Earnings Quality Analysis and Equity Valuation Technique Generates Remarkable Returns

52 SEPTEMBER 2006 ©2006, CFA Institute cfapubs.org
Earnings Quality Analysis and Equity
Valuation
Richard G. Sloan
Professor of Accounting
Ross School of Business, University of Michigan
Ann Arbor, Michigan
have long been interested in fundamental analy-
sis, but I was originally told that markets are
efficient and thus it is futile to engage in fundamen-
tal analysis. Then, academics started to discover
what seemed to be violations of market efficiency,
such as the size effect and the January effect. These
violations struck me as being fairly technical and
mechanical. Thus, the door had been opened to
investigate whether fundamentally based tech-
niques might work.
I began by looking at a simple quantitative screen
based on the quality of earnings analysis (discussed
more fully later). When I first back tested this screen
against U.S. equity data, I thought I must have made
a mistake. I obtained what could be described only as
hedge fund returns. Returns averaged about 10 per-
cent a year above the market over the 30 years tested;
in only 2 of the years were the returns less than the
market. Predictable returns of that magnitude just
had not been documented before; returns from strat-
egies based on the size effect and the January effect

were a lot smaller. Interestingly, in the 10 years that
have passed since I did the original research, this
screen has continued to work well. In fact, this tech-
nique has been refined to obtain even bigger returns.
Needless to say, it has generated a great deal of
interest in the quantitative investment community.
To me, this technique demonstrates the viability
of the concept that simple fundamental analysis com-
bined with mechanical trading rules based on quality
of earnings analysis works. Moreover, I believe that
this is just the tip of the iceberg in terms of what good
fundamental analysis can do. Although over time
simple quantitative trading rules will get arbitraged
away, the important point is that gains may always
be found by digging deeper—by understanding the
accounting and the company’s business model and
how they fit together.
Why Analyze Earnings Quality?
A natural question to ask is why earnings quality
should be analyzed. Certainly, everyone is aware that
earnings numbers can be manipulated. Thus, some
practitioners have taken the position that they will
focus only on the cash flows and perform their intrin-
sic value analysis based on those numbers. Earnings,
and the underlying subjective assumptions, are irrel-
evant. I think earnings quality analysis works so well
because, despite the shortcomings of earnings, the
bulk of the market is looking at earnings. If you had a
crystal ball that allowed you to look at the value of one
variable (other than stock price) one year or one quar-
ter from now, your best pick would be earnings. By
comparing that value with the current consensus
expectations of earnings, you could generate a pow-
erful trading strategy. Even if your crystal ball told

you the true intrinsic value of a stock, knowing that
For years, a widely held belief was that markets are efficient
and that fundamental
analysis is futile. But after the discovery of several market
anomalies, the stage was set
for exploring the use of fundamentally based techniques. A
simple quantitative trading
strategy based on the quality of earnings analysis has worked
remarkably well. And
although this particular opportunity will inevitably be
arbitraged away, it does support
the concept that fundamental analysis works.
This presentation comes from the Equity Research and
Valuation Tech-
niques conference held in Boston on 1–2 December 2005.
I
©2006, CFA Institute cfapubs.org SEPTEMBER 2006 53
Earnings Quality Analysis and Equity Valuation
number would not necessarily help you generate
trading strategies in the short run because it could take
many years, if ever, for the stock price to revert to that
intrinsic value. Knowing future earnings is better than
knowing intrinsic value for those interested in fore-
casting stock returns over the next 3–12 months.
Targeting earnings quality is also important
because it forces the investor to focus on what I call
the “continuous evolution” of business operations

and accounting assumptions. The right accounting for
a company depends critically on the business it is
engaged in, the way it is conducting its business, and
the things it is doing relative to its competitors. For
example, consider Krispy Kreme Doughnuts, whose
stock has taken significant losses in the past few years.
Krispy Kreme invested heavily in doughnut making
equipment and used the straight-line method to
depreciate this equipment over a 10–15 year useful
life. For Krispy Kreme, this was the wrong way to
depreciate. I do not have any qualms with the useful
life in terms of how long the machines will physically
make doughnuts. But to me, this product seemed like
a fad. Remember that when Krispy Kreme first
opened new stores, people would form lines outside
to purchase the doughnuts. Krispy Kreme would
broadcast this phenomenon in press releases, and in
the early days, the stock price would go higher. But
clearly, it was going to wear off fairly quickly. Cer-
tainly, people would not be forming lines outside two
or three years after a store opened, which is what
happened. Krispy Kreme would never have booked
a profit had it used an accounting policy that front-
loaded the depreciation and matched it to the cash
flows that the doughnut machines generated.
Following is another example. Netflix, which
rents DVDs through the mail, seems to be doing quite
well. It is giving Blockbuster tough competition. But
most of its profits over the past 18 months have come
from extending the depreciation period from one year
to three years for its DVD library, what Netflix calls its
“back catalog”—the DVDs that are not new releases.
Netflix has done so because it thinks these DVDs will
physically last a long time and will be in demand three
years from now. This practice looks similar to what

