Keynes: Sticky prices, so if Demand falls, Supply will fall, and employment falls
Expenditures GDP: Consumer Spending, Private Investment, Government expenditures
If Actual Expenditures < Planned Expenditures, then inventory exists, employees will be
laid off, output will fall. Thus, investment is the primary source of instability.
If I get an additional $1,000, I spend MPC*$1000 with a group of vendors. This group
then spends (MPC*$1000)*MPC and so on. The expenditures multiplier is thus
expressed: M = 1 Aggregate spending increases by M*1000
(1 – MPC)
LRAS
AD2 AD3
SRAS
AD1
GDPf
At AD1, increased expenditures increase output. At AD2, increased expenditure
increases prices.
If expansionary fiscal policy is used to thwart recessions, some argue that budget deficits
lead to higher interest rates and crowd out private investments. Keynesians argue that
there are excess loanable funds. Then again, this excess could be from foreign sources
which causes the dollar to rise and then raises the value of imports and decrease the value
of exports.
Classical / Supply-Side: Demand falls then Wages fall, Supply is constant, and
Employment is constant
Resource Cost-Income Approach:
Employee Compensation, Proprietor’s Income, Rents, Corporate Profits, Interest Income,
Indirect Business taxes, Depreciation, Net income of foreigners
Expansionary fiscal policy such as a tax cut will be saved by consumers in anticipation of
a future tax hike. This savings increases the supply of loanable funds leaving interest
rates unchanged.
Automatic stabilizers ensure deficits in a recession and surpluses during booms and, thus,
mitigate policy lags. The three main are Unemployment Compensation, Corporate Profit
Taxes, Progressive Personal Income Taxes.
Supply-siders say that taxes should be cut to stimulate investment and savings, more
working, and a reduction in the use of tax shelters.
Expansionary monetary policy: Fed buys T-bonds which raises bond prices and drives
down yields (rates). Lower real rates cause more investments to be profitable, hence
raising investment spending. AD shifts to the right. In the short run, investment, output,
and prices increase. Lower real rates depreciate the dollar which increases exports.
Lower rates cause stocks, bonds, and houses to rise in price, thus increasing personal
wealth.
Thus, if money supply increases while velocity and quantity is fixed, prices must rise.
P = MV/Y
In the long run, nominal rates rise because expected inflation rises. N = I + R
If a policy change is fully anticipated, contracts reflect higher prices. Thus, prices and
rates increase, causing no gain in output.
Individuals who use adaptive expectations will tend not to anticipate policy changes, thus
leading to a change in output over the short-run but only a change in prices over the long-
run. Inviduals using rational expectations will tend to anticipate policy changes, thus
affecting prices over both the short- and long-run.
When actual inflation exceeds expected inflation, unemployment drops below the natural
rate and vice versa.
Stagflation.
Supply curves are elastic when producers can add resources inexpensively.
Changes in resource prices: higher costs shift supply curve left (reduce supply and
increase prices)
Changes in technology: lower cost techniques increase supply (shift curve right)
Slope of demand curve is not the price elasticity. Price elasticity is higher at higher
prices.
Unitary price elasticity – total expenditures on a good are constant because a change in
price equals the change in quantity demanded at all price levels. For an individual firm,
revenue is maximized at UPE.
Demand curve facing oligopolist is very elastic or flat so a small decrease in P, leads to a
large change in Q.
Game Theory: Prisoner’s dilemma
Natural Monopoly – Economies of scale are so pronounced that Government imposes the
price ceiling of Average Cost to ensure normal (zero) economic profit. But this gives the
monopolist no incentive to reduce costs and maintain quality.
Demand for productive resources is a derived demand since demand for the final good it
produces determines demand for the resource. In the short run, if there are no good
substitutes for a resource and demand for the final good is inelastic, then demand for the
resource is inelastic. If a resource has few other uses, then it has low resources mobility
and a low elasticity of supply…in the short-run. Demand for a resource also increases as
its productivity increases.
For a given firm that holds all other resource inputs constant, a curve depicting the
marginal revenue product will be identical to the firm’s demand curve for the resource.
Comparative advantage is the ability to produce a good at a lower opportunity cost than
others can produce it. Absolute advantage refers to using the fewest resources to produce
a product.
