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Financial Statement Analysis and Security Valuation Stephen H. Penman

Financial Statement Analysis and Security Valuation Stephen H. Penman. Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University

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Financial Statement Analysis and Security Valuation Stephen H. Penman

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  1. Financial Statement Analysisand Security ValuationStephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

  2. Creating Accounting Value and Economic Value Chapter 17

  3. Chapter 17 Page 559 What you will learn in this chapter • How rates of return and residual earnings can be created by accounting methods • How growth in earnings and residual earnings can be created by accounting methods • The difference between economic value added and accounting value added • How residual earnings valuation techniques produce valuations that are not affected by accounting methods • How accounting methods affect continuing value calculations • What are "conservative" accounting and "liberal" accounting and how they affect valuation • Accounting methods should not affect the value of a firm, so how can accounting-based residual earnings techniques produce valuations that are not affected by the accounting?

  4. Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Chapter 17 Page 560 Table 17-1

  5. Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Free cash flow 240 220 Chapter 17 Page 560 Table 17-1

  6. Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Free cash flow 240 220 RNOA 10% 10% Chapter 17 Page 560 Table 17-1

  7. Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Free cash flow 240 220 RNOA 10% 10% ReOI (.10) 0 0 PV of ReOI 0 0 Total PV of ReOI 0 Value of project 400 Chapter 17 Page 560 Table 17-1

  8. Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Free cash flow 240 220 RNOA 10% 10% ReOI (.10) 0 0 PV of ReOI 0 0 Total PV of ReOI 0 Value of project 400 “Conservative” Accounting Treatment Sales 240 220 Depreciation 40 180 180 Operating income (40) 60 40 Net operating assets 360 180 0 Free cash flow 240 220 Chapter 17 Page 560 Table 17-1

  9. Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Free cash flow 240 220 RNOA 10% 10% ReOI (.10) 0 0 PV of ReOI 0 0 Total PV of ReOI 0 Value of project 400 “Conservative” Accounting Treatment Sales 240 220 Depreciation 40 180 180 Operating income (40) 60 40 Net operating assets 360 180 0 Free cash flow 240 220 Chapter 17 Page 560 Table 17-1

  10. Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Free cash flow 240 220 RNOA 10% 10% ReOI (.10) 0 0 PV of ReOI 0 0 Total PV of ReOI 0 Value of project 400 “Conservative” Accounting Treatment Sales 240 220 Depreciation 40 180 180 Operating income (40) 60 40 Net operating assets 360 180 0 Free cash flow 240 220 RNOA 16.7% 22.2% Chapter 17 Page 560 Table 17-1 Accounting Value Added Economic Value Added

  11. Value Conservation Principle Accounting Treatments for a Project Required Return of 10% p.a. and a Two-Year Life - Investment in the Project is $400 2000 2001 2002 “Neutral” Accounting Treatment Sales 240 220 Depreciation 200 200 Operating income 40 20 Net operating assets 400 200 0 Free cash flow 240 220 RNOA 10% 10% ReOI (.10) 0 0 PV of ReOI 0 0 Total PV of ReOI 0 Value of project 400 “Conservative” Accounting Treatment Sales 240 220 Depreciation 40 180 180 Operating income (40) 60 40 Net operating assets 360 180 0 Free cash flow 240 220 RNOA 16.7% 22.2% ReOI (.10) 24 22 PV of ReOI 21.82 18.18 Total PV of ReOI 40 Value of project 400 Chapter 17 Page 560 Table 17-1

  12. Projects: Accounting Effectsand Valuation Effects • Accounting Effects: • Residual earnings and RNOA can be created by the accounting • Valuation Effects: • Residual earnings created by the accounting does not affect the valuation Distinguish: • Economic value added • Accounting value added Economic value added is measured with residual earnings techniques irrespective of the accounting: the value conservation principle

  13. Neutral Accounting, Conservative Accounting and Liberal Accounting • Neutral (Unbiased) Accounting: yields expected RNOA equal to the cost of capital when operations add no value • Conservative Accounting: yields expected RNOA greater than the cost of capital when operations add no value • Liberal Accounting: yields expected RNOA less than the cost of capital when operations add no value The funny thing about conservative accounting: it makes firms look more profitable than they are

