True/False Multiple Choice Exercises Problems Essays
LO1 – Define equity valuation models and explain the information required to value equity securities.
1 1, 2
LO2 – Describe and apply the residual operating income model to value equity securities.
1-5 2-13 3-11 1-4 1-3
LO3 – Explain how equity valuation models can aid managerial decisions.
14, 15 12, 13 5 4, 5
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-1

Topic: Weighted Average Cost of Capital
LO: 2
1.
The weighted average cost is computed as: WACC=(r d
× % of debt) + (r e
× % of net income)
Answer: False
Rationale: Discount rate WACC = (r d
× % of debt) + (r e
× % of equity)
Topic: RNOA, WACC, and Company Value
LO: 2
2. All else equal, when WACC is higher than RNOA, the company’s market value is increasing.
Answer: False
Rationale: For a given level of NOA, company value increases when RNOA > WACC.
Topic: Residual Operating Income (ROPI) Valuation Model
LO: 2
3.
Differing accrual accounting policies have an impact on the estimated value of equity when using the
ROPI model.
Answer: False
Rationale: Expected ROPI offsets different levels of NOA resulting from differing accounting policies, leaving estimated value unaffected by accounting policies.
Topic: Company Value under ROPI Model
LO: 2
4. The residual operating income (ROPI) model estimates firm value as the current book value of net operating assets plus the present value of expected residual operating income.
Answer: True
Rationale: The ROPI model estimates firm value as the current book value of net operating assets plus the present value of expected ROPI.
Topic: ROPI Valuation Model
LO: 2
5.
The residual operating income (ROPI) model focuses on net income which is a more accurate measure of future profitability than expected cash flows.
Answer: False
Rationale: NOPAT is the key value driver of the ROPI model.
©Cambridge Business Publishers, 2013
14-2 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: Insights from ROPI Model
LO: 3
6.
The power of the residual operating income (ROPI) model is that it allows managers to focus on either the income statement or balance sheet to increase firm value.
Answer: False
Rationale: The ROPI model focuses managers’ attention on both the income statement and the balance sheet.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-3

Topic: Earnings and Equity Values
LO: 1
1. On April 24, 2009, Ford Motor Company reported a net loss of $1.4 billion for the fiscal quarter. That day, Ford’s stock price climbed from $4.49 per share to $5.00. This demonstrates that:
A) Equity valuation models are not related to company earnings
B) Dividends are unrelated to earnings
C) Equity valuation models can be irrational
D) The net loss was smaller than investors expected
E) All of the above
Answer: D
Rationale: Equity valuation models are based on expected future earnings. The loss that Ford reported was less than investors expected, so in a way, it was good news.
Topic: Projecting Revenue One Year Out – Numerical calculations required
LO: 2
2.
Following is information from Morse Inc. for 2012.
Total 2012 revenue
Total revenue growth rate
Terminal revenue growth rate
Net operating profit margin (NOPM)
Net operating asset turnover (NOAT)
Projected 2013 total revenue would be:
A) $258,364
B) $234,696
C) $185,868
D) $240,614
E) None of the above
Answer: A
Rationale: $219,138 × 1.179 = $258,364
$219,138
17.9%
7.1%
9.8%
2.12
©Cambridge Business Publishers, 2013
14-4 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: Projecting Net Operating Profit After-Tax (NOPAT) – Numerical calculations required
LO: 2
3.
Following is information from Hewlett Packard for 2011 ($ in millions).
Total revenue
Projected revenue growth rate
$127,245
1.0%
Net operating profit margin (NOPM)
Net operating assets (NOA)
5.9%
$62,249
Net operating asset turnover (NOAT)
Projected net operating profit after tax (NOPAT) for 2012 is:
A) $7,583 million
B) $7,950 million
C) $3,684 million
D) $8,258 million
E) None of the above
2.04
Answer: A
Rationale: $127,245 million × 1.01 × 0.059 = $7,583 million
Topic: Projecting Net Operating Profit After-Tax (NOPAT) – Numerical calculations required
LO: 2
4.
Following is information from American Eagle Outfitters for 2011 ($ in thousands).
Total revenue $3,159,818
Total revenue growth rate
Net operating profit margin (NOPM)
6.5%
4.7%
Net operating profit after tax (NOPAT)
Net operating asset turnover (NOAT)
Projected net operating assets (NOA) for 2012 is:
A) $ 795,272 thousand
B) $ 716,001 thousand
C) $1,253,293 thousand
$148,063
4.16
D) $ 808,944 thousand
E) None of the above
Answer: D
Rationale: $3,159,818 thousand × 1.065 / 4.16 = $808,944 thousand
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-5

