Accounting Flashcards
1
Q
How would a $10 increase in depreciation affect the statements?
A
Income statement: (40% tax): $10*(1-0.4)=$6 less income
CF statement: inc. red. by $6, depr. incr. by $10, $4 net incr. in cash from ops -> cash increases $4
Balance Sheet: $4 increase in cash, $10 loss in assets (depr.) -> net decrease of $6 -> drop in retained earnings
2
Q
What are the 3 statements?
A
- Income Statement: Shows revenue and expenses which yield net income
- Balance Sheet: Shows assets and how company finances them
- Cash Flow Statement: Shows cash-flows since not every revenue or expense is cash-flow
effective
3
Q
Which statement if only one?
A
Cash flow statement; positive cash-flows over long-term almost always mean healthy business
4
Q
Which statement if only two?
A
Inc. statement and balance sheet because (assuming opening and closing statements available) you can use those to create the cash flow statement
5
Q
How do the three statements link together?
A
To link them, make Net Income the top line for the Cash-Flow statement. Adjust the Net Income for any non-cash items such as D&A. Next, reflect changes to operational Balance Sheet items such as Acc. Receivable, which may increase or decrease the cash flow. That gets you to Cash-Flow from Operations. Then reflect investing and financing activities. Link cash on the Balance Sheet to the ending Cash number on the CFS and add Net Income to Retained Earnings within Equity on the Balance Sheet. Link non-cash adjustment to appropriate Asset or Liability (subtract links on asset side and add links on L&E side).
6
Q
Which types of Cash-Flow are there?
A
- Cash-Flow from Operations
- Cash-Flow from Investments
- Cash-Flow from Financing
7
Q
What does the Change in Working Capital mean, intuitively?
A
Tells you if the company needs to spend in advance of its growth or if it generates more money as a result of its growth
8
Q
What does Equity Value and EV mean, intuitively?
A
Equity Value: Value of ALL asset but only to equity investors
EV: Value of core assets but to ALL investors
9
Q
How/why unlever beta?
A
To set off debt part and see how equity reacts to market changes, alternatively use comparables if no market data available
10
Q
A company goes from 20% debt to 30% debt. How does it change cost of equity, cost of debt and WACC?
A
Cost of debt and cost of equity always increase because risk of bankruptcy becomes higher. As company goes from no debt to some debt WACC decreases first because debt is cheaper than equity but then risk of bankruptcy outweighs lower cost of debt and WACC starts to increase
11
Q
Could you have negative shareholders’ equity?
A
Yes, because of eiter
- LBO with dividend recapitalizations
- Company loses money consistently leading to negative retained earnings
12
Q
What is working capital?
A
WC (“Umlaufvermögen”) = Current Assets – Current Liabliities
NWC = Acc. Rec. + Inventory – Acc. Payable …short-term assets are compared to short-term liabilities
If positive, then company can pay off its short-term liabilities with its short-term assets. It’s often used to tell if company is healthy.
13
Q
When should Cash be included in WC?
A
Usually, cash is not included because WC wants to answer how much cash is tied up in WC. But there are exceptions such as Cash that is not freely available to use (“trapped cash”) such as in a register in a supermarket, that cannot be used for other purposes
14
Q
Is negative WC bad?
A
Not necessarily, following situations:
- Subscriptions with high deferred revenue
- Retail companies like Amazon or McDonald’s often have negative WC because customers pay upfront. This can be a sign of business efficiency
- Could also point to financial trouble and possible bankruptcy
15
Q
How is a cash outflow or cash inflow through WC calculated?
A
NWC CF = NWC (t0) – NWC (t-1)
16
Q
When would you receive $100 but don’t recognize it as revenue?
A
If customer decides to prepay for service that is not yet delivered (in accr. accounting)
17
Q
When customer cash is received but not yet recognized as revenue, what happens with it?
A
CF increases; Liabilities from prepayment gets created. Nothing happens on IS until revenue is recognized, liability disappears, while income and therefore retained earnings increase.
18
Q
A company creates $100 of inventory and Accounts Receivable, while Accounts Payable increase by $50. Is the WC cash outflow necessarily $50 ($100 - $50)?
A
In most cases yes, but if there is an FX change it could be different (e.g. inventory is valued at $120 while FX reduces value to $100, then WC cash outflow could be $70).
19
Q
What are the main drivers in NWC development?
