Corporate Financial Analysis (Capstone) Final Exam Notes

5 Steps of Financial Statement Analysis

Identify economic characteristics of an industry
o Examine the industrys market conditions, trends, performance of
companies in the industry, profitability, potential growth for the
future
o Conduct comparative ratio analysis for firms in the industry, by
comparing the firms ratios to an industry benchmark or to other
similar firms, by creating common size financial statements
(everything is comparable as theyre all represented as a %)
o Analyse industry characteristics value chain analysis, porters 5
forces and economic attributes.
o 5 Forces (SERBS): Threat of Substitutes, Threat of New Entrants,
Rivalry amongst Existing Firms, Buyer/Supplier Power (Switching
Costs / Distribution Channels)
o Economic Attributes: Supply/Demand of Products, Economic Cycle
(Fluctuation of Sales), Competitiveness, Barriers to Entry,
Capital/Labour Intensive
Identify strategies that a firm pursues
o Nature of product or service --> analyse customers perception of
the company (high-end or low-end company), volume of sales,
branding strategies, competitive advantage/unique selling points,
customer base, target market how does the customer perceive the
companys products (is it high quality?)
o Degree of integration with value chains
o Degree of geographical or industry diversification
Assess the quality of financial statements
o Use of different accounting frameworks & principles across different
firms may cause inconsistencies when comparing financial
statements between firms
E.g. different inventory costing methods (LIFO, FIFO, Avg. Cost),
Purchase Accounting, Lease Accounting and Revenue Recognition
(Accrual v. Cash Basis)
o The balance sheet reflects historical values, not market values
o Difficult to assess the value of intangible assets --> estimates may
not be accurate
o Does not account for off-balance sheet assets (contingent assets
and liabilities)
o Does not provide information about the quantitative aspects of
a business; such as changes in staff or management, agreements
with suppliers, does not tell anything about daily operations or the
companys future plans, projects or future prospects
Analyse future profitability and risk
o Current ratio = Current assets / Current liabilities
Measures the companys ability to pay short term obligations
o Debt / Equity ratio = Total Debt / Total Equity
Measures the companys financial leverage, and level of D&E to
fund the business
o Inventory Turnover = Total COGS / Average Inventory
Where Average Inventory = (Inventory @ start of year + Inventory
@ end of year) / 2

Measures the number of times inventory is sold over a year

For example: For the financial year ended 2015, Company A had
annual COGS of $150m, with an average inventory of $25m.
Inventory Turnover = 6 times
o Days Sales Inventory Turnover = 365 / Inventory Turnover
ratio
Measures the number of days it takes for a company to sell its
stock/inventory
For example: 365 / 6 = 60.83 days to sell one FULL round of
inventory
o Accounts Receivables Turnover = Total credit sales / Average
Accounts Receivable
Where Average A/R = (Accounts Receivable @ start of year +
Accounts Receivable @ end of year) / 2
Measures the number of times receivables are collected over a year.
The ratio is intended to evaluate the ability of a company to
efficiently issue credit to its customers and collect funds from them
in a timely manner. A high turnover ratio indicates a combination of
a conservative credit policy and an aggressive collections
department, as well as a number of high-quality customers. A low
turnover ratio represents an opportunity to collect excessively old
accounts receivable that are unnecessarily tying up working capital.
o Average Collection Period = 365 days / Receivables Turnover
ratio
o Days sales outstanding = Accounts receivables / Total credit
sales X 365
(Days sales outstanding = Average Collection Period -->
represents how long (in days) it takes for a business to
collect its average receivables)
o Accounts Payable Turnover = Total Purchases /Average
Accounts Payable
(Measures how long it takes for a business to pay it accounts
payables)
Where Purchases = Cost of Goods Sold + Ending Inventory
Beginning Inventory
Where Average Accounts Payable = (Accounts Payable @ start of
year + Accounts Payable @ end of year) / 2
o Days Payable Outstanding (DPO) = 365 / Accounts payable
turnover ratio
o Profit Margin = Net Income / Sales
o ROA = Net Income / Total Assets
o ROE = Net Income / Total Equity
o Price Earnings Ratio (P/E) = Price per share / Earnings per share
Measures how much investors are willing to pay for every $1 of
earnings
o Earnings per share = Net Income / No. of Ordinary Shares
o Dividend Yield (%) = Dividends per share / Market Price per share
Value the firm
o Ball & Brown (1968): if earnings increases, then stock returns > market
average returns