Topic: Net Operating Profit After-Tax
LO: 2
5.
Which of the following items should not be included in net operating profit after tax (NOPAT)?
A) Revenue
B) Cost of Goods Sold
C) Selling, General & Administrative Expenses
D) Decrease in Accounts Receivable
E) None of the above
Answer: D
Rationale: Accounts Receivable is an asset and is not included in the calculations of NOPAT.
Reductions in accounts receivable are a component of the statement of cash flows.
Topic: ROPI Valuation Model
LO: 2
6.
Which of the following descriptions of the residual operating income (ROPI) model is inaccurate ?
A) ROPI analysis focuses on the amount by which shareholder value is created during a period.
B) ROPI is positive when NOPAT is higher than WACC × NOA
Beg
.
C) ROPI is useful as a management tool as it forces managers to pay attention to both the income statement and the balance sheet.
D) One critique of the ROPI model is that it focuses managers’ attention solely on short-term operating assets and neglects investment in long-term operating assets.
E) None of the above
Answer: D
Rationale: ROPI= NOPAT- (WACC × NOA
Beg
) NOA is the book value of all net operating assets at the beginning of the current period. This includes current and long-term operating assets. Managers must, therefore, focus on both short-term and long-term operating assets.
Topic: Computing Residual Operating Income – Numerical calculations required
LO: 2
7. Thomas Railways reports the following information. What is the company’s residual operating income
(ROPI) for 2012?
Cash
Operating assets
Operating liabilities
Net operating profit after tax
Weighted average cost of capital
2012
$2,200
$9,800
$5,300
$1,800
6.0%
A) $1,248
B) $1,348
C) $1,530
D) $1,548
E) None of the above
Answer: D
Rationale: ROPI = NOPAT- (NOA
Beg
× Weighted average cost of capital)
$1,800 – [($9,200 - $5,000) × 0.06] = $1,548
2011
$2,000
$9,200
$5,000
$1,600
6.0%
©Cambridge Business Publishers, 2013
14-6 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: Computing Residual Operating Income – Numerical calculations required
LO: 2
8.
Magee and East, Inc., have a fiscal year ending May 31. Based on the following information, what is the company’s residual operating income (ROPI) for the year ended May 31, 2012?
October 31 2012 2011
Cash
Net operating working capital
Net long-term operating assets
Net nonoperating obligations
Net operating profit after tax
Weighted average cost of capital
A) $194
B) $254
C) $244
D) $180
E) None of the above
$4,400
$1,400
$2,400
$300
$400
5.4%
Answer: B
Rationale:
ROPI = NOPAT- (NOA
Beg
× Weighted average cost of capital)
NOA = Net operating working capital + Net long-term operating assets
2011 NOA = $700 + $2,000 = $2,700
ROPI = $400 – ($2,700 × 0.054) = $254
Topic: Residual Operating Income (ROPI) Valuation Model
$3,560
$700
$2,000
$200
$360
5.8%
LO: 2
9.
Which of the following descriptions of Residual Operating Income (ROPI) is incorrect ?
A) The estimations of value per share of companies are the same when employing the ROPI and
DCF model if the firm is growing at a constant rate.
B) ROPI = NOPAT- (WACC × NOA), and WACC × NOA is the dollar amount of return that lenders and shareholders expect the company to earn on their investment.
C) If a company utilizes overly conservative/aggressive accounting practices, its book value is understated/ overstated and will affect the estimate of the stock price using the ROPI model.
D) ROPI model uses information from both the income statement and balance sheet.
E) None of the above
Answer: C
Rationale: While it is true that aggressive accounting practices can affect a company’s book value, this is offset by higher/lower expected residual operating income, leaving the estimate of stock price unaffected.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-7

Topic: ROPI Model – More challenging
LO: 2
10.
Which of the following is incorrect (r w
is the weighted average cost of capital)?
A) ROPI = NOPAT - (r w
× NOA)
B) NOPAT - (r w
× NOA) = (NOPAT/NOA - r w
) × NOA
C) RNOA = NOPAT / average NOA
D) ROPI = (RNOA × r w
) – NOA
E) None of the above
Answer: D
Rationale: ROPI = NOPAT - (r w
× Net operating assets) = (NOPAT/ NOA - r w
) × NOA, and RNOA is defined as NOPAT / average NOA. Therefore D is incorrect by definition.
Topic: ROPI Model – Numerical calculations required
LO: 2
11.
Assume the following forecasted residual operating income (ROPI) for Jenkins & Co. for 2012:
($millions)
Current
2012 2013
Forecast Horizon
2014 2015 2016
Terminal
Year
Residual operating income (ROPI) $512 $788 $1,136 $1,290 $1,422 $1,578
The value of the firm using the ROPI valuation model and NOA for 2012 of $8,024 and a discount rate of 8% and an expected terminal growth rate of 3.5%, is
A) $29,548
B) $25,775
C) $30,060
D) $ 3,772
E) None of the above
Answer: E
Rationale: $788/1.08 + $1,136/1.08
2
+ $1,290/1.08
3
+ $1,422/1.08
4
+ ($1,578 / (0.08 - 0.035))/1.08
4
+
$8,024 = $37,572
Topic: ROPI Model
LO: 2
12.
All of the following are attributes of the ROPI model except :
A) ROPI utilizes both the balance sheet and the income statement, capturing information in accrual accounting.
B) ROPI is immune from the effects of differing accounting policies.
C) ROPI is falsely perceived as influenced by accrual accounting policies.
D) ROPI model is accurately perceived as influenced by accrual accounting policies.
E) None of the above
Answer: D
Rationale: ROPI valuation is immune from accounting policies, as ROPI changes to offset changes in
NOA arising from differing accounting policies.
©Cambridge Business Publishers, 2013
14-8 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: ROPI Model
LO: 2
13.
Which of the following statements is true :
A) ROPI = NOPAT+ (r w
× NOA)
B) ROPI = NOPAT – (r w
× NOA)
C) ROPI = NOPAT – [(r w
– g) × Net operating assets]
D) ROPI = NOPAT – [NOA t
– NOA t-1
]
E) None of the above
Answer: B
Rationale: ROPI=NOPAT-(r w
× NOA)
Topic: Advantage of DCF over ROPI
LO: 3
14.
Which of the following items is an advantage of the discounted cash flow (DCF) model, compared with the residual operating income (ROPI) model?
A) It forecasts residual operating income which is easier than forecasting cash flow.
B) It utilizes information from both the balance sheet and income statement for valuation model.
C) It is well known and widely accepted model
D) It focuses on value drivers such as margins and turnovers
E) All of the above
Answer: C
Rationale: The DCF model is a well-known and widely accepted model.
Topic: ROPI Model Insights
LO: 3
15.
Which of following is an advantage of the ROPI model?
A) Well known and widely accepted valuation model
B) Cash flows are not affected by accrual accounting
C) Utilizes both the balance sheet and the income statement, and captures the information in accrual accounting
D) Does not depend on an arbitrary discount rate.
E) None of the above
Answer: C
Rationale: Utilizes both the balance sheet and the income statement, and captures the information in accrual accounting.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-9

