SOLUTION MANUAL for Financial Statement Analysis A Data Analytics Approach 2024 Release By Robert Re

SOLUTION MANUAL for Financial Statement Analysis A Data Analytics Approach 2024 Release By Robert Resutek and Vernon Richardson

Chapter 1 End-of-Chapter Assignment Solutions Multiple Choice Questions 1. The component from the FSA framework, which includes master the past, primarily includes which type of analytics? a. Machine Learning b. Diagnostic analytics c. Predictive analytics d. Prescriptive analytics 2. Which of the following is the most important question to an equity investor? a. Will the company go bankrupt? b. Will dividends be discontinued due to solvency concerns? c. How do the company’s projected future cash flows and earnings map into company value? d. Will the company be able to pay its obligations over the next year?

3. Which of the following is the most important to a potential lender? a. What is the company’s revenue-generating capability? b. Can the company convert its revenues into sustainable future cash flows? c. How do the company’s projected cash flows and earnings map into company value? d. Will the company go bankrupt?

4. Data identification and data incorporation are an important part of which component of the general FSA framework? a. Ask the question b. Master the data c. Predict the future d. Support the findings 5. What term is defined as the process of evaluating raw, unstructured, and unrefined data to address all types of questions? a. data wrangling b. data analytics c. financial statement analysis d. descriptive analytics 6. Which of the following financial statement user would ask for a forecast of the company’s product demand to have sufficient product available to support company sales? a. Supplier b. Creditor c. Investor

d. Employee Porter’s five forces are primarily used to evaluate the company’s . a. financial statements b. strategic positioning c. competitive environment d. capital structure 8. Which of the following are one of Porter’s five forces? a. Power of competitor b. Bargaining power of buyers c. Strength of the economy d. Supplier’s financial position 9. Which of Porter’s five forces addresses the ease of switching from one competitor to another? a. Power of competitor b. Threat of substitute products or services c. Strength of the economy d. Supplier’s financial position 10. A company that competes on the basis of cost is more likely to have a advantage, as compared to its competitors. a. comparative b. differential c. opportunistic d. niche 7.

Discussion Questions 1. What data might an analyst use in addition to the financial statements, to address a company’s FSA questions?

Potential solution: Answers will vary, but include competitor financial statements, industry reports, company SEC filings, regulatory filings, other analyst forecasts, conference calls, customer financial statements, press releases, product reviews, etc.

2. Most accounting courses/curriculums focus on carefully measuring the past. Why is that important in predicting the future and ultimately addressing the most important FSA questions?

Potential solution: In general, we expect persistence between past performance and future performance. To the extent that we can carefully measure the past, our expectation is that will be a key input into forecasting the future.

3. Why is forecasting sales so important for an analyst? Why is it considered to be one of the most important FSA questions?

Potential solution: Generally the first input into a model forecasting earnings and cash flows is the sales forecast. That will help a company determine how much product to produce, and how profitable a company will be.

4. What is the difference between predictive and prescriptive analytics? Why does financial statement analysis employ both, and how do they complement each other?

Potential solution: While predictive analytics works to form expectations of the future by forecasting future performance, prescriptive analytics takes the predictive analytics further by addressing questions of ‘What should we do given our predictions of the future?” or “What should we do if our predictions of the future change?”. Prescriptive analytics is analytics that inform on the best action given a specific set of assumptions and constraints. In financial statement analysis, we predict future sales, earnings and cash flows using predictive analytics, and then value those cash flows using prescriptive analytics.

5. Why is sensitivity analysis considered to be prescriptive analytics?

Potential solution: Sensitivity analysis is used to tell how much the outcome will change based on various assumptions. Since prescriptive analytics help the analyst understand what to do based on predictions, the assumptions made in predictive analytics are key to ultimately deciding whether to go forward with a decision (such as buying or selling a stock). That is, prescriptive analytics is analytics that inform on the best action given a specific set of assumptions and constraints.

6. What is the difference between a company’s competitive environment and its strategic positioning?

Potential solution: A firm’s competitive environment describes the economic dynamics and forces that affect different facets of a firm’s industry and business model. A firm’s strategic positioning is the result of a set of carefully considered decisions by the firm to position it within its industry to maximize profits. A firm’s strategic positioning is often a response to its competitive environment.

7. Which of Porter’s five forces would you think most affects the competitive environment for Apple Inc? Or for Tesla?

Potential solution: Answers will vary. With such a strong competitor in Samsung and its Android (Google) operating system, rivalry among existing competitors is likely the one of Porters five forces that most affects its competitive environment. While Apple works to differentiate their product, there is still a strong competitor in Samsung and Google. Tesla likewise has strong competitors and attempts to differentiate their luxury car in the electric vehicle space.

8. Comparing Walmart to Target, which is likely to have a cost advantage and which is likely to have a differential advantage?

Potential solution: With Walmart’s “Every Day Low Price (EDLP)” as the cornerstone mantra of Walmart’s corporate strategy, the corporation conveys to customers that every item that Walmart sells is always at the lowest price that Walmart can offer. To generate sustainable profits with a cost leadership strategy, Walmart relies on selling higher volumes than its competitors. Target however, focuses less on cost and more on product offering and product differentiation. For this reason, Walmart is likely to have a cost advantage, and Target is more likely to have a differential advantage.

Brief Exercises

1. (LO 1-1; 1-2) Match the financial statement user (e.g., investor, creditor, supplier, manager, customer, employee) to the specific question, “What is the company’s revenue-generating capability?”.

Specific financial Financial Statement User(e.g., investor, userquestion creditor, supplier, manager, customer, employee) Will our current capacity be Manager able to produce the expected number of products?

Supplier Will we have enough product available to support our customer’s level of sales?

Will the company sell enough product to stay in business and pay their loans?

Creditor

Will the company achieve the expected revenue growth to support the current stock price?

Investor

Will the projected company growth allow sufficient job opportunities in the future?

Employee

Will there continue to be new, innovative products in the future available for purchase?

Customer

2. (LO 1-1; 1-2) Match the analytics type (e.g., descriptive, diagnostic, predictive, and prescriptive) with the example financial statement analysis questions.

Example Financial Statement Analytics Type (e.g., descriptive, Analysis Questions diagnostic, predictive or prescriptive analytics) Did the amount of interest expense as a Descriptive percentage of sales increase in the past year?

How did the company’s return on assets compare to the industry as a whole?

Diagnostic

What happens to Bank of America’s profits if the interest rates change in the future from 3 percent to 4 percent or 5 percent or more?

Prescriptive

Which company’s financial statements have a high probability of misstatement or fraud?

Predictive

How can you use analysts’ forecasts to value Chipotle’s stock price?

Prescriptive

Did the focal company spend more on interest expense as a percentage of sales than its competitors?

What was the amount of business interruption loss that was incurred due to a fire?

Diagnostic

Predictive

3. (LO 1-3) Match the indicators in the left column with Porter’s five forces (e.g., rivalryamong competitors, potential of new entrants, power of suppliers, power of customers/buyers, and threat of substitutes).

Indicators of the State of the Five Forces

Number and closeness of substitutes, switching costs of substitutes Number, concentration, and size of suppliers Number and diversity of competitors; Product differentiation Barriers of Entry (Required Time, Size of Investment, Access to Technology to Enter Market) Number, concentration, and size of customers

The Five Forces That Correspond to Shaping the Competitive Environment Threat of Substitutes

Power of Supplies Rivalry among Competitors

Potential of New Entrants

Power of Customers/Buyers

4. (LO 1-3) Match the company’s strategic positioning term (e.g., cost advantage, competitive advantage, focus strategy, product differentiation and niche product) to its definition.

Strategic Positioning Definition

a corporate strategy where the company offers lower priced goods or services than competitors to stimulate demand for its goods

Strategic Positioning Term (e.g., cost

advantage, competitive advantage, focus strategy, product differentiation and niche product) Cost advantage

the leverage that a company has over its competitors that puts the company in a favorable or superior business position

Competitive advantage

a corporate strategy where the company seeks to offer products or services that are distinct from those offered by competitors.

Product differentiation

focus on a narrow market instead of a broad market a corporate strategy where the company chooses a narrow operating scope and either seeks to become the low-cost provider in a narrow range of product offerings or seeks to offer seeks to offer differentiated products within narrow scope of products.

Niche product Focus strategy

5.

(LO 1-3) Match the step of the AMPS model to Data Analytics tasks. Each model step may be used more than once.

Data Analytics Task

AMPS Model Step (i.e., Ask the Question, Master the Data, Perform the Analysis, Share the Story)

Deciding which question to ask that might help management bestassess strategy.

Ask the Question

Running a regression analysis to evaluate the impact of advertising.

Extracting data from the financial reporting system and prep for use ina pivot table.

Perform the Analysis Master the Data

Publishing financial projections store-by-store.

Analyzing how profits will change if gasoline prices go up in the comingyear.

Share the Story Perform the Analysis

Problems 1. The FSA framework suggests that firms “Master the Past” and “Predict the Future” to address stakeholder questions to provide input into stakeholder decisions. For each stakeholder, identify examples of needed data points from the past, and expected items needed to help stakeholders make decisions.

Stakeholder

Vendor

Stakeholder Decision as a Result of Financial Statement Analysis Extend or not Extend Trade Credit

Creditor

Extend or not Extend Loan

Shareholder

Buy, Sell or Hold Stock Continue Career at Company (or not)

Employee

Data Needed to Evaluate to “Master the Past”

Analysis Needed to “Predict the Future”

Accounts Payable Turnover, Liquidity (Available Cash) Capital Structure (Debt vs. Equity); Past Cash Flows Past Cash Flows; Past Dividends Stable Company, Career Progression

Expectation of Future Cash Flows

Expectation of Future Cash Flows

Expectation of Future Cash Flows Volatility of Future Cash Flows; Expected Company Growth and Career Opportunities

2. You’re asked to predict cash flows for Netflix over the next five years as input into a loan decision, whether to offer to them a loan and a loan at a lower-than-market interest rate. What information sources do you use? Name 10 different possible data sources and how you’d analyze them to predict Netflix cash flows and their ability to repay the loan.

Potential Solution:

Possible Data Sources: 10-K Annual and 10-Q Filings (Annual and Quarterly Analyst reports/Analyst forecasts Financial Statements of industry and competitors Bond Ratings/Debt Ratings Press releases Conference calls Analyst Presentations Chat Boards/Twitter/StockTwits Annual Meeting Attendance Macroeconomic Reports and Statistics These data sources might be used to master the past and predict the future, and ultimately to value the company.

3. Name five questions that creditors will have for prospective borrowers.

Potential Solution: a. Will the prospective borrower be able to repay their loan back to their creditor? b. Will the prospective borrower go bankrupt? c. Does the prospective borrower have the ability to pay their interest each period? d. How big of a loan does the prospective borrower want? e. How much existing debt does the prospective borrower have already? f. How will the prospective borrower use the new funds?

4. Describe each of the five forces of the airline industry in the United States. Thinking broadly, what is the threat of substitution? Who are its suppliers – who holds superior power, the airline industry or the airline manufacturers? Who are its customers – who holds superior power, the airlines or the customers?

Potential Solution: Porter’s Five Forces

Indicators of the State of the Five Forces

Threat of Substitutes

Number and closeness of substitutes, switching costs of substitutes

Automobiles may be used in place of flights of small to medium distance.

Power of Supplies

Number, concentration, and size of suppliers

At mercy of fuel prices from suppliers.

Unionized labor for pilots

and flight attendants Rivalry among Competitors

Number and diversity of competitors; Product differentiation

Sector highly competitive.

Regulated

Potential of New Entrants

Barriers of Entry (Required Time, Size of Investment, Access to Technology to Enter Market)

Huge capital investment required to enter the segment.

Sometimes challenging to get slots/gates at airports.

Power of Customers/Buyers

Number, concentration, and size of customers

Buyers use online platforms to find cheapest or most appropriate flights.

5. Describe each of the five forces of the electric vehicle industry in the United States. Thinking broadly, what is the threat of substitution from other fuel sources such as fossil fuels or hydrogen? Who are its suppliers – who holds superior power, the EV manufacturer industry, or EV manufacturers? Who are its customers – who holds superior power, the airlines or the customers? How will this affect future margins?

Potential Solution: Porter’s Five Forces

Indicators of the State of the Five Forces

Impact on EV Manufacturer or EV Manufacturing Industry

Threat of Substitutes

Number and closeness of substitutes, switching costs of substitutes

The threat of substitute products is high as consumers see internal combustion engines as very similar to electric vehicles in most respects.

Power of Supplies

Number, concentration, and size of suppliers

Scale and in-house production of batteries are highly important to reduce the total production cost and to make

an attractive offering.

Rivalry among Competitors

Number and diversity of competitors; Product differentiation

The level of competition among electric vehicle manufacturers is medium as the industry has received dramatic support from government agencies across the world.

Potential of New Entrants

Barriers of Entry (Required Time, Size of Investment, Access to Technology to Enter Market)

Large capital investments, large spending on research and development, experience in the industry, economies of scale are required to enable the efficient manufacturing.

However, with government support, many new entrants are possible.

Power of Customers/Buyers

Number, concentration, and size of customers

Overall, a high purchase price, the lack of range of an electric vehicle and time-consuming re-charging make the electric vehicle ownership relatively less attractive to internal combustion engine vehicles.

As a company is threatened by external forces, their profit margins would be expected to decrease.

6. What is the competitive advantage of Disney? How does it compare/contrast with Comcast Universal? Does Disney compete on the basis of cost or differentiation? Does it have a niche or a broad market? In your view, how does this affect future margins?

Potential Solution: Disney arguably uses product differentiation as its generic strategy for competitive advantage.

Michael Porter's model states that this strategy involves unique products offered to many market segments. Their theme parks, their movies (and related content creation) are unique in the marketplace. What might have started as a niche product increasingly is viewed as a broad market. Future margins will likely continue at a similar high level as it works to maintain its competitive advantage. The answers with respect to Comcast will vary with respect to student knowledge of Comcast Universal.

Chapter 2 End-of-Chapter Assignment Solutions Multiple Choice Questions 1. Which of the following refers to any setting where one party in a transaction has more information than the other party? a. Information superiority b. Information subjectivity c. Information asymmetry 2. Whereas bias captures the systematic, predictable, differences between the reported value and ‘true’ value, which of the following captures unpredictable difference between the reported value and the ‘true’ value? a. error b. misstatement c. volatility d. noise 3. Whereas financial statements would generally be considered to structured data, which of the following would generally be considered to be unstructured data. a. product reviews b. stock prices c. geolocation d. addresses 4. An announcement of a new CEO would most likely be reported on which SEC form? a. 10-K b. 10-Q c. 8-K d. S-1 5. The biggest difference between a 10-K and a 10-Q is which of the following? a. frequency of disclosure b. agency that receives the disclosure c. financial statements included in the disclosure d. company providing the disclosure 6. Which of the following is an aggregation of all earnings recognized by the company since inception, less amounts paid to shareholders via dividends or share buybacks? a. Common stock b. Cash c. Retained Earnings d. Capital Stock 7. Which of these liabilities has the most reporting discretion? a. Accounts payable b. Warranty provisions c. Litigation d. Wages payable

8. The phrase, ‘Trust, but verify” would be an example of which of the following? a. external auditing b. professional skepticism c. bias d. internal auditing 9. Descriptive and diagnostic analytics would be most closely associated with which component of the AMPS model? a. Ask the Question b. Master the Past c. Predict the Future d. Support your Findings 10. For Apple, what is the functional equivalent of capital expenditures? a. Payments made in connection with business acquisitions b. Purchases of Marketable Securities c. Payments for Acquisition of Property, Plant and Equipment d. R&D expenditures

Discussion Questions 1. (LO1) How does the discretion associated with choosing the useful lives utilized to depreciate fixed assets (plant and equipment) affect the quality of financial statements?

Potential Solution: If management consistently changes the useful life of assets to increase or decrease reported income to maximize bonuses or other purposes, it will lower the quality of the financial statements.

2. (LO1) Identify the relevant benchmarks used to compare performance for a focal company from multiple dimensions.

Potential Solution: Benchmarks include a company’s past performance, a competitor’s performance, industry (where the company has membership) performance, and to the economy as a whole.

3. (LO1) How can a conservative bias be evaluated?

Potential Solution: GAAP imposes a conservative bias to not overstate assets and revenues and not understate liabilities and expenses. If you know that the asset values reported on the balance sheet generally understate the fair market value of those assets, you may need to try to adjust those to their fair market value based on your knowledge of the assets and the market conditions.

4. (LO1) Why is any discretion allowed in measuring and reporting transactions?

Potential Solution: While all companies are required to file their financial statements following the same set of GAAP rules, this does not mean that all companies will account for the same

economic dynamics the same way. GAAP allows managers discretion with respect to the accounting methods they choose to use and discretion with respect to the accounting estimates they make when applying the accounting method. Both types of discretion affect comparability.

5. (LO2) What do credit analysts do?

Potential Solution: Credit analysts review the financial statements on a regular basis and provide ratings, or assessments, that indicate the likelihood that the company will pay their debt investors the interest and principal owed in a timely manner.

6. (LO3) Form 10-K, an annual submission to the Securities and Exchange Commission, requires management to explain its results from the most recent time period using their own words. Why would this be valuable data for a data analyst? How would a data analyst use this data?

Potential Solution: While the financial statements use quantitative methods to evaluate performance, management explains prior results and forecasts of future performance in the MD&A section of the 10-K. Data analysts can perform text and other analyses to evaluate the sentiment of management with regards to prior results and forecasts of future performance.

7. (LO3) Why does the SEC maintain a repository of financial statements (using EDGAR)?

Potential Solution: These filings are all available, in real time, via the EDGAR website.

EDGAR is the Electronic Data Gathering, Analysis, and Retrieval system https://www.sec.gov/edgar.shtml. The EDGAR system is maintained by the Securities and Exchange Commission (SEC) and serves as a repository for all forms submitted to the SEC to provide a historical look at all companies to perform descriptive and diagnostic analytics.

