SOLUTIONS TO PRACTICE QUESTIONS

E7.5. Using Accounting Relations

(a)
Income Statement:
Start with the income statement where the answers are more obvious:
A = $9,162
B = 8,312
C=

94

(Comprehensive income = operating revenues operating expenses net financial expenses)

Balance sheet:
D = 4,457
E = 34,262
F = 34,262
G = 7,194
H = 18,544
Before going to the cash flow statement, reformulate the balance sheet into net
operating assets (NOA) and net financial obligations (NFO):
Jun-09 Dec
Operating assets
Operating liabilities

28,631
7,194

30,024
8,747

Jun-09 Dec
Financial obligations
Financial assets
Net financial obligations
Common equity

Net operating assets

21,437

21,277

Cash Flow Statement:

Free cash flow:

J = 690

[C - I = OI - NOA]

Cash investment:

I = (106)
(a liquidation)

[I = C - (C - I)]

7,424
4,457
2,967

6,971
4,238
2,733

18,470
21,437

18,544
21,277

Total financing flows:

M = 690

[C - I = d + F]

Net dividends:

K = 865

[Net dividends = Earnings - CSE]

Payments on net debt:

L = (175)
[F = d + F - d]
(more net debt issued)

(b)
Operating accruals can be calculated in two ways:
1.

2.

(c)

NFO

Operating accruals

Operating accruals

Operating income Cash from operations

850 584

266

NOA Investment

160 (-106)

266

NFE (C - I) + d

59 690 + 865

=
(d)

234

The net dividend of $865 was generated as follows:

Operating income
less NOA
Free cash flow
less net financial expenses
plus increase in net debt

850
160
690
59
631
234
865

E7.6. Inferences Using Accounting Relations

(a)
This firm has no financial assets or financial obligations so CSE = NOA and total
earnings = OI. Also the dividend equals free cash flow (C - I = d).

Price
CSE (apply P/B ratio to price)
Free cash flow
Dividend (d = C - I)
Price + dividend
Return (246.4 224)
Rate of return

2009

2008

224
140

238
119
8.4
8.4
246.4
22.4
10%

(b)
There are three ways of getting the earnings:
1.

2.

Earnings

OI

Stock return - premium

22.4 (119 - 84)

(12.6)

C - I + NOA

8.4 + (119 140)

(a loss)

3.

(12.6)

(Earnings

OI as there are no financial items)

Earnings

CSE + dividend

-21 + 8.4

(12.6)

E8.9. Calculating Comprehensive Income to Shareholders: Intel Corporation

Net income

10,535

Unrealized loss on securities

(3,596)

Loss on conversion of notes (350-207)

(143)

Comprehensive income

6,796

The loss on conversion of subordinated notes is the difference between the market price of
the common shares and the exercise price at conversion. This is a loss from issuing shares at
less than market price.

Intel also incurred a loss from the exercise of stock options by employees. Method 1
determines the loss on exercise of stock options:

Loss on shares issued to employees calculated from the reported tax benefit:

Loss before tax

887

2,334

0.38

Tax

887

Loss after tax

1,447

This loss is a real loss to shareholders than might be included in comprehensive income.
However, with FASB Statement No. 123R and IFRS No. 2, grant date accounting brings
some of the cost (but not all) into income, so adding the loss at exercise could be double
counting to some extent. As it is, however, the reported income understates the loss.

E8.10. Loss on the Conversion of Preferred Common Stock: Microsoft Corporation

In 1999, Microsofts shares traded at an average price of $88.

With 14.901 million common shares issued -- 1.1273 shares for every one of the 12.5 million
preferred shares -- common stock worth $1,240 million was issued. As the carrying value of
the preferred stock was $990 million, the loss in conversion was $260 million:
Market value of common shares issued: 14.901 $88

= $1,240

Carrying value of the preferred stock

980

Loss on conversion

$ 260

E8.12. Reformulation of an Equity Statement: Dell Computer Corporation

a.

Loss on stock option exercise

260

743

0.35
Tax effect

260
483

b.

