Financial statement analysis ch 3

SOLUTIONS TO EXERCISE AND CASES

For

FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION

Stephen H. Penman

CHAPTER ONE

Introduction to Investing and Valuation

Exercises

Drill Exercises

E1.1. Calculating Enterprise Value

Enterprise Value = $1,800 million

E1.2. Calculating Value Per Share

Equity Value = $1,800

E1.3 Buy or Sell?

Value = $850 + $675

= $1,525 million

Value per share = $1,525/25 = $61

Market price = $45

Therefore, BUY!

Applications

E1.4. Finding Information on the Internet: Dell Computer and General Motors

This is an exercise in discovery. The links on the book’s web site will help with the

search. Here is the link to yahoo finance:

http://finance.yahoo.com

E1.5. Enterprise Market Value: General Mills and Hewlett-Packard

(a) General Mills

Market value of the equity =

Book value of total (short-term and long-term) debt =

Enterprise value

Note three points:

(i) Total market value of equity = Price per share ! Shares outstanding.

(ii) The book value of debt is typically assumed to equal its market value, but

financial statement footnotes give market value of debt to confirm this.

(iii) The book value of equity is not a good indicator of its market value. The price-to-

book ratio for the equity can be calculated from the numbers given:

$20,925/$6,215.8 = 3.37.

(b) This question provokes the issue of whether debt held as assets is part of enterprise value

(a part of operations) or effectively a reduction of the net debt claim on the firm. The issue arises

in the financial statement analysis in Part II of the book: are debt assets part of operations or part

of financing activities? Debt is part of financing activities if it is held to absorb excess cash

rather than used as a business asset. The excess cash could be applied to buying back the firm’s

debt rather than buying the debt of others, so the net debt claim on enterprise value is what is

important. Put another way, HP is not in the business of trading debt, so the debt asset is not part

of enterprise operations. The calculation of enterprise value is as follows:

Market value of equity = $47 ! 2,473 million shares = $116,231 million

Book value of net debt claims:

Short-term borrowing $ 711 million

Long-term debt 7,688

Total debt $8,399 million

Debt assets 11,513 (3,114)

Enterprise value 113,117 million

E1.6. Identifying Operating, Investing, and Financing Transactions

(a) Financing

(b) Operations

(c) Operations; but advertising might be seen as investment in a brand-name asset

(d) Financing

(e) Financing

(f) Operations

(g) Investing. R& D is an expense in the income statement, so the student might be

inclined to classify it as an operating activity; but it is an investment.

(h) Operations. But an observant student might point out that interest – that is a part

of financing activities – affects taxes. Chapter 9 shows how taxes are allocated

between operating and financing activities in this case.

(i) Investing

(j) Operations

CHAPTER TWO

Introduction to the Financial Statements

Exercises

Drill Exercises E2.1. Applying Accounting Relations: Balance Sheet, Income Statement and Equity Statement

a. Liabilities = $150 million b. Net Income = $205 million c. Ending equity = $32 million As net income (in the income statement) is $30 million, $2 million was reported as “other comprehensive income” in the equity statement. d. Net payout = Dividends + Share repurchases – Share issues As there were no share issues or repurchases, dividend = $12.

E2.2. Applying Accounting Relations: Cash Flow Statement Change in cash = $195 million E2.3. The Financial Statements for a Savings Account a. ___________________________________________________________________________

BALANCE SHEET INCOME STATEMENT

Assets (cash) $100 Owners’ equity $100 Revenue $5

Expenses 0

Earnings $5

STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY

Cash from operations $5 Balance, end of Year 0 $100

Cash investment 0 Earnings, Year 1 5

Cash in financing activities: Dividends (withdrawals), Year 1 (5)

Dividends (5) Balance, end of Year 1 $100

Change in cash $ 0

b. As the $5 in cash is not withdrawn, cash in the account increases to $105, and owners’

equity increases to $105. Earnings are unchanged.