P Domestic A – Domestic Producers Gain
Supply Quota B, D – Deadweight Loss
WorldPrice + Supply A, B, C, D – Consumer Loss
Tariff C – Government Revenue
A B C D
WorldPrice Domestic
Demand
Q
Quotas are worse than tariffs because government gets nothing, foreign producers gain
from higher prices.
Current Account is the exchange of merchandise goods, services, investment income, and
unilateral transfers (gifts to and from other nations). All other factors constant, a deficit
balance on the current account implies that there is an excess supply of dollars in the
Foreign Exchange markets. Hence, the dollar should depreciate.
An unanticipated shift to expansionary monetary policy will lead to more (1) rapid
economic growth, (2) an accelerated inflation rate, and (3) lower real interest rates.
(1) leads to more imports, (2) to fewer exports, and (3) to reduced foreign
investments.
The weaker $ then leads to more exports more than offsetting the move to deficit in the
capital account. An unanticipated shift to a more restrictive fiscal policy will result in
budget surpluses. Reduced aggregate demand causes an economic slowdown and lower
inflation. These discourage imports and encourage exports, resulting in a stronger $.
Less demand for borrowing weakens the $. So results conflict.
Expansionary fiscal policy coupled with restrictive monetary policy causes higher real
interest rates, net capital inflow, appreciation of currency, and a deficit in the current
account.
J-curve: When a country’s currency depreciates, the current account may worsen while
the country continues to buy the previously contracted for (but now higher-priced)
imports instead of domestic goods.
Forward markets are used by traders (import/export) and hedgers (home currency value
of foreign-currency denominated assets) to manage currency risk associated with
conducting business. Arbitrageurs use them to take advantage of differing interest rates.
Speculators buy and sell currency and provide liquidity.
Spot Quotations
Interbank Dealer Quotes: American Terms – USD/FC & European Terms – FC/USD
Non-bank Public Customer: Direct Quotes – DC/FC & Indirect Quotes – FC/DC
Leptokurtic: greater percentage close to the mean or far from the mean (greater risk)
than Normal.
Platykurtic – flatter than a normal distribution.
Semi-logarithmic scales use an arithmetic scale on the horizontal axis and a logarithmic
scale on the vertical axis. Then equal vertical movements reflect equal percentage
changes. Move from 10 to 20 and 1000 to 2000 would be identical: 100%.
Bayes formula is used to update a given set of prior probabilities for a given event in
response to the arrival of new information.
Using Bayes’, we can compute P(B⎥A) given P(B), P(A⎜B), and P(A⎢Bc)
Var(x) = σ2(x) = ΣP(xi)[xi - E(x)2]
Cov(Ri, Rj) = E{[Ri – E(Ri)]*{Rj – E(Rj)}
Cov(Ra, Ra) = var(RA)
Ex: How many ways can 3 stocks be sold from an 8 stock portfolio?
nCr = n! = 56
(n-r)!*r!
Binomial Distribution
Binomial RV: # of successes in a given # of trials whereby the outcome is “success” or
“failure.”
The Binomial Distribution defines the probability of “x” success in “n” trials.
p(x) = P(X=x) = # of ways to choose x from n, px(1-p) x where
# of ways to choose x from n = nCr = n! = (n) “n choose x”
(n-x)!*x! (x)
p = probability of success on each trial
E(x) = expected # of successes = np
Var(x) = expected # of successes = np(1-p)
Lognormal
Distribtuion
Hypothesis Testing
H0: µ ≥ 0 2-tailed (µ = 0, µ ≠ 0)
Ha: µ > 0
One-tailed
Reject H0 if test statistic > 1.645 = Z.05
p-value = Z-2.67 = .0038 < .05 = α, reject H0
To reject the null hypothesis, look for big test statistics and small p-values
p-value is the probability that lies above (below) the computed test statistic for upper
(lower) tail tests
t-distribution is more conservative and thus more difficult the reject the null hypothesis
than the z-. Use the t- if the population variance is unknown and
1. sample is large (n≥30)
2. sample is small but distribution is ~N
tn-1 = X(bar) - µ0
s/√n
z-statistic = X(bar) - µ0 for unknown population variance and large size, else standard
deviation is σ s/√n
Tests of differences between means (used when samples are independent)
H0: µ1 - µ2 = 0 vs Ha: µ1 - µ2 ≠ 0
H0: µ1 - µ2 ≤ 0 vs Ha: µ1 - µ2 > 0
H0: µ1 - µ2 ≥ 0 vs Ha: µ1 - µ2 < 0
Compounding
FV = PV(1+r/m)m where m = payments per year and r = annual interest rate
FV = PVert, for continuous compounding
EAR = (1 + periodic rate)m – 1
Coefficient of Determination:
% of total variation in the dependent variable is explained by the independent variable.
