Quiz 2 Fins Notes

8/10/2019 Quiz 2 Fins Notes

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Chapter 2: Introduction to financial statement analysis

Financial statements are accounting reports issued periodically by a firm,describing its past performance and providing a snapshot of its assets and thefinancing of those assets

Investors, financial analysts, managers and creditors rely on financial statementsto obtain reliable information on a corporation

Firms send annual reports (form 4E) to shareholders including a financialstatement

Generally Accepted Accounting Principles (GAAP) is a common set of rules andformat used by public companies in preparing financial reportso Differences and difficulties interpreting GAAP from different countries

discourages firms from investing abroado Harmonisation is a process of establishing basic rules on financial

reporting which can be globally acceptedo The International Financial Reporting Standards (IFRS) is most widely used

An auditor is a neutral third party hired by firms to check the firms financialstatements to ensure that they are prepared according to the A-IFRS, and tosupport the reliability of the information

Four financial statements are requiredo The management discussion and analysis is a preface which discusses the

recent financial year, providing a background on the firm, its goals andprojects and any risks that may affect liquidity or resources. Off-balancesheet transactions are transactions that can have material impact on thefirms future performance that do not appear on the balance sheet, e.g.guarantees to compensate for losses

o

The balance sheet (statement of financial position)o The income statement (profit and loss statement)o The cash flow statemento The statement of changes in equity: depicts the composition of the

shareholders equity anddetails the amount generated from issuing sharesand from retained earnings

o Notes

The balance sheet is a list of the firms assets and liabilitiesand provides asnapshot of the firms financial position at a given point in timeo Assets include the firms cash, inventory, property, plant and equipment

and investments/capital

Current assetsare either cash or assets that are converted into cashwithin one year.

Cash and marketable securities: e.g. government debt, that areshort-term, low-risk investments that are easily sold andconverted into cash.

Accounts receivable: amounts owned to a firm by customerswho have purchased goods or services on credit

Inventories: firms raw materials, finished goods and work-in-progress

Other current assets: prepaid expenses that are paid in advance

(rent, insurance) Non-current assetsproduce intangible benefits for more than one

year.


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Plant and equipment depreciate over time: a yearly deduction afirm makes from the value of its fixed assets (excluding land)according to the depreciation scheduleBook value = acquisition cost accumulated depreciation

Property not used in business operations, and property held for

sale Start up costs

Intangibles (trademarks and patents)o Liabilities lists the firms obligations to creditors

Current liabilitiesare liabilities that will be satisfied in one year

Accounts payable: amounts owed to suppliers for productspurchased on credit

Notes payable and short-term debt: loans that must be repaid inthe next year. Repayments of long-term loans occurring in thenext year are listed as current maturities on long-term debt

Accrual items: salary or taxes owed and unearned revenue

received for goods not yet delivered or service yet to beprovided

Working capital = Current assets Current liabilities

Non-current liabilities: loan or debt obligation with maturity ofmore than one year

o Shareholders equity(book value of equity) is the difference between theassets and liabilities, measuring the firms net worth Shareholders equity is not an accurate measure of the firms

worth/equity as it is hard to quantify the value of employees, thequality of management, the potential for growth, or the value of assets

(as assets are valued based on historical costs less accumulateddepreciation) Total market value of equity or market capitalisation = market

price per share x number of shares

The market value of a share depends on what investors expect assetsto produce in the future, and it does not reflect historical costs

Negative book value of equity does not indicate poor performance asfirms can borrow in excess and acquire assets that are of greaterworth

Liquidation value is the firms actual value left after assets are sold and liabilities

are paid

Balance sheet analysiso The market-to-book ratio or the price-to-book ratio or (P/B) ratio

(decimal) is the ratio of the firms market capitalization to the book value ofthe shareholders equity. The ratio indicates potential growth and thefirms ability to generate value from its assets above their historical costsP/B = Market value of equity / Book value of equity Successful firms (growth stocks) usually have P/B >1, indicating that thevalue of the firms assets exceeds historical costs or liquidation value. Firmswith low P/B are value stocks.

o The firms leverage,the extent to which the firm relies on debt as a source

of financing, is measured by the debt-equity ratio. The debt-equity ratio(%) is the ratio of the total short and long term debt to the equity value(book or market)


