FinTree
JuiceNotes 2023
Financial Statement Analysis |Corporate Issuers
Chartered Financial Analyst - Level I
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INDEX
Financial Statement Analysis
Name of Reading
Financial Statement Analysis:Introduction
6
16
Financial Reporting Standards
8
17
Understanding Income Statement
11
18
Understanding Balance Sheet
20
19
Understanding Cash Flow Statement
26
20
Financial Analysis Techniques
29
21
Inventories
33
22
Long-Lived Assets
23
Income Taxes
24
Long Term Liabilities
25
Financial Reporting Quality
26
Financial Statement Analysis:Applications
Tr
Corporate Issuers
ee
15
39
44
47
53
56
Corporate Structures and Ownership
60
28
Introduction to Corporate governance & other ESG
64
29
Business Models
69
30
Capital Investments
74
31
Sources of Capital
78
32
Cost of Capital - Foundational Topics
81
33
Capital Structure
84
34
Measures of Leverage
87
Fi
n
27
Financial Statement
Analysis
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It is an independent review of an entity’s financial statements
Conducted by public accountants
To provide an opinion on fairness and reliability of financial statements
Auditor examines the company’s accounting and internal control systems, confirms
assets and liabilities, and tries to determine the financial statements are free of any
material errors
Unqualified opinion (Clean opinion) - Issued when financial statements are free from
material omissions and errors
Qualified opinion - Issued when financial statements deviate from accounting principles
Adverse opinion - Issued when financial statements are not presented fairly or are
materially nonconforming with accounting standards
Disclaimer of opinion - Issued when auditor is unable to express an opinion
Company’s management is responsible for maintaining an effective internal control
system to ensure the accuracy of its financial statements, not the auditor
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● The SEC has the responsibility of enforcing the act (SOX).
● The act prohibits a company’s external auditor from providing
certain additional paid services to the company
● The act requires a company’s executive management to certify
that the financial statements are presented fairly management
is required to include a statement about the effectiveness of
company’s internal controls of financial reporting.
● Additionally, the external auditor must provide a statement
confirming the effectiveness of the company’s internal controls.
● In the European Union, each member state has its own
securities regulations, but all countries in the EU are required to
report using IFRS.
8
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= Gross Profit
COGS
Interest
Depreciation
= EBITDA
= EBIT
= EBT
= EAT
(+) Unrealised Losses/
Salaries
Total
11
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Receiving cash from Accounts Receivable in future
Note : Sales is recorded after revenue earning activity (delivery of goods) is complete.
Note : Since goods are delivered now the liability is settled.
12
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During the first year of construction, the builder incurs $60 million of costs.
13
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14
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15
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16
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17
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Stock split and Bonus Shares examples
also called
as stock dividend
18
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20
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21
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Debt Securities acquired
with intent to sell
Debt Securities
No intent to sell
in near term
No intent
to hold
24
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26
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27
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29
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30
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31
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33
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34
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+
+
+
35
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40
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41
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PAT, assets, equity
and ROE and ROA
will decrease
Upward revaluation
will increase assets
and equity
Incase of loss PAT
and assets will
decrease
Asset turnover ( )
Asset turnover ( )
Asset turnover ( )
Subsequent periods;
PAT and ROE and
ROA will increase
Debt-to-assets and
debt-to-equity will
decrease
in case of gain PAT
and assets will
increase
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44
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45
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47
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48
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Lease is treated as capital lease for tax purposes
and operating lease for accounting purposes
49
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50
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Recognise “right of use”
(ROU) assets & lease
liability
Recognise “right of use”
(ROU) assets & lease
liability
inf low
51
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53
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Corporate Issuers
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indetification will also be reported to CFA Institute.