R2 = r2 for one independent variable
F-statistic
H0: b1 = b2 = b3 = …. = bk = 0, Ha: at least 1 bi ≠ 0
F = mean square regression, MSR = SSR/k
Mean square error, MSE = SSE/(n-k-1)
F-test, goodness-of-fit test, whether at least one independent variable in the set of
independent variables explains a significant portion of the variation of the dependent
variable.
With only one independent variable, F-statistic equals t-statistic.
1. Movements along the line mean the security’s risk has changed
2. Change in the slope of the SML means that investors have changed their risk
premium per unit of market risk. If an increase in the premium, the SML will
rotate counterclockwise about the risk-free rate.
3. Change in capital market conditions and the rate of inflation will cause the SML
to experience a parallel shift. Upward for increasing inflation. Downward for
decreasing.
Asset Allocation
Policy: Asset Classes
Policy: Weighting 85-95% of return
Timing: How far can the manager deviate
Selection: of securities
Introduction of a risk-free asset changes the Markowitz efficient frontier from a curve
into a straight line called the Capital Market Line.
rc = wrp + (1 – w)rf;
E(rc) = wE(rp) + (1 – w)rf = rf + w[E(rp) - rf]
E(rp) - rf is the risk premium
σc = wσp since σf = 0
E(rc) = rf + σc[E(rp) - rf]
σp
(Jensen’s) α = (rI - rf) - βi(RM - rf)
Security Market Line: α = Rs – (Rf + β(RM) )
E(Ri) = Rf + (E(Rm) – Rf)* βi
Asset with E(R) (given our forecasts of future prices and dividends) to identify
undervalued assets and create the appropriate trading strategy
βI = covi,m = (σ1) * ρi,m
σ2 m σ m
1. Costs can’t be estimated Æ Completed Contract (conservative, less stable
earnings)
2. Incomplete Earnings Process and costs can be estimated Æ Percentage of
Completion Method (approximates sales basis)
3. Use Cost-Recovery for sales complete with contingencies and revenue either
assured or not. Similar to Completed Contract in that income and revenue are
recognized when the contract is complete
4. Installment Sales: Use when earnings process is complete but revenue is not
assured.
5. Sales Basis: Goods provided upfront and collection very likely.
Change prior years’ financial statements if:
a. Change from LIFO to another method
b. Change to or from the Full-Cost Method
c. Change to or from the Percentage-of-Completion Method
d. Any change just prior to an IPO
e. Distinct operation is discontinued, changes occur below the line
Liabilities will most likely be greater under the completed contract method compared to
the percentage of completion method.
Cash collections = sales – increase in A/R
Cash Inputs = COGS + Increase in Inventory – Increase in A/P
Direct
Method Cash Expenses = Wages – Increase in Salaries Payable
Cash Interest = Interest – Increase in Interest Payable
Cash Taxes = Taxes – Increase in Taxes Payable – Increase in Deferred Taxes
Indirect Method
NI + Depreciation – Gain from Sale of PPE + Increase in A/R + Increase in Inventory –
Increase in A/P – Increase in Salaries Payable – Increase in Interest Payable – Purchase
of PPE (+ Sale of PPE) + Debt Issue + Stock Issue – Dividends + Increase in Dividend
Payable + Increase in Deferred Taxes
FCF = Cash Flow from Operations – Capital Spending + Sale of fixed assets
If strike price of the warrants < average share price, warrants are dilutive. Complex EPS
denominator increases by (# of warrants) * (1 – Strike Price)
Avg Market Price
# of shares issued to satisfy warrants proceeds used to repurchase shares
Use LIFO when examining profitability or cost ratios and FIFO values when examining
asset or equity ratios.
Capitalize interest on debt used to purchase an asset. Add weighted average of interest
on other non-asset specific debt on any cost not covered by asset-specific debt used in
purchase.
Analyst should expense interest and deduct it from depreciation expense of prior years.
No CF impact.
Analysis of Inventories
GAAP requires inventory valuation at lower of cost or market.
