Online Exam: Financial Statement Analysis and Security Valuation

This document provides a comprehensive solution to a financial statement analysis and security valuation online exam. The solution covers various exercises, including calculations and interpretations of key financial metrics such as Earnings Per Share (EPS), Dividends Per Share (DPS), Book Value per Share, Return on Capital Employed (ROCE), and residual earnings. It analyzes the impact of increasing residual income, the role of put options in risk mitigation, and the effects of changes in equity and sales on a company's financial performance. The document also addresses the relationship between market value and book value of equity and calculates implicit growth rates. Furthermore, it includes a detailed analysis of a company's financial statements, including the calculation of missing values and the significance of deferred revenue in financial statement analysis. The solution provides detailed explanations and calculations, making it a valuable resource for students studying finance.

FINANCIAL STATEMENT
ANALYSIS AND SECURITY
VALUATION ONLINE EXAM

TABLE OF CONTENTS
EXCERCISE 1.................................................................................................................................1
a)..................................................................................................................................................1
b)..................................................................................................................................................2
EXERCISE 2 ..................................................................................................................................3
a)..................................................................................................................................................3
b)..................................................................................................................................................3
EXERCISE 3 ..................................................................................................................................4
a) .................................................................................................................................................4
b)..................................................................................................................................................4
EXCERCISE- 4...............................................................................................................................5
EXCERCISE- 5...............................................................................................................................6
a) Missing values of the company at 35% tax rate......................................................................6
b) Deferred revenue is an important part of the financial statement analysis..............................6
REFERENCES................................................................................................................................8

EXCERCISE 1
a)
2020 2021E 2022E 2023E 2024E 2025E
EPS 5.04 6.47 5.24 6.72 7.32
DPS 1.16 1.45 1.62 1.76 1.99
Book
value per
share
$37 $40.88 $45.9 $49.52 $54.48 $59.81
ROCE 13.6% 15.8% 11.4% 13.5% 13.4%
Residual
earnings
(10%)
$1.3 $2.37 $0.64 $1.73 $1.85
Explanation
The Earnings per Share and Dividends per Share is given in the question.
 The Book Value per Share is computed as (Book value in prior year + EPS – DPS).
 The ROCE is calculated as (EPS / Book value in prior year *100).
 Residual earnings = (Book value in prior year * ROCE in current year – Required rate of
return)
Assuming the residual earnings will grow at a rate equal to the growth in the historical GDP of
4% after 2025, thus, it has also been assumed that EPS and DPS will also increase with the same
percentage the book value of the share in the company will be:
Residual earnings = 10*(1+4%) = 10.4%
Residual earning is computed as
EPS = 7.32 * (1+4%) = $7.61
DPS = 1.99 * (1+4%) = $2.06
Book value per share = 59.81 + 7.61 – 2.06 = $65.36
It can be stated from the above that as the residual earrings are positive and are also showing an
increase in trend, this indicates that the company is profitable and along with that the share price
of the company is also increasing at premium over the book value of the share (Christodoulou,
Ma and Vasnev, 2018). This means that the shareholders are earnings returns which is greater
than the required rate of return.
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b)
It can be interpreted that increasing the residual income is part of operational activity as it
can be enhanced by practices activities like crowd funding real estate, considering investing,
working with affiliates, etc. It is measurement of net income that investment can earn. This is
significant pattern to approve a reject the capital investment or estimated value of business
(Sanchez and Wellschmied, 2020). From this it can evaluated that enterprise’s value can be
determined after accounting cost of Capital. in terms of firm’s equity valuation it may identified
that it is income generated by organization for the trust cost of capital. Profitability for the
specified accounting period may be judged through this for more accurate estimate of company’s
financial position.
These measures the company’s success or projects financial growth based on the residual
wealth. The company generates the capital invested into the overall objective for modifying the
performance of organization. Residual income is basically value of the organization’s practices
that reflects the amount firm can expect to receive when the particular mentioned component
disposed (Reggiani, 2020). From this it can be analyzed that increasing residual earnings refers
to having more liquidity in company. It may evaluated from the statement that longer would be
the life of asset lower will be its residual income. In addition to this, by disposing the machine,
plant, equipment or any other asset of company which enable it to have some worth in form of
money so that carrying forward of operational activity with obtained amount can become
possible. Residual income is one the main objective of organization for increasing its
profitability with continuous development.
From the above given description it can be assessed that it is accurate to state the
statement correct and rely on it as increasing residual earning refers to enhancing firm’s value.
This helps in enhancing the financial position in industry through inclining its profitability which
is left over after the operating profit (Pandit and Das, 2020). It is determined by after paying all
cost of capital to generate the revenue. Organizations take various types of efforts to increase its
residual earnings so that at the end it can obtain sustainability and higher profitability to beat the
competition prevailing in industry. residual income aids in deriving economies of scale by
increasing opportunity for growth and development The other types of benefits that company
can attain are motivation of success, team development approach, minimum rate of return can
depending upon the riskiness of division, different assets can be acquired to earn varying return
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for mitigating risk, etc.
