Cash flow yield (CFY)

Cash flow yield (CFY) is one method of valuing mortgage-backed securities.

Cash flow yield (CFY)

			description
Advantage
Weakness			The CFY is dependent on prepayment assumptions; if prepayment rates differ from the assumption, the CFY will not be realized The assumption that interim cash flows will be reinvested at the CFY. This is rarely true for mortgage-backed securities.

NOPLAT

NOPLAT

Year	Real 1	Real 2	Nominal 2
Revenues	100	100 * 1.02 (*1) = 102	102*1.15(*4)
EBITDA	27	27 * 1.02 (*1) = 27.54	27.54*1.15(*4)
Depreciation	12	100 * 1.02 * 12.5% (*2) = 12.75	12.75*1.15(*4)
EBIT	27-12 = 15	27.54 - 12.75 = 14.79	14.79*1.15(*4)
Taxes	6	14.79 * 0.40 (*3) = 5.916	5.916*1.15(*4) = 6.8034
NOPLAT (*5)	15-6 = 9	14.79 * (1-0.40) = 14.79-5.916 = 8.874	(14.79-5.916)*1.15 =10.2051

(*1) Real revenue growth rate (per year) = 2%
(*2) Real depreciation expense = 12.5% of future real revenues
(*3) Tax rate = 40% per year
(*4) Annual inflation rate (per year) = 15%
(*5) NOPLAT = EBIT * (1-t), or (Net operating profit - Adjusted tax) = EBIT - Taxes

High inflation adjustment to the financial statement (of emerging market stocks)

• Inflation (upward) adjustments (e.g. deflating) to reported
• sales
• depreciation

NAV premiums in closed-end country funds

NAV premiums in closed-end country funds

NAV premiums in closed-end country funds:
add to the risk of the fund			Correct
add to the return of the fund			Incorrect (*)
are not steady but quite volatile			Correct

(*1) They tend to decrease as the country liberalizes foreign access to their financial markets.

Emerging country/market investments

Emerging country/market investments

		Closed-end country funds	Direct investing
Immediate diversification within the subject country		Yes	No
More volatile?		Yes (*1)	No
Strongly correlated to the U.S. stock market?		Yes	No

(*1) more volatile than their underlying assets due to the added volatility induced by the fund premium to net asset value

Buying country funds is NOT always a better choice than direct investment for most emerging markets. (e.g. higher volatility by fund premium)

Initial growth phase and Terminal value in the 3-stage dividend growth model

Analysts discuss the characteristics of firms in various stages of growth, where firms experience an initial growth phase, a transitonal phase, and a maturity phase in their life.

An analyst also makes the following statements.

1. For firms in the initial growth phase, earnings are rapidly increasing, there are little or no dividends, and there is heavy reinvestment. The return on equity is, however, higher than the required return on the stock, the free cash flows to equity are positive, and the profit margin is high.
2. When estimating the terminal value in the 3-stage dividend growth model, it can be estimated using the Gordon Growth Model or a price-multiple approach.

Are these statements correct?

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1. Answer: Incorrect.
• All of the description of the initial growth phase is correct except that, in this stage, the free cash flows to equity (FCFE) are actually negative.
• This is due to the heavy capital investment.
2. Answer: Correct.
• The terminal value in the three-stage dividend growth model can be estimated using either approach, i.e.
• Gordon Growth Model or
• price-multiple approach

Percentage of a leading P/E related to PVGO

P₀ = E₁/r + PVGO

Leading P/E = P₀/E₁ = 1/r + PVGO/E₁

Percentage of a leading P/E related to PVGO
= (PVGO/E₁)/Leading P/E = (PVGO/E₁)/(P₀/E₁)

Value impact, Strategic policy risk, Accounting risk

A group of shareholders, upset about the board's plan, submit a formal objection to the Company's board as well as to the SEC. In the objection, the shareholders state that the independence of the board has been compromised to the detriment of rhe company and its shareholders. The objection also states that:

• The value of the Company's common stock has been impaired as a result of the poor corporate governance system.
• The liability strategic policy risk of the Company has increased due to the increased possibility of future transactions that benefit the Company's directors, without regard to the long-term interests of shareholders.
• The asset accounting risk of the Company increased due to the inability of investors to trust the Spin-off company financial disclosures necessary to value the division.

