FSA

Question 1

Week 1:
Who are the information intermediaries that link savings and business ideas together?
What mechanisms help match savings with businesses required funding?

Answer 1

Information intermediaries = venture capitalists, banks, investment banks, managed funds, insurance companies

mechanisms = Stock exchanges, bond markets, bank loans, private equity

Question 2

Week 1:

What does a good accounting system comprise of?

Answer 2

Accrual accounting
Accounting standards
Auditing of financial information
Managers reporting strategy

Question 3

Week 1
What do business intermediaries use financial statements to accomplish (4)

What hinders the system?

Answer 3

Business strategy analysis
Accounting analysis
Financial analysis
Prospective analysis

Hindrances = fraud, Errors and mistakes, professional judgement

Question 4

Week 2
What is economic analysis and what factors do we look at?

What is forecasting error?

Answer 4

Economic analysis = Understand how changes in the broader economy will influence the firm you are valuing

Factors:
GDP = market value of final goods and services produced within a country
Inflation = Revenues (price you receive for sales) and Expenses (price you pay for inputs)
Foreign Exchange = exporter or importer? how currency influences business
Interest rates = interest expense (effect on profit), Cost of capital, consumer behaviour (will it effect sales)
Commodity prices = key expenses and revenues

Forecasting error = past performance does not indicate future performance

Question 5

Week 2

What is industry analysis and what factors do we look at?

Answer 5

Industry analysis = understanding the industry in which the firm operates so as to ascertain the likelihood of a firm creating value within the industry

Factor 1: Degree of actual and potential competition

1. Threat of new entrants = barriers to entry are economies of scale, first mover advantage, access to channels of distribution and relationships with suppliers and customers, legal barriers..
2. Threat of substitute products = relative price and performance + buyers willingness to switch
3. Rivalry among existing firms = push prices towards marginal cost AND make non-price dimensions of products or services more important = intensity of competition depends on industry growth rate, concentration and balance of competitors, degree of differentiation in products and services and switching costs, scale/learning economies and ratio of fixed to variable costs, excess capacity and exit barriers.

Factor 2: Bargaining power in input and output markets

1. Bargaining power of buyers = factors affecting bargaining power are number of buyers, volume per buyer, switching costs, differentiation, importance of product for costs and quality and buyer price sensitivity
2. Bargaining power of suppliers = same factors as above

Question 6

Week 2
Outline the 4 types of competition in an industry

What factors limit competition?

Answer 6

Perfect competition = Large amount of firms = low influence on price
Monopolistic competition = Medium amount of firms = medium influence on price
Oligopoly = a handful of firms = strong influence on price
Monopoly = one firm = full control of price (without government intervention)

Factors limiting competition = patents, geography, regulation, technology, licenses, economies of scale

Question 7

Week 2
What is competitive strategy analysis and what factors are we concerned with? Why is competitive strategy analysis useful?

For each of the two factors what are some characteristic ratios?

Answer 7

Competitive strategy analysis = concerns an understanding of the ways in which a firm can achieve competitive advantage

Useful because = Understanding a firm’s strategy and industry helps in forecasting profit margin (PM) and asset turnover (ATO).

Factors

1. Cost leadership = achieved through economies of scale and scope, efficient production, simpler product design, lower input costs, low-cost distribution, little research and development or brand advertising, tight cost control
2. Differentiation = achieved through quality, variety, customer service, flexible delivery, brand image, research and development, creativity and innovation = cost must be lower than the price customer is willing to pay for differentiation

Ratios

1. Cost leadership = characterised by low profit margin AND high turnover
2. Differentiation = characterised by high profit margin AND low turnover

Question 8

Week 2

What are 5 important questions to ask in relation to competitive strategy analysis?

Answer 8

1. Does the firm have appropriate resources?
2. Has the firm made appropriate commitments to achieving this competitive advantage?
3. Are the firm’s activities structured consistent with the competitive strategy?
4. Is the competitive advantage sustainable? Are there any barriers that make imitation by competitors difficult?
5. Are there any potential changes to the industry that might reduce the competitive advantage?

Question 9

Week 2

What is Corporate strategy analysis and what factors are we concerned with?

Answer 9

Corporate strategy analysis = analysis of the impact of having multiple businesses within one corporation = the impact of diversification (Acquiring entirely different companies) horizontal (acquiring similar companies) and vertical integration (acquiring companies within the production production process)

Factors
Economic theory = we look at the relative transaction costs of performing functions inside the firm versus outside the firm = it is not worthwhile to have multiple differing companies if they cannot work together due to transaction costs being higher than they would be to simply outsource the same products/services.

Question 10

Week 2

What are abnormal returns owed to?

Answer 10

Abnormal returns

1. economic factors
2. industry structure
3. how firms compete within and industry
4. how firms develop competitive strategies

Question 11

Week 3

What are three reasons for accounting distortions?

