Chapter 1: Why value value?

1:1 What is the theme that links most major financial crises and how does the pattern looks? Aggressive use of leverage is the theme that links most major financial crises. The pattern is always the same: Companies, banks, or investors use short-term debt to by long-lived, illiquid assets. Typically some event triggers unwillingness to refinance short-term debt when it falls due. Since borrowers dont have enough cash to repay the debt, they must sell some assets. The assets are illiquid and other borrowers are doing the same, so the price each borrower can realize is too low to repay the debt. In other words, the borrowers assets and liabilities are mismatched. 1:2. Describe how companies in the United States and the United Kingdom are governed, compared to companies in Continental Europe, for example in the Netherlands and Germany. In the USA and UK the objective of the corporation is to maximize share holder value, because shareholders are the owners of the corporation who elect the board of directors to represent their interests in managing the corporations development. In the Netherlands and Germany they have a broader view of the objectives of business organizations. For example, the board of a large corporation has a duty to support the continuity of the business and to do that in the interests of all the corporations stakeholders, including employees and the local community. 3. What is the correlation in the U.S and Europe between total return to shareholders and employment growth? During the last 15 years companies that create the most shareholder value also have the highest employment growth.

Chapter 2: Fundamentals principles of value creation

2:1. What was the reason the fast growing company Walgreen and the significantly slower growing company Wrigley, between 1968-2007 had nearly the same shareholder return? The reason Wrigley could create slightly more value than Walgreens despite 40% slower growth was that it earned a 28% ROIC, while the ROIC for Walgreens was 14%. 2:2. In the chapter there is an example comparing the two companies Value Inc and Volume Inc. Both has the same earnings growth. Which of the two companies has the highest value, and why? Value Inc has the highest value because it generates higher cash flows with the same earnings. It invest only 25% of its profits (making its investment rate 25%) to achieve the same profit growth as Volume Inc., which invest 50% of its profits. 2:3. Describe how growth, return on invested capital (ROIC) and the investment rate are tied mathematically. Growth, ROIC, and cash flow (as represented by the investment rate) are tied together mathematically: Investment Rate = Growth/Return on invested Capital 2:4. Assume a company has a cost of capital that is higher than achieved ROIC. What will happen to the value of the company if the growth increases? When ROIC is lower than the companys cost of capital, faster growth destroy value.

2:5. Assume a company has a constant growth rate, what will happen to the value if ROIC increases? For any level of growth, value increases with improvement of ROIC. In other words, when all is equal, a higher ROIC is always good. 2:6. Assume a company has a cost of capital that is equal to the achieved ROIC. What will happen to value if growth increases? Value is neither created or destroyed.

2:7. What is the conclusions regarding growth strategies based on organic growth, compared to acquisitions. Which strategy has normally the highest return, and why? Growth strategies based on organic new product development frequently have the highest returns because they dont require much new capital; companies can add new products to their existing factory lines and distribution systems. Acquisition, require that the entire investment be made up front. The amount of up-front payment reflects the expected cash flows from the target plus a premium to stave off other bidders. So even if the buyer can improve the target enough to generate an attractive ROIC, the rate of return is typically only a small amount higher than its cost of capital.

2:8. What was the conclusion drawn from the work of Miller and Modigliani, regarding the relationship between debt, equity, cash flow and value? Miller and Modigliani concluded that the value of a company shouldnt be affected by changing the structure of debt and equity ownership unless the overall cash flows generated by the company also change.

2:9. Why is it not possible to increase the value of a company by borrowing capital and repurchase shares, even if this leads to an increase in earnings per share? Because the total cash flow of the business has not increased. While EPS (earnings per share) has increased by 5%, the companys debt has increased as well. With higher leverage, the companys equity cash flows will be more volatile, and investors will demand a higher return. This will bring down the companys P/E, offsetting the increase in EPS.

2:10. Define NOPLAT. Net Operating Profits Less Adjusted Tax (NOPLAT) represent the profits generated from the companys core operations after subtracting the income taxes related to the core operations.

2:11. Define invested capital. Invested Capital represents the cumulative amount the business has invested in its core operations- primarily: property, plant, equipment and working capital. 2:12. Define FCF. Free Cash Flow (FCF) is the cash flow generated by the core operations of the business after deducing investments in new capital FCF = NOPLAT Net Investment 2:13. Define ROIC.

Return On Invested Capital (ROIC) is the return the company earns on each dollar invested in the business: ROIC= NOPLAT/Invested Capital

2:14. Define IR in relation to NOPLAT Investment Rate (IR) is the portion of NOPLAT invested back into the business: IR=Net Investment/NOPLAT

2:15. Define the value formula when the cash flow in a company is growing at a constant rate Value= FCFt=1/ WACC-g

Chapter 3: The expectations treadmill

3:1. Define TRS. Total Return to Shareholder (TRS) this measure combines the amount shareholders gain through any increase in the share price plus the sum of dividends paid over the same period. 3:2. Describe in general the expectations treadmill Improving TRS is much harder for managers leading an already successful company than fore those leading a company with substantial rum fore improvement. The reason is that a companys progress toward performance leadership in any market will attract investors expecting more of the same, pushing up the share price. Managers then have to pull off Herculean feats of real performance improvement to satisfy those expectations and continue improving TRS.

3:3. Explain why the company Target ended up with higher total shareholder return than Wal-Mart, although Wal-Mart had better development of important value drivers. The expectations treadmill explains the mismatch between TRS and the underlying value created by the companies. Using price-to-earnings ratios (P/Es) as a proxy for market expectations, Wal-Marts P/E at the beginning of 1995 was 15 times, compared with only 11 for Target. By the beginning of 2006, Wal-Marts P/E had increased slightly to 16 times, while Target caught up with and overtook Wal-Mart, reaching 18 times. Relative to Wal-Mart. Target was starting from a position of low shareholder expectations. The companys low P/E in 1995 reflected serious concerns about its Mervyns brand, which was eventually sold. After the sale it beat expectations-thereby raising expectations of its future performance.

Chapter 4: Return on invested capital

4:1 What is the SCP-structure and which researcher developed the structure further in the beginning of the eighties? Structure-Conducting-Performance (SCP) It is a model about what drives competitive advantage and ROIC. According to this framework, the structure of an industry influences the conduct of the competitors, which in turn drives the performance of the companies in the industry. Michael Porter developed the structure further in 1980. 4:2. Grade the following three sectors according to historical ROIC Pharmaceuticals, consumer goods and commodities. What is the reason for the differences in performance? Pharmaceutical companies have outperformed both consumer goods and commodity-based companies, when it comes to ROIC. Reasons: Pharmaceutical companies can develop innovative products that are subsequently protected by long-lasting patents. In the consumer goods industry, companies such as Procter & Gamble and Unilever have developed long-lasting brands that make it difficult for new competitors to gain a foothold. The companies also tend to compete for shelf space on factors other than just price. Commodity based companies have undifferentiated products and few opportunities for innovation. This makes it difficult fore any competitor to charge a price premium or buld a sustainable cost advantage.

4:3. Which are the five sources of competitive advantage, to allow companies to charge price premiums? Innovative products: Difficult-to-copy or patented products, services or technologies. Quality: Customers willing to pay a premium for a real or perceived difference in quality over and above competing products or services. Brand: Costumers willing to pay a premium based on a brand, even if there is no clear quality difference. Customer lock-in: Costumers unwilling or unable to replace product or service they use with a competing product or service. Rational price discipline: Lower bound on prices established by large industry leaders through price signalling or capacity management.