AOL did with its subscriber acquisition costs in the
late 1990s, which it eventually had to write down. One
could make the argument that Netflix faces a similar
situation. Three years from now, if video on demand
and internet downloading of movies do indeed
become available, little demand will exist for Netflix’s
mail-order service. Thus, getting the accounting right
involves understanding the business, which is why no
quantitative analyst will ever be able to come up with
a mechanical formula to screen stocks. A fundamental
analyst will always be needed to understand the busi-
ness and look at the accounting.
Impact of Earnings Surprises
As is widely known, stock prices do indeed respond
to earnings surprises, as shown in Figure 1. Quarterly
abnormal returns are plotted on the vertical axis as a
function of quarterly forecast error (realized earnings
versus the I/B/E/S consensus forecast adjusted by
the stock price) for a large sample of companies. The
result is an S-shaped nonlinear curve. For high-
growth stocks, a 1 percent earnings surprise as a
percentage of price triggers a 12 percent increase on
the upside and a 15 percent decrease on the down-
side. If one could perfectly forecast these earnings
surprises, one could generate a 27 percent quarterly
hedge portfolio return. Earnings quality analysis is
powerful because it is very good at forecasting these
earnings surprises.
I would like to emphasize the asymmetric nature
of this graph for high-growth stocks. Earnings qual-
ity analysis is most useful in picking “earnings torpe-
does” in growth stocks (i.e., growth stocks that are
trading at high valuations but are doing it through

the use of aggressive accounting). These valuations
get addictive to the managers of these companies.
They are great when managers are raising capital.
They are also great when managers have stock
options in the company, so they tend to be the ones
where management pushes the envelope with
respect to the accounting assumptions. When the
company is finally forced to take a write-down, the
price crashes, even if the company just misses the
consensus by a small amount. Thus, analyzing
growth stocks is one area where these techniques are
particularly helpful.
Defining Earnings Quality
To develop a technique for assessing earnings quality,
I first had to understand what accounting would look
like in a “perfect” world. In my view, the way to think
of a company is as a portfolio of investment projects.
If I, as a company manager, knew the future cash
flows of these investment projects, I could compute
the internal rate of return (IRR). Rather than dis-
counting the cash flows at an appropriate discount
rate, I could estimate the implied rate of return based
on the investment required in these projects and the
future cash flows they will pay out. In my perfect
accounting system, I would then set book value equal
to invested capital and the accounting rate of return
would equal the IRR.
CFA Institute Conference Proceedings Quarterly
Simple Accruals Example

An illustration will show how accruals can be used
to discover poor accounting. This simple example
begins with an investment opportunity, initially just
$100. I am not going to grow my investments, so I will
invest only $100 every year thereafter. And I will
track this investment for five years. This investment
only generates a return one period from now. The
return comes in the form of cash revenues equal to
165 percent of the investment and a cash cost equal
to 55 percent. So, I invest $100 cash today. I then get
$110 at the end of the period, and my investment
expires. Thus, this investment generates a return of
capital plus a 10 percent return in the next period, and
so the IRR on this investment project is 10 percent.
The correct accounting should be obvious. Clearly, I
should capitalize the whole amount in the period I
make the investment and then expense the whole
amount in the next period. If I do so, invested capital
is equal to book value and the accounting rate of
return is equal to my IRR of 10 percent.
I will now show how, in turn, conservative and
aggressive accounting assumptions alter the results.
In my conservative accounting scenario, I initially
capitalize only 80 percent of the investment. Ironi-
cally, this bad accounting is what the Financial
Accounting Standards Board requires that companies
do for all R&D (and marketing) expenditures. This is
a real investment that generates future benefits, but I
have to expense it all immediately. On the flip side, I
have the aggressive accounting scenario where I cap-
italize too many costs—120 percent of the investment.
In the real world, I would do this by capitalizing some
operating costs, which is exactly what WorldCom did.
Table 1 shows the neutral accounting scenario,

the “perfect” accounting scenario. The investment is
$100 each year. I capitalize 100 percent of that invest-
ment and then expense it in the income statement in
the very next year as an amortization expense. Start-
ing in Year 2, I get an accounting profit equal to $10,
which is equal to the economic profit. The net oper-
ating assets (NOA)—operating assets minus operat-
ing liabilities—equal the capitalized assets. Each
year, I amortize the previous year’s investment and
capitalize the new year’s expenditure. The accruals,
the key to this analysis, are just the change in the
NOA. After the first year, the investment hits a steady
state and the accruals are always zero. So, the com-
pany is in a steady state with respect to growth and
has a constant business model. The accruals should
be zero if the accounting is perfect. The statement of
cash flows is at the bottom of the table. It shows that
the free cash flow (FCF) after the first period is always
$10. (Another way to obtain accruals is to take the
difference between earnings and FCF.) High accruals
are indicative of a company with potentially high
earnings but no cash flow to back up those earnings.
When the accounting is perfect and the firm is in
steady state, there are no accruals.
Table 2 shows the conservative accounting sce-
nario. Note that the conservative accounting assump-
tions are used only in the third year and are reversed
in the following year. Because I am failing to capital-
ize $20 of the investment, operating income drops by
$20 and I report operating income of –$10, which is
to be expected. But look what happens in the very
next year, Year 4, when the conservative assumptions
are reversed. I have to amortize only $80 instead of
Figure 1. Earnings Surprise Response Functions for High-