  14. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales 240 220 Operating expenses (depreciation) 200 200 Operating income 40 20 Net operating assets 400 200 0 Investment 400 Free cash flow (400) 240 220 RNOA 10.0% 10.0% ReOI (.10) 0 0 Value 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  15. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 Operating income 40 Net operating assets for investments in 2000 400 200 2001 400 200 Investment 400 400 Free cash flow (400) RNOA 10.0% 10.0% ReOI (.10) 0 0 Value 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  16. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 Operating income 40 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 Investment 400 400 400 Free cash flow (400) RNOA 10.0% 10.0% ReOI (.10) 0 0 Value 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  17. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 Operating income 40 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 Investment 400 400 400 400 400 Free cash flow (400) RNOA 10.0% 10.0% ReOI (.10) 0 0 Value 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  18. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 2003 200 200 400 400 400 Operating income 40 60 60 60 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 10.0% 10.0% ReOI (.10) 0 0 Value 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  19. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 2003 200 200 400 400 400 Operating income 40 60 60 60 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 2003 400 200 2004 400 400 600 600 600 600 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 10.0% 10.0% 10.0% 10.0% ReOI (.10) 0 0 Value 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  20. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 2003 200 200 400 400 400 Operating income 40 60 60 60 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 2003 400 200 2004 400 400 600 600 600 600 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 10.0% 10.0% 10.0% 10.0% Profit margin 16.7% 13.0% 13.0% 13.0% Asset turnover .60 .77 .77 .77 Growth in NOA 150% 0 0 0 ReOI (.10) 0 0 0 0 Value 400 600 600 600 600 Premium 0 0 0 0 0 P/B 1.0 1.0 1.0 1.0 1.0 P/E 11.0 11.0 11.0 11.0 Value of firm = 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  21. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 2003 200 200 400 400 400 Operating income 40 60 60 60 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 2003 400 200 2004 400 400 600 600 600 600 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 10.0% 10.0% 10.0% 10.0% Profit margin 16.7% 13.0% 13.0% 13.0% Asset turnover .60 .77 .77 .77 Growth in NOA 150% 0 0 0 ReOI (.10) 0 0 0 0 Value 400 600 600 600 600 Premium 0 0 0 0 0 P/B 1.0 1.0 1.0 1.0 1.0 P/E 11.0 11.0 11.0 11.0 Value of firm = 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  22. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 2003 200 200 400 400 400 Operating income 40 60 60 60 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 2003 400 200 2004 400 400 600 600 600 600 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 10.0% 10.0% 10.0% 10.0% Profit margin 16.7% 13.0% 13.0% 13.0% Asset turnover .60 .77 .77 .77 Growth in NOA 150% 0 0 0 ReOI (.10) 0 0 0 0 Value 400 600 600 600 600 Premium 0 0 0 0 0 P/B 1.0 1.0 1.0 1.0 1.0 P/E 11.0 11.0 11.0 11.0 Value of firm = 400 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  23. Neutral Accounting: A firm investing $400 each year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 200 200 2001 200 200 2002 200 200 2003 200 200 400 400 400 Operating income 40 60 60 60 Net operating assets for investments in 2000 400 200 2001 400 200 2002 400 200 2003 400 200 2004 400 400 600 600 600 600 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 10.0% 10.0% 10.0% 10.0% Profit margin 16.7% 13.0% 13.0% 13.0% Asset turnover .60 .77 .77 .77 Growth in NOA 150% 0 0 0 ReOI (.10) 0 0 0 0 Value 400 600 600 600 600 Premium 0 0 0 0 0 P/B 1.0 1.0 1.0 1.0 1.0 P/E 11.0 11.0 11.0 11.0 Value of firm = 400 Continuing Value = 0 Accounting Treatments for a Project Chapter 17 Page 563 Table 17-2

  24. Chapter 17 Page 565 Box 17.2 Going Concerns with ConstantInvestment: AccountingEffects and Valuation Effects • Accounting Effects: • Operating income is not affected by the accounting once a constant level of investment is reached • NOA are permanently lower with conservative accounting • RNOA and residual operating income are permanently above-normal with conservative accounting • RNOA and residual operating income are constant for both types of accounting once a constant level of investment is reached • Valuation Effects • Value is not affected by the accounting • Conservative accounting induces non-normal P/B ratios • P/E ratios are not affected by the accounting • The valuation with conservative accounting is a case 2 valuation [Liberal accounting has opposite effects]

