Test Bank for Valuation Using Financial Statements 2nd Edition by Gregory Sommers - Complete

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TEST BANK

2023

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COMPLETE Elaborated Test Bank for

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

Prof.Exams

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

ISBN-10 1618533630 ISBN-13 978-1618533630

Test bank 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 The Link between Valuation and Financial Statement Analysis

PART 2 Business analysis and valuation tools Chapter:2 Role of Accounting Chapter:3 Reformulation to Identify Operating Activities Chapter:4 Use of Additional Information to Enhance Reformulation Chapter:5 Adjusting Accounting Information Chapter:6 Analysis of Enterprise Operations Chapter:7 Full-Information Forecasting for Valuation Chapter:8 Market Multiple Valuation

PART 3 Business analysis and valuation applications Chapter:9 Cost of Capital for Operations and Equity Chapter:10 Valuation Using Forecasts of Cash Flows Chapter:11 Valuation Using the Residual Operating Income Model Chapter:12 Communication and governance Chapter:13 Valuation of Equity Chapter:14 Steady state and Forecast Horizon

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Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter:1 A framework for business analysis and valuation using financial statements

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

Explain whether valuation concepts, tools, and techniques are applicable beyond the valuation of publicly traded firms.

The fundamental elements of valuation (i.e., understanding the business, identifying and evaluating the drivers of value creation, forecasting future payoffs culminating in a valuation) are applicable to a variety of settings, including valuation of privately held firms, merger transactions, project analysis, and implementation of accounting standards involving fair value estimates.

2.

What is the role of financial accounting with respect to valuation?

Financial accounting provides information about the amount, timing, and uncertainty of future payoffs; the essential elements required for valuation.

3.

What are the advantages of using accounting-based valuation models over cash flow valuation models?

People typically forecast earnings, not cash flows. The earnings forecast is converted to a cash flow forecasts. Accounting based valuation models avoid the additional step of converting the earnings to cash flows. Additionally, firms with negative free cash flows are not problematic with earningsbased forecasts.

4.

What is the benefit of valuing the enterprise operations relative to valuing the firm’s equity?

By valuing the enterprise operations, the analyst does not need to forecast the firm’s future leverage (i.e., the portion of debt to equity). This approach allows a cleaner analysis with fewer assumptions.

5.

Explain why the financial statements need to be reformulated when conducting a valuation.

Operating activities are primarily how companies create value. By reformulating the financial statements between operating and financing activities, there is greater visibility of the value creation drivers for the organization. This allows for better historical analysis as well as forecasting future payoffs within the valuation. © Cambridge Business Publishers, 2021

Test Bank, Chapter 1

1-1

6.

How do revenues and expenses differ from the resulting cash flows?

The difference between revenues and expenses from the related cash flows is the accruals. The accruals represent the timing differences between the recognition of the revenue and expense and the cash flows. Additionally, the accruals include accounting estimates (e.g., bad debt expense).

For example, the change in accounts receivable including the allowance for bad debts explains the difference between sale revenues and the resulting cash flows.

7.

What is a limitation of using a company’s Form 10-K, section 1A, Risk Factors, as the source of the material risks facing the company?

The Risk Factors section of the Form 10-K provides an accurate list of potential risks and uncertainties for the company. However, the number of risk factors disclosed can be extensive and it effectively weighs all risks equally. The risks need to be evaluated by their impact and relevance in impacting the firm’s future financial position and performance.

8.

How does Understanding the Business and the Business Environment provide a more accurate valuation.

Without a solid understanding of the business and its environment, the financial analysis and, subsequent forecasts, can be misleading resulting in poor estimates of expected payoffs. Financial analysis requires a strong understanding of the business to correctly evaluate the firm’s financial position and performance. Additionally, having a strong understanding of the business and its environment allows for better forecasts that reflect the firm’s economic reality. Financial analysis and forecasting resulting in better estimates of future payoffs results in a more accurate valuation.

9.

Identify the fundamentals in Understanding the Business and the Business Environment.

The essential elements to understanding the business are (1) knowing the company’s primary operating activity(ies), (2) the company’s customers, (3) and suppliers, and (4) identifying the company’s material risk and uncertainties.

10.

How does understanding a company’s life cycle stage impact forecasts of operating asset turnover and profit margin.

The expectation of operating asset turnover and profit margin change as a company moves through the various life cycle stages. In the Introduction phase, operating asset turnovers and profit margins are generally lower than in growth or mature phase. As the company moves to shake-out or decline, profit margins will decrease as will operating asset turnover. Having an understanding of the firm’s life cycle stage will facilitate more accurate forecasts.

© Cambridge Business Publishers, 2021 1-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter:1 A framework for business analysis and valuation using financial statements

EXERCISES 11.

Convert the fundamental accounting equation Assets = Liabilities + Equity to the reformulated Net operating assets (NOA) = Net financial liabilities (NFL) + Common shareholders’ equity (CSE).

(1) Assets = Liabilities + Equity (2) (Operating assets + Financial Assets) = (Operating Liabilities + Financial liabilities) + (Preferred stock + Common stock + Retained Earnings) (3) (Operating assets – Operating liabilities) = (Financial liabilities – Financial assets + Preferred stock) + (Common stock + Retained Earnings) (4) NOA = NFL + CSE

© Cambridge Business Publishers, 2021 Test Bank, Chapter 1

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CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors as well as Procter & Gamble (PG) and Kimberly-Clark (KMB). This will facilitate the application of the valuation steps to similar real-life firms.

12.

Use Dickinson’s (2011) cash flow matrix to evaluate the life cycle stage classification for FedEx (FDX).

Based on the fiscal year 2019 Consolidated Statement of Cash Flows, FedEx has positive operating cash flows, negative investing cash flow and negative financing cash flow which indicates that FedEx is in its Mature stage of its life cycle. © Cambridge Business Publishers, 2021 1-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter:1 A framework for business analysis and valuation using financial statements

13.

Use Dickinson’s (2011) cash flow matrix to evaluate the life cycle stage classification for United Parcel Service (UPS).

Based on the 2019 Consolidated Statement of Cash Flows, UPS has positive operating cash flows, negative investing cash flow and negative financing cash flow which indicates that UPS is in its Mature stage of its life cycle.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 1

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14.

A Strength, Weaknesses, Opportunities and Threats (SWOT) for the Global Couriers & Local Deliver Services is presented below. FedEx (FDX) and United Parcel Service (UPS) are the two largest companies in this industry with a combined 30 percent market share of industry revenues.

Source: IBISWorld What factors would appear to be most important in an industry analysis for FedEx (FDX) and United Parcel Service (UPS)?

The global courier and local delivery services industry is most impacted by consumer spending, world trade, e-commerce and the price of oil. Revenues are highly correlated with consumer spending. As the consumer spending increases, demand for items to be delivered increases resulting in increased revenues. A decline in consumer spending will adversely impact revenues.

The expanded availability of e-commerce allows for more consumer spending, which increases industry demand. Changes in world trade impact industry revenues similarly as consumer spending. Lastly, Changes in fuel prices are not readily passed on to customers which directly impacts the profit margins for FDX and UPS.

© Cambridge Business Publishers, 2021 1-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter:2 Role of Accounting

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

Chapter 2 Role of Accounting QUESTIONS 1.

Why do executives focus on earnings?

Earnings, as opposed to cash flows, are closely linked to value creation. Thus, executives can more effectively report the firm’s value created through earnings than cash flows. For example, revenues are generally recognized when the good or service is provided while the cash flow can be either prepaid, paid at the time the good or service is provided, or paid later. Correspondingly, expenses are typically recognized when the related good or service is used to generate the revenue. The cash can be paid prior, at the time the good or service is consumed or afterwards. Thus, the accounting earnings provides the financial statement user with a better sense when value is created than the related cash flows.

2.

Do analysts typically forecast earnings or cash flows? Explain.

Analysts typically forecast earnings. Earnings forecasts follow in line with how analysts view the firm’s value creation process. That is, analysts take the expected growth in revenues along with expected profit margin and supporting net operating assets to build the earnings forecasts.

Accordingly, analysts transform the earnings forecasts into cash flow forecasts.

3.

How do accruals match the timing of reported earnings to when the change in economic value occurs?

Accruals are the timing differences between the revenues and expenses and the related cash flows.

Accounting uses accruals to match the revenue and expense recognition in the same period as the related economic activity. For example, consider the accounting for the purchase of a depreciable asset that is depreciated over its service life. The economic value of the depreciable asset is expected to decline over time. The recognition of depreciation expense over the asset’s service life more closely follows the change of the asset’s economic value over than the related cash flow (i.e., at the purchase date).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 2

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4.

Are accounting accruals subject to earnings management? Explain.

Yes, where earnings management is defined as the use of accounting discretion to distort reported earnings. Accounting accruals reflect management’s estimation and judgment in its application.

Managers who have incentives to manage earnings, for either good or bad purposes, can manipulate the accounting accruals through by the inherent estimation and judgment within accrual recognition process. This manipulation results in earnings management.

5.

Over the life of a project, are the project’s accounting earnings equal to its net cash flows? Explain.

Yes, the accounting earnings are an allocation of the project’s net cash flows over the project’s life.

The difference between the accounting earnings and the net cash flows are the accruals. At the end of a project’s life, there are no accruals. That is, over the project life, the operating cash inflows are recognized as revenues while the operating cash outflows are recognized as expenses.

In total the net cash flows will equal the accounting earnings.

6.

Are the free cash flows calculated from net operating profit after tax (NOPAT) and the change in net operating assets (NOA) the same as the calculations from the statement of cash flows?

Explain.

No, in the statement of cash flows the operating and investing cash flow sections are not entirely related to operating activities. Free cash flows are the excess cash flows from the firm’s operating activities. The operating and investing sections of the statement of cash flows contain investment income and interest expense. Additionally, the distinction of income taxes between operating and financing activities is not recognized in the financial statements. Finally, significant non-cash transactions are omitted from the statement of cash flows that may impact operating activities and the calculation of FCF.

7.

What do free cash flows represent?

Free cash flows are the cash flows between the firm’s operating and financial activities. Positive free cash flows are the excess cash flows from operating activities after funding the changes in net operating assets (NOA). These excess cash flows can be held as financial investments, paid to creditors or distributed to shareholders (i.e., dividends or buybacks). Conversely, negative free cash flows arise when the firm’s operating activities do not sufficiently fund the change in its net operating assets (NOA). Cash from financial investments or from creditors/shareholders will be used to fund operating activities.

8.

When a firm generates free cash flows, what are its two potential usages?

With free cash flows, a firm makes a financial transfer (Free Cash Flows to Financing or FCFFin) or a shareholder transfer (Free Cash Flows to Equity or FCFEq). A financial transfer is when the firm either holds the excess cash, invests the cash into marketable securities, or makes payments for interest and return of capital to debt holders. Shareholder transfers use the free cash flows for dividend payments and share repurchases. Free cash flows are either held by the firm or paid to debtors or shareholders.

© Cambridge Business Publishers, 2021 2-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter:2 Role of Accounting

9.

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

Are all firms with negative free cash flows destroying value? Explain.

Negative free cash flows can represent investments in value creating projects. When a firm is in its introductory or growth stage of its life cycle, it is not unusual for it experience negative free cash flows as its NOPAT is insufficient to funds its NOA growth needs. As a company expands its operations, additional funding from its financial assets or debtors/shareholders is needed, resulting in negative free cash flows. The underlying assumption is that the investments will generate a return over its cost of capital (i.e., create value).

10.

Why are free cash flows described as “operating profits not retained to fund future operations?”

As a firm creates cash flows from its operations, the cash can either be reinvested into its operating activities (i.e., increases in NOA) or released to its debtholders or shareholders.

If a firm has no change in its net operating assets (NOA) over the period, any net operating profits after tax (NOPAT) would be free cash flow available for financial investment or paid to debtors//shareholders. A firm that is increasing its NOA will have free cash flows if its NOPAT is greater than the increase in NOA; otherwise, the free cash flows are negative.

11.

What is an accounting accrual?

Accounting accruals are the difference between a revenue or expense and its related cash flow.

When a revenue (or expense) is recognized at the same time as the cash flow is received (or paid), there is no accrual. Accruals arise when the revenue (or expense) are recognized separately from the related cash receipt (or payment). For example, revenue earned prior to cash collection from the customer, results in an accrual (e.g., an increase in accounts receivable). Thus, the accruals are the timing differences between the income statement recognition and cash flows reflected in the related balance sheet accounts.

12.

What are the typical cash flows for Free Cash Flows to Financing (FCFFin)?

Free Cash Flows to Financing represent the cash flows to and from debt holders and cash reserves.

These cash outflows include additional investments to cash reserves (e.g., marketable securities), interest payments, and principle repayments to debt holders. Cash inflows from financing are decreases in cash reserves and the proceeds of debt issuances.

13.

What are the typical cash flows for Free Cash Flows to Equity (FCFEq)?

Free Cash Flows to Equity are the cash flows to and from the firm’s equity holders. The cash outflows are dividends and share repurchases while the cash inflows are stock issuances (e.g., secondary offerings or exercised stock options).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 2

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EXERCISES 14.

G.O. May Corp’s December 31, 2019, and 2020 balance sheet lists shareholders’ equity of $750,000 and $800,000 respectfully. Assume May’s transactions with shareholders during 2020 included (1) cash dividends declared and paid in the amount of $40,000 and (2) stock options exercised with an exercise price of $65,000, but with a market value of $120,000, and (3) treasury repurchases (i.e., stock buybacks) of $150,000 for shares that were originally issued years ago for $70,000.

What is May’s 2020 net income (loss) assuming no other comprehensive income?

Shareholders Equity, Dec. 31, 2019 (1) Dividends

(40,000)

(2) Stock options exercised

65,000

(3) Stock repurchases

(150,000)

Net Income

175,000

Shareholders Equity, Dec. 31, 2020

15.

$750,000

$800,000

Andrews Company reported the following selected financial results for 2019 and 2020.

2019

2020

Operating assets

$350,000

$430,000

Financial assets

25,000

20,000

Operating liabilities

110,000

125,000

Financial liabilities

175,000

210,000

NOPAT

$25,000

FEAT

15,000

Comprehensive income (CI)

10,000

continued

© Cambridge Business Publishers, 2021 2-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter:2 Role of Accounting

a.

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

Calculate Andrews’ NOA, NFL and CSE for 2019 and 2020 NOA2019 = $350,000 – 110,000 = $240,000 NOA2020 = $430,000 – 125,000 = $305,000

NFL2019 = $175,000 – 25,000 = $150,000 NFL2020 = $210,000 – 20,000 = $190,000

CSE2019 = $240,000 – 150,000 = $90,000 CSE2020 = $305,000 – 190,000 = $115,000

b.

Calculate Andrews’ FCF, FCFFin and FCFEq for 2020.

FCF = NOPAT – NOA = $25,000 – ($305,000 - $240,000) = $25,000 – $65,000 = ($40,000) FCFFin = FEAT – NFL = $15,000 – ($190,000 – $150,000) = $15,000 – $40,000 = ($25,000) FCFEq = CI – CSE = $10,000 – ($115,000 – $90,000) = $10,000 – $25,000 = ($15,000)

16.

Demonstrate that the total earnings and the cash flows are the same for the following scenario: Purchase of a specialized machine with a three-year life for $300,000 with an expected salvage value of $60,000. After three years, the actual disposition proceeds are $50,000. Assume straightline depreciation with a full year’s depreciation in the year of acquisition and year of disposal.

Initial

Accounting Earnings $0

Cash Flows $ (300,000)

Year 1

$ (80,000)

$0

Year 2

$ (80,000)

$0

Year 3

$ (90,000)

$ 50,000

Total

$ (250,000)

$ (250,000)

© Cambridge Business Publishers, 2021 Test Bank, Chapter 2

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17.

Demonstrate that the total earnings and the cash flows are the same for the following scenario: On October 1, Brundage, LLC paid a $300,000 premium for its Errors and Omission insurance coverage for the coming year (12 months). Sprague has a December 31st year end.

18.

Oct. – Dec.

Accounting Earnings ($ 75,000)

Cash Flows ($ 300,000)

Jan. – Sept.

($225,000)

$0

Total

($300,000)

($300,000)

Demonstrate that the total earnings and the cash flows are the same for the following scenario: Grady Construction signs a $12 million contract to construct a new building. Grady estimates construction will take two years and will cost $10,000,000 to build. Progress payments of $500,000 are received each month. Grady uses the cost-to-cost approach for its revenue recognition. Grady anticipates being 40 percent by the end of the first year.

19.

Year 1

Accounting Earnings $800,000

Cash Flows $2,000,000 ($6,000,000 – 40% x $10,000,000)

Year 2

$1,200,000

$0

Total

$2,000,000

$2,000,000

($6,000,000 – 60% x $10,000,000)

Demonstrate that the relation shown in Equation 2.2, 𝐹𝐶𝐹𝑡 ≡ 𝑁𝑂𝑃𝐴𝑇𝑡 − ∆𝑁𝑂𝐴𝑡 , holds for the following transactions: a.

Borrow $20,000 to purchase of specialized equipment: FCF

($20,000)

Cash inflow from debt holders

NOPAT

$0

There is no revenue or expense

ΔNOA

$20,000

Long-term operating assets increase by $20,000 increasing NOA.

($20,000) = $0 – $20,000

b.

The equipment’s annual depreciation is $5,000: FCF

$0

There is no cash flow to credit or equity holders

NOPAT

($5,000)

Depreciation expense of $5,000

ΔNOA

($5,000)

Decrease in equipment book value of $5,000

$0 = ($5,000) – ($5,000)

© Cambridge Business Publishers, 2021 2-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter:2 Role of Accounting

c.

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

Management extends the expected life of the equipment reducing depreciation to $4,000: FCF

$0

There is no cash flow to credit or equity holders

NOPAT

($4,000)

Depreciation expense of $4,000

ΔNOA

($4,000)

Decrease in equipment book value of $4,000

$0 = ($4,000) – ($4,000)

d.

Equipment is sold for $3,000 resulting in a $500 gain on sale: FCF

$0

There is no cash flow to credit or equity holders

NOPAT

$500

The gain on sale is a $500

ΔNOA

$500

Increase in operating cash of $3,000 and decrease in equipment for $2,500

$0 = $500 – $500 Note that if the cash proceeds of $3,000 was assumed “extra” to be distributed to debt or equity holders and therefore a financial item, the equation would be: FCF

$3,000

Cash outflow of $3,000

NOPAT

$500

The gain on sale is a $500

ΔNOA

($2,500)

Decrease in equipment for $2,500

$3,000 = $500 – ($2,500)

20.

Dickinson Ltd. is evaluating a potential project with the following expected future cash flows: Purchase price:

$5,000

Payoffs: Year 1

$2,000

Year 2

2,500

Year 3

3,000

Year 4

1,500

At the end of the project, the salvage value for the project assets is estimated at $1,000. The project assets are depreciated on a straight-line basis over its four-year life.

continued © Cambridge Business Publishers, 2021 Test Bank, Chapter 2

2-7

© Cambridge Business Publishers, 2021 2-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter:2 Role of Accounting

a.

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

Prepare the income statement for the four years of the project.

1

2

3

4

Revenues

$2,000

$2,500

$3,000

$1,500

Depreciation

(1,000) (1,000) (1,000) (1,000)

Income Statement

Gain on sale

-

Net income

$1,000

$1,500

$2,000

$500

Notes: Depreciation = (Cost – Residual Value) / # of years = ($5,000 – 1,000) / 4 = $1,000 per year Expected Gain = Est. Selling price – (Cost – Acc. Dep.) = $1,000 – ($5,000 – 1,000) = 0

b.

Prepare the “statement of cash flows” for the four years of operation including the acquisition.

Statement of Cash Flows 0 Contribution to purchase

1

2

3

4

($5,000)

Revenues

$2,000 $2,500 $3,000 $1,500

Proceeds from disposition Distributions

c.

1,000 ($5,000) $2,000 $2,500 $3,000 $2,500

Prepare the statement of changes in equity for the four years of operation including the acquisition.

Statement of Changes in Equity 0

1

2

3

4

Beginning book value of project

-

$5,000

$4,000

$3,000

$2,000

Plus net income

-

1,000

1,500

2,000

500

Less distributions

$5,000 (2,000) (2,500) (3,000) (2,500)

Ending book value of project

$5,000

$4,000

$3,000

$2,000

-

© Cambridge Business Publishers, 2021 Test Bank, Chapter 2

2-9

© Cambridge Business Publishers, 2021 2-10

Valuation Using Financial Statements, 2nd Edition

21.

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter:2 Role of Accounting Scovill Inc. completed another successful year along with its initial public offering (IPO). The Company earned comprehensive income (CI) of $40 million that included net operating profit after tax (NOPAT) of $45 million. During the year, Scovill completed its initial public offering of $250 million with no prior shareholders selling which brought its common stock equity (CSE) balance at year-end to $400 million. A portion of the IPO proceeds were used to fund the increase of net operating assets (NOA) from $350 million at the beginning of the year to $500 million as of the end of the year. The remaining IPO proceeds were held as financial assets. As a result, the net financial liabilities (NFL) decreased during the year. Scovill does not pay a dividend nor did it buyback any outstanding shares. However, Scovill received $5 million from the exercise of employee stock options. a.

What is financial expense after tax (FEAT) for the year?

$5 million – see the color key below.

Color key: Given

CI

Solving for

40

=

NOPAT 45

–

FEAT 5

Previously solved for b.

What are free cash flows (FCF) for the year?

Negative $105 million

First, solve for the Δ in NOA,

ΔNOA

=

150

NOAEnd

–

500

NOABeg 350

Then solve for free cash flow, FCF

FCF (105)

=

NOPAT 45

–

ΔNOA 150

© Cambridge Business Publishers, 2021 Test Bank, Chapter 2

2-11

c.

What is the amount of decrease in net financial liabilities (NFL) during the year?

$145 million.

First, solve for cash flow to equity, FCFEq FCFEq

=

dividends

(255)

+

buybacks

0

–

0

issuances 255

Then solve for the change in net financial liabilities (Δ NFL)

FCFEq

=

(255)

22.

FCF

–

FEAT

(105)

5

+

ΔNFL (145)

Sanders Inc. completed another successful year including opening new subsidiaries in Ireland and Chile. Sanders generated $300 million in comprehensive income (CI) of which $330 million was net operating profit after tax (NOPAT) and $30 million was financial expense after tax (FEAT). Due to a positive business climate the firm expanded its operations internationally resulting in an increase in net operating assets (NOA) from $1,250 million to $1,600 million that was financed by an increase in net financial liabilities (NFL) of $130 million from $500 million at the beginning of the year. During the year, the firm paid a cash dividend of $50 million. Additionally issued $10 million in stock from employee stock options exercised. To avoid dilution of existing shareholders, Sanders maintains an active share repurchase (i.e., “buyback”) plan to purchase stock on the open market to support its stock option issuances. a.

What are the free cash flows (FCF) for the year?

Color key: Given Solving for Previously solved for

FCF

=

(20)

NOPAT 330

–

ΔNOA 350

Negative $20 million.

© Cambridge Business Publishers, 2021 2-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter:2 Role of Accounting

b.

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

What are the cash flow to equity, FCFEq, for the year (i.e., net payout to shareholders)?

FCFEq

=

80

FCF

–

(20)

FEAT

+

30

ΔNFL 130

$80 million

c. What is the cost of shares repurchased during the year?

FCFEq 80

=

dividends 50

+

buybacks 40

–

issuances 10

$40 million.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 2

2-13

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

Chapter 3 Reformulation to Identify Operating Activities QUESTIONS 1.

What are reformulated financial statements?

Reformulated financial statements are a firm’s GAAP financial statements separated into the its operating activities (NOPAT & NOA) from its financial activities (FEAT and NFL). Through an understanding of the firm’s business activities, each account from the income statement and the balance sheet is classified as operating or financial. The reformulated allows for analysis, forecasting and valuation of the company’s operations (i.e., its value creation activities).

2.

How does an enterprise operations approach avoid the issue of forecasting management’s financing decision?

The source of funding is irrelevant when valuing the firm’s operations. The risk of the firm’s operating activities does not change whether the firm is financed by debt, equity, or a combination of the two.

The cash flows from operations (i.e., free cash flows (FCF)) available to debt holders or equity holders does not impact the firm’s expected future payoffs. By definition, free cash flows are not required to support current operations and, therefore, management’s decision as to how to distribute the funds will not affect the firm’s operations.

Valuing a firm’s enterprise operations does not need to consider the source of funding along with the choice of the destination of any free cash flow distributions.

3.

Valuation is a function of future payoffs, so what is the purpose of evaluating prior year financial statements?

Past financial trends tend to continue into the future unless there is a change in the business environment or firm strategy. That is, what has held true for the past will hold for the future. The reformulated financial statements allow for a better analysis of the firm’s historical performance and financial position. This understanding provides a better foundation on which to base the forecasts of the firm’s future payoffs.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

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4.

When reformulating the balance sheet, what is the criterion for evaluating whether an account is an operating or financing item?

The determination for whether an account is operating or financing depends primarily on one’s understanding of the company’s structure and goals. When there is an account that is not clearly operating or financing, a consideration is whether the account is reported at fair value. If there is doubt regarding the valuation, then the account is typically classified as operating. Thus any valuation difference in the account’s reported amount will be reflected in the subsequent enterprise operation valuation.

5.

Explain whether a financing division that supports a firm’s sales effort is classified as operating or financing.

Firms which have a supporting financial division need to be carefully considered. The classification will impact the valuation as well as the operation’s risk measure. If the supporting financial division’s accounts are reported on the balance sheet at fair value, then the accounts are classified as financial activities. The impact of the financing division activities will be reflected in the firm’s sales and related operating activities. Alternatively, if the accounts are not reported at fair value on the balance sheet, the financial division accounts are classified as operating activities.

6.

Why is cash and cash equivalents typically split between operating and financing activities?

While firm’s need cash to operate its day-to-day activities, in many instances, the firm holds more cash than needed to support its operating activities. Any excess cash not needed for operating activities is classified as a financing activity as it could have been distributed to debt or equity holders. To determine the operating cash needs, a general rule of thumb of two percent of sales (i.e., one week of sales) is often used.

7.

When reformulating the financial statements, does the distinction between current and noncurrent assets and liabilities need to be maintained? Explain.

No, the distinction between current and non-current assets and liabilities does not need to be maintained. The financial analysis and forecasting of future payoffs stages in the valuation process do not require the current/non-current distinction. Thus, there is no need to distinguish the difference in the reformulations.

8.

Why is preferred stock classified as a financial item?

The valuation approach is taken from the common shareholder, i.e., the residual claimant, perspective. In a liquidation, when all debt and obligations are satisfied, the remaining assets belong to the common shareholders. Preferred shareholders have a liquidation preference before common shareholders and, therefore, are not the residual claimant. Also, preferred shareholders have constant payouts and are typically valued based on those expected payments, similar to debt holders.

© Cambridge Business Publishers, 2021 3-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

9.

Why are noncontrolling interests (NCI) classified as a financial item?

Noncontrolling interests represent the minority shareholders’ equity interest in a consolidated firm’s subsidiary. Noncontrolling interests have a claim on a portion of the subsidiary’s net assets and income. From a consolidated perspective, noncontrolling interests have claims against the firm, but do not have an equity in the consolidated firm. Similar to debt holders, noncontrolling interests are classified as a financial item.

10.

Describe the process to allocate income tax expense between operating and financial activities.

The reported income tax expense (or income tax provision) represents the tax impact for both operating and financing items. That is, reported income tax expense = income tax expense (benefit) from operating activities + income tax expense (benefit) from financing activities.

Accordingly, the income tax expense needs to be allocated between the two activities. Although the actual tax impact is not known for operating versus financial activities, an estimation is done by estimating the tax impact on the financial activities first. With few deferred tax items associated with the financial activities, estimating the income tax impact is done by multiplying the pre-tax financial expense (income) with the firm’s marginal tax rate yielding the income tax expense (benefit) from financing activities. The next step in allocating the reported income tax expense is to solve for the income tax expense (benefit) from operating activities.

11.

Explain whether discontinued operations are classified as an operating activity or not?

Discontinued operations are operating activities when reformulating a firm’s financial statements.

While the discontinued operations will not impact future operating results (including forecasted future payoffs), inclusion in historical operating activities (NOPAT and NOA) is appropriate as it reflects management’s operating decisions and performance.

12.

In reformulating a balance sheet, equity method investments (e.g., joint ventures, affiliates and partnerships) should be classified as operating or financial? Explain briefly. Equity method investments represent a firm’s equity interest in another company at less than 50 percent (i.e., control) but more than 20 percent. That is, the investor has the ability to exert significant influence on the investee.

Equity method investments should be classified as operating activities because joint ventures, subsidiaries, partnerships, etc. represent an operational interest and by the company in the joint venture, and it is intrinsically linked to their enterprise operations.

An investment of 20 percent or more into a company’s ownership is more than a financial investment. The investor is creating a strong relationship with the entity. Typically, such investors have a seat (or more) on the board. Also, there is often a supplier/customer relationship or a R&D relationship. These elements demonstrate the investor’s ability to exert significant influence on the investee.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-3

EXERCISES 13.

Below is a recent Balance Sheet for Under Armour (UA). For each item listed, determine the classification that would be used in reformulation from the following list: • • • • •

O – Operating activities F – Financial activities S – Split between operating and financial activities ? – Desire more detailed information but will initially classify as related to operating activities CSE – Common shareholders’ equity

Note: all of Under Armour’s common stock (Class A, B and C) have identical distribution and liquidation rights.

© Cambridge Business Publishers, 2021 3-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

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

Property and equipment, net – O Operating lease right-of-use assets – O Goodwill – O Intangible assets, net – O Deferred income taxes – ?

Other long-term assets – ?

Accounts payable – O Accrued expenses – O Customer refund liabilities – ?

Operating lease liabilities – F Current maturities of long-term debt – F Other current liabilities – ?

Long-term debt, net of current maturities – F Operating lease liabilities, non-current – F Other long-term liabilities – ?

Preferred stock – F (if they had issued some shares) Class A Common stock – CSE Class B Convertible common stock – CSE Class C Common stock – CSE Additional paid-in capital – CSE Retained earnings – CSE Accumulated other comprehensive income – CSE

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-5

14.

Below is a recent Balance Sheet for Netflix (NFLX) For each item listed, determine the classification that would be used in reformulation from the following list: • • • • •

O – Operating activities F – Financial activities S – Split between operating and financial activities ? – Desire more detailed information but will initially classify as related to operating activities CSE – Common shareholders’ equity

© Cambridge Business Publishers, 2021 3-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

Cash and cash equivalents – S Current content assets, net – O Other current assets – ?

Non-current content assets, net – O Property and equipment, net – O Other non-current assets – ?

Current content liabilities – O Accounts payable – O Accrued expenses and other liabilities – ?

Deferred revenue – O Non-current content liabilities – O Long-term debt – F Other non-current liabilities – O Common stock – CSE Accumulated other comprehensive income – CSE Retained earnings – CSE

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-7

15.

