Documente Academic
Documente Profesional
Documente Cultură
net
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Who?
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When?
Section A
Section B
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Attending OtherSSections:
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Check with.B
me first . Usually No
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Problem
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What?
Primary Objectives
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What My objectives
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You have many commitments But, the lowestcost, lowest effort approach to benefit from and
cruise through this class is to attend class.
Basically, I am serving it to you on silver platter.
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Why?
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This W
information will be extremely useful for your
job
Winterviews and your job.
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How?
Coursepack
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Lecture Notes & ClassEHandouts
V
S
Also accessible through
the class server prior to
S
each class. .B
If you are missing material for a
particularW
class, please obtain them from the Web
Wsure you do not fall behind.
to make
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How Grading
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50 pts
200 pts
150 pts
100 pts
500 pts
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How Assignments
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Performance evaluation
Competitive analysis
Investment decisions
Valuation of targets
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Stock recommendations
Lenders
Loan decisions
Monitoring
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Investment bankers
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Combine that understanding
with financial statement
S
information .to
Bdiagnose problems and come up with
solutions/recommendations
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It is not easy to make money
above the expected rate for
return for a given levelSofV
(beta) risk.
S
Trading strategies
are
not free of risk (Long Term Capital).
B
.
Regardless W
of your allegiance, knowing state-of-theW and lingo from the The Street (postart techniques
W announcement drift, PEG ratio, B/M effect)
earnings
will certainly help get you a great job!
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15.535
Class #2
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Valuation
Basics
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Homepage Address
http://mit.edu/wysockip/www
Or
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(ClickSon
V Analysts)
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CheckW
here for examples of projects
fromWprior years.
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Where Next?
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Readings for Class #3E(Tuesday)
Cash
V
Flow Analysis
S
S
Skim Section.B
D of Course Pack: Income versus
W
Cashflow
W
Reminder
W to form teams for project
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Market Efficiency
Financial Statement Information used for:
Valuation
Contracting
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Today lay the S
groundwork
for valuation
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Take baby steps
.B by end of class will have
Wto do a full-blown valuation
basic tools
W
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Expected future
cash
flows
versus
B
.
actual future
W cash flows
W
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N
I
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If a company has a great
idea that will generate
E
V
huge profits, competitors
soon will follow!
S
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Barriers to entry,
first-mover advantage, monopoly
B
.
W generate its future sales,
How will Compaq
W
profits,
cash
flows?
W
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N
P/E multiples, PEG ratios,
price targets
I
.
E
These all are transformations
of
DCF.
V
S
S
Other factors
.Bthings like real options are
W to basic DCF model!
just extensions
W
W
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V
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(Obtain r from
S
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http://research.stlouisfed.org/fred/data/irates.html
PV = $100/(1+0.0136)
PV = $98.66
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PVToday=E(CF1)/(1+r)
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Use a higher discount
rate
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Systematic
risk is only relevant!
W
Discount rate only determined
WCAPM
diversifiable risk.
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PV = 10/(1.10)+10/(1.10)
+10/(1.10)
.B
W + 8.26 + 7.51 = $24.86
PV = 9.09
W
W
2
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Perpetuity Formula:
P = CF/r = E/r
CF= Free Cash flows, E = Earnings
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E
V
These are nominal
amounts.
S
S
The discount
.B rate also takes into account
inflation.W
W
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PV = CF/(r-g)
PV = 10/(0.12-0.05)
PV = $142.86
S
.B
W
Warnings!!!
W
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PV = CF1/(1+r)+CF2/(1+r)2+CF3/(1+r)3+
V
S
S
.B
Growing Perpetuity:
W
PVW
= CF/(r-g) (1 CF at end of year 1, then grow at g)
W
Understanding
P/E ratio (just restating DCF!)
st
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Warnings!!!
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All Investors? (Shareholders
and Lenders)?
E
V
Known as Enterprise
Value
S
S
.Bsame: PV = CF/(1+r), but
DCF looks the
W
CFs are usually different for equity versus enterprise.
W
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Risk is different.
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Valuation
1) Equity valuation:
Forecast free cash flows available to equity.
Discount expected cash flows by the cost of equity
capital.
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Forecasting CFs
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V
S EBITDA to keep it simple,
Some analysts S
forecast
but this is a simply
.B an approximation.
W
W
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2) Enterprise valuation
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Assume future average CapEx=Depreciation
E
V
Assume constant average
debt (Issue=Repay)
S
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Steady state working
capital accruals average to zero.
B
.
Therefore,
WFree Cash Flow to Equity = Net Income
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PV = CF/r OR
PV = CF/(r-g)
WARNING: This is the present value standing in
year 4! This terminal value that must be
discounted back to the present
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Step 4:W
Calculate
PV of all cash flows
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N
I
. a based on the
Note that each case isE
just
simple ideas we discussed
in class today!
V
S
S
Reading for next
class: Skim pages 69-88 of
B
.
Section D of
Course
Pack: Income versus
W
Cashflow
(from Financial Reporting and
W
Statement
W Analysis Stickney and Brown)
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Class #3
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Quickie Announcements
V
S
S
.B
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affecting
N
I
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E
V
S
Changes in receivables
and inventories
S
.B and potential fraud/manipulation
Real changes
Win accounts payable and taxes
Changes
W
payable
W
Depreciation
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Sales
Net
Income
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V
S
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CFO
Investing CF
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Financing CF
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Example
$6,295
Adjustments
Depreciation and amortization
Increase in Accounts Receivable
2,868
(422)
N
I
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E
Increase in Inventories
Increase in Accounts Payable
S
.B
V
S
2,061
11
342
Other
(1,795)
244
$9,604
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N
I
.
E
= 6,295 [422+1,795-2,061-11] +
V
S
S
= 6,295 422
.B - 1,795 + 2,061+ 11 +
W
W
= 9,604
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$10.3
(7.7)
$2.6
N
I
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The next year, 50-Off Stores
changed the
E
V
classification to operating
activity
S
S
Comparison: The
Gap,
Inc.
Annual
Report
B
.
W
W
W
Costs associated with the opening or remodeling of stores, such as preopening rent and payroll, are expensed as incurred. The net book value of
fixtures and leasehold improvements for stores scheduled to be closed or
expanded within the next fiscal year is charged against current earnings.
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1997
1999
N
I
.
2000
2001
2002
E
V
-5
S
S
-10
CFO
EBX
.B
-15
Year
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N
I
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E
Overcapitalization
V
S
S
.B
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Operating Section
Consider year ended December 31, 2002
GAAP NI = ($149M)
Pro forma net income = ($66M)
Cash flow from operations = $174M
Question: What are main reasons for difference?
Why would Amazon focus on Pro forma
numbers in its press releases?
N
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E
V
S
S
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Investing activity
Managements expectations
Increased investments if high growth is forecasted
N
I
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E
Capital intensive
V
S
Distribution/retailing
S
.B
Leased outlets
Capital leases or operating leases
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Investing activity
What does cash largest inflow come from?
Does this provide useful information about
operational investments?
N
I
.
Compare 1999 to 2002
for Sales vs
E
V
Purchases of marketable
securities:
S
S
What does
this
.B tell us about cash-burn?
W
W
W
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Financing activity
Effect of the nature of business
Who finances with debt?
Growth options versus assets in place
N
I
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E
V
S
S
.B
W
Growth associated with investing and financing
W
W
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Financing activity
N
I
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E
V
S
S
.B
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N
I
.
Take current financial statements
(Income
E
Statement, Balance V
Sheet and Statement of Cash
S
Flows) and project
into the future
S
B are sustainable trends and what things
.
Key Issue: What
are transitory?
W
How
much reinvestment is required now (or in the future)
W
to maintain and grow the business?
W
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Unlevered FCF
N
I
.
E
V
S
S
.B
W
Waste
WManagement example
W
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Industry:
N
I
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E
V
S
S
.B
W
Peer
W firm comparison
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N
I
.
E
V
S
S
.B
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Airlines
Cash flow from operations is large
compared to Net Income, even in loss
years
Large depreciation and large investing
amounts
Debt financing
N
I
.
