978-0078025679 Chapter 6 Lecture Note

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

CHAPTER 6

THE ROLE OF FINANCIAL INFORMATION IN

VALUATION AND CREDIT RISK ASSESSMENT

CHAPTER OVERVIEW

This chapter provides a framework for understanding the role that accounting numbers have in

business valuation and credit risk assessment. Alternative valuation models and approaches to credit

risk assessment are presented to illustrate what it means to assess the amounts, timing, and

uncertainty surrounding the prospects for net cash inflows of a business.

A critical part of understanding the decision-usefulness of accounting information is

understanding which accounting numbers are used, why they are used, and how they are used in

investment and credit decisions. Knowing how earnings, book values, and cash flows are used in

investment and credit decisions will assist students and readers of financial statements in evaluating

the value-relevance of alternative accounting measures discussed in subsequent chapters of this

book – not only those recognized directly in the financial statements but also those disclosed in the

financial statement’s notes. This knowledge is important for understanding the incentives that

management has for structuring transactions in certain ways or for choosing among alternative

generally accepted accounting treatments for a particular event or transaction. Financial statement

users also need to be aware of “off–balance sheet” obligations that could distort the valuation of a

corporation.

CHAPTER

OUTLINE

I. BUSINESS VALUATION

A. Corporate valuation involves estimating the worth or the intrinsic value of a company,

one of its operating units, or its ownership shares.

B. Equity investors, lenders, and analysts often use fundamental valuation approach to

estimate the value of a company. This valuation approach is comprehensive and rigorous,

and it uses basic accounting measures (or fundamentals) to assess the amount, timing, and

uncertainty of a firm’s future operating cash flows or earnings.

1. Fundamental valuation approach is the focus of this chapter.

2. Business valuation involves three basic steps:

a. Forecasting future amounts of some financial attributes also referred to as value-

relevant attribute such as distributable or free cash flows, accounting earnings,

balance sheet book values, etc.

b. Determining the risk or uncertainty associated with the attribute’s forecasted

future value.

c. Determining the discounted present value of the expected future values of the

value-relevant attribute, where the discount rate reflects the risk or uncertainty

inherent in the value attribute of interest.

3. Cash flow assessment is critical to credit risk analysis since estimates of future

cash flows can be compared to debt-service requirements.

C. Technical analysis, on the other hand, focuses on business cycles and the past price

record of a firm.

D. Corporate valuation techniques, such as the discounted free cash flow, are required by U.S.

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

GAAP for assessing the impairment of goodwill.

II. THE DISCOUNTED FREE CASH FLOW APPROACH TO VALUATION

A. The distributable—or free—cash flow valuation model combines the elements in the

three steps listed above to express what a stock is worth (its intrinsic value) as the

discounted present value of expected future distributable cash flows.

B. Free cash flow has many definitions, but is sometimes defined as the company’s operating

cash flows (before interest) minus cash outlays for the routine replacement of existing

operating capacity like buildings, equipment, and furnishings.

1. It is the amount available to finance planned expansion of operating capacity, to reduce

debt, to pay dividends, or to repurchase stock.

2. This is an appropriate measure for valuing the company as a whole and without regard

to its capital structure.

C. Free cash flow available to common shareholders is an appropriate measure for valuing

just the company’s common stock.

1. The free cash flow measure defined above is refined by also subtracting cash interest

payments, debt repayments, and preferred dividends.

2. This refined measure is the free cash flow that is available to common shareholders.

3. Equation (6.1) in the text illustrates an equity valuation model using this definition of

free cash flow.

a. The valuation model’s cash flow stream continues, with uncertainty, over an

infinite horizon. Simplifying assumptions may include zero-growth perpetuities

(for mature firms) or constant-growth perpetuities (for growth firms).

b. The discount rate (equity cost of capital) is adjusted to reflect the uncertainty or

riskiness of the expected cash flow stream.

c. Simply put, this equation says that intrinsic value (and market price) of each

common share depends on investors’ current expectations about the future

economic prospects of the firm as measured by free cash flows.

