CFA

Risks of Poor Corporate Governance and Stakeholder Management

four potential issues are: Weak control systems Ineffective decision making Legal, regulatory, and reputational risks Default and bankruptcy risks

exercise

A low receivables turnover ratio suggests that the company has problems collecting money on time from customers. This will most likely be indicated by high bad debts and credit losses compared to competitors.

incremental cash flow

An incremental cash flow is the additional cash flow realized as a result of a decision. Incremental cash flow equals cash flow with a decision minus the cash flow without the decision.

Weak Control Systems

Audit deficiencies due to a weak control environment at Enron Corporation, led to one of the largest bankruptcies in history.

EBITDA per share

EBITDA per share= EBITDA/ Average number of shares outstanding

Asset-Based Loans

If a company fails to qualify for an unsecured bank loan, it may opt for asset-based loans. These are loans that are collateralized by the company's assets. Assets that are used to secure short-term loans usually include current assets, such as receivables and inventory.

Price to Book Value

Price to Book Value P/BV= Price per share Book value per share

Operating risk

The risk associated with a company's operating cost structure is referred to as operating risk. As shown earlier, a company that has a greater proportion of fixed costs in its cost structure has greater operating risk.

Debt to Equity

This ratio measures the amount of debt capital relative to a firm's equity capital. A higher ratio is undesirable and indicates higher financial risk. A ratio of 1.0 indicates equal amounts of debt and equity in the company's capital structure.

Cost of capital

We can also think of the cost of capital as the opportunity cost of funds for the providers of capital. Unless the return offered by a company meets or exceeds the rate that could be earned elsewhere from an investment of similar risk, a potential supplier of capital will not provide capital to the company.

Profitability Ratio

The ability of a company to generate profits is a key driver of the company's overall value and the value of the securities it issues. Therefore, many analysts consider profitability to be the focus of their analysis.

Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) states that the expected rate of return from a stock equals the risk-free interest rate plus a premium for bearing risk

Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach.

The cost of fixed rate capital is the cost of debt financing when a company issues a bond or takes a bank loan.

Balance Sheet Information: Inventory Account

The difference in cash flows is the only direct economic difference that results from the choice of inventory valuation method. It does not matter whether prices are rising (as in our example) or falling; FIFO will always give a better reflection of the current economic value of inventory because the units currently in stock are valued at the most recent prices. The difference between the original cost of inventory and its current replacement cost is known as a holding gain or inventory profit. If prices are rising, LIFO and AVCO will understate ending inventory value. If prices are falling, LIFO and AVCO will overstate ending inventory value. When prices are stable, the three methods will value inventory at the same level.

Discounted Payback Period

The discounted payback period equals the number of years it takes for cumulative discounted cash flows from the project to equal the project's initial investment outlay. A project's discounted payback period will always be greater than its payback period because the payback period does not discount the cash flows.

Dividend Discount Model Approach

The dividend discount model asserts that the value of a stock equals the present value of its expected future dividends. We will use the constant-growth dividend discount model, (also known as a Gordon growth model) in which dividends grow at a constant rate, to determine the cost of equity. calculate the price of a stock assuming a constant growth rate in dividends: P0 = D1/ re−g where: P0 = current market value of the security. D1= next year's dividend. re = required rate of return on common equity. g = the firm's expected constant growth rate of dividends. >>>Rearranging the above equation gives us a formula to calculate the required return on equity: re = D1/ P0+g

Capital budgeting processes tell us two things about company management:

The extent to which management pursues the goal of shareholder wealth maximization. Management's effectiveness in pursuit of this goal.

Calculating the Sustainable Growth Rate

The following data is available for Sedag Inc. Calculate its sustainable growth rate EPS $3 Dividends per share $1 Return on equity 10% Solution: Dividend payout ratio = $1/$3 = 0.33 Retention Ratio = 1 − 0.33 = 0.67 Sustainable growth rate (g) = 0.67 × 10% = 6.7%

Not capitalized items as inventory costs

The following items are not capitalized as inventory costs; they are expensed on the income statement as incurred under IFRS and U.S. GAAP. Abnormal costs from material wastage. Abnormal costs of labor or wastage of other production inputs. Storage costs that are not a part of the normal production process. Administrative expenses. Selling and marketing costs.

Employee Laws and Contracts

The framework that outlines employee rights is based on labor law. This will vary by geographic area, but will include such items as working hours, hiring and firing, pensions, and other employee benefits. Employment contracts are for the individual and outline the employee's rights and responsibilities; they are not all-encompassing, leaving some discretion within the relationship. Other items such as the code of ethics and human resources documents are intended to outline the relationship in order to manage and mitigate any legal or reputational risks.

Gross profit

The gross profit margin tells us the percentage of a company's revenues that are available to meet operating and nonoperating expenses. A high gross profit margin can be a combination of high product prices (reflected in high revenues) and low product costs (reflected in low COGS).

exercise

The increase in the current ratio over the years, from 1.7 to 2.2, suggests that the company's liquidity position has strengthened. However, the decline in the quick ratio over the years, from 0.9 to 0.7, suggests that the liquidity position of the company has deteriorated. Both ratios have current liabilities as the denominator. Therefore, the difference must be due to the changes in certain current assets that are not included in the quick ratio (e.g., inventories).

Ratios

The information available on cash flow statements can be used to compute cash flow ratios. These ratios, like income statement and balance sheet ratios, can be used for comparing the company's performance over time (time-series analysis) or against other companies within the same industry (cross-sectional analysis). Cash flow ratios can be categorized as performance (profitability) ratios and coverage (solvency) ratios.

Inventory Valuation Methods (Cost Formulas)

>>>>Separate Identification: COGS reflects actual costs incurred to purchase or manufacture the specific units that have been sold over the period. EI (ending inventory) reflects actual costs incurred to purchase or manufacture the specific units that still remain in inventory at the end of the period. This method is used for items that are not interchangeable and for goods produced for specific projects. It is used for expensive goods that can be identified individually (e.g., precious gemstones). This method matches the physical flow of a particular inventory item with its actual cost. ***Under separate identification, costs remain in inventory until the specific unit is sold. Under FIFO, LIFO, and AVCO companies make an assumption about which goods are sold and which ones remain in inventory. Therefore, the allocation of costs to units sold and those in inventory can be different from the physical movement of inventory units.

EBIT

operating profit operating income

Calculate and interpret the cost of noncallable, nonconvertible preferred stock

A company promises to pay dividends at a specified rate to its preferred stock holders. When preferred stock is noncallable and nonconvertible, has no maturity date, and pays dividends at a fixed rate, the value of the preferred stock can be calculated using the perpetuity formula. Vp = Dp/ rp where: Vp = Current value (price) of preferred stock. Dp = Preferred stock dividend per share. rp = Cost of preferred stock. Rearranging this equation gives us the formula to calculate the cost of preferred stock rp = Dp/ Vp

Decision Rules for IRR

A company should invest in a project if its IRR is greater than the required rate of return. When the IRR is greater than the required return, NPV is positive. A company should not invest in a project if its IRR is less than the required rate of return. When the IRR is lower than the required return, NPV is negative.

Return on Equity

This ratio measures the rate of return earned by a company on its equity capital. Equity capital includes minority equity, preferred equity, and common equity. It measures a firm's efficiency in generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses its investment dollars to generate earnings. ROE is commonly used to compare the profitability of a company to that of other firms in its industry.

common-size balance sheet

A vertical common-size balance sheet expresses each balance sheet item as a percentage of total assets. This allows an analyst to perform historical analysis (time-series analysis) and cross-sectional analysis across firms within the same industry

highlights important differences between IFRS and U.S. GAAP with respect to cash flow statements.

Topic IFRS U.S. GAAP Classification of cash flows: Interest received Operating or investing. Operating Interest paid Operating or financing. Operating Dividends received Operating or investing. Operating Dividends paid Operating or financing. Financing Bank overdrafts Considered part of cash equivalents. Not considered part of cash and cash equivalents and classified as financing Taxes paid Generally operating, but a portion can be allocated to investing or financing if it can be specifically identified with these categories. Operating Format of statement Direct or indirect; direct is encouraged Direct or indirect. Direct is encouraged. A reconciliation of net income to cash flow from operating activities must be provided regardless of method used

Total asset turnover

Total asset turnover measures the company's overall ability to generate revenues with a given level of assets. A high ratio indicates efficiency, while a low ratio can be an indicator of inefficiency or the level of capital intensity of the business. This ratio also identifies strategic decisions by management. For example, a business that uses highly capital-intensive techniques of production will have a lower total asset turnover compared to a business that uses labor-intensive production methods.

Activity ratios

Activity ratios are also known as asset utilization ratios or operating efficiency ratios. They measure how well a company manages its operations and particularly how efficiently it manages its assets—working capital and long-lived assets Inventory turnover: Cost of goods sold/ Average inventory Days of inventory on hand (DOH): Number of days in period/ Inventory turnover Receivables turnover: Revenue/ Average receivables Days of sales outstanding (DSO): Number of days in period/ Receivables turnover Payables turnover: Purchases/ Average trade payables Number of days of payables: Number of days in period/ Payables turnover Working capital turnover: Revenue/ Average working capital Fixed asset turnover: Revenue/ Average net fixed assets Total asset turnover: Revenue/ Average total assets

Per Share Quantities that are Important in Equity Analysis

Basic EPS= Net income − Preferred dividends/ Weighted average number of ordinary shares outstanding

A break point is calculated using the following formula

Break point = Amount of capital at which a component's cost of capital changes/ Proportion of new capital raised from the component

Debt to capital ratio

this ratio measures the proportion of a company's total capital (debt plus equity) that is composed of debt. A higher ratio indicates higher financial risk and is undesirable.

conclusion:

Under FIFO, in periods of rising prices the prices assigned to units in ending inventory are higher than the prices assigned to units sold. Under LIFO, in periods of rising prices the prices assigned to units in ending inventory are lower than the prices assigned to units sold. Under AVCO, regardless of whether prices are rising or falling, the prices assigned to units in ending inventory are the same as the prices assigned to units sold. In the first year of operations, all three methods of inventory valuation will come up with the same value for cost of goods available for sale (OI + P). However, in subsequent years, the cost of goods available for sale under each method would typically differ because of the different amounts allocated to opening inventory (EI in the previous year). The total cost allocated to COGS and EI is the same across the three different cost flow methods. If one method reports higher COGS, it must report lower EI.

Under IFRS, the following information should be included in the statement of changes in equity

Under IFRS, the following information should be included in the statement of changes in equity: Total comprehensive income for the period; The effects of any accounting changes that have been retrospectively applied to previous periods. Capital transactions with owners and distributions to owners; and Reconciliation of the carrying amounts of each component of equity at the beginning and end of the year

Illustration of Periodic and Perpetual Inventory Systems

Under the LIFO cost flow assumption, in a period of rising prices, use of the periodic system for inventory results in a: Lower ($60 versus $84) value of ending inventory. Higher ($588 versus $564) value for COGS. Therefore, gross profit would be lower under the periodic system. Under the LIFO cost flow assumption, in a period of rising prices, use of the periodic system for inventory results in a: Lower ($60 versus $84) value of ending inventory. Higher ($588 versus $564) value for COGS. Therefore, gross profit would be lower under the periodic system.

Using CAPM to Estimate the Cost of Equity

Using CAPM to Estimate the Cost of Equity Becker Inc.'s equity beta is 1.3. The risk-free rate is 6% and the equity risk premium stands at 10%. What is Becker's cost of equity using the CAPM approach? Solution: re=RF+βi[E(RM)−RF] re=0.06+1.3(0.10)=0.19or19%

Credit risk

Credit risk is the risk of loss that is caused by a debtor's failure to make a promised payment. Credit analysis is the evaluation of credit risk.

Creditworthiness

Creditworthiness is the perceived ability of a borrower to satisfy the payment terms on a borrowing in a timely manner. Liquidity contributes to a company's creditworthiness.

Total Leverage

DOL looks at the sensitivity of operating income to changes in units sold, while DFL looks at the sensitivity of net income to changes in operating income. The degree of total leverage (DTL) looks at the combined effect of operating and financial leverage (i.e., it measures the sensitivity of net income to changes in units produced and sold).

DTL

DTL= Percentage change in net income/ Percentage change in the number of units sold DTL = DOL x DFL DTL = Q x (P - V)/ [Q(P - V) - F - C] where: Q = Number of units produced and sold P = Price per unit V = Variable operating cost per unit F = Fixed operating cost C = Fixed financial cost

DuPont

Decomposing ROE into its components through DuPont analysis has the following uses: It facilitates a meaningful evaluation of the different aspects of the company's performance that affect reported ROE. It helps in determining the reasons for changes in ROE over time for a given company. It also helps us understand the reasons for differences in ROE for different companies over a given time period. It can direct management to areas that it should focus on to improve ROE. It shows the relationship between the various categories of ratios and how they all influence the return that owners realize on their investment.

Default and Bankruptcy Risks

Default and Bankruptcy Risks When corporate governance is poor and there is weak management of the creditors' interest, this can lead to poor decision making from management. These decisions can easily affect the company's financial position, which can lead to default and bankruptcy.

WACC

WACC = (wd)(rd)(1-t)+(wp)(wp)+(we)(re) where: wd = Proportion of debt that the company uses when it raises new funds rd = Before-tax marginal cost of debt t = Company's marginal tax rate wp = Proportion of preferred stock that the company uses when it raises new funds rp = Marginal cost of preferred stock we = Proportion of equity that the company uses when it raises new funds re = Marginal cost of equity

Price to Cash Flow

Price to Cash Flow P/CF = Price per share Cash flow per share

Acquisition of Long-Lived Tangible Assets Acquired through a Purchase

When a long-lived asset is purchased, expenses other than the purchase price may be incurred (e.g., costs of shipping and installation and other costs necessary to prepare the asset for its intended use). These costs are also capitalized and included in the value of the asset on the balance sheet. Subsequent expenses related to the long-lived asset may be capitalized if they are expected to provide economic benefits beyond one year, or expensed if they are not expected to provide economic benefits beyond one year. Expenditures that extend an asset's useful life are usually capitalized.

Declining Prices

When prices of the firm's products fall over a given period, the firm will see a decline in its LIFO reserve. If the change in LIFO reserve is negative, COGS FIFO will be greater than COGS LIFO. FIFO would continue to reflect the latest (and in this case lower) prices in inventory, and will provide the most economically accurate measure of inventory value, while LIFO would continue to reflect current replacement costs in COGS. When the reduction in LIFO reserve is caused by declining prices, no analytical adjustments are necessary.

Dividend Discount Model Approach1

Dividend Discount Model Approach Diamond Inc. has an earnings retention rate of 60% and a return on equity of 20%. Its next year's dividend is forecasted to be $2 per share and the current stock price is $40. What is the company's cost of equity? Solution: g= (Earnings retention rate)×(ROE)= 60%×20% = 12% Cost of equity=re=D1P0+g re= 240+0.12= 17%

Dividend payout ratio

Dividend payout ratio= Common share dividends/ Net income attributable to common shares **The dividend payout ratio measures the percentage of earnings that a company pays out as dividends to shareholders. The per-share dividend paid by companies is typically fixed, so this ratio fluctuates as a percentage of earnings. Therefore, conclusions about a company's dividend payout policy should be based on examination of the payout ratio over a number of periods.

exercise

Ending inventory = Opening inventory + Purchases - Cost of goods sold Purchases = Payables turnover × Average trade payables Purchases = 8 × 11,000 = 88,000 Therefore, ending inventory = 32,000 + 88,000 - 74,000 = $46,000

Ending inventory for the second quarter under the perpetual system is closest to:

Ending inventory at the end of Q2 = (15 × 28) + (2 × 26) = $472

Free cash flow to the firm

Net income $2,050 Depreciation $345 Interest expense $150 Tax rate 30% Net capital expenditure $1,500 Net debt repayment $20 Working capital investment $325 Net borrowing $1,500 XYZ's free cash flow to the firm for 2009 is closest to: $675 $615 $720 FCFF = 2,050 + 345 + (150 × (1 − 0.3)) - 1,500 - 325 = $675

Net profit margin

Net profit margin shows how much profit a company makes for every dollar it generates in revenue. A low net profit margin indicates a low margin of safety. It alerts analysts to the risk that a decline in the company's sales revenue will lower profits or even result in a net loss (reduction in shareholder wealth).

There is no standard approach to managing stakeholders, and it will vary across companies and cultures. However, there are 10 common elements that are seen among various companies:

General meetings Board of directors Audit function Reporting and transparency Remuneration policies Say on pay Contractual agreements with creditors Employee laws and contracts Contractual agreements with customers and suppliers Laws and regulations

Leverage is affected by a company's cost structure

Generally companies incur two types of costs. Variable costs vary with the level of production and sales (e.g., raw materials costs and sales commissions). Fixed costs remain the same irrespective of the level of production and sales (e.g., depreciation and interest expense).

Remuneration Committee

Given the role the board plays in its oversight of management, it plays a crucial role in remuneration. In this committee, it will develop and propose policies and present them for approval. It will also deal with other aspects, including setting performance criteria, establishing human resource policies, and setting and overseeing the implementation of various employee benefits.

Goodwill

Goodwill (an example of an asset that is not separately identifiable) is the excess of the amount paid to acquire a business over the fair value of its net assets.

Cost of Inventories

IFRS and U.S. GAAP suggest a similar treatment of various expenses in the determination of inventory cost. The following items are capitalized inventory costs, which are included in the cost or carrying value of inventories on the balance sheet. Costs of purchase, which include the purchase price, import duties, taxes, insurance, and other costs that are directly attributable to the acquisition of finished goods, trade discounts, and other rebates that reduce costs of purchase. Costs of conversion, which include direct labor and other (fixed and variable) direct overheads.

Fixed costs include

Operating costs (e.g., rent and depreciation). Financial costs (e.g., interest expense).

CAPM

re = RF+βi[E(RM)−RF] where: [E(RM) − RF] = Equity risk premium. RM = Expected return on the market. βi = Beta of stock. Beta measures the sensitivity of the stock's returns to changes in market returns. RF = Risk-free rate. re = Expected return on stock (cost of equity)

Long-Lived Tangible Assets: Property, Plant, and Equipment (PP&E)

>>>Capitalization versus Expensing: If an item is expected to provide benefits to the company for a period longer than one year, its cost is capitalized. If the item is expected to provide economic benefits in only the current period, its cost is expensed.

A company or project's beta is exposed to the following systematic (nondiversifiable) risks:

Business risk comprises of sales risk and operating risk. Sales risk refers to the unpredictability of revenues and operating risk refers to the company's operating cost structure. Financial risk refers to the uncertainty of profits and cash flows because of the use of fixed-cost financing sources such as debt and leases. The greater the use of debt financing, the greater the financial risk of the firm.

Liquidity Ratios

Analysis of a company's liquidity ratios aims to evaluate a company's ability to meet its short-term obligations. Liquidity measures how quickly a company can convert its assets into cash at prices that are close to their fair values

Segment Analysis

Analysts often need to analyze the performance of underlying business segments to understand the company as a whole. A business segment is a separately identifiable component of a company that is engaged in providing an individual product or service or a group of related products or services. It is subject to risks and returns that are different from those of other business segments of the company.

