Chapter 4

Question 1

Growth in CSE

Answer 1

= [CSE(EP) - CSE(BP)]/CSE(BP) x100%

Question 2

CSE(EP)

Answer 2

= CSE(BP) + CE - Div

Question 3

AE

Answer 3

= (ROCE - re) x CSE (BP)

or

= CE - r*CSE(BP)

Question 4

Growth in AE

Answer 4

= [(AE previous - AE current)/ AE previous] x 100%

Question 5

ROCE (yr, FIFO)

Answer 5

= [CE/CSE (BP)] x 100%

Question 6

Conservative Accounting

Answer 6

= carrying value of net assets is lower than otherwise. Thus, conservative acc. yields higher intrinsic P/B ratios. This is also observed in the results above.

= result in reduced earning & lower book value’

Examples:

• expensing R&D expenses vs capitalizing
• accelerated depn & amortization methods
• overestimates of liabilities and expenses
• underestimates of revenue and income
• higher provision for doubtful debts: lower earnings & lower acc. receivable

Question 7

Calculate the value of the company equity using PVAE model

Answer 7

CE
- Div
= Retained

CSE(EP)
E(CE)
E(AE)
Discount PV rate
= PV

Question 8

Accounting - based meaures

Answer 8

1. comprehensive earnings (CE) $
2. Return on Common Equity (ROCE/ROE) %
3. Abnormal Return on Common Equity (AROCE) %
4. Abnormal Earnings (AE) $

Question 9

Market - based measures

Answer 9

1. Stock Return (SR) $
2. Stock Rate of Return (SRR) %
3. Stock Abnormal Rate of Return (SARR) %
4. Stock Abnormal Return (SAR) $

Question 10

Accounting-based measure: Comprehensive Earnings (CE)

Answer 10

= change equity - net payout to owners (d)

CE current = CSE current - CSE beginnning + Net div. (d)

Note: change equity = closing CSE - Opening CSE
and Net Payout to owners (d) = Dividends paid + shares buy back - shares issued

Question 11

Accounting-based measure: ROCE = ROE

Answer 11

Based on opening book value:
ROCE = CE current/ CSE(BP) X 100%

Based on average book value:
CE/[1/2(CSE(BP) + CSE(EP))]

Question 12

Accounting-based measure: Abnormal ROCE %

Answer 12

= ROCE - re

where re = Rf + Be(Rm - Rf)

Question 13

Accounting-based measure: Abnormal Earning

Answer 13

= CE - (re X CSE(BP))

Alternatively:

AE = AROCE x CSE (BP)
= (ROCE - re) x CSE(BP)

where
AE > 0 if ROCE > re creating economic value
AE< 0 if ROCE < re destroying economic value
AE = 0 if ROCE = re firm earns a normal rate of return

Question 14

Reason for -ve & -ve AE

Answer 14

+ve - firm may be in an attractive industry & its strategic position may enable it to generate returns on (ROCE) common equity in excess of its cost of equity (re) in the SR.

-ve - the firm might be at some competitive disadvantage in the SR, leading to subnormal AE. Alternatively, firm may be very skilled ( or underskilled) in financial engineering & may be able to generate supernormal (or subnormal) economic profits.

Question 15

Market-based measures: Stock Return (SR)

Answer 15

= change MV + d

where
change MV = MV(EP) - MV(BP)
d = CE + CSE(BP) - CSE(EP)
CE = CSE(EP) - CSE(BP) + d

SR = CE + (MV - CSE) current - (MV - CSE) beginning
= CE + change (price to book premium)

Question 16

Market-based measure: Stock Rate of Return (SRR)

Answer 16

1. = (change MV + d) / MV(BP) x 100%
2. = SR/MV(BP) x 100%
   = CE + [(MV - CSE) end - (MV-CSE) beginning] / MV beginning
   = [(ROCE x CSE(BP)) x change (PB premium)] / MV(BP)
   = ROCE x (CSE(BP)/MV(BP)) + (changePB premium/MV(BP))
3. = (change share price + div per share) / share price = SRR for each share

special case: current premium of MV is nil.
no premium MV = CSE(EP), change (PB premium) = zero
(i) where PB premium is constant zero : CSE(BP) = MV(BP)
SRR = ROCE

(ii) where PB premium is constant positive (MV(BP) - CSE(BP) > 0) :
CSE(BP) < MV(BP)
SRR < ROCE

(iii) where PB premium is constant negative (MV(BP)>CSE(BP) :
CSE(BP) > MV(BP)
SRR > ROCE

Question 17

Market-based measure: Stock Abnormal Rate of Return %

Answer 17

= SRR - re

where re - calculate by CAPM

Question 18

Market-based measure: Stock Abnormal Return $

Answer 18

= SR - (re x MV(BP))

where re = normal return

Question 19

ABM vs MBM

Answer 19

ABM

1. historical cost data
2. accrued acc. (non-cash flows)
3. prudence acc. choices
4. assets vs expenses contentions

ABM are backwards-looking: usefulness & relevance are questionable.
But offers comparability, consistency & stability.

MBM

1. assumptions based.
2. driven by market opinions which may be fad-driven.
3. measures highly volatile (extreme swings)

MBM is difficult to interpret (from bullish vs bearish)
bullish = characterized by rising share prices./ confident/positive/optimizing
bearish = characterized by or associated with falling share prices.

But forward bias.

Question 20

PVAE Model

Answer 20

V E beginning = CSE beginning + PVAE

CSE beginning -> where ROCE = rE = return on BV = return on equity
~ BV = Equity MV

PVAE -> Excess above ROCE = returns beyond BV x rE

~ rE benchmark against ROCE to determine value beyond BV or conversely below BV.

Note: V E beginning there is symbol top of V is E and below of V is O

Question 21

PVAE model & PB Premium

Answer 21

PB beginning = V E beginning /CSE beginning

V E beginning = CSE beginning + PVAE beginning

(i) where PVAE beginning < equivalent 0,
~ V E beginning < equivalent CSE beginning and PB premium < equivalent 0 or -ve.

(ii) where PVAE beginning > 0,
~ V E beginning > CSE beginning and PB premium > 0 or +ve