Solution

SOLUTIONS TO EXERCISE AND CASES

For

FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION

Stephen H. Penman

CHAPTER ONE

Introduction to Investing and Valuation

Exercises

Drill Exercises

E1.1. Calculating Enterprise Value

Enterprise Value = $1,800 million

E1.2. Calculating Value Per Share

Equity Value = $1,800

E1.3 Buy or Sell?

Value = $850 + $675

= $1,525 million

Value per share = $1,525/25 = $61

Market price = $45

Therefore, BUY!

Applications

E1.4. Finding Information on the Internet: Dell Computer and General Motors

This is an exercise in discovery. The links on the book’s web site will help with the

search. Here is the link to yahoo finance:

http://finance.yahoo.com

E1.5. Enterprise Market Value: General Mills and Hewlett-Packard

(a) General Mills

Market value of the equity =

Book value of total (short-term and long-term) debt =

Enterprise value

Note three points:

(i) Total market value of equity = Price per share × Shares outstanding.

(ii) The book value of debt is typically assumed to equal its market value, but

financial statement footnotes give market value of debt to confirm this.

(iii) The book value of equity is not a good indicator of its market value. The price-to-

book ratio for the equity can be calculated from the numbers given:

$20,925/$6,215.8 = 3.37.

(b) This question provokes the issue of whether debt held as assets is part of enterprise value

(a part of operations) or effectively a reduction of the net debt claim on the firm. The issue arises

in the financial statement analysis in Part II of the book: are debt assets part of operations or part

of financing activities? Debt is part of financing activities if it is held to absorb excess cash

rather than used as a business asset. The excess cash could be applied to buying back the firm’s

debt rather than buying the debt of others, so the net debt claim on enterprise value is what is

important. Put another way, HP is not in the business of trading debt, so the debt asset is not part

of enterprise operations. The calculation of enterprise value is as follows:

Market value of equity = $47 × 2,473 million shares = $116,231 million

Book value of net debt claims:

Short-term borrowing $ 711 million

Long-term debt 7,688

Total debt $8,399 million

Debt assets 11,513 (3,114)

Enterprise value 113,117 million

E1.6. Identifying Operating, Investing, and Financing Transactions

(a) Financing

(b) Operations

(c) Operations; but advertising might be seen as investment in a brand-name asset

(d) Financing

(e) Financing

(f) Operations

(g) Investing. R& D is an expense in the income statement, so the student might be

inclined to classify it as an operating activity; but it is an investment.

(h) Operations. But an observant student might point out that interest – that is a part

of financing activities – affects taxes. Chapter 9 shows how taxes are allocated

between operating and financing activities in this case.

(i) Investing

(j) Operations

CHAPTER TWO

Introduction to the Financial Statements

Exercises

Drill Exercises E2.1. Applying Accounting Relations: Balance Sheet, Income Statement and Equity Statement

a. Liabilities = $150 million b. Net Income = $205 million c. Ending equity = $32 million As net income (in the income statement) is $30 million, $2 million was reported as “other comprehensive income” in the equity statement. d. Net payout = Dividends + Share repurchases – Share issues As there were no share issues or repurchases, dividend = $12.

E2.2. Applying Accounting Relations: Cash Flow Statement Change in cash = $195 million E2.3. The Financial Statements for a Savings Account a. ___________________________________________________________________________

BALANCE SHEET INCOME STATEMENT

Assets (cash) $100 Owners’ equity $100 Revenue $5

Expenses 0

Earnings $5

STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY

Cash from operations $5 Balance, end of Year 0 $100

Cash investment 0 Earnings, Year 1 5

Cash in financing activities: Dividends (withdrawals), Year 1 (5)

Dividends (5) Balance, end of Year 1 $100

Change in cash $ 0

b. As the $5 in cash is not withdrawn, cash in the account increases to $105, and owners’

equity increases to $105. Earnings are unchanged.

______________________________________________________________________


Assets (cash) $105 Owners’ equity $105 Revenue $5

Expenses 0

Earnings $5



Cash investment 0 Earnings, Year 1 5



Change in cash $ 5

______________________________________________________________________

c. With the investment of cash flow from operations in a mutual fund, the financial

statements would be as follows:

_______________________________________________________________________


Assets (cash) $100 Revenue $5

Mutual Fund 5 Equity $105 Expenses 0

Total assets $105 Total $105 Earnings $5



Cash investment (5) Earnings, Year 1 5



Change in cash $ 0

E2.4. Preparing an Income Statement and Statement of Shareholders’ Equity

Income statement:

Sales $4,458 Cost of good sold 3,348 Gross margin 1,110 Selling expenses (1,230) Research and development (450) Operating income (570) Income taxes 200 Net loss (370) Note that research and developments expenses are expensed as incurred.

Equity statement: Beginning equity, 2009 $3,270 Net loss $(370) Other comprehensive income 76 (294) ($76 is unrealized gain on securities) Share issues 680

Common dividends (140) Ending equity, 2009 $3,516

Comprehensive income (a loss of $294 million) is given in the equity statement. Unrealized gains and losses on securities on securities available for sale are treated as other comprehensive income under GAAP.

Net payout = Dividends + share repurchases – share issues

= 140 + 0 – 680 = - 540 That is, there was a net cash flow from shareholders into the firm of $540 million. Taxes are negative because income is negative (a loss). The firm has a tax loss that it can carry forward. E2.5. Classifying Accounting Items

a. Current asset

b. Net revenue in the income statement: a deduction from revenue

c. Net accounts receivable, a current asset: a deduction from gross receivables

d. An expense in the income statement. But R&D is usually not a loss to shareholders; it

is an investment in an asset.

e. An expense in the income statement, part of operating income (and rarely an

extraordinary item). If the restructuring charge is estimated, a liability is also

recorded, usually lumped with “other liabilities.”

f. Part of property, plan and equipment. As the lease is for the entire life of the asset, it

is a “capital lease.” Corresponding to the lease asset, a lease liability is recorded to

indicate the obligations under the lease.

g. In the income statement

h. Part of dirty-surplus income in other comprehensive income. The accounting would

be cleaner if these items were in the income statement.

i. A liability

j. Under GAAP, in the statement of owners equity. However from the shareholders’

point of view, preferred stock is a liability

k. Under GAAP, an expense. However from the shareholders’ point of view, preferred

dividends are an expense. Preferred dividends are deducted in calculating “net income

available to common” and for earnings in earnings per share.

l. As an expense in the income statement.

E2.6. Violations of the Matching Principle

a. Expenditures on R&D are investments to generate future revenues from drugs, so are

assets whose historical costs ideally should be placed on the balance sheet and amortized

over time against revenues from selling the drugs. Expensing the expenditures

immediately results in mismatching: revenues from drugs developed in the past are

charged with costs associated with future revenues. However, the benefits of R&D are

uncertain. Accountants therefore apply the reliability criterion and do not recognize the

asset. Effectively GAAP treats R&D expenditures as a loss.

b. Advertising and promotion are costs incurred to generated future revenues. Thus, like

R&D, matching requires they be booked as an asset and amortized against the future

revenues they promote, but GAAP expenses them.

c. Film production costs are made to generate revenues in theaters. So they should be

matched against those revenues as the revenues are earned rather than expensed

immediately. In this way, the firm reports its ability to add value by producing films.

E2.7. Using Accounting Relations to Check Errors

Ending shareholders’ equity can be derived in two ways: 1. Shareholders’ equity = assets – liabilities

2. Shareholders’ equity = Beginning equity + comprehensive income – net dividends

So, if the two calculations do not agree, there is an error somewhere. First make the calculations

for comprehensive income and net dividends:

Comprehensive income = net income + other comprehensive income

= revenues – expenses + other comprehensive income

= 2,300 –1,750 – 90

= 460

Net dividend = dividends + share repurchases – share issues

= 400 +150 –900

= - 350

Now back to the two calculations:

1. Shareholders’ equity = 4,340 – 1,380

= 2,960

2, Shareholders’ equity = 19,140 + 460 – (-350)

= 19,950

The two numbers do not agree. There is an error somewhere.

Applications

E2.8. Finding Financial Statement Information on the Internet

This is a self-guiding exercise. Students can take it further by downloading financial statements

into a spreadsheet. Go to the links of the book’s web site.

E2.9. Testing Accounting Relations: General Mills Inc.

This exercise tests some basic accounting relations.

(a) Total liabilities = Total assets – stockholders’ equity = 12,826

(b) Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders

6,216 = 5,319 +? – 782

? = 1,679

Net payout to common = cash dividends + stock purchases – share issues = 782

E2.10. Testing Accounting Relations: Genetech Inc.

(a) Revenue = $4,621.2 million

(b) ebit = $1,136.8 million

(c) ebitda =$1,490.0 million

Depreciation and amortization is reported as an add-back to net income to get cash flow from

operations in the cash flow statement.

Long-term assets = $5,980.6 million

Total Liabilities = $2,621.2 million

Short-term Liabilities =$1,243.3 million

(c) Change in cash and cash equivalents = Cash flow from operations – Cash used in investing

activities + Cash from financing activities

Change in cash and cash equivalents is given by the changes in the amount is the balance sheet

= $270.1 – 372.2 = -$102.1

So, -$102.1 = $1,195.8 - $451.6 + ?

So ? = -$846.3 million

That is, there was a cash outflow of $846.3 million for financing activities.

E2.11. Find the Missing Number in the Equity Statement: Cisco Systems Inc.

Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders a.

$32,304 = $31,931 + 6,526 -?

? = $6,153

b. Net payout to common = cash dividends + stock purchases – share issues

6,153 = 0 + ? – 2,869

= 9,022

E2.12. Find the Missing Numbers in Financial Statements: General Motors

a.

Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders -56,990 = -37,094 + ? – 283 ? = -19,613 (a loss) b. Comprehensive income = Net income + Other comprehensive income -19,613 = -18,722 + ? ? = - 891 c. Net income = Revenue – expenses and losses -18,722 = ? – 60,895 ? = 42,173 d. June 30, 2008 December 31, 2007 Assets 136,046 148,883 Liabilities ? = 193,036 ? = 185,977 Equity -56,990 -37,094

E2.13. Mismatching at WorldCom

Capitalizing costs takes them out of the income statement, increasing earnings. But the

capitalized costs are then amortized against revenues in later periods, reducing earnings. The net

effect on income in any period is the amount of costs for that period less the amortization of

costs for previous periods. The following schedule calculates the net effect. The numbers in

parentheses are the amortizations, equal to the cost in prior periods dividend by 20.

1Q, 2001 2Q, 2001 3Q, 2001 4Q, 2001 1Q, 2002

1Q, 2001 cost: $780 $780 $ (39) $ (39) $ (39) $ (39)

2Q, 2001 cost: 605 605 (30) (30) (30)

3Q, 2001 cost: 760 760 (38) (38)

4Q, 2001 cost: 920 920 (46)

1Q, 2002 cost: 790 790

Overstatement of earnings $780 $566 $691 $813 $637

The financial press at the time reported that earnings were overstated by the amount of the

expenditures that were capitalized. That is not quite correct.

E2.14. Calculating Stock Returns: Nike, Inc.

The stock return is the change in price plus the dividend received. So, Nike’s stock return for

fiscal year 2008 is 12.875/55 = 23.41%.

CHAPTER THREE

How Financial Statements are Used in Valuation

Exercises

Drill Exercises

E3.1. Calculating a Price from Comparables Average of the two prices = $55 per share E3.2. Stock Prices and Share Repurchases Market price per share after repurchase = $1,800/90 = $20 E3.3 Unlevered (Enterprise) Multiples Market price of equity = 80 × $7 = $560 million Market value of debt 140 (assumes book value – market value) Market value of enterprise $700 million Book value of shareholders’ equity = $250 - 140 = $110million

a. P/B = 560/110 = 5.09 b. Unlevered P/S = 700/560 = 1.25 c. Enterprise P/B = 700/250 = 2.8

E3.4. Identifying Firms with Similar Multiples

This is a self-guided exercise.

E3.5. Valuing Bonds

For this question, first calculate discount factors for each of five years ahead. You can also get them from present value tables where the discount factor is given as 1/1.05t. At a 5% required return, the discount factors are: Year Ahead (t) Discount factor (1.05t)

1 1.05 2 1.1025 3 1.1576 4 1.2155 5 1.2763

a. The only cash flow is the $1,000 at maturity Present value (PV) of $1,000 five years hence = $1,000/1.2763 = $783.51 b. This is easy. If the coupon rate is the required rate of return, the bond is worth its face value, $1,000. You

can show this by working the problem as in part b, but with an annual coupon of $50.

c. The yearly cash flows and their present value are:

Year Ahead (t) Discount factor (1.05t) Cash Flow PV 1 1.05 40 38.10 2 1.1025 40 36.28 3 1.1576 40 34.55 4 1.2155 40 32.91

5 1.2763 1, 040 814.86 Total Present Value $956.70

(Your answers might differ by a couple of cents if you use discount factors to 5 or 6 decimal places.)

E3.6. Applying Present Value Calculations to Value a Building

This is a straight forward present value problem: the required return--the discount rate--is applied to

forecasted net cash receipts to convert the forecast to a valuation:

Present value of net cash receipts of 1.1 million for 5 years at 12% (annuity factor is 3.6048)

$3.965 million

Present value of $12 million “terminal payoff” at end of 5 years (present value factor is 0.5674)

6.809

Value of building $10.774

Applications

E3.7 The Method of Comparables: Dell, Inc. First calculate the multiples for the comparable firms from the price and accounting numbers:

Sales

Earnings

Book Value

Market Value

Hewlett-Packard Co. $45,226 $ 624 $13,953 $32,963 Gateway Inc. 6,080 (1,290) 1,565 1,944 HP: Price/Sales = 0.73 P/E = 52.8 P/B = 2.4 Gateway: Price/Sales = 0.32 P/E - (not applicable: negative earnings) P/B = 1.2 Now apply the multiples to Dell: Average Multiples Dell’s Dell’s for Comparable Number Valuation Sales 0.53 x 31,168 = $16,519 million Earnings 52.8* x 1,246 = 65,789 Book value 1.8 x 4,694 = 8,449 Average of valuations 30,252 * HP only

With 2,602 million shares outstanding, the estimated value per share = $30,252/2,602 = $11.63 Difficulties:

- P/E can’t be calculated for a loss firm - The “comparables” are not exactly like Dell - The calculation assumes the market prices for the “comps” are efficient - Not sure how to weight the three valuation based on sales, earnings and book values;

the valuations differ considerably, depending on the multiple used

E3.8. A Stab at Valuation Using Multiples: Biotech Firms

Multiples of the various accounting numbers for the five firms can be calculated and the average multiple applied to

Genentech’s corresponding accounting numbers. This yields prices for Genentech:

Multiple

Comparison Firm Mean

Estimated Genentech

Value (millions)

P/B 4.16 $5,610.9 E/P

.0245*

5,077.6

(P-B)/R&D

10.66

4,699.2

P/Revenue

6.05

4,809.0

Mean over all values

5,049.2

*Excludes firms with losses.

E/P is used rather than P/E because a very high P/E due to very small earnings can affect the mean

considerably. The mean E/P also excludes the loss firms since Genentech did not have losses.

Research and development (R&D) expenditures are compared to price minus book value. As the R&D

asset is not on balance sheets, its missing value is in this difference. The average ratio of 10.66 is applied to

Genetech’s R&D expenditures to yield a valuation for its R&D asset of $3,350.4 million which, when added to the

book value of the other net assets, gives a valuation of $4,699.2 million for Genentech. This is clearly very rough.

The average of the values based on the mean multiples is $5,049.2 million. Genetech’s actual traded value

in April 1995 was $5,637.6 million.

E3.9. Pricing Multiples: General Mills, Inc.

E3.10. Measuring Value Added

(a) Buying a stock:

Value of a share = 12.0

2 =

$ 16.67

Price of a share 19.00

Value lost per share $ 2.33

(b) Value of the investments:

Present value of net cash flow of

$1M per year for five years (at 9%)

$ 3.890 million

Initial costs 2.000

Value added $ 1.890 million

E3.11. Forecasting Prices in an Efficient Market: Weyerhaeuser Company

This tests whether you can forecast future prices, ex-dividend, using the no-arbitrage relationship between

prices at different points in time.

The T-Bill rate at the end of 1995 was 5.5%.

So the CAPM cost of capital = 5.5% + (1.0 × 6.0%) = 11.5% (using an 6% risk premium).

(a) 1995

21997 PP ρ= = 1.1152 × 42 = 52.22

This is the cum-dividend price

(b) 199719961995

21997 ddPP −ρ−ρ=

= (1.1152 x 42) - (1.115 × 1.60) - 1.60 = 48.83

84.16095.0

16.1/ =×=×=

E

S

S

PEP

E3.12. Valuation of Bonds and the Accounting for Bonds, Borrowing Costs, and Bond

Revaluations

The purpose of this exercise is to familiarize students with the accounting for bonds.

The cash flows and discount rates for each bond are as follows:

2007 2008 2009 2010 2011 2012

40 40 40 40 40 Coupon

1000 Redempt.

1.08 1.1664 1.2597 1.3605 1.4693 Discount rate (a) Present value of cash flows = value of bond = $840.31.

(b) (1) Borrowing cost = $840.31 × 8% = $67.22 per bond

(2) This is the way accountants calculate interest (the effective interest method): $67.22 per bond will be

recorded as interest expense. This will be made up of the coupon plus an amortization of the bond discount. The

amortization is $67.22 - $40.00 = $27.22. This accrual accounting records the effective interest of $67.22, not the

cash flow.

(c) (1) As the firm issued the bonds at 8%, it is still borrowing at 8%. Of course, if the firm issued new debt at the

end of 2009, its borrowing cost would be 6%.

(2) Interest expense for 2009 will be $69.40 per bond. This is the book value of the bond at the end of 2008

times 8%: $867.53 × 8% = $69.40. The book value of the bond at the end of 2008 is $840.31 + $27.22 =

$867.53, that is, the book value at the beginning of 2008 plus the 2008 amortization.

(d) The future cash flows at the end of 2009 are:

2010 2011 2012

40 40 40 Coupon

1000 Redemption 1.08 1.1664 1.2597 Original Discount rate 1.06 1.1236 1.1910 New discount rate Present value of remaining cash flows at 8% discount rate = $896.92

Present value of remaining cash flows at 6% discount rate = 946.55

Price appreciation $ 49.63

(1) The bonds are marked to market so they are carried at $946.55 at the end of 2009. Note that bonds are marked

to market only if they are assets, not if they are liabilities. Debtor Corporation’s carrying amount would not be

affected by the change in yield.

(2) The interest income in the income statement will be as before, $69.40 per bond. However, an unrealized gain of

$49.63 per bond will appear in other comprehensive income to reflect the markup. (Unrealized gains and losses on

securities go to other comprehensive income rather than the income statement. See Accounting Clinic III.)

Note that, if Debtor Corporation had sold the bonds at the end of 2009 (for $946.55 each), it would have realized

a loss of $49.63 per bond which would be reported with extraordinary items in the income statement. If it

refinanced at 6% for the last three years, it would lower borrowing costs that, in present value terms, would equal

the loss.

E3.13. Share Issues and Market Prices: Is Value Generated or Lost By Share Issues?

This exercise tests understanding of a conceptual issue: do share issues affect shareholder value per share? The

understanding is that issuing shares at market price does not affect the wealth of the existing shareholders if the

share market is efficient: New shareholders are paying the “fair” price for their share. However, if the shares are

issued at less than market price, the old shareholders lose value.

(a)

Shares outstanding after share issue = 188 million

Price per share after issue = $55

Like a share repurchase, a share issue does not affect per share value as long as the shares are issued at the

market price. Old shareholders can’t be damaged or gain a benefit from the issue. Of course, if the market

believes that the issue indicates how insiders view the value of the firm, the price may change. But this is

an informational effect, not a result of the issue. Old shareholders would benefit if the market were

inefficient, however. If shares are issued when they are overvalued in the market, the new shareholders pay

too much and the old shareholders gain.

The idea that share issues don't generate value (if at market prices) is the same idea that dividends don't

generate value. Share issues are just dividends in reverse.

(b)

Shares outstanding after exercise 200 million

Price per share $60.10

The (old) shareholders lost $1.90 per share through the issue: issue of shares at less than market causes

“dilution” of shareholder value.

E3.14. Stock Repurchases and Value: Dell, Inc.

This exercise makes the same conceptual point as the previous exercise on stock issues: stock repurchases

(which are reverse stock issues) don't create value, if the market price is at fair value.

There is no effect on the price per share at the date of repurchase. The total value of the company (price

per share x shares outstanding) would drop by $335 million, the amount of cash paid out. But the number of shares

outstanding would also drop by 7.5 million leaving the price per share unchanged.

Price per share before repurchase = $4,004M/179M = $22.37

Total value of the equity before repurchase = $22.37 × 2,239M = $50,086M

Total value of the equity after repurchase = $50,086M − $4,004M = $46,082M

Shares outstanding after repurchase = 2,239M − 179M = 2,060M

Price per share after repurchase = $46,082/2,060 = $22.37

Note: the announcement of a share repurchase might affect the price per share if the market inferred that the

management thinks the shares are underpriced. That is, the repurchase might convey information. But the actual

repurchase itself will not affect the per-share price. If the shares are not priced efficiently in the market, value will

be gained (or lost) for shareholders who do not participate in the repurchase.

E3.15. Dividends, Stock Returns, and Expected Payoffs: Weyerhaeuser Company

If no dividends are to be paid, the expected 1997 price would be higher by the amount of the terminal value

of the dividends.

Terminal value in 1997 of 1996 dividend = $1.60 × 1.115 = $1.784

Terminal value in 1997 of 1997 dividend = 1.600

$3.384

Ex-dividend price, 1997 $48.83

Cum-dividend price $52.214

Stock repurchases have no effect on per-share price so the expected price would be the cum-dividend price

of $52.22.

This conclusion ignores any “signaling effect” from the announcement of the stock dividend and any

differences in tax effects between capital gains at dividends.

E3.16. Betas, the Market Risk Premium, and the Equity Cost of Capital: Sun Microsystems

a) The CAPM equity cost of capital is given by

Cost of capital = Risk-free rate + (Beta × Market risk premium)

= 4.0% + (1.38 × ?)

Market Risk

Premium

Cost of

Capital

4.5% 10.21% 6.0% 12.28% 7.5% 14.35%

9.0% 16.42%

b)

Market Risk

Premium

Beta Cost of Capital

4.5% 1.25 1.55

9.63% 10.98%

6.0% 1.25 1.55

11.5% 13.30%

7.5% 1.25 1.55

13.38% 15.63%

9.0% 1.25 1.55

15.25% 17.95%

c) Lowest cost of capital: 9.63%

Highest cost of capital: 17.95%

Forecasted price in June 2000 = $0.54 × 20 = $10.80

Present value at 9.63% discount rate (no dividends) = $10.80 = $9.85 1.0963

Present value at 17.95% discount rate (no dividends) = $10.80 = $9.16 1.1795

E3.18. Implying the Market Risk Premium: Procter & Gamble

The CAPM cost of capital is given by

Cost of Capital = Risk-free rate + (Beta × Market risk premium)

7.9% = 4.0% + (0.65 × ?)

? = 6.0%

CHAPTER FOUR

Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation

Exercises

Drill Exercises

E4.1. A Discounted Cash Flow Valuation

2009 2010 2011 2012 Cash flow from operations $1,450 1,576 1,718 Cash investment $1,020 1,124 1,200 Free cash flow $ 430 452 518 Discount rate (1.10)t 1.10 1.21 1.331 PV of cash flows 391 374 389 Total PV to 2012 $1,154 Continuing value* 8,979 PV of CV 6,746 a. Enterprise value $7,900 million Net debt 759 b. Value of equity $7,141 million

* Continuing value = =−

×

04.110.1

04.15188,989

E4.2. A Simple DCF Valuation = $8,600 million E4.3. Valuation with Negative Free Cash Flows Calculate free cash flow from the forecasts of cash flow from operations and cash investments. Your will see that free cash flow is negative in all years except 2009: 2009 2010 2011 2012 Cash flow from operations 730 932 1,234 1,592 Cash investments 673 1,023 1,352 1,745 Free cash flow 57 ( 91) ( 118) ( 153) If you calculate the present value of these free cash flows (with any discount rate), you’ll get a negative price. Prices can’t be negative (with limited liability). The continuing value must be greater than 100% of the price, but we have no way to calculate it. One would have to extend the forecast horizon. E4.4. Calculate Free Cash Flow from a Cash Flow Statement

Cash flow from operations reported $5,270 Interest payments $1,342 Interest receipts 876 Net interest payments 466 Tax at 35% 163 303 Cash flow from operations 5,573

Cash investments reported $6,417 Purchase of short-term investments (4,761) Sale of short-term investments 547 2,203 Free Cash Flow 3,370

Applications

E4.5. Calculating Cash Flow from Operations and Cash Investment for Coca-Cola Cash from operations = $7,258 million Coke’s free cash flow was = $190. E4.6. Identifying Accruals for Coca-Cola

Accruals are the difference between net income and cash flow from operations:

Accruals = -$1,169 million

That is, accruals were negative, yielding net income below cash flow from operations.

E4.7. Converting Forecasts of Free Cash Flow to a Valuation: Coco-Cola Company

Unlike the case in Exercise E 4.3, the free cash flows here are positive:

________________________________________________________________________ 2004 2005 2006 2007 Cash flow from operations 5,929 6,421 5,969 7,258 Cash investments 618 1,496 2,258 7,068 Free cash flow 5,311 4,925 3,711 190

However, although positive, the free cash flow are declining over the four years. If cash flows from operations and

cash investments were declining at about the same rate, we might conclude that the firm indeed was in a state of

decline: declining cash flows from the business lead to declining investments. However, cash flows from operations

are increasing and cash investment is increasing at a faster rate: Coke is investing heavily. While free cash flow is

declining over these years, one would thus expect it to increase in future years as cash from the rising investment

here comes in. These cash flow are not a good indication of future free cash flows (and nor is the $190 million of

free cash flow in 2007 a good base to calculate a continuing value.)

The exercise is a good example of why free cash flow does not work, in principle: Investment (which is made to

generate cash flows actually decreases free cash flow, so rising investment relative to cash flow from operations

(lower free cash flow) typically means higher free cash flow later.

E4.8. Cash Flow and Earnings: Kimberly-Clark Corporation

Part a. Adjust cash flow from operations for after-tax net interest payments and cash investment for net investments in interest-bearing assets: Cash flow from operations $3,071.0 Free cash flow $2,572.0

Note: As cash interest receipts are not reported (as is usual), use interest income from the income statement. Part b. Accruals = $(1,169.4) E4.9. A Discounted Cash Flow Valuation: General Mills, Inc.

a. The exercise involves calculating free cash flows, discounting them to present value, then adding the present

value of a continuing value. For part (a) of the question, the continuing value has no growth:

2005 2006 2007 2008 2009 Cash flow from operations 2,014 2,057 2,095 2,107 Cash investment in operations 300 380 442 470 Free cash flow (FCF) 1,714 1,677 1,653 1,637 Discount rate 1.09 1.1881 1.2950 1.4116 Present value of FCF 1,572 1,411 1,276 1,160 Total of PV to 2009 5,419 Continuing value (CV) 18,189 PV of CV 12,885 Enterprise value 18,304 Net debt 6,192 Equity value 12,112 Value per share on 369 million shares = $32.82

CV (no growth) = 189,1809.0

637,1=

PV of CV = 885,124116.1

189,18=

b. With growth of 3% after 2009, the continuing value is:

102,28$03.109.1

03.1637,1=

−

×=CV

The present value of the continuing value is $28,102/1.4116 = $19,908.

Do the valuation is as follows:

Total of PV to 2009 5,419 Continuing value (CV) 28,102 PV of CV 19,908 Enterprise value 25,327 Net debt 6,192 Equity value 19,135 Value per share on 369 million shares = $51.86. E4.10. Free Cash Flow for General Motors

Appropriate free cash flow calculation: 2005 2004 Cash flow from operations reported $3,676 $12,108 Net interest $4,059 $3,010 Tax at 36% 1,461 2,589 1,084 1,926 $6,274 $14,034 Cash investment reported $(179) (24,209) Net investment in debt securities (1,618) (1,797) ( 592) (24,801) Free cash flow $4,477 $(10,767) Mistakes by analyst:

1. Includes net sales of marketable (debt) securities as cash investment in operations rather than sales of these securities to satisfy a cash shortfall. In both years, there is more sales (liquidations) of these securities than purchases, reducing reported cash investment.

2. Treats the liquidation of investments in companies (of $1,367 million in 2005) as good news because it

increases free cash flow. Selling off investments increases current cash flow but reduces future free cash flows.

