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Tutorial 1

1. John, who has just completed his first finance course, is unsure whether he should take a course in
business analysis and valuation using financial statements since he believes that financial analysis
adds a little value, given the efficiency of capital markets. Explain to John when financial analysis can
add value, even the capital markets are efficient.
Answer: The efficient market hypothesis implies that there is no further need for analysis involving a
search for mispriced securities. However, if all investors adopted this attitude, no equity analysis would
be conducted, mispricing would go uncorrected, and markets would no longer be efficient. This is why
there must be just enough mispricing to provide incentives for the investment of resources in security
analysis. Even in an extremely efficient market, where information is fully impounded in prices within
minutes of its revelation (i.e., where mispricing exists only for minutes), John can get rewards with
strong financial analysis skills:
1. He can interpret the newly-announced financial data faster than others and trade on it within
2. Financial analysis helps him to understand the firm better, placing him in a better position to
interpret other news more accurately as it arrives.
Markets may be not efficient under certain circumstances. Mispricing of securities may exist even days
or months after the public revelation of a financial statement when the following three conditions are
1. Relative to investors, managers have superior information on their firms’ business strategies and
2. Managers’ incentives are not perfectly aligned with all shareholders’ interests;
3. Accounting rules and auditing are imperfect.
When these conditions are met in reality, he could get profit by using trading strategies designed to
exploit any systematic ways in which the publicly available data are ignored or discounted in the price-
setting process. Capital in market efficiency is not relevant in some areas. He can get benefits by using
financial analysis skills in those areas. For example, he can assess how much value can be created
through acquisition of target company, estimate the stock price of a company considering initial public
offering, and predict the likelihood of a firm’s future financial distress.
3. Joe Smith argues that “learning how to do business analysis and valuation using financial statements
is not very useful, unless you are interested in becoming a financial analyst.”
Answer: It should be noted that business analysis and valuation is not useful exclusively to financial
analysts. It can actually prove to be beneficial for corporate managers and loan officers as well.
For one, it can be used for equity security valuation to help corporate managers in assessing investor
valuation of the firm. It facilitates the production of superior information on strategies, which helps
companies to perform their own equity security analysis and estimate their fundamental value, which
can then be compared to the current share market price. If improper valuation by investors occurs,
corporate managers can explain and help them better understand the company’s strategies,
accounting policies and expected future performance to ensure proper valuation. Furthermore,
business analysis and valuation can help companies in mergers and acquisitions. It is useful in
identifying potential takeover target and assessing its value once acquired. On the other end,
companies being acquired can use business analysis to ensure reasonable offer from the acquirer.
Business analysis and valuation can also be beneficial to loan officers, especially in assessing liquidity,
solvency and risks of borrower companies. It helps in predicting the ability of companies to fulfill the
debt and any possibility of future financial problems. It helps in their decision to whether or not extend
a loan, how the loan is to be structures and priced.
4. Four steps for business analyst are discussed in the chapter (strategy analysis, accounting analysis,
financial analysis, and prospective analysis). As a financial analyst, explain why each of these step s
is a critical part of your job and how they relate to one another.
 Business Strategy analysis: allows for better subsequent steps, for example more sound
forecasts, competitive strategy analysis to evaluate whether profit is sustainable.
 Accounting analysis: rectify any distortions by recasting to improve financial analysis
 Financial analysis: the outcome is incorporated into prospective analysis
 Prospective analysis: synthesized the previous steps to forecast and value
5. Coca-Cola and Pepsi are both very profitable soft drinks. Inputs for these products include corn syrup
bottle/cans, and soft drink syrup. Coca-Cola and Pepsi produce the syrup themselves and purchase
the other inputs. They then enter into exclusive contracts with independent bottlers to produce
their products. Use the five forces framework and your knowledge of the soft drink industry to
explain how Coca-Cola and Pepsi are able to retain most of the profits in this industry.
Answer: Threat of new entrants is restricted because they have their own patented formula for their
famous soft drinks. The main ingredients of syrup are sugar and flavoring, which is a market of high
competition and low switching costs, which is why they then switched to using corn syrup and were
able to retain profits. Since they enter into exclusive contracts with independent bottlers to produce
their products, the bottling companies are the one that need to compete with other competitors (low
bargaining power of suppliers)
6. In the early 1980s, United, Delta, and American airlines each started frequent flier programs as a
way to differentiate themselves in response to excess capacity in the industry. Many industry
analyst, however, believe that this move had only mixed success. Use the competitive advantage
concepts to explain why.
Answer: Airlines tried to bundle frequent flier mileage programs with regular airline transportation to
create product differentiation and increase customer loyalty;
Airlines anticipated that the programs would fill seats that would otherwise have been empty and
hence would have had a low marginal cost. However, because the costs of implementing a program
were low, there were few barriers to other airlines starting their own frequent flier programs .Before
long; every airline had a frequent flier program with roughly the same requirements for earning free
air travel. Simply having a frequent flier program no longer differentiated airlines.
7. Explain why you agree or disagree with each of the following statements: a. It’s better to be a
differentiator than a cost leader, since you can then charge premium prices. b. It’s more profitable to
be in a high technology industry than a low technology one. c. The reason why industries with large
investment have high barriers to entry is because it is costly to raise capital.
a. Disagree. Sure high prices may be charged by differentiators firms, but they come with higher
costs too. Cost leadership can produce profits too, will often be able to maintain larger margins
and turnover. Both can be profitable
b. Disagree. It’s true that high tech usually creates high entry barrier, but it’s not always effective,
and can be associated with high levels of competition among existing firms, high threat of new
entrants, substitute products, and high bargaining power of buyers and/or sellers. For example, PC
industry is a high-tech business, yet is highly competitive. There are very low costs of entering the
industry, little product differentiation in terms of quality, and two very powerful suppliers
(Microsoft and Intel). Consequently, firms in the PC business typically struggle to earn a normal
return on their capital. In contrast, Wal-Mart is a cost leader in a very low-tech industry, and is one
of the most profitable companies in the U.S.
c. Disagree. The cost of raising capital is generally related to risk of the project rather than the size of
the project. As long as the risks of the project are understood, the costs of raising the necessary
capital will be fairly priced. However, large investments can act as high entry barriers in several
other ways. First, where large investments are necessary to achieve scale economies, if additional
capacity will not be fully used, it may make it unprofitable for entrants to invest in new plant.
Second, a new firm may be at an initial cost disadvantage as it begins to learn how to use the new
assets in the most efficient manner. Third, existing firms may have excess capacity in reserve that
they could use to flood the market if potential competitors attempt to enter the market.

