PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted BooK - FINANCIAL REPORTING AND ANALYSIS AND CORPORATE FINANCE Readings and Learning Outcome Statements v Study Session - Financial Reporting and Analysis: Inventories and Long-lived Assets Study Session - Financial Reporting and Analysis: lntercorporate Investments, Post-Employment and Share-Based Compensation, and Multinational Operations 59 Study Session - Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis 15 Self-Test - Financial Reporting and Analysis 206 Study Session - Corporate Finance 214 Study Session - Corporate Finance: Financing and Control Issues 307 Self-Test - Corporate Finance 388 Formulas 392 Index 397 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted SCHWESERNOTES™ 2016 LEVEL II CFA® BOOK 2: FINANCIAL REPORTING AND ANALYSIS AND CORPORATE FINANCE ©2015 Kaplan, Inc All rights reserved Published in 2015 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4754-3530-6 PPN: 3200-6842 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 pursuing potential violators of chis law is greatly appreciated Required CFA Institute disclaimer: "CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser CFA ® and Chartered Financial Analyst® are trademarks owned by CFA Institute." Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "Copyright, 2015, CFA Institute Reproduced and republished from 2016 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 2016 Level II CFA 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 Page iv ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted 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 CPA Institute STUDY SESSION Reading Assignments Financial Reporting and Analysis, CFA Program Curriculum, Volume 2, Level II (CFA Institute, 2015) 16 Inventories: Implications for Financial Statements and Ratios 17 Long-lived Assets: Implications for Financial Statements and Ratios page page 25 STUDY SESSION Reading Assignments Financial Reporting and Analysis, CFA Program Curriculum, Volume 2, Level II (CFA Institute, 2015) 18 Intercorporate Investments 19 Employee Compensation: Post-Employment and Share-Based 20 Multinational Operations page 59 page 94 page 119 STUDY SESSION Reading Assignments Financial Reporting and Analysis, CFA Program Curriculum, Volume 2, Level II (CFA Institute, 2015) 21 Evaluating Quality of Financial Reports 22 Integration of Financial Statement Analysis Techniques page 158 page 184 STUDY SESSION Reading Assignments Corporate Finance, CFA Program Curriculum, Volume 3, Level II (CFA Institute, 2015) 23 Capital Budgeting 24 Capital Structure 25 Dividends and Share Repurchases: Analysis ©2015 Kaplan, Inc page 214 page 262 page 281 Page v PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted 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, 2015) 26 Corporate Performance, Governance, and Business Ethics 27 Corporate Governance 28 Mergers and Acquisitions page 307 page 318 page 337 LEARNING OUTCOME STATEMENTS (LOS) The CFA 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 CFA Institute assigned reading: 16 Inventories: Implications for Financial Statements and Ratios The candidate should be able to: a calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods (page 1) b explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios (page 6) c convert a company's reported financial statements from LIFO to FIFO for purposes of comparison (page 13) d describe the implications of valuing inventory at net realisable value for financial statements and ratios (page 14) e analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods (page 16) f explain issues that analysts should consider when examining a company's inventory disclosures and other sources of information (page 18) The topical coverage corresponds with the following CFA Institute assigned reading: 17 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 25) b explain and evaluate how the different depreciation methods for property, plant, and equipment affect financial statements and ratios (page 32) c explain and evaluate how impairment and revaluation of property, plant, and equipment and intangible assets affect financial statements and ratios (page 37) d analyze and interpret financial statement disclosures regarding long-lived assets (page 40) e explain and evaluate how leasing rather than purchasing assets affects financial statements and ratios (page 42) f explain and evaluate how finance leases and operating leases affect financial statements and ratios from the perspectives of both the lessor and the lessee (page 42) Page vi ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Reading and Learning Outcome Statements STUDY SESSION The topical coverage corresponds with the following CFA Institute assigned reading: 18 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 59) b distinguish between IFRS and US 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 59) c analyze how different methods used to account for intercorporate investments affect financial statements and ratios (page 82) The topical coverage corresponds with the following CFA Institute assigned reading: 19 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 94) 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 95) c describe the components of a company's defined benefit pension costs (page 99) d explain and calculate the effect of a defined benefit plan's assumptions on the defined benefit obligation and periodic pension cost (page 104) 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 106) f interpret pension plan note disclosures including cash flow related information (page 108) g explain issues associated with accounting for share-based compensation (page 109) 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 109) The topical coverage corresponds with the following CFA Institute assigned reading: 20 Multinational Operations The candidate should be able to: a distinguish among presentation (reporting) currency, functional currency, and local currency (page 119) b describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses (page 120) c analyze how changes in exchange rates affect the translated sales of the subsidiary and parent company.