Instructor’s solution manual
To accompany Business Analysis and
Valuation IFRS: Text and Cases (second
edition) and Business Analysis and Valuation
IFRS: Text Only (third edition).
 Krishna G. Palepu
 Paul Healy
 Erik Peek
Solutions – Chapter 1
Chapter 1 A Framework for Business Analysis Using Financial
Statements
Question 1.
Matti, who has just completed his first finance course, is unsure whether he should take a course in
business analysis and valuation using financial statements since he believes that financial analysis
adds little value given the efficiency of capital markets. Explain to Matti when financial analysis can
add value, even if capital markets are efficient.
The efficient market hypothesis states that security prices reflect all available information, as if such
information could be costlessly digested and translated immediately into demands for buys or sells.
The efficient market hypothesis implies that there is no further need for analysis involving a search
for mispriced securities.
However, if all investors adopted this attitude, no equity analysis would be conducted,
mispricing would go uncorrected, and markets would no longer be efficient. This is why there must
be just enough mispricing to provide incentives for the investment of resources in security analysis.
Even in an extremely efficient market, where information is fully impounded in prices within
minutes of its revelation (i.e., where mispricing exists only for minutes), Matti can get rewards with
strong financial analysis skills:
1. Matti can interpret the newly-announced financial data faster than others and trade on it
within minutes; and
2. Financial analysis helps Matti to understand the firm better, placing him in a better position to
interpret other news more accurately as it arrives.
Markets may be not efficient under certain circumstances. Mispricing of securities may exist even
days or months after the public revelation of a financial statement when the following three
conditions are satisfied:
1. Relative to investors, managers have superior information on their firms’ business strategies
and operation;
2. Managers’ incentives are not perfectly aligned with all shareholders’ interests; and
3. Accounting rules and auditing are imperfect.
When these conditions are met in reality, Matti could get profit by using trading strategies designed
to exploit any systematic ways in which the publicly available data are ignored or discounted in the
price-setting process.
Capital in market efficiency is not relevant in some areas. Matti can get benefits by using
financial analysis skills in those areas. For example, he can assess how much value can be created
through acquisition of target company, estimate the stock price of a company considering initial
public offering, and predict the likelihood of a firm’s future financial distress.
Question 2.
Accounting statements rarely report financial performance without error. List three types of errors
that can arise in financial reporting.
Three types of potential errors in financial reporting include:
1. Error introduced by rigidity in accounting rules;
2. Random forecast errors; and
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Solutions – Chapter 1
3. Systematic reporting choices made by corporate managers to achieve specific objectives.
Accounting Rules. Uniform accounting standards may introduce errors because they restrict
management discretion of accounting choice, limiting the opportunity for managers’ superior
knowledge to be represented through accounting choice. For example, IAS 38 requires firms to
expense all research expenditures when they are occurred. Note that some research expenditures
have future economic value (thus, to be capitalized) while others do not (thus, to be expensed). IAS
38 does not allow managers, who know the firm better than outsiders, to distinguish between the
two types of expenditures. Uniform accounting rules may restrict managers’ discretion, forgo the
opportunity to portray the economic reality of firm better and, thus, result in errors.
Forecast Errors. Random forecast errors may arise because managers cannot predict future
consequences of current transactions perfectly. For example, when a firm sells products on credit,
managers make an estimate of the proportion of receivables that will not be collected (allowance
for doubtful accounts). Because managers do not have perfect foresight, actual defaults are likely to
be different from estimated customer defaults, leading to a forecast error.
Managers’ Accounting Choices. Managers may introduce errors into financial reporting through
their own accounting decisions. Managers have many incentives to exercise their accounting
discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting.
For example, many top managers receive bonus compensation if they exceed certain prespecified
profit targets. This provides motivation for managers to choose accounting policies and estimates to
maximize their expected compensation.
Question 3.
A finance student states: “I don’t understand why anyone pays any attention to accounting earnings
numbers, given that a ‘clean’ number like cash from operations is readily available.” Do you agree?
Why or why not?
There are several reasons for why we should pay attention to accounting earnings numbers. First,
net profit predicts a company’s future cash flow better than current cash flow does. Net profit aids
in predicting future cash flows by reporting transactions with cash consequences at the time when
the transactions occur, rather than when the cash is received or paid. Net profit is computed on the
basis of expected, not necessarily actual, cash receipts and payments.
Second, net profit is potentially informative when there is information asymmetry between
corporate managers and outside investors. Note that corporate managers with superior information
choose accounting methods and accrual estimates which determine the net profit number. Because
accrual accounting requires managers to record past events and to make forecasts of future effects
of theses events, net profit can be used to convey managers’ superior information. For example, a
company’s decision to capitalize some portion of current expenditure, which increases today’s net
profit, conveys potentially informative signals to outside investors about the company’s ability to
generate future cash flows to cover the capitalized costs.
Question 4.
Fred argues: “The standards that I like most are the ones that eliminate all management discretion
in reporting—that way I get uniform numbers across all companies and don’t have to worry about
doing accounting analysis.” Do you agree? Why or why not?
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Solutions – Chapter 1
We don’t agree with Fred because the delegation of financial reporting decisions to corporate
managers may provide an opportunity for managers to convey their superior information to
investors. Corporate managers are typically better than outside investors at interpreting their firms’
current condition and forecasting future performance. Since managers have better knowledge of
the company, they have the potential to choose appropriate accounting methods and accruals
which portray business transactions more accurately. Note that accrual accounting not only requires
managers to record past events, but also to make forecasts of future effects of these events. If all
discretion in accounting is eliminated, managers will be unable to reflect their superior information
in their accounting choices.
When managers’ incentives and investors’ incentives are different and contracting mechanisms are
incomplete, giving no accounting flexibility to managers may result in a costlier solution to investors.
Further, if uniform accounting standards are required across all companies, corporate managers
may expend economic resources to restructure business transactions to achieve a desired
accounting result. Manipulation of real economic transactions is potentially more costly than
manipulation of earnings.
Question 5.
Bill Simon says, “We should get rid of the IASB, IFRS, and E.U. Company Law Directives, since free
market forces will make sure that companies report reliable information.” Do you agree? Why or
why not?
We partly agree with Bill on the point that corporate managers will disclose only reliable
information when rational managers realize that disclosing unreliable information is costly in the
long run. The long-term costs associated with losing reputation, such as incurring a higher capital
cost when visiting a capital market to raise capital over time, can be greater than the short-term
benefits from disclosing false information. However, free market forces may work for some
companies but not all companies to disclose reliable information.
Note that Bill’s argument is based on the assumption that there is no information asymmetry
between corporate managers and outside investors. In reality, the outside investors’ limitation in
accessing the private information of the company makes it possible for corporate managers to
report unreliable information without being detected immediately.
The E.U. and IASB standards attempt to reduce managers’ ability to record similar economic
transactions in dissimilar ways either over time or across firms. Compliance with these standards is
enforced by external auditors, who attempt to ensure that managers’ estimates are reasonable.
Without the E.U., IASB standards, and auditors, the likelihood of disclosing unreliable information
would be high.
Question 6.
Juan Perez argues that “learning how to do business analysis and valuation using financial
statements is not very useful, unless you are interested in becoming a financial analyst.” Comment.
Business analysis and valuation skills are useful not only for financial analysts but also for corporate
managers and loan officers. Business analysis and valuation skills help corporate managers in
several ways. First, by using business analysis for equity security valuation, corporate managers can
assess whether the firm is properly valued by investors. With superior information on a firm’s
strategies, corporate managers can perform their own equity security analysis and compare their
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Solutions – Chapter 1
estimated “fundamental value” of the firm with the current market price of share. If the firm is not
properly valued by outside investors, corporate managers can help investors to understand the
firm’s business strategy, accounting policies, and expected future performance, thereby ensuring
that the stock price is not seriously undervalued.
Second, using business analysis for mergers and acquisitions, corporate managers (acquiring
management) can identify a potential takeover target and assess how much value can be created
through acquisition. Using business analysis, target management can also examine whether the
acquirer’s offer is a reasonable one.
Loan officers can also benefit from business analysis, using it to assess the borrowing firm’s liquidity,
solvency, and business risks. Business analysis techniques help loan officers to predict the likelihood
of a borrowing firm’s financial distress. Commercial bankers with business analysis skills can
examine whether or not to extend a loan to the borrowing firm, how the loan should be structured,
and how it should be priced.
Question 7.
Four steps for business analysis are discussed in the chapter (strategy analysis, accounting analysis,
financial analysis, and prospective analysis). As a financial analyst, explain why each of these steps is
a critical part of your job and how they relate to one another.
Managers have better information on a firm’s strategies relative to the information that outside
financial analysts have. Superior financial analysts attempt to discover “inside information” from
analyzing financial statements. The four steps for business analysis help outside analysts to gain
valuable insights about the firm’s current performance and future prospects.
•
Business strategy analysis is an essential first step because it enables the analysts to frame the
subsequent accounting, financial, and prospective analysis better. For example, identifying the
key success factors and key business risks allows the identification of key accounting policies.
Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is
sustainable. Finally, business strategy analysis enables the analysts to make sound assumptions
in forecasting a firm’s future performance.
•
Accounting analysis enables the analysts to “undo” any accounting distortion by recasting a
firm’s accounting numbers. Sound accounting analysis improves the reliability of conclusions
from financial analysis.
•
The goal of financial analysis is to use financial data to evaluate the performance of a firm. The
outcome from financial analysis is incorporated into prospective analysis, the next step in
financial statement analysis.
•
Prospective analysis synthesizes the insights from business strategy analysis, accounting
analysis, and financial analysis in order to make predictions about a firm’s future.
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Solutions – Chapter 1
Problem 1. The Neuer Markt
1. Do you think that exchange market segments such as the EuroNM markets can be a good
alternative to venture capital? If not, what should be their function?
2. This chapter described four institutional features of accounting systems that affect the
quality of financial statements. Which of these features may have been particularly
important in reducing the quality of Neuer Markt companies’ financial statements?
3. The decline of the Neuer Markt could be viewed as the result of a ‘lemons problem.’ Can you
think of some mechanisms that might have prevented the market’s collapse?
4. What could have been the Deutsche Börse’s objective of introducing two new segments and
letting Neuer Markt firms choose and apply for admission to one of these segments? When
is this strategy most likely to be effective?
1. In general, exchange market segments such as the EuroNM markets cannot effectively serve as
an alternative to venture capital. Firms that obtain venture capital are typically firms with large
information problems. That is, the degree of information asymmetry between these firms’
insiders and potential investors is high because start-up firms’ inside information is often highly
proprietary (risk of other firms entering the same market) or their operating environment is
highly uncertain and/or unstable. These information problems cannot be easily overcome by
means of public reporting (because information is proprietary, the environment changes quickly,
management has strong incentives to misreport, or management still needs to build a
reputation etc.). Instead, venture capitalists obtain insider access to the firms’ private
information and use their expertise to separate good from bad business ideas.
The function of the EuroNM markets should be to offer venture capitalists the opportunity to
cash in on their investments once the start-up firms have reached a more mature development
phase and their business idea has proven successful (i.e., there are less information problems). If
this opportunity is available, venture capitalists will have a stronger incentive to screen and
finance (smaller) business ideas.
2. (Note that the four features are: accrual accounting, accounting conventions and standards,
auditing, reporting strategy):
a. Accrual accounting: the large investments in intangibles (goodwill, R&D etc.) and
tangibles (PP&E, inventories) made by fast-growing, innovative start-up companies tend
to make the difference between cash accounting and accrual accounting more
pronounced.
b. Accounting standards: Although International Accounting Standards (IAS/IFRS) and US
GAAP tend to be considered high-quality standards, inexperience with these standards
(both on the side of reporting firms and on the side of investors) might have reduced the
usefulness of IFRA/US GAAP-based reports. Further, the IFRS were still under
development during the late 1990s/early 2000s.
c. Auditing: European auditors’ inexperience with international standards and the absence
of strict enforcement in most countries may have reduced firms’ compliance with the
accounting standards.
d. Reporting strategy: the need for additional financing creates a strong incentive for
management to overstate the value of its business idea.
3. Mechanisms that may have helped to prevent the collapse:
a. Stricter admission criteria (accept only the more mature firms);
b. Improve the enforcement of accounting standards (SEC-type enforcement);
c. Make management more liable for its actions (i.e., reduce incentives to overstate
performance).
4. One of the main objectives might have been to separate the lemons from the high-quality firms.
If this strategy works, “lemons” (lower quality firms) should choose for a listing on the General
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Solutions – Chapter 1
Standard segment; high-quality firms should differentiate themselves from the lemons by
voluntarily choosing for a more strict regime (i.e., apply for a listing on the Prime Standard
segment). Of course, this signaling game only works if a listing on the Prime Standard segment is
more costly for low-quality firms than it is for high-quality firms. This is likely to be the case
when the enforcement of the admission, listing and accounting standards is strict, both in
expectation and practice.
Problem 2. Fair Value Accounting for Financial Instruments
1. Discuss how the changes in the reclassification rules affect the balance between noise
introduced in accounting data by rigidity in accounting rules and bias introduced in
accounting data by managers’ systematic accounting choices.
2. The move from marking to market to marking to model during the credit crisis increased
managers’ accounting flexibility. Managers of financial institutions may have incentives to
bias their valuations of financial instruments. Summarize the main incentives that may affect
these managers’ accounting choices.
3. Some politicians argued that fair value accounting needed to be suspended and replaced by
historical cost accounting. What is the risk of allowing financial institutions to report their
financial securities such as asset-backed securities at historical cost?
1. The reclassification rules intend to prevent that managers abuse their reporting discretion, that
is, move financial instruments back and forth between categories to strategically time the
recognition of gains or losses on these instruments. In doing so, however, the rules also prevent
managers from making perfectly justified reclassifications. One could therefore argue that the
rules are too rigid and, as such, introduce noise in banks’ accounting performance. Allowing
reclassifications would reduce the noise caused by the rigidity of the rules but, at the same time,
potentially increase the strategic bias in managers’ accounting decisions.
2. Managers of financial institutions may have (at least) the following incentives:
a. Management compensation. Performance-related bonuses have been common practice
in the financial industry. Managers of financial institutions may therefore be inclined to
overstate the values of assets under their control in order to overstate their investment
performance.
b. Regulatory considerations. Banks are strongly regulated and need to meet strict capital
requirements that are typically enforce by a central bank supervisor. Especially during
economic downturns, bank managers have the incentive to overstate the value of assets
to avoid violating capital requirements.
c. Stakeholder considerations. An important group of stakeholders of a bank are the bank’s
account holders. Strong declines in the bank’s asset values could create uncertainty
among such account holders, increasing withdrawals, and in the worst case scenario
cause a bank run. To avoid this, managers may be inclined to overstate assets.
3. Two potential drawbacks of historical cost accounting are:
a. If historical cost accounting allows managers to delay the recognition of asset value
declines as long as such declines are perceived as temporary, managers may avoid
recognizing losses on financial instruments by holding on to these assets, while selling
financial instruments with unrealized gains. This would help managers to (temporarily)
overstate performance.
b. The recognition of fair values of financial instruments on the balance sheet as well as fair
value changes in the income statements improves the extent to which the balance sheet
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Solutions – Chapter 1
and income statement of financial institutions reflect the risk of the institutions’
investments.
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Solutions – Chapter 10
Chapter 10 Credit Analysis and Distress Prediction
Question 1.
What are the critical performance dimensions for (a) a retailer and (b) a financial services company
that should be considered in credit analysis? What ratios would you suggest looking at for each of
these dimensions?
The critical performance dimensions of a retailer are related to its inventories turnover and profit
margins. Inventories turnover ratio is the cost of sales divided by average inventories balance. One
measure of margins is net profit divided by sales.
The critical performance of a financial services company includes the quality of assets (e.g., default
risks of loan portfolio), duration matching between assets and liabilities (i.e., its risk to interest rate
change), and profitability. The quality of loans that financial institution holds can be measured as
bad debt allowance divided by loans outstanding. Risk exposure can be measured by comparing the
duration between assets and liabilities. Profitability can be measured as net profit divided by net
worth.
Question 2.
Why would a company pay to have its public debt rated by a major rating agency (such as Moody’s
or Standard and Poor’s)? Why might a firm decide not to have its debt rated?
The public debt rating influences the yield that must be offered to sell the debt instrument. Suppose
that a company has information which is favorable in borrowing but confidential. It would disclose
the confidential information to the rating agency on the condition that its confidentiality be
maintained. The rating agency can work as an intermediary which will close the information gap
between the company and public investors. A rating agency with credibility may help a company to
get low cost financing.
Since debt ratings can be used as a mechanism to monitor management performance, corporate
managers may not want debt rating, which is another monitoring tool. Since the downgrades of
debt rating are greeted with drops in both bond and stock prices, both debt holders and
shareholders will question corporate managers’ performance in cases of downgrades.
Question 3.
Some have argued that the market for original-issue junk bonds developed in the U.S. in the late
1970s as a result of a failure in the rating process. Proponents of this argument suggest that rating
agencies rated companies too harshly at the low end of the rating scale, denying investment grade
status to some deserving companies. What are proponents of this argument effectively assuming
were the incentives of rating agencies? What economic forces could give rise to this incentive?
Rating agencies are conservative, because the cost of incorrect rating is asymmetrically severe if the
investment-grade firms go bankrupt. There are two types of errors in the rating decision: (1) rating
below investment-grade when the firm is healthy; (2) rating investment-grade when the firm is not
healthy (i.e., defaults in the future). Since the latter type of error is more damaging to the rating
agency’s reputation, the bond rating is likely to be conservative.
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Solutions – Chapter 10
Commercial banks and many pension funds are allowed to invest only in investment-grade (a rating
of BBB or higher) bonds. Shareholders of commercial banks and the ultimate owners of pension
funds, who worry about fund managers’ risky investment decisions but cannot monitor the fund
managers’ day-to-day investment decisions, may want bond rating agencies to be conservative in
their investment-grade ratings.
Question 4.
Many debt agreements require borrowers to obtain the permission of the lender before undertaking
a major acquisition or asset sale. Why would the lender want to include this type of restriction?
When the firm is in financial difficulty, conflicts may arise between debtors and stockholders.
Managers who are likely to represent stockholders’ interest may invest in riskier assets. Since the
stock has an option value, a major acquisition of risky assets under financial distress can increase
the value of stock but decrease the value of debt. To protect against the possibility of increased
business risk, lenders establish debt covenants that borrowers obtain permission of the lender
before making a major acquisition. Asset sales potentially reduce the security lenders have in the
case of financial distress.
Question 5.
Betty Li, the Financial Director of a company applying for a new loan, argues: “I will never agree to a
debt covenant that restricts my ability to pay dividends to my shareholders, because it reduces
shareholder wealth.” Do you agree with this argument?
Betty argues that restricting the flexibility of management decisions (such as dividend payout
decisions) would reduce the shareholder wealth. However, if the dividend payout decisions are not
restricted, management (or other agents of the shareholders) can liquidate the company by paying
cash dividends to shareholders in the case of financial distress. Unless there is a restriction on
dividend payout, rational lenders, concerned about the liquidation of the firm through cash
dividend, will demand higher interest rates. Contrary to Betty’s argument, shareholder wealth is
reduced when there is no restriction on dividend payout, because no restriction would result in a
higher cost of borrowing.
Question 6.
A bank extends three loans to the following companies: an Italy-based biotech firm; a France-based
car manufacturer; and a U.K.-based food retailer. How may these three loans from each other in
terms of loan maturity, required collateral, and loan amount?
Banks tend to extend loans with shorter maturities when a country’s laws provide them less
protection (in case of bankruptcy). By doing so they are able to regularly reevaluate the loan and
adjust the terms of the loan if necessary. Consequently, the bank may be more inclined to extend
loans with long maturities to U.K.-based companies than to Italy-based or France-based companies.
Additionally, the bank may decide to extend only small loan amount to the Italy-based and Francebased companies. This would force these companies to borrow from more than one bank, thereby
making it more difficult (costly) for the borrowers to strategically default and spreading the risk of
the total loan across a few banks.
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Solutions – Chapter 10
In Italy and France the bank would typically also demand more collateral to reduce the risk of the
loan than in the U.K. In the example, especially the French car manufacturer has assets that can
serve as collateral. The biotech firm has mostly intangible assets that banks typically do not accept
as collateral.
In summary, the three loans could have the following characteristics:
- Italy-based biotech firm: little collateral; short maturity; small amount
- France-based car manufacturer: much collateral; medium maturity; medium amount
- U.K.-based retailer: little collateral; long maturity; large amount
Question 7.
Cambridge Construction Plc follows the percentage-of-completion method for reporting long-term
contract revenues. The percentage of completion is based on the cost of materials shipped to the
project site as a percentage of total expected material costs. Cambridge’s major debt agreement
includes restrictions on net worth, interest coverage, and minimum working capital requirements. A
leading analyst claims that “the company is buying its way out of these covenants by spending cash
and buying materials, even when they are not needed.” Explain how this may be possible.
Under the revenue recognition method of Cambridge Construction, the company can accelerate
revenue (and net profit) recognition by purchasing materials. Suppose that the company purchased
€70 of raw materials when its cost of sales is 70% of sales (or the gross margin of long-term contract
is 30%) and its profit margin is 10%. The accounting journal entries for this purchasing transaction
are as follows:
1) Inventories and Trade payables increase by 70%.
2) Trade receivables and Sales increase by €100 (= €70/0.7). Inventories decreases by €70 and Cost
of sales increases by €70; Other expenses increase by €20 and Trade payables increases by €20.
3) Net profit and retained earnings both increase by €10 (= €100 x 0.1).
Under Cambridge Construction’s accounting policy, the €70 purchase of materials increases
retained earnings by €10 and increases the interest coverage ratio by boosting up the EBIT
(numerator in ratio). It also helps the company to meet the minimum working capital requirement
by increasing net working capital by €10 or more. Note that current assets (trade receivables)
increased by €100 whereas current liabilities increased by €90.
Question 8.
Can Cambridge improve its Z score by behaving as the analyst claims in Question 7? Is this change
consistent with economic reality?
Cambridge can improve its Z score by accelerating revenue recognition even if this change is not
consistent with economic reality. Accounting choice in Question 7 positively influences all of the five
components of the Altman Z-score: net working capital/total assets; retained earnings/total assets;
EBIT/total assets; shareholders’ equity/total liabilities; sales/total assets. Question 6 shows why
accounting analysis is important in credit analysis and distress prediction. Purely quantitative
models, such as the Altman Z-score, cannot substitute for the hard work of financial analysis
(business strategy analysis, accounting analysis, financial analysis, and prospective analysis).
Question 9.
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Solutions – Chapter 10
A banker asserts: “I avoid lending to companies with negative cash from operations because they are
too risky.” Is this a sensible lending policy?
No. A banker should decide whether the borrowing firm has the ability to service the debt at the
scheduled rate. Current period negative cash flow from operations is one of the factors that the
banker needs to consider but it is not the only factor. A banker should ask the following questions:
 Can the company turn around its cash flows in future periods? If the company can generate
positive cash flow from operations in the future, lending to that company may not be risky.
 Can the bank secure the loan with sufficient collateral in lending to the company? When the
amount of available security is sufficient to support the loan, the bank can minimize the risk of
loss in case of default.
 Is there any third-party loan guarantee? If the borrower is the subsidiary and the parent
presents some financial strength independent of the subsidiary, a guarantee of the parent will
reduce the risk of loss.
Question 10.
A leading retailer finds itself in a financial bind. It doesn’t have sufficient cash flow from operations
to finance its growth, and is close to violating the maximum debt-to-assets ratio allowed by its
covenants. The Vice-President for Marketing suggests: “We can raise cash for our growth by selling
the existing stores and leasing them back. This source of financing is cheap, since it avoids violating
either the debt-to-assets or interest coverage ratios in our covenants.” Do you agree with his
analysis? Why or why not? As the firm’s banker, how would you view this arrangement?
No, for several reasons. First, depending on the terms of the lease, accounting rules may ensure that
there is no material change in the retailer’s debt ratio or coverage ratio. This will happen if the lease
is recorded as a finance lease. Second, an operating lease arrangement may allow the company to
reduce the debt, but it will also reduce the asset base. Therefore, the banker may find the firm to be
more risky.
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Solutions – Chapter 11
Chapter 11 Mergers and Acquisitions
Question 1.
Since the year 2000, there has been a noticeable increase in mergers and acquisitions between firms
in different countries (termed cross-border acquisitions). What factors could explain this increase?
What special issues can arise in executing a cross-border acquisition and in ultimately meeting your
objectives for a successful combination?
Several factors could help explain the increase in merger and acquisition activity between firms in
different countries. These factors may include:
Relaxation of foreign ownership laws. As countries have allowed greater foreign ownership of
companies in certain industries (e.g., broadcasting, telephone, steel, automobile), foreign
companies have undertaken mergers that were previously prevented due to governmental
restrictions.
Expansion of regional free trade areas. Once a regional trading block is implemented, it can become
more difficult for foreign firms to export its products to countries within the block. As a result, a
foreign firm may purchase a company within the block to guarantee access to the block. For
example, many American firms rushed to purchase European firms before January 1, 1996 to assure
continued access to markets of European Union members as integration of the EU markets entered
its next phase. Similarly, increased free trade can create new opportunities for firms within the
block to expand their markets. Acquisitions can provide a way of taking advantage of these
opportunities. For example, the integration of markets in Europe may provide opportunities for, say,
German and U.K. banks to use cross-border acquisitions to develop into a European bank.
Globalization of certain industries. Once a company has reached the maximum production in its
home market, it may seek greater economies of scale and scope by purchasing competitors in
foreign markets. By expanding its production to the greatest extent possible, the firm hopes to
achieve the most efficient cost structure. This globalization forces the remaining companies to
consolidate to achieve the same level of scale and scope economies.
Search for new markets. Once domestic markets for a specific product have matured, a domestic
firm will often try to continue its expansion in foreign markets. Often, the easiest way to enter a
foreign market is to purchase a company already operating in that market. It guarantees immediate
market share and instant name recognition with local consumers.
International mergers will create special issues that will ultimately affect the success of the merger.
These special issues may include valuing a foreign company that operates and prepares its financial
reports under different accounting rules. Differences in accounting rules may include:
 Treatment of intangibles, such as research and development expenses, brand names, goodwill,
patents, etc.
 Treatment of inflation.
 Foreign exchange exposure.
 Hedging acquisition price.
 Hedging future cash flows from the foreign firm.
 Regulatory considerations.
 Foreign government investment approvals.
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Solutions – Chapter 11
Foreign government antitrust approvals.
Ability to expatriate earnings from the foreign country.
Differences in laws, regulations, and rules governing personnel and human resources areas.
Differences in the operations of foreign markets and companies, including differences in
management practices, worker norms and expectations, roles of government in the economy,
and corruption in the business and political environments of the economy.
 Management and coordination of domestic and foreign operations.
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Question 2.
Private equity firms have become an important player in the acquisition market. These private
investment groups offer to buy a target firm, often with the cooperation of management, and then
take the firm private. Private equity buyers tend to finance a significant portion of the acquisition
with debt.
a. What types of firms would make ideal candidates for a private equity buyout? Why?
b. How might the acquirer add sufficient value to the target to justify a high buyout
premium?
Ideal target firms are those that:
 Generate relatively stable cash flows to repay the debt that has been used to finance the
acquisition.
 Have relatively low tax shields prior to the buyout, so that the leveraged buyout can create new
value through interest tax shields.
 Have assets in place, versus growth options or intangible assets. If buyout firms have high
growth opportunities, any financial distress due to high leverage will probably reduce their
ability to fund the new opportunities. Buyout firms with intangible assets (such as star research
personnel) will also be affected by financial distress since these highly-valued assets can leave,
whereas assets in place cannot.
 Opportunities for better management of the firm’s operations. Debt financing imposes fiscal
discipline on a firm’s managers and employees. The firm is required to make large debt
payments on a regular basis; otherwise the firm could be in default and taken over by its
creditors. Management and employees alike would probably lose their jobs. In order to make
debt payments, management and employees are forced to eliminate any wasted expenditures,
reduce the firm’s cost structure, and increase the firm’s efficiency.
Question 3.
Kim Silverman, Finance Director of the First Public Bank, notes: “We are fortunate to have a cost of
capital of only 10 percent. We want to leverage this advantage by acquiring other banks that have a
higher cost of funds. I believe that we can add significant value to these banks by using our lower
cost financing.” Do you agree with Silverman’s analysis? Why or why not?
Disagree. In general, a company’s cost of capital is related to the riskiness of its underlying assets. As
long as the risk of the assets does not change, then the cost of capital related to those assets will
remain the same, regardless of who owns the assets. If a firm with a low cost of capital buys a firm
with a higher cost of capital, the purchasing firm’s cost of capital will increase accordingly.
One exception, however, is if there are capital market imperfections that make external financing
more expensive. These imperfections could arise from information asymmetries between managers
and outside investors. This type of information problem is likely to occur for newly-formed, high-
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Solutions – Chapter 11
growth companies. The rapid changes in the business and growth prospects of these firms are often
difficult to communicate adequately to outside investors. Because outside investors have incomplete
information about the company, they require additional compensation, increasing the cost of capital.
It is unlikely that the First Public Bank will be able to find any other banks with a higher cost of capital,
due to capital market imperfections. Banks are not typically newly-formed, high-growth companies.
The banking industry in Western Europe and the U.S. is a relatively stable and mature industry. As a
result, banks are unlikely to have the types of information asymmetries that are associated with
capital market imperfections. Banks will have higher capital costs due to riskier assets rather than to
information asymmetries. Unless the First Public Bank changes the risk of the portfolio of assets held
by a bank it purchases, the other bank’s cost of capital will not change. Consequently, First Public Bank
will not be able to take advantage of its lower cost of capital to generate value by merging with a bank
with a higher cost of capital.
Question 4.
The Munich Beer Company plans to acquire Liverpool Beer Co. for £60 per share, a 50 percent
premium over current market price. Jan Höppe, the Financial Director of Munich Beer, argues that
this valuation can easily be justified, using a price-earnings analysis. Munich Beer has a priceearnings ratio of 15, and we expect that we will be able to generate long-term earnings for Liverpool
Beer of £5 per share. This implies that Liverpool Beer is worth £75 to us, well below our £60 offer
price.” Do you agree with this analysis? What are Höppe’s key assumptions?
Disagree. Höppe has made two key assumptions, each of which is questionable and could lead to
the Munich Beer Company paying too much for Liverpool Beer. First, he assumes that Liverpool Beer
will have long-term earnings of £5 per share beginning almost immediately after purchase. It may
take several years for Liverpool Beer’s earnings to reach £5 per share once changes in management
and operations have been put into place. If earnings of £5 per share are not immediately attainable,
Höppe will have to adjust the expected earnings downward. Otherwise, using £5 per share with the
given P/E multiple will generate a price for Liverpool Beer that is too high.
Second, Höppe assumes that the market will value earnings from Liverpool Beer using the Munich
Beer Company’s P/E multiple. Just because the Munich Beer Company owns Liverpool Beer does not
mean that the two companies will have the same earnings multiples. Firms are likely to have the
same P/E multiple if their growth and risk characteristics are similar, but Höppe has not given us any
reasons to expect that this is the case for Liverpool Beer and the Munich Beer Company. Instead of
using the Munich Beer Company’s P/E multiple, Höppe should have used a multiple based on that of
firms similar to Liverpool Beer to obtain a more accurate value for Liverpool Beer. Hence, Höppe’s
estimation of Liverpool Beer’s value is likely to be wrong, and a successful bid for Liverpool Beer
using his valuation could cause the Munich Beer Company to overpay.
Question 5.
You have been hired by GS Investment Bank to work in the merger department. The analysis required
for all potential acquisitions includes an examination of the target for any off-balance-sheet assets
or liabilities that have to be factored into the valuation. Prepare a checklist for your examination.
Off-Balance Sheet Liabilities
 Executory contracts
 Contingent obligations
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Solutions – Chapter 11
 Operating leases
 Liabilities under environmental regulations
Off-Balance Sheet Assets—Depending on the specific circumstance, these assets may already be
included on the balance sheet. These assets are either valued (e.g., intangible assets) or revalued
(e.g., land held for sale) once they have been purchased by another company.





