CFA 2014 Notes Flashcards
Minority Passive Classification
Held-to-Maturity
Debt securities acquired with the intent and ability to hold-to-maturity; they cannot be sold prior to maturity except in unusual circumstances
***Reported on the balance sheet at amortized cost (original cost); amortized cost is simply the PV of the remaining cash flows (coupon and face amount) discounted at the market rate of interest AT ISSUANCE
Minority Passive Classification
Held for Trading
Debt and equity securities acquired for the purpose of profiting in near-term, or under 3 months
***These are reported on the balance sheet at fair value; Changes in fair value both realized and unrealized are recognized in the income statement along with any dividend or interest income
Minority Passive Classification
Available-for-Sale
Debt and equity securities
- **Reported on the balance sheet at fair value; Only the realized gains or losses and the dividend or interest income are recognized in the income statement
- **Foreign exchange gains and losses are excluded from the income statement
- **Unrealized gains and losses are excluded from the income statement and reported as a separate component of stockholders equity under “other comprehensive income” under GAAP
Minority Passive Classification
Designated as Fair Value
Both IFRS and GAAP allow entities to initially designate investments at FAIR VALUE, debt or equity securities, that would others be treated as held-to-maturity or available-for-sale as fair value
- **Unrealized gains and losses on designated financial assets and liabilities are recognized on the income statement
- **This is very similar treatment as held-for-trading
Reclassification of Investments-IFRS 1
IFRS generally prohibits the reclassification of securities into or out of the designated at fair value category, and reclassification out of the held for trading is severely restricted
Held to maturity securities can be reclassified as available for sale if a change in intention or a change in ability to hold the security until maturity occurs. At time of reclassification, the security is remeasured at fair value with the difference between its carrying amount (amortized cost) and fair value recognized in other comprehensive income
Debt securities initially designated as available for sale may be reclassified to held for maturity if a change in intention has occurred. The fair value carrying amount of the security at the time of reclassification becomes ints new cost. Any previous gain or loss that had been recognized in other comprehensive income is amortized to profit or loss over the remaining life of the security using the effective interest method.
Reclassification of Investments-GAAP
GAAP allows reclassification of securities between ALL categories using the fair value of the security at the date of transfer.
For a security initially classified as held for trading that is being reclassified as available-for-sale, any unrealized gains and losses (arising from the difference between its carrying value and current fair value) are recognized in income. For a security transferred into the held for trading category, the unrealized gains or losses are recognized immediately. In the case of transfer from available-for-sale, the cumulative amount of gains and losses previously recognized in other comprehensive income is recognized in income on the date of transfer. For a debt security transferred into the available- for-sale category from held-to-maturity, the unrealized holding gain or loss at the date of the transfer (i.e., the difference between the fair value and amortized cost) is reported in other comprehensive income. For a debt security transferred into the held-to-maturity category from available-for-sale, the cumulative amount of gains or losses previously reported in other comprehensive income will be amortized over the remaining life of the security as an adjustment of yield (inter- est income) in the same manner as a premium or discount.
Minority Passive Investments Results may be misleading because of inconsistent treatment of unrealized gains and losses
If prices are up, an investor that classifies an investment as held-for-trading will report higher earnings than if the investment is classified as available-for-sale
Minority Active Significant Influence Evident By:
Board Representation Involvement in policy making Material inter company transactions Interchange of Managerial Personnel Dependence on Technology ****Any apply, no matter the percent owned, use the equity method
EQUITY METHOD
Under this method, the initial investment is recorded at cost and reported on the Balance Sheet as a non-current asset
Ongoing BS and IS Ongoing periods, pro-rata share of invests earnings increase the investment account on the balance sheet and are recognized in the investors income statement
Dividend received from invest are treated as ROC and thus reduce the investment account *not recognized on income statement
the investor reports the investment in one-line on the balance sheet. This one-line investment account includes the pro-rata share of the invests net assets at fair value and the goodwill
Equity Method-Diff from passive investments
Unlike passive investments, the investment account is not reported at fair value
although equity method income is reported in the investors income statement, it is usually excluded from operating income
***Although equity method income is reported in the investors income statement, it is usually excluded from operating income
Impairments on Equity Method:
If fair value falls below carrying value and decline is PERMANENT, the investment is written down to fair value and a loss is recognized in the income statement
- **Under GAAP, assets cannot be written UP
- **Under IFRS, recoveries are permitted
Equity Method accounting vs minority passive investments
Equity method usually results in higher earnings as compared to the accounting method used for minority passive investment
Cannot measure invests leverage and debt and margin ratios higher since invests revenue are ignored and leverage for invest is ignored
This influences debt ratios and net margin being overstated in equity method
Also must consider quality of equity method earnings
Joint Ventures-IFRS vs GAAP methods
Under IFRS, preferred method is consolidation but equity is permitted
Under GAAP, equity method required except in very limited situations
JV Proportionate consolidation vs Equity Method for reporting purposes Proportionate consolidation results in higher assets and liabilities, as compared to the equity method, but stockholders equity is the same
Proportionate consolidation results in higher revenue and expenses verses equity method, but net income is the same
Business Combinations
GAAP- Categorized into 3 entities:
Merger- only one of the entities remains in existence, so A+B=A
Acquisition-Both maintain separate financials, but parent provides consolidated statements, so A+B=(A+B)
Consolidation- New legal entity is formed and none of predecessors remain, so A+B=C
Controlling Investments-owning less than 100% Where parent owns less than 100%, its necessary to create a minority interest account for the pro-rata share of the subsidiary net assets that are not owned by the parent IFRS- No distinction among business combinations based on structure
Controlling Investments- Consolidation Method
Assets, liabilities, revenue, expenses are combined and inter-company transactions are excluded
Minority interest line created by multiplying the subsidiary’s equity by the percent of the company not owned
Controlling Investments- Consolidation vs Equity Method
Consolidation results in higher assets and liabilities verses equity method, but stockholders equity is the same
Consolidation higher revenue and expenses verses equity method, but net income is the same
Acquisition Method
IFRS and GAAP REQURE acquisition method
All the assets, liabilities, revenue, and expenses of the subsidiary are combined with parent
Intracompany transactions are excluded
Where parent owns less then 100% of the subsidiary, it is necessary to create a non-controlling (minority_ interest account for the proportionate share of the subsidiary’s net assets that are not owned by the parent
Assets and liabilities are combined using book value as acquirer and Fair Value of acquiree
Investment Costs that Exceed the Book Value of the Investee Many investees assets and liabilities reflect historical cost rather than fair value.
When investment cost exceeds investors percent of assets, difference first allocated to specific assets, then amortized to P&L over economic life of assets whose fair value exceed book value
Any excess above fair value of assets that cannot be allocated to specific assets is treated as Goodwill
PP&E measured GAAP vs IFRS
IFRS- Allows entity to measure PP&E with either historical cost or fair value
GAAP- Can only use historical cost on PP&E
NOTE: on increase in book value of PPE to PV at purchase date from another company, this new depreciation needs to be deducted and subtracted from yearly income from the equity income from equity method…mock exam Q 8 afternoon test…
Full Goodwill Approach/Partial Goodwill Approach
IFRS permits the sue of the full goodwill approach
Company purchases 70% of a sub for $1.4M. FV of sub is 1.4M/70% = $2M. FV of ID asses less ID liab is $1.7M. Full goodwill is $300,000 Partial goodwill is 70%*300K=$210k
Goodwill Impairment Test
Goodwill is not amortized but instead tested annually
Impairment occurs when carrying value exceeds fair value
GAAP: If the carry value of the reporting unit exceeds the fair value of the reporting unit, an impairment exists
**loss in income statement part of continuing operations
Special Purpose Entity (SPE)
A legal structure created to isolate certain assets and liabilities of the sponsor
The main motivation is to reduce risk
Motivation for these is to obtain low-cost financing
Its created to purchase assets, fund R&D, lease assets, hedge and enhance the balance sheet
Variable Interest Entity (VIE)
If considered a VIE under FIN 46(R), it must be consolidated by the primary beneficiary
The firm that absorbs the majority of the risks or receives the majority of the rewards is required to consolidate the VIE- This firm is known as the primary beneficiary
**Not all SPE’s are considered VIE’s. A SPE that is not a VIE does not need to be consolidated
Why do a VIE?
Often used to lower the cost of capital since assets are isolated from other creditors
Usually financed with both debt and equity (equity component is small) and can be JV’s corporations, partnerships or trusts
Qualifying Special Purpose entity (QSPE)
IFRS does not permit QSPE’s
It can only hold financial assets and the assets are usually received that are transferred from the sponsor
Legal separate, independent entity, has total control of the assets
Sponsor is not expected to receive a beneficial interest and the sponsors financial risk is limited to its initial investment
The sponsor is beyond the reach of bankruptcy. If not met, entity is not a QSPE and consolidation reverts to FIN 46(R)
Analyze the effects on financial ratios of the different methods used to account for inter corporate investments
All 3 report the same net income and same equity
Assets and liabilities are higher under consolidation and lowest under equity
Sales are higher under consolidation and lowest under equity
Current Service Cost
The PV of benefits earned by the employee during the current period
***For PBO, this includes an estimate of compensation growth
Interest Cost
The increase in the obligation due to the passage of time. increase in PBO resulting from interest owed on the current benefit obligation
Expected return on plan assets Actuarial vs Actual
Actuarial G/L or return effects PBO not plan assets
An actuarial gain will decrease the benefit obligation and an actuarial loss will increase the obligation
Actuarial G/L recognized in other comprehensive income (OCI).
