[SOLVED] CS flex finance ACCT6101 Session #1: Introduction to Valuation

ACCT6101 Session #1: Introduction to Valuation

PART 1 Background

1
ACCT7106 Session #9: Ratio Analysis
overarching objective:
to conduct the fundamental valuation exercise for the purpose of estimating the intrinsic value of a firms common shares
requires an understanding of the firms value drivers
need to accumulate a tool kit as the basis for developing the pro forma Financial Statements

1

2

projected over the forecast horizon

core inputs into the valuation modelxg

Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows (SCF)

2

3

STEP 1
Understanding the past

Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis

STEP 2
Forecasting the future

Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts

STEP 3
Valuation

Cost of capital
Valuation models AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction

Figure 1.1Lundholm & Sloan, Framework for Equity Valuation

Sessions #3 #10

Sessions #10 #11
Sessions #1 #3; #11 #13

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Financial Statements AASB 101:
Balance Sheet
Income Statement and/or Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Cash Flows
Notes to the financial statements
building blocks definitions specific to accounting
accounting principles AASB / IFRS rules to guide accounting decisions/choices
recognition (item to F/S) versus disclosure (notes)
accountability & stewardship
accountabilitypreservation by management of the resources entrusted to them
stewardship efficient use by management of resources entrusted to them (earning a return)

articulationFinancial Statements constitute an integrated system

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beginning stock
Beginning Balance Sheet
Cash
+ Other assets
= Total Assets
Liabilities
= Shareholders Equity (BVt-1)
Statement of Changes in S/E
Cash from operations
+ Net Income & OCI
= Net Change in S/E
Cash Flow Statement
Cash from operations
+ Cash from investing
+ Cash from financing
= Net change in cash
Income Statement
Revenue
Expenses
= Net Income (NPAT)
Ending Balance Sheet
Cash
+ Other assets
= Total Assets
Liabilities
= Shareholders Equity (BVt)

flows
ending stock

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Objectives:
separate operating activities from financing activities
Operations: buying and selling goods and services
Financing: the companys use of debt and equity to finance its operations, as well as the companys investment in financial assets
Why? industrial companies generate value from their operations, not from their financial activities
alter several accounting classifications
for the Income Statement, separate revenues and expenses based on their driver (sales volume or other), and whether they are recurring or non-recurring
for Statement of Cash Flows, separate operating from financing activities; determine free cash flows operations-related cash flows split by operating versus investing; and separate equity and debt financing cash flows
Reformulation

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Accounting Quality / Earnings Management
***the identification of statements materially affected by earnings management activity is critical when deciding whether to rely on the Financial Statements as a basis for developing forecasts of the firms future financial performance
earnings management
choices by management to influence earnings in a systematic direction
mechanisms available to manage earnings:
accounting-based selection and/or application of accounting principles
real activities managementbusiness strategy / operations
definition:earnings quality
a firms reported earnings number is said to be of high quality if it accurately and reliably measures current economic value-added and is a good predictor of economic value likely to be added in the future

ongoing debate rules-based versus principles-based
rules-based
accounting standards prescribe in detail exactly how to account for various items and situations without providing discretion
more limited scope for earnings management type behaviour BUT also limited opportunity for management to use accounting policy choice as a means of communication

principles-based
accounting standards provide guidance on how various items and situations should be accounted for, but also provide flexibility for management to exercise judgement within the spirit of the guidance
more opportunity for management to use accounting policy choice as a means of communication BUT also increased scope for earnings management type behaviour

debate about trade-offs between costs and benefits of allowing discretion
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The 3 basic questions that frame the notion of power to detect are the following:

Where is it most profitable to look?
under what set of circumstances is earnings management activity most likely to occur?
which firms are the most suspicious (in the most suspicious circumstances)?
what are managements incentives? (earnings targets? contractual obligations? compensation?)
i.e., small positive earnings; small earnings increases; earnings volatility (smooth earnings)

2. What should be examined?
what should the search focus on? what lever is management most likely to utilize to accomplish the earnings management?
i.e., accounting (accruals); real activities

3. How should the investigation be conducted? technique(s)?

**** our focus accounting statements (especially Income Statement) accruals ****
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Penman Figure 18.2 Diagnostics to Detect Manipulation of Operating Income

Step #1 investigate the quality of sales revenue
Step #2 investigate the quality of core expenses
Step #3 investigate unusual items
Step #1
note much of the investigation will involve ratios (value of one account(s) relative to value of another account(s))

