Summary of Course Topics

Chapter 1: Introduction

1. Types of Business activities – Operating, Investing, Financing Activities

2. How do Managers add value to the firm through financing activities?
1. Optimizing capital structure (trade-off between higher risk imposed by leverage and
benefit of tax shield from interest costs)
2. Minimizing taxes (choice of financial instrument issued)
3. Minimizing transaction costs (example fees paid to investment bankers)
4. Exploiting inefficiencies in markets (timing a security issue to take advantage of high
prices)
3. Dividend Discount Model
4. Net Distributions to shareholders

Cash Dividends + Stock Repurchases – Equity Issuances

Chapter 2: Information Collection

1. SEC Filings: 10-K, 10Q; Indian Filings: Annual reports, Limited reviews, Other Disclosures
2. Company Website, press releases, conference calls
3. News articles
4. Analyst Reports – incentives of analysts; buy-side versus sell-side analysts

Chapter 3: Understanding the Business

1. Macroeconomic factors: GDP growth, interest rates, inflation, foreign exchange rates, oil prices,
hedging
2. Industry Factors: Correlation between Industry sales and business cycle, operating leverage,
interest rates, and oil prices
3. We did not cover this: Industry competition: Porter Model – rivalry among firms, threat of new
entrants, availability of substitutes, bargaining position of customers, bargaining position of
suppliers
4. Firm strategy – Cost Leadership, Product Differentiation, Focus.

Chapter 4: Accounting Analysis

1. Assets = Liabilities + Owners Equity

2. Book Value of Equity ≠Market Value of Equity
 Assets/Liabilities omitted or incorrectly measured
3. Sources of measurement error
a. GAAP -> reliability, conservatism
b. Lack of perfect foresight
c. Earnings management
4. Assets, Liabilities, Owner’s Equity defined
5. Accounting Relations:

Ending Equity = Beginning Equity + Income – Net Distributions to Equity Holders

Income = Change in Equity (Reinvested Income) + Net Distributions to Equity

6. Revenues, Expenses, Gains, Losses

7. Irregular Items
8. Perfect Accounting:

Net Income = Economic Income

Return on Equity = Economic Rate of Return

9. Imperfect Accounting
Book Value of Equity = True Value of Investment + ε

Net Income = Distributions to Equity + Increase in Equity

= Distributions to Equity + Increase in Investment + Increase in ε
= Economic Income + Increase in ε
ROE = Net Income/Beginning Book Value of Equity
= (Economic Income + Increase in ε)/(Beginning Investment + Beginning ε)

10. Temporary aggressive accounting

 Example: understate operating expenses in year 1; overstate depreciation in year 2

 Effect: Operating income and ROE overstated in period of aggressive accounting and
understated in period of reversal.
 Real world examples: revenue recognition, expense capitalization

11. Temporary conservative accounting:

 Example: additional investment expense in year 1, understate depreciation in year 2

 Effect: Operating income and ROE understated in period of conservative accounting and
overstated in period of reversal.
 Real world Examples: Cookie jar reserves: warranty costs, restructuring charges

12. Permanent Conservative accounting

Example: Additional investment expense in every period, understate depreciation in the

following years
Effect: Equity is understated, Income is understated in periods of growth, correctly stated when
a firm is stable, and overstated when growth reverses
 Real World Examples: Expensing R&D (Review Intel Example that we studied in class)

13. Imperfections in GAAP

a. When assets are depreciated too quickly, assets and equity are understated leading to
permanently conservative accounting -> leads to “old plant trap”
b. Asset Impairments: asymmetric treatment of value changes, catch-up depreciation
c. Contingent Liabilities

14. Managerial Manipulation

a. Incentives for manipulation
b. Revenue manipulation
c. Expense manipulation
d. Related party transactions: We did not cover this
e. Off Balance Sheet activities: We did not cover this

Chapter 5: Financial Ratio Analysis

1. Motivation: Standardization facilitates comparisons over time and in cross-sections

2. Mean reversion in extreme ratios
3. Limitations of ratios
a. Extreme Values (small denominator)
b. Negative Denominators
c. Window dressing
4. Growth analysis: sales, assets, equity, income
5. Sustainable growth = Return on Equity *(1 – Dividend Payout ratio): Maximum rate that a firm
can grow without resorting to additional financing
6. Return on Equity (ROE) = Net Income / Average Common Equity
7. Basic Dupont Model: ROE = Net Profit Margin * Asset Turnover * Total Leverage
8. ROA = Net Profit Margin * Asset Turnover
9. Advanced Dupont Model: Create a measure (RNOA) that is unaffected by changes in capital
structure
ROE = RNOA + Spread*Leverage

