Valuation Differences: Dividends vs. Free Cash Flows & Porter's 5 Forces - Prof. Jon Bartl, Study notes of Accounting

Download Valuation Differences: Dividends vs. Free Cash Flows & Porter's 5 Forces - Prof. Jon Bartl and more Study notes Accounting in PDF only on Docsity! ACC 411-003 – Final Exam 2010 1. (2) What is the reason that we don’t use dividend payments to stockholders in our valuation model, but use free cash flows instead? Very difficult to know exactly how much dividends a firm pays due to management discretion. NPV of FCF is a decent substitute to NPV of dividends paid. 2. (4) If you are using data from a commercially available database such as COMPUSTAT, what significant limitations of the data (identify at least two) are potential problems for your analysis? Data could be manipulated or contain bias. 3. (2) What does the framework of Porter’s 5 forces help us estimate in the process valuing a company (your answer will be more than helping estimate cash flows)? Threat of new entrants, Threat of substitutes, Rivalry, Bargaining power of consumers, bargaining power of suppliers 4. (2) Netflix has a sterling record of increasing revenues, profits and free cash flows. Is it possible that an analyst would nevertheless say that Netflix has “low quality” earnings? Explain your answer. It is possible that an analyst would say Netflix has a low quality of earnings. If earnings were attributed to outside source such as inflation this could be considered low quality of earnings. 5. (4) Income statements have a bottom line of either “net income” or “comprehensive income.” What is a general description of what is the difference between net income and comprehensive income? Give one specific example of an income statement item that is included in comprehensive income but not in net income? Net income is the firms profit earned while comprehensive income is net income after all recognized changes in equity have been subtracted out. 1 6. (3) If management decides to reduce the 2010 expenses by overvaluing the inventory by $2,000, the reduction in the COGS is temporary rather than permanent so long as the 2011 inventory is correctly stated. Create a simple example to demonstrate this reversal of the erroneous accounting (ignore taxes). When going to sell the inventory next year, will be overvalued and thus would create an overvalue in your expenses for the following year. 7. (3) If you decide that a company’s contingent liability is understated by $1,000, and you correct the balance sheet for this error, what journal entry would you make (or what accounts would you increase/decrease and by what amounts?) to achieve the adjustment (assume the average tax rate is 30%)? 8. (2) Why is long-term operating leases a problem when you analyze a company’s financial position and performance? finance the acquisition of resources without showing the associated assets and liabilities off the balance sheet. Hopes to create impression of less financial risk. 9. (3) Name three general types of benchmark ratios. ROE, 10.(2) If you think a company is depreciating its plant and equipment over periods that are longer than the useful lives of the assets and you estimate the dollar amount of the understatement of depreciation expense for the current year, why is it still nearly impossible to calculate the impact of this error on ROE? 2 19.(2) If Netflix were to allow its cash balance to increase, and it invested this excess cash in safe securities that earn 4% annually, would this strategy increase, decrease, or leave unchanged the value of the company? Explain your answer. 20.(2) What are the implications of a long-run trend toward lower total asset turnover for a company are ROE and its valuation assuming that profit margins and leverage remain unchanged and revenues are increasing at a constant rate? A long run trend toward total asset turnover will decrease the value of the firm. It means sales have decreased in comparison with the increase in dollar of assets. Less cash flow. 21. (3) Give an example of how a management compensation plan that bases bonus amounts on the improvement in the current year’s earnings may motivate managers to take actions reduce the value of the firm. Management compensation plans to hit earnings marks propel management to act dishonestly in revenue and expense recognition. 22.(2) If Blockbuster has a forecast of negative operating and investing cash flows for the next few years, what will determine whether it is able to survive until its performance improves? Firm may hold cash or other assets In excess of what is needed to support operations. 23. (3) Do you expect the financing cash flows to be positive or negative for a mature, profitable company that growing at a steady rate of 5% and producing an ROE equal to its cost of equity capital (no changes in capital structure or asset efficiency)? Explain your answer. Expect financing cash flows to be positive for a mature growing company, 5 24.