Semester Two Examination 2006
Faculty of Business and Economics
Department of Accounting and Finance
TITLE OF PAPER: FINANCIAL STATEMENT ANALYSIS
EXAM DURATION: 3 hours
READING TIME: 10 minutes
THIS PAPER IS FOR STUDENTS STUDYING AT: (office use only - tick where applicable)
o Berwick o Clayton o Peninsula o Distance Education o Open Learning
þ Caulfield o Gippsland o Sunway o Enhancement Studies o Other (specify)
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(Permitted calculators: Citizen SRT-135, Casio FX82MS scientific calculator, the Casio FX82AU scientific calculator, and Sharp EL-735 financial calculator, or calculators with an 'approved for use' Faculty label)
OPEN BOOK o YES þ NO
SPECIFICALLY PERMITTED ITEMS o YES þ NO
if yes, items permitted are:
This paper consists of eight (8) questions printed on four (4) pages
STUDENTS ARE REQUIRED TO ANSWER ALL QUESTIONS
PLEASE CHECK THE PAPER BEFORE COMMENCING. THIS IS A FINAL PAPER.
THIS EXAMINATION PAPER MUST BE INSERTED INTO THE ANSWER BOOK AT THE COMPLETION OF THE PAPER. NO EXAMINATION PAPERS SHOULD BE REMOVED FROM THE EXAMINATION ROOM
Question 1 Industry Analysis
The purpose of an industry analysis is to evaluate the factors that affect industry profitability. The profitability of an industry may be influenced by the industry structure whereby some industries are, by structure, more profitable than others.
1. Describe a fragmented industry.
2. Explain whether this type of industry will result in higher or lower profitability.
3. Justify your answer to part (2) above.
(2.5 + 2.5 + 2.5 = 7.5 marks)
Question 2 Earnings management
Earnings management occurs when companies over (under)-state reported earnings to meet certain goals including higher managerial bonus payments and influencing share prices.
Provide two reasons why managers may decide to under-state reported earnings.
Question 3 Accounting Analysis: Implementation
In an effort to increase the share price, management team of XYZ Company has overstated closing inventory of 2005 by $5,000,000 and consequently the 2005 earnings performance of the company has been overstated by the same amount.
Briefly explain how this overstatement affects the following, and by how much (tax rate is 30%):
1. Closing book value of equity at the end of 2005;
2. Reported earnings of 2006 (assuming no earnings management in 2006); and
3. Closing book value of equity at the end of 2006.
(5 + 5 + 5 = 15 marks)
Question 4 Return on Assets (ROA) Analysis
Operating ROA is a measure of how profitably a firm is able to deploy its operating assets to generate operating profits.
Briefly explain why time-series observations of ROE have a mean reverting pattern.
Question 5 Equity Beta
Equity beta is an important factor in determining cost of equity, which in turn is used in business valuation models.
1. Explain clearly how equity beta is estimated. In answering this question you must write down the relevant model and define the variables and coefficients in the model.
2. Present the model which is used to compute cost of equity. Define all variables and coefficients in that model.
3. Explain the role of cost of equity in a Discounted Cash Flow (DCF) model?
(5 + 5 + 5 = 15 marks)
Question 6 Business Valuation
In valuing a business one can either value the common equity (ordinary shares) of the business or value the entire business (debt + equity = total assets). Furthermore, different cash flow streams are used in valuation of equity and valuation of the entire business.
1. What discount rate and what cash flow stream are used in valuation of equity?
2. What discount rate and what cash flow stream are used in valuation of total assets (entire business)?
(10 + 10 = 20 marks)
Question 7 Fundamental Beta
In circumstances where a company is not listed on the stock exchange or where a listed company does not have sufficient share price data points, historical beta cannot reliably be estimated. One way of overcoming this problem is to use a fundamental beta.
1. Name the three factors that contribute to fundamental beta.
2. Explain clearly why these factors increase/decrease fundamental beta.
(5 + 15 = 20 marks)
Question 8 Accounting Beta
Accounting beta can be used as an alternative to fundamental or historical beta.
1. Write down the model that estimates accounting beta.
2. Explain all variables in the model including the coefficients.
(5 + 5 = 10 marks)
END OF PAPER