Accounting and Capital Markets: Exercise Package

Fall 2019

Accounting and Capital Markets

Fall 2019

Exercise Package with Solutions

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Articulation of financial statements

Please fill in the empty cells below.

Balance Sheet 20X2 20X1 Income Statement 20X2

Property, Plant, and Equipment 100 50 Sales 500
Intangibles 200 140 - deprecation -15
- amortization -20
Inventories 40 20 - other costs of goods sold -30
Receivables 30 50 = gross profit 435
Cash 41 20 - operating expenses -100
= EBIT 335
Total assets 411 280 interest expense -5
= EBT 330
Share capital 100 200 taxes -99
Retained earnings 221 0 = net income 231
Total equity 321 200

Bonds 60 30 Statement of Cash Flows

Accounts payables 30 50 Cash at the beginning of the year 20
net income 231
Total liabilities and equity 411 280 + depreciation 15
+ amortization 20
- change in inventories -20
- change in receivables 20
+ change in payables -20
= OCF 246

- investments in PP&E -65

- investments in intangibles -80
= CFI -145

- dividends -10
+ changes in share capital -100
+ changes in bods 30
= CFF -80

Total cash flow 21

Cash at the end 41

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Accrual accounting and valuation

Assume you want to value a company. What are the benefits of basing your valuation on the

company’s financial statements prepared under accrual accounting, rather than cash

accounting? Which potential issues can arise when you rely on accrual figures?

Note that there is more than one correct answer as this is a discussion question. Good

answers likely refer to the following arguments:

 Firm value can be defined as the present value of expected future cash flows. Hence,

valuation hinges on the prediction of future cash flows.

 Accrual accounting helps predicting future cash flows because accrual assets and

liabilities “store” future cash flows on the balance sheet. By contrast, cash accounting

will only reflect a firm’s past, but not its future cash flows.

 Because future cash flows cannot be observed, accruals need to be based on

judgments and accounting estimates. A potential issue with using accruals is that they

can be prone to measurement error.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Market value versus book value

Why can there be differences between a firm’s book value of equity and its market value of

equity?

Note that there is more than one correct answer as this is a discussion question. Good

answers likely refer to the following arguments:

 Accrual assets and liabilities do not capture all future cash flows, but are restricted by

the recognition criteria. For example, future cash flows expected to be generated by a

firm’s PP&E may only be recognized up to the purchase price of the asset.

 Some future cash flows cannot be recognized on the balance sheet, such as internally-

generated brand value, customer lists, or a firm’s competitive advantage.

 By contrast, market prices can incorporate all future cash flows expected by the market

participants.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Goodwill impairment

Fact pattern:
The following information describes CGU X of ABC AG as of 31 December 20X1 (after
depreciation, and after the acquisition of DBE AG).

Balance sheet of CGU X, as of 31 December 20X1 (in TEUR)

Goodwill 50 Equity 830
Patent 150
PPE 350
Inventories 280
Sum 830 Sum 830

Data on CGU X as of 31 December 20X1

Future cash flows (in TEUR) 200 (decreasing by 50 each year)
Useful life 4 years
Fair value (in TEUR) 1,200
Cost to sell (in TEUR) 650
Discount rate 10%

The remaining useful life of the PP&E is four years. The remaining useful life of the patent is

four years. Both are depreciated/amortized on a straight-line basis.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Questions:

a) Please test CGU for an impairment and conduct the necessary journal entries. (4

points)

b) In 20X2, you learn that the economic reasons that lead to the impairment have ceased

to exist. The recoverable amount of CGU XX has risen to 900 TEUR as by the end of

20X2. Please determine the impariment reversal for the patent. (4 points)

c) Assume a manager wants to minimize the probability of goodwill impairment in

subsequent periods after a business combination. Would she try to allocate goodwill to

a CGU with rather high or rather low hidden reserves in the other assets? Please

explain. (2 points)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a)