Research (and possibly development) expenditures
Patents, trademarks, and other intellectual property
Brand names
Goodwill
Land held for sale
Question 6.
A target company is currently valued at €50 in the market. A potential acquirer believes that it can
add value in two ways: €15 of value can be added through better working capital management, and
an additional €10 of value can be generated by making available a unique technology to expand the
target’s new product offerings. In a competitive bidding contest, how much of this additional value
will A have to pay out to the target’s shareholders to emerge as the winner?
There are two sources of value in Firm A’s bid for Company T. One source of value is €15 per share
due to improved working capital management. Firm A, however, is not the only firm that can make
the necessary management changes to generate this value. Any new owners of Company T could
generate €15 in value through better working capital management. Hence, Firm T is worth €65 per
share in the hands of any outside management that can make the necessary changes to working
capital. A second source of value, proprietary technology, is unique to Firm A and will generate an
additional €10 in value per share, but only if the company is purchased by Firm A. As a result,
Company T is worth €75 per share to Firm A and a maximum of €65 per share to any other firms
that would bid. Because Company T is worth more than €65 to Firm A, Firm A could bid slightly
higher than €65,acquire Company T, and keep the difference between the purchase price and €75.
Hence, Firm A should be able to keep most of the unique value that it can generate for Company T.
Question 7.
A leading oil exploration company decides to acquire an electronics company at a 50 percent
premium. The acquirer argues that this move creates value for its own stockholders because it can
use its excess cash flows from the oil business to help finance growth in the new electronics segment.
Evaluate the economic merits of this claim.
The oil company is arguing that a merger could create value by providing low-cost financing to a
financially-constrained electronics firm. This argument is based on the idea that capital market
imperfections have prevented the electronics company from investing in all of its growth
opportunities. These imperfections may have developed as a result of information asymmetries
between management and outside investors. If the electronics firm has to rely on outside investors
to finance its growth, capital market constraints could prevent it from undertaking worthwhile
projects because public capital markets would probably be a costly source of funds for the firm.
However, by purchasing the electronics company, the oil company can help it overcome the capital
market imperfections and enable the electronics firm to invest in all of its growth opportunities.
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Solutions – Chapter 11
The merits of the oil company’s argument for buying the electronics company depend on two
conditions. First, financial constraints must be preventing the electronics firm from undertaking
some profitable projects. If the electronics firm is not financially-constrained or does not have a set
of unfunded but profitable projects, then having access to the additional capital of the oil company
will not create value. The only projects the firm would have left would be unprofitable ones.
Second, the financial constraints must be due to capital market imperfections. It is plausible that the
electronics firm could face capital market imperfections due to information asymmetries.
Information problems are likely to be severe for newly-formed, high-growth companies, a
description typical of many electronics firms. If information problems make it difficult for outside
investors to value the electronics firm because of its short track record or because its financial
statements provide little insight about the value of its growth opportunities, then outside investors
could be an expensive source of funds.
However, there should be some doubts about the value of this acquisition by the oil firm. First, why
does an oil company have a comparative advantage assessing the merits of future investments in
the electronics industry than the financial market at large or than other investors that specialize in
electronics? Management’s lack of expertise in electronics is likely to lead it to over-estimate the
value of the target’s investments and therefore to overpay for the firm. Consequently, it seems that
the oil company’s stockholders would be better served if its management paid out the surplus cash
intended for the acquisition and subsequent investment in electronics. Second, will the acquisition
divert the oil company’s management’s attention away from managing the oil business effectively,
by requiring them to also develop expertise in electronics, thereby reducing the value of the core
business? Recently, many diversified businesses have actually been divesting unrelated businesses
primarily to refocus on their core activities.
Question 8.
Under current International Financial Reporting standards, acquirers are required to capitalize
goodwill and report any subsequent declines in value as an impairment charge. What performance
metrics would you use to judge whether goodwill is impaired?
Examples of performance metrics that can be used as indicators of goodwill impairment are:
- changes in value added of the industry in which the acquired firm operates;
- operating performance or share price performance of the acquired firm’s industry peers;
- operating performance of the product segment in which the acquired firm operates.
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Solutions – Chapter 2
Chapter 2 Strategy Analysis
Question 1.
Judith, an accounting major, states: “Strategy analysis seems to be an unnecessary detour in doing
financial statement analysis. Why can’t we just get straight to the accounting issues?” Explain to
Judith why she might be wrong.
Strategy analysis enables the analyst to understand the underlying economics of the firm and the
industry in which the firm competes. There are a number of benefits to developing this knowledge
before performing any financial statement analysis.
1. Strategy understanding provides a context for evaluating a firm’s choice of accounting policies
and hence the information reflected in its financial statements. For example, accounting policies
(such as revenue recognition and cost capitalization) can differ across firms either because of
differences in business economics or because of differences in management’s financial
reporting incentives. Only by understanding differences in firms’ business strategies is it
possible to assess how much to rely on a firm’s accounting information.
2. Strategy analysis highlights the firm’s profit drivers and major areas of risk. An analyst can then
use this information to evaluate current firm performance and to assess the firm’s likelihood of
maintaining or changing this performance based on its business strategy.
3. Strategy analysis also makes it possible to understand a firm’s financial policies and whether
they make sense. As discussed later in the book, the firm’s business economics is an important
driver of its capital structure and dividend policy decisions.
In summary, understanding a firm’s business, the factors that are critical to the success of that
business, and its key risks is critical to effective financial statement analysis.
Question 2.
What are the critical drivers of industry profitability?
Rivalry Among Existing Firms. The greater the degree of competition among firms in an industry,
the lower average profitability is likely to be. The factors that influence existing firm rivalry are
industry growth rate, concentration and balance of competitors, degree of differentiation and
switching costs, scale/learning economies and the ratio of fixed to variable costs, and excess
capacity and exit barriers.
Threat of New Entrants. The threat of new entry can force firms to set prices to keep industry
profits low. The threat of new entry can be mitigated by economies of scale, first mover advantages
to incumbents, greater access to channels of distribution and existing customer relationships, and
legal barriers to entry.
Threat of Substitute Products. The threat of substitute products can force firms to set lower prices,
reducing industry profitability. The importance of substitutes will depend on the price sensitivity of
buyers and the degree of substitutability among the products.
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Solutions – Chapter 2
Bargaining Power of Buyers. The greater the bargaining power of buyers, the lower the industry’s
profitability. Bargaining power of buyers will be determined by the buyers’ price sensitivity and their
importance to the individual firm. As the volume of purchases of a single buyer increases, its
bargaining power with the supplier increases.
Bargaining Power of Suppliers. The greater the bargaining power of suppliers, the lower the
industry’s profitability. Suppliers’ bargaining ability increases as the number of suppliers declines
when there are few substitutes available.
Question 3.
One of the fastest growing industries in the last twenty years is the memory chip industry, which
supplies memory chips for personal computers and other electronic devices. Yet the average
profitability has been very low. Using the industry analysis framework, list all the potential factors
that might explain this apparent contradiction.
Concentration and Balance of Competitors. The concentration of the memory chip market is
relatively low. There are many players that compete on a global basis, none of which has a
dominant share of the market. Due to this high degree of fragmentation, price wars are frequent as
individual firms lower prices to gain market share.
Degree of Differentiation and Switching Costs. In general, memory chips are a commodity product
characterized by little product differentiation. While some product differentiation occurs as chip
makers squeeze more memory on a single chip or design specific memory chips to meet
manufacturers’ specific power and/or size requirements, these differences are typically short-lived
and have not significantly reduced the level of competition within the industry. Furthermore,
because memory chips are typically interchangeable, switching costs for users of memory chips
(computer assemblers and computer owners) encouraging buyers to look for the lowest price for
memory chips.
Scale/Learning Economies and the Ratio of Fixed to Variable Costs. Scale and learning economies
are both important to the memory chip market. Memory chip production requires significant
investment in “clean” production environments. Consequently, it is less expensive to build larger
manufacturing facilities than to build additional ones to satisfy additional demand. Moreover, the
yield of acceptable chips goes up as employees learn the intricacies of the extremely complicated
and sensitive manufacturing process. Finally, while investments in memory chip manufacturing
plants are typically very high, the variable costs of materials and labor are relatively low, providing
an incentive for manufacturers to reduce prices to fully utilize their plant’s capacity.
Excess Capacity. Historically, memory chip plants tend to be built in waves, so that several plants
will open at about the same time. Consequently, the industry is characterized by periods of
significant excess capacity where manufacturers will cut prices to use their productive capacity (see
above).
Threat of Substitute Products. There are several alternatives to memory chips including other
information storage media (e.g., hard drives and disk drives) and memory management software
that “creates” additional memory through more efficient use of computer system resources.
Price Sensitivity. There are two main groups of buyers: computer manufacturers and computer
owners. Faced with an undifferentiated product and low switching costs, buyers are very price
sensitive.
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Solutions – Chapter 2
All the above factors cause returns for memory chip manufacturers to be relatively low.
Question 4.
Joe argues: “Your analysis of the five forces that affect industry profitability is incomplete. For
example, in the banking industry, I can think of at least three other factors that are also important;
namely, government regulation, demographic trends, and cultural factors.” His classmate Jane
disagrees and says, “These three factors are important only to the extent that they influence one of
the five forces.” Explain how, if at all, the three factors discussed by Joe affect the five forces for the
banking industry.
Government regulation, demographic trends, and cultural factors will each impact the analysis of
the banking industry. While these may be important, they can each be recast using the five forces
framework to provide a deeper understanding of the industry. The power of the five forces
framework is its ability to incorporate industry-specific characteristics into analysis for any industry.
To see how government regulation, demographic trends, and cultural factors are important in the
banking industry, we can apply the five forces framework as follows:
Rivalry Among Existing Firms. Government regulation has played a central role in promoting,
maintaining, and limiting competition among banks. Banks are regulated at the national and
European levels. In the past, national regulations restricted banks from operating across (some
European) borders. The government also regulates the riskiness of a bank’s portfolio in an effort to
prevent banks from competing for new customers by taking on too many high-risk investments,
loans, or other financial instruments. These regulations have limited the degree of competition
among banks. However, European deregulation of the industry has made it easier for banks to
expand into new geographic areas, increasing the level of competition.
Threat of New Entrants. Government regulations have limited the entry of new players into the
banking industry. New banks must meet the requirements set by regulators before they can begin
operation. However, as noted above, deregulation of some aspects of banking has made it easier for
out-of-country banks to enter new markets. Further, it appears to be relatively easy for non-banking
companies to successfully set up financial services units (e.g., car manufacturers). Finally, as
consumers have become more comfortable with technology, “Internet banks” have formed. These
“banks” provide the same services as traditional banks, but with a very different cost structure.
Threat of Substitute Products. The primary functions of banks are lending money and providing a
place to invest money. Potential substitutes for these functions are provided by thrifts, credit
unions, brokerage houses, mortgage companies, and the financing arms of companies such as car
manufacturers. Government regulation of these entities varies dramatically, affecting how similar
their products are to those of banks. In addition, consumers have been become increasingly familiar
with non-bank options for investing money. As another example, some brokerage houses provide
money market accounts that function as checking accounts. As a result, the threat of substitutes for
bank services has grown over time.
Bargaining Power of Buyers. Business and consumer buyers of credit have little direct bargaining
power over banks and financial institutions. The buying power of customers is probably also
stronger in relationship banking than under a transactions approach, where consumers seek the
lowest-cost lender for each new loan. Because the use of these approaches varies across countries
(due to legal differences; see chapter 10), the bargaining power of buyers may also vary.
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Solutions – Chapter 2
Bargaining Power of Suppliers. Depositors have historically had little bargaining power.
In summary, bank regulations have historically had a very important role in determining bank
profitability by restricting competition. However, deregulation in the industry as well as the
emergence of non-bank substitutes has increased competition in the industry.
Question 5.
Examples of European firms that operate in the pharmaceutical industry are GlaxoSmithKline and
Bayer. Examples of European firms that operate in the tour-operating industry are Thomas Cook and
TUI. Rate the pharmaceutical and tour operating industries as high, medium, or low on the following
dimensions of industry structure: (1) Rivalry; (2) Threat of new entrants; (3) Threat of substitute
products; (4) Bargaining power of suppliers, and (5) Bargaining power of buyers. Given your ratings,
which industry would you expect to earn the highest returns?
Pharmaceutical firms historically have had some of the highest rates of return in the economy,
whereas tour operators have had moderate returns. The following analysis reveals why.
Rivalry
Threat
of
New Entrants
Threat
of
Substitute
Products
Pharmaceutical Industry
Medium
Firms compete fiercely to develop
and patent drugs. However, once a
drug is patented, a firm has a
monopoly
for
that
drug,
dramatically reducing competition.
Competitors can only enter the
same market by developing a drug
that does not infringe on the patent.
Low
Economies of scale and first mover
advantages are very high for the
industry. Patents deter new
entrants. In addition, drug firms’
sales forces have established
relationships with doctors which act
as a further deterrent for a new
entrant. This distribution advantage
is changing as managed-care firms
have begun negotiating directly with
drug companies on behalf of the
doctors in their network.
Low
New drugs are protected by patents
giving manufacturers a monopoly
position. Competitors are forced
either to invent around the patent
or to wait until the patent expires.
Once the patent expires, a company
will reduce prices as other
manufacturers enter the market.
4
Tour Operating Industry
High
In the 1990s the European tourism
industry exhibited strong growth. After a
slowdown in growth due to the 2001
terrorism attacks, growth has been steady
in the 2000s. However, the trend towards
short-term bookings and web-based
bookings (in combination with high price
transparency) has structurally changed
the industry and increased competition.
Medium to high
“Tourism
e-mediaries”
such
as
expedia.com can relatively easily enter
the market. In addition, suppliers of
accommodation and travel services (such
as Ryanair) start bypassing tour operators
by offering their products online.
Solutions – Chapter 2
Bargaining
Power
of
Buyers
Bargaining
Power
of
Suppliers
The threat of substitute products,
however, is likely to increase as
biotech products enter the market.
Low
Historically, doctors have had little
buying power. However, in some
countries managed-care providers
have become more powerful
recently,
and
have
begun
negotiating substantial discounts for
drug purchases.
Low
The chemical ingredients for drugs
can be obtained from a variety of
chemical suppliers.
High
The online offering of accommodation,
flight services, car rentals etc. has
increased price transparency and,
consequently,
increased
buyers’
bargaining power.
Medium
Tour
operators
are
large
and
concentrated relative to the suppliers of
accommodation and other services.
However, suppliers have the ability to
“bypass” tour operators by selling their
accommodation directly through the
internet. Tour operators respond to this
threat by means of vertically integrating
their activities (e.g., owning their own
hotels and airlines).
Question 6.
In 2011, Puma was a very profitable sportswear company. Puma did not produce most of the shoes,
apparel and accessories that it sold. Instead, the company entered into contracts with independent
manufacturers, primarily in Asia. Puma also licensed independent companies throughout the world
to design, develop, produce and distribute a selected range of products under its brand name. Use
the five forces framework and your knowledge of the sportswear industry to explain Puma’s high
profitability in 2011.
While consumers perceive an intensely competitive relationship between companies such as Puma
Adidas, these major players in the sportswear industry have structured their businesses to retain
most of the profits in the industry by concentrating operations in its least competitive segments.
Puma competes primarily on brand image rather than on price. The company sources the
manufacturing of its sports products to smaller independent manufacturers, located in Asia and
Eastern Europe, over which the company has significant bargaining power.
The threat of new entrants is restricted by limited access to adequate distribution channels, (even
more) by the valuable brand name that has been created by Puma, and Puma’s expertise in
development and design. While sportswear is relatively inexpensive and easy to make (also given
the large number of independent manufacturers), a sportswear manufacturer would have difficulty
finding a distributor that could get its products to retail stores and placed in desirable shelf space.
The high levels of advertising by Puma (including sponsoring contracts with celebrity athletes) have
created a highly valued, universally recognized brand, which would be difficult for a potential
competitor to replicate.
Puma’s valuable brand name and the great demand for the company’s products improve the
company’s bargaining power over its distributors (retail stores). To reduce the power of
distributors/retail stores even more, the company has started to open own stores in an increasingly
5
Solutions – Chapter 2
number of large cities around the world (such as in Amsterdam, Stockholm, Frankfurt, London,
Rome, Milan, Melbourne, Tokyo, Boston, Seattle, Sydney, Osaka, Philadelphia, and Las Vegas).
Puma also makes money by licensing other companies to produce and distributes products under
the Puma brand name. The sports licensing business tends to be highly competitive, which makes
that Puma has substantial bargaining power over licensees.
Potential threats to Puma’s competitive position are the following:
- Puma needs to continue investing substantial amounts in advertising, sponsoring, design
and innovation in order to sustain its brand image.
- Some of the companies to which Puma sources its production are by no means small,
powerless production companies. For example, in 2005, one of Puma’s suppliers was HongKong-based Yue Yuen. This supplier employed 252,000 people, had production plants in
China, Vietnam and Indonesia with in total 3.4 million square meters of floor space, and
produced 167.2 million pairs of shoes per year for most of the larger athletic shoe sellers.
Question 7.
In response to the deregulation of the European airline industry during the 1980s and 1990s,
European airlines followed their U.S. peers in starting frequent flier programs as a way to
differentiate themselves from others. Industry analysts, however, believe that frequent flyer
programs had only mixed success. Use the competitive advantage concepts to explain why.
Initially, frequent flier programs had only limited success in creating differentiation among airlines.
Airlines tried to bundle frequent flier mileage programs with regular airline transportation to
increase customer loyalty and to create a differentiated product. Furthermore, the airlines
anticipated that the programs would fill seats that would otherwise have been empty and would, so
they believed, have had a low marginal cost. However, because the costs of implementing a
program were low, there were very few barriers to other airlines starting their own frequent flier
programs. Before long, every airline had a frequent flier program with roughly the same
requirements for earning free air travel. Simply having a frequent flier program no longer
differentiated airlines.
Airlines have had some success in differentiating frequent flier programs by creating additional ways
to earn frequent flier mileage and increasing the number of destinations covered. Airlines have
developed “tie-ins” with credit card companies, car rental companies, hotels, etc. to allow members
of a particular frequent flier program more ways to earn frequent flier mileage. They have also
reached agreements with foreign airlines (within alliances) so that frequent flier mileage can be
redeemed for travel to locations not served by the carrier. Finally, the programs have provided
additional services for their best customers, including special lines for check-in and better flight
upgrade opportunities. As a result of these efforts, airline programs have been somewhat successful
in increasing customer loyalty.
Question 8.
What are the ways that a firm can create barriers to entry to deter competition in its business? What
factors determine whether these barriers are likely to be enduring?
Barriers to entry allow a firm to earn profits while at the same time preventing other firms from
entering the market. The primary sources of barriers to entry include economies of scale, absolute
6
Solutions – Chapter 2
costs advantages, product differentiation advantages, and government restrictions on entry of
competitors. Firms can create these barriers through a variety of means.
1. A firm can engineer and design its products, processes, and services to create economies of
scale. Because of economies of scale, larger plants can produce goods at a lower cost that
smaller plants. Hence, a firm considering entering the existing firm’s market must be able to
take advantage of the same scale economies or be forced to charge a higher price for its
products and services.
2. Cost leaders have absolute cost advantages over rivals. Through the development of superior
production techniques, investment in research and development, accumulation of greater
operating experience or special access to raw materials, or exclusive contracts with distributors
or suppliers, cost leaders operate at a lower cost than any potential new entrants to the market.
3. Differentiation of the firm’s products and services may also help create barriers to entry for
other firms. Firms often spend considerable resources to differentiate their products or services.
Soft drink makers, for example, invest in advertising designed to differentiate their products
from other products in the market. Other competitors that would like to enter the market will
be forced to make similar investments in any new products.
4. Firms often try to persuade governments to impose entry restrictions through patents,
regulations, and licenses. In the U.S., AT&T fought with the government for many years to
prevent other providers of long distance telephone service from entering the market. Similarly,
the local Bell operating companies have lobbied the federal government to write laws to make it
difficult for other firms to provide local phone service.
Several factors influence how long specific barriers to entry are effective at preventing the entry of
competitors into an industry.
 Economies of scale depend on the size and growth of the market. If a market is growing quickly,
a competitor could build a larger plant capable of producing at a cost lower than the incumbent.
If a market is flat, there may not be enough demand to support additional production at the
efficient scale, which forces new entrants to have higher costs.
 Absolute cost advantages depend on competitors’ difficulty in designing better processes. Some
processes receive legal protection from patents. Entrants must either wait for the patent to
expire or bear the expense of trying to invest around the patent. Similarly, differentiation
advantages last only so long as a firm continues to invest in differentiation and it is difficult for
other firms to replicate the same differentiated product or service.
 Incumbent firms and potential entrants can both lobby the government. If potential entrants
launch intensive lobbying and public interest campaigns, laws, regulations, and rules can change
to ease entry into a once-protected industry. Several recent examples in Europe are
deregulation of the airline and banking industries.
Question 9.
Explain why you agree or disagree with each of the following statements.
a. It’s better to be a differentiator than a cost leader, since you can then charge premium prices.
Disagree. While it is true that differentiators can charge higher prices compared to cost leaders,
both strategies can be equally profitable. Differentiation is expensive to develop and maintain.
It often requires significant company investment in research and development, engineering,
training, and marketing. Consequently, it is more expensive for companies to provide goods and
services under a differentiated strategy. Thus, profitability of a firm using the differentiated
7
Solutions – Chapter 2
strategy depends on being able to produce differentiated products or services at a cost lower
than the premium price. On the other hand, the cost leadership strategy can be very profitable
for companies. A cost leader will often be able to maintain larger margins and higher turnover
than its nearest competitors. If a company’s competitors have higher costs but match the cost
leader’s prices, the competitors will be forced to have lower margins. Competitors that choose
to keep prices higher and maintain margins will lose market share. Hence, being a cost leader
can be just as profitable as being a differentiator.
b. It’s more profitable to be in a high-technology than a low-technology industry.
Disagree. There are highly profitable firms in both high technology and low technology
industries. The argument presumes that high technology always creates barriers to entry.
However, high technology is not always an effective entry barrier and can be associated with
high levels of competition among existing firms, high threat of new entrants, substitute
products, and high bargaining power of buyers and/or sellers. For example, the personal
computer industry is a high-technology business, yet is highly competitive. There are very low
costs of entering the industry, little product differentiation in terms of quality, and two very
powerful suppliers (Microsoft and Intel). Consequently, firms in the PC business typically
struggle to earn a normal return on their capital. In contrast, Aldi is a cost leader in a very lowtech industry, and is one of the most profitable retailers in Europe.
c. The reason why industries with large investments have high barriers to entry is because it is
costly to raise capital.
Disagree. The cost of raising capital is generally related to risk of the project rather than the size
of the project. As long as the risks of the project are understood, the costs of raising the
necessary capital will be fairly priced. However, large investments can act as high entry barriers
in several other ways. First, where large investments are necessary to achieve scale economies,
if additional capacity will not be fully used, it may make it unprofitable for entrants to invest in
new plant. Second, a new firm may be at an initial cost disadvantage as it begins to learn how to
use the new assets in the most efficient manner. Third, existing firms may have excess capacity
in reserve that they could use to flood the market if potential competitors attempt to enter the
market.
Question 10.
There are very few companies that are able to be both cost leaders and differentiators. Why? Can
you think of a company that has been successful at both?
Cost leadership and differentiation strategies typically require a different set of core competencies
and a different value chain structure. Cost leadership depends on the firm’s ability to capture
economies of scale, scope, and learning in its operations. These economies are complemented by
efficient production, simpler design, lower input costs, and more efficient organizational structures.
Together, these core competencies allow the firm to be the low cost producer in the market. On the
other hand, differentiation tends to be expensive. Firms differentiate their products and services
through superior quality, variety, service, delivery, timing, image, appearance, or reputation. Firms
achieve this differentiation through investment in research and development, engineering, training,
or marketing. Thus, it is the rare firm that can provide differentiated products at the lowest cost.
Companies that attempt to implement both strategies often do neither well and as a result suffer in
the marketplace. Differentiation exerts upward pressure on firm costs while one of the easiest
8
Solutions – Chapter 2
sources of cost reduction is reducing product or service complexity which leads to less
differentiation.
Question 11.
Many consultants are advising diversified companies in emerging markets, such as India, Korea,
Mexico, and Turkey, to adopt corporate strategies proven to be of value in advanced economies, like
the U.S. and Western Europe. What are the pros and cons of this advice?
Economic theory suggests that the optimal level of diversification depends on the relative transaction
costs of performing activities inside or outside the firm. A focus on core businesses, as is popular in
advanced economies, is economically efficient if markets, such as capital, product, and labor
markets, work well. However, market failures in emerging economies are a good reason to choose
for diversification. For example, in some emerging economies, information problems prevent
companies from raising capital at economically efficient rates in public capital markets. Instead, these
companies rely strongly on internal sources of financing. Because subsidiaries of diversified
companies can cross-subsidize each other, diversification is necessary in emerging markets to create
and benefit from internal capital markets. Similarly, large diversified companies in emerging
economies can benefit from having internal labor markets.
Problem 1. The European Airline Industry
1. Evaluate how the rivalry among existing firms has developed after 2004.
2. Evaluate the influence of rising fuel prices on the AEA airlines’ profitability between 2003
and 2006. If fuel prices had not increased after 2003, what would have been the pre-interest
breakeven load factor in 2006 (assuming all other factors constant)?
3. During the period examined, some airlines started to charge fuel surcharges to their
customers. For example, late 2007 KLM charged its customers €27 on European flights and
€80 on intercontinental flights. Other airlines had similar surcharges. How do such practices
affect your answer to question 2?
4. The operating margins of the AEA airlines became positive, on average, in 2004 and
gradually improved thereafter. What do you think are the most important drivers behind this
development? (Also consider your answers to questions 2 and 3.)
1. As described in the chapter, the primary drivers of rivalry among existing airlines are (a) industry
growth, (b) concentration, (c) differentiation and switching costs, and (d) excess capacity. The
AEA statistics illustrate that during the period 2002 – 2007, these drivers developed as follows:
a. Industry growth. During 1995 – 2004, industry growth averaged 5 percent. The average
growth in revenue passenger kilometers between 2004 and 2007 was 7 percent. This
growth rate is similar to the industry growth rate prior to 2001, a period in which the
rivalry among European airlines was intense. In 2006/2007, the growth in revenue
passenger and cargo tonne kilometers approached rates of 5 and 3 percent,
respectively, suggesting that industry growth has not led to a reduction in rivalry.
b. Concentration. The market share of the four (eight) largest AEA airlines changed only