E
V
S
S
.B
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Retailers:
Walmart: Large wedge between CFO and
Net income: Why?
Compare to Abercrombie and Fitch
ANF
2000
Net Income
$158M
CFO
S
.B
V
S
N
I
.
E
$152M
1999
1998
$149M
$102M
$153M
$169M
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I
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E
V
S
S
.B
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Class #4
for Valuation
N
I
aka EBO Valuation
or
.
E
Abnormal Earnings
Valuation
or
V
S
S
Residual
.B Income Valuation
W
W
W
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we going?
Today
N
I
.
E
V
S
S
.B
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Dell Valuation
N
I
.
Must estimate earnings, cashflows,
balance sheet items.
E
Must avoid the pitfalls ofV
misleading financial reports
S
managers may want
to
fool you.
S
B growth, etc.
Must estimate risk,
.
Yahoo! data
Wand analysts estimates are a crutch right now.
W
W
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Performance Measurement?
N
I
.
E
V
S
S
.B
Qualifications?
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N
I
= Net Operating Profit after tax. Capital charge
E
V
S
S
Residual Income
for
Equityholders:
B
.
= Net Income Capital charge
W
W
W
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N
I
.
E
V
S
S
.B
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Intuition:
N
I
.
E
V
S
S
Abnormal return
.B on Invested Capital
W
W
W
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The Model
N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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Earnings Valuation
N
I
.
E
V
S
r = Rf + E* [E(RM) - Rf ] where
Rf = Riskless return
E = Beta on common stock
E(RM) Rf = Expected risk premium on market portfolio
S
.B
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Steps - Continued
N
I
.
E
V
S
S
.B
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PERPETUITY METHOD
Estimate AE in year T+1
Assume AE constant beyond year T+1
N
I
.
E
V
S
S
.B
12
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N
I
.
E
V
S
S
.B
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Example.
Inputs:
BV0 = $1.80 (Book value of equity per share at the
end of the 3rd quarter of fiscal year. From latest
financials on Yahoo!
http://biz.yahoo.com/z/a/d/dell.html
N
I
.
E
V
S
S
.B
E1 = $0.99
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Example.
Inputs:
% 5 year growth in EPS is projected to be: 15%
N
I
.
E
V
S
Cost of Capital (from
CAPM)
S
.B
R = Rf + Beta*(Rm-Rf)
= 5% +W
1.79*(8%) = 19.3%
W
W
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Example.
Calculations:
BV3=
BV4=
BV5=
N
I
.
E
V
S
AE3 = ?
AE4 = ?
AE5 = ?
S
.B
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Example.
Final Calculation:
P = BV0 + AE1/(1+r) + AE2/(1+r)2 + PV of future AE?
N
I
.
In this case, lets assume
AE 0 in year 9:
E
V
S
S
P = 2.03 + 0.60/(1+r)
B + 0.56/(1+r) + 0.51/(1+r) +
.
0.45/(1+r)
W+ 0.38/(1+r) + .
W
W
2
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0.2
Mean Earnings
0.15
z
z
z
0.1
0.05
V
S
`
S
.B
-0.05
W
-3 -2 -1 0 1 2
W
Event Year
-0.1
-5 -4
N
I
.
E
`
Low Earnings
Portfolio
High Earnings
Portfolio
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in the Future?
N
I
.
E
V
S
Potential Problems:
S
What if Book.B
Value of Equity (BV) is incorrectly
measured?
W
Why W
might BV be too low?
W
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N
I
.
What is current price of DELL?
Around $23.00
E
V
S
S
Is our assumption
about future AE valid? Why?
B
.
W
W
W
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N
I
.
E
V
S
S
.B
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Valuation
N
I
.
E
V
S
do generate cashflows!
AEt = Et r*BVt-1
Intangibles:
patents,
R&D,
trademarks,
brandnames, etc.
S
.B
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Intangibles
Intangibles:
N
I
.
E
V
Patents, trademarks,
brandnames, etc.
S
S
Account for investments
in a factory?
.B
Account W
for investments R&D, advertising,
W training?
employee
W
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Real Options
N
I
.
E
V
S
S
.B
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N
I
.
Consider the type of assets
on the balance sheet
E
tangible versus intangible
(cash versus brand-name)
V
S
What type of assets
are valuable if firm crashes?
S
B
The Worst .Case
Scenario valuation of assets on
balanceW
sheet . Explains why balance sheets often
have conservative valuation of assets (Historical cost).
W
W
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Where Next?
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N
Class.I#5
E
V
Comparative
Analysis
S
S
.B
W
W
W
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Announcements
Assignment #1:
Hand in at start of class on Tuesday, Feb, 25th.
2 page memo (any format)
Complete individually or in group of up to 3 people
N
I
.
Valuation Projects (Post
tomorrow at NOON):
E
V & due diligence
Teams, company S
choices
matches can B
beSfound on Sloanspace.
.
W
W
W
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DCF Analysis
Equity Valuation
All valuation models based on DCF framework.
Key is to estimate future cashflows.
Earnings are generally the starting point and then we can back
out cashflows.
Abnormal Earnings (or EBO or Residual Income) Valuation is a
DCF-based model that relies on accounting earnings.
N
I
.
E
V
S
S
.B
Draw time-line!
Summary of Assumptions
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N
I
.
E
V
S
S
.B
W
Financial
W Ratio Comparisons
W
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Valuation Comparison:
DCF Limitations
N
I
.
E
. DCF is tough!
V
S
S
.B
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Earnings Multiple
99%
P-E
97%
Relative P-E
35%
Revenue Multiple
15%
N
I
.
E
Price-to-Book
V
S
CF Multiple
DCF
S
.B
13%
13%
W
Model
W
EVA
25%
2%
4%
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Assume all firms have the same risk (systematic & industry).
Assume cashflow growth is similar for all the firms.
Assume accounting techniques to calculate earnings (or
book equity or sales or EBITDA) are similar for all the firms.
N
I
.
E
V
S
S
.B
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Use of Multiples:
N
I
.
E
Steps:
V
S
S
.B
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Approach to Multiples
N
I
.
E
V
S
S
.B
W
How toW
identify comparables?
W
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P/E Multiples
or
P/E = 1/(r-g)
N
I
.
E
V
S
S
.B
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P/E Multiples
N
I
.
E
V
S
S
.B
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P/E Multiples
Operating Income
Special or Unusual Items (usually negative)
Either infrequent or not part of normal business
Extraordinary Items (usually negative)
Both infrequent and not part of normal business
Use Price to operating cash flow (does not contain
one-time accounting items)
N
I
.
E
V
S
S
.B
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P/E Applications
N
I
.
E
P/E=1/(r-g)
V
S
S
.B
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PEG ratio:
N
I
.
E
B
.
Apple WIndustry
W 1.80
6.11
W
Sector
1.88
S&P500
1.36
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
W
WhatW
do you expect the M/B to be?
W
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N
I
.
E
V
S
S
.B
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Guideline approach
N
I
.
Enterprise/Revenue, P/Sales
E
V
Price to clicks, Price
to subscribers, Price to page
S
S
views, etc
B
.
Problems:
1) Are these measures of future
W
cashflows?
W 2) What if all prices are wrong?
W
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Ratios: Valuation
S
.B
Profitability ratios
Short-term liquidity ratios
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Profitability Ratios:
N
I
.
E
ROA =
V
S
Net Income
+ (1 - Tax Rate)(Interest Exp)
S
.B Average Total Assets
W
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Return on Assets
N
I
.
E
V
S
S
.B
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S
.B
V
S
N
I
.
E
___ Sales___
Average fixed assets
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N
I
.
E
V
S
S
.B
Or
ROE
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Decomposition of ROE
Common
ROE =
ROA
Earnings
Leverage
(CEL)
N
I
.
E
Capital
x Structure
Leverage
(LEV)
V
S
NI Avail to Common / Avg
CEquity
=
S
B
.
(NI*/Avg TA)x(NI Avail
W to Common/NI*)x(Avg TA/Avg CEquity)
W
W
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Du Pont Analysis
N
I
.
