Week 1

Investment styles:

• Intuitive investing: relies on intuition and hunches: no analysis.

• Passive investing: accepts market price as value: no analysis.
This is the “efficient market” approach.
• Momentum investing: those stocks that have gone up have
momentum to continue going up more.
• Fundamental investing: uses Fundamental analysis or
valuation analysis (also called security analysis when securities
such as stocks or bonds are involved). It examines information
about firms for the purpose of reaching conclusion about the
underlying value. It challenges market prices.
• Fundamental investing could be either: active investing or defensive investing.

2
1-2
Costs of Each Approach
• Danger in intuitive approach: self deception; ignores ability to check
intuition.
• Danger in passive approach: there is a risk of paying too much.
•Danger in momentum approach: nothing can go up forever.
speculation feeds on itself, creating bubbles.

• Fundamental analysis: requires work !

• The defensive investor: prudence requires analysis; a defense
against paying the wrong price (or selling at the wrong price).
• The active investor: activism requires analysis; an opportunity to
find mispriced investments.

3
1-3
• Fundamental investors try to discover the Intrinsic value (warranted value
or fundamental value or fair value or true economic value): is the worth
of an investment that is justified by the information about its payoff.

• To arrive at it we need to make fundamental analysis. While this

analysis does not entirely remove uncertainty, it gives you a sense of
the true value.

Fundamental risk: is the risk that results from business operations.

Price risk: is the risk of trading at the wrong price. Paying too much or selling
for too little.

4
1-4
The settings: investors, firms, securities,
and capital markets

The firm: The investors:

The claimants on value
The value generator

ld y
h o ar
s

s
Cash from loans

er

er
bt nd
Cash from sale of

ld

De eco
ho
debt

bt

S
De
Interest and loan
repayments
Operating

Financing
Activities

Activities

Activities
Investing

rs
Cash from share issues

ol ry
de

rs
eh d a
de
ol
Cash from sale of

ar on
h
re
shares

Sh Sec
a
Sh
Dividends and cash from
share repurchases

Business investment and the firm: value is surrendered by investors to the firm. The firm
adds or loses value, and value is returned to investors. Financial statements inform about
the investments. Investors trade in capital markets on the basis of information on financial
statements.
5
1-5
The settings: investors, firms, securities,
and capital markets
Firms Households and Individuals

Business Business Business Debt Household

Assets Debt (Bonds) Liabilities

Business Equity Business Equity Net

(Shares) Worth

Other
Assets

Value of the firm = Enterprise value = Value of Assets

= Value of Net Debt +Value of Equity

V0F  V0D  V0E

Typically, valuation of debt is a relatively easy task.

6
1-6
Business Activities

Financing activities: raising cash from investors and returning cash

to investors

Investing activities: investing cash raised from investors and funds

generated from operations in operational assets

Operating activities: utilizing investments to produce and sell

products. Cash generated from operations might be re-invested.

7
1-7
Measurements of assets in the Balance
Sheet
• Cash and cash equivalents: usually equals their fair value.
• Shot-term investments and marketable securities: recorded at fair market value.
• Receivables: quasi fair value because they are based on expected cash collected.
• Inventories: Lower of cost or market value.
• Long-term tangible assets: recorded at historical cost and depreciated over their
useful lives. They are also subject to impairment down to fair value if the fair value is
below the depreciated cost, but there is no upward revaluation.
• Recorded intangible assets: recorded at historical cost and amortized like tangible
assets. They are also subject to impairment down if the fair value is below the
amortized cost, but there is no upward revaluation
• Goodwill: carried at historical cost (no amortization, but subject to impairment down)
• Other intangible assets: not recorded such as R&D, brand assets, knowledge assets,
etc.

8
2-8
 Measurements of assets in the Balance
Sheet
• Investment in Long-term debt securities:

o Investment held for active trading: recorded at fair value in the balance sheet.
Unrealized gains and losses are reported in the income statement).

o Investment available for sales: they are not for active trading, but could be sold
before maturity. Recorded at fair value in the balance sheet. Unrealized gain or
losses are reported in other comprehensive income on balance sheet equity
section).

o Investment held to maturity: recorded at historical cost on the balance sheet. The
fair value is reported in the footnotes. Unrealized gains/losses are unrecognized.
Interest received during their lives are reported in the income statement.
9
2-9
 Measurements of assets in the Balance
Sheet
• Investments in equities of other firms:

o If the investment < 20% of the other firm’s shares those held for active trading or
available for sale or held to maturity are treated like debt investments.

o If the investment is 20-50% of the other firm’s shares: using the equity method
( at cost but carrying value is increased by the share of earnings less dividends
paid and wrote off of goodwill acquired on purchase). The share of earnings less
dividends paid and wrote off of goodwill acquired on purchase are reported in
income statement.

o If the investment > 50% of the other firm’s shares, in this case the other firm
financial reports are consolidated in the parents firm with a deduction for the
minority interest from net assets and net income of the parent firm.
10
2-10
Measurements of liabilities in the Balance
Sheet
• Short-term payables (at fair value)

• Borrowings (approximate fair value when initially recorded). They are not
marked to market. Market values are footnoted.

• Accrued and estimated liabilities such as pension liabilities, warranty liabilities,

unearned deferred revenue, etc (quasi fair value because based on estimation
which could be biased).

• Commitments and contingencies such as losses of a lawsuits, product

warranty, debt guarantees (many of these items may not be recorded but
footnoted). Reporting in the balance sheet is required if: The contingent event
is “probable” and the amount of loss can be “reasonably” estimated.

11
2-11
Measurements in the income
statement

Accounting value added = Ending equity book value – Beginning

equity book value + Dividend
=Comprehensive earnings

Market Value added = Ending price – Beginning price + Dividend

Pt  Pt 1  d t
Stock Return =

( note that stock return is equal to market value added)

12
2-12
Week 2
The Method of Comparables:
Comps

The method of comparables or multiple comparison analysis is simply the ratio of

the stock price to a particular number in the financial statement. It involves:

1. Identifying comparable firms that have similar operations to the firm whose
value is in question (the “target”). Usually use firms in the same industry.

2. Identifying measures for the comparable firms in their financial statements –

earnings, book value, sales, cash flow – and calculate multiples of those
measures at which the firms trade.

3. Applying an average or median of these multiples to the corresponding

measures for the target firm to get that firm’s value.

 14
3-14
The Method of Comparables:
Hewlett Packard, Lenovo, and Dell 2011

• The average valuation for Dell is $33,347m. Given 1,918m shares outstanding, this would give a value of
$17.39/share. The market price at that time was $14.62. Thus, based on our valuation, the stock is cheap.

 15
3-15
How good is this Method?

• Conceptual Problems:
• Circular reasoning: Price is ascertained from prices of the comparables.
• Violates the tenet: “When calculating value to challenge price, don’t put price into the
calculation”
• If the market is efficient for the comparable companies....Why is it not for the target company ?
• What if the whole industry is mispriced?

• Implementation Problems:
• Finding the comparables that match precisely
• Different accounting methods for comparables and target
• Different prices from different multiples
• What about negative denominators?