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Debt-equity ratio = total debt / total equity (book or market)

o Equity multiplier also measures a firms financial leverage.Equity multiplier = total assets / total equity

o Enterprise value is the total market value of the firms equity and debt lessthe value of its cash and marketable securities. It measures the value of theunderlying business assets less cash and marketable securities. Theenterprise value represents the cost of taking over/acquiring the business.Enterprise value = Market capitalization + Debt Cash

o Current ratio (decimal) is the ratio between the firms current assets tocurrent liabilitiesCurrent ratio = current assets / current liabilities

o Quick ratio or acid-test ratio (decimal) is the ratio of current assets otherthan inventory to current liabilitiesQuick ratio = (current assets inventory) / current liabilities

o Liquidity is measured through the current and quick ratio. A high currentor quick ratio implies that the firm has less risk in experiencing a cash

shortfall. E.g. a high increase in inventory could indicate the firms difficultyin selling products

The income statement (profit and loss statement) is a list of the firms revenuesand expenses over a period of time. The bottom line of the income statement isthe firms net profit or earnings.o Revenues and costs from product sales are recorded in the 1st and 2nd line.

Gross profit 3rdline = revenues costs

o Operating expenses are expenses incurred from the day-to-day running ofthe business that does not directly relate to producing products sold. Thisincludes: administrative, overhead, salaries, marketing costs expenses,depreciation and amortization (change in value of acquired asset due todeterioration)Operating profit = gross profit operating expenses

o Earnings before interest and taxes (EBIT) other sources of income andexpenses that arise from activities not central to the firms operation areincluded. E.g. cash flows from firms investments

o Net profit represents the total earnings of the firms equity holders,

reported as earnings per share (EPS)Net profit before tax = EBIT interest on debt corporate taxes

EPS = Net profit / outstanding shares

o Shares can be increased or diluted: an increase in total number of shares

which will divide a fixed amount of earnings. Issuing share options which give the holder the right to buy a certain

number of shares by a specific date at a specific price Issuing convertible bonds a form a debt that can be converted into

ordinary shares Diluted EPS indicates the potential for dilution and it represents the

firms EPS if these share options are exercised. Diluted EPS < EPS.

Diluted EPS = increase in number of shares from exercising shareoptions + number outstanding shares

Income statement analysis details the firms profitability and how this relates to

its share valueo

Profitability ratios represents the firms operating ornet profit as a fractionof sales, indicating its efficiency and pricing strategy


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Gross margin (%) reflects the firms ability to sell product for morethan its costsGross margin = gross profit / sales revenue

Operating margin (%) reveals how much a company has earned fromeach dollar of sale before interest and taxes are deducted. Operatingmargin is used to assess the efficiency of a firms operation.Differencesin operating margin can also arise from different sales strategies, e.g.offering low prices to sell a higher volumeOperating margin = operating profit / total sales

Net profit margin demonstrates the fraction of each dollar of revenueavailable to equity holders after firm pays its expenses, interests andtaxesNet profit margin = net profit / total sales

o Asset turnover indicates whether a firm is generating enough revenue fromsales per dollar of assets. Asset turnover measures the efficiency of assetsin generating sales revenue.

Asset turnover = sales / total assetso The management of working capital

Accounts receivable days, or average collection period or dayssalesoutstanding, calculates how long it takes to collect payments frombuyers. An increase can indicate that a firm is ineffectively collectingreceivables from customers or it is trying to boost sales by offeringgenerous credit terms.Accounts receivable days = accounts receivable / average daily

sales

Accounts payable days = accounts payable / average daily sales

Inventory days = inventory / average daily sales

Inventory turnover ratio shows how efficiently a firm can turn theirinventory into sales. A higher inventory turnover ratio is desired. Inventory turnover ratio = sales / inventory

o EBITDA is a calculation of a firms earnings before interest, taxes,

depreciation and amortization are deducted. EBITDA reflects the cash afirm earns from its operations

o Interest coverage ratio or times interest earned (TIE) ratio is used bylenders to assess a firms leverageand how easily it can cover its interestpayments (financial strength)Interest coverage ratio = earnings / interest

o

Analysts and financial managers evaluate a firms return on investmentthrough the return on equity ratio (ROE) (%). ROE measures the return afirm earns on past investments, and a high ROE indicates that a firm is ableto find profitable investment opportunities.ROE = Net profit / book value of equity