Topic: Stock Price Reaction to Earnings Announcement
LO: 1
1.
In a recent quarterly earnings announcement, Meridian Inc. announced that its earnings had markedly increased (up 20 cents per share over the prior year). Meridian’s stock price dropped nearly
5% on the earnings report. Why do you believe that Meridian’s stock reacted as it did?
Answer:
The likely explanation is that the market had expected a greater earnings increase. This expectation had already been impounded in the company’s stock price. Because the expectation was not met, the price declined.
Topic: Calculating WACC
LO: 1
2.
Kling Industries has an after-tax cost of debt of 5.04%. Your online investigation reveals that the company has a beta of 1.50. Assume that the risk free rate in 2012 is 4.5% and an appropriate “spread” of equities over the risk-free rate is 5%. The company has 77% of its capitalization from equity.
Calculate the company’s weighted average cost of capital for 2012.
Answer:
WACC = (cost of debt × debt % capitalization) + (cost of equity × equity % capitalization).
Cost of debt after tax = 5.04%. Cost of equity = 4.5% + (1.50 × 5%) = 12.00.
WACC = (5.04% × 23%) + (12.00% × 77%) = 10.40%.
Topic: Per Share Value – ROPI Model
LO: 2
3.
Calculate the per share value of Gleem Chemical Corporation if the cumulative present value of horizon period ROPI is $5,500, the present value of terminal ROPI is $6,550, the net operating assets
(NOA) are $22,000, and net nonoperating obligations (NNO) are $2,440. The company has 600 shares outstanding.
Answer:
Cumulative PV of ROPI
PV of terminal value of ROPI
NOA
Total enterprise value
Net nonoperating obligations
Value of equity
Shares outstanding
Value per share
$ 5,500
6,550
22,000
34,050
(2,440)
$31,610
600
$52.68
©Cambridge Business Publishers, 2013
14-10 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: ROPI Calculations
LO: 2
4.
Following are financial statement numbers and select ratios for Target Corp. for the fiscal year 2011
(dollars in millions). Use the information to determine the residual operating income (ROPI) in 2012.
2011 Total revenues
2011 Net operating assets (NOA)
Sales growth, 2012 through 2015
Net operating profit margin (NOPM)
$69,865
$32,510
3.7%
5.0%
Net operating asset turnover (NOAT)
Terminal growth rate
2.15
3%
Discount rate
Answer:
ROPI = NOPAT – (WACC × NOA
Beg
)
2012 NOPAT = $69,865 million × 1.037 × 0.05 = $3,623 million.
2012 ROPI = $3,623 million – (5% × $32,510) = $1,997.
5%
Topic: ROPI Calculations
LO: 2
5. Following are financial statement numbers and select ratios for Darden Restaurants Inc. for the year ended May 27, 2012 (dollars in millions). Use the information to determine the residual operating income (ROPI) in 2013.
2012 Sales
2012 Net operating assets (NOA)
Sales growth, 2013 through 2016
Net operating profit margin (NOPM)
$7,998.7
$3,892.2
6.6%
6.8%
Net operating asset turnover (NOAT)
Terminal growth rate
2.06
4%
Discount rate
Answer:
ROPI = NOPAT – (WACC × NOA
Beg
)
2013 NOPAT = $7,998.7 million × 1.066 × 0.068 = $579.8 million.
2013 ROPI = $579.8 million – (5% × $3,892.2 million) = $385.2 million.
Topic: Terminal Value
LO: 2
5%
6.
Given the horizon period from 2013 to 2017, with the terminal year 2018, calculate the present value at December 31, 2012 of the terminal value of ROPI given the following additional information:
Annual ROPI during the terminal period (2018) = $18,000
Discount rate = 8.4%
Growth rate= 2.5%
Answer:
[($18,000) / (0.084 - 0.025)] / (1 + 0.084)
5
= $203,833
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-11

