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INTRODUCTION
Course Description:
This course deals with solving common financial problems. The emphasis is on financial
statement analysis and interpretation of financial disclosures to help improve risk assessment,
forecasting and decision making. The methods of fundamental analysis will be examined in
detail and applied in cases. Topics include models of shareholder value, methods of financial
statement analysis, testing the quality of financial reports, forecasting earnings and cash flows &
pro forma analysis for strategy and planning.
Overview:
On each firm, the Finance and Accounting Department plays an integral part in helping make
the decision for the firm’s future business decisions. The Financial Analysis and Reporting will
help you learn how to grasp and analyze a company’s behavior based on past performance
using its records of Financial Statements.
This subject is essential to the finance students to help them prepare for their future career
experience. We will be evaluating all the core financial statements and get each of the
significant figures for financial ratios, that will be our basis on operational decisions.
You will be able to distinctly understand the fundamental tools and principles of Finance, by
reading the financial statements in a logical manner. Each of the main topics in the course
materials will have an activity / assessment that will help exercise your understanding of the
subject matter.
We know that it will be a challenging semester as we will not be having a face to face
discussion. But I hope this instruction material will help you understand the subject and get to
adapt it in your future careers.
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Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
TABLE OF CONTENTS
Topic Page
Course Outcome 5
(Course Materials)
Week 1: Introduction to the course contents, activities, and requirements 5
Week 2: Integration of Accounting Concepts 10
Week 3: Analysis of Past and Present Performance 28
Week 4 - 5: Financial Analysis 34
Week 6 - 7: Forecasting Techniques 50
Week 8: Financing Operations and Expansion 69
Week 10: Introduction to Financial Markets 80
Week 11: Business Valuation & Corporate Restructuring 92
Week 12 - 13: Asset Valuation Models for Mergers and Acquisitions 101
Week 14 - 15: Capital Raising for Corporations 112
Week 16: Capital Structure: Stock Valuation 120
Week 17: Capital Structure: Bond Valuation 125
(Activities / Assessments)
Week 2: Integration of Accounting Concepts 128
Week 3: Analysis of Past and Present Performance 130
Week 4 - 5: Financial Analysis 135
Week 6 - 7: Forecasting Techniques 140
Week 8: Financing Operations and Expansion 140
Week 9: Midterm Examination 141
Week 10: Introduction to Financial Markets 145
Week 11: Business Valuation & Corporate Restructuring 147
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COLLEGE OF ACCOUNTANCY AND FINANCE
Week 12 - 13: Asset Valuation Models for Mergers and Acquisitions 149
Week 14 - 15: Capital Raising for Corporations 150
Week 16: Capital Structure: Stock Valuation 152
Week 17: Capital Structure: Bond Valuation 154
Week 18: Final Examination 156
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COLLEGE OF ACCOUNTANCY AND FINANCE
COURSE OUTCOME:
By the end of the semester, the learners will be able to:
• Use Financial Statements to evaluate a firm’s performance.
• Conduct financial analysis and make the recommendations based on the analysis results.
• Analyze a firm’s performance to determine its strengths & weaknesses and be able to use
financial analysis to improve performance.
• Forecast a firm’s financial needs.
Week 1
Introduction to the course contents, activities, and requirements.
LEARNING OUTCOME:
For this topic, we will be learning the scope of the Financial Analysis and Reporting subject. You
will be seeing the whole picture of the course syllabus and have it connected to one of your
major subjects i.e. Financial Management. This will demonstrate interest and appreciation of the
importance of knowing the course.
Each of the topic in the syllabus will be detailed, mostly with a sample case study together with
an activity. This will be the general approach for you to be able to exercise the knowledge you
have just learned.
COURSE MATERIAL:
The next page will show the Course syllabus that includes the topics, methodology, resources
and assessment that you will take for the whole semester. Each topic will have a learning
outcome and course material that will help you go through this instruction material.
Furthermore, case studies & activities will be provided for knowledge-check. At the end of the
semester, you will now be able to select the necessary data for proper decision-making to
critically & analytically view the firm’s standing based on their financial statements.
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Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
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Republic of the Philippines
Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
Week 9
MIDTERM EXAMINATION
Week Asset Valuation Models for Course Material Refer to the Written
12-13 Mergers and Acquisitions Online examination
Short answer / references
Capital Asset Quiz
Pricing Model
Dividend Discount
Model
Gordon Growth
Model
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Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Week 2
Integration of Accounting Concepts
• Review of the Income Statement and the Balance Sheet
• Cash Flow Statement Preparation
• Cash Flow Statement Interpretation
• Notes to Financial Statements
• Introduction to Annual Company Reports
• Financial Statements of Banks, Insurance Firms and other Financial Institutions
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Review of the Income Statement and the Balance Sheet
Overview
There are three financial statements which are the income statement (statement
of comprehensive income), balance sheet (statement of financial position) and cash flow
statement. These three core statements are intricately linked to each other and this guide
will explain how they all fit together.
Income Statement
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COLLEGE OF ACCOUNTANCY AND FINANCE
The income statement is also known as the statement of operations, profit and loss
statement, and statement of earnings. It is one of a company's main financial statements.
The purpose of the income statement is to report a summary of a company's revenues,
expenses, gains, losses, and the resulting net income that occurred during a year, quarter,
or other period of time.
Revenues, which are the amounts earned through the sale of goods and/or the
providing of services
Expenses, which include the cost of goods sold, SG&A expenses, and interest
expense
Gains and losses, such as the sale of a noncurrent asset for an amount that is
different from its book value
Net income, which is the result of subtracting the company's expenses and losses
from the company's revenues and gains. Corporations with shares of common
stock that are publicly traded often refer to net income as earnings and their income
statements must include the earnings per share of common stock
Balance Sheet
The balance sheet displays the company’s total assets, and how these assets are
financed, through either debt or equity. It can also be referred to as a statement of net
worth, or a statement of financial position. The balance sheet is based on the fundamental
equation: Assets = Liabilities + Equity.
Current Assets
Cash and Equivalents - The most liquid of all assets, cash, appears on the first
line of the balance sheet. Cash Equivalents are also lumped under this line item and
include assets that have short-term maturities under three months or assets that the
company can liquidate on short notice, such as marketable securities. Companies will
generally disclose what equivalents it includes in the footnotes to the balance sheet.
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COLLEGE OF ACCOUNTANCY AND FINANCE
Accounts Receivable - This account includes the balance of all sales revenue
still on credit, net of any allowances for doubtful accounts (which generates a bad debt
expense). As companies recover accounts receivables, this account decreases and cash
increases by the same amount.
Non-Current Assets
Plant, Property, and Equipment (PP&E) - Property, Plant, and Equipment (also
known as PP&E) capture the company’s tangible fixed assets. This line item is noted net
of depreciation. Some companies will class out their PP&E by the different types of assets,
such as Land, Building, and various types of Equipment. All PP&E is depreciable except
for Land.
Intangible Assets - This line item includes all of the company’s intangible fixed
assets, which may or may not be identifiable. Identifiable intangible assets include patents,
licenses, and secret formulas. Unidentifiable intangible assets include brand and goodwill.
Current Liabilities
Current Debt/Notes Payable - Includes non-AP obligations that are due within
one year’s time or within one operating cycle for the company (whichever is longest).
Notes payable may also have a long-term version, which includes notes with a maturity of
more than one year.
Current Portion of Long-Term Debt - This account may or may not be lumped
together with the above account, Current Debt. While they may seem similar, the current
portion of long-term debt is specifically the portion due within this year of a piece of debt
that has a maturity of more than one year. For example, if a company takes on a bank
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loan to be paid off in 5-years, this account will include the portion of that loan due in the
next year.
Non-Current Liabilities
Bonds Payable - This account includes the amortized amount of any bonds the
company has issued.
Long-Term Debt - This account includes the total amount of long-term debt
(excluding the current portion if that account is present under current liabilities). This
account is derived from the debt schedule, which outlines all of the company’s outstanding
debt, the interest expense, and the principal repayment for every period.
Shareholders’ Equity
Share Capital - This is the value of funds that shareholders have invested in the
company. When a company is first formed, shareholders will typically put in cash. For
example, an investor starts a company and seeds it with $10M. Cash (an asset) rises by
$10M, and Share Capital (an equity account) rises by $10M, balancing out the balance
sheet.
Retained Earnings - This is the total amount of net income the company decides
to keep. Every period, a company may pay out dividends from its net income. Any amount
remaining (or exceeding) is added to (deducted from) retained earnings.
The Statement of Cash Flows (also referred to as the cash flow statement) is one
of the three key financial statements that report the cash generated and spent during a
specific period of time (e.g., a month, quarter, or year). The statement of cash flows acts
as a bridge between the income statement and balance sheet by showing how money
moved in and out of the business.
Cash Flow: Inflows and outflows of cash and cash equivalents (learn more in CFI’s
Ultimate Cash Flow Guide)
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Cash Balance: Cash on hand and demand deposits (cash balance on the balance
sheet)
Cash Equivalents: Cash equivalents include cash held as bank deposits, short-
term investments, and any very easily cash-convertible assets – includes overdrafts and
cash equivalents with short-term maturities (less than three months).
Investing Activities: Any cash flows from the acquisition and disposal of long-term
assets and other investments not included in cash equivalents
Financing Activities: Any cash flows that result in changes in the size and
composition of the contributed equity capital or borrowings of the entity (i.e., bonds, stock,
dividends)
The company’s chief financial officer (CFO) chooses between the direct and
indirect presentation of operating cash flow:
Indirect Presentation: Operating cash flows are presented as a reconciliation from profit to
cash flow:
Profit P
Depreciation D
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Amortization A
Impairment expense I
Change in working capital ΔWC
Change in provisions ΔP
Interest Tax (I)
Tax (T)
Operating cash flow OCF
The items in the cash flow statement are not all actual cash flows, but “reasons
why cash flow is different from profit.”
Depreciation expense reduces profit but does not impact cash flow (it is a non-
cash expense). Hence, it is added back. Similarly, if the starting point profit is above
interest and tax in the income statement, then interest and tax cash flows will need to be
deducted if they are to be treated as operating cash flows.
Cash Flow from Investing Activities includes the acquisition and disposal of non-
current assets and other investments not included in cash equivalents. Investing cash
flows typically include the cash flows associated with buying or selling property, plant, and
equipment (PP&E), other non-current assets, and other financial assets.
Cash spent on purchasing PP&E is called capital expenditures (or CapEx for
short).
Cash Flow from Financing Activities are activities that result in changes in the size
and composition of the equity capital or borrowings of the entity. Financing cash flows
typically include cash flows associated with borrowing and repaying bank loans, and
issuing and buying back shares. The payment of a dividend is also treated as a financing
cash flow.
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COLLEGE OF ACCOUNTANCY AND FINANCE
Under IFRS, there are two allowable ways of presenting interest expense in the
cash flow statement. Many companies present both the interest received and interest paid
as operating cash flows. Others treat interest received as investing cash flow and interest
paid as a financing cash flow. The method used is the choice of the finance director.
Investment bankers and finance professionals use different cash flow measures
for different purposes. Free cash flow is a common measure used typically for DCF
valuation. However, free cash flow has no definitive definition and can be calculated and
used in different ways.
The operating section of the statement of cash flows can be shown through either
the direct method or the indirect method. With either method, the investing and financing
sections are identical; the only difference is in the operating section. The direct method
shows the major classes of gross cash receipts and gross cash payments. The indirect
method, on the other hand, starts with the net income and adjusts the profit/loss by the
effects of the transactions. In the end, cash flows from the operating section will give the
same result whether under the direct or indirect approach, however, the presentation will
differ.
There are two methods of producing a statement of cash flows, the direct method,
and the indirect method.
In the direct method, all individual instances of cash that is received or paid out are
tallied up and the total is the resulting cash flow.
In the indirect method, the accounting line items such as net income, depreciation,
etc. are used to arrive at cash flow. In financial modeling, the cash flow statement is
always produced via the indirect method.
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Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
Direct Method
Operating Activities
Cash received from customers $800,000
Cash paid to suppliers (150,000)
Employee compensations (200,000)
Other operating expenses paid (250,000)
Net cash from operating activities $200,000
Investing Activities
Sale of land $200,000
Purchase of equipment (300,000)
Net cash from investing activities $ (100,000)
Financing Activities
Common share dividends (200,000)
Payment on long-term debt (300,000)
Net cash from financing activities $ (500,000)
Beginning Cash Balance $ 700,000
Ending Cash Balance $ 300,000
Indirect Method
Operating Activities
Net Income $50,000
Add: Depreciation Expense 10,000
Decrease in Accounts Receivable 2,000
Increase in Inventory 3,000
Decrese in Prepaid Expense 4,000
Increase in Accounts Payable 5,000 24,000
Net Cash provided by Operating Activities $74,000
Investing Activities
Sale of land $200,000
Purchase of equipment (300,000)
Net cash from investing activities $ (100,000)
Financing Activities
Common share dividends (200,000)
Payment on long-term debt (300,000)
Net cash from financing activities $ (500,000)
Beginning Cash Balance $ 700,000
Ending Cash Balance $ 174,000
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COLLEGE OF ACCOUNTANCY AND FINANCE
Cash from operating activities can be compared to the company’s net income to
determine the quality of earnings. If cash from operating activities is higher than net
income, earnings are said to be of “high quality.”
This statement is useful to investors because, under the notion that cash is king, it
allows investors to get an overall sense of the company’s cash inflows and outflows and
obtain a general understanding of its overall performance.
If a company is funding losses from operations or financing investments by raising money (debt
or equity) it will quickly become clear on the statement of cash flows.
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Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
Journal Entry
A journal is a record of transactions listed as they occur that shows the specific
accounts affected by the transaction. Used in a double-entry accounting system, journal
entries require both a debit and a credit to complete each entry. So, when you buy goods,
it increases both the inventory as well as the accounts payable accounts.
Journal entries are the foundation for all other financial reports. They provide
important information that are used by auditors to analyze how financial transactions
impact a business. The journalized entries are then posted to the general ledger.
Financial statement notes are the supplemental notes that are added to the
published financial statements of a company. The notes are used to explain further the
numbers included in the financial statements, as well as the accounting policies adopted
by the company. They help different types of users, such as financial analysts and
investors, to interpret all the numbers added in the financial statements.
The following are the common items that may appear in the notes to the financial
statements:
1. Basis of presentation - The first section in the financial statement notes explains the
basis of preparing and presenting the key financial statements.
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Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
Some of the disclosures included here are the depreciation method used, how the
company values inventory, accounting for intangibles, etc. All the accounting policies
adopted in the financial statements must be disclosed in the section.
4. Valuation of inventory - The valuation of inventory note informs users how the company
valued its inventory, making it easy for them to compare inventory figures from one period
to another or vis-à-vis other competing entities. The section provides information on two
main inventory issues, i.e., how inventory amount is stated and the method used to
determine inventory cost.
GAAP rules require companies to state their inventory lower of cost or market (LCM). It
means that the company will value the inventory at the lowest replacement cost, which
can be either the wholesale cost of inventory or the cost of the inventory in the market. On
the method of determining inventory cost, GAAP allows three different assumptions, which
include the weighted average, specific identification, and the first-in, first-out (FIFO)
method.
5. Subsequent events - Information on any subsequent events can be found also in the
financial statement notes section. Subsequent events refer to events that occur after the
balance sheet date but before the release of the financial statements. How the company
handles the events depends on whether they are recognized or unrecognized.
Recognized events are events that affect the financial statements, and, therefore, require
changes to be made to the financial statements. On the other hand, unrecognized events
have not been captured as of the balance sheet date and, therefore, do not affect the
financial statement being issued.
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Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
6. Intangible assets - The notes to the financial statement also include information on any
intangible assets owned by the company. Intangibles are assets that have no physical
form, and they include trademarks and patents. The section details all the intangible
assets that the company owns and how it determined the value of intangibles reported on
the balance sheet.
8. Employee benefits - The employee benefits section of the footnotes mentions the
benefits that the company provides to its employees, including health insurance, health
savings accounts, retirement plans, etc.
Some of the information that a company should disclose in the footnotes include the health
and welfare plans for its employees, such as the medical, vacation, and fringe benefits. It
should also provide information about the paid and unpaid expenses and liabilities for
employee retirement plans, including the medical costs of retired employees.
9. Contingent liability - A contingent liability refers to liability that has not occurred, but the
conditions are favorable for the liability to occur in the future. An example of a contingent
liability is a lawsuit against the company or an income tax dispute. Disclosing the
contingent liabilities informs users that the company will incur a loss in the future if the
impending event ends up against the company’s favor.
Annual reports provide information on the company’s mission and history and
summarize the company’s achievements in the past year. While financial achievements
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are included, other achievements also are noted, such as research advances, market
share gains or honors awarded to the company or its employees. The achievement
section also may include information on such things as sales increases or new
machinery that increases profitability and productivity. The chief purpose of the
achievements section is to make shareholders and stakeholders feel good about their
investments or participation in your company.
While the general structure of financial statements for banks isn’t that much
different from a regular company, the nature of banking operations means that there are
significant differences in the sub-classification of accounts. Banks use much more
leverage than other businesses and earn a spread between the interest income they
generate on their assets (loans) and their cost of funds (customer deposits).
The main operations and source of revenue for banks are their loan and deposit
operations. Customers deposit money at the bank for which they receive a relatively small
amount of interest. The bank then lends funds out at a much higher rate, profiting from the
difference in interest rates.
As such, loans to customers are classified as assets. This is because the bank expects to
receive interest and principal repayments for loans in the future, and thus generate
economic benefit from the loans.
Deposits, on the other hand, are expected to be withdrawn by customers or also pay out
interest payments, generating an economic outflow in the future. Deposits to customers
are, thus, classified as liabilities.
In the questions of financial statements for banks, where do these banks store their
money? It’s like the age-old question: do barbers cut their own hair?
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COLLEGE OF ACCOUNTANCY AND FINANCE
The answer isn’t too crazy. Most countries have a central bank, where most (or all) national
banks will store their money and profits. Deposits from a bank in a central bank are
considered assets, similar to cash and equivalents for a regular company. This is because
the bank can withdraw these deposits rather easily. It also expects to receive a small
interest payment, using the central bank’s prime rate.
Loans from the central bank are considered liabilities, much like normal debt.
Banks may hold marketable securities or certain currencies for the purposes of trading.
These will naturally be considered trading assets. They may have trading liabilities if the
securities they purchase decline in value.
Non-interest Revenue
Non-interest revenues consist of ancillary revenue the bank makes in supporting its services. This
can consist of:
Broker fees
Commissions and fees from products and services
Underwriting fees
Gain on sale of trading assets
Other customer fees (NSF fees, swipe fees, overdrawn fees)
These revenues come from anything that does not constitute interest revenue.
Interest Revenue
Interest revenue captures the interest payments the bank receives on the loans it issues.
