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business
financial reporting financial statement analysis and valuation
Business Analysis And Valuation Using Financial Statements Text And Cases 2nd Edition Krishna G. Palepu, Paul M. Healy, Victor Lewis Bernard, W.Gordon Filby - Solutions
Rate the pharmaceutical and lumber industries as high, medium, or low on the following dimensions of industry structure:Pharmaceutical Industry Lumber Industry Rivalry Threat of new entrants Threat of substitute products Bargaining power of buyers Bargaining power of suppliers.Given your ratings,
One of the fastest growing industries in the last twenty years is the memory chip industry, which supplies memory chips for personal computers and other electronic devices. Yet the average profitability for this industry has been very low. Using the industry analysis framework, list all the
What are the critical drivers of industry profitability?AppendixLO1
Judith, an accounting major, states, “Strategy analysis seems to be an unnecessary detour in doing financial statement analysis. Why can’t we just get straight to the accounting issues?” Explain to Judith why she might be wrong?AppendixLO1
Evaluate the quality of Comdisco’s disclosure in its annual report regarding the company’s lease accounting policies. Do you think the disclosure is adequate to evaluate the company’s performance?AppenidxLO1
Analyze the relative contribution of rentals, sales of computer equipment, and financial services to Comdisco’s reported profits during fiscal years 1981 and 1982 and the first nine months of fiscal year 1983. What are the reasons for the differences in the profit margins of these three
Using the information in Comdisco’s financial statements and footnotes, fill in the following to the extent possible (use plug figures if necessary):Account Balance as of 9/30/81 Increases during fiscal ‘82 Decreases during fiscal ‘82 Balance as of 9/30/82 Obligations under capital leases
Evaluate Comdisco’s business activities and the company’s strategy.AppenidxLO1
German firms are traditionally financed by banks, which have representatives on the companies’ boards. How would communication challenges differ for these firms relative to U.S. firms, which rely more on public financing?AppenidxLO1
When companies decide to shift from private to public financing by making an initial public offering for their stock, they are likely to face increased costs of investor communications. Given this additional cost, why would firms opt to go public?AppenidxLO1
Why might the CEO of the bio-technology firm discussed in Question 7 be concerned about the firm being undervalued? Would the CEO be equally concerned if the stock is overvalued? Do you believe that the CEO would attempt to correct the market’s perception in this overvaluation case?AppenidxLO1
Two years after a successful public offering, the CEO of a bio-technology company is concerned about stock market uncertainty surrounding the potential of new drugs in the development pipeline. In his discussion with you, the CEO notes that even though they have recently made significant progress
You are approached by the management of a small start-up company that is planning to go public. The founders are unsure about how aggressive they should be in their accounting decisions as they come to the market. John Smith, the CEO, asserts:“We might as well take full advantage of any
Under a management buyout, the top management of a firm offers to buy the company from its stockholders, usually at a premium over its current stock price. The management team puts up its own capital to finance the acquisition, with additional financing typically coming from a private buyout firm
Financial reporting rules in many countries outside the U.S. (e.g., the U.K., Australia, New Zealand, and France) permit management to revalue fixed assets (and in some cases even intangible assets) which have increased in value. Revaluations are typically based on estimates of realizable value
Management frequently objects to disclosing additional information on the grounds that it is proprietary. Consider the recent FASB proposals on expanding disclosures on (a) executive stock compensation and (b) business segment performance. Many corporate managers expressed strong opposition to both
a. What are likely to be the long-term critical success factors for the following types of firms?• a high technology company, such as Microsoft• a large low-cost retailer, such as Kmartb. How useful is financial accounting data for evaluating how well these two companies are managing their
Apple’s inventory increased from $1 billion on December 29, 1994, to $1.95 billion one year later. In contrast, sales for the fourth quarter in each of these years increased from $2 billion to $2.6 billion. What is the implied annualized inventory turnover for Apple for these years? What
