KAN-CFIVO1004U Financial Statement Analysis Autumn 2021

TABLE OF CONTENTS
1 CHP2 Exercises: Book-Keeping...................................................................................................3
1.1 Exercise 1: Revenue Recognition.................................................................................................................3
1.2 Exercise 2: Expense Recognition..................................................................................................................4
2 CHP3 Exercises: Accural Vs. Cash-Flow....................................................................................5
2.1 Exercise 1: Cash Flow from Operating Activities........................................................................................5
2.2 Exercise 2: Operating Activities Statement of Cash Flows..........................................................................5
3 Chapter 4 Exercises.......................................................................................................................6
3.1 Exercise 1......................................................................................................................................................6
3.2 Exercise 2......................................................................................................................................................7
4 Chapter 5 Exercises.......................................................................................................................8
4.1 Exercise 1......................................................................................................................................................8
5 Chapter 6 Exercises.......................................................................................................................9
5.1 Exercise 1......................................................................................................................................................9
6 Chapter 7 Exercises.....................................................................................................................10
6.1 Exercise 1....................................................................................................................................................10
7 Chapter 8 Exercises.....................................................................................................................11
7.1 Exercise 1....................................................................................................................................................11
7.2 Exercise 2....................................................................................................................................................11
8 Chapter 9 Exercises.....................................................................................................................12
8.1 Exercise 1....................................................................................................................................................12
8.2 Exercise 2....................................................................................................................................................12
9 Chapter 10 Exercises...................................................................................................................14
9.1 Exercise 1....................................................................................................................................................14
9.2 Exercise 2....................................................................................................................................................14
9.3 Exercise 3....................................................................................................................................................14
9.4 Exercise 4....................................................................................................................................................15
10 Chapter 11 Exercises...................................................................................................................16
10.1 Exercise 1...............................................................................................................................................16
11 CH12: Management Performance..............................................................................................17
12 CH13: Accounting Quality and Flexibility................................................................................18
13 CH14: Topics in Accounting Flexibility.....................................................................................19
14 CH15: Management Misuse of Accounting Flexibility.............................................................20
15 CH16: Accounting Flexibility and Consequences for Users.....................................................21

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1 CHP2 EXERCISES: BOOK-KEEPING

Petersen, Plenborg & Kinserdal (2017): Chapter 2

1.1 Exercise 1: Revenue Recognition

Rock N Roll offered an outdoor concert festival from June 28, 2016 to July 1, 2016. Concertgoers
needed to pay $80 for a four-day pass to the festival, and all 10,000 tickets were sold out by May 1,
2016, which was the deadline to buy the tickets. Assume that this company prepared adjusting entries
at the end of each month, please answer the following questions:

Q1.1: Please prepare the journal entry for selling the tickets on May 1, 2016.

Answer: The revenue recognition principle becomes important here. The general principle is that
we recognize revenue only if we have already provided the service or if we have delivered the goods.
On May 1, 2016 no services (i.e., the concert) has been provided and thus no revenue should be rec-
ognized. However, on this date all tickets were sold for a total of $800,000.

With no payment information, we assume the firm receives cash. When cash increases, we should
debit the account (as cash is an asset). If we imagine the event is cancelled, the firm will have to re-
pay the money. Due to this, we have a liability in terms of a pre-payment, i.e., tickets sold in advance.
The liability increases, so we should credit the tickets sold in advance account (as it is a liability):

Q1.2: Please prepare the adjusting journal entries for June 30 and July 31, respectively (Hints: Rock
N Roll will recognize revenue at the end of each month).

Answer: The exercise assumes that the firm prepares adjusting entries at the end of each month. The
festival itself runs from June 28, 2016 to July 1, 2016 giving a total of 4 days with 3 days placed in
June and 1 day placed in July. This is important for how we should allocate the revenue, as we cf. the
revenue recognition principle should recognize revenue once we have provided the service.

So, on June 30, 2016 75 percent of the revenue should be recognized. This is done by decreasing the
liability tickets sold in advance by $600,000, so debit the account. At the same time, the revenue of
$600,000 should be recognized in the income statement, so we credit the revenue (income) account.
On July 31, the same principle is done for the remaining $200,000:

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1.2 Exercise 2: Expense Recognition

On April 1, 2016, the Briggs Corporation purchased a 24-month property insurance for $72,000. The
policy is effective immediately. Assume that Briggs prepares adjusting entries only once a year on
December 31. Please answer the following questions:

Q2.1: Please calculate the monthly cost of the insurance.

Answer: The insurance is for 24-months at a total cost of $72,000 giving a monthly cost of $3,000

Q2.2: Prepare the journal entry to record the purchase of insurance on April 1, 2016.

Answer: When the insurance is paid (assuming cash payment), cash decreases and as cash is an asset,
we must credit the cash account. At the same time, an asset in the shape of prepaid insurance is cre-
ated (i.e., increases), so we must debit this account with the $72,000. Thereby the entry is:

Q2.3: Please prepare the adjusting entry on December 31, 2016.

Answer: The firm only prepares adjusting entries annual at the end of the year. So, on December 31,
2016 the insurance has run for 9 months, indicating an expense of 9 times $3,000, i.e., $27,000. We
should only recognize the expense for the months already passed – similar to the revenue recognition
principle. So, we have an insurance expense of $27,000 (i.e., an increase) meaning we have to debit
this account. At the same time, the prepaid insurance asset decreases, so we must credit this account.

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2 CHP3 EXERCISES: ACCURAL VS. CASH-FLOW

Petersen, Plenborg & Kinserdal (2017): Chapter 3

2.1 Exercise 1: Cash Flow from Operations

The operating income of in 2018 was 200,000 DKK, and the depreciation expense was 20,000 DKK.
It had the following changes in its balance sheet. Calculate its cash flow from operating activities

Answer: The cash flow from operations is here given as the operating income (EBIT) plus deprecia-
tion expenses less the change in net working capital. The change in net working capital is given as:

Δ NWC= ΔAccounts receivables+ Δ Inventory + Δ Prepaid expenses− Δ Accounts payable

Δ NWC=( 7,200−1,000 ) + ( 8,500−4,000 )− (1,300−6,500 )=15,900

This means that net working capital has increased with 15,900 DKK. The CFO is then

200,000+20,000−15,900=204,100

2.2 Exercise 2: Cash Flow from Operations

The Suffolk Company’s net operating income for 2016 was $40,000, and the depreciation expense
was $20,000. Its account balances for the noncash current assets and current liabilities are listed as
follows. Please prepare the operating activities section of the statement of cash flows.

Answer: We have an operating income of $40,000 and a depreciation expense of $20,000. We also
need to show adjustments for changes in current assets and current liabilities. Remember than an in-
crease in assets is negative, while an increase in liabilities is positive We have:

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3 CHP4 EXERCISES: ANALYTICAL FINANCIAL

STATEMENTS
Petersen, Plenborg & Kinserdal (2017): Chapter 4 + Lecture 4

3.1 Exercise 1: Analytical Income Statement

The income statement of the Lego group in 2017 and 2016 is shown below. Please transform Lego’s
income statement in 2017 for analytical purposes.

Answer: The idea behind the analytical income statement is to separate operations from financing. It
is the firm’s operations which is the primary driving force behind value creation and should therefore
be isolated. When transforming the income statement for analytical purposes, we obtain the net oper-
ating profit after tax (NOPAT), which is an after-tax measure of earnings where an estimated tax is
deducted from EBIT. To estimate the tax on EBIT, we must calculate the effective tax rate:

Tax on profit of the year

Effective rax rate=
Net profit before tax

This gives us the analytical income statement below, where NOPAT is 7,924 mDKK for 2017

3.2 Exercise 2: Analytical Financial Statements

You should conduct financial statement analysis for the company Scanpack AB. Scanpack AB’s
balance sheets for 2016 and 2017 are shown as below (amounts in million). 

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Assume only ‘Financial assets’ and ‘Long term debt’ are interest bearing. Furthermore, the equity
statement of Scanpack AB for 2017 is shown as follows (amount in million) :

You know Scanpack reported financial income of 45 million and financial expenses of 310 million in
its income statement for 2017. Its net sales were 8340 million. The effective tax rate was 28%. Please
reformulate Scanpack’s balance sheets for analytical purposes and also prepare its analytical income
statement for 2017. Please keep zero decimal for the number calculated in the financial statements.

Answer: To reformulate the balance sheets, we first identify which items are considered operating
and financing to separate the core operations. Intangible and tangible assets, inventories, and accounts
receivable are considered operating assets, while provisions, accounts payable, and accrued expenses
are considered operating liabilities. As we know that financial assets and long-term debt are interest
bearing, they are considered a financing asset and liability respectively. The purpose of doing this
differentiation is to calculate the invested capital or the net operating assets. This is the net amount a
firm has invested in its operating activities, and which requires a return. This is given as:

Net operating assets (invested capital)=Operating assets−Operating Liabilities

Using the formula gives an invested capital of 6,885 in 2017 and 6,330 in 2016. For the analytical in-
come statement, we have the effective tax rate, the net financial expenses, the net earnings, and the net
sales given. From this, we can back out NOPAT in 2017 as 1,251.

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4 CHP5 EXERCISES: PROFITABILITY ANALYSIS

Petersen, Plenborg & Kinserdal (2017): Chapter 5

4.1 Exercise 1: Analytical Financial Statements, Profitability Analysis

The assignment is to conduct financial statement analysis for a pharmaceutical company. The
company’s income statement (2018) and balance sheet (2017 and 2018) are shown in Excel.