Tutorial 2

1. A finance student states, “I don’t understand why anyone pays any attention to accounting earnings
numbers, given that a clean number like cash form operation is readily available”. Do you agree? Why
or Why not?
Answer: Accounting earnings numbers i.e. net income predicts a company’s future cash flow better than
current cash flow does, because it is computed on the basis of expected, rather than actual cash receipts
or payments. Net income is also potentially informative when there is information asymmetry between
corporate managers and outside investors. Because accrual accounting requires managers to record
past events and to make forecasts of future effects of these events, net income can be used to convey
managers’ superior information. For example, a company’s decision to capitalize some portion of
current expenditure, which increases today’s net income, conveys potentially informative signals to
outside investors about the company’s ability to generate future cash flows to cover the capitalized
2. Fred argues, “The standards that I like most are the ones that eliminates all management discretion in
reporting---that way I get uniform numbers across all companies and don’t have to worry about doing
accounting analysis.” Do you agree? Why or why not?

Answer: Disagree. Because managers possess superior knowledge of the firm’s business activities and
should be able to choose appropriate accounting methods and accruals which portray business
transactions more accurately. If all discretion in accounting is eliminated, managers will be unable to
reflect their superior information in their accounting choices. Further, if uniform accounting standards
are required across all companies, corporate managers may expend economic resources to restructure
business transactions to achieve a desired accounting result. Manipulation of real economic transactions
is potentially more costly than manipulation of earnings.

3. Bill Simon says, “We should get rid of the FASB and SEC since free market forces will make sure that
companies report reliable information.” Do you agree? Why or Why not?
Answer: Disagree. The reason for this is the FASB creates standards and forces companies to follow suit,
however, free market forces doesn’t necessarily mean the firm will follow those rules, it’d be generally
highly recommended that they do, however, there is no laws in place to force them to follow it. Also, free
market forces would mean there is no standard, and in essence companies would be able to withhold
certain information.
4. Many firms recognize revenues as the point of shipment. This provides an incentive to accelerate
revenues by shipping goods at the end of the quarter. Consider two companies, one which ships its
product evenly throughout the quarter, and the second which ships all its products in the last two
weeks of the quarter. Each company’s customers pay thirty days after receiving shipment. Using
accounting ratios, how can you distinguish these companies?
Answer: There will be no difference between the two companies in terms of their income statements.
Both companies have the same amount of revenues and expenses. However, the two companies will
differ in terms of their balance sheets. Assuming that all other things are equal, the company that sells
product evenly will have higher cash and a lower accounts receivable balance at the quarter-end than
the company which ships all products in the last two weeks. Accounts receivable turnover, average
collection period and cash ratio can be used to distinguish between the two. The company with even
sales will have higher a/r turnover and cash ratio and lower average collection period.
5. The conservatism principle arises because of concerns about management’s incentive to overstate the
firm’s performance. Joe Banks argues, “we could get rid of conservatism and make accounting
numbers more useful if we delegated financial reporting to independent auditors rather than to
corporate managers.” Do you agree? Discuss.
Answer: Disagree. Because auditors possess less info and firm specific knowledge. Further, the lack of
info is more exacerbated for firms with distinct business strategies and ones in emerging industries.
Even if they prepare the financial reports truthfully, they still wouldn’t be able to properly choose the
appropriate accounting policies and estimates. They also might have their own incentive in choosing acc.
policies and estimates that would require them to exercise minimum business judgment in assessing a
transaction’s economic consequences.

