Objective 2: Accounting and Value Measures / Managerial Accounting

State the determinant formulas associated with growth and firm value.

(DoV13)

Describe how the free cashflow to firms ratio is derived.

(DoV7)

Describe the determinant that yields the price/sales ratio.

(DoV7)

State the determinant formulas for value multiples.

(DoV9)

Describe how absorption costing produces inaccurate product costs.

Abs. Costing produces inaccurate product costs: - More OH from more departments, transactions, etc. Leads to distorted product costs since not every activity tracked · E.g. two factories, one produces one soap; one produces three (including specialty soaps). OH for second is higher, so higher product cost. Market may drive price down, and specialty soaps may command higher price making second factory seem more profitable à OH traced to allocation base(s) - if not accurate, inaccurate costs. (ADMC11)

Define the following terms: - Absorption Cost System - Job order costing - Process costing - Over-absorbed - Underabsorbed - Cost pool - Cost drivers - Job order costing - Process costing - Expected volume - Normal volume

Absorption Cost System: Costs traced directly to products. Main problem is allocating costs can't always be directly traced Job order costing: Costs by job order Process costing: Used where production is continuous; batches don't exist. Over-absorbed: Expected exceeds actual Underabsorbed: Actual exceeds expected. Cost pool: Accumulation of cost accounts. Cost drivers: Factors increasing costs Types of manufacturing processes: Job shops, batch manufacturing, assembly processes, continuous flow Job order costing: Items are cost objects & costs are traced directly, so portion of OH allocated. Input measure is the allocation base (e.g. machine hours). OH rate set beginning of year, where reported costs are average (E.g. raw materials + direct labor = total / # of units = average cost) Process costing: Costs assigned to products through continuous process. Expected volume: Projected volume over upcoming year Normal volume: Long-run average volume. Stabilizes earnings (ADMC9)

Describe accounting measures used in controlling behavior, and the controllability principle.

Accounting performance measures: Accounting measures used for controlling behavior. Differences in performance measures could be w.r.t. use of earnings, accounting manipulations (e.g. depreciation expense), efficient use of assets (via capital charge). May lead to misleading results, but no performance measurement system is perfect - should use multiple systems. · Net income: Considers debt financing, but doesn't consider equity financing, Incentivizes overinvestment if it will produce pos. net income (no matter how small). · Return on investment = NI / Total Assets Invested or ROA = NI / Total Assets. Provides ability to compare to market yields, recognizes G/L. Ignores value increases (appreciation) & intangibles & could lead to overinvestment (ROI lower than capital charge) or underinvestment (ROI higher than capital charge, but lower than usual ROI) · Residual income: Profits - opp. CoC (weighted avg.) Single, absolute number, so difficult to compare small & large divisions. EVA = Adj earnings - CoC. CoC based on total division / firm assets. Example of adj earnings: Add back in R&D costs since LT focus Controllability principle: Only holding mgmt. accountable for controllable actions/events, but disincentivizes actions to mitigate & ignores benchmarks/comparisons available. May also create opportunism. (ADMC5)

Describe activity based costing & its pros/cons.

Activity based costing (ABC): Breaks costs down into four categories (cost drivers) · Per unit: Cost per each unit · Per batch: Costs associated with a batch of units (e.g. purchase orders, inspections) · Per product level: Cost for product line support (vary by product line, e.g. engineering orders, product enhancement, etc.) · Capacity sustaining: Factory cost (security, admin) Benefits: Better understand cost drivers, trace costs, cost control, more accurate, more focused incentives for managers Cons: · Must assign decision rights to do / manage all these things · Not free & more complex (e.g. costs of bookkeeping, analyzing, etc.) · Opportunism from managers manipulating drivers & gaining numbers (outside of monitoring scope), · ABC doesn't allocate opportunity cost, only historical costs. · Indirect costs of managing system (interviews, logs, observations, complexity). · ABC measures costs not benefits: Evaluates costs, but doesn't consider benefits of systems, e.g. can't allocate joint benefits TC = VC * Q + BC * B + PC * L + OC VC = unit BC = Batch PC = product OC = capacity FC = BC * B + PC * L + OC FC = fixed costs (ADMC11)

Define/describe the following terms: - Agency costs - Free rider problem - Horizon problem - Adverse selection - Moral hazard

Agency costs: Maximizes own utility (goal incongruence). · Result from information asymmetries - can't observe effort so must pay to compensate for work & not shirk · Firms incur costs to control behavior (e.g. security guards), but agency costs limited since can replace managers · Goals aligned through incentive scheme Free rider problem: Teams: 1) Produce more together, 2) thereby creates larger opportunity set. Incentive to shirk, reduced output spread w/more team members Horizon problem: Agent expects to leave before principal, so focuses on ST actions Adverse selection: insureds know more about own circumstances than insurer Moral hazard: Tendency to engage in risky behavior when insulated from consequences of own actions (ADMC4)

Describe when allocating costs equals, exceeds or falls short of marginal costs.

Allocating costs & marginal costs: · Cost allocation usually average cost · If cost rate = total cost / base < Marginal Cost, underallocating costs (used when rising average cost overallocating; slope of R lower than M) · If R >M (slope of R greater than M), overallocating costs. Can discourage managers & disincentivize investing/profiting · If R = M, cost allocations are exactly equal to marginal costs (requires special studies to understand (ADMC7)

Describe the following relative valuation step: · Analytical tests of multiples

Analytical Tests · Determinants: Every multiple function of risk, growth & CF generating potential. Formulas for different multiples should be analyzed in terms of these three variables. (See formulas.) · Relationships: How multiples change as fundamentals change. Multiples assume linear relationship between one variable and the next (e.g. PEG ratio, (Price/Earnings) / Growth) · Companion variable: Variable that dominates the multiple (not the same for each multiple) (DoV7)

Describe how ABC compares to absorption costing.

