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www.onlineeducation.bharatsevaksamaj.
net
www.bssskillmission.in
Business Valuation and

Analysis Using Financial
Statements
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(15.535)
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www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
www.onlineeducation.bharatsevaksamaj.net
Who?
Professor Peter Wysocki Peter

Office Hours:
Anytime Make appointment by e-mail.
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When?
Section A
Section B
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Attending OtherSSections:
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Check with.B
me first . Usually No
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Problem
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What?
Primary Objectives
Provide knowledge to help you get a great job.

Provide information for job interview questions.
Promote you as MIT students website.
Learn how to use financial information to Value
and Analyze firms.
Apply your economics/accounting/finance skills to
issues in todays news to help understand:
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What is contained in financial reports

Why firms report certain information
How to be a sophisticated user of this information.
What My objectives
My objective is not to make your life

miserable.
My objective is not to overload you with
irrelevant assignments or make-work tasks.
My objective is to make this class relevant,

useful, stimulating, fun and enjoyable.
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You have many commitments But, the lowestcost, lowest effort approach to benefit from and
cruise through this class is to attend class.
Basically, I am serving it to you on silver platter.
Why?
Provide up-to-date applied knowledge of:

Fundamental valuation techniques
Pitfalls of accounting reports
Reading between-the-lines of financial reports.
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Very useful for your career as:
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Financial analyst, I-banker, consultant, etc.
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Discuss up-to-date and hot topics that

companies face today.
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This W
information will be extremely useful for your
job
Winterviews and your job.
How?
Coursepack
There is no required coursepack! I will provide

handouts and lecture notes during each class.
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Lecture Notes & ClassEHandouts
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Also accessible through
the class server prior to
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each class. .B
If you are missing material for a
particularW
class, please obtain them from the Web
Wsure you do not fall behind.
to make
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How Prep for Class
Short reading assignments from the text and

handouts will be provided at the end of each
class.
The textbook chapters to be covered in the
next class will be listed in the class handouts.
We will not cover every part of each chapter
in the text! Concentrate your efforts on the
short assigned readings.
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How Grading
6 "e-assignments" (count best 5)

2 Quizzes (in class)
Analyst Reports/Presentation (Team)
Class Contribution (Particip/other)
Total
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50 pts
200 pts
150 pts
100 pts
500 pts
How Assignments
These short applied assignments will be

assigned about 1 week before each due
date.
You may work alone Ior
in a team of up
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to 4 students.
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Be prepared toSS
discuss and defend your
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(or yourWteams) analysis during the
class discussion
on the due date!
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How Analyst Reports
Student teams (up to 4 students) will be

responsible for creating and presenting an
analyst report on a company of their choice.
This comprehensive analysis is similar to the
reports generated by Wall Street analysts.
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How Classroom Approach
The classes will be casual, fun and informal.
I think the best way to learn is through

numerous examples. Therefore, we will
examine many interesting cases from the
todays financial press on topics of current
importance.
To keep things lively, I will ask questions and
get your input during class. My questions are
not intended to put you on the spot I am a
very easygoing and forgiving person -!
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Financial Statement Information
Used extensively by internal users
Management at various levels
Performance evaluation
Competitive analysis
Investment decisions
Valuation of targets
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Current and future employees
Is this firm going to meet its payroll and will the

stock options be worth anything?
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Financial Statement Information
Used primarily by external users

Financial intermediaries (analysts)
Stock recommendations
Lenders
Loan decisions
Monitoring
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Investment bankers
Valuation for M&A and IPO

Top management performance evaluation
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Financial Statement Analysis
Financial statement analysis and business

analysis applications
Focus is more than a mechanical analysis of
financial statements.
Draw heavily on your understanding of finance,
economics, marketing, and strategy.
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Combine that understanding
with financial statement
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information .to
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solutions/recommendations
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What the course is NOT about
Extreme details of financial reporting rules

and financial statement preparation.
T-accounts and journal entries.
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Market Efficiency and the Role of
Implications of stock market efficiency:

Many profit-maximizing, actively competing traders
Information almost freely available to all participants
Competition means that the full effects of new information
on intrinsic values are reflected instantaneously in prices
Stock prices rapidly adjust to new information such that
the new price promises only a normal rate of return to an
investor
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If markets are efficient, then whats the use of

Fundamental Analysis and Valuation?
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Market Efficiency and the Role of
Conflicting evidence on market efficiency
Markets are Efficient:

Markets reaction to news events is instantaneous.
Mutual funds have on average been unable to outperform
broad indexes; in fact, generally under-performed.
Why publish secrets instead of making money
yourself?.
Markets are Inefficient:
Growing evidence of easy ways to beat market.
Greater acceptance of Behavioral Explanations for
stock market fluctuations.
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Market Efficiency: What is My View?
I am not dogmatic about efficiency.

Let the evidence accumulate and speak for itself.
Then you can decide.
On the other hand, financial (stock) markets are very

competitive.
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It is not easy to make money
above the expected rate for
return for a given levelSofV
(beta) risk.
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Trading strategies
are
not free of risk (Long Term Capital).
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Regardless W
of your allegiance, knowing state-of-theW and lingo from the The Street (postart techniques
W announcement drift, PEG ratio, B/M effect)
earnings
will certainly help get you a great job!
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Where Next? .. Prep for next week
1) Make sure you register on class server!

2) Form teams for assignments and the Analyst
Project (maximum of 4 people). Submit the
names of your team members (and e-mails)
to me on a piece of paper by end of Next
Class.
3) Next Class Valuation Basics.
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Preparation: Review your Finance Notes on DCF

(or skim section in Brealy and Myers)
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15.535
Class #2
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Valuation
Basics
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Homepage Address
http://mit.edu/wysockip/www
Or
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(ClickSon
V Analysts)
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CheckW
here for examples of projects
fromWprior years.
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Where Next?
Readings for Class #2 (Today)

Review your Finance notes on DCF
Skim Section B of Course Pack: Free Cash Flow
to Equity Discount Models (from Chapter 14 of
Investment Valuation by Damodaran)
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Readings for Class #3E(Tuesday)
Cash
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Flow Analysis
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Skim Section.B
D of Course Pack: Income versus
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Cashflow
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Reminder
W to form teams for project
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Recap From Last Class
Market Efficiency
Financial Statement Information used for:
Valuation
Contracting
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Today lay the S
groundwork
for valuation
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Take baby steps
.B by end of class will have
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basic tools
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Firm Value and Future Cash Flows
The value of a firm (or shares in that

firm) must be related to the (net) cash
flows returned to owners of the firm.
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If this is not true, then we have an arbitrage

opportunity (money-making machine)
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Expected future
cash
flows
versus
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actual future
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What is the source of flows?
As a first step, one must understand how firm

will generate cash flows in the future!
Strategy, Economics, Marketing, Operations, etc.
Must appreciate competitive market forces:
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If a company has a great
idea that will generate
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huge profits, competitors
soon will follow!
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Barriers to entry,
first-mover advantage, monopoly
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How will Compaq
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profits,
cash
flows?
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DCF is fundamental to everything we
will do in this course
Must understand DCF analysis!
When we perform any type of valuation

analysis It will always boil down to DCF!
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P/E multiples, PEG ratios,
price targets
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These all are transformations
of
DCF.
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Other factors
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just extensions
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Baby Step #1: Simple PV
Question: How much would you be willing to

pay to purchase 1 share in a company that
will pay you a one-time cash flow of $100 to
be paid (with no risk) in one year?
PV = CF1/(1+r)
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(Obtain r from
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http://research.stlouisfed.org/fred/data/irates.html
PV = $100/(1+0.0136)
PV = $98.66
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Present Value of Free Cash Flows
If you could buy shares in this firm for less

than $98.66, what would you do?
If the price of the shares is more than $98.66,
what would you do?
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People are greedy (which is good)! While

markets may not be perfectly efficient, they
are certainly competitive!
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PV - Fundamental part of Valuation
PVToday=E(CF1)/(1+r)
This simple version of general DCF analysis says

it all and it it really simple all we need to do
is:
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1) Estimate future cash flows

2) Estimate discount rate (future risk)
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Where do we get future cash flows (crystal

ball?) Financial statements!
Where do we get estimate of future risk?
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Baby Step #2: Future CF and Risk
What is the present value of a one-time

riskless cash flow of $100 to be paid in two
years (Assume r=1.36%)?
PV = CF/(1+r)2 = 100/(1+0.0136)2 = $97.33
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What if we are not certain that we will receive

exactly $100 two years from now?
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Use a higher discount
rate
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Systematic
risk is only relevant!
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Discount rate only determined
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diversifiable risk.
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Baby Step #3: Many CFs
What if the firm will generate many cash flows

at different times in the future?
PV = CF1/(1+r)+CF2/(1+r)2+CF3/(1+r)3+
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Example: Calculate the present value of three

$10 cash flows paid at end of year 1, year 2
and year 3. Assume discount rate of 10%.
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PV = 10/(1.10)+10/(1.10)
+10/(1.10)
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PV = 9.09
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2
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Baby Step #4: Perpetuity
What if we received $10 a year

indefinitely? Seems like a lot of work .
PV = CF1/(1+r)+CF2/(1+r)2+CF3/(1+r)3+
Formula for perpetuity: PV = P = CF/r
Check back of todays handouts for a proof of
this nifty formula.
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Useful for calculating terminal values
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Quick Aside: P/E ratios
As a preview to topic on Comparative

Analysis (Class #5), we can see that
P/E Ratio is really just a DCF formula!
As a first approximation,
accounting can
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be thought of a proxy
for net cash flows
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available to shareholders.
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What if W
firm will generate constant
Earnings
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P/E ratios example
Perpetuity Formula:
P = CF/r = E/r
CF= Free Cash flows, E = Earnings
Therefore, re-arrange to get:

P/E = 1/r
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What is the P/E ratio of a stock randomly

picked from the S&P 500?
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Baby Step #5: Growing Perpetuity
It seems a little extreme to assume that

cash flows will be constant forever.
Why might cash flows grow in the
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These are nominal
amounts.
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The discount
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inflation.W
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Value of Growing Perpetuity
Example: Calculate the present value of a

cash flow stream that starts at $10 one year
from today, and then grows at a rate of 5%
per year thereafter. Assume discount rate of
12%.
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PV = CF/(r-g)
PV = 10/(0.12-0.05)
PV = $142.86
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Warnings!!!
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After just just 5 baby steps!
Single cash flow:

PV = CF1/(1+r)
Single cash flow in n years from now:

PV = CFn/(1+r)n
Multiple cash flows in future:
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PV = CF1/(1+r)+CF2/(1+r)2+CF3/(1+r)3+
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Perpetuity of fixed cash flows:

PV = CF/r
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(1st CF is at the end of year 1!)
Growing Perpetuity:
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PVW
= CF/(r-g) (1 CF at end of year 1, then grow at g)
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Understanding
P/E ratio (just restating DCF!)
st
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Warnings!!!
Always draw a time-line for yourself and

label the cashflows!
Know when they occur (beginning/end of
period)
Make sure discount rate and growth rates
are reasonable!
Growing perpetuity:
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Discount rate r must be larger than cash flow

growth rate. Otherwise you will get garbage.
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PV of what? Equity or Enterprise?
Equityholders? (i.e. shareholders) Valuation

goal is often to determine price of 1 share:
Equityholders are residual claimants.
They receive the leftover cash after paying who?
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All Investors? (Shareholders
and Lenders)?
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Known as Enterprise
Value
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DCF looks the
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CFs are usually different for equity versus enterprise.
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Risk is different.
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Valuation
1) Equity valuation:
Forecast free cash flows available to equity.
Discount expected cash flows by the cost of equity
capital.
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2) Enterprise (firm or asset) valuation:
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Forecast cash flows available to all providers of

capital (debt and equity).
Discount expected cash flows by weighted
average cost of (debt and equity) capital
Can get equity value by subtracting value of debt.
Widely used in practice.
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General Valuation Approach:
First: Forecast cashflows over finite horizon

(usually 5 to 10 years), final year is terminal
year.
Second: Forecast cashflows beyond terminal
year (invoke assumptions)
Third: Discount by appropriate cost of capital
(if Enterprise, then WACC)
Fourth: (if using Enterprise valuation):
Subtract estimated market value of debt to
get current estimate of equity value
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Forecasting CFs
Not as easy as it might appear! This is where

analysts earn their keep!
We will spend a whole class on this topic.
Key issue is that we need to find free cash

flow that is leftover for investors.
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Some analysts S
forecast
but this is a simply
.B an approximation.
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Examples: DCF Valuation
Back of the envelope valuation of

Compaq Computer using:
1) Equity Valuation
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Use analysts estimates of earnings to help us

get future cash flow estimates
Use CAPM to get estimate of r
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2) Enterprise valuation
- Similar approach, but value CFs available to

all investors.
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Method #1: Equity Valuation
Step 1: Forecast earnings for the future

Often difficult to directly forecast free cash flows.
Where can we get quick estimates of future CFs?

Lets forecast earnings: Analysts forecast earnings
But, earnings are NOT cash flows!
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Step 2: Adjust earnings (net income) to get

free cash flow to equity:
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Free Cash Flow to Equity = Net Income

(CapEx Depreciation) Working capital
Accruals + (New debt issued Debt Repayment)
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Equity Valuation continued
Step 3: Forecast capex, depreciation, working

capital accruals, & debt transactions
PROBLEMS: Investment and debt issuance are
often lumpy! What does depreciation tell us?
A useful simplification for quick and dirty analysis:
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Assume future average CapEx=Depreciation
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Assume constant average
debt (Issue=Repay)
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Steady state working
capital accruals average to zero.
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Therefore,
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Wclass, we will spend time doing detailed

In next
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calculation
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Equity Valuation Continued
Step 4: Calculate the PV of equity cashflows:
Years 1-4 are easy!

Year 5 & beyond: Use our special formulas.
PV = CF/r OR
PV = CF/(r-g)
WARNING: This is the present value standing in
year 4! This terminal value that must be
discounted back to the present
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Equity Valuation: Compaq Computer
Step 1: Use analysts earnings forecasts from

Yahoo! Finance
EPS(Year ended Jan. 2003) = $1.78
EPS(Year ended Jan. 2004) = $2.04
5 year average growth forecast = 14%
EPS(2005) = EPS(2004) *1.14 = $2.33
EPS(2006) = EPS(2005) *1.15 = $2.65
EPS(2007) = EPS(2006) *1.15 = $3.02
What about 2006 and beyond? Assume growth

rate based on understanding of economics!
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Equity Valuation: Compaq Computer
Step 2: Adjust Earnings to get Free

Cash Flow:
Quick and dirty assumption 1: Working
Capital Accruals equals zero
Quick and dirty assumption 2: Depreciation
equals long-run capital reinvestment
Quick and dirty assumption 3: Average
debt issued = debt repayments
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Step 4:W
Calculate
PV of all cash flows
Today, we will use CAPM

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Enterprise Valuation: Compaq Computer
The alternate method is Enterprise

Valuation.
If Firm has no debt, then
just
apply
the
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straightforward equity
valuation method.
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However, if firm
has debt, then we want
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to create W
an What if scenario: What if
the firmW
had no debt?
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Enterprise Valuation: Compaq Computer
RESULT: Steps 1 and 2 are the same.
New Step 3: Forecast after-tax net

interest payments.
New Step 4: Calculate cash
flows
for
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unlevered firm.
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New Step 5: Discount
cash flows using
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WACC. W
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Review Examples in Coursepack
See example valuations in Coursepack

(Section B Free Cash Flow to Equity
Discount Models Ch 14 of Damodaran)
Singapore Airlines: Page 360-361
Nestle: Pages 365-367
Tsingtao Breweries: Pages 370-372
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Note that each case isE
just
simple ideas we discussed
in class today!
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Reading for next
class: Skim pages 69-88 of
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Section D of
Course
Pack: Income versus
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Cashflow
(from Financial Reporting and
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Statement
W Analysis Stickney and Brown)
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Class #3
Cash Flow Analysis
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Quickie Announcements
In class on Thursday: Submit form with

names of team members and your 3
company choices for project.
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Matching team members.
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Cash Flow Statement
Cash flow statement
Undo the current period accrual adjustments
affecting
Operating, Investing, and Financing activities
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Operating activities (income statement)
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Changes in receivables
and inventories
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Real changes
Win accounts payable and taxes
Changes
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payable
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Depreciation
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Cash Flows over the Firms Life Cycle:
Implications for CF Projections
Sales
Net
Income
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CFO
Investing CF
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Financing CF
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Indirect Cash Flow Statement:
Example
Indirect method: Walmart Stores, FY ending January

31, 2001 (000 dollars)
Net income
$6,295
Adjustments
Depreciation and amortization
Increase in Accounts Receivable
2,868
(422)
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Increase in Inventories
Increase in Accounts Payable
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Increase in Accrued Liabilities

Deferred income taxes
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2,061
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342
Other
(1,795)
244
Cash flow from operating activities
$9,604
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Cash Flow Analysis - Walmart
CFO = NI WC Accruals + Deprec

= NI ['NonCash CA - 'CL) + Deprec
= NI ['AR + 'Inv - 'AP - 'AccLiab] + Dep
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= 6,295 [422+1,795-2,061-11] +
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342 + 244 + 2,868
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= 6,295 422
.B - 1,795 + 2,061+ 11 +
W 342 + 244 + 2,868
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= 9,604
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Cash Flow Statements: Look for
Creativity in Classifying Cash Flows
Classification of pre-opening costs by 50-Off Stores

(a retailer)
Pre-opening costs of $7.7 million as investing activity
Operating cash flow in millions

Reported
Reclassifying pre-opening costs
Adjusted operating cash flow
$10.3
(7.7)
$2.6
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The next year, 50-Off Stores
changed the
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classification to operating
activity
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Comparison: The
Gap,
Inc.
Annual
Report
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Costs associated with the opening or remodeling of stores, such as preopening rent and payroll, are expensed as incurred. The net book value of
fixtures and leasehold improvements for stores scheduled to be closed or
expanded within the next fiscal year is charged against current earnings.
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Cash Flow Analysis: Trend Analysis
Red flags: Growing discrepancy between net income

and cash flows
Premature recognition of revenues
At a later date, A/R written off

IBM in early 1990s: Over-booked revenues from
leases and shipments to distributors
Bausch and Lomb
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New sales strategy in 1993: Instead of direct shipments to

high-volume customers, business through distributors
Shipments to distributors included in revenues
$25 million revenues booked in the final weeks
B&L collected only 15% of the cash that distributors were
scheduled to pay
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Cash Flow Analysis: Trend Analysis
EBX & CFO( $ millions)
Lucent: CFO vs Earnings Before Extraordinary Items

5
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S
-10
CFO
EBX
.B
-15
Year
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Cash Flow Analysis
Red flags: Growing discrepancy between net

income and cash flows
Undervaluation of liabilities
Reduced accrual for warranty expense
N
I
.
E
Overcapitalization
Asset write downs in later periods, no cash flow

effect
V
S
S
.B
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63
Cash Flow Analysis Amazon.com
Operating Section
Consider year ended December 31, 2002
GAAP NI = ($149M)
Pro forma net income = ($66M)
Cash flow from operations = $174M
Question: What are main reasons for difference?
Why would Amazon focus on Pro forma
numbers in its press releases?
N
I
.
E
V
S
S
.B
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64
Cash Flow Analysis
Investing activity
Managements expectations
Increased investments if high growth is forecasted
Effect of the nature of business
N
I
.
E
Capital intensive
High investment in PP&E
V
S
Distribution/retailing
S
.B
Leased outlets
Capital leases or operating leases
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65
Cash Flow Analysis: Amazon.com
Investing activity
What does cash largest inflow come from?
Does this provide useful information about
operational investments?
N
I
.
Compare 1999 to 2002
for Sales vs
E
V
Purchases of marketable
securities:
S
S
What does
this
.B tell us about cash-burn?
W
W
W
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66
Cash Flow Analysis
Financing activity
Effect of the nature of business
Who finances with debt?
Growth options versus assets in place
N
I
.
E
Debt capacity of assets
Tangible assets, Steady cash flow generation

Investment not unique to the firm
Tax advantage of debt
V
S
S
.B
Related to current operating performance
W
Growth associated with investing and financing
W
W
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67
Cash Flow Analysis: Amazon.com
Financing activity
Proceeds from exercise of stock options key

thing to examine. Is this a good thing?
What type of firm is Amazon?
N
I
.
E
Growth options versus assets in place?
What type of financing would you expect?
V
S
S
.B
Lets examine financing in past 5 years:
Look at 1999 Proceeds from long-term debt

What type of debt did Amazon issue?
Is this debt financing?
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68
Cash Flows: Definitions
Back to course objective: Valuation and

Analysis For DCF Valuation, we want FCF!
Use Operating, Investing and Financing sections
Other Definitions of Cash Flow? (handout)
General Strategy for Valuation
N
I
.
Take current financial statements
(Income
E
Statement, Balance V
Sheet and Statement of Cash
S
Flows) and project
into the future
S
B are sustainable trends and what things
.
Key Issue: What
are transitory?
W
How
much reinvestment is required now (or in the future)
W
to maintain and grow the business?
W
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69
Cash Flows: Levered versus
Unlevered FCF
FCF to a levered firm (ie the FCF to the

equityholders of a firm with debt) is simple to
calculate:
FCF = CFO + CFI
(CFO is usually >0, CFI is usually < 0)
N
I
.
E
What about enterprise valuation?
Must determine FCF to levered firm (ie create

an all equity firm):
V
S
S
.B
W
Waste
WManagement example
W
FCF = CFO + after-tax interest CF + CFI
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70
Cash Flow Analysis
Performance assessment: What is the

benchmark?
Stage in a firms (product) life cycle:
Young, growing versus mature firm
Industry:
N
I
.
E
V
S
Capital intensive versus labor intensive

Length of operating cycle
Assets in place versus growth options
S
.B
W
Peer
W firm comparison
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71
Cash Flow Analysis
Technology, growth firms like Microsoft
Software, growth options firm: Not much

depreciation
Financing activity: primarily related to
equity
N
I
.
E
V
S
S
.B
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72
Cash Flow Analysis
Airlines
Cash flow from operations is large
compared to Net Income, even in loss
years
Large depreciation and large investing
amounts
Debt financing
N
I
.
E
V
S
S
.B
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73
Cash Flow Analysis
Retailers:
Walmart: Large wedge between CFO and
Net income: Why?
Compare to Abercrombie and Fitch
ANF
2000
Net Income
$158M
CFO
S
.B
V
S
N
I
.
E
$152M
1999
1998
$149M
$102M
$153M
$169M
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74
Next Class: Using Accounting
Earnings for Valuation
Reminder about projects team names and

company picks due next class
Additional reading for todays class: Look at
examples in Section D of course packet
(Income versus cash flows),Netscape (page
72), Walmart (page 73), Merck (page 75),
American Airlines (page 76).
Reading for next class: Handout about
accounting valuation
Assignment #1 will be distributed on
Thursday.
N
I
.
E
V
S
S
.B
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75
Class #4
Using Accounting Earnings
for Valuation
N
I
aka EBO Valuation
or
.
E
Abnormal Earnings
Valuation
or
V
S
S
Residual
.B Income Valuation
W
W
W
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Where have we been & where are
we going?
Where have we been?