IFRS- actuarial G/L not amortized. stay in OCI forever.
GAAP- actuarial G/L are amortized using corridor approach
Actual G/L or return effects Plan Assets not PBO
Under IFRS, the expected return on plan assets is implicitly assumed to be the same as the discount rate used for PBO.
Funded Status of a pension plan- plan assets (Diff between plan assets and PBO is funded status of the plan)
Plan Assets: Fair value at the beginning of the year \+ contributions \+ actual return - Benefits paid = Fair value at end of year
Funded Status of pension plan- PBO (Diff between plan assets and PBO is funded status of the plan)
Beginning Funded Status = fair value of plan assets - PBO
PBO
PBO at beginning of the year
+ service cost
+ interest cost
+ past service cost (plan amendments during the year)
+/- Actuarial losses/ gains during he year
- benefits paid
= PBO end of year
balance sheet asset (liability) = funded status
Amortization of unrecognized prior service cost:
Amortized costs for changes in PBO that result from amendments to the plan (GAAP only).
Under IFRS, prior service costs are expensed immediately and not amortized.
amortization caused by
1. changes in actuarial assumptions,
2. differences between actaual and expected return on plan assets. GAAP, actuarial gains and losses are recognized in OCI and amortized using the corridor method. Under IFRS, actuarial G/L are recognized in OCI and not amortized.
Total periodic pension costs
Elminiates the smoothing amounts and including the actual return on assets
TPPC = ending PBO - beginning PBO + benefits paid - actual return on assets
or
TPPC = contributions - (ending funded status-beginning funded status)
Main Difference Between GAAP and IFRS on pension accounting
The allocation of total periodic pension cost between the income statement (i.e. reported pension expense) and OCI.
Amortization of past service cost- amended pension plan PBO increases immediately.
GAAP-reported as part of OCI and amortized over service life. this combined with actuarial G/L smooths the pension expense.
IFRS- recognized in pension expense immediately and expensed. Actuarial G/L never leaves OCI.
Corridor Approach (US GAAP only)
Once actuarial G/L exceed 10% of the greater of the beginning PBO or plan assets, amortization is required. The EXCESS amount over the corridor is amortized as a component of pension expense over remaining service life of the employees.
Amortization of actuarial gain reduces pension expense.
IFRS- not subject to corridor method and never transfer out of OCI into income statement.
Recognition of components of pension- GAAP vs IFRS
Current service cost- both on income statement
Interest Cost- Both on income statement
Expected Return- Both on income statement
Past Service Cost- GAAP; OCI, amortized. IFRS; Income statement
Actuarial G/L- GAAP; amortized portion in income statement. Unamortized in OCI. IFRS; All in OCI not amortized.
Explain how adjustments for pension and other post employee benefits affect financial statements and ratios
1.Gross vs net pension asset/liabilities- Netting affects certain ratios because both assets and liabilities are less vs gross amount.
2.Differences in assumptions used- Assumption of different discount rates, with guy higher rate underestimating its PBO and pension expense.
3.Difference between IFRS and GAAP- Analyst could simply use comprehensive income (net income + OCI) as metric for comparison.
4. Differences due to classification in the income statement- operating/non-operating differ under GAAP and IFRS.
GAAP- net pension expense shown as operating expense
IFRS- Components included in various line items.
Adjust GAAP by adding back pension expense and subtracting only service cost in operating income. Interest cost added to firms interest expense and actual return added to non operating income.
Pension Cost on Cash Flows
firms contribution exceed total pension cost, can be viewed as a reduction in pension obligation and the opposite viewed as a source of borrowing.
If difference is material, reclassifying difference from operating activities to financing activities in CF statement is appropriate.
Share Based Comp Plans- Stock Options
Similar under both GAAP and IFRS
Stock Options- comp exp based on fair value of options (based on model) on grant date. Comp expense is allocated in income statement over the service period (grant date - vesting date)
***Comp expense will decrease net income and retained earnings BUT paid-in capital increases same amount resulting in no change to total equity
Lower volatility assumption, shorter term, higher dividend yield, or lower RF rate typically decrease fair value of option
Share Based Comp Plans- Stock Grants
Based on fair value of stock on grant date. Comp expense allocated over employee service period.
Share based comp plans- stock appreciation rights
Gives employee the right to receive payment based on increase in stock over a predetermined period. can pay in cash, equity or both.
employee has limited downside and unlimited upside potential. there is no dilution to existing shareholders.
Phantom Stock similar to stock appreciation except the payoff is based on performance of hypothetical stock.
IFRS example: Fair Value plan Assets = $100
PBO = $110 No unrecognized deferrals
So funded status and net pension liability are both $10
Now suppose a loss of $5 on the forecasted life expectation of employees increased
Fair value is still $100
PBO is now $115
Funded Status is now $15
**Since less not recognized on income statement, the net pension liability remains $10 (-$15 funded status + 5 unrecognized loss)
Example of GAAP vs IFRS
Prior report:
Fair Value 1,100
PBO 2,250
=Funded status ($1,150)
Unrecognized prior service cost 920
Unrecognized actuarial losses 160
= net pension asset or liabilities on balance sheet ($70)
Now under new GAAAP rules:
Under new standard, firm would have reported a net pension liability of ($1,150)
So to compare it is necessary to increase liability $1,080 and decrease shareholder equity
SFAS 158 new GAAP rule only affects the net pension asset or liability reported on the balance sheet and also applies to other post-retirement benefit plans
IFRS vs GAAP balance sheet pension
IFRS- Require companies to report on their balance sheet a pension liability or asset equal to the defined obligation- the fair value of plan assets, with certain adjustments for unrecognized actuarial gain/loss and any past service costs
**IFRS restrict the amount of a pension asset that can be reported
GAAP- Require companies to report on their balance sheet a pension liability or asset equal to the projected benefit obligation- Fair Value of plan assets, with NO additional adjustments
**No limit on amount of a pension asset that can be reported
Local Currency
Currency of the country being referred to
Functional Currency
Determined by management, is the currency of the primary economic environment in which the entity operates. It is usually the currency in which the entity generates and expends cash. The functional currency can be the local currency or some other currency
Presentation (reporting) currency
Currency in which the entity prepares its financial statements
Two methods used to remeasure or translate the financial statements of a foreign subsidiary to the parents presentation currency
Remeasurment- converting local currency into function currency using the temporal method
Translation- converting the function currency into he parent currency using all-current method
All determined by the functional currency relative to the parents presentation currency
All current Method (converting function to parent)
All balance sheet accounts = current rate
(except for common stock, which is translated at the historical (actual) rate that applied when the stock was issued)
Dividends = rate that applied when they were paid
All income statement accounts = average rate
Translation G/L is reported in shareholders equity as a part of the cumulative translation adjustment (CTA)R
REMEMBER CURRENT =CTA
Temporal Method (converting local to functional)
Monetary assets and liabilities = current exchange rate (ie cash, receivables, payables, and ST and LT debt)
All other assets and liabilities = historical (Actual) rate (ie inventory, fixed assets, and intangible assets)
Like all-current, common stock and dividends paid are remeasured at the historical rate
Revenue and all other expense = average rate
Expenses like depreciation, COGS, are remeasured based on the historical rates prevailing at the time of purchase
Translation G/L is recognized on the income statement. (this creates more volatile net income)
Factors in deciding on functional currency:
Currency that influences sales prices for goods and services
Currency of the country whose competitive forces and regulations mainly determine the sales price of goods and services
The currency that influences labor, material, and other costs
The currency from which funds are generated
The currency in which receipts form operating activities are usually retained
appropriate translation method
If functional currency and parents presentation currency differ, THE ALL-CURRENT METHOD is used to translate the foreign currency financial statement. Translation usually involves self-contained, independent subsidies whose operating, investing, and financing activities are decentralized from the parent.
IF functional currency is the same as parents presentation currency, the TEMPORAL METHOD is used to remeasure. Remeasurement usually occurs when subsidiary is well integrated with the parent
If local, functional, and presenting currencies differ both methods are used.
All-Current and Temporal example
US company has a subsidiary in Japan and they maintain their books in Yen and parent presents in US dollars:
Since functional and parents presentation currency differ, the ALL-CURRENT METHOD is used to translate form Yen to dollars
Now assume Japan subsidiary functional currency is Dollars. Since functional and parent are the same, the TEMPORAL METHOD is used to remeasure the subsidiary financial statements from Yen to Dollars.
A US firm owns a German subsidy who function in Euros. The German company also works with Swiss Francs. The Temporal Method is used to remeasure from the local currency (franc) into functional currency (Euro). then all-current is used to translate Euros into Dollars.