Key Ratios

Profitability ratios (Profitability = Net Income)

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

Capitalisation or financial leverage ratios

o Equity Multiplier = Total Assets / Total Equity
Measures the amount of a firms assets that are funded by its
shareholders. The equity multiplier shows a companys total
assets per dollar of shareholders equity.
For example: an equity multiplier of 3, means that for every $1 of
shareholder equity, total assets are worth $3 --> so that means that
equity = $1, debt = $2.
o Current Ratio: Current Assets / Current Liabilities
Current Assets = Cash, marketable securities, inventory,
receivables
o Acid test ratio = Current assets Inventories / Current
liabilities
= cash + marketable securities+
receivables / current liabilities
o Debt service ratios or debt coverage ratios (loan protection): how
many times can we cover the interest payments with earnings?
o EBIT coverage = EBIT / interest expense
o Cash flow coverage = EBIT + Depreciation / interest expense
o Debt service ratio = EBIT / interest expense + [principal
payments / (1 tax rate)]
o Dividend Payout Ratio (DPO) = Dividends Paid / Net Income
o Earnings Retention = (Net Income Dividends Paid) / Net
Income; OR (1 DPO)

Sustainable growth rates: the maximum rate a company can

grow by using internally generated funds (by only using
retained earnings)
o Formula: Return on Equity x Retention Ratio = ROE x (1
DPO)
o For example: if ROE = 6%, and the DPO = 30%; then SGR = 4.2%
Capital market ratios (Per share basis)
o Price Earnings Ratio (P/E) = Price per share / Earnings per share
o Earnings per share = Net Income / No. of Ordinary Shares
o Dividend Yield (%) = Dividends per share / Market Price per share
o Market to book value = Market price per share / Book value per
share
Economic Value Added: a measure of a companys financial
performance based on residual wealth --> calculates whether a company
has been profitable by determining whether the profit generated
exceeds the companys cost of capital (WACC).
EVA = Net Operating Profit After Tax (Capital Invested x WACC);
OR
= Invested Capital x (Return Earned Required Rate of
Return to Investors)
o

Framework for Analysis

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

What reasons do managers have to minimise reported earnings?

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

To minimise requests to provide dividends and retain cash for growth

opportunities.

2. a) During a time of inflation, would a manager prefer to use FIFO or

LIFO?
During inflation, prices are increasing therefore FIFO would give a HIGHER
profit figure as the COGS wouldve been purchased at a lower price.
Conversely, LIFO would give a LOWER profit figure as the COGS wouldve
been purchased at a higher (and more recent) price.
Note: An increase in COGS may mean the business has increased sales (and
increased revenues), increases in inflation, or there are higher commodity input
costs (higher inventory costs)
3. Identify industries that should typically have high leverage (stable
companies) and those industries that should typically have low
leverage (volatile companies).
High leverage: low margin high turnover industries like grocery
stores/supermarkets + popular restaurants, and stable industries like utilities
such as electricity/gas/water companies, airports, hospitals, manufacturing
companies and phone companies. Financial companies typically have huge
amounts of leverage they would not make a respectable profit otherwise since
margins are so low.
Low leverage: high value added companies that are not stable like service
companies such as lawyers/investment bankers, technology/software developers,
mining companies
4. Explain why firms have different P/E ratios.
P/E ratios indicate growth in earnings. The numerator (price) is based on
expected future earnings whereas the denominator is current earnings.
If future earnings are expected to be higher than current earnings (that is,
growth in earnings is expected), the P/E will be high. If future earnings are
expected to be lower, the P/E ratio will be low. So differences in P/E ratios are
determined by differences in growth in future earnings from the current
level of earnings.
Cash Flow Analysis
Young companies with profitable investment opportunities do not pay out
cash and rarely repurchase stock. Growth companies finance investments
as much as they can with internally generated cash flow. Retaining cash
avoids cost of issuing securities and minimizes shareholders taxes. Young
companies and growth companies typically experience high levels of risk
in relation to cash flows, as they usually incur negative income (and
negative cash flows) cash flows only start to become positive once they
enter the maturity phase.
As firms mature, growth opportunities gradually fade away and surplus
cash accumulates. Investors press for payout because they worry that
managers will overinvest if there is too much idle cash is lying around.
A firm with surplus cash will probably start by repurchasing shares, which
is more flexible than dividends. By repurchasing shares, the number of
shares in the market decrease and the value (price) per share increases.
Once a company announces a regular cash dividend, investors expect the
dividends to continue unless the company encounters serious financial