Topic: ROPI Valuation Model
LO: 2
7.
Use the following information (in millions) and the residual operating income (ROPI) model, to value the equity of a small publicly-traded company. The company’s stock is currently trading at $130 per share. Would you purchase shares of this stock at $130? Why or why not?
Cumulative present value of horizon period ROPI
Present value of terminal period ROPI
Net operating assets, beginning of year
$16,000
44,000
18,000
6,000
625
Net nonoperating obligations
Number of shares outstanding, in millions
Answer:
Total firm value = $16,000 + $44,000 + $18,000 = $78,000
Total equity value = $78,000 - $6,000 = $72,000
Per share value = $72,000 / 625 = $115.20
No, I would not purchase shares of the stock, because it appears to be overvalued based on the
ROPI model. My valuation puts the price at $115.20, so at $130 it is not a good deal.
Topic: ROPI Valuation Model
LO: 2
8.
In its 2012 fiscal year report, a company reported the following information:
2012 2011 2010
Net operating profit after tax
Net operating assets, end of year
$112,486
$1,335,543
$91,816
$1,158,543
$77,345
$1,074,922
The company’s WACC is 8%. What is the residual operating income (ROPI) for 2012? Is this an improvement over the previous year? Is this a good sign for investing in this company?
Answer:
ROPI = NOPAT – (WACC × Net Operating Assets
BEG
)
2012 ROPI = $112,486 – (0.08 × $1,158,543) = $19,803
2011 ROPI = $91,816 – (0.08 × $1,074,922) = $5,822
2012 ROPI was $19,803. This is a big improvement over the 2011 ROPI. This is a good sign for investors; however, we would want to determine if the NOPAT above reflects expected future
NOPAT, or if it was affected by one-time items.
©Cambridge Business Publishers, 2013
14-12 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: ROPI Valuation Model
LO: 2
9.
In its 2012 fiscal year report, a company reported the following information:
Net operating profit after tax
2012
$56,243
2011
$45,908
2010
$38,673
Net operating assets, end of year $1,335,543 $1,158,543 $1,074,922
At what weighted average cost of capital would the company report residual operating income (ROPI) of $0 in 2012?
Answer:
With a WACC of about 4.9%, the company would report zero ROPI.
ROPI = NOPAT – (WACC × NOA
BEG
)
When ROPI = $0, NOPAT = (WACC × NOA
BEG
), and that WACC = NOPAT / NOA
BEG
2012 WACC = $56,243 / $1,158,543) = 4.9%
Topic: ROPI Computation
LO: 2
10.
Given the following information, calculate the ROPI for the latest fiscal year. At what WACC will the company report zero ROPI?
Revenues
NOPAT
$40,000
$3,000
WACC
Net operating assets beginning of year
5%
$20,000
Net operating assets end of year $22,000
Net debt
Answer:
ROPI = NOPAT – (WACC × NOA
BEG
)
ROPI = $3,000 – (0.05 × $20,000) = $2,000
$10,000
ROPI equal to zero implies that WACC = NOPAT / NOA
BEG
WACC = $3,000 / $20,000 = 0.15. The company will report zero ROPI with a WACC of 15%
Topic: Computing RNOA from ROPI – More challenging
LO: 2
11.
A firm has expected residual operating income of $8.4 million, the weighted average cost of capital
(WACC) of 5.5%, and net operating assets (NOA) at the beginning of the period of $220 million. NOA is projected to grow to $260 million by the end of the year. What is the projected return on net operating assets (RNOA) for the year?
Answer:
ROPI = NOPAT – (WACC × NOA
BEG
).
$8.4 = NOPAT – (0.055 × $220) NOPAT= $20.5
RNOA = $20.5 / [($220 + $260) / 2] = 8.5%
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-13

