2023 CFA L2 Book 2 FRA - CI-2

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JuiceNotes 2023
Financial Statement Analysis | Corporate Issuers
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INDEX
Financial Statement Analysis
Name of Reading
1 Financial Statement Modelling 6
2 Intercorporate Investments 18
3 Employee Compensation: Post Employment and Share-Based 29
4 Multinational Operations 34
5 Analysis of financial Institutions 39
6 Evaluating Quality of Financial Reports 45
7 Integration of Financial Statement Analysis Techniques 52
Corporate Issuers
1 Analysis of Dividends and Share Repurchases 58
2 ESG Considerations in Investment Analysis 65
3 Cost of Capital: Advanced Topics 74
4 Corporate Restructuring 92
Financial Statement
Analysis
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Financial Statement Modelling
compare top-down, bottom-up, and hybrid approaches for developing inputs to equity
valuation models
compare “growth relative to GDP growth” and “market growth and market share”
approaches to forecasting revenue
ª Analyst begins with a review of the company and its environment—its industry,
key products, strategic position, management, competitors, suppliers, and
customers.
ª Analyst identifies key revenue and cost drivers
Financial statement modeling is not merely a quantitative or accounting

exercise, it is the quantitative expression of an analyst's expectations for a
company and its competitive environment.
ª Financial statement modeling generally begins with the income statement
ª Exceptions include banks and insurance companies, for which the value of
existing assets and liabilities on the balance sheet might be more relevant to the
companies' overall value than projected future income.
Revenue Modelling
Companies receive revenue from multiple sources and can be analyzed by

ª geographical source, business segment, or product line.
ª Segment disclosures in companies' financial reports are often a rich source of

information (typically in the notes to financial statements)
ª A product line analysis provides the most granular level of detail. A product line
analysis is most relevant for a company with a manageably small number of
products that behave differently but when combined, account for most of the
company's sales.
ª A top-down approach usually begins at the level of the overall economy.

Forecasts can then be made at lower levels, such as sector, industry, and
market for a specific product, to arrive at a revenue projection for the
individual company.
6
ª In contrast, a bottom-up approach begins at the level of the individual

company or a unit within the company, such as individual product lines,
locations, or business segments
ª A hybrid approach combines elements of both top-down and bottom-up

analysis and can be useful for uncovering implicit assumptions or errors that
could arise from using a single approach.
Top-Down Approaches to Modeling Revenue
ª Two common top-down approaches to modeling revenue are:

1. Growth relative to GDP growth
2. Market growth and market share.
Growth relative to GDP growth
ª First forecasts the growth rate of nominal GDP. The analyst then considers how
the growth rate of the specific company being examined will compare with
nominal GDP growth
ª The analyst can use a forecast for real GDP growth to project volumes and a
forecast for inflation to project prices.
ª Example : health care company's revenue will grow at a rate of 200 bps above
the nominal GDP growth rate or if GDP is forecast to grow at 4% and the
company's revenue is forecast to grow at a 50% faster rate, the forecast
percent change in revenue would be 4% × (1 + 0.50) = 6.0%, or 200 bps
higher in absolute terms.
Market growth and market share approach
ª If a company is expected to maintain an 8% market share of a given product

market and the product market is forecast to grow from CNY144 billion to
CNY154 billion in annual revenue, the forecast growth in company revenue is
from a level of 8% × CNY144 billion = CNY11.5 billion to a level of 8% ×
CNY154 billion = CNY12.3 billion
7
Bottom-Up Approaches to Modeling Revenue
Bottom Approach
Time series: forecasts Returns-based Capacity-based

based on historical measure: forecasts measure: for example,
growth rates or time- based on balance in retailing, based on
series analysis. sheet accounts. For same-store sales
example, interest growth (for stores that
revenue for a bank can have been open for at
be calculated as loans least 12 months) and
multiplied by the sales related to new
average interest rate. stores.
ª Note that time-series methods can also be used as tools in executing a top-
down analysis, such as projecting GDP growth in a growth relative to GDP
growth approach.
Top-Down Approaches to Modeling Revenue
ª Hybrid approaches combine elements of both top-down and bottom-up

analysis, and in practice, they are the most common approaches
Evaluate whether economies of scale are present in an industry by analyzing operating

margins and sales levels
ª Disclosure about operating costs is frequently less detailed than disclosure

about revenue.
ª More frequently, analysts will be forced to consider costs at a more aggregated

level than the level used to analyze revenue. Analysts should keep in mind their
revenue analysis when deriving cost assumptions.
ª In a top-down approach, analysts might consider such factors as the overall

level of inflation or industry-specific costs before making assumptions about
the individual company.
ª In contrast, in a bottom-up approach analysts would start at the company

level, considering such factors as segment-level margins, historical cost growth
rates, historical margin levels, or the costs of delivering specific products
8
ª Variable costs are directly linked to revenue, and they might be best modeled
as a percentage of revenue or as projected unit volume multiplied by unit
variable costs.
ª By contrast, fixed costs are not directly related to revenue; rather, they are
related to investment in property, plant, and equipment (PP&E) and to total
capacity. Practically, fixed costs might be assumed to grow at their own rate,
based on an analysis of future PP&E and capacity growth
ª Gross and operating margins tend to be positively correlated with sales levels
in an industry that enjoys economies of scale.
Sales year 1 = 100

EBIT = 20
OPM = 20%
Sales year 2 = 150

EBIT = 45
OPM = 30%
Positive Correlation between sales and OPM, Proof of Economies of Scale.
Demonstrate methods to forecast cost of goods sold and operating expenses
COGS
ª Forecasting COGS as a percentage of sales and forecasting gross margin

percentage are equivalent in that a value for one implies a value for the other.
ª Forecasting this item as a percentage of sales is usually a good approach
ª Consider the impact of a company's hedging strategy.
ª Competitors' gross margins can also provide a useful cross check for estimating
a realistic gross margin. Gross margin differences among companies within a
sector should logically relate to differences in their business operations
ª Note that differences in competitors' gross margins do not always indicate a

superior competitive position but could simply reflect differences in business
models
9
S,G&A
ª Selling and distribution expenses often have a large variable component and
can be estimated, like COGS, as a percentage of sales. The largest component
of selling expenses is often wages and salaries linked to sales.
ª Other general and administrative expenses are less variable. Overhead costs
for employees, for example, are more related to the number of employees at
the head office and supporting IT and administrative operations than to short-
term changes in the level of sales
ª By analyzing the cost structure of a company's competitors, the efficiency
potential and margin potential of a specific company can be estimated.
Demonstrate methods to forecast non-operating items, financing costs, and income

taxes.
Financing Expenses
ª Financing expenses consist of interest income and interest expense, which are
typically netted.
ª Interest income depends on the amount of cash and investments on the

balance sheet as well as the rates of return earned on investments
ª Interest expense is typically presented net of interest income on the income

statement, with the individual components disclosed in the notes to financial
statements.
Corporate Income Tax
ª Income taxes are primarily determined by the geographic composition of

profits and the tax rates in each geography but can also be influenced by the
nature of a business.
Statutory Tax Rate Effective Tax Rate Cash Tax Rate
Ÿ Corporate tax rate in Ÿ Reported income tax Ÿ Tax actually paid (cash
the country in which expense amount on the tax) divided by pre-tax
the company is income statement income.
domiciled. divided by the pre-tax Ÿ 17%
Ÿ 33% income.
Ÿ 25%
10
ª The cash tax rate is used for forecasting cash flows, and the effective tax rate
is relevant for projecting earnings on the income statement
ª Govt of India = 33%
ª PBT = 100, tax Expense = 25
ª Cash Taxes Paid = 17
ª Dividends : A company's stated dividend policy helps in modeling future

dividend growth. Analysts will often assume that dividends grow each year by
a certain dollar amount or as a proportion of net income.
ª Equity Method vs Consolidation Method

Finally, unusual charges can be almost impossible to predict, particularly past
the next couple of years. For this reason, analysts typically exclude unusual
charges from their forecasts. But if a company has a habit of frequently
classifying certain recurring costs as “unusual,” analysts should consider some
normalized level of charges in their model.
ª Company strategy is also an important factor. Faced with rising input prices, a
company might decide to preserve its margins by passing on the costs to its
customers, or it might decide to accept some margin reduction to increase its
market share. In other words, the company could try to gain market share by
not fully increasing prices to reflect increased costs
Evaluate the effects of technological developments on demand, selling prices, costs,

and margins
ª Technological developments have the potential to change the economics of

individual businesses and entire industries. Quantifying the potential impact of
such developments on an individual company's earnings involves making
certain assumptions about future demand. Such assumptions should be
explored through scenario and/or sensitivity analysis so that a range of
potential earnings outcomes can be considered
ª When a technological development results in a new product that threatens to

cannibalize demand for an existing product, a unit forecast for the new product
combined with an expected cannibalization factor can be used to estimate the
impact on future demand for the existing product. When developing an
estimate of the cannibalization factor, it might be useful to segment the market
if the threat of substitution differs across segments.
11
Explain considerations in the choice of an explicit forecast horizon

explain an analyst's choices in developing projections beyond the short-term forecast
horizon
ª The choice of the forecast time horizon can be influenced by certain factors,
including the investment strategy for which the security is being considered,
the cyclicality of the industry, company-specific factors, and the analyst's
employer's preferences
ª Most professionally managed investment strategies describe the investment

time frame, or average holding period, in the stated investment objectives of
the strategy; the time frame should ideally correspond with average annual
turnover of the portfolio.
ª For example, a stated investment time horizon of three to five years would
imply average annual portfolio turnover between 20% and 33% (average
holding period is calculated as one/portfolio turnover).
ª Normalized earnings are the expected level of mid-cycle earnings for a

company in the absence of any unusual or temporary factors that affect
profitability (either positively or negatively).
ª One of the greatest challenges facing the analyst is anticipating inflection

points, when the future will look significantly different from the recent past.
Most DCF models rely on a perpetuity calculation, which assumes that the cash
flows from the last year of an explicit forecast grow at a constant rate forever.
ª Because the perpetuity can account for a relatively large portion of the overall
valuation of the company, it is critical that the cash flow used is representative
of a “normalized” or “mid-cycle” result.
Describe approaches to balance sheet modeling
ª Some balance sheet line items—such as retained earnings—flow directly from

the income statement, whereas other lines like working capital accounts—such
as accounts receivable, accounts payable, and inventory—are very closely
linked to income statement projections.
ª Working capital projections can be modified by both top-down and bottom-up

considerations.
12
ª In the absence of a specific opinion about working capital, analysts can look at
historical efficiency ratios and project recent performance or a historical
average to persist in the future, , which would be a bottom-up approach.
ª Projections for long-term assets—such as PP&E and intangible assets—are less

directly tied to the income statement for most companies.
ª Capital expenditures can be thought of as including both maintenance capital

expenditures, which are necessary to sustain the current business, and growth
capital expenditures, which are needed to expand the business.
ª All else being equal, maintenance capital expenditure forecasts should

normally be higher than depreciation because of inflation.
Demonstrate the development of a sales-based pro forma company model
Income Statement Forecast Process
1. Revenue forecast
2. Operating I. COGS forecast

expense forecast II. SG&A forecast
3. Pro forma Segments

EBIT forecast forecast check
I. Interest expense
III. Shares
4. Non-operating forecast
outstanding
expense forecast II. Income tax forecast
expense forecast
5. Pro forma
income statement
forecast
13
Statement of Cash Flows Projection Process
Net income (income statement)
Shared based compensation

A. Cash flows from operating activities
Working Capital
Depreciation & amortization
Capex B. Cash flows from investing activities
Share repurchase and issuance
Dividends C. Cash flows from financing activities
Debt issuance and repayment
Explain how behavioral factors affect analyst forecasts and recommend remedial
actions for analyst biases
ª Overconfidence bias is a bias in which people demonstrate unwarranted faith in

their own abilities.
ª Studies have also suggested that individuals are more confident when making
contrarian predictions that counter the consensus. That is, overconfidence
arises more frequently when forecasting what others do not expect.
ª To mitigate overconfidence bias, analysts should record and share their

forecasts and review them regularly, identifying both the correct and incorrect
forecasts they have made.
ª The goal is to recognize that forecast error rates are high, so mitigating actions
that widen the confidence interval of forecasts should be taken. One such
action is scenario analysis. By asking, “Where could I be wrong and by how
much?” an analyst can generate different forecast scenarios.
ª Illusion of control is a tendency to overestimate the ability to control what

cannot be controlled and to take ultimately fruitless actions in pursuit of
control.
ª This bias often manifests in analysts' beliefs that forecasts can be rendered
more accurate in two ways: by acquiring more information and opinions from
experts and by creating more granular and complex models.
14
ª Illusion of control can be mitigated by restricting modeling variables to those

that are regularly disclosed by the company, focusing on the most important or
impactful variables, and speaking only with those who are likely to have unique
or significant perspectives.
ª Conservatism bias is a bias in which people maintain their prior views or

forecasts by inadequately incorporating new information.
ª A different name for conservatism bias in this context is anchoring and

adjustment, referring to an analyst using their prior estimates as an “anchor”
that is subsequently adjusted.
ª Although nothing is wrong with modifying a previous forecast, the previous

forecast or anchor tends to exert significantly influence; in other words, the
adjustment is too small, and the updated forecast is too close to the previous
forecast.
ª Representativeness bias refers to the tendency to classify information based on

past experiences and known classifications.
ª Base-rate neglect is a common form of representativeness bias in forecasting.