Growth and
Low-Growth Stocks: Quarterly Abnormal Returns vs. Quarterly
Forecast Error
0
Abnormal Return
High Growth
Low Growth
0.20
0.15
0.10
0
−0.10
−0.15
0.05
−0.05
−0.20
−0.07 0.07−0.05 −0.01−0.03 0.01 0.03 0.05
Forecast Error

$100. As a result, I get $30 of net income, which
directly affects return on net operating assets
(RNOA). In Year 3, the RNOA is –10 percent, and
then in Year 4, it is 37.5 percent. Thus, conservative
accounting drives the accounting rate of return down
in the year that the conservative accounting is
applied, and then in the subsequent year, it has the
opposite effect and the accounting rate of return goes
up. Therefore, if I can pick a company that is using
conservative accounting, I know that in the subse-
quent year its earnings will increase, which is why
earnings quality analysis is useful.
Table 1. Financials for Neutral Scenario
Item
Year
1 2 3 4 5
Growth rate in investment 0.0% 0.0% 0.0% 0.0%
Investment $100 $100 $100 $100 $100
Capitalized operating costs $ 0 $ 0 $ 0 $ 0 $ 0
Capitalized investment costs 100 100 100 100 100
Total $100 $100 $100 $100 $100
Sales $ 0 $165 $165 $165 $165
Operating expense 0 55 55 55 55
Investment expense 0 0 0 0 0

Amortization expense 0 100 100 100 100
Net operating income $ 0 $ 10 $ 10 $ 10 $ 10
Net operating assets (NOA) $100 $100 $100 $100 $100
Accruals 100 0 0 0 0
Return on beginning net operating assets (RNOA) 10.0% 10.0%
10.0% 10.0%
Cash inflows $ 0 $165 $165 $165 $165
Cash outflows 100 155 155 155 155
Free cash flow (FCF) –$100 $ 10 $ 10 $ 10 $ 10
Note: In neutral accounting, 100 percent of investment costs are
capitalized in Year 3.
Table 2. Financials for Conservative Scenario
Year
Item 1 2 3 4 5
Investment $100 $100 $100 $100 $100
Total $100 $100 $ 80 $100 $100
Sales $ 0 $165 $165 $165 $165

Net operating income $ 0 $ 10 –$ 10 $ 30 $ 10
Net operating assets (NOA) $100 $100 $ 80 $100 $100
Accruals 100 0 –20 20 0
Return on beginning net operating assets (RNOA) 10.0% –
10.0% 37.5% 10.0%
Cash inflows $ 0 $165 $165 $165 $165
Cash outflows 100 155 155 155 155
Note: In conservative accounting, 80 percent of investment
costs are capitalized in Year 3.
Aggressive accounting, shown in Table 3, is the
flip side of conservative accounting. In this case, I am
capitalizing too much in Year 3—$20 of my operating
costs. So, my operating costs drop from $55 to $35.
Compared with the neutral scenario, my income
becomes $30 instead of $10, and as a result, I overstate
my income on my accounting rate of return in Year 3.
In Year 4 when it reverses, I have to expense through
amortization the extra $20. As a result, net operating
income becomes –$10, the mirror image of the conser-
vative scenario. That is, at first earnings are too high,
and then predictably, earnings drop in the next period.
Figure 2 graphically illustrates these three

accounting scenarios. Therefore, by going out and
looking at whether accruals are positive (signaling
aggressive accounting) or negative (signaling con-
servative accounting), I can predict earnings rever-
sals in the next period, which is all there is to my
simple method.
If the world were this simple—if companies did
not grow and their business models stayed constant—
this analysis would lead to an easy strategy. Analysts
would just have to look at the size of the accruals for
a perfect measure of earnings quality. Unfortunately,
the world is not that simple. Legitimate growth in
investment will also obviously cause the amounts
capitalized on the balance sheet to increase and cause
accruals to be positive. Conversely, with negative
growth, accruals will be negative.
For example, Figure 3 shows three growth
scenarios—that is, what happens if I increase my
investment from $100 to $200. My capital assets, of
course, go from $100 to $200. If the return on my
investments stays constant, a change in accruals does
not create any predictable changes in RNOA. So, I
have to be able to discriminate earnings management
or bad accruals from legitimate growth in the under-
lying business. Keep in mind that if a company legiti-
mately changes its business model or if the
competitive landscape changes, these changes can
affect accruals in unpredictable ways, which is another
example why this analysis can never be automated.
Decomposing Earnings
The idea of earnings decomposition comes directly
from the 1934 edition of Benjamin Graham and David