• Applications:
• It could be useful to price IPOs; thinly traded firms, firms that are not traded (to approximate
price, not value)

 16
3-16
Screening Analysis

• Two types: technical screens and fundamental screens.

 Technical Screens: identify positions based on trading indicators

• Price screens: buy stocks whose prices have dropped a lot relative to the market and sell
those whose prices have increased a lot. Logic large movement may deviate from
fundamental.
• Small-stock screens: buy stocks with low market value. Small stock typically earn higher
return.
• Neglected stocks screens: buy stocks that are not followed by many analysts. Likely
undervalued.
• Seasonal screens: buy stocks at a certain time in the year. Example: early January.
• Momentum screens: buy stocks that have had increases in stock prices. Momentum to
continue to increase.
• Insider trading screens: mimic the trading of insiders (who must file details of their trades
with SEC). Logic: have inside information.
 17
3-17
Screening Analysis
 Fundamental Screens: identify positions based on fundamental indicators of the
firm’s operations relative to price

• Price/Earnings (P/E) ratios

• Price/Book Value (P/B) ratios (sometimes called Market/Book ratio)
• Price/Cash Flow (P/CFO) ratios
• Price/Dividend (P/D) ratios

• Any combination of these methods is possible

• The idea here is to buy firms with low multiples and short sell those with high
multiples.

 18
3-18
How fundamental screening (some
times called Multiple Screening)
Works
1.Identify a multiple on which to screen stocks.
2.Rank stocks on that multiple, from highest to lowest.
3.Buy stocks with the lowest multiples and (short) sell stocks with the highest multiples.

• Stocks with high multiples are called growth or glamour or fashionable stocks, because their
prices are fashionably driven up relative to fundamentals as they are assumed to have a lot of
growth potentials.

• Stocks with low multiples are called value stocks because their value is high relative to price , or
contrarian stocks because they have been ignored by the market. Contrarian investors buy these
stocks that have been ignored by fashion herd.

• Using one multiple for fundamental screening is risky if this multiple is not a good indicator of the
intrinsic value. Therefore, some screeners combine strategies to exploit more information.

• Example: buy firms with both low P/E and P/B firms (two-way screening). See next slides

 19
3-19
Fundamental Screening: Returns to P/E Screen (1963-2006)

One-way shopping from screening solely on P/E or P/B would have paid off. Two-way shopping
using both P/E and P/B screen would have improved the return: for a given P/E, ranking on P/B adds
further returns.
 20
3-20
Risk in this strategy:

• No guarantee that the past will replicate in the future.

• Return differential could be due to risk differential
• Uses very little information
• The multiple could be high or low for a reason. The low multiple could be still
overpriced and the high one underpriced.

• Solution : build up a model of anticipations that

incorporate all available information about payoffs.
i.e., we have to make a formal fundamental analysis.

 21
Week 3
The Dividend Discount Model: Forecasting Dividends

d1 d2 d3 d4
V 0
E
     ...
 E  E2  E3  E4

Clearly, forecasting dividends for many infinite periods in the future is a problem.

Hence, we need to define an investment horizon T, but still we face the problem of
finding the terminal stock price at time T. Circularity problem!

d1 d d d P
V0E   22  33  ...  TT  TT
E E E E E

4-23
The Dividend Discount Model: Forecasting
Dividends

Terminal Values for the DDM

To find the TV at the end of our forecasting horizon (T) we have two methods:

A. Capitalize expected terminal dividends if you believe that dividends at the forecast horizon will be the same forever
afterward. (Perpetuity)

d T 1
TVT  PT 
E  1

B. Capitalize expected terminal dividends with growth if you believe that dividend at forecast horizon will grow at a
constant growth rate afterward. (Growing perpetuity)

d T 1
TVT  PT 
E  g
Where g = (1+ forecasted growth rate)

4-24
Dividend Discount Analysis:
Advantages and Disadvantages

Advantages Disadvantages

• Relevance: dividends payout is not

• Easy concept: dividends are what related to value, at least in the short run;
shareholders get, so forecast them dividend forecasts ignore the capital gain
component of payoffs.
• Predictability: dividends are usually
fairly stable in the short run, so • Forecast horizons: typically requires
dividends are easy to forecast (in forecasts for long periods; terminal
the short run) values for longer periods are hard to
calculate with any reliability
When It Works Best

When payout is permanently tied to the value generation in the firm.

For example, when a firm has a fixed payout ratio (dividends/earnings).

Dividends are cash flows paid out of the firm (to shareholders)
 Can we focus on cash flows within a firm instead?

4-25
Free cash flow and value added: Will
DCF Valuation Always Work?

A Firm with Negative Free Cash Flows: General Electric Company

In millions of dollars, except per-share amounts.

2000 2001 2002 2003 2004

Cash from operations 30,009 39,398 34,848 36,102 36,484

Cash investments 37,699 40,308 61,227 21,843 38,414
Free cash flow (7,690) (910) (26,379) 14,259 (1,930)

Earnings 12,735 13,684 14,118 15,002 16,593

Earnings per share (eps) 1.29 1.38 1.42 1.50 1.60
Dividends per share (dps) 0.57 0.66 0.73 0.77 0.82

4-26
Will DCF Valuation Work for these firms?

• The answer is no because the free cash flow does not measure value added
from operations.

• As we can see from the previous examples, the two firms were really
profitable, but their FCFFs were negative because they invest more than
they receive from operations.

• Cash flow from operations (value added) is reduced by investments (which

also add value in the future): investments are treated as value losses. So,
value received is not matched against value surrendered to generate value.

• So, we need to forecast earnings, not cash flows.

4-27
Discounted Cash Flow Analysis:
Advantages and Disadvantages

Advantages
• Easy concept: cash flows are
“real” and easy to think about;
they are not affected by
accounting rules
• Familiarity: is a straight
application of familiar net
present value techniques
Disadvantages
• Suspect concept:
• Free cash flow does not measure value added in the
short run; value gained is not matched with value
given up.
• Free cash flow fails to recognize value generated
that does not involve cash flows
• Investment is treated as a loss of value
• Free cash flow is partly a liquidation concept; firms
increase free cash flow by cutting back on
investments.

• Forecast horizons: typically requires forecasts for long

periods; terminal values for longer periods are hard to
calculate with any reliability

When It Works
• Not alignedBest
with what people forecast: analysts forecast
When the investment pattern is suchearnings,
as to produce constant
not free cash free cashadjusting
flow; flow or free
earnings
cash flow growing at a constant rate.forecasts to free cash forecasts requires further
4-28
forecasting of accruals
Week 4
The Big Picture for the Chapter

• Book value of equity represents shareholders’ investment in the firm. Usually

recorded at historical costs on the balance sheet. Therefore, book value of equity
does not reflect the current value of shareholders’ equity.

• The P/B ratio measures the expected return on book value.

• This ratio should increase only if earnings from investments yield a return that is
greater than the required return on book value.

Value of Equity = Anchor (book value) + Extra Value (premium)

The principle for adding extra value to book value: a firm adds extra value if the rate of return on the book value of its investment is
expected to be greater than the required return on this investment.