4. Accountants and auditors must know how to use the discounted free cash flow

valuation approach for accounting for goodwill.

a. Accounting goodwill arises when one company buys another company and

pays more than the acquired company’s individual net assets are worth.

b. Accounting Standards Codification (ASC) 350, “Goodwill and other

Intangibles” requires companies to “test” for goodwill impairment at least once

a year.

D. The role of earnings in valuation:

1. If investors are interested in a company’s future cash flows, what role does earnings

have in valuation?

a. The role of accounting earnings information is indirect—earnings are only useful

because they help generate improved forecast of future free cash flows.

b. The FASB asserts that current earnings provide a better measure of long-run expected

operating performance than do current cash flows.

Teaching Tip: Recall the Canterbury Publishing example from Chapter 2. Cash flows are

“lumpy,” but accrual accounting earnings measurement takes a long-horizon perspective that

smoothes out the “lumpiness” in year–to-year cash flows.

c. Empirical research finds that current earnings are a better predictor of future

cash flows than are current cash flows. In addition, stock returns correlate

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

better accrual accounting earnings than with realized operating cash flows.

Teaching Tip: The important implication is that investors are better able to predict a

company’s future free cash flows using accrual earnings than by using realized cash flows.

2. Through the use of accruals and deferrals, accrual accounting produces an earnings

number that smoothes out the unevenness or “lumpiness” in year–to–year cash flows,

and it provides an estimate of sustainable “annualized” long-run future free cash flows.

3. Equation (6.4) illustrates a valuation model where current observed earnings replace

current cash flows that were used in equation (6.2).

4. Under the assumption of zero growth, equation (6.4) reduces to equation (6.6).

a. The left-hand side of equation (6.6) is the implied price-earnings (P/E) ratio, also

called the earnings multiple, which is a measure of the relation between a firm’s

current earnings and its intrinsic share value.

b. The price-earnings ratio in equation (6.6), under the assumption of zero growth, is

the reciprocal of the risk-adjusted interest rate used to discount future earnings.

III. THE ABNORMAL EARNINGS APPROACH TO VALUATION

A. Earnings and equity book value numbers are direct inputs into the valuation process.

1. This new approach is based on the notion that the value of a company and its share

price is driven not by the level of earnings themselves but by the level of earnings

relative to a fundamental economic benchmark —the cost of capital, expressed in

dollars.

2. This benchmark reflects the level of earnings that investors demand from a company

as compensation for the risks of the investment.

3. Equation (6.5) shows that share price is a function of the book value of equity

plus capitalized expected future abnormal earnings.

a. Investors pay a premium for firms that earn more than the cost of capital—

meaning the firms produce positive abnormal earnings.

b. Firms whose earnings are “ordinary” or “normal”—that is, where the earnings

rate is equal to the cost of capital—investors are willing to pay an amount equal

to the underlying book value of equity.

c. Firms that earn less than the cost of capital—they produce negative abnormal

earnings—have a share price below book value.

d. Abnormal earnings represent any difference between actual earnings for the

period and stockholders’ required return on invested capital at the beginning of

the period (i.e., the cost of beginning equity capital).

e. ROCE (return on common equity) combines information about earnings and

equity book value – both essential to the abnormal earnings valuation

approach.

f. ROCE is compared to its required rate of return (cost of equity capital) or to

industry averages to evaluate is potential for generating “abnormal earnings.”

g. Companies with ROCEs consistently higher than the industry average

generally have shares that sell for a premium (that is, a higher market-to–book

ratio).