Reformulated Equity Statement:

Balance, February 1, 2002

4,694

Net transaction with shareholders:

Share issue, at market value (418 + 483)
Share repurchase, at market value

901
(1,400)

(499)

(2,290 890)
Comprehensive income:
CI reported

2,051

Loss on share repurchase

(890)

Balance, January 31, 2003

1,161

5,356

The loss on the stock repurchase occurred because shares were repurchased at $45.80 when
the shares traded at $28. The $45.80 repurchase price is the total amount paid, $2,290 million,
divided by 50 million shares repurchased. The repurchase at such a high price was a result of
a share repurchase agreement that gave the counter party the right to sell shares to Dell at
$28. See Box 8.4 in the chapter. The loss is calculated as follows:
Market value of shares repurchased
Amount paid on repurchase
Lost on repurchase

28 x 50 million shares =

1,400
2,290
890

The loss on exercise of options has not been included in comprehensive income because of
the potential double counting problem.

E9.4 Reformulation of a Balance Sheet and Income Statement

Balance sheet:

Operating cash

23

Accounts receivable

1,827

Inventory

2,876

PPE

3,567

Operating assets

8,293

Operating liabilities:
Accounts payable

$1,245

Accrued expenses

1,549

Deferred taxes

712

Net operating assets

3,506
4,787

Net financial obligations:

Cash equivalents

$( 435)

Long-term debt

3,678

Preferred stock

432

Common shareholders equity

3,675
$1,112

Income statement:

Revenue

$7,493

Operating expenses

6,321

Operating income before tax

1,172

Tax expense:
Tax reported
Tax on interest expense

$295
80

Operating income after tax

375
797

Net financial expense:

Interest expense
Tax benefit at 36%

221
80
141

Preferred dividends

26

Net income to common

167
$630

E9.6. Testing Relationships in Reformulated Income Statements

The solution has to be worked in the following order:
A

= Operating revenues operating expenses

= 5,523 4,550
= 973

= Interest expense after tax/ (1 tax rate)

= 42/0.65

= 64.6
F

= E 42
= 22.6

= 610 + 42
= 652

= F
= 22.6

= ACD
= 973 22.6 652
= 298.4

Effective tax rate on operating income

= Tax on operating income/ Operating income before tax
= (B + C)/A
= 33.0%

E10.8. Free Cash Flow and Financing Activities: General Electric Company
a. General Electric, while generating large cash flow from operations, has had a huge
investment program as it acquired new businesses, leaving it with negative free cash
flow.

b. Given that cash from operations from the businesses in place continues at, or grows
from the 2004 level, free cash flow will increase and will become positive (probably
by big amounts). Rather than borrowing or issuing shares to finance a free cash flow
deficit, GE will have cash to pay out. It can either,
1. But down its debt
2. Invest the cash flow in financial assets
3. Pay out dividends or buy back its stock.
The firm would not invest in financial assets for too long, but rather buy back debt
or pay out to shareholders. Indeed, in 2005, the firm announced a large stock
repurchase program.

E10.10. Free Cash Flow for Kimberly-Clark Corporation

a.
Reformulate the balance sheet:

Operating assets
Operating liabilities
Net operating assets (NOA)
Financial obligations
Financial assets
Common equity (CSE)
By Method 1,

$6,496.4
382.7

2007

2008

$18,057.0
6,011.8
12,045.2

$16,796.2
5,927.2
10,869.0

6,113.7

$4,395.4
270.8 4,124.6

$ 5,931.5

$ 6,744.4

Free cash flow = Operating income Change in net operating assets

= $2,740.1 (12,045.2 10,869.0)
= 1,563.9
By Method 2,

Free cash flow = Net financial expense NFO + d

= 147.1 (6,113.7 4,124.6) + 3,405.9
= 1,563.9

Net payout to shareholders (d) = Comprehensive income CSE

= (2,740.1 147.1) (-812.9)
= 3,405.9
b.