Value in use: 200/1.1+150/1.1²+100/1.1³+50/1,1 4=415

FV-cost to sell=550

Recoverable amount: 550

Impairment loss: 830-550=280

Dr. Impairment loss Cr. Goodwill 50

Cr. Patent 69

Cr. PPE 161

b) Write-up patent limited to amortized costs without impairment: 150 – 150/4 = 112.5
Carrying amount before reversal of impairment in 20X2: (150 – 69) – (150-69)/ 4 = 60.75
 Reversal: 112.5 – 60.75 = 51.75

c)
Rather high; would allow her to avoid impairment because of the understated carrying
amount of the CGU relative to its recoverable amount.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Provisions

Fact pattern:

At the beginning of 20X1, Company X buys a power plant with an expected useful life of 40

years. At the same time, Company X enters into an obligation to dismantle the site at the end of

the useful life of the plant. At the end of 20X1, Company X records a depreciation expense for

the power plant of 48,800 EUR and an interest expense for the provision relating to the

dismantling obligation of 9,100 EUR. Company X uses a discount rate of 2%.

Questions:

a) Please calculate the purchase price of the power plant, the present value of the

provision for dismantling as at the beginning of 20X1, and the expected costs of

dismantling. (5 points)

b) Please provide the journal entries to account for the transaction in 20X2. If you could

not calculate a present value for the provision in (a), assume a present value of 500,000

EUR. (3 points)

c) Please explain whether you agree or disagree with the following statement: “Due to the

provision, the carrying amount of the power plant asset is overstated.” (2 points)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a)

Depreciation expense is 48,800  carrying amount at the beginning of 20X1 was 48,800 *

40 = 1,952,000

Interest expense is 9,100  amount of the provision at the beginning of 20X1 was 9100 /

0.02 = 455,000

 Expected costs of dismantling are 455,000 * (1.02 ^ 40) = 1,004,658

 Purchase price of the power plant was 1,952,000 – 455,000 = 1,497,000

b)

Dr. Depreciation Cr. Power Plant 48,800

Dr. Interest expense Cr. Provision 9,282*

(* = [455,000 + 9,100] * 0.02)

c)

Disagree. At the point in time of the purchase, Company X should expect to earn at least

the depreciation of the power plant and the future dismantling costs from the plant. If the

company’s expectations fall below that point, an impairment might be necessary. (Different

reasoning may also yield full points, depending on quality of arguments.)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Financial instruments

Fact pattern:

At the beginning of 20X1, Company X purchased security X. At the end of 20X2, Company X

records the following journal entries, all relating to its investment in security X:

Dr. OCI 500 Cr. Security X 500

Dr. Cash 10,000 Cr. Security X 10,000

Dr. Accumulated OCI 1,000 Cr. Retained earnings 1,000

Questions:

a) Please explain the events that can have given rise to the journal entries above. In doing

so, please explain, giving reasons for your answer:

I. Whether security X is a debt or equity instrument;

II. According to which category (IFRS 9) Company X accounts for security X;

III. The price for which security X was bought by Company X.

IV. The market value of security X at the end of 20X1. (6 points)

b) Please explain whether in the situations below the contractual cash flow characteristics

tests are met. (4 points)

I. A company purchases a bond with interest payments depending on the

inflation rate.

II. A company purchases a stock.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a)

I. Equity instrument because there was no recycling;

II. Fair value through OCI because OCI (without recycling) is involved;

III. 9,000 (corresponding to the sales price of 10,000 less the accumulated OCI

booked to retained earnings of 1,000).

IV. 10,500 (corresponding to the purchase price of 9,000 plus the accumulated OCI

at the end of 20X2, net of the revaluation relating to 20X2: 9,000 + 1,000 –(-

500)).

b)

I. Yes; variable interests do not prevent meeting the contractual cash flow

characteristics test.

II. No; it is an equity instrument.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Equity method

Fact pattern:

At the beginning of 20X1, KAUF AG buys 30% of the shares of ZIEL AG. KAUF AG pays

3,000 TEUR. ZIEL AG’s stock capital 2,000 TEUR and its equity reserves are 2,900 TEUR. In

20X1, ZIEL AG’s net income is 100 TEUR. During the transaction, hidden reserves on land

(2,000 TEUR) and machinery (1,000 TEUR; useful life: five years) have been uncovered.

