ch06sol

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Financial Reporting and Analysis

Chapter 6 SolutionsThe Role of Financial Information in Valuation,

Cash Flow Analysis, and Credit Risk AssessmentProblems/Discussion Questions

ProblemsP6-1. Quality of earnings essay

Requirement 1:Quality of earnings relates to how well accrual accounting earnings capturesthe underlying economic performance of an enterprise for a particular periodof time. One important dimension of earnings quality is how sustainable orpersistent the reported earnings number is. Poor earnings quality occurswhen there are transitory components embedded in earnings that are notsustainable, rendering the current earnings number a poor indicator of futureperformance.

Requirement 2:Management can improve earnings in the short-run by:

Changing accounting methods. Adjusting expense estimates (e.g., increasing estimated useful lives of

fixed assets or reducing bad debt expense estimates). Altering timing of revenue or expense recognition (i.e., shifting revenues or

expenses from one period to the next).

Requirement 3:Examples of low-quality earnings items include:

One-time gains and losses from sales of assets. Liberal accounting choices that increase short-run profits. Changes in discretionary expenditures for R&D, advertising, and

maintenance. Illusory profits from LIFO liquidations.

A variety of other examples could be listed here. See articles on earningsquality referenced in the chapter.

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P6-2. Discussion questions on the role of accounting numbers in valuation

Requirement 1:The role of accounting numbers in corporate valuation:

Corporate valuation involves estimating the worth or price of a company, oneof its operating units, or its ownership shares. Some equity valuationapproaches are based on discounting a firms future earnings or operatingcash flows. In such settings, the role of accounting numbers (i.e., theinformation in financial statements) is to aid in the development of projectionsof the firms future earnings or operating cash flows. These projections arethen discounted at the firms risk-adjusted cost of equity capital to arrive atan estimate of the equitys value.

Requirement 2:The role of accounting numbers in cash flow assessment:

Cash flow assessment is important to assessing the credit risk of a company.Banks and other lenders use accounting numbers (as well as otherinformation) to estimate a firms future cash flows. These estimates are thencompared to projected future debt-service requirements. Companies withprojected operating cash flows in excess of debt principal and interestpayments are classified as good credit risks, while those with less favorableoperating cash flow prospects are classified as high credit risks and may bedenied credit, be charged higher interest rates, or have stringent conditionsplaced on their loans. Simply stated, accounting numbers play a key role inlending decisions by providing information that is used to assess the amount,timing, and uncertainty (i.e., risk) of a firms future cash flows.Requirement 3:Sustainable earnings:

Sustainable or permanent earnings is the component of earnings that isvaluation-relevant and is expected to persist into the future. Earningsgenerated from repeat customers or from a high-quality product that enjoyssteady customer demand is an example of sustainable earnings. Examples ofunsustainable earnings items include gains or losses resulting from debtretirement, write-off of assets from corporate restructuring and plant closings,or a reduction in discretionary expenditures for advertising, or research anddevelopment.

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Requirement 4:The process of valuation:

The process of valuation involves the following steps:1) Forecasting the future values of the financial attributes deemed to drivethe value of a firm (i.e., value-relevant attributes). Examples of commonly usedvalue-relevant attributes include distributable or free cash flows, accountingearnings, and balance sheet book values.

2) Determining the risk or uncertainty associated with the value-relevantattribute(s).3) Determining the discounted present value of the expected future values ofthe value-relevant attribute(s). The discount rate will reflect the risk oruncertainty inherent in the value attribute(s) of interest.Requirement 5:The free cash flow approach to valuation:

Free cash flow is operating cash flow minus cash outlays for the replacementof existing operating capacity like buildings, equipment, and furnishings. Acompanys free cash flow thus represents the amount available to financeplanned expansion of operating capacity, reduce debt, pay dividends, orrepurchase stock.

Under the free cash flow approach to valuation, the price of the stock at time= 0, P0 , is equal to the sum of the future stream of expected free cash flow pershare discounted back to the present at the firms cost of equity capital.Multiplying the estimated stock price, P0 , by the number of common sharesoutstanding produces an estimate of the total common equity value of thecompany. Simply put, the free cash flow model expresses todays marketvalue of each common share as a function of investors current expectationsof the firms future economic prospects as measured by its expected futurefree cash flows.

Requirement 6:The abnormal earnings approach to valuation:

Abnormal earnings is the difference between actual earnings for period t (Xt )and stockholders required dollar return on invested capital at the beginningof the period (r BVt-1). More specifically:

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Abnormal Earnings X r BVt t t 1- - -

6 7444 8444

ActualEarnings

RequiredEarnings

Perhaps the most important aspect of the abnormal earnings model is thatinvestors will pay a premium only for the stocks of firms that earn more thantheir cost of equity capital (i.e., firms that earn positive abnormal earnings).Conversely, investors will pay less than book value for firms that earn negativeabnormal earnings. As described in the text, the abnormal earnings valuationmodel is:

P BV

E (Abnormal Earningst)(1 r)0 0

0t= + +=

6 74444 84444

t 1

Book value ofequity at time 0

Discount factors for allfuture periods

Price of equity at time 0

Expected abnormal earnings in allfuture periods

where

BV denotes equity book value (assets minus liabilities) shareholders haveinvested in the firm;

E0 denotes the expectation about future abnormal earnings formed at time 0;and

r is the cost of equity capital.

The cost of equity capital, r, also corresponds to the risk-adjusted returnstockholders require from their investment. Therefore, r BVt-1 orstockholders required rate of return multiplied by beginning of periodinvested capitalis the earnings level the company must generate in period tto satisfy stockholders. Any difference between actual earnings for period t(Xt ) and stockholders required dollar return on invested capital at thebeginning of the period (r BVt-1) represents abnormal earnings.

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Requirement 7:Earnings surprise:

An earnings surprise represents new information that is conveyed toinvestors at the time of a firms quarterly or annual earnings announcement.An earnings surprise occurs when the earnings that a firm reports is differentfrom what the market was expecting the firm to report. Investors use earningssurprises to revise their expectations of the firms future earnings and cashflow prospects. The stock price change will be positive when the earningssurprise is good news (i.e., reported earnings exceeded what the markethad expected). The stock price change will be negative when the earningssurprise is bad news (i.e., reported earnings was less than what the markethad expected).

P6-3. Explaining differences in P/E ratiosIn general, price-earnings (P/E) ratios are inversely related to risk, positivelyrelated to growth opportunities, and positively related to the quality ofearnings.

Requirement 1:Group A:

These firms are all from different industries. General Motors is an automobilemanufacturer, Merck is a drug company, and Microsoft is in the computersoftware industry. Here are some reasons for the observed differences intheir P/E ratios:

General Motors probably has the worst set of growth options. Merck,undoubtedly, has some growth options and probably far more so than GM,but probably not as many or ones as valuable as Microsoft. Thus, theordering of their P/E ratios appears to roughly correspond to their apparentgrowth opportunities. In fact, this seems like the most compelling reason forthe observed differences in the firms P/E ratios.Turning to risk, it seems unreasonable to suspect that GM, being from acyclical industry, is likely to be riskier than either Merck or Microsoft. On thesurface, it also seems reasonable to presume that Merck and Microsoft areunlikely to differ significantly in terms of risk. Thus, the ordering of the firmsP/E ratios also appears to roughly correspond to their apparent risk.Without a detailed study of the accounting methods used by the three firms, itis difficult to draw any conclusions about the extent to which the observeddifferences might also be related to differences in the quality of their reportedearnings. Given the ordering of the P/E ratios of the firms, one would be led tosuspect that Microsofts earnings are the highest quality, followed by Merckand GM, respectively.

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As noted above, in all likelihood, most of the variation in the P/E ratios ofthese firms is due to differences in their growth opportunities.Requirement 2:Group B:

These firms are all from the same industry, personal computer manufacturing.Consistent with this, there is less variation among their P/E ratios whencompared to the firms in Group A. In addition, the P/E ratios of CompaqComputer and Gateway 2000 are not that far apart. The primary differenceamong the firms is that Dells P/E ratio is much larger than that of the othertwo. Some possible reasons for this might be:1) Investors perceive that Dell has more valuable growth opportunities, or isbetter prepared to exploit its existing growth opportunities, when compared toCompaq and Gateway 2000.2) Investors assign a lower level of risk (i.e., discount rate) to Dell whencompared to Compaq and Gateway 2000.

3) Finally, it might be that investors perceive that Compaq and Gateway2000s earnings are of similar quality, but that both are inferior to the quality ofDells reported earnings.Of the three explanations above, (1) seems to be the most compelling. Withregard to the quality of earnings issue in (3), we often find that firms in thesame industry tend to use the same accounting methods. Thus, within anindustry, quality of earnings issues may be of less importance in explainingdifferences in P/E ratios than in comparisons across industries (i.e., as inGroup A).

P6-4. Abnormal earnings: Some simple examples

Abnormal earnings (AE) = NOPAT - (r BVt-1).Requirement 1:

AE = $5,000 - (0.15 $50,000)= $5,000 - $7,500= -$2,500

Requirement 2:

AE = $25,000 - (0.18 $125,000)= $25,000 - $22,500= $2,500

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Requirement 3:

AE = $30,000 - (0.18 $125,000)= $30,000 - $22,500= $7,500

NOTE: Higher NOPAT without additional investment (i.e., the same BVt-1) isgood.

