BS3520 ANALYSIS OF FINANCIAL REPORTING INFORMATION 3
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BS3520
ANALYSIS OF FINANCIAL REPORTING INFORMATION
SECTION A
ANSWER BOTH QUESTIONS IN THIS SECTION
1. In your capacity as an investment manager you are required to appraise two companies’ credit worthiness. The following summary information is available
The first company, Wet plc has total assets of £40m of which £22m comprise current assets. The company’s total liabilities amount to £25m with negative working capital of £10m. This year the company reported a net loss of £11m in contrast to the profit of £4m last year and £3m the year before. Wet plc’s flow of working capital from its operations was £12m.
A rival company Dry plc, reported net profits of £3m this year, £4m last year and £2m the year before. The company’s total assets of £45m exceed its total liabilities by £10m. Its current assets are valued at £4m while the current liabilities amount to £17m. Dry plc generated a flow of working capital from operations of £5m.
The appropriate GNP price index has a value of 120 for both companies.
REQUIRED:
a) Use Ohlson’s (1980) logit model to estimate the probability of failure for Wet plc and Dry plc. The coefficients of the Ohlson model are as follows:
Y = -1.32 -0.407*SIZE + 6.03*TL/TA – 1.43*WC/TA + 0.0757*CL/CA – 2.37*NI/TA – 1.83*FUTL + 0.285*INTWO -1. 72*OENEG -0.521*CHIN (10 marks)
b) Briefly discuss the relative probabilities in a) above when compared with the companies’ profitability. (3 marks)
c) Explain using numerical examples the relative costs of type 1 and type 2 errors in corporate failure prediction models. What is the relevance of the likely differences in these costs for the design of such models? (6 marks)
d) Explain the advantages of the Ohlson (1980) model over the seminal multivariate corporate failure prediction model by Altman (1968). (6 marks) (Total 25 marks)
2. Your client has requested advice as to whether to hold or sell their current equity in Traeth plc. The following information is available to you for the purposes of your analysis.
i) Earnings available for ordinary shareholders for the year 2015 were £100m.
ii) Management of Traeth plc forecast earnings to grow by 4% for the year 2016 and confirm the opening book value for the year 2016 is £500m.
iii) Residual earnings post 2016 are expected to grow at a constant rate of 3%.
iv) Forecast revenue for 2016, 2017 and 2018 is £350m, £370m and £370m respectively.
v) Asset turnover for 2017 and 2018 is forecast to be 0.73 and 0.57 respectively.
vi) Opening net operating assets for the year 2016 is £750m.
vii) Operating margin for the years 2016 – 2018 is forecast to be 28%.
viii) The weighted average cost of capital for the Traeth plc’s operating divisions is 8%.
ix) Future growth of residual operating income post 2018 is forecast to be 5%.
x) The shares price of Traeth plc at the start of 2016 is £20.00 per share.
xi) Cost of equity of the firm is 9%.
Traeth plc has 100m shares in issue as at the start of 2016. The firm has no expectations to issue any further shares or dividends in the future.
(note the above information in i) to ix) relates to the operating divisions of the firm which exclude anyfinancing activities
REQUIRED:
a) Using both the residual (abnormal) earnings valuation model (REVM) and the residual operating income model (ReOIM), advise your client as to whether to sell or hold their investment in Traeth plc. Explain briefly why the two models applied give differing valuations. (22 marks)
b) Briefly discuss the assumptions underlying the residual (abnormal) earnings valuation model (REVM). (3 marks) (Total 25 marks)
SECTION B
ANSWER ONE QUESTION IN THIS SECTION
3. Critically evaluate the various methods proposed in the academic literature to either measure “Earnings Quality” (Dechow, Ge and Schrand, 2010) or to detect instances when Earnings Quality may be compromised.
(Dechow, Ge and Schrand, 2010. “Understanding earnings quality: a review of the proxies, their determinants and their consequences”). (25 marks)
4. Disuses the motivational theories that can explain why managers may use corporate narrative disclosures for the purposes of Impression Management. (25 marks)
2023-01-31