In base-rate neglect, a phenomenon's rate of incidence in a larger population,
or characteristics of a larger class to which a specific member belongs—its base
rate—is neglected in favor of situation- or member-specific information.
ª Considering the base rate is sometimes known as the “outside view,” while the
situation-specific is known as the “inside view.”
ª For example, an analyst is modeling operating costs and margins for a

biopharmaceutical company. The “inside view” approach would consider
company-specific factors such as the types of drugs the company sells, the
number of salespeople needed in each geography for each drug, and so on. The
“outside view” approach would view the company as a member of the
“biopharmaceuticals” industry, of which there are many others, and use
industry or sector averages for gross margin, R&D expense as percentage of
sales, and so on in the model.
ª Neither the outside nor inside view is superior; what makes for a superior
forecast is considering both.
ª Confirmation bias is the tendency to look for and notice what confirms prior
beliefs and to ignore or undervalue whatever contradicts them.
ª Two approaches to mitigating confirmation bias in the forecasting process are

to speak to or read research from analysts with a negative opinion on the
security under scrutiny and to seek perspectives from colleagues who are not
economically or psychologically invested in the subject security.
15
Explain how competitive factors affect prices and costs

evaluate the competitive position of a company based on a Porter's five forces analysis
ª Government is not best understood as a sixth force.
ª The best way to understand the influence of government on competition is to

analyze how specific government policies affect the five competitive forces
Explain how to forecast industry and company sales and costs when they are subject
to price inflation or deflation.
ª The impact of inflation or deflation on revenue and expenses differs from

company to company. Even within a single company, the impact of inflation or
deflation is generally different for revenue and expenses categories.
ª A company's efforts to pass on inflation through higher prices can have a

negative impact on volume if the demand is price elastic, which is the case if
cheaper substitutes are available.
ª If selling prices could be increased 10% while maintaining unit sales volume to
offset an increase of 10% in input costs, gross profit margin percentage would
be the same but the absolute amount of gross profit would increase.
ª In an inflationary environment, raising prices too late will result in a profit

margin squeeze but acting too soon could result in volume losses. In a
deflationary environment, lowering prices too soon will result in a lower gross
margin, but waiting too long will result in volume losses.
16
ª The impact of higher prices on volume depends on the price elasticity of

demand (i.e., how the quantity demanded varies with price). If demand is
relatively price inelastic, revenues will benefit from inflation. If demand is
relatively price elastic (i.e., elasticity is greater than unit price elasticity),
revenue can decline even if unit prices are raised.
ª High inflation in a company's export market relative to a company's domestic

inflation rate generally implies that the export country's currency will come
under pressure and any pricing gain could be wiped out by the currency losses.
17
Intercorporate Investments
LOS a & b
Investments
Passive Active
Investments in Investments in Business

financial assets associates combinations
(Less than 20%) (20% − 50%) (More than 50%)
Fair value
Amortized FV through Equity
through profit Consolidation
cost OCI method
or loss
BS: Fair value

BS: Amortized cost BS: Fair value
IS: Realized and
IS: Realized gains IS: Realized gains
unrealized gains
OCI: − OCI: Unrealized gains
OCI: −
ª Influence:
Investments in financial assets - Not significant
Investments in associates - Significant
Business combinations - Controlling
ª Joint ventures: Both IFRS and US GAAP require equity method. However
proportionate consolidation is allowed under rare circumstances
Significant influence can be evidenced by the following
ª Board of directors representation
ª Involvement in policy making
ª Material inter-company transactions
ª Interchange of managerial personnel.
ª Dependence on technology.
Investments in financial assets

1 Amortized Cost (for debt securities only)
Eg. N = 12 YTM t0 = 18% YTM t3 = 12% Coupon = 12% FV = 1000
t0 t2 t3 Mar. 31
BS: 712 BS: 730 BS: 741
IS: (730 × 18%) = 131
or [120 + (741 − 730)] = 131
18
Debt Securities should meet following 2 Criteria
Cash Flow
Business Model Test
Characteristic Test
Debt securities are being held The contractual cash flows are
to collect contractual cash either principal, or interest on
flows principal, only
Eg. Equity = 20,000 No of shares= 1000 Price t0 = 20
Price t1 = 27 Dividend received = 3 per share
2 Available for sale 3 Fair Value Through Profit or Loss

(for Debt and Equity Securitietis)
Liabilities Assets Liabilities Assets
ESC: 20,000 AFS: 20,000 ESC: 20,000 Trading: 20,000

+ 7,000 + 7,000
Reserves: 3,000 Reserves: 10,000
OCI: 7,000 Cash: 3,000 Cash: 3,000
Total: 30,000 Total: 30,000 Total: 30,000 Total: 30,000
Expenses Income Expenses Income
Div: 3,000 Div: 3,000

URG: 7,000
NI: 3,000 NI: 10,000
Derivatives that are not used for hedging are always carried at FVPL.
If an asset has an embedded derivative (e.g., convertible bonds), the asset as a whole is
valued at FVPL
Equity securities that are held for trading must be classified as FVPL. Other equity securities
may be classified as either fair value through profit or loss, or fair value through OCI, Once
classified, the choice is irrevocable
Reclassification of investments (IFRS)

Reclassification of equity securities under the new standards is not permitted as the initial
designation (FVPL or FVOCI) is irrevocable.
Reclassification of debt securities is permitted only if the business model has changed.
For example, unrecognized gains/losses on debt securities carried at amortized cost and
reclassified as FVPL are recognized in the income statement.
Debt securities that are reclassified out of FVPL as measured at amortized cost are transferred
at fair value on the transfer date, and that fair value will become the carrying amount.
19
Reclassification Reclassification
of debt of equity
Reclassify if objective for

holding the financial assets
has changed which
significantly affects Reclassification is not
operation permitted
No restatement of prior
period is required
IFRS 9
To be measured at amortized cost, financial assets must meet two criteria:
Ÿ Business Model test: The financial assets are being held to collect contractual cash flows
Ÿ Cash flows characteristic test : The contractual cash flows are solely payments of principal and interest on
principal
Classification of financial assets as per IFRS 9
Measured at amortized Measured at fair

cost value
Meets business model test & Multi business model test &
cash flow characteristic test cash flow characteristic test
but are intended to be held but are intended to be sold
at till maturity
Measured at FVOCI or FVPL
Debt Equity
Debt instruments are

measured at amortized cost, Held for trading Other equity
fair value through other instruments
comprehensive income
(FVOCI), or fair value
through profit or loss (FVPL)
dependig upon the business Measured at Measured at
model FVPL FVPL or FVOCI
Choice is
irrevocable
If measured at FVOCI
only divident income is
recorded in P & L
20
Impairment of financial assets
Ÿ Key features of IFRS 9 was that the incurred loss model for loan impairment was replaced by the
expected credit loss model.
Ÿ This requires companies to not only evaluate current and historical information about loan (including
loan commitments and lease receivables) performance, but to also use forward-looking information
Ÿ The new criteria results in an earlier recognition of impairment (12-month expected losses for
performing loans and lifetime expected losses for nonperforming loans)
Investments in associates
Basic principles
è Ownership: 20% − 50% Single line item Dividends received from investee
è Method: Equity Proportionate share of investee’s are not recognized in the investor’s
è Reporting: At cost profit is recorded on investor’s IS IS. They are reduced from
è BS: Non current asset and BS investment A/c and trfd. to cash
ª MV of shares is irrelevant
ª If investment A/c falls to zero because of continuous losses, equity method is

discontinued. It is resumed after all previous losses are absorbed
Investment cost above net book value of investee

ª Excess of investment cost over book value is allocated to investee’s identifiable assets
and liabilities based on their Fvs. Remainder is treated as goodwill
ª Investment A/c is still a single line item
ª Investor adjusts its IS and BS for additional expense (eg. depreciation)
Fair value option

ª Both IFRS and US GAAP allow to report investments at FV
ª US GAAP: Option is available to all entities

ª IFRS: Option is only available to VCs, MFs, Unit trusts and similar entities
ª The option is available at the time of initial recognition and is irrevocable
ª Unrealized and realized gains are transferred to IS
Impairment
ª Both IFRS and US GAAP require testing for impairment at each reporting period
ª Impair if,
ª US GAAP: FV < CV and the decline is other than temporary
ª IFRS: Impair if at least one loss event occurs
ª Loss is recognized on income statement in both IFRS and US GAAP
ª Reversal of impairment is prohibited under both IFRS and US GAAP
21
Transactions with associates
ª Upstream: Investee to investor
ª Downstream: Investor to investee
ª Profit is eliminated to the extent of investor’s share in investee
ª Profit to be eliminated: Total unrealized profit × % of shareholding
ª Total unrealized profit = Profit margin × unsold inventory
Business combinations (US GAAP)
Merger Acquisition Consolidation
Acquirer + Target Acquirer + Target Acquirer + Target
Acquirer Acquirer + Target New company
Under IFRS business combinations are not differentiated based on

resulting structure of larger entity
Accounting for business combination
Pooling of interests
Acquisition method
method
Aka uniting of interests method
Consolidation was done as if the

Viewed as a transaction of net companies were a single
asset purchased at FV economic entity
Cost such as legal fees are Assets and liabilities were
expensed as incurred reported at BV. Because of this
depreciation was lower and
Required by both IFRS and US profits were higher
GAAP
Neither IFRS nor US GAAP allow
this method
22
Eg. (US GAAP)

80% stake for 50,000
Acquirer’s BS Target’s BS
ESC: 20,000 Building: 50,000 ESC: 20,000 Building: 20,000

Reserves: 70,000 Furniture: 50,000 Reserves: 20,000 Furniture: 20,000
Inventory: 20,000 AP: 40,000 AR: 10,000
Loan: 110,000 Cash: 80,000 Loan: 20,000 Cash: 50,000
FVs of target’s assets: Building: 30,000 Furniture: 10,000 AR: 0
Full Goodwill Partial Goodwill
US GAAP IFRS
70% à 500 FV identifiable asset à 200

100% à 714 for 70% we should pay 140
Amount Paid 500
GW = 714-200=514
GW 360
Acquiree BS FV
Equity 100 GW 100 200 FV of net identifiable assets:
Debt 500 PPE 200 500 = 500 + 100 + 100 - 500
Inventory 200 100
Cash 100 PPE Inventory Cash Debt
= 200
600 600
Acquirer acqured 70% ownership @ 500
23
Consolidated BS (full goodwill)
Liabilities Assets
ESC: 20,000 Goodwill: 32,500

Reserves: 70,000 Building: 80,000
MI: 12,500 Furniture: 60,000
Inventory: 20,000
AP: 20,000 AR: −
Loan: 150,000 Op. cash: 80,000
Cash paid: (50,000)
T’s cash: 50,000
Total: 272,500 Total: 272,500
Total value of target Net BV of target Goodwill
Building: 30,000 Total value of target

−
Furniture: 10,000 Net BV of target
80% 50,000
Cash: 50,000
100% 62,500
Loan: (40,000)
AP: (20,000) 62,500 − 30,000 = 32,500
30,000
Minority interest (MI): That Portion of subsidiary which is not owned by the parent
MI = 62,500 × 20% = 12,500
Eg. (IFRS)
60% stake for 25,000
ESC: 10,000 Building: 40,000 ESC: 5,000 Goodwill: 10,000

Building: 10,000
AP: 40,000
FV of target’s asset: Building: 20,000
24
Consolidated BS (partial goodwill)
Liabilities Assets
ESC: 10,000 Goodwill: 22,000

MI: 2,000 Building: 60,000
Op. cash: 60,000
AP: 40,000 Cash paid: (25,000)
Loan: 70,000 T’s cash: 5,000
Total: 122,000 Total: 122,000
Total value of target Proportionate valuation Goodwill
Cash paid
Building: 20,000 −
100% 5,000 Proportionate valuation
Cash: 5,000
Loan: (20,000) 60% 3,000
5,000 25,000 − 3,000 = 22,000
MI = 5,000 × 40% = 2,000
ª While calculating net BV, recognize identifiable assets at FV. Also recognize assets
and liabilities previously not recognized by the investee
ª Bargain purchase: Acquisition price < FV of net assets acquired
ª Difference is recognized in IS (both IFRS and US GAAP)
ª Minority interest is to be treated as a part of equity (both IFRS and US GAAP)
ª Contingent liabilities : IFRS - Include if the FV can he reliably measured
ª US GAAP divides contingent assets and liabilities into contractual and non
contractual.
ª Contractual contingent assets and liabilities are recorded at their fair values on the
acquisition date.
ª Non contractual contingent assets are also recorded if, “more likely than not” they
meet the definition of an asset or liability.
ª Restructuring cost are expensed when incurred and not capitalized as part of the
acquisition cost under both IFRS and US GAAP
25
Goodwill impairment
IFRS US GAAP
Goodwill is allocated to each

Goodwill is allocated to each cash reporting unit (RU)
generating unit (CGU) that will
benefit from the synergies Two-step approach
One-step approach First, compare the carrying value

of RU to its FV
Impairment loss: Difference b/w
recoverable amount of CGU and Then calculate impairment loss:
its carrying value Difference b/w implied FV of
goodwill and its carrying value
Goodwill impairment is a separate line item in both IFRS and US GAAP & reversal is not allowed in both
Eg. Carrying value of CGU/RU (including GW) = 1,400 Goodwill = 300 FV of identifiable assets = 1,200
Recoverable amount of CGU/RU = 1,300
IFRS US GAAP
Impairment loss = 1,400 − 1,300 = 100 FV of RU (1,300) < Carrying value of RU (1,400)
(Impairment required)
New goodwill = 300 − 100 = 200 Implied goodwill = 1,300 − 1,200 = 100
Impairment loss = 300 − 100 = 200
Proportionate consolidation
Eg. 50% stake for 50,000

ESC: 100,000 ESC: 60,000 Building: 50,000
FV of target’s asset: Building: 60,000
Consolidated BS (proportionate consolidation) Loan: 100,000 + (50% × 40,000) = 120,000
Liabilities Assets Building: 50% × 60,000 = 30,000
ESC: 100,000 Goodwill: 15,000 Cash: 200,000 − 50,000 + = 175,000

(50% × 50,000)
Building: 30,000
Goodwill: Net BV = 70,000
Proportionate valuation = 35,000
Loan: 120,000 Cash: 175,000 (50%)
Total: 220,000 Total: 220,000 Cash paid = 50,000

Goodwill (cash paid − = 15,000
proportionate valuation)
26
Contingent Assets
& Liability
Contractual Non Contractual
Otherwise
Contingent Asset
More likely than Not incorporated into
Contingent Liabilities
not balance sheet
Record @ immediately
FV
Special purpose entities (SPEs) and variable interest entities (VIEs)
SPEs are created to accommodate specific needs of sponsoring entity
Under US GAAP, VIEs are SPEs that meets certain conditions viz:
Total equity at risk is insufficient to finance activities without additional financial support or,
Equity investors lack any one of the following:
Ÿ Ability to make decisions
Ÿ Obligation to absorb losses
Ÿ Right to receive returns
If an SPE is a VIE, it must be consolidated
Under IFRS, SPE is consolidated if sponsor controls the SPE
LOS c Effects of using different methods on financial statements

Proportionate Acquisition
Impact on: Equity method
consolidation method
Net income Same Same Same
Equity Same Same Higher
Assets and liabilities Lowest In between Highest
Revenues and expenses Lowest In between Highest
27
ª In particular, companies are required to migrate from an incurred loss model to an expected credit loss
model.
ª This results in companies evaluating not only historical and current information about loan performance,
but also forward-looking information
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28
Employee Compensation: Post-employment

and share based compensation
LOS a Types of post-employment benefit plans
Defined contribution Other post

Defined benefit plan
plan employment benefits
Agreed upon contributions Promise by the employer to