Requirement 4:

AE = $23,000 - (0.18 $100,000)= $23,000 - $18,000= $5,000

NOTE: Eliminating unproductive assets that do not earn as high a rate ofreturn as other assets increases AE. In this case, the unproductive assetswere earning a return of only 8% ($2,000/$25,000).

Requirement 5:

AE = $32,600 - (0.18 $165,000)= $32,600 - $29,700= $2,900

AE increases by $400 (from $2,500 to $2,900). Adding the division makessense. The new division earns a return of 19% ($7,600/$40,000), which ismore than the firms 18% required rate of return, so value is added, and thechange in AE is positive.

Requirement 6:

AE = $8,500 - (0.15 $75,000)= $8,500 - $11,250= -$2,750

AE falls by $250. Adding the new division does not make sense. In essence,the new division does not earn a high enough rate of return to justifyinvestment. The new division earns a return of 14% ($3,500/$25,000) which isless than the firms 15% required rate of return, so value is lost, and thechange in AE is negative.

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P6-5. Value creation by two companies

Requirement 1:The abnormal earnings of the two firms for 1997-2001 appears below.

1997 1998 1999 2000 2001Company A

NOPAT $66,920 $79,632 $83,314 $89,920 $92,690BVt-1 478,000 504,000 541,000 562,000 598,000Cost of equity capital 0.152 0.167 0.159 0.172 0.166Return on capital 0.140 0.158 0.154 0.160 0.155Abnormal earnings ($5,736) ($4,536) ($2,705) ($6,744) ($6,578)

Company B

NOPAT $192,940 $176,341 $227,700 $198,900 $282,964BVt-1 877,000 943,000 989,999 1,020,000 1,199,000Cost of equity capital 0.188 0.179 0.183 0.175 0.186Return on capital 0.220 0.187 0.230 0.195 0.236Abnormal earnings $28,064 $7,544 $46,530.95 $20,400 $59,950

Requirement 2:Company B created value each year via positive abnormal earnings,while Company A actually destroyed value each year by earningnegative abnormal earnings.

P6-6 Determinants of P/E ratios

Requirement A:Present value of growth opportunities:

Price-earnings ratios are positively related to the present value of a firmsgrowth opportunities. The reason is that the value of the stock is a function ofthe expected return earned on the assets in place as well as the firms growthopportunities. Thus, firms with little or no current earnings may still have veryhigh P/E ratios because they have an incredible array of growth options totake advantage of in the future. Some examples are biotechnology orcomputer software and hardware companies.

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Requirement B:Risk:

Price-earnings (P/E) ratios are inversely related to a firms risk (r) as riskincreases, the P/E ratio decreases. You can see this from the P/E equation.To simplify matters, consider a firm with no growth opportunities. In this case:

P/E=1/r

A low-risk firm with r = 0.05 would have a P/E of 20, but a higher-risk firm withr = 0.10 would have a P/E of 10. Higher risk, lower P/E.

The intuition behind the inverse relationship between P/E and risk is straight-forward. As risk (the discount rate) increases, investors assign a lower pricefor each dollar of future earnings. This lower price means a lower P/E ratio.Again, higher risk means lower P/E.

Requirement C:Accounting methods:

Firms that use conservative accounting methods (i.e., those that tend torecognize expenses sooner rather than later and revenues later rather thansooner) will report lower earnings than would otherwise be the case. Thelower earnings means that these firms will tend to have higher P/E ratios thanmight otherwise be the case. Conversely, firms that use aggressiveaccounting methods (i.e., those that tend to recognize expenses later ratherthan sooner and revenues sooner rather than later) tend to report higherearnings than would otherwise be the case. The higher earnings means thatthese firms will tend to have lower P/E ratios than might otherwise be thecase. An interesting issue is the extent to which investors in the marketadjust for such accounting method differences when setting the market pricesof otherwise similar firms.

P6-7 Valuing growth opportunities

Requirement 1:The cost of equity capital for eToys is higher than that of Wal-mart becauseeToys has a riskier cash flow stream than that of Wal-mart. Wal-mart has along history of earnings and operating cash flows, and is less volatile thaneToys.

Requirement 2:Dell:38.44 = .68/.176 + NPVGO38.44 = 3.86 + NPVGONPVGO = 34.58

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eToys:8.84 = -1.78/.183 + NPVGO8.84 = -9.73 + NPVGONPVGO = 18.57

Ford Motor:53.31 = 5.29/.124 + NPVGO53.31 = 42.66 + NPVGONPVGO = 10.65

Home Depot:56.63 = 1.08/.125 + NPVGO56.63 = 8.64 + NPVGONPVGO = 47.99

United Airlines:77.56 = 12.55/.137 + NPVGO77.56 = 91.61 + NPVGONPVGO = -14.05

Wal-Mart:54.75 = 1.3/.135 + NPVGO54.75 = 9.63 + NPVGONPVGO = 45.12

Requirement 3:It appears that United Airlines has negative growth. The firms value comesfrom assets already in place. Future growth is destroying that value.

Requirement 4:Ford Motor company is a mature company while Wal-Mart is continuing togrow. Most of the value in Ford Motor comes from existing assets but Wal-Marts value is still heavily based on future growth possibilities.

P6-8 Interpreting stock price changes

Requirement 1:A stock price change would be expected, i.e., the stock price is likely to fall.This is because the market was expecting the company to earn $5.00 pershare and now managers are reporting that the firm will earn only $4.50. Sincethe stock price just prior to the announcement is based on expectedearnings of $5.00, it will fall to reflect the bad news that earnings will only be$4.50.

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Requirement 2:The magnitude of the stock price drop is likely to be greater in case (b) thanin (a). This is because the drop in earnings in (a) is due to a transitory event(i.e., the labor strike), while the earnings decline in (b) is due to an event thatis likely to have an impact on the firms permanent earnings.

However, one cannot rule out the possibility that the magnitude of the stockprice drop might be greater in (a) than in (b). Such might be the case if themarket actually thought that leaving the market for sports-utility vehicleswould be good for the firm because the companys operations in that markethave led to low profits or even losses.

P6-9 Components of earnings

Requirement 1:a) Permanent earnings refers to that component of a firms reported earningsthat is value-relevant. Moreover, permanent earnings are those earningsexpected to continue into the future. This component roughly corresponds toincome from continuing operations as reported in a firms income statement.

b) Transitory earnings refers to that component of a firms reported earningsthat is value-relevant, but not expected to persist into the future. Thiscomponent roughly corresponds to income from discontinued operations andextraordinary gains and losses as reported in a firms income statement.

c) Value-irrelevant earnings is the noise component of a firms reportedearnings. This component is unrelated to a firms future profitability or futurecash flows, and thus irrelevant when it comes to valuation of the firms stock.This component roughly corresponds to the item cumulative effect ofchanges in accounting methods as reported in a firms income statement.

Requirement 2:A. Consider an airline company:

An example of permanent earnings would be the earnings that arise from thefirms ongoing/recurring passenger and cargo operations.

An example of transitory earnings would be the one-time earnings effect of aspecial contract to handle all of the charter flights for an outside travelcompany for one year only. Another example of transitory earnings is theearnings effect of the retirement of some long-term debt (an extraordinaryitem).An example of value-irrelevant earnings would be the increase in earningsdue to a change in the useful lives and/or salvage values of the firms aircraft.

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B. Consider an automobile manufacturer:

An example of permanent earnings would be the earnings that arise from thefirms ongoing/recurring sales and leasing of passenger cars, trucks, etc. Anexample of an increase in the firms permanent earnings would be a contractto supply all of the new vehicles every year in the future to one of the nationsrental car companies.

An example of transitory earnings would be the one-time earnings effect of aspecial purchase of cars by one of the nations rental car companies.Another example of transitory earnings is the earnings effect of a labor strikeby one of the firms unions.

An example of value-irrelevant earnings would be the increase in earningsdue to a change in the method used to depreciate the firms long-term assets.

Numerous other student responses to this question are possible.

P6-10 Stock price assimilation of earnings information

Requirement 1:The good news firms are those that report earnings better than expectedwhen they eventually announce their earnings on day 0. In other words,these are firms that are performing well during the quarter leading up to theearnings announcement date. The reason for the upward drift during thequarter is that accounting earnings and its announcement at the end of thequarter is not the sole source of value-relevant information about firms.Moreover, during the quarter, other pieces of information will come to themarket indicating that these firms are doing better than expected as of thebeginning of the quarter (e.g., analyst reports, management forecasts, etc.),and, as a result, their stock prices will increase. The outcome of this processis a plot like the one illustrated in the chapter where the stock prices of thesegood news firms will tend to drift upward during the quarter as they reflectmore and more information confirming the firms better than expectedperformance during the period. This good performance is confirmed at theend of the period when, on average, the firms report earnings greater thanexpected at the beginning of the quarter.

Requirement 2:The bad news firms are those that report earnings worse than expectedwhen they eventually announce their earnings on day 0. In other words,these are firms that are performing poorly during the quarter leading up to theearnings announcement date. The reason for the downward drift during thequarter is that accounting earnings and its announcement at the end of thequarter is not the sole source of value-relevant information about firms.Moreover, during the quarter, other pieces of information will come to the

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market indicating that these firms are doing worse than expected as of thebeginning of the quarter (e.g., analyst reports, management forecasts, etc.),and, as a result, their stock prices will decrease. The outcome of this processis a plot like the one illustrated in the chapter where the stock prices of thesebad news firms will tend to drift downward during the quarter as they reflectmore and more information confirming the firms worse than expectedperformance during the period. This poor performance is confirmed at the endof the period when, on average, the firms report earnings lower than expectedat the beginning of the quarter.

