Mc Inc. Part One Questions [1-6] and Part Two Questions (1-8] Individual case assignment. Each student is to hand-in the case write-up to me at the beginning of class. NOTE: This case is a review of basic accounting and basic finance, both of which are prerequisites for the course. You should find this tedious, and you might make a few small mistakes, which is normal; after talking through the solutions in class you should feel comfortable that you could redo everything correctly with ease. [On the other hand, if you find yourself completely overwhelmed by this exercise, then the remainder of the course will prove exceedingly difficult.] 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 IRRO) 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 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% Hint: while the company only operates for 5 years (i.e., it only generates Sales Revenue for 5 years), you will need to create a spreadsheet that has 7 columns: Year 0 (right after the initial investment), Year 1, Year 2, Year 3, Year 4 Year 5, & Year 6. Part I Questions What is the total initial investment that is required at the beginning of the first period in order to start Mc Inc.? Compute the value of Mc Inc. immediately after the initial investment at the beginning of period 1 using the discounted free cash flow method. (You may find it helpful to fill-out Table 1 on the next page.) Compute Mc Inc.'s internal rate of return. Prepare financial statements (income statements and balance sheets) for Mc Inc. for each of the five periods that it is in business. Compare Mc Inc.'s free cash flows and earnings for each of the five periods. Overall, which of the two measures do you think provides the best measure of Mc Inc.'s periodic performance? Why? Compute Mc Inc.'s return on equity (ROE, computed as earnings for the period divided by book value of equity at the beginning of the period) for each of the five periods. Compare Mc Inc.'s ROE for each period to Mc Inc.'s IRR and provide a qualitative explanation for any major differences. (You may find it helpful to fill-out Table 2 on the next page.) Mc Inc. Part One Questions [1-6] and Part Two Questions (1-8] Individual case assignment. Each student is to hand-in the case write-up to me at the beginning of class. NOTE: This case is a review of basic accounting and basic finance, both of which are prerequisites for the course. You should find this tedious, and you might make a few small mistakes, which is normal; after talking through the solutions in class you should feel comfortable that you could redo everything correctly with ease. [On the other hand, if you find yourself completely overwhelmed by this exercise, then the remainder of the course will prove exceedingly difficult.] 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 IRRO) 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 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% Hint: while the company only operates for 5 years (i.e., it only generates Sales Revenue for 5 years), you will need to create a spreadsheet that has 7 columns: Year 0 (right after the initial investment), Year 1, Year 2, Year 3, Year 4 Year 5, & Year 6. Part I Questions What is the total initial investment that is required at the beginning of the first period in order to start Mc Inc.? Compute the value of Mc Inc. immediately after the initial investment at the beginning of period 1 using the discounted free cash flow method. (You may find it helpful to fill-out Table 1 on the next page.) Compute Mc Inc.'s internal rate of return. Prepare financial statements (income statements and balance sheets) for Mc Inc. for each of the five periods that it is in business. Compare Mc Inc.'s free cash flows and earnings for each of the five periods. Overall, which of the two measures do you think provides the best measure of Mc Inc.'s periodic performance? Why? Compute Mc Inc.'s return on equity (ROE, computed as earnings for the period divided by book value of equity at the beginning of the period) for each of the five periods. Compare Mc Inc.'s ROE for each period to Mc Inc.'s IRR and provide a qualitative explanation for any major differences. (You may find it helpful to fill-out Table 2 on the next page.)