trouble. As firm ages, more and more payout are called for. The payout
may come as higher dividends or larger repurchases.
Free cash flow: operating cash flow capital expenditures
Where operating cash flow = net income + noncash expenses + changes
in working capital
Jensens (1986) agency costs of free cash flow: firms will too much free
cash flow will have high agency costs; managers will tend to overspend
money and will make decisions that are not in the best interests of
shareholders.

Cash flow Statement

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

Cash flows from operations

Cash flows from investing
Cash flows from financing

Start Up

Growth

Maturity

Decline

Negative
Negative
Positive

Positive
Negative
Positive

Positive
Negative
Negative

Positive
Positive
Negative

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

5. Calculate cash payments to suppliers. A retailer reports the

following:
Cost of goods sold = $24,165
Inventories beg = $4,584
Inventories end = $5,982
Accounts payable beg = $2,212
Accounts payable end = $2,687
Calculate the amount of cash paid to its suppliers.
Answer:
Purchases = (Cost of goods sold + Inventory at end of period Inventory at beg. of period)
= 24,165 + 5,982 4,584
= 25,563 (amount paid in $$)
Accounts payable = (Inventory purchases + accounts payable at beg.
accounts payable at end)
= 25,563 + 2,212 - 2,687
= $25,088 cash paid to suppliers
Reliability of Accounting Information
Accounting quality is defined as the precision with which financial
reporting informs equity investors about future cash flows of a firm.
Financial statements only reflect the financials for the current period
according to accounting rules (involves estimates); it does not show
anything about economic effects, future profitability and risk of the firm.
A companys management is responsible for the fair presentation of
financial statements in accordance with GAAP principles that portray the
companys performance and position (financials) to all end-users of
financial statements.
There are a few qualities and characteristics that make financial
statements reliable for decision making:
o Relevance: the financial information is viewed to be relevant if it
makes a difference to the decisions made by stakeholders and
helps users to assess past performance and predict future
performance.
o Timeliness: this means the financial statements are able to
provide end-users with the relevant information before it loses its
value. Online financial reports, together with analyst reports and
news articles, enables end-users to keep up to date with the
companys news and progress.
o Reliability: financial information is reliable when investors and
creditors consider the information to reflect current economic
conditions or events. Reliability is a measure of the integrity and
objectivity of financial reports. Financial statements are now
required to reflect the fair value of a companys assets and
liabilities.
o Verifiability: the extent that different individuals are able to obtain
the same result or same value when calculating the companys
financials.

o
o

Representational faithfulness: the degree to which the

companys financials reflect actual events that have occurred to the
company.
Neutrality: the companys financial statements should be free
from biasedness, and should be consistently prepared by using
standardized and uniform accounting principles to calculate
financial values.
Transparency: high-quality financial statements must be
transparent in the sense that it provides the complete reporting and
disclosure of notes.

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

Backdating Options
Options backdating occurs when companies grant options to their
executives that correspond to a day where there was a significantly lower
share price. This is illegal, because the company has manipulated the date
of the option granted to the executive, and chosen a day (in the past)
where the strike price would be significantly lower, to enable the
executives to make more profit.
For example, suppose that it is August 16, 2014, and the closing share
price of XYZ Corp. is $45. On June 1, 2014, XYZ Corp.'s stock price was at
a six-month low of $25. Technically, any options granted today (August 16)
should bear a strike price of $45. In a backdated situation, however, the
options would be granted today (August 16), but their listed day of
granting would be June 1 in order to give the options a lower strike price.
Options backdating defeats the purpose of linking an executive's
compensation to the company's performance, because the bearer of the
options will already have experienced a gain.
Big Bath Accounting
Big bath accounting is an earnings management technique where publicly
traded corporations write-off or write-down certain assets from their
balance sheets in a single year. The write-off removes or reduces the asset
from the financial books and results in lower net income for that year. The
objective is to make poor results look even worse in a single year, so that
future years will show increased net income. This technique is often
employed in a year when sales are down from other external factors and
the company would report a loss in any event. For example, inventory