Valuation Basics
Calculating Cash flows
Today
N
I
.
E
Overview of Dell Abnormal Earnings Valuation
Quickly discuss accounting and real options
V
S
What we still need?
S
.B
Other techniques: Multiples Valuation (Next Class)

Forecasting earnings and cashflows
Avoid being fooled by financial statements
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Discussion of E-Assignment #1:
Dell Valuation
Approach to teaching Financial Valuation &

Analysis:
First, we define the problem we are facing, then knowing the
context, we build a set of tools to solve the problem.
N
I
.
Must estimate earnings, cashflows,
balance sheet items.
E
Must avoid the pitfalls ofV
misleading financial reports
S
managers may want
to
fool you.
S
B growth, etc.
Must estimate risk,
.
Yahoo! data
Wand analysts estimates are a crutch right now.
W
W
We are starting to see the issues:
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Aside What is Value Added in
Performance Measurement?
What is Value Added?

Can we determine if company has invested capital wisely?
Starting Point: Market Value Added (MVA)

MVA for All Investors (Debt+Equity)
N
I
.
E
MVA = Market Value (D+E) Invested Capital (D+E)
V
S
MVA for Equityholders (just Equity)
S
.B
MVA = Market Value (Equity) Invested Capital (Equity)
Qualifications?
Invested Capital is from the past! Market Value is from Today!
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What is Value Added in Valuation?
The value added methodologies are used to

measure the profits (or losses) generated by a firm
for a given level of capital investment & the risk of
these investments:
Also called residual income or abnormal earnings
N
I
= Net Operating Profit after tax. Capital charge
E
V
S
S
Residual Income
for
Equityholders:
B
.
= Net Income Capital charge
W
W
W
Value Added (for all investors Debt + Equity):
NOPAT = Net Operating Profit after Tax

Capital charge = rassets * Value of Assets at start of year
Capital charge = requity* Value of Equity at start of year
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Why Abnormal Earnings or
Residual Income Valuation?
REMINDER! Valuation ultimately boils down to DCF

(or discounted dividends).
Big Problem: Estimating future FCFs or dividends.
Does there exist a meaningful way to map accounting

numbers into equity value given that cash is real?
Traditional answer: NO, given that
N
I
.
E
Accrual-based accounting numbers do not take into account

the timing of cash flows.
Earnings do not perfectly reflect investments in the same way
as FCF does.
(Most of all) Accounting numbers can be manipulated.
V
S
S
.B
BUT: DCF is based on forecasting accruals (sales,

profit margins, earnings) and then unraveling them.
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Starting Point for AE" Valuation:
Intuition:
The value of the firm (or equity in the firm) can

be the sum of three components:
1) Original Invested Capital
-
N
I
.
E
What is the starting value of funds originally contributed by

investors (equityholders).
V
S
2) Normal rate of return on Invested Capital

3)
S
Abnormal return
.B on Invested Capital
W
W
W
Basically determined by cost of capital (r).
Abnormal earnings (residual income) above normal rate of

return.
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The Model
Use this idea to express current equity value

of the firm as a function of book value of the
firms and abnormal earnings:
f
Equity Value0 = BV0 + [AEt /(1+r)t]
t=1
N
I
.
E
V
S
S
.B
where: BVt = Book value of equity at beginning of year t

r = Cost of equity capital
AEt = Expected value of abnormal earnings in year t
= Projected earnings in yr t - (r * BV of equity at
beginning of year t)
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Where does model come from?
Basically a rearrangement of the discounted dividend

or FCF valuation models.
Combines current value on the balance sheet with
the present value of future abnormal earnings.
In theory, should give the same answer as

discounted dividend and DCF (or free cash flow)
valuation models.
Uses accounting numbers (which are easy to
observe) and future projections of earnings (which
are easier to project analysts).
N
I
.
E
V
S
S
.B
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Overview of Steps of Abnormal
Earnings Valuation
Step 1: Forecast earnings in each year t=1,...,T in

the forecast horizon.
Step 2: Estimate r, the cost of equity capital.
N
I
.
E
Example using CAPM:
V
S
r = Rf + E* [E(RM) - Rf ] where
Rf = Riskless return
E = Beta on common stock
E(RM) Rf = Expected risk premium on market portfolio
S
.B
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85
Steps - Continued
Step 3: Estimate expected abnormal earnings in

each yr t = 1,..,T in forecast horizon:
AEt = Et - (r * BVt-1)
Step 4: Use r to estimate the PV of abnormal
earnings during the forecast horizon:
AE1/(1+r)1 + AE2/(1+r)2 + .... + AET/(1+r)T
Step 5: Estimate the PV of expected abnormal
earnings beyond the forecast horizon:
Use perpetuity
Use growing perpetuity
N
I
.
E
V
S
S
.B
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86
Steps Terminal Values
PERPETUITY METHOD
Estimate AE in year T+1
Assume AE constant beyond year T+1
N
I
.
E
PV of AE beyond yr T = [AET+1 / r ] / (1+r)T
V
S
GROWING PERPETUITY METHOD
S
.B
Estimate AE in year T+1

Assume AE grow beyond year T+1 forever at rate g/year
PV of AE beyond yr T = [AET+1 / (r g) ] / (1+r)T

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87
Steps Final Step
Step 6: Computer equity value by summing

together the parts:
N
I
.
E
Equity Value = BV of equity at beginning of yr 1

+ PV of AE during forecast horizon (Step 4)
+ PV of AE beyond forecast horizon (Step 5)
V
S
S
.B
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88
EBO Valuation using Dell Computer
Example.
Inputs:
BV0 = $1.80 (Book value of equity per share at the
end of the 3rd quarter of fiscal year. From latest
financials on Yahoo!
http://biz.yahoo.com/z/a/d/dell.html
N
I
.
E
2003 year end is NOW!

Therefore, small adjustment to BV0
Use estimate of current (4th quarter earnings = $0.23)
Therefore, updated BV0 = BV0 + EPS4thQ = 1.80 + 0.23 =
$2.03
V
S
S
.B
Take Yahoo! earnings forecasts for 2004:
E1 = $0.99
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89
Example.
Inputs:
% 5 year growth in EPS is projected to be: 15%
E2 = E1*(1+g) = $0.99*(1.15) = $1.14

E3 = E2*(1+g) = $1.14*(1.15) = $1.31
E4 = E3*(1+g) = $1.31*(1.15) = $1.51
E5 = E4*(1+g) = $1.51*(1.15) = $1.73
N
I
.
E
V
S
Cost of Capital (from
CAPM)
S
.B
R = Rf + Beta*(Rm-Rf)
= 5% +W
1.79*(8%) = 19.3%
W
W
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90
Example.
Calculations:
BV1=BV0 + (E1 DIV1) = 2.03 + (0.99 0) =$3.02
BV2=BV1 + (E2 DIV2) = 3.02 + (1.14 0) =$4.16
BV3=
BV4=
BV5=
N
I
.
E
V
S
AE1 = E1 r*BV0 = 0.99 - (0.193)*2.03 = $0.60
AE2 = E2 r*BV1 = 1.14 - (0.193)*3.02 = $0.55
AE3 = ?
AE4 = ?
AE5 = ?
S
.B
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91
Example.
Final Calculation:
P = BV0 + AE1/(1+r) + AE2/(1+r)2 + PV of future AE?
N
I
.
In this case, lets assume
AE 0 in year 9:
E
V
S
S
P = 2.03 + 0.60/(1+r)
B + 0.56/(1+r) + 0.51/(1+r) +
.
0.45/(1+r)
W+ 0.38/(1+r) + .
W
W
2
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92
Extreme Earnings Reverts to
Normal Rate of Return
0.2
Mean Earnings
0.15
z
z
z
0.1
0.05
V
S
`
S
.B
-0.05
W
-3 -2 -1 0 1 2
W
Event Year
-0.1
-5 -4
N
I
.
E
`
Low Earnings
Portfolio
High Earnings
Portfolio
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93
How Will Abnormal Earnings Evolve
in the Future?
By their very definition, AE are hard to

sustain:
Positive abnormal earnings Competitors enter
Negative abnormal earnings Takeover,
management fired, restructuring, etc.
N
I
.
E
V
S
Potential Problems:
S
What if Book.B
Value of Equity (BV) is incorrectly
measured?
W
Why W
might BV be too low?
W
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94
Final Calculations for DELL
Predicted Price of Dell based on abnormal earnings

valuation is:
P = _____
N
I
.
What is current price of DELL?
Around $23.00
E
V
S
S
Is our assumption
about future AE valid? Why?
B
.
W
W
W
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95
Comparison with DCF Equivalent?
Simpler than DCF:

Forecast accounting variables directly
Cost of capital calculation is easier (than WACC)
Terminal value is less important than in DCFcontext Easier to implementation assumption
about future earnings (or abnormal earnings).
Compare this with your DCF analysis for DELL!
Terminal value represents only stream of
abnormal earnings beyond the forecast horizon
N
I
.
E
V
S
S
.B
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96
Problems with Residual Income
Valuation
If the balance sheet does not recognize the

current value of assets (or fails to recognize
them at all), then what does this imply for
abnormal earnings?
N
I
.
E
V
S
Book value fails to account for certain assets that
do generate cashflows!
AEt = Et r*BVt-1
Implications for future AE?
Intangibles:
patents,
R&D,
trademarks,
brandnames, etc.
S
.B
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97
Intangibles
If the balance sheet does not recognize

intangible assets, then what does this imply
for abnormal earnings?
Measured abnormal earnings may persist
forever.
Intangibles:
N
I
.
E
V
Patents, trademarks,
brandnames, etc.
S
S
Account for investments
in a factory?
.B
Account W
for investments R&D, advertising,
W training?
employee
W
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98
Real Options
Most valuation approaches (DCF, AE,

etc) fail to account for real options:
Option to abandon poorly-performing
businesses
Option to expand the winners
Option to redeploy or adapt assets to

superior use
Option to wait before investing (gold-mine
example)
N
I
.
E
V
S
S
.B
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99
Real Options: Practical Issues
How do you take into account real options?
Practical approach #1: Consider P/E ratio or M/B

ratio for valuation. If firm is earning losses then
which should you use?
Berger, Ofek and Swary (JFE 1995)
N
I
.
Consider the type of assets
on the balance sheet
E
tangible versus intangible
(cash versus brand-name)
V
S
What type of assets
are valuable if firm crashes?
S
B
The Worst .Case
Scenario valuation of assets on
balanceW
sheet . Explains why balance sheets often
have conservative valuation of assets (Historical cost).
W
W
15.535 - Class #4
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100
Where Next?
Next Class Comparative Analysis
Priced Based Financial Ratios

Accounting Based Ratios
Skim Section F of.INCourse Reader

E
(Introduction to VProfitability
and Risk
S
Analysis).
S
B
.
Assignment
W #1 is due in class on
W February 25, 2003.
Tuesday,
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101
15.535
N
Class.I#5
E
V
Comparative
Analysis
S
S
.B
W
W
W
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102
Announcements
Assignment #1:
Hand in at start of class on Tuesday, Feb, 25th.
2 page memo (any format)
Complete individually or in group of up to 3 people
N
I
.
Valuation Projects (Post
tomorrow at NOON):
E
V & due diligence
Teams, company S
choices
matches can B
beSfound on Sloanspace.
.
W
W
W
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Recap From Prior Classes
DCF Analysis
Equity Valuation
All valuation models based on DCF framework.
Key is to estimate future cashflows.
Earnings are generally the starting point and then we can back
out cashflows.
Abnormal Earnings (or EBO or Residual Income) Valuation is a
DCF-based model that relies on accounting earnings.
N
I
.
E
V
S
Strengths and weaknesses of abnormal earnings
S
.B
Recap of Back of Envelope Valuation of Dell
Draw time-line!
Summary of Assumptions
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Today- Comparative Analysis
Valuation Comparisons (Multiples

analysis):
N
I
.
E
Compare market price (stock price) to a

benchmark of fundamental value
(i.e. cashflows)
V
S
S
.B
W
Financial
W Ratio Comparisons
W
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105
Valuation Comparison:
DCF Limitations
What if firm has:

Unknown history, Unknown implementation timing
Unfathomable market, Unknown competition, Untested product, Unknown
cost structure, Unknown market acceptance
N
I
.
E
Projecting an unknown growth trajectory
. DCF is tough!
V
S
Other DCF Limitations:
S
.B
DCF may miss growth options, options to expand, options to redirect

You may need to adjust projections for GAAP expense treatment of R&D,
customer acquisition costs, selected L/T marketing, etc. All difficult!
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Equity Valuation Analysis: What Do
Analysts Use? (Asquith et al, 2001)
Earnings Multiple
99%
P-E
97%
Relative P-E
35%
Revenue Multiple
15%
N
I
.
E
Price-to-Book
V
S
CF Multiple
DCF
S
.B
13%
13%
W
Model
W
EVA
25%
2%
4%
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CASE FOR MULTIPLES:
You wish to value Target (retailer):

Find benchmark firms: ie Walmart, JCPenny, Sears

Assume market correctly sets competitors stock prices.
Assume all firms have the same risk (systematic & industry).
Assume cashflow growth is similar for all the firms.
Assume accounting techniques to calculate earnings (or
book equity or sales or EBITDA) are similar for all the firms.
Implication: the P/E model (perpetuity or growing perpetuity)

is the same for competitors and Target Corp.
A Multiples Valuation Approach:
N
I
.
E
V
S
S
.B
Take average P/E of competitors

Multiply by Targets EPS of obtain the predicted price of Target.
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Overview of Comparative Analysis
Use of Multiples:
Method is simple to implement:

Is stock price too high/low relative to a measure of future

cash flows? (Implicit is a DCF model)
N
I
.
E
No detailed multi-year forecasts necessary.
Steps:
V
S
1) Select financial performance measure (ie sales, cash flow,

earnings, book value of equity, etc).
2) Estimate price multiples for comparable firms using the
measure of performance. Take average/median/other.
3) Apply comparable firm(s) multiple to the performance

measure of the firm being analyzed.
S
.B
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Approach to Multiples
Implicit assumptions of multiples analysis:
Assume stock market prices are mean reverting

with (not same as perfect market efficiency!)
Rely on the stock market to evaluate the prospects
of profitability and growth of
comparable/competitor firms.
Assume that the same prospects apply to firm of
interest.
N
I
.
E
V
S
S
.B
W
How toW
identify comparables?
W
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P/E Multiples
In Class #2, we showed that the perpetuity and

growing perpetuity formulae gave us direct insights
into P/E multiples:
P/E = 1/r
or
P/E = 1/(r-g)
N
I
.
E
For multiples comparisons, we assume:
V
S
Risk (r ) is the same for firms
S
.B
Therefore, industry, leverage are important

Higher risk implies lower P/E
Growth is the same for firms
Starting point is important (stage in life cycle)

Higher growth implies higher P/E
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111
P/E Multiples
What if todays earnings are not a good measure

of future earnings (cashflows)?
Solution 1: Use the forward P/E ratio (maybe firm
has write-down today)
Example: Apple Computer
N
I
.
E
Current price is $14.80 (Yesterdays price)

Earnings for last 12 months is $0.05
Trailing (or current) P/E = 296
Industry P/E is 28
Is company overvalued?
But predicted earnings for 2004 year is $0.27/share
Therefore, forward P/E = 55 (less overvalued?)
V
S
S
.B
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112
P/E Multiples
Solution 2: Use pro forma earnings

that is remove non-recurring items.
Components of Earnings:
Operating Income
Special or Unusual Items (usually negative)
Either infrequent or not part of normal business
Extraordinary Items (usually negative)
Both infrequent and not part of normal business
Use Price to operating cash flow (does not contain
one-time accounting items)
N
I
.
E
V
S
S
.B
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113
P/E Applications
Solution 3: Directly model and understand

implications of future earnings growth!
The growing perpetuity is a better
interpretation of P/E multiple in this case.
N
I
.
E
P/E=1/(r-g)
Higher expected future growth (g) means

higher current P/E ratio.
Again, higher risk (r) still implies lower P/E
V
S
S
.B
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114
Accounting for future growth directly
in ratios The PEG ratio
PEG ratio:
New metric used on the Street DCF Analysis

PEG = (P/E) / (5 yr future earnings growth rate)
See handout on PEG Ratio
Pitfalls Little theoretical underpinnings
N
I
.
E
Example: Apple computer

(see
V
S
http://biz.yahoo.com/z/a/a/aapl.html
S
B
.
Apple WIndustry
W 1.80
6.11
W
Sector
1.88
S&P500
1.36
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115
Other types of P/E ratios
Two generic categories

Using levered (after interest) flows in denominator:
Standard P/E = price (per share) of common / EPS
P/CF= price of common stock / CFO (usually
before changes in WC)
Using unlevered flows in denominator:
N
I
.
E
V
S
S
.B
[Debt + Equity] / EBIT

[Debt + Equity] / EBITDA
[Debt + Equity] / Sales
Newer jargon: Enterprise Value (EV)/EBITDA
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116
Balance Sheet multiples
What if todays (and near-term) earnings are not

relevant?
Firm is generating losses now and near future.
Difficult to predict future cash flows.
N
I
.
E
What other financial information can we use?