slightly during 2004 – 2007, suggesting that industry concentration has neither increased
nor decreased.
c. Differentiation and switching costs. The statistics do not directly indicate how
differentiation and switching costs have developed during the period 2004 – 2007.
However, the statistics do show that operating margins of the AEA airlines are very close
9
Solutions – Chapter 2
to zero, leaving little opportunity for the airlines to compete on anything other than
price. The improvement in operating margins observed at the end of the period may
suggest that airlines have found ways to differentiate and reduce price competition.
However, these margin improvements are more likely to be the result of efficiency
improvements (see e.g., the increase in passenger load factor and the small increase in
cost per kilometer despite the substantial increase in fuel costs). The growth in revenue
per kilometer does not exceed typical inflation rates (and is also affected by fuel
surcharges; see question 3).
d. Excess capacity. Whereas the passenger load factor has increased, the cargo load factor
has decreased, resulting in a close to constant overall load factor. The growth in
available seat and tonne kilometers parallels the growth in RPKs and CTKs, thereby
preventing airlines from substantially reducing their excess capacity.
In sum, the rivalry among European airlines appears not to have changed substantially since
2004.
2. Fuel costs represent an increasingly bigger portion of total costs. The European airlines have
been able to keep their costs per kilometer close to constant by achieving efficiency
improvements that offset the increase in fuel costs. The change in the (adjusted) pre-interest
break-even factor nicely illustrates this. This factor is defined as cost per kilometer / revenue per
kilometer. In 2006, fuel costs per kilometer were 13€c/k (22.8% x 56.9€c/k); in 2003, these costs
were 6.5€c/k. If fuel prices had not increased after 2003, the pre-interest breakeven load factor
in 2006 would have been: (56.9 - [13 – 6.5]) / 84.5 = 59.3% versus the actual percentage of
69.7%. In other words, in the absence of fuel cost increases, airlines would have needed close to
10 percent less passengers to break even.
3. These surcharges increase the revenue per kilometer ratio by, presumably, 2 – 3 €cents per
kilometer. The adjusted pre-interest breakeven factor would be: (56.9 - [13 – 6.5]) / (84.5 – 3) =
61.8% versus the actual percentage of 69.7%. Even after (crudely) adjusting the factor for fuel
surcharges, it appears that the European airlines have become more efficient during the period
2004 – 2007.
4. The previous analysis showed that during 2004 – 2007, the rivalry among existing airlines
remained relatively constant. The airlines have become more efficient, possibly as the result of
mergers among airlines. The effects of these efficiency improvements have, however, been
partly (though not fully) offset by a substantial increase in fuel costs. Airlines have also slightly
reduced their excess capacity, thereby increasing their load factors. In sum, capacity and cost
reductions, rather than changes in the structure of the industry, are the most likely drivers of the
airlines’ improvements in margins.
10
Solutions – Chapter 3
Chapter 3 Overview of Accounting Analysis
Question 1.
Many firms recognize revenues at the point of shipment. This provides an incentive to accelerate
revenues by shipping goods at the end of the quarter. Consider two companies, one of which ships its
product evenly throughout the quarter, and the second of which ships all its products in the last two
weeks of the quarter. Each company’s customers pay thirty days after receiving shipment. How can
you distinguish these companies, using accounting ratios?
There is no difference between the two companies in their income statements. Both companies
have the same amount of revenues and expenses. However, the two companies are different in
their balance sheets. Assuming that all other things are equal, the company that sells product evenly
has a higher cash and a lower trade receivables balance at the quarter-end than the company which
ships all products in the last two weeks. The following accounting ratios can be used to differentiate
the two companies:
Trade Receivables Turnover
=
Sales
Trade Receivables
The company with even sales will have a higher receivable turnover ratio.
Days’ Receivables
=
Trade Receivables
Average Sales per Day
The company with even sales will show lower days’ receivable.
Cash Ratio
=
Cash + Marketable Securities
Current Liabilities
The company with even sales will have a higher cash ratio.
Question 2(a).
If management reports truthfully, what economic events are likely to prompt the following
accounting changes?
Increase in the estimated life of depreciable assets. Managers may increase the estimated life of
depreciable assets when they realize that the assets are likely to last longer than was initially
expected. For example, Delta Airlines extended the estimated life of the Boeing 747, a relatively
new product, by 5 years when Delta found out that some of the first Boeing 747s manufactured
were still flying in commercial service. Excellent maintenance and less usage than initially expected
may also prompt corporate managers to extend the estimated life of depreciable assets.
Decrease in the allowance for doubtful accounts as a percentage of gross trade receivables. The
firm’s change of customer focus may prompt managers to decrease the allowance for uncollectible
receivables. For example, when a firm gets large sales orders from reliable customers such as Tesco
1
Solutions – Chapter 3
and Volvo, it does not have to reserve the same percentage of allowance used for small (or high
default risk) customers.
Recognition of revenues at the point of delivery, rather than at the point cash is received. Revenues
can be recognized when the customer is expected to pay cash with a reasonable degree of certainty.
Suppose that a company re-evaluated its customer’s credit and found out that its customer’s
financials improved significantly. In dealing with that customer, the company can recognize
revenues at the point of delivery rather than at the point when cash is received, because the risk of
cash collection is no longer significant.
Capitalization of a higher proportion of development expenditures. According to IAS No. 38, costs
incurred on product development (after the establishment of technical feasibility and commercial
feasibility) are to be capitalized. Technical feasibility is considered to be established when the firm
has completed a product design. Commercial feasibility is established when the uncertainty
surrounding the development of new products or processes is sufficiently reduced. If the company
completes the product design earlier than it initially expected, it can capitalize a higher proportion
of development costs during that period.
Question 2(b).
What features of accounting, if any, would make it costly for dishonest managers to make the same
changes without any corresponding economic changes?
Third-Party Certification. Public companies are required to get third-party certification (auditor’s
opinion) on their financial statements. Unless the accounting policy changes are reasonably
consistent with underlying economic changes, auditors would not provide clean auditor’s opinion. A
qualified auditors’ opinion will penalize the company by increasing its cost of capital.
Reversal Effect. Aggressive accounting choices may inflate net profit in the current period but they
hurt future net profit due to the nature of accrual reversal. For example, aggressive capitalization of
software R&D expenditures may boost current period earnings but it will lower future periods’ net
profit when the capitalized costs have to be subsequently written-off.
Investors’ Lawsuit. If a company disclosed false or misleading financial information and investors
incurred a loss by relying on that information, the company may have to pay legal penalties.
Labor Market Discipline. The labor market for managers is likely to penalize individuals who are
perceived to be unreliable in their dealings with external parties.
Question 3.
The conservatism (or prudence) principle arises because of concerns about management’s incentives
to overstate the firm’s performance. Joe Banks argues, “We could get rid of conservatism and make
accounting numbers more useful if we delegated financial reporting to independent auditors rather
than to corporate managers.” Do you agree? Why or why not?
We don’t agree with Joe Banks because the delegation of accounting decisions to auditors may
reduce the quality of financial reporting. Auditors possess less information and firm-specific
business knowledge than corporate managers when portraying the economic reality of a firm. The
divergence between managers’ and auditors’ business assessments is likely to be most severe for
firms with distinctive business strategies or ones which operate in emerging industries. With such an
2
Solutions – Chapter 3
information disadvantage, even if auditors report truthfully without having any incentive problem,
they cannot necessarily choose “better” accounting methods and accruals than corporate managers
do.
Auditors also have their own incentive to record business transactions in a mechanical way, rather
than using their professional judgment, which leads to poor quality of financing reporting. For
example, auditors are likely to choose accounting standards that require them to exercise minimum
business judgment in assessing a transaction’s economic consequences, especially given their legal
liability risk. The current debate on market value accounting for financial institutions illustrates this
point. While there is considerable agreement that market value accounting produces relevant
information, auditors typically oppose it, citing concerns over audit liability.
Question 4.
A fund manager states: “I refuse to buy any company that makes a voluntary accounting change,
since it’s certainly the case that its management is trying to hide bad news.” Can you think of any
alternative interpretation?
One of the pitfalls in accounting analysis arises when analysts attribute all changes in a firm’s
accounting policies and accruals to earnings management motives. Voluntary accounting change
may be due merely to a change in the firm’s real economic situations. For example, unusual
increases in receivables might be due to changes in a firm’s sales strategy. Unusual decreases in the
allowance for uncollectable receivables might be reflecting a firm’s changed customer focus. A
company’s accounting change should be evaluated in the context of its business strategy and
economic circumstances and not mechanically interpreted as earnings manipulation.
Promises that require future expenditures are liabilities even if they cannot be measured precisely.
According to the definition, liabilities are economic obligations of a firm arising from benefits
received in the past that are (a) required to be met with a reasonable degree of certainly and (b) at
a reasonably well-defined time in the future. Airline companies have economic obligations to serve
frequent flyer program passengers due to ticket sales (benefits) in the past to the frequent flyer
program passengers. These obligations are (a) likely to be met (for example, United Airline frequent
flyer program totaled 1.2 million free trips in 1990) and (b) fulfilled within a well-defined time in the
future (for example, within 3 to 5 years after the revenue ticket sales are made).
A frequent flyer program has an impact not only on the balance sheet but also on the income
statement. In principle, the costs associated with benefits that are consumed in this time period are
estimated and recognized as expenses (matching concept). Note that airline companies increased
revenue ticket sales (i.e., benefits) in this period by promising free-trip tickets (i.e., costs) in the
future.
However, it is not easy to measure the costs associated with frequent flyer program accurately. At
least the following three cost categories should be considered in the estimation:
1. The administrative costs, such as maintaining the accounting system for the program, mailings
to program members, and providing service to those who request free flights
2. The costs related to the flight itself, including meal expenses, luggage handling costs, addition
fuel expenditure, etc.
3. The opportunity costs that airline companies may incur because the seats used by flight award
passengers could have been sold to revenue paying passengers
3
Solutions – Chapter 3
Question 5.
On the companion website to this book there is a spreadsheet containing the financial statements of:
1. Vodafone plc for the fiscal year ended March 31, 2012
2. The Unilever Group for the fiscal year ended December 31, 2011.
3. Audi AG for the fiscal year ended December 31, 2011.
Use the templates shown in Tables 3.1-3.5 to recast these companies’ financial statements.
[See spreadsheets ‘CH3 Q5 Vodafone - solution.xlsx’, ‘CH3 Q5 Unilever - solution.xlsx’, and ‘CH3 Q5
Audi - solution.xlsx’]
4
Solutions – Chapter 3
Problem 1. Key Accounting Policies
1. Identify the key accounting policies for each of these companies.
2. What are these companies’ primary areas of accounting flexibility? (Focus on the key
accounting policies.)
1. Key accounting policies
2. Areas of accounting flexibility
Juventus F.C.:
Revenue recognition: One of the key
accounting issues for Juventus is how to
account for its revenues. The primary sources
of revenues are ticket sales, media rights, and
sponsorship contracts. In exchange of these
revenues, Juventus often has a long-term
commitment to provide services (i.e., play
games). Key accounting choice: when to
consider these revenues as realized.
Timing of expense recognition / Accounting for
players’ long-term contracts: Juventus often
pays substantial amounts to a player’s previous
club when it hires a new player. These outlays
are initially capitalized and must be recognized
as an expense sometime during the contract
period of the player. Another issue is the
recognition of write-downs once a player gets
injured or otherwise impaired.
Operating lease agreement: How to account for
the operating lease payments for the stadium?
-
Timing and
recognition
-
Determining the fair value of
considerations given to players’
previous clubs
Amortization method choice
Determining the timing and amount of
write-downs
-
amount
of
revenue
Spyker Cars:
Accounting for inventories: Spyker has large
inventories and experiences significant
problems in selling its products. One of the key
accounting
decisions
that
Spyker’s
management has to make is whether or not to
recognize write-offs for the impairment of
inventories.
Accounting for R&D: Whether and to what
extent
the
company’s
development
expenditures will result in future revenues is
very uncertain. Based on its assessment of the
expenditures’ future benefits, management
should decide whether these expenditures
must be capitalized.
Carry forward losses: Only if it is probable that
management will realize the tax-deductible
carry forward losses in future years, such carry
forward losses constitute a true asset to the
firm. If a proportion of the carry forward losses
-
Determining the timing and amount of
write-downs
-
Determining the proportion of
development expenditures that should
be capitalized
Amortization method and period
choice
Determining the timing and amount of
write-offs
Determining the necessity and size of
an allowance for non-realizable carry
forward losses
-
5
Solutions – Chapter 3
is unlikely to be realized, the recognition of an
allowance warranted.
Sainsbury:
Accounting for property: One of the retailer’s
key assets is its property. A key accounting
choices that Sainsbury must make is deciding
on the value of its property and determining
whether write-downs are necessary. Further,
retailers often have large amounts of operating
lease agreements. Assets leased under
operating lease agreements can be kept offbalance or recognized as economically owned
by the retailer.
Accounting for personnel: A retailer typically
has a large staff for which it provides pensions.
Pension obligations arising from defined
benefit plans increase during the year because
employees provide service to the retailer, thus
giving rise to a need to recognize a pension
expense (i.e., an increase in the obligation). The
pension expense is reduced if the retailer earns
a return on its pension plan investments.
-
-
-
Choice between fair value and
historical cost accounting for property
Determining the fair values of property
Determining the timing and amount of
write-offs
Determining whether leased assets are
economically owned
Determining the (change in the)
present value of future pension
obligations (e.g., discount rate
assumption)
Determining the (change in the) fair
value of the pension plan assets
Problem 2. Fashion Retailers’ Key Accounting Policies
1. Based on your knowledge of the fashion retail industry, discuss for each of the above
accounting policies why the accounting policy is considered as ‘‘key’’ by one or more of the
eight fashion retailers.
2. Discuss which economic, industry, or firm-specific factors may explain the observed variation
in key accounting policies across the eight retailers.
Key accounting policies:
- have a material effect on the company’s accounting for its critical success factors and risks
and
- require significant judgment.
Using these two general characteristics of key accounting policies, students can systematically
evaluate the key accounting policy choices of the eight fashion retailers. The table of the next page
helps to evaluate and discuss the various accounting policies.
6
Solutions – Chapter 3
Key policy
Depreciation and/or
impairment of
property, plant and
equipment, Impairment
of assets in stores
Discontinued
operations
Succes factor
Efficient management of
investments in stores, storage
capacity (logistics management),
and store equipment
Areas of judgment
Estimates about economic useful lives and
residual values, impairment testing
assumptions
Especially relevant if…
Effectiveness of turnaround
management
… the retailer is restructuring.
Employee/postretirement benefits
Management of personnel cost
(operating efficiency) +
management of investments
pension assets
Making value-creating acquistions
Assets held for sale must be recorded at
their fair values if lower than the carrying
value (causing an impairment loss).
Estimation of such fair value requires
significant judgment.
Further, firms may shift regular operating
expenses to discontinued operations.
Pension assumptions (expected return on
plan assets, discount rate, inflation rate).
Further, until recently firms could keep
pension liabilities off balance.
Goodwill impairment testing strongly
relies on assumptions about future
(growth rates in) cash flows and discount
rates.
Receivable impairment testing strongly
relies on assumptions about default rates.
Impairment of goodwill
Impairment of trade
receivables, Provision
for doubtful accounts
Income and deferred
taxes, Recoverability of
deferred tax assets
Monitoring and managing the
collection of receivables from
internet and catalog sales and/or
affiliated companies
Effective tax management,
including managing the value of tax
loss carryforwards
Other provisions
(litigation)
Operating efficiency (i.e., managing
costs)
Estimation of the realizable value of tax
loss carryforwards (deferred tax assets)
requires making assumptions about (a
business unit’s) future profitability.
Estimation of provisions requires making
assumptions about the size and
7
… the retailer has material defined
benefit pension plans.
… the retailer has made material
acquisitions in the past.
… the retailer has a internet or
catalog sales or significant
transactions with affiliate
companies.
… the retailer has had a loss-making
business unit in one of the previous
(or the current) fiscal year(s).
… probable claims exist.
Solutions – Chapter 3
Put option liability over
noncontrolling interests
Efficient investment management
Refunds and loyalty
scheme accruals
Managing customer retention
Share-based payments
Efficient management of personnel
cost
probability of future (litigation) claims.
The valuation of put options depends on
the fair value of (potentially non-public)
subsidiaries
Estimating refunds and loyalty scheme
accruals requires making assumptions
about future customer claims
The valuation of share-based payments
(e.g. options) requires making
assumptions about, for example, inputs to
option valuation models or future option
exercise behavior
8
… the retailer has granted put
options to its subsidiary’s
noncontrolling shareholders.
… the retailer grants share-based
payments to its management and/or
employees.
Solutions – Chapter 3
Problem 3. Euro Disney and the First Five Steps of Accounting Analysis
1.
Identify the key accounting policies (step 1) and primary areas of accounting flexibility (step
2) for Euro Disney.
2. What incentives may influence management’s reporting strategy (step 3)?
3. What disclosures would you consider an essential part of the company’s annual report, given
its key success factors and key accounting policies (step 4)?
4. What potential red flags can you identify (step 5)?
1. Key accounting policies and areas of accounting flexibility for Euro Disney are:
a. Accounting for the special-purpose financing companies. Euro Disney leases land and
hotels from special-purpose financing companies. This could potentially help the
company to keep some of its assets off the balance sheet; however, the company has
chosen to consolidate all special-purpose companies because of the influence that it
(and its primary shareholder) has on the SPEs. From an investor’s perspective, this is
certainly the most desirable and informative solution (note that most operating lease
commitments automatically arise on the balance sheet).
b. Revenue recognition. Areas of discretion are:
i. Timing of revenue recognition (especially regarding pre-sold entrance tickets,
multi-day tickets and pre-paid hotel/convention/show fees). Revenues
should be recognized when services have been provided. In the past, Euro
Disney has had a significant liability for deferred revenues (approximately 10
percent of total sales). This liability has become smaller over time.
ii. Amount of revenues (especially regarding discounts and promotional
activities).
c. Accounting for property. One of Euro Disney’s key assets is its property. A key
accounting choices that Euro Disney must make is deciding on the value of its
property and determining whether write-downs are necessary. The company’s
management has discretion in the choice between fair value and historical cost
accounting, the assessment of fair values, the timing and amount of write-offs and
the assessment of whether leased property is economically owned.
d. Accounting for employee expenses. Euro Disney has a large number of employees
with permanent contracts. Because of the high uncertainty surrounding the future
values of pension commitments and assets, the determination of pension expenses is
discretionary.
e. Recognition of royalties and management fees. An important accounting choice
related to royalties and management fees is when these should be recognized as an
expense (when the liability arises or when they are paid).
2. Some incentives that may influence management’s reporting strategy are:
a. Large controlling shareholder. The Walt Disney Company (TWDC) controls Euro
Disney’s operating and financing decisions (via the Gerant and via the finance
agreements between Euro Disney and TWDC). Consequently, TWDC has the
incentive and means to “expropriate wealth” from Euro Disney’s minority
shareholders. Also note that the incentives of the CEO of the Gerant are closely
aligned with the incentives of TWDC as the result of the CEO’s TWDC stock and
option holdings.
b. Recent management change and poor performance. Euro Disney has performed
poorly in the past, also after the restructuring in 2005 and after the management
change in 2008. The company has been making losses and the company’s average
9
Solutions – Chapter 3
stock return has been negative during the past years. At the same time, the company
is highly leveraged. If Euro Disney plans to issue equity, the company’s management
has the incentive to overstate performance in an attempt to boost the company’s
share price.
c. Powerful unions. Unions play an important role in France. An improvement in
performance might affect the union’s demands. This could create an incentive to
understate company performance around union negotiations.
d. Euro Disney’s interest payments to TWDC may create an incentive to understate
performance.
3. Examples of relevant disclosures are:
a. Disclosures about related-party transactions, in particular transaction with the
company’s primary shareholder TWDC.
b. Disclosures about the company’s governance and compensation structure.
c. Disclosures about revenue recognition policies.
d. Disclosures about pension assumptions.
e. Disclosures about property values and impairment methods/decisions.
4. The following potential red flags can be identified:
a. The presence of a controlling shareholder.
b. Unusual financing mechanisms and related party transactions.
c. A significant reduction in the allowance for uncollectible receivables; decrease in
liability for deferred revenues.
d. The company has significant tax loss carry forwards. Currently, the company does not
recognize a deferred tax assets for these tax loss carry forwards; however, it may do
so in future years (helping it to boost income).
10
Solutions – Chapter 4
Chapter 4 Implementing Accounting Analysis
Question 1.
Refer to the Lufthansa example on asset depreciation estimates in this chapter. What adjustments
would be required if Lufthansa’s aircraft depreciation were computed using an average life of 25
years and salvage value of 5 percent (instead of the reported values of 12 years and 15 percent)?
Show the adjustments to the 2010 and 2011 balance sheets, and to the 2011 income statement.
In 2010 Lufthansa, the German national airline, reported that it depreciated its aircraft over 12 years
on a straight-line basis, with an estimated residual value of 15 percent of initial cost. These
assumptions imply that Lufthansa’s annual depreciation expense was, on average, 7.1 percent ([1 –
.15]/12) of the initial cost of its aircraft.
Using an average life of 25 years and salvage value of 5 percent, the following financial
statement adjustments would then be required in Lufthansa’s financial statements:
1. Increase the book value of the fleet at the beginning of the year. The necessary
adjustment is equal to the following amount: original minus adjusted depreciation rate ×
average asset age × initial asset cost. At the beginning of 2010, Lufthansa reported in the
notes to its financial statements that its fleet of aircraft had originally cost €21,699
million, and that accumulated depreciation was €11,699 million. This implies that the
average age of Lufthansa’s fleet was 7.6 years, calculated as follows:
€ (millions unless otherwise noted)
Aircraft cost, 1/1/2004
Depreciable cost
Accumulated depreciation, 1/1/2004
Accumulated
depreciation/Depreciable cost
Depreciable life
Average age of aircraft
€21,699
€18,444.15
€11,699
63.43%
Reported
12 × .6343
years
Under the “new” assumptions, the annual depreciation rate would have been 3.8 percent
([1 – .05]/25), implying that given the average age of its fleet, accumulated depreciation
would have been €6,276 (7.612 × .038 × 21,699) versus the reported €11,699.
Consequently, the company’s Non-Current Tangible Assets would have increased by
€5,423 (11,699 – 6,276).
2. Given the 25 percent marginal tax rate, the adjustment to Non-Current Tangible Assets
would have required offsetting adjustments of €1,356 (.25 × 5,423) to the Deferred Tax
Liability and €4,067 (.75 × 5,423) to Shareholders’ Equity.
3. Assuming that €1,215 million net new aircraft purchased in 2011 were acquired
throughout the year, and therefore require only half a year of depreciation, the
depreciation expense for 2011 (included in Cost of Sales) would have been €848 million
{.038 × 21,699 + (1,215/2)]} versus the €1,580 {(.85/12) × [21,699 + (1,215/2)]} million
reported by the company. Thus Cost of Sales would decline by €732 million.
4. Given the 25 percent tax rate for 2011, the Tax Expense for the year would increase by
€183 million. On the balance sheet, these changes would increase Non-Current Tangible
Assets by €732 million, increase Deferred Tax Liability by €183 million, and increase
Shareholders’ Equity by €549 million.
In summary, Lufthansa’s financial statements for the years ended December 31, 2010 and 2011,
would have to be modified as follows (references to the above described steps are reported in
brackets):
1
12 years
7.612 years
Reported
Cost × (1 – .15)
Reported
Solutions – Chapter 4
€ (millions)
Balance Sheet
Non-Current
Tangible Assets
Deferred Tax
Liability
Shareholders'
Equity
Adjustments
December 31, 2007
Assets
Liabilities
Adjustments
December 31, 2008
Assets
Liabilities
+€5,423 (1)
+€732 (3)
+€5,423 (1)
+€1, 356 (2)
+€4,067 (2)
Income Statement
Cost of Sales
Tax Expense
Net Profit
+€1,356
+€183
+€4,067
+€549
(2)
(4)
(2)
(4)
–€732 (3)
+€183 (4)
+€549 (4)
Question 2.
At the beginning of 2011, the Rolls-Royce Group reported in its footnotes that its plant and
equipment had an original cost of £2,538 million and that accumulated depreciation was £1,497.
Rolls-Royce depreciates its plant and equipment on a straight-line basis under the assumption that
the assets have an average useful life of 13 years (assume a 10 percent salvage value). Rolls-Royce’s
tax rate equals 26.5%. What adjustments should be made to Rolls-Royce’s (i) balance sheet at the
beginning of 2011; and (ii) income statement for the year 2011, if you assume that the plant and
equipment has an average useful life of 10 years (and a 10 percent salvage value)?
At the beginning of 2011, the average age of Roll-Royce’s P&E was 8.5 years, calculated as follows:
£ (millions unless otherwise noted)
P&E cost, 1/1/2011
Depreciable cost
Accumulated depreciation, 1/1/2004
Accumulated
depreciation/Depreciable cost
Depreciable life
Average age of P&E
2,538
1,899
1,497
65.53%
Reported
Cost × (1 – .10)
Reported
13 years
8.52 years
Reported
13 × .6553
years
Under the “new” assumptions, the annual depreciation rate is 9.0 percent ([1 – .10]/10), implying
that given the average age of P&E, accumulated depreciation would be €1,946 (8.52 × .09 × 2,538)
versus the reported 1,497. Consequently, the company’s P&E should be decreased by 449 (1,946 –
1,497).
Given the 26.5 percent marginal tax rate, the adjustment to P&E requires offsetting adjustments of
119 (.265 × 449) to the Deferred Tax Liability and 330 (449 – 119) to Shareholders’ Equity.
Assuming that no new P&E will be purchased in 2011, the depreciation expense for 2011 will be 228
million {.09 × 2,538} rather than 176 {(.9/13) × 2,110} million. Thus Cost of Sales will increase by 53
million.
Given the 26.5 percent tax rate for 2011, the Tax Expense for the year will decrease by 14 million;
net profit will decrease 39 million.
2
Solutions – Chapter 4
Question 3.
Car manufacturers Volvo and Fiat disclosed the following information in their 2008 financial
statements:
Volvo
SEK 119,089m
SEK 61,819m
SEK 3,885m
28%
Property, plant and equipment (PP&E) at cost
Accumulated depreciation on PP&E
Deferred tax liability for depreciation of PP&E
Statutory tax rate
Fiat
€ 36,239m
€ 23,632m
€ 679m
27.5%
Purely based on the companies’ deferred tax liabilities, which of the two companies appears to be
most conservative in its depreciation policy?
Volvo’s deferred tax liability for depreciation is SEK 3,885m. This deferred tax liability result from
the fact that Volvo’s tax depreciation rate exceeds its book depreciation rate. The difference
between accumulated depreciation in Volvo’s tax statement and accumulated depreciation in its
financial statements amounts to SEK 13,875m (3,885 / 0.28), or 22.4 percent of Volvo’s accumulated
(book) depreciation.
The same difference amounts to € 2,469m (679 / 0.275), or 10.4 percent of accumulated (book)
depreciation, for Fiat.
These numbers imply that Volvo’s tax depreciation has exceeded its book depreciation by, on
average, 22.4 percent; Fiat’s tax depreciation has exceeded its book depreciation by, on average,
10.4 percent. Hence, Fiat appears to be more conservative in its depreciation policy.
Question 4.
Dutch Food retailer Royal Ahold provides the following information on its finance leases in its
financial statements for the fiscal year ended January 1, 2012:
Finance lease liabilities are principally for buildings. Terms range from 10 to 25 years and include
renewal options if it is reasonably certain, at the inception of the lease, that they will be
exercised. At the time of entering into finance lease agreements, the commitments are recorded
at their present value using the interest rate implicit in the lease, if this is practicable to
determine; if not the interest rate applicable for long-term borrowings is used.
The aggregate amounts of minimum lease liabilities to third parties, under noncancelable finance
lease contracts for the next five years and thereafter are as follows:
(€ millions)
Within one year
Between one and five years
After five years
Total
Current portion of finance lease liabilities
Non-current portion of finance lease liabilities
Future minimum
lease payments
€165
Present value of
minimum lease payments
€67
643
2,003
1,916
312
846
1,225
67
1,158
What interest rate does Ahold use to capitalize its finance leases?
3
Solutions – Chapter 4
A simple, efficient method to estimate the interest rate used to capitalize finance leases is to use
the information about the current and non-current portion of the finance lease liabilities. The
expected future minimum lease payment for 2012 is 165 million. The expected decline in the
current portion of the finance lease liabilities is 67 million. The difference between these two
numbers is the expected interest expense on the finance lease liabilities. Hence, the interest rate
equals:
Interest rate = (165 – 67) / 1,225 = 8.0 percent.
Question 5.
On January 1, 2012, Royal Ahold disclosed the following information about its operating lease
commitments
(€ millions)
2007
2008
Within one year
Between one and five years
After five years
Total
€655
2,194
3,130
5,979
€677
2,245
3,016
5,938
Ahold’s operating lease expense in 2011 amounted to €635 million. Assume that Ahold records its
finance lease liabilities at an interest rate of 8.4 percent. Use this rate to capitalize Ahold’s operating
leases at January 1, 2011 and 2012.
i.
Record the adjustment to Ahold’s balance sheet at the end of 2010 to reflect the
capitalization of operating leases.
ii.
How would this reporting change affect Ahold’s income statement in 2011?
To estimate the present value of operating lease payments, students have to first make an
assumption about how to split the payments after five years over time. One possible assumption is
that the lease payments in the sixth and subsequent years are equal to the lease payment in the fifth
year. Under this assumption, the present value of operating leases using a 8.4% discount rate is as
follows:
Year
1
2
3
4
5
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6 and
6 subsequent
7
8
9
10
Assumed
Assumed
Payment PV 2011 Payment PV 2011
2010
2011
€ 655
€ 604
€ 677
€ 625
548.5
€ 467
561.25
€ 478
548.5
€ 431
561.25
€ 441
548.5
€ 397
561.25
€ 406
548.5
€ 366
561.25
€ 375
548.5
548.5
548.5
548.5
548.5
4
€ 338
€ 312
€ 288
€ 265
€ 245
561.25
561.25
561.25
561.25
561.25
€ 346
€ 319
€ 294
€ 272
€ 251
Solutions – Chapter 4
11
387.5
Total
Of which: current
Of which: non-current