EXERCISE 2
a)
Cash flow = 60 million
Company tax rate @ 22%
Stock option expense after tax = 1320000
From this it can be identified that company has incurred stock option expenses 1320000
which is large amount and need consideration of firm for increasing its cash flow in the
company. The given tax rate helps in deriving the essential requirement of case study which
is estimation of stock option expenses.
b)
Put Option (PO) is the contract giving right but not the obligation to sell a particular
amount of underlying stock at the pre estimated value within specified period of time. This helps
the investors to understand the position which gives opportunity to protect from the downward
moves in long stock position (Gao and Jia, 2021). In addition o this, there are various reason for
which investors keep put option of their stock. The one of the crucial reason behind this is to
mitigate the risk of obtaining losses due to changing circumstances and prices of shares. The put
options works in very systematic pattern that enables the investor to derive opportunity to reduce
chances of losses. A put option increases the worth such as premium rises as the value of
underlying stock declines. On the other side PO losses value when there is rise in stock prices.
Another purpose for which investors’ uses this component of derivative market which is
put option is to decline the negative impact of fall in stock market. basic strategy behind
utilization of mentioned is to grant the right to sell at particular fixed price in turn effective
outcome can be derived by overcoming the challenges of volatile market. It has the feature to act
as proactive to hedge an existing position while a long put is used to speculate on move lower in
prices. The biggest benefit that stock trader derives from this is to get the ability of obtaining
high leverage as by investing small amount of capital (Hu and Jacobs, 2020). From this put
option one can protect his equity portfolio from a decline in market by having proactive
approach in order to have desirable outcome.
The rationale behind keeping put option is to attract the investor as it provides the above
mentioned opportunities which enable them to be active in trade practices. in addition to this, it
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helps in increasing firm’s financial position by showing active participation of shareholders
which enhances reputation and financial condition of organization. Put option enables the user to
get limited liability with no margin deposits that enhances trustworthiness among investors and
aids firm in raising large amount of capital. Cost efficient, lower risk, high return potential, etc
are the key factors which require to provide by company to stock holders for accomplishing the
business objectives.
EXERCISE 3
a)
There has been a change in equity in the year 2020 by 13.9% increase which is having a huge
impact due to change in sales as there has been an increase in sales 51.8%. this can be supported
with the help of the analyzing the change in net assets and the net financial borrowings of the
company. In order to increase the sales, the company required a huge amount of funds in respect
to product development, market analysis, innovation and so forth, this resulted into increase in
the financial obligations of the company. The made use of both debt and equity in order to meet
with its capital requirements (Easton and et.al., 2018). This has caused a greater change in the
value of these two. In addition to this, for the purpose of increasing the production or for
implementing required plan pertaining to the products and services, the company invested some
amount in purchased fixed assets like machinery to equipment which was necessary for
producing the desired level of product and output for meeting the demand of the customers. The
common equity changed mainly due to the change in sales and change in the net operating assets
and not because of financial obligations.
b)
Market value of equity is much often higher than its book worth. It can be analyzed by
giving emphasis on the statement that validates it. The main reason behind is related with its
perception of investors believes that if the market value is higher than investing in company is
worthwhile. Market and book value are sued to determine the stock fair position through
identifying under and overvalue reasons (LEE, 2020). An organization’s book value is amount
of money shareholders would obtain if the assets are disposed for overcoming company’s
obligation. Whereas market value is worth of firm based on current prices of stocks. For this
purpose every investor wants to secure funds and have motive to earn higher return on it. To
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attract the shareholders for raising money it becomes essential for the company to have good
credibility in the market. It all helps in deriving the essential requirement for gaining attention of
shareholders (Battisti and et.al., 2020). Higher market value than book represents Company has
good potential in increasing its earnings. Financial market position is largely focused while
making investment decisions by stakeholders. When book value is less investors has the low
confidence in business activities and earning capabilities. It enables in decrease capital raising
capacity of organization.
It becomes crucial for concerned firm to put efforts in increasing its market position so
that higher confidence of investors can be derived for having smooth functioning of organization.
Greater value in market reflects financial strength of company which enables it to win the
competition in industry by gaining competitive advantages (Nduati and Wepukhulu, 2020). By
comparing both mentioned components invest as well get opportunity to evaluate that firm’s
stock is over or undervalue for generating income. This indicates that company has enhanced
power of earning than its assets. In addition o this, excellence future of company can be
predicted in terms of expansion, growth, etc.
EXCERCISE- 4
a) Market price= 140
Earning per share in 2021= $4.61
Earning per share in 2022= $5.94
Earnings growth rate= (5.94 – 4.61) / 4.61 * 100
= 28.85%
Book value per share= $6.50
Required rate of return= 11%
Implicit growth rate through residual earnings valuation model
EPS= (Book-value * Rate of return) + residual earnings
5.94= (6.50 * 0.11) + x
x= 8.307
growth rate
140= 6.50 + 8.307 / 1.11 + g
g= 1.004%
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b) As the financial analyst predicts that the future growth rate of the competitors is 1 % but for
the company Flex bet it can be analysed that the implicit growth rate in its share prices is 1.004%
(How to Calculate Growth Implied in Stock Price, 2021). not much but it is considerately higher
than the competitors which shall lead to its efficiency and attract the investors towards the
company instead of the competitor's business. The growth rate shall assume the benefit for the
shareholders in the market price of the shares as no dividends are being paid by the company.