Tutorial 4
1. Which of the following types of firms do you expect to have particularly high or low asset turnover?
Explain why. a. A supermarket b. A pharmaceutical company c. A jewelry retailer d. A Steel company
Answer: a. High. Supermarkets tend to be high volume businesses. Many of the food products in
supermarkets are perishable, and freshness is often used to differentiate products, forcing a certain
amount of inventories turnover. Apart from inventories, a supermarket’s largest assets are its
warehouses and stores, all constructed to be relatively inexpensive. Thus, high sales volumes generate a
high measured level of asset turnover.
b. High. Drugs typically have a limited shelf-life. Once past their expiration date, drugs cannot be sold
and are worthless. Consequently, pharmaceutical companies try to limit production to quantities which
can be expected to be sold before the expiration date. A pharmaceutical company’s assets are relatively
low for two reasons. First, its investment in research and development is expensed rather than
recorded as an asset on the company’s books. Second, patents do not typically show up as assets on
the pharmaceutical company’s books. Thus, high sales combined with lower reported asset levels
generate a high measured level of asset turnover.
c. Low. Jewelry is typically durable, expensive, and infrequently purchased and a strongly differentiated
product. Customers will usually only pick one out of many collections. Hence, the jewelry store must
maintain a large inventory to support its sales. Because the jewelry store’s main asset is inventory,
which has a slow rate of turnover, the typical jewelry store will show low asset turnover.
d. Low. Production of steel is extremely asset intensive. A steel company will invest hundreds of millions
in PPE necessary to manufacture steel. Moreover, steelmaking equipment has a useful lifetime
measured in decades. Relative to this enormous investment, a steel company’s sales will be low.
Consequently, a steel company will typically have low asset turnover.

2. Which of the following types of firms do you expect to have high or low sales margins? Why? a. A
supermarket b. A pharmaceutical company b. A jewelry retailer c. A steel company d. A software
Answer: a. Low. Competition in the supermarket industry is very intense. Different supermarkets carry
most of the same brands so there is little differentiation of products. Consumers are sensitive to
changes in the prices, and switching costs are very low. Consequently, pricing is the major area of
competition among supermarkets, leading to extremely low margins.
b. High. Drugs manufactured by pharmaceutical companies are often protected from competition by
patents, allowing them to charge monopoly prices. Even where drugs are not protected by patents,
pharmaceutical companies invest considerable resources in differentiating their products along non-
price dimensions such as efficacy and ease-of-use. Consequently, pharmaceutical companies typically
boast very high sales margins.
c. High. Jewelry is a differentiated product where the typical buyer cannot easily assess the quality of the
item being purchased. Consequently, differentiation among jewelry retailers falls along lines of
intangibles such as service, quality, and reputation. The greater the differentiation, the higher the
expected margin.
d. Low. They operate in a highly competitive market and there are many entities involved in the supply
chain. Nationwide and global economic outlooks also influence the sales. The persistence of price
fluctuation affects the competitiveness and that of industry as a whole.
e. High. Because of high switching costs, low production costs and most of the initial software
development costs have been previously expensed.

