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financial reporting financial statement analysis and valuation

Questions and Answers of Financial Reporting Financial Statement Analysis And Valuation

Financial analysts typically measure financial leverage as the ratio of debt to equity.However, there is less agreement on how to measure debt, or even equity. How would you treat the following items
a. How would the following ratios differ for a company that used the purchase method to account for an acquisition versus the pooling-of-interests method in the year following the acquisition?•
A leading oil exploration company decides to acquire an Internet company at a 50 percent premium. The acquirer argues that this move creates value for its own stockholders because it can use its
In 1995 Disney acquired ABC television at a significant premium. Disney’s management justified much of this premium by arguing that the acquisition would guarantee access for Disney’s programs on
Company T is currently valued at $50 in the market. A potential acquirer, A, believes that it can add value in two ways: $15 of value can be added through better working capital management, and an
You have been hired by GS Investment Bank to work in the merger department. The analysis required for all potential acquisitions includes an examination of the target for any off-balance-sheet assets
The Boston Tea Company plans to acquire Hi Flavor Soda Co. for $60 per share, a 50 percent premium over current market price. John E. Grey, the CFO of Boston Tea, argues that this valuation can
Kim Silverman, CFO of the First Public Bank Company, notes: “We are fortunate to have a cost of capital of only 10 percent. We want to leverage this advantage by acquiring other banks that have a
In the 1980s leveraged buyouts (LBOs) were a popular form of acquisition. Under a leveraged buyout, a buyout group (which frequently includes target management)makes an offer to buy the target firm
During the early 1990s there was a noticeable increase in mergers and acquisitions between firms in different countries (termed cross-border acquisitions). What factors could explain this increase?
Mary Saxon, a Dutch investment banker, is advising a local client on a potential foreign acquisition in the U.S. Currently, there is a competing cash bid for the target by a U.S. competitor. However,
A leading retailer finds itself in a financial bind. It doesn’t have sufficient cash flow from operations to finance its growth, and is close to violating the maximum debt-toassets ratio allowed by
A banker argues: “I avoid lending to companies with negative cash from operations because they are too risky.” Is this a sensible lending policy?AppenidxLO1
Can Cambridge improve its Z score by behaving as the analyst claims in Question 6?Is this change consistent with economic reality?AppenidxLO1
Cambridge Construction Company follows the percentage-of-completion method for reporting long-term contract revenues. The percentage of completion is based on the cost of materials shipped to the
Betty Li, the CFO of a company applying for a new loan, argues: “I will never agree to a debt covenant that restricts my ability to pay dividends to my shareholders, because it reduces shareholder
Many debt agreements require borrowers to obtain the permission of the lender before undertaking a major acquisition or asset sale. Why would the lender want to include this type of
Some have argued that the market for original-issue junk bonds developed in the late 1970s as a result of a failure in the rating process. Proponents of this argument suggest that rating agencies
Why would a company pay to have its public debt rated by a major rating agency(such as Moody’s or Standard and Poor’s)? Why might a firm decide not to have its debt rated?AppenidxLO1
What are the critical performance dimensions for (a) a retailer and (b) a financial services company that should be considered in credit analysis? What ratios would you suggest looking at for each of
Joe states: “I can see how ratio analysis and valuation help me do fundamental analysis, but I don’t see the value of doing strategy analysis.” Can you explain to him how strategy analysis
Intergalactic Software Company’s stock has a market price of $20 per share and a book value of $12 per share. If its cost of equity capital is 15 percent and its book value is expected to grow at 5
Joe Klein is an analyst for an investment banking firm that offers both underwriting and brokerage services. Joe sends you a highly favorable report on a stock that his firm recently helped go public
Many market participants believe that sell-side analysts are too optimistic in their recommendations to buy stocks, and too slow to recommend sells. What factors might explain this bias?AppenidxLO1