Cash flow from operations reported

Net interest payments
Tax on net interest payments

$2,429.0 million
142.4
52.1

Cash flow from operation

Cash investment reported

Liquidation of short-term investments

Free cash flow

90.3
2,519.3

898.0
56.0

954.0

$1,565.3 million

E11.5 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A What-If
Question
The effect would be (almost) zero.
Existing RNOA = PM ATO
= 3.8% 2.9
= 11.02%

RNOA from new product line is

RNOA = 4.8% 2.3
= 11.04%

E11.7. Analysis of Profitability: The Coca-Cola Company

Average balance sheet amounts are as follows:

2007
Net operating assets
$22,905

$26,858

Net financial obligations

3,573
Common shareholders equity
$19,332

5,114

2,032

$21,744

$16,920

a.
RNOA = 6,121/22,905 = 26.72%
NBC

= 140/3,573

2006
Average
$18,952

= 3.95%

b.

FLEV = 3,573/19,332 = 0.185

c.
ROCE = RNOA + [FLEV (RNOA NBC)]
= 26.72% + [0.185 (26.72% - 3.95%)]

= 30.93 % = 5,981/19,332
d.
PM = 6,121/28,857 = 21.21%
ATO = 28,857/22,905 = 1.26
RNOA = 21.21% 1.26 = 26.72%
e.
Gross margin ratio = 18,451/28,857 = 63.94%
Operating profit margin from sales = 5,453/28,857 =18.90%
Operating profit margin = 6,121/28,857 = 21.21%

E12.3. Analyzing the Growth in Shareholders Equity

Change in CSE = 583
Change in sales = 5,719
Change in 1/ATO = 1/2.4 1/2.5 = 0.4167 0.4 = 0.0167
Change in NFO = 1,984

Following Box 12.10,

Change in CSE = 583 = (5,719 x 0.4) + (0.0167 x 16,754) 1,984
= 2287.6 + 279.8 1,984.0

Due to

Due to

Due to

Sales

NOA

Borrowing

E12.7. Core Income and Core Profitability for The Coca Cola Company
Average balance sheet amounts are as follows:

Net operating assets

Net financial obligations
Common shareholders equity

2007

2008

Average

$26,858

$18,952

$22,905

5,114

2,032

3,573

$21,744

$16,920

$19,332

As no unusual items are reported in the income statement, all income reported is core income.
So,
Core income from sales (after tax) = $5,453 million
Core operating income

= $6,121 million

One might be tempted to treat equity income from bottling subsidiaries as non-core income.
However, this is part of Cokes business of selling beverages (they just do this business
through bottling firms). The equity income is not income from top-line sales, however; rather
it is income from sales in the subsidiaries that is reported here on a net basis (after expenses).
Here are the measures requested:
a. Core profit margin from sales = 5,453/28,857 =18.90%
b. Core profit margin = 6,121/28,857 = 21.21%
c. Core RNOA = 6,121/22,905 = 26.72%

E13.14.

Enterprise Multiples for IBM Corporation

Here are the totals for IBMs balance sheet, first with book values and then with market
values:
Book Value
Net operating assets (NOA)

48,089

Market Value
160,909

Net financial obligation (NFO)

19,619

Common equity (CSE)

28,470

19,619
1,385.2 $102 =

141,290

The amounts for NOA and the market value of NOA are obtained by adding NFO back to
CSE. The book value of NFO is considered to be the market value.
a. Levered P/B = 141,290/28,470 = 4.96
Unlevered (enterprise) P/B = 160,909/48,089 = 3.35
Leverage explains the difference according to the formula,
Levered P/B = Unlevered P/B + FLEV [Unlevered P/B 1.0]

4.96 = 3.35 + (0.689 2.35)

b. Forward levered P/E = $102/$8.73 = 11.68
To get the unlevered P/E, first calculate forward OI:
Earnings forecast for 2008: $8.73 1,385.2 shares
Net financial expense for 2008: $19,619 3.3%
Forward operating income

$12,092.8
647.4
$12,740.2

Forward unlevered (enterprise) P/E = $160,909/$12,740 = 12.63

E13.15. Residual Operating Income and Enterprise Multiples: General Mills, Inc.

a. Free cash flow = OI NOA

= 1,901 (12,847 12,297)
= 1,351

b. ReOI (2008) = 1,901 (0.058 12,297)

= 1,188

c. Market value of equity = $60 337.5 shares = 20,250

Net financial obligations
6,458
Minority interest ($242 3.26)
Enterprise market value

789
27,497

(Minority interest is valued at book value multiplied by the P.B ratio for common
equity).

