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