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Corporate Structures and Ownership
LOS a
Business
Structure
Legal
Operated
Identity
by
Liability
Profits
Risks
Business
Growth
Sole
Proprietorship
No
Owner
Owner has
unlimited
liability
Owner
Owner
Limited owner’s
ability to
finance and
personal risk
appetite
General
Partnership
No
Partners
Partners
have
unlimited
liability
Shared by
partners
Shared by
partners
Limited by partners
ability to
finance and
their risk appetite
Limited
Partnership
No
Partners
GP has
unlimited
liability; LP
has limited
liability
Shared by
partners
Shared by
partners
Limited by partners
ability to
finance and
their risk appetite
Corporation
Separate
Owner
Limited by
equity
investment
In
proportion
of equity
investment
Limited by
equity
investment
Unlimited potential
and
access to capital
Taxation
US LLC
US
Corporation
Personal Level
Personal &
Corporate
Level
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Business Liability
· Limited Liability: maximum loss is the amount invested
· Unlimited Liability: in case of insolvency, personal assets are also at stake
Public For-Profit
- Listed on
stock exchange
For-Profit
Private For-Profit
- not listed on
stock exchange
Types of
Corporations
Non-Profit
-main objective is not
to earn profits
-no shareholders
-no dividends
-exempt from paying taxes
Capital
Ownership Capital
Equity
· Shareholders
· Earn Dividends (Non tax deductible)
Borrowed Capital
Debt
· Bondholders
· Earn Interest (Tax deductible)
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LOS b
· Market Capitalization = Current Stock Price x Total Shares Outstanding
· Market Capitalization is the market value of the shares
· Enterprise Value = Market Value of Shares (+) Market Value of Debt (-) Cash
IPO, DL, Acquisition
Private
Public
LBO, MBO
IPO
DL
Underwriting
Yes
No
New Capital
Yes
No
ŸSpecial Purpose Acquisition Company (SPACs) is a means of acquiring a company. A SPAC is a shell
company (or blank check company), because it exists solely for the purpose of acquiring an unspecified
private company sometime in the future. SPACs raise money through IPOs, which is then kept in a
Trust A/c. SPACs have 18 months to complete the acquisition or else the money has to be returned to
the investors
Leveraged Buyout (LBO): Investors are not affiliated with the company
Management Buyout (MBO): Investors are members of the company (usually the management of the
company)
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Life Cycle
Stages
Start Up
Growth
Maturity
Decline
Revenues
Low to none
Increasing
Positive and Predictable
Deteriorating
Cash Flow
Negative
Increasing
Positive and Predictable
Deteriorating
Business Risk
High
Moderate
Low
Increasing
Financial Need
Proof Of
Concept
Scale
Business as usual
Shortfalls
Financing
Difficulty
Very High
Very High to
High
Moderate to low
Increasing
Financial Claims:
Debt Vs Equity Claim Difference
Legal recourse
Contractual
obligation
Claim priority
Lender
Lender
Lender
Corporation
No legal recourse
Shareholder
Shareholder
Shareholder
Residual claim to net assets
Shareholder
Shareholder
Shareholder
Shareholder
Shareholder
Shareholder
Debt Vs Equity
Debt
Equity
Cheaper
Costlier
Riskier
Less risky
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Corporate Governance and ESG
LOS a
1
Corporate governance
System of internal controls and procedures by which individual
companies are managed.
A framework that defines rights, roles and responsibilities of
various groups
Arrangement of checks and balances a company needs to
minimize and manage the conflicting interests between insiders
and external shareowners.
2
Corporate governance theories
Stakeholder
theory
Primary focus is the interest of
firm’s shareholders
Focus under this theory is
broader
ee
Shareholder
theory
Maximization of MV (not BV) of
firm’s common equity
CG is concerned with the conflict
of interest between managers
and owners
LOS b
It considers conflict of interest
among several groups such as
shareholders, employees,
suppliers, customers and others.
nT
r
Primary stakeholders of a
company
Shareholders
Ÿ
Ÿ
Ÿ
Ÿ
Responsibility to protect the interest of shareholders
To hire, fire and set the compensation of the firm’s senior managers
Monitor financial performance and other ongoing activities.
Firm’s executives (most-senior managers) serve on BOD along with directors who are
not otherwise employed by the firm.
Ÿ One-tier - Both executive and non-executive board members serve on a single BOD
Ÿ Two-tier - Non-executive board members serve on a supervisory board that oversees a
management board, made up of company executives.
Fi
BOD
Ÿ Voting rights
Ÿ Residual interest
Ÿ Ongoing interest in profitability and growth, both increasing the value of their shares
Senior managers
Employees
Creditors
Suppliers
Ÿ Compensation - salary, bonus and perquisites
Ÿ Executive bonuses are tied to same measure of firm performance, giving them a strong
interest in financial success of the firm.
Ÿ They have interest in the pay, opportunities for career advancement, training and
working conditions
Ÿ Providers of debt capital
Ÿ Do not have voting rights
Ÿ Do not participate in the firm’s growth beyond their promised interest and principal
payment
Ÿ Ongoing relationship with the firm
Ÿ Typically short-term creditors
Ÿ They have interest in the firm’s solvency and ongoing financial strength
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LOS c
Conflict of interest
ª It arises because an agent is hired to act in the interest of the principal but
the agent’s interest may not coincide exactly with those of the principal.
Shareholders
and managers
or BOD
ª Shareholders are principals and board members are their agents
ª Managers and directors are dependent on firm for employment
ª They may choose lower level of business risk than the shareholders would
since their employment is dependant on firm’s performance.