COGS = purchases + beginning inventory – ending inventory
Rising Prices: LIFO COGS > FIFO COGS Æ LIFO NI < FIFO NI &
LIFO Inventory < FIFO Inventory
LIFO Current Ratio (CA/CL) < FIFO Current Ratio (CA/CL)
LIFO Inventory Turnover (COGS/Avg Inventory) < FIFO
By decreasing inventory to levels below normal, firm can proclaim high profit in a LIFO
liquidation.
FIFO provides the most useful estimate of the inventory value and LIFO the most useful
estimate of COGS.
LIFO reserve = InvF – InvL
1. COGSF = COGSL – change in the LIFO reserve
2. purchases = EIL – BIL + COGSL
EIF = EIL + LIFO reserveE
BIF = BIL + LIFO reserveB
COGSF = purchases + BIF – EIF
2. Fair Value Method (SFAS #123) uses an option pricing model to determine
compensation expense on the grant date. The CE is expensed over the service
period.
Tax Savings from the effect of expensing options in prior years should be recorded as a
deferred tax asset offset by a reduction in retained earnings and an increase in paid-in-
capital.
Adjust the # of shares outstanding to reflect any dilution from the exercise of the options
that are at- or in-the-money.
Because firms do not recognize compensation expense related to granting options, they
record a tax deduction related to their exercise directly to the shareholder’s equity
account. This tax benefit is also included as a component in the operating Cash Flows.
Cash Flow is not immediately affected by the granting of options.
Management can re-classify securities between classifications at current fair market value
and can recognize any unrealized gains or losses in income.
Security Classification
Trading Available-for-Sale Held-to-Maturity
B/S (carrying) value Fair Market Value Fair Market Value Amortized Cost
with unrealized G/L
in equity
Recognized as • Dividends • Dividends • Interest
income • Interest • Interest • Realized G/L
• Realized G/L • Realized G/L
• Unrealized G/L
Although the pre-tax income for available-for-sale and held-to-maturity securities is the
same, the book rate of return varies because unrealized gains and losses are included in
the carrying value of the securities under the available-for-sale method, while the cost of
the securities is used under the held-to-maturity method.
In consolidated reporting, two firms are presented as one economic entity with all income
of the affiliate (less any minority interests) is reported on the parent’s income statement.
Income is higher under the equity method than under the cost or market method. The
remainder owned by other investors is accounted for as a liability by use of the minority
interest account and is computed as (1 – parent’s ownership) times subsidiary’s net
worth. Each account consists of the sum of the corresponding accounts from each of the
individual firms, less any intercompany transactions (revenues and COGS are both
lowered by the proportionate value of intercompany transactions and A/R and A/P are
adjusted). Do not add the equity accounts together.
Current Assets = Parent’s CA + Parent’s share of Sub’s CA - year’s investment in Sub
Total Assets = Parent’s TA + Parent’s share of Sub’s TA - year’s investment in Sub
Net Income = Parent’s NI + Sub’s NI – Minority Income Interest
COGS = Parent’s COGS + Parent’s share of sub’s COGS – Parent’s share of sub’s
intercompany revenues
Consolidation and the equity method both result in the same net income and the same net
worth. If the subsidiary is profitable, the equity method reports better results.
Proportionate Consolidation
“Equity in JV” is a Revenue Account equal to (ownership share) * (JV’s net income)
“Investment in JV” is a B/S Account equal to (ownership share) * (JV’s equity)
Results for the consolidated firm reflect combined results of the combination date
Recognize target intangible assets of target such as software development costs, licenses,
in-process R&D. Then, amortize these (except R&D for US GAAP) on income
statement. Goodwill is not amortized under US GAAP.
Increase in inventory is expensed in COGS. IPR&D and goodwill are amortized over 4
& 10 years respectively under IASB GAAP.
Sales growth is smaller under pooling because past results are re-stated as if the
combination had existed all along.
Shareholders of the acquired company do not recognize a gain or loss on the exchange of
shares. They use the old basis in the shares of the acquired company as the basis for the
shares they receive.
Under IASB Purchase Method depreciate FMV of PPE over its remaining useful life.
Interest expense related to acquired company’s long-term debt will increase if the debt’s
market value is lower than book, because the difference between FMV of the long-term
debt and its par value must be amortized as interest expense.
Transition Liability and Related Amortization: asset or liability amount that was
created when FAS No. 87 was first applied, usually 1987.