Carve-out tsansactions and Spin-off transactions

Spin-off transactions and Carve-out tsansactions

		Spin-off	Carve-out
Creating a new entity out of a company's business line or one of its subsidiaries		Yes	Yes
Granting shares in the new entity to the existing shareholders of the parent company.		Yes
The shareholders are then free to sell their shares in the spin-off company in the marketplace.		Yes
Generally viewed as a favorable sign in the market?		Yes (*1)
Minority of shares is sold to the public while the majority portion of the new shares are held by the parent company (they are NOT distributed to existing shareholders).			Yes

(*1) because they often result in greater efficiency for the spin-off company and the parent company.

Static trade-off capital structure theory

The optimal level of debt is achieved when the extra cost of financial distress equals the tax benefit of debt.

It states that all firms have an optimal level of debt.

Pecking order theory

Pecking order theory prefers internally generated equity (retained earnings) over new debt and new debt over new equity.

More preferable← →Less preferable
Internally generated equity (retained earnings) > new debt > new equity

It does NOT state that debt financing is preferable to all equity financing.

Miller and Modigliani Proposition II (without taxes)

The cost of equity is linear function of a company's debt/equity ratio.

It does NOT state that cost of equity is not affected by capital structure changes.

Net agency costs of equity and Static trade-off capital structure theory

"In selecting a refinancing plan, we must not push our leverage ratio too high. An overly aggressive leverage ratio will likely cause debt rating agencies to downgrade our debt rating from its current rating, causing our cost of debt to rise dramatically."

• This effect is explained using the static trade-off capital structure theory, which states that if our debt usage becomes high enough, the marginal increase in the interest shield will be more than the marginal increase in the costs of financial distress.
• However, using some additional leverage will benefit the company by reducing the net agency costs of equity required to align the interests of the company's management with its shareholders.

Are these staments correct?

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Answer: Only correct with respect to the net agency cost of equity.


Static trade-off capital structure theory
A company should lever up to the point at which the additional increase in the costs of financial distress exceeds the additional increase in the tax shield from interest rate payments. Once this point is reached, adding more leverage to the company will decrease its value.

So, the correct statement should be "if our debt usage becomes high enough, the marginal increase in the interest shield will be less than the marginal increase in the costs of financial distress."


Net agency cost of equity
Agency costs include equity holders' cost to monitor the firm's executives, management's bonding costs to assure owners that their best interests are guiding the company's actions, and residual losses that result even when sufficient monitoring and bonding exists. Adding additional debt reduces the agency costs to equity holders because less of their capital is at risk. The leverage effectively shifts some agency costs to bondholders. Additionally, managers have less cash to squander when higher leverage is employed because higher interest costs will restrict discretionary free cash flow.

Optimal capital structure

Optimal capital structure

plan		A	B	C	D
Debt/equity		2.33	1.86	1.22	0.82
Kd(after-tax)		8.5%	6.2%	4.4%	3.9%
Ke		16.0%	13.5%	11.2%	10.9%
Expected EPS		$6.00	$6.33	$5.47	$4.89
wd		(2.33/(2.33+1))	(1.86/(1.86+1))	(1.22/(1.22+1))	(0.82/(0.82+1))
we		(1/(2.33+1))	(1/(1.86+1))	(1/(1.22+1))	(1/(0.82+1))
WACC		10.75% (*1)	8.75% (*2)	7.46% (*3)	7.75% (*4)

(*1) (2.33/(2.33+1))*8.5% + (1/(2.33+1))*16.0% = 10.75%
(*2) (1.86/(1.86+1))*6.2% + (1/(1.86+1))*13.5% = 8.75%
(*3) (1.22/(1.22+1))*4.4% + (1/(1.22+1))*11.2% = 7.46%
(*4) (0.82/(0.82+1))*3.9% + (1/(0.82+1))*10.9% = 7.75%

The plan with the lowest WACC maximizes the firm's stock price and thus reflects the optimal capital structure.