• The extra return is captured by the residual income (also called residual earnings,
abnormal profit, excess profit )

30
Prototype valuations: Residual
Earnings Model: Valuing a One-Period
Project (1)

Investment (Book value) $400

Required return 10%
Revenue forecast $440
Expense forecast $400
Forecasted earnings $ 40

Residual earnings t  Earnings t  (Required return on equity x Book value of equity t -1 )

 40 - (0.10 x 400)  0

Project Value  Book Value  PV(Expected Residual Earnings)

0
 400   400
1.10

This is a Zero-Residual earnings project or a zero NPV project; because the value is equal to the initial cost, so no value added.

31
Valuing a One-Period Project (2)

Investment (BV) 400

Required return 10%
Revenue forecast $448
Expense forecast 400
Earnings forecast $ 48
Residual earnings1  48 - (0.10 x 400) = 8

8
Value Project  400   407.27
1.10

The project adds a value equal to 407.27 - 400 = $7.27 = NPV

32
Converting Analysts’ Forecast to a
Valuation:

• Analysts usually forecast earnings for 1 or 2 years ahead.

• They also forecast intermediate-term growth rate (3-5 years).
• These forecasts are available on Yahoo! and Google Finance
Websites.

• Be careful, the growth rate forecasted are very likely to be a guess.

• We could start from analysts’ forecast, then build our valuation model.
• Analysts usually do not forecast dividends, so one could start by assuming the current
DPS/EPS (payout ratio) will be maintained in the future or take the average over the past 3-5
years.
• We could also use the long-term average growth rate in GDP for growth after T (our forecast
horizon) to calculate the CV at time T.
• You can build your own valuation engine by building your own spreadsheet to value the stock
starting with analysts’ forecast.
• See next slide for an example.
33
Converting an Analyst’s Forecast to a
Valuation: Nike, Inc., 2010

• Analysts’ forecasts: 2011 $4.29 (consensus estimate made by sell-side analysts)

27% payout
ratio 2012 $4.78 (consensus estimate made by sell-side analysts)
Five-year EPS growth rate forecast: is 11%
Required Return = 9%

(4% in this example):

34
Project Evaluation: Residual Earnings
Approach

Value added: PV of RE = $330 (same as NPV =1,530 -1200 =$330)

35
Advantages and Disadvantages
of the Residual Earnings Model
Advantages
• Focuses on value drivers: focuses on profitability of investment and growth in investment
that drive value; directs strategic thinking to these drivers
• Incorporates the financial statements: incorporates the value already recognized in the
balance sheet (the book value); forecasts value added in the income statement and balance
sheet rather than the cash flow statement
• Uses accrual accounting: uses the properties of accrual accounting that recognize value
added ahead of cash flows, matches value added to value given up and treats investment as
an asset rather than a loss of value
• Versatility: can be used with a wide variety of accounting principles (Chapter 17)

• Aligned with what people forecast: analysts forecast earnings (from which forecasted
residual earnings can be calculated)
• Protection: protects from paying too much for growth

• Reduces reliance on speculation: relies less on uncertain continuing values and uncertain
long-term growth rates
36
Challenging the Stock Market
Price: Google Inc, May 2011
Price: $535, Book value: $143.92, Analysts’ EPS forecast for 2011: $33.94
Analysts’ EPS forecast for 2012: $39.55, Required return: 10%

Value = Value based on what we know + Speculative value

(1) Value based on what we know is the no-growth valuation

What we know

Value of what we know = $359.54

(2) Speculative value = Market price – No-growth value

= $535 - $359.54 = $175.46

Next, ask yourself, is the speculative value too high? To answer this, we reverse engineering
for g as shown next.

37
The Building Blocks of the Market: Valuation of
Google

Market price = $535 in May 2011

38
The Implied Growth Rate: Google

19.548 21.764
Price of Equity  143.92  
1.10 1.101.10  g 

19.548 21.764
535  143.92  
1.10 1.101.10  g 

Solving the above we find that g = 1.047 (a 4.7% implied growth rate in RE).

Accordingly, the RE forecasted for 2013 = 21.764 × 1.047 = $22.787

We could use the calculated growth rate of RE to calculate the implied earnings
growth rate by reverse engineering the residual earnings calculations! See the
next slide.

39
Converting a Residual Earnings
Growth Rate to an EPS Growth Rate

EPS 2013   217.41  0.10  22.787  $44.53

EPS growth rate for 2013 = 44.53/39.55 – 1 = 12.6%

Doing similar calculations for some years in the future, we can obtain a plot of
growth rates implied by the market price as shown below:

40
Week 5
 Cash Flows Between the Firm
and Claimants in the Capital
Market
• Cash received from debtholders and shareholders is (temporarily) invested in financial
assets (marketable securities, which are debt held).

• Cash payments to debtholders and shareholders are made by liquidating financial assets
(that is, selling debt held).

• Net financial assets (NFA) are debt purchased from issuers (financial assets, FA) minus
debt issued to debtholders (financial liabilities or Obligations, FO)). Net financial assets
can be negative (that is, debt issued is greater than debt purchased making the firm have
a Net financial Obligations NFO).

• Cash generated from operations is temporarily invested in net financial assets (that is, it
is used to buy financial assets or to reduce financial liabilities).

• Cash investment in operations is made by reducing net financial assets (that is, by
liquidating financial assets or issuing financial obligations).

• Cash investment may be negative (such that, for example, cash can be generated by
liquidating an operating asset and investing the proceeds in a financial asset).

42
Business Activities: All Cash Flows
F = net cash flow to debtholders and issuers = net purchase of financial assets-interest received - net
issue of financial liabilities + interest paid

Net purchase of financial assets = purchase of debt– principal repayments from issuers

Net issue of financial liabilities = debt issued (raised)– principal repayments on existing debt

NFA = net financial assets = financial assets – financial liabilities.

(if the difference is negative, it becomes net financial obligations NFO)

d = net cash flow to shareholders = cash dividends + stock repurchases –stock sales
C = cash flow from operations
I = cash investment

Operating assets: all assets used to run the operations of the firm such as receivables,
inventory, fixed assets, etc.

Operating liabilities: all liabilities incurred to run the operations of the firm such as A/P,
wages payable, pension liabilities, other accrued expenses, etc

NOA = net operating assets = operating assets – operating liabilities

43
The Cash Conservation Equation (sources and uses of
cash)
A fundamental accounting identity:

CI  dF

C = Net cash from operations

I = Net cash outflow for investing in operating assets NOT financial assets
C-I = Free cash flow
d = Net dividends (common cash dividends + share repurchases – share issues)
F = Net cash outflow to debtholders and debt issuers

The treasurer’s rule:

If C  I  i  d : lend (buy debt securities) or reduce existing debt

If C  I  i  d : borrow or reduce financial assets (lending)

Where i : is the net interest cash outflow (interest paid minus interest received). Net interest
is after tax.

