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LOYOLA UNIVERSITY COLLEGE OF BUSINESS ADMINISTRATION FINANCE ...

  1. 1. LOYOLA UNIVERSITY COLLEGE OF BUSINESS ADMINISTRATION FINANCE – B305-001--ANALYSIS OF FINANCIAL STATEMENTS Spring II, 2006 Ten-Week Post-Katrina Semester May 8, 2006 – July 21, 2006 Grades due to Dean's Office by July 31, 2006 Mon-Wed 8:00 AM - 9:50 AM Miller Hall 204 Pre-requisites: Finance B300, Accounting B205. Only those students who have completed at least 56 credit hours may enroll in 300 or 400 level Business Administration courses. Check your Loyola University e-Mail account daily for important University communications. Dr. J. Stuart Wood Miller Hall 306; Phone: (504) 864-7973; (504) 866-7200; (504) 495-6443 ACADEMIC REGULATIONS: See the Loyola University New Orleans Undergraduate Bulletin 2005-2006, pp. 47-55. FIN 305 CATALOG DESCRIPTION: This course examines techniques for the analysis of financial statements, explores the relationship between the selection of accounting procedures and the quality of the resulting statements, analyzes the profitability and riskiness of the firm through the entrepreneurial alertness of management, forecasts future pro-forma financial statements, and values the firm. Valuation is the crux of finance. Valuation is subjective and proceeds from forecasted future expected cash flows discounted at the risk-adjusted cost of capital. The relationship between expenses and sales and between assets and liabilities and sales is discovered through historical analysis of the financial statements. Forecasts of future relationships allow the construction of future pro-forma statements. Valuing the firm is the goal of this course: first, by forecasting the future pro-forma financial statements through the Terminus T; second, by forecasting the free cash flows through the Terminus T; third, by forecasting the Terminal Value at the Terminus T; and fourth, by discounting the stream of future forecasted cash flows and Terminal Value at the risk-adjusted cost of equity.
  2. 2. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 2 of 38 of Syllabus FINANCE 305: TEXTBOOKS: 1. Fridson and Alvarez, Financial Statement Analysis, Third Edition. Wiley, 2002. This is the best short book ever written about the analysis of financial statements. This third edition has been extensively added to, compared with prior editions, and it focuses on issues of misleading accounting. You should read this book intensively. It has an excellent Glossary on pages 375-391. Notes are provided on pages 393-404. The theme of this course is excellently stated by the title of Chapter 1: "The Adversarial Nature of Financial Reporting." 2. Stickney, Brown and Wahlen, Financial Reporting and Statement Analysis, 5th ed. This is the best book for learning about how to analyze financial statements because of its Chapters 10, 11, and 12 on constructing pro-forma financial statements, and how to use these pro-forma financial statements to value the firm. We will spend considerable time in forecasting pro-forma financial statements, and the goal of the course is to forecast future financial statements and thereby value the firm. The framework of financial analysis is the two- dimensional analysis of risk and expected return, which results from the forecast of profit and the assessment of risk: the evaluation of the profitability and riskiness of the firm, discussed in Chapter 4 and Chapter 5 of Stickney. Website: "http://stickney.swlearning.com" Download Financial Statement Analysis Package (FSAP) and User's Guide. 3. Higgins, Analysis for Financial Management, 7th ed. Irwin/McGraw-Hill, 2005. Higgins Glossary, pp. 371-383. Answers to end of chapter problems on pp. 385-402. An excellent book regarding Ratio Analysis and du Pont Analysis (Chapter 2), Financial Forecasting (Chapter 3), and Sustainable Growth (Chapter 4) 4. Fraser and Ormiston, Understanding Financial Statements, 7th Edition. Prentice Hall, 2005 Summary of Financial Ratios pp. 243-245; Glossary pp. 248-255. This is an excellent short review of financial statements and accounting, with an excellent Chapter 5 on Analysis of Financial Statements, and Appendix A on earnings quality. 5. Holden, Excel Modeling in Corporate Finance, Second Edition, Book and CD-ROM. Pearson/Prentice Hall, 2005. ISBN 0-13-142427-0. This is the first book I have seen to teach students how to build spreadsheet models in Finance. Finance proceeds by means of spreadsheet models of the firm. Only with spreadsheets can one forecast and value a business. This is the essence of what we shall do. You will copy the spreadsheets in this book for homework. 6. Handouts I give to you. 7. Hewlett-Packard 12C Financial Calculator. 8. Computer running Microsoft Excel Spreadsheet Software. All of your homework and your Term Project will be done in Excel.
  3. 3. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 3 of 38 of Syllabus COURSE PURPOSE: To Analyze the Financial Statements of the Firm to Determine its Value Analysis of the financial statements consists in the forecasting of future financial statements, the conversion of income into free cash flow to equity, the computation of the value of the equity of the enterprise by discounting the free cash flow to equity, and the evaluation of the quality of the entrepreneurship of the firm's managers. Valuation is subjective, so it is based on forecast assumptions which create the future forecasted cash flows to equity. Financial statement analysis is a comprehensive process of thought which creates in the analyst's mind an understanding of the entrepreneurial capabilities and success of management and management's changes in the value of equity. Valuing the firm is the goal of this course: first, by forecasting the future pro-forma financial statements through the Terminus T; second, by forecasting the free cash flows through the Terminus T; third, by forecasting the Terminal Value at the Terminus T; and fourth, by discounting the stream of future forecasted cash flows and Terminal Value at the risk-adjusted cost of equity. This course will teach you: (1) to understand the physical and financial conditions and relationships revealed by analyzing the financial statements; (2) to understand the relationships among the financial and operating parameters, as revealed by computations involving past data, so that we can understand how income has been earned and whether profits have been created; (3) to forecast accurately the future parameters, cash flows, and Terminal Value of the firm in the anticipated future conditions; (4) to forecast the future pro-forma financial statements, cash flows, and Terminal Value of the firm, based on the present and anticipated future conditions and operations of the firm in the environments of its product market, supply market, and security market; (5) to compute the present value of the equity of the enterprise by discounting the future cash flows and Terminal Value at the risk-adjusted cost of capital; and (6) to evaluate the quality of the entrepreneurship of the firm's managers based on its changes in the value of equity. ACADEMIC INTEGRITY STATEMENT: All work in this course is strictly individual; no written or electronic source of assistance is forbidden. You must do yourself all work which you turn in for the course. All work is take-home and is open-book. You may discuss concepts and principles with each other and discuss how to do the homework, but you must write your own term project, and you must not discuss examination questions. Ask me any questions you may have. The penalty for compromise of your academic integrity by receiving live help from another student or giving help to another student, is disenrollment from the course with a grade of "F". See the Loyola University New Orleans Undergraduate Bulletin 2005-2006, pp. 50-52. ATTENDANCE POLICY: Students are expected to attend all classes, arrive on time, not leave early, have cell phones and pagers disabled, behave professionally, answer questions posed by the instructor, and participate in class discussion. "Preparation precedes progress." Class attendance is required. Roll will be taken daily. If you must miss class, telephone me prior to that class at (504) 495-6443 and tell me why you will miss class; leave a message if I do not answer. At the next class, turn in a written note explaining your absence. I shall give you a written note informing you whether or not the absence has been excused. Three unexcused absences will result in a grade of "WF" automatically. DISABILITY POLICY: "A student with a disability that qualifies for accommodations should contact Sarah Mead Smith, Director of Disability Services at 865-2990 (Academic Resource Center, Room 405, Monroe Hall). A student wishing to receive test accommodations; e.g., extended test time, should provide the instructor with an official Accommodation Form from Disability Services in advance of the scheduled test date."
  4. 4. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 4 of 38 of Syllabus FINANCE 305 COURSE LEARNING OBJECTIVES: This is a lecture/discussion class, combining assigned text readings, homework exercises, examinations, and a term project. Valuation is the crux of finance. Valuation is subjective. Valuation proceeds from the forecasted future free cash flows to equity. Valuing the firm is the goal of this course: first, by forecasting the future pro-forma financial statements through the Terminus T; second, by forecasting the free cash flows through the Terminus T; third, by forecasting the Terminal Value at the Terminus T; and fourth, by discounting the stream of future forecasted cash flows and Terminal Value at the risk-adjusted cost of equity. Students completing this course successfully will be able to: o Deal with the subjectivity of valuation through alternative sets of forecasts; o Create pro-forma spreadsheets forecasting future financial statements to value the firm; o See beneath the financial statements to the true events which have happened and the true condition of the firm in the two dimensions of profitability and riskiness; o Evaluate the financial ratios of the firm for liquidity, activity, leverage, and profitability; o Evaluate the profitability of the firm and the contributions to profitability of operating efficiency and capital structure; o Evaluate the flow of funds in the firm and the flow of cash through the firm; o Perform a duPont analysis of the causes of the Return on Equity; o Evaluate the growth of the firm's sales using sustainable growth g* = PRAT^, and the Gordon constant growth model g∞ = br ; P0 = d1 / (ke - g∞ ); o Forecast failure using the Altman Z-Score: Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5; o Analyze the fixed and variable costs of the firm using regression analysis; o Build spreadsheet models in Excel; o Forecast the pro-forma financial statements of the firm for several years into the future; o Compute the Leveraged Free Cash Flows to Equity and compute the value of equity by discounting them and the Terminal Value at the risk-adjusted cost of equity capital ke = RF + β (E[RM] – RF) + ϕ ; o Form the Terminal Value at the end of forecast life using the Gordon Model TVT = LFCFET ( 1 + g∞) / ( ke - g∞) ; o Value the firm and value the equity of the firm as the present value of future cash flows and Terminal Value discounted at the risk-adjusted cost of equity capital; o Simulate the value of the firm by altering forecast parameters repeatedly; o Evaluate the entrepreneurial alertness of firm management in creating profits.