Accounting Treatment of Expensed Costs

A cost that is immediately expensed reduces net income for the current period by its entire after-tax amount. This hefty, one-off charge against revenues results in lower income, and lower retained earnings for the related period. The associated cash outflow is classified under operating activities on the statement of cash flows. Crucially, no related asset is recognized on the balance sheet, so no related depreciation or amortization charges are incurred in future periods.

A drag on liquidity

A drag on liquidity occurs when there is a delay in cash coming into the company.

Accumulated other comprehensive income

Accumulated other comprehensive income: This represents cumulative other comprehensive income

***Financing Cash Flow

Changes in interest-bearing debt and equity are used to determine sources and uses of financing cash flow. If debt issuance contributes significantly to financing cash flow, the repayment schedule must be considered. Increasing use of cash to repay debt, repurchase stock, or make dividend payments might indicate a lack of lucrative investment opportunities for the company.

Degree of operating leverage (DOL)

DOL = percentage change in operating income/ percentage change in units sold

ESG Market Overview

Investors are becoming more aware of the various situations that have a negative impact not only on the environment but also on society. In the recent past, Walmart has had several strikes and lawsuits that have cost hundreds of millions of dollars to settle. Therefore, there is a growing emphasis on investing that utilizes ESG criteria. Some large institutional asset owners embrace the concept of being a universal owner. This is a long-term investor with a diversified global portfolio that is linked to economic growth while being exposed to costs resulting from environmental damage. It is thus important to consider various factors while performing investment analysis.

Advantage

It accounts for the time value of money and risks associated with the project's cash flows.

Last In, First Out (LIFO)

Last In, First Out (LIFO): Newest units purchased or manufactured are assumed to be the first ones sold. Oldest units purchased or manufactured are assumed to remain in ending inventory. COGS is composed of units valued at most recent prices. EI is composed of units valued at oldest prices.

It is important for analysts to understand a company's use of leverage for the following reasons:

Leverage increases the volatility of a company's earnings and cash flows, thereby increasing the risk borne by investors in the company. The more significant the use of leverage by the company, the more risky it is and therefore, the higher the discount rate that must be used to value the company. A company that is highly leveraged risks significant losses during economic downturns.

Leverage

Leverage refers to a company's use of fixed costs in conducting business.

Liquidity Ratios

Liquidity Ratios Current ratio: Current assets/Current liabilities Quick ratio (acid test ratio): Cash + marketable securities + receivables / Current liabilities Cash ratio: Cash + marketable securities/ Current liabilities ***Higher solvency ratios, on the other hand, are undesirable and indicate that the company is highly leveraged and risky.

Major pulls on payments include

Making payments early instead of waiting until the due date to make them. Reduced credit limits as a result of a history of not being able to make payments on time. Limits on short-term lines of credit: These can be mandated by the government, market-related, or company-specific. Low existing levels of liquidity.

Cash Ratio

The cash ratio is a very reliable measure of an entity's liquidity position in the event of an unforeseen crisis. This is because it only includes cash and highly liquid short-term investments in the numerator.

Governance Committee

The governance committee will monitor the adoption and implementation of good corporate governance practices. The committee will determine if the implementation is occurring and will review whether the policies and standards are in compliance with applicable laws and regulations.

Laws and Regulations

The government and regulators seek to protect the public through developing laws and monitoring compliance. Regulations vary by industry and increase with the level of risk that the public is exposed to.

ESG Implementation Methods

The implementation of ESG mandates can include the following five methods: Negative screening Positive screening and best-in-class ESG integration/incorporation Thematic investing Impact investing

The nomination committee

The nomination committee will create the nomination policies and procedures for new board members and executive management. It will recruit new board members who have the needed qualities and experience for the company. In addition, the committee will regularly examine various aspects of the existing board members to determine if their skills, expertise, and performance meet the current and future needs of the company and the board.

Profitability Index

The profitability index (PI) of an investment equals the present value (PV) of a project's future cash flows divided by the initial investment. PI = PV OF FUTURE CASH FLOWS/ INITIAL INVESTMENT = 1+ NPV/ INITIAL INVESTMENTS The PI indicates the value we receive in exchange for one unit of currency invested. It is also known as the "benefit-cost" ratio. The project's PI is greater than 1 so the company should invest in the project.

Depreciation Methods and Calculation of Depreciation Expense1

There are two primary models for reporting long-lived assets. >>>The cost model is required under U.S. GAAP and permitted under IFRS. Under this model, the cost of long-lived tangible assets (except land) and intangible assets with finite useful lives is allocated over their useful lives as depreciation and amortization expense. Under the cost model, an asset's carrying value (also called carrying amount or net book value) equals its historical cost minus accumulated depreciation/amortization (as long as the asset has not been impaired). >>>The revaluation model is permitted under IFRS, but not under U.S. GAAP. Under this model, long-lived assets are reported at fair value (not at historical cost minus accumulated depreciation/amortization).

Decline in LIFO Reserve

There can be two reasons for a decline in LIFO reserve: LIFO liquidation. Declining prices.

Cash flow from investing activities (CFI):

These are inflows and outflows of cash generated from the purchase and disposal of long-term investments. Long-term investments include plant, machinery, equipment, intangible assets, and nontrading debt and equity securities.

Intangible Assets Acquired in Situations Other than Business Combinations (e.g., Buying a Patent)

These intangible assets are recorded at their fair value when acquired, where the fair value is assumed to equal the purchase price. They are recognized on the balance sheet, and costs of acquisition are classified as investing activities on the cash flow statement. If several intangible assets are acquired as a group, the purchase price is allocated to each individual asset based on its fair value.

Acquired intangible assets may be reported as separately identifiable intangibles (rather than goodwill) if:

They arise from contractual rights (e.g., licensing agreements), or other legal rights (e.g., patents); or Can be separated and sold (e.g., customer lists).

Non-controlling interest (minority interest):

This is the minority shareholders' pro rata share of the net assets of a subsidiary that is not wholly owned by the company.

Return on common equity

This ratio measures the return earned by a company only on its common equity.

Fixed Charge Coverage Ratio

This ratio relates the fixed charges or obligations of the company to its earnings. It measures the number of times a company's operating earnings can cover its interest and lease payments. A higher ratio suggests that the company is comfortably placed to service its debt and make lease payments from the earnings it generates from operations

Treasury shares

Treasury shares: These are shares that have been bought back by the company. Share repurchases result in a reduction in owners' equity and in the number of shares outstanding. These shares do not receive dividends and do not have voting rights. While Treasury shares may be reissued at a later date, no gain or loss is recognized when they are reissued

Trend analysis

Trend analysis provides important information about a company's historical performance. It can also offer assistance in forecasting the financial performance of a company. When looking for trends over time, horizontal common-size financial statements are often prepared. Dollar values of accounts are divided by their base-year values to determine their common-size values. Horizontal common-size statements can also help identify structural changes in the business.

The LIFO Method and the LIFO Reserve

U.S. GAAP requires firms that use the LIFO inventory cost flow assumption to disclose the beginning and ending balances for the LIFO reserve (LR) in the footnotes to the financial statements. The LIFO reserve equals the difference between the value of inventory under LIFO, and its value under FIFO. In periods of rising prices and stable inventory levels, LIFO EI is lower than FIFO EI. Therefore, EI FIFO= EI LIFO + LR ending First it is important for us to understand that the choice of LIFO, FIFO, or AVCO affects only how inventory costs are allocated between EI and COGS. It does not affect purchases (P).

Direct method

Under the direct method, income statement items that are reported on an accrual basis are all converted to cash basis. All cash receipts are reported as inflows, while cash payments are reported as outflows.

Straight-Line Depreciation

Under the straight-line method, the cost of the asset is allocated evenly across its estimated useful life. Depreciation expense is calculated as depreciable cost divided by estimated useful life. -Depreciable cost is the historical cost of the tangible asset minus the estimated residual (salvage) value. -The residual value is the estimated amount that will be received from disposal of the asset at the end of its useful life. >>>Depreciation expense = Original cost − Salvage value Depreciable life

Working capital management

Working capital management deals with short-term aspects of corporate finance activities. Effective working capital management ensures that a company has ready access to funds that are needed for day-to-day expenses and that it invests its assets in the most productive manner at the same time.

Takeaway

***The larger the proportion of debt in a company's capital structure, the greater the sensitivity of net income to changes in operating income, and therefore the greater the company's financial risk. Bear in mind that taking on more debt also magnifies earnings upward, if the company is performing well (illustrated by the higher ROEs in Scenario B).

IMPORTANT

***The lower the proportion of fixed costs in a company's cost structure, the less sensitive its operating income is to changes in units sold and therefore, the lower the company's operating risk.

Definitions of Some Common Industry and Task-Specific Ratios

>>>Business Risk Coefficient of variation of operating: Standard deviation of operating income/ Average operating income Coefficient of variation of net income: Standard deviation of net income/ Average net income Coefficient of variation of revenues: Standard deviation of revenues/ Average revenue >>>Financial Sector Ratios Capital adequacy—Banks: Various components of capital/ Risk weighted assets, market risk exposure, and level of operational risk assumed Monetary reserve requirement: Reserves held at central bank/ Specified deposit liabilities Liquid asset requirement : Approved "readily marketable securities"/ Specified deposit liabilities Net interest margin: Net interest income/ Total interest-earning assets >>>Retail Ratios Same store sales: Average revenue growth year on year for stores open in both periods/ Not applicable Sales per square foot (meter): Revenue/ Total retail space in feet or meters >>>Service Companies Revenue per employee: Revenue/ Total number of employees Net income per employee: Net income/ Total number of employees >>>Hotels Average daily rate: Room revenue/ Number of rooms sold Occupancy rate: Number of rooms sold/ Number of rooms available

Analysts use the pure-play method to estimate the beta of a particular project or of a company that is not publicly traded. This method requires adjusting a comparable publicly-listed company's beta for differences in financial leverage

>>>First we find a comparable company that faces similar business risks as the company or project under study and estimate the equity beta of that company. Betas vary with the level of financial risk in a company. Highly leveraged companies have higher financial risk, which is reflected in their high equity betas. >>>To remove all elements of financial risk from the comparable's beta we "unlever" the beta. This unlevered beta reflects only the business risk of the comparable and is known as asset beta. Finally, we adjust the unlevered beta of the comparable for the level of financial risk (leverage) in the project or company under study.

Flotation cost

>>>Flotation costs refer to the fee charged by investment bankers to assist a company in raising new capital. >>>In the case of debt and preferred stock, we do not usually incorporate flotation costs in the estimated cost of capital because the amount of these costs is quite small, often less than 1%. However, for equity issues, flotation costs are usually quite significant. >>>There are two ways of accounting for flotation costs. The first approach, which is often found in finance textbooks, incorporates flotation costs into the cost of capital. When this approach is applied, the cost of capital is calculated in the following manner: >>>>> re = [D1/ P0(1−f)]+g where: f = flotation costs as a percentage of the issue price.

Calculate and compare the following for 2012 under LIFO and FIFO: inventory turnover ratio, days of inventory on hand, gross profit margin, net profit margin, return on assets, current ratio, and total liabilities-to-equity ratio.

>>>Inventory turnover ratio = Cost of goods sold ÷ Average inventory LIFO = 16,775 ÷ [(2,510 + 2,030) ÷ 2] = 7.39 FIFO = 16,525 ÷ [(3,840 + 3,110) ÷ 2] = 4.76 The ratio is higher under LIFO because, given stable inventory levels and rising inventory costs, COGS would be higher and inventory carrying amounts will be lower under LIFO. If the difference in inventory methods were not taken into account, an analyst may (erroneously) conclude that a company using LIFO manages its inventory more efficiently. >>>Gross profit margin = Gross profit ÷ Total revenue LIFO = [(21,350 − 16,775) ÷ 21,350] = 21.43% FIFO = [(21,350 − 16,525) ÷ 21,350] = 22.60% The gross profit margin is lower under LIFO because COGS is higher. >>>Net profit margin = Net income ÷ Total revenue LIFO = 1,560 ÷ 21,350 = 7.31% FIFO = 1,760 ÷ 21,350 = 8.24% The net profit margin is lower under LIFO because COGS is higher. However, note that the absolute percentage difference in the NP margin under the two cost flow assumptions is less than that of the GP margin because of income taxes on the higher income under FIFO. >>>Return on assets = Net income ÷ Average total assets LIFO = 1,560 ÷ [(8,950 + 7,880) ÷ 2] = 18.54% FIFO = 1,760 ÷ [(8,950 + 1,330 − 374) + (7,880 + 1,080 − 324) ÷ 2] = 18.98% Total assets are higher under FIFO (even after accounting for the cash paid for additional income taxes). The return on assets is lower under LIFO because the impact of lower net income (due to higher COGS) outweighs the impact of lower total assets (due to lower inventory carrying amounts). The company appears to be less profitable under LIFO. >>>Current ratio = Current assets ÷ Current liabilities LIFO = 4,060 ÷ 3,300 = 1.23 FIFO = [(4,060 + 1,330 - 374) ÷ 3,300] = 1.52 The current ratio is lower under LIFO because of the lower carrying amount of inventory. The company appears to be less liquid under LIFO. >>>Total liabilities-to-equity ratio = Total liabilities ÷ Total shareholders' equity LIFO = 6,750 ÷ 2,200 = 3.07 FIFO = [6,750 ÷ (2,200 + 956)] = 2.14 The ratio is higher under LIFO because of lower retained earnings. The company appears to be more highly leveraged under LIFO.

Intangible Assets Acquired in a Business Combination

>>>When a company acquires another company, the transaction is accounted for using the acquisition method (under both IFRS and U.S. GAAP). Under this method, if the purchase price paid by the acquirer to buy a company exceeds the fair value of its net assets, the excess is recorded as goodwill. >>>Goodwill is an intangible asset that cannot be identified separately from the business as a whole. Only goodwill created in a business acquisition can be recognized on the balance sheet; internally generated goodwill cannot be capitalized. Under IFRS, acquired intangible assets are classified as identifiable intangible assets if they meet the definitional and recognition criteria that we listed earlier. If an item acquired does not meet these criteria and cannot be recognized as a tangible asset, it is recognized as a part of goodwill. >>>Under U.S. GAAP, an intangible asset acquired in a business combination should be recognized separately from goodwill if: >The asset arises from legal or contractual rights, or >The item can be separated from the acquired company. Examples of intangible assets treated separately from goodwill include intangible assets like patents, copyrights, franchises, licenses, and Internet domain names.

Accounting Treatment of Capitalized Costs

A capitalized cost is recognized as a non-current asset on the balance sheet. The associated cash outflow is listed under investing activities on the statement of cash flows. In subsequent periods, the capitalized amount is allocated (expensed) over the asset's useful life as depreciation expense (for tangible assets) or amortization expense (for intangible assets with finite lives). These expenses reduce net income and decrease the book value of the asset. However, since they are noncash items, depreciation and amortization do not have an impact on future cash flows (apart from a possible reduction in taxes payable)

Breakeven point

A company's breakeven point occurs at the number of units produced and sold at which its net income equals zero. It is the point at which a company's revenues equal its total costs and the company goes from making losses to making profits.

Key Elements of the Trade Credit Granting Process

A company's credit policy can have a significant impact on sales. A company may be able to enhance sales by loosening acceptance criteria, and could end up restricting sales if the terms offered to customers are too strict. An effective credit management system must follow a proper strategy that is tailored to the company's needs and reflects its goals. Companies offer different forms of credit terms to customers depending on their financial strength, the nature of their relationship with the company, and the type of credit terms offered by competitors. Some of the forms of terms of credit (excluding cash) include: Ordinary terms Cash before delivery (CBD) Cash on delivery (COD) Bill-to-bill Monthly billing Credit managers typically use credit scoring models to evaluate customers' credit worthiness. These models consider factors such as availability of ready cash, type of organization (i.e., corporation, sole proprietorship, etc.), and how quickly payments are made to suppliers. The benefit of using credit scoring models is that they allow companies to make decisions quickly, and do not require a great deal of paperwork.

Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget

A company's marginal cost of capital (MCC) increases as it raises additional capital. why? This is because most firms must pay a higher cost to obtain increasing amounts of capital. consequence: The more a company borrows, the greater the risk that it will be unable to repay its lenders, and therefore, the higher the return required by investors. The profitability of a company's investment opportunities decreases as the company makes additional investments. The company prioritizes investments in projects with the highest IRRs. As more resources are invested in the most rewarding projects, remaining opportunities offer lower and lower IRRs. This fact is represented by an investment opportunity schedule (IOS) that is downward-sloping.

This ratio is used to evaluate the effectiveness of a company's inventory management. Generally, this ratio is benchmarked against the industry average.

A high inventory turnover ratio relative to industry norms might indicate highly effective management. Alternatively, it could also indicate that the company does not hold adequate inventory levels, which can hurt sales incase shortages arise. A simple comparison of the company's sales growth to the industry's growth in sales can indicate whether sales are suffering because too little stock is available for sale at any given point in time. A low inventory turnover relative to the rest of the industry can be an indicator of slow moving or obsolete inventory. It suggests that the company has too many resources tied up in inventory. Inventory turnoverof ABC Company = 380,000 (16,000+34,000) /2 = 15.2

A high receivables turnover ratio

A high receivables turnover ratio might indicate that the company's credit collection procedures are highly efficient. However, a high ratio can also result from overly stringent credit or collection policies, which can hurt sales if competitors offer more lenient credit terms to customers. A low ratio relative to industry averages will raise questions regarding the efficiency of a company's credit or collection procedures As with the inventory turnover ratio, a simple comparison of the company's sales growth with industry sales growth can help determine whether the reason behind a high receivables turnover ratio is strict credit terms or efficient receivables management. Analysts can also compare current estimates of the company's bad debts and credit losses with its own past estimates and peer companies' estimates to assess whether low receivables turnover is the result of credit management issues. The receivables turnover ratio and days of sales outstanding are inversely related. The higher the receivables turnover ratio, the lower the DSO.

Current Ratio

A higher ratio is desirable because it indicates a higher level of liquidity. A current ratio of 1.0 indicates that the book value of the company's current assets equals the book value of its current liabilities. A low ratio indicates less liquidity and implies a greater reliance on operating cash flow and outside financing to meet short-term obligations. The current ratio assumes that inventory and accounts receivable can readily be converted into cash at close to their fair values.

Payback Period

A project's payback period equals the time it takes for the initial investment for the project to be recovered through after-tax cash flows from the project. All other things being equal, the best investment is the one with the shortest payback period. Note that if two projects have the same payback period and identical cash flows after the payback period, the project for which cash flows within the payback period occur earlier would be preferred, as it would have a higher NPV.

A stakeholder

A stakeholder is any person or group that has an interest in the company. Not all stakeholders' interests are aligned in the same manner, and they often are in conflict with one another.

Ratios are typically classified into the following categories

Activity ratios: measure how productive a company is in using its assets and how efficiently it performs its everyday operations. Liquidity ratios: measure the company's ability to meet its short-term cash requirements. Solvency ratios: measure a company's ability to meet long-term debt obligations. Profitability ratios: measure a company's ability to generate an adequate return on invested capital. Valuation ratios: measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specific claim (e.g., common stock).