ª There is an information asymmetry between shareholders and managers
because managers have more and better understanding of the functioning
of the firm. This decreases the ability of the shareholders or non-executive
directors to monitor and evaluate whether managers are acting in the best
interest of the shareholders.
Groups of
shareholders
ª A single shareholder or a group of shareholders may hold a majority of the
votes and act against the minority shareholders.
ª Some firms have different classes of shares, some with more voting power
than others.
ª In the event of an acquisition, controlling shareholders may be in a
position to get better terms for themselves than minority shareholders.
Creditors and
shareholders
ª Shareholders may prefer more risk than creditors do because creditors
have a limited upside from good result.
Shareholders
and other
stakeholders
ª The company may raise prices or reduce product quality to increase
profits to the detriment of customers.
ª The company may employ strategies that significantly reduce taxes they
pay to the government.
LOS d
e
Principal-agent
Stakeholder management - Management of company relations with stakeholders
re
Infrastructures
Contractual
infrastructure
Organizational
infrastructure
Governmental
infrastructure
Legal recourse of
stakeholders when
their rights are
violated
Contract that spell out
rights and responsibilities
of company and the
stakeholders
Company’s CG
procedures
including its
internal systems
Comprises
regulations to
which companies
are subject
LOS e
nT
Legal
infrastructure
Mechanism to manage stakeholder relationships
Fi
Voting by Assigning one’s right
proxy
to vote to another
Proxy is often a
director, member of
management or
shareholder’s
investment advisor
Ordinary Requires majority of
resolution votes. Eg. approval
of auditors, election
of directors
Special
May require a
resolution supermajority vote.
Typically 2/3rd or
3/4thof votes Eg.
mergers, takeovers.
Such special
resolutions can also
be addressed at EGMs
Majority Candidate with most
votes for each single
voting
board position is
elected
Cumulative Shareholders can
cast all their votes to
voting
one single board
candidate or divide
them among others.
This can result in
greater minority
shareholder
representation on
the board compared
to majority voting
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LOS f
Board
structure
1
One-tier
board
Two-tier
board
Single BOD
Two BODs
Internal directors /
Executive directors
Senior managers
employed by the firm
External directors /
Non executive directors
No other relationship
with the company. Also
termed as independent
directors
Supervisory board
Management board
Excludes executive
directors
Made up of executive
directors
Led by company’s CEO
Chairman of the board is
sometimes the CEO
e
Lead independent director - Ability
to call meetings of independent
directors, separate from meetings
of the full board
Staggered board - Elections for some board positions are held each year, thus limiting the ability of
shareholders to replace board members in any one year
2
re
Board responsibilities
ª Selecting senior management, setting their compensation, evaluating their performance
and replacing them as needed.
nT
ª Setting strategic direction.
ª Approving capital structure changes, acquisitions and large investment expenditures.
ª Reviewing company performance and taking necessary corrective steps.
ª Planning for continuity of management and succession of the CEO.
ª Establishing, monitoring and overseeing firm’s internal controls and risk management
system.
ª Ensuring the quality of the firm’s financial reporting and internal audit.
3
Governance
committee
Fi
Audit
committee
Ÿ Implementation
of accounting
policies
Ÿ Effectiveness of
internal controls
Ÿ Recommending
external auditor
Ÿ Proposing
remedies based
on audits.
Ÿ CG code
Ÿ Implementing code of
ethics and policies
regarding conflict of
interest
Ÿ Monitoring changes in
laws and regulations
Ÿ Ensuring company is
complying with all
laws and regulations
Board committees
Nominations
committee
Ÿ Proposes qualified
candidates for
election to the
board
Compensation
committee
Ÿ Recommends to
the board the
amounts of
compensation to
be paid to
directors and
senior managers.
Risk
committee
Ÿ Informs the board
about appropriate
risk policy and
risk tolerance of
the organization
Ÿ Oversees
enterprise-wide
risk management
process
Investment
committee
Ÿ Reviews and
reports to the
board on
management
proposals for
large
acquisitions, sale
or disposal of
company assets
or segments
66
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LOS g
1
Factors that affect stakeholder relationships and CG
Activist
shareholders
They pressure companies in which they
hold significant number shares for changes
Hedge funds have engaged in shareholder activism to
increase the MV of firms in which they hold significant stakes
Proxy fight can be initiated by the group by seeking the proxies of
shareholders to vote in favour of their alternative proposals and policies
An activist group may make a tender offer for specific no.
of shares to gain enough votes to take over the company
A threat of hostile takeover (the one not supported by management) can act as
an incentive thus influencing management and board to pursue policies more in
alignment with the interests of shareholders
2
Legal
environment
Civil law system
Judges’ rulings become law
in some instances
Judges are bound to rule
based only on enacted laws
LOS h
Rights of creditors are
more clearly defined than
those of shareholders.