3. James, an analyst with an established brokerage firm, comments: “Critical number I look at for any
company is operating cash flow.” If cash flows are less than earnings, I consider a company to be a
poor performer and a poor investment prospects. “Do you agree with this assessment? Why or why
Answer: Operating cash flows and earnings numbers are both important in evaluating the performance
prospects of a company, but they will differ due to short- and long-term accruals. Some current accruals,
such as credit sales, will cause earnings to be greater than operating cash flows while others, such as
unpaid expenses by the firm, will cause operating cash flows to exceed earnings. Non-current accruals,
such as depreciation and deferred taxes, will also cause differences between earnings and operating
cash flows. The fact that operating cash flows are not as high as earnings is not nearly as important as
understanding why the two are different.
Operating cash flows could be below earnings for several reasons, each suggesting differences in the
firm’s performance and future investment prospects. For example, a firm that introduces a successful
new product will probably have earnings exceeding operating cash flows due to working capital needs
(inventory and receivables) that affect cash flows but not earnings. Yet, provided inventory can be sold
and receivables collected, this difference is a positive sign that the firm’s sales are growing and that the
firm has good investment prospects. In contrast, firms that are declining are likely to have earnings
lower than cash flows, as working capital needs are diminished. In summary, earnings are likely to be a
better signal of future cash flow performance than current cash flows, particularly for firms with long
working capital (operating) cycles. Of course, earnings exceeding cash flows can be a negative signal for
future cash flow performance if management is reporting aggressively, making analysis of cash flows a
useful financial tool.
4. In 2005, IBM had return on equity of 27.6 percent,. Whereas Hewlett Packard’s return was only 6.4%.
Use the decomposed ROE framework to provide possible reasons for this difference based on the data
Answer: ROE depends on a company’s ROA (which can in turn be decomposed into ROS and operating
asset turnover), and leverage gain from leverage (which is driven by whether the firm can generate a
higher ROA than the after tax cost of debt financing and leverage. Differences in these factors will drive
differences in ROE.
ROS measures profit per dollar of sales (higher ROS suggests possible greater operational efficiency or
lower tax rates). ROS of IBM (9%) is higher than that of HP (2.73%), playing a role in the ROE
differences. This could be because IBM’s strategy is to focus on higher margin business, since IBM has
outsourced its low margin PC business and grown its higher margin equipment & consulting business.
Conversely, HP continues to focus on equipment and the difficult PC business.
Asset turnover assesses productivity of asset use (higher turnover suggests a fixed level of asset
generates higher sales). HP has focused more on the low-margin, but high turnover PC business,
whereas IBM is focused on the higher-margin but lower turnover business. Product of ROS and Asset
Turnover is ROA (IBM: 19.44%; HP: 7.45%). As a result, it appears that IBM’s strategy has been more
effective in generating superior asset returns than HP’s strategy.
Leverage describes capital structure; leverage increases, ROE increases. Both companies are able to
generate higher ROAs than the after-tax cost of interest. But, IBM has a higher ROA, meaning its
borrowing spread also gives it a potential edge (IBM: 16.44-7.4=17.04%; HP: 7.45-1.1=6.35%). It is
magnified by the debt policy of the two companies. HP’s leverage is actually negative, indicating that it
has more cash and short-term investments than interest-bearing debt, which consequently dampens the
ROA and costs shareholders in the short term. The net effect is that ROE is less than ROA (6.4% vs.
7.45%). The difference is simply the spread of 6.35% times its Net Financial Leverage (-0.16). In contrast,
IBM takes advantage of positive leverage so that its ROE is greater than ROA (27.6% vs. 19.44%). Once
again, the difference is the spread of 17.04% times its Net Financial Leverage (0.42).
5. What ratios would you use to evaluate operating leverage for a firm?
Answer: Operating leverage measures the extent to which an additional euro of sales increases the
firm's net profit. (the greater the increase in Net Profit for a given increase in sales, the greater the
firm’s operating leverage)
There is no single measure of a firm's operating leverage, but there is several ratios can help :
1. Changes in net profit relative to changes in sales, or return on sales ratios relative to sales
volume, provide rough guides of operating leverage.
2. Asset ratios: (Net PPE/Sales) or (Capital Expenditure/Sales), provide a way of assessing how
much of a firm’s production costs are fixed.
3. More detailed information, including (salary expense of production workers/Sales) and (raw
material expenses/Sales), can provide a finer picture of a firm’s operating leverage. Estimating a
firm’s operating leverage requires understanding of which of the firm’s costs are fixed and which
are variable.

Tutorial 5
1. Which of the following types of businesses do you expect to show a high degree of seasonality in
quarterly earnings? Explain why. a. A supermarket b. A pharmaceutical company c. A software
Answer: a. Low. The sales of supermarkets are not seasonal. There is not likely to be a peak in grocery
shopping in any particular month.
b. For a pharmaceutical company whose cold medicine is its major product, the sales may peak in the
winter months.
c. Sales of software are high during December, due to holiday sales. Many software companies also
make efforts to push sales at the fiscal year end in order to meet their annual targets.

2. Johnny, an analyst with Steven Inc. claims,” It is not worth my time to develop detailed forecast of
sales growth, profit, margin, and etc, to make earnings projections. I can be almost as accurate, as
virtually no cost, using random walk model to forecast earnings.” What is the random walk model? Do
you agree or disagree with this strategy? Why or why not?
Answer: The random walk theory suggests that stock price changes have the same distribution and are
independent of each other, so the past movement or trend of a stock price or market cannot be used to
predict its future movement. In short, this is the idea that stocks take a random and unpredictable path.

We disagree with John. According to the random walk model, the forecast for year t+1 is simply the
amount observed for year t. The random walk model only describes the average firm’s behavior.
Random walk model may not be applicable to those firms that erect barriers to competition and protect
margins for extended periods. The art of financial statement analysis requires knowing not only what
the “normal” patterns are but also how to identify those firms that will not follow the norm. This can
only be done if the analyst performs a strategy analysis.
3. The earnings per share of Wal Mart Stores for the fiscal years ending January 2001 ( FY2000) through
January 2005 (FY2004) are as follows:
Fiscal Year 2000 2001 2002 2003 2004
EPS $1.41 $1.48 $1.8 $2.08 $2.41
a. What would the forecast for earnings per share FY2005 be for each model?
Answer: Random Walk Model: $2.41; Mean Reverting Model: ($1.41 + $1.48 + $1.80 + $2.08 + $2.41)/5
= $1.84
b. Actual earnings per share for Walmart in FY2005 were $2.68. Given this information, what would be
FR 2006 forecast for earnings per share for each model? Why do the two models generate quite
different forecasts? Which do you think would better describe earnings per share patterns? Why?
Answer: Random walk model uses current year EPS as a benchmark, hence, $2.68. Mean reverting
model uses average of the prior five years’ EPS as a benchmark, hence $2.09 (($1.48 + $1.80 + $2.08 +
$2.41 + $2.68)/5).
Sales information more than one year old is useful only to the extent that it contributes to the average
annual trend. The average level of sales over five prior years do not help in forecasting future EPS. Thus,
model 1 describes earnings per share patterns better than Model 2.