€ 160
€ 3,873
€ 330
€ 3,543
323.75
€ 133
€ 3,939
€ 346
€ 3,593
Note that the assumed maximum economic life of the operating leases is 11 years.
The adjusted balance sheet for January 1, 2011 is as follows:
(€ millions)
Balance Sheet
Non-Current Tangible Assets
Non-Current (and Current) Debt
Adjustment January 1,
2011
Liabilities
Assets
& Equity
+3,873
+3,873
At the end of 2010, the present value of Ahold’s operating lease obligations for 2011 and beyond was
3,269. If in 2011, Ahold would have had no new leases, the present value of its lease obligation at the
end of 2011 would have been: 3,269 * 1.084 = 3,543. The actual present value of the obligation at
the end of 2011 is 3,939, implying that the increase in the lease obligation due to new leases was 396
(3,939 – 3,543).
Further, Ahold’s 2011 lease expense was 635; the expected 2011 lease expense at the end of 2010
was 655. This implies that the decrease in Ahold’s lease expense due to cancelled leases was 20 (635
– 655).
With a maximum economic useful life of 11 years, the depreciation rate equals:
11/[1+2+3+4+5+6+7+8+9+10+11] = 16.67%
Consequently, the depreciation adjustment for 2011 is: 3873*0.1667 + 50%*(396 - 20)/11 = 663. The
interest expense adjustment for 2011 is: 3,873 * 0.084 + 376 * 50% * 0.08 = 341.
For the year ended January 1, 2012, the impact on net profit would be as follows:
Income Statement
Cost of Sales:
Lease expense
Depreciation expense (1/13*€3,054)
Interest Expense (.08 * €3,054)
Tax Expense (35% of sum)
Net Profit
-635
+663
+341
-129
-240
Note that the negative effect on net profit is partly caused by our conservative estimate of the
maximum economic useful life of the leases. The adjustment approach discussed next would help to
solve this.
Question 6.
5
Solutions – Chapter 4
When bringing operating lease commitments to the balance sheet, some analysts assume that in
each year of the lease term depreciation on the operating lease assets is exactly equal to the
difference between (a) the operating lease payment and (b) the estimated interest expense on the
operating lease obligation.
i.
Explain how this simplifies the adjustments.
ii.
Do you agree that this is a valid assumption?
This assumption simplifies the adjustments because it causes the net effect of the adjustments to be
zero. Because the interest expense on the lease liability is high at the beginning of the lease period,
this assumption also implies that the depreciation rate of the operating lease assets increases over
time. Whether or not it is reasonable to assume this depends on several factors, such as the firm’s
operating environment and the type of asset.
Question 7.
Refer to the AstraZeneca example on intangibles in this chapter. What would be the value of
AstraZeneca’s R&D asset at the end of fiscal years 2009 and 2010 if the average expected life of
AstraZeneca’s R&D investments is only three years?
As in the chapter, assume for simplicity that R&D spending occurs evenly throughout the year and
that only half a year’s amortization is taken on the latest year’s spending. What is different is that the
average expected life of R&D investments is three years. Given R&D outlays for the years 2007 to
2010, the R&D asset at the end of 2010 is $ 7.48 billion, calculated as follows:
Year
R&D
Outlay
2010
2009
$5.3b
4.4
2008
5.2
(1 – .33/2 – .33)
2.60
2007
Total
5.2
(1 – .33/2 – .67)
0.87
$7.13
Proportion
Capitalized
12/31/09
Asset
12/31/09
(1 – .33/2)
$3.67b
Proportion
Capitalized
12/31/10
(1 – .33/2)
(1 – .33/2 –
.33)
(1 – .33/2 –
.67)
Asset
12/31/10
$4.42b
2.20
0.87
$7.48
The R&D amortization expense (included in Other Operating Expenses) for 2009 and 2010 are $4.85
billion and $4.95 billion, respectively, and are calculated as follows:
Year
R&D
Outlay
2008
2007
2006
2005
2004
Total
$5.3b
4.4
5.2
5.2
3.9
Proportion
Amortized
12/31/09
Expense
12/31/09
.33/2
.33
.33
.33/2
$0.73b
1.73
1.73
0.65
$4.85
6
Proportion
Amortized
12/31/10
.33/2
.33
.33
.33/2
Expense
12/31/10
$0.88b
1.47
1.73
0.87
$4.95
Solutions – Chapter 4
Since AstraZeneca will continue to expense software R&D immediately for tax purposes, the change
in reporting method will give rise to a Deferred Tax Liability. Given a marginal tax rate of 28 percent,
this liability will equal 28 percent of the value of the Intangible Asset reported, with the balance
increasing Shareholders’ Equity.
In summary, the adjustments required to capitalize software R&D for AstraZeneca for the years 2009
and 2010 are as follows:
($ billions)
Balance Sheet
Non-Current
Intangible
Assets
Deferred Tax
Liability
Shareholders'
Equity
Adjustments Dec. 31,
2009
Assets
Liabilities
+7.13
Adjustments Dec. 31,
2010
Assets
Liabilities
+7.48
Income
Statement
Other Operating
Expenses
Tax Expense
Net Profit
+2.00
+2.09
+5.13
+5.39
–4.40
+4.85
-0.12
-0.33
–5.30
+4.95
+0.10
+0.53
Question 8.
1. Estimate the average expected life of Philips’ investments in development at the end of
2008.
2. Using the estimate derived under i, what adjustments should an analyst make to the 2008
beginning balance sheet and 2008 income statement to immediately expense all
development outlays and derecognize the development asset?
3. What adjustments should be made to the 2008 beginning balance sheet and 2008 income
statement to recognize an asset for both research and development investments? Assume
that the average expected life of Philips’ investments in research at the end of 2007 and
2008 is equal to that of Philips’ development investments at the end of 2008.
1. Following the procedure described in Chapter 4 to estimate the book value of a development
asset, one can calculate the value under various expected life assumptions. If the average
expected life approaches 2.8 years, the estimated book value of the development asset
approaches €357 million, which is the asset’s actual book value.
Asset
Development Capitalization beginning
Amortization
factor
Year
Amortization factor
outlays
2008
2008
0.18
27.50
2008
154
0.8214
191.39
0.36
83.21
2007
233
7
Solutions – Chapter 4
2006
2005
295
259
2004
233
0.4643
0.1071
136.96
27.75
0.36
0.11
356.11
Average expected life assumption:
105.36
27.75
243.82
2,8
Note: the amortization factor in 2005 is set equal to 1 minus the sum of the
amortization factors in 2006-2008.
2. As shown in the previous table, if the average expected life of Philips’ investments in
development equals 2.8 years, the expected amount of amortization in 2008 equals €244
million. Because the development expenditure in 2008 was €154 million, immediate expensing
of development outlays would increase Philips’ pre-tax profit by €90 million (244 – 154),
increase its tax expense by €23 million (0.255 x 90) and increase net profit by €67 million (90 –
23).
3. Following the procedure described in Chapter 4 and assuming an average expected life of 2.8
years, the estimated book value of the research asset at the beginning of 2008 is €1,924 million.
The estimated amortization expense in 2008 is €1,392 million:
Year
2008
Research Capitalization
outlays
factor
1468
Asset
beginning
2008
Amortization factor
0.18
Amortization
2008
262.14
2007
2006
1396
1364
0.82
0.46
1146.71
633.29
0.36
0.36
498.57
487.14
2005
2004
1343
1382
0.11
143.89
0.11
143.89
Sum
Average expected life assumption:
1923.89
2.8
1391.75
Note: the amortization factor in 2005 is set equal to 1 minus the sum of the
amortization factors in 2006-2008.
Consequently, the following adjustments must be made to the 2008 beginning balance
sheet and 2008 income statement:
(€millions)
Balance sheet
Non-Current Intangible Assets
Deferred Tax Liability
Shareholders’ Equity
Income statement
Other Operating Expenses
Other Operating Expenses
Tax Expense
Net Profit
Adjustments
Dec. 31, 2007
Assets
Liabilities
Adjustments
Dec. 31, 2008
Assets
Liabilities
+1,924
+491
+1,433
–1,468
+1,391
+20
+57
8
Solutions – Chapter 4
Question 9.
What approaches would you use to estimate the value of brands? What assumptions underlie these
approaches? As a financial analyst, what would you use to assess whether the brand value of £5.2
billion reported by consumer goods company Reckitt Benckiser plc in 2011 for its health and personal
care brands Strepsils and Clearasil was a reasonable reflection of the future benefits from these
brands? What questions would you raise with the firm’s CFO about the firm’s brand assets?
Generally, firms that, like Reckitt Benckiser, report brand value on their balance sheets must hire
independent valuation experts to value the brand assets. The valuation experts may use any of the
following approaches to estimate brand value.
Given
the firm’s sales volume of branded products, the expected life of the brand, and a discount rate, it is
possible to estimate the present value of any price premium over the foreseeable future.
Several assumptions underlie the above brand valuation approaches. First, under the price
premium approach, brands will only have value if:
s.
The second and third valuation approaches requires that the valuer assume that the product
being valued requires the same level of advertising or has the same relative value as comparable
brands used to benchmark the valuation.
A financial analyst should question the 5.2 billion pounds reported on Reckitt Benckiser’s
financials. Is this value reasonable or excessive compared to similar companies that report brands
on their balance sheet? How was the figure calculated? Was an independent valuation expert hired?
Did the independent auditors question the amount? Has the amount grown or declined in the past
couple years? Why? What activities and expenditures did Reckitt Benckiser incur to maintain the
brand name?
Question 10.
In early 2003 Bristol-Myers Squibb announced that it would have to restate its financial statements
as a result of stuffing as much as $3.35 billion worth of products into wholesalers’ warehouses from
1999 through 2001. The company’s sales and cost of sales during this period was as follows:
Net sales
Cost
of
products
sold
2001
2000
1999
$18,13
9
$17,695
$16,502
5,454
4,729
4,458
9
Solutions – Chapter 4
The company’s marginal tax rate during the three years was 35 percent. What adjustments are
required to correct Bristol-Myers Squibb’s balance sheet for December 31, 2001? What assumptions
underlie your adjustments? How would you expect the adjustments to affect Bristol-Myers Squibb’s
performance in the coming few years.
In the Bristol-Myers Squibb example, the firm's Trade Receivables, Sales, and Net Profit are
overstated. To correct for this problem in the 2001 balance sheet, Trade Receivables needs to
decline by $3.35 billion, and Inventories need to increase by an amount that reflects the effect of
gross profit margins. The Inventories adjustment can be achieved by multiplying the Trade
Receivables adjustment by the ratio of Cost of Sales to Sales. The increase in Inventories is
approximately $1 billion (3.35 * (5,454/18,139)). The $3.35 billion decline in Trade Receivables is
mirrored by a decline in 2001 Sales of the same amount. Similarly, the $1 billion increase in
Inventories reflecting unsold product corresponds to a decline in the Cost of Sales by the same
amount. Multiplying the -$2.35 difference between the reduction in Sales and the reduction in Cost
of Sales by the firm's 35% marginal tax rate results in a $.82 billion reduction in Tax Expense, with
the remaining $1.53 billion ($2.35-.82) difference being charged to Net Profit. The decline in both
Tax Expense and in Net Profit are reflected in the Balance Sheet by a decline in Deferred Taxes and
in Ordinary Shareholders' Equity, respectively.
Adjustments for Dec.31, 2001
Assets
Liabilities & Equity
($billions)
Balance Sheet
Trade Receivables
Inventories
Deferred Taxes
Ordinary Shareholders' Equity
Income Statement
-3.35
+1.00
-.82
-1.53
Adjustments for Dec.31, 2001
Sales
Cost of Sales
Tax Expense
-3.35
-1.00
-.82
Net Profit
-1.53
Question 11.
As the CFO of a company, what indicators would you look at to assess whether your firm’s noncurrent assets were impaired? What approaches could be used, either by management or an
independent valuation firm, to assess the value of any asset impairment? As a financial analyst,
what indicators would you look at to assess whether a firm’s non-current assets were impaired?
What questions would you raise with the firm’s CFO about any charges taken for asset impairment?
10
Solutions – Chapter 4
Impairment is the loss of a significant portion of the utility of an asset through casualty,
obsolescence, or lack of demand for the asset’s service. A loss should be recognized when an asset
suffers permanent impairment. A CFO should look for evidence of such potential impairment of the
firm’s assets.
Assessing the monetary value of an asset impairment:
If the current book value exceeds the assets’ recoverable amount (i.e., the higher of the value in use
and the fair value less cost to sell), an asset impairment has occurred. The conservatism principle
requires that a firm write down its asset to its then recoverable amount. The accounting transaction
would show the asset and any contra-asset being written off, the new value of the asset being
recorded, and the residual amount recorded as a loss due to impairment of the asset. Hence, the
loss amount that appears in the income statement is the difference between the old net book value
and the current recoverable amount.
A financial analyst should look for the same types of indicators that the CFO looks for, of course
understanding that the CFO, as an insider of the company, has a great deal more information about
such issues as casualty, obsolescence, or lack of demand of certain assets. Indicators of impairment
include sustained declines in a firm’s and/or industry’s return on assets relative to its cost of capital,
recognition of asset impairments by competitors, and the introduction of new technologies that
make existing assets obsolete.
The financial analyst should question the CFO concerning the cause of the asset impairment.
Was the loss due to casualty, obsolescence, or lack of demand? If not, what did cause the loss? The
analyst should inquire about the method the impairment of asset loss was calculated? If it was
calculated using a fair market value, how was the fair value determined?
Question 12.
On December 31, 2011, Germany’s largest retailer Metro AG reported in its annual financial
statements that it held inventories for 52 days sales. The inventories had a book value of €7,608
million. How much excess inventory do you estimate Metro is holding in December 2011 if the firm’s
optimal Days’ Inventories is 45 days? Calculate the inventory impairment charge for Metro if 50
percent of this excess inventory is deemed worthless? Record the changes to Metro’s financial
statements from adjusting for this impairment.
Metro’s inventories on December 31, 2011 were €7.608 billion, equivalent to 52 days. If the optimal
days’ inventories was 45 days, the value of the optimal inventories would be 45/52*€7.608 billion,
or $6.584 billion. If 50% of the gap (50%*(7.608-6.584)=$0.512 billion was impaired, the changes to
Metro’s financial statements would be as follows:
Adjustment
Liabilities &
Assets
Equity
(€millions)
Balance Sheet
Inventories
Deferred Tax Liability
Ordinary Shareholders’ Equity
Income Statement
Cost of Sales
Tax Expense
-512
-179
-333
+512
-179
11
Solutions – Chapter 4
Net Profit
-333
Question 13
On December 31, 2010 and 2011 Deutsche Telekom AG had net trade receivables in the amount of
€6,766 million and €6,455 million, respectively. The following proportion of the receivables was past
due on the reporting date:
2010
(48.7%) 2,295
(51.3%) 3,471
(100.0%) 6,766
Not past due on the reporting date
Past due on the reporting date
Total
2011
(49.4%) 3,109
(50.6%) 3,265
(100.0%) 6,455
The changes in Deutsche Telekom’s allowance for doubtful receivables were as follows:
Item
Allowance on January 1
Currency translation adjustments
Additions (allowance recognized as expense)
Use
Reversal
Allowance on December 31
2010
1,178
15
822
(529)
(163)
1,323
2011
1,323
(9)
830
(589)
(323)
1,232
Assume that Deutsche Telekom’s statutory tax rate was 30.5 percent in 2010 and 2011. Further
assume that an analyst wishes to recognize an additional allowance for 20 percent of the receivables
that are past due on the reporting date.
i.
What adjustments should the analyst make to Deutsche Telekom’s balance sheet at the
end of 2010?
ii.
What adjustments should the analyst make to Deutsche Telekom’s 2011 income
statement?
If the analyst decided that receivable allowances for DT in 2010 should be 20 percent (of receivables
past due) higher, the following adjustments would have to be made:
1. Decrease Trade Receivables on December 31, 2010 by €694 million (0.2 × 3,471) to reflect
the adjustment to the allowance.
2. Given the company’s marginal tax rate of 30.5 percent, decrease Shareholders’ Equity for
2010 by 482 million ([1 – .305] × 694), and increase the Deferred Tax Liability for 2010 by
€212 million (.305 × 694).
3. After adjustment, the beginning and ending balances of the allowance for 2011 are €2,017
million (1,323 + 694) and € 1,885 million (1,232 + 0.2 × 3,265), respectively. Whereas the
actual write-off on receivables, currency translation adjustments, and reversals for 2011
remain unchanged (€ 921 million), the adjusted provision for bad debts is € 789 million
(1,885 – 2,017 + 921). Because the unadjusted provision for 2007 was € 830 million,
decrease Cost of Sales for 2011 by € 41 million (830 – 789).
4. Increase the tax expense and net profit. Given the tax rate of 30.5 percent, the Tax
Expense for 2011 would increase by € 12.5 million (.305 × 41), whereas Net Profit would
increase by € 28.5 million ([1 – .305] × 59).
12
Solutions – Chapter 4
Question 14.
Refer to the British American Tobacco example on provisions in this chapter. The cigarette industry is
subject to litigation for health hazards posed by its products. In the U.S., the industry has been
negotiating a settlement of these claims with state and federal governments. As the CFO for U.K.based British American Tobacco (BAT), which is affected through its U.S. subsidiaries, what
information would you report to investors in the annual report on the firm’s litigation risks? How
would you assess whether the firm should record a provision for this risk, and if so, how would you
assess the value of this provision? As a financial analyst following BAT, what questions would you
raise with the CFO over the firm’s litigation provision?
The litigation risks that BAT faces are reported as contingent liabilities defined in IAS 37. Contingent
liabilities arise from events or circumstances occurring before the balance sheet date, here the
filling of lawsuits against BAT, the resolution of which is contingent upon a future event, the court
ruling or a potential settlement.
The accounting treatment for BAT’s pending litigation depends on the likelihood that it will
lose or settle the lawsuit and whether the amount of damages the firm will be liable for is
reasonably estimable. Accounting rules on required disclosure for these types of liabilities depend
on whether the loss is probable, possible, or remote.
Probable – If it is probable that BAT will lose the lawsuit and the loss can be reasonably estimated,
the estimated loss should be reported as a charge to profit and as a liability. If the loss is probable
but no specific reasonable estimate can be agreed upon, rather only a range of possible losses can
be estimated without any amount being more reasonable than the other, the amount that should
be accrued by BAT is the minimum amount in the range. Note that this contradicts the
conservatism principle of accounting.
Possible - Where the likelihood that BAT will lose the lawsuit is reasonably possible, no amount
needs to be accrued as a liability but the nature of the suit needs to be disclosed in the footnotes of
the annual report.
Remote - Where the likelihood that BAT will lose the lawsuit is remote, no amount needs to be
recorded as a liability nor is any disclosure required in the footnotes of the annual report.
The CFO of BAT faces a dilemma. It is widely recognized that the company faces huge potential
litigation costs. It is therefore important that the CFO confront these issues in the annual report,
explaining the nature of the suits, the amount of the claims against the company, and the
company’s plans for responding to the suits. To fail to provide adequate disclosure about these
issues, potentially leads investors to fear the worst, reducing the value of the firm’s stock. However,
the CFO also has to be careful not to make statements that could undermine the company’s legal
position or its negotiating position with the claimants.
As a financial analyst following BAT I would push the CEO for as much information as possible
about the likelihood that the company will lose the lawsuits or come to a settlement with the
claimants. This requires that the analysts understand the law and case history for the industry. It
also requires information on the company’s plans to either take the cases to trial or to settle, as well
as the costs of a legal battle, the company’s assessment of its chances of victory, and the costs of a
potential settlement.
In addition, given that the company’s stock is depressed due to fears of losing these suits,
analysts can probe management on what actions the company is considering to increase the stock
13
Solutions – Chapter 4
price and maximize shareholder value. For example, what is the firm doing to maintain employee
moral and retain executives that might be inclined to accept jobs with similar companies not tied to
tobacco products? Is BAT considering raising the annual dividend payment to compensate
shareholders for lower stock prices?
Question 15.
Refer to the Carlsberg example on post-employment benefits in this chapter. Discuss the components
of the pension expense. In your opinion, is it reasonable to exclude some components of the change
in the unfunded obligation from earnings? Is the calculation of the pension charge in the income
statement appropriate (from an analyst’s perspective)?
When discussing the rationale of current pension accounting rules, key issue is which method leads
to the optimal matching of expenses (pension costs) and benefits (employees’ service). The
following issues are relevant:
1. Recognizing actuarial gains/losses and past service costs outside the income statement
seems sensible because both cost components are related to past service years or
expected to be offset by future actuarial gains/losses.
2. The recognition of past service in the income statement may add noise to earnings, as this
component of the pension cost is highly transitory.
3. Recognizing actuarial gains/losses (and past service costs) in comprehensive income but
not in “core” earnings, as is currently allowed under IFRS may (a) “hide” actuarial losses
from investors and/or (b) create the incentive to understate pension expenses because
later reversals of these understatements will only flow through equity, not earnings.
4. The current approach to calculating the pension expense implicitly assumes that the
return on pension plan assets is equal to the discount rate. In reality, it is likely that the
expected return on plan assets exceeds the discount rate. Consequently, the current
approach may overstate firms’ pension expense.
Question 16.
Some argue that (1) because estimating the value of a contingent claim (such as executive stock
options) is surrounded with uncertainty and (2) the claims do not represent a cash outlay, the value
of these claims should not be included in the income statement as an expense? Do you agree with
these arguments?
The value of contingent claims is, indeed, uncertain and this could potentially be a reason not to
recognize such contingent claims. However, counterarguments are that the issuance of contingent
does represent opportunity costs to the firm. For example, convertible bonds have a relatively low
interest expense. However, the firm incurs additional expenses upon conversion of the bond: the
price at which the equity is issued to the bondholders is a lower price than the firm could have
obtained in the market. The same argument holds for stock options.
One argument against the current treatment of contingent claims is that the recognized value is
typically the expected value of the claim at the time that the firm issued the claim. For example, the
stock option expense during the vesting period of options is based on the value of the options at the
issue date. From a stewardship perspective, this seems fine (i.e., management is held accountable
for its decisions, given the available information at the time of the decision). However, there can be
substantial changes in the value of the claim after the issuance that are “value relevant”. The
financial statements do not provide information about such changes in value.
14
Solutions – Chapter 4
Problem 1. Merger accounting
1. Discuss why, from an analyst’s point of view, purchase accounting is preferable over pooling
accounting.
2. What adjustments should an analyst make to GlaxoSmithKline’s 2006 beginning balance
sheet to correct for the distortions from using pooling accounting?(Assume that
GlaxoSmithKline’s marginal tax rate is 30 percent. Note that the international accounting
rules for income taxes prohibit the recognition of deferred taxes on nondeductible goodwill.)
3. What adjustments should an analyst make to GlaxoSmithKline’s 2006 income statement?
1. Pooling does not reflect the true economic cost of the acquisition on the acquirer’s books,
making it more difficult for shareholders to understand the economic performance of the new
firm after the merger. Pooling understates the investment that the acquirer has made and,
consequently, overstates the acquirer’s future abnormal return on equity.
2. To adjust for the distortion from using pooling accounting, the analyst can restate the acquirer’s
based financial statements as follows:
a. Revalue the target’s assets (and potentially its liabilities) to their fair values.
b. Recognize any goodwill from the transaction, computed as the difference between the
purchase price and the fair value of the identifiable net assets of the target.
c. Record the consideration paid by the acquirer – usually acquirer shares – at its fair value.
For Glaxo Wellcome’s acquisition of SmithKline Beecham, under pooling accounting, the cost of
acquiring SmithKline Beecham is shown at its book value of £2.7 billion, far below the actual
purchase price of £43.9 billion. To record the acquisition under the purchase method, the
analyst requires information on the fair value of SmithKline Beecham’s identifiable assets such
as the acquired product rights. If this information were not available, the (second best) solution
would be to assign the full £41.2 billion asset adjustment (£43.9 billion less £2.7 billion) to
goodwill. This would implicitly assume that the book and fair values of SmithKline Beecham’s
assets are roughly similar. However, the price paid by Glaxo Wellcome includes a premium for
acquired product rights precisely because Glaxo Wellcome expects that some of these products
will generate future benefits for shareholders. The U.S. GAAP information helps to assess the
fair value of these acquired product rights. The adjustment to the financial statements of the
combined firm on December 31, 2005 would therefore be as follows:
(£ millions)
Balance Sheet
Non-Current Intangible Assets
Deferred Tax Liability
Shareholders’ Equity
Assets
Adjustment
Liabilities and Equity
+28.0
+3.6
+24.4
Note that both goodwill (£15.9 billion) and acquired product rights (£12.1 billion) have been
classified as Non-Current Intangible Assets. The distinction between goodwill and acquired
product rights does, however, affect the adjustment made to the Deferred Tax Liability. Because
the international accounting rules for income taxes (IAS 12) prohibit the recognition of deferred
taxes on nondeductible goodwill, the Deferred Tax Liability adjustment relates only to the fair
value adjustments for acquired product rights (£12.1 billion × 30 percent marginal tax rate).
3. The fair value adjustments of (£12.1 billion) would cause an additional depreciation expense in
GlaxoSmithKline’s 2006 income statement. The size of this additional expense depends on the
analyst’s assumption about the acquired product rights useful life.
15
Solutions – Chapter 4
Problem 2. Impairment of non-current assets
1. What balance sheet adjustments should an analyst make if she decided to record an
additional write-down of €1.41 billion in the December 2000 financials?
2. What effect would this additional write-down have on EM.TV’s depreciation expense in
2001? (Assume that the adjustments to EM.TV’s balance sheet are in conformity with
current IFRSs.)
1. If an analyst decided to record an additional write-down of €1.41 billion in the December 2000
financials, it would be necessary to make the following balance sheet adjustments:
a. Reduce Non-Current Intangible Assets by €1.41 billion.
b. Reduce the Deferred Tax Liability and the Tax Expense for the tax effect of the writedown. Assuming a 50 percent tax rate, this amounts to €705 million.
c. Reduce Shareholders’ Equity and Net Profit for the after-tax effect of the write-down
(€705 million).
Assets
(€ millions)
Balance sheet
Non-Current Intangible Assets
Deferred Tax Liability
Shareholders’ Equity
Income statement
Other Expenses
Tax Expense
Net Profit
Adjustment
Liabilities and Equity
–1.410 (a)
–0.705 (b)
–0.705 (c)
+1.410 (c)
–0.705 (b)
–0.705 (c)
2. Note that the write-down of depreciable assets at the beginning of the year will require the
analyst to also estimate the write-down’s impact on depreciation and amortization expense for
the year. For EM.TV, since the asset is goodwill, which is not amortized, no such expense
adjustment is required.
Problem 3. Audi, BMW and Skoda’s research and development
1. Estimate the average economic lives of the car manufacturers’ development assets. What
assumptions make your estimates of the average economic lives consistent with those
reported by the manufacturers?
2. The percentages of R&D expenditures capitalized fluctuate over time and differ between car
manufacturers. Which factors may explain these fluctuations and differences? As an analyst,
what questions would you raise with the CFO about the levels of and fluctuations in these
capitalization percentages?
3. In accordance with IAS 38, the three car manufacturers do not capitalize research
expenditures. From an analyst’s perspective, which arguments would support capitalization
(rather than immediate expensing) of research expenditures?
4. What adjustments to the car manufacturers’ 2011 financial statements are required if you
decide to capitalize (and gradually amortize) the firms’ entire R&D? Which of the three
manufacturers is most affected by these adjustments?
16
Solutions – Chapter 4
1. Refer to the spreadsheet “CH4 P3 BMW Audi Skoda – solution.xlsx” for calculation details.
Following the procedure described in Chapter 4 to estimate the book value of a development
asset, we can calculate the value under various expected life assumptions. To calculate the
values of development assets and amortization expenses for economic lives exceeding six years
we need to extend the table by a few more years under the simplifying (but not too influential)
assumption that R&D spending and capitalization was held constant prior to 2004.
For BMW, for example, the calculations are as follows:
2011
BMW
Research and development expense (EUR millions)
Amortization and impairment
Developent costs capitalized in the current year
Total R&D expenditure
Capitalized development costs (asset) at the end of the year
End-of-year total assets
Sales
Operating profit
2007
2006
2005
3,610 3,082 2,587 2,825 2,920
-1,209 -1,260 -1,226 -1,185 -1,109
972
951 1,087 1,224 1,333
3,373 2,773 2,448 2,864 3,144
2010
2009
2008
2,544
-872
1,536
3,208
2,464
-745
1,396
3,115
2004 2003
2002
assumed assumed
2,334
2,334
2,334
-637
1,121
2,818
1,121
1,121
0.063
0.000
0.000 @
0.000
4,388 4,625 4,934 5,073 5,034 4,810 4,146 3,495
123,429 110,164 101,953 101,086 88,997 79,057 74,566 67,634
68,821 60,477 50,681 53,197 56,018 48,999 46,656 44,335
8,018 5,111
289
921 4,212 4,050 3,793 3,774
Amortization factors
Capitalization factors
0.063
0.938
Development asset - estimate
Amortization of development asset - estimate
4,515
1,212
0.125
0.813
0.125
0.688
0.125
0.563
0.125
0.438
0.125
0.313
0.125
0.188
0.125
0.063
8 years
calculations suggest that the average economic useful life of the car manufacturer’s
Note, however, that the estimates are
sensitive to the assumption about whether the manufacturers start amortizing their
expenditures immediately after capitalization or, say, 1 or 2 years after capitalization, i.e.,
when the development assets start to generate economic benefits. Assuming that amortization
starts after one year, which seems plausible, has a positive effect on the estimated book value
of the development asset and, consequently, reduces the estimate economic useful life of the
car manufacturers’ development assets to around six years. For BMW the calculations are as
follows:
2011
BMW
Research and development expense (EUR millions)
Amortization and impairment
Developent costs capitalized in the current year
Total R&D expenditure
Capitalized development costs (asset) at the end of the year
End-of-year total assets
Sales
Operating profit
2007
2006
2005
3,610 3,082 2,587 2,825 2,920
-1,209 -1,260 -1,226 -1,185 -1,109
972
951 1,087 1,224 1,333
3,373 2,773 2,448 2,864 3,144
2010
2009
2008
2,544
-872
1,536
3,208
2,464
-745
1,396
3,115
2004 2003
2002
assumed assumed
2,334
2,334
2,334
-637
1,121
2,818
1,121
1,121
0.000
0.000
0.000 @
0.000
4,388 4,625 4,934 5,073 5,034 4,810 4,146 3,495
123,429 110,164 101,953 101,086 88,997 79,057 74,566 67,634
68,821 60,477 50,681 53,197 56,018 48,999 46,656 44,335
8,018 5,111
289
921 4,212 4,050 3,793 3,774
Amortization factors
Capitalization factors
0.083
0.917
Development asset - estimate
Amortization of development asset - estimate
3,210
1,219
0.167
0.750
0.167
0.583
0.167
0.417
0.167
0.250
0.167
0.083
0.083
0.000
0.000
0.000
6 years
4,429 if amortization starts after one year
1,269 if amortization starts after one year
2. The capitalization percentages (development expenditures capitalized as a percentage of tot
development expenditures) of the three car manufacturers were as follows:
17
Solutions – Chapter 4
Capitalization percentages
BMW
Audi
Skoda
2011
2010
2009
2008
2007
2006
2005
2004
26.9%
22.5%
36.2%
30.9%
25.5%
37.6%
42.0%
25.8%
20.9%
43.3%
25.3%
36.1%
45.7%
22.3%
64.4%
60.4%
31.5%
64.1%
56.7%
34.3%
61.8%
48.0%
53.7%
57.7%
Some factors that may explain the variation in capitalization percentages over time and across
manufacturers are:
 Consumer demand (during the economic downturn). The economic crisis that started in
2008 has negatively affected consumers’ demand for Audis, BMWs, and Skodas. The
table shows that capitalization percentages have significantly decreased after 2008,
illustrating that consumer demand (i.e., the economic benefits derived from
development) is a determinant of capitalization.
 Strategy. The capitalization percentage also depends on a manufacturer’s researchdevelopment ratio, i.e., what proportion of R&D is directly related to new products
(development) and what proportion has a more general or fundamental focus
(research)? Car manufacturers with a differentiation strategy, such as BMW and Audi,
spend relatively more on research and, consequently, typically have a relatively low
capitalization percentage.
 Introduction of new models. Immediately prior to the introduction of new models a
larger proportion of development outlays may satisfy the capitalization criteria because
of the closeness to the end of the development phase (and hence the lower uncertainty