4. If return on equity (ROE) exceeds return on assets (ROA), then the firm has the

ability to earn a return on its investments that exceeds its cost of debt financing.

a. This is because ROA measures the company’s earnings returned on all invested

capital (since total assets must equal debt plus equity), whereas ROE is the return

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

on equity capital.

b. Interest paid on debt financing (net of taxes) is added back to net income to form

the numerator of the ROA calculation, leaving an adjusted earnings number that

measures the return on all invested capital.

c. Firms with ROEs that consistently exceed the industry average generally will

have shares that sell for a higher premium relative to book value (i.e., market-to–

book ratio).

5. Financial Statements and related footnotes provide a wealth of information for

assessing the relationship expressed by equations (6.7) and (6.8) in the text.

a. The balance sheet provides detailed information on the book value of equity

(assets minus liabilities).

b. The income statement provides detailed information for assessing a firm’s

earnings.

c. In making comparisons across firms, the analyst must be careful to gauge the

quality and comparability of the accounting policies or methods used. Much of

the information needed for assessing the quality and value-relevance of a

company’s reported accounting numbers appears in footnotes that accompany the

financial statements.

IV. FAIR VALUE ACCOUNTING

Fair value accounting is much more prevalent in financial statements than ever before. As

one example among other applications, GAAP requires that fair value be used to assess goodwill

impairment.

1. ASC Topic 820: Fair Value Measurement and Disclosures (based on SFAS No. 157), defines

fair value, establishes a framework for measuring fair value, and requires expanded

disclosure about fair value measurements. This standard was issued to increase consistency

and comparability in determining fair values. It also provides a three-level hierarchy that

prioritizes the information used to arrive at fair value.

a. Level 1 uses quoted prices from active markets for identical assets or liabilities. This

is the preferred level.

b. Level 2 includes observable inputs other than Level 1 quoted prices.

c. Level 3 covers unobservable inputs such as management’s estimates of expected

future cash flows or abnormal earnings.

d. Firms must disclose at each reporting date the hierarchy level at which the fair values

were determined.

2. Fair value is defined as the price that would be received to sell an asset or paid to transfer a

liability in an orderly transaction between market participants at the measurement date.

3. ASC Topic 820 gives companies, auditors, and investors much needed guidance on how to

measure fair values but also creates opportunity for potential accounting abuses.

4. Expanded use of fair values only means that auditors must have technical knowledge of the

valuation tools and how they are used in practice.

V. GLOBAL VANTAGE

A. The IASB and FASB are currently concluding a joint convergence project on fair

value measurement and disclosure with the aim to ensure that both U.S. GAAP and

IFRS reflect a shared view about fundamental principles such as what fair value means

and how best to measure it.

B. As part of the convergence project, the IASB issued IFRS 13 “Fair Value

Measurement” in May 2011 that fundamentally agrees with U.S. GAAP on the definition

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

of fair value as an exit price, the three-level measurement hierarchy, and most disclosure

requirements. As part of the convergence project, FASB released Accounting Standards

Update No. 2011-04 in May 2011, revising ASC 820–10 to bring U.S. fair value disclosure

rules in line with recent IFRS.

VI. RESEARCH ON EARNINGS AND EQUITY VALUATION

Research on the value-relevance of financial accounting information has been researched for

more than 40 years with the goal of furthering our understanding of the relation between actual

stock prices and earnings.

1. Equation (6.7) suggests that current earnings can “explain” actual stock prices.

2. It immediately follows that earnings differences across firms should help explain

differences in these firms’ stock prices (i.e., earnings are value-relevant). That

is, if investors view accounting earnings as an important piece of information

for assessing firm value, then earnings differences across firms should help

explain differences in firms’ stock prices.

3. Cross-sectional tests (i.e., tests that examine the association between stock prices and

earnings across many firms at a given point in time) indicate that the proportion of

variation in share prices explained by earnings is only about 61.7%.

VII. SOURCES OF VARIATION IN P/E MULTIPLES: Current earnings, a poor forecast of future

expected earnings

A. Risk Differences:

1. Firms with the same level of current and future earnings can sell for different

prices because of differences in risk or uncertainty associated with those

earnings.

