Questions

Q1-

The chapter encourages analysts to develop forecasts that are realistic, objective, and unbiased. Some firms’ managers tend to be optimistic. Some accounting principles tend to be conservative. Describe the different risks and incentives that managers, accountants, and analysts face. Explain how these different risks and incentives lead managers, accountants, and analysts to different biases when predicting uncertain outcomes.

Development of forecasts is extremely important as various stakeholders rely on them to make important financial decisions. Depending on who is making the forecast, there will be some difference as there will be different incentives and risks associated.

When a manager is making the forecast, he/she/they will be more optimistic as this will make their work and the image of the business positive. Managers can try different ways to give that optimistic outlook in their forecast. After all, it's their own business and it's their duty to be better. They also have incentive for career growth and may be extra bonuses and benefits.

When accountants are making the forecast, they tend to be more conservation as they will use all the rules and regulations strictly as they need to make sure they are protecting the reputation of Their own and the company they work for. It is also professional ethics to report unbiased forecasts and therefore they tend to be more conservation.

When an analyst is making a forecast, they tend to be different from the manager and the accountant as well because they aren’t only using the data from that company alone but are doing the industry analysis, economic analysis, and competitive analysis to make a realistic forecast. They evaluate all the past figures but also compare it and make the forecast. An analyst can’t get emotional and get biased. Therefore, analysts forecast a perfect balance between managers’ optimism and accountants’ conservatism.

Q2-

Six Interrelated Sequential Steps in Financial Statement Analysis

1. Identifying Economic Characteristics Competitive Dynamics in the Industry

One of the major as well as the first step necessary in the valuation process is Industry Analysis. It is very important to know the economic trends, what the competition is doing as well as how many competitions are there. What is the technological advancement and changes taking place? For example, the companies of my project are Starbucks and Dunkin’. Therefore, I need to evaluate the coffee industry, all the new advancement going on in that industry, its demand and supply as well as longevity of the companies. Coffee industry will be in business if people drink coffee but to evaluate the two companies, I can also look at how much the company is adapting to new technology such as mobile order, perhaps new coffee brewing machines etc.

2. Identifying Company Strategies

Company strategies is one of the crucial factors of valuation as it helps us determine if the company has any competitive advantage or not, how sustainable it is, are they using low-cost strategy or differentiation or may be best cost. It is important to know these because we get a clear idea of where the company is standing currently and where it’s future lies. For my company. Starbucks has focused differently as they are focused on providing quality products and they have adopted strategies such as no franchise, direct relation with supplier, benefits to the employees so that they stay for long term, etc. and even when their products are expensive, people buy and their brand value is high. In this example, just with the knowledge of focused different ions as their strategy helped us decode so many things.

3. Assessing the Quality of the Financial Statements

It is important to check the quality of the financial statements as sometimes they aren’t complied with the standard of GAAP, sometimes managers might manipulate the data and it won’t give the correct information of the firm. According to Wahlen et al., 2017, p.” It is essential to understand the quality of the firm’s accounting information to effectively analyze the firm’s profitability and risk and to project its future balance sheets, income statements, and cash flows.” If the financial statements don’t provide accurate information, the valuation we do based on those statements won’t project the correct valuation of the company.

4. Analyzing Profitability and Risk

There are various ratios and calculations analysts should analyze about the firm such as rate of return, profitability, risks involved, return for common equity, profit margin, comparison of rate of return to competition, to make correct valuation. According to Wahlen et al., 2017, p “By understanding the firm’s current and past profitability and risk, you will establish important information you will use in projecting the firm’s future profitability and risk and in valuing its shares”

5. Projecting Future Financial Statements

This step is very tricky as now we are projecting the future instead of using the data we already have specially for those analysts with little experience like myself. One important thing to keep in mind is that there will probably not be a big drastic change in one year depending on how much uncertainty is involved. For my companies, I think they are relatively stable products but while I am doing my valuations, I will have to keep in mind about the pre-pandemic, pandemic, and post pandemic years.

6. Valuing the Firm

This is the last step of the valuation and after collecting all the various information and analysis from the steps above, we can now make the valuation of the firm. This step also includes estimations of the share values as well as the recommendations analysts can make regarding buying, selling, or holding securities.

These six steps are formulated in an amazing sequence and although valuation of an organization can seem overwhelming, with these steps, it is easier to do the valuation as well as also include everything and not miss out on any factor to determine the valuation of the firm.

Q3-

Discuss the strength and weaknesses of cash-flow based valuation models. How do variations in the required cost of capital for debt and equity shareholders affect valuation?

Advantages of Cash flow valuation models:

1. It doesn't depend on any external base for providing meaningful analysis.

2. It considers all information relevant for ascertaining cashflows.

3. Useful tool for determining the intrinsic value of the proposed investment.

4. Can be easily performed in many finances’ application tools like spreadsheets, etc.

5. Efficient tool for analyzing mergers and acquisitions.

Weaknesses of cash-flow based valuation models:

1. Simple errors in basic data can result in wrong computations and conclusions.

2. Terminal value is difficult to estimate.

3. Determining the discount factor is another challenge.

4. Based on too many assumptions.

5. Difficult to understand and involves complex computations.

2. Generally Cost of Capital is average weights of cost of equity and cost of debt. Cost of debt is generally lesser than the Cost of equity. Thus, when debts increase, due to the cheaper cost, overall Weighted Cost of Capital will come down. But this won't continue for long. As equity holders will demand more returns. As a result, the reduced cost of debt is offset by increased cost of equity. Hence overall Cost of Capital remains same.

Q4-

Accounting for Off-Balance-Sheet Financing. On June 24, Year 4, a major airline entered into a revolving accounts receivable facility (Facility) providing for the sale of $489 million of a defined pool of accounts receivable (Receivables) through a wholly owned subsidi- ary to a trust in exchange for a senior certificate in the principal amount of $300 million (Senior Certif- icate) and a subordinate certificate in the principal amount of $189 million (Subordinate Certificate). The subsidiary retained the Subordinate Certificate, and the company received $300 million in cash from the sale of the Senior Certificate to a third party. The principal amount of the Subordinate Certif- icate fluctuates daily depending on the volume of Receivables sold and is payable to the subsidiary only to the extent that the collections received on the Receivables exceed amounts due on the Senior Certificate. The full amount of the allowance for doubtful accounts related to the Receivables sold has been retained, as the company has substantially the same credit risk as if the Receivables had not been sold. Under the terms of the Facility, the company is obligated to pay fees that approximate the purchaser’s cost of issuing a like amount of commercial paper plus certain administrative costs.

REQUIRED

The airline’s management requests your advice on the appropriate accounting for this transac-

tion. How would you respond?