about future economic benefits).
 Profitability. Manufacturers may attempt to manage reported earnings by capitalizing a
larger proportion of development outlays in years of low profitability.
3. Capitalizing investment outlays and amortizing such outlays in the years in which they lead to
revenues improves earnings as a predictor of future performance. The IASB’s decision not to
allow the capitalization of research outlays is primarily based on the idea that future revenues
cannot be traced back to individual research projects, making it impossible to determine which
research outlays can and which outlays cannot be capitalized. This decision has not been based
on the idea that research outlays do not generate future revenues at all. The analyst’s view may
therefore be that a pool of research projects jointly contribute to future revenues and that one
project could not have been carried out without the other.
Consequently,
under this approach it could make sense to capitalize a nonzero proportion of research outlays.
4. Under the assumptions that (a) the economic useful life of (incremental) R&D investments is six
years and (b) amortization starts after one year, non-current assets of BMW, Audi, and Skoda
should be increased by 7,653 EUR million, 6,962 EUR million, and 18,144 CZK million,
respectively. These increases are equal to 6.2%, 18.1%, and 11.8% of total assets, respectively,
illustrating that the adjustments affect Audi most. The calculations follow the procedure
described in Chapter 4 and are as follows:
18
Solutions – Chapter 4
2011
2010
2009
2008
2007
2006
2005
Q3
BMW
Audi
2002
Amortization factors
Capitalization factors
0.083
0.917
0.167
0.750
0.167
0.583
0.167
0.417
0.167
0.250
0.167
0.083
0.083
0.000
assumed assumed
0.000
0.000
0.000 @
0.000
0.000
0.000
Research and development expense (EUR millions)
Developent costs capitalized in the current year
Difference (a)
3,610
972
2,638
3,082
951
2,131
2,587
1,087
1,500
2,825
1,224
1,601
2,920
1,333
1,587
2,544
1,536
1,008
2,464
1,396
1,068
2,334
1,121
1,213
2,334
1,121
1,213
2,334
1,121
1,213
2,469
629
1,840
2,050
528
1,522
2,161
547
1,614
2,226
497
1,729
1,982
625
1,357
1,585
543
1,042
1,214
652
562
1,214
652
562
1,214
652
562
8,222
3,093
5,129
7,139
1,493
5,646
5,721
2,066
3,655
4,812
3,097
1,715
4,307
2,762
1,545
4,633
2,862
1,771
4,252
2,453
1,799
4,252
2,453
1,799
4,252
2,453
1,799
Development asset at the end of 2011
4429
Development asset amortization in 2011
-1209
Estimated incremental R&D asset at the end of 2011
Estimated incremental R&D asset amortization in 2011 (b)
Change in operating profit (a - b)
7653
1406
1232
Increase in non-current assets as a percentage of total assets
Change in operating profit as a percentage of sales
6.20%
1.79%
Research and development expense (EUR millions)
Developent costs capitalized in the current year
Difference (a)
2,641
595
2,046
Development asset at the end of 2011
Development asset amortization in 2011
2249
-397
Estimated incremental R&D asset at the end of 2011
Estimated incremental R&D asset amortization in 2011 (b)
Change in operating profit (a - b)
6962
1411
635
Increase in non-current assets as a percentage of total assets
Change in operating profit as a percentage of sales
Skoda
2004 2003
18.81%
1.44%
Research and development expense (CZK millions)
Developent costs capitalized in the current year
Difference (a)
9,133
3,306
5,827
Development asset at the end of 2011
Development asset amortization in 2011
10726
-3072
Estimated incremental R&D asset at the end of 2011
Estimated incremental R&D asset amortization in 2011 (b)
Change in operating profit (a - b)
18144
2966
2861
Increase in non-current assets
Change in operating profit
11.82%
1.13%
Problem 4. H&M’s and Burberry’s Non-Current Assets (updated 1/2011)
1. Two measures of the efficiency of a firm’s investment policy are (a) the ratio of land,
buildings and equipment to sales and (b) the ratio of depreciation to sales. Calculate both
ratios for H&M and Burberry based on the reported information. Which of the two
companies appears to be relatively more efficient in its investment policy?
2. Calculate the depreciation rates that H&M and Burberry use for their equipment.
3. What adjustments to (a) the beginning book value of H&M’s equipment and (b) the
equipment depreciation expense would be required if you would assume that H&M uses the
Burberry’s depreciation rate?
4. What adjustments to (a) the beginning book value of H&M’s and Burberry’s land, buildings
and equipment and (b) H&M’s and Burberry’s depreciation expense would be required if you
would capitalize the retailers’ operating leases?
5. Recalculate the investment efficiency measures using the adjusted data. Do the adjustments
affect your assessment of the retailers’ investment efficiency?
1. The ratio of land, buildings and equipment to sales is 11.9 percent and 17.7 percent for H&M
and Burberry, respectively:
H&M
19
Burberry
6 years
Solutions – Chapter 4
Land and buildings book value at the beginning of the year
Book value of land, buildings, and equipment leased
under finance leases at the beginning of the year
Equipment at cost at the beginning of the year
Equipment book value at the beginning of the year
Cost of equipment acquired during the year
Average Land, buildings and equipment
Sales
Ratio
fiscal 2007
SEK 420m
SEK 222m
fiscal 2007
£58.2m
£0.0m
SEK 13,605m
SEK 7,134m
SEK 3,466m
SEK 9,509m
SEK 78,346m
£192.8m
£99.2m
£38.3m
£176.6m
£995.4m
11.1 %
17. 7 %
The ratio of depreciation to sales is 2.25 percent (1,764/78,346) and 2.90 percent (28.9/995.4)
for H&M and Burberry, respectively. Based on the ratios, H&M appears to be the more efficient
investor.
2. H&M and Burberry use the following depreciation rates for equipment:
Equipment at cost at the beginning of the year
Cost of equipment acquired during the year
Average equipment (at cost)
Equipment depreciation expense
Depreciation rate (assuming zero residual values)
H&M
fiscal 2007
SEK 13,605m
SEK 3,466m
SEK 15,338m
SEK 1,750m
Burberry
fiscal 2007
£192.8m
£38.3m
£212.0m
£27.0m
11.41 %
12. 736 %
3. The average age of H&M’s equipment (at the beginning of the year) can be calculated as
follows:
Equipment at cost at the beginning of the year
Equipment book value at the beginning of the year
(a) Book value as a percentage of the initial cost
(b) Depreciation rate
Average age of equipment (1 - a) / b
H&M
Fiscal 2007
SEK 13,605m
SEK 7,134m
52.437 %
11.410%
4.169 years
Using a depreciation rate of 12.736 percent the following financial statement adjustments
would then be required in H&M’s financial statements:
1. Decrease the book value of equipment at the beginning of the year. The necessary
adjustment is equal to the following amount: original minus adjusted depreciation rate ×
average asset age × initial asset cost: SEK752m ([0.1141 – 0.12736] × 4.169 × 13,605).
2. Given the 28 percent marginal tax rate, the adjustment to Non-Current Tangible Assets
requires offsetting adjustments of SEK211m (.28 × 752) to the Deferred Tax Liability and
SEK541m (752 - 211) to Shareholders’ Equity.
3. Assuming that SEK3,466m of equipment purchased in 2007 require only half a year of
depreciation, the depreciation expense for 2007 (included in Cost of Sales) would have
20
Solutions – Chapter 4
been SEK1,953 million {.12736 × [13,605 + (3,466/2)]} versus the SEK1,750 million
reported by the company. Thus Cost of Sales would increase by SEK203 million.
4. Given the 28 percent tax rate for 2007, the Tax Expense for the year would decrease by
SEK57 million.
In summary, H&M’s financial statements for fiscal 2006 and 2007, would have to be modified as
follows:
Adjustments
Fiscal 2006
Assets
Liabilities
€ (millions)
Balance Sheet
Non-Current
Tangible Assets
Deferred Tax
Liability
Shareholders'
Equity
Adjustments
Fiscal 2007
Assets
Liabilities
-SEK752
-SEK211
-SEK541
Income Statement
Cost of Sales
Tax Expense
Net Profit
+SEK203
-SEK57
-SEK146
4. At the beginning of 2006 and 2007, the present values of H&M’s and Burberry’s operating lease
commitments were as follows:
Future values
1
2
3
4
5
6
7
8
9
10
11
Total present value
at 4.4 and 5.4
percent
Of which current
Of which noncurrent
Actual minimum
lease payment
H&M
(SEKm)
2007
6,801.0
4,933.0
4,933.0
4,933.0
4,933.0
4,933.0
4,933.0
2,612.0
0.0
0.0
0.0
H&M
(SEKm)
2006
6,169.0
4,422.3
4,422.3
4,422.3
4,422.3
4,422.3
4,422.3
2,748.5
0.0
0.0
0.0
Burberry
(GBPm)
2007
39.1
28.2
28.2
28.2
28.2
28.2
28.2
28.2
28.2
28.2
26.4
Burberry
(GBPm)
2006
31.5
21.5
21.5
21.5
21.5
21.5
21.5
21.5
21.5
17.8
0.0
32,815.5
6,514.4
29,775.3
5,909
238.9
37.1
170.1
29.8
26,301.1
23,866.3
201.8
140.3
7,810
7,030
43.0
31.0
21
Solutions – Chapter 4
The new lease commitments during 2007 can be derived from the present values and actual
lease payments:
Future values
(a) Total present
value at 4.4 and 5.4
percent
(b) Of which noncurrent
(c)Planned
minimum lease
payment
(d) Actual minimum
lease payment
(e) discount rate
H&M
(SEKm)
2007
H&M
(SEKm)
2006
Burberry
(GBPm)
2007
Burberry
(GBPm)
2006
32,815.5
29,775.3
238.9
170.1
26,301.1
23,866.3
201.8
140.3
New lease
commitments = a (1 + e)*bt-1 + (d – ct1)
6,169.0
31.5
7,810
4.4%
7,030
4.4%
9,540.1
43.0
5.4%
31.0
5.4%
102.5
Consequently, the adjusted beginning book values of land, buildings and equipment are as
follows:
Future values
Land and buildings
book value at the
beginning of the year
Book value of land,
buildings, and
equipment leased
under finance leases
at the beginning of
the year
Equipment book value
at the beginning of
the year
Total present value at
4.4 and 5.4 percent
Total book value
(adjusted)
H&M (SEKm)
Fiscal 2007
SEK 420m
Burberry
(GBPm)
Fiscal 2007
£58.2m
222m
0.0m
7,134m
99.2m
29,775.3m
170.1m
37,551.3m
327.5m
Adjusted depreciation equals:
H&M (SEKm)
22
Burberry
Solutions – Chapter 4
(GBPm)
Future values
Buildings depreciation
expense
Equipment
depreciation expense
Depreciation on
leased assets at the
beginning of the year
Fiscal 2007
SEK 14m
Fiscal 2007
£1.9m
SEK 1,750m
£27.0m
3,397m
(11.41 % *
29,775.3)
544m
(11.41 % *
9,540.1/2)
21.1m
(12.376 % *
170.1)
6.3m
(12.376 % *
102.5/2)
5,705m
56.3m
Depreciation on
acquired leased assets
Total depreciation
expense (adjusted)
5. The adjusted ratio of land, buildings and equipment to sales is 11.9 percent and 17.7 percent for
H&M and Burberry, respectively:
Total book value (adjusted)
Cost of equipment acquired during the year
New lease commitments
Average Land, buildings and equipment (adjusted)
Sales
Ratio
H&M
fiscal 2007
SEK 37,551.3m
SEK 3,466m
SEK 9,540.1m
SEK 44,054.4m
SEK 78,346m
Burberry
fiscal 2007
£327.5m
£38.3m
£102.5m
£397.9m
£995.4m
56.2 %
40.0 %
The adjusted ratio of depreciation to sales is 7.28 percent (5,705/78,346) and 5.66 percent
(56.3/995.4) for H&M and Burberry, respectively. Based on the ratios, Burberry appears to be
the more efficient investor!
23
Solutions – Chapter 5
Chapter 5 Financial Analysis
Question 1.
Which of the following types of firms do you expect to have particularly high or low asset turnover?
Explain why.
Supermarket—High asset turnover. Supermarkets tend to be high volume businesses. Many of the
food products in supermarkets are perishable, and freshness is often used to differentiate products,
forcing a certain amount of inventories turnover. The typical consumer buys groceries on a regular
basis, guaranteeing grocery stores a certain level of overall business. Apart from inventories, a
supermarket’s largest assets are its warehouses and stores, all constructed to be relatively
inexpensive. Thus, high sales volumes generate a high measured level of asset turnover.
Pharmaceutical Company—High asset turnover. Drugs typically have a limited shelf-life. Once past
their expiration date, drugs cannot be sold and are worthless. Consequently, pharmaceutical
companies try to limit production to quantities which can be expected to be sold before the
expiration date. A pharmaceutical company’s assets are relatively low for two reasons. First, its
investment in research and development is expensed rather than recorded as an asset on the
company’s books. Second, patents do not typically show up as assets on the pharmaceutical
company’s books. Thus, high sales combined with lower reported asset levels generate a high
measured level of asset turnover.
Jewelry Retailer—Low asset turnover. Jewelry is typically durable, expensive, and infrequently
purchased by most consumers. Jewelry is also a strongly differentiated product. A single jewelry
store may carry over 150 different styles of watches. The consumer will choose one watch from
among the entire selection. Hence, the jewelry store must maintain a large inventory to support its
sales. Because the jewelry store’s main asset is inventory, which has a slow rate of turnover, the
typical jewelry store will show low asset turnover.
Steel Company—Low asset turnover. Production of steel is extremely asset intensive. A steel
company will invest hundreds of millions of euros in property, plant, and equipment necessary to
manufacture steel. Moreover, steelmaking equipment has a useful lifetime measured in decades.
Relative to this enormous investment, a steel company’s sales will be low. Consequently, a steel
company will typically have low asset turnover.
Question 2.
Which of the following types of firms do you expect to have particularly high or low sales margins?
Why?
Supermarket—Low margins. Competition in the supermarket industry is very intense. Different
supermarkets carry most of the same brands of food so there is little differentiation of products.
Consumers are sensitive to changes in the prices, and switching costs are very low, usually no more
than the opportunity cost of going to another supermarket. Consequently, pricing is the major area
of competition among supermarkets, leading to extremely low margins.
Pharmaceutical Company—High sales margins. Drugs manufactured by pharmaceutical companies
are often protected from competition by patents, allowing them to charge monopoly prices. Even
where drugs are not protected by patents, pharmaceutical companies invest considerable resources
1
Solutions – Chapter 5
in differentiating their products along non-price dimensions such as efficacy and ease-of-use.
Consequently, pharmaceutical companies typically boast very high sales margins. As an aside, drug
companies argue that these high margins are necessary to support their ongoing and expensive
research for new drugs, much of which never makes it to market.
Jewelry Retailer—High sales margins. Jewelry is a differentiated product where the typical buyer
cannot easily assess the quality of the item being purchased. Consequently, differentiation among
jewelry retailers falls along lines of intangibles such as service, quality, and reputation. The greater
the differentiation, the higher the expected margin.
Software Company—High sales margins. Margins are high for several reasons:
1. there are relatively high switching costs for consumers learning a new system,
2. production costs are very low—just the expense of disks or CD-ROMs and manuals, or the costs
of distributing software via the Internet and providing help on-line, and
3. most of the initial software development costs have been previously expensed.
Hence, software companies tend to enjoy large margins.
Question 3.
Sven Broker, an analyst with an established brokerage firm, comments: “The critical number I look at
for any company is operating cash flow. If cash flows are less than earnings, I consider the company
to be a poor performer and a poor investment prospect.” Do you agree with this assessment? Why
or why not?
Disagree. Operating cash flows and earnings numbers are both important in evaluating the
performance prospects of a company, but they will differ due to short- and long-term accruals.
Some current accruals, such as credit sales, will cause earnings to be greater than operating cash
flows while others, such as unpaid expenses by the firm, will cause operating cash flows to exceed
earnings. Non-current accruals, such as depreciation and deferred taxes, will also cause differences
between earnings and operating cash flows. The fact that operating cash flows are not as high as
earnings is not nearly as important as understanding why the two are different.
Operating cash flows could be below earnings for several reasons, each suggesting differences
in the firm’s performance and future investment prospects. For example, a firm that introduces a
successful new product will be probably have earnings exceeding operating cash flows due to
working capital needs (inventories and receivables) that affect cash flows but not earnings. Yet,
provided inventories can be sold and receivables collected, this difference is a positive sign that the
firm’s sales are growing and that the firm has good investment prospects. In contrast, firms that are
declining are likely to have earnings lower than cash flows, as working capital needs are diminished.
In summary, earnings are likely to be a better signal of future cash flow performance than
current cash flows, particularly for firms with long working capital (operating) cycles. Of course,
earnings exceeding cash flows can be a negative signal for future cash flow performance if
management is reporting aggressively, making analysis of cash flows a useful financial tool.
Question 4.
2
Solutions – Chapter 5
In 2005 France-based food retailer Groupe Carrefour has a return on equity of 19 percent, whereas
France-based Groupe Casino’s return is only 6 percent. Use the decomposed ROE framework to
provide possible reasons for this difference.
ROE can be decomposed in three steps, as follows:
=
Net Profit
Shareholders’ Equity
2.
=
Net Profit
Assets
x
Assets
Shareholders’ Equity
3.
=
Net Profit
Sales
x
Sales
Assets
1.
ROE
x
Assets
Shareholders’ Equity
Using this decomposition, ROE depends on a company’s return on sales, asset turnover, and
leverage. Differences in these three factors will drive differences in ROE. Without knowing specific
company information, it is possible to speculate about the root causes of Casino’s 6 percent and
Carrefour’s 19 percent ROE.
Return on Sales measures a firm’s profit per euro of sales. As a profitability measure, higher return
on sales suggests possible greater efficiency of operations or lower tax rates. Holding asset turnover
and leverage constant, a higher return on sales could explain Carrefour’s greater ROE. This would be
the case if Carrefour had implemented more effective management control systems, designed
better organized distribution facilities, or did better tax planning than Casino.
Asset Turnover assesses how productively a firm uses its assets. A higher asset turnover ratio
suggests that a fixed level of assets generates a greater level of sales, i.e., the firm put its assets to
more productive uses. Assuming return on sales and leverage are the same for both firms, a higher
asset turnover ratio would cause Carrefour’s ROE to be greater than Casino’s.
Leverage describes the capital structure of the firm. As leverage increases, the return on equity also
increases. From Step 2 of the decomposition, we see that ROE = (return on assets) x (leverage).
Holding return on assets constant, it would be possible to explain Carrefour’s higher ROE if it were
more highly levered than Casino.
Question 5.
Joe Investor claims: “A company cannot grow faster than its sustainable growth rate.” True or false?
Explain why.
False. The sustainable growth rate is the speed at which a company can expand without changing
either its level of profitability or its financial policies. Mechanically, sustainable growth rate = ROE x
(1 – dividend payout ratio). From this equation, we see that ROE and the dividend payout ratio
determine the funds remaining in the firm and available to finance the firm’s growth. If a company
wants to exceed its sustainable growth rate, it can increase its return on equity by improving its
profitability (return on sales), increasing its asset turnover, or increasing leverage. Alternatively, it
can reduce its dividend payout rate, thereby increasing funds available for reinvestment.
3
Solutions – Chapter 5
Question 6.
What are the reasons for a firm having lower cash from operations than working capital from
operations? What are the possible interpretations of these reasons?
Cash from operations will differ from working capital from operations due to current accruals
related to operations. In general, the differences between the two methods can be reconciled using
the following approach:
–
–
–
+
+
Working capital from operations
Increase (+ decrease) in trade receivables
Increase (+ decrease) in inventories
Increase (+ decrease) in other assets, excluding cash and marketable securities
Increase (– decrease) in trade payables
Increase (– decrease) in other current liabilities, excluding notes payable and debt
Cash from operations
Cash from operations will be lower than working capital from operations when current assets (e.g.,
trade receivables, inventories, and other non-cash assets) increase and when current liabilities (e.g.,
trade payables and other current liabilities, excluding notes payable and debt) decrease.
Trade receivables and inventories could be increasing because the firm is growing to meet
additional market demand. Conversely, trade receivables and inventories could be growing if the
firm’s customers are having difficulty paying for goods or services, or if sales have slowed causing
inventories to climb.
Trade payables could be decreasing because the firm’s financial position has improved and
the firm pays its suppliers sooner than before.
Question 7.
ABC Company recognizes revenue at the point of shipment. Management decides to increase sales
for the current quarter by filling all customer orders. Explain what impact this decision will have on
the following:
Days’ receivable for the current quarter. Increase, provided that, prior to the transaction, quarterly
sales are less than receivables. To see this, let receivables and quarterly sales prior to the
transaction be R and S respectively, and the increased $X of credit sales remain unpaid at the end of
the quarter. The change in quarterly days receivable will then be as follows:
Days Receivable before transaction
=
R
S
x
Days Receivable after transaction
=
R
S
Difference
=
X (R – S)
S (S + X)
+
+
365
X
X
x
365
x
365
Thus, if R < S, days receivable will increase after the transaction. This is especially likely for
companies with short credit periods (less than one quarter) and those that measure days receivable
on an annual basis, since annual sales are very likely to exceed receivables.
4
Solutions – Chapter 5
Days’ receivable for the next quarter. No change. Since sales would have been recorded in this
quarter if they had not been accelerated, there is not likely to be any change in days receivable.
Sales growth for the current quarter. Increase. Management’s decision will move sales from the next
quarter into the current quarter, making sales appear to grow relative to the previous quarter.
Sales growth for the next quarter. Decrease. Sales for the current quarter have increased, and sales
for the next quarter have declined. Sales growth for this next quarter will therefore decline.
Return on sales for the current quarter. Increase. Provided additional sales make a positive
contribution to the bottom line (net profit), the transaction will increase return on sales. If the net
margin on the sales is negative, return on sales will decline.
Return on sales for the next quarter. Decline. As noted above, the transaction reduces sales for the
next quarter. Provided these sales make a positive contribution to the bottom line (net profit), the
transaction will reduce return on sales. If the net margin on the sales is negative, return on sales will
increase.
Question 8.
What ratios would you use to evaluate operating leverage for a firm?
Operating leverage measures the extent to which an additional euro of sales increases the firm’s net
profit. The greater the increase in Net Profit for a given increase in sales, the greater the firm’s
operating leverage. For example, if a firm only had variable costs, each additional euro of sales
would be expected to generate additional profit equal to the existing Net Profit/Sales ratio for the
firm. Conversely, if the firm had only fixed costs, an additional euro of sales would generate an
additional euro of net profit (assuming the firm did not pay taxes). Thus, understanding a firm’s
operating leverage requires estimating how much of the firm’s costs are fixed and how much are
variable. This concept is complicated by the fact that in the long run most costs are variable.
While there is no single measure of a firm’s operating leverage, several ratios can help
evaluate a firm’s operating leverage and compare it with those of other firms. Information from
financial statements is typically crude and only gives a rough approximation of operating leverage. A
more thorough analysis requires specific cost-accounting information from within the firm. Changes
in net profit relative to changes in sales, or return on sales ratios relative to sales volume, provide
rough guides of operating leverage. Asset ratios, such as (Net PPE/Sales) or (Capital
Expenditures/Sales), can also provide a way of assessing how much of a firm’s production costs are
fixed. More detailed information, including (salary expense of production workers/Sales) and (raw
material expenses/Sales), can provide a finer picture of a firm’s operating leverage. Estimating a
firm’s operating leverage requires understanding which of the firm’s costs are fixed and which are
variable. The ratios mentioned above are very general. Depending on the specific firm and industry,
other ratios may be more useful.
Question 9.
What are the potential benchmarks that you could use to compare a company’s financial ratios?
What are the pros and cons of these alternatives?
Comparison to Firm’s Prior History. By comparing the company with itself over time, it is possible to
document changes (improvements or declines) in the company’s performance. Changes in capital
structure or improvements in gross margins or return on assets may evolve slowly as the firm
5
Solutions – Chapter 5
implements the necessary changes in operations and financing. Only by looking at the pattern of
these changes over time can we see if the individual changes in financial ratios from year to year are
permanent or temporary. However, this approach does not tell us how well the firm is doing
compared to other companies. For example, a firm may appear to have performed poorly (well)
relative to its own historical performance, yet relative to other firms in the economy or its own
industry, it may have performed quite well (poorly).
Comparison to Firm’s Expected or Budgeted Performance. This could be relative to management or
external analysts’ forecasts. These types of comparisons can be very helpful by showing how well
the firm has performed relative to expectations. An obvious limitation is that the comparisons are
only meaningful if the expectations are carefully constructed.
Comparison to Industry Average. Industry average financial ratios provide a benchmark against
which to interpret individual company ratios. A firm’s return on sales, asset turnover, and financial
leverage can be compared to industry averages. What are the implications if a firm has a lower
return on equity or lower days payable than the industry? Are any differences consistent with the
firm’s operating policies and goals? Industry comparisons can provide only a partial picture if the
industry as a whole has performed well or poorly, or if the firm is following a different strategy from
other firms in the industry. It can also be quite difficult to assess what the appropriate industry
comparison group is, since many firms operate in more than one business segment.
Comparison to Market. Benchmarking the performance of an individual firm against the market can
be informative. Ultimately, investors want to allocate resources within the economy as a whole. A
firm that is a strong performer relative to its industry may therefore be a relatively weak overall
performer if its industry is underperforming. However, market analysis can be difficult for many key
financial ratios which are industry specific and do not lend themselves to cross-industry comparison
or evaluation. For example, important ratios for banks include those on regulatory capital, which are
not relevant for most other industries. Working capital ratios typically differ across industries, so
that it makes little sense to compare days inventories or days receivable for a supermarket relative
to the same ratios for a steel manufacturer. Finally, differences in ratios can arise because of
differences in business risk across industries. For example, ROEs and leverage are likely to be very
different for construction firms than for supermarkets.
Question 10.
In a period of rising prices, how would the following ratios be affected by the accounting decision to
select LIFO, rather than FIFO, for inventory valuation?
The impact of the selection of LIFO rather than FIFO for inventory valuation will appear in
Inventories and Cost of materials. Under LIFO, the most recent and most expensive (during
inflationary periods) items in inventories will be the first used for accounting purposes. Relative to a
firm using FIFO, the LIFO firm will report a lower value for inventories because its ending inventories
contains the oldest and least expensive items. As a result of using its higher priced inventories first,
the LIFO firm has a higher cost of materials.
Gross margin is lower for the LIFO firm. The LIFO firm has higher cost of materials expenses which
makes its gross margin appear lower than the FIFO firm.
6
Solutions – Chapter 5
Current ratio falls. The current ratio equals current assets divided by current liabilities. Current
assets is lower under LIFO because inventories are lower. Hence, the value of current assets divided
by current liabilities drops under LIFO.
Asset turnover increases. Asset turnover equals sales divided by assets. Sales remains the same but
assets are lower under LIFO, so asset turnover declines.
Debt-to-equity ratio increases using the book value of equity. The debt-to-equity ratio equals
(current debt + non-current debt) divided by book value of shareholders’ equity. The LIFO decision
does not affect either the current or non-current debt levels, but LIFO has a negative net impact on
the book value of shareholders’ equity. Under LIFO, the higher cost of materials leads to lower net
profit, which in turn leads to a decrease in book shareholders’ equity.
This decrease may be mitigated if the firm has a lower tax bill due to lower taxable profit. Overall,
however, the decline in net profit is likely to be greater than the decrease in tax payments, yielding
a decline in shareholders’ equity and increasing the debt-to-equity ratio.
Average tax rate remains the same. The LIFO firm reports higher expenses which lowers profit
before tax. Because the firm reports smaller profit before tax, it has less taxable profit and, hence,
has a smaller tax liability. However, the average tax rate is likely to remain the same.
Problem 1. ROE Decomposition
1. Calculate Inditex’s net operating profit after taxes, operating working capital, net noncurrent assets, net debt and net assets in 2007 and 2008. (Use the effective tax rate [tax
expense/profit before taxes] to calculate NOPAT.)
2. Decompose Inditex’s return on equity in 2007 and 2008 using the traditional approach.
3. Decompose Inditex’s return on equity in 2007 and 2008 using the alternative approach.
What explains the difference between Inditex’s return on assets and its operating return on
assets?
4. Analyze the underlying drivers of the change in Inditex’s return on equity. What explains the
decrease in return on equity? How strongly appears Inditex to be affected by the economic
crisis of 2008? (In your answer, make sure to address issues of store productivity, cost
control, pricing and leverage.)
[See spreadsheet ‘CH5 P1 Inditex - solution.xlsx’]
Problem 2. Ratio analysis and acquisitions
1. Summarize the main factors behind the decrease in TomTom’s ROE in 2007 and the increase
in the company’s ROE in 2008.
2. What effect did the acquisition of a 29.9 stake in Tele Atlas have on the components of
TomTom’s ROE in 2007?
3. What effect did the acquisition of a majority stake in Tele Atlas have on the components of
TomTom’s ROE in 2008?
The decrease in TomTom’s ROE in 2007 is primarily caused by a significant decrease in net operating
asset turnover, which in turn is partly offset by the positive effects the increases in the firm’s profit
7
Solutions – Chapter 5
margin and net financial leverage gain. The decomposition of asset turnover helps to understand why
net operating asset turnover decreased. Whereas TomTom had almost no non-current assets
recognized on its 2006 balance sheet, the acquisition of a minority stake in TeleAtlas during 2007 led
to a substantial increase in the firm’s non-current financial assets to sales. An interesting point for
discussion is that when using the equity method to account for a minority investment, such an
investment increases the acquirer’s operating assets but leaves its sales unaffected. Consequently,
the investment (if profitable) leads to a mechanical increase in the profit margin and a decrease in
asset turnover, thereby distorting the ratio analysis.
The increase in TomTom’s ROE in 2008 is the result of an increase in the net financial
leverage. TomTom’s net operating asset turnover and its profit margin decrease in 2008. The
decrease in profit margin is at least partially mechanically induced by the accounting treatment of
the company’s acquisition of a majority stake in TeleAtlas. That is, because TomTom accounts for the
investment in TeleAtlas using the consolidation method, while previously using the equity method,
the effect of the change in the investment from a minority to a majority investment has a greater
effect on sales than it has on net profits. Similarly, the effect of this change on sales is greater than its
effect on net operating assets, thus mechanically improving the net operating asset turnover ratio.
Interestingly, net operating asset turnover decreases in 2008, suggesting that TomTom’s investment
efficiency has been negatively affected by the acquisition. However, the decrease in asset turnover
from 11.11 in 2006 to 1.03 in 2008 may be a direct result of the fact that typically only acquired
intangible assets are recognized on the balance sheet. TomTom’s high asset turnover was abnormally
high in 2006 because its investments in intangibles were kept off balance.
Problem 3. Ratios of three fashion retailers
1. The return on equity (ROE) decomposition shows that the underlying drivers of ROE
performance vary across retailers. Which economic or strategic factors may explain these
differences in the components of ROE?
2. How did performance trends (during the period 2008 to 2011) differ among the three
retailers? Which factors contributed most to these differences?
1.
Operating and Investment Management
The composition of the return on operating assets varies significantly across the three fashion
retailers. In particular, Benetton tends to combine relatively high operating profit margins with low
operating asset turnover. In contrast, Etam combines low operating profit margins with high
operating asset turnover. These differences in ROA composition partly reflect the differences in
strategy among the retailers. None of the retailers follow a fast-fashion strategy such as H&M or
Inditex. However, Benetton and French Connection can be characterized as following a
differentiation strategy (e.g., operating stores at potentially more expensive locations, significant
investments in marketing and branding), which partly explains the firms’ higher operating margins
