2014 Level II I Book SchweserNotes''"' for the CFA\\) Exam Financial Reporting and Analysis and Corporate Finance ® I{ A p LA N SCHOOL OF PROFESSIONAL AND CONTINUING EDUCATION BooK - FINANCIAL REPORTING AND ANALYSIS AND CORPORATE FINANCE Readings and Learning Outcome Statements Study Session - Financial Reporting and Analysis: Inventories and Long-lived Assets 10 Study Session - Financial Reporting and Analysis: lntercorporate Investments, Post-Employment and Share-Based Compensation, and Multinational Operations 68 Study Session - Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis 163 Self-Test - Financial Reporting and Analysis 221 Study Session - Corporate Finance 229 Study Session - Corporate Finance: Financing and Control Issues 321 Self-Test - Corporate Finance 390 Formulas 394 lndex 399 SCHWESERNOTES™ 2014 CFA LEVEL II BOOK 2: FINANCIAL REPORTING AND ANALYSIS AND CORPORATE FINANCE ©2013 Kaplan, Inc All rights reserved Published in 2013 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4277-4911-6 I 1-4277-4911-6 PPN: 3200-4012 If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation of global copyright laws Your assistance in p ursuing potential violators of this law is greatly appreciated Required CFA Institute disclaimer: "CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute CFA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan Schweser." Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "Copyright, 2013, CFA Institute Reproduced and republished from 2014 Learning Outcome Statements, Level I, II, and III questions from CFA ® Program Materials, CFA Institute Standards of Professional Conduct, and CFA lnstitute's Global Investment Performance Standards with permission from CFA Institute All Rights Reserved " These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth by CFA Institute in their 2014 CFA Level II Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review of the Financial Reporting and Analysis, and Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute STUDY SESSION Reading Assignments Financial Reporting and Analysis, CFA Program Curriculum, Volume 2, Level II (CFA Institute, 2013) 17 Inventories: Implications for Financial Statements and Ratios 18 Long-lived Assets: Implications for Financial Statements and Ratios page 10 page 34 STUDY SESSION Reading Assignments Financial Reporting and Analysis, CFA Program Curriculum, Volume 2, Level II (CFA Institute, 2013) 19 Intercorporate Investments 20 Employee Compensation: Post-Employment and Share-Based 21 Multinational Operations page 68 page 101 page 124 STUDY SESSION Reading Assignments Financial Reporting and Analysis, CFA Program Curriculum, Volume 2, Level II (CFA Institute, 2013) 22 The Lessons We Learn 23 Evaluating Financial Reporting Quality 24 Integration of Financial Statement Analysis Techniques page 163 page 172 page 200 STUDY SESSION Reading Assignments Corporate Finance, CFA Program Curriculum, Volume 3, Level II (CFA Institute, 2013) 25 Capital Budgeting 26 Capital Structure 27 Dividends and Share Repurchases: Analysis ©201 Kaplan, Inc page 229 page 276 page 295 Page Book - Financial Reporting and Analysis and Corporate Finance Readings and Learning Outcome Statements STUDY SESSION Reading Assignments Corporate Finance, CFA Program Curriculum, Volume 3, Level II (CFA Institute, 2013) 28 Corporate Governance 29 Mergers and Acquisitions page 321 page 340 LEARNING OUTCOME STATEMENTS (LOS) The CPA Institute Learning Outcome Statements are listed below These are repeated in each topic review; however, the order may have been changed in order to get a better fit with the flow of the review STUDY SESSION The topical coverage corresponds with the following CPA I nstitute assigned reading: 17 Inventories: Implications for Financial Statements and Ratios The candidate should be able to: a calculate and explain how inflation and deflation of inventory costs affects the financial statements and ratios of companies that use different inventory valuation methods (page 10) b explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios (page 15) c convert a company's reported financial statements from LIFO to FIFO for purposes of comparison (page 22) d describe the implications of valuing inventory at net realisable value for financial statements and ratios (page 23) e analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods (page 25) f explain issues that analysts should consider when examining a company's inventory disclosures and other sources of information (page 27) The topical coverage corresponds with the following CPA Institute assigned reading: 18 Long-lived Assets: Implications for Financial Statements and Ratios The candidate should be able to: a explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios (page 34) b explain and evaluate how the different depreciation methods for property, plant, and equipment affect financial statements and ratios (page 41) c explain and evaluate how impairment and revaluation of property, plant, and equipment, and intangible assets affect financial statements and ratios (page 46) d analyze and interpret financial statement disclosures regarding long-lived assets (page 49) e explain and evaluate how leasing assets instead of purchasing them affects financial statements and ratios (page 51) f explain and evaluate how finance leases and operating leases affect finan cial statements and ratios from the perspective of both the lessor and the lessee (page 51) Page ©2013 Kaplan, Inc Book - Financial Reporting and Analysis and Corporate Finance Readings and Learning Outcome Statements STUDY SESSION The topical coverage corresponds with the following CFA