4:4.Which are the four sources of competitive advantage, to cost and capital efficiency? Innovative business method: Difficult-to-copy business method that contrast with established industry practice. Unique resources: Advantage resulting from inherent geological characteristics or unique access to raw materials. Economies of scale: Efficient scale or size for the relevant market.

Scalable product/process: Ability to add custumers and capacity at negligible margin cost.

4:5. Which are the three factors determining if a company can have a sustainable high ROIC? Whether a company can sustain a high ROIC depends on: Length of product life cycle. Persistence of competitive advantages. Potential for product renewal.

4:6. What was the median ROIC between 1963-2008 for US-based non-financial compnies? The median ROIC between 1963-2008 was around 10% and remained relatively constant during the period.

4:7. Which type of industry tend to have a high median ROIC? What is the characteristic for this group of companies? High median ROIC: Pharmaceutical and Personal products. Industries that rely on sustainable competitive advantage such as patents and brand.

4:8. Which is most stable over time ROIC or growth? ROIC tend to remain fairly stable- especially compared with rates of growth.

4:9. What is the conclusions regarding superior performance in ROIC over time? What is the conclusion regarding the group of high-performing companies? Companies earning an inicial high ROIC tend to see their ROIC fall gradually over time frome above 25% to around 15% although they still outperforms the low earning ROIC companies with more than 13%. High-performance companies are in general remarkably capable of sustaining a competitive advantage in their businesses and can therefore maintain a higher return on invested capital. Chapter 5: Growth 1. It is important to understand the reasons for variations in growth. Which are the three main components for growth? 1. Portfolio momentum: This is the organic revenue growth a company enjoys because of overall expansion in the market segments represented in its portfolio. 2. Market share performance: This is the organic revenue growth (or reduction) a company records by gaining or losing share in any particular market. (We define market share as the companys weighted average share of the segment in which it competes.) 3. Mergers & Acquisitions (M&A): This represents the inorganic growth a company achieves when it buys or sells revenues through acquisitions or divestments. 2. Which factor of these three explains most of the growth for large companies in 19992006? How much of the growth rate of 10.1 percent was explained by this factor? Which factor was least important?

6, 6 % came from Portfolio momentum, 3, 1 % from M&A and 0, 4 % from Market share performance. 3. Which three types of growth strategies has a value creation below average? *Gain share from rivals through incremental innovation * Gain share from rivals through product promotion and pricing. *Make large acquisitions. 4. Explain the so called Scurve in sustaining growth and how it relates to market penetration. The market for a product - by which we mean the market for a narrow product category sold to a specific customer segment in a specific geography typically follows an S-curve over its life cycle until maturity (p.90). First, a product has to prove itself with early adopters. Growth then accelerates as more people wants to buy the product, until it reaches its point of maximum penetration. After this point of maturity, and depending on the nature of the product, either sales growth falls back to the same rate of growth as the population or the economy, or sales may start to shrink. 5. What is the only way to sustain consistently high growth? Consistently find new product markets and enter them successfully in time to enjoy their more profitable high-growth phase. 6. In a study of USbased nonfinancial companies 19632007, there were some conclusions regarding the sustainability for high growth which? *High growth rates decay very quickly. Companies growing faster than 20 percent (in real terms) typically grow at only 8 % within five years and at 5 % within 10 years. 7. There are three possible explanations to why the inflation adjusted average growth rate of 5.4 percent 19632007 is higher than the GDP growth in the U.S of 3.2 percent which are they? *Self selection: companies with good growth opportunities need capital to grow. Since public market are large and liquid, high-growth companies are more likely to be publicly traded than privately held ones. *As companies become increasingly specialized and outsource more services, firms providing services will grow and develop quickly without affecting the GDP figures. *Global expansion. Many of the companies in our sample create products and generate revenue outside the US, which again will not affect US GDP. Chapter 6: Frameworks for valuation 1. Explain the four parts in valuing a company according to the DCFmodel. 1. Value the companys operations by discounting free cash flow at the WACC. 2. Identify and value nonoperating assets, such as excess marketable securities, nonconsolidated subsidiaries, and other equity investments. Summing the value of operations and nonoperating assets gives enterprise value. 3. Identify and value all debt and other nonequity claims against the enterprise value. Debt and other nonequity claims include (among others) fixed-rate and floating-rate debt, unfunded pension liabilities, employee options, and preferred stock. 4. Subtract the value of nonequity financial claims from enterprise value to determine the value of common stock. To estimate price per share, divide equity vale by the number of current shares outstanding. 2. Define the Value of Operations using estimates of free cash flow. The value of operations equals the discounted value of future cash flow. Free cash flow equals the cash flow generated by the companys operations, less any reinvestment back to into the business. 3. How is the WACC calculated? WACC (Weighted average cost of capital)= kd * (1-tax)*(D/(D+E))+ke*(E/D+E)) Ke=Rf+*(Rm-Rf) 4. Why must nonoperating assets be valued separately?

Many companies own assets that have value but whose cash flow are not included in accounting revenue or operating profit. As a result, the cash generated by these assets is not part of free cash flow and must be valued separately. 5. In what way is an SPE a problem when nonequity claims is to be calculated? p.115-116 6. Which are the six most common nonequity claims? 1. Debt: If available, use the market value of all outstanding debt, including fixed- and floatingrate debt. 2. Operating leases: These represent the most common form of off-balance-sheet debt. 3. Unfunded retirement liabilities: If not explicitly visible (line items are often consolidated), check the companys note on pensions to determine the size of any unfunded liabilities and where they are reported on the balance sheet. 4. Preferred stock: Although the name denotes equity, preferred stock in well-established companies more closely resembles unsecured debt. 5. Employee options: Each year, many companies offer their employees compensation in the form of options. Since options give the employee the right to buy company stock at a potentially discounted price, they can have great value. 6. Minority interest: When a company controls a subsidiary but does not own 100 %, the investment must be consolidated on the parent companys balance sheet. 7. Why should we not divide the equity value by the diluted number of shares? We have already valued convertible debt and employee stock options separately. If we were to use diluted shares, we would be double-counting the options value. 8. Define Economic Profit in relation to NOPLAT. Economic profit= NOPLAT-(Invested Capital * WACC) 9. Define the value of the company at time 0 using economic profit for year 1. Value0 = Invested Capital0 + (Economic profit1/(WACC-g)) Chapter 7: Reorganization the financial statements 1. Define invested capital from the equity liability side of the balance sheet. Invested Capital= Debt + Equity 2. Net earnings is the profit available to equity holders. To whom is NOPLAT available to? NOPLAT is the profit available to all investors, including providers of debt, equity, and any other types of investor financing. 3. What is the difference between free cash flow and cash flow from operations, reported in the annual report? FCF is the after-tax cash flow available to all investors: debt- and equity holders. Unlike cash flow from operations reported in a companys annual report, FCF is independent of financing and nonoperating items. It can be thought of as the after-tax cash flow- as if the company held only core operating assets and financed the business entirely with equity. 4. If ROIC is calculated without goodwill, what does it measure, compared to if goodwill is included in the calculation? ROIC with GW and acquired intangibles measures a companys ability to create value after paying acquisition premiums. ROIC without GW and aquired intangibles measures the competitiveness of the underlying business. 5. Name some nonoperating assets. Nonoperating assets include excess cash and marketable securities, certain financing receivables(e.g., credit card receivables), nonconsolidated subsidiaries, and excess pension assets. 6. What is the difference between operating taxes and operating cash taxes? Operating cash taxes = Operating taxes + increase in operating deferred taxes 7. Which are the most common non cash operating expenses that you add back when calculating NOPLAT?