The Balance Sheet!
V
S
What is break-up value of company if it liquidated?
S
.B
Compare market value of equity (M=P) to the

book value of equity: M/B ratio
W
WhatW
do you expect the M/B to be?
W
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Screening Stocks on Financial Ratios
Stock screens based on financial ratios:
www.stockscreener.com (Provided by Hoovers)

www.quicken.com/investments/stocks/search
(Quicken.com)(Click on Full Search)
http://screen.yahoo.com/stocks.html (Yahoo)
N
I
.
E
V
S
S
.B
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118
Guideline approach
During Internet Bubble:

Internet valuation shifted to Guideline Method
Ignored traditional value relationships (P/E, M/B,
Enterprise value/EBITDA).
Focused on new valuation metrics like:
N
I
.
Enterprise/Revenue, P/Sales
E
V
Price to clicks, Price
to subscribers, Price to page
S
S
views, etc
B
.
Problems:
1) Are these measures of future
W
cashflows?
W 2) What if all prices are wrong?
W
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119
Preview of Non-Price Financial
Ratios: Valuation
Non-price ratios can also be relevant for

valuation, performance measurement,
and prediction
N
I
Ratios allow for comparisons
across
.
E
firms and over time:
V
S
S
.B
Profitability ratios
Short-term liquidity ratios
Long-term solvency ratios
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120
Profitability Ratios:
Example - Return on Assets
The objective is to assess how successful a firm's

operating performance as been (i.e., how successful
has the firm been at generating profits?).
Measures a firm's success in using assets to
generate earnings, independent of the financing of
those assets (i.e., debt versus equity).
N
I
.
E
ROA =
V
S
Net Income
+ (1 - Tax Rate)(Interest Exp)
S
.B Average Total Assets
W
The numerator is operating income after income taxes,

excluding any financing costs.
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Return on Assets
Decomposition of ROA: Insights into a firm's

profitability can be gained by decomposing ROA into
its components, profit margin and asset turnover.
N
I
.
E
V
S
ROA = Profit Margin X Assets Turnover
S
.B
Net Income + Interest

Net Income + Interest
Expense (net of taxes) = Expense (net of taxes) X
Sales
_
Avg Total Assets
Sales
Avg Total Assets
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Fixed Asset Turnover
Measures the relation between sales and the investment in

property, plant, and equipment.
How efficiently is the firm using its fixed assets to generate
sales?
Fixed asset turnover
S
.B
V
S
N
I
.
E
___ Sales___
Average fixed assets
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123
Return on Common Equity (ROE)
ROE measures the return to common shareholders after

accounting for the cost of debt and (preferred) equity
financing.
ROE
N
I
.
E
Net Income - Preferred Dividends
Average Common Equity
V
S
S
.B
Or
ROE
Net Income Available to Common
WAverage Common Equity
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124
Decomposition of ROE
Common
ROE =
ROA
Earnings
Leverage
(CEL)
N
I
.
E
Capital
x Structure
Leverage
(LEV)
V
S
NI Avail to Common / Avg
CEquity
=
S
B
.
(NI*/Avg TA)x(NI Avail
W to Common/NI*)x(Avg TA/Avg CEquity)
W
W
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125
Du Pont Analysis
Dis-aggregating ROE (Du Pont analysis)

ROE = Net Income / Shareholders equity
N
I
.
E
ROE = Profit margin X Turnover X Leverage
V
S
Profit margin = Net Income / Sales

Turnover = Sales / Assets
Leverage = Assets / Shareholders equity
S
.B
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126
Preview of Short-Term Liquidity
Commonly used measure of short-term debt paying

ability:
Current Ratio =
Current Assets
Current Liabilities
Matches the amount of cash & other current assets that will
become cash within 1 year against obligations that come due

in the next year. Basic rule of thumb: Minimum ratio of 1.0.
A variation of the current ratio is the Quick Ratio (or Acid

Test Ratio):
Quick Ratio = Current Assets- Inventory

Current Liabilities
N
I
.
E
V
S
S
.B
Why would we use this ratio?
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127
Operating Cash Flow to Current
Liabilities Ratio
Another measure a firms short-term liquidity.
The advantage is that it is based on cash flow

AFTER the funding needs for working capital (i.e.,
accounts receivables and inventory) been made.
N
I
.
E
V
S
Operating Cash Flow
S
.B
Average Current Liabilities
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128
Long-Term Solvency Ratios
Measure firms ability to meet interest & principal payments on

long-term debt when they come due.
The best indicator for assessing long-term solvency is the firm's
ability to generate earnings in long term.
Long-Term =
Debt Ratio
Long-Term Debt________________
Long-Term Debt + Shareholders Equity
Debt/Equity =
Ratio
Long-Term Debt
Shareholders Equity
N
I
.
E
V
S
S
.B
Liabilities/Assets = Total Liabilities
Ratio
Total Assets
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129
Summary of Financial Ratio
Analysis
Analysis of a particular firm's financial ratios

over a period of years allows one to track
historical trends and variability in the ratios
over time.
An important part of the analyst's job is to use
financial ratios to identify aspects of the firm
that warrant deeper investigation.
We will return to other ratios (ie receivables,
inventories, payables) in a future class.
N
I
.
E
V
S
S
.B
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130
Where Next?
Assignment #1 is a practical implementation

of the valuation techniques we have covered
so far:
Due at the beginning of next class
N
I
.
E
Next Class Turbo Accounting
V
S
A review of how to read a financial statement

Some recent hot accounting issues
Readings:
S
.B
Course Reader: Read pages 21-32 of Section A

(Overview of Financial Statement Analysis)
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131
Class #6
Turbo Accounting:
Reading FinancialNStatements
I
.
E
V
S
S
.B
W
W
W
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Where Now?
Where have we been?
Know how to value a company, but now we

need to understand the financials (to get
the numbers!)
Where Next?
N
I
.
E
V
S
Today Overview of Income Statement,

and Balance Sheet.
Next Two Classes: Detecting Accounting
Manipulations
S
.B
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Components of Financial Statements
MD&A, Letter to Shareholders

Selected Financial Data
What is meant by Consolidated
N
I
.
E
1) Balance Sheet
2) Statement of Income
3) Statement of Cash Flows
4) Statement of Shareholders Equity
V
S
S
.B
Footnotes
15.535 - Class #6
134
Where Next?
Next Class How Companies Cook

the Books
Readings:
N
I
.
E
Skim Course Reader pages 594-606 of

Section (E) The Qulaity of Current
Earnings.
V
S
S
.B
Handout W
Today: Sample Questions for
W
Quiz
W#1
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135
Class #7
How Companies Cook the
Books
N
I
.
E
V
S
S
.B
W
W
W
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136
Announcements
Optional Review Session for Quiz #1:

Tentatively scheduled for Wednesday, March 5
Quiz #1: In Class on Thursday, March 6. The
quiz will be approximately 50 minutes long.
Team Projects:
N
I
Provide hints/guidance today and
during Tuesdays class.
.
E counterparty part 1 of your
E-mail me and your due V
diligence
S
Teams Project Report
by noon on Friday, March 7.
S
I will be in on.B
Sunday starting by noon, to answer
questions W
about Part I of the project
W
W
www.bsscommunitycollege.in www.bssnewgeneration.in
www.bsslifeskillscollege.in
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Guidance on Part I of Project
Cash Flow Projections & Earnings Quality
Provide an descriptive analysis of your company,

its strategy for generating profit/cashflow growth,
potential competition, technological risks, etc.
Ie: How cashflows will be generated
N
I
.
E
Then, based on this strategic analysis, use

techniques we discussed in class and for the Dell
case to provide estimates of FCFE for:
V
S
S
.B
Current Year
Next 5 Years
Years 5-10 (or 20) . If necessary
Cash flows in perpetuity (growing perpetuity)
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Guidance on Part I of Project
Cash Flow Projections & Earnings Quality
Provide robustness analysis CF projections:

Differing growth rate estimates
Different assumptions on Working Capital Accruals,
CapEx, Depreciation, Financing changes
N
I
.
Analyze Earnings Quality using

discussed in this and next class.

techniques
E
V
Excessive accruals
Wedge between CFO and Operating Income
Growth in receivables that exceeds growth in sales
Aggressive accounting techniques compared to competitors
S
S
.B
W
SEE PROJECTS
W FROM PRIOR YEARS ON WEB
W
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139
Cooking the books and earnings
management/manipulation
Central theme: Firms & managers often have

incentives to misstate earnings/balance sheet
items:
Contracting incentives:
Avoid violating accounting covenants in loan agreements
Avoid taxation (Progressive tax scheme)
Maximize bonus (managers)
Avoid regulatory/government/union intervention
(understate profits)
Avoid detection of managerial shirking or outright
stealing
N
I
.
E
V
S
S
.B
Stock market incentives: Meet analysts targets
Stock options; issuing equity in near future

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Outcome of Accounting Manipulation
at Oracle in early 1990s
What happened after the revelation of overlyaggressive accounting:

Stock market impact
What happened to executives
Litigation
SEC fines
N
I
. In the end, there usually is. a settling up.
E
Do companies learnV
from mistakes of others?
S
S
Fast-forward to now:
B
2001: Lucent. Technologies
W
2002: Worldcom
W
W
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Types of Possible Manipulation
Unacceptable methods: Too liberal:
Not writing off the cost of unsaleable inventory.

Depreciation of long-lived assets over longer period than
they will be useful to the business.
Recording sales before they final (or failure to recognize the
likelihood of returns or bad debts)
N
I
.
E
V
S
Expensing cost of inventory
that will not be sold until future.
S
Over depreciating
.Bassets with long lives.
W sales that have already occurred.
Delaying recording
W
W
Unacceptable methods: Too conservative:
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Red Flags
Warnings signs to watch out for:
Reported NI grows faster than CFO.

AR growth faster than sales growth.
Sales slow while inventories pile up.
Bad debt reserves debt cut.
Methods for calculating revenue & costs change.
Sales are booked before payments received.
Dramatic change in gross margin.

Turnover of auditor, key execs or lawyers.
N
I
.
E
V
S
S
.B
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Industry-Specific Manipulation:
Warnings for your company analysis!
Computer/Telecom Hardware:
Technological change: impact on receivables & inventory,
appropriate depreciation allowances?
Retailing:
Are accounts receivables questionable?
Do sales factor on rebate programs?
Warranties liabilities
N
I
.
E
V
S
Subscription Services:
S
.B
How are promotion costs treated (capitalizes? i.e AOL)
Subscriptions paid in advance: quality of deferred revenues
W
Real Estate:
W
Carrying
W values for real property
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Problems with New Economy Firms
Recognizing sales before they exist

(iVillage)
Net vs Gross (Priceline)
Barter transactions (Starmedia)
N
I
.
E
Coupons/discounts/loss
leaders (AOL)
V
S
S
Fulfillment costs
(Amazon.com)
B
.
W
Swap Transactions:
W
See
W Handout
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145
Tricks of the Trade
Big Bath:
Take big write-off today to set up the books for the future
PROBLEM: Investors may forget write-off, Expenses are
understated in the future and earnings are overstated.
Example of Kodak with Special items
Vendor Financing:
N
I
.
Make loans to customers with
questionable ability to
E
repay loans
V
S
Understate bad debt
reserves (ie Lucent)
S
Profits too high
.B today . Big potential losses in future.
W
Booking Revenues
Too Early:
Wagain SEC SAB 101 Statement!
Check
W
Classic cases of Cendant and Microstrategy
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146
Tricks of the Trade
Defined Benefit Pension Plan Games:
What is a defined benefit plan?

Fund assets are separate from the company. Funds are
used to pay present and future pension obligations to
retirees. It must be properly funded! (ERISA ACT 1974).
Is there enough money? Need to know:
N
I
.
E
Who are beneficiaries and amount required

Rate of return of investments
Attrition rate
Growth rate in future retiree benefits
V
S
S
B make periodic payments if plan is
Company must
.
underfunded
W
BIG
WQUESTION: Is it underfunded or overfunded
WThis vagueness creates the cookie-jar for managers

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147
Expectations Management of
Analysts Earnings Forecasts
Forecast Error= (Actual EPS Forecast EPS)
N
I
.
E
V
S
S
.B
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148
Continue with Earnings Management
Next Class: We will discuss actual

techniques for detecting earnings
management for your team project.
Reminder about Review Session for
N
I
.
Quiz #1 on Wednesday.
E
V
S
S
.B
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149
Class #8
Detecting Earnings
Management
N
I
.
E
V
S
S
.B
W
W
W
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150
Recap: Why firms/managers
Cook the books?

items:
N
I
.
E
Avoid violating contracts

Avoid detection of managerial shirking
V
S
S
.B
15.535 - Class #8
151
Why do we care about earnings
management?
Avoid being fooled!:

Earnings used in deriving numbers for DCF and multiples
(P/E, PEG, etc) valuation analysis.
Use the wrong numbers & you will misvalue the firm
Earnings (and other accounting #s) to determine

financial health and the ability of the firm to pay
obligations:
Employees
Creditors
Suppliers
Etc
N
I
.
E
V
S
S
.B
What is the outcome when accounting

misstatement is detected?
Stock price reaction and legal recourse is immediate!
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152
Watch Out for Expectations
Management of Analysts!
Forecast Error= (Actual EPS Forecast EPS)
N
I
.
E
V
S
S
.B
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153
Methods for Detecting Earnings

Management
Compare volatility of accrual income
measures with underlying volatility of sales
and CFO:
Vol(Op Inc) = stdev(Op Inc over 5 years)/average (Op Inc over 5 years)
Vol(Sales)
stdev(Sales over 5 years)/average (Sales over 5 years)
N
I
.
E
V
S
S
.B
Vol(Op Inc) = stdev(Op Inc over 5 years)/average (Op Inc over 5 years)
Vol(CFO)
stdev(CFO over 5 years)/average (CFO over 5 years)
Vol( NI ) = stdev( NI over 5 years) / average (NI over 5 years)

Vol(CFO) stdev(CFO over 5 years)/average (CFO over 5 years)
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Analysis: Shared Medical Systems
Perform quality of sales analysis
Test for Earnings Smoothing

AR/SALES
% Growth in AR
% Growth in Sales
25.2%
Vol(Op Inc) = Std(Op Inc)/Avg(Op Inc)

Vol(CFO) = Std(CFO)/Avg(CFO)
N
I
.
E
V
S
S
.B
Vol(Op Inc)/Vol(CF0)
26.4%
23.9%
18.2%
27.4%
22.2%
17.9%
28.0%
19.6%
16.9%
29.9%
34.8%
26.1%
24.20%
32.64%
74.13%
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155
Team Project: Methods for Detecting
Earnings Management
What you must calculate for Part I of your Project:
Compare % growth in sales with the % growth in AR over

the past 5 years (quarters).
Calculate the ratio of the scaled standard deviation of
Operating Income over the past 5 years to the scaled
standard deviation of CFO over the past 5 years. Also,
calculate this same ratio for two of the firm's competitors
and then make a relative comparison of these ratios.
N
I
.
E
V
S
Other things you might look at (depending on your

industry):
S
.B
Compare change in NI to change in Basic EPS (Is firm

managing the EPS number by adjusting number of
shares outstanding?)
Check list of Diagnostics from last class.
15.535 - Class #8
156
Where Next?
Quiz #1 in Class on Thursday.
Open notes. No laptop
computers/PDAs/cellphones, pagers!
Bring a calculator
50 minutes long.
Priority for review:
N
I
.
E
V
S
Review sample questions

Review class notes
Review all class handouts
Skim over selected reading assigned in class
S
.B
Review Session this evening in this room.
15.535 - Class #8
157
Team Project
Part 1 of your Team Project:
I answer more questions in class on Thursday

(after quiz).
Report is due by noon on Friday, March 7.
Please ensure that the names of all team
members are on team's report.
Your complete report should merged into one file

(either PDF or MS Word format).
This file must be e-mailed to both Professor
Wysocki and to 2 members of your corresponding

Due Diligence Team by noon on Friday.
N
I
.
E
V
S
S
.B
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158
Class #12: Risk Assessment
Do Financial Statements
Capture Risk?
N
I
.
E
V
S
S
.B
W
W
W
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159
Where Have We Been &
Where Are We Going?
Team Projects
Part 1 of Projects posted on the web
Comments on projects and due dilgence
hand back after break
Part 2 Valuation: Due May 9, 2003
N
I
.
E
V
S
Quiz #1
S
.B
Solutions on class server

Comment on Re-grades
Quiz statistics
15.535 - Class #12

160
Where Have We Been &
Where Are We Going?
Class 1 through Quiz #1
Valuation Basics, Accounting-based Valuation, Multiples

Analysis
Cash Flow Analysis, Refresher on Financial Statements
Detecting Accounting Manipulations

Part 1 of Project (Cash Flow Projections/Earnings Quality
Analysis)
N
I
.
Class 12 through Quiz #2
E
Risk Assessment (Credit),
Cost of Capital Calculations
V
S
Risk and AnalyzingS
Accounting
Trading Strategies
Mergers and Acquisitions,

Stock Options
.B
Class 20 through
W Final Project Presentations
Off Balance
Sheet Activities, Pension Plans, International
W
Accounting
W and Valuation
15.535 - Class #12
161
Risk Assessment
Common-Size Financial Statements (crosssectional analysis)

e.g. Deflate all financial numbers by total assets
N
I
.
E
Trend Financial Statements (time-series

analysis)
V
S
S
.B
Compare growth rates over time
Financial Ratio Analysis
Profitability ratios, short-term liquidity ratios, longterm solvency ratios
15.535 - Class #12
162
Accounts Receivable Turnover
Measures how soon sales will be become cash:

Accounts Receivable
Turnover
=
Net Sales on Account

Avg Accounts Receivable
N
I
.
E
Perhaps a more intuitive measure of the rate at which A/R are

being collected is the days receivable outstanding:
Days Receivable
Outstanding
S
.B
W=
V
S
365 / Accounts Receivable Turnover
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163
Inventory Turnover Ratio
This ratio measures how quickly inventory is being sold.
Inventory
Turnover
Cost of Goods Sold
Average Inventory
N
I
.
E
V
S
Perhaps a more intuitive measure of the rate at which

inventory is being sold is the days inventory held:
S
.B
W
Days Inventory
W Held =
W
365/Inventory turnover
15.535 - Class #12

164
Fixed Asset Turnover
Measures the relation between sales and the investment in

property, plant, and equipment.
How efficiently is the firm using its fixed assets to generate
sales?
Fixed asset turnover
V
S
N
I
.
E
S
.B
___ Sales___
Average fixed assets
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165
Accounts Payable Turnover
Measures how quickly a firm is paying its suppliers.
Accounts Payable
Turnover
=
Purchases____
Average Accounts
Payable
N
I
.
E
V
S
Also can be expressed as:
S
.B
Days Payable Outstanding = 365 / (Accounts Payable

Turnover Rate)
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166
Analysis of Short-Term Liquidity
Sheds light on a firms ability to pay for

obligations that come due during its operating
cycle (e.g., wages, purchases of inventory).
Commonly used measures of short-term debt
paying ability include:
N
I
.
E
V
S
S
Current Ratio
.B
W
Quick Ratio
W
Operating
W Cash Flow to Current Liabilities Ratio
15.535 - Class #12

167
Current Ratio
Current Ratio =
Current Assets
Current Liabilities
This ratio matches the amount of cash and other
current assets that will become cash within one year
against the obligations that come due in the next
year.
Basic rule of thumb: A minimum current ratio of 1.0.
N
I
.
E
V
S
S
.B
15.535 - Class #12

10
168
Quick Ratio
A variation of the current ratio is the quick ratio or acid

test ratio.
Quick
Ratio
Cash + Mkt Securities + AR = CA-Inv

Current Liabilities
CL
N
I
.
E
V
S
Include in the numerator
only those current assets that
S
.B quickly into cash
the firm could convert
W
W
W
15.535 - Class #12
11
169
Operating Cash Flow to Current
Liabilities Ratio
Another measure a firms short-term liquidity.
The advantage is that it is based on cash flow

AFTER the funding needs for working capital (i.e.,
accounts receivables and inventory) been made.
N
I
.
E
V
S
Operating Cash Flow
S
.B
Average Current Liabilities
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12
170
Measure a firms ability to meet interest and principal

payments on long-term debt (and similar obligations,
like long-term leases) when they come due.
Obviously, the best indicator for assessing long-term
solvency risk is a firm's ability to generate earnings
over a period of years.
N
I
.
E
V
S
S
.B
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171
Long-Term
Debt Ratio
Debt/Equity
Ratio
Long-Term Debt
Long-Term Debt +
Shareholders Equity
N
Long-Term Debt
I
.
E
V
S
Shareholders Equity
S
Liabilities/Assets
B=
.
Ratio
W
W
W
Total Liabilities
Total Assets
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172
Interest Coverage Ratio
Measures how many times a firm's net income before

interest expense and income taxes exceeds its interest
expense.
N
I
.
Net Income + Interest Expense
+ Income Tax
E
V
Expense + Minority S
Interest
in Earnings
S
Interest
Expense
B
.
W
Interest coverage
ratios less than 2.0 suggest
W
a riskyW
situation.
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15
173
Cash Interest Coverage Ratio
Interest coverage ratio using cash flows is:
N
I
.
E
[Cash Flow from Operations +

Cash Payments for Interest +
Cash Payments for Income Taxes]
Cash Payments for Interest
V
S
S
.B
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174
Accounting, Risk and Hedging:
What is hedging?
What is hedging?
In response to financial market risks, companies

engage in hedging: business and financial
transactions designed to insulate them from
commodity price, interest rate, exchange rate, or
other risks. Derivative securities are often used to
accomplish this insulation.
N
I
.
E
V
S
Different from speculation: How?
Examples:
S
.B
Options, futures contracts, swaps, other complex

combinations of derivatives.
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175
Why do firms hedge?
The value of equity claims in the firm are:
Price = E(CF1)/(1+r) + E(CF2)/(1+r)2 + .
How can we increase firm value?

