W2 Stratergy Analysis

Industry analysis
Rivalry among Existing Firms
Industry growth rate.
Concentration and balance of competitors.
Degree of differentiation and switching
costs.
Scale/Learning economies and ratio of fixed
costs to variable costs.
Excess capacity and exit barriers.
Threat of New Entrants
Factors affecting the barriers to entry are:
Economies of scale
First mover
advantage
Relationships with suppliers and customers
Legal barriers
Threat of Substitute Products
Relative price and performance;
Buyers willingness to switch
Bargaining Power of Buyers
Switching cost;
Differentiation;
Importance of product for costs and quality;
Number of buyers;
Volume per buyer
Bargaining Power of Suppliers
few substitutes; suppliers few;
Competitive Strategy Analysis
Two basic competitive strategies are:
Cost leadership
Product/ service differentiation
Resources and capabilities to implement
strategies.
Activities,
infrastructure,
and
other
operating elements consistent with its
competitive strategy.
Corporate Strategy Analysis
Companies with multiple business segments
may generate synergy benefits
Transaction costs may be lower
Communication cost
Headquarter coordination
Assets/capital sharing g
But synergy benefits are difficult to achieve

Conflicting culture/bureaucracy Lack of

expertise
SWOT Analysis
What are the companys strengths and
weaknesses?
Management competence
Cost leadership or product differentiation
Market leadership
Low financial risk

What are the opportunities and threats?

New products/markets
New competitors/substitute products
Economy/policy changes

W3&4 Accounting analysis

Managers accounting discretions

Advantages
Managers have intimate knowledge of their
firms business
Accounting discretions allow managers to
reflect inside information in reported financial
statement
Disadvantages
Managers can use the discretions to report
distorted accounting information
Incentives
Accounting information and contracts
Managers compensation contracts
Performance based pay
Stock options
Personal reputation
Contracts with lenders
Loan covenants
Credit rating
(Social) Contract with stakeholders
Employees and Employees, customers
Regulators, and competitors
Pressure from financial markets
Avoid negative news/image
Maintain share prices
Avoid volatility in earnings
Meet analyst and investor expectations
Positive earnings
Earnings in the same quarter last year
Last quarters quarter s earnings

Analysts earnings forecasts

Earnings = Cash Flows + Accruals
Characteristics of manipulating firms
(Evidence)

Strong
performance
prior
to
the
manipulations
Abnormally high P/E and P/B ratios
Pressure from the market to maintain high
growth rate
In manipulation years
Cash profit margins and earnings growths
decline
Accruals increase
Demand decreases for their products
Free cash flows drops
Financing activity increases
Asset distortion: Overstated assets
Delayed write-down of current assets
Growing days inventory and days
receivables
Write-down by competitors
Business difficulties for its major clients
Delayed write-down of long-term assets
Underestimated provisions
Accelerated recognition of revenues
Understated depreciation/amortisation
Understated assets
To deflate reported earnings
Save for the future Take a big bath
Overstated write-down of assets
Overestimated provisions
Overstated depreciation
Off-balance sheet lease

W5 financial analysis

Profit margins Measures how much the

firm can keep as profit from one dollar sales
Gross profit margin: gross profit / sales
Net profit margin: net income / sales

ROE = Operating ROA + Spread x Net

financial leverage
Operating ROA = NOPAT / Net Assets
Spread=Operating ROAEffective after-tax
interest rate
Net financial leverage = Net debt / Equity
Turnovers ratios evaluate investment
management: how effectively the firm uses
its assets
Low turnover ratios imply inefficient use of
assets
Very high turnover ratios may indicate overturnover or insufficient assets
Short-term liquidity ratios
Measure ability to repay its short-term
liabilities
use current liabilities as denominator
Current ratio (current assets)
Quick ratio (cash + receivables)
Cash ratio Operating cash flow ratio
Debt and Long-term Solvency
Debt to equity ratio
Debt to net capital ratio
Interest
coverage

W6 Forecasting
: Sales; Profit margin; Assets turnover;
Capital structure
for companies with stable operations
Turnover ratios will remain stable
Assets will grow at the same rate of sales
Capital structure will remain stable
Debt to-Equity ratio will be the same
Interest rate will not change

normal forward P/E ratio:

P/B ratio is driven by the level of RE while
P/E ratio is driven by the change or growth
in RE
Discount rate = required rate of return

W7&8 Valuations
Discounted Dividend Model (DDM)

Discounted Abnormal Earnings Model

D1= B0+ E1B1

RE = E (re*BVE) = (ROE re)*BVE

CAPM: Re= rf + [E(rm) rf] expected risk

premium
Multifactor model: re= rf +[E(rm) rf] + rsize
+ rbm + rmom
firms capital structure changasset=wd*d+ (1wd)*e
Sensitivity Analysis
Make different assumptions and re-do the
valuation
Perturb key inputs by 5% or 10%
Construct scenarios with different
combination of assumptions
Normal case, worst case and best case

W9 Equity Security Analysis

Market Efficiency
Weak Form; Semi-Strong Form; Strong Form
Both mispricing and arbitrage exist.
Approaches
Fundamental analysis
based projections(historical data& current
information)of future earnings& cash flows.