FX impact on Temporal and All Current to the Parent
Under all-current, net assets (A>L) or the subs equity, is what is exposed to changing rates.
net asset exposure, foreign currency appreciating = gain
Net asset exposure, foreign currency depreciating = loss
Temporal, net monetary assets/liabilities are only exposed to changing rates. most firms will have net monetary liabilities.
net monetary liability, foreign currency appreciating = loss
Net monetary liability, foreign currency depreciating = gain
***under temporal, firms can eliminate exposure to changing rates by balancing mon assets with mon liab. IE US firm mon liab $1M, if euro appreciates they see a loss. if they sell euro denominated fixed asset or inventory, making non monetary asset monetary, they can offset this loss. under all current is more difficult
All-Current rate vs Temporal- Same under both methods
Monetary asset and liabilities (payables, ST< debt, cash and receivables)-Current Rate
Common Stock-Historical Rate
Revenue and SG&A-Average Rate
All-Current rate vs Temporal- Temporal
1.Temporal 2.All-Current Nonmonetary A&L 1.Historical 2.Current (inventory, fixed assets, and intangibles) (Nonmonetary liability id deferred rev) COGS 1.Historical 2.Avg. Rate D&A 1.Historical 2.Avg. Rate Equity 1.Mixed 2.Current Net Income 1.Mixed 2.Avg. Rate Exposure 1.Net monetary AorL 2.Net Assets Exchange Rate G&L 1.I.S. 2.Equity
All Current effect on ratios
Pure balance sheet and pure income statement ratios will be the same (IE: current ratio, all profit margin measures, LTD/cap ratio, EBIT/Interest)
If foreign currency is depreciating, translated mixed ratios will be larger than original
IF foreign currency is appreciating, translated mixed ratios will be smaller than the original ratio
Analyze how using the temporal method versus the current rate method will affect the parent company’s financial ratios
In comparing the ratio effects of the temporal method and all current method, ti is necessary to:
Determine whether the local currency is appreciating or depreciating
Determine which rate (historical, average, or current rate) is used to convert the numerator under both methods and analyze the effects on the ratio
Determine which rate is used to convert the denominator under both methods and analyze the effects on the ratio
Determine whether the ratio will increase, decrease, or stay the same based on the direction of change in the numerator and the denominator
hyper inflationary economies
Cumulative inflation exceeds 100% over a 3 year period (26% annualized)
Hyper Inflation-GAAP-Temporal Method is REQUIRED when the subsidiary is operating in hyperinflation
Hyper Inflation-IFRS: Foreign currency statements are first restated for inflation and then translated using the all-current method.
Hyperinflation holding cash, receivables and payables Holding cash and receivables during inflation results in a purchasing power loss
Holding payables during inflation results in purchasing power gains (more monetary liabilities then assets)
Steps in the equity valuation process:
Understand the business Forecast company performance Select the appropriate valuation model Convert the forecasts into a valuation Apply the valuation conclusion
Holding Period Return-
Increase in price of an asset plus any cash flow received from that asset, divided by initial price
((Price +Cash Flow) / original price) - 1
annualized holding period return.
..IF one month return is 1%, then you report annualized as:
(1 + .01)^12 -1 = 12.68%
equity risk premium Historical estimate
the difference between the historical mean return for a broad-based equity index and a risk free over a given period of time. Strength: objectively and simplicity and unbiased; weakness: assumes mean and variance of the returns are constant overtime and this is not the case and app read to be countercyclical low in good times and high in bad times
equity risk premium Forward-Looking estimate or ex ante estimates
Strength of this method is that it does not rely on an assumption of stationarity and is less subject to problems like survivorship bias. There are 3 main approaches to forward looking: Gordon growth model, supply side models and estimates from surveys.
Gordon Growth Model
Estimates the risk premium as the expected dividend yield plus the expected growth rate minus the current long-term government bond yield
(D1 / P) + hatG - Rlt
Weakness: Forward looking st will change through time and need to be updated. Also the assumption of a stable growth rate, which is often not appropriate in rapidly growing economies
equity risk premium Macroeconomic Model Estimate (Supply-side estimates)
Calculate equity risk premium based on macro variables and financial variables. strength: use of proven models and current information; weakness: only good for developed countries where public equities are a large share of the economy.
Ibbotson-Chen model:
equity risk premium = (1+expected inflation) * (1+expected real growth in GDP) * (1+expected changes in the PE ratio) - 1 + the expected yield on the index + the expected RF rate
to get inflation outlook, you derive from the differences in the yields for T-bonds and TIPS with similar maturities
GDP est is sum of labor productivity growth and growth in labor supply
required rate of return on equity investment-CAPM
Estimate required return on equity using the following formula
required return = RF + (equity risk premium)*(beta of j)
required rate of return on equity investment-Fama-French Model
Multi-factor that attempts to account for the higher return generally associated with small-cap stocks
required return = RF + beta market(return of market - RF) +best small cap(return of small cap - return of big cap) +beta book value(return high book value market - return low book market)
Example applying the CAPM and the Fama-French Model
Market data provides following values for the factors:
Rmkt - RF = 4.8%,Rhbm - Rlbm = 1.6%,Rsmall-Rbig = 2.4%,RF rate = 3.4%
Stock J has CAPM beta equal to 1.3 and is small-cap, growth stock Beta market j = 1.2; beta small j = .4 beta hmlj = -.2
Calculate required return on equity using both models:
CAPM estimate = 3.4% + 1.3(4.8%) = 9.64%
Fama-French = 3.4% + 1.2(4.8%)+ .4(2.4%)+ -.2(1.6%) = 9.8%
required rate of return on equity
investment-Pastor-Stambaugh Model Adds a liquidity factor to the Fama-French Model
Base = 0
Less liquid assets have a positive beta and more liquid assets should have a negative beta
follow on example above and assume liquidity premium of 4%
beta of market k = .9, beta small-cap= -.2, beta of high book = .2, beta liquidity = -.1
3.4% +.9(4.8%)+ -.2(2.4%)+ .2(1.6%)+ -.1(4%) = 7.16%
required rate of return on equity
investment-Bond Yield Plus Risk
Used with companies that have publicly traded debt adding risk premium to the YTM of the debt
Company has bonds 15 yr maturity and a coupon of 8.2% and price of 101.70. Risk premium is 3.8% and YTM=8%
Cost of equity = 8% + 3.8% = 11.8%
Adjusted Beta
Adjusted Beta = (2/3) * (regress beta) + (1/3) * (1.0)
Beta estimate for thinly traded stocks and non-public companies
This is a 4 step procedure:
- ID a benchmark, or a company which is public and similar to ABC, for the company ABC
- Estimate the beta of the benchmarked company (done with regression analysis) denoted as XYZ
- Un-lever the beta estimate of XYZ
- Lever up the unlevered beta for XYZ using debt and equity measure of ABC this process isolates systematic risk
* in 3, (beta of XYZ)1 / (1+(debt XYZ/equity XYZ))
* **in 4, (unlevered beta of XYZ)(1+(debt of ABC/equity of ABC))
WACC
WACC = (MV of debt / MV of debt and equity) * required return on debt * (1-tax rate) + (MV of equity / MV of debt and equity) * required return on equity
- since estimate is forward looking, always use the marginal tax rate, which reflects the future cost of raising funds
- *We usually assume that the market weights for debt and equity are equal to their target weights. When this is not the case, the WACC calculation should use the target weights for debt and equity
Porter 5 forces: (industry level analysis)
- Threat of new entrants in the industry
- Threat of substitutes
- Bargaining power of buyers
- Bargaining power of supplier
- Rivalry among existing competitors
Consider effect of each force on LT profits (ROE) and determine whether each force makes the industry more or less attractive
bad forces=low profits
Force 1: the threat of new entrants into the industry key issue: will new industry entrants add capacity and compete away the value added component of price? FACTORS: economies of scale, product differentials, brand ID, capital requirements, switching costs, hight of entry barriers, access to distribution channels, gov. policy, cost advantage
Force 2: the threat of substitute products Note the is not only exists for potential substitutes now, but also those that could become available in the future.
Key: Do alternative products put a ceiling on the price buyers are willing to pay? FACTORS: price of subs, buyer propensity to sub, switching costs
Force 3: The bargaining power of buyers The bargaining power of buyers comes from 2 main sources, bargaining leverage and price sensitivity
KEY: will buyers capture the value-added component of price? FACTORS: bargaining leverage, buyer concentration, sub, switching cost, etc, threat of backward integration, high fixed costs vs total costs
Force 4: The bargaining power of suppliers the stronger the bargaining position of the suppliers, the greater their ability to increase their share of the value added in the form of higher prices for the input they sell to the industry. Remember the greater the switching costs, the greater the supplier power
KEY: Will suppliers capture the value-added component of price? FACTORS: differentiation of inputs, availability of substitute inputs, supplier concentration, importance of volume to supplier, threat of forward integration
Force 5: The degree of Rivalry among existing competitors main points are two fold. Do the firms follow sensible pricing policies or engage in price competition that cannot be won? do the firms engage in non-price competition that increases costs but fails to increase profits?