Tutorial 6
1. James, an analyst at EMH Securities, states: "I don't know why anyone would ever try to value
earnings. Obviously, the market knows that earnings can be manipulated and only values cash flows."
Answer: It should be noted that even when there is earnings manipulation, earnings-based valuation
can still give an accurate representation of the company’s value. In some cases, it would even give the
same value results as that from the DCF method, primarily because of the self-correcting nature of
double-entry bookkeeping. However, in some cases, it takes a bit more work than that. The analyst
would have to recognize and correct the earnings manipulation. Otherwise, yes, it would give a false
representation of a company’s value. Furthermore, the earnings-based valuation method proves to be a
simpler method to compute for most shares and is widely available, making comparisons across shares
2. Manufactured Earnings is a “darling” of European analysts. Its current market price is $20 per share,
and its book value is $4 per share. Analysts forecast that the firm’s book value will grow by 10 percent
per year indefinitely, and the cost of equity is 18 percent. Given these facts, what is the market’s
expectation of the firm’s long-term average ROE?
𝑃 (𝑅𝑂𝐸 −𝑟)
Answer: =1+ , where:
𝐵 (𝑟−𝑔)
ROE is long term average growth
g= long term average growth in book value
r= cost of equity
P= stock price
B= book value per share
20 (𝑅𝑂𝐸 −0,18)
=1+ , ROE = 0.5 = 50%
4 (0,18−0,10)
3. Given the information in Question 2, what will be Manufactured Earnings' stock price if the market
revises its expectations of long-term average ROE to 20 percent?
𝑃 (𝑅𝑂𝐸 −𝑟)
Answer: =1+
𝐵 (𝑟−𝑔)
𝑃 (0,2 −0,18)
= 1+ ,P=5
4 (0,18−0,10)
4. What types of companies have: a. a high PE ratio and a low market-to-book ratio? b. a high PE ratio
and a high market-to-book ratio? c. a low PE ratio and a high market-to-book ratio? d. a low PE ratio
and a low market-to-book ratio?
Answer: a. Recovering firms like Apple in 1993, are expected to rebound from temporarily low earnings
levels but will not be able to return to an abnormally high level of ROE due to competition. PE ratio looks
high due to low current earnings.
b. “Rising stars” which are expected to grow quickly and enjoy high ROEs during the growth period
and/or after the growth occurs.
c. “Falling stars” that enjoy high ROEs on existing investments but are no longer growing fast. PE ratio is
low due to relatively high earnings in current year.
d. “Dogs” which have little prospect for either growth or high ROEs.

5. Janet Stringer argues that "the DCF valuation method has increased managers' focus on short-term
rather than long-term performance, since the discounting process places much heavier weight on
short-term cash flows than long-term ones." Comment.
Answer: Despite the difficulty in making long-term predictions using the DCF method, the fact remains
that the DCF method is simply a measurement of the time value of money; therefore we would have to
disagree with Stringer’s comment. The decision whether to focus on valuating the amounts for the long-
term period or short-term period, at the end of the day, lies on the manager. One cannot simply blame
the DCF method for some managers’ focus on short-term rather than long-term. It is a tool, after all,
how people utilize it is a decision that they make themselves.
6. John Company is valued at $20 per share. Analysts expect that it will generate free cash flows to
equity of $4 per share for the foreseeable future. What is the firm's implied cost of equity capital?
𝐹𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦
Answer: 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
20 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 0.2 = 20%

Tutorial 7
7. Calculate the proportion of terminal values to total estimated value of equity under the abnormal
earnings method and the discounted cash flow method for the results shown in table 8-7. Why area
these proportions different?
Answer: Under the abnormal earnings method, the terminal value in Table 8-7 comprises 47.01% of the
total value (87,108/185,314). In contrast, the terminal value in the free cash flow to equity method is
73.18% of the total value (135,606/185,314). The reason for the difference is that the abnormal earnings
method contains the current book value of equity as its base, and then counts only superior earnings
each year. By the terminal years, given competition, this superior performance is expected to be
modest. In contrast, the free cash flow method values the full cash flows to shareholders, whether they
are generated by normal of abnormal performance. The cash flows therefore grow steadily during the
terminal value period, even though much of this performance reflects merely a normal return on capital.
8. What will Wal Mar’s cost of equity be if the equity market risk premium is 5 percent? The company’s
estimated equity beta was 1.9 at the end of 2016. The average ten-year government bond rate in the
US at that time was 3 percent.
Answer: Cost of Equity = 3 + (1.9*5) = 12.5