A
- Bargaining power against suppliers: more power means longer payment horizons, more Acc. Payable and therefore less WC
- Bargaining power against buyers: reduces accounts receivables
- Inventory management: efficient inventory management leads to less inventory
- Company growth: two possible effects:
o Every variable in calculation usually gets bigger (already negative NWC companies get even more negative and positive ones get more positive)
o Growth can improve bargaining power and therefore move company from positive to negative NWC
20
Q
Walk me through a $100 bailout and how it affects the 3 statements?
A
Confirm which type of bailout (debt, equity, combination of both,…). Usually an equity bailout by govt.
- No change in Income Statement
- CF Statement: CF from Financing +100
- BS: Cash +100; Equity +100
21
Q
Walk me through a $100 write-down of debt – as in OWED debt. How does it affect the 3 statements?
A
When liability is written down, it’s recorded as a gain:
- Inc. Statement: +$100 pretax; +$60 NI (assuming 40% tax rate)
- CF: $60 NI - $100 write-down: Net Chg. In Cash is -$40
- BS: Cash -$40; debt -$100, RE +$60
22
Q
When would company collect cash from customer and not record it as revenue?
A
- Web-based subscription software
- Cell phone carriers charging annual contracts
- Magazine subscriptions
23
Q
If cash collected is not recorded as revenue, what happens to it?
A
Usually deferred revenue under liabilities. Over time it turns into real revenue on the IS
24
Q
Difference between accounts receivable and deferred revenue?
A
Acc. Rec. has not been collected and represents how much rev. the company is waiting on. Def. Rev. has been collected but not recorded as revenue yet.
25
What’s the difference between cash-based an accrual accounting?
Cash-based recognizes revenue and expenses when cash is actually received or paid out. Accrual accounting recognizes revenue when collection is reasonably certain (e.g. after an order happened). Most large companies use accrual accounting because credit cards etc. are very common. Smaller businesses use cash-based acc. as it is simpler.
26
What would a TV purchase look like in both accounting types?
Cash-based: revenue would not show up until company charges the card, at which point it would show up as revenue on IS and cash on BS. In accrual accounting it would show up as revenue right away but instead of appearing in cash on BS it would go into Accounts Receivable first. It would only turn into cash once cash is actually received.
27
Under what circumstances would Goodwill increase?
Can increase if company re-assesses its value and finds out it is worth more, but it is very rare. Two types of scenarions:
- Company gets acquired (premium)
- Company buys other company and reflects newly acquired Goodwill in their statements
28
What impact does Goodwill have on NI?
Usually doesn’t, only during impairment, when NI is decreased.
29
What is a Goodwill Impairment?
Happens when company doubts actually paid price for investment. In the IS like D&A.
30
What’s the main difference between Goodwill and other Intangibles?
Other Intangibles usually get depreciated over time will Goodwill only does in case of an Impairment
31
How are subsidiaries consolidated in financial statements?
- Financial Asset (<20%): As financial asset in BS; value changes in IS (financial gain not operating income)
- Investments in Associates (20%-50%): Not consolidated, recognized with “at equity” method
- JVs (usually two parties hold 50% each): Also valued via “at equity” method
- Majority holdings (>50%): Total consolidation; everything that is not owned by mother is minority interest in equity. It is more important how much mother really controls than the actual percentage (40% could be enough for full consolidation)
32
How does the At-Equity Method work?
It is used to quantify investments at cost or FMV pro-rata to how big the investment from the mother company is. There is therefore no consolidation happening but a separate investment on the BS. Dividends and financial losses reduce the value of the investment, while profits increase the value. Dividends don’t go through mother IS, while profits and loss does.
33
A company buys 90% of another. What impact does this have on Equity?
Because company consolidates full financial statements it has to introduce Minority Interest on BS to account for other 10%.
34
What are Retained Earnings used for?
Cumulates profits and loss (after dividends)
35
How is GAAP accounting different from tax accounting?
- GAAP is accrual-based but tax is cash-based
- GAAP uses staright-line depreciation or similar whereas tax accounting uses accelerated depreciation
- GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in current period and what income tax you owe
36
What are deferred tax assets/liabilities and how do they arise?
They arise because of temporary differences between what company can deduct for cash tax purposes vs. what they can deduct for book tax purposes. The most common way they occur is with asset write-ups and write-downs in M&A deals. Asset write-up creates def. tax liab. while asset write-down creases def. tax asset.