KEY: Will existing firms compete away the value-added component? FACTORS: industry growth, fixed costs, value added, product differences, brand ID, competitor diversity, exit barriers, informational complexity
Various facts may affect an industry on a temporary basis but do not determine industry profitability and structure in the long term. (non-porter forces)
- Industry Growth Rate- high growth diminishes rivalry but does nto assure profitability if other forces are detrimental to profits
- Innovation and technology- Improved technology does not improve profits if it attracts competitors. Low tech industries can be very profitable if the overall effect of the 5 forces is positive
- Government policies- These can be good or bad and are prone to change through time. Examples include patent protection, licensing requirements, labor policies, bankruptcy code, etc
- Complementary products- These are products that are used in conjunction with the firms products, and these can have a positive or negative effect
Factors such as these should be analyzed in terms of their impact on Porters five forces.
KEY: these impact only in the short run
Real vs Nominal:
Real- Inflation adjusted. used when inflation rates are high and volatile, usually good with international markets
Real rate = nominal rate - inflation rate
or
nominal rate = real rate + inflation rate
One-period DDM:
V0 = (D1 + P1) / 1+r D1= dividend at end of year 1 P1= price upon sale at end of year 1 r= required return on equity example: Stock pay dividend end of year of $1.25. Required return of 8% and expected price at end of year is $28. Current price is $26. Calculate value of shares today, and determine whether stock overvalued or undervalued.
Current value = (1.25+28) / 1.08 = $27.08
Stock is undervalued: current price is $26 and funds is $27.08
Two-Period DDM
Vo = D1 / (1+r)^1 + (D2+P2) / (1+r)^2
Example: Stock dividend is $1.55 and $1.72 in year 2. Price end of year 2 is $42 with a required rate of 14%.
What is current value?
1.55/1.14^1 + (1.72+42)/1.14^2 = $35
Multi-period DDM
Dividend is $1.50, $1.60, and $1.75
Price end of year 3 is $54
Required return is 15%
Cash flow in calculator is as follows: year 1 $1.50 Year 2 $1.60 Year 3 $55.75 Rate 15% CPT NPV $39.17
Gordon Growth Model:
Vo = D1 / (r-g)
***this assumes dividend increases at a constant rate indefinitely
Only works when paid dividend and at a constant rate and growth rate is less than the required return
r= required rate of return
g=dividend growth rate
Firm cannot grow indefinitely faster than LT growth of real GDP and LT inflation
Anything over 5% is suspect
Gordon Growth Model Example:
Dow paid dividend of $1.80 aussi dollars. We expect firm dividend growth at constant rate of 3.5% indefinitely. Dow beta is 1.5 and risk free is 4% and expected return on market portfolio is 8%. What is current value?
Use CAPM:
r= 4% + 1.5(8-4) = 10%
then use Gordon:
(1.80*1.035) / (.10-.035) = $28.66
PVGO- Present value of the growth opportunities
The fundamental value then represents not only the PV of future dividends (non-growth basis) but also the PV of the growth opportunities (PVGO):
PVGO- Present value of the growth opportunities-Formula
Vo = (E/r) + PVGO
E=no-growth earnings level
r=required return on equity
The value of a firms equity has 2 components:
The value of assets in place (e/r), or PV of perpetual cash flow of E
The PV of its future investment opportunities (PVGO)
PVGO example
Example:
Share trades at $60 and will earn $5/share and required return equal to 10%. Assume shares are properly priced. Calculate the PVGO, and the portion of the leading P/E related to PVGO?
$60 = $5/.10 + PVGO = $10
P/E firm (60/5)= 12X
P/E PVGO (10/5)= 2X
16.7% of the firms leading P/E ratio is attributable to PVGO
Justified Leading P/E
P/E = (1-b) / r-g b= retention ratio g= dividend growth rate 1-b = dividend payout ratio r= required return
Justified Trailing P/E
P/E = ((1-b)(1g)) / r-g
b= retention ratio
g= dividend growth rate
1-b = dividend payout ratio
r= required return
We can conclude from formula that PE is affected by growth rate and required rate of return and payout ratio
assumes no interaction between g, payout, and ROE
PE inversely related to required return (real rate, inflation, and equity risk premium)
Justified PE Example
Stock at $16 currently and earnings of $3 and dividend of $1.50.
Dividend will grow at 3.5% per year indefinitely
Risk free rate is 4% and equity risk premium is 6%
Beta is 1.1
Calculate justified leading an trailing PE?
Required return = 4% + (1.16%) = 10.6%
retention ratio = b = 1.50/3.00 = 50%
payout ratio= 1-b = 1-.5 = 50%
justified leading PE = 1-b / r-g = .5 / .106-.035 = 7.04
justified trailing = ((1-b)(1+g)) / r-g = .51.035 / .106-.035 = 7.29
***Justified trailing P/E will be larger than leading PE by a factor of 1+g
Justified PE example #2
Company with higher ROE then required return, if they raise retention ratio, firm can raise most valuation and share price
company generates a ROE of 13% and pays out 50% earnings in dividends with a required return for the firm at 10%
tangible PE value = 1/r = 1/.10 = 10.00
franchise factor = (1/r)-(1/ROE) = 1/.10-1/.13 = 2.31
Sustainable growth rate = g= ROEb = .13.5 = .065
growth factor = G = g/r-g = .065/.10-.065 = 1.86
franchise PE value = FFG = 2.311.86 = 4.30
Intrinsic PE value = tangible PE + franchise PE = 10+4.30 = 14.30
H-Model
Vo = Do(1+gl) / r-gl + Do(H)(gl-gs) / r-gl
H=t/2 ; t=length of high growth ; gs=ST growth rate; gl=LT growth rate; r=required return
H-Model Example Omega pays dividend of $2. Growth rate=20% decline linearly over 10 years to a stable 5% rate. RRR=12%. What current value?
(21.05)/.12-.05 + 2(10/2)*(.20-.05)/.12-.05 = 30 + 21.43 = $51.43
Terminal Value Example:
Company expected earnings in 10 years of $12/share. Dividend payout is 50% and expected return is 11%. It has a dividend growth perpetuity of 4% and trailing PE is 8X?
Dividend in 10 years will be $6 (12*.5) ; in year 11 its $6.24
Gordon growth = $6.24 / (.11-.04) = $89.14
Multiple approach = earnings $12 * 8X PE = $96
Calculating value with 2-stage DDM
Sea Island pays $1 dividend. An analyst forecasts growth of 10% for next 3 years followed by 4% growth in perpetuity. RRR=12%. What is current value/share? timeline: 1-1*1.1=$1.10 2-$1.21 3-$1.3331 4-$1.3842
Constant growth 4% begins after year 3, we employ the DDM to determine the value of the stock at time t=3?
terminal value = 1.3842 / .12-.04 = $17.30
So, 1=$1.10, 2=$1.21, 3=$17.30+$1.33=$18.63
CFO=0, c1=1.10, c2=1.21 and c3=18.63 with I=12%
CPT NPV = $15.21
Valuing a non-dividend paying stock
Arena currently pays now dividends. They reported $1.50 per share and expect to grow at 15% rae for next 4 years. Beginning year 5, they expect to distribute 20% of earnings in form of dividend and have constant growth of 5%. The RRR is 12%. what is value today?
First forecast earnings in year 5.
E4 = 1.50 * 1.15^4 = $2.62
E5 = 2.62 *1.05 = $2.75
Then calculate the dividends in year 5 at 20% of 5 year earnings
$2.75 * .2 = .55
Applying the Gordon growth model in year 5 dividends gives us an est of the terminal value in year 4. the terminal value discounted back 4 years is the current value.
V4 = .55 / (.12-.05) = $7.86
V0 = $7.86 / 1.12^4 = $5
Example: Calculating expected return with Gordon growth model
S&W stock is expected to pay a dividend of $1.60 has a current price of $40, and has a projected growth rate of 9%. What is required rate of return?
R = $1.60 / $40 + .09 = 13%
solving for expected return with the H-model
Fisheries just paid a div of .75, which has been growing at 10%. this rate is expected to decline to 5% over next 5 years and then remain at 5% indefinitely. calculate the implied required return for Fisheries based on the current price of $30
R = (.75/$30) * ((1+.05)+((5/2)*(.10-.05))) + .05 = 7.94%
Sustainable growth rate (SGP)
rate at which earnings can continue to grow indefinitely, assuming that the firms debt-to-equity ratio is unchanged and it does not issue new equity. its a simple function of retention ratio and ROE.
