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2. Fixed Assets:
Fixed assets can be operating or non-operating
Depreciation is calculated on depreciable value and not on the cost of the asset
Based on the useful life decided by management, the depreciation value is decided for
every year. E.g. If depreciable value of an asset is 85 and useful life decided by
management is 2 years then depreciation per year is 85/2. But the real value of any
asset is: Purchase cost Scrapped value + Transportation charges
3. Quality Earnings:
If one company takes useful life of asset as 5 years and other company takes useful
life of 3 years, then the values reported by both companies are just reported values
and not the real values.
Dirty Profit:
4. Capital Work-in-Progress:
If a company is constructing 2 buildings out of which only one building construction has
been completed and one is still under construction, so till the completion of under
construction building, no depreciation will be applied on this building and it will be
entered as Capital-work-in progress and will not be written in building account.
5. Intangible Assets under development:
A company has to get the patent registered. Once the patent is registered then only
company can start amortizing it.
A company cannot have goodwill as forever or fixed asset in the balance sheet and so
need to be amortized over certain number of years(In India, goodwill has to be
amortized over 5 years)
Once a company apply for a patent, it cannot include in a patent account, as it is not
yet approved (i.e. registration in progress), instead it should be entered as an intangible
asset under development. Once the patent is registered, it can be transferred to patent
account
All intangible assets have to be write off.
6. Deferred Tax:
A company shows the profit based on its financial reports, but it has to pay the tax
based on Income Tax Act and not the tax based on its reported profit.
This happens when the depreciation calculation method used by the company is
different from the depreciation calculation method used by Government Income Tax
Act
So if there is a difference between the tax calculated by company is different than the
tax based on Income tax act, the difference is called as deferred tax
If the tax calculated by company is lower than the tax based on Income tax act, it is
entered as a deferred tax liability, else it is entered as deferred tax asset.
So the company is just postponing or differing its tax amount at this time and so
deferred tax is a temporary asset or liability.
Session 3
7. Shareholders equity:
Shareholders equity consists of share capital and reserves and surplus.
Share capital is nothing but the book value of common stock
Reserves and Surplus has 2 parts, unused reserves and undistributed retained
earnings
Some part of PAT(Profit after tax) is kept aside by a company for future is called reserve
Retained earnings can be distributed as dividends to common stockholders or can be
reinvested in business for 1 year. So it is an internal source of finance for a company.
If company doesnt distributes the retained earnings as dividends, it is good for long
term investors as they can get more returns on their investment in future, but short term
investors will not get any advantage.
So every company has 2 sources of internal finance, one is undistributed retained
earnings and other one is depreciation. As depreciation is a noncash expense, it will
make additional cash available for business. Business can invest retained earnings
and depreciation as internal source of finance or can invest outside.
9. Provisions
Provisions are the mandatory obligations, which you have not paid yet, but which you
cannot postpone and thus need to be mentioned in your balance sheet as provisions.
Unlike reserves which are created after PAT, provisions are created before PAT.
Reserves are not mandatory obligations.
Session 4
Example 1:
Example 2: If 20% sales are credit sales out of 100000 total sales
Direct Method Indirect Method
Cash Sales 80000 Profit Before Tax 30000
Less: Purchases (-)40000 Add: Depreciation 20000
Less: Other Expense (-)11000 Add: Opening Stock 1000
Less: Closing Stock 2000
Less: Credit Sales 20000
Cash flow from Operations 29000 29000
Note: This can be also shown as increase in account receivables (assets) which means cash
outflow, in case of indirect method
Note: This can also be shown as increase in account payables (liability), which means cash
inflow in case of indirect method
Example 4:if 2000 outstanding other expenses out of total other expenses of 11000
Direct Method Indirect Method
Cash Sales 80000 Profit Before Tax 30000
Less: Purchases (-)36000 Add: Depreciation 20000
Less: Other Expense (-)9000 Add: Opening Stock 1000
Less: Closing Stock 2000
Less: Credit Sales 20000
Add: Credit purchases 4000
Add: Outstanding expense 2000
Cash flow from Operations 35000 35000
Accounting Analysis:
o Growth in revenue and growth in profit is not in synchronization. So company
growth is not a sustainable growth. Fixed costs is 83%. If you increase the
number of customers through marketing, the fixed costs will be distributed in
these increased number of customers and so fixed cost per customer will
decrease.
o Company is showing high intangible assets in fixed assets so that It can raise
more debt
o Lease debt is off balance sheet item or hidden item. Lease payment was not
shown by company as long term debt in balance sheet.
o Due to high debt, interest expenses increase and so profitability reduces
o Company has written goodwill under Intangible assets. But company need to
write off this goodwill in x years ( x= 5 years for India). Goodwill cannot be
liquidated.