Contributions are payments made by company or participants into the pension account.
Benefits paid are payments made from the pension account to retirees. Both the plan’s
obligations and assets decrease when the firm pays out benefits.
3 key assumptions: discount rate, rate of compensation increase, E(R) on plan assets
A higher discount rate improves reported results by lowering PBO and service cost
(though it does increase the interest cost) which lowers pension expense.
Higher expected return on plan assets will improve reported results by not affecting
PBO/ABO, result in higher expected future pension assets and reducing net pension
liability, and resulting in a lower pension expense.
Lower Healthcare Inflation Rate improves reported results because it decreases the
APBO and post-retirement benefit expense.
Funded Status = PBO – FMV Pension Plan Assets
Net Pension Liability/Asset = PBO – Reported Value Pension Plan Assets
FMV Plan Assets at end of the year = FMV Plan Assets at Beginning of the year
+ Employer Contributions + Plan Participant Contributions
- Benefits paid to retirees during the year
PBO at end of the year = PBO at Beginning of year + Service Cost + Interest Cost
± Amortization of actuarial losses or gains & plan amendments
- Benefits paid to retirees during the year
Any difference between the actual return on plan assets and the expected return is
deferred and accumulated. Similarly with any liability gains and losses. This net amount
is deferred to future years and is amortized when it exceeds the corridor amount of 10
percent of the greater of PBO or plan assets. If unamortized deferred and accumulated
amount falls below the corridor amount, the amortization stops until the corridor amount
is exceeded in a future year.
Market-related value of the plan assets is an “average” asset value given by amortizing
the differences between actual and expected return over a period of five years.
Ending Market-Related Value = Beginning Market-Related Value
+ Expected Return on Plan Assets + Employer Contributions
- Benefits Paid
± 20% of deferred asset gains/losses over past 5 years
Reported Pension Expense = Service Cost + Interest Cost – E(R) on Plan Assets
+ Amortization of unrecognized prior service costs
+ Amortization of deferred actuarial and investment losses
OR (- Amortization of deferred actuarial and investment gains)
If we assume that deferred taxes will be reversed in the future, an increase in pension
liability (or a decrease in a pension asset) will result in offsetting declines in deferred tax
liabilities and equity.
If we instead assume that the deferred taxes will not be reversed in the future, there will
be no effect on deferred taxes and an increase in pension liability (or a decrease in a
pension asset) will result in a decline in equity.
Adjusted Pension Expense = Service Cost + Interest Cost – E(R) on Plan Assets
Economic Pension Expense = Service Cost + Interest Cost – Actual Return o Plan Assets
VARIABLE INTEREST ENTITY: partnerships, LLC’s, trusts, etc. that conduct business
or hold assets, often passively (receivables or real estate), or as entities that service
(R&D) for other companies. VIE is distinguished as a legal entity if:
1) Equity investors have no voting rights
2) Equity investors do not provide sufficient capital (<10%) to support the entity’s
activities
Variable interests are those that change with changes in the value of assets of the VIE.
For example, management service contracts, leases, subordinated debt, equity, and
options to purchase assets.
In situations where one interest receives a majority of the income and/or gains, while
another is exposed to a majority of losses, the interest exposed to the losses must
consolidate the VIE.
The Primary Beneficiary consolidates VIE’s Assets, Liabilities, and non-consolidated
interests at FMV. Assets transferred from PB to VIE are at carrying value.
Exchange rates can impact the reporting firm’s financial statements in two ways:
1) flow effects: those changes on flow variables such as revenue
2) Holding effects: those changes on assets and liabilities held
Functional currency is that of the primary economic environment in which the foreign
subsidiary generates and expends cash.
Current rate is the exchange rate as of the b/s date.
Average rate is the average exchange rate over the reporting period.
Re-measurement is the translation of local currency transactions into the functional
currency using the temporal method, with gains and losses flowing to the I/S.
Translation is the conversion of the functional currency of a subsidiary into the reporting
currency uses the all-current method with gains and losses flowing to the B/S.
Temporal Method
1. Cash, Accounts Receivable, Accounts Payable, and long-term debt (defined as
monetary assets and liabilities) are translated using the current rate.
2. All other assets and liabilities (non-monetary assets and liabilities) are translated
at the historical rate. Hence, a major drawback of the temporal method is that you
need to keep track of many different historical exchange rates.