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Step #2
Step #3

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intended to shed light on how well a company is doing in achieving its objectives
earning a satisfactory return on investment
maintaining a sound financial position i.e., owners want capital protected from more than normal amount of risk

structure of analysis an examination of the relationships between items in the F/S
in absolute terms
changes over a period of time
relative to other firms (in same industry)

three basic techniques for analysing the Financial Statements
ratio analysis
common-size financial statements
trend (indexed) financial statements
PART 2 Financial Statement Analysis (in general)

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1) Financial Ratios 5 basic categories of commonly used ratios (some overlap)
a) liquidity ratios access to cash to pay bills
b) leverage ratios dependency on debt financing & ability to make interest payments
c) profitability ratios earnings relative to sales, S/E, assets, etc.
d) activity ratios emphasis on productivity of assets
e) market ratios based on market value information (e.g., price-earnings (P/E), market-to book ratio (M/B))
2) Common Size Financial Statements
express accounts on the B/S as a % of total assets
express accounts on the I/S as a % of sales (total revenue)
can compare relative weights of various accounts across firms or with industry norm
3) Trend (Index) Analysis
establish a bench-mark year and set all accounts (or ratios) to 100 in that year
in subsequent years, express accounts relative to the base year
can identify relative (percentage) changes over time

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Financial Ratios:

a) liquidity ratios access to cash to pay bills
e.g.,current ratio = CA/CL(*ignores quality and liquidity of assets)
quick ratio = (CA inventory)/CL
inventory turnover = COGS/inventory
receivables turnover = sales/AR

notes:liquidity refers to companys ability to pay its current liabilities when due

solvency refers to companys ability to repay its long-term obligations as well
relates to idea of financial flexibilitycompanys ability to alter its capital structure to take advantage of new investment opportunities or deal with economic change

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b) leverage ratios dependency on debt financing & ability to make interest payments
e.g.,debt to equity = (CL + L-T debt)/shareholders equity
times interest earned = (PBT + interest)/interest

c) profitability ratios earnings relative to sales, S/E, assets, etc.
e.g.,profit margin = NI/rev
ROA = EBIT/total assets(or earnings after tax / total assets)
ROE = NI/(S/E)

d) activity ratios emphasis on productivity of assets
e.g.,inventory turnover
receivables turnover
asset turnover = sales/(tot assets)

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Coles Income Statement20202019

Sales Revenue37,40838,176
Other operating revenue376288
Total operating revenue37,78438,464
Cost of sales(28,043)(29,253)
Gross Profit9,7419,211
Other income108428
Administrative expenses(8,081)(8,031)
Other expenses(146)
Share equity investments(6)5
EBIT1,7621,467
Financing costs(443)(42)
PBT1,3191,425
Income tax expense(341)(347)
Profit from continuing operations9781,078
Profit from discontinued operations (after tax)357
Profit (NPAT)9781,425
OCI(12)(1)
Total Comprehensive Income9661,434

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Coles Balance Sheet20202019

Assets
Current Assets
cash & cash equivalents992940
receivables434360
inventories2,1661,965
income tax receivable42
assets held for resale7594
other assets7047
Total current assets3,7793,406

Non-current Assets
property, plant and equipment4,1274,119
right-of-use assets7,660
intangible assets1,5971,541
deferred tax assets849365
equity accounted investments217212
other assets120134
Total non-current assets14,5706,371

Total Assets18,3499,777

Liabilities20202019
Current Liabilities
payables3,7373,380
provisions861743
lease liabilities885
other198168
Total Current Liabilities5,6814,291

Non-current Liabilities
interest-bearing liabilities1,3541,460
provisions472598
lease liabilities8,198
other2971
Total non-current liabilities10,0532,129

Total Liabilities15,7346,420

Net Assets2,6153,357

Shareholders Equity
contributed equity1,6111,628
reserves4342
retained earnings9611,687

Total Equity2,6153,357

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Liquidity ratios20202019

current ratio = CA / CL0.6650.794
quick ratio = (CA inv) / CL0.2840.336

inventory turnover = COGS / inventory12.94714.887
days inventory = 365 / inventory turnover29.19224.518

receivables turnover = revenue / receivables87.060106.844
average collection period = 365 / receivables turnover4.1933.416

Leverage ratios
debt-to-equity = total liabilities / total equity6.0171.912
debt-to-assets = total liabilities / total assets0.8570.657
times interest earned = EBIT / interest3.97734.929

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Profitability ratios20202019

gross profit margin = gross profit / revenue0.2580.239
profit margin = NPAT / revenue0.0260.037

return on assets (ROA) = EBIT / total assets0.0960.150
return on equity (ROE) = NPAT / (S/E)0.3740.424