Answer 11

Reason 1 = GAAP does not equal economic reality
(R&D capitalisation, contingent liabilities not recorded, Land prices at cost, Brand values not recognised as asset)

Reason 2 = Forecast errors (errors in estimates (depreciation, bad debts))

Reason 3 = Managerial manipulation
why = 1) meet benchmarks 2) CEO change (ensure bad first year and follow up with excellent one) 3) Income smoothing 4) IPO

Question 12

Week 3

Outline steps 1 and 2 in the Accounting analysis process

Answer 12

Step 1: Identify key accounting policies
- Key policies and estimates used to measure risks and critical factors for success must be identified.
1) Looking at income statement can identify key areas of revenue and key areas of expenditure.
2) Looking at balance sheet can identify key assets and expenses (notes to financial statements provide further information e.g. composition of PPE account)
Step 2: Assess Accounting Flexibility
- Accounting information is more open to distortion if managers have a higher degree of flexibility in choosing policies and estimates

Question 13

Week 3

Outline step 3 in the accounting analysis process

Answer 13

Step 3: Evaluate accounting strategy
- flexibility in accounting choices allows managers to strategically communicate economic information or distort performance
Issues to consider include:
- norms for accounting policies with industry peers (what is normal for industry and business strategy)
- incentives for managers to manage earnings
- changes in policies and estimates and the rationale for doing so
- whether transactions are structured to achieve certain accounting objectives

Question 14

Week 3

Outline step 4 in the accounting analysis process

Answer 14

Step 4: Evaluate the quality of disclosure (notes to financial statements and other disclosures)
Issues to consider include:
1) Whether disclosures seem adequate
2) Adequacy of footnotes to the financial statements
3) Whether notes sufficiently explain and are consistent with current performance
4) Whether GAAP reflects or restricts the appropriate measurement of key measures of success
5) Adequacy of segment disclosures

Question 15

Week 3

Outline step 5 in the accounting analysis process

Answer 15

Step 5: identify Potential Red Flags
Issues to consider include:
1) Unexplained changes in accounting, especially when performance is poor
2) Unexplained transactions that boost profit
3) Unusual increases in inventory or receivables in relation to sales revenue
- Inventory / sales increase may indicate obsolete inventory
- Accounts receivable / sales increase may indicate selling more on credit so we should see more allowance for bad debt (if they haven’t then may indicate aggressive accounting)
4) Increases in the gap between net income and cash flows or taxable income
5) Use of R&D partnerships, SPEs or the sale of receivables to finance operations
6) unexpected large asset write-offs (or lack of write-offs if other firms have been writing off a particular type of asset)
7) Large fourth-quarter adjustments
8) Qualified audit opinions or auditor changes
9) Related-party transactions

Question 16

Week 3

Outline step 6 in the accounting analysis process

Answer 16

Step 6: Undo Accounting Distortions
- Financial statement footnotes often provide information from which the analyst can undo accounting distortions or make the financial statements more comparable

Question 17

Week 4
Is financing important to ROE, why?

What is the issue with using ROE to measure operating performance?

Discuss investing, operating, and financing activities in relation to value creation

Answer 17

Financing relation with ROE = Financing is indeed important. The impact of financing becomes apparent through the Equity Multiplier component of ROE. By undertaking debt instead of utilising equity we raise the value of the equity multiplier and in turn raise our ROE. However!! the impact of interest expense will lower the Profit Margin and result in a lower ROE. There is a trade off. Ideally it is important to balance the effects of leverage with the implications of interest expense to achieve an ideal ROE.

ROE in terms of measuring operating performance = As discussed above, financing influences ROE. Therefore, ROE does not provide clean analysis of operating performance, it mixes operating and financing performance.

Value creation = Operating and investing activities create value. Financing activities distribute value, they do not create value (because they occur at the cost of capital).
For example:
1. (Equity financing) Company X issues shares. The total amount of outstanding shares will increase, but share price will remain the exact same. No value is created. However, value could be destroyed if shares are issued at a lower price than market value
2. (Debt financing) Company X undertakes additional debt. Due to the interest expense the company will have assumed a negative position. The amount borrowed will be less than the amount owed over the long-run.

Question 18

Week 4

Summarise Modigliani and Miller (1961)

Answer 18

MandM = Dividend payments are irrelevant to the value of the firm = paying dividends wont create or destroy value = they simply distribute value

Question 19

Week 4
Reformatting the financial statements involves classifying every Income Statement and Balance Sheet account as either an Operating or Financing activity.

How do we determine if an account relates to Operating or Financing?

Answer 19

Determining Operating vs Financing:
Financing = have an interest payment associated
Operating = all other activities

Question 20

Week 4

Outline step 1 of the reformatting process.

Answer 20

Step 1: Calculate Owners equity for the current year.