Promises by the employer to
are made to employee's pay a defined amount of
pay benefits in the future
pension plan pension after retirement
such as life insurance
premiums, healthcare plans
Employer and employee both Only employer contributes to
contribute to the plan the fund
Accounting treatment is
similar to defined benefit
Investment decisions are left Since employee’s future
pension plan
to the employee who assumes benefit is defined, employer
all investment risk assumes the investment risk
Regulations do not require
such plans to be funded in
Firm makes no promise to Employer must estimate the
advance
employee regarding the future value of liability
future value of plan assets
Benefit depends on plan
Asset: Plan assets
specification
Contributions are expensed Liability: PBO
LOS b Calculation of PBO (Projected unit credit method)
Eg. Starting salary = 70,000 No of years of service = 30 years Promised annual payment = 3%
Discount rate = 12% Compensation growth rate = 5% Pension annuity payments = 20
Step 1: Calculate last salary N = 29 I/Y = 5 PV = 70,000 FV = 288,129
Step 2: Calculate annual payment 288,129 × 3% = 8,644
Step 3: Multiply with completed

8,664 × 1 = 8,644 8,664 × 2 = 17,288 8,664 × 3 = 25,932
years of service
Step 4: Calculate the PV on the

PV1 = 64,566 PV2 = 64,566 × 2 = 129,132
day of retirement
N = 20 I/Y = 12 PMT = 8,644
PV3 = 64,566 × 3 = 193,698
Step 5: Calculate PV for today N = 29 I/Y = 12 FV = 64,566 PV = 2,413

N = 28 I/Y = 12 FV = 129,132 PV = 5,406
N = 27 I/Y = 12 FV = 193,698 PV = 9,083
29
Year 1 Year 2 Year 3
PBO 2,413 5,406 9,083
Interest Service Interest Service

cost cost cost cost
2,413 N = 28 I/Y = 12 5,406 N = 27 I/Y = 12

× 12% FV = 64,565 CPT PV × 12% FV = 64,565 CPT PV
290 2703 648 3027
LOS c Components of a company’s defined benefit pension costs

èCurrent service cost
èInterest cost
èPast service cost (Plan amendments)
èChanges in actuarial assumptions
èBenefits paid
Presentation:
Income statement:
Ÿ IFRS: Components may be presented separately
Ÿ US GAAP: Components are aggregated and presented as a single line item
Balance sheet (both IFRS and US GAAP):

Ÿ Net amount is reported
Ÿ Overfunded plan - Asset, Underfunded plan - Liability
Ÿ Maximum amount of asset that can be shown is restricted to the PV of future
reduced contributions or PV of future refunds
Treatment of components of pension costs (IFRS)
Interest
Service cost Remeasurement
income/expense
Difference b/w
Current service Past service Actuarial
exp. and act.
cost cost gains/losses
return
Overfunded plan = Net interest income

Underfunded plan = Net interest expense
Recognized in IS Recognized in IS Recognized in OCI
Not amortized in IS
Discount rate = Expected return
30
Treatment of components of pension costs (US GAAP)
Interest
Service cost Remeasurement
income/expense
Current service Past service Actuarial Difference b/w

cost cost gains/losses exp. and act.
return
Expected income is reported separately

Interest expense is reported separately
Recognized in
Recognized in IS Recognized in OCI Recognized in IS
OCI/IS
Amortized over Amortized in IS using

remaining service life corridor method
Discount rate and expected return may be different
Eg. Beginning PBO = 10 mln Beginning plan asset = 15 mln Service cost = 2 mln
Plan amendments = 1.5 mln Actuarial losses = 4 mln Benefits paid = 1 mln Actual returns = 2 mln
Discount rate = 6% Expected return (US GAAP) = 10% Contribution to plan asset = 1 mln
PBO (both IFRS and US GAAP) Plan asset (both IFRS and US GAAP)
Beginning PBO 10 Beginning plan asset 15

Int. cost (10 × 6%) 0.6 Actual return 2
Service cost 2 Contribution 1
Past service cost 1.5 Benefits paid (1)
Actuarial losses 4 17
Benefits paid (1)
17.1
IS (IFRS) IS (US GAAP)

Service cost 2 Service cost 2
Past service cost 1.5 Interest cost 0.6
Net interest income (0.3) Expected income (1.5)
3.2 1.1
OCI (IFRS) OCI (US GAAP)

Actuarial losses (4) Actuarial losses (4)
Difference b/w
exp. and act. return 0.5
Difference b/w
exp. and act. return 1.1 Past service cost (1.5)
(2.9) (5)
31
Corridor method (US GAAP)
Amortize accumulated actuarial gains/losses over the remaining service life if,
Amount in OCI > 10% of higher of PBO or plan asset
Only the excess amount over 10% (corridor) is amortized
Periodic pension cost (economic pension expense)

Recognized in P&L (accounting expense): Reported periodic pension cost/Periodic pension
cost in P&L
Recognized in OCI: Periodic pension cost in OCI
Total periodic pension cost (TPPC) = Reported PPC + PPC in OCI

TPPC = Ending PBO − Opening PBO − Actual return + Benefits paid
TPPC = Service cost + Interest cost + Plan amendments + Actuarial losses − Actual return
TPPC = Ending fund status − Beginning fund status − Contributions
LOS d Impact of assumptions on expense and liability
Discount rate Compensation growth rate Expected return on plan assets

(if increases) (if increases) (if increases)
Liability: Decreases
Liability: Increases Liability: No impact
Expense:
New plan: Decreases Expense: Increases Expense: Decreases
Mature plan: Increases
Assumption are similar for other post employment benefit except the compensation growth rate is
replaced by a healthcare inflation rate
Inflation will become constant. This constant rate is known as the ultimate healthcare trend rate
LOS e Differences in accounting treatment for pensions

èNetting of pension asset/liability (leverage ratios will be lower)
èDifferences in assumptions (eg. discount rate)
èDifferences between IFRS and US GAAP
èDifferences due to classification in IS (operating/non-operating)
LOS f Pension plan note disclosures and cash flow related information
Item IFRS US GAAP
Amount on BS Net amount Net amount
Pension Dividend in various Operating expense

expense line items (including interest)
Cash flow Divided in CFO/CFF CFO
32
CF related disclosures:
Ideally, economic pension expense must equal contribution made to the

pension fund
If economic pension expense < Contribution, then difference net of tax

should be treated as CFF outflow (viewed as prepaying a loan)
If economic pension expense > Contribution, then difference net of tax

should be treated as CFF inflow (viewed as taking a loan)
LOS g Share-based compensation

Share based compensation can be in the form of stock options, share warrants etc.
Way to reward employees with no additional outlay of cash
Value of stock option must be estimated using options valuation model
Compensation expense should be spread over the service period
LOS h Effect of stock grants and stock options on financial statements
Compensation expense is based on the fair value (not intrinsic value) of option
Net income and reserves decrease
Share capital is increased by an identical amount
There is no change in total equity
Restricted stock: Ownership of the shares is returned to the company if certain

conditions are not met
Performance stock: Stock granted contingent on meeting performance goals such
as accounting earnings or ROA/ROE
SARs: Stock appreciation rights (SARs) compensate an employee on

the basis of changes in the value of shares without requiring
the employee to hold the shares
Phantom stock: Similar to SARs except the compensation is based on the

performance of hypothetical stock rather than the company’s
actual stock
33
Multinational Operations
LOS a
Presentation Functional Local
currency currency currency
Currency of the primary

economic environment in
Currency in which financial which the company operates Currency of the country in
statements are prepared which the company operates
Can be local or some other
currency
LOS b Foreign currency transaction exposure

All foreign currency transactions are recorded at the spot rate on the transaction date
If exchange rate changes, gains/losses are recognized on settlement date
If the balance sheet date occurs before the transaction is settled, gains/losses are
recognized based on exchange rate on the balance sheet date
Subsequent gains/losses are recognized when the transaction is settled
Gains/losses are reported on IS (not OCI)
Neither standard provides guidance on where to include these gains/losses (i.e.

operating/non-operating)
LOS c & d Foreign currency transaction exposure
Local currency Functional currency Presentation currency
Temporal Current rate

method method
Remeasurement Translation
Current rate method

Used when functional currency and parent’s presentation currency differ
Usually occurs when subsidiary is relatively independent of the parent
Current rate: Exchange rate on the balance sheet date
Average rate: Average exchange rate over the reporting period
Historical rate: Actual rate on the date of transaction
34
Liabilities Assets Expenses Income
Common
stock: Historical rate
Dividend
paid: Historical rate
All assets: Current rate
Reserves: Given All
Income: Current rate
expenses: Current rate
CTA: Plug figure
Liabilities: Current rate
Total: Current rate Total: Current rate
CTA: Cumulative translation adjustment is a component of equity and is used to keep

the translated BS in balance
Equity as a whole must be at current rate
Temporal method
Used when functional currency and parent’s presentation currency are same
Usually occurs when subsidiary is well integrated with the parent
Remeasurement gains/losses are reported on IS
Liabilities Assets Expenses Income
Common Non COGS: Historical rate

stock: Historical rate monetary Deprc: Historical rate
assets: Historical rate
Dividend Amort: Historical rate
paid: Historical rate Monetary
Reserves: Given assets: Current rate
Non Income: Average rate

monetary All other
liabilities: Historical rate expenses: Average rate
Monetary
liabilities: Current rate
Total: Current rate Total: Current rate
Non monetary assets: Inventory, prepaid expenses, fixed assets and intangible assets
Monetary assets: Cash and receivables
Non monetary liabilities: Unearned revenue

Monetary liabilities: Payables, short-term debt and long-term debt
35
Temporal method
Liabilities Assets Item Amount
ESC: 1,000 Building: 2,727 Sales: 3,333

Reserves: 900 Furniture: 2,727 COGS: 833
Net income: 632 SGA: 333
Div paid: (154)
Depreciation: 600
Remeasurement
Loan: 3,076
loss: 934
AP: 1,539 AR: 1,539
Net income: 632
Total: 6,993 Total: 6,993
Dividend paid: 154
LOS f Effect of current rate method and temporal

method on financial statements and ratios
Ratios (current rate method)
Pure BS/pure IS ratios Mixed BS/IS ratios
Ratios will change. The change

Unaffected because both will depend on relationship
numerator and denominator between the exchange rate of
are translated at current rate numerator and exchange rate
of denominator
Comparing results between current rate

method and temporal method
èDetermine whether the foreign currency is appreciating or depreciating
èDetermine which rate to use to convert the numerator under both methods. Also
determine whether the numerator will increase, decrease or stay the same
èDetermine which rate to use to convert the denominator under both methods. Also
determine whether the denominator will increase, decrease or stay the same
èDetermine whether the ratio will increase, decrease or stay the same based on
change in numerator and denominator
LOS g Alternative translation methods for subsidiaries

operating in hyperinflationary economies
IFRS US GAAP
Restate nonmonetary assets, nonmonetary

liabilities and IS items for inflation
Use current rate method for translation Use temporal method
Recognize net purchasing power gain/loss

on IS
36
Exposure to changing exchange rates
Current rate Temporal

method method
Exposure: Net monetary

Exposure: Net asset position
liability position (mostly)
Gain: If local currency is Gain: If local currency is

appreciating depreciating
Loss: If local currency is Loss: If local currency is

depreciating appreciating
LOS e Translation of a subsidiary’s BS and IS into

parent company’s presentation currency
Eg. Liabilities Assets Item Amount
ESC: 50,000 Building: 150,000 Sales: 200,000

Reserves: 50,000 Furniture: 150,000 COGS: 50,000
SGA: 20,000
Loan: 50,000
Depreciation: 30,000
AP: 100,000 AR: 100,000
Net income: 100,000
Total: 400,000 Total: 400,000
Dividend paid: 10,000
Historical rates: ESC: Building and furniture: COGS: Dividend:

Current rate: Average rate:
Opening reserves: Current rate method: $650 Temporal method: $900
Current rate method
Liabilities Assets Item Amount
ESC: 1,000 Building: 2,307 Net income: 1,667

Reserves: 650 Furniture: 2,307 Dividend paid: 154
Net income: 1,667
Div paid: (154)
CTA: (1,624)
Loan: 3,076
AP: 1539 AR: 1,539
Total: 6,153 Total: 6,153
37
LOS h Effect on company’s effective tax rate
ª Effective tax rate: Tax expense/PBT
ª Statutory tax rate: Tax rate of the country
ª Accounting standards require companies to provide a reconciliation

between effective tax rate and statutory tax rate
ª Changes in effective tax rate can be due to:

Ÿ Changes in the applicable tax rates and/or
Ÿ Changes in the mix of profits earned in different countries
LOS i Sustainability of sales growth

ª Sales growth that comes from changes in volume or price is more sustainable
than sales growth that comes from changes in exchange rates
ª Companies often include disclosures about the effect of exchange rates on

sales growth in the MD&A
ª Analyst should consider the effect of exchange rates on sales growth both for
forecasting future performance and evaluating historical performance
LOS j Effect of currency fluctuations on financial results

ª Disclosures about the effects of currency fluctuations often include
sensitivity analyses
ª If detailed disclosures are provided, the analysts can explicitly

incorporate foreign exchange impact
ª In the absence of detailed disclosures, analysts can conduct their

own sensitivity analysis
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38
Analysis of Financial Institutions

LOS a Difference between financial institutions and other companies
2.1 The Creation/Redemption Process
Financial institutions : It serves as intermediaries between providers and recipients of capital, facilitate
assets and risk management transactions involving cash, securities, and other
financial assets
Financial institutions differ from other companies in following ways,
Systemic
Regulations Assets
importance
Ÿ It includes linkages between Ÿ It include minimum capital Ÿ Financial institutions tend to

financial institutions introduce requirements, minimum have financial assets where as
a system wide risk of failure liquidity requirements and other companies primarily have
limits on risk taking own assets
Ÿ When one of the members of
institution fails results in
contagion effect
LOS b Key aspects of financial regulations of financial institutions
Ÿ Minimum required capital for a bank is based on the risk of the bank’s assets
Ÿ Bank should hold enough liquid assets to meet demands under a 30 day liquidity stress
scenario
Ÿ Stable funding relative to a bank’s liquidity needs over a one year time horizon
LOS c CAMELS approach to analyze a bank

1 Capital adequacy: It is based on risk weighted assets
Bases defines a bank’s capital in a tiered hierarchical approach,
Tier 1 capital (6%) + Tier 2 capital = Total capital of bank
Common equity Other tier 1

tier 1 capital capital Subordinated Must be at least 8%
instruments with of risk weighted
Common stock + assets
Subordinated original maturity of
additional paid in
instruments with no more than 5 years
capital + retained
earnings + DCI (-) specified maturity
intangibles (-) and no contractual
deferred tax assets dividend
Must be at least
4.5% of risk
weighted assets
39
2 Asset quality: Evaluation of asset quality includes analysis of current and potential
credit risk associated with banks asset which generally include
Loans Investment in securities
Debt Equity
Under both US GAPP and

US GAPP and IFRS 9 Carried at fair Carried at fair
IFRS 9 debt securities
loans are carried at value value
may be carried either at
amortized cost on the either through OCI through P&L
amortized cost (HTM) or
balance sheet or through P&L
fair value through OCI
(AFS) or fair value
through P & L (trading
securities)
Ÿ Allowance for loan losses is a contra asset account to loans