Therefore not difficult to
enforce through the courts
re
Interests of creditors and
shareholders are
considered to be more
protected in countries with
this system
e
Common-law system
Risks of poor CG and benefits of effective CG
nT
When governance is weak and managers are not monitored, they may choose
lower-than-optimal risk, reducing company value
Risk is that, some stakeholders can gain an advantage to the disadvantage
of other shareholders
Poor compliance procedures with respect to regulation and reporting can
easily lead to legal and reputational risks
Effective CG can improve operational efficiency by ensuring that management
and board member incentives align their interests with those of shareholders
Fi
Alignment of management interests with those of shareholders leads to better
financial performance and greater company value
LOS i
1
Factors relevant to the analysis of CG
Elements of CG that analysts
have found to be relevant -
è Ownership and voting structure
è Board composition
è Management remuneration
è Composition of shareholders
è Strength of shareholder rights
è Management of long term risks
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2
Dual class
structure -
One class of shares may be entitled to several votes per share, while another
class of shares is entitled to one vote per share
On average, companies with a dual class share structure have traded at a
discount to comparable companies with a single class of shares
LOS j
Environmental and social considerations in investment analysis
ESG integration/investing -
The use of environmental, social and governance factors in
making investment decisions
Also termed as sustainable investing, responsible investing
and socially responsible investing
1
Negative
screening Positive
screening -
Usage of ESG in investment analysis
Certain companies and certain sectors are excluded from portfolios.
Eg. mining and oil production sector.
No specific sectors are excluded from portfolios but investors identify
best practices across environmental sustainability.
e
LOS k
2
Impact
investing
Investing in order to promote specific social or environmental goals.
re
Investors seek to make profit while at the same time having a
positive impact on the environment
Thematic
investing
nT
Refers to investing based on a single goal. Eg.
development of clean water resources
Fi
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Business Models
Business model types
Business Model :
Helps analysts understand businesses
Channels :
Wholeseller
Retailer
End-Customer
Manufacturer
Direct Sales
Drop Shipping : Goods delivered directly from manufacturer to consumer without taking goods
into inventory
Omnichannel : Digital + Physical channels
Pricing and Revenue Models
Value Based
Cost Based
Based on value
received by customer
Based on costs
incurred
Pricing discrimination : •
Different prices for different customers
•
Tiered pricing: based on volume
•
Dynamic pricing: off-peak, surge, congestion
•
Auction/ reverse auction: through bidding
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Pricing for Multiple Products
Bundling
Razors and Blades
Pricing
Optional Product
Pricing
Combining multiple
products so that
customers are
incentivized.
Eg. Hotel rooms with
free breakfast
Low price on an
equipment + High
margin on repeat
purchase
consumable
Eg. Printer and printer
ink
Customer buys
additional products or
services either at the
time
of purchase or
afterwards
Pricing for Rapid Growth
Penetration
Pricing
Freemium
Pricing
Hidden Revenue
Business Models
Firm willingly
sacrifices margins to
build scale
Eg. Netflix
Customers get certain
level of usage at no
cost
Eg. News apps
Services to users at no
charge and generate
revenues
elsewhere.
Eg. Online
marketplaces
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Alternatives to Ownership
Recurring revenue/
Subscription Pricing
Customers can rent
a product/ service
for as long as they
want
Fractionalization
Leasing
Licensing
Franchising
selling assets in
smaller units
Eg. Co-working
Shifting ownership
of an asset from
the firm using it to
the one that has
lower costs for
capital and
maintenance
Access to
intangible assets
Franchiser gives
franchisee right to
sell or distribute
its product or
service
Value Proposition : Product / service attributes valued by the firm’s target customers
Value chain : Systems / processes that create value for customers
Supply chain : Sequence of processes involved in the creation of a product
Unit economics : Revenues and costs explained on a per unit bases
Business Model Variations
•
Private label / Contract
: Produce goods that are marketed by others
manufacturers
Licensing : Produce goods using other’s brand name in return for a royalty
Value added resellers : Distribute and handle complex aspects of product installation,
customization
Franchise models : Retailers have tightly defined and exclusive relationship with the parent
company
E-Commerce Business Model
Affiliate marketing : Generates commission revenue for sales generated on others website
Marketplace businesses : Creating network of buyers and sellers without taking ownership
of goods. Eg. Alibaba
Aggregators : Re-markets products/ services under its own brand
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Network Effects and Platform Business Models
Network effects : Increase in value of a network to its users due to which more users join.
