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Solution manual of Business Analysis & Valuation Using financial statement.
Chapter 13 Chapter 12 Communication and Governance Discussion Questions Amazon’s inventory increased from $3.2 billion on December 31, 2010, to $5.0 billion one year later In addition, sales for the fourth quarter of those years increased from $12.9 billion in 2010 to $17.4 billion in 2011 What is the implied annualized inventory turnover for Amazon for these years? What different interpretations about future performance could a financial analyst infer from this change? What information could Amazon’s management provide to investors to clarify the change in inventory turnover? What are the costs and benefits to Amazon from disclosing this information? What issues does this change raise for the auditor? What additional tests would you want to conduct as Amazon’s auditor? Amazon had annualized sales of $51.6 billion and an implied annualized inventory turnover rate of 16.1 at the end of 2010 and $69.6 billion and 13.9, respectively, at the end of 2011 Analysts could view this change in a positive manner if they anticipate that the increase in inventory is a signal that Amazon expects higher sales in the future Once these higher sales are realized, the turnover rate will return to its prior level (unless the company anticipates continual sales increases, which certainly is a possibility with a company such as Amazon) Analysts could also view this change in a negative way While sales have increased, inventories have increased faster, suggesting that Amazon is not managing its inventories well Because Amazon has more resources tied up in inventory, it will have to cut back on spending related to improving its operations and developing new products such as the Kindle series of e-readers To clarify the reasons for changes in inventory turnover, Amazon could provide information about: • The types of products in inventory Is the inventory mainly old products that have not sold and will have to be deeply discounted or written-off or is it new, popular products that have not yet been released to the public? • Forecasts of sales by product line • Technical specifications, marketing strategies and release dates for new product introductions • Changes in overall firm strategy that might be related to the increase in inventory The costs of providing this type of additional information include: • Disclosure of proprietary information about the firm Amazon’s competitors could use this information to adjust their business plans; Instructor’s Manual • Loss of credibility if Amazon’s forecasts turn out to be incorrect Investors and analysts will be more skeptical in the future; and • Potential legal liability if Amazon’s forecasts turn out to be incorrect and disgruntled shareholders sue The benefits of providing this type of additional information include: • Provide analysts and investors with a better understanding of the firm’s plans; and • Added credibility for the firm in the future if the current forecasts and information turn out to be correct The firm’s auditors would be interested in answering the same types of questions as outside analysts They would be especially concerned about whether the slower turns are attributable to old obsolete inventory that may have to be written off This will require tests that help clarify what type of inventory has increased, whether that inventory is for older lines or for new lines that are expected to be strong sellers next quarter/year a. What are likely to be the long-term critical success factors for the following types of firms? • a high-technology company, such as Microsoft • a large, low-cost retailer such as Wal-Mart Critical success factors for a high-tech firm, such as Microsoft: • Investment in research and development of new technologies and applications; • Continual improvement of existing products to keep ahead of competitors; and • Large installed base of customers Provides a ready market for compatible products and upgrades and makes it harder for competitors to build market share Critical success factors for a large, low-cost retailer, such as Wal-Mart: • Maintenance of its low cost structure; • Growth in sales per store; and • Ability to open new stores in untapped markets b. How useful is financial accounting data for evaluating how well these two companies are managing their critical success factors? What other types of information would be useful in your evaluation? What are the costs and benefits to these companies from disclosing this type of information to investors? For a high-tech firm, non-financial accounting types of useful information could include: © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 12 Communication and Governance 3 • Long-term strategy for the firm; • Market share by product; • Introduction schedules for new products and updates of existing ones; • Profitability of individual products; • Forecasts of future performance; • Third-party evaluations of firm’s products; and • Estimates of switching between firm’s products and those of its competitors For a large, low-cost retailer, types of useful non-financial accounting information could include: • Long-term strategy of the firm; • Sales and profitability per store, per existing store, per new store, and by region of the country; • Number and locations of new stores; • Number and locations of closed stores; • Management initiatives to reduce costs; • Disclosure of volume discounts negotiated with major suppliers; • Understanding of how firm manages its value chain through use of technology; and • Sales and cost projections In general, both types of firms will benefit from greater disclosure by increasing analysts’ and investors’ understandings of the firm They will both bear costs related to the release of proprietary information to competitors, decreased credibility if subsequent actions and results not match the disclosure, and legal liability from dissatisfied investors Overall, the benefits and costs of disclosing this type of information are likely to be greater for the high-technology firm than for the low-cost retailer Financial statement information will typically provide a better understanding of the low-cost retailer than the high-tech firm Most of the retailer’s