An analyst should evaluate financial ratios based on the following

Actual ratios should be compared to the company's stated objectives. This helps in determining whether the company's operations are moving in line with its strategy. A company's ratios should be compared with those of others in the industry. When comparing ratios between firms from the same industry, analysts must be careful because: Not all ratios are important to every industry. Companies may have several lines of business, which can cause aggregate financial ratios to be distorted. In such a situation, analysts should evaluate ratios for each segment of the business in relation to relevant industry averages. Companies might be using different accounting standards. Companies could be at different stages of growth or may have different strategies. This can result in different values for various ratios for firms in the same industry. Ratios should be studied in light of the current phase of the business cycle.

Correct Treatment of Flotation Costs exercicio ***While both approaches to incorporating flotation costs are illustrated, the LOS stresses the correct treatment only

Alex Company is planning to invest in a project. The following information is provided: Initial cash outflow = $75,000. Expected future cash flows = $20,000 every year for the next 5 years. Alex's before-tax cost of debt = 5%. Tax rate = 30%. Next year's expected dividend = $1 per share. The current price of the stock = $25. Expected growth rate = 4%. The target capital structure = 70% equity and 30% debt. Flotation costs for equity = 4%. Calculate the NPV of the project after adjusting cash flows to account for flotation costs. Solution: First, we determine the after-tax cost of debt and equity to calculate the WACC of the project: Weight Formula After-Tax Cost Debt 30% rd(1−taxrate) 0.05 (1 − 0.3) = 3.5% Equity 70% re=D1P0+g (1/25) + 0.04 = 8% WACC= 0.3(3.5%)+0.70(8%)= 6.65% Next, we calculate the dollar amount of flotation costs: Dollar amount of flotation costs= $52,500×4%=$2,100 >>>(70% of the investment is financed by using equity. 70% of $75,000 = $52,500) Finally, we calculate the NPV of the project: Initial cash outflow = Initial outlay for project + Flotation costs = $77,100 Cash inflows = $20,000 for the next 5 years WACC (discount rate) = 6.65% NPV=−$77,100+$20,000(1.0665)1+$20,000(1.0665)2+$20,000(1.0665)3+$20,000(1.0665)4+$20,000(1.0665)5NPV=$5,67.820

Remuneration Policies

Aligning pay with shareholder interests helps to ensure that long-term strategies are implemented that will benefit the overall value of the company. The most common potential issues arise when executives act in the short term ("short-termism") to increase their own pay or take on excessive risk. Some companies have even implemented claw-back provisions whereby they will recover previous remuneration if certain events or misconduct occurs.

conclusion:1

Analysts should be aware that management can inflate their company's reported gross profits and net income by intentionally reducing inventory quantities and liquidating older (cheaper) units of stock. Therefore, it is important to analyze the LIFO reserve footnote disclosures to determine if LIFO liquidation has occurred. If it is found that LIFO liquidation has occurred, analysts must exclude the increase in earnings due to LIFO liquidation from their analysis. COGS must be adjusted upward for the decline in LIFO reserve, and net income must be lowered. LIFO liquidations are more likely to occur with firms that break inventory down into numerous categories. When the different types of inventory are pooled into only a few broad categories, decreases in quantities of certain items are usually offset by increases in quantities of others.

Analysis of Corporate Governance and Stakeholder Management

Analyzing a company's corporate governance structure is a subjective endeavor. However, there are several potential items that should be considered, as a good structure leads to several benefits in the long-term success of a company. Six key areas of interest are: Economic ownership and voting control Board of directors representation Remuneration and company performance Investors in the company Strength of shareholders' rights Managing long-term risks

Contractual Agreements with Creditors

Another management tool is the contractual agreement with creditors. The indenture is a legal contract that outlines the obligations and rights of issuer and bondholder. Normally, there will be covenants within the indenture that identify actions that are both required (e.g., providing periodic financials) and prohibited (e.g., additional or excessive debt). Collaterals are another way to further increase the likelihood of repayment through the offering of assets or financial guarantees.

Industry-specific ratios

Aspects of performance that are deemed relevant in one industry may be irrelevant in another. Industry-specific ratios reflect these differences. For companies in the retail industry, changes in same store sales should be tracked. This is because it is important to distinguish between sales growth generated from opening new stores and sales growth resulting from higher sales at existing stores. Regulated industries are required to adhere to specific regulatory ratios. The banking sector has liquidity and cash reserve ratio requirements. Banking capital adequacy requirements relate banks' solvency to their specific levels of risk exposure.

Illustration of Methods of Inventory Valuation

At the beginning of the year, Nakamura Inc. had 5 units of inventory, which cost $8 each. Over the year the company purchased 52 units and sold 50 units, leaving it with 7 unsold units at the end of the year. Nakamura purchased 10 (cost = $10/unit), 12 (cost = $11/unit), 14 (cost = $12/unit), and 16 (cost = $13/unit) units and sold 13, 13, 12, and 12 units in the four quarters, respectively. All units were sold at $20 each. Determine the amounts that are allocated to EI and COGS for the year under the FIFO, LIFO, and AVCO cost flow assumptions. Solution: First we must determine the total cost of goods available for sale that must be allocated between EI and COGS. This is done by summing the values of opening inventory (OI) and quarterly purchases: Units Held/ Purchased-Unit Cost $-Total Cost $ Quarter Opening inventory 5 8 40 1 10 10 100 2 12 11 132 3 14 12 168 4 16 13 208 Total 57 648 FIFO Under this method: Older units are assumed to be the first ones sold. Units that are purchased recently are included in EI. COGS is composed of units valued at older prices EI is composed of units valued at recent prices. COGS $ EI $ 5 units at $8 from OI 40 7 units at $13 left over from Q4 purchases 91 10 units at $10 from Q1 purchases 100 12 units at $11 from Q2 purchases 132 14 units at $12 from Q3 purchases 168 9 units at $13 from Q4 purchases 117 50 units 557 7 units 91 LIFO Under this method: Recently acquired units are assumed to be the first ones sold. Oldest units are included in EI. COGS is composed of units valued at recent prices. EI is composed of units valued at older prices. COGS $ EI $ 16 units at $13 from Q4 purchases 208 5 units at $8 from OI 40 14 units at $12 from Q3 purchases 168 2 units at $10 from Q1 purchases 20 12 units at $11 from Q2 purchases 132 8 units at $10 from Q1 purchases 80 50 units 588 7 units 60 AVCO Under this method: COGS is composed of units valued at average prices. EI is also composed of units valued at average prices. Weighted average price= Value of goods available for sale/ Number of units available for sale =$648/57=$11.37/unit COGS $ EI $ 50 units at $11.37 568.42 7 units at $11.37 79.58

ROE - EXERCISE

Average total assets = Revenue / Asset turnover Average total assets = 17,000,000 / 1.24 = $13,709,677.42 Therefore, financial leverage = 13,709,677.42 / 30,000,000 = 0.45699 Net income = 17 - 5.5 - 4.2 - 2.4 - 3.3 = $1.6 million ROE = (1,600,000 / 17,000,000) × 1.24 × 0.45699 = 5.33%

Accounting for Flotation Costs Directly into the Cost of Equity

Ben Company currently pays a dividend of $1 per share, has a current stock price of $20, and has an expected growth rate of 4%. The company wants to raise equity capital and flotation costs will be 5% of the total issue. Calculate the company's cost of equity: >>>Before it issues new capital. >>>After it issues new capital, including flotation costs in the cost of equity. Solution: Cost of equity before Ben raises new capital: re= D1/ P0+g re= [$1(1+0.04) / $20]+0.04= 9.2% Cost of equity after issuance: re= [D1/ P0(1−f)]+g re= [$1(1+0.04) / $20(1−0.05)]+0.04= 9.47% Ben's cost of equity was 9.2% before it issued new equity. After issuance, when flotation costs are included in cost of equity, the cost rises by 27 basis points to 9.47%. ****However, adjusting the cost of capital for flotation costs is incorrect. Flotation costs are a part of the initial cash outlay for a project. Adjusting the cost of capital to account for flotation costs adjusts the present value of all future cash flows by a fixed percentage (27 basis points in Example. This adjustment will not necessarily equal the present value of flotation costs

Board of Directors Representation

Board of Directors Representation Evaluating the makeup of the board is another important aspect that should be reviewed. Do the directors have the proper backgrounds and skills to guide the company in the current environment and the future? Having a long-tenured board may have a negative impact on the future success of the company, if it limits the board's diversity and adaptability.

Approaches to Short-Term Borrowing

Borrowers should have planned strategies for short-term borrowings. They should: Ensure that there is sufficient capacity to handle peak cash needs. Maintain sufficient sources of credit to be able to fund ongoing cash requirements. Ensure that the rates obtained for these borrowings are cost effective. Diversify to have abundant options and not be too reliant on one lender or form of lending. Have the ability to manage different maturities in an efficient manner.

Business risk

Business risk refers to the risk associated with a company's operating earnings. Operating earnings are risky because total revenues and costs of sales are both uncertain. Therefore, business risk can be broken down into sales risk and operating risk.

Cash Flow Classification Under U.S. GAAP

CFO Inflows Cash collected from customers. Interest and dividends received Proceeds from sale of securities held for trading Outflows Cash paid to employees. Cash paid to suppliers. Cash paid for other expenses. Cash used to purchase trading securities. Interest paid. Taxes paid. CFI Inflows Sale proceeds from fixed assets. Sale proceeds from long-term investments Outflows Purchase of fixed assets. Cash used to acquire LT investment securities. CFF Inflows Proceeds from debt issuance. Proceeds from issuance of equity instruments Outflows Repayment of LT debt. Payments made to repurchase stock. Dividends payments.

Income Statement Information: Cost of Goods Sold

COGS should ideally reflect the replacement cost of inventory. The 50 units sold should each be valued at $13 (latest prices) in calculating the true replacement cost of goods sold during the year, which equals $650 (50 units × $13). LIFO estimates of COGS capture current replacement costs fairly accurately ($588), followed by AVCO ($568.42). FIFO measures of COGS ($557) are farthest away from current replacement cost of inventory. It does not matter whether prices are rising (as in our example) or falling; LIFO will always offer a closer reflection of replacement costs in COGS because it allocates recent prices to COGS. LIFO is the most economically accurate method for income statement purposes because it provides a better measure of current income and future profitability. If prices are rising, FIFO and AVCO will understate replacement costs in COGS and overstate profits. If prices are falling, FIFO and AVCO will overstate replacement costs in COGS and understate profits. When prices are stable, the three methods will value COGS at the same level. In the periodic system, the carrying value of EI and COGS is determined only at the end of the period (periodically).

Moon Traders' 2009 cost of goods sold, if it used the FIFO method for inventory valuation, would be closest to:

COGS under FIFO = COGS under LIFO - (Change in LIFO reserve) COGS under FIFO = 76,000 - (8,300 - 7,100) = $74,800

Calculation of a Project's Beta and WACC

Calculation of a Project's Beta and WACC Rukaiya Inc. is considering an investment in the confectionaries business. Rukaiya has a D/E ratio of 1.5, a before-tax cost of debt of 6%, and a marginal tax rate of 35%. Tastelicious Foods is a publicly traded company that operates only in the confectionaries industry and has a D/E ratio of 2, an equity beta of 0.7, and marginal tax rate of 40%. The risk-free rate is 4.5% and the expected return on the market is 11%. Calculate the appropriate WACC that Rukaiya should use to evaluate the risk of entering the confectionaries business. Solution: First we calculate Tastelicious Foods' (the reference company's) unlevered (asset) beta, which eliminates the impact of financial risk, and only reflects the business risk of the confectionaries industry. βASSET = βEQUITYx[11+((1−t)D/E)] βASSET = 0.7[11+((1−0.4)2)]

Capital budgeting

Capital budgeting is the process that companies use for making long-term investment decisions (e.g., acquiring new machinery, replacing current machinery, launching new products, and spending on research and development) A significant amount of capital is usually tied up in long-term projects. The success of these investments has a significant influence on the future prospects of the company. The principles of capital budgeting can also be used in making other operating decisions (e.g., investments in working capital and acquisitions of other companies). The valuation principles used in capital budgeting are also applied in security analysis and portfolio management. Sound capital budgeting decisions maximize shareholder wealth.

Capitalization of Interest Costs

Capitalization of Interest Costs Companies must capitalize interest costs associated with financing the acquisition or construction of an asset that requires a long period of time to ready for its intended use. if a company constructs a building for its own use, interest expense incurred to finance construction must be capitalized along with the costs of constructing the building. The interest rate used to determine the amount of interest capitalized depends on the company's existing borrowings or, if applicable, on borrowings specifically incurred to finance the cost of the asset.

Overstatement of net income

Capitalization of costs that should be expensed results in overstatement of net income for the year (due to the deferral of recognition of costs) and an overstatement of inventory value on the balance sheet.

Capitalization of costs

Capitalization of these costs results in a buildup of asset balances and delays recognition of these costs (in COGS) until inventory is sold

By what amount would WNF's 2012 and 2011 net cash flow from operating activities change if it had used FIFO instead of LIFO?

Changes in the inventory cost flow assumption result in a change in the allocation of inventory costs across COGS and EI, but the only cash flow-related consequence of the change is the change in income taxes. WNF would incur an increase in income taxes amounting to $50 million in 2012 and $36 million in 2011 if it were to use the FIFO method instead of the LIFO method.

Determining Break Points

Charlton Inc. has a target capital structure of 70% equity and 30% debt. The schedule of costs for components of capital for the company is contained in the table below. Calculate the break points and illustrate the marginal cost of capital schedule for Charlton. Amount of New Debt ($ millions). After-Tax Cost of Debt. Amount of New Equity ($ millions). Cost of Equity: 0 to 150 3.90% 0 to 300 6.00% 150 to 300 4.40% 300 to 600 7.80% 300 to 450 4.80% 600 to 900 10.00% Solution: Charlton Inc. will have a break point each time the cost of a component of capital changes. Specifically, its MCC schedule will have four break points. Break Point Calculation Amount When debt exceeds $150 million $150 million/0.3 = $500 million When debt exceeds $300 million $300 million/0.3 $1,000 million When equity exceeds $300 million $300 million/0.7 $428.57 million When equity exceeds $600 million $600 million/0.7 $857.14 million The following table shows the company's WACC at the different levels of total capital: Capital Equity (70%). Cost of Equity. Debt (30%). After-Tax. Cost of Debt. WACC: $100.00 70 6% 30 3.90% 5.37% $428.57 300 7.80% 128.57 3.90% 6.63% $500.00 350 7.80% 150 4.40% 6.78% $857.14 600 10.00% 257.14 4.40% 8.32% $1,000.00 700 10.00% 300 4.80% 8.44%

Cash Management Investment Policy

Companies with short-term investment portfolios should have a formal, written policy that guides the investment decision-making process. Having such a policy protects the company and its investment manager, and effectively communicates key aspects of the portfolio to investment dealers. An investment policy has the following basic structure: >>The purpose of the investment policy states reasons for the existence of the portfolio and describes its general attributes, such as the investment strategy to be followed >>It identifies the authorities who supervise the portfolio managers and details the actions that must be undertaken if the policy is not followed. >>It describes the types of investments that should be considered for inclusion in the portfolio. The policy also contains restrictions on the maximum proportion of each type of security in the portfolio and specifies the minimum credit rating of portfolio securities. ***The investment policy statement should be evaluated on the basis of how well it meets the goals of short-term investments (i.e., its ability to generate competitive returns without exposing the company to undue risks). The returns on short-term investments in different instruments should be expressed as bond equivalent yields so that various investment options can be easily compared.

Compare cost to NRV

Compare cost to NRV NRV = SP − SC

Inventory Method Changes

Consistency in the inventory costing method used is required under U.S. GAAP and IFRS. Under IFRS, a change in policy is acceptable only if the change results in the provision of more reliable and relevant information in the financial statements. Changes in inventory accounting policy are applied retrospectively. Information for all periods presented in the financial report is restated Adjustments for periods prior to the earliest year presented in the financial report are reflected in the beginning balance of retained earnings for the earliest year presented in the report. >>>U.S. GAAP has a similar requirement for changes in inventory accounting policies. However, a company must thoroughly explain how the newly adopted inventory accounting method is superior and preferable to the old one. The company may be required to seek permission from the Internal Revenue Service (IRS) before making any changes. If inventory-related accounting policies are modified, the changes to the financial statements must be made retrospectively, unless the LIFO method is being adopted (which is applied prospectively). Analysts should carefully evaluate changes in inventory valuation methods by assessing their impact on reported financial statements. A company may justify a switch in inventory valuation method by stating that the new method better matches inventory costs with sales revenue (or some other plausible reason), but the real underlying reasons could be different. For example, a company may switch from FIFO or AVCO to LIFO to reduce income tax expense. Alternatively, it may switch from LIFO to FIFO or AVCO to increase reported profits. Differences in inventory valuation methods should also be considered when comparing a company's performance with that of its industry or those of its competitors.

Corporate governance

Corporate governance is defined as the system of internal controls and procedures through which individual companies are managed. It aims to minimize and manage conflicts of interest between those within the company and stakeholder.

Cost of Equity Using the Bond Yield Plus Risk Premium Approach

Cost of Equity Using the Bond Yield Plus Risk Premium Approach The yield to maturity on Graf Inc.'s long-term debt is 9%. The risk premium is estimated to be 6%. Calculate Graf's cost of equity. Solution: re=rd+risk premium re=9%+6%=15%

Contractual Agreements with Customers and Suppliers

Customers and suppliers have contractual agreements that explain the relationship with the company, including the financial relationship (e.g., price, terms, support, and any guarantee provisions).

Customers

Customers would like a product that is a good value for the price and is safe to operate. In addition, they desire ongoing support. If done properly, this will increase the future value of the company through greater name recognition, safety records, and sales, but it requires potentially greater cost, which may harm profitability.

At the point where operating income equals zero, which of the following is most likely?

DOL is undefined when operating income equals zero. It is negative when the company makes operating losses and is most sensitive to changes in operating income when operating income equals zero.

The basic principles (assumptions) of capital budgeting are:

Decisions are based on actual cash flows: Only incremental cash flows are relevant to the capital budgeting process, while sunk costs are completely ignored. Analysts must also attempt to incorporate the effects of both positive and negative externalities into their analysis. Timing of cash flows is crucial: Analysts try to predict exactly when cash flows will occur, as cash flows received earlier in the life of the project are worth more than cash flows received later. Cash flows are based on opportunity costs: Projects are evaluated on the incremental cash flows they bring in, over and above the amount they would generate in their next best alternative use (opportunity cost). Cash flows are analyzed on an after-tax basis: The impact of taxes on cash flows is always considered before making decisions. Financing costs are ignored from calculations of operating cash flows: Financing costs are reflected in the required rate of return from an investment project, so cash flows are not adjusted for these costs. If financing costs were also included in the calculation of net cash flows, analysts would be counting them twice. Therefore, they focus on forecasting operating cash flows and capture costs of capital in the discount rate. Accounting net income is not used as cash flows for capital budgeting because accounting net income is subject to noncash charges (e.g., depreciation) and financing charges (e.g., interest expense).

Dividends per share

Dividends per share= Common dividends declared/ Weighted average number of ordinary shares

Reporting and Transparency

Due to additional transparency of reported information, shareholders can acquire a great deal of information from various sources. These sources include, but aren't limited to, required filings such as quarterly and yearly reporting, as well as information from social media. This reduces information asymmetry and allows the shareholders to better assess performance of the company and the board. The policies are put in place to reduce issues related to transparency, risk, and management of potential issues.

