CFA 5

• 1) GDP-total goods produced in country boundaries
• 2) GNI - produced by residents of country, gross national income
• 3) NNI - GNI less depreciation, most accurate

• GDP
• +Net property income from abroad
• =GNI
• -depreciation
• =NNI

begin inv + purchases - end inv = COGS

Specific indentifcation: actual cost of specific items included in end inv

• HIGHEST -----> Lowest
• End Inv: Fifo, Avg Cost, LIFO
• COGS: LIFO, AVG, FIFO

inventory/cogs determined at end of period or continuously updated

B) Inventory_FIFO=Inventory_LIFO + LIFO Reserve

• Cash_FIFO=Cash_LIFO-(Reserve x tax rate)
• Equity_FIFO=Equity_LIFO+[reserve x (1-t)]

A) COGS_FIFO = COGS_LIFO - change in reserve

• Taxes_FIFO = Taxes_LIFO+Change in resrve x tax rate)
• NI_FIFO = NI_LIFO + [change in reserve x (1-t)]

CA/CL ->higher inventory is partially offset by lower cash from taes

Lower COGS/Avg inv, lower COGS and higher inv

lower, higher equity from LIFo reserve net of tax

higher profits - lower COGS, profits partially offset by higher taxes

expected increase in demand

decrease in demnad

decrease in demand, may be the result of exeessive or obsolete inventory

capitalize if there is a future economic benefit, immeditely expense if the future benefit is unlikely or uncertain

Capitalizing: involves depreciating asset's cost over its useful life

expensing: results in an immediate reduction of net income

• CFI
• CFO

• 1) add capitalized interest to interest expense
• 2) remove depreciation of CI from earnings
• 3) deduct CI net of related depreciation from fixed assets
• 4) add CI to CFI
• 5) deduct CI from CFO
• 6) recalc interest coverage and profitability ratios

IFRS: resarch costs are expense as incurred but development costs are capitalized

GAAP: R&D costs are expensed as incurred

• For sale:
• IFRS/GAAP: expensed as incurred until feasibility is reached

• InternaL:
• IFRS: same as software developed for sale
• GAAP: capitalize all software development costs

SL= (Cost-salvage value) / useful life

DDB (Cost - Acc Depⁿ) x (2/useful life)

UOP = (Cost - Salvage value) x (unis used/ total capacity)

asset is imparied when book value (historical cost - acc. deprec) > recoverable amount

recoverable amount is greater of "fair value less selling costs" and "value in use"

• if impaired:
• -write-down asset to recoverable amount and recognize loss in I.S.
• -loss reversal is allowed up to original loss

1)identify impariemnt-impaired when book value > asset's estimated future undiscounted cash flows

2) loss recognition - if impaired, write down to fair value and put loss on I.S.

-loss reversal is prohibited for assets "held-for-use"

C) BS: reduces assets, liabilities (deferred taxes), and S.E.

IS: loss decreases current period net income; in future periods, reduced deprec. results in higher net income

CF: unaffected

Disclosure: MD&A, footnotes

1) fixed asset and total asset turnover ratios: increase due to reduced assets

2)debt-to-equity ratio: increases due to reduced equity

3) current year ROA and ROE: decrease, % reduction in net income > % reduction in Assets/equity

4) future ROA and ROE: increase due to lower assets and equity, higher net income with lower depreciation

• GAAP: depreciated historic cost
• IFRS: depcreciated historic cost or fair value

historical cost/ annual depⁿ

accum depⁿ/annual depⁿ

Net Book Value / Annual Depⁿ

1) title to the leased asset is transferred to the lessee at the end of the lease

2) a bargain purchase option exists

3) the lease term is >75% of the asset's economic life

4) the PV of the lease payments >90% of the leased asset's fair value

Treat as if leased asset was purchased with debt

Lower of fair value or PV of future lease payments reported as balance sheet ASSET AND LIABILITY

depreciated over time

interest expense is recognied on liability

lease payments treated like amortizing debt - each payment is part interest (CFO) and part principal (CFF)

• finance:
• -lessor reports lease receivable on BS
• -treat as either sale-type lease or direct-financing lease