Tutorial 8
1. Despite many years of research, the evidence on market efficiency described in this chapter appears
to be inconclusive. Some argue that this is because researchers have been unable to link company
fundamentals to stock prices precisely. Comment.
Answer: Evidence on market efficiency comes primarily from studies that show how stock prices change
with the announcement of new public information. In general, these studies show that stock prices
change quickly with these announcements, implying a high level of efficiency. However, more recent
efficient markets research suggests that this conclusion may be premature. This research finds, for
example, that earnings information is not completely impounded into price for several quarters, a
significant departure from the notion of a highly efficient market. The primary difficulty in interpreting
the evidence on market efficiency is that the empirical tests are joint tests of market efficiency with a
particular asset-pricing model. The abnormal returns generated by trading strategies based on firm
size and price-to-earnings ratios, for example, may therefore reflect the omission of important sources
of risk from the pricing model used to generate the abnormal returns, rather than market inefficiency.
2. Geoffrey Henley, a professor of finance, states: "The capital market is efficient. I don't know why
anyone would bother devoting their time to following individual stocks and doing fundamental
analysis. The best approach is to buy and hold a well-diversified portfolio of stocks.“ Do you agree?
Why or why not?
Answer: If the stock market is efficient, diversification permits investors to generate a risk-return
relation that strictly dominates that of investing in just a few stocks. However, if the stock market is not
completely efficient, it may be possible to use fundamental analysis to predict future stock prices. In this
sense, an informed investor can generate an even higher risk-return profile than holding a diversified
portfolio by investing in stocks where he/she has an information advantage. Of course, one could think
of the superior returns from this strategy as a return on the investment of time and money required to
acquire and evaluate information about the financial and strategic performance of a firm. Thus,
Professor Henley's recommendation is probably very sound advice to most investors, who do not invest
in following a few stocks very closely. However, it may not be the best advice for a professional investor
who has invested in developing industry or firm-specific knowledge from detailed fundamental analysis.
3. What is the difference between fundamental and technical analysis? Can you think of any trading
strategies that use technical analysis? What are the underlying assumptions made by these strategies?
Answer: Fundamental analysis uses information in a firm's financial statements and other sources of
public information to assess a firm's expected future performance, and hence its likely value. Firms with
estimated values greater than their current prices are then recommended as buys and those with
values lower than the current price as sells. In contrast, technical analysis uses market indicators
(patterns of past stock price changes, trading volume, or levels of short-sale interest in the stock) for
making recommendations on whether to buy or sell a stock. The key assumption underlying technical
trading strategies is that the stock market is inefficient. Technical descriptors of stock price movement,
past prices, volume, etc., are common knowledge and, in an efficient market, should fully reflected in
4. There are two major types of financial analysts: buy-side and sell-side. Buy-side analysts work for
investment firms and make stock recommendations that are available only to the management of
funds within that firm. Sell-side analysts work for brokerage firms and make recommendations that
are used to sell stock to the brokerage firms’ clients, which include individual investors and manager
of investment funds. What would be the differences in tasks and motivations of these two types of
Answer: Buy-side analysts make recommendations about investment opportunities that are consistent
with the fund's operating guidelines. They can put together their own report or evaluate competing buy
and sell recommendations made by sell-side analysts. Motivation is to earn the highest returns for the
investment fund, with their compensation closely tied to the quality of their recommendations.
Sell-side analysts analyse companies, usually using fundamental analysis, where there are opportunities
to interest customers to either buy or sell the stock, produce analysis report, make forecasts of future
financial information, and recommend clients to buy, sell, or hold a stock. Because brokers generate
income from commissions earned on stock trades carried out for these clients, they provide direct and
indirect incentives for sell-side analysts to write reports that generate commission business. Analyst’s
recommendation should turn out to be profitable, or else, clients will stop using their services.
5. Many market participants believe that sell-side analysts are too optimistic in their recommendations
to buy stocks, and too slow to recommend sells. What factors might explain this bias?
 Need for access to firms. Sell-side analysts often depend on information from the firm to answer
questions about firm performance and strategy not contained in other public information about the
firm. This information can make an analyst’s reports more thorough and persuasive to potential
investors. Furthermore, higher quality reports can increase revenues for the firm and compensation
for the analyst. After a sell recommendation, firms are less likely to be as open and forthcoming with
analysts who have recommended a sale. Conversely, a strong recommendation to buy a firm’s share
may result in greater access to the firm in the future. Hence, the sell-side analyst could provide
optimistic recommendations to help guarantee access to the firms they cover.
 Potential for investment banking services by the analyst’s firm. Investment banking services can be
a significant source of income for brokerage/investment banking firms. Moreover, firms are more
likely to use the investment banking services of brokerage/investment banking firms that issue
favorable recommendations. A negative recommendation may cause the brokerage/investment
banking firm the loss of significant additional revenues from underwriting or investment banking
services in the future. As a result, sell-side analysts may be more likely to be optimistic in
recommendations about a specific firm.
 Difficulty of taking advantage of a sell recommendation. It may be more difficult for a brokerage
firm’s client to take advantage of a sell recommendation. A much narrower group of clients can take
advantage of a sell recommendation. If a client owns the shares, he can sell them outright. If the
client does not own the shares, he must find another shareholder to borrow it from in order to short
it and take advantage of the recommendation. Furthermore, short sales are typically more expensive
than regular share purchases, last only a finite amount of time before expiring, and carry a higher risk
for the investor. Hence, a sell recommendation for a share is less likely to generate the same
revenues for the firm as a buy recommendation.
6. Joe Klein is an analyst for an investment banking firm that offers both underwriting and brokerage
services. Joe sends you a highly favourable report on a stock that his firm recently helped go public
and for which it currently makes the market. What are the potential advantages and disadvantages
in relying on Joe's report in deciding whether to buy the stock?
Advantages: He’s likely to have better knowledge of the firm than other analysts. He’ll also have
better relationships with the firm’s management team, so it’s easier to gather information from the
Disadvantages: He might be biased; it’s unlikely that he’ll provide negative feedbacks, which is why
he sent a highly favourable report to attract investors or to help the firm take out loan from
investment bank.

