Mock Exam Page 1 of 8
2021 Mock Exam


Mock exam paper and instructions to candidates:
AC332 – Financial Statement Analysis and
Valuation




Instructions to candidates

This paper contains four questions. Answer all four questions. All questions will be
given equal weight (25%).

Show all workings clearly and state clearly any assumptions you need to make.
Unless otherwise instructed, you may give your answers to the nearest million.


Mock Exam Page 2 of 8
QUESTION 1

In early 2020, SeruCorp announced that it would have to restate its financial
statements as a result of stuffing as much as $3.35 billion worth of products into
wholesalers’ warehouses during the year 2019.

The following additional information is available:

(1) The company’s effective tax rate for the year 2019 was 35%.

(2) The company’s sales and cost of sales for the year 2019 were as follows:


($ millions) 2019
Net sales 18,139
Cost of products sold 5,454


REQUIRED:

(a) Helene Rey, a financial analyst following SeruCorp, wants to correct the
company’s improper recognition of revenues. Accordingly, explain what
adjustments Helene Rey would have to make to SeruCorp’s balance sheet and
income statement for the year ended December 31, 2019.
[9 marks]

(b) Discuss how the adjustments that Helene Rey would have to make to correct
SeruCorp’s improper recognition of revenues are likely to affect the company’s
2019 total financial leverage, inventory turnover, net profit margin, and return on
equity.
[4 marks]

(c) Discuss the concept of big bath accounting.
[3 marks]

(d) Explain why a constantly increasing inventory with stable sales might signal a
potential earnings manipulation.
[4 marks]

(e) Discuss why firms that meet or just beat analysts’ earnings per share
consensus forecasts are likely to be engaging in earnings manipulation.
[5 marks]

[Total 25 marks]

Mock Exam Page 3 of 8
QUESTION 2

BertrandTech is a company operating in the semiconductor industry. BertrandTech’s
financial statements for the year ended December 31, 2020, with the comparative
figures for the year 2019, are as follows.


Balance sheet at December 31, 2020
($ millions)
December 31, 2020 December 31, 2019
Assets
Current assets
Cash and cash equivalents 712,300 425,000
Accounts receivables 408,000 106,250
Inventory 510,000 612,000
Total current assets 1,630,300 1,143,250
Non-current assets
Property plant and equipment (Gross) 714,000 654,500
Less: Accumulated depreciation 238,000 119,000
Land 425,000 170,000
Total non-current assets 901,000 705,500
Total assets 2,531,300 1,848,750
Liabilities and shareholders’ equity
Current liabilities
Accounts payable 297,500 382,500
Accrued salaries payable 93,500 136,000
Rent expense payable 37,400 17,000
Tax payable 117,300 68,000
Total current liabilities 545,700 603,500
Non-current liabilities
Long-term note payable 850,000 510,000
Total non-current liabilities 850,000 510,000
Total liabilities 1,395,700 1,113,500
Shareholders’ equity
Common stock 714,000 510,000
Retained earnings 421,600 225,250
Total shareholders’ equity 1,135,600 735,250
Total liabilities and shareholders’ equity 2,531,300 1,848,750


Mock Exam Page 4 of 8
Income statement for the year ended December 31, 2020
($ millions)
December 31, 2020 December 31, 2019
Operating revenues 2,499,000 2,317,000
Cost of goods sold 1,428,000 1,250,000
Gross profit 1,071,000 1,067,000
Depreciation expense 112,000 98,000
Salary expense 233,600 240,000
Insurance expense 40,000 37,500
Rent expense 160,000 229,000
Operating income 525,400 462,500
Financial expense 67,200 90,500
Income before tax 458,200 372,000
Tax expense 160,370 240,520
Net income 297,830 131,480

The following additional information is available:

(1) For both years 2019 and 2020, cash and cash equivalents are entirely financial.

(2) For both year 2019 and 2020, long-term notes payable are the only interest-
bearing debt.


REQUIRED:

Note that ratios, where one of the items in the ratio is a flow variable and the other
item is a stock variable, must be calculated by using ending balances for the stock
variable.