Depreciation and noncash employee compensation. 8. Which are the five primary areas in calculating investments in invested capital? 1. Change in operating working capital: Growing a business requires investment in operating cash, inventory, and other components of working capital. 2. Net capital expenditures: Net capital expenditures equals investments in PPE, less the book value of any PPE sold. 3. Change in capitalized operating leases: To keep the definition of NOPLAT, invested capital and FCF consistent, includes investments in capitalized operating leases in gross investment. 4. Investments in GW and acquired intangibles: For acquired intangible assets, where cumulative amortization has been added back, we can estimate investment by computing the change in net GW and acquired intagibles. 5. Change in other long-term operating assets, net of long-term liabilities: Substract investments in other net operating assets. Chapter 8: Analyzing performance and competitive position 1. When should you measure ROIC including goodwill? What is the perspective? For instance, a company that purchases another at a premium to book must spend real resources to acquire valuable economic assets. If the company does not properly compensate investors for the funds spent (or shares given away), it will destroy value. Thus when you measure aggregate value creation for the companys shareholders, measure ROIC with GW. 2. How can you calculate ROIC, using the relationship to revenue? ROIC = (1- Operating Cash Tax Rate)*EBITA/Revenues*Revenues/Invested Capital 3. Describe a line items analysis for factors in the balance sheet? For the balance sheet, each line item can also be taken as a percentage of revenues (or for inventories and payables, to avoid distortion caused by changing prices, as a percentage of cost of goods sold). 4. Why is it better to calculate the ratio for the inventory to cost of goods sold, rather than to sales? See answer above. 5. Which are the three major factors that can distort the analysis of yeartoyear revenue growth? Are the effects of changes in currency values, M&A, and changes in accounting policies. 6. If you use EBITDA and EBITDAR to measure ability to meet shortterm obligations, which factors do you compare them to? Interest expenses, to calculate the interest coverage ratio.

Chapter 9
1. Steady state is defined by: - the company grows at constant rate and reinvest a constant porportion on op. Profits every year.- Company earns constant rate of return on existing capital and new capital invested. 2. Six steps in forecasting process: - analyze historical financials- build the revenue forecast, consistent with historical economywide evidence on growth. Calculate ratios, ex. Cost of goods sold, and mulitply with forec. Revenues. Also for selling cost, RnD-Forecast income statement. Use economic drivers to estimate op. Expenses, depriciation, interst income/expense and taxes. Non op. Incomes might be non consolidated subsidiaries.-Forecast balance sheet: inv. cap and nonop. Assets (PPE, goodwill, accrued expenses, accounts rec. Inventories, accounts payable, accrued expenses. Estimate most of them as percentage of sales) Non. Op assets: euity

equvivaltens, scuh as pension liabilities and defferred tax, -Forecast balance sheet: investor funds (other equity accounts, excess cash and new debt. -calculate ROIC and FCF 3. top-down approach is when you estimate future revenues based on the market( market size, market share, prices, acknowledge market maturity, demands, competitiors...)Bottom-up is when it's customer based (existing customers, potential for new. Maybe constructing, where the customer have a long term idea of what they want. Also cost of retaining customers...) 4. Most items in the income statement is tied to revenues. (be thourough when you estimate this!) 5. As an outsider you can calculate it as % of revenues or % of PPE (if you work in the company you can calc it cased on depr. Schedules and purchases.) Percent of PPE is more accurate if acqusitions of PPE isn't regular 6. Interest expenses should be tied to the liability (or asset) that generates the expense. Use prior years debt to forecast. 7. Because many companys pay tax rates below that because of low foreign rates and tax credits. 8. The stock approach forecasts recievables as a function of revenues, while the flow approach forecaste the change in recievables as a function of growt in revenues.Stock approach is smoother and more stable (ex. Page 201) 9. Estimate PPE in 3 steps:-Forecaste net PPE as % of revenues-Forecast depriciation, % of gross or net PPE-Calc capital expenditures by smming the increase in net PPE+ depr. 10. Normally you set revenue growth from acquisitions to 0 and goodwill same as before. This because it is not clear how an aquisition adds value, often it doesn't 11. The plug is: excess cash, short-term debt, long-term debt, newly issued debt and common stock. It's these lines that after retained earnings, forecaste revenue for next year and dividens, is left to make the balance sheet balance. (pp 205-207) 12. The capital structure affects the WACC. To bring it in to the balance sheet you may adjust dividends ratio. The capital structure is not visible in FCF so it doesn't affect valuation.

Chapter 101 Because it often accounts for a large percentage of a companys

value.2 Continuing value = NOPLAT (1- (g/RONIC)) -------------------------------WACC -gNOPLAT is the year after the forecasting periodRONIC is the expected return on new invested capital (3 Each year in the continuing value period more of each dollar becomes FCF available for investors. If you don't conisder this, the cont.value might be very underestimated. 4. Without any competitive advantage, most companies will have a RONIC equal to WACC. If they have, set it to equal the last years in the forecasting period. 5. Hard to grow faster than the economy. Set g to expected long-term growth for consumption and adjust for inflation. 6. Consider the underlying business risk consistent with industry conditions when setting the WACC.7. IC (ROIC-WACC) + PV (Economic Profit t+2) such that PV(Economic profit t+2) = NOPLATt+1 (g/RONIC) (RONIC-WACC) --------------------------------------------------------------------------------------------------------------------WACC WACC-g WACCIC = inv. cap at the end of the explicit forecast period.ROIC = ROIC on existing capital after explicit forecast period.RONIC= expected rate of return on new inv. cap after explicit forecast period.(acknowledge what happens if RONIC=WACC) 8. NO, it just affects the distributions of the years between forecast and perpetuity. 9.No, it depends on how you distribute your forecasting years, and if the companys growth is on old/base capital or new investments.

10. You cannot calculate the 5 % growth on the previous growth, but instead so it's on a level so that revenues has a growth of 5 %. Calculate growth in working cap as a percentage of revenues.11. CV= NOPLAT t+1 -------------------this shows value if new investments doesn't add any value to the company WACC 12. Because it assumes that NOPLAT can grow without growing capital investment. 13. Because its hard to estimate any good ratio to multiply. If you use todays P/E it is not necessarliy the same ratio as in the end of the forecasting period, depending on ex. the maturity of the market, aqusitions, etc. So how will you know wath ratio is correct to multiply? 14. Replacement cost approach is when you value a company as the cost of replacing all its assets. Not all assets are replacable, and also, by the replacement cost of just the tangible assets may underestimate value greatly. And some assets may be to costly to replace, and should therefore not be taken in to account in such cases.

