Solution Manual - Valuation Using Financial Statements 2nd Edition by Gregory A. Sommers

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2023

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Valuation Using Financial Statements 2nd Edition Gregory A. Sommers 2023

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Valuation Using Financial Statements 2nd Edition by Gregory A. Sommers.

ISBN-10 1618533630 ISBN-13 978-1618533630

Solution Manual for Valuation Using Financial Statements 2nd Edition by Gregory A. Sommers

ISBN-10 1618533630 ISBN-13 978-1618533630

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TABLE OF CONTENTS PART 1 Framework Chapter:1 A framework for business analysis and valuation using financial statements

PART 2 Business analysis and valuation tools Chapter:2 Strategy analysis Chapter:3 Overview of accounting analysis Chapter:4 Implementing accounting analysis Chapter:5 Financial analysis Chapter:6 Prospective analysis: Forecasting Chapter:7 Prospective analysis: Valuation theory and concepts Chapter:8 Prospective analysis: Valuation implementation

PART 3 Business analysis and valuation applications Chapter:9 Equity security analysis Chapter:10 Credit analysis and digress prediction Chapter:11 Mergers and acquisitions Chapter:12 Communication and governance

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SM-Valuation Using Financial Statements 2E by Sommers(2024)

Chapter 1 The Link between Valuation and Financial Statement Analysis QUESTIONS 1.

Understanding the Business Environment Reformulation of the Financial Statements Financial Statement Analysis Forecasting Future Payoffs Calculating Value

2.

The goal of every business decision should be the maximization of shareholder value. If we do not understand valuation, it is very hard to determine the impact of potential choices.

3.

Potential processes include organizing information in line with Porter’s value chain, Porter’s five forces, or as analyzing SWOT.

4.

To be able to reformulate (separate operating from financial activities) we must understand the business activities of the company. Something that is financial for a manufacturer could be part of enterprise operations for a company in the financial industry. Our outstanding of the information gained in financial statement analysis will be highly dependent on the degree to which we have understood the company. We cannot compare two companies unless we understand the differences in their approach that may have led to differing operating results. Finally, our forecasts will directly depend on our understanding of the company, its’ plans, and the impacts of outside forces on the company. The reasonableness of our forecasts will be directly driven by the understanding we have arrived at about the company. Thus in each of these three steps we see a direct impact of the extent to which we have gained an understanding of the company.

5.

Reformulation is the process of separating the operations from the financial activities.

This will be beneficial because the focus of valuation is generally on operations where value is created.

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6.

Accounting-based valuation models as based on readily available information from reported financial statements prepared in accordance with GAAP. Earnings, a focus of financial market participants, is at the core of accounting-based models and is what most analysts forecast. Additionally, accounting-based valuation models are mathematically the same as cash-flow based valuation models. Differences in valuation are due to the estimates used in the respective models. With accounting-based estimates, the analyst is using estimates that commonly used (e.g., sales, earnings, asset turnover).

7.

Generally speaking, value is created through a firm’s operating activities (e.g., the buying and selling of goods and services), not through its financing activities (e.g., borrowing debt or issuing equity). The firm’s enterprise operations lead to the firm’s profitability and growth, which determines whether value is created or destroyed.

8.

Valuation models are based on estimates of future payoffs discounted back to the valuation date. Various future payoffs can include free cash flows, earnings per share, residual income and dividends.

9.

As a firm moves through the various life cycle stages, the expected profitability and growth changes along each stage. For example, as a start-up, a firm is not currently profitable, but may have growth opportunities leading to expected profitability in the future. These expectations impact the amount, timing and uncertainty of future payoffs used in the fourth step of valuation, forecasting future payoffs. Similarly, a firm in the Decline stage may be currently profitable, but with expected declining sales growth along with lower profit margins. These expectations are reflected in estimating future payoffs as well.

10.

Often referred to as the submarine problem, cash flow-based valuation models require firms with negative free cash flows to have a positive free cash flow by the end of the forecast horizon. An accounting-based model provides an alternative for such situations.

In many instances, negative free cash flows are the result of intensive growth in which investments swamp any operating cash flows (e.g., Netflix). While cash flow-based models treat investments as a reduction in valuation, accounting-based models allow for such investments to increase firm value.

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Valuation Using Financial Statements, 2nd Edition

Prof.Exams

SM-Valuation Using Financial Statements 2E by Sommers(2024)

EXERCISES 11.

These companies are a part of the specialty eateries industry. This industry consists of limited and quick service restaurants, cafes, bakeries, coffee shops, and juice bars that generally operate in the retail sector. As such, sales for the industry depend on consumer discretionary spending and overall retail performance in the US and internationally. The industry is characterized by intense competition—for retail locations, customers and low-price, high-quality goods—and adaptability to changing consumer preferences. The specialty eateries industry can be slightly narrowed into “fast casual” to more appropriately address these companies. According to Standard & Poor’s report “Industry Surveys Restaurants,” fast casual is a category in the restaurant industry in which companies offer higher quality food and beverage offerings at a lower price than full-service restaurants.

12.

Items discussed may include: • The industry is fragmented with large companies possessing 45% of total revenue (Need to update) • Critical competitive issues: LOCATION, commodities, the snacker and nonalcoholic beverage markets • Industry driven by consumer spending—may be impacted during economic downturns • Supply Chain Management is extremely important—must have a good inventory management system to reduce risk and waste • Impeccable Customer Service is an expectation • Regulations can govern eateries in regard to building codes, food safety and labor relations as well as health, fire, and safety regulations • As CMG has experienced, reputational effects due to food safety issues with the E. coli outbreaks • Important to take note of shifting consumer health attitudes • Volatile commodity prices for items such as coffee, sugar, chocolate, dairy, etc.

• Lack of control over franchisees • Quality and customer service Limited growth opportunities • Real estate market conditions • Franchise model versus company owned model

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13.

Items discussed may include: • • •

14.

Extent of franchising. Chipotle no longer franchises its stores while Del Taco actively markets its franchise opportunities.

Geographic concentration. Chipotle is expanding into Canada and Europe while Del Taco operates in a limited US geography.

Chipotle does not offer drive-thru except in a few locations.

Having an understanding of the business environment and where each company falls within the value-chain provides the analyst with possible reasons for the differences in the respective gross margins.

Gildan manufactures and sells to wholesale distributors, who then sell the Gildan products to companies that embellish or imprint with their designs and logos. The final markets are educational institutions, mass merchants, dollar stores, price clubs, department stores and sports specialty stores. For lululemon, they do not operate any manufacturing facilities, rather they outsource their fabrics and manufacturers. The company sells its product in company-owned stores as well as direct to consumer. That is, lululemon is marketing its brand and the related lifestyle experience through their activewear. Gildan is a commodity business with traditionally lower margins while lululemon is a marketing company whose brand image allows for a higher gross margin percentage.

15.

Understanding that the business environment and the firm’s operating strategies will change over time will help explain the differences in the gross margin over time.

• • • • • • • • • •

Potential explanations that can impact either sales or cost of goods sold include: Change in product mix (higher/lower margin items sold) International expansion where, for lululemon, brand awareness is lower Changes in input prices (e.g., commodity price changes, new manufacturing facilities) Changes in technology through the value chain and final product Foreign currency fluctuations Strengthening/weakening of the brand Changes in consumer preferences New entrants Understanding how ratios change over time allows the analyst to develop better forecasts of future payoffs regarding amounts, timing and uncertainty.

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Valuation Using Financial Statements, 2nd Edition

Prof.Exams

SM-Valuation Using Financial Statements 2E by Sommers(2024)

CONTINUING EXAMPLES 16.

Using information drawn from the companies’ annual reports and investor relation websites: General Mills and Kellogg are multi-billion companies that manufacture and sell branded consumer packaged foods worldwide. General Mills has eight brands with sales over $1 billion: Cheerios, Yoplait, Nature Value, Haagen-Daz, Old El Paso, Betty Crocker, Pillsbury and its latest acquisition, Blue Buffalo. Kellogg has billiondollar brands with Frosted Flakes, Special K, Pringles and Cheez-It. Oth significant Kellogg’s brands include Eggo, Pap-Tarts, Corn Flakes, Rice Krispies and NutriGrain.

General Mills manufactures its products in 13 countries that are marketed in more than 100 countries through mass merchandisers, grocery stores, membership club stores, drug stores, department stores, salons, high-frequency stores, and other retail outlets, as well as through other distributors and e-commerce. Kellogg manufactures its products in 21 countries, which are marketed in over 180 countries through similar channels.

Operating in a competitive mature industry, organic sales growth is in the singledigits for both companies. Their business models rely on continued growth and success of existing brands and products, as well as adapting to changes in consumer tastes and preferences. The markets and industry segments in which they offer their products are highly competitive.

17.

In analyzing Porter's Five Forces Model, we may classify the industry as having: High industry competition. The ultimate customers for the consumer goods desire the best price for the best experience; that is a good mix of price and functionality. As the companies within the industry are continually trying to innovate or remarket their products there is a high level of competition. Further, the retailers of these products have limited shelf space and thus getting your product in front of the ultimate customer can be an issue. The role of e-commerce is beginning to change the competitive landscape.

Moderate bargaining power of buyers. Both General Mills and Kellogg have higher strong bargaining power as the ultimate customer may expect to see their product available. General Mills and Kellogg have eight of the ten largest cereal brands in the U.S. by sales. (Statista, 2017). However, they have little bargaining power with the ultimate customer as consumers are free to switch amongst competing brands at any time particularly as other competitors continue to refine or innovate products.

Continued

Solutions Manual, Chapter 1

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Low bargaining power of suppliers. Due to the size of these companies, General Mills and Kellogg have a large number of suppliers with whom they work. Few of these suppliers would be able to significantly impact the industry through its demands. Also, as manufacturers many of the items purchased are, essentially, raw materials which usually are available through a variety of sources.

High threat of substitution. The ultimate customer can always choose to go to a competitor if unsatisfied. Quoting from General Mills s most recent MD&A: “We remain focused on our Consumer First strategy and our global growth priorities to further improve our topline momentum.” (GIS 2018 Annual Report, p. 20).

Low threat of entry. The required investment costs for product development, equipment, and distribution channels are very high. It would take significant investment and resources for a company to enter this industry and be able to compete with these firms.

18.

Items discussed may include: • •

•

• •

19.

Specific product types offered (General Mills recently acquired Blue Buffalo, which is in the pet food category).

Pricing power – Given the strength of the strong brand names, General Mills commands a higher average price per weight (e.g., ounce or pound) over its rivals including Kellogg. (Morningstar Equity Analyst Report, August 2, 2019).

Ability to respond to changes in consumer tastes and preferences – General Mills’ go-to-market process allows the company to quickly introduce new concepts E-commerce opportunities – General Mills anticipates its e-commerce sales will exceed $1 billion in FY 2020 while Kellogg has limited e-commerce sales.

Manufacturing approaches – Differences may be found in the extent of outsourcing of production to other companies or the use of overseas facilities.

A review of cash flows by operating, investing and financing provide a sense of which life cycle stage a company is operating.

Based on the 2018 annual reports, the following cash flows are: Operating Investing Financing

General Mills Positive Negative Positive*

Kellogg Positive Negative Negative

*General Mills acquired Blue Buffalo for $8.0 billion cash financed by $6.0 billion in debt, $1.0 billion in equity and cash on hand. In prior years, General Mills cash flows from financing were negative. A review of the past three years (2016 – 2018) statement of cash flows shows the General Mills had negative cash flows from financing in 2016 & 2017.

Both General Mills and Kellogg are in the Mature stage of a firm’s life cycle although General Mills is extending its reach into new markets.

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Valuation Using Financial Statements, 2nd Edition

20.

Thor Industries and Winnebago operate in the recreational vehicle (RV) manufacturing industry. The primary types of RVs are towable and motorized and include motor homes, travel trailers, fifth-wheel trailers, folding campers and truck campers. The industry has grown revenues by an average of 7.6% over the past five years to total market revenue of $23.3 billion in 2018. This growth is due to increased disposable income along with greater consumer confidence. The industry is characterized by a few large players including Thor (35%) and Winnebago (7.5%). The primary demographic consumer, Americans aged 50 or older, is expected growth from 115.2 in 2018 to 123.9 million in 2023. Most RV production remains in the U.S. with limited exports to foreign markets (approx. 10% of industry revenues). Factors impacting future growth include access to credit, price of oil, and the strength of the US dollar.

21.

Porter's Five Forces Model may classify the industry as having: High industry competition. The RV manufacturer industry had a moderate level of industry concentration with the four largest companies accounting for less than 70% of the total industry revenue. With recent mergers, the industry is becoming increasingly concentrated. Competition by RV manufacturers is on price and enhanced product features. Externally, non-RV competition comes from international travel and other forms of domestic travel (e.g., airplane or car) and domestic vacations (e.g., cruises, amusement parks, etc.).

Moderate bargaining power of buyers. RVs are sold through dealers to the endconsumer. The end-consumers are either retirees or young families with consumers aged 35 years or older representing two-thirds of the total industry revenue. As these families increase their disposable income and/or enter retirement, they are loyal and devoted customers for life. Demand is impacted economic activity and seasonality.

Customers willing to defer purchases to the winter months have better bargaining position than during the high spring/summer season.

Moderate bargaining power of suppliers. The level of capital intensity is low as RV manufacturers invest $0.05 in capital for dollar in labor. There is little automation in the manufacturing process. Additionally, RV manufacturers use subassemblies to better manage their supply chain and ability to adapt to changing market demands.

Moderate threat of substitution. RV customers tend to be loyal. However, there are many non-RV substitutes, such as cruises, vacations by car/hotel, AirBNB, air travel with rental cars, etc.). Also, the used RV market is a threat of substitution to the RV manufacturer.

Moderate threat of entry. There is significant initial capital costs into a competitive industry that is primarily dominated by four major firms. While capital intensity and technological change are low, the growth of the RV manufacturer industry is limited with estimated revenue growth to be in the low single digits.

Solutions Manual, Chapter 1

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22.

First, the RV manufacturing is dependent on the economic cycle as RV vehicles are discretionary purchase. When the economy is doing well and consumers have confidence, disposable income and access to the credit, the industry does well.

Alternatively, in a weak economy, the industry suffers from reduced demand.

Second, The RV manufacturer sells to a dealer network who sells to the end consumer.

There is a reliance on a healthy dealer network. Unlike the RV manufacturer industry dominated with several large well capitalized companies, the RV dealer market is highly fragmented. The impact of economic downturn is greater for these smaller, less capitalized companies. The RV dealers purchase and hold the RVs for resale; thus, this places additional pressure on the dealers during an economic slowdown.

https://www.statista.com/statistics/252752/wholesale-shipments-of-recreational-vehiclesin-the-us/ Third, there are many alternatives to RV’ing including cruises, travel by car, and international travel. The alternatives and the RV manufacturers are impacted by global issues such as the world price of oil, the trade-weighted index, access and cost of credit, and the strength of the US dollar. These macro factors will impact demand for RVs as well as its alternatives.

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Valuation Using Financial Statements, 2nd Edition

23.

Based on the most recent financial statements for Thor Industries (THO) and Winnebago (WGO), determine the life cycle stage based on the classification system of Dickinson (2011)? What is a potential implication for the valuation process?

Thor exhibits positive operating, negative investing, and negative & negative financing cash flows. Thus, Thor is in the mature phase but continues to grow. Winnebago also exhibits positive operating, negative investing, and negative & positive financing cash flows so WGO would also be considered to in the mature phase as well with continued growth.

Both companies have made significant acquisitions over the past few years. Thor acquired a competitor, Jayco, and Winnebago acquired Grand Design, manufacturer of towable RVs. These acquisitions suggest there is on-going consolidation within the industry. Additionally, Winnebago purchased Chris-Craft, a powerboat manufacturer, which implies that WGO is expanding its portfolio of products.

One potential implication is that forecasting will need to consider both organic and acquisitive growth for both companies.

Solutions Manual, Chapter 1

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Chapter 2 Role of Accounting QUESTIONS 1.

The most important measure for outsiders as viewed by management is earnings.

However, when estimating value the measure used depends on the process employed.

In valuation models, the most commonly used measure has historically been cash flows; that is, the discounted cash flow (or free cash flow) model is used. When estimating value using market based models the most common valuation method utilizes earnings often in the form of a Price-to-Earnings ratio.

2.

The difference between cash flows and earnings is accruals. Accruals are adjustments made in accounting to adjust the timing of revenues and expenses to reflect the economics rather than the timing of the cash flows. An example is when an employee works for the company in the last month of 2019 but is not paid until early 2020. The accrual captures the expense in 2019 to recognize the economic event even though the cash flow to the employee will not occur until 2020.

3.

Short answer is no. Given that over time the cash flows and earnings are the same, either can be used for valuation if done properly.

4.

Both operating and financial activities are intermingled on the U.S. GAAP financials. For instance, the income statement reports both sales revenue (operations related) and interest expense (financing related). Similarly, the balance sheet reports both inventory (operations related) and bonds payable (financing related).

5.

FCFt≡NOPAT t + NOAt −1−NOAt ¿ NOPAT t −( NOA t −NOAt −1 ) ¿ NOPATt − Δ NOAt

Solutions Manual, Chapter 2

(2.2)

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6.

The statement of cash flows omits some items that are free cash flows from operations but do not involve actual cash. For example, a purchase of a building by borrowing from the bank is a free cash flow into the operations from a credit holder and thus is a FCF. However, U.S. GAAP does not show this transaction in the statement of cash flows instead disclosing it as a significant non-cash transaction in the footnotes. As the building is an operating asset we would see this transaction reflected in Equation 2.2 as an increase in the NOA of the company.

7.

Free cash flows represent the cash generated from operations after funding the investments made in operating activities. The free cash flow is available to (1) hold as a financial asset, (2) pay creditors and debtors, or (3) distribute to shareholders as a dividend or share repurchase.

Free cash flows are positive when the cash generated from operations is greater than the investments in operating activities. Alternatively, negative free cash flows occur when the cash generated from operations is insufficient to fund the investments in operating activities. This results in cash being provided by creditors or shareholders.

Mathematically, free cash flow equals cash flow from operations minus net cash investments in operating activities or FCF = CFO – net cash investments in operating activities.

8.

The difference between NOPAT and cash flows from operations are the operating accruals. By removing the accruals from NOPAT (e.g., change in accounts receivable from sales) reveals the underlying cash flows from operating activities. The accruals are typically represented as the change in the related balance sheet account, while other accruals are non-cash items (e.g., depreciation, amortization, stock-based compensation).

Mathematically, net operating profit after tax equals cash flows from operations plus/minus operating accruals or NOPAT = CFO +/- Operating Accruals

9.

The difference between the change in net operating assets (NOA) and net cash investments in operating activities are the operating accruals. The change in the net operating assets reflects both the additional net cash investment and the change in the operating accruals. The net cash investment in operating activities can be additional (reduction in) working capital or the acquisition (sell) of operating assets, such as buildings and equipment. A change in operating accruals, such as an increase (decrease) in accounts receivable or deferred revenues, impacts the change in net operating assets.

The change in net operating assets can be expressed as NOA = CFIO +/- Operating Accruals.

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Valuation Using Financial Statements, 2nd Edition

10.

NOA = net cash investments in operating activities +/- Operating Accruals NOPAT = CFO +/- Operating Accruals NOPAT - NOA = CFO +/- Operating Accruals – (net cash investments in operating activities +/- Operating Accruals) NOPAT - NOA = CFO – net cash investments in operating activities NOPAT - NOA = FCF

11.

In a valuation, the analyst needs to understand how the firm creates value. Generally, financing activities do not create value. For example, typical financing activities such as borrowing money, repaying debt or issuing dividends do not create value. A firm creates value through its operating activities (e.g., the buying and selling of goods and services).

12.

Accounting earnings better reflect economic reality than cash flows. The earnings process of recognizing revenues when earned and matching expenses in the period when the related revenue is recognized more closely follow the economics of the firms.

Cash flows can occur in different periods than the relevant economic event. For example, purchase a building for cash that will have a 40-year useful life or accrue costs incurred as inventory for long-term construction projects.

Solutions Manual, Chapter 2

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EXERCISES 13.

a.

Initial Year 1 Year 2 Year 3 Total

Accounting Earnings $0 $ –80,000 $ –80,000 $ –80,000 $ –240,000

Cash Flows $ –240,000 $0 $0 $0 $ –240,000

November 2020 December 2020 January 2021 Total

Accounting Earnings $0 $ 300 $ 300 $ 600

Cash Flows $ 600 $0 $0 $ 600

b.

14.

a. FCF NOPAT ΔNOA

$0 $0 $0

There is no cash flow to credit or equity holders There is no revenue or expense Current assets increase by $700 and current liabilities increase by $700 therefore there is no change in net operating assets

$0 = $0 – $0 b. FCF NOPAT ΔNOA

$0 $1,200 $1,200

There is no cash flow to credit or equity holders Revenue of $1,900 less expense of $700 Increase in operating cash of $1,900 and reduction of inventory by $700

$0 = $1,200 – $1,200 Note that if the cash was assumed “extra” to be distributed to debt or equity holders and therefore a financial item, the equation would be: FCF NOPAT ΔNOA

$1,900 $1,200 $(700)

Cash outflow of $1,900 Revenue of $1,900 less expense of $700 Reduction of inventory by $700

$1,900 = $1,200 – $(700)

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Valuation Using Financial Statements, 2nd Edition

c. FCF NOPAT ΔNOA

$0 $1,200 $1,200

There is no cash flow to credit or equity holders Revenue of $1,900 less expense of $700 Increase in receivable of $1,900 and a reduction of inventory by $700

$0 = $1,200 – $1,200 d.

FCF NOPAT ΔNOA

$0 $0 $0

There is no cash flow to credit or equity holders There is no revenue or expense Increase in operating cash of $1,900 and reduction of accounts receivable by $1,900

$0 = $0 – $0 Note that if the cash was assumed “extra” to be distributed to debt or equity holders and therefore a financial item, the equation would be: FCF NOPAT ΔNOA

$1,900 $0 $(1,900)

Cash outflow of $1,900 There is no revenue or expense Reduction of accounts receivable by $1,900

$1,900 = $0 – $(1,900) 15.

a. FCF NOPAT

$0 $0

ΔNOA

$0

There is no cash flow to credit or equity holders There is no revenue or expense as dividends do not affect income There is no change in NEA as dividends payable is a financing obligation

$0 = $0 – $0 b. FCF NOPAT ΔNOA

$450 $0 $(450)

Cash outflow of $450 There is no revenue or expense Reduction of operating cash by $450

$450 = $0 – $(450) c. FCF NOPAT ΔNOA

$0 $(225) $(225)

There is no cash flow to credit or equity holders One year of insurance expense ($675 / 3) Increase in prepaid expense for two years of insurance expense ($675 / 3 * 2 = $450) and reduction in operating cash by $675

$0 = $(225) – $(225) d. FCF NOPAT ΔNOA

$0 $(225) $(225)

There is no cash flow to credit or equity holders One year of insurance expense Decrease in prepaid expense

$0 = $(225) – $(225)

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16.

a. Net operating assets (NOA) is defined as the operating assets less the operating liabilities.

The operating assets are Cash, Accounts receivable, Inventory Property and equipment, net, Goodwill and Other operating assets. The operating liabilities are Accounts payable, Accrued expenses and other and Unearned revenues.

NOA2019 = $34,060 and NOA2020 = $37,380. b. Free cash flow equals NOPAT less the change in NOA FCF = $3,150 – ($37,380 - $34,060) FCF = ($170)

17.

a. NOA2019 = $48.700 – 27,900 = $20,800 NOA2020 = $57,300 – 31,300 = $26,000 NFL2019 = $27,900 – 11,600 = $7,800 NFL2020 = $31,300 – 13,500 = $11,900 CSE2019 = $20,800 – 7,800 = $13,000 CSE2020 = $26,000 – 11,900 = $14,100 b. FCF = NOPAT - NOA = $2,550 – ($26,000 - 20,800) = $2,550 – 5,200 = ($2,650) FCFFIN = FEAT - NFL = $1,050 – ($11,900 – 7,800) = $1,050 – 4,100 = ($3,050) FCFEQ = CI - CSE = $1,500 – ($14,100 – 13,000) = $1,500 - $1,100 = $400

18.

a. Free cash flows from/to shareholders are the changes in common shareholders’ equity other than comprehensive income. For Cooper’s Corp., the changes to common stock equity were: Share repurchase Dividends Share issuance Free cash flows – Equity

$10 million paid to shareholders $ 7 million paid to shareholders $ 3 million received from shareholders $14 million outflow

b. Equation 2.1 states that FCF = FCFFIN + FCFEQ. Free cash flow (FCF) is $18 million and FCFEQ is $14 million outflow, then FCFFIN is $4 million outflow to creditors/debtors.

The $18 million in FCF generated from Cooper’s operating activities are invested in financial assets (an outflow of cash from the company), paid to creditors/debtors (an outflow of cash from the company) or distributed to equity holders (an outflow of cash from the company).

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Valuation Using Financial Statements, 2nd Edition

19.

Free cash flows from/to creditors/debtors are defined as FCFFIN = FEAT - NFO. FEAT = NOPAT – CI or $5 million ($50 million - $45 million).

The change in NFL is due to the changes in the financial assets (marketable securities) and financial obligations (short-term and long-term debt). NFL = FL - FA or ($30 million - $60 million) – ($38 million - $16 million) = $8 million decrease.

FCFFIN = FEAT - NFL = $5 million + $8 million = $13 million outflow

Solutions Manual, Chapter 2

© Cambridge Business Publishers, 2021 2-7

CONTINUING EXAMPLES 20.

a. Income Statement Revenues Depreciation Gain on sale Net income

1 600 (412)

2 700 (412)

3 750 (412)

4 625 (412)

188

288

338

213

5 500 (412) ― 88

Notes: Depreciation = (Cost – Residual Value) / # of years = (2,300 – 240) / 5 = 412 Expected Gain = Est. Selling price – (Cost – Accum Deprec) = 240 – (2,300 – 2,060) = 0 b. Statement of Cash Flows 0 Contribution to purchase Revenues Proceeds from disposition Distributions

1

2

3

4

5

600

700

750

625

500

625

240 740

(2,300)

(2,300) 600

700

750

c. Statement of Changes in Equity 0 1 2 3 4 5 Beginning book value of project ― 2,300 1,888 1,476 1,064 652 Plus net income ― 188 288 338 213 88 Less distributions 2,300 (600) (700) (750) (625) (740) Ending book value of project 2,300 1,888 1,476 1,064 652 ―

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Valuation Using Financial Statements, 2nd Edition

21.

a. Income Statement 1 Revenues Depreciation Gain on sale Net income

2 2,100 (2,200)

(100)

3 2,500 (2,200)

300

2,400 (2,200) ― 200

Notes: Depreciation = (Cost – Residual Value) / # of years = (7,000 – 400) / 3 = 2,200 Expected Gain = Est. Selling price – (Cost – Accum Deprec) = 400 – (7,000 – 6,600) = 0 b. Statement of Cash Flows 0 Contribution to purchase Revenues Proceeds from disposition Distributions

1

2

3

(7,000) 2,100 (7,000)

2,100

2,500

2,400 400 2,500 2,800

c. Statement of Changes in Equity Beginning book value of project Plus net income Less distributions Ending book value of project

Solutions Manual, Chapter 2

0 1 2 3 ― 7,000 4,800 2,600 ― (100) 300 200 7,000 (2,100) (2,500) (2,800) 7,000 4,800 2,600 ―

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4.

Chapter 3 Reformulation to Identify Operating Activities QUESTIONS 1.

The goal of reformulation is to isolate the financial information of the enterprise operations by separating it from the financial activities of the company. This will allow us to analyze, forecast and value the operating activities directly.

2.

The firm’s enterprise operations are the source of its value creation. By analyzing and then forecasting the firm’s operating activities, the foundation for valuing the firm is provided. The firm’s financing activities, generally, do not create value. That is, the decision to finance operating assets with funds from debt or equity does not impact the value created by the operating assets.

3.

We begin the reformulation process by separating the balance sheet in order to identify NOA and NFL. Then based on that separation, the related revenues and expenses are separated in order to compute NOPAT and FEAT. Note that the separation of revenues and expenses includes consideration of the items contained in other comprehensive income.

Is this item associated with operating activities? If yes, it will be reported as part of NOA and if not, it will be included in NFL as a financial item.

5.

Companies at times may stockpile cash. They may do so rather than paying dividends or paying down outstanding debt in order to provide a safety cushion. Additionally, they may want to keep cash on hand in case an opportunity arises in the future. The result is that companies may have cash not currently employed in operating activities. Often times this amount is invested in low risk securities.

Solutions Manual, Chapter 3

© Cambridge Business Publishers, 2021 3-1

6.

By default, when we are unable to classify, we will choose to include the item in operating activities. This is often necessary when a company has aggregated items together in manner that may obscure the components. A common example would be an item labeled “Other assets.”

7.

This is shown as an obligation as it is a financing claim on the enterprise. In that way, it is similar to a bond payable or a loan from a bank. The preferred shareholders must be paid prior to the common shareholders.

8.

What is the rationale behind classifying non-controlling interest as a part of NFL? Non-controlling interest presents the equity interest of non-controlling (minority) shareholders of a firm’s subsidiary. While non-controlling shareholders have a claim on the subsidiary’s net assets and earnings as does the parent’s shareholders, they are similar to debt holders in their claims against the firm. Accordingly, the non-controlling interests are treated as a financial liability and reported as part of NFL.

9.

Is this item associated with operating activities? If yes, it will be reported as part of NOPAT and if not, it will be included in FEAT as a financial item.

10.

Taxes are split between operating (as a part of NOPAT) and financial (as a part of FEAT) activities. The goal is to show the amount of tax that would have been reported absent financial expenses when calculating NOPAT.

11.

The primary difference between income tax expense reported on the income statement and the tax liability reported on the tax return is due to changes in the deferred tax accounts long with changes in the valuation allowance. Most deferred tax accounts arise from operating activities as does the need for a valuation allowance. The operating activities drive the difference reported income taxes and the tax liability. To maintain the drivers for the difference, remove the tax impact of financial activities first.

12.

To fully explain financial statement articulation among the balance sheet, income statement and statement of cash flows, comprehensive income – not net income – is required. That is, some balance sheet changes (e.g., foreign currency translation gains and losses) flow through comprehensive income, but not net income.

13.

The financing division is set up to support the company’s sales efforts and could be substituted by competing businesses (e.g., banks, leasing companies). If the supporting assets and liabilities are financial assets and liabilities, which are generally reported at fair value, then these items are part of NFL. However, if these items include assets and liabilities that would not be reported at fair value, then classify as part of operations so that they are part of the valuation.

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Valuation Using Financial Statements, 2nd Edition

EXERCISES 14.

Cash and cash equivalents – S Accounts receivable – O Inventory – O Prepaid expenses and other current assets - ?

Income tax receivable – O Investments – F Leasehold improvements – O Restricted cash – ?

Other assets - ?

Goodwill – O Accounts payable – O Accrued payroll and benefits – O Accrued liabilities - ?

Unearned revenue – O Income tax payable - ?

Deferred rent – O Deferred income tax liability - ?

Other liabilities - ?

Preferred stock – F (if they had issued some shares) Common stock – CSE Additional paid-in capital – CSE Treasury stock – CSE Accumulated other comprehensive income – CSE Retained earnings – CSE

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15.

Cash and cash equivalents – S Marketable investments - F Inventories – O Accounts receivables, net and other – O Property and Equipment – O Goodwill – O Other assets - ?

Accounts payable – O Accrued expenses and other – ?

Unearned revenue – O Long-term debt – F Other long-term liabilities - ?

Preferred stock – F (if they had issued some shares) Common stock – CSE Additional paid-in capital – CSE Retained earnings – CSE Treasury stock – CSE Accumulated other comprehensive income – CSE

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Valuation Using Financial Statements, 2nd Edition

16.

Cash and cash equivalents – S Accounts and notes receivable, net – O Prepaid expenses and other – ?

Assets held for sale – O Property and equipment, net – O Brands – O Contract acquisition costs and other – O Goodwill – O Equity method investments – O Notes receivable, net – F Deferred tax assets – ?

Other noncurrent assets – ?

Current portion of long-term debt – F Accounts payable – O Accrued payroll and benefits – O Liability for guest loyalty programs – O Accrued expenses and other – ?

Long-term debt – F Liability for guest loyalty programs – O Deferred tax liabilities - ?

Deferred revenue – O Other noncurrent liabilities – ?

Class A common stock – CSE Additional paid-in capital – CSE Retained earnings – CSE Treasury stock, at cost – CSE Accumulated other comprehensive income – CSE

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17.

Revenue – O Food, beverage and packaging – O Labor – O Occupancy – O Other operating costs – O General and administrative expenses - ?

Depreciation and amortization – O Pre-opening costs – O Impairment, closure costs, and asset disposals – O Interest and other income (expense), net – F Provision for income taxes – S Foreign currency translation adjustments – O Unrealized gain (loss) on available-for-sale securities – F Tax benefit (expense) – S

18.

Net product sales – O Net Service sales – O Cost of sales – O Fulfillment – O Marketing – O Technology and content – O General and administrative – ?

Other operating expense, net – O Interest income – F Interest expense – F Other income (expense) – ?

Provision for income taxes – S Equity-method investment activity, net of tax – O Foreign currency translation adjustment – O Unrealized gains (losses) on available for sale securities – F Reclassification adjustment for losses (gains) included in “Other income (expense), net of tax – F

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Valuation Using Financial Statements, 2nd Edition

19.

Base management fees – O Franchise fees – O Incentive management fees – O Contract investment amortization - ?

Owned, leased, and other revenue – ? (Due to other revenue) Cost reimbursement revenue – O Owned, leased, and other-direct expenses – O Depreciation, amortization, and other – O General, administrative, and other – O Merger-related costs and charges – ?

Reimbursed expenses – O Gains and other income, net - ?

Interest expense – F Interest income – F Equity in earnings – O Provision for income taxes – S Foreign currency translation adjustments – O Derivative instrument adjustments, net of tax – O Unrealized (loss) gain on available-for-sale securities, net of tax – F Pension and postretirement adjustments, net of tax – F Reclassification of losses, net of tax – F

Solutions Manual, Chapter 3

© Cambridge Business Publishers, 2021 3-7

20.

Top-Down Approach Revenue Cost of goods sold SG&A expenses R&D expenses Equity share in sub. income Net operating profit before taxes Tax Expense: Tax Reported Tax benefit on FEAT

$10,000 (5,000) (2,800) (350) 275 2,125 500 125

Net operating profit after tax Financial expense after tax (FEAT): Losses on debt retirement Interest income Interest expense Financial expense before tax Tax benefit at 25%

625 $1,500

(150) 50 (400) (500) 125

(375)

Net Income

$1,125

Bottom-Up Approach Net Income

$1,125

Financial expense after tax (FEAT): Losses on debt retirement Interest income Interest expense Financial expense before tax Tax benefit at 25% Net operating profit after tax

© Cambridge Business Publishers, 2021 3-8

(150) 50 (400) (500) 125

(375) $1,500

Valuation Using Financial Statements, 2nd Edition

21.

The Income tax expense of $3,435 million represents the combined tax impacts for both operating and financial activities. To allocate the Income tax expense, begin with the tax impact on financial activities.

Financial expense before tax Statutory tax rate Tax shield from financial activities Income tax expense on operating activities: Reported Income tax expense + Tax shield from financial activities Income tax expense on operating activities

22.

$958 million 21.0% $201 million

$3,435 million 201 million $3,636 million

The Provision for income taxes of $10,481 million represents the combined tax impacts for both operating and financial activities. To allocate the Income tax expense, begin with the tax impact on financial activities. The financial income items are Interest and dividend income of $4,961 million and Interest expense of $3,576 million resulting in Financial income before tax of $1,385 million. Note, the financial income tax impact will result in an income tax expense from financial activities, not a tax shield.

Financial expense before tax Statutory tax rate Income tax expense financial activities

$1,385 million 21.0% $ 291 million

Income tax expense on operating activities: Reported Income tax expense - Income tax expense financial activities Income tax expense on operating activities

$10,481 million 201 million $10,280 million

Solutions Manual, Chapter 3

© Cambridge Business Publishers, 2021 3-9

CONTINUING EXAMPLES 23.