Tutorial 9
1. Financial analysts typically measure financial leverage as the ratio of debt to equity. However,
there is less agreement on how to measure debt, or even equity. How would you treat the
following items in computing this ratio? Justify your answers.
a. Revolving credit agreement with bank: allows the company to borrow up to a certain amount (line
of credit) at an interest rate determined at the time of the agreement. The borrower pays interest
on the amount borrowed and interest of about 0.5 percent on the amount unused. Since the
borrower can convert the credit to straight debt, the used line of credit may be treated as debt.
b. Cash & marketable sec.: can be considered as negative leverages. Having high cash and marketable
securities has an effect on the company opposite to financial leverage. For example, a high cash
balance decreases the likelihood of financial distress.
c. Operating leases: depends on the nature of the lease. For example, if a firm leased a car for six
months, it would probably not be considered effective debt. But if an airline company signed a
multi-year operating lease for planes instead of purchasing the aircraft outright with a bank loan, it
does make sense to treat the present value of the future operating lease payments as equivalent to
debt. Capital lease is classified as debt, operating lease is not.
d. Unrecorded pension commitments: effective debt commitments, firms are required to include the
full unfunded pension obligation as a liability on the balance sheet.
e. Deferred tax liabilities: represent the increase in taxes payable in future years as a result of taxable
temporary differences between financial accounting and tax accounting existing at the end of the
current year. For mature firms or declining firms, DTL can be treated as an interest-free debt from
the government that may be repaid in the near future. However, for rapidly growing firms, deferred
taxes are unlikely to reverse any time soon, making it more like equity.
f. Preferred stock: treated as equity. Despite the fact that preferred stock offers a fixed dividend like
debt, the payment of dividend depends on management’s discretion. When the company is
seriously short of cash, management can decide to pay the preferred stock dividend in the next
period. Like common stock, preferred stock does not have a final principal payment date. Also,
preferred stockholders cannot force the company that skipped dividends to bankruptcy.
g. Convertible debt: gives its owner the option to exchange the bond for a predetermined number of
common shares at a fixed price. When the convertible debt holders decide to exercise their option
to buy common stock, they just exchange the convertible debt with common stock. Convertible
debt is treated as debt until it is converted to common stock.
2. What are the critical performance dimensions for the businesses in the next slides? What ratios
would you suggest looking at for each of these dimensions?
a. Retailer: The critical performance dimensions of a retailer are related to its inventory turnover and
profit margins. Inventory turnover ratio is the cost of goods sold divided by average inventory
balance. One measure of margins is net income divided by sales.
b. A financial services company: The critical performance of a financial services company includes the
quality of assets (e.g., default risks of loan portfolio), duration matching between assets and
liabilities (i.e., its risk to interest rate change), and profitability. The quality of loans that financial
institution holds can be measured as bad debt allowance divided by loans outstanding. Risk
exposure can be measured by comparing the duration between assets and liabilities. Profitability
can be measured as net income divided by net worth.
3. Why would a company pay to have its public debt rated by a major rating agency (such as Fitch’s,
Moody’s or Standard and Poor’s)? Why might a firm decide not to have its debt rated?
Answer: The public debt rating influences the yield that must be offered to sell the debt
instrument. Suppose that a company has information that is favorable in borrowing but
confidential. It would disclose the confidential information to the rating agency on the condition
that its confidentiality is maintained. The rating agency can work as an intermediary that will close
the information gap between the company and public investors. All public companies would have
to have its debt rated, because their decision would affect numerous people. However, small
private companies or businesses would find no need for a debt rating.
4. Many debt agreements require borrowers to obtain the permission of the lender before
undertaking major acquisition or asset sale. Why would the lender want to include this type
of restriction?
Answer: When the firm is in financial difficulty, conflicts may arise between debtors and
stockholders. Managers who are likely to represent stockholders’ interest may invest in riskier
assets. Since the stock has an option value, a major acquisition of risky assets under financial
distress can increase the value of stock but decrease the value of debt. To protect against the
possibility of increased business risk, lenders establish debt covenants that borrowers obtain
permission of the lender before making a major acquisition. Asset sales potentially reduce the
security lenders have in the case of financial distress.
5. Betty Li, the Financial Director of a company applying for a new loan, argues: “I will never agree
to a debt covenant that restricts my ability to pay dividends to my shareholders, because it
reduces shareholder wealth.” Do you agree with this argument?
Answer: If the dividend payout decisions are not restricted, management (or other agents of the
shareholders) can liquidate the company by paying cash dividends to shareholders in the case of
financial distress. Unless there is a restriction on dividend payout, rational lenders, concerned
about the liquidation of the firm through cash dividend, will demand higher interest rates. Contrary
to Betty’s argument, shareholder wealth is reduced when there is no restriction on dividend
payout, because no restriction would result in a higher cost of borrowing.
6. A banker asserts: “I avoid lending to companies with negative cash from operations because they
are too risky.” Is this a sensible lending policy?
Answer: No. A banker should decide whether the borrowing firm has the ability to service the debt
at the scheduled rate. Current period negative cash flow from operations is one of the factors that
the banker needs to consider but it is not the only factor. A banker should ask whether the
company can turn around its cash flows in future periods. If can, then may not be risky. Can the
bank secure the loan with sufficient collateral in lending to the company? When the amount of
available security is sufficient to support the loan, the bank can minimize the risk of loss in case of
default. Is there any third-party loan guarantee? If the borrower is the subsidiary and the parent
presents some financial strength independent of the subsidiary, a guarantee of the parent will
reduce the risk of loss.