relative to Etam. Although Etam has recently started to position its brand more a premium brand,
the retailer’s past strategy can be characterized as a low-cost strategy.
Another important factor is that the three companies place varying emphasis on wholesale
(franchise) sales. Franchise sales (wholesale) occur at (substantially) lower prices than retail sales,
thus leading to lower operating margins and lower asset turnover. Benetton derives the largest
proportion of its revenues from wholesale (about 75 to 80%), followed by French Connection
(slightly more than one-third). This potentially explains why FC’s operating asset turnover exceeds
that of Benetton but is lower than that of Etam.
Benetton’s low asset turnover can be attributed to both low non-current asset turnover and low
working capital turnover. Benetton’s investment in working capital, in particular trade receivables,
exceeds that of Etam and French Connection, despite the fact that Benetton makes more use of
8
Solutions – Chapter 5
vendor financing, as shown by the firm’s high days’ payables. For a retailer such as Benetton trade
receivables are not likely to be receivables from retail customers. Instead, such receivables are
primarily receivables from wholesale customers. The trade receivable turnover ratios thus indicate
that French Connection more efficiently manages its receivables from wholesale customers.
French Connection has invested a larger proportion of its capital in non-operating assets (in
particular excess cash and minority equity investments) than Benetton and Etam. Because the
return that FC earns on its excess cash and marketable securities is close to the firm’s return on
operating assets, the investments in non-operating assets do not significantly affect the firm’s
return on business assets. If, however, in future years FC’s return on operating assets will increase
to approach the required return on operating assets, the investments in excess cash will likely start
to have a negative effect on the firm’s return on business assets. Benetton’s and Etam’s investments
in non-operating assets are not material.
Financial Management
The financial leverage effect is positive for each of the three retailers. French Connection is more
leveraged than Benetton and Etam, most likely because of poor financial performance (decreasing
equity) during the years prior to 2010. Absent the effect of past financial performance, the retailers’
financing strategies seem to be very similar, with financial leverage ratios close to 1 – 1.2.
2.
Operating and Investment Management
During the period 2008 – 2011, Benetton’s operating performance steadily declined. The primary
driver of the retailers’ decrease in return on operating assets was the decrease in net operating
profit margin from 9.8 percent in 2008 to 5.8 percent in 2011. The retailer’s operating asset
turnover remained relatively constant. The analysis of Benetton’s common-size income statement
identifies the following potential explanations for the decline in Benetton’s net operating margin:
- Benetton’s cost of materials has increased from 46.9 to 50.4 percent of sales. A likely
explanation for this increase is the steady rise in cotton prices (as discussed in Chapter 5).
- Benetton’s sales decreased in 2009 and 2011. Stickiness of personnel and depreciation
expenses may explain the increases in personnel expense as a percentage of sales and
depreciation and amortization expense as a percentage of sales in both years.
Etam has managed to gradually improve its operating asset turnover, mostly through improving
non-current asset turnover. During the years 2009 – 2011, the positive ROA effect caused by the
increase in Etam’s operating asset turnover was slightly offset by the retailer’s decreasing operating
profit margin. This may indicate that Etam has stimulated sales by cutting its prices. In addition, the
increase in the retailer’s cost of materials as a percentage of sales shows that Etam was also
affected by the increase in cotton prices in 2010 and 2011.
FC has been able to improve its operating margins and operating asset turnover after restructuring
its business in 2009-2010. However, in 2011 the retailer was also adversely affected by the effect of
rising cotton prices.
Financial Management
During the period 2008 – 2010 French Connection’s financial leverage has increased, most likely
because of the retailer’s poor financial performance. Etam’s financial leverage has also increased
during the period 2008 – 2011, probably also because of the retailer’s relatively low performance.
Problem 4. The Fiat Group in 2008
Decompose Fiat’s return on equity and evaluate the drivers of the company’s performance during
the period 2006-2008. What trends can you identify in the company’s performance? What has likely
been the effect of the credit crisis on Fiat?
9
Solutions – Chapter 5
The following tables display some of the key financial ratios calculated for Fiat during the period
2006-2008 (based on standardized financial statements):
Financial Statement Items
Tax rate
Net interest expense after tax
Sales
Net operating profit after taxes
(NOPAT)
Operating working capital
Net non-current assets
Net debt
Net assets
Net capital
ROE decomposition
Net operating profit margin
x Net operating asset turnover
=Operating ROA
Spread
x Financial leverage
=Financial leverage gain
ROE = Operating ROA + Financial leverage gain
2008
21.3%
745.2
59,380.0
2007
25.9%
417.8
58,529.0
2006
29.9%
404.0
51,832.0
2,466.2
13,300.0
22,894.0
25,840.0
36,194.0
36,194.0
2,471.8
9,029.0
21,451.0
19,874.0
30,480.0
30,480.0
1,555.0
9,826.0
20,599.0
21,063.0
30,425.0
30,425.0
2008
4.2%
1.64
6.8%
3.9%
2.50
9.8%
16.6%
Common-sized income statement
Sales
Cost of Sales (function)
SG&A (function)
Other Operating Income, Net of Other Operating
Expenses (function)
Net Interest Expense or Income
Investment Income
Other Income
Other Expense
Tax Expense
Minority Interest
Net Profit/Loss
Asset turnover ratios
Operating working capital/Sales
Net non-current assets/Sales
PP&E/Sales
Operating working capital turnover
Net long-term asset turnover
PP&E turnover
Accounts receivable turnover
Inventory turnover
Accounts payable turnover
Days' accounts receivable
2008
22.4%
38.6%
22.1%
4.5
2.6
4.5
3.4
4.4
3.7
106.3
10
2007
4.2%
1.92
8.1%
6.0%
1.87
11.3%
19.4%
2006
3.0%
1.70
5.1%
3.2%
2.25
7.2%
12.3%
2008
100.0%
-83.2%
-11.1%
2007
100.0%
-83.6%
-11.0%
2006
100.0%
-84.7%
-11.8%
-0.7%
-1.6%
0.3%
0.0%
0.0%
-0.8%
0.0%
2.9%
-0.3%
-1.0%
0.6%
0.0%
0.0%
-1.2%
0.0%
3.5%
-0.8%
-1.1%
1.5%
0.0%
0.0%
-0.9%
0.0%
2.2%
2007
15.4%
36.7%
19.9%
6.5
2.7
5.0
3.5
4.9
3.3
102.4
2006
19.0%
39.7%
20.8%
5.3
2.5
4.8
3.1
5.1
3.5
115.9
Solutions – Chapter 5
Days' inventory
Days' accounts payable
82.6
96.6
73.5
108.4
70.1
103.4
These ratios provide the following information about Fiat’s performance during the period 20062008:
1. After an improvement in 2007, Fiat’s ROE worsened again in 2008. The primary driver of this
decrease in profitability was a decrease in asset turnover. Fiat’s profit margin remained stable
at 4.2 percent; the car manufacturer’s leverage increased, thereby partly offsetting the effect of
the decrease in the financial spread on the financial leverage gain.
2. The decomposition of Fiat’s profit margin reveals that the company’s financial spread not only
decreased as a result of the decline in operating ROA, but also because of a significant increase
in its net interest expense.
3. The analysis of Fiat’s asset turnover ratios shows that the decline in net operating asset
turnover has been driven by declines in both working capital turnover and PP&E turnover. The
crisis may have affected both ratios:
a. Working capital turnover. Fiat’s inventory turnover decreased, suggesting that the
company experienced problems selling its inventory during the crisis period. To
illustrate, in its Management Report, management indicated that:
“The €3,371 million increase in working capital for 2008 (€3,786 million on a
comparable scope of operations and at constant exchange rates) is largely
attributable to reduced business volumes in the second half, particularly in the 4th
quarter which, for the full year, resulted in an increase in inventories of
approximately €1.5 billion (€2.1 billion on a comparable scope of operations and at
constant exchange rates), principally for Iveco and CNH.”
Further, the company increased its accounts payable turnover. This might be the
result of suppliers becoming more cautious and less able to provide supplier
financing during the credit crunch. Alternatively, and more in line with Fiat’s
explanation, the company reduced its purchases in anticipation of a reduction in
production:
“…trade payables reduced €1.5 billion from the 2007 year-end level due to lower
production levels.”
Finally, receivables turnover decreased, suggesting that, like many other companies,
Fiat started to experience difficulties in collecting its receivables.
b. PP&E turnover. New investments in PP&E tend to be less effective during economic
downturns.
4. The increase in Fiat’s working capital investments led to a substantial decrease in the
company’s operating cash flow. Consequently, the cash outflow from investments exceeded
the cash inflow from operations, forcing Fiat to attract new debt capital. The increase in net
debt, both due to an increase in non-current debt and a decrease in cash, had a positive effect
on Fiat’s return on equity (see the ROE decomposition table).
5. Noteworthy is that Fiat’s asset-backed financing decreased in 2007 and remained low (relative
to its 2006 level) in 2008. This may suggest that it had become more difficult for Fiat after the
start of the credit crisis in 2007 to securitize its receivables. Consequently, Fiat had to rely more
on bank loans to finance its operations.
In sum, Fiat’s ratios reflect the following effects of the credit crisis:
 Reduced efficiency of investments in working capital (primarily inventory) and property,
plant and equipment;
 Increased need for debt financing because of the reduction in cash generated by the
company’s operations;
 Reduced opportunities for asset-backed financing.
11
Solutions – Chapter 6
Chapter 6 Prospective Analysis: Forecasting
Question 1.
GlaxoSmithKline is one of the largest pharmaceutical firms in the world, and over an extended period
of time in the recent past, it consistently earned higher ROEs than the pharmaceutical industry as a
whole. As a pharmaceutical analyst, what factors would you consider to be important in making
projections of future ROEs for GlaxoSmithKline? In particular, what factors would lead you to expect
GlaxoSmithKline to continue to be a superior performer in its industry, and what factors would lead
you to expect GlaxoSmithKline’s future performance to revert to that of the industry as a whole?
Factors contributing to GlaxoSmithKline continuing to be a high ROE performer:
 Barriers to competition. GlaxoSmithKline can enjoy superior ROEs for long period of time if it
builds high entry barriers such as patents, economies of scale arising from large investments in
R&D, and a strong brand name due to advertising or past performance.
 Artifacts of accounting methods. The tendency of high ROEs may be purely an artifact of
accounting methods. At GlaxoSmithKline, major economic assets, such as the intangible value of
research (and development), are not recorded on the balance sheet and are therefore excluded
from the denominator of ROE.
Factors causing GlaxoSmithKline to revert to the industry mean:
 The economics of competition. Abnormally high profit attracts competition. Increased
competition may lower GlaxoSmithKline’s high ROEs.
 Increase of investment base. Firms with higher ROEs expand their equity bases more quickly
than others, which causes the denominator of the ROE to increase. Of course, if firms could earn
returns on the new investments that match the returns on the old ones, then the level of ROE
would be maintained. However, firms have difficulty pulling that off. In the face of competition,
one would typically not expect a firm to continue to extend its supernormal profitability to
additional, new projects year after year. It is likely that GlaxoSmithKline’s earnings growth will
not keep pace with growth in its equity base, ultimately leading ROE to fall.
Question 2.
An analyst claims: “It is not worth my time to develop detailed forecasts of sales growth, profit
margins, et cetera, to make earnings projections. I can be almost as accurate, at virtually no cost,
using the random walk model to forecast earnings.” What is the random walk model? Do you agree
or disagree with the analyst’s forecast strategy? Why or why not?
We don’t agree with the analyst. According to the random walk model, the forecast for year t + 1 is
simply the amount observed for year t. The random walk model only describes the average firm’s
behavior. Random walk model may not be applicable to those firms that erect barriers to
competition and protect margins for extended periods. The art of financial statement analysis
requires knowing not only what the “normal” patterns are but also how to identify those firms that
will not follow the norm. This can only be done if the analyst performs a strategy analysis.
Question 3.
1
Solutions – Chapter 6
Which of the following types of businesses do you expect to show a high of degree of seasonality in
quarterly earnings? Explain why.
Supermarket. The sales of supermarkets are not seasonal. There is not likely to be a peak in grocery
shopping in any particular month.
Pharmaceutical Company. For a pharmaceutical company whose cold medicine is its major product,
the sales of that company may peak in winter.
Software Company. Sales of software are high during December, due to holiday sales. Many
software companies also make efforts to push sales at the fiscal year-end in order to meet their
annual targets.
Auto Manufacturer. Auto sales are seasonal due to the introduction patterns of new models. Note
that many new car models are introduced around September.
Clothing Retailer. Clothing sales are strongly seasonal; they are highest around holiday seasons.
Question 4.
What factors are likely to drive a firm’s outlays for new capital (such as plant, property, and
equipment) and for working capital (such as receivables and inventories)? What ratios would you use
to help generate forecasts of these outlays?
First, corporate managers decide the outlays for new capital, based on their expectation of future
growth of the company. For example, when large sales growth is expected, a manager may decide
to expand the firm’s plant and equipment. Second, the company may increase investment in plant
and property in order to lower future (potential) competition. In some industries, capacity
expansion is a strategy that a company can make to deter potential competitors from entering the
market.
Since capital expenditure is a strategic decision, it is difficult to forecast without some
guidance from management. In the absence of such guidance, a good rule of thumb is to assume
that the ratio of plant to sales will remain relatively stable and that outlays for new capital will be
whatever amount is needed to maintain that ratio.
Managers may decide to decrease the outlays for working capital when
1. they expect that the sales will shrink in the future,
2. they expect that operating efficiency will improve, and thus require less working capital (e.g.,
implementation of just-in-time manufacturing), or
3. the way of doing business is likely to change (e.g., change to OEM business).
Just like the forecast of capital expenditures, it is difficult to estimate future outlays of
working capital without understanding management’s plans. The rule of thumb, however, is to
assume that the ratio of net working capital to sales will remain the same and that investment for
working capital will be the amount which is needed to keep that ratio constant.
Question 5.
2
Solutions – Chapter 6
How would the following events (reported this year) affect your forecasts of a firm’s future net
profit?
An asset write-down: A firm’s managers’ choice to write-down (for example, inventories writedown) could reveal new information about the salability of the inventories or demand for products
produced by an existing plant. If so, management’s decision to take a write-down would
unfavorably affect the expectations of a company’s future net profit.
A merger or acquisition: The way the acquisition is financed and the accounting method used to
record the transaction will affect the forecasts of future net profit. Further, research shows that the
merged firms have a significant improvement in operating cash flow return and net profit after the
merger, resulting from increases in asset productivity. These improvements are particularly strong
for transactions involving firms in overlapping businesses. A merger or acquisition with related
business would affect the expectations of future net profit positively.
The sale of a major division: If the motive for selling a major division is to concentrate on the
company’s main activity, the sale will improve the efficiency, accountability, and future net profit of
the company. If the division sold is related to the company’s main business, the effect of this
transaction is not clear.
The initiation of dividend payments: Dividends initiation may be meaningful when (1) managers
have better information than investors about the firm’s future earnings and (2) managers use that
information to initiate dividend payments. The cash dividend initiation of this year can be thought of
as management forecast of future earnings improvement. The initiation of dividend payments sends
a good signal to the capital market participants.
Question 6.(a.)
What would be the year 6 forecast for earnings per share for each of the two earnings forecasting
models?
Model 1 (random walk model):
€0.58
Model 2 (mean-reverting model): €0.19 (= average of five years’ EPS)
Question 6.(b.)
Actual earnings per share for Telefonica in 6 were €0.91. Given this information, what would be the
year 7 forecast for earnings per share for each model? Why do the two models generate quite
different forecasts? Which do you think would better describe earnings per share patterns? Why?
Model 1: €0.91
Model 2: €0.25 (= average from year 2 to year 6)
Model 1 describes earnings per share patterns better than Model 2. Model 1 is a simple random
walk model which uses current year earnings per share as a benchmark, whereas Model 2 uses the
average of the prior five years’ earnings per share as a benchmark. Research indicates that, for
typical firms, sales information more than one year old is useful only to the extent that it
3
Solutions – Chapter 6
contributes to the average annual trend. The average level of sales over five prior years does not
help in forecasting future EPS.
Question 7.
An investment banker, states: “It is not worth my while to worry about detailed, long-term
forecasts. Instead, I use the following approach when forecasting cash flows beyond three years. I
assume that sales grow at the rate of inflation, capital expenditures are equal to depreciation, and
that net profit margins and working capital to sales ratios stay constant.” What pattern of return on
equity is implied by these assumptions? Is this reasonable?
Based on the banker’s assumptions, the ROEs after three years will keep increasing forever because,
implicitly, he is assuming that the fixed asset turnover ratio will grow every year at the rate of
inflation. If all the other ratios (margins and leverage) remain constant, this implies an increasing
pattern of ROE forever. Such a pattern is inconsistent with the evidence that ROEs revert to a mean
on average.
Problem 1. Predicting Tesco’s 2009/2010 earnings
1. Predict Tesco’s 2009/2010 sales using the information about the company’s store space and
revenues (per geographical segment).
2. Predict the 2009/2010 book values of Tesco’s non-current assets and working capital using
the information about the company’s investment plans. Make simplifying assumptions
where necessary.
3. During fiscal year 2008/2009, at least two factors influenced Tesco’s operating expenses: (a)
the increase in depreciation and (b) the cost savings of approximately GBP 550 million.
Assume that all other changes in the company’s operating profit margin were caused by the
economic downturn.
a. What was the net effect of the downturn on Tesco’s operating margins?
b. Estimate Tesco’s 2009/2010 operating expense under the assumption that the effect
of the economic downturn fully persists in 2009/2010. (Estimate the company’s
depreciation and amortization expense separately from the other operating
expenses.)
4. Estimate Tesco’s 2009/2010 interest expense and net debt-to-equity ratio under the
assumption that the company reduces its net debt in 2009/2010, as planned.
5. What do the above estimates (and your estimate of Tesco’s 2009/2010 tax expense) imply
for the company’s free cash flow to equity holders in 2009/2010? How likely is it that Tesco
will be able to reduce its net debt in 2009/2010?
This problem has an infinite number of acceptable solutions. Following is only one of those possible
solutions.
1. To predict next year’s sales, it is helpful to focus on one identifiable sales driver. An obvious
sales driver for Tesco is square feet store space. We assume that new openings, extensions,
adjustments, disposals, and acquisitions contribute half a year of sales, on average. Under this
assumption, Tesco’s realized store productivity (by geographical area) in 2008/2009 was:
UK
Revenues
38,191
4
Rest of
Europe
8,862
Asia
7,068
US
206
Solutions – Chapter 6
Operating profit
2,540
479
343
-156
29,549
1,773
22,517
3,502
23,363
3,006
530
620
239
3,015
0
0
Square feet store space (x 1,000):
Beginning-of-year
Openings, extensions,
adjustments
Acquisitions
Closures/disposals
-276
-196
-190
0
End-of-year
31,285
28,838
26,179
1,150
Average square feet store space
(x 1,000)
30,417
25,678
24,771
840
Sales per square feet store space
(x 1,000)
1.256
0.345
0.285
0.245
If store productivity remains constant in 2009/2010 and new openings, extensions,
adjustments, disposals, and acquisitions contribute half a year of sales, as we assumed
previously, next year’s revenues will be close to £58 billion:
UK
Rest of
Europe
Asia
US
Square feet store space (x 1,000):
Beginning-of-year
Openings, extensions,
adjustments
31,285
1,897
28,838
2,697
26,179
2,733
1,150
600
98
-225
0
0
0
-63
0
0
End-of-year
33,055
31,535
28,849
1,750
Average square feet store space
(x 1,000)
32,170
30,187
27,514
1,450
Sales estimate (based on 53
weeks)
Sales estimate (adjusted for 52
weeks)
40,392
10,418
7,851
356
39,630
10,222
7,703
349
Total sales
57,903
Acquisitions
Closures/disposals
2. In the absence of detailed information about future investments in working capital, non-current
intangible assets and non-interest bearing liabilities, a reasonable approach is to assume that
the book values of these items follow sales growth:
5
Solutions – Chapter 6
2008/2009
ending
book
2007/2008
value as %
ending
of
book
revenues
value
2007/2008
ending
book value
as % of
revenues
2009/2010
ending book
value as %
of revenues
(estimate)
2009/2010
ending book
value
(estimate)
-5,235
detailed
estimate
(see below)
Balance sheet item
2008/2009
ending
book value
Net working capital
-4,912
-3,885
-9.04%
-8.21%
23,152
19,787
42.62%
41.83%
-9.04%
detailed
estimate
(see below)
4,027
2,336
7.41%
4.94%
7.41%
4,292
3,469
1,725
6.39%
3.65%
6.39%
3,697
-888
-954
-1.63%
45.74%
-2.02%
40.19%
-1.63%
-946
Non-current
tangible assets
Non-current
intangible assets
Other Non-current
assets
Non-interest
bearing liabilities
Total
The information provided by Tesco’s management about the company’s expected capital
expenditures helps us in producing a more detailed estimate of next-year’s ending noncurrent tangible assets. First, we estimate the initial cost of non-current tangible assets that
Tesco will dispose of during 2009/2010:
Disposals of noncurrent tangible
assets (at cost)
Disposals of
square feet
store space
(expected)
[a]
Beginning
square
feet store
space [b]
[a] as % of
[b] = [c]
288
87,452
0.33%
Beginning
noncurrent
tangible
assets at
cost [d]
29,844
Disposals
(estimate) =
[c] x [d]
98
Then we calculate the ending value of non-current tangible assets at cost:
2009/2010
Beginning value of non-current tangible
assets at cost
Capital expenditures (expected)
Disposals (estimate)
Ending value of non-current tangible
assets at cost
29,844
3,500
-98
33,246
Finally, we estimate 2009/2010 depreciation and the ending value of accumulated
depreciation on non-current tangible assets (ignoring the effect of accumulated depreciation
on disposals for simplicity):
6
Solutions – Chapter 6
Depreciation
in 2008/2009
[a]
2008/2009
average
noncurrent
tangible
assets at
cost [b]
1,036
27,697
Depreciation on
non-current
tangible assets
[a] as % of
[b] =
depreciation
rate[c]
2009/2010
average
noncurrent
tangible
assets at
cost [b]
Depreciation
in 2009/2010
(estimate) =
[c] x [d]
3.74%
31,545
1,180
2009/2010
Beginning value of accumulated
depreciation
6,692
Depreciation (estimate)
1,180
Disposals (assumption)
Ending value of accumulated
depreciation
0
7,872
Consequently, the estimated ending book value of non-current tangible assets is:
Balance sheet
item
2009/2010
ending
value at
cost
Non-current
tangible assets
2009/2010 2009/2010
ending
ending
accumulated
book
depreciation
value
33,246
7,872
25,374
2009/2010
ending
book value
as % of
revenues
43.82%
Note that the expected percentage change in non-current tangible assets exceeds the
expected percentage change in revenues, implying that Tesco’s investment efficiency slightly
decreases. In sum, the above calculations imply that Tesco’s net assets will increase from
£24,848 million (45.74 % of sales) in 2008/2009 to £27,182 million (47.12% of sales) in
2009/2010. Of course, the prediction that Tesco’s investment efficiency will decrease is also
partly caused by our assumption that the company’s store productivity will not improve.
However, in the absence of more detailed information about possible store productivity
improvements and given the economic downturn in 2008/2009 and 2009/2010, this
assumption is not unreasonable.
3. The calculations under (a) are:
2008/2009
7
2007/2008
Solutions – Chapter 6
Sales
Operating expenses
Operating expenses as % of sales
54,327
-51,121
-94.10%
47,298
-44,507
-94.10%
1,036
876
153
116
Operating expenses before depreciation
and amortization
Cost savings
-49,932
-550
-43,515
0
Operating expenses before depreciation
and amortization and cost savings
-50,482
-43,515
Operating expenses before depreciation
and amortization and cost savings as %
of sales
-92.92%
-92.00%
Depreciation of non-current tangible
assets
Amortization of non-current intangible
assets
Hence, the effect of the economic downturn was to decrease Tesco’s (pre-tax) profit margin
by approximately 0.9 percentage points.
To estimate Tesco’s 2009/2010 operating expense (requirement (b)), we first estimate the
company’s 2009/2010 depreciation and amortization expense. As discussed under (2), Tesco’s
depreciation expense estimate is £1,180 million. The company’s amortization rate (based on
beginning values for reasons of simplicity) in 2008/2009 equaled 5.20% (153 / 2,944). Using
the same amortization rate for 2009/2010, Tesco’s 2009/2010 amortization expense will be
close to £249 million (5.20% x 4,790).
Under the assumption that Tesco’s operating expense before depreciation, amortization and
cost savings as a percent of sales will remain constant in 2009/2010, the company’s operating
expense will be as follows:
Estimates
2009/2010
Sales
Operating expenses before depreciation and
amortization and cost savings as % of sales
Operating expenses before depreciation and
amortization and cost savings
Depreciation
Amortization
Cost savings
57,903
-92.92%
-53,805
-1,180
-249
550
Operating expenses
-54,684
Operating expenses as % of sales
-94.44%
4. In 2008/2009, Tesco’s net debt to equity ratio was 92.05 percent (11,910/12,938). Tesco’s
management wishes to reduce net debt by £1 billion, i.e., from £11,910 million to £10,910
8
Solutions – Chapter 6
million. Given the previous estimate of net assets of £27,182 million, Tesco’s 2009/2010 net
debt to equity ratio would decrease to 67.05 percent (10,910/[27,182–10,910]) if the company
manages to reduce its debt.
Assuming that the reduction in leverage would not significantly affect Tesco’s cost of debt, the
£1 billion debt reduction would decrease Tesco’s net interest expense by £56 million (0.056 x
1,000), i.e., from £284 million to £228 million.
In summary, the above discussion leads to the following estimated 2009/2010 income
statement and balance sheet:
Income statement
Sales
Operating expenses
Net Interest Expense or Income
Investment Income (assumed constant)
Pre-tax profit
Tax expense (assumed 27 percent)
Net profit
2009/2010E
57,903
(54,684)
(228)
32
3,023
(816)
2,207
Balance sheet
Net working capital
2009/2010E
(5,235)
Non-current tangible assets
Non-current intangible assets
Other Non-current assets
Non-interest bearing liabilities
Net non-current assets
25,374
4,292
3,697
(946)
32,417
Net debt
Equity
Net assets = net capital
10,910
16,272
27,182
5. Tesco’s expected 2009/2010 (condensed) cash flow statement can derived from the above
income statement and balance sheet:
Free cash flow to equity
Net profit
Net interest expense after tax (228 x (1-.27))
Change in net assets
Free cash flow to debt and equity
Net interest expense after tax
Change in net debt
Free cash flow to equity
2009/2010E
2,207
166
(2,334)
39
(166)
(1,000)
(1,127)
Under the above assumptions, which are based on our interpretations of management’s
guidance, Tesco’s 2009/2010 free cash flow to equity will not be sufficient to pay out dividends.
In contrast, the forecasting assumptions imply that Tesco needs to issue new equity in order to
finance its investment plans and debt repayments. Given the costs of issuing equity during an
economic downturn as well as the negative signal that a dividend cut would provide to
investors, it is highly unlikely that Tesco will indeed do so. Hence, under the above forecasting
assumptions, it is more likely that Tesco will increase rather than decrease leverage. Questions
that an analyst could raise in her communications with management would thus focus on
9
Solutions – Chapter 6
management’s plans for taking actions that will improve the efficiency of Tesco’s operations
and investments (and thus help in reducing net debt).
On April 10, 2010, Tesco announced its preliminary results for fiscal 2009/2010. Sales amounted to
£56.9 billion, 1.7 percent less than predicted. Pre-tax profit for the year was £3,176 million, 5.1
percent above the predicted amount of £3,023 million.
The company also announced that it had been able to reduce net debt by a larger amount than it
had planned, by £1.7 billion. However, capital expenditures had been lower (£3.1 billion) than we
accounted for (based on the information available at the beginning of the fiscal year). Further, Tesco
indicated that it had been able to improve working capital management and that it had engaged in
profitable property sale and leaseback transactions.
10
Solutions – Chapter 7
Chapter 7 Prospective Analysis: Valuation Theory and
Concepts
Question 1.
Jonas Borg, an analyst at EMH Securities, states: "I don't know why anyone would ever try to value
earnings. Obviously, the market knows that earnings can be manipulated and only values cash
flows." Discuss.
Valuing earnings is an alternative way of valuing a company even if earnings can be manipulated.
Note that, with an infinite forecast horizon, the valuation based on discounted abnormal earnings
delivers exactly the same estimate as DCF-based methods, even if there is earnings manipulation.
The estimated values using accounting-based valuation are not affected by accounting choices
because of the self-correcting nature of double-entry bookkeeping. Current period earnings can be
manipulated, but the values estimated with accounting-based valuation are not to be manipulated.
However, with finite horizons, earnings manipulation can affect value unless the analyst recognizes
and undoes the manipulation. Also, when accounting data is used to forecast cash flows, even a DCF
valuation is potentially vulnerable to accounting manipulation.
There are two practical advantages to valuing earnings. First, accounting-based valuation
(using earnings) frames the valuation task differently and can immediately focus the analyst's
attention on the key measure of performance: ROE and its components (i.e., value drivers such as
profit margins, sales turnover, and leverage).
Second, if it is more natural to think about future performance in terms of accounting returns,
and if the analyst faces a context where a "back-of-envelope" estimate of value would be of use, the
accounting-based technique can be simplified to deliver such an estimate. "Short-cut" estimates are
useful in a variety of contexts where the cost and time involved in a detailed DCF analysis is not
justified. In this context, the detailed DCF method is analogous to a manual camera for which the
distance, light exposure, and shutter speed need to be set before taking a picture whereas the
"short-cut" accounting-based valuation is analogous to an automatic camera.
Question 2.
Explain why terminal values in accounting-based valuation are significantly less than those for DCF
valuation.
DCF terminal values include the present value of all expected cash flows beyond the forecast
horizon. Note that the expected cash flows beyond the forecast horizon can be broken down into
two parts: normal and abnormal. Since the terminal value in the accounting-based technique
includes only the abnormal earnings (expected earnings minus cost of capital times beginning book
value of equity), the terminal values in accounting-based valuation are significantly less than those
for DCF valuation. The accounting-based approach recognizes that current book value and earnings
within the forecast horizon already reflect many of the cash flows expected to arrive after the
forecast horizon.
Question 3.
Manufactured Earnings is a “darling” of European analysts. Its current market price is €15 per share,
and its book value is €5 per share. Analysts forecast that the firm’s book value will grow by 10
1
Solutions – Chapter 7
percent per year indefinitely, and the cost of equity is 15 percent. Given these facts, what is the
market’s expectation of the firm’s long-term average ROE?
P
ROE  r 
1 
B
 r  g
where ROE is the long-term average ROE,
g is the long-term average growth in book value,
r is the cost of equity,
P is the stock price, and
B is the book value per share.
Using the information in the question,
 ROE  0.15
15
1 
0.15 0.10
5
or ROE = 0.25 (or 25%).
Question 4.
Given the information in Question 3, what will be Manufactured Earnings' stock price if the market
revises its expectations of long-term average ROE to 20 percent?
Once again, using the same formula as in the answer to Question 3, we have
0.2  0.15
P
1 
5
0.15  0.10 
or P = €10
Based on above equation, the Manufactured Earnings' stock price will be revised to €10.
Question 5.
Analysts reassess Manufactured Earnings’ future performance as follows: growth in book value
increases to 12 percent per year, but the ROE of the incremental book value is only 15 percent. What
is the impact on the market-to-book ratio?
Since the ROE from the incremental growth value is equal to cost of equity, there is no increase in
value.
Question 6.
How can a company with a high ROE have a low PE ratio?
2
Solutions – Chapter 7
Accounting-based valuation suggests that the stock price (a numerator of the PE ratio) can be viewed
as the sum of the current book value per share plus the discounted expected future abnormal
earnings per share.
Price per share = Book value per share x


 E 1 ROEt 1  rE  Et  ROEt1  rE 1  g t 1  Et  ROEt 1  rE 1 gt 1 2



 
1 
3
2

r


1






r
r
1
1
E


E
E
A company with a high (current period) ROE may have a low price and PE ratio when
1. cost of equity capital (rE ) is high;
2. expected growth of book value is low; and
3. expected future ROE is low (relative to current period ROE).
Question 7.
What type of companies have:
a. a high PE ratio and a low market-to-book ratio?
Recovering firms, like Apple in 1993, are expected to rebound from temporarily low earnings levels
but will not be able to return to an abnormally high level of ROE due to competition. PE ratio looks
high due to low current earnings.
b. a high PE ratio and a high market-to-book ratio?
"Rising stars" which are expected to grow quickly and enjoy high ROEs during the growth period
and/or after the growth occurs.
c. a low PE ratio and a high market-to-book ratio?
"Falling stars" that enjoy high ROEs on existing investments but are no longer growing fast. PE ratio is
low due to relatively high earnings in current year.
d. a low PE ratio and a low market-to-book ratio?
"Dogs" which have little prospect for either growth or high ROEs.
Question 8.
Which of the following items affect free cash flows to debt and equity holders? Which affect free
cash flows to equity alone? Explain why and how.
All answers assume a tax rate > 0.
3
Solutions – Chapter 7
An increase in trade receivables will cause both FCFE and FCFD+E to decrease, since it increases the
firm's cash required for working capital.
A decrease in gross margins will cause both FCFE and FCFD+E, to decrease by lowering both EBIT
(1 - tax rate) and NI.
An increase in property, plant, equipment will decrease both FCFE and FCFD+E due to an increase in
capital expenditures.
An increase in inventories will decrease both FCFE and FCFD+E through an increase in cash required for
working capital.
Interest expense will decrease FCFE only. For calculating free cash flows to debt, additional interest
expense does not change EBIT (1 - tax rate).
An increase in prepaid expenses will cause both FCFE and FCFD+E to decrease through an increase in
working capital.
An increase in notes payable to the bank will increase FCFE only. The increase in notes payable will
increase debt, increasing the FCFE by the same amount.
Question 9.
Starite Company is valued at €20 per share. Analysts expect that it will generate free cash flows to
equity of €4 per share for the foreseeable future. What is the firm's implied cost of equity capital?
With a single, unchanging free cash flow to equity for the foreseeable future, we can calculate the
implied cost of equity capital using the following formula:
Value per share 
Free cash flow to equity
Cost of equity capital
Using a value per share = 20 and a free cash flow to equity = 4, solving the equation for cost of equity
capital yields, rE = 20%.
Question 10.
Janet Stringer argues that "the DCF valuation method has increased managers' focus on short-term
rather than long-term performance, since the discounting process places much heavier weight on
short-term cash flows than long-term ones." Comment.
While it is true that DCF valuation places more weight on earlier cash flows than on later ones, this
reflects the time value of money. A euro in one year is more valuable than a euro in five year's time.
However, this does not imply that the long-term is less important than the short-term. Typical DCF
valuations show that the value of cash flows beyond, say, five years is a substantial fraction of the
overall firm value. If managers believe that long-term performance of the firm is the most significant
driver of value, they will certainly focus appropriately on making sure that they do not
under-emphasize the long-term.
DCF valuation helps a manager understand the tradeoffs between short-term and long-term
actions. Consider management's decision if it has a choice between two mutually exclusive
4
Solutions – Chapter 7
investments that generate equivalent cash flows, one with a short horizon and the other with a long
horizon. DCF analysis implies that firm value will increase more if the management takes the
short-term project. In this sense, DCF helps managers trade off how much they should focus on
short-term versus long-term considerations.
One concern often raised about DCF analysis is that it focuses attention on quantifiable costs
and benefits from investing. It is probably more difficult to quantify long-term costs and benefits
than short-term ones. If management ignores these types of costs and benefits, they may end up
making decisions that have a short-term focus. However, this is really not the fault of DCF as a
method. It is simply an indication of the difficulty in making decisions with highly uncertain payoffs.
Problem 1. Estimating Hugo Boss’ equity value
1. Calculate free cash flows to equity, abnormal earnings, and abnormal earnings growth for
the years 2009 – 2011.
2. Assume that in 2012 Hugo Boss AG liquidates all its assets at their book values, uses the
proceeds to pay off debt and pays out the remainder to its equity holders. What does this
assumption imply about the company’s:
a. Free cash flow to equity holders in 2012 and beyond?
b. Abnormal earnings in 2012 and beyond?
c. Abnormal earnings growth in 2012 and beyond?
3. Estimate the value of Hugo Boss’ equity on April 1, 2009 using the above forecasts and
assumptions. Check that the discounted cash flow model, the abnormal earnings model and
the abnormal earnings growth model yield the same outcome.
4. The analyst estimates a target price of €20 per share. What is the expected value of Hugo
Boss’ equity at the end of 2011 that is implicit in the analysts’ forecasts and target price?
5. Under the assumption that the historical trends in the company’s ROE (i.e., approximately
18 percent), payout ratio (70 percent) and book value growth (5.5 percent) continue in the
future, what would be your estimate of Hugo Boss’ equity value-to-book ratio before the
company paid out its special dividend? How does the special dividend payment change your
estimate of the equity value-to-book ratio?
1. The calculations are:
2008R
815.4
616.4
199.0
Assets
Debt
Equity
Implied dividends
Net profit
- Change in assets
+ Change in debt
Free cash flow to equity
Net profit
Beginning BE x 12%
Abnormal profit
Change in net profit
(Profit t-1 - Dividends t-1) x 12%
Abnormal earnings growth
5
2009E
802.5
602.3
200.2
97.1
2010E
811.5
589.9
221.6
78.5
2011E
838.7
579.7
259.0
80.3
98.3
12.9
-14.1
97.1
99.9
-9.0
-12.4
78.5
117.7
-27.2
-10.2
80.3
98.3
23.880
74.420
99.9
24.024
75.876
117.7
26.592
91.108
1.6
0.144
1.456
17.8
2.568
15.232
Solutions – Chapter 7
2. If Hugo Boss liquidates all its assets at their book values in 2012, the company’s 2012 net profit
is zero and
a. 2012 free cash flow to equity, defined as net profit minus the change in net assets
plus the change in net debt, is equal to: 0 – (-891.0) + (-632.0) = 259 (i.e., expected
equity at the end of 2011).
b. 2012 abnormal earnings, defined as net profit minus 12 percent of 2011 ending
equity, is equal to: 0 – 0.12 x 259 = -31.08.
c. 2012 abnormal earnings growth, defined as the change in abnormal earnings, is
equal to: -31.08 - 91.108 = 122.188.
In 2013 (and beyond), free cash flows to equity and abnormal earnings are zero. Abnormal
earnings growth is equal to 31.08 in 2013 (0 – [-31.08]) and zero in the years after 2013.
To summarize:
2009E
97.1
74.42
Free cash flow to equity
Abnormal profit
Abnormal earnings growth
2010E
78.5
75.876
1.456
2011E
80.3
91.108
15.232
2012E
259
-31.08
-122.188
2013E
0
0
31.08
3. On January 1, 2009, the value of Hugo Boss’ equity equals:
FCFE 2009 FCFE 2010 FCFE 2011 FCFE 2012



1 re 
1 re 2
1 re 3
1 re 3
97.1
78.5
80.3
259.0




 371.03
1.12  1.12 2 1.12 3 1.12 4
Equity value end2008

Equity value end2008
 BVE end2008 
Or
 199 
74.42
1.12 
AE 2009
1 re 


75.876
1.12 2
AE2010

AE 2011

AE 2012
1 re 2 1 re 3 1  re 4

91.108

31.08
1.12 3 1.12 4
 371.03
Or
Equity value end 2008
Profit 2009 1  AEG 2010 AEG 2011 AEG2012 AEG 2013 
 




re
re  1 re 
1 re 2 1 re 3 1 re 4 
98.3
1  1.456 15.232 122.188 31.08 





 371.03

0.12 0.12  1.12  1.122
1.123 1.124 

An equity value of €371.03 million on January 1, 2009, corresponds with a value of €381.55
million (371.03 x 1.1290/365), €5.42 per share (381.55/70.4), on April 1, 2009.
4. A target price of €20 per share implies a market value (on April 1, 2009) of €1,408 million. A
market value of €1,408 million on April 1, 2009, corresponds with a market value of €1,369.20
million on January 1, 2009. The discounted value of Hugo Boss’ expected free cash flows in
2009-2011 equals:
6
Solutions – Chapter 7
Value

FCFE2009 FCFE 2010 FCFE2011


1 re 
1 r e 2
1 re 3
97.1
78.5
80.3



 206.43
1.12 1.122 1.123
Hence, with a current equity value of €1,369.20 million, the present value of the expected
equity value at the end of 2011 must be equal to: 1,369.20 – 206.43 = 1,162.77. The future
value of the expected equity value at the end of 2011 is therefore €1,633.60 million (1,162.77 x
1.123), or €23.20 per share. Note that this future expected market value of equity is
substantially higher than the expected future book value of equity of (€1,633.60 million versus
€259 million).
5. As described in Chapter 7, for a firm in steady state, the value-to-book multiple formula
simplifies to:
Equity value - to - book multiple  1
ROE 0 re
re  gequity
For Hugo Boss, this would imply that the equity value-to-book multiple is:
Equity value - to - book multiple  1
0.18  0.12
1.923
0.12 0.055
The special dividend of €345.1 million decreases both the market value and the book value of
equity by the same amount. Consequently, the expected value-to-book multiple would increase
from 1.923 to 3.524:
Adjusted equity value - to - book multiple 
1.923 199 345.1  345.1
199
3.524
This multiple would imply an equity value of €701.25 million, or €9.96 per share, on January 1,
2009. This would be equivalent to €10.24 per share on April 1, 2009, when Hugo Boss’ shares
traded at €11.
Problem 2. Estimating Adidas’ equity value
1. Check whether all changes in the book value of equity that the analyst predicts can be fully
explained through earnings and dividends. Why is this an important property of the analyst’s
equity estimates?
2. When using these forecasts to estimate the value of equity, the analyst can deal with
minority interests in the following ways:
a. (1) Classify minority interests on the balance sheet as a non-interest-bearing liability
(and hence as a negative operating asset) and (2) exclude income from minority
interests from earnings (i.e., focus on net profit);
b. (1) Classify minority interests on the balance sheet as (group) equity, (2) include
income from minority interests in earnings (i.e., focus on group profit), and (3)
subtract the book value of minority interests from the estimated value of group
equity to arrive at the value of shareholders’ equity.
These approaches may yield different values. Discuss potential drawbacks of both
approaches.
7
Solutions – Chapter 7
3. Based on a market value of €12,247 million on March 31, 2012 and the analyst’s estimates,
Adidas’ leading market value-to-earnings ratio is 15.2. What does this ratio suggest about
the analyst’s expectations about future abnormal earnings growth?
4. Calculate abnormal earnings for the years 2012 – 2014.
5. Assume that abnormal earnings in 2015 and beyond are zero. Estimate the value of Adidas’
group equity (group equity is the sum of shareholders’ equity and minority interests). What
might explain the difference between your equity value estimate and Adidas’ actual market
value (of €12,247 million)?
1. If all changes in the book value of equity can be explained through earnings and dividends, this
means that the analysts’ predictions are consistent with the clean surplus assumption. This is a
necessary requirement for the equivalence of the dividend discount model and the abnormal
earnings valuation model.
2011R
Beginning shareholders' equity
Net profit
Dividends
Ending shareholders' equity
5327
2012E
2013E
5327
803.2
-251.7
5878.5
2014E
5878.5
952.7
-311.3
6519.9
6520
1128.8
-376.6
7272.2
2. The first approach implicitly assumes that the investors holding the minority interest hold a
claim on non-current assets only and that none of the consolidated liabilities “belongs” to these
investors. Although these assumptions do not affect the valuation analysis directly they do
affect the ratios in the financial analysis and, as such, may indirectly affect the analyst’s
predictions. The second approach implicitly assumes that the value of minority interests equals
its book value, which is typically lower than the value of other equity components.
3. The leading market value-to-earnings ratio is calculated as follows:
Leading equity value - to - earnings ratio 


 



t
t
t
t
t
t
 d1  1re 1 gprofi
 d2  1re
 d 3  1re 
1 1  gprofi
gprofi
1 gprofi
1 gprofi
gprofi
2
3
2
3
4
  2