8. (LO3) What type of discretion is shown in the mixed measurement model affecting liability values?

Potential Solution: 1. Zero or no reporting discretion Many liabilities can be estimated with a high degree of certainty. Companies know exactly how much they owe to a trade vendor when they receive an invoice. Companies can compute exactly how much they owe hourly employees by multiplying hours worked by hourly wage. Companies know exactly how much they owe their banks because companies know exactly how much principal they borrowed. Thus, liabilities such as Accounts Payable, Wages and Salary Payable, and debt principal outstanding are measured with almost zero discretion and reported on the balance sheet at close to fair market value.

2. Some reporting discretion Some liability accruals require managers to make estimates of the cash payments that they expect to make in the future. These estimates are subject to managerial reporting discretion and include such future cash flows as warranty provisions, pension obligations, and restructuring

liabilities. The key element of the discretion that factors into the estimates of these accruals centers on how much managers believe the company will need to pay in the future.

3. Significant recognition and reporting discretion Contingent liabilities represent potential obligations that may occur in the future. For example, pending litigation against the company may or may not turn into a judgment against the company.

There are two key elements to the discretion in this liability. If the liability is likely to occur and the amount of the liability can be reasonably estimated, the liability should be recognized on the balance sheet. If, however, managers do not believe that the cash outflow is likely or that the value of the cash out flow cannot be reasonably estimated (even if a cash outflow is likely), the liability is not recognized on the balance sheet.

9. (LO4) How do the income statement and the balance sheet link to each other?

Potential Solution: Net Income from the income statement is closed out (or included) in the ending retained earnings balance at the end of the reporting period.

10. (LO4) How do revenue recognition policies affect the revenue reported on the income statement? How could reporting too much or too little revenue bias the financial statements??

Potential Solution: Revenues represent value earned over the period from products and services sold by the company. The key principle that relates to revenue is the revenue recognition principle that describes when, and under what conditions, revenue can be recorded (or recognized) by the company.

Too much reported revenue will increase net income and too little reported revenue will decrease net income. Either way, the income statement and related accounts on the balance sheet are misstated and misleading to financial statement users.

Brief Exercises

1. Match the parties to the financial statements (e.g., Board of directors, Credit analysts, External auditors, Internal auditors, Secured creditors) to their descriptions.

Description of Parties to the Financial Statements (Board of Directors, Credit Analysts, External Auditors, Internal Auditors, Secured Creditors) Assess the likelihood that

Parties to the Financial Statements (Board of directors, Credit analysts, External auditors, Internal auditors, Secured creditors)

Credit analysts

the company will pay their debt investors the interest and principal owed on time. a group of individuals, many who are not part of the company’s executive team, who are elected by shareholders and who monitor the performance of the company.

Board of directors

impose rules, known as covenants, on what the company can (and can’t) do with its cash. employees of the company that design and oversee a systems of controls (known as internal controls) that reduce likelihood of material misstatement.

Secured creditors

hired by the company, but are not company employees, and examine the supporting documentation for all parts of the financial statements to ensure they are free of material misstatement.

External auditors

Internal auditors

2. Match the information terms (e.g., information asymmetry, information subjectivity, bias, noise, professional skepticism) to their definitions.

Definition of Information Terms

a quality of the data that implies indisputable truth does not exist

Information Terms (Bias, Information Asymmetry, Information Subjectivity, Noise, Professional Skepticism) Information subjectivity

any setting where one party in a transaction has more information than the other party.

Information asymmetry

captures unpredictable differences between the reported values and the ‘true’ values.

Noise

represents an attitude that includes a questioning mind which is alert to areas in the financial statements where the reported numbers don’t align with other evidence.

Professional skepticism

the systematic, or predictable, difference between the reported value and ‘true’ value.

Bias

3. Match the Securities and Exchange Commission-related terms (e.g., 10-K, 10-Q, EDGAR, 8-K, structured data, unstructured data) to their descriptions.

Description of Securities and Exchange Commission-related terms

A required submission to the Securities and Exchange Commission that is used to notify investors of important events or announcements.

Securities and Exchange Commission-related terms (10-K, 10-Q, EDGAR, 8K, structured data, unstructured data) 8-K

A required annual submission to the Securities and Exchange Commission reporting a company’s financial performance.

10-K

Financial statements

Unstructured data

system automatically collects, validates, and indexes and serves as a repository for all forms submitted to the Securities and Exchange Commission.

Electronic Data Gathering, Analysis, and Retrieval (EDGAR)

A required quarterly (every 3 months) submission to the Securities and Exchange Commission reporting a company’s financial performance.

10-Q

Management Discussion and Analysis

Unstructured data

4. (LO 12-2) Match the data source name (Annual filing to the SEC, Economic Data, Financial Statements, Footnotes to the Financial Statements, Stock Price Data, Text of Conference Calls, XBRL) to its data description.

Data Description

Detailed description of accounting principles and methods employed by the company; Detailed debt and lease payment information.

Data Source Name (Annual filing to the SEC, Economic Data, Financial Statements, Footnotes to the Financial Statements, Stock Price Data, Text of Conference Calls, XBRL) Footnotes to the financial statements

The computer-based standard for transmitting financial statement data between computer systems.

XBRL

Executive compensation, management discussion and analysis, board composition, etc.

Annual Filing to the SEC

CEO and CFO commenting on recent financial performance.

Income statement, balance sheet, statement of cash flows, statement of stockholder’s equity.

Text of Conference Calls

Indicators of economic and

Economic data (GDP, housing

Financial Statements

financial markets performance.

starts, unemployment, etc.) financial markets data, commodities pricing

Current and historical daily, monthly, annual stock price data and stock returns.

Stock Price Data

5. Match the accounting data term to the definition provided.

Definition

Accounting Data Term (8- k, Accounting Data Analytics, EDGAR, Fixed Assets)

Plant (factories, office buildings, stores, etc.) and equipment (vehicles, fork lifts, computers, machinery, power tools, technical apparatus).

Fixed Assets

Automatically collects, validates, indexes and services as a repository for all forms submitted to the Securities and Exchange Commission.

EDGAR

A required submission to the Securities and Exchange Commission that is used to notify investors of important events or announcements that either the SEC or shareholders might be interested in receiving.

8-K

The technologies, systems, practices, methodologies, databases, statistics, and applications used to analyze diverse accounting and nonaccounting data to give organizations the information they need to make sound and timely business decisions.

Accounting data analytics

Problems 1. Each of the following independent situations represents amounts shown on the four key financial statements. Fill in the blanks with the correct amounts. a. Revenues = $25,000; Expenses = $10,000; Net income = $ .

Solution: $25,000 (Revenues) – $10,000 (Expenses) = $15,000 (Net income) b. Decrease in stockholders’ equity = $16,000; Issuance of common stock = $10,000; Net income = $12,000; Dividends = $ .

Solution: $10,000 (Issuance of common stock) + $12,000 (Net income) + 16,000 (Decrease in stockholders’ equity) = $38,000 (dividends) c. Assets = $25,000; Stockholders’ equity = $18,000; Liabilities = $ .

Solution: $25,000 (Assets) – $18,000 (Stockholders’ equity)= $7,000 (Liabilities) d. Decrease in total cash = $25,000; Net operating cash flows = $32,000; Net investing cash flows = $16,000; Net financing cash flows = $ .

Solution: -$25,000 (Decrease in total cash) – $32,000 (Net operating cash flows) – $16,000 (Net investing cash flows) = -$73,000 (Net financing cash flows) 2. Each of the following independent situations represents amounts shown on the statement of cash flows. Fill in the blanks with the correct amounts. a. Increase in total cash = $45,000; Net operating cash flows = $12,000; Net investing cash flows = -$32,000; Net financing cash flows = $ .

Solution: $45,000 (Increase in total cash) – $12,000 (Net operating cash flows) + $32,000 (Net investing cash flows) = $65,000 (Net financing cash flows) b. Increase in total cash = $ ; Net operating cash flows = $93,000; Net investing cash flows = -$63,000; Net financing cash flows = $67,000.

Solution: $93,000 (Net operating cash flows) — $63,000 (Net investing cash flows) + $67,000 (Net financing cash flows) = $97,000 (Increase in total cash) c. Increase in total cash = $65,000; Net operating cash flows = $ ; Net investing cash flows = -$138,000; Net financing cash flows = -$16,000.

Solution: $65,000 (Increase in total cash) + $138,000 (Net investing cash flows) + $16,000 (Net financing cash flows) = $219,000 (Net operating cash flows) d. Increase in total cash = $37,000; Net operating cash flows = $43,000; Net investing cash flows = $ ; Net financing cash flows = -$1,000.

Solution: $37,000 (Increase in total cash) – $43,000 (Net operating cash flows) + $1,000 (Net financing cash flows) = -$5,000 (Net investing cash flows)

3. Address the following questions and their impact on the items listed in the financial statements.

1. If Company A underestimates bad debt expense this year, what impact (if any) will it have on the following items: net income, assets, liabilities?

Solution: Net income will be understated, and assets will be overstated. There is no impact on liabilities.

2. If Company B wrote down inventory last year to market value (which was below its cost) and the value of this inventory increased in the current year, what impact (if any) will it have on the following items: net income, assets, liabilities, assuming half of the inventory was sold?

Solution: The inventory (assets) balance that was previously written down will increase, and the previous writedown expense will be reversed. There is no impact on liabilities.

4. What is the impact of each of the various independent situations on various accounts and the financial statements in general?

1. Company 1 need to write down $1 million of uncollectible receivables. Which accounts are affected? How is each financial statement affected? Are cash flows effected?

Solution: When a company establishes bad debt expense of $1 million, it will reduce net income on the income statement. However, when they are writing down receivables (or writing off receivables) it will reduced the allowance for doubtful accounts (the contra asset) and accounts receivable, with the net effect being zero on assets and the balance sheet. There is no other impact on income, liabilities or cash flows.

2. Company 2 purchases supply chain software to pursue leaner inventory. Leaner inventory means less assets to finance. How does an efficient supply chain affect the balance sheet and income statement? What assumptions do you need to make?

Solution: Assets are reduced since less inventory is carried. Those reduced assets free up cash that can be used to reduce liabilities like long-term debt. The lower the debt, the lower the interest expense (affecting the income statement) and greater the income. We make the assumption here that freed up cash from holding less inventory goes to reduce debt; however, the company may decide there are other needs that can be addressed with the cash.

3. Due to non-performance, the company writes off $2 million of goodwill writedown. What is the impact on the three financial statements?

Solution: There is a loss on goodwill impairment which reduces net income on the income statement by $2 million. But this is a non-cash expense so has no effect on the statement of cash flows. The intangibles asset of goodwill on the balance sheet is also reduced by $2 million which in turn, reduces total assets by $2 million.

5. What is the impact of each of the various independent situations on the company’s cash?

1. Depreciation increases by $13.2 million in the current year.

Solution: Depreciation does not affect cash flow in the current year.

2. The interest on the debt outstanding increases by 2%, payable annually.

Solution: When interest accrues, it does not affect cash. However, when interest expense is ultimately paid that reduces cash.

3. Goodwill is written down by $14.2 million, a one-time event. The goodwill was initially recognized as the result of an acquisition ten years earlier.

Solution: Cash is not affected by goodwill writedowns.

4. Inventory is written down by $3.2 million due to obsolescence.

Solution: Inventory writedowns do not affect cash. It does mean that the company is unlikely to be able to sell that inventory in the future though, or will sell it for less.

5. Salaries increase by $17.7 million due to an increase in the total number of employees.

Solution: Cash is reduced when salaries are paid. The company can expect a reduction of an additional $17.7 million due to the increase in total salaries paid.

6. Income taxes increase by 5% as compared to last year.

Solution: Cash is reduced when taxes are paid. The company can expect a reduction in cash when the income taxes are paid.

Chapter 3 End-of-Chapter Assignment Solutions Multiple Choice Questions 1. The SEC regulation requires reconciliation of non-GAAP performance numbers to GAAP performance numbers? a. Regulation FD b. Regulation NG c. Regulation G d. Regulation 20-F 2. Which of the following are considered to be firm voluntary disclosures? a. Analyst forecasts b. Management forecasts c. Financial statements d. Footnotes 3. What type of analysts evaluate companies for the singular purpose of deciding which companies to purchase for their investment portfolios? a. Sell-side b. Credit c. Buy-side d. Management 4. The names of different types of industry classifications used in industry reports include all but which of the following? a. Standard Industry Classification (SIC), b. Global Industry Classification Standard (GICS), c. North American Industry Classification System (NAICS) d. Industry Classification System (ICS) 5. Which of the following emphasizes analysis of systematic, macroeconomic factors that affect the earnings- and sales-generating process of the firm and other similar firms? a. Conference calls b. Industry reports c. Analyst forecasts d. Credit analyst reports 6. Whereas Internet blogs such as Motley Fool and Zerohedge offer opinions from a select set of individuals, message boards such as Seeking Alpha, Stocktwits and Yahoo! offer opinions from which of the following? a. credit analysts b. sell-side analysts c. buy-side analysts d. anyone 7. Which of the following highlights key elements of the business that managers believe are persistent vs. those elements that managers believe are transitory or unimportant? a. Management forecasts b. Non-GAAP earnings c. GAAP earnings d. Analyst forecasts 8. Which of the following represent voluntary disclosures made by the firm? a. Conference calls b. Industry reports c. Analyst forecasts d. Credit analyst reports 9. According to the proprietary cost hypothesis, the extent to which firms are willing to voluntarily disclose information is negatively related to the costs they incur (or the benefits their

competitors gain) from the release of this information. a. True b. False 10. Which type of analysts work for brokerage houses producing research directly to clients of the brokerage house or indirectly to clients via the trading commissions that clients direct back to the brokerage? a. Sell-side b. Credit c. Buy-side d. Management

Discussion Questions 1. Why do some companies disclose a lot of voluntary information, while other firms disclose almost no voluntary information? How do the incentives relate?

As noted in the chapter, voluntary disclosure is the generic term for the mechanism that firms use to convey additional information to reduce the costs of information asymmetry and information subjectivity. For some companies, there are proprietary costs that suggest that the extent to which firms are willing to voluntarily disclose truthful information is negatively related to the costs they incur (or the benefits their competitors gain) from the release of this information.

In some cases firms are not legally compelled to provide information, but doing so would help investors and other parties better understand it and view it more favorably.

This gives the firm an incentive to disclose the information.

2. Why do firms disclose non-GAAP earnings? Why is it considered to be a voluntary disclosure? What does it offer beyond GAAP earnings?

Non-GAAP earnings can be viewed as manager’s preferred performance measure. NonGAAP is the operative word as it conveys that certain elements of the performance measure, that are required for GAAP reporting purposes, have been excluded. Given their voluntary nature, the non-GAAP values firms report and the items managers choose to exclude are heavily influenced by incentives.

Perhaps not surprisingly, most of the items excluded from non-GAAP earnings are expense items. Restructuring charges, R&D expenditures, and customer development costs (i.e., advertising) are a few examples of common non-GAAP exclusions. In fact, academic research highlights that the non-GAAP earnings reported by firms are higher than GAAP-based earnings more than 70 percent of the time.

3. What is the difference between a sell-side and a buy-side analyst? What different incentives do they face?

While buy-side analysts analyze companies for the singular purpose of deciding which companies to buy for or sell from their investment portfolios, sell-side analysts work for brokerage houses and their research is sold either directly to clients of the brokerage house or indirectly to clients via the trading commissions that clients direct back to the brokerage house. While buy-side analysts are trying to maximize the return on their investments, sell-side analysts “sell” their research to interested investors.

4. What can be learned from conference calls from management that will help address the primary

questions?

Conference calls have both prepared remarks from the CEO, CFO and COO and others from the C-suite, and selected questions from analysts and other investors. These questions will span the continuum from technical questions relating to how the company accounted for a specific transaction to questions aimed at understanding management’s expectations of future sales, earnings, capital expenditures, and so on.

5. Why should the frequency of analyst forecast updates make a difference to those using analyst forecasts to predict future performance?

Analysts have incentives to cover a firm and being the most accurate and the most timely may not be what analysts are incentivized to do. But when considering analyst forecasts of future sales and earnings, investors would want to make sure that the forecasts reflect the most current information available. For this reason, they may want to consider the most current forecasts available rather than those made months/years ago for the current forecast.

6. Between 1996 and 2019, non-GAAP earnings were higher than GAAP-based earnings for 92 percent of firms. What incentives would cause this to happen?

All other things equal, managers have incentives to put the company in a favorable light.

As a voluntary disclosure, non-GAAP earnings serve as a one-way communication with outsiders. Managers choose what they want to report, what revenues they want to include, and which expenses they want to exclude. Furthermore, managers can choose where certain expense items are classified on the income statement.

To present things in a favorable light, managers will often omit certain expenses, yet include all revenues which makes non-GAAP earnings higher than GAAP-based earnings.

7. Compare and contrast Regulation G and Regulation FD from the Securities and Exchange Commission. How do they apply to different types of voluntary disclosures? Given that one of the key missions of the Securities and Exchange Commission is “to protect investors”, how are these regulations consistent with that mission?

Here are the definitions of each: Regulation FD (Fair Disclosure) – SEC regulation preventing selective disclosure by publicly traded companies to some financial analysts or a subset of shareholders.

Regulation G – SEC regulation requiring reconciliation of their non-GAAP performance measure to GAAP net income for those firms that publish non-GAAP disclosures.

Regulation FD is associated with making sure all investors, big or small, have access to the same information other investors receive from management. In contrast, Regulation G makes sure that investors are able to understand the differences between GAAP and non-GAAP earnings disclosures. Both work “to protect investors”.

8. How would you compare the accuracy of earnings estimates generated using crowdsourcing to the accuracy of earnings estimates from professional analysts? Would it differ depending on the company?