Requirement 3:The no news firms are those that report earnings equal to those expectedwhen they eventually announce their earnings on day 0. In other words,these are firms that are performing as the market expected during the quarterleading up to the earnings announcement date. The reason for the near flatprice plot during the quarter is that the information the market receives aboutthese firms during the quarter just confirms that these firms are performing asexpected as of the beginning of the quarter. As a result, their stock prices willnot change much. This expected performance is confirmed at the end of theperiod when, on average, the firms report earnings approximate thoseexpected at the beginning of the quarter.

Requirement 4:A. On day 0, the good news firms report earnings that are higher thanexpected. This positive earnings surprise causes the stock prices of thesefirms to increase, on average.

B. On day 0, the bad news firms report earnings that are lower thanexpected. This negative earnings surprise causes the stock prices of thesefirms to decrease, on average.

C. On day 0, the no news firms report earnings that are equal to thoseexpected. Since there is no earnings surprise, the stock prices of these firmsdo not change, on average.

Requirement 5:One possibility is that the market reaction to earnings information isincomplete; thus, the plot of the good (bad) news group continues on anupward (downward) trend after the earnings announcement date. Thissuggests that the market is not efficient in processing earnings-relatedinformation. The existence of this post-earnings announcement drift in stockreturns has been corroborated by over 40 studies, although the cause of thedrift remains unclear. Its magnitude has declined in recent years.

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Requirement 6:If we assume that more information is produced by external parties (e.g.,financial analysts, etc.) about large firms when compared to small firms priorto their earnings announcements, the plots may look something like thefollowing. The good and bad news plots of large firms would begin driftingupward and downward earlier in the quarter when compared to those of smallfirms as a result of more information being produced and released soonerabout large firms vis--vis small firms. Stated differently, the plots of smallfirms would begin to drift upward and downward later in the quarter becauseless information is produced about them prior to their earningsannouncements when compared to larger firms.

Turning to the stock price behavior at the time of the actual earningsannouncements of large versus small firms, if we assume that moreinformation is produced by external parties (e.g., financial analysts, etc.) aboutlarge firms when compared to small firms prior to their earningsannouncements, then the stock price effects of the earnings announcementsof small firms should be larger in magnitude than those for large firmsbecause there is more information left to be communicated by the accountingearnings of small firms.

There is some empirical evidence that supports the stock price behaviornoted above. (See R. Freeman, The Association Between AccountingEarnings and Security Returns for Large and Small Firms, Journal ofAccounting and Economics (July 1987), pp. 195227, and D. Collins, S. P.Kothari and J. Rayburn, Firm Size and the Information Content of Prices withRespect to Earnings, Journal of Accounting and Economics (July 1987), pp.111138.)

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P6-11. Applying P/E multiples to earnings components

Requirement 1:ABC Corp.Reported EPS: $5.00EPS decomposition:Valuation multiple for permanent earnings (1/0.15) = 6.67Valuation multiple for transitory earnings = 1.0Valuation multiple for value-irrelevant earnings = 0.0

Implied valuation

Permanent 75% ($5.00 0.75) 6.67 = $25.00Transitory 20% ($5.00 0.20) 1 = 1.00Value-irrelevant 5% ($5.00 0.05) 0 = 0.00

Implied share price: $26.00Implied earnings multiple (share price/reported EPS): 5.2XYZ Corp.Reported EPS: $5.00EPS decomposition:Valuation multiple for permanent earnings (1/.015) = 6.67Valuation multiple for transitory earnings = 1.0Valuation multiple for value-irrelevant earnings = 0.0

Implied valuation


Implied share price: $19.58Implied earnings multiple (share price/reported EPS): 3.9The implied share price and earnings multiple of ABC Corp. is higher thanthat of XYZ Corp. because the reported earnings of ABC Corp. are higherquality than those of XYZ Corp. Moreover, XYZ Corp.s reported earningshas both a higher permanent earnings component and a lower value-irrelevant component.

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Requirement 2:ABC Corp.Reported EPS: $5.00EPS decomposition:Valuation multiple for permanent earnings (1/0.08) = 12.5Valuation multiple for transitory earnings = 1.0Valuation multiple for value-irrelevant earnings = 0.0

Implied valuation


Implied share price: $47.875Implied earnings multiple (share price/reported EPS): 9.6XYZ Corp.Reported EPS: $5.00EPS decomposition:Valuation multiple for permanent earnings (1/0.08) = 12.5Valuation multiple for transitory earnings = 1.0Valuation multiple for value-irrelevant earnings = 0.0

Implied valuation


Implied share price: $35.625Implied earnings multiple (share price/reported EPS): 7.1As before, the implied share price and earnings multiple of ABC Corp. ishigher than that of XYZ because the reported earnings of ABC Corp. arehigher quality than those of XYZ Corp. Moreover, XYZ Corp.s reportedearnings has both a higher permanent earnings component and a lowervalue-irrelevant component.

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P6-12. Abnormal earnings valuationCompaq Computer

Requirement 1:Using the information provided, Compaq Computers cost of equity capital isestimated to be 14.13% (or 6.33% + 1.30 x 6.00%). Inserting the forecastassumptions into the Excel valuation spread sheet produces an estimatedstock price of $4.67. This is considerable below the companys April 2000trading price of $29.19.One reason for the low valuation estimate is that the forecast assumptionsimply that Compaq will generate negative abnormal earnings over the 5-yearhorizon, and beyond. This seems odd because analysts are forecasting thecompany to report hefty profits in 2000 and to grow those profits at 20%annually over the forecast horizon. However, our forecasts also call forCompaq to add more capital to the business ($1.50 of stock issued eachyear). This capital infusion offsets the growth in profits and results innegative abnormal earnings.

What happens to the valuation estimate if the company does issue morestock and all other forecasts remain unchanged? The estimated stock pricebecomes $13.03, still considerable below the April 2000 trading price.A copy of the Excel valuation solution appears on the next page.

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Requirement 2:These more optimistic earnings forecasts produce a value estimate of$19.11. If we again assume that Compaq does not issue more stock andkeep the other forecasts unchanged, the value estimate increases to $27.47per share. This is close to the April 2000 trading price of $29.19.Requirement 3:Both valuations are suspect. The value estimates in (2) are more in line withthe market price of the stock, but the earnings forecasts seem quiteheroic30% annual earnings growth for a company facing intensecompetition in most of its markets. Hindsight suggests that achieving the20% earnings growth forecasts in (1) will prove difficult for the company.On the other hand, the value estimates in (1) seem too low. One culprit is ourforecasted stock sale by the company. The market may also have assignedthe company a cost of equity capital that is lower than the 14.13% used in ouranalysis.

Beyond

1997 1998 1999 2000 2001 2002 2003 2004 2004

a) Earnings Forecasts

Reported earnings per share 1 $1.23 ($1.71) $0.35

Last year's earnings per share $0.35 $1.07 $1.47 $1.76 $2.12

x (1 + Forecasted earnings growth) 3.0571 1.3738 1.2000 1.2000 1.2000

= Forecasted earnings per share $1.07 $1.47 $1.76 $2.12 $2.54

b) Equity Book Value Forecasts

Equity book value at beginning of year $4.49 $6.21 $6.73 $8.74 $11.21 $14.08 $17.24 $20.76

+ Earnings per share 1.23 (1.71) 0.35 $1.07 $1.47 $1.76 $2.12 $2.54

+ Stock issued (repurchased) 0.50 2.29 1.75 1.50 1.50 1.50 1.50 1.50

+ Other comprehensive income per share $0.00 $0.00 $0.00 0.00 0.00 0.00 0.00 0.00

- Dividends per share 0.01 0.06 0.09 0.10 0.10 0.10 0.10 0.10

= Equity book value at year-end $6.21 $6.73 $8.74 $11.21 $14.08 $17.24 $20.76 $24.70

ROE = EPS / Equity book value at beginning of year 27.4% -27.5% 5.2% 12.2% 13.1% 12.5% 12.3% 12.2%

c) Abnormal Earnings


x Equity cost of capital 14.1% 14.1% 14.1% 14.1% 14.1% 14.1% 14.1% 14.1%

= Normal earnings $0.63 $0.88 $0.95 $1.23 $1.58 $1.99 $2.44 $2.93

Actual or forecasted earnings $1.23 ($1.71) $0.35 $1.07 $1.47 $1.76 $2.12 $2.54 - Normal earnings 0.63 0.88 0.95 1.23 1.58 1.99 2.44 2.93

= Abnormal earnings $0.60 ($2.59) ($0.60) ($0.16) ($0.11) ($0.23) ($0.32) ($0.39)

c) Valuation

Future abnormal earnings in forecast horizon ($0.16) ($0.11) ($0.23) ($0.32) ($0.39)

x Discount factor at 14.13% 0.87619 0.76772 0.67267 0.58939 0.51642

= Abnormal earnings discounted to present ($0.14) ($0.09) ($0.15) ($0.19) ($0.20)

Abnormal earnings in year 2005 ($0.42) Assumed long-term growth rate 7.5%

Perpetuity factor for year 2004 15.08

Discount factort at 14.13% 0.51642

Present value of terminal year abnormal earnings ($3.29)

d) Estimated share price

Sum of discounted abnormal earnings over horizon ($0.78)

+ Present value of terminal year abnormal earnings ($3.29)

= Present value of all abnormal earnings ($4.07) + Current equity book value $8.74

= Estimated current share price at April 2000 $4.67

Actual share price at April 2000 $29.19

Problem 6-12 COMPAQ COMPUTERAbnormal Earnings Valuation as of April 2000

Actual Results Forecasted Results

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What would an analyst do at this point? Dig more deeply into the company,its operating profitability, and the competitive environment the company islikely to face over the next five years. Several key aspects of the valuationanalysis need to be sharpened. These include validating the cost of capitalestimate; taking a more careful look at planned stock sales; and developingmore plausible forecasts of earnings growth over the 5-year horizon and inthe terminal year. It might be helpful to contact management for informationabout earnings growth and competitive pressures in the marketplace.