Selected Credit Ratios Used by Standard & Poor's

EBIT interest coverage: EBIT/ Gross Interest (prior to deductions for capitalized interest or interest income) EBITDA interest coverage: EBITDA/ Gross Interest (prior to deductions for capitalized interest or interest income) Funds from operations to total debt: FFO (net income adjusted for noncash items)/ Total debt Free operating cash flow to total debt: CFO (adjusted) less capital expenditures/ Total debt Return on capital: EBIT/ Capital = Average equity (common and preferred equity) and short-term portions of debt, noncurrent deferred taxes, minority interest Total debt to total debt plus equity: Total debt/ Total debt plus equity

Two basic approaches for managing inventory levels are economic order quantity and just-in-time.

Economic order quantity is the order quantity for inventory that minimizes its total ordering and holding costs. Companies typically use the economic order quantity-reorder point (EOQ-ROP) method, under which the ordering point for inventory is determined on the basis of costs of ordering and carrying inventory, such that total cost associated with inventory is minimized. This method relies on expected demand, which makes it imperative that short-term forecasts are reliable. The just-in-time method reduces in-process inventory and associated carrying costs through evaluation of the entire system of delivery of materials and production. Under this method, the reorder point is primarily determined on the basis of historical demand.

Benefits of Effective Governance

Effective governance can lead to four benefits: Operational efficiency Improved control Better operating and financial performance Lower default risk and cost of debt

Employees

Employees have a significant stake in the company's operation, as they are paid salaries as well as other incentives and perquisites for their work It is in their best interest to protect their position, and to increase their compensation in different time frames through incentives, even though it may not be in the best interest of the company in the short or long term.

Ending inventory if the company uses LIFO cost flow assumption is closest to:

Ending inventory consists of 92 - 57 = 35 units Ending inventory value using LIFO = (15 × 30) + (15 × 30) + (5 × 35) = $1,075

Star Manufacturers' ending inventory if it used the FIFO method for inventory valuation would be closest to:

Ending inventory under FIFO = Ending inventory under LIFO + LIFO reserve Ending inventory under FIFO = 78,000 + 7,300 = $85,300

Estimating Proportions of Capita

Estimating Proportions of Capital The market value of Becker Inc.'s debt is $25 million and the market value of its equity is $35 million. What is the weight of debt and equity in the company's current capital structure? If the company announces that a debt-to-equity ratio of 0.6 reflects its target capital structure, what weights should be assigned to debt and equity in calculating the company's WACC? Solution: Using the current capital structure: Weight of debt = wd = $25 million / ($25 million + $35 million) = 0.417 Weight of equity = we = $35 million / ($25 million + $35 million) = 0.583 The weight of debt in the target capital structure is calculated by dividing the target D/E ratio by (1 + D/E): wd = D/ D+E = (D/E)/ 1+D/E wd = 0.6/ (1+0.6) wd= 0.375 we = 1 - 0.375 = 0.625

What net income would WNF report for 2012 and 2011 if it had used FIFO instead of LIFO?

FIFO net income = LIFO net income + Increase in LIFO reserve × (1 - Tax rate) Note that an increase in the LIFO reserve results in lower COGS under FIFO and an increase in operating profit LIFO net income 2012 2011 $1,560 $1,085 Increase in LIFO reserve 250 (250 x 20%)= 50 120 (120 x 30%)= 36 (Increase in operating profit) Taxes on increased operating profit* (50) (36) FIFO net income $1,760 $1,169

Degree of financial leverage (DFL).

Financial risk can be measured as the sensitivity of cash flows available to owners to changes in operating income. This measure is known as the degree of financial leverage (DFL). DFL = Percentage change in net income/ Percentage change in operating income

Financial risk

Financial risk refers to the risk associated with how a company chooses to finance its operations. If a company chooses to issue debt or acquire assets on long-term leases, it is obligated to make regular payments when due. Failure to perform on these obligations can lead to legal action against the company, so by taking on these fixed obligations the company increases its financial risk. On the other hand, if it uses its retained earnings or issues shares (common equity) to finance operations, the company does not incur fixed obligations. Therefore, the higher the amount of fixed financial costs taken on by a company, the greater its financial risk.

First In, First Out (FIFO)

First In, First Out (FIFO): Oldest units purchased or manufactured are assumed to be the first ones sold. Newest units purchased or manufactured are assumed to remain in ending inventory. COGS is composed of units valued at oldest prices. EI is composed of units valued at most recent prices.

Internal Rate of Return (IRR)

For an investment project with only one investment outlay that is made at inception, IRR is the discount rate that makes the sum of present values of the future after-tax cash flows equal to the initial investment outlay. Alternatively, IRR is the discount rate that equates the sum of the present values of all after-tax cash flows for a project (inflows and outflows) to zero. Therefore, IRR is the discount rate at which NPV equals zero

Calculating the Cost of Debt Using the YTM Approach

Fordova Inc. issues a semiannual-pay bond to finance a new project. The bond has a 10-year term, a par value of $1,000, and offers a 6% coupon rate. Assuming that the bond is issued at $1,010.30 and that the tax rate for the company is 40%, calculate the before-tax and after-tax cost of debt. Solution: Present value = $1,010.30 Future value = Par = $1,000 Periodic payment = 6%/2 × 1,000 = $30 Number of discounting periods = 10 × 2 = 20 Or using our calculator: N = 20; PV = −$1,010.30; FV = $1,000; PMT = $30; CPT I/Y; I/Y = 2.931 The yield to maturity on the bond equals 2.931 × 2 = 5.862%. This is the before-tax cost of debt (rd). After-tax cost of debt = rd (1 − t) = 5.862 (1 − 0.4) = 3.52%

NPV and its Effect on Stock Price

Freeman Corp. is planning to invest $50 million in a new project. The present value of the future after-tax cash flows from the project is estimated to be $75 million. This is new information and is independent of other expectations regarding the company. The company has 5 million shares outstanding and the market price of the company's stock is $100. What should be the effect of the new project on: The value of the company. The company's stock price. Solution: NPV of the new project = $75 million − $50 million = $25 million Company value before the new project = 5 million shares × $100 = $500 million Company value after the new project = $500 million + $25 million = $525 million Price/share after the new project = $525 million/5 million shares = $105 The new project will have a positive effect of $25 million on the value of the company (shareholder wealth). The stock price should increase to $105. The positive NPV of the new project should have a positive direct impact on its stock price.

Research and Development (R&D) Costs1

Generally speaking, U.S. GAAP requires that R&D costs be expensed when incurred. However, it does require that certain costs related to software development be capitalized. Costs incurred to develop software for sale are expensed until the product's technological feasibility has been established. Once feasibility has been established, associated development costs are capitalized. Costs related directly to the development of software for internal use are also expensed until it is probable that the project will be completed and that the software will be used as intended. After that, related development costs are capitalized. >>>Note the following: The probability that "the project will be completed" is easier to establish than "technological feasibility." The involvement of subjective judgment in determining technological feasibility means that capitalization practices vary to a significant extent across companies. Capitalized costs related directly to developing software for sale or for internal use include the cost of employees who help build and test the software. The treatment of software development costs under U.S. GAAP is similar to the treatment of all costs of internally developed intangible assets under IFRS. >>>Expensing rather than capitalizing development costs results in: Lower net income in the current period. Lower operating cash flow and higher investing cash flow in the current period. >>>Note that if current period software development costs exceed amortization of prior periods' capitalized development costs, net income would be lower under expensing. >>>If, however, software development expenditures were to slow down such that current year expenses are lower than amortization of prior periods' capitalized costs, net income would be higher under expensing.

Presentation and Disclosure

IFRS requires companies to make the following disclosures relating to inventory: The accounting policies used to value inventory. The cost formula used for inventory valuation. The total carrying value of inventories and the carrying value of different classifications (e.g., merchandise, raw materials, work-in-progress, finished goods). The value of inventories carried at fair value less selling costs. Amount of inventory-related expenses for the period (cost of sales). The amount of any write-downs recognized during the period. The amount of reversal recognized on any previous write-down. Description of the circumstances that led to the reversal. The carrying amount of inventories pledged as collateral for liabilities. U.S. GAAP does not permit the reversal of prior-year inventory write-downs. U.S. GAAP also requires disclosure of significant estimates applicable to inventories and of any material amount of income resulting from the liquidation of LIFO inventory.

Research and Development (R&D) Costs

IFRS requires that expenditures on research or during the research phase of an internal project be expensed rather than capitalized as an intangible asset. Research is defined as "original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding." The research phase of an internal project refers to the period during which a company cannot demonstrate that an intangible asset is being created. >>>IFRS allows companies to recognize an intangible asset arising from development or the development phase of an internal project if certain criteria are met, including a demonstration of the technical feasibility of completing the intangible asset and the intent to use or sell the asset. Development is defined as "the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use."

Stakeholder Management

Identifying the various stakeholder positions and relationships is the basis for managing the potential conflicts that arise. It then requires understanding and prioritizing these positions, and dealing with them in a methodical and logical manner. The two most important aspects of stakeholder management are effective communication and active engagement. In order to balance the various positions and reduce conflict, a framework is built. The foundation is constructed from the various legal, contractual, organizational, and governmental components that define the rights, responsibilities, and powers of each group. The legal infrastructure lays out the framework of rights established by law as well as the ease or availability of legal recourse. The contractual infrastructure is the means used to secure the rights of both parties through contractual agreements between the company and its stakeholders. The manner in which the company manages its stakeholder relationships through its governance procedures, internal systems, and practices is the organizational structure. The regulations imposed on the company are considered the governmental infrastructure.

Other Stakeholder Conflicts

If a company decides to reduce product safety, this can cause a conflict between customers and shareholders, as customers want a safe product, but shareholders want to reduce costs and increase profits. Customers and suppliers may be at conflict when the company extends lenient credit terms to customers. This will affect the ability of the company to repay suppliers on time. If a government reduces the tax burden on a company, that is beneficial for the shareholders but detrimental to the tax base of the government, thereby causing a conflict.

Inventory Ratios

If a company has a higher inventory turnover ratio and a lower number of days of inventory than the industry average, it could mean one of three things: It could indicate that the company is more efficient in inventory management, as fewer resources are tied up in inventory. It could also suggest that the company does not carry enough inventory at any point in time, which could hurt sales. It could also mean that the company might have written down the value of its inventory. To determine which explanation holds true, analysts should compare the firm's revenue growth with that of the industry and examine the company's financial statement disclosures. A low sales growth compared to the industry would imply that the company is losing out on sales by holding low inventory quantities. A higher inventory turnover ratio combined with minimal write-downs and a sales growth rate similar to or higher than industry sales growth would suggest that the company manages inventory more efficiently than its peers. Frequent, significant write-downs of inventory value may indicate poor inventory management. A firm whose inventory turnover is lower and number of days of inventory higher than industry average could have a problem with slow-moving or obsolete inventory. Again, a comparison with industry sales growth and an examination of financial statement disclosures would provide further information. The gross profit margin indicates the percentage of sales that is contributing to net income as opposed to covering the cost of sales. Firms in relatively competitive industries have lower gross profit margins. Firms selling luxury products tend to have lower volumes and higher gross profit margins. Firms selling luxury products are likely to have lower inventory turnover ratios. Remember that inventory ratios are directly affected by the cost flow assumption used by the company. When making comparisons across firms, analysts must understand the differences that arise from the use of different cost flow assumption

Acquisition of Long-Lived Tangible Assets Acquired through an Exchange

If an asset is acquired in a nonmonetary exchange (e.g., exchanges of mineral leases and real estate), the amount recognized on the balance sheet typically equals the fair value of the asset acquired. In accounting for such exchanges, the carrying amount of the asset given up is removed from non-current assets on the balance sheet, the fair value of the asset acquired is added, and any difference between the two values is recognized on the income statement as a gain or a loss. If the fair value of the asset acquired is greater than the value of the asset given up, a gain is recorded on the income statement; if the fair value of the asset acquired is lower than that of the asset given up, a loss is recorded. In rare cases, if the fair value of the acquired asset cannot be determined, the amount recognized on the balance sheet equals the carrying amount of the asset given up. In this case, no gain or loss is recognized.

What would be the change in WNF's cash balance if it had used FIFO instead of LIFO?

If the FIFO method were used, an additional $374 million would have been paid in taxes, so cash would decline. If WNF were to now switch to FIFO, it would have an additional tax liability of $374 million as a consequence of the switch.

Positive Screening and Best-in-Class

In contrast to negative screening, positive screening or best-in-class approaches focus on including investments with favorable ESG aspects. This could include companies that promote human dignity, workplace well-being, respect for the environment, and so forth. Best-in-class approaches will evaluate and score companies on ESG criteria and choose those with the highest rating in each industry.

Increase in LIFO Reserve

In every period during which prices are rising and inventory quantities are stable or rising, the LIFO reserve will increase as the excess of FIFO ending inventory over LIFO ending inventory increases.

Ineffective Decision Making

In the absence of sufficient monitoring, there may be information asymmetry, leading to ineffective decision making. This situation would give one stakeholder group an advantage over another group. In particular, if managers have better information, they would have the ability to make decisions for their benefit. This would undermine the board which monitors them, as the board would be unable to act on behalf of the shareholders to maximize corporate value.

Under IFRS, but not U.S. GAAP

Income earned from temporarily investing borrowed funds that were acquired to finance the cost of the asset must be subtracted from interest expense on the borrowed funds to determine the amount that can be capitalized. If a company is constructing the asset for its own use, capitalized interest is included in the cost of the asset and appears on the balance sheet as a part of property, plant, and equipment. Once the asset is brought into use, the entire cost of the asset, inclusive of capitalized interest, is depreciated over time, so capitalized interest is then a part of depreciation expense, not interest expense. As a result of this accounting treatment, a company's interest costs can appear on the balance sheet (when capitalized) or on the income statement (when expensed)

Independent versus mutually exclusive projects

Independent projects are those whose cash flows are unrelated. Mutually exclusive projects compete directly with each other for acceptance. If Project A and B are mutually exclusive, the firm may only accept one of them, not both.

Intangible Assets

Intangible assets lack physical substance and include items that involve exclusive rights such as patents, copyrights, and trademarks. Some intangible assets have finite lives, while others have indefinite lives. The cost of an intangible asset with a finite life (e.g., patent) is amortized over its useful life. The cost of an intangible asset with an indefinite life (e.g. goodwill) is not amortized; instead, the asset is tested (at least annually) for impairment. If deemed impaired, the asset's balance sheet value is reduced and a loss is recognized on the income statement.

current liabilities

International Accounting Standards allow some liabilities such as trade payables and accruals for employees to be classified as current liabilities even though they might not be settled within 1 year. Financial liabilities expected to be settled within 1 year are classified as current liabilities even if their original term was more than 1 year. If the entity has an unconditional right to defer the settlement of the liability for at least 1 year after the balance sheet date, it must recognize it as a noncurrent liability.

Liquidity Ratios

Liquidity Ratios Numerator Denominator Current ratio: Current assets/ Current liabilities Quick ratio: Cash + Short-term marketable investments + Receivables/ Current liabilities Cash ratio: Cash + Short-term marketable investments/ Current liabilities Defensive interval ratio: Cash + Short-term marketable investments + Receivables/ Daily cash expenditures Additional Liquidity Measure: Cash conversion cycle (net operating cycle) DOH + DSO - Number of days of payables

Long-lived assets

Long-lived assets are expected to provide economic benefits to a company over an extended period of time, typically longer than one year. There are three types of long-lived assets: Tangible assets have physical substance, (e.g., land, plant, and equipment). Intangible assets do not have physical substance (e.g., patents and trademarks). Financial assets include securities issued by other companies.

NOTE

Looking at the formula for DOL you should realize that if there are no fixed costs, DOL would equal one. This implies that if there are no fixed costs, there would be no operating leverage. Interpretation: At 400,000 units, a 1% change in units sold will result in a 1.238% change in Blue Horizons' operating income. See Figure 1.4. Conclusion: DOL is different at different levels of sales. If the company is making operating profits, the sensitivity of operating income to changes in units sold decreases at higher sales volumes (in units).

Evaluating Management of Accounts Payable

Managing accounts payable is an important part of working capital management, as accounts payable can be a source of working capital for the firm. By paying too early, a company loses out on interest income. If it pays late, the company risks ruining its reputation and relationships with suppliers. Further, penalties and interest charges for late payment can be very significant . Companies should consider a variety of factors as guidelines for managing their accounts payable effectively. These include: Financial organization's centralization: The management of a company's payables is affected by the degree to which its core financial system is centralized or decentralized. Number, size, and location of vendors: The sophistication of a company's payables system is affected by its supply chain and how dependent the company is on its trading partners. Trade credit and cost of borrowing or alternative cost: The standardization of a company's payables procedures is dependent on the importance of credit to the company and its ability to evaluate trade credit opportunities (e.g., trade discounts). Control of disbursement float: The disbursement float (the amount of time between the issuance of a check and its clearance) allows companies to use their funds longer than if they had to fund their checking accounts on the day the checks were mailed. Inventory management: Newer management techniques and systems are required to process the increased volume of payments generated through newer inventory control techniques. E-commerce and electronic data interchange (EDI): Making payments electronically may be more efficient and cost-effective than making payments through checks. Checks are only more valuable when the value of the disbursement float and interest rates are high.

Project sequencing

Many projects can only be undertaken in a certain order, so investing in one project creates the opportunity to invest in other projects in the future. For example, a company might invest in a project today and then invest in a second project after three years if the first project is successful and the economic scenario has not been adversely affected. However, if the initial project does not do so well, or if the economic environment is no longer favorable, the company will not invest in the second project.

ESG Factors in Investment Analysis

Material events that impact the environment can be costly in terms of legal and regulatory issues, such as fines and litigation. They very well may include clean-up costs as well as reputational costs. Therefore, in any analysis, it is important to factor in both the risk and the potential costs if an error occurs. Societal issues can be very broad, including issues within the workplace, human rights, and welfare. They can also include the impact on the community. Companies that incorporate social factors into their business can potentially benefit from a sustainable competitive advantage, as workforce training, safety, turnover, and morale (to name a few) positively impact a company. This can lead to higher productivity and lower costs

marketable and non-marketable financial instruments according to the measurement base used to value them

Measured at Fair Value Financial Assets Financial assets held for trading (stocks and bonds). Available-for-sale financial assets (stocks and bonds). Derivatives. Non-derivative instruments with face value exposures hedged by derivatives. Measured at Cost or Amortized Cost Financial Assets Unlisted instruments. Held-to-maturity investments. Loans and receivables.

***Financial ratios provide insights into

Microeconomic relationships within the company that are used by analysts to project the company's earnings and cash flows. A company's financial flexibility. Management's ability. Changes in the company and industry over time. How the company compares to peer companies and the industry overall.

these are linked in the income statement as follows:

Net sales − Cost of goods sold = Gross profit − Operating expenses = Operating profit (EBIT) − Interest = Earnings before tax (EBT) − Taxes = Earnings after tax (EAT) +/− Below the line items adjusted for tax = Net income − Preferred dividends = Income available to common shareholders

Operating profit margin

Operating profits are calculated as gross profit minus operating costs. An operating profit margin that is increasing at a higher rate than the gross profit margin indicates that the company has successfully controlled operating costs. A decreasing operating profit margin when gross profit margins are rising indicates that the company is not efficiently controlling operating expenses.