• operating:
• -lessor reports leased asset on bs
• depreciation expense on asset
• lease payments as rental income

lessor is typically a dealer or the asset

PV of lease payments > carrying value of leased asset

lessor is not the dealer

PV of lease payments = carrying value of leased asset

financial assets <20%

• investments in associates 20-50%
• -equity method

• Busines combinations >50%
• -acquisition method

• shared control by 2+= joint venture
• -IFRS: proportionate consolidation
• -GAAP: equity method

GAAP: Equity

IFRS: proportionate consolidation or equity

• debt securities where the company has the intent and ability to hold to maturity
• Initially reported:
• GAAP: cost including transaction costs
• IFRS: Fair value including tranasction costs
• COST METHOD

debt and equity securities acquired for the purpose of selling in the near future

MARKET METHOD

debt and equity that are neither held-to-maturity nor trading securities

HYBRID

management has the option to report held-to-maturity or available-for-sale assets at fair value

treated like Held-for-trading

FX gains and losses on debt to income statement in IFRS not GAAP

balance sheet: reported at cost + earnings - dividents

IS: earnings

• representation on board of directors
• participation in policy making
• material transactions between the parties
• interchange of key personnel
• technological dependency

Influence: finance, operating, amount and timing of dividends

fair value < carrying value AND deemed to be permanent

asset written down to fair value and impariemnt loss on IS

no reversal in GAAP or IFRS

upstream profit on transaction in associates accounts (Dunder Mifflin sells paper to Sabre)

downstream profit on transaction in parent's accounts (sabre sells printers to Dunder mifflin)

both must eliminate proportionate share of profit from equity income

1) elminate investment account of parent and equity accounts of subsidiary

2) create minority interest (share of equity not owned)

3) combine assets and liabilities of both firms (net of intercompany transactions)

4) eliminate subsidiary earnings from parent

5) subtract minority share of earnings (share of earnings not owned)

6) combine revenues and expenses of both firms (net of intercompany transactions)

equity method for GAAP

• 1) net profit margin overstated
• 2) ROA overstated
• 3) debt ratios skewed

• 1) jointly controlled entities: sharing control of a separate entity
• 2) jointly controlled operations: each venture uses its own assets for a shared project
• 3) jointly controlled assets: a project carried out with assets that are jointly owned

• GAAP requires full
• IFRS allwos bowth

full goodwill = total fair value of subsidiary minus FV of net identifiable assets

Partial: goodwill is purchase price, minus the % owned times fair value of net identifiable assets

• 1)
• IFRS: allocated across cash generating units that will benefit from acquisition
• GAAP: Allocated across reporting units: operating segment or component

• 2)
• IFRS: One-step process
• -if recoverable amount < carrying value, recognize difference as impairment

• GAAP: 2-step process
• -if fair value of reporting unit < carrying value, goodwill is impaired
• -amount of impairment is unit's reported goodwill - current fair value of unit's goodwill

• 3)
• IFRS: if loss is greater than unit goodwill, remainder is allocated to impairment of other assets of the cash generating assets

GAAP: If loss is greater than the current fair value of a unit goodwill, unit goodwill is reduced to zero, no other allocation of impairment amount

EQUITY METHOD = best ratios

IS = employer contribution

BS = asset/liability = excess or shortfall in payments relative to specified contribution

no issues for analyst

pension benefits are based on future compensation

PBO: projected benefit obligation: PV of all future pension payments earned to date based on expected salary increases overtime. Going concern basis

ABO, accumulated benefit obligation: PV of all future pension payments earned to date based on current salary levels, liability on liquidation basis

Vested benefit obligation: only vested units

IAS 19: a measure of Defined benefit obligation similar to PBO

SC: change in PBO attributed to employees efforts during the year. The actuarial PV of pension benefits earned in a year

IC: increase in the PBO resulting from passage of time: PBO at start of period x discount rate

Actuarial g/l: g/l resulting from changes in actuarial assumptions

Prior service costs: retroactive benefits awarded to employees

Benefits paid: payments made from the fund to retirees

• Beninning PBO
• +Service Cost
• +Interest Cost
• +/- Actuarial g/l
• + prior service cost
• - benefits paid
• ________
• Ending PBO