valued on the books at $100 per item is written down to $50 per item
resulting in a net loss of $50 per item in the current year. Note there is no
cash impact to this write-down. When that same inventory is sold in later
years for $75 per item, the company reports an income of $25 per item in
the future period. This process takes an inventory loss and turns it into a
profit. Corporations will often wait until a bad year to employ this
technique to clean up the balance sheet.
Seven Financial Shenanigans
o Recording revenue before it has been earned
o Recording bogus revenue --> income (bottom line) revenue (top line)
o Boosting income with one-off gains
o Shifting current expenses to a later or earlier period (capitalising expenses
over multiple years, changing accounting techniques to shift expenses to
another period, failing to write down or write off impaired assets,
understating bad debts and loan losses)
o Failing to record or improperly reduce liabilities
o Shifting current revenue to a later period (holding back revenue for future
years)
o Shifting future expenses to the current period
The following are two basic strategies underlying all accounting tricks:
o To inflate current-period earnings by inflating current-period revenue and
gains or by deflating current-period expenses
o To deflate current-period earnings (and, consequently, inflate future
periods' results) by deflating current-period revenue or by inflating
current-period expenses
o Financial shenanigans are often used by fast-growth companies, whose
real growth is beginning to decline, basket-case companies that are
struggling to survive, newly listed companies, private companies, and
companies that have a weak control environment, or are under extreme
competitive pressure.
o Case study: AOL was a media company that spent more capital than it
earned. The company excluded current marketing costs in its profit instead
of immediately expensing them in the current period. The company shifted
the costs onto the balance sheet as an asset (capitalising costs), and
expensed them off in future periods. The amortization period of these
costs gradually increased from 12 months, to 18 months to 24 months -->
way of inflating company earnings for the current period.
o Capitalising costs An accounting method used to delay the recognition
of expenses by recording the expense as a long-term asset. In general,
capitalizing expenses is beneficial as companies acquiring new assets with
a long-term lifespan can spread out the cost over a specified period of
time. Companies take expenses that they incur today and deduct them
over the long term without an immediate negative affect against
revenues.
Factors that explain differences in ROA between industries
o Operating leverage fixed costs vs. variable costs
o A company with higher fixed costs will need to generate high level of sales
to cover the fixed costs. Higher risk if there are a lot of fixed costs in the
business, as fixed costs may not always be covered.

o
o

o
o
o
o
o
o
o
o
o
o
o
o

o
o

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

Net Income Sales

Assets Net Income
X
X
=
Sales
Assets Equity
Equity

COGS increase: increase in raw material prices, increase in demand/sales

(higher quality), prices lowered to sell inventory more quickly
COGS decrease: less sales, resort to lower quality (and cost) materials,
buying less

Dividend Discount Model (DDM) v Cash Flow Valuation

o The main difference between the two models is that the DDM
values a company based on the amount of dividends (retained
profits) given back to investors whereas the FCF model values a
company based on its ability to generate profits (FCF).

The DDM is arbitrary, because it only relies on company dividends;

however not all companies pay dividends (i.e. young and growth firms).
The dividends are also not periodic, the amount of the dividends does not
vary with performance --> so it is very difficult to use the DDM to
accurately value a firm.
A cash flow valuation is more accurate; for example, free cash flow
represents the amount that is (potentially) available to be paid out to
shareholders (similar to dividends).

Free Cash Flow Valuation

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

o
o
o
o
o
o
o
o
o

How to calculate new beta with change in capital structure

Levered Beta = Unlevered Beta x (1 + ((1 Tax Rate) x (Debt/Equity)))
E.g. Current (levered) beta = 0.9, Tax rate = 35%, old D/E = 0.6, risk free rate = 6%,
market risk premium = 7%, new D/E = 1.4
Step 1: Calculate your current unlevered beta

0.9 = X * (1 + (0.65) x 0.6) --> X = 0.65

Step 2: Calculate new beta by substituting everything into the formula
X = 0.65 * (1 + (0.65) x 1.4) --> X = 1.24
FCF requires more estimations and forecasting --> potential errors!
However, it takes into account cash flows, which has more economic
meaning than earnings

5.