This is accomplished by deducing the following amounts

1. OE (last year) = Owners Equity (last year)
2. CI (current year) = Comprehensive income (current year)
3. d = Net payments to shareholders
4. Change in OI = Ownership Interest

Then simply follow the formula:
OE (cy) = OE (ly) + CI (cy) - d + OI change

Note: Comprehensive Income = Net income + OCI
Note: Net payments to shareholders = dividends, share-based payments, and share buy-backs

Question 21

Week 4
Outline step 2 of the reformatting process

How does the formula A - L = E change?

Answer 21

Step 2: Calculate Net Operating Assets (NOA) and Net Financial Obligations (NFO)

1. Identify which assets and liabilities are financing (generally anything interest bearing) and calculate NFO
2. All other items are identified as operating activites to calculate NOA with.
3. Confirm balance sheet still balances (OE = NOA - NFO)

A - L = E = This formula will change to NOA - NFO = E

Question 22

Week 4

Outline step 3 of the reformatting process

Answer 22

Step 3: Reformat P and L statement

1. Identify what is financing (interest paid or received + any others?) and calculate net interest expense
2. Adjust net interest expense for tax shelter to calculate a Net Financing Expense after tax: NFEat = Net Interest x (1 - t)
3. Identify other revenues and expenses as operating and calculate operating profit before tax
4. Adjust reported tax expense for tax shelter on net interest to calculate NOPAT. If we calculated a positive NFEat (interest expense < interest revenue) we reduce tax expense by tax shield amount. If we calculated negative NFEat we increase tax expense by tax shield amount
5. NI = NOPAT - NFEat
6. If there is OCI, CI = NOPAT - NFEat + OCI

Question 23

Week 4

Outline step 4 of the reformatting process

Answer 23

Step 4: Calculate FCF generated by operations and FCF spent on financing and ensure both equal the same amount.

1. FCF generated by operations:
   FCF = NOPAT - change in NOA + OCI
2. FCF spent on financing:
   FCF = NFEat - change in NFO + d - change in Ownership Interest
   Note: d refers to net payments to shareholders

Question 24

Week 5
Ratio Analysis requires comparison against which four benchmarks?

What should effective ratio analysis do?
Which two factors drive firm value?
Which four levers achieve growth and profit targets?

Answer 24

1. Ratios over time from prior periods (time series)
2. Ratios of other firms in the industry (cross-sectional)
3. Absolute benchmarks (cost of capital for the firm would be an example for which ROE could be compared against, because ROE needs to be higher)
4. Common size analysis (e.g. each asset as percentage of total assets)

Effective ratio analysis = must attempt to relate underlying business factors to the financial numbers (e.g. why did Firm X’s profit margin increase?)

Drivers of firm value = Profitability and growth

Four levers = Operating management, investment management, financing strategy, dividend policy

Question 25

Week 5 What is the simple Du Pont formula and its various component uses? What are the issues with the simple Du Pont?

Answer 25

ROE = (NI / Sales) * (Sales / Avg Total Assets) * (Avg Total Assets / Avg OE) = Profit margin * Asset Turnover (ATO) * Financial Leverage (FLEV) Therefore: ROE = NI / Avg OE Issue 1: Interest impacts operating returns. I.e. the PM will change if we introduce debt into our capital structure. This is because we will have to pay an interest expense which will lower NI and therefore lower PM. This results in a PM which does not accurately reflect the profitability of operations alone. Issue 2: Simple operating transactions influence ATO and FLEV. For example, paying a liability with cash will lower total assets (less cash asset). This will result in less Avg Total Assets and therefore a greater ATO as well as a greater FLEV. The ROE will remain the same, however the components of ROE will not be accurate reflections. Issue 1 + Issue 2 = Overall problem The overall problem is that Basic DuPont analysis doesn't correctly attribute changes in operating and financing activities to the respective ratios... This is because Operating changes should impact PM and ATO (issue 2 shows this is not always the case) and Financing activities should impact FLEV ( issue 1 shows this is not always the case).

Question 26

Week 5 What is the advanced DuPont analysis formula and what does the advanced DuPont do for us in regards to the basic DuPont? Which ratios are Shareholders, Firms, and Debtholders interested in?

Answer 26

ROE = RNOA + FLEV *SPREAD ROE = (NOPAT / Sales) * (Sales / AvgNOA) + (Avg NFO / Avg OE) * (RNOA - NBC) ROE = Operating Profit Margin * Operating Asset Turnover + FLEV * Spread Note: RNOA = OROA (same thing) = NOPAT/ AvgNOA Note: Spread captures interest effects Note: NBC = Net Borrowing Cost = NFEat / AvgNFO = reflects credit risk Advanced DuPont ensures changes in operating and financing activities impact the correct ratios so that we have a clearer picture of how a business is performing ``` Shareholders = ROE Firms = RNOA Debtholders = NBC ```

Question 27

Week 5 | What ratios are useful for analysis of Operating Profit Margin?