Amounts in millions Cash and cash equivalents Accounts receivable, net Inventories Other current assets Property, net Goodwill Other intangible, net Investments in equity companies Other assets Trade accounts payable Other current liabilities Deferred income taxes Pension liability Other Liabilities NOA

2015 251 1,344 1,250 391 3,621 4,968 2,268 456 716 (1,907) (1,362) (685) (946) (468) 9,897

2016 259 1,231 1,238 191 3,569 5,166 2,369 438 629 (2,014) (1,391) (525) (1,024) (464) 9,672

2017 257 1,389 1,217 149 3,716 5,504 2,639 429 1,027 (2,269) (1,474) (355) (839) (605) 10,785

2018 271 1,375 1,330 131 3,731 6,050 3,361 413 1,068 (2.427) (1,416) (730) (651) (504) 12,002

Amounts in millions Cash and cash equivalents Current maturities of long-term debt Note payable Long-term debt Noncontrolling interest NFL

2015 0 (1,266) (1,204) (5,289) (10) (7,769)

2016 21 (631) (438) (6,698) (16) (7,762)

2017 24 (409) (370) (7,836) (16) (8,607)

2018 50 (510) (176) (8,207) (558) (9,401)

Notes: Cash is allocated 2% of sales to operating activities and the balance to financial activities.

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Valuation Using Financial Statements, 2nd Edition

24.

Amounts in millions Net sales Cost of goods sold Selling, general and administrative expense Other income (expense), net Income taxes Earnings from unconsolidated entities Foreign currency translation adjustments, net of tax Cash flow hedges, net of tax Venezuela deconsolidation loss NOPAT

2016 12,965 (8,131) (3,351) (143) (377) 1 (254) (28) 63 745

2017 12,854 (8,155) (3,312) 526 (500) 7 79 6 0 1,505

2018 13,547 (8,821) (3,020) (90) (241) 196 (48) 8 0 1,531

Amounts in millions Interest expense Income taxes Net income attributable to noncontrolling interests Net experience gain Prior service credit Other comprehensive income attributable to noncontrolling interests, net FEAT

2016 (406) 142 (1) 18 2

2017 (256) 90 0 32 1

2018 (287) 60 (8) (11) 1

0 (245)

0 (133)

7 (238)

Notes: Allocation of income taxes assumes a 35% tax rate for 2016 & 2017 and 21% tax rate for 2018.

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25.

Amounts in millions Cash and cash equivalents Accounts receivable, trade Inventories, net Prepaid expenses and other Deferred income taxes, net Property, plant and equipment, net Goodwill Amortizable intangible assets, net Deferred income taxes, net Equity investments in joint venture Other assets Accounts payable Compensation and related items Product warranties Income and other taxes Promotion and rebates Product, property and related liabilities Other current liabilities Unrecognized tax benefits Deferred income taxes, net Other liabilities NOA

2015 80,136 244,052 246,115 8,323 59,864 234,045 312,622 169,018 0 0 11,722 (162,587) (51,984) (108,206) (11,000) (19,817)

2016 91,642 370,085 403,869 10,548 0 344,267 377,693 507,391 53,417 0 25,838 (263,774) (81,159) (201,840) (25,531) (40,452)

2017 144,939 453,754 460,488 11,577 0 425,238 377,693 443,466 92,969 0 38,398 (328,601) (100,114) (216,781) (51,211) (46,459)

2018 166,578 467,488 537,909 11,281 0 522,054 377,693 388,348 78,444 48,463 51,989 (286,974) (97,122) (264,974) (19,345) (59,133)

(10,892) (13,849) (11,945) (20,563) (27,218) 927,836

(15,969) (22,927) (9,975) 0 (38,615) 1,484,508

(16,521) (21,359) (10,263) 0 (45,082) 1,612,131

(17,815) (24,013) (12,446) 0 (59,148) 1,809,323

Amounts in millions Cash and cash equivalents Accounts receivable, other Note receivable Long-term debt Preferred stock – no par value NFL

2015 103,342 25,642 8,367 0 0 137,351

2016 118,260 22,454 0 (360,000) 0 (219,286)

2017 78,319 31,090 0 (145,000) 0 (35,951)

2018 108,671 19,747 0 0 0 128,418

Notes: Cash is allocated 2% of sales to operating activities and the balance to financial activities.

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Valuation Using Financial Statements, 2nd Edition

26.

Amounts in millions Net sales Cost of product sold Selling, general and administrative expense Impairment charges Amortization of intangible assets Other income, net Income taxes Loss from discontinued operations, net of tax NOPAT Amounts in millions Interest income Interest expense Income taxes FEAT

2016 4,582,112 (3,855,787)

2017 7,246,952 (6,203,369)

2018 8,328,909 (7,164,243)

(306,269) (9,113) (27,962) 1,181 (125,588)

(419,847) 0 (63,925) 5,382 (185,214)

(477,444) 0 (55,118) 3,964 (203,695)

(1,503) 257,071

0 379,979

0 432,373

2016 743 (1,592) 297 (552)

2017 923 (9,730) 3,082 (5,725)

2018 2,148 (5,187) 817 (2,222)

Notes: Allocation of income taxes assumes a 35% tax rate for fiscal 2016 and 21% tax rate for fiscal 2017 & 2018.

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27.

Amounts in millions Cash and cash equivalents Receivables, net Inventories Prepaid expenses and other assets Deferred income taxes Property, plant and equipment, net Goodwill Other intangible assets, net Deferred income taxes Other assets Accounts payable Income taxes payable Accrued compensation Product warranties Promotional Other current liabilities Deferred income taxes Unrecognized tax benefits Deferred compensation benefits and postretirement benefits Other Liabilities NOA Amounts in millions Cash and cash equivalents Investment in life insurance Current maturities of long-term debt Self-insurance Accrued on loss on purchase Accrued interest Long-term debt, less current maturities NFL

2015 19,530 66,936 112,165 6,882 9,995 37,250 1,228 0 21,994 9,313 (33,158) (2,314) (18,346) (11,254) (3,149) (5,818) 0 (2,511)

2016 19,505 66,184 122,522 6,300 0 55,931 1,228 0 18,753 7,725 (44,134) (19) (19,699) (12,412) (4,756) (5.236) 0 (2,461)

2017 30,942 124,539 142,265 11,388 0 71,560 242,728 228,440 12,736 5,493 (79,194) (7,450) (24,546) (30,805) (6,560) (6,503) 0 (1,606)

2018 2,342 164,585 195,128 9,883 0 101,193 274,370 265,717 0 10,290 (81,039) (15,655) (29,350) (40,498) (11,017) (11.269) (4,457) (1,745)

(57,090) 0 151,653

(26,949) 0 182,482

(19,270) (15,282) (1,078) (250) 693,079 812,946

2015 50,709 26,172 0 (6,242) 0 0

2016 66,078 26,492 0 (5,812) 0 0

2017 2018 5,003 0 27,418 28,297 (2,850) 0 (6,122) (12,262) (3,128) (3,095) (271,726) (291,441)

Notes: Cash is allocated 2% of sales to operating activities and the balance to financial activities.

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Valuation Using Financial Statements, 2nd Edition

28.

Amounts in millions Net revenues Cost of goods sold Selling General and administrative Transaction costs Amortization of intangible assets Non-operating income Provision for income taxes NOPAT Amounts in millions Postretirement health care benefit income Interest expense Provision for income taxes Amortization of prior service credit Amortization of net actuarial loss Increase in actuarial loss Plan amendment Change in fair value of interest rate swap FEAT

2016 975,226 (862,577) (19,823) (33,209) 0 0 457 (18,559) 41,515 2016 6,124 0 (2,143) (4,788) 1,010 (674) 17,701 0 17,230

2017 1,547,119 (1,324,542) (35,668) (55,347) (6,592) (24,660) 330 (34,483) 66,157 2017 24,796 (16,837) (2,786) (25,035) 9,705 (57) 3,903 (514) (6,825)

2018 2,016,829 (1,716,933) (49,850) (78,089) (2,177) (9,328) 494 (45,647) 115,239 2018 0 (18,246) 5,364 0 27 0 0 1,947 (10,908)

Notes: Allocation of income taxes assumes a 35% tax rate for fiscal 2016 and 21% tax rate for fiscal 2017 & 2018.

Solutions Manual, Chapter 28

© Cambridge Business Publishers, 2021 3-15

Chapter 4 Use of Additional Information to Enhance Reformulation QUESTIONS 1.

We seek to refine our estimates of NOA and NOPAT for forecasting and valuation.

Getting a cleaner split between the operating and financial activities will provide this.

There were several items in the chapter such as other assets that with additional information we will better understand what they are comprised of and if any amounts should be transferred from operating to financial.

2.

The starting point is usually the footnotes to the financial statements. These often contain additional details or breakdowns of the balances of some of the items on the face of the financials. An additional place to seek out information is the MD&A. While the MD&A section contains a great deal of forward-looking information useful in forecasting, the forward-looking information may be supported by historical information that provides additional information useful for reformulation. Additional sources may be company released information or press releases although this generally would assist in understanding the nature of operating activities rather than providing breakdown of financial statement items.

3.

Thus far, we have assumed the role of out an outsider considering a buy/sell/hold decision relative to the stock. If we are management, an insider, we would have a great deal of additional information available to us. This would allow us to arrive at a very accurate split between operating and financial activities. Some outsiders may have more information than is generally available. An example would be a lender who can ask more detailed questions than a general investor.

4.

No, it may not. There are times in accounting where items are combined and only the net amount is reported on the face of the financial statements. This may result in a need to recognize an additional implied asset or liability as the result of the additional information we find. The inclusion of these items can potentially alter the amount of NOA or NOPAT as well as cause changes in ratio analysis.

Solutions Manual, Chapter 29

© Cambridge Business Publishers, 2021 4-1

5.

The goal of splitting the tax provision is to allocate to NOPAT the amount of tax that would have been reported if the firm was only funded with equity. That is, we allocate to financial the amount of tax that would have been avoided had the firm not had any financial expense. This amount is referred to as the interest tax shield. To do so, the desired tax rate is the marginal tax rate on the financial expense. Note that this desired rate is unobservable.

6.

The marginal tax rate is the tax rate associated for an additional dollar of income. The effective tax rate is the income tax expense divided by pre-tax income from continuing operations. Topic 740, Accounting for Income Taxes, requires a rate reconciliation from the statutory rate to the effective tax rate. The rate reconciliation will capture how the effective tax rate will be impacted by book-tax differences, changes in the valuation allowance, tax credits and differences in tax rates over time.

7.

Numerous accounts have additional information that can help with refining the estimate of NOA and NOPAT that will provide better forecasts and valuation. Common accounts are pension and other postretirement benefits; property, plant and equipment; goodwill and intangible assets; inventory; income taxes; revenue by segment; accounts receivable; other assets and liabilities; and related expense for advertising and research and development.

8.

Occasionally, the footnote detail will not reconcile with the reported amounts on the balance sheet. To ensure the integrity of the total balances reported on the balance sheet, an implied asset or liability account is used to maintain balance.

For example, the accounting for income taxes permits companies to combine deferred tax accounts in with other accounts. Thus, it is not uncommon for the deferred tax accounts on the face of the financial statement not to reconcile with income tax footnote.

To reconcile the footnotes to the reported deferred tax accounts on the balance sheet, an implied asset or liability is created and added to the detailed information in the footnote so that the total amount of the detail matches the report amounts on the balance sheet. The implication is that the implied asset or liability is included with other assets or liabilities or some other place on the balance sheet.

9.

The service component is an operating activity as it represents the incremental pension expense resulting from an additional year of work provided by the plan participant. The other components, such as interest cost, expected return on plan assets, amortization of prior service cost, etc., are financial activities as these items represent the firm’s decision to defer compensation from direct payment to a pension plan.

© Cambridge Business Publishers, 2021 4-2

Valuation Using Financial Statements, 2nd Edition

EXERCISES 10.

11.

In the prior chapter, the Restricted cash balance is considered as uncertain whether it relates to operating or financing activities. The cash held by the paying agent for the SodaStream acquisition, which is part of PepsiCo’s operations is assigned as an operating activity. Similarly, the Accounts payable and other current liabilities is assigned a part of NOA because we lacked further breakdown in order to determine if any part of it was financial. A review of the supporting details results further assigns the elements from the two footnotes as follows: For the Restricted Cash footnote: Cash and cash equivalents Restricted cash Restricted cash included in other assets

$8,721 – Split $1,997 – NOA $51 – NFL

For the Supplement Financial Information footnote: Accounts Payable Accrued marketplace spending Accrued compensation and benefits Dividends payable SodaStream consideration payable Other current liabilities

$7,213 – NOA $2,541 – NOA $1,755 – NOA $1,329 – NFL $1,997 – NOA $3,277 – NOA

A review shows that the Accrued expenses components are reported in multiple footnotes. Footnote 1, Description of Business and Accounting Practices, describes the Accrued expenses as liability primarily related to leases and asset retirement obligations, payroll and related expenses, unredeemed gift cards, customer liabilities, current debt, acquired media content and other operating expenses. A review of the related footnotes identifies the following components of Accrued expenses: Return allowances (Footnote 1) $623 million – NOA Payroll related expenses (Footnote 1) 3,400 million – NOA Unredeemed gift cards (Footnote 1) 2,800 million – NOA Capital lease obligation, including interest (Footnote 7) 7,700 million – NFL Finance lease obligations, including interest (Footnote 7) 411 million – NFL This detail explains $14,934 million of the reported $23,663 million. This leaves $8,729 million as unidentified. Absent additional information, this unidentified portion is considered an operating activity and, as such, included in NOPAT.

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12.

In reviewing the components, the only items that would be classified as NFL are the deferred tax assets related to Stock-based compensation and Assets held for investment. Additionally, Amazon did not report any deferred tax asset or liability on the face of its balance sheet. For December 31, 2018, we need to recognize an implied asset in the amount of $3,784 million and an implied liability for $544 million. These additional increases in assets and liabilities were not readily apparent from the disclosures on the face of the financial statements.

13.

For Other assets, $266 ($185 + $81) & $371 ($286 + $85) would be included in NFL for 2018 and 2017.

For Other current liabilities, $149 ($107 + $1 + $41) & $150 ($74 + $1 + $75) would be included in NFL for 2018 and 2017.

For Other assets, $2,385 ($1,627 + $88 + $670) & $3,312 ($2,407 + $114 + $791) would be included in NFL for 2018 and 2017.

14.

Initially, the Cost of sales and Selling, general and administrative expenses would be included in NOPAT, no adjustment is needed as the service cost is an operating activity and is included in these accounts. The “Other pension and retiree medical benefits income (expense) represents the remaining components of the net periodic benefit cost included in FEAT. The additional information in the footnote confirms that the account is properly classified.

15.

The disclosure from the face of the financial statements was the amounts shown at the bottom of the disclosure in the footnotes as “Recognized in the balance sheet.” In reviewing the components, we would probably want to move the Investments, Interest and state benefits and Unrealized losses related deferred tax assets from NOA to NFL for Hyatt. Similarly, we would want to move the deferred tax liability arising from the Investments and Unrealized gains from NOA to NFL as well.

© Cambridge Business Publishers, 2021 4-4

Valuation Using Financial Statements, 2nd Edition

CONTINUING EXAMPLES 16.

Per Footnote 3, Goodwill and Other Intangible Assets:

Goodwill US Morning Foods US Snacks US Specialty North America Other Europe Latin America Asia Pacific

Intangible assets subject to amortization US Morning Foods US Snacks US Specialty North America Other Europe Latin America Asia Pacific

Intangible assets accumulated amortization US Morning Foods US Snacks US Specialty North America Other Europe Latin America Asia Pacific

2015

2016

2017

2018

131 3,568 82 456 431 76 224 4,968

131 3,568 82 457 376 328 224 5,166

131 3,568 82 836 414 244 229 5,504

313 3,568 82 830 392 218 829 6,050

2015

2016

2017

2018

8 42 5 45 3 10 116

8 42 5 40 36 10 141

8 42 22 45 74 10 201

8 42 24 43 63 428 608

2015

2016

2017

2018

8 16 4 11 6 2 47

8 19 4 14 6 3 54

8 22 5 18 10 4 67

8 25 6 20 12 16 87

Continued

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Intangible assets not subject to amortization US Morning Foods US Snacks US Specialty North America Other Europe Latin America Asia Pacific

17.

2016

2017

2018

1,625 158 416 2,199

1,625 176 383 98 2,282

1,625 360 434 86 2,505

1,625 360 415 73 2,840

2015

2016

2017

2018

889 261 44 1,204

80 306 52 438

196 96 78 370

15 161 176

Per Footnote 8, Debt:

Notes payable: US commercial paper Europe commercial paper Bank borrowings

18.

2015

a. The funded status provides the amount of net underlying assets and liabilities related to the plans.

From Footnotes 10 Pension Benefits & 11 Nonpension Postretirement and Postemployment Benefits: 2015

2016

2017

2018

Pension benefits Benefit obligation Plan assets Funded status

(5,316) (5,510) (5,648) (5,117) 4,584 4,544 5,043 4,677 (732) (966) (605) (440)

Postretirement benefits Benefit obligation Plan assets Funded status

(1,163) 1,084 (79)

(1,161) 1,136 (25)

(1,190) 1,292 102

(1,069) 1,140 71

Postemployment benefits Benefit obligation Plan assets Funded status

(108) (108)

(87) (87)

(43) (43)

(42) (42)

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Valuation Using Financial Statements, 2nd Edition

b.

Pension benefits Other assets Other current liabilities Other liabilities Postretirement benefits Other non-current assets Other current liabilities Other liabilities Postemployment benefits Other current liabilities Other liabilities

2015

2016

2017

2018

231 (17) (946) (732)

66 252 (11) (19) (1,021) (838) (966) (605)

228 (17) (651) (440)

(2) (77) (79)

17 (2) (40) (25)

144 (2) (40) 102

107 (2) (34) 71

(8) (100) (108)

(8) (79) (87)

(4) (39) (43)

(5) (37) (42)

c.

Pension benefits Service cost Interest cost Expected return on plan assets Amortization of unrecognized prior service cost Recognized net actuarial loss Curtailment and special termination benefits Defined contribution plans Postretirement benefits Service cost Interest cost Expected return on plan assets Amortization of unrecognized prior service cost Recognized net (gain) loss Curtailment Defined contribution plans Postemployment benefits Service cost Interest cost Amortization of unrecognized prior service cost Recognized net (gain) loss

2015

2016

2017

2018

114 206 (399) 13 303 (1) 40 276

98 174 (352) 13 323 1 36 293

96 164 (371) 9 (36) (151) 34 (255)

87 165 (361) 8 269 (30) 27 165

29 48 (100) (5) 112 14 98

21 39 (90) (9) (19) 17 (41)

18 37 (98) (9) (90) 3 16 (123)

18 36 (94) (9) 81 11 43

7 4 1 3 15

7 3 1 3 14

6 3 1 10

3 1 1 (5) -

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 4

4-7

d. 401k plan expense 2015 40

19.

2016 39

2017 41

2018 38

a.

Deferred tax assets US state income taxes Advertising and promotion-related Wages and payroll taxes Inventory valuation Employee benefits Operating loss, credit & other carryforwards Hedging transactions Deferred compensation Stock options Other Valuation allowance Deferred tax liabilities US state income taxes Hedging transactions Depreciation and asset disposals Trademarks and other intangibles

2015

2016

2017

2018

13 15 21 31 366

17 42 28 403

22 26 20 154

11 20 14 132

55 43 35 42 86 (630 644

181 38 41 31 (131) 650

239 42 25 33 71 (153) 479

270 10 20 31 26 (166) 368

43 345 576 964 (320)

34 48 51 318 208 602 332 1,005 588 (355) (109)

19 220 613 852 (484)

b.

Other current assets Other current liabilities Other assets Other liabilities

2015 227 (9) 147 (685) (320)

2016 170 (525) (355)

2017 246 (355) (109)

2018 246 (730) (484)

© Cambridge Business Publishers, 2021 4-8

Valuation Using Financial Statements, 2nd Edition

20.

Per Footnote 18, Reportable Segments:

US Morning foods US Snacks US Specialty Channels North America other Europe Latin America Asia Pacific

21.

2015 2,992 3,234 1,181 1,687 2,497 1,015 919 13,525

2016 2,917 3,197 1,207 1,593 2,383 772 896 12,965

2017 2,709 3,110 1,242 1,612 2,291 944 946 12,854

2018 2,643 2,957 1,235 1,853 2,395 947 1,517 13,547

2016 1,106 (8) 24 109 1,238

2017 1,250 (10) 23 126 1,217

a.

2015 193

2016 182

2017 148

2018 154

b.

2015 898

2016 735

2017 732

2018 752

c.

Trade Allowance for doubtful accounts Refundable income taxes Other receivables

2015 1,169 (8) 27 156 1,344

2018 1,163 (10) 28 194 1,330

d.

Raw materials Finished goods & materials in progress

2015 315 935 1,250

2016 315 923 1,238

2017 333 884 1,217

2017 339 991 1,330

e.

Deferred income taxes Other

2015 227 164 391

2016 191 191

2017 149 149

2017 131 131

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4-9

f.

2015 142 2,076 5,617 328 694 (5,236) 3,621

Land Buildings Machinery and equipment Capitalized software Construction in progress Accumulated depreciation

2016 131 2,020 5,646 366 686 (5,280) 3,569

2017 111 2,200 6,018 403 634 (5,650) 3,716

2017 120 2,061 5,971 438 583 (5,442) 3,731

g.

2015 231 485 716

2016 66 170 393 629

2017 252 246 529 1,027

2017 228 246 594 1,068

Accrued income taxes Accrued salaries and wages Accrued advertising and promotion Other

2015 42 325 447 548 1,362

2016 47 318 436 590 1,391

2017 30 311 582 551 1,474

2017 48 309 557 502 1,416

Income taxes payable Nonpension postretirement benefits Other

2015 77 391 468

2016 48 40 376 464

2017 192 40 373 605

2017 115 34 355 504

Pension Deferred income taxes Other

h.

i.

j.

2015 4

2016 9

2017 14

2018 4

© Cambridge Business Publishers, 2021 4-10

Valuation Using Financial Statements, 2nd Edition

22.

a.

Depreciation Expense

2015 15,366

2016 24,613

2017 34,333

2018 38,105

2015

2016

2017

2018

13,004 2,362 15,366

20,801 3,812 24,613

28,623 5,710 34,333

33,070 5,035 38,105

b.

Depreciation Expense: Cost of products sold Selling, general & administrative

c.

Allowance for bad debts

2015 1,283

2016 625

2017 692

2018 -

Advertising expense

2015 12,515

2016 14,472

2017 24,997

2018 26,874

Product warranty expense

2015 114,429

2016 114,119

d.

e.

2017 195,799

2018 259,845

Product warranty expense is reported in the Cost of product sold account. f.

401(k) plan expense

2015 565

2016 917

2017 1,797

2018 2,689

g.

Deferred compensation asset and liability

23.

2015

2016

2017

2018

10,803

15,529

28,095

43,316

Per Footnote 4, Business Segments

Recreational vehicles - Tow ables Recreational vehicles Motorized Other Intercompany eliminations

2015 2016 2017 2018 3,096,405 3,338,659 5,127,491 6,008,700 870,799 1,094,250 1,971,466 2,146,315 56,594 218,673 253,557 305,947 (16,979) (69,470) (105,562) (132,052) 4,006,819 4,582,112 7,246,952 8,328,909

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 4

4-11

24.

Finished products – RV Finished products – other Work in progress Raw materials Chassis Excess of FIFO costs over LIFO costs

2015 35,693 18,045 51,556 133,482 37,739

2016 39,943 20,141 97,872 173,362 102,686

2017 24,904 27,862 117,319 214,518 109,555

2018 44,998 35,320 124,703 258,426 116,308

(30,400) 246,115

(30,135) 403,869

(33,670) 460,488

(41,849) 537,909

2015 27,447 214,462 106,959 (114,823) 234,045

2016 46,422 300,902 133,112 (136,169) 344,267

2017 48,812 380,139 161,724 (165,437) 425,238

2018 57,413 468,824 197,294 (201,477) 522,054

25.

Land Buildings and improvements Machinery and equipment Accumulated depreciation

In fiscal 2017, Thor reported, in Other income, a gain on facility for $2,165.

26.

Amortizable intangible assets: Dealer networks/customer relationships Dealer networks/customer relationships – Acc amort Trademarks Trademark – Acc amort Design technology and other intangibles Design technology and other intangibles – Acc amort Non-compete agreement Non-compete agreement – Acc amort Backlog Backlog – Acc amort

Goodwill: Towables Other

2015

2016

2017

2018

143,860

404,960

404,960

404,960

(37,194) 55,282 (7,608) 22,400

(55,191) (101,795) 148,117 147,617 (10,539) (17,570) 22,400 19,300

(147,077) 146,117 (24,364) 18,200

(8,168) (10,8700 (9,203) 4,710 450 450 (4,264) (203) (293) 12,400 (4,133) 169,018 507,391 443,466

(9,555) 450 (383) 388,348

2015

2017

2018

334,822 42,871 377,693

334,822 42,871 377,693

268,751 42,871 312,622

2016 334,822 42,871 377,693

© Cambridge Business Publishers, 2021 4-12

Valuation Using Financial Statements, 2nd Edition

27.

2015 2016 467 1,196 3,625 4.587 10,411 10,504 39,486 43,388 3,959 5,154 1,520 1,642 2,067 2,607 (340) (4,164) 6,367 9,145 110 (30,246) (22,308) 3,913 4,105 (2,038) (2,430) 39,301 53,417

Inventory basis Employee benefits Self-insurance reserves Accrued product warranties Accrued incentives Sales returns and allowances Accrued expenses Property, plant and equipment Deferred compensation Tax credit carry forward Intangibles Unrecognized tax benefits Other

28.

2017 2018 1,460 922 6,471 3,427 9,940 6,368 73,393 62,332 6,175 5,235 2,340 1,741 3,399 1,905 (8,151) (9,060) 15,556 12,864 (17,184) (9,151) 3,925 2,581 (3,355) (720) 92,969 78,444

a.

Advertising expense

2015 5,500

2016 4,900

2017 5,700

2018 7,400

Warranty expense

2015 12,892

2016 16,503

2017 31,631

2018 42,377

b.

c.

2015 Net Revenues: Motorized Towables Other

904,821 71,684 976,505

2016

2017

881,363 853,360 89,412 685,197 4,451 8,562 970,7515,538,557

2018 860,675 1,127,723 28,431 1,988,398

29.

Finished products Work in progress Raw materials LIFO reserve

2015 2016 2017 2018 12,179 19,129 16,947 26,513 66,602 76,350 60,818 68,339 65,928 60,740 99,919 139,039 (32,544) (33,697) (35,419) (38,763) 112,165 122,522 142,265 195,128

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 4

4-13

30.

2015 Land Buildings and building improvements Machinery and equipment Software Transportation Accumulated depreciation

2016

2017

2018

1,874 53,388 94,034 8,033 8,913 (128,992) 37,250

3,864 62,073 95,087 15,878 8,956 (129,927) 55,931

3,914 73,831 99,952 17,844 8,993 (132,974) 71,560

6,747 94,622 105,663 23,388 8,837 (138,064) 101,193

2015

2016

2017

2018

1,228 1,228

1,228 1,228

242,728 242,728

244,684 29,686 274,370

2015

2016

2017

2018

-

-

148,000 80,500 18,000 4,600 2,000 253,100

177,250 95,581 19,527 5,347 2,000 299,705

2015

2016

-

-

31.

Goodwill: Towables Corporate / All Other

Intangibles: Trade name Dealer network Backlog Non-compete agreements Leasehold interest-favorable

Intangibles – Accumulated Amortization: Dealer network Backlog Non-compete agreements Leasehold interest-favorable

2017

2018

(5,348) (18,000) (1,116) (196) (24,660)

(12,328) (19,135) (2,084) (441) (33,988)

© Cambridge Business Publishers, 2021 4-14

Valuation Using Financial Statements, 2nd Edition

32.

2015 Deferred tax assets Inventory basis Employee benefits Self-insurance reserves Accrued product warranties Accrued incentives Sales returns and allowances Accrued expenses Property, plant and equipment Deferred compensation Tax credit carry forward Intangibles Unrecognized tax benefits Other

33.

2016

2017

467 1,196 3,625 4.587 10,411 10,504 39,486 43,388 3,959 5,154 1,520 1,642 2,067 2,607 (340) (4,164) 6,367 9,145 110 (30,246) (22,308) 3,913 4,105 (2,038) (2,430) 39,301 53,417

2018

1,460 922 6,471 3,427 9,940 6,368 73,393 62,332 6,175 5,235 2,340 1,741 3,399 1,905 (8,151) (9,060) 15,556 12,864 (17,184) (9,151) 3,925 2,581 (3,355) (720) 92,969 78,444

a.

2015 Deferred compensation benefits: Postretirement health care benefit cost Non-qualified deferred compensation Executive share option plan liability SERP benefit liability Executive deferred compensation Officer stock-based compensation Less current portion (in accrued compensation)

2016

2017

2018

34,535 19,508 4,788 2,649 299 242 62,021

6,346 18,003 3,341 2,681 389 763 31,523

16,476 1,498 2,534 447 1,664 22,619

14,831 935 2,309 421 1,528 20,024

(4,931) 57,090

(4,574) 26,949

(3,349) 19,2070

(4,742) 15,282

2015

2016

2017

2018

1,382 427 (5,538) 1,465 (2,264)

327 108 (7,736) 1,612 (5,689)

29 16 (40,444) 15,648 (24,751)

b.

Net periodic postretirement benefit income: Interest cost Service cost Amortization of prior service benefit Amortization of net actuarial lost

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 4

4-15

-

34.

From Footnote 13, Income Taxes, gather information on the underlying deferred tax assets and liabilities of Winnebago for 2015-2018.

Deferred tax assets: Deferred compensation Warranty reserves Postretirement health care benefits Self-insurance reserve Accrued vacation Stock based compensation Inventory Unrecognized tax benefit Other

Deferred tax liabilities: Inventory Intangibles Depreciation

2015

2016

2017

2018

10,757 4,288

9,609 4,729

9,135 11,675

4,730 9,842

12,792 2,378 1,938 1,239 726 1,592

2,262 2,214 2,006 1,030 698 1,785

1,967 2,142 943 437 2,072

2,601 1,298 1,277 615 584 1,797

35,710

24,333

28,371

22,744

2015

2016

2017

2018

(2,383) (1,338) (3,721)

(1,930) (1,919) (7,455) (21,292) (3,650) (6,261) (5,909) (5,580) (15,635) (27,201)

© Cambridge Business Publishers, 2021 4-16

Valuation Using Financial Statements, 2nd Edition

Chapter 5 Adjusting Accounting Information QUESTIONS 1.

Just as in Chapter 4, we seek to adjust the accounting information in order to refine our estimates of NOA and NOPAT for forecasting and valuation. Getting a cleaner split between the operating and financial activities will provide this. There are several items in accounting where adjusting the information will yield information more suitable for forecasting.

2.

When a company chooses amongst acceptable accounting methods, it results in different reported balance sheet and income statement information. Generally, the effect is a shifting of income amongst periods. That is, differences in accounting methods cause changes in which period the income is reported.

3.

No, value should not be changed! This is because the economics do not change just because we use a different method to capture the accounting. The implications primarily lie in steps three to five. In step three, we try to understand where the company is currently. This can be helped or hindered by the accounting method used. In step four, we forecast the future payoffs. Here some methods of accounting will lead to easier forecasting as they produce relatively smooth patterns while others may produce very volatile information. However, in step five when we compute value, the estimate should not be changed as the underlying economics do not change. We will see that ease of forecasting is the primary issue affected by the accounting method choice.

4.

It is not advisable to compare (Chapter 6 will introduce ratio analysis more formally) a company using LIFO directly with a company using another method. The reason is the inventory reflects very different patterns. For the LIFO company, the inventory may be reflecting purchases that are very old while using other methods they inventory amounts will be much closer to current values.

Comparing two LIFO companies would only be appropriate if we felt the recording of older inventory had similar effects. This generally occurs when the inventory being considered is composed of items of similar age. Rather than making that assumption, it is better to adjust any LIFO companies to FIFO to ensure compatibility.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 5

5-1

5.

Accruals management represents changes in judgment in applying principles (e.g., depreciation salvage values) while earnings management requires changes in operating activities (e.g., shifting R&D expenditures to a later period).

6.

The expectation is the leased asset (e.g., machinery, aircraft, etc.) will be used in the firm’s operations. Thus, it is appropriate to classify the lease asset as part of NOA. The lease obligation is a financing decision by the firm. Instead of leasing, the firm could choose to purchase the asset with excess cash or with borrowed funds. The decision as to how to acquire the asset benefits, while multi-faceted, is a financing decision. Thus, it is appropriate to classify the lease obligation as part of NFL.

7.

Under the old lease rules, the lease payments for an operating lease were accounted as a lease expense and included in NOPAT. With constructive capitalization, the balance sheet adjustments provide for both a lease asset and a lease obligation. The corresponding income statement adjustment for the lease asset is amortization/depreciation expense, which is part of NOPAT. For the lease obligation, the corresponding income statement adjustment is interest expense, which is included FEAT.

8.

By segregating assets from the firm through bankruptcy-remote special purpose entity (SPE), that is separate from the firm’s creditors, the SPE can access the credit markets independently of the sponsoring’s firm credit risk. Generally, the assets within the SPE are of sufficient quality that the SPE has a lower credit risk with access to lower cost of debt capital than the sponsoring firm.

9.

There are no adjustments needed to a firm’s NOPAT and NˆOA as the SPEs are consolidated into the sponsoring firm’s financial statements. The impact of the SPE’s are the qualitative assessment of the sponsoring firm’s cost of debt capital and liquidity.

10.

Current GAAP is based on the share-based compensation (SBC) value as of the grant date. The subsequent rise in the value of the stock options or the equity-classified share units is not reflected in the subsequent accounting following the SBC’s grant. For firm’s with substantial share price appreciation, the resulting wealth transfer can be significant.

Alternatively, firms that suffer dramatic share declines may have little to no wealth transfer.

© Cambridge Business Publishers, 2021 5-2

Valuation Using Financial Statements, 2nd Edition

EXERCISES 11.

The relevant data required to convert LIFO to “as-if” FIFO are the LIFO Reserve and change in LIFO Reserve, which is $178,144 and ($2,532) [(178,144 – 180,676].

The LIFO Reserve represents the additional inventory allocation to cost of goods sold since the firm’s use of LIFO accounting. Had FIFO been used instead of LIFO, the December 31, 2108 inventory balance reported on the balance sheet would be higher by $178,144. With the LIFO conformity requirement that LIFO must be used on the firm’s financial statements if used on the firm’s tax return, the LIFO Reserve multiplied by the expected future statutory tax rate presents the taxes deferred by the use of LIFO. Thus, Hershey has deferred $37,410 ($178,144 x 21%) in income taxes. This represents the adjustment for the tax payable.

The change in the LIFO Reserve represents the current year impact between LIFO and FIFO. Since the use of LIFO accounting by HSY, the company has reported an additional $178,144 in cost of goods sold. The change in the LIFO Reserve, ($2,532), suggests that costs of goods sold in 2018 would have higher (not lower, as the change in the LIFO Reserve is negative). The resulting lower 2018 tax expense for the higher cost of goods sold is $532. Lastly, the adjustment for the prior year cost of goods sold is reflected in the retained earnings, net of taxes or $142,734.

In journal entry format, the adjustments are: Inventory Taxes payable Cost of goods sold Tax expense Retained earnings

Dr Cr $178,144 $37,410 2,532 532 142,734 $180,676 $180,676

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 5

5-3

12.

a. The estimated amounts of unrecognized asset and liability are:

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Payment 294,191 296,579 294,941 295,290 290,980 290,980 290,980 290,980 290,980 290,980 290,980 290,980 290,980 150,557

PV 287,101 275,649 261,073 248,935 233,621 222,496 211,901 201,810 192,200 183,048 174,331 166,030 158,124 77,919 2,894,238

b. The reported total liabilities were $824,179. Adding in the estimated additional $2,894,238 would more increase liabilities by over 300%!

