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EnCom Corporation
The Analysis of Earnings Quality
Defining Earnings Quality
⚫What criteria would a high quality accounting
prior to the one in which it is sold
–no other income or expenses
–At end of each period, all free cash flow is paid as out as a
dividend
Stage 1 Questions
1. What is the total initial investment that is
required at the beginning of the first period in
2. Compute the value of EnCom immediately
3. Compute EnCom’s internal rate of return.
Solution (double click to see computations)
End of Period 0 1 2 3 4 5 6
Discount Factor at 10% 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
DCF Valuation
Cash Inflows 0 600 1,200 1,200 1,200 1,200 600
Cash Outflows -1,720 -720 -720 -720 -720 0 0
Free Cash Flow -1,720 -120 480 480 480 1,200 600
DCF -1,720.00 -109.09 396.69 360.63 327.85 745.11 338.68
DCF Valuation 2,059.87
IRR 14.76%
Stage 1 Questions
4. Prepare financial statements (income
statements and balance sheets) for EnCom
for each of the five periods that it is in
business.
Solution (double click to see formulas)
0 1 2 3 4 5 6
Income Statement
Revenue 0 1,200 1,200 1,200 1,200 1,200 0
Cost of Goods Sold 720 720 720 720 720 0
Depreciation 0 200 200 200 200 200 0
Net Income 0 280 280 280 280 280 0
Dividends -1,720 -120 480 480 480 1,200 600
Balance Sheet
Accounts Receivable 0 600 600 600 600 600 0
Stage 1 Questions
5. Compare EnCom’s free cash flows and
earnings for each of the five periods. Overall,
which of the two measures do you think
Stage 1 Questions
7. Compute EnCom’s return on equity for each of the
five periods. Compare EnCom’s ROE for each period
to EnCom’s IRR and provide a qualitative explanation
for any major differences.