2. Riskier firms have higher discount rates (risk-adjusted cost of capital) that lead to

lower share prices.

B. Growth opportunities:

1. The market values firms’ growth opportunities—that is, the possibility of earnings

from reinvesting current earnings in projects that will earn a rate of return in excess of

the cost of equity capital (i.e., the discount rate).

2. The net present value of growth opportunities (NPVGO) adds a positive

increment to a firm’s average P/E multiples.

3. Equation (6.9) shows the pricing function that includes NPVGO.

4. The pricing equation contains two terms:

a. The current operations where current earnings are viewed as a level

perpetuity.

b. The future growth value of a firm (NPVGO).

C. Permanent, transitory, and valuation-irrelevant components of earnings

1. If investors view firms’ current earnings levels as likely to persist in perpetuity, then

the slope coefficient (β) in equation (6.9) should equal the average earnings multiple

for the particular firms and time period examined.

2. However, for many firms, the earnings multiple falls well below this theoretical value,

in part because of distinctly different earnings components, each subject to different

earnings capitalization rates.

a. A permanent earnings component is value relevant and expected to persist into

the future.

i. In theory, the multiple for this component should approach 1/r.

ii. Income from continuing operations (exclusive of special or nonrecurring

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

items) is generally considered a recurring, sustainable component of a

company’s profit performance.

Teaching Tip: Keep in mind that while restructuring charges are generally considered

nonrecurring items, once a firm has recorded them it is likely that they will record additional

restructuring charges within the next three years.

b. A transitory earnings component is value-relevant, but is not expected to persist

into the future.

i. The multiple for this component should approach 1.0.

ii. Income (loss) from discontinued operations and extraordinary gains and losses

are nonrecurring items that are more likely to be viewed as transitory

components of earnings.

c. A value-irrelevant or noise component is unrelated to future free cash flows and

is not relevant to assessing current share price.

i. Such earnings components should carry a multiple of zero.

ii. Income (loss) from discontinued operations and extraordinary gains (losses)

are nonrecurring and viewed as transitory components of earnings.

iii. The current year impact of a change in accounting principles has no future

cash flow consequences and is viewed as noise that is value-irrelevant.

3. The capital market does not react naively to earnings, but instead, it appears to distinguish

among permanent, transitory, and value-irrelevant earnings components.

4. Theor etically, p ermanent (s ustainabl e) earnings should have a h igher earn ings multip le

than transitory earnings because it is expected that the former will persist longer into the

future.

D. The concept of earnings quality:

1. Quality of earnings measures how much the profits companies publicly report diverge

from their true operating earnings.

a. Low quality means the bottom line is padded with paper gains.

b. A decline in quality means companies’ reported earnings are less sustainable than

they appear.

2. Earnings quality is multifaceted and there is no consensus on how to measure it.

3. However, earnings are considered to be high quality when they are sustainable.

a. Sustainable earnings are generated from repeat customers, or from a high quality

product that enjoys steady customer demand based on brand name identity, etc.

b. Unsustainable earnings derive from gains and losses from debt retirement; write-

offs of assets from corporate restructuring and plant closings, or reduction in

discretionary expenditures for advertising and research and development, etc.

4. Earnings quality is also affected by the accounting methods chosen by management to

describe routine, ongoing activities of a company and by the subjectivity of accounting

estimates.

B. Earnings surprises:

1. Both the earnings capitalization model and the abnormal earnings model require

estimates of future earnings.

a. Estimates usually prove to be incorrect, resulting in earnings surprises.

b. An earnings surprise represents information that investors will use to revise their

expectations about the company’s future earnings and cash flow prospects.

c. This change in investor expectations will cause a change in the company’s stock

price.

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

3. Earnings surprises are “information” to the capital market as long as expectations

about the company’s earnings and cash flows are unbiased. Unbiased means that, on

average, the market’s expectations will be correct—not systematically high or

systematically low.