Q1.1: Prepare the analytical income statement and the analytical balance sheet. Assume that this
pharmaceutical company holds cash for financing rather than operating.

Answer: To reformulate the balance sheet, we first identify which items are considered operating and
financing to separate the core operations. Intangible and tangible assets, deferred tax assets, invento-
ries, and accounts receivable are considered operating assets, while deferred tax liabilities, provi-
sions, accounts payable, income tax payable, and other liabilities are considered operating liabilities.
The remaining assets and liabilities are considered a financing asset and liability respectively. The
purpose of doing this differentiation is to calculate the invested capital or the net operating assets, i.e.,
the net amount a firm has invested in its operating activities, and which requires a return. This is:

Net operating assets (invested capital) =Operating assets−Operating Liabilities

Using the formula gives an invested capital of 5,433 in 2018 and 6,172 in 2017. This may also be cal-
culated as equity less NIBL (financing liabilities less financial assets) for an identical conclusion

For the analytical income statement, we calculate the effective tax rate from the given income state-
ment as taxes paid divided by profit before tax, giving 24%. We use this to calculate tax on EBIT,
given us a NOPAT of 2,441.

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Q1.2: Calculate (a) the profit margin, (b) the turnover rate of invested capital, and (c) the return on in-
vested capital for 2018. For the ratios based on balance sheet numbers, use the value of beginning
balance. Please keep two decimals for the results.

Answer: All calculations are seen below. EXPLANATIONS IN SAMPLE EXAM 2

NOPAT 2,441
Operating profit margin after tax= × 100= × 100=18.41 %
Revenues 13,257

Revenue 13,257
Turnover rate of invested capital= = =2.15
Invested capital 6,172

NOPAT 2,441
ROIC (after tax)= × 100= ×100=39.55 %
Invested capital 6,172

Q1.3: Suppose that the cost of capital for operations (i.e., WACC) is estimated to be 8%, please
calculate the economic value added in 2018. Please keep zero decimal for the results.

Answer: Subtracting WACC from ROIC gives Economic Value Added (EVA), i.e., super profit.
Value recreation requires the accounting profit measured as a percentage of invested capital (ROIC)
exceeds the average cost of capital (WACC) to all capital providers. We have:

EVA=( ROICafter tax−WACC ) ×Invested capital =( 39.55 %−8 % ) × 6,172=1,947

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5 CHP6 EXERCISES: GROWTH ANALYSIS

Petersen, Plenborg & Kinserdal (2017): Chapter 6 + Lecture 6

5.1 Exercise 1: Analytical Financial Statements, Growth Analysis

In the beginning of 2017 Martin started a company, the PRINTTASK CITY, performing large
printing services for companies. He asked you to help him with a few tasks related to the financial
analysis of the company. The original income statement and the balance sheet are attached

Q1.1: Prepare an analytical income statement for the PRINTTASK CITY.

Answer: The idea behind the analytical income statement is to separate operations from financing. It
is the firm’s operations which is the primary driving force behind value creation and should therefore
be isolated. When transforming the income statement for analytical purposes, we obtain the net oper-
ating profit after tax (NOPAT), which is an after-tax measure of earnings where an estimated tax is
deducted from EBIT. To estimate the tax on EBIT, we must calculate the effective tax rate:

Tax on profit of the year 225

Effective rax rate= = =25 %
Net profit before tax 900

The procedure is as follows: Start with the revenue and subtract operating expenses. This gives an
EBITDA of 3,500. Subtracting any depreciation expenses gives us an EBIT of 1,500. Using the effec-
tive tax rate above, the tax on EBIT is calculated to be 375, giving a NOPAT of 1,125 for 2017

Q1.2: Please provide an analytical balance sheet. Assume all cash is excess cash (financing asset).

Answer: To reformulate the balance sheet, we first identify which items are considered operating and
financing to separate the core operations. Printers, inventories, and accounts receivable are considered
operating assets, while accounts payable is considered an operating liability. The remaining assets
and liabilities are considered a financing asset and liability respectively. The purpose of doing this
differentiation is to calculate the invested capital or the net operating assets, i.e., the net amount a
firm has invested in its operating activities, and which requires a return. This is:

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Net operating assets (invested capital)=Operating assets−Operating Liabilities

Using the formula gives an invested capital of 14,875 in 2017. This may also be calculated as equity
less NIBL (financing liabilities less financial assets) for an identical conclusion

Q1.3: Calculate the return on invested capital, the profit margin, the turnover rate of invested capital,
and the return on equity. Please keep four decimals for the results.

Answer: All calculations are seen below. EXPLANATIONS IN SAMPLE EXAM 2

NOPAT 1,125
Operating profit margin after tax= × 100= ×100=8.33 %
Revenues 13,500

Revenue 13,500
Turnover rate of invested capital= = =0.9076
Invested capital 14,875

NOPAT 1,125
ROIC (after tax)= × 100= ×100=7.56 %
Invested capital 14,875

Net profit after tax 675

ROE= ×100= × 100=6.323 %
BVE 10,675

Q1.4: Suppose Martin took 300 Euros as dividends, please calculate this company’s sustainable
growth rate in the future. Please keep four decimals for the result.

Answer: The sustainable growth rate ( g) indicates at what pace a firm can grow its revenues while
preserving its financial risk, i.e., maintain its leverage ratio at the same level despite growth. So calcu-
late it, we need after-tax ROE, which we calculated to be 6.32%, and the payout ratio. The latter is the
dividend as a percentage of net profit. With a dividend of €300, the payout ratio is

300
PO= =0.4444
676

The sustainable growth rate can then be calculated to be g=3.513 %

g=ROE× ( 1−PO )=6.32 % × ( 1−0.4444 )=3.513 %

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6 CHP7 EXERCISES: LIQUIDITY RISK ANALYSIS

Petersen, Plenborg & Kinserdal (2017): Chapter 7 + Lecture 7

6.1 Exercise 1: Solvency Ratios

Your company is considering having a joint venture with a leading fashion company from Sweden.
Aanalyze this Swedish company’s financial situation. The original income statement and balance
sheet of this Swedish company are attached. It is also known that this company’s cash flow from
operations in 2019 was 5,823 Million SEK. Please keep three decimals for the results.

Q1.1: Calculate the financial leverage of this Swedish fashion company.

Answer: A commonly used solvency ratio for assessing whether a firm has sound financial structure
is financial leverage. Generally, a high financial leverage (e.g., compared to industry standard and
comparable firms) indicate a small capital buffer for unforeseen events and a high long-term liquidity
risk. The Swedish firm has 46,849 mSEK in (total) liabilities and 59,713 mSEK in equity. Thus:

Total liabilities 46,849

Financial leverage= = =0.785
Equity 59,713

Q1.2: Calculate this company’s current ratio.

Answer: The current ratio compares current assets with current liabilities. The greater the ratio, the
greater the likelihood that the proceeds from liquidation of current assets would cover current liabilit-
ies. Usually, a ratio greater than 2 indicates low short-term liquidity risk. The Swedish firm has
55,746 mSEK worth of current assets and 40,723 mSEK worth of current liabilities. Thus, we have

Current assets 55,746

Current ratio= = =1.369
Current liabilities 40,723

The shortcoming of this measure is (a) doesn’t consider current operating liabilities are continuously
refinanced as a consequence of ongoing business, (b) the book value of current assets often does not
reflect the realisation value, and (c) it may be difficult to estimate when the current ratio is adequate.

Q1.3: Assess whether this company’s cash flow from operations was enough for it to repay liabilities.

Answer: Cash flow from operations to debt ratio is an indicator of firms’ long-term ability to repay
loans. It measures the extent to which current cash flows from operations are sufficient to repay liabil-
ities. A high ratio signals a low long-term liquidity risk. It is calculated as:

Cash flow from operations 5,823

CFO to debt ratio= = =0.1243
Total liabilities 46,849

Usually, this ratio should be around 0.2 (arbitrary number, should also compare to peers), so this indi-
cates a high liquidity risk. In real life, we do not have to repay liabilities in one year.

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7 CHP8 EXERCISES: FORECASTING

Petersen, Plenborg & Kinserdal (2017): Chapter 8 + Lecture 8

7.1 Exercise 1: Pro Forma Statements

You will find a firm’s initial financial statements in year zero and the forecasting for year one. Please
fill in the pro forma statements for year one based on all the available information.

Answer: The proforma statements for year one using the forecasting assumptions are seen below.
EXPLANATIONS IN SAMPLE EXAM 1+2

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7.2 Exercise 2: Forecast FCFF

In 2018, a financial institute was considering investing in a German fashion company. It got the
forecasting for a series of value drivers for this German fashion company. The financial situation of
this German fashion company in 2018 was as follows: its sales revenue was 23,678 million Euros, and
its invested capital was 6,690 million Euros. Based on the above information, please predict this
German fashion company’s free cash flow to the firm in 2019-2023

Answer: The free cash flow to the firm in the forecast years is seen calculated below and in Excel.

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8 CHP9 EXERCISES: VALUATION

Petersen, Plenborg & Kinserdal (2017): Chapter 9 + Lecture 11

8.1 Exercise 1: EV using DCF (One-Period)

In 2015, a private company was considering an IPO. The following information was given: 

Its invested capital in 2016 is predicted to be 104,427,763, and the NOPAT in 2016 is predicted to be
12,692,635. The firm also predicted a growth rate of 2% in all the items of balance sheet and income
statement would be observed after 2016. The weighted average cost of capital in 2012-2015 was
7.86%, and was expected to stay the same. Given the information, please estimate its enterprise value
at the end of 2015 based on the discounted cash flow model. Please keep zero decimal for the results.