Below is a recent Balance Sheet for PepsiCo, Inc. (PEP) For each item listed, determine the classification that would be used in reformulation from the following list: • • • • •

O – Operating activities F – Financial activities S – Split between operating and financial activities ? – Desire more detailed information but will initially classify as related to operating activities CSE – Common shareholders’ equity

© Cambridge Business Publishers, 2021 3-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

Cash and cash equivalents – S Short-term investments – F Restricted cash – F Accounts and notes receivable, net – ?

Inventories – O Prepaid expenses and other current assets – ?

Property, plant and equipment, net – O Amortizable intangible assets, net – O Goodwill – O Other indefinite-lived intangible assets – O Investments in noncontrolled affiliates – O Deferred income taxes – ?

Other assets – ?

Short-term debt obligations – F Accounts payable and other current liabilities – ?

Long-term debt obligations – F Deferred income taxes – ?

Other liabilities – ?

Common stock – CSE Capital in excess of par value – CSE Retained earnings – CSE Accumulated other comprehensive loss – CSE Repurchased common stock, in excess of par – CSE Noncontrolling interests – F

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-9

16.

Below is a recent Income Statement for Under Armour (UA). For each item listed, determine the classification that would be used in reformulation from the following list: • • • •

O – Operating activities F – Financial activities S – Split between operating and financial activities ? – Desire more detailed information but will initially classify as related to operating activities

Net revenues – O Cost of goods sold – O Selling, general and administrative expenses – O Restructuring and impairment charges – O Interest expense, net – F Other expense, net – ?

Income tax expense (benefit) – S Foreign currency translation adjustment – O Unrealized gain (loss) on cash flow hedge, net of tax benefit – O Loss on intra-entity foreign currency transactions – O © Cambridge Business Publishers, 2021 3-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

17.

Below is a recent Income Statement for Netflix (NFLX). For each item listed, determine the classification that would be used in reformulation from the following list: • • • •

O – Operating activities F – Financial activities S – Split between operating and financial activities ? – Desire more detailed information but will initially classify as related to operating activities

Revenues – O Marketing – O Technology and development – O General and administrative – O Interest expense – F Interest and other income (expenses) – ?

Provision for (benefit from) income taxes – S Foreign currency translation adjustments – O © Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-11

Change in unrealized gains (losses) on available-for-sale securities, net of tax – F

© Cambridge Business Publishers, 2021 3-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

18.

Below is a recent Income Statement for PepsiCo (PEP). For each item listed, determine the classification that would be used in reformulation from the following list: • • • •

O – Operating activities F – Financial activities S – Split between operating and financial activities ? – Desire more detailed information but will initially classify as related to operating activities

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-13

Net revenue – O Cost of sales – O Selling, general and administrative expenses – O Other pension and retiree medical benefits (expenses)/income – O Interest expense – F Interest income and other – ?

Provision for/(benefit from) income taxes – S Net income attributable to noncontrolling interests – F Net currency translation adjustment – O Net change on cash flow hedges – O Net pension and retiree medical adjustments – O Net change on available-for-sale securities – F Other – ?

19.

The following is the Eaton Corp’s 2020 income statement (in thousands). Based on the reformulations presented in the course, calculate net operating income after tax (NOPAT). Assume Eaton has a marginal tax rate of 21 percent.

Revenue

100,000

Cost of goods sold

(50,000)

SG&A expenses

(20,000)

R&D expenses

(5,000)

Restructuring charges

(3,000)

Realized gains on marketable securities

1,000

Interest income

500

Interest expense

(4,000)

Income tax expense

(7,000)

Net Income

12,500

Continued

© Cambridge Business Publishers, 2021 3-14

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

Top Down Approach: Revenue

100,000

Cost of goods sold

(50,000)

SG&A expenses

(20,000)

R&D expenses

(5,000)

Restructuring

(3,000)

Operating Income before taxes

22,000

Tax Expense: Tax Reported Tax benefit on FEAT

(7,000) (525)

Net operating income after tax (NOPAT)

(7,525) 14,475

Financial expense after tax (FEAT): Realized gains on Mkt Sec

1,000

Interest income

500

Interest expense

(4,000)

Net financial expense

(2,500)

Tax benefit at 21%

(525)

Net Income

(1,975) 12,500

Bottom up approach: Net Income

12,500

Financial expense after tax (FEAT): Realized gains on Mkt Sec

1,000

Interest income

500

Interest expense

(4,000)

Net financial expense

(2,500)

Tax benefit at 21%

(525)

Net operating income after tax (NOPAT)

(1,975) 14,475

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-15

20.

For the year ended December 31, 2019, Amazon reported revenues of $160,408 million resulting in income before taxes of $13,962 million and net income of $11,588 million. A reformulation results in net operating income before tax of $14,507 million and financial expense before tax of $545 million. Amazon’s marginal tax rate for 2019 was 21.0 percent.

What is Amazon’s 2019 net operating profit after tax (NOPAT) and financial expense after tax (FEAT)?

The Income tax expense of $2,374 million ($13,962 million – $11,588 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

$545 million

Statutory tax rate

21.0%

Tax shield from financial activities

$114 million

Financial expense after tax (FEAT)

$431 million ($545 million - $114 million)

Income tax expense on operating activities: Net operating income before tax

$14,507 million

Reported Income tax expense

$2,374 million

+ Tax shield from financial activities

141 million

Income tax expense on operating activities

$2,488 million

Net operating income after tax (NOPAT)

$12,019 million ($14,507 million - $2,488 million)

© Cambridge Business Publishers, 2021 3-16

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

21.

Lowe’s Companies reported the following income statement for fiscal year 2019, 2018 and 2017,

For fiscal year 2019, calculate Lowe’s income tax provision between operating and financing activities. Lowe’s reported that its statutory tax rate is 21.0 percent.

The income tax provision of $1,342 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 includes only the Interest – net of $691.

Financial expense before tax

$691 million

Statutory tax rate

21.0%

Income tax expense on financial activities

$19 million

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

$1,342 million 19 million $1,361 million

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-17

22.

Calculate Union Pacific’s income tax expense allocation between operating and financial activities for 2019. Union Pacific reported its statutory tax rate was 21.0 percent. Assume that Other income (Note 7) is a financial item.

Income tax expense is allocated to financial activities initially with the remainder going to operating activities.

1.

Determine pre-tax financial expense/income (FEBT): $1,050 – 243 = $807

2.

Calculate the tax shield on financial activities by multiply FEBT by the marginal tax rate of 21.0%: $807 x .210 = $169

3.

Add the tax shield to income tax expense resulting in taxes on operating activities: $1,828 + 169 = $1,997

© Cambridge Business Publishers, 2021 3-18

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

CONTINUING EXAMPLES 23.

Below is a recent balance sheet for FedEx (FDX), reformulate the balance sheet to calculate NOA and NFL for fiscal year 2019. Note, FDX’s fiscal year 2019 revenues were $69,693 million.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-19

(Amounts in millions)

2019

Cash and cash equivalents Receivables. Less allowances Spare parts, suppliers and fuel, less allowances Prepaid expenses and other Aircraft and related equipment Package handling and ground support equipment Information technology Vehicles and trailers Facilities and other, net Accumulated depreciation and amortization Goodwill Other assets Accrued salaries and employee benefits Accounts payable Accrued expenses Deferred income taxes Pension, postretirement healthcare and other benefit obligations Self-insurance accruals Deferred gains, principally related to aircraft transactions

1,394 9,116 553 1,098 22,793 10,409 6,268 8,339 11,702 (29,082) 6,884 4,004 (1,741) (3,030) (3,278) (2,821) (5,095) (1,899) (99)

Other liabilities

(571)

NOA

34,944

(Amounts in millions)

2019

Cash and cash equivalents Current portion of long-term debt Long-term debt, less current portion Deferred lease obligations

925 (964) (16,617) (531)

NFL

(17,187)

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

© Cambridge Business Publishers, 2021 3-20

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

24.

Below are a recent income statement and statement of comprehensive income for FedEx (FDX), reformulate the income statement to calculate NOPAT and FEAT for fiscal year 2019. Assume FDX’s marginal tax rate is 21.0%.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-21

(Amounts in millions)

2019

Revenues Salaries and employee benefits Purchased transportation Rental and landing fees Depreciation and amortization Fuel Maintenance and repairs Business realignment costs Goodwill and other asset impairment charges Other Foreign currency translation adjustments, net of tax benefit

69,693 (24,776) (16,654) (3,360) (3,353) (3,889) (2,834) (320) 0 (10,041) (195)

Provision for income taxes (split)

(915)

NOPAT

3,356

(Amounts in millions)

2019

Interest expense Interest income Other retirement plans (expense) income Other, net Amortization of prior service cost Provision for income taxes (split)

(588) 59 (3,251) (31) (92) 800

FEAT

(3,103)

© Cambridge Business Publishers, 2021 3-22

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

25.

Below is a recent balance sheet for United Parcel Service (UPS), reformulate the balance sheet to calculate NOA and NFL for fiscal year 2019. Note, UPS’s fiscal year 2019 revenues were $74,094 million.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-23

(Amounts in millions)

2019

Cash and cash equivalents (2 percent of revenues) Accounts receivable, net Current income tax receivable Other current assets Property, plant and equipment, net Operating lease right-of-use asset Goodwill Intangible assets, net Deferred income tax assets Other non-current assets Accounts payable Accrued wages and withholdings Self-insurance reserves, current Accrued group welfare and retirement plan contributions Other current liabilities Pension and postretirement benefit obligations Deferred income tax liabilities Self-insurance reserves, non-current

1,482 9,552 382 1,428 30,482 2,856 3,813 2,167 330 1,082 (5,555) (2,552) (914) (793) (1,641) (10,604) (1,632) (1,282)

Other noncurrent liabilities

(1,437)

NOA

27,167

(Amounts in millions)

2019 3,756 503

Cash and cash equivalents Marketable securities Investments and restricted cash Current maturities of long-term debt and commercial paper Current maturities of operating leases

24 (3,420) (538)

Long-term debt and finance leases

(21,818)

Non-current operating leases

(2,391)

Noncontrolling interests NFL

(16) (23,900)

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

© Cambridge Business Publishers, 2021 3-24

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter-3 Reformulation to Identify Operating Activities

26.

Below are a recent income statement and statement of comprehensive income for United Parcel Service (UPS), reformulate the income statement to calculate NOPAT and FEAT for fiscal year 2019. Assume UPS’s marginal tax rate is 21.0%.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 3

3-25

(Amounts in millions)

2019

Revenue Compensation and benefits Repairs and maintenance Depreciation and amortization Purchased transportation Fuel Other occupancy Other expenses

74,094 (38,908) (1,838) (2,360) (12,590) (3,289) (1,392) (5,919) 48

Change in foreign currency translation adj., net of tax Income tax expense (split) NOPAT

(1,663)

(Amounts in millions)

2019

Investment income (expense) and other Interest expense Change in unrealized gain(loss) on marketable securities, net of taxes Change in unrealized gain(loss) on cash flow hedges, net of taxes Change in unrecognized pension and postretirement benefit costs, net of tax

(1,493)

Income tax expense (split) FEAT

6,183

(653) 6 72 (1,129) 211 (2,746)

© Cambridge Business Publishers, 2021 3-26

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

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

Explain the benefit of including additional information beyond the financial statements in a reformulation.

The primary benefit for gathering additional information is to better delineate the identification of operating and financial activities. That information will be used to improve financial analysis and, ultimately, forecasting. By improving the quality of information gathered with respect to operating and financial activities, which improves our expectations of future payoffs, the result is a change in our estimate of value.

2.

Identify the two primary sources for additional information beyond the financial statements in a reformulation.

The primary sources for additional information are (1) the footnotes to the financial statements and (2) the management discussion and analysis (MD&A).

3.

What is the role of an implied asset/liability?

Detailed information about an account (e.g., deferred income taxes) may not fully reconcile with the amount recognized on the financial statements. To ensure that the reported balance is maintained when additional information is included, an implied asset or liability is created. Thus, the implied asset/liability maintains the integrity of the financial statement balance.

4.

Assume that during an analysis of Other Assets, an account named Income tax receivable is identified. Explain whether the account should be classified as operating, financial or split.

It is not possible to identify the differences between financial accounting for taxes from the taxes paid or refunded, thus the receivable is classified as an operating activity and included in net operating assets (NOA).

5.

What tax rate (historical, current or future) is used when allocating income tax expense between operating and financial activities? Explain.

When allocating income taxes, use the marginal tax rate for the current year. The purpose for the income tax expense allocation is to split the expense for that year between operating and financial activities. Thus, the marginal for the specific year is the appropriate tax rate for the allocation. © Cambridge Business Publishers, 2021

Test Bank, Chapter 4

4-1

6.

Explain why pension assets and liabilities are classified as a financial item when reformulating the balance sheet.

Pension plans represent deferred compensation. Rather than pay employees in the current period, some companies elect to defer employee compensation into the future. This deferral is a financial decision, not an operating decision. Accordingly, the pension assets and liabilities are classified as financial activities.

7.

Explain why when considering net periodic pension cost, the service cost is classified as an operating item and the other items (e.g., interest cost, return on plan assets) are classified as a financial item in a reformulated income statement.

The service cost represents the present value of the projected pension benefits earned by plan participants during the year. As this is a function of the plan participants’ employment during this year, this cost is classified as an operating activity. The other items in net periodic pension cost are associated with the pension assets (e.g., return on plan assets) and the pension liability (e.g., interest cost, amortization of actuarial gains/losses, amortization of prior service cost). The pension assets and liabilities are financial items as they represent deferred employee compensation.

8.

When digging deeper into the footnotes supporting the financial statements, the detailed footnote information may not tie to the same amount on the financial statements (e.g., deferred tax accounts). How does the analyst reconcile these differences in the reformulated financial statements?

There are multiple reasons as to why the footnote information does not always tie into the same amount as the main financial statements.

In the case of Deferred Tax accounts, this could be because US GAAP allows for deferred tax assets and liabilities to be netted and combined with other accounts. Thus, when reviewing the Deferred Tax footnotes, there may be an implied additional liability/asset built into other line items of the Balance Sheet. Thus, an analyst should include the "implied additional liability/asset" when summing their reformulation to confirm the final numbers still equals the numbers presented on the original balance sheet.

Another example of this is Net Earnings and Comprehensive Income attributable to NonControlling Interests. Due to how the Income Statement and the Statement of Comprehensive Income are formulated separate of each other, there is often Other Comprehensive Income Attributable to Non-controlling Interests that are built into other line items.

Ultimately, when there are differences between footnote information and the main financial statements, it is usually due to netting and multiple sets of data being built into other line items. An analyst should be aware of this, and look to always find what other comprehensive income, implied liabilities/assets, and such need to be accounted for, and always confirm that these newly created items sum the footnotes to the reported financial statements.

© Cambridge Business Publishers, 2021 4-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

EXERCISES 9.

Starbucks Corporation’s (SBUX) fiscal year 2019 balance sheet reports a liability, “Accrued Liabilities” in the amount of $1,753.7 million. Based on the footnote below which elements would be used in calculating NOA and in calculating NFL?

Accrued occupancy costs – NOA Accrued dividends payable – NFL Accrued capital and other operating expenditures – NOA Self insurance reserves – NOA Accrued business taxes – NOA

10.

Autozone, Inc.’s (AZO) fiscal year 2019 balance sheet reports a liability, “Accrued Expenses and Other” in the amount of $621,932 thousand. Based on the footnote below which elements are classified as part of NOA and NFL?

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-3

Accrued compensation, related payroll taxes and benefits – NOA Property, sales and other taxes – NOA Medical and casualty insurance claims – NOA Capital lease obligation – NFL Accrued interest – NFL Accrued gift cards – NOA Accrued sales and warranty returns – NOA Other – NOA

11.

Microsoft Corporation’s (MSFT) fiscal year 2019 income statement reported “Other income, net” of $729 million. Based on the footnote below which elements are classified as part of NOPAT and FEAT.

Interest and dividends income – FEAT Interest expense – FEAT Net recognized gains on investments – FEAT Net gains (losses) on derivatives – NOPAT Net losses on foreign currency remeasurements – FEAT Other, net – NOPAT

© Cambridge Business Publishers, 2021 4-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

12.

Microsoft Corporation’s (MSFT) 2019 income statement reported “Provision for income taxes” of $4,448 million. Based on the footnote below, explain what the appropriate tax rate is for allocating income taxes between operating and financial activities in each of these years.

Use the federal statutory rate (i.e., marginal tax rate) of each of the years when allocating income taxes between operating and financial activities. Since the actual tax rate for each item is not available, the income tax allocation effectively determines the taxes for an unlevered firm. The marginal tax rate yields the best estimate of the tax burden for the firm’s operating activities.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-5

13.

On its fiscal year 2019 balance sheet, Autozone, Inc. (AZO) reported “Deferred tax assets” of $26,861 thousand and “Deferred tax liabilities” of $311,980 thousand. Autozone’s Income Tax footnote provides additional information about the components within the deferred tax accounts.

Given this additional information, which components are classified as part of NOA or NFL? Is there an additional asset or liability implied by this disclosure that was not readily apparent from the information on the face of the financial statements?

Net operating loss and credit forwards – NOA Accrued benefits – NOA Other – NOA Valuation allowance – NOA Property and equipment – NOA Inventory – NOA Prepaid expenses – NOA Other – NOA

Net deferred tax liabilities per footnote = $(285,119) million Net deferred tax liabilities per balance sheet = $(285,119) million ($26,861– 311,980 million)

No implied asset or liability is needed.

© Cambridge Business Publishers, 2021 4-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

14.

Whirlpool Corporation (WHR) provides pension and other postretirement benefits to certain employees. In the footnotes to its 2019 annual report, WHR reports the funding status of its pension and other postretirement plans along with the related financial statement accounts.

For 2019, identify the expanded balance sheet components associated with WHR’s pension and other postretirement benefits.

US pension benefits: Plan assets - $2,934 million International pension benefits: Plan assets - $593 million

US pension benefits: Benefit obligations- $(3,141) million International pension benefits: Benefit obligations - $(348) million Other postretirement benefits: Benefit obligations - $(355) million

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-7

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors. This will facilitate the application of the valuation steps to similar real-life firms.

15.

FedEx (FDX) reported Goodwill $6,884 million and Other Assets $4,004 million on its May 31, 2019 balance sheet. Using the footnote information below, prepare the expanded balance sheet for Goodwill and Other Assets. Indicate whether the component is an Operating or a Financial activity.

continued

© Cambridge Business Publishers, 2021 4-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

Goodwill (in millions): FedEx Express FedEx Ground FedEx Freight FedEx Services Corporate, Other and Eliminations

$5,016 840 634 348 46

Operating Operating Operating Operating Operating

$6,884 Other intangible assets (in millions): Customer relationships Customer relationships – Accumulated amortization Technology Technology – Accumulated amortization Trademarks and other Trademarks and other – Accumulated amortization

$685 (293) 66 (51) 137 (128)

Operating Operating Operating Operating Operating Operating

$3,278 16.

The FedEx (FDX) May 31, 2019 balance sheet, FDX reported Accrued salaries and employees benefits of $1,741 million and Accrued expenses of $3,030 million. Using the footnote information below, prepare the expanded balance sheet for the two accounts. Indicate whether each component relates to an Operating or a Financial activity.

Accrued salaries and employee benefits (in millions): Salaries Employee benefits Compensated absences

$ (425) (552) (764)

Operating Operating Operating

$(1,741) Accrued expenses (in millions): Self-insurance accruals Taxes other than income taxes Other

$(1,104) (304) (1,870)

Operating Operating Operating

$(3,278) © Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-9

© Cambridge Business Publishers, 2021 4-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

17.

The FedEx (FDX) May 31, 2019 balance sheet, FDX reported Noncurrent deferred tax assets of $1,340 million reported in Other assets and Noncurrent deferred tax liabilities of $2,821 million.

Using the footnote information below, prepare the expanded balance sheet for the two accounts.

Indicate whether each component relates to an Operating or a Financial activity.

Deferred tax assets (in millions): Property, equipment, leases and intangibles Employee benefits Self-insurance accruals Other Net operating loss/credit carryforwards Valuation allowances

$592 1,256 585 510 1,139 (590)

Operating Operating Operating Operating Operating Operating

$3,492 Deferred tax liabilities (in millions): Property, equipment, leases and intangibles Other

$(4,633) (340) (4,973)

Operating Operating

$(1,481) As reported (in millions): Noncurrent deferred tax assets

1,340

Noncurrent deferred tax liabilities

(2,821) $(1,481)

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-11

18.

The FedEx (FDX) May 31, 2019 balance sheet, FDX reported its Pension, postretirement healthcare and other benefit assets and obligations in various accounts on the balance sheet. Using the footnote information below, prepare the expanded balance sheet for (1) the Pension assets and (2) the Benefit obligation. Indicate whether each component relates to an Operating or a Financial activity.

Plan assets (in millions): US Pension Plans International Pension Plans Postretirement Healthcare Plans

Benefit obligation (in millions): US Pension Plans International Pension Plans Postretirement Healthcare Plans

$23,320 1,578 $24,898

Financial Financial

$(26,554) (2,301) (1,221) $(30,076)

Financial Financial Financial

© Cambridge Business Publishers, 2021 4-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

19.

The FedEx (FDX) May 31, 2019 income statement, FDX reported Revenues of $69,693 million.

Using the footnote information below, prepare the reformulated expanded income statement for Revenues. Indicate whether each component relates to an Operating or a Financial activity.

Revenues (in millions): FedEx Express package – US overnight box FedEx Express package – US overnight envelope FedEx Express package – US deferred FedEx Express package – International priority FedEx Express package – International economy FedEx Express package – International domestic FedEx Express freight – US FedEx Express freight – International priority FedEx Express freight – International economy FedEx Express freight – International airfreight FedEx Express other FedEx Ground FedEx Freight FedEx Services Eliminations, corporate and other

$7,663 1,829 4,225 7,405 3,446 4,540 3,025 2,070 2,123 314 691 20,522 7,582 1,691 2,567 $69,693

Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-13

© Cambridge Business Publishers, 2021 4-14

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

20.

From FedEx’s (FDX) fiscal year 2019 pension footnote below, indicate which components of the net benefits cost for pensions, postretirement and postemployment benefits are related to an Operating or a Financing activity.

Service cost – Operating Interest cost – Financing Expected return on plan assets – Financing Amortization of prior service credit – Financing Actuarial losses (gains) and other – Financing 21.

As of December 31, 2019, United Parcel Service (UPS) reported Property, Plant and Equipment, net of $30,482 million. Using the footnote information below, prepare the 2019 expanded balance sheet for Property, Plant and Equipment, net. Indicate whether each component relates to an Operating or a Financial activity.

continued

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-15

Property, Plant and Equipment, net (in millions): Vehicles Aircraft Land Building Building and leasehold improvements Plant equipment Technology equipment Construction-in-progress Less: Accumulated depreciation and amortization

22.

$10,613 19,045 2,087 5,046 4,898 13,486 2,206 1,983 59,727 (29,245) $30,482

Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating

United Parcel Service (UPS) reported Goodwill $3,813 million and Intangible Assets, net of $2,167 million on its December 31, 2019 balance sheet. Using the footnote information below, prepare the expanded balance sheet for Goodwill and intangible Assets, net. Indicate whether each component relates to an Operating or a Financial activity.

Goodwill (in millions): US domestic package International package Supply chain & freight

$715 Operating 416 Operating 2,682 Operating $3,813 continued

© Cambridge Business Publishers, 2021 4-16

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

Intangible assets (in millions) Capitalized software Capitalized software, Acc amortization Licenses Licenses, Acc amortization Franchise rights Franchise rights, Acc amortization Customer relationships Customer relationships, Acc amortization Trade name Trademarks, patents and other Trademarks, patents and other, Acc amortization

23.

$4,125 (2,704) 117 (64) 146 (109) 730 (282) 200 29 (21) $2,167

Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating Operating

The United Parcel Services (UPS) December 31, 2019 balance sheet, UPS reported Deferred tax assets of $330 million and Deferred tax liabilities of $1,632 million. Using the footnote information below, prepare the expanded balance sheet for the two accounts. Indicate whether each component relates to an Operating or a Financial activity.

continued

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-17

Deferred tax liabilities (in millions): Fixed assets and capitalized software Operating lease right-of-use assets Other

Intangible assets (in millions) Pension and postretirement benefits Loss and credit carryforwards Insurance reserves Stock compensation Accrued employee compensation Operating lease liabilities Other Valuation allowance

24.

$(4,720) Operating (685) Operating (538) Operating $(5,943)

$2,522 328 413 249 287 691 205 (54) 4,641 $(1,302)

Financial Operating Financial Financial Operating Operating Operating Operating

The United Parcel Service (UPS) pension and postretirement benefits footnote provides additional information about the amounts reported on its December 31, 2019 balance sheet. For the 2019 reformulated expanded balance sheet identify the related pension and postretirement (1) plan asset and (2) benefit obligation. Indicate whether each component relates to an Operating or a Financial activity.

US pension benefits: Plan assets US postretirement medical benefits: plan assets International pension benefits: Plan assets US pension benefits: Benefit obligation US postretirement medical benefits: Benefit obligation International pension benefits: Benefit obligation

$46,172 37 1,558 (54,039) (2,616) (348)

Financial Financial Financial Financial Financial Financial

© Cambridge Business Publishers, 2021 4-18

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 4 - Use of Additional Information to Enhance Reformulation

25.

The United Parcel Service (UPS) 2019 income statement shows Revenues of $74,094 million. Using the footnote information below, prepare the reformulated expanded income statement for Revenues. Indicate whether each component relates to an Operating or a Financial activity.

Revenue: (in millions) US domestic package: Next day air

$8,479 Operating

US domestic package: Deferred

5,180 Operating

US domestic package: Ground

32,834 Operating

International package: Domestic

2,836 Operating

International package: Export

10,837 Operating

International package: Cargo & other

547 Operating

Supply chain and freight: Forwarding

5,867 Operating

Supply chain and freight: Logistics

3,435 Operating

Supply chain and freight: Freight

3,265 Operating

Supply chain and freight: Other

814 Operating $74,094

© Cambridge Business Publishers, 2021 Test Bank, Chapter 4

4-19

26.

From United Parcel Service’s (UPS) 2019 pension footnote below, indicate which components of the net benefits cost for pensions, postretirement and postemployment benefits are an Operating or a Financing activity.

Service cost – Operating Interest cost – Financing Expected return on plan assets – Financing Amortization of prior service credit – Financing Actuarial (gains) loss – Financing

© Cambridge Business Publishers, 2021 4-20

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

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

Chapter 5 Adjusting Accounting Information QUESTIONS 1.

Explain whether a firm’s accounting method choice impacts its valuation.

Most accounting method choices result in shifting reported income across periods. That is, the total income recognized does not change, rather the period in which the revenues/expenses are recognized. Consequently, most accounting method choices do not impact valuation. Accounting method choices that impact the timing of cash flows particularly for taxes (e.g., LIFO/FIFO) can impact a firm’s valuation.

2.

Explain whether a firm’s accounting method choices impacts forecasting.

Shifting the period in which revenues/expenses are recognized through accounting method choices can impact forecasting. If forecasts are based on past accounting data, income shifting impacts past sales growth, NOPAT, NOA and related components.

3.

How does the inventory accounting choice (LIFO / FIFO) impact a firm’s valuation?

With the LIFO conformity rule, where LIFO is used for tax purposes it must also be used for financial reporting purposes. This can result in different cash flows than with FIFO accounting. By changing the timing of cash flows, the firm’s valuation is impacted. By deferring tax payments via LIFO accounting, the firm’s valuation is increased.

4.

What is the process to adjust a firm’s LIFO inventory balance to FIFO accounting?

US publicly traded companies that report their inventory on a LIFO bases must disclose the LIFO adjustment to FIFO (i.e., LIFO Reserve). With the LIFO adjustment, the LIFO inventory and related Cost of goods sold can be converted to “as-if” FIFO basis.

To update the LIFO inventory to “as-if” FIFO just add the LIFO reserve to the LIFO inventory balance. To capture the tax impact, the taxes payable would increase by the LIFO reserve multiplied by the current marginal tax rate. The balance is an adjustment to equity (i.e., Retained earnings).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-1

5.

What is the primary change between the old and the new lease accounting rules? What are the implications with respect to reformulating the financial statements?

The capital lease method rules are effectively the same. The operating lease method went from no balance sheet recognition to creating a right-of-use asset and a financial lease liability based on the discounted lease payments. The operating lease payments remain as rent (lease) expense.

To provide comparability across time for firms reporting leases under both the old and current lease accounting rules, the financial statements under the old rules need to include a constructive capitalization of its operating leases. Constructive capitalization is a process that captures the impact on the financial statements as if the operating leases were accounted for as capital leases.

6.

Identify the three approaches to determining the appropriate discount rate when conducting an operating lease adjustment (i.e., constructive capitalization).

To determine the appropriate discount rate for an operating lease constructive capitalization, the analyst can (1) infer the discount rate associated the capital leases, (2) use the rate that corresponds to the company’s credit rating or (3) use the weighted-average interest rate for the firm’s debt. Whatever rate is used, the analyst must ensure that the rate is reasonable.

7.

Explain whether an operating lease adjustment (i.e., constructive capitalization) should increase or decrease NOA and NOPAT. The balance sheet adjustments to the operating leases will increase NOA as the lease asset is an operating item and the lease liability is a financial item. Thus, the leased asset recognized will increase NOA. For the income statement, a portion of the rent (lease) expense will be reclassified as interest expense (a financial item), resulting in an increase in NOPAT.

8.

What are the two main implications when analyzing firms that utilize special-purpose entities (SPE)?

While a special-purpose entity (SPE) does not directly impact NOPAT or NOA directly, SPEs can affect (1) a firm’s cost of debt capital and (2) the liquidity of the company. A firm may be able to reduce its borrowing cost through a SPE that is bankruptcy remote. Also, by being able to package loans for sale through a SPE, a firm can improve its liquidity.

9.

Explain how the accounting of stock options and equity-classified share units creates a potential unrecognized wealth transfer from current shareholders to exercising option/unit holders.

Under GAAP, the value of the stock option and equity-classified share unit is recognized at the time of grant. The related compensation expense is recognized over the vesting period. Subsequent changes in the value of the stock options and equity-classified share units are not captured by GAAP. That is, as the firm’s share price increases the additional transfer of wealth from current shareholders is not reflected in the financial statements. This creates the potential for significant wealth transfers from current shareholders to exercising option/unit holders.

© Cambridge Business Publishers, 2021 5-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

10.

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

What is meant by the phrase “stock option overhang?”

The stock option overhang is the unrecognized value of the outstanding stock options not captured

by GAAP. The stock-based compensation (SBC) adjustment for options provides an estimate of the stock option overhang by multiplying the number of options by the options’ intrinsic value (i.e., the difference between the end-of-period share price and the weighted-average exercise price).

Beginning in 2019, companies must disclose the aggregate intrinsic value of stock options (and share units).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-3

EXERCISES 11.

The following data was obtained from the 2018 Form 10-K of Horngren Corp.