The equity cost of capital (=r) depends on the
systematic risk of the firms cash flows.
Insurable or hedgeable risks are generally
nonsystematic
Since insurance purchases apparently do not

affect a firms systematic risk, then they should not
change the firms cost of capital.
If insurance purchases affect firm value, then they
must change future expected cash flows!
N
I
.
E
V
S
S
.B
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176
Hedging and the Modigliani-Miller
Theorem
If hedging affects current firm value,

then it must:
N
I
.
E
1)
V
S
S
.B
2)
3)
W
15.535 - Class #12
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177
How Hedging Impacts Firm Value
Taxes:
A progressive tax scheme (or, at a minimum,

incomplete tax refunds of losses) means that the
more volatile a firms taxable income, the higher
its expected taxes. (See notes from last day)
N
I
.
Stockholders, employees,
bondholders, suppliers
E
V high incentives to avoid
and customers allS
have
S
financial distress.
Why?
B
.
Customers: Product warranties & long-term service
W
arrangements
W
Suppliers: Undiversified locked in to single client
Contracting Costs:
15.535 - Class #12

20
178
Hedging and the Firms Employees
Employees (from the CEO down to temp

workers) face real costs to financial distress
If the firm is risky, employees require higher
compensation (risk aversion)
Executive incentive compensation should
only impose risk on managers if they have
control over the outcomes.
N
I
.
E
V
S
S
.B
Maybe managers are hedging too much?
15.535 - Class #12

21
179
Hedging and Bondholder-Shareholder
Conflict
The agency costs of debt increase as leverage
increases and financial distress approaches
Remember: stockholders and managers are self-intereseted
Therefore, we get:the:
Dividend payout problem

Claim dilution problem
Asset substitution problem
Underinvestment problem
N
I
.
E
V
S
Hedging can reduce the likelihood of financial

distress, and consequently reduce the agency
problems of debt This means firms can have
easier access to the debt markets.
What does this mean for future expected cash flows?
S
.B
15.535 - Class #12

22
180
Summary of Risk Assessment
using Financial Informtion
Analysis of a particular firm's financial ratios

over a period of years allows one to track
historical trends and variability in the ratios
over time.
Key is compare with industry benchmarks.
An important part of the analyst's job is to use

financial ratios to identify aspects of the firm
that warrant deeper investigation.
N
I
.
E
V
S
S
.B
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181
Where Next?
Readings Related to Todays Class:
Risk Analysis pages 145-159 of Section (F) of

Course Reader (Introduction to Profitability and
Risk Analysis)
Reading for Next Class after the break

(Tuesday, April 1) Cost of Capital
Calculations
N
I
.
E
V
S
S
.B
Skim over cost of capital issues in Section (C) of

Course Reader (Firm Valuation: Cost of Capital)
15.535 - Class #12

24
182
Class #13: Risk 1
Cost of Capital
N
I
.
E
V
S
S
.B
W
W
15.535 - Class #13
183
Road Map: Where do things fit?
Valuation Fundamentals:
DCF Analysis
Comparative Analysis
Abnormal Earnings Valuation
Cash Flow Analysis
Where Now?
N
I
.
E
V
S
Equity (CAPM, 3-Factor
Model, Implied Cost of Capital)
S
Cost of Capital:
International Companies
B
.
Debt
W
Enterprise
W
W
Properly calculating cost of capital:
15.535 - Class #13

184
Approaches to Calculating Equity Cost
of Capital (Discount Rate)
CAPM based on historical information
What if risk has changed?

Recent change in capital structure?
Application:
N
I
Discounting the cash .flows (earnings)
E
available to equityholders.
V
S
S
Which cashflows?
Answer: The FCFs after
B
.
all otherW
parties have been paid (lenders,
taxes,
Wetc)
W
15.535 - Class #13
185
Calculation of CAPM discount rate
CAPM: E( R ) = Rf + E*(Rm-Rf)
Expected return is increasing in systematic

risk!
What is Beta?
N
I
Cov( R
,R
R .)/Var( R
R )
E
)/Var( R
)
Usually = Cov( RV ,R
S
Think of it asS
Co-wiggling
B
.
According
Wto this model, why does the
W risk only matter?
systematic
W
stock
market
stock
market
market
market
15.535 - Class #13
186
Where do we get the information?
Where do we get Beta?
KEY ISSUE! This is an estimate from historical

data
Estimation period is typically 60 months
Why not longer? Why not shorter?

Sources: Bloomberg, Analysts, Yahoo! Finance, or
estimate it yourself!
N
I
.
E
V
S
S
Where do we.B
get RF?
FederalW
Reserve Bank of St. Louis:
W
research.stlouisfed.org/fred/data/irates.html
W
15.535 - Class #13
187
Example of CAPM Calculation:
What is Equity Cost of Capital for

Microsoft?
Beta = 1.49
Rf = 4.87% (20 year treasury bond)
(Rm Rf) = 7.95%
N
I
.
E
V
S
S
E( R ) = R.B
+ E*(R -R )
W
= 4.87% + 1.49*(7.95%)
W =16.7%
W
f
15.535 - Class #13
188
Is the CAPM correct?
Facts: Even after accounting for Beta risk:
Small stocks tend to have higher returns than big

stocks.
Firms with high B/M ratios have higher returns.
N
I
.
E
Maybe the CAPM is a not perfect model:

Other sources of risk beyond single risk factor?
Maybe small stocks have greater systematic risk?
V
S
S
Is there a size
.B risk factor?
Are firmsW
that are near financial distress riskier?
W a financial distress factor?

Is there
W
15.535 - Class #13
189
The Fama-French 3-factor model
Origins:
Fama and French, 1993, Common Risk Factors

in the Returns on Stocks and Bonds, Journal of
Financial Economics, for a complete description.
N
I
.
R
=R + E*(R -R ) +E
*(R ) + E *(R )
E
V
Every stock has different
market E, E , E
S
S
Where do we.B
get (Rm-Rf), RSMB, RHML?
Wof Professor Ken French:
Homepage
W
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/
Wdata_library.html
An extension of the CAPM:

stock
SIZE
SMB
BM
SIZE
15.535 - Class #13

HML
BM
190
Fama-French Factor Returns
What are long-run average values of these

factors?
Long-run average (Rm-Rf) = 7.95% per year
N
I
Long-run average R . = 3.32% per year
E
V
S
S
= 5.05% per year
Long-run average
R
B
.
W
W
W
SMB
HML
15.535 - Class #13

191
Example Calculation of 3-factor Cost of
Capital
Microsoft:
Market Beta = 0.98
Size Beta = -0.40 (!)

HML Beta = -1.24 (!)
N
I
.
E
Rstock=Rf + E*(Rm-Rf) +ESIZE*(RSMB) + EBM*(RHML)

= 4.87%+0.98*7.95%+(-0.4)*3.32%+
(-1.24)*5.05%
= 5.1% !!!!!
V
S
S
.B
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192
Implied Cost of Capital
Lets assume that the stock market has set

the stock price correctly.
Can we use this price information (plus
information about future cashflows/earnings)
to obtain a estimate of the implied cost of
equity capital?
Use Discounted FCF formula:
N
I
.
E
V
S
S
.B
P0 = CF1/(1+r) + CF2/(1+r)2 + CF3/[(r-g)(1+r)2]
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11
193
Example of Implied Cost of Capital
Calculation
Microsoft:
Earnings per share 2003: $1.02/share
Earnings per share 2004: $1.08/share
5-year growth rate: 15%

Current Stock Price = $24.25/share
Use standard DCF model (see handout):
N
I
.
E
V
S
S
.B
P0 = CF1/(1+r) + CF2/(1+r)2 + CF3/[(r-g)(1+r)2]
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12
194
Example of Implied Cost of Capital
Calculation:
Can also use the Residual Income

Valuation Model (EBO Model, abnormal
earnings model)
N
I
.
E
P0 = BV0 + AE1/(1+r) + AE2/(1+r)2 +
Key is the terminal value
V
S
S
.B
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195
International Cost of Capital Models
World CAPM or Multifactor Model (SharpeRoss)

World CAPM:
Rstock - Rf = E*(Rworld - Rf )
Rworl d is a world index (ie MSCI World Index), E uses Rworld
N
I
Segmented/Integrated CAPM
(Bekaert.
E
Harvey)
V
S
S
Credit Rating.(Erb-Harvey-Viskanta)
B
W Model
Country Spread
W
W
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14
196
International Cost of Capital:
Developed by Bekaert and Harvey (1995)
If countrys stock market is integrated with rest of

world, then World CAPM holds:
Rstock - Rf = E*(Rworld - Rf )
Rworld is a world index (ie Morgan Stanley Capital World Index)
http://www.msci.com/equity/index.html
E calculation is based on uses Rworld
N
I
.
E
V
S
If countrys stock market is segmented from the

rest of world, then local CAPM holds:
S
.B
Rstock - Rf = E*(Rcountry - Rf )
Rcountry is a countrys stock index, E uses Rcountry
W
If country
is going through process of integration, a
W
combination of two holds.
W
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15
197
Expected return is related to both covariance

with world and local indices
Weights (world versus local beta) determined
by proxy for degree of integration (like size of
trade sector & ratio of stock market
capitalization to total GDP)
Downside:
N
I
.
E
V
S
S
.B
Hard to implement
Only appropriate for countries with equity markets.
15.535 - Class #13

16
198
Credit Rating Model
Developed by Erb, Harvey, and Viskanta
Uses country credit rating as a measure of

systematic risk:
Institutional Investor magazine has rankings of country
credit risk on scale of 0-100.
Run regression: Rcountyr = D+ E*Risk Rank
Estimate average cost-of capital in each country.
Can use in 136 countries (even countries without equity

markets).
Impressive fit to the data.
N
I
.
E
V
S
S
.B
Assumes country credit rating is a good measure

of risk
W
Political
risk, expropriation risk, exchange rate controls and
W
volatility, etc.
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17
199
Country Spread Model (Goldman Model)
Can be used for individual stocks
Steps:
Estimate foreign company beta by regressing
Rstock = D + E*RM
(where RM is return on S&P500 - standard CAPM)
- Then, calculate predicted cost of capital using a modified
CAPM:
Rstock = rf + E*(U.S. equity premium) + SYS
N
I
.
E
V
S
S
.B
where: U.S. Equity premium is historical (RM-Rf)

SYS is the countrys Sovereign Yield Spread
- Sovereign Yield Spread is difference between countrys
government bond yield (bonds denominated in U.S. dollars)
and U.S. treasury bond yield.
15.535 - Class #13

18
200
Where Next
No Class this Thursday, April 3.
Assignment #2 will be handed out next

Tuesday
Direct calculations of cost of capital for your
project company (part 2) using various methods
N
I
.
E
Next Class: Accounting Trading Strategies
V
S
S
.B
15.535 - Class #13

20
201
Class #15
Accounting Trading Strategies
Do Investors Understand Accounting?
N
I
.
E
V
S
S
.B
15.535 - Class #15
202
Road Map: Where do things fit?
Risk Analysis:
CAPM
3 Factor Model: Size and B/M Matter
Combine with Cash Flow Analysis
N
I
. class about market
Recall discussion in Efirst
efficiency edbate SV
Application of S
Fundamental Analysis Can we use
B
.
financial accounting
numbers to identify mis-priced
stocks?W
W
W
Where Now?
15.535 - Class #15
203
Does the market set stock prices
correctly all the time?
EMPHASIZE: Mkts are very competitive!
But .. Evidence that markets may not be

perfectly efficient Possible (risky) arbitrage
opportunities.
Question: Can we use current (historical)
financial
accounting
information
and
fundamental analysis to pick which stocks
will do better/worse in the upcoming
months/years?
N
I
.
E
V
S
S
.B
Answer: There is growing evidence that this

appears to be possible!
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204
What is the correct benchmark for
Beating the Market?
A high stock return (relative to other stocks)

does not immediately imply you are getting a
free lunch or an arbitrage opportunity exists!
Asset pricing models: There is a trade-off
between risk and return.
N
I
.
E
Higher risk stocks should have higher returns.
V
S
What is the expected
return on stock? It
S
.B stocks systematic risk!
depends on the
W
SimpleW
case CAPM: E( R ) = Rf + E*(Rm-Rf)
W return is increasing in systematic risk!
Expected
15.535 - Class #15
205
Abnormal Stock Returns:
Getting the benchmark correct
Abnormal stock performance must be

calculated relative to the stock return
predicted by CAPM (or other model):
D = Abnormal return = Actual return { Rf + E*(Rm-Rf) }
N
I
.
E
Abnormal return is known as the alpha.

A positive (negative) alpha means that the stock
provided a higher (lower) return than predicted for
a given level of systematic risk.
Strategy: Attempt to go long in stocks that will
have future positive alphas and short in stocks
that will have negative alphas.
V
S
S
.B
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206
How might we predict alphas?
Keys to fundamental analysis:
First, get the benchmark correct for determining

abnormal returns.
Next, find a technique for picking stocks that will
systematically overperform (underperform) the
benchmark.
Involves historical analysis Hope that past
strategies will work in future. Why might a
successful strategy from the past disappear?
N
I
.
E
V
S
S
.B
What is an alternative interpretation that we

can systematically identify firms with high/low
alphas?
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207
Valuation & Beating the Market
Valuation
implicitly
assumes
market
inefficiency basis for active management.
Quantitative Models:
There should be a direct link between current

stock price and:
N
I
.
E
Current earnings (proxy for future earnings and CFs)

Current book value of equity (proxy for liquidating value)
V
S
If this link is absent, then there may be an (risky)

arbitrage opportunity. (Go back to DCF!)
Value Models: Find companies that are cheap
relative to others in terms of fundamentals derived
from income statements and balance sheets.
S
.B
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208
Value Strategies
Quantitative Models Value Strategies:
Assumption: Investors do not understand

fundamentals today, but stock prices will adjust
once investors see realized accting performance.
Examples: Strategies based on Book-to-price
(B/M), Earnings-to-Price (E/P)
What does high B/M mean? Low B/M?
What does high E/P mean? Low E/P?
Key assumption . earnings and book equity are

comparable across firms. Get the accounting right!
N
I
.
E
V
S
S
.B
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209
Misunderstanding information events
and Drift Strategies
Drift Models:
Does the market immediately (and correctly) react

to an information release that affects company risk
or future cash flows?
Post earnings announcement drift
N
I
.
Company announces higher
than expected earnings
E
(lower than expectedV
earnings) . Stock price increases
(decreases) on announcement
S
S
But stock price
continues to go up (down) in the
B
.
subsequent weeks and months.
W
Appears to be a profitable trading strategy
W
W
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210
Other Drift Strategies
In general, there appears to be momentum

in stock returns:
GENERAL MOMENTUM: Firm with highest
(lowest) stock returns over past 6-12 months are
likely to experience high (low) stock returns in next
6-12 months.
Post earnings announcement drift is one example
of underreaction to earnings news momentum.
Other examples: Underreaction to bond-rating
changes (which are positively autocorrelated).
Evidence that momentum may be attributable to
industry effects vs firm-specific effects.
N
I
.
E
V
S
S
.B
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10
211
Quality of Earnings Trading Strategy
(Accruals Anomaly)
Managers often have incentives to fool the market

by using their financial reporting discretion to report
high earnings. (Why?)
Example: Accruals
N
I
.
E
Aggressively book sales before they are justified.

Underreport expenses (or defer current expenses).
V
S
Key Question: Do investors and analysts understand

that managers may be misreporting earnings? Do
they know how to back out the accounting
distortions?
S
.B
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11
212
Some Red Flags
Managers that use different accounting

methods/estimates compared to other firms in
the industry.
Unexplained
changes
in
accounting
methods/estimates.
Large gap between reported income and
cash flow from operations.
Unusual transactions that boost earnings.
Significant related party transactions.
N
I
.
E
V
S
S
.B
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213
The Quality of Earnings Ratio
( Earnings ) (Cash _ From _ Operations )
Average _ Total _ Assets
N
I
.
E
Annual ratio lowSV

=> Low Quality
S
.B
W
Annual
Wratio high => High Quality
W
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214
Widely-Accepted Evidence on
Fundamental Trading Strategies
Strategy
Claimed Direction of Effect
E/P ratio
High E/P leads to high future abnormal stock returns
B/M ratio
High B/M leads to high future abnormal stock returns
CF/P ratio
High CF/P leads to high future abnormal stock returns
var(CF)/P ratio
High var(CF)/P leads to low future abnormal stock returns
V/P ratio
Use predicted firm value from abnormal earnings model and

compare to stock price: High V/P leads to low returns.
Short term
reversal
High stock return this month leads to low stock return next month.
Short-term overreaction to information.
Medium term
momentum
High stock return in past 6-12 months leads to high stock return in
next 6-12 months. Underrreaction to information.
N
I
.
E
V
S
S
.B
Accrual anomaly
High accounting accruals this quarter lead to low stock returns in

next quarter (and beyond).
15.535 - Class #15
14
215
Assignment #2 and Readings
Assignment #2:
Assignment is also posted on class server (with

links to necessary data).
Hand in completed homework in class on
Tuesday, April 15th. Be prepared to discuss your
answers in class!
N
I
.
E
Readings for Next Class: Risk II Contracts

& Bankruptcy Detection
V
S
S
Skim Section G.B
of Course Reader The Role of Financial
InformationW
in Contracting (pages 295-304).
Skim Section
H of Course Reader Credit Analysis and
W
Distress
W Prediction (pages14-11 through 14-17).
15.535 - Class #15
15
216
Class #16
Ratio Analysis & Bankruptcy
Detection
N
I
.
E
V
S
S
.B
W
W
W
15.535 - Class #16
217
Where have we been/where next?
Complete discussion of accounting
trading strategies from last class
Cost of capital discussion

N
I
.
http://www.ibbotson.com/content/cc_lvl1.asp
E
V
Charge of $15 per
beta!
S
S
.B
W
W
W
15.535 - Class #16
218
Contracting and Accounting
Examples of Contracts:
Loan Agreements:
Principal Bank, Bondholders, Private lenders
Agent Equityholders (managers)
Compensation Agreements (Class 18):
N
I
.
E
Principal Equityholders
Agent Managers (CEO, division managers)
V
S
Agreements with Suppliers, Customers, Partners
S
.B
Principal Equityholders
Agent(s) Third parties
W
Agreements
with Government/Regulators
W
W
Principal IRS (tax authority, regulatory agency)
Agent Firm
15.535 - Class #16
219
Contract terms should be designed to

address conflicting incentives of selfinterested parties:
Accounting numbers (such as earnings, book
value of assets, cash flows, etc) can be used to
specify contract terms and as a tool to monitor
performance and contract compliance.
N
I
.
E
V
S
Why use GAAP accounting numbers?
S
.Bobjective,
Are
they
verifiable,
unbiased,
consistent, comparable, timely, reliable, and
neutral?
15.535 - Class #16
220
Lending Contracts
The Agency Problems of Debt:

Dividend Payout Problem (Repayment)
Claim Dilution Problem (Repayment)
N
I
.
E
V
S
Asset Substitution Problem
S
.B
Underinvestment Problem
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221
Lending Contracts - Continued
How do we get around the lemons problem

and other failures in the lending market?
Solution Debt Covenants
Affirmative Covenants:
N
I
.
E
Using the loan for the agreed-upon purpose

Financial covenants and reporting requirements
Compliance with laws
Rights of inspection
Maintenance of insurance, properties and records
V
S
S
.B
15.535 - Class #16

222
Lending Contracts
Negative covenants:
For example -Limits amount of total debt, amount

of investment and capex, size of dividend
payments, etc.
N
I
.
E
Use of accounting numbers in debt

agreements:
V
S
i.e. Fixed charge coverage =
EBITDA/(Interest + debt due now + dividends +

replacement Capex)
What if the firm is about to violate the terms of a lending
agreement?
S
.B
15.535 - Class #16
223
Lending Contracts
URS Corp:10-Q Report (March, 2001)
The senior collateralized credit facility is governed by

affirmative and negative covenants. These covenants
include restrictions on incurring additional debt, paying
dividends or making distributions to our stockholders,
repurchasing or retiring capital stock and making
subordinated junior debt payments, and require us to submit
quarterly compliance certification. The financial covenants
include maintenance of a minimum current ratio of 1.20 to
1.00, a minimum fixed charge coverage ratio of 1.10 to 1.00,
an EBITDA minimum of $160,000,000 and a maximum
leverage ratio of 4.00 to 1.00 for the period ended January
31, 2001. We were fully compliant with these covenants as
of January 31, 2001.
N
I
.
E
V
S
S
.B
15.535 - Class #16

224
Lending Contracts
URS Corp:10-Q Report (March, 2001)
PERFORMANCE PRICING:
Why?
What does Performance Pricing Address?
The term loans each bear interest at a rate per annum

equal to, at our option, either the Base Rate or LIBOR, in
each case plus an applicable margin. The revolving credit
facility bears interest at a rate per annum equal to, at our
option, either the Base Rate, LIBOR or the Adjusted Sterling
Rate, in each case plus an applicable margin. The
applicable margin adjusts according to a performancepricing grid based on our ratio of Consolidated Total Funded
Debt to Consolidated Earnings Before Income Taxes,
Depreciation and Amortization ("EBITDA").
N
I
.
E
V
S
S
.B
15.535 - Class #16