Institute assigned reading: 19 lntercorporate Investments The candidate should be able to: a describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities (page 68) b distinguish between IFRS and U.S GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities (page 68) c analyze how different methods used to account for intercorporate investments affect financial statements and ratios (page 90) The topical coverage corresponds with the following CFA Institute assigned reading: 20 Employee Compensation: Post-Employment and Share-Based The candidate should be able to: a describe the types of post-employment benefit plans and implications for financial reports (page 101) b explain and calculate measures of a defined benefit pension obligation (i.e., present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset) (page 102) c describe the components of a company's defined benefit pension costs (page 106) d explain and calculate the effect of a defined benefit plan's assumptions on the defined benefit obligation and periodic pension cost (page 109) e explain and calculate how adjusting for items of pension and other postemployment benefits that are reported in the notes to the financial statements affects financial statements and ratios (page 111) f interpret pension plan note disclosures including cash flow related information (page 112) g explain issues associated with accounting for share-based compensation (page 113) h explain how accounting for stock grants and stock options affects financial statements, and the importance of companies' assumptions in valuing these grants and options (page 114) The topical coverage corresponds with the follo wing CFA Institute assigned reading: 21 Multinational Operations The candidate should be able to: a distinguish among presentation currency, functional currency, and local currency (page 124) b describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses (page 125) c analyze how changes in exchange rates affect the translated sales of the subsidiary and parent company (page 126) ©201 Kaplan, Inc Page Book - Financial Reporting and Analysis and Corporate Finance Readings and Learning Outcome Statements d compare the current rate method and the temporal method, evaluate how each affects the parent company's balance sheet and income statement, and determine which method is appropriate in various scenarios (page 126) e calculate the translation effects and evaluate the translation of a subsidiary's balance sheet and income statement into the parent company's presentation currency (page 132) f analyze how the current rate method and the temporal method affect a company's financial statements and ratios (page 140) g analyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial statement and ratios (page 144) h describe how multinational operations affect a company's effective tax rate (page 147) explain how changes in the components of sales affect earnings sustainability (page 148) J· analyze how currency fluctuations potentially affect financial results, given a company's countries of operation (page 149) STUDY SESSION The topical coverage corresponds with the following CFA Institute assigned reading: 22 The Lessons We Learn The candidate should be able to: a distinguish among various definitions of earnings (e.g., EBITDA, operating earnings, net income, etc.) (page 164) b explain how trends in cash flow from operations can be more reliable than trends in earnings (page 165) c describe the accounting treatment for derivatives being used to hedge exposure to changes in the value of assets and liabilities, exposure to variable cash flows, and foreign currency exposure of investments in foreign corporations (page 165) The topical coverage corresponds with the following CFA Institute assigned reading: 23 Evaluating Financial Reporting Quality The candidate should be able to: a contrast cash-basis and accrual-basis accounting, and explain why accounting discretion exists in an accrual accounting system (page 172) b describe the relation between the level of accruals and the persistence of earnings and relative multiples that the cash and accrual components of earnings should rationally receive in valuation (page 17 4) c explain opportunities and motivations for management to intervene in the external financial reporting process and mechanisms that discipline such intervention (page 175) d describe earnings quality and measures of earnings quality, and compare the earnings quality of peer companies (page 177) e explain mean reversion in earnings and how the accrual component of earnings affects the speed of mean reversion (page 181) f dxplain potential problems that affect the quality of financial reporting, including revenue recognition, expense recognition , balance sheet issues, and cash flow statement issues, and interpret warning signs of these potential problems (page 182) Page ©2013 Kaplan, Inc Book - Financial Reporting and Analysis and Corporate Finance Readings and Learning Outcome Statements The topical coverage corresponds with the fallowing CPA Institute assigned reading: 24 Integration of Financial Statement Analysis Techniques The candidate should be able to: a demonstrate the use of a framework for the analysis of financial statements, given a particular problem, question, or purpose (e.g., valuing equity based on comparables, critiquing a credit rating, obtaining a comprehensive picture of financial leverage, evaluating the perspectives given in management's discussion of financial results) (page 200) b identify financial reporting choices and biases that affect the quality and comparability of companies' financial statements, and explain