Answer: The enterprise value of a firm can be determined by the present value of future free cash
flows to the firm (FCFF), i.e., using a discounted cash flow model. FCFF is given as net operating
profit after tax (NOPAT) plus the change in invested capital. Note that invested capital is equal to net
operating assets. So, the change in invested capital from 2015 to 2016 is given as

Δ Invested capital t =102,380,160−104,427,763=−2,047,603

Further, in 2016 there is a predicted NOPAT of 12,692,635. This gives us a FCFF for 2016 as:

FCFF=12,692,635+ (−2,047,603 ) =10,645,032

We know that all items on the balance sheet and income statement are expected to grow by 2% annu-
ally in perpetuity. This logically implies that the firm’s FCFF will also grow with this rate. Now, to
find the present value of a perpetuity with a constant growth rate, g, we use the formula below, where
WACC is the weighted average cost of capital for the firm used as a discount factor. This gives us an
estimated enterprise value based on the given predictions:

FCFF 10,645,032 10,645,032

Enterprise value= = = =181,655,836
WACC−g 7.86 %−2 % 5.86 %

8.2 Exercise 2: EV using DCF (Multi-Period)

In 2018, a financial institute was considering investing in a fashion company. It has the forecasting for
value drivers for the company. The financial situation of this fashion company in 2018 is: its sales
revenue was 23,678 million Euros, and its invested capital was 6,690 million Euros. The weighted

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average cost of capital is 6.4%, and we assume the free cash flow to the firm after 2024 would
permanently increase by 3.5% per year. Estimate the enterprise value in 2018 based on the discounted
cash flow model. Keep zero decimal for the results (and three decimals for the discount factors).

Answer: The enterprise value of a firm can be determined by the present value of future free cash
flows to the firm (FCFF), i.e., using a discounted cash flow model. FCFF is given as net operating
profit after tax (NOPAT) plus the change in invested capital.

The first step is to use the forecasted value drivers to formulate the pro forma statements. The rev-
enue for each year is forecasted based on the revenue of the year before and the growth rate. EBITDA
is forecasted as a percent of revenue. The tangible and intangible assets are forecasted as a percent of
revenue, and from these the depreciation and amortisation expenses can be calculated giving us an es-
timate of EBIT. Using the (effective) tax rate given, we can calculate the tax on EBIT to finally give
us a yearly estimate of NOPAT. Net working capital is given as a percentage of revenue. Adding tan-
gible and intangible assets together with net working capital gives us an estimate of the invested cap-
ital (net operating assets). Now, FCFF is calculated as NOPAT plus the change in invested capital.

The second step is to find the enterprise value by applying a DCF model to the calculated FCFF. We
have n=5 years in the forecast period, followed by a terminal year value expected to permanently in-
crease by g=3.5 %. The appropriate discount factor is the firm’s WACC at 6.4%. We apply:
n
FCFFt FCFFn +1 1
Enterprise value=∑ + ×
t =1 ( 1+WACC ) t
WACC−g ( 1+ WACC )n

Put into words, we find the sum of the present value of the first 5 years by discounting the FCFF back
to 2018 using WACC. Then we add this the present value of a perpetuity (terminal value) weighted by
the last expression. As seen below, this gives

Enterprise value=11,223+75,646=86,869

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8.3 Exercise 3: EV using EVA (One-Period)

In 2015, a private company was considering an IPO. The following information was given:

In 2016, its invested capital is predicted as 104,427,763, and its NOPAT is predicted as 12,692,635.
The firm predicts a growth rate of 2% in all the items of balance sheet and income statement after
2016. The weighted average cost of capital in 2012-2015 was 7.86%, and is expected to be the same.
Estimate its enterprise value at the end of 2015 based on the economic value added model.

Answer: The enterprise value of a firm can be determined by the initial invested capital (net operating
assets) plus the present value of all future Economic Value Added (EVA), i.e.:
∞
EVA t
Enterprise value0=Invested capital0+ ∑
t =1 ( 1+ WACC )t

EVA is a measure of value creation or super profit in the firm. A positive EVA indicates value cre-
ation, which is conditioned by that the accounting profit exceeds the average cost of capital. It is thus
given as NOPAT t −WACC × Invested capital t−1.

Looking at the specific firm, we have a NOPAT of 12,692,635 in 2016. The invested capital in 2015
is 102,380,160, and the WACC is 7.86%. Therefore, we have an EVA of

EVA=12,692,635−7.86 % ×102,380,160=4,645,554

As we expected an average growth of 2% in all items in the financial statements, we also expected a
perpetual growth in EVA of 2% from 2016 and beyond. As we need to find the present value of a per-
petuity, the formula is slightly different than the one presented above, but the intuition is the same.
The enterprise value of the firm is then given as:

4,645,554
Enterprise value=102,380,160+ =181,655,833
7.86 %−2 %

8.4 Exercise 4: EV using EVA (Multi-Period)

At the end of fiscal year 2017, Global reported 5,444 million DKK of invested capital and 7,130
million DKK of equity in its balance sheet. The sales in 2017 were 17,238 million DKK. The

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forecasting of value drivers in 2018-2021 are seen in Excel. Fiscal year 2021 is the first year in the
terminal period, and the economic value added is expected to permanently increase by 3% per year
after 2021. The WACC in all the periods is 7%. Prepare the pro forma statement and estimate the
enterprise value at the end of 2017 based on the economic value added model.

Answer: The enterprise value of a firm can be determined by the initial invested capital (net operating
assets) plus the present value of all future Economic Value Added (EVA). This exercise assumes that
the growth rate of the firm will be 3% after the terminal year (steady-state assumption). So, let n be
the number of periods with non-constant growth rates (forecast horizon) and g be the long-term stable
growth rate (continuing period), then the model is
n
EVA t EVA n+1 1
Enterprise value0=Invested capital0+ ∑ + ×
t =1 ( 1+ WACC ) t
WACC−g ( 1+ WACC )n

EVA is a measure of value creation or super profit in the firm. A positive EVA indicates value cre-
ation, which is conditioned by that the accounting profit exceeds the average cost of capital. It is thus
given as NOPAT t −WACC × Invested capital t−1.

Turning to the exercise, the pro forma statements are prepared to calculate each financial year’s EVA.
The procedure is as follows: (1) revenue is forecasted using the previous year’s revenue and the
growth rate, (2) EBIT is forecasted as a percentage of expected revenue, (3) tax on EBIT is given us-
ing the effective tax rate, (4) NOPAT is calculated by subtracting tax from EBIT, (5) non-current as-
sets and NWC is forecasted as a percentage of sale, and (6) invested capital is calculated as non-cur-
rent assets plus NWC. We now calculate EVA for each year, given that WACC is 7%. E.g., for 2019:

EVA 2019=1,412−7 % ×5,444=1,031

For the three years in the forecasting period (2019-2020), we calculate the present value of EVA. The
present value of EVA in the terminal period is given by the last term in the equation above. We have:

Enterprise value 0=5,444+2,477+17,736=25,658

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9 CHP10 EXERCISES: COST OF CAPITAL

Petersen, Plenborg & Kinserdal (2017): Chapter 10 + Lecture 9+10

9.1 Exercise 1: ROE in the Dividend Discount Model

The Fish Loving produces and sells fish feed in the European market. The table shows key financials

Assume the revenue of this company would increase by 2% per year after 2017, leading to a constant
dividend growth of 2% per year. Assume that WACC in all the future years is the same as in 2016.
The dividend in 2017 is expected to be 394,307.76. Based on the discounted cash flow model, an
analyst estimated the Fish Loving’s enterprise value in 2016 to be 10,251,401. Calculate the required
rate of return on equity that yields the same valuation. Please keep four decimals for the results.

Answer: From the dividend discount model, the market value of equity can be calculated using the
formula below, given that the dividend grows as a constant rate g perpetually:

Div
MV of equity=
r e −g

r e is the required rate of return on equity. Now, the market value of equity is given as the enterprise
value less the net interest bearing liabilities. The enterprise value is estimated to be 10,251,401 while
the NIBL is calculated as financing liabilities less financing assets. In 2016, this gives

NIBL 2016=285,520−450,428=−164,908

We can then calculate the market value of equity as

MV of equity2016 =10,251,401− (−164,908 )=10,416,309

We also know that the dividend expected in 2017 is 394,307.76 To find the return on equity that
yields this market value of equity, we rearrange:

Div 394,307.76
re= + g= +2 %=5.79 %
MV of equity 10,416,309

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9.2 Exercise 2: MVE using Peer EV/EBIT ratio

In 2018, a financial institute was considering investing in a fashion company. The financial situation
of this company in 2018 was as follows: its sales revenue was 23,678 million EUR, and its invested
capital was 6,690 million EUR. Information on industry peers can be seen in Excel. The industry
average ratio of enterprise value to EBIT is a reliable predictor for the value of the company. The
EBIT margin of the company in 2018 was 12.5%, and net interest-bearing liabilities accounted for
40% of invested capital in 2018. What is the implied market value of equity in 2018? Please keep two
decimals for the results

Answer: To find the implied market value of equity, we need to use the information that the average
EV-to-EBIT ratio for the peer firms is a reliable predictor. This can be calculated in Excel to be equal
to 30.80. The fashion company has a sales revenue of 23,678 mEUR and a EBIT-margin of 12.5%,
giving an EBIT of 2,959.75 mEUR. We can now calculate the implied enterprise value of the firm:

Enterprise value
=30.80 ⟹ Enterprise value=30.80 ×EBIT
EBIT

Enterprise value=30.80 ×2,959.75=91,160.30 mEUR

To find the market value of equity, we must subtract net interest-bearing liabilities from the enterprise
value. The fashion company’s invested capital is 6,690 mEUR and NIBL is given as 40% of invested
capital, i.e., 2,767.00 mEUR. So, the market value of equity is:

MV of equity =91,160.30−2,767.00=88,484.30 mEUR

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10 CHP11 EXERCISES: CREDIT ANALYSIS

Petersen, Plenborg & Kinserdal (2017): Chapter 11 + Lecture 12

10.1 Exercise 1: Altman Z-score, Write-downs

Matas is listed on the Nasdaq OMX. In Excel, see the financial information of Matas. The fiscal year
of Matas differs from its calendar year, and it runs from April 1 st to March 31st of next year.