Def. tax liab. arise when you have a tax expense on the IS but haven’t actually paid yet. Def. tax assets arise when you pay taxes but haven’t expensed them yet
Other example: Netflix incurs monthly cost for Jan. already in Dec. P&L now has additional cash for tax purposes but not for book purposes and therefore pays more taxes than it needs to acc. to books -> DTA is created
37
Walk me through how you create a revenue model for a company.
Two ways: bottoms-up build and tops-down build.
- Bottoms-Up: Start with individual products, estimate avg. sale and then growth rate in sales to tie everything together
- Tops-Down: Start with big picture metrics like overall market size, then estimate company’s market share and how it will change over time
38
Walk me through major items in Shareholders’ Equity.
- Common Stock: Value of however much stock the company has issued
- Retained Earnings: How much NI it has saved up over time
- Additional Paid in Capital: How much stock-based compensation has been issued and how much new stock employees exercising options have created. Also includes how much over par value a company raises in an IPO or other equity offering
- Treasury Stock: The dollar amount of shares that the company has bought back
- Accumulated Other Comprehensive Income: Catch-all that includes otherer items like FX rates changing
39
What is the Statement of Shareholders’ Equity and why do we use it?
Major items in Shareholders’ Equity as described above and how you achieve them. Can help analyzing companies with unusual stock-based comp.
40
What are examples of non-recurring charges we need back to EBIT/EBITDA when looking at financial statements?
- Restructuring charges
- Goodwill Impairment
- Asset Write-downs
- Bad Debt Expenses
- Legal Expenses
- Disaster Expenses
- Chg. In Accounting Procedures
41
How do you project BS items like Acc. Rec. and Accrued Expenses in a 3-statement model?
- Acc. Rec. & Def. Rev.: % of revenue
- Acc. Payable: % of COGS
- Accrued Expenses: % of operating expenses or SG&A
42
How should you project D&A or Capex?
% of revenue or previous PP&E balance. More complex: create PP&E schedules that splits out different assets by their useful lives, assuming straight-line depr. and assumed Capex based on historical data
43
How do Net Operating Losses (NOLs) affect a company’s 3 statements?
Quick & dirty: reduce taxable income by portion of NOLs, apply tax rate and get to NI.
The way you should: create book vs. cash tax schedule where you calculate Taxable Income based on NOLs and then look at what you would pay in taxes without the NOLs. Then book the difference as an increase to Def. Tax Liability on BS. Existing DTLs don’t change NI on IS but are reflected as a cash inflow in the CFS and therefore increased cash on the BS.
44
What’s the difference between capital leases and operating leases?
Operating l. are used for short-term leasing equipment and property and show up as operating expenses on the IS.
Capital leases are used for longer-term items and give lessee ownership rights. They depreciate and incur interest payment and are accounted as debt. Capital lease if any of the below conditions is true:
- Transfer of ownership at the end of the term
- Option to purchase asset at bargain price at end of term
- Term of lease greater than 75% of useful life of asset
- PV of lease payments is greater than 90% of the asset’s FMV.
45
Why would D&A on IS be different from D&A on CF statement?
Happens if D&A is embedded in other IS line items. Then you need to use CF statement number to arrive at EBITDA to not undercount D&A.
46
A company orders same amount for inventory and uses same amounts each period. Inflation rate is at 2% p.a. Is Inventory higher with LIFO or FIFO?
Higher inventory with FIFO method because expensive goods that are just acquired will stay in, while with LIFO they immediately leave inventory again
47
What are short-term investments and cash equivalents?
Things like commercial papers, short-term bonds and similar things
48
What is PP&E (property plant & equipment)?
Long lasting, physical economic goods that are depreciated over time. Properties, machines, accessories, etc.
49
What are typical Intangibles?
Goodwill, software licenses, patents, copyright, etc.
50
What are Purchase Price Allocations (PPAs) and how are they related to Goodwill?
When buying asset in M&A deal you revalue them at FMV. Especially intangibles can be hard to value but once it is done, the asset might have a FMV $15m that the seller acquired for $10m (book value). The buyer now pays $18m for it. Now the $5m ($15 - $10) are PPAs, while the $3 ($18 - $15) are Goodwill.
51
What are reasons to aim for low or high PPAs?
PPAs are amortized, while Goodwill isn’t, so companies can gauge PPAs for tax purposes. High PPAs are used to pay lower taxes but ROE decreases. Therefore, lower PPAs lead to higher financials but high Goodwill leads to additional risk in case of impairment.