Crowdsourcing is the practice of obtaining information about a specific task, input, or variable from a large set of people typically over the internet. Over the past ten years, a growing trend has emerged where earnings estimates of individuals—who are often not professional analysts—are aggregated together to form consensus forecasts. Often these forecasts are compared to that of professionals, and often are more accurate than the professional analyst forecast. These amateurs may include company insiders, or more timely forecasts that incorporate up-to-the-minute forecasts. At the same time, professionals may have incentives that don’t include the most accurate forecast, since they may be more interested in recommending whether to buy or sell the stock, or forecast long-term sales and earnings growth rather than the analyst forecast for the next period.

Brief Exercises 6. Match the firm’s voluntary disclosures (e.g., conference calls, management forecasts, non-GAAP earnings, press releases, sustainability reports) to their descriptions.

Description of Voluntary Disclosures

Voluntary Disclosures

a. Voluntary disclosure with forecasts of future earnings made by a firm

Management Forecasts

b. Company manager’s preferred performance measure that is often disclosed to the public c. Top management live-stream conversations with interested parties d. Official statements issued to newspapers regarding specific firm matters

Non-GAAP earnings

e. Firm’s voluntary disclosures on environmental and social performance

Sustainability reports

Conference calls Press releases

7. Match the external financial information sources (e.g., buy-side analysts, crowdsourcing, industry reports, macroeconomic data, sell-side analysts, sustainability reports) to their descriptions.

Description of External Information Sources

External Information Sources

a. Individuals who work for brokerage houses producing research directly to clients of the brokerage house or indirectly to clients via the trading commissions that clients direct back to the brokerage

sell-side analysts

b. Individuals who analyze companies for the singular purpose of deciding which companies to purchase for their investment portfolios

buy-side analysts

c. Analysis which discusses systematic, macroeconomic factors that affect the earnings- and sales-generating process of the firm

Industry reports

d. Indicators of overall economy performance

macroeconomic data

e. Firm’s voluntary disclosures on environmental and social performance

sustainability reports

f. Obtaining information from a large number of people typically over the internet

crowdsourcing

8. Match the credit ratings (AAA, A, BB, C, D ratings from Standard & Poor’s) to theirdescriptions.

Description of Credit Rating

Credit Rating

a. Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions. Substantial credit risk. b. Currently highly vulnerable; default has not yet occurred but is expected to be a virtual certainty. Possibility of recovery. c. Has strong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances. Low credit risk.

BB

d. Payment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed or similar action taken. Little chance of recovery. e. Has extremely strong capacity to meet financial obligations.

Minimal credit risk.

D

Problems

C A

AAA

1. You are working to update your own financial forecasts for the following two firms and you see these sets of forecasts from professional financial analysts: 1. Firm A is followed by 20 different analysts with EPS estimates between $0.95-$1.15.

Each analyst updated her forecast on 4/12, the day after the 1Q earnings conference call.

2. Firm B is followed by 40 different analysts with EPS estimates between $0.75-$1.25.

Twenty analysts updated their forecasts on 4/12, the day after the 1Q earnings conference call. The other twenty analysts, with forecasts between $1.10 and $1.15, have not updated their forecasts in over 6 months.

Required: 1. If you had to choose between these two groups of analyst forecasts to do your own forecasting, which would be the most useful, those from Firm A or Firm B? Why? Answers may vary. Although Firm B has more forecasts, Firm A forecasts appear to be tighter and have less variance than Firm B forecasts. The 20 firm B forecasts that have been updated recently are wider suggesting more uncertainty around upcoming earnings.

2. Why is updating forecasts important given the most recent company announcements and macroeconomic reports?

Every day, there is more information, disclosures, news reports about the company, its competitors, its industry and that macoeconomy where it operates. Many of these forecasts will likely affect the company’s forecasted performance.

3. Would you prefer less or more standard deviation around earnings per share estimates?

Why? All other things equal, we would prefer less standard deviation around earnings forecasts. This suggests there is less uncertainty about expected earnings.

2. You are trying to forecast GAAP-based earnings over the next five years and have historical GAAP and non-GAAP data available to help with the prediction.

Required: 1. How would you assess whether the past five years of GAAP-based earnings or nonGAAP-based earnings are most useful in forecasting future GAAP-based earnings?

A regression analysis could be conducted with future forecasted earnings as the dependent variable and either GAAP-based or non GAAP-based earnings (or both) as the independent variables. Since there is a high correlation between GAAP-based and non GAAP-based earnings, perhaps a regression analysis could use the following analysis in its regression:

Forecasted earnings = f(GAAP earnings, Difference between GAAP-based and non GAAP-based earnings) 2. How would you potentially use both GAAP and non-GAAP earnings in your analysis?

Since there is a high correlation between GAAP-based and non GAAP-based earnings, perhaps a regression analysis could use the following analysis in its regression: Forecasted earnings = f(GAAP earnings, Difference between GAAP-based and non GAAP-based earnings)

3. How would your answer to question 1 change if you were trying to forecast nonGAAP-earnings for the next five years, instead of GAAP-based earnings?

The same analysis could be done with a different dependent variable, that is non-GAAP earnings. Often when considering non-GAAP earnings, the question is if they will consistently include the same metrics from quarter to quarter and year to year (that is, the same revenues and same expenses each period).

4. How could you test to see which is more correlated with stock price, GAAP earnings, non-GAAP earnings or both?

Run the correlation between quarter-end stock price and non-GAAP earnings.

Run the correlation between quarter-end stock price and GAAP earnings.

Determine which one exhibits higher correlation as input into the use of GAAP and nonGAAP earnings.

3. You have access to your own analysis and forecasts, analyst forecasts, forecasts from management, or forecasts from Estimize. Which of these four would you use to forecast earnings for the quarter ahead or the year ahead?

Required: 1. How would you assess which analysis/forecasts to use? Would you select the most accurate forecasts to actual performance in the past? Would you select those most correlated with stock prices? Or would you select forecasts that are closest to the date of actual earnings and forecasted frequently?

All offer great possible qualities and each might offer the most accurate forecasts. As part of Master the Past, we could look at the recent past for all companies that have all four of these forecasts and assess which are most accurate.

It may be that a full-year ahead, that management forecasts are most accurate.

Management forecasts are usually not given close to the announcement of actual earnings so perhaps they are most accurate further away from the announcement of actual earnings.

Crowdsourced earnings forecasts likely provides the most recent forecasts, suggesting they might be most accurate close to the earnings announcement.

Analyst earnings forecasts might be most accurate if their forecasts are timely or are reaffirmed at a certain point in time.

2. Does it make sense to combine multiple forecasts? How could you combine them?

Would you give more weight to some as compared to others?

Yes, different combinations of forecasts may be used to determine which are most accurate. You could equal weight the forecasts or weigh some more heavily based on timeliness and recent accuracy.

4. Analysts need information about current and past performance to help predict the future.

1. May analysts call management to get additional information and ask specific questions?

2. Why or why not?

Regulation FD (Fair Disclosure) – SEC regulation preventing selective disclosure by publicly traded companies to some financial analysts or a subset of shareholders.

Due to Regulation FD, analysts may not call management to ask specific questions when not in the presence of other investors, but may ask these questions as part of a conference call or an annual shareholder meeting.

5. The following table shows the actual outcomes (EPS Actual) and the related analyst forecasts (EPS Est.) for Chipotle in recent quarters. It also computes various statistics to evaluate analyst forecast accuracy.

Source: https://finance.yahoo.com/quote/CMG/analysis?p=CMG, accessed March 22, 2023.

Required: 1. How is the difference computed? How is the surprise % computed?

The difference is computed as (EPS Actual less EPS Est.), so for 3/30/2022, $5.70 – $5.64 = $0.06.

The surprise is computed as (EPS Actual less EPS Est.)/EPS Est., so for 3/30/2022, ($5.70 – $5.64)/$5.64 = 1.10%.

2. Which of the four forecasts were the most optimistic? Which of the forecasts were pessimistic?

It looks like the 12/30/2022 was the most optimistic forecast, because it was greater than the actual forecast. The remaining forecasts were all pessimistic (that is, all of the remaining forecasts were lower than the actual earnings realized). The 9/29/2022 consensus forecast was the most pessimistic estimated EPS. 3. What would be some reasons that forecasts were not exactly correct? Given the discussionin the text, why would some forecasts be more correct than others?

While analysts know a lot about the companies they cover, they don’t know everything.

Forecasts are rarely exactly right for the analysts simply because of firm-specific, competitive, and macroeconomic events that all affect the accuracy of the forecast.

Chapter 4 End-of-Chapter Assignment Solutions Multiple Choice Questions 1. The DuPont model disaggregates ROCE into its component parts of asset turnover, leverage, and which of the following? a. net income b. profit margin c. gross margin d. sales 2. Whereas time series analysis is a comparison of a single firm’s financial performance over a span of time, a cross-sectional analysis compares which of the following? a. Multiple companies at multiple points in time. b. A single company at a single point in time. c. Multiple companies at a single point in time. d. A single company at multiple points in time.

3. The cash conversion cycle equals which of the following? a. DSO +DSI + DPO b. DSO + DSI - DPO c. DSO + DPI - DPO d. DSO - DPI – DPO 4. According to Porter’s Five Forces, vendors requiring quicker payment, or cash payment, from their customers may be indicative of the power of which of the following and may have what impact on the accounts receivable turnover? a. Vendor power and faster accounts receivable turnover b. Customer power and faster accounts receivable turnover c. Vendor power and slower accounts receivable turnover d. Customer power and slower accounts receivable turnover 5. While cross-sectional analysis is an assessment relative to other companies, which of the following types of analyses is an assessment relative to a company’s own past? a. diagnostic b. descriptive c. prescriptive d. time-series 6. The Dupont Analysis 2.0, or Penman ratios, segregates operating revenues, expenses, assets and liabilities from which of the following revenues, expenses, assets and liabilities? a. investing b. financing c. persistent d. non-operating 7. All but which of the following are ways of evaluating the asset turnover ratio, or assets/sales? a. Cash/Sales + AR/Sales + Other Current Assets/Sales + Non-Current Assets / Sales b. Current Assets/Sales + Non-Current Assets / Sales c. Cash/Sales + Current Assets/Sales + Non-Current Assets / Sales d. Operating Assets/Sales + Non-Operating Assets/Sales 8. Which of the following is a financial transaction where a firm sells its receivables to a third party at a discount? a. Discounting b. Factoring c. Receivership d. Pledging 9. Data analytics uses which of the following to change the definition of a variable without changing the inferences drawn?

a. variable definition b. variable transformation c. variable adjustment d. variable translation 10. Purchases can be defined as follows: a. Purchasest = Sales/ Ending Inventory – Beginning Inventory b. Purchasest = Sales - COGSt c. Purchasest = COGSt - Ending Inventory – Beginning Inventory d. Purchasest = Ending Inventory – Beginning Inventory + COGSt

Discussion Questions 1. What different analyses can be performed by looking at both the gross margin ratio and the EBITDA ratios for the same company?

Solution: While gross margin ratio considers the amount that is made after deducting for the cost of the goods or services, the EBITDA ratio considers all other expenses including operating expenses, interest, depreciation and taxes. The comparison of these two ratios over time may be a powerful look at company performance both in current and prior periods where trends can also be evaluated.

2. What different characteristics of performance can you uncover by performing time series analysis versus cross-sectional analysis?

Solution: Time-series analysis allows a comparison of variable, such as sales, earnings, or operating cash flows over time. Cross-sectional analysis, in contrast, allows comparisons to other companies, including comparisons to competitors, industry and the economy in general.

3. Why is the return on common equity (ROCE) important to shareholders? Would it also be important to bondholders?

Solution: Shareholders invest in the company via purchase of common shares of stock. ROCE allows a computation of the return earned that might allow the shareholder to compare to other potential investments. Bondholders may assess their ability to be paid by examining how well the company is performing, including measures such as ROCE. In general, the higher the ROCE, the more likely bondholders will both be paid for their interest that is due as well as ultimately the return of the loan (i.e., bonds) made to the company.

4. What does it say about a company’s liquidity or operations if a company's accounts receivable turnover is increasing faster than its accounts payable turnover, what does this indicate about its liquidity and operations?

Solution: The faster the accounts receivable turnover, the faster the company is collecting from its customers, which leads to favorable liquidity. Likewise, the faster the accounts payable turnover, the quicker the company is paying its customers. If accounts receivable turnover is increasing faster than the accounts payable turnover, that would suggest that cash collections (or cash inflows) are increasing faster than cash outflows. This all suggests that liquidity is improving.

5. Imagine a company has increasing EPS (earnings per share) but decreasing ROCE (Return on Common Equity). Why could that occur?

Solution: If the common equity per share in the denominator is growing faster (stock options exercised or new equity issues, for example) than the earnings per share, there will be a decreasing ROCE even if EPS has increased.

6. Why would an explanation of return on common equity which focus on the operating and financing components be a useful disaggregation?

Solution: The return on common equity is disaggregated into operating and financing components. This allows the analyst to understand how the firm uses its operating assets to generate operating income. In contrast, how the firm is financed, and the costs associated with the firm’s financing choices, is a second-order concern.

7. Financial statement analysis requires you to understand whether differences in financial ratios are due to differences in fundamental performance, differences in operating choices, or differences in accounting policies. If one company uses an accelerated depreciation method and another company uses straight-line depreciation, how should these companies be evaluated with respect to each other?

Solution: If one company uses an accelerated depreciation method, and another company uses straight-line depreciation, differences in performance would potentially be due to a differences in accounting policies. By working to restate the financial statements based on depreciation methods, we can work to compare the two companies to each other.

8. Explain the terms NOPM and NOATO, and explain what components of performance they are measuring.

Solution: The net operating profit margin ratio (NOPM) builds from the gross margin ratio by removing other operating expenses. These expenses are often recognized in the selling, general, and administrative (SG&A) section of the income statement. Operating costs contained in SG&A are often viewed as fixed and include such expenses as salaries, R&D, advertising, and rent.

These expense items do not covary with sales levels.

The net operating asset turnover ratio (NOATO) captures the dollars generated per dollar of net operating assets. Accordingly, NOATO is a function of not only how efficiently the firm uses its operating assets to generate sales, but also how it ‘finances’ its operating assets with operating liabilities.

9. What does the persistent earnings margin ratio remove from after-tax earnings? Why is this an important element to remove before forecasting future performance?

Solution: The persistent earnings margin ratio removes the distortive effects to income related to activities that are not expected to occur in future fiscal periods. If it isn’t expected to persist, we do not want or need it in our forecast of future performance.

Brief Exercises 9. Match these terms (capital structure, comparability, cross-sectional analysis, flow, stock, time series analysis) to their descriptions.

Description

Term

data quality that balance sheet line items represent a value at a point in time.

stock

a quality of a variable or metric that allows it to be used to form relative rankings across different observations.

comparability

data quality that income statement items represent firm performance over a period of time

flow

a comparison of a firm’s financial performance over a span of time helps to identify trends and/or unusual performance

time-series analysis

an assessment of how the firm is performing relative to others facing similar economic opportunities and challenges at a single point in time.

cross-sectional analysis

relative mix of debt and equity to help determine how the company is financed

capital structure

10. Match these terms (e.g., cash conversion cycle, DuPont model, Return on common equity, Return on net operating assets, persistence, working capital cycle) to their descriptions.

Description

Terms (cash conversion cycle,

DuPont model, Return on common equity, Return on

net operating assets, persistence, working capital cycle) the repeatability (or continuity) and durability of the financial statement variables (e.g., earnings, sales, cash flows) over time

persistence

Summarizes and disaggregates company performance into three ratios: profit margin, asset turnover, and financial leverage. the time duration between buying the products to sell (or inputs to manufacture inventory) until the final product is sold, and cash is collected.

DuPont model

the number of days a firm holds inventory before selling it plus the number of days it takes to collect cash on those sales minus the number of days before the firm pays its vendors for the inventory.

cash conversion cycle

a measure of firm performance and measures how much money a common shareholder receives from a company compared to their original investment.

Return on common equity (ROCE)

a measure of performance of the assets that are generating revenue.

Return on net operating assets (RNOA)

working capital cycle

Problems 1. Compute the DuPont ratios (profit margin, asset turnover, and financial leverage ratios) for Walmart and Target from 2017 to 2022 given their performance from 2016–2022. Check your numbers to make sure that Profit margin × Asset turnover × Financial leverage = Return on Equity. The data file, DuPont Analysis Walmart Target Data.xls is available in Connect or via the Additional Student Resources page. (Note the data is in $ millions.) Remember to use average assets and average stockholder’s equity in your calculations.

2. Compute the DuPont ratios (profit margin, asset turnover, and financial leverage ratios) for Amazon and Kroger from 2017 to 2022 given their performance from 2016–2022. Check your numbers to make sure that Profit margin × Asset turnover × Financial leverage = Return on Equity. The data file, DuPont Analysis Amazon Kroger Data.xls is available in Connect or via the Additional Student Resources page. (Note the data is in $ millions.) Remember to use average assets and average stockholder’s equity in your calculations.

3.

4.

5. Compare and contrast the disaggregation of ROCE using time-series analysis, including profit margin, asset turnover, and leverage for Deere & Co. (DE) over time. Are these numbers flat or improving in the most recent three years? Do they appear persistent enough to facilitate prediction of future performance? (Download the Excel file “Deere Data”).

DE Profit Asset Financial Return on Data Year - Fiscal Margin Turnover Leverage Equity 2022 0.1367 0.5993 4.5007 0.3686 2021 0.1356 0.5522 5.0754 0.3802 2020 0.0774 0.4799 6.0822 0.2260 2019 0.0829 0.5486 6.3046 0.2866 2018 0.0647 0.5383 6.5192 0.2272 The performance appears to be improving over the most recent years including stronger profit margins, asset turnover, and lower leverage. This all results in a higher return on common equity.

6. Compare and contrast the disaggregation of ROCE using time-series analysis, including profit margin, asset turnover, and leverage for Caterpillar (CAT) over time. Are these numbers flat or

improving? Do they appear persistent enough to facilitate prediction of future performance?

(Download the Excel file “Caterpillar Data”).