Q1.1: You plan to implement a credit analysis for Matas based on the Altman Z-score. In the fiscal
year 2009-2012, Matas was not listed, so we assume its share price was 150 DKK per share. The net
working capital in Altman Z-score can be directly calculated as current assets minus current liabilities.

Answer: A key part of a credit analysis is to assess the firm’s financial health based on historical data.
One of the ways of doing this is by relying on statistical models. This can be used to predict bank-
ruptcy and can help select the most relevant financial ratios. Altman (1968) used a multiple discrimi-
nant analysis to develop a model to classify a firm into a bankruptcy and non-bankruptcy groups de-
pending on their Z-score. He found the following model using five financial ratios:

Z-score=1.2 ( Working capital

Total assets )+ 1.4 (
Retained earnings
Total assets ) +3.3 (
EBIT
Total assets ) +0.6 (
MV of equity
BV of liabilities )+ 1.0 (
Sale
Tota

A firm with a Z-score below 1.81 has a high probability of bankruptcy, while a score above 2.99 gives
a low probability. The in-between scores are a grey area we will classify as medium probability.

To calculate the Z-score for each year of Matas’ financial statements, we need to calculate each of the
five financial ratios. Total assets, retained earnings, EBIT, book value of liabilities, and sales can be
seen directly in the financial statements. Working capital is simply calculated as current assets less
current liabilities. The market value of equity is found by multiplying the given share price with the
number of shares outstanding. The Z-score for each year is calculated using the formula above. We
see that in 2009-10 there is a high probability of default while the remaining years have a medium
probability according to the model. This indicates that the financial health is improving.

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Q1.2: Suppose that you conduct an impairment test for the intangible assets of Matas, and you
estimate a possible write-down of 70 million DKK on the intangible assets for the fiscal year 2015.
Please demonstrate how this write-down would affect the Altman Z-score of fiscal year 2015. Assume
that the market value of equity would stay the same, and the dividend payout would not change with
the write-down. Please keep one decimal for accounts and three decimals for the Z-score.

Answer: We have a write-down of 70 million on intangible assets. From the financial statements, we
can calculate the effective tax rate inn 2015 to be 23.6%. This means that the after-tax value of the
write-down is 70 × ( 1−23.6 % ) =53.48 million giving a tax shield of 16.52 million. To understand
how this will affect the Z-score, we need to figure out how it affects each component in the financial
ratios used to calculate the score.

The market value of equity, sales, and the book value of liabilities is unaffected by the write-down.
The write-down is an operating expense, so EBIT falls with the amount of the expense, i.e., 70 mil-
lion. This affect tickles down to the retained earnings that decrease with the after-tax value of the ex-
pense, i.e., 53.48 million as the tax shield is deducted. The tax shield impacts the NWC, which in-
creases with the amount of the tax shield, i.e., 16.52 million. Lastly, the total assets fall by the after-
tax value of the write-down. The remaining calculations are seen below. The combined effect is that
the Z-score of 2015 decreases with the write-down relative to no write-down.

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11 CHP12 EXERCISES: MANAGEMENT PERFORMANCE

Petersen, Plenborg & Kinserdal (2017): Chapter 12 + Lecture 13

11.1 Exercise 1: Growth Rate in EVA, EV-to-EBIT

You are assigned to conduct a financial statement analysis for a company. Based on the income
statement and balance sheets, at the end of fiscal year 2018, the book value of equity was 9,370 and
net financing assets were 3,137 (i.e., net interest-bearing liabilities were -3,137), sale revenue is
13,257, and EBIT is 3,205. A colleague forecasted the value drivers. The cost of capital for operations
(WACC) is estimated as 8%. Based on industrial peers, a reasonable EV/EBIT ratio is 20.53.

Q1.1: What was the long-run constant growth rate of EVA in the terminal period implied by the
above EV/EBIT ratio? Please keep zero decimal for accounts and keep three decimals for discount
factors and the results.

Answer: The enterprise value of a firm can be determined by the initial invested capital the present
value of all future Economic Value Added (EVA). The growth rate of the firm after the terminal
period (steady-state assumption) is unknown. Let n be the number of periods with non-constant
growth rates (forecast horizon) and g be the long-term stable growth rate (continuing period), then:
n
EVA t EVA n+1 1
Enterprise value0=Invested capital0+ ∑ + ×
t =1 ( 1+ WACC ) t
WACC−g ( 1+ WACC )n

EVA is a measure of value creation or super profit in the firm. A positive EVA indicates value cre-
ation, which is conditioned by that the accounting profit exceeds the average cost of capital. It is thus
given as NOPAT t −WACC × Invested capital t−1.

Before we determine the growth rate, we must calculate the value of EVA in each year. So, we pre-
pare pro forma statements. The procedure is: (1) sales is forecasted using the previous year’s sales and
the growth rate, (2) EBIT is found as a percentage of expected sales, (3) tax on EBIT is found using
the effective tax rate, (4) NOPAT is found by subtracting tax from EBIT, (5) non-current assets and
NWC is forecasted as a percentage of sales, and (6) invested capital is calculated as non-current assets
plus NWC. Note that in 2018, invested capital must be calculated as book value of equity plus net in-
terest-bearing liabilities. We now calculate EVA for each year, given WACC is 9%. E.g., for 2019:

EVA 2019=2,680−8 % × 6,682=2,181

Now, to determine the growth rate, we can reformulate the equation above giving:

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EVA n+1
g=WACC−

( )
n
EVA t
EV 0 −IV0 −∑
t=1 (1+ WACC )t
1
( 1+ WACC )n

The last thing we need to calculate to get the growth rate is the enterprise value. We know that EBIT
in 2018 is 3,205 and that the peer EV/EBIT ratio is 20.53. The EV of the firm is estimated as

EV 0 =3,205× 20.53=65,799

We can now insert all the known values cf. the Excel screenshot below:

2,235
g=9 %− =4.86 %

( )
65,799−6,233−7,264
1
( 1+9% )4

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12 SAMPLE EXAM 1

12.1 Assignment 1: Multiple Choice

For each question, at least one choice is correct. Indicate ALL the correct choice(s) for each question.

Q1.1: The free cash flows to the firm can be calculated as

(a) NOPAT 1+(Net operating assets1−Net operating assets0 )

(b) NOPAT 1+(Net working capital 1−Net working capital 0)
(c)
NOPAT 1−( ( N on-current tangible and intangible assets1−N on-current tangible and intangible assets1 ) +Depr
(d)
NOPAT 1+ Depreciation 1−( Net working capital 1−Net working capital 0 ) −( ( Non-current tangible and intangib

Q1.2: The capital expenditure ratio informs about

(a) How much cash a firm invests on annual basis

(b) Investments in intangible assets
(c) The proportion of capital expenditure that a company can fund through its operations
(d) Whether the firm’s assets are liquid enough to meet its financial obligations

Q1.3: The improvement on a positive EVA can be a result of

(a) Higher ROIC

(b) Lower ROIC
(c) Higher WACC
(d) Lower WACC
(e) Higher invested capital
(f) Lower invested capital

Q1.4: Useful benchmark(s) when assessing the level of ROIC is (are)

(a) Cost of equity

(b) Sales growth
(c) WACC
(d) Profit margin
(e) Capital expenditure ratio

Q1.5: Which of the following items lead to the difference between EBITDA and NOPAT?

(a) Tax on NFE

(b) Amortization

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(c) Sales
(d) Tax on EBIT
(e) Depreciation
(f) NFE, before tax

12.2 Assignment 2: True or False

State either ‘True’ or ‘False’ for each statement, and support your answer with a brief explanation.

Q2.1: Inventory is usually treated as financial assets because it is an effective way to get funding from
outsiders.

Answer: False. Inventory is treated as an operating asset, as it is directly related to the firm’s opera-
tion. It is also an important part of the net working capital.

Q2.2: The weighted average cost of capital can be used as a benchmark to set price for electricity by
Ørsted, which is the biggest provider of electricity in Denmark.

Answer: True. WACC reflects the weighted average cost of capital (i.e., equity and debt) for Ørsted,
as thus has a direct effect on how much it should charge for its services. In fact, WACC is widely
used as a benchmark to set profit for utility industries around the world.