Topic: Using ROPI in a Management Setting
LO: 3
12.
A company wants to assess the performance of its management using the ROPI-based analysis. At the beginning of the period, the company has net operating assets of $56 million, and its weighted cost of capital (WACC) for this period is 7.5%. a. What is the minimum level of NOPAT the company will need in this year for management to report it has achieved an acceptable level of profit under the ROPI analysis? b. Why is it often advantageous for a company to use ROPI analysis to evaluate managers?
Answer: a. ROPI = NOPAT – (WACC × NOA
BEG
). For ROPI to equal zero, NOPAT – (0.075 × $56 million).
In this case, NOPAT must be greater than $4.2 million, meaning that the firm must have a net operating profit after tax greater than $4.2 million for it to report positive ROPI. b. Many large companies use ROPI or a similar analysis to evaluate their managers because it forces company managers to pay attention to the balance sheet in addition to the income statement.
Topic: Using ROPI in a Management Context
LO: 3
13.
Consider a management team that has its incentive compensation package tied to residual operating income (ROPI). Discuss how the team can improve ROPI by 1) driving improvements in operating margin, and/or 2) reducing the company’s operating asset base.
Answer:
The primary drivers of the ROPI equation are NOPAT, WACC, and operating asset base. ROPI =
NOPAT – (WACC × Net operating assets). If management can increase the business’s operating margin through cost savings, the company will increase reported NOPAT, and therefore ROPI.
Similarly, if management can reduce its net operating asset base, it can reduce the “charge” incurred against the NOPAT generated. This will result in greater ROPI for a given level of NOPAT.
©Cambridge Business Publishers, 2013
14-14 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: Calculating FCFF and ROPI from Financial Statements
LO: 2
1.
Following are the balance sheet and income statement for Silver Toys Inc.
Silver Toys Inc.
Balance Sheet at December 31
2012 2011
Cash
Accounts Receivable
Inventories
Total Current Assets
Plant Assets, Net
Total Assets
$ 2,046
2,946
9,136
14,128
21,974
$36,102
$ 1,958
3,192
7,714
12,864
21,250
$34,114
Accounts Payable
Accrued Liabilities
Total Current Liabilities
Long-term Debt
Total Stockholder's Equity
Total Liabilities and Equity
$ 1,982
1,750
3,732
8,944
23,426
$36,102
$ 1,696
1,490
3,186
10,398
20,530
$34,114
Silver Toys Inc.
Income Statement for the year ended December 31
(in thousands) 2012
Revenues
Cost of Books Sold
Gross Profit
$24,164
11,876
12,288
2011
$20,874
10,028
10,846
Selling, General and Admin Expenses
Operating Profit
Interest Expense
7,938
4,350
500
7,014
3,832
450
Pretax Income
Income Tax Expense
Net Income
3,850
1,156
$ 2,694
3,382
1,014
$ 2,368 a. Calculate net operating profit after tax (NOPAT) for 2012. Assume that the company’s statutory tax rate is 30%. b. Calculate net operating assets (NOA) for 2011 and 2012. c. What is the free cash flows to the firm (FCFF) for 2012 for the Silver Toys? d. What is the residual operating income (ROPI) for 2012 for the Silver Toys? The company’s weighted average cost of capital is 8.45%.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-15

Answer: a. 2012 NOPAT = $4,350 – [$1,156 + ($500 × 0.30)] = $3,044 b. 2011 NOA = $34,114 – $3,186 – $1,958 = $28,970
2012 NOA = $36,102 – $3,732 – $2,046 = $30,324 c.
NOPAT $ 3,044
Ending Net Operating Assets 30,324
Beginning Net Operating Assets 28,970
Increase in NOA 1,354
FCFF = NOPAT – Increase in NOA $ 1,690 d.
NOPAT $ 3,044
Beginning Net Operating Assets
ROPI = NOPAT – (WACC × Beginning Net
Operating Assets)
28,970
$596
Topic: Valuing Equity Securities using ROPI Model
LO: 2
2.
Following are financial statement numbers and select ratios for Target Corp. for the fiscal year 2011
(ending January 28, 2012).
($ millions)
Sales
Net operating profit after tax (NOPAT)
Net operating assets (NOA)
Current
2011 2012
Forecast Horizon
2013 2014 2015
Terminal
Year
69,865 72,450 75,131 77,910 80,793 83,217
3,483 3,623 3,757 3,896 4,040 4,161
32,510 33,698 34,945 36,237 37,578 38,706
Forecast assumptions and other financial information for Target are as follows:
Sales growth 3.7%
Net operating profit margin (NOPM)
Net operating asset turnover (NOAT)
Terminal growth rate
Discount rate
5.0%
2.15
3%
5%
Shares outstanding in millions
Stockholders' equity
669.3
$15,821
Net nonoperating obligations (NNO) $ 16,689 a. Use the residual operating income (ROPI) model to estimate the value of Target’s equity, per share at fiscal year end. b. Target Corp. shares closed at $50.05 per share on January 28, 2012. How does your valuation compare with this closing price?
©Cambridge Business Publishers, 2013
14-16 Financial Statement Analysis & Valuation 3 rd
Edition

Answer: a.
($millions)
NOPAT
NOA
Beg
ROPI (NOPAT- [NOA
Beg
× r w
])
Discount factor [1 / (1 × r w
) t
]
PV of horizon ROPI
Cum PV of horizon ROPI
PV of terminal ROPI
NOA
Total firm value
Less NNO
Firm equity value
Shares outstanding (millions)
Stock value per share
Current
2011 2012
3,623
Forecast Horizon
2013 2014
3,757 3,896
2015
Terminal
Year
4,040 4,161
32,510 33,698 34,945 36,237
1,998 2,072 2,149 2,228
0.95238 0.90703 0.86384 0.82270
37,578
2,282
$7,471
1,903 1,879 1,856 1,833
93,870
32,510
133,851
16,689
117,162
669.3
$175.05 b. The valuation of Target at $175.05, above, suggests that the firm is undervalued at the closing market price of $50.05. This could be because the discount rate used here is too low or because growth projections are too aggressive.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-17

