Discuss the financial structure of the firm: how much debt relative to equity is the company using? What is, in your opinion, the optimal amount of debt that the company should use?

Assignment

In the special case of conglomerates with multiple segments, it may not be possible to find a comparable with either the same segments or with the same relative sizes of segments. In that case, you may want to find one comparable for each individual segments and weight each comparable as a function of the relative size of the segment (only use largest segments 20%+ of sales).

Part 4 (1 page): Capital structure

Discuss the financial structure of the firm: how much debt relative to equity is the company using?

What is, in your opinion, the optimal amount of debt that the company should use?

In certain cases, for example, a company may be very close to being non-investment grade (check its debt rating) and be at risk of losing its investment grade status; or it may be more highly levered than its peers or relative to its free cash flows or cash flow from operations. These may indicate situations in which the company may be better-off reducing leverage.

In other cases, a company may have very favorable credit ratios which may indicate under-utilization of debt. Consider whether the company is in a position to borrow more without severely hurting its debt rating?

Compare ratios in lecture 3 and evaluate how much extra debt the company may use. You may want to reconnect your recommendation about debt capacity to your forecasted business plan for the next 5 to 10 years — will the company have enough cash on hand to pay the extra debt?

Is the company growing? If it is growing, evaluate how much capital it will need and discuss a financing plan (which may include equity). If the company is not growing or is mature, examine how much cash it is generating and discuss its planned uses of cash? How much of it should it invest, how much should it return to shareholders in dividends or share repurchase?

Part 5 (1 pate): Accounting assumptions

Identify key accounting choices adopted by the firm that may affect the interpretation of accounting numbers. Are there large off-balance sheet transactions?

Subsidiaries over which the company has control that are not consolidated?

Does the company use any financial instruments? Are there contingencies that may affect earnings in the near future? Is revenue being recognized when earned? Is the firm being conservative with respect to its allowance (are there any recent trends in unpayables)? Is the company using LIFO for its inventory?

The cases discussed from lectures 2 to 6 provide good examples of readjustments due to special assumptions. For example, the allowance may be too low (check for write-off, large increases in receivables or whether the allowance is keeping up with revenue). Or, some parts of the business are currently not consolidated (i.e., using the equity method) but are sufficiently strategic that they should be consolidated. There could be some ongoing litigation that is not yet incorporated as a liability, etc.

Sometimes you may find an item that is large and slightly odd, but you do not know whether it is fairly accounting for or may indicate a larger problem (e.g., Enron’s reliance on partnerships before the crash). While you may not quantitatively measure their impact, you should flag these as accounting risk areas.

 

Discuss the financial structure of the firm: how much debt relative to equity is the company using? What is, in your opinion, the optimal amount of debt that the company should use?
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