P6-13. Abnormal earnings valuationDell Computer

Requirement 1:Using the information provided, Compaq Computers cost of equity capital isestimated to be 16.05% (or 6.33% + 1.62 x 6.00%). Inserting the forecastassumptions into the Excel valuation spread sheet produces an estimatedstock price of $14.52. This is considerable below the companys April 2000trading price of $50.13.Based on our forecasts, Dell is predicted to earn positive abnormal earningsover the 5 years and beyond. However, this level of earnings is not sufficientto justify the current $50.13 share price. What long-term earnings growthrate does the $50.13 market price imply? If we substitute a long-term growthforecast of 14.15% for our original 7.5% estimate, the valuation spreadsheetsays the company is worth $50.00.A copy of the Excel valuation solution appears on the next page.

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Requirement 2:These more optimistic earnings forecasts produce a value estimate of $24.61.The long-term growth rate needed to justify a $50 share price is now only12.4%.

Requirement 3:Both valuations are somewhat suspect. The value estimates in (2) are more inline with the market price of the stock, but the earnings forecasts seem quiteheroic45% annual earnings growth over the 5-year horizon followed by 12.4%perpetual growth! This seems a bit optimistic for a company facing intensecompetition in most of its markets. Hindsight suggests that achieving the 33%earnings growth forecasts in (1) will prove difficult for the company.On the other hand, the value estimate in (1) seems too low. There are tworeasons why this value estimate may understate what the company is worth.One possibility is that our cost of capital estimate (16.05%) is too high. The useof a CAPM cost of capital estimate remains one of the most controversialaspects of applied valuation analysis. A second possibility is that our terminalgrowth estimate of 7.5% is too low. Notice that our forecast has earningsgrowing by 33% in the last year of the forecast horizon, and then the

Beyond1997 1998 1999 2000 2001 2002 2003 2004 2004

a) Earnings Forecasts

Reported earnings per share 1 $0.36 $0.57 $0.66 Last year's earnings per share $0.66 $0.92 $1.21 $1.61 $2.14

x (1 + Forecasted earnings growth) 1.3939 1.3152 1.3300 1.3300 1.3300

= Forecasted earnings per share $0.92 $1.21 $1.61 $2.14 $2.85

b) Equity Book Value Forecasts


+ Earnings per share 0.36 0.57 0.66 $0.92 $1.21 $1.61 $2.14 $2.85

+ Stock issued (repurchased) (0.25) (0.16) 0.49 0.00 0.00 0.00 0.00 0.00 + Other comprehensive income per share $0.00 $0.00 $0.00 0.00 0.00 0.00 0.00 0.00

- Dividends per share 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

= Equity book value at year-end $0.50 $0.91 $2.06 $2.98 $4.19 $5.80 $7.94 $10.79

ROE = EPS / Equity book value at beginning of year 92.3% 114.0% 72.5% 44.7% 40.6% 38.4% 36.9% 35.9%

c) Abnormal Earnings


x Equity cost of capital 16.1% 16.1% 16.1% 16.1% 16.1% 16.1% 16.1% 16.1% = Normal earnings $0.06 $0.08 $0.15 $0.33 $0.48 $0.67 $0.93 $1.27

Actual or forecasted earnings $0.36 $0.57 $0.66 $0.92 $1.21 $1.61 $2.14 $2.85

- Normal earnings 0.06 0.08 0.15 0.33 0.48 0.67 0.93 1.27 = Abnormal earnings $0.30 $0.49 $0.51 $0.59 $0.73 $0.94 $1.21 $1.57

c) Valuation

Future abnormal earnings in forecast horizon $0.59 $0.73 $0.94 $1.21 $1.57 x Discount factor at 16.05% 0.86170 0.74252 0.63983 0.55134 0.47509

= Abnormal earnings discounted to present $0.51 $0.54 $0.60 $0.67 $0.75

Abnormal earnings in year 2005 $1.69 Assumed long-term growth rate 7.5%

Perpetuity factor for year 2004 11.70

Discount factort at 16.05% 0.47509

Present value of terminal year abnormal earnings $9.39

d) Estimated share price

Sum of discounted abnormal earnings over horizon $3.06

+ Present value of terminal year abnormal earnings $9.39

= Present value of all abnormal earnings $12.46 + Current equity book value $2.06

= Estimated current share price at April 2000 $14.52

Actual share price at April 2000 $50.13

Problem 6-13 DELL COMPUTERAbnormal Earnings Valuation as of April 2000

Actual Results Forecasted Results

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growth rate immediately drops to only 7.5%. Perhaps a more accurateapproach would be to use a 10-year forecast horizon where we allow theearnings growth rate to fade down gradually from 33% to a 7.5% long-termestimate over several years.

It is also worth noting that by May 2001, Dells stock price had fallen to $26per share.

P6-14. Calculating sustainable earnings

Requirement 1:The original income statements for 19982000 appear on the next pagealong with the calculation of sustainable earnings for each of the three years.Except for the transitory revenue of $1 billion in 2000, which was given in thecase, all of the adjustments required to calculate each years sustainableearnings appear on the original income statements. The adjustments fall intotwo categories: (1) Non-recurring/transitory losses and expenses thatneeded to be added back (on an after-tax basis) to net income; and (2) Gainsand credits that needed to be subtracted (on an after-tax basis) from netincome.

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Colonel Electric Inc.(in millions of $) As Reported Earnings Sustainable Earnings CalculationFor Years Ended December 31, 2000 1999 1998 2000 1999 1998RevenuesSales of goods $54,196 $53,177 $52,767 $54,196 $53,177 $52,767Sales of services 11,923 10,836 8,863 11,923 10,836 8,863Royalties and fees 1629 753 783 629 753 783

Total revenues 67,748 64,766 62,413 66,748 64,766 62,413

Costs and Expenses:Cost of goods sold (24,594) (24,308) (22,775) (24,594) (24,308) (22,775)Cost of services sold (8,425) (6,785) (6,274) (8,425) (6,785) (6,274)Restructuring charges (+ reversals) 1,000 0 (2,500) 0 0 0Interest charges (595) (649) (410) (595) (649) (410)Other costs and expenses (6,274) (5,743) (5,211) (6,274) (5,743) (5,211)Litigation charges (+ income) 550 0 (250) 0 0 0Losses (+ gains) on sales of investments (75) 0 25 0 0 0Losses (+ gains) on sales of misc. assets 0 55 0 0 0 0Losses (+ gains) on sales of fixed assets 25 0 (35) 0 0 0Inventory write-offs 0 (18) 0 0 0 0Asset impairments 0 0 (24) 0 0 0Special item charges (34) 0 (8) 0 0 0Loss from labor strike 0 (20) 0 0 0 0Total costs and expenses (38,422) (37,468) (37,462) (39,888) (37,485) (34,670)

Earnings from continuing operations before income taxes 29,326 27,298 24,951 26,860 27,281 27,743Provision for income taxes (34%) (9,971) (9,281) (8,483) (9,132) (9,276) (9,433)Earnings from continuing operations 19,355 18,017 16,468 17,728 18,005 18,310Loss (+ income) from discontinued operations (net of tax) 0 (250) 1,100 0 0 0Loss (+ gain) on sale of discontinued operations (net of tax) 750 0 0 0 0 0Extraordinary loss (+ gain) on early debt retirement (net of tax) (50) 0 10 0 0 0Cumulative loss (+ gain) from change in accounting methods (net of tax) ___(110 ) ______0 _____55 ______0 ______0 ______0 Net Earnings $19,945 $17,767 $17,633 $17,728 $18,005 $18,310

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Requirement 2:An interesting conclusion emerges when reported earnings are comparedwith sustainable earnings. While the firms reported earnings increased eachyear from 1998 to 2000, its sustainable earnings fell each year from 1998-2000. This points to the importance of identifying and adjusting for thepresence of non-recurring and other transitory Items in the income statementwhen attempting to gauge a firms potential long-run earnings generatingability.

P6-15. Net accruals and discretionary accruals

Requirement 1:Total accruals are the difference between operating cash flow and netincome:

Total accruals = Operating cash flow - Net income= ($38,460) - $12,540= ($51,000)

Requirement 2:The individual components are:

Adjustments to net income:Add to net income:

Depreciation expense $14,000Decrease in prepaid expenses 5,000Increase in accounts payable 65,000Increase in interest payable 12,000

Net additions $96,000 Subtract from net income:

Increase in accounts receivable 20,000Increase in inventories 30,000Decrease in accrued payables 80,000Decrease in income tax payable 17,000

Net subtractions $147,000 Net accruals ($51,000)

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Requirement 3:a) Depreciation policy because the manager selects the depreciationmethods, useful lives, and salvage values.

b) The change in accounts receivable is also subject to managerialdiscretion through the provision for bad debts.

c) The change in the inventories account also is subject to some managerialdiscretion as the manager has control over the level of the firms inventory(i.e., purchasing policy) and makes decisions about the timing of the write-offof obsolete inventory.

d) Managers also have control over prepaid expenses as they decide whatitems, if any, to prepay during or at the end of the accounting period.

e) The change in the accounts payable and accrued payables accounts alsogive managers discretion over the firms net accruals. This is becausemanagement has influence over when payment is made to suppliers.Payments can be accelerated or delayed at the end of the accounting period,and this will affect the firms total accruals.