44
6/3/19
45
6/3/19  46
46
 Business Activities and the Financial
Statements: The Big Picture
This figure shows how reformulated
income statements, balance sheets,
and the cash flow statements report
the operating and financing activities
of a business, and how the stocks and
flows are uncovered in the financial
statements. Operating income
increases net operating assets and
net financial expense increases net
financial obligations. Free cash flow
is a “dividend” from the operating
activities to the financial activities:
free cash flow reduces net operating
assets and also reduces net financial
obligations. Net dividends to
shareholders are paid out of net
financial obligations.

47
Tying it Together: What Generates Value?

• From the balance sheet equation

CSE t  NOA t  NFO t

• Given the way that NOA and NFO are calculated,

CSE t  NOA t 1  OI t   C t  I t   NFO t-1   C t  I t   NFE t  d t
 NOA t 1  NFO t-1  OI t  NFE t  d t
 CSE t 1  Earn t  d t

Which is the stocks and flows equation.

• For this to be true, however, accounting must be Clean Surplus.

• Free cash flow drops out in this calculation: Free cash flow (C - I) does not add value to shareholders. What generates
value for shareholders is the income from operating activities and sometimes from financing activities.

48
Introduction

• When accounting income is used in valuation, it must be the comprehensive

income.

• Unfortunately, earnings reported in income statements in most countries are not

comprehensive.

• In this chapter we will correct this problem by learning how to reformulate this
statement for the purpose of valuation.

• Value is generated for equityholders through operations rather than financing

activities.

• Thus, careful analysis of the statement of shareholders’ equity is important to

identify the source of the change in equity as well as calculating the
comprehensive income.

49
Standard Statement of Shareholders’ Equity
Opening book value of equity (common, preferred, and non-controlling equity)

+ Net share transactions with common stockholders =

+ Capital contributions (paid in capital from share issues)

- Share repurchases (into treasury stock or against paid-in capital)

+ Net share transactions with preferred shareholders =

+ Capital contributions (share issues)

- Share redemptions

+ Change in retained earnings =

+ Net income (including non-controlling interest income)
- Common dividends
- Preferred dividends
- Some share repurchases
+ Other comprehensive income
+ Earnings restatements due to change in accounting
+ Increase in equity from issuing stock options

Closing book value of equity (common, preferred, and non-controlling equity)

50
Reformulated Statement of Common Stockholders’ Equity

51
 Reformulation: The Steps

1.Restate beginning and ending balances for items incorrectly included in or excluded from
common equity
– (Remove) Preferred equity if reported under equity section.
– (Remove) Non-controlling interest (minority interest) equity if reported within equity
+ (add) dividends payable to common shareholders’ equity if reported under liabilities.

2.Calculate net transactions with common shareholders (-net dividends) =

Share issues - Cash dividends - share repurchases
Cash dividends = dividends (reported in equity section) - ∆ dividends payable

3.Calculate comprehensive income to common shareholders =

Net income – Non-controlling interest in income
+ Other comprehensive income (usually reported on after tax basis).
– Preferred dividends

52
The Standard Statement: Nike, Inc.,
2010

53
Nike: The Reformulated Statement

Cash dividends = Dividends declared – ∆ dividends payable

= $514.8 – (130.7 – 121.4) = $505.5
Com. Equity beginning balance = reported balance (8,693.1) + dividend payable (121.4) = $8,814.5

Com. Equity ending balance = reported balance (9753.7) + dividends payable (130.7) = $9,884.4

Stock issued for stock options and Stock-based compensations above need further treatment as we shall see
shortly.
54
Week 6
The Standard Balance Sheet

 56
10-56
Reformulating the Balance Sheet:
The Governing Accounting
Relations

Net Operating Assets (NOA) = Operating Assets (OA) – Operating Liabilities (OL)

Net Financial Obligations (NFO) = Financial Obligations (FO) – Financial Assets (FA)

Common Shareholders’ Equity (CSE) = NOA – NFO

____Reformulated Balance Sheet___

OA FO
(OL) (FA)
NFO
CSE
NOA = NFO + CSE
________________________________

 57
10-57
Typical Financial and Operating Items

 58
10-58
Issues in Reformulating the Balance
Sheet
• Cash: cash balance is to be treated as an operating asset. But when cash is lumped with
cash equivalents, it is ok to treat all as financial asset, although some analysts use 0.5%
of sales to define operating cash.

• Short-term notes receivables: if trade notes are temporary investments of cash they
should be treated as financial assets. If trade notes arise from trading with customers,
they should be treated as operating assets and the interest on them as operating
income.

• Debt investments: treat them as financial assets for non-financial firms.

• Long-term equity investments: treat them as operating assets.

• Short-term equity investments (usually marked to market): if part of a trading portfolio

treat them as operating assets. If bought to use excess cash treat them as financial
assets.
 59
10-59
 Issues in Reformulating the Balance
Sheet (continued)
• Short-term notes payable: trade notes are operating liabilities if the interest rate is less than
the market rate. If these notes are borrowing treat them as financial liabilities.
• Lease assets: treat them as operating assets.
• Lease liabilities: treat them as financial obligations
• Deferred tax assets and liabilities: treat them as operating assets or liabilities
• Common dividends payable: should be treated as a part of shareholders’ equity not as a
liability.
• Preferred stocks: treat them as financial obligations.
• Minority interest “non-controlling interest”: not a financial obligation not an equity, but to be
treated separately as an addition to the following equation:
NOA= NFO+CSE +Minority interest

• Pay close attention to other liabilities, other assets, accrued liabilities, etc
• For financial firms, many “financial items” are operating assets and liabilities

 60
10-60
Standard Balance Sheet: Nike, Inc.

 61
Reformulated Balance Sheet: Nike, Inc.

 62
10-62
Nike, Inc.: Notes on the Reformulation

1. Cash and cash equivalents have been split between operating cash and
interest-bearing cash investments

2. Interest-bearing accounts payable are classified as financing items

3. Accrued liabilities exclude dividends payable (now added to

shareholders’ equity)

4. Notes payable are interest bearing and classified as financing liabilities

 63
10-63
The reformulated income statement

The reformulated income statement should be on

comprehensive income basis. i.e., dirty-surplus
items that are usually reported in the equity
section are reclassified to the income statement.

1. Operating items should be separated from financing items.

2. Operating income from sales should be separated from other
operating income.
3. Tax should be allocated to components of the statement, with no
allocation to items reported on an after-tax basis.

4. See example on the next slide

 64
The Reformulated Comprehensive Income
Statement

Net sales
– Expenses to generate sales
Operating income from sales (before tax)
– Tax on operating income from sales =
+ Tax as reported
+ Tax benefit from net financial expenses
– Tax allocated to other operating income
Operating income from sales (after tax)
±Other operating income (expense) requiring tax allocation =
Restructuring charges and asset impairments
Merger expenses
Gains and losses on asset sales
Gains and losses on security transactions
− Tax on other operating income
± After-tax operating items
Equity share in subsidiary income
Operating items in extraordinary income
Dirty-surplus operating items in Table 91
Hidden-dirty surplus operating items
Operating income (after tax) = enterprise income = NOPAT

 65
10-65
The Reformulated Income Statement
(cont.)

 66
10-66
The Allocation of Taxes
• In the income statement only one tax number is reported: It must be allocated to the operating and
financial components to put both on an after-tax basis.

