HINT1: Your first important task is to agree on the facts. The facts relate primarily to cash flows, so make sure you have the cash flows accurately mapped out on a timeline. HINT2: The exercise is intentionally based on restricted assumptions, including (i) NO CASH BALANCES, (ii) NO CREDITORS (i.e., no payables, no debt), (iii) NO TAXES. Do not make any additional assumptions beyond those specified. HINT3: The (i) NO CASH BALANCES assumption means there are no cash balances. Anytime. Not at the end of period 0. Never. HINT4: When the exercise asks you to use the "discounted free cash flow" method, don't try to force the facts into the robotic definition of free cash flows you may have learned previously. Free cash flows here simply means the net of cash inflows minus cash outflows each period. HINT5: For PART I Questions, the answers to the first several questions (or hints) are as follows: #1. $4,100; #2. $5,783.65 (i.e., $9,883.65 is incorrect); #3. Use the IRR() function in Excel; #4. You should get the same income #s for periods 1-5. HINT6: In PART II, the additional case facts mean cash flows get reduced by $600 in period 1, but increase by $400 in periods 1, 2 and 3. Introduction 101 Mc Inc. is more like a detailed problem than a case. It is designed: To provide a review of basic accounting and basic finance To illustrate the impact of aggressive and conservative accounting on the quality of earnings; To illustrate the correspondence between the discounted free cash flow model (DCF) and the residual income model (RIM) approach to equity valuation. Mc Inc. is a very simple corporation that operates a business for just five years. At the end of each year, all free cash flow generated by the business is paid out to the owners as a dividend. The case proceeds in Three Part. In Part I we value Mc Inc. using the traditional DCF approach and we also compute Mc Inc.'s internal rate of return (IRR) and prepare accrual-based financial statements for Mc Inc. In Part II of the case introduces a marketing project representing an incremental investment opportunity for Mc Inc. By considering different methods of accounting for the marketing project, we illustrate the impact of aggressive and conservative accounting on the quality of earnings. In Part III of the case requires you to use the Residual Income Model (RIM) approach to valuing Mc Inc. This portion of the case illustrates the correspondence between the DCF and RIM approaches to valuation and also illustrates the robustness of RIM valuations to accounting distortions. (We will do Part III of this case later in the course, after we learn the RIM.) Initial Case Facts Mc Inc. commences business and engages in operating activities for 5 periods, with data as follows: The initial required investment in plant and equipment at the beginning of the first period (end of Year 0) is $2,500. The plant and equipment have a 5-year useful life and zero salvage value. For accounting purposes the plant and equipment is depreciated using the straight-line method. Depreciation expense is treated as a separate operating expense (i.e., it is not included in COGS). Mc Inc. earns $3,000 in sales revenue each year for 5 years. Half of the revenue is collected in cash at the end of the year in which the sale is made and the other half is collected in cash at the end of the following year. COGS is $1,600 each year and represents the inventory sold. Mc Inc. has to purchase the inventory with cash at the end of the year prior to the year in which inventory is sold. There are no other expenses or sources of income and no other required working capital or investment requirements. And there are no taxes. At end of each period, all free cash flow is paid as out as a dividend (i.e., if free cash flow is negative, then shareholders must contribute capital, such that the CASH balance is equal to zero at the end of each accounting period.) The discount rate is 10% Me Inc. -Part II Additional Case Facts: An incremental investment project is available to Mc Inc., with data as follows: Mc Inc. can engage in a marketing campaign during period 1, with total marketing costs of $600, payable in cash at the end of period 1. The marketing project increases cash inflows at the end of periods 1, 2 and 3 by $400 per period. (i.e., Increases Cash Revenues by $400 per period without a corresponding increase in COGS; Accounts Receivables are also unaffected, because the incremental Revenues are collected in cash.) All other facts remain the same. Part II Questions Compute the value of Mc Inc. with the incremental project immediately after the initial investment at the beginning of period 1 using the discounted free cash flow method. Should Mc Inc. invest in the incremental project? Compute Mc Inc.'s IRR with the incremental investment project. Assume that Mc Inc. accounts for the incremental marketing project by expensing all marketing costs in the period that they are incurred. Prepare financial statements for each of the five periods under this accounting assumption. Do you think that this accounting assumption is aggressive, conservative or neutral? Assume that Mc Inc. accounts for the incremental marketing project by capitalizing marketing costs and then amortizing them in proportion to the benefits received. Prepare financial statements for each of the five periods under this accounting assumption. Do you think that this accounting assumption is aggressive, conservative or neutral? Assume that Mc Inc. accounts for the incremental marketing project by capitalizing marketing costs and then expensing all of these costs in the first period in which no benefits are received from the project. Prepare financial statements for each of the five periods under this accounting assumption. Do you think that this accounting assumption is aggressive, conservative or neutral? Which of the above three accounting methods do you think provides the best measure of Mc Inc.'s periodic performance? Why? Compute Mc Inc.'s ROE for each of the five periods using each of the above three accounting methods. Explain how each of the different accounting methods impacts Mc Inc.'s ROE. Using the insights from the Mc Inc. example, provide a qualitative explanation of the impact of aggressive and conservative accounting on a firm's ROE relative to its