CAT Profit Asset Financial Return on Data Year - Fiscal Margin Turnover Leverage Equity 2022 0.1128 0.7215 5.0918 0.4145 2021 0.1273 0.6327 5.0642 0.4079 2020 0.0718 0.5326 5.2400 0.2004 2019 0.1133 0.6855 5.4830 0.4257 2018 0.1123 0.7040 5.6054 0.4433 The performance at Caterpillar seems to have been affected by the pandemic in 2020 with profit margins and asset turnover recovering in the recent two years. The question is if the improving trend will persist into the future. The 40%+ ROE each year (except for 2020) appears to be a strong return to shareholders each year.

For problems 7-10, use the 2021 JB Hunt Data, 2021 Walmart Data, and 2021 Tyson Data files.

7. Compare A/R and A/P Turnover for Walmart, Tyson and JB Hunt for 2019, 2020 and 2021. Which one has the greatest difference between the rate that cash is collected from its customers and cash is paid to its suppliers? What fundamental reasons are there for this difference?

Walmart has the greatest difference between A/R Turnover and A/P Turnover. Except for insurance companies that owe Walmart for prescriptions, all other transactions are cash, suggesting a fast A/R turnover ratio. Walmart, in particular, extends payment terms to its suppliers, suggesting they have market power.

JB Hunt A/R Turnover A/P Turnover Tyson A/R Turnover A/P Turnover Walmart A/R Turnover A/P Turnover

2021 4.62 13.55

2020 4.51 12.28

2019 4.44 10.20

21.41 20.28

21.62 20.02

20.94 19.85

76.75 8.44

86.76 8.76

82.74 8.40

8. Compare the capital expenditures to the depreciation for JB Hunt, Tyson, and Walmart by looking on the statement of cash flows. Should the amount of capital expenditures (new investment in long-lived assets) be comparable to depreciation (the systematic allocation of the usage of long-lived assets in the current period) for each of these companies?

JB Hunt CapEx Depreciation

2021 ($877,018,000) $557,093,000

2020 ($612,957,000) $527,375,000

2019 ($803,962,000) $499,145,000

Tyson CapEx Depreciation

($1,887,000,000) $945,000,000

($1,209,000,000) $934,000,000

($1,199,000,000) $900,000,000

Walmart CapEx Depreciation

($6,015,000,000) $10,658,000,000

($10,071,000,000) $11,152,000,000

($9,128,000,000) $10,987,000,000

In general, the absolute value of these numbers are comparable to each other. It also gives some idea of the expected growth and need for new capital expenditures as the businesses grow and change their business models.

9. Calculate the ROE and the ROA for JB Hunt, Tyson, and Walmart. What accounts for the difference between these numbers? Does financial leverage enhance or hurt the return to shareholders?

JB Hunt ROA ROE Tyson ROA ROE Walmart ROA ROE

2021 11.96% 26.61%

8.89% 17.25%

5.61% 15.54%

2020 8.88% 20.79%

2019 9.78% 23.64%

8.65% 18.41%

6.15% 14.05%

5.61% 16.21%

6.67% 18.86%

Given the DuPont ratio, the difference between ROA and ROE is the way that the company is leveraged, or financed. We see in each case that ROE is greater than ROA, suggesting that financial leverage enhances the return to shareholders.

10. Calculate the inventory turnover ratio for JB Hunt, Tyson, and Walmart. (Note: JB Hunt doesn’t explicitly have a cost of goods sold, so we’ll make our own estimate by making “Rents and purchased transportation” and “Salaries, wages and employee benefits” be their “Cost of Goods Sold”.) Why is JB Hunt’s inventory turnover ratio so high? What is included in their inventory?

JB Hunt Inventory Turnover

2021 377.21

2020 325.18

2019 310.87

Tyson Inventory Turnover

9.42

9.83

9.71

9.40

8.90

Walmart Inventory Turnover

8.46

JB Hunt does not have inventory in the traditional sense. While they list inventory in their balance sheet, they are supplies for their trucks (tires, engine parts, trailer parts, etc.).

Therefore, each time a ratio is computed, it may or may not be directly comparable to other companies.

11. Download the file “2022 Apple Financials Data” which has the income statement and balance sheet! Compute RNOA for Apple, evaluating the ROOA (Return on Operating Assets) and OLLEV(Operating Liability Leverage). What can we learn about the various components?

Apple’s ROOA is extremely high, but because of the way it is financed there is negative operating leverage which explains the RNOA. This all helps to explain the RNOA for Apple in 2022.

Chapter 5 End-of-Chapter Assignment Solutions Multiple Choice Questions 1. An estimate associated with increased warranty expenses will impact which working capital account? a. increased warranty asset b. increased warranty liability c. decreased warranty asset d. decreased warranty liability 2. An estimate associated with increased bad debt expense will impact which working capital account? a. Net accounts receivable b. Net accounts payable c. Bad debt expense d. Bad debt revenue 3. Deciding not to spend money on research and development expenditures in the current year and postpone it to a subsequent year is an example of income. a. persistent b. real transitory c. managed transitory d. extraordinary 4. Deciding to extend the useful life of equipment from five to seven years for depreciation purposes to increase income in the current period would be an example of income. a. persistent b. real transitory c. managed transitory d. extraordinary 5. According to Dichev, et al., the most likely incentive for managers to misrepresent economic performance is . a. because they feel other companies misrepresent performance b. to influence stock price c. to avoid violation of debt covenants d. to reduce expectations of future earnings 6. According to Dichev, et al., the least likely incentive for managers to misrepresent economic performance is . a. because they feel other companies misrepresent performance b. to influence stock price c. to avoid violation of debt covenants d. to reduce expectations of future earnings 7. Which of the following is the correct disaggregation of reported earnings? a. = NIPerfect + errorUnintent b. = NIPersistent + NITransitory + errorUnintent c. = NIPersistent + NIReal_Transitory + NIManaged_Transitory d. = NIPerfect + errors 8. The characteristic of the firm that jointly describes the underlying economic process used by the firm to generate value and how transparently the firm’s income statement conveys this value generation to financial statement users is called .: a. accrual quality b. accounting quality c. earnings quality d. disclosure quality

9. A characteristic of the data that describes how reliably the data describes a real-world construct is called . a. data quality b. accrual quality c. accounting quality d. disclosure quality 10. Accrual errors that are correlated with the incentives facing management is called . a. unintentional errors b. intentional errors c. transitory errors d. nontransitory errors

Discussion Questions 1. What four components of financial statements and financial disclosure make up accounting quality?

Suggested solution: a. Earnings quality: a characteristic that jointly describes the firm’s underlying economic process to generate value, and how transparently the firm’s income statement conveys this value generation to financial statement users. b. Balance sheet quality: a characteristic of the firm’s balance sheet that describes how precisely and completely the firm’s economic resources (assets), and non-equity claims against them (liabilities), are reflected on the balance sheet. c. Cash flow quality: a characteristic of the firm’s cash flows that jointly describes (i) how cleanly the firm’s statement of cash flow (SCF) matches the cash inflows and outflows associated with its operating, investing, and financing activities, and (ii) how easily an analyst can predict the level and timing of future cash flows related to operating, investing, and financing activities. d. Disclosure quality: a characteristic of the firm’s required financial disclosures (e.g., 10K footnotes, MD&A, and 8Ks) and voluntary disclosures (e.g., conference calls, management earnings forecasts, and non-GAAP earnings metrics) that describes how well these disclosures clarify the true underlying condition and economic performance of the firm and reduces the frictions of information asymmetry.

2. What is the objective of managing earnings? What are managers trying to achieve?

Suggested solution: Exhibit 5.3 provides a number of motivations that help explain whymanaging earnings is important, including influencing stock price, to hit earnings benchmarks, to influence executive compensation, and to avoid violation of debt covenants.

3. What is the difference between real transitory income (or real-activities management) and managed transitory income?

Suggested solution: Transitory income that is due to real-activities management) are operating choices that managers make to affect current period earnings in a suboptimal way. In contrast, managed transitory income including intentional accrual errors which are due to accounting choices.

4. Why does real transitory income due to real-activities management have an impact on cash flows, while managed transitory income does not?

Suggested solution: Operational decisions such as deciding whether or not to spend money on training this period or next have both earnings and cash flow implications. In contrast, managed transitory income, such as deciding the amount of bad debt expense to increase the allowance for

doubtful accounts this period, does not.

5. How does an estimate related to the extent of warranty costs affect earnings and working capital?

Suggested solution: Estimating the extent of costs associated with warranties offered will affect current period costs (to match with the revenues earned in the period) and the liability account since the company will have to wait until the warranty claims are presented before paying them off. The higher the liability, the lower the working capital.

6. Why are Unintentional Accrual Errors not predictable, but not unexpected? By this we mean these errors are directionally unpredictable and will vary in magnitude from year to year.

Suggested solution: Since they are unintentional, we would expect these errors to occur but not be biased in any direction.

7. How does the allowance for doubtful accounts affect earnings? Is there more/less expense or more/less revenue?

Suggested solution: Increasing the allowance for doubtful accounts is associated with an increase in bad debt expense. Current-period expenses decrease current-period earnings.

8. Describe how the definition of data quality is the ability of a given data set to serve, or meet, its intended purpose emphasizing the use of earnings in answering financial statement analysis questions. How does earnings quality relate then to data quality?

Suggested solution: Earnings quality is defined as the extent that a firm’s reported earnings accurately reflect income for that period, as well as the ability of reported earnings data to predict a company’s future earnings. If the analyst is attempting to use earnings data to answer financial statement analysis questions, then earnings that exhibit high earnings quality are desirable.

Brief Exercises Brief Exercises

11. Match these quality terms (e.g., accounting quality, accruals quality, data quality, earnings quality, balance sheet quality) to their descriptions.

Description

Term

1. Extent to which working capital accruals map into operating cash flow realizations

accruals quality

2. Ability of a given data set to serve, or meet, its intended purpose.

data quality

3. Extent that a firm’s reported earnings accurately reflect income for that period as well as the ability of reported earnings to predict a company's future earnings

earnings quality

4. Ability of financial statements and disclosures to convey a firm’s true economic performance and financial condition.

accounting quality

5. Extent that the balance sheet provides transparency and faithfully represent the underlying financial condition of the firm

balance sheet quality

12. There are five components of earnings of reported income, NIReported, where NIReported = NIPersistent + NITrans-Economic + NITrans-Managed + Accrual errorUnintent + Accrual errorIntent

For each of the examples below, please identify which of the five components are represented.

Examples

1. Reduction in R&D expenditures in the fourth quarter coupled with an increase in R&D expenditures in the next quarter.

Components of Net Income (Earnings) (Persistent Income, Trans-Econ Income, Trans- Mang Income, Accrual Error Unintentional, Accrual Error Intentional Errors) Trans-Econ Income (NITrans-Econ)

2. Income from normal, ongoing operations.

3. Accrual estimation errors, like management purposely having a smaller warranty expense than is required, with goal of reporting higher earnings.

Persistent Income (NIPersistent)

4. Despite their best efforts, management overestimates bad debt expense.

Accrual Error Unintentional (Accrual ErrorsUnint)

Accrual Error Intentional (Accrual ErrorsInt)

5. A firm has plans to divest business units in the near future and will report earnings from these soon-tobe divested units separately.

Trans-Mang Income (NITrans-Mang)

Problems 1. The following represents a request to remove a negative rating from an Amazon seller. a. How would this request to remove a negative Amazon review hurt the data quality of Amazon reviews for subsequent users considering the product?

Proposed solution: If negative reviews are removed at the seller’s request, the overall ratings no longer represent the true underlying sentiment regarding the product, and the data quality of that rating is compromised. b. If higher Amazon ratings are associated with subsequent sales, what does this mean?

Proposed solution: The first question is which rating is used – the true rating that reflects the sentiment of product users, or one where the seller encourages those with negative ratings to change or remove them. In general, one would expect that the Amazon ratings would be positively associated with subsequent product sales. The lingering question is whether there would be a higher correlation if the data quality of the reviews is high (not manipulated, etc.).

2. The figure in In Exhibit 5.1 (in the opening vignette) shows some of the characteristics of high-quality earnings.

Required: Answer the following questions. a. The figure notes that one characteristic of high-quality earnings reflect consistent reporting choices over time. Why is that?

Proposed solution: When similar accounting choices and procedures are made each period consistently, it raises confidence regarding the true economic and financial performance reported by the company. b. The figure notes that one characteristic of high-quality earnings is that the earnings are sustainable? What does that mean?

Proposed solution: Sustainability suggests that the earnings are persistent, that they will continue each period into the foreseeable future. It also suggests that similar accounting choices and procedures are used each period.

c. The figure notes that one characteristic of high-quality earnings is that the earnings serve as useful predictors of future earnings. Why is that?

Proposed solution: If there is a belief that reported earnings exhibit high quality, then we would assume that there is some level of persistence that would allow a forecast of future earnings. d. The figure notes that one characteristic of high-quality earnings is that the earnings serve as useful predictors of future cash flows. Why is that, and how is that different from predicting earnings?

Proposed solution: Proposed solution: If there is a belief that reported earnings exhibit high quality, then we would assume that there is a high correlation with forecasts of future cash flows, and that there is some level of persistence that would allow a forecast of future cash flows.

3. The chapter suggests NIPerfect-GAAP is equal to NIReported when (Accrual errorUnint + Accrual errorInt ) if equals zero.

Required: a. Would setting the allowance for doubtful accounts based on all available knowledge thatended up being wrong due to changes in the economy be an example of intentional or unintentional Accrual Errors?

Proposed solution: If the estimate reflected all available information and had no bias associated with it, it would be regarded as an intentional accrual error. b. Would setting the allowance for doubtful accounts to achieve a certain level of earnings to maximize a bonus be due to changes in the economy be an example of intentional or unintentional Accrual Errors?

Proposed solution: If the estimate reflected all available information but had bias associated with it, it would be regarded as an unintentional accrual error.

4. Exhibit 5.X shows the motivations to use earnings to misrepresent economic performance.

Required: Answer the following questions: a. The figure notes that one motivation of using earnings to misrepresent economic performance is to influence stock price. Why is that motivation important to management?

Proposed solution: There are many reasons to want to influence stock price. Shareholders are happy if the stock price is high and are much less likely to fire management. Management often has stock options or shares in hand, so they also want to see a high stock price as part of their own portfolio.

b. The figure notes that motivations of using earnings to misrepresent economic performance is due to both inside and outside pressure to hit earnings benchmark. What insiders and outsiders pressure management to hit certain earnings benchmarks?

Proposed solution: Once earnings forecasts are set (either by analysts or management), there is significant pressure to hit those targets/benchmarks. Sometimes there is litigation if management predicted one amount but came up well short of that. For this reason, there is often significant pressure to hit earnings benchmarks using earnings management techniques. c. How is executive compensation affected by earnings levels and hitting earnings benchmarks? Is that sufficient incentive to manage earnings?

Proposed solution: Often bonuses, stock options, stock appreciation rights and other forms of executive compensation depend on hitting certain earnings thresholds. If management determines they will not meet those thresholds, they may use various earnings management such as intentional accruals or real earnings management techniques to help meet those thresholds. d. Which is more costly to a firm? Intentional accruals manipulation or real earnings management? Why is it more costly?

Proposed solution: Real earnings management involves operating decisions, such as delaying or speeding up the spending of R&D, advertising, training or other similar expenditures.

Such operating decisions have a significant and potentially costly impact on the company and its performance. In contrast, accruals management is not very costly, if at all. Changing for example, the useful life of its property, plant and equipment to change depreciation expense likely has no impact on subsequent company performance.

5. Let’s assume that you note that BBB reduced its fourth quarter 2025 training expenditures by $12,000. (In past years, BBB spends $12,000 per quarter on training and, in 2025 overall spent, it spent $15,000.) You know that BBB’s executives will earn an annual bonus if BBB’s earnings in 2025 are above $77,200. You also know that payoffs to training lag by a couple years or so.

Without such training, some employees might turnover since they are not appropriately trained in their jobs, so a reduction in training in 2025 will tend to lead to a reduction in earnings the following years.

Required: Answer the following questions: a. Does this represent real-activities management (or real earnings management) or accrual management?

Proposed solution: This is an example of real activities management, with management making operational choices to potentially hit an earnings benchmark to get their bonus. b. How would one assess the ultimate cost of this training expense?

Proposed solution: A lack of training might increase accidents, or make less effective employees. It might also lead to more employee turnover. Traditionally, these type of costs are difficult to quantify, but they could be material in size.

c. What if it were R&D that was reduced instead of training? When would that ultimately impact earnings?

Proposed solution: Less R&D in the current period might affect the quality of current products and/or the pipeline of new products that will ultimately impact earnings. The impact likely won’t be felt immediately, but this would likely affect the long-term trajectory of firm performance.

Chapter 6 End-of-Chapter Assignment Solutions Multiple Choice Questions 11. Which financial ratio is most likely to give an overall view of the capital structure of a company? a. PP&E turnover ratio b. Debt-to-equity ratio c. Interest coverage ratio d. Return on assets ratio 12. Which tactic used to increase comparability? a. variable demeaning b. Altman’s Z scores c. credit ratings d. multivariate models 13. Which two adverbs that describe balance sheet quality in terms of the firm’s economic resources (assets), and non-equity claims against the resources (liabilities), are reflected on the balance sheet. a. Timely and completely b. Precisely and completely c. Accurately and precisely d. Correctly and completely 14. One of the issues associated with the use of credit ratings is the lack of which of the following? a. credit analyst training b. independence between the credit rating agency and the firm seeking the credit rating c. the use of sophisticated models used in the analysis. d. data available to evaluate the credit rating.