______________________________________________________________________


Assets (cash) $105 Owners’ equity $105 Revenue $5

Expenses 0

Earnings $5



Cash investment 0 Earnings, Year 1 5



Change in cash $ 5

______________________________________________________________________

c. With the investment of cash flow from operations in a mutual fund, the financial

statements would be as follows:

_______________________________________________________________________


Assets (cash) $100 Revenue $5

Mutual Fund 5 Equity $105 Expenses 0

Total assets $105 Total $105 Earnings $5



Cash investment (5) Earnings, Year 1 5



Change in cash $ 0

E2.4. Preparing an Income Statement and Statement of Shareholders’ Equity

Income statement:

Sales $4,458 Cost of good sold 3,348 Gross margin 1,110 Selling expenses (1,230) Research and development (450) Operating income (570) Income taxes 200 Net loss (370) Note that research and developments expenses are expensed as incurred. Equity statement: Beginning equity, 2009 $3,270 Net loss $(370) Other comprehensive income 76 (294) ($76 is unrealized gain on securities) Share issues 680

Common dividends (140) Ending equity, 2009 $3,516

Comprehensive income (a loss of $294 million) is given in the equity statement. Unrealized gains and losses on securities on securities available for sale are treated as other comprehensive income under GAAP.

Net payout = Dividends + share repurchases – share issues

= 140 + 0 – 680 = - 540 That is, there was a net cash flow from shareholders into the firm of $540 million. Taxes are negative because income is negative (a loss). The firm has a tax loss that it can carry forward. E2.5. Classifying Accounting Items

a. Current asset

b. Net revenue in the income statement: a deduction from revenue

c. Net accounts receivable, a current asset: a deduction from gross receivables

d. An expense in the income statement. But R&D is usually not a loss to shareholders; it

is an investment in an asset.

e. An expense in the income statement, part of operating income (and rarely an

extraordinary item). If the restructuring charge is estimated, a liability is also

recorded, usually lumped with “other liabilities.”

f. Part of property, plan and equipment. As the lease is for the entire life of the asset, it

is a “capital lease.” Corresponding to the lease asset, a lease liability is recorded to

indicate the obligations under the lease.

g. In the income statement

h. Part of dirty-surplus income in other comprehensive income. The accounting would

be cleaner if these items were in the income statement.

i. A liability

j. Under GAAP, in the statement of owners equity. However from the shareholders’

point of view, preferred stock is a liability

k. Under GAAP, an expense. However from the shareholders’ point of view, preferred

dividends are an expense. Preferred dividends are deducted in calculating “net income

available to common” and for earnings in earnings per share.

l. As an expense in the income statement.

E2.6. Violations of the Matching Principle

a. Expenditures on R&D are investments to generate future revenues from drugs, so are

assets whose historical costs ideally should be placed on the balance sheet and amortized

over time against revenues from selling the drugs. Expensing the expenditures

immediately results in mismatching: revenues from drugs developed in the past are

charged with costs associated with future revenues. However, the benefits of R&D are

uncertain. Accountants therefore apply the reliability criterion and do not recognize the

asset. Effectively GAAP treats R&D expenditures as a loss.

b. Advertising and promotion are costs incurred to generated future revenues. Thus, like

R&D, matching requires they be booked as an asset and amortized against the future

revenues they promote, but GAAP expenses them.

c. Film production costs are made to generate revenues in theaters. So they should be

matched against those revenues as the revenues are earned rather than expensed

immediately. In this way, the firm reports its ability to add value by producing films.

E2.7. Using Accounting Relations to Check Errors

Ending shareholders’ equity can be derived in two ways: 1. Shareholders’ equity = assets – liabilities

2. Shareholders’ equity = Beginning equity + comprehensive income – net dividends

So, if the two calculations do not agree, there is an error somewhere. First make the calculations

for comprehensive income and net dividends:

Comprehensive income = net income + other comprehensive income

= revenues – expenses + other comprehensive income

= 2,300 –1,750 – 90

= 460

Net dividend = dividends + share repurchases – share issues

= 400 +150 –900

= - 350

Now back to the two calculations:

1. Shareholders’ equity = 4,340 – 1,380

= 2,960

2, Shareholders’ equity = 19,140 + 460 – (-350)

= 19,950

The two numbers do not agree. There is an error somewhere.

Applications

E2.8. Finding Financial Statement Information on the Internet

This is a self-guiding exercise. Students can take it further by downloading financial statements

into a spreadsheet. Go to the links of the book’s web site.

E2.9. Testing Accounting Relations: General Mills Inc.

This exercise tests some basic accounting relations.

(a) Total liabilities = Total assets – stockholders’ equity = 12,826

(b) Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders

6,216 = 5,319 +? – 782

? = 1,679

Net payout to common = cash dividends + stock purchases – share issues = 782

E2.10. Testing Accounting Relations: Genetech Inc.