SGR = B * ROE
b= retention ratio = 1-dividend payout rate ROE = return on equity
**SGR is important because it tells us how quickly a firm can grow with internally generated funds
or
SGR = retention ratio * net profit margin * asset turnover * equity multiplier
DuPont:
ROE = (net income / sales) * (sales/total assets) * (total assets / stockholder equity) or ROE = net profit margin * asset turnover * equity multiplier (leverage ratio)
**always use beginning of year balance sheet numbers on exam (unless told otherwise) **
ROE Details We can also calculate this using PRAT model, which is ROE and retention ratio in one formula: (p=profit margin, r=retention rate, a=asset turnover, t=financial leverage)
g= (net income - dividends / net income) * (net income/sales) * (sales/total assets) * (total assets / stockholder equity)
**two functions are a function of the firms financing decisions (leverage and earnings retention, and two are function of performance (return on assets equals profit margin multiplied by asset turnover)
FCFF and FCFE breakdown
Cash Revenues - Working capital investment - Capex - Cash operating expenses (includes taxes but excludes interest exp) = FCFF
then, FCFF is broken up into interest payments to bondholders and FCFE
Net borrowings from bondholders is given back to FCFE
FCFF from Net Income
FCFF = NI +NCC+ (Interest*(1-tax rate)) - FCInv - WCInv
NCC=non cash charges
FCInv= fixed capital investment (capex) = (capex-proceeds form sales of LT assets or ending gross PP&E - beginning gross PP&E)
WCInv= Working capital = changes in working capital excluding cash, cash equivalents, notes payable, current portion of LT debt
NCC= most significant is depreciations, amortization, restructuring charges and deferred taxes
Noncash charges
Most significant noncash charge is usually depreciation.
others include:
Amortization
Gain on asset sale- (subtract)
Loss on asset sale- (add)
Restructuring expense (income)- add(subtract)
increase deferred tax liability- (add if they are not expected to reverse in future)
Amortization bond discounts and premiums- add discounts, subtract premiums
gain and loss on asset will show up in capex*
think deferred tax liability will be big one in questions
Working Capital Adjustments
Decrease in WC which is increase in FCF: a decrease in assets or increase in liabilities lower inventory lower accounts receivable higher accounts payable higher accrued taxes and expenses
Details on fixed capital (area messed up by people)
If given net PP&E, use the following equation: Beg net PP&E - depreciation +asset purchased - book value of assets sold = ending net PP&E
**if company receives cash in DISPOSING/SELLING OF A FIXED ASSETS, the analyst must deduct this cash in arriving at net investment in PP&E
***gain/loss on asset sale= proceeds from sale-book value of asset
subtract gains on sales of FCF, add losses on sales of FCF
deduct the proceeds from sale in arriving at the net FCInv
FCFF from EBIT
FCFF = (EBIT*(1-tax rate)) + Depreciation - FCInv - WC
FCFF from EBITDA
FCFF= (EBITDA(1-tax rate)) + (depreciationtax rate) - FCInv - WC
*Only have to add back the depreciation tax shield even though depreciation is a noncash charge, the firm reduces its tax bill by expensing it so the free cash flow available is increased by the taxes saved
FCFF and FCFE using cash flow statement
**recall, CFO = NI+NCC-WCinv, so CFO is after interest starting point
FCFF = CFO + interest*(1-tax rate) - FCInv
FCFE from FCFF
FCFE = FCFF - (interest *(1-tax rate)) + net borrowings
*****For preferred stock, treat preferred stock just like debt, except preferred dividends are not tax deductible
Calculate FCFF and FCFE
Net income \+ Non csh charges (NCC) - WCInv = CF from operations (CFO) - FCInv \+ Interest (1-tax rate) = FCFF (actual) \+ Net Borrowing - Interest (1-tax rate) = FCFE - Dividends \+/- Common stock issues (repurchases) = Net change in cash
Use FCFF or FCFE?
FCFE is easier and more straightforward to use in cased where the company’s capital structure is not particularly volatile. If a company has negative FCFE and significant debt outstanding, FCFF is generally the best choice. We can always estimate equity value indirectly by discounting FCFF to find firm value and then subtracting out the market value of debt to arrive at equity value.
Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE
Dividends, share repurchases, and share issues have NO EFFECT on FCFF and FCFE and change in leverage have only a minor effect on FCFE and no effect on FCFF.
FCFF Formula Review
FCFF= NI + NCC +(int(1-t))-WC-Capex FCFF= CFO + (int(1-t)) - Capex FCFF= (EBIT(1-t)) + NCC - WC - Capex FCFF= EBITDA(1-t) + (NCC*t) - WC - capex
FCFE Formula Review
FCFE= NI + NCC - WC - Capex + net borrowings FCFE= CFO - capex + net borrowings FCFE = EBIT(1-t) - Int(1-t) + NCC - WC - capex + net borrowing FCFE= EBITDA(1-t) - Int(1-t) + NCC(t) - WC - Capex + net borrowing FCFE = FCFF - (int(1-t)) + net borrowing
example for FCFF and FCFE For a $100 increase in below using a 40% tax rate:
Net Income=both FCFF and FCFE increase $100
Cash operating expense= both decrease $60
Depreciation= both increase $40
Int expense= FCFF is 0 and FCFE is decrease of $60
EBIT= both increase $60
accounts receivable= both decrease $100
Accounts payable= both increase $100
PP&E= both decrease $100
notes payable= FCFF is 0 and FCFE is increase of $100
cash dividend= 0 for both
new share issued= 0 for both
share repurchase = 0 for both
WACC
WACC = (Were)+(Wdrd*(1-tax rate))
We= market value of equity / market value of equity+market value of debt
Wd= market value of debt / market value of equity+market value of debt
PE Ratio:
Rationales for:
Earnings power, as measured by earning per share (EPS), is the primary determinant of investment value
The PE ratio is popular in the investment community
Empirical research shows that PE differences are significantly related to long-run average stock returns
Drawbacks:
Earnings can be negative
The volatile, transitory portion of earnings makes the interpretation of PE difficult for analysis
Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the comparability of PE across firms
**Trailing PE is not useful for forecasting and valuation if the firms business has changed (result of acquisition)
**Leading PE may not be relevant if earnings are sufficiently volatile so that next years earnings are not forecastable with any degree of accuracy
P/B Ratio:
Rationals for:
Book value is a cumulative amount that is usually positive, even when the firm has negative EPS. Thus, PB can be used when PE cannot
Book value is more stable than EPS, so it may be more useful than PE when EPS is particularly high low or volatile
Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples are finance, investment, insurance, and banking
PB can be useful in valuing companies that are expected to go out of business
Empirical research shows that PB help explain differences in long-run average stock returns
Drawbacks:
PB do not reflect the value of intangible economic assets, such as human capital
PB can be misleading when there are significant differences in the asset size of the firms under consideration because in some cases the firms business model dictates the size of its asset base. A firm that outsources its production will have fewer assets, lower book value, and a higher PB ratio than an otherwise similar firm in the same industry that doesn’t outsource.
Different accounting conventions can obscure the true investment in the fimr made by shareholders, which reduces the comparability of PB across firms and countries. For example, research and development costs (R&D) are expensed in the United States, which an understate investment
Inflation and technological change can cause the book and market values of assets to differ significantly, so book value is not an accurate measure of the value of shareholders investment. this makes it more difficult to compare PB across firms.
PB = market value of equity/book value of equity = market price per share/book value per share
book value of equity = common shareholders equity = total assets - total liabilities - preferred stock
- **common adjustment to PB is to use tangible book value, which is equal to book value of equity less intangible assets (goodwill and patents)
- **need to also make adjustments for significant off-balance-sheet assets and liabilities and for differences between the fair and recorded value of assets and liabilities
- **also need adjustments for LIFO and FIFO
P/S ratio:
Rational:
PS is meaningful even for distressed firms, since sales rev is always positive
Sales rev is not as easy to manipulate or distort as eps and book value
PS ratios are not as volatile as PE multiples
PS ratio are particularly appropriate for valuing stocks in mature or cyclical industries and start up companies with no record of earnings
Like PE and PB, empirical research finds that differences in PS are significantly related to differences in long-run average stock returns
Drawbacks:
High growth n sales does not necessarily indicate high operating profits as measured by earnings and cash flow
PS ratios do not capture differences in cost structures across companies
While less subject to distortion, revenue recognition practices can still distort sales forecasts. Example is sales on a bill and hold basis, which involves selling products and delivering them at a later date. this practice accelerates sales into an earlier reporting period and distorts the PS ratio
P/CF Ratio:
Rational:
cash flow is harder for managers to manipulate than earnings
price to CF is more stable than PE
reliance on CF rather than earnings handles the problem of differences in the quality of reported earnings, which is a problem for PE
empirical evidence indicates that differences in P/CF are significantly related to differences in long run avg stock returns
Drawbacks:
Items affecting accrual CF from operations are ignored when the EPS plus noncash charges estimate is used. for example, noncash revenue and net changes in working capital are ignored
From a theoretical perspective, FCFE is preferable to operating cash flow. However, FCFE is more volatile than operating CF, so it is not necessarily more informative
Normalized Earnings
Adj EPS to remove cyclical component of earnings and capture mid-cycle earnings or avg earnings under normal market conditions. two methods: method of historical avg EPS and method of avg ROE. **Key, with Avg ROE, use avg ROE BUT use current book value in formula ROE*BV=normalized earnings. avg ROE is preferred method as its more accurately reflects effect of growth and company size on eps
earnings yield (E/P)
the inverse of PE, used when negative earnings render PE meaningless. In these cases, it is common to use normalized EPS and or restate the ratio as the EP because price is never negative. Higher EP is cheap.