• Fair value at start of year
• +/- actual return on plan assets
• + Employer contributions
• - benefits paid to retirees
• ______
• fair value of plan asset at year end

• Net period benefit costs
• +service costs
• + interest costs
• -expected return on plan assets
• +/- amortization of g/l
• + amortization of prior service costs
• +/- amortization of transition (asset)/liability
• ___________
• Pension expense on IS

• 1) discount rate
• 2) expected return on plan assets
• 3) rate of compensation increase

• balance sheet (through effect on PBO)
• disclosures (ABO, VBO)
• income statement (pension cost)

• 1) deferred g/l
• -from changes in actuarial assumptions affecting the PBO
• -from differences in the actual and expected return on plan assets

• 2) trasition assets and liabilities
• -artifact of implementation of new accounting rule in 1985

• Funded status: +overfunded -underfunded
• Deferred (gain)/loss +/-
• Transition (asset)/liab +/-
• ___________

Balance sheet (liability)/asset

Total IS effect = service + interest - actual return

• Ending PBO
• -Beginning PBO
• =Change in PBO
• +benefits paid
• -actual return on assets
• =Economic pension expense

• > : principal payment
• CFO up, CFF down

< : borrowing

• 1) exercise price
• 2) stock price at the grant date
• 3) expected term
• 4) expected volatility
• 5) expected dividends
• 6) risk-free rate

1) currency that influences sales prices for goods and services

2) currency of the country that determines prices

3) currency that influences labor, material and costs

4) currency form in which funds are generated

5) currency which reciepts from operating activities are usually retained

current: exchange rate on the balance sheet date

avg: average over period

historical rate: actual rate during transaction

where cumulative inflation exceeds 100% over a 3-year period

purpose: offset exposure to changes in fiar value of an asset/liab

recog: gains and losses are recognized in the IS

offset exposure to variable cashflows from anticipated transactions

G/L report in equity. The gains and losses are eventually recognized in the IS

offest exposure from an existing investment in a foreign sub

g/L are recognized in equity along with translation g/l

• 1) indepedent audit
• 2) board of diretors
• 3) certification by senior management
• 4) class action litigation

accruals^BS = NOA_END - NOA_BEG

accruals ratio^BS=[(NOA_end-NOA_beg)]/[(NOA_end+NOA_beg)/2]

accruals^CF = NI - CFO - CFI

accruals^CF =

[NI - CFO - CFI] / [(NOA_END+NOA_BEG)/2]

(sales - COGS - SG&A) / sales

• 1) replacement projects to maintain the business
• 2) replacement projects for cost reduction
• 3) expansion projects
• 4) new product or market development
• 5) mandatory
• 6) other

• 1) decisions are based on cash flows, not accounting income
• 2) cash flows are based on opportunity costs
• 3)timing of cash flows is important
• 4) cash flows are analyzed on an after-tax basis
• 5) financing costs are reflected in the project's required rate of return

for capital budgeting purposes, we should use the same depreciation method used for tax reporting since captial budgeting analysis is based on after-tax cash flows and not accounting income

outlay = FCInv + NWCInv

NWCInv = change in non-cash current assets - change in non-debt current liab = change in NWC

CF = (S-C)(1-T)+(TD)

• S = sales
• C = cash operating costs
• D = depreciation expense
• T = Marginal tax rate

• TNOCF = Sal_T + NWCInv - T (Sal_T-B_T)
• Sal_T=pre-tax cash proceeds from sale of fixed capital
• B_T = book value of the fixed capital sold

outlay = FCInv + NWCInv - Sal₀+T(Sal₀-B₀)

hard: occurs when the funds allocated to managers under the capital budge can't be increasesd

soft: managers are allowed to incrase their allocated budget if they can justify

results in a probability distribution of project NPV outcomes, rather than just a limited number of outcomes as with sensitivity or scenario analysis.

risk analysis technique that considers both the sensitivity of some of key output variable to changes in a key input variable

allow managers to make future decisions that change the value of capital budgeting decisions

• timing
• abandonment
• expansion
• flexibility (price-setting,production)
• fundamental option (copper mine, open if profitable)

economic income = cash flow + ending market value - beginning market value

economic income = cash flow - economic depreciation

economic income = beginning market value - ending market value

reported net income on financial statements

• 1) accounting deprec is based on the orgininal cost
• 2) financing costs are considered as a separate line item and subtracted out to arrive at net income. in capital budgeting, financing costs are reflected in WACC