ROA = Net profit / total assets

A positive ROE and ROA is required for a firm to growo The DuPont Identity expresses ROE as a product of the profit margin, asset

turnover and a measure of leverage


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o Valuation ratios are used to determine the market value of a firm Price-earnings (P/E) ratio is used to assess if a share is over or under-

valued as shares should ideally be proportional to the level of earningsit can generate for shareholdersP/E ratio = Market capitalization / net profit = share price / EPS

PEG ratio is the ratio of a firms P/E to its expected earnings growth

rate EBITDA Enterprise value-to-revenue ratio Enterprise value-to-operating profit ratio

The cash flows statement depicts how a firm has used its earned cash during afinancial period

Under IFRS, cash flows from operating activities are report using:o Direct method: gross cash receipts and gross cash payments are recorded o Indirect method: profit is adjusted to take into effect transactions of non-

cash nature. In the cash flow statement, net profit is taken from the

income statement and this is adjusted by adding back all non-cashentries deriving from operating activities.

Operating activitieso Cash flows adjust net profit by including all non-cash items relating to

operating activitieso Depreciation is deducted in the income statement when calculating net

profit but it is not a cash expense so it is added back. Similarly other non-cash expenses such as deferred taxes are added back

o Accounts receivable: sales are recorded for net profit, but increases in cashthat is not received is deductedfrom the cash flow statement in accountsreceivable. Lending to customers decreases cash available

o

Inventory: the cost of increasing inventory is a cash outflow so increasesmust be deducted

o Accounts payable: borrowing increases cash available to the firm soincreases are added

Investment activityo Capital expenditures are purchases of new property, plant and equipmento Deductthe actual capital expenditure, assets or acquisitions

Financing activityo Retained earnings = net profits dividendso Payout ratio = dividends / net profitso

Cash flows include: paying dividends to shareholders, cash firm receivesfrom the sale of shares, cash spent repurchasing its own shares

E.g. a $1 million depreciation expense at tax rate 30% would reduce EBIT by $0.7million on the income statement. On the cash flow statement add $1 million as itis not a cash expense. Cash from operating activities increases by $0.3 million,this equals the tax savings from depreciation deduction.


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Chapter 3: Time value of money, an introduction

The valuation principle: the value of an asset is determined by its currentcompetitive market price. When the value of benefits exceeds the value of costs,the decision will increase the market value of the firm.

In competitive markets, goods must have the same price (law of one price) Arbitrage is the practice of buying and selling equivalent goods to take advantage

of a price difference


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Chapter 8: Investment decision rules

NPV rule is a direct application of the Valuation Principleo NPV = PV benefits PV costs

o A positive NPV corresponds to an increase the value of a firm and it is a

good decision regardless of current cash needso

NPV rule: When choosing between mutually exclusive investment options,take the alternative with the highest NPV

o If a project breaks evenin a certain year, the revenue of that year is $0o The NPV Profile graphs the PV over a range of discount rateso Multiplying cash flows by a certain number will also increase NPV by that

multipleo The disadvantages of the NPV rule is that it relies on an accurate discount

rate estimate and it can be time-consuming to compute

Payback rule: payback period is the amount of time it takes to pay-back theinitial investment

o

The payback investment rule: only projects whose cash flows pay backtheir initial investment within the pay-back period should be undertaken

o A project is accepted if the payback period is less than the specified lengthof time

o The payback rule is favourable for only short-term projects andinvestments. Also, if the payback period is short, most projects that satisfythe payback rule also have a positive NPV

o The payback rule DOES NOT discount future cash flows, it simply

sums up cash flows

o The advantages Simple to compute

Favours liquidityo The disadvantages

It ignores the time value for money Ignores cash flows after the payback cutoff period It assumes that there is a correct number of pay-back years required

for the payback period It is inconsistent with maximizing shareholder wealth

o The discounted payback rule is often used, but it still does not address theother 2 failings

IRR investment rule: accept any investment opportunities where IRR exceeds the

opportunity cost of capitalo The discount rate that sets the NPV of cash flows to zero is the internal rate

of return (IRR). It represents the average return of the investmento The IRR provides information in conjunction with the NPV rule. IRR depicts

the sensitivity of the NPV to errors in the cost of capital estimates.o Disadvantages of the IRR rule

Hard to compute, cannot be used to choose between projects, can bemisleading if inflows come before outflows

IRR rule fails for delayed investments: when cash is given up front butit is forgone in later years

Multiple IRR: when a deferred payment is made in later years may givemultiple IRR values. IRR values can be useful as bounds on the cost ofcapital estimates.