Comparable transaction approach (merger and acquisition)

(Question)
To justify the use of the comparable transaction approach to establish a fair acquisition for Target company, one would like to conclude his report with the most important reason for choosing this approach. Which of the following rationals would one most likely use?

A. The fair acquisition price developed for Target reflects a market based valuation approach, an advantage compared to discounted cash flow valuations, which are based on assumptions that do not incorporate market valuations.
B. The acquisition prices for recently acquired companies provide a reasonable approximation of their realistic intrinsic values.
C. The fair acquisition price developed for Target is a realistic estimate of potential value to Acquirer given that forecasts of future performance are unavailable.

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Answer: A

This is a key reason to use the comparable value method, particularly when contrasted with the use of discounted cash flow valuations. Acquisition prices are not necessarily approximations of intrinsic values. A price developed based on comparable transactions does not always indicate the potential value of the acquisition to the purchaser.

Bootstrap (earnings) effect

Bootstrap effect
The short-run increase in earnings per share which occurs in a share for share exchange when a company trading on a higher price to earnings ratio acquires a company trading on a lower price to earnings ratio.

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Financial and Market Data for Acquirer and Target

Financial/Price Data		Acquirer	Target
Sales		$400 million	$105 million
Net income		$80 million	$22 million
Cash flow		$140 million	$42 million
Book value		$320 million	$72 million
Number of common shares outstanding		50 million	20 million
Current market price of common stock		$30.50	$20.00
Recent market price range		$34-26	$22-18

(Question)
If Acquirer issues common stock at the current market price and uses the proceeds to acquire Target's outstanding common stock, the bootstrap earnings effect on post merger earnings would most likely occur if Target's acquisition price:
A. is $20 or lower.
B. is $20 or higher.
C. is $20 or lower and Acquirer's post merger P/E remains at the current level.

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Answer: C

The bootstrap effect only occur when

• Acquirer's P/E ratio is higher than Target's and
• Acquirer's P/E post merger does not decline.

Financial and Market Data for Acquirer and Target

Financial/Price Data		Acquirer	Target
P/E		$30.50/(80/50) = 19.06	$20.00/(22/20) =18.18

Therefore, the combined earnings per share after the merger would be higher if Acquirer issued stock at the current price and bought Target at current market price ($20) or less per share.

Acquisition method, Equity method, and Proportionate consolidation: sample questions

Acquisition

		Acquirer	Target
Accounting		U.S.GAAP	U.S.GAAP
Purchase price		-	$185 million in cash (20% stake)

Pre-Acquisition Balance Sheets (12/31/2010)

in million $		Acquirer	Target
Current assets		13,900	716
PP&E		26,977	108
Total assets		40,877	824
Current liabilities		10,363	220
Other liabilities		11,121	8
Common stock		6,127	108
Retained earnings		13,266	488
Total liabilities and equity		40,877	824

Pro-Forma (i.e. projected) Income Statement (for the year ending 12/31/2011)

in million $		Acquirer	Target
Revenue		66,176	2,176
Expenses		63,515	2,068
Net Income		2,661	108
Dividends		1,525	0

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(Questions and Answers)