 Quantitative analysis
Technical Analysis(historical share price;
predict short-term price movement; rules)
Statistical Analysis(regressions& historical
data to screen stocks; mathematical
models ;predict share price interest rates
Investment Industry
Financial analysts
Analysts may issue biased (over-optimistic)
recommendations in order to
Generate trading volume for brokerage
house
Gain access to private information from
managers
Win investment banking business
Fund managers
Approaches to invest herd
Passive& Active management; Style
investing
Size, value, growth, momentum; Mutual
funds and hedge funds

W10 Credit Analysis and Distress

Prediction
Consider nature& purpose of the
loan(amount; time horizon; Sole
financing , syndication & subordination)
Consider type of loan& available
security(Open& revolving lines of
credit; term deposit; Mortgage loans;
working capital Load; Lease financing;
hybrid debt) (receivables, inventory,
P&E, real estate)
Analyze potential borrower's
financial status (cash flows repay the
loan)
(Firms operating cycle-FSA
analysis&external-cosider shortterm&long-term)
Short term Liabilities
Current Ratio = CA/CL

Quick Ratio= Cash + Mkt. secs +

Recs)/CL
Operating Cash Flow Ratio = (Cash
Flow from Continuing Ops.)/ Average CL
Working Capital Commitments
Accts. receivable
Inventory
Accts. Payable
Long term Debt Commitment
Long Term Debt/Total (Equity) Assets
[ Adjust for off-balance sheet liabilities
(Leases, contingencies, etc.)]
Cash flow coverage =(Op. Cash Flow
+ Int. Paid + Tax Paid)/Interest Paid
Interest coverage =Operating
EBIT/Interest Expense
Cash burn ratios
Utilize forecasts to assess
payment prospects
Assemble the detailed loan
structure
Loan covenants
maintenance of min. net worth
min coverage ratios
max. total liabilities to net worth
min. working cap. balance or current ratio
Loan pricing
Lenders cost of borrowing funds
Lenders cost of admim. & serving of loan
Premium for exposure to default risk
At least a normal ROE (e.g. 1.5% above
prime orLIBOR)
Debt Ratings Determinants
Kaplan-Urwitz Models:
Profitability measures (return on capital)
Leverage measures (long-term debt to
capitalisation)
Profitability (interest coverage) & leverage
Firm Size (sales, total assets)

Other (risk- std. dev. of returns/,

subordination)
Recent research finds that corporate
governance and accounting quality affect
debt ratings.
Financial distress
Altmans Z-score model

W11 Mergers & Acquisitions

Horizontal merger
Two firms are in the same line of business
Vertical merger
Merger with suppliers or customers
Congeneric merger Alliance of two firms
in the same general industry

 Conglomerate merger Unrelated

companies combine
Offer Bid price:
Friendly takeover: negotiate with and seek
approval from targets Board of Directors
Hostile takeover: approach shareholders
directly
Motivation for M&A
Synergy: The whole is greater than the sum
of its parts
Economies of scale
Improved management
Increased market power
Tax Considerations
A profitable firm in the highest tax bracket
could
acquire a firm with large accumulated tax
losses.
Acquisition can serve as a way of
minimizing taxes

when disposing of excess cash.

Purchased under-valued assets
It would be cheaper to acquire
targets assets rather
than replace them.
Diversification
Diversification helps stabilize a firms
earnings
But shareholders can diversify
themselves
Diversified firms are worth
significantly less than the sum parts of
their individual
Managers personal incentives

Seek more corporate empires power

by building Increase salary by
managing larger company
Value the target = value as independent
firm + value of merger benefits
Signaling Effect
Corporate events as signals to the market
Issuing new shares signals over-valuation
Share repurchases signal under-valuation
Stock mergers signal over-valuation of
acquirers shares
Stock mergers also provide a way for
acquirers shareholders to share risk with
targets shareholders
Target firms can defend hostile takeover
by many
Change company bylaws requiring supermajority for
takeover approval
Try to convince shareholders not to approve
the takeov
Raise antitrust issues to regulators
Get a white knight who is friendly to
compete with the hostile bidder
Get a white squire who is friendly to be
major shareholder
Take poison pills by granting options to sell
assets at bargain prices to a friendly third
party

Grant golden parachutes to their

executives
Outcome:
On average, stock prices of target
firms increase by about, 30% in hostile
tender offers, and about 20% in friendly
mergers.

Stock prices of acquiring firms remain

constant.
Therefore acquisitions do create
value, but shareholders of target reap
all the benefits firms virtually benefits.
In case of leveraged buyouts,
acquisitions may increase shareholder
wealth at the expense of bondholders.
Red flag

Unexplained changes in accounting,

especially when performance is poor.
Unexplained transactions that boost
profits. Unusual increases in
accounts receivable in relation to
sales increases. Unusual increases in
inventories in relation to sales
increases.An increasing gap between
a firms reported income and its cash
flow from operating activities. An
increasing gap between a firms
reported
income
and
its
tax
income A tendency to use
financing mechanisms like research
and development partnerships and the
sale of receivables with recourse.
Unexpected large asset writeoffs.

Large
fourth-quarter
adjustments.;Qualified audit opinions
or changes in independent auditors
that are not well justified.; Relatedparty transactions or transactions
between related entities