E
V
S
S
.B
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Current Assets
Current Liabilities
Matches the amount of cash & other current assets that will
N
I
.
E
V
S
S
.B
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Liabilities Ratio
N
I
.
E
V
S
S
.B
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Long-Term Debt________________
Debt/Equity =
Ratio
Long-Term Debt
Shareholders Equity
N
I
.
E
V
S
S
.B
Ratio
Total Assets
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Analysis
N
I
.
E
V
S
S
.B
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Where Next?
N
I
.
E
V
S
S
.B
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Class #6
Turbo Accounting:
Reading FinancialNStatements
I
.
E
V
S
S
.B
W
W
W
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Where Now?
Where Next?
N
I
.
E
V
S
S
.B
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N
I
.
E
1) Balance Sheet
2) Statement of Income
3) Statement of Cash Flows
4) Statement of Shareholders Equity
V
S
S
.B
Footnotes
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Where Next?
N
I
.
E
V
S
S
.B
Handout W
Today: Sample Questions for
W
Quiz
W#1
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Class #7
Books
N
I
.
E
V
S
S
.B
W
W
W
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Announcements
Team Projects:
N
I
Provide hints/guidance today and
during Tuesdays class.
.
E counterparty part 1 of your
E-mail me and your due V
diligence
S
Teams Project Report
by noon on Friday, March 7.
S
I will be in on.B
Sunday starting by noon, to answer
questions W
about Part I of the project
W
W
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N
I
.
E
V
S
S
.B
Current Year
Next 5 Years
Years 5-10 (or 20) . If necessary
Cash flows in perpetuity (growing perpetuity)
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N
I
.
techniques
E
V
Excessive accruals
Wedge between CFO and Operating Income
Growth in receivables that exceeds growth in sales
S
S
.B
W
SEE PROJECTS
W FROM PRIOR YEARS ON WEB
W
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management/manipulation
N
I
.
E
V
S
S
.B
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Litigation
SEC fines
N
I
. In the end, there usually is. a settling up.
E
Do companies learnV
from mistakes of others?
S
S
Fast-forward to now:
B
2001: Lucent. Technologies
W
2002: Worldcom
W
W
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N
I
.
E
V
S
Expensing cost of inventory
that will not be sold until future.
S
Over depreciating
.Bassets with long lives.
W sales that have already occurred.
Delaying recording
W
W
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Red Flags
N
I
.
E
V
S
S
.B
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Industry-Specific Manipulation:
Computer/Telecom Hardware:
Technological change: impact on receivables & inventory,
appropriate depreciation allowances?
Retailing:
Are accounts receivables questionable?
Do sales factor on rebate programs?
Warranties liabilities
N
I
.
E
V
S
Subscription Services:
S
.B
W
Real Estate:
W
Carrying
W values for real property
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V
S
S
Fulfillment costs
(Amazon.com)
B
.
W
Swap Transactions:
W
See
W Handout
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Big Bath:
Take big write-off today to set up the books for the future
PROBLEM: Investors may forget write-off, Expenses are
Vendor Financing:
N
I
.
Make loans to customers with
questionable ability to
E
repay loans
V
S
Understate bad debt
reserves (ie Lucent)
S
Profits too high
.B today . Big potential losses in future.
W
Booking Revenues
Too Early:
Wagain SEC SAB 101 Statement!
Check
W
Classic cases of Cendant and Microstrategy
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N
I
.
E
V
S
S
B make periodic payments if plan is
Company must
.
underfunded
W
BIG
WQUESTION: Is it underfunded or overfunded
WThis vagueness creates the cookie-jar for managers
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Expectations Management of
N
I
.
E
V
S
S
.B
15.535 - Class #7
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V
S
S
.B
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Class #8
Detecting Earnings
Management
N
I
.
E
V
S
S
.B
W
W
W
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N
I
.
E
V
S
S
.B
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management?
Creditors
Suppliers
Etc
N
I
.
E
V
S
S
.B
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Management of Analysts!
N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
Vol(Op Inc) = stdev(Op Inc over 5 years)/average (Op Inc over 5 years)
Vol(CFO)
stdev(CFO over 5 years)/average (CFO over 5 years)
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25.2%
N
I
.
E
V
S
S
.B
Vol(Op Inc)/Vol(CF0)
26.4%
23.9%
18.2%
27.4%
22.2%
17.9%
28.0%
19.6%
16.9%
29.9%
34.8%
26.1%
24.20%
32.64%
74.13%
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Earnings Management
N
I
.
E
V
S
S
.B
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Where Next?
computers/PDAs/cellphones, pagers!
Bring a calculator
50 minutes long.
Priority for review:
N
I
.
E
V
S
S
.B
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Team Project
N
I
.
E
V
S
S
.B
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Do Financial Statements
Capture Risk?
N
I
.
E
V
S
S
.B
W
W
W
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Team Projects
Part 1 of Projects posted on the web
Comments on projects and due dilgence
hand back after break
Part 2 Valuation: Due May 9, 2003
N
I
.
E
V
S
Quiz #1
S
.B
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N
I
.
Class 12 through Quiz #2
E
Risk Assessment (Credit),
Cost of Capital Calculations
V
S
Risk and AnalyzingS
Accounting
Trading Strategies
Off Balance
Sheet Activities, Pension Plans, International
W
Accounting
W and Valuation
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Risk Assessment
N
I
.
E
V
S
S
.B
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N
I
.
E
S
.B
W=
V
S
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Inventory
Turnover
Average Inventory
N
I
.
E
V
S
S
.B
W
Days Inventory
W Held =
W
365/Inventory turnover
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V
S
N
I
.
E
S
.B
___ Sales___
Average fixed assets
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Accounts Payable
Turnover
=
Purchases____
Average Accounts
Payable
N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
Current Ratio
.B
W
Quick Ratio
W
Operating
W Cash Flow to Current Liabilities Ratio
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Current Ratio
Current Ratio =
Current Assets
Current Liabilities
This ratio matches the amount of cash and other
current assets that will become cash within one year
against the obligations that come due in the next
year.
Basic rule of thumb: A minimum current ratio of 1.0.
N
I
.
E
V
S
S
.B
10
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Quick Ratio
N
I
.
E
V
S
Include in the numerator
only those current assets that
S
.B quickly into cash
the firm could convert
W
W
W
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Liabilities Ratio
N
I
.
E
V
S
S
.B
12
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N
I
.
E
V
S
S
.B
13
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Long-Term
Debt Ratio
Debt/Equity
Ratio
Long-Term Debt
Long-Term Debt +
Shareholders Equity
N
Long-Term Debt
I
.
E
V
S
Shareholders Equity
S
Liabilities/Assets
B=
.
Ratio
W
W
W
Total Liabilities
Total Assets
14
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N
I
.
Net Income + Interest Expense
+ Income Tax
E
V
Expense + Minority S
Interest
in Earnings
S
Interest
Expense
B
.
W
Interest coverage
ratios less than 2.0 suggest
W
a riskyW
situation.
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N
I
.
E
V
S
S
.B
16
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What is hedging?
What is hedging?
N
I
.
E
V
S
Examples:
S
.B
17
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nonsystematic
N
I
.
E
V
S
S
.B
18
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Theorem
N
I
.
E
1)
V
S
S
.B
2)
3)
W
19
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Taxes:
N
I
.
Stockholders, employees,
bondholders, suppliers
E
V high incentives to avoid
and customers allS
have
S
financial distress.
Why?
B
.
Customers: Product warranties & long-term service
W
arrangements
W
Suppliers: Undiversified locked in to single client
Contracting Costs:
20
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N
I
.
E
V
S
S
.B
21
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Conflict
Therefore, we get:the:
N
I
.
E
V
S
S
.B
22
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N
I
.
E
V
S
S
.B
23
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Where Next?
N
I
.
E
V
S
S
.B
24
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Cost of Capital
N
I
.
E
V
S
S
.B
W
W
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Valuation Fundamentals:
DCF Analysis
Comparative Analysis
Abnormal Earnings Valuation
Cash Flow Analysis
Where Now?