Q2.3: The liquidation valuation approach leads to the same value as the present value approach.

Answer: False. The liquidation valuation approach estimates net value of a firm by calculating the
value if all assets were sold and liabilities settles in a forced sales situation. This value is the min-
imum value of the firm and is this only used if there is a risk of bankruptcy (usually be creditors).
Present value approaches give a higher value.

Q2.4: The relative valuation approach (i.c., multiples) is widely used by financial analysts, although it
could contain significant biases.

Answer: True. The method is popular as it is not that complex and fast to implement. However, it
does assume that the firms are truly comparable on profitability, growth, and risk, that accounting
numbers must be based on the same accounting policies, and that the impact of non-recurring items
must be excluded. In real life, all these criteria are hardly met making it biased.

Q2.5: For a company, if the owners’ required rate of return is 0.15, the required rate of return on debt
is 0.05, and market leverage (NIBL/Equity) is 5, then WACC is 0.067.

Answer: False. To calculate the WACC, we must know the marginal tax rate of the firm.

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12.3 Assignment 3: Analytical Financial Statements, Financial Ratios

You work in the accounting department in a fashion company in Denmark, and the company is con-
sidering launching a joint venture with a fashion company from Sweden. You are assigned to lead the
project and analyse this Swedish company’s financial situation. The original income statement and
balance sheet of this Swedish company are included in the attached Excel worksheet.

Q3.1: Prepare the analytical income statement and analytical balance sheet for the Swedish company.

(1) “Cash and cash equivalents” in this Swedish fashion company are excess cash.
(2) “Other liabilities” in this Swedish fashion company are not interest-bearing.

Answer: The idea behind preparing an analytical income statement and balance sheet is to separate
operating items from financing. The operations is the primary driver behind value creation and should
therefore be analysed isolated. We start by preparing the analytical income statement. Starting with
net sales, we subtract any operating expenses (cost of goods sold, selling expenses, and administrative
expenses) giving the firm’s earnings before interest and tax (EBIT), i.e., its operating profit. To es-
timate the tax on EBIT, we must calculate the effective tax rate given as

Tax on profit of the year

Effective rax rate=
Net profit before tax

Using this formula, we get the following effective tax rates for each year:

5.194 4,484
Effectiv e tax rat e2017 = =0.22 , Effectiv e tax rate 2018 = =0.22
23,607 2 0 , 382

Subtracting the tax on EBIT from EBIT gives us the net operating profit after tax (NOPAT). NOPAT
is 18,581 mSEK in 2017 and 16,044 mSEK in 2017. We calculate the net financial items (financial in-
come less financial expenses) and the tax shield generated from this using the effective tax rate.
Adding the net financial expenses after tax to NOPAT gives us the net earnings, identical to the profit
for the period in the accrual-based income statement given. The final analytical income statement is:

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To prepare the analytical balance sheet, we identify which balance sheet items are considered oper-
ating and financing to separate the core operations. Intangible and tangible fixed assets, current re-
ceivables, and deferred tax receivables are considered operating assets as they all seem to relate to
the firm’s core operations. Interest bearing long-term receivables, securities, and cash and cash equiv-
alents (c.f. assumptions) are thus financing assets. Any tax liabilities, accounts payable, accrued ex-
penses and prepaid income, and other liabilities (c.f. assumptions) are considered operating liabili-
ties. Interest bearing liabilities are considered financing liabilities, which includes provisions for pen-
sion, other interest-bearing liabilities, liabilities to credit institutions, and interest-bearing liabilities.

The purpose of doing this differentiation is to calculate the firm’s invested capital or the net operat-
ing assets, i.e., the net amount invested in operating activities, and which requires a return. There are
multiple ways of calculating this, but the most commonly used ones are:

I nvested capital=Operating assets−Operating Liabilities

I nvested capital=Equity+ Net interest-bearing liabilities

Thus, it is possible to prepare the analytical balance sheet in two different ways, giving the same val-
ues for invested capital. E.g., for 2018, this gives us

IC2018 =Operating assets−Operating Liabilities=62,093−36,184=25,909

IC2018 =Equity+ Net interest-bearing liabilities=59,713+ ( 10,665−44 , 46 9 ) =29,909

The total analytical balance sheet is seen below using both methods:

Q3.2: Please calculate following items for 2018. Please keep three decimals for the ratios: (a) Free
cash flow to the firm, (b) Free cash flow to equity holders, (c) EBIT margin, (d) Return on equity, and
(e) Current ratio

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Answer: The free cash flow to the firm (FCFF) is the cash flow after investments, i.e., the cash flow
from operations after accounting for depreciation, tax, and changes in net working capital and invest-
ments. It is thus the cash flow available for distribution to all investors of the firm, i.e., both debt and
equity holders. It can be calculated as

F CFF=NOPAT+ Δ Net operating assets=16,044+ ( 21,911−25,909 )=12,046

The FCFF for the firm in 2018 is 12,046 mSEK. Note the operating assets (invested capital) increases
from 2017 to 2018, which has a negative effect on FCFF, as more money is tied up in operations.

The free cash flow to equity holders (FCFE) is the cash flow available for distribution to equity
holder only. This means we must adjust FCFF with cash flows to debt holders, i.e.,:

FCFE=FCFF+ Δ NIBL+ NFE+Tax shield

¿ 12,046+ (−33,804−(−39,325 )) −187+ 41=17,421

The FCFE for the firm in 2018 is 17,421 mSEK. Note the net interest-bearing liabilities increases
from 2017 to 2018, which has a positive effect on FCFE.

The EBIT-margin shows the ratio of earnings remaining after operating expenses, depreciation, and
amortization but before interest and tax expenses, i.e., a measure of before-tax operating profitability

EBIT 20,569
EBIT-margin= = =0.103
Revenue 200,004

The EBIT-margin for the firm in 2018 is 0.103 meaning that 10.3% of the firm’s earnings remain after
operating costs, depreciations and amortizations.

The return on equity (ROE) measures the firm’s profitability while accounting for the effect of fi-
nancial leverage. This can be calculated as

Net profit after tax 15,898

Retu r n on equity= = =0.266
Book value of equity 59,713

The ROE for the firm in 2018 is thus 0.266 or 26.6%.

The current ratio compares current assets with current liabilities and is a measure of short-term li-
quidity risk. The greater the ratio, the greater the likelihood that the proceeds from liquidation of cur-
rent assets would cover current liabilities. Usually, a ratio greater than 2 indicates low short-term li-
quidity risk. It is given as

Current assets 55,746

Current ratio= = =1.369
Current liabilities 40,723

Thus, the current ratio is 1.369, which seems to indicate a medium short-term liquidity risk.

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12.4 Assignment 4: Forecasting, DCF model, Peers

You are considering acquiring a fashion company. After talking with a consulting company, you get
the value drivers for the company in the attached Excel worksheet. The financial situation of the com-
pany in 2018 is as follows: its revenue is 23,678 mEUR, and its invested capital is 6,690 mEUR.

Q4.1: Given that the weighted average cost of capital is 6.4%, and we assume the free cash flow to
the firm after 2024 would permanently increase by 3.5% per year. Please estimate the enterprise value
of this German fashion company in 2018 based on the discounted cash flow model. Please keep zero
decimal for the results and three decimals for the discount factors.

Answer: The enterprise value of a firm can be determined by the present value of future free cash
flows to the firm (FCFF), i.e., using a discounted cash flow model. FCFF is given as net operating
profit after tax (NOPAT) plus the change in invested capital.

The first step is to use the forecasted value drivers to formulate the pro forma statements. The rev-
enue for each year is forecasted based on the revenue of the year before and the growth rate. EBITDA
is forecasted as a percent of revenue. The tangible and intangible assets are forecasted as a percent of
revenue, and from these the depreciation and amortisation expenses can be calculated giving us an es-
timate of EBIT. Using the (effective) tax rate given, we can calculate the tax on EBIT to finally give
us a yearly estimate of NOPAT. Net working capital is given as a percentage of revenue. Adding tan-
gible and intangible assets to net working capital gives us an estimate of the invested capital (net oper-
ating assets). Now, FCFF is calculated as NOPAT plus the change in invested capital. E.g., for 2019
we can calculate the free cash flow to the firm as

FCFF=NOPAT+ Δ Invested capital=2,628+ ( 6,690−6,895 )=2,423 mEUR

The same procedure is followed for the other years. The prepared pro forma statements are below.

The second step is to find the enterprise value by applying a DCF model to the calculated FCFF. We
have n=5 years in the forecast period, followed by a terminal year value expected to permanently in-
crease by g=3.5 %. The appropriate discount factor is the firm’s WACC at 6.4%. We apply:
n
FCFFt FCFFn +1 1
Enterprise value=∑ + ×
t =1 ( 1+WACC ) t
WACC−g ( 1+ WACC )n

Put into words, we find the sum of the present value of the first 5 years by discounting the FCFF back
to 2018 using WACC as the discount rate. Then we add this the present value of a perpetuity (terminal
value) weighted by the last expression. As seen below, this gives

Enterprise value=11,223+75,646=86,869

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Thus, the enterprise value of the German fashion company is 86,869 mEUR.

Q4.2: The consulting company suggests you get inspiration from industry peers. The information
about industry peers is in the attached Excel worksheet. The consulting company claims that the in-
dustry average ratio of enterprise value to EBIT is a reliable predictor for the value of this fashion
company. You also know that the EBIT margin of this German fashion company in 2018 is 12.5%,
and net interest-bearing liabilities account for 40% of invested capital in 2018. What is the implied
market value of equity based on above information? Please keep two decimals for the results.