3. Treats increased sales of finance receivables (of $27,802 million in 2005) as increasing free cash flow

(and thus as good news). Sales of finance receivables merely speed the receipt of cash. Booking the receivables from customers is what adds value.

4. Treats the decrease in bookings of finance receivables (from a $31,731 million increase in 2004 to a

$15,843 million increase in 2005) as good news.

E4.11. Cash Flows for Wal-Mart Stores

a. Wal-Mart is an expanding company with opportunities to invest in new stores throughout the world. While

it generates considerable cash flow from operations, cash investments routinely exceed cash from

operations. So free cash flow is negative. This is a firm like General Electric in Exhibit 4.2. DCF analysis

will not work for this firm.

b. The difference between earnings and cash from operations is due net interest (after-tax) and accruals.

The difference between earnings and free cash flows is due to net interest (after

tax), accruals and investments in operations.

c. DCF will not work. Negative free cash flows yield negative values.

E4.12. Accruals and Investments for PepsiCo

The question in this exercise tests accounting relation 4.12:

Accruals = -$ 842 million

The second question modifies the investing section of the cash flow statement according to equation 4.11:

Cash investments reported $2,330 million Purchases of investments $1,007 Sales of investments 38 969 Cash investment in operations $1,361 million

E4.13. Accrual Accounting Relations

(a) Cash = $373 million

(b) Change in payable = $45 million

(c) PPE = $181 million

E4.14. An Examination of Revenues: Microsoft

Cash revenue = $35.430 billion

CHAPTER FIVE

Accrual Accounting and Valuation: Pricing Book Values

Exercises

Drill Exercises

E5.1. Calculating Return on Common Equity and Residual Earnings Set up the pro forma as follows: 2009 2010 2011 2012 Eps 3.00 3.60 4.10 Dps 0.25 0.25 0.30 Bps 20.00 22.75 26.10 29.90 ROCE 15.00% 15.83% 15.71% RE (10% charge) 1.00 1.325 1.49

a. The answer to the question is in the last two lines of the pro forma b. As forecasted residual earnings are positive, the shares of this firm are worth a premium over book value.

E5.2. ROCE and Valuation As expected ROCE is equal to the required return, expected residual earnings are zero. So the shares are worth their book value per share. Book value per share = $3,200/500 = $6.40.

E5.3. A Residual Earnings Valuation This question asks you to convert a pro forma to a valuation using residual earnings methods. First complete the pro

forma by forecasting book values from earnings and dividends. Then calculate residual earnings from the completed

pro forma and value the firm.

2010E 2011E 2012E 2013E 2014E Earnings 388.0 570.0 599.0 629.0 660.4 Dividends 115.0 160.0 349.0 367.0 385.4 Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0 ROCE 9.0% 12.4% 12.0% 12.0% 12.0% Residual earnings -43.0 111.7 99.7 104.7 109.9 (10%) Growth in RE -10.7% 5.0% 5.0% Growth in Book value 8.9% 5.0% 5.0% 5.0% Discount factor 1.110 1.210 1.331 1.464 1.611 PV of RE -39.1 92.3 74.9

a. Forecasted book values, ROCE, and residual earnings are given in the completed pro forma above. Book

value each year is the prior book value plus earnings and minus dividends for the year. So, for 2011 for

example,

Book value = 4583 +570 –160 = 4,993.

The starting book value (in 2009) is 4,310. Residual earnings for each year is earnings charged with the

required return in book value. So, for 2011,

RE is 570 – (0.10 × 4,583) = 111.7.

b. Forecasted growth rates in book value and residual earnings are given above.

c. The growth rate in residual earnings is 5% after 2012. Assuming this growth rate will continue into the

future, the valuation is a Case 3 valuation with the continuing value calculated at the end of 2012:

Book value, 2006 4,310.0 Total present value of RE to 2012 (from last line above) 128.1

Continuing value (CV), 2012: 0.209405.110.1

7.104=

−

Present value of CV: 2094/1.331 1,573.3

Value of the equity, 2009 6,011.4

Per share value (on 1,380 million shares) 4.36

d. The premium is 6,011.4 – 4,310 = 1,701.4, or 1.23 on a per-share basis.

The P/B ratio is 6,011.4/4,310 = 1.39.

E5.4. Residual Earnings Valuation and Target Prices (Easy) This problem applies the residual earnings model and its dividend discount equivalent. Develop the pro forma as follows:

2009 2010 2011 2012 2013 2014 Eps 3.90 3.70 3.31 3.59 3.90 Dps 1.00 1.00 1.00 1.00 1.00 Bps 22.00 24.90 27.60 29.91 32.50 35.40

(a) RE (0.12) 1.26 .71 0 0 0

Discount rate 1.12 1.2544

PV 1.125 .57

Total PV 1.70

(b) Value 23.70

(c) As residual earnings are expected to be zero after 2014, the equity is expected to be worth its book

value of $35.40.

(d) The expected premium at 2014 is zero because subsequent residual income is expected to be zero.

As aside:

Note that the dividend discount formula can be applied because we now have a basis for calculating its terminal

value. The terminal value is the expected terminal price, and this can be calculated at the end of 2011 because, at

this point, expected price equals book value.

∑=

− ρ+ρ=T

1t

TTt

tE

0 /TVdV

The TV2011 is given by the expected 2011 book value:

TV2011 = 27.60

So the calculation goes as follows:

2009 2010 2011

Dps 1.00 1.00

PV .89 .80 Total PV of divs. 1.69 TV 27.60 PV of TV 22.00 Value 23.69

E5.5. Residual Earnings Valuation and Return on Common Equity (a) Set the current year as Year 0.

Earnings, Year 1 = 15.60 × 0.15 = 2.34

Residual earnings, Year 1 = 2.34 – (0.10 × 15.60)

= 0.78

This RE is a perpetuity, so

10.0

REBV 0

00 +=

40.2310.0

78.060.15 =+=

1.515.6023.40BP ==

(b) No effect: future payout does not affect current price (unless you have a tax story) and future

dividends don’t affect current book value.

P/B is still 1.5

E5.6. Using Accounting-Based Techniques to Measure Value Added for a Project (a)

Time line: 0 1 2 3 4 5Depreciation 30 30 30 30 30Book value 150 120 90 60 30 0Earnings (15%) 22.5 18 13.5 9 4.5RE (0.12) 4.5 3.6 2.7 1.8 0.9PV of RE 4.02 2.87 1.92 1.14 0.51Total PV of RE 10.47Value of Project 160.47 The investment added $10.47 million over the cost. (b)

Time line 0 1 2 3 4 5

Earnings 22.5 18.0 13.5 9.0 4.5Depreciation 30.0 30.0 30.0 30.0 30.0Cash from operations 52.5 48.0 43.5 39.0 34.5

PV of cash flow (1.12t) 46.88 38.27 30.96 24.79 19.58

Total PV of cash flow 160.47Cost 150.00NPV 10.47

t

The NPV is the value added.

E5.7. Using Accounting-Based Techniques to Measure Value Added for a Going Concern (a)

Time line: 0 1 2 3 4 5 6 7

Investment 150 150 150 150 150 150 150 150

Depreciation1 30 60 90 120 150 150 150

Book value2 270 360 420 450 450 450 450

Revenue 52.5 100.5 144.0 183.0 217.5 217.5 217.5Depreciation 30.0 60.0 90.0 120.0 150.0 150.0 150.0Earnings (15%) 22.5 40.5 54.0 63.0 67.5 67.5 67.5

RE (0.12) 4.5 8.1 10.8 12.6 13.5 13.5 13.5

PV of RE 4.0 6.5 7.7 8.0

Total of PV of RE 26.2

112.5

PV of CV 71.5

Value 247.7Lost 150Value added 97.7

Continuing value3

1. Depreciation is $30 million per year for each project in place

2. Book value (t) = Book value (t-1) + Investment (t) – Depreciation (t)

3. CV = 12.0

5.13 = 112.5

The value of the firm is $247.7 million. The continuing value is based on a forecast of residual earning of 13.5 in

year 5 continuing perpetually with no growth. This is a Case 2 valuation.

(b) The value added is $97.7 million (c) The value added is greater than 15% of the initial investment because there is growth in investment: value is

driven by the rate of return of 15% (relative to a cost of capital of 12%) but also by growth.

E5.8. Creating Earnings and Valuing Created Earnings

a. Earnings = Revenues – Expenses = $440 - $360 = $80 Earnings in the text example were $40. Clearly earnings have been created, by expensing $40 of the investment in the prior period and thus reducing Year 1expenses by $40.

b. ROCE = $80/$360 = 22.22%

Residual earnings = $80 – (0.10 × 360) = 44

c. Value = 10.1

44$360$ + = $400

Even though earnings have been created, the calculated value is the same as that in the text (before earnings were created).

E5.9. Reverse Engineering With a P/B ratio of 2.0 and a price of $26, the book value per share is $13. Thus, Residual earnings (2010) = $2.60 – (0.10 × 13.0) = $1.30 Reverse engineering solves for g in the following model:

$26 = g−

+10.1

30.113$

The solution is g = 1.0. That is, the growth rate is zero: The market expects residual earnings to continue at $1.30 per share after 2010.

Applications

E5.10. Residual Earnings Valuation: Black Hills Corp The pro forma for the exercise is as follows: Forecast Year ____________________________________ 1999 2000 2001 2002 2003 2004 Eps 2.39 3.45 2.28 2.00 1.71 Dps 1.06 1.12 1.16 1.22 1.24

Bps 9.96 11.29 13.62 14.74 15.52 15.99 ROCE 24.0% 30.6% 16.7% 13.6% 11.0% RE (11% charge) 1.294 2.208 0.782 0.379 0.003 Discount rate (1.11)t 1.110 1.232 1.368 1.518 1.685 Present value of RE 1.166 1.792 0.572 0.250 0.002 Total present value of RE to 2004 3.78 Continuing value (CV) 0.0 Present value of CV 0.00 Value per share 13.74

a. ROCE and residual earnings are in the pro forma b. If ROCE is to continue at 11% after 2004, then residual earnings are expected to be zero. The continuing

value is zero. The value is $13.74 per share – a Case 1 valuation. c. As the CV = 0, the target price is equal to forecasted bps of $15.99 at 2004.

E5.11. Valuing Dell, Inc. a. The pro forma for 2009 and 2010 and the value it implies is as follows: 2008 2009 2010 EPS 1.47 1.77 DPS 0.00 0.00 BPS 1.813 3.283 5.053 RE (10%) 1.289 1.442 Discount rate 1.10 1.21 PV of RE 1.172 1.192 Total PV to 2010 2.364

Continuing value 04.110.1

04.1442.1

−

× 24.99

PV of continuing value 20.66 Value per share 24.84 Note: BPS at eh end of fiscal-year 2008 = $3,735/2,060 shares = $1.813.

b. The growth rate is calculated by reverse engineering:

)10.1(21.1

442.1

21.1

442.1

10.1

289.1813.150.20$2008

g

gP

−

×+++==

The solution for g = 1.025 (or a 2.5% growth rate) E5.12 Sellers Wants to But

a. The Pro Forma: 2006 2007 2008 Eps 2.98 3.26 Dps 0.60 0.70 Bps 12.67 15.05 17.61

Residual earnings (10%) 1.713 1.755 The current book value per share = Book value/Shares outstanding = $26,909/2,124 = $12.67 Reverse engineer Seller’s price:

rate)growth % 5.55 (a 1.0555 g

g) - (1.10 x 1.10

1.755

1.10

1.713 12.67 $50

=

++=

A. Getting to eps growth rates for 2009 and 2010:

2009 2010 RE growing at 5.55% 1.852 1.955 (1) Prior Bps 17.61 Prior Bps x 0.10 1.761 (2) Eps (1) + (2) 3.613 Eps growth rate Dps (at 2008 payout ratio) 0.776 Bps 20.447 Prior Bps x 0.10 2.045 (3) Eps (1) + (3) 4.00 Eps growth rate E5.13. Building Blocks for a Valuation: General Electric Co.

= $23.62 b. The first building block is the book value = $10.47 Market price 36.00 The three components are diagramed as follows:

10.83%%

10.71%%

Book Value from Value from Value Short-term Growth Forecasts c. Reverse engineer the model:

00.36$=

The solution is g = 1.0698, or approximately a 7% growth rate. d. For 2007: Earnings2007 = (12.30 × 0.10) + 0.886 = $2.116 per share EPS growth rate for 2007 = 2.116/1.96, which is a 7.96% growth rate For 2008: Earnings2008 = (13.358 × 0.10) + 0.948 = $2.284 per share Earnings growth rate for 2008 = 2.284/2.2116, which is a 7.94% growth rate E5.14. Reverse Engineering Growth Forecasts for the S&P 500 Index (a) With a P/B ratio is 2.5, investors are paying $2.50 for every dollar of book value in the S&P 500 companies. With

an ROCE of 18%, the current residual earnings on a dollar of book value is:

RE0 = (0.18 – 0.10) × 1.0

= 0.08

That is, 8 cents per dollar of book value. The value of an asset (with a constant growth rate is mind) is calculated as:

g

gREBV

−

×+=

ρ0

00

(One always capitalizes the one-year-ahead amount, which is the current residual earnings, RE0, growing one year at

10%.) So, for every dollar of book value worth $2.50,

g

g

−

×+=

10.1

08.00.150.2

Solving for g,

g = 1.044 (a 4.4% growth rate)

A good benchmark growth rate for the market as a whole is the GDP growth rate. This has historically been an

average of about 4.0%. So, if history is an indication of the future, a 4.4 % implied growth rate suggests that the

S&P 500 stocks, as a portfolio, are a little overpriced.

What does a growth rate of 4.4% for residual earnings mean? If the S&P 500 firms can maintain an ROCE of 18%, then investment in net assets must grow by 4.4%. Alternatively, if ROCE were to improve, a growth in residual earnings of 4.4% can be maintained with a lower growth rate. Is a 4.4% growth rate for residual earnings reasonable? What is the prospect for ROCE for the market as a whole? Is the market appropriately priced?

(Analysis in Part II of the book will help answer these questions.)

(b)

See the last paragraph. With a constant ROCE, the growth in residual earnings is determined by the growth in net

assets (book value). Remember, residual earnings is driven by two factors:

1. Profitability of net assets: ROCE

2. Growth in net assets

E5.15. The Expected Return for the S&P 500 a. Book value on January 1, 2008 = 564.62

Forward ROCE for 2008 = 12.85%

a. The reverse engineering problem: 468,1=

The following formula solves for the expected return (see equation 5.7 in Ch. 5):

= 7.403%

b. Required return = 4% + 5% = 9%

Do not buy, for the expected return is less than the required return.

c. Although the level of the index is not given, one can still work the problem based on the

price-to-book of 5.4. For every $1 of book, the price is 5.4, so the reverse engineering

problem can be set up as:

? = 7.515%

The following “weighted average” formula solves for the expected return (see equation 5.7a in Ch. 5): returnExpected = 7.5%

If the required return is 9%, this expected return indicates that the S&P 500 stocks are

overvalued. All the more so when one appreciates that a 23% ROCE used as an input is quite

a bit above the historical ROCE of 18%. A 23% ROCE means a high residual earnings base

to apply a 4% growth rate to.

E5.16. Valuing Dividends or Return on Equity: General Motors Corp.

a. P/B = 0.57; ROCE = 1.41% b. Yes; the required return is not stated, but any reasonable return is far greater than 1.41 percent. As GM is

expected to earn an ROCE far below its required return, it should have a P/B well below 1.0.

c. The analyst makes a mistake in focusing on the dividend (yield). An unprofitable firm will drop its

dividend – as GM has done in the past in bad times – and GM does not look profitable. The dividend they

have been paying is not a good indicator of value. A firm can pay a high dividend in the short run, but if

fundamentals give a different message, follow the fundamentals. The dividend yield (dividend/price) is

high because price is low, because of poor prospects.

E5.17. Residual Earnings Valuation and Accounting Methods

a. Inventory in the balance sheet is carried at historical cost but is written down to market value if market

value is less than cost. The carrying amount of inventory on the balance sheet becomes cost of good sold

when the inventory is sold. So, a write-down of $114 million in 2009 means cost of goods sold in 2010 will

be $114 million lower, and (assuming no change in the forecasts of sales) earnings will be $114 million

higher, that is, $502 million. The book value at the end of 2009 is $114 million lower, or $4,196 million.

So,

ROCE = 11.96 This is an increase over the 9% (388/4,310) before the impairment.

b. Refer to the answer to Exercise 5.3. With earnings of $502 million forecasted for 2010, residual earnings is

now 502 – (0.10 × 4,196) = $82.4 million. The present value of this RE is $82.4/1.10 = $74.9 million. As

the present value of RE for 2010 prior to the impairment was $-39.1 million, the change in the PV of RE in

the valuation is $114 million. As this is the change in the 2009 book, value the valuation remains

unchanged.

The full pro forma under the changed accounting is below: 2010E 2011E 2012E 2013E 2014E Earnings 502.0 570.0 599.0 629.0 660.4 Dividends 115.0 160.0 349.0 367.0 385.4 Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0 ROCE 11.96% 12.4% 12.0% 12.0% 12.0% Residual earnings 82.4 111.7 99.7 104.7 109.9 Growth in RE -10.7% 5.0% 5.0% Growth in Book value 8.9% 5.0% 5.0% 5.0% Discount factor 1.110 1.210 1.331 1.464 1.611 PV of RE 74.9 92.3 74.9 Note that the pro forma is unchanged after 2010 as 2010 book values are the same as before.

The valuation now runs as follows:

Book value, 2009 4,196.0 Total present value of RE to 2012 (from last line above) 242.1

Continuing value (CV), 2012: 209405.110.1

7.104=

−

Present value of CV: 2094/1.331 1,573.3

Value of the equity, 2009 6,011.4 Per share value (on 1,380 million shares) 4.36 This is the same valuation as before.

c. The taxes will affect 2010 earnings and 2009 book values by the after-tax amount of the impairment: After-tax effect on 2010 earnings = $74.1 After-tax effect on book value in 2009 = $74.1 Accordingly, ROCE, 2010 = 10.91% As both 2010 earnings and 2009 book values are affected by the same amount, the value of the equity is unchanged

(following the same calculation as in b).

E5.17. Impairment of Goodwill (a) As the asset is at fair value (the acquisition price) on the balance sheet, it is expected to earn at the required

return on book value: Residual earnings is projected to be zero. (Fair value in an acquisition always prices

the acquisition to earn at the required rate of return.)

(b) The book value must be marked down to fair market value under FASB Statement No. 142. The book value

at the end of 2009 before the write down, is 301 + 79 = 380 (the depreciated amount of the tangible assets

plus the good will).

Forecasted earnings for 2010 on this book value (at the forecasted ROCE of 9%) is

380 x 0.09 = 34.2

For a 10% required return, the book value that yields residual earnings in 2010 equal

Accordingly, the amount of impairment = 380 – 342 = 38.

CHAPTER SIX

Accrual Accounting and Valuation: Pricing Earnings

Drill Exercises

E6.1 Forecasting Earnings Growth and Abnormal Earnings Growth

The calculations are as follows:

2009 2010 2011 AEG 0.325 0.165 (a) Ex-div growth rate (from line 1) 20.0% 13.89% Cum-div growth rate (from line 2) 20.83% 14.58% - 3.625/3.00 for 2010

- 4.125/3.60 for 2011

(b) AEG is in pro forma above (c) Normal forward P/E = 1/0.10 = 10. (d) As AEG is forecasted to be greater than zero, then one would expect the forward

P/E to be greater than 10. Equivalently, as the cum-dividend earnings growth rate is expected to be greater than the required return of 10%, the P/E should be greater than the normal P/E

E6.2 P/E Ratios for a Savings Account

a. = $257 b. = 26 (This is the normal P/E for a 4% required return.)

= 25 (This is the normal forward P/E for a required return of 4%.)

E6.3. Valuation From Forecasting Abnormal Earnings Growth

This exercise complements Exercise 5.3 in Chapter 5, using the same forecasts. The

question asks you to convert a pro forma to a valuation using abnormal earnings growth

methods. First complete the pro forma by forecasting cum-dividend earnings and normal

earnings. Then calculate abnormal earnings growth and value the firm.

2010E 2011E 2012E 2013 2014 Earnings 388.0 570.0 599.0 629.0 660.45 Dividends 115.0 160.0 349.0 367.0 385.40 Reinvested dividends 11.5 16.0 34.9 36.70 Cum-div earnings 581.5 615.0 663.9 697.15 Normal earnings 426.8 627.0 658.9 691.90 Abnormal earn growth 154.7 -12.0 5.0 5.25 Growth rates: Earnings growth 46.91% 5.09% 5.00% 5.00% Cum-div earn growth (AEG) 49.87% 7.89% 10.83% 10.83% Growth in AEG 5.0% Discount rate 1.100 1.210 PV of AEG 140.64 -9.92 Note that the AEG for 2011 and 2012 are discounted back to the end of 2010.

a. Forecasted abnormal earnings growth (AEG) is given in the pro forma above.

AEG = 581.5 – 426.8 = 154.7.

Cum-dividend earnings = 570.0 + (115 × 10%) = 581.5

Normal earnings is prior year’s earnings growing at the required rate. So, for 2011,

Normal earnings = 388 × 1.10 = 426.8 Abnormal earnings growth can also be calculated as AEG = (cum-div growth rate – required rate) × prior year’s earnings

So, for 2011,

AEG = (0.4987 – 0.10) × 388 = 154.7

b. The growth rates are given in the pro forma.

The growth rate of AEG after 2012 is 5%. Assuming this rate will continue into Value per share on 1,380 million shares 4.36 This is a Case 2 valuation. If you worked exercise E5.3 using residual earnings methods, compare you value calculation with the one here.

c. The forward P/E = 6,013.6/388 =15.5. The normal P/E is 1/0.10 = 10.

E6.4. Abnormal Earnings Growth Valuation and Target Prices

This exercise complements Exercise 5.4 in Chapter 5, using the same forecasts.

Develop the pro forma to forecast abnormal earnings growth (AEG) as follows:

2010 2011 2012 2013 2014

Eps 3.90 3.70 3.31 3.59 3.90

Dps 1.00 1.00 1.00 1.00 1.00 Reinvested dividends (12%) 0.12 0.12 0.12 0.12 Cum-dividend earnings 3.82 3.43 3.71 4.02 Normal earnings (12%) 4.368 4.144 3.707 4.021 Abnormal earnings growth -0.548 -0.714 0.003 -0.001

(a) See bottom line of pro forma for answer. (b) As AEG is forecasted to be zero after 2012, the valuation is based on forecasted

AEG up to 2012:

= $23.68

Note that this is the same value as obtained using residual earnings methods in

Exercise 5.4.

(c) The expected trailing P/E for 2014 must be normal if abnormal earnings growth is

Expected to continue to be zero after 2014. The normal trailing P/E for a required

return of 12% is 1.12/0.12 = 9.33.

With a normal trailing P/E of 9.33,

= $36.387

As the dividend is expected to be $1.00, the 2014 value (ex-dividend) is $35.387.

E6.5. Dividend Displacement and Value

(a) Firm B will have higher earnings in 2011 because it will pay no dividend

in 2010. Firm A’s 2011 earnings will be displaced by its 2010 dividend.

= 18.90

(Assumes retained earnings are invested at the cost of capital.)

(b) Anticipated future dividends don’t affect current price (unless payment

reduces investment in value-generating projects). Firm A’s shareholders

expect to earn the earnings of Firm B’s shareholders by reinvesting the

dividend at the cost of capital. So, cum-dividend earnings are the same for

both firms.

E6.6. Normal P/E Ratios

The normal trailing P/E ratio is returnequity required

returnequity required1+

The normal forward P/E is the trailing P/E – 1.0

The schedule for the trailing P/E is as follows. Subtract 1.0 to get the forward P/E.

8% 13.50

9% 12.11

10% 11.00

11% 10.09

12% 9.33

13% 8.69

14% 8.14

15% 7.67

16% 7.25

Applications

E6.7. Calculating Cum-dividend Earnings Growth Rates: Nike

The pro forma is as follows:

2009 2010

Eps 3.90 4.45

Dps 0.92 Reinvestment of 2009 dividend at 10% 0.092 Cum-dividend eps 4.542 Cum-dividend eps growth rate (4.542/3.90 –1) 16.46% Ex-dividend eps growth rate (4.45/3.90 - 1) 14.10% E6.8. Calculating Cum-dividend Earnings: General Mills

Year

Eps

Dps

Earnings on prior

year’s reinvested

dividends

Cum-

dividend eps

2004 2.82 1.10 2005 3.34 1.24 0.11 3.45 2006 3.05 1.34 0.124 3.174 2007 3.30 1.44 0.134 3.434 2008 3.86 1.57 0.144 4.004

E6.9. Residual Earnings and Abnormal Earnings Growth: IBM

The pro forma for the forecast is as follows:

2002 2003 2004 2005 2006 2007

Eps 4.32 5.03 5.58 6.20 6.88

Dps 0.60 0.67 0.74 0.83 0.92

Bps 13.85 17.57 21.93 26.77 32.14 38.10

Reinvested dividends at 12% 0.072 0.080 0.089 0.100

Cum-dividend earnings 5.102 5.660 6.289 6.980

Normal earnings 4.838 5.634 6.250 6.944

Abnormal earnings growth 0.264 0.026 0.039 0.036

Residual earnings 2.658 2.922 2.948 2.987 3.023

Change in residual earnings 0.264 0.026 0.039 0.036

The answers to parts a, b and c of the question are in the last three lines of the pro forma.

E6.10. A Normal P/E for General Electric?

a. Forward P/E = $26.75/ $2.21 = 12.10

b. Earnings forecast for 2009 $2.30

2008 dividend reinvested: $1.24 x .09 0.1116 Cum-dividend earnings for 2009 $2.4116

AEG (2009) = 2.4116 – (1.09 × 2.21)

= 0.0027 or 0.27 cents per share

This is close to zero, indicating that the forward P/E should be normal. Put another way, the cum-dividend earnings growth for 2009 = 2.4116/2.21 – 1 = 9.1% which is close to the required return; thus the P/E should be normal.

E6.11. Plotting Earnings Implied Growth Rates for the S&P 500 The S&P example is the text reverse engineered to the growth rate from forecasts of earnings for two years ahead. The pro forma with these forecasts (given in the chapter) is:

2004 2005

Earnings $53.00 $58.20 Dividends (31% payout) 16.43 Reinvested dividends at 9% 1.479 Cum-dividend earnings $59.679 Normal earnings ($53 ×1.09) 57.770 AEG $ 1.909

With the forecast of forward earnings and AEG for 2005, we are ready to reverse engineer for a market price of 1000: The solution for g is 1.039, that is, a 3.9 percent growth rate. Using implied AEG growth rate, g = 1.039, we can calculate implied earnings growth rates for years from 2006 to 2011 as following. This reverse engineers the AEG formula: Earnings forecast = Normal earnings forecast + AEG Forecast

- Forecast of earnings from prior year’s dividends That is, Earningst = (ρ × Earningst-1) + AEGt – (ρ-1)dividendst-1

So, moving ahead to 2006, Earnings forecast for 2006 $63.797 The calculations for 2006 – 2010 are:

Year 2006 2007 2008 2009 2010

Earnings 63.797 69.820 76.296 83.259 90.740

Dividends (payout= 31%) 19.777 21.644 23.652 25.810 28.129

Dividends reinvested (at 9%) 1.624 1.780 1.948 2.129 2.323

Cum-dividend earnings 65.421 71.600 78.244 85.387 93.063

Normal earnings 63.438 69.539 76.103 83.163 90.752

Abnormal Earnings Growth (AEG)

1.983 2.060 2.141 2.224 2.311

Implied earnings growth rate 9.62% 9.44% 9.28% 9.13% 8.99%

Implied cum dividend growth rate 12.41% 12.23% 12.07% 11.92% 11.78%

Next we can plot the sequence of the implied earnings growth rates as in Figure 6.2.

9.62%

9.44%

9.28%

9.13%

8.99%

8.00%

8.50%

9.00%

9.50%

10.00%

10.50%

11.00%

2006 2007 2008 2009 2010

EP

S g

row

th r

ate

E6.12. Challenging the Level of the S&P 500 with Analysts’ Forecasts

The required return = 10% To develop the pro forma for the implied growth rate, first apply the forward P/E ratio to get an earnings forecast for 2006, then convert the PEG ratio to an earnings forecast for 2007: Forward P/E = Price/Earnings2006

Treat the 1271 as dollars to get earnings in dollars: $1,271/Earnings2006 = 15 Thus Earnings2006 = $84.73

PEG = 2007

/

forRateGrowth

EPForward= 1.47

BUY

SELL

Thus, for a forward P/E of 15, the 2007 growth rate for 2007 earnings is 10.2%. Thus, 2007 earnings forecasted is $84.73 × 1.102 = $93.37 a. The pro forma to calculate abnormal earnings growth (AEG) is as follows:

2003 2004

Earnings 84.73 93.37 Dividends (payout = 27%) 22.88 Reinvested dividends (at 10%) 2.288 Cum-dividend earnings 95.658 Normal earnings ($84.73 x 1.10) 93.203 AEG 2.455 b. If cum-dividend earnings are expected to grow at the required rate of return, 10%, after 2006, the P/E should be normal:

= 847.3 The normal P/E is appropriate if (cum-dividend) earnings are expected to grow at a rate equal to the required return, 10%. The P/E based on analysts forecast (15) is higher than this because the market sees earnings growing at a higher rate. Is this assessment reasonable? c. Applying the abnormal earnings growth (AEG) pricing model with the long-term growth rate for AEG of 4%:

= 1256 d. The S&P 500 index is appropriately priced (approximately) at 1271. This will not always be the case. The estimated level can different from the actual level for a number of reasons:

1. Analysts’ forecasts are too optimistic relative to how the rest of the market sees it. 2. The market agrees with analysts’ forecasts for 2006 and 2007, but sees the long-

term growth rate at less than 4%. 3. The market requires a higher or lower required return than 10% 4. The market is mispriced.

With respect to point 1, sell-side analysts’ forecasts are often overly optimistic, particularly two-year ahead forecasts on which the AEG is calculated. This exercise is dangerous when both the market and analysts are too optimistic (as in the bubble). Then you have to challenge the price with your own forecasts. Notice that the next exercise works with actual earnings numbers, not analysts’ forecasts.

E6.13. Valuation of Microsoft Corporation

a. The Pro Forma 2007 2008 Eps forecasted 1.44 1.67 Dps 0.40 Dps reinvested at 9% 0.036 Cum-dividend earnings 1.706 Normal earnings: 1.44 x 1.09 1.5696 AEG 0.1364 [Analysts’ consensus forecasts are from Yahoo Finance on 10/09/06] Valuation with a margin of safety (that avoids speculation about growth):

$33.58 = [Allow for rounding error] Implication: The market sees AEG declining in the future (because the market price of $27.20 is less than the no-growth value). The question that the fundamental investor has to answer: Is it the case that Microsoft can no longer grow AEG? Are the growth days over? b. Normal P/E for a 9% required return = 1/0.09 = 11.111

c. 15.97% 1 - 1.44

1.67 2008for rategrowth eps Analysts' ==

1.18 15.97

18.89 PEG ==

While the standard PEG ratio is based on eps growth rates, it is better calculated with a cum-dividend growth rate:

02.147.18

89.18==PEG

E6.14. Inferring Implied EPS Growth Rates: Kimberly-Clark Corporation Price, March 2005 $64.81 a.

18.24 3.64

1.60 64.81 P/E Trailing =

+=

17.01 3.81

64.81 P/E Forward ==

12.24 0.089

1.089 P/E trailingNormal ==

11.24 0.089

1 P/E forward Normal ==

b. Calculate AEG for 2006: 2004 2005 2006 Eps 3.64 3.81 4.14

Dps 1.60 1.80 1.96

Dividends reinvested at 8.9% 0.1602

Cum-dividend earnings 4.3002

Normal eps (3.81 x 1.089) 4.1491

Abnormal earnings growth (AEG)

0.1511

1 0.1511 64.81 = 3.81 +

0.089 1.089 - gP

=

( )rategrowth 1.2% 1.012 =g

c. 2005 2006 2007 2008 2009 2010

Eps 3.81 4.14 Dps 1.80 1.96 2.14 2.33 2.54 2.77 AEG 0.1511 0.1529 0.1547 0.1566 0.1585 (growing at 1.2%) Reinvested dividends (0.1744) (0.1905) (0.2074) (0.2261)

(at 8.9%)

Normal earnings 4.5085 4.8863 5.2822 5.6970

Eps 4.4870 4.8505 5.2314 5.6294

Eps growth rate 8.66% 8.38% 8.10% 7.85% 7.61% Note: Normal earnings are the earnings in the prior year growing at 8.9%. So, for 2008, normal earnings = $4.487 x 1.089 = 4.8863. d. The market was pricing approximately the same growth rates as forecasted by analysts. Put another way, the market was pricing KMB based on consensus analysts’ forecasts. e. Yes, as analysts were forecasting the same growth rates as those implied in the market price, they are saying that the market price is reasonable. The 2.6 rating – a HOLD – has integrity.

(If you are following the Continuing Case in the text, some of this material will be familiar to you.)

E6.15. Using Earnings Growth Forecasts to Challenge a Stock Price: Toro Company

a. With a required return of 10%, the value from capitalizing forward earnings is

Value2002 = $5.30/0.10 = $53

With a view to part d of the question, forward earnings explain most of the current

market price of $55. If one can forecast growth after the forward year, one would be

willing to pay more that $53.

b. First forecast the ex-dividend earnings based of analysts’ growth rate of 12%. Then

add the earnings from reinvesting dividends at 10%.

2003 2004 2005 2006 2007 2008

Eps growing at 12% 5.30 5.936 6.648 7.446 8.340 9.340

Dividends 0.53 0.594 0.665 0.745 0.834 0.934

Dividends reinvested at 10% 0.053 0.059 0.067 0.075 0.083


c. Abnormal earnings growth (AEG) is cum-dividend earnings minus normal growth

earnings. Normal earnings is earnings growing at the required return of 10%:


Normal earnings 5.830 6.530 7.313 8.191 9.174

Abnormal earnings growth (AEG) 0.159 0.177 0.200 0.224 0.249

d. With abnormal earnings growth forecasted after the forward year, the stock should be

worth more than capitalized forward earnings of $53, the approximate market price. (One

would have to examine the integrity of the analysts’ forecasts, however.)

The growth rate forecast for AEG for 2005-2008 is 12% (allow for rounding error

in calculating this growth rate from the AEG numbers above). This cannot be sustained if

the required return is 10%, but there is plenty of short-term growth to justify a price

above $55. (Of course, one can call the analysts’ forecasts into question.)

E6.16. Abnormal Earnings Growth and Accounting Methods

The revised pro forma is as follows:

2010E 2011E 2012E 2013E 2014E Earnings 502.0 570.0 599.0 629.0 660.45 Dividends 115.0 160.0 349.0 367.0 385.40 Reinvested dividends 11.5 16.0 34.9 36.70 Cum-div earnings 581.5 615.0 663.9 697.15 Normal earnings 552.2 627.0 658.9 691.90 Abnormal earn growth 29.3 -12.0 5.0 5.25 Growth rates: Earnings growth 13.55% 5.09% 5.00% 5.0% Cum-div earn growth (AEG) 15.84% 7.89% 10.83% 10.83% Growth in AEG 5.0% Discount rate 1.100 1.210 PV of AEG 26.64 -9.92

(a) Forecasted earnings for 2010 increase by $114 million, to $502 million, because

of the lower cost of good sold. (This assumes that the write-down has no effect on

forecasted revenues on which forecasts for other years are based: it is often the

case the an inventory write-down means that the firm will have more trouble

selling its inventory.)

(b) The valuation based on the revised pro forma is:

Forward earnings, 2010 502.00 Total present value of AEG for 2011-2012 16.72 (26.64 – 9.92 = 16.72)

Continuing value (CV), 2012 05.110.1

5

−= = 100.00

Present value of CV =210.1

0.100 82.64

601.36

Capitalization rate 0.10

Value of the equity10.0

36.601= 6,013.6

Value per share on 1,380 million shares 4.36

The valuation is the same at that in Exercise 6.3.

(c) As the additional earnings of $114 million in 2010 will incur a tax of $39.9

million, they will be lower by that amount, that is $462.1 million. However, the

lower earnings provide a lower base for calculating AEG for 2011, so AEG in

2011 is higher than that in the pro forma in (a). The net effect is to leave the

valuation unchanged. (This assumes forecasts for other years are already after

tax.)

E6.17. Is a Normal Forward P/E Ratio Appropriate? Maytag Corporation

a. Actual traded forward P/E = $28.80/$2.94 = 9.80.

The firm was trading below a normal P/E, so the market was forecasting negative abnormal earnings

growth after 2003.

b. A five-year pro forma with a 3.1% eps growth rate after 2004 and forecasted dps that maintains

the payout ratio in 2003:

2003 2004 2005 2006 2007

Eps 2.94 3.03 3.12 3.22 3.32

Dps 0.72 0.74 0.76 0.79 0.81

Dps reinvested at 10% 0.072 0.074 0.076 0.079

Cum-dividend earnings 3.102 3.194 3.296 3.399

Normal earnings at 10% 3.234 3.333 3.432 3.542

Abnormal earnings growth -0.132 -0.139 -0.136 -0.143

An AEG valuation based on just these five years of forecasts is:

= $25.07

So, even if abnormal earnings growth were expected to recover to zero after 2007, the current

price of $28.80 is too high.

CHAPTER SEVEN

Viewing the Business Through the Financial Statements

Exercises

Drill Exercises

E7.1. Applying the Cash Conservation Equation (Easy)

a. Apply the cash conservation: ? = $94 million

b. Net dividend (d) = $162 + 53 = $215

Debt financing flows (F) = -$86 Now apply the cash conservation equation: = $129 million

E7.2. Applying the Treasurer’s Rule

a. The treasurer’s rule: C – I – i – d = Cash applied to debt trading $2,348 – 23 – (14 + 54) = $2,365 million After paying interest and receiving $40 million (14 – 54) from the negative net dividend, there was $2,365 of cash left over from the free cash flow. The treasurer used it to buy debt, either by buying back the firm’s own debt or investing in debt assets.

b. From the treasurer’s rule, C – I – i = d + cash from trading in debt -$1,857 – 32 = d + cash from trading in debt = ($1,050 + stock repurchases – share issues) + cash from trading in debt (The dividend is $1.25 per share × 840 million shares = $1,050 million) The cash shortfall after paying the dividend is $1,857 + 32 + 1,050 = $2,939 million. The treasurer meets this shortfall by selling debt – either issuing the firm’s own debt or selling debt assets (financial assets) that the firm holds – or by issuing shares.

E7.3. Balance Sheet and Income Statement Relations Net financial assets = -$1,459 million That is, the firm has net financial obligation (negative NFA) Net operating assets = $2,056 million

Operating income (after tax) = $155 million

E7.4. Using Accounting Relations

The reformulated balance sheet:

Net Operating Assets Net Financial Obligations and Equity 2009 2008 2009 2008 Operating assets 205.3 189.9 Financial liabilities 120.4 120.4 Operating liabilities 40.6 34.2 Financial assets 45.7 42.0 NFO 74.7 78.4 CSE 90.0 77.3 NOA 164.7 155.7 164.7 155.7

(a) Dividends = Net income − ∆CSE (Clean-surplus equation) = 1.9 (These are net dividends)

(b) C − I = OI − ∆NOA

= 21.7 − 9.0 = 12.7 (c) RNOAt = OIt /½ (NOAt + NOAt-1) = 21.7/160.2 = 13.55% (d) NBC = Net interest/½ (NFOt + NFOt-1) = 7.1/76.55 = 9.27%

E7.5. Using Accounting Relations

(a)

Income Statement:

Start with the income statement where the answers are more obvious:

A = $9,162

B = 8,312

C = 94

(Comprehensive income = operating revenues – operating expenses – net financial

expenses)

Balance sheet:

D = 4,457

E = 34,262

F = 34,262

G = 7,194

H = 18,544

Before going to the cash flow statement, reformulate the balance sheet into net

operating assets (NOA) and net financial obligations (NFO):

Jun-09 Dec Jun-09 Dec

Operating assets 28,631 30,024 Financial obligations 7,424 6,971

Operating liabilities 7,194 8,747 Financial assets 4,457 4,238

Net financial obligations 2,967 2,733

Common equity 18,470 18,544

Net operating assets 21,437 21,277 21,437 21,277

Cash Flow Statement:

Free cash flow: J = 690 [C - I = OI - ∆NOA]

Cash investment: I = (106) [I = C - (C - I)] (a liquidation) Total financing flows: M = 690 [C - I = d + F]

Net dividends: K = 865 [Net dividends = Earnings - ∆CSE]

Payments on net debt: L = (175) [F = d + F - d] (more net debt issued) (b)

Operating accruals can be calculated in two ways:

1. Operating accruals = 266

2. Operating accruals = 266

(c) ∆NFO = 234

(d) The net dividend of $865 was generated as follows:

Operating income 850

less ∆NOA 160 Free cash flow 690 less net financial expenses 59 631 plus increase in net debt 234 865 E7.6. Inferences Using Accounting Relations (a)

This firm has no financial assets or financial obligations so CSE = NOA and total

earnings = OI. Also the dividend equals free cash flow (C - I = d).

2009 2008

Price 224 238 CSE (apply P/B ratio to price) 140 119 Free cash flow 8.4 Dividend (d = C - I) 8.4 Price + dividend 246.4 Return (246.4 – 224) 22.4 Rate of return 10%

(b)

There are three ways of getting the earnings:

1. Earnings = (12.6) (a loss)

2. OI = (12.6)

(Earnings = OI as there are no financial items)

3. Earnings = (12.6)

Applications

E7.7. Applying the Treasurer’s Rule: Microsoft Corporation

a. The treasurer would run through the following calculation to find the cash surplus or deficit: Cash flow from operations $ 23.4 billion Cash investment 3.2 Free cash flow 20.2 Interest receipts $702 million Taxes 253 0.449 Cash available to shareholders 20.649 Net payout to shareholders: Stock repurchase 40.0 billion Dividends 4.7 Share issued (2.5) 42.200 Cash surplus (21.551) As the surplus is actually a cash shortfall, the treasurer must sell debt. He or she does so by selling part of the $23.7 billion in financial assets on hand. b. In the treasurer’s plan, $4.2 billion would be added to cash investments:

Cash flow from operations $ 23.4 billion Cash investment (3.2 + 4.2) 7.4 Free cash flow 16.0 Interest receipts $702 million Taxes 253 0.449 Cash available to shareholders 16.449 Net payout to shareholders: Stock repurchase 40.0 billion Dividends 4.7 Share issued (2.5) 42.200 Cash surplus (25.751) Now the treasurer must liquidate more of the $23.7 billion in financial assets on hand. c.

With almost all of its financial assets of $23.7 billion distributed, under these scenarios, Microsoft might need cash for further stock repurchases, dividends, or investments in operations. E7.8. Accounting Relations for Kimberly-Clark Corporation a. Reformulate the balance sheet: 2007 2008 Operating assets $18,057.0 $16,796.2 Operating liabilities 6,011.8 5,927.2 Net operating assets (NOA) 12,045.2 10,869.0 (i) Financial obligations $6,496.4 $4,395.4 Financial assets 382.7 6,113.7 270.8 4,124.6 (ii) Common equity $ 5,931.5 $ 6,744.4 (iii)

b. Free cash flow = Operating income – Change in net operating assets

= $2,740.1 – (12,045.2 – 10,869.0)

= $1,563.9

a. NOA (end) = NOA (beginning) + Operating income – Free cash flow

= $12,045.2

CSE (end) = CSE (beginning) + Comprehensive income – Net payout

Comprehensive income = Operating income – Net financial expense

= $2,593.0

$5,931.5 = 6,744.4 + 2593.0 – Net payout

Thus, net payout = $3,405.9

CHAPTER EIGHT

The Analysis of the Statement of Shareholders’ Equity

Exercises

Drill Exercises

E8.1. Some Basic Calculations

a. = $205 million

b. = -$149 million (There was a net payment into the firm from shareholders.)

Comprehensive Earnings = $62 million

This applies the stocks and flow equation underlying the reformulated equity statement. See equation

2.4 in Chapter 2.

c. The difference of $25 million is other comprehensive income (dirty-surplus

income) reported in the equity statement.

E8.2. Calculating ROCE from the Statement of Shareholders’ Equity

. Comprehensive Earnings = 25.3 This applies the stocks and flow equation underlying the reformulated equity statement. See equation 2.4 in Chapter 2. The net dividend is negative, that is share issues are in excess on cash paid out in dividends and share repurchases. ROCE = 14.47% [Beginning CSE is used in the denominator because the share issue was at the end of the year. If the share

issue was half way through the year, use average CSE in the denominator]

E8.3. A Simple Reformulation of the Equity Statement

Beginning balance (1,206 – 200) $1,006 Net transactions with shareholders: Share issues $45 Dividends (94) (49) Comprehensive income to common: Net income $241 Currency translation loss (11) Unrealized gain on debt securities 24 Preferred dividends (15) 239

Ending balance (1396 – 200) $1,196 Preferred stock has been subtracted from beginning and ending balances (to make it a statement of common shareholders’ equity). E8.4. Using Accounting Relations that Govern the Equity Statement a. Balance, December 31, 2008 = $4,500 - 2,100 = $2,400 million Balance, December 31, 2009 = $5,580 – 2,100 = $3,480 million These numbers supply the missing balances in the statement. Given these balances, the only missing item is net income. This must be $1,083 million.

b. The reformulated statement is as follows: Balance, December 31, 2008 $2,400 Net transactions with shareholders: Issue of common stock $155 Common dividend (132) 23 Comprehensive income: Net income $1,083 Unrealized gain on securities 13 Translation loss (9) Preferred dividends (30) $1,057 Balance, December 31, 2009 $3,480

Comprehensive income is $1,057 million.

E8.5. Calculating the Loss to Shareholders from the Exercise of Stock Options

Market price of shares issued in exercise 305 × $35 $10,675 Exercise price 305 × $20 6,100 Loss on exercise before tax $ 4,575 Tax benefit (at 36%) 1,647 Loss after tax $ 2,928 E8.6. Reformulating an Equity Statement with Employee Stock Options Before the reformulation, calculate the loss on exercise of stock options:

The loss is obtained from the tax benefit, reported in the equity statement. The 34 (rounded) is the amount that draws a tax benefit at a 35% tax rate: Method 1 in the text. The after-tax loss, 22, goes into comprehensive income. The reformulation:

22 tax after on,Compensati

12 (35%) Benefit Tax

34 0.35

12 exercise on Loss ==

Balance, end of 2008 1,430 Net transactions with shareholders: Share issues from options (810 + 34) 844 Stock repurchases (720) Dividends (180) (56) Comprehensive income: Net income 468 Unrealized gain on debt investments 50 Loss on exercise of employee options (22) 496 Balance, end of 2009 1,870

Applications

E8.7. A Simple Reformulation: J.C. Penney Company

This reformulation is pretty straightforward. The main issue is taking out the preferred stock to convert the statement to a statement of common shareholders’ equity: Take out preferred stock from beginning and ending balances and omit preferred stock transactions (other than the preferred dividend) Balance, January 29, 2000 ($7,228 – 446) $6,782 Transactions with shareholders: Common stock issued $ 28 Common dividends (249 – 24) (225) (197) Comprehensive income (to common): Net income (705) Unrealized change in investments 2 Currency translation loss ( 14) Other comprehensive income 16 Preferred dividends (24) (725) Balance, January 27, 2001 ($6,259 – 399) $5,860 E8.8. Reformulation of an Equity Statement and Accounting for the Exercise of Stock Options: Starbucks Corporation

a.

Reformulated Statement of Shareholders’ Equity

(in millions)

Balance, October 1, 2006 $ 2,228.5

Net payout to shareholders:

Stock repurchase 1,012.8

Sale of common stock (46.8)

Issue of shares for employee stock option (225.2) (740.8)

Comprehensive Income:

Net income from income statement 672.6

Unrealized loss on financial assets (20.4)

Currency translation gains 37.7 689.9

Balance, September 30, 2007 $2,177.6

Note: The closing balance excludes $106.4 million for “Stock-based compensation

expense” which is a liability rather than equity. (It is added to operating liabilities in the

reformulated balance sheet).

b.

Tax benefit from exercise of options in equity statement = $95.276 million

Tax rate = 38.4%

Loss from exercise, before tax (Method 1 in the text)

95.276 $248.115

0.384

Tax benefit 95.276

Loss from exercise of options, after tax $152.839

C.

Market price per share 28.57

Weighted average exercise price 20.60

In-the-money amount 7.97

Number of options expected to be exercised 63,681,867

Option overhang (7.97 x 63,681.9 million) $507,544

Tax benefit (at 38.4%) 194,897

Option overhang after tax (a liability) $312,647

This is a floor estimate; it is only the in-the-money value of the options (it excludes

option value).

Note that the appropriate options number is the number that are expected to be

exercised. As options cannot be exercised until they vest (after a service period), the

appropriate number is the number expected to vest (some employees are expected to

leave before vesting). Here the number of options actually exercisable at the end of

2007 is 40,438,082. With a lower exercise price of $14.65, one calculates an option

overhang of $562.898 which could be recognized as the overhang. E8.9. Calculating Comprehensive Income to Shareholders: Intel Corporation

Net income 10,535 Unrealized loss on securities (3,596) Loss on conversion of notes (350-207) (143)

Comprehensive income 6,796

The loss on conversion of subordinated notes is the difference between the market price of the common shares and the exercise price at conversion. This is a loss from issuing shares at less than market price. Intel also incurred a loss from the exercise of stock options by employees. Method 1 determines the loss on exercise of stock options:

Loss on shares issued to employees calculated from the reported tax benefit:

Loss before tax 887 = 2,334 0.38

Tax 887 Loss after tax 1,447 This loss is a real loss to shareholders than might be included in comprehensive income. However, with FASB Statement No. 123R and IFRS No. 2, grant date accounting brings some of the cost (but not all) into income, so adding the loss at exercise could be double counting to some extent. As it is, however, the reported income understates the loss. E8.10. Loss on the Conversion of Preferred Common Stock: Microsoft Corporation In 1999, Microsoft’s shares traded at an average price of $88.

With 14.901 million common shares issued -- 1.1273 shares for every one of the 12.5 million preferred

shares -- common stock worth $1,240 million was issued. As the carrying value of the preferred stock was

$990 million, the loss in conversion was $260 million:

Market value of common shares issued: 14.901 × $88 = $1,240 Carrying value of the preferred stock 980 Loss on conversion $ 260 E8.11. Conversion of Stock Warrants: Warren Buffett and Goldman Sachs

The loss to shareholders is the difference between the market price of the shares and the issue price:

Market price of shares issued on exercise of warrants: 43.5 million x $150 $6,525.0 million Exercise price: 43.5 million x $115 $5,002.5 Loss: 43.5 million x $(150-115) $1,522.5 million The loss is not tax deductible. E8.12. Reformulation of an Equity Statement: Dell Computer Corporation a. Loss on stock option exercise = 260 = 743 0.35

Tax effect 260 483 b. Reformulated Equity Statement: Balance, February 1, 2002 4,694 Net transaction with shareholders: Share issue, at market value (418 + 483) 901 Share repurchase, at market value (1,400) (499) (2,290 – 890) Comprehensive income: CI reported 2,051

Loss on share repurchase (890) 1,161

Balance, January 31, 2003 5,356 The loss on the stock repurchase occurred because shares were repurchased at $45.80 when the shares traded at $28. The $45.80 repurchase price is the total amount paid, $2,290 million, divided by 50 million shares repurchased. The repurchase at such a high price was a result of a share repurchase agreement that gave the counter party the right to sell shares to Dell at $28. See Box 8.4 in the chapter. The loss is calculated as follows:

Market value of shares repurchased $ 28 x 50 million shares = 1,400 Amount paid on repurchase 2,290 Lost on repurchase 890

The loss on exercise of options has not been included in comprehensive income because of the potential double counting problem.

E8.13. Ratio Analysis for the Equity Statement: Nike and Reebok

Follow the ratio analysis in the chapter. Work from the reformulated equity statement in Exhibit 8.1. The following summary starts with the profitability ratio (ROCE).

Profitability:

ROCE = 25.9%

(Average CSE is used in the denominator. In ROCE calculated on beginning ROCE = 27.1%. As

earnings are earned over the whole year, we usually use average book value for the year in the

calculation.)

Payout:

Dividend payout = 8.931,1

8.412 = 21.4%

Total payout = 8.931,1

8.660,1 = 86.0%

Dividends-to-book value = 8.4128.457,7

8.412

+ = 5.2%

Retention ratio = 8.931,1

8.4128.931,1 − = 78.6%

Total payout-to-book value = 8.660,18.457,7

8.660,1

+ = 18.2%

Growth:

Net investment rate = 3.118,7

)8.252,1( = -17.6%

Growth rate in CSE = 3.118,7

0.679 = 9.5%

Nike added book value from business activities by over 25% of book value, as indicated by the ROCE.

Nike disinvested with cash dividends and share repurchases paid to shareholders in excess of share issues.

E8.14. Losses from Put Options: Household International

This exercise illustrates the trouble that a firm can get into with put contracts on its own shares, and how

GAAP failed to signal the trouble. (GAAP has since been modified: see the Postscript at the end of the

exercise.)

How share repurchase agreements work

Share repurchase agreements – and similar instruments like put options and put warrants --- are agreements

to purchase stock at a prespecified price, with settlement in cash or a net share transaction for equivalent

value. The agreements are written with private investors or banks who pay a premium for the option right.

Firms write put contracts – in this case forward share purchase agreements – presumably because they

think their shares are undervalued; they do not expect the option to be exercised. Or, if a share repurchase

program is in place, they may be hedging against increases in the repurchase price. But there may be more

sinister motives, as we will see.

GAAP accounting

When a firm is issuing stock for an average of $21.72 per share and using the cash to repurchase

stock at $53.88, one can easily see that it is losing value and endangering its liquidity and credit status. But

GAAP at that time treated the transactions as if they were plain vanilla share issues and repurchases at

market price, with no recognition of the losses. Further, in the case where settlement can be in shares, as

here, no liability is recorded when these contracts are entered into; rather the proceeds from the option

premium paid by the counterparties are treated as part of equity. So the firm treats a liability for current

shareholders to potentially give up value (and equity) as part of their equity. (A liability is recorded at the

amount of the premium if settlement is required in cash, that is, if the firm is required to repurchase shares

for cash rather than settling up in shares.)

If the option is not exercised (because the market price of the shares is above the strike price), the

firm pockets the premium paid for option and thus makes a gain for shareholders. GAAP does not report a

gain, however; rather the amount of the premium remains as part of issued capital, or is transferred to

equity if it had been carried as a liability. With Household International’s agreements, the counterparty is

required to deliver value, in the form of shares, for the difference between exercise price and market price,

augmenting the gain. If the option is exercised against the firm (because the market price is less than the

strike price), the share repurchase is recorded but no loss is recognized. But there is indeed a loss because

the firm repurchases shares at more than the market price.

a. Exercise of options. During the current quarter, Household International repurchased 2.1 million shares

at $55.68 under the agreements. The share issue (yielding $400 million from 18.7 million shares) was at

$21.39 per share. Taking this $21.39 as the market price at the time of the repurchase, the loss per share

(gross of the premium received for the contracts) was $34.29 per share (55.68 –21.39), for a total of

$72.009 million. See Box 8.4. In journal entry form, the appropriate accounting is (in millions of dollars):

Loss on stock repurchase Dr. 72.009 Common Stock Cr. 72.009

The $72.009 million credit to equity is the value of the stock net issued to settle. If settlement were in cash,

shares would be repurchased at market value (2.1 x $21.39 = $44.919 million), with the difference between

the share value and cash paid (2.1 x $55.68 = 116.928) recorded as the loss.

b. Options overhang. In addition, a liability exists at September 2002 for outstanding agreements. One

could apply option pricing methods to measure this liability, although this would be complex here because

of the varying triggers, the limits on shares to be delivered under the contracts, and the feature that the firm

receives shares if the stock price goes above the forward price. One can get a feel for the magnitude,

however, by comparing the weighted-average strike price for the 4.9 million options outstanding to the

closing market price at September 30, 2003:

Market price 4.9 x $28.31 $138,719 Exercise price 4.9 x $52.99 259,651 Liability $120,932 (Losses are not tax deductible, so there is no tax benefit to net out here.) This valuation of the liability

excludes the further option value and does not build in the effects of restrictions in the agreements. The

footnote does give some further information on the value of the liability because it indicates that 4.2 million

shares will have to be issued to settle outstanding contracts at the current market price of the shares. At

$28.31 per share, this is $118.902 million. But there are scenarios under the agreements, depending on the

price of the shares, where more shares would have to issued, up to a maximum of 29.8 million shares.