1. Assuming the acquisition goes through at the beginning of 2011, and that Acquirer will have a significant influence on Target, the total assets after acquisition would be:
• 40,877
• The accounting for an ownership interest of between 20% and 50% in an associate is handled using the equity method. Acquirer also have a significant influence (NOT control) on Target.
• Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a noncurrent asset.
• Because the acquisition in this case is fully funded by cash, there will be no change to total assets for Acquirer.
2. The fair value of Target's other assets PP&E is $250 million. The amount allocated to goodwill would be:
• 37.4
• (Partial) goodwill = Purchase price (cash) - Pro-rata book value of Target - Amount of excess purchase price allocated to PP&E = 185 - (108+488)*20% - (250-108)*20% = 37.4
• Full goodwill = 185/20% - (108+488) - (250-108) = 187.0 = 37.4/20%
3. For this question only, assume that as a result of the acquisition, Acquirer must depreciate an additional $50 million over a 10-year period to zero salvage value. Target's contribution to Acquirer's EBT for 2011 is projected to:
• 16.6
• Equity income: 108*20% - (50-0)/10 = 16.6
4. For this question only, assume that the acquisition occurs on December 31, 2010, and that there is no additional depreciation expense as a result of the acquisition. Compared to its beginning of year investment balance, the balance for Acquirer's investment in Target on December 31,2011, will be lower, higher, or unchanged?
• Higher
• No calculations are required to solve this problem.
• Acquirer's investment balance = Investment balance at the beginning of year + equity income - dividend paid (under no additional depreciation assumption)
• Increase/Decrease to Acquirer's investment balance = Target's equity income - Target's dividend paid (under no additional depreciation assumption)
• The equity income is positive Target had positive net income, and there is no additional depreciation expense to subtract. Additionally, Target is not expected to make any dividend payments for 2011.
• Based on this, Acquirer's investment balance will increase.
5. "Since Target is profitable and pays no dividends, the equity method will result in higher net income than proportionate consolidation. Additionally, the equity method will result in lower return on assets (ROA) than the acquisition method with partial goodwill." Is this stament correct for both net income and ROA?
• Under the condition above, the equity method, proportionate consolidation, and the acquisition method all report the same net income.
• ROA is higher under the equity method than under proportionate consolidation because the equity method does report lower assets than proportionate consolidation.
6. If an analyst were to follow IFRS instead of U.S. GAAP, the accounting method predescribed for this type of investment would most likely be (A) the equity method, (B) the acquisition method, or (C) proportionate consolidation?
• Equity method
• When the investment constitutes 20% to 50% of the associate, and the investor has significant influence on the associate, IFRS prescribes the equity method for accounting for the invesment.

Conditional heteroskedasticity

Finding:

There is a strong relationship between the regression error variance and the regression independent variables.

ε² ~ X_i

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A regression exhibits conditional heteroskedasticity if the variance of the regression errors (1)are not constant and (2)are related to the regression independent variables. This finding indicates that the regression exhibits conditional heteroskedasticity.

Serial correlation

Finding:

The correlation between regression errors across time is very close to 1.

ρ_{ε(t-1),ε(t)} = 1

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Indicating the presence of significant positive serial correlation. Positive serial correlation causes the standard errors to be too small, which then causes the t-statistics to be too large (biased upward).

F-value

F-value
= (Mean regression sum of squares)/(Mean squared error)
= ((Regression sum of squares)/k)/((Error sum of squares)/(n-k-1))

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(Example)
Number of observations = 76
Number of intercept = 1
Number of independent variables = 5
Regression sum of squares = 412,522
Error sum of squares = 17,188

F-value = (412,522/5)/(17,188/(76-5-1)) = 336

Threat of forward integration

• Threat of forward integration
• Bargaining power of suppliers

Threat of new entrants

• Threat of new entrants
• Product differences
• Brand identity
• Cost and/or quality advantages

Cap and Floor

A bank's exposure: $100 million debt obligation next 2 years; quarterly coupon, floating(90D LIBOR)

Following is an excerpt from a bank manager's memo:

• "Rather than using a cap or floor, the bank can effectively manage its exposure to interest rates resulting from the 2-year funding requirement by taking long positions in a series of put options on fixed-income instruments with expiration dates that coincide with the payment dates on the floating-rate note."
• "As a cheaper alternative, the bank can effectively manage its exposure to interest rates resulting from the 2-year funding requirement by creating a collar using long positions in a series of call options on interest rates and long positions in a series of call options on fixed-income instruments, all of which would have expiration dates that coincide with the payment dates on the floating-rate note."