3. Revenues and expenses are translated at the average rate.
4. Purchases of inventory and fixed assets are re-measured at the historical rate as of
the date of purchase.
5. Translation gain or loss is shown on the income statement.
Under FIFO, inventory is at the exchange rate at which the purchases were made.
Under LIFO, inventory is valued at the historical rate.
To calculate COGS, use COGS = Beginning Inventory + purchases – ending inventory
by converting these to the reporting currency
FIFO LIFO
Depreciating Local Higher Cogs Lower COGS
Currency Lower Ending Inventory Higher Ending Inventory
Appreciating Local Lower COGS Higher COGS
Currency Higher Ending Inventory Lower Ending Inventory
In a net asset position, the assets that are translated at the current rate exceed the
liabilities that are translated at the current rate (since equity > 0).
In a net liability position, the liabilities that are exposed to the current rate exceed the
assets that are exposed to the current rate. Under the temporal method, A/P and long-
term debt are translated at the current rate, but only cash and A/R are on the asset side.
If you hold a net asset position, a depreciating foreign currency reduces the USD value of
that net asset position. Thus, the translation adjustment will be negative.
If you hold a net liability position, a depreciating foreign currency increases the USD
value of the position. Hence, a positive translation adjustment.
1. In the all-current method, ratios are unaffected if the numerator and
denominator are both derived from either the B/S or I/S because
multiplying both by the exchange rate cancels out.
2. The all-current method results in small changes in ratios combining
income statement and balance sheet data.
3. Temporal method results in ratios that are materially different.
4. An appreciating (depreciating) local currency creates the illusion of higher
(lower) sales and earnings of foreign subsidiaries.
5. Translated sales, SG&A, and expenses are the same under both methods;
COGS, depreciation, and net income are not. Since COGS and
depreciation are translated at the average rate in the all-current method and
at the historical rate in the temporal method, COGS and depreciation are
lower, and profitability margins are higher, under the all-current method.
6. Translation gain increases the net profit margin under the temporal
method, though less so than under the all-current method.
7. All-current method results in lower total assets and a higher total asset and
inventory (due to measuring COGS at an average rate, rather than the
historical rate, which is higher as a result of the depreciating currency)
turnover than the temporal method.
8. If the local currency is depreciating, than COGS and depreciation will be
lower in the all-current method.
9. Debt/total capital and debt/equity ratios are lower under remeasurement if
the foreign currency depreciates. Total debt is converted at the same rate
under both methods. Lower COGS and depreciation expense under the
all-current method result in higher net income. Incremental net income is
more than offset by the translation adjustment to the equity account.
10. If a local currency is appreciating, the foreign subsidiary’s performance
will have a greater impact on the consolidated data.
Financial Shenanigans – Deception Strategies
Inflate reported current-period earnings by inflating reported current-period revenue and
gains or by deflating reported current-period expenses. Deflating reported current-period
earnings by deflating reporting current-period revenue and gains or by inflating reported
current-period expenses.
1. Recording Revenue
2. Recording Fictitious revenues
3. Shifting current expenses to a later period
4. Boosting income with one-time gains
5. Failing to record or disclose all liabilities
6. Shifting current income to a future period
7. Shifting future expenses to the current reporting period
High growth (high P/E makes stock prices vulnerable to declines in earnings), very weak,
private (not audited), and newly public companies are most prone to shenanagins.
Conservative Accounting Choices: LIFO, Rapidly writing off goodwill, not reporting
non-recurring gains, expensing initial start-up costs, not capitalizing software costs, not
capitalizing other expenses, providing adequate provisions for contingent liabilities, using
accelerated depreciation methods, using short useful life estimates for fixed assets, using
completed contract method for long-term projects, using high bad debt reserves vis-à-vis
the size of the accounts receivables, not using off-balance sheet financing, providing clear
and adequate disclosures explaining accounting practices, reporting net income that
closely matches cash flow from operations
6. Cash flow from operations that is significantly different from net earnings should
indicate that the firm’s quality of earning is suspicious due to a high-level of non-cash
expenses or non-cash income recorded on the income statement. Alternatively, the firm’s
expenditures for working capital may be too high.