Stock Based Compensation: Options Outstanding, December 31, 2017

20,000,000

Weighted average exercise price, Dec. 31, 2017 Options Outstanding, December 31, 2018

$40 21,000,000

Weighted average exercise price, Dec. 31, 2018

$50

Market closing price, December 31, 2017

$50

Market closing price, December 31, 2018

$60

Average market price - 2018

$55

All option outstanding are exercisable.

Horngren reported that its marginal tax rate is 20% and the tax benefit of options exercised in 2018 was $12 million. a.

Explain whether the adjustment for stock-based compensation (SBC) is an operating or a financial item.

Stock-based compensation (SBC) represents a deferral of compensation expense to future periods. Accordingly, SBC is a financial item.

b.

Calculate the stock option overhang for December 31, 2017 and 2018.

Stock option overhang for December 31, 2017 ($50 - $40) x 20 million options outstanding = $200 million Stock option overhang for December 31, 2018 ($60 - $50) x 21 million options outstanding = $210 million

© Cambridge Business Publishers, 2021 5-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

c.

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

What is the income statement impact (NOPAT or FEAT) for the 2018 adjustment for stockbased compensation (SBC).

The income statement impact will result from two unreported effects: 1. The tax benefit of $12 million suggests that the options exercised in 2018 were $60 inthe-money ($12 million  0.20 marginal tax rate). This results in $60 million in additional deferred compensation expense that was reported for tax, but not in the financial statements.

2. The increase in stock option overhang is $8 million (($210 - $200) x (1 - 0.20) represents an additional (unreported) deferred compensation expense. (Note, there is also an increase in deferred tax assets (DTA) for $2 million).

The additional (unreported) deferred compensation expense for 2018 is $68 million ($60 million + $8 million).

d.

Calculate the (unreported) impact on common stock equity (CSE) related to the 2018 adjustment for stock-based compensation.

The beginning balance for the (unreported) stock option overhang requires an adjustment to increase NFL for $200 million, increase in deferred tax asset (DTA) of $40 million ($200 million x 0.20) and prior period adjustment decreasing CSE for $160 million.

During 2018, FEAT increased by $68 million (see 11c above) resulting in a total decrease in CSE of $228 million.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-5

12.

Harley Davidson (HDI), a motorcycle manufacturer and retailer, reported in its 2019 Form 10-K that the company transfers its retail motorcycle receivables to special purpose entities (SPEs). The SPEs convert the receivables to cash through the issuance of debt backed by the expected cash flows from the receivables (i.e., asset-back financing).

During 2019, HDI disclosed the following in its footnotes to the financial statements:

Additionally, during 2019, HDI issued $1.1 billion in medium-term unsecured debt with a weighted average interest rate of 3.55%.

How does the usage of the SPE for asset-backed financing benefit HDI and what are the impacts on its NOA and NOPAT? The SPEs do not impact HDI’s NOA or NOPAT. Rather the SPEs allow the company to improve its liquidity and lower its effective borrowing rate. The SPEs raise cash for HDI through the issuance of debt backed by the receivables’ cash flows. Instead of holding the receivables until maturity, HDI has immediate access to cash from the receivables. Additionally, the effective cost of borrowing by the SPEs, the weighted average of the two outstanding balances of 2.70%, is lower than HDI’s unsecured borrowing rate of 3.55%. For $1 billion in borrowings, HDI pays $8.5 million less in interest.

© Cambridge Business Publishers, 2021 5-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

13.

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

Sturm, Ruger & Company (RGR), a firearms manufacturer, reports its inventory on the LIFO method. Using the information below from RGR’s footnote, what adjustments are needed to convert RGR’s 2019 NOA and NOPAT from LIFO to “as-if” FIFO. Assume the statutory tax rate is 21%.

The relevant data required to convert LIFO to “as-if” FIFO are the LIFO Reserve and change in LIFO Reserve, which is $47,137 and $796 ($47,137 – $46,341), respectfully.

The change in the LIFO Reserve represents the current year impact of differences between LIFO and FIFO. Since RGR started using of LIFO accounting, the company has reported an additional $47,137 in cost of goods sold resulting in a deferral of income tax payable of $9,899 ($47,137 x 21.0%). In adjusting to “as-if” FIFO, the additional inventory and taxes payable need to be recognized.

The change in the LIFO Reserve, $796, suggests that costs of goods sold in 2019 would have lower with “as-if” FIFO. Correspondingly, the resulting higher 2019 tax expense for the lower cost of goods sold is $167 ($796 x 21.0%). Lastly, the adjustment for the prior year cost of goods sold is reflected in the retained earnings, net of taxes or $36,609.

In journal entry format, the adjustments are: Dr Inventory (NOA)

Cr

$47,137

Taxes payable (NOA)

$9,899

Cost of goods sold (NOPAT) Tax expense (NOPAT)

796 167

Retained earnings

36,609 $47,304

$47,304

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-7

14.

Rite Aid Corporation (RAD), a national retail drug store chain, uses LIFO costing for its inventory. In its 2019 Form 10-K’s Management Discussion and Analysis (MD&A) section, Rite Aid reported its gross margin percentages for fiscal year (FY) 2018, 2019 and 2020. See the table below.

In its footnotes to the financial statements, Rite Aid disclosed its LIFO Reserves (in thousands) for FY 2017 - 2020 as: FY 2017 FY 2018 FY 2019 FY 2020 a.

$609,917 581,090 604,444 539,640

Calculate the gross margin percentages for FY 2018 - 2020 using “as if” inventory adjustment from LIFO to FIFO. To convert from Cost of goods sold on a LIFO basis to Cost of goods sold on a FIFO basis, the change in LIFO Reserve is added to existing Cost of goods sold resulting in: LIFO Reserve Change FY 2017 609,917 FY 2018 581,090 (28,827) FY 2019 604,444 23,354 FY 2020 539,640 (64,804)

Revenues Cost of revenues Gross profit Gross margin percentage "as-if" Gross profit "as-if" Gross margin b.

FY 2020 15,616,186 11,341,350 4,274,836 27.4%

FY 2019 15,757,152 11,498,436 4,258,716 27.0%

FY 2018 15,832,625 11,460,252 4,372,373 27.6%

4,210,032 27.0%

4,282,070 27.2%

4,343,546 27.4%

What are the implications from the adjustment with respect to the gross margin percentage trend analysis?

Instead of showing an erratic or slightly declining gross margin percentage from FY 2018 through FY 2020, the inventory adjustment reveals a continual decline in the gross margin percentage.

Consequently, the forecasts of future gross margin percentages will likely be improved.

Note: When using FIFO inventory costing, the most recent purchases are expensed resulting in better matching than with LIFO. This exercise demonstrates the importance of performing the LIFO adjustment when analyzing historical financial performance.

© Cambridge Business Publishers, 2021 5-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

15.

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

In its fiscal year 2018 Form 10-K, lululemon athletica (LULU) reported its future minimum operating lease payments. a.

Estimate the unrecognized operating lease asset and liability as of February 3, 2019 assuming a 4.0 percent discount rate. For payments labeled “Thereafter,” assume these payments will be paid out at the same amount per year as the expected payment in 2023.

The future expected minimum cash flows discounted at 4.0 percent (half year convention) is $699,189 thousand. This represents the estimated lease asset and lease liability.

Payment

Discount Present Value

FY 2019

$169,822

1.020

$166,524

FY 2020

147,541

1.061

139,111

FY 2021

123,032

1.103

111,541

FY 2022

99,471

1.147

86,712

FY 2023

73,213

1.193

61,367

FY 2024

73,213

1.241

59,007

FY 2025

73,213

1.290

56,738

FY 2026

24,408

1.342

18,188 $699,189

b.

The new lease accounting standard was adopted in FY 2019 by LULU. The company reported net lease expense of $176,367 thousand for its operating leases along with a lease liability of $739,961 thousand based on a weighted-average discount rate of 3.57%.

For the FY 2019, reclassify the net lease expense between interest expense and amortization expense.

The interest expense reclassification is based on the average lease liability, $719,575 thousand ($739,961 - $699,189) multiplied by the FY 2019 discount rate, 3.57% or $25,689 thousand. The estimated amortization expense is assumed to be equal to the principal payment $150,678 thousand ($176,367 - $25,689).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-9

16.

Starbucks (SBUX) provided its minimum future rental payment for its operating leases as of September 29, 2019 as follows:

Additionally, Starbucks report its long-term debt as follows:

© Cambridge Business Publishers, 2021 5-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

a.

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

In determining the appropriate discount rate for constructive capitalization of the operating lease payments, a proxy can be built based on the firm’s long-term borrowings. From the above list of debt instruments, which notes should be included or excluded in building the cost of debt capital proxy for constructive capitalization of the future minimum operating lease payments.

Included: Based on duration, all US dollar-dominated notes dated 2020 through 2029. Based on the operating lease payments, the lease terms range from fiscal years (FY) 2020 - 2028.

The inclusion of the 2029 notes, which was issued in FY 2019 provides an indication of current borrowing rates.

Excluded: The notes maturating in 2047 - 2049 reflect the borrowing cost for a longer duration than the current operating lease terms. Additionally, the March 2024 yendominated notes are subject to foreign currency exchange risk along with the associated borrowing risk.

b.

Based on your answer in 16a above, calculate the cost of debt capital proxy for discounting the future minimum operating lease payments.

(in millions, expect interest rates) Fair Value

Effective Rate Weighted Avg.

Nov 2020 notes

500

2.228%

0.147%

Feb 2021 notes

500

2.293%

0.151%

Feb 2021 notes

250

1.600%

0.053%

June 2022 notes

500

2.819%

0.185%

Feb 2023 notes

1,000

3.107%

0.409%

Oct 2023 notes

750

2.859%

0.282%

Aug 2025 notes

1,250

3.721%

0.612%

June 2026 notes

500

2.511%

0.165%

Feb 2028 notes

600

3.529%

0.279%

Nov 2028 notes

750

3.958%

0.391%

May 2029 notes

1,000

3.871%

0.509%

7,600

3.182%

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-11

c.

Assuming a 3.5 percent discount rate, estimate Starbuck’s unrecognized lease asset and liability as of September 29, 2019. For payments labeled “Thereafter,” assume these payments will be paid out at the same amount per year as the payment in 2024.

The future expected minimum cash flows discounted at 3.5 percent (half year convention) is $8,886.6 million. This represents the estimated lease asset and lease liability.

Payment

Discount

Present Value

FY 2020

$1432.9

1.017

$1,408.5

FY 2021

1342.2

1.053

1,274.7

FY 2022

1247.4

1.090

1,144.6

FY 2023

1124.3

1.128

996.8

FY 2024

996.4

1.167

853.5

FY 2025

996.4

1.208

824.6

FY 2026

996.4

1.251

796.7

FY 2027

996.4

1.294

769.8

FY 2028

996.4

1.340

743.8

FY 2029

102.1

1.387

73.6 $8,886.6

© Cambridge Business Publishers, 2021 5-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

17.

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

Tesla, Inc. (TSLA) reports both operating and capital leases. Estimate the discount rate on the capital leases for Tesla as of December 31, 2018. For payments labeled “Thereafter,” assume these payments will be paid out at the same amount per year as the payment in 2023.

Use the XIRR function (i.e., internal rate of return with dates specified) in Excel, the implied interest rate of return is 5.63 percent.

12/31/2018

(1,338,896)

6/30/2019

416,952

6/30/2020

503,545

6/30/2021

506,197

6/30/2022

23,828

6/30/2023

4,776

6/30/2024

4,776

6/30/2025

1,162

5.63%

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-13

18.

Zoom Video Communications (ZM), a video conferencing company, went public in April 2019 at $36 per share. Needless to say, Zoom’s share price has, well, zoomed. As of the end of its recent fiscal year, January 31, 2020, Zoom’s share price was $76.30 with a market capitalization of just under $10 billion. In its latest Form 10-K, Zoom reported net income of $25.3 million.

As part of Zoom’s compensation package, the company offers stock options to its employees. The footnote disclosure for Zoom’s stock options is presented below.

© Cambridge Business Publishers, 2021 5-14

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

a.

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

For the fiscal year ended January 31, 2020, what is the estimated amount of Zoom’s stock option overhang?

The option overhang liability represents the value of the unexercised stock options.

One approach to value the option overhang liability is to multiple the number of stock options outstanding as of the fiscal year end by the difference between the market price of the underlying share and the weighted-average exercise price for the “in-the-money” option.

In essence, the estimated intrinsic value of the options. 16,833,009 x ($76.30 - $5.73) = $1,187,905 A second approach (preferred) is to use Zoom’s reported Intrinsic Value for its options outstanding as of the end of the fiscal year. $1,191,881.

b.

For the fiscal year ending on January 31, 2020, what is the estimated amount of the wealth transferred from current shareholders to Zoom’s stock option holders who exercised their options in fiscal year 2020 (i.e., the implied additional compensation expense)? Note: Due to recent changes in GAAP, the excess tax benefit from stock options exercise is not reported in Zoom’s Form 10-K. The estimated wealth transfer is the difference between the stock option’s value as of the grant date and the value of the options when exercised. This appreciation in the options value is not captured anywhere in the financial statements.

One approach is to multiple the number of options exercised during fiscal 2020 by the difference in the average share price during the year (assuming the shares were exercised evenly over the year) less the average exercise price. 19,003,652 x [(($76.30 + $36.00)  2) $0.49] = $1,057,743 A second preferred approach is to use Zoom’s reported Intrinsic Value for its options exercised as of the end of the fiscal year. $767,336,000.

Note, the process from the textbook using the excess tax benefit disclosure is not possible as Zoom did not report the excess tax benefit its FY2020 financials.

c.

Compare your answers above to Zoom’s net income and revenues for fiscal 2020. What are the implications to current shareholders?

The wealth transfer from current shareholders to the stock option holders overwhelms the value created by the firm. With earnings of $25.3 million on sales of $622.7 million, Zoom transferred over $750 million via stock options during FY 2020 with another $1+ billion in the option overhang. Current shareholders need to consider the amount of wealth transferred to stock option holders in their analysis of Zoom’s market value available to them.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

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19.

Masimo (MASI), a medical device company, provides stock options for its employees and executives.

Prepare the stock option compensation adjustments for 2019. Masimo’s share price as of December 28, 2019 and December 29, 2018 was $159.49 and $105.56, respectfully. Masimo reported its excess tax benefits for 2019 was $15.7 million and faces a statutory tax rate of 21.0 percent.

The beginning stock option overhang liability is based on the number of options outstanding multiplied by the difference between the share price and weighted-average exercise price as of December 29, 2018. The stock option overhang liability, December 29, 2018: $351.6 million (5,676,000 x ($105.56 - $43.61)). And the deferred tax asset is computed using the assumed future tax rate of 21.0 percent. Or, $73.8 million ($351.6 million x 0.21).

The ending stock option overhang liability, December 28, 2019: $549.1 million (5,212,000 x ($159.59 - $54.23)). And the deferred tax asset is computed using the assumed future tax rate of 21.0 percent.

Or, $115.3 million ($549.1 million x 0.21).

During 2019, the stock option overhang liability increased by $197. 5 million and the deferred tax asset increased by $41.5 million. The changes in the liability and the deferred tax asset yield the implied current compensation expense of $156.0 million. Also, the excess tax benefit of $15.3 million results in additional compensation of $72.9 million ($15,300,000  0.21).

The resulting stock-based compensation adjustment is: Deferred tax assets Retained earnings Stock-based compensation liability Stock-based compensation expense Deferred tax assets Stock-based compensation liability Retained earnings

Dr $73.8 million 277.8 million

Cr

$351.6 million $230.8 million 41.5 million $197.5 million 74.8 million

© Cambridge Business Publishers, 2021 5-16

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

20.

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

Masimo (MASI), a medical device company, provides stock options for its employees and executives. In the footnotes to the financial statements, MASI reported the aggregate intrinsic value of options outstanding, with an exercise price less than the closing price of the Company’s stock price, as of December 28, 2019 and December 29, 2018 was $548.6 million and $416.2 million, respectfully. Additionally, the aggregate intrinsic value of the stock options exercised during 2019 was $93.9 million.

Prepare the stock option compensation adjustments for 2019. Masimo’s share price as of December 28, 2019 and December 29, 2018 was $159.49 and $105.56, respectfully. Masimo has a statutory tax rate of 21.0 percent.

The intrinsic value of the stock options outstanding as of December 31, 2018 is the beginning stock option overhang liability. The associated deferred tax liability is computed using the assumed future tax rate of 21.0 percent. Or, $87.4 million ($416.6 million x 0.21).

The ending stock option overhang liability, December 28, 2019 is the intrinsic value of the outstanding options of $548.6 million. And the deferred tax asset is computed using the assumed future tax rate of 21.0 percent. Or, $115.2 million ($548.6 million x 0.21).

During 2019, the stock option overhang liability increased by $132.4 million and the deferred tax asset increased by $27.8 million. The changes in the liability and the deferred tax asset yield the implied current compensation expense of $104.6 million. Also, the intrinsic value of the stock options exercise during 2019 of $93.9 million results in additional compensation.

The resulting stock-based compensation adjustment is:

Deferred tax assets Retained earnings Stock-based compensation liability Stock-based compensation expense Deferred tax assets Stock-based compensation liability Retained earnings

Dr $87.4 million 328.8 million

Cr

$416.2 million $198.5 million 27.8 million $132.4million 93.9 million

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-17

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors. This will facilitate the application of the valuation steps to similar real-life firms.

21.

Operating lease liability estimate – FedEx a.

Using a discount rate of 3.50% for FedEx (FDX) operating leases, estimate the unrecognized asset and liability for assets acquired under operating leases for FDX as of the end of its fiscal year 2019. Assume the payments after the fifth year are equal to those in the fifth year.

Disclosed future operating lease payments (in millions) are: 2020 $2,497 2021 2,263 2022 2,028 2023 1,779 2024 1,486 Thereafter 8,062 Payments spread out and lease liability (in millions) calculated: Operating Lease Payment Present Value 2020 $2,497 $2,454 2021 2,263 2,149 2022 2,078 1,861 2023 1,779 1,577 2024 1,486 1,273 2025 1,486 1,230 2026 1,486 1,188 2027 1,486 1,148 2028 1,486 1,109 2029 1,486 1,072 2030 632 440

Calculate estimated lease liability (note, the present value formula assumes that payment is made mid-year). $15,502

© Cambridge Business Publishers, 2021 5-18

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

b.

22.

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

For fiscal year 2019, prepare the related journal entries to record the liability and asset for the effective capitalization of the operating lease.

2019 Capital lease obligation $(15,502) million Asset under capital lease $15,502 million

Operating lease adjustments – FedEx a.

For fiscal year 2019, FedEx (FDX) operating lease payments was $2,471 million. Determine the estimated interest and principal payment and the related depreciation expense assuming the estimated operating liability is $15,457 million and the appropriate operating lease discount rate of 3.60%.

Operating lease payments

$2,471 million

Estimated interest payment

556 million

Estimated principal payment

$1,915 million

Estimate depreciation equal to principal payment b.

$1,915 million

For fiscal year 2019, prepare the related journal entries to record the amount of adjustment to SG&A, interest and depreciation expense.

2019 SG&A – Operating lease expense Interest expense Depreciation expense

$(2,471) million 556 million 1,915 million

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

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23.

Stock option compensation adjustments – FedEx a.

For FedEx’(FDX), use the data below calculate the stock option overhang liability as of May 31, 2019 As of May 31, 2019 Share price

$154.28

Average exercise price for stock options outstanding

$166.89

Number of stock options outstanding

13,622,515

FedEx does not have a stock option overhand liability as of May 31, 2019. The average exercise price for the stock options outstanding is greater than the its share price. b.

FedEx (FDX) Form 10-K footnotes reported the intrinsic value of the outstanding stock options was $1,326 million and $260 million for the fiscal years ending 2018 and 2019, respectfully. Compute the stock option compensation adjustment needed for fiscal year 2019 and prepare the related journal entries to record the amount of adjustment to for the stock option overhang liability, related deferred tax assets (DTA) and FEAT. Assume that FDX’s future marginal tax rate is 21.0%.

For Fiscal Year 2019 Assumed value of option overhang liability, Beg Balance

$1,326 million

Assumed future tax rate

21.0%

Estimated deferred tax asset (DTA) Beg Balance

278 million

Prior period adjustment to CSE ($1,326 – $278)

1,048 million

FY 2019 Adjustments for Stock Options Decrease in option overhang liability ($1,326 – $260)

$1,066 million

Decrease in related DTA ($278 – ($260 x 21.0%))

(224) million

Decrease in FEAT ($1,066 - $224)

(842) million

© Cambridge Business Publishers, 2021 5-20

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

24.

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

Restricted stock unit (RSU’s) adjustments – FedEx a.

As of FedEx’s (FDX), fiscal year 2019 (May 31, 2019), calculate the restricted stock unit (RSUs) overhang liability.

As of May 31, 2019 Share price

$154.28

Average exercise price for RSUs outstanding

$217.76

Number of RSUs outstanding

324,478

FedEx does not have a RSU overhang liability as of May 31, 2019. The average exercise price for the RSUs outstanding, $217.76, is greater than the its share price, $154.28. b.

Compute the adjustment needed for FedEx’s (FDX) RSU compensation for fiscal year 2019 as well as prepare the related journal entries to record the amount of adjustment to for the RSU overhang liability, related deferred tax assets (DTA) and FEAT. FedEx reported the RSU’s intrinsic value was $21.6 million as of May 31, 2018. The future marginal tax rate is 21.0%.

For Fiscal Year 2019 Reported value of RSU intrinsic value (overhang liability), Beg balance

$21.6 million

Assumed future tax rate

21.0%

Estimated deferred tax asset (DTA), Beg Balance

4.5 million

Prior period adjustment to CSE

17.1 million

FY 2019 Adjustments for RSUs Decrease in RSU overhang liability ($21.6 -$0)

$21.6 million

Decrease in related DTA ($4.5 - $0)

(4.5) million

Decrease in FEAT ($21.6 - $4.5)

(17.1) million

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

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25.

Operating lease liability estimate – UPS a.

Estimate the unrecognized asset and liability for United Parcel Service (UPS) operating leases as of December 31, 2019. The appropriate discount rate is 3.29%. For the future operating lease payments beyond 2024 assume the payments are equal to those in 2024.

Disclosed future operating lease payments (in millions) are: 2020

$619

2021

536

2022

451

2023

360

2024

256

Thereafter

1,267

Payments spread out and lease liability (in millions) calculated: Operating Lease Payment

Present Value

2020

$619

$609

2021

536

511

2022

451

416

2023

360

321

2024

256

221

2025

256

214

2026

256

207

2027

256

201

2028

256

195

2029

243

178

Calculated estimated operating lease liability is $3,074 million (note, the present value formula assumes that payment is made mid-year). b.

For fiscal year 2019, prepare the related journal entries to record the liability and asset for the effective capitalization of the operating leases.

2019 Capital lease obligation

$(3,074) million

Asset under capital lease

$3,704 million

© Cambridge Business Publishers, 2021 5-22

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

26.

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

Operating lease adjustments – UPS a.

For 2019, United Parcel Services (UPS) operating lease payments were $643 million.

Determine the estimated interest and principal payment and the related depreciation expense assuming the estimated operating liability is $3,704 million with the appropriate operating lease discount rate of 3.29%.

Operating lease payments

$643 million

Estimated interest payment

97 million

Estimated principal payment

$546 million

Estimate depreciation equal to principal payment

b.

$546 million

For fiscal year, prepare the related journal entries to record the amount of adjustment to Other expenses, interest expense and depreciation expense.

2019 Other expenses

$(643) million

Interest expense

97 million

Depreciation expense

546 million

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-23

27.

Stock option compensation adjustments – UPS a.

Using the data below, calculate the stock option overhang liability for United Parcel Service (UPS) as of December 31, 2019.

As of December 31, 2019 Share price

$117.06

Average exercise price for stock options outstanding

$100.74

Number of stock options outstanding

1,498,000

The stock option overhang liability is $1,498 thousand x ($117.06 - $100.74) or $24.4 million. b.

United Parcel Service (UPS) Form 10-K footnotes reported the intrinsic value of the outstanding stock option liability as $9 million and $24 million for 2018 and 2019, respectfully. Compute the stock option compensation adjustment needed for 2019 as well as prepare the related journal entries to record the amount of adjustment to for the stock option overhang liability, related deferred tax assets (DTA) and FEAT. Assume that UPS’s future marginal tax rate is 21.0%.

For 2019 Assumed value of option overhang liability, Beg Balance

$9.0 million

Assumed future tax rate

21.0%

Estimated deferred tax asset (DTA), Beg Balance

1.9 million

Prior period adjustment to CSE $24 - $5)

$7.1 million

2019 - Adjustments for Stock Options Increase in option overhang liability ($24 - $9)

($15.0 )million

Increase in related DTA ($1.9 – ($24 x 21.0%))

3.2 million

Increase in FEAT ($1,066 - $224)

11.9 million

© Cambridge Business Publishers, 2021 5-24

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 5 - Adjusting Accounting Information

28.

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

Restricted stock unit (RSU’s) adjustments – UPS a.

United Parcel Service (UPS) provides its non-executive managers restricted stock units (RSU) as part of its management incentive plan. Using the data below calculate the RSU overhang liability as of December 31, 2019.

As of December 31, 2019 Share price

$117.06

Average exercise price for RSUs outstanding

$106.94

Number of RSUs outstanding

10,739,000

The RSU overhang liability is $108.7 million or 10,739,00 RSUs x ($117.06 - $106.94). b.

Compute United Parcel Service’s (UPS) RSU compensation adjustment needed for 2019 as well as prepare the related journal entries to record the amount of adjustment to the RSU overhang liability, related deferred tax assets (DTA) and FEAT. UPS reported the RSU intrinsic value as of December 31, 2018 and 2019 was $989 million and $1,257 million, respectfully. The future marginal tax rate for UPS is 21.0%.

For 2019 RSU overhang liability, Beg Balance

$989 million

Assumed future tax rate

21.0%

Estimated deferred tax asset (DTA), Beg Balance

4.5 million

Prior period adjustment to CSE

17.1 million

2019 - Adjustments for RSUs Decrease in RSU overhang liability ($21.6 -$0)

$21.6 million

Decrease in related DTA ($4.5 - $0)

(4.5) million

Decrease in FEAT ($21.6 - $4.5)

(17.1) million

© Cambridge Business Publishers, 2021 Test Bank, Chapter 5

5-25

Prof.Exams Chapter 6 - Analysis of Enterprise Operations

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

Chapter 6 Analysis of Enterprise Operations QUESTIONS 1.

Explain the phrase “current financial statement ratios are deemed relevant for valuation if they predict future ratios.”

The purpose for financial statement analysis is to facilitate the estimation of a company’s future payoffs. That is, financial statement ratios are relevant for valuation if they predict future ratios.

To effectively use financial statement ratios, one needs to distinguish between which elements are temporary from those that are permanent. This determination requires a strong understanding of the business and related industry.

2.

What is primary difference between return on net operating assets (RNOA) and return on assets (ROA)?

Return on assets (ROA) includes both operating and financial elements while return on net operating assets (RNOA) focuses on operating activities. The inclusion of financial activities in ROA distorts the ability to properly analyze the firm’s performance. Typically, financial returns are lower than operating returns. Thus, ROA metrics tend to underestimate the firm’s operating returns.

3.

Many companies have 52/53-week fiscal years. What problem does this create for financial analysis of return on net operating assets (RNOA)? Describe the adjustment that corrects this issue?

When conducting time series or cross-sectional analysis, a 53-week return on net operating assets (RNOA) adds an additional week of operating income in the numerator when compare to a RNOA based on a 52-week fiscal year. This additional week in RNOA distorts the comparability. The adjustment is to multiply the numerator (NOPAT) by 52/53. This normalizes the RNOA ratio and provides for comparability.

4.

Describe the two components disaggregated from the return on net operating assets (RNOA).

Return on net operating assets (RNOA) is disaggregated into profit margin (PM) and operating asset turnover (ATO). Profit margin reveals the operating profitability per sales dollar while the operating asset turnover measures the productivity of the operating assets. The components can be further disaggregated to detailed analysis at the account level to understand the drivers of value creation.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 6

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5.

How does profit margin (PM) differ from profit margin from sales (PM from sales)?

Profit margin from sales excludes operating activities that are not driven by sales. Such activities include items like earnings from joint ventures, foreign currency translation, and gains/losses from cash flow hedges. By focusing on sales related activities, the metric PM from sales more clearly reflects the drivers of operating profitability.

6.

Explain how credit risk can adversely impact a firm’s operating activities.

Credit risk is a function of the firm’s financial activities. Credit risk can impact a company’s liquidity (meet short-term obligations as they come due) and solvency (meet long-term obligations as they become due). As credit risk increases, operating activities may be restricted. For example, operating growth may be restricted by reduced access to credit markets limiting its growth potential. Alternatively, rapid growth may tie up a firm’s operating capital which can present a liquidity crunch.

7.

What is the benefit of common-sized analysis using the inverse operating asset turnover (ATO) ratios?

With the inverse operating asset turnover, the item is expressed as a percentage of current year sales. With sales as the denominator, this provides a common denominator for all accounts and negates the issue with small denominators.

8.

How does the cash operating cycle, days in payables – (days in sales + days in inventory), facilitate the analysis of a firm’s operating efficiency?

The cash operating cycle provides information as to the balance between the time for purchasing inventory and collecting receivables versus paying suppliers. In some instances, companies are paid (days in inventory + days in sales) before they make payment (days in payables). Such firms are efficient with their operating capital. Other firms that pay their suppliers prior to collecting from customers are less efficient in their operations and must finance their operating capital.

9.

What are potential issues with comparing firms with differing year-end dates?

The primary issue with differing year-end dates within cross-sectional analysis is comparability.

Specifically, the impact of major events that occur between the various year-end dates. For example, the COVID-19 pandemic that shut down businesses in early 2020 impacted the comparability between a February year-end and a July year-end. Other major events that can impact comparability include acquisitions, technology shifts or regulatory changes.

10.

What is the difference between return on equity (ROE) and return on net operating assets (RNOA)?

Both metrics measure returns on investments. Return on net operating assets, RNOA, provides the return on operating activities while return on equity, ROE, measures the return on both operating and financial activities. The inclusion of the financial return in ROE captures the impact of financial leverage and the spread between RNOA and the return on net financial liabilities in addition to the return on operating activities.

© Cambridge Business Publishers, 2021 6-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 6 - Analysis of Enterprise Operations

11.

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

If a higher ROE is desirable, why don’t companies take on large amounts of debt?

As the degree of leverage increases, the cost of borrowing also increases. At some point, the cost of the additional debt will exceed the return on the additional assets acquired from the debt financing. Then subsequent financing does not make economic sense. Also, the company’s operating leverage (fixed costs as a percentage of total costs) increases making the company more sensitive to unexpected changes in revenues.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 6

6-3

EXERCISES 12.

A reformulation of Chipotle’s (CMG) financial statements provided the following results: (in millions) Sales Comprehensive income NOPAT

2018 $4,865 177 168

(in millions) Net operating assets (NOA) Net financial liabilities (NFL) Shareholders’ Equity

2019 $5,586 350 339 Dec. 31, 2017 $3,535 2,171 1,364

Dec. 31, 2018 $3,444 2,005 1,439

Dec. 31, 2019 $3,480 1,797 1,683

Calculate for 2018 and 2019: a.

Operating profit margin percentage (PM) PM = NOPAT  Sales 2018: $168  $4,865 = 3.5% 2019: $339  $5,586 = 6.1%

b.

Operating Asset turnover (ATO) Sales  Avg NOA 2018: $4,485  $3,462 = 1.39 2019: $5,586  $3,490 = 1.61

c.

Return on net operating assets (RNOA) NOPAT  Avg NOA 2018: $168  $3,462 = 4.8% 2019: $339  $3,490 = 9.8%

d.

Financial leverage (LEV) Avg NFL  Avg CSE 2018: $2,088  1,402 = 1.49 2019: $1,561  1,901 = 1.22

© Cambridge Business Publishers, 2021 6-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 6 - Analysis of Enterprise Operations

e.

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

Spread (RNOA – RNFL) RNFL = FEAT  Avg NFL, where FEAT = NOPAT – Comprehensive Income 2018: 0.048 – (168 – 177)  2,088 = 0.052 2019: 0.098 – (339 – 350) 1,901 = 0.104

f.

Return on Equity (ROE) RNOA + (LEV x Spread) 2018: 0.048 + 1.49 x 0.052 = 0.126 2019: 0.098 + 1.22 x 0.104 = 0.224

g.

Conduct a change in RNOA analysis to identify the drivers for the changes in RNOA from 2018 to 2019 (e.g., PM, ATO, or Leverage).

RNOA = ATO2019 x PM2019 + PM2019 x ATO2018 RNOA = (1.61 – 1.39) x 0.061 + (0.061 – 0.035) x 1.39 = 0.013 + 0.036 = 0.049 ATO2019 x PM2019 = 0.013 PM2019 x ATO2018 = 0.036 The change in the RNOA from 4.8% to 9.8% was driven more by the change in PM than ATO. The change in PM explained approximately 70% of the change in RNOA. h.

Explain whether the change in ROE is due to RNOA or leverage (FLEV x Spread).

Note that LEV decreases from 2018 to 2019 while RNOA increases. This indicates that the increase ROE is primarily due to a change in RNOA. The two components of ROE are operating returns (i.e., RNOA) and financial returns (LEV x Spread) where Spread is the difference in RNOA and RNFL. The change in Spread from 5.2% to 10.4% is due almost solely to the change in RNOA (4.8% to 9.8%). Thus, the change in ROE is due primarily to the change in RNOA for both the returns from operations and from financing.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 6

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13.

Below is the income statement for Whirlpool (WHR) from its 2019 financial statements. What items are part of NOPAT but would excluded in computing NOPAT from Sales?

For WHR, the items most likely to be omitted from NOPAT from Sales that was included in NOPAT are items directly related to sales. This includes restructuring costs, impairment of goodwill and other intangibles, loss of sale and disposal of businesses and from comprehensive income, foreign currency translation adjustments, and other items considered to deemed to be an operating activity (e.g., derivative instruments). These items would not be expected to increase or decrease as a result of changes in the level of sales.

© Cambridge Business Publishers, 2021 6-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 6 - Analysis of Enterprise Operations

14.

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

Below is the income statement for Sherwin-Williams (SHW) from its 2019 financial statements.

What items are part of NOPAT but would excluded in computing NOPAT from Sales?

For SHW, the items most likely to be omitted from NOPAT from Sales that was included in NOPAT are items directly related to sales. This includes impairment of trademarks, California litigation and from comprehensive income, foreign currency translation adjustments, and cash flow hedges. © Cambridge Business Publishers, 2021 Test Bank, Chapter 6

6-7

15.

Ross, Inc. is considering adding a loyalty program in which its customers can earn points for discounts in lieu of running storewide promotions. Additionally, Ross would collect information on its customers’ shopping transactions, which allow Ross to craft individualized promotions.

Currently Ross has $225 million in annual sales generating a profit margin of 3.0 percent on sales and an operating asset turnover of 4.5. Ross marketing group believes the loyalty program would increase sales by $20 million with an additional investment in working capital of $2.5 million to support the increased sales. Costs to run the loyalty program would reduce profit margin to 2.8 percent.

Based solely on the above financial consideration, explain whether you would recommend management consider adding this new program.

Net operating assets for $225 million in sales and an ATO of 4.5 are $50 million.

An increase in sales of $50 million and an increase in working capital of $2 million would increase the ATO to 225 + 20 = 4.67.

50 + 2.5

With a profit margin of 1.5%, the RNOA would be: RNOA = 2.8%  4.67 = 13.07% The current RNOA is = 3.0%  4.5 = 13.5% So, the membership program would decrease RNOA slightly and should not be considered by management.

© Cambridge Business Publishers, 2021 6-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 6 - Analysis of Enterprise Operations

16.

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

Good Eats, Inc., a national food company, is evaluating whether to extend its product line into plant-based foods. Given the recent success of alternative meat companies, Good Eats believes it can acquire the R&D talent to quickly develop similar plant-based products. The new product line would be marketed through its current distribution channels.

Good Eats’ management will introduce the new product line early next year. The CFO believes the plant-based product line will require $40 million in additional net operating assets for the R&D and related production facilities as well as supporting the sales initiative. The CFO estimates that the new plant-based product line sales will be $20 million.

For the current year, Good Eats anticipates its existing business will earn $480 million in sales generating a profit margin of 3.5 percent with an operating asset turnover of 3.0. When the new product line comes on board next year, the existing business line sales will be $480 million as the new product line will cannibalize some sales initially. However, Good Eats’ expected profit margin will increase to 4.3 percent on all sales.

Future growth for the plant-based food line is expected to be greater than the traditional food line, although management is uncertain what the difference will be as other new entrants will certainly enter into the plant-based food market as well.

Based solely on the above financial consideration, explain whether you would recommend management consider extending its product line into plant-based foods.

Before considering the plant-based product line, Good Eats has a RNOA = 10.50% (Profit Margin x ATO or 3.5%  3.0). Also, NOA is $160.0 million based on $480.0 million in sales divided by ATO of 3.0 ($480 ÷ 3.0).

According to the CFO, investing $40 million in the new product line will generate additional sales of $20.0 million.

ATO would decrease to

480+20 160+40

= 2.50.

With a new overall profit margin of 4.3%, the resulting RNOA would be 10.75% (4.3%  2.5).

With the current RNOA at 10.50%, the addition of plant-based products would increase RNOA slightly and should be considered by management.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 6

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17.

Mason Corp. reported the following results for the past two years.

Profit margin (PM) Operating asset turnover (ATO) Net borrowing cost (RNFL) Average net financial liabilities (NFL) (millions) Average common shareholders’ equity (CSE) (millions) a.

2020 7.0% 2.0 3.0% $2,250 $4,500

2019 5.0% 2.5 3.3% $1,000 $4,000

Calculate the return on net operating assets (RNOA) and show how much of its change from 2019 to 2020 is due to change in profit margin and the change in asset turnover.

RNOA = PM x ATO RNOA for 2020 = 7.0% x 2.0 = 14.0% RNOA for 2019 = 5.0% x 2.5 = 12.5%

Change in RONA = 14.0% - 12.5% = 1.5% Change in PM = 7.0% - 2.0% = 2.0% Change in ATO = 2.0 – 2.5 = -0.5

Change in RNOA

= 1.5% = (2.0% x 2.5) + (-0.5 x 7.0%) =

b.

5.0%

3.5%

Due to PM

Due to ATO

Explain how much of the change in ROCE from 2019 to 2020 is due to operating activities and how is due to financing activities. 𝟐,𝟐𝟓𝟎

ROCE for 2020: 19.5% = 14.0 + [𝟒,𝟓𝟎𝟎 𝒙 (𝟏𝟒. 𝟎 − 𝟑. 𝟎)] 𝟏,𝟎𝟎𝟎

ROCE for 2019: 14.8% = 12.5 + [𝟒,𝟎𝟎𝟎 𝒙 (𝟏𝟐. 𝟓 − 𝟑. 𝟑)]

 in ROCE = 4.7% (19.5% - 14.8%)  in ROCE due to operating ( in RNOA) = 1.5% (14.0% - 12.5%)  in ROCE due to financing = 3.2% ([𝟒,𝟓𝟎𝟎 𝒙 (𝟏𝟒. 𝟎 − 𝟑. 𝟎)] - [𝟒,𝟎𝟎𝟎 𝒙 (𝟏𝟐. 𝟓 − 𝟑. 𝟎)]) or (4.7% - 1.5%) 𝟐,𝟐𝟓𝟎

𝟏,𝟎𝟎𝟎

© Cambridge Business Publishers, 2021 6-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 6 - Analysis of Enterprise Operations

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

CONTINUING EXAMPLES 18.

For FedEx (FDX), review the selected income statement and balance sheet data: (in millions) Sales Comprehensive income NOPAT

FY 2018 $65,540 4,088 5,097

(in millions) Net operating assets (NOA) Net financial liabilities (NFL) Shareholders’ Equity

FY 2019 $69,693 1,112 5,592

May 31, 2017 $50,034 34,706 15,329

May 31, 2018 $54,001 36,650 18,351

May 31, 2019 $57,523 39,971 17,552

Calculate for FY 2018 and 2019: a.

Operating profit margin percentage (PM) PM = NOPAT  Sales 2018: $5,097  $65,540 = 7.78% 2019: $5,592  $69,693 = 8.02%

b.

Operating Asset turnover (ATO) Sales  Avg NOA 2018: $65,540  $35,178 = 1.26 2019: $69,693  $37,811 = 1.25

c.

Return on net operating assets (RNOA) NOPAT  Avg NOA 2018: $5,097  $55,762 = 9.80% 2019: $5,592  $52,018 = 10.03%

d.

Financial leverage (LEV) Avg NFL  Avg CSE 2018: $35,178  16,840 = 2.09 2019: $37,811  17,952 = 2.11

© Cambridge Business Publishers, 2021 Test Bank, Chapter 6

6-11

e.

Spread (RNOA – RNFL) RNFL = FEAT  Avg NFL, where FEAT = NOPAT – Comprehensive Income 2018: 0.0980 – (5,097 – 4,088)  35,178 = 0.0693 2019: 0.1003 – (5,592 – 1,112) 37,811 = -0.0182

f.

Return on Equity (ROE) RNOA + (LEV x Spread) 2018: 0.0980 + 2.09 x 0.0693 = 0.2428 or 24.28% 2019: 0.1003 + 2.11 x -0.0182 = 0.0619 or 6.19%

19.

For United Parcel Service (UPS), review the selected income statement and balance sheet data: (in millions) Sales Comprehensive income NOPAT

FY 2018 $71,861 5,662 5,978

(in millions) Net operating assets (NOA) Net financial liabilities (NFL) Shareholders’ Equity

FY 2019 $74,094 3,188 6,332

May 31, 2017 $30,592 30,781 (189)

May 31, 2018 $33,398 31,297 2,101

May 31, 2019 $37,271 35,172 2,099

Calculate for FY 2018 and 2019: a.

Operating profit margin percentage (PM) PM = NOPAT  Sales 2018: $5,978  $71,861 = 8.32% 2019: $6,332  $74,094 = 8.55%

b.

Operating Asset turnover (ATO) Sales  Avg NOA 2018: $71,861  $31,995 = 2.25 2019: $74,094  $35,335 = 2.10

© Cambridge Business Publishers, 2021 6-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 6 - Analysis of Enterprise Operations

c.

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

Return on net operating assets (RNOA) NOPAT  Avg NOA 2018: $5,978  $31,995 = 18.68% 2019: $6,332  $35,335 = 17.92%

d.

Financial leverage (LEV) Avg NFL  Avg CSE 2018: $31,039  956 = 32.47 2019: $33,235  2,100 = 15.83

e.

Spread (RNOA – RNFL) RNFL = FEAT  Avg NFL, where FEAT = NOPAT – Comprehensive Income 2018: 0.1868 – (5,978 – 5,662)  31,039 = 0.1767 2019: 0.1792 – (6,332 – 3,188)  33,235 = 0.0846

f.

Return on Equity (ROE) RNOA + (LEV x Spread) 2018: 0.1868 + 32.27 x 0.1767 = 5.9226 or 592.26% 2019: 0.1792 + 15.83 x -0.0846 = 1.5181 or 151.81%

© Cambridge Business Publishers, 2021 Test Bank, Chapter 6

6-13

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 7 - Full-Information Forecasting for Valuation

Chapter 7 Full-Information Forecasting for Valuation QUESTIONS 1.

What is the objective of forecasting?

The objective for forecasting is to make the best possible unbiased forecast based on the firm’s expected opportunities. Conservative forecasts will likely underestimate the firm’s future payoffs as the forecast will not recognize and incorporate the full array of opportunities facing the firm. Overly optimistic forecasts provide similarly poor payoff estimates.

2.

Why do forecasts need to be “internally consistent?”

Internal consistency occurs when the forecasted information articulates through the financial statements and across time. That is, the financial articulation required of NOPAT and NOA is maintained over the forecast horizon. This ensures that expected changes in sales growth, profit margin (PM) and asset turnover (ATO) can be achieved. For example, having sufficient infrastructure (NOA) to support expected sales growth.

3.

How does sensitivity analysis support a forecast?

Following the preparation of a forecast, sensitivity analysis highlights the impact of the assumptions on the expected payoffs. The assumptions that have the greatest effect need to be investigated thoroughly to ensure the forecast assumptions provides the best possible unbiased forecast.

4.

Identify the three required components needed to prepare a forecast.

Forecasts follow a three-step sequence: (1) forecast sales growth rates that yield a forecast of expected revenues, (2) forecast profit margin (PM) that yield a forecast of expected NOPAT, and (3) forecast asset turnover (ATO) that yield a forecast of expected NOA.

5.

Why do forecasts not include financial activities?

Forecasts of the financial activities are not needed in determining the value of the firm.

Forecasts value the firm’s operations resulting in a value of operations. Adjusting the firm’s enterprise value for the current value of the net financial liabilities provides an estimate of the firm’s current equity value. © Cambridge Business Publishers, 2021

Test Bank, Chapter 7

7-1

6.

What is the primary difference between a parsimonious forecast and a full-information forecast?

The level of detailed analysis in preparing the assumptions for the forecast is the primary difference between a parsimonious and a full-information forecast. While the three forecast components (sales growth, profit margin and asset turnover) are used in both forecasts, a full-information forecast will dig deeper into the forecasted components. The full-information forecast may separately forecast the individual elements of profit margin that are combined into a composite forecast of profit margin. This allows for the individual elements to evolve over time in a way that is consistent with expected future growth.

7.

How does a recent significant acquisition impact a forecast?

When a company makes a large acquisition, the ability to use historical sales growth, profit margin (PM) and asset turnover (ATO) as a basis for estimation is diminished. While GAAP provides for pro-forma estimates of sales and income, there is insufficient detail for a complete analysis. This requires additional analysis of information and forecasting to develop reasonable estimates of the revised business post-acquisition.

8.

Can the use of cumulative annual growth rates (CAGR) be misleading?

Cumulative annual growth rates (CAGR) aggregates prior years rates into a single measure.

This ignores the detailed information provided by the individual yearly data. If all years are similar in their growth rates, CAGR will reflect that pattern. If the growth rates are varied with an unusual outlier or increasing/decreasing rates over time, the use of CAGR will not fairly reflect the underlying growth rate patterns.

9.

How do unexpected macro events (e.g., COVID 19) impact a forecast?

Throughout any period, there exists the possibility of a macro event that distorts historical financial patterns and influences expectations going forward. COVID-19 is a recent example of such an unexpected macro event.

The business analysis must consider an assessment of the general economic activity and the impact on competitive forces within the broader business environment as well as the firm’s industry. Forecasts, at the individual product level, should factor in the competitive advantage, emerging cost trends, logistical requirements, marketing support, and customer service implications. This allows for reasonable assumptions that are consistent with economic realities facing the firm.

10.

Beyond the financial statements and its footnotes, what are some additional sources of information available to build a forecast?

Additional information available to develop a forecast include the management discussion and analysis (MD&A) within the Form 10-K. Other sources include investor relation presentations, management conference calls and guidance, analysts’ reports as well as information from competitors, suppliers and customers that provide information regarding broader trends impacting the firm.

© Cambridge Business Publishers, 2021 7-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 7 - Full-Information Forecasting for Valuation

EXERCISES Bear in mind, when forecasting there does not exist one set of “right” answers. Rather the question is whether the assumptions underlying the forecasts are sensible and have considered the appropriate information.

11.

To forecast financial statements, the analyst needs (1) a forecast of sales growth rates, (2) forecasts of operating PM and components of PM and (3) forecasts of operating ATO and components of ATO. On February 27, 2020, Bed Bath & Beyond (BBBY) announced a strategic restructuring program to rebuild its business foundation and create a sustainable, durable business model.

In its press release, BBBY stated that its action plan crosses five strategic pillars: Product, Price, Promise, Place and People. Specifically, the company announced:

Explain what impact (directionally, not quantitively) BBBY’s restructuring plan, if successfully implemented, will have on its future NOPAT and NOA. The impact on NOA and NOPAT are based on your estimates of Sales, PM and ATO. What is the expected impact of BBBY's restructuring on these elements? Your answers will lead to you to the impact on NOPAT and NOA.

Continued

© Cambridge Business Publishers, 2021 Test Bank, Chapter 7

7-3

BBBY's restructuring plan will have the following effects: For Items 1 & 2 o

Operating PM ▪ ▪ ▪ ▪

o

SG&A expenses lower over time Restructuring/etc. costs up through 2019, with a zero trend afterwards. However, these would be before tax costs Decrease in pension and post-retirement service costs Short-term decrease in income tax expenses

Operating ATO ▪ ▪

Decreased payroll/compensation liability Potential net change in Deferred Tax Assets/Liabilities depending on their structure

Item 3 o

Operating PM ▪ ▪

Reduction in overall Cost of Sales and operating expenses for PM from sales Increased efficiency in revenue growth

Item 4 o

Sales Rev ▪

o

Operating PM ▪ ▪

o

Increased revenue due to more efficient contributions to organic sales growth.

Higher Cost of Sales since additional expenses are built into the outsourcing for generating sales rather than through equity and PPE assets Lower operating costs and Cost of Sales due to increased focused on core competencies

Operating ATO ▪

Reduction in PPE leads to a higher asset turnover

Conclusion: NOPAT o

Item 1 & 2: net positive

o

Item 3: net positive

o

Item 4: some additional costs offset mostly by increased efficient revenue growth and lower operating costs.

Continued

© Cambridge Business Publishers, 2021 7-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 7 - Full-Information Forecasting for Valuation

NOA o

Items 1&2: Reduction in operating liabilities for compensation and benefits ▪

o

Potential change in deferred tax liability assets & liability depending

Item 4: Outright reduction in PPE leads to higher ATO, but lower NOA

Overall

12.

o

NOPAT trends upwards more consistently, but with some short-term additional costs in the next year or two.

o

NOA net goes down mostly as a result of lower PPE assets from item 4, leading to an increased ATO

Exxon Mobil (XOM) has a significant amount of Other Comprehensive Income (OCI) which increased or decreased its net income (NI) by up to 30 percent in some years. For 2017 – 2019, XOM reported the following OCI in its financial statements.

If this is the only information available, identify for each of XOM’s OCI items which approach (i.e., Steady Ratio, Steady Amount, Follow a Trend, Use other Information or Zero) you would use in your forecasting? Explain.

Typically, OCI items are estimated to be zero as they are driven by external events unrelated to the firm’s operating activities or there is no ability to forecast the future impact on earnings (positive or negative).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 7

7-5

13.

For Intuit Inc. (INTU), a leading financial software company whose portfolio includes TurboTax and QuickBooks, the following table has information for revenues, PM and ATO for the past four years. Product revenues include revenue from software licenses. Service revenues include revenues from support, electronic filing services, merchant payment processing services and royalty agreements.

Fiscal 2016

Fiscal 2017

Fiscal 2018

Fiscal 2019

Product revenues ($ millions)

$1,289

$1,483

$1,624

$1,623

Services revenues ($ millions)

$3,405

$3,713

$4,401

$5,161

PM

17.8%

19.4%

22.0%

22.6%

ATO

4.34

4.98

4.71

4.59

a. Using a parsimonious analysis, determine approaches (i.e., Steady Ratio, Steady Amount, Follow a Trend, Use other Information or Zero) and prepare reasonable assumptions for forecasting 2020 and 2021.

Fiscal

Fiscal

Fiscal

Fiscal

Fiscal

Fiscal

2016

2017

2018

2019

E2020

E2021

$1,289

$1,483

$1,624

$1,623

$1,623

$1,623

Steady amount

$3,405

$3,713

$4,401

$5,161

$5,935

$6,825

Trend

PM

17.80%

19.40%

22.00%

22.60%

23.00%

23.30%

Trend

ATO

4.34

4.98

4.71

4.59

4.59

4.59

Steady amount

Assumptions Product revenues ($ millions) Services revenues ($ millions)

b. Based your assumptions above, calculate expected NOPAT and NOA (in $ millions) for fiscal year 2020.

Based on the forecasted sales, PM and ATO: NOPAT2020 = ($1,623 + $5,935) x 0.23 = $1,738 NOA2020 = ($1,623 + $6,825)  4.59 = $1,841

© Cambridge Business Publishers, 2021 7-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 7 - Full-Information Forecasting for Valuation

14.

For lululemon athletica (LULU), its segmented information footnote reports net revenues by distribution channel and by product category as follows:

In preparing a forecast of expected sales growth, which revenue disaggregation should be used (distribution channel or product category)? What other factors would need to be taken into account in forecasting fiscal 2020?

As difficult as forecasting is, unexpected macro events such as the COVID-19 pandemic makes forecasting more difficult. When evaluating historical information, continuity between the past data to the forecasted data is desirable. That is, what has held true in the past will continue going forward.

The impact of pandemic with subsequent retail outlets being shut down for an extended period makes reliance on historical data challenging. As consumers shift from companyoperating stores to the direct to consumer channel, past sales are not reflective of expected future sales, in the near term. The better continuity of historical sales to forecasted sales is by product category as all products are sold through the various distribution channels.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 7

7-7

15.

For Cook Corporation, the following information on the past five years for revenues, profit margin (PM), and asset turnover (ATO) are: FY2016

FY2017

FY2018

FY2019

FY2020

Sales (millions)

$5,000

$5,500

$6,050

$6,655

$7,321

PM from sales

12.00%

12.25%

12.30%

12.40%

12.50%

PM

13.80%

13.60%

13.40%

13.35%

13.50%

ATO

4.00

4.05

3.99

4.02

4.00

Using a parsimonious analysis, prepare the assumptions for sales growth, PM and ATO. Sales have been growing at a constant 10%, thus sales growth forecast is 10%.

PM from sales and PM are relatively constant with PM being 13.5% ATO is also constant at 4.00

16.

Using only the information below, identify which approach (i.e., Steady ratio, Steady amount, Follow a trend, Use other information and Zero) to use in forecasting the components of operating profit margin (PM) for PepsiCo Inc. (PEP).

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

Steady ratio is appropriate for items such as cost of sales, cost of sales: depreciation and amortization expense, cost of sales: depreciation and amortization expense for operating leases, selling, general and administrative expense and provision for/(benefit from) income taxes.

Steady amount: None.

Follow a trend is appropriate for cost of sales (or cost of sales can be classified as Steady ratio).

Zero is appropriate for SG&A, amortization of intangible assets, SG&A pension service cost, SG&A retiree medical, SG&A lease/rent payments and net currency translation adjustment. © Cambridge Business Publishers, 2021 7-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 7 - Full-Information Forecasting for Valuation

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors. This will facilitate the application of the valuation steps to similar real-life firms.

17.

Parsimonious forecast assumptions for FedEx’s (FDX) sales growth rate, PM and ATO are provided below. Use those assumptions to form parsimonious forecasts of sales, NOPAT, and NOA for fiscal years 2020 - 2023. Sales for fiscal year 2019 were $69,693 million.

Sales growth

5.0%

Profit margin

6.15%

Asset turnover ratio

1.30

FY2020

FY2021

FY2022

FY2023

$73,178

$76,837

$80,678

$84,712

($69,693 x 1.05)

($73,178 x 1.05)

($76,837 x 1.05)

($80,678 x 1.05)

$4,500

$4,725

$4,962

$5,210

Sales

NOPAT

($73,178 x 6.15%) ($73,837 x 6.15%) ($80,678 x 6.15%) ($84,712 x 6.15%)

NOA

$59,105

$62,060

$65,163

$68,421

($76,837  1.30)

($80,678  1.30)

($84,712  1.30)

($88,948  1.30)

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

© Cambridge Business Publishers, 2021 Test Bank, Chapter 7

7-9

18.

From the segment level data for FedEx (FDX) for FY 2016 to FY 2019, analyze the changes in sales as driven by the change in FedEx Express, FedEx Ground, FedEx Freight, FedEx Services sales along with eliminations, corporate and other. Prepare a forecast of segment level sales growth and expected sales for FY 2020 and then combine to form a firm level sales forecast.

Estimated sales growth FedEx Express - 3.0% FedEx Ground - 10.5% FedEx Freight - 9.5% FedEx Services - 2.5% Eliminations, corporate and other - 5.0%

Forecasted sales - FY2020 FedEx Express - 3.0% x $37,331 = $38,451 FedEx Ground - 10.5% x $20,522 = $22,677 FedEx Freight - 9.5% x $7,582 = $8,302 FedEx Services - 2.5% x $1,691 = $1,733 Eliminations, corporate and other - 5.0% x $2,567 = $2,695

Total forecasted FY 2020 sales = $73,859 or 6.0% sales growth Note, given the limited data provided, there are many possible answers.

© Cambridge Business Publishers, 2021 7-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 7 - Full-Information Forecasting for Valuation

19.

Using only the information below, identify which approach (i.e., Steady ratio, Steady amount, Follow a trend, Use other information and Zero) to use in forecasting the components of operating profit margin (PM) for FedEx. (FDX).

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

© Cambridge Business Publishers, 2021 Test Bank, Chapter 7

7-11

20.

Parsimonious forecast assumptions for United Parcel Service’s (UPS) sales growth rate, PM and ATO are provided below. Use those assumptions to form parsimonious forecasts of sales, NOPAT, and NOA for fiscal years 2020 – 2023. Sales for fiscal year 2019 were $74,094 million.

Sales

NOPAT

Sales growth

3.0%

Profit margin

7.50%

Asset turnover ratio

2.00

2020

2021

2022

2023

$76,169

$78,301

$80,494

$82,748

($74,094 x 1.03)

($76,169 x 1.03)

($78,301 x 1.03)

($80,494 x 1.03)

$5,713

$5,873

$6,037

$6,206

($76,169 x 7.50%) ($78,301 x 7.50%) ($80,494 x 7.50%) ($82,748 x 7.50%)

NOA

$39,151

$40,247

$41,374

$42,532

($78,301  2.00)

($80,494  2.00)

($82,748  2.00)

($85,065  2.00)

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

© Cambridge Business Publishers, 2021 7-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 7 - Full-Information Forecasting for Valuation

21.

From the segment level data for United Parcel Service (UPS) for 2016 to 2019, analyze the changes in sales as driven by the change in US domestic package, international package, and supply chain & freight sales. Prepare a forecast of segment level sales growth and expected sales for 2020 and then combine to form a firm level sales forecast.

Estimated sales growth US domestic package - 6.7% International package - 0.0% Supply chain & freight - 0.0%

Forecasted sales - 2020 US domestic package - 6.7% x $49,493 = $52,809 International package - 0.0% x $14,220 = $14,220 Supply chain & freight - 0.0% x $13,381 = $13,381

Total forecasted 2020 sales = $80,410 or 4.3% sales growth Note, given the limited data provided, there are many possible answers.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 7

7-13

22.

Using only the information below, identify which approach (i.e., Steady ratio, Steady amount, Follow a trend, Use other information and Zero) to use in forecasting the components of operating profit margin (PM) for United Parcel Service. (UPS).

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

© Cambridge Business Publishers, 2021 7-14

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

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

Chapter 8 Market Multiple Valuation QUESTIONS 1.

Identify three common uses of market multiples.

Market multiples can be used as (1) a first-pass, parsimonious indicator of value, particularly for privately held firms, (2) a stock screening tool, and (3) a summary metric for comparison across a group of peer firms.

2.

What is the limitation of utilizing free cash flow (FCF) measures in market multiples.

Free cash flows measure the distribution of value as opposed to value creation. Market multiples should be tied forward-looking fundamental indicator (e.g., earnings, NOPAT), not to the distribution of value that FCF represents. For a company experiencing significant growth, FCF may be negative as the firm builds out its operations. A market multiple based on negative FCF would not be an indicator of value creation.

3.

What criteria needs to be considered when selecting a comparable firm?

There are many attributes on which comparable firms can be considered, such as size and industry.

The primary focus should consider operational risk including profitability, growth opportunities and risk profiles. Such firms tend to have similar cost structures that provides consistency for changes in the fundamental indicator in the market multiple.

4.

Are adjustments for differing year-ends necessary for comparable firms when using market multiple valuations?

Yes, differences can arise in a relatively short time frame that impacts the comparability of firms with differing year ends (e.g., COVID-19). To improve comparability, a TTM adjustment will align the dates closer to together. For example, a May 31 year-end firm can be aligned with a December 31 year end per by adjusting the peer’s year to March 31 with a TTM adjustment.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-1

5.

What issues arise with use of comparable firms that report under IFRS for a subject firm reporting under US GAAP? While there many of the accounting policies are similar between US GAAP and IFRS, there are substantial differences (e.g., research and development) as well. It is imperative that the impact of the differences between US GAAP and IFRS be known in determining whether a company is a proper comparable. Additionally, IFRS has limited interim reporting that impedes the ability to make TTM adjustments for differing fiscal year ends.

6.

What is the inherent inconsistency in using market multiples to value publicly traded companies?

With market multiples, there is the presumption that the subject firm is not fairly valued by the markets. Yet, the comparable firms are deemed to be fairly valued. The basis of determining which firms are fairly valued is arbitrary, at best. To the argument that a group of firms will be fairly valued collectively; however, it is difficult to ascertain whether a difference from the comparable group is a valid variance or a pricing error by the market.

7.

Under what conditions is it preferable to use a sales multiple as opposed to an earnings multiple?

When earnings are negative or near to zero, earnings multiples are meaningless. Accordingly, sales multiples are an appropriate alternative. The limitation with a sales multiple is the impact of the various cost structures of the comparables and subject companies’ on making reasonable inferences.

8.

In calculating various PE ratios (e.g., trailing, forward or PEG), what is the benefit of using NOPAT instead of earnings.

Earnings includes the results of both operating and financing activities while NOPAT reflects only operating activities. With NOPAT, the PE ratios are independent of a target firm’s and comparables’ capital structure. Thus, NOPAT PE ratios are not muddied by the financing activities.

9.

In evaluating firms with significant internally created assets (e.g., Disney or Facebook), which market multiples – those based in the income statement or balance sheet - are more closely aligned to value creation? Explain.