Dodd’s Security Analysis. Broadly, earnings can be
decomposed into the change in book value (retained
earnings) plus the dividend, which I define broadly
as the sum of cash dividends, including any cash paid
out for stock repurchases and less any cash brought
in through a capital transaction, such as a secondary
equity offering.
The change in the book value can be further
broken down. Remember that the change in book
value is equal to the change in assets less the change
in liabilities—or the change in NOA (accruals) plus
the change in cash holdings less the change in debt.
As a result, earnings can be decomposed into the
change in NOA (accruals) plus FCF. The result is two
pieces to earnings: a hard piece, the FCF, and a soft
Table 3. Financials for Aggressive Scenario
Year
Item 1 2 3 4 5
Investment $100 $100 $100 $100 $100
Total $100 $100 $120 $100 $100
Sales $ 0 $165 $165 $165 $165
Net operating income $ 0 $ 10 $ 30 –$ 10 $ 10

Net operating assets (NOA) $100 $100 $120 $100 $100
Accruals 100 0 20 –20 0
Return on beginning net operating assets (RNOA) 10.0% 30.0%
–8.3% 10.0%
Cash inflows $ 0 $165 $165 $165 $165
Cash outflows 100 155 155 155 155
Note: In aggressive accounting, 120 percent of investment costs
are capitalized in Year 3.
piece, the change in NOA, which as shown earlier
results from the accounting assumptions made (this
is also the area where the accounting envelope tends
to be pushed). Thus, I look at the aggregate magni-
tude of the accruals, the change in NOA, to evaluate
the quality of earnings.
More specifically, my rule of thumb is that if the
change in NOA divided by the average level of NOA
exceeds 5 percent, a red flag goes up. Enron Corpo-
ration and WorldCom were way above 5 percent for
the two years before their situation became public
knowledge. This simple metric would have picked
up both of them.

To further demonstrate the usefulness of this met-
ric, using 30 years of historical data I selected the top
10 percent and the bottom 10 percent for this accrual
measure. (Year 0 marks the year that companies fall
into the extreme 10 percent.) From this sample, I
formed a high-accrual portfolio and a low-accrual
portfolio. As Figure 4 shows, companies with high
accruals had a gradual run-up in earnings in the pre-
vious years. The metric plateaued in the high year and
then collapsed in the following year. Thus, companies
with high accruals today have predictably much
lower earnings tomorrow; conversely, companies
with low accruals today have predictably higher earn-
ings tomorrow. Just as suggested by the example in
Panel B of Figure 2, this metric works well in predict-
ing future earnings changes. But, of course, the impor-
tant question from an investment perspective is
whether the market sees these predictable earnings
changes coming (i.e., is the market indeed efficient)?
Figure 5 plots stock returns relative to the accrual
ranking year. As the graph shows, the market does
not seem to see these changes coming. High-accrual
stocks performed well in the years leading up to the
high-accrual year. In the high-accrual year, their per-
formance was average or slightly better. Then, they
Figure 2. Three Accounting Scenarios
Accruals ($)
A. Accruals
30

20
10
0
−10
−20
−30
2 53 4
Period
Aggressive Neutral
Conservative
RNOA (%)
B. RNOA
40
30
20
10
0
−10
−20

2 53 4
Period
Figure 3. Neutral Accounting with Three
Growth Scenarios
Accruals ($)
A. Accruals
25
20
10
5
15
0
−10
−5
−15
−20
−25
2 53 4
Period
Positive Growth No Growth
Negative Growth

RNOA (%)
B. RNOA
40
30
20
10
0
−10
−20
2 53 4
Period
did predictably badly. On average, they underper-
formed the market by roughly 600 bps in the follow-
ing year and by about 300 bps and 100 bps in the
following two and three years, respectively, because
some of these accruals can take more than one year to
reverse. Low-accrual companies, of course, demon-
strate the opposite behavior. Their earnings jumped,
and their stock prices increased in response. The
spread between the two lines in the figure is the

predictable hedge portfolio return. Clearly, stock
prices were acting as though investors did not see
these predictable earnings changes coming. This
graph presents convincing evidence regarding mar-
ket efficiency. Moreover, this “anomaly” has persisted
for the 10 years since I first documented it.
As a check on this metric, I gathered a sample of
about 100 companies that had been targeted by the
U.S. SEC for manipulating earnings upwards. Year 0
is the year that the SEC alleged that these earnings
abuses occurred, not the year that the SEC announced
the enforcement action, which typically did not occur
until several years after the abuses became common
knowledge. Figure 6 shows that the accruals peaked
in Year 0 and then plummeted in the following year.
The thin solid line in this figure mirrors the solid line
in Panel A of Figure 2 for aggressive accounting
almost perfectly. Thus, an accruals analysis picks up
incidences of aggressive accounting.
I want to emphasize that rising accruals can do
no more than raise a red flag. For example, if a com-
pany’s inventory is rising, that could be a bad sign of
obsolete inventory or it could be a good sign because
the company is growing. Perhaps the clearest way to
help disentangle these two possibilities is to analyze
accounts payable. If inventory is rising to meet
increasing sales, then accounts payable should be
rising accordingly. When inventories are rising but
payables are not increasing at the same rate, an earn-
ings quality problem caused by obsolete inventory is
most likely occurring. In this way, the liability side of
Figure 4. Accruals and Accounting Rates of