• Items below the tax figure such as unusual items are usually reported net of tax. The same applies to
dirty surplus items.

• So, we allocate tax to above tax line as follows:

• First, calculate the tax benefit (tax shield) provided by deducting interest expense
Tax Benefit  Net Interest Expense  t

Where t is the marginal (not effective) tax rate. The statutory rate is usually the marginal rate.

• Note : The effective tax rate for operations =

Tax on operating income/operating income before tax, equity income, and
extraordinary and dirty surplus items
 67
10-67
 The Allocation of Taxes (continued)

• From the operating income deduct both the total tax and the
tax benefit, to capture what the operating income would
have been, after tax, if there were no financing activities

Tax on operating income = reported tax + (net interest

expense * tax rate)

• The tax benefit (loss) is to be subtracted (added) to net

financial expense when we reformulate the financing
activities.

 68
10-68
Top-down and Bottom-up Methods for Tax
Allocation: Tax Rate = 30%

GAAP Top-down
Bottom-up
Income Statement Tax Allocation
Tax Allocation
Revenue $4,000
Operating expenses (3,400)
Interest expense (100)
Income before tax 500
Income tax expense (150)
Net income $350

Revenue
$4,000
Operating expenses (3,400)
Operating income before tax 600
Tax expense:
Tax reported $150
Tax benefit for interest 30 (180)
($100 x 0.30)
Operating income after tax $ 420
 69
10-69
Additional Tax Allocation within
Operations

Remember:

• Tax on operating income = reported tax + (net interest expense * tax rate)

• Once you have calculated tax on operating income, the next step is
allocate this tax figure between operating income from sales and other
operating income (not from sales) so that both are on after-tax basis as
follows:

 Tax on other operating income (not from sales) = other operating income *t

 Tax on operating income (from sales) =

Tax on operating income – Tax on other operating income (not from sales)

 70
10-70
Example: Income Statement: Nike, Inc.

 71
10-71
Reformulating the Income statement of Nike,
Inc.
The starting point for Income Statement Reformulation is to
identify the comprehensive income from the reformulated Equity
Statement (Check Lecture 5 notes)

 72
10-72
Reformulated Income Statement: Nike, Inc.

 73
10-73
Nike, Inc.: Notes on Reformulated
Income Statement

1. Advertising expense is found in the footnotes lumped with SG&A expenses; we report it
separately

2. Other expenses in the income statement in 2008 include gains from divestitures of 60.6,
classified as other operating income in 2008. other expense for 2008 = 68.5= 7.9+60.6

3. Statutory tax rate for tax allocation is 36.3%; federal tax (35%) plus state taxes (1.3%). (see
next slide for detailed tax allocation for 2009).

4. Dirty-surplus items come from the equity statement

5. Interest income is netted against interest expense in the GAAP statement

6. Preferred dividends are less than $0.5 million; hence ignored.

 74
10-74
Week 7
The Calculation of Free Cash Flow

Three methods to calculate FCF:

C - I = OI - ΔNOA
1. Use the sources of cash flow equation:

That is, free cash flow is operating income adjusted for the change in net operating assets.
C - I = NFE - ΔNFO + d
2. Use the disposition of cash flows equation:

That is, free cash flow is net financial expenses, adjusted for the change in net financial
obligations, plus net dividends to common shareholders.

Or C – I = DNFA - NFI + d

If minority interest is involved we add the following terms to the above equations:
+Minority interest in income - ∆Minority interest (equity) 11-76
Calculation of Free Cash Flow: Nike, Inc.:
2010

Method 1: C – I = OI - DNOA
Operating income 2010 $ 1,814
Net operating assets 2010 $ 5,514
Net operating assets 2009 6,346 - 832
Free cash flow 2010 2,646

Method 2: C – I = DNFA - NFI + d

Net financial income 2010 $4
Net financial assets 2010 4,370
Net financial assets 2009 2,468 1902
Net dividend 2010 740
Free cash flow 2010 $2,646

Note that under method 2, the firm had in 2010 net financial expense of $4m
although the firm had net financial assets in both 2009 and 2010. Hence,
we add $4m to the above equation rather than subtract.
11-77
Problems with the Standard Statement

1. Change in operating cash should be included in the investment section, and the change in cash
equivalents in the financing section

2. Some transactions in financial assets are included in the investment section rather than in the
financing section

3. Interest payments and receipts are included in the operating rather than in the financing section

4. Tax cash flows are all included in the operating section, and not allocated to operating and
financing

5. The statement does not incorporate non-cash transactions

11-78
1. Operating Cash and Cash in
Financial Assets: Nike

Change in cash and cash equivalents $788.0 m

Δ in operating cash $ 0.8 m

Δ in cash equivalents 787.2 m
$ 788.0 m

The determination of operating cash: use a normal percentage of sales for the industry
(0.5% of sales)

See Nike’s reformulated balance sheet in Chapter 10

11-79
2. Transactions in Financial Assets: Lucent Technologies

11-80
3. Net cash interest
4.Taxes on Net Interest Receipts: Nike

In millions

Interest receipts $42.1

Interest payments (48.4)
Net interest payments before tax 6.3
Tax benefit (at 36.3%) 2.3
Net interest payment after tax $4.0

Add back net interest payment after tax to the reported Cash from Operations and
classify it as financing outflow

11-81
5. Non-cash Transactions

• Acquisitions with shares

• Asset exchanges

• Assets acquired with debt

• Capitalized leases

• Installment purchases

• Debt converted to equity

• The above items do not affect the calculation of the operating cash flows, but my affect
the calculation of free cash through their effect on NOA and NFO

11-82
The Big Picture for this Chapter

A firm’s accountants may use accounting methods to package the firm or to

make it look better than it is.

Accounting quality analysis establishes the integrity of the accounting used

for forecasting.

Income shifting is one of the most methods used to manipulate earnings.

Accounting methods can be applied to:

 Borrow income from the future

 Push income from the present to the future

• But, this income shifting leaves a trail that can be followed by the quality
analyst.
18-83
 Introduction
• If current earnings are not a good indicator of the future , they are
said to be of poor quality

• The reversal property of accounting: earnings induced by

accounting methods always reverse in the future.

• Earning manipulation is commonly referred to “ Earnings

Management”:

• Manipulation that inflates current income is referred to as borrowing income from the future
“aggressive accounting”.

• Manipulation that reduces current income is called saving or banking income for the future: this one
mostly occurs when management bonuses are linked with future earnings. “Big-bath accounting”.

18-84
6/3/19  84
How Specific Balance Sheet Items are
Managed to Increase Income

18-85
How Specific Balance Sheet Items are
Managed to Increase Income (cont)

18-86
Week 8
The Big Picture for this Chapter

Valuation involves forecasting residual earnings and

residual earnings growth
So, what drives residual earnings?