  5. 5. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 5 of 38 of Syllabus FINANCE 305 COURSE REQUIREMENTS AND GRADING: Valuation is the crux of finance. Valuation is subjective. Valuation proceeds from the forecasted future free cash flows to equity. Valuing the firm is the goal of this course: first, by forecasting the future pro-forma financial statements through the Terminus T; second, by forecasting the free cash flows through the Terminus T; third, by forecasting the Terminal Value at the Terminus T; and fourth, by discounting the stream of future forecasted cash flows and Terminal Value at the risk-adjusted cost of equity. 1. Homework assigned daily from Holden book and turned in written, daily: 20% Take-home, open book and notes. Homework is indicated by a boldfaced-underlined "HW" preceding the assignment. 2. Two term examinations, take-home, open-book and notes, 15% each, totaling 30%. 3. Term Project, 50%. Take-home, open book and notes. The Term Project is to be handed in as Sections weekly during the Semester, as scheduled below; Section 15 of Term Project Due Monday, July 17, 2006; LATE SUBMISSIONS WILL NOT BE ACCEPTED. LATE SUBMISSIONS WILL CAUSE YOU TO FAIL THIS COURSE. Total number of pages of text = 66 or more (double-spaced) in addition to all required tables and computations. 4. There is NO Final Examination. 5. DO NOT SEND ME e-mail: I DO NOT READ OR SEND e-mail. Telephone me at 495-6443 with questions you have before 9:00 PM any day. 6. NO GRADE OF "INCOMPLETE" WILL BE GIVEN.
  6. 6. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 6 of 38 of Syllabus FINANCE 305: SUMMARY Valuation is the crux of finance. Valuation is subjective. Valuation proceeds from the forecasted future free cash flows to equity. Valuing the firm is the goal of this course: first, by forecasting the future pro-forma financial statements through the Terminus T; second, by forecasting the free cash flows through the Terminus T; third, by forecasting the Terminal Value at the Terminus T; and fourth, by discounting the stream of future forecasted cash flows and Terminal Value at the risk-adjusted cost of equity. A firm has an indefinite future lifetime; i.e., potentially "to infinity." Valuation of the firm is accomplished by discounting to present value at the appropriate risk-adjusted cost of capital rate the series of future free cash flows and Terminal Value at the terminus T, which capture the entire lifetime of the firm. The free cash flows are derived from the forecasted future financial statements of the firm, and we must capture the entire future lifetime of the firm. If we have successfully analyzed the financial statements, we know the value of the firm under a particular set of forecasted parameters, and we can determine the value under other sets of forecasted parameters. We have forecasted the future financial statements based on our understanding of the past financial statements and the changes which we expect to occur in the future. The goal of this course is forecasting the future financial statements and cash flows of the firm, based on the present and anticipated future conditions and operations of the firm in the environment of its product market and security market. Accounting information must be of high "quality" to accomplish this: "quality of accounting information" refers to the accuracy of the information in reflecting truth and the ability to forecast accurately on the basis of the information. If the reported information is not of high quality, we must first re-state the information so it becomes of high quality. The relationships between and among the various financial and operating parameters and between the firm's parameters and future conditions must be understood so that we can forecast the precise structure and values of the future financial statements as a function of the forecasted future parameters and exogenous variables which can occur. Once we have forecasted the future financial statements, income statement, balance sheet, and funds flows through the terminus, we can compute the "leveraged free cash flow to equity" and the "unleveraged free cash flow to the firm" for each future time period, and we can forecast the "terminal value" of the firm at the end of our forecasted future period of time, the "terminus". We then compute the value of the equity by discounting, at an appropriate risk-adjusted discount rate, those forecasted future cash flows to equity plus the terminal value; or from the value of the firm, from which we subtract the value of debt. Analysis of the financial statements consists in the computation of the value of the equity of the enterprise and the evaluation of the quality of the entrepreneurship of the firm's managers. Financial statement analysis is a comprehensive process of thought which creates in the analyst's mind an understanding of the entrepreneurial capabilities and success of management.
  7. 7. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 7 of 38 of Syllabus FINANCE 305, SPRING II, 2006 CLASS SCHEDULE Week 1: May 8, 10: Section 0. The Financial Statements. The Winn Company. Entrepreneurship. Spreadsheet construction for pro-forma statements and valuation. Regression Analysis of Mixed Costs to Determine Fixed and Variable Components Forecasting Pro-Forma Financial Statements: Stickney Chapter 10. Using Excel to Construct Pro-forma statements of the Winn Company. Valuing the Free Cash Flows of the firm from t = 1 through t = T: UFCFFt and the Free Cash Flows to Equity from t=1 through t=T: LFCFEt (See Stickney p. 817), and the Terminal Value at T, TVT. Forecasting methodology given on Stickney pages 742-744. 0. Identify length of forecast period and terminus T: t=1 ............ t=T; 1. Forecast Sales from t = 1 through t = T using growth rates; St+1 = St ( 1 + gt+1 ), etc. 2. Forecast Expenses using percentages of sales, fixed and variable costs, or financial ratios, and complete the Income Statement; 3. Forecast dividends from dividend payout ratio p = 1- b (b = retention rate = CRF/NIAT = portion of income retained and reinvested) p = CDE/NIAT = 1- [(NIAT – CDE)] / NIAT; 4. Forecast Balance sheet: Begin with either Sales/Total Assets or Sales/Fixed Assets; Use Cash and Short-term debt as a plug on each side; Tie interest expense on IS to interest-bearing debt on BS; Tie retained earnings on BS to income on IS minus dividends. 5. Determine cash flows from IS and BS and Dividends: Sources of Funds: Cash retained from operations. New short-term liabilities; Increase in a liability; Increase in common stock and APIC; Decrease in an asset; Uses of Funds: Payment of dividends; Payment of short-term liabilities; Increase in an asset; Decrease in a liability; Purchase of treasury stock. 6. Compute Free Cash Flows to Equity or to the Firm See Exhibit 11.1, page 817 of Stickney 7. Estimate g∞ constant perpetual growth rate beyond terminus. 8. Compute Terminal Value at terminus using Gordon model: TVT = FCFT (1 + g∞) / (k - g∞) 9. Discount Free Cash Flow Series plus Terminal ValueT to Present Value. LFCFEt 's and TVT are discounted at ke; UFCFFt 's and TVT are discounted at kf*
  8. 8. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 8 of 38 of Syllabus Example valuation spreadsheet with simulation. The value of the firm strongly depends on expectations of growth. Description of Term Project. Consistency of Dimensions and Units Required for Correct Analysis Stickney, Chap. 10: Preparing Pro-Forma Financial Statements Fridson, Chap. 1: The Adversarial Nature of Financial Reporting Stickney, Chap. 1: Overview of Financial Reporting and Financial Statement Analysis Stickney, Chap. 6: Quality of Information, pp. 342-386. Fraser & Ormiston: Appendix A, pp. 217-235, "A Guide to Earnings and Financial Reporting Quality" "Entrepreneurship" by JSW. HW 1: Holden, Chap. 1 (Fig. 1.1--1,2,3,4; Fig. 1.2—1,2,3,4; Problems 1, 2) Section 0. Eyeball growth analysis: Overall changes related to overall sales growth; Section 1. Common-Size Statements: Past Analysis and Forecasting Spreadsheet construction for pro-forma statements and valuation. Example valuation spreadsheet with simulation. Fraser & Ormiston, Chaps. 1, 2, 3, 4. The Financial Statements. Higgins, Chap. 1: Interpreting Financial Statements. Stickney, Chap. 1: Overview of Financial Analysis. Stickney, Chap. 7: Revenue and Expense Recognition. Stickney, Chap. 8: Liability and Expense Recognition. "Entrepreneurship" by JSW. HW 2: Holden, Chap. 2: (Fig. 2.1—1,2,3,4,; Fig. 2.2—1,2,3,4; Fig. 2.3—1,2,3,4,5; Problems 1, 2) Hand in Section 0, Complete Financial Statements and "eyeball analysis". Section 0. Eyeball growth analysis; Section 1. Common-Size Statements: Past Analysis and Forecasting Fridson, Chaps. 2, 3; Fraser & Ormiston: Chapters 1, 2, 3. "Entrepreneurship" by JSW. Stickney, pp. 93-99, "Framework for Analyzing Effects of Transactions..." HW 3: Holden, Chap. 3: (Fig. 3.1—1,2,3) Section 2. Annual Percentage Growth g, Index At/A0 Analysis Statements. g = ( St+1 – St ) / St ; "Entrepreneurship" by JSW. Stickney Chapter 2, Assets/Liabilities/Income Measurement HW 4: Holden, Chap. 3: (Fig. 3.2—1,2; Problems 1, 2)
  9. 9. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 9 of 38 of Syllabus Week 2: May 17: No Class Meeting on Monday, May 15, 2006. Hand in Section 1, Common-Size Analysis. Section 2. Combination of growth analysis with changes in common-size statements. HW 5: Holden, Chap. 4: (Fig. 4.1—1,2,3) Section 3. Financial Ratios. Stickney, Chap. 4: Profitability Analysis. Stickney, Chap. 5: Risk Analysis, pp. 262-281. Higgins, Chap. 2: Evaluating Financial Performance. Fraser, Chap. 5: The Analysis of Financial Statements. Fridson, Chap. 13: Credit Analysis. HW 6: Holden, Chap. 4: (Fig. 4.2--1,2,3) Hand in Section 2, Annual growth and Index Analysis. Section 3. Financial Ratios. Section 4. Average Collection Period, Average Payment Period. Stickney, Chaps. 4, 5; Higgins, Chap. 2; Fraser, Chap. 5; Fridson, Chap. 14. HW 7: Holden, Chap. 4: (Problems 1, 2) Section 5. duPont Analysis of Return on Equity: ROE = ROA ( 1 - θ ). ROE = NI/NW = (S/TA) X (NI/S) X (TA/NW) Stickney, Chaps. 4, 5; Higgins, Chap. 2; Fraser, Chap. 5; Fridson, Chaps. 13, 14 HW 8: Holden, Chap. 5: (Fig. 5.1—1 through 8)