Activity ratios
inventory turnover = COGS / inventory12.94714.887
receivables turnover = revenue / receivables87.060106.844
asset turnover = revenue / total assets2.0593.934

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Notes:
2019 and 2020 figures for Coles are largely non-comparable because of the changed treatment of leases (AASB 16) perhaps the more appropriate comparison is with Woolworths 2020 figures, or against industry averages (but this assumes that they use the same accounting methods and format)
the calculations above are based on year-end B/S figures more typically, they are based on average balances (i.e., the average of 2019 and 2020 reported figures BUTthere is no right way or wrong way it is important to understand how the calculations have been done)
to illustrateinv turn2020 = COGS2020 / [(inv2019 + inv2020)/2] = 28,043 / [(2,166 + 1,965)/2] = 13.577(vs 12.947)
the profitability ratios have been based on NPAT rather than Comprehensive Income (CI), although the latter is likely more defensible
more critically (concerning), the profitability ratios have been calculated based on the reported figures in contrast, we have argued that reformulated figures are more defensible and insightful

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RatiosColes 2020Woolies 2020

current ratio = CA / CL0.6650.616
quick ratio = (CA inv) / CL0.2840.280

debt-to-equity = total liabilities / total equity6.0173.260
debt-to-assets = total liabilities / total assets0.8570.765
times interest earned = EBIT / interest3.9773.117

gross profit margin = gross profit / revenue0.2580.292
profit margin = NPAT / revenue0.0260.019
return on assets (ROA) = EBIT / total assets0.0960.068
return on equity (ROE) = NPAT / (S/E)0.3740.134

inventory turnover = COGS / inventory12.94710.173
days inventory = 365 / inventory turnover29.19235.881
receivables turnover = revenue / receivables87.06086.047
average collection period = 365 / receivables turnover4.1934.242
asset turnover = revenue / total assets2.0591.655

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Finally
while trend and common size statements are relatively uninformative given the changed treatment of leases through the adoption of AASB16, their construction is illustrated in the next set of slides

Common-size statement all B/S items expressed as a % of total assets
all I/S items expressed as a % of revenue

Trend (indexed) statements all B/S and I/S items expressed as a % of their values in a base year (to display trends / growth over time)

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Common-size Income StatementW 2020C 2020C 2019

Sales Revenue0.9900.993
Other operating revenue0.0100.009
Total operating revenue111
Cost of sales0.7080.7420.761
Gross Profit0.2920.2580.239
Other income0.0030.0030.011
Administrative & Other expenses0.2530.2140.213
EBIT0.0410.0470.038
Financing costs0.0130.0120.001
PBT0.0280.0350.037
Income tax expense0.0090.0090.009
Profit from continuing operations0.0190.0260.028
Profit from discontinued operations (after tax)0.009
Profit (NPAT)0.0190.0260.037
Total Comprehensive Income0.0180.0260.037

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Common-size Balance SheetW 2020C 2020C 2019
Current Assets
cash & cash equivalents0.0540.0540.096
receivables0.0190.0240.037
inventories0.1150.1180.201
income tax receivable0.002
assets held for resale0.0090.0040.010
other assets0.0140.0040.005
Total current assets0.2110.2060.348
Non-current Assets
property, plant and equipment0.2270.2250.421
right-of-use (lease) assets0.3140.417
intangible assets0.2010.0870.158
deferred tax assets0.0340.0460.037
equity accounted investments0.0040.0120.022
other assets0.0050.0070.014
Total non-current assets0.7890.7940.652
Total Assets111

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Common-size Balance SheetW 2020C 2020C 2019
Current Liabilities
payables0.1950.2040.346
provisions0.0490.0470.076
lease liabilities0.0390.048
other0.0580.0110.017
Total Current Liabilities0.3430.3100.439
Non-current Liabilities
interest-bearing liabilities0.0500.0740.149
provisions0.0240.0260.061
lease liabilities0.3420.447
other0.0070.0020.007
Total non-current liabilities0.4220.5480.218
Total Liabilities0.7650.8570.657
Shareholders Equity
contributed equity0.1570.0880.167
reserves0.0100.0020.004
retained earnings0.0610.0520.173
Total Equity0.2350.1430.343

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Trend (Indexed) Income StatementC 2020C 2019