Ÿ Provision for loan losses is an expense
3 Management Capabilities: Management capability is the ability to identify and control risk and
develop and implement effective procedures for measuring and
monitoring risks along with identifying profitable opportunities
4 Earnings: Ÿ Earning are considered high quality if they are adequate and sustainable
Ÿ Major sources of bank’s earnings include,
1.Net interest income 2.Service income 3.Trading income
5 Liquidity: position: Having adequate liquidity is critical for a bank
Minimum liquidity standards
Liquidity coverage ratio

Net stable funding ratio
LCR= High liquid asset

NSFR= Available stable funding
Expected cash outflow
Required stable funding
Minimum LCR of 100% is Minimum NSFR of 100% is

recommended recommended
40
“Fair Value Hierarchy”
Level 1 Quoted Price Identical Active
Level 2 Observable Price Identical Active
Quoted Price Similar Active
Quoted Price Identical Inactive
Level 3 Unobservable & Subjective
Ratios helpful in assessing the quality of the allowance for loan losses
Ÿ The ratio of the allowance for loan losses to non-performing loans
Ÿ The ratio of the allowance for loan losses to net loan charge-offs
Ÿ The ratio of the provision for loan losses to net loan charge-offs
Liquidity monitoring metrics
Concentrated funding : Bank’s Maturity mismatch : Asset maturities

reliance only on few funding sources differ from maturity of liabilities
Increases Liquidity Risk
6 Sensitivity to market risk: Banks are sensitive to interest rate risk & changes in the shape of
yield curve which can be captured by Value at risk
LOS d Other factors to consider in analyzing banks
Government support Government ownership
Ÿ Larger banks enjoy the implicit Ÿ Depositors may not have

government support because faith in the banking sector in
it’s failure will have a the absence of government
contagion effect ownership
Implicit support level is inversely

related to the overall health of the
banking sector
41
Culture
Bank Mission
Ÿ Global banks have well

Ÿ Conservative culture leads to
diversified asset basis
calculated risk taking
reducing their overall risk, as
Ÿ Risk seeking culture leads to
against concentration of risk
overall risk stancev
increases in a community
bank’s asset portfolio
Culture evaluation can be done by review of :

Ÿ Diversity of bank’s assets
Ÿ Management compensation
Ÿ Speed with which loan loss provisions are adjusted relative to actual loss behaviour
Ÿ Accounting restatement indicates unethical culture
Insurance
Property and casualty insurance

Life and Health insurance
Ÿ Property insurance covers specific Ÿ Life insurance covers against loss

assets against loss of life
Ÿ Casualty insurance protects Ÿ Policy period is basic term life.

against legal liability Insurer makes payment if death
occurs during policy period
Ÿ Multiple peril policy covers both
property and casualty losses Ÿ Health insurance policies vary
globally by the type of coverage
Ÿ Policy period for property and provided
casualty insurance is very short
Ratios and other factors to consider in analyzing a property and

casualty insurance companies
1 Profitability : Profits depend on pricing of premiums, prudence in underwriting and

diversification of risk.
Combined Ratio = Total insurance expense >100

Premiums earned
Low - Hard pricing model Underwriting loss

High - Soft pricing model
42
Combined Ratio
Underwriting loss ratio

(loss & loss adjustment expense) Underwriting expense ratio
Measures efficiency of company’s

Measures efficiency of company’s operations
underwriting standards
Underwriting expense including commissions

Claims paid + loss reserves Net premiums written
Net premiums earned
Or
Loss expense + loss adjusted expense
Net premiums earned
Loss reserve: Estimated value of unpaid claims
Downward revision indicates company was conservative in the past
Upward revision indicates company is aggressive in booking profits in the past
Dividend to policy holders

Dividend to policy holders ratio =
Dividend to policy holders
CARD = Combined ratio + Dividends to policy holders ratio Measures total efficiency
Lower the better
2 Investment P & C insurers should be diversified by asset class and concentrated by

Return : type, maturity, industry classification and geographic location
Total insurance income

Total investment return ratio =
Invested assets
Higher the better
3 Liquidity : Liquidity of investment portfolio depends on fair value hierarchy reporting

i.e. level 1 asset - Trading securities, level 2 asset - lower liquid assets,
level 3 assets - least liquid assets
4 Capitalization : There are no global risk based capital requirements standards
43
Factors to analyze life and health insurers
Ÿ Revenue includes income from premiums (more stable), investment returns
Revenue
and fees.
diversification :
Ÿ Diversification of assets reduces risk
Earning Ÿ Profitability depends on acturial assumptions, current period claim expense

Characteristics: and amortization of cost of acquiring new and renewal policies
Ÿ Different valuation approaches for assets and liabilities can distort values if
interest rate changes
Ÿ Industry specific cost ratios: lower the better
Ÿ Total benefits paid / net premium written and deposits
Ÿ Comission and expense / net premium written and deposits
Ÿ It is a key component because of longer float period

Investment
returns: Ÿ Long term debt is major portion of investment portfolio
Total invested income

Invested assets
Liquidity : Ÿ It depends on insurer’s investment portfolio

Ÿ Liquidity risk is measured by,
Adjusted investment assets è Based on convertibility to cash

Adjusted obligations withdrawls è Based on assumptions about
44
Evaluating Quality of Financial Reports

LOS a Use of a conceptual framework for assessing the quality of financial reports
Financial report quality
Earnings quality Reporting quality
Pertains to the earnings and

cash generated by the
Pertains to the information
company
disclosed in financial reports
High-quality earnings: High
High-quality reporting:
level of earnings and
Decision useful information
sustainability of earnings
Low-quality reporting: No
Low-quality earnings:
relevance and faithful
Genuinely bad performance
representation
or misrepresentation of
economic reality
Earnings quality is also known as results quality
High-quality earnings assume high-quality reporting
Company could simultaneously have low-quality earnings and high-quality reporting

but can not have high-quality earnings and low-quality reporting
Quality spectrum of financial reports (high to low)

Œ GAAP compliant, decision-useful, high-quality earnings
GAAP compliant, decision-useful, low-quality earnings
Ž GAAP compliant but biased choices (aggressive/conservative)
Non-compliant accounting
Fictitious transactions
LOS b Potential problems that affect the quality of financial reports

Reported amounts (measurement) and timing of recognition: These choices
may focus on single financial element but affect more than one financial
statement because they are interrelated (aggressive/conservative)
Classification issues: These choices typically affect only one financial

statement (eg. reclassifying AR as long-term receivables)
45
Biased accounting choices
Misstatement of
profitability Warning signs
Revenue growth higher

than peers’
Contingent sales with right
of return Increases in discounts to
and returns from customers
Channel stuffing
Higher growth rate in
Bill and hold sales receivables than revenue
Fictitious sales Large proportion of revenue

in final quarter
Lessor use of finance lease
CFO is much lower than
Classifying non-operating operating income
income as operating
Increasing operating margin
Classifying operating
expenses as nonoperating Inconsistency in
operating/non-operating
Reporting gains in IS and classification over time
losses in OCI
Compensation largely tied
to financial results
Misstatement of
balance sheet items Warning signs
Inconsistency in model
inputs for valuation of
assets with that of liabilities
Typical current assets such

Choice of models and model as AR and inventory being
inputs to measure FV classified as non-current
Reclassification from Allowances and reserves

current to non-current that are not comparable
with peers and fluctuate
Over- or understating over time
reserves and allowances
High goodwill relative to
Understating identifiable total assets
assets and overstating
goodwill Use of SPEs
Large changes in DTAs/DTLs
Large off-balance-sheet
liabilities
46
Quantitative tools to assess the likelihood of misreporting
Beneish model variables
M score: Indicates probability of earnings manipulation
DSRI: Days sales receivable index

Receivablest/Salest
Receivablest−1/Salest−1
Change in relationship could indicate inappropriate revenue recognition
GMI: Gross margin index

Gross margint−1
Gross margint
Ratio > 1: Gross margin has deteriorated, Companies could manipulate
earnings
AQI: Asset quality index

Total assetst − PPEt − Current assetst/Total assetst
Total assetst−1 − PPEt−1− Current assetst−1/Total assetst−1
Increase in AQI could indicate excessive capitalization of expenses
SGI: Sales growth index

Salest
Salest−1
Growth companies could manipulate sales and earnings to maintain the
perception of continuing growth
DEPI: Depreciation index

Depreciationt−1/(Depreciation + PPE)t−1
Depreciationt/(Depreciation + PPE)t
Depreciation/(Depreciation + PPE) = Depreciation rate. Declining
depreciation rates could indicate understated depreciation (means of
manipulating earnings)
SGAI : Sales, general and administrative expenses index

SGAt/Salest
SGAt−1/Salest−1
Increase in SGA expenses suggests decreasing administrative and
marketing efficiency (means of manipulating earnings)
Depreciationt−1/(Depreciation + PPE)t−1
Accruals:
Depreciationt/(Depreciation + PPE)t
Higher accruals can indicate earnings manipulation
LEVI: Leverage index

Leveraget
Leveraget−1
Leverage: Total debt/Total assets. Increasing leverage can indicate
earnings manipulation
47
Overstatement
of CFO Warning signs
Increase in APs and

decrease in ARs and
inventory
Managing activities to affect
cash flow from operations
Capitalizing expenditures in
CFI
Misclassifying cash flows to
positively affect CFO
Sales and leaseback
Increases in bank overdrafts
Quality issues and M&As

ª M&As provide opportunities and motivations to manage financial results
ª Companies may be motivated to acquire other companies to increase CFOs
ª Acquisitions can conceal previous accounting misstatements
ª Companies could understate FV of assets, this will result in a higher amount of goodwill
ª Since goodwill is not amortized, the effect of understating FV of assets (and overstating
goodwill) is to increase future profits
GAAP compliance but no economic reality
An analyst may sometimes find financial reporting less useful

because he does not think it is economic reality
An analyst should adjust the reported information with his view of

economic reality
Earnings management results in overstatement/understatement of

income in prior periods
LOS c & d Evaluate the quality of financial reports
è Understand the company and its industry, understand why particular accounting principles used by
it are appropriate
è Learn about management. Review disclosures about compensation, insider trades and related-party
transactions
è Identify significant accounting areas
è Make cross-sectional and time series comparisons of financial statements. Also use ratio analysis
è Check for warnings signs (discussed previously)
è For firms operating in multiple segments, check whether inventory, sales and expenses are shifted
to show strong performance in a segment while consolidated results show negative or zero growth
è Use quantitative tools to assess the likelihood of misreporting

48
Altman model
ª A model to assess the probability of bankruptcy
ª This model overcomes the limitation of viewing ratios independently
ª Altman's z-score: Higher the better
ª Limitations: It uses only one set of financial measures, taken at a single point in time and
assumption that the company is a going concern
Other quantitative models

Variables that have been found useful for detecting misstatement:
Accruals quality
Deferred taxes
Market-to-book value
Whether the company is publicly listed and traded
Growth rate differences between financial and non-financial variables
Aspects of corporate governance and incentive compensation
Limitations of quantitative models

ª These models rely on accounting data, which may not reflect economic reality
ª Managers are just as aware as analysts of quantitative models to screen for possible
cases of earnings manipulation
ª A study found that the predictive power of the Beneish model is declining over time
LOS e & f Indicators of earnings quality

High-quality Low-quality
earnings earnings
Earnings that are sustainable

and represent returns equal to
or in excess of WACC Earnings that are insufficient
to cover WACC and/or
Increase the value of the earnings that are not
company more than low sustainable and/or
quality earnings misrepresentation of
economic reality
High-quality earnings assumes
high quality reporting
Sustainable (persistent) earnings

ª Sustainable (persistent) earnings are earnings that are expected to recur in the future
ª Persistence can be expressed as the coefficient on current earnings in a regression model
ª Earningst+1 = α + β1Earningst + ε
ª Higher coefficient represents (β1) more persistent earnings
49
Accruals
ª Earnings = CFs + accruals
ª Earnings are more sustainable when CFs dominate earnings
ª Discretionary accruals: Made with the intent to manipulate earnings

ª Non-discretionary accruals: Accruals that arise from normal transactions
ª Earningst+1 = α + β1CFt + β2 accrualst + ε
ª β1 > β2
Other indicators
ª Positive net income but negative CFO
ª Exactly meeting or only narrowly beating benchmarks
ª Enforcement actions by regulatory authorities and restatements of

previously issued financial statements
LOS g Mean reversion in earnings
Extreme levels of earnings (high/low) tend to revert to normal levels

over time. This phenomenon is known as mean reversion in earnings
Mean reversion will occur faster if earnings have a significant accruals

component and they are largely discretionary
LOS h Evaluation of earnings quality

Most common financial misreporting;
èImproper revenue recognition: Overstating revenues, revenues

generated through bill-and-hold sales, channel stuffing,
premature recording etc.
èImproper expense recognition: Understating expenses or

improper capitalization of operating expenses (line costs)
LOS i Indicators of cash flow quality
Similar to the ‘earnings quality’
High-quality CFs: Good economic performance and high-quality reporting

Low-quality CFs: Bad economic performance or misrepresentation of economic reality
Management may try to shift +ve CFs from CFI or CFF to CFO
For a start-up company it is okay to have − ve CFO, − ve CFI and +ve CFF, but if a
mature company has − ve CFO, it is a signal that these are Low-quality CFs
50
LOS j Evaluating CF quality
ª Check for unusual items or items that have not shown up in prior years
ª Check if there is steady growth in receivables
ª Check for reclassification of CF items
LOS k & l Evaluating balance sheet quality

ª High financial reporting quality is indicated by completeness, unbiased measurement and
clear presentation
ª High financial results quality is indicated by optimal leverage, adequate liquidity and
economically successful asset allocation
LOS m Sources of information about risk

èFinancial statements
èAuditor’s report
èNotes to financial statements
èMD&A
èInformation such as non-timely filing of financial
reports, change in management or M&A
èFinancial press
51
Integration of Financial
Statement Analysis Techniques
LOS a Financial statement analysis framework
Steps Sources of Information Output (examples)
Evaluating debt/equity Statement of purpose, list of

Define the purpose of investments, issuing a credit rating, specific question to be answered,
analysis communicating with client or nature and content of report,
supervisor, institutional guidelines Timetable and resource budget
Financial statements, communication

Organized financial statements,
Collect input data with management, suppliers,
financial data tables
customers and competitors, site visits
Adjusted financial statements,

Process data Data from previous step common-size statements, ratios
and graph, forecasts
Analyze data Data from step 2 & 3 Analytical results
Analytical results and previous Analytical report,

Develop and
reports, institutional guidelines for Recommendation (whether to
communicate conclusions
publishing a report invest or not)
Updated reports and