(a) Revenue = $4,621.2 million

(b) ebit = $1,136.8 million

(c) ebitda =$1,490.0 million

Depreciation and amortization is reported as an add-back to net income to get cash flow from

operations in the cash flow statement.

Long-term assets = $5,980.6 million

Total Liabilities = $2,621.2 million

Short-term Liabilities =$1,243.3 million

(c) Change in cash and cash equivalents = Cash flow from operations – Cash used in investing

activities + Cash from financing activities

Change in cash and cash equivalents is given by the changes in the amount is the balance sheet

= $270.1 – 372.2 = -$102.1

So, -$102.1 = $1,195.8 - $451.6 + ?

So ? = -$846.3 million

That is, there was a cash outflow of $846.3 million for financing activities.

E2.11. Find the Missing Number in the Equity Statement: Cisco Systems Inc.

Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders a.

$32,304 = $31,931 + 6,526 -?

? = $6,153

b. Net payout to common = cash dividends + stock purchases – share issues

6,153 = 0 + ? – 2,869

= 9,022

E2.12. Find the Missing Numbers in Financial Statements: General Motors

a.

Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders -56,990 = -37,094 + ? – 283 ? = -19,613 (a loss) b. Comprehensive income = Net income + Other comprehensive income -19,613 = -18,722 + ? ? = - 891 c. Net income = Revenue – expenses and losses -18,722 = ? – 60,895 ? = 42,173 d. June 30, 2008 December 31, 2007 Assets 136,046 148,883 Liabilities ? = 193,036 ? = 185,977 Equity -56,990 -37,094

E2.13. Mismatching at WorldCom

Capitalizing costs takes them out of the income statement, increasing earnings. But the

capitalized costs are then amortized against revenues in later periods, reducing earnings. The net

effect on income in any period is the amount of costs for that period less the amortization of

costs for previous periods. The following schedule calculates the net effect. The numbers in

parentheses are the amortizations, equal to the cost in prior periods dividend by 20.

1Q, 2001 2Q, 2001 3Q, 2001 4Q, 2001 1Q, 2002

1Q, 2001 cost: $780 $780 $ (39) $ (39) $ (39) $ (39)

2Q, 2001 cost: 605 605 (30) (30) (30)

3Q, 2001 cost: 760 760 (38) (38)

4Q, 2001 cost: 920 920 (46)

1Q, 2002 cost: 790 790

Overstatement of earnings $780 $566 $691 $813 $637

The financial press at the time reported that earnings were overstated by the amount of the

expenditures that were capitalized. That is not quite correct.

E2.14. Calculating Stock Returns: Nike, Inc.

The stock return is the change in price plus the dividend received. So, Nike’s stock return for

fiscal year 2008 is 12.875/55 = 23.41%.

CHAPTER THREE

How Financial Statements are Used in Valuation

Exercises

Drill Exercises E3.1. Calculating a Price from Comparables Average of the two prices = $55 per share E3.2. Stock Prices and Share Repurchases Market price per share after repurchase = $1,800/90 = $20 E3.3 Unlevered (Enterprise) Multiples Market price of equity = 80 ! $7 = $560 million Market value of debt 140 (assumes book value – market value) Market value of enterprise $700 million Book value of shareholders’ equity = $250 - 140 = $110million

a. P/B = 560/110 = 5.09 b. Unlevered P/S = 700/560 = 1.25 c. Enterprise P/B = 700/250 = 2.8

E3.4. Identifying Firms with Similar Multiples

This is a self-guided exercise.

E3.5. Valuing Bonds

For this question, first calculate discount factors for each of five years ahead. You can also get them from present value tables where the discount factor is given as 1/1.05t. At a 5% required return, the discount factors are: Year Ahead (t) Discount factor (1.05t)

1 1.05 2 1.1025 3 1.1576 4 1.2155 5 1.2763

a. The only cash flow is the $1,000 at maturity Present value (PV) of $1,000 five years hence = $1,000/1.2763 = $783.51 b. This is easy. If the coupon rate is the required rate of return, the bond is worth its face value, $1,000. You

can show this by working the problem as in part b, but with an annual coupon of $50.

c. The yearly cash flows and their present value are:

Year Ahead (t) Discount factor (1.05t) Cash Flow PV 1 1.05 40 38.10 2 1.1025 40 36.28 3 1.1576 40 34.55 4 1.2155 40 32.91

5 1.2763 1, 040 814.86 Total Present Value $956.70

(Your answers might differ by a couple of cents if you use discount factors to 5 or 6 decimal places.)