Chapter 11: Estimating the cost of capital

1. What is the most important principle underlying a successful implementation of the cost of capital (WACC)? The most important principle underlying successful implementation of the cost of capital is consistency between the components of the WACC and free cash flow. Since free cash flow is the cash flow available to all financial investors, the companys WACC must also include the required return for each investors. 2. To assure consistency the cost of capital must meet three criteria which? * It must include the opportunity cost of all investors- debt, equity, and so on- since free cash flow is available to all investors, who expect compensation for the risks they take. * It must weight each securitys required return by its target market-based weight, not by its historical book value * Any financing-related benefits or costs, such as interest tax shields, not included in free cash flow must be incorporated into the cost of capital or valued separately using adjusted present value. 3. Write down the formula for calculating the WACC in its simplest form. WACC= (D/V) * Kd * (1-Tm) + (E/V) * Ke D/V= target level of debt to enterprise value using market-based (not book) values E/V=target level of equity to enterprise value using market-based values Kd= cost of debt Ke= cost of equity Tm= companys marginal income tax rate 4. The cost of equity is determined by three factors, which? * Risk-free rate of return

* Market-wide risk premium (the expected return of the market portfolio less the return of riskfree bonds) *Risk adjustment that reflect each companys riskiness relative to the average company (CAPM) 5. What model and what factor in that model is used to estimate the company specific risk? Model=CAPM Factor= Beta The CAPM adjusts for company-specific risk through the use of beta, which measures a stock`s co-movement with the market and represents the extent to which a stock may diversify the investors portfolio. 6. If an investmentgrade firm with infrequent traded bonds is to be valued, how do you calculate the cost for debt? What adjustment for tax is necessary? 1) Use the companys debt rating to estimate the yield to maturity 2) Since free cash flow is measured without interest tax shields, measure the cost of debt on an after-tax basis using the companys marginal tax rate. 7. What is the beta value? Beta represents a stocks incremental risk to a diversified investor, where risk is defined as the extent to which the stock covaries with the aggregate stock market. 8. If a company has a beta of 0.6 and the riskfree rate of return is 3.9 percent and the market risk premium is 5.4 percent, what is the cost of equity? 3,9+0,6*5,4=7,14

9. How do you estimate the riskfree rate? What time frame is most common? 1) To estimate the risk-free rate in developed economies, use highly liquid, long-term government securities 2) 10-year 10. With in what interval does the market risk premium for equity varies? 4,5% - 5,5% 11. Which are the three steps for calculating the historical market risk premium? Calculate the premium relative to long-term government bonds. When calculating the market risk premium, compare historical market returns with the return on 10-year government bond. Use the longest period possible. If the market risk premium is stable, a longer history will reduce estimation error. Alternatively, if the premium changes and estimation error is small, a shorter period is better. Use an arithmetic average of longer-dated intervals (such as 10 years). An arithmetic average sums each year`s observed premium and divides by the number of observations.

12. If returns are volatile, which calculation of the market risk premium gives the highest outcome the arithmetic (simple) average or a geometric average? Arithmetic average exceed geometric averages when returns are volatile 13. What is the survivorship premium and how high is it, calculated for the US stock market between 19002005? 1) Even properly measured historical premiums cant predict future premiums, because the observable sample includes only countries with strong historical returns. 2) 0,8% 14. In a study of US companies between 1962 and 2008 the inflation adjusted market return of equity was calculated. How high was it? How can you use this figure to calculate the market risk premium? How high was the market risk premium, calculated this way? How does that compare to the calculation in assignment 10, above? 1) 7% 2) By subtracting the current real long-term risk-free rate from the real equity return 3) 5,4% (7-1,4) 4) Within the range of 4,5-5,5% 15. When calculating beta for Home Depot, monthly data for five years was used. Why not weekly data? Why not a ten year period? Raw regression should be based on monthly returns. Using more frequent return periods, such as daily and weekly returns, leads to systematic biases The measurement period for raw regression should include at least 60 data points ( e.g., five years of monthly returns). In subsequent tests of optimal measurement periods, researches confirmed five years as appropriate. 16. If a stock is rarely traded, is it better to calculate beta on a monthly or a weekly basis? Monthly. Using daily or even weekly returns is especially problematic when the stock is rarely traded. An illiquid stock will have many reported returns equal to zero, not because the stocks value is constant but because it hasnt been traded. 17. Why is it unnecessary to calculate the beta using a global index, instead of a local well diversified index, like the S&P 500 or MSCI Europe? Because well-diversified indexes, such as the S&P 500 and MSCI World Index, are highly correlated. Thus, the choice of index will have only a small effect on beta. 18. When calculating the beta in Home Depot the result was that, within two standard deviations, the beta was between 0.85 and 1.71, which was not particularly useful. How did they proceed to come up with something more useful? In this concept there is one factor you need to adjust for, to come up with a beta for an individual company. Which factor?

1) To improve the precision of beta estimation, use industry, rather than company-specific, betas. Companies in the same industry face similar operating risks, so they should have similar operating betas 2) Leverage. To compare companies with similar operating risks, you must first strip out the effect of leverage. 19. If a company has debt below investment grade (rated BB or lower) what method is recommended when calculating the cost of capital? Adjusted present value (APV) based on the unlevered cost of equity rather than the WACC 20. What is the reason the calculation of WACC should rely on target weights for debt to value rather than current rates? The cost of capital should rely on target weights, rather than current weights, because at any point, a companys current capital structure may not reflect the level expected to prevail over the life of the business. 21. If a company has a debt to value ratio that differs from the target weight, in a simple scenario, how can you adjust your valuation? In the simplest scenario, the company will rebalance immediately and maintain the new capital structure. In this case, using the target weights and a constant WACC (for all future years) will lead to a reasonable valuation. 22. If you adjust your capital structure for debtequivalent claims, what other adjustment is necessary? Include operating leases in debt only if you plan to adjust free cash flow for operating leases as well. Consistency between free cash flow and the cost of capital is paramount. Any pension adjustment made to free cash flow must be properly represented in the debt portion of the cost of capital

Chapter 12: Moving from enterprise value to value per share.

1. Which are the most common nonoperating assets? What other nonoperating assets do you probably need to add, to end up with the total enterprise value? The most common non- operating assets are excess cash, non-consolidated subsidiaries (also known as equity investment) and financial subsidiaries. 2. If a nonconsolidated subsidiary, accounted for according to the equity method, is privately held how can you incorporate it in the enterprise value? You need to perform a DCF valuation separately for the subsidiarys equity. Adjust the cost of capital so it is consistent with the subsidiary company. When completed the valuation remember to only account for the value that the parent company holds in the subsidiarys equity.

3. Why is it necessary to treat a finance subsidiary, even 100 percent controlled, as a nonoperating asset in the enterprise value?

If you dont, it will distort ROIC, the cash-flow and ultimately the (your) perspective on the companys value.

4. How should you incorporate a discontinued business in the enterprise value? How do you value the discontinued business? Discontinued operations are business being sold off or closed down. Because discontinued operations are no longer a part of a companys operations, their values should not be in the model as a part of the free cash flow. The assets and liabilities associated with the discontinued operations are written down to their fair value and disclosed as a net asset on the balance sheet, so the most recent book value is usually a reasonable approximation.

5. How can you value tax losses carried forward and incorporate them in the enterprise value? Three types of Deferred tax assets, operating, non-operating and tax loss carry forwards. Only tax loss carry forwards should be valued separately. These losses can be used to lower future taxes. To value these forwards you need to create a account for accumulated tax loss carry forwards and forecast the development of this account by adding any future losses and subtracting any future taxable profits on a year-by-year basis. Discount the tax savings at the cost of dept.

6. What is the difference between the total enterprise value and the equity value? Enterprise value includes debt (market value of equity + market value of debt). Equity value (market value of equity)

7. How should you treat unfunded retirement liabilities when calculating the equity value? Unfunded retirement liabilities should be treated as debt equivalents and deducted from the enterprise value to determine equity value.

8. How should you treat a possible liability from pending litigation in the calculation of the equity value? Estimate the associated expected after-tax cash flows, and discount these at the cost of dept. See the book for more information. Page 286 first paragraph.

9. There are three methods used to value convertible debt in the calculation of equity value, which? Market value: Use if value per share is near market price and if the convertible bond is actively traded. Black-Scholes value, when the market is inappropriate, use Black-Scholes option-based valuation for convertible dept. See page 286

Conversion value: The conversion value approach assumes that all convertible bonds are immediately exchanged for equity and ignores the time value of the conversion option.