13.

a. Utilizing the IRR function (internal rate of return) function on Excel for the stream (– 427, 34, 35, 36 for 20 periods, 35) yields an implied interest rate of 6.3% percent. b. The estimated amounts of unrecognized asset and liability are: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Payment 227 214 193 183 175 175 175 175 175 175 175 175 175 175 175 175 175 115

PV 200 196 167 149 135 127 120 113 107 101 95 90 84 80 75 71 67 41 2,038

Costco’s operating leases if effectively capitalized would increase its assets and liabilities $2,038 or approximately $2 billion. © Cambridge Business Publishers, 2021 5-4

Valuation Using Financial Statements, 2nd Edition

14.

The February 3, 2019 overhang calculation by SBC plan: Stock options = Performance-based RSUs = Restricted shares = Restricted stock units = Total SBC overhang liability

870,000 x ($146.12 - $73.34) = 280,000 x ($146.12 - $78.01) = 6,000 x ($146.12 - $124.19) = 440,000 x ($146.12 - $73.73) =

$63,318,600 $19,070,800 $131,580 $31,851,600 $114,372,580

Note the Restricted stock units (liability accounting) are at reported at fair value and do not need an adjustment for the SBC overhang.

The deferred tax asset as February 3, 2019 is: Total SBC overhang liability x expected future statutory tax rate Deferred tax asset, Feb 3, 2019

$114,372,580 x 21% $ 24,018,242

15.

Excess tax benefit from share based compensation Assumed current tax rate Implied financial expense Less tax benefit Omitted financial expense, net of tax

1/31/17

1/31/18

1/31/19

95 35.0% 271 (95) 176

135 33.8% 399 (135) 264

137 21.0% 652 (137) 575

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 5

5-5

CONTINUING EXAMPLES 16.

a. Interest rate is:

Weighted average interest rate on notes

2015

2016

2017

2018

3.68%

3.27%

3.05%

3.16%

2016 187 137 94 67 39 73

2017 127 89 61 49 40 89

2018 121 97 73 57 48 129

2017 127 89 61 49 40 40 40 9 420

2018 121 97 73 57 48 48 48 33 478

Disclosed future operating lease payments are:

Year plus 1 Year plus 2 Year plus 3 Year plus 4 Year plus 5 Thereafter

2015 142 115 86 67 53 82

Payments spread out and lease liability calculated: Year plus 1 Year plus 2 Year plus 3 Year plus 4 Year plus 5 Year plus 6 Year plus 7 Year plus 8 Calculated lease liability

2015 142 115 86 67 53 53 29 ― 497

2016 187 137 94 67 39 34 34 ― 555

b.

2015 Assumed operating lease payments Estimated interest payment Estimated principal payment Estimate depreciation equal to principal payment

2016 142 18 124 124

2017 187 18 169 169

2018 127 13 114 114

Notes: • Assumed operating lease payments are equal to the current payment from the prior year end (year plus 1 payment from prior year).

• Estimated interest payment is equal to the calculated lease liability times the weighted average interest rate on notes.

• Just as with General Mills, we assume that total expense is the same under the operating and capital leases. Thus we are simply substituting interest and depreciation under capital leases for the amount of SG&A expense originally reported under operating lease treatment. © Cambridge Business Publishers, 2021 5-6

Valuation Using Financial Statements, 2nd Edition

c.

Capital lease obligation Asset under capital lease

2015 (497) 497

2016 (555) 555

2017 (420) 420

2018 (478) 478

2015

2016 (142) 18 124

2017 (187) 18 169

2018 (127) 13 114

d.

SG&A – Operating lease expense Interest expense Depreciation expense 17.

a.

Solutions Manual, Chapter 5

© Cambridge Business Publishers, 2021 5-7

b.

2015

2016 95 (33) (62)

2017 96 (45) (51)

2018 80 (17) (63)

Increase (decrease) in FEAT CSE (upward) downward adjustment

2015 -

2016 67 (67)

2017 -

2018 -

Decrease (increase) in RSU overhang Increase (decrease) in related financial DTA Increase (decrease) in FEAT

2015 -

2016 -

2017 7 (3) (4)

2018 5 (1) (4)

Opening share-based compensation liability Opening DTA (Financial) Prior period adjustment to CSE

2015 -

2016 (283) 99 184

2017 (188) 66 122

2018 (85) 18 67

2015

2016

2017

2018

-

(283) (33) 5 (67)

(188) (48) (55) -

(85) (18) (67) -

Decrease (increase) in stock option overhang Increase (decrease) in related financial DTA Increase (decrease) in FEAT c.

d.

e.

f.

g.

Adjustment to share-based compensation liability Adjustment to DTA (Financial) Adjustment to FEAT Adjustment to CSE via FEAT

© Cambridge Business Publishers, 2021 5-8

Valuation Using Financial Statements, 2nd Edition

18.

a. In THO’s footnote 1, Summary of Significant Accounting Policies, THO reports it certain inventories are determined on a LIFO basis with the remaining inventory determined on a FIFO basis. All inventory is stated at the lower of cost of net realizable value. b.

LIFO Reserve Future statutory tax rate

7/31/15 30,400 35%

7/31/16 30,135 35%

7/31/17 33,670 21%

7/31/18 41,849 21%

Inventory Taxes payable Cost of goods sold Tax expense Retained earnings

7/31/15 7/31/16 7/31/17 7/31/18 30,400 30,135 33,670 41,849 (10,640) (10,547) (7,071) (8,788) 265 (3,555) (8,179) (93) (3,477) 1,718 (19,760) (19,760) (19,588) (26,599)

c.

19.

a. Per THO’s Long-term Debt footnote:

Weighted average interest rate on borrowings

2015 2.55%

2016 2.55%

2017 2.72%

2018 2.72%

Disclosed future operating lease payments are:

Year plus 1 Year plus 2 Year plus 3 Year plus 4 Year plus 5 Thereafter

2015 2,490 1,993 1,409 752 676 13,496

2016 2,517 1,864 1,437 849 619 12,914

2017 2,547 2,152 1,434 1,123 907 15,656

2018 2,301 1,544 1,259 1,046 1,011 13,884

Continued

Solutions Manual, Chapter 5

© Cambridge Business Publishers, 2021 5-9

a. continued Payments spread out and lease liability calculated: Year plus 1 Year plus 2 Year plus 3 Year plus 4 Year plus 5 Year plus 6 Year plus 7 Year plus 8 Year plus 9 Year plus 10 Year plus 11 Year plus 12 Year plus 13 Year plus 14 Year plus 15 Calculated lease liability

2015 2,490 1,993 1,409 752 676 676 676 676 676 676 676 676 676 676 92 11,857

2016 2,517 1,864 1,437 849 619 619 619 619 619 619 619 619 619 619 57 11,394

2017 2,547 2,152 1,434 1,123 907 907 907 907 907 907 907 907 907 237 13,622

2018 2,301 1,544 1,259 1,046 1,011 1,011 1,011 1,011 1,011 1,011 1,011 657 12,161

b.

Assumed operating lease payments Estimated interest payment Estimated principal payment Estimate depreciation equal to principal payment

2016 2017 2018 2,490 2,517 2,547 302 291 371 2,188 2,226 2,176 2,188 2,226 2,176

Notes: • Assumed operating lease payments are equal to the current payment from the prior year end (year plus 1 payment from prior year).

• Estimated interest payment is equal to the calculated lease liability times the weighted average interest rate on notes.

• Just as with General Mills, we assume that total expense is the same under the operating and capital leases. Thus we are simply substituting interest and depreciation under capital leases for the amount of SG&A expense originally reported under operating lease treatment. c.

Capital lease obligation Asset under capital lease

2015 2016 2017 2018 (11,857) (11,394) (13,622) (12,161) 11,857 11,394 13,622 12,161

d.

SG&A – Operating lease expense Interest expense Depreciation expense © Cambridge Business Publishers, 2021 5-10

2016 2017 2018 (2,490) (2,517) (2,547) 302 291 371 2,188 2,226 2,176

Valuation Using Financial Statements, 2nd Edition

20.

a. Thor offers restricted stock awards (RSAs) and restricted stock units (RSUs) provided through its 2016 Equity and Incentive Plan and its 2010 Equity Incentive Plan. b.

c.

2015

2016 (22) 8 14

2017 124 (63) (61)

2018 139 (29) (110)

2015 -

2016 67 (67)

2017 -

2018 -

Decrease (increase) in RSA overhang Increase (decrease) in related financial DTA Increase (decrease) in FEAT d.

Increase (decrease) in FEAT CSE (upward) downward adjustment e.

Solutions Manual, Chapter 5

© Cambridge Business Publishers, 2021 5-11

f.

Decrease (increase) in RSU overhang Increase (decrease) in related financial DTA Increase (decrease) in FEAT

2015 -

2016 2017 2018 (5,851) (4,608) 11,953 2,048 (61) (2,510) 3,803 4,669 (9,443)

Opening share-based compensation liability Opening DTA (Financial) Prior period adjustment to CSE

2015 -

2016 2017 2018 (1,734) (7,607) (12,091) 607 2,662 2,539 1,127 4,945 9,552

2015

2016

g.

h.

Adjustment to share-based compensation liability Adjustment to DTA (Financial) Adjustment to FEAT Adjustment to CSE via FEAT

22.

-

2017

2018

(5,873) (4,484) (12,091) (2,055) (123) (2,539) 3,817 4,608 (9,552) -

a. In WGO’s Footnote 1, Summary of Significant Accounting Policies, WGO reports its Motorhome segment inventories are determined on a LIFO basis with the remaining inventory determined on a FIFO basis. All inventory is stated at the lower of cost of net realizable value. b.

LIFO Reserve Future statutory tax rate

8/29/15 32,544 35%

8/27/16 33,697 35%

8/26/17 35,419 21%

8/25/18 38,763 21%

Inventory Taxes payable Cost of goods sold Tax expense Retained earnings

8/29/15 8/27/16 8/26/17 8/25/18 32,544 33,697 35,419 38,763 (11,390) (11,794) (7,438)(8.140) (1,153) (1,722) (3,344) 404 (4,356) 702 (21,154) (21,154) (21,903) (27,981)

c.

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Valuation Using Financial Statements, 2nd Edition

23.

a. Per WGO’s Long-term Debt footnote: Weighted average interest rate on borrowings • •

2015 5.70%

2016 5.70%

2017 2.72%

2018 2.72%

Assumed 2015 and 2016 same as 2017 2018 is based on LIBOR as of August 25, 2018 plus 2.32%

Disclosed future operating lease payments are:

Year plus 1 Year plus 2 Year plus 3 Year plus 4 Year plus 5 Thereafter

2015 113 83 71 54 -

2016 128 77 60 6 4 -

2017 2,540 2,423 2,356 2,351 2,570 6,802

2018 2,700 2,424 2,370 2,245 2,683 4,041

2017 2,540 2,423 2,356 2,351 2,570 2,570 2,570 1,662 15,474

2018 2,700 2,424 2,370 2,245 2,683 2,683 1,358 14,011

2016 113 17 96 96

2017 128 15 113 113

Payments spread out and lease liability calculated:

Year plus 1 Year plus 2 Year plus 3 Year plus 4 Year plus 5 Year plus 6 Year plus 7 Year plus 8 Calculated lease liability

2015 113 83 71 54 293

2016 128 77 60 6 4 256

b.

Assumed operating lease payments Estimated interest payment Estimated principal payment Estimate depreciation equal to principal payment

2018 2,540 882 1,658 1,658

Notes: • Assumed operating lease payments are equal to the current payment from the prior year end (year plus 1 payment from prior year).

• Estimated interest payment is equal to the calculated lease liability times the weighted average interest rate on notes.

• Just as with General Mills, we assume that total expense is the same under the operating and capital leases. Thus we are simply substituting interest and depreciation under capital leases for the amount of SG&A expense originally reported under operating lease treatment.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 5

5-13

c.

Capital lease obligation Asset under capital lease

2015 (293) 293

2016 (256) 256

2017 2018 (15,474) (14,011) 15,474 14,011

2016 (113) 17 96

2017 (128) 15 113

d.

SG&A – Operating lease expense Interest expense Depreciation expense

24.

2018 (2,540) 882 1,658

a. Winnebago through its 2014 Omnibus Equity, Performance Award and Incentive Compensation Plan is authorized to grant or issue stock options, share awards and other equity compensation to key employees and to non-employee directors. b.

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Valuation Using Financial Statements, 2nd Edition

c.

Decrease (increase) in stock option overhang Increase (decrease) in related financial DTA Increase (decrease) in FEAT

2016 (72) 25 47

2017 (349) 63 286

2018 152 (32) (120)

d.

e.

Decrease (increase) in stock award overhang Increase (decrease) in related financial DTA Increase (decrease) in FEAT

2015 -

2016 (982) 344 638

2017 2018 (1,685) 1,749 216 (367) 1,468 (1,381)

Opening share-based compensation liability Opening DTA (Financial) Prior period adjustment to CSE

2015 -

2016 -

2017 2018 (1,055) (3,088) 369 648 686 2,439

2015

2016

2017

f.

g.

Adjustment to share-based compensation liability Adjustment to DTA (Financial) Adjustment to FEAT Adjustment to CSE via FEAT

Solutions Manual, Chapter 5

-

2018

(1,055) (2,033) 1,900 369 279 (399) 686 1,754 (1,501) -

© Cambridge Business Publishers, 2021 5-15

Chapter 6 Analysis of Enterprise Operations QUESTIONS 1.

DuPont analysis focuses on identification of the profitability and asset turnover of the operating activities.

2.

The scaling of NOPAT by NOA compares the profitability to the resources employed.

This is necessary because the profit does not tell the whole picture. For example, if you earn $1,000 in an hour that is great, but if you put in forty hours every week to earn $1,000 in a month it is not as impressive. Of course, Wal-Mart is going to earn more total dollars than a local mom and pop store. The appropriate question we want to consider is whether Wal-Mart earned more per dollar of resource employed.

3.

The amount of resources employed by the company is constantly changing. Ideally, we would want to know the balance each day. However, we attempt to capture the notion of changing resources by taking a simple average of beginning and ending NOA. Note that if we could have captured the computation of NOA through Chapter 5 each quarter, we might take a simple average of the four quarters rather than just averaging the beginning and ending numbers. The decision on whether to compute information more often than annually would be based on whether it improves our ability to forecast and thus improves our value estimate.

4.

Operating PM is a measure of profit earned by operating activities from each dollar of sales. It is a measure of profitability and should be a good approximation of the marginal profitability of sales. That is, if the company were to sell one more dollar, how much additional profit would be recognized.

5.

The PM from Sales alters the numerator to exclude items (generally expenses) not deemed to be directly driven by sales. Examples could include impairment charges, discontinued operations, financial statement translation, gains/losses on cash flow hedges, and gains/losses on sales of operating assets.

Solutions Manual, Chapter 6

© Cambridge Business Publishers, 2021 6-1

6.

ATO is a measure of productivity of the operating assets. It captures the amount of sales generated per each dollar of assets employed. That is, if the company added one additional dollar of operating assets, how much more sales could be generated.

7.

Generally, ATO is more stable. The measure compares sales to net assets and the assets are generally not as easy altered in the short-run. Adding a factory or altering the production process is significant. PM compares sales to profits. The profit reflects the expenses the company is incurring. The altering of expenses as firms “cut back” can often result in a quick change to the firm’s PM. Note that a short-term change in spending can also have longer-term consequences.

8.

We must not blindly compare two companies’ measures of operating PM and ATO without giving consideration to the industry(s) in which they operate. A grocery store operates on very low margins but relies on high turnover. On the other hand, a power company will have much higher margins but lower turnover. Comparison of these firms, or thinking you could achieve the turnover of a grocery store combined with the margins of a power company, is inappropriate. When employing the DuPont method, we need to know and understand the industry and forces affecting the company.

9.

The inverse of ATO is generally utilized as it allows for more direct comparison since sales is the denominator for all elements. Also, examining the inverse of ATO can be advantageous as it avoids issues related to small denominators. If a firm has a very small amount of receivables (most sales are for cash) the ATO related to receivables would be extremely high.

10.

Time-series analysis looks at how the operations of a company are changing year-byyear. It is essentially a comparison of the company to itself. The cross-sectional analysis instead compares the company to other firms who are considered comparable.

As no firm is an exact match to another company, the time-series analysis yields a great fit and may yield insights as to how the company is evolving over time. The crosssectional analysis instead may provide information on potential changes the company may try to implement as a result of operating in a competitive environment. Also, it may reveal competitive advantages currently in place that we will evaluate for sustainability.

11.

As shown in Equation 6.1, we can write the relation between ROE and RNOA as ROE = RNOA + LEV x (RNOA – RNFL). In doing so, we recognize that the return to the company is driven by the profitability of the operating activities with an additional return resulting from the leverage created by financial transactions.

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Valuation Using Financial Statements, 2nd Edition

EXERCISES 12.

The items most likely to be omitted from NOPAT from Sales that were included in NOPAT are Impairment, closure costs and asset disposals and Foreign currency translation adjustments. The magnitude of these items is not directly impacted by the sales. (This assumption may not hold if the sales are primarily international and the foreign currency effects are related to this.)

13.

For TACO, the item most likely to be omitted from NOPAT from Sales that was included in NOPAT is Impairment of long-lived assets, Restaurant closure charges, net, Loss of disposal of assets, net.

14.

We would expect a great comparability for PM from Sales than from PM. This is because we are more directly isolating the profitability achieved from the sales of the operations.

Omitting these items not directly tied to sales will increase the comparability of the information.

15.

The increased NOA will drastically reduce ATO. The effect on RNOA will probably be a reduction, but that is not guaranteed. The reason is that with the adjustment from operating to capital lease we increase NOPAT due to the removal of the financial expense for interest. ROE should be unchanged as we have added the same amount to both assets and liabilities (in other words, equity is unaffected) and net income is unchanged.

16.

Currently, Littleton has $220 million in net operating assets (NOA) and $440 million in annual sales generating a net operating profit after tax (NOPAT), of $33 million.

Littleton’s management group believes expanding international would result in incremental sales of $90 million requiring an investment in additional net operating assets (NOA), including supporting working capital, of $30 million. Due to a substantial marketing effort, Littleton anticipates its international operating income, after tax, to be $6 million.

Based solely on the above financial consideration, explain whether you would recommend management to expand internationally.

Based solely on the financial aspect along, expanding internationally makes financial sense.

Existing RNOA = PM  ATO = ($33 / $440) × ($440 / $220) = 7.5%  2.0 = 15.0% Continued

Solutions Manual, Chapter 6

© Cambridge Business Publishers, 2021 6-3

RNOA from international activities is expected to be: International RNOA = ($6 / $90) × ($90 / $30) = 6.67% x 3.0 = 20.0% Expansion internationally would increase RNOA.

17.

Before considering the robotics program, Bedford has a RNOA = 11.25% (Profit Margin x ATO or 4.5%  2.5). Also, NOA is $100.0 million based on $250.0 million in sales times a ATO of 2.5 ($250 ÷ 2.5).

According to the CFO, installing $30 million in robotics into the assembly line will generate additional sales of $16.5 million.

ATO would decrease to

250+100 100+30

= 2.05.

With a new profit margin of 6.0 percent, the resulting RNOA would be 12.3 percent (6.0%  2.05).

With the current RNOA at 11.25 percent, the addition of robotics would increase RNOA slightly and should be considered by management.

18.

Before considering the data analytics program Moonitz has a RNOA = 20.0 (PM x ATO or 4.0%  5.0). Also, NOA is $77.0 million based on $385.0 million in sales divided by ATO of 5.0 ($3850 ÷ 5.0).

According to marketing, a data analytics program would generate additional sales of $40.0 million supported by an increase in working capital of $4.0 million.

ATO would increase to

= 5.25.

With a new firm-wide profit margin of 3.9 percent, the resulting RNOA would be 20.46 percent (3.9%  5.25).

With the current RNOA at 20.0 percent, the data analytics program would increase RNOA slightly and should be considered by management.

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Valuation Using Financial Statements, 2nd Edition

19.

Using the RNOA = ATO2018 x PM2018 + PM2018 x ATO2017 formula: RNOA = 76.1% - 33.7% = 42.4% ATO2018 x PM2018 = (4.60 – 2.90) x 16.6% = 28.1% PM2018 x ATO2017 = (16.6% - 11.6%) x 2.90 = 14.3% Thus, of the 42.4 percent increase in RNOA, 28.1 percent is due to the change in ATO and 14.3 percent is due to the change in PM at the prior year ATO.

20.

Using the RNOA = ATO2018 x PM2018 + PM2018 x ATO2017 formula: RNOA = 10.3% - 16.6% = (6.3%) ATO2018 x PM2018 = (2.73 – 2.75) x 3.8% = (0.1%) PM2018 x ATO2017 = (3.8% - 6.0%) x 2.88 = (6.3%) Thus, of the 6.3 percent decrease in RNOA, 0.1 percent is due to the change in ATO and 6.3 percent is due to the change in PM at the prior year ATO.

21. a. – g.

TJX Macy’s

Gross Margin 28.6% 40.9%

PM 7.9% 4.0%

ATO 9.3 2.6

RNOA 74.0% 10.2%

LEV (0.18) 0.66

Spread 0.78 0.12

ROE 60.0% 18.0%

h. While Macy’s has significant higher gross margins, it falls behind TJX with respect to the firm’s overall profit margin, PM. This suggests that TJX has superior scale. Even more striking is the efficiency of TJX which has a dominate asset turnover than Macy’s. Macy’s investment in its infrastructure results in fewer sales per dollar invested in NOA. Additionally, a quick review of TJX’s inventory turn is under 60 days while Macy’s is over 120 days. The result is Macy’s advantage with its gross margin is lost through its lack of scale and efficiency as TJX has a substantially larger RNOA. Due to TJX’s financial success, its financial assets are greater than its financial liabilities, resulting in a negative NFL. Not surprisingly, TJX’s financial assets do not earn the same return as its NOA resulting in a lower ROE from its RNOA. Macy’s has a positive Spread that results in an additional benefits to the shareholders as ROE is greater than RNOA.

Solutions Manual, Chapter 6

© Cambridge Business Publishers, 2021 6-5

CONTINUING EXAMPLES 22.

a.

2015 NOPAT NOA Average NOA RNOA

$11,196

2016 $813 11,080 11,138 7.30%

2017 $1,167 11,815 11,447.5 10.19%

2018 $1,590 12,949 12,382 12.84%

Each of Kellogg’s fiscal years are 52 weeks and do not need an adjustment in the ROA calculation. b.

2015 NOPAT Sales Operating PM

$13,525

2016 $813 12,965 6.27%

2017 $1,167 12,854 9.08%

2018 $1,590 13,547 11.74%

c.

NET SALES Cost of products sold 401k plan expense Pension - Service cost Pension - Defined contribution plans Research and development expense Advertising expense Bad debt expense Depreciation on capitalized leases Other selling, general and administrative expense Income taxes NOPAT from Sales PM from Sales

2015 2016 $20,846 $19,467 (14,660) (13,387) (39) (98) (36) (182) (735) (9) (124)

2017 2018 $19,561 $19,724 (12,941) (13,063) (41) (38) (96) (87) (34) (27) (148) (154) (732) (752) (14) (4) (169) (114)

(1,906) (2,405) (1,748) (235) (410) (181) $ 1,470 $ 650 $ 1,621 6.27% 9.08% 11.74%

d.

Sales Beginning NOA Ending NOA ATO

© Cambridge Business Publishers, 2021 6-6

2015 2016 2017 2018 $13,525$12,965 $12,854 $13,547 11,196 11,080 11,815 11,080 11,815 12,949 1.164 1.123 1.094

Valuation Using Financial Statements, 2nd Edition

e.

2015 FEAT Beginning NFL Ending NFL RNFL

$9,252

2016 $251 9,292 9,272.3 2.71%

2017 $(279) 9,685 9,488.6 -2.94%

2018 $249 10,348 10,016.5 2.49%

f.

2016 22.50% 24.66% 9.31% 12.29% 18.38% 5.95% 6.91% 100.00% Cost of products sold (62.72)% Gross Profit 37.28% 401k plan expense (0.30)% Pension - Service cost (0.76)% Pension - Defined contribution plans (0.28)% Postretirement - Service cost (0.16)% Postretirement - Defined contribution plans (0.13)% Postemployment - Service cost (0.05)% Research and development expense (1.40)% Advertising expense (5.67)% Bad debt expense (0.07)% Depreciation on capitalized leases (0.96)% Other selling, general and administrative expense (14.70)% Other income (expense), net (1.66)% Income taxes (3.19)% Earning from unconsolidated entities 0.01% Foreign currency translation adjustments, net of tax (1.96)% Cash flow hedges, net of tax (0.22)% Venezuela deconsolidation loss 0.49% Operating PM 6.27% Net sales - US Morning Foods Net sales - US Snacks Net sales - US Specialty Channels Net sales - North America Other Net sales - Europe Net sales - Latin America Net sales - Asia Pacific

2017 21.08% 24.19% 9.66% 12.54% 17.82% 7.34% 7.36% 100.00% (63.44)% 36.56% (0.32) % (0.75)% (0.26)% (0.14)% (0.12)% (0.05)% (1.15)% (5.69)% (0.11)% (1.31)% (18.71)% 2.90% (2.47)% 0.05% 0.61% 0.05% 0.00% 9.08%

2018 19.51% 21.83% 9.12% 13.68% 17.68% 6.99% 11.20% 100.00% (65.11)% 34.89% (0.28)% (0.64)% (0.20)% (0.13)% (0.08)% (0.02)% (1.14)% (5.55)% (0.03)% (0.84)% (12.90)% (0.58)% (1.90)% 1.45% (0.35)% 0.06% 0.00% 11.74%

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 6

6-7

g. Total Sales

$12,965 2016

$12,854

2017

$13,547

2018

Operating Assets (OA) Cash and cash equivalents

0.017

0.014

0.013

Accounts Receivable: Trade

0.088

0.092

0.089

Accounts Receivable: Allowance for doubtful accounts

(0.001)

(0.001)

(0.001)

Accounts Receivable: Refundable income taxes

0.002

0.002

0.002

Accounts Receivable: Other receivables

0.010

0.009

0.012

Inventories: Raw materials and supplies

0.024

0.025

0.025

Inventories: Finished goods and materials in progress

0.072

0.070

0.069

Other current assets

0.014

0.013

0.010

Property, net: Land

0.011

0.009

0.009

Property, net: Buildings

0.158

0.164

0.157

Property, net: Machinery and equipment

0.434

0.454

0.442

Property, net: Capitalized software

0.027

0.030

0.031

Property, net: Construction in progress

0.053

0.051

0.045

Property, net: Accumulated depreciation

(0.406)

(0.425)

(0.409)

Capitalized lease asset

0.041

0.038

0.033

Goodwill: US Morning Foods

0.010

0.010

0.010

Goodwill: US Snacks

0.275

0.278

0.263

Goodwill: US Specialty

0.006

0.006

0.006

Goodwill: North America Other

0.035

0.050

0.061

Goodwill: Europe

0.031

0.031

0.030

Goodwill: Latin America

0.016

0.022

0.017

Goodwill: Asia Pacific Intangible assets subject to amortization: US Morning Foods

0.017

0.018

0.039

0.001

0.001

0.001

Intangible assets subject to amortization: US Snacks Intangible assets subject to amortization: North America Other

0.003

0.003

0.003

0.000

0.001

0.002

Intangible assets subject to amortization: Europe

0.003

0.003

0.003

Intangible assets subject to amortization: Latin America

0.002

0.004

0.005

Intangible assets subject to amortization: Asia Pacific Intangible assets accumulated amortization: US Morning Foods

0.001

0.001

0.016

(0.001)

(0.001)

(0.001)

Table continued

© Cambridge Business Publishers, 2021 6-8

Valuation Using Financial Statements, 2nd Edition

g. continued Table continued

2016

2017

2018

(0.001)

(0.002)

(0.002)

(0.000)

(0.000)

(0.000)

Intangible assets accumulated amortization: Europe Intangible assets accumulated amortization: Latin America Intangible assets accumulated amortization: Asia Pacific Intangible assets not subject to amortization: US Snacks Intangible assets not subject to amortization: North America Other Intangible assets not subject to amortization: Europe Intangible assets not subject to amortization: Latin America Intangible assets not subject to amortization: Asia Pacific

(0.001)

(0.001)

(0.001)

(0.000)

(0.001)

(0.001)

(0.000)

(0.000)

(0.001)

0.125

0.126

0.120

0.013 0.031

0.021 0.032

0.027 0.031

0.004

0.007

0.006

0.000

0.000

0.014

Investments in unconsolidated entities

0.034

0.034

0.031

Deferred tax assets: US state income taxes

0.001

0.000

0.000

Deferred tax assets: Advertising and promotion-related

0.001

0.002

0.001

Deferred tax assets: Wages and payroll taxes

0.002

0.003

0.002

Deferred tax assets: Inventory valuation Deferred tax assets: Operating loss, credit and other carryforwards

0.002

0.002

0.001

0.009

0.016

0.019

Deferred tax assets: Hedging transactions

0.002

0.002

0.002

Deferred tax assets: Deferred compensation

0.003

0.002

0.002

Deferred tax assets: Other

0.005

0.004

0.004

Deferred tax assets: Valuation allowance

(0.007)

(0.011)

(0.012)

Other assets

0.028

0.030

0.032

Operating Assets (OA) cont.

Intangible assets accumulated amortization: US Snacks Intangible assets accumulated amortization: North America Other

Continued

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 6

6-9

g. continued 2016

2017

2018

Accounts payable

(0.151)

(0.167)

(0.173)

Other current liabilities: Accrued income taxes

(0.003)

(0.003)

(0.003)

Other current liabilities: Accrued salaries and wages Other current liabilities: Accrued advertising and promotion

(0.025)

(0.024)

(0.023)

(0.034)

(0.040)

(0.042)

Other current liabilities: Other

(0.042)

(0.043)

(0.037)

Deferred tax liabilities: US state income taxes

(0.003)

(0.003)

(0.002)

Deferred tax liabilities: Hedging transactions Deferred tax liabilities: Depreciation and asset disposals Deferred tax liabilities: Trademarks and other intangibles

(0.002)

(0.002)

0.000

(0.026)

(0.020)

(0.016)

(0.045)

(0.036)

(0.035)

Deferred tax liabilities: Unremitted foreign earnings

0.000

0.000

0.000

Other liabilities: Income taxes payable

(0.002)

(0.009)

(0.011)

Inverse of Operating ATO

0.859

0.891

0.914

Operating ATO

1.164

1.123

1.094

Operating Liabilities (OL)

Long-term debt

h.

RNOA RNFL FLEV Spread (RNOA – RNFL) ROE

2012 7.30% 2.71% 4.9698 4.59% 30.12%

2013 10.19% (2.94)% 4.8439 13.14% 73.83%

2014 12.84% 2.49% 4.2344 10.35% 56.69%

© Cambridge Business Publishers, 2021 6-10

Valuation Using Financial Statements, 2nd Edition

23.

a.

7/31/15

7/31/16 $257,095

7/31/17 $387,179

7/31/18 $439,071

1,504,986 1,227,014.3 20.95%

1,642,667 1,573,826.8 24.60%

1,848,120 1,745,393.7 25.16%

NOPAT NOA Average NOA RNOA

$949,04 2

Each of Thor’s fiscal years are 52 weeks and do not need an adjustment in the ROA calculation. b.

7/31/15 NOPAT Sales Operating PM

$4,006,819

7/31/16 $257,095 4,582,112 5.61%

7/31/17 $387,179 7,246,952 5.34%

7/31/18 $439,071 8,328,909 5.27%

c.

NET SALES Cost of products sold 401k plan expense Product warranty expense Selling, general, and administrative expenses Depreciation on capitalized leases Advertising costs 401(k) plan expense Impairment charges Amortization of intangible assets Gain on sale of facility Income taxes NOPAT from Sales PM from Sales

7/31/16 7/31/17 7/31/18 $975,226 $1,547,119 $2,016,829 (3,721,132) (5,975,412) (6,863,149) (24,613) (34,333) (38,105) (114,119) (195,799) (259,845) (284,578) (384,826) (440,299) (2,188) (2,226) (2,222) (14,472) (24,997) (26,874) (917) (1,797) (2,689) (9,113) 0 0 (27,962) (63,925) (55,118) 0 2,165 0 (125,601) (181,840) (205,500) $ 257,417 $ 383,962 $ 435,107 5.61%

5.34%

5.27%

d.

Sales Beginning NOA Ending NOA Operating ATO

7/31/15 7/31/16 7/31/17 7/31/18 $4,006,819 $4,582,112 $7,246,952 $8,328,909 949,042 1,504,986 1,642,667 949,042 1,504,986 1,642,667 1,848,120 3.734 4.605 4.772

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6-11

e.

7/31/15 FEAT Beginning NFL Ending NFL RNFL

7/31/16 7/31/17 7/31/18 $4,566 $10,521 $(7,093) (134,778) 225,121 49,080 (122,681) 45,171.9 137,100.7 (36,800.7) 10.11% 7.67% 19.27%

f.

Net sales: Recreational vehicles - Towables Net sales: Recreational vehicles - Motorized Net sales: Other Net sales: Intercompany eliminations Cost of products sold Gross Profit 401k plan expense Depreciation expense Product warranty expense Selling, general, and administrative expenses Depreciation on capitalized leases Advertising costs 401(k) plan expense Impairment charges Amortization of intangible assets Gain on sale of facility Other (income) and expense, net Income taxes Loss from discontinued operations, net of income taxes Operating PM

7/31/16 72.86% 23.88% 4.77% (1.52)% 100.00% (81.21)% 18.79% (0.54)% (2.49)% (6.21)% (0.05)% (0.32)% (0.02)% (0.20)% (0.61)% 0.00% 0.03% (2.74)% (0.03)%

7/31/17 70.75% 27.20% 3.50% (1.46)% 100.00% (82.45)% 17.55% (0.47)% (2.70)% (5.31)% (0.03)% (0.34)% (0.02)% 0.00% (0.88)% 0.03% 0.04% (2.51)% 0.00%

7/31/18 72.14% 25.77% 3.67% (1.59)% 100.00% (82.40)% 17.60% (0.46)% (3.12)% (5.29)% (0.03)% (0.32)% (0.03)% 0.00% (0.66)% 0.00% 0.05% (2.47)% 0.00%

(0.54)% 5.61%

(0.47)% 5.34%

(0.46)% 5.27%

© Cambridge Business Publishers, 2021 6-12

Valuation Using Financial Statements, 2nd Edition

g. Total Sales

$12,965 7/31/16

$12,854

7/31/17

$13,547 7/31/18

Operating Assets (OA) Cash and cash equivalents

0.019

0.016

0.019

Accounts receivable, trade

0.067

0.057

0.055

Allowance for doubtful accounts

(0.000)

(0.000)

(0.000)

Inventory: Finished products - RV

0.008

0.004

0.004

Inventory: Finished products - other

0.004

0.003

0.004

Inventory: Work in progress

0.016

0.015

0.015

Inventory: Raw materials

0.033

0.027

0.028

Inventory: Chassis

0.015

0.015

0.014

Prepaid expenses and other

0.002

0.002

0.001

Property, plant and equipment: Land Property, plant and equipment: Buildings and improvements Property, plant and equipment: Machinery and equipment Property, plant and equipment: Accumulated depreciation

0.008

0.007

0.006

0.056

0.047

0.051

0.026

0.020

0.022

(0.027)

(0.021)

(0.022)

Asset under capital lease

0.003

0.002

0.002

Goodwill: Towables

0.066

0.046

0.040

Goodwill: Other Amortizable intangible assets: Dealer networks/customer relationships Amortizable intangible assets: Dealer networks/customer relationships - Accum amort

0.009

0.006

0.005

0.060

0.056

0.049

(0.010)

(0.011)

(0.015)

Amortizable intangible assets: Trademarks Amortizable intangible assets: Trademark - Accum amort Amortizable intangible assets: Design technology and other intangibles Amortizable intangible assets: Design technology and other intangibles - Accum amort Amortizable intangible assets: Non-compete agreements Amortizable intangible assets: Non-compete agreements - Accum amort

0.022

0.020

0.018

(0.002)

(0.002)

(0.003)

0.005

0.003

0.002

(0.002)

(0.001)

(0.001)

0.001

0.000

0.000

(0.000)

(0.000)

(0.000)

Amortizable intangible assets: Backlog

0.001

0.001

0.000

Amortizable intangible assets: Backlog - Accum amort

(0.000)

(0.000)

0.000

Deferred tax assets: Inventory basis

0.000

0.000

0.000

Deferred tax assets: Employee benefits

0.001

0.001

0.001

Deferred tax assets: Accrued product warranties

0.009

0.008

0.008

Table continued © Cambridge Business Publishers, 2021 Solutions Manual, Chapter 6

6-13

g. continued Table continued

7/31/16

7/31/17

7/31/18

Operating Assets (OA) cont.