Justified P/B
Justified P/B = ROE-g / r-g
Conclude that PB increases as ROE increases
The larger the spread between ROE and r, all else equal, the higher the PB ratio
Justified P/s ratio
Justified P/S = (E0/S0)(1-b)(1+g) / r-g
Net profit margins (E0/S0) influences PS directly as well as indirectly through its effect on the sustainable growth, g.
g=retention rationet profit margin(sales/assets)*(assets/shareholders equity)
So, PS increases if profit margins or earnings growth rates increase
PEG ratio
PEG ratio = PE ratio / g
The PEG is interpreted as P/E per unit of expected growth. the PEG in effect standardizes the PE ratio for stocks with different expected growth rates. The implied valuation rule is that stocks with lower PEG’s are more attractive than stocks with higher PEG’s, assuming the expect return and risk are similar. problems are seeing risk attributes between firms, the duration of the growth and nonlinear relationship between growth and pe
Drawbacks of PEG ratio
The relationship between PE and g is not linear, which makes comparisons difficult
The PEG ratio still doesn’t account for risk
The PEG ratio doesn’t reflect the duration of the high-growth period for a multistage valuation model, especially if the analyst uses a short-term high-growth forecast.
Enterprise value
EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments
standardized unexpected earnings (SUE)
standardized unexpected earnings (SUE) = earnings surprise / SD of earnings surprise
Harmonic Mean vs other averages
portfolio or index PE and other relative value ratios based on price are best calculated like this
harmonic mean = 1 / (Wi/Xi)
example using one stock price of $10 and earnings of $1 (PE=10) and one priced at $16 with earnings of $2 (PE=8)
what is the mean of the portfolio for 1 share?
earnings per share = 1+2=3
price of a portfolio share is 10+16 = 26
arithmetic mean = (8+10) / 2 = 9
weighted mean = (10/26) *10 + (16/26) * 8 = 8.76
harmonic mean = 2 / (1/10)+(1/8) = 8.88
weighted harmonic mean = 1 / (10/26)(1/10)+(16/26)(1/8) = 8.67
note when there are extreme outliers, arithmetic mean will be the most affected
Harmonic mean puts more weight on smaller values
for equal weighted portfolio or index, the harmonic mean and weighted harmonic mean will be equal
residual income model
RI model breaks intrinsic value of equity into 2 components: Current book value of equity B, plus PV of expected future RI.
so: RIt= Et (R*Bt-1) OR RIt = (ROEt - r) * BVt-1
The RI valuation model breaks the intrinsic value of a stock into two elements:
1.Current book value of equity
2.Present value of expected FUTURE residual income
**RI models, value is recognized earlier in the approach, unlike FCFE and DDM that get the majority of its value from the PV of the terminal value.
**RI terminal value estimates are less of a focus, because the models include the firms current book value and the current book value usually represents a substantial % of the estimated intrinsic value
Discuss the fundamental determinants of residual income
The general RI model make no assumptions regarding the long-term future earnings or dividend growth.
Value instead can be expressed in terms of book value: (single stage RI model)
Vo = Bo + ((ROE-r)*Bo / r-g)
ROE and required return on equity relationship
If ROE is equal to required return on equity, the justified market value of a share of stock is equal to its book value.
When ROE is higher, the firm will have positive RI and will be valued at more than book value
the single stage model assumes constant ROE and earnings growth, which implies that RI will persist indefinitely
persistence factor
the projected rate at which residual income is expected to fade over the life cycle of the firm, which can be between 0 and 1
the more sustainable the competitive advantage and the better the industry prospects, the higher the persistence factor
High factor associated with low dividend payments. Low factor associated with significant levels of nonrecurring items.
higher persistence factors higher persistence factors will be associated with the following:
low dividend payouts
historically high residual income persistence in the industry
low persistence factors low persistence factors will be associated with the following:
high return on equity
significant levels of nonrecurring items
high accounting accruals
EVA
EVA = NOPAT - (WACC*invested capital)
= (EBIT * (1-t)) - WACC
RI vs EVA
***note RI is net income (After subtracting interest expense) minus a charge for equity capital based n the cost of equity. EVA is NOPAT (before subtracting interest expense minus a charge for debt and equity capital based on the WACC)
Defining Residual Income
RI = net income less opportunity cost of equity capital
So, RI = net income - (equity capital * cost of equity) OR
RI= EBIT(1-t) - (total capital * WACC%)
accounting income will overstate returns from equity investor perspective because ignores cost of equity
example: 2009 EPS $1.20, BV/share 2008=$10 and equity required return is 10%, what is RI ? RI = EPS - (BVr) so $1.20 - (10.10) is 20 cents, so the firm earned positive RI of 20 cents
adjustments in calculating NOPAT and invested capital:
Capitalized and amortize R&D charges (rather then expense them) and add them back to earnings to calculate NOPAT
Add back charges on strategic investments that will generate returns in the future
Capitalized (but do not amortize)goodwill, add amortization expense back to earnings to get NOPAT, and add accumulated amortization back to invested capital. these are important the financial statements are prepared using IAS. under new rules for GAAP, goodwill is not amortized.
Eliminate deferred taxes and consider only cash taxes as an expense
Treat operating leases as capital leases and adjust nonrecurring items
Add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT.
Market value added (MVA)
difference between the market value of a firms long term debt and equity and the book value of invested capital supplied by investors.
***Measures the value created by management decisions since the firms inception
MVA = market value - invested capital
Tobin’s Q:
Q = (market value of debt+ market value of equity) / replacement cost of total assets
strengths of the residual income model
terminal value does not dominate the intrinsic value estimate, as is the case with DDM and FCFE models
RI models use accounting data, which is usually easy to find
the models are applicable to firms that do not pay dividends or that do not have positive expected FCF in the short run
The models are applicable even when CF are volatile
the models focus on economic profitability rather than just on accounting profits
weaknesses of the residual income model
The models rely on accounting data that can be manipulated by mgmt
Reliance on accounting data requires numerous and significant adjustments
the models assume that the clean surplus relation holds or that its failure to hold has been properly taken into account (ending BV=beginning BV+earnings-dividends, excluding ownership transactions; any accounting charges that are taken directly to the equity accounts, such as currency translation G&L, will cause the clean surplus relation not to hold)
RI are appropriate when:
a firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable
expected FCF are negative for the foreseeable future
the terminal value forecast is highly uncertain, which makes dividend discount or FCF models less useful
accounting issues in applying residual income models-Clean Surplus Violations
Clean Surplus Violations
This may not hold when items are charged directly to shareholders equity and do not go through the income statement. therefore we have to adjust net income to account for these items:
foreign currency translation gains and losses that flow directly to retained earnings under the all-current method
The minimum liability adjustment in pension accounting
Changes in the market value of debt and equity securities classified as available for sale
**violations here is the fact net income is not correct but book value is
accounting issues in applying residual income models-Variations from Fair Value Variations from Fair Value:
Common adjustments to the balance sheet necessary to reflect fair value include the following:
Operating leases should be capitalized by increasing asset and liability by the PV of the expected future operating lease payments
Special purpose entities (SPEs) whose assets and liabilities are not reflected in the financial statements of the parent should be consolidated
Reserves and allowances should be adjusted. Example, the allowance for bad debts, which is an offset to accounts receivable, should reflect the expected loss experience
Inventory for companies that use LIFO should be adjusted to FIFO by adding the LIFO reserve to inventory and equity, assuming no differed tax impact
The pension asset or liability should be adjusted to reflect the funded status of the plan, which is equal to the difference between the FV of the plan assets and the projected benefit obligation (PBO)
Deferred tax liabilities should be eliminated and reported as equity if the liability is not expect to reverse.
example private company beta.
company peer has a beta of 1.09. the public company is funded by 60% debt while the private company is funded with 49% debt. What is private company beta? need to deliver the beta. = (1/(1+D/E))beta
so (1/ (1+.6/.4))1.09 = .436
now need to lever this beta back up to private company leverage. This is (1+D/E)beta
so (1+.49/.51).436 = .854
Competitive environments
differ based on their degree of PREDICTABILITY and MALLEABILITY (ability of firm to change the industry)
Appropriate Style Less malleable and less predictable = adaptive
Less malleable and more predictable = classical
More malleable and less predictable = Shaping
More malleable and more predictable = Visionary
Competitive Environment Detail
Classical strategy formulation Predictable and less malleable:
ID company strength and formulate a plan to get most favorable market position
Methodical multi-year, long term forecast
Porters 5 force analysis
Adaptive strategy formulation Less predictable and less malleable:
Constantly update goals
Quickly react to new information
Maximize flexibility (not efficiency)
Shaping strategy formulation Less predictable and malleable
Short planning cycle with flexibility
network of customers/partners/suppliers
Defining new markets, practices
Visionary strategy formulation predictable and malleable
“Build it and they will come”
Ford’s 1908 intro of an affordable car for the masses
Have adequate resources
stay committed to the plan
*none of these work in a crisis, where its all about survival for all in safeguarding resources, controlling costs, restructuring, an dST plans until crisis passes
CAGR Formula
CAGR = (ending value / beginning value)^(1/#of years) - 1
H model example.
Tata chem last 5 years paid divvy of 5.50,6.50,7,8,9 for 13% growth. Use 3 stage model, with linear growth rate in stage 2. Stage 1 to be 6 years and stage 2 to be 10 years. Growth stage 1 is 14% and 10% in stage 3. Rate of return is 16%. Divvy in stage 2 and 3 can use Hmodel which est value at beginning of stage 2 which would be divvy6. Then PV divvy1-6 need to be added.