10. If the value of employee stock options are subtracted from the enterprise value as a nonequity claim, what other adjustment must be done to avoid double accounting? Hittar ej, ngonstans runt 288

11. If a subsidiary with a minority interest is publicly traded, how can you adjust for the minority interest in the calculation of the equity value? if it is not publicly traded? If the minority stake is publicly listed you must use the proportional market value owned by outsiders to deduct from enterprise value. You need to deduct the value of the third party minority stake in the subsidiary as a nonequity financial claim.

Chapter 13: Calculating and interpreting results

1. There are three steps to take, to secure the valuation model is technical robust, which? In the adjusted financial statements, the balance sheet should balance every year, both historically and in the forecast years. Check that net income flows correctly into dividends paid and retained earnings. In the rearranged financial statements, check that the sum of invested capital plus nonoperating assets equals the cumulative sources of financing. Is net operating profit less adjusted taxes(NOPLAT) identical when calculated top down from sales and bottom up from net income? Does net income correctly link to dividends and retained earnings in adjusted equity? Does the change in excess cash and debt line up with the cash flow statement 2. There are four steps to take, to secure the model is economical consistent, which? Are the patterns intended? For example, does invested-capital turnover increase over time for sound economic reasons(economy of scale) or simply because you modelled future capital expenses as a fixed percentage of revenues. Are future cash tax rates changing dramatically because you forecast deferred tax assets as a percentage of revenues or operating profit? Are the patterns reasonable? Avoid large steps changes in key assumptions from one year to another, because these will distort key ratios and could lead to false interpretations. For example, a large single-year improvement in capital efficiency could make capital expenditures in that year negative, leading to an unrealistically high cash flow. Are the patterns consistent with industry dynamics? In the end of the explicit forecast period, has the company reached its steady state?

3. If a group has multiple businesses in different business segment, how should that affect your valuation? Divide the business into different units so that you can use different forecast for different areas. If you value the company as a whole you risk missing critical trends and consequently distorting the valuation.

4. If a group has multiple businesses in different business segment, how should that affect your calculation of the cost of capital? Each business unit should be valued at a different cost of capital because systematic risk (beta) of operating cash flows will differ between business units.

Chapter 14: Using multiples to triangulate results

1. Why is it better to evaluate the valuation by using a multiple based on EBITA, than a multiple based on net earnings? - EBITA tells more about a companys value than any other multiple. The price-to-earnings multiple has two major flaws. First, the P/E is affected by a companys capital structure. Second, unlike EBITA, net income is calculated after non-operating items such as amortization of intangible assets and one-time gains and losses. 2. Within what interval did the EV/EBITmultiple fell for a majority of the nonfinancial companies in the S&P index in December 2009? What was the most frequent single EV/EBITmultiple at that time? - The majority fall between 7 times and 11 times EBITA. 3. Why EV/EBITA and not EV/EBIT? - EBITA leads to a better enterprise value multiple than EBIT does. Amortization is an accounting artifact that arises from past acquisition. Since it is not tied to future cash flows, amortization will distort an enterprise value multiple. 4. Why should you use a forward looking multiple, than an historical multiple? - When building multiples, the denominator should use a forecast of profits, rather than historical profits. Forward-looking multiples are consistent with the principles of valuation- in particular that a companys value equals the present value of future cash flow, not sunk cost. Second, forward-looking earnings are typically normalized, meaning they better reflect longterm cash flows by avoiding one-time past charges. Empirical evidence shows that forward-looking multiples are indeed more accurate predictors of value than historical multiples are. 5. There are two major techniques for finding the correct peer group to a company, which? - Standard Industrial Classification (SIC), contains more than 20 companies, many of which are not directly comparable because they sell very different products or rely on different business models. Second, Global Industry Classification Standard (GICS) system, recently developed by Standard & Poors and Morgan Stanley. A recent study found that GICS classifications do a

significantly better job of explaining cross-sectional variations in valuation multiples, forecast and realized growth rates, research and development expenditures and key financial ratios. 6. Compared to a EV/EBITAmultiple, what additional important restrictions does the Price/Salesmultiple require? 7. There are two cautionary notes about using nonfinancial multiples to analyze and value a company, which? - First, nonfinancial multiples should be used only when they provide incremental explanatory power above financial multiples. Second, nonfinancial multiples, like all multiples, are relative valuation tools. They measure one companys valuation relative to another, normalized by some measure of size. They do not measure absolute valuation levels.

Chapter 15: Market value tracks return on invested capital and growth
1. What is the average return on US equities the past 200 years, adjusted for inflation? - Total returns to shareholders of about 6 percent annually 2. What is the average P/Eratio in the US stock market over time? - A level of about 15 over the long term. 3. How much has real corporate profits in the US grown the last 70 years? - It has grown about 3 to 3 percent per year. 4. How much has corporate America reinvested each year? - About 50 percent of its profits every year to achieve this profit growth 5. If you take the factors 2, 3 and 4 above, what is the conclusion regarding the US equity markets longterm performance compared to economic fundamentals? 6. How has the actual P/Eratio for the US stock market developed since 1962, compared to the fundamental P/E calculated by the use of a DCFmodel? DCF-model fits the stock markets actual P/E levels over the 4 decades. (s.343-344) 7. What is the relationship between a companys achieved ROIC and the relative market value for a given level of revenue growth? At what level of ROIC does an increase in revenue result in a decrease in value? - When rates of ROIC fall below the cost of capital, higher growth leads to lower valuations. 8. Assume a three year investment horizon, what is most important for total return to shareholders a high ROIC or to exceed expectations? Within which timehorizon will probably a high achieved ROIC be the best investment tool?

- Expectation has a stronger influence on TRS over the short term. Over the long term, companies with higher ROIC and growth do tend to deliver stronger returns to shareholders.

Chapter 16: Managing earnings not worth the effort

1. Companies try to avoid earnings surprises in three ways, which? Which of the three affect current and future cash flow, and possible the value? Give an example. - 1) They sensibly try to lead analysts to adjust their earnings forecasts over time and in a controlled manner by gradually providing new information. 2) They manage the earnings number toward the analyst target, but in a manner that has no impact on value. 3) The last and more detrimental forms of earnings management involve changes to a companys business. These do directly affect current or future cash flows, and possible shareholder value. Examples include reducing marketing expenses, providing customer incentives, or deferring divestments to meet a profit target. 2. What was the conclusion regarding earnings volatility and market value in a research conducted by Koller and Rajan on 1500 European companies between 2000 and 2007? Did this study confirmed or rejected earlier studies? - The results confirmed their earlier results: variability in earnings growth rates had no meaningful effect on shareholder returns on value. 3. How much of total return to shareholders (TRS) over a five year period was explained by longterm earnings growth, ROIC and industry sector? How much of TRS was explained by earnings variability? - 34 percent. Earnings variability did not explain market performance measures to any significant degree at all. 4. How many companies in the study had stable earnings growth during the seven year period? How many had stable earnings growth for a four year period? - A handful had earnings growth that was steady for four or more years, and only one with seven years of steady earnings growth. 5. In a US study between 19921997, how large part of the share price volatility was explained by earnings surprises in the four weeks surrounding the announcement? How large part of the companies with positive earnings surprises had negative return? - Earnings surprises explained less than 2 percent of share price volatility. More than 40 percent of the companies had a negative return. 6. The a study 2007 long-term and short-term earnings revisions were studied. If a company failed to meet earnings expectations in one quarter, the share price normally did not fall. However, if one other factor was in place, the share price fell, which other factor? - Surprises on earnings per share 7. Did the change in accounting treatment of goodwill in the US in 2001, affect share prices?

