New on FinoLib · Volume II: Capital Markets
I have just published a new article on FinoLib, my free finance education library: Finance Case Studies: Accounting Scandal Valuation and FX Hedge. It is part of Volume II: Capital Markets. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
12.3 Case Two — Valuing a Company Mid-Accounting-Scandal
The idea in plain words
This case values a company in the middle of an accounting scandal. First size the allegation with forensic ratios, then rebuild the valuation from restated numbers. For Harbor Tools, $50 million of reversed sales and a $15 million reserve release cut EBIT by 25%. But the equity value falls by 37%, from $15.24 to $9.55 a share, because the $500 million of net debt does not shrink.
Key points
■DSO rising from 60 to 78 days on 8% sales growth flags about $50 million of unexplained receivables.
■Cutting the price by the earnings drop ($11.43) overvalues the stock by about 20%.
■Restated leverage rises from 3.33x to 4.14x EBITDA and coverage falls from 3.89x to 2.92x.
A closer look
The situation: A whistleblower alleges that Harbor Tools, the company valued at $15.24 a share in Section 1.3: Discounted Cash Flow (DCF) — Building the Model, booked year-end sales before customers took control (the revenue recognition abuse of Section 6.2: Revenue Recognition — Where Manipulation Hides) and released warranty reserves, an expense manipulation, to hit its targets: the pressure-to-hit-a-number pattern of Section 6.8: Famous Cases as Pattern Templates. No restatement has been confirmed. An analyst must value the equity, and the company’s lenders must decide what to do with $600 million of loans.
Decision rule
Value a company under an accounting allegation in three passes: size the allegation from the triage ratios, rebuild the model from the restated base and run-rate margin, then add a discount-rate or probability layer for what is still unknown. If the triage-sized adjustment moves value by more than 10%, do not publish a target price from reported numbers; publish the range between the reported and the restated values instead. Ignore the rule only when the allegation has been independently investigated and rejected.
The costliest mistake
Cutting the share price by the same percentage as earnings. EBIT fell 25%, so an analyst marks Harbor at 0.75 × $15.24 = $11.43. The restated DCF gives $9.55, so that shortcut overvalues the stock by 20%, because the debt does not shrink with the earnings. Always rebuild enterprise value first and subtract net debt; the equity’s percentage loss exceeds the earnings loss whenever the company carries debt.
Recap
Under an accounting allegation, size the problem with forensic ratios (DSO, reserves, profit versus cash) and rebuild the DCF from the restated base: Harbor Tools’ 25% EBIT cut becomes a 37% equity cut, $15.24 to $9.55 a share, because net debt is fixed.
12.4 Case Three — Structuring a Hedge During a Currency Crisis
The idea in plain words
This case structures a hedge for a company facing a currency crisis. The one-year forward rate comes from interest-rate parity: 1.1355 × 1.04592 ÷ 1.03005 gives 1.1530. Selling €75 million forward, which is 75% of the forecast, locks in $1.31 million more than today’s rate. And if the euro falls to parity, the company keeps $111.47 million, against $100 million if unhedged.
Key points
■The forward premium is the interest gap, not a forecast, so waiting for the crisis only costs the move you waited through.
■A put struck at 1.1530 costs $2.47 million and beats the forward only above 1.1875.
■Collateral under a CSA can demand $7.5 million per 10-cent euro rally on €75 million.
Decision rule
Hedge a forecast currency cash flow with forwards for 50% to 80% of the amount you are confident of, rising toward 100% as it becomes contractual, and layer the trades over time. Use options when the cash flow may not happen at all (a bid, an acquisition). Before trading, check the quote against parity and compute the collateral a 10% adverse move would demand. If you cannot fund it, hedge less or negotiate a threshold first. The percentages are working heuristics.
The costliest mistake
Waiting for the crisis to confirm itself. A forward locks today’s spot plus the interest gap, not the pre-crisis level. If the euro first falls to 1.05, the forward becomes 1.05 × 1.04592 ÷ 1.03005 = 1.0662, and €75 million sold then brings $6.51 million less than selling at 1.1530 today. The forward is never a forecast, so there is no cheap moment to wait for: the cost of delay is the move you waited through.
Recap
Interest-rate parity sets the one-year EURUSD forward at 1.1530, so a company selling €75 million forward locks $1.31 million above spot and, if the euro falls to parity, keeps $111.47 million against $100 million unhedged.
What the full article covers
In the full article I take you through these sections:
■12.3 Case Two — Valuing a Company Mid-Accounting-Scandal
■12.4 Case Three — Structuring a Hedge During a Currency Crisis
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Finance Case Studies: Accounting Scandal Valuation and FX Hedge, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
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