N
I
.
E
V
S
Equity (CAPM, 3-Factor
Model, Implied Cost of Capital)
S
Cost of Capital:
International Companies
B
.
Debt
W
Enterprise
W
W
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Application:
N
I
Discounting the cash .flows (earnings)
E
available to equityholders.
V
S
S
Which cashflows?
Answer: The FCFs after
B
.
all otherW
parties have been paid (lenders,
taxes,
Wetc)
W
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CAPM: E( R ) = Rf + E*(Rm-Rf)
N
I
Cov( R
,R
R .)/Var( R
R )
E
)/Var( R
)
Usually = Cov( RV ,R
S
Think of it asS
Co-wiggling
B
.
According
Wto this model, why does the
W risk only matter?
systematic
W
stock
market
stock
market
market
market
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N
I
.
E
V
S
S
Where do we.B
get RF?
FederalW
Reserve Bank of St. Louis:
W
research.stlouisfed.org/fred/data/irates.html
W
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N
I
.
E
V
S
S
E( R ) = R.B
+ E*(R -R )
W
= 4.87% + 1.49*(7.95%)
W =16.7%
W
f
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N
I
.
E
V
S
S
Is there a size
.B risk factor?
Are firmsW
that are near financial distress riskier?
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Origins:
N
I
.
R
=R + E*(R -R ) +E
*(R ) + E *(R )
E
V
Every stock has different
market E, E , E
S
S
Where do we.B
get (Rm-Rf), RSMB, RHML?
Wof Professor Ken French:
Homepage
W
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/
Wdata_library.html
SIZE
SMB
BM
SIZE
HML
BM
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N
I
Long-run average R . = 3.32% per year
E
V
S
S
= 5.05% per year
Long-run average
R
B
.
W
W
W
SMB
HML
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Capital
Microsoft:
Market Beta = 0.98
N
I
.
E
= 5.1% !!!!!
V
S
S
.B
10
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N
I
.
E
V
S
S
.B
11
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Calculation
Microsoft:
Earnings per share 2003: $1.02/share
N
I
.
E
V
S
S
.B
12
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Calculation:
N
I
.
E
V
S
S
.B
13
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N
I
Segmented/Integrated CAPM
(Bekaert.
E
Harvey)
V
S
S
Credit Rating.(Erb-Harvey-Viskanta)
B
W Model
Country Spread
W
W
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Segmented/Integrated CAPM
Rstock - Rf = E*(Rworld - Rf )
Rworld is a world index (ie Morgan Stanley Capital World Index)
http://www.msci.com/equity/index.html
N
I
.
E
V
S
S
.B
Rstock - Rf = E*(Rcountry - Rf )
Rcountry is a countrys stock index, E uses Rcountry
W
If country
is going through process of integration, a
W
combination of two holds.
W
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Segmented/Integrated CAPM
N
I
.
E
V
S
S
.B
Hard to implement
Only appropriate for countries with equity markets.
16
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N
I
.
E
V
S
S
.B
W
Political
risk, expropriation risk, exchange rate controls and
W
volatility, etc.
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Steps:
Estimate foreign company beta by regressing
Rstock = D + E*RM
(where RM is return on S&P500 - standard CAPM)
- Then, calculate predicted cost of capital using a modified
CAPM:
N
I
.
E
V
S
S
.B
18
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Where Next
N
I
.
E
V
S
S
.B
20
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Class #15
N
I
.
E
V
S
S
.B
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Risk Analysis:
CAPM
3 Factor Model: Size and B/M Matter
Combine with Cash Flow Analysis
N
I
. class about market
Recall discussion in Efirst
efficiency edbate SV
Application of S
Fundamental Analysis Can we use
B
.
financial accounting
numbers to identify mis-priced
stocks?W
W
W
Where Now?
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
What is the expected
return on stock? It
S
.B stocks systematic risk!
depends on the
W
SimpleW
case CAPM: E( R ) = Rf + E*(Rm-Rf)
Expected
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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Valuation
implicitly
assumes
market
inefficiency basis for active management.
Quantitative Models:
N
I
.
E
V
S
S
.B
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Value Strategies
N
I
.
E
V
S
S
.B
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Drift Models:
N
I
.
Company announces higher
than expected earnings
E
(lower than expectedV
earnings) . Stock price increases
(decreases) on announcement
S
S
But stock price
continues to go up (down) in the
B
.
subsequent weeks and months.
W
Appears to be a profitable trading strategy
W
W
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N
I
.
E
V
S
S
.B
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(Accruals Anomaly)
N
I
.
E
V
S
S
.B
11
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N
I
.
E
V
S
S
.B
12
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N
I
.
E
S
.B
W
Annual
Wratio high => High Quality
W
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Widely-Accepted Evidence on
Strategy
E/P ratio
B/M ratio
CF/P ratio
var(CF)/P ratio
V/P ratio
Short term
reversal
High stock return this month leads to low stock return next month.
Short-term overreaction to information.
Medium term
momentum
High stock return in past 6-12 months leads to high stock return in
next 6-12 months. Underrreaction to information.
N
I
.
E
V
S
S
.B
Accrual anomaly
14
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Assignment #2:
N
I
.
E
V
S
S
Skim Section G.B
of Course Reader The Role of Financial
InformationW
in Contracting (pages 295-304).
Skim Section
H of Course Reader Credit Analysis and
W
Distress
W Prediction (pages14-11 through 14-17).
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Class #16
Detection
N
I
.
E
V
S
S
.B
W
W
W
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I
.
http://www.ibbotson.com/content/cc_lvl1.asp
E
V
Charge of $15 per
beta!
S
S
.B
W
W
W
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Examples of Contracts:
Loan Agreements:
Principal Bank, Bondholders, Private lenders
N
I
.
E
Principal Equityholders
Agent Managers (CEO, division managers)
V
S
S
.B
Principal Equityholders
Agent(s) Third parties
W
Agreements
with Government/Regulators
W
W
Principal IRS (tax authority, regulatory agency)
Agent Firm
15.535 - Class #16
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N
I
.
E
V
S
S
.Bobjective,
Are
they
verifiable,
unbiased,
consistent, comparable, timely, reliable, and
neutral?
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Lending Contracts
N
I
.
E
V
S
S
.B
Underinvestment Problem
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N
I
.
E
V
S
S
.B
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Lending Contracts
Negative covenants:
N
I
.
E
V
S
S
.B
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Lending Contracts
N
I
.
E
V
S
S
.B
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Lending Contracts
PERFORMANCE PRICING:
Why?
What does Performance Pricing Address?
N
I
.
E
V
S
S
.B
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Manipulation
Ie Debt covenant
N
I
.
E
V
S
S
.B
W
Taxation
W
10
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Debt Contracts:
N
I
.
E
V
S
S
.B
11
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How is it performed?
Identify sample of bankrupt firms
N
I
.
E
V
S
S
.B
12
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A well-known MDA bankruptcy prediction model is Altmans Zscore. Altman used data for manufacturing firms to develop
the model.
Calculation of the models Z-score is as follows:
N
I
.
E
V
S
S
.B
13
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Altman's Z- score
risk.
N
I
.
E
current profitability.
V
ratio, but incorporates markets S
assessment of firm equity value. Captures
S
long-term solvency risk and
the market's overall assessment of the firms
B
.
profitability and risk.
Sales/Total Assets:
generate sales.
W
W
Market Value of Equity/Book Value of Liabilities: A debt/equity
14
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N
I
.
E
V
S
S
.B
15
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Where Next?
N
I
. Acquisitions:
16
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Class #17
Acquisitions
N
I
.
E
V
S
S
.B
W
W
W
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N
I
.
E
V
Enterprise Valuation
S
S
.B
Calculating Unlevered
Betas Why?
W
A Review
W of the Latest in M&A Accounting
W
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N
I
.
E
V
S
S
.B
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Companies or Divisions
N
I
.
E
V
S
Problems?
S
.B
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private company?
N
I
.