  25. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  26. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  27. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  28. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  29. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  30. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  31. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  32. Conservative Accounting: A firm investing $400 each year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240 220 2001 240 220 2002 240 220 2003 240 240 460 460 460 Operating expenses (depreciation) for investments in 2000 40 180 180 2001 40 180 180 2002 40 180 180 2003 40 180 2004 40 40 200 400 400 400 Operating income (40) 20 60 60 60 Net operating assets for investments in 2000 360 180 2001 360 180 2002 360 180 2003 360 180 2004 360 360 540 540 540 540 Investment 400 400 400 400 400 Free cash flow (400) (160) 60 60 60 RNOA 5.6% 11.1% 11.1% 11.1% Profit margin 8.3% 13.0% 13.0% 13.0% Asset turnover .67 .85 .85 .85 Growth in NOA 150% 0 0 0 ReOI (.10) (16) 6 6 6 Value 400 600 600 600 600 Premium 0 60 60 60 60 P/B 1.11 1.11 1.11 1.11 1.11 P/E 22.0 11.0 11.0 11.0 Value of firm = 360 - 16/1.1 + (6/.10)/1.10 = 400 Accounting Treatments for a Project Chapter 17 Page 564 Table 17-3

  33. Accounting Treatments for a Project Neutral Accounting: A firm with investment growing at 5% per year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 Operating expenses (depreciation) for investments in 2000 200.0 200.0 Net operating assets for investments in 2000 400.0 200.0 Chapter 17 Page 566 Table 17-4

  34. Accounting Treatments for a Project Neutral Accounting: A firm with investment growing at 5% per year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 Operating expenses (depreciation) for investments in 2000 200.0 200.0 2001 210.0 210.0 Net operating assets for investments in 2000 400.0 200.0 2001 420.0 210.0 Chapter 17 Page 566 Table 17-4

  35. Accounting Treatments for a Project Neutral Accounting: A firm with investment growing at 5% per year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 Operating expenses (depreciation) for investments in 2000 200.0 200.0 2001 210.0 210.0 2002 220.5 220.5 Net operating assets for investments in 2000 400.0 200.0 2001 420.0 210.0 2002 441.0 220.5 Chapter 17 Page 566 Table 17-4

  36. Accounting Treatments for a Project Neutral Accounting: A firm with investment growing at 5% per year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 200.0 200.0 2001 210.0 210.0 2002 220.5 220.5 2003 231.5 200.0 410.0 430.5 452.0 Operating income 40.0 62.0 65.1 68.4 Net operating assets for investments in 2000 400.0 200.0 2001 420.0 210.0 2002 441.0 220.5 2003 463.1 231.5 2004 486.2 400.0 620.0 651.0 683.6 717.7 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 Chapter 17 Page 566 Table 17-4

  37. Accounting Treatments for a Project Neutral Accounting: A firm with investment growing at 5% per year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 200.0 200.0 2001 210.0 210.0 2002 220.5 220.5 2003 231.5 200.0 410.0 430.5 452.0 Operating income 40.0 62.0 65.1 68.4 Net operating assets for investments in 2000 400.0 200.0 2001 420.0 210.0 2002 441.0 220.5 2003 463.1 231.5 2004 486.2 400.0 620.0 651.0 683.6 717.7 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 10.0% 10.0% 10.0% 10.0% Chapter 17 Page 566 Table 17-4

  38. Accounting Treatments for a Project Neutral Accounting: A firm with investment growing at 5% per year with no value added 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 200.0 200.0 2001 210.0 210.0 2002 220.5 220.5 2003 231.5 200.0 410.0 430.5 452.0 Operating income 40.0 62.0 65.1 68.4 Net operating assets for investments in 2000 400.0 200.0 2001 420.0 210.0 2002 441.0 220.5 2003 463.1 231.5 2004 486.2 400.0 620.0 651.0 683.6 717.7 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 10.0% 10.0% 10.0% 10.0% Profit margin 16.7% 13.1% 13.1% 13.1% Asset turnover .60 .76 .76 .76 Growth in NOA 55% 5% 5% 5% ReOI (.10) 0 0 0 0 Growth in ReOI 0% 0% 0% Growth in cum-dividend OI 10% 10% 10% Value 400 620.0 651.0 683.6 717.7 Premium 0 0 0 0 0 P/B 1.0 1.0 1.0 1.0 1.0 P/E 11.0 11.0 11.0 11.0 Value of firm = 400 Chapter 17 Page 566 Table 17-4