In 1990 U.S. tax law increased capital gains rates from 20 percent to the same level as ordinary income rates, between 28 and 34 percent. What implications does this change have for corporate dividend policy and capital structure?AppenidxLO1
It is frequently argued that Japanese and German companies can afford to have more financial leverage and to follow lower dividend payout policies than U.S.companies because they are largely owned by financial institutions that have longterm horizons. Does this argument make economic sense? If so,
U.S. public companies with “low” dividend payouts have payout ratios of 0 percent or less, firms with “medium” payouts have ratios between 1 and 48 percent, and“high” payout firms have a ratio of 49 percent or more. Given these data, how would you classify the following firms in terms
The following table reports (in millions) earnings, dividends, capital expenditures, and R&D for Intel for the period 1990–95:Year Net Income Dividends Capital Expenditures R&D 1990 $650 $0 $680 $517 1991 819 0 948 618 1992 1,067 43 1,228 780 1993 2,295 88 1,933 970 1994 2,288 100 2,441 1,111
A rapidly growing Internet company, recently listed on NASDAQ, needs to raise additional capital to finance new research and development. What financing options are available, and what are the trade-offs between each?AppenidxLO1
U.S. public companies with “low” leverage have an interest-bearing net debt-to-equity ratio of 0 percent or less, firms with “medium” leverage have a ratio between 1 and 62 percent, and “high” leverage firms have a ratio of 63 percent or more. Given these data, how would you classify
One important driver of a firm’s capital structure and dividend policy decisions is its business risk. What ratios would you look at to assess business risk? Name two industries with very high business risk and two industries with very low business risk.AppenidxLO1
Finance theory implies that the debt-to-equity ratio should be computed using the market values of debt and equity. However, most financial analysts use book val-ues of debt and equity to compute a firm’s financial leverage. What are the limitations of using book values rather than market values
Until 1987 Master Limited Partnerships (MLPs) were treated as partnerships for tax purposes. This meant that no corporate taxes were paid by the entity. Instead, taxes were paid by partners (at their individual tax rates) on entity profits (both distributed and undistributed). The marginal tax rate
Financial analysts typically measure financial leverage as the ratio of debt to equity.However, there is less agreement on how to measure debt, or even equity. How would you treat the following items in computing this ratio? Justify your answers.• Revolving credit agreement with bank• Cash and
a. How would the following ratios differ for a company that used the purchase method to account for an acquisition versus the pooling-of-interests method in the year following the acquisition?• Return on sales• Return on assets• Asset turnoverb. Two years after the acquisition, the company
A leading oil exploration company decides to acquire an Internet company at a 50 percent premium. The acquirer argues that this move creates value for its own stockholders because it can use its excess cash flows from the oil business to help finance growth in the new Internet segment. Evaluate the
In 1995 Disney acquired ABC television at a significant premium. Disney’s management justified much of this premium by arguing that the acquisition would guarantee access for Disney’s programs on ABC’s television stations. Evaluate the economic merits of this claim.AppenidxLO1
Company T is currently valued at $50 in the market. A potential acquirer, A, believes that it can add value in two ways: $15 of value can be added through better working capital management, and an additional $10 of value can be generated by making available a unique technology to expand T’s new
You have been hired by GS Investment Bank to work in the merger department. The analysis required for all potential acquisitions includes an examination of the target for any off-balance-sheet assets or liabilities that have to be factored into the valuation.Prepare a checklist for your
The Boston Tea Company plans to acquire Hi Flavor Soda Co. for $60 per share, a 50 percent premium over current market price. John E. Grey, the CFO of Boston Tea, argues that this valuation can easily be justified, using a price-earnings analysis.“Boston Tea has a price-earnings ratio of 15, and
Kim Silverman, CFO of the First Public Bank Company, notes: “We are fortunate to have a cost of capital of only 10 percent. We want to leverage this advantage by acquiring other banks that have a higher cost of funds. I believe that we can add significant value to these banks by using our lower