ROCE Growth in
Book Value
of CSE

What drives
ROCE? What drives
This Chapter growth?
Next Chapter

12-88
Analysis is the Preamble to
Forecasting and Valuation

• Analysis establishes where the firm is now

• Forecasting asks how it will be different in the future

RE1 RE2
V  CSE0 
0
E
 2 
E E

RE1   ROCE1    E  1  CSE0
 
ROCE Driver Growth Driver

12-89
Analyzing ROCE: The Scheme

12-90
1. The Base for Growth: Sustainable
Earnings
Sustainable earnings are earnings that can be repeated (sustained) in the future and
which can grow.

Also called:
 Core Earnings
 Persistent Earnings
 Underlying earnings

 Identifying core earnings is sometimes referred to as normalizing earnings because

it establishes “normal” ongoing earnings unaffected by one-time components.
 Key question: can the firm maintain its core earnings?

Unsustainable earnings are also called

 Unusual Items
 Transitory Earnings
 Extraordinary

13-91
2. Analysis of Growth
Remember that Residual earnings t = (ROCE t -Cost of equity capital)×CSEt-1

Growth in Residual Earnings is driven by changes in ROCE and CSE

A) Explaining the Change in ROCE

ROCE  RNOA  [FLEV x SPREAD]

Definitely, the change in ROCE is driven by a change in one of the above.

(i) (ii) (iii)

Effect of change in Effect of change in Effect of change in

operating profitability spread leverage

13-92
 Analysis of Growth

Growth through Profitability

DRNOA1  DCore PM1 x ATO 0   DATO 1 x Core PM1   D  UI 
 
 NOA 

Ask yourself: Where the change in RONA mainly

comes from?

6/3/19  93
Effect of Changes in Financing: Reebok
Stock Repurchase
In 1996, Reebok borrowed $600 million to repurchase stocks

If financial leverage had been maintained at 1995 level,

ROCE  RNOA  (FLEV x SPREAD)
ROCE1996  14.1   0.187 x (14.1 - 4.9)  15.8%
Explaining ΔROCE
DROCE1996  - 0.3%  - 2.8%   - 2.9% x 0.187   0.328 x 9.2%
 -2.8% - 0.54%  3.02%

13-94
Explaining Changes in the SPREAD

SPREAD = RNOA – NBC

DRNOA has been explained

Explain Change in NBC: need to distinguish core and unusual borrowing cost
Core net financing exp. Unusual financing exp.
NBC  
NFO NFO

Core financing expenses may include:

• Change in interest rates (risk free and risk premium)
• Change in tax rates (and shield)
• Substitution of preferred for debt financing

Unusual financing expenses may include:

• Tax effect from unusually high or low taxes 13-95
B) Analysis of Growth in Common Equity

ΔCSE = ΔNOA - ΔNFO

But, as ATO = Sales ,

NOA

NOA = Sales x 1
ATO

ΔCSE= Δ �
Sales x
� 1 �- ΔNFO
�
�
� ATO �
�

These are the components of growth in equity:

1. Growth in sales
2. Change in net operating assets that support each dollar of sales
3. Change in the amount of net debt that is used to finance the change in net operating assets rather
than equity

Sales growth is the primary driver or at least should be

13-96
Week 9
A Modification of the RE Model

 The RE Model, V0E  CSE 0  PV of RE

 Since some assets and liabilities (especially financial ones (NFOs)) are measured at
market value; if the market value of these assets and liabilities is equal to their intrinsic
(fair) value, in this case, the expected RE of these assets and liabilities is zero.

 As such, we can drop these assets and liabilities from our forecasting, and focus, instead,
on net assets (especially net operating assets (NOA)) that are not at market value. In this
case, the model becomes:

V0E  CSE0  PV of residual earnings from net assets not at market value

 However, if you cannot separate operating from financial assets and liabilities, in this case
we should use the RE model.

14-98
Earnings Components and Corresponding
Residual Earnings Measures

 Because NFO items are usually reported at or close to their market value, the
expected RE from these items is zero if their market value is equal to their fair value.
Hence, under these conditions, we can drop them from our forecasting.

 Focus on residual operating income (ReOI) to value the firm.

 The Residual Operating Income (ReOI) is sometimes called Economic Profit or EVA
(The Economic Value Added).

Re OI t  OI t  (ρ F  1) NOA t 1
14-99
The Value of the NFO and the Value of the NOA
 If the residual earnings from NFO are expected to be zero, this means that the
value of these NFO would be equal to their reported book value.

V0NFO  NFO0

 However, net operating assets (NOA) are not usually at market value on the
balance sheet. Hence, the value of these NOA is:
ReOI1 ReOI2 ReOIT CVT
V 0
NOA
 NOA0   2
 ...  T
 T
ρF ρF ρF ρF
CVT  0 Case 1

Re OI T 1
CVT  Case 2
F  1
Re OI T 1
CVT  Case 3
F  g

14-100
 The Value of the Common Equity
 The previous formula gives us the value of the firm, or sometimes called
enterprise value, or the value of operations.

 And, to value the whole firm we must use the weighted average cost of
capital WACC as the discount rate. Hence, =
1+WACC.
F

Because CSE = NOA – NFO, it follows that :

V0E  V0NOA  V0NFO

14-101
Residual Operating Income Valuation: Nike,
Inc. (Using 9.1% cost of capital)

(Using 4% average GDP growth rate)

14-102
The Drivers of Residual Operating Income

• The Drivers of ReOI:

ReOI t  OI t    F  1 NOA t 1   RNOA t    F  1  NOA t 1
(1) (2)

(1) RNOA

(2) NOA put in place to earn at RNOA

When calculating ReOI, we should use the core operating income and
on after-tax basis. Unusual items are excluded because their expected
value is zero.

14-103
Advantages of Valuing Operations

• Financing activities can be ignored for forecasting: focus on

operations where the value is generated. In other words, all you
need is to forecast the core operating income and NOA.

• Required return does not have to be adjusted as leverage

changes.

14-104
Week 10
 Simple forecasts and Valuations
• Simple forecasts ground our speculative forecasting on “ what we know” from the
financial statements. The assumption here is that the present is an indicator of the future.

• Simple forecasts can be, for example, converted into a simple valuation using the following
simple version of the ReOI model.

We can get the ingredients from the financial statements:

• Date 0 items are in the financial statements
• Date 1 items can be forecasted from the financial statements
• Growth, g, can be forecasted from the financial statements
• One could use a two-period model

• We will explain this process using a dummy firm called PPE.

15-106
 Reformulated

Required return on operations (cost of capital) = 10%. Required return on debt = 4%

15-107
The No-growth Forecast and
Valuation
The no growth case assumes that forward core ReOI1 = ReOI0 (current).
implication: addition to NOA earns the required return

15-108
The No-growth ReOI Valuation
Core ReOI 0
V0NOA  NOA 0 
ρF  1
For PPE Inc.,
2.81
V0NOA  74.4 
0.10
 102.5

V0E  V0NOA  V0NFO

 102.5 - 7.7
 94.8

15-109
No-growth Valuation: Nike, Inc.