Answer: To find the implied market value of equity, we need to use that the average EV-to-EBIT ra-
tio for the peer firms is a reliable predictor. This can be calculated in Excel to be equal to 30.80 (using
the AVERAGE function). The fashion company has a sales revenue of 23,678 mEUR and an EBIT-
margin of 12.5%, giving an EBIT of 2,959.75 mEUR. The implied enterprise value of the firm is:

Enterprise value
=30.80 ⟹ Enterprise value=30.80 ×EBIT
EBIT

Enterprise value=30.80 ×2,959.75=91,160.30 mEUR

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The implied enterprise value of the firm using the average peer EV-to-EBIT ratio is then 91,160.30
mEUR. To find the market value of equity, we must subtract net interest-bearing liabilities from the
enterprise value. The fashion company’s invested capital is 6,690 mEUR and NIBL is given as 40%
of invested capital, i.e., 2,767.00 mEUR. So, the market value of equity is:

MV of equity=91,160.30−2,767.00=88,484.30 mEUR

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13 SAMPLE EXAM 2

13.1 Assignment 1: Multiple Choice

For each question, at least one choice is correct. Indicate ALL the correct choice(s) for each question.
The answers with missing or too many choice(s) is as incorrect and cannot be granted any credit.

Q1.1: Which of the following items give(s) rise to the difference between revenue and EBIT?

(a) Cost of goods sold

(b) Financial income
(c) Financial expense
(d) Selling, distribution and administration expenses
(e) Income tax expense
(f) Dividend payment

Q1.2: Which of the following statements regarding liquidity is(are) correct?

(a) Current ratio captures whether cash flow from operations can repay liabilities.
(b) It is beneficial to use multiple proxies for liquidity in the analysis.
(c) The COVID-19 outbreak put significant challenge on tourist shops’ liquidity.
(d) Capital expenditure ratio is positive related to a firm’s capital expenditure.
(e) The lack of liquidity could lead to bankruptcy.
(f) Airline companies refused to pay back cash to clients after the COVID-19 outbreak due to
their liquidity concern.

Q1.3: Which of the following activities can be classified as strategical analyses in forecasting?

(a) Analyze the public’s viewpoints on online shopping.

(b) Check whether the accounting policies change.
(c) Check the effective tax rate.
(d) Identify the key competitors.
(e) Analyze the firm’s cooperation with suppliers.
(f) Calculate the key value drivers.

Q1.4: Which of the following statements regarding the required rate of return on equity are correct?

(a) It is a benchmark when assessing a firm’s operating profitability.

(b) It is calculated as risk free rate plus risk premium.
(c) It is negatively related to beta.
(d) It is used to calculate the discount factor in the dividend discount valuation model.
(e) It increases with financial leverage when the return on invested capital is greater than net borrow-
ing cost.

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13.2 Assignment 2: True or False

Please clearly state either ‘True’ or ‘False’ for each statement, and then support your answer with a
brief explanation with maximum four lines.

Q2.1: Most financial markets are not efficient enough; thus, this leads to significant biases when ad-
opting the relative valuation approach.

Answer: True. Inefficient financial market cause stock prices to deviate from economic fundamen-
tals. This makes relative valuation biased, as it assumes markets are efficient and peers comparable.

Q2.2: The linear pay to performance structure generates high incentives for management team to en-
gage into earnings management.

Answer: False. Using a non-linear pay-to-performance structure with, e.g., a floor for bonus pay-
ments will increase the risk of the management engaging in earnings management by increasing earn-
ings to hit the floor of the incentive plan.

Q2.3: A beta value that is greater than zero indicates that the risk is above the market level.

Answer: False. A beta of zero means that the cash flow is risk-free, while a beta of one is equal to the
market risk. Greater than one indicated the risk is above the market level.

Q2.4: Most European countries have adopted the International Financial Reporting Standards (IFRS),
and it targets to eliminate accounting flexibility and earnings management.

Answer: False. While the EU has adopted IFRS, there is still a certain level of accounting flexibility
to allow management to incorporate proprietary firm information.

Q2.5: In certain circumstances, with a firm divesting and selling some of its segments, the firm valu-
ation would increase.

Answer: True. If the segments have a negative EVA, divesting it will increase the firm value.

13.3 Assignment 3: Analytical Financial Statements, Profitability

A German company operates in the manufacturing industry. In recent years it faces the increasing
challenge from new entrants with revolutionary technology. Its balance sheet and income statement
are shown in the Excel appendix. Suppose you work in a pension fund in Denmark and are consider-
ing whether to include this German company’s stocks into the investment portfolio. To help the in-
vestment director make the final decision, you conduct the following financial analyses.

Q3.1: To analyze this German company’s financial position, you reformulate its balance sheet for
analytical purpose. The following assumptions are given to facilitate you making the transformation:
Trade receivables do not charge interest in the short term, but they are interest bearing in the long

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term; the company holds cash for operating purposes. Please keep zero decimal for the accounts, and
please clearly demonstrate the classification for important accounts.

Answer: To prepare the analytical balance sheet, we identify which balance sheet items are operating
and financing to separate core operations. Financing assets are assets held for financing purposes, are
interest-bearing, and/o not a part of the firm’s core operations. It includes investment property, equity
investments, long-term trade receivables (interest-bearing c.f. assumptions), and marketable securi-
ties. The remaining assets relate to the firm’s core operations and are operating assets. This includes
intangible assets, PPE, deferred tax assets, inventories, trade, tax and other receivables (current re-
ceivables are not interest bearing), and cash (held for operating purposes c.f. assumptions). Financial
liabilities are generally interest bearing and includes non-current and current financial liabilities and
provisions for pensions. The remaining liabilities are operating liabilities, which include deferred tax
liabilities, trade and tax payables, provisions for taxes and non-current and current provisions.

The purpose of doing this differentiation is to calculate the firm’s invested capital or the net operat-
ing assets, i.e., the net amount invested in operating activities, and which requires a return. There are
multiple ways of calculating this, but the most commonly used ones are:

Invested capital=Operating assets−Operating Liabilities

Invested capital=Equity+ Net interest-bearing liabilities

Thus, it is possible to prepare the analytical balance sheet in two different ways, giving the same val-
ues for invested capital. E.g., for 2019, this gives us

IC201 9=Operating assets−Operating Liabilities=3 6 4 ,650−79,614=285 , 036

IC201 9=Equity+ Net interest-bearing liabilities=123,650+ ( 284,807−123,421 )=2 85 , 036

The total analytical balance sheet is seen below using both methods:

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Q3.2: Analyze the operating profitability, the evolution during the fiscal year 2018 and 2019, and the
main driving force for the change in its operating profitability. Keep three decimals for the results.

Answer: To implement an analysis of the operational profitability, we first need to prepare an analyt-
ical income statement to calculate the NOPAT. The procedure for calculating NOPAT is as follows:
Starting with revenue (sales revenue and other operating income), we subtract any operating expenses
(cost of sales, distribution expenses, administrative expenses, and other operating expenses) giving
the earnings before interest and tax (EBIT), i.e., its operating profit. To estimate the tax on EBIT, we
must calculate the effective tax rate given as

Tax on profit of the year

Effective rax rate=
Net profit before tax

Using this formula, we get the following effective tax rates for each year:

4,327 3 , 4 90
Effectiv e tax rat e201 9= =0.236 , Effectiv e tax rat e201 8= =0.223
18 ,356 15 ,643

Subtracting the tax on EBIT from EBIT gives us the net operating profit after tax (NOPAT). NOPAT
is 12,962 mEUR in 2019 and 10,814 mEUR in 2018. We can stop the preperations here, but to com-
plete the analytical statement, we calculate the net financial expenses (NFE) and the tax shield gener-
ated from this using the effective tax rate. Adding the NFE after tax to NOPAT gives us the net earn-
ings. The final analytical income statement is:

We are now ready to start the profitability analysis. One of the most crucial ratios here is the return
on invested capital (ROIC). It measures operational profitability as a percentage of invested capital.
Invested capital represents (net operating assets) is the total amount invested in the firm by share-
holder and debtholders, i.e., the book value of equity plus the net interest-bearing liabilities. Given the
analytical income statement and the analytical balance sheet, we can then calculate

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NOPAT 12,962
ROIC2019 = = =0.045
Invested capital 285,036

NOPAT 10,814
ROIC201 8= = =0.041
Invested capital 262,693

There is an increase in ROIC of 0.004 from 2018 to 2019, which is a positive thing as there is an in-
crease in profitability. To understand whether the general level of ROIC is good, we need to know the
firm’s cost of capital (WACC), i.e., the required rate of return to all lenders and shareholder. If ROIC
is greater than this, there is value creation.

To understand what drives this change in ROIC, we can decompose it into:

ROIC=Operating profit margin × Turnover rate of invested capital

The turnover rate of invested capital expresses the firm’s efficiency in managing its invested capi-
tal. The higher the ratio, the more efficient the firm is at generating revenue from its invested capital.
In both years, we can calculate the ratio as

Revenue 264,085
Turnover rate of invested capital2019 = = =0.926
Invested capital 285,036

Revenue 247,480
Turnover rate of invested capital201 8= = =0.9 42
Invested capital 262,693

We see there has been a slight deterioration from 2018 to 2019. Obviously, this does not explain the
increase in ROIC. Instead, we look at the operating profit margin, which describes the relation be-
tween revenue and expenses by expressing operating profit as a percentage of revenue. This is: c

NOPAT 12,962
Operating profit margin 2019= = =0. 049
Revenue 264,085

NOPAT 10,814
Operating profit margin 2018 = = =0. 04 4
Revenue 247,480

The operating profit margin has thus increased by 0.005. This means that the operating profitability
measured by ROIC has improved in 2019 due to the increase in operating profit margin, which has
more than outweighed the decrease in asset turnover rate.

