
risk and time-horizons.
9)
Under
the
CAPM assumption,
investors
have
wide-ranging
divergences
of
expectations regarding volatility and expected return of securities.
10) According to the CAPM, the best possible combination
of risk and return for any
level of return are various combinations of market portfolio and risk-free investments.
11) According to the CAPM,the cost of capital of an investment is equal to the expected
return
of the best available
portfolio
in the market
with the same sensitivity
to
systematic risk.
12) In the CAPM, the risk-free
rate directly
affects the expected
return
of any
investment.
13) The security market line is he set of portfolios with the highest possible expected
return for any level ofvolatility.
14) According to Modigliani-Miller,
the firms value is independent
of the capital
structure in perfect markets.
15) If a company has a equity-to-capital
ratio of 45%, then its debt-to-equity
ratio is
equal to 81.82%.
16) Assume a perfect capital market without any imperfections. A company exhibits the
following characteristics.
Its debt-to-equity
ratio is equal to 50%. Furthermore,
company's cost of debt is 2.5% and the cost ofunlevered

The company's levered cost of equity is equal to 13.75%.
equity is 10%.
the
17) Assume a Modigliani-Miller world with taxes but without bankruptcy
costs. The
corporate tax rate is equal to 35.00%. UM [ne. is a leading computer manufacturer

has a cost of equity of 14.00%. Furthermore
has a debt-to-capital
and it
it can borrow at 4.50%. Current[y, UM [ne.
ratio of 3/8.
UM [nc's weighted average cost of capital is lower than 10.00%
18) In a Modigliani-Miller world with corporate taxes and without bankruptcy costs, the
cost of equity rises and the weighted cost of capital (with taxes) stays constant when the
debt-to-value ratio is increased.
19) The overinvestment
problem refers to the fact that shareholders
have an incentive
to invest in risky projects when the firm faces financial distress.
20) The free cash-flow hypothesis

money in unprofitable
claims that it is more Iikely that managers
waste
investment projects when they have high levels of excess cash at
their disposal.
21) Assume the following tax rates: taxes on capital gain (Tg) and taxes on dividends
(Td). These are equal to: Tg= 20% and Td= 40%
The effective dividend tax rate is equal to 33.33%.
22) In general, an increase in the dividend level is a positive signal to the capital market.
23) Assume the following characteristics

35%. Furthermore,
of company X. X has a debt-to value ratio of
its levered beta is equal to 1.50. The risk-free rate equals to 4% and
the market return is 10.45%. The corporate tax rate is 40% and X's cost of debt is 5%
after tax.
X's weighted average cost of capital is smaller than 9.00%.
24) If a firm in financial distress is losing employees, then this loss is a form of direct
financial distress costs.
25) Because interest
expense is deductible,
leverage decreases
the total amount of
income available to all investors.
26) Investors in high tax brackets prefer stocks with a low or zero dividend.
27) Corporations are reluctant to change dividend levels. This practice is called dividena
smoothing.
28) When a holder of a call option sells a share of stock at the agreed-upon
price, he is
exercising the option.
29) An American option may be exercised only on the expiration date.
30) If the spot price of the underlying a~set is lower than the exercise price of the put
option, the put option is in-the-money.
31) The combination of a long option and a long call with different strike prices an the
same expiration date is known as astraddie.
32) A combination of options called a butterfly spread involves the purchase of two put
options with different strike prices and the sale of two call options with the same strike
price.
33) The Payoff from buying a put option and buying the underlying
same as the payoff from the buying call on the underlying
stock will be the
stock and buying a zero-
coupon bond with a price equal to the present value of the option's strike price.
34) Consider a 2-year call option and a 2-year put option both having a strike price of
10. The current price of the call option is 2 and the price of the put option is 3. The
one year risk-free rate will remain constant
The stock underlying both options pays a
dividend of 1 in 2 years, which is still during the Iife of the options.

If the current price of the underlying stock is 9 Euro, then the implied risk-free rate is
5.00%.
35) The value fa call option generally decreases with the voIatility of the underIying
stock.
36) The vaIue of a call option generally increases wit a rising strike price.
37) The intrinsic value of an option is the value it would have i fit expired immediately.
38-39) Consider a stock with a price of 90 and an American call option on this stock.
which has a time to maturity of 12 months and an exercise price of 75. The price of the
option is currently 10.
38) The call option has a long time to maturity and therefore
its time value is higher
than its intrinsic value.
39) When the price ofthe stock remains the same until maturity. both intrinsic and time
value of the call option will decrease.
40) The current stock price of ABC Ltd is 15. The stock pays no dividends. The exercise
price of a one-year put option on ABC's stock is 16. N(dl) is equal to 0.626 and N(d2)
is equal to 0.078. Assume a risk-free rate of 5% and a standard deviation of 0.6.
Using the Black-Scholes Option Pricing Model, the value of the put option is equal to
6.14.
41) A costless collar involves the purchase of a put option and the sale of a call option.
42-44) Atlantie Oil Corporation has bought the right to drill 50,000 barrels of erude oil
out of the North Sea in the next year. The eurrent oil priee is $80 per barrel. The eosts
associated with the exeavation are $4,950,000.
42) The option has only time value
43) The exercise priee ofthis option is $4,000,000.
44) When the eurrent risk-free rate is known, this option ean be valued using the
Blaek-Seholes Option Pricing Model.
Accounting
1) From an accounting
viewpoint,
a proprietorship
is aseparate
entity from the
proprietor
2) Dividends are classified as expenses
3) The going-concern
concept
of accounting
holds that the entity will remain
in
operation for the foreseeable future.
4) The calculation of ending retained earnings considers current net income or net loss
and dividends.
5) Retained earnings is a component of stockholders'
equity.
6) Accounts receivable would appear as a current asset on the balance sheet.
7) Expense accounts always represent expired assets.
8) Accrued Liabilities is a liability account.
.9) Consider the following transactions:

Borrowed cash on a note payable, $80,000.
Provided services on account, $10,000
Received cash from a customer as payment on account, $8,000.
The effect of recording these transactions
on total assets would be $88,000.
10) Purchasing supplies on account would increase both assets and liabilites.
11) The purchase of land for cash has no effect on total assets.
12) The entry to record $1,000 received
from a customer
for services
previously
rendered would be:

$1,000
Service revenue
$1,000
Cash
13) The requirement
to report accounting information at regular intervals is known
ase
the time-period concept.
14) The process of transferring
information from the jounral to the ledger is known as
posting
15) An accrual refers to an event where the expense or revenue is recorded before the
cash settlement.
16) lf cash for merchandise
to be delivered in 2009 is received in 2008, the revenue
should appear on the 2008 income statement.
17) lf, on September
1, 2008, $6,000 maintenance
costs are prepaid for six month_
$2,000, of this amount should be applied toward net income in 2008.
18) A journal entry that contains adebit
to a liability account and a credit to revenue
account could relate to the recording ofunearned
revenue.
19) lftwelve months' insurance is paid in advance totaling $9,000, the adjusting entry at
the end of the first month would include adebit to lnsurance Expense for $8,250.
20) The debt ratio measures a firm's ability to pay both current and long-term debt.
21) Unrealized gains and losses on trading investments
are reported
as part of net
income.
22) If trading investments
purchased
in 2008 for $15,000 were valued at $ 20,000 on
December 31, 2008 and the securities were sold at the beginning of 2009 fo r $17,000,
then the effect on 2009 pre-tax income would be $2,000.
23) Company A's year-end
review of accounts
receivable
($20,000)
and estimated
uncollectible percentages revealed the following:

Accollnts receivable
$15,000
$3,000
$2.000
1 - 30 days
31 - 60 davs
61 - 90 days
Before the year-end
Uncollectible
review, the balance in Allowance for Uncollectible Accounts was
$200.
Using the aging-of receivables
method, the balance in the Allowance for Uncollectible
Accounts at year-end should be $830.
24) Under the direct write-off method, the entry to write off an uncollectible account
includes a credit to Accounts Receivable and adebit to Uncollectible-Account
25) Company A uses the percentage-of-sales
Expense.
method to estimate uncollectible accounts.
The Allowance for doubtful accounts prior to adjustment has a credit balance of $25,000,
net credit sales for the current year amount to $ 7,500,000 and management
estimates
that 1% will be uncollectible.

After all necessary
adjusting
entries have been made, the balance in Allowance for
Uncollectible Accounts will be $75,000.
26 - 27) Consider the following information over a year about company A

Beginning inventory: 100 units at $75 per unit
Purchases:
150 units at $63 per unit
Sales:
190 units at $100 per unit
26) If company A wouId use the LIFO inventory costing method, gross profit equaIs
$6,550 and ending inventory equaIs $3,780.
27) If company A wouId use the average-cost
inventory costing method, gross profite
equals $5,890 and ending inventory equals $4,140.
28) If company _Awould use the FIFO inventory costing method, cost of goods sold is
higher and ending inventory is lower than under the LIFO method.
29) If a company ending inventory (at cost) is higher than the inventory's market value
it should make adebit to Cost of Goods Sold and a credit to inventory.
30) A LIFO liquidation
occurs when the inventory
prices fall below prices of the
previous period.
31 - 33) On january 1 2007, company A purchases a machine for $1,000,000 with
ae
estimated usefullife of 10 years and salvage value of$50,000.
31) Under the double-declining
balance depreciation
method, depreciation
expense for
2009 is $121,600.
32) In 2010, depreciation
expense under the double-declining
method is higher than under the straight-Iine depreciation method.
balance depreciation
33) If company A uses the straight-line depreciation method and on 1 January 2010 seils
the machine for $750,000, this results in a loss on the sale of a machine.
34) Goodwill should be amortized.
35) Company A purchased
an oil field that had been estimated
to have 14,500,000
barrels of oil 870$ million in 2008. In 2008 and 2009, 800,000 barrels and 1,500,000 of
oil, respectively were extracted.
The net book value of the oil field reported as December 31, 2009 is higher than $700
million.
36) If a company replaces a product sold under warranty, the journal entry to record
this transaction involves adebit to liabilities and a credit to assets.
37) A contingent liability that has a remote chance of occurrence should be disclosed in
the financial statement footnotes.
38) A contingent liability that has a remote chance of occurrence should be disclosed in
the financial statement footnotes.
39) The beginning balance in the Warranty Payable Ca liability) account was $10,000.
Sales were $200,000 and warranty costs were estimated at 2% of sales. During the year,
$6,000 was paid to settle warranty claims.
Warranty expense is $4,000 and the ending balance ofWarranty
Payable is $12,000.
40) The gain or loss on the disposal of a business segment is not shown on the income
statement
41) Company Areports
net income for the current year of $480,000. Company A has
8,500 shares of $100 par value, 15% preferred stock outstanding
and 50,000 shares of
$10 par value common stock outstanding for the entire year.
Earnings per share are less than $7,20.
42) A qualified audit opinion means that the financial statements have been prepared by
a certified public accountant.
43) Under the indirect method of preparing a cash flow statement,
depletion expense
must be added back to net income under the operating activities section.
Answer sheet
Finance
1) T
24) T
2) F
25) F
3) T
26) F
4) T
27) F
5) T
28) T
6) T
29) T
7) F
30) F
8) T
31) F
9) F
32) T
10) T
33) F
11) T
34) F
12) F
35) T
13) T
36) T
14) T
37) F
15) T
39) F
16) F
40) F
17) F
41) T
18) T
42) F
19) F
43) T
20) T
44) T
21) T
45) T
22) F
46) F
23) F
Accounting
1) F
27) T
2) F
28) F
3) F
29) F
4) F
30) T
5) F
31) F
6) T
32) F
8) T
33) T
9) F
34) F
10) T
35) F
11) T
36) F
12) T
37) T
13) F
38) F
14) T
39) F
15) F
40) F
16) T
41) T
17) T
42) T
18) F
43) F
19) T
44) F
20) T
21) F
22) T
23) F
24) F
25) F
26) T
Trial exam 2006B Finance and Accounting - Finance par1