Analyzing ABC · Generally, differences between ABC vs. absorption costing not material, but can be dramatic sometimes. High volume = lower ABC; lower volume = lower absorption cost (ADMC11)

Describe the following relative valuation step: · Application tests of multiples

Application tests Comparable firms: Similar cashflow, risk & growth potential; sector/industry doesn't matter. May continue to add on additional criteria (e.g., same size) if sample size is very large. · Alternatives to conventional practice: 1) May use firms similar in valuation fundamentals (e.g., beta, ROE, etc.) or 2) consider all firms in market as comparable and control for differences in fundamentals using statistical techniques Controlling for differences across firms: 1) Subjective adjustments: Adjustments usually subjective, biased & inconsistent. 2) Modified multiples, e.g., PEG ratio, where PE ratio divided by growth rate. Assumes comparability on all other measures & variable relationship is linear 3) Statistical techniques involve regression on sectors and markets. · Assumes multiples are normally distributed, variables are independent, distribution doesn't change with time, and focuses more on acceptable range of R-squared (tighter range for greater accuracy) rather than how high R-squared can get. (DoV7)

Define the following: · Budgeted volume (aka denominator volume) · Standard (earned or allowed) volume · Actual volume:

Budgeted, standard & actual volume · Budgeted volume (aka denominator volume): Forecasted volume. Calc'ed at BOY. Expected & normal budgeted volume. · Standard (earned or allowed) volume: How much input should have been used under standard units. Calc'ed during or EOY. · Actual volume: Volume actually incurred. Calc'ed during the year. (ADMC13)

Describe common transfer pricing methods.

Common transfer pricing methods · Market-based transfer price: Use ext. market price: Quick, easy, objective, no manipulations. Can underestimate profitability, ignores synergies from saving money, not reflective of opportunity costs · Variable cost transfer price: Use variable cost as transfer price, but seller may not recover fixed costs, so could have fixed fee to compensate, but then won't sell as many units (affects overall firm profits). Variable cost may also change if volume changes - Difficult in passing costs to all divisions if not all divisions' volume increased. Could incentivize fixed costs to be treated as variable costs · Full cost transfer price: Objective, full cost of labor & materials, avoids manipulations of fixed costs as variable, simple, low cost. May overstate opportunity cost & be less efficient for firm or sell too few units. Very common - full cost approaches opportunity cost as firm reaches capacity. · Negotiated transfer price: Agree on transfer price to max profits for both divisions; may not maximize firm value If all else fails, reorg. firm to better achieve transfer price (ADMC5)

Describe some consequences of illiquidity on a firm.

Consequences of illiquidity · Public or private firm: Tradeoffs of control vs. illiquidity. · IPOs: Hot/cold periods. Clustering in certain sectors where illiquidity discount is high. · Portfolio mgmt.: Consider time horizon when considering liquidity for portfolio (long vs. short). Returns should be the same for liquid vs. illiquid, once considering for transaction costs. (DoV14)

Describe considerations when adjusting the discount rate for illiquidity.

Considerations: Firm characteristics: Size, type of firm, liquidity/marketability of firm's assets, financial health, revenues, IPO potential, control component, relationships with investors. Economic / Market Characteristics: Demand/desire, time horizon, transaction costs, bid-ask spread, stock discount. Regressing using public stocks could produce variables, but coefficients unstable and/or R-Squareds moderate, large standard errors, etc. Discount Rate Adjustment: · Compare against stock premium or venture capital returns over long periods compared with traded stocks (i.e., what you could've earned otherwise) · Relate observed illiquidity premium on traded assets to specific characteristics of those assets - healthier firms should have smaller illiquidity premium · Firm-specific premiums would need betas (near impossible) Quantitative Marketability Discount Model (QMDM): Method: · Adjustment to discount rate for illiquidity factors, · Then values illiquidity as percent of firm value for different holding periods. · Then firm value is, PV(CFs) during holding period + PV(terminal value) (what's paid out at the end). Failures of this model: · CF during holding period wasted by stockholders & don't accrue value for firm · Illiquidity discount is consequence of control & illiquidity, but one can exist without the other · Model claims to quantify non-marketability, but adjustment to discount rate for illiquidity can be backed out from observed illiquidity discounts in stock studies (DoV14)

Describe some differences between liquid and illiquid firms w.r.t. corporate finance.

Corporate finance considerations Higher illiquidity, higher CoC Illiquid firms: Harder investing in LT projects w/ negative CF in early years since won't be able to fund those CFs. Liquid firms, · Greater dividends, · Easier ability to raise/borrow capital w/lower transaction costs. · Liquid mgmt. compensation (stock, options) in liquid firm. (DoV14)

Describe the following w.r.t. MCEV: · Hedgable risks · Non-hedgable risks

Cost of Residual NH'able Risks (CRNHR): Hedgable risks: Included in PVFP & TVOG. NH'able risk: · Illiquid, non-existent markets, assumptions not based on credible data (e.g. mortality, operational risk, etc.) · Best est. assumptions reflect asymmetry of risk, impact to s/h · Discount NH'able risk at CoC, risk charge calculated from EC at 99.5% confidence over 1 year. · Diversification allowed within covered business over projection, but other div. benefits not allowed. (SDM172)

Describe the costs of standard costs.

Costs of standard costs: · Costly to implement/operate · Rapid changes in tech & process improvement causes standards to become obsolete · Costly for managers time to investigate cost variances (only do so if material) · Can create specialized knowledge, leading to higher firm value · Must be implemented carefully or will create dysfunctional behavior (e.g. too much emphasis on labor variances (ADMC12)

Describe the following: - Decision rights - Influence costs - Decision management - Decision control

Decision rights designated to managers (employee empowerment) - but how much? · Generally knowledge linked to decision rights - knowledge costly to transfer, especially when technical or it changes quickly · But difficult to monitor, so another person may hold decision right Influence costs: Not assigning decisions - Influence costs lower since no one to lobby, but evidence may be needed for some decisions (e.g. promotions) Decision mgmt. vs. decision control · Decision management: Initiates / implements decisions · Decision control: Ratifies/monitors decisions · Example: FT hire (initiate) --> authorized by mgmt. (ratify) --> hire candidate (implement) --> evaluate (monitor) (ADMC4)

Describe the following relative valuation step: · Definitional tests of multiples

Definitional tests: Analysts may use different values or adjust. Consistency: E.g., P/E - current price, average price, etc. · Consistency between numerator & denominator (e.g. equity measure vs. firm measure). · Inconsistent ratios (e.g. price/EBITDA) do not account for debt or other differences among firms. Uniformity: · Multiple has to be defined uniformly (e.g. accounting standards differences, differences in calendar year for earnings, ) (DoV7)

Describe the following relative valuation step: · Descriptional tests of multiples

Descriptional tests: Distribution: How do multiples compare across entire market, not just within sector - Helps determine if multiple is high/low. Median/percentiles in place of avg./std. dev. - Predisposition in normal distribution biases our thinking. Outliers/averages: If outliers over threshold thrown out, comparisons of sectors/markets won't necessarily line up. Biases where estimates drop out (e.g. from negative multiples.) Solved by adjusting analysis for dropouts, computing aggregate multiples, or multiples that can be computed for group. · Time variations: Multiples change over time, so relative valuations have short shelf lives. (DoV7)

Describe the determinants of firm value.

Determinants of firm value Asset CFs: Cash after taxes & reinvestment to maintain assets, but before debt pmts. Expected & length of growth: · ST growth of inforce assets due to limited efficiency; · LT growth from new assets if firm reinvests at RoC. · Length of growth period towards stable growth - dependent on sustainable comp. adv., & RoC and CoC Cost of capital: Cost of risk/debt/equity Other: Cash, cross holdings, nonoperating assets (DoV13)

Describe the following variances: · Direct labor variance · Direct materials variances

Direct labor variance Total labor variance = actual cost of labor - std. cost of labor = (actual wage x actual hours) - (std. wage x std. hours) = (Actual wage - std. wage) x actual hours + (actual hours - std. hours) x std. wage = wage variance + efficiency variance Direct materials variances: Same as labor, with additional piece for raw materials inventory: Total materials variance = (actual quantity bought - actual quantity used in production) * standard raw materials cost (ADMC12)

Describe how disclosures and EV are useful to investors.

Disclosures should help users, · Understand VoB impacts (events, experiences, decisions), risks, drivers & sensitivities · Mgmt's view/approach of business where judgement is required, · Comparisons w/other firms · Reconcile business to financials · See mgmt. as credible Uses of EV: · Change in margin signals future performance (definition of NB by firm important here) · Convey credibility via sign-off by mgmt. and/or third party audit (SDM172)

Describe how to dispose of standard cost variances.

Disposition of standard cost variances same as for over/underabsorbed OH: 1) writing it off through CoGS, 2) allocating it among work in progress, finished goods, & cost of sales or 3) recalculating cost of each job. (Pro-rating sends signal that prices should be increased) (ADMC12)

Describe distributional characteristics of value multiples.

Distributional characteristics of value multiples: Constrained to be greater than zero, so distributions skewed positive. Value / operating earnings multiples, e.g. EV/EBIT, EV/EBITDA: · Negatively skewed, average values are above median. Indicates falsehood that that rule of thumb stating firms trading at less than 7x EBITDA are cheap for M&A (many trade less than 7x) · Firms with negative EPS or negative income can't have earnings multiples computed, so less potential for bias than with P/E ratios (espec. true for firms with very large depreciation Value / Book Capital = (MV equity + MV debt) / (BV equity + BV debt) EV / invested capital = (MV equity + MV debt- Cash) / (BV equity + BV debt - Cash) · Both heavily negatively skewed, but EV/BV capital higher avg. median values EV/Revenues: Tend to have higher values than PE ratios for most firms since debt exceeds cash (except where cash exceeds debt, i.e. tech firms) (DoV9)

List the five EV multiples.

EV / EBITDA EV / EBIT EV / EBIT(1-t) EV / Capital invested EV / Sales

Describe the following w.r.t. MCEV · Economic projection assumptions

Economic Assumptions: In line with prices of similar CFs, actively set/monitored, internally consistent. With regard to Investment Returns & Discount Rates: · Certainty equivalent valuation: Adjust cashflows, not discount rate. Can use reference rate for investment return & discount rate · Risk-neutral valuation (risk-adjusted CFs) & State-price deflators (scenario-specific discount factors): Use when model is market consistent (SDM172)

Describe the following w.r.t. MCEV: · Financial options & guarantees

Financial Options & Guarantees · TVFOG = Stochastic valuation PVFP - deterministic valuation PVFP. · Assets projected at reference rate. May include NH risks (e.g., interaction between p/h behavior & guarantees, CIRs, NH'able risks) · Use stochastic valuation (with and without moneyness paths): TVOG = Stochastic Valuation of PVFP - Deterministic valuation of PVFP · Credited rates locked in at beginning - excess distributed to p/h, so no stochastic needed. P/h floors or bonuses at other end of contract need stochastic projection · Be consistent w/markets, but TVFOG CFs may consider historical experience, current economic environment, and future behaviors & costs (SDM172)

Define flexible overhead budget and the OH rate function.

Flexible overhead budget = Fixed OH + Variable OH * volume (V). V could be budgeted volume Overhead rate: The OHR function is defined as, = BOH / BV = FOH + (VOH*BV) / BV = FOH / BF + VOHOHR Budgeted OH is that for the year and BV is budgeted volume (e.g. in hours). OH rate is slope of line through origin & point (BV, BOH) Overhead is absorbed using standard volume & standard costs (ADMC13)

Describe some ways to control for differences in value multiples when making forward revenue comparisons.

Forward Revenues Comparisons · Firm is young, but higher CFs expected in future. · Firm is dressed currently, but revenues in future better reflect potential. · Easier to estimate multiples of revenues after growth rates have leveled off & risk profile is stable Methods: · PV(Multiple * Value): Use multiples of today against expected future revenues, then discount to present. · Current Value to Future Revenues: Forecast revenue in five years & divide current firm value by these forecasted revenues. · Regression w/Comparable Firms: Regress multiples of comparable firms, derive coefficients, and derive firm-specific expected multiples. Apply these to future revenues & discount back. · Exit Multiples: Estimating earnings in future year then applying exit multiple to reflect sale or public offering. Pitfalls of forward revenues Methods: · Using best-case estimates instead of expected values: Need to account that some firms may not last. · Double-counting growth: Inflating multiples & justifying it as potential - But revenues already reflects growth. · Not PV'ing to Time 0 (DoV9)

List the four steps for doing relative valuation.

Four steps to using multiples · Definitional tests: Define the multiple consistently · Descriptional tests: Awareness of cross-sectional distribution of the multiple · Analytical Tests: Drivers/behaviors of the multiple under different changes. · Application tests: Finding the right firms and controlling for differences. (DoV7)

Describe the following w.r.t. MCEV: · Free surplus · Required capital · Value of inforce · Frictional Costs of Capital

Free surplus: Held at MV, no FrCoC - doesn't support liabilities. Required capital: Why hold more? · Convey financial strength to regulators/investors · Establish credit rating · Meet internal risk-capital goals Value of Inforce (VIF): · Arbitrage free, i.e. No time value of money · PVFP includes provision for moneyness of options & guarantees Frictional Costs of (Required) Capital · Taxes, agency costs, financial distress. Offset by PVFP & indep. NH'able risk (SDM172)

Describe the goals and key ideas of the CFO forum for MCEV.

Goals: · MCEV very important measure for s/h, so need consistent principles-based guidance. · Seek to address criticisms & reduce subjectivity. · Assumptions should be economic. Noneconomic may use entity-specific approach · Reflect mgmt. views, but aligned w/market. · Provide appropriate disclosures Key Ideas of MCEV · MCEV = free surplus + req. capital + value of inforce. · Risk reflected in discount rate, CoC & TVOG. · Explicit quantification of hedgable risks (PVFP, TVOG), FrCoC, and NH'able risks. (SDM172)

Describe the relationships between multiples & fundamentals.

Growth & Risk: · Growth factor drives up EV, so when comparing companies, some firms may look cheaper. · Risk: Higher risk --> Higher cost of debt & cost of equity --> High CoC --> lower EV. Implications: · Riskier firms trade at lower EV multiples than mature/safer companies w/predictable CFs. · Differences in financial leverage can affect EV multiples indirectly, especially if close to their optimal leverage (while others are over/under levered) · Companies in emerging markets trade at lower multiples than more mature firms in developed markets --> Skews comparison. Quality of investments effect: · Higher reinvestment rate needed as ROC decreases to support growth rate. If ROC < CoC, firm will trade below book capital. · RoC = post-tax op. margin * Sales / Invested capital · Comparing EV/Sales, control for differences in margins since EV multiples change consistently with them Tax rates: · Pre-tax multiples will decrease disproportionately more than after-tax multiples as tax rates increase --> high-tax rate firms look cheap compared to those with low tax rates (DoV9)

Contast historical costs, OH, and standard costs.

Historical costs tell what costs were; Over/under-absorbed OH says if expectations were met. Standard costs set benchmarks for what expected future costs should be. (ADMC12)

Describe how to value control premiums in acquisitions.

How to value control premiums in acquisitions: 1) Calculate the status quo valuation 2) Calculate the valuation w/restructuring changes & value of control premium (restructure less status quo) 3) Determine what premium should be paid for the acquisition. The greater the premium, the greater the value of control paid to the target. If value of control = optimally run firm less status quo, · Value of control will vary across firms (poorly vs. quality-run, smaller vs. larger) · No rule of thumb on control premium · Control premium varies w/poor perf. reasons · Control premium function of mgmt. change ease (DoV13)

Describe some general considerations in modeling illiquidity.

Illiquidity value: Subjective estimate, but reflects inability to trade during liquid period. One illiquidity size doesn't fit all: Shouldn't use same factors/discounting across firms, since illiquidity will depend on many factors: · Firm/asset size, · Timespan, · Type of asset/sector, · Markets Where illiquidity is observed: - untradeable options/futures, - different share classes (ownership/control shares), - stock price IPO, - real assets, - restrictions on sales (e.g., priv. placements), - stock discounting (e.g. for compensation to investor). Liquidity premium: Reflects credit/default risk. Transaction costs reflect liquidity, price reversals/differences. (DoV14)

Describe the incentives to overproduce from absorption costing & how to reduce it.

Incentives to Overproduce from Absorption Costing · Fixed costs to units sold = fixed costs / units produced * units sold · All else equal, more units produced leads to more costs inventoried leading to higher profits. Reducing incentive to overproduce · Charging managers for inventory holding costs via residual income. But would have to be backed out in reporting · Having a policy against building inventory, but cumbersome & generates influence costs · Just in time production (JIT), but difficult to manage & time (ADMC10)

Describe some incentives & organizational reasons for cost allocations

Incentives/Organizational Reasons for Cost Allocations · Allocating costs act as a tax on profit centers & can alter how managers invest in people, resources, etc. (e.g. hiring more sales people vs. more ads) · Externalities: Costs/benefits from production/people through marginal addition of production/people (e.g. applie core dropped on road à cost to pick it up; add'l cost to HR to hire/admin one more person). Can be positive (e.g. benefits educated citizens) or negative (e.g. pollution) (ADMC7)

Contrast insulation & non-insulating methods of cost allocations.

Insulation method: costs don't depend on other BUs' performance. Based more on share of allocation base Non-insulating: costs do depend on other BUs' performance. Diversifies by allocating more to higher performance. Can incentivize to help other BUs perform better (so more costs allocating à helps monitor each other & cooperate), but can distort performance measure. (ADMC7)

Describe methods & analyses for use in EV.

MCEV Methods & Analysis Method used: Distributable earnings, MV BS method Movement analysis for comparability via standard template. Adjustments for capital & dividend flows, FX, acquired/divested business, model errors/improvements/changes, judgement, assumption changes, changes in experience during reporting period (restatement) Rate determination for expected earnings on free surplus and req. capital, and expected change in VIF Expected contribution broken into two components: · Investment return is BOP ref. rate, · Expected excess investment return over BOP period ref. rate (real world basis to reflect mgmt. expectation of business). · Underlying assumptions for investment return should be disclosed. Rate could be negative. · Don't' need to disclose economic assumptions/variances · Std. template may not work if firms perform analysis in different order with second order impacts · Timing of line items may differ among companies (BOP, MOP, EOP) (SDM172)

Describe some ways to control for differences in value multiples when making market comparisons.

Market comparisons: Better for comparing companies across sectors - Daunting, but regression analysis can actually provide insight (e.g., entire sector is misvalued) · Regressions on EV/Operating Income Multiples · Regressions on EV/Capital ratios · Regressions on Value to book vs. price to book: Parallel each other, but value to book is stronger for firms with high/shifting leverage - stabilizes estimates of relative value. · Regressions on EV/Sales ratios (DoV9)

Describe the impact of market efficiency on firm organizational architecture.

Market efficiency: Firms have lower transaction costs than customers (Coase) - cost of knowledge, lengthy contract terms; however, markets still outperform firms. Markets force firms to use resources in best possible way since it does three things better than firms · Measure performance · Reward performance · Partition rights to highest valued use Three-legged stool (org. architecture structure): Firm incurs costs to do what market already does efficiently · Measure performance · Reward/punish performance · Partition decision rights One leg falls, they all fall. May use objective/subjective and financial/nonfinancial measures (ADMC4)

Define the following market variances: · Price variance · Quantity variance · Mix variance · Sales variance

Marketing variances: Price & quantity variances Price variance = (actual price - std price) * actual quantity Quantity variance = (actual quantity - std qty) * std price Mix variance = (actual mix % - std mix %)*actual units of products sold * std price Sales variance = (actual units of all products sold - std units of products)*std mix% * std price · Mix & sales variances helpful when company sells multiple products that tend to be substitutes (ADMC13)

Describe how to model an illiquidity adjustment as an option value.

Model liquidity adjustment as option value: · Option-based discount: Illiquidity priced as option with horizon set equal to restriction on trading and perfect market timing during illiquid period (upper bound of marketability). This sets an upper bound on the marketability during a period of illiquidity. Weaknesses: 1) liquidity gives right to sell at prevailing market price - not a strike price, and 2) pricing models based on continuous price movements and arbitrage-free pricing - not clear how would hold in illiquidity. (DoV14)

Describe the following w.r.t. MCEV · New business and renewals

New Business and Renewals: · Analyze A/E renewals - Assumptions consistent between inforce & NB (but not necessarily the same). · NB margins defined as ratio of VofNB / PVNBP. Should reflect additional s/h value from NB. · Do not need to restate if assumptions change, but should disclose if they do. (SDM172)

Describe the following w.r.t. MCEV · Non-economic projection assumptions

Non-Economic Projection Assumptions: · Use past experience, trending, margins. Actively review assumptions. Experience not needed to be constantly updated, but LT assumptions should be updated/consistent w/experience. · Expenses best estimate & reflect business as going-concern (HR, inflation, development expenditure for future new business, system improvements, maint. vs. acq.), taxes. (SDM172)

Define the following variances: · Overhead efficiency, volume & spending variances · OH spending variance · OH efficiency variance · OH volume variance · Total OH variance

Overhead efficiency, volume & spending variances Total OH variance = actual OH costs incurred - OH absorbedOver/under-absorbed OH = actual OH incurred - OH absorbed= AOH - (OH rate * SV) Total OH variance disaggregated into three variances summing to total OH variance: OH spending variance = actual OH incurred - flexible budget at actual volume= AOH - (FOH + VOH*AV) OH efficiency variance = flexible budget at actual vol - flexible budget - std vol= (FOH + VOH*AV) - (FOH + VOH*SV) OH volume variance = flexible budget at standard volume - OH absorbed = (FOH + VOH*SV) - (OHR*SV) = FOH(BV - SV)/BV (ADMC13)

Describe allocating OH via job costing

Overhead rate = average cost / volume · Accumulate all indirect costs & develop prospective rates at BOY · Input measure to measure volume (machine hours, direct material dollars or labor) · Base is "taxed" choose allocation base that imposes tax on the one imposing the most externalities · Volume measure should be the one with the greatest association w/OH Over/under absorbed costs: Usually immaterial. Three ways to allocate excess from over/under-absorbed · Direct Write-off: Credit/debt CoGS entirely · Pro-rata: Allocate pro-rate to work in progress (WIP), finished goods, cost of goods sold (p.402) · Recalculation method: Recalculate each job using actuals to revise EOY OH rate - expensive, but used if revenues tied to reported costs under cost plus contracts. If affects investment decisions, use recalculation method Cost flows through t-accounts: T-account deducting indirect labor and indirect materials to overhead t-account Flexible budgets: OH = [Fixed costs + variable costs * volume] / allocation base (e.g. machine hours) (ADMC9)

Describe the following w.r.t. MCEV · Par business

Par Business: · Difficult to define MCEV since drivers of profit participation vary in nature, by product & market. · Goal to limit judgment to consistency w/ regulation, other assumptions / future returns, past company practice, and market practice/influences. · Residual assets have value to s/h & should be considered if needed for going-concern of business or if they can be released. · PVFP = sufficient assets - liabilities - req. capital - FrCoC (SDM172)

Describe how to calculate the minority discount / control premium when buying a private firm.

Private company valuations / Minority discounts & control premiums · If buying 51% of firm, pay 51% of optimal value of firm. · If 49% or less, pay 49% of status quo valuation. · Difference between the two is the minority discount. The following implications apply for minority discounts & control premiums: · Minority discount should vary inversely with mgmt. quality · Control may not always require 51%. · Value of an equity stake will depend on if it provides owner with a say in the way a firm is run (DoV13)

Describe the probability of changing management in a firm.

Probability of changing mgmt. Mechanisms for changing mgmt.: · Activist investors, · Proxy contests, · Forced CEO turnover, · Hostile acquisitions 1 - need to be target for acquisition, 2 - reasonable chance of success, 3 - acquirer has to change mgmt. & policies Determinants of mgmt. change: · Institutional constraints: capital, regulatory/political, passive, or interest-conflicting · Firm-specific constraints, i.e., corporate antitakeover amendments in charter, limited voting rights in shares, complex corporate holding structures (e.g., pyramids, or large stock held by s/h or managers) What may cause likelihood of mgmt. changing to shift · Rules governing corporate governance change over time · Activist investors · Publicizing hostile takeover or ousting of CEO Estimating probability of mgmt. change: May coincide with reasons for CEO changes - · CEO making poor acquisitions or paying too much · Forced CEO change more likely when board is small & composed of outsiders · High instructional investors and low insider holders and/or firm more dependent on equity markets · Competitive industry structure (DoV13)

List some reasons to allocate costs, and the steps for cost allocation.

Reasons to Allocate Costs · External reporting & taxes require inventory, etc. at cost · Cost based reimbursement (e.g. hospitals, universities) Decision making & control: Splitting bill evenly incentivizes more eating Cost allocation steps · Define cost objects · ID/accumulate common costs · Choose method for allocating using allocation base Examples: Gov. incentives for reimbursement, multiple profit centers (ADMC7)

List some reasons why it's important to study cost variances.

Reasons to study variances: · A/Es, judge performance, · Contract bidding, evaluating alternatives, · Transfer prices within firm, · Benchmarks for decision. · Assessing random variation: The sum of the aggregate variance should be near-zero - Otherwise, it indicates that the variance is not random fluctuation. · Variances might indicate that standards are unrealistic or unreasonable, or that system is out of control. (ADMC12)

Describe the following w.r.t. MCEV · Reference rates

Reference rates: Swap rates. Proxy for risk-free rate. If liabilities are liquid (not reasonably predictable), use swap YC as the reference rate. Else include liquidity premium w/swap YC. Advantages of swap rates · More liquid than gov. bond markets · Synthetic instruments that don't suffer from systematic distortions · Widely adopted · Consistent with implied volatilities · Do not include liquidity premium (inconsistent as to how much would/should be used other rates) Disadvantages of swap rates · Contain small margin for credit risk · Not available in all markets or in all durations - use gov. yields or other justified reference rates (SDM172)

Describe some considerations of illiquidity on relative valuation.

Relative valuation with illiquid assets: Using comparables, need the following: · Sufficient number of private firms w/similar characteristics (growth, risk, CF), · Large number of transactions for these private firms/assets, · Sufficiently available transaction information. However, information not easily available and accounting differences skew measures like revenues & earnings Relative valuation with illiquidity discount: When using comparable firms data/multiples w/private firms, discount rate adjusted in same way those multiples/data are adjusted. (DoV14)

Describe responsibility accounting & types of responsibility centers.

Responsibility accounting: Divisions divided into units/subunits w/decision rights & responsibility. Helps measure performance, output, efficiency, etc. Each has unique performance measurement / reward · Cost center: Measured on efficiency, output, & quality. Optimize budget & total output constraints. Managers in cost center effective if possess cost function understanding, can observe output & quality, & have specific knowledge of optimal input mix · Profit center: Collection of cost centers w/decision rights around input, product & selling. Effective most when costly to transfer knowledge. Evaluated using A/E profits. Complications from transfer pricing & corp. overhead allocation. · Investment centers: Collection profit centers w/specific knowledge. Decision rights around ROI. Constraints from product quality & market rules. Measured by net income, ROI & residual income. Points of note: Maximizing output for budget or minimizing costs for one center <> max firm profits. May overproduce despite inventory levels. May tie compensation to all BUs. (ADMC5)

Describe considerations with respect to scaling variables.