E
V
S
S
.B
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companies
be expressed as:
Betaequity = Betaassets*[1+(1-t)*(D/E)]
N
I
. can easily estimate
This is useful becauseEwe
V
the (levered) equity
beta of publicly-traded
S
S
firms and then
find
.B the (unlevered) asset
beta:
W
Beta W = Beta
/[1+(1-t)*(D/E)]
W
assets
equity
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Company Beta
D/E
tax rate
Equity Beta/[1+(1-t)*D/E]
#1
1.21
1
0.32
0.72
#2
1.54
0.8
0.37
1.02
#3
1.05
0.55
0.39
0.79
#4
0.92
0.48
0.27
0.68
#5
0.86
0
0.34
0.86
N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
241
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N
I
.
E
V
S
S
.B
11
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and Acquisitions
N
I
.
E
V
S
S
.B
12
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N
I
.
E
V
S
S
.B
13
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N
I
.
E
V
S
S
.B
14
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Purchase Method
N
I
.
E
V
S
S
.B
15
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and Acquisitions
N
I
.
E
V
S
S
.B
16
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N
I
.
E
V
S
S
B may purchase more than 50%
2) The acquiring firm
.
of the outstanding
voting common stock of the
W
target firm.
W In this case, the financial statements of
the W
two firms are consolidated.
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Where Next?
N
I
.
E
V
S
S
.B
18
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Class #18
Valuation
N
I
.
E
V
S
S
.B
W
W
W
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Management Compensation
Horizon Problem
Over-retention Problem
Risk Aversion Problem
Effort Problem
N
I
.
E
V
S
S
.B
W
Compensation
contracts
W
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Structure of Management
Compensation Contracts
Base Salary
Why?
Short-term incentives:
Examples?
What do these address?
V
S
Long-term incentives:
N
I
.
E
S
.B
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Management Compensation
N
I
.
E
V
S
S
.B
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Stock Compensation
N
I
.
E
V
S
S
.B
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Employee/Executive Option
Compensation Pricing
N
I
.
European option versusE
American option
V
Value of stock option
(use modified Black-Scholes
S
S
formula):
.B
W
Value
Wof Call Option = C( S, X, T, V, r )
W
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Typical Restrictions:
N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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N
I
.
E
Stock Price
Exercise Price
Vesting Period
Time to Expiration (Maturity)
Fraction of options that will be forfeited (employees
leave before vesting).
V
S
S
.B
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Example:
N
I
.
E
V
S
S
.B
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Employee
None on grant date if
incentive stock option and issued at the money
N
I
.
E
See http://www.mystockoptions.com
V
S
Company
S
.Bdate
None on grant
Wfrom taxable income at corporate rate
Deduction
W of option by employee
on exercise
W
(difference between stock price and exercise price).
11
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Next Classes
N
I
Readings for Class #20
.
E
V
Section J of Course
Reader (Leases and
S
S
Off-BalanceB
Sheet
Debt): Skim pages 531.
543, 547-551,
W 554-557
W
W
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Class #20
N
I
.
E
V
S
S
.B
W
W
W
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N
I
.
Today: Off Balance E
Sheet Activities
V
S
Readings: Skim
Section J of Course
S
.B and Off-Balance-Sheet
Reader Leases
W
DebtW
(pages 531-540, 547-551)
W
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N
I
.
E
V
S
S
Examine the details
.B of Off Balance Sheet
Activities atW
Enron
W
W
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N
I
.
Economic Rationale for
Leases:
E
V
Operational:
S
Leasing for shortSperiods protects against obsolescence.
.B equipment avoids set-up costs.
Lease ready-to-use
W that is used seasonally, temporarily, or
For equipment
W
sporadically.
W
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N
I
.
E
V
S
S
.B
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Lease
Purchase
N
I
.
Capital Lease: LesseeEeconomically owns the
V
property. Lessee records
the leased asset on
S
S capitalizes the asset) and
balance sheet.B
(ie
reflects theW
corresponding lease obligation.
W
W
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Capitalization
N
I
.
E
V
S
S
.B
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Operating Lease
(Rent Expense)
N
I
.
Capital
Lease
E
V
Interest
Expense +
S
S
Depreciation
Expense
.B
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Capital Lease:
Liability
Lease Obligation
(Capital Lease)
N
I
.
E
Asset
Leased Asset
(Capital Lease)
V
S
S
.B
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Background on Enron
N
I
.
Approved Off-Balance E
Sheet Partnerships run by
Enron EmployeesSV
S
Failed to effectively
B monitor these partnerships
.
Failed toW
react to warnings about those
transactions
W as they came to light
W
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N
I
.
E
V
S
S
.B
11
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N
I
.
E
V
S
S
B contingent liabilities realized,
Stock price decline,
.
earnings W
hedges became insolvent, and finally
bankruptcy
W ensued. All VERY fast!
W
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N
I
.
Lack of board independence
& oversight
E
V
The auditor (Arthur
Andersen) failed in its role as
S
S
an independent
certifier of results.
B
.
Compensation
W plans provided managers with
W to maintain stock price at any cost.
incentives
W
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growth
in
N
I
.
E
V
S
S
.B
14
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N
I
.
E
V
S
S
.B
15
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N
I
.
E
V
S
S
.B
16
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N
I
.
E
V
S
S
.B
17
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2)
I
.
Have at least 3%Eoutside equity at risk.
V
But Koppers stake
was not equity at risk!
S
S
Sponsoring
.B firm (Enron) cannot control
W But, Kopper was employee of
the SPE.
W and under control of Enron.
Enron
W
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Enron recorded prior profits on gains on stock using mark-tomarket accounting. But, Enron wanted to avoid mark-to-market
losses if investment lost value.
Enron used LJM Caymen SPE to enter into agreements with
banks using forward contracts. If the value of Enrons stock went
up, then so did forward contracts.
Normally, you cannot realize gains in your own stock price as
profits.
N
I
.
E
V
S
S
.B
19
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N
I
.
E
V
S
S
.B
20
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Next Class:
N
I
.
E
V
S
S
Assignment
#3
will
be
distributed
next
B
.
class W
W
21
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Class #21
N
I
.
E
V
S
S
.B
W
W
W
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Announcements
N
I
.
E
V
S
S due
Assignment .B#3
Thursday,W
May 8.
in
class
on
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
W
Employer
Wbears investment risk in the plan
W
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N
I
.
E
V
S
S
.B
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N
I
.
U.S. regular, full-time and part-time
employees are covered by a
E
noncontributory plan that is V
funded by company contributions to
S
an irrevocable trust fund,
which is held for the sole benefit of
S
employees. Under.B
a new formula, which is being phased in
over five years, retirement benefits will be determined based on
W
points accumulated for each year worked and final average
W period. Benefits become vested upon the
compensation
W of five years of service.
completion
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V
S
Funding incentives:
Tax
Financial
Labor
Contracting
N
I
.
E
S
.B
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pension plans
N
I
.
Underfunded when PA<PBO
E
Liability to the firm?
V
S
S
B
.
Where do we get this information?
W
In financial
W statement footnotes
W PepsiCo 2001
Example:
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Change
(PBO):
in
Benefit
N
.I
Projected
Obligation
E
V
Service cost
Interest cost
Benefits paid
Plan amendments
Actuarial gains and losses
S
S
.B
10
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Balance Sheet?
N
I
.
E
V
S
S
.B
11
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financial analysis
N
I
.
E
V
Problems are even more
pronounced for international
S
S
firms
B
.
Accounting for Pension Plans is even more opaque in other
countries W
Wother countries rely more on Defined Benefit Plans
Firms in
W Defined Contribution Plans)
(versus
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N
I
.
E
V
S
Older firms (carryover
Defined Benefit Plans)
S
.Bplans (ie General Motors)
13
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Next Class
N
I
.
E
V
S
S
.B
14
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Class #22
International Financial
Analysis
N
I
.
E
V
S
S
.B
W
W
W
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N
I
.
E
V
S
S
.B
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Valuation
N
I
.