  10. 10. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 10 of 38 of Syllabus Week 3: May 22, 24: Hand in Section 3a, Ratio Analysis—Liquidity and Activity. Section 5. duPont Analysis of Return on Equity. Stickney, Chaps. 4, 5; Higgins, Chap. 2; Fraser, Chap. 5; Fridson, Chap. 14. Section 6. Analysis of Growth: Sustainable Growth g* = PRAT∧. P = NI/S; R = b = CRF/NIAT; A = S/TA; T = TA/NW∧ If g > g*, either operating efficiency was improved or cash flowed in to buy new assets; If g < g*, then cash flowed out of the firm or operating efficiency fell. Higgins, Chap. 4: Managing Growth; Sustainable Growth, g* Stickney, Chap. 4: Sustainable Earnings and Sustainable Growth, g* Fridson, Chap. 14: Equity Analysis; Sustainable Growth, Return on Equity HW 9: Holden, Chap. 5: (Sec. 5.2, Fig. 5.3—1,2,3,4) Section 6. Analysis of Growth: Sustainable Growth g*. Higgins, Chap. 4; Stickney, Chap. 4; Fridson, Chap. 14. HW 10: Holden, Chap. 5: (Problems 1, 2, 3) Hand in Section 3b, Ratio Analysis—Leverage and Profitability. Section 6. Analysis of Growth: Sustainable Growth g* vs. Actual Growth g. Section 6. Gordon Model of Constant, Perpetual Growth: Section 6. Normalization of Earnings; Gordon Model of Constant Growth. Stickney, Chap. 8: Profitability Analysis: An Extended Look. Fraser, Appendix A, pp. 217-235: Quality of Earnings HW 11: Holden, Chap. 6: (Sec. 6.1/Fig. 6.1—1,2,3,4; Sec 6.2/Fig 6.2—1,2,3,4,5,6) Section 7. Funds Flow Statements. Cash-Flow Statements. Free Cash Flows. Stickney, Chap. 3; Fridson, Chap. 4; Fraser and Ormiston, Chap. 4 Stickney, Chap. 11, pp. 816-820. The "Leveraged Free Cash Flow to Equityt" or the "Free Cash Flow to Equityt" is the amount of cash the firm can afford to pay out in dividends in year t (CDEt ) after paying all debt principal and interest for the year, and without adversely affecting the planned growth of the firm; i.e., after purchasing all necessary capital equipment (IVSt ) and purchasing the needed increase in net working capital for the ∆ year, (∆NWCt ) which is required for the new capital equipment. Recall that net working capital is current assets minus current liabilities: (NWCt = CAt – CLt ) HW 12: Holden, Chap. 6: (Section 6.3/Fig. 6.4—1,2,3,4,5; Sec. 6.4/Fig. 6.5—1-6); Chap. 15: (Sec. 15.1/Fig. 15.1—1,2,3)
  11. 11. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 11 of 38 of Syllabus THE GORDON MODEL OF CONSTANT, PERPETUAL GROWTH AT THE RATE g∞ FOR ALL-EQUITY, UNLEVERED FIRMS: g∞ = the constant perpetual growth rate of all income items b = retention rate, the portion of income retained and reinvested = NIAT - Dividends; r = the average rate on new investment earned by the invested capital = ∆NIAT/IVSt. P0 = V0 = d1 / (ke - g∞ ) VT = dT+1 / (ke - g∞) ke = (d1 / P0 ) + g∞ g∞ = br for all-equity firm THE GORDON MODEL FOR LEVERED FIRMS USING DEBT-CAPITAL FINANCING M = the ratio of the market value of retained earnings to the dollar size or book value of retained earnings. If all investments have positive Net Present Values, then M > 1.0. If we relax the assumption that the firm is all-equity financed by allowing the firm to adopt a constant debt/equity ratio, (VD/VE), it can be shown that, if M = 1.0: g = r b + b[r – kd ( 1- tc )] (VD/VE). Using debt financing can (but will not always) increase the growth rate, when the rate of return on the assets purchased exceeds the interest rate paid on the debt. This situation is called “favorable financial leverage”. When financial leverage is favorable, use of debt will raise the return on equity above the return on assets. Financial leverage always increases the risk borne by the equity holders. If some financial leverage is employed, then VD > 0, and (VD/VE) > 0, and if M > 1.0, then g = ∆E/E = r b + [r – kd (1-tc)] M b (VD/VE). The above is the general case. This general case dissolves to the all-equity Gordon model if VD = 0 because then the second term vanishes and g = r b = b r. If the least-profitable accepted project has IRR = kf*, then the average rate of return on new investment, r > kf*, and M > 1.0. If M = 1.0, which is what occurs when the average rate of return on new investment r equals the cost of capital, meaning that some projects are accepted whose rate of return is less than kf*, then g = r b + b [ r – kd (1-tc)] (VD/VE), only when M=1.0 -------------------------------------------end of Gordon Model----------------------------------------------------------
  12. 12. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 12 of 38 of Syllabus Week 4: May 29, 31: Hand in Sections 4, ACP, APP; and 5, du Pont Analysis: basic, intermed, extended. Section 7. Funds Flow Statements. Cash-Flow Statements. Section 7. Time-Spectrum Analysis of Funds Flows. Stickney, Chap. 3; Fridson, Chap. 4, 5, 6, 7; Fraser and Ormiston, Chap. 4 HW 13: Holden, Chap. 6: (Sec. 6.5/Fig. 6.6—1-6; Prob 1-5); Chap. 15: (Prob 1,2) Section 8. Financial Cash Flows Handout: "Financial Cash Flows" HW 14: Holden, Chap. 7: (Sec. 7.1/Fig. 7.1—1 through 8; Sec. 7.2/Fig 7.2—1-9) Hand in Section 6, Sustainable Growth Analysis, Gordon Growth Analysis. Section 8. Financial Cash Flows HW 15: Holden, Chap 10: (Sec. 10.1/Fig. 10.1—1 through 5) Section 9. Operating Leverage and Business Risk Stickney, Chaps. 4, 5. HW 16: Holden, Chap. 10: (Sec. 10.2/Figs. 10.2, 10.3—1,2,3,4) Week 5: June 5, 7: Hand in Section 7, Funds Flow Analysis, Time-Spectrum of Funds Flow Analysis. Section 10. Fixed and Variable Cost Analysis Stickney, Chap. 4, 5 HW 17: Holden, Chap.10: (Sec. 10.3/Figs. 10.4, 10.5—1,2,3,4) Section 10. Fixed and Variable Cost Analysis; Operating Leverage Stickney, Chaps. 4, 5 HW 18: Holden, Chap. 10: (Sec10.4/Fig. 10.6, 10.7—1,2.3,4,5) Hand in Section 8, Financial Cash Flow Analysis. Section 10. Fixed and variable cost analysis: regression of expenses on sales Stickney, Chaps. 4, 5 HW 19: Holden, Chap. 10: (Problems 1, 2, 3, 4) Section 11. Financial Leverage. Higgins, Chap. 6: Financing and Capital Structure Stickney, Chap. 5: Risk Analysis HW 20: Holden, Chap. 11: (Sec. 11.1/Fig. 11.1—1,2,3,4,5,6,7)
  13. 13. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 13 of 38 of Syllabus Week 6: June 12, 14: Hand in Section 9, Operating Leverage and Business Risk Analysis. Section 11. Financial Leverage. Higgins, Chap. 6. HW 21: Holden, Chap. 11: (Sec. 11.2/Fig. 11.2—1,2,3); Chap 12: (Sec. 12.1/Fig. 12.1, 12.2, 12.3—1-6). Section 12. Altman Z-Score to Predict Corporate Failure Stickney, Chap. 5 pp. 281-296. Fridson, Chap. 8: Altman Z-Score to Forecast Failure HW 22: Holden, Chap. 12: (Sec. 12.2, Figs. 12.4,5,6—1-9); Chap. 13: (Sec. 13.1/Fig. 13.1—1,2,3,4,5,6,7) Hand in Section 10, Fixed and Variable Cost Regression Analysis. Section 13. Financial Forecasting: Pro-forma statements. Higgins, Chap. 3: Financial Forecasting Fridson, Chap. 12: Forecasting Financial Statements Stickney, Chap. 10: Pro-Forma Financial Statements HW 23: Holden, Chap. 13: (Sec. 13.2/Fig. 13.2—1,2,3,4,5,6) Section 13. Financial Forecasting: Pro-forma statements. Higgins, Chap. 3: Financial Forecasting Fridson, Chap. 12: Forecasting Financial Statements Stickney, Chap. 10: Pro-Forma Financial Statements HW 24: Holden, Chap. 13: (Sec. 13.3/Fig. 13.3—1,2,3,4,5,6)
  14. 14. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 14 of 38 of Syllabus Week 7: June 19, 21: Hand in Sections 11 and 12, Financial Leverage, Altman Z-Score Section 13. Financial Forecasting: Pro-forma statements. Section 14. Simulation of Variables in Pro-Forma Statements. Stickney, Chap. 10: Pro-Forma Financial Statements Fridson, Chap. 12: Forecasting Financial Statements Higgins, Chap. 3: Financial Forecasting HW 25: (Holden, Chap. 13: (Problems 1, 2, 3) Section 14. Simulation of Variables in Pro-Forma Statements Section 15. Business Valuation: Valuing the Entire Firm using Free Cash Flows and Terminal Value TVT. HW 26: Holden, Chap. 14: (Sec. 14.1/Figs. 14.1, 14.2—1,2,3,4,5,6; Sec. 14.2/Figs. 14.3, 14.4, 14.45—1,2,3,4,5,6,7,8) The "Leveraged Free Cash Flow to Equityt" or the "Free Cash Flow to Equityt" is the amount of cash the firm can afford to pay out in dividends in year t (CDEt ) after paying all debt principal and interest for the year, and without adversely affecting the planned growth of the firm; i.e., after purchasing all necessary capital equipment (IVSt ) and purchasing the needed increase in net working capital for the ∆ year, (∆NWCt ) which is required for the new capital equipment. Recall that net working capital is current assets minus current liabilities: (NWCt = CAt – CLt ) Higgins, Chap. 9: Business Valuation Stickney, Chap 11 and 12: Valuation of the Entire Firm Stickney p. 817 Computation of Free Cash Flows TVT(FCFE) = FCFET ( 1 + g∞) / (ke - g∞ ) TVT(FCFF) = FCFFT ( 1 + g∞) / (kf* - g∞ ) VE0 = [ t=1Σt=T (FCFEt/(1 + ke )t ] + TVT / (1+ke)T VF0 = [t=1Σt=T (FCFFt / ( 1 + kf* )t ] + TVT / (1 + kf*)T Section 15. Business Valuation: Valuing the Entire Firm using Free Cash Flows and Terminal Value. Higgins, Chap. 9: Business Valuation Stickney, Chap 11 and 12: Valuation of the Entire Firm HW 27: Holden, Chap. 14: (Sec. 14.3/Fig. 14.6—1,2,3,4,5) Section 15. Business Valuation: Valuing the Entire Firm; CAPM, FCF's, TVT Capital Asset Pricing Model: ke = RF + β (E[RM] – RF) + ϕ Higgins, Chap. 9: Business Valuation Stickney, Chap 11 and 12: Valuation of the Entire Firm HW 28: Holden, Chap. 14: (Sec. 14.4/Fig. 14.7—1,2,3,4,5,6; Sec. 14.5/Fig. 14.8—1,2,3) HW 29: Holden, Chap. 14: (Section 14.6—Nike, Inc. Figs. 14.9-14.15—1-13)
  15. 15. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 15 of 38 of Syllabus Week 8: June 26, 28: Week 9: July 5: Hand in Section 13, Pro-forma Statements for two years. Week 10: July 10, 12, 17: Hand in Section 14, Alternative Simulated Pro-forma Statements. Hand in Section 15, Valuation of Equity of the Firm.