Topic: Valuing Equity Securities using ROPI Model
LO: 2
3.
Following are financial statement numbers and select ratios for Hewlett-Packard Corp. for the year ended October 31, 2011.
($millions)
Current
2011 2012
Forecast Horizon
2013 2014 2015
Terminal
Year
Total net revenue $127,245 $128,517 $129,803 $131,101 $132,412 $133,736
Net operating profit after tax (NOPAT) 7,522 7,583 7,658 7,735 7,812 7,890
Net operating assets
(NOA) 62,249 62,999 63,629 64,265 64,908 65,557
Forecast assumptions and other financial information for HP are as follows:
Revenue growth
Terminal growth rate
Net operating profit margin (NOPM)
1.0%
1.0%
5.9%
Net operating asset turnover (NOAT)
Discount rate
Shares outstanding in millions
Stockholders' equity
2.04
5.6%
1,991
$38,625
NNO $23,624 a. Use the residual operating income (ROPI) model to estimate the value of Hewlett-Packard’s equity, per share at October 31, 2011. b. Hewlett Packard’s shares closed at $26.61 per share on October 31, 2011. How does your valuation compare with this closing price?
Answer: a.
($ millions)
NOPAT
Current
2011 2012
7,583
Forecast Horizon
2013
7,658
2014
7,735
2015
7,812
Terminal
Year
7,890
NOA
Beg 62,249 62,999 63,629 64,265 64,908
ROPI (NOPAT- [NOA
Beg
× r w
])
Discount factor [1 / (1 × r w
) t
]
PV of horizon ROPI
Cum PV of horizon ROPI
PV of terminal ROPI
NOA
Total firm value
Less NNO
Firm equity value
Shares outstanding (millions)
Stock value per share
$14,515
4,097 4,130 4,172 4,213
0.94697 0.89675 0.84920 0.80416
3,880 3,704 3,543 3,388
74,385
62,249
151,149
23,624
127,525
1,991
$64.05
4,255 b. The valuation of HP at $64.05, above suggests that the firm is undervalued at the closing market price of $26.61. This could be because the discount rate used here is too low or because growth projections are too aggressive.
©Cambridge Business Publishers, 2013
14-18 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: Valuing Equity Securities using ROPI Model
LO: 2
4.
Following are the income statements and balance sheets for Darden Restaurants, Inc. for the fiscal year ending May 27, 2012.
Darden Restaurants, Inc.
Consolidated Balance Sheet s
(In millions)
Assets
Cash and cash equivalents
Receivables, net
Inventories
Prepaid income taxes
Prepaid expenses and other current assets
Deferred income taxes
Total current assets
Land, buildings and equipment, net
Goodwill
Trademarks
Other assets
Total assets
Accounts payable
Short-term debt
Accrued payroll
Accrued income taxes
Other accrued taxes
Unearned revenues
Current portion of long-term debt
Other current liabilities
Total current liabilities
Long-term debt, less current portion
Deferred income taxes
Deferred rent
Obligations under capital leases
Other liabilities
Total liabilities
Common Stock (129 shares outstanding)
Retained Earnings
Treasury Stock
Accumulated other comprehensive (loss)
Unearned compensation
Total stockholders’ equity
Total liabilities and stockholders’ equity
May 27, 2012 May 29, 2011
$ 70.5 $ 70.5
71.4
404.1
12.2
74.9
124.5
757.6
65.4
300.1
5.2
77.0
145.6
663.8
3,951.3
538.6
464.9
231.8
$5,944.2
$ 260.7
262.7
154.3
--
60.4
231.7
349.9
454.4
1,774.1
1,453.7
312.9
204.4
54.4
302.7
4,102.2
2,518.8
3,172.8
(3,695.8)
(146.6)
(7.2)
1,842.0
$5,944.2
3,622.0
517.1
454.0
209.7
$5,466.6
$ 251.3
185.5
167.1
9.3
64.3
200.0
--
409.3
1,286.8
1,407.3
345.4
186.2
56.0
248.7
3,530.4
2,408.8
2,921.9
(3,325.3)
(59.8)
(9.4)
1,936.2
$5,466.6
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-19