Q3.3: Suppose you apply the clean-surplus assumption to this company, that is, it releases all the free
cash flow to equity holders as dividends. Please estimate the sustainable growth rate, then assess its
long-term liquidity risk. Note that this question is restricted to fiscal year 2019.

Answer: To estimate the sustainable growth rate we need to know return on equity (ROE) and the
payout ratio. As all free cash flows to equity holders (FCFE) are paid as dividends, we must first esti-
mate this to obtain the payout ratio. We first need to calculate the free cash flow to the firm (FCFF)

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is the cash flow after investments, i.e., the cash flow available for distribution to all investors of the
firm, i.e., both debt and equity holders. It can be calculated as

F CFF=NOPAT+ Δ Net operating assets=12 , 962+ ( 2 62,693−2 8 5,0 36 )=−9,381 mEUR

The FCFF for the firm in 2019 is -9,381 mEUR. Note the operating assets increases from 2018 to
2019, which has a negative effect on FCFF, as more money is tied up in operations. To obtain the free
cash flow to equity holders (FCFE) we must adjust FCFF with cash flows to debt holders, i.e.,:

FCFE=FCFF+ Δ NIBL+ NFE+Tax shield

¿ 12,046+ ( 161,386−145,351 )+ 1,396−329=7 ,7 21

The FCFE for the firm in 2019 is 7,721 mSEK. Note the net interest-bearing liabilities increases from
2018 to 2019, which has a positive effect on FCFE. Given that the net earnings (after tax) in 2019 was
14,029 mEUR, the payout ratio can be calculated as

FCFE 7,721
PO= = =0.550
Net earnings after tax 14,029

This means the firm effectively pays out circa 55% of its after-tax profit as dividends in 2019. We can
also calculate the ROE for 2019 as

Net profit after tax 4,029

ROE= = =0.113
Book value of equity 123,650

Finally, the sustainable growth rate ( g) can be calculated. This indicates at what pace a firm can
grow its revenues while preserving its financial risk (financial leverage). We then have:

g=ROE× ( 1−PO )=0.11× (1−0.550 )=0.051

This means the firm can sustainably grow its revenues at circa 5.1% annually. There is a close link be-
tween revenue growth and liquidity, so we should consider the firm’s liquidity risk. Focussing on the
long-term liquidity risk, the most common solvency ratios should be assessed. The equity ratio and
the financial leverage ratio for the firm is given as:

Equity 123,650
Equity ratio= = =0.253
Total assets 488,071

Total liabilities 488,071−123,650

Financial leverage= = =2.947
Equity 123,650

In general, a high financial leverage and a low equity ratio indicate a high long-term liquidity risk,
which is seen here. However, this should ideally be compared to an industry benchmark. Basing the
financial leverage ratio on NIBL, gives a slightly less dramatic and perhaps more realistic image:

NIBL 161 , 387

Financial leverage= = =1.305
Equity 123,650

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13.4 Assignment 4: Forecasting, EVA model, Peers, MVE/BVE-ratio

The Four Wheels is a leading automobile manufacturing company. It owns three brands that focus on
fossil fuel vehicles. Recently, it launched a new brand Zero Carbon to explore the electronic vehicles
market. In fiscal year 2019, the sales revenue of brand one was 12,414 mEUR; the revenue of brand
two and brand three were 8,893 mEUR and 785 mEUR, respectively; the revenue of brand Zero Car-
bon was 64 mEUR. At the end of fiscal year 2019, the Four Wheels’ operating assets were 35,912
mEUR and operating liabilities were 15,748 mEUR.

Q4.1: The Four Wheels makes forecasting for fiscal year 2020-2024 shown in the Excel appendix. All
the items in its balance sheet and income statement are expected to increase with a permanent annual
growth rate of 1.57% after fiscal year 2024. The weighted average cost of capital in the future will be
7.61% per year. Help the Four Wheels estimate its enterprise value at the end of fiscal year 2019
based on the economic value added valuation model. Please keep three decimals for discount factors
and keep zero decimal for accounts and the results.

Answer: The enterprise value of a firm can be determined by the initial invested capital (net operating
assets) plus the present value of all future Economic Value Added (EVA), i.e., using an EVA model.
EVA is a measure of value creation or super profit in the firm. A positive EVA indicates value cre-
ation, which is conditioned by that the accounting (operating) profit exceeds the average cost of cap-
ital. It is thus given as NOPAT t −WACC × Invested capital t−1.

The first step is to use the forecasted value drivers to formulate the pro forma statements. The sales of
each year are forecasted based on the sales of the year before and the growth rate for each individual
brand. Total revenue is the sum of all four brands’ sales. EBITDA is forecasted as a percent of total
revenue. The tangible and intangible assets are forecasted as a percent of revenue, and from these the
depreciation and amortisation expenses can be calculated giving us an estimate of EBIT. Using the
(effective) tax rate given, we can calculate the tax on EBIT to finally give us a yearly estimate of NO-
PAT. Net working capital is given as a percentage of revenue. Adding tangible and intangible assets
to net working capital gives us an estimate of the invested capital (net operating assets). Note that in
2019, the invested capital is simply calculated as the operating assets less operating liabilities.

Now, EVA is calculated as NOPAT minus WACC times the invested capital of last period. We know
that WACC is 7.61%. E.g., for 2020 we can calculate the economic value added as

EVA 20 20=NOPAT20 20−WACC ×Invested capital201 9=2 ,390−7.61 % ×20,164=855 mEUR

The same procedure is followed for the other years. The prepared pro forma statements are below.

The second step is to find the enterprise value using the EVA model. We have n=4 years in the fore-
cast period, followed by a terminal year value expected to permanently increase by g=1.5 7 %
(steady-state assumption). The appropriate discount factor is the firm’s WACC at 7.61%. We apply:

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n
EVA t EVA n+1 1
Enterprise value0=Invested capital0+ ∑ + ×
t =1 ( 1+ WACC ) t
WACC−g ( 1+ WACC )n

Put into words, we find the sum of the present value of the first 4 years by discounting the EVA back
to 2018 using WACC as the discount rate. Then we add this the present value of a perpetuity (terminal
value of EVA) weighted by the last expression. Both present values are added to the invested capital
in 2019 to get the enterprise value at the end of 2019. As seen below, this gives

Enterprise value=20,164+ 2,329+6,576=29 ,0 69

Thus, the enterprise value of the company is 29,069 mEUR

Q4.2: The Four Wheels is particularly interested in the value of its brand Zero Carbon. At the end of
fiscal year 2019, the invested capital of Zero Carbon was 59 mEUR, and its net interest-bearing liabil-
ities was 29 mEUR. The value drivers for Zero Carbon (including tax rate, EBITDA margin, depreci-
ation & amortization as a percentage of tangible and intangible assets, tangible and intangible/Sales,

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net working capital/Sales) and the weighted average cost of capital are the same as the parent group.
The sales revenue of Zero Carbon is predicted to permanently increase with annal growth rate of
5.05% after fiscal year 2024. At the end of year 2019, the P/B ratio of Telsa was 10.14. Please estim-
ate Zero Carbon’s P/B ratio at the end of fiscal year 2019 based on economic valued added valuations
model, then compare it with Telsa. Please keep two decimals for the results.

Answer: The first step is to estimate the enterprise value of the brand Zero Carbon. The exact same
value drivers from the previous question are valid, so the method follows what was explained. The fi-
nal pro forma statement is seen below. Now, the EVA of each year is calculated as before, but when
applying the terminal growth rate, we use 5.05% (assuming that EVA increases with the same rate as
sales revenue). Thus, we get an enterprise value in 2019 of 202.08 mEUR.

4.48 1
Enterprise value 0=59.00+ 12.46+ × =202.08 mEUR
7.61%−5.05 % ( 1+7.61% ) 4

To calculate the MV of equity for the brand, we subtract NIBL of 29 mEUR from the enterprise
value, giving a MVE of 173.08 mEUR. The book value of equity is given as IC less NIBL, which
gives 30 mEUR. So the market value to book value of equity is 5.77, significantly lower than Tesla

P/ B=173.08/30=5.77

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14 WORKSHOP QUIZZES

14.1 Chapter 1 and 2

Q1: Which one of the following is usually viewed as an equity-oriented stakeholder?

Answer: Investors, firms, corporate finance analysts, etc

Q2: Which accounting standard is widely used in Europe?

Answer: IFRS

Q3: "Employees only get salaries, therefore they are not the users of corporate financial statements".
Is this true or false?

Answer: False, as they can have equity in the firm or similar.

Q4: Income statements inform about

Answer: Expenses

Q5: Statements of changes of equities inform about

Answer: Dividends

Q6: "A debit is an entry made to the right side of an account and always increases an account
balance", is it true or false? 

