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Transcript of FINS3625_L2
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FINS3625 Applied Corporate Finance
Semester 1, 2015
Week 2
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Chapter 2 Introduction to Financial Statement Analysis
2.1 Firms Disclosure of Financial Information
2.2 The Balance Sheet
2.3 The Income Statement
2.4 The Statement of Cash Flows
2.5 Other Financial Statement Information
2.6 Financial Statement Analysis
2.7 Financial Reporting in Practice
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2.1 Financial Statement
Financial Statement Financial statements are accounting reports that a firm issues
periodically to describe its past performance.
Investors, financial analysts, managers and other interested parties rely on financial statements to obtain reliable information about a corporation.
Preparation of Financial Statements Generally Accepted Accounting Principles (GAAP).
International Financial Reporting Standards (IFRS).
Makes it easier to compare financial results of different firms.
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2.1 Financial Statement
Types of Financial Statements Balance sheet
Income statement
Statement of cash flows
Statement of changes in shareholders (or stockholders) equity
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2.2 Balance Sheet
A snapshot in time of the firms financial position
The Balance Sheet Equation: Assets = Liabilities + Shareholders Equity
Assets What the company owns
Liabilities What the company owes
Shareholders Equity The difference between the value of the firms assets and liabilities
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2.2 Balance Sheet
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2.2 Assets
Current Assets: cash or asset expected to be turned into cash within one year Cash
Accounts receivable
Inventories
etc
Long-Term (or Non- Current) Assets: assets that produce benefits for more than one year Property, plant, & equipment
Depreciation
Goodwill Amortization
etc
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2.2 Liabilities
Current Liabilities: due to be paid within one year Accounts payable
Short-term debt payable
Wages payable
etc
Long-Term Liabilities: liabilities that extend beyond one year Long-term debt
Capital leases
etc
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2.2 Liabilities
The difference between current assets and current liabilities is the firms net working capital, the capital available in the short term to run the business.
Net Working Capital = Current Assets Current Liabilities
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2.2 Shareholders Equity
The difference between the firms assets and liabilities is the shareholders equity, also called the book value of equity. Based on historical costs rather than true value.
Fails to capture some valuable assets such as reputation.
Not necessarily an accurate assessment of the true value of the firms equity.
Market value of equity (market capitalization) Market Price per Share x Number of Shares Outstanding.
Depends on what investors expect those assets to produce in the future.
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2.6 Balance Sheet Analysis
Market-to-Book Ratio
Value shares: low M/B ratio; Growth shares: high M/B ratio
Debt-Equity Ratio
Measures the extent to which the firm relies on debt as a source of financing, or leverage.
Enterprise Value
Assesses the value of the underlying business assets.
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Market Value of EquityMarket-to-Book Ratio
Book Value of Equity
Total DebtDebt-Equity Ratio
Total Equity
Enterprise Value Market Value of Equity Debt Cash
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2.6 Balance Sheet Analysis
Example: In January 2009, Rylan Corporation had a market capitalization of 110 million, a market-to-book ratio of 2.2, a book debt to equity ratio of 1.4, and cash of $6.3 million. What was Rylans enterprise value? Book value of equity = $110m / 2.2 = $50m
Total debt = $50m 1.4 = $70m
Enterprise value = $110m + $70m - $6.3m = $173.7m
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2.3 Income Statement
Total Sales Cost of Sales = Gross Profit
Gross Profit Operating Expenses = Operating Income
Operating Income Other Income/Expenses = Earnings Before Interest and Taxes (EBIT)
EBIT Interest Income/Expenses Taxes = Net Income
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2.3 Income Statement
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2.6 Income Statement Analysis
Profitability Ratios
Gross Margin
Reflects firms ability to sell a product for more than the cost of producing it.
Net Profit Margin
Shows the fraction of each dollar in revenues that is available to equity holders after the firm pays its expenses plus interest and taxes.
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Sales
ProfitGrossMarginGross
Net IncomeNet Profit Margin
Total Sales
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2.6 Income Statement Analysis
EBITDA
Earnings Before Interests, Taxes, Deprecation and Amortization Depreciation and amortization are not actual cash expenses.
EBITDA reflects the cash a firm has earned from its operations.
Investment Returns
Return on Equity (ROE)
Return on Assets (ROA)
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Net IncomeReturn on Equity
Book Value of Equity
AssetsTotal
IncomeNetAssetsonReturn
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2.6 The DuPont Identity
First term measures firms overall profitability.
Second term measures firms efficiency in utilizing its assets to generate sales.
Third term is another measure of leverage. A higher Equity multiplier implies a greater reliance on debt financing.