(In millions)
Sales
Costs of sales:
Food and beverage
Restaurant labor
Restaurant expenses
Total cost of sales
Darden Restaurants, Inc.
Consolidated Statements of Earnings
Selling general and administrative
Depreciation and amortization
Interest, net
Total costs and expenses
Earnings before income taxes
Income taxes
May 27, 2012
$7,998.7
2,460.6
2,502.0
1,200.6
6,163.2
746.8
349.1
101.6
7,360.7
638.0
161.5
May 29, 2011
$7,500.2
2,173.6
2,396.9
1,129.0
5,699.5
742.7
316.8
93.6
6,852.6
647.6
168.9
Earnings from continuing operations
Losses from discontinued operations, net
476.5
1.0
478.7
2.4
Net earnings $475.5 476.3
Required: a. Calculate the following metrics for 2012:
•
Net operating profit after tax (NOPAT) – assume the statutory tax rate is 37.5%
•
Net operating assets (NOA)
•
Net operating profit margin (NOPM)
•
Net operating asset turnover (NOAT)
•
Net nonoperating obligations (NNO), and
•
Sales growth. b. Use the residual operating income (ROPI) model to estimate the per share value of Darden
Restaurant’s equity, at May 27, 2012. The company’s weighted average cost of capital is 9% and terminal growth rate is expected to be 4%. c. Darden Restaurant’s shares closed at $53.06 per share on May 27, 2012. How does your valuation compare with this closing price?
©Cambridge Business Publishers, 2013
14-20 Financial Statement Analysis & Valuation 3 rd
Edition

Answer: a. NOPAT = $540.0: $476.5 + ($101.6 × (1 – 37.5%))
NOA = $3,892.2: ($5,944.2 – $70.5) – ($1,774.1 – $262.7 – $349.9 + $312.9 + $204.4 + $302.7)
NOPM = 6.8%: $540.0 / $7,998.7
NOAT = 2.06: $7,998.7 / $3,892.2
NNO = = $2,050.2: $262.7 + $349.9 + $1,453.7 + $54.4 – $70.5
Sales growth = 6.6%: ($7,998.7 / $7,500.2) – 1 b.
($millions)
NOPAT
Current
2012 2013
579.8
Forecast Horizon
2014 2015
618.1 658.9
2016
702.4
Terminal
Year
730.4
NOA
Beg 3,892.2 4,139.1 4,412.3 4,703.5 5,014.0
ROPI (NOPAT- [NOA
Beg
× r w
])
Discount factor [1 / (1 × r w
) t
]
229.5 245.6 261.8 279.1
0.91743 0.84168 0.77218 0.70843
279.1
PV of horizon ROPI
Cum PV of horizon ROPI
$817.2
210.6 206.7 202.2 197.7
PV of terminal ROPI
3,954.5
NOA
3,892.2
Total firm value
8,663.9
Less NNO
2,050.2
Firm equity value
6,613.7
Shares outstanding (millions)
129.0
Stock value per share
$51.27 c. The valuation of Darden Restaurants at $51.27 above suggests that the firm is overvalued at the closing market price of $53.06. This could be because the discount rate used here is too high or because growth projections are too conservative.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-21

Topic: Using ROPI in a Management Context
LO: 3
5.
Suppose you are an officer for Jordan Corporation and are presented with the following information regarding your two operating divisions:
U.S. division
Latin America division
Revenues
Net operating profit after tax (NOPAT)
$12,800
7,900
$13,400
6,500
Weighted average cost of capital (WACC) 8.00% 8.00%
Beginning Net Operating Assets (NOA)
Ending Net Operating Assets (NOA)
38,160
40,280
34,760
35,800 a. Compute the residual operating income (ROPI) for each division. b. Compare the residual operating income (ROPI) for each division. Which division is performing better? c. What would you recommend to each division’s top manager to improve its performance?
Answer: a.
U.S. division
Latin America division
Net operating profit after tax (NOPAT)
Weighted average cost of capital (WACC)
Beginning Net Operating Assets (NOA)
Expected NOPAT = NOA beg x WACC
$7,900
8.00%
38,160
3,053
$6,500
8.00%
34,760
2,781
ROPI = NOPAT - Expected NOPAT $4,847 $3,719 b. Although the U.S. Division generates less revenue, Net Operating Profit After Tax (NOPAT) is much higher than that of the Latin America Division. Further, U.S. Division has only slightly higher Net Operating Assets, although both divisions have the same WACC. The ROPI of U.S.
Division therefore is higher than that of the Latin America Division. c. Division managers can improve ROPI by increasing NOPAT, by decreasing NOA or by reducing the division’s risk profile to reduce the WACC. To increase NOPAT, the division could increase revenues (holding costs constant) or decrease costs (relative to revenues). To decrease NOA in the short run, the division could reduce working capital assets (inventory and accounts receivable) or increase accounts payable. In the longer run, the division can reduce levels of PPE so as to improve efficiency. Reducing risk is more challenging yet because financing decisions are not typically made at the divisional level.
©Cambridge Business Publishers, 2013
14-22 Financial Statement Analysis & Valuation 3 rd
Edition