The amount of residual income earned is seen as a contribution to

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

Five-Step Summary of Residual Income Model

1. Determine the book value of a firms equity (balance sheet) and project
residual income after calculating the return on equity (CAPM equation)
--> RI = NI (RE x BV)
2. Project long run growth
3. Estimate the appropriate discount rate (this depends on the firms
capital structure; if the firm is completely funded with equity, then use
RE as the discount rate, otherwise if the firm is funded with both debt
and equity, use the WACC)
4. Add book value of equity to PV, then divide by the number of shares
outstanding (SP)
5. Examine sensitivity analysis of estimates

Income statement and cash flows:

EBIT
800
Interest paid
225
Profit before tax
575
Taxes (40%)
Profit after tax
345
Depreciation
200

230

What is the FCF to shareholders?

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

6. Investors have $200,000 invested in common equity of a company and the

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

Value of company = Book value of Equity + PV of all future residual

income
Residual Income = Net Income (Return on Equity x Book value of
Equity)
Residual Income
Present Value
Year 1: (16,000 28,000) / 1.14
-10,526
Year 2: (28,000 28,000) / 1.142
0
Year 3: (30,000 28,000) / 1.143
1350
Year 4: (32,000 28,000) / 1.144
2368
4
Year 5: (37,000 28,000) / 1.14
38,062
Total Value of Company = $200,000 + PVs ($31,254) = $231,254
7. Investors have $200,000 invested in common equity of a company and the
required rate of return is 14%. Income for the first four years is expected to be
$16,000, $28,000, $30,000 and $32,000. In the fifth and subsequent years the
company is expected to earn $37,000 per year (perpetuity). Calculate the value
of the company using the residual income approach assuming 50% payout.
With a 50% payout, the company pays out 50% of net income and
retains 50% of net income. So the book value of equity will increase by
50% by net income earned every year --> BV1 = BV0 + 0.5NI
Year

Net
Income
16,000

Book Value of
Equity
200,000

Equity
Charge
28,000

Residual
Income
-12,000

PV

Year
-10,526
1
Year
28,000
208,000
29,120
-1,120
0
2
Year
30,000
222,000
31,080
-1,080
1350
3
Year
32,000
237,000
33,180
-1,180
2368
4
Year
37,000
253,000
35,420
11,286
38,062
5
Total Value of Company = $200,000 + PVs (-$6,134) = $193,866 -->
business should not run!
Note: the first book value of equity is $200,000 and not $208,000 because net
income is generated at the end of the (financial) year, but equity charge is
calculated at the beginning of the year. So the change does not come into effect
until the second year.
8. What does the decision to begin paying dividends signal?
It can be viewed as a (positive) signal that the firm is not wasting money on
unproductive projects, or a (negative) signal there are no attractive projects to
invest in. A dividend payout may signal to investors that the firm rather pays out
dividends to shareholders rather than wasting on perquisites or empire building
(agency costs).
9. A firm has shareholders equity on the balance sheet with a book value of
$100 at the end of year t-1. Suppose that during year t, the firm earns net
income of $50, pays dividends to shareholders of $25, issues new stock to raise

$10 of capital, and uses $5 to repurchase common shares. What is the allinclusive dividends in year t?
BVt = BVt-1 + NIt - Dt
= 100 + 50 25 + 10 5 = 130
Dt = NIt + BVt-1 - BVt
= 50 + 100 130 = 20
4. The following capital structure is in place:
LTD 10% coupon
$20 million
Pref stock 4% dividend
$5 million
Common equity
$15 million
Debt yields 8%, tax rate 35%, beta 0.9, RF=6% Market risk premium 9%
Calculate the weighted average cost of capital.
After tax cost of debt: 8% x (1-0.35) = 5.2%
Cost of equity: 6% + 0.9 x 9% = 14.1%
Debt: 50% x 5.2% = 2.6%
Preferred Stock: 12.5% x 4.0% = 0.5%
Common equity: 37.5% x 14.1% = 5.29%
WACC = 8.39%