Answer 27

Gross profit margin = (Sales - Cost of sales) / Sales | Various expense margins = depreciation / sales... etc.

Question 28

Week 5 What two components can Operating ATO be broken into? What various ratios are useful for analysis of the two components of Operating ATO?

Answer 28

1: Working capital management = how well are current assets and current liabilities being managed - Operating working capital / Sales - Sales / Operating working capital = turnover ratio - Sales / Avg accounts receivable - COGS / Avg Inventory = Inventory turnover ratio - COGS / Avg accounts payable = Accounts payable turnover ratio - Avg accounts receivable / Avg sales per day = Days receivable - Avg inventory / Avg COGS per day = Days inventory - Avg accounts payable / Avg COGS per day (or purchases per day) = Days payables 2: Long-term asset management - Sales / Avg net long-term assets = Net long-term asset turnover - Sales / Avg PPE = PPE turnover

Question 29

Week 5 What relation exists between FLEV and NBC? What are the benefits of debt financing? Which factor primarily determines how much debt to take on?

Answer 29

FLEV and NBC = positive correlation (FLEV up = NBC up) = because as you borrow more (FLEV up) your risk will increase and so lenders will require greater interest to compensate (NBC up) Debt financing benefits: 1. tax effect of interest 2. Extra discipline on management (debt covenants, etc.) 3. Easier to communicate privately to debtholders than equityholders 4. Typically cheaper than equity (because of predefined payment plans) (risk reduction) Determining how much debt to take on = Operating risk = low debt for high Op risk and higher debt for low Op risk

Question 30

Week 5 | What ratios are useful to liquidity analysis? (the ability of a firm to pay its current obligations)

Answer 30

Liquidity Analysis: - Current ratio = current assets / current liabilities - Quick ratio = (Cash + short term investment + Accounts receivable) / Current liabilities - Cash ratio = (Cash + marketable securities) / Current liabilities - Operating cash flow ratio = Cash flow from operations / current liabilities

Question 31

Week 5 | What ratios are useful to solvency analysis? (ability of a firm to meet long-term obligations)

Answer 31

Solvency Analysis: Liabilities-to-equity ratio = Total liabilities / shareholders equity Interest coverage ratio (earnings basis) = (Net income + Interest expense + Tax expense) / Interest expense = EBIT / Interest expense Interest Coverage ratio (cash flow basis) = (Cash flow from operations + interest expense + taxes paid) / Interest expense Also important to analyse WHEN principal and interest payments are due i.e. will we be able to borrow again in the near future

Question 32

Week 5 | What must we look at in regards to Cash Flow statements?

Answer 32

Operating activities: 1) How strong is the firms internal cash flow generation? 2) How well is working capital being managed Investing activities 1) How much cash did the company invest in growth assets? Financing activities 1) What type of external financing does the company rely on? 2) Did the company use internally generated funds for investments? 3) Did the company use internally generated funds to pay dividends?

Question 33

Week 6 Which 6 items are essential to successfully forecasting a businesses performance? What happens to sales growth over time for industry leaders?

Answer 33

1: Sales Growth 2: Asset Turnover (ATO) 3: Profit Margin (PM) 4: OCI (OCI) 5: Net Dividends (d) 6: Net after tax cost of debt (NBC) Sales growth over time: Sales growth cannot be maintained at record levels, it will always fall down to converge with industry competitors. This is due to saturation of the market.

Question 34

Week 6 | Outline the steps in forecasting

Answer 34

Step 1: Forecast sales growth as Quantity x Price - Analyse industry trends, macroeconomic trends, competitive environment, - Are new stores being opened? Any new technologies for cost or sales improvements? Step 2: Forecast ATO and calculate NOA - NOA = sales/ATO - Tends to be stable over time as it is a function for the technology of the industry Step 3: Forecast PM and calculate NOPAT - NOPAT = Sales x PM - PM is one of the more volatile figures, however it will trend towards normal over time due to competition Step 4: Forecast any other operating income (unusual items) and OCI (not the most important, however give it some consideration) Step 5: Calculate FCF - FCF = NOPAT - change in NOA - requires calculation of change in NOA (easy) Step 6: Forecast net payments to shareholders - d = NOPAT * div payout ratio (also consider share repurchase or share issues) - How much of NOPAT will be returned back to shareholders as dividends? - Typically kept reliably constant Step 7: Calculate net payments to debt holders (F) - F = FCF - d Step 8: Forecast net after tax cost of debt (NBC), and apply to opening NFO to calculate NFEat (Also check leverage as NFO/NOA) - NFEat = NFO prior x NBC - NFO = NFO prior + NFEat - F - Requires forecasting of interest rates (will they go up or down in the economy? does the firm have locked in rates for long-term borrowing?) Step 9: calculate comprehensive income (CI) - CI = NOPAT - NFEAat + OCI Step 10: Calculate equity (and check it both ways!) - OE = NOA - NFO - OE = OE prior + CI - d

Question 35

Week 7 | Outline some general guidance on successfully forecasting business figures.