There are two major types of financial analysts: buy-side and sell-side. Buy-side analysts work for investment firms and make stock recommendations that are available only to the management of funds
Three months ago, Intergalactic Software Company went public. You are a sophisticated investor who devotes time to fundamental analysis as a way of identifying mispriced stocks. Which of the
Investment funds follow many different types of investment strategies. Income funds focus on stocks with high dividend yields, growth funds invest in stocks that are expected to have high capital
What is the difference between fundamental and technical analysis? Can you think of any trading strategies that use technical analysis? What are the underlying assumptions made by these
Geoffrey Henley, a professor of finance, states: “The capital market is efficient. I don’t know why anyone would bother devoting their time to following individual stocks and doing fundamental
Despite many years of research, the evidence on market efficiency described in this chapter appears to be inconclusive. Some argue that this is because researchers have been unable to link company
Nancy Smith says she is uncomfortable making the assumption that Sigma’s dividend payout will vary from year to year. If she makes a constant dividend payout assumption, what changes does she have
Can accounting distortions, if not recognized by an analyst, affect cash flow-based valuations? Construct a numerical example to verify your answer.AppenidxLO1
Can accounting analysis improve accounting-based valuations? Explain why or why not.AppenidxLO1
Calculate the proportion of terminal values to total estimated values of equity and assets under the abnormal earnings method and the discounted cash flow method.Why are these proportions
Verify the terminal value calculations in Table 12-9. How will the terminal values in Table 12-9 change if the sales growth in years 2004 and beyond is 5 percent(keeping all the other assumptions in
Verify the present value calculations in Table 12-3. How will the present values in the table change if the cost of equity changes to 15 percent?AppenidxLO1
Calculate Sigma’s dividend payments in the years 1999–2003 implicitly assumed in the projections in Table 12-2. How will these payments change if the ratio of net debt to net capital is changed
Recalculate the forecasts in Table 12-2 assuming that the ratio of net operating working capital to sales is 30 percent, and the ratio of net long-term assets to sales is 50 percent. Keep all the
Recalculate the forecasts in Table 12-2 assuming that the NOPAT profit margin declines by 1.5 percent per year (keep all the other assumptions unchanged).AppenidxLO1
Verify the forecasts in Table 12-2. How will the forecasts change if the assumed growth rate in sales from 1999 to 2003 is changed to 15 percent (and all the other assumptions are kept
Janet Stringer argues that “the DCF valuation method has increased managers’focus on short-term rather than long-term performance, since the discounting process places much heavier weight on
Starite Company is valued at $20 per share. Analysts expect that it will generate free cash flows to equity of $4 per share for the foreseeable future. What is the firm’s implied cost of equity
Free cash flows (FCF) used in DCF valuations discussed in the chapter are defined as follows:FCF to debt and equity = Earnings before interest and taxes × (1 – tax rate)+ Depreciation and deferred
What type of companies have:a. a high PE and a low market-to-book ratio?b. a high PE ratio and a high market-to-book ratio?c. a low PE and a high market-to-book ratio?d. a low PE and a low
How can a company with a high ROE have a low PE ratio?AppenidxLO1
Analysts reassess Manufactured Earnings’ future performance as follows: growth in book value increases to 12 percent per year, but the ROE of the incremental book value is only 15 percent. What is
Given the information in question (3), what will be Manufactured Earnings’ stock price if the market revises its expectations of long-term average ROE to 20 percent?AppenidxLO1
Manufactured Earnings is a “darling” of Wall Street analysts. Its current market price is $15 per share, and its book value is $5 per share. Analysts forecast that the firm’s book value will
Explain why terminal values in accounting-based valuation are significantly less than those for DCF valuation.AppenidxLO1
Joe Watts, an analyst at EMH Securities, states: “I don’t know why anyone would ever try to value earnings. Obviously, the market knows that earnings can be manipulated and only values cash