E
V
S
S
.B
Differences
W in Opacity and Cost of
CapitalWAcross Countries
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Across Countries
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Austria
28.3
South Korea
26.8
Italy
24.8
Taiwan
22.5
Switzerland
22.0
Singapore
21.6
Germany
21.5
Japan
20.5
Hong Kong
19.5
India
19.1
Spain
18.6
Indonesia
18.3
Thailand
18.3
Pakistan
17.8
Malaysia
14.8
France
13.5
Finland
12.0
U.K.
7.0
Sweden
6.8
Canada
5.3
Australia
4.8
15.535
Class
#22
U.S.
2.0
N
I
.
E
V
S
S
.B
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Countries
N
I
.
E
V
S
S
.B
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N
I
.
E
Result:
V
S
S
.B
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Law) Countries
N
I
.
E
V
UK, United States,SCanada, Australia, New Zealand.
S
B toward greater litigation in the
Because of trend
.
U.S., theW
financial reports of U.S. companies have
become
Wfar more conservative.
W
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N
I
.
E
V
S
The O-Factor
S
.B
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Across Countries
N
I
.
E
V
S
S
Why is this allowed
B in some countries?
.
What is this
Wentry called under U.S. GAAP and law?
W
W
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in Similar Countries
USA
United Kingdom
Accounting
for Goodwill
Purchased goodwill
either immediately write
off or amortize
LIFO for
Inventories
Not allowed
Intangible
Assets
N
I
.
E
V
S
S
.B
Only purchased
W
W intangibles recognized
11
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N
I
.
E
V
S
S
.B
12
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N
I
.
E
V
S
S
.B
13
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Types of ADRs
Expand Existing
Shareholder Base
Level I
Level II
Level III
public offer
Private
placement
GDR
(global)
Description
Unlisted in
the U.S.
Listed on
US
exchange
Shares
Placement
offered &
with
listed in US Institutions
Global
offering
Trading
OTC
Amex,
NYSE,
Nasdaq
Amex,
NYSE,
Nasdaq
U.S. and
non-U.S.
exchanges
U.S.
reporting
rules
Exempt
V
S
S
.B
N
I
.
E
Private
Placement
Market
Varies
14
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Daimler-Benz Case
N
I
.
E
V
S
S
.B
15
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International Standards
N
I
.
Shareholders, lenders, E
employees, suppliers &
V
customers can use one
set of comparables and not have
S
to translate #sSacross firms from different countries.
B a uniform system for comparing
Businesses.have
numbers
Wof operations in different countries.
W
Multinational
companies will only have to prepare one set
Wof statements for its worldwide operations.
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International Standards
N
I
.
E
V
S
S
.B
17
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N
I
.
Due diligence on other team
reports
E
V
All teams must send their
completed reports (Parts 1 and 2)
S
S
to their opposing due
diligence teams.
B
.
Due Diligence Teams should only evaluate PART 2 of the
analysis (ieW
the valuation using DCF and relative multiples
W
comparions.
W
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Class #23
Capstone to FSA
N
I
.
E
V
S
S
.B
W
W
W
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Act of 2002
N
I
.
E
V
S
S
.B
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317
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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N
I
.
E
V
S
S
.B
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N
I
Each firm must disclose on a .very timely basis additional
E
information about the firms
financial condition as the SEC
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determines is necessary
or useful to investors.
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PV = CF1/(1+r)+CF2/(1+r)2+CF3/(1+r)3+
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Growing Perpetuity:
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= CF/(r-g) (1 CF at end of year 1, then grow at g)
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Understanding
P/E ratio (just restating DCF!)
st
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Valuation
1) Equity valuation:
Forecast cash flows available to equityholders.
Discount expected cash flows by the cost of equity
capital. Remember unlevered Beta!
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Earnings Multiple
99%
P-E
97%
Relative P-E
35%
Revenue Multiple
15%
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Price-to-Book
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CF Multiple
DCF
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Model
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25%
13%
13%
2%
4%
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Approach to Multiples
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How to identify comparables?
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Assumptions of same
industry, risk, size, growth,
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accounting methods,
etc.
B
.
Note: Use
Multex (through Yahoo!) to get quick
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industry
Wbenchmarks.
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Cost of Capital
CAPM: E( R ) = Rf + E*(Rm-Rf)
Expected return is increasing in systematic risk!
What is Beta?
Cov( Rstock,Rmarket Rf )/Var( Rmarket Rf )
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formula:
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PW
= CF /(1+r) + CF /(1+r)
0
+ CF3/[(r-g)(1+r)2]
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Strategies: Implementation
Risky Arbitrage
These are average returns over many years.
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Brokerage fees
Bid-Ask spread
Taxes (different rates for short-term vs long-term)
Shorting a stock is often impossible or very costly
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Loan Agreements: Principal
Bank, Bondholders, Private
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lenders, Agent .B
Equityholders (managers)
Compensation
Agreements: Principal Equityholders Agent
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Managers
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Agreements
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Examples of Contracts:
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management/manipulation
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Management
Methods:
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Analysis
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B Defined Benefit Plans)
Older firms (carryover
.
Firms with large
plans (ie General Motors)
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Non-U.S.
Wfirms using different accounting rules
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Potential Solutions:
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International Accounting
.B Standards (IAS):
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The End
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and the thought
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will remain much the
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we developed some life-long
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tools this semester!
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The Acid
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Class #2.)
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Necessary Data
d) Assume that equity "free cash flow" per share equals forecasted EPS
---> annual depreciation charge is a good approximation of annual investment cash flows
Link http://www.stls.frb.org/fred/data/irates.html
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b) You can calculate the average M/B ratio in the computer hardware industry by taking the
After completing your analysis using each of the 4 approaches, please write a memo summarizing
your analysis.
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2) Go to the Wharton WRDS database and click on "Members Login". Then, login using the class username
password.
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3) Click on the CRSP link. Then click on the Stocks link on the left side of the webpage. This will link you
4) On the "CRSP Monthly Stock" page, you should proceed with the following:
- Step One: Date Range Select monthly frequency and beginning date of Jan 1990 and ending date of Dec
2002.
- Step Two: Search Search by ticker and select method 1 (company codes). Enter your company's ticker
- Step Four: Output Select "comma-delimited text (*.csv)" under Output Format.
5) The data will take about 30 second to download. The following screen will then appear:
Data Request Summary
Data Request ID
081028073
Library/Data Set
crsp/msf
Frequency/Date Range
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Search Variable
TICKER
Input Codes
1 item(s)
MSFT
Conditional Statements
n/a
Output format/Compression
csv/
Variables Selected
RET
n/a
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8) Adjust the monthly stock return for each month for YOUR stock between January 1990 and December
2002 by multplying the value by 100:
x
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9) Now you are ready to calculate the the CAPM BETA and the THREE-FACTOR BETAS for your
company!
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QUESTION A)
Using standard regression analysis in Microsoft Excel, estimate the CAPM BETA for your company using
monthly stock returns for the most recent 60 months (5 years). Attach the regression output for this estimate.
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QUESTION D)
Using standard regression analysis in Microsoft Excel, estimate the 3-factor BETA's for your company using
monthly stock returns for the most recent 60 months (5 years). Attach the regression output for this estimate.
Note: Your regression model should be of the form:
Rstock = a0 + a1*Rf + BETA1*(Rm-Rf) + BETA2*Rsmb + BETA3*Rhml
QUESTION E)
Discuss each of the coefficient estimates that you estimated in QUESTION D):
- What does the value of a0 mean or imply?
- What does the value of BETA1 mean? Is the firm risky relative to the market?
- What does the value of BETA2 (size BETA) tell us about your stock? Think about whether your stock is
large or small relative to other stocks traded in the U.S.
- What does the value of BETA2 (distress BETA) tell us about your stock? Think about whether your stock
has a high or low B/M ratio relative to other stocks traded in the U.S.
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(b) Even though Dells M/B ratio is high relative to its industry, this ratio may tell us nothing about
whether Dells stock is either under- or over-priced. Explain. (Hint: Accounting reasons).