KAUF AG accounts for the investment using the equity method.

Question:

a) Please perform a purchase price allocation for the transaction, calculating the resulting

goodwill. (3 points)

b) Please provide the journal entries to account for the investment in KAUF AG’s

consolidated statements in 20X1. What is the carrying amount of the investment at the

end of 20X1? (3 points)

c) Please discuss the issues created by the equity method for financial statement analysis.

(4 points)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a) Purchase price allocation

 30% of stock capital and reserves: 30% * (2,000 + 2,900) = 1,570

 30% of hidden reserves:

o Machinery (depreciated) 30% * 1,000 = 300

o Land 30% * 2,000 = 600

 Goodwill: 3,000 – 1,570 – 300 – 600 = 630

b) Journal entries

Dr. Investment in ZIEL Cr. Income from investment in ZIEL 30

(share in net income)

Dr. Income from investment in ZIEL Cr. Investment in ZIEL 60

(depreciation of hidden reserves)

Carrying amount: 3,000 – 60 + 30 = 2,970

c) „One-line“ consolidation, that is, we cannot see through to ZIEL AG’s individual assets

and liabilities. Therefore, margins and turnover ratios calculated for the group are

potentially distorted.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Financial ratio analysis

Fact pattern

Below you find the financial statements of Blueberry AG for 20X1.

Balance Sheet 20X1 Income Statement 20X1

Assets Sales 25,000
Non-current Cost of sales -1,000
Intangibles 7,500 Gross profit 24,000
Property, Plant &
Equipment 2,500 R&D expense -3,000
Investments in associates 500 SG&A expense -2,700
Current Other operating income 200
-
Securities held for trading 1,800 Other operating expense 15,000
Trade accounts receivable 2,500 Operating profit (EBIT) 3,500
Inventories 2,000 Income from associates 100
Cash and cash equivalents 300 Interest income 150
TOTAL 17,100 Interest expense -600
Profit before tax 3,150
Equity &Liabilities Tax expense -700
Common stock 6,000 Net income 2,450
Retained earnings 2,450
Total shareholders' equity 8,450
Non-current liabilities
Provisions 670
Long-term debt 6,000
Current liabilities
Accounts payable 600
Short-term debt 1,380
TOTAL 17,100

All interest income is generated from securities held for trading. All of Blueberry’s cash

holdings are of operating nature.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Questions:

a) Please disaggregate Blueberry’s income using the Advanced DuPont model.

b) Assume that Blueberry could take on a new loan at an effective rate of 15%. Assume

that the loan would be invested into a project that earns the same rate on return as

Blueberry’s current average operations, would you recommend that Blueberry takes on

the loan? Please explain briefly.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solutions:

a)

20X2
Net operating assets (NOA) 13,530
Net financial obligations (NFO) 5,080
Effective tax rate (ETR) 22.22%
Net operating income (NOI) 2,722
Net financing expense (NFE) 272
Equity direct 8,450
Equity (NOA - NFO) 8,450
Profit after tax direct 2,450
Profit after tax (NOI - NFE) 2,450

Advanced DuPont Analysis 20X2

Net operating assets (NOA) 13,530
Net financial obligations (NFO) 5,080
Equity (NOA - NFO) 8,450
Return on net operating assets (RNOA) 20.12%
Net borrowing costs (NBC) 5.36%
Spread (RNOA - NBC) 14.76%
Leverage (NFO / Equity) 0.6
ROE (via advanced DuPont decomposition) 28.99%

NOI margin 10.89%

NOA turnover 1.84775

b)

Yes. The average return on Blueberry’s operations is its RNOA of 20.12%, so NBC after tax of

less than 15% would result in a positive spread.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Forecasting

Fact pattern:

Below you find Uncertainty AG’s income statement forecasted for 20X2 as well as its

forecasted balance sheets for 20X1 and 20X2.