Balance sheets do not capture internally created assets (e.g., Mickey Mouse or Facebook’s algorithms). The value from these assets is captured in the firm’s income, thus, income-based multiples are better aligned with the firm’s value creation.

© Cambridge Business Publishers, 2021 8-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

10.

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

Joel Greenblatt is the founder of the hedge fund Gotham Capital and an adjunct professor at Columbia. From 1985 to 2006, Gotham Capital reported annualized returns over 40 percent. In 2005, Mr. Greenblatt published The Little Book that Beats the Market, which presented an investment strategy of “magic formula investing” based on a screen of earnings yield & return on capital. In fact, Mr. Greenblatt has a website dedicated to the book. With a free registration, one can create their own investible set of stocks.

Here is one list:

What could possibly go wrong with this portfolio?

© Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-3

Screening uses limited information with no forecasting as it is quick and easy to perform. 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 when you are only looking behind you and not anticipating what is in front of you.

Fundamental research is very thorough and does not ignore information in the way that screening does. The tenets of fundamental analysis allow you to make a fully informed, 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 then 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.

By the way, check out the disclaimer for Mr. Greenblatt’s website.

Go figure …

© Cambridge Business Publishers, 2021 8-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

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

EXERCISES 11.

For Chipotle (CMG), 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 YUM Brands! (YUM) which owns Taco Bell, to Jack in the Box (JACK) which owns Qdoba, to Del Taco (TACO), 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 CMG allowing for an appropriate estimate of value? For example, are the impacts of international operations versus domestic operations or the ratio of firm-owned to franchise-owned locations similar or online versus in-place service. For Taco Bell and Qdoba, both companies are held by firms that own a portfolio of various quick service restaurants that may differ significantly from CMG. These issues alone would be expected to result in substantial differences in the some of the multiples one would consider.

12.

For American Airlines Group (AAL) or Delta Airlines (DAL), what is an example of an industry multiple useful in estimating firm valuation? What concerns are associated with using an industry multiple?

The airline industry utilizes two key performance measures: Revenue per available seat mile (RASM) defined as operating income divided by available seat miles (ASM) and Revenue passenger mile (RPM) defined as the number of paying passengers divided by the distance traveled. These metrics provide information about an airlines’ efficiency, load factors and earnings capabilities.

However, they do not reflect differences in cost structure that may arise or in the geographical marketplace in which the airline competes. As such, despite these being widely focused on measures, one must exercise caution when employing these industry measures.

13. Sea Limited (SE), based in Singapore, is a leading mobile and PC gaming platform and developer as well as an e-commerce marketplace operator (Shopee) in ASEAN and Taiwan. Sea Limited also runs a digital-payments platform (SeaMoney).

In July 2020, Bank of America Merrill Lynch published an analyst report with a price objective of $135 based on a sum of the parts valuation of its three primary business activities. As of the date of the analyst report, SE was trading at $112.90.

Continued

© Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-5

Note that GMV stands for Gross Merchandise Value, the total annual value of merchandise sold through a customer-to-customer (C2C) exchange site. SeaMoney is valued at 0.15x EV/GMV sales.

The largest component of SE’s valuation is based on its e-commerce business activities. The report noted that the e-commerce multiple was based 20% off the global average as illustrated below.

Critique the set of SE’s e-commerce comparable firms used to value the firm.

There are a number of potential issues with the set of comparable firms for SE. While each comparable firm operates a customer to customer exchange, there are significant differences across comparable firms as well as the range of price to GMV multiples (i.e., 0.25 to 3.25). In selecting a comparable firm on size and industry are commonly used. More importantly, comparable should be similar in terms of profitability, growth and risk profiles as well as cost structures and regulatory environments. The variation of these attributes is significant across all the firms. For example, eBay is an auction site while Amazon is a primarily direct to consumer site. Both ZOZO and Alibaba have a significant business to business platform in addition to their consumer to consumer platforms.

Alibala and Pinduoduo operate in a significantly different regulatory environment that Amazon, Wayfair and Etsy. © Cambridge Business Publishers, 2021 8-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

14.

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

Eaton Corp. is considering acquiring Kohler, LLC, a privately held company. Three small cap publicly traded firms (Anthony Inc, Baker Companies, and Chambers Corp.) in the same industry were selected as comparable firms to estimate Kohler’s equity value. For Kohler, next year’s expected sales, NOPAT and earnings per share next year are $50 million, $15 million and $2.50 per share, respectfully. Currently, Kohler has $20 million in debt with 700,000 common shares outstanding.

Eaton gathered estimates of next fiscal year’s sales, NOPAT an EPS along with the current price, market capitalization and operating (enterprise) value (VOper).

Anthony Inc. Baker Companies Chambers Corp.

Price $/share 15.00 36.48 30.30

Market Data Market Cap $M 3,750 3,100 9,800

Financial Data (FY + 1) Sales NOPAT EPS $M $M $/share 2,000 625 0.40 3,000 520 1.20 10,000 1,600 0.60

OV $M 5,000 3,900 12,000

For each of the comparable firms, calculate the individual firm VOper/Sales, VOper/NOPAT and P/E ratios along with the average ratios of each market multiple. What recommendation should the Eaton’s CFO make regarding Kohler’s equity value?

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

Valuation (FY + 1) VOper /Sales

VOper /NOPAT

P/E

Anthony Inc.

2.5x

8.0x

37.5x

Baker Companies

1.3x

7.5x

30.4x

Chambers Corp.

1.2x

7.2x

50.5x

Average

1.7x

7.6x

39.5x

For the VOper/Sales: Average of 1.7 x $50 million = $83.3 million - $20 million debt = $63.3 million in equity value.

For the VOper/NOPAT: Average of 7.6 x $15 million = $113.5 million - $20 million debt = $93.5 million in equity For the P/E ratio: Average of 39.5 x $2.50 = 98.75 per share x 700,000 shares = $69.125 million in equity Using the averages for the above multiples to Kohler’s expected financial results in a range for the firm’s equity from $63.3 million to $93.5 million. A detailed analysis from full fundamental analysis will provide more information as to the Kohler’s value of equity. © Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-7

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company.

Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors. This will facilitate the application of the valuation steps to similar real-life firms.

For the examination of FedEx (FDX) and United Parcel Service (UPS), we include two additional companies, ZTO Express (ZTO) and Expeditors International (EXPD). ZTO is a leading express delivery company in China. Operating a network partner model for pickup and last-mile delivery services. EXPD provides global logistical services include airfreight and ocean freight along with customer solutions such time-definite transportation, warehousing, temperature-controlled transit and customized logistic solutions.

The table below summarizes the relevant balance sheet metrics as of the latest quarter or year end to the October 1, 2020 measurement date.

(in millions)

FDX

UPS

ZTO

EXPD

Operating value

$106,789

$181,489

$20,496

$14,590

Equity value

$69,248

$147,875

$22,942

$15,166

NOA

$57,003

$37,957

$3,056

$1,583

Book value of equity

$19,462

$4,343

$5,502

$2,159

NFL

$37,541

$33,614

($2,446)

($576)

Sales

$71,490

$77,380

$3,176

$8,602

NOPATt

$2,381

$5,902

$748

$591

NOPATt+1

$4,766

$7,626

$661

$608

NOPATt+2

$5,142

$8,438

$864

$627

Net Income

$230,529

$4,377

$815

$604

262,592 sh.

863,375 sh.

781,947 sh.

167,659 sh.

Common shares outstanding

© Cambridge Business Publishers, 2021 8-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

15.

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

Using the data above for UPS, ZTO and EXPD, estimate the value per share of FDX using an NOA multiple. Determine whether, based on this estimate, FDX is over- or under-priced at its October 1, 2020 price of $263.30. (in millions, except per share)

FDX

UPS

ZTO

EXPD

–

$181,553

$20,496

$14,590

$57,003

$37,957

$3,056

$1,583

Operating value NOA Common shares outstanding NOA market multiple

262,592 sh. 863,375 sh. 781,947 sh. 167,659 sh.

6.90

Operating value

$393,319

Equity value

$355,799

Equity value per share

$1,354.87

4.78

6.71

9.21

Based on the estimate of $1,354.87, FDX was undervalued at October 1, 2020. This estimate represents a significant deviation from FDX’s current share price. Given the differences in the magnitude of the comparables’ NOA, the deviation may be the results of FDX’s economies of scale above ZTO and EXPD.

16.

Continue using the data above for UPS, ZTO and EXPD, estimate the value per share of FDX using a BV multiple. Determine whether, based on this estimate, FDX is over- or under-priced at its October 1, 2020 price of $263.30. 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

FDX

UPS

ZTO

EXPD

–

$147,939

$22,942

$15,166

$19,462

$4,363

$5,502

$2,159

262,592 sh. 863,375 sh. 781,947 sh. 167,659 sh.

15.08

Equity value

$293,487

Equity value per share

$1,117.65

34.06

4.17

7.02

Based on the estimate of $1,117.65, FDX was undervalued at October 1, 2020. This estimate represents a significant deviation from FDX’s current share price. Given the differences in the magnitude of the comparables’ BV, the deviation may be the results of FDX’s economies of scale above ZTO and EXPD. © Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-9

17.

Using the data above for UPS, ZTO and EXPD, estimate the value per share of FDX using a NOPAT multiple. Determine whether, based on this estimate, FDX is over- or under-priced at its October 1, 2020 price of $263.30. Discuss the validity of the result and what drives your conclusions. (in millions, except per share)

FDX

UPS

ZTO

EXPD

–

$181,553

$20,496

$14,590

$2,381

$5,902

$748

$591

Operating value NOPAT Common shares outstanding NOPAT market multiple

262,592 sh. 863,375 sh. 781,947 sh. 167,659 sh.

27.61

Operating value

$65,739

Equity value

$28,199

Equity value per share

$107.39

30.76

27.39

24.67

Based on the estimate of $107.39 per share, FDX was overvalued at October 1, 2020.

18.

Continue using the data above for UPS, ZTO and EXPD, estimate the value per share of FDX using an NI multiple. Determine whether, based on this estimate, FDX is over- or under-priced at its October 1, 2020 price of $263.30. (in millions, except per share) Equity value NI Common shares outstanding NI market multiple

FDX

UPS

ZTO

EXPD

–

$147,939

$22,942

$15,166

$1,786

$4,377

$815

$604

262,592 sh. 863,375 sh. 781,947 sh. 167,659 sh.

29.02

Equity value

$51,830

Equity value per share

$197.38

33.80

28.15

25.12

Based on the estimate of $197.38 per share, FDX was overvalued at October 1, 2020.

© Cambridge Business Publishers, 2021 8-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

19.

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

Using the data above for UPS, ZTO and EXPD, estimate the value per share of FDX using an operating Forward PE multiple. Determine whether, based on this estimate, FDX is over- or underpriced at its October 1, 2020 price of $263.30. (in millions, except per share)

FDX

Operating value

UPS

ZTO

EXPD

– $181,553 $20,496 $14,590

NOPATt+1

$4,760

$7,629

$661

$608

Forward PE

26.27

23.80

31.01

24.00

Implied operating value

$125,045

Equity value

$87,504

Equity value per share

$333.23

Based on the estimate of $333.23, FDX was undervalued at October 1, 2020.

20.

Continue using the data above for UPS, ZTO and EXPD, estimate the value per share of FDX using an operating PEG ratio multiple. Determine whether, based on this estimate, FDX is over- or under-priced at its October 1, 2020 price of $263.30. (in millions, except per share) Operating value

FDX

UPS

ZTO

EXPD

– $181,553 $20,496 $14,590

NOPATt+1

$4,760

$7,629

$661

$608

NOPATt+2

$5,135

$8,441

$864

$627

Short-term NOPAT growth

$375

$812

$203

$19

PEG

3.64

2.24

1.01

7.68

Implied operating value

$136,500

Equity value

$98,959

Equity value per share

$376.86

Based on the estimate of $376.86, FDX was undervalued at October 1, 2020.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-11

21.

Using the data above for UPS, ZTO and EXPD, estimate the value per share of FDX using a sales multiple. Determine whether, based on this estimate, FDX is over- or under-priced at its October 1, 2020 price of $263.30. (in millions, except per share) Operating value Sales Price to Sales

FDX

UPS

ZTO

EXPD

– $181,553 $20,496 $14,590 $71,490

$77,380

$3,176

$8,602

3.50

2.35

6.45

1.70

Implied operating value

$250,215

Equity value

$212,674

Equity value per share

$809.90

Based on the estimate of $809.90 FDX was significantly undervalued at October 1, 2020. It is likely that market has failed to effectively value FDX by this fundamental indicator.

22.

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

For FDX, across the seven estimates above, estimates ranging from $107.39 for the NOPAT market multiple to $1,354.87 for the NOA multiple were found. While certain multiples can be easily dismissed, it still calls into question the use of the methodology for this firm at this time. 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.

© Cambridge Business Publishers, 2021 8-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

23.

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

Using the data above for FDX, ZTO and EXPD, estimate the value per share of UPS using an NOA multiple. Determine whether, based on this estimate, UPS is over- or under-priced at its October 1, 2020 price of $171.35. (in millions, except per share)

UPS

FDX

ZTO

EXPD

–

$106,681

$20,496

$14,590

$37,957

$69,140

$3,056

$1,583

Operating value NOA Common shares outstanding NOA market multiple

863,375 sh. 262,592 sh. 781,947 sh. 167,659 sh.

5.93

Operating value

$225,085

Equity value

$191,471

Equity value per share

$221.77

1.87

6.71

9.21

Based on the estimate of $221.77, UPS was undervalued at October 1, 2020.

24.

Continue using the data above for FDX, ZTO and EXPD, estimate the value per share of UPS using a BV multiple. Determine whether, based on this estimate, UPS is over- or under-priced at its October 1, 2020 price of $171.35. 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

UPS

FDX

ZTO

EXPD

–

$69,140

$22,942

$15,166

$4,363

$19,462

$5,502

$2,159

262,592 sh. 863,375 sh. 781,947 sh. 167,659 sh.

4.91

Equity value

$21,324

Equity value per share

$24.70

3.55

4.17

7.02

Based on the estimate of $24.70, UPS was overvalued at October 1, 2020. This estimate represents a significant deviation from UPS’s current share price. It is unlikely that the market mispriced UPS by a multiple of seven.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-13

25.

Using the data above for FDX, ZTO and EXPD, estimate the value per share of UPS using a NOPAT multiple. Determine whether, based on this estimate, UPS is over- or under-priced at its October 1, 2020 price of $171.35. Discuss the validity of the result and what drives your conclusions. (in millions, except per share)

UPS

FDX

ZTO

EXPD

–

$106,681

$20,496

$14,590

$5,902

$2,381

$748

$591

Operating value NOPAT Common shares outstanding NOPAT market multiple

262,592 sh. 863,375 sh. 781,947 sh. 167,659 sh.

32.29

Operating value

$190,576

Equity value

$156,962

Equity value per share

$181.80

44.81

27.39

24.67

Based on the estimate of $181.80 per share, UPS is undervalued at October 1, 2020.

26.

Continue using the data above for FDX, ZTO and EXPD, estimate the value per share of UPS using an NI multiple. Determine whether, based on this estimate, UPS is over- or under-priced at its October 1, 2020 price of $171.35. (in millions, except per share) Equity value NI Common shares outstanding NI market multiple

UPS

FDX

ZTO

EXPD

–

$69,140

$22,942

$15,166

$4,377

$1,786

$815

$604

262,592 sh. 863,375 sh. 781,947 sh. 167,659 sh.

30.66

Equity value

$134,199

Equity value per share

$155.44

38.71

28.15

25.12

Based on the estimate of $155.44 per share, UPS was overvalued at October 1, 2020.

© Cambridge Business Publishers, 2021 8-14

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 8 - Market Multiple Valuation

27.

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

Using the data above for FDX, ZTO and EXPD, estimate the value per share of UPS using an operating Forward PE multiple. Determine whether, based on this estimate, UPS is over- or underpriced at its October 1, 2020 price of $171.35. (in millions, except per share)

UPS

Operating value

FDX

ZTO

EXPD

– $106,681 $20,496 $14,590

NOPATt+1

$7,629

$4,760

$661

$608

Forward PE

25.81

22.41

31.01

24.00

Implied operating value

$196,904

Equity value

$163,290

Equity value per share

$189.13

Based on the estimate of $189.12, UPS was undervalued at October 1, 2020.

28.

Continue using the data above for FDX, ZTO and EXPD, estimate the value per share of UPS using an operating PEG ratio multiple. Determine whether, based on this estimate, UPS is over- or under-priced at its October 1, 2020 price of $171.35. (in millions, except per share) Operating value

UPS

FDX

ZTO

EXPD

– $106,681 $20,496 $14,590

NOPATt+1

$7,629

$4,760

$661

$608

NOPATt+2

$8,411

$5,135

$864

$627

Short-term NOPAT growth

$812

$375

$203

$19

PEG

3.84

2.84

1.01

7.68

Implied operating value

$311,808

Equity value

$278,194

Equity value per share

$322.22

Based on the estimate of $322.22, UPS was undervalued at October 1, 2020.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 8

8-15

29.

Using the data above for FDX, ZTO and EXPD, estimate the value per share of UPS using a sales multiple. Determine whether, based on this estimate, UPS is over- or under-priced at its October 1, 2020 price of $171.35. (in millions, except per share) Operating value Sales Price to Sales

UPS

FDX

ZTO

EXPD

– $106,681 $20,496 $14,590 $77,380

$71,490

$3,176

$8,602

3.21

1.49

6.45

1.70

Implied operating value

$248.390

Equity value

$214,776

Equity value per share

$248.76

Based on the estimate of $248.76 UPS was significantly undervalued at October 1, 2020. It is likely that market has failed to effectively value FDX by this fundamental indicator.

30.

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

For UPS, across the seven estimates above, estimates ranging from $24.70 for the Book Value market multiple to $322.22 for the PEG 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.

Further, we could form an average close to the observed price by choosing to include all the multiples but PEG ratio ($170.27). However, we would have let the desired outcome of a number close to the trading price of $171.35 drive our choice of information. This is a very dangerous risk in the use of market multiples.

© Cambridge Business Publishers, 2021 8-16

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 9 - Cost of Capital for Operations and Equity

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

What are the two costs that investors expect to recover when providing capital to use in operations?

Investors expect to receive the time of value of money for the funds invested as well as compensation for the operating risk (i.e., the uncertainty of future payoffs). These two components are typically referred as risk-adjusted discount rate.

2.

For an unlevered firm (i.e., no debt), what is the source of risk for its equity cost of capital?

As an owner of a firm with no debt, the risk of ownership is based solely on the operations. Equity cost of capital typically includes the operational risk plus default risk. As an unlevered firm, there is no default risk leaving only the operational risk. This is counterintuitive as equity cost of capital is used to estimated cost of capital for operations.

3.

What are the elements used in computing the weighted average cost of capital for operations?

The weighted average cost of capital for operations is a weighted combination of the cost of equity capital and the cost of debt, where the weights are the market value of equity and debt.

4.

Which is typically less risky, debt or equity? Explain.

Debt tends to be less risky than equity. Debt holders claims to the firm’s net assets have precedence over equity holders as they have only the operational risk to bear. Equity holders hold both operational risk and debt risk.

5.

What are the implications to equity cost of capital when the firm is a “net lender” (having NFA instead of NFL)?

With a net financial asset position, an equity holder has essentially two investments, one in the operations of the firms and a second in the firm’s net financial assets. Typically, the risk of the firm’s operations is greater than the risk of net financial assets resulting in the firm’s cost of equity capital being lower than the firm’s cost of operational capital. The cost of equity capital is a weighted average of the “two investments”.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 9

9-1

6.

In the capital asset pricing model (CAPM), the historical volatility of an individual stock is compared to the historical volatility of the market portfolio. How does this relation facilitate the estimation of a firm’s cost of equity capital?

A measure of a firm’s non-diversifiable risk is calculated from the comparison of the firm’s historical volatility to the market’s historical volatility. Within the CAPM, this relation is referred to as market beta or the risk that cannot be completely diversified away. Together with the risk-free rate and the market risk premium, they are the components of the CAPM that yields an estimate of the cost of equity capital.

7.

What concerns are there with using market beta () in estimating cost of equity capital.

Market beta has a number of limitations with its use in the CAPM. As a backward-looking estimate based on the regression of the share price to a broader market index, there are multiple to ways to calculate the market beta. Thus, market beta inevitably is measured with error. Being a backwardlooking measure, changes in future market conditions or industry shifts that impact a firm’s future equity risk are not reflected in the historical market beta. Another concern includes mean reversion of market beta over time. The implication of a market beta estimate away from the market average, 1.0, will tend toward to the mean over time.

8.

What reasonable tests can be applied to cost of debt capital estimates?

Estimates of cost of debt capital need to be evaluated in context of reasonableness. One such test is whether the cost of debt capital estimate is below the relevant US Treasury rate. It is highly unlikely that firms can access lower borrowing rates than the US government. The risk-free rate should be considered a minimum required return for a debtholder and estimates below that level should not be used. At the upper end, cost of debt capital estimates should not exceed high yield (junk) bonds.

9.

In calculating the weighted average cost of capital for operations, how is the value of debt determined?

The value of debt starts with its book value (NFL) adjusted to market value. The market value for long-term debt is generally reported in the footnotes to the financial statements. The difference between the long-term debt’s carry amount and market value is the market value adjustment to NFL. An additional adjustment is needed for the value of the interest tax shield as the company does not bear the full cost of debt due to its tax deductibility. A common interest tax shield adjustment treats the current interest expense as a perpetuity implying that debt levels will be unchanged in the future. The value of debt is estimated by NFL adjusted for the fair market value of long-term debt and the interest rate tax shield.

© Cambridge Business Publishers, 2021 9-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 9 - Cost of Capital for Operations and Equity

10.

In calculating the weighted average cost of capital for operations, how is preferred stock reflected in the calculation?

When a company has preferred stock, a third component is added to the weighted average cost of capital operations for relative impact of the preferred stock. The value of the operations is the sum of the value of debt, common stock and preferred stock (typically book value is market value is difficult to determine). The cost of preferred stock capital is estimated as the dividend payout rate of the preferred stock.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 9

9-3

EXERCISES 11.

Per ycharts.com, the October 2020 estimates of market beta () for Domino’s Pizza (DPS), Restaurant Brands (QSR) the parent company for Burger King, Tim Hortons and Popeye’s, Darden Restaurants (DRI) the parent company for Olive Garden and LongHorn Steakhouse, were 0.33, 1.20 and 1.25 respectively. What do these beta estimates imply about the riskiness of the equity of these firms?

Domino’s Pizza (beta = 0.33) is considered less risky than both Restaurant Brands and Darden (betas = 1.20 & 1.25, respectively). Given the impact of the Covid-19 pandemic on quick service restaurants and casual dining, Domino’s Pizza with its online presence and delivery services were better adapted to the changing the business environment. The lower market beta reflects the market’s assessment of lower riskiness of DPS over the other companies.

12.

Per ycharts.com, the following is a graphic of market beta () for Nvidia (NDVA) for the three years from 2018 to 2020. What are the potential implications of this information on our estimation of cost of capital for NVDA in particular and other companies in general?

This graph illustrates that market 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.

© Cambridge Business Publishers, 2021 9-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 9 - Cost of Capital for Operations and Equity

13.

Previts Corp. for its current year ending December 31 reported the following data: FEAT

$75.6 million

Beginning NFL

$1,291 million

Ending NFL

$1,569 million

Calculate Previts’ cost of debt capital, rD, assuming the future tax rate is 21.0 percent. rD = 14.

FEAT avg NFL⁄

(1 − 0.21) =

75.6 (1,291+1,569)÷2⁄

(1 − 0.21) = 0.0669 or 6.69%

The Clorox Company (CLX) reported the following information about their long-term debt in the footnotes to its financial statements.

Calculate Clorox’s cost of debt capital, rD, using the pretax borrow rate for long-term debt.

Use the long-term debt to estimate the pretax borrowing rate for debt. The weighted-average cost of debt capital is estimated by the interest rate for each Senior unsecured note and debenture multiplied by the June 30, 2020 carry amount percentage of the total notes carrying amount.

3.80%

$300

0.00356

3.05%

600

0.00572

3.50% 3.10% 3.90%

500 400 500

0.00547 0.00388 0.00609

1.80%

900

0.00506

$3,200

2.98%

The estimated cost of debt capital for Clorox is 2.98%.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 9

9-5

15.

The following data is available for Vatter Inc.

Total Assets

$14,000

Interest-bearing debt

$8,000

Average borrowing rate for debt

5.0%

Common equity: Book value

$5,000

Market value

$25,000

Future marginal income tax rate Market equity beta

21.0% 1.0

a. Assuming the risk-free rate is 4.0% and the market risk premium is 6.0%, calculate Vatter’s cost of equity capital, using the capital asset pricing model.

Cost of equity capital = 4.0% + 1.0 x (11.0% - 5.0%) = 10%

b. What is the value of Vatter’s debt, adjusted for the interest tax shield?

Value of interest tax shield =

$8,000×5.0%×21.0% = $1,680 5.0%

Value of net debt = $8,000 – $1,680 = $6,320 c. Calculate Vatter’s weighted average cost of capital for operations.

𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐷 × = 5% ×

𝑉 𝑁𝐹𝐿 𝑉𝐸𝑞 + 𝑟 × 𝐸𝑞 𝑉 𝑂𝑝𝑒𝑟 𝑉 𝑂𝑝𝑒𝑟

6,320 25,000 + 10% × = 9.0% (6,320 + 25,000) (6,320 + 25,000)

© Cambridge Business Publishers, 2021 9-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 9 - Cost of Capital for Operations and Equity

16.

Calculate the cost of capital for operations (rWACC) for The Schipper Industries. The Schipper financial statement footnotes report the long-term debt’s carry value is $80 million above fair value.

U.S. Government long-term bond rate

1.60%

Market risk premium

6.00%

Equity beta

0.90

Per-share market price

$50.00

Shares outstanding

20.0 million

Average NFL on balance sheet

$1,000.0 million

FEAT

37.5 million

Interest expense

28.3 million

Statutory tax rate

21.0%

Equity cost of capital = 1.60% + [0.90 x 6.00%] = 7.00% Debt cost of capital, pre-tax = [$37.5  (1 – 0.21)]  $1,000 = 4.75% Value of interest tax shield = ($28.3 x 0.21)  4.75% = $125.2

Market value of equity Market value of debt Market value of operations

$ 1,000 ($50.00 per share x 20.0 million shares) 795 ($1,000 - $125.2 - $80) $ 1,795

Cost of capital for operations (WACC) = (4.75%

795 1,,795

) + (7.00%𝑥

1,000 1,795

) = 6.00%

© Cambridge Business Publishers, 2021 Test Bank, Chapter 9

9-7

CONTINUING EXAMPLES 17.

At May 1, 2020, FedEx (FDX) had an adjusted market beta of 1.21 (Bloomberg), the 10-year Treasury Yield was 0.64% and the assumed market risk premium is 6.00 percent. Using this information estimate the required cost of equity capital for FDX at May 1, 2020.

At May 1, 2020 the estimated cost of equity capital (rEq) estimate for FDX is 7.9 percent, which is computed as 0.0064 + [1.21 × (0.0664 – 0.0064)]. This estimate implies that an equity investor requires a return of approximately 7.96 percent for an investment in FDX’s stock. That is, the cost of equity capital for investment in FDX’s stock is 7.96 percent.

18.

For the three approaches to estimating the cost of debt capital, indicate for FedEx (FDX) at May 31, 2019 which of the three estimates might be used as a proxy for the cost of debt capital.

• • •

Pretax return on net financial liabilities (RNFL) - 17.98% Pretax borrowing rate for debt - 7.07% Weighted average interest rate on long-term debt - 3.50%

The selection of cost of debt capital proxy from the three far ranging estimates is as much as on art as it is science. After examining the three estimates of 17.98, 7.07, and 3.50 percent, the choice is to use the median value rounded to the nearest tenth of a percent yielding a proxy for cost of debt capital of 7.10 percent.

© Cambridge Business Publishers, 2021 9-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 9 - Cost of Capital for Operations and Equity

19.

Using the methodology described in the textbook, Appendix A, estimate the cost of equity capital for FedEx (FDX) as of May 1, 2020 from the regression output below. How does this estimate of beta compare to the one on Bloomberg of 1.21?

SUMMARY OUTPUT Regression Statistics Multiple R

0.815955977

R Square

0.665784157

Adjusted R Square

0.660021815

Standard Error

0.050951034

Observations

60

ANOVA df

SS

MS

F

Significance F

115.5405463

1.99484E-15

P-value

Lower 95%

Regression

1

0.299944165

0.299944165

Residual

58

0.150568455

0.002596008

Total

59

0.45051262

Coefficients Standard Error Intercept X Variable 1

-0.01015549 1.331582461

0.006601246 0.123879903

t Stat -1.53842063 10.74897885

Upper 95%

Lower 95.0%

0.129383968 -0.023369323 0.003058337 -0.023369323 0.003058337 1.99484E-15 1.083609893 1.57955503 1.083609893 1.57955503

The beta estimate from the regression is 1.33 as compared to the Bloomberg estimate of 1.21. 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 modules. Differences in the assumed risk-free rate may also exist.

Combining the estimated beta of 1.33 with an assumed market premium of 6.00 percent and an assumed risk-free rate of 0.64 percent at May 1, 2020 yields an estimated cost of equity capital of 8.6 percent (rounded to the nearest tenth), which is computed as 0.0064 + [1.33 × (0.0664 – 0.0064)]. In looking at the estimated beta of 1.33 and the resulting cost of equity capital estimate of 8.6 percent, we may feel these are higher than we are comfortable using. Noting that the beta per Bloomberg is 1.21, we could choose to rely on this value resulting a cost of equity capital to 7.9 percent.

Although we may be more comfortable with and choose to use the 8.6 percent rather than 7.9 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 Test Bank, Chapter 9

Upper 95.0%

9-9

20.

The book value of NFL for FedEx (FDX) is $39,971 at May 31, 2019. The footnotes to the financials report the Company’s long-term debt carry amount is $17,518 and its fair value is $17,800.

Combine this information with the proxies for the cost of equity capital of 8.6 percent and cost of debt capital of 7.1 percent to form an estimate of FDX’s weighted average cost of capital for operations at May 1, 2020.

Additional information includes: At May 1, 2020, FDX price per share was $118.20. Also, per the financials there were 261.25 million shares outstanding for an estimated value of equity of $30,880. The net interest expense of $529 with an assumed future tax rate of 21.0%.

The value of the interest tax shield would be estimated as the net interest expense of $529 divided the cost of debt capital of 7.10 percent yielding a value of $1,565 ((529 x 0.21)  0.071). When combined with the value of debt of $40,253 ($39,971 + fair value adjustment of $282) provided we arrive at an operating value of $69,569 ($30,880 + $40,253 - $1,565). Using this information, we estimate the weighted average cost of capital as:

𝑟𝑊𝐴𝐶𝐶 = (𝑟𝐷 ∙

= (7.10% ∙

𝑉 𝑁𝐹𝐿 − 𝑉 𝐼𝑇𝑆 𝑉𝐸𝑞 ) + (𝑟 ∙ ) 𝐸𝑞 𝑉 𝑂𝑝𝑒𝑟 𝑉 𝑂𝑝𝑒𝑟

40,253 − 1,565 30,880 ) + (8.60% ∙ ) 69,569 69,569 = 7.80 %

© Cambridge Business Publishers, 2021 9-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 9 - Cost of Capital for Operations and Equity

21.