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The company reported losses (GAAP net income) for the past 3 years. Q-Aqua currently trades at
$6.55 per share. In a recent press release, the company highlighted the fact that it had positive
operating income last year. In addition, sales have been growing at a rate of 25% per year
for the past 2 years. Based on the fact the Q-Aqua trades at a <Price-to-Sales> ratio of only
2 and a <Price-to-Operating Income> ratio of only 7, the management believes that our company
is currently undervalued.
As part of your research, you examined Q-Aquas most recent annual financial statement and
focused on the supplemental footnotes to the income statement. In particular, the footnotes state that
the company entered into 17 water supply swap transactions in 2001 and 38 water supply swap
transactions in 2002. We are conservative in accounting for these swaps in that we fully book for all
revenues and expenses related to these transactions each year. Later in the same footnote,
company management states that that We view the supply capacity received in these swap
transactions as building of our overall capital abilities.
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b) Why might you question the companys claim that we believe the company is currently
undervalued. (Focus on the <Price-to-Sales> ratio)
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(b) The book value of equity of Valanium at the end of fiscal 2002 was $15.00 per share. Calculate
abnormal earnings for the fiscal year ended 2003. (Show your calculations)
(c) Assuming a perpetuity in abnormal earnings, calculate the predicted stock price of Valanium Inc.
using the residual income (EBO) valuation model.
(d) What factors would allow you to justify a perpetuity in abnormal earnings?
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Year ended
2002
2,600
4,900
5,500
29,500
$42,500
Year ended
2001
1,500
3,200
4,100
32,500
$41,300
3,300
1,500
25,400
30,200
12,300
$42,500
2,800
2,200
25,400
30,400
10,900
$41,300
Accounts Payable
Accrued Liabilities
Long Term Debt
Total Liabilities
Shareholders Equity
Total Liabilities & Shareholders Equity
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(a) Calculate CFO (cash flow from operations) for the fiscal year 2002. Please show all your
work. State any assumptions you may make in deriving your calculations.
V
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S
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The company is expected to have relatively stable sales for the next 3 years (2003-2006).
(b) Do you expect the working capital accruals in 2003 to be higher, lower, or the same as
working capital accruals reported in 2002? Provide reasons to support your answer.
(c) What do you expect free cash flow to equity (FCFE) to be in 2006? Please state any
assumptions you make and provide reasons for your answer.
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Sample Solutions
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Dell may have differences in the way it accounts for it assets and liabilities compared to other
firms in its industry. For example, its book value of equity may be relatively too low (ie
unrecognized intangible assets) or too high (ie impaired assets not written down).
10pts
S
.B
The company reported losses (GAAP net income) for the past 3 years. Q-Aqua currently trades at
$6.55 per share. In a recent press release, the company highlighted the fact that it had positive
operating income last year. In addition, sales have been growing at a rate of 25% per year
for the past 2 years. Based on the fact the Q-Aqua trades at a <Price-to-Sales> ratio of only
2 and a <Price-to-Operating Income> ratio of only 7, the management believes that our company
is currently undervalued.
As part of your research, you examined Q-Aquas most recent annual financial statement and
focused on the supplemental footnotes to the income statement. In particular, the footnotes state that
the company entered into 17 water supply swap transactions in 2001 and 38 water supply swap
transactions in 2002. We are conservative in accounting for these swaps in that we fully book for all
revenues and expenses related to these transactions each year. Later in the same footnote,
company management states that that We view the supply capacity received in these swap
transactions as building of our overall capital abilities.
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(d) What factors would allow you to justify a perpetuity in abnormal earnings?
- Accounting Factors: Current BV is understated which means that calculated abnormal can
persist because of a persistently understated book value.
- Economic Factors: Firm can somehow prevent competitors from entering the market who
might otherwise drive abnormal earnings (rents) to zero (i.e. a monopoly)
5pts
QUESTION 4: Cash Flow Analysis (20 pts)
Listed below is the summary balance sheet for FGST Corp for fiscal years ended 2001 and 2002
(all numbers in millions of dollars). The company reported net income in 2002 of $1,400 million.
FGST had no capital expenditures or asset sales in 2001 and 2002. Shares outstanding remained
constant over the 2 years. The companys long-term debt matures in the year 2010.
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Year ended
2002
2,600
4,900
5,500
29,500
$42,500
Year ended
2001
1,500
3,200
4,100
32,500
$41,300
3,300
1,500
25,400
30,200
12,300
$42,500
2,800
2,200
25,400
30,400
10,900
$41,300
Accounts Payable
Accrued Liabilities
Long Term Debt
Total Liabilities
Shareholders Equity
Total Liabilities & Shareholders Equity
(a) Calculate CFO (cash flow from operations) for the fiscal year 2002. Please show all your
work. State any assumptions you may make in deriving your calculations.
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Quickie Method: Given no financing or investment changes in cash, then CFO equals
change in cash: CFO2002 = 'Cash2002 = Cash2002 Cash2001 = 2,600-1,500=$1,100M
Indirect Method (Standard Method):
V
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10 pts
The company is expected to have relatively stable sales for the next 3 years (2003-2006).
(b) Do you expect the working capital accruals in 2003 to be higher, lower, or the same as
working capital accruals reported in 2002? Provide reasons to support your answer.
WC Accruals in 2002 are positive and equal to $3,300M (see part (a)). Given that firm will
have no sales growth and that WC accruals tend to revert to zero over time when there is
no growth, then one should expect WC accruals to be lower over the next 3 years.
5 pts
(c) What do you expect free cash flow to equity (FCFE) to be in 2006? Please state any
assumptions you make and provide reasons for your answer.
Given no sales growth, then one should expect flat NI for the net several years. It we
assume that over the long run average (i) depreciation=Capex, (ii) WC accruals will
smooth to zero, and the firm has no debt repayment or issuances until 20010, then it
would reasonable to assume that predicted FCFE2006 = NI2006 = NI2002 = $1,400M
5 pts
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(b) Why might the growing perpetuity model used in part (a) overstate the cost of capital for
Krispy Kreme? If you still used the implied cost of capital method, what changes to the model or
different assumptions would you make to obtain a better estimate of Krispy Kremes cost of capital?
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Yahoo! Finance reports that the current Beta for Krispy Kreme is 1.39. However, you re-estimate
the CAPM Beta using monthly stock returns for the past 12 months and find that the Beta is 0.81
with a standard error of 0.55.
(c) Give three reasons why your estimated Beta appears to be different than the one reported by
Yahoo! Finance.
(d) The current yield on long-term government treasuries is 4.9%. What is the estimated cost of
capital for Kripsy Kreme using the CAPM using the estimated Beta=0.81? How confident are you of
your estimate (You should reply on statistical numbers to comment on this result).
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(e) Using the 3-factor model, you estimate Krispy Kremes Size Beta to be 0.66 and its Distress
Beta to be -1.22. What do these coefficients mean? Do they imply a higher or lower cost of capital
compared to the CAPM?
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(b) You also ranked the ten retail companies based on their reported Accruals for the latest fiscal
year. The ratio of Accruals-to-Total Assets was essentially the same for 8 companies. Of the two
remaining companies, one company had very high accruals and the other company had very low
accruals. What do you predict the stock returns will be for these two companies over the next 12
months?
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(c) When do you expect the abnormal returns for these two companies to occur?
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Rackham Corporation raised $23 million in early 2002 from private debt placement. In 2002, its
debt-to-EBITDA ratio was 3.5. The debt contract stipulated that Rackham would have to pay an
additional 30 basis points in quarterly interest payments for each additional 0.5 increase in its Debtto-EBITDA ratio (For example, Debt-to-EBITDA greater than 4.0 would add 30 basis points, Debtto-EBITDA greater than 4.5 would add 60 basis points, etc.). In early 2003, Rackham reported a
Debt-to-EBITDA ratio of 3.99.
(b) Why might you be suspicious of potential accounting manipulation at Rackham in the current
year?
(c) What are the advantages of the Z-score over simple financial ratios (such as the current ratio) in
predicting the financial health of a firm? Give at least two major advantages.