Follow up Periodically updated information
recommendation or
Focus of analysis
Sources of Capital structure Cash flow Off balance sheet

Capital allocation
earnings & ROE analysis analysis financing
Asset base
Segment analysis Earnings quality Decomposition
composition
52
LOS b, c, d & e
Reporting choices and biases that affect quality and
comparability of financial statements
DuPont analysis (ROE)
Net profit Asset Financial

margin turnover leverage ratio
Net profit Sales Avg. assets

Sales Avg. assets Equity
Tax burden Interest

EBIT margin
ratio burden ratio
Net profit EBT EBIT

EBT EBIT Sales
To examine the performance on standalone basis, subtract income from associates

from net income and amount of investment in associates from total assets
Analyst must also consider firm’s sources of earnings and whether the earnings are
generated internally or externally
Asset base
ª Examination of changes in the composition of assets over time
ª Examine the balance sheet by converting it to common-size format
Capital structure
ª Determine if the capital structure is able to support future
obligations and management’s strategic objectives
ª Some liabilities do not necessarily result in cash outflow

(eg. deferred tax, unearned revenue)
Segment analysis and capital allocation

ª Helps the analyst examine company’s different businesses based on the
products offered and the geographical areas the company operates in
ª More capital allocation toward low-margined businesses: −ve signal
ª More capital allocation toward high-margined businesses: +ve signal
53
Accruals and earnings quality
Measures of financial reporting quality
Balance sheet Cash flow

accruals ratio accruals ratio
NOAt − NOAt−1 NI − CFO − CFI

Average NOA Average NOA
Lower the ratio, higher the earnings quality
Operating assets = Total assets − Cash − Cash equivalents − Marketable securities
Operating liabilities = Total liabilities − Total debt
Cash flow analysis
Cash generated from operations CFO + Interest + Taxes

Operating income EBIT
CGO < Operating income, ratio will be less than 1 (−ve signal)
CGO > Operating income, ratio will be more than 1 (+ve signal)
Decomposition
Eg. Company A: Ownership in B = 30% Market cap. = $2,700 mln Earnings = $300 mln
Company B: Valuation = €1,000 mln Earnings in A = €75 mln
Exchange rate = $1.6/€
2,700
P/E: = 9
300
2,700 − (1,000 × 1.6 × 30%) 2,200

Adjusted P/E: = 12.2
300 − (75 × 1.6) 180
54
Off-balance-sheet financing
Balance sheet should be adjusted for off-balance-sheet financing activities
Capitalize operating lease for analytical purposes by increasing assets and

liabilities by the PV of remaining lease payments
Also, adjust IS for depreciation(subtract), lease payments(add) and

interest expense(subtract)
55
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Analysis of Dividends & Share Repurchases

LOS a Types of dividends and their effect on
shareholders’ wealth and company’s ratios
Cash dividends
èIn theory value of a stock reduces by the

Regular Special Liquidating amount of dividend on ex-dividend date
dividend dividend dividend
èPayment of cash dividend reduces
Consistent Extra/irregular Proceeds of company’s assets and MV of its Equity
schedule eg. dividend liquidation
quarterly
Stock Reverse stock

Stock splits
dividends splits
Cash dividend decreases asset (cash) and
Division of each Combination of shareholders’ equity (retained earnings)
Dividends in share into multiple multiple shares
shares/stocks shares into one Other things equal, decrease in cash
Retained earnings
decreases liquidity ratios and increases
No. of shares Shareholder’s
decrease increase wealth is debt-to-assets ratio
Price of shares unchanged
Equity share decrease Decrease in retained earnings, increases
capital increases A company whose debt-to-equity ratio
Value of stock has fallen
Total equity shareholder’s total dramatically may
remains unchanged shares is declare reverse
unchanged stock split
Stock dividends, stock splits and reverse stock splits have no effect on company’s
leverage ratios or liquidity ratios
Dividend reinvestment plans (DRPs/DRIPs): All or a portion of cash dividends is

automatically reinvested in additional shares of the company
Open-market DRP: Company purchases shares in open market to acquire additional
shares credited to plan participants
New-issue DRP: Company issues additional shares instead of purchasing them

Advantages of DRP: Easy means to accumulate additional shares, no flotation cost
involved in case of new-issue DRP
Disadvantages of DRP: Detailed records must be kept by the investor and cash
dividends are fully taxed in the year received even when reinvested
58
LOS b Compare theories of dividend policy
1 MM dividend irrelevance
ª Modiglian and Miller argued that under perfect capital market assumptions (no taxes, no
transaction costs, symmetric information and infinitely divisible shares) company's
dividend policy should have no impact on its WACC and shareholders’ wealth
ª Homemade dividend: If a company does not declare dividend for a year, the shareholder
can construct his own dividend policy by selling sufficient shares to create the desired CF
ª The irrelevance argument does not state that dividends per se are irrelevant but that
dividend policy is irrelevant
2 The bird in the hand argument
ª Investors prefer a dollar of dividends to a dollar of expected capital gains
ª Company that pays dividends will have lower Ke compared to the company
that does not pay dividends
3 Dividend policy matters: Tax argument
ª Investors would prefer companies that pay low dividends and reinvest
earnings (when tax rates for dividends are more than the tax rates for
capital gains) so that they don’t have a burden of high taxes
LOS c Types of information (signals) that the following may convey
Dividend Dividend Dividend Dividend

initiations increase decrease omissions
Empirical studies Empirical studies

show that dividend show that dividend Empirical studies
initiations convey decrease convey −ve show that dividend
+ve signal Empirical studies signal omissions convey
show that dividend
−ve signal
Dividend initiation increase convey +ve Dividend decrease
can help reduce signal could mean that Management may
information management is believe that
asymmetry A company may view unable to run the shareholders will
the policy of business efficiently receive greater
Dividend initiation increasing dividends and can not maintain benefits by
may increase share as a tool to convey current dividend in reinvesting earnings
price potential investors the future than paying them
that it has been
out as dividends. In
It could also mean generating positive In rare such cases it might
that company has earnings and CFs circumstances it be viewed as a +ve
fewer reinvestment could be viewed as a signal
opportunities +ve signal
59
LOS d Clientele effect
Clientele effect: Existence of varying dividend preferences of groups of investors (clientele)
Eg. institutional investors invest only in companies that pay dividend, some mutual funds
and ETFs seek high dividend yield
Clientele effect does not contradict MM theory. The change entails only a change in clientele
and dividend policy would not affect the firm value
Impact of tax rates on share price after declaring dividend
Eg. Dividend = $12 Marginal tax rateD = 30% Marginal tax rateCG = 20%
Pre tax Post tax
Dividend 1 0.7
$12 12 − (12 × 0.3) = $8.4
Capital gain 1 0.8

$10.5 $8.4
Share price would reduce by $10.5
Agency issues
Between shareholders Between shareholders

and managers and bondholders
Payment of dividend reduces

Managers may have an incentive cash which might impair the
to overinvest. This problem may position of bondholders. This
be solved by paying dividends problem can be solved by
covenants in the bond indenture
LOS e Factors that affect dividend policy

èInvestment opportunities: Profitable investment opportunities → Low dividend payout
èExpected volatility of future earnings: Volatility of earnings → Companies are more cautious
in changing dividend payout
èFinancial flexibility: Companies that do not initiate, or reduce or omit dividend and retain cash
instead are in a relatively strong position to meet unforeseen operating need
èTax considerations: After-tax return is most relevant to investors. Taxes on dividend and
capital gains vary from country to country
èFlotation costs: These are the costs of issuing new equity. Higher floatation costs → lower
dividend payout
èContractual and legal restrictions: Companies may be restricted from paying dividends by
legal requirements. Contractual restrictions are imposed by bondholders in bond indenture
60
LOS f Effective tax rate on corporate earnings under following methods
Double Dividend Split-rate tax

taxation imputation system
Eg.
Tax on earnings = 30%
Eg. Tax on dividends = 20%
Eg. Corporate tax rate = 30% Individual tax rate = 25%
Corporate tax rate = 30% Individual tax rate = 50%
Individual tax rate = 25% PBT 100
PBT 100
PBT 100 Dividend 60
Tax(30%) (30)
Tax(30%) (30) Tax(20%) (12)
PAT 70
PAT 70 Dividend 48
Dividend 70 distributed
Dividend 70
Tax(50%) (50) Tax(25%) (12)
Tax(25%) (17.5)
Tax credit 30 Net returns 36
Net returns 52.5
Net returns 50 Effective tax rate:
Effective tax rate: 100 − 36 = 64%
100 − 52.5 = 47.5% Effective tax rate is same as
individual tax rate = 50%
Tax rate on earnings is
irrelevant
Calculation of effective tax rate is same under

double taxation method and split-rate tax system
LOS g
Stable dividend Constant dividend
policy payout ratio policy
Dividends are based on long-

term forecast of sustainable Dividend payout ratio is
earnings determined by the
management and is applied
Target payout ratio each year to determine the
adjustment model: amount of dividend
Expected dividend = Previous
dividend + (Expected increase Dividend fluctuate with
in EPS × Target payout ratio earnings in the short term
× Adjustment factor)
Rarely used in practice
Adjustment factor = 1/n
61
LOS h Share repurchase methods
Open market Tender offer Dutch auction Direct negotiation
Prevailing market Premium to Premium to Premium to

price market price market price market price
Gives company Specific number of Similar to tender Direct negotiation

the flexibility to shares are offer but company with a large
choose the timing repurchased at a stipulates a range shareholder to
of the transaction fixed price of acceptable buyback a block of
prices shares
LOS i Effect of share repurchase on EPS

Profit after tax EPS
EPS = Earning yield = Cost of borrowing = YTM × (1 − t)
No. of shares outstanding MPS
If earning yield > borrowing cost: EPS
If borrowing cost > earning yield: EPS
Eg. Share price before buyback = $40 Shares outstanding before buyback = 120,000
EPS before buyback = $3 Cost of debt = 9% Tax rate = 30% Planned buyback = 20,000
Earning yield = EPS/MPS After tax cost of debt = 9 × (1 − t)

= 3/40 = 9 × (1 − 0.3)
= 7.5% = 6.3%
EPS will increase after buyback, because earning yield > after tax cost of debt
Net income − After tax cost of funds

EPS after buyback =
Shares outstanding after buyback
(3 × 120,000) − (20,000 × 40 × 6.3%)
=
(120,000 − 20,000)
360,000 − 50,400
=
100,000
= $3.096
LOS j Effect of share repurchase on BVPS
If BVPS (old) > MPS: BVPS (new)

BV of Assets − BV of Liabilities
BVPS =
No. of shares outstanding
If MPS > BVPS (old): BVPS (new)
62
Eg. Share price before buyback = $40 Shares outstanding before buyback = 120,000
Book value = $2.4 mln Planned buyback = $800,000
2,400,000
Current BVPS =
120,000
= $20
New BVPS will decrease, because Current BVPS < MPS
No. of shares in buyback = $800,000

$40
= 20,000
Opening BV − Planned buyback

New BVPS =
Shares outstanding after buyback
2,400,000 − 800,000
120,000 − 20,000
= $16
LOS k Choice between paying cash dividends and repurchasing shares

èPotential tax advantages: If dividends are taxed at higher rates than capital gains, share
repurchases have a tax advantage over cash dividends
èShare price support/signaling: Management of a company may think its own shares are
undervalued and hence a good investment. Share repurchase is often considered a +ve signal
èAdded flexibility: Timing of share repurchases is at managers' discretion
èOffsetting dilution from ESOPs: Share repurchase program is often used to offset the possible
dilution of EPS that may result from the exercise of ESOPs
èIncreasing financial leverage: Share repurchases increase leverage
LOS l Broad trends in corporate dividend policies
In most of the developed markets (US, Canada, EU etc), the proportion of

companies paying dividends has declined over the long term
Since 1980s in the US and 1990s in the UK, the proportion of companies engaging
in share repurchases has increased
LOS m Dividend coverage ratios
Based on net Based on

income FCFE
Dividend coverage ratio: FCFE coverage ratio:

Net income/Dividends FCFE/(Dividends + Share
repurchases)
Higher dividend coverage
ratio: Lower probability of a Ratio greater than 1: Company
dividend cut is improving liquidity
63
LOS n Characteristics of companies that may not be

able to sustain their cash dividend
ª Dividend coverage ratio = 1, dividend is considered to be in jeopardy
ª FCFE coverage ratio = 1, company is returning all available cash to shareholders
ª FCFE coverage ratio < 1, dividends are not sustainable
64
Environmental, Social and Governance (ESG)

considerations in Investment Analysis
LOS a Global variation in ownership structures and the possible effects of
these variation on CG policies and practices
Corporate Ownership structures are generally classified as dispersed, concentrated,

or a hybrid of the two.
Dispersed Concentrated
Ÿ Reflects on individual share

Ÿ Reflects the existence of
holders or a group (controlling
many shareholders, none of
shareholders) with the ability
which can exercise control
to exercise control over the
over the corporation.
corporation
Ÿ Less common as compared
Ÿ Common as compared to
to concentrated ownership
dispersed ownership
structure.
structure.
ª Degree of share ownership alone doesn’t necessarily reflect if the

corporate ownership is concentrated or dispersed.
ª Controlling Shareholders may either be majority shareholders (i.e own more than 50%
of corporation’s shares ) or minority shareholders (i.e., Own less than 50% of shares. )
Horizontal or Vertical ownership

Vertical Ownership
Horizontal Ownership
(Pyramid Ownership)
Companies with mutual business

interests that have cross-holding A Company or group that has a
share arrangements with each controlling interest in two or more
other. holding companies, which in turn
This structure can help facilitate have controlling interests in
strategic alliances and foster long- various operating companies.
term relationships among such
companies.
ª Dual-Class (Multiple-Class) shares serves to disconnect the degree of share

ownership from actual control.
ª Dual-Class shares grant one share class superior or even sole voting rights,
whereas the other share class has inferior or no voting rights.
65
Conflicts within Different Ownership Structures

The type of corporate ownership structure affects corporate governance policies and practices because
of potentially different set of conflicts that may exist between shareholders and managers, as well as
among shareholders themselves
Types of ownership structures:

Œ Dispersed ownership and dispersed voting power:
Shareholders that lack the power to exercise control over managers. Such shareholders are known as
weak shareholders and such managers are known as strong managers.
This leads to principal-agent problem: Manager's interests are in conflict with those of shareholders to
whom they report to. This problem can be mitigated with the presence of controlling shareholders
because they may have control over the board of directors and have the incentive to monitor
management.
Concentrated ownership and concentrated voting power:
Controlling (strong) shareholders maintain a position of power over both (weak)

managers and minority shareholders.
Strength: Controlling owners may effectively monitor management and control their appointment
because they have control over board of directors
Limitation: Controlling shareholders may allocate company resources to their benefit at the expense of
minority shareholders. This conflict is known as a principal–principal problem.
Ž Dispersed ownership and concentrated voting power:

The strong controlling shareholders do not own a majority of the shares of a company.
Controlling shareholders with less than majority ownership can exert control over other minority owners
through certain mechanisms, such as dual-class share structures and pyramid structures, and can also
monitor management owing to their outsized voting power.
Concentrated ownership and dispersed voting power:

This conflict arises when there are legal restrictions on the voting rights of large share positions, known
as voting caps. Voting caps have been imposed by a number of sovereign governments to deter foreign
investors from obtaining controlling ownership positions in strategically important local companies.
Types of Influential Shareholders

Banks Families
Interlocking directorates: Same family or same
member of a corporate group controls several
In Asia and Europe, banks have control over
corporations.
corporations with which they have a lending
relationship in addition to equity interest. Strength: Lower risks associated with principal-
agent problems as families have concentrated
This dual relationship can give rise to conflicts
ownership and management responsibility.
of interest where banks pressurize such Limitation:
organizations to take out large loans to the Ÿ Poor transparency
detriment of other shareholders. Ÿ Lack of management accountability
Ÿ Less consideration of minority shareholder rights
Ÿ Difficulty in acquiring quality talent
for management positions.
66
State-Owned
Enterprises (SOEs) Institutional Investors Group Companies
Institutional investors Cross-holding share
collectively represent a arrangements and long-term
significant proportion of equity relationships between group
Listed SOEs are partially owned
market ownership. They have companies with horizontal and
by the government and have
the resources to make vertical ownership structures
publicly traded shares (mixed-
informed judgement in may restrict transfer of share
ownership model).
exercising their shareholder ownership as well as create an
This model is subject to lower rights. obstacle for outsiders to
market scrutiny of management purchase a significant stake in
When ownership is widely
compared to corporate the organization.
dispersed, institutional
ownership models (implicit or
investors may not qualify as a There is a greater risk that
explicit state guarantees to
controlling shareholder but companies with group
prevent corporate bankruptcy)
can promote good corporate structures may engage in third-
governance by holding a party transactions at the
company's board or expense of minority
management accountable. shareholders.
Managers and
Private Equity Firms Foreign Investors Board of Directors
When foreign investors invest

a significant amount in
emerging markets, there can
Insiders (managers and
be a considerable impact on
shareholders with ownership
corporate governance
Involvement of private equity positions) will have economic
practices for the local
firms such as venture capital interests which are more
company:
and leveraged buyout (LBO) aligned with external
Ÿ Investors from countries
firms in the management of shareholders, i.e. they will
with greater levels of
corporations may bring seek to maximize the long-
transparency and
important changes to a term value of a company.
accountability may demand
companies' corporate the same in the investee A drawback is that insiders
governance. country with large ownership
Ÿ Local companies cross- positions may seek to protect
listing in countries with their own interests at the
greater transparency and expense of shareholders.
stringent investor
protection laws may
benefit local minority
shareholders
67
Effects of Ownership Structure on Corporate Governance
Special Voting
Director Independence Board Structures Arrangements
The percentage of A corporation's board of

independent directors is directors is typically
higher in countries with structured as either one tier or
dispersed ownership two tier.
structures. One-tier board structure:
Consists of a single board of Several countires have special
They serve a narrow role in directors, composed of arrangements in place ensure
concentrated ownership executive (internal) and non- the engagement of minority
structures executive (external) directors. shareholders in board
It is the most common board nomination and election
In countries with concentrated structure process.
structures nomination and
remuneration committees are Two-tier board structure:
not mandatory but if they exist Consists of a supervisory
they are mostly composed of board that oversees a
independent directors. management board. A number
of countries mandate this
structure.
Corporate Governance Codes,

Stewardship Codes
Laws, and Listing Requirements
Many countries have adopted national

corporate governance codes where
Many countries have
companies have to disclose their
introduced voluntary codes,
adoption of recommended corporate
known as stewardship
governance or explain why they haven't
codes, that encourage
done so.
investors to exercise their
Other countries need more than this legal rights and increase
“comply or explain” approach, where their level of engagement in
companies need to justify why they corporate governance.
aren't following these practices. Some
In some cases, stewardship
countries do not have national
codes are not entirely
corporate governance codes but make
voluntary.
use of company law or regulation or
stock exchange listing requirements.
68
LOS b Evaluating Corporate Governance Policies and Procedures

● Regular dialogue and engagement efforts with companies can help investors understand the
benefits of corporate governance policies and procedures.
● Shareholder activism refers to strategies used by shareholders to compel a company to act in a

desired manner.
● Evaluation of a company’s board of directors is often a starting point for investors when evaluating
the quality of corporate governance.
Benefits of effective corporate governance include:
● Higher profitability ● Growth in return on equity

● Better access to credit; ● Higher and sustainable dividends
● Favourable long-term share performance and ● Lower cost of capital
Board Policies and Practices
Board of Directors Structure Board Independence Board Committees
If it is a one-tier or two-tier Board committees include

structure, providing sufficient audit, governance,
oversight, representation, and remuneration, nomination,
accountability to shareholders. The absence of independent and risk and compliance
directors is a negative committees.
CEO duality may raise concerns aspect of corporate
that the monitoring and governance. Investors assess whether
oversight role of the board there are sufficiently
may be compromised relative Without independent independent committees
to independent chairperson directors, the potential for that focus on key
and CEO roles. management to act in a self- governance concerns, such
serving manner exists. as audit, compensation, and
When the chairperson is not Consequently, a lack of the selection of directors.
independent, a company may independent directors on a
appoint a lead independent board may increase The presence of non-
director to help protect investors' perception of the independent committee
investor interests. corporation's risk. members or executive
directors may prompt the
“CEO duality,” whereby the
consideration of potential
chief executive officer (CEO)
conflicts of interests.
also serves as chairperson of
the board.
69
Board Skills and Experience Board Composition
Primarily reflects the number and diversity

of directors along with their professional,
A board with concentrated skills and cultural, and geographical background, as
experience may lack sufficient expertise to well as gender, age, and tenure.
govern, as may a board with diverse skills and
expertise that are not directly related to the Boards with too many members or those
company's core operations. which lack diversity are less effective
compared to boards that are smaller and
In certain sectors/industries that rely on more diverse. Other Considerations in
natural resources or face potentially large ESG Board evaluation is necessary to maintain a
risks, board members typically have expertise company's competitive position and to
in environmental, climate, or social issues. meet the expectations of investors.
A board director's tenure is considered long if A board evaluation can be performed by the
it exceeds 10 years. A board member with a board itself (self-evaluation), by an
long tenure may have a comprehensive outsider on behalf of the board(external
understanding of how the corporation's review), on an “as needed” basis; or using a
business operates, the other hand a board periodic external review.
member with a long tenure may have a
comprehensive understanding of how the A board evaluation coves how the board
corporation's business operates or may result performs its duties, the board's leadership,
in directors being less willing to embrace the board's structure, and interaction
changes in the corporation's business. between members and management
(including culture).
Executive Remuneration
● Involves issues such as transparency of compensation, performance criteria for
incentive
plans (both short term and long term), the linkage of remuneration with the company
strategy, and the pay differential between the CEO and the average worker.
● “Say-on-pay” provision allows shareholders to vote and provide feedback on

remuneration issues.
● Claw-back policy allows a company to recover previously paid remuneration if certain

events, such as financial restatements, misconduct, breach of the law, or risk
management deficiencies, are uncovered.
● Investors will need to use tools and/or rely on metrics which indicate that executive
incentive plans provide appropriate incentives for management to drive the value of
the corporation.
70
Shareholder Voting Rights

Straight voting structures: Shareholders are entitled to one vote for each share owned.
Dual-class share structures: company founders and/or management have more voting power than the
class of shares available to the general public.
Dual class share structures can create conflicts of interest because they can benefit one group of
shareholders over another – company founders and/or management over minority shareholders.
LOS c Identifying ESG-related Risks And Opportunities
Identifying and obtaining information that is relevant and useful is one of the primary challenges in
integrating ESG factors into investment analysis. The sources of this data are publicly available corporate
filings, documents, and communications.
Materiality and Investment Horizon
Materiality
In an ESG-context, materiality cover ESG-related issues expected to affect a company's operations, its
financial performance and the valuation of its securities.
Company definition of materiality may differ in usefulness: Defining positive ESG information as material
is not useful as it may have little impact on a company's operations and financial performance.
Alternatively, a company may not report negative ESG information which investors consider material.
Investment horizon:
ESG issues differ in their impact depending on the length of the time horizon and how to perceive these
issues.
Investors with short-time horizons may find that longer term ESG issues have little impact on security's
valuation in the near term.
Relevant ESG-Related Factors:

Not-for-profit industry
Proprietary methods ESG data providers
organizations and initiatives
Analysts consider not-for-

profit initiatives which provide
data and insights on ESG
issues. These organizations
Analysts use their own include:
Analysts use information
judgment and the firm's
provided by ESG data Ÿ International Integrated
proprietary tools to identify
providers which is reflected in Reporting Council (IIRC)
ESG information by
individual ESG analyses,
researching companies, news Ÿ Global Reporting Initiative
scores, and/or rankings, for
reports, and other relevant (GRI)
each company in the vendor's
sources. Ÿ Sustainable Accounting
universe.
Standards Board (SASB)
Company disclosures can be
Vendors may rank or score IIRC provide a standardized
found on their websites and/or
companies within their framework of ESG disclosures
in corporate citizenship or
industries and provide detailed in corporate reporting.
sustainability reports.
ESG-related industry analyses.
GRI works with various
stakeholder groups to develop
sustainability reporting
standards.
71
Equity vs. Fixed-Income Security Analysis
ESG integration: The implementation of qualitative and quantitative ESG factors in

traditional security and industry analysis.
ª ESG integration differs for equity and fixed income (debt) analysis. In equity security analysis, ESG
integration is used to identify potential opportunities and mitigate downside risk. In fixed-income analysis,
ESG integration is used to mitigate downside risk.
ª The process of identifying and evaluating different ESG-related factors is similar for equity and corporate
credit analysis.
ª For valuation of credit sources, analysts may rely on relative value, spread, duration, and sensitivity/
scenario analysis
Equity securities valuation Fixed-income valuation
Ÿ Analyzing them in the

context of forecasting Ÿ Internal credit
financial ratios and enhancements
metrics Ÿ Forecasting financial
Ÿ Adjusting them in ratios and
valuation model Ÿ Relative ranking of
variables companies (or
Ÿ Using sensitivity and/or governments)
scenario analysis
Los d Green bonds
Green bonds are bonds in which the proceeds are designated by issuers to fund a
specific project or portfolio of projects that have environmental or climate benefits
Green bonds are typically similar to an issuer's conventional bonds, with the exception
that the bond proceeds are earmarked for green projects.
In addition to conventional or “plain vanilla” corporate bonds, other types of green

bonds include project bonds, mortgage-backed and asset-backed securities, and
municipal bonds
Because only the use of proceeds differs, the analysis and valuation of green bonds are
essentially the same as those of conventional bonds
One unique risk of green bonds is green washing, which is the risk that the bond's
proceeds are not actually used for a beneficial environmental or climate-related project.
Liquidity risk may also be a consideration for green bonds, given that they are often
purchased by buy-and-hold investors
Evaluating ESG-related Risks And Opportunities
The process of incorporating ESG considerations in the investment process helps investors to take a
broader perspective of industry and company analysis. The integration of ESG factors in financial
statement analysis and valuation can help drive investment decisions.
72
ESG-related adjustments
IS & CF Balance sheet
Ÿ Projected revenues
Ÿ Operating/non-operating costs
Ÿ Operating margins Ÿ Analyst’s estimate of impaired

assets
Ÿ Earnings
Ÿ Capital expenditures
Valuation adjustment for equities include adjusting a company’s cost of capital using the discount rate or a
multiple of price or terminal value
Valuation adjustments for bonds include adjusting the issuer’s credit spread or CDS to reflect CDS
considerations.
Watch video with important

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FinTree Forum for the reading
73
Cost of Capital: Advanced Topics

Warm Up
RFR = 8% YTM = 12% Weight Eq = 70%
Beta = 1.5 Tax Weight Debt = 30%

Rate = 30%
ERP = 6%
WACC
Ke = 8% + 1.5 x 6% = 17%
Ked = 12% x (1-30%) = 8.4%
WACC = 70% x 17% (+) 30% x 8.4%
= 14.42%
Cost of Capital: Advanced Topics
Module 1.1: FACTORS AFFECTING THE COST OF CAPITAL AND THE COST OF DEBT
Module 1.2: ERP AND THE COST OF EQUITY
Explain top-down and bottom-up factors that impact the cost of capital.
Macro Company Specific
74
Legal and
regulatory
Capital Market
considerations, Tax Jurisdiction
Availability Conditions
country risk
Top Down
Factors affecting
cost of Capital
Bottom Up
Financial Strength
and Security Features
Business or Asset nature
profitability
Operating risk and liquidity
75
Top-down (i.e., external or macro) factors include:
Capital availability
· Economies with plentiful availability of capital will have lower cost of capital.
· Developed economies with established liquid capital markets tend to have

more stable currency values and better investor protections via rule of law,
and accordingly will have greater capital availability compared to developing
economies.
· In some less-developed countries that lack corporate debt markets,

businesses must rely on bank lending or a shadow banking system of
unregulated, non-bank sources.
Market conditions
· Lower levels of expected inflation lead to lower nominal risk-free rates.
· Risk premiums on both debt and equity shrink during economic expansions,
· The transparent and predictable monetary policies of developed economies

tend to reduce risk premiums and interest rates.
· Countries with higher currency volatility will need to offer higher risk
premiums to risk-averse investors.
Legal and regulatory considerations and country risk
· Countries that follow common law–based legal systems offer stronger

protection to investors, leading to lower risk premiums compared to countries
with civil law–based legal systems.
76
Tax jurisdiction
· Tax code affects the deductibility of interest expense on debt.
· All else equal, the higher the marginal tax rate, the greater the tax benefit of
using debt in the capital structure.
Bottom-up (i.e., company-specific) factors that affect the cost of

capital include:
Business or operating risk
· Volatility in revenues, earnings, and cash flows is a measure of business risk.
· Businesses with stable revenues (e.g., utilities or subscription-based services)

have relatively stable earnings and cash flows, and are therefore less risky than
businesses with more-volatile revenues (e.g., cyclical industries)
· Companies generating most of their revenues from only a few customers face
customer concentration risk
· Use of debt in the capital structure increases financial leverage, which

increases the volatility of earnings and cash flows.
· Companies with poor corporate governance, as well as companies with high

ESG related risk exposures, will see investors demand higher risk premiums.
Asset nature and liquidity
· Companies with tangible, non-specialized (i.e., fungible) assets and more

liquid assets would have a higher recovery rate and hence a lower risk
premium.
· Specialized assets and intangibles (e.g., goodwill, patents, proprietary

production processes, etc.) Do not have a ready liquid market, resulting in
a lower recovery rate.
> Snr-Sec 1000
· Assets specifically designated as collateral reduce the cost of secured debt,
but increase the cost of other subordinated unsecured debt as their claim
becomes inferior.
> Jnrsec 1000

77
Financial strength and profitability
· Companies with higher profitability, higher ability to generate cash, and

lower leverage, have a lower probability of default; therefore, investors will
accept a lower risk premium.
Security features
· Embedded call options make a security less desirable and increase the risk
premium.
· While a callable bond increases the current cost of borrowing for the issuer, it
does allow the company to refinance the debt at a favorable rate should interest
rates decline in the future.
· Conversely, a put option or conversion option reduces the cost of borrowing

for the company, because a putable bond is issued at a favorable rate. However,
the borrowing cost may increase in the future if investors put back the bond in a
rising interest rate scenario and the company is forced to refinance at a higher
rate.
· A cumulative preferred stock accumulates missed dividends when the company

is unprofitable; such stock has a lower risk premium than equivalent non-
cumulative preferred stock. Classes of common equity that have superior rights
have a lower cost than those classes with inferior rights.
Compare methods used to estimate the cost of debt.