(2) We know that bad managers may use accounting flexibility to manipulate earnings to make the firm’s performance appear more favorable than it is. Does this accounting manipulation also manipulate our estimate free cash flows? Yes it affects our estimate of free cash flows. Accounting transactions such as capitalizing certain assets can affect cash flows. 25.(2) If you are preparing a cash flow statement, does a credit change in a liability account signal a net increase, decrease, (or it depends on the liability) change in cash flow ? A credit change in liability signals a decrease in cash flow. We are just adding to the balance in the liability account. If this was a credit change to an asset, this would signify movement in cash flows. 26.(3) Economists describe the cost of equity capital as the investor’s opportunity cost. Explain what is meant by “opportunity cost.” Opportunity cost is the return on the next best alternative investment with equivalent risk. 27.(3) We use the “risk free” interest rate in the estimate of a company’s cost of equity capital. Explain why this risk free rate is the rate on long-term government bonds rather than a rate on corporate bonds or a short-term rate. Government bonds are considered risk free b/c it is perceived as the government defaulting on its loans as very unlikely. The short maturity date of these bonds also protects the investor from the interest rate risk present in all fixed rate bonds. 28.(3) Most of us conducted sensitivity analysis on the valuation of BBI or NFLX by allowing the estimated cost of equity capital to vary. If you had sufficient time, what other variables would be important to vary in your sensitivity analysis (name the two most important)? Why these two? Vary the cost of equity capital around your point of estimate Test a wider range of cost of capital amounts when less confident 6 29.(2) In the short-run, selling, general and administrative costs can be difficult to forecast. This is especially true during a recession when revenues decline. Why is this case? SGA expenses are highly variable in the short run bc many expenditures are discretionary, such as research and development costs 30.(4) If you are using quarterly reports to help forecast the current year’s annual financial statements, what two techniques can be used to avoid the distortions caused by seasonality? Trailing 12 months comparisons Year over year comparisons 31.(4) When determining the optimal capital structure of a company, the CFO balances competing arguments for higher leverage and for lower leverage. What are the two competing arguments? Since leverage allows you to use other peoples money then a high leverage places you in a riskier position. This puts you in great position if price goes up, but a worse position if price goes down. 32.(3) Earnings per share forecasts are produced by eVal. What is the importance or use of these forecasts in determining the value of a company? EPS is important, however two companies could generate the same EPS but one could do so with less equity. This company would be more efficient at using its capital to generate income. 7 a. Price/Earnings Ratio? P/E increases as cost of capital decreases b. Market/Book ratios? M/B increases as cost of capital decreases 51.What are four possible explanations for the long term upward trend in average M/B ratios over the past 40 years? Lower COC, Higher Growth, Residual Income, Acc distortion. 52.If accounting values are equal to true economic values, residual income is expected to grow 5% annually forever, and the company does not pay dividends, what is its theoretical forward price/ earnings ratio if the cost of equity capital is 25%? F. P/E= 1/r-g 53.On average do you expect large cruise companies such as CCL and RCl to have high, low, or average A. Price to earnings ratios? Why? above average, they are mature companies but expected to still grow, cost of capital can be controlled, average risk, middle road. B. Market/Book ratios? Why? Average, profit and growth all average. 54.We are always interested in the opinions of other financial analysts, but we know to not completely trust the objectivity of many analysts. What is the basis of our caution? High amount of bias, have financial interest in the company. Data could be manipulated. Analysts try to stay in the good graces of companies. Poor ratings will allow managers to blackball analysts. 