15. What does Altman’s Z-scores help to assess? a. stock performance b. risk of liquidity issues c. risk of bankruptcy d. profitability 16. What does the interest coverage ratio help assess for a company? a. stock performance b. solvency c. risk of bankruptcy d. profitability 17. Which debt securities held as investments are valued at amortized cost? a. Trading b. Available-for-sale c. Held-to-maturity d. Investment-grade 18. Which equity securities held as investments are valued at capitalized value equals purchase price plus share of earnings minus paid dividends? a. Trading b. Available-for-sale c. Equity Method d. Consolidation Method 19. What is an example of a contingent liability? a. Payments to a supplier for supplies b. Loan payments to a bank c. Preferred stock dividends d. Product warranties 20. Which ratio is often used to assess a company’s financing and its capital structure?

a. PPE b. debt-to-equity c. interest coverage d. return on assets 10. Connect Update for #10: If a firm is performing on par with its industry peers, its industry adjusted financial ratios will be: a. positive ratios. b. approximately zero. c. negative ratios. d. undetermined.

Discussion Questions 9. How can understanding balance sheet quality help address the FSA questions and equity valuation? How are they connected?

Proposed Solution: Balance sheet quality is a characteristic of the firm’s balance sheet that describes how precisely and completely the firm’s economic resources (assets), and non-equity claims against the resources (liabilities), are reflected on the balance sheet.

The general GAAP principle that requires firms to reduce the carrying value of their operating assets in light of a negative event but prohibits firms from increasing the carrying value of their operating assets in light of positive news, can lead to large differences in the capitalized value of the asset and its market value. Many other differences exist with respect to how GAAP requires firms to account for the different asset and liability items reflected on a common balance sheet, differences that when combined with different business models, can affect the comparability of financial ratios.

The second adverb—completely—draws attention to the fact that some “economic resources” of the firm that will produce future revenue are not capitalized as assets and some “financial obligations” that will require the firm to make cash payments are not recognized as liabilities.

Both of these aspects help assess valuation based on the quality of the underlying balance sheet.

10. What does comparability between companies allow the analyst to determine regarding a company’s prospects? Why is it often useful to compare one to the other?

Proposed Solution: Comparability is critical in data analytics. Diagnostic analytics requires the financial analyst to assess a firm’s financial performance and condition against that of comparable firms or groups of firms. Without valid comparative analysis, numerical financial statement values are largely meaningless.

11. How does the type of liability affect the valuation?

Proposed Solution: Liabilities are not all equal. While some are unwritten promises to pay (such as accounts payable), others have covenants regulating interest, firm performance, payouts to equity holders (e.g., dividends). For this reason, the commitments and covenants made associated with some types of liabilities often effect the equity valuation.

12. State your case for why R&D expenditures should be capitalized or expensed. Since GAAP

currently requires that R&D be expensed, why would some capitalize those expenditures in order to evaluate firm value?

Proposed Solution: Firms generally invest in R&D to innovate and create new products that will help company profitability and firm performance in the long term. In some sense, they are creating an intangible assets with expectations it will pay off in the future. From this perspective, the R&D expenditures should be capitalized as an asset. However, from another perspective, it is not clear if the R&D projects individually or collectively will pay off. And it is a challenge to consider how it should be capitalized and the appropriate period over which that asset/benefit is realized to approximate an amortization policy over subsequent years.

Company insiders and financial analysts may have insights as to this intangible R&D benefit and may choose to adjust current and prospective earnings based on these prospects.

13. How does an estimate related to the extent of warranty costs affect earnings and working capital?

Proposed Solution: Under the accrual basis (GAAP), estimated warranty costs are recorded when sales are made. This entails an expense (reduced earnings) and a liability (warranties payable or accrued warranties). This has the affect of reducing working capital in the year of the sale and recognition of the expense.

When the warranty costs are paid, it will reduce both the warranty liability and the cash or product paid out.

14. Describe how the definition of data quality is the ability of a given data set to serve, or meet, its intended purpose emphasizing the use of earnings in answering financial statement analysis questions. How does balance sheet quality relate then to data quality?

Proposed Solution: Balance sheet quality is a characteristic of the firm’s balance sheet that describes how precisely and completely the firm’s economic resources (assets), and non-equity claims against the resources (liabilities), are reflected on the balance sheet. Since the balance sheet and firm earnings are intertwined, the quality of the one deeply affects the others. Have all liabilities been recorded? Are all assets recorded at the appropriate amount? With so many estimates made to arrive at balance sheet amounts (such as the allowance for doubtful accounts, inventory obsolescence, depreciation policy over time to arrive at net PP&E, etc.)

15. Is it still possible to compare a company that uses the last in first out (LIFO) cost flow assumption to another company that uses the first in first out (FIFO) cost flow assumption? Why or why not?

Proposed Solution: In general, it is very difficult to compare a company that values inventoryusing a LIFO cost flow assumption to a company that uses a FIFO cost flow assumption.

This difference affects the direct comparability between the companies. However, astute financial observers may know that there is a requirement for US companies to disclose the difference in a corporation's earnings from using LIFO instead of FIFO can be determined by theamounts reported in the balance sheet account labeled LIFO Reserve. In general, the amount of composition of the LIFO Reserve information is found in the footnotes to the financial statements.

16. (LO4) Give a few examples of contingent liabilities. What are the criteria for recording contingent liabilities?

Proposed Solution: Examples of contingent liabilities include the following: • Lawsuits (pending litigation)

• Product Warranties • Bank Guarantees • Potential Environmental Contamination (for which the company is deemed responsible) GAAP requires firms to recognize a contingent liability if the resolution of the event is both probable and the amount owed can be reasonably estimated. If both criteria are not met, no liability is recognized.

17. (LO5) What do credit agencies assess? Why is the lack of independence of a credit rating agency a possible concern for investors?

Proposed Solution: Credit rating agencies assess a firm’s ability to make interest and principal payments on their debt obligations as they come due. One concern of credit rating agencies is that the issuers of the debt are the ones that contract with a credit rating agency to provide credit ratings. At the same time, the issuers of the debt prefer a higher rating, which may allow them to attract more potential lenders and a lower interest rate.

Brief Exercises

13. (LO 1, LO 2, LO4, LO5) Match the definition used in this chapter to its term (Altman’s Z, balance sheet quality, Beneish M-Score, demeaning, multivariate models, contingent liabilities).

Definition Term a characteristic of the firm’s balance sheet that describes how precisely and completely the firm’s economic resources (assets), and non-equity claims against the resources (liabilities), are reflected on the balance sheet.

balance sheet quality

statistical prediction tools that use more than one variable to estimate (or predict) a future outcome

Multivariate models

data analytics technique that subtracts from an observationlevel variable the average (or median) of that variable computed from a set of other comparable observations

demeaning

An obligation that depends on the resolution of an uncertain event

Contingent liabilities

a method of predicting, or classifying, the bankruptcy risk companies face Model used to predict fraud

Altman’s Z Beneish M-Score

14. (LO 1, LO 2, LO4, LO5) Match the type of equity security to its valuation on the balance sheet.

Balance Sheet Valuation

Capitalized value equals FMV

Type of Equity Security (Available for Sale, Trading, Equity Method, Ownership) Trading

Capitalized value equals FMV

Available-for-Sale Securities

Capitalized value equals purchase price plus share of earnings minus paid dividends

Equity Method

Consolidated Results

Ownership of more than 50% of the company

15. (LO 4) Match the ratio to the ratio type (e.g., liquidity, solvency, profitability). If needed, research these ratios using the internet.

Ratio a. Times interest earned ratio b. Gross profit ratio c. Profit margin d. Receivables turnover ratio e. Inventory turnover ratio f. Debt-to-equity ratio

Type Solvency Profitability Profitability Liquidity Liquidity Solvency

Problems

1. (LO 3; LO4) Some advocate capitalizing R&D expenditures; others believe that expensing R&D is best. An analyst can do either or both to predict earnings and value stock. What would that look like?

Required: a. To see the impact of such capitalization of R&D Expenditures, think about model that compares a company that capitalizes its R&D Expenditures to a company that expenses its R&D Expenditures immediately? How would you compare them? What would you adjust?

Proposed Solution: If capitalized, there would be changes to current period net income (increase since R&D expenditures would not be immediately recognized as expense) and future periods net income (decrease since the capitalized R&D asset would be amortized into expense over time).

b. Would you just compare current and prospective earnings on the income statement, or would you compare the balance sheet as well? What account would you adjust on the balance sheet side of the capitalization?

Proposed Solution: There are many possible entries that can be used. For example, to book an R&D asset would be: R&D Asset (Debit or Increase) Cash (Credit or Decrease) At the same time, there would not be an R&D expense recorded in the current period, so less expense means more current-period income. b. (continued) Assuming you capitalize R&D (as RDAsset t ), does it make sense to capitalize $1 for each $1 spent? Or follow a policy like this more appropriate?

RDAssett = RD + 0.25 RD t + 0.75 RD t-1 + 0.5 RD t-2 t-3 b. (continued) Proposed Solution: While both models work, the first model would need an amortization policy as the R&D is consumed (or value dissipates) over time. c. If you capitalize R&D, does that also mean you to need to amortize/depreciate R&D as well? What seems to be a reasonable period over which to amortize R&D? What would it depend on?

Proposed Solution: An amortization policy generally entails a systematic allocation method to allocate the consumption of the R&D asset over time. Such consumption will be different for different companies and different products. Each R&D asset will be context specific, of course, but as product cycles speed up and customer preferences change quicker, you could probably expect that the reasonable period of time over which the R&D would be amortized would get shorter over time. d. At some point, would the results be similar if you invested the same amount in R&D each year and then amortized consistently over time? Make a model in Excel to show what this might look like.

Proposed Solution: Once it reaches steady state some years into the future, the amount charged to R&D amortization would likely be comparable to annual R&D expense.

2. (LO2) Analysts will create equal-weighted industry ratios for some comparison purposes, and create value-weighted ratios for other comparison purposes.

Required: Answer the following Questions: 1. What is the difference between equal-weighted vs. value-weighted industry ratios? When would you use each for comparison purposes?

Proposed Solution: A value-weighted index weighs each company based by size. Value weighted indexes are used because larger companies have greater economic impact and thus deserve a greater weighting in an index. An equal-weighted index weighs the same for every observation/company. This gives equal importance to each observation or company regardless of size.

2. For each of the following questions, would you recommend the use of equal-weighted industry ratios or value-weighted industry ratios for comparison purposes?

Value weighted or Equal weighted?

Likely equal weighted ratio as most To value a mom and pop laundromat laundromats are small in size, and no one laundromat company dominates the industry To compare Walmart to an individual etsy Likely value weighted since Walmart is store so much bigger/different than other smaller companies To get a feel for what is happening in the Likely value weighted so bigger companies entire economy will have higher weights.

To compare steel production in China to Value weighted for China and value steel production in the United States weighted for the United States To compare one Subway restaurant to Equal weighted since most subway another restaurants are close to the same size.

To compare Kia and Tesla to the car Depending on what characteristics industry considered, could be either

3. (LO 2) As part of assessing the Balance Sheet and Balance Sheet Quality, it is important to assess the loans/receivables we make. Navigate to the Connect Additional Student Resources page. Under Chapter 6 Data Files, download and consider the LendingClub data dictionary file “LCDataDictionary,” specifically the LoanStats tab. This represents the data dictionary for the loans that were funded. Choose among these attributes in the data dictionary and indicate which are likely to be predictive that loans will go delinquent, or that loans will ultimately be fully repaid and which are not predictive.

Predictive Attributes 1. acceptD (Date when the borrower accepted the offer) 2. desc (Loan description provided by borrower) 3. dti (A ratio of debt owed to income earned) 4. grade (LC assigned loan grade) 5. home_ownership (Values include Rent, Own, Mortgage,Other) 6. loanAmnt (Amount of the loan) 7. next_pymnt_d (Next scheduled payment date) 8. term (Number of payments on the loan) 9. tot_cur_bal (Total current balance of all accounts)

Predictive?

(Yes/No) No No Yes Yes Yes Yes No No Yes

4. (LO 2) As part of assessing the Balance Sheet and Balance Sheet Quality, Navigate to the Connect Additional Student Resources page. Under Chapter 6 Data Files, download and consider the rejected loans dataset of LendingClub data titled “Rejected Loans Data.”

Choose among these attributes in the data dictionary, and indicate which are likely to be predictive of loan rejection, and which are not.

Predictive Attributes 1. Amount Requested 2. Zip Code 3. Loan Title 4. Debt-To-Income Ratio 5. Application Date 6. Risk_Score 7. Employment Length

Predictive? (Yes/No) Yes Yes No Yes No Yes Yes

5. Download and consider the rejected loans dataset of LendingClub data titled Rejected Loans Data and perform an Excel PivotTable by state; then figure out the number of rejected applications for the state of Arkansas. That is, count the loans by state and compute the percentage of the total rejected loans in the United States that came from Arkansas. How close is that to the relative proportion of the population of Arkansas as compared to the overall U.S. population (per 2010 census)? Use your browser to find the population of

Arkansas and the United States and calculate the relative percentage and answer the following questions.

Required:

1. Multiple Choice: What is the percentage of total loans rejected in the United States that came from Arkansas? a. Less than 1%. b. Between 1% and 2%. c. More than 2%.

Answer: b Percentage of total loans rejected that live in Arkansas = 1.219%

2. Multiple Choice: Is this loan rejection percentage greater than the percent of the U.S. population that lives in Arkansas (per 2010 census)? a. Loan rejection percentage is greater than the population. b. Loan rejection percentage is less than the population.

Answer: a 2,915,918 population in Arkansas divided by USA population of 308,745,538 = 0.9444% The loan rejection percentage is greater than the percent of the USA population that lives in Arkansas (per 2010 census), but is reasonably close.

3.

Put the following states in order of their loan rejection percentage based on the count of rejected loans (from high [1] to low [11]) of the total rejected loans.

State 1. Arkansas (AR) 2. Hawaii (HI) 3. Kansas (KS) 4. New Hampshire(NH)

Rank 1 (High) to 11 (Low) 2 9 5

5. New Mexico (NM) 6. Nevada (NV) 7. Oklahoma (OK) 8. Oregon (OR) 9. Rhode Island (RI) 10. Utah (UT) 11. West Virginia (WV)

8 1 3 4 11 6 7

10

4.

What is the state with the highest percentage of rejected loans?

Answer: CA (please see below) 5.

What is the state with the lowest percentage of rejected loans?

Answer: ND State CA TX NY FL PA IL OH NJ GA VA MI NC MA MD AZ MO WA CO AL CT SC LA WI MN KY NV (1) AR (2) OK (3) OR (4) KS (5) UT (6) WV (7) NM (8) HI (9)

Loan Rejection % 0.13292708 0.08344411 0.0797736 0.07688089 0.04401981 0.04246422 0.03779744 0.03708008 0.03683527 0.03131478 0.02718255 0.02672393 0.02547822 0.02340048 0.02142811 0.01954559 0.0187585 0.01812325 0.0169798 0.01640652 0.01569535 0.01450077 0.01430865 0.01407314 0.01367649 0.01275305 0.01219062 0.01103943 0.00954581 0.00862547 0.00692579 0.00643153 0.00590939 0.005756

NH (10) RI (11) DE MT VT AK DC SD WY IN MS TN NE IA ME ID ND

0.00551739 0.00498905 0.00354346 0.00284933 0.00250537 0.00249142 0.00236128 0.00223887 0.00220479 0.00149516 0.00059962 0.00055003 0.00022311 0.00017043 0.0001379 8.0568E-05 4.6482E-05

6. Analysis: Does each state’s loan rejection percentage roughly correspond to their relative proportion of the U.S. population (by 2010 U.S. census at https://en.wikipedia.org/wiki/2010_United_States_census)?

While the loan rejection percentage roughly corresponds with the population of each state, there is still substantial variation between the rejection percentage of each state.

Chapter 7 End-of-Chapter Assignment Solutions Multiple Choice Questions 1. Is the format of the direct method of reporting operating cash flows similar or dissimilar to the formatting used for cash flows from investing and financing activities? a. similar b. dissimilar c. cannot be determined 2. Accruals equals which of the following? a. Net income plus operating cash flows. b. Net income less operating cash flows. c. Operating cash flows less net income. d. Investing cash flows plus net income.

3. What is the term for the amount of time between when cash is invested in the main operations of the company until cash is received from the sale of the product or service? a. operating cycle b. financing cycle c. product cycle d. cash cycle 4. All other things equal, the more net income is supported by operating cash flows, the higher or lower the quality of earnings? a. higher b. lower c. relationship cannot be determined 5. Which characteristic explains why there is a mismatch in the between cash inflows (sales) and cash outflows (inventory buildup due to seasonality)? a. measurement b. size c. timing d. nature 6. Negative cash flows (or cash outflows) from investing activities could result from which of the following? a. cash payments to employees b. cash receipts from the sale of a factory c. cash payments on loan principal d. cash payments for the purchase of new equipment 7. Commercial paper is which of the following? a. unsecured short-term debt instruments b. unsecured long-term debt instruments c. secured long-term debt instruments d. secured short-term debt instruments

8. Per GAAP, items all firms must disclose as supplemental cash flows such as cash outflows tied to interest payments and which of the following? a. dividend payments b. payments to foreign governments c. income taxes paid d. bribe payments 9. Which level of cash flow quality implies that a large proportion of the cash flows classified in each section of the SCF strictly relate to operating, investing, and financing activities of the firm? a. High b. Medium c. Low d. Cannot tell 10. The process of total cash generated by the firm over the fiscal period is divided into three subgroups such as CFO, CFI, and CFF is called which of the following? a. Cash flow assignment b. Cash flow classification c. Cash flow timing d. Cash flow quality Discussion Questions 1. (LO1) In your opinion, should net income and cash flow financial performance measures be viewed as substitutes (similar signals that duplicate each other) or complements (each signal offers some unique information) with respect to overall financial performance?

Proposed Solution: Net income and cash flow financial performance measures provide perspective on different aspects of performance and should be viewed as complementary signals with respect to overall performance. There is likely a positive correlation between these measures, but not likely a perfectly positive correlation suggesting they offer different signals. In addition, while cash flow realization principles are positively correlated with earnings quality, they are still distinct from earnings recognition principles.

2. (LO3) Explain how seasonality affects the timing and recognition of cash flows.