Sometimes, this line item will only state gross interest revenue. Other times, this line will
consolidate gross interest revenue and deduct interest expense to find net interest revenue. This
interest expense is the direct interest expense paid to the deposits used to fund the loans, and
does not include interest expense from general debt.
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Polytechnic University of the Philippines
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COLLEGE OF ACCOUNTANCY AND FINANCE
Just like accounts receivables and bad debt expense, a company must prepare in the event that
borrowers are not able to pay off their loans. These bad pieces of credit are written off in the
income statement as a provision for credit loss.
Insurance revenue reflects the consideration to which the insurer expects to be entitled in
exchange for the services provided on an earned basis. Insurance revenue under IFRS 17 is no
longer equal to the premium received in the period. IFRS 17 makes it clear that an insurer should
not present premium information in profit or loss if that information is not in line with the definition
of insurance revenue.
Entities apply IFRS 9 to account for distinct investment components (not interrelated with
insurance and able to be sold separately). That is, the related net investment income is excluded
from the insurance service result and presented separately.
Insurance revenue includes insurance claims and other directly attributable expenses as
expected at the beginning of the reporting period and does not include experience adjustments
relating to these amounts (insurance service expenses) that arise during the year. Experience
adjustments related to premium receipts for current and past periods are included in insurance
revenue, however.
Under IFRS 4, many insurers recognize deferred acquisition cash flows separately as
assets. Under IFRS 17, for insurance contracts measured under the general measurement model
(GMM) and the variable fee approach (VFA), insurance acquisition cash flows decrease the CSM
and are thus implicitly deferred within the CSM, leading to a lower amount of CSM amortization
recognized in revenue in future reporting periods as services are rendered. However, for
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COLLEGE OF ACCOUNTANCY AND FINANCE
Under the premium allocation approach (PAA), an entity should recognize insurance
acquisition cash flows in the liability for remaining coverage (LRC) and amortize insurance
acquisition cash flows as insurance service expenses. Alternatively, an entity can choose to
recognize insurance acquisition cash flows as an expense when incurred if each insurance
contract in a group has a coverage period of one year or less.
When applying IFRS 17, any lack of recoverability of the acquisition cash flows is reflected
in the measurement of the insurance contracts, eliminating complex mechanisms that exist under
IFRS 4 to deal with amortization and impairment of the separate asset.
The risk adjustment in the insurance liability reflects the compensation that an insurer
requires for bearing the uncertainty arising from non-financial risk. For insurance contracts issued,
a portion of the risk adjustment for nonfinancial risk relating to the LRC is recognized in insurance
revenue as the risk is released, while a portion relating to the liability for incurred claims (LIC) is
recognized in insurance service expenses. An insurer is not required to include the entire change
in the risk adjustment for non-financial risk in the insurance service result. Instead, it can choose
to split the amount between the insurance service result and insurance finance income or
expenses. Among other impacts, disaggregation would result in higher insurance revenue and
higher finance expenses, though it represents a more complex option operationally.
Only items that reflect insurance service expenses (i.e. incurred claims and other
insurance service expenses arising from insurance contracts the Group issues) are reported as
insurance expenses. As a result, when applying IFRS 17, repayment of non-distinct investment
components is not presented as an insurance expense but rather as a settlement of an insurance
liability.
IFRS 17 allows options in presenting income or expenses from reinsurance contracts held,
other than insurance finance income or expenses. The Group elected to present a single net
amount in net expenses from reinsurance contracts held. An alternative would be to gross up this
single amount and present separately the amounts recovered from the reinsurer (as income) and
an allocation of the premiums paid (as reinsurance expenses) in line items separate from
insurance revenue and insurance service expenses.
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COLLEGE OF ACCOUNTANCY AND FINANCE
Post-adoption of IFRS 9, the line item ‘Interest revenue’ can contain only interest income
on assets that are measured at amortized cost (AC) or fair value through other comprehensive
income (FVOCI) (subject to the effect of applying hedge accounting to derivatives in designated
hedging relationships). If, as a matter of accounting policy
choice, additional line items are presented on the face of the statement of profit or loss for interest
on instruments measured at fair value through profit or loss (FVTPL), this policy, including how
such amounts are calculated and on which instruments, should be disclosed.
Gains and losses on the derecognition of financial assets measured at AC and credit
impairment losses are now required to be presented separately on the face of the statement of
profit or loss.
IFRS 7(20) requires, among other things, a disclosure, either in the statement of profit or
loss or in the notes, of net gains or net losses on financial assets or financial liabilities measured
at FVTPL, showing separately those designated upon initial recognition and those that are
mandatorily measured at FVTPL. For financial liabilities, gains or losses recognized in profit or
loss and those recognized in other comprehensive income (OCI) should be shown separately.
IFRS 17 requires all rights and obligations from a group of insurance contracts, such as
insurance liabilities, policyholder loans, insurance premium receivables and insurance intangible
assets, to be presented net in one line on the balance sheet, unless the components of the
insurance contract are separated.
Groups of insurance contracts in an asset position are presented separately from those in
a liability position (no offsetting). Groups of insurance contracts issued are presented separately
from groups of reinsurance contracts held.
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COLLEGE OF ACCOUNTANCY AND FINANCE
When applying IFRS 17, investment components, certain embedded derivatives and
goods and non-insurance services are separated from insurance contracts if and only if they are
distinct from the insurance component.
IFRS 7(8) requires disclosure, either on the balance sheet or in the notes, of the carrying
amounts of financial assets and liabilities by the following categories:
Financial assets measured at FVTPL, showing separately: (i) those mandatorily classified;
(ii) those designated upon initial recognition; (iii) those measured as such in accordance
with the exemption for repurchase of own financial liabilities (IFRS 9 (3.3.5)); and (iv) those
measured as such in accordance with the exemption for reacquisition of own equity
instruments (IAS 32(33A)).
Financial liabilities measured at FVTPL, showing those that meet the definition of held for
trading and those designated upon initial recognition.
Financial assets measured at AC.
Financial liabilities measured at AC.
Financial assets measured at FVOCI, showing separately debt and equity instruments.
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Week 3
Analysis of Past and Present Performance
• Vertical Analysis
• Horizontal and Trend Analysis
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Vertical Analysis
The use of vertical analysis on an income statement, balance sheet or cash flow statement
is to understand the proportions of each line item to the whole, understand key trends that occur
over time, compare multiple companies of varying sizes or compare a company's financial
statements to averages within their industry.
Using percentages to perform these financial analytics and comparisons makes the data
gathered more meaningful and easier to understand. Because the vertical analysis method uses
percentages to represent each line item, the analysis can proportionately compare a company's
relative account balances to those of another company or the company's industry average
regardless of whether the total sales for the other company or industry average are higher or
lower than the company that is being analyzed.
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Performing a vertical analysis on a financial statement that does not already show each
line item as a percentage, it can be found the percentage of each line item by dividing the line
item amount by the base figure and multiplying the resulting dividend by 100.
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*Current assets:
Accounting periods can be two or more than two periods. Accounting period can be a
month, a quarter or a year. It will depend on the analyst’s discretion when choosing an appropriate
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number of accounting periods. During the investment appraisal, the number of accounting periods
for analysis is based on the time horizon under consideration.
Horizontal analysis of financial statements can be performed on any of the item in the
income statement, balance sheet and statement of cash flows. For example, this analysis can be
performed on revenues, cost of sales, expenses, assets, cash, equity, and liabilities. It can also
be performed on ratios such as earnings per share (EPS), price-earnings ratio, dividend payout,
and another similar ratio.
The primary difference between vertical analysis and horizontal analysis is that horizontal
analysis uses percentages to represent each line item's percent change quarter over quarter
(QoQ) or year over year (YoY). While the formula for a vertical analysis looks at the percentage
of an item to the whole, the formula for a horizontal analysis looks at the item's percent change
from one period to another. Here is a comparison of each of the formulas for vertical analysis and
horizontal analysis:
Vertical analysis formula = (Statement line item / Total base figure) X 100
Horizontal analysis formula = {(Comparison year amount - Base year amount) /
Base year amount} X 100
However, it is important to remember that you can still use vertical analysis to compare a line
item's percentages from one quarter or year to another. The main difference is that the
percentages in a vertical analysis do not represent the percentage of change.
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Week 4 - 5
Financial Analysis
• Liquidity Ratios
• Solvency and Capital Structure ratios (include discussion of Du Pont Method)
• Asset Utilization and Efficiency Ratios (include discussion of Du Pont Method)
• Profitability Ratios
• Measures of Returns
• Cost Volume Profit Analysis
• Financial Leverage
• Break-even Point Analysis
• Variance Analysis
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Financial Statement Analysis
The analysis of financial statements means different things to different people depending
on their individual interests. Financial statement analysis is the process of analyzing a company's
financial statements for decision-making purposes. External stakeholders use it to understand the
overall health of an organization as well as to evaluate financial performance and business value.
Internal constituents use it as a monitoring tool for managing the finances.
Financial Ratios
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creditors, and internal company management understand how well a business is performing and
of areas needing improvement.
Liquidity Ratios
Does your enterprise have enough cash on an ongoing basis to meet its operational
obligations? This is an important indication of financial health.
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Solvency Ratios
To what degree does an enterprise utilize borrowed money and what is its level of risk? Lenders
often use this information to determine a business’s ability to repay debt.
Too much debt can put your business at risk, but too
little debt may limit your potential. Owners want to get
some leverage on their investment to boost profits. This
has to be balanced with the ability to service debt.
Measures your ability to meet interest payment
Interest Coverage =
obligations with business income. Ratios close to 1
indicates company having difficulty generating enough
EBITDA Interest
cash flow to pay interest on its debt. Ideally, a ratio
Expense
should be over 1.5
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Net Sales The higher the turnover, the shorter the time between sales and
Average Accounts Receivable collecting cash.
Days in Accounts Receivable What are your customer payment habits compared to your payment
= terms. You may need to step up your collection practices or tighten
your credit policies. These ratios are only useful if majority of sales are
Average Accounts credit (not cash) sales.
Receivable Sales x 365
Inventory Turnover =
The number of times you turn inventory over into sales during the year
or how many days it takes to sell inventory.
Cost of Sales
Average Inventory
This is a good indication of production and purchasing efficiency. A
high ratio indicates inventory is selling quickly and that little unused
Days in Inventory =
inventory is being stored (or could also mean inventory shortage). If the
ratio is low, it suggests overstocking, obsolete inventory or selling
Average Inventory
issues.
Cost of Sales x 365
Accounts Payable Turnover =
The number of times trade payables turn over during the year.
Cost of Sales
The higher the turnover, the shorter the period between purchases and
Average Accounts Payable
payment. A high turnover may indicate unfavourable supplier
repayment terms. A low turnover may be a sign of cash flow problems.
Days in Accounts Payable =
Compare your days in accounts payable to supplier terms of
Average Accounts Payable
repayment.
Cost of Sales x 365
Total Asset Turnover =
Revenue
How efficiently your business generates sales on each dollar of assets.
Average Total Assets
An increasing ratio indicates you are using your assets more
Fixed Asset Turnover =
productively.
Revenue
Average Fixed Assets
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Profitability Ratios
How well is our business performing over a specific period, will your social enterprise have the
financial resources to continue serving its constituents tomorrow as well as today?
Gross Profit Total Sales Is your gross profit margin improving? Small
Total Sales changes in gross margin can significantly affect
profitability. Is there enough gross profit to cover
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Indirect Costs (sales, general, admin) Look for a steady or decreasing ratio which means
Sales you are controlling overhead
Measures your ability to turn assets into profit. This
is a very useful measure of comparison within an
industry.
Return on Assets =
A low ratio compared to industry may mean that
Net Profit Average your competitors have found a way to operate
Total Assets more efficiently. After tax interest expense can be
added back to numerator since ROA measures
profitability on all assets whether or not they are
financed by equity or debt
Rate of return on investment by shareholders.
DuPont Method
The DuPont Analysis Formula is an alternate way to calculate and deconstruct ROE
(Return on Equity) in order to get a better understanding of the underlying factors behind a
company’s ROE.
It is done through adding additional factors and data points into the basic ROE equation
in order to get a clearer glimpse of what is driving the changes over time in a company’s ROE.
The DuPont Method has three main components.
Operating efficiency, which is measured by net profit margin.
Asset efficiency is measured by total asset turnover.
Financial leverage determined by the equity multiplier.
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Dupont Equation
The simplest Dupont formula, the three-step method, is done by simply multiplying the three
determinants of three main components–net profit margin, total asset turnover, and equity
multiplier–to determine the ROE.
When broken down into the calculations for the different components, the Dupont three-
step method formula looks like this:
This is simply a more detailed version of the basic ROE calculation, which can still be
reached by simply cross-canceling out the sales and total assets metrics.
There is a second, slightly more detailed version of the Dupont method called the five-step
Dupont.
This allows investors to see whether a company is propping up its ROE through
accumulating debt while suffering from a low profit margin and/or depreciating asset.
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The individual calculations for determining asset efficiency and financial leverage remains the
same, but the net profit margin formula, used to calculate operational efficiency, changes to better
show a company’s earnings before interest and taxes, or EBIT.
The EBIT is calculated by subtracting a company’s earnings before taxes (EBT) by its
interest expense (IE).
The rest of the equation is then multiplied by one minus the tax rate in order to determine
the tax hit on a company.
When spelled out, the five-step Dupont equation looks like this:
Five Way DuPont Method
DuPont Analysis
The DuPont Analysis allows analysts to understand where a company is strong and where
it is weak when it comes to generating profitability.
It gets its name from the company that pioneered the detailed model in the 1920s, the
DuPont Corporation.
Whereas ROE relies on a simple calculation of net income divided by shareholder equity
in order to evaluate a company’s performance, the DuPont formula goes deeper, focusing on the
three crucial categories of ROE.
Measures of Return
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Financial market assets generate two different streams of return: income through cash
dividends or interest payments and capital growth through the price appreciation of the asset.
Headline stock market indices typically report on price appreciation only and do not include the
dividend income unless the index specifies it is a “total return” series. It is important to be able to
compute and compare different measures of return to properly evaluate portfolio performance.
A holding period return is a return earned from holding an asset for a specified period of
time. The time period may be as short as a day or many years and is expressed as a total return.
This means we look at the return as a composite of the price appreciation and the income stream.
When we have assets for multiple holding periods, it is necessary to aggregate the returns into
one overall return. An arithmetic mean is a simple process of finding the average of the holding
period returns. For example, if a share has returned 15%, 10%, 12% and 3% over the last four
years, then the arithmetic mean is as follows:
interest. The previous year’s returns are compounded to the beginning value of the investment at
the start of the new period in order to earn returns on your returns. A geometric return provides a
more accurate representation of the portfolio value growth than an arithmetic return. Using the
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same annual returns of 15%, 10%, 12% and 3% as above, we compute the geometric mean as
follows:
Arithmetic and geometric returns do not consider the money invested in a portfolio in
different time periods. A money-weighted return is similar in computation methodology to an
internal rate of return (IRR) or a yield to maturity. We examine the cash flows from the perspective
of the investor where amounts invested in the portfolio are seen as cash outflows and amounts
withdrawn from the portfolio by the investor are cash inflows.
The IRR is the discount rate applied to determining the present value of the cash flows
such that the cumulative present value of all the cash flows is zero. The IRR provides the investor
with an accurate measure of what was actually earned on the money invested but does not allow
for easy comparison between individuals.
Annualized Return
If the period during which the return is earned is not exactly one year, we can annualize the
return to enable an easy comparative return. To annualize a return earned for a period shorter
than one year, the return must be compounded by the number of periods in the year. A monthly
return must be compounded 12 times, a weekly return 52 times and a daily return 365 times. A
weekly return of 2%, when annualized, is as follows:
When the holding period is longer than one year, we need to express the year as a fraction of
the holding period and compound using this fractional number. For example, a year relative to a
20-month holding period is a fraction of 12/20. If we had a return of 12% for 20 months, then the
annualized return is as follows:
Portfolio Return
When a portfolio is made up of several assets, we may want to find the aggregate return of the
portfolio as a whole. In order to compute this, we weight the returns of the underlying assets by
the amounts allocated to them. A portfolio that consists of 70% equities which return 10%, 20%
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bonds which return 4%, and 10% cash which returns 1% would have a portfolio return as
follows:
There are other measures of returns that need to be taken into account when evaluating
performance. These are as follows:
A gross return is earned prior to the deduction of fees (management fees, custodial fees,
and other administrative expenses). A net return is the return post-deduction of fees.
In general, returns are presented pre-tax and with no adjustment for the effects of inflation.
Tax considerations like capital gains tax and tax on interest or dividend income will need to be
deducted from the investment to determine post-tax returns.
Real returns
Returns are typically presented in nominal terms which consist of three components: the
real risk-free return as compensation for postponing consumption, inflation as compensation for
the loss of purchasing power and a risk premium. Real returns are useful for comparing returns
over different time periods as inflation rates vary over time.
Leverage returns
If an investor makes use of derivative instruments within a portfolio or borrows money to invest,
then leverage is introduced into the portfolio. The leverage amplifies the returns on the
investor’s capital, both upwards and downwards.
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The regular income statement follows the order of revenues minus cost of goods sold and
gives gross margin, while revenues minus expenses lead to net income. A contribution margin
income statement follows a similar concept but uses a different format by separating fixed and
variable costs.
The contribution margin is the product’s selling price, less the variable costs associated
with producing that product. The value can be given in total dollars or per unit.
Consider the following example in order to calculate the five important components listed above.
CM ratios and variable expense ratios are numbers that companies generally want to see
to get an idea of how significant variable costs are.
A high CM ratio and a low variable expense ratio indicate low levels of variable costs
incurred.
#2 Break-Even Point
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The break-even point (BEP), in units, is the number of products the company must sell to
cover all production costs. Similarly, the break-even point in dollars is the amount of sales the
company must generate to cover all production costs (variable and fixed costs).
The BEP, in units, would be equal to 240,000/15 = 16,000 units. Therefore, if the company
sells 16,000 units, the profit will be zero and the company will “break even” and only cover its
production costs.
It is quite common for companies to want to estimate how their net income will change
with changes in sales behavior. For example, companies can use sales performance targets or
net income targets to determine their effect on each other.
In this example, if management wants to earn a profit of at least $100,000, how many units
must the company sell?
Therefore, to earn at least $100,000 in net income, the company must sell at least 22,666
units.
#4 Margin of Safety
In addition, companies may also want to calculate the margin of safety. This is commonly
referred to as the company’s “wiggle room” and shows by how much sales can drop and yet still
break even.
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Therefore, sales can drop by $240,000, or 20%, and the company is still not losing any
money.
Finally, the degree of operating leverage (DOL) can be calculated using the following
formula:
The DOL number is an important number because it tells companies how net income
changes in relation to changes in sales numbers. More specifically, the number 5 means that a
1% change in sales will cause a magnified 5% change in net income.