Requirement 4:Reasons to manipulate accruals include the following:

The manager may have a bonus plan that is a function of the firms reportedearnings. In most cases, a bonus is paid if net income exceeds a minimumlevel (the floor) and increases until a maximum level of earnings is reached(the ceiling). In cases where net income is above the floor but below theceiling, a manager may try to increase income (e.g., via adjustments todepreciation policy and the bad debt allowance) to increase his bonus. Incases where net income is well below the floor or above the ceiling, themanager may try to decrease income via various accruals because there isno advantage to higher income in these two settings. Doing this is likely toincrease the probability of receiving a bonus in a future year.

P6-16. Earnings-based equity valuations

With no growth in earnings and dividends, and a 100% payout ratio, thefollowing valuation formula applies to the value of a share of equity:

Price = Expected earnings/Cost of equity

Requirement 1:Dennisons required rate of return:$28.00 = $7.00/rr = 25.0%

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Requirement 2:Sampsons current price:Price = $5.00/0.22= $22.73Requirement 3:Johnsons expected earnings:$40.00 = Expected earnings/0.15Expected earnings = $6.00

P6-17. Growth, expansion, and equity valuation

Requirement 1:The per share value is the same for both companies. Each company has a10% cost of capital, $10 million in equity book value, and annual net income of$2 million. So, abnormal earnings are $2 million minus (10% x $10 million), or$1 million at each company. The total value of equity for each company is:

Vo = $10 million + $1 million/0.10 = $20 millionwhich corresponds to stock price of $200 per share ($20 million / 100,000shares outstanding)Requirement 2: Allison Manufacturing:

Sales Growth:$30,000,000/$20,000,000 = 1.5 or 50% growth

Net Income Growth:$2,500,000/$2,000,000 = 1.25 or 25% growth

Before ROE:$2,000,000/$10,000,000 = 0.20 or 20% return

After ROE:$2,500,000/$10,000,000 = 0.25 or 25% return

BSJ ManufacturingSales Growth:

$30,000,000/$20,000,000 = 1.5 or 50% growthNet Income Growth:

$3,000,000/$2,000,000 = 1.5 or 50% growthBefore ROE:

$2,000,000/$10,000,000 = 0.20 or 20% returnAfter ROE:

$3,000,000/$20,000,000 = 0.15 or 15% return

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Requirement 3: Allison Manufacturing

Abnormal earnings = Actual earnings Required earningsAbnormal earnings = $2.5 million ($10,000 million * 10%)Abnormal earnings = $1.5 millionVo = BV0 + Abnormal earnings/(discount rate) = $10 million + $1.5 million/0.10 = $25 million or $250 per share ($25 million / 100,000 shares)

BSJ ManufacturingAbnormal earnings = Actual earnings Required earningsAbnormal earnings = $3 million ($20 million * 10%)Abnormal earnings = $1 millionVo = BV0 + Abnormal earnings/(discount rate) = $20 million + $1 million/0.10 = $30 million or $150 per share ($30 million / 200,000 shares)

Requirement 4:While both companies have increased sales and net income, they haveachieved growth in very different ways. Allison Manufacturing increasedsales and earnings without adding more capital to the company. This meansthat the entire earnings increase (from $2 million to $2.5 million) went directlyto abnormal earnings and firm value.

BSJ, on the other hand, had to raise an additional $10 million in capital tofinance its expansion plan. This additional capital produced $10 million ofnew sales but only $1 million of new earnings. Since BSJs cost of capital is10%, the expansion project just broke even: i.e., zero additional abnormalearnings were produced ($1 million of new earnings - $10 million x 10%). Tomake matters worse, the companys original value is now spread among twiceas many shares. The result is that the value per share has declined eventhough sales and earnings increased.

P6-18. The usefulness of management earnings forecasts to financial analystsand investors

Requirement 1:Since managers are inside the firm, they have access to information thatexternal users (e.g., analysts) do not have. Thus, disclosures by managershave the potential to convey new information to external users, where newinformation is taken to mean information that is not publicly available. To theextent that the new information is value-relevant, it has the potential to beuseful to external parties in their decision-making; for example, the valuationof a firms common stock by an analyst or investor.

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Requirement 2:Managers often claim that the stock market excessively punishes firms whenthey report earnings that are lower than expected, where punishing meansbidding the price of the firms stock downward. Thus, managers might issueconservative forecasts so that when actual earnings are announced, thedeviation from expectations is positive, and the perception is that the firm dideven better than expected (where the amount expected was the amountforecast by the manager).

In addition, it may be costly for a manager in terms of lost reputation (his andthe firms) to issue forecasts that are overly optimistic and not alwaysachieved by the firm. The bottom line to this line of reasoning is that, forwhatever reason, managers perceive that it is better to do a bit better thanexpected than to do a bit worse.

Requirement 3:One thing that an analyst could do is estimate the amount or percent bywhich management has been consistently understating its forecasts in thepast, and use this amount to adjust subsequent forecasts upward to eliminatethe downward bias built into the managers forecast.

Requirement 4:One potential disadvantage is that external parties may start paying lessattention to the managers forecasts. Another disadvantage is that analystsmay tire of managements actions and devote their time to following otherfirms (i.e., the firms reputation with analysts may suffer, and its following in theinvestment community may be affected). Finally, issuing forecasts that areknown to be overly conservative means that the price of the firms stockmight be lower than it would otherwise be because of the value-relevantinformation not being disclosed in the form of a more accurate forecast.

Requirement 5:For the reason discussed in (3), it seems unlikely that external users wouldconsistently be fooled over and over again by managers who consistentlyissue conservative earnings forecasts. What seems more likely is thatexternal users (i.e., the market) would begin to make adjustments to theforecasts issued by such firms so as to correct for any built-inunderstatement. The result of such adjustments would be that the firmsexpected earnings would be more accurate estimates of the actual earningsthat firms would subsequently report, and there would be no reason to expectany stock price increases (changes) at the time of the actual earningsannouncements of firms that attempt to continually low ball analysts withconservative forecasts.

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P6-19. Information disclosure by retail firms

Requirement 1:Assuming that a firms net profit margin is relatively stable from quarter toquarter and year to year, as each months sales are reported by the firm, theanalyst would be able to update his forecast for the upcoming quarter andyear with one additional month of actual results. This should result in theforecast becoming more and more accurate.

Consider the following example. Assume that a given retail firms net profitrate is 5.0% and that this rate has been quite stable in the past. If an analystexpected the firms sales to be $1,200, $1,000, and $1,500, respectively, ineach month of the upcoming quarter, the analyst would be forecastingearnings of $185.00 ($3,700 0.05). Now assume that the firm reports salesof $1,300 for the first month of the fiscal quarter.Assuming the analyst still expects sales of $1,000 and $1,500 in each of thenext two months, he/she would issue a revised earnings forecast of $190.00($3,800 0.05). Thus, the retailers monthly sales announcement has allowedthe analyst to update his/her forecast with more current information. In theabsence of the monthly sales announcement, the updated forecast might notbe possible.

Requirement 2:The most likely reason is that the firms sales are highly seasonal. Thus, itmakes more sense to compare the sales of April 1997 with April 1996(Easter shopping season) and December 1997 with December 1996(Christmas shopping season) and so on, rather than to compare sales on amonth-to-month basis (e.g., April 1997 with March 1997, and March 1997 withFebruary 1997, etc.). Controlling for these known seasonal variations in thesales of retailing firms allows more meaningful inferences to be drawn aboutthe level of, and changes in, their sales over time.

Requirement 3:Some possibilities include:

a) monthly earnings,b) expected sales in coming months,c) gross and/or net profit margins on a monthly basis along with the sales

data, andd) sales by geographic region.

Other student responses are possible.

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Requirement 4:The most likely reason that firms might not want to voluntarily release suchadditional information is that they may feel that doing so would put them at acompetitive disadvantage. To the extent that such additional disclosures by afirm point out sources (i.e., markets) of high or increasing profitability, theattention of competitors might be attracted to these markets, thereby reducingthe firms profitability as a result.

Requirement 5:It seems likely that most analysts would object to the discontinuance of thesedisclosures. This is because these monthly sales data are not available fromany other source. Thus, there would be a loss of potentially valuableinformation if the disclosures were discontinued.

Also see the discussion above under Requirement 1.Other student responses are possible.

P6-20. Restructuring charges (and reversals) and the quality of earningsRequirement 1:Analysts claim the earnings and book values are the cleanest in many yearsbecause the write-offs explicitly recognized events that had previously notbeen recognized on the balance sheet or income statement. The effect of thisrecognition is to decrease earnings and book values in the year ofrecognition. The decrease in book values can occur by a write-down ofassets, a write-up of liabilities or a non-recurring charge to earnings. Eachof the three previous events results in a decrease in owners equity. Thus,analysts feel the earnings and book values are clean because assets,liabilities, and owners equity are now expressed closer to their fair values.