how such biases affect financial decisions (page 201) c evaluate the quality of a company's financial data, and recommend appropriate adjustments to improve quality and comparability with similar companies, including adjustments for differences in accounting standards, methods, and assumptions (page 214) d evaluate how a given change in accounting standards, methods, or assumptions affects financial statements and ratios (page 216) e analyze and interpret how balance sheet modifications, earnings normalization, and cash flow statement related modifications affect a company's financial statements, financial ratios, and overall financial condition (page 209) STUDY SESSION The topical coverage corresponds with the fallowing CPA Institute assigned reading: 25 Capital Budgeting The candidate should be able to: a calculate the yearly cash flows of expansion and replacement capital projects, and evaluate how the choice of depreciation method affects those cash flows (page 232) b explain the effects of inflation on capital budgeting analysis (page 239) c evaluate capital projects and determine the optimal capital project in situations of 1) mutually exclusive projects with unequal lives, using either the least common multiple of lives approach or the equivalent annual annuity approach, and 2) capital rationing (page 240) d explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project (page 244) e explain and calculate the discount rate, based on market risk methods, to use in valuing a capital project (page 247) f describe types of real options and evaluate a capital project using real options (page 248) g describe common capital budgeting pitfalls (page 25 1) h calculate and interpret accounting income and economic income in the context of capital budgeting (page 252) distinguish among the economic profit, residual income, and claims valuation models for capital budgeting and evaluate a capital project using each (page 256) ©2013 Kaplan, Inc Page Book - Financial Reporting and Analysis and Corporate Finance Readings and Learning Outcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: 26 Capital Structure The candidate should be able to: a explain the Modigliani-Miller propositions regarding capital structure, including the effects of leverage, taxes, financial distress, agency costs, and asymmetric information on a company's cost of equity, cost of capital, and optimal capital structure (page 276) b describe the target capital structure and explain why a company's actual capital structure may fluctuate around its target (page 284) c describe the role of debt ratings in capital structure policy (page 284) d explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation (page 285) e describe international differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis (page 286) The topical coverage corresponds with the following CFA Institute assigned reading: 27 Dividends and Share Repurchases: Analysis The candidate should be able to: a compare theories of dividend policy, and explain implications of each for share value given a description of a corporate dividend action (page 295) b describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey (page 296) c explain how clientele effects and agency issues may affect a company's payout policy (page 297) d explain factors that affect dividend policy (page 299) e calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems (page 300) f compare stable dividend, constant dividend payout ratio, and residual dividend payout policies, and calculate the dividend under each policy (page 302) g explain the choice between paying cash dividends and repurchasing shares (page 305) h describe broad trends in corporate dividend policies (page 308) calculate and interpret dividend coverage ratios based on 1) n et income and 2) free cash flow (page 309) J· identify characteristics of companies that may not be able to sustain their cash dividend (page 309) STUDY SESSION The topical coverage corresponds with the following CFA Institute assigned reading: 28 Corporate Governance The candidate should be able to: a describe objectives and core attributes of an effective corporate governance system, and evaluate whether a company's corporate governance has those attributes (page 321) b compare major business forms, and describe the conflicts of interest associated with each (page 322) Page ©2013 Kaplan, Inc Book - Financial Reporting and Analysis and Corporate Finance Readings and Learning Outcome Statements c d e f g h explain conflicts that arise in agency relationships, including manager-shareholder conflicts and director-shareholder conflicts (page 323) describe responsibilities of the board of directors , and explain qualifications and core competencies that an investment analyst should look for in the board of directors (page 325) explain effective corporate governance practice as it relates to the board of directors, and evaluate strengths and weaknesses of a company's corporate governance practice (page 325) describe elements of a company's statement of corporate governance policies that investment analysts should assess (page 328) describe environmental, social, and governance risk exposures (page 328) explain the valuation implications of corporate governance (page 330) The topical coverage corresponds with the following CPA Institute assigned reading: 29 Mergers and Acquisitions The candidate should be able to: a classify merger and acquisition (M&A) activities based on forms of integration and relatedness of business activities (page 340) b explain common motivations behind M&A activity (page 341) c explain bootstrapping of earnings per share (EPS) and