- It affected the share price, but within two weeks the price had returned to normal.

8. In a research of 54 companies, writedown of goodwill was analyzed. What was the conclusion regarding the share price effect at the time when the writedown was announced? - They did not find a statistically significant drop in share price. Because the market had already anticipated the lower benefits from past acquisition and had reduced the stock price by an average of 35 percent in the six months preceding the write-off announcement.

9. In a research in the US the effect on share prices from stock splits was analyzed. What was the conclusion and what is the theory behind the effect? - Conclusion: the stock market reacts positively to stock split announcement because they signal higher future cash flows 10. What does academic research show, regarding the longterm and shortterm share price performance in companies that are either included or excluded from a share price index (like the S&P 500)? - In most cases neither inclusion nor exclusion gives a long term change in share performance. In short term, exclusion can bring down the share price and inclusion can bring up share prices, where some studies show that some of the gain can be sticky (s.375-376)

Chapter 17: Emotions and mispricing in the market

1. What three major patterns regarding share price deviations from fundamentals has the authors found? -Individual company share prices deviate significantly from the companys fundamental value only in rare circumstances typically when barriers to trading, such as too limited free float of shares, prevent rational investors from moving in to correct the price. - Market-wide price deviations from fundamental valuations, as in the dot-com boom of the late 1990s or the soaring prices triggered by expectations of unsustainable corporate profits in 2007, are even less frequent, although they may appear to be becoming more so. - They are usually temporary, market deviation gets corrected within 3 years and company-specific as long as the barriers hold. 2. What was the difference between the technology bubble in 2000 and the credit bubble in 2007? The high-tech bubble was a valuation bubble, in which the stock market priced companies at levels that were unjustified by underlying performance and growth; expectations of future earnings far above current earnings levels were unrealistic. The credit bubble was not a valuation bubble but an earnings bubble. Given the preceding performance and growth of companies, stock market values were not unreasonable. Unfortunately, that level of underlying performance was unsustainable (a fact that stock markets did not take sufficiently into account)

Chapter 19: Corporate portfolio strategy

1. What makes an owner the best? Explain the five factors that are recognized in the book, regarding what makes an owner the best. - Unique Links with other businesses owners can add value through links to other businesses within their portfolio, especially when only the parent company can make such links - Distinctive skills owners should have managerial skills from which the new business can benefit. Such skills have to be a key driver of success in the industry - Better governance owners can add value through better governance (=the way the companys owners interact with the management team to create maximum value in the long term) - Better insight and foresight insight into how a market and industry will evolve and then act on that insight to expand existing businesses or develop new ones - Influence on critical stakeholders This applies primarily to companies in emerging markets 2. In constructing the corporate portfolio, the authors suggest a fivestep strategy. Which are the five steps? - Determine the companys current market value and compare it with the companys value as is. Any gaps imply that the company managers have a different perspective on the value of the businesses than investors have. - Identify and value opportunities to improve operations internally e.g. by increasing margins, accelerating core revenue growth and improving capital efficiency - Evaluate whether some businesses should be divested - Identify potential acquisitions or other initiatives to create new growth and estimate their impact on value - Estimate how the companys value might be increased through changes in its capital structure or other financial strategy changes. Adding these increases to the level of value after step 4 gives the total potential value of the company 3. Why is diversification regarded as a myth? Because over the years different ideas have been floated to encourage or justify diversification but these theories simply dont hold water

Chapter 20;Performance Management: Which are the financial value drivers? A value driver is an action that affects business performance in the short or long term and thereby creates value. Value drivers include increasing the number of stores for a supermarket chain, reducing the levels of working capital for a consumer goods company and building employee loyalty in a software company. Long term growth, ROIC and Cost of Capital 1. Which are the short-term value drivers? Value depends on performance in the short term and the long term, so the value drivers must include those related to short-term performance and those related to long-term health of the business. A short-term value driver is to apply appropriate cost controls to manage shortterm earnings and cash flow. The business has to keep in mind the trade-offs between the delivery of short-term performance and the activities that build the long-term health of the business to sustain future performance. Increasing investment for the long-term will cause short-term returns to decline. Short-term value drivers of historical ROIC and growth: Sales productivity(growth), Operating cost productivity(ROIC), capital productivity(ROIC), s.431-432 2. Which are the long-term value drivers? Long term value drivers can be product development or increasing investment. Core business and growth opportunities Chapter 21; Mergers and acquisitions: 1. 2. 3. Some empirical studies have examined the stock market reaction to M&A announcements. What was the conclusion? The conclusion was that the value-weighted average deal lowers the acquirers stock price between 1 and 3 percent. The acquirers share price decreases in the 10-day window around the announcement of the transaction. 4. 5. Which are the three characteristics that can be identified that differentiate deals that are successful, in terms of the return to the acquirers shareholders? - Strong operators are more successful. Acquirers whose earnings and share price grow at a rate above the industry average for three years before the acquisition earn significant returns on announcement. - Low transaction premiums are better. Acquirers paying a high premium earn negative returns on announcement. - Being the sole bidder helps. Acquirer stock returns are negatively correlated with the number of bidders; the more companies trying to buy the target, the higher the price. 6. 7. Which are the five archetypes that constitute an acquisition that creates value? - Earn the right to acquire by having a strong core business. - Consider only targets for which you can improve future free cash flow. - Excel in estimating overall value creation. - Maintain discipline during negotiation. - Rigorously plan and execute the integration. Or: - Improve the performance of the target company - Consolidate to remove excess capacity from an industry - Create market access for the targets products

Acquire skills or technologies more quickly or at lower cost than they could be built inhouse Pick winners early and help them develop their business

8. How to pay for an acquisition- in cash or stock? What does the research show? What do the authors believe? When paying in cash. The acquirers shareholders carry the entire risk of capturing synergies and paying too much. If you exchange shares, the targets shareholders assume a portion of the risk. Two key issues should influence your choice of payment: - Whether you think the target or your company is overvalued or undervalued. If you believe your shares are more overvalued than the targets, they are valuable in their own right as transaction currency. - The more confident you are in the value creation, the more willing you should be to pay in cash. If the capital structure of the combined entity cannot take the debt from the original acquisition, you need to consider paying partially of fully in shares, regardless of the desired risk sharing. Chapter 22; Value creation from divestitures: 1. What is the conclusion from academic research, regarding a companys possibility to create value through divestures? Academic research provides abundant evidence for divestures potential to create value. A study of 370 companies found significant positive excess returns around the announcement of different types of divestitures. 2. According to a study of McKinsey, most executives seem to shy away from an active approach to divestures- why? Many managers dislike divestitures because these transactions reduce corporate earnings, also earnings per share may fall. But if another party is willing to pay more for the subsidiary than the value the parent company expects to get, the divestiture will create value and should be pursued. 3. If a company have the possibility to divest a business either through a private transaction or a public, what should they choose, and why? In most cases, companies should choose a private transaction if they can identify other parties that are better owners of the business. Private transactions allow the company to sell the business unit at a premium and capture value immediately. If the company cannot identify better owners, it will have to choose a public restructuring alternative. 4. What is the most common form of public restructuring of a business, and how is it conducted? The most common form of public ownership transactions is a spin-off. The parent company gives up control over the business unit by distributing the subsidiary shares to the parent shareholders. This full separation maximizes the strategic flexibility of the subsidiary and avoids conflicts of interest between the parent company and the business unit. 5. What is a carve-out of a business and what is the downside risk? Carve-outs are public transactions and a sale of part of the shares in a subsidiary to new shareholders in the stock market. If the company does not want to give up control, it should consider a minority carve-out. The downside is the possibility of unclear governance. If the parent enforces a minimum stake to retain control, this may restrict growth and value creation by the separated business, which would destroy the benefits that the carve-out was intended to deliver. These companies risk further conflicts as the business units executives pursue the best interests of their own company and shareholders.