Operational Efficiency

Operational Efficiency When a company clarifies the organizational structure that outlines responsibilities, reporting lines, and the internal control environment, employees will have a clear understanding of their perspective duties. This will increase the likelihood that the company will experience operational efficiencies.

Opportunity cost

Opportunity cost is the value of the next best alternative that is foregone in making the decision to pursue a particular project. For example, if we invest $1 million in a piece of equipment, the opportunity cost of investing in that piece of equipment is the amount that $1 million would have earned in its next most profitable use. Opportunity costs should be included in project costs.

Graphs

Pie charts are most useful in illustrating the composition of a total value. For example, a pie chart should be used when presenting the components of total expenses for the year (COGS, SG&A, depreciation). Line graphs help identify trends and detect changes in direction or magnitude. For example, a line graph that illustrates a marked increase in accounts receivable while cash balances are falling indicates that the firm might have problems managing its working capital going forward.

Valuation Ratios

Price-to-Earnings Ratio P/E=Price per share Earnings per share The P/E ratio expresses the relationship between the price per share of common stock and the amount of earnings attributable to a single share. It basically tells us how much a share of common stock is currently worth per dollar of earnings of the company.

NPV and IRR Applied to Independent Projects

Project A has a higher IRR (21.43% vs. 12.96%), but Project B has a higher NPV ($59,323 vs. $47,196). The conflict in recommendations is due to the different pattern of cash flows. Project A receives a lump sum amount of $425,000 in the first year while Project B receives equal cash flows in the first two years and then a lump sum amount of $466,000 in the third year. When NPV and IRR rank two mutually exclusive projects differently, the project with the higher NPV must be chosen. NPV is a better criterion because of its more realistic reinvestment rate assumption. IRR assumes that interim cash flows received during the project are reinvested at the IRR. This assumption is sometimes rather inappropriate, especially for projects with high IRRs. NPV on the other hand, makes a more realistic assumption that interim cash flows are reinvested at the required rate of return. Aside from cash flow timing differences, NPV and IRR may also give conflicting project rankings because of differences in project size.

A 270-day U.S. T-bill with a par value of $1,000 is issued at a discount of 6%. Its discount basis yield is closest to:

Purchase price = Face value - Unannualized discount Purchase price = 1,000 - (0.06 × 1,000 × 270/360) = $955 Discount basis yield = [(Face value - Price) / Face value] × (360 / Days till maturity) Discount basis yield = [(1,000 - 955) / 1,000] × (360 / 270) = 6.00%

A 90-day U.S. T-bill with a par value of $1,000 is issued at a discount of 9%. Its bond equivalent yield is closest to:

Purchase price = Face value - Unannualized discount Purchase price = 1,000 - (0.09 × 1,000 × 90/360) = $977.50 Bond equivalent yield = [(Face value - Price) / Price] × (365 / Days till maturity) Bond equivalent yield = [(1,000 - 977.5) / 977.5] × (365 / 90) = 9.34%

Capital budgeting projects can usually be classified into the following categories:

Replacement projects:These projects help in maintaining the normal course of business and do not usually require very thorough analysis. For example, if a piece of equipment becomes obsolete, the decision whether to replace it usually does not require detailed analysis Expansion projects: These are projects that increase the size of the business. Expansion decisions require more careful consideration compared to simple replacement projects because there are more uncertainties involved. New products and services: Venturing into new products and services brings added uncertainties to the firm's overall operations. These decisions require extremely detailed analysis along with the participation of a lot more people in the decision making process. Regulatory, safety, and environmental projects: These projects are sometimes made mandatory by a governmental agency or some external party. They might not generate any revenues themselves, but may accompany other revenue-generating projects undertaken by the company. Other projects: Some projects cannot be analyzed through capital budgeting techniques. They could be pet projects of senior management and so needless or so risky that they are difficult to evaluate and justify using the typical assessment methods. An example of such a decision is the acquisition of a new private jet by the CEO of a company.

Retention rate

Retention rate= Net income attributable to common shares − Common share dividends Net income attributable to common shares This ratio measures the percentage of earnings that a company retains and reinvests in the business. Retention rate = (1 − Dividend payout ratio)

Return on assets - ROA

Return on assets measures the return earned by the company on its assets. The higher the ROA, the greater the income generated by the company given its total assets.

The results of the regression will be in the following format

Ri = a+bRmt

There are approximately seven primary stakeholder groups within a corporation:

Shareholders Creditors Employees (managers, executives, other) Board of directors Customers Suppliers Governments/regulators

Cash Management Investment Strategies

Short-term investment strategies can be categorized as passive or active. >>A passive strategy involves a limited number of transactions, and is based on very few rules for making daily investments. The focus is simply on reinvesting funds as they mature with little attention paid to yields. >>An active strategy involves constant monitoring to exploit profitable opportunities in a wider array of investments. Active strategies call for more involvement, more thorough study, evaluation, forecasts, and a flexible investment policy. >>Matching strategies involve matching the timing of cash outflows with investment maturities. A matching strategy makes use of similar types of investments as passive strategies. >>Mismatching strategies involve intentionally mismatching the timing of cash outflows with investment maturities. A mismatching strategy is riskier and requires very accurate and reliable cash forecasts. This strategy typically involves the use of liquid instruments and derivatives. >>Laddering strategies involve scheduling the maturities of portfolio investments such that maturities are spread out equally over the term of the ladder.

Solvency Ratios***

Solvency refers to a company's ability to meet its long-term debt obligations. Solvency ratios measure the relative amount of debt in a company's capital structure and the ability of earnings and cash flows to meet debt-servicing requirements. The amount of debt in the capital structure is important to assess a company's degree of financial leverage (its financial risk). If the company can earn a return on borrowed funds that is greater than interest costs, the inclusion of debt in the capital structure will increase shareholder wealth

No IRR Problem

Sometimes cash flow streams have no IRR (i.e., there is no discount rate that results in a zero NPV). Figure 1.3 illustrates the NPV profile of a nonconventional cash flow stream that suffers from the "no IRR" problem. The figure also illustrates that projects with no IRRs may have positive NPVs.

Sources of liquidity

Sources of liquidity can be classified as: >>>Primary sources, which are readily available resources such as cash balances and short-term funds. >>>Secondary sources, which provide liquidity at a higher cost than primary sources. They include negotiating debt contracts, liquidating assets, or filing for bankruptcy protection.

Strength of Shareholders' Rights

Strength of Shareholders' Rights The strength of shareholders' rights is another aspect to consider. The framework of the rights will help determine whether there could be structural obstacles to certain transactions in the company's charter or bylaws. Can shareholders remove board members? Can they convene special stockholder meetings? These and other questions should be answered. Some rights vary by country.

Describe uses of country risk premiums in estimating the cost of equity

Studies have shown that a stock's beta captures the country risk of a stock accurately only in developed markets. Beta does not effectively capture country risk in developing nations. To deal with this problem, the CAPM equation for stocks in developing countries is modified to add a country spread (also called the country equity premium) to the market risk premium. re= RF +β [ E(RM) − RF + CRP ] The country risk premium (CRP) is calculated as the product of sovereign yield spread and the ratio of the volatility of the developing country's equity market to the volatility of the sovereign bond market denominated in terms of the currency of a developed country. The sovereign yield spread is the difference between the developing country's government bond yield (denominated in the currency of a developed country) and the yield of a similar maturity bond issued by the developed country. >>>>Country risk premium= Sovereignyieldspread × Annualized standard deviation of equity index/ Annualized standard deviation of sovereign bond market in terms of the developed market currency ***The sovereign yield spread captures the general risk of an investment in a particular country. This spread is then adjusted for the volatility of the stock market relative to the bond market

Sunk costs

Sunk costs are those costs that cannot be recovered once they have been incurred. Capital budgeting ignores sunk costs because it is based only on current and future cash flows. An example of a sunk cost is the market research costs incurred by the company to evaluate whether a new product should be launched.

Sustainable growth rate

Sustainable growth rate=Retention rate × ROE A company's sustainable growth rate is a function of its profitability (ROE) and its ability to finance its operations from internally generated funds (measured by the retention rate). Higher ROE and higher retention rates result in a higher sustainable growth rates.

Table 1.1-5b Sensitivity of Net Income to Fixed Financial Costs

Table 1.1-5b Sensitivity of Net Income to Fixed Financial Costs of $1,200,000 Fixed Financing Cost = $1,200,000 Percentage Change Operating Income 1,600,000 1,920,000 20.00% Less Interest 1,200,000 1,200,000 0.00% Net Income 400,000 720,000 80.00% Notice that at higher levels of fixed financing costs ($1.2 million versus $800,000) the same percentage change in operating income (20%) leads to a higher percentage change in net income (80% versus 40%). This implication here is that higher fixed financial costs increase the sensitivity of net income to changes in operating income

Average Accounting Rate of Return (AAR)

The AAR is the ratio of the project's average net income to its average book value. AAR = AVERAGE NET INCOME/ AVERAGE BOOK VALUE

Payables turnover

The amount for purchases over the year is usually not explicitly stated on the income statement; it is typically only disclosed in the footnotes to the financial statements. You might be expected to calculate purchases using the following formula: purchase= ending inventory + cogs - opening inventory Payables turnover measures how many times a year the company theoretically pays off all its creditors. A high ratio can indicate that the company is not making full use of available credit facilities and repaying creditors too soon. However, a high ratio could also result from a company making payments early to avail early payment discounts. A low ratio could indicate that a company might be having trouble making payments on time. However, a low ratio can also result from a company successfully exploiting lenient supplier terms. If the company has sufficient cash and short-term investments, the low payables turnover ratio is probably not an indication of a liquidity crisis. It is probably a result of lenient supplier credit and collection policies. The number of days of payables is inversely related to the payables turnover ratio. The higher the payables turnover, the lower the number of days of payables.

Audit Function

The audit function not only helps to provide assurances that financial statements are properly reported, but also provides a service that evaluates the control environment within a company The external auditors are independent from the company and elected by the shareholders (though recommended by the audit committee).

Investment Committee

The board is responsible for the strategic direction of the company, and will be involved in large investments. The investment committee will establish and regularly review and update the investment policies. The committee will review and reach conclusions on material investment opportunities, including expansion projects, acquisitions, and major divestitures.

The board plays

The board plays an active role in managing the company through managers, who are given the responsibility for day-to-day operations of the company. The board will establish milestones for the company based on the strategic direction it oversees. In monitoring progress, the board will select, appoint, and terminate the employment of senior management. They thereby play a key role in ensuring leadership continuity. The board will establish committees to aid in the oversight of key functions. These committees will provide feedback and recommendations. Committees vary by organization; however, six common committees are: Audit committee Governance committee Remuneration committee Nomination committee Risk committee Investment committee

Bond Yield Plus Risk Premium Approach

The bond yield plus risk premium approach is based on the assumption that the cost of capital for riskier cash flows is higher than that of less risky cash flows. Therefore, we calculate the return on equity by adding a risk premium to the before-tax cost of debt. re= rd+risk premium

Yield-to-Maturity Approach

The bond's yield to maturity (YTM) is a measure of the return on the bond assuming that it is purchased at the current market price and held till maturity. It is the yield that equates the present value of bond's expected future cash flows to its current market price

*****DuPont

The calculated value for ROE will be the same under every kind of decomposition. DuPont analysis is a way of decomposing ROE to see more clearly the underlying changes in the company's operations that drive changes in its ROE. In general, higher profit margins, asset turnover, and leverage will lead to higher ROE. However, the five-way decomposition shows that an increase in leverage will not always increase ROE. This is because as the company takes on more debt, its interest costs rise and the interest burden ratio falls. The reduction in interest burden ratio (as the difference between EBT and EBIT increases) offsets the effect of the increase in the financial leverage ratio.

Cash Conversion Cycle

The cash conversion cycle (also known as net operating cycle) measures the length of the period between the point that a company invests in working capital and the point that the company collects cash proceeds from sales. Specifically, it is the time between the outlay of cash (to pay off accounts payable for credit purchases) and the collection of cash (from accounts receivable for goods sold on credit). A shorter cycle is desirable, as it indicates greater liquidity. A longer cash conversion cycle indicates lower liquidity. It implies that the company has to finance its inventory and accounts receivable for a longer period of time.

The corporate governance industry

The corporate governance industry has arisen out of the demand for information surrounding the subject. Information wasn't available previously, until the industry was required to change. The reporting services are concentrated and exert significant influence, as corporations must pay attention to their ratings and thus change their behavior if necessary.

The cost of equity

The cost of equity is the rate of return required by the holders of a company's common stock. Estimating the cost of equity is difficult due to the uncertainty of future cash flows that common stock holders will receive in terms of their amount and timing. Three approaches are commonly used to determine the cost of common equity.

The credit-rating process

The credit-rating process involves the analysis of a company's financial reports and a broad assessment of a company's operations. It includes the following procedures: Meetings with management. Tours of major facilities, if time permits. Meetings of ratings committees where the analyst's recommendations are voted on, after considering factors that include: >>>Business Risk, including the evaluation of: Operating environment. Industry characteristics. Success areas and areas of vulnerability. Company's competitive position, including size and diversification. >>>Financial risk, including: The evaluation of capital structure, interest coverage, and profitability using ratio analysis. The examination of debt covenants. >>>Evaluation of management Monitoring of publicly distributed ratings, including reconsideration of ratings due to changing conditions. ***In assigning credit ratings, rating agencies emphasize the importance of the relationship between a company's business risk profile and its financial risk.

What is the cumulative amount of income tax savings that WNF has generated as of the end of 2012 by using LIFO instead of FIFO?

The cumulative amount of tax savings that WNF has generated by using LIFO instead of FIFO equals $374 million. This amount is calculated as the sum of cumulative tax savings as of 2011 (computed using a tax rate of 30%) and the incremental savings for 2012 (computed using a tax rate of 20%). Cumulative tax savings as of 2011 = $1,080 × 30% = $324 million. Addition tax savings for 2012 (computed in Solution 3) = $50 million. Note that if a uniform tax rate were applicable during the entire period, we could have calculated the cumulative amount of tax savings from using LIFO as of the end of 2012 as LIFO reserve 2012 × (Tax rate).

debt-to-asset ratio

The debt-to-asset ratio measures the proportion of the firm's total assets that have been financed by debt. A higher D/A ratio is undesirable because it implies higher financial risk and a weaker solvency position.

The legal environment

The legal environment varies around the world and offers different protection to the shareholder or creditor. Creditors generally have a better protected position due to the contractual nature of their relationship.

Evaluating Inventory Management

The main goal of inventory management is to maintain a level of inventory that ensures smooth delivery of sales without having more than necessary invested in inventory. A high level of inventory is undesirable as it inflates storage costs, can result in losses from obsolescence or damage, and can squeeze liquidity from the firm. A shortage of inventory, on the other hand, can hurt sales as the company loses out on potential customers.

Quick ratio

The quick ratio recognizes that certain current assets (such as prepaid expenses) represent costs that have been paid in advance in the current year and cannot usually be converted into cash. This ratio also considers the fact that inventory cannot be immediately liquidated at its fair value. Therefore, these current assets are excluded from the numerator in the calculation of the quick ratio. When inventory is illiquid, this ratio is a better indicator of liquidity than current ratio. A high quick ratio indicates greater liquidity.

Comments

The return on assets declined significantly and was actually negative in 2008. This implies that the company made a net loss in 2008 despite the improvement in its gross profit margins over the year. This could be the result of a decrease in sales revenue, an increase in operating expenses, or both. Given that prices have been rising over the period and that inventory quantities were relatively stable, COGS would have been higher and the gross profit margin would have been lower if Atlas had used the LIFO cost flow assumption. This is because LIFO allocates the most recent (in this case higher) prices to COGS. Consequently, the company's reported gross profit, net income, retained earnings, and taxes would be lower under LIFO

The risk committee

The risk committee plays a critical role in establishing, implementing, and monitoring the appropriate level of risk within the company. The committee seeks to systematically manage existing and potential issues by identifying, assessing, and mitigating risk throughout the enterprise.

Sales risk

The uncertainty associated with total revenue is referred to as sales risk. Revenue is affected by economic conditions, industry dynamics, government regulation, and demographics.

Thematic investing

Thematic investing is utilized when a strategy is implemented utilizing only one factor to evaluate companies relative to ESG criteria. For example, a thematic approach could include clean water technologies, climate change, energy efficiencies, or a myriad of other specific focuses.

Intangible Assets Developed Internally

These are generally expensed when incurred, but may be capitalized in certain situations. Due to the differences in requirements regarding expensing/capitalizing when it comes to intangible assets developed internally versus those acquired, a company's strategy (developing versus acquiring intangible assets) can significantly impact reported financial ratios. >>>A company that develops intangible assets internally will expense costs of development and recognize no related assets, whereas a firm that acquires intangible assets will recognize them as assets. >>>A company that develops intangible assets internally will classify development-related cash outflows under operating activities on the cash flow statement, whereas an acquiring firm will classify these costs under investing activities.

Retained earnings

These are the cumulative earnings (net income) of the firm over the years that have not been distributed to shareholders as dividends.

PG 60 BOOK 4

These calculations verify that the higher the use of fixed financing sources by a company, the greater the sensitivity of net income to changes in operating income and therefore the higher the financial risk of the company. Also note that the degree of financial leverage is also different at different levels of operating income. The degree of financial leverage is usually determined by the company's management. While operating costs are similar among companies in the same industry, capital structures may differ to a greater extent. Generally, companies with relatively high ratios of tangible assets to total assets or those with revenues that have below-average business cycle sensitivity are able to use more financial leverage than companies with relatively low ratios of tangible assets to total assets or those with revenues that have high business cycle sensitivity. This is because stable revenue streams and assets that can be used as collateral make lenders more comfortable in extending credit to a company

Companies may have a variety of motives for holding inventory

These include: The transactions motive: Inventory is just kept for the planned manufacturing activity. The precautionary motive: Inventory is kept to avoid any stock-out losses. The speculative motive: Inventory is kept to ensure its availability in the future when prices are expected to increase.

Three-Way DuPont Decomposition

This decomposition expresses ROE as a product of three components. ROE = net income/ revenue (NET PROFIT MARGIN) x revenue/ average total assets (ASSET TURNOVER) x average total assets/ average shareholders equity (LEVERAGE) This decomposition illustrates that a company's ROE is a function of its net profit margin, asset turnover ratio, and financial leverage ratio. Net profit margin is an indicator of profitability. It shows how much profit a company generates from each money unit of sales. Asset turnover is an indicator of efficiency. It tells us how much revenue a company generates from each money unit of assets. ROA is a function of its profitability (net profit [NP] margin) and efficiency (asset turnover [TO]). Financial leverage is an indicator of solvency. It reflects the total amount of a company's assets relative to its equity capital. The increase in Company A's ROE is a result of better NP margins (improved profitability) and higher asset turnover (improved efficiency), which improved its ROA and its ROE.

ESG Integration/Incorporation

This implementation approach uses ESG factors alongside traditional analysis, looking for opportunities and risks. It seeks to evaluate a company's ability to manage its ESG resources within a sustainable business model and make investment decisions based on its findings.

Impact Investing

This investing model seeks to achieve social or environmental objectives while meeting identified financial returns. It focuses on doing this through engagement with the company or by direct investments in companies or projects. Two examples are venture capital investing directly in a company and purchasing "climate bonds," which finance environmental projects related to climate change.