calculate a company's postmerger EPS (page 344) d explain, based on industry life cycles, the relation between merger motivations and types of mergers (page 346) e contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management (page 347) f distinguish among pre-offer and post-offer takeover defense mechanisms (page 350) g calculate and interpret the Her6ndahl- Hirschman Index, and evaluate the likelihood of an antitrust challenge for a given business combination (page 353) h compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each (page 367) calculate free cash flows for a target company, and estimate the company's intrinsic value based on discounted cash flow analysis (page 355) J· estimate the value of a target company using comparable company and comparable transaction analyses (page 360) k evaluate a takeover bid, and calculate the estimated post-acquisition value of an acquirer and the gains accrued to the target shareholders versus the acquirer shareholders (page 368) explain how price and payment method affect the distribution of risks and benefits in M&A transactions (page 372) m describe characteristics of M&A transactions that create value (page 373) n distinguish among equity carve-outs, spin-offs, split-offs, and liquidation (page 373) o explain common reasons for restructuring (page 374) ©2013 Kaplan, Inc Page Study Session Cross-Reference to CFA Institute Assigned Reading #29 - Mergers and Acquisitions 19 C The calculation for the fair acquisition price under the comparable transaction approach is shown in the following figures: Company Statistics Takeover pnce Bullseye Dart Industries Arrow Corp $22.00 $35.00 $52.00 PIE Ratio $22 00 I 0.95 PIB Ratio $22.00 I 6.1 o = 3.61 $35.00 I 9.85 PIS Ratio $22.00 I 17.60 $35.00 I 26.75 Company Statistics = 23 16 = M ean 1.25 $35.00 I 1.65 = 21.21 $52.00 I 2.50 3.55 $52 00 I 14.20 1.31 $52.00 I 39.75 = = Flueger Systems Statistics = Mean 20.80 21.72 = 3.66 3.61 = 1.31 1.29 Flueger Systems Valuation PIE Ratio 21.72 1.75 $38.01 PIBRatio 3.61 9.75 $35.20 PIS Ratio 1.29 29.75 $38.38 Fair acquisition value using the comparable transaction approach: $37.20 20 B Both Collier's statement and Baldwin's statement are incorrect Collier suggests using a fair price amendment after the takeover is announced; however, a fair price amendment is a pre-offer defense, not a post-offer defense Baldwin's statement is incorrect because he is actually describing a white squire defense, not a white knight defense ©2013 Kaplan, Inc Page 389 SELF-TEST: CORPORATE FINANCE Use the following information for Questions through The CEO of Edgington Enterprises, Nicole Johnson, is conferring with her finance staff regarding the plans for capital projects during the upcoming year Like most firms, Edgington is capital constrained, and Johnson wants to make the most out of what is available During the meeting, several issues are raised While inflation has recently been low, some evidence is present in the commodities markets to suggest that it could become a concern during the life of even a mediumterm project Johnson knows that inflation can have a significant impact on project selection The staff is asked how an increase in the rate of inflation might affect the capital budgeting process The following data pertains to two capital proj ects currently under consideration The cost of both projects is $30,000,000 Net Present Value Life in Years Project Andover $35,000,000 Project Baltimore $25,000,000 Johnson informs the staff that it appears that the firm will have only $30, 000,000 available for investment during the upcoming year, so a choice will have to be made The finance staff estimates that the firm's after-tax WACC is 5% In recent months, there has been a vigorous discussion in the financial press about the need to manage risk During this past November, Johnson attended a 3-day seminar on risk management at the University of Chicago One of the key points made by seminar faculty was that reducing risk, even if there is a cost incurred to so, can increase firm value Johnson has asked the finance team how project risk is evaluated, and what type of risk is being measured during the capital budgeting process Another key point made during the seminar was that some projects are not well evaluated with traditional capital budgeting methods , such as NPV These are projects that require management to make critical decisions after the commitment to undertake the project has been made, and at least part of the project's capital has been invested She wonders if the finance staff is familiar with the evaluation of such projects As the meeting was coming to a close, Marques Wilson, CFA, suggested to the staff that it may be useful to try to connect project performance with incremental changes in firm value To this end, he suggests that it may be useful to attempt to m easure a project's economic profits These can be used to infer how the project is affecting overall firm value Johnson charged the staff with giving consideration to the matters raised during the meeting before they reconvene at the end of the week Page 390 ©2013 Kaplan, Inc Self-Test - Corporate Finance After work, Johnson heads out to teach a CFA review course for her local society The topic for that evening coincides with her work in corporate finance, but focuses more on mergers and acquisitions She presents the class with the following case study: Toulouse Tempered Steel Industries {TTS) is weighing its strategic options following a wave of mergers in the industry across Europe and worldwide Pascal LaPage, managing director of TTS is wondering whether it makes sense for the firm to position itself as a