55.Describe the method that eVal uses to quantitatively estimate the probability that a company will default on its debts. Net Income/Total Assets is a ratio used to estimate the probability company will default on its debts. Other ratios are TL/TA. Also historical data. 56.Earning quality is widely used concept when analysts discuss a company’s financial reporting. What are the characteristics of financial statements that would lead to an analysts saying that a company has “high” earnings quality? Statements were prepared in accordance with GAAP and can be relied upon to make decisions. Be concerned if NI-OCF is greater than 5% of total assets. If NI is increasing faster than OCF, bad news. 57.Do you expect financing cash flows to be positive or negative for a rapidly growing company, and why? Positive, this is due to the borrowing of money for infusions of cash into the company. 58.If you decide that company’s liabilities should be increased to reflect a contingent loss, what entry would you make to prepare a pro forma balance sheet containing the additional liability? Assume that the amount of the increase in liabilities is $2000 and the marginal corporate tax rate is 35%. RE 1300 Deferred Tax Asset 700 Liability 2000 59.Describe how an analyst could use cash flow information to detect the manipulation of reported earnings by management most often takes the form of reporting earnings 10 that overstate the actual performance of the company. Check the operating cash flow section to see if cash was positive or negative. Can view if earnings are from normal operating activities. 60.When financial analysts talk about quality of earnings what do they mean by this term? Quality of earnings refers to the strength of earnings as related to how they are presented. Analysts focus on prediction of future performance. 61.Give eight examples of accounting methods that are likely to distort financial statements or are easily manipulated by management. Lifo Inventory Depreciable lives of asset Straight line depreciation Deferred tax assets Contingent liabilities Operating Leases Deferred tax liabilities Amortization Any estimates 62.When a company has a gain (loss) from selling a fixed asset, why is the gain subtracted from net income to arrive at cash flows from operations? Non cash gain (loss) included in NI needs to be back out to obtain cash flow. 63.What are the four broad categories of financial ratios that we use to evaluate companies? Asset turnover, Profitability, Short term liquidity, Leverage 64.What are two of the reasons ROE displays the mean reversion characteristic over time? ROE reverts back to the mean over time b/c highs and lows in ROE can be attributed to seasonality, or a sale of a onetime asset that cannot be repeated. 65.What is the formula that is commonly described as the basic DuPont Model? ROE=NI/Sales X Sales/AVG TA X AVG TA/AVG CSE 66.What are three ratios that can be used to decompose the efficiency of a company’s net asset use?Asset Turnover Ratio, Inventory Turnover ratio, NWC turnover 67.Why is maintain a cash balance that is larger than necessary to support normal operations generally good for a company’s creditors but bad for a company’s equity investors? Know have a better chance of collection all company owes them, more likely to pay debt. Investors do not like this b/c would rather have money given to them in dividends. 68.Why might you be concerned if you observed a large decrease in a company’s inventory turnover ratio? Holding inventory for longer periods of time before they sell it. Means inventory efficiency is lower, possible reasons are lower sales or lower purchasing of inventory. 69.If you were the CFO for RCL or CCL and you were responsible for deciding on the optimal capital structure of your company what is the most critical variable you would be concerned about in the determination of how much debt the company 11 should have in its capital structure? Balance operating and financial risk, minimize weighted average cost of capital. 70.If a company has a history of several years of negative cash flow to all investors and you expect this to continue for at least 5 years, what are two factors that will determine whether the company can survive that long? How much they have in cash reserves or ability to bring in new cash from loans or other investors. 71.What is the conceptual differences between free cash flow available to equity investors and the increase(decrease) I an company’s cash balance(or your may define free cash flow? Free cash flow can be defined as amount of cash that a company is able to generate after laying out the money required to maintain or expand its asset base 72.We know that bad managers may use accounting flexibility to manipulate earnings to make the company’s performance appear more favorable than it is. Does this accounting manipulation change net cash flows? Why or why not? Yes does change cash flows, accounting manipulation such as capitalizing what should be expensed. 73.If you are preparing a cash flow statement, does a debit change in an asset signal a net increase, decrease change in cash flow when you prepare a cash flow statement? Decrease in cash flow, example would be increase in A/R, this means money owed to you has increased, not that you have collected any of it. 12