225
Contracts and Accounting
Manipulation
When do managers have the greatest

incentive to manager earnings?
When contract provisions are about to be violated.
Ie Debt covenant
N
I
.
E
Minimum capital requirements in banks:
V
S
Capital adequacy ratio = Invested Capital/Total Assets
S
.B
Other cases: Regulated industries

Allowed Revenue=Operating Costs + Depreciation +
Taxes + (ROA*Asset Base)
W
Taxation
W
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226
Debt Contracts:
Tools for early detection of financial distress?
Covenants in debt contracts
N
I
.
E
Used as early warning indicators of financial distress
Avoid risk of non re-payment
V
S
S
.B
Question/Key Issue: Are simple financial ratios timely

indicators of risk and financial distress?
15.535 - Class #16

11
227
Predicting Bankruptcy Using Multiple
Discriminant Analysis (MDA)
How is it performed?
Identify sample of bankrupt firms
Match firms with healthy firms of same size and same

industry.
Matching procedure also attempts to control for firm size
and industry factors.
Calculate a number of financial statement ratios that are
expected to be related to the likelihood of bankruptcy.
N
I
.
E
V
S
S
.B
15.535 - Class #16
12
228
Bankruptcy Prediction: Altman's Z-score
A well-known MDA bankruptcy prediction model is Altmans Zscore. Altman used data for manufacturing firms to develop
the model.
Calculation of the models Z-score is as follows:
Z-score = 1.2(Net Working Capital/Total Assets) +

1.4(Retained Earnings/Total Assets) +
3.3(Earnings Before Interest and Taxes/Total
Assets) +
0.6(Market Value of Equity/Book Value of
Liabilities) +
1.0(Sales/Total Assets)
N
I
.
E
V
S
S
.B
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229
Altman's Z- score
The ratios capture different aspects of profitability & risk:
Net Working Capital/Total Assets: Captures short-term liquidity
risk.
Retained Earnings/Total Assets: Captures accumulated profitability
and relative age of a firm.
N
I
.
E
Earnings before Interest and Taxes/Total Assets: Measures
current profitability.
V
ratio, but incorporates markets S
assessment of firm equity value. Captures
S
long-term solvency risk and
the market's overall assessment of the firms
B
.
profitability and risk.
WIndicates the ability of a firm to use assets to
Sales/Total Assets:
generate sales.
W
W
Market Value of Equity/Book Value of Liabilities: A debt/equity
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230
Real World Applications of Z-Score
Bond rating services (Moodys and

Standard & Poors) use models similar
to the Z-Score to rate corporate bonds.
Details on ratings at Moodys:
N
I
.
E
For example, check out the research methods (the Z-Score)

for determining private firm default risk:
http://riskcalc.moodysrms.com/us/research/crm/45768.pdf
Information on default analysis methods at Moodys:
http://riskcalc.moodysrms.com/us/research/defrate.asp
V
S
S
.B
Attached page with S&P rating definitions
15.535 - Class #16

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231
Where Next?
Assignment #2 is due in class next

Tuesday.
Be prepared to discuss your results in
class.
N
I
. Acquisitions:
Next Class: MergerEand

V out next class.
Reading will beShanded
S
.B
W
W
W
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232
Class #17
Issues in Mergers and
Acquisitions
N
I
.
E
V
S
S
.B
W
W
W
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Mergers & Acquisitions: The Issues
Why take over another firm?

What are the gains to takeovers?
Strategies for Valuing Private Firms
N
I
.
E
What to do when there is no observable market

price?
V
Enterprise Valuation
S
S
.B
Calculating Unlevered
Betas Why?
W
A Review
W of the Latest in M&A Accounting
W
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234
Why take over another firm?
What are the gains to mergers/takeovers?
N
I
.
E
V
S
S
.B
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235
Valuation Methods for Private
Companies or Divisions
Use comparable ratios for publicly-traded firms:

P/E, M/B, P/Sales, etc.
Ensure same industry, risk (capital structure, and asset risk)
Use DCF or abnormal earnings valuation analysis

Asset Valuation:
N
I
.
E
Book Value (Net Worth)
V
S
Problems?
Tangible Net Worth

Economic Net Worth (Adjusted Book Value)
S
.B
Fair market value of net assets plus Goodwill

Where do you estimate Goodwill?
Could use abnormal earnings.
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236
What is the cost of capital for a
private company?
Assume that a private company that you wish

to value has 5 reasonably comparable
publicly-traded competitors. However, each of
these firms has a different capital structure
which affects the equity beta.
How would we calculate the equity cost of
capital of the private firm?
N
I
.
E
V
S
S
.B
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Unlevering the beta of publicly-traded
companies
It can be shown that a firms levered beta can
be expressed as:
Betaequity = Betaassets*[1+(1-t)*(D/E)]
Equity risk increases in firm leverage
N
I
. can easily estimate
This is useful becauseEwe
V
the (levered) equity
beta of publicly-traded
S
S
firms and then
find
.B the (unlevered) asset
beta:
W
Beta W = Beta
/[1+(1-t)*(D/E)]
W
assets
equity
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238
Example of Estimating Equity
Discount Rate for Private Firm
Consider a private company (or division) with 5 publicly-traded

comparable firms. But, the capital structure of the firms is very
different and we need to estimate the equity cost of capital for
the private company (or division).
Step 1) Calculate asset betas for public companies
Step 2) Determine asset beta for private company using average or

median of industry asset betas.
Step 3) Re-lever the private firms beta to get equity beta.
Company Beta
D/E
tax rate
Equity Beta/[1+(1-t)*D/E]
#1
1.21
1
0.32
0.72
#2
1.54
0.8
0.37
1.02
#3
1.05
0.55
0.39
0.79
#4
0.92
0.48
0.27
0.68
#5
0.86
0
0.34
0.86
N
I
.
E
V
S
S
.B
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Example of Estimating Equity
Discount Rate for Private Firm
Now assume that the private firm has a D/E ratio of

1.5 and an effective tax rate of 26%. Therefore, the
equity beta for the private firm is:
Betaequity = Betaassets*(1+(1-t)*D/E)
= 0.84 * (1+(1-0.26)*1.5)
= 1.77
Heres the rub:
N
I
.
E
V
S
S
.B
Would like to use market values in the D/E calculation, but

you cannot observe this for the private company. Therefore,
you must use the book value of equity as an approximation.
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240
Overview of M&A Accounting
Accounting Method depends on ownership stake.

Why do firms hold minority ownership stakes in other firms?
Minority Passive Ownership: <20% Ownership

Case #1: Trading Securities intent to sell within 1 year
Mark-to-market on the balance sheet

Unrealized gains (losses) are recognized as income each
period (quarter or year)
N
I
.
E
V
S
Case #2: Available-for-Sale Securities intent to hold for

more than 1 year, but can sell whenever appropriate
S
.B
Mark-to-market on balance sheet
Unrealized gain/loss not recorded as income, but goes directly

to increase/decrease shareholders equity
Examples of Intel and Cisco
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Minority Active Ownership: 20% to 50%Ownership
Investor can influence management

Use Equity Method of Accounting
The Equity Method:

Basically, 1-line consolidation in income statement and
balance sheet
Original investment recorded at cost (Balance Sheet
Account = Investment in Affiliate)
N
I
.
E
V
S
S
.B
Investment account increases for investors proportionate share

of investees income and decreases when investor firm
receives dividends.
Share of investees income appears on investors inc statement
Dividends paid by investee do not affect investors income

because dividends are a return of capital (increase cash,
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decrease investment).
241
242
Asset combinations: Occur when a company acquires the

assets of one or more other firms, or when a new firm is
formed to acquire the assets of two or more existing firms.
Target firms cease to exist as operating entities and may be
liquidated.
Stock combinations: Occur when one firm acquires more
than 50% of the outstanding voting common stock of one or
more target firms, or when a new firm is formed to acquire
controlling interest in the outstanding voting common stock of
two or more target firms.
N
I
.
E
V
S
S
.B
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243
Financial Reporting Methods for Mergers
and Acquisitions
The past methods:
The Old Purchase Method Goodwill asset created and

amortized over 40 years.
N
I
.
E
Pooling of Interests Method - The pooling method was

available when certain criteria were met. If the pooling
criteria are not met, the purchase method would be used.
V
S
S
.B
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244
Why did most firms prefer pooling of
interests in the past?
It appears that managers used pooling-of-interests to

increase future accounting income. How?
Is the market fixated on earnings?
N
I
.
E
There is evidence that, on average, acquiring firms

were willing to pay larger premiums for target firms if
the acquisition could be accounted for as a poolingof-interests?
V
S
S
.B
Example of the Daimler Benz and Chrysler merger
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245
The New Merger Accounting Rules
New rule now in effect:
Statement 141 requires that all M&A be accounted

for under a single method - The new purchase
method (pooling-of-interests is no longer
permitted). Purchase method must be used for
M&A starting July 1, 2001.
Statement 142 Goodwill no longer has to be
amortized to earnings, but instead be reviewed for
impairment. This rule is retroactive! Amortization
of Goodwill ceases for most companies on
January 1, 2002.
Implications for comparison?
N
I
.
E
V
S
S
.B
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246
The New Financial Reporting Rules:
Purchase Method
Under the new purchase method, the combined firm

reports the previously recorded assets and liabilities of
the target firm at FMV on acquisition date.
Any excess of the FMV of the target over the FMV of the
net assets recorded on its balance sheet is reported as
goodwill.
N
I
.
E
V
S
S
.B
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247
Financial Reporting Methods for Mergers
and Acquisitions
- Business combinations accounted for by the purchase

method are recorded at cost.
- In exchanges involving cash, the net assets are
recorded in the amount of cash disbursed.
- In exchanges involving the issuance of securities, the
market value of the securities is the basis for recording
the acquisition.
N
I
.
E
V
S
S
.B
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248
Types of Purchase Business Combinations
A purchase method combination may be approached

in one of two ways:
1) The acquiring firm may purchase the assets
(asset acquisition) of the target firm. In this case,
normally the target firm is liquidated and only one
firm continues.
N
I
.
E
V
S
S
B may purchase more than 50%
2) The acquiring firm
.
of the outstanding
voting common stock of the
W
target firm.
W In this case, the financial statements of
the W
two firms are consolidated.
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249
Where Next?
Next Class: Employee Stock Options and

Valuation
Course Reader: Section (I) Stock Options and
Valuation skim pages 317-334
N
I
.
E
Sample and Practice problems for Quiz #2

will be distributed next class
Review session for Quiz #2
V
S
S
.B
Tentatively scheduled for Wednesday, April 23.
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250
Class #18
Employee Stock Options and
Valuation
N
I
.
E
V
S
S
.B
W
W
W
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251
Management Compensation
Key Issue: Managers are self-interested and

risk-averse
Management Agency Problems:
Horizon Problem
Over-retention Problem
Risk Aversion Problem
Effort Problem
N
I
.
E
V
S
S
.B
How can equityholders (the principals)

overcome managerial agency problems?
W
Compensation
contracts
W
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Structure of Management
Compensation Contracts
Base Salary
Why?
Short-term incentives:
Examples?
What do these address?
V
S
Long-term incentives:
N
I
.
E
S
.B
Long-term accounting based-performance plans

Stock holdings (restricted stock grants)
Stock options (vesting, sensitivity to risk)
Stock appreciation rights, other
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Management Compensation
Advantages of accounting-based comp:

Incentives to improve performance/profitability.
Can shield managers from risk of volatile stock
price (outside their control?).
N
I
.
E
Disadvantages of accounting-based comp:
Imposes risk on managers if events affecting

accounting #s are outside their control.
Focus on short-term accounting performance vs
maximizing long-term value.
Provide distorted incentives (investment vs EPS)
Accounting numbers can be manipulated!
V
S
S
.B
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Stock Compensation
Companies use stock options to augment
cash compensation for several reasons:
Incentives: Help align managers/ employees

interests with those of shareholders
Financing: Start-up and high-growth companies
are often cash starved and cannot afford to pay
cash salaries today.
Reporting: Can increase EPS today (no comp
charge for options) But, future rule change
Taxes: Option comp is not taxable to employ on

grant date (if options issued at or out of money)
AND company gets tax write-off at exercise.
N
I
.
E
V
S
S
.B
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Employee/Executive Option
Compensation Pricing
The option gives the employee the right to:
Purchase company stock

For a pre-specified price (exercise or strike price)
After a specific date (vesting period)
Until a maturity date (expiration date)
N
I
.
European option versusE
American option
V
Value of stock option
(use modified Black-Scholes
S
S
formula):
.B
W
Value
Wof Call Option = C( S, X, T, V, r )
W
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Differences between Publicly-Traded
Options and ESOs
Typical Restrictions:
Required vesting period before exercise.

Why?
Employees forfeit unvested options when
employee leaves firm. Why?
Employees cannot sell options. Why?
Employees may not hedge options. Why?
N
I
.
E
V
S
S
.B
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257
How to Account for Stock Options
How do firms account for salaries paid

employees?
Firms have a choice of accounting methods:
Choice #1: Intrinsic Value Method (APB 25)
N
I
.
E
Options issued at or below the money produce no

compensation expense. Are these option worthless?
Options issued in the money are simply expensed as
the difference between the stock price and the exercise
price over the vesting period. Is this the true value of the
option?
Must also report (in financial footnotes) the true cost of
options and impact on EPS if company used SFAS 123.
V
S
S
.B
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258
Choice #2: Use SFAS 123

A fair value method
Use Modified Black-Scholes formula
Key inputs:
N
I
.
E
Stock Price
Exercise Price
Vesting Period
Time to Expiration (Maturity)
Fraction of options that will be forfeited (employees
leave before vesting).
V
S
S
.B
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259
Example:
Stock options with 2 year vesting period and 3

years to maturity
Stock price when options issued = $30 (at the
money)
Strike (exercise) price of options = $30
N
I
.
E
V
S
S
.B
Compare APB 25 versus SFAS 123.
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260
Tax Implications of Stock Options
Employee
None on grant date if
incentive stock option and issued at the money
Option exercise: Ordinary income

Sale of stock: Use Appropriate capital gains rate
AMT Implications for stock held:
N
I
.
E
See http://www.mystockoptions.com
V
S
Company
S
.Bdate
None on grant
Wfrom taxable income at corporate rate
Deduction
W of option by employee
on exercise
W
(difference between stock price and exercise price).
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261
Next Classes
Review Sessions for Quiz #2:
Attend either Tuesday evening OR
Wednesday evening Class 13
N
I
Readings for Class #20
.
E
V
Section J of Course
Reader (Leases and
S
S
Off-BalanceB
Sheet
Debt): Skim pages 531.
543, 547-551,
W 554-557
W
W
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262
Class #20
Off Balance Sheet Activities
N
I
.
E
V
S
S
.B
W
W
W
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Where have we been/where next?
Quiz #2 will be handed back in Class on

Thursday
Overview of Part 2 of Projects
Key due date is Friday, May 9, 2003.
N
I
.
Today: Off Balance E
Sheet Activities
V
S
Readings: Skim
Section J of Course
S
.B and Off-Balance-Sheet
Reader Leases
W
DebtW
(pages 531-540, 547-551)
W
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264
Off Balance Sheet Activities
Start with a simple example of lease

accounting:
Understand the rationale for leasing and the
distinction between Operating and Capital leases
Understand the Income Statement and Balance
Sheet differences between Operating and Capital
leases from the lessees perspective.
N
I
.
E
V
S
S
Examine the details
.B of Off Balance Sheet
Activities atW
Enron
W
W
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The Nature of Leases
A lease conveys the right to use property,

plant or equipment for a stated period of time.
Lessee (the user or renter)
Lessor owner of the property
N
I
.
Economic Rationale for
Leases:
E
V
Operational:
S
Leasing for shortSperiods protects against obsolescence.
.B equipment avoids set-up costs.
Lease ready-to-use
W that is used seasonally, temporarily, or
For equipment
W
sporadically.
W
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Economic Rational for Leases
Financial Advantages to Lessee:
Lease payments can be tailored to suit the

lessees cash flows (up to 100% financing, instead
of the 80% limit by banks)
Properly structured leases my be off-balance
sheet, avoiding debt-covenant restrictions
Leasing provides tax advantages from accelerated

depreciation and interest expense.
N
I
.
E
V
S
S
.B
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Economic Substance of Leases
Operating Lease: Lessee rents the property.

Lessee records rent expense on income
statement.
Rent
Lease
Purchase
N
I
.
Capital Lease: LesseeEeconomically owns the
V
property. Lessee records
the leased asset on
S
S capitalizes the asset) and
balance sheet.B
(ie
reflects theW
corresponding lease obligation.
W
W
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Accounting Criteria for Lease
Capitalization
A lease is considered a capital lease if ANY

of the following conditions apply (SFAS 13):
Transfer of ownership at the end of the lease term.
Existence of a bargain purchase option payment

below market value after the lease term.
Minimum present value of lease payments at least
90% of assets market value.
Lease term is for 75% or more of the assets
remaining useful life.
N
I
.
E
V
S
S
.B
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Capital Vs Operating Lease:
Income Statement Effects
Operating Lease
(Rent Expense)
N
I
.
Capital
Lease
E
V
Interest
Expense +
S
S
Depreciation
Expense
.B
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270
Capital Lease:
Balance Sheet Effects
Liability
Lease Obligation
(Capital Lease)
N
I
.
E
Asset
Leased Asset
(Capital Lease)
V
S
S
.B
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271
Background on Enron
On December 2, 2001, Enron Corp (7th

largest U.S. company) declared bankruptcy.
Stock closed at $1 (down $83 within 1 year).
U.S. Senate Committee concluded that

Enrons Board of Directors failed in its duties:
N
I
.
Approved Off-Balance E
Sheet Partnerships run by
Enron EmployeesSV
S
Failed to effectively
B monitor these partnerships
.
Failed toW
react to warnings about those
transactions
W as they came to light
W
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272
The Bottom Line on Enron:
During 1990s, Enrons growth was driven by

large investments in energy trading & energy,
water and broadband assets long delay
before CF returns.
Instead of issuing equity, Enron chose
borrowing
through
Off-Balance
Sheet
Partnerships (or SPEs) to finance growth.
The SPEs borrowed money from lenders
who often required Enron to guarantee the
debt (often done using Enrons stock).
N
I
.
E
V
S
S
.B
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273
The effect of the SPE transactions was to link

Enrons credit rating (which was necessary
for conducting its trading operations), and
thus its viability, to its own stock price.
The effects of the slowing economy, poorly
performing international investments, and the
failure of a broadband initiative led the
following:
N
I
.
E
V
S
S
B contingent liabilities realized,
Stock price decline,
.
earnings W
hedges became insolvent, and finally
bankruptcy
W ensued. All VERY fast!
W
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274
Enron used financial leverage to manipulate

reported earnings
Poor corporate governance placed firm in this
position:
N
I
.
Lack of board independence
& oversight
E
V
The auditor (Arthur
Andersen) failed in its role as
S
S
an independent
certifier of results.
B
.
Compensation
W plans provided managers with
W to maintain stock price at any cost.
incentives
W
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275
Prior Accounting Issues at Enron:
Enron reported 60% annual

revenues between 1995-2000
growth
in
Most of this was from energy trading revenues
Enron reported total dollar value of its trading volume

as revenues (and cost of filling those contracts as
COGS) industry practice at the time
N
I
.
E
V
S
In 2001, Enron restated financial statements

for 1997-200 to reflect the consolidation of
previously unconsolidated SPEs:
S
.B
Little impact on reported EPS: The consolidation did

not reflect the debt of other unconsolidated SPEs
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276
The Death Spiral at Enron:
When Enrons credit rating declined,

counterparties refused to trade, unwound
existing positions, and Enrons trading
business ground to a halt.
Enron had contingent liabilities (through
SPEs) & exposures were revealed -> large
magnitude of exposures hurt Enrons credit
rating. Enron could no longer support its
energy trading operations.
N
I
.
E
V
S
S
.B
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277
Off-Balance Sheet SPEs at Enron:
SPE: an entity created by a sponsoring firm to

carry out transactions:
Limited partnership, limited liability company, trust,
or corporation
Sometimes called Structured Financing Vehicles
if used to raise money or manage risk
N
I
.
E
V
S
S
.B
In 1999, Enron had $33 billion of assets on its

balance sheet and had an additional $27
billion in off balance sheet SPEs.
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278
Controversy over Enrons SPEs:
Several large SPEs formed at the beginning

of 1997 were run by related parties (Enron
employees)
SPEs contained contingent liabilities that
were not consolidated with Enrons financial
statements.
Some SPEs did not meet requirements for
Off-Balance-Sheet reporting and should have
been consolidated
N
I
.
E
V
S
S
.B
Chewco Investments, L.P.; LJM Caymen, L.P.;

LJM2 Co-Investment, L.P.
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279
Questionable Financial Reporting:
Chewco Investments, L.P
Enron established Chewco SPE with

financing guaranteed by Enron
(managed by Enrons Michael Kopper)
For non-consolidation,N2 requirements:
1)
2)
I
.
Have at least 3%Eoutside equity at risk.
V
But Koppers stake
was not equity at risk!
S
S
Sponsoring
.B firm (Enron) cannot control
W But, Kopper was employee of
the SPE.
W and under control of Enron.
Enron
W
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280
Earnings Hedging Transactions:
LJM Cayman, L.P.
Established in 1999 by Enron CFO Andrew Fastow (general

partner) Fastow invested $1 million and receive a 25%
return plus a management fee
Enron had $300 million in gains in investment in Rhythms
NetConnection stock.

