Schweser book 4 p. 305 Challange problems Mr. CFA, values Olympic Productions at $78 per share with an RI model using historical data to est. ROE and BV as reported on the BS. Subsequently, he determines that Olympic has, for the past five years, been improperly capitalizing and amortizing expenditures that it should have expensed as they were incurred. What will be the effect on his forecasts of ROE, BV and intrinsic value if he revises his valuation estimate to take the “financial shenanigans” into account? ROE******BV******Intrinsic Value A. No effect No effect No effect B. Decrease No effect Decrease C. Decrease Decrease Decrease D. No effect Decrease Decrease I have a specific point I would like to raise after I get a couple of answers.
Torn between B and C, although I’m guessing B.
I’ll say B. NI will be reduced. BV is assets - liabities, adjusting will lower each but still keep BV the same. Intrinsic value will be reduced because discounting smaller RI’s?
^ but Nib, don’t you think the NI which got reduced due to expensing the interest, now is spread over a lower Equity (A-L). So the ROE should be in some mezzanine state? I am guessing on D?
Ok. Since it is probably a little too late at night to get many more answers, here is what Schweser says: C. Improperly capitalizing expenditures that should have been expensed will cause ROE and BV forecasts to be overstated. Correcting the valuation to reflect the overstatement of both of these forecasts would cause the ROE estimate to decease, BV per share to decrease, and the intrinsic calue from the residual income model to decrease. ****************************** Could the BV part have to due with the fact the the assets were being amortized? I can’t remember the accounting treatment for those. If they were being depreciated we would add the whole value of the asset to the A side of A=L+E, but then slowly write it off with depreciation right? Would that explain the decrease in BV? ***EDIT: In other words Equity would increase, which is why BV would be overstated and we would need to decrease it to reverse the transaction.*** But if that were the case then BV would be higher and NI would be higer before adjustments so I don’t see how you could determine what would happen afterwards.
dinesh.sundrani Wrote: ------------------------------------------------------- > ^ but Nib, don’t you think the NI which got > reduced due to expensing the interest, now is > spread over a lower Equity (A-L). So the ROE > should be in some mezzanine state? > I am guessing on D? This is the exact problem I am having trouble reconciling.
I reasoned this question as follows: ROE= NI/Equity since expenses where capitalised, the capitalised expenses are now hitting the Income Statement reducing Net Income. then A=L+E. Assets are higher thus reduce assets and to make the balance sheet balance Equity has to fall as well. The intrinsic value is lower due to ROE being lower. my only question is this: ROE = NI/Equity if we have reduced NI due to expensing costs and Equity is reduced to make the balance sheet balance we have the numberator and denominator both going down then what should be the impact on ROE increase or decrease? Can someone please explain? Thank you
We all are waiting on Super-I to clear this for us. Can’t bet even a single (depreciating) penny on FSA!
Hi , as usual always late to join the party…confusion seems to be on ROE… everyone agree here that NI will reduce and Equity will reduce too. ROE= NI/Equity Now if both numerator and denominator reduce by equal amount then ROE will decrease assuming that Equity was more than NI ( fair assumption). Hope this helps ( or will give a numerical eg).
can u please give a numerical eg? Thank you
Rakesh Wrote: ------------------------------------------------------- > Hi , as usual always late to join the > party…confusion seems to be on ROE… everyone > agree here that NI will reduce and Equity will > reduce too. ROE= NI/Equity > Now if both numerator and denominator reduce by > equal amount then ROE will decrease assuming that > Equity was more than NI ( fair assumption). > Hope this helps ( or will give a numerical eg). brilliant Rakesh - that’s exactly where the mental block was and this concept from L1 was clicking. Thanks!
wonder2008 Wrote: ------------------------------------------------------- > can u please give a numerical eg? > > Thank you Hi Wonder, A—$500 (inc Capitalize exp—$20) L—$400 E—$100 (including NI of $50) BS is in sync. ( A=L+E=500) Now $20 needs to expensed. NI=30(50-20) E=80(100-20) ROE before adj=0.5 50/100) ROE after adj=.375(30/80) BV will reduce too as A redcue by 20 and after adj BS is still in sync (A=L+E=480) Hope this helps…
Big thank you!!!