United Parcel Service (UPS) had an adjusted market beta of 1.20 (Bloomberg) immediately prior to the Covid -19 pandemic. Assume any impact of the pandemic is temporary as the prior market beta was relatively stable beforehand. See the graph of UPS’ beta over the two-year period of the valuation date of May 1, 2020.

Calculate the estimated cost of equity capital using the Capital Asset Pricing Model (CAPM) as of May 1, 2020 where the 10-year Treasury Yield was 0.64% and the market risk premium is 6.00 percent.

At May 1, 2020, the estimated cost of equity capital (rEq) estimate for UPS is 7.8 percent (rounded to the nearest tenth), which is computed as 0.0064 + [1.20 × (0.0664 – 0.0064)]. This estimate implies that an equity investor requires a return of approximately 7.8 percent for an investment in UPS’ stock. That is, the cost of equity capital for investment in UPS’ stock is 7.8 percent.

22.

For the three approaches to estimating the cost of debt capital, indicate for United Parcel Service (UPS) at December 31, 2019 which of the three estimates might be used as a proxy for the cost of debt capital.

• • •

Pretax return on net financial liabilities (RNFL) - 14.57% Pretax borrowing rate for debt - 2.72% Weighted average interest rate on long-term debt - 3.30%

The selection of cost of debt capital proxy from the three far ranging estimates is as much as on art as it is science. After examining the three estimates of 14.57, 2.72, and 3.30 percent, the choice is 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 Test Bank, Chapter 9

9-11

23.

Using the methodology described in the textbook, Appendix A, estimate the cost of equity capital for United Parcel Service (UPS) as of May 1, 2020 from the regression output below. How does this estimate compare to the one formed using the Bloomberg beta of 1.20?

SUMMARY OUTPUT

Regression Statistics Multiple R

0.647974041

R Square

0.419870358

Adjusted R Square

0.409868123

Standard Error

0.055847325

Observations

60

ANOVA df

SS

MS

F

Significance F

41.97765296

2.18537E-08

P-value

Lower 95%

Regression

1

0.130925098

0.130925098

Residual

58

0.180897576

0.003118924

Total

59

0.311822674

Coefficients

Standard Error

t Stat

Lower 95.0%

Upper 95.0

Intercept

-0.00427636

0.007235613

-0.5910158

0.556806131 -0.018760014

0.010207291 -0.018760014

0.0102072

X Variable 1

0.879750072

0.135784512

6.479016357

2.18537E-08

1.151552303

1.1515523

0.607947841

Upper 95%

0.607947841

The beta estimate from the regression is 0.88 as compared to the Bloomberg estimate of 1.20. 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 modules. Differences in the assumed risk-free rate may also exist.

Combining the estimated beta of 0.88 with an assumed market premium of 6.00 percent and an assumed risk-free rate of 0.64 percent at May 1, 2020 yields an estimated cost of equity capital of 5.9 percent (rounded to the nearest tenth), which is computed as 0.0064 + [0.88 × (0.0664 – 0.0064)]. In looking at the estimated beta of 0.88 and the resulting cost of equity capital estimate of 5.9 percent, we may feel these are lower than we are comfortable using. Noting that the beta per Bloomberg is 1.20, we may choose to rely on this value resulting a cost of equity capital to 7.8 percent.

Although we may feel more comfortable using the 7.8 percent rather than 5.9 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 9-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 9 - Cost of Capital for Operations and Equity

24.

The book value of NFL for United Parcel Service (UPS) is $35,175 at December 31, 2019. The footnotes to the financials report the Company’s long-term debt carry amount is $25,238 and its fair value is $26,949.

Combine this information with the proxies for the cost of equity capital of 7.8 percent and cost of debt capital of 3.3 percent to form an estimate of UPS’ weighted average cost of capital for operations at May 1, 2020.

Additional information includes: At May 1, 2020, UPS price per share was $91.90. Also, per the financials there were 858.5 million shares outstanding for an estimated value of equity of $78,895.

The net interest expense of $2,146 with an assumed future tax rate of 21.0%.

The value of the interest tax shield would be estimated as the net interest expense of $2,146 divided the cost of debt capital of 3.30 percent yielding a value of $13,656 ((52,146 x 0.21)  0.033). When combined with the value of debt of $36,883 ($35,172 + fair value adjustment of $1,711) provided we arrive at an operating value of $102,122 ($78,895 + $36,883 - $13,656). Using this information, we estimate the weighted average cost of capital as:

𝑟𝑊𝐴𝐶𝐶 = (𝑟𝐷 ∙

= (3.30% ∙

𝑉 𝑁𝐹𝐿 − 𝑉 𝐼𝑇𝑆 𝑉𝐸𝑞 ) + (𝑟 ∙ ) 𝐸𝑞 𝑉 𝑂𝑝𝑒𝑟 𝑉 𝑂𝑝𝑒𝑟

36,883 − 13,656 78,895 ) + (7.80% ∙ ) 102,122 102,122 = 6.80 %

© Cambridge Business Publishers, 2021 Test Bank, Chapter 9

9-13

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 10 - Valuation Using Forecasts of Cash Flows

Chapter 10 Valuation Using Forecasts of Cash Flows QUESTIONS 1.

Do analysts typically forecast free cash flows (FCFs) directly or indirectly?

Most forecasts of FCFs are typically inferred from earnings forecasts as direct forecasting is challenging in determining the amount and timing of the future cash flows. Indirect cash flow forecasts based on forecasts of earnings (e.g., NOPAT) and assets (e.g., NOA) are easier to form and ensure the reasonableness of FCFs from an adequate asset base and earnings.

2.

Describe the relation between free cash flows (FCF) and operating earnings (NOPAT).

Free cash flows are defined as the operating earnings in excess of the change in net operating assets. That is, FCFt  NOPATt - NOAt. Assuming a constant change in NOA, free cash flows change directly with NOPAT. As NOPAT grows, so do FCFs.

3.

In choosing between $1,000 today and $1,100 a year from today, which amount would an investor prefer if the required annual rate of return is (a) 8.0%, (b) 10.0% or (c) 12.0%?

An investor prefers the amount with the greatest present value (i.e., value today). For the $1,000 today, the present value is $1,000. For the $1,100 option, the amount needs to be discounted to its present value with the required rate of return. a. $1,000 or $1,100 in year discounted at 8.0% (

$1,100 ) = $1,018.52? $1,100 in one year is 1+0.08

preferred. b. $1,000 or $1,100 in year discounted at 10.0% (

$1,100 1+0.10

) = $1,000.00? The investor is indifferent

between the two options. c. $1,000 or $1,100 in year discounted at 8.0% (

$1,100 ) = $892.86? $1,000 today is preferred.

1+0.12

© Cambridge Business Publishers, 2021 Test Bank, Chapter 10

10-1

4.

For analyzing a project, how does an accounting profit differ from economic profit?

Accounting profits are reported in nominal amounts while economic profits are based on real amounts. Over the life of the project, the net revenues less expenses and investments determine whether the project returned an accounting profit. Essentially, the total net cash flows from the project represent the project’s accounting profit. To determine an economic profit, the payoffs are discounted back and netted against the initial investment. Economic profit and net present value (NPV) represent the economic return of the project. It is not unusual for a project to yield an accounting profit, yet not provide an economic profit.

5.

When analyzing a project that has a positive net present value (NPV), what are the implications for accepting the project?

Having a positive net present value (NPV) implies that the project is economically viable as the present value of the cash inflows is greater than the present value of the cash outflows. However, a project with positive NPV is not sufficient for it to be accepted. There are numerous non-financial reasons for rejecting an economically viable project. For example, the project may not be consistent with the company’s strategy, may not fit within the current portfolio of other projects, or may not be economically competitive with other proposed projects.

6.

When estimating the continuing value (CV) within a discounted cash flow (DCF) valuation model, what assumption is made about the future payoffs beyond the forecast horizon?

In a DCF valuation, the free cash flows (FCFs) are assumed to follow a predictable pattern beyond the forecast horizon. In most models, the FCFs are assumed to grow at a constant rate indefinitely.

The last estimated FCF in the forecast horizon is assumed to grow at a constant growth rate, g, discounted by the cost of operating capital, rWACC, less the constant growth rate, g.

7.

When estimating the continuing value (CV) within a discounted cash flow (DCF) valuation model, what are the expectation of the future free cash flows (FCFs) when the expected growth rate, g, is (a) greater than zero but less than the cost of operating capital, rWACC, (b) equal to zero, and (c) is between -1.0 and zero? a. When the expected growth rate is positive and less than the cost of operating capital, r WACC, the future FCFs are expected to grow at a constant rate following the forecast horizon. This growth rate would be appropriate for a company that is expected to continue growing its operations. b. When the expected growth rate is equal to zero, the future FCFs are expected to remain constant following the forecast horizon. This growth rate would be appropriate for a company is at maturity with no expected growth or decline. c. When the expected growth rate is negative (-1.0 to 0), the future FCFs are expected to decline following the forecast horizon. This growth rate would be appropriate for a company in decline.

© Cambridge Business Publishers, 2021 10-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 10 - Valuation Using Forecasts of Cash Flows

8.

When estimating the continuing value (CV) within a discounted cash flow (DCF) valuation model, the assumption of a constant growth rate, g, is appropriate under what conditions?

When the forecast horizon has reached its steady state (expected future free cash flows (FCFs) will grow at a constant rate), all subsequent growth will occur at the rate of g. When the FCF growth rate stabilizes, the estimated growth rate will be constant beyond the forecast horizon. For high growth companies, the forecast horizon can be many years before achieving its steady state.

9.

For most discounted cash flow (DCF) valuations, explain whether the majority of the company’s estimated value is captured in its forecast horizon or its continuing value.

In most DCF valuations, the continuing value captures more of the firm’s value than is captured by the forecast horizon. Near term estimates, which the analyst has the highest confidence in, typically capture a small percentage of the company’s value. This fact raises concerns as to the reliability of the longer-term estimates of the company’s valuation.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 10

10-3

EXERCISES 10.

The Stans Corporation is evaluating an opportunity to invest a project expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price

$3,500

Payoffs: Year 1

$900

Year 2

1,400

Year 3

1,250

Year 4

850

Proceeds from disposition

500

In addition, the anticipated risk of the project implies a cost of capital of 12.0 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

12.0%

Forecast year

0

Revenues

1 900

2

3

4

1,400

1,250

Disposition

850 500

Discount factor Present value of cash flow Total present value of cash flows

3,668

Value of project

3,668

Less investment

3,500

Net present value

168

1.1200

1.2544

1.4049

1.5735

804

1,116

890

858

The net present value is positive, so the project is economically viable. The project is anticipated to result in an increase in value of $168. *Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 10-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 10 - Valuation Using Forecasts of Cash Flows

11.

The Grady Companies is evaluating an opportunity to invest a project expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price Payoffs: Year 1 Year 2 Year 3 Year 4 Proceeds from disposition

$3,500 $900 1,100 1,200 750 250

In addition, the anticipated risk of the project implies a cost of capital of 10.0 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

10.0%

Forecast year

0

Revenues

1 900

Disposition Discount factor Present value of cash flow Total present value of cash flows

3,312

Value of project

3,312

Less investment

3,500

Net present value

(188)

2

3

4

1,100

1,200

750

1.1000

1.2100

1.3310

250 1.4641

818

909

902

683

The net present value is negative, so the project is not economically viable. The project is anticipated to result in a loss in value of $188. *Note to instructor that depending on rounding, student’s answer may differ slightly.

12.

If you invested $100,000 today in a fund that earns 12% compounded annually, to what amount will the investment grow in 5 years?

From Equation 10.4, we can solve as follows: 𝑉0 =

𝑉𝑇 (1 + 𝑟)𝑇

100,000 =

𝑉5 (1 + 0.12)5

100,000 𝑥 1.125 = 𝑉5 𝑉5 = 176,234 © Cambridge Business Publishers, 2021 Test Bank, Chapter 10

10-5

13.

To have $100,000 in 10 years, how much would you invest today if you can earn 8% compounded annually?

From Equation 10.4, we can solve as follows: 𝑉0 =

𝑉𝑇 (1 + 𝑟)𝑇

𝑉0 =

100,000 (1 + 0.08)10

100,000 ÷ 1.0810 = 𝑉𝑜 𝑉0 = 50,835

14.

The “Rule of 72” is a rule of thumb technique used to determine the length of time for an investment to double in value. The formula is Years to Double=

72 .

Interest Rate

Confirm whether the Rule of 72 approximates the value for a given interest rate (e.g., 10.0%).

Rule of 72 = Years to Double =

72 72 or Years to Double = = 7.2 years Interest Rate 10

From Equation 10.4, we can solve as follows: 𝑉0 =

𝑉𝑇 (1 + 𝑟)𝑇

100 =

200 (1 + 0.10)𝑇

1.10𝑇 = 2 𝑙𝑛1.10𝑇 = 𝑙𝑛2 𝑇𝑙𝑛1.10 = 𝑙𝑛2 𝑇=

𝑙𝑛2 𝑙𝑛1.10

𝑇 = 7.27 𝑦𝑒𝑎𝑟𝑠 As a general rule, the Rule of 72 provides a close approximation of the length of time needed to double the value of an investment for a given annual interest rate.

© Cambridge Business Publishers, 2021 10-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 10 - Valuation Using Forecasts of Cash Flows

15.

The recent sales, NOPAT and NOA of ACME Inc. for the year ended December 31, 2020, as well as forecasts for 2021 to 2023 are shown below. Assume that the cost of capital of operations for AMCE is 10%.

Time period Forecasted sales

2020A

2021E

2022E

2023E

100,000

102,000

104,040

106,120

15,300

15,606

15,918

26,010

26,530

27,061

NOPAT NOA

25,500

Calculate the value of AMCE’s operations as of December 31, 2020 using the discounted cash flow (DCF) valuation model.

Required rate of return (rWACC)

10.0%

Growth rate (g)

2.0% 2020

2021

2022

2023

Forecasted sales

102,000

104,040

106,121

NOPAT

15,300

15,606

15,918

26,010

26,530

27,061

14,790

15,086

15,387

1.10

1.21

1.331

13,445

12,468

11,560

NOA

25,500

FCF (NOPAT - ∆NOA) Discount factor (1 + rWACC) PV Sum of PV

37,473

CV

196,184

PV of CV

147,396

Operating value

184,869

In both 2022 and 2023, the FCF has grown by 2% so it is assumed this growth rate will continue beyond the horizon. CV = (15,387 * 1.02) / (0.10 – 0.02) *Note to instructor that depending on rounding, student’s answer may differ slightly.

16.

Mautz Incorporated generated $10.0 million in free cash flows (FCF) for the fiscal year just ended and expects FCFs to increase 4% per year indefinitely. What is Mautz’ operating value (VOper) if its cost of operating capital (WACC) is 7.0%?

Value of operations is current FCF, $10.0 million, divided by Mautz’ WACC less the expected growth rate or $10.0 million  (7.0% - 4.0%) or $333.3 million. © Cambridge Business Publishers, 2021

Test Bank, Chapter 10

10-7

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors.

This will facilitate the application of the valuation steps to similar real-life firms.

17.

Using the following forecast assumptions for FedEx (FDX), the weighted average cost of capital for operations of 7.8 percent and a continuing growth in cash flows beyond the forecast horizon of 3.0 percent, calculate the value of FDX’s operations.

FY2019A

FY2020E FY2021E

FY2022E FY2023E

FY2024E FY2025E

Assumptions: Sales growth

6.59%

5.60%

4.56%

4.20%

3.70%

3.00%

Operating PM

5.93%

5.93%

6.24%

6.15%

6.15%

6.15%

Operating ATO

1.291

1.318

1.290

1.299

1.299

1.299

Forecast (millions):

FY2019A

FY2020E FY2021E

FY2022E FY2023E

FY2024E FY2025E

Sales

$69,693

$74,284

$78,441

$82,017

$85,462

$88,624

$91,283

4,405

4,652

5,118

5,256

5,450

5,614

59,537

63,563

65,806

68,240

70,288

72,396

∆NOA

2,014

4,027

2,242

2,435

2,047

2,109

FCF (NOPAT–∆NOA)

2,391

625

2,876

2,821

3,403

3,505

NOPAT NOA

57,523

Continued

© Cambridge Business Publishers, 2021 10-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 10 - Valuation Using Forecasts of Cash Flows

Required rate of return (rWACC) Time period

7.8% FY2020

FY2021

FY2022

FY2023

FY2024

FY2025

Sales

74,284

78,441

82,017

85,462

88,624

91,283

NOPAT

4,405

4,652

5,118

5,256

5,450

5,614

59,537

63,563

65,806

68,240

70,288

72,396

∆NOA

2,014

4,027

2,242

2,435

2,047

2,109

FCF (NOPAT–∆NOA)

2,391

625

2,876

2,821

3,403

3,505

-73.87% 360.18%

-1.89%

20.63%

3.00%

NOA

FY2019

57,523

Growth in FCF Discount factor (1 + rWACC)t

1.0780

1.1621

1.2527

1.3504

1.4558

Present value of cash flow from operations

2,218

538

2,295

2,089

2,338

Sum of present value of cash flows

9,478

Continuing value FCF at horizon

3,505

Capitalized

73,026

Present value of continuing value

50,163

Operating value

59,641

* Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 10

10-9

18.

Using the following forecast assumptions for United Parcel Service (UPS), the weighted average cost of capital for operations of 6.8 percent and a continuing growth in cash flows beyond the forecast horizon of 2.8 percent, calculate the value of UPS’ operations.

FY2019A

2020E

2021E

2022E

2023E

2024E

2025E

Sales growth

2.90%

2.80%

2.56%

2.60%

2.70%

2.80%

Operating PM

8.11%

7.68%

7.61%

7.47%

7.45%

7.45%

Operating ATO

2.063

2.050

2.049

2.062

2.062

2.062

Assumptions:

Forecast (millions):

FY2019A

2020E

2021E

2022E

2023E

2024E

2025E

Sales

$74,094

$74,284

$78,441

$82,017

$85,462

$88,624

$91,283

6,183

6,020

6,117

6,161

6,310

6,487

38,233

39,229

40,002

41,082

42,232

43,415

962

996

773

1,080

1,150

1,182

5,222

5,024

5,345

5,081

5,160

5,305

NOPAT NOA

37,271

∆NOA FCF (NOPAT–∆NOA)

Continued

© Cambridge Business Publishers, 2021 10-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 10 - Valuation Using Forecasts of Cash Flows

Required rate of return (rWACC)

6.8%

Time period

2019

2020

2021

2022

2023

2024

2025

Sales

76,245

78,384

80,388

82,478

84,705

87,076

NOPAT

6,183

6,020

6,117

6,161

6,310

6,487

38,233

39,229

40,002

41,082

42,232

43,415

962

996

773

1,080

1,150

1,182

5,222

5,024

5,345

5,081

5,160

5,305

-3.79%

6.40%

-4.94%

1.56%

2.80%

NOA

37,271

∆NOA FCF (NOPAT–∆NOA) Growth in FCF Discount factor (1 + rWACC)t

1.0680

1.1406

1.2182

1.3010

1.3895

Present value of cash flow from operations

4,889

4,404

4,388

3,905

3,714

Sum of present value of cash flows

21,300

Continuing value FCF at horizon

5,305

Capitalized

132,617

Present value of continuing value

95,443

Operating value

116,743

* Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 10

10-11

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

Chapter 11 Valuation Using the Residual Operating Income Model QUESTIONS 1.

Explain the concept of residual operating income (ROPI).

Residual operating income is the earnings over and above the required return from the net operating assets (NOA). For a given investment in NOA, the cost of operating capital, (r WACC) determines the expected return. The operating income (NOPAT) is compared to the expected return. If NOPAT is greater than the required return, the excess income is called residual operating income (ROPI). Residual operating income can be positive, negative or equal to zero.

2.

Why is a positive residual operating income (ROPI) an indication of value creation?

When operating income (NOPATt) exceeds the required return (rWACC x NOAt) the company is earning a return above its required return. That is, the firm is creating value. When residual operating income (ROPI) is equal to the required return (i.e., NOPAT t = rWACC x NOAt), the firm earns the cost of its operating capital. When ROPI is positive, the firm earns more than is required for its net investment in operations (i.e., NOA). The excess income over the required return represents the value created beyond what is required.

3.

What are the drivers of the residual operating income model (ROIM)?

Residual operating income (ROPI) is a function of net operating assets (NOA) and net operating profit after tax (NOPAT). Specifically, ROPIt = NOPATt - rWACC x NOAt . Value is created from increasing NOPAT for a given NOA (i.e. earning more from the same net investment in operations).

Additionally, value is created by additional investments to NOA earning a positive residual operating income. Growth in both NOPAT and NOA, when earning a positive ROPI, will drive ROPI.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-1

4.

Does a residual operating income model (ROIM) capture the value created by internally created intangible assets that are not reflected on the firm’s balance sheet (e.g., Disney’s Mickey Mouse or Facebook’s algorithms)? Explain.

Yes, the residual operating income model (ROIM) captures the impact of internally created intangible assets not reported on the balance sheet. In a ROPI model, the two drivers are net operating asset (NOA) and net operating profit after tax (NOPAT). While NOA is understated from an economic asset perspective due to the intangible asset being omitted, the resulting NOPAT from the accounting net operating assets plus the unrecorded economic assets will capture the value creation from all assets, recorded or not.

5.

Does an accounting policy choice (e.g., depreciation method) impact the company’s economic valuation?

No, accounting policy choices should not affect the company’s valuation. Whether depreciation methods or capitalize versus expense decisions (e.g., research and development), the fundamental economic transactions do not change. Accordingly, the valuation will not change either. The primary impact on accounting policy choice is on the accruals, not the cash flows. Only if an accounting policy choice changes cash flows (e.g., LIFO causing changes in timing of tax payments), then the company’s valuation will change as well.

6.

To form forecasts for the residual operating income model (ROIM), what aspects of operations must be forecasted?

The residual operating income model (ROIM) requires forecasts of sales growth, PM, and ATO. Forecasts of Operating PM will provide the estimates of NOPAT based on expected sales, and forecasts of Operating ATO will provide the required level of NOA necessary to support the sales.

With the NOPAT and NOA estimates, we can compute ROPI. Note, the same forecasts are required for the discounted cash flows (DCF) model to estimate free cash flows (FCF).

7.

In a residual operating income model (ROIM), what does the continuing value represent?

Continuing value is the expected difference between the intrinsic value and book value of a firm’s operations at the forecast horizon. The continuing value is estimated by expected residual operating income (ROPI) at the forecast horizon projected to grow at a rate, g, indefinitely. The expected ROPI following the forecast horizon is discounted back to the horizon at r WACC - g.

8.

When estimating the continuing value (CV) within a residual operating income model (ROIM), what is the implication when CV is (a) positive (b) equal to zero, and (c) negative? a. When the continuing value (CV) is positive, the firm is expected to earn an operating return greater than the required rate of operating capital, r WACC. The firm will continue to create value beyond the forecast period. b. When the continuing value (CV) is equal to zero, the firm is expected to earn an operating return equal to its required rate of operating capital, r WACC.. The firm will not create value beyond the forecast period.

© Cambridge Business Publishers, 2021 11-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

c. When the continuing value (CV) is negative, the firm is expected to earn an operating return less its required rate of operating capital, rWACC.. The firm will destroy value beyond the forecast period.

9.

In the residual operating income model (ROIM), identify the components of operating value.

Operating value in a residual operating income model (ROIM) is the net operating assets, NOA 0, plus the present value of the forecasted residual operating income (ROPI) within the horizon and the continuing value (CV). That is, the value of operations is the book value of the NOA0 plus the present value of the expected future NOPAT earnings over the required return (r WACC x NOAt)

10.

What is the assumption regarding growth, g, that allows the valuation to be the same for the discounted cash flow (DCF) model and the residual operating income model (ROIM)?

For the discounted cash flow (DCF) model, growth, g, represents the growth of the free cash flows (FCFs) following the forecast horizon. For the residual operating income model (ROIM), growth, g, represents the growth of the residual operating income (ROPI) following the forecast horizon. For the valuation of both the DCF and ROIM models to be equal, the growth in the FCFs has to be the same as the growth in the ROPI.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-3

EXERCISES 11.

The Stans Corporation is evaluating an opportunity to invest a project expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price Payoffs: Year 1 Year 2 Year 3 Year 4 Proceeds from disposition

$3,500 $900 1,400 1,250 850 500

In addition, the anticipated risk of the project implies a cost of capital of 12.0 percent would be appropriate. Using the residual operating income method (ROIM), determine the value of the project and evaluate whether it is economically viable to make an investment in this project.

Assume straight-line depreciation such that there would be no gain or loss anticipated at the end of the project.

Cost of capital Forecast year Revenues Depreciation Gain on sale Net income (NOPAT) “Dividends” Book value of project (NOA) Net income Expected income given book value Residual operating income Discount factor Present value of residual income Total of present value of residual income Value of project

12.0% 0

3,500

1 900 (750)

2 1,400 (750)

3 1,250 (750)

4

150 900 2,750

650 1,400 2,000

500 1,250 1,250

850 (750) 0 100 1,350 0

150 420 (270) 1.1200 (241)

650 330 320 1.2544 255

500 240 260 1.4049 185

100 150 (50) 1.5735 (32)

167 3,667

The value of the project, $3,667 is higher than the cost of the project, $3,500, so the investment is economically viable. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior module using discounted free cash flows. * Note to instructor that depending on rounding, student’s answer may differ slightly. © Cambridge Business Publishers, 2021 11-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

12.

The Grady Companies is evaluating an opportunity to invest a project expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price Payoffs: Year 1 Year 2 Year 3 Year 4 Proceeds from disposition

$3,500 $900 1,100 1,200 750 250

In addition, the anticipated risk of the project implies a cost of capital of 10.0 percent would be appropriate. a. Assume straight-line depreciation such that there would be no gain or loss anticipated at the end of the project. Using the residual operating income method (ROIM), determine the value of the project and evaluate whether it is economically viable to make an investment in this project.

Cost of capital

10.0%

Forecast year

0

1

2

3

4

Revenues

900

1,100

1,200

750

Depreciation

(813)

(813)

(813)

(811)

Gain on sale

0

Net income (NOPAT)

87

287

387

(61)

900 2,687

1,100 1,874

1,200 1,061

1,000 0

Net income

87

287

387

(61)

Expected income given book value

350

269

188

106

Residual operating income

(263)

18

200

(167)

Discount factor Present value of residual income

1.1000 (239)

1.2100 15

1.3310 150

1.4641 (114)

"Dividends" Book value of project (NOA)

3,500

Total present value of residual income

(188)

Value of project

3,312

The value of the project, $3,312 is lower than the cost of the project, $3,500, so the investment is not economically viable. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior module using discounted free cash flows. * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-5

b. Assume the Grady Companies choices to record depreciation at $600 per year with $1,100 expected residual value. Use the residual operating income valuation model (ROIM) to value the project with the same cash flows as above. 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

Revenues

900

1,100

1,200

750

Depreciation

(600)

(600)

(600)

(600)

Loss on sale

(850)

Net income (NOPAT)

300

500

600

(700)

"Dividends"

900

1,100

1,200

1,000

2,900

2,300

1,700

0

300

500

600

(700)

350 (50) 1.1000

290 210 1.2100

230 370 1.3310

170 (870) 1.4641

(45)

174

278

(594)

Book value of project (NOA)

3,500

Net income Expected income given book value Residual operating income Discount factor Present value of residual income Total present value of residual income

(187)

Value of project

3,313

The value of the project, $3,313 is lower than the cost of the project, $3,500, so the investment is not economically viable even with the shift in income with depreciation. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior module using discounted free cash flows (beyond rounding). * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 11-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

13.

The recent sales, NOPAT and NOA of ACME Inc. for the year ended December 31, 2020, as well as forecasts for 2021 to 2023 are shown below. Assume that the cost of capital of operations for AMCE is 10%.

Time period

2020A

2021E

2022E

2023E

Forecasted sales

100,000

102,000

104,040

106,120

15,300

15,606

15,918

26,010

26,530

27,061

NOPAT NOA

25,500

Calculate the value of AMCE’s operations as of December 31, 2020 using the residual operating income model (ROIM).

Required rate of return (rWACC)

10.0%

Growth rate (g)

2.0% 2020

2021

2022

2023

Forecasted sales

102,000

104,040

106,121

NOPAT

15,300

15,606

15,918

26,010

26,530

27,061

ROPIt (NOPATt - rWACC x NOAt-1)

12,750

13,005

13,265

Discount factor (1 + rWACC)

1.100

1.210

1.331

PV

11,591

10,748

9,966

NOA

Sum of PV

25,500

32,305

CV

169,129

PV of CV

127,069

Operating value

184,874

In both 2022 and 2023, the residual operating income (ROPI) has grown by 2% so it is assumed this growth rate will continue beyond the horizon. CV = (13,265 * 1.02) / (0.10 – 0.02) * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-7

14.

Edwards Inc. completed the year with sales of $15.0 million and NOPAT of $1.8 million. Net operating assets (NOA) at year end is $22.5 million. Management estimates for the next three years, sales will grow at 10.0, 8.0 and 5.0 percent per year then continuing at 5.0 percent indefinitely. The operating profit margin (PM) of 18 percent and operating asset turnover (ATO) of 0.75 times will continue going forward. a. Using the residual operating income model (ROIM), calculate Edwards’ operating value with a 10.0 percent weighted-average cost of capital (WACC).

Required rate of return (rWACC)

Forecasted sales ($ thousands)

10.0% Current

Year 1

Year 2

Year 3

Year 4

15,000

16,500

17,820

18,711

19,647

2,970

3,208

3,368

23,760

24,948

26,196

720

832

873

15.6%

5.0%

1.100

1.210

1.331

655

688

656

NOPAT NOA

22,500

ROPIt (NOPATt - rWACC x NOAt-1) Growth in ROPI Discount factor (1 + rWACC) PV of ROPI Sum of PV of ROPI

1,999

Continuing Value (CV) ROPI4 = ROPI3 x (1 + 0.05)

917

ROPI4 ÷ (0.10 - 0.05)

18,340

PV of CV

13,779

Operating value

38,278

* Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 11-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

b. Edwards Inc. is evaluating an acquisition of Bell Corp. The resulting entity, The Edwards and Bell Companies, will have combined sales of $25.0 million, an operating profit margin (PM) of 15.0 percent and an operating asset turnover (ATO) of 0.85 times. The combined net operating assets will be $33.0 million. Edwards and Bell expects an increase in sales of 15.0 percent in the first year following the acquisition. The second- and third-year sales increases are expected to be 10.0 percent and 5.0 percent, respectfully. The subsequent sales growth will continue at 5.0 percent. Using the residual operating income model (ROIM) as well as assuming no changes to the weighted-average cost of capital (rWACC) and the forecasted PM and ATO, what is the maximum amount that Edwards should pay to acquire Bell?