Consequently, analysts feel conservative accounting produces high qualitybook values because assets that were over-valued are written down tomarket value, liabilities are more explicitly recognized, and, thus, ownersequity is adjusted to account for these transactions. Conservative earningsare higher quality because charges are included to account for thetransactions noted above. Note, that conservatism implies that possibleerrors in measurement be in the direction of understatement rather thanoverstatement of net income and net assets. This distinction is an importantone because of GAAPs tendency to understate assets, net income, andowners equity while overstating liabilities.

Thus, a profitable firm with conservative earnings must have really earned aprofit because the accountants have been conservative and, when in doubt,have understated income. Similarly, the balance sheet is strong because,when in doubt, owners equity is understated as a result of understatedassets and overstated liabilities.

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Agree:The basis for agreement is outlined in the above answer. Essentially,conservatism allows financial statement users to know that managementmanipulation of the balance sheet and income statement is limited. Thus,financial statement users have some confidence that management has notexcessively manipulated the financial statements to make the firm look better.

Disagree:The basis for disagreement could focus on the notion that managementmanipulation is still possible. This manipulation may be to overstate netassets and net income or, alternatively, to understate net assets and netincome. Thus, financial statement users are not receiving the true picture.

Requirement 2:For one thing, accruals and subsequent reversals of restructuring chargesinduce volatility in earnings. This is because when the charge is recognizedearnings are lower while the reversal increases earnings. Thus, a case canbe made that earnings quality decreases because of this induced volatility.On the other hand, an argument for an increase in quality of earnings can bebased on the idea that when the charge was recognized, it was anappropriate estimate and the reversal was subsequently made when theestimate was determined to be incorrect. Again, conservatism plays a role inthis situation. Namely, GAAP recognizes the charge against earnings at atime when it is reasonably estimated. The reversal, which increases income,is allowed only after the charge is found to be too high. This issue is whyanalysts main focus is on net income before non-recurring charges. Thefocus should be on sustainable earnings and, thus, non-recurring chargesare less important because they are not likely to occur again.

Requirement 3:Perhaps the most obvious reason to over-accrue restructuring charges isthat the over-accrual provides a bank of earnings that is available tomanipulate the reported earnings of a future year(s). By definition, an over-accrual means that the firm took too large of a charge in the current period(i.e., current years income was reduced by more than it should have been).As a result, at some point in the future, the over-accrual will have to becorrected. The correction will entail an increase to the reported earnings ofone or more future years. As a result, managers have the opportunity toincrease the reported earnings of a future year, perhaps a year when the firmhas not performed well. Thus, the over-accrual creates a bank of earningsthat managers will be able to draw upon when they need a little help in thefuture.

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Requirement 4:To the extent that firms do not report a write-on as a separate line item onthe income statement in the year it is taken, there is reason for analysts to beconcerned. This is because, in the absence of being clearly labeled as areversal of a previous years write-off, in all likelihood the amount of thewrite-on would implicitly be considered to be a part of the firms sustainableearnings, when, in fact, it is not sustainable. To the extent that write-ons arenetted against an expense account, or included as part of other income orother credits to income on the income statement, the analyst has no way ofbacking this number out when calculating the firms sustainable earnings.

Requirement 5:As noted in Requirement 4, the biggest problem is likely to be knowing whenthe firm is taking a write-on or making a reversal in its income statement.

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Financial Reporting and AnalysisChapter 6 Solutions

The Role of Financial Information in Valuation,Cash Flow Analysis, and Credit Risk Assessment

Cases

CasesC6-1. Illinois Tool Works (JB): Abnormal earnings valuation

Requirements 1 and 2:The Excel spread sheet solution is presented on the next page. The 10-yearabnormal earnings valuation model produces a value estimate of $12,091million for the company (or $42.73 per share). This estimate is considerablybelow the companys trading range of $67 - $73 per share in late 1999. Onereason for this discrepancy is that the spreadsheet does not incorporate aterminal value estimatecompany performance beyond year 10 does notaffect the valuation.

This feature of the spreadsheet is not appropriate for a company like IllinoisTool Works. Why? Because forecasted ROE of 25% in year 10 issubstantially above the companys 12.5% cost of capital. Positive abnormalearnings are generated in year 10, and the market (but not the spreadsheet)presumably expects those economic profits to persist into the future. As aresult, the market has assigned a higher share price to the company thandoes the valuation model.

Requirement 3:

When the forecasted ROE is reduced to 20%, the value estimate drops to$30.08.

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Cost of captial 12.5%Initial book value 12/31/99 $4,815Dividend payout 20%Forecasted ROE on beginning equity 25%

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 102000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Forecasted earnings $1,204 $1,445 $1,733 $2,080 $2,496 $2,995 $3,594 $4,313 $5,176 $6,211

Beginning book value $4,815 $5,778 $6,934 $8,320 $9,984 $11,981 $14,378 $17,253 $20,704 $24,844 + Forecasted earnings 1,204 1,445 1,733 2,080 2,496 2,995 3,594 4,313 5,176 6,211 - Forecasted dividends (241) (289) (347) (416) (499) (599) (719) (863) (1,035) (1,242) Ending book value $5,778 $6,934 $8,320 $9,984 $11,981 $14,378 $17,253 $20,704 $24,844 $29,813

Forecasted earnings (from above) $1,204 $1,445 $1,733 $2,080 $2,496 $2,995 $3,594 $4,313 $5,176 $6,211 - Normal earnings (602) (722) (867) (1,040) (1,248) (1,498) (1,797) (2,157) (2,588) (3,106) Abnormal earnings $602 $722 $867 $1,040 $1,248 $1,498 $1,797 $2,157 $2,588 $3,106 x Discount factor 0.8889 0.7901 0.7023 0.6243 0.5549 0.4933 0.4385 0.3897 0.3464 0.3079 Present value of abnormal earnings $535 $571 $609 $649 $693 $739 $788 $841 $897 $956

Initial book value $4,815 PV of abnormal earnings over 10 years 7,276 Estimated value of equity $12,091 Number of shares (millions) 283 Predicted share price $42.73

Actual high $73.00 Actual low $67.00

Forecasted Results (rounded to nearest $)

Case 6-1 ILLINOIS TOOL WORKSAbnormal Earnings Valuation as of early 2000

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C6-2.General Motors (CW): Income statement discussionOptional Note to Instructors:

Included as part of the solution are edited versions of General Motorsbalance sheets, income statements, and cash flow statements for the periodcovered by the case. When covering the case, you might consider handingthese out before or on the day you cover the case in class.

1) Some points made in the article that are worth mentioning include: 4 th Quarter Annual

a) Net loss ($651.8 M) ($23.5 B)b) Revenue $35.76 B $132.43 B

(year-ago) $33.60 B $123.08 B Increase 6.4% 7.6%

c) Pre-charge income $273.3 M(year-ago fourth quarter) ($519.8 M)

1992 1 991

d) Income before $92 M ($3.45 B)various charges

e) North American ($3.5 B) ($6.89 B) $3.4 B improvementOperations

f) Cash $7.2 B $3.98 B (Increase of $3.32 B)g) Unfunded pension $14 B $8.4 B

liability

While the primary theme of the article is the huge annual loss due to theaccounting change for retiree medical benefits of $22.2 billion, the positiveaspects of the article tend to outnumber the negative aspects. Moreover:

Requirement 1:Positives:

a) Revenue for the fourth quarter increased by 6.4% compared to the year-earlier quarter. Revenue for the year increased by 7.6% compared to theprevious year.

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b) Income before write-offs and charges for the fourth quarter of the currentyear was $273.3 million, compared to a loss of $519.8 in the same period ofthe previous year.

c) Income before various charges for the current year was $92 million,compared to a loss of $3.45 billion for the prior year.d) The firms cash position improved from $3.98 billion at the end of 1991 to$7.2 billion at the end of 1992.e) The firms loss on North American Operations narrowed to $3.5 billion inthe current year from $6.89 billion in the prior year.Negatives:

The firms unfunded pension liability increased from $8.4 billion at the end oflast year to $14 billion in the current year. It is important to note, however, thatthis amount represents a liability to be paid over a period of years in thefuture, not a liability that all comes due in a single year.

Requirement 2:Possible responses to issues (1)(10).1) The article states that the losses reported for the fourth quarter and for theyear are primarily attributable to one-time charges for restructuring charges of$1.5 billion and $22.2 billion for an accounting change related to retireemedical benefits. The key feature to appreciate about these items is that theyare non-cash charges. In other words, they reduced income in the currentyear or quarter, but did not reduce cash (i.e., did not require a cash outflow inthe current period). Moreover, the Liability for retiree medical benefitsconstitutes a claim against the firms future cash flows, not its current cashflows. Thus, these charges themselves do not reduce the ability of the firm topay dividends. In fact, as noted in the article, the firm ended the year with$3.98 billion more in cash on hand than at the beginning of the year.

2) As noted in (1), the one-time charges have no immediate impact on thefirms cash flow in the current year. These charges represent claims to futurecash flows. Thus, the real issue is whether the firm will generate sufficientcash flows in the future to pay its retirees medical benefits and the payoutsrelated to the restructuring of its operations (e.g., employee buyouts).

3) One rationale is commonly referred to as the big bath. A big bath occurswhen a firm is already doing poorly in a particular period and, because of this,it decides to take a host of income-reducing write-offs and/or charges thatwould otherwise need to be taken in a future year. Given that their firm is

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already doing poorly, it is often alleged that managers feel that this is the idealtime to bite the bullet and take whatever additional charges are on thehorizon (i.e., were already going to report a loss so whats the difference ifwe make the loss bigger by taking some additional charges?). Theperceived benefit is that such write-offs obviate the need to reduce theincome of a future year (i.e., taking a big bath clears the deck for reportingimproved profitability in the future).