Mitigating the interest rate rise risk

approach		Underlying	Long/short	IR↑	IR↓
	Interest rate cap	Interest rates	Long	↑(**)
Cap or floor alternative	Put	Fixed-income instruments	Long	↑
Artificial collar (*)(***)	Call	Interest rates	Long	↑	↓
Artificial collar (*)(****)	Call	Fixed-income instruments	Long Short	↑	↓

(*) Long cap & Short floor
(**) It means the value increases when the interest rate rises.
A long cap can be replicated either through (1) long put on fixed-income instruments or (2) long call on interest rates.
Short floor can be replicated either through (1) short call on fixed-income instruments or (2) short put on interest rates.
(***)Long cap
(****)Short floor

Market Segmentation Theory

(Question)
"The Treasury spot rate curve currently has a similar shape of to the yield curve on Treasury coupon securities, which according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term structures. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage."

Is this statement correct?

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Answer: No. It's incorrect.

The market segmentation theory says that the term structure of interest rates is determined solely by the supply/demand for a given maturity sector. The statement is incorrect because high demand from investors (who wish to lend money) would push interest rates lower, not higher, as observed in the term structure.

Interest rate volatility

(Question)
"The variance of daily interest rate changes has been trending higher over the past three months, leading us to believe that a period of high volatility is approaching in the next 12 to 18 months. However, the reliability is questionable because the volatility estimates were derived using an option pricing model, which assumes constant interest rates."

Is this statement correct?

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Answer: No. It's incorrect.

Option pricing models assumes a constant volatility of interest rates but not a constant level of interest rates.

Direct capitalization, IRR, and NPV

Capitalization rate

Approach				Stable NOI	Erratic net operating income(*1)
IRR					No (*3)
Direct capitalization				Yes (*4)
NPV					OK (*2)

(*1) (e.g.) A real estate generated several years of positive cash flows followed by negative cash flows, and then a return to a positive cash flow.

(*2) If a real estate property's cash flow fluctuates, the best valuation approach is the net present value (NPV).

(*3) IRR has a number of limitations, including multiple solutions when the investment has positive cash flow one year and a negative cash flow the next year.

(*4) The direct capitalization approach is best used when the investment's net operating income is stable.

IRR and NPV

(Question)
"The net present value (NPV) of the apartment complex investment is positive and that the internal rate of return (IRR) is less than required rate of return."

Are the statements correct?

A. Only the NPV statement is correct.
B. Only the IRR statement is correct.
C. Both the NPV and IRR statements are correct.

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Answer: A

-CF₀ + CF₁/(1+r)¹ + ... + CF_n/(1+r)ⁿ > 0
-CF₀ + CF₁/(1+IRR)¹ + ... + CF_n/(1+IRR)ⁿ = 0
Then IRR > r

After-tax cash flow

Cost of any loan = 8%
Loan amortization = 20 years (with annual payments)
Equity contribution = $1,000,000
Loan-to-value ratio = 75%

Required rate of return = 11%

Total value = $1,000,000/(1-75%)= $4,000,000
Debt = Total value - Equity = $4,000,000 - $1,000,000 = $3,000,000

After-tax cash flow

Year	Operating income	Tax payable	Annual debt service	After-tax cash flow	PV after tax cash flow
1	$400,000	$40,000	$305,557 (*1)	54,443 (*4)	49,047.75 (*8)
2	$420,000	$42,000	$305,557 (*1)	72,443 (*2)	58,796.36 (*9)
3	$441,000	$44,000	$305,557 (*1)	91,443 (*5)	66,862.33 (*10)
4	$463,000	$46,000	$305,557 (*1)	111,443 (*6)	73,410.96 (*11)
5	$486,000	$49,000	$305,557 (*1)	131,443 (*7)	78,005.02 (*12)
ERAT (*3)	$2,000,000			2,000,000	1,186,902.66 (*13)

(*1)
20 N
8 I/Y
3,000,000 PV
0 FV
CPT PMT -305,557

(*2) $420,000 - $42,000 - $305,557 = 72,443

(*3) After-tax equity reversion or called as Equity Reversion After-Tax (ERAT)