15-110
 The Growth Forecast and Valuation
Assumption : next year return RNOA1 is similar to this year return RNOA0

For PPE, Inc. the current core RNOA = 9.8/69.9 = 14.02%

ReOI1 = 10.431 – (0.10 × 74.4) = $2.991 or (0.1402 – 0.10) × 74.4 = $2.991

15-111
The Forecasted Growth Rate
[RNOA1   ρ F  1 ] NOA 0
Growth Rate in ReOI1 
[RNOA 0   ρ F  1 ] NOA 1
NOA 0
Growth Rate in ReOI1 
NOA 1

If RNOA1 = RNOA0 , then

If the growth calculated above is expected to be the same forever, then:

For PPE: g =ReOI

74.4/69.9 = 1.0644,
2.991 hence G =6.44%
V0NOA  NOA 0  1
 74.4   158.41
ρ-g 1.10 - 1.0644

V0E  V0NOA  NFO  158.41  7.7  150.71

We could normalize the growth rate above using the average of the last 3-5 years
provided there was no unusual events such as acquisition.
15-112
Growth Valuation: Nike, Inc.

15-113
Adding information to financial
statement information
Simple forecasts and valuation may work for mature well-established firms that have
stable income stream or growth rate, but for start up firms with little information, one
should also refer to external information.

Weighted-average forecast of growth in ReOI:

 To assume that NOA will earn at the current RNOA and that current RNOA and
growth in NOA will stay forever is too optimistic. Profitability declines with the
passage of time due to competition.

 An alternative way to deal with this issue is to use a weighted average forecast of
growth in ReOI as follows:

Forecasted growth rate for ReOI = (0.70 × Current growth rate for ReOI) + (0.30 × 4%)

where 4% is the historical GDP growth rate

________________________________________________________________
For Nike Inc., Forecasted NOA growth rate = (0.70 × 4.6%) + (0.30 × 4.0%) = 4.42%

(This implies a value for Nike of $71.54 per share)

15-114
Sales Growth Can Replace NOA
Growth

Another way1 to deal with it is to use sales growth rate

NOA  Sales 
ATO

1
Growth in NOA  Growth in Sales 
ATO

If ATO is constant,

Forecast growth in NOA with forecasted sales growth

rate

15-115
The Big Picture for this Chapter
 Pro forma analysis is the tool to add speculative information to the simple
valuation of Chapter 15.
 Pro forma analysis involves forecasting the future financial statements.

 The future financial statements are forecasted by the same drivers of our
financial statement analysis:

 Sales growth
 Operating profit margin
 Asset turnovers

These drivers drive residual operating income. These drivers are themselves
driven by economic factors.

 Hence, knowing the business and the external factors that affect it is crucial for
full information forecasting (Refer to Lecture1).

16-116
Four Points of Focus

1. Focus on Residual Operating Income and its

Drivers
2. Focus on Change
3. Focus on Key Drivers
4. Focus on Choice versus Conditions

Let us examine each in more details

16-117
1- Focus on Residual Operating Income
(ReOI) and its drivers
Two drivers of ReOI:

Core Other OI UI
1. RNOA  Core Sales PM  ATO  
NOA NOA
2. Growth in NOA

These drivers can be captured in one expression for ReOI:

 Required return for operations 

Re OI  Sales  Core Sales PM -   Core Other OI  UI
 ATO 
• Sales is the primary driver: Sales = number of units sold × price/unit. We need to ask: what factors
drive the demand and price?

• The next important one is the Core Sales Profit margin: What factors
drive the margin?
• The third is the Margin vs ATO relative to required return.

• Remember that unusual items (UI) are expected to be zero.

16-118
2- Focus on Change
A. Establish typical driver pattern for industry: drivers usually exhibit mean reversion: value drivers tend
to become more like the average over time. High levels of core RNOA, for example, tend to be lower
in the future and vice versa.

Driver’s patterns have two features:

1- The current level of the driver relative to the median industry level.
2- The rate of reversion to the long run level, called fade rate or persistence rate. Competitive
advantage period is the period over which a driver fades to a typical level.

Core other/NOA: tend to converge towards a certain percentage

Unusual items tend to disappear quickly.
Unusual Sales growth rates tend to fade quickly
Change in sales PM fades quickly toward zero
Change in asset turnover: fades quickly towards common level.

B. Modify typical driver pattern for forecasted changes for the industry and the economy. Knowing the
business requires a knowledge of industry trends and a knowledge of the susceptibility of the
industry to macroeconomics changes.

16-119
Week 11
 How are resource firms different
from other firms?

• Volatility of share prices

• Resources firms historically have higher returns in the short term but accompanied
by higher risk than other industrial firms

• Exploration
• The need to explore in order to find and define an economic resource
• Success rate is relatively low
• In 2011, Australian annualized mineral exploration expenditure was $4 billion with 40
economic discoveries as a result

• Finite reserves
• Finite volume, therefore finite life, depending on production rate


121
How are resource firms different
(from other firms)?-continued

 After exploration success, drilling program follows to define the resource (to
determine amount and quality)

• Commodity price volatility

• Resource stocks exposed to greater external commodity price volatility than
industrial stocks
• Most exporters are price takers rather than price makers

• Capital intensity
•Due to high expenditure: exploration; economies of scale, isolation;
power and water


122
How are resource firms different (from
other firms)?-continued

• Environmental impact
• Environmental impact statement (EIS) required for development of new resource
projects, describes impact on all aspects of environment including air and water
quality, noise, disposal of waste

• Some countries impose carbon tax on emitted CO2-e.

• Financial bonds: required by governments to ensure remedial work undertaken at

conclusion.

• Land rights: some firms buy the land, and sometimes the
firm just has the right to mine. It is important to distinguish
between the two when valuing these firms.


123
Undeveloped reserves as option
• In a natural resource investment, underlying asset is the
natural resource and its value is based on estimated quantity
and price of resource.

• Initial cost of developing resource, K.

• Estimated value of resource, V.

• Payoff on investment = Max (0, V – K)

= V – K, if V > K
= 0, if V ≤ K

• Resembles a call option


124
Payoff from developing natural
resource reserves


125
Inputs for valuing a natural resource
option
• Estimated value of the resource if extracted today net of production cost (St)

• Estimated cost of developing the resource i.e., the exercise price of option (K)

• Time to expiration of option (depending on the time period under the rights to the
reserves or the time until the reserves are exhausted) (T)

• Variance in ln(value) of underlying asset: variability in the price of resource (σ 2)

• Cost of delay: also called convenience yield or net production revenue. It is the annual
after-tax cash flow as a percentage of the resource value. Once the reserve becomes
viable, this is what the firm is losing by not developing the reserve, like dividend yield in
option models) (d)

• The risk-free rate of return (rc )

126
Multiple sources of uncertainty

• The method of valuing non-financial assets using options is called

real option valuation (ROV).

• However, one complexity in valuing real options is the source of

uncertainty. In addition to variance of the resource value, mining
firms also face uncertainty in the quantity of reserves discovered.

• Two ways to deal with this problem:

• Combine variance of price of reserves with variance in reserves

• Keep variances separate and value option as rainbow option. Rainbow option allows for more than one
source of variance and allows us to keep variances separate. ( This topic is beyond the scope of this
unit).