IRR. HINT1: Your first important task is to agree on the facts. The facts relate primarily to cash flows, so make sure you have the cash flows accurately mapped out on a timeline. HINT2: The exercise is intentionally based on restricted assumptions, including (i) NO CASH BALANCES, (ii) NO CREDITORS (i.e., no payables, no debt), (iii) NO TAXES. Do not make any additional assumptions beyond those specified. HINT3: The (i) NO CASH BALANCES assumption means there are no cash balances. Anytime. Not at the end of period 0. Never. HINT4: When the exercise asks you to use the "discounted free cash flow" method, don't try to force the facts into the robotic definition of free cash flows you may have learned previously. Free cash flows here simply means the net of cash inflows minus cash outflows each period. HINT5: For PART I Questions, the answers to the first several questions (or hints) are as follows: #1. $4,100; #2. $5,783.65 (i.e., $9,883.65 is incorrect); #3. Use the IRR() function in Excel; #4. You should get the same income #s for periods 1-5. HINT6: In PART II, the additional case facts mean cash flows get reduced by $600 in period 1, but increase by $400 in periods 1, 2 and 3. Introduction 101 Mc Inc. is more like a detailed problem than a case. It is designed: To provide a review of basic accounting and basic finance To illustrate the impact of aggressive and conservative accounting on the quality of earnings; To illustrate the correspondence between the discounted free cash flow model (DCF) and the residual income model (RIM) approach to equity valuation. Mc Inc. is a very simple corporation that operates a business for just five years. At the end of each year, all free cash flow generated by the business is paid out to the owners as a dividend. The case proceeds in Three Part. In Part I we value Mc Inc. using the traditional DCF approach and we also compute Mc Inc.'s internal rate of return (IRR) and prepare accrual-based financial statements for Mc Inc. In Part II of the case introduces a marketing project representing an incremental investment opportunity for Mc Inc. By considering different methods of accounting for the marketing project, we illustrate the impact of aggressive and conservative accounting on the quality of earnings. In Part III of the case requires you to use the Residual Income Model (RIM) approach to valuing Mc Inc. This portion of the case illustrates the correspondence between the DCF and RIM approaches to valuation and also illustrates the robustness of RIM valuations to accounting distortions. (We will do Part III of this case later in the course, after we learn the RIM.) Initial Case Facts Mc Inc. commences business and engages in operating activities for 5 periods, with data as follows: The initial required investment in plant and equipment at the beginning of the first period (end of Year 0) is $2,500. The plant and equipment have a 5-year useful life and zero salvage value. For accounting purposes the plant and equipment is depreciated using the straight-line method. Depreciation expense is treated as a separate operating expense (i.e., it is not included in COGS). Mc Inc. earns $3,000 in sales revenue each year for 5 years. Half of the revenue is collected in cash at the end of the year in which the sale is made and the other half is collected in cash at the end of the following year. COGS is $1,600 each year and represents the inventory sold. Mc Inc. has to purchase the inventory with cash at the end of the year prior to the year in which inventory is sold. There are no other expenses or sources of income and no other required working capital or investment requirements. And there are no taxes. At end of each period, all free cash flow is paid as out as a dividend (i.e., if free cash flow is negative, then shareholders must contribute capital, such that the CASH balance is equal to zero at the end of each accounting period.) The discount rate is 10% Me Inc. -Part II Additional Case Facts: An incremental investment project is available to Mc Inc., with data as follows: Mc Inc. can engage in a marketing campaign during period 1, with total marketing costs of $600, payable in cash at the end of period 1. The marketing project increases cash inflows at the end of periods 1, 2 and 3 by $400 per period. (i.e., Increases Cash Revenues by $400 per period without a corresponding increase in COGS; Accounts Receivables are also unaffected, because the incremental Revenues are collected in cash.) All other facts remain the same. Part II Questions Compute the value of Mc Inc. with the incremental project immediately after the initial investment at the beginning of period 1 using the discounted free cash flow method. Should Mc Inc. invest in the incremental project? Compute Mc Inc.'s IRR with the incremental investment project. Assume that Mc Inc. accounts for the incremental marketing project by expensing all marketing costs in the period that they are incurred. Prepare financial statements for each of the five periods under this accounting assumption. Do you think that this accounting assumption is aggressive, conservative or neutral? Assume that Mc Inc. accounts for the incremental marketing project by capitalizing marketing costs and then amortizing them in proportion to the benefits received. Prepare financial statements for each of the five periods under this accounting assumption. Do you think that this accounting assumption is aggressive, conservative or neutral? Assume that Mc Inc. accounts for the incremental marketing project by capitalizing marketing costs and then expensing all of these costs in the first period in which no benefits are received from the project. Prepare financial statements for each of the five periods under this accounting assumption. Do you think that this accounting assumption is aggressive, conservative or neutral? Which of the above three accounting methods do you think provides the best measure of Mc Inc.'s periodic performance? Why? Compute Mc Inc.'s ROE for each of the five periods using each of the above three accounting methods. Explain how each of the different accounting methods impacts Mc Inc.'s ROE. Using the insights from the Mc Inc. example, provide a qualitative explanation of the impact of aggressive and conservative accounting on a firm's ROE relative to its IRR