Teaching Tip: A number of empirical studies have compared analyst and mechanical model

forecasts. The results generally indicate that analyst forecasts are superior, but not

dramatically so. However, there are some caveats. The superiority of analyst forecasts is

related to firm size. In addition, analyst forecasts provide less benefit as earnings uncertainty

increases (Brown, Richardson, and Schwager, 1987). This result is troublesome since it is in

the environment of high uncertainty that there is a need for analyst services, yet they may not

outperform mechanical models. In direct contrast, another study of individual analysts notes

that those analysts with the best forecasting record were those whose forecasting behavior was

the most difficult to predict (Stickel, 1990). Furthermore, Brown, Foster, and Noreen (1985)

find that analyst forecasts follow the market rather than lead it. Thus, if a firm’s stock is

moving strongly in one direction, analyst forecasts will be revised in that same direction.

3. Companies that report a positive earnings surprise tend to have an upward drift in

stock price returns prior to the actual earnings announcement date while

companies that report a negative earnings surprise tend to have a downward drift

prior to the announcement.

4. A risk-based assessment may be appropriate when valuing a business opportunity

based on expected future cash flows and a valuation based on expected abnormal

earnings.

5. Sensitivity analysis, involving the analysis of “best case” and “worst case” scenarios,

should be calculated no matter which methodology is used.

VIII. CREDIT RISK ASSESSMENT

A. Traditional lending products:

1. Commercial bank loans are a common source of cash for most businesses.

a. Loans with maturities of one year or less, called short-term loans, comprise

more than half of all commercial bank loans.

i. Seasonal lines of credit and special purpose loans are the most common

short-term borrowing.

ii. Short-term loans are used primarily to finance working capital needs.

b. Long-term loans have maturities of more than one year, with maturities ranging

from two to five years being most common.

i. Term loans are often used to finance the purchase of long-term assets, the

acquisition of another company, the refinancing of long-term debt, or

permanent working capital needs.

ii. They are frequently secured by the pledging of the assets acquired with the

loan proceeds.

iii. It is generally presumed that principal and interest payments will come from

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

the borrower’s future operating cash flows.

c. Revolving loans have a commitment period extending beyond one year, and

allow borrowing up to a maximum level at any time over the life of the loan.

i. Revolving loans are often used to finance cash imbalances, seasonal needs,

or permanent working capital needs when normal trade credit is inadequate

to support a company’s sales volume.

ii. In addition to interest, the borrower pays a “commitment fee” that is based

on the total amount of the credit facility.

2. Commercial paper. These are short-term notes sold directly to investors by large

and highly rated companies.

a. These notes usually mature in 270 days or less.

b. Since commercial paper is issued directly to investors and is usually secured by a

bank credit line, the interest rate the company pays is often significantly below the

rate a bank would charge for a direct loan.

3. Long–term forms of public debt financing include bonds, debentures, and

notes

B. Credit analysis encompasses several steps:

1. Financial analysis of a potential borrower begins with an understanding of the firm, its

business, its key risks and success factors, and the competitive dynamics of the

industry.

2. Next, analysis of the quality of accounting earnings and financial reporting choices is

made to determine whether traditional ratios and statistics derived from the financial

statements can be relied on to measure accurately the company’s economic

performance and financial condition.

3. Evaluate the company’s profit performance and balance sheet strength using financial,

operating, and leverage ratios discussed in Chapter 5.

4. Prepare pro forma (i.e., forecasted) financial statements to assess the borrower’s ability

to generate sufficient cash flows to make interest and principal payments when due.

5. Perform “due diligence” evaluation by qualitatively assessing management’s character

and capability.

6. Finally, conduct a comprehensive risk assessment that involves evaluating

and summarizing the various individual risks associated with the loan.

C. Credit Rating Agencies

1. These agencies assess and grade the credit worthiness of companies and

public entities that sell debt to investors.