Answer 35

1. Use comprehensive forecasts, they avoid inconsistent assumptions being made. Each detail can have major ramifications. Each detail can provide insight into other details. 2. utilise research illustrating known trends and patterns 3. Don't believe everything that management and analysts forecast 4. Consider arguments from opposing perspectives, each side may have valid arguments

Question 36

Week 7 What role do financial analysts play in the economy? What are the three general categories of financial analysts? Are there any conflict of interests?

Answer 36

Importance of financial analysts: Financial analysts serve the role of analysing, interpreting and disseminating information to capital market participants Financial analyst categories: 1. Sell-side (report produced for external use): typically work for investment banks or brokerage houses and issue stock recommendations on securities they follow. They typically follow specific industries or a handful of companies within an industry. There job is to know everything there is to know about the industry/companies by speaking with management, customers, suppliers, etc. They will attempt to disclose sound investment advice to the firms clients. - Conflict of interests = these analysts tend to be overoptimistic or positive due to their relationships with the businesses they analyse e.g. ownership interests 2. Buy-side (report produced for internal use): Typically work for institutional money managers such as mutual funds and hedge funds that purchase securities for their own accounts 3. Independent: sell independent research reports on a subscription basis, emphasise their lack of conflicts of interests

Question 37

Week 7 In regards to Management forecasts, what are the motivations for managements voluntary disclosure of forecasts? Do management forecasts tend to be higher or lower?

Answer 37

Motivation: 1. Pump up share price in short term 2. Align investor expectations with managements Management forecasts optimistic vs pessimistic? - Overall management forecasts are not systematically higher than existing analyst forecasts or actual earnings, this is because the forecasts would lose credibility if they were consistently overoptimistic.

Question 38

Week 7 Given a material change in the macroeconomic, business, or industry environment would it be viable to utilise historical averages or trend analysis?

Answer 38

If the change is something that has been experienced before (within a reasonable amount of time) it would be appropriate to utilise the historical average or trend analysis to inform understanding of the direction the business may take. However, if the change is completely different to anything before then past data will provide no useful insight into future outcomes.

Question 39

Week 8 Under the Price multiples valuation method what three ratios do we utilise? How do we use these ratios to value a company using competitors and using only the company? if a company had a high book value and lower market value, what could this indicate?