Financial Ratio Analysis:
o Return on Sales: company is adding short term debt to long term debt in
calculating Debt Equity ratio which is wrong.
o Return on Equity: ROE is 7.5 in 2007 and 4.7 in 2006 which is less than cost
of equity(11.37%), so shareholders are not getting expected return
o Fixed costs as % of sales is 83% and variable costs are 17%. So fixed cost is
huge cost for company as fixed cost remains same even if number of
customers change.
o Out of total assets, 70% are intangible assets, mainly licenses of stores,
which cannot be liquidated
o Company is using short term borrowings to run the business. Company
should have taken long term loan instead of short term borrowings.
o Lease payments not included in debt.
Valuation Analysis:
o Projected share price = 8.52 per share
o Equity = 1744.5
o Projected PE Ratio= (projected market price)/EPS=8.52/0.43=19.814
o Number of shares outstanding = 475 million
o Projected PE ratio= 1/(cost of equity growth rate)= 19.814
o As cost of equity = 0.1137, so Projected growth rate = 6.32%
o Price to Book Ratio = {1+ {[(Expected ROE)-(Cost of Equity)]/[(cost of equity)-
(projected growth rate)]}} => 2.12 = {1 +{ [(E(ROE)-0.1137]/(0.1137-0.0632)}}
=> E(ROE)=16.42%
o But Present ROE is 7.5%.
o As Expected ROE is greater than actual ROE, so the share price is
overvalued.
Nuware R.P.Stuart
2013 2012 2013 2012
I. Account Receivables
Net Account Receivables 295888 363424 269115 217123
Provisions for bad debts(PBD) 9438 16140 12650 10327
Gross Account Receivables 305326 379564 281765 227450
PBD as a % of Gross Account Receivables 3.09% 4.25% 4.49% 4.54%
if Nuware also use the RP's policy 4269.785 1093.491
3176.294
III.Depreciation (difference in useful life assumption)
Net Fixed Assets(PP&E) 374493 370262
Accumulated Depreciation(exhibit4-pp&e) 304500 268500
Gross fixed assets 678993 638762 430256 356096
Accumulated Depreciation(exhibit4-pp&e) 304500 268500 135692 11092
Depreciation expenses(annual)(exhibit4&exhibit7) 35698 31572 26900 24000
Approximate useful life(in years) 19.02048 20.23191 15.99465 14.83733
Approximate Present Age of the fixed Assets 8.52989 8.504371 5.044312 0.462167
Nuware depreciation expense (as per RP's useful life) 42451.27
Additional depreciation expense for Nuware 6753.266
IV. Inventory(Nuware using LIFO whereas RP is using FIFO)
Inventory(from balance sheet)(exhibit3&) 247502 230911 131344 109829
COGs(from Income Statement)(exhibit2&5) 1001892 1009893 352682 316500
LIFO Reserves(exhibit-4-page7) 29500 35100
Change in LIFO reserves from 2012 to 2013 5600
Summary of Adjustments
Income Before Tax Effect on After Tax Effect
Balance Sheet Statement Profit on Profit
Account receivables will Bad Debt
be reduced by expenses will go
Account Receivables 3176.294 up by 3176.294 -3176.294 -2001.997323
this will increase
the profit by
6700, so we need
to subtract this
gain on sale of
Gain on sale of investments investments -6700 -4222.966155
depreciation
expense will be
fixed assets will be increased by
Depreciation reduced by -6753.266 6753.266 -6753.266 -4256.539367
Inventory value will go COGS will go up
Inventory down by 5600 -5600 -3529.643354
profit should go down by -22229.56 -14011.1462
Reported Income(i.e. income
before tax) 137363 86579
Profit afer doing adjustments 115133.44 72567.8538
so profit will go down by -16.18% -16.18%
Given Data
taxes 50784
reported profit(i.e. income
before income tax) 137363
income tax % 36.97%
Analysis:
Nuware is trying to show higher profit by showing less Provisions for bad debt(PBD)
% of PBD is always calculated on gross account receivables and not on net account
receivables
% rate of depreciation is calculated on gross fixed assets and not on net fixed assets
In case of Nuware, as useful life is considered high as compared to RP, so annual
depreciation expense is lower for Nuware which leads to higher profit for Nuware
COGs will be increased as LIFO reserves have been reduced from 35100 to 29500=>profit
will be reduced by 5600
So buying shares is worthwhile as they are not considered growth, if they consider growth also
market price will be higher than this.
Given
Expected cost of capital 10.00%
Citigroup
1996 1998 2000 2002 2004 2006 2008
PAT 7.6 7 13.5 15.3 17 21.5 -27.7
Book value of equity 40.5 48.8 64.5 85.3 108.2 119.8 71
Average book value of equity 40.5 44.65 56.65 74.9 96.75 114 95.4
-
Return on equity 0.187654 0.156775 0.238305 0.204272 0.175711 0.188596 0.29036
Residual value of equity(by formula 1) 3.55 2.535 7.835 7.81 7.325 10.1 -37.24
Residual value of equity(by formula 2) 3.55 7 13.5 15.3 17 21.5 -27.7
Value of Equity 76 74.15 142.85 163.4 181.45 220.8 -301.4
Given
Expected cost of capital 10.00%
In 2010, calculate value of equity per share is $19.889 and actual share price is #20,
which means zero growth.