Joe Fatcat, an investment banker, states: “It is not worth my while to worry about detailed long-term forecasts. Instead, I use the following approach when forecasting cash flows beyond three
How would the following events (reported this year) affect your forecasts of a firm’s future net income?• an asset write-down• a merger or acquisition• the sale of a major division• the
What factors are likely to drive a firm’s outlays for new capital (such as plant, property, and equipment) and for working capital (such as receivables and inventory)?What ratios would you use to
Which of the following types of businesses do you expect to show a high degree of seasonality in quarterly earnings? Explain why.• a supermarket• a pharmaceutical company• a software company•
John Right, an analyst with Stock Pickers Inc., claims: “It is not worth my time to develop detailed forecasts of sales growth, profit margins, etcetera, to make earnings projections. I can be
Merck is one of the largest pharmaceutical firms in the world. In the period 1985 to 1995 Merck consistently earned higher ROEs than the pharmaceutical industry as a whole. As a pharmaceutical
In a period of rising prices, how would the following ratios be affected by the accounting decision to select LIFO, rather than FIFO, for inventory valuation?• Gross margin• Current ratio•
What are the potential benchmarks that you could use to compare a company’s financial ratios? What are the pros and cons of these alternatives?AppenidxLO1
What ratios would you use to evaluate operating leverage for a firm?AppenidxLO1
ABC Company recognizes revenue at the point of shipment. Management decides to increase sales for the current quarter by filling all customer orders. Explain what impact this decision will have
What are the reasons for a firm having lower cash from operations than working capital from operations? What are the possible interpretations of these reasons?AppenidxLO1
Joe Investor claims: “A company cannot grow faster than its sustainable growth rate.” True or false? Explain why.AppenidxLO1
In 1995 Chrysler has a return on equity of 20 percent, whereas Ford’s return is only 8 percent. Use the decomposed ROE framework to provide possible reasons for this difference.AppenidxLO1
James Broker, an analyst with an established brokerage firm, comments: “The critical number I look at for any company is operating cash flow. If cash flows are less than earnings, I consider a
Which of the following types of firms do you expect to have high or low sales margins?Why?• a supermarket• a pharmaceutical company• a jewelry retailer• a software company AppenidxLO1
Which of the following types of firms do you expect to have particularly high or low asset turnover? Explain why.• a supermarket• a pharmaceutical company• a jewelry retailer• a steel company
The CFO of a large bank argues: “It is ridiculous to recognize any fair-value gains or losses on our debt instruments that we intend holding to maturity. Since we intend holding these securities,
In a meeting of the Board of Directors over a proposal to restructure, a firm’s CEO states: “I recommend we take as large a charge against current earnings as our auditors will permit, since Wall
In its 1998 annual report, Eastman Kodak reported the following information on its stock option program:Pro forma net earnings and earnings per share information, as required by SFAS No.123,
Eastman Kodak reported the following information on inventory valuation in its 1998 annual report:(In millions) 1998 1997 At FIFO or average cost (approximates current cost) $ 907 $ 788 Work in
In the contingent liability section of its 1998 annual report, Dow Chemical Company reported the following:Accruals for environmental matters are recorded when it is probable that a liability has
A firm hires a 27-year-old MBA at a salary of $85,000 for the first year. It also agrees to provide a pension upon retirement at age sixty-five and estimates that the present value of that pension is
Procter and Gamble is a consumer products firm that owns such brands as Pampers diapers, Crisco vegetable shortening, Tide laundry detergent, and Crest toothpaste.In its 1998 annual report, the
In 1997 Peoplesoft, a software company, presented the following footnote information in its annual report:The Company capitalizes software purchased from third parties if the related software product
On February 9, 1996, Walt Disney Co. acquired Capital Cities/ABC Inc. for $10.1 billion in cash and 155 million shares of Disney valued at $8.8 billion, based on the stock price at the date the
A firm purchases an asset for $10,000,000. Management forecasts that the asset will have an expected life of ten years and a salvage value of 5 percent. What are the financial statement effects from