7. Change in accounting estimate or principle, auditor, CFO, or outside counsel
Balance Sheet
1.Consolidate assets and liabilities of VIE’s
2.Capitalize PV of operating leases, take-or-pay commitments, contingencies (which
increases the leverage ratio)
3.Mark-to-market marketable securities, long-term investments, long-term debt
4.A/R: Check fluctuation in Bad Debt Expense as % of A/R
5.Inventories: Add LIFO reserve to the LIFO inventory balance to get FIFO
6.PPE- Mark-to-market real estate, run impairment test on fixed assets
7.PPE- Uncapitalize interest expense
8.Eliminate Goodwill
9.Reduce/Increase equity by increase/decrease in marking-to-market long-term debt
10. Eliminate reported pension plan asset. Use funded status of the pension and post-
retirement benefit plans to get the economic liability (asset). Reduce equity by
elimination of asset + increase in liability (which increases ROE).
11. Stock option plans cause reclassification of paid-in-capital and RE.
12. Change deferred tax liability (due to accelerated depreciation and employee benefits)
to expected tax liability. If significant upward trending, then low possibility of reversal,
so zero out the liability and increase the equity.
13. Change deferred tax assets (due to PPE leases, employee benefits, self-insurance
accruals) to zero.
14. Use FMV of Comprehensive Loss Account which contains accruals for minimum
pension liabilities, unrealized securities gains and losses, and cumulative translation
adjustments. Changes should be offset by changes in other B/S accounts.
Comprehensive income allows for all changes in equity (other than owner contributions
and distributions) from valuation changes to assets and liabilities (minimum pension
liabilities, unrealized gains/losses on available-for-sale securities, cumulative foreign
currency translation adjustments. You can include the other B/S changes such as change
in deferred tax liability and asset, adjustment for long-term debt mark-to-market,
adjustment for capitalized interest, change in pension plan funded status.
CASH FLOW
Capitalizing R&D results in higher current cash flow over expensing.
If operating leases are capitalized, CFO should be split into interest paid (CFO) and
repayment of debt (CFF)
Equity method instead of consolidation distorts cash flows.
Return on Total Capital = net income + interest expense = net income + interest expense
Average total capital average total assets
Business Risk = (σ of operating income)/(mean operating income) for btw 5-10 yrs of dat
Sales Variability = (σ of sales)/(mean sales)
Operating Leverage = mean[absolute value(%∆Operating Earnings)]
%∆Sales
Total Debt Ratio = (Current Liabilities + Total Long-term Debt)/Total Capital
Interest Coverage = EBIT/(Interest Expense)
External Liquidity:
number of shares traded during a given time period
size of the bid-ask spread is negatively related to liquidity
total market value of the outstanding securities
number of shareholders is positively related to liquidity
trading turnover is positively related to liquidity
DUPONT ANALYSIS
ROE = (Net Income/Equity)
ROE * Sales = Net Income * Sales = (Net Profit Margin)*(Equity Turnover)
Sales Sales Equity
ROE = Net Profit Margin * Total Asset Turnover * Financial Leverage Multiplier
If the firm does not earn ke on that portion of the investment project that is financed with
the new equity capital, the firm’s growth rate of 7.2% will not be met, and the price of the
firm’s stock will fall. Thus, the sale of new equity is not by itself dilutive. The dilution
of earnings comes about only if the new funds are not invested in such a manner as to
cover the return of new equity capital.
Relevant Cash Flows are the Incremental Cash flows that occur iff the project is
accepted. Sunk costs, such as a fee to a marketing research firm to forecast cash flows,
are not included. Opportunity costs from using the asset (say, cash) in the project
versus another should be included. Externalities (cannibalization) should be included.
Shipping and installation costs are included in the depreciable basis of the asset.
MACRS is based on actual cash flows so it should be used for capital budgeting. It
assumes that the asset is placed in service in the middle of the first year. Salvage value is
not considered when determining depreciation.
Monte Carlo Simulation – Scenario Analysis repeated 1000 times to generate mean,
variance
Project Risk – Beta
1.Pure Play Method: Look for other companies with single product lines similar to that
of the project being evaluated and then take an average to estimate the project’s beta.
2.Accounting Beta Method runs a regression of the company’s accounting ROA against
the S&P return on assets.
Optimal capital structure maximizes the firm’s stock price by taking on as much debt
(cheaper capital) as possible without adding too much default risk.
The higher the firm’s inherent business risk (demand variability, sales price variability,
input price variability, ability to adjust output prices as input prices change, operating
leverage—the extent to which costs are fixed), the lower its optimal debt ratio.
