B8110 – Fall 2012
Solution
Exercise Set 2
Exercise 1.
Review of Accounting Relationships
a. (i) Total Liabilities = Total Assets – Shareholders’ Equity
= $19,042 – 6,216
= $12,826
Plug the statement of shareholders’ equity:
(ii)
_________________________________________________
Shareholders Equity 2007
5,319
Net payment to shareholders
Dividends
530
Share repurchases
Share issues
1,385
(1,133)
Comprehensive income
Shareholders equity 2008
(782)
?
6,216
________________________________________________
? = 1,679
(iii)
Net income = Comprehensive income – other comprehensive income
= $1,679 – 456
= $1,223
b. Common shares outstanding = shares issued – shares in treasury
= 377.3 – 39.8
= 337.5 millions
Book value per share
= $6,216 / 337.5
= $18.42
Exercise 2. Working with Accounting Relations
Reconstruct the reformulated statements and plug to the missing numbers:
Statement of Common Shareholders’ Equity
Beginning balance
Net payout to shareholders
Comprehensive income
Ending balance
$250
? = 17
40
$307
Balance Sheet
NOA
Totals
2012
2011
? = 477
___
450
___
477
2012
NFO
CSE
450
2011
170
307
? = 200
250
477
450
Income Statement
Operating income
Net financial expense
Comprehensive income
a.
b.
c.
d.
? = 50
(10)
40
ROCE = 40/250 = 16%
RNOA = 50/450 = 11.11%
NBC = 10/200 = 5%
Net payout to shareholders = -17 (plug in equity statement; this is negative, a net share
issue)
e. Net payout = Cash dividends + stock repurchases – share issues
-17 = ?
+
0
- 25
?
= 8
f. Free cash flow (C –I) = OI – ΔNOA
= 50 – 27
= 23
g. C – I = d + F
23 = -17 + ?
? = 40
h. The financing leverage equations is:
ROCE = RNOA + [FLEV × (RNOA – NBC)]
FLEV = NFO/CSE = 200/250 = 0.8
Thus,
ROCE = 11.11% + [0.8 ×(11.11% - 5%) = 16%]
Exercise 3. 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:
a. Market price of shares issued (if warrants are exercised on Oct. 18, 2012):
Exercise price
Loss
43.5 million x $125
$5,437.5 million
43.5 million x $115
$5,002.5 million
43.5 million x $(170-115)
$ 435.0 million
The loss is not tax deductible
b. No cost is recorded: the share issue is booked at $115 per share rather than $125: lowquality accounting.
Exercise 4. Analysis of the Profitability of an Insurance Company
Reformulated Balance Sheet, 2011
Net Operating Assets:
Investments
1,500
Insurance:
Operating assets
Operating liabilities:
Insurance claims
Unearned premiums
300
700
140
840
NFO (Long term debt)
Common shareholders’ equity
Reformulated Income Statement, 2012
Insurance income:
Premiums
Insurance losses and expenses
365
405
(40)
Investment income:
Dividends and interest
Realized gains
Unrealized losses
Comprehensive income
60
80
(65)
a. Rate of return on investments
= 75/1,500
= 5.0%
b. Net operating assets (insurance) = -540
Insurance earnings
= -40
Insurance residual earnings = -40 – (0.09 * -540)
= +8.6
75
35
(540)
960
150
810
Exercise 5. An Analysis of Starbucks Corporation
1. Reformulated statement of common shareholders’ equity
Reformulated Statement of Common Shareholders’ Equity
(in millions of dollars)
Balance, October 3, 2010 (excluding noncontrolling interest)
3,674.7
Net transactions with shareholders
Share issue
Stock option exercised
19.1
(216.4 + 256.3)
472.7
Share repurchase
(555.9)
Cash dividend
(419.5)
(483.6)
Comprehensive Income
Net income
1,245.7
Unrealized holding loss
(4.4)
Translation adjustment
(6.5)
Loss on stock options, after tax
160.2
Stock compensation recognized
147.2
Cost to purchase noncontrolling interest
Loss on stock options is calculated as follows:
Tax benefit
Stock option expense, after tax
1,221.8
(28.0)
Balance, October 3, 2011 (excluding noncontrolling interest)
Stock option expense (96.1/0.375)
(13.0)
256.3
96.1
160.2
4,384.9
The shares issued for the exercise of stock options are recorded at their market price in the
reformulated statement, that is, the issue price (excluding the tax benefit) plus the before-tax
expense. (The before-tax expense is the difference between market price and exercise price.)
The after-tax expense is recorded as part of comprehensive income, but is reduced by the
stock compensation recognized at grant date (to avoid double counting). See Chapter 9 of the
text.
There is a small tax benefit of $0.1 associated with other share issues—there must have been
some employee compensation involved—but this is ignored as immaterial.
For Questions 2 – 4, work from a reformulated income statement (although preparing a full reformulated
statement is not necessary to answer the questions).
The reformulation of the income statement requires a careful survey of the footnotes to discover income
that is not core income. Here is what the notes reveal:

Trading securities are recorded at fair value with unrealized holding gains and losses
included in net earnings (Note 1, investment note). The loss for 2011 was $2.1 million
(Note 3: Fair Value Measurements). This loss is included in “interest income and other”
on the income statement. The loss is treated as non-core income because the current year
gain or loss is not an indication of the future gain or loss.

There were net impairment and disposition losses of $36.2 million, $67.7 million, and
$224.4 million in fiscal 2011, 2010, and 2009, respectively (Note 1, Long-lived assets
note). For 2011, these are in store opening costs. (Note 1, Long-lived assets note).