Eg. LinkedIn
Platform Business : Value is created in the network outside the firm.
Crowdsourcing and Business Models
Crowdsourcing : Users contribute directly to a product/ service/ online content.
Eg. Wikipedia
Firm Specific Factors
Asset-light business models : Shift in ownership of high-cost assets to other firms
Pay-in-advance : Reduce/ eliminate need for working capital
Explain and Classify types of Business and Financial Risks for a Company
Macro Risk :
Risk from political, economic, legal and other institutional factors. These affect all businesses
Business risk :
Risk that the firm’s operating results will be different from the expectations. It includes both industry
risk and company-specific risk
Financial risk :
Risk arising from company’s capital structure
Company-specific risk :
Ÿ Competitive risk: risk of a loss of market share or pricing power to competitors. Also arises from
potential disruption
ŸProduct market risk: risk that the market for a new product will fall short of expectations
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Components of Leverage
Contribution
Operating
Leverage
EBIT
Total
Leverage
EBIT
Financial
Leverage
EBIT
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Capital Investments
LOS a
1
Describe the capital allocation process and basic principles of capital allocation
Categories of capital
budgeting projects
2
Capital budgeting process
Idea generation
Replacement
projects to maintain
the business
Replacement
projects for cost
reduction
Without detailed
analysis
Fairly detailed
analysis
Expansion Projects
New product or
market
development
Analyzing project
proposals
Create the firm- wide
capital budget
Very detailed
analysis
Detailed analysis
Monitoring decisions and
conducting a post-audit
1
Basic principles of capital
budgeting
ee
Mandatory Projects
Other projects
such as R&D
Without detailed
analysis
2
Externalities
Positive
Negative
Positive effect on
sales of a firm’s
other product lines.
Negative effect on
sales of a firm’s
other product lines.
Eg. Sales of cars will
increase business of
auto components in
future.
Cannibalization - New
project taking sales from
an existing product. Eg.
Coke Vs Diet coke
nT
r
4Decisions are based on cash flows, not
accounting income.
4Consider opportunity costs.
4Timing of cash flows is important.
4Consider cash flows after tax.
4Ignore financing cost as a cash outflow.
4Ignore sunk cost as it is irrelevant for
Fi
decision making
Conventional
cash flow
pattern
3
Unconventional
cash flow
pattern
Sign on the cash flows
changes only once
Sign on the cash flows
changes more than once
0
1
2
3
0
1
2
3
- 1000
500
500
500
- 1000
800
-600
300
Problem of no IRR
or multiple IRR
74
LOS b
Demonstrate the use of net present value (NPV) and internal rate of return (IRR) in allocating
capital and describe the advantages and disadvantages of each method
Selection of capital projects
Independent
Unlimited
funds
Mutually exclusive
´ Unlimited access
select all
projects, if NPV
>0
to capital
´ Firm can
undertake all
profitable projects
select only one
project (with the
highest NPV)
Capital
rationing
´ Constraints on
raising capital
´ Undertake
projects with
highest NPV
Project sequencing - Investment in a project today creates opportunity to invest in projects in future
IRR
Payback
period
PV of inflows −
PV of outflows
Rate at which NPV
=0
Time taken to
recover initial
investment
NPV = -ve
[Reject]
Time taken to
recover initial
investment
considering TVM
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re
NPV = +ve
[Accept]
Discounted
payback
period
e
NPV
PV of inflows = PV
of outflows
IRR > WACC =
Accept
IRR < WACC =
Reject
Shorter the
better
Poor measure of
profitability
nT
Good measure
of liquidity
Poor measure of
profitability
Good measure of
liquidity
Profitabilit
y index
PV of inflows
PV of outflows
PI > 1 = Accept
PI < 1 = Reject
PI > 1 = +ve
NPV
PI < 1 = −ve
NPV
DPB > PB
Fi
Doesn’t
consider TVM &
CFs after PB
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LOS c
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Describe expected relations among a company's investments, company value, and
share price
The NPV criterion is the criterion most directly related to stock prices.
+ NPV
- NPV
Increase company value
Decrease company value
Effect of inflation on capital budgeting analysis
Nominal cash flow
Real cash flow
Nominal discount rate
Real discount rate
If inflation is higher than expected
Value of the project will be lower than expected
Inflation reduces tax savings from depreciation
Inflation decreases the value of bond payment to bondholders
e
Inflation will affect revenues and costs differently
LOS d
re
Describe types of real options relevant to capital investment
Real options
Abandonment
options
Expansion/growth
options
nT
Timing
options
Fi
Allow company to
delay making an
investment
Allow management
to abandon a
project if PV of
incremental CFs
from abandoning a
project exceeds
the PV of
incremental CFs
from continuing a
project
Similar to put
options
Allow company to
make additional
investment in a
project if doing so
creates value
Similar to call
options
Flexibility
options
Give managers
choices regarding
the operational
aspects of a
project
Price-setting
options:
Demand > Supply
Productionflexibility options:
Using different
inputs/producing
different outputs
Fundamental
options
Whole investment
is an option.