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IRR does not describe how much is returned when there aredifferences in scale (different initial investments). Multiplying the cashflows will not change IRR but it will change the NPV. Hence pickingthe investment with higher IRR may not have a higher NPV.

Differences in timing of cash flows (graphs will have different gradientsand intersect)

o

The modified internal rate of return (MIRR) is the discount rate that setsthe NPV of modified cash flows to zero. There are many ways to calculateMIRR 1. Discount all negative cash flows to present values and compound all

positive cash flows to the end of project 2. For MIRR, discount all negative cash flows to time 0 (present value)

and leave positive cash flows the same 3. Leave initial cash flow alone, compound all remaining cash flows to

the end of the project A=P(1-R)^n The rate used is the cost of capital rate

Using the MIRR, only 2 values are present at the end. Cash flows aremodified so there is only one sign-change to ensure only one IRR.

o The crossover point is the discount rate that makes NPV of 2 investmentsequal, so equate the two NPVs and solve. At the crossover point bothprojects have the same NPV so the incremental value of choosing one overthe other is 0.

Equivalent annual annuity (EAA) is used to evaluate projects with different lives,NPV may not be effectiveo EAA is the value of annual cash flow (starting from Year 1) that has the

same PV as the cash flows of a projectCash flow (negative) = PV (negative) / annuity factor

o

1. Calculate PV = initial payment NPV annuity

2. Calculate equivalent annuity = PV / annuity factor

o Considerations: The equipment may not be used every year for its required life The replacement costs for the equipment may change over time

When resources are limited, not all the positive NPV projects can be chosen. Acombination of project can be chosen.o The profitability index is used to determine the optimal combination of

projects. It is the ratio of the projects NPV to its initialinvestment. The PImeasures the NPV per unit of resource consumed.

PI = Value created / resources consumed = NPV / initial investmento Resources are assigned to projects in descending order according to their

profitability index. This maximizes the NPV for the limited resourcesavailable.

o Benefits: uses NPV to measure benefito Disadvantages: problems that arise from using the PI is that some

resources may be left over at the end as it does not divide evenly into theprojects. For example, small projects that may have the lowest positive NPVshould be undertaken as it uses the remaining resources. Also PI breaksdown when multiple resource constraints apply.


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Chapter 9: Fundamentals of capital budgeting

A capital budget is a list of all the project a firm plans to undertake during thefinancial period

Capital budgeting is the process of evaluating investment opportunities,

determining their NPVs and deciding which ones to accept Incremental earnings are the amount by which the firms earnings are expected

to change due to an investment decisiono Operating expenses vs. capital expenditures

Operating expenses include marketing surveys, developing prototypes,launching advertising campaign

Investments in plant, property and equipment are not listed as expensesbut firms deduct a fraction of these costs as depreciation (not an actualcash outflow). The depreciable life may not be the same as the economiclife of the asset.Straight line depreciation = capital expenditure cost / depreciable

life Transport and installing equipment is also added to the cost of capital

o Incremental revenue and cost estimates (only additional sales and costsgenerated by the project are considered). Factors that influence revenue andcost estimates: New projects have lower sales at start as customers become more aware

of the product. Sales then accelerate, plateau and decline as productbecomes obsolete or faces increased competition

Average selling price and cost of production changes over time. Priceand costs rise with inflation. Prices of technology falls over time asnewer technologies emerge and production costs for them decline.

Competition reduces profit margins over time Incremental earnings before interest and tax (EBIT) = Incremental

revenues Incremental costs Depreciation

*Incremental revenues do not include the purchase of equipment, this isadded to incremental FCFs

*Reductions in incremental costs are represented by a positive valueo The marginal corporate tax rate (income tax) is the tax rate a firm pays on

incremental dollar of pre-tax income (EBIT)Marginal corporate tax rate = EBIT x firms marginal corporate tax rate

Incremental earnings = (Incremental revenue incremental costs

depreciation) x (1 tax rate) = EBIT x (1-T) A pro-forma statement is not based on actual data but depicts a firms financials

under hypothetical assumptions

Capital budgeting decisions do not include interest expenses. Incemental interestexpenses will relate to how the firm decides to finance the project so this is aseparate decision. Hence net profit assumes no debt or leverage, so unleverednet profit is used (does not include interest expenses associated with debt).