EP = NOPAT - $WACC

• NOPAT = net operating profit after tax
• $WACC = dollar cost of capital = WACC x capital
• capital = dollar amount of investment

NPV = MVA = Sum of [EP_t / (1+WACC)^t]

RI_t = NI_t - r_eB_t-1

• RI = residual income in period t
• NI = net income in period t
• r = required return on equity
• B=beginning of period book value of equity

divides operating cash flows based on the claims of deby and equity holders that provide capital to the company

calculates the value of the company, not the project. this is different from the economic profit and residual income approahes, which calc both project and company value

MM 1958: no taxes, no costs of financial distress

to

MM 1963: taxes, no costs of financial distress

to

Static trade-off theory with taxes and costs of financial distress

• -capital markets are perfectly competitive
• -investors have homogeneous expectations
• -riskless borrowing and lending
• -no agency costs
• -investment decisions are unaffected by financing decisions

no taxes

value of levered firm = value of unlevered firm

capital structure doesn't matter

• no taxes
• cost of equity increases linearly as a company increases its proportion of debt financing

tax shield provided by debt

V_L=V_U+(t x d)

optimal structure is 100% debt

increased costs a company faces when earnings decline and the firm has trouble paying its financing costs

• 1)direct/indirect: direct fees, legal
• -indirect: lost opportunities

2)probability of financial distress: use of leverage

costs associated with the conflicts of interest between managers and owners

• 1) monitoring costs
• 2) bonding costs (non-competes, etc)
• 3) residual losses

signals management sends to investors through financing

• most favored to least favored
• -internally generated equity
• -debt
• -external equity

seeks to balance the costs of financial distress with the tax shield benfits from using debt

V_L=V_U +(t x d)-PV(costs of financial distress)

• 1) changes in structure over time
• 2) relative to competitors with similar business risk
• 3) company-specific factors

• 1) total debt
• 2) debt maturity
• 3) emerging market difference

change in P = [D(1-T_D)] / (1-T_CG)

• 1) investment opportunities
• 2) expected volatility of future earnings
• 3) financial flexibility
• 4) tax considerations
• 5) flotation csots
• 6) contractual /legal restrictions

effective tax rate = corporate tax rate + (1-corporate tax rate)(individual tax rate)

double taxation

earnings distributed as dividends are taxed at a lower rate

taxes paid at corporate level but are attributed to the shareholder, so all taxes are effectively paid at the shareholder rate

previous dividend + expected increase in EPS x target ratio ratio x adjustment factor

adjustment = 1/number of years which the adjustment in dividends will take place

dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget

• 1) potential tax advantages
• 2) share price support/signaling
• 3) added flexibility
• 4) offsetting dilution from employee stock options
• 5) increasing financial leverage

1) lower proportion of US companies pay dividends as compared to europeans

2) proportion of firms paying cash dividends has trended downward

3) % of companies making stock repurchases has been trending upwards

FCFE coverage ratio - FCFE / (Dividends + share repurchases)

the system of principles, policies, procedures, and cleraly defined responsibilities and accountabilities used by stakeholders to overcome conflicts of interest inherent in the corporate form

• 1) eliminate or reduce conflicts of interets
• 2) use the company's assets in a manner consistent with the best interests of investors and other stakeholders

businesses owned by a single individual

conflicts between creditors and suppliers

2 or more owners/managers

creditors and supplires, potential conflicts between partners, can be addresssed by delineating rolse and responsibilities

• distrinct legal entities that have rihgts similar to those of an individual
• -easier to raise capital
• -ownership is transferable
• -limited liability

conflicts: agency. conflict between shareholders and management

using funds to expand the size of the firm

granting excessive comp and perquisites

investing in risky ventures

not taking enough risk

lack of independence

board members have personal relationships with management

board members have consulting agreements with firm

interlinked boards

directors are overcompensated

• 1) code of ethics
• 2) directors' oversight/review responsibliities
• 3) management's responsibility to the board
• 4) reports of directors' oversign
• 5) board self assessments
• 6) management performance assessments
• 7) director training