(a) Prepare a growth balance sheet and a growth income statement for
BertrandTech for the year ended December 31, 2020.
[4 marks]

(b) Calculate BertrandTech’s current ratio, cash ratio, inventory turnover, return on
net operating assets (RNOA), and debt-to-capital ratio for the year 2020.
[6 marks]

(c) Describe the effect (i.e., an increase, a decrease, or no effect) on
BertrandTech’s current ratio and inventory turnover for the year 2020 had the
following transactions or events occurred during the year 2020 (no calculation
required):

(i) BertrandTech declared but did not pay a cash dividend.
(ii) Customers returned invoiced goods for which they had not paid.
(iii) Accounts payable were paid at year-end.
Mock Exam Page 5 of 8
(iv) BertrandTech recorded both a receivable from an insurance company
and a loss on a building due to fire damage.
(v) Early in the year 2020, BertrandTech increased the selling price of one
of its products because customer demand far exceeded production
capacity. The number of units sold the year 2020 was the same as the
previous year.
[7 marks]

(d) Discuss the main differences between cost leadership and differentiation
strategies.
[4 marks]

(e) Discuss the main limitations of industry analysis.
[4 marks]

[Total 25 marks]


Mock Exam Page 6 of 8
QUESTION 3

OstromLab is a distributor of building supplies. The company’s management has
developed the following forecasts of net income:

Forecasted
Year Net income
2021 $111,432
2022 $131,490
2023 $156,473
2024 $178,379
2025 $199,784


The following additional information is available:

(1) OstromLab’s management expects net income to grow at a rate of 7% per
annum after 2025 and the company's cost of equity capital is 14%.

(2) OstromLab’s management expects residual earnings to grow at a rate of 7% per
annum after 2025.

(3) OstromLab’s management has set a dividend payout ratio equal to 25% of net
income and plans to continue with this policy.

(4) OstromLab’s common shareholders' equity at January 1, 2021 is $544,902.


REQUIRED:

(a) Calculate the market value of equity of OstromLab at the beginning of 2021
using the residual earnings valuation technique.
[9 marks]

(b) Discuss why the terminal values of residual income models and discounted
cash flow models tend to be different.
[5 marks]

(c) Explain the concept of “functional fixation” and its implications for value
investing.
[5 marks]

(d) Discuss the different types of risk models that can be used to estimate
abnormal returns.
[6 marks]

[Total 25 marks]
Mock Exam Page 7 of 8
QUESTION 4

Betsey Stevenson, an analyst working for a credit rating agency, is conducting credit
analysis and has developed a Stata code to estimate the probability of default for the
universe of Compustat firms. Below, you can find a snippet of the code that Betsey
Stevenson has developed.

Stata code

gen bankruptcy=0
replace bankruptcy=1 if BANK_BEGIN_DATE>(datadate+90) &
BANK_BEGIN_DATE<(datadate+90+365)
egen max_fyear = max(fyear), by(gvkey)
gen bankruptcy_year=year(BANK_BEGIN_DATE)
replace bankruptcy=1 if fyear==max_fyear & bankruptcy_year!=. &
bankruptcy_yeardrop if bankruptcy==1 & max_fyear>bankruptcy_year
sum bankruptcy, d

sort gvkey fyear
joinby gvkey fyear using "$path/data/crsp_bh_aret.dta", unmatched(master)
drop _merge
joinby gvkey fyear using "$path/data/crsp_ret_volatility.dta", unmatched(master)
drop _merge
sort gvkey fyear
duplicates drop gvkey fyear, force
xtset gvkey fyear

gen profitability=oibdp/l.at
gen loss=0
replace loss=1 if profitability<0 & profitability!=.
gen debt_coverage=ebitda/(l.dltt+l.dlc)
gen leverage=(dltt+dlc)/l.at
gen size=log(prcc_f*csho)

winsor2 loss leverage, cuts(1 99) replace

logit bankruptcy loss leverage, cluster(gvkey)


REQUIRED:

(a) Prepare an amended version of the Stata code provided above that encompasses
the following changes:

(i) Estimation of an additional default prediction model that, along with the
loss and the leverage predictors, also includes predictors for size, debt
coverage, and profitability.
Mock Exam Page 8 of 8
(ii) Produce plots for the receiver operating characteristic (ROC) curves of
each default prediction model.
(iii) The variables in both regression models are winsorized at the 5th and 95th
percentiles of their respective distributions.
[11 marks]

(b) Describe the different steps involved in the process of credit analysis in private
credit markets.
[6 marks]

(c) Explain how factors such as the market value of assets and the volatility of
market value of assets affect the probability of default of corporations.
[3 marks]

(d) Discuss why over the years accounting information has become less relevant for
the purpose of default prediction.
[5 marks]

[Total 25 marks]


Mock Exam Page 7 of 8 QUESTION 4 Betsey Stevenson, an analyst working for a credit rating agency, is conducting credit analysis and has developed a Stata code to estimate the probability of default for the universe of Compustat firms.