Market Valuation Methods

Value to Book Ratio
o VB = value of equity to book value of equity
= 1 + PV of abnormal returns (or Residual ROCE) x cumulative
BV growth
o Example: if a company earns a 15% rate of return for 3 years, has a cost
of capital of 10% and the companys book value of equity increases by
15% every year for the 3 year period, calculate the VB ratio.
o Year 1 BV = 1.0, Year 2 BV = 1.152, Year 3 BV = 1.153
o Multiply individual BV by Residual ROCE (0.05)
o Discount individual values back to PV by using a 10% required rate of
return.
o VB ratio = 1 + PV = 1.14265
Market to Book Ratio
o M/B = market value of equity to book value of equity. Price to book value
tells whether investors in general value the company above, at or below
the face value of the company's assets as they appear in its financial
reports.
o M/B of company (total value) = current market capitalisation /
total shareholders equity
o M/B of company (per share) = market price per share / book value
per share
o Penmann: M/B should be 1 when market expects company to earn
required rate of return (no residual income)
10. In what industries do you expect the M/B ratio to be close to 1? In
what industries do you expect the M/B ratio to be high? Be prepared to
provide a reason for your answers.
Low (close to 1): Banks, insurance, and finance companies, since their assets are
recorded at market value or recorded close to fair value.

High (above 1): Industries with investments in R&D like pharmaceuticals,

chemical companies or mining companies. Also industries with human capital
such as service or knowledge firms such as Google or high-tech companies.
Price to Earnings Ratio Perpetual Growth
o It is calculated as current period share price divided by reported earnings
per share for the most recent year or four quarters (trailing 12 months)
o It reflects the markets optimism concerning a companys growth
prospects. If a company has a P/E ratio higher than the market or industry
average, then the market has high expectations of the company in the
future.
o P/E ratios can be used to project firm value from permanent
earnings perpetuity!
o P0 = E1/R or P/E = 1/R
o Example: A company is expected to generate $700 of earnings at
a 14% return on equity. Therefore, the market value of the firm =
700/0.14 = $5,000
o Adjusting for P/E ratio with Perpetual Growth --> P/E = 1/R-G
o You could also find the P/E multiple by using the second equation.
o Example: companys earnings are expected to grow 5% perpetually and
required rate of return is 15%. Find the P/E multiple.
o P/E = 1/R-G = 1/0.15-0.05 = 1/0.1 = 10
o General rule: companies that are low growth and low risk have low P/E
ratios. Companies that are high growth and high risk have high P/E ratios.
o Companies that are able to generate profits (ROCE exceeds required rate
of return) and are able to sustain profits will have a high P/E ratio
Price-Earnings Growth Approach (PEG) Short term Growth
o PEG ratio (short term growth) is calculated as the P/E ratio divided by the
expected short-term earnings growth rate (expressed in percent)
o PEG = P/E ratio / growth rate
o A PEG value 1.0 means the market price reflects expected earnings
growth
o A PEG value > 1 means a companys share price is overpriced (bad
investment)
o A PEG value < 1 means a companys share price is undervalued (good
investment)
o Note: always invest in the company with a PEG value less than 1.
o