Sales Revenue0.9801
Other operating revenue1.3061
Total operating revenue0.9821
Cost of sales0.9591
Gross Profit1.0581
Other income0.2521
Administrative & Other expenses0.9881
EBIT1.2011
Financing costs10.5481
PBT0.9261
Income tax expense0.9831
Profit from continuing operations0.9071
Profit (NPAT)0.6861
Total Comprehensive Income0.6741

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Common-size Balance SheetC 2020C 2020
Current AssetsCurrent Liabilities
cash & cash equivalents1.055payables1.106
receivables1.206provisions1.159
inventories1.102lease liabilities
income tax receivableother1.179
assets held for resale0.798Total Current Liabilities1.324
other assets1.489Non-current Liabilities
Total current assets1.110interest-bearing liabilities0.927
Non-current Assetsprovisions0.789
property, plant and equipment1.002lease liabilities
right-of-use (lease) assetsother0.408
intangible assets1.036Total non-current liabilities4.722
deferred tax assets2.326Total Liabilities2.451
equity accounted investments1.024Shareholders Equity
other assets0.896contributed equity0.990
Total non-current assets2.287reserves1.024
Total Assets1.877retained earnings0.570
Total Equity0.779

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Objectives of Reformulation:
separate operating activities from financing activities
alter several accounting classifications (largely around equity)
for the Income Statement, separate revenues and expenses based on their driver (sales volume or other), and whether they are recurring or non-recurring
for Statement of Cash Flows, separate operating from financing activities; determine free cash flows operations-related cash flows split by operating versus investing; and separate equity and debt financing cash flows
PART 3 Reformulated F/S & Profitability

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Assets
=
Liabilities
+
Shareholders Equity
Operating Assets (OA)
Financial Assets (FA)
Operating Liabilities (OL)
Financial Obligations (FL)
accounting equation

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AASB / IFRS Balance Sheet
AssetsLiabilities & Equity
Operating AssetsOA Operating LiabilitiesOL
Financial AssetsFA Financial ObligationsFO
Shareholders EquityS/E
Total AssetsOA + FATotal ClaimsOL + FO + S/E

Reformulated Balance Sheet
Net Operating AssetsFinancial Obligations & Shareholders Equity
Operating AssetsOA Financial ObligationsFO
Operating LiabilitiesOL Financial Assets(FA)
Net Financial ObligationsNFO
Shareholders EquityS/E
TotalOA OLTotalNFO + S/E

AASB/IFRS Income Statement & Statement of Comprehensive Income

Sales
COGS
= Gross margin
Other expenses
= EBITDA
Depreciation & amortisation
= EBIT
+ Interest revenue
Interest expense
= PBT
Income tax expense
= NPAT
+OCI (with tax effects)
= Comprehensive Income (CI)
Reformulated Income Statement

Core Operating Income from Sales (before-tax)
Core Other Operating Income (before-tax)
Unusual Operating Income (before-tax)
Net Financial Expense (before-tax)

Steps 1 and 2
Step 3
Step 4
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Mark Wallis, UQ
Operating OCI (after-tax)
Financing OCI (after-tax)
Tax allocation:
Tax shield from NFE
Tax on Core Other OI
Tax on Unusual OI
Tax on Core OI from Sales

31

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Reformulated Statement of Cash Flows
Adjusted Cash flow from operationsC
Adjusted Cash investment in operating assets I
Free Cash Flow (FCF)C + I
Equity financing flows
dividends & share repurchasesXX
share issuances(XX)E
Debt financing flows
net purchase of financial assets(XX)
interest on financial assets (after tax)XX
net issue of debtXX
interest on debt (after tax)(XX)F
Total Financing cash flowsE + F

Uses of FCF in financing activities

Generation of FCF from operating activities

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Reformulated Statement of Changes in Shareholders Equity
Beginning Book Value of Common Equity BVt-1
+ Net effect of Transactions with Common Shareholders
+ capital contributions (share issues)
share repurchases
cash dividends to common shareholders
= Net cash contributions
+ Effect of operations and non-equity financing
+ Net Income (from the I/S)
+ Other Comprehensive Income (OCI)
preferred share dividends
= Comprehensive income available to common shareholders
Ending Book Value of Common Equity BVt

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Penman E10.6 & E12.3
Prepare a reformulated B/S and I/S
Calculate FCF for 2012
Calculate operating profit margin, asset turnover, and return on NOA for 2012
Calculate individual asset turnovers and show that they aggregate to the total asset turnover
Show that the financing leverage equation holds:
ROCE = RNOA + (FLEV x operating spread)
Calculate the after-tax net borrowing cost. If this borrowing cost were to be sustained in the future, what would the ROCE be if RNOA fell to 6% and FLEV decreased to 0.8?
The implicit cost of credit on A/P and accrued liabilities is 3%. Show that the following leverage equation holds:
RNOA = ROOA + [OLLEV x (ROOA 3%)]