52
A company does an IPO and sells a million shares at par value of $1 and gets $20m. Additionally, the owner sells a million existing shares. What happens in financial statements?
It is important to note that company earns $20m (which is larger than the $1m par value). $1m goes into “Grundkapital” while $19m goes into retained earnings in Equity. Sale of shares by owner doesn’t affect company at all.
53
How is Net Debt calculated?
Financial Debt
+ Pension Liabilities
+ Asset Retirement Obligations (AROs)
+ Other Interest-bearing liabilities
+ Minority Interest (not interesting bearing but you could argue that minority shareholders still receive company returns)
- Excess Cash (never only cash but also short-term investments and cash equivalents and only excess so no trapped cash etc.)
= Net Debt
54
What are Pension Liabilities?
Two possible pensions:
- Defined Benefit
- Defined Contribution
For Defined Benefit, company knows what it has to pay in future, so it has liabilities. Companies can finance these future payments with reserves that grow from interest, and dividends. If these reserves are not made, the liability is not covered, and accruals have to be made by discounting future pension payments (which is why it is interest bearing).
55
Where in FS of a company are financial leases and operating leases and what is the difference between them?
Financial leases are financial liabilities on BS (Similar to acquisition via debt). Operating Leases are not in FS (just in IS for current payments), they are however in the Appendix of the Annual Report.
56
How would you adjust a company’s net debt for operating leases?
Two possible ways:
- Capitalisation Multiple (usually 8x): If company pays $100 in Operating Leases, Net Debt is adjusted by $800
- Discounting future payments of operating leases (S&P uses 7%)
57
What are Asset Retirement Obligations (AROs)?
AROs are estimate future Liabilities for which reserves have already been made and that are resulting from abandonment costs of certain assets (e.g. mines and nuclear plants). Future abandonment costs are estimated and discounted. PV of AROs are then put on BS.
58
What are COGS?
Costs Of Goods Sold – variable costs from selling goods
59
What is Gross Profit?
“Bruttomarge” after COGS. Subtract other things like SG&A to get to EBITDA.
60
What is SG&A?
Selling, General and Administrative Expenses. General fixed costs that are not included in COGS. Typical positions are wages, property costs, rent, electricity, water etc. Usually it also includes D&A (when not separately mentioned)
61
What are Operating Results in P&L of company?
Profit or Loss from operating activity only (pre-interest and pre-tax).
62
What is the normalization of financials? Do you know examples?
Companies sometimes have extraordinary costs/revenues that are not directly related to their future expenses/income like extraordinary D&A etc. They list separate financials adjusted for these one time events to give a more long-term view.
63
Why is EBITDA so important?
Rather close to cash flow but still very high in IS. Especially for D&A there is a wide margin that can falsify financials.
64
Is EBITDA a good approximation for generated cash?
No, because it does not important figues such as WC and Capex.
65
What is FCF and how is it calculated?
Remaining Cash Flow after subtracting all cash expenses to all investors (FCF to firm) or equity investors (FCF to Equity). FCF is also used for DCF, although using NOPAT.
66
How do you get from NI to FCF?
```
Important: Do you want to get to FCF to firm or FCF to equity?
FCF to Firm: You first calculate back to EBITDA then:
FCF to Firm =
EBITDA
- Inc in NWC
- Capex
- Other Cash positions not in IS
+ Other non-Cash positions in IS
```
```
If you then want to get to FCF to Equity:
FCF to Equity =
FCF to Firm
- Taxes
- Interest payments
- Debt principal repayments
```
67
Are Interest payments included in CF from Operations?
Depends on accounting standards companies have voting right if they want to assign them to CF from Operations or Financing. CF from Operations is more common because interest is comparable to operating recurring costs
68
What are Funds From Operations (FFO)?
Operating Cash Flow adjusted for the change in WC. (OCF of $100 and WC Cash outflow of $20 then FFO is $120).
69
Why are WC changes neutralized in FFO?
WC can be highly seasonal (“WC swings”) and therefore you may also want to look at Op. CF excluding these volatile cash flows.
70
What’s the difference between EBIT and Operating Result?
EBIT is a “clean” pro-forma metric that is adjusted for one-time effects like restructuring costs. The Operating Result is the actual metric according to accounting standards and therefore complete and without adjusting for one-time effects.