  39. Conservative Accounting: A firm with investment growing at 5% per year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 2004 48.6 40.0 222.0 413.1 433.8 455.5 Operating income (40.0) 18.0 58.9 61.8 64.9 Net operating assets for investments in 2000 360.0 180.0 2001 378.0 189.0 2002 396.9 198.5 2003 416.8 208.4 2004 437.6 360.0 558.0 585.9 615.2 646.0 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 5.0% 10.6% 10.6% 10.6% Profit margin 7.5% 12.5% 12.5% 12.5% Asset turnover .67 .85 .85 .85 Growth in NOA 55% 5% 5% 5% ReOI (.10) (18.0) 3.10 3.25 3.42 Growth in ReOI 5% 5% Growth in cum-dividend OI 127% 10.3% 10.3% Value 400 620.0 651.0 683.6 717.7 Premium 0 62.0 65.1 68.4 71.8 P/B 1.11 1.11 1.11 1.11 1.11 P/E 24.6 11.6 11.6 11.6 Value of firm = 360 - 18/1.10 + [3.1 / (1.10 - 1.05)] / 1.10 = 400 (Case 3) Accounting Treatments for a Project Chapter 17 Page 566 Table 17-4

  40. Conservative Accounting: A firm with investment growing at 5% per year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 2004 48.6 40.0 222.0 413.1 433.8 455.5 Operating income (40.0) 18.0 58.9 61.8 64.9 Net operating assets for investments in 2000 360.0 180.0 2001 378.0 189.0 2002 396.9 198.5 2003 416.8 208.4 2004 437.6 360.0 558.0 585.9 615.2 646.0 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 5.0% 10.6% 10.6% 10.6% Profit margin 7.5% 12.5% 12.5% 12.5% Asset turnover .67 .85 .85 .85 Growth in NOA 55% 5% 5% 5% ReOI (.10) (18.0) 3.10 3.25 3.42 Growth in ReOI 5% 5% Growth in cum-dividend OI 127% 10.3% 10.3% Value 400 620.0 651.0 683.6 717.7 Premium 0 62.0 65.1 68.4 71.8 P/B 1.11 1.11 1.11 1.11 1.11 P/E 24.6 11.6 11.6 11.6 Value of firm = 360 - 18/1.10 + [3.1 / (1.10 - 1.05)] / 1.10 = 400 (Case 3) Accounting Treatments for a Project Chapter 17 Page 566 Table 17-4

  41. Conservative Accounting: A firm with investment growing at 5% per year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 2004 48.6 40.0 222.0 413.1 433.8 455.5 Operating income (40.0) 18.0 58.9 61.8 64.9 Net operating assets for investments in 2000 360.0 180.0 2001 378.0 189.0 2002 396.9 198.5 2003 416.8 208.4 2004 437.6 360.0 558.0 585.9 615.2 646.0 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 5.0% 10.6% 10.6% 10.6% Profit margin 7.5% 12.5% 12.5% 12.5% Asset turnover .67 .85 .85 .85 Growth in NOA 55% 5% 5% 5% ReOI (.10) (18.0) 3.10 3.25 3.42 Growth in ReOI 5% 5% Growth in cum-dividend OI 127% 10.3% 10.3% Value 400 620.0 651.0 683.6 717.7 Premium 0 62.0 65.1 68.4 71.8 P/B 1.11 1.11 1.11 1.11 1.11 P/E 24.6 11.6 11.6 11.6 Value of firm = 360 - 18/1.10 + [3.1 / (1.10 - 1.05)] / 1.10 = 400 (Case 3) Accounting Treatments for a Project Chapter 17 Page 566 Table 17-4

  42. Conservative Accounting: A firm with investment growing at 5% per year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 2004 48.6 40.0 222.0 413.1 433.8 455.5 Operating income (40.0) 18.0 58.9 61.8 64.9 Net operating assets for investments in 2000 360.0 180.0 2001 378.0 189.0 2002 396.9 198.5 2003 416.8 208.4 2004 437.6 360.0 558.0 585.9 615.2 646.0 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 5.0% 10.6% 10.6% 10.6% Profit margin 7.5% 12.5% 12.5% 12.5% Asset turnover .67 .85 .85 .85 Growth in NOA 55% 5% 5% 5% ReOI (.10) (18.0) 3.10 3.25 3.42 Growth in ReOI 5% 5% Growth in cum-dividend OI 127% 10.3% 10.3% Value 400 620.0 651.0 683.6 717.7 Premium 0 62.0 65.1 68.4 71.8 P/B 1.11 1.11 1.11 1.11 1.11 P/E 24.6 11.6 11.6 11.6 Value of firm = 360 - 18/1.10 + [3.1 / (1.10 - 1.05)] / 1.10 = 400 (Case 3) Accounting Treatments for a Project Chapter 17 Page 566 Table 17-4