Deferred tax assets: Accrued incentives

0.001

0.001

0.001

Deferred tax assets: Property, plant and equipment

0.000

0.000

0.000

Deferred tax assets: Deferred compensation

0.001

0.000

0.000

Deferred tax assets: Tax credit carry forward

(0.000)

(0.001)

(0.001)

Deferred tax assets: Intangibles

0.002

0.002

0.002

Deferred tax assets: Unrecognized tax benefits

0.000

0.000

0.000

Deferred tax assets: Other

(0.006)

(0.003)

(0.002)

Equity investment in joint venture

0.001

0.001

0.000

Other assets

(0.000)

(0.000)

(0.000)

0.392

0.324

0.311

7/31/16

7/31/17

7/31/18

(0.047)

(0.041)

(0.037)

Compensation and related items

(0.015)

(0.013)

(0.012)

Product warranties

(0.034)

(0.029)

(0.029)

Income and other taxes

(0.006)

(0.007)

(0.005)

Promotion and rebates

(0.007)

(0.006)

(0.006)

Product, property and related liabilities

(0.003)

(0.002)

(0.002)

Other

(0.004)

(0.003)

(0.003)

Unrecognized tax benefits

(0.002)

(0.001)

(0.001)

Other liabilities

(0.007)

(0.006)

(0.006)

(0.124)

(0.107)

(0.102)

Inverse of Operating ATO

0.268

0.217

0.210

Operating ATO

3.734

4.605

4.772

Operating Liabilities (OL) Accounts payable Accrued liabilities:

h.

RNOA RNFL FLEV Spread (RNOA – RNFL) ROE

7/31/16 20.95% 10.11% 0.0382 10.85% 21.37%

7/31/17 24.60% 7.67% 0.0954 16.93% 26.22%

7/31/18 25.16% 19.27% (0.0206) 5.88% 25.03%

© Cambridge Business Publishers, 2021 6-14

Valuation Using Financial Statements, 2nd Edition

24.

a.

8/29/15 NOPAT NOA Average NOA RNOA 52/53-week adj RNOA

211,675

8/27/16 44,211 226,628 219,151.7 20.17% 20.17%

8/26/17 73,889 762,743 494,685.8 14.94% 14.94%

8/25/18 121,473 896,197 829,470.2 14.64% 14.64%

8/27/16 44,211 975,226 4.53%

8/26/17 73,889 1,547,119 4.78%

8/25/18 121,473 2,016,829 6.02%

b.

8/29/15 NOPAT Sales Operating PM

976,505

c.

NET SALES Cost of products sold Warranty expense Advertising expense Depreciation on capitalized leases SG&A: Selling SG&A: General and administrative SG&A: Amortization of intangible assets Provision for income taxes NOPAT from Sales PM from Sales

8/27/16 8/26/17 8/25/18 $975,226 $1,547,119 $2,016,829 (844,921) (1,291,189) (1,671,272) (16,503) (31,631) (42,377) (4,900) (5,700) (7,400) (96) (113) (1,658) (14,923) (29,968) (42,450) (31,161) (53,574) (73,249) 0 (18,968) $ 43,754

(24,660) (30,132) 80,151

(9,328) (45,939) $ 123,156

$

4.53%

4.78%

6.02%

8/27/16 $975,226 211,675 226,628 3.127

8/26/17 $1,547,119 226,628 762,743 2.431

8/25/18 $2,016,829 762,743 896,197

d.

Sales Beginning NOA Ending NOA ATO

Solutions Manual, Chapter 6

8/29/15 $976,505 211,675 4.450

© Cambridge Business Publishers, 2021 6-15

e.

8/29/15 FEAT Beginning NFL Ending NFL RNFL

(30,441)

8/27/16 (16,533) (62,948) (46,694.8) 35.41%

8/26/17 8,588 295,528 116,289.8 7.39%

8/25/18 10,554 331,923 313,725.2 3.36%

f.

Net sales: Motorized Net sales: Towable Net sales: Other Cost of products sold Warranty expense Gross Profit Advertising expense Depreciation on capitalized leases SG&A: Selling SG&A: General and administrative SG&A: Transaction costs SG&A: Amortization of intangible assets Non-operating income Provision for income taxes Operating PM

© Cambridge Business Publishers, 2021 6-16

8/27/16 90.38% 9.17% 0.46% 100.00% (86.64)% (1.69)% 11.67% (0.50)% (0.01)% (1.53)% (3.20)% 0.00% 0.00% 0.05% (1.94)% 4.53%

8/26/17 55.16% 44.29% 0.55% 100.00% (83.46)% (2.04)% 14.50% (0.37)% (0.01)% (1.94)% (3.46)% (0.43)% (1.59)% 0.02% (1.95)% 4.78%

8/25/18 42.67% 55.92% 1.41% 100.00% (82.87)% (2.10)% 15.03% (0.37)% (0.08)% (2.10)% (3.63)% (0.11)% (0.46)% 0.02% (2.28)% 6.02%

Valuation Using Financial Statements, 2nd Edition

g. Total Sales

$975,226 $2,016,829 8/27/16

$1,547,119

8/26/17

8/25/18

Operating Assets (OA) Cash and cash equivalents

0.020

0.016

0.008

Receivables, net

0.068

0.062

0.072

Inventories: Finished goods

0.016

0.012

0.011

Inventories: Work-in-process

0.073

0.044

0.032

Inventories: Raw materials

0.065

0.052

0.059

Prepaid expenses and other assets

0.007

0.006

0.005

Property, plant and equipment: Land Property, plant and equipment: Buildings and building improvements Property, plant and equipment: Machinery and equipment

0.003

0.003

0.003

0.059

0.044

0.042

0.097

0.063

0.051

Property, plant and equipment: Software

0.012

0.011

0.010

Property, plant and equipment: Transportation Property, plant and equipment: Accumulated depreciation

0.009

0.006

0.004

(0.133)

(0.085)

(0.067)

Capitalized lease asset

0.000

0.005

0.007

Goodwill: Towable

0.001

0.079

0.121

Goodwill: Corporate / All Other

-

-

0.007

Intangibles: Trade name

-

0.048

0.081

Intangibles: Dealer network

-

0.026

0.044

Intangibles: Backlog

-

0.006

0.009

Intangibles: Non-compete agreements

-

0.001

0.002

Intangibles: Leasehold interest-favorable

-

0.001

0.001

Intangibles - Accum Amortization: Dealer network

-

(0.002)

(0.004)

Intangibles - Accum Amortization: Backlog Intangibles - Accum Amortization: Non-compete agreements Intangibles - Accum Amortization: Leasehold interestfavorable

-

(0.006)

(0.009)

-

(0.000)

(0.001)

-

(0.000)

(0.000)

Deferred tax assets: Warranty reserves

0.005

0.005

0.005

Deferred tax assets: Accrued vacation

0.002

0.001

0.001

Deferred tax assets: Inventory

-

-

0.000

Deferred tax assets: Unrecognized tax benefit

0.001

0.000

0.000

Deferred tax assets: Other

0.002

0.001

0.001

Other assets

Solutions Manual, Chapter 6

0.009

0.004

0.004

0.316

0.403

0.500

© Cambridge Business Publishers, 2021 6-17

continued

© Cambridge Business Publishers, 2021 6-18

Valuation Using Financial Statements, 2nd Edition

g. continued 8/27/16

8/26/17

8/25/18

Operating Liabilities (OL) Accounts payable

(0.040)

(0.040)

(0.040)

Income taxes payable

(0.013)

(0.009)

(0.010)

Accrued expenses: Accrued compensation

(0.015)

(0.012)

(0.011)

Accrued expenses: Product warranties

(0.012)

(0.014)

(0.018)

Accrued expenses: Promotional

(0.004)

(0.004)

(0.004)

Accrued expenses: Other

(0.006)

(0.004)

(0.004)

Unrecognized tax benefits

0.003)

(0.001)

(0.001)

-

(0.000)

(0.000)

(0.092)

(0.083)

(0.088)

Inverse of Operating ATO

0.225

0.320

0.411

Operating ATO

4.450

3.127

2.431

Other liabilities

h.

RNOA RNFL FLEV Spread (RNOA – RNFL) ROE

Solutions Manual, Chapter 6

8/27/16 20.17% 35.41% (0.1756) (15.23)% 22.85%

8/26/17 14.94% 7.39% 0.3073 7.55% 17.26%

8/25/18 14.64% 3.36% 0.6083 11.28% 21.51%

© Cambridge Business Publishers, 2021 6-19

Chapter 7 Full-Information Forecasting for Valuation QUESTIONS 1.

No, we want to be unbiased to avoid the possibility of missing out on opportunities. We seek the best possible forecast. After we have formed our best possible forecast we can later check its sensitivity to our assumptions prior to finalizing a decision.

2.

False. The accuracy of our forecasts is not based on the use of spreadsheets. The spreadsheets only serve to facilitate the process. Accuracy is a function of the assumptions we make. While spreadsheets may show numbers with many decimal points making them look precise, this does not make them more accurate.

3.

Sensitivity analysis allows for changing forecast assumptions so that as we adjust forecast assumptions, we can identify those that that have the greatest effect on our estimate of value. Critical assumptions must be investigated thoroughly to ensure that forecast assumptions are as accurate as possible to ensure the best business decisions.

4.

We first forecast sales growth, then NOPAT, then NOA. The forecasts of NOPAT are most often formed by forecasting operating PM and its components and the forecasts of NOA are most often formed by forecasting operating ATO and its components.

5.

Management and/or owners have complete control over whether operations are financed with debt or equity. These decisions result in a change in leverage and financial expenses. By focusing on the forecasting of operations, we do not have to anticipate how the firm will be funded in the future.

6.

The level of detail is dependent on the availability of information and also the desired level of effort in making the forecasts. We are limited by the information available just as we were in our reformulation. Then depending on the information available, we can choose how detailed our forecasts should be. A significant element of that decision may be the time available.

Solutions Manual, Chapter 7

© Cambridge Business Publishers, 2021 7-1

7.

The remainder of the income statement as well as the balance sheet can be thought of (and are forecasted) in relation to sales. The level of expenses will be determined primarily by the amount of sales expected. Even fixed expenses will be adjusted over time as the firm grows or shrinks it sales. Likewise, the net operating assets required will be determined primarily by the amount of sales expected. Increases in resources like inventory change with sales, but over time so do plant and equipment needed to support the sales expected.

8.

By having sales as the denominator instead of numerator, each element forecast will have a similar basis and can be added up to form the estimate of ATO. Additionally, issues with small denominator or zeros in some years for balance sheet items can be eliminated. For example, if a company had a very small prepaid balance in a particular year, the ATO for that item would be huge but when examining the inverse a small value is not a problem.

9.

After forecasting sales, PM and ATO, the implied RNOA should be evaluated.

Specifically, the evaluation needs to consider potential over-optimism regarding the assumptions. Unless the firm has an unusual competitive advantage, the implied RNOA is expected to revert to the historical mean.

10.

Having a strong knowledge of the business along with a level of professional skepticism provides the basis for evaluating whether the forecast values are higher or lower than the actual value will be or whether the firm has reached steady state or not. The deeper one’s knowledge about the company, the industry and the overall macro environment will allow for better estimates and not be influenced by potential suspect accounting.

© Cambridge Business Publishers, 2021 7-2

Valuation Using Financial Statements, 2nd Edition

EXERCISES 11.

Note, the U.S. franchise advertising represents each franchisee’s required six percent of retail sales contributed to fund national marketing and advertising campaigns. Domino’s recognized a corresponding expense for the same amount. In prior years, these revenues and expenses were netted against each other. Supply chain revenues present the equipment, dough and other ingredients Domino’s sells to its franchisees.

A first pass set of growth assumptions might be based either on total revenues or on revenues by source. Looking at total revenues, growth in the last four years has been growing slowly from 11.2 to 11.6 to 12.8 to 23.8 percent. The jump in 2018 total revenue growth is due to the inclusion of U.S. franchise advertising that previously was netted against its expense. The total revenue trend might lead to an assumption that growth will continue around 11 - 12 percent.

Alternatively, each of the types of revenue shown is growing at a different pace. Growth for U.S. Company-owned stores is declining from 13.9 to 10.6 to 11.8 to 4.9 percent. A similar pattern is noted for U.S. franchise royalties and fees. Moving from 18.5 to 14.5 to 12.5 to 11.4 percent, sales growth is slowing as well. Determining whether growth will slow further or rebound would require looking at plans for openings of additional stores as well as economy-wide factors.

The Supply chain consisting of equipment, dough and other product sales to franchisees show a different pattern from the franchise royalties. The pattern of increasing sales growth moves from 9.6 to 11.6 to 12.6 followed by a decline to 11.4 percent. This suggests that the U.S. franchises are increasing their use of the Domino’s Supply chain.

An assessment of the U.S. franchise use of the Supply chain will help evaluate expected future sales.

International franchise royalties and fees moved from 7.2 to 11.6 to 12.8 followed by a decline to 8.7 percent sales growth over the past four years. As with U.S. franchise growth, the revenue trend depends on Domino’s future expansion plans.

By evaluating the individual sources of revenues, a more directed inquiry is identified so better forecasts of total revenues are made. A trend analysis of the total revenues most likely will yield a poorer estimate than a detailed analysis of the individual sources of revenues.

Solutions Manual, Chapter 7

© Cambridge Business Publishers, 2021 7-3

12.

The issue here is the impact of diversity of revenue sources and geographic location on anticipated future revenues. Would each type of revenue above grow at the same rate or do we need to have detailed forecasts for each type. Similarly, how will the differing geographic (and economic) climates affect future revenues? Additionally, while we don’t have the breakdown, we are led to wonder about the intersection of these types such as how many franchised hotels or how many managed joint ventures internationally?

Understanding the types and locations will impact our forecasts for MAR. Another very important issue that must be understood for MAR is the cost reimbursements. This is very common in the lodging industry (know the business!) where they report an item of equal amount as a revenue and as an expense. These types of pass-through items (buying toilet paper for a managed hotel and being reimbursed for it) should probably be omitted completely as they create no value for capital providers. Clearly, omitting the $15,005 from this year and the $14,864 from last year alters our perception of revenue growth for MAR. Growth in revenues is increased from 1.5 to 3.0 percent.

13.

The level of property, plant and equipment would be directly tied to hotel properties MAR owns but is independent of those that they manage. This distinction is very important as forecasting for MAR requires consideration not only of growth but the elements of growth in each area.

Notice also that the issue of Cost reimbursements discussed in the answer to the question above comes into play as well. Should we calculate ATO for MAR with revenues that include or exclude the cost reimbursements? It would probably be most appropriate to exclude the cost reimbursements.

14.

Despite the desire to rely solely on the company’s guidance, the company guidance should inform the forecasts and not drive the forecasts. For publicly traded firms, guidance is not a required disclosure subject to regulations. As a voluntary disclosure, the firm is establishing an expectation for its future performance. When the actual results are announced, share price reactions tend to be significant depending whether the guidance was meet or not. Thus, firms tend to set lower expectations that can most likely be meet. Additionally, company guidance provides a good reasonable test for the analyst’s forecasts.

© Cambridge Business Publishers, 2021 7-4

Valuation Using Financial Statements, 2nd Edition

15.

Lacking additional information beyond the above table, the option to Use other information is not considered for this exercise.

Steady ratio is appropriate for items such as Warranty expense, Advertising costs, Research and development costs, Other retiree benefits service cost, Depreciation, Income taxes on continuing operations and Postretirement benefit plans- Amortization of prior service costs.

Steady amount is appropriate for Other cost of products sold and Other selling, general and administrative expense.

Follow a trend is appropriate for Defined contribution plan expense and Pension service cost as these costs are increasing over time as a percentage of sales.

Zero is appropriate for Pension Amortization of prior service cost, Pension settlement cost, Gain on sale of interest in subsidiary, other non-operating income(expense) and the remaining comprehensive income items.

16.

a. There are multiple correct answers. The issue is how to handle the most recent year’s results. Sales growth was declining from 16.5 to 11.2 to 4.6 percent only to increase to 11.9 percent in fiscal 2018. Additionally, PM from sales is relatively flat while operating PM has steadily increased, suggesting that the profit margin growth is not from its core activities and is not likely to be sustainable. The ATO was stable for fiscal years 2014 – 2017 with a significant jump in 2018. Without the fiscal 2018 results, the forecasted components for Sales, PM and ATO would be lower. Thus, the question is whether fiscal 2018 is a temporary or a new shift in expectations. b. Using the trends from fiscal 2014 through fiscal 2017, estimates for sales growth would be at 3.0%, PM at 11.0% and ATO at 2.90 resulting in a forecasted RNOA of 31.9%, a high but potential sustainable RNOA for the foreseeable future. By including the fiscal 2018 results, sales growth could be at 5.0 or 6.0 percent, PM would be over 12%, say 12.5% and ATO over 4.0, say 4.25. The resulting RNOA would be over 50%, which would be difficult to sustain for an extended period without an distinctive competitive advantage.

Solutions Manual, Chapter 7

© Cambridge Business Publishers, 2021 7-5

CONTINUING EXAMPLES 17.

Sales growth Profit margin Asset turnover ratio

2.00% 10.50% 1.10

Based on the recent results, sales growth between 2011 and 2014 has had a wide range from -4.14% to 5.39% with improving sales growth rates each year. This makes it hard to choose a growth rate. A reasonable assumption (that also considers what we have learned from General Mills) might be 2.00%. This amount lies between what we have recently observed and economic growth that might be expected. PM from sales has ranged from 6.27% to 11.74% with improving profit margins each year. For ATO, the past three years ranged from 1.094 to 1.164. What pattern is expected to continue is a question we would need to investigate in a full information forecast. These assumptions lead us to the following forecasts:

Sales

NOPA T

NOA

2019

2020

2021

2022

$13,818 ($13,547 x 1.02)

$14,094 ($13,818 x 1.02)

$14,376 ($14,094 x 1.02)

$14,664 ($14,376 x 1.02)

$1,451 ($13,818 x 10.5%)

$1,480 ($14,094 x 10.5%)

$1,509 ($14,376 x 10.5%)

$1,540 ($14,664 x 10.5%)

$12,812 ($14,094/1.10)

$13,069 ($14,376/1.10)

$13,331 ($14,664/1.10)

$13,597 ($14.957/1.10)

Note that NOA is forecast off of subsequent year sales since we are anticipated the assets required to be in place to support the sales.

© Cambridge Business Publishers, 2021 7-6

Valuation Using Financial Statements, 2nd Edition

18.

Table continued

Solutions Manual, Chapter 7

© Cambridge Business Publishers, 2021 7-7

18.

Table continued

© Cambridge Business Publishers, 2021 7-8

Valuation Using Financial Statements, 2nd Edition

19.

Continued

Solutions Manual, Chapter 7

© Cambridge Business Publishers, 2021 7-9

19.

continued

© Cambridge Business Publishers, 2021 7-10

Valuation Using Financial Statements, 2nd Edition

20.

Sales growth Profit margin Asset turnover ratio

5.00% 5.50% 4.80

For the past three years, sales growth between fiscal 2015 and 2018 has had a wide range from 14.36% to 58.16%. The Jayco acquisition in late fiscal 2016 resulted in the large increase in sales growth. Outside the Jayco acquisition, THO’s increased sales growth is due to both increased number of units sold as well as price increases. As noted in Dickinson and Sommers, reversion to mean over time will be expected. A reasonable estimate of future organic sales growth is 5.00% PM from sales has ranged from 5.27% to 5.61% with declining profit margins each year. For ATO, the past three years ranged from 3.734 to 4.772 increasing each year. Given the number of models, the ATO is expected to stabilize over the future at 4.80. What pattern is expected to continue is a question we would need to investigate in a full information forecast. These assumptions lead us to the following forecasts: 2019

2020

2021

2022

Sales

$8,745,354 ($8,328,909 x 1.05)

$9,182,622 ($8,745,354 x 1.05)

$9,641,753 ($9,182,622 x 1.05)

$10,123,841 ($9,641,753 x 1.05)

NOPAT

$480,994

$530,296

$556,811

($8,745,354x5.50%)

$505,044 ($9,182,622x5.50% )

($9,641,753x5.50%)

($10,123,841x5.50%)

$1,913,046 ($9,182,622/4.80)

$2,008,699 ($9,641,753/4.80)

$2,109,134 ($10,123,841/4.80)

$2,214,590 ($10,630,033/4.80)

NOA

Note that NOA is forecast off of subsequent year sales since we are anticipated the assets required to be in place to support the sales.

Solutions Manual, Chapter 7

© Cambridge Business Publishers, 2021 7-11

21.

© Cambridge Business Publishers, 2021 7-12

Valuation Using Financial Statements, 2nd Edition

22.

Continued

Solutions Manual, Chapter 7

© Cambridge Business Publishers, 2021 7-13

22.

continued

© Cambridge Business Publishers, 2021 7-14

Valuation Using Financial Statements, 2nd Edition

23.

Sales growth Profit margin Asset turnover ratio

2.00% 6.00% 2.50

Based on the recent results, sales growth between fiscal years 2015 and 2018 has had a wide range from -0.13% to 58.64%. The Grand Design acquisition in fiscal 2017 impacted sales growth. Organic growth remained close to flat over these periods. This makes it hard to choose a growth rate. A reasonable assumption (that also considers what we have learned from General Mills) might be 2.00%. This amount lies between what we have recently observed and economic growth that might be expected. PM from sales has ranged from 4.53% to 6.02% with improving profit margins each year. The high end of 6.00% is selected for expected PM from sales. For ATO, the past three years ranged from 4.450 to 2.431. However, ATO is decreasing each year. Again, select an ATO near the end of the forecast periods, such as 2.50. What pattern is expected to continue is a question we would need to investigate in a full information forecast. These assumptions lead us to the following forecasts: 2019

2020

2021

2022

Sales

$2,117,670 ($2,016,829x1.02)

$2,223,554 ($2,117,670x1.02)

$2,334,732 ($2,223,554x1.02)

$2,451,468 ($2,334,732x1.02)

NOPAT

$127,060 ($2,117,670x6.0% )

$133,413

$147,088

($2,223,554x6.0%)

$140,084 ($2,334,732x6.0% )

($2,451,468x6.0%)

$889,422 ($2,223,554/3.30)

$933,893 ($2,334,732/3.30)

$980,587 ($2,451,468/3.30)

$1,029,617 ($2,574,042/3.30)

NOA

Note that NOA is forecast off of subsequent year sales since we are anticipated the assets required to be in place to support the sales.

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24.

25.

Continued

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Valuation Using Financial Statements, 2nd Edition

25.

continued

Solutions Manual, Chapter 7

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Chapter 8 Market Multiple Valuation QUESTIONS 1.

What are the biggest concerns when using multiples?

Amongst the concerns are the choice of the appropriate multiple(s) to consider, the choice of comparable firms, and the way to combine the multiples for the different comparables into a single measure. Each of these steps involves assumptions and/or choices that can drastically change the estimate obtained.

2.

How hard is it to find appropriate comparables?

As most firms are not “pure play” in a single industry, it is hard to determine who should be used as a comparable. Often the things that makes a firm special (and presumably more valuable) are not present in other companies. Thus we fail to pick up a key characteristic of the firm of interest. For example, what firm is truly comparable to WalMart whose special characteristics are its just-in-time inventory system, data tracking, and relationship with suppliers? Finding comparables always requires compromises that result in variation amongst the firms considered.

3.

What is the primary advantage to using an operating-based multiple rather than a company level multiple?

The main advantage is by focusing on operating activities, we do not have issues arising due to differences in leverage. If two companies who are otherwise comparable in operations have different sources of funding (creditors vs. equity holders), that will cause differences in their valuation. The use of operating-based multiples controls for these differences.

4.

Why would we use industry-based multiples to estimate value?

There are factors that are viewed as being of primary importance and drivers of value that may be particular to an industry. Investors feel that a particular measure may better reflect the growth or profitability of the companies within the industry. If the investors are focused on these things, then it makes sense to utilize them when estimating value using multiples.

Solutions Manual, Chapter 8

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5.

When utilizing the multiples method, we assume the market is appropriate valuing the comparable firms. Why might this assumption be a cause for concern?

When we utilize multiples, we accept the valuation by the market of the comparable firms as appropriate. However, if the company we are examining is publicly traded why the market not have an appropriate price for this firm as well. This creates a circularity where we assume firm B is appropriately valued when using it to estimate firm A, but if instead we were estimating firm B we would change our assumption. Now we would assume firm A is appropriately valued when using it to estimate firm B. Justifying these changing assumptions requires us to assume the market correctly values all firms except the one under consideration.

6.

What are the steps to using market multiples?

There are five steps in estimating value with market multiples. Step 1, select the fundamental indicator of value (e.g., earnings, book value); step 2, select the comparable companies; step 3, compute the market multiple from the comparable companies’ market value and fundamental indicator (e.g., P/E ratio); step 4, compute the value of the target company using its fundamental indicator and the market multiple; and step 5, if the fundamental indicator is an operating indicator, subtract the value of debt from total operating value to arrive as equity value.

7.

When combining estimates from different multiples, what is the primary benefit for this analysis?

The primary benefit to average various estimates across several multiples is to reduce the estimation error by selecting relevant multiples. This avoids having to evaluate the merits of the individual multiples. The combined estimate can be done by a simple average of the estimates or by weighted average. The analyst needs to avoid selecting estimates for the confirmation of an expected outcome.

8.

A commonly used multiple in practice is EV/EBITDA, Enterprise (Operating) Value-toEBITDA (earnings before interest, taxes, depreciation and amortization) multiple. What are the limitations associated with using EBITDA based multiples?

The concept of EBITDA does not capture value creation as NOPAT does. By ignoring operating taxes along with depreciation and amortization, EBITDA overstates the value created by the firm. As a proxy for FCF, EBITDA does not effectively capture operating cash flows or investments into/from operating activities. Thus, EBITDA does not represent either value created or value distributed.

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Valuation Using Financial Statements, 2nd Edition

9.

When is it appropriate to use market multiples for valuation?

The use of market multiples is commonplace in practice. Without all the assumptions required for a full-blown valuation, market multiples can provide a quick read on a firm’s valuation. For firms without a readily known market value in a public market (e.g., private companies, divisions to spun out), market multiples are appropriate. Additionally, for publicly traded firms, market multiples provide a reasonableness check as well as identify outliers for a deeper investigation.

10.

When the target company has negative earnings and/or negative equity, can market multiples be used for valuation?

Yes, when the target company or the comparable firms have negative earnings or equity, market multiples can be used. The metrics are based on items such as Price to Sales or R&D/Advertising ratios or industry specific ratios (e.g., occupancy rates, sales per square foot, net bookings, monthly active users) that provide meaningful results.

Solutions Manual, Chapter 8

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EXERCISES 11.

For McDonald’s (MCD) who might we use as comparable firms if implementing the multiples method? What concerns might we have about the companies chosen?

There are numerous options available. From Jack in the Box (JACK) to Wendy’s (WEN), to YUM Brands! (YUM), which owns KPC, Pizza Hut and Taco Bell, to Restaurant Brands (QSR), which owns Burger King, Tim Hortons and Popeye’s, there are numerous potential comparable firms. The question becomes whether these firms are truly comparable? Will the business model, profitability, efficiency, and risk of these firms mirror MCD allowing for an appropriate estimate of value? For example, the impact of international operations versus domestic operations or the ratio of firm-owned to franchise-owned locations similar. These two issues alone would be expected to result in substantial differences in the some of the multiples we might consider.

12.

For Hyatt (H) and Marriott (MAR), what is an example of an industry multiple we might employ to estimate firm valuation? What might be a hindrance to the use of this measure?

The hotel industry utilizes two key performance measures: Average Daily room Rate (ADR) and Revenue per Available Room (RevPAR = ADR * Occupancy rate). As such, we might employ these in forming a multiple such as ADR-to-price. A hesitation might arise in using these measures as attempt to recognize the revenue being generated by each room. That is, they do not reflect differences in cost structure that may arise.

Additionally, they do not reflect differences that may exist across companies in the geographic location of rooms which would directly impact the amount charged. As such, despite being a widely focused on industry measure, we may still need to exercise caution when employing these measures.

13.

Beyond Meat (BYND), a plant-based protein company, went public in May 2019. The IPO was priced at $25 per share but started trading at $46 per share before ending the day at $65.75 per share. Over the next few months, BYND’s share price topped $240 per share with a market capitalization over $15 billion. With under $100 million in 2018 sales and negative earnings, BYND’s market valuation was difficult to support. In August 2019, Bank of America Merrill Lynch published an analyst report with a price objective of $182 per share. Evaluate the implicit assumptions necessary to support a price objective of $182 per share with an EV (or operating value)/sale multiple.

Continued

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Valuation Using Financial Statements, 2nd Edition

In the current valuation, the 2020 EV/Sales multiple is 11.0x. Presumably, this multiple includes expected sales growth of 40 – 50 percent over the next several years. To extend the 2023 EV/Sales multiple to 12.0x requires BOA Merrill Lynch to believe that the market is currently underestimating the expected future sales growth for BYND. The EBITDA growth rates are greater than the corresponding sales growth rates. To achieve such EBITDA growth rates requires that BYND maintain a significant comparative advantage over plant-based protein companies for many years.

The discount rate appears to be independent of the expected growth rate. As the expected growth increases, the corresponding operational risk increases. That is, the higher the growth rate, the more risk is associated with the growth.

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14.

Forbes magazine wrote the following excerpt a number of years ago.

Jim O’Shaugnessy, a money manager in Stamford, Conn., has been using computers for the past 30 years to help him find out what makes the market tick. He originally published “What Works On Wall Street” in 1996 and just put out the book’s fourth edition. There is no magic ratio that assures marketbeating returns, says O’Shaughnessy, but screens with tried and true value criteria do have a pronounced propensity to turn up winning stocks.

In short, if you want the best results over time, go with small cap stocks trading at lower-than-average multiples of earnings, sales and book value– and buy them when they’re trending higher. Momentum does matter as history shows that winners tend to keep on winning.

As for the merit of one popular measure of value, the price-earnings ratio, O’Shaughnessy’s research makes a compelling case for buying low P/E stocks. From January 1, 1964 to December 31, 2009, an investment of $10,000 in the 10% of stocks with the lowest P/E ratios would have grown to $10,202,345.

If investing is as easy as putting $10,000 into the 10 percent of stocks with the lowest P/E ratios over 35 years and end up with a portfolio worth over $10 million, then should not everyone be doing this? Explain why an analyst needs to consider doing fundamental research as opposed to relying on stock screens.

Screening uses limited information, no forecasting, and limited analysis so it is quick and easy to do. The risk with screening is that it ignores information about the future. It uses historic information, which is a bit limited for prediction of the future since past trends don’t necessarily translate into what will happen in the future. You can miss valuable information only looking behind you and not anticipating what is in front of you.

Fundamental research is a very thorough and does not ignore information as screening does. The tenets of fundamental analysis allow you to make an educated trading decision vs. looking at only limited pieces of information. It allows you to get to know the company (its business, its management, its competitive environment, etc…), analyze information you see on and off the financial statements (including macroeconomic trending), develop measures for a forecast, execute a forecast, and make a determination to trade based off of the forecast. Although fundamental research is more labor intensive than simple screening, it allows an investor to make an educated decision about investment weighing many factors.

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Valuation Using Financial Statements, 2nd Edition

15.

Barth Co. is a fast growing company that is considering an initial public offering (IPO) early next year. Barth’s next year’s expected sales, NOPAT and earnings per share next year are $250 million, $50 million and $4.00 per share, respectfully. Currently, Barth has $50 million in debt with 10.0 million common shares outstanding.

Barth’s CFO identified five public companies which operate in the same industry and gathered estimates of next fiscal year’s sales, NOPAT an EPS along with the current price, market capitalization and operating (enterprise) value (OV).

Market Data Price Market Cap $/share $M Paton Corp.

29.45 2,400 Hatfield Ltd. 45.65 6,650 Andersen Inc. 29.50 13,200 Sells Corp.

68.25 9,500 Sprague Companies 145.75 10,850

Financial Data (FY + 1) OV Sales NOPAT EPS $M $M $M $/share 2,850 950 190 0.90 8,000 3,200 640 1.70 15,190 4,900 1,6001.60 9,990 3,700 800 3.05 10,120 4,600 600 6.75

For each of the comparable firms, calculate the individual firm OV/Sales, EV/NOPAT and P/E ratios along with the average and median ratios. What recommendation should the CFO make regarding Barth’s equity value?

Applying the financial data to the market data results in the following valuation multiples.

Paton Corp.

Hatfield Ltd. Andersen Inc. Sells Corp.

Sprague Companies Average Median

Valuation (FY + 1) OV/Sales OV/NOPAT 3.0x 15.0x 2.5x 12.5x 3.1x 9.5x 2.7x 12.5x 2.2x 16.9x 2.7x 2.7x

13.3x 12.5x

P/E 32.7x 26.9x 18.4x 22.4x 21.6x 24.4x 22.4x

For the OV/Sales: 2.7 x $250 million = $675 million - $50 million debt = $625 million in equity value.

For the OV/NOPAT: Median –12.5 x $50 million = $625 million - $50 million debt = $575 million in equity Average – 13.3 x $50 million = $664 million - $50 million debt = $614 million in equity Using the averages and medians for the above multiples to Barth’s expected financial results in a range for the firm’s equity from $575 million to $625 million of $57.50 to $62.50 per share assuming no additional shares are issued.

A review of the comparable companies, Paton is the smallest firm and closest to Barth by sales and operating value, has OV/Sales and OV/NOPAT above the averages and medians. This may suggest that the growth potential may be greater for Paton and, potentially, for Barth. A detailed analysis from full fundamental analysis will provide more information as to the Barth’s value of equity.

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CONTINUING EXAMPLES For the examination of Kellogg (K), we will be using the same data we used in chapter for the valuation of General Mills (GIS). However, in this case we will be assuming GIS is appropriately valued by the market and use it to estimate the value of K. 16.

Using the data in Exhibit 8.2 for GIS, CPB and SJM, estimate the value per share of K using an NOA multiple. Additional information for the process is that the operating value and equity value of GIS are $46,409 and $30,735, respectively. Determine whether, based on this estimate, K is over- or under-priced at its May 1, 2019 price of $59.39. (in millions, except per share) Operating value NOA Common shares outstanding NOA market multiple Operating value Equity value Equity value per share

K – $12,002

GIS

CPB

SJM

$46,409 $22,604

$21,099 $10,834 301

$20,004 $14,059

344 shares 599 shares 1.81 $21,724 $12,323 $35.82

2.05

shares 1.95

114 shares 1.42

Based on the estimate of $35.82, K was overvalued at May 1, 2019.

17.

Continue using the data in Exhibit 8.2 for GIS, CPB and SJM to estimate the value per share of K using a BV multiple. Determine whether, based on this estimate, K is over- or under-priced at its May 1, 2019 price of $59.39. Discuss the validity of the result and what drives your conclusions. (in millions, except per share) Equity value Book value of equity Common shares outstanding BV market multiple Equity value Equity value per share

K

GIS

CPB

SJM

– $2,604

$30,735 $6,930

$11,534 $1,269 301

$13,967 $8,022

344 shares 599 shares 5.09 $13,239 $38.49

4.43

shares 9.09

114 shares 1.74

Based on the estimate of $38.82, K was overvalued at May 1, 2019.

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Valuation Using Financial Statements, 2nd Edition

18.

Using the data in Exhibit 8.5 for GIS, CPB and SJM estimate the value per share of K using a NOPAT multiple. Additional information for the process is that the operating value and equity value of GIS are $46,409 and $30,735, respectively. Determine whether, based on this estimate, K is over- or under-priced at its May 1, 2019 price of $59.39. Discuss the validity of the result and what drives your conclusions. (in millions, except per share) Operating value NOPAT Common shares outstanding NOPAT market multiple Operating value Equity value Equity value per share

K

GIS

CPB

SJM

– $1,531

$46,409 $1,866

$21,099 $156 301

$20,004 $736

344 shares 599 shares 62.43 $95,580 $86,179 $250.52

24.87

shares 135.25

114 shares 27.18

Based on the estimate of $250.52 per share, this is not a reasonable estimate. The market having overvalued the firm by almost five-fold seems unlikely! The high market multiple of CPB is driving this unusually high valuation. Even deleting CPB from the analysis results in an equity value of $88.50 for K.