(page 121) 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 121) ©2015 Kaplan, Inc Page vii PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Reading and Learning Outcome Statements e f g h j 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 127) analyze how the current rate method and the temporal method affect financial statements and ratios (page 135) analyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial statements and ratios (page 139) describe how multinational operations affect a company's effective tax rate (page 142) explain how changes in the components of sales affect the sustainability of sales growth (page 143) analyze how currency fluctuations potentially affect financial results, given a company's countries of operation (page 144) STUDY SESSION The topical coverage corresponds with the following CPA Institute assigned reading: 21 Evaluating Quality of Financial Reports The candidate should be able to: a demonstrate the use of a conceptual framework for assessing the quality of a company's financial reports (page 158) b explain potential problems that affect the quality of financial reports (page 159) c describe how to evaluate the quality of a company's financial reports.(page 162) d evaluate the quality of a company's financial reports (page 162) e describe the concept of sustainable (persistent) earnings (page 165) f describe indicators of earnings quality (page 165) g explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion (page 167) h evaluate the earnings quality of a company (page 167) describe indicators of cash flow quality (page 170) j evaluate the cash flow quality of a company (page 170) k describe indicators of balance sheet quality (page 171) evaluate the balance sheet quality of a company (page 171) m describe sources of information about risk (page 172) The topical coverage corresponds with the following CPA Institute assigned reading: 22 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 184) b identify financial reporting choices and biases that affect the quality and comparability of companies' financial statements, and explain how such biases may affect financial decisions (page 185) 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 199) Page viii ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Reading and Learning Outcome Statements d e evaluate how a given change in accounting standards, methods, or assumptions affects financial statements and ratios (page 200) 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 193) STUDY SESSION The topical coverage corresponds with the following CPA Institute assigned reading: 23 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 217) b explain how inflation affects capital budgeting analysis (page 224) 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 225) 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 230) e explain and calculate the discount rate, based on market risk methods, to use in valuing a capital project (page 233) f describe types of real options and evaluate a capital project using real options (page 234) g describe common capital budgeting pitfalls (page 237) h calculate and interpret accounting income and economic income in the context of capital budgeting (page 238) distinguish among the economic profit, residual income, and claims valuation models for capital budgeting and evaluate a capital project using each (page 242) The topical coverage corresponds with the following CPA Institute assigned reading: 24 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 262) b describe target capital structure and explain why a company's actual capital structure may fluctuate around its target (page 270) c describe the role of debt ratings in capital structure policy (page 270) d explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation (page 271) e describe international differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis (page 272) ©2015 Kaplan, Inc Page ix PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Reading and Learning Outcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: 25 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 281) b describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey (page 282) c explain how clientele effects and agency issues may affect a company's payout policy (page 283) d explain factors that affect dividend policy (page 285) 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 286) f compare stable dividend, constant dividend payout ratio, and residual dividend payout policies, and calculate the dividend under each policy (page 288) g explain the choice between paying cash dividends and repurchasing shares (page 291) h describe broad trends in corporate dividend policies (page 294) calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow.(page 295) j identify characteristics of companies that may not be able to sustain their cash dividend (page 295) STUDY SESSION The topical coverage corresponds with the following CFA Institute assigned reading: 26 Corporate Performance, Governance and Business Ethics The candidate should be able to: a compare interests of key stakeholder groups and explain the purpose of a stakeholder impact analysis (page 307) b discuss problems that can arise in principal-agent relationships and mechanisms that may mitigate such problems (page 309) c Discuss roots of unethical behavior and how managers might ensure that ethical issues are considered in business decision making (page 31 O) d Compare the Friedman doctrine, Utilitarianism, Kantian Ethics, and Rights and Justice Theories as approaches to ethical decision making (page 311) The topical coverage corresponds with the following CFA Institute assigned reading: 27 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 318) b compare major business forms and describe the conflicts of interest associated with each (page 319) c explain conflicts that arise in agency relationships, including managershareholder conflicts and director-shareholder conflicts (page 320) Page x ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Reading and Learning Outcome Statements d e f g h 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 322) 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 322) describe elements of a company's statement of corporate governance policies that investment analysts should assess (page 325) describe environmental, social, and governance risk exposures (page 325) explain the valuation implications of corporate governance (page 327) The topical coverage corresponds with the following CFA Institute assigned reading: 28 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 337) b explain common motivations behind M&A activity (page 338) c explain bootstrapping of earnings per share (EPS) and calculate a company's postmerger EPS (page 341) d explain, based on industry life cycles, the relation between merger motivations and types of mergers (page 343) e contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management (page 344) f distinguish among pre-offer and post-offer takeover defense mechanisms (page 347) g calculate and interpret the Herfindahl-Hirschman Index, and evaluate the likelihood of an antitrust challenge for a given business combination (page 350) 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 364) calculate free cash flows for a target company, and estimate the company's intrinsic value based on discounted cash flow analysis (page 352) j estimate the value of a target company using comparable company and comparable transaction analyses (page 357) 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 365) I explain how price and payment method affect the distribution of risks and benefits in M&A transactions (page 369) m describe characteristics of M&A transactions that create value (page 370) n distinguish among equity carve-outs, spin-offs, split-offs, and liquidation (page 370) o explain common reasons for restructuring (page 371) ©2015 Kaplan, Inc Page xi PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted 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 projects 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 7.5% 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 measure 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 388 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted 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 Clamon 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 the sale of significant assets 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 B Andover 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 ©2015 Kaplan, Inc Page 389 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test - Corporate Finance Page 390 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, 100,000 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, he 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 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test - Corporate Finance SELF-TEST ANSWERS: CORPORATE FINANCE C The three typical categories regarding capital project cash flows are initial investment outlay, operating, and terminal year A If the projects cannot be replicated, then the project with the greatest NPV should be selected, and this is Andover If the projects can be replicated, we can evaluate the 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 the 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 Both methods indicate that Baltimore should be chosen if the projects can be replicated A When a project's value is a function of managerial decisions that must be made in periods following the investment, the project is said to contain real options The other answers are simply types of real options that may be present in a project A The economic profit is calculated as: EP = NOPAT - $WACC = $6(1 - 0.35) - $40(0.075) = $0.9 million B Pursuing a merger where the underlying rationale is to eliminate operating inefficiencies is generally considered sensible A merger in pursuit of diversification is generally not seen as sensible, since it is ordinarily much