Many might think that the higher the DOL, the better for companies. However, the higher the
number, the higher the risk, because a higher DOL also means that a 1% decrease in sales will
cause a magnified, larger decrease in net income, ultimately decreasing its profitability.
Putting all the pieces together and conducting the CVP analysis, companies can then
make decisions on whether to invest in certain technologies that will alter their cost structures and
determine the effects on sales and profitability much quicker.
For example, let’s say that XYZ Company from the previous example was considering
investing in new equipment that would increase variable costs by $3 per unit but could decrease
fixed costs by $30,000. In this decision-making scenario, companies can easily use the numbers
from the CVP analysis to determine the best answer.
The hardest part in these situations involves determining how these changes will affect
sales patterns – will sales remain relatively similar, will they go up, or will they go down? Once
sales estimates become somewhat reasonable, it then becomes just a matter of number
crunching and optimizing the company’s profitability.
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Variance Analysis
Variance analysis can be summarized as an analysis of the difference between planned and
actual numbers. The sum of all variances gives a picture of the overall over-performance or
under-performance for a particular reporting period. For each individual item, companies assess
its favorability by comparing actual costs and standard costs in the industry. For example, if the
actual cost is lower than the standard cost for raw materials, assuming the same volume of
materials, it would lead to a favorable price variance (i.e., a cost savings). However, if the
standard quantity was 10,000 pieces of material and 15,000 pieces were required in production,
this would be an unfavorable quantity variance because more materials were used than
anticipated.
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Week 6 - 7
Forecasting Techniques
• Strategic Planning and the Budget
• Economic and Industry Evaluation
• Cash Flow Forecasting
• Statistical Forecasting
• Pro-Forma Forecasting
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE OUTCOME:
Strategic planning is the art of creating specific business strategies, implementing them,
and evaluating the results of executing the plan, in regard to a company’s overall long-term goals
or desires. It is a concept that focuses on integrating various departments (such as accounting
and finance, marketing, and human resources) within a company to accomplish its strategic goals.
The term strategic planning is essentially synonymous with strategic management.
The concept of strategic planning originally became popular in the 1950s and 1960s, and
enjoyed favor in the corporate world up until the 1980s, when it somewhat fell out of favor.
However, enthusiasm for strategic business planning was revived in the 1990s and strategic
planning remains relevant in modern business.
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The strategic planning process requires considerable thought and planning on the part of
a company’s upper-level management. Before settling on a plan of action and then determining
how to strategically implement it, executives may consider many possible options. In the end, a
company’s management will, hopefully, settle on a strategy that is most likely to produce positive
results (usually defined as improving the company’s bottom line) and that can be executed in a
cost-efficient manner with a high likelihood of success, while avoiding undue financial risk.
The development and execution of strategic planning are typically viewed as consisting of
being performed in three critical steps:
1. Strategy Formulation
In the process of formulating a strategy, a company will first assess its current situation by
performing an internal and external audit. The purpose of this is to help identify the organization’s
strengths and weaknesses, as well as opportunities and threats (SWOT Analysis). As a result of
the analysis, managers decide on which plans or markets they should focus on or abandon, how
to best allocate the company’s resources, and whether to take actions such as expanding
operations through a joint venture or merger.
2. Strategy Implementation
After a strategy is formulated, the company needs to establish specific targets or goals
related to putting the strategy into action and allocate resources for the strategy’s execution. The
success of the implementation stage is often determined by how good a job upper management
does in regard to clearly communicating the chosen strategy throughout the company and getting
all of its employees to “buy into” the desire to put the strategy into action.
3. Strategy Evaluation
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Any savvy businessperson knows that success today does not guarantee success
tomorrow. As such, it is important for managers to evaluate the performance of a chosen strategy
after the implementation phase. Strategy evaluation involves three crucial activities: reviewing the
internal and external factors affecting the implementation of the strategy, measuring performance,
and taking corrective steps to make the strategy more effective. For example, after implementing
a strategy to improve customer service, a company may discover that it needs to adopt a new
customer relationship management (CRM) software program in order to attain the desired
improvements in customer relations.
All three steps in strategic planning occur within three hierarchical levels: upper
management, middle management, and operational levels. Thus, it is imperative to foster
communication and interaction among employees and managers at all levels, so as to help the
firm to operate as a more functional and effective team.
The volatility of the business environment causes many firms to adopt reactive strategies
rather than proactive ones. However, reactive strategies are typically only viable for the short-
term, even though they may require spending a significant amount of resources and time to
execute. Strategic planning helps firms prepare proactively and address issues with a more long-
term view. They enable a company to initiate influence instead of just responding to situations.
Among the primary benefits derived from strategic planning are the following:
This is often the most important benefit. Some studies show that the strategic planning
process itself makes a significant contribution to improving a company’s overall performance,
regardless of the success of a specific strategy.
Strategic planning also helps managers and employees show commitment to the
organization’s goals. This is because they know what the company is doing and the reasons
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behind it. Strategic planning makes organizational goals and objectives real, and employees can
more readily understand the relationship between their performance, the company’s success, and
compensation. As a result, both employees and managers tend to become more innovative and
creative, which fosters further growth of the company.
The increased dialogue and communication across all stages of the process strengthens
employees’ sense of effectiveness and importance in the company’s overall success. For this
reason, it is important for companies to decentralize the strategic planning process by involving
lower-level managers and employees throughout the organization. A good example is that of the
Walt Disney Co., which dissolved its separate strategic planning department, in favor of assigning
the planning roles to individual Disney business divisions.
Budgeting
There are four dimensions to consider when translating high-level strategy, such as mission,
vision, and goals, into budgets.
Objectives are basically your goals, e.g., increasing the amount each customer spends at
your retail store.
Then, you develop one or more strategies to achieve your goals. The company can
increase customer spending by expanding product offerings, sourcing new suppliers,
promotion, etc.
You need to track and evaluate the effectiveness of the strategies, using relevant
measures. For example, you can measure the average weekly spending per customer
and average price changes as inputs.
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Finally, you should set targets that you would like to reach by the end of a certain period.
The targets should be quantifiable and time-based, such as an increase in the volume of
sales or an increase in the number of products sold by a certain time.
The process gets managers to consider how conditions may change and what steps they
need to take, while also allowing managers to understand how to address problems when they
arise.
Budgeting encourages managers to build relationships with the other parts of the
operation and understand how the various departments and teams interact with each other and
how they all support the overall organization.
Budgeting gets managers to focus on participation in the budget process. It provides a challenge
or target for individuals and managers by linking their compensation and performance relative to
the budget.
5. Control activities
Managers can compare actual spending with the budget to control financial activities.
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Budgeting provides a means of informing managers of how well they are performing in meeting
targets they have set.
Types of Budgets
1. Operating budget
Revenues and associated expenses in day-to-day operations are budgeted in detail and
are divided into major categories such as revenues, salaries, benefits, and non-salary expenses.
2. Capital budget
Capital budgets are typically requests for purchases of large assets such as property,
equipment, or IT systems that create major demands on an organization’s cash flow. The
purposes of capital budgets are to allocate funds, control risks in decision-making, and set
priorities.
3. Cash budget
Cash budgets tie the other two budgets together and take into account the timing of payments
and the timing of receipt of cash from revenues. Cash budgets help management track and
manage the company’s cash flow effectively by assessing whether additional capital is required,
whether the company needs to raise money, or if there is excess capital.
Economic Evaluation
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Economic evaluation makes use of historical data points that have been released in
previous economic reports for countries or geographical regions. Generally, economic forecasting
is centered around predicting the growth in Gross Domestic Product (GDP) for an economy.
GDP measures the total value of goods and services produced in an economy over a
period. It is widely considered to be a proxy for the wealth of an economy since an economy that
produces more is considered more affluent.
Businesses use economic forecasts to plan their operating activities. If the growth in GDP
is expected to be strong, they can expect to have more disposable income, and they may decide
to ramp up their capital expenditures.
Government entities use forecasts to plan their policy-making efforts as well. Fiscal
policies and monetary policies are implemented based on the expectation of GDP growth.
If the growth in GDP is expected to be strong, the government may enact tighter policies.
On the other hand, if GDP growth is expected to be slow, the government may enact expansionary
policies.
Investors also use GDP growth forecasts to make informed decisions. If the economy is
expected to be strong, they may be more comfortable investing in riskier assets, whereas if the
economic conditions are expected to weaken, investors may be more conservative with their
asset allocation.
Economic Indicators
An economy will release what is known as indicators, which are specified data points
relating to the economy. The indicators relate to the economic cycle, which is the state of the
economy that is being experienced. There are two types of indicators:
1. Lagging Indicators
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Lagging indicators are used to inform which stage of the business cycle an economy is in.
They are also used to identify the overall trend of the economy and are used by individuals,
businesses, and government entities to make informed decisions.
The common characteristic among the lagging indicators is that the shift in them occurs only after
there has been a shock to the economy.
For example, during the 2008-2009 Global Financial Crisis, corporate earnings of companies
were not observed to have fallen until after the housing market bubble had already popped.
2. Leading Indicators
Leading indicators are used to predict when changes in the economic cycle may occur
and predict other significant shifts in the economy. As you can imagine, leading indicators are
critically important in economic forecasting since they are the main inputs in the statistical models
used to forecast economic conditions.
It should be noted that the data points are gathered from the past, and the past does not
necessarily inform future conditions. Therefore, leading indicators are not always accurate, but
they provide some insights and are widely used by individuals, businesses, and government
entities.
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Yield Curve
Housing Starts
Retail Sales
Jobless Claims
Corporate Capital Expenditures
Purchasing Managers Index (PMI)
Consumer Confidence Index
Industrial Production
Worker Productivity
The common characteristic among the indicators above is that the shift in them occurs before
there is a shock to the economy.
For example, when the COVID-19 global outbreak occurred in 2020, the stock market crashed
heavily in March, before the impact on the real economy had been felt.
A more general example is if aggregate corporate capital expenditures are falling, future
earnings growth can be expected to be lower and negatively impact the real economy in the
future.
Industry Evaluation
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environment is to understand the differences between yourself and your competitors in the
industry and use it to your full advantage.
There are three commonly used and important methods of performing industry evaluation.
The three methods are:
One of the most famous models ever developed for industry analysis, famously known as
Porter’s 5 Forces, was introduced by Michael Porter in his 1980 book “Competitive Strategy:
Techniques for Analyzing Industries and Competitors.”
According to Porter, analysis of the five forces gives an accurate impression of the industry and
makes analysis easier. In our Corporate & Business Strategy course, we cover these five forces
and an additional force — power of complementary good/service providers.
The number of participants in the industry and their respective market shares are a direct
representation of the competitiveness of the industry. These are directly affected by all the factors
mentioned above. Lack of differentiation in products tends to add to the intensity of competition.
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High exit costs such as high fixed assets, government restrictions, labor unions, etc. also make
the competitors fight the battle a little harder.
This indicates the ease with which new firms can enter the market of a particular industry.
If it is easy to enter an industry, companies face the constant risk of new competitors. If the entry
is difficult, whichever company enjoys little competitive advantage reaps the benefits for a longer
period. Also, under difficult entry circumstances, companies face a constant set of competitors.
This refers to the bargaining power of suppliers. If the industry relies on a small number
of suppliers, they enjoy a considerable amount of bargaining power. This can particularly affect
small businesses because it directly influences the quality and the price of the final product.
The complete opposite happens when the bargaining power lies with the customers. If
consumers/buyers enjoy market power, they are in a position to negotiate lower prices, better
quality, or additional services and discounts. This is the case in an industry with more competitors
but with a single buyer constituting a large share of the industry’s sales.
The industry is always competing with another industry producing a similar substitute
product. Hence, all firms in an industry have potential competitors from other industries. This takes
a toll on their profitability because they are unable to charge exorbitant prices. Substitutes can
take two forms – products with the same function/quality but lesser price, or products of the same
price but of better quality or providing more utility.
Broad Factors Analysis also commonly called the PEST Analysis stands for Political, Economic,
Social and Technological. PEST analysis is a useful framework for analyzing the external
environment.
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To use PEST as a form of industry analysis, an analyst will analyze each of the 4 components
of the model. These components include:
1. Political
Political factors that impact an industry include specific policies and regulations related to
things like taxes, environmental regulation, tariffs, trade policies, labor laws, ease of doing
business, and overall political stability.
2. Economic
The economic forces that have an impact include inflation, exchange rates (FX), interest
rates, GDP growth rates, conditions in the capital markets (ability to access capital), etc.
3. Social
The social impact on an industry refers to trends among people and includes things such
as population growth, demographics (age, gender, etc.), and trends in behavior such as health,
fashion, and social movements.
4. Technological
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#3 SWOT Analysis
SWOT Analysis stands for Strengths, Weaknesses, Opportunities, and Threats. It can be a
great way of summarizing various industry forces and determining their implications for the
business in question.
1. Internal
Internal factors that already exist and have contributed to the current position and may
continue to exist.
2. External
External factors are usually contingent events. Assess their importance based on the
likelihood of them happening and their potential impact on the company. Also, consider whether
management has the intention and ability to take advantage of the opportunity/avoid the threat.
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associated with entering and exiting the industry. It is very important when planning a small
business. Analysis helps to identify which stage an industry is currently in; whether it is still
growing and there is scope to reap benefits, or has it reached its saturation point.
With a very detailed study of the industry, entrepreneurs can get a stronghold on the operations
of the industry and may discover untapped opportunities. It is also important to understand that
industry analysis is somewhat subjective and does not always guarantee success. It may
happen that incorrect interpretation of data leads entrepreneurs to a wrong path or into making
wrong decisions. Hence, it becomes important to collect data carefully.
The first step in our cash flow forecast is to forecast cash flows from operating activities, which
can be derived from the balance sheet and the income statement.
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From the income statement, we use forecast net income and add back the forecast
depreciation. We then use the forecast balance sheet to calculate changes in operating assets
and liabilities. For each operating asset and liability, we must compare our forecast year in
question with the prior year. In this example, changes in receivables and inventory have the
effect of increasing the total cash flows. In other words, receivables and inventory in our
forecast year are both lower than the prior year.
Changes in trade and other payables have a reverse effect – decreasing total cash flows
from operating activities. In other words, the payables figure must be lower in our forecast year
than the prior year.
Now that we have learned how to calculate cash flows from operating activities, let’s look
at investing activities. All investing activity items come from specific fixed assets or property plant
& equipment (PP&E) forecasts.
Our model forecasts fixed assets in detail in the “Supporting Schedules” section, where we
assume:
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Assets are fully depreciated when disposed of and no cash flows are associated with the
disposals.
No purchase or sale of businesses.
As a result, the only item we will forecast in our model will relate to the acquisition of fixed
assets or property, plant & equipment (PP&E). It is often referred to as CAPEX, short for capital
expenditures.
After forecasting investing activities, we will now learn how to calculate cash flows from
financing activities. Most financing activity items are calculated by simply comparing the forecast
year with the prior year. In our model, we included dividends in our financing activity. In practice,
some organizations include dividend cash flows in operating activities. The choice should reflect
how dividends are reported in financial statements.
Although FCF to the firm is the preferred approach to equity valuation, it is not the only FCF
calculation used. There is another FCF variant that is used called FCF to equity.
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Free cash flows to equity are used to determine how much cash is available to equity investors
after paying off debt interest and satisfying sustainable obligations. In simple terms, FCF to
equity is cash flow from operations, minus capital expenditures, plus net debt issued.
Since there are only two major differences between FCF to the firm and FCF to equity, it is
relatively easy to reconcile the two.
Starting with FCF to equity, we simply deduct the net debt issued, add back the interest
expense, and deduct the tax shield on interest. The tax shield on interest is the difference
between taxes calculated on EBIT and taxes calculated on earnings before tax.
Statistical Forecasting
There are four main types of statistical forecasting methods that financial analysts use to
predict future revenues, expenses, and capital costs for a business. While there are a wide range
of frequently used quantitative budget forecasting tools, in this article we focus on the top four
methods: (1) straight-line, (2) moving average, (3) simple linear regression, and (4) multiple linear
regression.
#1 Straight-line Method
The straight-line method is one of the simplest and easy-to-follow forecasting methods. A
financial analyst uses historical figures and trends to predict future revenue growth.
#2 Moving Average
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Moving averages are a smoothing technique that looks at the underlying pattern of a set
of data to establish an estimate of future values. The most common types are the 3-month and 5-
month moving averages.
Regression analysis is a widely used tool for analyzing the relationship between variables
for prediction purposes.
A company uses multiple linear regression to forecast revenues when two or more
independent variables are required for a projection.
Pro-forma Forecasting
Pro-forma financials used in the pro-forma forecast will usually reflect the predicted state
of the business after a large or important transaction has taken place. The inclusion of anticipated
future events in the pro-forma financial statements allows the company a unique opportunity to
sculpt the presentation of the company's financial situation in a way that normally wouldn't be
allowed under generally accepted accounting principles (GAAP) rules.
Often, events depicted in the pro-forma financial statements have yet to occur, so the
actual financial picture of the company may be very different from the picture presented.
Forecasts made from these financial statements may or may not contain an even higher degree
of deviation from the actual state of the company.
A pro-forma forecast, similar to any sort of pro-forma report, is not required to abide by
GAAP. As a result, they often reflect the best-case scenario, which the firm would like to portray
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to investors. It takes a skilled analyst to unpack the marketing from the actual numbers. Of course,
the analyst can always just use the audited financial statements in their analysis as opposed to
pro-forma statements and forecasts; however, these forecasts can be a valuable clue as to how
the company intends to increase its value and what type of growth they are aiming for.
For example, XYZ Company is a publicly-traded maker of widget presses. After many
years of research and development (R&D), they have applied for a patent on a new type of widget
press technology. If they are granted the patent, they will be the only company that can use this
new technology for 10 years. This new technology will allow XYZ Company to manufacture widget
presses at half their current cost and several times more quickly. This could potentially make them
the preferred provider in the space and help them gain market share.
To demonstrate this potential good fortune on the company's financial statements, XYZ
Company may draw up pro-forma financial statements that show the predicted effects of lower
costs and increased sales on the company's financial situation. Pro-forma forecasts made off of
the assumption that this patent will be granted might show larger than normal yearly sales
increases as XYZ Company steals market share from its less technologically advanced and
more expensive competitors. Of course, if the patent isn't granted, all of this would be highly
inaccurate.
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Week 8
Financing Operations and Expansion
• Concept of Risk
• Asset and Liability Management
• Cost of Capital
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Concept of Risk
Risk
In finance, risk is the probability that actual results will differ from expected results. In the
Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns. The concept of
“risk and return” is that riskier assets should have higher expected returns to compensate
investors for the higher volatility and increased risk.
Types of Risk
Broadly speaking, there are two main categories of risk: systematic and unsystematic.