4) Conservative accounting means income that is unlikely to be overstatedand/or book values that are unlikely to be overstated. By reducing its bookvalue by the entire amount of its retiree medical benefit liability in the currentyear; by lowering the expected rate of return on its pension assets; and byincreasing the amount of expense related to product warranties, thecompanys accounting became more conservative. Moreover, current andfuture years income is less likely to be overstated, and the book value of thefirm is much lower (i.e., less likely to be overstated).

5) The turnaround the CFO is referring to is that GM earned $273.3 millionbefore one-time charges in the fourth quarter of the current year compared toa loss of $519.8 in the fourth quarter of the prior year.6) The stock price increase is likely a reflection of the fact that the hugereported loss was heavily influenced by one-time charges, while, beforesuch charges, the firms performance actually improved from the prior period.Furthermore, in spite of the huge reported loss, the firms cash positionactually improved by about $3.5 billion during the current period.7) Based on reported balance sheet numbers, GM may appear to be morehighly leveraged. However, this ignores the fact that external parties wereaware of GMs retiree medical benefit liabilities long before the FASB requiredthe firm to bring this liability onto its balance sheet. Because bond-ratingagencies like Moodys and Standard and Poors will have previouslyincorporated this information into their bond-rating process, it seems unlikelythat GMs credit rating would be affected.

8) Perhaps the best earnings number is GMs sustainable earnings. Thiswould be measured as the firms Income from continuing operations adjustedfor any non-recurring gains and/or losses.

9) As discussed above under (1) and (2), much of the loss was attributableto one-time charges that did not require a cash outlay in the current year.

10) As discussed under (7), the firms credit rating is unlikely to be impacted;thus, the firms ability to secure financing is unlikely to be adversely affected.

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Requirement 3:Frankly, this is a difficult question to answer in a precise manner based solelyon the information contained in the article. An argument in favor of maintainingthe clubs current holdings could be based on the fact that the stock marketresponded favorably to the announcement (the stock price increased $1.25).In other words, the market did not interpret the information in the article as anegative signal about GMs future opportunities and profitability. On the otherhand, given the ongoing uncertainty associated with GMs North AmericanOperations, an argument could be made that now might be a good time tosell off some of the clubs equity in GM, especially since the announcementbumped the stock price up $1.25 a share.Requirement 4:Additional information that might be useful:

1) GMs financial statements for the current year (i.e., income statement,balance sheet, statement of cash flows).

2) Reports by financial analysts that follow GM.

3) The results reported by GMs competitors (Ford and Chrysler) for thecurrent period.

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General Motors CorporationConsolidated Balance Sheet

December 31($ in millions, except per-share amounts) 1992 1991

AssetsCash and cash equivalents $7,789.9 $4,281.9Other marketable securities 7,485.3 5,910.5

Total cash and marketablesecurities 15,275.2 10,192.4

Finance receivablesnet 67,032.7 81,373.8Accounts and notes receivable (less

allowances) 6,476.7 6,498.5Inventories (less allowances) 9,343.6 10,066.0Contracts in process 2,456.4 2,283.1Net equipment on operating leases 11,427.1 8,653.0Deferred income taxes 18,394.6 4,265.2Prepaid expenses and other deferred charges 5,686.2 5,027.7Other investments and miscellaneous assets 10,055.1 9,425.3Property

Net real estate, plants, and equipment 27,371.1 27,939.8 Special toolsat cost 7,979.1 8,419.5

Total property 35,350.2 36,359.3Intangible assets 9,515.0 10,181.2

Total assets $191,012.8 $184,325.5

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General Motors CorporationConsolidated Balance Sheet (continued)

December 31($ in millions, except per-share amounts) 1992 1991

Liabilities and Stockholders EquityAccounts payable (principally trade) $ 9,678.4 $ 10,061.3Notes and loans payable 82,592.3 94,022.1Income taxesdeferred and payable 3,140.1 4,491.2

Postretirement benefits other thanpensions 35,550.7 -

Other liabilities 51,506.1 45,602.2Deferred credits 1,554.6 1,531.5

Total liabilities $184,022.2 $155,708.3

Stocks subject to repurchase 765.0 1,289.6

Stockholders equityPreferred stocks 234.4 234.4Preference stocks 4.5 3.9Common stocks

$ 1-2/3 Par value 1,178.1 1,034.9Class E 24.2 10.4Class H (issued) 7.0 3.8

Capital surplus 10,971.2 4,710.4Net income retained for use in the business (accumulated deficit) (3,354.2) 21,525.2

Subtotal $ 9,065.2 $ 27,523.0Minimum pension liability adjustment (2,925.3) (936.8)Accumulated foreign currency translation

Adjustments and net unrealized gains (losses)on marketable equity securities 85.7 741.4

Total stockholders equity $ 6,225.6 $ 27,327.6

Total liabilities and stockholders equity $191,012.8 $184,325.5

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General Motors CorporationConsolidated Financial Statements Of Consolidated Income

Years Ended December 31($ in millions, except per-share amounts) 1992 1991 1990

Net sales and revenuesManufactured products $113,323.9 $105,025.9 $107,477.0Financial services 10,402.1 11,144.2 11,785.0Computer systems services 4,806.7 3,666.3 2,787.5Other income 3,896.7 3,219.6 2,655.6

Total net sales and revenues $132,429.4 $123,056.0 $124,705.1

Costs and expensesCost of sales 105,063.9 97,550.0 96,155.7Selling, general, and administrative expenses 11,621.8 10,817.4 10,030.9Interest expense 7,305.4 8,296.6 8,771.7Depreciation 6,144.8 5,684.9 5,104.1Amortization of special tools 2,504.0 1,819.5 1,805.8Amortization of intangible assets 310.2 411.4 451.7Other deductions 1,575.4 1,547.0 1,288.3Special provision for scheduled plant closings and other restructurings 1,237.0 2,820.8 3,314.0

Total costs and expenses $135,762.5 $128,948.3 $126,922.2 Loss before income taxes (3,333.1) (5,892.3) (2,217.1)Income tax credit (712.5) (900.3) (231.4) Loss before cumulative effect of accounting changes (2,620.6) (4,992.0) (1,985.7)

Cumulative effect of accounting changes _(20,877.7) 539.2 ____ - ____

Net loss ($23,498.3) ($4,452.8) ($1,985.7)

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General Motors CorporationStatement Of Consolidated Cash Flows

Years Ended December 31($ in millions) 1992 1991 1990Cash flows from

operating activities

Loss before cumulative effect of accounting changes ($2,620.6) ($4,992.0) ($1,985.7)

AdjustmentsDepreciation 3,646.3 3,719.8 3,662.9Depreciation of leased assets 2,498.5 1,965.1 1,441.2Amortization of special tools 2,504.0 1,819.5 1,805.8Amortization of

intangible assets 310.2 411.4 451.7Amortization of discount and

issuance costs on debtissues 118.1 194.4 291.7

Provision for financing losses 144.5 947.1 814.5Special provision for

scheduled plant closingsand other restructurings 1,237.0 2,820.8 2,848.0

Provision for inventoryallowances 28.5 40.1 92.2

Pension expense, net of cashcontributions 273.4 1,167.7 364.9

Gain on the sale ofDaewoo Motor Co. (162.8) - -

Net gain on sale of building - (610.3) -Write-down of investment in

National Car Rental 813.2 - -

Provision for ongoingPostretirement benefitsother than pensions, netof cash payments 2,198.8 - -

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General Motors CorporationStatement Of Consolidated Cash Flows (continued)

Years Ended December 31($ in millions) 1992 1991 1990

Change in other investments,miscellaneous assets,deferred credits (298.7) (1,034.8) 246.5

Proceeds fromsale of receivables - 349.3 -

Net change in other operatingassets and liabilities:

(Details omitted)Accounts receivable 34.7 (1,067.6) (285.2)Inventories (*) 886.4 (310.4) (1,431.8)Prepaid expenses and other

deferred charges (399.3) 129.0 (516.5)Deferred taxes and income

taxes payable (*) (1,956.6) (3,874.9) (1,711.8)Other liabilities (*) 1,560.8 3,390.4 1,701.9Other (*) (469.8) 1,192.4 (1,008.7)

Net cash provided byoperating activities 10,346.6 6,257.0 6,781.6

Cash flows frominvesting activities

(Details omitted)

Net Cash Provided by (used in)investing activities 1,245.8 (4,609.3) (8,354.4)

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General Motors CorporationStatement Of Consolidated Cash Flows (continued)

Years Ended December 31($ in millions) 1992 1991 1990Cash Flows from

Financing ActivitiesNet decrease in short-term

loans payable (12,072.2) (4,670.7) (2,133.7)Increase in long-term debt 18,884.8 15,830.4 14,406.5Decrease in long-term debt (18,588.0) (12,665.1) (10,355.8)Redemption of preference stocks (243.9) (225.1) (207.2)Redemption of put options (300.0) (600.0) -Repurchases of common stocks (7.2) (10.4) (362.3)Proceeds from issuing common

and preference stocks 5,555.7 2,506.6 375.7

Cash dividends paid tostockholders (1,376.8) (1,162.3) (1,956.5)

Net cash used in financingactivities (8,147.6) (996.6) (233.3)

Effect of exchange rate changeson cash ___63.2 _(57.7 ) _(130.8 )

Net increase (decrease) in cash 3,508.0 593.4 (1,936.9)

Cash and cash equivalents atbeginning of the year _4,281.9 3,688.5 5,625.4

Cash and cash equivalents atend of the year $7,789.9 $4,281.9 $3,688.5

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Accounting Changes

Effective January 1, 1992, the corporation adopted SFAS No. 106,Employers Accounting for Postretirement Benefits Other Than Pensions.This Statement requires that the cost of such benefits be recognized in thefinancial statements during the period employees provide service to theCorporation. The corporations previous practice was to recognize the cost ofsuch postretirement benefits when incurred (i.e., pay-as-you-go method). Thecumulative effect of this accounting change as of January 1, 1992 was$33,116.1 million, or $20,837.7 million after-tax ($33.38 per share).