There is a one-time gain in the cash flow statement: Gain resulting from acquisition of
joint ventures $55.2 million, This is included in net interest income and other (see Note
17: Acquisitions). The gain on sale of properties of $30.2 million in the cash flow
statement is identified in the income statement
.

The detail of the unrealized loss in Other Comprehensive Income (OCI) is in Note 11,
Comprehensive Income. Separate into operating (-4.8) and NFE (+0.4).

Advertising expenses totaled $141.4 million, $176.2 million, and $126.3 million in fiscal
2011, 2010, and 2009, respectively (Note 1). Separate out from “Other Operating
Expenses.”

The interest income and other is made up of:
Gain on acquisition of joint ventures
55.2 (Note 17)
Unrealized loss on trading securities
(2.1) (Note 3)
Interest income (plug)
62.8
Total
115.9
The following is relevant to the reformulation of the balance sheet:

All securities (beside the trading securities) are debt securities, both short-term and long
term (Note 1, investment note and Note 3: Fair Value Measurements).
Reformulated Income Statement, 2011
(in millions of dollars)
Net revenue
11,700.4
Cost of sales
4,949.3
Gross margin
6,751.1
Core operating expenses
Store operating expenses (3,665.1 - 36.2)
3,628.9
Advertising Expenses
141.4
Other operating expenses
260.6
Depreciation and amortization
523.3
General and administrative expenses
636.1
Core operating income from sales, before tax
1,560.8
Tax reported
563.1
Tax on interest income
(11.0)
Tax on non-core income
(17.7)
Core operating income from sales, after tax
5,190.3
534.4
1,026.4 (Q2)
Other core operating income
Income from equity invitees (reported after tax)
Core operating income, after tax
173.7
1200.1 (Q4)
Other operating income (non-core, unsustainable)
Before-tax items:
Gain on sale of properties
30.2
Gain from acquisition of joint ventures 55.2
Unrealized loss on trading securities
(2.1)
Impairment losses
(36.2)
47.1
Tax @ 37.5%
After-tax items:
17.7
29.4
Unrealized loss in OCI
(4.8)
Translation loss
(6.5)
Net loss on exercise of stock options
(13.0)
Operating income
5.1
1,205.2 ( Q3)
Net Financial Income
Interest income
62.8
Interest expense
33.3
Net interest
29.5
Tax @ 37.5%
11.0
Net interest offer tax
18.5
Unrealized gain on debt investments
0.4
18.9
1,224.1
Noncontrolling interest
Comprehensive income to common
(2.3)
1,221.8
Note that store opening costs are treated as core income because they happen every year. But there is an
argument to separate these out as non-core.
Reformulated Balance Sheet
(in millions of dollars)
2011
2012
Average
1,098.1
1,114.0
Short-term investments
855.0
236.5
Long-term investments
107.0
191.8
2,060.1
1,542.3
549.5
549.4
Net financial assets (NFA)
1,510.6
992.9
1,251.8
Net Operating Assets (NOA)
2,876.7
2,689.4
2,783.0
Total Equity
4,387.3
3,682.3
4,034.8
2.4
7.6
5.0
4,384.9
3,674.7
4,029.8
Net Financial assets:
Cash and cash equivalents (less $50m)
Financial assets
Long-term debt
Noncontrolling interest
Common shareholders’ equity (CSE)
Note: Net operating assets are given by a plus: NOA = total equity – NFA. Students cans list our the NOA
to confirm this.
Now to the questions:
Read off the answers to Q 2 – 4 from the reformulated income statement.
2. Core operating income from sales, after tax
1,026.4
3. Operating income
1,205.2
4.
1200.1
Core operating income, after tax
5. The numbers come from the reformulated balance sheet:
Net Operating Assets (NOA)
Net financial assets (NFA)
2,876.7
1,510.6
2,689.4
992.9
6.
1,224.1
 30.34%
4,034.8
1,221.8
 30.32%
ROCE (after noncontr interest) 
4,029.8
1,205.2
 43.31%
RNOA 
2,783.0
ROCE (before noncontr interest) 
Core RNOA 
1,200.1
 43.12%
2,783.0
FLEV 
- 1,251.8
 - 0.310
4,034.8
RNFA 
18.9
 1.51%
1,251.8
Note: the ROCE to common shareholders is after noncontrolling interest (30.32%). But the ROCE before
noncontrolling interest is used for Q7.
7.
Using the version of the leveraging equation with negative leverage,
ROCE =
RNOA + [FLEV × (RNOA – RNFA)]
=
43.31% + [-0.310 × (43.31% - 1.51%)]
=
30.34%
This is ROCE before noncontrolling interest. There is an adjustment to get ROCE after noncontrolling
interest: See Box 12.5 on Page 372 ot the text. (It is very small here).
(Allow for rounding error)
8.
Core profit margin from sales 
Asset turn over

1,026.4
 8.77%
11,700.4
11,700.4
 4.204
2,783.0
9.
C - I  OI -  NOA
 1,205.2 - (2,876.7 - 2,689.4)
 1,017.9
10..
Financial leverage at end of 2011 
- 1,510.6
 - 0.344
4,387.3
ROCE for 2011  43.12%  [-0.344 x (43.12% - 1.51%)]
 28.81%
Residual earnings  (0.2881 - 0.09)  4,384.9
 868.6
(This might be reduced by a forecast of the very small amount of noncontrolling interest
income, but this is ignored here: noncontrolling interest in the balance sheet now down to
$2.4million at the end of 2011).