Estimate the cost of debt or required return on equity for a public
company and a private company.
Publicly Traded Debt
· If the company's debt is publicly traded, the yield to maturity for the longest
maturity straight debt outstanding is generally the best estimate of the cost of
debt.
· However, if the longest maturity debt is thinly traded, and a shorter-maturity
debt with more-reliable market price information is available, we may use the
yield on this shorter maturity debt instead.
78
Non-Traded/Thinly Traded
· If the company's debt is not traded or is thinly traded, we can use matrix
pricing to consider the yields on traded securities with the same maturity and
credit ratings.
· If the debt is not credit rated, then financial ratios of the company such as
interest coverage (IC) ratio or financial leverage (D/E) ratio may be used to
infer a credit rating for that debt.
· It is also common to obtain credit spreads for specific ratings and add those
to the benchmark rates to arrive at the cost of debt.
· When using credit ratings, analysts should realize that an issuer rating may
differ from the ratings of the issuer's individual series of debt, depending on
the seniority of the specific series and whether it is secured by a collateral.
· In many countries, bank debt is the primary source of debt capital. Because
we are interested in the marginal cost or the cost of a new bank loan, the rate
on existing debt will not be a good estimate if the company's characteristics or
the general level of rates has changed.
ABC Corp
A. Snr – Sec.bonds AAA+

B. Jnr – Sec.bonds AAA
C. Snr – Unsec.bonds AA
D. Jnr – Unsec.bonds AAA-
· Leases—and specifically, finance (i.e., capital) leases—can be used to estimate

the cost of borrowing. The Rate Implicit In the Lease (RIIL) is the implied cost
of capital in a lease. RIIL is the IRR in the following equation:
· PV of lease payments + PV of residual value = Fair value of leased asset +
Lessor's initial direct cost
· Usually, the terms of a finance lease are disclosed. If they are not, then the
incremental borrowing rate (IBR), the rate on a new secured loan over the
same term, may be used.
79
Company A has signed a 15-year lease on an asset, calling for annual

payments of $12 million at the end of each year. The lease residual value is
$50 million. The fair value of the asset is $140 million, and the lessor incurs a
cost of $7 million at the time of lease initiation.
Calculate the RIIL for this lease.
0 1 2 3 ------------------------- 14 15
147 -12 -12 -12 -12 -12

-50
IRR = 5.13%
7 bond AA YTM?
C = 5%
Comparable bonds > AA
A B C D
Mature 4 4 9 9
C 5% 6% 6% 5%
YTM 7% 7% 10.5% 10.3%
Average 4yr YTM = 7.05%
Average 9yr YTM = 10.4%
80
4yrs 7yrs? 9yrs
7.05 10.4
5yrs = 3.35 3.35 x 3

= 2.01
5
3yrs = ?
7yrs = 7.05 + 2.01 = 9.06%
International Considerations
· For foreign borrowers, the cost of debt should include a country risk
premium.
· A country risk rating (CRR) reflects risks related to economic conditions,

political stability, exchange rate risk, and the level of capital market
development.
· Country ratings can be similar in format to debt ratings (e.g., AA), or can be a
numerical rating (e.g., 8).
· A country may be assigned a rating relative to a benchmark country. The

excess of the median interest rate for that country relative to the benchmark
country rate determines the country risk premium.
Country RFR CRP

5
A 3 0
B 4.5 1.5
C 6 3
D 6.1 3.1
E 7 4
81
Explain historical and forward-looking approaches to estimating an equity risk
Required Return on Equity = RFR + ERP + Company Specific Risk Premium
There are two types of estimates of the equity risk premium: historical
estimates and forward-looking estimates.
Historical
Estimates
Analysts making a
historical estimate need
to decide on four
important issues:
4. Risk-free rate
1. Index selection 2. Sample Period 3. Mean Type
proxy
Forward Looking
Estimates
Dividend Macroeconomic
Survey Estimates
Discount Models Models
82
Historical Estimates premium.
· ERP = Returns on Market – RFR

Analysts making a historical estimate need to decide on four important issues:
· Index selection: The equity market index chosen should be one that serves as a
good proxy for the average return's equity investors earn over time.
· Sample period: Analysts generally choose a longer sample period because
covering multiple business cycles and a variety of market conditions, the
standard error (i.e., noise) should be lower.
· However, older data may not reflect current market conditions.
· Mean type: AM vs GM?
· An arithmetic mean is a good estimate of a one-period expected return, but

does a poor job of estimating multiperiod return, which is needed to determine
expected terminal wealth.
· A geometric mean gives lower weight to outliers, and estimates the expected
terminal wealth more accurately. While the geometric mean is preferred, both
means are used in practice.
· Risk-free rate proxy: Analysts may use either short-term or long-term

government bond rates as a proxy for the risk-free rate.
· The short-term (i.e., T-bill) rate is a good proxy for the true risk-free rate
because (unlike long-term rates) it does not include reinvestment (of coupon)
risk.
· However, because the duration of equity is long-term (infinite), many analysts

favor using long-term government bond rates as proxies for the risk-free rate.
· A weakness of the historical approach is the assumption that the mean and
variance of the returns are constant over time (i.e., the ERP time series is
stationary). This does not seem to be the case.
· In fact, the equity risk premium appears to be countercyclical—it is low during

good times and high during bad times.
· Another concern with a historical estimate is that it may suffer from

survivorship bias: it will be upward-biased if only firms that have survived during
the period of measurement are included in the sample.
83
Forward-Looking Estimates
· Do not rely on an assumption of stationarity and is less subject to problems like

survivorship bias.
Survey Estimates
· Consensus of opinions, typically experts

· Surveys tend to estimate higher erps for developing markets relative to
developed markets
· Weakness is that the surveys tend to be biased toward recent market returns
Dividend Discount Models
Equation
D1 V0 = D1 ; Ke - g = D1 ;
+g
P0
Ke - g V0
· E = D1 + g
P0
· ERP = KE - RFR
· The first term is the expected dividend yield on a broad-based index; this
measure should be relatively free from large surprises.
· The second term is the earnings growth rate for the index, based on consensus
forecasts.
· For developing economies, where the current high growth rate is transitory, we
might incorporate three stages of growth (high, moderate, and mature) and
model the stock market index value this way:
Current index value = PV(stage 1) + PV(stage 2) + PV(stage 3)
The IRR that balances this equation is then our estimate of required rate of
return. After subtracting the current risk-free rate, we can obtain the ERP for
that market.
84
Macroeconomic Models
We will use the Grinold-Kroner (2001) model to illustrate a macroeconomic

model. The Grinold-Kroner model decomposes 'g' (the capital gains yield, CGY) in
the dividend discount model as:
CGY = ΔP/E + expected inflation (i) + real economic growth rate (G) + ΔS
Where:
ΔP/E = expected repricing or expansion/contraction in P/Es
ΔS = change in shares outstanding, on an aggregate basis
ΔS reflects the net buyback of stock, which is another way corporations can
effectively pay cash to their shareholders.
· One approach to estimate expected inflation is to compare the nominal yield on

a U.S. Treasury bond to the yield on an equivalent inflation-protected Treasury
security (TIPS).
Treasury = 7%
TIPS = 5.5%
I = 1 + YTMTREAS - 1
1 + YTMTIPS 1.07
- 1 = 1.42%
1.055
Nifty Div Yield = 1.5% Regd GDP = 4%
Real RFR = 3%
Inflation = 5% }
Multiple exp ∆P = 2%
E
Net buy back = 1% Price = EPS x PlE

∆S
85
Expected return 13.5%

= Equity
on Equity?
Div Yield/ Cap. appr.

CF Yield CGY
2.5%
Nominal Expansion
Div Yield Buy back Growth PE ratio
1.5% 1% earnings 2%
9%
Real (+) Inflation

Growth 5%
4%
ERP = Ke - RFR
= 13.5% - 8%
=5.5%
Compare methods used to estimate the required return on equity.

Estimate the cost of debt or required return on equity for a public company
and a private company.
DDM
Bond Yield Plus

Risk Premium
Required Rate of
Return on Equity
Build-up
Approaches
Risk Premium
Models
86
DDM
· For an individual company, cost of equity is dividend yield plus capital gains
yield.
· Re = DY + CGY
XYZ Is expected to pay a dividend of $6 at the end of its first year. Dividends
are expected to grow at a constant rate of 5% per year. The current XYZ stock
price is $100.
ABC Inc. Is expected to pay a dividend of $1.70, $2.10, $2.90, and $3.50 at the
end of each of the next four years, respectively. The current ABC stock price is
$55, and is expected to be $69 at the end of four years.
Calculate Cost of Equity
XYZ = 6 + 5% = 11%
100
0 1 2 3 4
ABC =
-55 1.7 2.1 2.9 3.5
IRR = 9.98%
Bond-Yield-Plus–Risk-Premium Method
· The bond-yield-plus-risk-premium (BYRPM) method is a build-up approach

appropriate for estimating the cost of equity for a company that has publicly
traded debt
· This method simply adds a risk premium to the yield to maturity (YTM) of the
company's long-term debt.
· One approach to selecting a risk premium is to use an average of the historical

difference between equity returns and cost of debt, similar to the historical
estimation of the equity risk premium.
· An issue with this method is that the risk premium is rather arbitrary and if the
firm has several debt securities outstanding, there is no perfect option regarding
which security's yield to use.
87
Capital Asset Pricing Model
Ke = RFR + beta * ERP
Fama–French Models
Required return of stock = r f + β1 ERP + β2 SMB + β3 HML

A five-factor Fama–French model adds to the model above two additional
factors: profitability (RMW), and investment factor (CMA).
Required return of stock = rf + β1 ERP + β2 SMB + β3 HML + β4 RMW + β5 CMA
Where:
RMW = profitability premium = average difference in portfolio returns of

companies with “robust profitability” over “weak profitability”
CMA = investment premium = average difference in portfolio returns of
companies with “conservative” investments over companies with
“aggressive” investments
Cost of Equity for Private
· CAPM and Fama–French models are not suitable to apply directly to private
companies.
· Appropriate risk premiums for a private company include: size premium

(SP), industry risk premium (IP), and specific company risk premium (SCRP).
· SCRP is a general risk premium covering unique risks of the private

company such as key-person risk, geographical location risk, etc., which are
difficult to diversify away.
88
Ÿ Lower corporate
governance quality
Ÿ Large proportion of
intangibles in total assets,
Ÿ Poor Competitive standing
in the industry,
Ÿ Management without
Qualitative Factors adequate skill and
experience,
Ÿ Geographical
Concentration,
Ÿ Customer Concentration,
Factors Affecting
or supplier concentration
SCRP
Ÿ All indicate higher risk
Quantitative Higher leverage and

Factors volatility indicate higher
risk.
89
There are two approaches to estimate the cost of equity for private
companies—expanded CAPM and build-up approach.
Expanded CAPM Build UP
Ÿ The expanded CAPM approach starts with Ÿ The build-up approach starts with the risk-
using the standard CAPM (with a peer beta) free rate, and adds the equity risk premium
and then adding risk premia as needed: to arrive at the required return on an
average large public company (because ERP
Ÿ Required return = rf + βpeer x ERP + SP + IP + is calculated using a market-cap weighted
SCRP index, large caps dominate the index, and no
beta is used).
Where:
Ÿ Further risk premia for size, industry, and
Βpeer = the industry beta from peer public
company-specific characteristics are added
companies
as needed, depending on how different the
SP = size premium subject company from the average large
IP = industry risk premium public company.
SCRP = specific company risk premium
Ÿ Required return = rf + ERP + SP + SCRP
International Considerations
Ÿ While CAPM may work well for developed market securities, risks unique to
emerging markets require additional premiums.
Ÿ The country-spread model and the country risk rating model are alternative
ways to estimate these risk premiums.
The country-spread model estimates a country risk premium (CRP) (also called a
country spread premium) for a specific emerging market. The estimated equity
risk premium then becomes:
ERP emerging Market = ERP developed + λ × CRP

Where:
λ = exposure of the company to the local (emerging market) economy.
3.6% x 10% = 7.2%

5%
India = 7.3
US = 3.7
3.6
90
For countries operating globally, several approaches are used to estimate re including
Ÿ Global CAPM (GCAPM): GCAPM uses a global market index to estimate the ERP,
rather than using only a local market index.
Ÿ International CAPM (ICAPM): ICAPM is a 2-factor model, based on (1) a global

market index (e.g., MSCI All Country World Index) factor, and (2) a foreign currency
denominated, wealth-weighted market index.
E(re) = Df + βG[E(rgm)-rf] + βc[E(rc)-rf]
Where:
βG = sensitivity to the global market index
rgm = global market return
βc = sensitivity to the foreign currency index
rc = foreign currency index return
The first factor captures the company's relationship with the local economy relative
to the global economy: lower values of βg indicate lower integration of the company
with the global economy.
The second factor captures the sensitivity of the company's cash flows to changes in
its local currency exchange rate.
· In summary, for companies with global operations that are limited to developed
markets, GCAPM or ICAPM are appropriate approaches to estimating the required
return on equity.
· For companies with exposure to developing markets, the appropriate approach is

less well defined. For these firms, a country risk premium (CRP) can be used, if we
can assume that the historical estimate is representative of the risk premium going
forward.
Evaluate a company's capital structure and cost of capital relative to peers
Ÿ Comprehensive Case Study
RFR
Venezuela = 7%
Europe = 2% }
σequation = 15%
σdebt = 7.5%
ERP V.Goods Company = ERP + λ x CRP

