Business Analysis & Valuation
(IFRS Edition) Text and Cases
3e Krishna Palepu Paul Healy
Erik Peek (Solutions Manual
All Chapters, 100% Original
Verified, A+ Grade)
All Chapters Solutions Manual
Supplement files download link
at the end of this file.
,Solutions – Chapter 1
Chapter 1 A Framework for Business Analysis Using Financial
Statements
Question 1.
Matti, who has just completed his first finance course, is unsure whether he should take a course in
business analysis and valuation using financial statements since he believes that financial analysis
adds little value given the efficiency of capital markets. Explain to Matti when financial analysis can
add value, even if capital markets are efficient.
The efficient market hypothesis states that security prices reflect all available information, as if such
information could be costlessly digested and translated immediately into demands for buys or sells.
The efficient market hypothesis implies that there is no further need for analysis involving a search
for mispriced securities.
However, if all investors adopted this attitude, no equity analysis would be conducted,
mispricing would go uncorrected, and markets would no longer be efficient. This is why there must
be just enough mispricing to provide incentives for the investment of resources in security analysis.
Even in an extremely efficient market, where information is fully impounded in prices within
minutes of its revelation (i.e., where mispricing exists only for minutes), Matti can get rewards with
strong financial analysis skills:
1. Matti can interpret the newly-announced financial data faster than others and trade on it
within minutes; and
2. Financial analysis helps Matti to understand the firm better, placing him in a better position to
interpret other news more accurately as it arrives.
Markets may be not efficient under certain circumstances. Mispricing of securities may exist even
days or months after the public revelation of a financial statement when the following three
conditions are satisfied:
1. Relative to investors, managers have superior information on their firms’ business strategies
and operation;
2. Managers’ incentives are not perfectly aligned with all shareholders’ interests; and
3. Accounting rules and auditing are imperfect.
When these conditions are met in reality, Matti could get profit by using trading strategies designed
to exploit any systematic ways in which the publicly available data are ignored or discounted in the
price-setting process.
Capital in market efficiency is not relevant in some areas. Matti can get benefits by using
financial analysis skills in those areas. For example, he can assess how much value can be created
through acquisition of target company, estimate the stock price of a company considering initial
public offering, and predict the likelihood of a firm’s future financial distress.
Question 2.
Accounting statements rarely report financial performance without error. List three types of errors
that can arise in financial reporting.
Three types of potential errors in financial reporting include:
1. Error introduced by rigidity in accounting rules;
2. Random forecast errors; and
1
,Solutions – Chapter 1
3. Systematic reporting choices made by corporate managers to achieve specific objectives.
Accounting Rules. Uniform accounting standards may introduce errors because they restrict
management discretion of accounting choice, limiting the opportunity for managers’ superior
knowledge to be represented through accounting choice. For example, IAS 38 requires firms to
expense all research expenditures when they are occurred. Note that some research expenditures
have future economic value (thus, to be capitalized) while others do not (thus, to be expensed). IAS
38 does not allow managers, who know the firm better than outsiders, to distinguish between the
two types of expenditures. Uniform accounting rules may restrict managers’ discretion, forgo the
opportunity to portray the economic reality of firm better and, thus, result in errors.
Forecast Errors. Random forecast errors may arise because managers cannot predict future
consequences of current transactions perfectly. For example, when a firm sells products on credit,
managers make an estimate of the proportion of receivables that will not be collected (allowance
for doubtful accounts). Because managers do not have perfect foresight, actual defaults are likely to
be different from estimated customer defaults, leading to a forecast error.
Managers’ Accounting Choices. Managers may introduce errors into financial reporting through
their own accounting decisions. Managers have many incentives to exercise their accounting
discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting.
For example, many top managers receive bonus compensation if they exceed certain prespecified
profit targets. This provides motivation for managers to choose accounting policies and estimates to
maximize their expected compensation.
Question 3.
A finance student states: “I don’t understand why anyone pays any attention to accounting earnings
numbers, given that a ‘clean’ number like cash from operations is readily available.” Do you agree?
Why or why not?
There are several reasons for why we should pay attention to accounting earnings numbers. First,
net profit predicts a company’s future cash flow better than current cash flow does. Net profit aids
in predicting future cash flows by reporting transactions with cash consequences at the time when
the transactions occur, rather than when the cash is received or paid. Net profit is computed on the
basis of expected, not necessarily actual, cash receipts and payments.
Second, net profit is potentially informative when there is information asymmetry between
corporate managers and outside investors. Note that corporate managers with superior information
choose accounting methods and accrual estimates which determine the net profit number. Because
accrual accounting requires managers to record past events and to make forecasts of future effects
of theses events, net profit can be used to convey managers’ superior information. For example, a
company’s decision to capitalize some portion of current expenditure, which increases today’s net
profit, conveys potentially informative signals to outside investors about the company’s ability to
generate future cash flows to cover the capitalized costs.
Question 4.
Fred argues: “The standards that I like most are the ones that eliminate all management discretion
in reporting—that way I get uniform numbers across all companies and don’t have to worry about
doing accounting analysis.” Do you agree? Why or why not?
2
, Solutions – Chapter 1
We don’t agree with Fred because the delegation of financial reporting decisions to corporate
managers may provide an opportunity for managers to convey their superior information to
investors. Corporate managers are typically better than outside investors at interpreting their firms’
current condition and forecasting future performance. Since managers have better knowledge of
the company, they have the potential to choose appropriate accounting methods and accruals
which portray business transactions more accurately. Note that accrual accounting not only requires
managers to record past events, but also to make forecasts of future effects of these events. If all
discretion in accounting is eliminated, managers will be unable to reflect their superior information
in their accounting choices.
When managers’ incentives and investors’ incentives are different and contracting mechanisms are
incomplete, giving no accounting flexibility to managers may result in a costlier solution to investors.
Further, if uniform accounting standards are required across all companies, corporate managers
may expend economic resources to restructure business transactions to achieve a desired
accounting result. Manipulation of real economic transactions is potentially more costly than
manipulation of earnings.
Question 5.
Bill Simon says, “We should get rid of the IASB, IFRS, and E.U. Company Law Directives, since free
market forces will make sure that companies report reliable information.” Do you agree? Why or
why not?
We partly agree with Bill on the point that corporate managers will disclose only reliable
information when rational managers realize that disclosing unreliable information is costly in the
long run. The long-term costs associated with losing reputation, such as incurring a higher capital
cost when visiting a capital market to raise capital over time, can be greater than the short-term
benefits from disclosing false information. However, free market forces may work for some
companies but not all companies to disclose reliable information.
Note that Bill’s argument is based on the assumption that there is no information asymmetry
between corporate managers and outside investors. In reality, the outside investors’ limitation in
accessing the private information of the company makes it possible for corporate managers to
report unreliable information without being detected immediately.
The E.U. and IASB standards attempt to reduce managers’ ability to record similar economic
transactions in dissimilar ways either over time or across firms. Compliance with these standards is
enforced by external auditors, who attempt to ensure that managers’ estimates are reasonable.
Without the E.U., IASB standards, and auditors, the likelihood of disclosing unreliable information
would be high.
Question 6.
Juan Perez argues that “learning how to do business analysis and valuation using financial
statements is not very useful, unless you are interested in becoming a financial analyst.” Comment.
Business analysis and valuation skills are useful not only for financial analysts but also for corporate
managers and loan officers. Business analysis and valuation skills help corporate managers in
several ways. First, by using business analysis for equity security valuation, corporate managers can
assess whether the firm is properly valued by investors. With superior information on a firm’s
strategies, corporate managers can perform their own equity security analysis and compare their
3