Financial Leverage Ratio

This ratio measures the amount of total assets supported by each money unit of equity. For example, a leverage ratio of 2 means that each dollar of equity supports $2 worth of assets. This ratio uses average values for total assets and total equity and plays an important role in Dupont decomposition. The higher the leverage ratio, the more leveraged (dependent on debt for finance) the company.

Interest Coverage Ratio

This ratio measures the number of times a company's operating earnings (earnings before interest and tax, or EBIT) cover its annual interest payment obligations. This very important ratio is widely used to gauge how comfortably a company can meet its debt-servicing requirements from operating profits. A higher ratio provides assurance that the company can service its debt from operating earnings.

Intangible assets can also be classified as identifiable or unidentifiable intangible assets.

Under IFRS, identifiable intangible assets must meet three definitional criteria and two recognition criteria. >>>Definitional criteria: They must be identifiable. This means that they either should be separable from the entity or must arise from legal rights. They must be under the company's control. They must be expected to earn future economic benefits. >>>Recognition criteria: It is probable that their expected future economic benefits will flow to the entity. The cost of the asset can be reliably measured.

Financial Statement Analysis Issues

Under both IFRS and U.S. GAAP, companies are required to disclose (either on the balance sheet or in the notes to the financial statements) the carrying amounts of inventories in classifications suitable to their business. For example, a manufacturing company may classify its inventory as production supplies, raw materials, work-in-progress (WIP), and finished goods. On the other hand, a retailer may group inventories with similar attributes together. Analysts should carefully evaluate these disclosures to estimate a company's future sales and profits. A significant increase in unit volumes of raw materials and/or WIP inventory may suggest that the company expects an increase in demand for its products. An increase in finished goods inventory with declining raw materials and WIP inventory may signal a decrease in demand for the company's products. In such cases, there may also be a possibility of future write-down of finished goods inventory. If growth in inventories is greater than the growth in sales, it could indicate a decrease in demand, which may force a company to sell its products at lower prices. Further, there may be a possibility of future write-down of inventory. Note that too much inventory also entails additional costs such as storage costs and insurance. It also means that the company has less cash and working capital available for other purposes.

Weighted Average Cost (AVCO)

Weighted Average Cost (AVCO) This method allocates the total cost of goods available for sale (beginning inventory, purchases, and other inventory-related costs) evenly across all units available for sale. COGS is composed of units valued at average prices. EI is also composed of units valued at average prices.

Capitalized Borrowing Costs

What amount of interest cost would the company capitalize under IFRS and under U.S. GAAP? Where will the capitalized interest costs appear on the company's financial statements? Solution: Under U.S. GAAP, the company would capitalize the amount of interest paid on the loan during construction. This amount equals ($10m × 0.06 × 3) = $1,800,000. Under IFRS, the amount that can be capitalized must be adjusted for income earned from temporarily investing borrowed funds. Therefore, capitalized interest would equal $1,800,000 − $65,000 = $1,735,000 Capitalized interest will be included in the carrying amount of the asset (building) under noncurrent assets on the balance sheet. The amount of interest that is capitalized will appear on the cash flow statement under investing activities (during the 3 years of construction). Once construction is complete and the asset is in use, capitalized interest will be depreciated as a part of depreciation on the office building on the income statement. Once construction is complete, depreciation of capitalized interest (as a part of total depreciation) will appear on the company's cash flow statement each year if prepared using the indirect method (added to net income in the calculation of CFO).

LIFO liquidation 1

When a LIFO firm sells more units than it purchases, some of the units sold are drawn from beginning inventory. We know that LIFO allocates the oldest prices to inventory, and in some cases these older prices could be extremely outdated. When a company includes older, cheaper units of stock in its COGS, it severely understates COGS, and LIFO COGS no longer reflects recent, current prices. Consequently, a firm with LIFO liquidation overstates net income. The higher profits are unsustainable because eventually the firm will run out of cheaper, older stock to liquidate. The higher net income also comes at the cost of higher taxes that reduce operating cash flows. To postpone the taxes on holding gains on old units of inventory, a LIFO firm must always purchase as many if not more units than it sells.

Key Relationships in Corporate Governance

When a principal hires an agent to act on its behalf, a principal-agent relationship is created. The relationship are characteristics involving trust, an expectation of loyalty, and other obligations to act in the best interest of the principal. However, conflicts can occur due to the inherent interests of both parties. Five key relationships to consider for potential conflicts are the following: Shareholder and manager/director relationships Controlling and minority shareholders Manager and board relationships Shareholder versus creditor interests Other stakeholder conflicts

Debt-Rating Approach

When a reliable current market price for the company's debt is not available, the before-tax cost of debt can be estimated using the yield on similarly rated bonds that also have similar terms to maturity as the company's existing debt Debt-Rating Approach: Alextar Inc. has a capital structure that includes AAA-rated bonds with 10 years to maturity. The yield to maturity on a comparable AAA-rated bond with a similar term to maturity is 6%. Using a tax rate of 40%, calculate Alextar's after-tax cost of debt. Solution: Alextar's after-tax cost of debt=rd(1−t)=0.06(1−0.4)=3.6% ***When using the debt-rating approach, adjustments might have to be made to the before-tax cost of debt of the comparable company. The relative seniority and security of different issues affect ratings and yields, and these factors should be considered when selecting a comparable bond and using its before-tax cost of debt as a proxy for the cost of debt of the company being studied.

Competition and Takeover

When shareholders believe the company's performance is not acceptable, they may pursue a more aggressive stance, which leads to the third market factor: competition and takeover. If the company is underperforming a competitor, senior managers may lose their positions and directors can be voted out by shareholders. It is in the best interest of board members and management to maximize the value of the company. However, if not viewed in this manner, a corporate takeover may ensue, which could be a proxy contest, a tender offer, or a hostile takeover. In a proxy contest (or proxy fight), shareholders are persuaded to vote for a group seeking to take positions that will control the company's board of directors. A tender offer is one that attempts to persuade shareholders to sell their shares to the group seeking to gain control. A hostile takeover results when an entity acquires a company without the consent of company management. In addition, staggering board member terms can dilute shareholder rights, as the entire board cannot be removed immediately. Non-market factors present an environment that can change governance and its relationship with stakeholders. There are generally three factors: The legal environment Media The corporate governance industry

Unlimited funds versus capital rationing

When the company has no constraints on the amount of capital it can raise, it will invest in all profitable projects to maximize shareholder wealth. The need for capital rationing arises when the company has limited funds to invest. If the capital required to invest in all profitable projects exceeds the resources available to the company, it must allocate funds to only the most lucrative projects to ensure that shareholder wealth is maximized.

exercise1

Which of the following choices best describes a reasonable conclusion that an analyst might make about the companies' efficiency levels? Over the 4-year period, Company A has shown greater improvement in efficiency than Company B, as indicated by its total asset turnover ratio increasing from 0.60 to 1.19. In 2007, Company A's DOH of only 5.01 indicates that it was less efficient at inventory management than Company B, which had a DOH of 41.23. In 2008, Company B's receivables turnover of 7.98 indicates that it was more efficient at receivables management than Company A, which had a receivables turnover of 11.57. Over the 4 years, Company B has shown greater improvement in efficiency than Company A, as indicated by its net profit margin of 4.62%. Comments: Choice A is correct because over the given period, Company A has shown greater improvement in efficiency than Company B. Company A's total asset turnover (a measure of operating efficiency) has almost doubled from 0.60 to 1.19. Over the same period, Company B total asset turnover has declined from 1.19 to 1.05. Choice B is incorrect because it misinterprets DOH. All other factors constant, a lower DOH indicates better inventory management. Choice C is incorrect because it misinterprets receivables turnover. All other factors constant, a higher receivables turnover indicates greater efficiency in receivables management. Choice D is incorrect because net profit margin is not an indicator of efficiency. It is an indicator of profitability.

Controlling and Minority Shareholders

conflicts is between a controlling and a minority shareholder group who adopt a straight voting structure (one vote for each share owned) allowing the controlling group significant power as they hold enough shares to exercise control a controlling group has the power to vote on items that are in their best interest, but not in the minority group's interest. ***An equity structure that has multiple share classes in which one class is non-voting (or limited) will create a divergence between ownership and control rights. This has traditionally been called a dual-class structure whereby the founders, executives, and other key insiders control the company by holding the superior voting power.

General Meetings

shareholders have the right to participate in these meetings and exercise their voting rights. When they are unable to attend a meeting, they have the ability to have their shares voted by another person they authorize. This is called proxy voting. With a cumulative voting structure (compared to straight voting), shareholders have the ability to accumulate and vote all their shares for a single candidate in an election involving more than one director. Extraordinary general meetings may be called and could include special resolutions that will require larger voting margins to pass, typically including amendments to bylaws, mergers, and so on.

Inventory Valuation Methods

Opening inventory+Purchases=Cost of goods sold+Ending inventory...

Yields on Short-Term Investments

Discount instruments are instruments that are purchased at less than face value, and pay back face value at maturity.

Free cash flow to equity (FCFE)

Free cash flow to equity (FCFE) refers to cash that is available only to common shareholders. FCFE=CFO−FCInv+Net borrowing

the steps typically involved in the capital budgeting process are as follows:

1. Generating ideas: Generating good investment ideas is the most important step in the process. These ideas can be generated from any part of the organization or even from sources outside the company. 2. Analyzing individual proposals: This step involves collecting information to forecast the cash flows of a particular project as accurately as possible. Cash flows are then used to evaluate the feasibility of the project. 3. Planning the capital budget: Projects that are undertaken should fit into the company's overall strategy. Further considerations include the timing of the project's cash flows and availability of company resources. 4. Monitoring and post-auditing: In this step, actual performance is compared to forecasts and the reasons behind any differences are sought. Post-auditing helps monitor the forecasts to improve their accuracy going forward and to improve operations to make them more efficient. Concrete ideas for future investments may also abound from this step.

The growth rate, g, is a very important variable in this model. There are two ways to determine the growth rate.

1. Use the forecasted growth rate from a published source or vendor. 2. Calculate a company's sustainable growth rate using the following formula: g = (1−D/EPS)×(ROE) where (1 − (D/EPS)) = Earnings retention rate

Beta estimates are sensitive to many factors and the following issues should be considered when determining beta

>>>Beta estimates are based on historical returns and are therefore sensitive to the length of the estimation period. >>>Smaller standard errors are found when betas are estimated using small return intervals (such as daily returns). >>>Betas are sensitive to the choice of the market index against which stock returns are regressed. Betas are believed to revert toward 1 over time, which implies that the risk of an individual project or firm equals market risk over the long run. Due to "mean reversion," smoothing techniques may be required to adjust calculated betas. >>>Small-cap stocks generally have greater risks and returns compared to large-cap stocks. Some experts argue that the betas of small companies should be adjusted upward to reflect greater risk.

exercise

A relatively high number of days of inventory on hand implies a low inventory turnover ratio, which suggests that the company has too much inventory on hand.

Return on equity

Return on equity = (Net income / Average total assets) × (Average total assets/Average shareholders' equity) Return on equity = (53,100 / 659,500) × 0.55 Return on equity = 4.43%

Negative Screening

Also referred to as exclusionary screening, negative screening is used to exclude certain sectors as defined by the investor, such as fossil fuels, companies with human rights or environmental concerns, or companies that do not align with religious or personal beliefs. This is the most common form of ESG-related investing.

Takeaways:

DOL is negative when operating income (the denominator in the DOL equation) is negative, and is positive when the company earns operating profits. Operating income is most sensitive to changes in sales around the point where the company makes zero operating income. DOL is undefined when operating income is zero.

Issues in Estimating Cost of Debt

Fixed-rate versus floating-rate debt: The cost of floating-rate debt is reset periodically based on a reference rate (usually LIBOR) and is therefore, more difficult to estimate than the cost of fixed-rate debt. For floating-rate bonds, analysts may use the current term structure of interest rates and term structure theory to estimate the cost of debt. Debt with option-like features: If currently outstanding bonds contain embedded options, an analyst can only use the yield to maturity on these bonds to estimate the cost of debt if she expects similar bonds (with embedded options) to be issued going forward. If however, option-like features are expected to be removed from future debt issues, she should adjust the yield to maturity on existing bonds for their option features, and use the adjusted rate as the company's cost of debt. Nonrated debt: If a company does not have any debt outstanding (to be rated) or yields on existing debt are not available (due to lack of relevant current prices), an analyst may not be able to use the YTM or the debt-rating approach to estimate the company's cost of debt. Leases: If a company uses leases as a source of finance, the cost of these leases should be included in its cost of capital.

Drawback

It ignores cash flows that occur after the payback period is reached. Therefore, it does not consider the overall profitability of the project

Drawbacks

It ignores the risk of the project. Cash flows are not discounted at the project's required rate of return. It ignores cash flows that occur after the payback period is reached. It is not a measure of profitability so it cannot be used in isolation to evaluate capital investment projects. The payback period should be used along with the NPV or IRR to ensure that decisions reflect the overall profitability of the project being considered.

Advantages

It is simple to calculate and explain. It can also be used as an indicator of liquidity. A project with a shorter payback period may be more liquid than one that has a longer payback period.

Capitalization versus Expensing: Impact on Financial Statements and Ratios

Noon reports lower income in the first year because it expenses the entire cost of the equipment in Year 1. Clark reports lower net income in subsequent years as it continues to depreciate the asset, whereas Noon has already written it off entirely. Lower income in Year 1 allows Noon to pay lower taxes in Year 1. If we were to build interest income on cash savings into the analysis, Noon would benefit.

A pull on liquidity

Occurs when cash leaves the company too quickly.

Preferred shares

Preferred shareholders receive dividends (at a specified percentage of par value) and have priority over ordinary shareholders in the event of liquidation Preferred shares may either be classified as equity or financial liabilities depending on their characteristics. For example: perpetual, non-redeemable preferred shares are classified as equity, while preferred shares with mandatory redemption are classified as financial liabilities

Pretax margin

Pretax income is also called earnings before tax (EBT). It is calculated as operating income minus nonoperating expenses plus nonoperating income. If a company's pretax margin is rising primarily due to higher nonoperating income, the analyst should evaluate whether this source of income will continue to bring in significant earnings going forward.

Price to Sales

Price to Sales P/S= Price per share Sales per share

Decomposing on ROE

ROE= Net income/ Average total equity This decomposition breaks ROE down into two components. ROE= net income/ average total assets (ROA) x average total assets/ average shareholders equity (LEVERAGE) ***The two-way breakdown of ROE illustrates that ROE is a function of company's return on assets (ROA) and financial leverage ratio. A company can improve its ROE by improving ROA or by using leverage (debt) more extensively to finance its operations. As long as a company is able to borrow at a rate lower than the marginal rate it can earn by investing the borrowed money in its business, taking on more debt will result in an increase in ROE. However, if a company's borrowing costs exceed its marginal return, taking on more debt would depress ROA and ROE as well.

Remuneration and Company Performance

Remuneration is one way to incentivize management to act in the long-term interests of the company. Reviewing compensation programs and ensuring they align with shareholder interests are important. Various warning signs could present themselves, including: The lack of equity incentives to align with shareholders Little variation in results over multiple years due to inadequate hurdles Excessive payouts relative to comparable companies with comparable results Strategic implications of incentives that may not be appropriate Plans that have not changed with the company's life cycle change

Say on Pay

Say on pay is a concept that helps to decrease potential conflicts and issues with shareholders by gaining their insights on the company's remuneration policy The implementation varies by country. Some have non-mandatory and non-binding say on pay systems (e.g., Canada) which means the company is required to ask for feedback on renumeration policies, but is not required to act upon it. Those systems that have less force draw criticism because of the limited impact they may have. By contrast, in the Netherlands, the United Kingdom, and China, the system is mandatory and binding. Other systems are found somewhere between the two extremes.

Problems with the IRR

The Multiple IRR Problem A project has a nonconventional cash flow pattern when the initial outflow is not followed by inflows only. The direction of cash flows changes from positive to negative over the project's life (i.e., there is more than one sign change in the cash flow stream). Figure 1.2 illustrates the NPV profile of a nonconventional cash flow stream that suffers from the multiple IRR problem. Notice that the NPV profile intersects the x-axis at two different points.

Shareholder activism

Shareholder activism is the second market factor that seeks to modify the behavior within a company. The ultimate goal is to increase shareholder value. It is a more forceful path that seeks to compel the company to act in a particular manner. There are several ways to accomplish this, but they are not available in all countries. Lawsuits can be brought against various groups, including the board of directors, management, and/or controlling shareholders. Raising public awareness to exert pressure on the company is another way, or a proxy battle. Hedge funds tend to draw the largest amount of activism due to their loosely regulated nature.

Accelerated Depreciation

Under accelerated depreciation methods, the allocation of depreciable cost is greater in the early years of the asset's use. A commonly used accelerated method is the declining balance method in which the amount of depreciation expense for a period is calculated as some percentage of the carrying amount (i.e., cost net of accumulated depreciation at the beginning of the period). When an accelerated method is used, depreciable cost is not used to calculate depreciation expense, but the carrying amount should not be reduced below the estimated salvage value. Double declining balance depreciation= 2Depreciable life × Beginning book value

Under the units-of-production method

Under the units-of-production method, the amount of depreciation expense for a period is based on the proportion of the asset's production during the period compared with the total estimated productive capacity of the asset over its useful life. Depreciation expense is calculated as depreciable cost times production in the period divided by estimated productive capacity over the life of the asset.

The LIFO Method and the LIFO Reserve

We already know that COGSLIFO is greater than COGSFIFO in an inflationary environment. We have just learned that the difference between the two equals the change in LIFO reserve over the year. Since COGSFIFO is lower than COGSLIFO during periods of rising prices, FIFO gross profits and net income before taxes are greater than their values under LIFO by an amount equal to the change in LIFO reserve. However, net income after tax under FIFO will be greater than LIFO net income after tax by: Change in LIFO reserve×(1-Tax rate)

The board of directors

acts in the best interest of the shareholders who elect them. They oversee the operations through monitoring the company and management performance while providing strategic direction.

the statement of changes in equity

presents the effects of all transactions that increase or decrease a company's equity over the period

shareholders

shareholders provide capital to the company and are entitled to the company's net value. focused on those efforts that support growing the profitability of the company and maximizing the value of it they elect the board of directors and vote on important resolutions

suppliers

suppliers have a goal of being paid for their services and materials. They are viewed alongside creditors as they see financial stability as an important attribute toward achieving their objective.

Audit Committee

the board plays a key role in the audit and control systems within the company. This would include setting the overall structure and making certain it is properly implemented. The audit committee can be crucial in this role, as it helps to evaluate the effectiveness of the control system. The audit committee will: Review information technology. Evaluate policies and procedures. Supervise the internal audit group. Appoint and evaluate the findings from the external auditors. Perform other necessary processes and procedures.

Non-current liabilities include the long-term financial liabilities and deferred tax liabilities

Long-term financial liabilities:These may either be measured at fair value or amortized cost. Measured at Fair Value Financial Liabilities Derivatives. Financial liabilities held for trading. Non-derivative instruments with face value exposures hedged by derivatives. Measured at Cost or Amortized Cost Financial Liabilities All other liabilities (bonds payable and notes payable).