standalone entity, or if the firm should be pursuing a merger/ acquisition of another firm that would provide a good strategic fit Lyon Bank has been the firm's primary lender for many years, and Alaine Clamon, CFA, from Lyon's corporate finance department is due to meet with LaPage and other members of the firm's finance group to discuss some strategic options Clamon begins his presentation with the underlying rationale for even considering a merger or acquisition as a strategic alternative Some reasons cited by Clamon that can be used to justify a merger are the pursuit of economies of scale, the elimination of operating inefficiencies, and diversification of the firm's assets In general, the underlying rationale helps to determine what type of merger the firm will be undertaking LaPage asks his staff to keep these in mind as they seek suitable candidates for evaluation LaPage's team has already identified two firms that might be good acquisition candidates for TTS One is Aragon Metals, and the other is Brittany Engineered Products A member of the staff asks Claman about types of takeover defenses that might by employed by either Aragon or Brittany Clamon replies that these fall broadly into two categories: pre-offer and post-offer defenses As examples of preoffer defenses, he describes staggered boards and supermajority voting provisions As an example of post-offer defenses, he describes asset restructuring He notes that, obviously, TTS must take care to account for the ramifications of the presence of any takeover defenses The three categories of cash flows that are typically associated with a capital project are: A financing, operating, and terminal year B initial investment outlay, operating, and financing C initial investment outlay, operating, and terminal year Suppose that there are two scenarios for projects Andover and Baltimore Under Scenario 1, the projects cannot be replicated, while under Scenario 2, the projects can be replicated Which project should be accepted? Scenario Scenario A Andover Baltimore Andover B Andover C Baltimore Andover When the value of a given project is contingent upon future decisions of management, the project can be best described as containing: A real options B flexibility options C timing options ©201 Kaplan, Inc Page 391 Self-Test - Corporate Finance Page 392 Suppose that the firm has a project code named Richmond The dollar amount of the investment in Richmond is $40 million Last year, Richmond's EBIT was $6 million If the relevant tax rate is 35%, what was Richmond's economic profit during the past year? A $900,000 B $3,900,000 C $2, I 00,000 With regard to the list of sensible motives for undertaking a merger cited by Clamon in Johnson's case study, he is: A correct with regard to operating inefficiencies, and correct with regard to diversification B correct with regard to operating inefficiencies, but incorrect with regard to diversification C incorrect with regard to operating inefficiencies, but correct with regard to diversification With respect to the takeover defenses described by Clamon, h e is: A incorrect with regard to the pre-offer defenses listed, and incorrect with regard to the post-offer defense listed B incorrect with regard to the pre-offer defenses listed, but correct with regard to the post-offer defense listed C correct with regard to the pre-offer defenses listed, and correct with regard to the post-offer defense listed ©201 Kaplan, Inc Self-Test - Corporate Finance SELF-TEST ANSWERS: CORPORATE FINANCE C The rhree typical categories regarding capital project cash flows are initial investment ouday, operating, and terminal year A If rhe projects cannot be replicated, rhen rhe project wirh rhe grearesr NPV should be selected, and rhis is Andover If rhe projects can be replica red, we can evaluate rhe projects using either a least common lives approach or an equivalent annual annuity approach The least common multiple of the projects' lives is 40 years, and rhe replacement chain NPVs are $75.25 million for Andover and $77.83 million for Baltimore The equivalent annual annuity values are $5.975 million for Andover and $6.179 million for Baltimore Borh methods indicate rhat Baltimore should be chosen if rhe projects can be replicated A When a project's value is a function of managerial decisions rhar musr be made in periods following rhe invesrmenr, rhe project is said ro contain real options The orher answers are simply rypes of real options rhar may be present in a project A The economic profit is calculated as: EP = NOPAT - $WACC = $6(1 - 0.35) - $40 (0.07 5) = $0.9 million B Pursuing a merger where rhe underlying rationale is ro eliminate operating inefficiencies is generally considered sensible A merger in pursuit of diversification is generally nor seen as sensible, since it is ordinarily much more cost-effective for shareholders ro diversify on their own C In borh cases, Claman has correcrly provided examples of pre-offer and posr-offer takeover defenses ©2013 Kaplan, Inc Page 393 FORMULAS STUDY SESSIONS 5, 6, AND 7: FINANCIAL REPORTING AND ANALYSIS ending inventory = beginning inventory + purchases - COGS FIFO inventory = LIFO inventory + LIFO reserve FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve) accumulated depreciation average age = depreoation expense bl c ending gross investment average deprec1a e 1Ire = depreoanon expense remammg use ful c 1Ire = ending net investmenc depreciation expense funded status of the plan: funded status = fair value of plan assets - PBO total periodic pension cost = contributions - (ending funded status - beginning funded status) accruals 85 = N OAEND - N OABEG accruals ratio BS = (NOAEND - NOABEG) -~~ -~~- (NOA END+ NOABEG ) / accrualsCF = NI - CFO - CFI accruals ratio CF (NI - CFO - CFI) = (NOA END+ NOABEG ) / sales - COGS - SG&A core operatmg margm = - - - - - - - - sales Professor's Note: Not all of the following ratios are used in this book However, this list includes most of the common ratios that you are likely to encounter on exam day current assets current r a t i o = - - - - - - currenc liabilities Page 394 ©2013 Kaplan, Inc Book - Financial Reporting and Analysis and Corporate Finance Formulas k cash +marketable securities+ receivables qmc ratio = - - - - - - - - - - - - - - - - current liabilities cash+ short-term marketable securities cas h ratio= - - - - - - - - - - - - - - - current liabilities defensive interval ratio = (cash + short-term marketable investments + receivables) daily cash expenditures + net annual sales receivables turnover = - - - - - - average receivables ble co11ectton per10 d= average receiva 365 receivables turnover cost of goods sold inventory turnover = - - - - - - - average mventory days of sales outstanding (DSO) = 365 receivables turnover ratio 365 days of inventory on hand (DOH)= -.- - - - - mventory turnover purchases payables turnover = - - - - - - average payables 365 number of days of payables = - - - - - - payables turnover net sales total asset turnover = - - - - - - - - average total net assets net sales fixed asset turnover = - - - - - - - - average net fixed assets STUDY SESSIONS AND 9: CORPORATE FINANCE outlay = FClnv + NWCinv ©2013 Kaplan, Inc Page 395 Book - Financial Reporting and Analysis and Corporate Finance Formulas after-tax operating cash flow (CF) = (S - C - 0)(1 - T) + D = (S-C)(l -T) +(TD) TNOCF = SalT + NWCinv - T (SalT - BT) economic income = cash flow+ (ending market value - beginning market value) or economic income = cash flow - economic depreciation economic profit: EP = NOPAT - $WACC market value added: NPV = MVA = f: (i + wAccr EPr t= l residual income = net income - equity charge project cost of equity = Rp + ~project [E(RMKT )- Rp ] weighted average cost of capital: WACC = [rd x (1 - t)( debt )] + [re x (equity)] assets assets MM Proposition I (no taxes): V L = Vu MM Proposition II (no taxes): re = r0 + D ( r0 - rd) E MM Proposition I (with taxes): V1 =Vu+ (t x d) MM Proposition II (with taxes): re = r0 + D (r0 - rd )(I - Tc) E static trade-off theory: VL = Vu + ( t x d) - PV (costs of financial distress) (1- To) change in price when stock goes ex-dividend: 6.P = - - - ( 1- TcG) Page 396 ©2013 Kaplan, Inc Book - Financial Reporting and Analysis and Corporate Finance Formulas effective tax rate= corporate tax rate + (1 - corporate tax rate)(individual tax rate) l[ l( ) rev10us ad ustment target ) [expected Jf expected d1v1dend = ( Pd d d + mcrease x payout x 1v1 en EPS actor m ratio FCFE coverage ratio = FCFE I (dividends + share repurchases) n Herfindahl-Hirschman Index: HHI = l:: (MSi xl00) i = free cash flow: Net income + Net interest after tax = Unlevered net income ± Change in deferred taxes =Net operating profit less adjusted taxes (NOPLAT) + Net noncash charges ±Change in net working capital - Capital expenditures (capex) = Free cash flow (FCF) terminal value: TVT = FCFy (l + g) (WACCadjusred -g) or TVT = FCFT x (PI FCF) takeover premium: TP = DP - SP SP post-merger value of an acquirer: VAT =VA +VT + S - C gain to target: GainT = TP = PT - VT gain to acquirer: GainA = S-TP = S-(PT - VT) price of target in stock deal: PT = (N X PAT) gross profit gross profit margm = - - - - net sales ©201 Kaplan, Inc Page 397 Book - Financial Reporting and Analysis and Corporate Finance Formulas operating profit operatmg profit margm = -= -~= net sales EBIT net sales net income net profit margm = - - - - net sales net income return on assets= - - - - - - - average total assets EBIT return on total capital= - - - - - - - - - - - - - - - - - (interest bearing debt+ shareholders' equity) return on total eqmty = net income average total equity to cal assets financial leverage ratio = - - - - total equity long-term debt-to-equity ratio debt - to - eqwty ratio = total long-term debt total equity total debt total equ1ty shore-term debt+ long-term debt al d eb t- to - capit ratio = - - - - - - - - - - - - - - - - - - short-term debt+ long-term debt + total equity EBIT interest coverage = - - - - - - mterest expense dividends paid payout ratio = n et mcome retention ratio = - payout ratio h earmngs per s are = net income - preferred dividends average common shares outstanding b ook val ue per sh are = Page 398 common stockholders' equity total number of common shares outstanding ©2013 Kaplan, Inc INDEX A abandonment options 248 abnormal sales growth 188 accelerated depreciation 42 accounting income 252 accounting scandals 163 accounts receivable risk 166 sale 193 turnover 186 accrual basis 172 accruals 174 accruals ratio 177, 210 accrued expenses 175 accrued revenue 175 acquirer 340 acquisition 80, 340 acquisition goodwill 84 acquisition method 81 after-tax operating cash flows (CF) 233 agency costs of equity 280 agency issues 298 agency relationship 323 amortized cost 70, 75 anticiparing changing accounting standards 216 asset base 204 asset purchase 348 asset's economic life 185 available-for-sale securities 70 average age 49 average depreciable life 50 average rate 128 B backward integration 34 balance sheet approach 177 bargain purchase option 52, 185 barter transactions 188 bear hug 350 benefits paid 103 best practices 325 bill and hold 188 bird-in-hand argument 295 board of directors 176 attributes 325 bond ratings Moody's 285 Standard & Poor's 285 bootstrap effect 344 bootstrapping 344 bootstrapping EPS 