Topic: DCF, ROPI and Earnings Quality
LO: 2
1.
Which is the better model for valuation when earnings quality is a major concern, DCF or ROPI?
Explain.
Answer:
Both approaches are suitable. When earnings quality is an issue, the ROPI model can still be used because it is unaffected by companies’ accounting practices. If a company uses overly conservative accounting practices, its book value is understated. However, this is offset by higher expected residual operating income (remember, ROPI = NOPAT – (WACC × Net Operating Assets).
Topic: NOPAT vs. Net Income in ROPI Valuation
LO: 2
2.
Discuss why NOPAT is used in calculating the value of a company instead of net income in the ROPI equity valuation model.
Answer:
NOPAT, rather than net income, is used in calculating the value of a company in the ROPI model because NOPAT reflects the operating side of the firm as opposed to net income, which includes both operating activities and borrowing and security investing activities. NOPAT is, then, compared with
NOA, another operating metric. When net income is used, stockholders’ equity, rather than NOA, is the appropriate balance sheet amount.
Topic: ROPI Model
LO: 2
3.
Explain the concept behind the Residual Operating Income (ROPI) model.
Answer:
The ROPI model is the idea that owners and non-owners (e.g. bondholders) each expect a certain amount of return in exchange for the money that they give to the firm. For the firm, this return amounts to a cost. This cost, calculated as WACC × Net Operating Assets, is often referred to as expected net operating profits after tax (Expected NOPAT).
Anything the firm earns over and above the Expected NOPAT is money that creates value for the firm. The difference between the firm’s actual NOPAT and the Expected NOPAT is called Residual
Operating Income (ROPI). Hence, firms that can produce substantial Residual Operating Income should be valued higher, while companies that have low, or negative, Residual Operating Income, should be valued lower.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-23

Topic: Advantages/Disadvantages of DCF and ROPI Models
LO: 3
4.
Name and describe some of the advantages/disadvantages of both the Discounted Cash Flow (DCF) and the Residual Operating Income (ROPI) valuation models.
Answer:
The DCF method is well known and has been adopted by a number of investment firms. It’s perceived advantage is the use of cash flows, which are not affected by accrual accounting rules.
Although DCF has received vast attention, some of the drawbacks are that DCF penalizes firms for investing in net operating working capital and long-term operating assets, which are essential to a firm’s long-run survival. Although both may create value and are critical to the effective operations of a firm, additions to either reduce Free Cash Flows to the Firm (FCFF). Thus, some companies may be tempted to decrease investing in assets in order to increase FCFF. Another weakness is that
FCFF may often fluctuate, creating difficulties at arriving at the true value of the firm.
The Residual Operating Income (ROPI) model, on the other hand, utilizes the accrual concept of accounting and uses both the balance sheet and the income statement to arrive at a firm’s value.
Advantages include the fact that the ROPI model captures information, such as margins and turnover, which is valuable in understanding a firm’s value. A disadvantage is that the financial statements do not reflect all company assets.
Topic: Using ROPI in a Management Context
LO: 3
5.
You have recently taken a position as CFO of High Tech Corporation, a leading manufacturer of consumer electronics. The industry is widely regarded as one of the more stable across the economic spectrum and offers good long-term growth prospects. In addition to High Tech Corp., there are several other well-capitalized competitors, and each company commands roughly identical market shares. Each competitor has highly efficient manufacturing processes and operates at virtually identical margins. In your new position as CFO, your incentive compensation plan is primarily driven by ROPI. High Tech Corp. has historically been ROPI neutral while its peers in have been ROPI positive. Looking at the information below, what would be your immediate objectives for
High Tech Corp. in order to drive positive ROPI. Explain your actions.
High Tech
Corp.
Industry
Peers
Net operating profit margin (NOPM) 12.0% 12.0%
Working Capital as % of NOA
Debt to market value of equity (%)
Cost of Debt
Cost of Equity
Weighted average cost of capital (WACC)
20.0%
0.0%
4.0%
9.0%
9.0%
15.0%
34.0%
4.0%
10.0%
8.0%
©Cambridge Business Publishers, 2013
14-24 Financial Statement Analysis & Valuation 3 rd
Edition

Answer:
ROPI = NOPAT – (WACC × NOA), our job as CFO is to manipulate the components of the ROPI equation so that High Tech Corp. generates positive ROPI. First, while increasing NOPAT can result in the desired outcome, the problem outlined an industry in which this looks to be challenging over the near-term. All competitors have identical market shares and margins, so High Tech would need to increase its sales by taking share from a strong field of competitors. While this will ultimately be the objective of executive management, as CFO we can take more immediate actions to increase ROPI.
Two ROPI drivers at High Tech appear out of balance relative to the company’s industry peers. First,
High Tech has 20% of its net operating assets tied up in working capital, compared to just 15% for the peers. By optimizing the supply chain at High Tech, the company will reduce its net operating asset base. This will result in a decreased “charge” against NOPAT in the ROPI equation. Second, High
Tech does not appear to be maximizing its capital structure relative to its peers. As CFO, increasing the amount of debt carried on the balance sheet to a reasonable level will decrease the WACC component in the ROPI equation. Again, this too will result in a smaller “charge” against NOPAT for
ROPI calculation. It is important to note that High Tech should not experience a significant increase in its cost of equity due to the addition of reasonable leverage; at a 34% debt to cap level, High Tech would expect its cost of equity to mirror that of its close industry peers.
Test Bank, Module 14
©Cambridge Business Publishers, 2013
14-25