Systematic risk is the market uncertainty of an investment, meaning that it represents external
factors that impact all (or many) companies in an industry or group. Unsystematic risk represents
the asset-specific uncertainties that can affect the performance of an investment.
Below is a list of the most important types of risk for a financial analyst to consider when
evaluating investment opportunities:
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Financial Risk – The capital structure of a company (degree of financial leverage or debt burden).
Social Risk – The impact of changes in social norms, movements, and unrest.
Environmental Risk – Uncertainty about environmental liabilities or the impact of changes in the
environment.
Operational Risk – Uncertainty about a company’s operations, including its supply chain and the
delivery of its products or services.
Management Risk – The impact that the decisions of a management team have on a company.
Competition – The degree of competition in an industry and the impact choices of competitors
will have on a company.
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The farther away into the future a cash flow or an expected payoff is, the riskier (or more
uncertain) it is. There is a strong positive correlation between time and uncertainty.
See the example, we will look at two different methods of adjusting for uncertainty that is both a
function of time.
Risk Adjustment
Since different investments have different degrees of uncertainty or volatility, financial analysts
will “adjust” for the level of uncertainty involved. Generally speaking, there are two common
ways of adjusting: the discount rate method and the direct cash flow method.
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The discount rate method of risk-adjusting an investment is the most common approach,
as it’s fairly simple to use and is widely accepted by academics. The concept is that the expected
future cash flows from an investment will need to be discounted for the time value of money and
the additional risk premium of the investment.
The direct cash flow method is more challenging to perform but offers a more detailed and
more insightful analysis. In this method, an analyst will directly adjust future cash flows by applying
a certainty factor to them. The certainty factor is an estimate of how likely it is that the cash flows
will actually be received. From there, the analyst simply has to discount the cash flows at the time
value of money in order to get the net present value (NPV) of the investment. Warren Buffett is
famous for using this approach to valuing companies.
Risk Management
There are several approaches that investors and managers of businesses can use to
manage uncertainty. Below is a breakdown of the most common risk management strategies:
#1 Diversification
#2 Hedging
#3 Insurance
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There is a wide range of insurance products that can be used to protect investors and
operators from catastrophic events. Examples include key person insurance, general liability
insurance, property insurance, etc. While there is an ongoing cost to maintaining insurance, it
pays off by providing certainty against certain negative outcomes.
#4 Operating Practices
There are countless operating practices that managers can use to reduce the riskiness of
their business. Examples include reviewing, analyzing, and improving their safety practices ;using
outside consultants to audit operational efficiencies; using robust financial planning methods; and
diversifying the operations of the business.
#5 Deleveraging
Companies can lower the uncertainty of expected future financial performance by reducing
the amount of debt they have. Companies with lower leverage have more flexibility and a lower
risk of bankruptcy or ceasing to operate.
It’s important to point out that since risk is two-sided (meaning that unexpected outcome can be
both better or worse than expected), the above strategies may result in lower expected returns
(i.e., upside becomes limited).
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The concept of uncertainty in financial investments is based on the relative risk of an investment
compared to a risk-free rate, which is a government-issued bond. Below is an example of how
the additional uncertainty or repayment translating into more expense (higher returning)
investments.
As the chart illustrates, there are higher expected returns (and greater uncertainty) over time of
investments based on their spread to a risk-free rate of return.
Asset and liability management (ALM) is a practice used by financial institutions to mitigate
financial risks resulting from a mismatch of assets and liabilities. ALM strategies employ a
combination of risk management and financial planning and are often used by organizations to
manage long-term risks that can arise due to changing circumstances.
The practice of asset and liability management can include many factors, including
strategic allocation of assets, risk mitigation, and adjustment of regulatory and capital frameworks.
By successfully matching assets against liabilities, financial institutions are left with a surplus that
can be actively managed to maximize their investment returns and increase profitability.
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At its core, asset and liability management is a way for financial institutions to address
risks resulting from a mismatch of assets and liabilities. Most often, the mismatches are a result
of changes to the financial landscape, such as changing interest rates or liquidity requirements.
A full ALM framework focuses on long-term stability and profitability by maintaining liquidity
requirements, managing credit quality, and ensuring enough operating capital. Unlike other risk
management practices, ALM is a coordinated process that uses frameworks to oversee an
organization’s entire balance sheet. it ensures that assets are invested most optimally, and
liabilities are mitigated over the long-term.
Traditionally, financial institutions managed risks separately based on the type of risk
involved. Yet, with the evolution of the financial landscape, it is now seen as an outdated
approach. ALM practices focus on asset management and risk mitigation on a macro level,
addressing areas such as market, liquidity, and credit risks.
Unlike traditional risk management practices, ALM is an ongoing process that continuously
monitors risks to ensure that an organization is within its risk tolerance and adhering to regulatory
frameworks. The adoption of ALM practices extends across the financial landscape and can be
found in organizations, such as banks, pension funds, asset managers, and insurance
companies.
Using ALM frameworks allows an institution to recognize and quantify the risks present on
its balance sheet and reduce risks resulting from a mismatch of assets and liabilities. By
strategically matching assets and liabilities, financial institutions can achieve greater efficiency
and profitability while reducing risk.
The downsides of ALM involve the challenges associated with implementing a proper
framework. Due to the immense differences between different organizations, there is no general
framework that can apply to all organizations. Therefore, companies would need to design a
unique ALM framework to capture specific objectives, risk levels, and regulatory constraints.
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Also, ALM is a long-term strategy that involves forward-looking projections and datasets. The
information may not be readily accessible to all organizations, and even if available, it must be
transformed into quantifiable mathematical measures.
Finally, ALM is a coordinated process that oversees an organization’s entire balance sheet. It
involves coordination between many different departments, which can be challenging and time-
consuming.
Although ALM frameworks differ greatly among organizations, they typically involve the
mitigation of a wide range is risks. Some of the most common risks addressed by ALM are interest
rate risk and liquidity risk.
Interest rate risk refers to risks associated with changes to interest rates, and how
changing interest rates affect future cash flows. Financial institutions typically hold assets and
liabilities that are affected by changing interest rates.
Two of the most common examples are deposits (assets) and loans (liabilities). As both
are impacted by interest rates, an environment where rates are changing can result in a
mismatching of assets and liabilities.
Liquidity Risk
Liquidity risk refers to risks associated with a financial institution’s ability to facilitate it’s
present and future cash-flow obligations, also known as liquidity. When the financial institution is
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unable to meet its obligations due to a shortage of liquidity, the risk is that it will adversely affect
its financial position.
To mitigate the liquidity risk, organizations may implement ALM procedures to increase
liquidity to fulfill cash-flow obligations resulting from their liabilities.
Aside from interest and liquidity risks, other types of risks are also mitigated through ALM.
One example is currency risk, which are risks associated with changes to exchange rates. When
assets and liabilities are held in different currencies, a change in exchange rates can result in a
mismatch.
Another example is capital market risk, which are risks associated with changing equity prices.
Such risks are often mitigated through futures, options, or derivatives.
Cost of Capital
Cost of capital is the minimum rate of return that a business must earn before generating
value. Before a business can turn a profit, it must at least generate sufficient income to cover the
cost of the capital it uses to fund its operations. This consists of both the cost of debt and the cost
of equity used for financing a business. A company’s cost of capital depends, to a large extent,
on the type of financing the company chooses to rely on – its capital structure. The company may
rely either solely on equity or solely on debt or use a combination of the two.
The choice of financing makes the cost of capital a crucial variable for every company, as it will
determine the company’s capital structure. Companies look for the optimal mix of financing that
provides adequate funding and minimizes the cost of capital.
In addition, investors use the cost of capital as one of the financial metrics they consider in
evaluating companies as potential investments. The cost of capital figure is also important
because it is used as the discount rate for the company’s free cash flows in the DCF analysis
model.
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The most common approach to calculating the cost of capital is to use the Weighted Average
Cost of Capital (WACC). Under this method, all sources of financing are included in the
calculation and each source is given a weight relative to its proportion in the company’s capital
structure.
The cost of debt in WACC is the interest rate that a company pays on its existing debt.
The cost of equity is the expected rate of return for the company’s shareholders.
Cost of capital is an important factor in determining the company’s capital structure. Determining
a company’s optimal capital structure can be a tricky endeavor because both debt financing and
equity financing carry respective advantages and disadvantages.
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Debt is a cheaper source of financing, as compared to equity. Companies can benefit from their
debt instruments by expensing the interest payments made on existing debt and thereby
reducing the company’s taxable income. These reductions in tax liability are known as tax
shields. Tax shields are crucial to companies because they help to preserve the company’s
cash flows and the total value of the company.
However, at some point, the cost of issuing additional debt will exceed the cost of issuing new
equity. For a company with a lot of debt, adding new debt will increase its risk of default, the
inability to meet its financial obligations. A higher default risk will increase the cost of debt, as new
lenders will ask for a premium to be paid for the higher default risk. In addition, a high default risk
may also drive the cost of equity up because shareholders will likely expect a premium over and
above the rate of return for the company’s debt instruments, for taking on the additional risk
associated with equity investing.
Despite its higher cost (equity investors demand a higher risk premium than lenders), equity
financing is attractive because it does not create a default risk to the company. Also, equity
financing may offer an easier way to raise a large amount of capital, especially if the company
does not have extensive credit established with lenders. However, for some companies, equity
financing may not be a good option, as it will reduce the control of current shareholders over the
business.
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Week 10
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Financial markets typically refer to any marketplace where shares are traded, including, though
not limited to, the stock market, the bond market, the forex market and the derivatives market.
For the smooth running of capitalist economies, financial markets are important.
It plays a critical role in promoting the smooth running of capitalist economies. Financial markets
help through the allocation of resources and the development of liquidity for companies and
entrepreneurs. Markets make it easier for buyers and sellers to exchange their financial
holdings. Financial markets produce securities products that offer a return to those who have
surplus capital (investors / lenders) and make these funds available to those who need
additional money (borrowers).
When a company needs to purchase new equipment or construct a new building, it always must
go to the financial market to collect funds. Businesses will typically add capacity during
economic growth as profits are on the rise and market demand is high. Business investment is
one of the primary ingredients required to support economic development. Financial markets, by
their very name, are a type of marketplace that offers an avenue for the selling and purchasing
of assets such as shares, stocks, foreign exchange and derivatives. They are also called by
different names, like "Wall Street" and "capital market," but all of them still mean one and the
same thing. Simply put, companies and investors will go to financial markets to raise capital to
expand their businesses and make more money.
There are various types of financial markets and their characterization depends on the
properties of the financial claims being exchanged and the needs of the different market
participants. We identify many types of markets that differ depending on the form and maturity
of the instruments traded.
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Capital market
Capital market enables raising capital on a long-term basis, usually over 1 year. It consists of a
primary and a secondary market and can be divided into two main sub-groups – the bond
market and the stock market.
The primary market, or the so-called "new issue market," is where securities such as shares
and bonds are produced and exchanged for the first time without any intermediary, such as an
exchange in the process. When a private corporation chooses to become a publicly traded
entity, it issues and sells its shares in the so-called Initial Public Offering. IPOs are a strictly
regulated process, facilitated by investment banks or underwriting groups, which set the starting
price range and then oversee its sale directly to investors. These transactions provide an
opportunity for investors to purchase securities from a bank that had initially subscribed to a
stock. An IPO occurs when, for the first time, a private company issues a stock to the public.
A secondary market or so-called "aftermarket" is the place where investors purchase previously
issued securities such as stocks, bonds, futures and options from other investors, rather than
from the companies themselves. The secondary market is where the bulk of exchange trading
takes place and what people are talking about when they refer to the "stock market." However,
some previously issued stocks are not listed on an exchange but are traded directly between
dealers on the phone or on a computer. These are so-called over-the-counter traded stocks, or
'unlisted stocks.'
Stock markets are real and electronic exchanges that allow the purchasing and sale of
securities. It invests in public company ownership shares. Each share comes with a price and
investors make money from stocks when they do well on the market. It's quick to buy stocks.
The real challenge is to select the right stocks that will make money for the investor.
The Bond market offers financing through debt accumulation of bond issuance and bond
trading. It gives businesses and government the ability to secure funds to fund a project or an
investment. In the bond market, investors purchase bonds from a company and the company
returns the value of the bonds during the negotiated duration plus interest.
Money market
The money market enables economic units to maintain their liquidity positions by short-term
lending and borrowing, typically less than 1 year. It encourages contact between individuals and
organizations with temporary surpluses of funds and their counterparts who are facing a
temporary lack of funds. It is characterized by a high degree of safety and a relatively low return
in interest.
At the wholesale level, money markets require large-volume transactions between banks and
traders. At the retail stage, these include money market mutual funds purchased by individual
investors and money market accounts opened by bank customers. Individuals can also invest in
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The foreign exchange market is the market in which participants can purchase, sell, exchange
and bet on currencies. As such, the forex market is the most liquid market in the world, as cash
is the most liquid of assets.
As with the OTC markets, the forex market is also decentralized and consists of a global
network of computers and brokers from all over the world. The forex industry consists of banks,
commercial businesses, central banks, investment management firms, hedge funds and forex
traders and investors.
Commodity market
The commodity market is where traders and investors buy and sell natural resources or
commodities such as corn, oil, meat and gold. A specific market for these resources is created
because their price is unpredictable. Commodities are commonly classified in two subgroups:
- Hard commodities are raw materials typically mined, such as gold, oil, rubber, iron ore
etc.
- Soft commodities are typically grown agricultural primary products such as wheat,
cotton, coffee, sugar etc.
Derivatives market
A derivative is a contract between two or more parties, the value of which is based on an
agreed-upon underlying financial asset (like security) or a set of assets (like an index).
Derivatives are secondary securities, the value of which is derived solely from the value of the
primary security to which they relate.
The derivatives market allows trading in financial instruments, such as futures contracts and
options to help manage financial risk. The instruments often derive their value from the value of
the underlying asset that can come in several ways – stocks, shares, commodities , currencies
or mortgages.
Capital Adequacy
The Capital Adequacy Ratio (CAR) is the capital ratio of a bank in terms of its risk-weighted
assets and current liabilities. Central banks and bank regulators work together to prevent
commercial banks from exceeding their leverage and becoming insolvent in the process.
It further sets expectations for banks by looking at the capacity of the bank to pay liabilities and
to respond to credit risks and operational risks. A bank with a good CAR has enough money to
cover future losses. As a result, there is less chance of it losing depositors' funds.
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Moreover, it is also known as the risk-weighted capital ratio, which calculates the financial
strength of a bank by using its capital and assets. It is used to protect depositors and to facilitate
the stability and performance of financial markets around the world.
The capital adequacy ratio is determined by dividing the capital of the bank by its risk-weighted
assets. The capital used to measure the capital adequacy ratio is divided into two Tiers.
The formula is: (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets
Tier 1 capital or core capital is the primary way to calculate the financial stability of a bank. It
generally requires shareholder’s equity and retained profits, which are disclosed in the financial
statements. Specifically, it is comprised of equity capital, ordinary share capital, intangible
assets and audited revenue reserves, or what the bank will use to absorb losses and does not
require a bank to cease operations.
Tier 2 money on the other hand, contains revalued stocks, undisclosed reserves, general loss
reserves and hybrid securities. Since this form of capital is of lower quality, less liquid and more
difficult to quantify, it is known as supplementary capital. This capital bears losses if the firm
ends up or liquidates. It is seen as less secure than Tier-1.
Lastly, risk-weighted assets are the sum of a bank’s assets, weighted by risk. Risk weighting is
decided on the basis of the likelihood that the asset will decline in value. Banks usually have
different classes of assets, such as cash, debentures, and bonds, and each class of asset is
associated with a different level of risk. Asset classes that are secure, such as government debt,
are at risk of weighing close to 0 per cent. In contrary, assets backed by little to no collateral,
such as a mortgage, have a higher risk weighting. This is because there is a greater risk that the
bank will not be able to recover the loan.
Sample of Capital Adequacy Ratio (CAR) calculation:
Bank A has the below necessary information to calculate their CAR:
The risk-weighted assets will be the result of Bank A’s assets multiplied by its corresponding
risk weight.
Loans to the Government: 250,000 * 0% = Php 0
Debenture: 300,000 * 90% = Php 270,000
Mortgage: 500,000 * 70% = Php 350,000
Finally, the calculation of the CAR is the following:
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Deposit withdrawals
Borrowing repayments
Dividend payments
Acceptable loan requests
Other operating expenses
Supplies of liquidity
The demands for liquidity can be termed as cash outflows, while the supplies of liquidity pertain
to as cash inflows. The difference between the two will be determined as the firm’s Net Liquidity
Position.
If demand exceeds supply, i.e. the outflows outweigh the inflows, the company has a liquidity
deficit. Hence, additional funds need to be collected. Deficits would compromise the smooth
running of the bank, at worst bringing things to a grinding halt.
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If supply exceeds demand, i.e. if inflows outweigh outflows, the company has a liquidity surplus.
It will need to invest the surplus funds in order to fulfill potential liquidity needs. Surpluses would
imply suboptimal use of resources.
A cashflow statement is a report of cash inflows and outflows and is a measure of liquidity.
Keeping the cashflow in an operating format enables management to understand how much
working capital is being spent on core operating activities.
You may see the below article by James L. Graves on ‘Meeting the liquidity challenge;
Strategies to help your clients cope with the credit crisis’ (Published July 20, 2009):
“The attention to liquidity and working capital management has been accentuated by the
ongoing impact of the global credit crisis.
As a result, one of the biggest challenges that U.S. businesses face is maintaining positive cash
flow and liquidity in today's recessionary, capital-constrained environment. While maintaining
liquidity and cash are important, it is crucial to have a full understanding of your financial picture
to incorporate strategic working-capital solutions.
By employing specific cash-management strategies focused on optimizing cash flow,
maximizing liquidity, mitigating risk and managing credit more efficiently, a business can
maximize its availability of working capital, even in these tough times.
Although technology is a tool that can be utilized to improve overall efficiency and cut costs, it is
not a replacement for a back-to-basics approach to cash management, which is the foundation
for an effective working-capital strategy.
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will enable companies to segregate transactions based on defined criteria and more efficiently
match payments to forecasted transactions.
Banks also have an important role in supporting cash forecasting. Although the critical data is
typically held by the company within its ERP systems, banks provide transparency with respect
to a company's payments and receivables data through their expertise and investment in
technology. They provide complete disclosure of your company's finances, which, in turn, allows
you to make sound decisions with a complete financial picture.
Banks also play a role in consolidating data and presenting it to the corporate treasurer in a way
that is consistent, timely and of value. Working with your banking partner to implement cash
forecasting can help you optimize cash flow.
Maximizing Liquidity
Liquidity solutions also present opportunities for businesses to maximize cash flow. While there
may not be an end-all solution to the liquidity challenges that businesses are currently facing,
there are ways in which these challenges can be overcome or, at the very least, effectively
managed.