71
What’s the difference between Depreciation and Amortization?
Depreciation is used for physical assets (tangible) like machines, plants, properties etc. Amortization is used for intangibles like software, licenses, etc.
72
What is Window Dressing and do you know examples?
Act of optimizing or (legally) manipulating financial statements to look better than they actually are. E.g. Company usually pays after 45 days but before publication of financials, they stop their payments; products in inventory are sold at large discount prior to publication
73
What is Capex and in which two categories is it divided usually?
Capital Expenditure for investment. Maintenance capex (replacing and repairing existing things) and Expansion capex (buying new machines or buildings). Company is almost forced to pay maintenance capex whereas they are free to choose their expansion capex.
74
What are deferred tax assets and deferred tax liabilities?
The taxes that a company pays are not necessarily the taxes that are included in the IS. If company gets large payment it can pay taxes in advance and thereby create a deferred tax asset (DTA) or the other way around.
75
What is Return on Equity (ROE)?
Net Income/Equity Value. Tells equity holders how much return they made on equity investment.
76
What is Return on Capital Employed (ROCE)?
Same as ROE but for entire company: ROCE = EBIT / CE
Capital Employed is usually not clearly defined but often it is calculated as:
CE = Total Asset – Short Term Liablilities – Cash
77
What is Return on Invested Capital (ROIC)?
Another metric for entire company’s profitability:
ROIC = (EBIT * (1-t)) / CE = NOPAT / CE
The idea behind it is that EBIT never totally goes to investors but taxes have to be paid first. Subtracting “real” tax would distort calculation because of different capital structures and therefore falsify ROIC.
78
What’s included in an Annual Report?
- CEO Letter
- Business Profile
- Management Discussion & Analysis
- Financial Statements
79
What is the Statement of Comprehensive Income?
IS and CFS can’t reflect all changes in Equity as there are special effect that change it that are not included in them. An example would be FX returns from foreign subsidiaries. These effects are included in the Statement of Comprehensive Income.
80
CFO tells you company will run out of money in 30 days. What will you do?
- Stop non-vital payments
- Defer payments
- Collect payments earlier
- Sell-off of goods
- Use of existing revolver
- Deferring investments
- Usage of Factoring: Sale of existing customer liabilities at discount for sooner payment
- Intercompany-Loan from subsidiary etc.
81
What are Basic EPS, Fully Diluted EPS and Adjusted EPS?
NI / # of Shares. Fully Diluted EPS recognizes EPS on assumption of dilution from exercising of existing derivatives that create new stock. Examples are Convertible Bonds or Option of the Management. Treasury Stock Method is used for calculation of dilution.
Adjusted EPS is published by some companies as pro-forma metric. NI as accounting metric can be adjusted by special effect that only occur once.
82
What is the Treasury Stock Method?
Used to calculate Fully Diluted EPS. TSM calculates stock that is created after exercising derivatives. These instruments therefore have to be in-the-money to actually be calculated (otherwise it wouldn’t be exercised). TSM calculates how many options are exercised and what the proceeds from it are to calculate how many shares could be bought at back at current price from those that are newly created.
83
A company buys news machines and changes from linear to degressive depreciation. How do cash-flows change in the first year from previously?
Depreciations in first year are now higher than before. Therefore NI is lower and the company has to pay less tax, which is why cash flow is higher.
84
Is there a situation in which it doesn’t matter to the company if it uses linear or degressive depreciations?
Yes, if the company pays no taxes (e.g. if it operates or operated at a loss).
85
A company buys a product for $1 that it has in its inventory and then sells at $2. What happens in the 3 statements (while ignoring tax)?
Customer pays $2, which is why cash goes up $2 in BS. Inventory is reduced by $1. Net increase of assets of $1. Retained Earnings increase by $1 of profit (after $1 of COGS and $2 of revenue). CF increases by $2 from CF from Operations. No cash outflow for product since it is bought beforehand.
86
The company above buys new product for $1000. What happens in IS?
Nothing. Buying new inventory is just a change in assets. IS is only touched once the product is sold as COGS.
87
The company expands and buys new site for $100k. It can pay all-stock or all-debt. What happens in both cases?
All debt: Cash goes up $100k, debt goes up $100k shortly. Cash Flow from Financing is up $100k Then cash is used to buy plant as Capex. Cash Flow from Investing therefore is down $100k. No changes in IS at first but after first year it affects D&A and Interest payments (CF from Operations (or Financing depending on Acc. Standards)). No effect on CFS (other than changed tax payments!)