Proposed Solution: Seasonality in cash flows reflects timing differences in the timing of cash inflows and outflows across the year due to when cash expenses are paid and cash sales (or collections) occur.

3. (LO2, LO3) Explain the connections between cash flow quality and earnings quality. How can an assessment of cash flow quality inform the analyst regarding earnings quality?

Proposed Solution: We define cash flow quality as a measure of the ability of cash flows to predict the level and timing of future cash flows. Likewise earnings quality is the ability of earnings to predict the level and timing of future earnings. To the extent that there is a positive correlation between these measures, firms with high cash flow quality are more likely to have higher earnings quality.

4. (LO2, LO3) What is the difference between persistent and transitory net income? Would cash flows be considered as components of persistent income, transitory income, or both?

Proposed Solution: Persistent net income is that income that is expected to continue into the future, not just a one-time or short-term income bump. Transitory income is income that is there for a short period of time but is unlikely to continue into the future. Cash flows may be either part of persistent income, transitory income or both, depending on whether the analyst expects them to continue into the future.

5. (LO3) Why are cash flows from investing and financing activities generally regarded as beingmore lumpy? Does that suggest that they are less persistent?

Proposed Solution: Cash flows from investing and financing activities such as investments in new factories, or issuance of new debt, etc. would generally not be evenly distributed over time. This suggests they will likely be more lumpy, particularly as compared to cash flows from operating activities.

The more lumpy they are, the less persistent they are likely to be.

6. (LO3) If a company does not have consistent positive cash flows from operations as it matures, what are its likely prospects?

Proposed Solution: As a company matures, if they do not have consistent positive cash flows from operations, they will likely be a target for another company, or potentially go bankrupt. Negative or unfavorable cash flows from operations generally can’t persist over time without severe financial consequences.

7. (LO3) Would we expect cash flows from operations for a company to be more volatile than earnings? Why or why not?

Proposed Solution: In general, the accrual basis of accounting accepted by GAAP: 1) recognizes revenue in the period it was earned 2) matches the expenses with those revenues they helped generate.

The accrual basis which is used to record and measure earnings (net income), is likely to be less volatile than cash flows, therefore we would expect cash flows from operations for a company to be more volatile than earnings.

8. (LO4) How is the statement of cash flows used to evaluate cash flow quality?

Proposed Solution: The statement of cash flows (using the indirect method) provides a detailed reconciliation between net income and the change in cash during the year. The first line item of every SCF reported using the indirect method is net income. Immediately below net income are the accrual reconciling items that reconcile net income to CFO. These accrual-reconciling items

can be broken into two sets of accruals, representing the accrual-based earnings components and the accrual-reconciling items as changes in net working capital.

9. (LO5) How is cash flow analysis helpful in liquidity analysis, long-term solvency analysis, and corporate treasury function analysis?

Proposed Solution: • Liquidity analysis: Liquidity analysis involves assessing how easily can the firm pay its shortterm obligations as they come due. Employees, trade creditors, banks and other counterparties require cash payments. Analysis of the timing, amount, and volatility of the firm’s cash flows helps the analyst assess the firm’s liquidity position.

• Long-term solvency analysis: Long-term solvency analysis centers around understanding the likelihood that the firm will be able to pay its expected obligations and fund its required future investment expenditures. Long-horizon shifts in the company’s operating environment, and the associated shifts in the company’s cash flows, play a role in long-term solvency analysis.

• Corporate treasury planning: Corporate treasury planning centers on understanding if the company will be able to maintain a consistent dividend payout policy or share repurchase program given the cash flows that it is expected to generate from its operating and investing activities.

10. (LO5) What is the difference between the cash interest coverage ratio and the cash earnings coverage ratio?

Proposed Solution: The cash interest coverage ratio can be interpreted as a margin of safety ratio as it provides the analyst perspective of how much cash remains from the company’s operations to pay its interest obligations.

The cash earnings coverage ratio provides perspective of how easily the firm can cover its interest obligations from cash-based earnings, holding constant the effects of transitory working capital swings. Net working capital can vacillate, sometimes significantly, from period to period for non-economic reasons. The cash earnings coverage ratio is more persistent from year to year and, therefore, provides a different, though related, perspective on how easily the firm can pay its interest obligations.

11. (LO6) Why is a treasury function needed? How does that treasury function evaluate its cash needs?

Proposed Solution: Corporate treasury planning centers on understanding 1) If the company will be able to have the cash it needs to operate its business. 2) If the company will pay down its debts, maintain a consistent dividend payout policy or share repurchase program.

Brief Exercises

16. (LO2, LO3, LO4, LO6) Match the definition used in this chapter to its term (cash interest coverage ratio, operating cycle, indirect method, cash flow quality, direct method, seasonality in cash flows).

Term (cash interest Definition coverage ratio, operating cycle, indirect method, cash flow quality, direct method, seasonality in cash flows) a ratio based on the relationship between cash flows and interest since interest is paid with cash.

interest coverage ratio

a format of disclosing operating cash flows that explains the reason for differences between net income and operating cash flows.

indirect method

a measure of the ability of cash flows to predict the level and timing of future cash flows. a format of disclosing operating cash flows as cash inflows and outflows (similar to how the investing and financing cash flows are disclosed).

cash flow quality

differences in the timing of cash inflows and outflows across the year due to when expenses are paid and cash sales (or collections) occur.

seasonality in cash flows

direct method

17. (LO1, LO4) Match each company transaction to its to its type of cash flow activity.

Company Transaction

Type of Cash Flow Activity

Cash from customers

Operating

Cash from loan proceeds

Financing

Capital expenditures (made with cash) Dividend cash payments

Investing

Repurchase common stock with cash Trade common stock for patent Purchase supplies on credit

Financing

Proceeds from Sale of Equipment Purchase equipment with cash

Investing

Customer who buys from us and promises to pay later

Non-Cash

Financing

Non-Cash Non-Cash

Investing

18. (LO 5) Match the various ratios to their type..

Ratio

Ratio Type

Cash Flows to Assets Ratio

Profitability

Interest Coverage Ratio

Solvency

Cash Flows to Net Income Ratio

Profitability

Current Ratio

Liquidity

Quick Ratio

Liquidity

Debt Coverage Ratio

Solvency

Problems 1. There is a relationship between the beginning balance of cash, the ending balance of cash andthe various cash flows from operating, investing and financing activities.

Required: Compute the cash flow balances/totals for each of the following scenarios: a. What is the beginning cash balance if the ending cash balance is $2,000, net cash inflow from operating activities is $3,000, net cash outflow from investing activities is $2,500 and net cash inflow from financing activities is $1,500?

b. What is the ending cash balance if the beginning cash balance is $12,000, net cash outflow from operating activities is $9,000, net cash inflow from investing activities is $2,500 and net cash inflow from financing activities is $1,500? c. What is the net cash inflow or outflow from financing activities if the beginning cash balance is $3,000, the ending cash balance is $2,000, net cash inflow from operating activities is $4,000, and the net cash inflow from investing activities is $3,000? d. What is the net cash inflow or outflow from financing activities if the beginning cash balance is $6,000, the ending cash balance is $3,000, net cash inflow from operating activities is $4,000, and the net cash inflow from investing activities is $3,000? e. What is the net cash inflow or outflow from investing activities if the beginning cash balance is $6,000, the ending cash balance is $4,000, net cash inflow from operating activities is $7,000, and the net cash outflow from financing activities is $2,000?

Proposed Solution:

2. The following scenarios provide two financial performance measures. But we need to compute the third.

Required: Calculate the net income, cash flows from operating activities and accruals, for each of the following scenarios? a. b. c. d. e. f.

Net Income $300; Accruals $100 Net Income $800; Accruals $-200 Cash flows from Operating Activities $600; Net Income $300 Cash flows from Operating Activities $400; Net Income $600 Cash flows from Operating Activities $300; Accruals $-200 Cash flows from Operating Activities $700; Accruals $400

3. The table below represents the relationship between net income, depreciation, other accrual adjustments and cash flow from operating activities. The negative numbers in the other accrual adjustments line item are income-increasing adjustments.

Company A

Company B

Company C

Company D

Net Income

1000

1000

1000

1000

Depreciation

100

100

100

100

Other Accrual Adjustments Cash Flow from Operating Activities

400

-400

-800

-1200

1500

700

300

-100

Required: a. Company A, B, C and D all have the same net income, but different levels of cash flow from operations. How would an analyst approach these numbers?

Proposed Solution: Often times the highest quality earnings are those that are 1) supported by a high amount of cash flows, and 2) have income decreasing accruals, therefore an analyst would look for these characteristics, and here would conclude that Company A is the most well-positioned company.

b. In your opinion, which company has the highest quality earnings? Why? Proposed Solution: An assessment of these various reported income, accruals and cash flows will help.

Given that criteria, company A would have the highest quality earnings and would also likely have the highest amount of persistence. c. In your opinion, which company has the lowest quality earnings? Why? Proposed Solution: Company D would likely have the lowest quality of earnings, given the wide gap between the reported earnings and cash flows.

d. In your opinion, which company has the highest quality cash flows from operating activities? Why?

Proposed Solution: Generally those that have the highest quality earnings may well also have the highest quality cash flows. Since company A has the highest correlation between earnings and cash flows, it would be a good candidate for highest quality cash flows.

4. The following scenarios provide two financial performance measures. Required: Use the following performance measures to determine which of the following cases has the highest quality of earnings. a. Cash flows from Operating Activities $300; Accruals $-200 b. Cash flows from Operating Activities $700; Accruals $400 c. Cash flows from Operating Activities $700; Net Income $300 d. Cash flows from Operating Activities $-100; Net Income $600 e. Net Income $700; Accruals $200 f. Net Income $800; Accruals $-200

Proposed Solution: Using the equation, Net Income = Cash Flows + Accruals, we can solve for the missing value.

Cases b and e both have a small difference between cash flows and net income and also have income decreasing accruals, suggesting they are a candidate for highest quality earnings and highest quality cash flows.

5. Net cash flows may change each period for any given company. Some periods may report a net cash inflow and other periods a net cash outflow. *Note: The Connect assignment version has been modified for auto grading and is shown below.

Required: Give concrete examples for Walmart on each of the following scenarios. What happened in each? a. Net Cash Outflows from Operating Activities Cash outflows paying costs for its core retail business such as products and Walmart associates are more than the cash inflows paid by its customers. b. Net Cash Inflows from Financing Activities Walmart receives proceeds from loans that exceed the payback of loan and other financing. c. Net Cash Outflows from Investing Activities

Walmart acquires more real estate (stores and distribution centers), trucks and other equipment than what they sell. d. Net Cash Inflows from Operating Activities Cash inflows paid by its customers for its retail products are more than the cash outflows paying its suppliers for products to sell and to its Walmart associates for services performed. e. Net Cash Outflows from Financing Activities Walmart uses cash to pay down its debts or buy back shares of its own stock more than it gets cash from loans and stock issuance. f. Net Cash Inflows from Investing Activities Walmart sells more real estate (stores and distribution centers), trucks and other equipment than it acquires.

5. [Connect auto graded version] New cash flows may change each period for any given company. Some periods may report a net cash inflow and other periods a net cash outflow.

Required: Identify the cash flow type for each of the following scenarios at Walmart.

Cash Flow Scenario

Cash Flow Type

a. Costs for its core retail business such as products and Walmart associates are more than the cash inflows paid by its customers.

Net cash outflow from operating activities

b. Walmart receives proceeds from loans that exceed the payback of loan and other financing.

Net cash inflow from financing activities

c. Walmart acquires more real estate (stores and distribution centers), trucks, and other equipment than what they sell d. Cash paid by its customers for retail products is more than the cash paid to suppliers for products to sell and cash paid to Walmart associates for services performed.

Net cash outflow from investing activities Net cash inflow from operating activities

e. Walmart uses cash to pay down its debts or buy back shares of its own stock more than the cash it receives from loans and stock issuance.

Net cash outflow from financing activities

f. Walmart sells more real estate (stores and distribution centers), trucks, and other equipment than it acquires.

Net cash inflow from investing activities

Chapter 8 End-of-Chapter Assignment Solutions Multiple Choice Questions 21. What is the computation of next year’s sales? a. Current year sales * Expected Sales Growth b. Prior year sales * Expected Sales Growth c. Current year sales * (1 + Expected Sales Growth) d. Prior year sales * (1 + Expected Sales Growth) 22. Sales growth either comes from an increase in unit price or an increase in quantity sold, and therefore is consistent with the equation, sales growth = ((1+Δp)(1+ Δq))-1. In an equilibrium, generally when price increases, the quantity sold decreases, except in the case that the price is what? a. Elastic b. Inelastic c. Neutral d. Insensitive 23. Which of these forecasting methods/sources is able to more easily incorporate real-time information? a. Time-series analysis b. Analyst forecasts c. Segment information d. Ratios and Pro Formas 24. When a firm operates in a volatile industry and managers have proprietary information on how their R&D products are coming along, which forecast is likely going to be more informative for forecasting purposes? a. Management forecasts b. Analyst forecasts c. Auditor forecasts d. Internal Revenue Service forecasts 25. What is the period over which the analyst detailed estimates are made? In the case of Exhibit 8.12, this is the years t+1 to t+4. In contrast, what is the period over which the analyst is not able to make detailed estimates and is expected to last through perpetuity? a. forecast; final b. final; terminal c. immediate; terminal d. forecast; terminal 26. The Exponential Triple Smoothing is particularly useful when time series data exhibits both a trend and which of the following? a. volatility b. seasonality c. cyclicality d. stability 27. In the time series analysis, extreme earnings realizations that are not expected to recur will have what effect on the accuracy of the earnings forecast produced by the time-series model? a. Increase the accuracy of the earnings forecast b. Decrease the accuracy of the earnings forecast 28. Which of the following firm performance measures has the highest level of persistence? a. Operating Income

b. Cash flows from operating activities c. Cash flows from financing activities d. Cash flows from investing activities 29. Based on the level of persistence associated with sales, earnings and cash flows, which would you expect to have a wider distance standard deviation relative to its mean? a. Sales b. Operating Income c. Cash flows from operating activities d. Cash flows from financing activities 30. Which is not one of the required ratios for the indirect past ratio/pro forma forecasting? a. Dividend payout ratio b. Profit margin ratio c. Leverage ratio d. Asset turnover ratio

Discussion Questions 18. Why is forecasting sales, which is also critical for forecasting earnings or cash flows, particularly critical for the indirect method of using past ratios to forecast pro forma financial statements?

Proposed Solution: If profit margins are static, then variable costs and related earnings and cash flows will be related to the level of the sales forecast. Usually future earnings and cash flows are determined by first forecasting the level of sales.

19. What is the difference between the direct and the indirect method of forecasting future performance? Which is better, the more detailed or the less detailed method, or is one always better than another?

Proposed Solution: The direct method uses past measures of all relevant financial ratios to produce pro forma financial statements. In contrast, the indirect method using DuPont ratios uses just four financial ratios (sales growth, profit margin, asset turnover, and leverage) to produce pro forma financial statements to forecast future sales and earnings.

Sometimes the fewer assumptions associated with the indirect DuPont method are best.

However, if one knows the details and can make the detailed assumptions, the direct method might be better. But one method is not always better than the other.

20. What advantages do management forecasts of financial performance have over analyst forecasts? And conversely, what advantages do analyst forecasts of financial performance have over management forecasts? How are both useful?

Proposed Solution: Management has the inside details, and knows the company better than the outside analysts. But they may be wanting to avoid litigation from shareholders, and therefore may be more conservative than analysts. Conversely, analysts do not need to avoid litigation, so thus may not have a conservative bias. Due to the number of analysts and the frequency of

updating forecasts, the analyst earnings forecast might be more timely than the management earnings forecasts.

21. How would we think about combining time series analysis with analyst forecasts into one composite, hopefully more accurate, forecast? Any different than combining analyst forecasts with management forecasts?

Proposed Solution: Time series forecasts of performance measures only use one variable using for example, past sales to predict future sales, or past earnings to forecast future earnings. In contrast, analysts use a wider source of information that may or may not include forecasts from time series information. One tactic would be to combine forecasts to see if accuracy is better when combined or better when not combined. The same is true for combining analyst forecasts with management forecasts.

22. Locate the segment information for Walmart in their annual report or 10-K. Given all you know about Walmart, is this how you would divvy up their segments? Do you believe the current segment structure allows for better structure than just analyzing the company as a whole? Can you think of a better segment structure they could use that help with forecasts of firm performance measures, such as grocery vs. non-grocery?

Proposed Solution: Walmart divvies up its segments into three parts (Walmart US, Walmart International and Sam’s Club) the way the company is organized. While Walmart US and Walmart International are similar in the product markets, there are major geographical differences. And the business model of Sam’s Club is quite different than that of Walmart US. All three of these segments have grocery vs. non-grocery, so that might be a ways of assessing future performance. You could also divvy up the analysis by looking at all operations geographically, so all Walmart operations (including Sam’s Club) in the US, Europe and Asia, for example. There might be other ways to divvy this up as well.

23. What does product, division or geographical segment information offer that the other forecasting techniques/data sources do not offer? Why is this useful?

Proposed Solution: Most of these ways of divvying up segment information allow financial statement users to disaggregate performance information in a more granular way. Although it is reasonable toquestion whether that allows for more accurate forecasts, the expectation is that this approach can be useful in at least some circumstances.

