SOLUTIONS TO PRACTICE QUESTIONS

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 6,971Operating liabilities 7,194 8,747 Financial assets 4,457 4,238

Net financial obligations 2,967 2,733

Common equity 18,470 18,544Net 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 = Operating income Cash from operations

= 850 584

= 266

2. Operating accruals = NOA Investment

= 160 (-106)

= 266

(c) NFO = NFE (C - I) + d

= 59 690 + 865

= 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 = Stock return - premium

= 22.4 (119 - 84)

= (12.6) (a loss)

2. OI = C - I + NOA

= 8.4 + (119 140)

= (12.6)

(Earnings = OI as there are no financial items)

3. Earnings = CSE + dividend

= -21 + 8.4

= (12.6)

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, Microsofts 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

E8.12. 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.

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

E9.6. 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%

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.

E10.10. 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 = Operating income Change in net operating assets = $2,740.1 (12,045.2 10,869.0) = 1,563.9

By Method 2,

Free cash flow = Net financial expense NFO + d

= 147.1 (6,113.7 4,124.6) + 3,405.9

= 1,563.9

Net payout to shareholders (d) = Comprehensive income CSE

= (2,740.1 147.1) (-812.9)

= 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

E11.5 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A What-If Question

The effect would be (almost) zero.

Existing RNOA = PM ATO

= 3.8% 2.9

= 11.02%

RNOA from new product line is

RNOA = 4.8% 2.3

= 11.04%

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%

E12.3. Analyzing the Growth in Shareholders Equity

Change in CSE = 583

Change in sales = 5,719

Change in 1/ATO = 1/2.4 1/2.5 = 0.4167 0.4 = 0.0167

Change in NFO = 1,984

Following Box 12.10,

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

E12.7. 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 Cokes 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%

E13.14. Enterprise Multiples for IBM Corporation

Here are the totals for IBMs 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 = 141,290/28,470 = 4.96

Unlevered (enterprise) P/B = 160,909/48,089 = 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 = $102/$8.73 = 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.

a. Free cash flow = OI NOA = 1,901 (12,847 12,297)

= 1,351

b. ReOI (2008) = 1,901 (0.058 12,297) = 1,188

c. 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

d. (This question is not in all printings of the book) Trailing P/E =

EdP +

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

649,1752250,20 +

= = 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? Its 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?

E13.18. 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 =

1.04-1.086895.6

5,644 +

= $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

AOIGOIFF

211

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 = 4,632 1.04

= 4,817.3

OI2007 = 4,817.3 0.2794

= 1,345.9

FCF2006 = OI2006 - NOA2006

= 1,294.0 185.3

= 1,108.7

AOIG2007 = OI2007 + FCF2006 reinvested (1.086 OI1997)

= 1,345.9 + (0.086 1,108.7) (1.086 1,294)

= $35.95 million

Method 2 (much simpler!): AOIG is growth in residual operating income from the previous

year

AOIG2007 = ReOL2006 0.04

= 895.6 0.04

= 35.82 (allow for rounding error)

Accordingly, the valuation is:

Value of equity =

+04.1086.1

82.35294,1086.01

+ 1,012

= $25,113 million or $96.18per share

(d) Value of operations = Value of equity - NFA

= 25,113 1,012

= $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

+=

11

01

1

0

1

0 1NBCOI

VELEV

OIV

EarnV NOANOAE

= 18.63 - [0.0244 (18.83 1/0.032]

= 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.