Enron recorded prior profits on gains on stock using mark-tomarket accounting. But, Enron wanted to avoid mark-to-market
losses if investment lost value.
Enron used LJM Caymen SPE to enter into agreements with
banks using forward contracts. If the value of Enrons stock went
up, then so did forward contracts.
Normally, you cannot realize gains in your own stock price as
profits.
N
I
.
E
V
S
S
.B
Solution: Enron settled the forward contracts in return for shares of

Enron stock. Then, Enron sold these shares to LJM1 for a note
receivable and a put option on the Rhythms NetConnection shares.
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281
Earnings Hedging Transactions:
LJM Cayman, L.P.
Key element of LJM Caymen L.P.:
The value of Enrons Rhythms put option

was the fact that it relied on Enrons
share price.
This meant that the hedge was really only
intended to convert the embedded value
of the forward contract into a form that
could be recognized as income (ie the
payoff to the put option)
N
I
.
E
V
S
S
.B
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282
Next Class:
Next Class: Pension Plans: The Next

Accounting Disaster?
Reading from Course Reader: Section K
Valuation of Firms with Pension Plans
and Other Post Retirement Benefits
Pages 349-364.
N
I
.
E
V
S
S
Assignment
#3
will
be
distributed
next
B
.
class W
W
Due in class on Thursday, May 8.
15.535 - Class #20

21
283
Class #21
Accounting for Pension Plans
N
I
.
E
V
S
S
.B
W
W
W
15.535 - Class #21
284
Announcements
Todays Class - Readings:
Course Reader: Section K Valuation of

Firms with Pension Plans and Other Post
Retirement Benefits Pages 349-364.
N
I
.
E
V
S
S due
Assignment .B#3
Thursday,W
May 8.
in
class
on
15.535 - Class #21
285
Pension Plans and Other Post-
Employment Benefits: What and Why
Firms establish retirement pension plans to

attract and retain quality employees.
Part of compensation package
N
I
.
E
Two Main Types of Plans:
V
S
S
.B
Defined Contribution Plan
Defined Benefit Plan
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286
Defined Contribution Plan (401K)
Defines amount employer contributes each year to

employees pension account.
% of employee wages or firm net income (ie Walmart)
Contributions invested in pension plan (401-K)

No specification of benefits
Employees own the assets, but also bear the risk!
Amounts are often portable
N
I
.
E
V
S
Upon retirement, benefit payments to employee is

based on value of accumulated contributions.
Defined contribution plans present no accounting
problems for firms:
S
.B
Contribution is expensed each year (GAAP & IRS).
15.535 - Class #21
287
Define the employees benefit upon retirement.
Benefit formula often based on fixed % of

ending salary for each year of service.
Uses PV to determine todays contributions to
support promised future benefits.
N
I
.
E
V
S
Employer needs to make a prediction of the future
benefits to determine contribution
S
.B
= Projected benefit obligation
W
Employer
Wbears investment risk in the plan
W
15.535 - Class #21
288
Actuaries provide estimates of current pension

expense and liability:
Age, sex, service years, salary & employee life span
Anticipated salary increase
Anticipated employee turnover rates
Anticipated earnings rate on plan assets
Appropriate discount rate for PV calculations
N
I
.
E
V
S
S
.B
All estimates involves discretion (important)
15.535 - Class #21

289
Defined Benefit Plan: Other Features
Implications of Defined Benefit Plans:
Incentives for employees to stay with firm until

retirement (issue of vesting).
Incentives for employees to perform well to get the
last raise to increase the defined benefit.
N
I
.
U.S. regular, full-time and part-time
employees are covered by a
E
noncontributory plan that is V
funded by company contributions to
S
an irrevocable trust fund,
which is held for the sole benefit of
S
employees. Under.B
a new formula, which is being phased in
over five years, retirement benefits will be determined based on
W
points accumulated for each year worked and final average
W period. Benefits become vested upon the
compensation
W of five years of service.
completion
From IBM Annual Report (Footnotes)
15.535 - Class #21

290
Defined Benefit Plans: Other Issues
If plan is underfunded, employees may lose
earned benefits if the company goes bankrupt.
The Employees Retirement Income Security Act (ERISA) of

1974, requires firms to contribute a minimum of the service
cost each year unless the plan is overfunded at the
beginning of the year.
Tax incentives to fund pension plan - only the actual
amounts contributed each year are tax deductible.
V
S
Funding incentives:

Tax
Financial
Labor
Contracting
N
I
.
E
S
.B
15.535 - Class #21

291
Calculating the funding status of a
pension plans
Funded Status: Difference between plan

assets (PA) and Projected Benefit Obligation
(PBO)
Overfunded when PA>PBO
Asset to the firms?
N
I
.
Underfunded when PA<PBO
E
Liability to the firm?
V
S
S
B
.
Where do we get this information?
W
In financial
W statement footnotes
W PepsiCo 2001
Example:
15.535 - Class #21
292
What changes funded status?
Yearly change in Plan Assets (PA):
Return on plan assets

Contributions by employer
Benefits paid to retirees
Change
(PBO):
in
Benefit
N
.I
Projected
Obligation
E
V
Service cost
Interest cost
Benefits paid
Plan amendments
Actuarial gains and losses
S
S
.B
15.535 - Class #21

10
293
Funded status: What is reported on
Balance Sheet?
The true funded status is not what is reported

a firms consolidated balance sheet!
Make sure you look at footnotes (PepsiCo example)
Certain changes in funded status are

smoother under GAAP rules (not recognized
immediately)
N
I
.
E
V
S
S
.B
Changes in pension plan assumptions and

contribution levels from year-to-year can
allow firm to also manage earnings.
15.535 - Class #21
11
294
Implication of funded status for
financial analysis
Defined benefit pension plans can lead to hidden

assets and (especially) hidden liabilities
Information in footnotes can be used to determine
some of the hidden components:
See PepsiCo example
N
I
.
E
V
Problems are even more
pronounced for international
S
S
firms
B
.
Accounting for Pension Plans is even more opaque in other
countries W
Wother countries rely more on Defined Benefit Plans
Firms in
W Defined Contribution Plans)
(versus
15.535 - Class #21
12
295
Summary of Pension Accounting
Major Impact: Defined Contribution Plans
Potential for Large Unreported Pension Assets

and Liabilities
Accounting for Defined Benefit Plans can result
in Earnings Manipulation
Particularly important
N
I
.
E
V
S
Older firms (carryover
Defined Benefit Plans)
S
.Bplans (ie General Motors)
Firms with large

Non-U.S. W
firms using different accounting rules
W
W
15.535 - Class #21
13
296
Next Class
International Financial Reporting and Analysis
N
I
.
E
Assignment #3 due on class next Thursday.
V
S
S
.B
15.535 - Class #21

14
297
Class #22
International Financial
Analysis
N
I
.
E
V
S
S
.B
W
W
W
15.535 - Class #22
298
Next Steps for Projects
Analyst Project Presentations
In Class on May 12 and 14

Same Format as previous presentations (should be no
longer than 8 minutes!)
Due Diligence Presentations (4-5 minutes in length)
Presentation Schedule is Posted in Announcements
N
I
.
E
Due diligence on other team reports
V
S
All teams must send their completed reports (Parts 1 and 2)

to their opposing due diligence teams.
Due Diligence Teams should only evaluate PART 2 of the
analysis (ie the valuation using DCF and relative multiples
comparions.
S
.B
15.535 - Class #22
299
International Financial Analysis and
Valuation
Differences in Accounting Across

Countries
Outsider versus Insider Economies
N
I
.
E
Legal Tradition and Law Enforcement
Observed Differences in Accounting

Across Countries
V
S
S
.B
Differences
W in Opacity and Cost of
CapitalWAcross Countries
15.535 - Class #22
300
Framework for Analyzing Accounting
Across Countries
Financial reports for firms from different

countries are often very different from
each other. WHY?
N
See attached tables describing
I
.
E
properties of accounting
earnings
V
S
S
across countries
B
From Leuz, Nanda and Wysocki (2001)
15.535 - Class #22
301
Earnings Management Around the
World (Leuz, Nanda, Wysocki, 2003)
Austria
28.3
South Korea
26.8
Italy
24.8
Taiwan
22.5
Switzerland
22.0
Singapore
21.6
Germany
21.5
Japan
20.5
Hong Kong
19.5
India
19.1
Spain
18.6
Indonesia
18.3
Thailand
18.3
Pakistan
17.8
Malaysia
14.8
France
13.5
Finland
12.0
U.K.
7.0
Sweden
6.8
Canada
5.3
Australia
4.8
15.535
Class
#22
U.S.
2.0
N
I
.
E
V
S
S
.B
302
Accounting in Insider (Code-Law)
Countries
Insider Economies (Codified System)
Legal system/accounting rules typically codified by

government ministries
Close interplay between government & major
constituents (large firms, banks, labor unions)
N
I
.
E
Capital supplied by large banks and other big investors.
V
S
Governing boards of firms include banks, labor

unions and major suppliers/customers.
Transactions rely less on public information in
financial reports.
S
.B
15.535 - Class #22
303
Accounting in Insider Countries
Insider Economies (Codified System)
Continental European Origin

Belgium, Denmark, France, Germany, Italy, Norway,
Spain, and Sweden.
Japan: German commercial code & French
accounting code adopted in (1800s)
N
I
.
E
Result:
V
S
Public disclosure has smaller role in accounting

reports and rules.
S
.B
Dominance of private communication
Fewer publicly-traded companies in these countries /

Fewer small outside investors
15.535 - Class #22

304
Accounting in Outsider (Common-
Law) Countries
Common Law System (Anglo-American)

Evolves from bottom up (vs top down)
Dispersed parties involved in arms-length transactions
Final arbiter is often the court system:

Financial reports try to present a True & Fair
picture of firm performance.
Financial disclosures are more detailed.
Generally former UK colonies
N
I
.
E
V
UK, United States,SCanada, Australia, New Zealand.
S
B toward greater litigation in the
Because of trend
.
U.S., theW
financial reports of U.S. companies have
become
Wfar more conservative.
W
15.535 - Class #22
305
Implications of Poor Disclosure and
Opaque Financial Reports
What happens if outside investors cannot
decipher a companys financial report?
Who bears the costs? What are the costs?
PriceWaterhouse Coopers Survey of Corporate

Opacity:
N
I
.
E
V
S
The O-Factor
Oi =average of (corruption, judicial and legal rights,

economic opacity, accounting and governance opacity,
regulatory opacity)
S
.B
15.535 - Class #22
306
Some Differences in Accounting
Across Countries
Accounting Rules in many countries allow for

Hidden Reserves
DEFINITION: An amount by which a firm has understated
Shareholders Equity in a given year. The understatement
arises from an undervaluation of assets or an overvaluation
of liabilities. By undervaluing the net assets on this years
balance sheet, the firm can overstate net income in the
future by disposing of the asset.
N
I
.
E
V
S
S
Why is this allowed
B in some countries?
.
What is this
Wentry called under U.S. GAAP and law?
W
W
15.535 - Class #22
10
307
Big Differences in Accounting Even
in Similar Countries
USA
United Kingdom
Since 1934, cannot

Revaluations allowed.
Asset
Revaluations revalue assets upwards Professional appraisers
(writedowns allowed)
assess value of assets
Accounting
for Goodwill
Purchased goodwill not

amortized (check for
impairment)
Purchased goodwill
either immediately write
off or amortize
LIFO for
Inventories
Allowed (must be same

for IRS report)
Not allowed
Intangible
Assets
N
I
.
E
V
S
S
.B
Only purchased
W
W intangibles recognized
All intangibles valued

Use DCF or royalty
method (appraisers)
15.535 - Class #22
11
308
Differences in Accounting: Solutions
Investors & analysts need information that is

consistent across companies COMPARISON
Diversity of accounting rules makes it difficult to
compare companies across countries
Potential Solutions:
N
I
.
E
Convenience Report: use local GAAP but print the report in

language of users
Create 2 sets of reports under different standards (20-F
reconciliation)
Use International Standards or adopt U.S. GAAP
V
S
S
.B
15.535 - Class #22

12
309
Differences in Accounting: Solutions
American Depository Receipts:
An American Depositary Share ("ADS") is a U.S. dollar

denominated form of equity ownership in a non-U.S.
company.
Represents the foreign shares of the company held on
deposit by a custodian bank in the company's home country
and carries the corporate and economic rights of the foreign
shares, subject to the terms specified on the ADR certificate.
An American Depositary Receipt ("ADR") is a physical
certificate evidencing ownership in one or several ADSs. The
terms ADR and ADS are often used interchangeably.
Each ADR is backed by a specific # or fraction of shares in
the non-U.S. company. The relationship between the # of
ADRs and the # for foreign shares is called the ADR ratio.
N
I
.
E
V
S
S
.B
15.535 - Class #22

13
310
Types of ADRs
Expand Existing
Shareholder Base
Raising Capital with ADRs
Level I
Level II
Level III
public offer
Private
placement
GDR
(global)
Description
Unlisted in
the U.S.
Listed on
US
exchange
Shares
Placement
offered &
with
listed in US Institutions
Global
offering
Trading
OTC
Amex,
NYSE,
Nasdaq
Amex,
NYSE,
Nasdaq
U.S. and
non-U.S.
exchanges
U.S.
reporting
rules
Exempt
V
S
S
.B
N
I
.
E
Private
Placement
Market
Form 20-F Form 20-F Exempt

reconcile to reconcile to
US GAAP
US GAAP
15.535 - Class #22
Varies
14
311
Daimler-Benz Case
Daimler Benz filing with the U.S. SEC in

1993:
As a condition for listing on the NYSE, Daimler
Benz had to meet the SECs requirements of
reconciling its accounts to US GAAP.
Net income based on German GAAP was DM 615
million.
Based on US GAAP, it had a loss of DM 1,839
million.
N
I
.
E
V
S
S
.B
Given the embarrassingly large difference,
why did Daimler Benz accept to reveal this
information in the US GAAP reconciliation?
15.535 - Class #22

15
312
International Standards
The International Accounting Standards

Committee (IASC) is an independent private
sector body. Objectives:
Create uniform worldwide accounting standards
(Worldwide GAAP)
Benefits:
N
I
.
Shareholders, lenders, E
employees, suppliers &
V
customers can use one
set of comparables and not have
S
to translate #sSacross firms from different countries.
B a uniform system for comparing
Businesses.have
numbers
Wof operations in different countries.
W
Multinational
companies will only have to prepare one set
Wof statements for its worldwide operations.
15.535 - Class #22
16
313
International Standards
Limitations of International Accounting

Standards:
Lack of consistent enforcement and application of
penalties across countries:
Mexican firms with ADRs (Subject to SEC rules and
enforcement).
Even in cases of fraud, SEC did not apply penalties
Question: Do firms bear the cost of misreporting financial

numbers?
N
I
.
E
V
S
S
.B
Other institutions have to change as well
15.535 - Class #22

17
314
Next Steps for Projects
Analyst Project Presentations
In Class on May 12 and 14

Same Format as previous presentations (should be no
longer than 8 minutes!)
Due Diligence Presentations (4-5 minutes in length)
Presentation Schedule is Posted in Announcements
N
I
.
Due diligence on other team
reports
E
V
All teams must send their
completed reports (Parts 1 and 2)
S
S
to their opposing due
diligence teams.
B
.
Due Diligence Teams should only evaluate PART 2 of the
analysis (ieW
the valuation using DCF and relative multiples
W
comparions.
W
15.535 - Class #22
18
315
Class #23
Sarbanes-Oxley Act &
Capstone to FSA
N
I
.
E
V
S
S
.B
W
W
W
15.535 - Class #23
316
An Overview of the Sarbanes-Oxley
Act of 2002
A series of recent accounting undermined

investor confidence in firms and capital
markets. In response to the crisis, the U.S.
Congress passed the Sarbanes-Oxley Act of
2002, changing forever the financial reporting
landscape for finance professionals.
Major national securities exchanges (NYSE,
NASDAQ, AMEX) have also implemented
reforms to their own membership standards
as well.
N
I
.
E
V
S
S
.B
15.535 - Class #23
317
Provisions of Sarbanes-Oxley Act
Congress has mandated numerous
changes to financial reporting:
Real time disclosures

Officer certification
Increasing transparency
Independence - now a law
Mandated SEC review
New rules for pro forma statements
New audit committee requirements
Loans and certain trades prohibited
N
I
.
E
V
S
S
.B
15.535 - Class #23

318
Provisions of Sarbanes-Oxley Act
Congress has given new powers to the U.S.

Securities and Exchange Commission
(SEC):
New Public Company Accounting Oversight
Board
Criminal penalties for white collar crimes
strengthened
Statutes of limitations changed
New analyst conflicts of interest rules
New attorney professional responsibility rules
Protection for whistleblowers
N
I
.
E
V
S
S
.B
15.535 - Class #23

319
Sarbanes-Oxley Act: Key Changes
In April 2003, the SEC directed the NYSE and Nasdaq to

prohibit listing any company whose audit committee does not
comply with a new list of requirements affecting auditor
appointment, compensation and oversight.
Audit committee must consist solely of independent directors.
CEOs and CFOs must certify in each periodic report containing

financial statements that the report fully complies with the
Securities Exchange Act of 1934 and that the information fairly
presents the companys financial condition and results of
operations
N
I
.
E
V
S
S
.B
Officers will face penalties for false certification of $1,000,000

and/or up to 10 years imprisonment for knowing violation and
$5,000,000 and/or up to 20 years imprisonment for willing
violation.
15.535 - Class #23
320
No publicly-traded firm may make any personal loan to its

executive officers or directors, with limited exceptions.
The Act changes the deadline for insiders to report any
trading in their firms securities to within 2 business days
after the execution date of the transaction.