o
o
o

Example: You are considering two potential investments in the TV

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

Price-Earnings to Growth and Dividend Yield

o PEGY ratio is relevant to stocks that pay a substantial dividend.
o Variant of PEG ratio but also includes dividend yield in the denominator
(%)
o PEGY ratio = P/E ratio / Growth (%) + Dividends (%)
o Example: A company has 40% annual growth in net income, an 8%
dividend yield and a P/E ratio of 50. The PEGY ratio 50/48% = 1.04
Credit Judgement
o The credit decision process is quite simple either yes, grant loan or no,
do not grant loan
o Two errors that might arise:
Type 1 Error: giving credit to companies that default
Type 2 Error: not giving credit to companies that have the ability
to pay it back
Credit Suppliers:
o Commercial Banks e.g. bank loans (private debt)
o Non-banks and other financial institutions e.g. finance companies,
credit unions, insurance companies, investment bankers, venture capital
companies, government agencies (private debt)
o Security Markets e.g. public debt markets; involves a primary
market (organisations selling debt to the public directly for example,
corporate/government bonds, CDs or securitised loans) and a secondary
market (trading of debt securities between investors)
o Trade Credits e.g. credit obtained from sellers and manufacturers;
usually unsecured with for 30-60 days but sometimes secured with a note
(depending on value).
Question: Whats the difference between public and private debt?
Private debt is owed by individuals and private sector businesses to their
lenders. It encompasses informal loans between friends and family, credit card
and bank loans, and corporate bonds issued by private companies. There is
usually a close relationship between borrowers and lenders.
Public debt is accumulated by national, regional or local government bodies or
by public sector organisations. Public debt includes government bonds, the sale
of which constitutes borrowing from private citizens and businesses, and also
sovereign debt, whereby one country borrows money from another. Public
debtholders (borrowers) must rely on professional debt analysts to assess credit
risk.
The 5 Cs of Credit
o Character: examine borrowers past financial statements and borrowing
history
o Capacity: examine the borrowers capacity to repay credit ratings, debt
repayment ratios
o Capital: examine the firms ability to lend the amount of money would it
impact their D/E
o Collateral: examine the type of collateral/security the borrower is willing
to provide
o Condition: examine the current industry and economy

The Credit Decision Process

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

Funds flow coverage ratio =

Funds flow coverage = cash flow + interest paid + taxes

paid / interest expense

EBIT + Depreciation
debt repayment pref . dividends
interest expense+
+
(1tax rate)
(1tax rate)

Debt service ratio =

EBIT
principal payments
Interest expense+
(1tax rate)

4. Utilise forecasts to assess payment prospects

Includes preparing forecasting and planning how the loan will be
repaid, and creating control mechanisms in case of default
5. Assemble the detailed loan structure, including loan covenants
Factors that drive debt ratings
o What are the key ratios debt rating agencies look at when rating a
company?
o Profitability: return on long term capital
o Leverage: long term debt to market capitalisation
o Interest and Cash flow coverage ratios
o Firm size and sales / Systematic risk
o Debt rating models: Kaplan-Urwitz & EDF
o Prediction of bankruptcy (models) and financial distress: Altman and FSI
o
o
o

Altmans Z-score Bankruptcy Model & (Public/Private Companies)

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
For public companies, bankruptcy occurs if the Z-score is <1.81

o
o
o

For private companies, bankruptcy occurs if the Z-score is <1.2

Financial Strength Index: suitable for measuring a firms financial condition
if they have large profits, great liquidity, low levels of debt and
new physical facilities.
FSI values range between -3 and 3 --> a higher number is better; better
financial health

Risk Analysis
Types of Risk
o International: government regulations, political, cultural differences,
exchange rates
o Domestic: business cycle, inflation, interest rate, demographic/lifestyle
changes
o Industry: technology, competition between businesses both domestically
and internationally; economies of scale or substitutes (cheaper), source of
materials/labour as well as prices
o Firm-specific: management strategies and company decisions, plans,
investments
Financial Statement Analysis of Risk
o Short term liability risk
Current ratio
Quick ratio
Operating cash flow to current liabilities ratio
Working capital activity ratio (turnover ratios)
o Long term solvency risk
Long term debt to total assets ratio
Debt/Equity ratio
Liabilities to assets ratio
Interest coverage ratio
Operating cash flow to total liabilities
o Credit risk
5 Cs of credit analysis character, capital, capacity, collateral,
condition
o Bankruptcy risk
Can derive from financial distress, which can range from:
1. Failing to make interest payments
2. Defaulting on a principal payment
3. Filing for bankruptcy and liquidating the business
Bankruptcy arises when the company cannot pay interest
payments, creditors can seize collateral, firm can reorganise if
possible to continue operations, or liquidate
One Ratio Bankruptcy Prediction Models: William Beaver (1936)
Altmans Bankruptcy Model for Public/Private Companies
Logit analysis: provides a probability of bankruptcy
Ohlson (1980) bankruptcy cut-off is 3.8%
o Market equity beta risk
Studies have identified three principal explanatory variables:
1. Degree of operational leverage
2. Degree of financial leverage
3. Variability of sales

Financial reporting manipulation risk

Reasons firms manipulate earnings:
1. Obtain debt financing at a lower cost
2. Earnings management to prevent volatility of share prices
3. Positively influence stock prices
4. Increase management bonuses
5. Avoid violation of debt covenants