FINAL REVIEW DECK Flashcards
What are the adjustments to convert LIFO inventory to FIFO inventory?
BALANCE SHEET Inventory = Inventory + LR Cash = Cash - (LR x tax rate) Equity = Equity + [LR x (1-t)] i.e. Adjusting assets = add LR net of tax
Income Statement
COGS = COGS - change in LR
Tax Expense = Taxes + (change in LR x tax rate)
Net Income = NI + [change in reserve x (1-t)]
*adjusting equity and net income are the same, just using the LR vs the change in LR
Impact of adjusting LIFO to FIFO in rising price environment?
Current Ratio = Higher
Gross and Net Profit = Higher
Inventory Turnover= Lower
LT Debt / Equity = Lower
LIFO vs FIFO which is better for the Balance Sheet? Income Statement? Why?
LIFO for Income Statement: better representation of current margin environment
FIFO for Balance Sheet: better representation of economic cost
Capitalizing Interest Costs - implications
- report as CFI, depreciate when the project is complete
2. Capitalizing usually results in higher interest coverage
Analyst Adjustments - Capitalizing Interest Costs
- Add Capitalized Interest (CI) to interest expense
- Remove depreciation of CI from earnings
- Deduct CI net of related depreciation from fixed assets
- Add CI to CFI
- Deduct CI from CFO
- Recalculate interest coverage and profitability ratios
Key differences between capitalizing R & D and Software
Research and Development (R & D)
IFRS: R = expense D = capitalize
GAAP: R & D = expense
Software developed for sale:
IFRS & GAAP: expensed until feasibility is reached
Software developed for internal use
IFRS: expensed until feasibility is reached
GAAP: capitalized all software development cost
Impairment
IFRS: BV > Recoverable Amount (write down to greater of FV - selling cost or PV of future cash flows) & allow loss reversal
GAAP: BV > undercounted cash flows (write down to fair value - or discounted future cash flows) only assets not held for use are allowed to reverse impairment
*DO NOT AFFECT CASH FLOW (non cash charge)
**Impairment means an asset was not depreciated fast enough
Fixed Asset Disclosure applications:
Estimated Useful Life: Historical Cost / Annual Depreciation
Estimated Age: Accum. Depr / Annual Depreciation
Estimated Remaining Life: Net PPE (NBV) / Annual Depreciation
Adjusting an operating lease into a financing (capital) lease:
- Lower of fair value or PV of future lease payments is reported as an asset and liability
- Asset is depreciated
- Interest expense is recognized on liabilty
- Lease payments like amortizing debt - each payment is part interest (CFO) and part principal (CFF).
Calculate IRR to determine implicit rate (us PV of future minimums as the outflow, and then use the payments as inflows)
SIMPLIFIED
- Increase A & L’s by PV of remaining lease payments
- Remove rent expense from I/S and replace with depreciation and interest expense
Calculating a change in an Equity Method investment:
- %share of company x change in RE
2. %share of company x (Earnings - Dividends)
Steps in the Acquisition Method
BALANCE SHEET
- Eliminate investment account of parent and equity accounts of subsidiary
- Create minority (non controlling) interest = share not owned
- Combine assets and liabilities of both firms (net of intercom any transactions)
INCOME STATEMENT
- Eliminate subsidiary earnings from parents (dividends)
- Subtract minority share of earnings
- Combine revenues and expenses net of inter company transactions
GOODWILL
GAPP: requires full goodwill
IFRS: permits partial also
Full goodwill = total fair value of subsidiary minus FV of net identifiable assets and
Minority interest = % not owned times total fair value of subsidiary
_______________________________
Partial goodwill = purchase price of partial interest minus the % owned times FV of net identifiable assets
Minority interest = % not owned times fair value of net identifiable assets
COMPONENTS OF PBO
BEGINNING PBO \+ Service Cost \+ Interest Cost \+/- Actuarial (gains) losses \+/- Past service cost - Benefits Paid =ENDING PBO
Fair Value of Plan Assets
BEGINNING FAIR VALUE OF PLAN ASSETS \+/- Actual return on plan assets \+ Employer contributions -Benefits paid to retirees =ENDING FAIR VALUE OF PLAN ASSETS
TOTAL PERIODIC PENSION COST
TPPC = Contributions - change in funded status
Components = Current and past service cost + Net Interest + Remeasurement (actuarial gain / loss and difference in actual vs expected return)
PENSION EXPENSE
GAAP Pension Expense= \+ Service cost (actual) \+ Interest cost (actual) - Expected return \+/- Amortization of actuarial (gain) and loss \+/- Amortization of past service costs = GAAP Pension expense on I.S.