more cost-effective for shareholders to diversify on their own C In both cases, Claman has correctly provided examples of pre-offer and post-offer takeover defenses ©2015 Kaplan, Inc Page 391 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted 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) average age = accumulated depreciation depreoatJon expense ending gross investment bl l'f, average d eprec1a e e = deprec1at1on expense rema1n1ng use ful l'f, 1e = ending net investment depreciation expense funded status of the plan: funded status total periodic pension cost = = fair value of plan assets - PBO contributions - (ending funded status - beginning funded status) 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 ratio = current assets current liabilities k cash+ marketable securities+ receivables qmc r a t i o = - - - - - - - - - - - - - - - - current liabilities cash+ short-term marketable securities cas h rat10 = - - - - - - - - - - - - - - - current liabilities defensive interval ratio = (cash + short-term marketable investments + receivables) daily cash expenditures net annual sales receivables turnover = - - - - - - - average receivables ble co11ect10n • peno d= average recetva Page 392 365 receivables turnover ©2015 Kaplan, Inc + PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Formulas mventory turnover cost of goods sold = -~. -average mventory days of sales outstanding (DSO) days of inventory on hand (DOH) payables turnover 36 = receivables turnover ratio = -.- - -365 -mventory turnover purchases = -average payables = - - -365 number of days of payables payables turnover net sales total asset turnover = - fixed asset turnover = - average total assets STUDY SESSIONS outlay = net sales average fixed assets AND 9: CORPORATE FINANCE FCinv + NWCinv after-tax operating cash flow (CF) TNOCF = = (S - C - D)(l - T) + D = (S - C)(l - T) + (TD) SalT + NWCinv - T (SalT - BT) economic income = cash flow+ (ending market value - beginning market value) = cash flow - economic depreciation or economic income economic profit: EP = NOPAT - $WACC market value added: NPV = MVA = I: (1 + r=l EPr WACC)r ©2015 Kaplan, Inc Page 393 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Formulas residual income = net income - equity charge project cost of equity = Rp + ~project [E(RMKT ) - Rp] weighted average cost of capital: WACC MM Proposition I (no taxes): VL = = Vu MM Proposition II (no taxes): re = r0 + D ( r0 - q) E MM Proposition I (with taxes): VL = Vu static trade-off theory: VL = Vu [rd x (1 - t) (debt - )] + [re x (equity)] -assets assets + (t x d) + (t x d) - PV ( costs of financial distress) D(l - To) change in price when stock goes ex-dividend: D.P = - - - (1- TcG ) effective tax rate = corporate tax rate + (1 - corporate tax rate)(individual tax rate) l[ l ( ) rev1ous ad ustment ) [expected target expected dividend = ( ~- d d + mcrease x payout x Jf !VI en in EPS ratio actor FCFE coverage ratio = FCFE I (dividends + share repurchases) n Herfindahl-Hirschman Index: HHI = 2:)MSi x 100)2 i =1 Page 394 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Formulas free cash How: Net income + Net interest after tax = U nlevered net income ± Change in deferred taxes = Net operating profit less adjusted taxes (NOPLAT) + Net non cash charges ± Change in net working capital - Capital expenditures (capex) = Free cash flow (FCF) terminal value: TVT = FCFr (l + g) (wACCadjusced -g) or TVT = FCFr 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: Gain A = S-TP = S-(PT - VT) price of target in stock deal: PT = (N X PAT) gross profit gross profit margm = - - - - net sales 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 c a p i t a l = - - - - - - - - - - - - - - - - - ( interest bearing debt+ shareholders' equity) ©2015 Kaplan, Inc Page 395 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Formulas return on total eqmty = financial leverage rat10 net income average total eqmty total assets = total equity total long-term debt long-term debt-to-equity ratio total equity debt - to - eqmty rat10 = total debt total equity al short-term debt+ long-term debt d e b t - to - cap1t rat10 = - - - - - - - - - - - - - - - - - - - short-term debt+ long-term debt+ total equity interest coverage EBIT = -.- - - - - mterest expense dividends paid payout rauo = -.-~~net mcome retention ratio = - payout ratio h earmngs per s are = net income - preferred dividends average common shares outstanding b oo k v al ue per sh are = Page 396 common stockholders' equity total number of common shares outstanding ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted INDEX A abandonment options 234 accelerated depreciation 33 accounting income 238 accruals 166 accruals ratio 195 acquirer 337 acquisition 71, 337 acquisition goodwill 75 acquisition method 72, 161 after-tax operating cash flows (CF) 218 agency costs of equity 266 agency issues 284 agency relationship 320 Altman model 164 amortized cost 61, 66 anticipating changing accounting standards 200 anticompetitive behavior 310 asset base 188 asset purchase 345 available-for-sale securities 61 average age 40 average depreciable life 41 average rate 123 B backward integration 338 balance sheet quality 171 bargain purchase option 43 bear hug 347 benefits paid 96 Beneish model 163 best practices 322 biased accounting 160 bird-in-hand argument 281 board of directors attributes 322 bond ratings Moody's 271 Standard & Poor's 