Share repurchase agreements and put options have a sharp barb for shareholders. When the share

price goes down, they of course lose. But if, in addition, the firm has these agreements, the shareholder gets

hit twice; the loss is levered. Yet GAAP (at that time) did not account for the loss.

The counterparties here were banks. So you could see the premium received as a loan from the

bank to be paid back in stock, with the expected interest being any difference between market and strike

price. However, this “loan” was not recorded as such, but rather as equity, so enhancing capital ratios and

improving book leverage. Effectively, the transactions took loans off balance sheet. Put it down as another

structured finance deal to move debt off the balance sheet.

c. Here is how Floyd Norris described it in an article in The New York Times, November 8, 2002,

page C1:

Here's how it worked. Household, following the strategy recommended by Wall Street, decided in 1999

that it would embark on a big share-buyback program. It figured the stock was cheap. There was, however,

a limitation on how many shares Household could buy. It had promised investors that it would maintain

certain capital ratios, which required that it limit leverage. If it spent all that money, capital ratios would

fall too low.

It could have just waited to buy back the stock until it could afford to do so, but Household had a better idea. It signed contracts with banks in which it promised to buy the shares within a year, for the market price when it signed the contract plus a little interest to cover the cost of the bank's buying the stock immediately. In reality, that amounted to a loan from the bank. But that is not the way that Household accounted for it. It structured the contracts so that it had a right to pay off the loan by issuing new stock, even though that was not what it intended to do. By doing that, it was able to pretend that the shares it had agreed to buy were still outstanding, and to keep its capital ratios up. All that was in accord with some easily abused accounting rules. Postscript: In early 2003 the FASB began deliberations on dealing with the accounting issues posed by forward purchase agreements, put warrants, and put options. As a result, FASB Statement No. 150 was issued, requiring a liability to be recognized.

CHAPTER NINE

The Analysis of the Balance Sheet and Income Statement

Exercises

Drill Exercises

E9.1. Basic Calculations

a. Reformulated balance sheet Operating assets $547 Financial obligations $190

Operating liabilities 132 Financial assets 145 Net financial obligations 45 Common shareholders’ equity 370 Net operating assets $415 $415 Operating liabilities = $322 – 190 = $132 million.

b. Reformulated income statement Revenue $4,356 Cost of goods sold 3,487 Gross margin 869 Operating expenses 428 Operating income 441 Net financing expense: Interest expense $132 Interest income 56 76 Earnings $ 365 E9.2 Tax Allocation = $909 million (This is the bottom-up method on Box 9.2) E9.3 Tax Allocation: Top-Down and Bottom-Up Methods Top-down method: Revenue $6,450 Cost of goods sold 3,870 2,580 Operating expenses 1,843 Operating income before tax 737 Tax expense: Tax reported $181 Tax on interest expense 50 231 Operating income after tax 506 Net interest: Interest expense 135 Tax benefit at 37% 50 85 Earnings 421 Bottom-down method: Earnings $421 Net interest: Interest expense 135 Tax benefit at 37% 50 85 Operating income after tax $506 E9.4 Reformulation of a Balance Sheet and Income Statement Balance sheet: Operating cash $ 23 Accounts receivable 1,827

Inventory 2,876 PPE 3,567 Operating assets 8,293 Operating liabilities: Accounts payable $1,245 Accrued expenses 1,549 Deferred taxes 712 3,506 Net operating assets 4,787 Net financial obligations: Cash equivalents $( 435) Long-term debt 3,678 Preferred stock 432 3,675 Common shareholders’ equity $1,112 Income statement: Revenue $7,493 Operating expenses 6,321 Operating income before tax 1,172 Tax expense: Tax reported $295 Tax on interest expense 80 375 Operating income after tax 797 Net financial expense: Interest expense 221 Tax benefit at 36% 80 141 Preferred dividends 26 167 Net income to common $630 E9.5. Reformulation of a Balance Sheet, Income Statement, and Statement of Shareholders’ Equity

a. Reformulated balance sheet Operating cash $ 60 Accounts receivable 940 Inventory 910 PPE 2,840 Operating assets 4,750 Operating liabilities: Accounts payable $1,200 Accrued expenses 390 1,590 Net operating assets 3,160 Net financial obligations: Short-term investments $( 550) Long-term debt 1,840 1,290 Common shareholders’ equity $1,870 Reformulated equity statement: Balance, end of 2008 $1,430 Net transactions with shareholders:

Share issues $ 822 Share repurchases (720) Common dividend (180) ( 78) Comprehensive income: Net income $ 468 Unrealized gain on debt investments 50 518 Balance, end of 2009 $1,870

b. Reformulated statement of comprehensive income

Revenue $3,726 Operating expenses, including taxes 3,204 Operating income after tax 522 Net financing expense: Interest expense $ 98 Interest income 15 Net interest 83 Tax at 35% 29 Net interest after tax 54 Unrealized gain on debt investments 50 4 Comprehensive income $ 518

After calculating the net financial expense, the bottom-up method is used to get operating income after tax. That is, net interest expense is calculated first (= $4 million). Then, as comprehensive income is $518 million, operating income must be 518 + 4 = 522. The number for operating expense (3,204) is then a plug to get back to the $3,726 million revenue number. Bottom up.

E9.6. Testing Relationships in Reformulated Income Statements

The solution has to be worked in the following order:

A = Operating revenues – operating expenses

= 5,523 – 4,550

= 973

E = Interest expense after tax/ (1 – tax rate)

= 42/0.65

= 64.6

F = E – 42

= 22.6

D = 610 + 42

= 652

C = F

= 22.6

B = A – C – D

= 973 – 22.6 – 652

= 298.4

Effective tax rate on operating income

= Tax on operating income/ Operating income before tax

= (B + C)/A

= 33.0%

Applications

E9.7. Price of “Cash” and Price of the Operations: Realnetworks, Inc. a. Price/book = 564.5/876 = 0.64 b. NOA = 422 million c. Price of operations = 564.5 – 454 = 110.5 million E9.8. Analysis of an Income Statement: Pepsico Inc. a. The reformulation:

Net Sales 20,367

Operating expenses 17,484

Operating income from sales (after tax)(before tax) 2,883

Tax reported 1,606

Tax benefit of debt 88

Tax on non-core itemson other operating income (367) 1,327

Operating income from sales (after tax) 1,556

Other operating income

Gain on asset sales 1,083

Restructuring charge 65

1,018

Tax on other operating income(37%)income, 36.1 367 651

Operating income (after tax) 2,207

Net financial expense:

Interest expense 363

Interst income 118

245

Tax on net interest (37%)interest (36.1%) 88 157

Net Income 2,050

c. Effective tax rate on operating from sales = %0.46883,2

327,1=

You might ask why the tax rate is so high: Pepsico had a special 10.6 percent extra tax charge on its bottling operations in 1999.

E9.9. Financial Statement reformulation for Starbucks Corporation

a.


(In millions)


Note: The closing balance excludes $106.4 million for “Stock-based compensation expense” which is a liability rather than equity. (It is added to operating liabilities in the reformulated balance sheet). b.

Reformulated Comprehensive Income Statement, 2007

(in millions)

Net revenues $ 9,411.5

Cost of sales and occupancy costs 3,999.1

Store opening expenses 3,215.9

Other operating expenses 294.1

Depreciation and amortization 467.2

General and administrative expenses 489.2

Operating income from sales (before tax) 946.0

Tax reported $ 383.7

Tax benefit of net interest 5.6

Tax on other operating income (6.6) 382.7

Operating income from sales (after tax) 563.3

Other operating income, before-tax item

Gain on asset sales 26.0

Other operating charges (8.9)

17.1

Tax at (38.4%) 6.6

10.5

Operating income, after tax-items

Income from equity investees 108.0


Operating income (after tax) 719.5

Net financing expenses

Interest expense 38.2

Interest income (19.7)

Net interest expense 18.5

Realized gain on financial assets (3.8)

14.7

Tax (at 38.4%) 5.6

9.1

Unrealized loss on financial assets 20.4 29.5

Comprehensive income 689.9

Note: Interest income and interest expense are given in the notes to the financial

statements in the exercise. That note also identifies the other operating income here.

Reformulated Balance Sheets

(in millions)

2007 2006

Operating Assets

Cash and cash equivalents 40.0 40.0

Short-term investments—trading securities 73.6 53.5

Accounts receivable, net 287.9 224.3

Inventories 691.7 636.2

Prepaid expenses and other current assets 148.8 126.9

Deferred income taxes, net 129.5 88.8

Equity and other investments 258.8 219.1

Property, plant and equipment, net 2,890.4 2,287.9

Other assets 219.4 186.9

Other intangible assets 42.0 37.9

Goodwill 215.6 161.5

Total operating assets 4,997.7 4,063.0

Operating liabilities

Accounts payable 390.8 340.9

Accrued compensation and related costs 332.3 288.9

Accrued occupancy costs 74.6 54.9

Accrued taxes 92.5 94.0

Other accrued expenses 257.4 224.2

Deferred revenue 296.9 231.9

Other long-term liabilities 460.5 262.9

Total operating liabilities 1,905.0 1,497.7

Net operating assets 3,092.7 2,565.3

Net financial obligations

Short-term borrowing 710.2 700.0

Current maturities of long-term debt 0.8 0.8

Long-term debt 550.1 2.0

Cash equivalents (281.3-40.0 in 2008) (241.3) (272.6)

Short-term investments (available for sale) (83.8) (87.5)

Long-term investments (available for sale) (21.0) (5.8)

Net financial obligations 915.0 336.9

Common shareholders’ equity 2,177.6 2,228.5

Notes:

1. Short-term investment (trading securities) is operating assets connected to

employees.

2. Stock-based compensation, excluded from the equity statement, has been

added to other liabilities.

c.

ROCE = 689.9 / 2,228.5 = 30.96% RNOA = 719.5 / 2,565.3 = 28.05% NBC = 29.5 / 336.9 = 8.76% E9.10. Reformulation and Effective Tax Rates: Home Depot, Inc.

First establish the firm’s marginal tax rate. This is the statutory rate (federal plus state) at which interest

income is taxed (or interest expense gets a tax saving). The footnote gives the effective rate (36.8% for

2005), which is the effective rate from the income statement (2,911/7,912 = 36.8%). But this is not the

marginal rate for it includes tax credits and foreign tax benefits, amongst other things. The marginal rate is

the statutory rate, federal and state combined (with the state rate recognizing that state taxes are deductible

in federal tax returns).

The federal statutory rate is 35%, but the state rate is not given. (Many firms do report it.) Home

Depot operates in many states; without more information, the statutory rate is somewhat of a guess. Home

Depot reports a ratio of state-to-federal taxes of 215/2,769 = 7.79% for 2005. Applied to the federal rate of

35%, this implies a state rate of 2.72%, or a total rate of 37.72%.

In the reformulation below, this 37.72% rate is used for the tax allocation. The top-down approach

proceeds as follows:

Reformulated Income Statement, January 30, 2005

($ millions)

Net sales 73,094 Cost of sales 48,664 Gross profit 24,430 Selling and store operating costs 15,105 General and administrative 1,399 16,504 Operating income before tax 7,926 Tax as reported 2,911 Tax benefit of net debt 5 2,916 Operating income after tax 5,010 Interest expense 70 Interest income 56 Net interest expense 14 Tax on net interest (37.72%) 5 9

Net income 5,001

Effective tax rate on operating income = 2,916 = 36.79% 7,926 This effective rate is almost the same as the reported rate because the net interest is almost zero.

The bottom-up approach proceeds as follows (in millions of dollars):

Net income 5,001

Interest expense 70 Interest income 56 Net interest expense 14 Tax on net interest (37.72%) 5 9

Operating income after tax 5,010

CHAPTER TEN

The Analysis of the Cash Flow Statement

Drill Exercises

E10.1. Classification of Cash Flows A cash flow that affects cash flow from operation also affects free cash flow.

Cash from operations FCF Financing Flows a. Yes Yes No b. No No No c. No Yes No d. Yes Yes No e. No No Yes f. No No Yes g. Yes Yes No Interest payments affect the GAAP number for cash from operations, but not the real number. Purchases of short-term investments affect the GAAP measure of cash investment, but not the real investment in operations nor free cash flow. E10.2 Calculating Free Cash Flow from the Balance Sheet and Income Statement First reformulate the balance sheet:

Method 1:

Free cash = 240 Method 2:

= 376 – (1,870 – 1,430) = -64

So,

= 240

E10.3. Analyzing Cash Flows

a) As there is no debt or financial assets, = $150,000

OR

As there is no change in shareholders’ equity and no financial income or expenses,

2009 2008

NOA 3160 2900

NFO 1290 1470

CSE 1870 1430

= $150,000 So, = $150,000

(There is no change in net operating assets because there is no change in shareholders’ equity and no net financial obligations.)

b) The increase in cash comes from operations, the sale of land (and dividends decreased the cash):

Cash from operations = $135,000

Sale of land $400,000 $535,000 Dividends 150,000 Change in cash $385,000

c) No change. The investment in the short-term deposit is a financing activity, not an investment in operations, so free cash flow is not affected. It’s a disposition of cash from operations, not generation of free cash flow.

E10.4. Free Cash Flow for a Pure Equity Firm

So free cash flow is -$26.1 million

Another solution

Earnings = $25.3 million

= -26.1 million

E10.5 Free Cash Flow for a Net Debtor

By Method 2 in Box 10.1,

C - I = NFE – ∆NFO + d

∆NFO = 37.4 – 54.3 = -16.9 (net debt declined)

d = 8.3 – 34.3 = -26.1 (negative net payout)

So, C – I = 4 – (-16.9) + (-26.1)

= -5.2 (free cash flow was negative)

OR, using Method 1,

C - I = OI - ∆NOA = 29.3 - 34.5 = -5.2 Where

OI = Comprehensive income (25.3) + NFE (4.0) = 29.3

∆NOA = ∆CSE - ∆NFO = 51.4 - 16.9 = 34.5 Comprehensive income is plugged from the equity statement.

E10.6. Applying Cash Flow Relations

(a) = - $40 million (The firm reduced its investment in net operating assets.)

(b) = - $69 million

Or, as ∆NOA is made up of investment and operating accruals,

= - $69 million (c) C - I = NFE - DNFs + d

So, with a negative net dividend of $13 million

∆NFO = - $400 million (The firm reduced its NFO by $400 million by applying free cash flow and the net dividend to reducing net debt).

E10.7. Applying Cash Flow Relations

(a) Use the free cash flow generation equation: C - I = OI - ∆NOA

As there was no net financial income or expense, operating income (OI)

equals the comprehensive income of $100 million. The net operating

assets for 2009 and 2008 are as follows:

2009 2008

Operating assets 640 590 Operating liabilities 20 30 NOA 620 560

C - I = $ 40 million

(b) Use the free cash flow disposition equation: C - I = ∆NFA - NFI +d

The net dividend (d) = - $60 million (a net capital contribution)

The net financial assets for 2009 and 2008 are as follows:

2009 2008

Financial assets 250 110 Financial liabilities 170 130 NFA 80 (20)

C - I = $40 million

The firm invested the $40 million of free cash flow in financial assets. In

addition, it raised a net $60 million from shareholders which it also

invested in financial assets.

(c) Net financial income or expense can be zero if financial income and

financial expense exactly offset each other. This firm moved from a net

debtor to a net creditor position in 2009 such that the weighted-average net

financial income was zero.

Applications E10.8. Free Cash Flow and Financing Activities: General Electric Company

a. General Electric, while generating large cash flow from operations, has had a huge investment program as it acquired new businesses, leaving it with negative free cash flow.

b. Given that cash from operations from the businesses in place continues at, or

grows from the 2004 level, free cash flow will increase and will become positive (probably by big amounts). Rather than borrowing or issuing shares to finance a free cash flow deficit, GE will have cash to pay out. It can either,

1. But down its debt 2. Invest the cash flow in financial assets 3. Pay out dividends or buy back its stock.

The firm would not invest in financial assets for too long, but rather buy back debt or pay out to shareholders. Indeed, in 2005, the firm announced a large stock repurchase program. E10.9. Method 1 Calculation of Free Cash Flow for General Mills, Inc, By Method 1, Free cash flow = $1,351 million E10.10. Free Cash Flow for Kimberly-Clark Corporation a. Reformulate the balance sheet: 2007 2008 Operating assets $18,057.0 $16,796.2 Operating liabilities 6,011.8 5,927.2 Net operating assets (NOA) 12,045.2 10,869.0 Financial obligations $6,496.4 $4,395.4 Financial assets 382.7 6,113.7 270.8 4,124.6 Common equity (CSE) $ 5,931.5 $ 6,744.4

By Method 1,

Free cash flow = 1,563.9

By Method 2, Free cash flow = 1,563.9 Net payout to shareholders (d) = 3,405.9 b. Cash flow from operations reported $2,429.0 million Net interest payments 142.4 Tax on net interest payments 52.1 90.3 Cash flow from operation 2,519.3 Cash investment reported 898.0 Liquidation of short-term investments 56.0 954.0 Free cash flow $1,565.3 million E10.11. Extracting Information from the Cash Flow Statement with a Reformulation: Microsoft Corporation

a. Cash dividends are read off the financing sections of the cash flow statement: $33,498 million. A large dividend indeed! This dividend would also be reported in the statement of shareholders’ equity.

Net dividend = 33,672 million As Microsoft has no debt, the net dividend is equal to the total of financing activities.

b. Cash flow for operations reported $3,619 million Interest received $378 Tax on interest (at 37.5%) 142 236 Cash from operations $3,383 (Note: there is no interest paid.) c. Cash generated from investments, reported $23,414 (Positive number means cash has been generated, not used) Net sales of short-term investments 23,591 Cash generated from investing in operations $ (177) That is, $177 million was invested in operations. d. Free cash flow = $3,383 – 177 = $3,206

e. The actual cash invested in operations for 2003 (after adjusting for net investment in interest-bearing securities) was $172, almost the same as 2004. Both year’s numbers are affected by the net investment in interest-bearing securities.

f. The net investment in financial assets is the net investment in short-term

investments (in part d above) plus the change in cash and cash equivalents. (As $60 million of working cash is the same at the beginning and end of the period, the change in cash and cash equivalents (a negative $6,639 million) is all investment in financial assets).

Investment in financial assets = -$23,591 - $6,639 = -$30,230 million That is, Microsoft liquidated $30,230 of financial assets (to pay the large dividend).

The Reformulated Cash Flow Statement (in millions of dollars) Cash flow for operations reported $3,619 million Interest received $378 Tax on interest (at 37.5%) 142 236 Cash from operations $3,383 Cash generated from investments, reported $23,414 Net sales of short-term investments 23,591 Cash generated from investing in operations (177) Free cash flow $3,206 Cash in financing activities: Net dividend $33,672 Sale of financial assets (30,230) Interest in financial assets, after tax ( 236) $ 3,206

CHAPTER ELEVEN

The Analysis of Profitability

Drill Exercises

E11.1 Leveraging Equations

(a) By the stocks and flows equation for equity Net dividends = (93) (i.e. net capital contribution)

(This answer assumes no dirty-surplus accounting) 2007 2008 Average NOA 1,900 2,400 2,150 NFO 1,000 1,200 1,100 CSE 900 1,200 1,050 ROCE = 207/1,050 = 19.71% Operating income (OI = 279.6 RNOA = OI/ave. NOA = 279.6/2,150 = 13.0%

ROCE = [PM ×ATO] + [FLEV × (RNOA − NBC)]

PM = OI/Sales = 279.6/2,100 = 0.1331 (or 13.31%) ATO = Sales/ave. NOA = 2,100/2,150 = 0.9767 FLEV = Ave. NFO/ave. CSE = 1,100/1,050 = 1.0476

NBC = Net interest expense/ave. NFO = (110 × 0.66)/1,100 = 6.6% So,

19.71% = (0.1331 × 0.9767) + [1.0476 × (13.0% - 6.6%)]

(b)

2007 2008 Average Operating assets 2,000 2,700 2,350

Operating liabilities (100) (300) (200) NOA 1,900 2,400 2,150

Implicit interest on operating liabilities (OL) = 9

Return on operating assets (ROOA) = 12.28%

Operating liability leverage = 0.093

So,

13.0% = 12.28% + [0.093 × (12.28% - 4.5%)]

(c) This is the case of a net creditor firm (net financial assets).

Net dividends = (361)

ROCE = 339/3,050 = 11.11%

Operating income = 279.6 (as before)

RNOA = 279.6/2,150 = 13.0% (as before)

Return on net financial assets (RNFA) = 6.6%

FLEV = -900/3,050 = -0.295

PM and ATO are as before.

So,

11.11% = (0.1331 × 0.9767) – [0.295 × (13.0% - 6.6%)]

E11.2 First-level Analysis of Financial Statements

(a) First reformulate the financial statements:


2008 2007 Average NOA 1,395 1,325 1,360

NFO 300 300 300 CSE 1,095 1,025 1,060

Reformulated Income Statement, 2008

Sales 3,295 Operating Expenses 3,048 247 Tax reported 61 Tax on NFE 9 70 OI 177 Net interest 27 Tax on interest at 33% 9 NFE 18 Comprehensive Income 159 CSE2008 = CSE2007 + Earnings2008 – Net Dividends2008

1,095 = 1,025 + 159 - 89 Stock repurchase = 89

(b) ROCE = 060,1

159 = 15.0%

RNOA = 360,1

177 = 13.0%

FLEV = 060,1

300 = 0.283

SPREAD = RNOA – NBC

= 13.0% - 6.0% = 7.0%

300

18 =

NFO

NFE = NBC

C – I = OI - ∆NOA

= 177 – 70

= 107

(b) The ROCE of 15% is above a typical cost of capital of 10% - 12%. So

one might expect the shares to trade above book value. But, to trade at

three times book value, the market has to see ROCE to be increasing in the

future or investment to be growing substantially.

E11.3. Reformulation and Analysis of Financial Statements

c. Reformulated balance sheet 2009 2008

Operating cash $ 60 50 Accounts receivable 940 790 Inventory 910 840 PPE 2,840 2,710 Operating assets 4,750 4,390 Operating liabilities: Accounts payable $1,200 1,040 Accrued expenses 390 1,590 450 1,490 Net operating assets 3,160 2,900

Net financial obligations: Short-term investments $( 550) ( 500) Long-term debt 1,840 1,290 1,970 1,470 Common shareholders’ equity $1,870 1,430 Reformulated equity statement (to identify comprehensive income): Balance, end of 2008 $1,430 Net transactions with shareholders: Share issues $ 822 Share repurchases (720) Common dividend (180) ( 78) Comprehensive income: Net income $ 468 Unrealized gain on debt investments 50 518 Balance, end of 2009 $1,870

Reformulated statement of comprehensive income

Revenue $3,726 Operating expenses, including taxes 3,204 Operating income after tax 522 Net financing expense: Interest expense $ 98 Interest income 15 Net interest 83 Tax at 35% 29 Net interest after tax 54 Unrealized gain on debt investments 50 4 Comprehensive income $ 518

After calculating the net financial expense, the bottom-up method is used to get operating income after tax. Free cash flow = 262 d. Ratio analysis

Profit Margin (PM) = 522/3,726 = 14.01% Asset turnover (ATO) = 3,726/2,900 = 1.285 RNOA = 522/2,900 = 18% e. Individual asset turnovers Operating cash turnover = 3,726/5 = 74.52 Accounts receivable turnover = 3,726/790 = 4.72

Inventory turnover = 3,726/840 = 4.44 PPE turnover = 3,726/2,710 = 1.37 Accounts payable turnover = 3,726/1,040 = 3.58 Accrued expenses turnover = 3,726/450 = 8.28 1/individual turnover aggregate to 1/ATO: 1/ATO = 1/1.285 = 0.778 = 0.013 + 0.212 + 0.225 + 0.730 – 0.279 – 0.121 (allow for rounding error) f. ROCE = 518/1,430 = 36.22%

Financial leverage (FLEV) = 1,470/1,430 = 1.028 Net borrowing cost (NBC) = 4/1,470 = 0.272% ROCE = 36.22% = 18.0% + [1.028 × (18.0% - 0.272%)]

g. NBC = 4/1,470 = 0.272% (as in part e) If RNOA = 6% and FLEV = 0.8, ROCE = 6.0% + [0.8 × (6.0% - 0.0.272%] = 10.58% Note: it is more likely that NBC will be at the core borrowing rate (that excludes The unrealized gain of debt investments): Core NBC = 54/1,470 = 3.67%. Chapter 12 identifies core borrowing costs. h. Implicit cost of operating liabilities = 1,490 × 0.03 = 44.7

Return on operating assets (ROOA) = 390,4

7.44522 += 12.91%

Operating liability leverage (OLLEV) = 1,490/2,900 = 0.514 RNOA = 18.0% = 12.91% + [0.514 × (12.91% - 3.0%)]

E11.4 Relationship Between Rates of Return and Leverage

(a) ROCE = RNOA + [FLEV × (RNOA – NBC)]

13.4% = 11.2% + [FLEV × (11.2% - 4.5%)]

FLEV = 0.328

(b) RNOA = ROOA + (OLLEV × OLSPREAD)

11.2% = 8.5% + [OLLEV × (8.5% - 4.0%)]

OLLEV = 0.6

(c) First calculate NFO and CSE using the financial leverage ratio (CSE

NFO)

applied to the net operating assets of $405 million.

FLEV = CSE

NFO

NOA = CSE + NFO

So CSE

NFO = 1 + FLEV

= 1.328

As NOA = $405 million

Then CSE = 1.328

million 405$

= $305 million

and NFO = $100 million

Now distinguish operating and financing assets and liabilities

OLLEV = NOA

OL = 0.6

So OL = 0.6 × $405 million

= $243 million

OA = NOA + OL

= 405 + 243

= $648 million

Financial assets = total assets – operating assets

= 715 – 648

= $67 million

Financial liabilities = NFO + financial assets

= 100 + 67

= $167 million

Reformulated Balance Sheet

Operating assets 648 Financial liabilities 167 Operating liabilities 243 Financial assets 67 100 Common equity 305 405 405 E11.5 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A What-If Question The effect would be (almost) zero. Existing RNOA = 11.02%

RNOA from new product line is

RNOA = 11.04%

Applications

E11.6. Profitability Measures for Kimberly-Clark Corporation The exercise is best worked by setting up the reformulations balance sheet: 2007 2008 Operating assets $18,057.0 $16,796.2 Operating liabilities 6,011.8 5,927.2 Net operating assets (NOA) 12,045.2 10,869.0 a (1) Financial obligations $6,496.4 $4,395.4 Financial assets 382.7 6,113.7 270.8 4,124.6 a (2) Common equity (CSE) $ 5,931.5 $ 6,744.4 a (3) a. The answers to question (a) are indicated beside the reformulated statement. b. Comprehensive income = 2,740.1 – 147.1 = 2,593 million ROCE = 2,593/6,744.4 = 38.45% RNOA – 2,740.1/10,869.0 = 25.21% FLEV = NFO/CSE = 4,124.6/6,744.4 = 0.612 NBC = 147.1/4,124.6 = 3.57% c. The financial leveraging equation is:

ROCE = RNOA + [FLEV × (RNOA – NBC)]

= 25.21% + [0.612 × (25.21% - 3.57%)]

= 38.45%

d.

On sales of $18,266 million for 2007,

PM = 2,740.1/18,266 × ATO = 18,266/10,869

15.00% × 1.68

= 25.2% E11.7. Analysis of Profitability: The Coca-Cola Company

Average balance sheet amounts are as follows:

2007 2006 Average

Net operating assets $26,858 $18,952 $22,905 Net financial obligations 5,114 2,032 3,573 Common shareholders’ equity $21,744 $16,920 $19,332

a. RNOA = 6,121/22,905 = 26.72% NBC = 140/3,573 = 3.95% b. FLEV = 3,573/19,332 = 0.185 c.

ROCE = RNOA + [FLEV × (RNOA – NBC)]

= 26.72% + [0.185 × (26.72% - 3.95%)]

= 30.93 % = 5,981/19,332

d.

PM = 6,121/28,857 = 21.21%

ATO = 28,857/22,905 = 1.26

RNOA = 21.21% × 1.26 = 26.72%

e.

Gross margin ratio = 18,451/28,857 = 63.94%

Operating profit margin from sales = 5,453/28,857 =18.90%

Operating profit margin = 6,121/28,857 = 21.21%

E11.8. A What-If Question: Grocery Retailers Net operating assets for $120 million in sales and an ATO of 6.0 are $20 million.

An increase in sales of $15 million and an increase in inventory of $2 million

would

increase the ATO to 120 25

20 2

+

+= 6.59.

With a profit margin of 1.5%, the RNOA would be:

RNOA = 9.89%

The current RNOA is:

RNOA = 9.6%

So the membership program would increase RNOA slightly.

E11.9. Financial Statement Reformulation and Profitability Analysis for Starbucks Corporation a. To prepare a reformulated income statement, first identify comprehensive income in the equity statement. If you worked Exercise E9.9, you would have done this and produced the statement below. If not, you just need to calculate the comprehensive income of $689.9 million in the statement here.


(in millions)

Balance, October 1, 2006 $

2,228.5

Net payout to shareholders:

Stock repurchase 1,012.8

Sale of common stock (46.8)

Issue of shares for employee stock options (225.2) (740.8)

Comprehensive Income:

Net income from income statement 672.6

Unrealized loss on financial assets (20.4)

Currency translation gains 37.7

689.9


Note: The closing balance excludes $106.4 million for “Stock-based compensation expense” which is a liability rather than equity. (It is added to operating liabilities in the reformulated balance sheet).

With comprehensive income identified, reformulate the (comprehensive) income statement that totals to comprehensive income:

Reformulated Comprehensive Income Statement, 2007

(in millions)











Operating income from sales (after tax) 563.3

Other operating income, before-tax item



17.1

Tax at (38.4%) 6.6

10.5


Income from equity investees 108.0








14.7

Tax (at 38.4%) 5.6

9.1



Note: Interest income and interest expense are given in the notes to the financial

statements in the Exercise 9.9. That note also identifies the other operating income

here.

The reformulated balance sheet is as follows:


(in millions)

2007 2006

Operating Assets

Cash and cash equivalents 40.0 40.0

Short-term investments—trading securities 73.6 53.5

Accounts receivable, net 287.9 224.3

Inventories 691.7 636.2

Prepaid expenses and other current assets 148.8 126.9

Deferred income taxes, net 129.5 88.8

Equity and other investments 258.8 219.1

Property, plant and equipment, net 2,890.4 2,287.9

Other assets 219.4 186.9

Other intangible assets 42.0 37.9

Goodwill 215.6 161.5

Total operating assets 4,997.7 4,063.0

Operating liabilities

Accounts payable 390.8 340.9

Accrued compensation and related costs 332.3 288.9

Accrued occupancy costs 74.6 54.9

Accrued taxes 92.5 94.0

Other accrued expenses 257.4 224.2

Deferred revenue 296.9 231.9

Other long-term liabilities 460.5 262.9

Total operating liabilities 1,905.0 1,497.7

Net operating assets 3,092.7 2,565.3

Net financial obligations

Short-term borrowing 710.2 700.0

Current maturities of long-term debt 0.8 0.8

Long-term debt 550.1 2.0

Cash equivalents (281.3-40.0 in 2008) (241.3) (272.6)

Short-term investments (available for sale) (83.8) (87.5)

Long-term investments (available for sale) (21.0) (5.8)

Net financial obligations 915.0 336.9

Common shareholders’ equity 2,177.6 2,228.5

Notes:

3. Short-term investment (trading securities) is operating assets connected to

employees.

4. Stock-based compensation, excluded from the equity statement, has been

added to other liabilities.

b.

ROCE = 689.9 / 2,228.5 = 30.96% RNOA = 719.5 / 2,565.3 = 28.05% NBC = 29.5 / 336.9 = 8.76%

c.

ROCE = 28.05% + [0.151 x (28.05% - 8.76%)] = 30.96% d. Operating profit margin = 719.5/9,411.5 = 7.64% Operating profit margin from sales = 563.3/9,411.5 = 5.99% ATO = 9,411.5/2,565.3 = 3.67 e. OLLEV = 1,497.7/2,565.3 = 0.584 f. Implicit interest on operating liabilities = 0.036 × 1,497.7 = 53.92

ROOA = =+

0.063,4

92.535.719 19.04%

RNOA = ROOA + OLLEV× (ROOA – 3.6%) = 19.04% + 0.584 × (19.04% - 3.6%) = 28.05% E11.10. Operating Profitability Analysis: Home Depot, Inc.

a. Reformulation

If you have worked Exercise 9.10 in Chapter 9, you will have calculated the tax rate to

use in the income statement reformulation for 2005. This is the statutory rate (federal plus

state) at which interest income is taxed (or interest expense gets a tax saving). The

footnote gives the effective rate (36.8% for 2005), which is the effective rate from the

income statement (2,911/7,912 = 36.8%). But this is not the marginal rate for it includes

tax credits and foreign tax benefits, amongst other things. The marginal rate is the

statutory rate, federal and state combined (with the state rate recognizing that state taxes

are deductible in federal tax returns).

The federal statutory rate is 35%, but the state rate is not given. (Many firms do

report it.) Home Depot operates in many states; without more information, the statutory

rate is somewhat of a guess. Home Depot reports a ratio of state-to-federal taxes of

215/2,769 = 7.79% for 2005. Applied to the federal rate of 35%, this implies a state rate

of 2.72%, or a total rate for 2005 of 37.72%.

Following the same procedure for 2004, the ratio of state-to-federal taxes for 2004

is 217/2,395 = 9.06% and the implied state tax rate = 9.06% × 35% = 3.17%, giving a

total of 38.17%.

In the reformulation below, these rates are used for the tax allocation. Of course, given

the small net interest, the precise calculation does not matter.

Reformulated Income Statements, 2005 and 2004

($ millions)

2005 2004 Net sales 73,094 64,816 Cost of sales 48,664 44,236 Gross profit 24,430 20,580 Selling and store operating costs 15,105 12,588 General and administrative 1,399 16,504 1,146 13,734 Operating income from sales, before tax 7,926 6,846 Tax as reported 2,911 2,539 Tax benefit of net debt 5 2,916 1 2,540 Operating income from sales, after tax 5,010 4,306 Other operating income – currency translation gains Operating income

137 5,147

172 4,478

Interest expense 70 62 Interest income 56 59 Net interest expense 14 3 Tax on net interest 5 9 1 2 Comprehensive income 5,138 4,476

Note: Currency translations gains are after tax (as are all items in other comprehensive income)

2005 2004 2003

Operating assets:

Operating cash 50 50 50

Receivable 1,499 1,097 1,072

Inventories 10,076 9,076 8,338

Other current assets 450 303 254

PPE (net) 22,726 20,063 17,168

Goodwill 1,394 833 575

Other assets 228 129 244

36,423 31,551 27,701

Operating liabilities:

Accounts payable 5,766 5,159 4,560

Accrued salaries 1,055 801 809

Sales tax payable 412 419 307

Deferred revenue 1,546 1,281 998

Income tax payable 161 175 227

Other accrued taxes 1,578 1,210 1,127

Deferred income tax 1,309 967 362

Other liabilities 763 653 491

12,590 10,665 8,881

Net operating assets 23,833 20,886 18,820

Net financial obligations:

Cash equivalents (456) (1,053) (2,138)

Short-term investments (1,659) (1,749) (65)

Notes receivable (369) (84) (107)

Current debt 11 509 7

Long-term debt 2,148 856 1,321

(325) (1521) (982)

Common equity 24,158 22,407 19,802

Averages:

Operating assets 33,987 29,626

Operating liabilities 11,628 9,773

Net operating assets 22,359 19,853

Net financial obligations (923) (1,252)


Reformulated Balance Sheets, 2003-2005

b. Analysis of Operating Profitability

2005 2004

Second Level

ROCE 22.07% 21.21%

RNOA 23.02% 22.56%

PM 7.04% 6.91%

ATO 3.269 3.265

PM×ATO 23.02% 22.56%

Income statement ratios:

Profit Margin drivers (%)

Gross margin 33.42 31.75

Selling expense ratio (20.67) (19.42)

G&A Expense Ratio (1.91) (1.77)

Operating Sales PM before tax 10.84 10.56

Tax expense ratio (3.99) (3.92)

Sales PM 6.85 6.64

Other item PM 0.19 7.04 0.27 6.91

Note that the income statement ratios aggregate to the PM.

Turnover ratios (using average balance sheet amounts)

2005 2004

Asset turnover drivers ATO 1/ATO ATO 1/ATO

Accounts receivable turnover 56.31 0.018 59.77 0.017

Inventory turnover 7.63 0.131 7.44 0.134

PPE turnover 3.42 0.293 3.48 0.287

Other asset turnover 42.53 0.024 53.17 0.019

Operating asset turnover 2.15 0.465 2.19 0.457

Accounts payable turnover -13.38 (0.075) -13.34 (0.075)

Other liability turnover -11.86 (0.084) -13.19 (0.076)

3.27 0.306 3.26 0.306

Note that the sum of individual 1

ATOequals

1

ATO for all operating assets and liabilities.

1

ATO is the amount of the asset or liability that is put in place to support sales.

CHAPTER TWELVE

The Analysis of Growth and Sustainable Earnings Drill Exercises

E12.1 Analyzing a Change in Core Operating Profitability

∆Core RNOA = -1.47% = (-0.4% x 2.5) + (-0.1 x 4.7%)

= -1.0% - 0.47%

↓ ↓

[Due to ∆PM] [Due to ∆ATO]

E12.2. Analyzing a Change in Return on Common Equity

ROCE for 2009: 15.2% = 11.28 + [0.4678 x (11.28 – 2.9)]

ROCE for 2008: 13.3% = 12.75 + [0.0577 x (12.75 – 3.2)]

∆ROCE 1.9%

∆RNOA -1.47%

∆ROCE due to financing 3.37%

This change due to financing is due to a change in leverage and a change in SPREAD:

∆FLEV 0.4101

∆SPREAD -1.17%

The explanation of the change in ROCE due to change in operating profitability

(∆RNOA) is given in Exercise E12.1. Using a similar scheme, the explanation of the

change due to financing is

∆ROCE due to financing = 3.37% = (-1.17% x 0.0577) + (0.4101 x 8.38%)

= -0.07% + 3.44%

↓ ↓

[Due to change in spread] [Due to change in leverage]

E12.3. Analyzing the Growth in Shareholders’ Equity

Change in CSE = 583 = (5,719 x 0.4) + (0.0167 x 16,754) – 1,984

= 2287.6 + 279.8 – 1,984.0

↓ ↓ ↓

Due to Due to Due to Sales NOA Borrowing

E12.4. Calculating Core Profit Margin

The reformulated statement that distinguishes core and unusual items is as follows (in

millions of dollars):

Sales 667.3

Core operating expenses 580.1

Core operating income before tax (73.4 +13.8) 87.2

Tax as reported 18.3

Tax benefit of net debt (0.39 × 20.5) 8.0

Tax on operations 26.3

Tax allocated to unusual items: 5.4 31.7

Core operatimg inome after tax 55.5

Unusual items

Start-up costs (4.3)

Merger charge (13.4)

Gain on asset disposals 3.9

(13.8)

Tax effect (0.39) 5.4

(8.4)

Translation gain 8.9 0.5

Comprehensive operating income 56.0

Note:

1. The currency translation gain is transitory; it does not affect core

income.

2. Translation gains, like all items reported in other comprehensive

income are after-tax.

3. The gain on disposal of plant may attract a higher tax rate than 39% due

to depreciation recapture.

Core operating income (after tax) = 55.5

Core profit margin Sales

)(after tax income operating Core=

%32.8=

E12.5. Explaining a Change in Profitability

Reformulate balance sheets and income statements:

Balance Sheets

NOA NFO NOA NFO NOA NFO

Cash 100 100 120

A/R 900 1,000 1,250 Inventory 2,000 1,900 1,850

PPE 8,200 9,000 10,500 Accr. Liab. (600) (500) (550)

A/P (900) (1,000) (1,100)Def. Taxes (490) (500) (600)

S/T investm ents (300) (300) (330)Bank loan 3,210

Bonds payable 4,300 4,300 1,000 Preferred stock 1,000 1,000 1,000

9,210 5,000 10,000 5,000 11,470 4,880 CSE 4,210 5,000 6,590

9,210 10,000 11,470

Leverage (NFO/CSE) 1.188 1.000 .741

Average leverage 1.086 0.853

2009 2008 2007

Income Statements

Sales 22,000 24,000

CGS 13,000 13,100

S&A 8,000 21,000 8,250 21,350

Core OI b/4 tax 1,000 2,650

Tax on OI 337 812

Core OI after tax 663 1,838

Restructuring charge 190

Tax Benefit 65 (125)

Operating income 538

Net Financial expenses

Net interest expenses 406 405

Tax Benefit (138) (137)

268 268

Gain on retirement (after tax) 0 100

268 168

Preferred divs. 80 (348) 80 (248) NI available for common 190 1,590

2009 2008

Tax on Core OI (2009) = 134 + 138 + 65 = 337 Tax on Core OI (2008) = 675 + 137 = 812

Net borrowing cost (NBC): Net fin. exp/average NFO

2009: 348/5,000 = 6.96% 2008: 248/4,940 = 5.02%

Return on net operating assets (RNOA): OI/average NOA

2009: 538/9,605 = 5.60% 2008: 1,838/10,735 = 17.12%

Core profit margin (PM): Core OI/Sales

2009: 663/22,000 = 3.01% 2008: 1,838/24,000 = 7.66%

Asset turnover (ATO): Sales/average NOA

2009: 22,000/9,605 = 2.290 2008: 24,000/10,735 = 2.236 Unusual items to net operating assets: UI/average NOA

2009: -125/9,605 = -1.30% 2008: = 0 Spread: RNOA - NBC

2009: -1.36% 2008: 12.10%

Explaining ∆ROCE:

ROCE (2009) = CI avail for common/Average CSE = 190/4,605 = 4.13% ROCE (2008) = 1,590/5,795 = 27.44%

∆ROCE (2009) = -23.31% As ROCE = RNOA + [FLEV × (RNOA - NBC)], this change in ROCE is determined by: ∆RNOA = -11.52% ∆FLEV = 1.086 – 0.853 = 0.233 ∆NBC = 1.94%

Explaining the ∆ RONA component:

∆ RNOA = [∆ core profit margin × turnover (2008)] + [∆ turnover × core

profit margin (2009)] + ∆ unusual items/NOA

= [-0.0465 × 2.290] + [0.054 × 0.0766] - 0.0130 = -0.1152 In words, the decrease in ROCE is explained by an decrease in profit margin (despite a small increase in asset turnover) that was levered up by an decrease in the spread over net borrowing costs, the effect of which was further increase by an increase in leverage. In addition there were unusual changes in 2009 that reduced operating profitability.

E12.6. Analysis of Growth in Common Equity for a Firm with Constant Asset Turnover The ingredients:

2,009 2,008

Average CSE 4,560 4,259

Growth in average CSE 301

Growth in average NFO 0Growth in sales 902

Asset turnover (Sales/Average NOA) 3 3

As asset turnover is constant and average net financial obligations did not change from 2004 to 2006, the growth in CSE is explained solely by the growth in sales:

Growth in CSE = Growth in sales ×ATO

1

= 301

Applications

E12.7. Core Income and Core Profitability for The Coca Cola Company

Average balance sheet amounts are as follows: 2007 2008 Average

Net operating assets $26,858 $18,952 $22,905 Net financial obligations 5,114 2,032 3,573 Common shareholders’ equity $21,744 $16,920 $19,332

As no unusual items are reported in the income statement, all income reported is core income. So,

Core income from sales (after tax) = $5,453 million

Core operating income = $6,121 million

One might be tempted to treat equity income from bottling subsidiaries as non-core income. However, this

is part of Coke’s business of selling beverages (they just do this business through bottling firms). The

equity income is not income from top-line sales, however; rather it is income from sales in the subsidiaries

that is reported here on a net basis (after expenses).

Here are the measures requested:

a. Core profit margin from sales = 5,453/28,857 =18.90%

b. Core profit margin = 6,121/28,857 = 21.21%

c. Core RNOA = 6,121/22,905 = 26.72%

E12.8. Identification of Core Operating Profit Margins for Starbucks

To reformulate the income statement to identify core income, first separate net financial income from

operating income, then separate core operating income from unusual items, then separate core operating

income from sales from other core income.

Reformulated Comprehensive Income Statement Identifying Core Operating Income,

2007

(in millions)











Core OI from sales (after tax) 563.3

Equity income from investees (after tax)

Core operating income

108.0

671.3

Unusual items, before-tax item



17.1

Tax at (38.4%) 6.6 10.5


Currency translation gains 37.7







14.7

Tax (at 38.4%) 5.6

9.1



The question only asked for calculations of operating income, but the financing part of the statement is also

prepared to calculate the tax benefit ($5.6 million) from financing activities to allocate to the operating

activities. (You need only get to the $5.6 million number.) Note that taxes have also been allocated between

(taxable) unusual items and core operating income. The reformulated statement brings in the currency gains

and losses from the equity statement (which is an unusual item). Unusual items also include items in “net

interest and other income” that are detailed in the footnote. (Realized gains on available-for-sale

investments are gains on financial asset s, often called “investments as in the footnote.)

a. Core operating income from sales = $563.3 million

b. Other core income = $108.0 million (this is income from sales in subsidiaries but it is a net figure,

that is, sales minus expenses)

c. Core operating profit margin from sales = $563.3 million/$,=9,411.5 million = 5.99%.

d. Unusual items = $48.2 million

E12.9. Analysis of Changes in Operating Profitability: Home Depot, Inc.

First reformulate the statements, then carry out an analysis of profitability, followed up with an analysis of

the changes in profitability.

1. The reformulated statements:

Reformulated Income Statements, 2005 and 2004

($ millions)

2005 2004 Net sales 73,094 64,816 Cost of sales 48,664 44,236 Gross profit 24,430 20,580 Selling and store operating costs 15,105 12,588 General and administrative 1,399 16,504 1,146 13,734 Operating income from sales, before tax 7,926 6,846 Tax as reported 2,911 2,539

Tax benefit of net debt 5 2,916 1 2,540 Operating income from sales, after tax 5,010 4,306 Unusual operating income – currency gains Operating income

137 5,147

172 4,478

Interest expense 70 62 Interest income 56 59 Net interest expense 14 3 Tax on net interest 5 9 1 2 Comprehensive income 5,138 4,476

Note: Currency translations gains are after tax (as are all items in other comprehensive income). The tax rates for the allocation of taxes were calculated as follows (from the solution for Exercise 9.10 in Chapter 10): The tax rate for the tax allocation is the marginal tax rate. The footnote gives the effective

rate (36.8% for 2005), which is the effective rate from the income statement (2,911/7,912

= 36.8%). But this is not the marginal rate for it includes tax credits and foreign tax

benefits, amongst other things. The marginal rate is the statutory rate, federal and state

combined (with the state rate recognizing that state taxes are deductible in federal tax

returns). The statutory tax rates are given in the Exercise.

2005 2004 2003

Operating assets:

Operating cash 50 50 50

Receivable 1,499 1,097 1,072

Inventories 10,076 9,076 8,338

Other current assets 450 303 254

PPE (net) 22,726 20,063 17,168

Goodwill 1,394 833 575

Other assets 228 129 244

36,423 31,551 27,701

Operating liabilities:

Accounts payable 5,766 5,159 4,560

Accrued salaries 1,055 801 809

Sales tax payable 412 419 307

Deferred revenue 1,546 1,281 998

Income tax payable 161 175 227

Other accrued taxes 1,578 1,210 1,127

Deferred income tax 1,309 967 362

Other liabilities 763 653 491

12,590 10,665 8,881

Net operating assets 23,833 20,886 18,820

Net financial obligations:

Cash equivalents (456) (1,053) (2,138)

Short-term investments (1,659) (1,749) (65)

Notes receivable (369) (84) (107)

Current debt 11 509 7

Long-term debt 2,148 856 1,321

(325) (1521) (982)

Common equity 24,158 22,407 19,802

Averages:

Operating assets 33,987 29,626

Operating liabilities 11,628 9,773

Net operating assets 22,359 19,853

Net financial obligations (923) (1,252)


Reformulated Balance Sheets, 2003-2005

2. The operating profitability analysis (as in the solution to Exercise E 11.8 in Chapter 11, modified to distinguish core profitability):

2005 2004

ROCE 22.07% 21.21%

RNOA 23.02% 22.56%

PM 7.04% 6.91%

ATO 3.269 3.265

PM XATO 23.02% 22.56%

Core RNOA 22.41% 21.69%

UI/NOA 0.61% 0.87%

Income statement ratios:

Gross margin ratio 33.42% 31.75%

Selling expense ratio (20.67) (19.42)

G&A expense ratio (1.91) (1.77)

Operating PM before tax 10.84 10.56

Tax expense rationse ratio (3.99) (3.92)

Core PM from sales 6.85% 6.64%

Unusual operating income to sales 0.19 0.27

Operating PM 7.04% 6.91%

Note that the income statement ratios agregate to the PM.

Currency gains are unusual items (UI), outside core operating income. Turnover ratios (using average balance sheet amounts)

2005 2004

Asset turnover drivers ATO 1/ATO ATO 1/ATO

Accounts receivable turnover 56.31 0.018 59.77 0.017

Inventory turnover 7.63 0.131 7.44 0.134

PPE turnover 3.42 0.293 3.48 0.287

Other asset turnover 42.53 0.024 53.17 0.019

Operating asset turnover 2.15 0.465 2.19 0.457

Accounts payable turnover -13.38 (0.075) -13.34 (0.075)

Other liability turnover -11.86 (0.084) -13.19 (0.076)

3.27 0.306 3.26 0.306

Note that the sum of individual 1

ATOequals

1

ATO for all operating assets and liabilities.

1

ATO is the amount of the asset or liability that is put in place to support sales.

3. Analysis of Changes in Profitability ∆RNOA = ∆Core RNOA + ∆(UI/NOA) = 0.46% The increase in RNOA of 0.46% in 2005 was due to an increase in core profitability of 0.72% and a drop in the profitability effect of currency changes of 0.26%. ∆Core RNOA = (∆Core PM x ATO2004) + (∆ATO x Core PM2005) = (0.21% x 3.269) + (0.004 x 6.85%) = 0.69% + 0.03% = 0.72% (allow for rounding error) The increase in core profitability of 0.72% was due to an increase in core profit margin of 0.69% and a 0.03% effect from the increase in ATO. The reasons for the increase in core PM and ATO can be discovered by comparing the changes in expense ratios and individual ATOs above. E12.10. Explaining Changes in Income: US Airways

First prepare the reformulated income statements to distinguish core operating income from sales, other core income, unusual items and net financial expenses:

1998 1997

8,688 8,514

Personnel costs 3,101 3,179

Aviation fuel 623 805

Commissions 519 595

Aircraft rent 440 475

Other rent and landing fees 417 420

Aircraft maintenance 448 451

Other selling expenses 342 346

Depreciation and amortization 318 401

Other 1,466 1,258

Total operating expenses 7,674 7,930

1,014 584

Tax as reported 364 (353)

Tax benefit of debt (38%)1

43 56

Tax on unusual items 1 408 (73) (370)

606 954

1 30

607 984

Other income (4) 13

Gain on sale of interests in affiliates 0 180

(4) 193

Less tax (38%)2

1 (3) (73) 120

604 1,104

Net interest 112 148

Tax effect (38%)1

43 56

69 92

Preferred dividends 6 75 64 156

529 948

Core operating revenues

Core operating expenses

Core operating income before tax

Core operating income from sales

Operating income

Net financial expenses

Net income, adjusted3

Other core income: equity income in affiliates

Core operating income

Unusual items

Notes: 1. Marginal tax rate is assumed to be 38%.

2. Gains on sale of securities may be taxed at a lower capital gains tax rate.

3. Net income and net interest are before capitalized interest. ($3million in 1998 and $13 million in 1997).

(a) Explaining increase in before-tax operating income from $584 million to $1,014 million; standardizing for the increase in sales:

1998 1997

As a percentage of sales:

Personnel costs 35.7 37.3

Fuel 7.2 9.5

Commissions 6.0 7.0

Aircraft rent 5.1 5.6

Other rent and landing fees 4.8 4.9

Aircraft maintenance 5.2 5.3

Other selling expenses 3.9 4.1

Depreciation and amortization 3.7 4.7

Other expenses 16.9 14.8

Total core operating expenses 88.5 93.2

Core PM before tax 11.7 6.9

100.2 100.1

Operating expenses as a percentage of sales declined in 1998;

the largest declines were in personnel costs, commissions and depreciation and amortization. But "other

expenses" (for which there is limited information) increased. Note that operating income, as reported, does

not include all components of operating income. Gains on sale of shares in operating affiliates are also

operating income. But reported operating income does identify core income (before tax).

While core operating income increased before tax, it decreased after tax. The after-tax decrease

was due to negative taxes in 1997 (see below). One could classify the negative taxes in 1997 as an unusual

item.

(b) The decline in net income (on an increase in before-tax operating income) can be explained as

follows:

1. Transitory effect of negative taxes in 1997

2. Transitory gain on sale of shares of affiliates in 1997

3. Change in interest capitalization

4. Decrease in "other income"

5. Change in net financial expenses: a decrease in both after-tax net interest and

preferred dividends.

(c) The negative taxes with positive income seems strange. This could be due to

either:

1. Tax credits in 1997 from features of operations that are given credits; this is

unlikely for an airline.

2. Changes in deferred taxes.

The second reason was indeed the case. US Airways had accumulated tax

benefits from operating losses in the year prior to 1997. In 1997 it determined

that it was "more likely than not" that it would be able to utilize these tax

benefits in the future. So it reduced its previous valuation allowance on

deferred tax assets substantially.

The calculation of 1997 tax expense, relative to 1996, was as follows (in

thousands):

1997 1996

Federal $ 100,879 $ 6,423

State 7,680 3,000

Total current provision 108,559 9,423

Federal (406,571) -

State (54,651) 2,686

Total deferred provision (461,222) 2,686

$(352,663) $12,109

Current provision:

Deferred provision:

Provision (credit) for income taxes

You see that taxes were assessed but the change in the deferred tax provision

yielded negative taxes.

The accounting for the deferred tax asset in the exercise shows the change

in the valuation allowance. The change of $642 million should be treated as a

transitory item. Accordingly, the tax on core operating income would be

calculated as follows:

Tax on core operating income before unusual component (370)

Change in valuation allowance 642

Core tax on operating income 272

(d) 1998 income is more indicative of future income:

1. It is the more recent income year.

2. It has fewer transitory items.

E12.11. Analysis of Effects of Operating Leverage: US Airways

(a) The fixed and variable operating cost breakdown is:

Variable cost (VC) $3,636 million Fixed cost (FC) 4,038 $7,674 million

One measure of operating leverage is FC = 1.11 VC Another measure is OLEV = 4.98 (b) % change in core operating income = 4.98% That is, operating income will increase 4.98% for an increase in sales by 1%.

This can be proofed: 1% increase in sales $86.88 million Variable cost (at 41.9%) 36.40 Contribution Margin 50.48

Additional contribution as a % of operating income = 014,1

48.50 = 4.98%

(c) Breakeven occurs at the point where sales = fixed costs + variable costs, or where contribution margin equals fixed costs. As fixed costs are $4,038 million, that point is

Breakeven = 4,038/0.581 = $6,950 million of sales

where 0.581 is the contribution margin ratio (contribution margin/sales).

CHAPTER THIRTEEN

The Value of Operations and the Evaluation of Enterprise Price-to-Book Ratios and Price-Earnings Ratios

Drill Exercises

E13.1. Residual Earnings and Residual Operating Income Using beginning of period balance sheet amounts, Residual earnings (RE) = 900 – (0.12 × 5,000) = $300 million Residual operating income (ReOI) = 1,400 – (0.11 × 10,000) = $300 Residual financing expense (ReNFE) = 500 – (0.10 × 5,000) = 0

E13.2. Calculating Residual Operating Income and its Drivers

2006 2007 2008 2009

Operating income (OI) 187.00 200.09 214.10 229.08

Net operating assets (NOA) 1,214.45 1,299.46 1,390.42 1,487.75

RNOA (%) 16.48 16.48 16.48

Residual operating income (ReOI) 77.48 82.90 88.71

Growth rate for NOA 7.0% 7.0% 7.0% E13.3. Calculating Abnormal Operating Income Growth The long-hand method: 2006 2007 2008 2009

Operating income (OI) 187.00 200.09 214.10 229.08 Net operating assets (NOA) 1,214.45 1299.46 1,390.42 1,487.75

Free cash flow (C-I = OI - ∆ NOA) 107.55 115.08 123.31 131.76

Income from reinvested free cash flow (at 10.1%) 10.86 11.62 12.45 Cum-dividend OI 210.95 225.72 241.53 Normal OI 205.89 220.30 235.72 Abnormal OI Growth (AOIG) 5.06 5.42 5.81

The short hand method: AOIG = ∆ReOI, so just calculate the changes in ReOI from the ReOI calculated in Exercise E13.2. 2007 2008 2009 Residual operating income (ReOI) 77.48 82.90 88.71

Abnormal operating income growth (AOIG) 5.42 5.81 (As there is no ReOI for 2006, the ∆ReOI cannot be calculated for 2007)

E13.4. Residual Operating Income and Abnormal Operating Income Growth

2009 2008 Residual operating income 2,700 - (0.10 × 20,000) 2,300 – (0.10 × 18,500) (ReOI) = 700 = 450 Abnormal operating income growth (AOIG = ∆ReOI) 250 E13.5. Cost of Capital Calculations By CAPM, Equity cost of capital = 4.3% + [1.3 × 5.0%] = 10.8% Debt cost of capital = 7.5% × (1- 0.36) = 4.8% Equity cost of capital 10.8% Cost of capital for debt 4.8% (after tax) Market value of equity $2,361 million ($40.70 x 58 million) Net financial obligations 1,750 Market value of operations 4,111

Cost of capital for operations (WACC) = %25.8%8.4`111,4

750,1%8.10

111,4

361,2=

×+

×

E13.6. Calculating the Required Return for Equity = 11.47% E13.7. Residual Operating Income Valuation This carries Exercise E13.2 over to valuation.

2005A 2006E 2007E 2008E 2009E


Net operating assets (NOA) 1,135 1,214.45 1,299.46 1,390.42 1,487.75

RNOA (%) 16.48 16.48 16.48 16.48

Residual operating income (ReOI) 72.37 77.48 82.90 88.71

Discount rate (1.101t ) 1.101 1.212 1.335 1.469

PV of ReOI 65.73 63.91 62.12 60.37

Total PV of ReOI 253

Continuing value (CV) 3061.93

PV of CV 2,084

Value of NOA 3,472

Book value of NFO 720

Value of equity 2,752

The continuing value calculation:

CV = 07.1101.1

07.171.88

−

× = 3,061.93

PV of CV = 469.1

93.061,3 = 2,084.36

As ReOI is growing at 7% from 2007 to 2009, this is extrapolated into the future as the long-term growth rate. (Allow for rounding errors)

Residual operating income (ReOI) is OIt – (ρF – 1)NOAt-1. So, for 2006, ReOI = 187.00 – (0.101 x 1,135) = 72.37

E13.8. Abnormal Operating Income Growth Valuation This extends Exercises E13.2 and E13.3 to valuation.

2005A 2006E 2007E 2008E 2009E


Net operating assets (NOA) 1,135 1,214.45 1,299.46 1,390.4of CV2

1,487.75

RNOA (%) 16.48 16.48 16.48 16.48

Residual operating income (ReOI) 72.37 77.48 82.90 88.71

Abnormal operating income growth (AOIG) 5.06 5.42 5.81

In this calculation, AOIG is just the change in ReOI. One can also calculate AOIG as follows, and proceed from there to the valuation:

2005A 2006E 2007E 2008E 2009E

Operating income (OI) 187.00 200.09 214.10 229.08 Net operating assets (NOA) 1,135 1,214.45 1299.46 1,390.42 1,487.75

Free cash flow (C-I = OI - ∆ NOA) 107.55 115.08 123.31 131.76

Income from reinvested free cash flow (at 10.1%) 10.86 11.62 12.45 Cum-dividend OI 210.95 225.72 241.53 Normal OI 205.89 220.30 235.72 Abnormal OI Growth (AOIG) 5.06 5.42 5.81 Discount rate 1.101 1.212 1.335 PV of AOIG 4.60 4.46 4.35 Total PV of AOIG 13.41 Continuing value 200.54 PV of continuing value 150.22 Forward OI for 1997 87.00 350.63 Capitalization rate 0.101 Value of operations 3,472 ↵

Book value of NFO 720 Value of equity 2,752

The continuing value calculation:

54.200

07.1101.1

07.181.5=

−

×=CV

Present value of CV:

PV of CV = 22.150335.1

54.200=

As AOIG is growing at 7% from 2007 to 2009, this is extrapolated into the future as the

long-term growth rate. Note that ReOI is also growing at 7%: if ReOI grows at 7%, then

AOIG must also grow at 7%.

The calculations above are as follows: Income from reinvested free cash flow is prior year’s free cash flow earning at the required return of 10.1%. So, for 2007, income from reinvested free cash flow is 0.101 x 107.55 = 10.86. Cum -dividend OI is operating income plus income from reinvesting free cash flow. So, for 2007, cum-dividend OI is 200.09 + 10.86 = 210.95. Normal OI is prior years operating income growing at the required return. So, for 2007, normal OI is 187.00 x 1.101 = 205.89.

Abnormal OI growth (AOIG) is cum-dividend OI minus normal OI. So, for 2007,

AOIG is 210.95 – 205.89 = 5.06. AOIG is also given by OIt-1 × (Gt - ρF). So, for 2007,

AOIG is (1.1281 – 1.101) × 187.00 = 5.06. But AOIG is also always equal to the change on ReOI. E13.9 Growth, the Cost of Capital, and the Normal P/E Ratio

(a) The repurchase was at fair value (value received was equal to value

surrendered). So there is no effect on value. More technically, the value

of the equity is driven by the value of the operations and the value of the

operations did not change. The total dollar value of the equity changed,

but not the per-share value.

(b) The $10.00 million is operating income (from operations) with no debt

service. The net financial expense increased to $2.50 million due to the

new debt, reducing earnings (to the equity) to $7.5 million.

(c) Although forecasted earnings decreased to $7.5 million, shares

outstanding dropped from 10 million to 5 million, increasing eps: stock

repurchases increase eps (providing leverage is favorable).

(d) The required return for the equity is given by the following calculation:

Required Equity Return = Required Return for Operations

+ (Market Leverage × Required Return Spread)

where

Market Leverage = Equity of Value

DebtNet of Value

Required Return Spread = Required Return for Operations -

After- tax Cost of Debt

So, after the stock repurchase,

Required return for equity = 10% + ( )

−× %5%10

$50million

50million $ = 15%

(e) The expected ROCE for Year 1 is 15%, an increase over the 10% before

the repurchase. As the required return was 15%, the expected residual

earnings is zero – as must be the case for the equity is worth its book

value.

(f) The case with leverage:

The equity must be worth its book value (as expected residual operating

income for years after Year 1 is zero), and expected Year 1 book value, is

$57.50 million, or $11.50 per share.

The case with no leverage:

Again, the value of the equity must be worth its book value, $110.0

million, or $11.00 per share.

The leverage case gives a higher expected price per share (target

price) at the end of Year 1, so it looks as if leverage has added value. But,

the expected price must be higher in the leverage case to yield a higher

expected return to compensate for the higher risk of not getting the

expected price. Equity value is always expected to grow at the required

equity return (before dividends). In the leverage case, Year 0 per-share

value is $10.00 and the required return is 15%, giving an expected Year 1

value of 11.50 ($10.00 x 1.15). In the no leverage case, Year 0 per-share

value is also $10.00, but the required return is only 10%, giving an

expected Year 1 value of $11.00 ($10.00 x 1.10). In both cases, the present

value of the expected Year 1 price is $10.00, discounting with the

(leverage) risk adjusted discount rate.

Note that the value of the equity in the leverage case is expected to

grow at 14.6% in Year 2 because that is the required return for equity at

the beginning of Year 2: financial leverage has changed over Year 1,

changing the required return. Note that the ROCE for Year 2 is 14.6%

also, giving expected residual earnings of zero for Year 2. Do you see

how accounting data and required returns fit together?

(g) For the leverage case:

The eps in Year 1 is expected to be $1.50 and the price-per-share is

expected to be $11.50. So the P/E is 7.67. This P/E is appropriate for a

normal P/E. The required equity return is 15%. (after the stock

repurchase) and so the normal P/E is =15.0

15.17.67.

For the no-leverage case:

Eps in Year 1 are expected to be $1.00 and the price $11.00. So the P/E is

expected to be 11.0. This is a normal P/E for a required return of 10%.

Why are the two P/Es different? Well, they are both normal P/Es, so

earnings growth is expected at a rate equal to the required return. But the

required equity return is different, and P/E ratios are based on both

expected growth and the required return.

E13.10 Levered and Unlevered P/B and P/E

Value of the equity = $233 × 2.9 = $675.7

Value of the operations = $675.7 + 236 = $911.7

(a) Levered P/E = 675.7/56 = 12.07 (no dividends)

(b) Enterprise P/B = 911.7/469 = 1.94

Enterprise P/E = (VNOA + FCF)/ OI

What was the free cash flow? Free cash flow is equal to

C – I = NFE - ∆NFO + dividends = 14

Thus, Enterprise P/E = 13.22

You might prove that the levered and unlevered multiples reconcile according to

equations 13.10, 13.11, and 13.12 in the text. (The net borrowing cost (NBC) = 5.93%).

E13.11. Levered and Unlevered P/E Ratios

First value the firm from forecasted residual operating income or abnormal operating

income growth:

2009A 2010E 2011E 2012E

Residual operat ing income 18 18 18

Abnormal operating income growth 0 0

PV of ReOI(18/0.09) 200

Net operating assets 1300

Value of operations 1500

Net financial obligat ions 300

Value of equity 1200

Forecasted free cash flow: 135 135 135

OI-�NOA

Forecasted div idend: 120 120 120

d=Earnings - �CSE

(a) Forecasted value of oper ations 1,500 1,500 1,500

Forecasted value of equi ty 1,200 1,200 1,200

(b) Levered P/E ratio 11.00 11.00 11.00

Unlevered P/E ratio 12.11 12.11 12.11

The forecasted residual operating income is expected to be a perpetuity of $18

million, and net operating assets are expected to be $1,300 always. So the value of the

operations is expected to be 1,300 +

09.0

18=1,500 in all years. The "cum-dividend"

value of the operations in 2010 is expected to be 1,500 + free cash flow = 1,500 + 135 =

1,635. So the "cum-dividend" value is growing at the required return of 9% (and so on

for subsequent years).

The value of the operations can also be calculated using the abnormal earnings

growth method. As residual earnings are not forecasted to grow, abnormal operating

income growth (AOIG) is forecasted to be zero. Accordingly, the value of the operations

in calculated by capitalizing forward operating income:

NOAV = 135/0.09 = 1,500

and so for all years.

The value of the equity is (with similar reasoning) expected to remain at $1,200.

The cum-dividend equity value in 2010 is expected to be 1,200 + 120 = $1,320

The levered and unlevered trailing P/E ratios are calculated using these cum-

dividend (dividend-adjusted) values:

Unlevered Trailing P/E = 12.11

This P/E is a normal for a cost of capital for operations of 9%: 11.1209.0

09.1= .

The unlevered forward P/E is:

Unlevered Forward P/E = 11.11

This is normal for a cost of capital of 9%: 09.0

1= 11.11. Normal unlevered P/E’s are

appropriate because residual operating income is forecasted to be constant and abnormal

operating income growth is zero.

Now to the levered P/E:

Trailing Levered P/E = 11.0

This is a normal P/E for a cost of capital of 10%.

Forward Levered P/E = 10

This is a normal P/E for a cost of capital of 10%.

(c) As earnings are expected to be constant (at $1,000 million), residual

earnings (on equity) must also be constant. So the levered P/E is a normal

P/E. For a normal P/E of 11.0, the equity cost of capital is 10%.

You can prove this with the calculation:

Required equity return = ( ) %10%5%9200,1

300%9 =

−×+

Applications

E13.12. The Quality of Carrying Values for Equity Investments: SunTrust Bank

Sun Trust Banks acquired the Coke shares many years earlier. The historical cost of

$110 million is a poor indicator of their value. The current market value of $1,077

million is a better quality number. But beware: was the market value an efficient price,

or was Coke undervalued or overvalued in the market? Would we accept the market

value of Coke’s shares during the bubble of 1997-2000 as fair value? Coke was a hot

stock then whose market price subsequently declined.

E13.13. Using Market Values in the Balance Sheet: Penzoil

The investment in Chevron is an operating asset and the income from the investment is operating income. But the income reported from the investment is in the form of dividends and unrealized gains and losses, neither of which is very informative about the value of the Chevron shares. The fair value is, however.

So, to value PennzEnergy, include the Chevron shares in net operating

assets at market value and apply the residual operating income model to the rest

of the operations. Calculate residual operating income by excluding Chevron

dividends and unrealzed gains from operating income and exclude the Chevron

investments from the NOA to be charged at the cost of capital:

Value of PennzEnergy’s operations

= Net operating assets + Present value of residual earnings from operations other than the Chevron investment.

The ReOI adjusted for the Chevron investment is: Operating income before Chevron dividends and unrealized gains

- [cost of capital for operations x (NOA – Fair Value of Chevron investments)]

This applies the principle that forecasting is not required for assets at fair value on the balance sheet.

Note: This evaluation does assume that the fair (market) value of Chevron’s shares is an “efficient”

one.

E13.14. Enterprise Multiples for IBM Corporation

Here are the totals for IBM’s balance sheet, first with book values and then with market values:

Book Value Market Value

Net operating assets (NOA) 48,089 160,909

Net financial obligation (NFO) 19,619 19,619

Common equity (CSE) 28,470 1,385.2 × $102 = 141,290

The amounts for NOA and the market value of NOA are obtained by adding NFO back to CSE. The book value of NFO is considered to be the market value.

a. Levered P/B = 4.96

Unlevered (enterprise) P/B = 3.35

Leverage explains the difference according to the formula,

Levered P/B = Unlevered P/B + FLEV × [Unlevered P/B – 1.0] 4.96 = 3.35 + (0.689 × 2.35)

b. Forward levered P/E = 11.68

To get the unlevered P/E, first calculate forward OI:

Earnings forecast for 2008: $8.73 × 1,385.2 shares $12,092.8

Net financial expense for 2008: $19,619 × 3.3% 647.4

Forward operating income $12,740.2

Forward unlevered (enterprise) P/E = $160,909/$12,740 = 12.63

E13.15. Residual Operating Income and Enterprise Multiples: General Mills, Inc.

Free cash flow = 1,351

a. ReOI (2008) = 1,188

b. Market value of equity = $60 × 337.5 shares = 20,250 Net financial obligations 6,458 Minority interest ($242 × 3.26) 789 Enterprise market value 27,497

(Minority interest is valued at book value multiplied by the P.B ratio for common equity). Enterprise P/B = 27,497/12,847 = 2.14

c. (This question is not in all printings of the book)

Trailing P/E = E

dP +

The trailing P/E is usually calculated on a per-share basis, with dividends being dividends per share. Per-share amounts are not giving in the Exhibits, but one can calculate a P/E on a total dollar basis, with the dividend being the net dividend. The net dividend = Comprehensive income – ∆CSE = 752. So the trailing P/E is

649,1

752250,20 += = 12.74

On the required return: The WACC number calculated in Box 13.2 uses a number of inputs that give one pause (see Box 13.3):

- market values are used for the weighting, but it is market value that valuation tries to challenge. One is building the speculation in price into the calculation.

- Market risk premiums used to get the equity required return (5% here) are just a guess. More speculation.

- Betas are estimated with error. Does 5.4% seem a lit low? It’s only 1.4% above the risk-free rate (of 4% in Box 13.2). This is a low beta firm, but surely less risky high-grade bonds would yield more? E13.16. Calculating Residual Operating Income: Dell Computer NOA, beginning of year = 13,230 – 20,439 = -7,209 (NOA are negative)

ReOI = OI – (0.12 x NOA)

= 3,483 Because Dell’s NOA were negative, its ReOI is greater than is operating income. Dell generated value in operations from

(1) Operating income of $1,325 million (sales less operating expenses in

trading with customers)

(2) A negative investment in NOA: shareholders earned 12% on operating

debt in excess of operating assets. (Operating creditors financed operating

assets and more). Dell used other people’s money. See Chapter 9 for

coverage of Dell.

Further analysis of the drivers of residual operating income would involve analysis of profit margins and asset turnovers.

E13.17. Residual Operating Income Valuation: Nike, Inc., 2004 Here are the totals for Nike’s balance sheet at the end of 2004, first with book values and then with market values:

Book Value Market Value

Net operating assets (NOA) 4,551 19,444

Net financial assets (NFA) 289 289

Common equity (CSE) 4,840 263.1 × $75 = 19,733

The amount for the market value of NOA is obtained by subtracting NFA from the market value of CSE. The book value of NFO is considered to be the market value.

a. Levered P/B = 4.08

Unlevered (enterprise) P/B = 4.27

b. ReOI = 588.6

c. RNOA = 22.19%

d. OI for 2005 = NOA at the end of 2004 × Forecasted RNOA

= 1,010

ReOI for 2005 = 618.6

d. If ReOI is expected to be constant for 2005 onwards, the value is

g

OICSEV

F

E

−+=

ρ2005

20042004

Re

04.1086.1

6.618840,42004 −

+=EV = $18,287.8 or $69.51 per share

E13.18. Valuation of Operations: Nike, Inc., 2005

(a)

Analysts’ eps forecast Shares outstanding Analysts’ earnings forecast Forecast of net financial income

1,012 × 0.032 Forecast operating income

Forecasted RNOA = 1,294/4,632

(using beginning-of-year NOA)

$5.08 261.1 million

$1,326.4 million

32.4 $1,294.0 million

27.94%

(b) [ ] million8.6% - 27.94% ReOI Forecasted 6.895632,4 =×=

Value = $25,114 million, or $96.18 per share (c) If ReOI is to grow at 4%, then abnormal operating income growth will also grow at

at 4%, and the formula for calculating the value of the equity will be

Value of equity =

−+

− g

AOIGOI

FF ρρ2

11

1+ NFA

where g is the forecasted growth rate of 4%.

First calculate AOIG two years ahead (2007). There are two methods for doing this.

Method 1: Difference between cum-FCF OI for 2007 minus normal OI for 2007

Forecast of OI for 2007 = NOA2006 × RNOA2007

NOA2006 = 4,817.3

OI2007 = 1,345.9

FCF2006 = 1,108.7

AOIG2007 = $35.95 million

Method 2 (much simpler!): AOIG is growth in residual operating income from the

previous year

AOIG2007 = 35.82 (allow for rounding error)

Accordingly, the valuation is:

Value of equity = $25,113 million or $96.18per share

(d) Value of operations = $24,101 million (e) ReOI is driven by RNOA and growth in net operating assets. So, if RNOA is

forecasted to be constant, net operating assets must be forecasted to grow at 4% per year.

(f) Forward enterprise P/E = $24,101/$1,294 = 18.63

Forward levered P/E = $25,113/$1,326.4 = 18.93

(ELEV1 = NFE/Earnings = -32.4/1,326.4 = -0.0244

(g) Stock repurchases change financial leverage; in this case, Nike liquidated its financial

assets to pay for the stock repurchase. Operating income will not be affected because

NOA are not affected by stock repurchase. With fewer shares outstanding, eps will

increase, as the denominator effect (fewer shares) overwhelms the number effect (loss in

interest income on the financial assets). The only exception is the case where financing

leverage is unfavorable (RNOA less than RNFA). Also, the expected eps growth rate

will increase. But, if the share repurchase is at fair market value, price will not change.

See Boxes 13.5 and 13.6.

E13.19 Stock Repurchases: Expedia, Inc.

a. EPS and the EPS growth rate are likely to increase. See Box 13.5.

b. Risk increases for shareholders. See the reversed WACC formula in equation

13.8: the required return for operations does not change, but the increase in

leverage increases the required return for equity.

c. If repurchases are made at fair value, they cannot add to the per-share value.

However, if the firm pays less than fair value (buying the shares cheaply), it will

add value for shareholders (who did not sell their shares). See Box 13.6. A P/E of

26 looks high; if Expedia is overpaying, then it is losing value for shareholders.

d. No. Management can increase EPS with a stock repurchase but not add value for

shareholders, yet get a bonus.

CHAPTER FOURTEEN

Anchoring on the Financial Statements: Simple Forecasting and Simple Valuation

Drill Exercises

E14.1. An SF2 Forecast and a Simple Valuation a. ReOI2010 = $35.7 million Therefore, OI2010 = $161.4 million b. With ReOI2010 forecasted to be a constant, an SF2 valuation applies: = $1,614 million Forward (enterprise) P/E = 10.0 Constant ReOI (and an SF2 valuation) implies a normal P/E ratio for a 10% required return) E14.2. An SF3 Forecast and a Simple Valuation

a. Core RNOA2009 = 990/9,400 = 10.53%. This is the SF3 forecast of RNOA for 2010.

SF3 forecast of OI for 2010 = $1,019.5 million

b. Growth rate for NOA in 2009 = 9,682/9400 = 1.03 (3%) ReOI2010 = 1,019.5 – (0.09 × 9,682) = 148.12 An SF3 valuation applies the NOA growth rate from the financial statements:

= $10,153.7 million Enterprise value = 12,140.7 Enterprise P/B = 12,140.7/9,682 = 1.25

E14.3. Two-Stage Growth Valuation Free cash flow for 2010 = 334 Reinvested FCF for 2008 =334 × 0.09 = 30.06 OI for 2011 = 868.00 Cum-dividend OI for 2011 898.06 Cum-div OI growth rate for 2011 = 898.06/782 = 1.1484 (14.84%)

a. = $18,837.5 million Value of equity = Enterprise value – NFO = $18,081.5 million b. Forward enterprise P/ = 24.09 (This is equal to the term that multiplies the forward earnings of 782 in Part b)

E14.4. Reverse Engineering Reverse engineer the SF3 formula:

g

gRNOANOAP

F

NOA

−

−−×=

ρ)1(1

The solution for the expected return is ρ = 1.1287 (12.87%) The following formula gives the solution for the expected return:

−×

−+

×= )1(1 gP

NOARNOAForecasted

P

NOAreturnExpected

NOANOA (equation 14.8)

= 12.87% (Note: this is the expected return for investing in the firm, not the (levered( return for investing in the stock) E14.5. Reverse Engineering with Two-stage Growth Rates a. Free cash flow for 2010 = 334

Reinvested FCF for 2008 =334 × 0.09 = 30.06 OI for 2011 = 868.00 Cum-dividend OI for 2011 898.06 Cum-div OI growth rate for 2011 = 898.06/782 = 1.1484 (14.84%)

b. Use the two stage growth valuation formula:

−

−

−×=

longF

long

F

NOA

G

GGOIV

ρρ2

101

1

Set VNOA equal to the current enterprise price, 756 + ($52 × 450) = $24,156 million:

24,156 =

−

−×

g

g

09.1

1484.1

09.0

1782

Thus, g = 1.057, a growth rate of 5.7%

The market is forecasting a 5.7% growth rate while you are forecasting a growth rate

of 4%. The stock looks expensive to you.

(The solution can also be obtained by plugging in your forecasts and comparing the

intrinsic value they imply with the market price.)

E14.6. Simple Valuation with Sales Growth Rates If RNOA is constant and ATO is also constant, the growth rate for ReOI is given by the

sales growth rate. So,

−

−−×=

g

gRNOANOAV

F

NOA

ρ)1(

0

Hence, the enterprise P/B ratio = 05.1095.1

05.1155.0

−

−

= 2.33 E.14.7 Simple Forecasting and Valuation

(a) Residual operating income (ReOI) is

91.4 = (12% - required return) × 4,572

So required return = 10%

(b) Value of equity = $4,243 million

(c) Required return for equity = 11.17%

So the comprehensive earnings forecast for 2008 is

Operating income 548.6 (4,572 × 12%)

Net financial expense 74.6 (1,243 × 6%)

Comprehensive 474.0

The residual earnings forecast is

RE = 474.0 - (0.1117 × 3,329) = 102.2

Applications

E14.8. Simple Valuation for General Mills, Inc.

a. An SF2 valuation forecasts ReOI for 2009 as the same as Core ReOI for 2008.

ReOI2008 = 1,560 – (0.08 × 12,297) = 576.2

One can also forecast the ReOI for 2009 by forecasting OI for 2009 as an SF2

forecast:

OI2009 = 1,604

ReoI2009 = 576.2

The SF2 valuation:

08.0

2.576216,62008 +=E

V

= $13,418.5 million or $39.76 per share

b. The SF3 forecast of OI for 2009 in NOA at the end of 2008 earning at the core

RNOA rate:

Core RNOA2008 = 1,560/12,297 = 12.69%

OI2009 = 12,847 × 0.1269 = 1,630.3

ReOI2009 = 1,630.3 – (0.08 × 12,847) = 602.5

ReOI2009 can also be calculated by growing ReOI2008 by the NOA growth rate

for 2008:

NOA growth rate for 2008 = 12,847/12,297 = 4.47%

ReOI2009 = 576.2 × 1.0447 = 602.5 (allow for rounding error)

The SF3 valuation applies the NOA growth rate in 2008 as ReOI growth:

0447.108.1

5.602216,62008 −

+=EV

= $23,285 million or $68.99 per share

The SF3 valuation can also be calculated by applying the enterprise P/B multiplier

to NOA, as in model 14.3a:

−

−−×=

g

gRNOACoreNOAV

F

NOA

ρ)1(

0

−

−×=

0447.108.1

0447.01269.0847,120

NOAV

= 12,847 × 2.329

= 29,916

NFO 6,631 (NOA – CSE)

VE 23,285 or $68.99 per share

E14.9. Simple Valuation for Coca-Cola Company

a.

2005 2004 2003 2002

Core PM (CoreOI/Sales) 21.40% 22.40% 21.30% 22.10%

ATO (Sales/NOA)* 1.395 1.382 1.397

Core RNOA (PM × ATO) 29.85% 30.96% 29.76%

* On beginning-of-year NOA

b.

Sales growth rate 6.26% 4.24% 6.61%

Average sales growth rate 5.70%

c.

Enterprise value is given by the SF3 multiplier formula:

−

−−×=

g

gRNOACoreNOAV

F

NOA

ρ)1(

0

NOA = $16,945 + 1,010 = $17,955

Set Core RNOA = 29.85% (as in 2005; one can also use average of 30.19% for 2003-05)

Set growth (g) = average sales growth rate

= 5.70% (this is NOA growth rate with constant ATO)

−

−×=

057.110.1

057.02985.0955,170

NOAV

= $100,840 million

NFO 1,010

VE $ 99,830 or 42.14 per share on 2,369 million shares

E14.10. Reverse Engineering for Starbucks Corporation

a.

(1) Core operating PM = 671 / 9,412 = 7.13 %

(2) Core RNOA = 671/ 2,565 = 26.16 %

(3) ATO = 9,412/2,565 = 3.669

(4) NOA growth rate = 3,093/2,565 – 1 = 20.58%

Operating income, 2008 = NOA2007 x Core RNOA2007

= 809.4

b.

ReoI2008 = (0.2616 – 0.09) x 3,093

= 530.8

(One can also get the number by forecasting OI2008 = NOA2007 × 0.2616)

c.

Market price of equity = $20 x 738.3 million shares = 14,766

The reverse engineering problem:

g−

+=09.1

8.530178,2766,14

g = 1.048 (a growth rate of 4.8 %)

d,

Now reverse engineer the SF3 model for the expected return: Solve for ρ:

−

−−×=

g

gRNOANOAP

F

NOA

ρ)1(

0

The formula is:

−×

−+

×= )1(1 gP

NOARNOAForecasted

P

NOAreturnExpected

NOANOA (eq. 14.8)

Enterprise price = Equity price + NFO = 15,681

Enterprise book/price = 0.197

[ ] [ ]%5.3803.0%16.26197.0 ×+×=returnExpected

= 7.96%

E14.11. A Simple Valuation and Reverse Engineering: IBM a. OI2005 = $7,915.6 million ReOI2005 = $2,736.8 million

b.

−

−×=

088.1123.1

088.0188.0104,422004

EV - 12,357

= 120,298 -12,357.0 = $107,941 million or $65.59 per share on 1,645.6 million shares Forward enterprise P/E = 120,298/7,915.6 = 15.20 Enterprise P/B ratio = 120,298/42,104 = 2.86 (the amount in the square brackets above)

a. Set VE = $95 × 1,645.6 million shares = $156,332 million:

$156,332 = 42,104 × 088.1

088.0188.0

−

−

ρ - 12,357

The solution for ρ, the expected return, is 1.1130 (an 11.3% return) This expected return is less than the required return, so the stock is expensive. Note that the expected return is solved with the following formula (equation 14.8)

E14.12. A Simple Valuation with Short-term and Long-term Growth Rates: Cisco Systems

Pro forma Cisco as follows:

2003 2004

Eps 0.54 0.61

Dps 0.00 Reinvested dividends 0.00

Cum-dividend earnings 0.61 Cum-div growth rate (G2) 12.96% Long-term growth (Glong) 4.0% Applying the two-stage growth formula:

−

−

−×=

longF

long

F

NOA

G

GGOIV

ρρ2

120021

1

= $10.75 per share (The forward P/E is 19.9). This valuation is less than the market price of $15. The

market is pricing Cisco at a forward P/E of 15/0.54 = 27.8. So the market implicitly is

seeing long-term growth in excess of 4% (if the required return is 9%) if one takes

analysts forecasts for 2003 and 2004 as sound estimates.