Brief Exercises 19. Match these definitions to the following forecast methods: • analyst forecasts • management forecasts • pro forma financial statements • time series analysis • forecasts using segment information

Definition

Forecast Methods (e.g., analyst forecasts, management forecasts, pro forma financial statements, time series analysis, forecasts using segment information)

using past ratios of performance to forecast financial statements a sales or earnings forecast made by a financial analyst forecasted values based on past values of the same variable

pro forma financial statements

a sales or earnings forecast made by management use of past disaggregated financial performance measures to forecast aggregate measures of future performance

management forecasts

analyst forecasts time series analysis

forecasts using segment information

20. Match the definitions to their appropriate FSA terminology to their definitions: • forecast period • persistence • seasonality • steady state • terminal period • trend Definition

FSA Terminology

predictable changes in product demand and usage that occur over a year in a company or economy

seasonality

the period over which the analyst detailed estimates are made the strength of the relationship between the past and the future values of one financial statement variable

forecast period

the period in which the firm’s annual sales growth is at its long-run average

steady state

a general direction in which something is going or changing

trend

the forecast period that follows the horizon period,

terminal period

persistence

and the period over which the analyst is not able to make detailed estimates 3. Match these advantages to the following different forecast methods: • analyst forecasts • management forecasts • pro forma financial statements • time series analysis • forecasts using segment information Advantages

Forecast Methods (e.g., analyst forecasts, management forecasts, pro forma financial statements, time series analysis, forecasts using segment information)

Use of the trend of multiple ratios to forecast financial performance

pro forma financial statements

Forecasted performance that is both timely and from professionals that perform these forecasts as part of their job

analyst forecasts

Focus on forecasting single performance metric

time series analysis

Forecasted performance that is both timely and from inside sources

management forecasts

Forecasts using smaller components of overall company performance

forecasts using segment information

Problems 1. A firm has many different firm performance measures that exhibit different levels of persistence.

Required:

Order the following financial performance measures in order from most persistent to least persistent.

• Operating income • Cash flows from financing activities • Cash flows from investing activities • Sales • Cash flows from operating activities What is the reason for this ordering? Use your knowledge of all of the financial statements the accrual- and cash-basis of accounting, and the different types of cash flows to support your answer. And the lumpiness associated with certain types of cash flows that might affect persistence, or the tie between past and future performance.

Proposed Solution: Exhibit 8.2 suggests that the ordering in terms of persistence is as follows from most to least persistent.

1. Sales – past sales most highly correlated with future sales.

2. Operating income - accrual-based operating income more persistent than cash flow measures.

3. Cash flows from operating activities – cash flows more lumpy than accrual-based items.

4. Cash flows from financing activities – loan issuances and repayments and share issuances and repayments do not happen consistently each period leading to lumpy cash inflows and cash outflows, but not generally as lumpy as cash flows from investing activities.

5. Cash flows from investing activities – capital expenditures purchases and sales are lumpy and are recorded in the period when they occur.

2. There are many potential inputs into a forecast of financial performance. As we learn more details about each of them, we learn about the advantages and disadvantages associated with each of them.

Required: What advantages or disadvantages do each of the following have in forecasting future performance? a. b. c. d. e. f.

Ratio analysis and pro forma financial statements Analysts forecasts Management forecasts Time series analysis Forecasts using disaggregated geographical information Times series of product segment sales and earnings.

Proposed Solution:

a. Ratio analysis and pro forma financial statements Past ratios can be extended to the future and used to create pro forma (or forecasted) financial statements. If the past ratios have been stable or exhibit a stable trend, and the prospects are not expected to be very different from the past, they might be a goodsource of a forecast of financial performance. The disadvantage is their use if there has not been or is not currently a stable trend from the past to the future. b. Analysts forecasts Analysts use a wide source of information that arguably uses all available information up to the time of the forecast. One tactic would be to combine forecasts to see if accuracy is better when combined with other forecast techniques or better when not combined with other forecasts. The same is true for combining analyst forecasts with management forecasts. One of the disadvantages of using analyst forecasts is that not all publicly traded firms are covered by analysts or may only be covered by 1-2 analysts. c. Management forecasts Management has the inside details, and knows the company better than the outside analysts. But they may be wanting to avoid litigation from shareholders, and therefore may be more conservative than analysts. Conversely, analysts do not need to avoid litigation, so thus may not have a conservative bias. Due to the number of analysts and the frequency of updating forecasts, the analyst earnings forecast might be more timely than the management earnings forecasts. One disadvantage of relying on management forecasts is that many companies do not issue any forecasts at all, making this not an available source of forecast data for the stakeholder. d. Time series analysis Time series forecasts of performance measures only use one variable for example, past sales to predict future sales, or past earnings to forecast future earnings. While it is often useful to include a wider set of data, to make sales or earnings forecasts, time series analysis is an important tool to consider. One disadvantage of time series data is that it is old, either representing data from last quarter or last year, and many events may have occurred which may have changed the company’s prospects since that time. e. Forecasts using disaggregated geographical information Different geographic markets have different tastes, and different macroeconomic characteristics. If there are different geographic markets, considering the forecasts using disaggregated geographic information might give additional detail to the overall company forecast. One disadvantage may be that the different geographic markets may not be the best way to disaggregate performance and might lead to inconclusive or spurious findings, rather than to a consensus earnings forecast. f.

Time series of segment sales and earnings.

Time series forecasts of segment performance measures only use one variable for example, past segment sales to predict future segment sales, or past earnings to forecast future earnings. Different segments often represent different product or geographic markets, so its disaggregation of overall company earnings might be useful. While it is often useful to include a wider set of data, to make a final company sales or

earnings forecast, time series of disaggregated segments is an important tool to consider. One disadvantage may be that the different segments may not be the best way to disaggregate performance and might lead to inconclusive or spurious findings, rather than to a consensus earnings forecast.

3. Forecasters generally forecast over two different time horizons, including the forecast period and the terminal period.

Required: a. What is the difference between the forecast period and terminal period? b. Would your forecasting technique change for each time period? c. Why is the terminal period particularly important? How long does it last? Is it a big number in the valuation scheme?

Proposed Solution: What is the difference between the forecast period and terminal period?

The forecast period is the period over which the analyst makes detailed estimates of how the analyst believes the income statement and balance sheet will change. The forecast horizon extends to that point in time when the firm’s sales growth and its financial ratios reach ‘steady state’. The terminal period is the period that follows the forecast period and extends to t=∞. The terminal period is the period over which the analyst is not able to make detailed estimates.

Would your forecasting technique change for each time period?

While the forecast period is in the immediate future, the terminal period is the point where the company hits a steady state. The forecast period might look at immediate product markets, competitors and whether the company has a competitive advantage. The terminal period requires a long-term view of the performance of the economy and the industry and whether the company has and can maintain a sustainable competitive advantage.

Why is the terminal period particularly important? How long does it last? Is it a big number in the valuation scheme?

The terminal period is the forecast period that follows the horizon period and extends to t=∞, or as long as the company exists. It can be a very long period of time, and thus is often an important and large value as part of the overall valuation. For this reason, careful consideration of the estimates and assumptions made regarding the terminal period projections should be made.

Chapter 9 End-of-Chapter Assignment Solutions Multiple Choice Questions 31. The expected risk of an investment is incorporated into the net present value computation through which of the following terms? a. Cash flows at time (CFt) b. The discount rate c. The summation of discounted cash flows over time d. Cash flows over the life of the investment 32. The present value of $45,000 received in year 5 cash flows would be computed as follows (assuming a 10% discount rate): a. $45,0005/(1.10) b. $45,000/(1.105) c. $45,0005/(1.100) d. $45,000/(1.104) 33. What is the present value of a series of infinite future cash flows (CFt) that continue in perpetuity? a. PV = CFt/r b. PV = CFt/(r-g) c. PV = CFt/(1+r)t d. PV = CFt/(1+r)CF 34. Which of the following is not a measure of free cash flows to common equity? a. Net Income + the Change in Common Equity b. Cash from Operations + Increase in Operating Cash + Cash Flows from Investing Dividends on Preferred Stock + Increase in Preferred Stock c. Cash Flows from Operating Activities d. Dividends on Common Stock and Net Issuance of Common Stock 35. Which of these dates corresponds to the period when the company reaches steady state, or its long-term average? a. horizon b. estimation c. terminal d. evaluation 36. Which of the following is a business valuation model assess company value based on the discounted amount of profit remaining once equity capital is paid? a. discounted cash flow valuation b. residual income valuation c. residual cash flows valuation d. dividend discount valuation 37. The time value of money concept states that a dollar today is how much compare to a dollar received tomorrow? a. dollar today worth more than a dollar tomorrow b. dollar today worth less than a dollar tomorrow c. dollar today is equal to a dollar tomorrow d. (cannot be determined) 38. Residual income is computed as all but which of the following? a. RIt = (ROCEt – re) CEt-1 b. RIt = Net Incomet – re CEt-1

c. RIt = re CEt-1—Net Incomet d. RIt = Net Income – Equity Charge 39. What is beta and how is it used in a Capital Asset Pricing Model (CAPM)? a. a measure of the volatility of a security as compared to the stock market index as a whole used in the CAPM model. b. a measure of the risk associated with the chance of losing your money on the investment c. a measure of the volatility of a security as compared to the bond market index. d. The interest rate used to discount future cash flows 40. Which business valuation model that estimates a company’s equity value based on expected future free cash flows discounted to the present value? a. Residual income valuation model b. Discounted cash flow valuation model c. Dividend discount valuation model d. Residual operating income valuation model

Discussion Questions 24. Why are there three different methods of valuation to estimate equity value instead of just one? What different assumptions do they make?

Suggested solution: While the DCF and RI are ‘different’ equity valuation models, they are both derived from the same set of mathematical assumptions. Specifically, both models are direct mathematical descendants of the dividend discount model (DDM) which centers on calculating equity value as the sum of the firm’s future dividends payments, discounted to their present value using the firm’s cost of equity. While the DCF and RI models use different accounting variables as inputs and differ slightly along other minor dimensions, both models should yield the same equity value if your assumptions are internally consistent.

25. What are some advantages and disadvantages of using the dividend discount model to value a company’s equity?

Advantages: 1. Structurally simple, only requiring estimates of cash transactions with shareholders.

Disadvantages: 1. Estimation of cash flows to/from shareholders are difficult as many firms do not have persistent (or even existent) dividend policies 2. Timing of cash flow disbursement and collection directly affect firm value and not the timing of value creation as measured by revenue and expense recognition.

26. What are some advantages and disadvantages of using the discounted cash flow model to value a company’s equity?

Advantages: 1. Multiple ways to compute free cash flow.

2. Ties directly into the proforma financial statements Disadvantages: 1. Timing of cash flow disbursement and collection directly affect firm value and not the timing of value creation as measured by revenue and expense recognition.

27. What are some advantages and disadvantages of using the residual income model to value a company’s equity?

Advantages: 1. Valuation is tied to GAAP-based value creation, not cash realization 2. Ties directly into the proforma financial statements Disadvantages: 1. Requires forecasts of income statement and balance sheet.

28. What are the key differences between discounted cash flow and residual income valuationmodels? If they arrive at the same estimated value, why is it useful to use both models? Which one do you prefer in thinking about equity valuation?

Suggested solution: While the DCF and RI are ‘different’ equity valuation models, they are both derived from the same set of mathematical assumptions. Specifically, both models are direct mathematical descendants of the dividend discount model (DDM) which centers on calculating equity value as the sum of the firm’s future dividends payments, discounted to their present value using the firm’s cost of equity. While the DCF and RI models use different accounting variables as inputs and differ slightly along other minor dimensions, both models should yield the same equity value if your assumptions are internally consistent. See Exhibit 9.2 Comparison of Firms’ Valuation Models, to review how they get there in different ways. The one making the valuation may feel that one is more consistent with the way the person thinks about value creation and thus is able to make better assumptions.

Often in practice, people (e.g., your boss, co-workers, clients) will have a preferred valuation model. Their preference is often driven by their view that other valuation models are ‘wrong’ or inferior because they yield different estimates. While everyone is entitled to their opinion, it is important to remember that different valuation estimates across the different valuation models are tied to incorrect forecasts or inconsistent forecast assumptions.

6. Because it’s possible to calculate free cash flows in several ways, which do you prefer for your measure? Why? Suggested solution: Answers will vary. Free cash flow is an indication of a company’s financial flexibility and availability to make payments and cover cash needs into the future including acquisitions. But

of course, if you hold on to too much cash, and don’t pay down other obligations, that would potentially be a waste of this financial resource. A popular measure that is easy to remember is the cash left over after a company pays for its operating expenses (OpEx) and capital expenditures (CapEx). That is, after the “required” expenses and expenditures are paid for, what other investments can still be paid. As noted, there are many other possible calculations.

Often times, the best measure of free cash flow is the measure that can be easily replicated and easily explained to others. Since this is a flexible measure, I’d find the one you like best and apply to several settings to assess if it is capturing the degree of financial flexibility.

7. Why is important to carefully consider the cost of equity (or cost of equity capital) for a valuation?

Suggested solution: The cost of equity represents the discount rate used in equity valuation models. More formally, the cost of equity represents the capital charge, or rate of return, investors require for taking an ownership stake in a firm which only offers uncertain future cash flows. The riskier the amount and timing of those future cash flows (will it come and if so, when?), the higher the rate of return that investors will require.

8. Equity valuation uses the firm’s cost of equity (re) to discount future flows while enterprise valuation uses the firms’ weighted average cost of capital (WACC) in the discounting process. Why are different cost of capital rates used?

Suggested solution: Equity holders will use the cost of equity to discount cash flows that will accrue to them. In contrast, the weighted average cost of capital will be used internally in the firm to assess the NPV and IRR associated with various firm-specific investments.

9. How does beta capture risk? Which type of risk does it capture? Why is capturing risk an important for shareholders and discounting cash flows?

Suggested solution: The Capital Asset Pricing Model (CAPM) is the most well-known factor model. The CAPM defines a firm’s cost of equity as equal the risk-free rate, which compensates investors for the time value of their money, and the firm’s exposure to collective systematic risk of the market, β, which compensates investors for the riskiness of the firm’s cash flows.

Specifically beta, β, captures a firm’s exposure to the market risk factor.

To appropriately value and discount the cash flows, shareholders need to understand the amounts, timing and uncertainty of future cash flows. More specifically, by understanding the appropriate level of risk, they can better determine the discount rate that should be used to discount the cash flows.

Brief Exercises 21. Match these valuation methods to their definitions and examples: • Discounted cash flow valuation • Residual income valuation • Dividend discount model valuation • Residual operating income valuation

Example or Definition

Valuation Method

a. Uses net operating profit after tax (NOPAT) and net operating assets (NOA) in its valuation

Residual operating income valuation

b. Requires the computation of free cash flows to equity holders

Discounted cash flow (DCF) valuation

c. Valuation based on the discounted amount of profit remaining once the use of equity capital is considered.

Residual income (RI) valuation

d. The sum of the discounted future dividends the firm is expected to distribute to equity investors over the life of the firm

Dividend discount model (DDM)

22. Match these valuation methods to their definitions and examples: • Capital Asset Pricing Model (CAPM) • Cost of equity capital • Beta • Risk-free rate • Market-risk premium Examples/Definition

Term

a. The financial returns expected by equity holders.

Cost of equity capital

b. The 10-year treasury bond rate is often used as a

Risk-free rate

proxy. c. Compensation for additional risk taken on above and beyond the riskfree rate.

Market-risk premium

d. A model that describes the expected return on an asset as a function of two components: the risk-free rate and the systematic risk.

Capital Asset Pricing Model (CAPM)

e. A measure of the volatility of a security as compared to the market as a whole.

Beta

Problems 1. An investment costs $100,000 at time zero, returns dividends of $8,000 per year at the end of each of five years and then the investment is sold at the end of the fifth year for $120,000 in proceeds with an equity cost of capital at 10%? (Use negative numbers for initial cost representing a cash outlay).

Required: 1. What is the net present value of this investment?

2. What is the internal rate of return?

3. If you have an available $100,000 to invest, would you make this investment?

Year 0 Initial Investment Year 1 Dividend Year 2 Dividend Year 3 Dividend Year 4 Dividend Year 5 Dividend Year 5 Proceeds

Present value = –$100,000/(1.100) = –$100,000 Present value = $8,000/(1.101) = $ 7,273 2 Present value = $8,000/(1.10 ) = $ 6,612 Present value = $8,000/(1.103) = $ 6,011 4 Present value = $8,000/(1.10 ) = $ 5,464 5 Present value = $8,000/(1.10 ) = $ 4,967 Present value = $120,000/(1.105) = $ 74,511

Sum of present values, or NPV Internal Rate of Return Use Excel IRR function

$

4,837 11.2%

With a positive net present value, and an internal rate of return that is greater than the 10% cost of equity capital, it would make sense to make this investment.

2. An investment that costs $120,000, returns dividends of $15,000 per year at the end of each of five years and then the investment is sold for $110,000 with an equity cost of capital at 8%? (Use negative numbers for initial cost representing a cash outlay).

Required: 1. What is the net present value of this investment?

2. What is the internal rate of return?

3. If you have an available $120,000 to invest, would you make this investment?

Year 0 Initial Investment Year 1 Dividend Year 2 Dividend Year 3 Dividend Year 4 Dividend Year 5 Dividend Year 5 Proceeds

Present value = –$120,000/(1.080) = –$120,000 Present value = $15,000/(1.081) = $ 13,889 Present value = $15,000/(1.082) = $ 12,860 3 Present value = $15,000/(1.08 ) = $ 11,907 4 Present value = $15,000/(1.08 ) = $ 11,025 Present value = $15,000/(1.085) = $ 10,209 5 Present value = $120,000/(1.08 ) = $ 74,864

Sum of present values, or NPV Internal Rate of Return (Use Excel IRR function)

$ 14,755 11.2%

With a positive net present value, and an internal rate of return that is greater than the 8% cost of equity capital, it would make sense to make this investment.

3. What is the estimate of equity value, using the residual income method under the following scenario?

• • • •

BV0 is 100 per share. re = 8% is our estimate of the equity cost of capital.

Forecasted net income of $12/share next year, and an estimated growth rate of net income of 3% into perpetuity.

1,000 common shares outstanding.

Required: Given these expectations of future performance, what would be the intrinsic price per share of common stock? = (Forecast income next year– (BV*re))/(re-g) =(12-(100*0.08))/(0.08-0.03) = $80 per share of stock 4. Determine the intrinsic price per share of common stock. The forecast period is 5 years, spanning fiscal years ending 12/31/24 through 12/31/28. The cost of equity is 8%, long-term growth rate (g) is 3%, and the valuation date is January 1, 2024.