Payoffs from the
investment are
dependant on the
underlying asset,
just like financial
options
Eg. Value of gold
mine is dependent
on the price of
gold
Real options: Options arising in capital budgeting decisions
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LOS e
Common capital budgeting pitfalls
Not incorporating economic responses into the investment analysis
Misusing standardized project evaluation templates
Having overly optimistic assumptions for pet projects of senior management
Basing long-term investment decisions on short-term EPS or ROE
Using IRR to make investment decision
Poor estimation of cash flows
Overestimation/undersestimation of overhead costs
Using a discount rate that does not accurately reflect the project’s risk
Spending the entire capital budget
Failure to consider investment alternatives
Handling sunk costs and opportunity costs incorrectly
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Sources of capital
LOS a
Describe types of financing methods and considerations in their selection
Internal and external Funding Sources
External
Internal
Financial
Intermedlarles
► After-tax operating
cash flows
► Accounts payable
► Accounts receivable
► Inventory &
marketable securities
► Uncommitted lines of
credit
► Committed lines of
credit
► Revolving credit
► Secured loans
► Factoring
Capital
Markets
► Commercial paper
► Public and private
debet
► Hybrid securities
Preferred equity
Convertibles
► Common equity
Other
► Leasing
Financing Considerations
Firm Specific
►
►
►
►
►
►
►
►
►
►
Company Size
Riskiness of assets
Assets for collateral
Public versus private equity
Asset liability management
Debt maturity structure
Currency risks
Agency costs
Bankruptcy cost
Flotation costs
Macroeconomic
►
►
►
►
Taxation
Inflation
Government policy
Monetary policy
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LOS b
Primary and secondary sources of liquidity and factors that influence a
company's liquidity position
1
Sources of liquidity
Primary
sources
2
Secondary
sources
Used in normal day to
day operations
Used in deteriorating
financial conditions
è Selling good
è Collecting from AR
è Short-term funding
è Trade credit
è Line of credit
è Selling assets
è Negotiating debts
(restructuring)
Factors that influence a
company’s liquidity position
PO
DI
Drag on Inflows
Pull on Outflows
Eg. Uncollected
receivables,
obsolete inventory
Eg. Paying vendors
sooner than is
optimal
Delay/reduce CF
or increase
borrowing cost
Accelerating cash
outflows
LOS c Compare a company's liquidity position with that of peer companies
Activity
Ratios
Liquidity
Ratios
Higher the better
4ARTR = Credit Sales / Avg Accounts Receivable
4Current ratio = CA / CL
4ITR = COGS / Avg Inventory
4Quick ratio (acid test ratio) = CA − Inventory/CL
4WCTR = Sales / Working Capital
4Cash ratio = Cash + Marketable Sec. / CL
4APTR = Purchases / Avg Accounts Payable
Lower the better
Accounts payable -
30
0
Inventory
50
30
AR
50
40
70
Cash
Operating cycle (70) = No. of days in Inventory (30) + No. of days in AR (40)
Cash conversion/Net operating cycle (20) = Operating cycle (70) − No. of days in AP (50)
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Evaluate choices of short-term funding
LOS d
The major objectives of a short-term borrowing strategy include the following:
• Ensuring that sufficient capacity exists to handle peak cash needs
• Maintaining sufficient sources of credit to be able to fund ongoing cash needs
• Ensuring that rates obtained are cost-effective and do not substantially exceed market
averages
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Cost of Capital - Foundational Topic
LOS a
1
Calculation and interpretation of WACC
Weight
Weighted
average
20%
20%
4%
2000
15%
40%
6%
Debt
2000
10%
40%
4%
Total
5000
100%
14%
Capital
component
Amount
Equity
1000
Marginal cost of capital = Weighted average cost of capital
Costs
e
2
Preferred
stock
re
Equity
Kce
Kps
LOS b
WACC
Debt
Tax Shield of
Interest
Kd x (1-t)
Impact of taxes on cost of capital
nT
Interest paid on corporate debt is tax deductible
No tax deduction is allowed for payments to common or preferred stockholders
LOS c
Calculate and interpret the cost of debt capital using the yield-to-maturity
approach and the debt-rating approach
Fi
1. YTM of the bond is the cost of debt and not the coupon rate.
a.