E3.6. Applying Present Value Calculations to Value a Building

This is a straight forward present value problem: the required return--the discount rate--is applied to

forecasted net cash receipts to convert the forecast to a valuation:

Present value of net cash receipts of 1.1 million for 5 years at 12% (annuity factor is 3.6048)

$3.965 million

Present value of $12 million “terminal payoff” at end of 5 years (present value factor is 0.5674)

6.809

Value of building $10.774

Applications

E3.7 The Method of Comparables: Dell, Inc. First calculate the multiples for the comparable firms from the price and accounting numbers:

Sales

Earnings

Book Value

Market Value

Hewlett-Packard Co. $45,226 $ 624 $13,953 $32,963 Gateway Inc. 6,080 (1,290) 1,565 1,944 HP: Price/Sales = 0.73 P/E = 52.8 P/B = 2.4 Gateway: Price/Sales = 0.32 P/E - (not applicable: negative earnings) P/B = 1.2 Now apply the multiples to Dell: Average Multiples Dell’s Dell’s for Comparable Number Valuation Sales 0.53 x 31,168 = $16,519 million Earnings 52.8* x 1,246 = 65,789 Book value 1.8 x 4,694 = 8,449 Average of valuations 30,252 * HP only

With 2,602 million shares outstanding, the estimated value per share = $30,252/2,602 = $11.63 Difficulties:

- P/E can’t be calculated for a loss firm - The “comparables” are not exactly like Dell - The calculation assumes the market prices for the “comps” are efficient - Not sure how to weight the three valuation based on sales, earnings and book values;

the valuations differ considerably, depending on the multiple used

E3.8. A Stab at Valuation Using Multiples: Biotech Firms

Multiples of the various accounting numbers for the five firms can be calculated and the average multiple applied to

Genentech’s corresponding accounting numbers. This yields prices for Genentech:

Multiple

Comparison Firm Mean

Estimated Genentech

Value (millions)

P/B 4.16 $5,610.9 E/P

.0245*

5,077.6

(P-B)/R&D

10.66

4,699.2

P/Revenue

6.05

4,809.0

Mean over all values

5,049.2

*Excludes firms with losses.

E/P is used rather than P/E because a very high P/E due to very small earnings can affect the mean

considerably. The mean E/P also excludes the loss firms since Genentech did not have losses.

Research and development (R&D) expenditures are compared to price minus book value. As the R&D

asset is not on balance sheets, its missing value is in this difference. The average ratio of 10.66 is applied to

Genetech’s R&D expenditures to yield a valuation for its R&D asset of $3,350.4 million which, when added to the

book value of the other net assets, gives a valuation of $4,699.2 million for Genentech. This is clearly very rough.

The average of the values based on the mean multiples is $5,049.2 million. Genetech’s actual traded value

in April 1995 was $5,637.6 million.

E3.9. Pricing Multiples: General Mills, Inc.

E3.10. Measuring Value Added

(a) Buying a stock:

Value of a share = 12.0

2 =

$ 16.67

Price of a share 19.00

Value lost per share $ 2.33

(b) Value of the investments:

Present value of net cash flow of

$1M per year for five years (at 9%)

$ 3.890 million

Initial costs 2.000

Value added $ 1.890 million

E3.11. Forecasting Prices in an Efficient Market: Weyerhaeuser Company

This tests whether you can forecast future prices, ex-dividend, using the no-arbitrage relationship between

prices at different points in time.

The T-Bill rate at the end of 1995 was 5.5%.

So the CAPM cost of capital = 5.5% + (1.0 ! 6.0%) = 11.5% (using an 6% risk premium).

(a) 19952

1997 PP "= = 1.1152 ! 42 = 52.22

This is the cum-dividend price

(b) 1997199619952

1997 ddPP #"#"=

= (1.1152 x 42) - (1.115 ! 1.60) - 1.60 = 48.83

84.16095.0

16.1/ =!=!=

E

S

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PEP

E3.12. Valuation of Bonds and the Accounting for Bonds, Borrowing Costs, and Bond

Revaluations

The purpose of this exercise is to familiarize students with the accounting for bonds.