2
3

re re 
1 re 
1 re 
1 re 

1
1

Sum of future (scaled)abnormal earnings growth 
.10 .10
1
10.0 
Sum of future (scaled)abnormalearnings growth  15.2
.10
Hence, the analyst expects that the sum of future abnormal earnings growth is positive.
4. When focusing on group equity and group profit, the calculations are:
2012E
5331.0
533.1
804.7
271.6
(a) Beginning group equity
(b) "Normal" profit = (a) x 0.12
(c) Group profit
(d) Abnormal earnings = (c) – (b)
2013E
5883.5
588.4
954.4
366.1
2014E
6526.1
652.6
1130.6
478.0
Alternatively, when focusing on shareholders’ equity and net profit, the calculations are:
8
Solutions – Chapter 7
2012E
5327.0
532.7
803.2
270.5
(a) Beginning shareholders' equity
(b) "Normal" profit = (a) x 0.12
(c) Net profit
(d) Abnormal earnings = (c) – (b)
2013E
5878.5
587.9
952.7
364.9
2014E
6520.0
652.0
1128.8
476.8
5. The calculations are:
2011R
5331.00
(a) Beginning group equity
(b) Abnormal (group) earnings
(c) Discount factor (r = 10%)
(d) Discounted abnormal (group) earnings
2012E
271.6
0.9091
246.91
Present value of future abnormal (group)
earnings
Group value
2013E
366.1
0.8264
302.52
2014E
478.0
0.7513
359.12
908.55
6239.55
Our estimate is much lower than Adidas’ current market value, primarily because our
assumption that abnormal earnings is zero after 2014. Although it is reasonable to expect that
competition will drive down Adidas’ abnormal earnings in the future, it is not likely that this will
happen overnight. Hence, it is necessary to include an estimate of the value of Adidas’ post2014 abnormal earnings in our calculations, i.e., the terminal value. Terminal value calculations
will be the topic in Chapter 8.
9
2015
2016
2017
2018
2019
2020
2021
11,460.4
74,365.2
12,033.4
78,083.4
12,635.1
81,987.6
13,266.8
86,087.0
13,930.2
90,391.3
14,626.7
94,910.9
15,065.5
97,758.2
+ Beginning investment assets
= Busi ness assets
13,085.1
94,444.5
13,859.9
95,633.1
14,552.9
98,231.9
15,280.5
101,106.0
13,370.4
103,487.3
12,635.1
107,257.7
11,792.7
111,146.5
10,834.6
115,156.1
9,751.1
119,288.7
8,369.7
121,193.4
Debt
49,695.8
50,321.2
51,688.6
53,201.0
54,454.0
56,438.0
58,484.2
60,594.0
62,768.5
63,770.8
+ Group equity
= Capital
44,748.7
94,444.5
45,311.9
95,633.1
46,543.2
98,231.9
47,905.1
101,106.0
49,033.3
103,487.3
50,819.8
107,257.7
52,662.3
111,146.5
54,562.1
115,156.1
56,520.2
119,288.7
57,422.6
121,193.4
115,499.0
18,941.8
389.6
19,331.5
-1,155.7
18,175.7
121,273.9
21,708.0
409.1
22,117.1
-1,258.0
20,859.1
127,337.6
23,048.1
429.6
23,477.7
-1,395.6
22,082.1
133,704.5
24,066.8
375.9
24,442.7
-1,649.2
22,793.4
140,389.7
23,866.2
355.2
24,221.4
-1,797.0
22,424.5
147,409.2
23,585.5
331.5
23,917.0
-1,975.3
21,941.7
154,779.6
23,216.9
304.6
23,521.5
-2,046.9
21,474.6
162,518.6
22,752.6
274.1
23,026.7
-2,120.8
20,905.9
167,394.2
21,761.2
235.3
21,996.5
-2,196.9
19,799.6
172,416.0
22,414.1
242.3
22,656.4
-2,232.0
20,424.4
Return on operating assets
Return on business assets
23.3%
20.5%
26.5%
23.1%
27.5%
23.9%
28.0%
24.2%
26.5%
23.4%
24.9%
22.3%
23.4%
21.2%
21.8%
20.0%
19.9%
18.4%
19.9%
18.7%
ROE
BV of operati ng assets growth rate
BV of business assets growth rate
BV of equi ty growth rate
40.6%
8.2%
2.8%
1.3%
46.0%
0.5%
1.3%
1.3%
47.4%
2.3%
2.7%
2.7%
47.6%
2.6%
2.9%
2.9%
45.7%
5.0%
2.4%
2.4%
43.2%
5.0%
3.6%
3.6%
40.8%
5.0%
3.6%
3.6%
38.3%
5.0%
3.6%
3.6%
35.0%
5.0%
3.6%
3.6%
35.6%
3.0%
1.6%
1.6%
18175.7
712.5
-1126.4
-774.8
625.4
17612.6
20859.1
144.4
-2050.1
-693.0
1367.4
19627.8
22082.1
60.6
-2207.2
-727.6
1512.4
20720.3
22793.4
-573.0
-3718.3
1910.1
1253.0
21665.2
22424.5
-601.7
-3904.2
735.4
1984.0
20638.0
21941.7
-631.8
-4099.4
842.3
2046.2
20099.1
21474.6
-663.3
-4304.3
958.2
2109.8
19574.8
20905.9
-696.5
-4519.6
1083.5
2174.5
18947.9
19799.6
-438.8
-2847.3
1381.4
1002.2
18897.2
20424.4
-452.0
-2932.7
-251.1
1913.1
18701.8
Income statement (SEK mil li ons)
Sal es
Net operati ng profit after tax
+ Net investment profit after tax
= net Business profit after tax
– Net i nterest expense after tax
= net profit
1
Net profit
– Change in net working capi tal
– Change in net non-current operating assets
– Change in investment assets
+ Change in debt
= Free cash flow to equity
Net operati ng profit after tax
18941.8
21708.0
23048.1
24066.8
23866.2
23585.5
23216.9
22752.6
21761.2
22414.1
– Change in net working capi tal
– Change in net non-current operating assets
= Free cash flow from operations
712.5
-1126.4
18528.0
144.4
-2050.1
19802.3
60.6
-2207.2
20901.6
-573.0
-3718.3
19775.5
-601.7
-3904.2
19360.4
-631.8
-4099.4
18854.3
-663.3
-4304.3
18249.3
-696.5
-4519.6
17536.5
-438.8
-2847.3
18475.1
-452.0
-2932.7
19029.4
Solutions – Chapter 8
2014
11,521.0
72,158.0
Chapter 8 Prospective Analysis: Value Implementation
2013
11,665.4
70,107.9
Question 1.
2012
12,377.9
68,981.5
A spreadsheet containing Hennes & Mauritz’s actual and forecasted financial statements as well as
the valuation described in this chapter is available on the companion website of this book. How will
the forecasts in Table 8.3 for H&M change if the assumed growth rate in sales from 2012 to 2019
remains at 5 percent (and all the other assumptions are kept unchanged)?
Fiscal year
Beginning balance sheet (SEK mil li ons)
Beginning net working capital
+ Beginning net non-current opera ti ng assets
2014
2015
2016
2017
2018
2019
2020
2021
12,377.9
68,981.5
13,085.1
94,444.5
12,395.2
74,494.1
14,727.0
101,616.3
13,251.1
82,993.6
16,738.2
112,982.9
14,318.6
92,912.1
19,091.5
126,322.2
16,036.9
104,061.5
17,818.8
137,917.1
17,640.6
114,467.7
17,640.6
149,748.8
19,051.8
123,625.1
16,934.9
159,611.8
20,194.9
131,042.6
15,707.2
166,944.7
21,002.7
136,284.3
14,001.8
171,288.8
21,632.8
140,372.8
12,018.2
174,023.8
Debt
+ Group equity
= Capital
49,695.8
44,748.7
94,444.5
53,469.5
48,146.8
101,616.3
59,450.5
53,532.4
112,982.9
66,469.5
59,852.7
126,322.2
72,570.6
78,796.3
65,346.5
70,952.5
137,917.1 149,748.8
83,986.2
75,625.7
159,611.8
87,844.6
90,130.5
79,100.0
81,158.3
166,944.7 171,288.8
91,569.6
82,454.2
174,023.8
Income statement (SEK millions)
Sales
Net operating profit after tax
+ Net investment profit after tax
= net Business profit after tax
– Net interest expense after tax
= net profit
122,725.0 139,485.0 159,096.0 178,187.5 196,006.3 211,686.8 224,388.0 233,363.5 240,364.4 247,575.3
20,126.9
24,967.8
28,796.4
30,470.1
31,557.0
31,964.7
31,638.7
30,570.6
31,247.4
32,184.8
414.0
470.5
536.7
500.9
495.9
476.1
441.6
393.6
337.9
348.0
20,540.9
25,438.4
29,333.1
30,971.0
32,052.9
32,440.8
32,080.3
30,964.2
31,585.2
32,532.8
-1,155.7
-1,336.7
-1,605.2
-2,060.6
-2,394.8
-2,757.9
-2,939.5
-3,074.6
-3,154.6
-3,204.9
19,385.2
24,101.6
27,727.9
28,910.4
29,658.1
29,682.9
29,140.7
27,889.7
28,430.7
29,327.8
2
Return on operating ass ets
Return on business as sets
24.7%
21.7%
28.7%
25.0%
29.9%
26.0%
28.4%
24.5%
26.3%
23.2%
24.2%
21.7%
22.2%
20.1%
20.2%
18.5%
19.9%
18.4%
19.9%
18.7%
ROE
BV of operating as sets growth rate
BV of business assets growth rate
BV of equity growth rate
43.3%
8.2%
2.8%
1.3%
50.1%
6.8%
7.6%
7.6%
51.8%
10.8%
11.2%
11.2%
48.3%
11.4%
11.8%
11.8%
45.4%
12.0%
9.2%
9.2%
41.8%
10.0%
8.6%
8.6%
38.5%
8.0%
6.6%
6.6%
35.3%
6.0%
4.6%
4.6%
35.0%
4.0%
2.6%
2.6%
35.6%
3.0%
1.6%
1.6%
Net profit
– Change in net working capital
– Change in net non-current operating assets
– Change in investment assets
+ Change in debt
= Free cash flow to equity
19385.2
-17.3
-5512.6
-1641.9
3773.7
15987.1
24101.6
-855.9
-8499.5
-2011.2
5981.0
18716.0
27727.9
-1067.6
-9918.5
-2353.3
7019.0
21407.6
28910.4
-1718.2
-11149.4
1272.8
6101.1
23416.6
29658.1
-1603.7
-10406.2
178.2
6225.7
24052.1
29682.9
-1411.2
-9157.4
705.6
5189.8
25009.7
29140.7
-1143.1
-7417.5
1227.8
3858.5
25666.4
27889.7
-807.8
-5241.7
1705.3
2285.8
25831.4
28430.7
-630.1
-4088.5
1983.6
1439.1
27134.8
29327.8
-649.0
-4211.2
-360.5
2747.1
26854.2
Net operating profit after tax
– Change in net working capital
– Change in net non-current operating assets
= Free cash flow from operations
20126.9
-17.3
-5512.6
14597.0
24967.8
-855.9
-8499.5
15612.5
28796.4
-1067.6
-9918.5
17810.3
30470.1
-1718.2
-11149.4
17602.4
31557.0
-1603.7
-10406.2
19547.2
31964.7
-1411.2
-9157.4
21396.0
31638.7
-1143.1
-7417.5
23078.1
30570.6
-807.8
-5241.7
24521.1
31247.4
-630.1
-4088.5
26528.8
32184.8
-649.0
-4211.2
27324.6
Solutions – Chapter 8
2013
Question 2.
2012
Recalculate the forecasts in Table 8.3 assuming that the NOPAT profit margin declines by 1
percentage point per year between fiscal 2015 and 2019 (keeping all the other assumptions
unchanged).
Fiscal year
Beginning balance sheet (SEK millions)
Beginning net working capital
+ Beginning net non-current operating as sets
+ Beginning investment assets
= Business assets
2014
2015
2016
2017
2018
2019
2020
2021
15836.6
35.4%
10637.5
19710.8
36.8%
16647.3
3874.2
22688.3
37.3%
18961.4
2977.5
24687.6
35.6%
23553.6
1999.3
25006.7
32.9%
24362.5
319.1
24578.8
29.7%
25523.9
-427.9
23669.7
26.8%
26436.4
-909.1
22134.3
23.9%
26875.1
-1535.4
20348.5
21.4%
26175.3
-1785.8
21093.5
21.8%
25866.0
745.0
13846.0
17.0%
3306.3
17388.3
17.7%
11559.8
3542.4
20181.8
18.1%
13107.6
2793.5
22248.0
17.5%
16800.5
2066.2
22316.2
15.7%
19066.1
68.2
21764.5
13.9%
21325.5
-551.7
20584.4
12.2%
23497.2
-1180.1
18812.7
10.5%
25490.5
-1771.7
16834.8
9.0%
25646.6
-1977.8
17339.9
9.0%
26416.0
505.0
0.927
0.928
0.858
0.862
0.795
0.800
0.737
0.743
0.683
0.689
0.633
0.640
0.586
0.594
0.543
0.552
0.503
0.512
0.466
0.475
1
1
1.20
1.21
1.36
1.37
1.55
1.56
1.70
1.75
1.85
1.93
1.97
2.08
2.07
2.21
2.12
2.29
2.16
2.36
Solutions – Chapter 8
3
Discount rates:
Equity
Net operating assets
Growth factors
Equity
Net operating assets
2013
Question 3.
Asset valuation (SEK millions)
Abnormal NOPAT
Abnormal ROA
Free cash flow from operations
Abnormal NOPAT growth
2012
Recalculate the forecasts in Table 8.4 assuming that the ratio of net operating working capital to
sales is 15 percent, and the ratio of net non-current operating assets to sales is 65 percent for all the
years from fiscal 2012 to fiscal 2021. Keep all the other assumptions unchanged.
Fiscal year
Equity valuation (SEK millions)
Abnormal earnings
Abnormal ROE
Free cash flow to equity
Abnormal earnings growth
Solutions – Chapter 8
Question 4.
Calculate H&M’s cash payouts to its shareholders in the years 2012–2021 that are implicitly
assumed in the projections in Table 8.3.
The cash payouts to shareholders are equal to the expected free cash flows to equity:
2012
19385.2
3398.1
15987.1
82.47%
Net profit
Change in s hareholders' equity
Implicitly assumed cash payout
Dividend payout ratio
2013
24101.6
5385.6
18716.0
77.65%
2014
27727.9
6320.3
21407.6
77.21%
2015
30514.1
5493.8
25020.3
82.00%
2016
31422.1
5606.0
25816.2
82.16%
2017
31588.1
4673.2
26914.9
85.21%
2018
31160.2
3474.4
27685.9
88.85%
2019
29989.9
2058.3
27931.6
93.14%
2020
28430.7
1295.9
27134.8
95.44%
2021
29327.8
2473.6
26854.2
91.57%
Question 5.
How will the abnormal earnings calculations in Table 8.4 change if the cost of equity assumption is
changed to 10 percent?
This will decrease abnormal earnings:
Net profit
Beginning equity
Required earnings
Abnormal earnings
Abnormal ROE
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
19385.19 24101.62 27727.91 30514.11 31422.14 31588.08 31160.23 29989.94 28430.66 29327.84
44748.74 48146.81 53532.4 59852.72 65346.51 70952.47 75625.67 79100.04 81158.34 82454.22
4474.874 4814.681 5353.24 5985.272 6534.651 7095.247 7562.567 7910.004 8115.834 8245.422
14910.3 19286.9 22374.7 24528.8 24887.5 24492.8 23597.7 22079.9 20314.8 21082.4
33.3%
40.1%
41.8%
41.0%
38.1%
34.5%
31.2%
27.9%
25.0%
25.6%
Question 6.
How will the terminal values in Table 8.6 change if the sales growth in years 2022 and beyond is 5
percent, and the company keeps forever its abnormal returns at the same level as in fiscal 2018
(keeping all the other assumptions in the table unchanged)?
Beginning
Value from Value
beyond
forecast
forecast
horizon
period
(terminal
book value 2012–2021 value)
Equity value (SEK billions)
Abnormal earnings
Abnormal ROE
Abnormal earnings growth
Free cash flows to equity
Operating assets value (SEK billions)
Abnormal NOPAT
Abnormal ROA
Abnormal NOPAT growth
Free cash flows to capital
Value per
share (SEK)
44.7
44.7
154.6
154.6
96.6
157.8
402.7
402.7
261.0
444.3
602.1
602.1
602.1
602.1
81.36
81.36
140.4
140.4
89.7
138.6
383.5
383.5
254.8
466.7
605.2 N.A.
605.2 N.A.
605.2 N.A.
605.2 N.A.
N.A.
N.A.
N.A.
N.A.
Total value
4
363.79
363.79
363.79
363.79
Solutions – Chapter 8
Question 7.
Calculate the proportion of terminal values to total estimated values of equity under the abnormal
earnings method, the abnormal earnings growth method and the discounted cash flow method. Why
are these proportions different?
Beginning
Value from Value
Total value
Value per
beyond
forecast
value as a
forecast
percentage
horizon
period
of total
(terminal
value)
book value 2012–2021
Equity value (SEK billions)
Abnormal earnings
Abnormal ROE
Abnormal earnings growth
Free cash flows to equity
44.7
44.7
N.A.
N.A.
153.4
153.4
87.7
158.6
share (SEK)
222.0
222.0
88.0
261.6
Terminal
420.1
420.1
420.1
420.1
253.85
253.85
253.85
253.85
value
52.8%
52.8%
20.9%
62.3%
Why are these proportions different? The abnormal earnings method begins with the book value
(which represents in some sense "normal earnings") and adds to it abnormal earnings over time.
The terminal value in this method, therefore, represents the present value of only that portion of
earnings that are above the cost of capital. The discounted cash flow method, in contrast, ignores
book value completely. Instead, it captures the present value of total cash flows - both normal and
abnormal. Therefore, the terminal value in this method is significantly larger than the terminal
value in accounting based valuation approaches. In essence, part of the terminal value in DCF is
substituted by the book value in accounting-based valuation.
Question 8.
Under the competitive equilibrium assumption the terminal value in the discounted cash flow model
is the present value of the end-of-year book value of equity in the terminal year. Explain.
Under the competitive equilibrium assumption, a firm is not able to earn abnormal returns on its
equity in the years beyond the terminal year. The firm’s value in the terminal year is, consequently,
equal to its book value. Shareholders would, therefore, be indifferent between receiving a terminal
cash flow equal to the book value of equity or continuance of firm operations.
Question 9.
Under the competitive equilibrium assumption the terminal value in the discounted abnormal
earnings growth model is the present value of abnormal earnings in the terminal year times minus
one, capitalized at the cost of equity. Explain.
Under the competitive equilibrium assumption, a firm is not able to earn abnormal returns on its
equity in the years beyond the terminal year. In the first year after the terminal year, the firm’s
abnormal earnings will thus revert to zero. Hence, the “last” change in abnormal earnings (i.e.,
abnormal earnings growth) is equal to minus one times abnormal earnings in the terminal year.
5
Solutions – Chapter 8
Question 10.
What will be H&M’s cost of equity if the equity market risk premium is 6 percent?
The company’s estimated equity beta was 0.45 at the end of 2011. The risk-free rate in the EU at
that time was 4.8 percent. Using the risk premium of 6 percent, we can calculate its cost of equity to
be 7.5 percent: 4.8 + 0.45 * 6 = 7.5
Question 11.
Assume that H&M changes its capital structure so that its market value weight of debt to capital
increases to 45 percent, and its after-tax interest rate on debt at this new leverage level is 4 percent.
Assume that the equity market risk premium is 7 percent. What will be the cost of equity at the new
debt level? What will be the weighted average cost of capital?
H&M’s asset beta was estimated at 0.41 at the end of 2011. At a debt-to-capital ratio of 45 percent,
H&M’s equity beta will be:
[1 + 0.45 / (1 – 0.45)] x 0.41 = 0.75
Consequently, H&M’s cost of equity will be 10.05 percent: 4.8 + 0.75 * 7 = 10.05. The weighted
average cost of capital will then be 13.22 percent: 0.45 * 4 + 0.55 * 10.05 = 7.33.
Question 12.
Nancy Smith says she is uncomfortable making the assumption that H&M’s dividend payout will vary
from year to year. If she makes a constant dividend payout assumption, what changes does she have
to make in her other valuation assumptions to make them internally consistent with each other?
If Nancy Smith doesn't want to allow dividend payout to vary across the years, then she can hold the
dividend payout constant. However, then she will have to allow for the capital structure to vary
from year to year, since a constant dividend payout may not result in a stream of equity values that
will result in a constant debt to equity ratio. If the capital structure is allowed to vary, then the cost
of capital will vary each period as well.
Problem 1. Hugo Boss’ and Adidas’ terminal values
1. The analyst following Hugo Boss estimates a target price of €20 per share. Under the
assumption that the company’s profit margins, asset turnover, and capital structure remain
constant after 2011, what is the terminal growth rate that is implicit in the analysts’
forecasts and target price?
2. Using the analyst’s forecasts, estimate Hugo Boss’ equity value under the following three
scenarios: (a) Hugo Boss enters into a competitive equilibrium in 2012; (b) after 2011, Hugo
Boss’ competitive advantage can only be maintained on the nominal sales level achieved in
2011, and (c) after 2011, Hugo Boss’ competitive advantage can be maintained on a sales
base that remains constant in real terms.
6
Solutions – Chapter 8
3. Using the analyst’s forecasts, estimate Hugo Boss’ equity value under the assumption that
the company’s profitability gradually reverts to its required level (i.e., AEt = 0.75 × AEt-1)
after the terminal year.
4. Using the analyst’s forecasts, estimate Adidas’ terminal values in the discounted cash flow
and the abnormal earnings growth models under the assumption that the company enters
into a competitive equilibrium in 2015.
1. A target price of €20 per share implies a market value (on April 1, 2009) of €1,408 million. A
market value of €1,408 million on April 1, 2009, corresponds with a market value of €1,369.20
million on January 1, 2009. The discounted value of Hugo Boss’ expected abnormal earnings
equals:
= BVE +
Value
= 199 +
AE 2009
(1+ re )
74.42
(1.12)
+
+
AE2010 AE 2011
(1+ g )× AE2011
+
+
(1 +r e )2 (1 +r e )3 (r e − g )× (1+ r e )3
75.88
+
91.11
+
(1+ g) × 91.11
(1.12) 2 (1.12)3 (0.12− g)× (1.12)3
= 1369.2
Because the sum of the beginning book value of equity and the present value of 2009-2011
abnormal earnings equals 390.78, the present value of the expected equity value at the end of
2011 must be equal to: 1,369.20 – 390.78 = 978.42. Consequently, the average expected
growth rate in abnormal earnings after the terminal year equals:
(1+ g) × 91.11
= 978.42
(0.12 − g )× (1.12 )3
(1+ g)
978.42 × (1.12)3
=
= 15.09
(0.12 − g)
91.11
g = 5.038%
It is more complicated to calculate the terminal growth rate using the free cash flow valuation
method. This is because the constant growth rate assumption requires that the end-of-year
equity and net debt book values in 2011 need to be adjusted, to ensure that the growth in the
beginning book value of equity from 2011 to 2011 is also 5.038 percent. Consequently, the
implied free cash flow to equity in 2011 is no longer equal to the free cash flow to equity
estimate of the analyst. Hugo Boss’ adjusted free cash flow to equity in 2011 equals 106.54.
After this adjustment,
Value
=
FCFE2009 FCFE2010 adjusted FCFE 2011 (1+ g)× adjusted FCFE 2011
+
+
+
(1+ re )
(1+ re )2
( 1+ re )3
(re − g )× (1 +re )3
=
97.1
(1.12 )
+
78.5
+
106.5
+
111.9
(1.12 )2 (1.12 )3 ( 0.12 − 0.05038)× (1.12)3
2. Hugo Boss’ equity value under scenario (a) is:
7
= 1369.2
Solutions – Chapter 8
Value
AE2009
= BVE +
= 199 +
74.42
(1.12 )
+
AE 2010
+
(1 +re )
+
AE2011
(1 +re )2 (1+ r e )3
75.88
91.11
+
(1.12)2 (1.12 )3
+0
+ 0 = 390.8
The company’s value under scenario (b) is:
Value
= BVE +
= 199 +
AE 2009
+
(1+ re )
74.42
(1.12)
+
AE 2010 AE2011
(1+ 0)× AE 2011
+
+
(1 +r e )2 (1+ r e )3 (re − 0)× (1+ re )3
75.88
91.11
+
(1.12)2 (1.12 )3
+
91.11
931.2
3 =
0.12 × (1.12 )
The company’s value under scenario (c) is (assuming that the long-term inflation rate is 4
percent):
= BVE +
Value
= 199 +
AE2009 AE2010 AE 2011 (1 + g) × AE 2011
+
+
+
(1+ re ) (1+ re )2 (1+ re ) 3 (re − g)× (1+ re )3
74.42
(1.12 )
+
75.88
91.11
+
1.04 × 91.11
+
(1.12)2 (1.12 )3 ( 0.12− 0.04)× (1.12)3
= 1233.8
To summarize:
Scenario
Value on 1/1
a
b
c
Value on 1/4
€390.8m
€931.2m
€1,233.8m
€401.9m
€957.6m
€1,268.8m
Value per share on
1/4
€5.71
€13.60
€18.02
3. Hugo Boss’ equity value under this scenario is:
Value
= BVE +
= 199 +
AE2009
(1 + re )
74.42
(1.12)
+
+
AE 2010 AE2011
(1+ g)× AE2011
+
+
(1 + re )2 (1 + r e )3 (re − g )× (1+ re )3
75.88
+
91.11
+
0.75 × 91.11
(1.12) 2 (1.12 )3 (0.12 − (− 0.25 )) × (1.12 )3
= 522.2
4. In a competitive equilibrium, the terminal value in the discounted free cash flow valuation
model is equal to the present value of the book value of equity at the end of the forecasting
period, i.e., 7272.2 / 1.103 = 5,463.7. The terminal value in the abnormal earnings growth
valuation model is equal to:
TV
=
1 − 1× AE 2014
1 − 478.0
=
= −3591.3
3
re (1 +r e )
0.10 (1.10 )3
8
Solutions – Chapter 8
Problem 2. Anheuser-Busch InBev S.A.
1. The analyst estimates that AB InBev’s weighted average cost of capital is 9 percent and
assumes that the free cash flow to debt and equity grows indefinitely at a rate of 1 percent
after 2018. Show that under these assumptions, the equity value per share estimate exceeds
AB InBev’s share price.
2. Calculate AB InBev’s expected abnormal NOPATs between 2009 and 2018 based on the
above information. How does the implied trend in abnormal NOPAT compare with the
general trends in the economy?
3. Estimate AB InBev’s equity value using the abnormal NOPAT model (under the assumption
that the WACC is 9 percent and the terminal growth rate is 1 percent). Why do the
discounted cash flow model and the abnormal NOPAT model yield different outcomes?
4. What adjustments to the forecasts are needed to make the two valuation models
consistent?
1. The calculations are:
Free cash flow to debt
and equity (FCFDE)
Discount factor
Present value of FCFDE
Sum of PV FCFDE
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
7425
0.9174
7590
0.8417
8077
0.7722
8014
0.7084
8301
0.6499
8556
0.5963
8777
0.5470
8958
0.5019
8915
0.4604
9011
0.4224
6811.9
6388.4
6236.9
5677.3
5395.1
5101.7
4801.3
4495.7
4104.7
3806.3
52,819.4
+ Terminal value
48,055.1
= Asset value
100,874.5
- Book value of debt
-45,231.0
= Equity value
Equity value per share
55,643.5
34.93
where the terminal value is calculated as:
TV
=
(1 + g) × FCFDE2018
(W ACC − g ) × (1 + W ACC )10
=
1.01× 9,011
(0.09 − 0.01) × (1.09 )10
= 48,055.1
2. Assume that in every year during the forecasting period, net non-current assets equals prior
year’s net non-current assets minus depreciation and amortization plus investments in noncurrent assets. Likewise, in every year, working capital equals prior year’s working capital plus
current year’s investment in working capital. Consequently, net assets between 2009 and 2018
are as follows:
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Net non-current assets
63,412
62,695
62,016
61,441
60,844
60,229
59,599
58,955
58,315
57,667
Working capital
-3,311
-3,891
-4,560
-4,995
-5,446
-5,911
-6,388
-6,875
-7,360
-7,850
Net assets
60,101
58,804
57,456
56,446
55,398
54,318
53,211
52,080
50,955
49,817
2015
2016
2017
2018
Abnormal NOPAT between 2009 and 2018 is calculated as follows:
2009
2010
2011
2012
9
2013
2014
Solutions – Chapter 8
Net assets
NOPAT
Net assets x 9%
60,101
58,804
57,456
56,446
55,398
54,318
53,211
52,080
50,955
6,169
6,294
6,729
7,003
7,254
7,476
7,669
7,828
7,790
49,817
7,874
5,522.1
5,409.1
5,292.4
5,171.0
5,080.1
4,986.8
4,889.6
4,789.0
4,687.2
4,586.0
Abnormal NOPAT
646.9
884.9
1,436.6
1,832.0
2,173.9
2,490.2
2,780.4
3,039.0
3,102.8
3,288.1
Abnormal ROA
1.05%
1.47%
2.44%
3.19%
3.85%
4.50%
5.12%
5.71%
5.96%
6.45%
These numbers show that the analysts assumes that AB InBev’s abnormal profitability steadily
increase over time. This contrasts with the general trends in the economy. This exercise nicely
illustrates why a focus on abnormal profitability, rather than on free cash flows, helps in
assessing how reasonable predictions are.
3. AB InBev’s asset value, calculated using the abnormal NOPAT valuation method, is:
Abnormal NOPAT
Discount factor
PV Abnormal NOPAT
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
646.9
884.9
1,436.6
1,832.0
2,173.9
2,490.2
2,780.4
3,039.0
3,102.8
3,288.1
0.9174
0.8417
0.7722
0.7084
0.6499
0.5963
0.5470
0.5019
0.4604
0.4224
593.5
744.8
1109.3
1297.8
1412.9
1484.8
1521.0
1525.2
1428.6
1388.9
Beginning book value
of net assets
+ Sum op PV abn
NOPAT
12,506.8
+ Terminal value
17,535.0
= Asset value
- Book value of debt
= Equity value
Equity value per
share
61,357
91,398.7
-45,231.0
46,167.7
28.98
This equity value estimate is considerably lower than the estimate obtained under 1. Both
models yield different outcomes because the analysts’ predictions imply that AB InBev is not
yet in a steady state at the end of the forecasting period. In particular, in the abnormal NOPAT
model we assumed that assets (like abnormal NOPAT) would grow at a constant rate of 1
percent after the terminal year. The assumption that the free cash flow to debt and equity
grows at a constant rate of 1 percent after the terminal year implies, however, that net assets
continue to decrease after the terminal year. This is an unrealistic assumption, which, as shown
under (2), results in an ever-increasing abnormal ROA.
4. To make the two models consistent, one needs to:
a. Extend the forecasting period with two years: 2019 and 2020;
b. Let net assets and NOPAT increase at a rate of 1 percent during 2019 and 2020;
c. Calculate free cash flows to debt and equity and abnormal NOPAT in 2019 and
2020;
d. Make 2020 the terminal year and assume constant growth (of 1 percent) during
2020 and beyond.
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Solutions – Chapter 9
Chapter 9 Equity Security Analysis
Question 1.
Despite many years of research, the evidence on market efficiency described in this chapter appears
to be inconclusive. Some argue that this is because researchers have been unable to link company
fundamentals to stock prices precisely. Comment.
Evidence on market efficiency comes primarily from studies that show how stock prices change with
the announcement of new public information. In general, these studies show that stock prices
change quickly with these announcements, implying a high level of efficiency. However, more
recent efficient markets research suggests that this conclusion may be premature. This research
finds, for example, that earnings information is not completely impounded into price for several
quarters, a significant departure from the notion of a highly efficient market.
The primary difficulty in interpreting the evidence on market efficiency is that the empirical
tests are joint tests of market efficiency with a particular asset-pricing model. The abnormal returns
generated by trading strategies based on firm size and price-to-earnings ratios, for example, may
therefore reflect the omission of important sources of risk from the pricing model used to generate
the abnormal returns, rather than a market inefficiency.
Question 2.
Geoffrey Henley, a professor of finance, states: "The capital market is efficient. I don't know why
anyone would bother devoting their time to following individual stocks and doing fundamental
analysis. The best approach is to buy and hold a well-diversified portfolio of stocks." Do you agree?
Why or why not?
Professor Henley's strategy is consistent with much of the literature in modern finance. If the stock
market is efficient, diversification permits investors to generate a risk-return relation that strictly
dominates that of investing in just a few stocks.
However, if the stock market is not completely efficient, it may be possible to use
fundamental analysis to predict future stock prices. In this sense, an informed investor can generate
an even higher risk-return profile than holding a diversified portfolio by investing in stocks where
he/she has an information advantage. Of course, one could think of the superior returns from this
strategy as a return on the investment of time and money required to acquire and evaluate
information about the financial and strategic performance of a firm.
Thus, Professor Henley's recommendation is probably very sound advice to most investors,
who do not invest in following a few stocks very closely. However, it may not be the best advice for
a professional investor who has invested in developing industry or firm-specific knowledge from
detailed fundamental analysis.
Question 3.
What is the difference between fundamental and technical analysis? Can you think of any trading
strategies that use technical analysis? What are the underlying assumptions made by these
strategies?
Fundamental analysis uses information in a firm's financial statements and other sources of public
information to assess a firm's expected future performance, and hence its likely value. Firms with
estimated values greater than their current prices are then recommended as buys and those with
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Solutions – Chapter 9
values lower than the current price as sells. In contrast, technical analysis uses patterns of past stock
price changes, trading volume, or levels of short-sale interest in the stock for making
recommendations on whether to buy or sell a stock.
The key assumption underlying technical trading strategies is that the stock market is
inefficient. Technical descriptors of stock price movement, past prices, volume, etc., are common
knowledge and, in an efficient market, should fully reflected in prices.
Question 4.
Investment funds follow many different types of investment strategies. Income funds focus on stocks
with high dividend yields, growth funds invest in stocks that are expected to have high capital
appreciation, value funds follow stocks that are considered to be undervalued, and short funds bet
against stocks they consider to be overvalued. What types of investors are likely to be attracted to
each of these types of funds? Why?
Income Funds. The main investors in income funds tend to be investors who need a relatively steady
stream of income, or those with relatively low tax rates on ordinary income. Retirees and parents
financing the educational costs of their children are two common groups that invest in income funds
since the companies in the fund pay dividends that provide a relatively predictable stream of income.
Investors with low ordinary income tax rates may also own income funds since they can earn higher
after-tax returns from these funds relative to other investors. Firms with high dividend to stock price
ratios tend to be lower risk firms in mature industries. Excess cash from their operations is returned
to stockholders via dividends rather than reinvested in the firm. However, dividend income is not
guaranteed which causes income funds to vary in their payouts to investors. Despite the fact that
firms try to avoid lowering dividends, firms can and do change their dividend policy depending on
their financial condition.
Growth Funds. Investors in growth funds are typically medium to long-term investors who are willing
to assume additional risk in hopes of earning higher long-run returns. In addition, investors with high
current tax rates may be attracted to growth funds because they typically generate capital gains,
which can be deferred, rather than dividends. Firms in growth funds tend to be in new and rapidly
expanding industries. Consequently, these firms tend to be riskier than average.
Value Funds. Investors in value funds are often medium to long-term investors who believe that it is
possible to find undervalued firms using publicly available information and that any mispricing for
undervalued firms is not corrected quickly. Furthermore, they expect the return on value funds to
increase as the market begins to reprice undervalued stocks.
Short Funds. The typical investor in a short fund is willing to assume the considerable additional risk
and expense related to short sales for the possibility of a higher return. The investment time horizon
is typically shorter than those of either growth or value funds. Short fund investors believe it is
possible to use publicly available information to find overvalued firms.
Question 5.
Three months ago, Intergalactic Software Company went public. You are a sophisticated investor
who devotes time to fundamental analysis as a way of identifying mispriced stocks. Which of the
following characteristics (market capitalization, average number of shares traded per day, bid- ask
spread for the stock, whether the underwriter is a Top Five investment banking firm, whether
the audit company is a Big Four firm, whether there are analysts from major brokerage firms
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Solutions – Chapter 9
following the company, and whether the stock is held mostly by institutional investors) would you
focus on in deciding whether to follow this stock?
Many of the characteristics mentioned in the question can be correlated with potential mispricing.
The size of the market capitalization will influence the extent of interest of institutional interests.
Below a certain threshold size level, it may not be economical for institutional investors to own the
stock because it will be difficult for them to make a significant investment in it without owning a
significant portion of the firm. The average number of trades per day and the bid-ask spread
influence trading costs. The reputation of the underwriter, the quality of the firm’s auditor, and the
number of analysts following the stock all influence the information environment of the firm. The
information environment, in turn, can influence the liquidity of the stock and the ease with which
the stock can be traded. Finally, if a stock is mainly held by retail investors, its potential for
mispricing is greater than if it is held mostly by sophisticated institutional investors.
Question 6.
There are two major types of financial analysts: buy-side and sell-side. Buy-side analysts work for
investment firms and make stock recommendations that are available only to the management of
funds within that firm. Sell-side analysts work for brokerage firms and make recommendations that
are used to sell stock to the brokerage firms' clients, which include individual investors and managers
of investment funds. What would be the differences in tasks and motivations of these two types of
analysts?
Sell-side analysts work for brokerage houses and provide brokers with information to provide to
their clients on the attractiveness of different firms as investment vehicles. The sell-side analyst's
main task, therefore, is to analyze companies, usually using fundamental analysis, where there are
opportunities to interest customers to either buy or sell the stock. Sell-side analysts produce a
report presenting their analysis, making forecasts of future financial information, and
recommending clients to buy, sell, or hold a stock.
Because brokerage houses generate income from commissions earned on stock trades carried
out for these clients, they provide direct and indirect incentives for sell-side analysts to write
reports that generate commission business. The analyst is viewed as valuable because he/she has
developed an intimate knowledge of recommended firms. In the short run, a persuasive analyst's
report can convince customers to buy or sell shares of a company immediately. Of course, if the
analyst's recommendations later turn out to be consistently unprofitable, investors will be unlikely
to continue using their recommendations for making buy/sell decisions. The most effective sell-side
analysts often play a role in selling new issues to institutional investors, by accompanying
investment bankers from their firm on road shows to promote new offers.
Buy-side analysts work for investment funds and make recommendations about investment
opportunities that are consistent with the fund's operating guidelines. In preparing a
recommendation, an analyst can either put together his/her own reports for individual companies
or evaluate the reports of several sell-side analysts. The buy-side analyst must be able to evaluate
competing buy and sell recommendations made by various sell-side analysts.
The buy-side analyst's motivation is to earn the highest returns for the investment fund. The
buy-side analyst is often compensated based on the success of her recommendations. Investment
funds typically charge fees based on the amount of capital managed by the fund. Moreover, a
successful fund attracts additional capital from investors, generating more revenue for the
investment fund's managers. Hence, the buy-side analyst's compensation is closely tied to the
quality of her recommendations.
Question 7.
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Solutions – Chapter 9
Many market participants believe that sell-side analysts are too optimistic in their recommendations
to buy stocks, and too slow to recommend sells. What factors might explain this bias?
Need for access to firms. Sell-side analysts often depend on information from the firm to answer
questions about firm performance and strategy not contained in other public information about the
firm. This information can make an analyst's reports more thorough and persuasive to potential
investors. Furthermore, higher quality reports can increase revenues for the firm and compensation
for the analyst. After a sell recommendation, firms are less likely to be as open and forthcoming with
analysts who have recommended a sale. Conversely, a strong recommendation to buy a firm's stock
may result in greater access to the firm in the future. Hence, the sell-side analyst could provide
optimistic recommendations to help guarantee access to the firms they cover.
Potential for investment banking services by the analyst's firm. Investment banking services can be a
significant source of income for brokerage/investment banking firms. Moreover, firms are more likely
to use the investment banking services of brokerage/investment banking firms that issue favorable
recommendations. A negative recommendation may cause the brokerage/investment banking firm
the loss of significant additional revenues from underwriting or investment banking services in the
future. As a result, sell-side analysts may be more likely to be optimistic in recommendations about a
specific firm.
Difficulty of taking advantage of a sell recommendation. It may be more difficult for a brokerage
firm's client to take advantage of a sell recommendation. A much narrower group of clients can take
advantage of a sell recommendation. If a client owns the stock, he can sell it outright. If the client
does not own the stock, he must find another stockholder to borrow it from in order to short it and
take advantage of the recommendation. Furthermore, short sales are typically more expensive than
regular stock purchases, last only a finite amount of time before expiring, and carry a higher risk for
the investor. Hence, a sell recommendation for a stock is less likely to generate the same revenues
for the firm as a buy recommendation.
Question 8.
Joe Klein is an analyst for an investment banking firm that offers both underwriting and brokerage
services. Joe sends you a highly favorable report on a stock that his firm recently helped go public
and for which it currently makes the market. What are the potential advantages and disadvantages
in relying on Joe's report in deciding whether to buy the stock?
The combination of brokerage and underwriting activities adds several advantages and
disadvantages that should be considered separately from those discussed in Question 6. These
additional advantages and disadvantages come from the information gathered by and the revenues
generated by the underwriting part of the firm.
Advantages. Better knowledge of the firm. If Mr. Klein has better knowledge of the firm than other
analysts, then his recommendation should be better as well. As part of the public offering process,
underwriters will conduct due diligence on the firm, gaining considerable knowledge and insight
about its current operations and future prospects. The firm's management may also have a better
relationship with Mr. Klein than other analysts from other brokerages because of an overall level of
comfort developed between management and Mr. Klein's firm during the public offering process. As
a result of this relationship, management may be responsive to Mr. Klein's questions about the firm.
In addition, to the extent that knowledge moves from the underwriting side to the brokerage side,
Mr. Klein may have access to additional information about the firm. It is important to note two
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Solutions – Chapter 9
mitigating factors in the United States. First, firms like Mr. Klein's are required to maintain a "Chinese
Wall" between their brokerage and underwriting businesses to eliminate the transfer of any private
information from the latter to the former. Second, firms are supposed to provide the same access to
information to all of their analysts, eliminating selective disclosure to specific analysts.
Disadvantages. Need for consistency between investment banking and brokerage operations. Since
underwriters are selling the stock, it is unlikely that they will provide negative reports on their clients.
The investment banking side of the business may therefore pressure Mr. Klein to make
recommendations that are generally supportive of the firm's underwriting decisions.
Desire for future investment banking business with the firm. Investment banking is likely a significant
source of revenue for Mr. Klein's firm. Firms whose brokerage operations issue negative
recommendations about a particular company are less likely to provide investment banking services
for that company than those that issue positive recommendations. Thus, Mr. Klein's positive
recommendation may be related either to his firm's desire to keep the company's future investment
banking business or to the fact that its historical optimism made it initially an attractive underwriter
for the client.
Question 9.
Intergalactic Software Company's stock has a market price of €20 per share and a book value of €12
per share. If its cost of equity capital is 15 percent and its book value is expected to grow at 5
percent per year indefinitely, what is the market’s assessment of its steady state return on equity?
Determine the market's assessment of its steady state return on equity using the discounted
abnormal earnings model.
V = 1 + ROE - re 
B
 re - g 
.
where V = 20,
b= 12,
g= .05, and
re = .15.
Solving for ROE yields ROE = 0.217. Hence, the market estimate of Intergalactic Software Company's
steady state return on equity is roughly 21.7 percent per year.
If the stock price increases to €35 and the market does not expect the firm's growth rate to change,
what is the revised steady state ROE?
Again using the discounted abnormal earnings model, the new V = 35 and all other variables remain
the same. Solving the model, we get a revised steady state return on equity of 34.2 percent per
year.
If instead the price increase was due to an increase in the market's assessments about long-term
book value growth, rather than long-term ROE, what would the price revision imply for the steady
state growth rate?
Let ROE equal 0.217 from the first part and solve for g instead. With ROE of 21.7 percent, a price of
$35 suggests a steady state growth rate of 11.5 percent.
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Solutions – Chapter 9
Question 10.
Joe states: "I can see how ratio analysis and valuation help me do fundamental analysis, but I don't
see the value of doing strategy analysis." Can you explain to him how strategy analysis could be
potentially useful?
Strategy analysis could aid fundamental analysis in two primary ways—by providing better insight
into a firm's future performance and by offering a more complete picture of a strategy's risks.
Strategy analysis helps an analyst evaluate the impact of strategy on a firm's future performance,
measured by sales, earnings, and other measures. As these performance measures change, the
fundamental value of the company will also change. Consider a computer company that decides to
switch from a differentiated-product strategy to a low-cost product strategy. Such a change in
strategy would have a significant impact on firm revenues, cost structure, and potential sales
growth. An analyst following the company will have to understand how each of these implications
of the change in strategy will effect the firm's fundamental value. Thus, understanding the impact of
strategy on future performance can be an integral part of an analyst's fundamental analysis.
Strategy analysis can also help highlight potential risks associated with a change in strategy. As
the firm's risks change, the firm's fundamental values will also change. First, there is the risk that the
firm will not be able to implement the strategy as promised. Consider again the change in strategy
from product differentiation to low-cost production. If the firm cannot reduce its cost structure, it
faces the unenviable task of selling undifferentiated products at higher prices than its competitors.
Hence, the fundamental value of the firm will depend on the likelihood of its strategy being
successfully implemented. Second, there may be changes in firm risk caused by the successful
implementation of the strategy change. If the strategy change involves entry into a new market or
industry, the firm may be changing the risk of its operations. Being either the low-cost producer of
an undifferentiated product or the producer of a differentiated product both entail risks to the firm.
The likelihood that competitors will be able to produce at a lower cost or develop differentiated
products superior to the firm's, suggests the risk involved with following a particular strategy.
Finally, the analyst must evaluate the firm's chances for success given the current industry structure
and profitability as well as the strategies of other firms in the industry. In each of these cases,
strategy analysis can be used to identify and evaluate the risks the firm faces which, in turn, will
affect the fundamental value of the firm.
6