Europe
91
Corporate Restructuring
Explain types of corporate restructurings and issuers' motivations for
Ÿ Synergies can be cost synergies (lower expenses), revenue synergies (increased

sales), or a combination of the two.
Ÿ Sometimes, inefficiencies or costs (i.e., negative synergies) may instead result from
these diverse holdings due to diseconomies of scale, or loss of focus on core
competencies.
Ÿ Exhibit below shows types of corporate transactions and company-specific motivations

for each.
Transaction Definition Motivations
Investment Increases the size of the company Realize synergies, increase

or the scope of the the company’s growth, improve company
operations, thereby increasing capabilities, acquire needed
company revenues and/or the resources/talent, or acquire an
revenue growth rate undervalued target
Divestment Reduces the size of the company Liquidity, valuation (i.e, fetching
by shedding parts of the business an attractive price), refocus on
that have lower profitability, core business, or to comply with
slower growth, or higher risk regulatory requirements
Restructuring Does not change the size of the Address financial challenges
company, but improves its cost (including bankruptcy and
structure and capital structure liquidation), or improve return on
to enhance profitability, increase capital
growth, or reduce risk
There are two top-down drivers of all three kinds of actions: high security prices overall
and industry shocks.
Ÿ All three corporate transactions tend to be cyclical, increasing in prevalence during

economic expansions and decreasing during contractions. There are several possible
explanations for this:
Ÿ Greater CEO confidence. CEO confidence levels rise during rising markets when
security prices are high; CEOs are more likely to execute major corporate actions in
this environment.
92
Ÿ Lower cost of capital. When stock and bond prices are high, the cost of capital is low,
allowing for less dilution to existing shareholders, or lower interest cost.
Ÿ Overvalued stock. It is attractive for the board and management to use an overpriced
security in corporate transactions (e.g., to finance an acquisition).
Ÿ Yet empirical studies suggest that corporate transactions taken during weaker
economic times tend to create more value.
Ÿ A BCG study found that weak-economy deals tend to have a 10% higher rate of return
than strong-economy deals over the three years following the transactions.
Ÿ Industry shocks. Corporate restructuring also tends to have industry-specific waves:
Mergers in an industry are often followed by more mergers. This phenomenon of
industry shocks suggests a reactionary motivation behind some corporate
transactions.
Ÿ Within the three major categories of corporate transactions, there are nine specific
types as shown below:
Investments Equity Investment

Joint venture
Acquisition
Investments Sale
Spin-off
Investments Cost restructuring

Ÿ Outsourcing
Ÿ Offshoring
Balance sheet restructuring
Ÿ Sale and leaseback
Ÿ Dividend recapitalization
Reorganization
Leveraged buyouts
Investment Actions
Ÿ Acquisitions can enable a company to expand quickly (e.g., into foreign

countries) or to access inputs at a favorable price (vertical integration). There
are three subtypes of investment actions:
Ÿ A purchase of a material but less-than-50% stake in another company is an

equity investment. While both companies maintain their independence, the
investor may get board representation in the investee (depending on the size
of the investment). An equity investment may represent a strategic investment
(to influence the investee), a move toward an eventual acquisition, or simply
an investment in a perceived undervalued asset
93
Ÿ In a joint venture, two or more companies contribute resources, knowledge, or

talent, and jointly control a separate, independent company. Often, a company
seeking to expand into a foreign market may undertake a joint venture with a
local company that has an existing distribution network and local know-how.
Ÿ Controlling investments are acquisitions where the investee company becomes
a subsidiary of the investor company. After the acquisition, the investor
company reports consolidated financial statements, including the results of the
investee company.
Divestment
Ÿ Divestment is the action of selling off subsidiary business interests.

Motivations for divestment include liquidity needs, regulatory requirements, or
simply refocusing on core competencies. Companies may also sell divisions that
have become overvalued by the market. Divestments can take two different
forms: sales and spin-offs.
Ÿ Sale of a division to another company is the opposite of an acquisition. After

the sale, the seller company has no exposure to the divested business. The sale
proceeds (i.e., capital freed up by divestiture) can be returned to shareholders
or otherwise put to better use.
Ÿ Spin-off involves creating a new, separate legal entity, and distributing equity
in the newly created spin-off to the divesting company's shareholders. A spin-
off is intended to improve the focus of the management and employees of the
new company, and allows stock-based compensation schemes to be
implemented. Unlike a sale, a spin-off does not generate any proceeds for the
divesting company.
Restructuring
Ÿ A restructuring can be forced or opportunistic.
Ÿ In an opportunistic restructuring, a business changes its balance sheet

composition, cuts costs, or alters its business model to improve the return on
capital.
Ÿ A forced restructuring may be necessitated by overcapacity, poor management,

falling demand, or a worsening competitive landscape.
Cost restructuring actions typically follow periods of underperformance, and

pursue improvements in the operational efficiency of the company. Two common
restructuring approaches are outsourcing and offshoring.
94
I. Outsourcing involves contracting out standardized business process (e.g.,

payroll, human resources) to third-party vendors that have lower costs due to
their economies of scale. A risk of outsourcing is the need to manage multiple
contractual obligations.
II. Offshoring uses cheaper foreign labor while keeping a business process
inhouse, and usually involves creating a wholly owned foreign subsidiary.
Outsourcing and offshoring are open combined, with a business process
outsourced to a foreign company.
B. Balance sheet restructuring involves changing the mix of assets, changing the
capital structure, or both. Types of balance sheet restructuring include:
I. Sale and leaseback involves selling an asset to a lessor, and then entering into
a lease contract over the remaining economic life of the asset. The result is an
immediate cash infusion for the seller. Lease payments should be higher than the
depreciation of the asset, reflecting interest charged by the lessor. One
motivation for a sale and leaseback transaction is if the lessor is able to obtain
financing at more favorable terms than the lessee.
II. Dividend recapitalization involves increasing leverage on the balance sheet by

increasing debt-financed dividends or by repurchasing shares. The objective is to
replace equity in the capital structure with cheaper debt, thereby reducing the
company's WACC. The higher risk that comes with increased leverage means that
dividend recapitalization is most appropriate for issuers with stable cash flows.
C. Reorganization may be mandated by a court during an insolvency proceeding.
Management's reorganization plan, which specifies the terms of exiting the

bankruptcy proceeding, must be approved by the court. The court then oversees
measures such as asset sales, refinancing, or conversion of debt to equity. If the
court does not approve management's plan, the company may be liquidated.
Explain the initial evaluation of a corporate restructuring.
Ÿ The steps involved in analyzing an announced corporate action include:
Ÿ Initial evaluation. - What, why, when, and is it material?

Ÿ Attempt to understand the real motivations behind the restructuring
Ÿ Preliminary valuation.
Ÿ Modeling and valuation.
Ÿ Analysts typically evaluate materiality along the dimensions of size and fit.
95
Explain the initial evaluation of a corporate restructuring.
Ÿ Update investment thesis.
Ÿ The change in the company's stock price when a restructuring is announced

is one indicator of the value that the market expects to be created or
destroyed.
Demonstrate valuation methods for, and interpret valuations of, companies
We now discuss preliminary valuation using relative valuation methods
Comparable Comparable Premium Paid

company transaction Analysis
Ÿ Uses relative Ÿ Uses actual takeover Ÿ In a takeover

valuation metrics of transaction prices transaction, the
comparable firms acquiring firm
Ÿ No need to estimate typically pays a
a separate takeover premium over the
Ÿ Adds a takeover premium. current market price
premium as an incentive for
the target to accept
Ÿ Because the Ÿ Unlike a discounted the offer. This
estimated value of cash flow approach, premium can be
the target under CCA estimates of value
does not include a are derived directly Ÿ Premium = (deal
control or takeover from recent prices price - un affected
premium, CCA is for actual deals price)/ unaffected
most commonly completed in the price
used in the valuation marketplace, rather
of spin-offs rather than from
than acquisitions. Ÿ Some effect of pre-
assumptions and
announcement
estimates about the
Ÿ Comparable rumors may be
future.
companies provide incorporated in the
an estimate of a fair trading price of the
stock price, rather target prior to the
than a fair takeover announcement;
price. An hence care should be
appropriate taken when
takeover premium estimating UP.
must be determined Analysts might use a
separately. week-old market
price or volume-
weighted trading
price over the prior
week as the UP to
mitigate this issue.
96
Demonstrate how corporate restructurings affect an issuer's EPS, net debt to EBITDA
ratio, and weighted average cost of capital.
The modeling and valuation phase.
The first step in this phase is to generate pro forma financial statements that reflect the
impact of the corporate action. The steps in this process are:
new number of shares

outstanding
Combined taxes
Combined int
expenses = original
int exp of both
Combine other entities plus new
income debt used for acquision,
if any
Combines
Depreciation
Combines expenses,
adjust for synergies
Combine Acquirer
and acquiree
revenue, adjust
for synegies
Estimating WACC and Valuation
Ÿ Restructuring can alter the cost of debt and equity capital.
Ÿ Weights of debt and equity are calculated using market values, and include any
financing raised or additional equity issued.
Ÿ Estimate of future WACC, then analyst can use discounted cash flow techniques to
value the target.
Evaluate corporate investment actions, including equity investments, joint ventures, and acquisitions.
Joint Ventures
Ÿ The accounting for a joint venture is similar to that of equity investments. The two
partners in the joint venture will report their stake in the venture using the equity
method, reporting their share of income from the venture in their respective income
statements.
97
Acquisitions
Ÿ The acquisition method calls for line-by-line consolidation of the investor's financial
statements with the financial statement of the subsidiary, with a recognition of
noncontrolling interest in the consolidated financial statements.
Evaluate corporate divestment actions, including sales and spin offs.
Ÿ When preparing pro forma financial statements, the proceeds from the sale (i.e., cash
or stock of the purchaser and/or assumption of debt) should be accounted for properly.
Ÿ Ratios such as debt-to-EBITDA can then be prepared to evaluate the impact of the sale
on the company's debt ratings.
Ÿ Unlike sales, spin-offs do not generate sale proceeds, and hence are easier to model.
Evaluate cost and balance sheet restructurings.
Ÿ The evaluation of a restructuring announcement involves preparing pro forma financial

statements that reflect our expectations about cost savings, as well as assessing the
likelihood of success in achieving the intended restructuring goals.
Ÿ Given a starting set of financial statements, you should be able to apply the given
assumptions to generate pro forma values
98
Financial Modelling
What is Financial Modelling?

ª Financial Modelling involves modelling Financial Data for Decision Making
ª Financial Modelling Skills are applied to variety of scenarios like Equity Research, Mergers and
Acquisition, Project Finance etc.
ª Financial Modelling Certification at FinTree equips candidates to develop a model from scratch without
using ready-made templates.
What is the Course Content?
We have divided Financial Modelling

Course into Four Parts:
R
Part I: Advance Excel Training
Part II: Building Financial Model

Infrastructure
Part III: Forecasting
Part IV: Valuation
What is the duration of the Course?

ª The duration of one batch is roughly three months. The Certification is provided by FinTree after the
completion of the batch.
ª For classroom, we operate on a club Membership model, wherein, in the same fees, candidates are
allowed to (and encouraged to) attend three more (1+3) subsequent batches. Every batch we pick up
models from different sectors and that provides deeper understanding to the participants.
ª Online course validity : 1 year
To Know more, visit www.fintreeindia.com
FinTree 99
FinTree
CFA® Level II JuiceNotes 2022
© 2022 FinTree Education Pvt. Ltd., All rights reserved.
FinTree Education Pvt. Ltd. FinTree Education Pvt. Ltd.

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16, Bhandarkar Rd, near by TVS Colony, 5th Block,
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Disclaimer: CFA Institute does not endorse, promote, review, or warrant the accuracy or quality of the
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Analyst® are trademarks owned by CFA Institute.
100

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FinTree

Financial Statement Analysis | Corporate Issuers

Chartered Financial Analyst - Level II

ª Quantitative analysis ª Credit risk measurement and management

ª Current issues in ﬁnancial markets

FinTree Placement Services

Our Placement Team purely leverages these contacts to

Financial Statement Modelling

ª Analyst identiﬁes key revenue and cost drivers

Financial statement modeling is not merely a quantitative or accounting

ª Financial statement modeling generally begins with the income statement

Companies receive revenue from multiple sources and can be analyzed by

ª Segment disclosures in companies' ﬁnancial reports are often a rich source of

ª A top-down approach usually begins at the level of the overall economy.

ª In contrast, a bottom-up approach begins at the level of the individual

ª A hybrid approach combines elements of both top-down and bottom-up

Top-Down Approaches to Modeling Revenue

ª Two common top-down approaches to modeling revenue are:

Growth relative to GDP growth

Market growth and market share approach

ª If a company is expected to maintain an 8% market share of a given product

Bottom-Up Approaches to Modeling Revenue

Time series: forecasts Returns-based Capacity-based

Top-Down Approaches to Modeling Revenue

ª Hybrid approaches combine elements of both top-down and bottom-up

Evaluate whether economies of scale are present in an industry by analyzing operating

ª Disclosure about operating costs is frequently less detailed than disclosure

ª More frequently, analysts will be forced to consider costs at a more aggregated

ª In a top-down approach, analysts might consider such factors as the overall

ª In contrast, in a bottom-up approach analysts would start at the company

Sales year 1 = 100

Sales year 2 = 150

Positive Correlation between sales and OPM, Proof of Economies of Scale.

Demonstrate methods to forecast cost of goods sold and operating expenses

ª Forecasting COGS as a percentage of sales and forecasting gross margin

ª Forecasting this item as a percentage of sales is usually a good approach

ª Consider the impact of a company's hedging strategy.

ª Note that diﬀerences in competitors' gross margins do not always indicate a

Demonstrate methods to forecast non-operating items, ﬁnancing costs, and income

ª Interest income depends on the amount of cash and investments on the

ª Interest expense is typically presented net of interest income on the income

Corporate Income Tax

ª Income taxes are primarily determined by the geographic composition of

Statutory Tax Rate Eﬀective Tax Rate Cash Tax Rate

ª Govt of India = 33%

ª PBT = 100, tax Expense = 25

ª Cash Taxes Paid = 17

ª Dividends : A company's stated dividend policy helps in modeling future

ª Equity Method vs Consolidation Method

Evaluate the eﬀects of technological developments on demand, selling prices, costs,

ª Technological developments have the potential to change the economics of

ª When a technological development results in a new product that threatens to

Explain considerations in the choice of an explicit forecast horizon

ª Most professionally managed investment strategies describe the investment

ª Normalized earnings are the expected level of mid-cycle earnings for a

ª One of the greatest challenges facing the analyst is anticipating inﬂection

Describe approaches to balance sheet modeling

ª Some balance sheet line items—such as retained earnings—ﬂow directly from

ª Working capital projections can be modiﬁed by both top-down and bottom-up