Note that the written exam contains 50 Finance and 50 Accounting questions. This trial exam consists of finance
questions only. Note that these questions are only indicative of some type of questions but are not
comprehensive in terms of type or topic. For additional practice, students are encouraged to consider the tests
and exercises available in the MyfinanceLab associated with the required chapters in the course' s textbook by
Berk and DeMarzo. No rights can be derived from this trial exam.
1. T/?/F
One of the differences of real options analysis over traditional NPV analysis is that real option
analysis takes a real discount rate into account whereas traditional NPV analysis uses a nominal
weighted average cost of capital as the discount rate.
[Questions 2-3]
A European company wants to hedge a payment of $1 million that it has to make in 3 months against currency
a:!sks.
The current exchange rate is 0.80 /$. The company's manager expects that the exchange rate will be 0.90
~/$
in 3 months. The following European options are available.
Underl in Asset
Strike Price in /$
Premium in I$
Time to Maturi
2. TI?/F
Both Put Option A and Call Option A can be used to completely eliminate exchange rate risk.
3. TI?/F
Given her expected exchange rate, the manager should choose Call Option A over Call Option B
because Call Option A will lead to a lower hedged value at the expected exchange rate.
4. T/?/F
The loss that the seiler of a put option can make is limited loss.
5. T/?/F
The strike price of an in-the-money call option is always smaller than the spot price of the
underlying assel.
[Questions 6-7]
The current stock price of company ABC is 19.92. A call option that expires in exactly two months and has an
exercise price of 18.25 is selling at 2.55. The put option with the same exercise price and maturity is selling
at 0.65. A call option with the same maturity and an exercise price of 20 is selling at 0.64.
e.
T/?/F
The price of a put option on stock ABC that matures in three months and that has an exercise price
of 20 can be calculated with the available information.
7. TI?IF
According to put-call parity the annual risk-free rate will be larger than 7.0%.
8. TI?/F
In the Black-Scholes option pricing model, risk-neutrality implies that the expected return on any
asset, including stocks and calls, is equal to the risk.free rate.
[Questions 9-10]
Consider a world of Modigliani and Miller without taxes.
9. T I?IF
If a firm lowers its dividend per share at a given date while holding the dividends per share for each
other date constant, the finn's stock price will fall.
10. T/?/F
A reduction in dividends through share repurchase neither helps nor hurts stock holders.
11. T/?fF
The risk of an inefficient portfolio solely consists of specific risk.
[Quest ions 12-13]

Assume a Modigliani and Miller world with corporate taxes. The firm's required return on levered equity is 12%
while its after-tax cost of debt equals 8% and its debt-to-equity ratio is equal to I. Consider the finn's Weighted
Average Cost of Capital (WACC).
12. T/?fF
For a constant capital structure, the firm's WACC decreases when the corporate tax rate increases.
13. T/?fF
The firm's WACC is equal to 10%.
[Quest ion 14]

Consider the Adjusted Present Value (APV), Flow to Equity (FTE), and Weighted Average Cost of Capital
(WACC) approaches that can be used to value a project.
Pro Fonna Income Statement for Aldaf Inc, 2000-2005

Year 2000
2001
Income Statement
75,000 88,358
1 Sales
2 Cost of Goods Sold
(16,000) (18,665)
3 Raw Materials
( 18,000) (21,622)
4 Direct Labor Costs
41,000 48,071
5 Gross Profit
(11,250) (14,579)
6 Sales and Marketing
(13,500) (13,254)
7 Administrative
16,250 20,238
8 EBITDA
(5,500) (5,450)
9 Depreciation
10,750 14,788
10 EBIT
(6,800)
(75)
11 Interest Expense (net)
12Pretax Income
10,675 7,988
(3,736) (2,796)
13 Income Tax
6,939
5,193
14 Net Income
Year
Increases in NWC
Net Borrowing
2001
2,250
5,000
0
2002
3,000
5,000
0
2003
3,250
20,000
15,000
2002
2003
2003
2005
103,234
119,777
138,149
158,526
(21,593)
(25,757)
55,883
(18,582)
(15,485)
21,816
(5,405)
16,411
(6,800)
9,611
(3,364)
6,247
(24,808)
(30,471)
64,498
(23,356)
(16,769)
24,373
(6,865)
17,508
(6,800)
10,708
(3,748)
6,960
(28,333)
(35,834)
73,982
(27,630)
(17,959)
28,393
(7,678)
20,715
(7,820)
12,895
(4,513)
8,382
(32,193)
(41,925)
84,407
(31,705)
(20,608)
32,094
(7,710)
24,383
(8,160)
16,223
(5,678)
10,545
2004
3,600
15,000
5,000
2005
4,000
8,000
0
15. T/?fF
The Free Cash Flow to the Firm in 2002 is equal to $ 8,072,000.
16. T/?fF
The Free Cash Flow to Equity in 2004 is larger than $2.5 million.
[Quest ion 17]

Consider the following income statement for Kroger Inc. (all figures in $ millions):
Year
Total Sales
Cost of goods sold
Selling, general & admin expenses
Depreciation
Operating Income
Other Income
EBIT
Interest expense
Earnings before tax
Taxes (35%)
Net Income
17. T/?fF
2006
60,553
45,565
11,688
1,265
2,035
2005
56,434
42,140
12,191
1,256
847
2004
53,791
39,637
11,575
1,209
1,370
2,035
510
1,525
534
991
847
557
290
102
189
1,370
604
766
268
498
The total amount available to payout to all the investors in Kroger in 2006 is larger than $ 1,501
million.
[Question 18]
Flagstaff Enterprises expected to have free cash f10w in the coming year of $8 million, and this free cash f10w is
expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of I 3%, a debt cost of
capital of 7%, and it is in the 35% corporate tax bracket.
18. T/?/F
If F1agstaff currently maintains a 0.5 debt to equity ratio, then the value of Flagstaff as an all equity
firm is smaller than $ 90 million.
19. T/?fF
In Modigliani and Miller's setting of perfect capital markets, firms could use any combination of
debt and equity to finance their investments withollt changing the value of the firm.
[QlIestion 20]
Consider the following equation: U = _E_E + ~
E+D
20. T/?fF
E+D
The term D in the equation is equal to zero ifthe firm's debt is riskless.
I. False
2. False
3. False
4. True
5. True
6. False
7. True
8. True
9. Tme
10. True
11. False
12. True
13. True
14. True
15. True
16. False
BM 22 and Real Options task, Real options model discounts at (nominal) risk-free rate, not at real
rate.
BM 20, Options Task. Investor can write put option but he will still face currency risk if option in
not exercised by holder.
BM 20, Options Task. Including premium, the firm pays 0.870+0.130=1.000 euros for each dollar
when using caU B. With call A this amount is higher with 0.850+0.155=1.005. Thus the dollars are
cheaper when buying them via call B.
BM 20, loss is limited to case where price of underlying asset is zero.
Lecture I. It is profitable to exercise an in-the-money option.
BM 20, put-call parity cannot be used here as maturity ofthe options does not match.
BM 20, put-call parity, p + s = c + X * 1I(1+r)"t ~ 0.65+19.92 = 2.55 * (18.25 /(1+r)"(2/12)) with
t = 2/12 for exactly 2 months. ~ Annual Riskfree rate = 7.90%,
BM21
BM 17, reason: stock price is larger after repurchase than after dividend.
BM 17, direct quote from text reversed to lower div => 10wer price
BM 11+12, systematic and specific risk.
BM 15; MM II with taxes; after-tax cost of debt and the required return on equity both will decreaseBM 15; It is exactly 10%. .
.
BM 18
BM 19. see below.
BM 19, see below.
Year
NetIncome
Plus: After Tax-Interest
Expense
Unlevered Net Income
Plus: Depreciation
Less: Increases in NWC
2001 2002 2003

5,193 6,247 6,960
4,420
9,613
5,450
(2,250)
4,420
10,667
5,405
(3,000)
2004 2005
8,382 10,545
4,420 5,083
11,380 13,465
6,865 7,678
(3,250) (3,600)
(20,000(15,000
(5,000) (5,000))
)
7,813 8,072 (5,005) 2,543
o
0
15,000 5,000
5,304
15,849
7,710
(4,000)
(8,000)
Less: Capital Expenditures
11,559
Free Cash Flow ofFirm
0
Plus: Net Borrowing
Less: After-Tax Interest
Expense
(4,420) (4,420) (4,420) (5,083) (5,304)
Free Cash Flow to Eguity
3,393 3,652 5,575 2,460 6,255
After Tax interest expense is = interest expense( 1 - TC) TC is 35% and can be computed from the
income statement.
17. False
BM 15, amount is 1,501 million exactly. See below.