Answer 39

``` Ratios: 1. Price to Sales 2. Price to Earnings 3. Price to book value Note: For these ratios 'Price' refers to total market value ``` Application of ratios to value company using competitors (no forecasting) : 1. First we will calculate the P/S, P/E, and P/B for competitor companies. 2. We then calculate the average for each ratio within the competitive environment 3. For the company we are valuing we now multiple each averaged ratio by the denominator of our company. For example if we determined an average P/S of 0.91 we would multiply our companies sales by 0.91. 4. Ultimately we should have three different values of market value = we could take an average if we wanted. Low MV to BV = this could indicate that the market has undervalued the company and it could be beneficial to purchase the company at the low MV and sell off the assets for the higher BV. Alternatively it could indicate that the market does not believe the company has accurately valued its assets.

Question 40

Week 8 Contrast the advantages and disadvantages of the price multiplies valuation method Why would we use this method?

Answer 40

Advantages: 1. Very simple to calculate 2. Does not require lengthy forecast analysis 3. A range of price multiples are available Disadvantages: 1. Range of price multiplies could lead to very different valuations (which one is right?) 2. Difficult to choose comparable firms (e.g. due to size, business life cycle (growth, dev, mature etc), different financing structures) 3. Comparable firms may not be comparable, would need to consider potential earnings management in numbers of competitors (Can use industry average instead) 4. Multiples easily impacted by marginal profitability / earnings shocks) Why use this method = in reality we would only use this method to gain a very simple and fast understanding of some possible valuation figures. However, we would never rely on this information

Question 41

Week 8 What is the standard valuation theory? Why is it relevant to valuing a company? Why is valuing a company using standard valuation theory more difficult than valuing a bond? What does the Discounted dividends valuation model value, equity or assets?

Answer 41

Standard valuation theory = The value of an asset is the net present value of future cash flows Relevant for valuing a company = because we can determine the net present value of dividends Company vs Bond valuation: 1. Bond payment number, timing, and amount are all known. For a company the dividend payment amount, number and timing are not known or are variable. 2. Cost of capital for a bond is known (it is the contracted rate). For a company the cost of equity capital is harder to estimate 3. For both the risk of bankruptcy changes throughout the life of the company making for some uncertainty DDM, assets or equity = Obviously equity, because the cash flows (dividends) stem from equity holdings.

Question 42

Week 8 How do we use the Discount Dividend Valuation Model?

Answer 42

DDM steps: 1. Forecast net dividends up to a forecast horizon (t) 2. Estimate cost of capital for equity 3. Discount future dividends to present value 4. Forecast dividend growth patterns beyond the forecast horizon t (may be 0 i.e. no dividend or could be a perpetuity or maybe a perpetuity with growth) 5. Calculate TV (terminal value) at the forecast horizon 6. Discount TV to present value 7. Add 3 and 6 for total equity value

Question 43

Week 8 What is the TV as per the DDM model? For the DDM why do we use the TV, instead of just taking dividends through to infinity? What would the math look like if we assumed the TV would be a constant perpetuity? What would the math look like if we assumed the TV would be a growth perpetuity? Why would we assume that TV is 0?

Answer 43

TV = the present value of dividends occurring beyond the terminal year Why use TV = this is actually really simple if you think about it... we use TV because it would not be possible to forecast dividends accurately over a period larger than 5 to 10 years (or so). Therefore the TV allows us to assess the company's performance beyond the forecast period by applying a simply assumption such as dividends will be 0 or will grow constantly, etc. Constant perpetuity = We would calculate TV as d / r We would need to remember to also discount the TV across the forecast period to time 0 Growth perpetuity = instead of dividing the dividend by r we need to incorporate the growth factors = (d*(1+g)) / (r-g) Again, remember to discount TV back to time 0 as well We assume TV is 0 = for fixed life assets (gold mines, etc.) because dividends will not be paid out into the future. Use TV = 0 when no dividends expected beyond forecast horizon.

Question 44

Week 8 Contrast the advantages and disadvantages of the DDM

Answer 44

Advantages: 1. Strong theoretical foundation (value of equity is equal to the NPV of future cash flows) 2. Easy to interpret Disadvantages (theoretical problems): 1. Dividends are distributions of value, not the creation of value and so dividends are not a true reflection of the companies performance. For example, a company performing poorly could simply take out a loan to pay some dividends... 2. MandM states that dividend policy irrelevant to valuation in an efficient market 3. Dividend policy can be arbitrary = profitable companies (like Warren Buffets) may pay 0 dividends and some poor performing companies may pay high dividends 4. Valuation is particularly sensitive to forecast horizon and growth assumption = very hard to get accurate assumptions

Question 45

Week 8 If using Price Multiples and industry averages to value your company, what are some steps you could take to improve the valuation accuracy?

Answer 45

1. Remove your firm from the industry analysis so their multiples are not included in the average for the industry 2. Remove firms from the industry that are obviously not comparable (e.g. airports and freight are different to airlines despite being in the Transportation industry) 3. Remove firms that are in a different stage of business cycle (e.g. high vs low growth) 4. Remove firms that have a different business strategy (e.g. Regional Express vs Qantas) 5. Remove firms that are unprofitable and are driving down the averages (prevent negative averages)

Question 46

Week 9 What is the formula for the Residual Income Model (RIM)? What is Residual Income (RI) AKA Abnormal Earnings (AE)? How do we calculate RI (AE)?

Answer 46