19.

Continue using the data in Exhibit 8.5 for GIS, CPB and SJM to estimate the value per share of K using an NI multiple. Determine whether, based on this estimate, KMB is over- or under-priced at its May 1, 2019 price of $59.39. (in millions, except per share) Equity value NI Common shares outstanding NI market multiple Equity value Equity value per share

K

GIS

CPB

SJM

– $1,344

$30,735 $1,563

$11,534 ($164) 301

$13,967 $629

344 shares 599 shares (9.49) ($12,755) ($37.08)

19.66

shares (70.33)

114 shares 22.21

Based on the estimate of negative $37.08 per share, we know this is not a valid estimate. A share cannot have a negative value. In this case, the estimate is driven by the negative value observed for CPB’s TTM NI.

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20.

Using the data in Exhibit 8.8 for GIS, estimate the value per share of K using an operating Forward PE multiple. Additional information for the process is that the operating value of GIS is $46,409. Determine whether, based on this estimate, K is overor under-priced at its May 1, 2019 price of $59.39. (in millions, except per share) Operating value NOPATt+1 Forward PE Implied operating value Equity value Equity value per share

K

19.59 $31,364 $21,963 $63.85

GIS CPB SJM $46,409 $21,099 $20,004 $2,330 $1,012 $1,112 19.92

20.85

17.99

Based on the estimate of $63.85, K was undervalued at May 1, 2019.

21.

Continue using the data in Exhibit 8.8 for GIS, estimate the value per share of K using an operating PEG ratio multiple. Determine whether, based on this estimate, K is overor under-priced at its May 1, 2019 price of $59.39.

CPB

SJM

(in millions, except per share) Operating value NOPATt+1

$46,409 $21,099 $20,004 $1,601 $2,330 $1,012 $1,112

NOPATt+2

$1,697

$2,426

$1,051

$1,144

Short-term NOPAT growth PEG Implied operating value Equity value Equity value per share

$96 5.50 $52,800 $43,99 $126.16

$96 4.83

$39 5.41

$32 6.25

K

GIS

Based on the estimate of $126.16, K was significantly undervalued at May 1, 2019.

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Valuation Using Financial Statements, 2nd Edition

22.

Using the data in Exhibit 8.9 for GIS, estimate the value per share of K using a sales multiple. Additional information for the process is that the operating value of GIS is $46,409. Determine whether, based on this estimate, K is over- or under-priced at its May 1, 2019 price of $59.39. (in millions, except per share) Operating value Sales Price to Sales Implied operating value Equity value Equity value per share

K

GIS

CPB

SJM

– $46,406 $21,099 $20,004 $13,547 $16,594 $9,751 $7,717 2.52 2.80 2.16 2.59 $34,138 $24,737 $71.91

Based on the estimate of $71.91 K was very undervalued at May 1, 2019.

23.

Continue using the data in Exhibit 8.9 for GIS, estimate the value per share of K using a ratio of (Price-Book) to R&D multiple. Determine whether, based on this estimate, K is over- or under-priced at its May 1, 2019 price of $59.39. Discuss concerns with the estimation process using this multiple for K. (in millions, except per share) Operating value NOA R&D Expenditures (Price - Book) / R&D Implied operating value Equity value Equity value per share

K

GIS

CPB

SJM

– $46,409 $21,099 $20,004 $12,002 $22,604 $10,834 $14,059 $154 $219 $103 $56 104.84 108.70 99.66 106.17 $28,147 $18,746 $54.49

Based on the estimate of $54.49, KMB was overvalued at May 1, 2019.

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24.

In reviewing the estimates of price for K based on the multiples method, comment on the confidence in the use of this model.

For Kellogg, across the eight estimates above, estimates ranging from negative $37.08 for the NI market multiple to $250.52 for the NOPAT multiple were found. While certain multiples can be easily dismissed, it still calls into question the use of the methodology.

The observed range leaves us with little confidence in these estimates as it demonstrates the importance of the choice of multiple. Additional issues could arise based on the choice of comparable companies used in the analysis.

For the examination of Thor Industries (THO) and Winnebago (WGO), we include two additional companies, Camping World Holdings (CWH) and LCI Industries (LCII).

Camping World Holdings is an outdoor and camping retailer that operating through three segments, Consumer Services and Plans, Dealership and Retail. Though Camping World does not build travel trailer but is impacted by the same industry related factors.

LCI Industries manufactures and supplies components for recreational vehicle manufacturers through its Original Equipment Manufacturers (OEM) segment and operates an Aftermarket segment to retail dealers, wholesale distributors and service centers.

The table below summarizes the relevant balance sheet metrics as of the latest quarter or year end to the May 1, 2019 measurement date. (in thousands) Operating value Equity value NOA Book value of equity NFL Sales NOPATt NOPATt+1 NOPATt+2 Net Income Common shares outstanding

© Cambridge Business Publishers, 2021 8-12

THO

WGO

CWH

LCII

$3,382,290 $1,379,042 $3,453,691 $2,474,759 $3,563,677 $1,114,599 $1,278,066 $2,181,231 $1,725,544 $835,109 $2,220,163 $999,783 $1,906,931 $570,666 $44,538 $706,255 ($181,387) $264,443 $2,175,625 $293,528 $7,172,233 $2,024,787 $4,792,017 $2,475,807 $230,344 $119,185 $148,550 $149,699 $290,648 $125,615 $112,855 $148,295 $393,065 $141,552 $169.990 $168,683 $230,529 $116,336 $10,398 $148,551 55,063 sh. 31,873 sh. 87,900 sh. 24,863 sh.

Valuation Using Financial Statements, 2nd Edition

25.

Using the data above for WGO, CWH, and LCII, estimate the value per share of THO using a NOA multiple. Determine whether, based on this estimate, THO is over- or under-priced at its May 1, 2019 price of $64.72. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value NOA Common shares outstanding NOA market multiple Operating value Equity value Equity value per share

THO

WGO

CWH

LCII

– $1,379,042 $3,453,691 $2,474,759 $1,725,544 $835,109 $2,220,163 $999,783 55,063 sh. 31,873 sh. 87,900 sh. 24,863 sh.

1.90 1.65 1.56 2.48 $3,278,533 $3,459,920 $62.84

Based on the estimate of $62.84, THO was slightly overvalued at May 1, 2019. At first glance, that may leads to a conclusion that the use of an NOA market multiple ratio is most appropriate for THO. However, remember that is we make that conclusion we have allowed the answer to dictate the question. We must ask ourselves why the use of an NOA market multiple ratio is appropriate for WGO, CWH, and LCII is the right choice to make rather than just rejoicing in the estimate it provides.

26.

Using the data above for WGO, CWH, and LCII, estimate the value per share of THO using a BV multiple. Determine whether, based on this estimate, THO is over- or underpriced at its May 1, 2019 price of $64.72. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Equity value Book value of equity Common shares outstanding BV market multiple Equity value Equity value per share

THO

WGO

CWH

LCII

– $1,114,599 $1,278,066 $2,181,231 $1,906,931 $570,666 $44,538 $706,255 55,063 sh. 31,873 sh. 87,900 sh. 24,863 sh.

11.25 1.95 28.70 3.09 $21,452,974 $389.61

Based on the estimate of $389.61, THO was grossly undervalued at May 1, 2019. This result is driven by Camping World which has a very low book value. Without Camping World, the equity value per share for THO is $87.27, a much closer value to the current share price. However, one must be careful to infer that a price close to the current share is due to causality.

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27.

Using the data above for WGO, CWH, and LCII, estimate the value per share of THO using a NOPAT multiple. Determine whether, based on this estimate, THO is over- or under-priced at its May 1, 2019 price of $64.72. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value NOPAT Common shares outstanding NOPAT market multiple Operating value Equity value Equity value per share

THO

WGO

CWH

LCII

– $1,379,042 $3,453,691 $2,474,759 $230,344 $119,185 $148,550 $149,699 55,063 sh. 31,873 sh. 87,900 sh. 24,863 sh.

17.12 11.57 23.25 16.53 $3,945,201 $4,126,589 $74.94

Based on the estimate of $74.94 per share, THO was undervalued at May 1, 2019.

28.

Using the data above for WGO, CWH, and LCII, estimate the value per share of THO using a NI multiple. Determine whether, based on this estimate, THO is over- or underpriced at its May 1, 2019 price of $64.72. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Equity value NI Common shares outstanding NI market multiple Equity value Equity value per share

THO

WGO

CWH

LCII

– $1,114,599 $1,278,066 $2,181,231 $230,529 $116,336 $10,398 $148,551 55,063 sh. 31,873 sh. 87,900 sh. 24,863 sh.

49.06 9.58 122.91 14.68 $11,309,75 3 $205.40

Based on the estimate of $205.40, THO was grossly undervalued at May 1, 2019. This result is driven by Camping World which has a very high net income multiple. Without Camping World, the equity value per share for THO is $50.78, which shows as being overvalues at May 1, 2019.

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Valuation Using Financial Statements, 2nd Edition

29.

Using the data above for WGO, CWH, and LCII, estimate the value per share of THO using an operating Forward PE multiple. Determine whether, based on this estimate, THO is over- or under-priced at its May 1, 2019 price of $64.72. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value NOPATt+1 Forward PE Implied operating value Equity value Equity value per share

THO 19.42 $5,644,384 $5,825,771 $105.80

WGO

CWH

LCII

$1,379,042 $3,453,691 $2,474,759 $125,615 $112,855 $148,295 10.98

30.60

16.69

Based on the estimate of $105.80, THO was undervalued at May 1, 2019.

30.

Using the data above for WGO, CWH, and LCII, estimate the value per share of THO using an operating PEG ratio multiple. Determine whether, based on this estimate, THO is over- or under-priced at its May 1, 2019 price of $64.72. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share)

THO

Operating value NOPATt+1

$1,379,042 $3,453,691 $2,474,759 $290,648 $125,615 $112,855 $148,295

NOPATt+2 Short-term NOPAT growth PEG Implied operating value Equity value Equity value per share

$393,065 $102,417 0.89 $9,115,113 $9,296,500 $168.83

WGO

$141,552 $15,937 0.87

CWH

$169.990 $57.135 0.60

LCII

$168,683 $20,388 1.21

Based on the estimate of $168.83, THO was significantly undervalued at May 1, 2019.

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31.

Using the data above for WGO, CWH, and LCII, estimate the value per share of THO using a sales multiple. Determine whether, based on this estimate, THO is over- or under-priced at its May 1, 2019 price of $64.72. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value Sales Price to Sales Implied operating value Equity value Equity value per share

THO

WGO CWH LCII – $1,379,042 $3,453,691 $2,474,759 $7,172,233 $2,024,787 $4,792,017 $2,475,807 0.80 0.68 0.72 1.00 $5,737,786 $5,919,173 $107.50

Based on the estimate of $107.50 THO was undervalued at May 1, 2019.

32.

In reviewing the estimates of price for THO based on the multiples method, comment on the confidence in the use of this model.

For THO, across the seven estimates above, estimates ranging from $74.94 for the NOPAT market multiple to $389.61 for the BV multiple were found. While certain multiples can be easily dismissed, it still calls into question the use of the methodology.

The observed range leaves us with little confidence in these estimates as it demonstrates the importance of the choice of multiple. Additional issues could arise based on the choice of comparable companies used in the analysis.

33.

Using the data above for THO, CWH, and LCII, estimate the value per share of WGO using a NOA multiple. Determine whether, based on this estimate, WGO is over- or under-priced at its May 1, 2019 price of $34.97. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share)

WGO

THO

CWH

LCII

Operating value NOA Common shares outstanding

– $3,382,290 $3,453,691 $2,474,759 $835,109 $1,725,544 $2,220,163 $999,783 31,873 sh. 55,063 sh. 87,900 sh. 24,863 sh.

NOA market multiple Operating value Equity value Equity value per share

2.00 $1,670,218 $1,405,775 $44.11

1.96

1.56

2.48

Based on the estimate of $44.11, WGO was undervalued at May 1, 2019.

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Valuation Using Financial Statements, 2nd Edition

34.

Using the data above for THO, CWH, and LCII, estimate the value per share of WGO using a BV multiple. Determine whether, based on this estimate, WGO is over- or underpriced at its May 1, 2019 price of $34.97. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Equity value Book value of equity Common shares outstanding BV market multiple Equity value Equity value per share

WGO

THO

CWH

LCII

– $3,563,677 $1,278,066 $2,181,231 $1,906,931 $1,906,931 $44,538 $706,255 31,873 sh. 55,063 sh. 87,900 sh. 24,863 sh.

11.22 1.87 28.70 3.09 $6,402,873 $200.89

Based on the estimate of $200.89, WGO was grossly undervalued at May 1, 2019. This result is driven by Camping World which has a very low book value. Without Camping World, the equity value per share for WGO is $44.40, a much closer value to the current share price.

35.

Using the data above for THO, CWH, and LCII, estimate the value per share of WGO using a NOPAT multiple. Determine whether, based on this estimate, WGO is over- or under-priced at its May 1, 2019 price of $34.97. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value NOPAT Common shares outstanding NOPAT market multiple Operating value Equity value Equity value per share

WGO

THO

CWH

LCII

– $3,563,677 $3,453,691 $2,474,759 $230,344 $230,529 $148,550 $149,699 31,873 sh. 55,063 sh. 87,900 sh. 24,863 sh.

18.15 14.68 23.25 16.53 $2,163,208 $1,898,765 $59,57

Based on the estimate of $59.57 per share, WGO was undervalued at May 1, 2019.

Solutions Manual, Chapter 8

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36.

Using the data above for THO, CWH, and LCII, estimate the value per share of WGO using a NI multiple. Determine whether, based on this estimate, WGO is over- or underpriced at its May 1, 2019 price of $34.97. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Equity value NI Common shares outstanding NI market multiple Equity value Equity value per share

WGO

THO

CWH

LCII

– $3,563,677 $1,278,066 $2,181,231 $230,529 $230,529 $10,398 $148,551 31,873 sh. 55,063 sh. 87,900 sh. 24,863 sh.

16.54 15.46 19.49 14.68 $1,924,197 $60.37

Based on the estimate of $60.37, WGO was undervalued at May 1, 2019.

37.

Using the data above for THO, CWH, and LCII, estimate the value per share of WGO using an operating Forward PE multiple. Determine whether, based on this estimate, WGO is over- or under-priced at its May 1, 2019 price of $34.97. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value NOPATt+1 Forward PE Implied operating value Equity value Equity value per share

WGO

THR

-

CWH

LCII

$3,382,290 $3,453,691 $2,474,759 $290,648 $112,855 $148,295

19.64 $2,467,079 $2,202,636 $69.11

11.64

30.60

16.69

Based on the estimate of $69.11, WGO was undervalued at May 1, 2019.

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Valuation Using Financial Statements, 2nd Edition

38.

Using the data above for THO, CWH, and LCII, estimate the value per share of WGO using an operating PEG ratio multiple. Determine whether, based on this estimate, WGO is over- or under-priced at its May 1, 2019 price of $34.97. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value NOPATt+1 NOPATt+2 Short-term NOPAT growth PEG Implied operating value Equity value Equity value per share

WGO THO CWH LCII $3,382,290 $3,453,691 $2,474,759 $290,648 $290,648 $112,855 $148,295 $393,065 $393065 $169.990 $168,683 $102,417 $102,417 $57.135 $20,388 0.71 0.33 0.60 1.21 $1,131,527 $867,084 $27.20

Based on the estimate of $27.20, WGO was overvalued at May 1, 2019.

39.

Using the data above for THO, CWH, and LCII, estimate the value per share of WGO using a Price to Sales multiple. Determine whether, based on this estimate, WGO is over- or under-priced at its May 1, 2019 price of $34.97. Discuss the validity of the result and what drives your conclusions. (in thousands, except per share) Operating value Sales Price to Sales Implied operating value Equity value Equity value per share

WGO

THO CWH LCII – $3,382,290 $3,453,691 $2,474,759 $2,024,787 $7,172,233 $4,792,017 $2,475,807 0.73 0.47 0.72 1.00 $1,478,095 1,213,652 $38.08

Based on the estimate of $38.08 WGO was undervalued at May 1, 2019. At first glance, that may leads to a conclusion that the use of an Price to Sales multiple ratio is most appropriate for WGO. However, remember that is we make that conclusion we have allowed the answer to dictate the question. We must ask ourselves why the use of Price to Sales market multiple ratio is appropriate for THO, CWH, and LCII.

40.

In reviewing the estimates of price for WGO based on the multiples method, comment on the confidence in the use of this model.

For WGO, across the seven estimates above, estimates ranging from $27.20 for the operating PEG ratio multiple to $200.89 for the BV multiple were found. While certain multiples can be easily dismissed, it still calls into question the use of the methodology.

The observed range leaves us with little confidence in these estimates as it demonstrates the importance of the choice of multiple. Additional issues could arise based on the choice of comparable companies used in the analysis.

Solutions Manual, Chapter 8

© Cambridge Business Publishers, 2021 8-19

Chapter 9 Cost of Capital for Operations and Equity QUESTIONS 1.

Which of the following are sources of risk? a. Enterprise operating activities b. Financial borrowings and related activities c. Equity of the firm The operating activities have risk depending on what industry the company operates in and the investments (projects) it chooses to take on. Financial borrowings and related activities have risk as there is the potential for non-payment to the creditors. Equity is the residual of the operating and financial activities and as such only has risk arising from the operating and financial activities.

2.

Why is the cost of capital related to operations referred to as the weighted average cost of capital? Is this name accurate?

The cost of capital related to operating activities is referred to as the weighted average cost of capital because it can be stated as a weighted average of the cost of debt and equity capital as shown in Equation 9.1. The name is accurate, but misleading. While it is the weighted average, it is not caused by the cost of debt and equity capital. A better characterization would be to consider the cost of equity capital as a weighted average cost of capital as it arises from the risk inherent in the enterprise operations and financial activities of the firm.

3. Why must investors be compensated for non-diversifiable risk but not diversifiable risk? In general, investors will require higher payment as more risk is taken on by them. However, due to the ability to diversify their investments they can remove the diversifiable portion by engaging in multiple investments with differing characteristics. As a result, only the nondiversifiable portion of the risk related to company must be considered.

Solutions Manual, Chapter 9

© Cambridge Business Publishers, 2021 9-1

4.

How is the cost of equity capital commonly estimated?

Many investors use the capital asset pricing model (CAPM) to estimate a firm’s cost of equity capital. This model assumes the riskiness of the company can be stated relative to the riskiness of the market as expressed through Beta.

5.

Why would a debt rating from a company such as Standard and Poor’s be useful in determining a company’s weighted average cost of capital?

When estimating the weighted average cost of capital, we use the formulation shown in Equation 9.1. One of the inputs to this is the cost of debt capital. The credit rating given by a rating service such as S&P can be useful in helping us determine an appropriate estimate of the cost of debt capital or as a reasonableness check for our estimate.

6.

What are the three ways for estimating the cost of debt capital?

The debt cost of capital represents a firm’s pre-tax borrowing rate for debt. One approach is to use RNFL before tax divided by the average NFL. In this approach, the pre-adjusted NFL from the Chapter 3 reformulation is a better approximation of the firm’s borrowing costs. The second approach is reported interest expense divided by the average interest-bearing debt. Again, use of the unadjusted numbers provide a better estimate of the cost of debt capital. The third approach is to review the firm’s footnote to calculate a weighted-average interest rate on long-term debt.

7.

For the weighted average cost of operating capital (rWACC), how is the interest tax shield calculated?

The interest tax shield is calculated as a perpetuity. The current interest expense is multiplied by the expected future tax rate then divided by the estimated cost of debt capital. The implicit assumption with this approach is the debt levels will by unchanged going forward.

8.

For calculating the weighted average cost of operating capital (rWACC), what adjustments to net debt (NFL) are needed?

In computing the rWACC, the NFL needs to be at its fair value. The two common adjustments are the interest tax shield and fair value adjustment from its carrying amount.

© Cambridge Business Publishers, 2021 9-2

Valuation Using Financial Statements, 2nd Edition

9.

Is market beta (β) a reliable metric?

Market beta represents the firm’s market return to the overall market return. That is, market beta is historical stock price volatility relative to the overall market volatility. Thus, the market beta is a historical, backward looking metric. Over time the market beta changes and is not stationary. The market beta can have significant moves over a relatively short period, say one year. Using different look-back periods, estimates of the overall market metric (e.g., S&P 500, NASDAQ) and estimates of the risk-free rate (e.g., 10-year Treasury, TIPS) can result in different market beta values for the same point in time. As a result, it is important to examine its sensitivity as we will see in Chapter 13.

10.

For an unlevered firm, how does a firm’s cost of equity capital differ its cost of capital for operations?

Assume a firm has no debt (i.e., unlevered), the shareholders would hold all the risk of the firm and its operations. That is, the cost of equity would simply be equal to the riskiness of the operations, ρWACC. Given the way, the WACC model is constructed, it incorrectly gives the impression that the cost of equity determines the cost of operations, not vice versa.

Solutions Manual, Chapter 9

© Cambridge Business Publishers, 2021 9-3

EXERCISES 11.

Per ycharts.com, the estimates of beta for Del Taco (TACO) and Chipotle (CMG) at December 1, 2019 were 0.21 and 0.70, respectively. What does this imply about the riskiness of the equity of these firms?

The stock of TACO is less risky than that of CMG. For every 1 percent change in the market, TACO will have a smaller (0.21 percent) change than CMG will (0.70 percent).

12.

Per ycharts.com, the following is a graphic of Beta for Marriott (MAR) for the ten years from 2010 to 2019.

What are the potential implications of this information on our estimation of cost of capital for MAR in particular and other companies in general?

We see from this graph that beta is not constant. This is to be expected as riskiness of equity changes over time based on changes in the riskiness of operations and borrowing. This reinforces the need to focus on operating activities’ risk which eliminates the need to consider future changes in leverage. (This concept will be further elaborated on in Chapter 14.)

© Cambridge Business Publishers, 2021 9-4

Valuation Using Financial Statements, 2nd Edition

13.

Cintas (CTAS), a leading provider of corporate rental uniforms, has significant borrowings and debt. Use the information in CTAS’s debt footnote disclosure to estimate its pretax borrowing cost at May 31, 2019.

Use the long-term debt to estimate the pretax borrowing rate for debt. The weightedaverage interest is the interest rate for each Senior note interest rate multiplied by the May 31, 2019 carry amount percentage of the total Senior notes carrying amount.

4.300% 2.900% 3.250% 2.780% 3.110% 3.700% 6.150%

$ 250 650 300 52 52 1,000 250 $2,554

0.00420908 0.00738058 0.00381754 0.00056601 0.0006332 0.01448708 0.00601997 3.71%

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 9

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14.

Beresford Corporation, a fast-growing company, has a market beta of 1.25. The expected market return is estimated to be 7.45 percent and the long-term US Treasury is at 2.75 percent. Calculate Beresford Corporation’s cost of equity capital using the capital asset pricing model (CAPM).

r Eq=rrf +[ β× ( rMkt −r rf )] r Eq =2.75+ [ 1.25 x ( 7.45−2.75) ] r Eq=8.625 percent 15.

Using the methodology described in Appendix A along with the data below to calculate the 24-month market beta for Salesforce.com (CRM), a provider of customer relationship management software at May 1, 2019.

Continued

© Cambridge Business Publishers, 2021 9-6

Valuation Using Financial Statements, 2nd Edition

15.

continued

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 9

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16.

Calculate the cost of capital for operations (rWACC) for Palmrose, Inc. The footnotes to Palmrose’s financial statements report the long-term debt approximates fair value.

U.S. Government long-term bond rate Market risk premium Equity beta Per-share market price Shares outstanding Average long-term debt on balance sheet Interest expense Statutory tax rate

2.75% 5.50% 1.30 $100.00 12.5 million $949.0 million 33.1 million 21.0%

Equity cost of capital = 2.75% + [1.30 x 5.50%] = 9.90% Debt cost of capital, pre-tax = $33.1 / $949 = 3.49% Value of interest tax shield = ($33.1 x 0.21) / 3.49% = $199 Market value of equity Market value of debt Market value of operations

$ 1,250 ($100.00 per share x 12.5 million shares) 750 ($949 – $199) $ 2,000

Cost of capital for operations (r WACC

17.

(

) = 3.49 %

)(

)

750 1,250 2,000 + 9.90 %x 2,000 = 7.50%

Calculate the cost of capital for operations (rWACC) for The Briloff Companies. The Briloff financial statement footnotes report the long-term debt’s carry value is $15 million below fair value.

U.S. Government long-term bond rate Market risk premium Equity beta Per-share market price Shares outstanding Average NFL on balance sheet FEAT Interest expense Statutory tax rate

2.50% 6.00% 0.85 $165.00 50.0 million $1,350.0 million 42.7 million 41.0 million 21.0%

Equity cost of capital = 2.50% + [0.85 x 6.00%] = 7.60% Debt cost of capital, pre-tax = [$42.7  (1 – 0.21)]  $1,350 = 4.00% Value of interest tax shield = ($41.0 x 0.21)  4.00% = $215 Market value of equity Market value of debt Market value of operations

) = 4.00 %

Cost of capital for operations (r WACC

© Cambridge Business Publishers, 2021 9-8

(

$ 3,250 ($65.00 per share x 50.0 million shares) 1,150 ($1350 - $215 + $15) $ 4,400

3,250 + ( 7.60 %x ) )= 6.66% 4,400 4,400 1,150

Valuation Using Financial Statements, 2nd Edition

CONTINUING EXAMPLES 18.

From Bloomberg, Kellogg (K) had an adjusted market beta of 0.699 at May 1, 2019. Find the estimate of the 10-year Treasury Yield at that date and then assume a market risk premium of 6.00 percent. Using this information estimate the required cost of equity capital for K at May 1, 2019.

At May 1, 2019, according to www.treasury.gov/resource-center/, the 10-year Treasury Yield was 2.52 percent. This yields a cost of equity capital (rEq) estimate for K of 6.71 percent, which is computed as 0.0252 + [0.699 × (0.0852 – 0.0252)]. This estimate implies that an equity investor requires a return of approximately 6.71 percent when he/she invests in K’s stock. Stated differently, the cost of equity capital for investment in K’s stock is 6.71 percent.

19.

The text offers three approaches to estimating the cost of debt capital. Compute for Kellogg (K) at May 1, 2019, the following three estimates and indicate which might be used as a proxy for the cost of debt capital.

• Pretax return on net financial liabilities (RNFL) • Pretax borrowing rate for debt • Weighted average interest rate on long-term debt An estimate of RNFL for K after including additional information and adjustments was shown in Exhibit 6.9 to be 2.49 percent. However, a more appropriate estimate would likely be formed using the information reported in the financial statements. Thus, using unadjusted FEAT ($238) and the average amount of unadjusted NFL [($8,607 + $9,401) / 2], we would arrive at an estimate at December 31, 2018 of 2.64 percent. This implies a pretax cost of debt capital of 3.35 percent [2.64% / (1 – 0.21].

Pretax borrowing rate = Interest expense/avg(Amount of interest-bearing debt). K’s unadjusted interest expense was $287. Interest bearing debt was $8,893 and $8,615 at December 31, 2019 and December 31, 2018, respectively. This is comprised Current maturities of long-term debt, Notes payable and Long-term debt. This yields a pretax borrowing rate of 3.28 percent.

In Note 8, Debt of the December 31, 2018 financials, an analysis of Kellogg’s long-term debt weighted-average interest rate on its Notes is 3.16 percent.

After examining the three estimates of 3.35, 3.28, and 3.16 percent, we choose to use the median value rounded to the nearest tenth of a percent yielding a proxy for cost of debt capital of 3.30 percent.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 9

9-9

20.

Using the methodology described in Appendix A, estimate the cost of equity capital for Kellogg as of May 1, 2019. How does this estimate compare to the one formed using the Bloomberg beta above?

Gathering monthly data from Yahoo! Finance for K, ^TNX, and ^GSPC for the last five years, we can run a regression and receive the following output:

The beta estimate from the regression is 0.587 as compared to the Bloomberg estimate of 0.699. The Bloomberg adjusted beta is an estimate of a security's future beta. It uses the historical data of the stock but assumes that a security’s beta moves toward the market average over time. Their formula for adjusting beta is as follows: Adjusted beta = (.67) * Raw beta + (.33) * 1.0. The decision on which beta should be used as the appropriate input to estimate the cost of equity capital will affect the estimate of our weighted average cost of capital proxy used in the valuation formulas in future chapters.

Differences in the assumed risk-free rate may also exist.

Combining the estimated beta of 0.587 with an assumed market premium of 6.04 percent and an assumed risk free rate of 2.55 percent at May 1, 2019 yields an estimated cost of equity capital of 6.00 percent (rounded to the nearest tenth), which is computed as 0.0252 + [0.587 × (0.0852 – 0.0252)]. In looking at the estimated beta of 0.587 and the resulting cost of equity capital estimate of 6.00 percent, we may feel these are lower than we are comfortable using. Noting that the beta per Bloomberg is 0.699, we may choose to rely on those to assume a beta of 0.699 which would yield a cost of equity capital to 6.71 percent.

Although we feel more comfortable using the 6.71 rather than 6.00 percent cost of equity capital, we must acknowledge that we have altered assumptions to help get data in line with our expectations. Much care must be taken in this process to avoid falling into a trap of choosing assumptions to suit our desired results. Be mindful that there is not a “best answer” on the calculation of beta specifically or cost of capital in general. Remember that the estimate is the result of the assumptions you make and you must consider the effect of choices on the resulting calculations.

© Cambridge Business Publishers, 2021 9-10

Valuation Using Financial Statements, 2nd Edition

21.

Per Chapter 5, the book value of NFL for Kellogg is $10,348 at May 1, 2019.

Additionally, in Note 14, Derivative Instruments and Fair Value Measurements to the financials reports the carrying amount Company’s long-term debt approximates fair value.

Combine this information with the proxies for the cost of equity capital from question CE9.20 and cost of debt capital from question CE9.19 above to form an estimate of Kellogg’s weighted average cost of capital for operations at May 1, 2019.

At May 1, 2019, Kellogg’s price per share was $59.39 per Yahoo!Finance. Also, per the financials there were 343.9 million shares outstanding for an estimated value of equity of $20,424. The value of the interest tax shield would be estimated as the net interest expense of $287 divided the cost of debt capital of 3.30 percent yielding a value of $1,826. When combined with the value of debt of $10,348 provided we arrive at an operating value of $28,946. Using this information, we estimate the weighted average cost of capital as:

rWACC =¿

(

)(

¿ 3.3 % ∙ 10,348−1,826 + 6.00 % ∙ 20,424 28,946 28,946

)

¿ 5.20 % 22.

From Bloomberg, Thor Industries (THO) had an adjusted market beta of 1.477 at May 31, 2019. Find the estimate of the 10-year Treasury Yield at that date and then assume a market risk premium of 6.0 percent. Using this information estimate the required cost of equity capital for THO at May 31, 2019.

At December 2, 2019, according to www.treasury.gov/resource-center/, the 10-year Treasury Yield was 2.21 percent. This yields a cost of equity capital (rEq) estimate for K of 4.8 percent, which is computed as 0.0221 + [0.521 × (0.0721 – 0.0221)]. This estimate implies that an equity investor requires a return of approximately 4.8 percent when he/she invests in K’s stock. Stated differently, the cost of equity capital for investment in K’s stock is 4.8 percent.

Solutions Manual, Chapter 9

© Cambridge Business Publishers, 2021 9-11

23.

The text offers three approaches to estimating the cost of debt capital. Compute for THO at May 1, 2019, the following three estimates and indicate which might be used as a proxy for the cost of debt capital.

• Pretax return on net financial liabilities (RNFL) • Pretax borrowing rate for debt • Weighted average interest rate on long-term debt An estimate of RNFL for THO after including additional information and adjustments was shown in Exhibit 6.9 to be 19.27 percent. However, a more appropriate estimate would likely be formed using the information reported in the financial statements. Thus, using unadjusted FEAT ($2,222) and the average amount of unadjusted NFL [($35,591 $128,418) / 2], we would arrive at an estimate at July 31, 2018 of -4.79 percent. This implies a pretax cost of debt capital of -6.55 percent [-4.79% / (1 – 0.269)].

Pretax borrowing rate = Interest expense/avg(Amount of interest-bearing debt). THO’s unadjusted interest expense was $5,187. Interest bearing debt was $145,000 and $0 at July 31, 2017 and July 31, 2018, respectively. This is comprised long-term debt. This yields a pretax borrowing rate of 7.15 percent.

In Note 12, Long-term Debt of the July 31, 2018 financials, THO reports that the weighted-average interest rate on its borrowing is 2.82 percent.

After examining the three estimates of -6.55, 7.15, and 2.82 percent, we choose to use the median value rounded to the nearest tenth of a percent yielding a proxy for cost of debt capital of 2.80 percent.

24.

Using the methodology described in Appendix A, estimate the cost of equity capital for THO as of May 1, 2019. How does this estimate compare to the one formed using the Bloomberg beta above?

Gathering data from Yahoo! Finance for THO, ^TNX, and ^GSPC for the last five years, we can run a regression and receive the following output:

continued © Cambridge Business Publishers, 2021 9-12

Valuation Using Financial Statements, 2nd Edition

The beta estimate from the regression is 1.613 as compared to the Bloomberg estimate of 1.477. The Bloomberg adjusted beta is an estimate of a security's future beta. It uses the historical data of the stock but assumes that a security’s beta moves toward the market average over time. Their formula for adjusting beta is as follows: Adjusted beta = (.67) * Raw beta + (.33) * 1.0. The decision on which beta should be used as the appropriate input to estimate the cost of equity capital will affect the estimate of our weighted average cost of capital proxy used in the valuation formulas in future chapters.

Differences in the assumed risk-free rate may also exist.

Combining the estimated beta of 1.613 with an assumed market premium of 6.0 percent and an assumed risk-free rate of 2.52 percent at May 1, 2019 yields an estimated cost of equity capital of 12.20 percent, which is computed as 0.0252 + [1.613 × (0.0852 – 0.0252)].

25.

Per Chapter 5, the book value of NFL for THO is $-122,681 at May 1, 2019 (that is, THO is a net lender with net financial assets). Additionally, in Note 12, Long-term Debt to the financials reports that the long-term debt approximate fair value.

Combine this information with the proxies for the cost of equity capital from question CE9.24 and cost of debt capital from question CE9.23 above to form an estimate of THO’s weighted average cost of capital for operations at May 1, 2019.

At May 1, 2019, THO’s price per share was $64.72 per Yahoo!Finance. Also, per the July 31, 2018 financials there were 52,695,365 shares outstanding for an estimated value of equity of $3,410,444 at May 1, 2019. The value of the interest tax shield would be estimated as the net interest expense of $266 divided the cost of debt capital of 2.80 percent yielding a value of $22,793. When combined with the value of debt of ($122,681) provided we arrive at an operating value of $3,264,970. Using this information, we estimate the weighted average cost of capital as:

rWACC =¿

(

¿ 2.80 % ∙

)(

)

( 122,681)−22,793 3,410,444 + 12.20 % ∙ 3,264,970 3,264,970

¿ 12.60 % 26.

From Bloomberg, Winnebago (WGO) had an adjusted market beta of 1.340 at May 1, 2019. Find the estimate of the 10-year Treasury Yield at that date and then assume a market risk premium of 6.0 percent. Using this information estimate the required cost of equity capital for WGO at May 1, 2019.

At May 1, 2019, according to www.treasury.gov/resource-center/, the 10-year Treasury Yield was 2.52 percent. This yields a cost of equity capital (rEq) estimate for WGO of 10.56 percent, which is computed as 0.0252 + [1.34 × (0.0852 – 0.0252)]. This estimate implies that an equity investor requires a return of approximately 10.56 percent when he/she invests in WGO’s stock. Stated differently, the cost of equity capital for investment in WGO’s stock is 10.56 percent.

Solutions Manual, Chapter 9

© Cambridge Business Publishers, 2021 9-13

27.

The text offers three approaches to estimating the cost of debt capital. Compute for Winnebago (WGO) at May 1, 2019, the following three estimates and indicate which might be used as a proxy for the cost of debt capital.