The collapse of the auction-rate securities market forced treasurers to seek out conservative,
low-risk investment vehicles. When that market seized up after the collapse of Lehman
Brothers, and dealer support did not materialize, losses were incurred, or funds were set aside
to cover those expected losses. This created a need for businesses to seek alternative liquidity
solutions.
The future is unknown, yet non-U.S. cash growth is projected to grow at a greater rate than U.S.
cash. Thus, if U.S. corporate treasurers are planning on holding cash going forward, they should
consider holding more non-U.S. cash.
The AFP liquidity surveys conducted over the last several years reveal some significant
findings. First, companies with more than $1 billion in annual revenue are decreasing
investments in all short-term instruments other than money market mutual funds and Eurodollar
deposits. Otherwise, their short-term investment policies are restricting the overall access to
other instruments.
On the other hand, companies with annual revenues less than $1 billion have already moved
their funds into safer investments. These companies took a more diversified approach to short-
term investments. The expectation is that the short-term investment funds will continue to be
invested in money market mutual funds and bank deposits.
In a time of turbulence, it is a return to the tried-and-true basics of cash management that is
fundamental to success. Effective investment management requires balancing the fundamental
principles of liquidity, return safety and security. By implementing processes and procedures
tailored to specific needs, banks can help businesses weather this storm.
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Mitigating Risk
In this global credit crisis, there are heightened concerns around risk and security for
businesses. Treasury must ensure that there are adequate controls and processes to address
not only fraud, but financial and accounting risk, given the heightened regulatory oversight
around financial management. Moreover, companies need to rely more and more on business
partners globally, without increasing risk.
It is imperative for businesses to incorporate specific tactics to help mitigate risk. These include
utilizing internal controls, such as account protection and daily reconciliation, and using
technology, including the electronification of payments, Web-based reporting and two-factor
authentication. The imposition of these controls, coupled with additional reporting requirements,
drives automation and standardization of treasury processes. The next logical steps in
optimizing the efficiency of working capital and improving transparency are the integration of
trade with liquidity and risk management, and then to create standardization for increased
efficiency, visibility and control.
Managing Credit
Managing credit efficiently is a cornerstone of a company's working-capital strategy. If
companies are electing to use credit as a part of their financial strategy during this time, then it
is crucial to maintain a strong balance sheet, which can help improve a business' access to
credit. Balance-sheet analysis will be a key component in a bank's evaluation of the
sustainability of a business.
Operating cash has to sit somewhere, and deposits are highly valued by banks right now.
Because banks are under tight scrutiny and need to shore up their financial reserves, they value
the deposits they receive from corporations in the form of operating capital or dollars that are
waiting to fund other projects. Companies that need to borrow capital should explore with their
lender how their deposits factor into the negotiation. For companies with excellent credit,
deposits could tip the scale in their favor for obtaining capital. Their money market deposits may
be the key to the operating capital that they need.
In addition, employing the previously mentioned cash-flow forecasting tools will strengthen their
credit position and the ability to secure working-capital loans. Lenders view a well-tailored,
efficiently administered cash management process as being indicative of a stable, capably
managed organization with lower risk levels.
Conclusion
There may not be one single solution to the liquidity challenges in the U.S. and globally;
however, it is important to be cognizant of the fact that by working with banking partners to
implement the tried-and-true basics of cash management, cash forecasting and working-capital
solutions, liquidity is attainable.”
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There are three strategies financial managers can choose from to deal with the liquidity
problems of a firm:
1. Asset Liquidity Management (or Asset Conversion) Strategies
It involves preserving liquidity by liquid assets, primarily marketable securities. (The liquid asset
has a ready demand, a stable price, and the principal can be recovered with little chance of
loss.)
Typical assets include T-bills, Certificates of Deposit and Repurchase Agreements.
2. Borrowed Liquidity (Liability) Management Strategies
It requires borrowing funds that can be used immediately to fulfill all the expected liquidity
needs. It is favored by most companies because it requires borrowing funds only when there is
a need to do so, and results to minor adjustments in the bank's asset portfolio. This approach
provides the highest projected returns with greater uncertainty.
Typical borrowing sources are Federal funds & Central bank borrowings.
3. Balanced (Asset and Liability) Liquidity Management Strategies
Its also called as a double-edged strategy. It combines the use of liquid asset holdings
(marketable securities) and borrowed funds to meet liquidity needs. In order to operate, the
bank needs to prepare and predict both its short-term and long-term financing needs.
Legal Reserves
The below article from Everyday Finance: Economics, Personal Money Management, and
Entrepreneurship will deep dive more on the Federal Deposit Insurance Corporation and will talk
about the importance of having a reserve amount of money set aside in a bank.
“WHAT IT MEANS
The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the U.S.
government whose mission is to maintain and strengthen public confidence in the American
financial system. The agency does this by insuring (guaranteeing) deposits in banks and thrift
institutions (which include savings banks, savings and loan associations, and credit unions) for
up to $100,000 per depositor in case of the institution’s failure. A bank or thrift institution is said
to fail when it becomes insolvent, meaning that the value of its liabilities (the money it owes) is
greater than the value of its assets (the money and other items of value it has). For instance, if
all the depositors at a bank tried to withdraw their money on the same day, the bank would not
be able to cover those withdrawals, and a failure would occur. If the bank is a member of the
FDIC, however, then every depositor is guaranteed to receive his or her money back (up to
$100,000).
The FDIC is not funded by Congress. It raises the funds to insure deposits by charging
premiums (insurance fees) to each of its membership institutions. The premiums are calculated
according to the amount of deposit insurance each institution requires. The FDIC also derives
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funds from its investments in U.S. Treasury securities (loans to the government that pay
interest). In 2007 the FDIC insurance fund totaled more than $49 billion, and the agency insured
more than $3 trillion worth of deposits in U.S. financial institutions.
In addition to its function as an insurer, the FDIC also conducts research and analysis to identify
and monitor banking activities and economic conditions that may pose risks to deposit
insurance funds. The FDIC also takes various measures to help banks avoid failure and to limit
the impact of bank failures on the economy as a whole. In each of these ways the FDIC plays a
critical role in stabilizing the U.S. economy.
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Comptroller of the Currency, a bureau within the U.S. Treasury Department) and two other
directors who are appointed by the president and approved by the Senate. Most of the FDIC’s
more than 5,000 employees are bank examiners (people who evaluate the solvency of banks).
FDIC insurance covers many kinds of accounts: checking accounts; savings accounts; money
market deposit accounts (also known as MMDAs; these are savings accounts that allow the
account holder to write a limited number of checks per month); money market accounts (high-
interest savings accounts, not to be confused with money market funds); certificates of deposit
(also known as CDs; these are deposits that earn high rates of interest but cannot be touched
for a preset amount of time); and outstanding cashier’s checks (a customer may purchase a
cashier’s check at a bank in a specific amount in order to make a payment to a specific third
party; an outstanding cashier’s check is one that has been purchased but not redeemed),
interest checks, and any other negotiable instrument (a written order to pay) that is drawn on the
accounts of the insured bank.
There are many financial items the FDIC does not cover, even if those items are purchased
through or held by an insured institution. Noninsured items include various kinds of investments
in corporations or in the federal government (such as stocks, bonds, money market funds,
mutual funds, and U.S Treasury securities) and the contents of safe-deposit boxes (boxes kept
in a bank vault in which customers can store valuables). Also, the FDIC does not cover
insurance policies, financial losses that arise from theft or fraud (banks are insured against
these eventualities by private companies), or losses because of bank errors in an individual’s
account (there are other procedures for pursuing compensation for this).
In order to have its deposits covered (insured) by the FDIC, every bank or other financial
institution must maintain certain standards of financial stability. A bank’s stability is a
measurement of its reserves and its liquidity. Reserves are the amount of money the bank sets
aside (and does not loan or invest) in order to meet the daily cash withdrawals of its customers.
Liquidity is the amount of assets a bank can convert into cash in a relatively short period of time
without losing substantial value (to liquidate an asset is to sell it; stocks, or shares of ownership
in corporations, are considered more liquid than real estate—property—as assets, because they
can be sold more quickly.) An optimally stable institution is described as well capitalized, which
means that it has a relatively high ratio of capital (money it has on hand) to risk-based assets
(investments that have value, generate money, or both but that are not as secure as, or are
riskier than, money in hand). Based on its analysis, the FDIC classifies banks in the following
categories:
1. Well capitalized: 10 percent or higher ratio of capital to risk-based assets
2. Adequately capitalized: 8 percent or higher ratio
3. Undercapitalized: less than 8 percent ratio
4. Significantly undercapitalized: less than 6 percent ratio
5. Critically undercapitalized: less than 2 percent ratio
If a bank becomes undercapitalized, the FDIC takes certain measures to prevent the bank from
failing. First, the agency issues a warning advising the bank to take corrective actions to
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improve its capital ratio. If necessary, the FDIC may impose certain corrective actions, such as
changing the bank’s management, loaning the bank money, buying off some of its assets, or
even facilitating a merger (whereby the unstable bank is unified with or absorbed by a stronger
bank). If a bank sinks to the level known as critically undercapitalized, the FDIC declares it
insolvent.”
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Week 11
Business Valuation
Corporate Restructuring
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Business Valuation
Business valuation is a general method of assessing the economic worth of a whole business or
business unit. Business valuation may be used to assess the fair value of a business for a
number of purposes, including sale value, partnership ownership, taxes and even divorce.
Owners will indeed turn to skilled business evaluators for an impartial assessment of the worth
of the business.
Here is an excerpt from a scholarly journal of Modica, Joseph regarding Business Valuation
101: The Fundamentals of Business Valuation in Marital Dissolution Matters that focuses on the
basic fundamentals of Business Valuation. It covers the standards of value and valuation
approaches & methods:
“Business valuation is 2/3 science (math, actually) and 1/3 art. The approaches and methods for
computing value are straightforward as far as their definitions and mechanics are concerned but
deciding which approach and method to use and what discounts or premiums might apply
requires expertise that is grounded in adequate training and practical experience.
A fundamental tenet of business valuation certification is the understanding that the valuation
professional is an unbiased individual abiding by the ethical standards and practice guidelines of
his/her certifying organization. The attorney in a legal dispute may advocate, but the business
valuation expert must present an unbiased professional opinion.
STANDARDS OF VALUE
It is important to understand the different Standards of Value that can be applied when
determining the value of a business. A commonly used standard is fair market value. Most
courts will use some form of the definition for fair market value provided by the Internal Revenue
Service (Revenue Ruling 59-60):
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The amount at which the property would change hands between a willing buyer and a willing
seller, when the former is not under any compulsion to buy, and the latter is not under any
compulsion to sell, both parties having reasonable knowledge of relevant facts.
Other standards of value are available for use in specific valuation situations. Investment value
looks at the value of any entity to a specific investor based on individual requirements and
expectations. Intrinsic value is defined in the International Glossary of Business Valuation
Terms as, "the value that an investor considers, on the basis of an evaluation or available facts,
to be the "true" or "real" value that will become the market value when other investors reach the
same conclusion. When the term is applied to options, it is the difference between the exercise
price or strike price of an option and the market value of the underlying security." Liquidation
value which represents the value if the entity is terminated and the assets are sold. Net book
value is the difference between the assets and liabilities as they appear on the balance sheet.
THE VALUATION PROCESS
The process of valuing a closely held business can be categorized into five major steps:
1. Define the engagement
2. Gather the necessary information
3. Analyze the information gathered
4. Estimate the value
5. Prepare the valuation report
Defining the engagement includes determining the purpose of the valuation, standard of value,
valuation date, and the interest to be valued. Some of the steps taken when analyzing the
information includes: develop a general knowledge of the Company and industry, financial
analysis, financial statement adjustments (to more closely reflect the true economic financial
position and earnings), and a comparative analysis (to specific other companies or industry
averages).
The standards of most business valuation organizations allow the reporting of a conclusion of
value for litigation purposes to be tailored to the specific needs of the attorney or court.
Generally, the valuation report should contain the following:
* Identification of subject being valued
* Description of interest being valued
* Valuation date
* Report date
* Purpose and use of the valuation
* Definition of the standard of value
* Identification of the premise of value
* Identification of the assumptions, limiting conditions, and scope limitations
* Statement of independence
* Company background
* Economic and industry data
* Financial statement data (including: historical, adjustments, and adjusted)
* Description of the fundamental analysis
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There are two processes used in the income approach: capitalization and discounting.
Capitalization involves a single-period valuation model that converts an income/benefit stream
into value. Discounting involves a multiple-period valuation model and converts future
income/benefit streams into value by discounting them to a present value at a rate of return that
considers inherent risk.
Market Approach
The market approach goes hand-in-hand with the fair market value standard. Information that is
available in the marketplace is used to estimate the value of an enterprise. The valuation
professional analyzes guideline public companies and/or guideline transactions to determine a
company's value. There are three market approach methods:
(1) Guideline public company method. Information about publicly traded companies is used to
create multiples which indicate value. These multiples are then applied to the appropriate
benefit stream, or other variable, to determine the Company's value.
(2) Transaction method. This method tracks actual transactions of comparable businesses that
can be translated into usable multiples. Again, these multiples are applied to the appropriate
benefit stream, or other variable, to determine the Company's value.
(3) Company specific method. This method considers the sale of a company's own stock (after
ensuring that it was an arm's length transaction).
Asset Approach
The asset approach values each component of a business separately. The fair market values of
the assets are totaled and the fair market values of the liabilities are subtracted for a total
enterprise value. If only the tangible assets and liabilities are considered, this approach offers a
"floor value" for an enterprise.
The most common method used to determine fair market value under the asset approach is the
adjusted net asset method. This method is generally used in the valuation of an asset-intensive
entity or an entity that does not generate a positive benefi t stream. All tangible and intangible
assets are adjusted to reflect fair market value. The value is calculated by adjusting each
tangible asset and identifiable intangible asset to its fair market value and then subtracting the
liabilities which have also been adjusted to their fair market value.
Once the approach and methodology for a business valuation have been decided, the valuation
expert will consider risk factors and future rates of return to begin refining the emerging
valuation picture.
CONCLUSION
Each valuation case is fact-intensive and there is no standardized formula or methodology that
can be applied to all cases. State laws and local precedents are the best indicator of the
standards of value and valuation approaches that are accepted. The professional valuator
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needs to rely on his/her experience and understanding of internal and external factors that may
impact enterprise value when researching, evaluating and valuing a business.”
Corporate Restructuring
Corporate restructuring is a step taken by a corporate organization to substantially change its
financial structure or operations.
Generally, organizational restructuring occurs when a firm is facing major difficulties and is in
financial jeopardy. It is a form of corporate action that involves dramatically changing the debt,
activities or its structure as a means of minimizing financial harm and improving the business
operations.
When a corporation has trouble making payments on its obligations, it frequently consolidates
and adjusts the terms of its debt in the form of debt restructuring, finding a way to pay off
bondholders. A business can also restructure its operations or structure by cutting expenses,
such as payroll, or reducing its size by selling properties.
To improve the Balance Sheet of the company (by disposing of the unprofitable division
from its core business)
Staff reduction (by closing down or selling off the unprofitable portion)
Changes in corporate management
Disposing of the underutilized assets, such as brands/patent rights.
Outsourcing its operations such as technical support and payroll management to a more
efficient 3rd party.
Shifting of operations such as moving of manufacturing operations to lower-cost
locations.
Reorganizing functions such as marketing, sales, and distribution.
Renegotiating labor contracts to reduce overhead.
Rescheduling or refinancing of debt to minimize the interest payments.
Conducting a public relations campaign at large to reposition the company with its
consumers.
It is a business decision to merge with another organization and to act as a single legal entity.
The businesses that agree to mergers are usually comparable in terms of size and scope of
operations. Companies are seeking mergers in order to gain access to a larger market and
customer base, reduce competition and achieve economies of scale.
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There are different types of mergers which companies can follow, depending on their business
objectives and operation strategies. A merger is different from an acquisition – mergers happen
when two or more companies combine to form a new entity, whereas an acquisition is the
takeover of a company by another company.
2. Demerger
Demerger can be described as the transition of a company's business to another company. The
source business, i.e. the company whose undertakings are being transferred, is referred to as
the demerged company. The other business is sometimes referred to as the resulting company.
3. Reverse Merger
A reverse merger is a merger in which a private corporation, by purchasing it, becomes a public
company. It saves a private corporation from the difficult process and costly compliance of being
a public company. Instead, it acquires a public company as an investment and turns itself into a
public company.
4. Disinvestment
Takeovers and acquisitions are normal occurrences in the world of industry. In certain cases,
takeover and acquisition terms are used interchangeably, but each has a somewhat different
connotation.
A takeover is a special type of acquisition that happens when a business assumes ownership of
another company without the consent of the acquired company. Takeovers that occur without
approval are usually referred to as hostile takeovers. Acquisitions, also referred to as friendly
takeovers, occur when the purchasing company has approval from the board of directors of the
target company to buy and take over the company.
6. Joint Venture (JV)
A joint venture is a cooperative partnership between two or more business organizations, mostly
for the purpose of beginning new business activities. Each individual shall contribute assets to
the joint venture and agree on how to divide profits and expenses.
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It is the act of modifying the business model of an organization in order to change it for the
better. These adjustments can include legislative, organizational procedures, ownership, etc.
The cause of such a change in the organization could be either external or internal.
Some firms are changing its organizational structure towards expansion and developing new
divisions to serve growing markets. Other businesses reorganize the organizational structure to
minimize or remove overhead retention divisions. New owners or managers also rearrange the
corporate structure to create a familiar business model.
2. Financial Restructuring
Financial restructuring is the method of reshaping or reorganizing the financial structure, which
consists mainly of equity capital and debt capital. Financial restructuring may be carried out
either by compulsion or as part of the company's financial plan. This financial reform can be
either on the assets side or on the liabilities side of the balance sheet. If one is updated, the
other will be modified accordingly.
Here is a case study about Deutsche Bank Restructuring last June 2019 from CFI Education
Inc.:
In June 2019, Deutsche Bank announced that they will be cutting 18,000 jobs in an effort to
restructure the corporation. Corporate restructuring can include a large variety of changes, all of
which are designed to make the company more profitable. Changes can include ownership
structure, debt and financing structures, and updating management systems. Of course,
changes can also be made to the business lines leading to an increase or decrease in jobs.
History of Deutsche Bank
Deutsche is a German banking institution founded in 1870. Unfortunately, throughout the years,
they have been involved with several scandals and poor business decisions. For example, the
bank took part in the subprime mortgage crisis. Even when the bank sensed that the market
was turning south, they continued to sell mortgage-based investments. To make things worse,
Deutsche also took bets against the products they were selling. These actions cost the bank
$7.2 billion in fines, which was adjusted from $14 billion after a settlement with the US
Department of Justice.