Chapter 23; Capital structure: 1. What are the key benefits with increased leverage? - Tax savings. The most obvious benefit of debt is the reduction of taxes. Interest charges for debt are tax deductible. Replacing equity with debt reduces taxable income and therefore increases the value of the firm. - Reduction of corporate overinvestment. Debt can help require investment discipline in managers, especially in firms with strong cash flow and low growth opportunities. Overinvestment refers to managers not acting in the best interest of the shareholders and investing too much. 2. Is there an optimal capital structure in practice, and does it matter? There seems to be no exact answer. Managers can find meaningful indications of an effective capital structure, that is, a structure that is hard to improve on in terms of creating shareholder value. When it comes to credit rating, companies with the same rating can have very different capital structures across industry sectors because of different business risk. 3. How many of the companies in S&P: s population has credit ratings between A+ and BBB-? 72 % of the companies have these credit ratings and that is the vast majority of the companies. 4. What does a stable credit rating imply for the possibility to use gearing to increase value? Companies with a credit rating of AAA to BBB- are in the range of being able to use gearing. Below the BBB-rating level interest rates are much higher because many investors cannot invest in debt that is not investment grade. Investment grade means that the company has a relatively low risk of default and sub investment grade means the opposite. Companies need to have a stable credit rating above BBB- in order to finance it operations using gearing. 5. What analysis does a company need to perform to create an effective capital structure? To find an effective structure, you can use several reference points: - Peer group comparison. By analyzing what capital structure most companies in the peer group have, you obtain at least some understanding for what a reasonable capital structure could be. - Credit-rating analysis. By analyzing only peers with investment-grade credit ratings and determine what it takes to achieve such a rating. This allows you to set a target structure and also asses how your credit rating would be affected if you deviated from that target structure. - Cash flow analysis. Carefully analyze future cash inflows and outflows and the capital structure implications. Every company faces different investment needs, dividend policies and other considerations. 6. What is the default probability in the highest and the lowest investment grade category, according to Standard and Poor? AAA has a default probability of 0,12. A BBB company has a probability of 3,84 . (Moodys: 0.12 2.16) 7. There are three types of interest coverage ratios, which? - EBITA/Interest. Measures how many times a company could pay its interest commitments out of its EBITA. - EBITDA/Interest. Measures available cash flow before any capital expenditures and taxes.

Net Debt/EBITDA. When interest rates are comparable across companies, so-called debt coverage, net debt to EBITDA, is sometimes used instead of interest coverage. It measures the companys ability to service its debt in the short term.

8. What median interest coverage ratio (EBITA/Interest) has companies in the group S&P AAA rating (approximately)? What is the median ratio for companies in S&P BBB and BB rating respectively (approximately)? AAA = EBITA/Interest = 25 BBB = 7 BB = 3

9. What are the drawbacks in using leverage (debt to market value of equity) as a way to measure and target a companys capital structure? First, companies could have very low leverage in terms of market value but still be at a high risk of financial distress if their short-term cash flow is low relative to interest payments. High growth companies are usually at very low levels of leverage, but this does not mean that their debt is low risk. A second drawback is that market value can change radically making leverage a fast moving indicator. 10. Investors typically interpret share repurchases positively for four major reasons, which? 1. Buying back shares indicates to investors that management believes that the companys shares are undervalued. 2. A share buyback shows that managers are confident future cash flows are strong enough to support future investments and debt commitments. 3. It signals that the company will not spend its excess cash on value destroying investments. 4. Share buybacks can result in lower taxes for investors than dividend payments in countries where capital gains are taxed at lower rates. 11. How is financial engineering defined by the authors? Financial engineering is defined as managing a companys capital structure for maximum shareholder value with financial instruments beyond straight debt and equity. It represents more than simply setting the most effective leverage or coverage level. Financial engineering typically involves more complex and sometimes even exotic instruments such as synthetic leasing, mezzanine finance, securitization, commodity-linked debt, commodity and currency derivatives and balance sheet insurance. These instruments are not discussed in the book, instead on the conditions under which financial engineering can create real value for shareholders. This can happen directly through tax savings or lower costs of funding, but also for example by increasing a companys debt capacity so that it can raise funds to capture more value-creating investment opportunities. Or: Managing a companys capital structure or maximum shareholder value with financial instruments beyond straight debt and equity. 12. Which are the three groups of financial instruments that are used? 1. Derivatives. Derivative instruments such as forwards, swaps and options enable a company to transfer particular risks to third parties that can vary these risks at a lower cost. 2. Off-balance sheet financing. Includes a wide range of instruments such as operating leases, synthetic lease, securitization and project finance. They have the common element that companies effectively raise debt funding without carrying the debt on their own balance sheet.

3. Hybrid financing. Involves forms of funding that share some elements of both equity and debt. Examples are convertible debt and convertible preferred stock.

Chapter 25: Taxes 1. The majority of corporate taxes are related to earnings (the statutory rate), but the authors gives some examples of nonoperating tax effects that are not included in the statutory rate, which? Non-operating taxes: Foreign-income adjustment, R&D tax credit, Audit revision etc. 2. There are two unsuitable alternatives to calculating taxes, which? 2 incorrect, yet common in practice: Use companys statutory tax rate Computing operating taxes by multiplying operating profit by the companys statutory tax rate typically leads to an upward-biased estimate of operating taxes, because it fails to recognize that foreign levels are often taxed at different levels. Use the companys effective rate with no adjustments Applying the effective tax rate to operating profit handles foreign earnings properly but does not exclude one-time nonoperating items. This can lead to biased and volatile estimates of operating taxes. 3. What is the problem with using the statutory rate? It relies heavily on properly matching each non-operating item with the appropriate marginal tax rate, a very difficult achievement in practice (relies on inadequate information). The unsuitable or more simple methods mentioned above may in practice lead to fewer implementation errors than the statutory rate. 4. What is the problem with using the effective tax rate? Applying effective tax rate to operating profit handles foreign earnings properly but does not exclude one-time nonoperating items, which can lead to biased or volatile estimates of operating taxes. 5. How can we convert operating taxes to operating cash taxes? To convert operating taxes to operating cash taxes (based on the operating taxes actually paid in cash to the government), subtract the increase in net operating deferred tax liabilities from operating taxes. Chapter 26: Nonoperating expenses 1. Which are the typical nonoperating expenses? Amortization expense, restructuring charges, unusual charges (such as litigation expense), asset write-offs, goodwill impairments, and purchased R&D. 2. Describe the three step process to find nonoperating expenses. - Reorganize the income statement into operating and non-operating items (items that grow in line with revenues and are related to the core business are treated as operating) - Search the notes for embedded one-time items (not every one-time charge will be disclosed in the consolidated income statement) - Analyze each extraordinary item for its impact on future operations (Its critical to analyze each non-operating line item separately and determine whether the charge is likely to continue in the future because if it does it should be included into FCF projections) 3. How should you treat amortizations of acquired intangibles when calculating NOPLAT?