Year
Total Sales
Cost of goods sold
Selling, general & admin expenses
Depreciation
Operating Income
Other Income
EBIT
Interest expense
Eamings before tax
Taxes (35%)
Netlncome
178.5
Total available to all investors

Interest expense + net income
1,501
E
E+D
BM 15,rwacc= --rE+
=~
.1I-.03
19. True
20. True
2,035
510
1,525
534
991
Tax Shield = .35 x Interest Exp
Total available to S.H. if no

Ieverage = EBIT(l - 0.35)
18. False
2006
60,553
45,565
11,688
1,265
2,035
1322.75
D
E+D
--rD
(Pre tax) rwacc= -.13+

'
1+.5
=$100m
BM 15.
BM chp 14.3, page 443 inbetween equation 14.1 and 14.11.
-'-.07=.11
1+.5
'
FCF
rE-g
V =--
Accounting
1) In a corpora tion, the owners are legally distinct from the business.
2) If a company receives cash in exchange for issuing stock, the journal entry to record this transaction
involves adebit to assets and a credit to revenues.
3) If a company pays cash for an amount owed to a creditor, the journal entry to record this transaction
involves adebit to Iiabilities and a credit to assets.
4) The recording ofthe cost of merchandise inventory by a trading company when the associated revenue
is recorded is an application of 'matching'.
5) Prepaid Insurance is an expense account
6 - 7) A company (i) receives $900 cash from a customer as a payment on account, (H) prepays 6 months
insurance of $600, (Hi) purchases $1,500 inventory on account, and (iv) performs services that it was
prepaid $700 for last month.
(i) Receives $900 as a payment on account
Cash (A+)
90
Accounts Receivable (A-)
90
(H) Prepays 6 months insurance of $600
Prepaid Expenses (A+) 600
Cash (A-)
600
(Hi) Purchases $1,500 inventory on account
Inventory (A+)
1,500
Accounts Payable (L+)
1,500
(IV) Performs services it was prepaid $700 for
Unearned Revenue (L-) 700
Service Revenue (R+)
700
6) As a result ofthese 4 transactions, total assets increases by $1,500.
7) As a result of these 4 transactions, totalliabilities decrease
8) If a company prepays $10,000 for 12 months re nt on October 1, 2008, the account 'Prepaid Expenses Rent' should appeal' on the Decernber 31, 2008 balance sheet for $2,500.
9) If a company needs to pay the 2008 interest on a bank loan on December 31, 2008, the recording of
rnonthly interest expenses are called 'deferral adjustrnents.
10) The journal entry to record the payrnent bya customer for a service to be perforrned by the company
in the future, gives rise to an increase in total assets and totalliabilities
11) Iftrading investments increase in value over a year, this increases net incorne over the year.
12 - 13) Consider the following information about Company A at 2008 fiscal year-end:
Sales 2008:
Accounts Receivable (gross):
Allowance for Uncollectible Accounts:
$200,000
$19,000
$SOO
Aging of receivables schedule:

Days outstanding Amount Likelihood of uncollectibility
1-30 days
$10,000
5%
30-60days
$4,000
10%
60-90 days
$5,000
30%
12) If 1% of sales is estimated to be uncollectible, the difference in Uncollectible Account Expense (also
cal1ed bad debt expense) between the aging-of receivables method and the percent-of-sales method is
$400.
13) The Al10wance for Uncol1ectible Accounts under the percent-of-sales method on the year-end balance
sheet is $2,500.
14) In periods of decreasing input prices during the fiscal year, the cost of goods sold under the LIFO
inventory costing lllethod is higher than under FIFOif inventory increases over the year.
15) If the book value of inventOlY needs to be written down following the lower-of-cost-or-lllarket
this involves adebit to liabilities and a credit to assets
rule,
16-17) On january 1, 2006, COlllpanyA purchases a machine for $10,000 with an economic life of 5 years
and a salvage value of$l,OOO.
16) If Company A uses the double-declining balance depreciation method, the depreciation expense in
2010 is $296.
17) If COlllpanyA uses the straight-li ne depreciation lllethod, the book value on Decelllber 31, 2006 would
be $8,000.
18) Only goodwill can be recorded as an intangible asset on the balance sheet.
19) Recording warranty expenses when a product is sold under warranty is an application of lllatching
20) 'Other comprehensive income' influences net inCOllle.
21) Preferred dividends should be taken into account when computing EPS.
22) An increase in accounts receivable should be subtracted from net incollle on a cash flow statement
prepared under the direct method.
Solutions - Accounting
1)T
2) F (Debit to asset and Credit to SE)
3)T
4)T
5) F (represents future economic benefits)
6)T
7) F (Increase by 1500 - 700 = 800)
8) F (10,000 - 3/12 * 10,000 = 7,500)
9) F (accrual adjustment, expense before cash)
10)T
l1)T
12) F (The difference is 100)
13)T
14) F (Iower)
15) F (debit to expenses)
16)T
17) F
18) F (same other intangibles as weil)
19)T
20) F (net income - 'other comprehensive income'
21)T
22) F (Under indirect method)
= 'comprehensive
incame')
Extras
Extras
Extras
In general,
helpful
the Extras part will supply you with several
for your exam preparation.
formula
sheet as weil as a glossary.
definitions
of the glossary,
because
In the script
extras that will be very
of this course,
You should try to learn as many as possible

it is easy to gain many points with this. Note:
The formula sheet we included
here does not contain all formulas,
need
formulas
for the exam,
procedure
as some
and therefore
you will find a
only make
sense
which you will
in the context
of a
are only included in the Theory part.
Table of Contents
Formulas
Finance
Accounting
Glossary
Uniseminar
Formula Sheet
Formula Sheet
Finance
1
For Stocks
Variance:
Var(R) = PR * (R - E[R])2
Standard Deviation
(Volati!ity):
SD(R) = ~Var(R)
For Portfolios:
Covariance:
Cov ()R," R,j
hostorical
= -I-T
r(R,
l,t
- R ,)
* (j.tR, - R- j)
(T = number of return observations, R = return,
R = expected return)
Correlation:
Corr(Ri Rj) =
CoV(Ri.Rj)
SD(Ri)*SD(Rj)
Cov(Ri.Rj)
Variance:
(Xj= weight, amount of j held in the portfolio)
Formula Sheet
Uniseminar
Standard Deviation
(Volatility):
The CAPM Equation (cost of capital):
rE = expected
return
rf = risk free interest
rate
= Beta with Market
rMkt = Return on Market

(rMkt - rf) = Market risk premium
Beta:
. =
SD(Ri)*Corr(Ri,RMkt)
SD(RMkt)
Cov(Ri,RMkt)
Var(RMkt)
Sharpe Ratio:
R. - rf
Sharpe Ratioi = -'-
Cfi
Capital Structure
Cost of Capital of Levered Equity: (without
taxes):
ru = risk without leverage
. (ru - rD)
E
additional risk due to leverage
Tax shield (assuming
Formula Sheet
Uniseminar
permanent
If debt is riskless:
Interest
~ and the PV(interest
If debt is not riskless:

~
debt):
tax shield
tax shield)
Interest
and the PV(interest
=D
= -- Tf
tax shield
tax shield)
* rf * Tc
D*rf*rc
=D
= D * TC
* rv * TC
= V*TV*TC
Tf
Cost of Capital of Levered Equity (with taxes):
Effective
Tax Advantage
T*
of Debt:
(l-Ti)-(l-Te)(l-Tc)
1_ (l-Te)(l-Tc)
i-Ti
i-Ti
Ti
= tax on interest
Te
= tax on equity
TC
= corporate
(1 -
T;)
(1 -
Te)(l
payments
income
ta rate
= Cash flow
Tc)
debt holder
= Cash flow
receive
shareholders
receive
WACC:
Pre-TaxWACC:
Tax-adjusted
rWACC= ...E-rE
E+V
+ ...!!-r
E+V v
WACC: rWACC= _E_rE

E+V
+ ...!!-r
* (1
E+V v
TJ
Uniseminar
Formula Sheet
Payout Policy
Effective
dividend
tax rate:
Td
= dividend tax rate
Tg
Effective tax disadvantage

*
Tretain
1
-
of retaining
(l-Tc)(l-Tg)
(l-Ti)
TC
= corporate tax rate
Tg
Ti
= investors
(1- Tc)( 1-
cash:
individual tax
Tg)
= the cash flows (taxed twice)
that investors
would
receive if cash were retained

(1 -
Ta = the cash flow investors
would receive when cash is paid out and
invested by each investor individually
Uniseminar
Formula Sheet
Accounting
11
Financial
Measuring
Statement
Analysis
the ability to pay current liabilities
Net Working Capital
Current Ratio =
Current
Current
Assets
Liabilities
Acid-Test (Quick) Ratio
Measuring
Current Assets - Current Liabilities
= Cash+Short-term
Ability to Selllnventory
Inventory
Turnover
'S
. R
ay s a es m ecewa
Receivables
and Collect Receivables
COGS
Averagelnventory
Accounts Receivable Turnover
investments+Net
Current
Current Liabilities
bl
es
Average
Average
N_e_t_S_al_e_s
_

One Day's Sales
Measuring Ability to Pay Debts

Debt Ratio = Total
Liabilities
Total Assets
Times-interest-earned
ratio
= lncome tram Operations

Interest
Expense
Uniseminar
Formula Sheet
Measuring
ProfitabiIity
Rate 0f Return on Sales
Net Income
Net Sales
Rate of Return on Total Assets = Netlncome+InterestExpense

Average
Rate of Return on Total Assets =
EPS of Common Stock =

Average
Analyzing
Total Assets
Dividends.
Average Common Stockholders'
EqUlty
Dividends
.
Number of Common Shares Outstandmg
Stock Investments
.
E
.
R'
Common Share Price
P nce- arnmgs- atlO = Earnings per Share
Dividend
Yield = Dividend
per share (common

Market
Book Value of Common Share
Fnce
or preferred)
per share
Total Stockholder's
Number
Equity-Preferred
of Common Shares
Equity
Outstanding
Uniseminar
Glossary
Glossary
Account
payable
- A liability backed by the general reputation and credit
standing of the debtor

abandonment
option - An option for an investor to cease making investments
in a project. Abandonment options can add value to a project because a firm can
drop a project if it turns out to be unsuccessful.
absolute
return - see cash multiple
accelerated
depreciation
method - A depreciation method that writes off a
relatively larger amount of the asset's cast nearer the start of its useful life than
the straight-Iine method does.
account
- The record of the changes that have occurred in a particular asset,
Iiability or stockholders'
equity during aperiod.
The basic summary device of
accounting.
account
format
- A balance-sheet
format that lists assets on the left and
liabilities and stockholders' equity on the right.

accounting
processes
- The information
that
information
into
system that measures

reports
and
business
financial
activities,
statements
and
communicates the results to decision makers

accounting
equation
- The most basic tool of accaunting: Assets = Liabilities
+ Owners' Equity
Uniseminar
Glossary
accounts
receivable
turnover
- Measures a company's ability to collect cash
from credit customers. To compute accounts receivable turnover, divide net

credit sales by average net accounts receivable.
accounts
receivable
turnover
- Net sales divided by average net accounts
receivable.
accrual
- An expense or revenue that occurs before the business pays or
receives cash. An accrual is the opposite of a deferral.