Return, 1972–2002
RNOA
High-Accrual Portfolio
Low-Accrual Portfolio
0.20
0.10
0.15
0.05
−5 5−2 1 4−3 0 3−4 −1 2
Event Year
Figure 5. Annual Size-Adjusted Returns for
Extreme-Accrual Portfolios, 1972–2002
Figure 6. Accruals and SEC Enforcement
Actions, 1987–2002
Note: Accruals are measured by the annual change in NOA
divided
by the beginning level of NOA.
Annual Size-Adjusted Return (%)
High Accruals
Low Accruals
30

0
10
−10
−20
20
−30
−5 5−2 1 4−3 0 3−4 −1 2
Year Relative to Accrual Ranking Year
Accruals
Mean
Median Average for All
Other Companies
0.40
0
0.15
−0.05
0.30
0.35
0.25

0.20
0.10
0.05
−0.10
−5 5−2 1 4−3 0 3−4 −1 2
Year Relative to the SEC Enforcement Action
the balance sheet can be used to help judge the quality
of the asset side of the balance sheet, where most of
the earnings quality problems arise.
Conclusion
The simple technique of earnings quality analysis
shown here would have done wonderfully over the
past half century in terms of generating superior
stock returns. Although this quantitative method has
worked well, it will probably get arbitraged away.
Still, I believe that using good fundamental analysis
to detect accounting distortions by understanding
the accounting and the company’s strategy and how
they fit together will always be an incredibly impor-
tant source of value added for the investment man-
agement community.

This article qualifies for 0.5 PD credits.
Question and Answer Session
Richard G. Sloan
Question: In the world of insur-
ance companies and banks, half
their books are accruals. Can this
type of analysis be used there?
Sloan: They do have assets and
liabilities, but it is more difficult to
distinguish what I call “propri-
etary assets” and “proprietary lia-
bilities” from the marketable
securities and debt that represent a
standard source of financing, such
as bonds or commercial paper
issued by a bank. What you must
do is identify the proprietary assets
and liabilities and focus on them.
For insurance companies, you
must focus on the spread between
the reinsurance receivables and the
reinsurance payables and also the
liability for claims reserves; these
are the proprietary assets and lia-
bilities. One of the important areas
we’re focusing on lately concerns

companies in the financial sector
that are issuing loans, particularly
residential loans and consumer
loans, and then securitizing and
selling them while holding a resid-
ual interest in these loans.
These residual interests hold
most of the risk because they are
the first not to be paid in the event
of a default. They are a small chunk
of the balance sheets of these com-
panies because the residual inter-
ests are small in dollar magnitude,
but the risk is enormous. So, you
could take $1 billion of receivables,
hold a residual interest in $20 mil-
lion, and basically have the risk of
$1 billion of loans concentrated in
$20 million of receivables.
If we see a downturn in the
housing market and people
defaulting on loans, these residual
interests will evaporate fairly
quickly. You can perform the same
analysis with banks and insurance
companies. It just becomes a little
more important to do the detailed
financial analysis and fundamen-
tal analysis to discriminate
between the high-risk assets and
liabilities, where the judgment
exists, and the low-risk ones,
which are just the marketable secu-
rities and the plain vanilla debt.

Question: Do mergers and
acquisitions lend themselves to
greater accrual subjectivity?
Sloan: We’ve tested for this by
going to the statement of cash flows
where we can exclude stock deals
and strip out the acquisitions as a
separate line item. By purging
mergers and acquisitions (M&A)
activity, we can get a cleaner mea-
sure of earnings quality. It turns out
that the measure actually works
slightly worse. I think the reason for
this is that most of these stock acqui-
sitions engage in a stock-for-stock
acquisition when the company’s
stock is the most overvalued.
Hence, the goodwill on the balance
sheet associated with that acquisi-
tion tends to be extremely subjec-
tive and often overstates assets. On
the face of it, it might seem like
something you want to strip out,
but for practical purposes, we find
that leaving the M&A activity in
actually helps the measure.
Question: Which areas should
we watch the most for accruals in
the future?
Sloan: This is why a fundamen-
tal analyst has such a competitive
advantage over a quantitative

analyst because new business
comes along, accounting rules
change, and it’s just a case of look-
ing at things differently.
One of my favorite examples
when I first got interested in this
was Boston Chicken and its receiv-
ables. In many cases, receivables
are not a problem. In this particular
case, however, receivables were
over half of Boston Chicken’s total
balance sheet—over half of its
assets. The franchisees were mak-
ing huge losses, and the only reason
they were surviving was because
Boston Chicken was lending them
money and they were paying it
back in the form of a royalty fee.
Normally, when I analyze a
company, I look at the company
and see which is its biggest asset. If
it is a proprietary asset that
involves subjective judgment, then
that is where I do my homework.
In the case of Enron, its equity
investments and its nonequity
investments were huge numbers
because much of the action was
taking place on these off-balance-
sheet entities. If they showed up at
all, they showed up on an equity
one-line consolidation-type entry.
So, that is one situation I would not
normally have focused on, but in