• Pretax return on net financial liabilities (RNFL) • •

Pretax borrowing rate for debt Weighted average interest rate on long-term debt

An estimate of RNFL for WGO after including additional information and adjustments was shown in Exhibit 6.9 to be 3.36 percent. However, a more appropriate estimate would likely be formed using the information reported in the financial statements. Thus, using unadjusted FEAT ($11,546) and the average amount of unadjusted NFL [($251,405 + $278,501) / 2], we would arrive at an estimate at August 25, 2018 of 4.36 percent. This implies a pretax cost of debt capital of 5.88 percent [4.36% / (1 – 0.259)].

Pretax borrowing rate = Interest expense/avg(Amount of interest-bearing debt). WGO’s unadjusted interest expense was $18,246. Interest bearing debt was $274,576 and $291,441 at August 26, 2017 and August 25, 2018, respectively. This data is from the two credit and loan agreements reported in Note 9, Long-Term Debt. This yields a pretax borrowing rate of 6.45 percent.

In Note 9, Long-Term Debt of the August 25, 2018 financials, WGO reports that the weighted-average interest rate on its Notes and debentures is 5.15 percent.

After examining the three estimates of 5.88, 6.45, and 5.15 percent, we choose to use the median value rounded to the nearest tenth of a percent yielding a proxy for cost of debt capital of 5.90 percent.

© Cambridge Business Publishers, 2021 9-14

Valuation Using Financial Statements, 2nd Edition

28.

Using the methodology described in Appendix A, estimate the cost of equity capital for WGO as of May 1, 2019. How does this estimate compare to the one formed using the Bloomberg beta above?

Gathering data from Yahoo! Finance for WGO, ^TNX, and ^GSPC for the last five years, we can run a regression and receive the following output:

The beta estimate from the regression is 1.524 as compared to the Bloomberg estimate of 1.340. The Bloomberg adjusted beta is an estimate of a security's future beta. It uses the historical data of the stock but assumes that a security’s beta moves toward the market average over time. Their formula for adjusting beta is as follows: Adjusted beta = (.67) * Raw beta + (.33) * 1.0. The decision on which beta should be used as the appropriate input to estimate the cost of equity capital will affect the estimate of our weighted average cost of capital proxy used in the valuation formulas in future chapters.

Differences in the assumed risk-free rate may also exist.

Combining the estimated beta of 1.524 with an assumed market premium of 6.0 percent and an assumed risk free rate of 2.52 percent at May 1, 2019 yields an estimated cost of equity capital of 11.66 percent, which is computed as 0.0252 + [1.524 × (0.0852 – 0.0252)]. Rounded to the nearest tenth percentage, WGO’s estimated cost of equity capital is 11.7 percent.

We must acknowledge that we have altered assumptions to help get data in line with our expectations. Much care must be taken in this process to avoid falling into a trap of choosing assumptions to suit our desired results. Be mindful that there is not a “best answer” on the calculation of beta specifically or cost of capital in general. Remember that the estimate is the result of the assumptions you make and you must consider the effect of choices on the resulting calculations.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 9

9-15

29.

Per Chapter 5, the book value of NFL for WGO is $331,923 at August 25, 2018.

Additionally, in Note 9, Long-Term Debt to the financials we find the book value of the debt approximates its fair value. Thus, our estimate of the fair value of the debt of WGO at August 25, 2018. This yields an estimated value for debt $331,923.

Combine this information with the proxies for the cost of equity capital from question CE9.28 and cost of debt capital from question CE9.27 above to form an estimate of WGO’s weighted average cost of capital for operations at May 1, 2019.

At May 1, 2019, WGO’s price per share was $34.97 per Yahoo!Finance. Also, per the August 25, 2018 financials there were 31,629,704 shares outstanding for an estimated value of equity of $1,106,091. The value of the interest tax shield would be estimated as the net interest expense of $17,752 divided the cost of debt capital of 5.90 percent yielding a value of $63,185. When combined with the value of debt of $331,923 provided we arrive at an operating value of $1,374,828. Using this information, we estimate the weighted average cost of capital as:

rWACC =¿

(

¿ 5.9 % ∙

)(

331,923−63,185 1,106,091 + 11.70 % ∙ 1,374,828 21,374,828

)

¿ 10.60 %

© Cambridge Business Publishers, 2021 9-16

Valuation Using Financial Statements, 2nd Edition

Chapter 10 Valuation Using Forecasts of Cash Flows QUESTIONS 1.

Why would it be natural for cash flows to be used as a basis for the estimation of value?

Anticipated cash flows are appropriate since the expected future payoffs are what is being purchased when investing. In general, more anticipated payoffs should equate to a higher estimated value.

2.

What characteristics of anticipated cash flows must be determined (or at least estimated) to allow for calculation of value?

We need to estimate the amount, timing, and uncertainty of anticipated future cash flows to be able to estimate value.

3.

What is the difference between these investments?

• A share of stock that can be purchased for $100 that has a related risk of 5 percent • •

Depositing $100 in a savings account that promises a return of 5 percent Buying a project for $100 that is expected to yield a 5 percent rate of return

Nothing. Each has a current value of $100 and would be expected to be worth $105 a year from now.

4.

To form forecasts of FCF from operations, what aspects of operations must be forecasted?

We must estimate sales growth, PM, and ATO. Operating PM will provide the estimates of NOPAT based on expected sales, and operating ATO will provide the required level of NOA necessary to support the sales. With the NOPAT and NOA estimates, we can compute FCF.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 10

10-1

5.

In cash flow based valuation, the continuing value equals …

The expected intrinsic value at the horizon.

6.

What are some disadvantages of using the discounted cash flow valuation model?

• Length of forecast horizon generally required • •

7.

Cash flows don’t necessarily capture value added If I don’t know value of operations today, how would I know it at the horizon?

In a cash-based valuation with forecasted negative FCFs, (e.g., a high growth company) what issues does this present?

Expected future negative FCF is commonly referred as the “submarine problem.” The company has yet to reach its steady state in which the assumed growth rate for future FCF is constant. The analyst will need to forecast sufficiently far in the future to when FCF are expected to be positive. The additional forecasted periods increase the uncertainty associated with the forecasts.

8.

When has a firm reached steady state?

A firm is at a steady state when the expected growth rate in future FCF is constant and reasonable.

9.

What issues arise with estimating FCFs from the Statement of Cash Flows?

Two main issues arise with estimating FCF from the Statement of Cash Flows. The ability to reformulate the Statement of Cash Flows between operating and financing activities is daunting. For example, tax cash flows need to be allocated, cash interest needs to moved to financing as does investment activity in financial assets. Additionally, the statement does not reflect all the non-cash transactions that impact FCF.

10.

In evaluating the value of a future payoff, should the analyst use a nominal or real discount rate?

The value of a future payoff is the same whether the nominal or real discount rate is used provided that nominal (real) rates are used to discount nominal (real) cash flows.

Given the additional work required to calculate the real discount rate, it is recommended that the analyst use the nominal rate.

© Cambridge Business Publishers, 2021 8-2

Valuation Using Financial Statements, 2nd Edition

11.

Netflix is a darling of Wall Street. An innovative company, which has transformed TV viewing habits for millions and millions of people, by successfully utilizing data & predictive analytics in determining TV watching patterns. Its market capitalization of nearly $150 billion is surprising given that it is recently became profitable and still has negative free cash flows. Indeed analysts suggest that Netflix will incur negative free cash flows for years to come. Using a cash-based valuation approach, reconcile (in words) Netflix’s market valuation to its current financial performance.

It does seem strange that Netflix can be worth so much in the market. This is because the financial statements report the results of the operations while the market focuses on the expected growth and risk going forward. In essence, the market believes the future is very promising for Netflix even though it has negative free cash flows. (Note, the investments by Netflix are made with the expectation of a payoff greater than its cost of capital.) The current market price reflects that, in time, Netflix will be very profitable and provide the expected returns that warrant its current valuation.

Solutions Manual, Chapter 10

© Cambridge Business Publishers, 2021 10-3

EXERCISES 12.

If you invested $15,000 today in a fund that earns 8% compounded annually, to what amount will the investment grow in 3 years?

From Equation 10.4, we can solve as follows:

V 0=

VT

( 1+r ) V 15 , 000= 3 ( 1+0 . 08 )3 15 , 000⋅1. 083=V 3 V 3=18 , 896

13.

T

Assume you will invest $30,000 today and you anticipate needing $150,000 in 21 years.

What annual interest rate must you earn?

From Equation 10.4, we can solve as follows:

V 0=

VT

( 1+r ) 150 , 000 30 , 000= ( 1+r )21 30 , 000⋅( 1+r )21=150 , 000 150 , 000 ( 1+r )21= 30 , 000 21 1+r= √ 5 r=0. 07965≈0 . 08

14.

T

Horngren Corporation has $6.5 million in free cash flows (FCF) this year and expects FCF to increase 6 percent per year indefinitely. What is Horngren’s operating value (OV) if its weighted-average cost of capital (rWACC) is 10 percent?

Value of operations is current FCF, $6.5 million, divided by Horngren’s rWACC less the expected growth rate or $6.5 million  (10.0% - 6.0%) = $162.5 million.

© Cambridge Business Publishers, 2021 8-4

Valuation Using Financial Statements, 2nd Edition

15.

The Moontiz Group recently reported sales of $20 million on net operating assets (NOA) of $11 million. Management believes, over the next five years, that sales will grow 10 percent with a 15 percent profit margin (PM) and asset turnover (ATO) of 2.0 times.

Calculate the expected free cash flows (FCF) for the next five years.

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Sales Growth

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

PM

15.00%

15.00%

5.00%

15.00%

15.00%

15.00%

ATO

2.00x

2.00x

2.00x

2.00x

2.00x

2.00x

22,000

24,200

26,620

29,282

32,210

35,431

3,300

3,630

3,993

4,392

4,832

12,100

13,310

14,641

16,105

17,716

∆NOA

1,100

1,210

1,331

1,464

1,611

FCF (NOPAT - ∆NOA)

2,200

2,420

2,662

2,928

3,221

Sales

20,000

NOPAT NOA

16.

10,000

Burton Enterprises reported $12.0 million in free cash flows (FCF) this year. Analyst consensus forecasts for the next five years for Burton’s FCF are $13.2 million, $14.5 million thousand, $15.75 million, $17.0 million and 18.2 million. Calculate Burton’s operating value (VOper) assuming that FCF beyond for the forecast horizon will continue to grow at 5 percent and Burton has a 9 percent weighted-average cost of capital (rWACC)?

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

12,000

13,200

14,500

15,750

17,000

18,200

Growth in FCF

10.00%

9.85%

8.62%

7.94%

7.06%

Discount factor (1 + rWACC)t

1.0900

1.1881

1.2950

1.4116

1.5386

Present value of FCF

12,110

12,204

12,162

12,043

11,829

FCF

Sum of present value of FCF

60,348

Continuing value (CV) FCF at horizon

19,110

Capitalized

477,750

Present value of (CV)

310,505

Operating value (VOper)

370,853

Solutions Manual, Chapter 10

© Cambridge Business Publishers, 2021 10-5

17.

On February 2, 2015, the end of Home Depot’s (HD) 2014 fiscal year (FY), Home Depot’s share price was $104.42. a. With 1,307 million shares outstanding, what was HD’s market capitalization at February 2, 2015?

At February 2, 2015, Home Depot’s market capitalization was $136,477 million (1,307 million shares x $$104.42) b. At February 2, 2015, HD’s net financial liabilities (NFL) were $15,474 million. What was HD’s operating value (VOper) at February 2, 2015?

At February 2, 2015, Home Depot’s operating value was $151,951 million ($136,477 million + $15,474 million) c. Assume the market had perfect foresight of HD’s future free cash flows (FCF) for FY 2015 – 2018, what is the implied growth rate the continuing value (CV) at February 2, 2015? Home Depot’s weighted-average cost of capital (rWACC) was 8 percent. The FCF (in $ millions) for FY 2015 – 2018 were: FY 2015 $6,489

FY 2016 $7,777

FY 2017 $9,138

FY 2018 $10,463

Operating value = Present value of FCF + present value of continuing value – NFLFY2014.

Present value of FCF: FY 2015 $6,489  1.0800 $6,008

FCF rWACC (8%) PV of FCF

FY 2016 $7,777  1.1644 $6,753

FY 2017 $9,138  1.2597 $7,254

FY 2018 $10,463  1.3605 $7,691

Sum of PV of FCF = $27,706 Present value of continuing value: NFLFY2018 :

PV of CV = [(FCFFY 2018 x g)  (1.08 - g))  1.3605 = [($10,463 x g)  (1.08 – g)]  1.3605

$15,474 from 17b above

Put together: $151,951 = $27,706 + [($10,463 x g)  (1.08 – g)]  1.3605 – $15,474 Solve for g: g = 1.0237 At February 2, 2015, assuming perfect foresight of future FCF through FY 2018 and a rWACC of 8 percent, the implied growth rate of the FCF CV was 2.37 percent. d.

What is the benefit to the analyst in understanding the implied growth rate for the FCF CV? Having the ability to accurately forecast future payoffs, provides the analyst to better understand the market expectations, such as the implied growth rate of the continuing value beyond the forecast horizon. The analysts can then decide whether she agrees with the market. If the analyst believes that the FCF will continue to grow above the 2.4 percent implied growth rate, then HD is a BUY. If the analyst believes that the FCF will not grow at the 2.4 percent implied growth rate, then HD is a SELL. © Cambridge Business Publishers, 2021 8-6

Valuation Using Financial Statements, 2nd Edition

CONTINUING EXAMPLES 18.

The company has been offered the opportunity to invest a project expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price $2,300 Payoffs: Year 1 $600 Year 2 700 Year 3 750 Year 4 625 Year 5 500 Proceeds from disposition 240 In addition, the anticipated risk of the project implies a cost of capital of 10 percent would be appropriate. Using the discounted cash flow method, determine the value of the project and whether to make an investment in this project.

Cost of capital Forecast year Revenues Disposition Discount factor Present value of cash flow Total present value of cash flows

10.0% 0

Value of project

2,573.81 2,573.81

Less investment Net present value

2,300.00 273.81

1

2

3

4

5

600.00

700.00

750.00

625.00

1.1000 545.45

1.2100 578.51

1.3310 563.49

1.4641 426.88

500.00 240.00 1.6105 459.48

The net present value is positive so the investment should be undertaken. The investment is anticipated to result in an increase in value of $273.81.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 10

10-7

19.

Assume that to undergo projects, you have decided to employ a hurdle rate of 15 percent in the evaluation of opportunities. As such, in the evaluation of the project described above in CE10.18 utilize a discount rate of 15 percent despite the 10 percent cost of capital. Will you make the investment in the project? What effects does this decision have?

Cost of capital Forecast year Revenues Disposition Discount factor Present value of cash flow Total present value of cash flows Value of project Less investment Net present value

15.0% 0

1

2

3

4

5

600.00

700.00

750.00

625.00

1.1500 521.74

1.3225 529.30

1.5209 493.13

1.7490 357.35

500.00 240.00 2.0114 367.90

2,269.42 2,269.42 2,300.00 (30.58)

If a discount rate of 15 percent is applied to the anticipated cash flows from this project as a hurdle rate, we see a negative present value of $30.58. This would result in a decision to not make this investment. However, as was seen in the prior calculation, there is a positive value based on the risk involved. The result is a missed opportunity to gain $273.81 by investing in this project.

20.

The Hatfield Company evaluates internal projects for their financial viability as part of their overall analysis. One proposed project is to automate a portion of the Hatfield’s production process. The additional equipment has an estimated useful life of six years.

The operations manager provided the expected cost savings from the installation of the robotic equipment. The project is expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price $8,500 Payoffs: Year 1 $700 Year 2 1,900 Year 3 2,900 Year 4 3,500 Year 5 3,000 Year 6 2,700 Proceeds from disposition 400

Continued

© Cambridge Business Publishers, 2021 8-8

Valuation Using Financial Statements, 2nd Edition

In addition, Hatfield’s management requires a hurdle rate of 16 percent for internally proposed projects, which is greater than the actual project risk. Using the discounted cash flow method, determine the financial viability of the project.

Cost of capital Forecast year

16.0% 0

1

2

3

4

5

6

Cost Savings Disposition

700

1,900

2,900

3,500

3,000

2,700 400

Discount factor Present value of cash flow Total present Value of project

1.16 603

1.3456 1,412

1.5609 1,878

1.8106 1,933

2.100 3 1,428

8,506 8,506

Less investment Net present value

8,500 6

2.4364 1,272

The net present value is barely positive so the investment should be considered.

Companies, such as Hatfield, often have hurdle rates substantially higher to compensate for optimistic financial projections, changes in technology, new competitive position and overall industry and general economic factors.

Solutions Manual, Chapter 10

© Cambridge Business Publishers, 2021 10-9

21.

Using the following forecast assumptions from Chapter 7 for Kellogg (K), the weighted average cost of capital for operations of 5.2 percent calculated in Chapter 9, and a continuing growth in cash flows beyond the forecast horizon of 0.4 percent, calculate the value of K’s operations.

Kellogg Multiyear Assumptions: 2019E Assumptions: Sales growth Operating PM Operating ATO Forecast (millions): Sales NOPAT NOA ∆NOA FCF (NOPAT–∆NOA)

2020E

2021E

2022E

2023E

2024E

2025E

2026E

2027E

0.57% 9.36% 1.052

2.41% 9.58% 0.974

-1.42% 10.00% 0.962

0.50% 10.17% 0.951

0.45% 10.55% 0.951

0.40% 10.55% 0.951

2.32% 10.55% 0.951

-1.49% 10.55% 0.951

0.40% 10.55% 0.951

2019E $13,625 $1,275 $13,261 $312 $964

2020E $13,953 $1,337 $14,126 $865 $471

2021E $13,754 $1,375 $14,362 $238 $1,139

2022E $13,823 $1,406 $14,608 $245 $1,161

2023E $13,885 $1,465 $14,666 $58 $1,406

2024E $13,941 $1,471 $15,007 $341 $1,130

2025E $14,264 $1,505 $14,784 $(223) $1,728

2026E $14,052 $1,483 $14,843 $59 $1,423

2027E $14.109 $1,488 $14,902 $59 $1,429

Continued

© Cambridge Business Publishers, 2021 10-10

Valuation Using Financial Statements, 2nd Edition

Required rate of return (rWACC) Time period

5.20% 2018

2019

Sales NOPAT NOA ∆NOA FCF (NOPAT–∆NOA)

12,949

Solutions Manual, Chapter 10

2021

2022

13,625 1,275

13,953 1,337

13,754 1,375

13,261 312 964

14,126 865 471

14,362 237 1,139

Growth in FCF Discount factor (1 + rWACC)t Present value of cash flow from operations Sum of present value of cash flows Continuing value FCF2027= FCF2026*(1+0.004) [FCF2026 / (0.052 – 0.004)] Present value of continuing value Operating value

2020

-51.10% 141.66% 1.052

1.1067

1.1643

916

426

978

13 3 1 14 8 245 1

2023

2024

13,885 1,465

2025

13,941 1,471

2026

14,264 1,505

14,052 1,483

14,666 15,007 14,784 14,843 58 341 (223) 59 1,406 1,130 1,728 1,423 52.92 1.91% 21.18% -19.65% % -17.63% 1.224 8 1.2885 1.3555 1.4260 1.5001 948

1,092 834

1,212 949

7,354 1,429 29,772 19,847 27,200

© Cambridge Business Publishers, 2021 10-11

22.

Using the following forecast assumptions from Chapter 7 for Thor Industries (THO), the weighted average cost of capital for operations of 12.60 percent calculated in Chapter 9, and a continuing growth in cash flows beyond the forecast horizon of 1.00 percent, calculate the value of THO’s operations.

THO Multiyear Assumptions:

Assumptions: Sales growth Operating PM Operating ATO Forecast (thousands): Sales NOPAT NOA ∆NOA FCF (NOPAT–∆NOA)

FY2019E

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

5.56% 5.78% 4.815

3.61% 5.77% 4.329

1.61% 5.40% 4.219

1.40% 5.35% 4.098

1.20% 5.15% 4.098

1.00% 5.15% 4.098

FY2019E FY2020E FY2021E FY2022E FY2023E FY2024E FY2025E $8,792,094 $9,109,310 $9,255,835 $9,385,417 $9,498,042 $9,593,022 $9,688,952 $508,183 $525,607 $499,815 $502,120 $489,149 $494,149 $498,981 $1,848,120 $2,138,098 $2,224,344 $2,317,522 $2,340,697 $2,364,104 $2,387,745 $43,796 $246,182 $86,246 $93,178 $23,175 $23,407 $23,641 $464,387 $279,425 $413,569 $408,941 $465,974 $470,634 $475,340

Continued

© Cambridge Business Publishers, 2021 10-12

Valuation Using Financial Statements, 2nd Edition

Required rate of return (rWACC) Time period

12.60% FY2018

Sales NOPAT NOA ∆NOA FCF (NOPAT–∆NOA) Growth in FCF Discount factor (1 + rWACC)t Present value of cash flow from operations Sum of present value of cash flows Continuing value FCFFY2024= FCFFY2023*(1+0.01) [FCFFY2024 / (0.126 – 0.01)] Present value of continuing value Operating value

Solutions Manual, Chapter 10

FY2019

FY2020

FY2021

8,792,094 9,109,310 9,255,835 508,183 525,607 499,815 1,848,120 1,848,120 2,138,098 2,224,344 43,796 246,182 86,246 464,387 279,425 413,569 -39.83% 48.01% 1.126 1.2679 1.4276 412,422

220,389

289,690

FY2022 FY2023 9,385,41 7 9,498,042 502,120 489,149 2,317,52 2 2,340,697 93,178 23,175 408,941 465,974 -1.12% 13.95% 1.6075 1.8101 254,394

257,436

1,434,331 470,634 4,057,187 2,241,471 3,675,801

© Cambridge Business Publishers, 2021 10-13

23.

Using the following forecast assumptions from Chapter 7 for Winnebago (WGO), the weighted average cost of capital for operations of 10.60 percent calculated in Chapter 9, and a continuing growth in cash flows beyond the forecast horizon of 0.90 percent, calculate the value of WGO’s operations.

WGO Multiyear Assumptions: FY2019E

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

FY2025E

FY2026E

53 4.56% 6.40% 2.309

52 0.11% 6.27% 2.288

52 1.38% 6.20% 2.294

52 1.10% 6.03% 2.294

52 2.82% 6.03% 2.294

53 -0.99% 6.03% 2.294

52 0.90% 6.03% 2.294

52 0.90% 6.03% 2.294

Forecast (thousand): FY2019E FY2020E Sales $2,108,746 $2,111,002 NOPAT $134,960 $132,360 NOA $914,409 $935,237 ∆NOA $18,212 $20,828 FCF (NOPAT–∆NOA) $116,748 $111,531

FY2021E $2,140,131 $132,688 $945,227 $9,990 $122,698

FY2022E $2,167,952 $130,728 $955,625 $10,398 $120,330

FY2023E $2,191,800 $132,166 $982,603 $26,978 $105,188

FY2024E $2,253,676 $135,897 $972,907 $(9,696) $145,593

Assumptions: Weeks Sales growth Operating PM Operating ATO

FY2025E FY2026E $2,231,437 $2,251,520 $134,556 $135,767 $981,663 $990,498 $8,756 $8,835 $125,799 $126,932

Continued

© Cambridge Business Publishers, 2021 10-14

Valuation Using Financial Statements, 2nd Edition

Required rate of return (rWACC) Time period Sales NOPAT NOA ∆NOA FCF (NOPAT–∆NOA) Growth in FCF Discount factor (1 + rWACC)t Present value of cash flow from operations Sum of present value of cash flows Continuing value (CV) FCFFY2026= FCFFY2025*(1+0.009) [FCFFY2026 / (0.106 – 0.009)] Present value of CV Operating value

Solutions Manual, Chapter 10

10.60% FY2018

896,197

FY2019 2,108,74 6 134,960 914,409 18,212 116,748 1.1060

FY2020 2,111,00 2 132,360 935,237 20,828 111,531 -4.47% 1.2232

FY2021 2,140,13 1 132,688 945,227 9,990 122,698 10.01% 1.3529

FY2022 2,167,95 2 130,728 955,625 10,398 120,330 -1.93% 1.4963

FY2023 2,191,80 0 132,166 982,603 26,978 105,188 -12.58% 1.6549

FY2024 2,253,67 6 135,897 972,907 (9,696) 145,593 38.41% 1.8303

FY2025 2,231,43 7 134,556 981,663 8,756 125,799 -13.60% 2.0244

105,599

91,177

90,693

80,418

63,561

79,544

62,143

573,095 126,932 1,308,57 4 646,417 1,219,51 1

© Cambridge Business Publishers, 2021 10-15

Chapter 11 Valuation Using the Residual Operating Income Valuation Model QUESTIONS 1.

Explain the role of the equation FCF = NOPAT – ΔNOA in arriving at the residual operating income valuation formula.

To arrive at the residual operating income valuation formula, we formed a zero-sum equality based on NOA that was added to the discounted cash flow model. Then the formula above was used to replace the FCF from operations in the equation. After simplifying and rearranging, we had arrived at residual operating income valuation.

2.

What is residual operating income? (The equation) ROPIt = NOPATt – rWACC ∙ NOAt-1

3.

What is residual operating income? (In words) Residual operating income is the NOPAT over and above the required return for the invested NOA. Simply put, this is the firm’s value creation. When a firm earns a residual income, it is earning income greater than is required by its operational risk and represents additional value to the firm’s investors and creditors.

4.

What are the three components in a residual operating income model (ROIM)?

The firm’s operating value (aka enterprise value) is the sum of (1) net operating assets (NOA), (2) the present value of the forecasted residual operating income (ROPI), and (3) the continuing value of the residual operating income beyond the forecast horizon.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 11

11-1

5.

What is the role of book value in the residual operating income valuation model?

NOA serves as the starting point (the anchor) in that the discounted residual operating income is added to current NOA to calculate value. Additionally, within the calculation of residual operating income, earnings (NOPAT) is compared to the amount expected given the level of book value at the beginning of the period (rWACC ∙ NOAt-1).

6.

In the residual operating income model (ROIM), the continuing value equals …

The premium at the horizon; that, is Price minus Book.

7.

What effect does income shifting have on the value calculated using ROIM? None and it should not!

8.

What is an example of income shifting that is allowable within accounting?

Choosing a different inventory assumption or choosing a different depreciation method would be examples that would result in a shift of income between periods.

9.

What is an example of income shifting that is not allowed under accounting rules, but may arise due to actions taken by managers?

Errors in accounting, whether accidental or nefarious, cause income shifting. Another example might be accelerating the reporting of sales to an earlier period from where it should be reported to increase current income.

10.

How is the residual operating income valuation model (ROIM) different from the free cash flow valuation model (FCF)?

Mathematically, the two models are equalivent. The ROIM is a transformation of the FCF model; thus, the model are the same. However, the ROIM requires less steps in the valuation (that is, the calculation of the FCF from the accounting estimates) makes the ROIM a preferred approach (i.e., Occam’s razor).

© Cambridge Business Publishers, 2021 11-2

Valuation Using Financial Statements, 2nd Edition

EXERCISES 11.

Beaver Co. completed the year with sales of $30.0 million and NOPAT of $4.5 million.

Net operating assets (NOA) at year end is $48.5 million. Management estimates for the next four years, sales will grow at 6 percent per year with an operating profit margin (PM) of 15 percent and operating asset turnover (ATO) of 0.65 times. Using the residual operating income model, calculate Beaver’s operating value with an 8.0 percent weighted-average cost of capital (rWACC).

0

1

2

3

4

5.0% 15.0% 0.65

5.0% 15.0% 0.65

5.0% 15.0% 0.65

5.0% 15.0% 0.65

0

1

2

3

4

Sales NOPAT

30,000 4,500

31,500 4,725

33,075 4,961

34,729 5,209

36,465 5,470

NOA ROPI Growth in ROPI Discount factor

48,500

50,885 845 1.0800

53,429 890 5.4% 1.1664

56,100 935 5.0% 1.2597

58,905 982 5.0% 1.3605

782

763

742

722

Sales growth Operating PM Operating ATO rWACC

PV of ROPI Sum of PV of ROPI Continuing Value (CV) ROPI5 = ROPI4 x (1+0.05) ROPI5 ÷ (0.08 - 0.05) PV of CV Operating value

Continuing 5.0%

8.0%

38,288

5.0%

3,010 1,031 34,361 25,257 76,766

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 11

11-3

12.

Continue with the data from E11.11, Beaver’s management is considering outsourcing some of its production. This will reduce the NOA required as well increase Beaver’s ATO from 0.65 to 0.80 times. However, estimated PM will decline from 15.0 percent to 13.0 percent. What impact will the outsourcing proposal have on Beaver’s operating value?

0

Continuin 4 g 5.0% 5.0% 13.0% 0.80

1 5.0% 13.0% 0.80

2 5.0% 13.0% 0.80

3 5.0% 13.0% 0.80

0

1

2

3

4

Sales NOPAT

30,000 4,500

31,500 4,095

33,075 4,300

34,729 4,515

36,465 4,740

NOA ROPI Growth in ROPI

48,500

41,344 215

43,411 992 361.5%

45,581 1,042 5.0%

47,861 1,094 5.0%

1.1664 851

1.2597 827

1.3605 804

Sales growth Operating PM Operating ATO rWACC

Discount factor PV of ROPI Sum of PV of ROPI Continuing Value (CV) ROPI5 = ROPI4 x (1+0.05) ROPI5 ÷ (0.08 - 0.05) PV of CV Operating value

© Cambridge Business Publishers, 2021 11-4

8.0%

1.0800 199

38,288

5.0%

2,681

1,149 38,288 28,143 79,324

Valuation Using Financial Statements, 2nd Edition

13.

Continue with the data from E11.11, Beaver’s management is considering a promotional opportunity to acquire the naming rights to prominent sports stadium. This proposal is expected to increase sales growth to 6 percent from 5 percent. However, estimated PM will decline from 15.0 percent to 14.0 percent. What impact will the stadium naming rights proposal have on Beaver’s operating value?

0

Continuin 4 g 6.0% 6.0% 14.0% 0.65

1 6.0% 14.0% 0.65

2 6.0% 14.0% 0.65

3 6.0% 14.0% 0.65

0

1

2

3

4

Sales NOPAT

30,000 4,500

31,800 4,452

33,708 4,719

35,730 5,002

37,874 5,302

NOA ROPI Growth in ROPI

48,500

51,585 572

54,970 570 -0.3%

58,268 605 6.0%

61,764 641 6.0%

1.0800 53

1.1664 489

1.2597 480

1.3605 471

Sales growth Operating PM Operating ATO rWACC

Discount factor PV of ROPI Sum of PV of ROPI Continuing Value (CV) ROPI5 = ROPI4 x (1+0.06) ROPI5 ÷ (0.08 - 0.06) PV of CV Operating value

Solutions Manual, Chapter 11

8.0%

40,147

6.0%

1,970

679 33,970 24,969 75,439

© Cambridge Business Publishers, 2021 11-5

14.

At February 2, 2019, Home Depot (HD) had net operating assets (NOA) of $25,546 million. Using a weighted-average cost of capital (rWACC) of 8.0 percent, the present value of the next four years (FY2019 – FY2022) of the estimated residual operating income (ROPI) is $47,462 million. a. Assume that the ROPIFY2022 at the forecast horizon is $17,300 million. Following the forecast horizon, it is expected that HD’s NOPAT will equal 8.0 percent of its NOA. That is, the expected ROPI beyond the forecast horizon is zero. What is Home Depot’s operating value at February 2, 2019 using a residual operating income model (ROIM)?

With expected NOPAT beyond the forecast horizon equal to 8.0 percent of NOA, there is no residual income. That is, Home Depot is earning at its required return resulting in no expected residual operating earnings. Thus, the continuing value is zero.

Home Depot Operating Value: Net operating asset at FY 2018 Present value of forecast ROPI Continuing value Operating Value

$25,546 47,462 0 $73,008

Home Depot’s operating value is $73,008 million b. Assume that the ROPIFY2022 at the forecast horizon is $17,300 million. Following the forecast horizon, it is expected that HD’s ROPI will not grow, but remain constant.

What is Home Depot’s operating value at February 2, 2019 using a residual operating income model (ROIM)?

Home Depot Operating Value: Net operating asset at FY 2018 Present value of forecast ROPI Continuing value Operating Value

$ 25,546 47,462 158,950 ($17,300 ÷ 0.08) ÷ 1.084 $231,958

Home Depot’s operating value is $231,958 million c. Assume that the ROPIFY2022 at the forecast horizon is $17,300 million. Following the forecast horizon, it is expected that HD’s ROPI will grow at 2.0 percent per year.

What is Home Depot’s operating value at February 2, 2019 using a residual operating income model (ROIM)?

Home Depot Operating Value: Net operating asset at FY 2018 Present value of forecast ROPI Continuing value Operating Value

$25,546 47,462 216,172 (($17,300 x 1.02) ÷ (0.08 – 0.02)) ÷ 1.084 $289,180

Home Depot’s operating value is $289,180 million © Cambridge Business Publishers, 2021 11-6

Valuation Using Financial Statements, 2nd Edition

15.

LKQ Corporation, an automotive specialty part manufacturer, announced a share repurchase program in late 2018. In the release, LKQ’s President and CEO states ”This repurchase program … reflects an efficient way to enhance long-term shareholder value.”

Do stock buybacks create shareholder value? Explain your answer from a residual operating income model (ROPI) perspective.

The principle idea with residual operating income earnings (ROPI) is that NOPAT is generating a return greater/less than its required cost of capital. With a share repurchase there is no impact on NOPAT or NOA. Thus, the ROPI is unaffected.

The key assumption driving this conclusion is the financial assets and liabilities are recorded in the financial statements at market value (i.e., fair or intrinsic value). That is, the financial assets and liabilities are forecasted to earn at the firm’s required rate of return and will have zero residual earnings; thus, the financial assets and liabilities are valued at its book (or intrinsic) value.

The exception to this approach is when management believes that its shares are undervalued in the market. In this instance, share repurchases are made at a lower value than its intrinsic value. Thus, value is created transferring wealth from selling shareholders to the remaining shareholders.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 11

11-7

CONTINUING EXAMPLES 16.

Once again, the company has been offered the opportunity to invest in a project expected to yield the following cash flows. Note that the anticipated risk of the project implies a cost of capital of 10 percent would be appropriate: Anticipated Cash Flows of Finite-Life Project Purchase price $2,300 Payoffs: Year 1 $600 Year 2 700 Year 3 750 Year 4 625 Year 5 500 Proceeds from disposition 240 Assume initially that the company plans to fully depreciate the project using the straightline method over the five-year period resulting in $412 in depreciation per period. Using the residual income valuation method, determine the value of the project and whether to make an investment in this project. How does this value compare to value computed based on cash flows in Chapter 10?

Cost of capital Forecast year

10.0% 0

Revenues Depreciation

1

2

3

4

5

600.00 (412.00)

700.00 (412.00)

750.00 (412.00)

625.00 (412.00)

500.00 (412.00)

Gain on sale

0.00

Net income (NOPAT) "Dividends" Book value of project (NOA)

188.00 600.00

288.00 700.00

2,300.00 1,888.00

338.00 750.00

1,476.00

213.00 625.00

88.00 740.00

1,064.60502.00

0.00

Net income Expected income given book value

188.00 230.00

288.00 188.80

Residual operating income Discount factor Present value of residual income

(42.00) 1.1000 (38.18)

99.20 190.40 106.60 1.2100 1.3310 1.4641 81.98 143.05 72.81

Total present value of residual income Value of project

338.00 147.60

213.00 106.40

88.00 65.20 22.80 1.6105 14.16

273.82 2,573.82

The value of the project ($2,573.82) is higher than the cost of the project ($2,300.00) so the investment should be undertaken. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior chapter using cash flows. © Cambridge Business Publishers, 2021 11-8

Valuation Using Financial Statements, 2nd Edition

17.

Assume that instead of fully depreciating the project, the company decides to record depreciation of $300 per year. Use the residual operating income valuation model to value the project. What effect does this change in profits due to altering depreciation have on the value calculation?