Incremental free cash flow is the incremental effect of a project on the firmsavailable cashFCF=EBIT(1-T)+Depreciation-CapEx-Changes in NWC

FCF=(Revenue-Cost)(1-T)-CapEx-Changes in NWC+(T)(Depreciation)o

Depreciation expenses reduce taxable earnings and taxes that are cash flows.So depreciation is added back as it is not a cash outflow.


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Incremental FCF = Incremental earnings + Depreciation

o Net working capital Net working capital = Current assets current liabilities

NWC = Cash + Inventory + Receivables Payables Net working capital does not include note payable or short-term debt as

financing decisions are separate from investment decisions.

Trade credit is the difference between receivables and payables and it isthe net worth of a firms capital consumedby credit transactions

Only CHANGES in NWC affects FCF. Increases in NWC correspond to cashoutflows as cash is used to purchase equipment (increase NWC = ties upor decrease NWC = frees up)

Change in NWC = NWC t NWC t-1o The depreciation tax shield (tax rate x depreciation) is the tax savings that

results from deducting the depreciation expense. Hence depreciationexpenses have a positive impact on FCF.

o The NPV of a project is the sum of all present values of the cash flows

PV(FCF) = FCF at time t / (1+r)t, discount rate r is the cost of capital Other changes effect incremental FCFs

o Opportunity cost is the value of the next-best alternative forgone whenanother resources is chosen. Opportunity costs are added to the FCF, e.g. theOC of selling land used for business. Idle assets are still opportunity costs.

o Project externalities are indirect effects of a project that may increase ordecrease profits of other business activities, e.g. lost sales in existing projectsas new projects displace sales (cannibalisation)

o Sunk costs are unrecoverable costs that have been paid regardless ofwhether or not a firm proceeds with a project.

o Fixed overhead expenses are expenses that are not directly attributed to asingle activity but many different areas of a corporation. E.g. cost ofmaintaining companys HQ and CEO salary. These expenses are notincremental but fixed, so they are deducted. Only additional overheadexpenses that arise from investment decisions that are incremental

expenses should be added.

o Past research and development expenditures is a sunk cost so it should beignored

The diminishing value method of depreciation assumes that the decline in anasset each year is a constant proportion of the remaining value and produces aprogressively smaller decline over time. Compared with straight line

depreciation, the diminishing value method allows for larger depreciationdeductions earlier in the assets life, increasing PV of depreciation tax shield and

project NPV.Annual depreciation = Base value (previous year) x (2 / depreciable life)

Assets may have a negative salvage value (liquidation or resale value) as it costsmoney to remove and dispose of the equipment. Liquidation value is added.Capital gain = sale price book value

= sale price (purchase price accumulated depreciation)After tax salvage value cash flow = sale price (tax rate x capital gain)= sale price (tax rate)(sale price (purchase price accumulated

depreciation)

Sensitivity analysis is a capital budgeting tool that determines how NPV varies asonly one parameter changes. E.g. NPV profile graphs NPV as function of discount


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rate highlighting the uncertainty of the correct capital costs used as discountrates. The best-case and worst-case scenarios are calculated and the NPV rangeis analysed.

Break even is the level of a parameter which makes the investments NPV equal0, e.g. IRR or EBIT break-even for sales. Other parameters are assigned fixed

values.o

EBIT = (Units sold x sales price) (Units sold x cost per unit) SG&A Depreciation = Revenue COGS SG&A - Depreciation

(SG&A: selling, general and administrative expenses)

Scenario analysis is a capital budgeting tool that determines how the NPV variesas multiple parameters change. E.g. determining the effectiveness of pricingstrategies which changes price and volumes sold

Real options in capital budgeting (greater flexibility will increase projectsNPV)o Delaying commitmento

Expanding if product is successfulo Abandon investment

Quiz 2 Fins Notes

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