When calculating NOPLAT you should NOT deduct amortization from operating profit (use EBITA not EBIT to determine operating profit). Since amortization is excluded from operating profit, remember to include the cumulative excluded amortization in your total for intangible assets on the balance sheet. Why not amortize intangibles? Only acquired intangibles are capitalized and amortized, while internally generated intangible assets, such as brand and distribution networks, are expensed when they are created. 4. What effect has writedowns of goodwill on ROIC the coming years? What is the recommended treatment to avoid this? ROIC can rise dramatically following a write-down of goodwill. To counteract this effect, goodwill impairments are treated as non-operating and cumulative impairments are added back to goodwill on the balance sheet. 5. Which are the two major writeoffs? Goodwill and R&D 6. Is restructuring charges operating or nonoperating? What is important in that decision? Restructuring charges can be employee layoffs, inventory write-downs, asset write-offs. I a restructuring charge is unlikely to recur, treat the charge as non-operating. If a pattern of ongoing restructuring charges emerges, further analysis is required. 7. Is litigation charges operating or nonoperating? What is important to consider? Litigation charge when theres a legal judgment against the company. If this charge recurs frequently and grows with revenue treat it as operating. If its a one-time expense treat it as non-operating and value any claims against the company separately from core operations. 8. Why should gains and losses on the sale of assets be treated as nonoperating? When an assets sale price differs from its book value the company will recognize a gain or loss. Since current gains and losses are back-ward looking (value has been created or destroyed in the past), treat them as non-operating. Double-check though, to make sure projected FCF will not be distorted by the asset recently sold. 9. The authors categorize provisions into four categories, which? Provisions are noncash expenses that reflect future costs or expected losses. Provisions related to ongoing operations, long-term operating provisions, one-time restructuring provisions, income-smoothing provisions. 10. In what category does restructuring charges fall into and what is the preferred treatment in NOPLAT, invested capital and in valuation? Restructuring charges fall into the category one-time restructuring provisions. The treatment in NOPLAT is to convert accrual provision into cash provision and treat as non-operating. Invested Capital treatment treat reserve as a debt equivalent.

Treatment in valuation deduct reserves present value from the value of operations. Chapter 27: Leases, pensions and other obligations 1. Which are the two most common forms of offbalancesheet debt? Operating leases and securitized receivables. 2. What effect has an operational lease on profits and assets, compared to owning the asset? When a company borrows money to purchase an asset the asset and the debt are recorded on the companys balance sheet and interest is deducted from operating profit to determine net income. When a company leases that same asset from another organization (=the lessor) and the lease meets certain criteria, the company (=lessee) records only the periodic rental expense associated with the lease. The operating profit for the lessee will be low (because rental expenses include an interest expense) and the capital productivity will be high (because the assets dont appear on the lessees balance sheet). The net effect is an increase in ROIC (because the reduction in profit will be less than the reduction in invested capital). 3. Which are the three steps in adjusting financial statements for operating leases? - Reorganize the financial statements by: Capitalizing the value of leased assets on the balance sheet and make a corresponding adjustment to long-term debt. Do also adjust operating profit by removing the interest in rental expenses. - Build a WACC that reflects adjusted debt-to-enterprise value. To do this use an adjusted debt-to-value ratio that includes capitalized operating leases. - Value the enterprise by discounting FCF (based on these new reorganized financial statements that you have created) at the adjusted WACC. Subtract traditional debt and the current value of operating leases from enterprise value to determine equity value. 4. Explain receivables securitization. A less common form of off-balance-sheet debt = a process where the company sells its accounts receivable to another company (a third party or a subsidiary). Although the receivables are legally owned by someone else the original company continues to process and collect them. By doing this the company will reduce accounts receivable on the balance sheet and increase cash flow from operations on the accountants cash flow statement. But this improvement is misleading. 5. Why is the improved keyratios from a receivable securitization misleading? Because in reality, the company pays a fee for the arrangement, reduces its borrowing capacity and pays higher interest rates on unsecured debt. To determine return on capital, FCF and leverage, add back securitized receivables to the balance sheet and make a corresponding increase to short-term debt. 6. Which are the three steps involved in how to incorporate excess pension assets and unfunded pension liabilities into enterprise value? - Identify excess pension assets and unfunded liabilities on the balance sheet. If the company doesnt separate pension accounts, search the pension footnote for their location. Excess pension assets should be treated as non-operating and

unfunded pension liabilities should be treated as debt equivalent. - Add excess pension assets and deduct unfunded pension liabilities from enterprise value. Valuations should be done on an after-tax basis. - To reflect accurately the economic expenses of pension benefits given to employees, remove the accounting pension expense from cost of sales, and replace it with the service cost and amortization of prior service costs reported in the notes. The pension expense, service cost, and amortization of prior service costs are reported in the companys notes.

Chapter 28: Capitalized expenses 1. There are three reasons for capitalizing R&D, which? - To represent historical investment more accurately or else an understatement of capital (by expensing items with long-term benefits) can for example boost ROIC making the business seem more attractive than it really is. - To prevent manipulation of short-term earnings. A manager looking to meet shortterm earnings targets can simply reduce R&D (when R&D is expensed, reductions in current R&D flow immediately through the income statement) - To improve performance assessments of long-term investments (you can set R&D budgets at a fixed percentage of revenue. For a company with stable costs and a fixed R&D budget, operating margins will remain constant regardless of the companys growth rate) 2. Will the accounting treatment of R&D affect the valuation of the company why or why not? Even though changing the accounting treatment of R&D can change perceptions of a companys performance it will not affect the companys valuation. FCF (cash outflows related to R&D will appear either in the income statement or in the investing section when capitalized) and valuation are unaffected by how R&D is treated. 3. What other expenses are suitable for capitalization? A few other intangible investments other than R&D are publicly reported which is why this discussion has been limited to R&D. But if you have internal company data you can apply the same process to any expense resulting in long-term benefits.

Chapter 30: Foreign Currency

1. Which four issues arise in crossborder valuations? - Forecasting cash flows in foreign currency (the currency of the foreign entity to be valued) and domestic currency (the home currency of the person doing the valuation) - Estimating the cost of capital in foreign currency - Incorporating foreign-currency risk in valuation - Using translated foreign-currency financial statements 2. Describe the so-called spot rate method for valuing foreign cash flows. Projects foreign cash flows in the foreign currency and discounts them at the foreign cost of capital. Then converts the present value of the cash flows into domestic currency using the spot exchange rate.

3. How does the spot rate method differ from the forward rate method? Forward rate method: Projects foreign cash flows in the foreign currency and converts these into the domestic currency using the relevant forward exchange rates. Then discount the converted cash flows at the cost of capital in domestic currency. 4. What inflation and interest rate assumptions should a Swedish company use, when estimating the WACC when valuing cash flows coming from the euro area Swedish based or euro based? The most important rule when you are estimating costs of capital for foreign businesses is to have consistent monetary assumptions. The expected inflation that determines the foreign-currency cash flows should equal the expected inflation included in the foreign-currency WACC through the risk-free rate. In all other aspects, estimating the WACC for a foreign entity is the same as estimating the WACC for a domestic entity. 5. What is best analyzing the historical performance for a foreign business in the foreign currency or in the parent companys currency? Analysis of historical performance of foreign businesses is best done in the foreign currency. But sometimes when the business statements of the subsidiary has been translated into its parent companys currency and included in the parents accounts it is not possible to follow this rule. A British subsidiary of a European corporate group will always prepare financial statements in pounds and when the European parent company prepares its financial statements it will translate the pounds at the current euro-pound exchange rate (if theres a lot of fluctuations from year to year, it would lead to a cash expenditure)