271 bootstrap effect 341 bootstrapping EPS 340 business combinations 59, 71, 72 c capital allocation decisions 191 capital asset pricing model (CAPM) 233 capital budgeting initial investment outlay 217 process 214 capitalization of expenses 169 capitalized 25 capitalized interest 27 capital lease 42 capital rationing 228 capital structure 189, 262, 272 carrying value 70 cash flow quality 170 cash offer 346, 366, 369 changes in actuarial assumptions 96 claims valuation approach 245 clean-surplus accounting 142 clientele effect 283 comparable company analysis 357, 364 comparable transaction analysis 361, 364 completeness 171 conflict between directors and shareholders 321 conflicts of interest 319 conglomerate merger 338 consolidation 71, 338 consolidation of variable interest entities 80 constant dividend payout ratio policy 289 contractual and legal restrictions 286 corporate governance 318, 327 corporations 319 costs of asymmetric information 267 costs of financial distress and bankruptcy 266 creditors 308 crown jewel defense 349 cumulative translation adjustment (CTA) 123, 126 current rate 123 current rate method 128 current service cost 96 customers 308 D debt covenants 286 debt ratings 270 decline phase 343 deferred revenue 124 deferred tax liabilities 33 defined benefit pension obligation 95 defined-benefit plan 94 defined-contribution plan 94 ©2015 Kaplan, Inc Page 397 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Index depreciating environment 125 depreciation 32, 218 designated fair value 61 direct financing lease 49, 50 director-shareholder conflicts 321 dirty-surplus 142 discounted cash flow (DCF) analysis 352, 364 discount rate 104 divestitures 70 dividend coverage ratio 295 dividend initiation 282 dividend payout ratio 295 dividend policy 281 dividend safety 295 double-declining balance method 33 double-taxation system 286 downstream sale 71 DuPont equation 186 E earnings quality 158, 165, 193 economic income 238 economic profit 242 effective corporate governance system 319 effective tax rate 142 effect of payment method 369 employees 307 environmental risk exposure 325 equity carve-outs 371 equity method 66 equivalent annual annuity (EAA) approach 227 ESG factors 325 excess of purchase price over book value acquired 68 exchange ratio 346 expansion options 234 expansion project analysis 218 expected return on plan assets 104 expected volatility of future earnings 285 expense capitalization 169 expensed 25 externalities 215 external stakeholders 308 F fair price amendment 348 fair value 61 fair value through other comprehensive income (FVOCI) 66 fair value through profit or loss (FVPL) 66 FIFO COGS 124 finance lease 42 financial assets impairment of 64 Page 398 reclassification of investments in 63 financial flexibility 285 financial markets and banking system factors 272 financial report quality 158 first-in, first-out (FIFO) 2, 124 flexibility 235 flip-in pill 348 flip-over pill 348 flotation costs 286 foreign currency disclosure 141 foreign exchange gains and losses 62 form of acquisition 344 forms of integration 338 forward integration 338 free cash flow (FCF) 352 Friedman Doctrine 311 friendly merger offers 346 full goodwill 75 functional currency 119 fundamental options 235 funded status of the plan 95 G gains accrued to the acquirer 366 gains accrued to the target 366 general public 308 golden parachutes 348 goodwill 68, 75 goodwill impairment 77 governance risk exposure 325 governments 308 greenmail 349 gross investment 41 H hard capital rationing 228 held-for-trading securities 61 held-to-maturity securities 61 Herfindahl-Hirschman Index (HHI) 350 high-quality earnings 158 historical rate 123 homemade dividends 281 horizontal merger 338 hostile merger offers 347 hurdle rate 234 hyperinflationary environment 139 I identifiable asset 75 impairment 37, 70 loss 77 impairment of capital rule 286 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Index impairment testing 77 implied fair value of goodwill 77 imputation tax system 287 industry life cycle 343 information asymmetry 282 information manipulation 31 O institutional and legal factors 272 intangible assets 31 intercorporate investments 59 interest cost 96 interest coverage ratio 27, 135 internal development costs 31 internal stakeholders 307 International Financial Reporting Standards (IFRS) 141 inventory accounting methods inventory cost flow method 14 inventory valuation method 14 investment in net working capital (NWCinv) 217 investment opportunities 285 investment opportunity schedule (105) 290 investments in associates 59, 60, 66 investments in financial assets 59 M macroeconomic factors 273 management discussion and analysis 142 management discussion and analysis (MD&A) 172 managers 307 manager-shareholder conflicts 320 market 14 market value added (MVA) 242 market value decomposition 197 mature growth phase 343 mean reversion in earnings 167 members of the board of directors 308 merger 71, 337 merger synergies, estimating 369 method of payment 346 minority interest account 72 mixed rate 127 mixed ratio 135 MM Proposition II (no taxes) 264 MM Proposition II (with taxes) 265 MM Proposition I (no taxes) 262 MM Proposition I (with taxes) 265 MM's capital structure irrelevance proposition 263 J modified accelerated cost recovery system (MACRS) 33, 216 monetary asset (liability) 124 Monte Carlo simulation 232 M-score 163 multinational firm 119 multinational organization 119 