Answer: False – with income, liabilities, and equity a debit decreases account balance

Q7: If a firm purchases inventory on account, it 

Answer: Credits accounts payable, as it is an increase in a liability

Q8: If a firm sells a product on cash basis, it 

Answer: Debits cash

Q9: If a firm pays salary to employee on cash, it 

Answer: Debits salary expenses, as expense increases.

Q10: A firm prepays the insurance expenses, then 

Answer: Assets stay the same, as prepaid expense (asset) increases while cash (asset) decreases.

14.2 Chapter 3 and 4

Q1: Cash flow-based performances better capture a firm’s value creation than accrual-based perfor-
mance measures.

Answer: No

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Q2: "Accrual-based performance measures are easy to be manipulated", is it true or false? 

Answer: True

Q3: "Share issues increase the cash flow of firms", is it true or false? 

Answer: True

Q4: "Stock repurchases increase the cash flow of firms", is it true or false? 

Answer: False

Q5: "Increases in inventory increases the cash flow of firms", is it true or false? 

Answer: False

Q6: "Decreases in accounts payable decrease the cash flow of firms", is it true or false?

Answer: True

Q7: "Invested capital is also called net operating assets", is it true or false?

Answer: True

Q8: "Cash and cash equivalents can be classified as either operating assets or financing assets
depending on their property", is it true or false?

Answer: True

Q9: "Tax payable is always classified as operating assets", is it true or false?

Answer: False

Q10: NOPAT is equivalent to

Answer: Net operating assets after tax

14.3 Chapter 5 and 6

Q1: Return on invested capital informs about

Answer: Utilization of invested capital AND revenue and expense relations

Q2: Profit margins informs about

Answer: Revenue and expense relations

Q3: Return on equity informs about

Answer: Profitability accounting both for operating and financial leverage.

Q4: "When the net borrowing cost is greater than ROIC, shareholders will benefit from borrowing
from banks because they achieve higher return on equity", is this true or false?

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Answer: False, financial leverage has a negative effect on ROE if ROIC> NBC

Q5: "The cost of equity can be used as the benchmark when assessing a firm's return on equity", is
this true or false？

Answer: True

Q6: A useful benchmark when assessing the level of ROIC is

Answer: Weighted average cost of capital (WACC)

Q7: "The ROIC of firms could fluctuate with time, so financial analysts would benefit from analyzing
firm performance in a long period", is this true or false?

Answer: True

Q8: The sustainable growth rate informs about 

Answer: How fast a firm can grow while maintaining the same financial leverage.

Q9: A higher payout ratio results in

Answer: Lower sustainable growth rate

Q10: Sales growth

Answer: Sometimes adds value.

Q11: Improved value creation can be obtained by

Answer: A lower WACC

Q12: "Share buybacks always improve earnings per share", is this true or false? 

Answer: False

Q13: "Growth in earnings per share always leads to value creation", is this true or false? 

Answer: False

Q14: "Analysts prefer growth in core business relative to the one in special items", true or false?

Answer: True

Q15: A house-keeping service company is generally characterized by

Answer: High turnover of invested capital and low profit margins.

14.4 Chapter 7 and 8

Q1: The current ratio is defined as

Answer: Current assets divided by current liabilities

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Q2: The capital expenditure ratio informs about

Answer: The proportion of capital expenditure a firm can fund through its operations.

Q3: "The financial ratios for liquidity risk are more useful when they are used together", true or false?

Answer: True

Q4: "A longer liquidity cycle is a signal of low liquidity risk", is this true or false?

Answer: False

Q5: "Interest coverage ratio capture whether a firm's current assets can be used to repay interest", is
this true or false?

Answer: False

Q6: "Lack of liquidity may force firms to dispose certain business units in order to get funds", is this
true or false?

Answer: True

Q7: "Capital structure can be employed as the predictors (or indicators) of bankruptcy", true or false? 

Answer: True

Q8: A strategic analysis

Answer: Is time consuming and it adds value when forecasting a firm’s performance.

Q9: It is generally recommended to work with

Answer: Most aggregated value drivers over a longer horizon.

Q10: Financial value drivers

Answer: Should be adjusted based on the specific situation.

Q11: Budget control helps ensure the forecasts be

Answer: Achievable

Q12: An easy way to conduct budget control is to compare

Answer: Forecasted ROIC with historical ROIC

Q13: Investments in tangible assets are defined as 

Answer: Tangible assets (end of period) + depreciation – tangible assets (beginning of period)

Q14: A financial value driver

Answer: Closely mirrors the firm’s financial performance.

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Q15: Which element is NOT contained in strategic analyses?

Answer: Liquidity risk analysis.

14.5 Chapter 10
Q1: Enterprise value is equal to

Answer: Market value of equity plus the market value of net interest-bearing liabilities

Q2: The dividend discount model provides a value estimate of

Answer: Equity value

Q3: The economic value added model discounts future EVA using

Answer: The weighted average cost of capital

Q4: The valuation based on P/B ratio yields the following value estimate:

Answer: Equity value

Q5: The liquidation valuation approach provides an indication of the

Answer: Minimum value of the firm

Q6: Different models in the present value approach yield

Answer: Identical value estimates

Q7: A valuation based on the relative valuation approach provides value estimates that serve as a

Answer: Useful benchmark to valuations

Q8: Firms that are included in a P/E relative valuation analysis ideally should have similar future

Answer: Profitability, risk and growth.

Q9: "An ideal valuation approach should generate unbiased and understandable value estimates." Is
this statement true or false?

Answer: True

Q10: "In the practice, the financial market is usually not efficient enough, but it doesn't lead to biases
in the relative valuation approach." Is this statement true or false? 

Answer: False

Q11: "The net asset value approach is designed for an extreme situation where firms have to liquidate
their assets in forced sales." Is this statement true or false?

Answer: False

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Q12: "If financial analysts try to comply with all the necessary assumptions in the relative valuation
approach, they can always find comparable industrial peers to conduct the analyses. " true or false? 

Answer: False

Q13: "Compared to DDM and DCF, the enterprise value obtained from EVA model is relatively
easier to understand and explain." Is this statement true or false?

Answer: True

Q14: "The liquidation valuation approach would lead to the same value as the present value
approach." Is this statement true or false? 

Answer: False

Q15: "The relative valuation approach is widely used by financial analysts in the practice, although it
could contain significant biases." Is this statement true or false?

Answer: True

14.6 Chapter 9 and 11

Q1: When estimating a firm’s WACC, the capital structure must be based on

Answer: Market values

Q2: WACC is a function of a firm’s

Answer: Neither earnings and total assets or growth rates and investment potential.

Q3: WACC signals a firm’s 

Answer: Hurdle rate for new investments

Q4: The capital structure for privately held firms is often measured as

Answer: The capital structure of peers

Q5: From the theoretical perspective, the risk free interest rate is equal to

Answer: The expected return on a zero-beta portfolio

Q6: A beta equaling to 1.2 indicates that the risk 

Answer: Is above the market level

Q7: "The weighted average cost of capital is determined by the cost of liabilities and the cost of
equity, and it is not influenced by corporate tax rate". Is this statement true or false?

Answer: False

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Q8: "The yield for 10-year or 30-year government bonds are often used as the proxy for risk free rate
for long-term projects". Is this statement true or false?

Answer: True

Q9: Estimating the expected loss includes

Answer: Estimating the probability of default and the loss given default

Q10: When estimating the probability of default

Answer: An analysis of the firm’s financial health is crucial.

Q11: According to Altman’s Z score, the probability of bankruptcy is high when the Z-score is 

Answer: Below 1.81

Q12: According to Standard & Poor’s credit rating scheme, a BBB rating corresponds to

Answer: Investment grade

Q13: The exposure at default is

Answer: The outstanding debt including unpaid interests

Q14: When estimating the recovery rate

Answer: The available securities, collaterals and liquidation value are assessed

Q15: "Creditors usually prefer intangible assets to tangible assets as collaterals." True or false?

Answer: False

14.7 Chapter 12, 13, 14 and 15

Q1: Congruence suggests that

Answer: The alignment of interests between management and shareholders

Q2: Controllability suggests that

Answer: There is a close link between management efforts and the performance measure in the incen-
tive plan.

Q3: Simplicity suggests that performance measures used in the incentive plan

Answer: Are easy to understand and communicate

Q4: Non-recurring accounting items should

Answer: Sometimes be included in performance measures for bonus plans. Depends on the nature of
non-recurring items.

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Q5: Performance measures in incentive plans can be

Answer: Both absolute and relative

Q6: A performance standard 

Answer: Is similar to a hurdle rate

Q7: An example of an internal performance standard is

Answer: Budgets

Q8: To avoid earnings management, the pay to performance structure should be

Answer: Linear

Q9: "Incentive plans should be designed to push managers to take into consideration both short-term
performance and long-term developments". Is this statement true or false?

Answer: True

Q10: "Ideally the changes in accounting policies and estimates on the performance measures used
should be eliminated." Is this statement true or false?

Answer: True

Q11: Why is accounting flexibility unavoidable?

Answer: Because firm specific facts and circumstances should be reflected in accounting.

Q12: What are the two key elements of high accounting quality?

Answer: Relevance and faithful presentation

Q13: What is the difference between earnings management and accounting frauds?

Answer: Accounting frauds are so material that they are clearly outside the law and subject to crimi-
nal prosecution.

Q14: "Earnings management is defined as the action to improve earnings". true or false?

Answer: False

Q15: "Managers' motivation to engage in earnings management activities is to increase shareholder

values". Is this statement true or false?

Answer: False

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