Enterprise P/B = 27,497/12,847 = 2.14

d. (This question is not in all printings of the book)

Trailing P/E =

P+d
E

The trailing P/E is usually calculated on a per-share basis, with dividends being
dividends per share. Per-share amounts are not giving in the Exhibits, but one can
calculate a P/E on a total dollar basis, with the dividend being the net dividend. The
net dividend = Comprehensive income CSE = 752. So the trailing P/E is

20,250 + 752
= 12.74
1,649

On the required return: The WACC number calculated in Box 13.2 uses a number of
inputs that give one pause (see Box 13.3):
-

market values are used for the weighting, but it is market value that valuation
tries to challenge. One is building the speculation in price into the calculation.
Market risk premiums used to get the equity required return (5% here) are just
a guess. More speculation.
Betas are estimated with error.

Does 5.4% seem a lit low? Its only 1.4% above the risk-free rate (of 4% in Box 13.2). This is
a low beta firm, but surely less risky high-grade bonds would yield more?

E13.18. Valuation of Operations: Nike, Inc., 2005

(a)
Analysts eps forecast
Shares outstanding
Analysts earnings forecast

$5.08
261.1 million
$1,326.4 million

Forecast of net financial income

1,012 0.032
Forecast operating income

Forecasted RNOA = 1,294/4,632

32.4
$1,294.0 million

27.94%

(using beginning-of-year NOA)

(b) Forecasted ReOI = [27.94% - 8.6% ] 4,632 = 895 .6 million

Value

= 5,644 +

895.6
1.086 - 1.04

= $25,114 million, or $96.18 per share

(c) If ReOI is to grow at 4%, then abnormal operating income growth will also grow at
at 4%, and the formula for calculating the value of the equity will be

Value of equity =

AOIG2
1
+ NFA
OI 1 +
F 1
F g

where g is the forecasted growth rate of 4%.

First calculate AOIG two years ahead (2007). There are two methods for doing this.

Method 1: Difference between cum-FCF OI for 2007 minus normal OI for 2007
Forecast of OI for 2007 = NOA2006 RNOA2007
NOA2006 = 4,632 1.04
= 4,817.3
OI2007 = 4,817.3 0.2794
= 1,345.9

FCF2006 = OI2006 - NOA2006

= 1,294.0 185.3
= 1,108.7
AOIG2007 = OI2007 + FCF2006 reinvested (1.086 OI1997)
= 1,345.9 + (0.086 1,108.7) (1.086 1,294)
= $35.95 million

Method 2 (much simpler!): AOIG is growth in residual operating income from the previous
year
AOIG2007 = ReOL2006 0.04
= 895.6 0.04
= 35.82 (allow for rounding error)

Accordingly, the valuation is:

Value of equity =

1
35.82
+ 1,012
1,294 +

0.086
1.086 1.04

= $25,113 million or $96.18per share

(d)

Value of operations = Value of equity - NFA

= 25,113 1,012

= $24,101 million

(e) ReOI is driven by RNOA and growth in net operating assets. So, if RNOA is forecasted
to be constant, net operating assets must be forecasted to grow at 4% per year.

(f) Forward enterprise P/E = $24,101/$1,294 = 18.63

Forward levered P/E = $25,113/$1,326.4 = 18.93

V NOA
V0E
V NOA
1

= 0
+ ELEV1 0

Earn1
OI 1
OI
NBC
1
1

= 18.63 - [0.0244 (18.83 1/0.032]

= 18.93
(ELEV1 = NFE/Earnings = -32.4/1,326.4 = -0.0244
(g) Stock repurchases change financial leverage; in this case, Nike liquidated its financial
assets to pay for the stock repurchase. Operating income will not be affected because NOA
are not affected by stock repurchase. With fewer shares outstanding, eps will increase, as the
denominator effect (fewer shares) overwhelms the number effect (loss in interest income on
the financial assets). The only exception is the case where financing leverage is unfavorable
(RNOA less than RNFA). Also, the expected eps growth rate will increase. But, if the share
repurchase is at fair market value, price will not change. See Boxes 13.5 and 13.6.