UNIVERSITY OF LONDON MSc ASSESSMENT 2021 For Internal Students of Royal Holloway MN5911: FINANCIAL STATEMENT ANALYSIS Assessment Submission Deadline: 10am on Saturday 27th March 2021 (Greenwich Mean Time) THIS ASSESSMENT IS DESIGNED TO TAKE THREE HOURS Answer the following ONE question Word Count 1200 © Royal Holloway University of London 2021 Page 1 of 7 2020-21 Answer the following ONE question You have just been hired by an investment bank as an analyst. You joined the oil & gas research team which is currently working on a report on BP. One team member has recently left the investment bank and you have been asked to work through his notes in order to use them in the report. You quickly realise that the notes contain numerous errors, i.e. wrong statements and wrong results of calculations. You conclude that there could be an error anywhere in the notes. REQUIRED: Identify the errors in the notes and correct them. Specifically: – If a wrong statement is made in a sentence, provide a correct sentence. – If there is a wrong result of a calculation, do the calculation by yourself and provide the correct result. – List the corrections in the order the errors appear in the notes. – Number your corrections consecutively, i.e. 1., 2., 3. etc. Marking (total 100 marks): – 10 marks are awarded for following the format requirements. Specifically, 5 marks for listing the corrections in the order the errors appear in the notes and 5 marks for numbering the corrections consecutively. – 90 marks are awarded for identifying the errors and correcting them. There are between 10 and 20 errors in the notes. Each error carries the same number of marks. No mark is awarded for identifying an error without a reasonable correction. For example, if a wrong statement says “current ratio equals 2.0”, you won’t get marks for simply saying “current ratio does not equal 2.0” – you need to do the calculation and provide the correct current ratio. There is no need to write many words and there is no need to show your calculations – the only task is to identify the errors and correct them. MN5911 Spring 2021 Page 2 of 7 NEXT PAGE Notes of the former team member: General company information – Company: BP plc – Date: 26 March 2021 – Accounting period end date of the most recent financial statements: 31 December 2019 Background research – BP’s auditor Deloitte confirms that BP has prepared its consolidated financial statements in accordance with IFRS as adopted by the EU and IFRS as issued by the IASB. – BP’s competitive strategy in their oil & gas extraction business (“upstream”) is cost leadership. – Recasting BP‘s financial statements into a standardised format is useful because it allows distinguishing profitable from non-profitable operations. – BP’s assets are overstated if key intangible assets are off the balance sheet. – BP’s return on equity will increase when its asset turnover increases. – A sensitivity analysis as part of forecasting BP’s financial statements includes a downside case, e.g. assuming that the oil price is lower. – According to the findings of Francis, Olsson and Oswald (Journal of Accounting Research, 2000), the discounted abnormal profit model generates more accurate value estimates than the discounted free cash flow model. – If a competitive equilibrium is forecasted beyond the terminal year, then the value estimate for BP increases when a higher terminal revenue growth is assumed. – Demirakos, Strong and Walker (Accounting Horizons, 2004) find evidence that supports their hypothesis that analysts who construct a multiperiod valuation analysis do not adopt valuation by comparatives as their dominant model. – In 2019, BP’s long-term credit rating from Standard & Poor’s is A−, and this indicates that BP has a low default probability. – According to BP’s annual report 2019, the 2018 acquisition of Petrohawk Energy Corporation did not result in an increase in goodwill in the balance sheet. NEXT PAGE Page 3 of 7 MN5911 Spring 2021 Ratio analysis BP’s financial statements (directly copied from BP’s annual report 2019): MN5911 Spring 2021 Page 4 of 7 NEXT PAGE Ratios: Ratio Return on equity Return on assets Net profit margin Asset turnover Current ratio Quick ratio Liabilities-to-equity ratio Debt-to-equity ratio 2019 4.14% 1.45% 1.48% 96.44% 1.03 0.65 193.1% 67.2% MN5911 Spring 2021 Interpretation: – The above profitability ratios suggest that BP is doing well. – Net profit margin decreased from 2018 to 2019 because profit decreased. – Current ratio and quick ratio decreased slightly from 2018 to 2019 and this indicates improved liquidity. – As the current ratio is above 1, there are no concerns about BP’s liquidity. – The increase in the liabilities-to-equity ratio from 2018 to 2019 is mainly driven by an increase in total liabilities. – The increase in the debt-to-equity ratio from 2018 to 2019 indicates improved solvency. – BP’s financial statements do not include the necessary information to calculate the gross profit margin. Page 5 of 7 NEXT PAGE Accounting adjustment: adjusting depreciation Information for BP in 2019 (assume that this does not contain any errors): – Property, plant and equipment (PPE) is depreciated over 20 years on a straight-line basis – Estimated residual value of 10% of initial cost – This implies an annual depreciation rate of 4.5% ([1 − 0.10]/20) – PPE cost on 1/1/2019: $306,348m Accumulated depreciation on 1/1/2019: $171,087m Net PPE purchased throughout the year 2019: $18,885m – Marginal tax rate of 40% Findings: – Adjusting BP’s depreciation rate to 4% results in an increase in non-current tangible assets on 31 December 2019 of $21,257 million. – If adjusting BP’s depreciation results in an increase in shareholders‘ equity on 31 December 2019 of $12,240 million, then non-current tangible assets need to increase by $21,400 million. – Adjusting depreciation does not affect operating cash flow. – Adjusting the depreciable life of BP’s PPE to 15 years results in a decrease in shareholders‘ equity. – Adjusting the residual value of BP’s PPE to 15% of initial cost results in a decrease in shareholders‘ equity. – Adjusting BP’s depreciation rate to 5% results in a decrease in profit. – Adjusting BP’s depreciation rate to 5% results in a higher asset turnover. Page 6 of 7 MN5911 Spring 2021 NEXT PAGE Valuation A=actual, E=estimate/forecast Earnings per share ($) EPS growth beyond 2023 Dividends per share ($) DPS growth beyond 2023 Free cash flow per share ($) FCF per share growth beyond 2023 Book value per share ($) Abnormal profit growth beyond 2023 Net debt per share ($) Cost of equity (estimate) WACC (estimate) 2019A 1.19 0.41 2.60 29.11 13.38 10.0% 8.0% 2020E -6.02 0.26 1.02 22.83 2021E 1.72 0.70 3.12 23.85 2022E 2.51 0.90 3.27 25.46 2023E 3.12 1.00 3.32 27.58 2024E 2.0% 6.5% 1.0% 0.5% MN5911 Spring 2021 Note: Assume that the table above does not contain any errors. – Using the dividend discount model with the data above generates a value estimate on 31 December 2019 of $26.77. – Using the discounted cash flow model with the data above generates a value estimate on 31 December 2019 of $26.77. – Using the discounted abnormal profit model with the data above generates a value estimate on 31 December 2019 of $26.77. – For BP, the cost of equity and WACC cannot be the same. – It is possible to estimate the abnormal profit growth beyond 2023 to be negative. – When the value estimate of BP according to all the three models above is higher than the current share price, then this implies that the market undervalues BP. END