E14.13. Comparing Simple Forecasts with Analysts’ Forecasts: Home Depot Inc.

A summary of the reformulated balance sheets is given in the exercise, but the

income statement has to be reformulated to identify core operating income:

Reformulated Income Statements, Fiscal Year Ended January 30, 2003 –

2005 ($ millions)

2005 2004 2003

Net sales 73,094 64,816 58,247

Cost of sales 48,664 44,236 40,139

Gross profit 24,430 20,580 18,108

Selling and store operating costs 15,105 12,588 11,276

General and administrative 1,399 16,504 1,146 13,734 1,002 12,278

Core operating income before tax 7,926 6,846 5,830

Tax as reported 2,911 2,539 2,208

Tax benefit of net debt 5 2,916 1 2,540 (16) 2,192

Core operating income after tax 5,010 4,306 3,638

Interest expense 70 62 37

Interest income 56 59 79

Net interest expense 14 3 (42)

Tax on net interest (37.7%) 5 (9) 1 (2) 16 26

Net income 5,001 4,304 3,664

Calculate Core RNOA, NOA growth and return on net financial assets (RNFA) from the

financial statements:

Core RNOA2005 = 5,010/22,356 = 22.41% (using average NOA)

NOA Growth2005 = 323,833/20,886 = 1.1411 (a 14.11% growth rate)

RNFA2005 = 9/923 = 0.98%

(The RNFA looks a bit low; there was a considerable change in NFA over the prior and

the average of beginning and ending balances is a crude average. But financial income is

a very small component of net earnings.)

Here are the forecast of OI for 2006 and 2007 based on the financial statements:

2006 2007

OI for 2006: NOA2005 × Core RNOA2005

23,833 × 0.2241 $5,341 OI for 2007: NOA2006 × Core NOA2005 27,196 × 0.2241 $6,095 Net interest income for 2006: NFA2005 × RNFA2005

325 × 0.0098 3 0 Net income forecast $5,344 $6,095

EPS (on 2,185 million shares) $2.45 $2.79

Analysts’ Forecasts 2.59 2.93

Note: NOA2006 = NOA2005 × NOA Growth2005 = 23833 x 1.1411 = 27,196 The net interest income for 2007 is set to zero One could also calculated Core RNOA and NOA based on averages over 2003-2005.

The forecasts from the financial statements are a little below those for the analysts. Either analysts have more information (outside the financial statements) or are being too optimistic. It is always good to check an analyst’s against what you get from the financial statements and ask: Why are they different?

Postscript:

One can also forecast from the financial statements by applying the 2005 sales growth

rate of 12.77% and converting forecasted sales into operating income at the 2005 core

PM of 6.85%. So,

2006 2007

Sales, 2006: $73,094 ×1.1277 $82,428

Sales, 2007: $82,429 × 1.1277 $92,954

Core PM, 2005 0.0685 0.0685

Operating income $5,646 $6,367

Net interest income 3 0

Net income $5,649 $6,367

EPS $2.59 $2.91

These forecast s almost precisely the same as the analysts’ forecasts.

E14.14. Valuation Grid and Reverse Engineering for Home Depot Inc.

a. First calculate the market price of the operations, for it is this number we are

challenging.

Market price of equity: $42 x 2,185 million shares = $91,770 million

Net financial assets 325

PNOA $92,095 million

Now, with Core RNOA = 22.41%, reverse engineer to the growth rate from this market

valuation using the formula:

−

−−×=

g

gRNOACoreNOAV

F

NOA

ρ)1(

00

Students have to choose a required return for the operations. The solution here uses 9%.

−

−×==

g

gV

NOA

09.1

2241.1833,23095,922005

Solving, g = 1.043 or a = 4.3% growth rate (approx), a little higher than the GDP growth

rate.

Note: the following version of the formula can also be reversed engineered:

g

NOACoreRNOANOAV

F

FNOA

−

−−+=

ρρ 01

00

)1(

b. Now reverse the simple valuation model for the expected return:

−

−×==

04.1

04.12241.1833,23095,922005 ρ

NOAV

The solution for the expected return is 8.745%. The formula (equation 14.8) is:

−×

−+

×= )1(1 gP

NOARNOAForecasted

P

NOAreturnExpected

NOANOA

c. Using a required return of 9%, model alternative scenarios and identify those that are consistent with the current price. For example, an RNOA of 18% with an NOA growth rate of 5% will justify the price for the operations (approximately):

−

−×=

06.109.1

06.018.0833,232005

NOAV = $95,332

Adding the NFA of $325 yield an equity value of $95,657 and a value per share of

$43.78.

Clearly, there a number of combinations of RNOA and g that will yield the current

market price. A full valuation grid gives these scenarios and the analyst can ask

whether these are reasonable scenarios with some probability. The following grid

gives enterprise value (in billions of dollars) for different combinations of growth in

sales and RNOA. Some cells are filled in, but the grid in easily completed.

Valuation Grid (per share)

RNOA Growth in NOA

14%

16%

18%

19%

20%

22%

23%

2%

4%

39.42

5%

35.60

6%

43.78

7%

Postscript: A grid can also be prepared for the expected return under alternative forecasts of RNOA

and growth. If the analyst has a relatively firm idea of RNOA and growth, the expected

return from investing at the market price can be estimated as in Part b of the Exercise:

−×

−+

×= )1(1 gP

NOARNOAForecasted

P

NOAreturnExpected

NOANOA

The grid takes the following form:

Expected Return Grid

RNOA Growth in NOA

14%

16%

18%

19%

20%

22%

23%

2%

4%

5%

8.9%

6%

7%

The 8.9% expected return for a 20% RNOA forecast and a 5% NOA growth rate is

indicated here. Fill out the expected returns for other combinations.

CHAPTER FIFTEEN

Full-Information Forecasting, Valuation, and Business Strategy Analysis

Drill Exercises

E15.1. A One-Stop Forecast of Residual Operating Income

a.

The one-stop formula is:

= 11.600

Proof:

OI = 1,276 ×0.05 = 63.8

NOA = 1,276/2.2 = 580

ReOI = 63.8 – (0.09 × 580) = 11.6

b.

00

2.2

09.0045.0276,1Re ++

−×=OI

= 5.220

c.

The calculation in the square must be negative to yield negative ReOI. So a PM less than

4.0909% will yield negative ReOI.

E15.2. A Revised Valuation: PPE, Inc.

The revised pro forma:

Year 0 Year 1 Year 2 Year 3

Sales (growing at 6%) 124.9 132.39 140.34 148.76 Operating income (PM = 0.07) 9.80 9.27 9.82 10.41 NOA 74.42 73.86 78.29 82.99 ReOI (11.34% charge) 0.894 0.942 0.999 Growth rate for ReOI 5.4% 6.0% OI = Sales x 0.07 NOA = Sales one year ahead/1.9 Sales, OI, NOA, and ReOI will grow at 6% after Year 3: constant ATO and PM. a.

Value of Equity = 1134.1)06.11134.1(

942.0

1134.1

894.072.66

×−++

= 83.37 (or $0.83 per share) b. Extending the pro forma: Year 0 Year 1 Year 2 Year 3

Sales (growing at 6%) 124.9 132.39 140.34 148.76 Operating income (PM = 0.07) 9.80 9.27 9.82 10.41 Net financial income (expense) (at 10%) (0.77) ( 0.20) ( 0.07) Earnings 8.50 9.62 10.34

NOA 74.42 73.86 78.29 82.99 NFA ( 7.70) (2.04) (0.70) 0.80 Free cash flow (OI – ∆NOA) 9.83 5.39 5.71 Dividends (40% of earnings) 3.40 3.85 4.14 Payment of debt 6.43 1.54 1.57

The NFA position each year is NFAt-1 + NFEt – (FCF – dividend).

E15.3. Forecasting Free Cash Flows and Residual Operating income, and Valuing a

Firm (a) 2009 2010 2011 2012 2013

Free cash flow (C – I = d) 70 75 75 75 75

Investment (I) 80 89 94 95 95

Cash from operations (C) 150 164 169 170 170

As the firm is “pure equity’ (no debt), free cash flow (C - I) is equal to dividends.

Forecast operating income and residual operating income:

2009 2010 2011 2012 2013

∆NOA 39 30 24 14 9

C – I 70 75 75 75 75

OI 109 105 99 89 84

Beginning net operating assets 596 635 665 689 703 ReOI (0.12) 37 29 19 6 0

As the firm is a “pure equity” firm, net operating assets (NOA) equal common

shareholders’ equity (CSE) and operating income (OI) equals comprehensive income.

And comprehensive income equals ∆CSE + dividends. As an alternative calculation, OI

= C – I + ∆NOA (as above),

(b) Based on the forecasted ReOI, with zero ReOI forecasted after 2013,

Value = 596 + 12.1

37 +

212.1

29 +

312.1

19 +

412.1

6

= 669.5

(c)

Using DCF analysis, one is tempted by the following calculation:

Value = 12.1

70 +

12.0

75/1.12

= 620.5

This is different from that value in part (b). The 75 in free cash flow after 2009 looks like a perpetuity, so has been capitalized as such in this valuation. But free cash flow cannot be a perpetuity at 75. Forecasted NOA for the beginning of 2012 is 703 + 84 - 75 = 712. If the firm were to hold net operating assets at 712 and thus earn 85.44 in operating income (at an RNOA of 12 % to yield a zero ReOI), free cash flow would be 76.44: C – I = OI – ∆NOA = 85.44 – (712 – 703) = 76.44. If the firm were to maintain a zero ReOI after 2013 and still grow net operating assets, free cash would be lower, but would have to grow.

The point:

1. Make sure you get to steady state before calculating a continuing value.

2. DCF valuation often requires longer forecasting horizons.

E15.4. Analysis of Value Added

Pro forma and valuation under the status quo:

0 1 2 3

Sales 857.0 882.7 909.2 936.5 (grows at 3%) Operating income (PM = 7%) 60.0 61.8 63.6 65.6 (grows at 3%) Net operating assets 441 454.2 467.8 481.9 (grows at 3%) PM 7% 7% 7% 7% ATO 2.0 2.0 2.0 2.0 RNOA 14% 14% 14% 14%

ReOI 17.64 18.18 18.73 (grows at 3%) Value of operations under the status quo:

Value of NOA = 441 + 03.110.1

64.17

−

= 693

Pro forma and valuation under the plan:

0 1 2 3

Sales 857.0 891.3 926.9 964.0 (grows at4%) Operating income 60.0 62.4 64.9 67.5 (grows at4%) (PM = 7%) Net operating assets 534.8 556.1 578.4 601.6 (grows at 4%) (ATO = 1.67) PM 7% 7% 7% 7% ATO 1.67 1.67 1.67 1.67 RNOA 11.67% 11.67% 11.67% 11.67% ReOI 8.93 9.29 9.66 (grows at 4%) Value of operations under the plan:

Value of NOA = 534.8 +

04.110.1

93.8

−

= 684

The plan (marginally) loses value. The additional growth (that generates additional profit

margin) is not sufficient to cover the required return on the additional investment in net operating

assets.

E15.5. Evaluating a Marketing Plan

(a)

This is an SF3 valuation:

Value of operations0 = NOA0 + g

OIRe

F

1

−ρ

1

OIRe = ( ) 498%11%15 ×−

= 19.92

For a profit margin (PM) of 7.5% and an RNOA of 15%, the ATO must be 2.0. With a constant ATO (implied by the constant PM and RNOA), the growth in ReOI is given by the growth in sales. So,

Value of operations = $896 million

(b)

A reduction of the ATO to 1.9 would reduce forecasted profitability (RNOA) to

14.25%:

RNOA = PM × ATO

= 14.25%

Under the status quo, residual operating income is expected to be generated as follows:

NOA at ReOI

Year beginning Sales PM ATO RNOA ReOI Growth

1 498.0 996.0 7.5% 2.0 15% 19.92 --- 2 527.9 1,055.8 7.5% 2.0 15% 21.12 6% 3 559.6 1,119.2 7.5% 2.0 15% 22.38 6%

↓

Under the marketing plan, residual operating income is expected to be generated as

follows:

NOA of ReOI

Year beginning Sales PM ATO RNOA ReOI Growth

1 498.0 996.0 7.5% 2.0 14.25% 19.92 ----

2 557.0 1,058.3 7.5% 1.9 14.25% 18.10 6.25% 3 591.8 1,124.4 7.5% 1.9 14.25% 19.23 6.25%

↓ 628.8 1,194.7 7.5% 1.9 14.25% 20.44 6.25%

[The plan is implemented in year 1, to take effect in year 2.]

The valuation under the plan is

Value of operations = NOA + 11.1

OIRe 1 +

− 0625.111.1

OIRe 2 /1.11

= $859 million

The plan reduces the value calculated in part (a). The additional investment in receivables loses value (when charged at the required return) even though it generates more value from the additional operating income that comes from the additional sales growth.

E15.6. Forecasting and Valuation

(a) Forecast return on net operating assets (RNOA) for 2010.

17.5% RNOA =

(b) Forecast residual operating income for 2010. Use a required return for operations of 9%.

268.6 ReOI2010 =

(c) Value the shareholders’ equity at the end of the 2009 fiscal year using residual

income methods.

10,823 VE =

(growth in ReOI is equal to growth in sales, 6%, because ATO is constant)

(d) Forecast abnormal growth in operating income for 2011.

Method 1:

16.12

0.06 x 268.6 AOIG

ReOI in growth AOIG

2011

=

=

=

Method 2: The Pro forma:

2009 2010 2011

Operating income 553.00 586.18

Net Operating assests 3,160.00 3,349.60FCF (OI - ∆NOA) 363.40

Reinvested FCF (at 9%) 32.71

618.89

Normal OI (553 x 1.09) 602.77

AOIG 16.12

Note: OI and NOA both grow at 6% per year. OI for 2007 = 3,160 x 0.175 = 553.

(e) Value the shareholders’ equity at the end of 2009 using abnormal earnings growth

methods.

[ ]553 0.175 x OI

10,825

1,290 - 1.06 - 1.09

16.12

0.09

1

NFO - g -

AOIG OI

0.09

1 V

2010

F

2011

2010

E

2009

==

=

+=

+=

160,3

553

ρ

(f) After reading the stock compensation footnote for this firm, you note that there are employee stock options on 28 million shares outstanding at the end of 2009. A modified Black-Scholes valuation of these options is $15 each. How does this information change your valuation?

10,552 valuation Adjusted

273 147 (@35%) benefit Tax

420 15 million 28

options goutstandin of Value

:overhang Option

10,825 overhang option before VE

2009

=×

(g) Forecast (net) comprehensive income for 2010.

Forecast of operting income for 2010 553

Forecast of net financial expense

NFO x NBC = 1,290 x 0.056 72

Tax benefit (at 35%) 25 47

Compensation income 506 [NBC for 2010 is the same as for 2009: 83/1,470=5.6%]

E15.7. Valuing a Property-Casualty Insurer

a. ReOI2009 = 254

b. Value of equity = Value of investments + Value of underwriting business = $6,901 million (Investments are marked to market on the balance sheet)

E15.8. Integrity of Pro Formas

(a)

(1) Net financial expenses are growing even though net financial obligations remain constant.

(2) Successive numbers for common equity are not reconciled by the stocks and

flows

equation: ∆CSE = Comprehensive income – Net dividends

(3) Free cash flow does not obey the relation, C – I = OI – ∆NOA.

(4) Successive net financial obligations do not obey the relation,

∆NFO = NFE – (C – I) + d.

In short, accounting discipline is lacking from the pro forma.

(b)

Sales are forecasted to grow at 6% per year. The forecasted asset turnovers are constant (at 2.0) and the RNOA is forecasted to be a constant 20% (on beginning NOA). So residual operating income must be forecasted to grow at the sales growth rate of 6%.

E15.9. Comprehensive Analysis and Valuation

Part I

(a)

Loss from exercise of stock options = 12/0.35 = 34 Tax benefit 12 Compensation expense, after tax 22 (b) Market price of shares repurchased 25 Amount paid for shares: 720/24 mill. 30 Loss per share 5 Number of shares 24 million Total loss 120 million (These losses are not tax deductible) (c) Comprehensive income statement Sales 3,726 Operating expenses (3,204) OI before stock compensation 522 Stock compensation (22) Operating income 500 Interest expense 98 Interest income (15) 83 Tax benefit 29 54 Unrealized gain on investments (50) Put option losses 120 124 Comprehensive income 376 (d)

2009 2008 Net operating assets 3,160 2,900 Net financial obligations 1,290 1,470 Common shareholders’ equity 1,870 1,430 Financial leverage (FLEV) = 1,290/1,870 = 0.690

Operating liability leverage (OLLEV) = 1,590/3,160 = 0.503

(Operating liabilities = 1,200 + 390 = 1,590)

(e) FCF = 240

Part II

(a) RNOA = 17.5%

(b) ReOI2010 = 268.6

(c) VE = = 10,823

(Growth rate in ReOI is the sales growth rate because ATO is constant)

(d)Method 1:

OI2011 586.18 FCF2010, reinvested 32.71 618.89 Normal OI 602.77 AOIG 16.12 Method 2: AOIG = growth in ReOI AOIG2011 = 268.6 x 0.06 = 16.12 (OI and NOA both grow at 6%) (e)

NFOg

AOIGOIV

F

E −

−+=

ρ2011

2010200909.0

1

290,106.109.1

116.16553

09.0

1−

−+=

= 10,823 (OI2010 = 3,160 x 0.175 = 553) (f) VE before option overhang 10,823 Option overhang: Value of outstanding options 28 mill x 15 420 Tax benefit (35%) 147 273 Adjusted valuation 10,550

(g) Forecast of operating income for 2010 553 Forecasts of net financial expense: NFO x NBC = 1,290 x 0.056 72 Tax benefit (at 35%) 25 47 Forecast of comprehensive income 506 (The NBC used is the core net borrowing cost on net debt for 2002: 83/1470 = 0.056)

Applications

E5.10. Forecasting and Valuation for General Mills, Inc.

General Mills Pro Forma

2008A 2009E 2010E 2011E 2012E

Sales 13,652 14,881 16,220 17,193 18,225

Operating income 1,560 1,701 1,854 1,965 2,083


Net financial obligations 6,631

Common equity 6,216

Core profit margin 11.43%

ATO 1.11

ReOI (8%) 673.2 685.0 725.9 769.5

Discount rate 1.08 1.1664 1.2597 1.3605

PV of ReOI 623.3 587.3 576.2 565.6

Total PV of ReOI 2,352.4

Continuing value (CV) 26,933

PV of CV 19,796.0

NOA 12,847.0

Enterprise Value 34,995.4

Net financial obligations 6,631.0

Value of equity 28,364.4 or $84.04 per share

[Forecasts of NOA are made by applying ATO to forecasted sales one year ahead] E5.11. Pro Forma Analysis and Valuation: Nike, Inc.

Nike Pro Forma

2008A 2009E 2010E 2011E 2012E

Sales 18,627 20,490 22,334 24,120 25,809

Operating income 1,844 1,898 1,930 1,936


Net financial assets 1,991

Common equity 7,797

ReOI (8.6%) 1,344.7 1,333.1 1,337.4 1,319.5

Discount rate 1.086 1.1794 1.2808 1.3910

PV of ReOI 1,238.2 1,130.3 1,044.2 948.6

Total Pv of ReoI 4,361

Continuing value (CV) 29,832

PV of CV 21,447

Value of equity 33,605 or $68.43 per share

E15.12. One-Step Residual Operating Income Calculation: Coca-Cola

a.

The one-step calculation of residual operating income is:

ReOI = $3,277.3 million

An alternative solution:

Core OI = ($24,088 × 0.20) + 102 = $4,919.6

NOA = $24,088/1.32 = 18,248.5

ReOI = $4,919.6 – (0.09 × 18,248.5) = 3,277.3 million

b.

ReOI = $24,088 ×

−

70.1

09.020.0 + 102

= $3,644.4 million

E15.13. A Valuation from Operating Income Growth Forecasts: Nike

(a)

2005 2006 2007 2008 2009 2010 ReOI (8.6% charge) 783.6 854.7 676.0 608.6 663.4 696.6

Abnormal OI Growth (= ∆ReOI) 71.1 -178.7 -67.4 54.8 33.2 Discount rate 1.086 1.179 1.281 1.391 PV of AOIG 65.47 -151.57 -52.62 39.40 Total PV to 2009 -99.3

CV 05.1086.1

17.33

−

921.39 PV of CV 662.4 Operating income 1,175.0 1,738.1 Capitalize at required return 0.086 Enterprise value (1,842.31/0.086) 20,211 Net financial assets 289 20,500 Option overhang 452 Value of equity 20,048 Note: AOIG is equal to the change in residual operating income (ReOI) given in Box 15.3. From 2010 onwards, ReOI is forecasted to grow at a 5% rate – and thus so is AOIG, for AOIG is always the change in ReOI. So the continuing value uses a 5% growth rate.

(b) The two-stage growth model (14.5) incorporates short-term and long- term growth rates, G2 and Glong:

−

−

−×=

longF

long

F

NOA

G

GGOIV

ρρ2

120041

1

Calculating G2: Cum-FCF OI for 2006 = normal income + abnormal income growth

= 1,347.15

G2 = 1,347.15/1,175 = 1.1465 (14.65%)

Set Glong = 1.05, the long-term growth rate forecasted by the analyst,

−

−×=

05.1086.1

05.11465.1

086.0

1175,12004

NOAV

= $36,628 million

The forward P/E is 31.17.

Why is this value greater than that in (a)? Because the two-stage growth model

implies a gradual decay in the growth rate from the 14.65 % in 2006 to the 5% in the

(very) long term. So, it does not pick up the slower AEG growth after 2006 that is

apparent in the full pro forma.

E15.14. Evaluating an Acquisition: PPE Inc. The important point in this exercise is to calculate the effect of the proposed

acquisition on the per-share value of PPE. As shareholders of the acquired firm are to

share in the benefits of the merger, the division of the value added in the merger between

PPE’s shareholders and those of the acquired firm has to be calculated. The value added

will depend on the value of the merged firm. The division of the value will depend on

the relative shares in the value (which depend on the rate of exchange of shares in the

acquisition).

(a)

To solve the problem proceed as follows:

1. Calculate the value of the equity of the merged firm at the end of Year 1.

2. Calculate the per-share value of the equity of the merged firm at Year 1.

3. Calculate the present value (at Year 0) of the per-share value of Year 1 plus

the present value of the Year 1 dividend.

4. Compare the Year 0 per share value with that calculated without the

acquisition (from the pro forma in the text: $0.96).

Is per-share value added?

The following calculates the value of the merged firm at the end of the year 1 and the per-

share value of the 220 shares in the new firm (steps 1 and 2):

Year 1 2 3 4 5 6

RNOA 7.16% 8.46% 9.92% 21.30% 21.31% Residual operating income (11%)

(4.90) (3.10) (1.27) 11.59 12.30

income (11%) PV of ReOI to Year 5

Year 5 1.63 Continuing value,

Year 5

246.0

PV of CV 162.05 Net operating

assets, Year 1 127.50

Value of NOA, Year 1

Year 1 291.18 Value of NFO 5.71

Value of equity 285.47

Value per share 1.298

(220 shares)

=

1.06 - 1.11

12.30 CV

Note that the ReOI is growing at 5% per year after Year 5. (Calculations use a 11% required return for operations.)

The Year 0 per share value to PPE’s shareholders (step3) is

[The discount rate for PPE pre-acquisition is used.] The value of a PPE share without the acquisition is $0.96, so the proposed acquisition adds value. (b) The revised pro forma, without amortization of goodwill, excludes the amortization

expense in the income statement and maintains goodwill in the balance sheet:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Income Statement Sales 131.15 189.00 200.34 212.36 225.10 238.61 Core expenses 120.86 168.87 179.00 189.74 201.13 213.19 Operating income 10.29 20.13 21.34 22.62 23.97 25.42 Balance Sheet Net operating assets 127.50 133.17 139.18 145.55 152.30 159.46 Net financial obligations 5.71 Common equity 121.79 (c) Calculate forecasts of residual operating income (ReOI) for the alternative pro forma and

value the operations from those forecasts.

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 ReOI 6.105 6.691 7.310 7.960 8.667 ReOI growth rate 9.60% 9.25% 8.89% 8.86%

Value at Year 1 $1.298 Dividend at year 1 0.038

Year 1 pay off 1.336 PV at Year 0 (1.1134) $1.200

The ReOI growth rate is declining each year, but is not in steady state. Sales and

operating income are growing at 6%, as in part (a), but the book values of NOA are not.

However, the book values will eventually converge to the 6% sales growth rate. You

need a computer: Input the pro forma into a spreadsheet and continue computations for

years after Year 6:

• Grow operating income at 6% per year

• Calculate the free cash flow each year from either pro forma: FCF = OI – ∆NOA.

(Free cash flow does not change with the changed accounting, of course, so will

be the same when calculated from either pro forma.) Appreciate that free cash

flow grows at a 6% rate. So, as FCF is $18.26 for Year 6, subsequent FCF can be

extrapolated at 6%.

• Calculate NOA each year as NOAt = NOAt-1 + OIt - FCFt

• Calculate ReOI and present value it

• Add NOA at the end of Year 1 to get the value of operations at that point.

This Year 1 value is the same at that in part (a) (the accounting does not affect the

value!), the value at Year 0 is also the same.

CHAPTER SIXTEEN

Creating Accounting Value and Economic Value

Drill Exercises

E16.1. A Simple Demonstration of the Effect of Accounting Methods on Value a.

Value of investment = Present value of cash expected cash flow

= 105.50

b.

Book value of investment = $100

Earnings, Year 1 = $115 - $100 = $15 ReOI1 = 15 – (0.09 × 100) = 6

Value of investment = $100 + Present value of expected ReOI = $105.50

c.

Book value of investment = $80

Earnings, Year 1 = $115 – 80

= $35

ReOI1 = 35 – (0.09 × 80) = 27.8

Value of investment = $80 + Present value of expected ReOI

= $105.50

E16.2. Valuation of a Project under Different Accounting Methods

a.

Year 0 Year 1 Year 2

Cash flows 1,540 1,540 Discount rate 1.09 1.1881 PV of cash flows 1,412.8 1,296.2 Total PV of cash flows 2,709

b.


Revenue 1,540 1,540 Depreciation 1,100 1,100 Earnings 440 440 Book value 2,200 1,100 0 RNOA 20.0% 40.0% Residual earnings 242 341 Discount rate 1.09 1.1881 PV of residual earning 222.0 287.0 Total PV 509

Value of project 2,709

c.


Revenue 1,540 1,540 Depreciation 1,300 900 Earnings 240 640 Book value 2,200 900 0 RNOA 10.91% 71.1% Residual earnings 42 559 Discount rate 1.09 1.1881 PV of residual earning 38.5 470.5 Total PV 509 Value of project 2,709

The value of the project does not change, but the accounting numbers do. The more

conservative depreciation in Year 1 decreases earnings, RNOA, and residual earnings in

that Year, but creates earnings, RNOA, and residual earnings in Year 2.

d.


Revenue 1,540 1,540 Depreciation 750 750 Earnings 790 790 Book value 1,500 750 0 RNOA 52.67% 105.33% Residual earnings 655 722.5 Discount rate 1.09 1.1881 PV of residual earning 600.9 608.1 Total PV 1,209 Value of project 2,709

The value is unchanged, but the conservative accounting (expensing advertising),

increases subsequent earnings, RNOA, and residual earnings.

e.

For capitalizing and expensing advertising in part b, P/B = 2,709/2,200 = 1.23

For expensing advertising on part d. P/B = 2,709/1,500 = 1.81

Conservative accounting increases P/B ratios.