Calculating CFI and CFF

Calculating cash flow from investing activities requires us to consider the effects of transactions relating to long-lived assets and long-term investments on cash. >>The value of gross fixed assets indicates the historical cost of the fixed assets owned by the company at the balance sheet date. If the figure for gross fixed assets changes from one year to the next, there has been an investing activity. If gross fixed assets increase, there has been a fixed asset purchase, and if gross fixed assets decrease, there has been a fixed asset disposal. >>Beginning gross fixed assets + Purchase price of new fixed assets − Historical cost of disposed fixed assets = Ending gross fixed assets. >>Net fixed assets equal gross fixed assets minus accumulated depreciation. ****The historical cost and accumulated depreciation of a long-lived asset is removed from the balance sheet once it is sold.

Performance Ratio

Cash flow to revenue: CFO / Net revenue Cash generated per unit of revenue. Cash return on assets: CFO / Average total assets Cash generated from all resources, equity, and debt. Cash return on equity: CFO / Average shareholders' equity Cash generated from owner resources. Cash to income: CFO / Operating income The ability of business operations to generate cash. Cash flow per share: (CFO - Preferred dividends) / Number of common shares outstanding Operating cash flow available for each shareholder.

Combining the effects of CFO, CFI, and CFF

Combining the effects of CFO, CFI, and CFF gives us change in cash and cash equivalents over the year: Net cash provided by operating activities 2,050 Net cash provided by investing activities 500 Net cash used for financing activities −1,400 Net change in cash over the year 1,150 The net increase in cash on the cash flow statement must equal the difference between the cash balances for 2007 and 2008. The company's cash balance in 2007 was $1,150, and in 2008 was $2,300. Notice that the difference between the two amounts ($1,150) is also the net increase in cash calculated on the cash flow statement.

Deferred tax liabilities

These usually arise when a company's income tax expense exceeds taxes payable. The company pays less taxes based on its tax return than it should pay according to its financial statements. These unpaid taxes will be paid in future periods and are therefore a liability for the company. Deferred tax liabilities have current and non-current portions.

EXERCISE CASH FLOW

>CFO = Net income + Depreciation expense CFO = 102 + 2.4 = $104.4 million >CFI = Sale of available-for-sale securities - Investment in new machinery CFI = 8,000 - 28,000 = −$20,000 >An increase in inventory (asset) is a use of cash. >Cash flow from operating activities = Cash received from customers - Cash paid to suppliers - Cash paid for other operating expenses - Cash paid for taxes Therefore, CFO = 27,300 - 11,400 - 7,400 - 3,250 = $5,250 >Cash paid to suppliers = Purchases - Increase in accounts payable Purchases = Cost of goods sold - Decrease in inventory Purchases = 44 - 7 = $37 million Therefore, cash paid to suppliers = 37 - 4 = $33 million >CFF = Issuance of common stock - Dividends paid CFF = 60,000 - 32,300 = $27,700 >Cash paid to suppliers = Purchases - Increase in accounts payable Cash paid to suppliers = 40 - 4 = $36 million >Cash received from customers = Revenue + Decrease in accounts receivable >Cash received from customers = Revenue - Increase in accounts receivable Net income $1,000 Decrease in interest payable $85 Gain on sale of equipment $45 Increase in accounts payable $90 Decrease in inventory $35 Increase in prepaid assets $105 Depreciation $85 Increase in taxes payable $125 CFO = 1,000 - 85 - 45 + 90 + 35 - 105 + 85 +125 = $1,100 Proceeds from sale of equipment $32,000 Loss on equipment sale $9,000 Dividends paid $12,500 Purchase of office premises $100,000 Common stock repurchases $45,000 Dividends received $8,500 Interest received $1,200 Supplier accounts paid $3,700 Cash collections from customers $14,200 Ending cash balance $98,000 CFI = 32,000 - 100,000 = −$68,000

Coverage Ratios

Debt coverage: CFO / Total debt Leverage and financial risk. Interest coverage: (CFO + Interest paid + Taxes paid) / Interest paid Ability to satisfy interest obligations. Reinvestment: CFO / Cash paid for long-term assets Ability to buy long-term assets with operating cash flows. Debt payment : CFO / Cash paid for long-term debt repayment Ability to meet debt obligations with operating cash flows. Dividend payment: CFO / Dividends paid Ability to make dividend payments with operating cash flows. Investing and financing: CFO / Cash outflows for investing and financing activities Ability to buy long-term assets, settle debt obligations and make dividend payments from operating cash flows.

Free cash flow to the firm (FCFF)

Free cash flow to the firm (FCFF) is cash that is available to equity and debt holders after the company has met all its operating expenses and satisfied its capital expenditure and working capital requirements. FCFF=NI+NCC+[Int×(1−tax rate)]−FCInv−WCInv where: NI = net income NCC = noncash charges FCInv = fixed capital investment (net capital expenditure) WCInv = working capital investment Int = Interest expense Notice that net income that has been adjusted for noncash charges and changes in working capital accounts equals the company's operating cash flows. Therefore: FCFF=CFO+[Int×(1−tax rate)]−FCInv

***Major Sources and uses of cash

Sources and uses of cash depend upon the company's stage of growth. Companies in the early stages of growth may have negative operating cash flows as cash is used by the company to finance inventory rollout and receivables. These negative operating cash flows are supported by financing inflows from issuance of debt or equity. Inflows of cash from financing activities are not sustainable. Over the long term, a company must generate positive cash flows from operating activities that exceed capital expenditures and payments to providers of debt and equity capital. Companies in the mature stage of growth usually have positive cash flows from operating activities. These inflows can be used for debt repayment and stock repurchases. They can also be used by the company to expand its scale of operations (investing activities).

The Code of Ethics

The Code of Ethics contains six components that address general areas of ethical behavior. The Standards of Professional Conduct are seven areas of Professional Conduct that deal with specific types of behavior in certain situations, e.g., Market Manipulation.

A conventional cash flow stream

A conventional cash flow stream is a cash flow stream that consists of an initial outflow followed by a series of inflows. The sign of the cash flows changes only once. For a nonconventional cash flow stream however, the initial outflow is not followed by inflows only, but the direction of the flows change from positive to negative again. There is more than one sign change in a nonconventional cash flow stream.

Decision Rules for NPV

A project should be undertaken if its NPV is greater than zero. Positive NPV projects increase shareholder wealth. Projects with a negative NPV decrease shareholder wealth and should not be undertaken. A project with an NPV of zero has no impact on shareholder wealth.

NPV Profiles

An NPV profile is a graphical illustration of a project's NPV at different discount rates. NPV profiles are downward sloping because as the cost of capital increases, the NPV of an investment falls.

Calculate and interpret the beta and cost of capital for a project

An analyst must estimate a stock's beta when using the CAPM approach to estimate a company's cost of equity. Beta can be calculated by regressing the company's stock's returns against market returns over a given period.

Analytical Issues Relating to Capitalization of Interest Costs

An analyst should consider the following issues related to capitalization of interest costs: Capitalized interest costs reduce investing cash flow, whereas expensed interest costs reduce operating cash flow. Therefore, analysts may want to examine the impact of classification on reported cash flows. To provide a true picture of a company's interest coverage ratio, the entire amount of interest expense for the period, whether capitalized or expensed, should be used in the denominator. If the company is depreciating interest that was capitalized in previous years, net income should be adjusted to remove the effect of depreciation of capitalized interest.

Using Country Risk Premium to Estimate the Cost of Equity

An analyst wants to calculate the cost of equity for a project in Malaysia. She has the following information: The yield on Malaysia's dollar-denominated 10-year government bond is 10%. The yield on a 10-year U.S. Treasury bond is 4.2%. The annualized standard deviation of Malaysia's stock market is 29%. The annualized standard deviation of Malaysia's dollar-denominated 10-year government bond is 20%. The project's beta equals 1.1. The expected return on the Malaysian equity market is 9%. The risk-free rate equals 5%. Calculate the country risk premium and the cost of equity for this project in Malaysia. Solution: CRP= (0.10−0.042)(0.290.20)= 8.41% re= RF+β[E(RM)−RF+CRP] re= 0.05+1.1[0.09−0.05+0.0841]= 18.65% >>>Malaysia's country risk premium equals 8.41% and the cost of equity for this project equals 18.65%.

An externality

An externality is the effect of an investment decision on things other than the investment itself. Externalities can be positive or negative and, if possible, externalities should be considered in investment decision-making. An example of a negative externality is cannibalization as a new product reduces sales of existing products of the company.

An unidentifiable intangible asset

An unidentifiable intangible asset is one that cannot be purchased separately and may have an indefinite life. The best example of such an asset is goodwill, which arises when one company purchases another and the acquisition price exceeds the fair value of the identifiable (tangible and intangible) assets acquired.

Equity Analysis

Analysts use a variety of methods to value a company's equity. One of the most common method involves the use of valuation ratios.

Calculation of accumulated depreciation on sold equipment

Beginning accumulated depreciation + Current year's depreciation on all assets − Accumulated depreciation on sold asset = Ending accumulated depreciation. $2,900 + $1,000 − Accumulated depreciation on sold equipment = $3,400 Accumulated depreciation on sold equipment = $500

Calculation of historical cost of sold equipment

Beginning gross fixed assets + Purchase price of new fixed assets − Historical cost of disposed fixed asset = Ending gross fixed assets. $8,500 + 0 − Historical cost of sold equipment = $7,700 Historical cost of sold equipment = $800

Given that the company uses LIFO, cost of goods sold for the third quarter under the perpetual system is closest to:

COGS = (18 × 20) + (6 × 15) = $450

Calculating FCFE

Calculating FCFE Continuing from our previous example of ABC Company and assuming a tax rate of 40%, calculate FCFE. Solution Recall the following information regarding ABC Company: CFO = $2,050 Fixed capital investment = -$500 (the company sold noncurrent assets for $500) Net borrowing = -$600 (the company repaid $600 worth of debt) Therefore: FCFE = CFO - FCInv + Net borrowing FCFE = 2,050 - (-500) + (-600) = $1,950 A positive FCFE suggests that the company has operating cash flows available after payments have been made for capital expenditure and debt repayment. This excess belongs to common shareholders. Note: Under IFRS, if the company has deducted dividends paid in calculating CFO, dividends must be added back to calculated FCFE.

Equity

Capital contributed by owners (common stock or issued capital): Owners contribute capital to an entity by investing in common shares

Cash flow per share

Cash flow per share= Cash flow from operations/ Average number of shares outstanding

Manager and Board Relationships

Conflicts between the board of directors and management can arise when limited information is provided to the board. This will reduce the directors' ability to perform their monitoring function. It is particularly pronounced for those who are not involved in day-to-day operations, specifically a non-executive director.

Determination of Inventory Costs

Determination of Inventory Costs ABC Company manufactures a single product. Various costs incurred during the year 2009 are listed here: Cost of raw materials $12,000,000 Direct labor conversion costs $25,000,000 Production overheads $5,000,000 Freight charges for raw materials $2,000,000 Storage costs for finished goods $800,000 Abnormal wastage $80,000 Freight charges for finished goods $100,000 Given that there is no work-in-progress inventory at the end of the year: What costs should be included in inventory for 2009? What costs should be expensed during 2009? Solution: Capitalized inventory costs include: raw material costs, labor conversion costs, production overheads, and freight charges on raw materials. Cost of raw materials $12,000,000 Direct labor conversion costs $25,000,000 Production overheads $5,000,000 Freight-in charges $2,000,000 Total capitalized costs $44,000,000 Costs that should be expensed on the income statement (and not included in the value of inventory on the balance sheet) include: storage costs of finished goods, abnormal wastage, and freight on finished goods. Storage costs of finished goods $800,000 Abnormal wastage $80,000 Freight on finished goods $100,000 Total expensed costs $980,000

Shareholder and Manager/Director Relationships

Directors and managers are agents of the shareholders. They are given the power to transact business on the shareholders' behalf, with the intent of serving the shareholders' best interest. However, these employees may take on more risk than is warranted to maximize their personal benefits for remuneration and perquisites. They have "information asymmetry" due to their proximity to the business. This situation may weaken the shareholders' control over them, while allowing the employees to make the principals' best interest second priority.

Economic Ownership and Voting Control

Evaluating the economic ownership and voting control helps to understand how decisions are made by shareholders. Generally, there is a structure that gives one vote for each share owned. However, there are dual-class systems that split voting rights by different classes. The differences in each setup will have implications, potentially on valuations, as dual-class companies tend to trade at a discount to their peers.

Legal, Regulatory, and Reputational Risk

If the company has weaknesses in its implementation of regulatory requirements, it could be exposed to various legal, regulatory, and reputational risks. Legally, the company could be held responsible for non-compliance, which would also bring regulatory risks. In addition, its reputation would be at stake when the information is disseminated almost instantly on one of the various news outlets, including social media.

Improved Control

Improved control can also be realized, which helps to minimize various risks, including regulatory, legal, and financial risks. This ultimately reduces costs as well.

Drawbacks

It is based on accounting numbers and not cash flows. Accounting numbers are more susceptible to manipulation than cash flows. It does not account for time value of money. It does not differentiate between profitable and unprofitable investments accurately as there are no benchmarks for acceptable AARs.

Advantage

It is easy to understand and easy to calculate.

Managing Long-Term Risks

It is important to investigate stakeholder relations and the ability of management to manage long-term risks. When poor, these have had an enormous impact on share value. One way to assess management quality is by examining patterns of fines, accidents, regulatory issues, and so on. If they are persistent, it is a good indicator there may be an issue. The analysis of these additional areas that are non-financial in basis is a subjective exercise. However, it provides a basic framework for uncovering incremental insights about a company.

LIFO versus FIFO with Rising Prices and Stable or Rising Inventory Levels

LIFO FIFO COGS Higher Lower Income before taxes Lower Higher Income taxes Lower Higher Gross profit & net income Lower Higher Total cash flow Higher Lower EI Lower Higher Working capital Lower Higher The difference in cash flows is the only direct economic difference that results from the choice of inventory valuation method.

LIFO liquidation

LIFO liquidation can result from strikes, recessions, or a decline in demand for the firm's product. The irony is that when there is LIFO liquidation, the firm reports surprisingly high profits (due to the realization of holding gains on inventory) in hard times as production cuts result in the liquidation of lower-cost LIFO inventory.

LIFO liquidation

LIFO liquidation occurs when a firm that uses LIFO sells more units during a given period than it purchases over the period. This causes year-end inventory levels to be lower than the beginning-of-year inventory levels.

The Risks of Creditors and Owners

Legal codes in most countries provide for companies to file for bankruptcy protection. There are two main types of bankruptcy protection. >>>Reorganization (Chapter 11), which provides the company temporary protection from creditors so that it can reorganize its capital structure and emerge from bankruptcy as a going concern. >>>Liquidation (Chapter 7), which allows for an orderly settlement of the creditors' claims. In this category of bankruptcy, the original business ceases to exist. ***Companies with high operating leverage have less flexibility in making changes to their operating structures, so bankruptcy protection does little to help reduce operating costs. On the other hand, companies with high financial leverage can use Chapter 11 protection to change their capital structure and, once the restructuring is complete, emerge as ongoing concerns. ***Under both Chapter 7 and Chapter 11, providers of equity capital generally lose out. On the other hand, debt holders typically receive at least a portion of their capital, but only after the period of bankruptcy protection ends.

Liquidity management

Liquidity management refers to the ability of a company to generate cash when required.

The two most popular measures used to evaluate a single capital project are net present value (NPV) and internal rate of return (IRR).

Net Present Value (NPV): For a project with one investment outflow, which occurs at the beginning of the project, the net present value is the present value of the future after-tax cash flows minus the investment outlay. NPV measures the amount in monetary units that a project is expected to add to shareholder wealth.

free cash flow to equity - exercise

Net income $2,050 Depreciation $345 Interest expense $150 Tax rate 30% Net capital expenditure $1,500 Net debt repayment $20 Working capital investment $325 Net borrowing $1,500 XYZ's free cash flow to equity for 2009 is closest to: $5,050 $2,050 $2,090 CFO = 2,050 + 345 - 325 = $2,070 FCFE = 2,070 - 1,500 + 1,500 - 20 = $2,050

Cost of goods sold, if the company uses FIFO cost flow assumption, is closest to:

Number of units sold = 57 COGS = (15 × 30) + (15 × 30) + (12 × 35) + (15 × 25) = $1,695

Some analysts choose to calculate ROA on a pre-interest and pre-tax basis as

Operating ROA= Operating income or EBIT/ Average total assets This ratio reflects the return on all assets used by the company, whether financed with debt or equity.

Calculation of proceeds from sale of equipment

Selling price − Book value = Gain/loss on sale of equipment Selling price − $300 = $200 Cash proceeds from the sale of equipment equal $500. These proceeds are classified as inflows from investing activities. >>>Cash flow from investing activities: Cash received from sale of equipment 500 Net cash flow from investing activities 500

Determining the Cost of Preferred Stock

Shirley Inc. has outstanding preferred stock on which it pays a dividend of $10 per share. If the current price of Shirley's preference shares is $100 per share, what is its cost of preferred stock?Solution: rp = $10/ $100 = 10%

Solvency Ratios

Solvency Ratios Long-term debt-to-equity ratio: Total long-term debt/ Total equity Debt-to-equity ratio: Total debt/ Total equity Total debt ratio: Total debt/ Total assets Financial leverage ratio: Total assets/ Total equity ***Ratio analysis is covered in detail in Reading 27. We also discuss the uses and limitations of ratio analysis in that reading.

Analysis of the NPV Profiles

The NPVs of the projects are equal at a cost of capital of 8.715%. This rate, where the NPVs of the two projects are the same and their NPV profiles intersect, is called the crossover rate. The crossover rate can be calculated by subtracting the cash flows of one project from the other and then calculating the IRR of the differences.

Explain the marginal cost of capital's role in determining the net present value of a project

The WACC is the discount rate that reflects the average risk of the company. When we choose WACC as the discount rate to evaluate a particular project, we assume that: The project under consideration is an average risk project. The project will have a constant capital structure (which equals the company's target capital structure) throughout its life. The cost of capital for a particular project should reflect the risk inherent in that particular project, which will not necessarily be the same as the risk of the company's average project. If the risk of the project under consideration is above or below the average risk of the company's current portfolio of projects, an adjustment is made to the WACC. Specifically: If a project has greater risk than the firm's existing projects, the WACC is adjusted upward. If the project has less risk than the firm's exiting projects, the WACC is adjusted downward. The WACC or MCC adjusted for the project's level of risk plays an important role in capital budgeting because it is used to calculate the project's NPV.

What amount would be added to WNF's retained earnings as of December 31, 2012, if it had used FIFO instead of LIFO?

The amount that would be added to WNF's retained earnings would be the cumulative increase in operating profit due to the decrease in COGS for each year. On a cumulative basis, COGS would be lower under FIFO by $1,330 million (LIFO reserve as of the end of 2012). However, cumulative taxes paid would be higher under FIFO by $374 million (calculated in Solution 5). Therefore, the increase in retained earnings if FIFO were used instead of LIFO would be $956 million (= 1,330-374).

Board of Directors

The board of directors acts as the link between shareholders and managers, as it is impractical in a complex ownership structure for shareholders to be involved in the direct running of the company. The main responsibilities of the board include evaluating management performance and assisting in strategy, as well as supervising the audit, control, and risk management functions.