  43. Conservative Accounting: A firm with investment growing at 5% per year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 2004 48.6 40.0 222.0 413.1 433.8 455.5 Operating income (40.0) 18.0 58.9 61.8 64.9 Net operating assets for investments in 2000 360.0 180.0 2001 378.0 189.0 2002 396.9 198.5 2003 416.8 208.4 2004 437.6 360.0 558.0 585.9 615.2 646.0 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 5.0% 10.6% 10.6% 10.6% Profit margin 7.5% 12.5% 12.5% 12.5% Asset turnover .67 .85 .85 .85 Growth in NOA 55% 5% 5% 5% ReOI (.10) (18.0) 3.10 3.25 3.42 Growth in ReOI 5% 5% Growth in cum-dividend OI 127% 10.3% 10.3% Value 400 620.0 651.0 683.6 717.7 Premium 0 62.0 65.1 68.4 71.8 P/B 1.11 1.11 1.11 1.11 1.11 P/E 24.6 11.6 11.6 11.6 Value of firm = 360 - 18/1.10 + [3.1 / (1.10 - 1.05)] / 1.10 = 400 (Case 3) Accounting Treatments for a Project Chapter 17 Page 566 Table 17-4

  44. Conservative Accounting: A firm with investment growing at 5% per year with no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 240.0 472.0 495.6 520.4 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 2004 48.6 40.0 222.0 413.1 433.8 455.5 Operating income (40.0) 18.0 58.9 61.8 64.9 Net operating assets for investments in 2000 360.0 180.0 2001 378.0 189.0 2002 396.9 198.5 2003 416.8 208.4 2004 437.6 360.0 558.0 585.9 615.2 646.0 Investment 400 420 441 463.1 486.2 Free cash flow (400) (180) 31 32.5 34.4 RNOA 5.0% 10.6% 10.6% 10.6% Profit margin7.5% 12.5% 12.5% 12.5% Asset turnover.67 .85 .85 .85 Growth in NOA55% 5% 5% 5% ReOI (.10) (18.0) 3.10 3.25 3.42 Growth in ReOI 5% 5% Growth in cum-dividend OI 127% 10.3% 10.3% Value 400 620.0 651.0 683.6 717.7 Premium 0 62.0 65.1 68.4 71.8 P/B 1.11 1.11 1.11 1.11 1.11 P/E 24.6 11.6 11.6 11.6 Value of firm = 360 - 18/1.10 + [3.1 / (1.10 - 1.05)] / 1.10 = 400 (Case 3) Accounting Treatments for a Project Chapter 17 Page 566 Table 17-4

  45. Conservative Accounting: Investment initially growing at 5% and then leveling off, no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 2005 2006 2007 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 254.7 2004 291.7 267.4 2005 291.7 267.4 2006 291.7 240.0 472.0 495.6 520.4 546.4 559.1 559.1 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 208.4 2004 48.6 218.8 218.8 2005 48.6 218.8 218.8 2006 48.6 218.8 2007 48.6 40.0 222.0 413.1 433.8 455.5 475.8 486.2 486.2 Operating income (40.0) 18.0 58.9 61.8 64.9 70.6 72.9 72.9 RNOA 5.0% 10.6% 10.6% 10.6% 10.9% 11.1% 11.1% Profit margin 7.5% 12.5% 12.5% 12.5% 12.9% 13.0% 13.0% Asset turnover .67 .85 .85 .85 .85 .85 .85 Growth in NOA 55% 5% 5% 5% 1.6% 0.0% 0.0% ReOI (.10) (18.0) 3.10 3.25 3.42 6.02 7.29 7.29 Growth in ReOI 5% 5% 76% 21% 0% Growth in cum-dividend OI 127% 10.3% 10.3% 14.0% 11.8% 10.0% Value 400 620.0 651.0 683.6 717.7 729.3 729.3 729.3 Value of firm = 360 - 18/1.10 + 3.1/1.21 + 3.25/1.331 + 3.42/1.464 + 6.02/1.611 + (7.29/.10)/1.611 = 400 (Case 2) Hidden Reserves Chapter 17 Page 571 Table 17-7