A publishing company delivers 130,000 copies of a new textbook to bookstores during the year. The bookstores pay the publisher $10 per book, but have the right to be reimbursed for any books returned
A real estate developer sells land parcels to its customers and provides them with financing.In 2000, the first year of operation, the firm signed new land sale contracts for $25,000,000. This land
Consider a lessor that sells the right to use a depreciable asset, with a book value of$1,500, to a customer for two years for $1,000 per year, payable at the beginning of the year. At the end of the
A firm sells $200,000 of interest-bearing two-year notes receivable to a bank, with recourse, for $208,978. The interest rate on the notes is 10 percent, and the bank’s effective interest rate is
United Airlines sells a round-trip ticket for a flight from Boston to London for $750.The customer also receives 5,000 award miles, equivalent to 20 percent of the miles required for a free domestic
A firm signs a long-term contract to construct a building for $10,000,000. The building is to be completed in two years at a cost of $8,000,000. At the end of the first year,$6,000,000 of costs has
A customer pays $1,000 in advance for a service agreement. What are the financial statement effects of this transaction if (a) revenue is recognized at receipt of cash, and(b) revenue is recognized
For the first quarter of 1998, Microsoft reported the following reconciliation between net income and comprehensive income:Three Months Ended September 30 (millions of dollars): 1997 1998 Net income
As discussed in the chapter, on August 11, 1998, Helix Hearing Care of America Corp. sold $2 million of convertible debentures. The debentures had a five-year term and a 13 percent coupon rate and
As discussed in the chapter, Muscocho Explorations Ltd., Flanagan McAdam Resources, and McNellen Resources Inc. signed an agreement in January 1996 with their principal secured creditor, Canadian
At the end of fiscal year 1997, Intel reported that it had set aside a liability of $87.9 million for potential warranty costs. At the end of 1998, Intel increased this estimate to $115.5 million. As
Acceptance Insurance Companies Inc. underwrites and sells specialty property and casualty insurance. The company is the third largest writer of crop insurance products in the United States. In its
Hewlett Packard reported the following information on its U.S. retiree medical plan:Key Assumptions 1998 1997 1996 Discount rate 6.5% 7.0% 7.5%Expected return on assets 9.0% 9.0% 9.0%Current medical
As discussed in the chapter, Hanson Plc incurred an environmental liability from its 1991 acquisition of the U.S. firm Beazer. In 1997 the company reported that, based on third party appraisal, its
The cigarette industry is subject to litigation for health hazards posed by its products.The industry has been negotiating a settlement of these claims with state and federal governments. As the CFO
What are the economic costs and benefits to airlines from frequent flyer programs?What information would you need to measure these costs and benefits? As a financial analyst, what questions would you
As discussed in the chapter, the following restructuring events were reported by McCormick:a. In October 1994, the company announced plans to lay off 7 percent of its 8,600-person staff, close two
Give two examples of instruments designed to hedge changes in the fair values of assets or liabilities. When would you recommend that a firm hedge against changes in the fair values of its assets or
As the CFO of a company, what indicators would you look at to assess whether your firm’s long-term assets were impaired? What approaches could be used, either by management or an independent
A firm records bad debt expenses on an accrual basis for financial reporting and on a cash basis for tax reporting. In its 1999 annual report, it reported that the opening and closing balances in
What approaches would you use to estimate the value of brands? What assumptions underlie these approaches? As a financial analyst, what would you use to assess whether the brand value of £1.575
AT&T’s managers had a strong preference for recording the acquisition of NCR under the pooling of interests method. Indeed, the offer was actually contingent on approval for pooling. Why do you
In 1991 AT&T, the largest long-distance telephone operator in the U.S., paid $7.5 billion to acquire NCR, a computer manufacturer. Prior to the acquisition, the book value of NCR’s assets was $4.5
The American Society for Training and Development has recently advocated that firms be permitted to report training costs as an asset on their balance sheet. As a corporate manager, how would you

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