E16.3. Valuation of a Going Concern Under Different Accounting Methods

Initial investment $2,200 million Further investment of $2,200 million each year Sales revenue 70 percent of the investment Accounting depreciation: straight-line over those two years Hurdle rate = 9%

a. Price-to-book ratio = 3.80 Foreward P/E = 19.01

Year 0 Year 1 Year 2 Year 3 Year 4

Sales

From investments in Year 1 1540.0 1540.0



From investments in Year 4 1540.0

1540.0 3080.0 3080.0 3080.0

Operating expenses (depreciation)





From investments in Year 5

0.0 1100.0 2200.0 2200.0 2200.0

Operating income - 440.0 880.0 880.0 880.0

Net Operating Asset (NOA)






2200.0 3300.0 3300.0 3300.0 3300.0

Investment 2200.0 2200.0 2200.0 2200.0 2200.0

Free cash flow (2,200.0) (660.0) 880.0 880.0 880.0

RNOA (%) 20.0 26.7 26.7 26.7

Profit margin (%) 28.6 28.6 28.6 28.6

Asset turnover 0.7 0.9 0.9 0.9

Growth in NOA (%) 50.0 0.0 0.0 0.0

ReOI 242.0 583.0 583.0 583.0

Growth in ReOI (%) N/A 140.9 0.0 0.0

Growth in cum-dividend OI (%) 86.5 9.0 9.0

AOIG (0.10) 341.0 0.0 0.0

Growth in AOIG (%) N/A N/A N/A

Value of firm 8364.9 9777.8 9777.8 9777.8 9777.8

Premium over book value 6477.8 6477.8 6477.8 6477.8

P/B 3.80 2.96 2.96 2.96 2.96

Trailing P/E 20.7 12.1 12.1 12.1

Forward P/E 19.01 11.1 11.1 11.1 11.1

Equity Return 9% 9% 9% 9%

b. 20 percent of the projected investment to be expensed each year. Price-to-book ratio = 4.75 Foreward P/E = 38.02


Sales





1540.0 3080.0 3080.0 3080.0


From investments in Year 1 440.0 880.0 880.0





440.0 1320.0 2200.0 2200.0 2200.0

Operating income (440.0) 220.0 880.0 880.0 880.0







1760.0 2640.0 2640.0 2640.0 2640.0

Investment 2200.0 2200.0 2200.0 2200.0 2200.0

Free cash flow (2,200.0) (660.0) 880.0 880.0 880.0

RNOA (%) 12.5 33.3 33.3 33.3

Profit margin (%) 14.3 28.6 28.6 28.6


Growth in NOA (%) 50.0 0.0 0.0 0.0

ReOI 61.6 642.4 642.4 642.4

Growth in ReOI (%) N/A 942.9 0.0 0.0


AOIG (0.10) 580.8 0.0 0.0

Growth in AOIG (%) N/A N/A N/A

Value of firm 8364.9 9777.8 9777.8 9777.8 9777.8


P/B 4.75 3.70 3.70 3.70 3.70

Trailing P/E 41.4 12.1 12.1 12.1

Forward P/E 38.02 11.1 11.1 11.1 11.1


c. 5% investment growth rate; no immediate expense Price-to-book ratio = 7.31 Foreword P/E = 36.53


Sales





1540.0 3157.0 3314.9 3480.6






From investments in Year 5

0.0 1100.0 2255.0 2367.8 2486.1

Operating income - 440.0 902.0 947.1 994.5







2200.0 3410.0 3580.5 3759.5 3947.5

Investment 2200.0 2310.0 2425.5 2546.8 2674.1

Free cash flow (2,200.0) (770.0) 731.5 768.1 806.5

RNOA (%) 20.0 26.5 26.5 26.5

Profit margin (%) 28.6 28.6 28.6 28.6


Growth in NOA (%) 55.0 5.0 5.0 5.0

ReOI 242.0 595.1 624.9 656.1

Growth in ReOI (%) N/A 145.9 5.0 5.0


AOIG (0.10) 353.1 29.8 31.2

Growth in AOIG (%) N/A -91.6 5.0

Value of firm 16071.1 18287.5 19201.9 20162.0 21170.1


P/B 7.31 5.36 5.36 5.36 5.36

Trailing P/E 39.8 22.1 22.1 22.1

Forward P/E 36.53 20.3 20.3 20.3 20.3


c. 5% investment growth rate; 20% immediate expense Price-to-book ratio = 9.13 Foreword P/E = 81.17


Sales





1540.0 3157.0 3314.9 3480.6







440.0 1342.0 2289.1 2403.6 2523.7

Operating income (440.0) 198.0 867.9 911.3 956.9







1760.0 2728.0 2864.4 3007.6 3158.0

Investment 2200.0 2310.0 2425.5 2546.8 2674.1

Free cash flow (2,200.0) (770.0) 731.5 768.1 806.5

RNOA (%) 11.3 31.8 31.8 31.8

Profit margin (%) 12.9 27.5 27.5 27.5


Growth in NOA (%) 55.0 5.0 5.0 5.0

ReOI 39.6 622.4 653.5 686.2

Growth in ReOI (%) N/A 1471.7 5.0 5.0


AOIG (0.10) 582.8 31.1 32.7

Growth in AOIG (%) N/A -94.7 5.0

Value of firm 16071.1 18287.5 19201.9 20162.0 21170.1


P/B 9.13 6.70 6.70 6.70 6.70

Trailing P/E 88.5 23.0 23.0 23.0

Forward P/E 81.17 21.1 21.1 21.1 21.1


Applications

E16.4. Inventory Accounting, P/B, and P/E Ratios: Ford Motor Company

(a) The LIFO reserve is the amount by which cumulative FIFO profits would have

been greater than LIFO profits. But that difference would attract taxes, so shareholders’

equity would be higher by the amount of the LIFO reserve, after tax. The LIFO reserve is

the amount by which inventories would be higher under FIFO than LIFO, but the extra

taxes payable would also be recognized, to net to the effect on shareholders’ equity.

1999 Shareholders’ Equity (FIFO) = $28.241 billion

1998 Shareholders’ Equity (FIFO) = $24.177 billion

(b) FIFO Earnings = $7.173 billion

(There was a liquidation of the LIFO reserve).

1999 ROCE (FIFO) = 29.67%

(c) Market value of equity = $64.13 billion

P/B (LIFO) = 2.33

P/B (FIFO) = 2.27

P/B (LIFO) is higher than P/B (FIFO) because book value is lower with LIFO.

(d) P/E (LIFO) = 8.86

P/E (FIFO) = 8.94

(Dividends are ignored in these calculations.)

P/E (LIFO) is lower than P/E (FIFO) because earnings are higher under LIFO due to the

inventory liquidation. Typically, however, LIFO P/E ratios are higher than FIFO P/E

ratios because, with inventory growth rather than liquidation, LIFO earnings are lower

than FIFO earnings.

E16.5. The Accounting for Research and Development and Economic Profit Measures

(a) 2008 2009 2010 2011 2012 2013 2014

Sales 160 320 480 640 800 800 Operating expenses (80%) 128 256 384 512 640 640

OI before R&D 32 64 96 128 160 160 R&D expense 100 100 100 100 100 100

Operating income (68) (36) (4) 28 60 60

Net operating assets 80 80 80 80 80 80 80 RNOA -85.0% -45.0% -5.0% 35.0% 75.0% 75.0% ReOI (10%) (76) (44) (12) 20 52 52 (b) OI before R&D 32 64 96 128 160 160 Amortization 20 40 60 80 100 100

Operating income 12 24 36 48 60 60

Net operating assets 180 260 320 360 380 380 380 RNOA 6.6% 9.2% 11.25% 13.3% 15.8% 15.8% ReOI (10%) (6) (2) 4 12 22 22

(c) The RNOA and ReOI are different because of the treatment of R&D

expenditures. Expensing initially gives lower RNOA and ReOI, but higher RNOA and

ReOI subsequently.

(d) RNOA2015 with expensing = 75.0%

RNOA2015 with capitalizing = 15.8%

ReOI2015 with expensing = $52 million

ReOI2015 with capitalizing = $22 million

(The firm is in steady-state.)

The forecasts differ because of the relative conservative accounting: expensing yields

higher RNOA and ReOI.

(e) With expensing:

( ) ( ) ( ) 4

432

NOA0 10.1/

10.0

52

10.1

20

10.1

12

10.1

44

10.1

7680V

+++++=

= $334 million

With capitalization:

( ) ( ) ( ) 4

432

NOA0 10.1/

10.0

22

10.1

12

10.1

4

10.1

2

10.1

6180V

+++++=

= $334 million

The valuations are the same: the accounting does not matter once steady-state is

forecasted.

(f) In both cases, the full valuation would not be captured because 2011 is prior to

steady-state.

E16.6. Depreciation Methods, Profitability, and Valuation (a) Pro forma with three-year estimated life 2009 2010 2011 2012 2013 2014 2015 2016 2017 Revenues -- 250 1,530 3,540 4,295 4,305 4,410 4,500 4,500 Depreciation -- 200 433 700 800 900 967 1,000 1,000 Other Expenses (70%) -- 175 1,071 2,478 3,007 3,014 3,087 3,150 3,150

Operating Income -- (125) (26) 362 488 391 356 350 350

Net Operating Assets 600 1,100 1,467 1,666 1,866 1,967 2,000 2,000 2,000 Investment 600 700 800 900 1,000 1,000 1,000 1,000 1,000 RNOA -- -20.8% -2.4% -24.7% 29.3% 21.0% 18.1% 17.5% 17.5%

Pro forma with five-year estimated life 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Revenues -- 250 1,530 3,540 4,295 4,305 4,410 4,500 4,500 4,500 4,500 Depreciation -- 120 260 420 600 800 880 940 980 1,000 1,000 Other expenses (70%) -- 175 1,071 2,478 3,007 3,014 3,087 3,150 3,150 3,150 3,150

Operating income -- (45) 199 642 688 491 443 410 370 350 350

Net operating assets 600 1,180 1,720 2,200 2,600 2,800 2,920 2,980 3,000 3,000 3,000 Investment 600 700 800 900 1,000 1,000 1,000 1,000 1,000 1,000 1,000 RNOA -- -7.5% 16.9% 37.3% 31.3% 18.9% 15.8% 14.0% 12.4% 11.7% 11.7%

(b) Depreciation over five years yields higher operating income in 2013: for the same

revenues and other expenses, depreciation expense is lower. And depreciation over five

years yields a higher RNOA in 2013 (31.3% compared with 29.3%). Even though net

operating assets are higher with five-year estimated lives, the numerator effect dominates

the denominator effect (prior to steady state). Note, however, that these RNOA are not a

good forecast of the relative RNOA once steady state is realized: steady-state RNOA

with three-year estimated lives is 17.5% compare to 11.7% with five-year estimated lives.

(c) Three-year estimated life 2013 2014 2015 2016 2017 2018 2019

ReOI 204 159 150 150 150 150 PV of ReOI to 2015 317

PV of continuing value

= 500,1

10.0

150

1,240

Net operating assets 1,866 Value at 2013 3,423 Five-year estimated life 2013 2014 2015 2016 2017 2018 2019

ReOI (10%) 231 163 118 72 50 50 PV of ReOI to 2017 482

PV of continuing value

= 500

10.0

50

341

Net operating assets 2,600 Value at 2013 3,423

(d)

Good analysis would find that the RNOA in 2013 is not indicative of the long-run

RNOA for this firm (see part (b)). But maybe the market does not see this. If an

investment banker were pricing the IPO on the basis of multiples of earnings from

comparison firms, and did not adjust for depreciation methods, she might price the

earnings with five-year lives higher for the IPO. Would the market penetrate this illusion?

(e)

In 2018, profit is the same for both depreciation methods (and so, of course, is the

value of the firm). However, RNOA is higher with three-year life depreciation. Would

the market interpret this higher profitability (incorrectly) as requiring a higher price? If

the officers of the firm believed that the market could be "fooled," they might choose the

three-year method to get a higher price for the shares obtained from exercise of the

options. Shareholders beware!

E16.7. The Quality of Free Cash Flow and Residual Operating Income: Coca-Cola

Company

(a)

Economic profit is similar to residual operating income (ReOI). To see the

difference between free cash flow and ReOI, see how they are calculated:

ReOIt = OIt – (cost of capital × NOAt - 1)

Free cash flowt = OI – ∆NOAt

So ReOI and free cash flow are the same if net operating assets grow at the cost of

capital. In 1995, the two methods were approximately the same and total capital grew at

approximately the 9% rate used to calculate economic profit.

The growth in the two measures are compared as follows:

Growth in ReOIt = ( )( )2t1t

1tt

NOAcapital ofcost OI

NOAcapital of tcosOI

−−

−

×−

×−

Growth in free cash flowt = 1−1− ∆ΝΟΑ−ΟΙ

∆ΝΟΑ−

tt

ttOI

So the growth rates are the same if net operating assets grow at the cost of capital

consistently.

(b)

Both methods would work with Coke.

E16.8. Research and Development Expenditures and Valuation

The pro forma for the firm is as follows:

0 1 2 3 4 5 6 7

Sales 1,000 1,500 2,000 2,500 3,000 3,500 3,675 3,859 R&D 350 350 350 350 350 350 368 386 Other expenses (80%) 800 1,200 1,600 2,000 2,400 2,800 2,940 3,087

Operating income (150) (50) 50 150 250 350 367 386

Net operating assets 714 1,429 1,786 2,143 2,500 2,625 2,756 ReOI (10%) (121) (93) (29) 36 100 105 110 PV of RE (110) (77) (22) 25 62 Total PV to Yr. 5 (122)

Continuing value 05.110.1

105

−

2,100

PV of CV 1,304

Value of firm 1,896

(a) Value of the firm is $1,896 million

(b) Earnings for years 1 to 3 are of low quality because they don’t forecast long-run

earnings. The low quality is due to the expensing of R&D expenditures.

(c)

1 2 3 4 5 6 7

R&D-to-sales 23.3% 17.5% 14.0% 11.7% 10.0% 10.0% 10.0%

The ratio settles down to a steady-state of 10% from year 5 onwards. Prior to that the

ratio is higher, indicating that the sales from R&D have not yet been realized.

E16.9. The Quality of Forecasted Residual Operating Income and Free Cash Flow

(a)

The pro forma is as follows:

2009 2010 2011 2012 2013 2014

Sales 240 484 530 576 622 Depreciation 200 420 460 500 540

Operating income 40 64 70 76 82

Net operating assets 400 640 700 760 820 880 RNOA 10% 10% 10% 10% 10% ReOI (10%) 0 0 0 0 0 Value of firm is book value = $400 (Zero ReOI is forecasted). (b) 2010 2011 2012 2013 2014

Free cash flow: Operating income 40 64 70 76 82 ∆NOA 240 60 60 60 60

Free cash flow (200) 4 10 16 22

Growth in free cash flow – – 150% 60% 38%

Free cash flow is low in years 2010 and 2012 but grows after that. However, the growth

rate in free cash flow is not constant, making the firm hard to value with a (constant growth)

continuing value. For discounted cash flow analysis, the forecast horizon has to be extended to a

point where the growth rate converges to its long-term rate. As free cash flow forecasting

requires a long forecast horizon, it can be said to be of low quality.

CHAPTER SEVENTEEN The Analysis of the Quality of Financial Statements

Drill Exercises

E17.1. Following the Trail: Identifying Hard and Soft Components of Income a. The “hard” part of the income in free cash flow = $234 million. The “soft” part of OI is

that which is due to change in net operating assets:

OI = Free Cash Flow + ∆NOA So, ∆NOA = $1,064 million. Cash flow from operations = $921 million Operating accruals = $377 million

E17.2. Income Shifting and Net Operating Assets

a. RNOA = 2,234/NOAt-1 = 9% Therefore, NOAt-1 = $24,822.22 million OI/24,822.22 = 12% Therefore, OI = 2,978.67, so $744.67 has to be added to income.

b. To add $744.67 to OI for the current year, the CFO will have to add the same amount to

NOA: OI = Free cash flow + ∆NOA. This NOA will be the base for next year’s RNOA,

reducing that RNOA.

E17.3. Following the Trail to the Balance Sheet

a. Increase receivables (and thus increase sales) or increase inventories (and thus reduce cost of goods sold)

b. Increase net accounting receivable (by reducing allowance for bad debt)

c. Increase net property, plant and equipment

d. Increase accrued expenses

e. Increase capitalized software costs

E17.4. Interpretation of Diagnostics Bad debt expense/Sales: lower ratio suggests lower RNOA in the future

Warranty expense/Sales: higher ratio suggests higher RNOA on the future

Net sales/Accounts receivable: higher ratio suggests higher RNOA in the future

Inventory/Sales: higher ratio suggests lower RNOA in the future

Depreciation/ Cap. Ex.: lower ratio suggests lower RNOA in the future

Deferred revenue/Sales: higher ratio suggests higher RNOA is the future

Note: these are the effects on future RNOA holding all else constant. A lower depreciation/Cap. Ex., for example, might mean that higher capital expenditures will produce a lot more revenues that will increase RNOA in the future. Higher inventory to sales might mean the firm is investing in inventory in anticipation of higher sales (and RNOA) rather than excess inventory that will reduce cost of good sold and RNOA. E17.5. Normalized Asset Turnover Free cash flow = -$157 million

Normalized operating income = $136 million This analysis indicates that operating income is of good quality: The net operating assets

increases as a percentage of sales at a normal level. Accordingly the ATO for the current year

(5,751/2,614 = 2.2) remained at the historical level.

E17.6. Change in Asset Turnover and Earnings Quality

a. PM = RNOA/ATO = 19.0%/1.9 = 10.0% b. A decrease in the ATO says that NOA have increased at a higher rate than sales. This could

be due to the firm booking fewer expenses to increase the profit margin.

E17.7. Red Flags in the Cash Flow Statement Red Flags:

1. Net income as a percentage of cash flow from operations has increased to 113.5%

of sales from 25.6% of sales: there is a higher accrual component to earnings.

2. Depreciation has decreased as a percentage of capital expenditures, even though

capital expenditures are growing: Will depreciation be higher in the future?

3. Accounts receivable have increased (by $33.3 million) even though sales have

declined: What is the quality of those receivables?

4. Deferred revenues have declined: Has sales be propped up by bleeding back

deferred revenues from the balance sheet?

5. The reverse restructuring charge increases income relative to cash flows. Is this

just a cash payment for a previous charge – there were none in 2008 – or is it a

bleed back of an earlier charge to income?

Applications

E17.8. The Quality of Revenues: Bausch & Lomb

A red flag on the quality of revenues is raised by comparing the percentage change in

sales with the percentage change in revenues. Days in accounts receivable also raises concerns.

1991 1992 1993

Percentage change in sales 11.1% 12.4% 9.5% Percentage change in receivables 1.1% 35.1% 38.8% Days in account receivable 49 days 59 days 75 days

Percentage change in receivables increased dramatically relative to the percentage change is

sales. Days in accounts receivable also increased significantly. The firm was booking sales (into

receivables) for which customers were not paying (to reduce receivables).

E17.9. The Quality of Gross Margins: Vitesse Semiconductor Corp.

2003 2002 2001

Gross margin ratio 53.21% 27.40% 47.50%

The charges increase cost of goods sold in the year that they are taken and so reduce gross

margins. However, the lower inventory amounts from the write-down become lower cost of

goods sold in subsequent years. Thus subsequent margins increase unless revenue is also

negatively affected. The higher gross margins in 2003 could be due to the write-downs in the

previous years.

E17.10. The SEC and Microsoft

(a)

The issue in question in the SEC’s investigation was the deferring of revenue in the

unearned revenue liability. The claim was that Microsoft was “over reserving” with this

unearned revenue and might bleed the unearned revenue back into income as it wanted.

Unearned revenue did decrease by $110 million in the September 1999 quarter, so $110 million

of revenue in the income statement was not from “new sales” but from revenue in the past that

was not recognized in the income statement. Microsoft might reply that revenue is legitimately

deferred because sales contracts (to provide upgrades, for example) require further services to the

customer.

(b)

Microsoft reported a decline in cash from operations while its revenues and earnings

increased. This raises a question as to whether there are unjustified accruals. You see that

$1.363 billion of the total $5.344 billion in sales is from recognizing unearned revenue from

prior periods (and only $1.253 billion of current period’s revenue was deferred to the future).

Note also that other current liabilities decrease on an increase in sales, also raising a red flag.

And $156 million of income was from a sale of a business.

E17. 11. Spot the Red Flags in a Cash Flow Statement: EDS and Cerner Corporation Electronic Data Systems: Red Flags

1. Increasing income relative to cash flow from operations:

1999 21.8% 2000 73.3% 2001 79.2%

Accruals are an increasing component of net income.

2. Constant depreciation and amortization on increasing income: One expects depreciation to grow with income unless the technology for producing income changes.

3. Continuing asset write-downs: Are their continuing problems; are write-downs

excessive?

4. What is the $340 million of “other” in 2001 that increases income relative to cash flow?

5. Receivable growth is high in 2001: Quality of receivables? Unbilled revenue?

6. Accounts payable and accrued liabilities drop in 2000 and 2001: Is the firm recognizing fewer expenses? (Prepaid expenses go the other way, however, reducing income.)

7. Deferred revenue drops in 2001 and 2000: More revenue in the income statement is

coming from revenue deferred from the past rather than current sales. Cerner Corporation: Red Flags

1. One-time gain of $4,308 thousand in 2002 increases income.

2. Write down of $127,616 thousand in 2001: Does that reduce expenses for 2002 via a bleed back?

3. Deferred taxes are down in 2002 on increasing income: Inspect deferred tax footnote for

the reason.

4. Large increase in receivables in 2002: Quality of receivables?

5. Deferred revenues in both 2001 and 2002 have been reduced: More revenue in the income statement is coming from revenue deferred from the past rather than current sales.

6. Accrued liabilities in 2002 have decreased, yielding lower expenses in the income

statement.

7. Cerner is capitalizing software development costs: Is the capitalization appropriate or excessive?

8. The cash investment of (a negative) $26,798 thousand is affected by $90,119 sale of

securities (a financing activity). Without this item, cash investment is (a positive) $63,321 and free cash flow is considerably lower than suggested by the cash flow statement. Cerner is actually selling off securities to finance a negative free cash flow.

9. While income increased significantly in 2002, cash flow from operations dropped

significantly. The reason, of course, is the accrual items mentioned in points 1 – 7.

E17.12. Tracking Changes in Net Operating Assets and the Asset Turnover: Regina Company

1984 1985 1986 1987 1988 Operating income before tax 4,456 9,826 14,878 21,904 Tax as reported 405 3,807 6,189 7,761 Tax benefit of interest 1,143 753 618 1,244 Tax on operating income 1,548 4,560 6,807 9,005 Operating income after tax 2,908 5,266 8,071 12,899 Net operating assets 28,800 28,435 30,457 40,342 93,622

NOA∆ (365) 2,022 9,867 53,280 Free cash flow (=OI - NOA∆ ) 3,273 3,244 (1,796) (40,381) ATO (on ending NOA 2.38 2.50 3.18 1.93

ATO∆ 0.12 0.68 -1.25 Note: NOA = Common equity + Long-term debt + Short-term borrowing + current portion of term-debt – cash equivalents Cash equivalents = Cash – $28 million

a. Normalized operating income = ATO Normal

Sales

∆+FCF

Set normal ATO at average ATO for 1985–1987 = 2.69

Normal OI for 1988 = 2.69

52,889 40,381 +−

= -$20,720 thousand This is well below reported operating income (after tax) of $12,899 thousand, calling into question the quality of the reported income.

b. Increase in ATO (as in 1987) implies income may be too low. Decrease in ATO (as in 1988) implies income may be too high.

A decreasing ATO suggests too few expenses are booked to income (and too much cost remains in the balance sheet). Further, there may be too much of sales in low quality receivables.

c. Other red flags:

1. Free cash flow is a large negative amount in 1988. Why?

2. Growth in NOA in 1988 is far greater that growth in sales (as the normalized OI captures). Changes in individual ATO ratios are also high:

- accounts receivables - inventory

3. Accounts payable and accrued liabilities declined in 1988 (inducing lower expenses): Are fewer expenses being accrued to income?

E17.13. Quality Diagnostics: Gateway, Inc.

To start, note the red flags in the text for Chapter 17:

A Red Flag. In 2000, Gateway, the personal computer manufacturer decided to finance computer sales to high-risk customers that outside financing companies were shunning. Its consumer finance receivables, net of allowances for bad debts, increased from 3.3 percent of sales to 7.3 percent of sales over the year. In the first quarter of 2001, the firm wrote off $100 million of these receivables. A Red Flag. Gateway, the computer manufacturer, had always operated on a high asset turnover. In 1999, its ATO was 13.2 on sales of $8,965 million, and even higher in earlier years. In 2000 sales increased by $636 million to $9,601 million, resulting in operating income, after tax, of $231 million. Net operating assets, however, grew by $1,086 (more than sales), resulting in a negative free cash flow of $855 million. The firm was investing rapidly in new stores and inventory, providing consumer credit and increasing accruals, yet sales growth was modest. Normalized operating income was -$855 + (636/13.2) = -$807 million, considerably less than reported operating income. In 2001, Gateway wrote off $876 million of net operating assets and reported an after-tax operating loss of $983 million.

From the information in the question, the following diagnostics can be calculated: 2000 1999 ATO 5.43 13.16

ATO∆ -7.73 Decline in ATO is a red flag Changes in individual ATOs: Accounts receivable (no red flag) 17.6 13.9 Inventory (red flag: inventory build up) 30.5 46.7 PPE (red flag: lower sales from plant) 10.7 12.0 Financing receivables (red flag: fin. receivables build up) 13.7 30.3

Warranties / Sales (no red flag) 1.98% 2.1% Other accrued liabilities / sales (red flag) 4.5% 5.2% Deferred revenue / sales (no red flag) 1.8% 1.9% Allowance for uncollectibles / receivables (slight red flag: lower allowance as a percentage of receivables)

2.3% 2.5%

The primary concern is in the build up of inventory and the increasing finance receivables. The

decline in accrued liabilities on rising sales also is a concern.

E17.14. A Financial Statement Restatement: Sunbeam Sunbeam’s financial statement restatement involved a restatement of revenues (as

indicated in the question). Sunbeam had a practice of “bill and hold,” that is, billing customers

(and booking revenue) while they still held the goods and allowed customers to cancel orders.

The revenue restatements involved reversing the revenue from “bill and hold” billings.

The question asks you to focus on the accruals in the cash flow statement. Comparing

the original and restated statements, you will see the following:

1. The accruals for restructuring charges and special charges totaling $283.7

million in 1996 were deemed to be excessive so were reduced.

Excessive restructuring accruals are bled back to future income statements

(so increasing profits), and you see in the original 1997 statement an income-increasing

reversal of a restructuring accrual of $43.4 million that is reduced in the restated

numbers.

2. Deferred income taxes were reduced in the 1997 restatement. Deferred

income taxes are for accruals recognized in the income statement but not in the tax return, so these accruals were reversed.

3. The increase in receivables of $84.6 million in 1997 was reduced to $57.8

million because revenues had to be restated. 1996 receivables were also reduced.

4. Inventories were restated upwards, reflecting the inventories that had been

deemed sold under the bill-and-hold policy but now are deemed not sold. This increase

in inventory reduces cost of goods sold and increases income. But inventories were

written down at the end of 1996, increasing 1997 income.

5. Prepaid expenses and other net current assets and liabilities in 1996 were

revised downwards, reducing 1996 income.

6. The “other” item was reduced in 1997, reducing 1997 income.

E17.15. Stock Market Reactions to Earnings Announcements: Eastman, Kodak, and Intel

(a)

(In millions of dollars) 1998 1997

Eastman Kodak Sales 3,400 3,780 Net income 398 231 Net profit margin 11.7% 6.1% Change in net profit margin 5.6% Intel Corporation Sales 6,700 6,147 Net income 1,600 1,600 Net profit margin 23.9% 26.0%

Eastman Kodak’s profit and profit margin increased on declining sales. The declining

sales in itself is bad news for the future, and increasing earnings on declining sales raise

questions as to the quality of the earnings. Were expenses reduced by manipulation? This is a

case of increasing margins with declining asset turnover, which raises a red flag.

Intel’s income is seen as high quality. Income did not increase on increasing sales. If

there were any manipulation, it would have to be recognizing mire expenses than necessary, so

reducing expenses to be recognized in the future. The market saw the sales increase as good

news and did not interpret the increase in expenses per dollar of sales as bad news.

(b)

The following red flags are raised in the cash flow statement:

1. Earnings increased while cash flow from operations decreased. So, accruals

increased even though sales increased, and accruals can involve manipulation.

2. Earnings in 1998 included a one-time gain on sale of a business of $107 million.

3. Even though sales decreased over 1997, 1998 net accounts receivable increased

by $216 million. Are these good quality receivables? Have bad debt allowances

been reduced?

4. There is inventory build-up in 1998 (by $334 million) on a decline in sales. Is the

firm having trouble moving its inventory?

5. Operating liabilities decreased in 1998 by $553 million, compared to $285 million

in 1997. Is the firm reducing expenses by reducing accrued expenses and other

operating liabilities?

Solution

Documents

equity statement

cash flow statement

market value of debt

share equity value

excess cash

cash investment5earnings

enterprise market value

itotal market value