The difference in the operating value of Edwards as a stand-alone company versus the combined companies, Edwards and Bell, provides the maximum which Edwards would pay for Bell Corp.

Required rate of return (rWACC)

Forecasted sales ($ thousands)

10.0% Current

Year 1

Year 2

Year 3

Year 4

25,000

28,750

31,625

33,206

34,866

4,313

4,744

4,981

37,206

39,066

41,019

1,013

1,023

1,074

1.0%

5.0%

1.100

1.210

1.331

921

845

807

NOPAT NOA

33,000

ROPIt (NOPATt - rWACC x NOAt-1) Growth in ROPI Discount factor (1 + rWACC) PV of ROPI Sum of PV of ROPI

2,573

Continuing Value (CV) ROPI4 = ROPI3 x (1 + 0.05)

1,128

ROPI4 ÷ (0.10 - 0.05)

22,560

PV of CV

16,950

Operating value

52,523

The change in operating value from the proposed acquisition of Bell is $14,245 ($52,523 – $38,278) which represents the maximum amount Edwards would consider to pay to acquire Bell. * Note to instructor that depending on rounding, student’s answer may differ slightly. © Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-9

15.

At the end of the current year, Beresford Ltd. had net operating assets (NOA) of $7.5 million. Using a weighted-average cost of capital (rWACC) of 7.0 percent, the present value of the next four years of the estimated residual operating income (ROPI) is $2.5 million. a. Assume that the ROPI at the forecast horizon is $1.0 million. Following the forecast horizon, it is expected that Beresford’s NOPAT will equal 7.0 percent of its NOA. That is, the expected ROPI beyond the forecast horizon is zero. What is Beresford’s operating value as of the end of the current year using a residual operating income model (ROIM)?

With expected NOPAT beyond the forecast horizon equal to 7.0 percent of NOA, there is no residual income. That is, Beresford is earning at its required return resulting in no expected residual operating earnings. Thus, the continuing value is zero.

Beresford’s Operating Value ($ thousands) Net operating assets - Current year

$7,500

Present value of forecast ROPI

2,500

Continuing value

0

Operating Value

$10,000

Beresford’s operating value is $10,000 million b. Assume that the ROPI at the forecast horizon is $1.0 million. Following the forecast horizon, it is expected that Beresford’s ROPI will not grow, but remain constant indefinitely. What is Beresford’s operating value as of the end of the current year using a residual operating income model (ROIM)?

With expected ROPI beyond the forecast horizon to remain constant, there is no expected growth in ROPI. Beresford’s continuing value is the present value of the capitalized ROPI at the forecast horizon.

Beresford’s Operating Value ($ thousands) Net operating assets - Current year

$7,500

Present value of forecast ROPI

2,500

Continuing value

10,899

Operating Value

$20,899

($1,000 ÷ 0.07) ÷ 1.074

Beresford’s operating value is $20,899 million * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 11-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

c. Assume that the ROPI at the forecast horizon is $1.0 million. Following the forecast horizon, it is expected that Beresford’s ROPI will grow at 4.0 percent per year. What is Beresford’s operating value as of the end of the current year using a residual operating income model (ROIM)?

Beresford’s continuing value is the present value of the capitalized ROPI at the forecast horizon growing at 4 percent.

Beresford’s Operating Value ($ thousands) Net operating assets - Current year

$7,500

Present value of forecast ROPI

2,500

Continuing value

26,447

Operating Value

$36,447

(($1,000 x 1.04) ÷ (0.07 – 0.04)) ÷ 1.074

Beresford’s operating value is $36,447 million * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-11

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors.

This will facilitate the application of the valuation steps to similar real-life firms.

16.

Using the following forecast assumptions for FedEx (FDX), the weighted average cost of capital for operations of 7.8 percent and a continuing growth in residual operating income (ROPI) beyond the forecast horizon of 3.0 percent, calculate the value of FDX’s operations.

FY2019A

FY2020E FY2021E

FY2022E FY2023E

FY2024E FY2025E

Assumptions: Sales growth

6.59%

5.60%

4.56%

4.20%

3.70%

3.00%

Operating PM

5.93%

5.93%

6.24%

6.15%

6.15%

6.15%

Operating ATO

1.291

1.318

1.290

1.299

1.299

1.299

Forecast (millions):

FY2019A

FY2020E FY2021E

FY2022E FY2023E

FY2024E FY2025E

Sales

$69,693

$74,284

$78,441

$82,017

$85,462

$88,624

$91,283

4,405

4,652

5,118

5,256

5,450

5,614

59,537

63,563

65,806

68,240

70,288

72,396

2,014

4,027

2,242

2,435

2,047

2,109

NOPAT NOA

57,523

∆NOA

© Cambridge Business Publishers, 2021 11-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

Required rate of return (rWACC)

7.80%

Time period

FY2019

FY2020

FY2021

FY2022

FY2023

FY2024

FY2025

Sales

74,284

78,441

82,017

85,462

88,624

91,283

NOPAT

4,405

4,652

5,118

5,256

5,450

5,614

59,537

63,563

65,806

68,240

70,288

72,396

-82

8

160

123

128

131

-109.40% 1980.52% -23.05%

3.70%

3.00%

NOA

57,523

ROPIt (NOPATt – rWACC ∙x NOAt-1) Growth in ROPI Discount factor (1 + rWACC)t Present value of ROPIt Sum of present value of ROPI

1.0780

1.1621

1.2527

1.3504

1.4558

-76

7

128

91

88

237

Continuing value ROPI at horizon

131

Capitalized

2,738

Present value of continuing value

1,881

Operating value

59,641

The use of the residual operating income model (ROIM) provides the same valuation as the discounted cash flow (DCF) model. * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-13

17.

Using the following forecast assumptions for United Parcel Service (UPS), the weighted average cost of capital for operations of 6.8 percent and a continuing growth in residual operating income (ROPI) beyond the forecast horizon of 2.8 percent, calculate the value of UPS’ operations.

FY2019A

2020E

2021E

2022E

2023E

2024E

2025E

Sales growth

2.90%

2.80%

2.56%

2.60%

2.70%

2.80%

Operating PM

8.11%

7.68%

7.61%

7.47%

7.45%

7.45%

Operating ATO

2.063

2.050

2.049

2.062

2.062

2.062

Assumptions:

Forecast (millions):

FY2019A

2020E

2021E

2022E

2023E

2024E

2025E

Sales

$74,094

$74,284

$78,441

$82,017

$85,462

$88,624

$91,283

6,183

6,020

6,117

6,161

6,310

6,487

38,233

39,229

40,002

41,082

42,232

43,415

NOPAT NOA

37,271

© Cambridge Business Publishers, 2021 11-14

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 11 - Valuation Using the Residual Operating Income Model

Required rate of return (rWACC)

6.8%

Time period

2019

2020

2021

2022

2023

2024

2025

Sales

76,245

78,384

80,388

82,478

84,705

87,076

NOPAT

6,183

6,020

6,117

6,161

6,310

6,487

38,233

39,229

40,002

41,082

42,232

43,415

3,649

3,420

3,450

3,441

3,517

3,615

-6.28%

0.87%

-0.26%

2.21%

2.80%

NOA

37,271

ROPIt (NOPATt – rWACC ∙x NOAt-1) Growth in ROPI Discount factor (1 + rWACC)t

1.0680

1.1406

1.2182

1.3010

1.3895

Present value of ROPIt

3,417

2,998

2,832

2,645

2,531

Sum of present value of ROPI

14,423

Continuing value ROPI at horizon

3,615

Capitalized Present value of continuing value

65,049

Operating value

116,743

The use of the residual operating income model (ROIM) provides the same valuation as the discounted cash flow (DCF) model. * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 11

11-15

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 12 - Valuation using the Abnormal Operating Growth Income Model

Chapter 12 Valuation using the Abnormal Operating Growth Income Model QUESTIONS 1.

Describe the two components of the abnormal operating income growth model (AOIGM).

The abnormal operating income growth model (AOIGM) is based on continued steady-state value plus a future value based on expected value creation. The steady-state value is the current NOPAT earnings capitalized at the cost of operating capital. This valuation assumes that current NOPAT will continue indefinitely. The future value is based on the capitalized expected excess cumdividend earnings over the expected future NOPAT earnings. The excess cum-dividend earnings over the expected earnings captures the value created beyond the steady-state value.

2.

Both residual operating income model (ROIM) and the abnormal operating income growth model (AOIGM) are accounting-based valuation models, what is the anchor for each model?

The anchor for the ROIM is net operating assets (NOAt) while the anchor for the AOIGM is the capitalized forecast next-year’s net operating profit after tax (NOPATt+1 / rWACC).

3.

For the abnormal operating income growth model (AOIGM), in computing the cum-free-cash-flow earnings, what is the assumption regarding about the prior year’s distributions?

The prior year’s distributions are assumed to be invested in an alternative investment with an equivalent risk. This assumption maintains the integrity of the AOIGM as it is neutral as to whether a distribution is made or not. Whether the cash flows are invested back into the firm or distributed, the model yields the same valuation if the assumed return is the cost of operating capital, r WACC.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 12

12-1

4.

The abnormal operating income growth model (AOIGM) is based on accounting earnings, specifically estimates of net operating profit after tax (NOPAT). Is the AOIGM impacted by accounting policies that shift income from one period to another? Explain.

Accounting policy choices that shift timing of income recognition, but do not impact cash flows (e.g., depreciation, software capitalization or R&D) have no impact on the AOIGM valuation. Due to the self-correcting nature of accounting, a shift in earnings from one period is reflected in subsequent periods. For example, expensing instead of capitalizing R&D costs leads to lower current earnings, but higher future earnings. Thus, the steady-state capitalization of current NOPAT will be affected by the accounting policy choice as well as the future value based on capitalized future excess cum-dividend earnings. This results in the same valuation, regardless of the accounting policy choice.

5.

Effective April 1, 2020, Aurora Cannabis (ACB), a Canadian cannabis producer, elected to change its accounting policy with respect to the allocation of production management salaries from general and administrative expense to inventory and cost of sales. The accounting change impacted current net operating profit after tax (NOPAT). What impact, if any, would this accounting policy change have on ACB’s valuation with abnormal operating income growth model (AOIGM)?

There is no impact on Aurora Cannabis’ valuation as the accounting policy changes impacts the timing of the expense recognition, not the cash flows. The steady-state capitalization of current NOPAT will be affected by the accounting policy choice but the future value based on capitalized future excess cum-dividend earnings is also impacted as well resulting in the same valuation.

6.

When estimating the continuing value (CV) within an abnormal operating income growth model (AOIGM), what is the implication when CV is (a) positive (b) equal to zero, and (c) negative? a. When the continuing value (CV) is positive, the firm is expected to earn excess cum-dividend earnings over expected earnings. The firm is expected to create value beyond the forecast period. b. When the continuing value (CV) is equal to zero, the firm is expected to earn excess cumdividend earnings equal to its expected earnings. The firm will neither create or destroy value beyond the forecast period. c. When the continuing value (CV) is negative, the firm is expected to earn excess cum-dividend earnings that is less than its expected earnings. The firm is expected to destroy value beyond the forecast period.

7.

Why does the abnormal operating income growth model (AOIGM) reach the steady-state a later than either the discounted cash flow (DCF) model or the residual operating income model (ROIM)?

The abnormal operating income growth model (AOIGM) uses the cum-dividend earnings which is based on the lagged free cash flow (FCF). The lagged FCF in turn is based on the lagged net operating assets (NOA) so that it takes one more year for AOIG to achieve its steady-state growth rate.

©Cambridge Business Publishers, 2021 12-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 12 - Valuation using the Abnormal Operating Growth Income Model

8.

How does anchoring on net operating profit after tax (NOPAT) provide greater confidence in the valuation with the abnormal operating income growth (AOIG) model as compared to the discounted cash flow (DCF) model?

Generally, there is greater confidence in near-term forecasts. With the abnormal operating income growth model (AOIGM), the majority of the valuation comes within the forecast horizon, but for the DCF model, the majority of the valuation is, typically, after the forecast horizon. Despite having the same valuation, when the steady-state rate is met, the AOIGM is based more on near-term than long-term forecasts.

9.

To form forecasts for the abnormal operating income growth model (AOIGM), what aspects of operations must be forecasted?

The abnormal operating income growth model (AOIGM) requires forecasts of sales growth, PM, and ATO. Forecasts of Operating PM will provide the estimates of NOPAT based on expected sales, and forecasts of Operating ATO will provide the required level of NOA necessary to support the sales. With the NOPAT and NOA estimates, we can compute free cash flows (FCF). The excess cumdividend earnings are based on the estimates of NOPAT, NOA, and FCF.

10.

In the abnormal operating income growth model (AOIGM), what are expected earnings (or normal earnings)?

Expected (or normal) earnings represent the growth in earnings at the require rate of return, rWACC. For a given net operating profit after tax (NOPAT t), the expected (or normal) earnings are the prior-year earnings growing at the required rate of return (NOPAT t+1 = NOPATt x rWACC).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 12

12-3

EXERCISES 11.

The Stans Corporation is evaluating an opportunity to invest a project expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price $3,500 Payoffs: Year 1 $900 Year 2 1,400 Year 3 1,250 Year 4 850 Proceeds from disposition 500 In addition, the anticipated risk of the project implies a cost of capital of 12.0 percent would be appropriate. Using the abnormal operating income growth model (AOIGM), determine the value of the project and evaluate whether it is economically viable to make an investment in this project. Assume straight-line depreciation such that there would be no gain or loss anticipated at the end of the project.

Cost of capital Forecast year Revenues Depreciation Gain on sale Net income (NOPAT) "Dividends" (FCF)

12.0% 0

Cum-dividend earnings Expected income (prior earnings growing at rWACC) Abnormal operating income growth (AOIG) Discount factor One-year ahead value of AOIG Total present value of expected AOIG Net Income (NOPAT) Earnings to be capitalized Value of project 3,667

1 900 (750)

2 1,400 (750)

3 1,250 (750)

150 900

650 1,400

500 1,250

4 850 (750) 0 100 1,350

758 668 250 162 168 728 560 112 590 (60) (310) 50 1.1200 1.2544 1.4049 1.5735 527 (48) (221) 32 290 150 440

The value of the project, $3,667 is higher than the cost of the project, $3,500, so the investment is economically viable. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior modules using discounted free cash flows or residual operating income. * Note to instructor that depending on rounding, student’s answer may differ slightly. ©Cambridge Business Publishers, 2021 12-4

5

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 12 - Valuation using the Abnormal Operating Growth Income Model

12.

The Grady Companies is evaluating an opportunity to invest a project expected to yield the following cash flows: Anticipated Cash Flows of Finite-Life Project Purchase price $3,500 Payoffs: Year 1 $900 Year 2 1,100 Year 3 1,200 Year 4 750 Proceeds from disposition 250 In addition, the anticipated risk of the project implies a cost of capital of 10.0 percent would be appropriate. a. Assume straight-line depreciation such that there would be no gain or loss anticipated at the end of the project. Using the abnormal operating income growth model (AOIG), determine the value of the project and evaluate whether it is economically viable to make an investment in this project.

Cost of capital Forecast year Revenues Depreciation Gain on sale Net income (NOPAT) "Dividends" (FCF) Cum-dividend earnings Expected income given prior earnings Abnormal operating income growth (AOIG) Discount factor One-year ahead value of AOIG Total present value of expected AOIG Net Income (NOPAT) Earnings to be capitalized Value of project

10.0% 0

1 900 (813)

2 1,100 (813)

3 1,200 (813)

87 900

287 1,100

387 1,200

4 750 (811) (61) 1,000

5

377 497 59 100 96 316 426 (67) 281 181 (367) 167 1.1000 1.2100 1.3310 1.4641 255 150 (276) 114 243 87 330 3,300

The value of the project, $3,300 is lower than the cost of the project, $3,500, so the investment is not economically viable. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior modules using discounted free cash flows or residual operating income (beyond rounding). * Note to instructor that depending on rounding, student’s answer may differ slightly. © Cambridge Business Publishers, 2021 Test Bank, Chapter 12

12-5

b. Assume the Grady Companies choices to record depreciation at $600 per year with $1,100 expected residual value. Use the abnormal operating income growth method (AOIG) to value the project with the same cash flows as above. What effect does this change in profits due to altering depreciation have on the value calculation?

Cost of capital Forecast year Revenues Depreciation Loss on sale Net income (NOPAT) "Dividends" (FCF) Cum-dividend earnings Expected income given prior earnings Abnormal operating income growth (AOIG) Discount factor One-year ahead value of AOIG Total present value of expected AOIG Net Income (NOPAT) Earnings to be capitalized Value of project

10.0% 0

1 900 (600)

2 1,100 (600)

3 1,200 (600)

300 900

500 1,100

600 1,200

4 750 (600) (850) (700) 1,000

590 710 (580) 100 330 550 660 (770) 260 160 (1,240) 870 1.1000 1.2100 1.3310 1.4641 236 132 (932) 594 30 300 330 3,300

The value of the project, $3,300 is lower than the cost of the project, $3,500, so the investment is not economically viable even with the shift in income with depreciation. The use of the accounting-based valuation model did not result in a change from the value calculated in the prior modules using discounted free cash flows and residual operating income (beyond rounding). * Note to instructor that depending on rounding, student’s answer may differ slightly.

©Cambridge Business Publishers, 2021 12-6

5

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 12 - Valuation using the Abnormal Operating Growth Income Model

13.

The recent sales, NOPAT, and NOA of ACME Inc. for the year ended December 31, 2020, as well as forecasts for 2021 to 2023 are shown below. Assume that the cost of capital of operations for AMCE is 10%.

Time period

2020A

2021E

2022E

2023E

Forecasted sales

100,000

102,000

104,040

106,120

15,300

15,606

15,918

26,010

26,530

27,061

NOPAT NOA

25,500

Calculate the value of AMCE’s operations as of December 31, 2020 using the abnormal operating income growth model (AOIGM).

Required rate of return (rWACC)

10.0%

Growth rate (g)

2.0% 2020

2021

2022

2023

Forecasted sales

102,000

104,040

106,121

NOPAT

15,300

15,606

15,918

26,010

26,530

27,061

14,790

15,086

15,387

Cum-dividends earnings (NOPATt + FCFt-1 x rWACC)

17,085

17,427

Expected income (NOPATt-1 x (1 + rWACC)

16,830

17,167

255

260

1.110

1.210

232

215

NOA

25,500

FCF (NOPAT -  NOA)

Abnormal operating income growth (AOIG) Discount factor (1 + rWACC) PV Sum of PV

447

CV [(AOIGt+1 x (1 + g))  (rWACC - g)]

3,315

PV of CV

2,740

Earnings to be capitalized

18,487

Operating value

184,870

In both 2022 and 2023, the growth in abnormal operating income growth (AOGI) was 2% which is the growth rate following the forecast horizon. This assures that the forecast was at the steady state. * Note to instructor that depending on rounding, student’s answer may differ slightly. © Cambridge Business Publishers, 2021 Test Bank, Chapter 12

12-7

14.

Pierce Incorporated forecasts its future sales, NOPAT, and NOA for the next four years as: 2020A

2021E

2022E

2023E

2024E

Sales

40,000

41,000

44,000

48,000

53,000

NOPAT

5,000

5,500

6,500

8,000

10,000

NOA

30,000

32,000

36,000

40,000

45,000

Pierce’s weighted-average cost of capital (rWACC) is 7.5%. Calculate Pierce’s free cash flow (FCF), abnormal operating income growth (AOIG), and AOIG growth rate for 2020 – 2023.

FCF

2021E

2022E

2023E

2024E

3,500

2,500

4,000

5,000

850

1,200

1,700

41.2%

41.7%

AOIG AOIG growth

Where AOIGt = [NOPATt + rWACC ∙ FCFt-1 – (1+rWACC) ∙ NOPATt-1] and FCF = (NOPAT–∆NOA)

15.

The Stringer Companies forecasts its future sales, operating profit margin (PM) and operating asset turnover (ATO) for the next four years as follows: 2020A

2021E

2022E

2023E

2024E

Sales

64,000

66,500

68,500

71,000

74,000

PM

7.5%

8.0%

8.3%

8.4%

8.5%

ATO

2.15

2.10

2.05

2.00

1.95

Stringer’s weighted-average cost of capital (WACC) is 9.0%. Calculate Stringer’s abnormal operating income growth (AOIG) for 2021 and 2022.

2020A

2021E

2022E

2023E

2024E

NOPAT (Salest x PMt)

4,800

5,320

5,686

5,964

6,290

NOA (Salest+1 / ATOt)

30,930

32,619

34,634

37,000

 NOA

1,689

2,015

2,366

FCF (NOPATt -  NOAt)

3,631

3,671

3,598

214

278

AOIG Where AOIG = [NOPATt + rWACC x FCFt-1 – (1+rWACC) x NOPATt-1]

©Cambridge Business Publishers, 2021 12-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 12 - Valuation using the Abnormal Operating Growth Income Model

16.

Dopuch Industries is expected to earn net operating profits after tax (NOPAT) next year followed by abnormal operating income growth (AOIG) for the following four years. ($ thousand) NOPAT

Year 1

Year 2

Year 3

Year 4

$952,500

$1,000,000

$1,040,000

$17,600,000

AOIG

Calculate Dopuch’s operating value (VOper) assuming the abnormal operating income growth will continue at 4.0 percent following the forecast horizon. Dopuch’s weighted-average cost of capital (rWACC) is 10.0 percent.

($)

Year 0

NOPAT

Year 1

Year 2

Year 3

Year 4

952,500

1,000,000

1,040,000

5.0%

4.0%

17,600,000

AOIG AOIG growth Discount factor

1.100

1.121

1.331

Discount AOIG

865,909

826,446

781,367

Total discounted AOIG

2,473,722

Continuing value AOIG at the horizon

1,081,600

Capitalized

18,026,667

PV of continuing value

13,543,702

Total to be capitalized

33,617,424

Operating Value

336,174,240

© Cambridge Business Publishers, 2021 Test Bank, Chapter 12

12-9

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors. This will facilitate the application of the valuation steps to similar real-life firms.

17.

Using the following forecast assumptions for FedEx (FDX), the weighted average cost of capital for operations of 7.8 percent and a continuing growth in abnormal operating income growth (AOIG) beyond the forecast horizon of 3.0 percent, calculate the value of FDX’s operations using the abnormal operating income growth model (AOIGM).

FY2019A

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

FY2025E

Sales growth

6.59%

5.60%

4.56%

4.20%

3.70%

3.00%

Operating PM

5.93%

5.93%

6.24%

6.15%

6.15%

6.15%

Operating ATO

1.291

1.318

1.290

1.299

1.299

1.299

Assumptions:

Forecast (millions):

FY2019A

FY2020E

FY2021E

FY2022E

FY2023E

FY2024E

FY2025E

Sales

$69,693

$74,284

$78,441

$82,017

$85,462

$88,624

$91,283

4,405

4,652

5,118

5,256

5,450

5,614

59,537

63,563

65,806

68,240

70,288

72,396

NOPAT NOA

57,523

©Cambridge Business Publishers, 2021 12-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 12 - Valuation using the Abnormal Operating Growth Income Model

Required rate of return (rWACC)

7.80%

Time period

FY2019

FY2020

FY2021

FY2022

FY2023

FY2024

FY2025

FY2026

Sales

$69,693

$74,284

$78,441

$82,017

$85,462

$88,624

$91,283

$94,021

4,405

4,652

5,118

5,256

5,450

5,614

5,782

59,537

63,563

65,806

68,240

70,288

72,396

74,568

 NOA

2,014

4,027

2,242

2,435

2,047

2,109

2,172

FCF (NOPAT –  NOA)

2,391

625

2,876

2,821

3,403

3,505

3,610

NOPAT

4,405

4,652

5,118

5,256

5,450

5,614

5,782

89

152

-37

5

4

4

70.24%

-124.22%

-112.35%

-15.92%

3.00%

1.0780

1.1621

1.2527

1.3504

1.4558

83

131

-29

3

3

NOPAT NOA

57,523

AOIG [NOPATt + (rWACC x FCFt-1) – (1 + rWACC) x NOPATt-1] Growth in AOIG Discount factor (1 + rWACC)t Present value of AOIG Sum of present value of AOIG

191

Continuing value AOIG at horizon

4

Capitalized

82

Present value of continuing value

56

Total earnings to be capitalized

4,652

Operating value

59,641

The use of the abnormal operating income growth model (AOIGM) provides the same valuation as the discounted cash flow (DCF) model and residual operating income model (ROIM).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 12

12-11

* Note to instructor that depending on rounding, student’s answer may differ slightly.

©Cambridge Business Publishers, 2021 12-12

Valuation Using Financial Statements, 2nd Edition

Prof.Exams TB-Valuation Using Financial Statements 2E by Sommers(2024) Chapter 12 - Valuation using the Abnormal Operating Growth Income Model

18.

Using the following forecast assumptions for United Parcel Service (UPS), the weighted average cost of capital for operations of 6.8 percent and a continuing growth in abnormal operating income growth (AOIG) beyond the forecast horizon of 2.8 percent, calculate the value of UPS’ operations using the abnormal operating income growth model (AOIGM).

FY2019A

2020E

2021E

2022E

2023E

2024E

2025E

Sales growth

2.90%

2.80%

2.56%

2.60%

2.70%

2.80%

Operating PM

8.11%

7.68%

7.61%

7.47%

7.45%

7.45%

Operating ATO

2.063

2.050

2.049

2.062

2.062

2.062

Assumptions:

Forecast (millions):

FY2019A

2020E

2021E

2022E

2023E

2024E

2025E

Sales

$74,094

$76,245

$78,384

$80,388

$82,478

$84,705

$87,076

6,183

6,020

6,117

6,161

6,310

6,487

38,233

39,229

40,002

41,082

42,232

43,415

NOPAT NOA

37,271

© Cambridge Business Publishers, 2021 Test Bank, Chapter 12

12-13

Required rate of return (rWACC) Time period Sales NOPAT NOA  NOA FCF (NOPAT –  NOA) NOPAT AOIG [NOPATt + (rWACC x FCFt-1) – (1 + rWACC) x NOPATt-1] Growth in AOIG Discount factor (1 + rWACC)t Present value of AOIG Sum of present value of AOIG Continuing value AOIG at horizon Capitalized Present value of continuing value Total earnings to be capitalized Operating value

6.80% 2019 $74,094 37,271

2020 $76,245 6,183 38,233 962 5,222 6,183

2021 $78,384 6,020 39,229 996 5,024 6,020

2022 $80,388 6,117 40,002 773 5,345 6,117

2023 $82,478 6,161 41,082 1,080 5,081 6,161

2024 $84,705 6,310 42,232 1,150 5,160 6,310

2025 $87,076 6,487 43,415 1,182 5,305 6,487

2026 $89,514 6,669 44,630 1,216 5,453 6,669

-229

30 -113.04% 1.1406 26

-9 -129.95% 1.2182 -7

76 -949.20% 1.3010 58

98 29.63% 1.3895 71

101 2.80%

1.0680 -214 (66)

101 2,531 1,821 7,939 116,743

The use of the abnormal operating income growth model (AOIGM) provides the same valuation as the discounted cash flow (DCF) model and residual operating income model (ROIM). * Note to instructor that depending on rounding, student’s answer may differ slightly.

©Cambridge Business Publishers, 2021 12-14

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 13 - Valuation of Equity

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

Chapter 13 Valuation of Equity QUESTIONS 1.

How does the value of equity differ from the value of operations?

The value of operations belongs to both debt and equity holders. The value of equity is the value of operations less the value of debt. That is, VEq = VOper– VNF. The value of operations represents the total enterprise value held by all claimants: debt holders, preferred shareholders, and noncontrolling interests as well as common shareholders. The value of equity is the value of the firm held by the common equity holders.

2.

Why is the value of debt adjusted by the interest tax shield?

Interest payments are tax deductible. For every dollar in interest (within limits under the Tax Cuts and Job Acts of 2017), the company pays less income taxes. Thus, the company does not incur the full cost of interest. The interest tax shield values the potential benefit of the expected future tax savings. The tax savings provide a benefit to the equity holders. This effectively reduces the cost of equity and the interest tax shield is subtracted from the value of debt in determining the value of equity.

3.

In the calculation of the interest tax shield, what is the implicit assumption regarding future debt levels?

In determining the interest tax shield, the interest expense is treated as a perpetuity, implying that the debt levels will not change in the future.

4.

In determining the value of debt, are all the net financial liabilities (NFL) considered or only the financial liabilities (FL)? Explain.

The value of debt is based on the net financial liabilities (NFL) comprised of the financial assets and financial liabilities which include preferred stock and noncontrolling interests. While the name suggests only interest-bearing debt should be considered, the reality is the value of debt is a broad and inclusive concept.

5.

Explain the concept of the residual earnings model (REM).

Residual earnings are the earnings over and above the required return from the common stock equity (CSE). For a given investment in CSE, the cost of equity capital, (rEq) determines the expected return. The comprehensive income (CI) is compared to the expected return. If CI is greater than the required return, the excess income is called residual earnings. Residual earnings can be positive, negative or equal to zero. © Cambridge Business Publishers, 2021

Test Bank, Chapter 13

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6.

What are the drivers of the residual earnings model (REM)?

Residual earnings is a function of common shareholders’ equity (CSE) and comprehensive income (CI). Specifically, REt = CIt - rEq x CSEt . Value is created from increasing CI for a given level of CSE (i.e., earning more from the same net investment in equity). Additionally, value is created by additional investments to CSE earn a positive residual income. Growth in both CI and CSE, when earning a positive residual income, will drive increases in residual earnings.

7.

How can analysts’ forecasts be used in a residual earnings model (REM) to arrive at a ballpark estimate of equity value?

Analyst forecasts of expected earnings per share (EPS) and dividends along with current book value provide the elements for residual earnings (RE) forecasts. The RE is forecasted comprehensive income (CI) over the required return on invested equity capital (r Eq x CSE). Assuming that other comprehensive income (OCI) is forecasted as zero, then EPS forecasts are the same as forecasted CI per share. Using clean surplus accounting, CSEt = CSEt-1 + CIt – Divt, forecasted CSE is based on forecasted EPS and dividends. The remaining item is the continuing value (CV) estimate. If the analyst forecasts reach a steady state, the CV is the continuation of the steady state; otherwise, the results from the dividend discount model will not equal the REM.

8.

What is free cash flow to equity holders, FCFEq? Free cash flow to equity holders are a subset of the free cash flows. Free cash flows can flow to common equity holders as cash dividends or share repurchases. Free cash flows can also flow from common equity holders for share issuances. These differ from the free cash flows to/from debt holders which include items such as borrowings, principal repayments, interest payments, financial asset investments or withdrawals.

9.

What the three adjustments to update the value of operations to the value of equity?

The three adjustments to the value of operations are: 1. Adjust to midyear payoffs. Rather than assume payoffs occur at year-end, this adjustment assumes the payoffs occur evenly throughout the year.