Between 2015 to 2018, Deutsche was also fined for other misdemeanors. They include rigging
the Libor interest rate, doing business with US-sanctioned countries, and failure to prevent
money laundering. In the money laundering case, Deutsche Bank was fined $630 million for not
preventing $10 billion of Russian money laundering.
Decisions that were made
In terms of business decisions, since 1989, Deutsche bank had plans to become a global bank.
They acquired banks in other countries and obtained a greater global presence. By
consolidating their US operations into one, they had plans to take on Wall Street banks such as
Goldman Sachs. However, after the financial crisis, the sluggish European economy, and new
regulations, such plans fell apart. In 2019, plans to merge with another German bank,
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Commerzbank, fell through. If the merger was successful, it would have created the eurozone‘s
second-largest bank. These plans were made as both banks were struggling, with Deutsche
trying to recover after the financial crisis.
Why cut 18,000 jobs?
Deutsche made the decision that their business operations are spread too thin or over-
diversified. One of the executives stated that the bank had tried to compete in too many
business lines. To ratify this situation, they have decided to close the equities sales and trading
business and decrease the rates division. By removing this business line from the banks, they
are also letting go of 18,000 employees. Originally, executives were reluctant to cut this
business line. Although it is high risk, issuing and trading derivatives can be very profitable if
done properly. However, as Deutsche Bank becomes less profitable, the bank seeks more
reliable business. Now the bank will shift focus to corporate money management.
The short-term cost of Deutsche Bank’s restructuring process is $8.29 billion with a majority
occurring in 2019. The cost mostly consists of severance packages for the employees that were
let go. The estimated benefit is $6.7 billion in cost savings by 2022. Cost savings originate from
lower salary expenses and bonuses paid each year. Other banks have called this plan
ambitious and the actions radical.
Management
Christian Sewing became the chief executive in 2018. Sewing had already cut over 3,000 jobs
and closed hundreds of branches. Sewing, along with the board, made the decision to cut the
equities sales and trading division as it lacks revenue reliability. As mentioned above, cost
savings are also expected from lower payment of bonuses. The previous chief executive was
criticized for the continuous payment of high bonuses for investment bankers.
Not all of the executives agree with or was unscathed by the decision. For example, Frank
Strauss, the head of retail business, has left the bank, as he did not agree with the restructuring
plan. Garth Ritchie, the chief of investment banking, will be leaving the bank as well.
What does it mean for investors?
The stock for Deutsche Bank has fallen by 95% since 2007 due to the difficulties the bank has
faced. For existing investors, the bank has stated that they will not raise additional capital to
fund the restructuring plan. Many investors or potential investors are waiting to see how the plan
will be executed, as well as the results it will deliver. While costs will be reduced, it is to be seen
whether the revenue will be negatively impacted.
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Week 12-13
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Generally, when evaluating a company, there are two different approaches to view the valuation
of the firm: the first is the liquidation value and the second is the value of the whole company as
a concern. Most frequently in a merger and acquisition deal, the target corporation would be
valued as a continuing concern, unless the target firm is in trouble and the purchasing firm
purchases it to strip and sell the assets or withdraw it from the market as a competitor.
Liquidation value is the most accurate approach for businesses in crisis or for an organization
needing restructuring. When a firm is evaluated as a continuing concern, it is believed that it will
continue to exist in the near future, contributing to its value beyond the amount of its properties.
The acquisition firm will look at the earning power of the corporation as well as its cash
generating potential of all the assets that make up the operations of the target company as it
undergoes valuations for the businesses. When the target business is measured as a matter of
concern rather than liquidation value, non-operating or intangible assets will be included in the
assessment, including items such as: brands, trademarks, patents, investments in other firms,
consumer and supplier relationships, management and expertise skills, technology, industry
know-how, infrastructure, etc.
In Mergers & Acquisitions, there are a variety of methods used in business valuation, with
different methods more appropriate under different circumstances. For example, if a business
has a low profitability but has a high value permanent asset, these assets will become more
important than their profitability in the valuation process. The following list will include most of
the ways to approach valuations in the mergers and acquisitions setting, from Professor Nurhan
Aydin, PhD of International Journal of Business and Social Science:
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1. Balance-Sheet-Based Methods
In the income statement and market-based method, the value of the company is determined
considering the income statement and market data, rather than the data on the balance sheet.
Market Price
The market price of company is usually calculated considering the market prices of their shares.
The market price of shares is a value that varies by supply and demand conditions on the
market. The market price may change in relation to economic conditions, the activeness rate of
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the company, and other conditions outside the company, although there is no change in the
activeness of the company itself. Thus, the price of the shares in the market may be higher or
lower than the real value of the company. Here are the main disadvantages of using the market
price of shares in M&As:
- When a majority of the company’s shares are not traded in the market, the market price does
not reflect the realistic value of the company.
- Economic and political conditions may give a high or low price for the company’s shares.
- The prices created on the market will not be consistent as the activeness of the markets
decreases.
- When news about M&As are heard in the market, there can be abnormal changes in the
market price.
Earnings/Price Ratio
In M&As, the earnings/price ratio (E/P) is commonly used, particularly in the valuation of non-
public companies, as it is easy to apply. The E/P for non-public companies is unknown because
there is no market price for their shares. In these situations, the reference is the E/P of another
company which is active in the same sector as the company to be valued, has similar
characteristics, and is traded in the stock exchange. In this method, the current or future values
of the establishment are multiplied by the E/P rate of the reference company, which creates the
value of the establishment. If there are no companies similar to the establishment to be valued
using E/P, the E/P rate of the sector can also be used, which is a more practical way as well.
Whether the E/P of a similar company or the E/P of the sector is used, this approach is not
suitable for M&As as it is based on the current or past values of the establishment. However, it
is accepted as an applicable and practical method where there is insufficient information about
the establishment, or the uncertainty about the future is high.
Price/Sales Ratio
The price/sales ratio (P/S) method is similar to the E/P method. The P/S of a company similar to
the establishment to be valued or the P/S of the sector is multiplied by the sales of the
establishment in question. This method has disadvantages similar to the E/P method.
3. Discounted Cash Flow Method
The fundamental valuation in M&As is the Discounted Cash Flow Method (DCF), which is based
on capital budgeting theory. The discounted-cash-flow approach in an M&A setting attempts to
determine the value of the company by computing the present value of cash flows over the life
of the company(Schill at al.2008; Mukherjee at al.2004; Luerhman, 1999; Damodaran, A. 2005;
Steiger, 2010; Brotherson at al.2014). Whereas the methods previously mentioned in this study
consider current or past values, DCF determines the company value according to the future
performance and risks of the company. Although M&A is actually an investment decision, it is
more complicated than other investments due to the fact that the risks of a typical investment
are similar to the current investments of the establishment, while M&A requires considering
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other factors besides the assets that are being merged, including the establishments’ debts,
managers and other employees, customers, and corporate culture.
For this reason, the decisions to perform M&A should be made after highly meticulous analyses.
In both M&As and decisions to go public, it is necessary to determine the free cash flow
expected in the future, the suitable discount rate, and the period over which to make the
predictions in order to use the DCF method in company valuation.
Discounted Cash Flow Method formula:
Problem example:
Catherine is the owner of the Femme Shoe Store. It begins with just an online shop, and then
converts it to a physical shop a year later, located at Quezon City.
Then months came, her Mom suggested her to have another branch at Rizal. She researched
the province and found a nice location that has a ‘for lease’ space.
Before making a decision, she wants first to determine if adding a new branch is worth pursuing.
Providing a capital of P100,000 for the Rizal branch and the following information:
(Projected Net Cash Flow)
1 20,000
2 30,000
3 50,000
4 30,000
5 20,000
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Furthermore, you may see below table for further DCF presentation:
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variety of ways. The synergy resulting from the increase in the effectiveness of activities after
the M&A is called the “operating synergy.” When establishments merge their activities, they can
obtain operating synergy by increasing their sales and reducing their fixed costs, such as
marketing expenses, research and development expenses, and management expenses. The
operating synergy is a result of economies of scale. It is even more important for capital-
intensive sectors, which include high levels of fixed costs (Gaugan, 1999; Damodaran, 2005).
“Financial synergy” consists of the financial advantages provided by the M&A. This synergy is
created by the increase in the debt capacity of the establishment, tax savings, and most
importantly, the reduction in costs of credit, which is an aspect of being a large-scale company.
This synergy is likely to show up most often when large firms acquire smaller firms, or when
publicly traded firms acquire private businesses. (Damodaran, DePamphilis, 2001).
Let us assume that Company A and Company B wish to perform a merger, and together
become Company AB. This merger needs to create an additional value in order to be rational.
This point can be expressed as follows:
Synergy = The Value of Company AB – (The Pre-merger Value of Company A + The Pre-
merger Value of Company B). When the earnings provided by the synergy are greater than the
spending made for the merger and the amount paid to the target company, this situation creates
an additional value. The value of the combined firms will always be the sum of the values of the
independent firms. The period of time to be estimated is as important as the accurate
determination of synergy. The estimation period should be short, especially when uncertainty is
strong. For instance, if the cash flows after the merger can be estimated reasonably for the
following five or six years, it is acceptable to make certain simplifying assumptions for the years
after that period. After the period that is estimated reasonably, it is possible to make further
assumptions including the cash flows staying the same or growing in consistency with the
growth rate of the sector. It is necessary to apply some effort to estimate the cash flows in
different scenarios to increase the consistency of estimations.
Following is the calculation of the FCFs to be obtained after the M&A:
FCF = NOPAT + Depreciation and Noncash Charges − CAPEX – ΔNWC
where;
NOPAT is equal to EBIT (1-t)
CAPEX is capital expenditures for fixed assets.
ΔNWC is the increase in net working capital defined as current assets less the non-interest-
bearing current liabilities.
t is the appropriate marginal tax rate
Deciding on the Discount Rate
After the identification of the FCFs following the M&A, with the assistance of the pro-forma
statements expressing the expected operating and financial synergies, it is necessary to
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determine the discount rate to be used for discounting these cash flows. Weighted average cost
of capital (WACC) is the discount rate that is commonly used in M&As. In M&As, however, the
WACC should be calculated for the company that is created by the merger, instead of the
WACC of the buyer or the target company. This is due to the fact that there will be a different
capital cost after the merger related to the operating and financial synergy. The determination of
the WACC has a variety of challenges, including whether the company is public or non-public,
the majority of the shares being traded in the market, and the development rate of the capital
markets. The more developed the capital markets, and the more shares being traded in the
market, the easier it will be to calculate the WACC.
WACC = Wd kd(1-t) + We ke
Where;
• kd is the cost of debt
• ke is the cost of equity capital.
• Wd & We, are target percentages of debt and equity
• t is the marginal tax rate.
The costs of debt and equity capital in the equation should be based on the desired capital
structure after the merger. The costs of debt and equity capital after the merger may be different
from the costs before, and it should also be noted that the tax rate may change as well. After the
determination of the FCFs and the WACC after the merger, the discounted value of these cash
flows is calculated. As stated above, this value is supposed to be greater than the total of the
discounted values of the individual companies. If this value is not greater than the total values of
individual companies, the merger will not make any sense in economic terms. The merger being
economically unreasonable does not mean that it will not be realized. Managers may wish to
administer larger establishments. Thus, M&As may be performed as a result of such
psychological reasons as well.
Conclusion
Valuation is one of the most important factors in the success and the maintenance of the
success of M&As. This study has examined a variety of valuation methods and focused on their
disadvantages and advantages. The main focus of the study was the DCF method that
determines the value of an establishment considering its future performance, rather than the
current and past performances, and which helps find a more accurate and realistic value than
the other methods. The accurate calculation of the synergy to be obtained from the M&A plays a
key role in the determination of the accurate value. There have been many cases where
mergers result in failure as the highly optimistic expectations are not realized at the end of the
merger.
However, pessimism about the synergy to be created by the merger is a barrier to a potentially
successful merger. If the synergy of the merger is determined using different scenarios (e.g.
optimistic, pessimistic, the most likely), this will reduce estimation errors. This study suggests
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that individuals should use multiple methods to decide on company value and give a weight to
each method considering the conditions of the company, country, and market.
Capital Asset Pricing Model
The capital asset pricing model is the most commonly accepted model for determining
systematic risk and estimating equity costs. It was invented by Nobel Prize winner Bill Sharpe.
The CAPM (pronounced Capem) finds the appropriate rate of return on the stock by comparing
its output to the market.
A fundamental question in finance is how the risk of an investment should affect its expected
return. The Capital Asset Pricing Model (CAPM) provided the first coherent framework for
answering this question. The CAPM is based on the idea that not all risks should affect asset
prices. In particular, a risk that can be diversified away when held along with other investments
in a portfolio is, in a very real way, not a risk at all. The CAPM gives us insights about what kind
of risk is related to return.
CAPM is calculated according to the below formula:
Ra = Rrf + [Ba x Rm – Rrf]
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
As per Perold A. (2004), the Capital Asset Pricing Model is an elegant theory with profound
implications for asset pricing and investor behavior. But how useful is the model given the
idealized world that underlies its derivation? There are several ways to answer this question.
First, we can examine whether real world asset prices and investor portfolios conform to the
predictions of the model, if not always in a strict quantitative sense, and least in a strong
qualitative sense. Second, even if the model does not describe our current world particularly
well, it might predict future investor behavior-for example, as a consequence of capital market
frictions being lessened through financial innovation, improved regulation and increasing capital
market integration. Third, the CAPM can serve as a benchmark for understanding the capital
market phenomena that cause asset prices and investor behavior to deviate from the
prescriptions of the model.
Example:
One of the earliest applications of the Capital Asset Pricing Model was a performance
measurement of fund managers (Treynor, 1965; Sharpe, 1966; Jensen, 1968). Consider two
funds, A and B, that are actively managed in the hope of outperforming the market. Suppose
that the funds obtained returns of 12 percent and 18 percent, respectively, during a period when
the risk-free rate was 5 percent and the overall market returned 15 percent. Assume further that
the standard deviation of funds A and B were 40 percent per annum and 30 percent per annum,
respectively. Which fund had the better performance?
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At first glance, fund A had greater risk and a lower return than fund B, so fund B would appear
to have been the better performing fund. However, we know from the CAPM that focusing on
stand-alone risk is misleading if investors can hold diversified portfolios. To draw a firmer
conclusion, we need to know how these funds are managed: Suppose that fund A consists of a
high-risk but "market-neutral" portfolio that has long positions in some shares and short
positions in others, with a portfolio beta of zero. Fund B, on the other hand, invests in selected
high beta stocks, with a portfolio beta of 1.5.
Instead of investing in funds A and/or B, investors could have held corresponding mimicking or
"benchmark" portfolios. For fund A, since its beta is zero, the benchmark portfolio is an
investment in the risk-free asset; for fund B, the benchmark is a position in the market portfolio
leveraged 1.5:1 with borrowing at the risk-free rate. The benchmark portfolios respectively
would have returned 5 percent and 20 percent (= 5 percent + 1.5 × (15 percent - 5 percent)).
Fund A thus outperformed its benchmark by 7 percent, while fund B underperformed its
benchmark by 2 percent, as shown in the table above.
In terms of the CAPM framework, funds A and B had alphas of 7 percent and - 2 percent,
respectively, where alpha is the difference between a fund's performance and that predicted
given the beta of the fund. Appropriately risk adjusted, fund A's performance (alpha = 7 percent)
exceeded that of fund B (alpha = -2 percent). An investor who held the market portfolio would,
at the margin, have obtained a higher return for the same risk by allocating money to fund A
rather than to fund B.7
The key idea here is that obtaining high returns by owning high beta stocks does not take skill,
since investors can passively create a high beta portfolio simply through a leveraged position in
the market portfolio. Obtaining high returns with low beta stocks is much harder, however, since
such performance cannot be replicated with a passive strategy. Investors therefore need to
assess performance based on returns that have been appropriately risk adjusted. The CAPM
provides a clear framework for thinking about this issue.
The Capital Asset Pricing Model is a fundamental contribution to our understanding of the
determinants of asset prices. The CAPM tells us that ownership of assets by diversified
investors lowers their expected returns and raises their prices. Moreover, investors who hold
undiversified portfolios are likely to be taking risks for which they are not being rewarded. As a
result of the model, and despite its mixed empirical performance, we now think differently about
the relationship between expected returns and risk; we think differently about how investors
should allocate their investment portfolios; and we think differently about questions such as
performance measurement and capital budgeting.
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PV = FV
1+r
PV = Present value of the cash flow
FV = Future value of the cash flow
r = rate of return we can get on the investment
The Dividend Discount Model for valuation uses the time value of money principle to measure
the net present value (NPV) of the cash flows that a corporation will produce in the form of
dividends to shareholders in the future. Under the DDMs are Gordon Growth Model, One-Period
DDM & Multi-Period DDM.
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in the long term, will converge towards zero, which is also not a steady state. Thus, though the
model's requirement is for the expected growth rate in dividends, analysts should be able to
substitute in the expected growth rate in earnings and get precisely the same result, if the firm is
truly in steady state.
In summary, the Gordon growth model is best suited for firms growing at a rate comparable to
or lower than the nominal growth in the economy and which have well established dividend
payout policies that they intend to continue into the future. The dividend payout of the firm has
to be consistent with the assumption of stability, since stable firms generally pay substantial
dividends. In particular, this model will under-estimate the value of the stock in firms that
consistently pay out less than they can afford and accumulate cash in the process.
(Damodaran, A., 2012)
Bond Yield plus Risk Premium
This approach would measure the value of the company's equity by applying the risk premium
to the maturity of the company's long-term debt. This is another tool that we can use to assess
the valuation of an asset, namely the publicly traded equity of a corporation. It helps us to
estimate the required return on equity by applying the risk premium to the return to maturity of
the company's long-term debt.
The formula is as follows:
Rr = Yltd + Erp
Rr = Required return
Yltd = Yield of the firm’s long-term debt
Erp = Equity’s risk premium
Plainly defined, the bond yield is the rate of return obtained from the investment. In this method,
we use the bond's maturity yield, which is the discount rate at which the amount of all expected
bond cash flows (coupon payments and principal payments) is equal to the bond's price. This is
often referred to as the Internal Return Rate (IRR).
The equity risk premium is basically the return that stocks are supposed to obtain over the risk-
free interest rate. The average historical equity risk premium for all equities was just over 6%. In
general, the equity risk premium would be between 5% and 7%.
Estimating the value of an equity using the bond yield plus risk premium approach has its
drawbacks. We can only utilize the BYPRP approach if the entity has publicly traded debt, and it
does not produce as accurate an estimate as the capital asset pricing model or discounted cash
flow analysis.
Moreover, equity risk premium estimates can be highly inaccurate, while also varying wildly
depending on which model is used. It can be very difficult to get an accurate estimate of the risk
premium on an equity, having a duration of roughly 50 years, using a risk-free rate of such short
duration as a 10-year Treasury bond.