343 business combinations 68, 80, c capital allocation decisions 207 capital asset pricing model (CAPM) 247 capital budgeting initial investment outlay 232 process 229 capitalized 34 capitalized interest 36 capital lease 51, 185, 190 capital markets 175 capital rationing 243 capital structure 205, 276, 286 carrying value 79 cash basis 172 cash collections 187 cash flow hedge 166 ignoring 186, 193 managing 186, 193 misclassified 185, 193 cash offer 369, 372 cash offerings 349 certification by senior management 176 changes in actuarial assumptions 103 channel stuffing 188 claims valuation approach 259 class action litigation 176 clean-surplus accounting 147 clientele effect 297 collateralized borrowing arrangement 193 comparable company analysis 360, 367 comparable transaction analysis 364, 367 conflict between directors and shareholders 324 conglomerate merger 34 consolidation 80, 34 Consolidation of Variable Interest Entities 88 constant dividend payout ratio policy 303 contractual and legal restrictions 300 contractual provisions 176 corporate governance 321 corporations 322 costs of asymmetric information 281 costs of financial distress and bankruptcy 280 crown jewel defense 352 cumulative translation adjustment (CTA) 128, 131 ©2013 Kaplan, Inc Page 399 Book - Financial Reporting and Analysis and Corporate Finance Index current rate 128 current rate method 132 current service cost 103 D days' inventory on hand (DOH) 188 days' inventory outstanding 188 days' sales outstanding (DSO) 186 debt covenants 176, 300 debt ratings 284 decline phase 346 deferred expenses 175 deferred revenue 129 deferred tax asset (DTA) 193 deferred tax liabilities 42 defined-benefit p Ian 101 defined-contribution plan 101 depreciating environment 129 depreciation 41, 233 depreciation estimates 174 derivatives 166 designated fair value 70 direct financing lease 58, 59 dirty-surplus 147 disclosures 164 discounted cash fl.ow (DCF) analysis 355, 367 discount rate 109 disproportionate quarterly revenues 188 divestitures 373 dividend coverage ratio 309 dividend initiation 296 dividend payout ratio 309 dividend policy 295 dividend safety 309 double-declining balance method 42 double-taxation system 300 downstream sale 80 DuPont equation 202 E earnings before interest and taxes (EBIT) 164 earnings before interest, taxes, depreciation, and amortization (EBITDA) 164 earnings quality 177, 209 economic income 252 economic profit 256 effective corporate governance system 322 effective tax rate 147 effect of paym ent method 372 Enron 164 equity carve-outs 374 equity method 75 equivalent annual annuity (EAA) approach 242 Page 400 excess of purchase price over book value acquired 77 exchange ratio 349 executive compensation 176 expansion options 248 expansion project analysis 233 expected return on plan assets 109 expected volatility of future earnings 299 expensed 34 expense recognition 183 expense recognition problems 188 expenses delaying 184, 189 unden~cing 183, 188 externalities 230 F fair price amendment 351 fair value 70 hedge 166 fair value through other comprehensive income (FVOCI) 75 fair value through profit or loss (FVPL) 75 FIFO COGS 129 finance lease 51, 185 financial assets impairment of 73 reclassification of investments in 72 financial flexibility 299 financial markets and banking system factors 286 first-in, first-out (FIFO) 11, 129 flexibility 249 flip-in pill 351 fl.i p-over pill flotation costs 300 forecast error 176 forecasting cash flows 174 foreign currency disclosure 146 foreign exchange gains and losses foreign exchange risk 166 form of acquisition 347 forms of integration 341 forward integration 341 free cash fl.ow (FCF) 355 friendly merger offers 349 full goodwill 84 functional currency 124 fundamental options 249 funded status of the plan 102 ©2013 Kaplan, Inc Book - Financial Reporting and Analysis and Corporate Finance Index G J gains accrued to the acquirer 369 gains accrued to the target 369 general market scrutiny 176 golden parachutes 351 goodwill 77, 84, 184, 185, 192 goodwill impairment 86 greenmail 352 gross investment 50 joint ventures 69, 87 "just say no" defense 352 L hard capital rationing 243 held-for-trading securities 70 held-to-maturity securities 70 Herfindahl-Hirschman Index (HHI) 353 historical rate 128 homemade dividends 295 horizontal merger 341 hostile merger offers 350 hurdle rate 248 hyperinflationary environment 144 last-in, first-out (LIFO) 12, 129 LIFO conformity rule 11 LIFO liquidation 20 LIFO reserve 15 lease 51 lease disclosures 56 least common multiple of lives approach 240 lessee 51, 52 lessor 51 leveraged recapitalization 352 LIFO COGS 129 LIFO liquidation 20, 189 LIFO reserve 16 liquidations 374 local currency 124 long-term residual dividend 305 I M identifiable asset 84 impairment 46, 79 goodwill 185 loss 86 impairment of capital rule 300 impairment testing 86 implied fair value of the goodwill 86 imputation tax system 301 independent audit 176 industry life cycle 346 information asymmetry 296 institutional and legal facrors 286 intangible assets 40 intercorporate investments 68 interest cost 103 interest coverage ratio 36, 140 interest rate risk 166 internal control system 176 internal development costs 40 International Financial Reporting Standards (IFRS) 146 inventory accounting methods 10 inventory cost flow assumptions 174 inventory cost flow method 23 inventory valuation method 23 investment in net working capital (NWCinv) 232 investment opportunities 299 investment opportunity schedule (IOS) 304 investments in associates 68, 69, 75 investments in financial assets 68 macroeconomic factors 287 management discussion and analysis 146, 163 manipulative behavior 