assets are tangible and its costs and performance are reasonably well captured by financial statements A high-tech firm’s most significant assets are often intangible (e.g., R&D, patents, trade secrets, etc.), and financial statements have a more difficult time capturing these values Thus, voluntary disclosure is likely more important to the understanding of the high-tech firm rather than the low-cost retailer Of course, voluntary disclosure is also likely to be more costly for high-tech firms, since their key information is more likely to be proprietary In addition, higher business uncertainty for high-tech firms potentially increases the risk of legal liability arising from voluntary disclosure © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 4 Instructor’s Manual 3. Management frequently objects to disclosing additional information on the grounds that it is proprietary For instance, when the FASB proposed to expand disclosures on (a) accounting for stockbased employee compensation (issued in December 2002) and (b) business segment performance (issued in June 1997), many corporate managers expressed strong opposition to both proposals What are the potential proprietary costs from expanded disclosures in each of these areas? If you conclude that proprietary costs are relatively low for either, what alternative explanations you have for management’s opposition? Expanded disclosure standards require firms to report using the same segments used for internal reporting and organization This information potentially provides additional information to a company’s competitors More detailed business segment data offers a better picture of performance and profitability across a company’s various business segments It also provides insight into differences in cost structures across components Using this information, competitors could choose to compete head to head with the firm’s most profitable segments or where the firm was most vulnerable due to high costs Thus, additional business segment disclosures are potentially quite costly to a company It is more difficult to identify any significant proprietary costs related to expanded disclosure of executive stock compensation Management’s opposition to the ongoing debates about whether to record an expense for stock options can probably be better explained by management’s concerns about providing stockholders with information about its stock compensation Management’s concerns are likely to be most severe when its compensation is difficult to justify given the performance of the firm 4. nI aconstr to SU GAP, IFRS permits manget ot revs mpainrte on dfixe aset whic have indcreas ni uvael ncesi het time of heirt impaenrt Revaluations are typically based on estimates of realizable value made by management or independent valuers Do you expect that these accounting standards will make earnings and book values more or less useful to investors? Explain why or why not How can management make these types of disclosures more credible? The usefulness of earnings and book values will depend on any information asymmetry between management and investors as well as management’s incentives to manage reported performance using fixed asset revaluations Consider the case where management has more precise information on the value of certain key assets than investors Asset revaluations are one way for them to provide information to investors on these values Of course, information asymmetry also provides management with the opportunity to use discretion in making revaluations to conceal poor performance, perhaps to increase compensation or job security, or to reduce the risk of violating debt contracts Hence, if there are effective institutional constraints on the abuse of management reporting discretion, such as monitoring by independent auditors and valuers, the press, the board of directors, and financial analysts, permitting management discretion in financial reporting will increase the © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 12 Communication and Governance 5 usefulness of financial accounting reports However, if these institutional constraints are ineffective, discretion will actually reduce the value of accounting data 5. Under a management buyout, the top management of a firm offers to buy the company from its stockholders, usually at a premium over its current stock price The management team puts up its own capital to finance the acquisition, with additional financing typically coming from a private buyout firm and private debt If management is interested in making such an offer for its firm in the near future, what are its financial reporting incentives? How these differ from the incentives of management that are not interested in a buyout? How would you respond to a proposed management buyout if you were the firm’s auditor? What about if you were a member of the audit committee? If management is interested in making a buyout offer for the firm, its primary concern may be paying as low a price as possible This goal may give management an incentive to use accounting discretion to make the firm appear to be under-performing This “bad news” might lower the stock price and eventual purchase price As a result, management may be able to arrange to purchase the firm at a price that is lower than its economic value Of course, management interested in a buyout also has to be concerned about audiences other than current stockholders, such as bankers and bond investors These parties will be asked to lend management funds to buy the firm, and will demand higher interest rates if they believe the firm is a poor performer In contrast, if management is not interested in a buyout, it probably has incentives to make financial reporting assumptions that increase earnings, thereby increasing its own compensation job security Alternatively, if management is concerned about establishing credibility in the capital market, it may report in an unbiased fashion, or perhaps even smooth performance, to ensure earnings reports not surprise investors Management incentives for reporting prior to a management buyout should be of interest to the external auditor and audit committee because they could affect the firm’s reporting If management has incentives to understate performance, to be able to acquire