The cash flows and discount rates for each bond are as follows:

2007 2008 2009 2010 2011 2012

40 40 40 40 40 Coupon

1000 Redempt.

1.08 1.1664 1.2597 1.3605 1.4693 Discount rate (a) Present value of cash flows = value of bond = $840.31.

(b) (1) Borrowing cost = $840.31 ! 8% = $67.22 per bond

(2) This is the way accountants calculate interest (the effective interest method): $67.22 per bond will be

recorded as interest expense. This will be made up of the coupon plus an amortization of the bond discount. The

amortization is $67.22 - $40.00 = $27.22. This accrual accounting records the effective interest of $67.22, not the

cash flow.

(c) (1) As the firm issued the bonds at 8%, it is still borrowing at 8%. Of course, if the firm issued new debt at the

end of 2009, its borrowing cost would be 6%.

(2) Interest expense for 2009 will be $69.40 per bond. This is the book value of the bond at the end of 2008

times 8%: $867.53 ! 8% = $69.40. The book value of the bond at the end of 2008 is $840.31 + $27.22 =

$867.53, that is, the book value at the beginning of 2008 plus the 2008 amortization.

(d) The future cash flows at the end of 2009 are:

2010 2011 2012

40 40 40 Coupon

1000 Redemption 1.08 1.1664 1.2597 Original Discount rate 1.06 1.1236 1.1910 New discount rate Present value of remaining cash flows at 8% discount rate = $896.92

Present value of remaining cash flows at 6% discount rate = 946.55

Price appreciation $ 49.63

(1) The bonds are marked to market so they are carried at $946.55 at the end of 2009. Note that bonds are marked

to market only if they are assets, not if they are liabilities. Debtor Corporation’s carrying amount would not be

affected by the change in yield.

(2) The interest income in the income statement will be as before, $69.40 per bond. However, an unrealized gain of

$49.63 per bond will appear in other comprehensive income to reflect the markup. (Unrealized gains and losses on

securities go to other comprehensive income rather than the income statement. See Accounting Clinic III.)

Note that, if Debtor Corporation had sold the bonds at the end of 2009 (for $946.55 each), it would have realized

a loss of $49.63 per bond which would be reported with extraordinary items in the income statement. If it

refinanced at 6% for the last three years, it would lower borrowing costs that, in present value terms, would equal

the loss.

E3.13. Share Issues and Market Prices: Is Value Generated or Lost By Share Issues?

This exercise tests understanding of a conceptual issue: do share issues affect shareholder value per share? The

understanding is that issuing shares at market price does not affect the wealth of the existing shareholders if the

share market is efficient: New shareholders are paying the “fair” price for their share. However, if the shares are

issued at less than market price, the old shareholders lose value.

(a)

Shares outstanding after share issue = 188 million

Price per share after issue = $55

Like a share repurchase, a share issue does not affect per share value as long as the shares are issued at the

market price. Old shareholders can’t be damaged or gain a benefit from the issue. Of course, if the market

believes that the issue indicates how insiders view the value of the firm, the price may change. But this is

an informational effect, not a result of the issue. Old shareholders would benefit if the market were

inefficient, however. If shares are issued when they are overvalued in the market, the new shareholders pay

too much and the old shareholders gain.

The idea that share issues don't generate value (if at market prices) is the same idea that dividends don't

generate value. Share issues are just dividends in reverse.

(b)

Shares outstanding after exercise 200 million

Price per share $60.10

The (old) shareholders lost $1.90 per share through the issue: issue of shares at less than market causes

“dilution” of shareholder value.

E3.14. Stock Repurchases and Value: Dell, Inc.

This exercise makes the same conceptual point as the previous exercise on stock issues: stock repurchases

(which are reverse stock issues) don't create value, if the market price is at fair value.

There is no effect on the price per share at the date of repurchase. The total value of the company (price

per share x shares outstanding) would drop by $335 million, the amount of cash paid out. But the number of shares

outstanding would also drop by 7.5 million leaving the price per share unchanged.

Price per share before repurchase = $4,004M/179M = $22.37

Total value of the equity before repurchase = $22.37 ! 2,239M = $50,086M

Total value of the equity after repurchase = $50,086M # $4,004M = $46,082M

Shares outstanding after repurchase = 2,239M # 179M = 2,060M

Price per share after repurchase = $46,082/2,060 = $22.37

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Financial statement analysis ch 3