*Unamortized past service cost and actuarial gain goes to OCI
IFRS Pension Expense = \+ Service cost \+/- Net interest expense (income) - use same rate \+/- Past service costs = Pension expense on I.S.
*Remeasurements are reflected in OCI unamortized
Analyst adjustments for Pensions
- Full pension expense is taken through operating expenses (SG&A)
- Only service cost is operating
- Remove pension expense from operating expenses and include service cost
- Add interest cost to interest expense
- Add actual return on plan assets to non operating income
- Amortization is ignored
**TOTAL I/S EFECT = Service + Interest - Actual Return
CASH FLOW ADJUSTMENT
Adjust CFO and CFF for the after-tax difference in economic pension expense and cash contributions.
When you contribute positive after tax it is like paying off debt, which increases CFO and decreases CFF
FX adjustments
Temporal: when functional currency does not equal reporting currency
Current Rate: when functional currency does equal reporting currency
TEMPORAL METHOD
- Produce top of balance sheet (total assets)
- Produce SH Equity and Liabilities (plug RE)
- Derive NI from reconciliation of RE
- Produce the Income Statement
* The difference between the income in RE and in the I.S. is the adjustment
TEMPORAL METHOD RATES
Current Rate
1. Monetary Assets & Liabilities
Historical rate
- All other assets and liabilities
- Capital Stock
- COGS, D & A
- Dividends
Average Rate
6. Income Statement
Monetary assets: cash, AR, AP, STD, LTD
CURRENT RATE METHOD RATES
Current Rate
1. All assets and liabilities
Historical rate
- Capital stock
- Dividends
Average Rate
4. All I.S. Accounts
CURRENT RATE METHOD
- Convert the I.S @ Average rate
- Derive closing RE (plug)
- Convert the B.S. @ Current rate (will not balance) as difference is currency gain/loss
CALCULATING CURRENCY EXPOSURE
Temporal Method
= Net Monetary Assets [(cash + A/R) - (A/P + current debt + LTD)]
Current Rate Method
= Assets - Liabilites = SH Equity
HYPERINFLATION
GAAP: Temporal method is required
IFRS: foreign currency financial statements are restated for inflation and then translated at current rate (marked to market)
KEY: monetary assets and liabilities are not restated & purchasing power gain or loss is recognized based on net monetary position (net monetary asset = loss)
MEASURING EARNINGS QUALITY
Aggregate Accruals = Accrual based earnings - cash based earnings
B.S. Based: Change in NOA / avg NOA
NOA = (Total Assets - Cash) - (Total Liabilities - Total Debt)
______________
CF Based: NI - (CFO + CFI) / avg NOA
*issue is different treatment of finance costs and dividends under IAS and US GAAP
**Lower the ratio, higher the quality of earnings
DUPONT
ROE = Interest Burden x EBIT Margin x Asset Turnover x Leverage
(NI / EBT) x (EBT / EBIT) x (Tot Rev / Avg Assets) x (Avg Assets / Avg Equity)
*to adjust remove the equity method income and the investment asset from extended DuPont equation
CASH FLOW ANALYSIS
Adjusted operating cash flow = OCF = add back cash interest and cash taxes
Cash flow return on assets = OCF / Avg Total Assets
Cash flow to reinvestment = OCF / Capex
Cash flow interest coverage = OCF / Cash interest
Capital Budgeting Steps
- Outlay = Capex + NWC Invest
* NWC = change in non cash current assets - change in non debt current assets - CF = (Sales - Cash Opex - Depreciation) x ( 1 - tax ) + Depreciation
- TV = Salvage Value + NWC - tax ( Salvage - BV )
ECONOMIC INCOME
EI = after-tax operating cash flow minus economic depreciation
economic depreciation = decline in investment’s market value (calculate by using discounting with the cost of capital)
ALTERNATIVE VALUATION METHODS
Economic Profit = EBIT ( 1 - t ) - $ WACC
MVA = NPV based on economic profit
Residual Income = NI - equity charge
Double taxation formula
effective tax rate = tax corporate + ( 1 - tax corporate) x (tax individual )
Target Dividend payout adjustment factor
Expected dividend = Do + [ ( E1 - Eo) x target payout x adjustment factor ]
adjustment factor = 1 / n (n = # of years to adjust)
Business cycle phases and mergers
- Horizontal mergers are common in all life cycle stages
- Tend to see vertical mergers primarily in mature growth stage