  46. Chapter 17 Page 568 Box 17.3 Going Concerns with GrowingInvestment: AccountingEffects and Valuation Effects • Accounting Effects: • Conservative accounting reports lower operating income • Conservative accounting produces above-normal RNOA and residual operating income • Conservative accounting produces lower RNOA and residual operating income than the no-growth case • Conservative accounting creates growth in operating income and residual operating income • Valuation Effects • Value is not affected by the accounting • P/B ratios with conservative accounting are the same as the no-growth case • P/E ratios with conservative accounting are higher than the no-growth case: P/E reflects anticipated growth • The valuation with conservative accounting is a case 3 valuation [Liberal accounting has opposite effects]

  47. Accounting Methods, Profit Margins and Asset Turnovers • Conservative accounting increases ATO; for both no-growth case and growth case • Conservative accounting does not affect PM in no-growth case • Conservative accounting reduces PM in growth case RNOA = PM x ATO

  48. An Exception: LIFO Accounting Creates Economic Value • If LIFO is used for tax purposes, it must be used for financial reporting • LIFO defers tax payments through higher cost of goods sold if inventories are growing • The present value of tax payments is lower, so firm value is higher • The higher firm value is captured in a residual earnings valuation through higher forecasted after-tax profits margins

  49. Conservative Accounting: Investment initially growing at 5% and then leveling off, no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 2005 2006 2007 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 Investment 2002 264.6 242.6 leveling off 2003 277.8 254.7 2004 291.7 267.4 2005 291.7 267.4 2006 291.7 240.0 472.0 495.6 520.4 546.4 559.1 559.1 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 208.4 2004 48.6 218.8 218.8 2005 48.6 218.8 218.8 2006 48.6 218.8 2007 48.6 40.0 222.0 413.1 433.8 455.5 475.8 486.2 486.2 Operating income (40.0) 18.0 58.9 61.8 64.9 70.6 72.9 72.9 RNOA 5.0% 10.6% 10.6% 10.6% 10.9% 11.1% 11.1% Profit margin 7.5% 12.5% 12.5% 12.5% 12.9% 13.0% 13.0% Asset turnover .67 .85 .85 .85 .85 .85 .85 Growth in NOA 55% 5% 5% 5% 1.6% 0.0% 0.0% ReOI (.10) (18.0) 3.10 3.25 3.42 6.02 7.29 7.29 Growth in ReOI 5% 5% 76% 21% 0% Growth in cum-dividend OI 127% 10.3% 10.3% 14.0% 11.8% 10.0% Value 400 620.0 651.0 683.6 717.7 729.3 729.3 729.3 Value of firm = 360 - 18/1.10 + 3.1/1.21 + 3.25/1.331 + 3.42/1.464 + 6.02/1.611 + (7.29/.10)/1.611 = 400 (Case 2) Hidden Reserves Chapter 17 Page 571 Table 17-7

  50. Conservative Accounting: Investment initially growing at 5% and then leveling off, no value added: 10% of investment expensed immediately 2000 2001 2002 2003 2004 2005 2006 2007 Sales from investments in 2000 240.0 220.0 2001 252.0 231.0 2002 264.6 242.6 2003 277.8 254.7 2004 291.7 267.4 2005 291.7 267.4 2006 291.7 240.0 472.0 495.6 520.4 546.4 559.1 559.1 Operating expenses (depreciation) for investments in 2000 40.0 180.0 180.0 2001 42.0 189.0 189.0 2002 44.1 198.5 198.5 2003 46.3 208.4 208.4 2004 48.6 218.8 218.8 2005 48.6 218.8 218.8 2006 48.6 218.8 2007 48.6 40.0 222.0 413.1 433.8 455.5 475.8 486.2 486.2 Operating income (40.0) 18.0 58.9 61.8 64.9 70.6 72.9 72.9 RNOA 5.0% 10.6% 10.6% 10.6% 10.9% 11.1% 11.1% Profit margin 7.5% 12.5% 12.5% 12.5% 12.9% 13.0% 13.0% Asset turnover .67 .85 .85 .85 .85 .85 .85 Growth in NOA 55% 5% 5% 5% 1.6% 0.0% 0.0% ReOI (.10) (18.0) 3.10 3.25 3.42 6.02 7.29 7.29 Growth in ReOI 5% 5% 76% 21% 0% Growth in cum-dividend OI 127% 10.3% 10.3% 14.0% 11.8% 10.0% Value 400 620.0 651.0 683.6 717.7 729.3 729.3 729.3 Value of firm = 360 - 18/1.10 + 3.1/1.21 + 3.25/1.331 + 3.42/1.464 + 6.02/1.611 + (7.29/.10)/1.611 = 400 (Case 2) Hidden Reserves Chapter 17 Page 571 Table 17-7

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