Simplified Income Statement, in Simplified Balance

T€ 20X2 Sheet, in T€ 20X1 20X2
revenues (sales) 104,500 Non-current Assets
- amortization on intangibles -5,450 intangible assets 20,000 21,800
- depreciation on PPE -4,944 PPE 60,000 44,500
- other cost of sales -77,606 Current Assets
= gross profit 16,500 inventories 10,000 25,200
- other operating expenses -11,000 receivables 35,000 17,250
= operating profit (EBIT) 5,500 cash 15,125 11,000
- interest expense -3,906 total assets 140,125 119,750
= profit before tax (EBT) 1,594 Equity
- income tax expense -478 shareholders’ equity 49,127 34,559
= profit after tax (net income) 1,116 retained earnings 2,078 2,636
Dividends 558 Total equity 51,205 37,195
Liabilities
debt 70,320 59,875
payables 18,600 22,680
total equity and
liabilities 140,125 119,750

Tasks:

a) Please provide the pro forma cash flow statement for 20X2. (7 points)

b) Please calculate the Free Cash Flow to all investors using the indirect method. (3

points)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a) Cash Flow statement:

Cash flow statement, in T€ 20X2

Cash (start of the year) 15,125
Profit after tax (net income) 1,116
+ amortization 5,450
+ depreciation 4,944
- increase in inventories -15,200
- increase in receivables 17,750
+ increase in payables 4,080
+ interest* 2,734
= Cash flow from operations 20,874
- investment in intangibles -7,250
- investment in PP&E 10,556
= Cash flow from investing 3,306
- interest* -2,734
+ increase in financial liabilities -10,445
+/- payments to/from shareholders -15,126
= Cash flow from financing -28,305
Net cash flow -4,125
Cash (end of the year) 11,000

b) Free Cash Flow (indirect method):

EBIT 5,500
EBIT * (1-ETR) 3850
Changes in non-cash working capital -6,630
Capex 3,306
D&A 10,394
FCF = EBIT *(1-ETR) + D&A + CFI – changes in non-cash working capital 24,180

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Forecasting

Fact pattern

On the next page, you are provided with excerpts of Company X’s cash flow

statement forecasted for 20X2, its income statement forecasted for 20X2 as well

as its balance sheet forecasted for 20X1.

Questions

a) Please derive Company X’s balance sheet of 20X2 by filling in the missing cells in the

table on the next page. (7 points)

b) Taking the cash flow statement as forecasted for 20X2, can you simply derive Free

Cash Flow to all investors by adding CFO and CFI? If not, why not? Please explain the

adjustment you would have to make so that Free Cash Flow to all investors would equal

the sum of CFO and CFI in the cash flow statement and calculate the firm’s Free Cash

Flow to all investors (3 points)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Statement of
Balance Sheet 20X1 20X2 Income Statement 20X2 Cash Flows 20X2
Property, Plant 5,000 Sales 40,000 Net income 13,325
and Equipment
Raw materials 6,700 - Cost of good sold - + Depreciation (PP&E) 1,500
inventory (COGS) 13,200
Accounts receivable 4,400 Gross profit 26,800 + Change in provisions 2,000

Cash 3,200 - R&D expenses -2,500 - Change in -6,500

accounts receivables
Total assets 19,300 - Selling expenses -7,000 - Change in 1,700
inventories
- Other operating -3,000 + Change in 5,500
expense accounts payable
Share capital 10,000 EBIT 14,300 Cash from operations 17,525

Retained earnings 4,700 - Interest expense -200 - Investment in PP&E -5,000

Total equity 14,700 EBT 14,100 Cash from investment -5,000

Accounts payable 2,300 - Income taxes -775 + Share issuance 5,000

Long-term loan 300 Net income 13,325 + Change in long-term 12,500

loan
Provision 2,000 - Dividend paid -800

Total equity and 19,300 Cash from financing 16,700

liabilites

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a)

Statement of
Balance Sheet 20X1 20X2 Income Statement 20X2 Cash Flows 20X2
Property, Plant 5,000 8,500 Sales 40,000 Net income 13,325
and Equipment
Raw materials 6,700 5,000 - Cost of good sold - + Depreciation (PP&E) 1,500
inventory (COGS) 13,200
Accounts receivable 4,400 10,900 Gross profit 26,800 + Change in provisions 2,000