- Conglomerate mergers only common at beginning and end of industry life cycle
HHI - merger index
HHI = Market share (decimal form x 100)^2
Post Merger < 1000 = not concentrated
Post merger between 1000 & 1800 with change of 100 or more, antitrust action is possible
Post merger > 1800 with change of 50 or more virtually certain
Valuing a Merger
- DCF (do not fret)
- Comparable Company Analysis (Valuation relative to minority prices) + takeover premium
- Comparable Transaction Analysis: no need to calculate takeover premium (it is embedded) takes a control perspective
Evaluating a merger bid
- Post-merger value of an acquirer = pre merger value of acquirer + pre merger value of target + synergies - cash
- Gains accrued to the target = takeover premium = price paid for target - pre merger value of target
Ibbotson-Chen Model
ERP = Dividend Yield
{
\+ (1 + expected inflation)
\+ (1+ real growth rate)
\+ (1+ PE growth due to market correction)
-1
}
- risk free
Strength: uses consensus of experts
Weakness - wide disparity of opinions
Build up method for equity models
Expected Return = Risk free + ERP + size premium + company specific premium
DOES NOT USE BETAs
Beta Estimation
- Identify a publicly traded firm with similar industry characteristics
- Estimate the beta of the publicly traded firm using regression = Be
- Unlever the beta = Bu = [1/(1+(D/Ecomp))] x Be
- Relever beta = Bnonpublic = [1 + D/E nonpublic] x Bu
Strategy Styles
Less Malleable + Less Predictable = Adaptive
Less Malleable + More Predictable = Classical
More Malleable + Less Predictable = Shaping
More Malleable + More Predictable = Visionary
EXAMPLES
Classical: Consumer finance, household products, autos
Adaptive: Office electronics, Construction Materials, Biotech
Shaping: Heathcare tech, automobile components, internet software
Visionary: healthcare provider, media, insurance
ECONOMIES OF SCALE
Defined: average cost of production decreases as industry sales increase
Evidence: larger companies will have higher margins
Tax Rates
Changes in deferred tax items account for the difference between income tax expense and cash taxes due.
Watch out for companies who consistently report an effective tax rate that is less than the statutory rate.
Forecasting the balance sheet
Forecasted Inventory: Forecasted COGS / inventory turnover
Forecasted A/R: days of sales outstanding x forecasted sales / 365
Net PPE = Begin balance + Capex - Depr
ROIC
ROIC = NOPLAT / invested capital
*ROIC is preferred over ROE for companies with different capital structures
Forecasting Value with Dividends
Advantages
- Less volatile
- Theoretically justified
- Accounts for reinvested earnings
Disadvantages
- Non-dividend paying firms
- Dividends artificially small for tax reasons
- Dividends may not reflect the control perspective
When suitable
- Company has history of paying
- Board has a dividend policy that has an understandable and consistent relationship with profitability
- Minority shareholder takes non-control perspective
- Mature firms
Assumptions of the constant growth or Gordon Growth Model
Assumptions:
- Dividend expected in one year
- Dividends grow at constant rate forever
- Growth rate less than required rate of return
MOST USEFUL:
- Mature firms
- Broad-based equity index
- Terminal value in more complex models
- International valuation
- Can be used to calculate P/E (justified)
PV of Growth Opportunities
Po = (E1 / r) + PVGO
USING LEADING P/E
Po / P1 = ( 1 / r ) + (PVGO / E1)
Weakness of Gordon Growth
- Terminal value very sensitive to rate estimates
- Difficult to use with non dividend paying stocks
- Minority perspective only (not useful for M & A valuation)
Phases of Growth and correct model to use
Initial : 3 stage model
Transitional: 2 stage or H model
Mature : GGM
FCF Strengths / Limitations
Strengths
- Used for firms with no dividends
- Functional model for assessing alternative financing polices
- Rich framework that provides additional insight into company
- Other measures like EBIT, EBITDA and CFO either double count or omit important cash flows
Limitations
- If FCF<0 due to large capital demands
- Requires detailed understanding of accounting and FSA
- Information not readily available or published