The higher the firm’s effective tax rate, the higher its optimal debt ratio.
The higher the firm’s financial leverage, the more sensitive EPS becomes to changes in
sales.
High operating leverage indicates that a small change in sales will cause a large change in
operating income.
The level of sales that a firm must generate to cover all of its fixed and variable costs is
called the breakeven point. The breakeven sales quantity, QBE, can be derived as:
Sales Revenues = Operating Costs
(Price per Unit)(Quantity) = (Variable cost per unit * Quantity) + Fixed Costs
QBE = F / (P – V)
Degree of Operating Leverage
DOL = percentage change in EBIT = ∆EBIT / EBIT
Percentage change in sales ∆Q/Q
DOLQ = Q(P-V) or, based on dollar sales rather than units, DOLS = S – VC
Q(P-V) – F S – VC – F
Degree of Total Leverage combines the degree of operating and financial leverage
DTL = (DOL)(DFL) = (%∆EBIT / %∆Sales)(% ∆EPSS / %∆EBIT) = %∆EPS/%∆Sales
DTL = [Q(P-V)] / [Q(P-V) – F – I]
DTL = [S – VC] / [S – VC – F – I]
Since P = (P/E)(EPS), by increasing financial leverage you increase the volatility of EPS
and thus increase the volatility of the stock’s price.
P0 = DPS/ks
WACC minimized where P0 maximized
Modigliani and Miller proved that under a very restrictive set of assumptions, the value
of a firm is unaffected by its capital structure. These assumptions are:
1) There are no transaction costs
2) Taxes are nonexistent
3) There is no cost of bankruptcy
4) Investors and corporations borrow at the same rate
5) Investors and managers have the same information about the future investment
opportunities of the firm. This is called symmetric information.
6) Debt has no effect on EBIT
In the MM no-tax world, the value of a company is based on the value of the firm’s
assets. The firm’s WACC is constant.
When these assumptions are relaxed, we realize that there is a difference between the
firm’s assets and what investors may be willing to pay for the shares that represent the
assets.
Since debt interest is tax deductible and dividends are not, optimal tax structure in a tax
world (all other assumptions holding) will be 100% debt.
With taxes and bankruptcy costs, WACC will fall at first as small amounts of debt are
added to the capital structure. As the firm continues to add debt to the capital structure,
the lender’s threshold level of risk is hit, and they start to raise interest rate. The WACC
finally starts to rise.
High-tax bracket investors (like individuals) prefer low dividend payouts and low-tax
bracket investors (like corporations and pension funds) prefer high dividend payouts.
Variable dividends result in a higher required return on a firm’s stock and thus a lower
stock price, so firms maintain stable dividends. Thus, firms should
1.Project average values for their marginal cost of capital and IOS over the near term
planning period (5 years)
2.Find the residual model payout ratio and dollars of dividends required during the
planning period using the forecasted marginal cost of capital
3.Set a target payout ratio on the basis of the projected data
Warrants are like options but they are issued by the firm so that capital is supplied to the
firm upon their exercise. Upon exercise, dilution occurs. They are most often issued
with private bond placements, but also with public debt, preferred and common stock.
Warrant = 1 * BSM call value; the 1/(1+q) provides the dilution effect
1+q q = # of warrants outstanding / total shares outstanding
Most convertibles are unsecured and junior to other debt issues. Therefore, smaller firms
or firms with hard-to-value products or business lines are more likely to issue such
securities. For these situations, it is hard to assess the risk of the debt. Issuing straight
debt with a higher interest rate causes the borrower to engage in asset substitution –
playing in overly risky ventures.
Mergers: Horizontal (same LOB), Vertical (Up toward the ultimate consumer, down
toward suppliers, to eliminate “hold up” problems), Conglomerate
Benefits: Economies of Scale, Complementary Resources (sum is greater than the parts)
Bootstrap Effect
Assume no net gains in value from a merger. When a high growth prospects firm (high
P/E) acquires with a low growth prospects firm (low P/E) by exchanging higher-priced
shares for lower-priced shares, the number of shares outstanding of the acquiring firm
increases, but by less than 1-for-1. Thus, the high-growth firm’s EPS goes even higher.
Ex Ante Alpha = expected return – required return = E(capital gain) + E(ROE) - E(ROE)
P = current stock price
Ex Post Alpha = HPR – Return on Similar Assets