  16. 16. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 16 of 38 of Syllabus TERM PROJECT CONTENTS : Total Pages = at least 66 pages of text, plus all the required tables and calculations: Section No. Contents: Numbers and Lengthy Analysis and Discussion of Each Technique Format all numbers correctly, and state their units. You must provide a written explanation and thorough analysis in English of at least the number of pages shown in parenthesis in each item below, typed, double-spaced. Focus on the entrepreneurial success as revealed by the analytical tool. 0. The financial statements of the previous four (4) years: Balance Sheets, Income Statements, Cash Flow Statements, Statements of Changes in shareholders' Equity, and the Notes to the Financial Statements: "Eyeball Analysis" (6 pp.) relating overall growth of expenses, assets, liabilities to sales. 1. Common-size analysis: balance sheet and income statement: historical. (4 pp.) 2. Index and annual percentage growth rate analysis: historical. (4 pp.) 3. Ratio analysis: liquidity, activity, leverage, profitability: historical. (6 pp.) 4. Average Collection Period, Average Payment Period: historical. (2 pp.) 5. du Pont analysis of return on equity: Basic {ROE = ROI/(1-θ) = (NI/TA) (TA/NW)}, Intermediate {ROE = (NI/S) (S/TA) (TA/NW)}, and Extended duPont analysis of the causes of Return on Equity: historical. (6 pp.) 6. Sustainable Growth analysis and Gordon Growth analysis: historical. (4 pp.) 7. Funds Flow analysis and time spectrum analysis of funds flows: historical. (6 pp.) 8. Financial cash flow analysis: historical. (1 p.) 9. Operating leverage analysis and business risk analysis: historical. (4 pp.) 10. Fixed and Variable Cost Analysis; Cost-Volume-Profit Analysis, including regression analysis of each expense on sales to determine fixed and variable components of each expense, to be used later in pro-forma statement construction. (4 pp.) 11. Financial leverage analysis, favorability or non-favorability of financial leverage, and financial risk analysis; estimation of the weighted-average cost of capital kf*. (4 pp.) 12. Prediction of corporate failure using Altman's Z-Score: historical. (1 p.) 13. Pro-forma statement construction for two future years, balance sheets, income statements, financial cash flows, and funds flows for each year forecasted, using the regression analysis of costs on sales to determine expenses. Include a terminal value. Explain how your growth rate is related to the Sustainable rate and to Gordon's growth rate. Common-Size analysis of forecasted (2 yrs) statements. Growth and Index Analysis for 2-yr forecast. Ratio analysis of 2-yr forecast. ACP, APP analysis of the forecast. DuPont analysis of the forecast. (Written analysis contrasting your forecast with the recent history of the firm, 6 pages.) 14. Production of a number of alternative pro-forma statements by simulation of variables. Include terminal values. List and explain the changed variables and how each is related to the statements. (4 pp.) 15. Valuation of Equity computation and analysis of each pro-forma scenario consisting of the pro- forma cash flow statements plus the terminal value.(4 pp.) Compute a value of equity of each pro-forma scenario; then average all the results. Value of Equity is the average value of the distribution of these individual values of equity, each of which is the present value of future leveraged cash flows to equity and the terminal value. (LFCFE, see Stickney Chapter 11.) Two years' of pro-forma statements forecasted, computation of the leveraged free cash flow to equity in each year, and a terminal value at t2 for all subsequent years of firm life. TV2 = LFCFE3/(ke - g∞). And LFCFE3 = LFCFE2 ( 1 + g∞). Estimate ke from the Capital Asset Pricing Model: ke = RF + β (E[RM] - RF). Add appropriate additional risk factors. State the Value of Equity = LFCFE1 / (1+ke)1 + LFCFE2 / (1+ke)2 + TV2 / (1+ke)2.
  17. 17. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 17 of 38 of Syllabus ANALYSIS SEQUENCE: I. For each year we analyze a company, we compute: 1) Capitalized Value, 2) Profitability, 3) Sustainable Growth, 4) Survival Z. As we analyze a firm, we compute for each year each one of these four diagnostic tools: 1) Capitalized Value = Vt = NIATt or t+1 / capitalization rate c Capitalization rate = c = ke - g∞ 2) Profitability = ROE = PAT = ROI / (1 - θ) (Sections 3, 5; See Higgins p. 32) P = ROS = NIAT / Sales; A = S/TA; T = TA/NW; ROI = NIAT / TA; ROE = NIAT / NW; θ = TL / TA 3) ∧ Sustainable Growth = g* = PRAT∧ (Section 6) g* = (NI/S) X [(NI – Div)/NI] X (S/TA) X (TA/NWt-1) ∧ R = (NI – Div)/NI; T∧ = TA/NWt-1 ; ( See Higgins, pages 66, 118.) 4) Survival Z = Altman Z-Score for either a public or a private firm. (Section 12) Zpublic = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5 > 3.0 safe Zprivate = 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420 X4 + 0.998 X5 > 2.9 safe X1 = NWC / TA; X2 = RE / TA; X3 = EBIT / TA; X4 = (M,B)VE / TL; X5 = S / TA (See Stickney pp. 284-285) II. We analyze the success of the entrepreneurial alertness demonstrated by management in the financial statements. This requires us to judge the competitive effectiveness of the firm from time to time, in both its product market and in its security market, against its competitors, in terms of the four diagnostic tools itemized above, and the firm's capital structure, investment behavior and operating leverage, and judge how well the managers forecasted at each prior time point the future desires of their customers of products and of their securities (the "customers" of the securities are called "investors"). III. Our analysis also includes other diagnostic tools: 0. "Eyeball analysis" 1. Common-size analysis 2. Index and annual growth rate analysis 3. Ratio analysis: liquidity, activity, leverage, profitability 4. Average Collection Period, Average Payment Period 5. duPont analysis of the causes of Return on Equity 6. Sustainable Growth analysis; Gordon Constant-growth-rate Analysis 7. Funds Flow analysis and time spectrum analysis of funds flows 8. Financial cash flow analysis 9. Operating leverage analysis and business risk analysis 10. Fixed and Variable Cost Analysis; Cost-Volume-Profit Analysis, including regression analysis of each expense on sales to determine fixed and variable components of each expense, to be used later in pro-forma statement construction 11. Financial leverage analysis, favorability or non-favorability of financial leverage, and financial risk analysis
  18. 18. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 18 of 38 of Syllabus IV. The Process of Analysis: "RAFV" "RAFV"--Restatement, Analysis, Forecasting, Valuation: How to infer from the financial statements what business events actually occurred, and what implications these events have for the future course of the firm. The focus is to value the firm; i.e., to estimate how much it is worth today to the owners. To value the firm, we must forecast its pro-forma financial cash flows, and then discount the entire stream of future free cash flows to equity (from next year to infinity, across the entire life of the firm) back to the present at an appropriate risk-adjusted cost of equity capital, ke. 1. To teach you how to restate (or "adjust") financial statements so that the numbers reflect what really happened according to a consistent basis from year to year, instead of merely what management wants you to know. 2. To teach you how to analyze the restated financial statements to discern past financial events and policies and evaluate management; in particular, to determine what specific "physical events" occurred which reflect particular policies and which explain explicitly how the present financial situation came about; and to understand the motivations and expertise of management so that their future actions can be predicted. The causes of events that determine the numerical values in the financial statements are always actions, either deliberate or unknowing, taken by managers or employees of the company, its suppliers, or customers. Actions are determined by the values and opinions held and the perceptions of the actors. Your analysis must focus on the actions of management and the opinions and perceptions of management which caused those actions. You must evaluate the entrepreneurial activities of the management. For example, some of the actions you identify as causal of the financial statement conditions you observe may be among the following incomplete list: Managers might give credit to too many customers, or not enough customers, or customers of weak financial or marketing condition. Sales volume may be too small to support the employees and suppliers of the firm. Managers might pay bills to quickly or too slowly. Managers may hoard too much cash or allow cash to drop too low. Managers might write off slow-paying accounts too soon. Managers might manufacture too many items for inventory, or keep an insufficient supply to meet demand. Managers might use too-expensive parts in manufacturing. Managers might allow inventory to be damaged. Managers might manufacture incorrect inventory items. Managers may mis-direct salespeople, or develop incorrect incentives for salespeople, or develop incorrect inventory policies, or poor policies governing collections. Managers may purchase too much or too little new capital equipment for the sales which might occur. Managers may borrow too much debt, or not enough debt. Managers might use debt funds inappropriately when equity funds would be more appropriate. Managers may withhold too large a portion of cash provided by operations so that dividends are too small, or they may release too much of operating cash flow for dividends. Managers might pay wages that are too high or too low. Growth may be supported by too much borrowing. Growth may be too rapid, or too slow. Growth may be achieved in weakening or strengthening ways. 3. To teach you how to forecast the future course of the firm, based on the demonstrated skills of management and the present financial condition of the firm and the likely future events which will occur to create the future financial statements which you are forecasting. Future forecasted financial statements are called "pro-forma statements". 4. To teach you how to value the firm; that is, to discount the entire stream of forecasted future cash flows of the pro-forma statements, all the way out to the end of the lifetime of the firm, back to present value, adjusting for industry and market conditions as necessary. To account for risk and