accrual accoun ting - Accounting that records the impact of a business event as
it occurs, regardless ofwhether the transaction affected cash.
accrued expense - An expense incurred but not yet paid in cash.
accrued
expense
- An expense incurred but not yet paid in cash. Also called
accrued jiability.
accrued liability
- A liability for an expense that has not yet been paid by the
company.
accrued
liability
- An liability for an expense that has not yet been paid. Also
called accrued expense.
accrued revenue - A revenue that has been earned but not yet received in cash.
accurnulated
depreciation
- The cumulative surn of all depreciation expense
from the date of acquiring a plant asset.
Uniseminar
acid-test
Glossary
ratio - Ratio of the sum of cash plus short-term investments plus net
current receivables to total current liabilities. Teils whether the entity can pay all
its current liabilities if they come due immediately. Also called the quick ratio.
acid-test
ratio - Ratio of the sum of cash plus short-term investments plus net
current receivables to total current liabilities. Teils whether the entity can pay all
its current liabilities if they come due immediately. Also called the quick ratio.
adjusted
betas - A beta that has been adjusted toward 1 to account for
estimation error.
adjusted
present
value
(APV) - A valuation method to determine
the
levered value of an investment by first calculating its unlevered value (its value
without any leverage) and then adding the value of the interest tax shield and
deducting any costs that arise from other market imperfections.
adjusted trial balance - A list of all the ledger accounts with their adjusted
balances.
adverse selection
- The idea that when the buyers and seilers have different
information, the average quality of assets in the market will differ from the
average quality overall.
agency costs - Costs that arise when there are conflicts of interest between a
firm's stakeholders
agency securities
- Securities issued by agencies of the V.S.government or by
V.S.government-sponsored
enterprises.
Glossary
Uniseminar
aging-of-accounts
receivable
- A way to estimate bad debts by analyzing
individual accounts receivable according to the length of time they have been
receivable from the customer.
Allowance
for Doubtful
Accounts
- Another name for AlJowance for
UncolJectible Accounts.
Allowance
for Uncollectible
Accounts
- A contra account, related to
accounts receivable, that holds the estimated amount of collection los ses. Anothere
name for Allowance for Doubtful Accounts.
allowance
method
- A method of recording
collection losses based on
estimates ofhow much money the business will not collect from its customers.
alpha - The difference between a stock's expected return and its required return
according to the security market line.
American
options - the most common kind of option, they allow their holders
to exercise the option on any date up to, and including, the expiration date.
amortization
- The systematic reduction of a lump-sum amount. Expense that
applies to intangible assets in the same way depreciation applies to plant assets
and depletion applies to natural resources.
angel investors
- Individual investors who buy equity in small private firms
APV - See adjusted present value

assets - An economic resource that is expected to be ofbenefit in the future
10
Glossary
Uniseminar
asymmetrie
information
- A situation
in which parties
have different
information. It can arise when, for example, managers have superior information
to investors regarding the firm's future cash flows.
at-the-money
- Describes options whose exercise prices are equaI to the
current stock price.
average
annual return - The arithmetic average of an investment's realized
returns for each year.

average-cost
method - Inventory costing method based on the average cost of
inventory during the period. Average cost is determined by dividing the cost of
goods available by the number of units available. Also called the weightedaverage method.
B ad-debt
balance
expense
- Another name for uncollectible-account expense.
sheet - List of an entity's assets, liabilities and owners' equity as of a
specific date. Also called the statement of financial position.

balloon
payment - A large payment that must be made on the maturity date of
abond.
bearer bond - Similar to currency in that whoever physically holds this bond's
certificate owns the bond. To receive a coupon payment, the holder of a bearer
bond must provide explicit proof of ownership by literally clipping a coupon off
the bond certificate and remitting it to the paying agent.
benchmarking
- The comparison of a company to a standard set by other
companies, with a view toward improvement.

11
Uniseminar
Glossary
Binomial
Option Pricing Model - A technique for pricing options based on
the assumption that each period, the stock's return can take on only two values.
binomial
tree - A timeline with two branches at every date representing
the
possible events that could happen at those tim es.
bird in the hand hypothesis
- The thesis that firms choosing to pay higher
current dividends will enjoy higher stock prices because shareholders
prefer
current dividends to future ones (with the same present value).
board of directors
- Group elected by the stock-holders to set policy for a
corporation and to appoint its officers

bonds payable - issued to multiple lenders called bondholders.
book
value
(of a plant
asset)
- The asset's
cost minus accumulated
depreciation.
book value per share
of common
stock - Common stockholders'
equity
divided by the number of shares of common stock outstanding. The recorded

amount for each share of common stock outstanding.
Bulldogs - A term for foreign bonds in the United Kingdom.
butterfly
spread
- An option portfolio that is long two calls with differing
strike prices, and short two calls with a strike price equal to the average strike
price of the first two calls.
buying stocks on margin (leverage)
12
- Borrowing money to invest in stocks.
Uniseminar
C all
Glossary
date - The right (but not the obligation) of a bond issuer to retire
outstanding bonds on (or after) a specific date.

call option - A financial option that gives its owner the right to buy an asset.
call price - A price specified at the issuance of a bond at which the issuer can
redeem the bond.
callable bonds - at a specified price whenever the issuer wants.
callable
bonds - Bonds that contain a call provision that allows the issuer to
repurchase the bonds at a predetermined price.

capital - Another name for the owners' equity of a business
Capital
Asset
relationship
Pricing
Model
(CAPM) - An equilibrium
between risk and return hat characterizes
model of the
a security's expected
return based on its beta with the market portfolio.

capital
charge - The amount that stockholders and lenders charge a company
for the use of their money. Calculated as: (Notes payable

Long-term debt
capital
+ Loans payable +
+ Stockholders' equity) x Cost of Capital
expenditure
- Expenditure
that increases an asset's
capa city or
efficiency or extends its useful Iife. Capital expenditures are debited to an asset
account.
capital
lease - Lease agreement that meets any 1 of 4 criteria: (1) The lease
transfer tide of the leased asset to the leesee. (2) The lease contains a bargain
purchase option. (3) The lease term is 75% or more of the estimated usefullife of
13
Uniseminar
Glossary
the leased asset. (4) The present value of the lease payments is 90% or more of
the market value of the leased asset.
capital
market
line
(CML) - When plotting expected
returns
versus
volatility, the line from the risk-free investment through the efficient portfolio of
risky stocks (the portfolio that has the highest possible Sharpe Ratio). In the
context of the CAPM, it is the line from the risk-free investment through the
market portfolio. It shows the highest possible expected return that can be
obtained for any given volatility.
cash - Money and any medium of exchange that a bank accepts at face value
cash equivalents
- Highly liquid short-term investments that can be converted
into cash immediately.

cash flows - Cash receipts and cash payments (disbursements).
cash multiple
(multiple
of money,
absolute
return)
- The ratio of the
total cash received to the total cash invested.

cash-basis
accounting
- Accounting that records only transactions
in which
cash is received or paid.

Chapter
11 reorganization
corporations
- A common form of bankruptcy
in which all pending
collection
suspended, and the firm's existing management
attempts
are
for large
automatically
is given the opportunity
to
propose a reorganization plan. While developing the plan, management continues

to operate the business as usual. The creditors must vote to accept the plan, and it
must be approved by the bankruptcy court. If an acceptable plan is not put forth,
the court may ultimately force a Chapter 7 liquidation of the firm.
14
Uniseminar
Chapter 7 liquidation
Glossary
- A provision of the U.S. bankruptcy code in wh ich a
trustee is appointed to oversee the liquidation of a firm's assets through an

auction. The proceeds from the liquidation are used to pay the firm's creditors
and the firm ceases to exist.
chart of accounts
classified
- List of a company's accounts and their account numbers.
balance
sheet - A balance sheet that shows current assets separate
from long-term assets and current liabilities separate from long-term liabilities.
clientele
effect - When the dividend policy of a firm ref1ects the tax preference
of its investor's clientele.

closing
entries
- Entries that transfer the revenue, expense and dividends
balances from the respective accounts to the Retained Earnings account.

closing
the books - The process of preparing the accounts to begin recording
the next period's transactions. Closing the accounts consists of journalizing and
posting the closing entries to set the balance sheet of the revenue, expense and
dividends accounts to zero. Also called closing the accounts.
common risk - perfectly related risk
common stock - The most basic form of capital stock
common-size
statement
- A financial statement that reports only percentages
(no dollar amounts).

conservatism
- The accounting concept by which the least favourable figures
are presented in the financial statements.
15
Glossary
consistency
principle
- A business must use the same accounting methods
and procedures from period to period.

constant
interest
coverage
ratio - When a firm keeps its interest payments
equal to a target fraction of its free cash flows
contra account - An account that always has a companion account and whose
normal balance is opposite that ofthe companion account.
conversion
price - The face value of a convertible bond divided by the number
of shares received ifthe bond is converted.

conversion
ratio - The number of shares received upon conversion of a
convertible bond, usually stated per $1000 face value.

convertible
bonds
- Corporate
bonds with a provision
that gives the
bondholder an option to convert each bond owned into a fixed number of shares
of common stock
convertible
bonds (or notes) - Bonds or notes that may be converted into the
issuing company's common stock at the investor's option.

convertible
preferred
stock - A preferred stock that gives the owner
ae
option to convert it into common stock on some future date.

copyright
- Exclusive right to reproduce and seil a book, musical composition,
film other work of art, or computer program. Issued by the federal government,
copyrights extend 70 years beyond the author's life.
corporate
investor,
corporate
partner,
corporation that invests in private companies.