2. Letter grades are used to express an opinion regarding default risk or the

borrowers ability to meet its financial commitments on time and in accordance

with the debenture’s provisions.

3. When firms are deemed to be aggressive in application of accounting standards

or when their financial statements lack transparency, credit risk increases.

D. Financial Ratios and Debt Ratings

1. Exhibit 6.5 describes an example of the key financial statement ratios used.

VIV. APPENDIX A— DISCOUNTED CASH FLOW AND ABNORMAL EARNINGS VALUATION APPLICATIONS

A. This appendix demonstrates the discounted free cash flow and abnormal earnings

valuation methods are used to value a business opportunity and determine the worth of a

company’s common stock.

B. Valuing a business opportunity – This section illustrates how to perform a

sensitivity analysis of free cash flows and abnormal earnings in order to learn how

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

alternative economic conditions might affect the business valuation and its return on

investment.

B. Valuing Whole Foods Market’s Shares – This section illustrates how the abnormal

earnings valuation model can be combined with security analysts’ published earnings forecast to

produce an intrinsic stock price estimate for a company.

X. APPENDIX B—FINANCIAL STATEMENT FORECASTS

A. This appendix demonstrates a comprehensive financial statement forecasts.

B. A financial forecast uses historical data and current operational ratios and calculates the

expected results of operations and financial position. This way it ensures the forecasted

financial statements (pro forma projections) are internally consistent.

C. A financial projection is a form of a prospective financial statement that changes an

assumption about the operational or financial fundamentals of the operation of the entity.

D. Preparing comprehensive financial statement forecasts involves six steps as illustrated in

the appendix of Ch 6.

E. This appendix also illustrates the preparation of Veto Equipment Supply Company’s

comprehensive financial statement forecasts.

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

CHAPTER QUIZ

1. Which of the following cash flow alternatives is used in discounted cash flow valuation

models?

a. Dividends.

b. Accounting earnings.

c. Free cash flows.

d. All of the above.

2. Which of the following contributes to high-quality earnings?

a. Gains or losses resulting from debt retirement.

b. Earnings generated from repeat customers.

c. Write-off of assets from corporate restructuring and plant closings.

d. The use of accounting estimates.

3. If investors are truly interested in knowing a company’s future cash flows, why would they care

about current earnings?

a. Net income provides an estimate of sustainable “annualized” long-run future free cash

flows.

b. Accruals and deferrals imitate the “lumpiness” inherent in year–to-year cash flows.

c. Investors are better able to predict a company’s future free cash flows using accrual

earnings

than by using realized cash flows.

d. All of the above.

4. Which of the following justifies a higher P/E multiple?

a. A lower level of risk, even though the potential payoff may be lower than for a riskier

project.

b. The retention of earnings to fund projects with zero net present value of future growth

opportunities.

c. A higher level of permanent earnings.

d. A change in accounting principle, which gives rise to a cumulative effect adjustment.

5. Assume that a firm’s net operating profit after taxes (NOPAT) is $24,000, discount rate is 15%,

and beginning book value of equity is $120,000. Calculate the firm’s abnormal earnings.

a. $0.

b. $3,600.

c. $6,000.

d. $18,000.

6. Assume that the firm in 5. above can add a new division at a cost of $80,000, which will

increase NOPAT by $15,200. Would the firm add the division?

a. Yes. Abnormal earnings would increase by $9,200, adding additional value to the firm.

b. Yes. This project has a positive net present value of more than $10,000, creating

additional value to the firm.

c. No. This project creates additional abnormal earnings of $3,200, which is less than the

15% required return.

d. No. The discount rate may increase, causing the value of the firm to decline.

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

7. Firms that have a share price below book value earn

a. below the industry average.

b. equal to the cost of equity capital.

c. below the cost of equity capital.

d. above the cost of equity capital.

8. If the Return on Equity exceeds the Return on Assets, the earnings are

a. below the cost of debt financing.

b. equal to the cost of debt financing.

c. above the cost of debt financing.

d. at least one-half of the cost of debt financing.

9. Earnings in excess of stockholders’ required dollar return on invested capital are

a. value-irrelevant earnings.

b. transitory earnings.

c. noise.

d. abnormal earnings.

10. Lee Corporation will generate earnings of $120,000 per year, in perpetuity, as long as no

investments are made. However, one year from now, Lee can invest $150,000 in a project that

will generate income of $80,000 forever. Lee has 15,000 shares outstanding and the

appropriate discount rate is 12%. Calculate the price of Lee’s stock assuming that investors

know the firm has the investment available.

a. $66.66.

b. $93.16.

c. $94.12.

d. $97.42.

QUIZ ANSWERS:

1. d. Discounted cash flow valuation models use three alternative cash flow measures:

dividends, accounting earnings, and free cash flows. Just as discounted cash flow valuation

models and asset-based valuation models are equivalent under the assumption of perfect

markets, dividends, earnings, and free cash flow measures can be shown to be equivalent.

Financial Reporting and Analysis 6e The Role of Financial Information in Valuation and Credit Risk Assessment

of McGraw-Hill Education.

used in capitalizing earnings will be lower, resulting in a higher price. The net present value of

future growth opportunities adds value when the investment projects have positive net present

value. Theoretically, an increase in permanent earnings will increase price, but are capitalized at

the theoretical P/E multiple, which is 1/r. Changes in accounting principles generally have no

cash flow consequences to shareholders, and are viewed as “noise” that is valuation-irrelevant.

5. c. Abnormal earnings = NOPAT – (r x BVt-1)

Abnormal earnings = $24,000 – (.15 x

120,000) Abnormal earnings = $6,000.

6. b. Abnormal earnings = $39,200 – (.15 x $200,000)

Abnormal earnings = $9,200

Abnormal earnings rise to $9,200, but that is an increase of only $3,200. In addition, the net

present value of the project is positive by more than $20,000 ($15,200 ÷ .15 – $80,000). Both

of these measures are consistent with the creation of additional value. While a change in risk is

a possibility, the discount rate would have to increase to 23% in this case, even if the project

was entirely financed with debt.

7. c. Firms that earn less than the cost of capital produce negative abnormal earnings and have a

share price below book value.

8. c If the return on equity exceeds the return on assets then the firm has the ability to earn a return

on its investment that exceeds the cost of its debt financing.

9. d. Abnormal earnings represents any difference between actual earnings for the period and

stockholders’ required return on invested capital at the beginning of the period.

10. b. Price p er share = ( PV of earnings from ass ets in pl ace + NPVGO ) ÷ shar es outstandin g

Present value of earnings from assets in place: $120,000 ÷ .12 = $1,000,000.

NPVGO: ($80,000 ÷ .12) – 1.122) – ($150,000 ÷ 1.12) = $397,534.02.

Price per share = $1,397,534.02 ÷ 15,000 = $93.16.

The calculation of the NPVGO requires some explanation. The $80,000 incremental

perpetuity is capitalized at the discount rate. This amount, however, will not be realized until

the end of the second year, so it is discounted back to the present. Similarly, the $150,000

outlay will take place at the beginning of year 2, so it is also discounted back to the present.

RECOMMENDED EXHIBITS

Exhibit 6.1—Illustration of the discounted free cash flow approach to valuation.

Exhibit 6.2—Illustration of the abnormal earnings approach to valuation.

Figure 6.1—Linkage between stock price and accrual earnings.

Figure 6.5—Stock returns and quarterly earnings surprises.

Exhibit 6.5—Standard & Poor’s key financial ratios and ratings of corporate debt.

Exhibit 6.10—Veto Equipment Supply Company historical financial statements

Exhibit 6.11—Veto Equipment Supply Company historical and projected income

statements and balance sheets.

Exhibit 6.12— Veto Equipment Supply Company historical and projected cash

flow statements.