All cash: Same as above although no interest payments
88
Could there be negative Equity on BS? What would that mean?
Yes! Negative equity is possible (BV; shareholders equity) if already low and you have negative NI reducing Retained Earnings. Equity Value (MV) can’t be negative as it is calculated by multiplying Share Price and # of Shares (which both can’t be negative).
There could also be healthy companies with $500 equity and $700 Goodwill that it decides to impair. Company could still be profitable but have negative equity now.
89
A company loses a machine at market value of $1.2m and BV of $800k in a fire. What happens in the three statements?
IS: Depreciation of $800k reduces EBITDA by $800k. Assuming 40% tax, NI is reduced by $480k.
CF: Start with $480k less NI. Add back $800k D&A. CF up by $320k.
BS: Machine less $800k. Cash up by $320k. RE down by $480k.
90
What is operating leverage?
Percentage of costs that are fixed vs. variable. A company whose costs are mostly fixed has a high level of leverage. This high level of leverage means a lot of more profit for additional revenue as no or low new costs get created with the new revenue.
91
If you have a public and a private company with same revenue, growth, risk etc. Which one is priced higher?
Most likely the public one due to liquidity premium. Another reason would be the transparency required to be listed on a public exchange.
92
What are some example of items that you may need to add back to EBITDA to get a better sense of the financial health of a company?
One-time, non-recurring items like legal expenses, one-time disaster payments or events, restructuring charges etc.
93
When building a model, what is the most common way to project items like accounts receivable, accounts payable, inventory, depreciation, and capex?
- Acc. rec.: Percentage of revenues
- Acc. payable: percentage of COGS
- Inventory: percentage of COGS
- D&A: percentage of prior year PP&E
- Capex: percentage of revenue
94
What are some differences between tax accounting and GAAP accounting?
Tax accounting is used to calculate what taxes a company owes in a year and is therefore focused on revenues and expenses and is cash based. GAAP accounting is more concerned with tracking a company long-term so it tracks assets and liabilities and is accrual based.
Another difference includes different depreciation schedules. Accelerated for tax accounting and straight line for GAAP accounting.
95
What’s the difference between LIFO and FIFO?
Different ways of keeping track of inventory value and COGS. Last in First Out vs. First in FO
96
What is the formula for AR?
DSO * Sales / 365
97
What is the formula for AP?
DPO * COGS / 365
98
What is the formula for Inventory?
DIO * COGS / 365
99
What is the formula for the cash conversion cycle?
CCC = DIO + DSO - DPO
100
What is the formula for cash conversion?
Cash conversion = (EBITDA - Capex) / EBITDA
101
What is the intuition for the cash conversion cycle?
It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash, or the capital investment, as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower the number for the CCC, the better it is for the company.
102
What are contingent liabilities?
Liabilities that are dependent on a certain outcome (lawsuit, etc.)
103
What are the three principles regarding contingent liabilities?
Full Disclosure Principle: All significant and relevant facts need to be disclosed in the financial statements
Materiality Principle: All important (could change economic decision) needs to be reflected on financial statements
Prudence Principle: If probability is >50% a fair value needs to be reflected
104
What is one real-world example of a contingent liability?
VW emission scandal; they created a $4.3b liability
105
Where would you put a convertible bond on the balance sheet?
A convertible bond is long-term debt so under debt but if it’s in-the-money, it causes additional dilution to the equity.
106
What happens if a bond gets converted?
You must debit the face value of the converted bonds in the bonds payable account and either debit the premium or credit the discount on bonds payable account for the unamortized amount remaining on the converted bonds. Then, credit the common stock account for the par value of the shares created and the paid-in capital in excess of par account for the remainder of the converted bonds’ book value (BV approach; can also use MV)
107
You have two oil drilling companies A and B with the same P/E ratio and market cap. A gets its oil from the Gulf of Mexico, B from Norway. Now we have an external shock and a rising oil price. Which company should we invest in?
Same P/E ratio and market cap means we have the same earnings in the beginning. Since oil drilling in Norway is more expensive than in the Gulf of Mexico, this means that company B (Norway) has to have a higher revenue to get to the same earnings. An increase in oil price would therefore lead to a larger increase in revenues for company B and we should invest in it.