  19. 19. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 19 of 38 of Syllabus uncertainty, which is manifested by ambiguity of the actual numerical values of forecast variables, you must explore the sensitivity of firm value to different values of input variables. When several different input variables are changed simultaneously, the process is called "scenario analysis" or "simulation". The value of the firm is the expected value of the distribution of present values of all of the possible alternative patterns of cash flows which will be received by the owners of the firm for the remaining life of the firm. BUILDING BLOCKS OF FINANCIAL ANALYSIS: In this course you will learn how to analyze the six major building blocks of financial analysis and how each and all together affect the value of the firm through the entrepreneurial success of the decisions. Entrepreneurial success refers to the success in forecasting and superior positioning of the firm against its competitors who sell competing products or sell competing financial securities (shares of stock, and bonds). 1. Short-term liquidity; 2. Funds flow; 3. Capital structure and long-term solvency; 4. Return on investment (ROI); 5. Asset utilization; 6. Operating Performance. OUTSIDE USERS OF FINANCIAL INFORMATION: You will learn how to perform a financial analysis of a company from the point of view of the three major outside groups of users of financial statements: 1. Credit Grantors--suppliers, bankers, and bond-buyers; 2. Equity Investors; 3. Acquisition and Merger Analysts. You will learn to focus continuously on the value of a firm and the changes in value which occur with different policies and actions of the management of that firm. We will focus on how the entrepreneurial success of the management changes the value of the firm from time to time. Value is the present discounted value of the future cash flows which are available to the equity suppliers of the firm; value is created by entrepreneurial success; i.e., superior forecasting of what customers want and superior providing for customers. Valuation is the crux of finance; each financial action changes the value of the firm up or down; the goal of management is to increase the value of the firm; that is to increase the wealth of the equity holders with each action. Analysis focuses on those actions which decreased the value of the firm, so that they can be avoided in the future, and also on those actions which increased the value of the firm, so they can be repeated or emulated. These actions are evaluated with respect to their entrepreneurial element; i.e., how well they anticipated and created the future within which the firm operates.
  20. 20. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 20 of 38 of Syllabus TERM PROJECT CONTENTS : Total Pages = at least 66 pages of text, plus all the required tables and calculations: Section No. Contents: Numbers and Lengthy Analysis and Discussion of Each Technique Format all numbers correctly, and state their units. You must provide a written explanation and thorough analysis in English of at least the number of pages shown in parenthesis in each item below, typed, double-spaced. Focus on the entrepreneurial success as revealed by the analytical tool. 0. The financial statements of the previous four (4) years: Balance Sheets, Income Statements, Cash Flow Statements, Statements of Changes in shareholders' Equity, and the Notes to the Financial Statements: "Eyeball Analysis" (6 pp.) relating overall growth of expenses, assets, liabilities to sales. 1. Common-size analysis: balance sheet and income statement: historical. (4 pp.) 2. Index and annual percentage growth rate analysis: historical. (4 pp.) 3. Ratio analysis: liquidity, activity, leverage, profitability: historical. (6 pp.) 4. Average Collection Period, Average Payment Period: historical. (2 pp.) 5. du Pont analysis of return on equity: Basic {ROE = ROI/(1-θ) = (NI/TA) (TA/NW)}, Intermediate {ROE = (NI/S) (S/TA) (TA/NW)}, and Extended duPont analysis of the causes of Return on Equity: historical. (6 pp.) 6. Sustainable Growth analysis and Gordon Growth analysis: historical. (4 pp.) 7. Funds Flow analysis and time spectrum analysis of funds flows: historical. (6 pp.) 8. Financial cash flow analysis: historical. (1 p.) 9. Operating leverage analysis and business risk analysis: historical. (4 pp.) 10. Fixed and Variable Cost Analysis; Cost-Volume-Profit Analysis, including regression analysis of each expense on sales to determine fixed and variable components of each expense, to be used later in pro-forma statement construction. (4 pp.) 11. Financial leverage analysis, favorability or non-favorability of financial leverage, and financial risk analysis; estimation of the weighted-average cost of capital kf*. (4 pp.) 12. Prediction of corporate failure using Altman's Z-Score: historical. (1 p.) 13. Pro-forma statement construction for two future years, balance sheets, income statements, financial cash flows, and funds flows for each year forecasted, using the regression analysis of costs on sales to determine expenses. Include a terminal value. Explain how your growth rate is related to the Sustainable rate and to Gordon's growth rate. Common-Size analysis of forecasted (2 yrs) statements. Growth and Index Analysis for 2-yr forecast. Ratio analysis of 2-yr forecast. ACP, APP analysis of the forecast. DuPont analysis of the forecast. (Written analysis contrasting your forecast with the recent history of the firm, 6 pages.) 14. Production of a number of alternative pro-forma statements by simulation of variables. Include terminal values. List and explain the changed variables and how each is related to the statements. (4 pp.) 15. Valuation of Equity computation and analysis of each pro-forma scenario consisting of the pro- forma cash flow statements plus the terminal value.(4 pp.) Compute a value of equity of each pro-forma scenario; then average all the results. Value of Equity is the average value of the distribution of these individual values of equity, each of which is the present value of future leveraged cash flows to equity and the terminal value. (LFCFE, see Stickney Chapter 11.) Two years' of pro-forma statements forecasted, computation of the leveraged free cash flow to equity in each year t1 and t2, and a terminal value at t2 for all subsequent years of firm life. TV2 = LFCFE3/(ke - g∞). And LFCFE3 = LFCFE2 ( 1 + g∞). Estimate ke from the Capital Asset Pricing Model: ke = RF + β (E[RM] - RF). Add appropriate additional risk factors. State the Value of Equity = LFCFE1 / (1+ke)1 + LFCFE2 / (1+ke)2 + TV2 / (1+ke)2.
  21. 21. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 21 of 38 of Syllabus The Difference Between Analysis and Observation The financial analyst explains the causes of the actions which caused the observed current state of the system. Explaining the causes is more fundamental than describing the actions or merely describing the current state of the system. The analyst does not merely state: "The liquidity of the company is weak." Rather, the analyst discovers the reasons why the liquidity was weak and how it became weak, and then the analyst states these reasons in the context of the forecasting and production failure of the management which lead to the weak liquidity: "The company gave credit to unworthy customers who did not pay for goods shipped to them, causing a reduced operating cash inflow and the inability to pay bills timely, and took goods which could have been profitably sold to other potential customers and wasted them. This demonstrates a failure to evaluate accurately the financial condition of customers; this entrepreneurial failure damaged the cash flow capability of the company, reduced its competitive position, and reduced the value of its equity. In addition, the company produced unsalable merchandise and allowed other merchandise to become damaged, thereby incurring expenses to suppliers and employees and precluding the sale of a large portion of inventory and the receipt of revenues to pay the already-incurred expenses. This entrepreneurial failure cost cash which could profitably have been spent elsewhere and reduced the ability of the company to sell in its markets because of the competitive disadvantage of its products compared with competing products. This failure reduced the competitive position of the firm, reduced the value of the firm, and harmed the equity suppliers." This is a different analysis from the following, which could also explain why the liquidity of the company is weak: "The company spent too much on non-operating assets and executive perquisites, thereby losing the ability to pay bills timely; this entrepreneurial failure wasted cash which could have gone to produce goods to sell to customers, and that reduced the competitiveness of the company and reduced its value. In addition, the company spent money on unsuccessful new lines of business which drained cash from the firm. This entrepreneurial failure consisted in the inability to see correctly what consumers were going to want, and therefore wasted cash which should have been spent on other lines of business which consumers more urgently desired. This waste reduced the company's competitiveness compared with firms which offered products which consumers more urgently desired, and that waste reduced the value of the business." Only one of these explanations is correct; the analyst must explain which one is correct and why. Both explanations explain why the liquidity is weak. The analyst must identify the true causes of the situation and then explain correctly the causes of the observed financial condition, while focusing on the entrepreneurial success or failure of the observed actions. "Observation" is description of the current state of a system. "Analysis" is the explanation of how the system came to be in its current state; i.e., what forces acted on it, or what decisions were made and actions taken, in the past. As an engineer, I tend to relate this difference to the description and analysis of mechanical systems from the point of view of physics. I think this metaphor helps understanding.
  22. 22. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 22 of 38 of Syllabus For example, consider USS Enterprise (NCC-1701, Capt. James T. Kirk commanding) discovering a tumbling spacecraft of unfamiliar design among the stars. Observation can establish the presence or absence of living beings aboard the spacecraft; the presence or absence of weapons, perhaps gun ports, guns, torpedo launchers, torpedoes, etc.; the velocity of the spacecraft relative to the center of the Galaxy and to the three Galactic axes identified for navigation, or to three nearby cataloged stars and perhaps the vector of motion toward or away from some identifiable planet; the rotation of the spacecraft relative to the three reference planes of the Galaxy, the condition of the hull of the spacecraft, weathering by micro-meteor dust and gases, craters due to meteor impacts, blast effects visible, structural soundness and distortion of the shape of the craft, such as bending, breaking, etc. Analysis then is brought to bear to explain how the characteristics which are observed came to be. Analysis is the discovering of causes: events in the past which caused the present condition. The presence of weapons would indicate a warship, or perhaps merely caution and readiness. Living creatures aboard a tumbling ship would indicate to the analyst a severe malfunction and loss of control, lack of propellant, etc. If there are no living beings aboard, were there once?, and we look for bodies, perhaps decomposed, we look for residues of atmosphere, or we ascertain that there are no open spaces within the craft, so we can conclude this was an unmanned ship. If there are open spaces and evidence of atmospheric pressure, suggesting a crew, but there are no bodies, did the bodies decompose long ago, in which case we observe empty clothing, or maybe the crew were nudists, or did the crew leave the vessel at some time, and if so, why--voluntarily or involuntarily? The velocity of the craft and its mass tell us the characteristics of the propulsion system, and any fuel still in the tanks clarifies plans for the end of the voyage. The type of engines and the fuel capacity tell us whether the ship was able to travel faster or maneuver at its destination. Absence of motors tells us that the ship was launched by an external gun at its point of origin, or that prior launch stages were jettisoned. From the velocity we can determine the amount of thrust applied to the vehicle; from the type of engines and the fuel, we can determine the time-length of burn and the acceleration. From the direction of motion, we can identify the last point at which acceleration was applied. From the design of the engines and the size of fuel tanks, we can determine whether course corrections have been applied, or where the launch point was. From the direction and speed, we can determine the destination of the vehicle. Coupled with our identification of the type of vehicle, we can determine whether its purpose was exploration, contact, trade, or war. The rotational state of the vehicle tells us the size of torque applied, and coupled with our knowledge of the interstellar medium through which the vehicle has traveled and its drag on the vehicle, we can determine, in combination with knowledge of the time the vehicle has been in space, perhaps when that torque was applied. The span of time during which the vehicle has been in space is shown by the condition of the hull, its weathering and the number of meteor impact craters, compared with the density and composition of the interstellar medium over the course of the vehicle. The observational report might state: "Captain, this is an uninhabited vehicle displacing 400,000 tons and 832,000 cubic feet, traveling at a speed of 100,000 miles per second and rotating at 4.2 rpm, on a line between the Klingon homeworld and the Andorian homeworld. The vessel has many gun emplacements, some of which are deployed and with residue in the bores. Fuel tanks are empty and have large holes in them. The finish of the hull is worn, very badly in spots, with many impact holes. Carbon film covers the interior furnishings, and the electronic components are mis-shapen." The analysis report might state: "Captain, this is a defeated Klingon warship of the Thunderbolt class which had been sent by the Klingons to attack the Andorians 152 years ago, but which was defeated in a battle 147 years ago at a point 79.03 light years from this present location, in which a thermal laser of 10-to-the-23rd watts power fired from the forward octant and port side of the vessel vaporized the 172 occupants, damaged the structure and component systems of the vessel, released fuel, and imparted
  23. 23. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 23 of 38 of Syllabus uncontrolled rotation with a torque of 172,577 pound-feet. The nature of the damage is consistent with the weapons now known to have been used by the Tnuctipin at that time. It appears that the Klingon vessel fired its disruptors first on the Tnuctipin vessel, who are known to be powerful but reticent, which returned fire and departed victorious." Notice that much information must be known besides the observations of the instant vessel. Notice the conclusions drawn and the description of the actions which occurred to cause the observed conditions. As a contrary example, in which observation did not lead to any analysis whatever, consider the movie Alien. On an uninhabitable planet, a large starship is discovered broadcasting a repeating message (which must therefore be a plea for help or a warning). Within the ship, at the pilot station, is only one large skeleton, with a hole in its midsection (suggesting some unpleasant demise subsequent to landing). Clearly, the pilot lived long enough to land the vehicle and begin the broadcast, but died while still strapped into his chair. Other crew are not found. In the hold of the ship is a large number of ellipsoidal objects (one is tempted to say "egg-shaped"), protected by a containment field, whose generator is still functioning. Yet the human fool still inspects the eggs closely, even when movement occurs. The greater fools (although the android is programmed to do this and unilaterally opens the door, in contravention to Ripley's order, but the others would have done so also) bring the first fool, now clearly forcibly inhabited by an alien creature, into Nostromo (not noticing the similarity of the behavior of the alien species to several Earth insect species which place eggs or hatchlings into hosts). When the first fool wakes up, nobody thinks about what is inhabiting his stomach, and when he goes into convulsions, all are surprised that something cuts its way out of his body, and nobody thinks to hit it with a skillet while it is still squirrel-sized. A scary movie follows, in which the only non-fool aboard (except for the cat) prevails—at least until the next movie. THE TERM ANALYSIS PROJECT Your term project is a written financial analysis of a real company. This is not the same thing as a fundamental stock analysis for the Investments course, but there are similarities. However, if you turn in to me the same paper you turn in to Dr. Christner, you will receive a grade of F from me. You will submit the report section-by-section across the semester, so that all but the final section will be completed by the last class, and only the final section must be completed following the last class. Each section will have two parts: a numerical computation and table of results portion, and a text portion in which you will analyze the company using the technique of the section and comment about the quality of entrepreneurship revealed by the technique. The main text of the report is a discussion of the financial events and activities which caused the observed condition of the company and an evaluation of the success of the entrepreneurship displayed by management and illustrated with the technical analysis tools, as you have deduced them from your various analyses for the four past years; you must present all of the analytical tools listed above, the calculations, and the results for each of the last four years; you must prepare pro-forma statements including balance sheets, income statements, and funds flow statements, for the next two years, and you must prepare a terminal value of the company covering years 3 to infinity; you must compute the value of the firm revealed by your forecasts of the two years and terminal value. You must explain how you modeled the firm to produce the pro-forma statements, and relate your forecasts to the past events and conditions of the firm and to the entrepreneurship displayed by the managers. If you forecast changes in financial conditions or in the entrepreneurial success of the firm, explain why. The text of the report describes the events, entrepreneurship, and changing financial condition, and it will consist of the text portions of all sections; the numerical portions of the sections can be considered a
  24. 24. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 24 of 38 of Syllabus separate portion consisting of the tables of figures, equations, calculations, statements, etc. which you produced. In the text of the report, refer to the relevant numbered table, statement, chart, etc. Focus on the events which have occurred and their effects on the financial condition of the company, and how these events reveal the entrepreneurial success of the management. The text of the report must completely describe all that you learned about the company from your various financial analyses. Write a separate section of your report for each of the fifteen (15) analytical methods listed above, and put the tables and calculations into a separate section for each method. Number the sections and provide sub-headings. Number the pages within each section: "3-7" means Section 3 page 7. Put a header on each page containing your name, the name of the company, this course name and number, and the section and page number. Sections 13 of the report must also forecast the next two years of financial performance which you think is most likely, and you must present the complete pro-forma statements and the modeling computations which produce them. For the remainder of the firm's lifetime, compute a terminal value to be discounted also. You should explain why you believe the forecasted component variables will have the numerical sizes you expect. In Section 14, you will alter the numerical value of these forecasted component variables to other possible values at least twice, thereby producing at least two other sets of pro-forma statements and terminal values. You must then in Section 15 value the firm, using these two years as explicit forecasts and the terminal value for the remainder of its life; you will compute a value of the firm for each set of pro-forma statements you have produced in Sections 13 and 14. In Section 14 you will simulate alternative values of input variables and the resulting distribution of possible firm values, and you will take these simulations into account in valuing the firm, as each set of pro-forma statements will result in a different numerical value of the value of the firm. Restatement of Project: 1. In Sections 1-12, you must apply each and every individual one of the fifteen financial analysis techniques covered in the course and listed on page 5 above to the last four years' financial statements of a particular company, present the results of these analyses in a set of tables, and write an analysis of the events that caused the information which is presented in the financial statements, keyed to the results of your analyses as given in the tables of results, and how these events reflect the success of the entrepreneurship of the managers. Remember, entrepreneurial action is unavoidable, but it need not be successful. 2. In Sections 1-12, explain in detail what actions of the firm brought about what is seen in the financial statements and the various ratios and other analytical figures you computed, and explain what you learn regarding the entrepreneurial action of the managers from the analysis and from the events you deduce occurred. 3. In Section 13, you must also present pro-forma financial statements, including funds flows or cash flows (See Stickney Chapter 10, pp. 738-786), for the next two years in the future, and the numerical values of the Unlevered free cash flows to the firm (UFCFF) and the Levered free cash flows to equity (LFCFE), (see Stickney, page 817) with an analysis of the assumptions and forecasts made which underlie these pro-forma statements, and an explanation of the management actions needed to bring about these pro-forma results. You must explain all of the assumptions underlying your pro-forma forecasts and show how these assumptions are related to the historical events which your financial analysis uncovered. You must produce also a terminal value of the firm in addition to the two years of forecasted financial statements.