RNOA=NOI/NOA = Return on net operating assets

NOI= Operating income, net of tax
NOA= Average Net Operating assets
Spread = RNOA – NBC
NBC = Net Financing Expense / Average Net Financing Obligations
Leverage = Average Net Financing Obligations/Average Common Equity
10. RNOA = Net Operating Profit Margin * Net Operating Asset Turnover
11. Margin ratios
 a. Gross Margin = (Sales – COGS)/Sales
Mark-up on product Impact of price-based competition felt here
b. EBITDA Margin = (Sales – COGS – R&D - SG&A)/Sales
Excludes depreciation, can be high for capital intensive firms
c. EBIT Margin = Earnings before interest and taxes/ Sales
Shielded from impact of changes in leverage and tax rates
d. Net Operating Margin before non-recurring items
= Net Operating Income + After-tax non-recurring items/ Sales
12. Operating Leverage; higher fixed costs increase operating risk – good times are really good and
bad times are really bad
13. Turnover ratios:
a. Working Capital Turnover: Sales/Average Working capital
b. Average days to collect receivables = 365*(Average Receivables/Sales)
c. Average Inventory Holding Period = 365*(Average Inventory/Cost of Goods sold)
d. Average days to pay Payables = 365 * Average Payables/Purchases
where Purchases = Cost of goods sold + Ending Inventory – Beginning Inventory
e. PP&E Turnover = Sales /Average net PP&E
14. Leverage ratios:
a. Debt-to-equity ratio: (Current debt + Long-term debt)/Common Equity
15. Short-term liquidity
a. Current Ratio = Total Current assets/Total current liabilities
b. Quick ratio = Cash & Marketable Securities + Receivables/ Total Current Liabilities
c. Interest coverage:
i. EBIT/Interest
ii. EBITDA/Interest

Chapter 6: Cash Flow Analysis

1. Cash flow statement: Change in Cash = - (Change in Non-cash Assets) + Change in Liabilities +
Change in Equity
2. Examples of items reported in the cash flow statement
3. How does the CFO become negative or lower than the income?
a. Performance
b. Working Capital increases
c. Earnings management
d. Large one-time cash payments
4. Evaluating Investing Cash flows
a. Cash from investing is usually negative because capital expenditures are recurring.
b. Useful way to assess growth is if capital expenditures exceed depreciation.
c. Compare growth rate in long-term assets with sustainable growth rate
5. Evaluating Financing cash flows: Burn rate = Free Cash flows/ 12
Cash Balance/Burn rate = # of months before a firm runs out of cash
6. Free cash flow to equityholders
 Definition 1: Free Cash Flow to Common Equity = Net Income – Increase in Equity

Definition 2: Free Cash Flow to Common Equity = Cash from Operations – Increase in Operating Cash
+ Cash from Investing + Increase in Debt – Preferred Dividends + Increase in Preferred Stock

Definition 3: Free Cash Flow to Common Equity = Dividends Paid – Net Issuance of Common Stock

7. Free cash flow to all investors

Definition 1: Free Cash Flow to Investors = Net Operating Income – Increase in Net Operating Assets

Definition 2: Free Cash Flow to Investors = Cash from Operations – Increase in Operating Cash +
Cash from Investing + Interest Expense – Tax Shield on Interest

Definition 3: Free Cash Flow to Investors = Dividends Paid + Interest Expense – Tax Shield on
Interest + Dividends on Preferred Stock - Net Issuance of Common Stock - Net Issuance of Debt –
Net Issuance of Preferred Stock

Chapter 7: Structured Forecasting

1. Steps in Forecasting (see PowerPoint slides)

2. Forecast Horizon
3. Terminal Period Assumptions; ROE greater than Cost of Equity; Exception: Conservative
accounting causes ROE to be understated
4. Forecasting Earnings per Share

Chapter 8: Forecasting Details

1. Forecasting sales growth

2. Forecasting expenses
3. Forecasting assets
4. Financing Assumptions

Chapter 9: Cost of Capital

1. Cost of capital is compensation for uncertainty and time value of money

2. CAPM: re= rf + b(rm – rf); Only risk that cannot be diversified away is variability of market return.
3. Example of CAPM calculation
4. Size Model: re = rf + rsize
5. Weighted Average Cost of Capital

Chapter 10: Valuation

1. Residual Income = RIt = NIt – reCEt-1

2. Residual Income Valuation Model for Equity Investors:

Pe = CE0 +  (1 + re ) −t RI t
t =1
 Price equals the current book value plus the discounted sum of expected future residual income
(abnormal earnings). Re is the cost of equity capital.

3. Price and Common Equity are measured as of the last financial statement date

4. Implications of Residual Income Model:

a. An asset is worth premium or discount to book value only if the book value is
expected to earn non-zero residual earnings
b. Earnings growth does not add value if the growth comes from investments that earn
the required rate of return
c. Even if an asset does not pay dividends it can be valued with its earnings and book
value
d. Valuation of the savings account does not depend on dividend payout

5. Discounted Cash Flow Model for equity investors:


Pe =  (1 + re ) − t Dt
t =1

where Dt is the net cash distributions to equity holders, or free cash flow to common equity,
computed as

1. NI – CE, or

2. From the SCF

3. Distributions to Shareholders

re is the cost of equity capital.

6. Discounted Cash Flow model for all investors

7. Bad Accounting and the Residual Income Valuation Model

Chapter 11: Valuation Ratios

1. Method of Comparables
2. P/B ratio
3. P/E ratio
4. PEG ratio
5. Screening