Kd = YTM*(1-t)
2. If market price of bond is not available, we use the following approach:
a.
Debt rating approach - estimate the before tax cost of debt by
using the YTM on comparable rated bonds for maturities that
closely match that of company's existing debt
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LOS d
Cost of Preferred Stock = Annual Preferred Dividends / Market Price of Preferred stock
LOS e
Calculate and interpret the cost of equity capital using the capital asset pricing
model approach and the bond yield plus risk premium approach
Cost of equity
Gordon Growth
Model / Dividend
discount model
Capital Asset
Pricing Model
Kce = RFR + (Rm - RFR) x β
Kce =
D1 + g
P0
Bond yield +
Risk Premium
PAT
Equity
Retention Ratio × ROE
Market Risk Premium
(MRP)
Analysts add a risk
premium to the
market yield on
firm’s long term debt
DPS
EPS
re
e
1 − Payout ratio
LOS f
Ad hoc approach
Explain and demonstrate beta estimation for public companies, thinly traded public
companies, and non public companies
1
Y = a + bx
Beta =
nT
Dependant variable
Covariance (s,m)
Variance (m)
Independent variable
Fi
Intercept Slope/beta
Beta of a comparable
company
2
Pure-play method
(Unlever)
Divide
D/E of
comparable
company
(Relever)
Asset beta
1 + D/E ratio
(1 − t)
Multiply
Project beta
(Equity beta)
D/E of
our
company
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3
Challenging issues with beta
Ê Beta is estimated using historical returns data. The estimate is sensitive to the length of
time used and frequency.
Ê Betas exhibit mean reversion tendency (aka beta drift).
Ê Beta of the entire market is 1, therefore all betas have a tendency to move toward 1 and
estimate may need to be adjusted.
Ê The estimate is affected by index chosen.
Ê Beta may need to be adjusted upward for small firms to reflect inherent risk in them.
LOS g
Treatment of floatation cost
The correct method to account for floatation costs is to calculate the dollar amount of cost
and increase the initial cash outflow by this amount.
It should not be incorporated directly into the cost of equity because it is not an ongoing
expense and it would lead to increase in WACC which in turn will reduce the NPV
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Capital Structure
LOS a
Capital structure and company life-cycle
+
Revenue
Cash flow
0
e
Time
Start-up
Growth
Revenue growth
Financial management
Rising
Beginning
re
Stage of life cycle
Mature
Slowing
Cash flow
Negative
Improving
Positive / Predictable
Business risk
High
Medium
Low
Debt capital/leverage
Very limited
nT
Availability
Limited/improving
High
Cost
High
Medium
Low
Typical cases
N/A
Secured (by receivables
fixed assets)
Unsecured (bank
and public debt)
Typical % of capital
structure1
Close to 0%
0%-20%
20%+
Fi
Note: These ratios are calculated based on the market values of equity and debt
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LOS b
Explain the Modigliani–Miller propositions regarding capital structure
Cost
Value
1
MM proposition I
MM proposition I
No taxes
With taxes
Value of a firm is unaffected
by its capital structure
Value is maximized at
100% debt
VL = VU
VL = VU + (t × d)
MM proposition II
MM proposition II
No taxes
With taxes
Ke increases linearly as the
company increases its debt
WACC is minimized at 100%
debt
Ke = Ko + D/E (Ko − Kd)
Ke = Ko + D/E (Ko − Kd) (1 − t)
Œ

Ž


LOS c
MM propositions
Assumptions:
No taxes, no transaction costs and no bankruptcy costs
Investors have same expectations with respect to CFs
Borrowing and lending at RFR
No agency costs
Operating income is unaffected by changes in capital
Trade-Off Theory with Taxes and Costs of Financial Distress. Firm Value and the Debt-to-Equity
Ratio
Marketed value of the firm
Value of
levered firm
PV of costs
of financial
distress
PV of interest
tax shields
Value of levered firm
with financial distress
Value of
unlevered firm
Optimal debt/equity ratio
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LOS d
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Explain factors affecting capital structure decisions
Corporate governance theories
2
Shareholder
theory
Stakeholder
theory
Primary focus is the interest of
firm’s shareholders
Focus under this theory is
broader
Maximization of MV (not BV) of
firm’s common equity
It considers conflict of interest
among several groups such as
shareholders, employees,
suppliers, customers and others.
Senior managers
Employees
Ÿ Compensation - salary, bonus and perquisites
Ÿ Executive bonuses are tied to same measure of firm performance, giving them a strong
interest in financial success of the firm.