If we subtract Net financial assets from value of equity, we will get the price of
operating assets. As operating assets are used for enterprise, we will get the
enterprise price.
If growth rate is zero, then out of core return on Net operating asset of 46.56%,
0.21375*46.56=9.9638% is because of operating assets and remaining (1-
0.21375)*46.56= 36.6 is effect of growth. So Effective rate of return is 9.9638%, but
in our calculations we have taken ERR as 9%.
If growth g=3% in sales, then effect because of operating assets = 9.9638%*3 %*( 1-
0.21375) = 12.33%. So effective rate of return is 12.33% which is higher than ERR
taken by us which is 9%, so we should buy as calculated ERR> 9%
Question B] would you attribute the drop in stock price from 2000 to 2002 to
problems in Ciscos operations?
Answer: Yes, partly. As stock price drops can lead to loss of fundamental value
Question C] clearly the great Cisco is now challenged. What is the lesson here?
Answer: Buying growth is risky
Question D] in 2010, Cisco announced that it would pay a dividend of $0.24 per
share for the first time. Why might cisco be doing this? What effect do you think it
had on the share price?
Answer: very small effect on share price, shareholders will be satisfied,Cisco may be
doing this as there is no opportunity to invest this money.
Question E] In 2010, cisco borrowed about $5 billion. The firm has a high level of
financial assets on its balance sheet. Why would it borrow?
Answer: Cheap interest rate of borrowing.so it can buy at cheap rate today and buy
back its shares using this money, which will increase the demand of shares and price
of shares will be increased.
Question F] Goodwill on the 2010 balance sheet stood at $16674 million, up from
$12121 billion in 2007 because of acquisitions. Given that these acquisitions have
not been successful, what do you think might happen to the carrying value of the
goodwill in the future?
Answer: Write off the goodwill in 5 years if successful. If market price is zero, show
loss of goodwill as impairment of goodwill
Also company has shown the unrealized investment gain in balance sheet
which it should show in income statement before net income, so net income
will go down. Translation gain should also be shown in income statement,
which will change the net income.
If comprehensive income is increased then residual value will also increase
and enterprise value will also increase.
Proceeds from sale of put warrants (value = 472) has been shown by
company in equity, but as per rules, till the times these put warrants are
exercised, the company should show this as a liability( this is a contingent
liability and should be shown in footnotes also which company has not done)
and if it is exercised then it should be shown as equity
So this value is increasing value of equity. So actual value of equity = 39792-
472=39320
Question 1 Answer:
o Net financial obligations = Financial liabilities financial assets =
1320-1221=-99
o Financial Leverage = Net financial Obligations/common equity=
99/16649=0.5946%
o Net Operating Assets = Operating assets operating
liabilities=23457-6709=16748
o Operating Liabilities Leverage = operating liabilities/Net Operating
assets = 6709/16748= 0.401
o Tax on interest income= 11(1-0.39)=4.29 and tax on operating
income=978-4.39=974
o So operating profit after tax = earnings before income tax tax=
2524-974=1549
o So after tax profit margin =operating profit after tax/sales
1549/26776=5.79%
Question 2 Answer:
o Return on beginning net operating assets = 9.3%
o RNOA = EBIT/(NWC + Fixed assets)=after tax profit margin*asset
turnover ratio
o So 9.3% = 5.79% * (26776/Net operating assets)
o So Net operating assets = 16772.478
o Residual Operating Income = Operating income after tax
Beginning cost of operating assets = 1549 (0.04*16672) = 882.12
Question 3 Answer:
o Net change in net operating assets = Closing Net operating assets
Beginning net operating assets = (23457-6709) 16672.478= 75.52
o Closing FCF = Operating Income after tax Net change in net
operating assets = 1549 75.52 = 1473.4778
Question 4 Answer:
o Value of Equity = common equity + (residual operating income/cost
of operating assets) = 16649 + (882.12/0.04)=38719
o Beginning FCF= closing FCF/(1+ Cost of operating Assets) =
1473/(1+0.04)=1416.3461
Question 5 Answer:
o Market value of equity = number of shares outstanding*market price
per share = 2336*50=116800
o So 116800 = 16649 + (882.8*g)/(0.04-g) where g is the growth rate
o On solving above equation we get growth rate g = 3.9%
Question 6 Answer:
o Enterprise price = Market Value of Equity + Net financial obligations
= 116800 + 99 = 116899
o Enterprise price to sales ratio= enterprise price/sales =
116899/26776 = 4.3658
o Market value of equity to sales ratio = 116800/26776 = 4.3621