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Net Operating Assets (NOA)20122011Net Financial Obligations (NFO)20122011
Operating Assets (OA)Financial Assets (FA)
operating cash6050short-term investments550500
accounts receivable940790
inventory910840Financial Obligations (FO)
property & plant2,8402,710long-term debt1,8401,970
Total Operating Assets4,7504,390
Operating Liabilities (OL)Net Financial Obligations (NFO)1,2901,470
accounts payable1,2001,040
accrued liabilities390450Shareholders Equity (S/E)1,8701,430
Total Operating Liabilities1,5901,490

Net Operating Assets (NOA)3,1602,900

a) Reformulated Balance SheetS/E = NOA NFO

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Reformulated Statement of S/E
2012
Beginning S/E (BVt-1)1,430
Net transactions with Shareholders
share issues822
share repurchases(720)
dividends(180)
(78)

Comprehensive Income
NPAT468
OCI50
Comprehensive Income (CI)518

Ending S/E (BVt)1,870

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Reformulated Income Statement (to extent possible)
AASB I/SNPAT OCI = CI
from Statement of Shareholders Equity
Net Income (NPAT)468
Other Comprehensive Income (OCI)
(unrealized gain on debt investment)50
Comprehensive Income (CI)518

Core Net Financing Expenses
from additional information
interest income15
interest expense98
net core NFE (before tax)(83)
tax shield = 83 @ 35%29
Core NFE (after tax)(54)

Reformulated I/SOI NFE = CI
from & above
Operating Income (after tax)???
Net Financial Expenses (after tax)
core NFE(54)
financial OCI (unrealized gain)50(4)
Comprehensive Income (CI)518

OI 4 = 518 OI = 522

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2012
Sales3,726
Operating Expenses?
Operating Income (before tax)?
Core NFE (before tax)
interest expense(98)
interest income1583
Tax Allocation (split)
income tax expense?
tax shield (83 @ 0.35)29
tax on operating income?
Operating Income (after tax)522
Core NFE (after tax)(54)
NPAT468
Financing OCI (after tax)50
Comprehensive Income (CI)518

Reformulated Income Statement (to extent possible)

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b) Free Cash Flow (FCF)(Slide 56, Session #7)

FCF = OI (after tax) NOAor FCF = NFE NFO + E
= 522 ( 3,160 2,900)= 4 (1,290 1,470) + 78
= 262= 262

c) profit margin = OI / Sales = 522 / 3,726 = 0.140114.01%
asset turnover = Sales / average NOA = 3,726 / [(3,160 + 2,900)/2] = 1.2297
RNOA = OI / average NOA = 522 / [(3,160 + 2,900)/2] = 0.172317.23%

note:RNOA == profit marginasset turnover

= 0.1401 * 1.2297 = 0.1723
** based on reformulated statements !!

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d) Further disaggregation of total asset turnover

NOA = {operating cash + receivables + inventory + property & plant}
[accounts payable + accrued liabilities]

asset turnover =

+ ++

= +++=0.8132

asset turnover =

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e) financial leverage equation

ROCE = RNOA + (FLEV x operating spread) = RNOA + FLEV x ( RNOA NBC)

ROCE===0.313931.39%

RNOA=0.172317.23%

FLEV =0.8364

net borrowing cost (NBC) = 0.0029

ROCE =0.1723 + 0.8364(0.1723 0.0029) = 0.3139
return on NOA less cost of financing

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f) modified

givenRNOA = 6%FLEV = 0.80

net borrowing cost (NBC) = 0.0029

ROCE =0.0600 + 0.80(0.0600 0.0029) = 0.105710.57%

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g) operating liability leverage equationRNOA = ROOA + [OLLEV x (ROOA 3%)]

RNOA=0.1723

implicit interest = 0.03 x average OL = 0.03[(1,590 + 1,490)/2] = 46.2

ROOA =0.1243

operating liability leverage (OLLEV)=0.5083

RNOA =0.1243 + 0.5083(0.1243 0.03) = 0.172317.23%

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So why does this all work?conceptual foundation

ROCE==
return on S/E after removing implications of debt financing
levered measure of profitability

RNOA == profit marginasset turnover
return on net operating assets before considering sources of financing
unlevered measure of profitability
PART 4 Conceptual Foundation