16
strategic
partner/investor
-A
Uniseminar
Glossary
corporation
- A business owned by stockholders. A corporation is a legal entity,
an "artificial person" in the eyes ofthe law.

correlation
- The covariance of the returns divided by the standard deviation of
each return; a measure of the common risk shared by stocks that does not depend
on their volatility.
cost
of capital
- A weighted average of the returns
demanded
by the
company's stockholders and lenders.

cost of goods sold - Cost of the inventory the business has sold to customers.
cost
principle
- Principle that states that assets and services should be
recorded at their actual cost

cost-of-goods-sold
model - Formula that brings together all the inventory
data for the entire accounting period: Beginning inventory
+ Purchases
= Goods
available. Then, Goods available - Ending inventory = Cost of goods sold.

covariance
- The expected product of the deviation of each return from its
mean.
covenants
- Restrictive clauses in a bond contract that limit the issuers from
undercutting their ability to repay bonds.

credibility
principle
- The principle that claims in one's self-interest
are
credible only if they are supported by actions that would be too costly to take if
the claims were untrue.
credit - The right side of an account.
17
Uniseminar
Glossary
creditor - The party to whom money is owed.
cum dividend
- When a stock trades before the ex-dividend date, entitling
anyone who buys the stock to the dividend.
cumulative
normal distribution
- The probability that an outcome from a
standard normal distribution will be below a certain value.
current
assets
- An asset that is expected to be converted to cash, sold
ore
consumed du ring the next 12 months or within the business's normal operating
cycle iflonger than a year
current
assets
- An asset that is expected to be converted to cash, sold or
consumed during the next 12 months or within the business's normal operating
cycle if longer than a year.
current instalment
of lang-term
debt - The amount of the principal that is
payable within one year.

current liabilities
- A debt due to be paid within 1 year or within the entity's
operating cycle if the cycle is longer than a year.

current
liabilities
- A debt due to be paid within one year or within
the
entity's operating cycle if the cycle is longer than a year.

current
ratio
- Current assets divided by current
liabilities. Measures a
company's ability to pay current liabilities with current assets.
18
Uniseminar
D ays'
Glossary
sales in receivables
- Ratio of average net accounts receivable to one
day's sales. Indicates how many days' sales remain in Accounts Receivable
awaiting collection. Also called the collection period.
days' sales
in receivables
- Ratio of average net accounts receivable to 1
day's sales. Indicates how many days' sales remain in Accounts Receivable
awaiting collection. Also called the collection period.
debentures
- A type of unsecured corporate debt Debentures typically have
longer maturities (more than ten years) than notes, another type of unsecured
corporate debt.
debit - The left side of an account.
debt capacity
- The amount of debt at a particular date that is required to
maintain the firm's target debt-to-value ratio.

debt
covenants
- Conditions of making a loan in which creditors
place
restrictions on actions that a firm can take.

debt ratio - Ratio of dividends per share stock to the stock's market price per
share. Teils the percentage of a stock's market value that the company returns to
stockholders as dividends.
debtor - The party who owes money.
debt-to-value
ratio
- The fraction
of a firm's
enterprise
value that
corresponds to debt
decision
node - Anode on adecision tree at which adecision is made, and so
corresponds to a real option.

19
Uniseminar
Glossary
decision
tree - A graphical representation
of future decision and uncertainty
resolution.
declaration
date - The date on which a public company's board of directors
authorizes the payment of a dividend.

deep-in-the-money
- Describes options that are in-the-money and for which
the strike price and the stock price are very far apart.
deep-out-of-the-money
- Describes options that are out-of-the-money and for
which the strike price and the stock price are very far apart.
default - When a firm fails to make the required interest or principal payments
on its debt, or violates a debt covenant.
deferral
- An adjustment
for which the business paid or received cash in
advance. Examples include prepaid rent, prepaid insurance and supplies.

depletion
expense - That portion of a natural resource's cost that is used up in
a particular period. Depletion expense is computed in the same way as units-ofproduction depreciation.
depreciable
expense - The cost of a plant asset minus its estimated residual
value.
depreciation
derivative
- The cost of a plant asset over its usefullife.

security - A security whose cash flows depend solelyon the prices
of other marketed assets
20
Glossary
Uniseminar
dilution
- An increase in the total number of shares that will divide a fixed
amount of earnings; often occurs when stock options are exercised or convertible
bonds are converted.
direct method - Format of the operating activities section of the statement of
cash flows; lists the major categories of operating cash receipts (collections from
customers
and receipts of interest
and dividends)
and cash disbursements
(payments to suppliers, to employees, for interest and income taxes).

direct write-off
method - A method of accounting for bad debts in which the
company waits until a customer's account receivable proves uncollectible and

then debits Uncollectible-Account Expense and credits the customer's Account
Receivable.
disclosure
principle
- A business's financial statements must report enough
information for outsiders to make knowledgeable decision about the business.

The company should report relevant, reliable and comparable information about
its economic affairs.
discount
(on abond)
- Excess of a bond's face (par) value over its issue price.
distribution
date - See payable date
diversifiable
risk - See firm-specific risk
diversificatio
n - The averaging of independent risks in a large portfolio
dividend
signalling
hypothesis
- The idea that dividend changes reflect
managers' views about a firm's future earnings prospects.
21
Uniseminar
Glossary
dividend
smoothing
- The praetice
of maintaining
relatively
eonstant
dividends.
dividend
yield - Ratio of dividends per share of stock to the stoek's market
priee per share. Teils the pereentage of a stoek's market value that the eompany
returns to stockholders as dividends.
dividend-capture
theory - The theory that absent transaction eosts, investors
ean trade shares at the time of the dividend so that non-taxed investors reeeivee
the dividend.
dividend-puzzle
- When firms eontinue to issue dividends despite their tax
disadvantage.
dividends
- Distributions (usually cash) bya eorporation to its stockholders
domestic
bonds - Bonds issued by a loeal entity and traded in a loeal market,
but purehased by foreigners

double-barrelled
- Deseribes municipal bonds for whieh the issuing loeal or
state government has strengthened
its promise to pay by eommitting itself to
using general revenue to pay off the bonds.

double-declining-balance
(DDB) method
- An aeeeierated depreciation
method that eomputes annual depreciation by multiplying the asset's deereasing

book value by a eonstant pereentage, whieh is 2 times the straight-line rate.
doubtful-account
Dutch auction
expense
- Another name for uncollectibJe-account expense.
- A share repurehase method in whieh the firm lists different
priees at whieh it is prepared to buy shares, and shareholders

22
in turn indieate
Glossary
Uniseminar
how many shares they are willing to seil at each price. The firm then pays the
lowest price at which it can buy back its desired number of shares.
dynamic
trading
strategy
- A replication strategy based on the idea that an
option payoff can be replicated by dynamically trading in a portfolio of the

underlying stock and a risk-free bond.
Earnings
per share - Amount of a company's net income earned for each
share of its outstanding common stock.

earnings
per share (EPS) - Amount of a company's net income per share of
its outstanding common stock.

economic
distress
- A significant decline in the value of a firm's assets,
whether or not the firm experiences financial distress due to leverage.

Economic
Value Added
(EVA) - The cash flows of project less a capital
charge that reflects the opportunity cost of the capital invested, as weil as any
capital consumed.
economic
value
added
(EVA) - Used to evaluate a company's operating
performance. EVA combines the concepts of accounting income and corporate

finance
to
measure
whether
the
stockholder wealth. EVA= Net income

efficient
capital
market
company's
operations
have
increased
+ Interest expense - Capital charge
- A capital market in which market prices fully
reflect all information available to the public.

efficient
capital market - When the cost of capital of an investment depends
only on its systematic risk, and not its diversifiable risk.

23
Uniseminar
Glossary
efficient
frontier - The set of portfolios that can be formed from a given set of
investments
with the property
that each portfolio has the highest possible
expected return that can be attained without increasing its volatility.
efficient
portfolio
- A portfolio that contains only systematic risk. An efficient
portfolio cannot be diversified further; there is no way to reduce the volatility of

the portfolio without lowering its expected return. The efficient portfolio is the
tangent portfolio, the portfolio with the highest Sharpe ratio in the economy.
empirical
distribution
- A plot showing the frequency of outcomes based on
historical data.
entity
- An organization or a section of an organization that, for accounting
purposes stands apart from other organizations and individuals as aseparate

economic unit.
equal-ownership
portfolio
- A portfolio containing an equal fraction of the
total nu mb er of shares outstanding of each security in the portfolio. Equivalent to

a value-weighted portfolio.
equivalent
annual
benefit
- The annuity payment
investment that has the same NPVas the investment.

equivalent
annual benefit
over the life of an
method - A method of choosing between projects
with different lives by selecting the project with the higher equivalent annual
benefit. It ignores the value of any real options because it assurnes that both
projects will be replaced on their original terms.
ESO - See executive stock option
24
Uniseminar
Glossary
estimated
residual
value - Expected cash value of an asset at the end of its
usefullife. Also called residual value, scrap value or salvage value.

estimated
useful
life - Length of services that a business expects to get from
an asset. May be expressed in years, units of output, miles or other measures.
Eurobonds
- International
bonds that are not denominated
in the local
currency of the country in which they are issued.

European
options
- Options that allow their holders to exercise the option
only on the expiration date; holders cannot exercise before the expiration date.
exchange-traded
fund - A security that trades directly on an exchange, Iike a
stock, but represents ownership in a portfolio of stocks.

ex-dividend
date - A date, two days prior to a dividend's record date, on or
after which anyone buying the stock will not be eligible for the dividend.
executive
stock
option
(ESO)
- A common practice for compensating
executives by granting them call options on their company's stock.

exercise
price - See strike price
exercising
(an option)
- When a holder of an option enforces the agreement
and buys or seils a share of stock at the agreed-upon price.

exit strategy
- An important consideration for investors in private companies,
it details how they will eventually realize the return from their investment.
expenses
- Decrease in retained earnings that results from operations; the cost
of doing business; opposite of revenues.