mutually exclusive projects with different lives joint ventures 60, 78 Justice theories 312 "just say no" defense 349 K Kantian ethics 311 L 225 last-in, first-out (LIFO) 3, 124 LIFO conformity rule LIFO liquidation 11 LIFO reserve lease 42 lease disclosures 47 least common multiple of lives approach 225 lessee 42, 43 lessor 42 leveraged recapitalization 349 LIFO COGS 124 LIFO liquidation 11 LIFO reserve liquidations 371 local communities 308 local currency 119 long-term residual dividend 291 N net monetary liability exposures 125 net pension liability (or asset) 95 net realizable value 14 noncontrolling interest 73, 76 nonmonetary asset (liability) 124 off-balance-sheet 80 off-balance-sheet financing 45, 199 offsetting dilution 291 operating lease 42, 51 operating lease adjustments 200 opportunistic exploitation 310 opportunity costs 215 other post-employment benefits 95 ©2015 Kaplan, Inc Page 399 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Index p Pac-Man® defense 350 partial goodwill 75 partnerships 319 past (prior) service costs 96 payout policy 281 pecking order theory 267 percentage of ownership (or voting control) 59 periodic system perpetual system persistent earnings 165 pioneer/development phase 343 plug figure 126 poison pill 347 poison put 348 pooling of interests method 72 post-employment benefit plans 94 post-merger value of an acquirer 365 post-offer defense mechanisms 349 pre-offer defense mechanisms 347 presentation currency 119 present value of defined benefit obligation (PVDBO) 95 price index 139 price-setting options 235 primary beneficiary 80 principal-agent 309 principal-agent problem 309, 320 probability of financial distress 266 production-flexibility options 235 projected benefit obligation (PBO) 95 proxy battle 347 purchasing power gain (loss) 139 pure balance sheet ratio 135 pure income statement ratio 135 Q quality of financial reports 158 R rapid growth phase 343 rate of compensation growth 104 real options 234 recoverability test 37 related party transactions 169 remaining useful life 41 remeasurement 121 replacement cost 14 replacement project analysis 222 reporting currency 119 reporting quality 158 research and development costs 31 residual dividend model 290 Page 400 residual income 243 restricted voting rights 348 restrictive takeover laws 348 results quality 158 return on equity (ROE) 186 revaluation to fair value 39 revenue recognition issues 167 reverse synergy 71 Rights theories 311 s sales-type lease 49 salvage values 35 scenario analysis 231 SEC form 'NT' 172 securities offering 346 Security Market Line (SML) 233 segment reporting 191 self-dealing 310 sensitivity analysis 230 share-based compensation 109 share repurchase 349 share repurchase using borrowed funds 294 significant influence 60 simulation analysis 232 social risk exposure 325 soft capital rationing 228 software development costs 31, 32 sole proprietorships 319 special purpose entity (SPE) 80 specific identification method spin-offs 371 split-offs 371 split-rate 287 stabilization phase 343 stable dividend policy 288 staggered board 348 stakeholders 307 statement of corporate governance policies 325 static trade-off theory 268, 269 statutory merger 338 statutory tax rate 142 stock grants 110 stockholders 307 stock offer 366, 369 stock options 109 stock purchase 345 straight-line depreciation 33 subsidiaries 119 subsidiary merger 338 sunk costs 215 supermajority voting provision 348 suppliers 308 sustainable earnings 165 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Financial Reporting and Analysis and Corporate Finance Index synergy 371 systematic risk 233 T takeover premium 358 target 337 target capital structure 270 target payout ratio adjustment model 289 tax aversion 282 tax considerations 285 tax shield provided by debt 265 temporal method 131 tender offer 347 terminal year after-tax non-operating cash flows (TNOCF) 218 timing options 234 transaction date 120 transactions with the investee 70 translation 121 translation gain (loss) 123 translation/remeasurement gain or loss 126 types of mergers 338 u ultimate healthcare trend rate 105 unbiased measurement 171 unearned revenue 124 unethical behavior 310 unexpected dividend decrease 283 unexpected dividend increase 283 unidentifiable asset 75 unions 308 uniting of interests method 72 units-of-production method 33 unrealized gains and losses 62 unsystematic risk 233 upstream sale 70 useful life 35 utilitarianism 311 v value of a levered firm 265, 268 value of an unlevered firm 265 variable interest entity (VIE) 80 vertical merger 338 w weighted average cost method weighted-average method 124 white knight defense 350 white squire defense 350 winner's curse 350 working capital 45 z Z-score, Airman's 164 ©2015 Kaplan, Inc Page 401 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Notes ... of $21 and $18 for 20 X6 and 20 X5, respectively Add LIFO reserve of $100 and $90 for 20 X6 and 20 X5, respectively Add LIFO reserve (net of tax) of $79 and $ 72 for 20 X6 and 20 X5, respectively 20 15... be prosecuted SCHWESERNOTES™ 20 16 LEVEL II CFA BOOK 2: FINANCIAL REPORTING AND ANALYSIS AND CORPORATE FINANCE 20 15 Kaplan, Inc All rights reserved Published in 20 15 by Kaplan, Inc Printed in... Curriculum, Volume 3, Level II (CFA Institute, 20 15) 23 Capital Budgeting 24 Capital Structure 25 Dividends and Share Repurchases: Analysis 20 15 Kaplan, Inc page 21 4 page 26 2 page 28 1 Page v PRINTED BY: