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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