C6-3. Financial variables/ratios and the prediction of bankruptcy and loandefault (CW)Requirements 1 and 2:Numerous empirical studies have examined the ability of various financialvariables/ratios to discriminate between firms that are likely to experiencefinancial difficulty (i.e., go bankrupt or into loan default). Some of thevariables/ratios typically studied are discussed below. Students are likely tosuggest others. In such cases, students should be asked to discuss how thevariable/ratio is likely to be an indication of a firms risk of default or ofchanges in the likelihood of a firms default.

Some variables/ratios typically used to capture the probability of bankruptcy/loan default:

a) Current ratio: The lower the current ratio, the more likely a firm willpotentially face a liquidity crisis and not be able to repay its debt or intereston its debt in a timely manner; thus, the greater the risk of default/bankruptcy.

b) Earnings variability: As measured by the standard deviation of earnings,percentage change in earnings, or the return on asset ratio. Assuming afirms accounting earnings track its true underlying economic profitability in ameaningful way, as earnings become more variable, the firms future earningsare more uncertain. Since future profitability is an important determinant of afirms long-term viability, the greater the variance of a firms earnings stream,the more likely it may encounter financial difficulty in the future; thus, thegreater the risk of default/bankruptcy.

c) Interest coverage ratio: The lower this ratio, the more likely a firm will beunable to make the interest payments on its outstanding obligations; thus, thegreater the risk of default/bankruptcy.

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d) Size: As measured by total assets or the market value of the firm. It isgenerally believed that large firms are better equipped to weather periods offinancial difficulty (i.e., economic downturns) than small firms. One reason isthat larger firms typically have more resources within the firm as well asgreater financial flexibility outside the firm (i.e., larger lines of credit and easieraccess to capital markets). Thus, the risk of default/bankruptcy decreases asthe size of the firm increases.

e) Capital structure (i.e., the mix of debt and equity): As measured by theratio of long-term debt to stockholders equity; long-term debt to total assets;total debt to total assets; or similar long-term solvency ratios. The intuitionhere is fairly clear. As the amount of debt in a firms capital structureincreases, the firms default risk increases because more of the firmsoperating cash flows (and earnings) are committed to interest payments onthe debt. In such cases, the firm becomes more sensitive to economicdownturns which may make it harder for the firm to service its long-term debt.

f) Variability of the firms operating cash flows: As measured by thestandard deviation of operating cash flow or the percentage change inoperating cash flow. Since servicing of a firms long-term payables requiresfixed interest payments, the greater the variability of a firms operating cashflow, the more likely it may encounter financial difficulty in the future; thus, thegreater the risk of default/bankruptcy.

Requirement 3:While students are unlikely to be able to articulate the specific statisticaltechniques that might be used to develop and test a model of bankruptcyprediction, they should be able to discuss in general terms how this processis likely to work.

In general terms, the process would begin by identifying samples of firmsthat went bankrupt and those that did not during a given period of time. Thenext step would be to see if the variables discussed above can distinguishbetween the two samples. Assuming that such variables are able todistinguish between the two samples, the next step of the process would beto develop a model that employs them in an attempt to predict futurebankruptcies in a new sample of firms (i.e., in a future time period).The above explanation is purposely very general. After such a generaldiscussion, the instructor might go on to briefly mention to students thatstatistical methods like discriminant analysis and logistic and probit modelsare often used to develop and test bankruptcy prediction models in the realworld.

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C6-4. Intel and Xerox: Free Cash Flows

Requirement 1:Intel had a higher credit rating because it has a history of producing largepositive free cash flows (except in 1995). These cash flows are be used topay dividends and repurchase the companys stock. The cash flowstatement also indicates little new borrowing by the company. Consequently,what debt the company does have would seem to have very little risk ofnonpayment.

Free cash flows at Xerox, on the other hand, are volatile and the companyhas issued significant amounts of debt every year except 1999. Theabsence of stable and positive free cash flows, coupled with what seem to belarge new borrowings, suggest that the companys outstanding debt is morerisky than is Intels debt.

Requirement 2:Several possibilities come to mind. Standard & Poors credit ratings reflectthe current and future credit risk of each company. Intel has a track record ofdeveloping new and better products to meet the changing needs of itscustomers. Product innovation and technological leadership are twohallmarks of Intel. Xerox, on the other hand, has been less successful inadapting its original technological leadership to a changing market place. So,one explanation for the difference in credit ratings is that Intel has betterfuture business prospects than does Xerox.

Other possible factors include the companys stock prices, the volatility of themarket that a company operates in, earnings per share, prior bankruptcies,and any major dependencies on suppliers or customers.

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C6-5. Microsoft Corporation (CW): Unearned revenues and earningsmanagement

Requirement 1:The net profit margin is equal to net income divided by sales. For Microsoft,the rates are:

Fourth quarter of 1996: Net profit margin = $559/$2,255 = 24.8%

Fourth quarter of 1997: Net profit margin = $1,057/$3,175 = 33.3%

Year 1996: Net profit margin = $2,195/$8,671 = 25.3%

Year 1997: Net profit margin = $3,454/$11,358 = 30.4%

By any standard, Microsofts net profit margin is very high, and itimproved from 1996 to 1997.

Requirement 2:Working capital is the difference between current assets and currentliabilities, and the current ratio is the ratio of current assets to currentliabilities. For Microsoft, the values are:

Year 1996: Working capital = $7,839 - $2,425 = $5,414

Year 1997: Working capital = $10,373 - $3,610 = $6,763

Year 1996: Current ratio = $7,839/$2,425 = 3.23

Year 1997: Current ratio = $10,373/$3,610 = 2.87

Microsoft is unlikely to face a short-term liquidity crisis. It had more than $5billion of working capital in 1996 and more than $6 billion in 1997. Its currentratio is high by any standard, and even though it fell from 3.23 in 1996 to 2.87in 1997, short-term liquidity will not be a problem for the firm.

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Requirement 3:Microsoft just exceeded analysts expectations in the fourth quarter. The firmearned 80 cents per share, and analysts were expecting 79 cents per share.

Requirement 4:Ending balance = Beginning balance + additions - reductions $1,418 = $1,285 + additions - 0; additions = $133.0Requirement 5:Income effect per share = increase in income/shares used to calculate fourthquarter EPS = $133.0/1,327 = 0.10 or 10 centsRequirement 6:Ending balance = Beginning balance + additions - reductions$1,418 = $560 + additions - $188.0; additions = $1,046.0Requirement 7:Income effect per share = increase in income/shares used to calculate fourthquarter EPS

= $1046.0/1,312 = $0.80 or 80 centsRequirement 8:This answer is the balance in the account of $1,418 divided by the number ofshares used to calculate 1997 annual earnings.

= $1,418/1,312 = $1.08Requirement 9:In periods when the firms earnings are less than management would like toreport, the balance in the Unearned revenues account could be drawn downin order to increase earnings to a level that management would like to report(subject, of course, to the available balance in the account).In periods when the firm is doing very well, management could try to banksome future earnings by increasing the amount reported in the Unearnedrevenues account.

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Requirement 10:This is a tough task for the analyst. One thing that the analyst might do ismonitor the firms balance sheets on a quarter-to-quarter basis, payingspecial attention to the Unearned revenues account. What the analyst couldwatch for are large increases in the account balance in periods when the firmis doing very well, and perhaps, more importantly, declines in the accountbalance in periods when the firm has done poorly, or periods where themarket expects the firm to do poorly. In either case, since the analyst will getto observe only the net change in the account balance from period-to-period,detecting with any degree of reliability that the account is being used tomanage the firms earnings will be a very difficult task.

Requirement 11:No. It might very well be that the firms managers believe that the propermatching of revenues and expenses requires that some of the revenuescollected from customers in a given year be deferred and recognized in alater period when product upgrades are delivered and/or various types ofservices are provided.

C6-6. M&W Retailing & Corp. (CW): Cash flow assessments and credit analysisRequirement 1:This case is based on Montgomery Ward & Co. This firm filed for bankruptcyprotection in July, 1997 and was liquidated in 2001. The data in the casecorrespond to 1991 through 1995. Using this firm provides an opportunity toillustrate how well and how far in advance financial statement numbers andratios begin to signal information about impending financial difficulty.

a) Income statement analysis:On balance, the information revealed by the trend and common-sizeincome statements is not favorable:

1) While M&Ws Sales grew each year from 1996 to 1999, so did its costof goods sold. In fact, the increase in cost of goods sold tended tooutstrip the increase in sales over the total period (125.74% versus125.29%).

2) The firms selling, general, and administrative expenses increaseddramatically in the last two years for which data are reported. The rateof increase of 37.25% far exceeded the total growth in the firms salesof 25.29% over the entire period.

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3) The common-size income statements reveal that the drop in the firmsIncome from continuing operations as a percent of sales from 2.38% in1995 to 0.15% in 1

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