Divvy6(1+gL)+divvy6H(GS-GL) / r-GL
Divvy6=divvy0(1+GS)^6 = 9(1.14)^6=19.75
So, 19.75(1.10)+19.75(5)(.14-.10) / .16- .10 = 428.02
Next, discount 9 dividend for 6 years and add 428.02 to the 6th year. So, cf1=8.8448,cf2=8.6923,cf3=8.5425,cf4=8.3952,cf5=8.2504,cf6=8.1082
Total is 226.51
Residual income model
RI= net income - equity change
Equity change = equity capital x cost of equity
Value = book value + ((ROE - r) x book value / r - g)
Clean surplus relation Ending book value = beginning book value + earnings - dividends. Ex ownership transactions
It may not hold when items bypass the IS and affect equity directly. FX G/L under current rate method bypass IS and reported under equity as CTA.
Residual Income example on per share basis
from test 1 AM
Book value calculation consisted of BOTH retained earnings and total equity common shares (i.e. what is left over between assets-liab)
I get a BV of $32.16 per share; EPS given is $4.50 with divvy payout of 5% with cost of equity of 12.8% and WACC 11.9%
Forecasted BV is BVt-1 +earnings - divvy so we get $32.16+4.50-.22 = $36.43
Equity Charge per share (rX BVt-1) so its .128 X 32.16 = $4.12
Per Share RI is $4.50 - $4.12 to get 38 cents per share
Economic Value Add and Market Value Add Follow up from RI example
$WACC= WACC X invested capital
EVA = NOPAT - $WACC
Market Value of company= market value of equity + market value of debt
Market Value add = market value - invested capital
WACC(long term debt+common shares+retained earnings) which is .119(6211+2100+2081)= 1236.65
NOPAT= EBIT(1-T)
EVA= 1868(1-.30) - 1236.65 = 70.952
Implied growth rate in residual income g= r - (BV(ROE-r)) / value of stock now - book value
R=12.8%; ROE=14%; stock price today $36
g= .128 - (32.16(.14-.128)) / $36 - 32.16 = 2.75%
Incremental Project CF
outlay = cost of fixed capital + change in working capital**
**chg non-cash CA - chg non-debt CL sunk costs not incremental externalities are incremental treat projects as if all equity financed Consulting fee in analysis is a sinking cost, so you have to ignore it in your calculations
After Tax Operating CF
CF=(sales-cash operating expenses-cep exp)(1-tax rate)+D
Terminal Year After Tax non-operating CF
TNOCF = pre-tax cash proceeds from sale + recovery of net working capital - T(pre-tax cash proceeds from sale - book value)
Replacement Projects
Reduce the initial outlay by the after tax proceeds from the sale
depreciation using only the difference between old and new del
operating CF’s consider only incremental CF from new project
Project with unequal lives-least common multiple of lives method
finding the least amount of time where we can allocate equally between the two projects
NPV’s can now be directly compared
Select the higher NPV on equal life basis
Project with unequal lives- Equivalent Annual Annuity (EAA)
EAA: Annual payment equivalent for each NPV.
use calculator, PV for outlay, time in years you will have project for N, your discount rate for I and solve for PMT
Pick the project with the biggest PMT
Modigliani and Miller on Capital Structure-Propositon 1 no tax
Concept 1: Value of firm no taxes: capital structure is irrelevant with levered and unleveled firms having same value
Holds in perfect market with no taxes, no transaction costs, no costs of financial distress
Modigliani and Miller Proposition ii no taxes
WACC unchanged by leverage. cost of equity increases linearly as company increases its proportion of debt financing
WACC is unaffected by capital structure
Same issus as Prop 1 with perfect market
Modigliani and Miller Prop 1 and 2 WITH taxes
debt creates tax shield. debt interest payments are tax deductible. so tax shield increases the size of the pie. optimize capital structure is 100% debt where WACC will be the lowest. in real life we worry about risk of bankruptcy
static trade-off theory
Costs of financial distress Higher cost of financial distress offsets any benefit from tax shield.
Agency Costs of Equity
Costs of conflict of interest between managers and owners. the key point is greater financial leverage reduces agency costs with managers having less FCF to squander
Pecking Order Theory
mgmt sends signals based on their financing choices. Internally generated funds are most favored with debt second and newly issued equity least favored
Dividend theories
Irrelevance theory- policy for dividends is irrelevant
Preference theory- investors prefer dividends over cap appreciation
Tax Preference theory- want small dividend payments vs large: cap gains taxed lower and not taxed till realized
Effective tax rate on dividends
double tax and split rate system:
eff tax rate= tax corp + (1-tax corp)(indiv. tax)
Imputation system:
eff tax rate= shareholders tax rate
Residual Dividend Model
- ID optimal capital budget
- determine amount of equity needed given target cap structure
- meet equity requirements to extent possible with retained earnings
- pay dividends with the residual earnings
Target Payout Adjustment model
expected dividend = Previous divvy +((exp increase in EPS)(target payout ratio)(adjustment factor))
**adj factor how many years it takes to bring to target payout
Dividend Ratios
Dividend Payout Ratio Dividend / Net Income
Dividend coverage Ratio Net Income / Dividend
FCFE Coverage Ratio FCFE / (dividends + share repurchases)
**higher coverage’s means higher sustainability
Sensitivity and scenario Analysis
Sensitivity analysis you change one input to see how it effects others
Scenario analysis several input variables are changed for each scenario
WACC
WACC (Market Weight of Debt * AFTER TAX cost of debt) + (Market weight of equity * cost of equity)
- **REMEMBER AFTER TAX COST OF DEBT
- **REMEMBER MARKET WEIGHT
- **USE PROJECT SPECIFIC RATES OF RETURN INSTEAD OF COMPANIES OVERALL RATE OF RETURN
economic profit calculation
EP =NOPAT - $WACC
EP= periodic measure of profit above and beyond the dollar cost of capital invested in the project
nopat=EBIT (1-T)
$WACC=dollar cost of capital = WACC*capital WACC
to value a company, add PV or EP to original investment discounted at WACC
Inflation effect on capital budgeting
nominal include effect with inflation with real adjusted CF downward removing effect of inflation
inflation reduces value of depreciation tax savings
profitability of the project will be lower in higher then expect inf.
inflation higher then expected, real interests expense decreases
inflation increases corporations real taxes because it reduces value of the depreciation tax shelter and decreases real interest expense
Agency Relationship Conflicts manger (agent) vs shareholder (principal):
agent unwisely expands size of firm
excessive comp
taking too much risk
not taking enough risk
Agency Relationship Conflicts Director (agent) vs shareholder (principal):
Lack of independence (managers on BOD)
Board members have personal relationship with mgmt.
Board members with consulting agreements
interlinked boards
directors are overcompensated
***BOD aligned with mgmt. not shareholders
Board of directors Best Practices
Composition of board; 7% of directors independent
Independent board chairman
qualified directors
election procedures
board self-assessment practices
frequency of separate session for independent directors (min annually)
Audit committee (only independent directors)
Nominating committee (only independent directors)
compensation committee (link to performance)
use of independent and expert legal counsel
Statement of governance policies
Disclosure and transparency
Board approval for related party transactions
Responsiveness to shareholder proxy votes
types of M&A
Statutory merger-target ceases to exist
subsidiary merger-target becomes sub of the acquirer
consolidation merger- two companies form to create new company
horizontal merger- operating in the same or similar industries
vertical merger- along supply chain of acquirer
conglomerate merger- 2 companies completely separate industries
industry lifecycles and common mergers
Horizontal mergers common in all life cycle stages
Tend to see vertical mergers primarily in mature growth stage
conglomerate mergers only common at beginning and end of industry life cycle
Pre-offer defense mechanisms
poison pill-right to purchase more shares at discount
poison put-bondholder demand immediate payment
states with restrictive takeover laws
Staggered board-winners win minority board seats each year
restricted voting rights-
supermajority voting provision for mergers-75%+ shareholder support
fair price amendment-fair price based on independent appraisal
golden parachutes-big cash payouts to mgmt
Post-offer Defense Mechanism
Litigation-lawsuit against acquirer
greenmail- target repurchases shares from acquirer at premium. payoff to acquirer think blackmail
share repurchase
leveraged recapitalization-take a big debt amount to buy shares
crown jewel defense- target sells major asset to 3rd party
pac-man defense- target makes counteroffer to acquirer
white knight defense- friendly 3rd party makes offer
white squire defense- friendly 3rd party buys minority stake
Herfindahl-Hirschman Index
HHI = # of firms (MS*100)^2 ms= market share of firm I n=number of firms in the industry under 1000 no action 1000-1800 possible as moderate over 1800 virtually certain will see action
Evaluating a merger bid
Vat = Va + Vt + S - C Vat=post merger value of combined firm Va= pre merger value of acquirer Vt=pre-merger value of target S=synergies c= cash paid to target shareholders
Evaluating a merger bid example:
Hardware acquiring tool. scenario 1 cash: $18 per share of tool or Scenario 2: .6 shares of hardware for each share of tool. Hardward price is $25, 35M shares outstanding; tool price is $15 with 26M shares outstanding; synergies are $85M scenario 1: post-merger valuation of combined firm = 875+390+85-468=882
Gain to target= 468 - 390 = 78
Gain to acquirer= 85 - (468-390) = 7
Scenario 2: # of new shares = 26*.6= 15.6M + 35M = 50.6M
post-merger valuation= 875+390+85-0 (stock deal not cash)=1350
new price = 1350 / 50.6 = 26.68
Price paid for target = 15.6 * 26.68 = 416.21
Gain to target = 416.21 - 390 = 26.21
Gain to acquirer= 85-(416.21-390)=58.79
**stock deal is probably tested on exam as easy to trip up on **
Major objective of corporate governance
To eliminate conflicts of interest, particularly those between managers and shareholders
To ensure that assets are used efficiently and productively and in best interests of its investors
Core attributes of an effective corporate governance system:
Delineation of the rights of shareholders
Clearly defined manager and director governance responsibilities to shareholders
ID and measure account abilities for the performance of responsibilities
Fairness and equitable treatment in all dealings between managers, directors, and shareholders
Complete transparency and accuracy in disclosures regarding operations, performance, risk and financial position
Investors and analysts should assess the following elements of a statement of corporate governance policies:
Code of ethics
Statement of oversight and monitoring for the board
Statement of management responsibilities to provide complete and timely info to the board prior to meeting and to give directors with free and unfettered access to control and compliance functions
Reports of directors examination and findings in their oversight and review function
Board and committee performance self-assessment
Management performance assessment
Training provided to directors prior to joining the board and periodically thereafter
No traditional business factors
Environmental, social, and governance risk exposures
Risks to these factors include legislative and regulatory risk, legal risk, reputation risk, operating risk, and financial risk
Income approach to valuing real estate-direct capitalization
Rental income if fully occupied \+ other income = Potential gross income - Vacancy and collection loss = effective gross income - Operating expense (includes property tax) = Net Operating Income (NOI)
Note: income tax and interest expense are not operating expenses. property taxes are included here
Example: Cap Rate and Discount Rate Apartment this years NOI is $5M. NOI expected to be $7.5M in absense of renovations. NOI is expected to grow at 5%, with renovations at sellers expense, required return is 10%?