N
I
Each firm must disclose on a .very timely basis additional
E
information about the firms
financial condition as the SEC
V
determines is necessary
or useful to investors.
S
S
.B
W
W
W
15.535 - Class #23
321
The Act introduces new crimes for securities

violations including:
Destroying, altering or falsifying records with the
intent to impede federal investigation or bankruptcy
proceeding.
N
I
.
E
Failure by an accountant to maintain all audit

documentation for 5 years.
V
S
S
.B
Knowingly defrauding investors in connection with

any security.
15.535 - Class #23
322
Sarbanes-Oxley: Public Company
Accounting Oversight Board
Section 201: Auditors Prohibited from

Consulting
It is now "unlawful" for accounting firms to
provide non-audit services at the same time
that they audit a client, including:
(1) bookkeeping; (2) financial information
systems consulting; (3) appraisal/valuation
services; (4) actuarial services; (5) internal
audit outsourcing services; (6) management
functions or human resources; (7) broker or
dealer, investment adviser, or investment
banking services; (8) legal services.
N
I
.
E
V
S
S
.B
15.535 - Class #23

323
A Capstone Review of 15.535
Some highlights of 15.535 in 30
N
I
. less.
minutesEor
V
S
S
.B
15.535 - Class #23
324
Back to Lecture #1: The Central
Theme of 15.535
Understand that the value of equity

(enterprise) should be related to the
discounted PV of future free cash flows:
PV = CF1/(1+r)+CF2/(1+r)2+CF3/(1+r)3+
N
I
.
E
The Big Problem: How do we estimate future

cash flows and risk!
V
S
S
.B
Cash Flows Current accounting information is

very useful!
Risk Use CAPM, 3-factor, implied cost of
capital
15.535 - Class #23
10
325
The 5 baby steps!
Single cash flow:

PV = CF1/(1+r)
Single cash flow in n years from now:

PV = CFn/(1+r)n
Multiple cash flows in future:
N
I
.
E
PV = CF1/(1+r)+CF2/(1+r)2+CF3/(1+r)3+
V
S
Perpetuity of fixed cash flows:

PV = CF/r
S
.B
(1st CF is at the end of year 1!)
Growing Perpetuity:
W
PVW
= CF/(r-g) (1 CF at end of year 1, then grow at g)
W
Understanding
P/E ratio (just restating DCF!)
st
15.535 - Class #23

11
326
Valuation
1) Equity valuation:
Forecast cash flows available to equityholders.
Discount expected cash flows by the cost of equity
capital. Remember unlevered Beta!
N
I
.
E
2) Enterprise (firm or asset) valuation:
V
S
Forecast cash flows available to all providers of

capital (debt and equity).
Discount expected cash flows by weighted
average cost of (debt and equity) capital
Can get equity value by subtracting value of debt.
More widely used in practice.
S
.B
15.535 - Class #23
12
327
Equity Valuation Analysis: What Do
Analysts Use? (Asquith et al, 2001)
Earnings Multiple
99%
P-E
97%
Relative P-E
35%
Revenue Multiple
15%
N
I
.
E
Price-to-Book
V
S
CF Multiple
DCF
S
.B
W
Model
W
EVA
25%
13%
13%
2%
4%
15.535 - Class #23
13
328
Approach to Multiples
Implicit assumptions of multiples analysis:
Rely on the market to evaluate the prospects of
profitability and growth for comparables firms.
Assume that the same prospects apply to firm of

interest.
N
I
.
How to identify comparables?
E
V
Assumptions of same
industry, risk, size, growth,
S
S
accounting methods,
etc.
B
.
Note: Use
Multex (through Yahoo!) to get quick
W
industry
Wbenchmarks.
W
15.535 - Class #23
14
329
The Residual Income Model (EBO)
Use this idea to express current equity value

of the firm as a function of book value of the
firms and abnormal earnings:
f
Equity Value0 = BV0 + [AEt /(1+r)t]
t=1
N
I
.
E
V
S
S
.B
where: BVt = Book value of equity at beginning of year t

r = Cost of equity capital
AEt = Expected value of abnormal earnings in year t
= Projected earnings in yr t - (r * BV of equity at
beginning of year t)
15.535 - Class #23

15
330
Cost of Capital
CAPM: E( R ) = Rf + E*(Rm-Rf)
Expected return is increasing in systematic risk!
What is Beta?
Cov( Rstock,Rmarket Rf )/Var( Rmarket Rf )
N
I
.
E
The Fama-French 3-factor model:

Rstock =Rf + E*(Rm-Rf) +ESIZE*(RSMB) + EBM*(RHML)
Every stock has different market E, ESIZE, EBM
V
S
S
.B
Implied Cost of Capital: Use Discounted FCF
formula:
W
PW
= CF /(1+r) + CF /(1+r)
0
+ CF3/[(r-g)(1+r)2]
15.535 - Class #23
16
331
Now that we can value a firm: Does the
market prices correctly all the time?
EMPHASIZE: Mkts are very competitive!
But .. it appears that they are not perfectly

efficient Possible (risky) arbitrage
opportunities.
Question: Can we use current (historical)
financial
accounting
information
and
fundamental analysis to pick which stocks
will do better/worse in the upcoming
months/years?
N
I
.
E
V
S
S
.B
Answer: There is growing evidence that this

appears to be possible!
15.535 - Class #23

17
332
Abnormal Stock Returns:
Getting the benchmark correct
Abnormal stock performance must be

calculated relative to the stock return
predicted by CAPM (or other model):
D = Abnormal return = Actual return { Rf + E*(Rm-Rf) }
N
I
.
E
Abnormal return is known as the alpha.

A positive (negative) alpha means that the stock
provided a higher (lower) return than predicted for
a given level of systematic risk.
Strategy: Attempt to go long in stocks that will
have future positive alphas and short in stocks
that will have negative alphas.
V
S
S
.B
15.535 - Class #23

18
333
Caveats on Apparent Trading
Strategies: Implementation
Risky Arbitrage
These are average returns over many years.
Is history a good predictor of the future?

Does risk explain the abnormal returns?
Transactions costs
N
I
.
E
Brokerage fees
Bid-Ask spread
Taxes (different rates for short-term vs long-term)
Shorting a stock is often impossible or very costly
V
S
S
.B
Put options often are not traded on a particular stock,

often have large spreads
Price Pressure! 15.535 - Class #23
19
334
Contract terms address conflicting incentives of

self-interested parties:
Accounting numbers (such as earnings, book value of
assets, cash flows, etc) used to specify contract
terms/compliance & monitor performance
Why use GAAP accounting numbers? Are they objective,
verifiable, unbiased, consistent, comparable, timely, reliable,
and neutral?
N
I
.
E
V
S
Loan Agreements: Principal
Bank, Bondholders, Private
S
lenders, Agent .B
Equityholders (managers)
Compensation
Agreements: Principal Equityholders Agent
W
Managers
W
Agreements
W with Suppliers, Customers, Partners
Examples of Contracts:
Agreements with Government/Regulators

15.535 - Class #23
20
335
Stock and Option Compensation
Companies use stock options to augment
cash compensation for several reasons:
Reporting: Can increase EPS today (no comp

charge for at or out-of-money options if you use
APB 25). Rules are likely to change this year!
Incentives: Options help align managers/
employees interests with those of shareholders
Financing: companies are often cash starved
and cannot afford to pay cash salaries today.
Taxes: Option comp is not taxable to employee on
grant date AND company gets tax write-off at
exercise (Microsoft: huge profits, zero federal tax)
N
I
.
E
V
S
S
.B
15.535 - Class #23

21
336
Cooking the books and earnings
management/manipulation

items:
Avoid violating accounting covenants in loan agreements
Avoid taxation (Progressive tax scheme)
(understate profits)
Avoid detection of managerial shirking or outright
stealing
N
I
.
E
V
S
S
.B
Stock options; issuing equity in near future

15.535 - Class #23
22
337
Real Methods for Detecting Earnings
Management
Methods:
Compare % growth in sales with the % growth

in AR over the past 5 years (quarters).
Calculate the ratio of the scaled standard
deviation of Operating Income over the past 5
years to the scaled standard deviation of CFO
over the past 5 years. Also, calculate this same
ratio for two of the firm's competitors and then
make a relative comparison of these ratios.
Compare change in NI to change in Basic EPS.
N
I
.
E
V
S
S
.B
15.535 - Class #23

23
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Evaluating Accounting, Hedging and
Transactions: Use Modigliani-Miller!
If accounting methods, hedging, or other

financial transactions affect current firm
value, then they must:
1) Affect the level of taxes (cash flows) paid
to the government
2) Affect transactions and contracting costs
(cash flows)
3) Affect real investment policy (cash flows)
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Types of Financial Statement
Analysis
Common-Size Financial Statements (crosssectional analysis)

e.g. Deflate all financial numbers by total assets
Trend Financial Statements (time-series

analysis)
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Compare growth rates over time
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Financial Ratio Analysis
Profitability ratios, short-term liquidity ratios, longterm solvency ratios
15.535 - Class #23
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Bankruptcy Prediction: Altman's Z-score
One prediction model is Altmans Z-score. Altman used data

for manufacturing firms to develop the model.
Calculation of the models Z-score is as follows:
Z-score = 1.2(Net Working Capital/Total Assets) +

1.4(Retained Earnings/Total Assets) +
3.3(Earnings Before Interest and Taxes/Total
Assets) +
0.6(Market Value of Equity/Book Value of
Liabilities) +
1.0(Sales/Total Assets)
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The New Merger Accounting Rules
New rule now in effect:
Statement 141 requires that all M&A be accounted

for under a single method - The new purchase
method (pooling-of-interests is no longer
permitted). Purchase method must be used for
M&A starting July 1, 2001.
Statement 142 Goodwill no longer has to be
amortized to earnings, but instead be reviewed for
impairment. This rule is retroactive! Amortization
of Goodwill ceases for most companies on
January 1, 2002.
Implications for comparison?
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15.535 - Class #23

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Summary of Pension Accounting
Will be major accounting issue in next year!
Major Impact: Defined Contribution Plans

Not an issue for Defined Contribution/401K Plans
Large Unreported Pension Assets and

Liabilities
Defined
Benefit
Accounting:
Earnings
Manipulation
Particularly important for:
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B Defined Benefit Plans)
Older firms (carryover
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Firms with large
plans (ie General Motors)
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Non-U.S.
Wfirms using different accounting rules
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International Financial Analysis
Across-Country Accounting Differences

Lack of Comparability: Be careful in analyzing companies!
Use Outsider vs Insider Economies (Legal Tradition/Laws)

Differences in Opacity:
Companies face higher cost of capital if they poor disclosures
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Potential Solutions:
Convenience Report: local GAAP but print the report in English
Reconcile to U.S. Standards (20-F reconciliation) ADR firms
Use International Standards (IAS) or adopt U.S. GAAP
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International Accounting
.B Standards (IAS):
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Mandatory in European Union in 2005 Possible acceptance in US

Lack of consistent enforcement across countries:
Other institutions have to change as well
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The End
Summary of the main goal of this course :
Develop a Framework for understanding,

evaluating and valuing companies.
It is certain that the following will change:
Accounting Rules, Technology, Integration of Markets,

Contracting Methods, Etc
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will remain much the
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we developed some life-long
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The Acid
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15.535 - Class #23
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15.535 Business Analysis Using Financial Statements Spring 2003

Assignment #1
VALUATION EXAMPLE: DELL COMPUTER

In the first three classes, we have been exposed to a number of real-world techniques used in
company valuation. This course is about the application of these techniques to valuing actual (vs
ficticous) companies in today's markets. Therefore, I would like you to dive right in and perform a
"quick and dirty" analysis of Dell Computer!
Please develop a prediction of the "fair value" of Dell Computer for each of the following valuation
techniques:
APPROACH 1:DCF using analysts' forecasts of EPS as proxies for future cash flows
(Please follow the equity valuation example for Compaq Computer example that we covered in
Class #2.)
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Necessary Data
a) Forecasted EPS in year 1 (Jan 2002).
b) Forecasted EPS in year 2 (Jan 2003).
c) Forecasted 5 year growth rate in EPS.
d) Assume that equity "free cash flow" per share equals forecasted EPS
---> working capital acccruals equals zero
---> annual depreciation charge is a good approximation of annual investment cash flows
e) DELL equity Beta.
f) Rf (risk free rate) (Use 30 year Treasury Constant Maturity):
Link http://www.stls.frb.org/fred/data/irates.html
g) Rm= Expected Market return = 15%
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APPROACH 2: Relative PE analysis (comparing multiples)

Necessary Data:
a) Current EPS (ttm= trailing 12 months) for Dell Computer.

b) P/E ratio (ttm) for Computer Industry.
APPROACH 3: Relative PEG analysis (comparing multiples)
Necessary Data:
a) Current EPS (ttm= trailing 12 months) for Dell Computer.
b) 5 year projected earnings growth for Dell.
c) PEG ratio for Computer Industry.
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APPROACH 4: Relative M/B analysis (comparing multiples)

Necessary Data:
a) Current book value of equity (per share) for Dell Computer.
b) You can calculate the average M/B ratio in the computer hardware industry by taking the
average (or median) M/B of several of Dell's competitors.
After completing your analysis using each of the 4 approaches, please write a memo summarizing
your analysis.
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Assignment #2 - Cost of Capital Calculations

This is a group assignment!
Please hand-in a single hardcopy of your completed analysis in class
on Tuesday, April 15, 2003. Please record the names of all your group members
on the first page of the assignment. Be prepared to discuss your solutions in class!
In this assignment, you must estimate the cost of capital for the stock that your team has picked for your
Analyst Project this semester. You should follow the example approach we covered in class.
Recommended Steps:
1) Download the Excel Spreadsheet template from Class 13 (Class 13 - Risk Factors Spreadsheet) which
contains monthly data from January 1990 to December 2002 on the following factors:
x
x
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x
(RM-Rf) - The monthly excess return on the market portfolio.

Rsmb - The monthly "size" return on a portfolio that goes long in a group of small stocks and short in
a group of large stocks.
Rhml - The monthly "distress" return on a portfolio that goes long in a group of high B/M stocks
(high financial distress) and short in a group of low B/M stocks (low financial distress).
Rf - The monthly return to an investment in short term U.S. T-bills.
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2) Go to the Wharton WRDS database and click on "Members Login". Then, login using the class username
password.
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3) Click on the CRSP link. Then click on the Stocks link on the left side of the webpage. This will link you
to a page titled "CRSP Monthly Stock".
4) On the "CRSP Monthly Stock" page, you should proceed with the following:
- Step One: Date Range Select monthly frequency and beginning date of Jan 1990 and ending date of Dec
2002.
- Step Two: Search Search by ticker and select method 1 (company codes). Enter your company's ticker
symbol (ie MSFT for Microsoft) on the company code line.
- Step Three: Variables Select Holding Period Return.
- Step Four: Output Select "comma-delimited text (*.csv)" under Output Format.
- CLICK on the "Submit Request" button.
5) The data will take about 30 second to download. The following screen will then appear:
Data Request Summary
Data Request ID
081028073
Library/Data Set
crsp/msf
Frequency/Date Range
mon/Jan 1990 - Dec 2002
Search Variable
TICKER
Input Codes
1 item(s)
MSFT
Conditional Statements
n/a
Output format/Compression
csv/
Variables Selected
RET
Estimated output size
n/a
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Your output is complete. Save the output in an Excel File.

6) Copy that stock return data (and matching date) for your stock from the spreadsheet to a blank column in
the Excel Spreadsheet template listed in the first step (above).
7) Ensure that the dates of the monthly stock prices match the dates of the stock returns in the template
spreadsheet!
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8) Adjust the monthly stock return for each month for YOUR stock between January 1990 and December
2002 by multplying the value by 100:
x
Adjusted Monthly Stock Return = Monthly Stock Return * 100
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9) Now you are ready to calculate the the CAPM BETA and the THREE-FACTOR BETAS for your
company!
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Please answer the following 5 parts in your analysis:
QUESTION A)
Using standard regression analysis in Microsoft Excel, estimate the CAPM BETA for your company using
monthly stock returns for the most recent 60 months (5 years). Attach the regression output for this estimate.
Note: Your regression model should be of the form:

Rstock = a0 + a1*Rf + BETA*(Rm-Rf)
QUESTION B)
Using standard regression analysis in Microsoft Excel, estimate the CAPM BETA for your company using
monthly stock returns for the past 24 months (2 years). Attach the regression output for this estimate.
QUESTION C)
Calculate the predicted cost of capital using the BETA estimates from PART A) and B). Show your
calculations. Is there a large difference using the 5 year (60 month) versus the 2 year (24 month) BETA?
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QUESTION D)
Using standard regression analysis in Microsoft Excel, estimate the 3-factor BETA's for your company using
monthly stock returns for the most recent 60 months (5 years). Attach the regression output for this estimate.
Note: Your regression model should be of the form:
Rstock = a0 + a1*Rf + BETA1*(Rm-Rf) + BETA2*Rsmb + BETA3*Rhml
QUESTION E)
Discuss each of the coefficient estimates that you estimated in QUESTION D):
- What does the value of a0 mean or imply?
- What does the value of BETA1 mean? Is the firm risky relative to the market?
- What does the value of BETA2 (size BETA) tell us about your stock? Think about whether your stock is
large or small relative to other stocks traded in the U.S.
- What does the value of BETA2 (distress BETA) tell us about your stock? Think about whether your stock
has a high or low B/M ratio relative to other stocks traded in the U.S.
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REMINDER - This is a group assignment!

Please hand-in a single hardcopy of your completed analysis in class
on Tuesday, April 15, 2003. Please record the names of all your group members
on the first page of the assignment.
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15.535 Winter 2003
Quiz #1 March 6,2003

QUESTION 1: Multiples Comparisons (20 pts)
Dell Computer trades at a M/B ratio of 13.86. The industry M/B ratio is 10.5.
(a) Provide 2 reasons why you might expect Dell to have lower stock returns than firms in its
industry over the next 5 years (Hint: Market Efficiency compared to Market Inefficiency)
(b) Even though Dells M/B ratio is high relative to its industry, this ratio may tell us nothing about
whether Dells stock is either under- or over-priced. Explain. (Hint: Accounting reasons).
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QUESTION 2: Accounting Quality and Ratio Analysis (20 pts)

Q-Aqua Resources is water pipeline and distribution company. It claims that the water supply
market is most important and, potentially, the fastest growing global resource market over the
next 50 years.
The company reported losses (GAAP net income) for the past 3 years. Q-Aqua currently trades at
$6.55 per share. In a recent press release, the company highlighted the fact that it had positive
operating income last year. In addition, sales have been growing at a rate of 25% per year
for the past 2 years. Based on the fact the Q-Aqua trades at a <Price-to-Sales> ratio of only
2 and a <Price-to-Operating Income> ratio of only 7, the management believes that our company
is currently undervalued.
As part of your research, you examined Q-Aquas most recent annual financial statement and
focused on the supplemental footnotes to the income statement. In particular, the footnotes state that
the company entered into 17 water supply swap transactions in 2001 and 38 water supply swap
transactions in 2002. We are conservative in accounting for these swaps in that we fully book for all
revenues and expenses related to these transactions each year. Later in the same footnote,
company management states that that We view the supply capacity received in these swap
transactions as building of our overall capital abilities.
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Based on all of the above information, answer the following questions:

a) Why might you question the validity of the companys reported operating income? Which
component?
b) Why might you question the companys claim that we believe the company is currently
undervalued. (Focus on the <Price-to-Sales> ratio)
QUESTION 3: Earnings-Based Valuation (20 pts)

Valanium Inc. is currently trading at a forward P/E ratio of 11. Analysts are projecting its earnings
per share for the year ended December 2003 at $2.10.
(a) Using a perpetuity model, estimate of the equity cost of capital for Valanium Inc. (Show all
calculations).
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(b) The book value of equity of Valanium at the end of fiscal 2002 was $15.00 per share. Calculate
abnormal earnings for the fiscal year ended 2003. (Show your calculations)
(c) Assuming a perpetuity in abnormal earnings, calculate the predicted stock price of Valanium Inc.
using the residual income (EBO) valuation model.
(d) What factors would allow you to justify a perpetuity in abnormal earnings?
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QUESTION 4: Cash Flow Analysis (20 pts)

Listed below is the summary balance sheet for FGST Corp for fiscal years ended 2001 and 2002
(all numbers in millions of dollars). The company reported net income in 2002 of $1,400 million.
FGST had no capital expenditures or asset sales in 2001 and 2002. Shares outstanding remained
constant over the 2 years. The companys long-term debt matures in the year 2010.
Summary Balance Sheet
FGST Corp (all amounts in $MM)
Cash
Accounts Receivable (net)
Inventory
Property Plant & Equipment (Net of Deprec)
Total Assets
Year ended
2002
2,600
4,900
5,500
29,500
$42,500
Year ended
2001
1,500
3,200
4,100
32,500
$41,300
3,300
1,500
25,400
30,200
12,300
$42,500
2,800
2,200
25,400
30,400
10,900
$41,300
Accounts Payable
Accrued Liabilities
Long Term Debt
Total Liabilities
Shareholders Equity
Total Liabilities & Shareholders Equity
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(a) Calculate CFO (cash flow from operations) for the fiscal year 2002. Please show all your
work. State any assumptions you may make in deriving your calculations.
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The company is expected to have relatively stable sales for the next 3 years (2003-2006).
(b) Do you expect the working capital accruals in 2003 to be higher, lower, or the same as
working capital accruals reported in 2002? Provide reasons to support your answer.
(c) What do you expect free cash flow to equity (FCFE) to be in 2006? Please state any
assumptions you make and provide reasons for your answer.
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15.535 Winter 2003
Sample Solutions
Quiz #1 March 6,2003

QUESTION 1: Multiples Comparisons (20 pts)
Dell Computer trades at a M/B ratio of 13.86. The industry M/B ratio is 10.5.
(a) Provide 2 reasons why you might expect Dell to have lower stock returns than firms in its
industry over the next 5 years (Hint: Market Efficiency compared to Market Inefficiency)
1} Inefficiency: Dells stock price is too high relative to fundamental value (ie book value
proxies for discounted future expected cash flows). As the market discovers this mispricing,
Dells stock price will drop (ie lower future stock returns).
2} Efficiency: Dells net assets (and the cash flows generated by these net assets) may have
lower systematic risk (ie lower discount rate) compared to other firms in the industry (one
possible reason: lower leverage). Given that Dells price is determined by the discounted
present value of the CFs from its assets, then its current price should be higher compared to
other firms (ie high M/B). However, its future expected returns (=discount rate) should be low
BECAUSE it has low systematic risk.
10 pts
(b) Even though Dells M/B ratio is high relative to its industry, this ratio may tell us nothing about
whether Dells stock is either under- or over-priced. Explain. (Hint: Accounting reasons).
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Dell may have differences in the way it accounts for it assets and liabilities compared to other
firms in its industry. For example, its book value of equity may be relatively too low (ie
unrecognized intangible assets) or too high (ie impaired assets not written down).
10pts
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QUESTION 2: Accounting Quality and Ratio Analysis (20 pts)

Q-Aqua Resources is water pipeline and distribution company. It claims that the water supply
market is most important and, potentially, the fastest growing global resource market over the
next 50 years.
The company reported losses (GAAP net income) for the past 3 years. Q-Aqua currently trades at
$6.55 per share. In a recent press release, the company highlighted the fact that it had positive
operating income last year. In addition, sales have been growing at a rate of 25% per year
for the past 2 years. Based on the fact the Q-Aqua trades at a <Price-to-Sales> ratio of only
2 and a <Price-to-Operating Income> ratio of only 7, the management believes that our company
is currently undervalued.
As part of your research, you examined Q-Aquas most recent annual financial statement and
focused on the supplemental footnotes to the income statement. In particular, the footnotes state that
the company entered into 17 water supply swap transactions in 2001 and 38 water supply swap
transactions in 2002. We are conservative in accounting for these swaps in that we fully book for all
revenues and expenses related to these transactions each year. Later in the same footnote,
company management states that that We view the supply capacity received in these swap
transactions as building of our overall capital abilities.
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Based on all of the above information, answer the following questions:

a) Why might you question the validity of the companys reported operating income? Which
component?
Operating income may only include revenues from swaps, but not the associated expenses.
Therefore, operating income is overstated. Even if the swap expenses are not capitalized, they
might be presented below operating income on the income statement.
10pts
b) Why might you question the companys claim that we believe the company is currently
undervalued. (Focus on the <Price-to-Sales> ratio)
The <Price-to-Sales> ratio may use a sales number that includes questionable swap revenues
that do not represent real economic value. For the <Price-to-Sales> ratio to be a meaningful
valuation metric, the Sales number must be related to future expected free cash flows that the
firm will generate from its operating business. This is questionable for these types of swaps.
10pts
QUESTION 3: Earnings-Based Valuation (20 pts)
Valanium Inc. is currently trading at a forward P/E ratio of 11. Analysts are projecting its earnings
per share for the year ended December 2003 at $2.10.
(a) Using a perpetuity model, estimate of the equity cost of capital for Valanium Inc. (Show all
calculations).
If one assumes a perpetuity model where next years earnings are related to a perpetuity of
future free cash flows, then P/E=1/r. Therefore, r=9.1%
5pts
(b) The book value of equity of Valanium at the end of fiscal 2002 was $15.00 per share. Calculate
abnormal earnings for the fiscal year ended 2003. (Show your calculations)
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AE2003 = E2003 r*BV2002 = 2.10 (0.091*15.00) = $0.74 per share

5pts
(c) Assuming a perpetuity in abnormal earnings, calculate the predicted stock price of Valanium Inc.
using the residual income (EBO) valuation model.
P = BV0 + AE1/(1+r) + AE2/(1+r)2 + .