127
Value of a mining company

• Once the undeveloped reserves of the firm are valued

using ROV, the value of the firm’s operating assets is
calculated as follows:

Value of Operating Assets = Value of developed reserves +

Value of undeveloped reserves

The equity value = Value of operating assets– net debt


128
ROV vs Other valuation methods:

• The value of a project estimated by the ROV is greater

than that estimated by the DCF method. In other words,
the DCF tends to undervalue mining investments.

• The ROV is better than the NPV method in dealing with

uncertainty and operating flexibility.

• The difference between the ROV and the DCF estimates

represents the value of operating or management
flexibility.


129
Week 12
Foreign currency transaction
exposure
– When companies from different countries agree to conduct business with one another, they
must decide which currency will be used.

– Foreign currency transactions are those denominated in a currency other than the company’s
own functional currency.

– Summary of above example: Mexican electronic components manufacturer sells goods to a

customer in Finland.
– If the two companies agree that the transaction will be denominated in Mexican pesos,
the Finnish import company has a foreign currency transaction but the Mexican export
company does not. If the purchase date is different from the payment date, in this case,
FinnCo is said to have an Exposure to foreign exchange risk. Specifically, FinnCo has a
Foreign currency transaction exposure.
– Although the Mexican company also has entered into an international transaction (an
export sale), it does not have a foreign currency transaction and no translation is
necessary.

– If the two companies agree that the transaction will be denominated in Euros, the Mexican
export company has a foreign currency transaction but the Finnish import company does not.

131
Changes in exchange rates impact
on sales: Example 1
• The basic principle is that all transactions are recorded at the spot rate (current
rate) on the date of the transaction.

• The foreign currency risk on transactions, therefore, only arises when the
transaction date and the payment date are different.

• FinnCo sells goods to a customer in the United Kingdom for £10,000 with
payment to be received in British pounds. Credit terms allow 45 days for receipt
of payment. FinnCo’s functional and presentation currency is the euro.

Exchange rate on the date of the transaction: £1 = €1.460

Exchange rate on the date of payment: £1 = €1.475

Question: What is FinnCo’s foreign exchange gain or loss?

132
Changes in exchange rates impact
on sales: Example 1

£ FX Rate €
Euro value of FinnCo’s receivable on
transaction date 10,000 1.460 14,600
Euro value of FinnCo’s receivable on
receipt date 10,000 1.475 14,750

FinnCo’s foreign exchange gain 150

133
Changes in exchange rates impact on
sales: Example 2

• FinnCo sells goods to a customer in the United Kingdom for £10,000 with
payment to be received in British pounds. Credit terms allow 45 days for
receipt of payment.

Exchange rate on the date of the transaction: £1 = €1.460

Exchange rate on the date of payment: £1 = €1.475

• Assume that the transaction date was in November Year 1, the payment
date was in January Year 2, and the company has a 31 December year-end.
Exchange rate on 31 December, Year 1: £1 = €1.480.

• Question: What is FinnCo’s foreign exchange gain or loss for Year 1? And
for Year 2? In other words, what happens when there is an intervening
balance sheet date?
134
changes in exchange rates impact on
sales: example 2

Transaction date Balance sheet date Payment receipt date

Exchange rate: Exchange rate: Exchange rate:

£1 = €1.460 £1 = €1.480 £1 = €1.475

Value of receivable: Value of receivable: Value of receivable:

€14,600 €14,800 €14,750

Gain of €200 Loss of €50

Overall actual realized foreign

currency gain = €150
135
– In Summary,
– The €200 gain—value of receivable at balance sheet date (€14,800) minus value
of receivable on transaction date (€14,600)—is shown as a foreign currency
transaction gain in Year 1 (even though it is an unrealized gain).
– The €50 loss—value of receivable on payment receipt date of (€14,750) minus
value of receivable at balance sheet date (€14,800) —is shown as a foreign
currency loss in Year 2.

– As we saw in the first part of the example, from the transaction date to the
settlement date, the British pound increased in value by €0.015 (€1.475 – €1.460),
which generates an overall realized foreign currency transaction gain of €150.
– Given the intervening balance sheet date, a gain of €200 was recognized in Year
1 and a loss of €50 is recognized in Year 2.
– Over the entire period from transaction date to payment date, the net gain
recognized in the financial statements is equal to the actual realized gain on the
foreign currency transaction.

136
changes in exchange rates impact on
sales and purchases

Foreign Currency
Transaction Type of Exposure Strengthens Weakens

Export sale Asset (account receivable) Gain Loss

Import purchase Liability (account payable) Loss Gain

137
Which method is the best for the
firm?

When the subsidiary’s functional currency When the subsidiary’s functional currency is the
is different from the parent’s functional same as the parent’s functional currency, the
currency, the current rate method is temporal method is recommended:
recommended:

• Monetary assets and liabilities: Translate at

• All assets and liabilities: Translate at current exchange rate
current exchange rate (current rate • Non-monetary assets and liabilities:
method) • Historical cost at historical
• Equity accounts: Translate at historical
exchange rates
exchange rates
• Current value at valuation
• Revenues and expenses: Translate at
average exchange rate, which date exchange rate
approximates exchange rate on • Equity accounts: Translate at historical exchange
transaction date. rates
• Revenues and expenses:
• Not related to non-monetary
assets, translate at average
exchange rate on transaction 138
 Which method is the best for the firm?
– The historical exchange rates used to translate inventory (and cost of goods sold) under the
temporal method will differ depending on the cost flow assumption—first in, first out (FIFO);
last in, first out (LIFO); or average cost—used to account for inventory.

– Ending inventory reported on the balance sheet is translated at the exchange rate that existed
when the inventory’s acquisition is assumed to have occurred.
– If FIFO is used, ending inventory is assumed to be composed of the most recently
acquired items and thus inventory will be translated at relatively recent exchange rates.
– If LIFO is used, ending inventory is assumed to consist of older items and thus inventory
will be translated at older exchange rates.
– The weighted-average exchange rate for the year is used when inventory is carried at
weighted-average cost.

– Similarly, cost of goods sold is translated using the exchange rates that existed when the
inventory items assumed to have been sold during the year (using FIFO or LIFO) were
acquired. If weighted-average cost is used to account for inventory, cost of goods sold will be
translated at the weighted-average exchange rate for the year.

139
 Where should the translation
adjustment be reported?

Under the current rate method: Under the Temporal method:

• Unrealized translation gain/loss is • Translation adjustment is

accumulated as a separate reported as a gain or loss in the
component of the parent’s equity. It parent’s net income.
is the cumulative translation
adjustment needed to keep the
translated balance sheet in balance

• Once the entity is sold the gain/loss is

considered a realized one and should
be removed from the equity section
and reported in the income
statement.

140
Changes in exchange rates impact on
translation adjustment
– A foreign operation will have a net asset balance sheet exposure when assets
translated at the current exchange rate are greater in amount than liabilities
translated at the current exchange rate.

– A net liability balance sheet exposure exists when liabilities translated at the
current exchange rate are greater than assets translated at the current exchange
rate.

Foreign Currency (FC)

Balance Sheet Exposure Strengthens Weakens

Positive translation Negative translation

Net asset adjustment adjustment

Negative translation Positive translation

Net liability adjustment adjustment

141