the firm at a low price, the auditors and audit committee would want to pay close attention to those areas where managers have room to manage earnings 6. You are approached by the management of a small start-up company that is planning to go public The founders are unsure about how aggressive they should be in their accounting decisions as they come to the market John Smith, the CEO, asserts: “We might as well take full advantage of any discretion offered by accounting rules, since the market will be expecting us to so.” What are the pros and cons of this strategy? As the partner of a major audit firm, what type of analysis would you perform before deciding to take on a new start-up that is planning to go public? Pros Generate better-looking financial statements More aggressive accounting decisions could make the firm’s performance appear better than it would otherwise © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 6 Instructor’s Manual Facilitate a future initial public offering If aggressive accounting decisions lead to higher earnings, etc., it may be easier for the company to go public with higher earnings than lower, all other things equal Promote interest in the firm With higher earnings due to aggressive accounting decisions, the company may capture a higher profile in the media Press coverage about the firm could lead to greater investor interest in the company and facilitate a subsequent initial public offering Cons Difficulties with auditors The firm’s auditors would have to approve the aggressive accounting decisions by the firm If the auditors did not sign off on some of the firm’s choices, then the firm would have to make less aggressive accounting choices or change accounting firms Either of these changes could serve as a warning about the firm to potential investors Difficulties with underwriters Even if auditors approved of the firm’s accounting decisions, the firm’s underwriters will also evaluate their accounting choices during the due diligence process before the firm goes public An underwriter that is not confident about a firm’s accounting may delay or cancel an underwriting rather than be embarrassed by poor firm performance subsequent to an underwriting Less accounting discretion going forward By making the most aggressive accounting choices today, the firm will have less flexibility in the future to change its accounting without generating considerable investor scrutiny Increasingly skeptical investors Firms that make more aggressive accounting choices may appear riskier to investors As a result, underwriters and investors will require greater compensation for that risk, increasing the firm’s cost of going public 7. Two years after a successful public offering, the CEO of a biotechnology company is concerned about stock market uncertainty surrounding the potential of new drugs in the development pipeline In his discussion with you, the CEO notes that even though they have recently made significant progress in their internal R&D efforts, the stock has performed poorly What options does he have to help convince investors of the value of the new products? Which of these options are likely to be feasible? The CEO could potentially take advantage of the following options to provide information about the value of the firm’s new projects: • Analysts meetings • Voluntary disclosure of internal R&D efforts • Initiating or increasing its dividend © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 12 Communication and Governance 7 • Stock repurchases • Sale of a block of stock to a pharmaceutical company or other knowledgeable firm While each of these options could be used to communicate directly or signal management’s private information about the value of the firm’s new projects, the firm may be either unable or unwilling to undertake some of these options Stock repurchases and initiating/increasing the dividend are likely to be infeasible Both of these strategies require cash that the firm probably does not have The typical biotech firm does not turn a profit for several years after going public In fact, it often returns to the capital markets for additional resources to support it while products are developed and the firm waits for regulatory approval Hence, these high-cost strategies are probably not realistic options for the firm Analysts meetings and increased voluntary disclosure are more likely actions for the firm These represent efficient ways for the firm to provide detailed information about its new projects If management information is not considered to be credible, investors and analysts may not pay attention to information provided in this manner Furthermore, management may be reluctant to provide detailed information to the diverse group of shareholders and analysts because of critical information it could provide to competitors Sale of a block of stock to a pharmaceutical company or other knowledgeable firm would also be feasible for the firm to It would signal to outsider investors and analysts that a very knowledgeable player with access to sensitive company information about the firm’s new projects has decided to make a substantial investment in the firm The firm may prefer not to sell a block of stock in this manner for reasons of corporate control If the potential blockholder sees the private information and decides that the firm is undervalued, it may decide to try to acquire the firm outright Furthermore, the firm may not want to disclose the information to a potential competitor However, there may be legal arrangements between the firm and a potential blockholder that could limit the likelihood of any of these events 8. Why might the CEO of the biotechnology firm discussed in Question be concerned about the firm being undervalued? Would the CEO be equally concerned if the stock were overvalued? Do you believe that the CEO would attempt to correct the market’s perception in this overvaluation case? How would you react to company concern about market under- or overvaluation if you were the firm’s auditor? Or if you were a member of the audit committee? The CEO could be concerned about the firm being undervalued for several reasons First, an undervalued firm makes a good takeover target Once another firm discovers that the firm is undervalued, it may try to acquire