RIM: Equity = bv + PV of expected abnormal earnings - This is just like the DDM, except we discount RI. Just like the DDM we also include a TV Residual income (abnormal earnings) = the value amount by which return exceeds cost of capital Calculate RI: RI = NI - (r * Equity last period)

Question 47

Week 9 When using RIM what are two important factors to consider? Why would RI approach 0? Why may RI remain above 0? Why may RI grow into the future?

Answer 47

Important factors for consideration: 1. Accounting policy = because the valuation is based upon earnings and book values and accounting choices ultimately effect earnings and book values (however, keep in mind that earnings management corrects itself with time) 2. Strategic and accounting analyses = because we are concerned essentially with income above that required to cover the cost of capital. Generating this level of income requires competitive advantage. So it is very important to understand the competitive advantage and whether or not it is sustainable advantage (and hence RI will continue into the future) or if it is not sustainable (and RI will not continue into the future) RI approaching 0: 1. Industry competition (point 2 above explains this) 2. Government intervention (for example government restricts monopolistic behaviour for airports, limiting RI) RI above 0: 1. Sustainable competitive advantage 2. Accounting conservatism ( for example, pharmaceutical companies are required to expense (rather than capitalise) certain things. So this would downplay bv of equity. If we have a low equity value our RI (RI = NI - r*equity last period) will be higher)) RI growing into future = very rare. Only for exceptional companies like apple, amazon, McDonalds, etc.

Question 48

Week 9 | What are the steps for using the RIM?

Answer 48

1. Forecast NI and OE 2. Estimate cost of capital for equity (r) and calculate discount factors (1+r)^t 3. Calculate RI values 4. Calculate RI growth patterns and make appropriate TV assumption 5. Calculate TV at time T (terminal year) 6. Discount RI and discount TV 7. Sum OE + pv of RI's + pv of TV

Question 49

Week 9 | Contrast the advantages and disadvantages of the RIM

Answer 49

Advantages: 1. Academic research suggests RIM out performs other models 2. Focus is on value drivers (such as profitability and growth) (remember how DDM focuses on value distributions, not value creation?) 3. Incorporate the financial statements and forecasts of them (holistic view of company) (remember how DDM focuses on dividend payouts which may simply be funded by taking out debt = not holistic view of company) 4. Uses accrual accounting and in doing so recognises value added and also matches value lost with value added (e.g. consider the FCFM where cash used for investments reduces FCF and fails to capture the value added of the investment. using the accrual method we capture the value loss (cash asset down) and match it with a value gain (investment asset up). 5. Versatility = can be used with a wide variety of accounting principles 6. Can be validated 7. Aligned with what people forecast Disadvantages: 1. Accounting complexity = requires understanding of how accounting works 2. Suspect accounting = accounting numbers can be suspect 3. Forecast horizon (problem with all models, except Price Multiples models) = Forecast horizon depends on quality of the accounting

Question 50

Week 9 How does the Residual Operating Income Model differ from the RIM? How are ROIM and RIM related mathematically? What is the formula for calculating Residual Operating Income (ROI) for the ROIM? What is the key final step of the ROIM?

Answer 50

ROIM v RIM: 1. ROIM values the firm, RIM values equity 2. ROIM concerns firm returns, RIM concerns equity returns 3. ROIM uses cost of capital of the firm, RIM uses cost of capital of equity Mathematical relationship: Ve = Vf - NFO - Where Ve equals value derived through RIM and Vf equals value derived through ROIM ROI = NOPAT - r(firm)*NOA last period Key final step = remember that ROIM produces v(firm) and not v(equity). Therefore, as shown with the mathematical relationship information above we need to subtract NFO to produce v(equity)

Question 51

Week 9 If we have growth for the TV of one of our valuation models, and the numerator factors is negative (e.g. ROIM produces a negative ROI) do we apply the growth rate to drive the negative value back to a positive? or do we apply it to make the negative grow even more negative?

Answer 51

Well, it wouldn't make much sense for the company to keep operating if it was going to continue to destroy value into the future. So we apply the growth rate in a way which will make the negative return back to 0 over time

Question 52

Week 9 How do we use the FCF valuation model (DCF)? What is the central limitation (disadvantage) of the FCFM as compared with RIM and ROIM? When does DCF work best?

Answer 52

DCF = just like the DDM except we discount FCF instead of d. Also, DCF produces a value for v(firm) so just like the ROIM we need to remember in the final step to calculate v(equity) as v(firm) less NFO Limitation (disadvantage) of DCF as compared with RIM and ROIM = The ROIM and RIM capture investments as an element of value, whereas the FCF does not. This is because FCF are calculated by subtracting cash used for investments. therefore, may have a negative FCF for many years DCF works best = when the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate = not optimal for firms in growth phase

Question 53

Week 9 | Contrast the advantages and disadvantages of the DCF

Answer 53

Advantages: 1. Cash flows are real and are not distorted by accounting rules. 2. Theoretically sound – the present value of future cash flows. 3. Relative to the DDM, FCF are more closely aligned to the firms value creation (E.g. Dividend payouts are arbitrary, a firm can borrow to pay a dividend) 4. DCF works well for mature companies that have stable investment patterns. Disadvantages: 1. Fails to match value gained with value given up (consider the case of negative FCF where lots of cash is put into investment = only captures the value lost. Also consider case where a firm sells lots of assets and produces extra cash, not really a result of great performance) 2. FCF is partly a liquidation concept; firms increase cash flow by cutting back on investments 3. Can require long forecast horizons to recognise cash inflows from investment expenditure 4. Validation = it is hard to validate FCF forecasts 5. Not aligned with what people forecast = analysts forecasting earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts required further forecasting of accruals