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at this stage, the difference between ROCE and RNOA appears to simply be whether consideration is given to (an adjustment made for) the implications of debt financing

net borrowing cost (NBC) = borrowing rate for financing NOA

FLEV =measure of financial leverage (essentially a debt-to-equity ratio)

now consider the following algebraic manipulation of the ROCE formula, starting with

ROCE==

46
ROCE===
=
=
= +
= + {

ROCE=RNOA +FLEV{RNOA NBC}

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In summary

ROCE is the return to the common shareholder after making the required payments to debtholders (interest expense)

RNOA is the return on the companys operations (before separating that required to satisfy debtholders and the remainder available to shareholders)

RNOA NBC (i.e., the spread) is difference between the return the company can earn on its operations and its cost of borrowing

if spread > 0, the company can increase its ROCE from increasing FLEV

for a profitable company, the extent of FLEV explains the difference between ROCE and RNOA, with ROCE > RNOA

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For Coles (from Session #7 after adjusting for the implications of AASB16, leases, in 2019)

Reformulated I/S2020OI = 1,288.1
NFE = 322.1
CI = 966

Reformulated (and adjusted) B/S2020 2019 ave
NOA12,20513,10212,653.5
NFO9,59010,57610,083.0
S/E2,6152,5262,570.5

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ROCE= 0.3758

RNOA=0.1018

FLEV = 3.9226

NBC =319spread = (0.1018 0.0319) = 0.0699

ROCE=RNOA +FLEV {RNOA NBC}

= 0.1018 + 3.9226 {0.1019 0.0319} = 0.3758

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ROCE=RNOA +FLEV {RNOA NBC}first-level break down of ROCE

given RNOA == profit marginasset turnover

ROCE = {profit marginasset turnover} + {FLEVspread}second-level break down of ROCE

Clearly there are number of ways in which each of OI, profit margin, asset turnover, and leverage can be further broken down there further breakdowns provide additional insights into how / why each of these measures or ratios have changed

We will consider some possible further dis-aggregations in Session #10
operations
financing

52
PART 5 Penman: E10.10 & E12.9

53

54

55

56

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Operating Assets (OA)20072006Operating Liabilities (OL)20072006
Operating cash40,00040,000 Accounts payable390,836340,937
S-T invest trading securities73,58853,496 Accrued compensation332,331288,963
Accounts receivable287,925224,271 Accrued occupancy costs74,59154,868
Inventories691,658636,222 Accrued taxes92,51694,010
Prepaid expenses/other CA148,757126,874 Other accrued expenses257,369224,154
DTA129,45388,777 Deferred revenue296,900231,926
Equity-accounted investments258,846219,093 Other long-term liabilities354,074262,857
property, plant & equipment2,890,4332,287,899Total OL1,798,6171,497,715
Other assets219,422186,917
Other intangible assets42,04337,955Net Operating Assets (NOA)3,199,1332,565,267
Goodwill215,625161,478
Total OA4,997,7504,062,982

a) Reformulated Balance Sheet

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Financial Assets (FA)20072006Shareholders Equity (S/E)20072006
financial cash241,261272,606 contributed capital738756
available for sale securities104,86793,353 other paid-in capital39,39339,393
346,128365,959 retained earnings (R/E)2,189,3662,151,084
accumulated OCI54,62037,273
Financial Obligations (FO)Total S/E2,284,1172,228,506
commercial paper710,248700,000
long-term debt550,8962,720Total NFO + S/E = NOA3,199,1332,565,267
1,261,144702,700

Net Financial Obligation (NFO)915,016336,761

Reformulated Balance Sheet (cont)

59
Core OI from Sales (before tax)Unusual OI (before tax)
revenue9,411,497 gain on asset sales26,032
COGS(3,999,124)
Gross Margin5,412,373Total OI before tax1,138,392
Other Operating Expenses
store operating expenses(3,215,889)Net Financial Expense (NFE) (before tax)
other operating expenses(294,136) interest income19,700
depreciation & amortisation expense(467,160) interest expense(38,200)
general & administrative expense(489,249) realised gain on avail-for-sale investment3,800
Core OI from Sales (before tax)945,939 NFE (before tax)(14,700)
Core Other OI (before tax)
profit equity-accounted investments175,334Profit Before Tax (PBT)1,123,692
other operating charges(8,913)
Core Other OI (before tax)166,421