Enron’s case, that was the one that
flagged the company’s problems.
Exam has two parts: Part 1 is Short
Answer/Multiple Choice) and Part 2 is Essay
questions/mini-case questions)
Any sources must be footnoted
Total points: 120 including 20 bonus
PART I: MULTIPLE CHOICE / SHORT ANSWER
QUESTIONS (50 points; 2 ½ points each)
1. A capital investment's internal rate of return:
a. Changes when the cost of capital changes.
b. Must exceed the cost of capital in order for the firm to
accept the investment.
c. Is similar to the yield to maturity on a bond.
d. Is equal to annual net CF divided by one half of the project's
cost when the cash flows are an
annuity.

e. Statements b and c are correct.
2. Risk in a revenue-producing project can best be adjusted for
by
a. Ignoring it.
b. Adjusting the discount rate upward for increasing risk.
c. Adjusting the discount rate downward for increasing risk.
d. Picking a risk factor equal to the average discount rate.
e. Reducing the NPV by 10 percent for risky projects
3. The primary goal of a publicly-owned firm interested in
serving its stockholders should be to:
a. Maximize expected total corporate profit.
b. Maximize expected EPS.
c. Minimize the chances of losses.
d. Maximize expected net income.
e. Maximize the shareholder equity.
4. A tender offer in M&A deal is
a. a goodwill gesture by a "white knight."

b. a would-be acquirer's friendly takeover attempt.
c. a would-be acquirer's offer to buy stock directly from
shareholders.
d. viewed as sexual harassment when it occurs in the workplace.
5. Insight Corporation’s return on equity is 15% and its
dividend payout ratio is 60%. The
sustainable growth rate of the firm’s earning and dividends
should be:
A). 8%
B). 9%
C). 7%
D). 6%
E). 5%
6. Recent M&A-related accounting changes in the United
States:
a. eliminated the purchase method, allowing only the pooling-
of-interests method for M&A.
b. eliminated the pooling-of-interests method, allowing only the
purchase method for M&A.

c. allow for both the purchase method and the pooling-of-
interests method for M&A.
d. outlawed the recording of goodwill for any merger or
acquisition.
e. none of above
7. What’s the future value of $1,500 after 5 years if the
appropriate interest rate is 6%,
compounded semiannually?
a. $1,819
b. $1,915
c. $2,016
d. $2,117
e. $2,223
8. An investor plans to buy a common stock and hold it for two
years. The investor expects to
receive $1.5 in dividend a year and $26 from the sales of the
stock at the end of year 2. If the
investor wants a 15% return (compound annually), the maximum
price the investor should pay for

the stock today is roughly:
A). $24
B). $28
C). $22
D). $32
E). $26
9. Amador Corporation has a stock price of $24 a share. The
stock's year-end dividend is expected
to be $2 a share. The stock's required rate of return is 12
percent and the stock's dividend is
expected to grow at the same constant rate forever. What is the
expected price of the stock six
years from now?
a. $35
b. $40
c. $25
d. $15
e. $30

State if flowing statements are True [T] or False [F]. Briefly
justify your answers.
10. Intrinsic value and market price of equity shares are always
equal.
True [T] False [F]
Justification:
11. Under DCF method, in general, higher the risk level, higher
will be the discount rete.
True [T] False [F]
Justification:
12. Market value per share is expected to be lower than the
book value per share in case of
profitable and growing firms.

True [T] False [F]
Justification:
13. Firms tend to be more profitable when there is higher real
growth in the underlying market than
when there is lower real growth.
True [T] False [F]
Justification:
14. A lower discount would be applied to the cash flows of the
government bond.
True [T] False [F]
Justification:

Questions 15-16 are related to an investment’s time value of
money (TVM)
15. How much would $6,000 due in 25 years be worth today if
the discount rate were 6%? Show
your calculations.
16. At a rate of 6%, what is the future value of the following
cash flow stream? Show your
calculations.
Years: 0 1 2 3 4
| | | | |
CFs: $0 $75 $225 $10 $350
17.

a. The company’s net income in 2008 was higher than in 2007.
b. The firm issued common stock in 2008.
c. The market price of the firm's stock doubled in 2008.
d. The firm had positive net income in both 2007 and 2008, but
its net income in 2008 was
lower than it was in 2007.
e. The company has more equity than debt on its balance sheet.
18. Stratigent Company is not a growing company and has
earnings before interests and taxes of
$20,000, interest payments to a local bank of $3,500 and pay
tax at 38% rate. Investors require a 9%
return on the stock and the firm has a cost of debt of 4.5%.
What’s the approximante value of the
company’s equity? Show your calculations.
19. A bond has a $1000 par value, 10 years to maturity, 7%
coupon payments (annual), and currently