Value of apartment: 7.5m / (.1 - .05) = $150M
PV of temp decline in NOI= N=1, Y=10 = pmt= 0 fv = 2.5M sold for PV?
PV is 2.272M
value of apartment is 150M - 2.272M = 147.727M
Gross income multiplier (like price to sales ratio)
MV = gross income * income mutiplier (M)
Gross income mutipler (M) = Sales price / Gross income
(determine this with comparable properties)
it ignores vacancies and operating expenses
Financial ratios that influence max loan amount
debt service coverage ratio DSCR = 1st yr NOI / debt service
LTV = loan amount / appraisal value
equity dividend rate (cash on cash return) = 1st yr CF / equity
Net asset value per share in REIT valuation
RE can be valued by capitalizing NOI
First calculate the market required rate of return (cap rate):
cap rate = NOI / property value
Second, capitalize the REIT rental stream:
Property value = NOI / cap rate
Financial statement adjustments to get appropriate REIT numbers
Accounting net earnings \+ depreciation \+deferred tax charges - gains (losses) form sales of property and debt restructuring = FUNDS FROM OPERATIONS (FFO)
- noncash straight line rent adjustment (none cash rent)
- recurring maintenance type capex and leasing commissions
= AFFO (adjusted funds from operations)
Leveraged buyout
Exit value = investment cost + earnings growth + mutiple expansion + reduction in debt
Financial performance of private equity funds
Paid in capital (PIC): percent of capital used by GP
Distributed to PIC (DPI): measures LP realized return, cash on cash return
Residual value to PIC (RVPI): measures LP’s unrealized return
Total value to PIC: measures LP’s realized and unrealized return, sum of DPI, and RVPI
All describe return on a per dollar investment. so dpi of .2 for each dollar invested, 20 cents has been returned. rvpi can be 1.3 with 20 cents distributed, there is still 1.3 in value for each dollar invested
private equity formulas
carried interest = 20% * (NAV before dis - committed capital)
NAV before distributions= previous year NAV after distribution + capital called down - mgmt gee + operating results
NAV after distribution = NAV before distribution - carried interest - distributions
DPI = cumulative distirbutions / paid in capital
RVPI = NAV after distribution / paid in capital
TVPI = DPI + RVPI
Venture capital investment rounds
Post money valuation = FV / (1+r)^n
Pre= post - investment
required fractional ownership = Investment / Post value
**if worth 11m in 5 years and we put in 7m, we need to own 62.75% of the firm. the shares the owners own is 1M so we take 1M*(.6275/1-.6275) = 1,684,564 shares to VC
VC multiple rounds:
need 4m now and 3m in 3 years IPO firm for 60M in 5 years, want 1 m shares and discount rate is 40%. calculate pre and post money valuations, ownership fraction and price per share compound discount rate: (1.40)^3 - 1 = 174.40%
r2=(1.40)^2-1 = 96%
Post valuation second round = 60M / (1+.96) = 30.612245M
Pre money valuation at second round = POST - INV so 30.612M - 3M = 27.612M
Post money valuation at first round = PRE2 / 1+r) so 27.612m / (1+1.7440) = 10.062M
Pre money valuation at first round is post 1- inv 1 so 10.062m - 4m = 6.062M
required ownership for second round investor = INV2/POST2 os 3M/30.612M = 9.80%
Required ownership for first round investor = INV1/POST1 SO, 4m / 10.062M = 39.75%
Required shares for first round investors = shares (f1/1-fv) SO 1m(.3975/1-.3975) = 659,751
stock price after first round of financing is INV1/Shares SO 4M/659,751= $6.06
required shares second round = (1M +659,751)* .098/(1-.098) = 180,328
stock price after 2nd round is 3M / 180,328 = $16.64
Backwardation and Contango
Backwardation commodity term has a negative trend with future prices lower then spot
Contango positive slop with future prices above the spot rate
Structural Models
Based on structure of a company’s balance sheet and insights form option pricing. IE: equity holders have call option on company’s assets with face value of debt as strike price.
Structural models require estimates of expected return on assets and volatility of asset returns. These inputs are not traded so have to use implicit estimation techniques (calibration) of the stock and where it is trading.
Structural Models Strength/Weakness
strength: uses option pricing theory to understand probability of default
inputs can be est with current market pricing.
weakness: Assumptions here are far fetched as they say rates do not move, assets trade in frictionless market and companies only have one debt instrument in their capital structure. So balance sheet cannot be modeled realistically using a single zero-coupon bond so recovery and default may be inaccurate.
Reduced Form Models
Impose assumptions on the output of structural models with no assumption’s on structure of balance sheet.
Allow inputs parameters like RF rate, default probabilities, loss given default to vary with economic conditions.
Input parameters can be estimated using historical data
Reduced Form Models Strength/Weakness
strength: model inputs can be estimated using historical data, credit risk is allowed to fluctuate with the business cycle, and no need to specify company’s balance sheet
weakness: past market conditions may not reflect the future
present value of expected loss
the max amount an investor would pay an insurer to bear the credit risk of the risky bond
PV of expected loss = value of a RF bond - Value of a credit risky bond
Yield Curve Shifts
Parallel shift: yields on all maturities change by same amount
Twist flatter: spread between LT and ST maturities narrows
Twist steeper: spread widens
Positive butterfly shift: curvature is less curved
Negative butterfly shift: curvature is more curved
Swap Rate Curve (LIBOR curve)
typically based on treasury securities, based on a series of fixed-rate quotes on interest rate swaps. not affected by gov regulation, more comparable across countries, and quotes at more maturities then treasury term structures
Pure Expectations Theory
forward rates are solely a function of expected future spot rates (no interest rate uncertainty)
implication is LT rates are equal to complex mean of future expected ST rates
fails to recognize price risk and reinvestment risk. This says the slope of the yield curve indicates direction of future rate changes
Liquidity Theory
Implied forward rate = expectations + liquidity premium
liquidity premium based on maturity risk
liquidity premium compensates for interest rate risk, with larger number for longer maturities
Preferred habitat Theory
Same as liquidity theory but premium not based on maturity
implied forward rate = expectations + premium
This theory can explain almost any yield curve shape
Effective Duration
% price change in bond = -1(duration)(change in yield)
Spread Measures
Nominal Spread- Difference between bond yield and yield on comparable maturity gov securities (just credit spread never on exam)
Z-spread- spread added to each rate on spot rate curve that makes PV of bond CF’s equal to market price (adds fixed spread to make model= market price)
Option adjusted spread (OAS)- spread added to each rate in binomial tree that makes bond value calculated from binomial model equal to market price
OAS= option removed spread
OAS = Z spread - cost of embedded option
OR OAS + option cost = Z spread
Binomial Tree- Backward induction methodology
Value bond by moving backward from last period to time zero
Value at maturity is known
Value at any node is avg PV of 2 possible values form next period
Discount rate is forward rate for that node