25
Uniseminar
Glossary
expiration
date - The last date on which an option holder has the right to
exercise the option.
Fair value - The amount that a business could seil an asset for, or the amount
that a business could pay to settle a liability.
FCFE - See free cash flow to equity

financial
accounting
- The branch of accounting that provides information to
people outside the firm.

financial
distress
- When a firm has difficulty meeting its debt obligations.
financial
option
- A contract that gives its owner the right (but not the
obligation) to purchase or seil an asset at a fixed price at some future date.

financial
statements
- Business documents that report financial information
about a business entity to decision makers.

financing
activities
- Activities that obtain from investors and creditors thea
cash needed to launch and sustain the business; a section of the statement of cashflows.
financing
activities
- Activities that obtain from investors and creditors the
cash needed to launch and sustain the business; a section of the statement of cash
flows.
26
Uniseminar
Glossary
firm-specific,
idiosyncratic,
unsystematic,
unique
or diversifiable
risk - Fluctuations of a stock's return that are due to firm-specific news and are
independent risks unrelated across stocks.
first-in,
first-out
(FIFO)
cost
(method)
- Inventory costing method by
wh ich the first costs into inventory are the first costs out to cost of goods sold.
Ending inventory is based on the costs of the most recent purchases.
fixed assets
- Another name for property, plant, an equipment
flow to equity
(FTE) - A valuation method that calculates the free cash flow
available to equity holders taking into account all payments to and from debt
holders. The cash flows to equity holders are then discounted using the equity
cost of capital.
foreign
bonds
- Bonds issued by a foreign company in a local market and are
intended for local investors. They are also denominated in the local currency.
franchises
and
licenses
- Privileges granted by a private business or a
government to seil a product or service in accordance with specified conditions.

free cash flow - The amount of cash available from operations after paying for
planned investments in plant assets.
free cash flow hypothesis
- The view that wasteful spending is more likely to
occur when firms have high levels of cash flow in excess of what is needed after
making all positive-NPV investments and payments to debt holders.
free
cash flow to equity
(FCFE) - The free cash flow that remains after
adjusting for interest payments, debt issuance and debt repayment.
27
Glossary
General
obligation
bonds - Bonds backed by the full faith and credit of a
local government.
generally
accepted
accounting
principles
(GAAP)
Accounting
guidelines, formulated by the Financial Accounting Standards Board, that govern

how accounting is practiced.
global
bonds - Bonds that are offered for sale in several different market~
simultaneously. Unlike Eurobonds, global bonds can be offered for sale in the
same currency as the country of issuance.
going-concern
concept - Holds that the entity will remain in operation for the
foreseeable future.
goodwill
- Excess of the cost of an acquired company over the sum of the
market values of its net assets (assets minus Iiabilities).

greenmail
- When a firm avoids a threat of takeover and removal of its
management by a major shareholder by buying out the shareholder, often at a

large premium over the current market price.
gross margin - Another name for gross profit.
gross margin method - Another name for the gross profit method.
gross margin percentage
- Another name for the gross profitpercentage.
gross profit - Sales revenue minus cost of goods sold. Also called gross margin.
28
Glossary
Uniseminar
gross profit method - A way to estimate inventory based ona rearrangement

of the cost-of-goods-sold inodel: Beginning inventory
+ Net purchases
= Goods
available - Cost of goods sold = Ending inventory. Also called the grass margin
methad.
gross
profit
percentage
- Gross profit divided by net sales revenue. Also
called the grass margin percentage.

growth
option
- A real option to invest in the future. Because these options
have value, they contribute to the value of any firm that has future possible
investment opportunities.
H edge
- To reduce risk by holding contracts or securities whose payoffs are
negatively correlated with some risk exposure.

high-yield
bonds - Bonds below investment grade which trade with a high
yield to maturity to compensate investors for their high risk of default.

homemade
leverage
- When investors use leverage in their own portfolios to
adjust the leverage choke made by a firm.

homogeneous
expectations
- A theoretical situation in which all investors
have the same estimates concerning future investment returns.

horizontal
analysis
- Study of percentage changes in comparative financial
statements.
hurdle rate - A high er discount rate created by the hurdle rate rule. lf a project
can jump the hurdle with a positive NPV at this higher discount rate, then it
should be undertaken.
29
Uniseminar
Glossary
hurdle
rate rule - Raises the discount rate by using a higher discount rate than
the cost of capital to compute the NPV, but then applies the regular NPV rule:
Invest whenever the NPVcalculated using this higher discount rate is positive.
Idiosyncratic
implied
risk - See firm-specific risk.
volatility
- The volatility of an asset's return that is consistent withe
the quoted price of an option on the asset

income
statement
- A financial statement
listing an entity's
revenues,
expenses and net income or net loss for a specific period. Also called the
statement of operations.
indenture
- Included in a prospectus, it is a formal contract between a bond
issuer and a trust company. The trust company represents the bondholders and
makes sure that the terms ofthe indenture are enforced. In the case of default, the
trust company represents the bondholders' interests.
independent
risk
- Risks that bear no relation to each other. If risks are
independent, then knowing the outcome of one provides no information abou_

the other. Independent risks are always uncorrelated, but the reverse needs no~
to be true.
index
funds
representation
indirect
- Mutual funds that invest in stocks in proportion
to their
in a published index, such as the S&P 500 or Wilshire 5000.
method
- Format of the operating activities section of the statement of
cash flows; starts with net income and reconciles to cash tlows from operating
activities.
30
Uniseminar
Glossary
inefficient
portfolio
- Describes a portfolio for which it is possible to find
another portfolio that has higher expected return and lower volatility.
information
node - A type of node on adecision
tree indicating uncertainty
that is out of the control of the decision maker.
e,
intangible
assets - An asset with no physical form, a special right to current
and expected future benefits.

interest
- The borrower's
cost of renting money from a lender. lnterest is
revenue for the lender and expense for the borrower.

interest
tax shield - The reduction in taxes paid due to the tax deductibility of
interest payments.
interest-coverage
in-the-money
ratio - Another name for the times-interest-earned-ratio.
- Describes an option whose value if immediately exercised
would be positive.
intrinsic value - The amount by which an option is in-the-money or zero if the
option is out-of-the-money.
inventory
inventory
- The merchandise that a company seils to customers.

turnover
- Ratio of cost of goods sold to average inventory.
Indicates how rapidly inventory is sold.

investing
activities
- Activities that increase or decrease the long-term assets
available to the business; a section of the statement of cash flows.

31
Uniseminar
Glossary
investing
activities
- Activities that increase or decrease the long-term assets
available to the business; a section of the statement of cash flows.
Journal - The chronological accounting record of an entity's transactions.
Last-in,
first-out
(LIFO) cost (method)
- Inventory costing method bye
wh ich the last costs into inventory are the first costs out to cost of goods sold.
This method leaves the oldest costs - those of beginning inventory and the
earliest purchases of the period - in enduring inventory.
LBO - See leveraged buyout
lease
- Rental agreement in which the tenant (leessee) agrees to make rent
payments to the property owner (lessor) in exchange for the use ofthe asset.
ledger - The book of accounts and their balances.

leessee
- Tenant in a lease agreement.
lemons
principle
- When a seiler has private information about the value of a
good, buyers will discount the price they are willing to pay due to adverse
selection.
lessor - Property owner in a lease agreement.
32
Glossary
Uniseminar
leverage
- Earning more income on borrowed money then the related interest
expense, thereby increasing the earnings for the business. Also called trading on
the equity.
leveraged
buyout
(LBO) - When a group of private investors purchases all
the equity of a public corporation and finances the purchase primarily with debt
leveraged
recapitalization
- When a firm uses borrowed funds to pay a large
special dividend or repurchases a significant amount of its outstanding shares.
levered
equity - Equity in a firm with outstanding debt
liabilities
- An economic obligation (a debt) payable to an individual or an
organization outside the business.

limited
liability
company
- A business organization in which the business
(not the owner) is liable for the company's debts.

linear regression
- The statistical technique that identifies the best-fitting line
through a set of points.

liquidating
dividend
- Areturn
of capital to shareholders
from a business
operation that is being terminated.

liq uidity - Measure of how quickly an item can be converted to cash.
long bonds - Bonds issued by the V.S. Treasury with the longest outstanding
maturities (30 years).
long position
- A positive investment in a security.
33
Uniseminar
Glossary
long-term
assets - An asset that is not a current asset.
long-term
debt - A liability that falls due beyond 1 year from the date of the
financial statements.
long-term
liabilities
- A liability that is not a current liability.
(LCM) rule - Requires that an asset be reported in
lower-of-cost-or-market
the financial statements at whichever is lower - it's historical cost or its marke_
value (current replacement cost for inventory).
Management
accounting
- The branch
of accounting
that generates
information for the internal decision makers of a business, such as top executives.
management
entrenchment
- A situation
arising as the result of the
separation of ownership and control in which managers may make decision that
benefit themselves at investors' expense.
management
entrenchment
theory
- A theory that suggests managers
choose a capital structure to avoid the discipline of debt and maintain their own
job security.
market capitalization
- The total market value of equity; equals the market
price per share times the number of shares.

market index - The market value of a broad-based portfolio of securities.
market interest
rate - Interest rate that investors demand for Ioaning their
money. Also called effective interest rate.
34
Uniseminar
Glossary
market portfolio
- A value-weighted portfolio of all shares of all stocks and
securities in the market

market proxy - A portfolio whose return is believed to closely track the true
market portfolio.
market value balance
sheet - similar to an accounting balance sheet, with
two key distinctions: First, all assets and liabilities of the firm are induded, even
intangible assts such as reputation,
brand name, or human capital that are
missing from a standard accounting balance sheet; second, all values are current
market values rather than historical costs.
marketable
securities
martingale
prices - See risk-neutral probabilities.
matching
principle
- Another name for short-term investments.
- The basis for recording expenses. Directs accounts to
identify all expenses incurred du ring the period, to measure the expenses, and to
match them against the revenues earned during that same period.
maturity - The date on which a debt instrument must be paid.
merchandise
inventory
- The merchandise that a company seils to customers,
also called inventory.

Modified
Accelerated
Cost
Recovery
System
(MACRS) - A special
depreciation method used only for income-tax purposes. Assets are grouped into
dasses, and for a given dass depreciation is computed by the double-dediningbalance method, the lSO%-dedining balance method or, for most real estate the
straight-line method.
35
Uniseminar
Glossary
mortgage
bonds - A type of seeured corporate debt. Real property is pledged
as collateral that bondholders have a direct claim to in the event of bankruptcy.

mortgage
interest
rate - The rate on a risk-free annuity that is prepay able
(callable) at any time; the yield on mortgage-backed bonds such as a GNMA.
multiple
of money
- The ratio of the total cash received to the total cash
invested.
multi-step
income statement
- An income statement that contains sUbtotals-
to highlight important relationships between revenues and expenses.

municipal
bonds - Bonds issued by state and local governments. They are not
taxable at the federal level (and sometimes at the state and local level as weil)
and so are sometimes also referred to as tax-exempt bonds.
N et
de bt - total debt outstanding minus any cash balances.
net earnings - Another name for net income

net income
- Excess of total revenues over total expenses. Also called
ne_
earnings or net profit

net loss - Excess oftotal expenses over total revenues.
net profit - Another name for net income.
note payable
payment
36
- A liability evidenced by a written promise to make a future
Glossary
Uniseminar
notes - A type of unsecured corporate debt. Notes typically are coupon bonds
with maturities shorter than 10 years.
o bjectivity
principle
OID (original
issue)
- Another name for the reliability principle.
discount
- Describes a coupon bond that is issued at a
discount
open interest
- The total number of contracts of a particular option that have
been written.
open market
repurchase
- When a firm repurchases
shares by buying its
shares in the open market.

operating
activities
- Activities that create revenue or expense in the entity's
major line of business; a section of the statement
of cash flows. Operating
activities affect the income statement.

operating
cyde - Time span during which cash is paid for goods and services
that are sold to customers who pay the business in cash.