Question 54

Week 9 | Why may we use the ROIM over the RIM?

Answer 54

ROIM over RIM: 1. If debt and financial assets are zero residual earnings producers we can ignore these components and focus on forecasting the profitability of operations (which is essentially what ROIM does). This reduces the amount we need to forecast because we only forecast NOPAT and NOA. 2. It is easier to forecast r(firm) than it is to forecast r(equity) because WACC is more stable over time.

Question 55

Week 10 Which is riskier Equity or Debt? Why? Therefore, which is higher Cost of Equity or Cost of Debt? What is the terminology Rd, Re, Rf?

Answer 55

Riskier Equity or debt = Equity is riskier than debt. This is because of several factors: 1. Debt holders will be paid first during financial stress or bankruptcy. 2. Debt holders will usually take out collateral or a mortgage for a loan 3. Debt investors are guaranteed interest repayments and their principal back at a known time 4. Equity investors are not guaranteed dividends or a liquidating payment Therefore, Cost of Equity is higher than Cost of Debt ``` Rd = Cost of debt capital - the interest rate on bank loans or bonds Re = Cost of equity capital - the return an equity investor requires to invest in a risky project Rf = Cost of firm capital - the weighted average of cost of capital of debt and cost of capital of equity ```

Question 56

Week 10 How can we determine Rd for a firm?

Answer 56

Determine Rd: 1. Deduce from financial statement liability notes. Look for 'after tax weighted average interest rate' this will be Rd 2. Calculate as NFEat / Avg. NFO (provides an after tax Rd) 3. Analyse bond rating of firm and search for current bond yield on the associated rating

Question 57

Week 10 We can use CAPM or Farm-French Factor Model to dedcuce Re ``` Under CAPM: What is the theory behind it? What is the formula? What does Beta measure? How can we ascertain rf? Interpret a positive and negative Beta How do we ascertain Beta? How do we ascertain rm? how could we ascertain the risk premium? ```

Answer 57

Re cannot be directly observed, therefore we require estimation methods including CAPM and Fama-French Factor Models. CAPM: Theory - CAPM recognises that the market will not provide a risk premium for risk that can be diversified away in a portfolio Formula - Re = rf + Beta * (rm - rf) Beta - sensitivity of investments return to the market return rf - Use Australian government bonds or notes (for assignment use RBA cash rate or government treasury bond yield) Positive Beta = firm return and market return move in the same direction = above 1 is riskier than market, below 1 is less risky, exactly 1 is perfectly correlated Negative Beta = firm return and market return move in the opposite direction Ascertain Beta = will either be given (in an exam) or for assignment we can just use Yahoo Finance Ascertain rm = Australian stock return averages Ascertain Risk premium = use the paper "The historical equity risk premium in Australia: post-GFC and 128 years of data" by Tim Brailsford, John C. Handley, Kirshnan Maheswaran

Question 58

Week 10 What are some issues associated with CAPM?

Answer 58

CAPM issues: 1. Estimates of the cost of capital are made from market prices and assume that the market is efficient 2. Model assumes stock returns are normally distributed (however, they are not) 3. Should the risk-free rate change? is a current or historical average appropriate? 4. What is the market premium? change? is a current or historical average appropriate? 5. How should Beta be estimated? What time period? Which market? Daily or monthly share price changes?

Question 59

Week 10 CAPM assumes Beta to be the only risk factor for a firm. Which additional 2 factors does the Fama-French model introduce as risk factors?

Answer 59

Fama French risk factors = Beta, Size, BV to MV. Also, they have found additional factors such as Investment, Profitability, Momentum

Question 60

Week 10 How do we determine Rf? We can go ones step further once we have deduced WACC. We can compare with ROE. How do we do this?

Answer 60

Rf = determined using WACC formula WACC = (NFO/ (NFO + Ve)) * Rd + (Ve/(NFO+Ve)) * Re Where: Ve = market value of equity (for assignment calculate Ve using RI model, not price x number of shares!) Compare with ROE: 1. First rearrange the WACC formula to - re = rf + NFO/Ve * (rf - rd)... where rf is WACC... this rearranged formula is the same as ROE = RNOA + FLEV*[RNOA-NBC], except its expressed in terms of risk and not return. 2. Put the formulas side by side and analyse the actual returns and required returns. e.g. if we put the formuals side by side we can see that rf corresponds with RNOA and therefore we can compare the actual return (RNOA) with required return of operations (rf)

Question 61

Week 11 Outline the efficient market hypothesis Does the Hypothesis have grounding?

Answer 61

EMH = security prices reflect all available information fully and immediately upon release Grounding = yes it does. Some evidence includes the fact that market reactions to public announcements are very quick and generating abnormal returns is highly exceptional.

Question 62

Week 11 | What does the evidence suggest about Active vs Passive fund management

Answer 62

Active = heavy reliance on security analysis and identifying miss-priced securities Passive = seeks to match some benchmark of performance through holding a portfolio of securities The evidence = suggest that active management tends to perform relatively poorly as compared with passive management strategies.

Question 63

Week 11 | Contrast Technical analysis and Fundamental analysis

Answer 63

Technical analysis = predict stock price movements based on market indicators Fundamental analysis = evaluate current market prices relative to future projections of earnings or cash flows

Question 64

Week 11 What does the size screen imply about the earnings of Small vs large firms?

Answer 64

Large firms tend to have a lower mean monthly return than small firms. Implying Smaller firms are a better investment

Question 65

Week 11 What are some of the issues associated with valuing a private firm?

Answer 65

1. Usually no active market 2. Pricing of private companies shares is invisible 3. What would be the appropriate valuation methodologies? (with limited information it would be hard to generate an accurate forecast) (using price multiples... well, which firms to compare against?)