Remember, the present value formulas assume free cash flows are completely realized at the end of each fiscal year (12/31) and the valuation date is at the beginning of the first fiscal year (1/1/24).

The five years of the forecast period show free cash flows growing by $25 from $125 in the first period to $225 in the fifth period. Thereafter, free cash flows are assumed to grow by 3% per year forever.

Required: Given these expectations of future performance, what would be the intrinsic price per share of common stock?

Suggested Solution: 125

150

175

200

225

PV Forecast Period FCF = (1+0.08)1 + (1+0.08)2 + (1+0.08)3 + (1+0.08)4 + (1+0.08)5 = 683.40 PV Terminal Period FCF =

232 5

(1+0.08) ×(0.08−0.03)

= 3,154.50

The present value of free cash flows (not adjusted for timing differences) is: $3,837.90 5. What is the estimate of equity value, using the residual income method under the following scenario?

• • •

BV0 is 250 per share. re = 7% is our estimate of the equity cost of capital.

Forecasted net income of $37/share next year, and an estimated growth rate of net income of 1.5% into perpetuity.

Required: Given these expectations of future performance, what would be the intrinsic price per share of common stock? = (Forecast income next year– (BV*re))/(re-g) =(37-(250*0.07))/(0.07-0.015) = $354.54 per share of stock 6. Determine the intrinsic price per share of common stock. The forecast period is 5 years, spanning fiscal years ending 12/31/24 through 12/31/28. The cost of equity is 8%, long-term growth rate (g) is 3%, and the valuation date is January 1, 2024.

Remember, the present value formulas assume free cash flows are completely realized at the end of each fiscal year (12/31) and the valuation date is at the beginning of the first fiscal year (1/1/24).

The five years of the forecast period show free cash flows growing by $3 from $73 in the first period to $850 in the fifth period. Thereafter, free cash flows are assumed to grow by 2% per year forever.

Required: Given these expectations of future performance, what would be the intrinsic price per share of common stock?

Suggested Solution: PV Forecast Period FCF = PV Terminal Period FCF

73 (1+0.12)1

+

76

(1+0.12)2 86.7

=(1+0.12)5×(0.12−0.02

+

79 (1+0.12)3

+

82 (1+0.12)4

85

+ (1+0.12)5 = 282.34

= 491.96

)

The present value of free cash flows (not adjusted for timing differences) is: $774.30 7. Let’s suppose we are trying to determine the cost of equity capital for Amazon. To estimate that amount, we’ll use the 10-year treasury bond rate is 3% as the risk-free rate (Rf), the market-risk premium (ERm – Rf) is 5.5%, and beta is 2.09.

Required: What would be the expected cost of equity capital?

Solution: ERi (Expected return on equity) = re (cost of equity capital) = Rf + βi (ERm – Rf) = 3% + 2.09 (5.5%) = 14.495% 8. Let’s suppose we are trying to determine the cost of equity capital for Amazon using the Capital Asset Pricing Model. To estimate that amount, we’ll use the 10-year treasury bond rate of 3% as the risk-free rate (Rf), the market-risk premium (ERm – Rf) is 5.5%, and beta is 1.27.

Required: What would be the expected cost of equity capital?

Solution: ERi (Expected return on equity) = re (cost of equity capital) = Rf + βi (ERm – Rf) = 3% + 1.27 (5.5%) = 8.985%

Chapter 10 End-of-Chapter Assignment Solutions Multiple Choice Questions 41. Which valuation model is a business valuation model that uses relevant market multiples of a set of a company’s industry peers or competitors to estimate a target company’s value? a. discounted cash flow b. residual income valuation c. residual operating income valuation d. market-based valuation 42. Which valuation model is a business valuation model that assesses company value based on the discounted amount of profit remaining once equity capital is paid? a. discounted cash flow b. residual income valuation c. residual operating income valuation d. market-based valuation 43. Sensitivity analysis is an example of which type of analytics? a. descriptive b. diagnostic c. predictive d. prescriptive 44. The comparable group used to compute market multiples for relative market evaluation purposes will likely involve similar companies in all but which of the following areas? a. Similar product markets b. Similar industry c. Similar headquarters location (city, etc.) d. Similar competitors 45. The market multiple used in relative market valuation that emphasizes balance sheet measure include which of the following? a. Price/Book Value of Stockholders’ Equity (P/B) b. Price/Liabilities c. Price/Long-term Liabilities d. Price/Assets 46. What is the term to describe the length of time from now until the company reaches its steady state (or its long-term average) a. Terminal period b. Forecast period c. Forecast horizon d. Period of estimation 47. Of the assumptions listed, which are least likely to be tested when performing quantitative sensitivity analysis? a. Varying rates of the cost of equity capital b. Varying rates of the horizon period sales growth c. Varying rates of the profit margin d. Varying dividend policies 48. Qualitative sensitivity analysis should be used a. In conjunction with quantitative sensitivity analysis b. To assess the reasonableness of a forecasted variable c. To confirm that a forecasted estimate is correct d. More than one of the answers is correct 49. Which type of sensitivity analysis utilizes accounting and valuation to break forecast variables into smaller components that vary in certainty or optimism? a. Disaggregation sensitivity analysis

b. Valuation sensitivity analysis c. Open-form sensitivity analysis d. Closed-form sensitivity analysis 50. When assessing the sensitivity of stock price estimates to cost of equity and long-run growth rate assumptions, which assumption is more important? a. Cost of equity (re) b. Long-run growth rate (g) c. Both are equally important d. It depends on the other assumptions

Discussion Questions 29. Describe the difference between quantitative and qualitative sensitivity analysis.

Quantitative sensitivity analysis is a prescriptive data analytics technique that provides formal quantitative estimates of how higher-order forecasts change if forecast assumptions change. In contrast, qualitative sensitivity analysis is a prescriptive data analytics technique that utilizes accounting- and valuation identities to break forecast variables into smaller components that have different interpretative meanings.

30. In your opinion, what is harder to evaluate, future sales growth or the cost of equity capital?

Defend your choice.

While both are challenging, there are likely more unknowns associated with sales forecasts, because they require forecasts for forever. While cost of equity capital are still difficult to assess, models like the CAPM have shown to capture risk and thus an adequate estimate for cost of equity capital.

31. Assume you’re more uncertain about the terminal period sales growth than the forecast horizon period sales growth. How could you incorporate that uncertainty into your sensitivity analysis?

Sensitivity analysis allows one to test the impact of different inputs on the outcome measure. In the valuation framework, important input variables include forecast horizon period, sales growth, terminal period sales growth, profit margins, asset turnover and the cost of equity capital. The sensitivity analysis can show the impact of varying levels of each of these inputs; in this case you could address the uncertainty regarding terminal period sales growth explicitly in your sensitivity analysis.

32. If a company’s sales are expected to grow quickly, which market multiple would you use to compare to other companies?

The use of market multiples generally depends on how well other companies match the industry and product market. If there are other comparable companies that are also experiencing rapid sales growth, it may make sense to use the price-to-sales ratios to see if each dollar of sales is valued in a similar way at both companies.

33. What is the advantage of using market multiples as a way to value a company?

Other similar companies are being valued by the market at the same time as the focal company. To the extent that the companies are similar enough, comparisons can be made by applying the same market multiple to the focal company.

34. What does it mean if the relative market valuation is different than the intrinsic equity valuation of the focal firm using a different valuation method?

None of these estimation or valuation methods are exactly the same, or require the same assumptions. For this reason each different method comes up at a different estimate of intrinsic value. Perhaps some methods require some assumptions that are more reasonable than others. Or the relative market valuation uses firms that are very similar or not as similar as we had hoped which would allow us to weigh it more heavily than other methods. The good news is that the more estimates we have, the more valuations we are able to consider in our analysis.

35. Why is it useful to decompose sales forecasts into their component parts? Why is that

considered qualitative analysis?

Qualitative sensitivity analysis centers on using accounting identities to break forecast estimates into smaller components with different interpretations. The exact breakout methodology the analyst uses to decompose the estimates is subjective. There is not a ‘one-size-fits-all’ variable-decomposition process. The only requirement is that the sum of the individual components equals the total forecasted value.

36. What do you believe has the most impact on our estimate of equity value? Sales growth rate, profit margin, asset turnover or cost of equity capital? What analysis would you perform to make your case?

Depending on the range of possibilities for each of these assumptions, they may each have the most impact on our estimate of equity value. Sensitivity analysis that spans the range of each of these inputs could help determine which one has the largest impact on our estimate of equity value.

37. Given that a firm’s cost of equity is never observed (in the same as realized earnings or other financial outcomes are seen), how should you address the inherent uncertainty in your assumed cost of equity?

The firm’s cost of equity is hard to measure, and since it is not directly observed, it is difficult to learn and adjust as underlying conditions change. Sensitivity analysis, however, allows the analyst to look at the impact varying levels of a firm’s cost of equity might have on intrinsic price, and the results decision to buy or sell a stock.

38. If you assume a firm’s abnormal residual earnings decays to zero over a 5-year horizon, does this assumption imply you are more certain about residual earnings in year 6 of the forecast horizon than if you assume abnormal residual earnings decays to zero over a 10-year horizon?

The assumptions do not imply you know with more or less certainty about the year 6 earnings or lack thereof. Let’s say a firm experiences higher than normal earnings for a period of time that show up in the firm’s profit margin. If that profit margin decays over a five-year period rather than over a ten-year period, there is less earnings and thus a lower stock price valuation.

Brief Exercises 23. Match the following valuation terms to their examples or definitions.

• cost of equity capital • horizon period • market multiple • market-based valuation • terminal period Examples or Definition

Term

a. Financial returns expected by equity holders

Cost of equity capital

b. Expression of market value relative to a key statistic that is assumed to relate to that value

Market multiple

c. Near-term forecast period over which cash flows can be more precisely determined by the analyst

Horizon period

d. Business valuation model that uses to a set of

Market-based valuation

company’s industry peers and/or competitors to estimate a company’s value e. Forecast period that follows the horizon period, and the period over which the analyst is not able to make detailed estimates of sales, earnings and cash flows

Terminal period

24. An investor currently holds stock. The investor bought the stock for $20 which currently trades on the stock market for $40. You don’t need to sell the stock investment any time soon (for liquidity reasons), and if you find a good investment opportunity in this stock, might be willing to buy more.

1. What are the types of transaction costs incurred for trading the stock? (Google stock transaction costs to determine what might be included in transaction costs) Proposed Solution: Transaction costs include: • Market impact costs • Spread costs • Getting bad fills • Commissions and taxes 2. Do you need to consider opportunity costs of other potential investments?

Proposed Solution: Yes, any time one investment is made, it means another investment can not. If a similar amount of money can be made by taking a similar level of risk, then it should serve as a measure of opportunity cost.

3. If considering the following potential investments, how does risk figure in here?

Proposed Solution: The more the expected risk, the more expected return. In general, investors are seeking the highest risk-adjusted return they can get.

Intrinsic Equity Valuation of the Stock $100

Investor Decision (Buy More, Hold, Sell) Buy More

$42

Hold

$20

Sell

$30

Sell

$80

Buy More

Problems 1. Market multiples valuation techniques are one approach to valuing Tesla.

Required: a. Calculate the P/E, P/B and P/S ratios for Tesla as of year-end 2022.

Proposed Solution: In this case, the financials come from 2022, with the fiscal year end price being Tesla’s price upon the last trading day of 2022.

b. Would you compare Tesla’s ratios to market multiples for EV (electronic vehicle firms), traditional car companies (Toyota, Ford, GM) or technology companies? How does it have elements of each of these comparison firms?

Proposed Solution: Tesla has higher market multiples than any of the traditional car companies, suggesting it may not be valued the same as a traditional car company. In many ways, it may be considered and valued as a technology company, which may make sense as it is an innovator and is valued at similar multiples of other technology companies. c. Why would it be challenging to find a good set of comparison companies for Tesla?

There just isn’t a perfect mix yet of innovative, profitable, proven electric vehicle automobile companies. Hence the challenge of finding good comparison companies. d. If a company is rapidly growing, and its comparison companies are not, would the use of market multiples be appropriate?

The valuation of high growth vs. value stocks is often quite different and would make it harder for an appropriate market multiple. Perhaps the analyst should look for other companies in a similar growth area that don’t directly compare on other dimensions. e. Choose one company, automotive or non-automotive, that you think might serve as a good comparison.

Rivian might be one since they are leading innovation, technology, and design in the electric vehicle space. Google or Apple or Netflix might also be a reasonable comparison company.

2. The exhibit below provides an example of a sensitivity analysis that might be performed by financial analysts. In their estimation, the two most important inputs to determine the estimated stock price is the cost of equity capital and the terminal sales growth figure. To perform sensitivity analysis, they vary sales growth from 1% to 5.5% (as shown in the columns) and the cost of equity capital from 6% to 11% (as shown in the rows). The colored columns are the estimated stock prices based on the changing input parameters.

When combined with conditional formatting, the estimated stock price can also be evaluated in a visual way.

Required: a. As the cost of equity capital increases, what happens to the estimated stock price?

Proposed Solution: As the cost of equity capital increases, the estimated stock price (and related equity) valuation decreases.

b. As the terminal period sales growth decreases, what happens to the estimated stock price?

Proposed Solution: As the terminal period sales growth assumption decreases, the estimated stock price (and related equity) valuation decreases.

c. If the terminal period sales growth is 4%, and the cost of equity capital is 11%, what is the estimated stock price?

Proposed Solution: $817.89

d. If the terminal sales growth is 5%, and the cost of equity capital is 6%, what is the estimated stock price?

Proposed Solution: $5,881.25

e. If the current price of the stock is $1,000, and you are relatively certain that the terminal period sales growth should be 3%, at what cost of equity rates would it make sense to buy the stock?

Should transaction costs be included in the analysis somehow?

Proposed Solution: We would buy it where the valuation is more than $1,000 (after considering any transaction costs) at a terminal period sales growth of 3%.

3. Please consider the sensitivity analysis in the exhibit shown in Problem 2. To perform sensitivity analysis, they vary terminal period sales growth from 1% to 5.5% (as shown in the columns) and the cost of equity capital from 6% to 11% (as shown in the rows). The colored columns are the estimated stock prices based on the changing input parameters.

When combined with conditional formatting, the estimated stock price can also be evaluated in a visual way.

Required: a. Which is more impactful on estimated stock price, a 0.5% increase in terminal period sales growth or a 0.5% increase in cost of equity capital?

Proposed Solution: This answer depends on where you are in the sensitivity analysis. b. Which is more impactful on estimated stock price, going from 1.5% to 1% terminal period sales growth at 6% cost of equity, or going from growth from 6.0% to 6.5% in cost of equity capital at 1% terminal period sales growth?

Proposed Solution: The change in cost of equity from 6.0% to 6.5% at 1% terminal period sales growth decreases the estimated valuation by $161.33. The change in the terminal sales growth going from 1.5% to 1% terminal period sales growth at 6% cost of equity reduces the estimated valuation by $119.79. Comparing the dollar change suggests the change in cost of equity from 6.0% to 6.5% at 1% terminal period sales growth is more impactful than going from 1.5% to 1% terminal period sales growth at 6% cost of equity. c. If the profit margin is not expected to change (per dollar of sales), why would it be more critical to consider sensitivity analysis around terminal period sales growth than profit margin? In that case does the estimated rate of sales growth equal the estimate rate of earnings growth? Proposed Solution: If the profit margin is not expected to change during the forecast period, there is no reason to evaluate the sensitivity of the valuation to profit margin. In contrast, there may be uncertainty about the terminal period sales growth, its impact on valuation and the decision to buy, sell, hold or ignore the stock. In that case, given the assumption that profit margin does not change, we are therefore assuming that the estimated rate of sales growth equals the estimated rate of earnings growth. d. How does conditional formatting help you to visualize the impact of these two important inputs on estimated stock price? Is there a different color scheme you’d recommend that would show the differences better?

Proposed Solution: Conditional formatting allows the eyes to quickly see the impact of different assumptions on the valuation, with green being more positive, red being less positive and the yellow color in between. Although other color schemes can certainly be used, the green/yellow/red combination displayed here is probably the best choice for conveying this range of data, as it’s meaning is easily understood by the end user.

4. Assume the exhibit below details the current market multiples for four retail firms. We’ll now use this analysis to first value Walmart (Ticker=WMT) and then Amazon (Ticker=AMZN).

Required: a. Based on the average market price to book (P/B) ratio for the three comparison firms Target (TGT), Kroger (KR), and Amazon (AMZN), compute the estimated stock value of Walmart (WMT) if its Book Value per share is $25/share .

Relative P/B value for TGT, KR and AMZN = 7.91 7.91 * $25 BV/Share for Walmart = $197.76 estimated stock value b. Based on the average market P/E ratio you compute for the three comparison firms (TGT, WMT, and COST), compute the estimated stock value of Amazon (Ticker=AMZN) if its Earnings per share are $6/share .

Relative P/E value for TGT, KR and WMT = 20.83 20.83 * $6 Earnings Per Share for Amazon = $124.97 estimated stock value

5. Assume the exhibit below details the current market multiples for four retail firms, and that we consider each of them to be a relevant comparison firm to the focal firm. We’ll now use the three comparison firms (WMT, AMZN and KR) to first value Target (Ticker = TGT) and then three comparison firms (WMT, AMZN and TGT) value Kroger (Ticker=KR).

Required: a. Based on the average market P/S ratio you compute for the three comparison firms (WMT, AMZN and KR), compute the estimated stock value of Target if its sales per share are $142.

Relative P/S value for WMT, AMZN and KR = 1.51 1.51 * $6 Sales Per Share for Target = $213.95 estimated stock value

b. Based on the average market P/E ratio you compute for the three comparison firms (WMT, AMZN and TGT compute the estimated stock value of Kroger (Ticker=KR) if its Earnings per share are $8.

Relative P/E value for TGT, AMZN and WMT = 31.41 31.41 * $8 Earnings Per Share for Kroger = $251.28 estimated stock value