  25. 25. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 25 of 38 of Syllabus 4. In Section 14, you simulate alternative possible values of input parameters to you pro- forma statements, thereby producing at least two additional complete sets of pro-forma statements, each of which reflects a different pattern of input parameters. These are possible values of the parameters, and using different numerical values alters their interactions, and this change in the interactions will cause a different value of the firm. You must produce a set of pro-forma statements and terminal value for each set of input parameters, which you identify. 5. In Section 15 of the report, you must estimate the value of the equity (ownership interest) of the company, as for a sale of the entire company to new owners. You must compute a terminal value as of the end of the second future year which encompasses the remaining years of lifetime of the firm. See Stickney, page 839. You will compute at least three values of equity, one from the forecast in Section 13, and one each from the alternative scenarios or simulations of Section 14. The value of the equity of the firm is the present value of the two years of pro-forma free cash flows to equity plus the present value of the terminal value. This project is a professional report, as might be issued by a good security analyst, or a C.F.A. or C.P.A. to a valued client. The project is to be typed, double-spaced, and the total text of all Sections of the report must be at least sixty-six (66) pages long, not including tables of data. Margins may not be larger than 0.75" on the sides and bottom, and not larger than 1.5" on the top of the page. The page header is within the top-of-page margin and must contain your name, the name of your firm, and the section number, and the page number. Tables of data and equations need not be typed, but may be handwritten. PAGES MUST BE NUMBERED as for example "5-4" which means Section 5, Page 4 of that Section. A page header might look like this: J. Stuart Wood Finance 305, Spring, 2006: Analysis of Boeing Company Section 15, Page 15-3 (or: "Section 15, Page 3")
  26. 26. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 26 of 38 of Syllabus ENTREPRENEURSHIP AND FORWARD THINKING: Entrepreneurship is the animating force of the market economy; it is how human beings achieve the future by acting in the present to change what the future would have been if they had not acted as they will; it requires creative thinking to foresee how alternative futures will be, depending upon what present actions are undertaken. Entrepreneurship is a creative and imaginative act of foresight and change; the action of the entrepreneur causes the future to be different than it would have been if he had acted differently. Entrepreneurship is carried on by every market participant, not merely by those business innovators or leaders we call "entrepreneurs" (although they certainly engage in entrepreneurship). Business activity is co- ordinated acts of entrepreneurship which we seek to understand through analysis of financial statements. "Understanding" refers to the past and to the future; i.e., learning what past entrepreneurial acts were carried out to achieve the present, and seeing what entrepreneurial acts are presently being carried out to change the future. Successful entrepreneurs forecast the future more accurately than do others, so their plans are more successful, and their revenues exceed their costs, allowing them to win profits. Unsuccessful entrepreneurs forecast the future less accurately than do others, so their plans are less successful, and their costs exceed their revenues, so they incur losses. Successful entrepreneurship increases the value of the firm and the value of equity; increases in the value of the firm and the value of equity indicate successful entrepreneurship. We call a market participant an "actor" because he acts; i.e., purposefully seeks to change the future from what it would have been if he had not acted into what he hopes to make it become. For this reason Ludwig von Mises' treatise on Economics is titled Human Action. Action requires two anticipations and their comparison: the forecasting of what the future will be if the actor does not act, and the forecasting of what the future will be if the actor acts in the way he is considering. If the actor acts, we know that he considered the former perceived future (which he has obliterated by his action) to be less satisfactory to him than he considered the latter perceived future (which he has sought to achieve). The actor may not have succeeded by means of his action in bringing about the future which he sought. These anticipations precede the action of the entrepreneur. Entrepreneurship consists not merely of the anticipations or forecasting of alternative futures, but also and inextricably the action seeking to bring about and achieve the future state by taking particular actions in the present: entrepreneurship is directed action associated with the forecasting of the future. Profits are won by successfully anticipating and achieving the future—that is, by offering customers opportunities superior, from their point of view, to other opportunities offered by others or to opportunities which formerly existed—this is "successful entrepreneurship." Unsuccessful entrepreneurship creates a state of affairs less attractive to the consumers than that which was foregone or that which is offered by competitors, so unsuccessful entrepreneurship creates losses. Profits are won by successful entrepreneurship. "Forward Thinking" is the process of considering the entire future of a business entity and collapsing that future lifetime into a present value: it consists in evaluating the business. Successful managements are those who always think forwardly and who are successful entrepreneurs. Nobody always forecasts perfectly, so sometimes even superior entrepreneurs are wrong, and sometimes even superior firms have losses. "Managerial performance" consists in successful entrepreneurship, which achieves profits, and accurate forward thinking, which values the profits.
  27. 27. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 27 of 38 of Syllabus Value is the present discounted value of the all of the future cash flows which the owners of the firm can take out of the firm over its entire lifetime through the future without impeding its continuing operation and future (planned) growth. We forecast future cash flows up through a terminus point T and add a Terminal Value at T to capture the entire lifetime of the firm. Financial statements can reflect genuine managerial performance or the illusion of such performance. Those who can tell the difference have a considerable advantage in dealing with the firm. We will learn in this course to tell the difference by seeing the managerial performance implied by the financial statements and evaluating whether the underlying financial relationships implied by the financial statements are accurate. Genuine managerial performance is understood by successful forecasting of the future achievements of the firm and the valuation of those future achievements. Genuine managerial performance wins profits for the entrepreneur. We will concentrate on understanding the effect on firm value of the financial statements. Firm value is the present value of all the future actions of the firm: value is the result of forward thinking. The future actions of the firm are the measure of the success of the entrepreneurship of its owners, managers, and employees. Successful entrepreneurship wins profits and increases the value of the firm. Unsuccessful entrepreneurship creates losses and decreases the value of the firm. This is a Finance course and not an Accounting course, so we are interested in learning the true financial condition of the firm from the financial statements, which may be accidentally or deliberately misleading or incomplete. We do not care what the accountants have said; we seek truth. Finance is the application of economic principles to decision making and decision analysis for inter-temporal action, just as engineering is the application of chemical and physical principles to solving problems. We wish to understand how the value of the firm has been affected by the economic events portrayed in the financial statements, and how the future actions of the firm can be foreseen in the financial statements. It is the future actions which cause the present value which we observe. We shall seek to understand the hidden meaning of the statements. We shall not spend much time on alternative accounting treatments of various concepts, but shall try to see through the accounting to the reality hidden beneath. You have already learned much about the accounting treatments of revenues, expenses, inventories, long-term debt, equity, earnings per share, etc. A thorough review of the accounting is contained in the Stickney, Brown, and Wahlen textbook; a shorter review is in the Fraser and Ormiston book. I shall presume you remember all of the accounting details. You must remember all accounting you have been exposed to. In a sense, this course is the reverse of the Finance 300 course, which began with finance theory and deduced results. We will begin with the results observed in the financial statements and use finance theory to discover what caused the statements and what are the implications for the future of those causes—we will measure the implications through our evaluation of the firm; i.e., estimating the present value of all its future activities. We will focus on the main topics of Finance theory: valuation, capital structure, investment evaluation or "capital budgeting", cost of capital, growth, capital acquisition and disbursement or "dividend policy". Review these topics in your Finance 300 textbook and in the thick handout "Principles of Finance" I give you in this course.
  28. 28. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 28 of 38 of Syllabus Entrepreneurial activity is the successful anticipation (i.e., foreseeing) and achievement (i.e., bringing about) of the future through present activity. We always seek to understand the entrepreneurial activity of the firm in analyzing the financial statements. This entrepreneurial activity, whether successful or not, is interpreted by us on the basis of our evaluation (i.e., estimating the present value of all future activities) of the future activities of the firm which we forecast on the basis of our analysis of the financial statements. This is a different point of view from that of the accountant. We know that the past decisions made by the firm, the results of which we see in the current financial statements (for example the degree of financial leverage or changes in the inventory turnover or the return on equity), were made in the past in an effort to improve the firm's present situation by increasing its value. We will evaluate the quality of the firm's past entrepreneurial actions on the basis of the present capital structure and the present business and economic conditions and the firm's current value and changes in that value during the recent past, in response to the firm's decisions. We will form a judgment regarding the entrepreneurial alertness and success of the management on the basis of this analysis of the success of past actions. Based on our evaluation of the quality of the entrepreneurial decisions of the firm, we will judge the likelihood of current and future entrepreneurial success. We likewise know that present decisions the firm is making are also aimed at improving future conditions by increasing the value of the firm forward from today, and we will forecast those future conditions on the basis of our present observations. Our analysis of the financial statements therefore focuses on how the value of the firm has been affected by past decisions and what the implications of present decisions are for potential changes in the firm's value. We value the firm based on our forecast of future financial statements and resulting cash flows to equity which will occur in the future, for the remainder of the lifetime of the firm, with the future cash flows to equity discounted at the cost of equity capital of the firm. The future cash flows to equity are forecasted based on our understanding of the present condition of the firm and our understanding of the entrepreneurial activities which we anticipate will be made. Valuing the firm is the goal of this course: first, by forecasting the future pro-forma financial statements through the Terminus T; second, by forecasting the free cash flows through the Terminus T; third, by forecasting the Terminal Value at the Terminus T; and fourth, by discounting the stream of future forecasted cash flows and Terminal Value at the risk-adjusted cost of equity.