(*4) 400,000 - 40,000 - 305,557 = 54,443
(*5) 441,000 - 44,000 - 305,557 = 91,443
(*6) 463,000 - 46,000 - 305,557 = 111,443
(*7) 486,000 - 49,000 - 305,557 = 131,443

(*8) 54,443/(1+11%)^1 = 49,047.75

(*9) 72,443/(1+11%)^2 = 58,796.36

(*10) 91,443/(1+11%)^3 = 66,862.33

(*11) 111,443/(1+11%)^4 = 73,410.96

(*12) 131,443/(1+11%)^5 = 78,005.02

(*13)2,000,000/(1+11%)^5 =1,186,902.66

NPV = (49,047.75 + 58,796.36 + 66,862.33 + 73,410.96 + 78,005.02 + 1,186,902.66) - 1,000,000 = 513,025.08 > 0

In this case, the NPV is positive and, therefore, the IRR must be greater than the required rate of return of 11%.

CF

CF0 -1,000,000

C01 54,443

C02 72,443

C03 91,443

C04 111,443

C05 131,443+2,000,000 = 2,131,443

IRR CPT 21.5268% > 11%

Capitalization rate (Market Capitalization rate)

Capitalization rate = R₀ = Discount rate - Growth rate = r - g

MV₀ = NOI/(r-g) = NOI/R₀
R₀ = NOI/MV₀
r = R₀ + g

Capitalization rate

Property type	Net operating income (NOI)	Growth rate(g)	Property value(MV0)	Capitalization rate(R0)	Discount rate(r)
Office building	$600,000	3%	$8,000,000	7.5% (*1)	7.5%+3% = 10.5%
Warehouse	$600,000	5%	$10,000,000	6% (*2)	6%+5% = 11%
Hotel	$900,000	7%	$9,000,000	10% (*3)	10%+7% = 17%

(*1) $600,000/$8,000,000 = 7.5%
(*2) $600,000/$10,000,000 = 6%
(*3) $900,000/$9,000,000 = 10%

Real estate investment

Real estate investment

	Raw land	Office Building	Warehouse
Tax shelter			Yes
Limited management role			Yes
Require hiring professional management?		Yes	No
High cash flows	-		Yes
Price appreciation (capital gain)			No

Financial leverage and Implied P/E multiple without regard to an associate

Italian Company I

Accounting standard					IFRS
Method to account for its investment in the U.S. associates					Equity method
Equity interest in a company located in the U.S.					30%
The U.S. associate's accounting standard					U.S. GAAP

Selected Financial Data--Company I

In EUR millions						2009	2008	2007
Income statement
Revenue						60,229	55,137
Earnings before interest and tax						7,990	7,077
Earnings before tax						7,570	6,779
Income from associatea						354	270
Net income						6,501	5,625
Unearned revenue						7,201	5,514
Balanace Sheet
Total assets						56,396	53,111	45,597
Investment in associate						5,504	5,193
Shareholder's equity						30,371	29,595	27,881

^a Not included in EBIT or EBT.

Company I

Financial leverage = Average total assets / Average equity
Financial leverage (2009) = ((56,396+53,111)/2) / ((30,371+29,595)/2) = 54,753.5/29,983 = 1.8262

Financial leverage (2008) = ((53,111+45,597)/2) / ((29,595+27,881)/2) = 49,354/28,738 = 1.7174

Although leverage was higher in 2009, the nature of the true leverage (in 2009) was lower (than the one calculated above). This is because the increasing unearned revenue will not require an outflow of cash in the future and are, thus, less onerous than the Company I's other liabilities.