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In his March 4, 2003 opinion editorial column in the Wall Street Journal, Mr T.J. Rodgers
(President and CEO of Cypress Semiconductor) concludes that We need a pro forma
accounting standards board, chartered to specify how to make clear, consistent corrections to
the GAAP statements to remove the phony assets from our balance sheets and the unwarranted
charges to earnings from our income statements. Alternatively, if FASB would listen to its
customers, GAAP could be restored to its pre-2001 level of usefulness, with pooling of interests
accounting restored and option accounting left as is.
(a) As the CEO of a high technology company whose stock price has dropped by 50% over the
past year, what are Mr Rodgers motives to restore the old M&A accounting standards? (Hint:
Consider the implications of SFAS 142 with regard to goodwill.)
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high GAAP profits in 1999 and 2000 and had effective federal tax rate of only 14%,
lower GAAP profits in 2001 and 2002 yet its effective tax rate increased to 27%.
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(c) Give three reasons why your estimated Beta appears to be different than the one reported by
Yahoo! Finance.
- Different estimation period (ie 60 months versus 12 months)
* Yahoo may use more data (60 months) which provides a better beta estimate
* Company risk has recently changed your estimate is more up-to-date
- There is no statistical difference between betas of 1.39 and .81. For example, the value of 1.39
falls within the 95% confidence interval of your estimated beta 0. In other words, 1.39 is
within 2 standard errors of 0.81 (0.55*2).
- Yahoo may use a different data to calculate its beta estimate (ie different risk-free rates or
different market benchmark)
6 pts
(d) The current yield on long-term government treasuries is 4.9%. What is the estimated cost of
capital for Kripsy Kreme using the CAPM using the estimated Beta=0.81? How confident are you of
your estimate (You should reply on statistical numbers to comment on this result).
CAPM: R=Rf + Beta*(Rm-Rf) = 4.9%+0.81*7.95% = 11.34% (Use long-term historical risk
premium from class notes)
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The 95% confidence interval for beta is 0.81 +/- 2*0.55 = [-0.29,1.91]. This includes the value
of zero which means that the firm may have no estimated market risk. Therefore, the
estimated cost of capital ranges from [2.60%, 20.08%]. You are not very confident about the
estimated very of 11.34%.
5 pts
(e) Using the 3-factor model, you estimate Krispy Kremes Size Beta to be 0.66 and its Distress
Beta to be -1.22. What do these coefficients mean? Do they imply a higher or lower cost of capital
compared to the CAPM?
The Size Beta of 0.66 means that the firms risk attributes appear to be more like a small stock
(ie positive factor loading). The Distress Beta of -1.22 means that the firms risk attributes
appear to be more like low B/M stock (ie negative factor loading means low distress).
The long term average annual returns on the Size and Distress portfolios are 3.32% and
5.05%.
Answer Option (A): Assuming the market beta is the same under the CAPM and the 3-factor
models, then the incremental return is 0.66*3.32% - 1.22*5.05% = -3.97% lower cost of
capital estimated using 3-factor model.
Answer Option (B): Do not have enough information to determine difference in cost of capital
because we do not know the market beta estimated using 3-factor model (can be different
from CAPM beta because of correlation in factor returns).
5 pts
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Post earnings announcement drift: Firms that announce highest (lowest) relative earnings
tend to have higher (lower) stock returns over next year. Therefore, after the announcement of
earnings on March 1, 2003, you could buy (go long) in the stocks with the highest earnings and
sell (go short) in stocks with the lowest relative earnings.
Note that we use ROE to scale for firm size.
10 pts
(b) You also ranked the ten retail companies based on their reported Accruals for the latest fiscal
year. The ratio of Accruals-to-Total Assets was essentially the same for 8 companies. Of the two
remaining companies, one company had very high accruals and the other company had very low
accruals. What do you predict the stock returns will be for these two companies over the next 12
months?
High accruals firm: expect low stock returns over the next 12 months
Low accruals firm: expect high stock returns over the next 12 months
5 pts
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(c) When do you expect the abnormal returns for these two companies to occur?
The majority of the abnormal returns are expected to occur around the next 4 subsequent
quarterly earnings announcements (when information about earnings/reversal of accruals is
revealed)
5 pts
QUESTION 3: Contracting (20 pts)
(a) Describe what is meant by performance pricing in debt contracts.
The borrowers periodic interest payments are variable and change as a function of financial
health/risk. The borrowers financial health/risk is measured using accounting ratios (i.e. Debt
to EBITDA ratio). The interest rate is typically a base rate (ie LIBOR) plus a premium
calculated based on the accounting ratio that is typically based on a pricing grid. Performance
pricing allows (1) the borrower to typically receive a lower upfront interest rate, and (2) the
lender to continually adjust the loan parameters to reflect repayment risk.
10pts
Rackham Corporation raised $23 million in early 2002 from private debt placement. In 2002, its
debt-to-EBITDA ratio was 3.5. The debt contract stipulated that Rackham would have to pay an
additional 30 basis points in quarterly interest payments for each additional 0.5 increase in its Debtto-EBITDA ratio (For example, Debt-to-EBITDA greater than 4.0 would add 30 basis points, Debtto-EBITDA greater than 4.5 would add 60 basis points, etc.). In early 2003, Rackham reported a
Debt-to-EBITDA ratio of 3.99.
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V
S
S
.B
(b) Why might you be suspicious of potential accounting manipulation at Rackham in the current
year?
Rackhams Debt-to-EBITDA ratio is suspiciously close to, but just below, the next
performance-pricing increment. Given the incentives to pay a lower interest rate, we should
check to see if Rackham manipulated (ie increased) its EBITDA. We could check its working
capital accruals to see if they are out of line.
5 pts
(c) What are the advantages of the Z-score over simple financial ratios (such as the current ratio) in
predicting the financial health of a firm? Give at least two major advantages.
(1) Individual ratios may not capture a firms true financial health (ie low current ratio may
mean poor liquidity (Bad) or good management of working capital (Good).
(2) The Z-score includes stock market information which is a more timely measure of health
compared to accounting numbers.
(3) It is easier for the firm to manipulate individual accounting numbers compared to a whole
range of accounting numbers.
5pts
QUESTION 4: Option Accounting (10 pts)
In his March 4, 2003 opinion editorial column in the Wall Street Journal, Mr T.J. Rodgers
(President and CEO of Cypress Semiconductor) concludes that We need a pro forma
accounting standards board, chartered to specify how to make clear, consistent corrections to
3
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the GAAP statements to remove the phony assets from our balance sheets and the unwarranted
charges to earnings from our income statements. Alternatively, if FASB would listen to its
customers, GAAP could be restored to its pre-2001 level of usefulness, with pooling of interests
accounting restored and option accounting left as is.
(a) As the CEO of a high technology company whose stock price has dropped by 50% over the
past year, what are Mr Rodgers motives to restore the old M&A accounting standards? (Hint:
Consider the implications of SFAS 142 with regard to goodwill.)
- May have overpaid for past acquisitions accounted for using the Purchase Method.
Under SFAS 142, firm will have to write down acquired goodwill if it is impaired. The
impairment test is triggered because the firms stock price has dropped by a large
amount. Firm will report a large loss which may adversely affect its stock price or it may
violate certain debt contracts.
- Alternate answer: Under old pooling rules firm did not have to recognize amortization of
goodwill nor did it have to recognize impairment (both reduce reported earnings).
5 pts
(c) Explain why Cypress Semiconductor reported (related to options):
N
I
.
E
(i)
(ii)
high GAAP profits in 1999 and 2000 and had effective federal tax rate of only 14%,
lower GAAP profits in 2001 and 2002 yet its effective tax rate increased to 27%.
(i)
High profits in 1999-2000 led to stock price increase which ensured that
employee stock options were in the money. Therefore, employees exercised their
stock options which provided the company with IRS tax deductions (difference
between stock price and exercise price of options). This lowered the effective
tax rate for the firm.
Economy and stock market turned down in 2001-2002. This meant lower
profits and a decrease in stock price. Fewer employee stock options were in-themoney and, therefore, fewer option exercises. This meant that firm had fewer
tax deductions.
(ii)
V
S
S
.B
5 pts