Optimal Investment Decision

The company should raise capital (at the given MCC) and undertake all projects (to earn the given IRR) to the left of the intersection point because these projects enhance shareholder wealth given the cost of financing them. To raise capital in excess of the optimal capital budget (to the right of the intersection point) the firm will be required to incur a cost of capital that is greater than the return on available investments. Undertaking these projects, given the MCC, will erode the firm's value.

exercise

The company's DOH has increased from 31 days to 56, which implies that the company is holding higher levels of inventory. The decrease in DSO indicates that the company is collecting on its receivables more quickly than before. Taking all these ratios together, we can reach the conclusion that although the company is collecting on its receivables more quickly than before, the proceeds from sales are being used to purchase inventory which is not being sold as quickly. Therefore, the company's quick ratio is suffering, but not its current ratio.

Correct Treatment of Flotation Costs

The correct way to account for flotation costs is to adjust the cash flows used in the valuation. We add the estimated dollar amount of flotation costs to the initial cost of the project.

shareholder engagement

The first is shareholder engagement. It is a growing trend that companies engage with shareholders on a more frequent basis throughout the year. The additional transparency and information sharing tend to increase management support and reduce the potential for efforts by shareholders to more actively pursue other means to influence outcomes.

The media

The media have played an important role in bringing attention to various topics to raise the awareness of stakeholders over the years. More recently, social media has become a powerful tool that has leveled the playing field between the company and stakeholders. It has the ability to influence stakeholder relationships instantly and at little cost.

The nomination committee1

The nomination committee is specifically concerned with the board and executive management. It is not directly concerned with all management positions, but focuses on those executive roles that play a bigger role in implementing their strategies and directives.

Adjusted ROA

The problem with this calculation of ROA (net income/average total assets) is that it uses only the return to equity holders (net income) in the numerator. Assets are financed by both equity holders and bond holders. Therefore, some analysts prefer to add interest expense back to net income in the numerator. However, interest expense must be adjusted for the tax shield that it provides. The adjusted ROA is computed as: Adjusted ROA= net income + interest expense (1-tax)/ Average total assets

Shareholder versus Creditor Interests

The relationship between shareholders and creditors has the basis for differences due to the risk tolerance and expected return of each side. A shareholder takes additional risk for greater return; however, a creditor looks for stability and lower risk. Increasing leverage creates risk and is at odds with a creditor's desire.

Stakeholder Relationships and Corporate Governance

There are three market factors that affect the stakeholder relationship and corporate governance. They are: Shareholder engagement Shareholder activism Competition and takeover

Common-size analysis

There are two ways to construct common-size cash flow statements: >>Express each item as a percentage of net revenues. This is the most commonly used format. >>Express each cash inflow item as a percentage of total cash inflows, and each cash outflow item as a percentage of total cash outflows.

Cash flow from operating activities (CFO)

These are inflows and outflows of cash related to a firm's day-to-day business activities.

Balance Sheet Ratios

These are ratios that have balance sheet items in the numerator and the denominator. The two main categories of balance sheet ratios are liquidity ratios, which measure a company's ability to settle short-term obligations, and solvency ratios, which evaluate a company's ability to settle long-term obligations. The higher a company's liquidity ratios, the greater the likelihood that the company will be able to meet its short-term obligations.

The fixed asset turnover ratio

This ratio measures how efficiently a company generates revenues from its investments in long-lived assets. A higher ratio indicates more efficient use of fixed assets in generating revenue. A low ratio could be an indicator of operating inefficiency. However, a low fixed asset turnover can also be the result of a capital intensive business environment. Companies that have recently entered a new business that is not fully operational also report low fixed asset turnover ratios. The fixed asset turnover ratio will be lower for a firm whose assets are newer than for a firm whose assets are relatively older. The older-asset firm will have depreciated its assets for a longer period so the book value of its fixed assets will be lower

Defensive Interval Ratio

This ratio measures how long the company can continue to meet its daily expense requirements from its existing liquid assets without obtaining any additional financing. A defensive interval of 40 indicates that the company can pay its operating expenses for 40 days by liquidating its quick assets. A high defensive interval ratio is desirable as it indicates greater liquidity. If a company's defensive interval ratio is very low compared to the industry average, the analyst might want to determine whether significant cash inflows are expected in the near future to meet expense requirements.

Return on total capital

This ratio measures the profits that a company earns on all sources of capital that it employs-short-term debt, long-term debt, and equity. Once again, returns are measured prior to deducting interest expense.

Five-Way DuPont Decomposition

To separate the effects of taxes and interest, we can further decompose ROE into five components. ROE= net income/ EBT (TAX BURDEN) X EBT/EBIT X EBIT/ revenue X revenue/ average total assets X average total assets/ avg. shareholders equity This decomposition shows that ROE is a function of the company's tax burden, interest burden, operating profitability, efficiency, and leverage.

Major drags on liquidity include

Uncollected receivables: The longer receivables are outstanding, the greater the risk that they will not be collected at all. Obsolete inventory: If inventory remains unsold for a long period, it might indicate that it is no longer usable. Tight credit: Adverse economic conditions can make it difficult for companies to arrange short-term financing.

Investors in the Company

Understanding the investor composition gives insights into control and directionality of decisions. If there is a concentrated holding that controls voting, this can dictate how the company is run for the immediate future, and potentially longer. In addition, if the shareholder group has a significant number of experienced activists, this can lean toward a short-term-oriented investor mentality, which can create substantial turnover in a very short period of time.

Acquisition of Long-Lived Assets

Upon acquisition, tangible assets with an economic life of longer than one year and intended to be held for the company's own use (e.g., PP&E) are recorded on the balance sheet at cost, which is typically the same as their fair value If several assets are acquired as part of a group, the purchase price is allocated to each asset on the basis of its fair value.

Valuation ratios

Valuation ratios P/E: Price per share/ Earnings per share P/CF: Price per share/ Cash flow per share P/S: Price per share/ Sales per share P/BV: Price per share/ Book value per share Pre-share quantities Basic EPS: Net income minus preferred dividends / Weighted average number of ordinary shares outstanding Diluted EPS: Adjusted income available for ordinary shares, reflecting conversion of dilutive securities/ Weighted average number of ordinary and potential ordinary shares outstanding Cash flow per share: Cash flow form operations/ Average number of shares outstanding EBITDA per share: EBITDA/ Average number of shares outstanding Dividends per share: Common dividends declared/ Weighted average number of ordinary shares outstanding Dividend-related quantities Dividend payout ratio: Common share dividends Net income attributable to common shares Retention rate (b): Net income attributable to common shares - common share dividends Net income attributable to common shares Sustainable growth rate: b × ROE

Better Operating and Financial Performance

With a strong control system, the company can see better operating performance and better information gathering. This leads to improved decision making and can decrease the response time to changes in the market.

Lower Default Risk and Cost of Debt

With a strong governance structure, business and investment risk is reduced. This will help to protect creditors' interests and will ultimately reduce the company's cost of debt and default risk.

Working capital turnover

Working capital turnover indicates how efficiently the company generates revenue from its working capital. Working capital equals current assets minus current liabilities A higher working capital turnover ratio indicates higher operating efficiency.

Creditors

have little influence on the company, other than covenants and restrictions they can put in place as its banks or bondholders. They receive interest and principal payments, and have a primary goal of being repaid through the company's ability to generate cash flow. Creditors look for stability, in contrast to shareholders, who may desire and are willing to tolerate higher risks to obtain higher returns.

when making comparisons across companies, it is important to account for differences in the companies' expenditure capitalizing policies. Analysts should be wary of companies that:

when making comparisons across companies, it is important to account for differences in the companies' expenditure capitalizing policies. Analysts should be wary of companies that: Inflate reported cash flow from operations by capitalizing expenditures that should be expensed. Inflate profits to meet earnings targets by capitalizing costs that should be expensed. Depress current period income by expensing costs that should be capitalized, in order to be able to exhibit impressive profitability growth going forward without any real improvement in operating performance.

The government and regulators

wish to protect the economy and the interests of the general public. Implementing procedures or guidelines that increase costs or additional burdens on the company can be at odds with other stakeholders. In addition, regulators have an interest in having corporations act within the guidelines of the law on a consistent basis.

Cash flow from financing activities (CFF)

These are cash inflows and outflows generated from issuance and repayment of capital (interest-bearing debt and equity).

Calculation of book value of sold equipment

Book value of sold equipment = Historical cost − Accumulated depreciation Book value of sold equipment = $800 − $500 = $300

Indirect cash flow statement into a direct statement.

There is a three-step process for converting an indirect cash flow statement into a direct statement. Step 1: Aggregate all revenues and all expenses Aggregate all operating and nonoperating revenues and gains such as sales and gains from sale of assets. Aggregate all operating and nonoperating expenses such as wages, depreciation, interest, and taxes. Step 2: Remove the effect of noncash items from aggregated revenues and expenses and separate the adjusted revenues and expenses into their respective cash flow items. Deduct noncash revenue items such as gain on sales of assets from total revenue. Deduct noncash expense items such as depreciation from total expenses. Break down the adjusted expenses into cash outflow items, such as cost of goods sold, wages, interest expense, and tax expense. Step 3: Convert the accrual-based items into cash-based amounts by adjusting for changes in corresponding working accounts. An increase (decrease) in an asset account is a cash outflow (inflow). An increase (decrease) in a liability account is a cash inflow (outflow). Convert revenue into cash receipts from customers by adjusting for accounts receivable and unearned revenue. Convert COGS into cash payments to suppliers by adjusting for inventory and accounts payable. Convert wages, interest, and tax expenses into cash amounts by adjusting for wages payable, interest payable, taxes payable, and deferred taxes.

The Direct Method to Compute CFO

>Total sales adjusted for changes in related working capital accounts are known as cash collections from customers: cash collections from customers. CASH COLLECTIONS = SALES - INCREASE IN ACCOUNTS RECEIVABLE *accounts receivable is an asset. An increase in asset is a use of cash. >Cost of goods sold adjusted for changes in related working capital items is known as cash payments to suppliers: Payment to suppliers CASH PAID TO SUPPLIERS = - COGS - INCREASE IN INVENTORY + INCREASE IN A/C PAYABLE *Accounts payable is a liability. An increase in liability is a source of cash. >Salaries and wages adjusted for related working capital accounts: CASH SALARIES AND WAGES = - WAGES AND SALARIES + INCREASE IN WAGES AND SALARIES PAYABLE >Depreciation is a noncash expense so it is ignored altogether. >Other operating expenses adjusted for changes in related working capital accounts: OTHER OPERATING EXPENSES (CASH) = - OTHER OPERATING EXPENSES (ACCRUAL BASIS) + DECREASE IN PREPAID EXPENSES + INCREASE IN OTHER ACCRUED LIABILITIES >Gain on sale of equipment relates to the sale of a long-lived asset. The proceeds from this transaction are classified under investing activities and ignored in the calculation of CFO. >Interest expense adjusted for related working capital accounts: CASH INTEREST PAID = - INTEREST EXPENSE - DECREASE IN INTEREST PAYABLE >Income tax expense adjusted for related working capital accounts: CASH TAX PAID = - INCOME TAX EXPENSE + INCREASE IN TAX PAYABLE

Accounting goodwill

Accounting goodwill is based on accounting standards and is only reported for acquisitions when the purchase price exceeds the fair value of the acquired company's net assets.

Marketable investment securities can be classified under the following categories

Available-for-sale securities: These are debt or equity securities that are neither expected to be traded in the near term, nor held till maturity. They may be sold to address the liquidity needs of the company. These securities are reported at fair market value on the balance sheet. While dividend income, interest income, and realized gains and losses on AFS securities are reported on the income statement, unrealized gains and losses are reported in other comprehensive income as a part of shareholders— equity.

Calculating FCFF

Calculating FCFF Continuing from our previous example of ABC Company and assuming a tax rate of 40%, calculate FCFF. Solution Recall the following information regarding ABC Company: CFO = $2,050 Interest expense = $300 Fixed capital investment = −$500 (the company sold noncurrent assets for $500) Therefore: FCFF = CFO + Interest expense (1 − Tax rate) − FCInv FCFF = 2,050 + 300 (1 − 0.4) − (−500) = $2,730 ***Under IFRS, if the company has classified interest and dividends received as investing activities, they should be added to CFO to determine FCFF. If dividends paid were deducted from CFO, they should be added back to CFO to calculate FCFF. Dividends must not be adjusted for taxes as dividends paid are not tax-deductible.

Calculating CFF

Cash flow from financing activities is generated from the issuance and repayment of capital (long-term debt and equity) and distributions in the form of dividends to shareholders. >>Long-term debt: An increase in long-term debt from one year to the next implies cash inflows from new borrowings. A decrease implies debt repayment and an outflow of cash. >>Equity: An increase in common stock from one year to the next implies cash inflows from issuance of new shares. A decrease implies a share repurchase that results in a cash outflow. >>Dividends: Cash dividends paid out can be computed from the following relationship: >>Cash dividends paid out = Beginning dividends payable + Dividends declared − Ending dividends payable. >>Dividends declared = Beginning retained earnings + Net income − Ending retained earnings. Cash flow from financing activities: Cash paid to retire long-term debt −600 Repurchase of common stock −300 Cash paid as dividends −500 Net cash flow from financing activities −1,400

The purchase price may exceed the fair value of the target company's identifiable (tangible and intangible) net assets because of the following reasons:

Certain items of value (e.g., reputation, brand) are not recognized in a company's financial statements. The target company may have incurred research and development expenditures that may have not been recognized on its financial statements but do hold value for the acquirer. The acquisition may improve the acquirer's position against a competitor or there may be possible synergies.

***Investing Cash Flow

Changes in long-term asset and investment accounts are used to determine sources and uses of investing cash flows. Increasing outflows may imply capital expenditures. Analysts should then evaluate how the company plans to finance these investments (i.e., with excess operating cash flow or by undertaking financing activities).

***Operating Cash Flow

Changes in relevant asset and liability accounts should be used to determine whether business operations are a source or use of cash. Operating cash flow should be compared to net income. If high net income is not being translated into high operating cash flow, the company might be employing aggressive revenue recognition policies. Companies should ideally have operating cash flows that exceed net income. The variability of operating cash flow and net income is an important determinant of the overall risk inherent in the company.

Cash flow statements prepared under IFRS and U.S. GAAP differ along the following lines:

Classification of cash flows: Certain cash flows are classified differently under IFRS and U.S. GAAP. IFRS offers more flexibility regarding the classification of certain cash flows. Presentation format: There is a difference in the presentation requirements for cash flow from operating activities. Classification of cash flows: Certain cash flows are classified differently under IFRS and U.S. GAAP. IFRS offers more flexibility regarding the classification of certain cash flows. Presentation format: There is a difference in the presentation requirements for cash flow from operating activities.

Common-size balance sheets

Common-size balance sheets express each item as a percentage of total assets. Common-size balance sheets are prepared to highlight changes in the mix of assets, liabilities, and equity Vertical common-size balance sheet percentage = Balance sheet account Total assets ×100

***Common-size statements

Common-size statements allow analysts to compare a company's performance with that of other firms and to evaluate its performance over time. A common-size income statement expresses all income statement items as a percentage of revenues. Common-size income statements are extremely useful in identifying trends in costs and profit margins >>>Vertical common size income statement percentage = Income statement account/ Revenue × 100

Economic goodwil

Economic goodwill, which is not reflected on the balance sheet, is based on a company's performance and its future prospects. Analysts are more concerned with economic goodwill as it contributes to the value of the firm and should be reflected in its stock price.

A company may develop intangible assets internally, but such assets can only be recognized under certain circumstances. Under both IFRS and U.S. GAAP, costs related to the following are usually expensed

Start-up and training costs. Administrative and overhead costs. Advertising and promotion costs. Relocation and reorganization costs.

Calculating CFO Using the Indirect Method

On the income statement, the only noncash expense is depreciation expense of $1,000, and the only nonoperating income/expense is the gain on sale of equipment of $200. We start by removing the effects of these two items from net income: Net income 1,500 Add: Depreciation expense 1,000 Less: Gain on sale of equipment −200 2,300 Next, we adjust the figure calculated above for changes in all working capital accounts, adding sources of cash and subtracting uses of cash. 2,300 Increase in accounts receivable (use) −50 Increase in inventory (use) −650 Decrease in prepaid expenses (source) 150 Increase in accounts payable (source) 200 Increase in salaries and 10 wages payable (source) Decrease in interest payable (use) −25 Increase in income tax payable (source) 15 Increase in accrued liabilities (source) 100 Net cash flow from operating activities 2,050 Additions : >>Noncash items Depreciation expense of tangible assets Amortisation expense of intangible assets Depletion expense of natural resources Amortisation of bond discount >>Nonoperating losses Loss on sale or write-down of assets Loss on retirement of debt Loss on investments accounted for under the equity method >>Increase in deferred income tax liability >>Changes in working capital resulting from accruing higher amounts for expenses than the amounts of cash payments or lower amounts for revenues than the amounts of cash receipts >>Decrease in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses) Increase in current operating liabilities (e.g., accounts payable and accrued expense liabilities) Subtractions: >>Noncash items (e.g., amortisation of bond premium) >>Nonoperating items Gain on sale of assets Gain on retirement of debt Income on investments accounted for under the equity method >>Decrease in deferred income tax liability >>Changes in working capital resulting from accruing lower amounts for expenses than for cash payments or higher amounts for revenues than for cash receipts Increase in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses) Decrease in current operating liabilities (e.g., accounts payable and accrued expense liabilities)

The Indirect Method

Step 1: Start with net income. Go up the income statement and remove the effects of all noncash expenses and gains from net income. For example, the negative effect of depreciation is removed from net income by adding depreciation back to net income. Cash-based net income will be higher than accrual-based net income by the amount of noncash expenses. Step 2: Remove the effects of all nonoperating activities from net income. For example, the positive effect of a gain on sale of fixed assets on net income is removed by subtracting the gain from net income. Step 3: Make adjustments for changes in all working capital accounts. Add all sources of cash (increases in current liabilities and declines in current assets) and subtract all uses of cash (decreases in current liabilities and increases in current assets)

The Direct Method

Step 1: Start with sales on the income statement. Go through each income statement account and adjust it for changes in related working capital accounts on the balance sheet. This serves to remove the effects of the timing difference between the recognition of revenues and expenses and the actual receipt or payment of cash. Step 2: Determine whether changes in these working capital accounts indicate a source or use of cash. Make sure you put the right sign in front of the income statement item. Sales are an inflow item so they have a positive effect on cash flow, while COGS, wages, taxes, and interest expense are all outflow items that have negative effects on cash flow. Step 3: Ignore all nonoperating items (e.g., gain/loss on sale of plant and equipment) and noncash charges (e.g., depreciation and amortization).

The CFA Institute Board of Governors

The CFA Institute Board of Governors maintains oversight and responsibility for the Professional Conduct Program (PCP), which, in conjunction with the Disciplinary Review Committee (DRC), is responsible for enforcement of the Code and Standards.

Indirect method

Under the indirect method, cash flow from operations is calculated by applying a series of adjustments to net income. These adjustments are made for noncash items (e.g., depreciation), nonoperating items (e.g., gains on sale of noncurrent assets), and changes in working capital accounts resulting from accrual accounting