Reformulated Income Statement before tax

60
Core OI from Sales (before tax)945,939
Core Other OI (before tax)166,421
Unusual OI (before tax)26,032
Total OI (before tax)1,138,392
NFE (before tax)(14,700)
Profit Before Tax (PBT)1,123,692

Reformulated Income Statement tax allocation
Tax Allocation (456,699 in total)
NFE (14,700 @ 0.384)5,645
Tax on Unusual OI (26,032 @ 0.384)9,996
Tax on Core Other OI (166,421 @ 0.384)63,906
Tax on Core OI from Sales (balance)
= 451,054 + 5,645 9,996 63,906)382,797

Tax to be allocated
reported tax expense383,726
tax on equity-accounted investments**67,328
Total451,054
** 2007 I/S income from equity investees = 108,006 after tax (note 5)
before tax amount = 108,006 / (1 0.384) = 175,334
tax = 175,334 108,006 = 67,328

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After-tax Amounts
Core OI from Sales (after tax) = 945,939 382,797563,142
Core Other OI (after tax) = 166,421 63,906102,515
Unusual OI (after tax) = 26,032 9,99616,036
NFE (after tax) = (14,700) + 5,645(9,055)
Net Profit After Tax (NPAT)672,638

Other Comprehensive Income (OCI)
Operating OCI (after tax)
translation adjustment37,727
Financing OCI (after tax)
unrealised holding loss(20,380)

Reformulated Income Statement after tax amount

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Operating Income (after tax)
Core OI from Sales (after tax)563,142
Core Other OI (after tax)102,515
Unusual OI (after tax)16,036
681,693
Operating OCI (after tax)37,727
Total Operating Income (OI) (after tax)719,420
Net Financing Expenses
NFE (after tax)(9,055)
Financing OCI (after tax)(20,380)
Total Financing Expenses(29,435)

Comprehensive Income689,985

Reformulated Income Statement final form

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b) ROCE===0.3096 30.96%

RNOA=0.280528.05%

net borrowing cost (NBC) = 0.0874

c)FLEV =0.1511

ROCE = RNOA + (FLEV x operating spread) = RNOA + FLEV x ( RNOANBC)

ROCE = 0.2805 + 0.1511(0.2805 0.0874) = 0.3097
(difference due to rounding to 4 decimal places only)

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d) profit margin===0.0764 7.64%

asset turnover= 3.6688

RNOA == profit marginasset turnover

= 0.07643.6688=0.2803(difference due to rounding to 4 decimal places only)

profit margin from sales =0.05985.98%

65
e)OLLEV =0.5838

f)Implicit interest on OL = 1,497,715 @ 0.036 = 53,918

ROOA = 0.1903

RNOA = ROOA + (OLLEV x OL spread) = ROOA + OLLEV x ( ROOASTBC)

= 0.1903 + 0.5838 (0.1903 0.036) = 0.2804

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financial leverageuse of debt financing with fixed interest payments

ROCE = RNOA + FLEV x ( RNOA NBC) RNOAROCE

operating leverageuse of operating liabilities (OL) to finance OA

RNOA = ROOA + OLLEV x (ROOA STBC)ROOARNOA

operating spread

financial leverage
PART 6 Profitability & Leverage: Further Examples
operating leverage

OL spread
leverage, both financial (FLEV) and operating (OLLEV), magnifies profit (& loss) available to the common shareholder

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Example 9-1 (typical firm profitable, RNOA > NBC)

Net operating assets (NOA)28,000
Net financial obligations (NFO)15,000
Shareholders Equity (S/E)13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) 1,500

ROCE===0.1154RNOA=0.0714

FLEV =NBC = 0.0333

ROCE = RNOA + FLEV x ( RNOA NBC) = 0.0714 + 1.1538(0.0714 0.0333) = 0.1154

use of debt financing (FLEV) magnifies ROCE relative to RNOA

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Example 9-2 (loss firm A)

Net operating assets (NOA)28,000
Net financial obligations (NFO)15,000
Shareholders Equity (S/E)13,000
Operating income (OI)(1,000)
Net Financial Expense (NFE)(500)
Comprehensive Income (CI)(1,500)

ROCE=== 0.1154RNOA=0.0357

FLEV =NBC = 0.0333

ROCE = RNOA + FLEV x ( RNOA NBC) = 0.0357 + 1.1538(0.0357 0.0333) =

use of debt financing (FLEV) magnifies negative loss to common shareholders

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Example 9-3 (loss firm B)

Net operating assets (NOA)28,000
Net financial obligations (NFO)15,000
Shareholders Equity (S/E)13,000
Operating income (OI) 1,000
Net Financial Expense (NFE)(1,500)
Comprehensive Income (CI) (500)

