Question

1. a)Why is the Statement of Cash Flows the most useful tool for analyzing highly leveraged companies? (b) What is the risk of heavy reliance on external financing for rapid growth?

2. a)Explain what analyst evaluating the Leveraged Buyout (LBO) would miss if they focused on earnings instead of cash flows?

(b) Given that expectations about future cash flows are not realized, and investors find themselves lacking the cash required to meet interest expense and the scheduled principal payments, discuss the options available to these investors.

3.Explain the two assumptions that misconstrue the motives that frequently underlie financial reporting, and what is the real scandal involving major financial reporting violation when they come to light?

4.Explain the main advantages of using historical cost as the basis of a system to value assets, and describe some of its disadvantages?

5 Determine the ROE for firms A and B tabulated below, using a tax rate of 40% and an Annual market interest rate of 10%

Based on the above information, calculate

	A	B
EBIT	100	100
Equity	2000	2500
Debt outstanding	500	0

a) ROE for Firms A and B; (b) ROE for each firm if the EBIT for each is $500; and (c) Compare the ROE for the two firms for two levels of operating activity. What is your conclusion regarding the effect of debt on ROE?

6(a) Explain the advantages of using market capitalization as a measure of equity, and then,its drawbacks.

(b)Explain how looking at the ratio of total assets to total liabilities can mislead the analyst.

7.Describe how the careful study of financial statements can help raise warning flags regarding risk in merger and acquisitions driven stock for stock transactions, and explain some examples of the need to watch for earnings discontinuities.

8 Explain some of the ways that companies downplay expenses? (b) What do most analysts do to benefit from the insights provided by the careful scrutiny of financial statements?

Answer 1

Answer to part 1 . Cash flow is the most important tool to analyse what amount of cash is being generated from various activites. When a company is leverage one the important criteria is to identify the amount of cash it as able to generate from operating activities since most of it will be utilised for payment of external financing.

1(b) . Risk of heavy external financing is that the lot of profit is eaten up in payment of interest and also the debt holders get preference in many ways more than the shareholders of the company.

2(a) Analyst while evaluating the heavily leveraged buyout companies if they focus on earnings and not on cashflows is that the majority of the earnings will go in payment of interest to financial lenders and equityholders will be left only with the small portion of it, which will not result in increasing the shareholders value.

2(b). Options available to investors is to convert the debt into equity, restructure the loans, extend the period of making payments to financial institutions or sale of the property to repay to the lenders and be debt free.

3(a). NUmbers reported in the income statement of profit are true to the very last $ and Profit is not linked to the financial condition of the company. The two are very different concepts when you go down to the understanding of financial statements as a whole. The real scandal involving major financial crisis when they come to light is the company runs out of cash for working capital or to repay the debt. Majority of the income has been moved from one entity to another known by every top managerial personnel of the company.

4. The advantages of historical method are

a. they provide straightforward to produce

b. do not records gains untill they are realised

c. are still used in majority of the systems

the disadvantages are

a. they do not represent the current values of the assets of the company

b. Do not record the opportunity costs of the use of older assets

c. they do not report/account the loss value of nominal monetary items.