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Week 14-15
• Debt Financing
• Equity Financing
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
When it comes to funding a business, "cost" is the visible price of acquiring capital. For debt,
this is the interest rate that a business spends on its loans. In the case of equity, the cost of
capital refers to the earnings right to the shareholder's shareholding in the company.
Types of Funding:
Debt financing – These are long-term borrowings that are typically used to fund investments
such as the purchase of property. The lenders will have priority if the business runs into trouble
and may even have some protection by taking security on the asset funded. Their reward will be
a predetermined rate of interest that is either fixed or linked to a central bank index.
Equity financing – This is the capital put in by investors – the owners of the business. They are
the last to be repaid if the business is in trouble and have to accept the risk that they may lose
all the money they put into the business (but no more than that). In return they are entitled to the
profits generated by the business, and to a potentially limitless return.
The two main types of funding can be split further into a variety of instruments to meet specific
needs of the company. The characteristics of each are shown in the below table:
Characteristics of different types of funding (as listed by Tennent J., 2013)
Permanent Ordinary
finance, although Ordinary shareholders own
Ordinary
there are legal shareholders are the the company and
shares/ Usually through
processes last to be paid in provide its core
common dividends paid out
available to allow event of a winding long-term funding.
stock of earnings
redemption up and have highest The equity also
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Effectively a
commercial
Secured on the mortgage to
Fixed with a property of the provide long-term
predetermined Fixed rate of company, usually loan finance for
Debentures repayment date interest freehold buildings assets
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To fund specific
asset purchases
without an up-front
Normally a fixed purchase. There
For the life of the interest rate cost can be tax and
asset being implicit in the Secured on the replacement
Leasing leased monthly payment asset being leased benefits
An arrangement
fee as well as a
percentage return
Often fixed with a that can be fixed Ranks before all
predetermined or variable. The shareholders and Funding for
repayment date variable rate is will sometimes be projects which will
and sometimes usually linked to a secured on assets generate sufficient
interim central bank rate with a fixed or funds to allow
Loans repayments plus an increment floating charge repayment
Secured on the
debts. Factoring can To accelerate the
The debts being be done with collection of
factored are recourse (any bad receivables and
discounted to take debts passed back prevent cash being
account of the to the business) or tied up in working
interest cost of the without recourse (the capital. It can also
The outsourcing money advanced lender accepts be used to reduce
of debt collection for the time taken liability for any bad overhead costs as
and hence its to collect the debt. debts, but will it outsources part
duration is for the There is also a charge a higher fee of the accounting
Factoring life of the contract management fee for doing so) function
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In selecting the most appropriate type of finance for a business there are two main
determinants: duration and cost.
Duration
For how long is the funding required? The repayment of funding should match the profile of the
investment it is used to finance.
For example, the purchase of property, which may have long-term use in the business, should
be funded by long-term finance with repayments matching the revenue expectations.
Potentially, these can be spread far into the future. This type of long-term funding would be
inappropriate for a business that needed to cover a short-term funding requirement while waiting
for a receivable to be paid.
Cost
What is the cost of the funding? The greater the risks taken by the providers of funding, the
higher is the rate of return they require. For example, if a provider of funds is promised that it
would be the first to be repaid if the business were in difficulty and that it can take a charge over
the physical assets (such as property that it could sell to clear the debt), it has a low risk of
losing its money and thus the business would expect the cost of this funding to be relatively low.
However, lowering the risk to one provider of funds increases the risk to another. With the
assets all used as security for one party, another will have no security that its money will be
repaid in event of difficulty. For this higher risk a higher return will be required. The cost of
funding is therefore determined by the level of risk to each type of funding.
With other factors considered, a corporation will decide based on the business strategy that will
further help their operations enable optimal profits. Decisions include a variety of considerations,
including how much debt the business already has on its books, the predictability of the cash
flow of the company, and how comfortable the owner is collaborating with partners.
The below consists of more details that will guide the owners for their significant business
decisions as per Woodruff J., (2019):
Advantages of Debt financing:
Control: Taking out a loan is temporary. The relationship ends when the debt is repaid. The
lender does not have any say in how the owner runs his business.
Taxes: Loan interest is tax deductible, whereas dividends paid to shareholders are not.
Predictability: Principal and interest payments are stated in advance, so it is easier to work
these into the company's cash flow. Loans can be short, medium or long term.
Disadvantages of Debt financing:
Qualification: The company and the owner must have acceptable credit ratings to qualify.
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Fixed payments: Principal and interest payments must be made on specified dates without fail.
Businesses that have unpredictable cash flows might have difficulties making loan payments.
Declines in sales can create serious problems in meeting loan payment dates.
Cash flow: Taking on too much debt makes the business more likely to have problems meeting
loan payments if cash flow declines. Investors will also see the company as a higher risk and be
reluctant to make additional equity investments.
Collateral: Lenders will typically demand that certain assets of the company be held as
collateral, and the owner is often required to guarantee the loan personally.
Advantages of Equity financing:
Less risk: You have less risk with equity financing because you don't have any fixed monthly
loan payments to make. This can be particularly helpful with startup businesses that may not
have positive cash flows during the early months.
Credit problems: If you have credit problems, equity financing may be the only choice for funds
to finance growth. Even if debt financing is offered, the interest rate may be too high and the
payments too steep to be acceptable.
Cash flow: Equity financing does not take funds out of the business. Debt loan repayments take
funds out of the company's cash flow, reducing the money needed to finance growth.
Long-term planning: Equity investors do not expect to receive an immediate return on their
investment. They have a long-term view and also face the possibility of losing their money if the
business fails.
Disadvantages of Equity financing:
Cost: Equity investors expect to receive a return on their money. The business owner must be
willing to share some of the company's profit with his equity partners. The amount of money
paid to the partners could be higher than the interest rates on debt financing.
Loss of Control: The owner has to give up some control of his company when he takes on
additional investors. Equity partners want to have a voice in making the decisions of the
business, especially the big decisions.
Potential for Conflict: All the partners will not always agree when making decisions. These
conflicts can erupt from different visions for the company and disagreements on management
styles. An owner must be willing to deal with these differences of opinions.
Funding duration
The duration of the funding has a significant influence on which will be most suitable. In
principle, long-term assets should be funded by long-term finance and short-term requirements
by short-term finance.
For example, the fixed assets of property or equipment might be funded by equity or debt
instruments as they are both for long-term duration, whereas an increase in working capital,
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Over 15 Use a form of equity funding (providing the amount is over $20m as the cost of
years raising this funding can be expensive)
5–15
years Consider a debt instrument (providing the amount is over $10m)
Under 5 Bank loans usually provide the cheapest and most flexible source (potentially fixed
years rate to remove an uncontrollable uncertainty – the central bank rate)
Under 1
year Bank overdraft
Repayment risk – The risk to debt providers increases as there is less of an equity buffer
to absorb losses that the business may make.
Interest risk – The interest cost must be met before dividends can be paid to
shareholders. If interest cannot be paid and there is a serious risk of the business not
being able to repay the debt, funders will exercise rights in their loan agreements to
force repayment from asset sales.
Cost – With enhanced risk to debt providers the cost of the loans is likely to rise in the
form of increased interest rates.
If there is too little debt, shareholders lose out through dilution of earnings which limits their
return owing to:
Greater WACC – As equity is more expensive than debt, the business can lower its
wacc by replacing equity with cheaper debt; the enhanced earnings can then be passed
back to shareholders.
Restrained growth – With too little borrowing, the business may be operating sub-
optimally as it could borrow more to fund expansion and achieve greater growth.
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For example, three businesses have the same total funds and the same operating income. The
difference is in the mix of debt and equity in each business. The interest rate is 10% for each
business. The return to the equity investors is as follows:
Business A B C
Debt 750 500 250
Equity 250 500 750
Total funds 1,000 1,000 1,000
Operating Income 200 200 200
Interest (10%) 75 50 25
Income before tax 125 150 175
Tax (30%) 38 45 53
Earnings 87 105 122
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To prevent businesses from borrowing too much, there are often covenants in a loan agreement
that constrain the business. A common covenant is that a loan becomes immediately repayable
if a certain debt to equity ratio is exceeded.
The optimum leverage for a business is seen to be around 50% of total funds. At this level the
interest rate on debt is optimized and the return on equity is maximized.
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Week 16
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Over a period of time, businesses purchase and use up the stock, which results in adjustments
to the stock level reported on the balance sheet. The stock balance shall be measured as
opening stock plus purchases minus closing stock. The net effect of the use of shares and
acquisitions of new shares will become part of the cost of sales on the profit and loss account
and will have an impact on taxable income.
The manner in which the stock is priced clearly affects the cost of sales in any period of time.
Businesses are obliged to use either the weighted average valuation basis for the cost of sales
or value using the first-in first-out (FIFO) process. Any investor who wants to beat the market
must master the skills of stock valuation. Essentially, stock valuation is a method of evaluating
the value (or potential value) of the stock. The significance of stock valuation is derived from the
fact that the value of the stock is not bound to its current price. By knowing the value of the
stock, the investor can decide whether the stock is over-or under-valued at its current market
price.
The principle behind most of the stock valuation strategies is that the value of a company is
equal to the value of all projected free cash flows. All future cash flows are discounted because
of the time value of the money. If you objectively know all of the company's potential cash flows,
and you have a target rate of return on your investment, then you will know the exact amount of
money you can pay for that company.
This valuation approach, therefore, is a blend of art and science. Given the inputs, the outputs
are factual. If we knew exactly how much cash flow is to be generated, and we have a target
rate of return, we can know exactly what to pay for a dividend stock or any company with
positive free cash flows regardless of whether it pays a dividend or not. But the inputs
themselves are only estimates and require a degree of skill and experience to be accurate with.
Hence, stock valuation is art and science. (Lumen Learning)
Stock valuation methods can be primarily categorized into two main types as defined by CFI
Education Inc.:
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1. Absolute
Absolute stock valuation relies on the company’s fundamental information. The method
generally involves the analysis of various financial information that can be found in or derived
from a company’s financial statements. Many techniques of absolute stock valuation primarily
investigate the company’s cash flows, dividends, and growth rates. Notable absolute stock
valuation methods include the dividend discount model (DDM) and the discounted cash flow
model (DCF).
2. Relative
Relative stock valuation concerns the comparison of the investment with similar companies. The
relative stock valuation method deals with the calculation of the key financial ratios of similar
companies and derivation of the same ratio for the target company. The best example of relative
stock valuation is comparable companies’ analysis.
Stock Valuation Methods
1. Dividend Discount Model (DDM) (also been discussed in Week 12-13)
Phil's Stock World: Dividend Discount Model: A Simple Three Step Guide to Valuation
“Dividends are such an important variable to building our wealth, it is in our best interests to
continue to add to our toolbox the different methods of calculating intrinsic value. The dividend
discount model is simplicity itself and requires only three inputs to determine the value of a
stock.
"It's better to be approximately right, than precisely wrong." That being said we should strive to
be as accurate as we can, to help narrow down our errors in finding intrinsic value.
The dividend discount model (DDM) is a procedure for valuing the price of a stock by using the
predicted dividends and discounting them back to the present value. If the value obtained from
the DDM is higher than what the shares are currently trading at, then the stock is undervalued.
One thing to keep in mind when utilizing this formula is the fact that it won't work for a company
that doesn't pay a dividend. So, companies like Tesla, Netflix, Facebook, Amazon, and Alphabet
wouldn't work with this formula.”
It is a quantitative method of valuation of the company's share price based on the premise that
the actual fair price of the stock is equal to the amount of all possible dividends of the company
discounted back to their present value.
2. Discounted Cash Flow Model (DCF) (also been discussed in Week 12-13)
Discounted cash flow pertains to a sum of money today that is having the same value as a
future stream of cash receipts and disbursements. It refers to a family of techniques for
analyzing investment opportunities that take into account the time value of money. A standard
approach to valuing investments and businesses uses discounted cash flow techniques to
calculate the present value of projected free cash flows.
According to Higgins R. (2012), absent market prices, the most direct way to estimate going-
concern value, if not always the most practical, is to think of the target company as if it were
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nothing more than a giant capital expenditure opportunity. Just as with any piece of capital
equipment, investing in a company requires the expenditure of money today in anticipation of
future benefits, and the central issue is whether tomorrow’s benefits justify today’s costs. As in
capital expenditure analysis, we can answer this question by calculating the present value of
expected future cash flows accruing to owners and creditors. When this number exceeds the
acquisition price, the purchase has a positive net present value and is therefore attractive.
Conversely, when the present value of future cash flows is less than the acquisition price, the
purchase is unattractive.
In equation form,
FMV of firm = PV {Expected cash flows to owners and creditors}
This formula says that the maximum price one should pay for a business equals the present
value of expected future cash flows to capital suppliers discounted at an appropriate risk-
adjusted discount rate. Moreover, as in any other application of risk-adjusted discount rates, we
know the rate should reflect the risk of the cash flows being discounted. Because the cash flows
here are to owners and creditors of the target firm, it follows that the discount rate should be the
target company’s weighted-average cost of capital.
A legitimate question at this point is: Why waste energy estimating firm value when the ultimate
goal of the exercise is usually to value equity? The answer is simple once you recall that the
value of equity is closely tied to the value of the firm. In equation form, we have our old friend
Value of equity = Value of firm – Value of debt
To determine the value of a company’s equity, therefore, we need only estimate firm value and
subtract interest-bearing debt. Moreover, because the market value and the book value of debt
are usually about equal to each other, estimating the value of debt amounts to nothing more
than grabbing a few numbers off the company’s balance sheet.1 If the fair market value of a
business is $4 million and the firm has $1.5 million in debt outstanding, its equity is worth $2.5
million. It’s that simple.2 (We ignore non-interest-bearing debt such as accounts payable and
deferred taxes here because they are treated as part of free cash flow, to be described
momentarily.)
You may see the below trade journal from Seeing the future. (2013) below:
Discounted cash flow: seeing the future
It is possible to see the future. All you need is a spreadsheet. Or so one might conclude after
reading the ruling a Delaware court reached this month.
3M acquired biometrics company Cogent in 2010, paying Cogent's shareholders $10.50 a
share. Merion, a hedge fund that owned Cogent shares, disliked the deal and sought a court's
opinion of fair value. Merion wanted $16 a share. 3M countered with $10.15. The judge, using a
discounted cash flow analysis, settled on $10.87. The judge said he would have preferred to
consider the earnings multiples of comparable companies and relevant transactions as well, but
he could find none that fit, leaving him with the DCF alone.
Conceptually, the DCF approach is correct. The value of an asset is the present value of its
future cash flows. But companies' and analysts' internal projections tend to show profits growing
steadily upward into the indefinite future. In the real world, economies falter, competition
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encroaches, and margins revert. The pre-crisis revenue peak reached by S&P 500 companies
was not reached again until 2012 - making a mockery of every DCF built in 2006.
Further, 75 per cent of any DCF's value estimate comes from the "terminal value", the worth of
the company at the end of the projection period. That, naturally, depends heavily on the profits
estimate in the final year modelled - a result, logically, of the trend in the early years.
DCFs need not be abolished. They are useful for testing what growth and margins levels would
justify a certain price, a process that often breeds scepticism. Issues arise when DCF is used by
management to divine the long-term value of its company - a process that lends itself the
illusion of prescience. Might as well use a crystal ball. And everyone can see the process for
what it is.
3. Comparable Company Analysis
Bankruptcy lawyers face valuation issues on a daily basis.1 Whether or not a firm at the time of
its bankruptcy filing was solvent is at the heart of fraudulent conveyance and preference claims.
While solvency can be assessed in more than one way, one of the more common solvency
analyses requires valuing a firm's assets and comparing that value to the firm's debts. As
discussed in this column in the December/January 2010 Journal,2 the market approach is a
frequently used method in valuation. The market approach looks beyond the firm and studies
the values of other similar companies. One of the most widely used methodologies under the
market approach is the comparable company multiple (CompCo) analysis.
The CompCo analysis determines a firm's value by comparing it to comparable publicly traded
companies. Multiples of earnings or other financial metrics are derived for each comparable
company and the appropriate multiple is applied to the subject company in order to determine
its value. Problems in the analysis may arise when the industry in which the firm operates is
going through a phase characterized by activities such as abnormally high growth,
restructurings, mergers and acquisitions, divestitures and significant capital expenditures. For
the sake of this, we will refer to it as an "unstable" phase or industry, which would be contrasted
with an industry experiencing a "stable" period of consistent, organic growth. Problems also
arise when the comparable companies have significant material investments in assets unrelated
to the operations of the company or assets that have material value but do not contribute to the
metric used for calculating multiples, such as earnings. At issue is making sure that the
measures of company value (the numerator of the multiple) and earnings metric (the
denominator of the multiple) are compatible.
The comparison should be scrutinized both from external (Industry classification, Geography)
and internal (size in terms of revenue, assets & employees, Growth rate and Margins &
profitability) factors. The significant financial information should be secured in order for a
comparable table analysis to be created and presented.
The financial data can be organized as shown in CFI Education Inc.’s example of Comparable
Companies Analysis shown below:
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Here you can see the valuation data in the last group of columns and come up with a business
decision based on the company’s target goal.
The CompCo valuation approach is both widely used and widely accepted for litigation
purposes. When performing a CompCo valuation, an appraiser faces the potential to
miscalculate multiples for the comparable companies by not accounting for unconsolidated
investments or investments that are not in the same line of business. Subtracting the value of
these investments from comparable company enterprise values and any earnings from these
investments from consolidated earnings is likely to yield more accurate comparable company
multiples with which the appraiser can often value the subject company.
If an appraiser is performing a valuation of a company in an unstable industry, one that is
experiencing regular financing transactions or mergers, acquisitions and asset sales, solely
relying on quarterly financiáis may result in the use of stale and inaccurate financial information.
In order to avoid use of stale data, the appraiser can look to additional SEC filings, press
releases, news articles and analyst reports to determine the total mix of information available to
the market for each comparable company as of the valuation date. Doing so can yield more
accurate comparable company multiples and. as a result, a more accurate valuation of the
subject company.
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Week 17
LEARNING OUTCOME:
By the end of this topic, you will be able to:
COURSE MATERIAL:
Bonds are long-term debt securities issued by corporations or government agencies to collect
debt funding. Investors investing in bonds give regular interest payments, called coupon
payments, and at maturity they receive the nominal value of the bond along with the last coupon
payment. Any payment received from the bonds, whether it is a coupon payment or a maturity
payment, is referred to as a cash flow for investors.
Bond valuation is the calculation of the fair value of the bond. As with every security or capital
investment, the theoretical fair value of the bond is the present value of the cash flow that it is
supposed to produce. As a result, the value of the bond is derived by discounting the estimated
cash flows of the bond to the present using an acceptable discount rate. In practice, the
discount rate is always calculated by comparison to similar instruments, given that such
instruments exist.