If perpetuity in AE, then P = BV0 + AE1/r = 15 + 0.74/0.091 =$23.09
5pts
(d) What factors would allow you to justify a perpetuity in abnormal earnings?
- Accounting Factors: Current BV is understated which means that calculated abnormal can
persist because of a persistently understated book value.
- Economic Factors: Firm can somehow prevent competitors from entering the market who
might otherwise drive abnormal earnings (rents) to zero (i.e. a monopoly)
5pts
QUESTION 4: Cash Flow Analysis (20 pts)
Listed below is the summary balance sheet for FGST Corp for fiscal years ended 2001 and 2002
(all numbers in millions of dollars). The company reported net income in 2002 of $1,400 million.
FGST had no capital expenditures or asset sales in 2001 and 2002. Shares outstanding remained
constant over the 2 years. The companys long-term debt matures in the year 2010.
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Summary Balance Sheet

FGST Corp (all amounts in $MM)
Cash
Accounts Receivable (net)
Inventory
Property Plant & Equipment (Net of Deprec)
Total Assets
Year ended
2002
2,600
4,900
5,500
29,500
$42,500
Year ended
2001
1,500
3,200
4,100
32,500
$41,300
3,300
1,500
25,400
30,200
12,300
$42,500
2,800
2,200
25,400
30,400
10,900
$41,300
Accounts Payable
Accrued Liabilities
Long Term Debt
Total Liabilities
Shareholders Equity
Total Liabilities & Shareholders Equity
(a) Calculate CFO (cash flow from operations) for the fiscal year 2002. Please show all your
work. State any assumptions you may make in deriving your calculations.
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Quickie Method: Given no financing or investment changes in cash, then CFO equals
change in cash: CFO2002 = 'Cash2002 = Cash2002 Cash2001 = 2,600-1,500=$1,100M
Indirect Method (Standard Method):
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No Capex, Assets Sales. Therefore, Deprec = Change in PPE = (32500-29500) = 3000

CFO = NI WC Accruals + Depreciation = NI ('Non-Cash WC) + Depreciation
= NI ['AR + 'Inventory - 'AP - 'AccLiab] + Depreciation
= 1,400 [(4900-3200) + (5500-4100) (3300-2800) (1500-2200)] + 3000
= $1,100M
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10 pts
The company is expected to have relatively stable sales for the next 3 years (2003-2006).
(b) Do you expect the working capital accruals in 2003 to be higher, lower, or the same as
working capital accruals reported in 2002? Provide reasons to support your answer.
WC Accruals in 2002 are positive and equal to $3,300M (see part (a)). Given that firm will
have no sales growth and that WC accruals tend to revert to zero over time when there is
no growth, then one should expect WC accruals to be lower over the next 3 years.
5 pts
(c) What do you expect free cash flow to equity (FCFE) to be in 2006? Please state any
assumptions you make and provide reasons for your answer.
Given no sales growth, then one should expect flat NI for the net several years. It we
assume that over the long run average (i) depreciation=Capex, (ii) WC accruals will
smooth to zero, and the firm has no debt repayment or issuances until 20010, then it
would reasonable to assume that predicted FCFE2006 = NI2006 = NI2002 = $1,400M
5 pts
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Quiz #2: 15.535 Winter 2003

QUESTION 1: Cost of Capital (30 pts)
Krispy Kreme Donuts is a fast growing donut store chain that is seeking to topple Dunkin Donuts as
the top snackfood store in the U.S. The following questions relate to an analysis of the risk and cost
of capital of this company.
(a) Krispy Kremes stock closed yesterday at price of $30.10 per share. Analysts predict earnings per
share for Krispy Kreme to be $0.87 next year. Analysts also predict that earnings will grow for the
foreseeable future at a rate of 30% per year. Using a growing perpetuity model, calculate the implied
cost of equity capital for Krispy Kreme. (You dont need beta here!)
(b) Why might the growing perpetuity model used in part (a) overstate the cost of capital for
Krispy Kreme? If you still used the implied cost of capital method, what changes to the model or
different assumptions would you make to obtain a better estimate of Krispy Kremes cost of capital?
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Yahoo! Finance reports that the current Beta for Krispy Kreme is 1.39. However, you re-estimate
the CAPM Beta using monthly stock returns for the past 12 months and find that the Beta is 0.81
with a standard error of 0.55.
(c) Give three reasons why your estimated Beta appears to be different than the one reported by
Yahoo! Finance.
(d) The current yield on long-term government treasuries is 4.9%. What is the estimated cost of
capital for Kripsy Kreme using the CAPM using the estimated Beta=0.81? How confident are you of
your estimate (You should reply on statistical numbers to comment on this result).
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(e) Using the 3-factor model, you estimate Krispy Kremes Size Beta to be 0.66 and its Distress
Beta to be -1.22. What do these coefficients mean? Do they imply a higher or lower cost of capital
compared to the CAPM?
QUESTION 2: Accounting Trading Strategies (20 pts)

(a) On March 1, 2003, ten companies in the retail sector announced their financial results for the
latest fiscal year. The ROE (=EPS/Book Value per share) for the ten companies ranged from 3% to
21%. Explain how you would implement a trading strategy using the earnings announcement drift
anomaly for these companies.
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(b) You also ranked the ten retail companies based on their reported Accruals for the latest fiscal
year. The ratio of Accruals-to-Total Assets was essentially the same for 8 companies. Of the two
remaining companies, one company had very high accruals and the other company had very low
accruals. What do you predict the stock returns will be for these two companies over the next 12
months?
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(c) When do you expect the abnormal returns for these two companies to occur?
QUESTION 3: Contracting (20 pts)

(a) Describe what is meant by performance pricing in debt contracts.
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Rackham Corporation raised $23 million in early 2002 from private debt placement. In 2002, its
debt-to-EBITDA ratio was 3.5. The debt contract stipulated that Rackham would have to pay an
additional 30 basis points in quarterly interest payments for each additional 0.5 increase in its Debtto-EBITDA ratio (For example, Debt-to-EBITDA greater than 4.0 would add 30 basis points, Debtto-EBITDA greater than 4.5 would add 60 basis points, etc.). In early 2003, Rackham reported a
Debt-to-EBITDA ratio of 3.99.
(b) Why might you be suspicious of potential accounting manipulation at Rackham in the current
year?
(c) What are the advantages of the Z-score over simple financial ratios (such as the current ratio) in
predicting the financial health of a firm? Give at least two major advantages.
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QUESTION 4: Option Accounting (10 pts)
In his March 4, 2003 opinion editorial column in the Wall Street Journal, Mr T.J. Rodgers
(President and CEO of Cypress Semiconductor) concludes that We need a pro forma
accounting standards board, chartered to specify how to make clear, consistent corrections to
the GAAP statements to remove the phony assets from our balance sheets and the unwarranted
charges to earnings from our income statements. Alternatively, if FASB would listen to its
customers, GAAP could be restored to its pre-2001 level of usefulness, with pooling of interests
accounting restored and option accounting left as is.
(a) As the CEO of a high technology company whose stock price has dropped by 50% over the
past year, what are Mr Rodgers motives to restore the old M&A accounting standards? (Hint:
Consider the implications of SFAS 142 with regard to goodwill.)
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(c) Explain why Cypress Semiconductor reported (related to options):

(i)
(ii)
high GAAP profits in 1999 and 2000 and had effective federal tax rate of only 14%,
lower GAAP profits in 2001 and 2002 yet its effective tax rate increased to 27%.
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Sample Solutions of Quiz #2: 15.535 Winter 2003

QUESTION 1: Cost of Capital (30 pts)
Krispy Kreme Donuts is a fast growing donut store chain that is seeking to topple Dunkin Donuts as
the top snackfood store in the U.S. The following questions relate to an analysis of the risk and cost
of capital of this company.
(a) Krispy Kremes stock closed yesterday at price of $30.10 per share. Analysts predict earnings per
share for Krispy Kreme to be $0.87 next year. Analysts also predict that earnings will grow for the
foreseeable future at a rate of 30% per year. Using a growing perpetuity model, calculate the implied
cost of equity capital for Krispy Kreme. (You dont need beta here!)
Growing Perpetuity Formula: E/(r-g) Therefore, r= E/P+g = 0.87/30.10 + 30% = 32.89%
10 pts
(b) Why might the growing perpetuity model used in part (a) overstate the cost of capital for
Krispy Kreme? If you still used the implied cost of capital method, what changes to the model or
different assumptions would you make to obtain a better estimate of Krispy Kremes cost of capital?
The lower bound of cost of capital is perpetual growth rate g. It appears that specified
growth rate of 30% in perpetuity is too high. Therefore, estimated cost of capital is too high.
Potential remedies:
Use a lower perpetual growth rate based on economic arguments (ie return to GDP
(i)
growth rate of 3 or 4%)
Use more realistic two-stage or three-stage DCF model with high earnings growth
(ii)
rate in next 5 years (30%), then lower earnings growth in the middle (years 6-10),
and then a low perpetual growth rate in years 11 and beyond.
4 pts
Yahoo! Finance reports that the current Beta for Krispy Kreme is 1.39. However, you re-estimate
the CAPM Beta using monthly stock returns for the past 12 months and find that the Beta is 0.81
with a standard error of 0.55.
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(c) Give three reasons why your estimated Beta appears to be different than the one reported by
Yahoo! Finance.
- Different estimation period (ie 60 months versus 12 months)
* Yahoo may use more data (60 months) which provides a better beta estimate
* Company risk has recently changed your estimate is more up-to-date
- There is no statistical difference between betas of 1.39 and .81. For example, the value of 1.39
falls within the 95% confidence interval of your estimated beta 0. In other words, 1.39 is
within 2 standard errors of 0.81 (0.55*2).
- Yahoo may use a different data to calculate its beta estimate (ie different risk-free rates or
different market benchmark)
6 pts
(d) The current yield on long-term government treasuries is 4.9%. What is the estimated cost of
capital for Kripsy Kreme using the CAPM using the estimated Beta=0.81? How confident are you of
your estimate (You should reply on statistical numbers to comment on this result).
CAPM: R=Rf + Beta*(Rm-Rf) = 4.9%+0.81*7.95% = 11.34% (Use long-term historical risk
premium from class notes)
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The 95% confidence interval for beta is 0.81 +/- 2*0.55 = [-0.29,1.91]. This includes the value
of zero which means that the firm may have no estimated market risk. Therefore, the
estimated cost of capital ranges from [2.60%, 20.08%]. You are not very confident about the
estimated very of 11.34%.
5 pts
(e) Using the 3-factor model, you estimate Krispy Kremes Size Beta to be 0.66 and its Distress
Beta to be -1.22. What do these coefficients mean? Do they imply a higher or lower cost of capital
compared to the CAPM?
The Size Beta of 0.66 means that the firms risk attributes appear to be more like a small stock
(ie positive factor loading). The Distress Beta of -1.22 means that the firms risk attributes
appear to be more like low B/M stock (ie negative factor loading means low distress).
The long term average annual returns on the Size and Distress portfolios are 3.32% and
5.05%.
Answer Option (A): Assuming the market beta is the same under the CAPM and the 3-factor
models, then the incremental return is 0.66*3.32% - 1.22*5.05% = -3.97% lower cost of
capital estimated using 3-factor model.
Answer Option (B): Do not have enough information to determine difference in cost of capital
because we do not know the market beta estimated using 3-factor model (can be different
from CAPM beta because of correlation in factor returns).
5 pts
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QUESTION 2: Accounting Trading Strategies (20 pts)

(a) On March 1, 2003, ten companies in the retail sector announced their financial results for the
latest fiscal year. The ROE (=EPS/Book Value per share) for the ten companies ranged from 3% to
21%. Explain how you would implement a trading strategy using the earnings announcement drift
anomaly for these companies.
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Post earnings announcement drift: Firms that announce highest (lowest) relative earnings
tend to have higher (lower) stock returns over next year. Therefore, after the announcement of
earnings on March 1, 2003, you could buy (go long) in the stocks with the highest earnings and
sell (go short) in stocks with the lowest relative earnings.
Note that we use ROE to scale for firm size.
10 pts
(b) You also ranked the ten retail companies based on their reported Accruals for the latest fiscal
year. The ratio of Accruals-to-Total Assets was essentially the same for 8 companies. Of the two
remaining companies, one company had very high accruals and the other company had very low
accruals. What do you predict the stock returns will be for these two companies over the next 12
months?
High accruals firm: expect low stock returns over the next 12 months
Low accruals firm: expect high stock returns over the next 12 months
5 pts
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(c) When do you expect the abnormal returns for these two companies to occur?
The majority of the abnormal returns are expected to occur around the next 4 subsequent
quarterly earnings announcements (when information about earnings/reversal of accruals is
revealed)
5 pts
QUESTION 3: Contracting (20 pts)
(a) Describe what is meant by performance pricing in debt contracts.
The borrowers periodic interest payments are variable and change as a function of financial
health/risk. The borrowers financial health/risk is measured using accounting ratios (i.e. Debt
to EBITDA ratio). The interest rate is typically a base rate (ie LIBOR) plus a premium
calculated based on the accounting ratio that is typically based on a pricing grid. Performance
pricing allows (1) the borrower to typically receive a lower upfront interest rate, and (2) the
lender to continually adjust the loan parameters to reflect repayment risk.
10pts
Rackham Corporation raised $23 million in early 2002 from private debt placement. In 2002, its
debt-to-EBITDA ratio was 3.5. The debt contract stipulated that Rackham would have to pay an
additional 30 basis points in quarterly interest payments for each additional 0.5 increase in its Debtto-EBITDA ratio (For example, Debt-to-EBITDA greater than 4.0 would add 30 basis points, Debtto-EBITDA greater than 4.5 would add 60 basis points, etc.). In early 2003, Rackham reported a
Debt-to-EBITDA ratio of 3.99.
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(b) Why might you be suspicious of potential accounting manipulation at Rackham in the current
year?
Rackhams Debt-to-EBITDA ratio is suspiciously close to, but just below, the next
performance-pricing increment. Given the incentives to pay a lower interest rate, we should
check to see if Rackham manipulated (ie increased) its EBITDA. We could check its working
capital accruals to see if they are out of line.
5 pts
(c) What are the advantages of the Z-score over simple financial ratios (such as the current ratio) in
predicting the financial health of a firm? Give at least two major advantages.
(1) Individual ratios may not capture a firms true financial health (ie low current ratio may
mean poor liquidity (Bad) or good management of working capital (Good).
(2) The Z-score includes stock market information which is a more timely measure of health
compared to accounting numbers.
(3) It is easier for the firm to manipulate individual accounting numbers compared to a whole
range of accounting numbers.
5pts
QUESTION 4: Option Accounting (10 pts)
In his March 4, 2003 opinion editorial column in the Wall Street Journal, Mr T.J. Rodgers
(President and CEO of Cypress Semiconductor) concludes that We need a pro forma
accounting standards board, chartered to specify how to make clear, consistent corrections to
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the GAAP statements to remove the phony assets from our balance sheets and the unwarranted
charges to earnings from our income statements. Alternatively, if FASB would listen to its
customers, GAAP could be restored to its pre-2001 level of usefulness, with pooling of interests
accounting restored and option accounting left as is.
(a) As the CEO of a high technology company whose stock price has dropped by 50% over the
past year, what are Mr Rodgers motives to restore the old M&A accounting standards? (Hint:
Consider the implications of SFAS 142 with regard to goodwill.)
- May have overpaid for past acquisitions accounted for using the Purchase Method.
Under SFAS 142, firm will have to write down acquired goodwill if it is impaired. The
impairment test is triggered because the firms stock price has dropped by a large
amount. Firm will report a large loss which may adversely affect its stock price or it may
violate certain debt contracts.
- Alternate answer: Under old pooling rules firm did not have to recognize amortization of
goodwill nor did it have to recognize impairment (both reduce reported earnings).
5 pts
(c) Explain why Cypress Semiconductor reported (related to options):
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(ii)
high GAAP profits in 1999 and 2000 and had effective federal tax rate of only 14%,
lower GAAP profits in 2001 and 2002 yet its effective tax rate increased to 27%.
(i)
High profits in 1999-2000 led to stock price increase which ensured that
employee stock options were in the money. Therefore, employees exercised their
stock options which provided the company with IRS tax deductions (difference
between stock price and exercise price of options). This lowered the effective
tax rate for the firm.
Economy and stock market turned down in 2001-2002. This meant lower
profits and a decrease in stock price. Fewer employee stock options were in-themoney and, therefore, fewer option exercises. This meant that firm had fewer
tax deductions.
(ii)
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5 pts

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Business Valuation and

Professor Peter Wysocki Peter

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Provide knowledge to help you get a great job.

What is contained in financial reports

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My objective is not to make your life

irrelevant assignments or make-work tasks.

My objective is to make this class relevant,

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Provide up-to-date applied knowledge of:

Very useful for your career as:

Financial analyst, I-banker, consultant, etc.

Discuss up-to-date and hot topics that

There is no required coursepack! I will provide

How Prep for Class

Short reading assignments from the text and

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6 "e-assignments" (count best 5)

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These short applied assignments will be

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How Analyst Reports

Student teams (up to 4 students) will be

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How Classroom Approach

The classes will be casual, fun and informal.

I think the best way to learn is through

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Financial Statement Information

Used extensively by internal users

Management at various levels

Current and future employees

Is this firm going to meet its payroll and will the

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Financial Statement Information

Used primarily by external users

Valuation for M&A and IPO

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Financial Statement Analysis

Financial statement analysis and business

What the course is NOT about

Extreme details of financial reporting rules

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Market Efficiency and the Role of

Financial Statement Analysis

Implications of stock market efficiency:

If markets are efficient, then whats the use of

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Market Efficiency and the Role of

Financial Statement Analysis

Conflicting evidence on market efficiency

Markets are Efficient:

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Market Efficiency: What is My View?

I am not dogmatic about efficiency.

On the other hand, financial (stock) markets are very

Where Next? .. Prep for next week

1) Make sure you register on class server!

Preparation: Review your Finance Notes on DCF

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