2. Adjust to the valuation date. Rarely is the valuation date the date of the fiscal year-end. The value of operations is adjusted from the fiscal year-end to the valuation date.

3. Adjust for the value of debt. This adjustment includes an update for the carrying amount of the net financial liabilities (NFL) to its fair market value, an update of the NFL for subsequent data (e.g., 10-Qs) since the fiscal year-end, and subtract the value of the interest tax shield.

10.

In adjusting the value of operations to the valuation date, what is the assumed rate of return over the adjustment period?

The adjustment of the value of operations from the fiscal year-end to the valuation date assumes the value of operations grows at the cost of operating capital, r WACC. The information from the fiscal year-end to the valuation date is already reflected in the forecasted NOPAT and NOA. Thus, the expected growth is the cost of operating capital.

©Cambridge Business Publishers, 2021 13-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 13 - Valuation of Equity

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

EXERCISES 11.

On June 30th, Miller Corporation closing share price was $685.33. An analysis of Miller’s financial statements for the year ending January 31 determined an enterprise value of $6,468 million with its net financial liabilities (NFL) of $2,025 million and a net interest expense of $90 million. Miller’s marginal tax rate is 21 percent. a. Prepare a mid-year adjustment to Miller’s estimated operating value, assuming Miller’s cost of capital for operations, rWACC, is 9.0 percent. $6,753 million = $6,468 x (1 + 0.09)0.5 b. Prepare the adjustment to Miller’s the estimated operating value from (a) above to June 30 th. $7,000 = $6,753 x (1 + 0.09)5/12 c. Based on Miller’s latest Form 10-Q, the fair market value of Miller’s NFL increased $45 million from its fiscal year end. Calculate the estimated value of Miller’s equity at June 30 th assuming Miller’s cost of debt capital, rD, is 4.5%.

The interest tax shield is $420 or [($90 x 21.0%)  4.5%] The value of equity is $5,350 = $7,000 – ($2,025 + $45 -$ 420) d. At June 30th, Miller had 7,500,000 common shares outstanding. What is the estimated per share price for Miller Corp. at June 30th? $713.33 per share = $5,350 million  7,500,000 shares e. Based on the above analysis what is your recommendation (Buy / Sell / Hold)?

The estimated value of equity of $713.33 is greater than the current share price of $685.33.

The recommendation is to BUY Miller Corp. * Note to instructor that depending on rounding, student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 13

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12.

Cooper Tire and Rubber (CTB) makes and sells replacement tires mainly for passenger cars and light trucks, but also for medium truck, motorcycles, and race cars for North American and international markets.

After reformulating the financials, making various accounting adjustments, financial analysis and forecasts, the valuation models generated a value of CTB’s operations of $3,217,918. Note all amounts are in thousands.

Relevant information from the financial analysis includes, in part: Required rate of return, rWACC: 7.20% Date of latest 10-K used in the forecasts: December 31, 2018 Date of valuation: March 31, 2018 NFL: $594,660.

Book value of long-term debt: $295,987 Fair value of long-term: $329,329 Net interest expense: $24,686 Cost of debt capital, rD: 4.50% Future tax rate: 21.0% Shares outstanding at December 31, 2018 = 50,797,944 shares Closing price, March 31, 2018: $29.30 a. Prepare CTB’s mid-year adjustment.

The value of operation with the mid-year adjustment is $3,331,750 = $3,217,918 x 1.0720.5 b. Update CTB’s value of operations to the valuation date.

The value of operations at the valuation date, March 31, 2018 is $3,390,167 = $3,331,750 x 1.0723/12 c. Determine the estimated fair value of CTB’s NFL? NFL +

$594,660 Fair value adjustment – LT debt ($329,329 - $295,987)

– Interest tax shield $24,686 x 0.21  4.50% NFL, adjusted

33,342 115,201 $512,801

d. Determine the estimated value of CTB’s equity?

The value of equity is $2,877,366 = $3,390,167 – 512,801 e. Determine the estimated value per share? $56.64 per share = $2,877,366(thousand)  50,797,944 shares f.

What is your recommended investment decision based solely on the analysis above? Explain.

The estimated value of equity of $56.64 is greater than the current share price of $29.30. The recommendation is to BUY Cooper Tire and Rubber. * Note to instructor that depending on rounding, student’s answer may differ slightly.

©Cambridge Business Publishers, 2021 13-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 13 - Valuation of Equity

13.

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

The TJX Companies (TJX) is a Fortune 200 company with nearly 4,000 stores worldwide under half a dozen retail brand names, including clothing stores such as TJ Maxx and Marshall’s. The TJX Companies’ fiscal year (FY) ends in January of each year. The following are TJX’s historical (A) and estimated (E) earnings per share (EPS) and dividend per share (DPS). The book value per share (BVPS) of TJX at the beginning of FY 2020 was $4.96.

EPS DPS BVPS

FY 2020 A $2.67 0.88 6.75

FY 2021 E $0.22 0.23 6.74

FY 2022 E $2.39 0.25 8.88

FY 2023 E $2.80 0.25 11.43

Assume that TJX has an equity cost of capital, rEq, of 9 percent and there are no additional shareholder equity transactions. a. Calculate the residual earnings (RE) per share for FYs 2020 – FY 2023.

FY 2020 residual earnings = $2.22

($2.67 - 4.96 x 0.09)

FY 2021 residual earnings = $(0.39)

($0.22 - 6.75 x 0.09)

FY 2022 residual earnings = $1.78

($2.39 - 6.74 x 0.09)

FY 2023 residual earnings = $2.00

($2.80 - 8.88 x 0.09)

* Note to instructor that depending on rounding, student’s answer may differ slightly. b. Investors use a variety of metrics to help explain value creation within a firm. The metrics, among others, include ROCE, free cash flow, EV/EBITDA, dividend yield, P/E multiples and book value. From a residual income perspective, explain whether TJX created value for the FY 2020? For the forecasted years FY 2021 - 2023?

TJX created value in FY 2020. The residual earnings of $2.22 represents the earnings over the required $0.45 ($4.96 x 0.09) return on beginning book value. The owners’ investment in TJX is represented by the TJX’s book value. The cost of equity capital is the required return for the owners’ investment. When TJX earns a return greater than the required return, TJX is creating value for its owners.

For the forecasted period, FY 2021 - FY 2023, TJX is expected to create value for the overall period. However, for FY 2021, TJX will not create value as the expected earnings, $0.22, will not meet the required return of $0.61 ($6.75 x 0.09). The lower earnings for FY 2021 reflect the impact of the COVID-19 pandemic.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 13

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14.

Bank of America (BofA) Merrill Lynch provides equity research on publicly traded firms. On November 1, 2020, BofA issued a research report on Apple (AAPL).

In the report, BofA noted a neutral position to Apple with a 12-month price target of $135.00 compared to it $115.97 share price at the date of the report. BofA provided its estimates of future earnings per share (EPS) and dividends per share (BPS) for Apple’s upcoming FY2021 – 2023.

Apple book value per share (BPS) at September 30, 2020 (Its fiscal year-end) is $5.10 per share.

Assume Apple’s equity cost of capital is 10.0 percent. a. Calculate Apple’s expected residual earnings (RE) for the forecast horizon (FY2021 – 2023)?

2020A 2021E 2021E 2023E EPS 3.96 4.28 4.66 DPS 0.84 0.88 0.88 BPS 5.10 8.22 11.62 15.40 RE (10.0%) 3.45 3.46 3.50 b. Assuming the residual earning estimate at the forecast horizon (FY2023) will continue to grow at a constant rate into the future, calculate the implied growth rate, g, in the market share price of $115.97 at November 1, 2020? 𝑃2020 = $115.97 = $5.10 +

3.45 3.46 3.50 + + + 1.10 1..21 1.331

3.50×(1+𝑔) ⁄0.10−𝑔 1.331

Where g = 7.24% c. Assuming the residual earning estimate at the forecast horizon (FY2023) will continue to grow at a constant rate into the future, calculate the implied growth rate, g, in the BofA price objective of $135.00 at November 1, 2020? 𝑃2020 = $135.00 = $5.10 +

3.45 3.46 3.50 + + + 1.10 1..21 1.331

3.50×(1+𝑔) ⁄0.10−𝑔 1.331

Where g = 7.67% * Note to instructor that depending on rounding, student’s answer may differ slightly.

©Cambridge Business Publishers, 2021 13-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 13 - Valuation of Equity

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

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors. This will facilitate the application of the valuation steps to similar real-life firms.

For questions 15 through 20 covering FedEx, use the following information: As of May 31, 2019, the estimate value of operations for FedEx (FDX) is $59,641 million. The estimated value of debt (before adjustments) is $39,971 million. Together the implied estimated unadjusted value of equity is $19,670 million. The weighted average cost of capital for operations, rWACC, is 7.80% and the cost of debt capital, rD, is 7.10%. The expected income tax rate is 21.0%.

15.

Why is a mid-year adjustment needed for FedEx (FDX)? 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 midyear adjustment moves all payoffs from the end of the year to the middle of the year.

For FedEx (FDX), our estimate of value for operating activities of $59,641 million is increased to $61,924 million when we multiply by (1 + 0.078)0.5 or 1.0383.

16.

Typically, analysis of cost of capital along with the forecasts for FedEx (FDX) are based on financial statement information available through the date of the most recent annual financial statements which is May 31, 2019. What adjustment is needed to update the estimate of value of operating activities as of May 1, 2020?

To adjust the valuation from the balance sheet date (May 31, 2019) to the valuation date (May 1, 2020), the estimated value of operations is expected to grow at the required cost of capital of operations to $66,337 million ($61,924 million x (1+ 0.078)11/12).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 13

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17.

FedEx filed its third quarter 10-Q with the SEC on March 17, 2020. Thus, this information was available on May 1, 2020 to update the value of debt, excluding the interest tax shield. a. FedEx’s fiscal year 2019 interest expense is $652 million and interest income is $59 million.

The information in the Form 10-Q shows a downward adjustment to NFL of $2,040 to $37,931.

What is value of the interest tax shield and adjusted net financial liabilities (NFL)?

The value of the interest tax shield for FedEx is estimated at $1,754 million computed as $593 million net interest expense ($652 – 59) times the 21.0 percent assumed tax rate, divided by an assumed cost of debt capital of 7.10 percent. This yields an adjusted value of NFL of $36,177 million ($37,931 – 1,754). b. What is the estimated value of equity of FedEx as of May 1, 2020?

The estimated value of FedEx’s equity as of May 1, 2020 is $30,160 million ($66,337 - 36,177).

18.

Compute the value per share of FedEx (FDX) at May 1, 2020 using the number of shares outstanding shown in the 2019 Form 10-Q for the third quarter of 267,215,207 shares. How does this amount compare to the closing price of FDX, $118.20, on May 1, 2020?

The estimate of the per-share value of equity is $112.87 as of May 1, 2020. The closing share price of $118.20 implies that financial statement analysis and valuation result in a lower valuation than those used by investors in setting prices. We would choose to sell the shares as FedEx appears overvalued by 4.5%.

19.

Reflecting on the valuation exercise, which of the following assumptions for FedEx (FDX) do you have the most concerns about relying on?

•

Continuing growth in sales of 3.00 percent

•

Ongoing operating profit margin of 6.15 percent

•

Weighted average cost of capital for operations, rWACC, of 7.80 percent

To examine the sensitivity to altering each of these assumptions up or down by 0.2 percent (e.g., sales growth at 2.80% & 3.20%). 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 $112.87 for FedEx adjusts to: –0.2%

+0.2%

Sales growth $112.54 $113.22 PM $101.99 $123.74 rWACC $123.53 $103.06 Continued ©Cambridge Business Publishers, 2021 13-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 13 - Valuation of Equity

19.

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

continued Here we see that changes in the profit margin as well as 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.” * Note to instructors. Students will need access to the valuation spreadsheets from chapter 10 – 12 for this analysis. Also, that depending on rounding, a student’s answer may differ slightly.

For questions 20 through 24 covering United Parcel Service, use the following information: As of December 31, 2019, the estimate value of operations for United Parcel Service (UPS) is $116,743 million. The estimated value of debt (before adjustments) is $35,172 million. Together the implied estimated unadjusted value of equity is $81,571 million. The weighted average cost of capital for operations, rWACC, is 6.80% and the cost of debt capital, rD, is 3.30%. The expected income tax rate is 21.0%.

20.

Why is a mid-year adjustment needed for United Parcel Service (UPS)? 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 midyear adjustment moves all payoffs from the end of the year to the middle of the year.

For United Parcel Service (UPS), our estimate of value for operating activities of $116,743 million is increased to $120,647 million when we multiply by (1 + 0.068)0.5 or 1.0334.

21.

Our calculations of cost of capital and our forecasting for United Parcel Service (UPS) have utilized information available through December 31, 2019. This has been applied to information drawn from the 2019 financial statements. What issues does this create and for UPS what is the estimate of value of operating activities as of May 1, 2020 after addressing this issue?

To adjust the valuation from the balance sheet date (December 31, 2019) to the valuation date (May 1, 2020), the estimated value of operations is expected to grow at the required cost of capital of operations to $123,322 million ($120,647 million x (1+ 0.068) 4/12).

© Cambridge Business Publishers, 2021 Test Bank, Chapter 13

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22.

The first quarter Form 10-Q for United Parcel Service (UPS) was filed with the SEC after May 1, 2020. Thus, no updated information is available on May 1, 2020. However, the December 31, 2019 financial statement stated that UPS’ long-term debt fair value was $1,711 more than its reported carrying amount. a. UPS’ 2019 net interest and investment expense is $2,146, what is value of the interest tax shield and adjusted net financial liabilities (NFL)?

The value of the interest tax shield for UPS is estimated at $13,656 million computed as $2,146 million net interest expense times 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 $23,227 million ($35,172 + 1,711 – 13,656). b. What is the estimated value of equity of UPS as of May 1, 2020?

The estimated value of UPS’ equity as of May 1, 2020 is $100,095 million ($123,322 - 23,227).

23.

Compute the value per share of United Parcel Service (UPS) at May 1, 2020 using the number of shares outstanding shown in the 2019 Form 10-K of 156,399,660 class A shares and 702,088,016 class B shares. (Class A share are distinguished from class B by their respective voting rights. Class A share are entitled to 10 votes per share while class B share are entitled to one vote per share).

How does this amount compare to the closing price of UPS, $91.90, on May 1, 2020?

The estimate of the per-share value of equity is $116.59 as of May 1, 2020 [$100,095 / (156,399,660 + 702,088,016)]. The closing share price of $91.90 implies that financial statement analysis and valuation result in a higher valuation than those used by investors in setting prices.

We would choose to purchase the shares as UPS appears undervalued by 26.9%.

©Cambridge Business Publishers, 2021 13-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 13 - Valuation of Equity

24.

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

Reflecting on the valuation exercise, which of the following assumptions for United Parcel Service (UPS) do you have the most concerns about relying on?

•

Continuing growth in sales of 2.80 percent

•

Ongoing operating profit margin of 7.45 percent

•

Weighted average cost of capital for operations, rWACC, of 6.80 percent

To examine the sensitivity to altering each of these assumptions up or down by 0.2 percent (e.g., sales growth at 2.60% & 3.00%). 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 $116.59 for UPS adjusts to: –0.2%

+0.2%

Sales growth

$112.63 $120.97

PM

$112.75 $120.45

rWACC

$110.03 $123.85

The changes in the weighted average cost of capital for operations lead to the largest changes in the value estimate, but similar to changes in sales growth and profit margin. This reminds us that much care must be taken in estimating risk and that we must never assume that our value calculation is “correct.” * Note to instructors. Students will need access to the valuation spreadsheets from chapter 10 - 12.

Also, that depending on rounding, a student’s answer may differ slightly.

© Cambridge Business Publishers, 2021 Test Bank, Chapter 13

13-11

Prof.Exams Chapter 14 - Steady State and Forecast Horizon

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

Chapter 14 Steady State and Forecast Horizon QUESTIONS 1.

When forecasting a valuation model, at what point is the steady state achieved?

The steady state is achieved when (1) forecasted sales are growing at a constant rate, (2) forecast operating profit margin (PM) is constant from year to year and (3) forecasted operating asset turnover (ATO) is constant from year to year.

2.

For the three valuation models (discounted cash flow, residual operating income and abnormal operating income growth), explain how the growth rate used in the continuing value can be the same across all three models?

The continuing value for each of the three valuation models relies on the continuing growth of free cash flows (FCF), residual operating income (ROPI) and abnormal operating income growth (AOIG) to have the same growth rate. This occurs when the steady state is reached. At this point, operating asset turnover (ATO) is constant implying that net operating assets (NOA) will grow at a constant rate a year before sales grows at a constant rate. Consequently, FCF and ROPI will have same growth rate. The following year, given that AOIG equals the change in ROPI, it will have the same growth rate.

3.

Under what conditions can the growth rate in the continuing value of the discounted cash flow model (DCFM) be the same growth rate in the residual operating income (ROPI) model?

At the steady state, constant operating asset turnover (ATO) along with constant sales growth results in net operating assets (NOA) growing at a constant rate (ATO t = Salest  NOAt-1). Also, operating profit margin (PM) is constant and is NOPAT  Sales.

With free cash flows (FCF) defined as NOPAT -  NOA and residual operating income (ROPI) defined as NOPATt - rWACC x NOAt-1, both FCF and ROPI will grow at the same constant rate.

©© Cambridge Business Publishers, 2021 Test Bank, Chapter 14

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4.

Critique the practice of using a market multiple (e.g., EBITDA) as the continuing value in the discounted cash flow model (DCFM).

While the usage of a market multiple for the estimate of continuing value in a discounted cash flow model (DCFM) is used in practice, there are significant issues. The typical concerns with using any market multiple include selection of comparable firms, appropriateness of the multiple, the question of average or median, the impact of near-zero or negative numbers for some of the selected firms, timing issues for firms with differing year-ends, public versus privately-held firms, and the impact of using a forecasted multiple that may shift over the forecast horizon. The use of a market multiple as the continuing value will also uncouple the valuation estimate from other valuation models.

5.

By what criterion should valuation models be evaluated? (p. 4) When selecting a valuation model among others that yield the same valuation, the preference is for the model(s) that capture more value during the explicit forecast horizon. Confidence in forecasts decline over time. This approach reduces the reliance on the forecasted growth at the forecast horizon (the continuing value). Typically, the accounting-based valuation models (residual operating income and abnormal operating income growth models) capture more of the firm’s value within the forecast horizon than the discounted cash flow model.

6.

What is the anchor for the following valuation models: (p. 6) a. Discounted cash flow model (DCFM)?

The discounted cash flow model (DCFM) does not have an anchor. The DCFM values the forecasted free cash flows. b. Residual operating income model (ROIM)?

The residual operating income model is anchored on net operating assets (NOA). Forecasted residual operating income is added to the NOA anchor. c. Abnormal operating income growth model (AOIGM)?

The abnormal operating income growth model is anchored on capitalized next period earnings (NOPATt+1  rWACC). Forecasted abnormal operating income growth is added to the capitalized earnings anchor.

7.

For a financially strong company, what is a reasonable ceiling and floor for the steady state growth rate in a valuation model’s continuing value?

The continuing value growth rate should not exceed the expected real growth rate for the economy. At a higher growth rate, the firm will eventually expand beyond the economy which is an unrealistic assumption. While the growth rate can technically be zero or negative, the minimum growth rate is the expected inflation rate. This will provide a real growth rate of zero.

©Cambridge Business Publishers, 2021 14-2

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 14 - Steady State and Forecast Horizon

8.

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

What is a consequence across the three valuation models (discount cash flow, residual operating income, and abnormal operating income growth) when forecasts do not reach a steady state?

When the forecast does not reach the steady state, the resulting valuation for the firm will not be the same across all three models. The value estimates for the three models could be vastly different creating doubt as to what is the best estimate of the firm’s value.

9.

For firms with historically high sales growth rates, it is recommended that forecasted future sales growth eventually fade over time. Do the forecasts of operating profit margin (PM) and operating asset turnover (ATO) need to fade accordingly as well?

The operating profit margin (PM) and operating asset turnover (ATO) are not required to fade as the sales growth rate fades. Nonetheless, it is reasonable to expect that as the sales growth fades, the PM and ATO will likely change as well. For example, when forecasted PM and ATO are above historical means, a reversion to the mean is likely do to erosion of competitive advantages unless there is a strong argument to support a deviation from the long-term mean.

10.

What assumption about the abnormal operating income (model AOIGM), 𝑉0 =

1 𝐴𝑂𝐼𝐺𝑡+1 × [𝑁𝑂𝑃𝐴𝑇𝑡 + ∑∞ 𝑡=1 ((1+ 𝑟 𝑡 )], allows it to be structured where the forward PE 𝑟𝑊𝐴𝐶𝐶 𝑊𝐴𝐶𝐶 )

ratio is equal to the inverse of operating risk, rWACC? Assuming that all future AOIG is zero, (i.e., no expected change in residual operating income (ROPI)), will update the equation to 𝑉0 = forward PE ratio results in

1 × 𝑁𝑂𝑃𝐴𝑇𝑡 . Rearranging the equation into 𝑟𝑊𝐴𝐶𝐶

𝑉0 1 = or the forward PE ratio equals to the inverse of 𝑁𝑂𝑃𝐴𝑇𝑡 𝑟𝑊𝐴𝐶𝐶

operating risk.

©© Cambridge Business Publishers, 2021 Test Bank, Chapter 14

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EXERCISES 11.

The following are the sales, in $ millions, reported by Salesforce Inc. (CRM), a provider of customer relationship management services and software, for each of the past 6 fiscal years (January 31).

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

Sales growth

2015

2016

2017

2018

2019

2020

$5,014

$6,667

$8,437

$10,540

$13,282

$17,098

2015

2016

2017

2018

2019

2020

-

33.0%

26.5%

24.9%

26.0%

28.7%

Salesforce is experiencing a consistent high-growth phase with sales increases ranging between 25% - 30%. Salesforce may be expected to 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 to 3.5 percent, a fade pattern of 2 or 3 percent per year could be appropriate. Of course, a faster or slower fade may be necessary depending on the analyst’s assumptions.

©Cambridge Business Publishers, 2021 14-4

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 14 - Steady State and Forecast Horizon

12.

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

Netflix (NFLX), a provider of subscription-based video on demand, has experienced significant sales growth for many years.

2014

2015

2016

2017

2018

2019

Sales growth 25.8% 23.1% 30.3% 32.4% 35.1% 27.6%

On October 29, 2020, NFLX announced they will raise its U.S. prices on various subscription plans by $1 to $2 per month. Analysts for BofA Global Research estimated that NFLX’s revenue growth would be 23.4% in 2020, 19.9% in 2021 and 15.2% in 2022. Assuming the projected average sales growth fade rate continues and the operating profit margins (PM) and operating asset turnover (ATO) are constant, in which year will Netflix reach its steady state?

Extending the sales growth data from the problem, the expected fade rate is approximately 4.1% during the forecasted 2020 - 2022 period.

2019 Sales growth Fade rate

2020

2022

2023

2024

2025

27.6% 23.4% 19.9% 15.2%

11.1%

7.0%

2.9%

4.1%

4.1%

4.1%

4.2%

2021

3.5%

4.7%

Using the average 4.1% fade rate going forward, Netflix will reach its steady state in 2025 when its expected sales growth slows to 2.9%, the long-term expected growth rate for the U.S. economy. * Note to instructor that student’s answer may differ slightly depending on rounding, student determinations of the average fade rate, and steady state sales growth rate.

©© Cambridge Business Publishers, 2021 Test Bank, Chapter 14

14-5

13.

Evaluate Sterling Incorporated’s alternative sets of forecasts for sales growth, operating profit margin (PM) and operating asset turnover (ATO). Indicate whether the steady state is achieved and in which year for each alternative. a.

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Sales growth

22.5%

18.5%

13.0%

7.5%

3.0%

2.5%

2.5%

Operating PM

12.5%

12.3%

12.7%

12.7%

12.0%

12.0%

12.0%

Operating ATO

1.25

1.30

1.40

1.40

1.35

1.35

1.35

Steady state occurs in year 6 when sales growth, PM and ATO are constant in future years.

b.

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Sales growth

16.0%

12.5%

9.0%

4.0%

3.0%

3.0%

3.0%

Operating PM

12.5%

12.5%

12.5%

12.5%

12.5%

12.5%

12.5%

Operating ATO

1.25

1.25

1.25

1.25

1.25

1.25

1.25

Steady state occurs in year 5 when sales growth, operating PM and operating ATO are constant. Even though PM and ATO are constant in every year, all three estimates must be constant to achieve steady state.

c.

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Sales growth

14.0%

18.5%

14.0%

11.5%

6.0%

3.0%

3.0%

Operating PM

12.5%

12.0%

12.0%

11.5%

10.5%

8.5%

7.5%

Operating ATO

1.25

1.60

1.5

1.35

1.25

1.25

1.25

Steady state is not achieved as the PM is not constant when the ATO and sales growth are constant.

©Cambridge Business Publishers, 2021 14-6

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 14 - Steady State and Forecast Horizon

14.

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

The following forecasts were developed for Groves, Incorporated based on: NOA0 = $1,788,356 NOPAT1 = $228,801 Sum of present value of forecasted free cash flow (FCF) = $912,613 Sum of present value of forecasted residual operating income (ROPI) =$457,054 Sum of present value of forecasted abnormal operating income growth (AOIG) to period 1 = ($1,000) Present value of FCF continuing value = $2,305,305 Present value of ROPI continuing value = $972,508 Present value of AOIG continuing value to period 1 = $3,890

a. Determine the estimated value for Groves using the discounted cash flow model, the residual operating income model and the abnormal operating income model, assuming a 7.20 percent operating cost of capital.

Discounted cash flow model = $3,217,918 or ($912,613 + $2,305,305) Residual operating income model = $3,217,918 or ($1,788,356 + $457,054 + $972,508) Abnormal operating income growth model = $3,217,918 or ($228,801 + –$1,000 + $3,890) ÷ 0.072 * Note to instructor that depending on rounding, student’s answer may differ slightly.

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.

Discounted Cash Residual Operating Abnormal Operating Flow Model Income Model Income Model Amount

Percent

Amount

Percent

Amount

Percent

No forecast necessary Based on forecasts within horizon Based on continuing value Total estimated value

Continued ©© Cambridge Business Publishers, 2021 Test Bank, Chapter 14

14-7

©Cambridge Business Publishers, 2021 14-8

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 14 - Steady State and Forecast Horizon

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

b. continued

No forecast necessary

Discounted Cash Flow Model

Residual Operating Income Model

Abnormal Operating Income Model

Amount

Amount

Amount

Percent -

0.0%

1,788,356

Based on forecasts within horizon

912,613

28.4%

Based on continuing value

2,305,305

Total estimated value

3,217,918

Percent 55.6%

Percent -

0.0%

457,054

14.2% 3,163,890

98.3%

71.6%

972,508

30.2%

54,028

1.7%

100.0%

3,217,918

100.0% 3,217,918

100.0%

c. Based on the analysis in (b) above which valuation model(s) is preferred?

Although all three models provide the same valuation estimate, the models that capture most of the valuation during the forecast horizon is preferred. For both the residual operating income and abnormal operating income model, the majority of the value (69.8% and 98.3%, respectfully) is within the forecast horizon. There is more uncertainty with longer range forecasts than near term forecasts; thus, the accounting-based models are preferred.

©© Cambridge Business Publishers, 2021 Test Bank, Chapter 14

14-9

CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors. This will facilitate the application of the valuation steps to similar real-life firms.

15.

Compare the breakdown of the value estimates for FedEx (FDX) based on the horizon by completing the following chart. What do you learn from this exercise?

Breakdown of FedEx Value Estimate based on Horizon Discounted Cash Flow Model Amount Percent No forecast necessary Based on forecasts within horizon 9,478 Based on continuing value 50,163 Total estimated value 59,641

Residual Operating Income Model Amount Percent 57,523 237 1,881 59,641

Abnormal Operating Income Growth Model Amount Percent 58,918 724 59,641

* Note to instructor, the amount columns can be deleted when the valuations from chapter 10 - 12 are available.

Breakdown of FedEx Value Estimate based on Horizon Discounted Cash Flow Model Amount Percent No forecast necessary 0.0% Based on forecasts within horizon 9,478 15.9% Based on continuing value 50,163 84.1% Total estimated value 59,641 100.0%

Residual Operating Abnormal Operating Income Model Income Growth Model Amount Percent Amount Percent 57,523 96.4% 0.0% 237 0.4% 58,918 98.8% 1,881 3.2% 724 1.2% 59,641 100.0% 59,641 100.0%

For the discounted cash flow model (DCFM) over 80 percent of the value is based on estimates beyond the forecast horizon. This is typical of DCF valuations which do not have an anchor to the valuation estimate. For the residual operating income model (ROIM), the anchor known today, net operating assets (NOA) captures over 96 percent of the FDX’s value while the forecasts add less than four percent. For the abnormal operating income (AOIG) model, nearly 99 percent of its valuation comes from the information captured in the forecast horizon. Both the ROIM and AOIGM have the vast majority (96+ percent) of their valuation based on their anchors and short-term forecasts while the DCF model has the majority of its value estimated beyond the forecast horizon.

©Cambridge Business Publishers, 2021 14-10

Valuation Using Financial Statements, 2nd Edition

Prof.Exams Chapter 14 - Steady State and Forecast Horizon

16.

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

Compare the breakdown of the value estimates for United Parcel Service (UPS) based on the horizon by completing the following chart. What do you learn from this exercise?

Breakdown of UPS Value Estimate based on Horizon Discounted Cash Flow Model Amount Percent No forecast necessary Based on forecasts within horizon 21,300 Based on continuing value 95,443 Total estimated value 116,743

Residual Operating Income Model Amount Percent 37,271 14,423 65,049 116,743

Abnormal Operating Income Growth Model Amount Percent 89,958 26,785 116,743

* Note to instructor, the amount columns can be deleted when the valuations from chapter 10 - 12 are available.

Breakdown of UPS Value Estimate based on Horizon Discounted Cash Flow Model Amount Percent No forecast necessary 0.0% Based on forecasts within horizon 21,300 18.2% Based on continuing value 95,443 81.8% Total estimated value 116,743 100.0%

Residual Operating Abnormal Operating Income Model Income Growth Model Amount Percent Amount Percent 37,271 31.9% 0.0% 14,423 12.4% 89,958 77.1% 65,049 55.7% 26,785 22.9% 116,743 100.0% 116,743 100.0%

For the discounted cash flow model (DCFM) over 80 percent of the value is based on estimates beyond the forecast horizon. This is typical of DCF valuations which do not have an anchor to the valuation estimate. For the residual operating income model (ROIM), the anchor known today, net operating assets (NOA) captures over 30 percent of UPS’ value while the forecast adds another 12 percent. The abnormal operating income model (AOIGM) yields 77 percent of its valuation with the forecast horizon. Both the ROIM and AOIGM have more of their valuation based on their anchors and short-term forecasts while the DCF model has the vast majority of its value estimated beyond the forecast horizon.

©© Cambridge Business Publishers, 2021 Test Bank, Chapter 14

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