EXCERCISE- 5
a) Missing values of the company at 35% tax rate
Particulars Amount
Operating revenues 5523
Cost of sales -3121
Other operating expenses -1429
Operating income before tax (A) 973
Tax as reported (B) -340.55
Tax benefit of interest expense (C) -22.61
Operating income after tax (D) 609.84
Interest expense before tax (E) 64.61
Tax benefit (F) 22.61
Interest expense after tax 42
Comprehensive income 610
b) Deferred revenue is an important part of the financial statement analysis
Deferred revenue is one of the most significant part of the financial statements that are
prepared by the business for their users to support their decision-making process. Deferred
revenue refers to the unearned income that is received in the form of prepayment or advances in
respect of the products that are not yet been delivered or the services whose performance is
pending at the end of the company (Zhong, Wang and Zhou, 2017). It can be regarded as the
revenues that are received from the customers before the actual delivery of the goods and
services. Such income shall be recorded on the liability side of the balance sheet in the name of
deferred revenues stating that it is pending obligation for the company which is yet to be settled
against the provided assets.
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The deferred revenues forms an important part of financial statements as prepared by the
business as it shall make disclosures regarding all the pending obligations and liability that are
due to be fulfilled by the company. In case the financial analysts or the various internal and
external stakeholders of the company review the financial statements to know the current
positions of the business it shall get a clear picture regarding the actual profitability of the
business and the assets and liabilities that are their in the company.
The disclosure regarding the deferred revenues in the balance sheet as a liability is
mandatory in compliance with the revenue recognition concept, matching principle and the
conservatism policy that is prescribed by the accounting standards and policies as mentioned in
the conceptual framework (Baker and et.al., 2020). The revenue recognition concept states that
the revenues and expenses belonging to any company must be recorded in financial statements of
the current accounting year only if they are earned or accrued by the company. The cash flow in
this particular concept does not matter if whether it has been received or paid by the company.
The other is the matching principle which states that the revenues and expenses related to a
particular activity must be simultaneously recorded in the income statement of the business. This
works on the cause and effect relationship which means that an income generated over some
expenses that have been made then both of them must be recorded in the same accounting year.
The other concept that is in the favour of argument of mentioning the deferred revenue in the
balance sheet as the liability is the conservatism policy. This policy states that the company must
anticipate for all the future losses and none of the future gains. This is an act of prudence such
that the company remain prepared for any of the future contingencies. It also states that the
revenues must never be recorded in advance as the income of the company.
So it can be assessed that deferred revenues is an important part of financial statements
properly complying with all the disclosure requirements in the business (Zha Giedt, 2018). This
makes the financial statements self-sufficient for use by the stakeholders in order to identify the
actual position if the business.
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REFERENCES
Books and Journals
Zhong, K., Wang, F. and Zhou, L., 2017. Deferred revenue changes as a leading indicator for
future financial performance: Evidence from China. Asian Review of Accounting.
Baker, H. K. and et.al., 2020. How deferred revenue changes impact future financial
performance,“. Corporate Ownership & Controlˮ. 17(4). pp.72-85.
Zha Giedt, J., 2018. Modelling receivables and deferred revenues to detect revenue
management. Abacus. 54(2). pp.181-209.
Battisti, E. and et.al., 2020. The impact of leverage on the cost of capital and market
value. Management Research Review.
Gao, Y. and Jia, L., 2021. Pricing formulas of barrier-lookback option in uncertain financial
markets. Chaos, Solitons & Fractals. 147. p.110986.
Hu, G. and Jacobs, K., 2020. Volatility and expected option returns. Journal of Financial and
Quantitative Analysis. 55(3). pp.1025-1060.
LEE, J. W., 2020. CSR Impact on the Firm Market Value: Evidence from Tour and Travel
Companies Listed on Chinese Stock Markets. The Journal of Asian Finance, Economics,
and Business. 7(7). pp.159-167.
Nduati, N. W. and Wepukhulu, J. M., 2020. Effect of retained earnings on financial performance
of saving and credit co-operative societies in Nairobi County, Kenya. International
Academic Journal of Economics and Finance. 3(6). pp.197-209.
Pandit, S. and Das, S., 2020. Residual Income Valuation. Equity Markets, Valuation, and
Analysis.
Reggiani, F., 2020. The Discount Rate of Normal and Residual Earnings. Available at SSRN
3648054.
Sanchez, M. and Wellschmied, F., 2020. Modeling life-cycle earnings risk with positive and
negative shocks. Review of Economic Dynamics, 37, pp.103-126.
Online
How to Calculate Growth Implied in Stock Price. 2021. [Online] Available through:
<https://www.nasdaq.com/articles/how-calculate-growth-implied-stock-price-2016-01-
30>
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