Scaling variable: If we scale, the variables we choose must be relative to entire firm: Earnings variables relative to entire firm include EBITDA, EBIT (Op. Inc), or EBIbAT (after-tax op. inc). If parent only (unconsolidated), exclude minority/majority holdings. If consolidated, add proportionate debt & cash BV variables: Focus on BV of capital, but may make adjustments for holdings in other companies. See table. Revenues: P/Sales inconsistent - use EV/total revenues. Subtract minority holdings from MV equity to get EV. If majority holdings fully consolidated, add back MV of minority interest to EV to get composite value of firm & then scale to total revenues of firm (which include revenues of subsidiary. Activity variables: Use EV in activity variables. E.g. EV / subscribers. (DoV9)

Describe some ways to control for differences in value multiples when making sector comparisons.

Sector comparisons: Controlling for differences across companies, & comparing them within a sector · Subjective judgments: Pausing to consider variables affecting multiples. · Matrix approach: Plotting multiples against companion variables, E.g. RoC less CoC vs. Value-to-Book (p.315) - Difficult to differentiate between firms not dramatically over/under valued, or control for more than two variables in a graph. · Regressions: Allow for many variables, nonlinear relationships among multiples & fundamentals. Not explain away all of the differences, but just those that make sense fundamentally. (DoV9)

Describe the pros/cons of using regression when controlling for differences across companies using relative valuation.

Sector regressions, Pros: · Inform about strength of variable relationships · Can be adjusted for nonlinearity · Can be extended to multiple regression & cross effects. Cons: · Using regression requires careful definition of sector (too few/many samples) · Narrowing our choice of fundamentals used for explanatory (independent) variables. Market regression is less restrictive w.r.t. comparable companies with similar risk (beta), growth, & CF (payout). Still uses market data & provides meaningful comparisons marketwide (including if our firm is over/undervalued relative to other firms in market). (DoV7)

Describe the following w.r.t. Standard Costs: · Standards · Target costing · Risk reduction

Standard Costs Standards: · Set at BOY. Changing standards incentivizes less control. · Tighter standards focus on decision control, loose standards focuses on decision mgmt. No universal practice to set. · Those w/control over variance thresholds usually have ratification rights over standards. · Standard costs derived from bottom up (engineer --> review --> revise/repeat). Target costing derived from top-down: Target cost = target price - target profit · Then costs looked at by subcomponent & those are targets for reducing costs. Once product is designed, opportunity to reduce cost is gone. Risk reduction: · Use of standard costs & booking to variance accounts removes uncontrollable factors from downstream users --> Salaries are less for not having to bear this risk. (ADMC12)

Discuss how standard costs and variances are used in conjunction with performance evaluation.

Standard costs & variances help control costs & undesirable incentives when used with performance evaluation: Incentives for higher inventories: · Lower costs, better accounting earnings, and favorable cost variances. · Ignores opportunity CoC w/raw materials in inventory. · Mitigate by charging for inventory holding costs (e.g., firm CoC in addition to warehousing/handling costs). But these have to be backed out for accounting. · Negative Externalities: · Purchasing managers can buy substandard materials to impose additional work on downstream production. · Offset by standards & specs around purchasing, and tying purchasing manager to variances around rework and/or raw materials quantity · Cooperation can be discouraged when individuals' evaluated based on variances: · Can encourage shirking. · Mitigated by variances for team or department, and evaluating individual & group accomplishments. · Mutual monitoring of managers (e.g. purchasing & production managers monitor each other) · Satisficing: · Only rewarding the standard disincentivizes managers to go further. · Compensation schemes should incentivize better performance. (ADMC12)

List and describe the values/multiples by which variables are scaled/standardized for appropriate comparison in relative valuation.

Standardized values/multiples for appropriate comparison Multiples of Earnings: E.g., EPS, P/E, four quarter avg. (trailing P/E), expected EPS over next year (forward P/E) BV or replacement value multiples: Since accounting can distort values, may look at · EV / BV · Tobin's Q: MV / replacement cost of assets (avoids using BV). Revenue multiples: · Price / sales or EV / sales. · Revenues multiples make it easier to compare firms in different markets Sector-specific: Not recommended, would depend on the sector, not easily comparable, over/undervaluations persistent. (DoV7)

Describe the following w.r.t. MCEV · Stochastic models

Stochastic Models: · Use implied volatilities, martingales, market data, correlations (where observable). · If these are not available, may use historic market (e.g., illiquid markets, practicalities in valuation), but need to disclose. · Consider moneyness, maturity, duration, options & guarantees (SDM172)

Describe temporary vs. permanent write-offs w.r.t. expenses.

Temporary changes in costs (due to demand) can be offset with one-time write-off Permanent changes can be offset with changes to plant, property, equipment, etc. (e.g. reducing depreciation schedule). Mgmt. reluctant to permanent write-offs since may signal to competitors, or may signal that they overinvested in capacity (hurts their careers) (ADMC9)

Define the following terms: - Cost allocation - Cost object - Common cost - Indirect cost - Allocation base

Terms: · Cost allocation: Assign individual/common costs to cost object · Cost object: Production, process, department, program wish to cost · Common cost: Used by several users · Indirect costs: Can't be directly traced. Common cost, indirect, overhead · Allocation base: Measure of activity w/common costs & cost objects (ADMC7)

Describe the following about relative valuation: · Three essential steps · Strengths/weaknesses · Comparing relative & DCF valuations

Three essential steps for relative valuation · Finding comparable assets. · Scaling variable to generate standardized prices · Adjusting for differences across variables for comparability Strengths: · Less time/resource intensive than DCF · Easier to sell/defend to investors · Reflect current mood of market · Widely used/accepted Weaknesses · Potential for inconsistent estimates · Market may systemically under/overvalues · Can be subject to analyst bias/manipulation How relative valuation compares to DCF: · Different views of market efficiency. · DCF corrected over time, while relative valuation correct on average. · If all firms overpriced, may be overpriced by DCF, but undervalued by relative valuation (and vice versa for underpriced market). (DoV7)

Contrast plantwide vs. multiple OH rules.