sells for $985. What’s the yield to maturity (YTM)? Please
show your calculations.
20. Relaxant Inc. operates as a partnership. Now the partners
have decided to convert the business
into a corporation. Which of the following statements is
CORRECT?
a. The company will probably be subject to fewer regulations
and required disclosures.
b. Assuming the firm is profitable, none of its income will be
subject to federal income taxes.
c. Relaxant’s shareholders (the ex-partners) will now be
exposed to less liability.
d. The firm's investors will be exposed to less liability, but they
will find it more difficult to
transfer their ownership.
e. The firm will find it more difficult to raise additional capital
to support its growth.
PART II: MINI-CASE QUESTIONS
Question 1 Define each of the following M&A terms. Give a

real world example of each. For
Example: vertical integration
“In a vertical merger, a company acquires another firm that is
"upstream" or "downstream"; for
example, in 2005, the Detroit-based automobile manufacturer
acquires a steel producer based in
Dayton (Ohio) for $xxx in an effort to create a vertical
integration…” (6 points)
▪ Business synergy
▪ Horizontal merger
▪ White knight
▪ Poison pill
▪ Leveraged buyout (LBO)
▪ Purchasing accounting and pooling of interest
Question 2 Lucent Technology is considering seller-finance for
an existing customer with the
following information. The net income is $95MM. The
depreciation cost is $15MM. What is the subject
firm's cash flow from operations (CFO)? (6 points)
Decrease in accounts receivable $30 MM
Issuance of new stocks 18

Proceeds from the sale of fixed assets 8
Increase in inventory 17
Increase in accounts payable 10
Dividends paid out 35
Decrease in wages payable 5
Question 3: Elaine Case, CFA, is an equity analyst with
Prudential Securities. She has gathered
the following information about Lone Star Plastics: (6
points)
▪ Assets: $100,000;
▪ Net profit margin: 6.5%;
▪ Tax rate: 35%;
▪ Debt ratio: 40.0%;
▪ Interest rate: 7.5 %;
▪ Total assets turnover: 3.0.
What is Lone Star's EBT (earning before tax)? Show your
calculations.
Question 4: A price-linked investment pays $300 if the oil price
over the next year increases by more
than 5%, an event that can happen with a 55% probability.
Otherwise, it pays $60. If the expected
return on the security is 12%, how much does the security cost?

Show your calculations. (4 points)
(Demo for your reference purpose):
Question 5 DuPont model for profitability & ROE analysis. Use
the following information on
Dylan Enterprises for questions. (8 points)
1). What are the firm’s gross and net profit margin (in %) for
the current year? Show your calculations.
2). Calculate current year’s ROE (using De Pont model) by
showing the value of each individual
component. Show your calculations.
Income Statement
Revenues $320,000,000
Less: Cost of Goods Sold $162,000,000
Gross Profit $158,000,000
Less: Operating Expenses $120,000,000
Less: Depreciation $11,000,000
Operating Profit $27,000,000

Less: Interest Expense $8,500,000
Net Profit Before Taxes $18,500,000
Less: Taxes $6,290,000
Net Income $12,210,000
Earnings Available to Common $12,210,000
Dividends Paid (60% of EAC) $7,326,000
Addition to Retained Earnings $4,884,000
Balance Sheet
Assets Current Year Prior Year Change
Cash $1,500,000 $3,000,000 ($1,500,000)
Marketable Securities $1,500,000 $3,200,000 ($1,700,000)
Accounts Receivable $57,000,000 $44,000,000 $13,000,000
Inventory $106,000,000 $99,000,000 $7,000,000
Pre-Paid Expenses $8,400,000 $11,000,000 ($2,600,000)
Total Current Assets $174,400,000 $160,200,000 $14,200,000
Long-Term Assets $148,000,000 $154,000,000 ($6,000,000)
Total Assets $322,400,000 $314,200,000 $8,200,000

Liabilities Current Year Prior Year Change
Accounts Payable $8,716,000 $6,400,000 $2,316,000
Short-Term Debt $102,000,000 $105,000,000 ($3,000,000)
Total Current Liabilities $110,716,000 $111,400,000
($684,000)
Long-Term Debt (8%) $115,000,000 $111,000,000 $4,000,000
Total Liabilities $225,716,000 $222,400,000 $3,316,000
Common Stock ($1 par value) $2,000,000 $2,000,000 $0
Paid-In Capital $65,000,000 $65,000,000 $0
Retained Earnings $24,800,000 $4,884,000
Total Equity $96,684,000 $91,800,000 $4,884,000
Total Liabilities and Equity $322,400,000 $314,200,000
$8,200,000
Question 6 (6 points)
Cumberland Industries December 31 Balance Sheets
(in thousands of dollars)
2003 2002

Assets
Cash and cash equivalents $91,450 $74,625
Short-term investments $11,400 $15,100
Accounts Receivable $103,365 $85,527
Inventories $38,444 $34,982
Total current assets $244,659 $210,234
Fixed assets $67,165 $42,436
Total assets $311,824 $252,670
Liabilities and equity
Accounts payable $30,761 $23,109
Accruals $30,477 $22,656
Notes payable $16,717 $14,217
Total current liabilities $77,955 $59,982
Long-term debt $76,264 $63,914
Total liabilities $154,219 $123,896
Common stock $100,000 $90,000
Retained Earnings $57,605 $38,774