operating
option
lease - Usually a short-term or cancellable rental agreement.
delta - The change in the price of an option given a $1 change in the
price ofthe stock. The number of shares in the replicating portfolio for the option.
option writer - The seiler of an option contract.
original
issue discount
(OID) - Describes a coupon bond that is issued at a
discount.
37
Uniseminar
Glossary
out-of-the-money
- Describes an option that if exercised immediately, results
in a loss of money.
over-investment
shareholders
problem
When
a firm
faces
financial
distress.
can gain at the expense of bondholders by taking a negative-NPV
project. if it is sufficiently risky.

owners'
equity - The claim of the owners of a business to the assets of the
business. Also called capital. stockholders' equity or net assets.
P aid-in
eapital - The amount of stockholders' equity that stockholders have
contributed to the corporation. Also called contributed capital.

partnership
- An association of 2 or more persons who co-own a business for
profit.
passive
portfolio
- A portfolio that is not rebalanced in response to price
changes.
pass-through
seeurity
-Describes securities whose payments derive directly
from other assets like mortgages.

patent - A federal government grant giving the holder the exclusive right for 20
years to produce and seil an invention.
payout poliey - The way a firm chooses between the alternative ways to pay
cash out to equity holders.
payroll - Employee compensation that will be received during retirement.
38
Uniseminar
Glossary
pecking
order hypothesis
- The idea that managers will prefer to fund
investments by first using retained earnings, then debt and equity only as a last
resort.
pension - Employee compensation that will be received during retirement.
percent-of-sales
method
Computes
uncollectible-account
expense
percentage of net sales. Also called the income statement approach because it
focuses on the amount of expense to be reported on the income statement.
perfeet capital markets - A set of conditions in which investors and firms can
trade the same set of securities at competitive market price with no frictions such
as taxes, transaction
costs, issuance costs, asymmetrie information, or agency
costs.
periodic inventory
system - An inventory system in which the business does
not keep a continuous record of the inventory on hand. lnstead at the end of the
period, the business makes a physical count of the inventory on hand and applies
the appropriate unit costs to determine the cost of the ending inventory.
permanent
accounts - Asset, liability and stockholders' equity accounts that
are not closed at the end of the period.

perpetual
inventory
system - An inventory system in which the business
keeps a continuous record for each inventory item to show the inventory on hand
at all times.
perpetuity
- A stream of equal cash flows that occurs at regular intervals and
lasts forever.
39
Uniseminar
Glossary
plant assets - Long-Iived assets, such as land, building and equipment, used in
the operation of the business. Also called fixed assets.
portfolio
insurance
- A protective put written on a portfolio rather than a
single stock. When the put does not itself trade it is synthetically created by
constructing a replicating portfolio.
portfolio
weights
- The fraction of the total investment in a portfolio held in
each individual investment in the portfolio.
posting - Copying amounts from the journal to the ledger.

post-money
valuation
- At the issue ofnew equity, the value ofthe whole firm
(odd plus new shares) atthe price the new equity is sold at.
preferred
stock - Preferred stock issued by mature companies such as banks
usually has a preferential
dividend
and seniority
in any liquidation
and
sometimes special voting rights. Preferred stock issued by young companies has
seniority in any liquidation but typically does not pay cash dividends and
contains a right to convert to common stock.
premium
(on abond)
- Excess of a bond's issue price over its face (par) value.
valuation
- At the issuance of new equity, the value of a firm's
pre-money
prior shares outstanding at the price in the funding round.

pre-packaged
bankruptcy
- A method for avoiding many of the legal and
other direct costs of bankruptcy in which a firm first develops a reorganization

plan with the agreement of its main creditors, and then files Chapter 11 to
implement the plan.
40
Uniseminar
prepaid
expense
Glossary
- A category of miscellaneous assets that typically expire or
get used up in the near future. Examples include Prepaid Rent, Prepaid lnsurance,
and Supplies.
prepayment
option
- An abandon me nt option that allows a mortgage holder
to pay off a mortgage before the end of its scheduled term.
present
value
- Amount a person would invest now to receive a greater
amount at a future date.

pricejearnings
ratio - Ratio ofthe market price of a share of common stock to
the company's earnings per share. Measures the value that the stock market
piaces on $1 of a company's earnings.
price-weighted
portfolio
- A portfolio that holds an equal number of shares
of each stock, independent of their size.

principal
- The amount borrowed by a debtor and lent by a creditor.
private debt - Debt that is not publicly traded.

private
placement
- A bond issue that is sold to a small group of investors
rather to the general public. Because private placement does not need to be
registered, it is less costly to issue.
pro forma - Describes the statement that is not based on actual data but rather
depicts a firm's financials under a given set ofhypothetical assumptions.
pro bability
distribution
- A graph that provides the probability of every
possible discrete state.
41
Uniseminar
Glossary
profitability
index - Measures the NPVper unit of resource consumed.
profitability
index rule - Recommends investment whenever the profitability
index exceeds some predetermined number.

property,
plant and equipment
- Long-lived assets, such as land, buildings
and equipment used in the operation of the business. Also called plant assets or
fixed assets.
proprietorship
protective
- A business with a single owner.
put - A long position in a put option .held on a stock you already
own.
purchase
allowance
- A decrease in the cost of purchases because the seiler
has granted the buyer a subtraction (an allowance) from the amount owed.
purchase
discount
- A decrease in the cost of purchases earned by making an
early payment to the vendor.

purchase
return
- A decrease in the cost of purchases because the buyer
returned the goods to the seiler.

put option - A financial option that gives the price of call option in terms of the
price of put option plus the price of the underlying stock minus the present value
of the strike price and the present value of any dividend payments.
put-call
parity - The relationship that gives the price of call option in terms of
the price of put option plus the price of the underlying stock minus the present
value ofthe strike price and the present value of any dividend payments.
42
Uniseminar
Glossary
Quick ratio - Another name for acid-test ratio.
Rate
of return on common stockholders'
equity - Net income minus
preferred dividends, divided by average common stockholders' equity. A measure

of profitability. Also called return on equity.
rate of return on net sales - Ratio of net income to net sales. A measure of
profitability. Also called return on saJes.
rate of return on total assets - Net income plus interest expense, divided by
average total assets. This ratio measures a company's success in using its assets
to earn income for the persons who finance the business. Also called return on
assets.
rational
expectations
- The idea that
investors
may have
different
information regarding expected returns, correlations, and volatilities, but they

correctly interpret that information and the information contained in market that
information and the information contained in market prices and adjust their
estimates of expected returns in a rational way.
real option
- The right to make a particular business decision, such as a capital
investment. A key distinction between real options and financial options is that
real options, and the underlying assets on which they are based, are often not
traded in competitive markets.
receivables
- Monetary claims against a business or an individual, acquired
mainly by selling goods or services and by lending money.
43
Uniseminar
Glossary
record date - When a firm pays a dividend, only shareholders of record on this
date receive the dividend.
refinance
- Repaying an existing loan and then taking out a new loan at a lower
rate.
registered
bonds - The issuer ofthis type ofbond maintains a list of all holders
of its bonds. Coupon and principal payments are made only to people on this list.
reliability
pdnciple
- The accounting principle that ensures that accounting
records and statements are based on the most reliable data available. Also called
the objectivity principle.
replicating
portfolio
- A portfolio consisting of a stock and a risk-free bond
that has the same value and payoffs in one period as an option written on the
same stock.
report format - A balance-sheet format that lists assets at the top, followed by
liabilities and stockholders' equity below.
required
return - The expected return of an investment that is necessary to
compensate for the risk of undertaking the investment.

retained
earnings
- The amount of stockholders' equity that the corporation
has earned through profitable operation and has not given back to stockholders.
return
of capital - When a firm, instead of paying dividends out of current
earnings (or accumulated retained earnings), pays dividends from other source,
such as paid-in capital or the liquidation of assets.
44
Uniseminar
Glossary
return on equity - Another name for rate of return on common stockholders

equity.
revenue bonds - Municipal bonds for which the local or state government can
pledge as repayment revenues generated by specific projects.
revenue principle - The basis for recording revenues; teils accountants when
to record revenue and the amount of revenue to record.
revenues
- Increase in retained earnings from delivering goods or services to
customers or clients.
reverse
split - When the price of a company's stock falls too low and the
company reduces the number of outstanding shares.

revolving
line of credit - A credit commitment for a specific time period,
typically two or three years, wh ich a company can use as needed.

risk-neutral
probabilities
- The probability
of future states
that are
consistent with current prices of securities assuming all investors are risk
neutral. Also known as state-contingent prices, state prices or martingale prices.
Samurai bonds - A termforforeign
secured
bonds in Japan.
debt (lo an) - A type of corporate loan or debt security in which
specific assets are pledged as firm's collateral.

security
market
line
(SML)
- The pricing implication
of the CAPM, its
specifies a linear relation between the risk premium of a security and its beta
with the market portfolio.
45
Uniseminar
Glossary
seniority
- A bondholder's priority in claiming assets not already securing other
debt
se rial bonds - A single issue of municipal bonds that are scheduled to mature
serially over aperiod of years.
serial bonds - Bonds that mature in instalments over aperiod of time.

shareholder
- Another name for stockholder.
Sharpe ratio - The excess return of an asset divided by the volatility of the
return of the asset; a measure of the reward per unit risk.
short position
short-term
- a negative amount invested in a stock.
investments
- Investments that a company plans to hold for one
year or less. Also called marketabJe securities.
short-term
signalling
notes payable - Note payabIe due within 1 year.
theory of debt - The use ofleverage as a way to signal information
to investors.
single-step
income
statement
- An income statement
that lists all the
revenues together under a heading such as Revenues or Revenues and Gains.