The valuation of a bond depend on several factors:
Present Value - The value of the bond is obtained by discounting the projected cash
flows of the bond to the present using an acceptable discount rate.
Coupon rate - Such bonds have an interest rate, also known as the coupon rate, which
is paid to bondholders on a moderately basis. The coupon rate is the fixed return that the
investor receives on a timely basis before it matures.
Maturity date - All bonds have maturity dates: short-term or long-term. If the bond
matures, the bond issuer repays the entire face value of the bond to the lender. The
nominal value is not always the principal invested or the purchasing price of the bond.
There are several factors such as inflation, bond credit scores and others that affect the value of
bonds. In addition, there are several aspects of the bond itself that decides its worth. In an
investor’s perspective, it is important to be fully aware of what we are investing in what the risks
involved are and how much return we can expect. Bond valuation aims to take all the attributes
into account in order to assess the precise present value.
There are two common kinds to measure a bond valuation based from the business’ bonds set-
up of an organization:
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Comparing the two computations, a coupon-paying bond is more beneficial than a zero coupon
bond.
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ACTIVITIVES / ASSESSMENT
Week 2:
Part I: Identification
Identify the correct term associated with the given definition on the question.
Some events may eventually give rise to a liability, but the timing and amount is not presently
sure. Such uncertain or potential obligations are known as ___________________.
Part II: Journal Entries
Date Transaction
2-Jan An amount of P36,000 was paid as advance rent for three months.
3-Jan Paid P60,000 cash on the purchase of equipment costing P80,000. The remaining amount was
recognized as a one year note payable with an interest rate of 9%.
4-Jan Purchased office supplies costing P17,600 on account.
13-Jan Provided services to its customers and received P28,500 in cash.
13-Jan Paid the accounts payable on the office supplies purchased on January 4.
14-Jan Paid wages to its employees for the first two weeks of January, aggregating P19,100.
18-Jan Provided P54,100 worth of services to its customers. They paid $32,900 and promised to pay the
remaining amount.
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23-Jan Received P15,300 from customers for the services provided on January 18.
25-Jan Received P4,000 as an advance payment from customers.
26-Jan Purchased office supplies costing P5,200 on account.
28-Jan Paid wages to its employees for the third and fourth week of January: P19,100.
31-Jan Paid P5,000 as dividends.
31-Jan Received an electricity bill of P2,470.
31-Jan Received a telephone bill of P1,494.
31-Jan Miscellaneous expenses paid during the month totaled P3,470
Prepare the journal entries for the following transactions listed below:
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Week 3:
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Week 4 – 5:
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a. How much cash and near cash does McCahon & Weaver have at year-end 2019?
b. What was the original cost of all of the firm’s real property that is currently owned?
c. How much in total liabilities did the firms have at year-end 2019?
d. How much did McCahon & Weaver owe for credit purchases at year-end 2019?
e. How much did the firm sell during 2019?
f. How much equity did the common shareholders have in the firm at year-end 2019?
g. What are the cumulative total earnings reinvested in the firm from its inception through the
end of 2019?
h. How much operating profit did the firm earn during 2019?
i. What is the total amount of dividends paid out by the firm during the year 2019?
j. How many shares of common stock did McCahon & Weaver have outstanding at year-
end 2019?
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Question 1: In the month of March, Itachi Salon services 620 clients at an average price
of $100. During the month, fixed costs were $14,016 and variable costs were 68% of sales.
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Week 6 – 7:
Answer the below questions in paragraph form. You may also use diagrams, theories, and other
articles to support your answer.
1. Explain the importance of free cash flow forecasting. What are the advantages and
disadvantages of free cash flow forecasting?
2. Why should we consider environmental and legal aspects in Broad Factors Analysis? How
do these factors affect the financial condition of the company?
3. Among the three industry evaluation techniques, what do you prefer the most? Explain.
Support your answer using an example company and its financial health.
4. Between statistical and pro-forma forecasting for a specific organization, what should a
company perform if the world recession repeat?
Explain the importance of strategic planning and how will it affect the organization and the
industry?
Week 8:
(No assessment / activity for week 8 in preparation for the Midterm Examination)
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1. ______________ This is the amount in excess of the net income after the company has
paid out its shareholders’ dividends.
2. ______________ The effect of decrease in prepaid expenses to the net cash provided by
operating activities.
3. ______________ This informs users how the company valued its inventory, making it
easy for them to compare inventory figures from one period to another or other competing
entities.
7. ______________ This is a return earned from holding an asset for a specified period of
time.
8. ______________ This is a way for companies to determine how changes in costs and
sales volume affect a company’s profit.
9. ______________ these are requests from purchases of large assets such as property,
equipment or IT systems that create major demands on an organization’s cash flow.
10. ______________ This is a practice used by financial institutions to mitigate financial risk
resulting from a mismatch of accounts in balance sheet (comprehensive or consolidated).
11. ______________ This is the number of products the company must sell to cover all
production costs.
12. ______________ This tells companies how net income changes in sales numbers.
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13. ______________ This is commonly referred to as the company’s “wiggle room” and
shows by how much sales can drop and yet still break even.
14. ______________ This is an analysis of the difference between planned and actual
numbers.
15. ______________ This reflects the consideration to which the insurer expects to be entitled
in exchange for the services provided on an earned basis.
Problem 1: Sasori’s Merchandising reported its Statement of Financial Position for the year
ended December 31, 2019. The balance sheet has P70,500 in cash, P12,785 in accounts
receivable, P7,870 prepaid insurance, P6,771 inventories, P89,833 total fixed assets, P45,788 in
accounts payable, P5,741 notes payable, P8,821 outstanding bonds, P22,000 long-term notes
payable.
2. Compute the Acid-test Ratio for Sasori’s Merchandising. What would be the decision
criteria after obtaining the Acid-test Ratio?
3. Compute the Cash Ratio for Sasori’s Merchandising. What would be the decision
criteria after obtaining the Cash Ratio?
4. What would be quick ratio for the company after overlooking that there is a P12,500
marketable securities that should be included in the assets?
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Problem 2: Deidara and Tobi’s Engineering Services reported its Statement of Financial Position
and Comprehensive Income for the year ended December 31, 2019 as follows:
Deidara & Tobi's Engineering Services
Balance Sheet At December 31, 2019
Assets Liabilities and Equity
Current Assets Current Liabilities
Cash on Hand PHP 114,120 Accounts Payable PHP 271,455
Cash in Bank 89,347 Notes Payable 123,345
Marketable Securities 477,813 Accruals 99,001
Accounts Receivable 321,802 Total Current Liabilities PHP 493,801
Inventories 321,641 Non-Current Liabilities
Total Current Assets PHP 1,324,723 Bonds Outstanding PHP 879,423
Fixed Assets Bank debt, long-term 671,542
Machinery PHP 871,542 Total Non-Current Liabilities PHP 1,550,965
Equipments 231,442 Shareholder's Equity
Less: Accumulated Depreciation 55,150 Preferred Stock PHP 87,941
Net Fixed Assets PHP 1,047,834 Common Stock (at par) 47,715
Total Assets PHP 2,372,557 Paid-in Capital in Excess of Par 125,423
Retained Earnings 66,712
Total Shareholder's Equity PHP 327,791
Total Liabilities and Equity PHP 2,372,557
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1. What would be the Accounts Receivable Turnover for the company after confirming
that P1,987,002 were services rendered through credit?
2. What is the operating self-sufficiency ratio for the company? What would be the
decision criteria after obtaining it?
3. What is the tax rate used in obtaining the total taxes paid by the company?
6. What would be the decision criteria for the operating efficiency, asset efficiency and
financial leverage after performing the DuPont Analysis for the company?
Problem 1: Tsunade Company plans to market a new product. Based on its market studies,
Tsunade estimates that it can sell 5,500 units in 2017. The selling price will be P2 per unit.
Variable cost estimated to be 40% of the selling price. Fixed cost is estimated to be P 6,000. What
is the break –even point?
Problem 2: Orochimaru Company’s variable costs are 70% of sales. At a P 300,000 sales level,
the degree of operating leverage is 10. If Sales increase by P60,000, what will be the degree of
operating leverage?
Problem 3: Jiraiya’s Corporation sells sets of encyclopedias. Jiraiya sold 4,000 sets last year at
P250 set. If the variable cost set was P175, and the fixed costs for Vivian were P100,000, what
is the Jiraiya’s Corp.’s degree of operating leverage (DOL)?
Problem 4: Danzo Company sells Products S, T and D. Danzo sells three units of S for each unit
of D and two units of T for each unit of S. The contribution margins are P1 per unit of S, P 1.50
per unit of T, and P3 per unit of D. Fixed costs are P600,000. How many units of S would Danzo
sell at the break-even point?
Problem 5: Sannin Company sells Product Rei for P5 per unit. The fixed cost is P210,000 and
the variable cost is 60% of the selling price. What amount of sales is needed to realize a profit of
10% of sales?
- End -
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Week 10:
Multiple choice: Select the appropriate statement that describes each of the following questions.
A. They enable funds to transfer from those without productive investment opportunities
to those with such opportunities.
B. They help business with their financial advice.
C. They lend money to everybody.
3. Which of these below are long term financial instruments?
A. Sales forecast
B. Cash flows
C. Liquidity
5. Whatever a society uses as currency, the distinguishing feature is that
Short answer: Kindly provide your thoughts and insights on the following statements.
1. A bank has reached out to you for financial advice regarding their current situation. You
got into a call with the Bank Manager and he explained that there has been an increase
in their customer loans, while getting lesser deposits and having a challenge in customer
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loan payments.
What will you advise to the bank so they can continue their operations without having a
problem on liquidation?
2. Name the different types of Financial Market and provide an example of it here in the
Philippines.
3. What will you advise to a firm that has a negative CAR result?
4. What financial statement helps determine the cash flow of a firm? Provide financial ratio
samples that can help in defining the liquidity status of the organization.
As a finance student, what are your advice to financial institutions on making sure they will still
continue their operations amidst the current pandemic situation?
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Week 11:
Multiple choice: Select the appropriate statement that describes each of the following questions.
1. In the business industry, business valuation can also be termed as:
A. Asset approach
B. Demand approach
C. Market approach
D. Income approach
3. The reason why a business may have ____________ to a specific purchaser over the
hypothetical ‘typical purchaser’ or ‘average purchaser’ is because that purchaser is
already engaged in the same or similar business in the industry.
A. lesser value
B. no value
C. greater value
D. nothing
4. It is defined as a corporate transaction where one company purchases a portion or all of
another company’s shares or assets.
A. Merger
B. Disinvestment
C. Acquisition
D. Joint Venture (JV)
5. Which of the following is not an advantage if a company do a corporate restructuring?
Short answer: Kindly provide your thoughts and insights on the following statements.
1. What are the things that you will consider before signing into a merger deal?
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2. What financial statement will you first see if you want to do a business valuation of a
firm?
3. Aside from merger approach, what would you recommend if you were one of the
business experts that should decide on Deutsche Bank Restructuring case? Can you
provide further actions that the bank may take to help improve their financial situation?
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Week 12-13:
True or False: Write T if the statement is true and accurate, otherwise indicate F if you think the
statement is false. Further justify your answer on each of the questions.
1. The cost of capital or WACC is not the right discount rate to be used for all projects
performed by a corporation.
2. If you can borrow all the money you need for a 13% business project, the cost of capital
for this will also be 13%.
3. The most effective way to measure the cost of Debt Capital for a company is to divide
the interest on the income statement by the interest on the balance sheet.
4. Not only for structuring merger set-ups and leveraged buyouts, the business valuation
principles standardly instruct security analysts in their quest for undervalued stocks.
Short answer: Kindly provide your thoughts and insights on the following statements.
1. How will the rise on financial leverage would impact the cost of equity capital of an
organization?
2. Why is business synergy important in the valuation phase of a merge & acquisition
activity?
3. If you can borrow all of the money you need for a business venture at 6% interest, is
the cost of capital for this will also be 6%?
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Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Week 14-15:
Multiple choice: Select the appropriate statement that describes each of the following questions.
2. Select the sentence that does not describe what a financial leverage is.
3. Which type in forms of debt has a long-term finance but has a low initial cost?
A. Convertibles
B. Bonds
C. Debentures
D. Overdraft
4. This is the type of risk to debt holders; it will continue to rise as the capital buffer is
smaller to absorb the losses that may be sustained by the company.
A. Interest risk
B. Repayment risk
C. Inflation risk
D. Credit risk
5. This is a type of disadvantage when a firm utilizes equity financing. It results when most
of the shareholders have different perception on the future of the organization, following
to an argument.
A. Cost decision
B. Loss of control
C. Sharing of profit
D. Potential for Conflict
Short answer: Kindly provide your thoughts and insights on the following statements.
1. What is financial leverage to you?
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
2. Explain why increasing financial leverage increases the risk tolerated by shareholders.
4. On the other hand, why do you suppose several promising small businesses fail to follow
the recommendation in item 3?
5. One determinant of a company’s debt capacity is the liquidity of its assets. Name two
common ratios that are exclusively intended to measure the liquidity of a company’s
assets relative to its liabilities. Give their specific use to the company’s performance
analyzation.
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Week 16:
Multiple choice: Select the appropriate statement that describes each of the following questions.
1. Which of the following types of shares is characterized by the fact that it does not obtain
any preferential treatment in respect of either dividends or bankruptcy proceedings?
A. common
B. cumulative
C. preferred
D. non- cumulative
2. You cannot attend the shareholder’s meeting for Almelor Corporation, so you allow
another shareholder to vote on your behalf. What is the name of the granting of this
authority?
A. Altering
B. Straight voting
C. Voting by proxy
D. Indenture agreement
3. This is a method that analyzes the value of a company’s asset and is derived only on the
basis of characteristics on that asset. It has no consideration regarding the valuation of
other comparable assets that are trading in the marketplace.
A. Relative valuation
B. Absolute valuation
C. Dividend Discount model
D. Discounted Cash flow model
4. This type involves the use of future free cash flow flanges and discounts them so as to
obtain the present value, which is then used to measure the potential for investment.
A. Relative valuation
B. Absolute valuation
C. Dividend Discount model
D. Discounted Cash flow model
A. profit
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
B. retained earnings
C. net income
D. dividends
True or False: Write T if the statement is true and accurate, otherwise indicate F if you think the
statement is false. Further justify your answer on each of the questions.
1. The free cash flow valuation model is based on the same principle as the P/E valuation
approach; that is, the value of a share of stock is the present value of future cash flows.
2. Preferred stock is a special form of stock having a fixed periodic dividend that must be
paid prior to payment of any interest to outstanding bonds.
3. A common stockholder has no guarantee of receiving any cash inflows but receives
what is left after all other claims on the firm’s income and assets have been satisfied.
4. Investors purchase a stock when they believe that it is undervalued and sell when they
feel that it is overvalued.
5. In common stock valuation, any action taken by the financial manager that increases risk
will also increase the required return.
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Week 17:
ASSESSMENT:
Multiple choice: Select the appropriate statement that describes each of the following questions.
1. Lilybeth just purchased a bond in Legits Printing company which pays Php 30,000 a year
in interest. What is this Php 30,000 called?
A. face value
B. discount amount
C. coupon
D. premium bond
2. Aaron owns a bond that will pay him Php 22,500 each year in interest plus a Php 40,000
principal payment at maturity. What is this Php 40,000 called?
A. face value
B. discount amount
C. coupon
D. premium bond
3. What do you call the agreed date on which the principal amount of a bond is payable?
A. coupon date
B. maturity date
C. dividend yield date
D. face value date
4. What do you call a bond that has only one-time payment which occurs at maturity?
A. debenture
B. zero coupon
C. Notes
D. callable
5. You are expecting that interest rates will decline in the near future because of the covid
pandemic, despite the bond market not indicating any signs of this change. Which of the
following bonds would you purchase today to maximize your gains if your expected rate
decline does occur?
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
True or False: Write T if the statement is true and accurate, otherwise indicate F if you think the
statement is false. Further justify your answer on each of the questions.
1. If a company decides to utilize debt financing and raises capital by selling new bonds,
the buyer is called the "issuing firm" and the coupon rate is generally set equal to the
required rate.
3. The prices of high-coupon bonds lean towards to be less sensitive to a given change in
interest rates compared to low-coupon bonds, given that other things equal and held
constant.
4. The present value of a bond is basically the ‘present value’ of all future cash flows from
the bond, discounted at the risk-adjusted discount rate.
5. Money has a time value mainly because inflation increases the purchasing power over
time.
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Part I. Identification
Write the correct answer in the space provided in each sentence. This part will be 2 points each.
2. The ____________ approach is to analyze long-term ventures that specifically takes into
account the time value of money.
5. The model for pricing a company’s securities or portfolio of shares and for evaluating the
projected returns on capital investments is _______________.
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
7. _______________ is the process of closing a firm, selling its properties, paying off its
creditors and distributing any remaining cash to its shareholders.
11. _______________ is simply the act or method of assessing the value and ownership
interest of a company.
12. The abbreviation for earnings before interest and taxes is _______________.
13. The _______________ is a type of strategy that includes maintaining the liquidity of
liquid assets, mainly marketable securities. (The liquid asset has a ready market, a
stable price, and the principal can be recovered with minimal risk of losing.)
14. It is a requirement that each bank and depository institution should have a
_______________ ratio because it is an important indicator of "safety and soundness"
for them as this acts as a buffer to sustain losses.
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Read all of the statements carefully and make sure to understand the facts given before you
begin answering. Explain your answer based on every information that you learn throughout this
course duration.
1. Problem 1:
Santos & Bucad Manufacturing is a no-growth company and is expected to pay a Php 50
per share annual dividend for the next quarter. In the balance sheet, you can see that
the cost of equity capital is at 15%. The new CEO detest the no-growth image of the firm
and proposes to halve the next year’s dividend to only Php 25 per share and use the
savings to acquire another company.
The CEO is convinced that this strategy will improve the organization’s assets, sales and
even earnings. Furthermore, he is confident that after the acquisition, dividends in Year-
2 and beyond can be increased to Php 53 per share.
1. What necessary information will you request to the CEO of Santos & Bucad
Manufacturing regarding the target company to be acquired? (5 points)
2. Do you agree that the acquisition move will likely improve the firm’s assets, sales and
even earnings? (5 points)
3. As a board member of the Santos & Bucad Manufacturing, would you support the CEO’s
proposal? Why or why not? (5 points)
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
2. Problem 2:
ASSETS
LIABILITIES
EQUITY
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Suppose the company is planning to undertake a certain business project that will require an
investment of P120,000 so as to increase its operating income by P50,000. The current
operating income of the company is 82,000 and Income tax is at 30%.
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
Seatwork
Short answer / Quizzes
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Republic of the Philippines
Polytechnic University of the Philippines
Office of the Vice President for Academic Affairs
COLLEGE OF ACCOUNTANCY AND FINANCE
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Office of the Vice President for Academic Affairs
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