175 market 23 market value added (MVA) 256 market value decomposition 212 mature growth phase 346 merger 80, 340 merger synergies, estimating 372 method of payment 349 minority interest account 81 mixed rate 132 mixed ratio 140 MM Proposition II (no taxes) 278 MM Proposition II (with taxes) 279 MM Proposition I (no taxes) 276 MM Proposition I (with taxes) 279 MM's capital structure irrelevance proposition 277 modified accelerated cost recovery system (MACRS) 42, 231 monetary asset (liability) 128 Monte Carlo simulation 246 multinational firm 124 multinational organization 124 mutually exclusive projects with different lives 240 H ©2013 Kaplan, Inc Page 401 Book - Financial Reporting and Analysis and Corporate Finance Index N net investment hedge of a foreign subsidiary 166 net monetary liability exposures 130 net realizable value 23 noncash transactions 186 noncontrolling interest 82, 85 nonmonetary asset (liability) 129 obsolete inventory 188 off-balance sheet 88 off-balance-sheet financing 54, 184, 190, 214 offsetting dilution 305 operating cash flow 164 operating earnings 164 operating expenses, nonoperatmg 184 operating expenses, nonrecurring 184, 190 operating lease 51 , 60, 184, 190 operating lease adjustments 215 opportunity costs 230 other post-employment benefits 102 p Pac-man defense 353 partial goodwill 84 partnerships 322 past (prior) service costs 103 payout policy 295 pecking order theory 281 pension assumptions 174 percentage of ownership (or voting control) 68 periodic system 14 perpetual system 14 pioneer/development phase 346 plug figure 131 poison pill 350 poison put 351 pooling of interests method 81 positive earnings surprise 176 post-merger value of an acquirer 368 post-offer defense mechanisms 352 pre-offer defense mechanisms 350 presentation currency 124 present value of defined benefit obligation (PVDBO) 102 price index 144 price risk 166 price-setting options 249 primary beneficiary 88 principal-agent problem 323 probability of financial distress 280 production-flexibility options 249 Page 402 pro-forma earnings 165 projected benefit obligation 102 proxy battle 350 purchasing power gain (loss) 144 pure balance sheet ratio 140 pure income statement ratio 140 R rapid growth phase 346 rate of compensation growth 109 real options 248 receivables, sale with recourse 193 recoverability test 46 regulators 176 remaining useful life 50 remeasurement 126 rent expense 185 replacement cost 23 replacement project analysis 237 reporting currency 124 research and development 186 purchased in-process 192 research and development costs 40 residual dividend model 304 residual income 257 restricted voting rights 351 restrictive takeover laws 35 restructuring charge 165 return on equity (ROE) 202 revaluation to fair value 48 revenue accelerating 183 misstating 182 nonoperating 183 nonrecurring 183 revenue recognition 174, 182 detecting acceleration 187 detecting misstatements 186 reverse synergy 374 s sales-type lease 58 salvage values 44, 184 scenario analysis 246 sector neutralizing 182 securities offering 349 Security Market Line (SML) 247 segment reporting 207 sensitivity analysis 244 share repurchase 352 share repurchase using borrowed funds 308 significant influence 69 simulation analysis 246 soft capital rationing 243 ©2013 Kaplan, Inc Book - Financial Reporting and Analysis and Corporate Finance Index software development costs 40, 41 sole proprietorships 322 special purpose entity (SPE) 88, 193 specific identification method 11 spin-offs 374 split-offs 374 split-rate 301 stabilization phase 346 stable dividend policy 302 staggered board 351 static trade-off theory 282, 283 statutory merger 341 statutory tax rate 147 stock offer 369, 372 stock option valuation 174 stock purchase 348 straight-line depreciation 42 strategic manipulation 175, 176 subsidiaries 124 subsidiary merger 341 sunk costs 230 supermajority voting provision 351 synergy 374 systematic risk 247 timing options 248 transaction date 125 transactions with the investee 79 translation 126 translation gain (loss) 128 translation/remeasurement gain or loss 131 transparency 163 types of mergers 341 u ultimate healthcare trend rate 110 unearned revenue 129, 174, 183 unexpected dividend decrease 297 unexpected dividend increase 297 unidentifiable asset 84 uniting of interests method 81 units-of-production method 42 unrealized gains and losses 71 unsystematic risk 247 upstream sale 79 useful life 44 v T takeover premium 361 target 340 target capital structure 284 target payout ratio adjustment model 303 tax aversion 296 tax considerations 299 tax shield provided by debt 279 temporal method 136 tender offer 350 terminal year after-tax non-operating cash flows (TNOCF) 233 valuation allowance 174 value of a levered firm 279, 282 value of an unlevered firm 279 variable interest entity (VIE) 88 vertical merger 341 vested options, "in the money" 187 w weighted average cost method 12 weighted-average method 129 white knight defense 353 white squire defense 353 winner's curse 353 ©201 Kaplan, Inc Page 403 ... Curriculum, Volume 3, Level II (CFA Institute, 20 13) 25 Capital Budgeting 26 Capital Structure 27 Dividends and Share Repurchases: Analysis ? ?20 1 Kaplan, Inc page 22 9 page 27 6 page 29 5 Page Book - Financial... Balance Sheet 20 X6 20 X5 $94 20 5 410 $709 $77 195 380 $6 52 Net plant and equipment $1,800 360 $1,440 $1,700 340 $1,360 Total assets $2, 149 $2, 0 12 $110 21 5 $ 325 715 300 400 409 $2, 149 $90 185 $27 5 785... Cost Per Unit Total Cost 20 X4 120 $10 $1 ,20 0 20 X5 20 X6 20 X7 140 140 160 560 11 12 13 1,540 1,680 2. 080 $6,500 Due to a strike, no units were produced during 20 X8 During 20 X8, Big sold 440 units