Expenses appear in aseparate category called Expenses or perhaps Expenses and
Losses.
sinking
fund - A method for repaying a bond in which a company makes
regular payments into a fund administered by a trustee over the life of the bond.
These payments are then used to repurchase bonds.
46
Glossary
Uniseminar
SML - The pricing implication of the CAPM,its specifies a linear relation between
the risk premium of a security and its beta with the market portfolio
sovereign
special
debt - Debt issued by national governments
dividend
- A one-time dividend payment a firm makes that is usually
much larger than a regular dividend.

specific-unit-cost
method
- Inventory - cost method based on the specific
cost of particular units of inventory.

speculate
- When investors use securities to place a bet on the direction in
which they believe the market is likely to move.

spin-off
- When a firm seils subsidiary by selling shares in the subsidiary alone
stable-monetary-unit
concept
- The reason for ignoring the effect of
inflation in the accounting records, based on the assumption that the dollar's
purchasing power is relatively stable.
standard
deviation
prob ability distribution,
- A common method used to measure the risk of a

it is the square root of the variance, the expected
squared deviation from the mean.

standard
error - The standard deviation of the estimated value of the mean of
the actual distribution around its true value; that is, it is the standard deviation of
the average return.
state prices - See risk-neutral probabilities
state-contingent
prices - See risk-neutral probabilities

47
Uniseminar
Glossary
stated
interest
rate - Interest rate that determines
the amount of cash
interest the borrower pays and the investor receives each year.
statement
of cash flows - Reports cash receipts and cash payments classified
according to the entity's major activities: operating, investing and financing.
statement
of cash-flows - Reports cash receipts and cash payments classified
according to the entity's major activities: operating, investing and financing.
statement
of financial position - Another name for balance sheet
e-
statement of operations - Another name for the income statement

statement
of retained
earnings - Summary of the changes in the retained
earnings of a corporation during a specific period.

stock - Shares into which the owners' equity of a corporation is divided.
stock split (stock dividend)
- When a company issues a dividend in shares
of stock rather than cash to its shareholders

stockholders
- A person who owns stock in a corporation.
shareholder.
stockholders'
Also called a
equity - The stockholders' ownership inte rest in the assets of a
corporation.
stop-out
yield - The highest yield competitive bid that will fund a particular
V.S. Treasury security issue when all successful bidders (including the noncompetitive bidders) areawarded
48
this yield.
Glossary
Uniseminar
straddle
- A portfolio that is long a call and a put on the same stock with the
same exercise date and the strike price.

straight-line
(SL) method - Depreciation method in which an equal amount
of depreciation expense is assigned to each year of asset use.

strike
(exercise)
price - The price at which an option holder buys or seils a
share of stock when the option is exercised.

STRIPS (Separate
Securities)
Trading
of Registered
Interest
and
Principal
- Zero-coupon Treasury securities with maturities longer than one
year that trade in the bond market.

subordinated
debenture
- Debt that, in the event of adefault,
has a lower
priority claim to the firm's assets than other outstanding debt.

syndicated
bank loan - A single loan that is funded by a group ofbanks rather
than just a single bank.

systematic,
undiversifiable,
or market
risk - Fluctuations of a stock's
return that are due to market-wide news representing common risk.
Tangent
portfolio
- A portfolio with the highest Sharpe ratio; the point of
tangency to the efficient frontier of a line drawn from the risk-free asset; the
market portfolio if the CAPMholds.
target
project's
leverage
ratio - When a firm adjusts its debt proportionally
value or its cash flows (where the proportion
to a
need not remain
constant). A constant market debt-equity ratio is a special case.

49
Uniseminar
Glossary
targeted
repurchase
- When a firm purchases shares directly from a specific
shareholder.
temporary
accounts
- The revenue and expense accounts that relate to a
limited period and are closed at the end of the period are temporary accounts.
For a corporation. the Dividends account is also temporary.
tender offer - A public announcement of an offer to all existing security holders
to buy back a specified amount of outstanding securities at a prespecified pricea
over a prespecified period of time.
,.,
term - The length of time from inception to maturity.

term bonds - Bonds that all mature at the same time for a particular issue.
term loan - A bank loan that lasts for a specific term.

time value - The difference between an option's price and its intrinsic value.
time-period
concept
- Ensures that accounting information is reported at
regular intervals.
times-interest-earned
ratio - Ratio of income from operations to interese
expense. Measures the number of times that operating income can cover interest
expense. Also called the interest-coverage ratio.
TI PS (Treasury-Inflation-Protected
Securities)
- An inflation-indexed
bond missed by the U.S.Treasury with maturities of S, 10 and 20 years. They are
standard coupon bonds with on difference: the outstanding principle is adjusted
for inflation.
so
Uniseminar
Glossary
trademark,
trade name - A distinctive identification of a product or service.
Also called a brand name.

trade-off
theory
- The firm picks its capital structure
by trading off the
benefits of the tax shield from debt against the costs of financial distress and
agency costs.
trading investments
- Stock investments that are to be sold in the near future
with the intent of generating profits on the sale.

trading
on the equity - Earning more income on borrowed money than the
related interest expense, thereby increasing the earnings for the owners of the
business. Also called Jeverage.
tranches
- Different classes of securities that comprise a single bond issuance.
All classes of securities are paid from the same cash flow source.
transaction
- Any event that has a financial impact on the business and can be
measured reliably.
trend percentages
- A form ofhorizontal analysis that indicates the direction a
business is taking.
trial balance - A list of ailiedger accounts with their balances.
Uncollectible-account
expense
- Cost to the seiler of extending credit
Arises from the failure to collect from credit customers. Also called doubtfulaccount expense or bad-debt expense.
51
Uniseminar
Glossary
under-investment
problem - A situation in which equity holders choose not
to invest in a positive NPVproject because the firm is in financial distress and the
value of undertaking
the investment opportunity
will accrue to bondholders
rather than themselves.

underwriter
- Organization that purchases the bonds from an issuing company
and resells them to its c1ients or seils the bonds for a commission, agreeing to buy
all unsold bonds.
undiversifiable
unearned
risk - See systematic risk.
revenue
- A liability created when a business collects cash from
customers in advance of earning the revenue. The obligation is to provide a

product or a service in the future.
unique risk - See firm-specific risk
units-of-production
(UOP) method - Depreciation method by wh ich a fixed
amount of depreciation is assigned to each unit of output produced by the plant

asset.
unlevered
beta - Measures the risk o{ a firm were its unlevered; beta of the
firm's assets; measures the market risk of the firm's business activities, ignOrin~
any additional risk due to leverage.
unlevered
cost of capital - The cost of capital of a firm, were its unlevered;
for a firm that maintains a target leverage ratio, it can be estimated as the
weighted average cost of capital computed without taking into account taxes
(pre-tax WACC).
unlevered
52
equity - Equity in a firm with no debt.
Glossary
Uniseminar
unlevered
PJE ratio - The enterprise value of a firm divided by its unlevered
net income in a particular year.

unsecured
debt - A type of corporate debt that, in the event of a bankruptcy,
gives bondholders
a claim to only the assets of the firm that re not already
pledged as collateral on other debt

unsystematic
risk - See firm-specific risk.
Value-weighted
portfolio
- A portfoIio in which each security is held in
proportion to its market capitalization. Also called an equal-ownership
portfoIio,
because it consists of the same fraction of the outstanding shares of each security.
variance
- A method to measure the risk of a probability distribution, it is the
expected squared deviation from the mean.

venture
capital firm - A Iimited partnership that speciaIizes in raising money
to invest in the private equity ofyoung firms.

venture
capitalist
- One of the general partners who work for and run a
venture capital firm.

vertical
analysis
- Analysis of a financial statement
that
reveals
the
relationship of each statement item to a specified base, which is the 100% figure.
volatility
- The standard deviation of areturn.
53
Uniseminar
Glossary
Warrant
- A call option written by the company itself on new stock. When a
holder of a warrant exercises it and thereby purchases stock, the company

delivers this stock by issuing new stock.
weighted-average
method - Another name for the average-cost method.
working
- Current assets
capital
minus current
liabilities; measures
business's ability to meet its short-term obligations with its current assets.
workout - A method for avoiding a declaration of bankruptcy in which a firm in

financial distress negotiates directly with its creditors to reorganize.
Yankee
yield
bonds - A term for foreign bonds in the United States.
to caU (YTC)
- The yield of a callable bond calculated under the
assumption that the bond will be called on the earliest call date.
54
Seminar
Uniseminar
Seminar
Seminar
In the following we have provided you with same notepaper so that you can take
notes during the seminar. Furthermore you will receive a third practice exam
during the seminar, which you can file in here. In case you have not subscribed
for the Finance & Accounting seminar yet, you can da so on our website www.uniserninar.nl-
at any time.
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods [
'.
Uniseminar
- Quantitative
Methods I
Notes
~
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods [
Notes
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods I
Uniseminar
- Quantitative
Methods I
Notes
Notes
Uniseminar
- Quantitative
Methods I

Finance&amp;Accounting Uniseminar112

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Finance&amp;Accounting Uniseminar112

Uploaded by

Copyright:

Available Formats

Theory

Finance & Accounting

Uniseminar - Firtance & Accounting

the most important

the whole theory

with the help

to the seven weeks of the course and is one of

of your exam preparation.

it is even more crucial to understand

in order to be able to calculate

the basic concepts

1 Capital Matkets - Risk & Return

4 Capital Budgeting and Valuation

7 Inventory & Cost of Goods Sold

8 Plant Assets and Intangibles

10 The Cash Flow Statement

11 Financial Statement Analysis

- Finance & Accounting

Capital Markets - Risk & Return

The fundamental principle regarding investments

of any kind (stocks, bonds,

risk and return.

As the risk increases,

Risk- Commonvs. Independent Risk

of a portfolio composed of different securities, one needs to understand that there

Common risk: risk that is perfectly correlated (such as an earthquake

Diversiftcation entails the averaging out of independent risks in a large portfolio

- Finance & Accounting

As the names already suggest, firm-specific risk can be diversified away in a

for holding firm-specific risk, they expect a rislk:premium for

Diverslfication - refers to the reduction of firm-specific risk. It is achieved

the assets the higher is the diversification

potential (exception: correlation of 1 -7 no diversification at all!). The

wjJJgo down if the prices for steel increase

A portfolio that contains only systematic risk (where all unsystematic

diversified) is called an efficient portfolio. A natural candidate for an efficient

- Finance & Accounting

HistoricalReturnsofStocks and Bonds

The expectl!d, or mean, return is the return we expect to earn on average:

contains two kinds of risk (1) diversifiable

risk and (2) undiversifiable

(systematic) risk. The total risk is

measured by the standard deviation while the systematic risk is measured by a

1.3.1 Variance I Standard Deviation (Volatility)

- Finance & Accounting

Variance (ofthe return distributiollt):

Standard Deviation (Volatility) (ohhe return distribution):

Variance (ofthe empirical distribution ofrealized returns):

- Finance & Accounting

for the degree of co-variation

securities' returns. Therefore, the covariance has to be taken into consideration

ofreturn observations, R = return,

correlation can be seen as the "standardized covariance" and is measured on a

+ 1. At the bottom end of the spectrum returns are perfectly

that bears no risk. At a correlation of 0, returns are uncorrelated and there is no

- Finance & Accounting

As discussed above the variance and standard

deviation of a portfolio are

dependent on the covariance of its individual securities. Therefore, the variance

(Xj= weight, amount of j held in the portiolio)

Standard Deviation (Volatility):

Each security contributes

to the volatility of the portfolio according to its

volatility, scaled by its correlation with the portfolio.

Finance&Accounting Uniseminar112

Finance&Accounting Uniseminar112