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Selected Market Capitalization Data

In millions except exchange rates					I			U.S. associate
Market cap					EUR 97,525			USD 32,330
Current exchange rate (EUR/USD)					0.70
Average exchange rate (EUR/USD)					0.73

Company I implied P/E multiple without regard to its U.S. associate
Implied value without its U.S. assosiate = Market cap (I) - Pro-rata share of associate's market cap
= 97,525 - 32,330*0.70*30% = 90,735.7

Net income without associate = 6,501 - 354 = 6,147


Implied P/E = 90,735.7/6,147 = 14.7610

Financial analysis framework

Financial analysis framework

phase		input	output
1st	Defining the purpose and context of the analysis.	The institutional guidelines related to developing the specifiic work product.
Data collection		(e.g.) Audited financial statements.
Data processing			Ratio analysis

Impairment loss under U.S. GAAP and IFRS

Impairment loss under U.S. GAAP and IFRS

G	Carrying value (*)				$1,425
G	Fair value				$1,475
G's identifiable net assets	Fair value				$1,350
G	Recoverable amount				$1,430

(*) including goodwill

U.S. GAAP


Fair value = 1,475 > Carrying value = 1,425
The goodwill is not impaired. Thus, no impairment loss is recognized.


IFRS


Recoverable amount = 1,430 > Carrying value = 1,425
No impairment loss is recognized.

Full goodwill method, Partial goodwill method, Pooling method

Preacquisition Balance Sheet Data

Company		V	V		G	G
in $ millions		Book value	Fair value		Book value	Fair value
Current assets		9,000	9,000		500	700
Noncurrent assets		7,500	7,800		900	950
Total assets		16,500	16,800		1,400	1,650

Preacquisition Balance Sheet Data

Company		V	V		G	G
in $ millions		Book value	Fair value		Book value	Fair value
Current liabilities		3,000	3,000		250	250
Long-term debt		7,700	7,500		400	300
Stockholders' equity		5,800	7,800		750	1,100
Total liabilities and equity		16,500	16,800		1,400	1,650

The company V is the U.S. company. (i.e. It follows U.S. GAAP.)

The company V purchased a 60% controlling interest in G for $900 million. V paid for the acquisition with shares of its common stock.


Full goodwill method
Fair value of G: $900/60% = $1,500
Fair value of G's identifiable net assets = $1,100
Goodwill: 1,500 - 1,100 = $400

Partial goodwill method

Purchase price of G: $900

Pro-rata share of G's identifiable net assets = $1,100*60% = $660

Goodwill: 1,100 - 660 = $240

Pooling method

Goodwill is NOT created under the pooling method.

Post-acquisition long-term debt-to-equity ratio

Company V:

Long-term debt = 7,700 (V,BV) + 300 (G,FV) = 8,000

Equity = 5,800 (V,BV) + 900(FV of shares to acquire G) + 600 (noncontrolling interest) = 7,300

Under U.S. GAAP, the noncontrolling interest is based on the full goodwill method. (1,500 Fair Value * 40% noncontrolling interest = 600)

Thus, the long-term debt-to-equity ratio is

8,000 / 7,300 = 1.0959

Carrying value: held-to-maturity and trading securities

1/1/2009 and 7/1/2009 (MM/DD/YYYY)

bond		FV(*1)	cost(*1)	coupon	yield	Maturity(yrs)
M	held-to-maturity	10	9.2(1/1/2009)	4% annual	5%	-
T	trading security	7	7(7/1/2009)	5% semiannual	-	20

12/31/2009

bond		FV(*1)	cost(*1)	coupon	yield	Maturity(yrs)	CV(*1)(*4)	Fair value(*1)
M	held-to-maturity	10	9.2(1/2/2009)	4% annual	-	-	9.26(*3)	9.6
T	trading security	7	7(7/1/2009)	5% semiannual	4%	19.5	Fair value	7.941591(*2)

(*1)$million

(*2)
39 N
2 I/Y
0.175 PMT
7 FV
PV CPT 7.9416

(*3) Held-to-maturity securities are reported on the balance sheet at amortized cost.
issue price + discount amortization
= issue price + (interest expense - coupon payment)
= 9.2 + (9.2*5%-10*4%)
= 9.2 + (0.46-0.40)

(*4) Carrying value is also reported value on the balance sheet.
= 9.26

At the end of 2009, the investment portfolio of bond M and T is reported at:
9.26 + 7.941591 = 17.201591 million USD = 17,201,591 USD