Ÿ They have interest in the pay, opportunities for career advancement, training and
working conditions
Ÿ Providers of debt capital
Ÿ Do not have voting rights
Ÿ Do not participate in the firm’s growth beyond their promised interest and principal
payment
Ÿ Ongoing relationship with the firm
Ÿ Typically short-term creditors
Ÿ They have interest in the firm’s solvency and ongoing financial strength
nT
Creditors
Ÿ Voting rights
Ÿ Residual interest
Ÿ Ongoing interest in profitability and growth, both increasing the value of their shares
re
Shareholders
e
Primary stakeholders of a
company
Suppliers
Fi
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Measures of Leverage
LOS a
1
Variable
cost
Variable
cost
Fixed
cost
Fixed
cost
Low leverage
High leverage
3
Leverage refers to the amount of
fixed costs a firm has.
2
Risks
Financial risk
Financing fixed
cost (FFC)
Degree of operating
leverage (DOL)
% ∆ EBIT
% ∆ sales
Sales − VC
EBIT
Highest at low level of
sales
If there’s no OFC,
DOL=1
Operating risk
Additional
uncertainty
about operating
earning
Additional risk borne
by shareholders
because of debt
financing
∆ net income
> ∆ operating
earnings
Fi
1
Uncertainty about
firm’s sales
nT
LOS b
e
Degree of
Financial
Leverage
Degree of
Operating
Leverage
∆ operating
earnings > ∆ sales
Sales risk
re
Operating fixed
cost (OFC)
Business risk
Degree of financial
leverage (DFL)
Degree of combined
leverage (DCL)
% ∆ EPS
% ∆ EBIT
DOL × DFL
EBIT
EBT
If there’s no FFC,
DFL=1
% ∆ EPS
% ∆ sales
Sales − VC
EBT
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+10%
2
DTL = DOL × DFL
Sales
1000
Variable
cost
400
Contribution
600
Operating
fixed cost
200
EBIT
400
Interest
200
EBT
200
Taxes
100
EAT
100
3
+30%
+10%
1.5
DOL =
Contribution
EBIT
Or
% ∆ EBIT
% ∆ Sales
+15%
+15%
2
DFL =
EBIT
EBT
Or
% ∆ EAT
% ∆ EBIT
+30%
% ∆ Sales = % ∆ Contribution
% ∆ EBT = % ∆ EAT
LOS c
e
% ∆ Net income = % ∆ PAT = % ∆ EPS
Effect of financial leverage on ROE
Use of financial leverage increases the risk of default but also
increases the potential return for equity shareholders
re
ROE = Net income
Equity
LOS d
LOS e
Level of sales a
firm must generate
to cover its FC & VC
Breakeven
sales -
Sales = FC + VC
nT
Breakeven
quantity -
Sales − VC
Fi
Contribution -
Net income = 0
Operating
breakeven
=
Operating fixed cost
Contribution per unit
Total
breakeven
=
OFC + Interest
Contribution per unit
Units to be sold
to generate =
desired EBIT
OFC + Desired EBIT
Contribution per unit
Units to be sold
OFC + Interest + Desired EBT
to generate =
Contribution per unit
desired EBT
To calculate units to be sold to generate desired EAT,
convert EAT to EBT then use the above formula
Breakeven point (in amount) =
Contribution ratio =
Fixed cost
Contribution ratio
Contribution
Sales
88
Eg.
Operating fixed cost = 10,000
Financing fixed cost = 20,000
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Tax rate = 50%
Selling price = 100 Variable cost = 60 Desired EBT = 30,000 Desired EBIT = 10,000 Desired EAT = 50,000
Contribution per unit =
Selling price − Variable cost
=
100 − 60
=
40
Contribution ratio =
Contribution per unit
Sales per unit
=
40
100
=
40%
Operating breakeven =
OFC
Contribution per unit
=
10,000
40
=
250
Total breakeven (quantity) =
OFC + FFC
Contribution per unit
10,000 + 20,000
40
=
750
OFC + FFC
Contribution ratio
re
Total breakeven (in amount) =
e
=
=
10,000 + 20,000
40%
=
75,000
nT
Units to be sold to generate desired EBT =
=
=
Fi
Units to be sold to generate desired EBIT =
=
=
OFC + FFC + Desired EBT
Contribution per unit
10,000 + 20,000 + 30,000
40
1,500
OFC + Desired EBIT
Contribution per unit
10,000 + 10,000
40
500
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Units to be sold to generate desired EAT =
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OFC + FFC + (Desired EAT/1 − t)
Contribution per unit
=
10,000 + 10,000 + (50,000/1 − 0.5)
40
=
3,250
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