  29. 29. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 29 of 38 of Syllabus FINANCE 305, SPRING II, 2006, DR. STUART WOOD FREE CASH FLOWS TO VALUE THE FIRM AND TO VALUE EQUITY See Stickney Chapter 11, pages 816 - 820, esp. p. 817. "Financial Free Cash Flows" Are Used to Value the Firm and to Value Equity. The value of the firm VF0 is the present value to the owners (debt holders and equity holders) of all the future benefits they will receive from the firm for the remainder of its lifetime forward from the present day. The value of equity VE0 is the value of the firm minus the value of debt: VE0 = VF0 – VD0. The value of equity VE0 is also the present value to the equity holders of all the future net benefits (dividends minus new equity capital supplied) they will receive from the firm for the remainder of its lifetime forward from the present day. We calculate the Value of the Firm VF0 by discounting the series of the "Unleveraged Free Cash Flows to the Firm at each time point" (UFCFFt) from t=1 through t=T plus the Terminal Value at T, TVT , all by the weighted-average cost of capital kf*. From VF0 we subtract the value of debt at time 0, VD0, to deduce the value of equity VE0. We calculate the Value of Equity VE0 by discounting the series of the "Leveraged Free Cash Flows to Equity at each time point" (LFCFEt) from t=1 through t=T plus the Terminal Value at T, TVT , all by the cost of equity capital ke. Free Cash Flow (FCF) or "Free Cash Flow to Equity" (FCFE) or "Leveraged Free Cash Flow to Equity" (LFCFE) is the annual cash flow the firm can use to pay common dividends after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations and without adversely affecting the planned growth of the firm; i.e., after purchasing plant and equipment needed to maintain operations and achieve growth, and after purchasing the net working capital required to operate the new plant and equipment. This definition of "Free Cash Flow" subtracts the required debt service ( PP + I ) for the year on the way to the computation of FCF. We call this "Leveraged Free Cash Flow to Equity Suppliers", LFCFE. (Stickney) Another definition is: Free Cash Flow is the cash flow the firm can distribute to all investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations and planned growth. This means that FCF is the cash which the firm can use to pay either stockholders (pay dividends or repurchase stock) or debtholders (PP or Interest) without adversely affecting the planned growth of the firm; i.e., after purchasing plant and equipment needed to maintain operations and achieve growth, and after purchasing the net working capital required to operate the new plant and equipment, but without having subtracted debt service. Stickney calls this "Unleveraged Free Cash Flow to the Firm", UFCFF. (Stickney, p. 750 or Brigham and Daves, p. 189). Note that these two definitions are different, so you must specify what definition you are using. References: 1. Boudreaux and Long, pp. 124-127; 2. Brigham and Daves, Eighth Edition, pp. 197-207; 3. Stickney: Chapter 11.
  30. 30. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 30 of 38 of Syllabus VALUE OF THE FIRM AND THE VALUE OF EQUITY See Stickney, Fifth Edition, Chapter 11, pp. 807-854, especially pages 838-840, and Brigham and Daves, Eighth Edition, Chapter 10, pp. 332-362. The value of the firm VF0 is the present value to the owners of all the future benefits they will receive from the firm for the remainder of its lifetime forward from the present day. If we include "bondholders" in "owners", then the value of the debt is included in this value. If we do not include bondholders, then the owners are only the equity holders, and the value considers only the equity. VALUE OF THE FIRM = VF0 = VD0 + VE0 (assuming flat term-structure of interest rates): VF0 = t= 1 Σ t = T [ (UFCFFt / (1 + kf*)t ]+ TVT / (1 + kf*)T t=T VF0 = t= 1 Σ [ (CAUt – IVSt) / (1 + kf*)t ] + TVT / (1 + kf*)T t=T VF0 = t= 1 Σ [ (CACt – IVSt) / (1 + kf)t ] + TVT / (1 + kf)T t=T VF0 = t= 1 Σ [ (NCDDt + NCDEt) / (1 + kf)t ] + TVT / (1 + kf)T t=T VF0 = t= 1 Σ [ (NCDDt + NCDEt - ITSt) / (1 + kf*)t ] + TVT / (1 + kf*)T Note that CAC > CAU, so we must use a larger discount rate (kf > kf*) to get the same present value when discounting CAC. VALUE OF EQUITY = VE0 (assuming flat term-structure of interest rates): VE0 = VF0 – VD0 t=T VE0 = t= 1 Σ [ ( NCDEt ) / (1 + ke)t ] + TVT / (1 + ke)T t=T VE0 = t= 1 Σ [ ( LFCFEt ) / (1 + ke)t ] + TVT / (1 + ke)T TERMINAL VALUE at time T = TVT: TVT = Terminal Value T = the value at a particular time point T of all of the following cash flows for the remaining lifetime of the firm. The value of a future cash flow occurring at some future time point, valued at a particular time point T, is computed by discounting that cash flow from its time point of occurrence back to the particular time point T at the proper discount rate or "cost of capital". All of the present values at time T of all of the future cash flows are then added together to get TVT.
  31. 31. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 31 of 38 of Syllabus NEW CONCEPTS TO RECONCILE ACCOUNTING INCOME WITH FINANCIAL CASH FLOWS: Depreciation Tax Savings (DTS) = τ DEP = the income tax the firm does not have to pay because depreciation expense (a non-cash expense) is deductible from taxable income = τ DEP, where τ is the firm's total income tax rate and DEP is the depreciation expense for the year. Interest Tax Savings (ITS) = τI = the income tax the firm does not have to pay because interest expense is tax-deductible = τI, where τ is the firm's income tax rate (Federal, State, and City) and I is this year's interest expense for all debt owed. In valuing the firm, we neglect the distinction between accrued revenues and expenses and cash receipts and expenditures. In real life, of course, only the cash receipts are received and only the cash expenditures are paid, but that information is often not available to the analyst. Analysis of past history of the firm must make this distinction; however, for forecasting the future, we generally assume no differences in the collection and payment rate across future time, so that we effectively ignore the increases in accounts receivable and in accounts payable. We recall that "operations" omits consideration of financing, so that "operating income" is the income prior to the subtraction of interest expense. NOPAT = Net Operating Profit After Taxes is the operating profit the firm would have if it had no debt. NOPAT is not a cash flow used in valuing the firm; it is merely used to compare firms with the same line of business but different capital structures, so as not to be misled by the differences in financial leverage between the firm. NOPAT is the net operating profit after tax. It is not related to the LFCFE or to the UFCFF, which are used to value the equity or to value the firm. NOPAT = Net Operating Profit After Taxes = Cash Available to the Unlevered Firm = CAU NOPAT ( = CAU) is the net income the firm would have had after tax if it had no debt and paid no interest. From the Operating Income we must subtract the hypothetical tax the firm would have paid if it had had no debt. This hypothetical tax is larger than the actual tax the firm paid because the hypothetical tax is not reduced by the interest tax savings. CASH FLOW NOTATION: $RCPT = cash receipts from operations, whether accrued as this year's revenues or not; $EXPT = cash expenditures for operating expenses, whether accrued for this year or not; expenditures omits depreciation expense because depreciation expense is not cash; expenditures omits interest expense because interest expense is not operating. GCFO = $RCPT - $EXPT = Gross Cash from Operations is a hypothetical operating cash flow If all revenues were collected and all expenses were paid, GCFO would be a real cash flow. GCFO is the operating cash flow, neglecting depreciation (because it is not cash) and interest. But income taxes, paid in cash, take account of both depreciation and interest, which reduce taxable income, so we must compute the cash income taxes paid correctly. $AITP = Actual Cash Income Taxes Paid = τ (GCFO) - DTS – ITS
  32. 32. Finance 305 – Analysis of Financial Statements Syllabus----Dr. Stuart Wood, Spring II, 2006 Page 32 of 38 of Syllabus NOPAT = CAU = GCFO - $AITP – ITS Notice that when computing NOPAT = CAU, we ignore the reduction in income taxes which results from the interest expense the firm pays. NOPAT = CAU is a smaller number than if we reduced the taxes for the effect of interest deductibility. NOPAT = CAU = GCFO – GTAX + DTS NOPAT is the after-tax net income the firm would have if it had no debt. To compute NOPAT, we do the following: 1. Subtract cash operating expenditures (i.e., cash operating expenses omitting depreciation and other non-cash charges, and ignoring interest) from cash receipts: $RCPT - $EXPT 2. Subtract the hypothetical income tax the firm would pay if it had no debt and therefore had no tax-deductible interest expense. That means, however, that the tax-deductible operating non-cash expense depreciation does have its effect of lowering taxes recognized. However, the effect of the interest expense in lowering taxes is not considered in this calculation. This is equivalent to EBIT – Adjusted Taxes, where "adjusted taxes" means the larger income tax which would be paid in the absence of interest expense. If we take account of the interest tax savings, ITS, we add the interest tax savings to NOPAT = CAU, and we get the Cash Available to All Capital Suppliers = CAC. CAC = CAU + ITS The Cash Available to All Capital Suppliers is available to pay: I = interest expense on debt PP = principal payments on debt (CDD = Cash distribution to debt suppliers = I + PP ) DIV = dividends on common stock and preferred stock TSTOCK = cash repurchase of common or preferred stock from the market. CDE = cash distribution to equity suppliers = DIV + TSTOCK If we subtract the investment outlays in new plant and equipment plus new net working capital IVS = New P&E + ∆NWC From the CAC, we get the cash available to pay to all capital suppliers without adversely affecting the growth of the firm: UFCFF = CAC – IVS. UFCFF = CAC – IVS There is a slight discrepancy between the two methodologies, in that we say that (CAC – IVS) is discounted at kf, while UFCFF is discounted at kf*, depending on the context. I think this is unavoidable due to the vagaries of accounting, although I may be incorrect. Cope as best you can.

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