Cash 3,200 32,425 - R&D expenses -2,500 - Change in -6,500

accounts receivables
Total assets 19,300 56,825 - Selling expenses -7,000 - Change in 1,700
inventories
- Other operating -3,000 + Change in 5,500
expense accounts payable
Share capital 10,000 15,000 EBIT 14,300 Cash from operations 17,525

Retained earnings 4,700 17,225 - Interest expense -200 - Investment in PP&E -5,000

Total equity 14,700 32,225 EBT 14,100 Cash from investment -5,000

Accounts payable 2,300 7,800 - Income taxes -775 + Share issuance 5,000

Long-term loan 300 12,800 Net income 13,325 + Change in long-term 12,500
loan
Provision 2,000 4,000 - Dividend paid -800

Total equity and 19,300 56,825 Cash from financing 16,700

liabilites

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 Accounting and Capital Markets: Exercise Package
Fall 2019

b) In the forecasted cash flow statement, the firm’s operating cash flow is net of interest expense. If we want to derive

FCF from CFO and CFI, we need to adjust CFO from interest expense after tax, hence adding an amount of 200 * (1 –

775/14,100) to the CFO of 17,525. The adjusted CFO then is 17,714 and FCF is 12,714.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Residual Income Model

Fact pattern:

You are provided with the following information relating to Company X:

Book value of equity, end of 2016: 50 TEUR

Earnings expected for 2017: 2 TEUR

Earnings expected for 2018: 10 TEUR

Cost of equity capital = discount rate (constant over time): 5%

Company X, as a general policy, does not pay dividends.

Questions:

a) Please calculate Company X’s equity value under a “no growth” scenario, assuming that

the firm’s residual income in 2018 reflects its steady state and remains constant from

this point onwards. (7 points)

b) Please explain how the residual income model provides a way to think about uncertainty

in equity valuation. (3 points)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a)
Required return_2017 2.5
Residual income 2017 -0.5
Present value of residual income -0.48

Book value of equity 2017 52

Required return 2018 2.6
Residual income 2018 7.4
Terminal value 148
PV of Terminal value 140.95238

Equity value 2016 190.48

b) The RIM anchors the valuation on book value, i.e., on expected future cash flows which are

sufficiently probable to meet recognition criteria required by accounting standards. To that, add

component of firm value from less certain future cash flows.

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Price-to-Book Ratio

Fact pattern

Analyst Alfred attempts to value Company X at the end of 20X0. By doing so, he applies a

constant growth rate from 20X1 onwards (perpetuity model) and assumes that Company X will

earn a constant RoE. In 20X0, Company X’s book value of equity is 15,000 TEUR. The

forecasted book value of equity for 20X1 is 15,450 TEUR. Residual income forecasted for

20X1 is 900 TEUR, and the present value of residual income forecasted for 20X1 and

discounted to 20X0 is 865.38 TEUR. Net income forecasted for 20X1 is 1,500 TEUR.

Question:

a) Please calculate Company X’s price-to-book ratio as at the end of 20X0. (8 points)

b) Alfred’s colleague Albert also performs a valuation for Company X. Albert’s valuation

yields a price-to-book ratio of 6. If Albert and Alfred agree on Company X’s risk and

forecasted profitability, does Albert assume a higher or lower growth ratio than Alfred?

(2 points)

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 Accounting and Capital Markets: Exercise Package
Fall 2019

Solution:

a)

Derive growth rate from book value of equity and forecast: 15,450/15,000 -1 = 3%

Derive discount rate from PV of residual income: 900 / 865 – 1 =4%

Derive RoE from book value as of 20X0 and forecasted net income for 20X1:

1,500/15,000 = 10%

Price to book ratio: 1+ (RoE – r) / (r-g) = 1+ 6% / 1% = 7

b) Lower, reflecting Albert’s lower growth expectations.

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