1) lowers value of company by increasing risks

2) financial disclosure risk

3) asset risk

4) liability risk

5) strategic policy risk

acquiring company acquires all the target's assets and liabilities

company becomes a subsidiary of the purchaser

both companies cease to exist in their prior form

two businesses operate in the same industries/competitors

acquiring company seeks to move up or down the product value chain. ice cream manufactuere acquires restaurant chain

2 companies operate in completely separate industries

way of packaging the combined earnings from two companies after a merger so that the merger generates an increase in the earnings per share

• stock
• -made directly to target company shareholders in exchange for their shares
• -majority shareholder approval required
• -none
• -shareholdres pay capital gains tax
• -acquirer assumes liabilities of target

• asset purchase
• -made directly to target company
• -no approval needed
• -target company pays capital gains taxes
• -none
• -acquirer usually avoids assumption of target's liabilities

1) distribution between risk and reward for the acquirer and target shareholders

2) relative valuations of companies involved

3) changes in capital structure

gives current shareholders right to purchase additional shares at low prices

focus on bondholders, puts give bondholders ths option to demand immediate repayment of their bonds if there is a hostile takeover

board split into 3 equal sized groups with staggered election

equity ownership above x% triggers loss of voting rights unless approved by board

increases majority to 66% or greater

restricts merger offer unless fair, as determined by some formula

gives managers lucrative cash payouts if they leave the target company after a merger

payoff to potential acquirer to terminate the hostile takeover attempt

target assumes a large amount of debt that is used to finance share repurchases

• -target sell a major asset to 3rd party
• -try to acquire the acquirer
• -3rd party comes to counter bid
• -3rd party buys minority stake

1890: The sherman antitrust act: made monopoly illegal, not enforceable

1914: The Clayton Antitrust Act: created FTC to enforce

1950: the Celler-Kefauver Act: addressed weaknesses in 1914 act

1976: the Hart-Scott-Rodino Antitrust: required all potentail mergers to be reviewed and approved by FTC

HHI = sum of (MS_i x 100)²

MS_i=market share of firm i

• 1) determine which cash flow model to use
• -2, 3 stage, etc

• 2) develop pro-forma financial estimates
• 3) calculate free cash flows using the pro forma data
• 4) discount CFs back to present
• 5) determine terminal value and discount back
• 6) add the FCF for the first stage and terminal value to determine final value

• Net Income
• +Net Interest after tax
• =Unlevered net income

• +_ change in deferred taxes
• =NOPLAT
• +net noncash charges
• +_change in NWC
• - capital expenditures
• =FCF

NWC = current assets - current liabN

et interest after tax = (interest expense - interest income) * (1-t)

terminal value_T = [FCF_T*(1+g)] / (WACC_adjusted - g)

• 1) find comp firms
• 2) calc multiples
• 3) calc descriptive stats and apply to firm
• 4) estimate takeover premium
• 5) calc the estimated takeover price for the target as the sume of estimated stock value based on comps and takeover premium

TP = (DP - SP) / SP

• TP = takeover premium
• DP = deal price per share
• SP = target co's stock price

1: identify a set of recent takeover transactions

2: calc various relative value measures based on completed deal prices for the companies in the sample

3: calc descriptive stats for the relative value metrics and apply those measures to the target firm

V_AT=V_A+V_T+S-C

• A: acquirer
• T: Target
• S=synergies
• C=cash paid to target shareholders

• Gain_T=TP=P_T-V_T
• TP: takeover premium
• P= price paid for target
• V=pre-merger value of target

• Gain_A=S-TP=S-(P_T-V_T)
• synergies - takeover price

cash offer: acquirer assumes the risk and potential reward.

stock offer: some risks shift to target firm

comapny selling a division or subsidiary

create a new independent company by giving equity interest in a subsidiary to outside shareholders

like carve-outs in that they create a new independent company that is distinct from the parent company

allow shareholders to receive new shares of a division of the parent comapny in exchange for a portion of their shares in the parent company

break up the firm and sell its asset piece by piece, most associated with bankruptcy

• 1) division no longer fits into management's long-term strategy
• 2) lack of profitability
• 3) individual parts are worth more than the whole
• 4) infusion of cash