Total common equity $157,605 $128,774
Total liabilities and equity $311,824 $252,670
Cumberland Industries December 31 Income Statements
(in thousands of dollars)
2003 2002
Sales $455,150 $364,120
Expenses excluding depr. and amort. $386,878 $321,109
EBITDA $68,272 $43,011
Depreciation and Amortization $7,388 $6,752
EBIT $60,884 $36,259
Interest Expense $8,575 $7,829
EBT $52,309 $28,430
Taxes (40%) $20,924 $11,372
Net Income $31,385 $17,058
Common dividends $12,554 $6,823
Addition to retained earnings $18,831 $10,235

Other Data 2003 2002
Year-end Stock Price $17.25 $14.75
# of shares (in thousands) 10,000 9,000
Lease payment $75,000 $75,000
Sinking fund payment $0 $0
Tax rate 40% 40%
Ratio Analysis 2003 2002
Liquidity Ratios
Current Ratio 3.14 3.50
Quick Ratio 2.65 2.92
Asset Management Ratios
Inventory Turnover 11.84 10.41
Days Sales Outstanding 82.89 85.73
Fixed Assets Turnover 6.78 8.58
Total Assets Turnover 1.46 1.44
Debt Management Ratios
Debt Ratio 49.46% 49.03%

Times-interest-earned ratio 7.10 4.63
EBITDA coverage ratio 1.71 1.42
Profitability Ratios
Profit Margin 6.90% 4.68%
Basic Earning Power 19.53% 14.35%
Return on Assets 10.06% 6.75%
Return on Equity 19.91% 13.25%
Market Value Ratios
Earnings per share $3.14 $1.90
Price-to-earnings ratio 5.50 7.78
Cash flow per share $3.88 $2.65
Price-to-cash flow ratio 4.45 5.58
Book Value per share $15.76 $14.31
Market-to-book ratio 1.09 1.03
a. Has Cumberland's liquidity position improved or worsened?
Briefly explain with supporting
financial ratios. Show your calculations.

b. Has Cumberland's ability to manage its assets improved or
worsened? Briefly explain with
supporting financial ratios. Show your calculations.
c. Has Cumberland's ability to manage its debts improved or
worsened? Briefly explain with
supporting financial ratios. Show your calculations.
d. How has firm's profitability changed during the last year?
Briefly explain with supporting financial
ratios. Show your calculations.
e. How has firm's market value ratios changed during the last
year? Briefly explain with supporting
financial ratios. Show your calculations.
Question 8. Review the file attachment from the CFA Institute.
Prepare a short memo (< = three
pages) summarizing the key points and key take-away. Add
charts / analytics / graphics if deemed
appropriate. (10 points)
The Readings
Earning Quality & Equity Valuation.pdf

BONUS QUESTIONS FOR EXTRA CREDITS
(CHALLENGING)
1. Swann Systems is forecasting the following income statement
for the upcoming year:
Sales $5,000,000
Operating costs (excluding depreciation) $3,000,000
Gross margin $2,000,000
Depreciation $500,000
EBIT $1,500,000
Interest $500,000
EBT $1,000,000
Taxes (40%) $400,000
Net income $ 600,000
The company’s president is disappointed with the forecast and
would like to see Swann generate
higher sales and a forecasted net income of $2,000,000. Assume
that operating costs (excluding
depreciation) are always 60 percent of sales. Also, assume that
depreciation, interest expense, and

the company’s tax rate, which is 40 percent, will remain the
same even if sales change. What level of
sales would Swann have to obtain to generate $2,000,000 in net
income? (6 points)
2. American Hardware, a national hardware chain, is
considering purchasing a smaller chain, Eastern
Hardware. American's analysts project that the merger will
result in incremental free flows and
interest tax savings with a combined present value of $72.52
million, and they have determined that
the appropriate discount rate for valuing Eastern is 16 percent.
Eastern has 4 million shares
outstanding and no debt. Eastern's current price is $16.25.
What is the maximum price per share that
American should offer? Show your calculations. (6 points)
3. Blazer Breaks, Inc. is considering an acquisition of Laker
Showtime Company. Blazer expects
Laker’s NOPAT to be $9 million the first year with zero net
investment in operating capital and zero
interest expense. For the second year, Laker is expected to have
NOPAT of $25 million and interest
expense of $5 million. Also, in the second year only, Laker will
require net investment in operating

capital of $10 million to finance future growth. Laker's
applicable marginal tax rate is 40 percent.
After the second year, the free cash flows and the tax shields
from Laker to Blazer will both grow at a
constant rate of 4 percent. The firm has determined that Laker’s
cost of equity is 17.5 percent. Laker
currently has no debt outstanding. Assume that all cash flows
are end-of-year and that the Laker
acquisition will cost Blazer $45 million. Calculate the value to
Blazer of Laker’s equity and determine
the NPV of the proposed acquisition to Blazer? Show your
calculations. (8 points)

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