ROCE=== 0.0385RNOA=0.0357

FLEV =NBC = 0.1000

ROCE = RNOA + FLEV x ( RNOA NBC) = 0.0357 + 1.1538(0.0357 0.1000) = 0.0385

use of debt financing (FLEV) can even drive ROCE down into a loss from a positive RNOA

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Example 9-4(borrowing cost > earnings return)

Net operating assets (NOA)28,000
Net financial obligations (NFO)15,000
Shareholders Equity (S/E)13,000
Operating income (OI) 2,000
Net Financial Expense (NFE)(1,500)
Comprehensive Income (CI) 500

ROCE===0.0385RNOA=0.0714

FLEV =1.1538NBC = 0.1000

ROCE = RNOA + FLEV x ( RNOA NBC) = 0.0714 + 1.1538(0.0714 0.1000) = 0.0384

NBC > RNOA means that the use of FLEV drives ROCE down relative to RNOA

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Example 9-5(net financial assets)

Net operating assets (NOA)28,000
Net financial obligations (NFO)15,000i.e., net financial assets (NFA)
Shareholders Equity (S/E)43,000
Operating income (OI) 2,000
Net Financial Income (NFI) 500 i.e., not an expense (NFE)
Comprehensive Income (CI) 2,500

ROCE=== 0.0581RNOA=0.0714

FLEV = 0.3488RNFA = 0.0333

ROCE = RNOA + FLEV x ( RNOA NBC) = 0.0714 0.3488(0.0714 0.0333) = 0.0581

lower return on NFA (3.33% versus 7.14% on NOA) drives ROCE down relative to RNOA

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ROCE = RNOA + FLEV x ( RNOA NBC)

Summary
if profitable & RNOA > NBC ROCE > RNOAi.e., FLEV magnifies profit (example #9-1)
if unprofitable ROCE < RNOAi.e., FLEV magnifies (creates) loss (examples #9-2 & #9-3)if NBC > RNOAROCE < RNOA i.e., FLEV hurts if cost of borrowing is higher than return on investment in NOA (example #9-4)if net financial assets (i.e., negative borrowing)RCOE < RNOA since return on financial assets (NFA) is typically lower than RNOA (example #9-5)74Example 9-6 (typical firm profitable, ROOA > STBC)

Net operating assets (NOA)28,000OA = 40,000OL = 12,000
Net financial obligations (NFO)15,000FA = 2,000FO = 17,000
Shareholders Equity (S/E)13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (500)
Comprehensive Income (CI)1,500

OLLEV = assume STBC = 0.07(1 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588

ROOA =0.0647

RNOA = ROOA + OLLEV(ROOA STBC) = 0.0647 + 0.4286(0.0647 0.049) = 0.0714

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Example 9-7 (loss firm A)

Net operating assets (NOA)28,000OA = 40,000OL = 12,000
Net financial obligations (NFO)15,000FA = 2,000FO = 17,000
Shareholders Equity (S/E)13,000
Operating income (OI)(1,000)
Net Financial Expense (NFE) (500)
Comprehensive Income (CI)(1,500)

OLLEV = assume STBC = 0.07(1 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588

ROOA = 0.0103

RNOA = ROOA + OLLEV(ROOA STBC) = -0.0103 + 0.4286(-0.0103 0.049) = 0.0357

Summing Financial Leverage and OperatingLiability Leverage Effects on ROCE
ROCE= ROOA + (RNOA ROOA) + (ROCE RNOA)

Return
With no leverage

Effect of
Operating Liabilities

Effect of
Financing Liabilities
profitable firm (examples #9-1 & #9-6)
0.1154 = 0.0647+(0.0714 0.0647) + (0.1154 0.0714)

loss firm (examples #9-2 & #9-7)
-0.1154=-0.0103+ (-0.0357 0.0103) +(-0.1154 0.0357)

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77
overarching objective:
to conduct fundamental value for the purpose of estimating the intrinsic value of a firms common shares
requires an understanding of the firms value drivers
need to accumulate a tool kit as the basis for developing the pro forma Financial Statements

STEP 1
Understanding the past

Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis

STEP 2
Forecasting the future

Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts

STEP 3
Valuation

Cost of capital
Valuation models AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction

PART 7 Summary

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external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory

Industry dynamics
Porters five forces
(suppliers, buyers, new entrants, substitutes, rivalry)

Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
ratio analysis ** Sessions #9 & #10

analysts reports
management forecasts
financial press
???

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