Tutorial 10
1. Since the year 2000, there was a noticeable increase in mergers and acquisitions between firms in
different countries (termed cross-border acquisitions). What factors could explain this increase?
What special issues can arise in executing a cross-border acquisition and in ultimately meeting
your objectives for a successful combination?
Answer: Drivers of increasing trends:
• Relaxation of Foreign Ownership Laws
 Government policies such as investment liberalisation, revocation of previous laws restricting
cross-border M&A, has increased access to industrial targets for acquisition.
• Technological Advancement and Globalization
 Since that time, technology has been advancing at an extremely rapid rate, which in turn
facilitates the international expansion of firms, to explore opportunities for research and
development is one example.
 It has also put pressure on firms to continue expanding or to restructure in order to keep up
with this rapid advancement.
• Expansion of Free Trade Areas
 The increasing trend of countries signing an FTA agreement is also a factor. An FTA
agreement would mean that member countries can trade freely with each other while
trade barriers and tariffs would be maintained for non-member countries.
 Therefore, to ensure access to the trading bloc, most companies opt to purchase companies
within that bloc.
• Access to New Markets
 Enterprises increasingly seek to exploit the technology, human resources, brand names in
other countries.
 The easiest way to enter the market in a foreign country is to purchase or merge with a
company already operating in that market, guaranteeing immediate market share and
instant name recognition with local consumers.
Special issues:
• People
 Challenges in language, culture, salary discrepancies, time-zone management, workplace
norms and expectations, government involvement, corruption and political environment.
 Challenge to keep everything equal in a merger. Even though a true merger, where both
parties are equal, is intended, it is extremely challenging because generally, one company will
be perceived as being on top, no matter how it is portrayed.
• Products
 Rationalization will most definitely occur and the integration of technology and products is
even more difficult in international setting.
 Government regulations may also prohibit the production of certain products.
• Finance
 Uncontrollable fluctuations in currencies might cause heightened valuation discrepancies,
for example.
 Difference in accounting rules, such as treatment of intangibles, makes integration and
identification value creation opportunities harder.
2. You have been hired by GS Investment Bank to work in the merger department. The analysis
required for all potential acquisitions includes an examination of the target for any off-balance-
sheet assets or liabilities that have to be factored into the valuation. Prepare a checklist for your
Answer: Off-Balance Sheet Liabilities
 Executory contracts; Contingent obligations; Operating leases;
 Liabilities under environmental regulations

Off-Balance Sheet Assets—Depending on the specific circumstance, these assets may already be
included on the balance sheet. These assets are either valued (e.g., intangible assets) or revalued
(e.g., land held for sale) once they have been purchased by another company.

 Research and development expenditures

 Patents, trademarks, and other intellectual property
 Brand names; Goodwill; Land held for sale
3. A leading oil exploration company decides to acquire an Internet company at a 50 per cent
premium. The acquirer argues that this move creates value for its own stockholders because it
can use its excess cash flows from the oil business to help finance growth in the new Internet
segment. Evaluate the economic merits of this claim.

Answer: The argument is based on the idea that capital market imperfections have prevented the
Internet company from investing in all of its growth opportunities. These imperfections may have
developed as a result of information asymmetries between management and outside investors. If the
Internet firm has to rely on outside investors to finance its growth, capital market constraints could
prevent it from undertaking worthwhile projects because public capital markets would probably be a
costly source of funds for the firm. However, by purchasing the company, the oil company can help it
overcome the capital market imperfections and enable the internet firm to invest in all of its growth
The merits of the oil company’s argument for buying the electronics company depend on two
conditions. First, financial constraints must be preventing the firm from undertaking some profitable
projects. If the firm is not financially-constrained or does not have a set of unfunded but profitable
projects, then having access to the additional capital of the oil company will not create value. The only
projects the firm would have left would be unprofitable ones. Second, the financial constraints must be
due to capital market imperfections. It is plausible that the electronics firm could face capital market
imperfections due to information asymmetries. Information problems are likely to be severe for newly-
formed, high-growth companies, a description typical of many electronics firms. If information
problems make it difficult for outside investors to value the electronics firm because of its short track
record or because its financial statements provide little insight about the value of its growth
opportunities, then outside investors could be an expensive source of funds.