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EquityofValueBook
AssetsTotal
AssetsTotal
Sales
Sales
IncomeNetROE
Net Profit Margin Asset Turnover Equity Multiplier
Return On Assets
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2.6 Valuation Ratios
PriceEarnings Ratio (P/E)
A very commonly used measure.
Meaningless when the firm has negative earnings.
Solution: look at enterprise value relative to sales.
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Market Capitalization Share PriceP / E Ratio
Net Income Earnings per Share
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2.4 The Statement of Cash Flows
Net income typically does not equal the amount of cash the firm has earned because of: Non-Cash Expenses (e.g. Depreciation and Amortization)
Uses of cash not on the Income Statement (e.g. Investment in Property, Plant, and Equipment)
Three sections of cash flow statements: Operating activities
Investment activities
Financing activities
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2.4 Three sections in cash flow statement
Operating Activities
Adjust net income by all non-cash items related to operating activities and changes in net working capital Add depreciation and amortization
Deduct accounts receivable
Deduct inventories
Add accounts payable
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2.4 Three sections in cash flow statement
Investment Activities
Shows the cash required for investment activities Capital Expenditures (i.e. purchases of new property, plant, and
equipment) do not appear immediately as expenses on the income statement => deduct
Similarly, sales of properties etc are not recognized as income => add
Financing Activities
Shows the cash flows from financing activities Examples of cash outflows: dividend payments, share repurchases
Examples of cash inflows: increase in borrowing
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2.4 Three sections in cash flow statement
Example:
Solution: Depreciation affects cash flow via 2 channels: net income & operating
activities cash flow.
Pre-tax income falls by 1m tax expense falls by 0.26m net income falls by 0.74m.
Operating activities cash flow rises by 1m.
Therefore, the net impact is 1m - 0.74m = 0.26m
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2.7 Financial Reporting in Practice
Enron Considered as one of the most successful companies in America.
Executives manipulated financial statements to mislead investors.
Example: recording money borrowed as income while hiding the future obligations to pay it back.
WorldCom Another record-breaking scandal.
Fraud: reclassify operating expenses as long-term capital expenditures.
Sarbanes-Oxley Act (SOX)
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Chapter 19 Valuation and Financial Modeling
19.1 Valuation Using Comparables
19.2 The Business Plan
19.3 Building the Financial Model
19.4 Estimating the Cost of Capital
19.5 Valuing the Investment
19.6 Sensitivity Analysis
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19.1.1 Valuation Using Comparables
A useful approach to obtain a rough idea of the value of the firm.
The trick is to find a comparable firm that: (1) has a fair and observable price; and
(2) is similar to the firm of interest as possible.
Consider Ideko Corporation, a privately held firm. Assume that we are interested in knowing whether $150 million is a reasonable price for this firm.
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19.1.1 Valuation Using Comparables
Based on the proposed price of $150 million, further assume that we have obtained the following ratios:
Problem of using comparables: unreliable for a precise estimation
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Comparable firms
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19.2 & 19.3 Building the Financial Model
Computation 1:
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19.2 & 19.3 Building the Financial Model
Computation 2:
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19.2 & 19.3 Building the Financial Model
Computation 3:
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Our ultimate mission
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19.2 & 19.3 Building the Financial Model
Useful information:
1. Sales = Market Size x Market Share x Average Sales Price
2. Raw Materials = Market Size x Market Share x Raw Materials per Unit
3. Direct Labor = Market Size x Market Share x Direct Labor Cost per Unit
4. S&M = Sales x (S&M % of Sales)
5. Admin = Sales x (Admin % of Sales)
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19.2 & 19.3 Building the Financial Model
Computation 1:
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19.2 & 19.3 Building the Financial Model
Computation 2
:
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19.2 & 19.3 Building the Financial Model
Computation 3:
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19.5 Valuing the Investment
The Multiples Approach to Continuation Value
Practitioners generally estimate a firms continuation value (also called the terminal value) at the end of the forecast horizon using a valuation multiple The EBITDA multiple is the multiple most often used in practice.
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Continuation Enterprise Value at Forecast Horizon
EBITDA at Horizon EBITDA Multiple at Horizon
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19.5 Valuing the Investment
Based on the information we have so far:
A few notes: EV/Sales = 292,052 / 158,626 = 1.8
P/E (levered) = 172,052 / 10,545 = 16.3
P/E (unlevered) = 292,052 / 15,849 = 18.4
The estimation seems reasonable, or arguably conservative.
One issue: future multiples of the firm are being compared with current multiples of its competitors.
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Homework
Chapter 2: 8, 25
Chapter 19: 1, 5, 9
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