Cost of capital

10.0%

Forecast year

0

1

2

3

4

5

Revenues Depreciation Loss on sale

600.00 (300.00)

700.00 (300.00)

750.00 (300.00)

625.00 (300.00)

500.00 (300.00) (560.00)

Net income (NOPAT) "Dividends"

300.00 600.00

400.00 700.00

450.00 750.00

325.00 625.00

(360.00) 740.00

Book value of project (NOA)

2,300.00 2,000.00

1,700.00

450.00 170.00

1,100.00 .00

Net income Expected income given book value

300.00 230.00

Residual operating income Discount factor Present value of residual income Total present value of residual income

70.00 200.00 280.00 185.00 (470.00) 1.1000 1.2100 1.3310 1.4641 1.6105 63.64 165.29 210.37 126.36 (291.83)

Value of project

400.00 200.00

1,400.00

325.00 140.00

(360.00) 110.00

273.83 2,573.83

Altering the depreciation did not result in a different value for the project. Economically this makes sense as the value should not be altered by an accounting decision.

Solutions Manual, Chapter 11

© Cambridge Business Publishers, 2021 11-9

18.

Repeat the valuation of the project one more time utilizing the assumption that the company forgot to record any depreciation at all during the project’s life. What effect does this change in profits due to altering depreciation have on the value calculation?

Cost of capital Forecast year

10.0% 0

1

2

3

4

Revenues Depreciation Loss on sale

600.00 0.00

700.00 0.00

750.00 0.00

625.00 0.00

500.00 0.00 (2,060.00)

Net income (NOPAT) "Dividends"

600.00 600.00

700.00 700.00

750.00 750.00

625.00 625.00

(1,560.00) 740.00

Book value of project (NOA)

2,300.00 2,300.00

2,300.00

750.00

2,300.000.00

Net income

600.00

Expected income given book value Residual operating income Discount factor Present value of residual income

230.00 230.00 230.00 230.00 230.00 370.00 470.00 520.00 395.00 (1,790.00) 1.1000 1.2100 1.3310 1.4641 1.6105 336.36 388.43 390.68 269.79 (1,111.46)

Total present value of residual income Value of project

700.00

2,300.00

5

625.00

(1,560.00)

273.80 2,573.80

Having no depreciation causes there to be large loss at the time of sale ($2,060) but does not result in a different value for the project. Again, economically this makes sense as the value should not be altered by an accounting decision (or in this case omission).

© Cambridge Business Publishers, 2021 11-10

Valuation Using Financial Statements, 2nd Edition

19.

The Hatfield Company evaluates internal projects for their financial viability as part of their overall analysis. One proposed project is to automate a portion of the Hatfield’s production process. The additional equipment has an estimated useful life of six years. The operations manager provided the expected cost savings from the installation of the robotic equipment. The project is expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price $8,500 Payoffs: Year 1 $700 Year 2 1,900 Year 3 2,900 Year 4 3,500 Year 5 3,000 Year 6 2,700 Proceeds from disposition 400 In addition, Hatfield’s management requires a hurdle rate of 16 percent for internally proposed projects, which is greater than the actual project risk. Assume initially that the company plans to fully depreciate the project using the straight-line method over the six-year period resulting in $1,350 in depreciation per period. Using the residual income valuation method, determine the value of the project and whether to make an investment in this project.

How does this value compare to value computed based on cash flows in Chapter 10?

Cost of capital Forecast year

16.0% 0

1

3 1,900

4 2,900

5 3,500

6 3,000

2,700

1,350

1,350

1,350

1,350

1,350

1,350

(650) 700 7,150

550 1,900 5,800

1,550 2,900 4,450

2,150 3,500 3,100

1,650 3,000 1,750

0 1,350 3,100 0

Net income (NOPAT) Expected income given BV

(650) 1,360

550 1,144

1,550 928

2,150 712

1,650 496

1,350 280

Residual operating income Discount factor PV of residual income

(2,010) (594) 1.16 1.3456 (1,733) (441)

Cost Savings

700

Depreciation Gain on sale Net income (NOPAT) “Dividends” Book value of project (NOA)

Total present value Value of project

2

8,500

622 1.5609 398

1,438 1,154 1,070 1.8106 2.1003 2.4364 794 549 439

7 8,507

The net present value is barely positive so the investment should be considered. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior chapter using cash flows.

Solutions Manual, Chapter 11

© Cambridge Business Publishers, 2021 11-11

20.

Using the following forecast assumptions from Chapter 7 for Kellogg (K), the cost of enterprise capital of 5.2 percent calculated in Chapter 9, and a continuing growth in residual operating income beyond the forecast horizon of 0.4 percent, calculate the value of Kellogg’s operations. How does this estimate of value compare to that arrived at using the cash flow-based valuation method in Chapter 10?

Kellogg Multiyear Assumptions: 2019E Assumptions: Sales growth Operating PM Operating ATO

0.57% 9.36% 1.052

Forecast (millions): Sales NOPAT NOA

2019E $13,625 $1,275 $13,261

2020E

2021E

2022E

2023E

2024E

2025E

2026E

2027E

2.41% 9.58% 0.974

-1.42% 10.00% 0.962

0.50% 10.17% 0.951

0.45% 10.55% 0.951

0.40% 10.55% 0.951

2.32% 10.55% 0.951

-1.49% 10.55% 0.951

0.40% 10.55% 0.951

2020E $13,953 $1,337 $14,126

2021E $13,754 $1,375 $14,362

2022E $13,823 $1,406 $14,608

2023E $13,885 $1,465 $14,666

2024E $13,941 $1,471 $15,007

2025E $14,264 $1,505 $14,784

2026E $14,052 $1,483 $14,843

2027E $14.109 $1,488 $14,902

Continued

© Cambridge Business Publishers, 2021 11-12

Valuation Using Financial Statements, 2nd Edition

Required rate of return (rWACC) Time period Sales NOPAT NOA ROPIt (NOPATt – rWACC ∙ NOAt-1) Growth in ROPI Discount factor (1 + rWACC)t Present value of ROPIt Sum of present value of ROPI Continuing value ROPI2027 = ROPI2026 * (1 + 0.004) ROPI2026 / (0.052 – 0.004) Present value of continuing value Operating value

5.20% 2018

12,949

2019 2020 2021 2022 13,625 13,953 13,754 13,823 1,275 1,337 1,375 1,406 13,261 14,126 14,362 14,608 602 647 641 659 7.51% -0.97% 2.82% 1.0520 1.1067 1.1643 1.2248 572 585 550 538

2023 13,885 1,465 14,666 705 7.03% 1.2885 547

2024 13,941 1,471 15,007 708 0.40% 1.3555 522

2025 14,264 1,505 14,784 725 2.32% 1.4260 508

2026 14,052 1,483 14,843 714 -1.49% 1.5001 476

4,299 717 14,930 9,952 27,200

The use of the residual operating income valuation model did not alter the estimate from that calculated using anticipated cash flows.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 11

11-13

21.

Using the following forecast assumptions from Chapter 7 for Thor Industries (THO), the cost of enterprise capital of 12.60 percent calculated in Chapter 9, and a continuing growth in residual operating income beyond the forecast horizon of 1.00 percent, calculate the value of THO’s operations. How does this estimate of value compare to that arrived at using the cash flow-based valuation method in Chapter 10?

THO Multiyear Assumptions: FY2019E

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

5.56%

3.61%

1.61%

1.40%

1.20%

1.00%

5.78%

5.77%

5.40%

5.35%

5.15%

5.15%

4.815

4.329

4.219

4.098

4.098

4.098

Assumptions: Sales growth Operating PM Operating ATO Forecast (millions): Sales NOPAT NOA

FY2019E FY2020E FY2021E FY2022E FY2023E FY2024E FY2025E $8,792,094 $9,109,310 $9,255,835 $9,385,417 $9,498,042 $9,593,022 $9,688,952 $508,183 $525,607 $499,815 $502,120 $489,149 $494,149 $498,981 $1,848,120 $2,138,098 $2,224,344 $2,317,522 $2,340,697 $2,364,104 $2,387,745

Continued

© Cambridge Business Publishers, 2021 11-14

Valuation Using Financial Statements, 2nd Edition

Required rate of return (rWACC) Time period Sales NOPAT NOA ROPIt (NOPATt – rWACC ∙ NOAt-1) Growth in ROPI Discount factor (1 + rWACC)t Present value of ROPIt Sum of present value of ROPI Continuing value ROPIFY2024 = ROPIFY2023 * (1 + 0.01) ROPIFY2024 / (0.126 – 0.01) Present value of continuing value Operating value

12.60% FY2018

FY2019 FY2020 FY2021 FY2022 FY2023 8,792,094 9,109,310 9,255,835 9,385,417 9,498,042 508,183 525,607 499,815 502,120 489,149 1,848,120 1,848,120 2,138,098 2,224,344 2,317,522 2,340,697 275,320 287,226 230,415 221,852 197,141 4.32% -19.78% -3.72% -11.14% 1.126 1.2679 1.4276 1.6075 1.8101 244,511 226,541 161,397 138,010 108,915 879,374 199,113 1,716,489 948,307 3,675,801

The use of the residual operating income valuation model did not alter the estimate from that calculated using anticipated cash flows.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 11

11-15

22.

Using the following forecast assumptions from Chapter 7 for Winnebago (WGO) the cost of enterprise capital of 10.60 percent calculated in Chapter 9, and a continuing growth in residual operating income beyond the forecast horizon of 0.90 percent, calculate the value of WGO’s operations. How does this estimate of value compare to that arrived at using the cash flow-based valuation method in Chapter 10?

WGO Multiyear Assumptions:

Assumptions: Weeks Sales growth Operating PM Operating ATO Forecast (thousand): Sales NOPAT NOA

FY2019E

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

FY2025E

FY2026E

53 4.56% 6.40% 2.309

52 0.11% 6.27% 2.288

52 1.38% 6.20% 2.294

52 1.10% 6.03% 2.294

52 2.82% 6.03% 2.294

53 -0.99% 6.03% 2.294

52 0.90% 6.03% 2.294

52 0.90% 6.03% 2.294

FY2020E FY2021E $2,111,002 $2,140,131 $132,360 $132,688 $935,237 $945,227

FY2022E $2,167,952 $130,728 $955,625

FY2025E $2,231,437 $134,556 $981,663

FY2026E $2,251,520 $135,767 $990,498

FY2019E $2,108,746 $134,960 $914,409

FY2023E FY2024E $2,191,800 $2,253,676 $132,166 $135,897 $982,603 $972,907

Continued

© Cambridge Business Publishers, 2021 11-16

Valuation Using Financial Statements, 2nd Edition

Required rate of return (rWACC) 10.60% FY2024 FY2025 Time period FY2018 FY2019 FY2020 FY2021 FY2022 FY2023 Sales 2,108,746 2,111,002 2,140,131 2,167,952 2,191,800 2,253,676 2,231,437 134,960 132,360 132,688 130,728 132,166 135,897 134,556 NOPAT 896,197 914,409 935,237 945,227 955,625 982,603 972,907 981,663 NOA ROPIt (NOPATt – rWACC ∙ NOAt-1) 39,963 35,432 33,553 30,533 30,869 31,741 31,428 -11.34% -5.30% -9.00% 1.10% 2.82% -0.99% Growth in ROPI 1.1060 1.2232 1.3529 1.4963 1.6549 1.8303 2.0244 Discount factor (1 + rWACC)t 36,133 28,966 24,801 20,406 18,653 17,342 15,525 Present value of ROPIt 161,825 Sum of present value of ROPI Continuing value (CV) ROPIFY2064 = ROPIFY2025 * (1 + 0.01) 31,710 326,911 ROPIFY2026 / (0.126 – 0.01) 161,489 Present value of (CV) 1,219,511 Operating value

The use of the residual operating income valuation model did not alter the estimate from that calculated using anticipated cash flows.

Solutions Manual, Chapter 11

© Cambridge Business Publishers, 2021 11-17

Chapter 12 Valuation Using the Abnormal Operating Income Growth Model QUESTIONS

1.

What is abnormal operating income growth? (The equation) What are the two “pieces” and what do they each represent?

AOIGt+1 = NOPATt+1 + rWACC ∙ FCFt – (1 + rWACC) ∙ NOPATt •

•

2.

NOPATt+1 + rWACC ∙ FCFt is cum-dividend earnings. That is, the earnings in the firm in period t+1 combined with the earnings outside the firm on the prior year’s distributions (1 + rWACC) ∙ NOPATt is the expected earnings in the subsequent period given the level of earnings in the current year. The earnings would be expected to grow at the cost of capital.

What is abnormal operating income growth? (In words) The abnormal operating income growth is based on (1) the capitalized current earnings plus (2) the capitalized excess cum-dividend earnings over the expected earnings in the subsequent periods. The capitalized current earnings represent the steady-state value of the firm. The expected excess future cum-dividend earnings over the expected future earnings represents the anticipated growth in earnings over the required earnings growth or the future value creation. The value of the firm equals the steady-state value plus the future value creation.

3.

What is the role of earnings in the abnormal operating income growth valuation model?

Capitalized NOPAT (NOPAT/rEnt) serves as the starting point (the anchor) in that the discounted abnormal operating income growth is added to current capitalized NOPAT to calculate value. Additionally, within the calculation of abnormal operating income growth, cum-dividend earnings (NOPATt+1 + rWACC ∙ FCFt) is compared to the amount expected given the level of earnings in the prior period [(1 + rWACC) ∙ NOPATt]. © Cambridge Business Publishers, 2021

Solutions Manual, Chapter 12

12-1

4.

In the AOIG model, the continuing value equals …

The premium at the horizon; that, is Price minus Capitalized Earnings.

5.

The abnormal operating income growth valuation model requires “an extra period” relative to the cash flow or residual operating income models. Explain why this is necessary.

Since the earnings in the calculation of abnormal operating income growth are cumdividend, there is one more period necessary as the current FCF has an effect in the next period when we consider the potential earnings outside the firm.

6.

What are cum-free-cash-flow earnings?

Free cash flows (FCF) are the current earnings (NOPAT) in excess of the change in net operating assets (NOA). When FCF are positive, the excess funds are available for distribution to the firm’s creditors and investors or can be held by the firm as a financial asset. Had the FCF been reinvested into the firm’s operations, the expectation is the invested FCF would earn the required return of its operations, WACC. With cum-freecash-flow earnings, the current earnings are to assumed to earn the required return whether the earnings are reinvested into the firm’s operations or are available for distribution.

7.

Does accounting policy choice impact the abnormal operating income growth (AOIG) valuation model?

No, not in the total valuation. The accounting policy choice can impact the first component of the AOIG model. However, in the later periods the future AOIG will capture the necessary adjustment to the counter the effect of the accounting policy choice had on the capitalized earnings, the first component.

8.

Under what condition(s) is the abnormal operating income growth (AOIG) model equivalent to the free cash flow (FCF) model?

Mathematically the two models are the same. However, with the AOIG model, distributions are assumed to be invested in alternative investment with equivalent risk. If a distribution is made, there are fewer assets available to earn the required return in subsequent periods. Thus, the model requires that distributions are invested elsewhere at an equivalent rate of return.

© Cambridge Business Publishers, 2021 12-2

Valuation Using Financial Statements, 2nd Edition

9.

Can a firm grow its earnings, but not impact the firm’s operating value?

A firm that grows earnings at the required rate will have no abnormal operating income growth; therefore, the firm’s operating value is not impacted. Also, a firm can increase earnings through accounting policy choices (e.g., depreciation) that do not impact the firm’s value.

10.

What is the difference between abnormal operating income growth (AOIG) and the change in residual operating income (ROPI)?

Nothing, AOIG and change in ROPI are the same. Both metrics are measuring the change in residual earnings over a period of time.

Solutions Manual, Chapter 12

© Cambridge Business Publishers, 2021 12-3

EXERCISES 11.

Baxter Inc. forecasts (in $ thousands) its future sales, NOPAT and NOA for the next four years as follows:

Sales NOPAT NOA

2019A 7,000 900 12,500

2020E 7,500 1,100 13,400

2021E 8,300 1,350 14,250

2022E 9,100 1,700 15,000

2023E 10,000 2,200 15,900

Baxter’s weighted-average cost of capital (rWACC) is 10.0%. Calculate Baxter’s FCF, AOIG and AOIG growth rate for 2020 – 2023.

FCF AOIG AOIG growth

2020E 200

2021E 500 160

2022E 950 265 65.6%

2023E 1,300 425 60.4%

Where AOIGt = [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1] and FCF = (NOPAT–∆NOA)

12.

Trueblood Enterprises’ is expected to earn net operating profits after tax (NOPAT) next year followed by abnormal operating income growth for the following four years.

Year 0 NOPAT AOIG

Year 1 $5,000,000

Year 2

Year 3

Year 4

Year 5

$75,000

$85,000

$92,250

$94,000

Calculate Trueblood’s operating value (OV) assuming that the abnormal operating income growth will continue at 1.90 percent following the forecast horizon. Trueblood’s weightedaverage cost of capital (rWACC) is 8.0 percent. ($) NOPAT AOIG AOIG growth Discount factor Discount AOIG Total discounted AOIG Continuing value AOIG at the horizon Capitalized PV of continuing value Total to be capitalized Operating Value

Year 0

Year 1 5,000,000

Year 2

Year 3

Year 4

Year 5

75,000

85,000 13.3% 1.1664 72,874

92,250 8.5% 1.2597 73,231

94,000 1.90% 1.3605 69,093

1.0800 69,444 284,642

95,783 1,569,449 1,153,592 6,438,234 80,477,928

© Cambridge Business Publishers, 2021 12-4

Valuation Using Financial Statements, 2nd Edition

13.

Wyatt Corporation is considering a project requiring a $15.0 million initial investment.

The expected project income and distributions are: ($ thousand) Net project income (NOPAT) Distributions (FCF)

Year 1 2,500 3,200

Year 2 3,900 4,500

Year 3 4,300 5,300

Year 4 4,100 4,700

Year 5 2,700 3,600

Using the abnormal operating income growth (AOIG) model, determine whether the project is financially feasible assuming the project rate of return is 12%.

0

Year 1

Net project income (NOPAT) Earnings from reinvestment of distributions (rp x FCF t-1)

Year 2

2,500

Year 3

3,900 384

Year 4

4,300 540

Year 5

4,100 636

Year 6

2,700 564

432

Cumulative-FCF earnings Expected income given prior period earnings [(1 + rp) x NOPATt-1]

4,284

4,480

4,736

3,264 432

2,800

4,368

4,816

4,592

3,024

AOIG

1,484 472

(80)

(1,328)

(2,592)

1.2544

1.4049

1.5735

1,325 376

(57)

(844)

Discount factor

1.1200

Discount AOIG Total discounted AOIG

(1,471)

(670)

Total to be capitalized Value of project

1.7623

1,830 15,247

With project value of $15.247 million and the initial investment of $15.000 million, the project is financially feasible.

14.

Finney Inc. is a construction company specializing in commercial real estate projects.

Finney has contracted with the Perry Companies to build an office building for $20.0 million. Finney estimates the construction costs will be about $16.0 million with the construction taking over two years to complete. Due to the uncertainties with such a project, Finney requires a 14 percent return. The expected net operating income on a percentage of completion basis and distributions over the next three years are: ($ thousand)

Year 0

Year 1

Year 2

Year 3

-

1,500 1,500

2,100 2,100

2,400 2,400

Net project income (NOPAT) Distributions (FCF)

continued

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 12

12-5

a. Assume Finney uses the percentage of completion method for recognizing revenue (i.e., revenue is recognized each period as it earned), determine the value of the project with the abnormal operating income growth (AOIG) model. ($ thousand) Net project income (NOPAT) Earnings from reinvestment of distributions (rp x FCF t-1) Cumulative-FCF earnings Expected income given last period earnings [(1 + rp) x NOPATt-1] AOIG Discount factor Discount AOIG Total discounted AOIG Total to be capitalized Value of project

Year 0

Year 1 Year 2 Year 3 Year 4 1,500 2,100 2,400 — 210 2,310

294 36 2,694 336

1,710 2,394 2,736 600 300 (2,400) 1.1400 1.2996 1.4815 526 231 (1,620) (863) 637 4,552

b. Assume Finney uses the completed contract method for recognizing revenue (i.e., all profit recognized in the final period) determine the value of the project with the abnormal operating income growth (AOIG) model. ($ thousand) Net project income (NOPAT) Earnings from reinvestment of distributions (rp x FCF t-1) Cumulative-FCF earnings Expected income given last period earnings [(1 + rp) x NOPATt-1] AOIG Discount factor Discount AOIG Total discounted AOIG Total to be capitalized Value of project

Year 0

Year 1 —

Year 2 —

Year 3 Year 4 6,000 —

210 210

294 36 6,294 336

— 210 1.1400 184

— 6,840 6,294 (6,504) 1.2996 1.4815 4,843 (4,390)

637 637 4,552

c. Explain whether the choice of the accounting revenue recognition policy impacts the project’s value.

The project’s value is the same regardless of the accounting policy choice when using the abnormal operating growth (AOIG) model. The underlying economic events are the same for both accounting policy choices.

© Cambridge Business Publishers, 2021 12-6

Valuation Using Financial Statements, 2nd Edition

CONTINUING EXAMPLES 15.

Once again, the company has been offered the opportunity to invest in a project expected to yield the following cash flows. Note that the anticipated risk of the project implies a cost of capital of 10 percent would be appropriate: Anticipated Cash Flows of Finite-Life Project Purchase price

$2,300

Payoffs: Year 1

$600

Year 2

700

Year 3

750

Year 4

625

Year 5

500

Proceeds from disposition

240

Assume initially that the company plans to fully depreciate the project using the straight line method over the five year period resulting in $412 in depreciation per period. Using the abnormal operating income growth (AOIG) valuation method, determine the value of the project and whether to make an investment in this project. How does this value compare to value computed based on cash flows in Chapter 10 and residual operating income in Chapter 11?

Continued

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 12

12-7

Cost of capital Forecast year Revenues Depreciation Gain on sale Net income (NOPAT) "Dividends" (FCF) Cum-dividend earnings Expected income given earnings Abnormal operating income growth Discount factor One-year ahead value of abnormal income growth Total one-year ahead value of abnormal income growth Net income Earnings to be capitalized Value of project

10.0% 0

1 600.00 (412.00)

2 700.00 (412.00)

3 750.00 (412.00)

4 625.00 (412.00) 213.00 625.00

5 500.00 (412.00) 0.00 88.00 740.00

6 0.00 0.00 0.00 0.00 0.00

188.00 600.00

288.00 700.00

338.00 750.00

348.00 206.80 141.20 1.1000

408.00 316.80 91.20 1.2100

288.00 371.80 (83.80) 1.3310

150.50 234.30 (83.80) 1.4641

74.00 96.80 (22.80) 1.6105

128.36

75.37

(62.96)

(57.24)

(14.16)

69.38 188.00 257.38 2,573.82

The value of the project ($2,573.82) is higher than the cost of the project ($2,300.00) so the investment should be undertaken. The use of this accounting-based valuation model did not result in a change from the value calculated using cash flows or the residual operating income valuation model (ROIM).

© Cambridge Business Publishers, 2021 12-8

Valuation Using Financial Statements, 2nd Edition

16.

Assume that instead of fully depreciating the project, the company decides to record depreciation of $300 per year. Use the abnormal operating income growth valuation model to value the project. What effect does this change in profits due to altering depreciation have on the value calculation?

Cost of capital Forecast year Revenues Depreciation Gain on sale Net income (NOPAT) "Dividends" (FCF) Cum-dividend earnings Expected income given earnings Abnormal operating income growth Discount factor One-year ahead value of abnormal income growth Total one-year ahead value of abnormal income growth Net income Earnings to be capitalized Value of project

10.0% 0

1 2 3 4 5 600.00 700.00 750.00 625.00 500.00 (300.00) (300.00) (300.00) (300.00) (300.00) (560.00) 300.00 400.00 450.00 325.00 (360.00) 600.00 700.00 750.00 625.00 740.00

6 0.00 0.00 0.00 0.00 0.00

460.00 520.00 400.00 (297.50) 74.00 330.00 440.00 495.00 357.50 (396.00) 130.00 80.00 (95.00) (655.00) 470.00 1.1000 1.2100 1.3310 1.4641 1.6105 118.18

66.12

(71.37)

(447.37) 291.83

(42.62) 300.00 257.38 2,573.84

Altering the depreciation did not result in a different value for the project. Economically this makes sense as the value should not be altered by an accounting decision.

Solutions Manual, Chapter 12

© Cambridge Business Publishers, 2021 12-9

17.

Repeat the valuation of the project one more time utilizing the assumption that the company forgot to record any depreciation at all during the project’s life. What effect does this change in profits due to altering depreciation have on the value calculation?

Cost of capital Forecast year Revenues Depreciation Gain on sale Net income (NOPAT) "Dividends" (FCF)

10.0% 0

1 600.00 0.00

2 3 4 700.00 750.00 625.00 0.00 0.00 0.00

600.00 600.00

700.00 750.00 625.00 700.00 750.00 625.00

Cum-dividend earnings 760.00 820.00 700.00 Expected income given earnings 660.00 770.00 825.00 Abnormal operating income growth 100.00 50.00 (125.00) Discount factor 1.1000 1.2100 1.3310 One-year ahead value of abnormal income growth 90.91 41.32 (93.91) Total one-year ahead value of abnormal income growth (342.61) Net income 600.00 Earnings to be capitalized 257.39 Value of project 2,573.89

5 6 500.00 0.00 0.00 0.00 (2,060.00)0.00 (1,560.00)0.00 740.00 0.00 (1,497.50 7)4.00 687.50 (1,716.00) (2,185.00) 1,790.00 1.4641 1.6105 (1,492.38) 1,111.46

Having no depreciation causes there to be large loss at the time of sale ($2,060), but does not result in a different value for the project. Also, this creates a large amount of positive AOIG in year 6 due to the expected negative earnings following the year 5 loss. Again, economically this makes sense as the value should not be altered by an accounting decision (or in this case omission).

© Cambridge Business Publishers, 2021 12-10

Valuation Using Financial Statements, 2nd Edition

18.

Once again, the Hatfield Company evaluates internal projects for their financial viability as part of their overall analysis. One proposed project is to automate a portion of the Hatfield’s production process. The additional equipment has an estimated useful life of six years. The operations manager provided the expected cost savings from the installation of the robotic equipment. The project is expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price $8,500 Payoffs: Year 1 $700 Year 2 1,900 Year 3 2,900 Year 4 3,500 Year 5 3,000 Year 6 2,700 Proceeds from disposition 400 In addition, Hatfield’s management requires a hurdle rate of 16 percent for internally proposed projects, which is greater than the actual project risk. Assume initially that the company plans to fully depreciate the project using the straight-line method over the six-year period resulting in $1,350 in depreciation per period. Using the abnormal operating income growth (AOIG) method, determine the value of the project and whether to make an investment in this project. How does this value compare to value computed based on cash flows in Chapter 10?

Continued

Solutions Manual, Chapter 12

© Cambridge Business Publishers, 2021 12-11

0

1

2

Revenues Depreciation

700 1,350

Gain on sale Net income (NOPAT) "Dividends" (FCF)

5

6

7

2,900 1,350

3,500 1,350

3,000 1,350

2,700 1,350

-

-

-

-

-

-

-

-

(650) 700

550 1,900

1,550 2,900

2,150 3,500

1,650 3,000

1,350 3,100

-

662

1,854

2,614

2,210

1,830

496

1,798 2,494 816 (284)

1,914 (84)

(754) 1,416

Discount factor One-year ahead value of AOIG Total one-year value of AOIG Net income Earnings to be capitalized

4

1,900 1,350

Cumulative-dividend earnings Expected income given last period earnings Abnormal operating income growth

Value of project

3

1.1600

638 1,216

1.3456 1,221 904

1.5609 523

1.8106 (157)

2.1003 (40)

1,566 (1,070)

2.4364 (439)

2,011 (650) 1,361 8,507

The value of the project, $8,507, is slightly higher than the cost of the project, $8,500, so the investment is financially viable.

The use of this accounting-based valuation model did not result in a change from the value calculated using cash flows or the residual operating income valuation model (ROIM).

© Cambridge Business Publishers, 2021 12-12

Valuation Using Financial Statements, 2nd Edition

19.

Using the following forecast assumptions from Chapter 7 for Kellogg (K), the weighted average cost of capital for operations of 5.2 percent calculated in Chapter 9, and a continuing growth in abnormal operating income growth (AOIG) beyond the forecast horizon of 0.4 percent, calculate the value of Kellogg’s operations. How does this estimate of value compare to that arrived at using the cash flow-based valuation method in Chapter 10 or the residual operating income model in Chapter 11?

Kellogg Mulityear Assumptions: 2019E

2020E

2021E

2022E

2023E

2024E

2025E

2026E

2027E

Sales growth

0.57%

2.41%

-1.42%

0.50%

0.45%

0.40%

2.32%

-1.49%

0.40%

Operating PM

9.36%

9.58%

10.00%

10.17%

10.55%

10.55%

10.55%

10.55%

10.55%

Operating ATO

1.052

0.974

0.962

0.951

0.951

0.951

0.951

0.951

0.951

Assumptions:

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

13,547

13,625

13,953

13,754

13,823

13,885

13,941

14,264

14,052

14,109

14,165

1,275

1,337

1,375

1,406

1,465

1,471

1,505

1,483

1,488

1,494

13,261

14,126

14,362

14,608

14,666

15,007

14,784

14,843

14,902

14,962

∆NOA

312

865

237

245

58

341

-223

59

59

60

FCF (NOPAT–∆NOA)

964

471

1,139

1,161

1,406

1,130

1,728

1,423

1,429

1,435

45

-6

18

46

3

16

-11

3

3

Forecasted sales (growing at XX%) NOPAT (Sales X PM of XX%) NOA (Sales / ATO of XX)

AOIGt [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1]

12,949

Continued

Solutions Manual, Chapter 12

© Cambridge Business Publishers, 2021 12-13

Required rate of return (rWACC) Forecasted sales (growing at XX%)

5.20% 2018

2019

13,547

2020

2021

2022

2023

2024

2025

2026

2027

13,625

13,953

13,754

13,823

13,885

13,941

14,264

14,052

14,109

1,275

1,337

1,375

1,406

1,465

1,471

1,505

1,483

1,488

13,261

14,126

14,362

14,608

14,666

15,007

14,784

14,843

14,902

∆NOA

312

865

237

245

58

341

59

59

FCF (NOPAT–∆NOA)

964

471

NOPAT (Sales X EPM of XX%) NOA (Sales / EATO of XX)

12,949

NOPATt

1,275

AOIGt [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1]

1,139

1,161

1,406

1,130

1,728

1,423

1,429

1,337

1,375

1,406

1,465

1,471

1,505

1,483

1,488

45

-6

18

46

3

16

-11

3

-113%

-389%

156%

-93%

483%

-165%

-126%

Growth in AOIG Discount factor (1 + rWACC)t

-223

1.0520

1.1067

1.1643

1.2248

1.2885

1.3555

1.4260

1.5001

43

(6)

16

38

2

12

(8)

2

Present value of AOIGt 99

Sum of present value of AOIGt Continuing value AOIG2028 = AOIG2027 X (1 + 0.4%)

3

AOIG2028 / (5.2% – 0.4%)

60 40

Present value of continuing value

1,414

Total to be capitalized Operating value

27,200

The use of the abnormal operating income growth valuation model did not alter the estimate from that calculated using anticipated cash flows or residual operating income.

© Cambridge Business Publishers, 2021 12-14

Valuation Using Financial Statements, 2nd Edition

20.

Using the following forecast assumptions from Chapter 7 for Thor Industries (THO), the cost of enterprise capital of 12.60 percent calculated in Chapter 9, and a continuing growth in abnormal operating income growth (AOIG) beyond the forecast horizon of 1.00 percent, calculate the value of THO’s operations. How does this estimate of value compare to that arrived at using the cash flow-based valuation method in Chapter 10?

THO Multiyear Assumptions: FY2019E

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

5.56% 5.78% 4.815

3.61% 5.77% 4.329

1.61% 5.40% 4.219

1.40% 5.35% 4.098

1.20% 5.15% 4.098

1.00% 5.15% 4.098

Assumptions: Sales growth Operating PM Operating ATO

($ thousands) Forecasted sales (growing at XX%) NOPAT (Sales X PM of XX%) NOA (Sales / ATO of XX)

FY2018

FY2019

FY2020

FY2021

FY2022

FY2023

FY2024

FY2025

8,792,094 9,109,310 9,255,835 9,385,417 9,498,042 9,593,022 9,688,952 8,792,094 508,183

525,607

499,815

502,120

489,149

494,149

498,981

508,183

1,848,120 2,138,098 2,224,344 2,317,522 2,340,697 2,364,104 2,387,745 1,848,120

∆NOA

43,796

246,182

86,246

93,178

23,175

23,407

23,641

FCF (NOPAT–∆NOA)

464,387

279,425

413,569

408,941

465,974

470,634

475,340

11,906

(56,811)

(8,562)

(24,711)

1,971

1,991

AOIGt [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1]

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 12

12-15

Required rate of return (rWACC) ($ thousands) Forecasted sales (growing at XX%) NOPAT (Sales X EPM of XX%) NOA (Sales / EATO of XX) ∆NOA FCF (NOPAT–∆NOA) NOPATt AOIGt [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1] Growth in AOIG

12.60% FY2018 FY2019 FY2020 FY2021 FY2022 FY2023 FY2024 8,328,909 8,792,094 9,109,310 9,255,835 9,385,417 9,498,042 9,593,022 508,183 525,607 499,815 502,120 489,149 494,041 1,848,120 1,891,9 16 2,138,098 2,224,3 44 2,317,522 2,340,697 2,364,104 43,796 246,182 86,246 93,178 23,175 23,407 464,387 279,425 413,569 408,941 465,974 470,634 508,183

525,607 11,906

Discount factor (1 + rWACC)t

1.1260

Present value of AOIGt Sum of present value of AOIGt Continuing value AOIGFY2025 = AOIGFY2024 X (1 + 1.0%) AOIGFY2025 / (12.6% – 1.0%) Present value of continuing value Total to be capitalized Operating value

499,815

489,149

494,041

(56,811) (8,562) (24,711) 1,971 -577.2% -84.9% 188.6% -108.0% 1.2679

10,574

502,120

1.4276

(44,808)

1.6075

(5,998)

1.8101

(15,372)

(54,515) 1,991 17,165 9,483 463,151 3,675,801

The use of the abnormal operating income growth model did not alter the estimate from the cash flow and residual operating income valuation models.

© Cambridge Business Publishers, 2021 12-16

1,089

Valuation Using Financial Statements, 2nd Edition

21.

Using the following forecast assumptions from Chapter 7 for Winnebago (WGO) the cost of enterprise capital of 10.60 percent calculated in Chapter 9, and a continuing growth in abnormal operating income growth (AOIG) beyond the forecast horizon of 0.90 percent, calculate the value of WGO’s operations. How does this estimate of value compare to that arrived at using the cash flow-based valuation method in Chapter 10?

WGO Multiyear Assumptions: FY2019E

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

FY2025E

FY2026E

53 4.56% 6.40% 2.309

52 0.11% 6.27% 2.288

52 1.38% 6.20% 2.294

52 1.10% 6.03% 2.294

52 2.82% 6.03% 2.294

53 -0.99% 6.03% 2.294

52 0.90% 6.03% 2.294

52 0.90% 6.03% 2.294

FY2020

FY2021

Assumptions: Weeks Sales growth Operating PM Operating ATO

($ thousands) Forecasted sales (growing at XX%)

FY2018

FY2019

FY2022

FY2023

FY2024

FY2025

FY2026

2,016,829 2,108,746 2,111,002 2,140,131 2,167,952 2,191,800 2,253,676 2,231,437 2,251,520

NOPAT (Sales X PM of XX%)

134,960

132,360

132,688

130,728

132,166

135,897

134,556

135,767

914,409

935,237

945,227

955,625

982,603

972,907

981,663

990,498

∆NOA

18,212

20,828

9,990

10,398

26,978

(9,696)

8,756

8,835

FCF (NOPAT–∆NOA) AOIGt [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1]

116,748

111,531

122,698

120,330

105,188

145,593

125,799

126,932

(4,530)

(1,880)

(3,020)

336

871

(313)

283

NOA (Sales / ATO of XX)

896,197

Continued

Solutions Manual, Chapter 12

© Cambridge Business Publishers, 2021 12-17

Required rate of return (rWACC)

10.60% FY2018

Forecasted sales (growing at XX%)

FY2019

FY2020

FY2021

FY2022

FY2023

FY2024

FY2025

FY2026

2,016,829 2,108,746 2,111,002 2,140,131 2,167,952 2,191,800 2,253,676 2,231,437 2,251,520

NOPAT (Sales X EPM of XX%)

134,960

132,360

132,688

130,728

132,166

135,897

134,556

135,767

914,409

935,237

945,227

955,625

982,603

972,907

981,663

990,498

∆NOA

18,212

20,828

9,990

10,398

26,978

(9,696)

8,756

8,835

FCF (NOPAT–∆NOA)

116,748

111,531

122,698

120,330

105,188

145,593

125,799

126,932

NOPATt

134,960

132,360

132,688

130,728

132,166

135,897

134,556

135,767

(4,530)

(1,880)

(3,020)

336

871

(313)

283

-111.1%

159.5%

-135.9%

-190.3%

1.4963

1.6459

1.8303

2.0244

224

527

(171)

140

NOA (Sales / EATO of XX)

896,197

AOIGt [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1] Growth in AOIG

-58.5%

Discount factor (1 + rWACC)t

1.1060

Present value of AOIGt

(4,906)

Sum of present value of AOIGt

1.2232 (1,537)

60.7% 1.3529 (2,232)

(7,145)

Continuing value AOIGFY2027 = AOIGFY2026 X (1 + 0.9%)

285

AOIGFY2027 / (10.6% – 0.9%)

2,942

Present value of continuing value Total to be capitalized Operating value

1,453 129,268 1,219,511

The use of the abnormal operating income growth model did not alter the estimate from the cash flow and residual operating income valuation models.