Three ways to allocate costs (depends on firm) · Plantwide: Good if using homogenous process (e.g. one product). Not so if produces heterogenous products · Individual cost accounts for individual cost items: good for understanding cost drivers · OH rates by department: Increased bookkeeping costs if large firm (ADMC9)

Describe why transfer pricing is used in firms.

Transfer pricing used to pay lower taxes (international firms) or assist in performance measures for profit / investment centers. Both are costly in terms of bookkeeping costs. Opportunity cost changes if business opportunities change. Can't always just use variable cost or opportunity cost to price · Economic transfer pricing: Transfer price = opportunity cost. Only if perfect information. · Asymmetric information: Higher price, fewer units transferred, company profits not maximized (ADMC5)

Describe the use of value multiples and Enterprise Value with and without cross holdings

Value Multiples: · Determinants of the multiple must be consistent (i.e., firm measure vs. equity measure). · Easier than equity multiples when different debt ratios. · Should include equity options issued in MV equity. · Cash may be 'non-wasting cash' · Cross holdings should have consistent proportions of cash, debt & equity if including minority or majority (>55%) holdings. Enterprise value = MV of assets = MV equity + MV debt - cash See image. (DoV9)

Describe the value of control.

Value of Control: Value of firm from current mgmt., and value if it were changed. i.e., status quo value (current mgmt.), or optimal value (optimal mgmt.) The value is the product of two components: · Value of controlling the business = Optimal firm value - status quo value · Probability of changing mgmt. (DoV13)

Describe the value of control in publicly traded companies

Valuing publicly traded companies: · Analysts price in some amount of value of control of the firm in normal stock price. In perfect world, valuation = status quo. · If mgmt. were to change it would be, valuation = status quo + Pr(mgmt. change) * value of control. · If analysts build in expected value of control, the following implications apply: 1) Paying a premium for control can result in overpayment 2) Stock affected by changes in perception of likelihood of mgmt. change 3) Poor corp. governance leads to lower stock prices - If governance is effective, value of control will be high (easier to change mgmt.); if ineffective, value of control will be lower

Describe variable costing, the incentive to overproduce from it, & other problems of variable costing.

Variable (direct) costing: Fixed costs written off in the period they occur. Contrasts to absorption costing which averages them over production & creates inventoried costs Overproducing incentive from variable costing: If actual costs exceed expected at EOY, question if they were fixed, variable, or both? · If fixed, no change under variable cost - profits still the same YoY · If variable, then gets averaged out over units produced even if sales haven't changed (p.459). Can lead to managing of earnings by managers. Problems with Variable Costing · Classifying fixed costs as variable costs · Difficult to evaluate costs @EOY · Someone must have decision rights to allocate fixed vs. variable, which may put them outside of the monitoring accounting is meant to control. Can lead to persuasion by managers to sr. mgmt. · Ignores opportunity loss of capacity · Variable costing ignores fixed costs, can lead to managers overconsume; absorption costing better measure of opportunity cost (but not exact) · But if overcapacity exists, including fixed costs overstates opportunity costs Unit Costs: If constraints on costs, then neither variable or fixed costs will account for costs beyond those constraints (since they're based on historical data) (ADMC10)

Describe the premiums on voting shares w.r.t. the value of control.

Voting & nonvoting shares MV = status quo + (optimal - status quote)*Pr(Mgmt. Change) If voting share premium exists from the value of control, · Difference between voting/nonvoting shares goes to zero if no chance of changing mgmt./control · Higher premium on voting shares, 1) ...at badly managed firms 2) ...where fewer voting shares 3) ...greater percentage of voting shares available for trading by general public Any event showing power of voting shares relative to nonvoting shares is likely to affect premium at which all voting shares trade (DoV13)

Describe some ways of increasing firm value.

Ways of increasing value: Optimize existing assets: · Redeploy / divest assets · Improve efficiency of existing assets · Reduce taxes or reduce capital for maintenance or working capital Increase expected growth during high growth period Lengthen period of high growth, e.g. prevent new entrants and/or create competitive advantages Reduce cost of financing: · Make products less discretionary to customers · Reduce leverage, · Improve debt/equity mix, · Improve ALM (ST/ST, LT/LT assets/debts) Improve use of nonoperating assets: · Use cash / marketable securities more efficiently (i.e. invest it or pay out dividends) · Spinning off holdings in other companies or divest cross-holdings · Better invest / reduce pension fund obligations (DoV13)

Describe the implications of accounting for controlling behavior.

· Accounting most useful for monitoring: Performance (CEO, managers, etc.), used by Board via audit firm · Financial measures used for decision control; non-financial measures for decision mgmt. Implications · Financial measures not under control of those being monitored · Non-financial measures available more frequently & more timely · Decisions made with aggregate data - no ratifying or monitoring individual decisions · Operations management relies on its own non-financial data (ADMC4)

Describe two common mistakes made by analysts when dealing with cross-holdings in measuring value for value multiples.

· Counting equity of minority holdings but not debt & cash · Adding minority interest from the BS (which is in BV) to EV to obtain total MV of consolidated firm (DoV9)

Describe the impact of shifts in demand on OH costs.

· If volume increases, avg. cost increases. Incentivizes increasing prices, but demand is actually lower so should lower prices. Using normal volume helps changes in demand so cost volatility lowered · Allocating higher OH to multiple cost centers creates death spiral (e.g. two factors w/one closing). · Underabsorbed OH should be directly passed to profits (lower profits). · Overabsorbed leads to higher profits. · Increased OH leads to pressure from upstream managers on downstream manages, and leads to increased monitoring · Normal volume improves decision management; expected volume improves decision control (ADMC9)