the firm If successful, the acquiring firm may fire the CEO Second, undervaluation makes raising equity capital more expensive If the firm’s shares are trading below their true value, the firm will have to sell a larger portion of the company to raise the same amount of new equity capital Finally, the CEO’s compensation may be tied to firm value It is © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 8 Instructor’s Manual unlikely if the firm is undervalued that the CEO will earn a substantial bonus Moreover, the CEO may be rewarded if the stock price moves from being undervalued to being fairly valued The CEO has different incentives to take action if he believes that the firm is overvalued Equity capital is less expensive to raise if the firm is overvalued Academic research suggests that there are more equity issues during periods when firms are likely to be overvalued In addition, the CEO’s bonus may depend on the firm’s value If the stock price falls as a result of his actions, the CEO could lose his bonus as well as put his job at risk The CEO also has an incentive to correct the overvaluation to reduce the firm’s legal liability Assume the CEO has private information that suggests that his company is overvalued Even if the CEO never discloses the information, at some point the market will learn the information and adjust the firm’s stock price Dissatisfied shareholders may sue the company with the belief that the CEO manipulated the market by not revealing his private information sooner Top management may also lose credibility with the market if they delay reporting bad news Thus, it is unclear whether the CEO would attempt to correct the market’s overvalued perception of the firm 9. When companies decide to shift from private to public financing by making an initial public offering for their stock, they are likely to face increased costs of investor communications Given this additional cost, why would firms opt to go public? Despite the increased costs of investor communications, firms go public for many reasons, including: • Improved access to capital markets Some quickly growing firms find their growth outstrips the ability of their private funding sources Some firms find it easier and less expensive to raise capital in public markets Some investors (some types of mutual funds, retirement funds, trusts, etc.) cannot invest in privately held companies Thus, for a variety of reasons, firms go public to take advantage of greater access to public capital markets • A significant portion of employees’ wealth is the firm’s stock Just like publicly held firms, many private firms compensate employees with stock or stock options Over time, an employee’s stockholdings may represent a large portion of her personal wealth Unless the stock is publicly traded, it is difficult for employees to sell their stock to diversify their holdings, to raise cash to purchase a house, etc., or even just to leave the firm for another job • Current owners want to “cash out” or reduce their holdings in the firm This category could include managers of an LBO who want to take the firm public again and receive compensation for their work It could also include family-owned businesses where the family is no longer interested in running the company • Provide outside value for the firm It is difficult to value the equity of a privately held firm A company will often sell a share of its equity to get better information about the value of the remaining equity Until Microsoft went public, it was almost impossible, even for people © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 12 Communication and Governance 9 working within the firm, to begin to value the intangible assets that the firm had developed It allows people who owned stock when the firm was privately held to place a better value on their holdings • Easier evaluation of firm performance A firm’s publicly traded stock price provides one measure of its performance Stock price and performance measures based on it can be used to compare the firm with itself, others in its industry, and the market as a whole This information may be valuable to a firm’s managers as they make operating decisions and form plans for the future 10. German firms are traditionally financed by banks, which have representatives on the companies’ boards How would communication challenges differ for these firms relative to U.S firms, which rely more on public financing? German firms face a different set of communications challenges than American firms, due to variations in the ownership structure Relative to American firms, German firms tend to have far fewer individual investors and a greater level of holdings by financial institutions In addition to their equity holdings, financial institutions are often represented on these companies’ boards of directors These differences in ownership imply that German firms can communicate with their major owners through board meetings and informal channels, so that the major owners not have to rely on published financial information This reduces the information available to German firms’ competitors, a potential advantage over broad dissemination of information As a result, major shareholders of German companies have the opportunity to have access to more detailed and proprietary information than U.S public shareholders An interesting question is whether German firms actually take advantage of this opportunity Some have argued that the German model of capital market creates a cozy relationship between financial institutions and their clients, and that the board of directors provides limited oversight of a firm’s management © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... likely to be the long-term critical success factors for the following types of firms? • a high-technology company, such as Microsoft • a large, low-cost retailer such as Wal-Mart Critical success... greater for the high-technology firm than for the low-cost retailer Financial statement information will typically provide a better understanding of the low-cost retailer than the high-tech firm Most... performance; • Third-party evaluations of firm’s products; and • Estimates of switching between firm’s products and those of its competitors For a large, low-cost retailer, types of useful non-financial