© Cambridge Business Publishers, 2021 12-18

Valuation Using Financial Statements, 2nd Edition

Chapter 13 Valuation of Equity QUESTIONS 1.

We have focused on valuing operating activities. What is necessary for moving to an estimate of equity value?

Having estimated the value of operating activities, the only adjustment needed is to subtract the market value of the net financial liabilities including the adjustment for the interest tax shield.

2.

Can we assume debt is at fair value?

Generally, the debt shown on the books will be at fair value. Additionally, at the times when the fair value diverges from book value the company should disclose that fact within the footnotes. (Note that the market value of the financial liabilities will need to include the value of the interest tax shield.)

3.

Describe how the valuation using DCF in Chapter 10 is related to the valuation of dividends shown in this chapter.

FCF from operations based valuation calculates the value available to capital providers, both creditors and equity holders, based on the anticipated payments that will be made to them. Dividend based valuation calculates value available to just the equity holders based on the anticipated payments that will be made to them. The discount rate used (rWACC for FCF and rEq for dividends) reflects the risk related to the particular payouts being valued.

4.

How does the residual earnings (RE) model differ from the residual operating income model (ROIM)?

The residual earnings (RE) model estimates the value of the firm’s equity while the residual operating income model (ROIM) estimates the value of operations. The RE model is focused on the firm’s comprehensive earnings over a required return of book value (i.e., common stock equity or CSE) while the ROIM model is focused on the firm’s NOPAT over the required return on NOA. The RE model requires the consideration of the leverage in its calculations while the RIOM does not. © Cambridge Business Publishers, 2021

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5.

V NFL r Eq=r WACC + Eq ⋅( r WACC −r D ) V

Explain the implication of a model that values operating activities or equity.

on the choice between using

The risk of the equity results from the risk of the operations and the financial activities which comprise the equity. This is the notion shown in Chapter 9 that equity is not a source of risk, but rather the result of the risk in the operating and financial activities. As a result, changes in leverage (VNFL/VEq) will result in changes in the discount rate for equity and we would need to forecast leverage in each future period. As leverage is a choice based on whether additional funding is sought from creditors or equity holders, it is more appropriate to value the operating activities thus allowing us to ignore potential cost of capital fluctuations due to leverage changing over time.

6.

What assumptions must be made in the use of analysts’ forecasts for estimating value?

Assumptions are generally made that leverage, weighted average cost of capital for operations, and cost of debt capital will be unchanged going forward allowing us to use a constant cost of equity. Additional assumptions that may be necessary are the amounts of dividends per period and the continuing value.

7.

Do dates matter in valuation?

Yes! We are calculating value at a particular time, but must take into account when the accounting information we are using in the calculation is made available. Adjustments for this can and should be done. Also, the formulas presented in Chapters 10 to 12 assume flows occur at the end of the period. Thus, a mid-year adjustment may be necessary to try to compensate for the dates when actual flows might occur.

8.

What two adjustments are used to adjust the firm’s operating value from its year-end balance sheet date to the valuation date?

Valuation model implicitly assume the payoff (e.g., FCF, residual income, or AOI) occur at year-end. A mid-year adjustment changes the assumption to the payoffs occurring evenly through the year. The mid-year adjustment factor can be either (1 + rWACC)0.5 or [1 + (rWACC / 2)].

To adjust from the firm’s balance sheet date to the valuation date, assume the operating value continues to grow at the weighted-average cost of capital evenly during the period.

That is, the operating value at the balance sheet date multiplied by 1 + rWACC for the appropriate period of time to the valuation date.

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9.

What are the implications for determining an equity value per share for publicly traded companies?

With the estimated firm equity value on a per share basis, one can determine whether the company is a Buy/Hold/Sell. If the estimated equity value per share is above the current share price, then the stock is a Buy as our expectations are greater than the current market’s expectations. Conversely, if the estimated equity value per share is below the current share price, then the stock is a Sell as our expectations are less than the current market’s expectations.

10.

What role does sensitivity analysis play?

Sensitivity analysis reminds us that the estimate of value is based on our assumptions and that with different assumptions, a different value estimate would arise. Further, it informs us about which of those assumptions has the largest effect on the value estimate. As a result, we may be able to focus efforts on increasing our confidence that the most important assumptions made are valid.

11.

The End of Accounting (Wiley, 2016) is a book that is critical of current GAAP and the related financial statements. The book notes the widening differences between book value per share and market value per share. That is, the book to market ratio is increasing over time as business has changed over time. The book states that intangible assets (e.g., patents, brands, information technology) are the “prime value creators of businesses.” Of course, internally created intangible assets are not reflected on the firm’s balance sheet. For example, Disney’s Mickey Mouse, Google’s algorithms, and Facebook’s data mining abilities are not reflected on their balance sheet.

Is the residual earnings (RE) model effective for valuing companies with substantial amounts of internally created intangible assets not reflected in its book value?

A residual earnings model is effective for firms with unrecorded economic assets (e.g., brand names, R&D, or management know how). In a residual earning model, the two drivers are book value (i.e., common stock equity) and comprehensive income (CI).

While book value is understated from an economic asset perspective, the resulting CI from the accounting net assets plus the unrecorded economic assets will capture the value creation from these unrecorded assets. That is, the firm’s earnings will include the earnings from assets that are not on the balance sheet.

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EXERCISES 12.

The following forecasts of earnings per share (EPS) and dividend per share (DPS) were made at the end of 2019 for Haskins Inc. with a book value per share (BVS) of $25.00: EPS DPS

2020E 3.50 1.00

2021E 3.85 1.00

2022E 4.24 1.00

2023E 4.66 1.00

2024E 5.12 1.00

Haskins has an equity cost of capital of 10 percent.

EPS DPS BPS RE (EPSt – (rEq x BPSt-1) RE Growth EPS Growth

2020E 3.50 1.00 27.50 1.00

2021E 3.85 1.00 30.35 1.10

2022E 4.24 1.00 33.59 1.20

2023E 4.66 1.00 37.24 1.30

2024E 5.12 1.00 41.37 1.40

10.00% 10.00%

9.09% 10.00%

8.33% 10.00%

7.69% 10.00%

a. Calculate book value per share for 2020 - 2024.

See table above. b. Calculate residual earnings per share for 2020 - 2024.

See table above. c. Calculate the year over year (YOY) forecasted EPS growth rates and residual earnings (RE) growth rates for the period 2020 - 2024.

See table above. d. Review the EPS & RE growth rate trends over the forecast horizon. Explain why the EPS is not the same as the RE growth rate.

The EPS growth rate is 10 percent per year reflecting constant grow in its expected earnings. The RE growth rate; however, declines year after year. This is due to an increasing book value that increases the required earnings each year. Even though EPS grows year to year, this does not imply the residual earnings will grow at the same rate.

This illustrates that a growing EPS rates does not necessarily mean that the RE growth rate is increasing as well. While the financial press focuses on EPS results and its growth rates, an analyst needs to take that extra time to determine the RE implications to ascertain the level of value creation.

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13.

Bank of America (BofA) Merrill Lynch provides equity research on publicly traded firms.

On June 27, 2019, BofA issued a research report on Nike (NKE).

In the report, BofA lowered its expectations of NKE to Underperform with a 12-month price target of $70. Nike’s share price at the date of the report is $83.66. Additionally, BofA provided its estimates of future earnings per share (EPS) and dividends per share (BPS) for NKE’s FY2020 – 2022.

Nike’s book value per share (BPS) at May 31 is $5.77 per share. Assume Nike’s equity cost of capital is 9.0 percent. a. Calculate NKE’s expected residual earnings (RE) for the forecast horizon (FY2020 – 2022)?

2019A EPS DPS BPS RE (9.0%)

5.77

2020E 2.95 0.93 7.79 2.43

2021E 3.50 1.02 10.27 2.80

2022E 4.00 1.12 13.15 3.08

b. Assuming the residual earning estimate at the forecast horizon (FY2022) will continue to grow at a constant rate into the future, calculate the implied growth rate, g, in the market share price of $83.66 at June 27, 2019?

3.08 ×g 2.43 2.80 3.08 1.09−g P2019 =$ 83.66=$ 5.77+ + + + 1.09 1.188 1.295 1.295 Where g = 5.47%

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c. Assuming the residual earning estimate at the forecast horizon (FY2022) will continue to grow at a constant rate into the future, calculate the implied growth rate, g, in the BofA price objective of $70.00 at June 27, 2019?

3.08 × g 2.43 2.80 3.08 1.09−g P2019 =$ 70.00=$ 5.77+ + + + 1.09 1.188 1.295 1.295 Where g = 4.66% d. What is the benefit of determining the implied growth rates in a residual earnings valuation model.

The analyst can determine the market’s expected growth rate embedded in the current share price to decide whether they agree with the market consensus. The analyst, based on their understanding of the business, industry and overall economic conditions, may hold a different actionable viewpoint as to the expected growth rate of the Nike RE’s growth rate at the forecast horizon.

14.

On August 31st, an analyst evaluating Zeff Co. has an estimated Zeff’s operating value (VOper) at $1,250 million as of December 31st, its year end date. The net financial liabilities (NFL) at December 31 were estimated to be $300 million. a. Prepare a mid-year adjustment to Zeff’s estimated operating value, assuming Zeff cost of capital for operations is 8.0 percent. $1,299 = $1,250 x (1 + 0.08)0.5 b. Prepare the adjustment to Zeff’s the estimated operating value from (a) above to August 31st. $1,367 = $1,299 x (1 + 0.08)8/12 c. Based on Zeff’s latest Form 10-Q, the fair market value of Zeff’s NFL is $35 million lower than at December 31st. Calculate the estimated value of Zeff’s equity at August 31st. $1,102 = $1,367 – ($300 – $35) d. At December 31st, Zeff reported 25,000,000 common shares outstanding. By August 31st, the latest Form 10-Q reported 22,500,000 common shares outstanding. What is the analyst’s estimated per share price for Zeff Co. at August 31st? $48.98 per share = $1,102  22.5

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CONTINUING EXAMPLES 15.

Before the adjustments for dates and fair value of financial liabilities detailed in the chapter, what is the first pass estimated value of Kellogg’s equity based on our estimates of the value of operating activities in Chapters 10 to 12 and the NFL calculated in Chapter 5?

In the prior chapters, we estimated the value of Kellogg’s operating activities to be $27,200. Additionally, in Chapter 5 we arrived at an estimate of NFL of $10,348.

Together these would imply an estimated value of equity of $37,548.

16.

Why is a mid-year adjustment needed for Kellogg? What is the estimated value of operating activities after performing a mid-year adjustment?

A mid-year adjustment is necessary because the valuation formulas assume that all payoffs occur at the end of each period. We know that this is not the case. A better assumption is that they occur evenly throughout the period which is equivalent to having them all occur at mid-year. The mid-year adjustment moves all payoffs from the end of the year to the middle of the year.

For Kellogg, our estimate of value for operating activities of $27,200 is increased to $27,899 when we multiply by (1 + 0.052)0.5.

17.

Our calculations of cost of capital and our forecasting for Kellogg have utilized information available through May 1, 2019. This has been applied to information drawn from the 2018 financial statements. What issues does this create and for Kellogg what is the estimate of value of operating activities as of May 1, 2019 after addressing this issue?

We are using information not publicly available to calculate the estimated value. This can be addressed by recognizing that if no new information was learned by the market between December 31, 2018 and May 1, 2019 the value of the stock should only change by the weighted average cost of capital for operations. Thus, we can take our estimated value of operating activities of $27,899 (after the mid-year adjustment in question 15) and multiply by (1+0.052)4/12 yielding an estimated value of operating activities of $28,374 at May 1, 2019.

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18.

The first quarter 10-Q for Kellogg was filed with the SEC on May 3, 2019. Thus, it was not available on May 1, 2019. Consequently, given the estimated NFL at December 2018 along with the estimate of the value of operating activities at May 1, 2019, what is the estimated value of equity of Kellogg as of May 1, 2019?

Without the first quarter 10-Q not filed with the SEC as of May 1, 2019, we can’t update the values for the NFL elements for the first quarter in 2019. That is, the elements of NFL remain unchanged at their December 2018 balance as we do not have enough information to adjust them. The value of NFL is $10,348.

The value of the interest tax shield for Kellogg is estimated at $1,826 computed as $287 net interest expense, divided by 21.0 percent assumed tax rate, divided by an assumed cost of debt capital of 3.3 percent. This yields an adjusted value of NFL of $8,522.

Thus, the estimated value of Kellogg’s equity as of May 1, 2019 is $19,852 ($28,374 – $8,552).

19.

Now as a final step to the valuation process, compute the value per share of Kellogg at May 1, 2019 using the number of shares outstanding shown in the December 2018 Form 10-K. How does this amount compare to the closing price of Kellogg on that day?

The 2018 Form 10-K (the most recent report at May 1, 2019) reveals that at January 26, 2019 there were 343,894,654 shares outstanding. Therefore, our estimate of the pershare value of equity is $57.73 as of May 1, 2019. The closing share price was $59.39 implying our set of expectations result in a lower valuation than those used by investors in setting prices. We would choose to sell the shares (or not acquire them) as Kellogg appears overvalued.

20.

Reflecting on the valuation exercise, which of the following assumptions for Kellogg do you have the most concerns about relying on?

• Continuing growth in sales of 0.40 percent • Ongoing operating profit margin of 10.55 percent • Weighted average cost of capital for operations of 5.20 percent Examine the sensitivity to altering each of these assumptions up or down by 0.2 percent.

Which appears to be most critical and how would this effect the valuation effort?

Continued

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Valuation Using Financial Statements, 2nd Edition

Before performing a sensitivity analysis, the weighted average cost of capital for operations most likely harbors the most concerns due to the layers of assumptions necessary in its estimation. When we alter the assumptions, our value estimate of $57.73 for Kellogg adjusts to:

Sales growth PM rWACC

–0.2% $56.46 $56.29 $61.38

+0.2% $59.10 $59.16 $54.37

Here we see that changes in the weighted average cost of capital for operations lead to the largest changes in the value estimate. This reminds us that much care must be taken in estimating risk and that we must never assume that our value calculation is “correct”.

21.

Before the adjustments for dates and fair value of financial liabilities detailed in the chapter, what is the first pass estimated value of Thor Industries (THO) equity based on our estimates of the value of operating activities in Chapters 10 to 12 and the NFL calculated in Chapter 5?

In the prior chapters, we estimated the value of THO’s operating activities to be $3,675,801. Additionally, in Chapter 5 we arrived at an estimate of NFL of $-122,681 (that is, net financial assets). Together these would imply an estimated value of equity of $3,798,483.

22.

Why is a mid-year adjustment needed for THO? What is the estimated value of operating activities after performing a mid-year adjustment?

A mid-year adjustment is necessary because the valuation formulas assume that all payoffs occur at the end of each period. We know that this is not the case. A better assumption is that they occur evenly throughout the period which is equivalent to having them all occur at mid-year. The mid-year adjustment moves all payoffs from the end of the year to the middle of the year.

For THO, our estimate of value for operating activities of $3,675,801 is increased to $3,900,509 when we multiply by (1 + 0.126)0.5.

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23.

Our calculations of cost of capital and our forecasting for THO have utilized information available through May 1, 2019. This has been applied to information drawn from the 2018 financial statements. What issues does this create and for THO what is the estimate of value of operating activities as of May 1, 2019 after addressing this issue?

We are using information not publicly available to calculate the estimated value. This can be addressed by recognizing that if no new information was learned by the market between July 31, 2018 and May 1, 2019 the value of the stock should only change by the weighted average cost of capital for operations. Thus, we can take our estimated value of operating activities of $3,900,509 (after the mid-year adjustment in question 21) and multiply by (1+0.126)9/12 yielding an estimated value of operating activities of $4,263,586 at May 1, 2019.

24.

Below is the balance sheet of THO from the January 31, 2019 Form 10-Q:

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The second quarter 10-Q for THO was filed with the SEC on March 6, 2019. Using this information, our estimated NFL at July 31, 2018, and our estimate of the value of operating activities at May 1, 2019, what is the estimated value of equity of THO as of May 1, 2019?

From this information, we can update the values for the NFL elements for the second quarter in FY2019. Specifically, accounts receivable, other, net decreases from $19,747 to $18,999. All the other elements of NFL remain unchanged at their July 31, 2018 balance as we do not have enough information to adjust them. The value of NFL is $121,933.

The value of the interest tax shield for THO is estimated at $22,793 computed as $3,039 net interest expense, divided by 21.0 percent assumed tax rate, divided by an assumed cost of debt capital of 2.80 percent. This yields an adjusted value of NFL of ($144,726).

Thus, the estimated value of THO’s equity as of May 1, 2019 is $4,408,312 ($4,263,586 + $144,726).

25.

Now as a final step to the valuation process, compute the value per share of THO at May 1, 2019 using the number of shares outstanding shown in the 2019 Form 10-Q for the second quarter. How does this amount compare to the closing price of THO on that day?

The 2019 Form 10-Q2 reveals that at February 28, 2019 there were 55,063,473 shares outstanding. Therefore, our estimate of the per-share value of equity is $80.06 as of May 1, 2019. The closing share price was $64.72 implying our set of expectations result in a higher valuation than those used by investors in setting prices. We would choose to buy the shares as THO appears undervalued.

26.

Reflecting on the valuation exercise, which of the following assumptions for THO do you have the most concerns about relying on?

• Continuing growth in sales of 1.00 percent • Ongoing operating profit margin of 5.15 percent • Weighted average cost of capital for operations of 12.60 percent Examine the sensitivity to altering each of these assumptions up or down by 0.2 percent.

Which appears to be most critical and how would this effect the valuation effort? continued

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Before performing a sensitivity analysis, the weighted average cost of capital for operations most likely harbors the most concerns due to the layers of assumptions necessary in its estimation. When we alter the assumptions, our value estimate of $80.06 for THO adjusts to:

Sales growth PM rWACC

–0.2% $79.68 $77.91 $82.57

+0.2% $80.45 $82.20 $78.87

Here we see that changes in the weighted average cost of capital for operations lead to the largest changes in the value estimate. This reminds us that much care must be taken in estimating risk and that we must never assume that our value calculation is “correct”.

27.

Before the adjustments for dates and fair value of financial liabilities detailed in the chapter, what is the first pass estimated value of Winnebago (WGO) equity based on our estimates of the value of operating activities in Chapters 10 to 12 and the NFL calculated in Chapter 5?

In the prior chapters, we estimated the value of WGO’s operating activities to be $1,219,511. Additionally, in Chapter 5 we arrived at an estimate of NFL of $331,923.

Together these would imply an estimated value of equity of $887,589.

28.

Why is a mid-year adjustment needed for WGO? What is the estimated value of operating activities after performing a mid-year adjustment?

A mid-year adjustment is necessary because the valuation formulas assume that all payoffs occur at the end of each period. We know that this is not the case. A better assumption is that they occur evenly throughout the period which is equivalent to having them all occur at mid-year. The mid-year adjustment moves all payoffs from the end of the year to the middle of the year.

For WGO, our estimate of value for operating activities of $1,219,511 is increased to $1,282,518 when we multiply by (1 + 0.106)0.5.

29.

Our calculations of cost of capital and our forecasting for WGO have utilized information available through May 1, 2019. This has been applied to information drawn from the FY2018 financial statements. What issues does this create and for WGO what is the estimate of value of operating activities as of May 1, 2019 after addressing this issue?

We are using information not publicly available to calculate the estimated value. This can be addressed by recognizing that if no new information was learned by the market between August 25, 2018 and May 1, 2019 the value of the stock should only change by the weighted average cost of capital for operations. Thus, we can take our estimated value of operating activities of $1,282,518 (after the mid-year adjustment in question 27) and multiply by (1+0.106)8/12 yielding an estimated value of operating activities of $1,371,619 at May 1, 2019.

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30.

Below is the balance sheet of WGO from the February 23, 2019 Form 10-Q:

continued

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The second quarter 10-Q for WGO was filed with the SEC on March 26, 2019. Using this information, our estimated NFL at August 25, 2018, and our estimate of the value of operating activities at May 1, 2019, what is the estimated value of equity of WGO as of May 1, 2019?

From this information, we can update the values for the NFL elements for the second quarter in FY2019. Specifically, Investment in life insurance decreases from $28,297 to $26,963; Current maturities of long-term debt increase from $0 to $2,750; Accrued expenses: Self-insurance increased from $12,262, to $14,488; Accrued expenses: Accrued interest decreased from $3,095 to $3,002; and Long-term debt, less current maturities decreased from $291,441 to $274,168. All the other elements of NFL remain unchanged at their August 31, 2018 balance as we do not have enough information to adjust them. The adjust value of NFL is $320,867.

The value of the interest tax shield for WGO is estimated at $63,185 computed as $17,752 net interest expense, divided by 21.0 percent assumed tax rate, divided by an assumed cost of debt capital of 5.90 percent. This yields an adjusted value of NFL of $257,681.

Thus, the estimated value of WGO’s equity as of May 1, 2019 is $1,113,938 ($1,371,619 - $320,867).

31.

Now as a final step to the valuation process, compute the value per share of WGO at May 1, 2019 using the number of shares outstanding shown in the 2019 Form 10-Q for the second quarter. How does this amount compare to the closing price of WGO on that day?

The 2019 Form 10-Q2 reveals that at March 20, 2019 there were 31,873,494 shares outstanding. Therefore, our estimate of the per-share value of equity is $34.95 as of May 1, 2019. The closing share price was $34.97 implying our set of expectations result in a valuation essentially the same as those used by investors in setting prices. We would choose to hold (not buy or sell) the shares as WGO appears to be fairly valued.

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32.

Reflecting on the valuation exercise, which of the following assumptions for WGO do you have the most concerns about relying on?

• Continuing growth in sales of 0.90 percent • •

Ongoing operating profit margin of 6.03 percent Weighted average cost of capital for operations of 10.60 percent

Examine the sensitivity to altering each of these assumptions up or down by 0.2 percent.

Which appears to be most critical and how would this effect the valuation effort?

Before performing a sensitivity analysis, the weighted average cost of capital for operations most likely harbors the most concerns due to the layers of assumptions necessary in its estimation. When we alter the assumptions, our value estimate of $34.95 for WGO adjusts to:

Sales growth PM rWACC

–0.2% $34.82 $33.78 $35.77

+0.2% $35.08 $36.12 $34.16

Here we see that changes in the profit margin lead to the largest changes in the value estimate. This reminds us that much care must be taken in estimating risk and that we must never assume that our value calculation is “correct”.

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Chapter 14 Steady State and Forecast Horizon QUESTIONS 1.

What are the requirements for steady state?

Steady state is achieved when: a. sales are growing at a constant rate, b. the NOPAT from each dollar of sales (operating PM) is constant and c. the NOA required for each dollar of sales (operating ATO) is constant.

That is, steady state is achieved when everything is growing at the sales growth rate.

2.

In which period does each of the valuations models have constant growth when the steady state is reached?

For the discounted cash flow model and the residual operating income model, the constant growth is reached in the same period as the steady state is reached. For the abnormal operating income growth model, constant growth occurs one period after the steady state is reached.

3.

If sales begin to grow at a constant rate in 2024, PM becomes constant in 2024, and ATO becomes constant in 2024, what is the first year’s payoff that can be used to calculate the continuing value in each of our three valuation models?

Discounted cash flow model – Starting with 2024 to 2025, we see steady growth. That is, FCF2025 = FCF2024 X (1 + g). Therefore, the 2024 FCF will be used in the calculation of the continuing value as all subsequent free cash flow grows from there.

Residual operating income model – Starting with 2024 to 2025, we see steady growth.

That is, ROPI2025 = ROPI2024 X (1 + g). Therefore, the 2024 ROPI will be used in the calculation of the continuing value as all subsequent residual operating income grows from there.

Continued

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Abnormal operating income growth model – Starting with 2025 to 2026, we see steady growth. That is, AOIG2026 = AOIG2025 X (1 + g). Therefore, the 2025 AOIG will be used in the calculation of the continuing value as all subsequent abnormal operating income growth values grow from there. (Remember that it takes one more period to reach steady state under AOIGM than the other two models.)

4.

Which is more critical to successful estimation of value, choice of model or having achieved steady state?

We have seen that the models are mathematically equivalent and that the value calculated for GIS’ operations is the same with each model. Therefore, the choice of model does not matter provided the firm is in steady state. If they are not in steady state, the choice would make a difference. Therefore, achievement of steady state is critical and must be a priority.

5.

When choosing a steady state growth rate for use in calculating continuing values, what constrains the choice of reasonable values? What is the implication for forecasts and calculations of value?

The growth rate cannot exceed long-term economic growth. Choosing a rate higher than the long-term economic growth would imply that the company will grow to an infinite size over time. As a result, we must forecast for a sufficiently long horizon to allow for any growth in excess of the economy to fade to a sustainable level. For growth companies, this may be especially hard and cause concerns when balanced with our knowledge that the farther in the future we forecast, the less confident we are in our assumptions.

6.

In the discounted cash flow model, typically the final free cash flow in the forecast horizon is used to determine the continuing value. What alternative metric can be used for the continuing value in the discounted cash flow model?

Due to uncertainty with the free cash flow forecasts, a multiples approach can be used.

As illustrated in the chapter, an EBITDA multiple is sometimes used as the continuing value for the discounted cash flow model.

7.

In evaluating valuation models, what attribute is preferred?

When the valuation models are at the steady state, the valuation is the same across all three models. The model which captures more of the valuation in the near-term as forecasts longer into the future are less reliable. Typically, the accounting based models will have the majority of the valuation within the forecast horizon.

8.

What are the accountant’s measure of value and value earned in a period?

A firm’s value creation is derived from its operations. Accordingly, value is measured by the firm’s NOA and the value creation is measured by NOPAT.

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9.

For a company with a high sales growth rate, what technique is used to extend the forecast horizon to the steady state?

Use a fade pattern after the explicit forecasting horizon if the sales growth rate is above a reasonable sustainable long-term growth rate. The fade pattern is based on the estimated number of years needed to achieve the long-term rate. Also, the fade pattern over the estimated pattern can be an same rate per year (e.g., 2.5 percent per year) or a declining rate (e.g., 6 percent, 5 percent, 4 percent …).

10.

What are the five steps to valuing a company?

The five valuation steps are: 1. Know the company’s business – Understanding the Business Environment 2. Identify the company’s enterprise operations – Reformulation of the Financial Statements 3. Determine the company’s current status – Financial Statement Analysis 4. Formulate expectations about the company’s future – Forecasting Future Payoffs 5. Calculate the company’s worth – Valuation

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EXERCISES

11.

The following are the sales, in $ millions, reported by Tesla Inc. (TSLA) for each of the past 7 years. Given the sales growth realizations, what might be a reasonable parsimonious steady state growth assumption? Is a fade or adjustment period needed between now and the achievement of that growth assumption and, if yes, what path might you consider?

Sales

2012 2013 2014 $413.

2 $2,103.5 $3,198.4

Growth

409.1%

52.1%

2015 2016 2017 2018 $4,046.

0 $7,000.1 $11,758,7 $21,461.3 26.5%

73.0%

68.0%

82.5%

Tesla is in the midst of a high-growth phase with continued sales growth consistently over 50 percent per year. Most likely, Tesla will continue to grow sales significantly in the near future. Any forecast of future payoffs will have to be extended beyond the explicit forecast horizon. To transition from these high growth rates to an assumed sustainable level of 2.5 percent, a fade pattern of 3 or 4 percent year would be appropriate. Should we feel a faster or slower fade is necessary, other assumptions can be implemented.

12.

Evaluate the forecasts of Benson’s sales growth, operating PM, and operating ATO as to whether the steady state is achieved and in which year. a.

Sales growth Operating PM Operating ATO

Year 1 Year 2

Year 3 Year 4 Year 5 Year 6 Year 7

15.0% 20.0% 0.85

10.0% 17.0% 0.88

12.0% 21.0% 0.91

5.0% 14.0% 0.85

3.0% 11.0% 0.80

3.0% 11.0% 0.80

3.0% 11.0% 0.80

Steady state occurs in year 5 when sales growth, operating PM, and operating ATO are constant in future years. b.

Sales growth Operating PM Operating ATO

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 15.0% 12.0% 10.0% 5.0% 3.0% 3.0% 3.0% 20.0% 21.0% 18.0% 16.0% 15.0% 12.0% 12.0% 0.85 0.91 0.88 0.85 0.80 0.80 0.80

Steady state occurs in year 6 when sales growth, operating PM, and operating ATO are constant in future years as operating PM is not constant until year 6. All three estimates must be constant to achieve steady state.

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Valuation Using Financial Statements, 2nd Edition

c.

Sales growth Operating PM Operating ATO

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 15.0% 12.0% 10.0% 9.0% 7.0% 6.0% 6.0% 20.0% 21.0% 17.0% 14.0% 11.0% 11.0% 11.0% 0.85 0.91 0.88 0.85 0.80 0.80 0.80

Steady state would appear to occur in year 6, when all three estimates are constant in subsequent years. However, sales growth is too high to be sustainable over the long-run. A fade pattern should be considered following the explicit forecast horizon.

13.

The following forecasts were developed for Burns, LLC based on a NOA 0 of $215,000 and sales of $500,000.

NOPAT1 = $58,850 Sum of present value of forecasted FCF = $208,027 Sum of present value of forecasted ROPI =$155,410 Sum of present value of forecasted AOIG to period 1 = $6,608 Present value of FCF continuing value = $541,276 Present value of ROPI continuing value = 378,893 Present value of AOIG continuing value to period 1 = $9,472 a. Determine the estimated value for Burns using the free cash flow model, the residual operating income model and the abnormal operating income model, assuming a 10.0 percent operating cost of capital.

Free cash flow = $749,303 or ($208,027 + $542,276) Residual operating income model = $749,303 or ($215,000 + $155,410 + $378,893) Abnormal operating income growth model = $749,303 or [($58,850 + $6,608) ÷ 0.10 + ($9,472 ÷ 0.10)] b. Prepare a breakdown of each valuation model by estimated value, in $, and percentage by (1) no forecast necessary, (2) based on forecasts within the horizon and (3) based on estimated value.

Free Cash Flow Model Amoun t Percent No forecast necessary Based on forecasts within horizon Based on continuing value Total estimated value

Residual Operating Income Model

Abnormal Operating Income Model

Amount

Percent

Amount

Percent

-

0.0%

215,000

28.7%

-

0.0%

208,027

27.8%

155,410

20.7%

654,580

87.4%

541,276 749,303

72.2% 100.0%

378,893 749,303

50.6% 100.0%

94,723 749,303

12.6% 100.0%

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 14

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14.

The Forward PE ratio for Edwards Inc. and Bell Corp. is 20 and 10, respectfully.

Assuming all future abnormal operating income growth (AOIG) is zero, which company has the lower risk (i.e., the lower rWACC)?

Given the assumption there is no future AOIG, equation 12.3 can be stated as:

V 0=

1 ×NOPAT rWACC

t

or

V0

= 1 .

NOPAT t rWACC

Solving for rWACC, Edwards has a rWACC = 5 percent while Bell’s rWACC is 10 percent. Thus, Edwards has a lower operating risk than Bell.

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Valuation Using Financial Statements, 2nd Edition

CONTINUING EXAMPLES 15.

Compare the breakdown of the value estimates for Kellogg based on the horizon by completing the following chart. What do you learn from this exercise?

Breakdown of Kellogg’s Value Estimate based on Horizon

No forecast necessary Based on forecasts within horizon Based on continuing value Total estimated value

Discounted Cash Flow Model Amount Percent 0.0%

Residual Operating Income Model Amount Percent 12,949 47.6%

Abnormal Operating Income Growth Model Amount Percent 0.0%

7,354

27.0%

4,299

15.8%

26,435

97.2%

19,874 27,200

73.0% 100.0%

9,952 27,200

36.6% 100.0%

766 46,273

2.8% 100.0%

For Kellogg, over 70 percent of value comes from estimates beyond the forecast horizon if we forecast based on cash flows. This is not surprising since the continuing value is price at the horizon. Again, remember that if we don’t know the value of the firm today, we are likely to have very little confidence in our forecasted value at the horizon! For the accounting-based models more value is captured within the horizon with the abnormal operating income growth model capturing over 95 percent of value within the horizon.

Given that companies, analysts, and investors generally focus on forecasting profitability and resources required, using the accounting information such as sales, NOA, and NOPAT is natural. Often, to implement cash flow forecasting, additional assumptions are added which do not improve the forecasting process.

© Cambridge Business Publishers, 2021 Solutions Manual, Chapter 14

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16.

Compare the breakdown of the value estimates for Thor Industries (THO) based on the horizon by completing the following chart. What do you learn from this exercise?

Breakdown of THO’s Value Estimate based on Horizon:

No forecast necessary Based on forecasts within horizon Based on continuing value Total estimated value

Discounted Cash Flow Model Amount Percent 0.0%

Residual Operating Income Model Amount Percent 1,848,120 50.3%

1,434,331

39.0%

879,374

2,241,471 3,675,801

61.0% 100.0%

948,307 3,675,801

Abnormal Operating Income Growth Model Amount Percent 0.0%

23.9% 3,600,539

98.0%

25.8% 100.0%

2.0% 100.0%

75,262 46,273

For THO, more of the value comes from the estimates within the forecast horizon, but the majority is from estimates beyond the forecast horizon. Similarly, the accountingbased models more value is captured within the horizon with the abnormal operating income growth model capturing over 95 percent of value within the horizon.

Given that companies, analysts, and investors generally focus on forecasting profitability and resources required, using the accounting information such as sales, NOA, and NOPAT is natural. Often, to implement cash flow forecasting, additional assumptions are added which do not improve the forecasting process.

17.

Compare the breakdown of the value estimates for Winnebago (WGO) based on the horizon by completing the following chart. What do you learn from this exercise?

Breakdown of WGO Value Estimate based on Horizon:

No forecast necessary Based on forecasts within horizon Based on continuing value Total estimated value

Discounted Cash Flow Model Amount Percent 0.0%

Residual Operating Income Model Amount Percent 896,197 73.5%

Abnormal Operating Income Growth Model Amount Percent 0.0%

573,095

47.0%

161,825

13.3%

1,205,800

98.9%

646,417 53.0% 1,219,511 100.0%

161,489 1,219,511

13.2% 100.0%

13,711 1,219,511

1.1% 100.0%

For WGO, the cash flow model is nearly evenly split between the estimates within and beyond the forecast horizon. For the accounting-based models nearly the entire value is captured within the horizon with the abnormal operating income growth model capturing almost 99 percent of value within the horizon.

Given that companies, analysts, and investors generally focus on forecasting profitability and resources required, using the accounting information such as sales, NOA, and © Cambridge Business Publishers, 2021 14-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams

SM-Valuation Using Financial Statements 2E by Sommers(2024)

NOPAT is natural. Often, to implement cash flow forecasting, additional assumptions are added which do not improve the forecasting process.

Solutions Manual, Chapter 14

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