In the 1980s leveraged buyouts (LBOs) were a popular form of acquisition. Under a leveraged buyout, a buyout group (which frequently includes target management)makes an offer to buy the target firm at a premium over its current price. The buyout group finances much of the acquisition with debt
During the early 1990s there was a noticeable increase in mergers and acquisitions between firms in different countries (termed cross-border acquisitions). What factors could explain this increase? What special issues can arise in executing a crossborder acquisition and in ultimately meeting your
Mary Saxon, a Dutch investment banker, is advising a local client on a potential foreign acquisition in the U.S. Currently, there is a competing cash bid for the target by a U.S. competitor. However, Saxon argues that the target should be worth more to the Dutch client than to the U.S. competitor,
A leading retailer finds itself in a financial bind. It doesn’t have sufficient cash flow from operations to finance its growth, and is close to violating the maximum debt-toassets ratio allowed by its covenants. The Vice-President for Marketing suggests:“We can raise cash for our growth by
A banker argues: “I avoid lending to companies with negative cash from operations because they are too risky.” Is this a sensible lending policy?AppenidxLO1
Can Cambridge improve its Z score by behaving as the analyst claims in Question 6?Is this change consistent with economic reality?AppenidxLO1
Cambridge Construction Company follows the percentage-of-completion method for reporting long-term contract revenues. The percentage of completion is based on the cost of materials shipped to the project site as a percentage of total expected material costs. Cambridge’s major debt agreement
Betty Li, the CFO of a company applying for a new loan, argues: “I will never agree to a debt covenant that restricts my ability to pay dividends to my shareholders, because it reduces shareholder wealth.” Do you agree with this argument?AppenidxLO1
Many debt agreements require borrowers to obtain the permission of the lender before undertaking a major acquisition or asset sale. Why would the lender want to include this type of restriction?AppenidxLO1
Some have argued that the market for original-issue junk bonds developed in the late 1970s as a result of a failure in the rating process. Proponents of this argument suggest that rating agencies rated companies too harshly at the low end of the rating scale, denying investment grade status to some
Why would a company pay to have its public debt rated by a major rating agency(such as Moody’s or Standard and Poor’s)? Why might a firm decide not to have its debt rated?AppenidxLO1
What are the critical performance dimensions for (a) a retailer and (b) a financial services company that should be considered in credit analysis? What ratios would you suggest looking at for each of these dimensions?AppenidxLO1
Joe states: “I can see how ratio analysis and valuation help me do fundamental analysis, but I don’t see the value of doing strategy analysis.” Can you explain to him how strategy analysis could be potentially useful?AppenidxLO1
Intergalactic Software Company’s stock has a market price of $20 per share and a book value of $12 per share. If its cost of equity capital is 15 percent and its book value is expected to grow at 5 percent per year indefinitely, what is the market’s assessment of its steady state return on
Joe Klein is an analyst for an investment banking firm that offers both underwriting and brokerage services. Joe sends you a highly favorable report on a stock that his firm recently helped go public and for which it currently makes the market. What are the potential advantages and disadvantages in
Many market participants believe that sell-side analysts are too optimistic in their recommendations to buy stocks, and too slow to recommend sells. What factors might explain this bias?AppenidxLO1
There are two major types of financial analysts: buy-side and sell-side. Buy-side analysts work for investment firms and make stock recommendations that are available only to the management of funds within that firm. Sell-side analysts work for brokerage firms and make recommendations that are used
Three months ago, Intergalactic Software Company went public. You are a sophisticated investor who devotes time to fundamental analysis as a way of identifying mispriced stocks. Which of the following characteristics would you focus on in deciding whether to follow this stock?• The market
Investment funds follow many different types of investment strategies. Income funds focus on stocks with high dividend yields, growth funds invest in stocks that are expected to have high capital appreciation, value funds follow stocks that are considered to be undervalued, and short funds bet
What is the difference between fundamental and technical analysis? Can you think of any trading strategies that use technical analysis? What are the underlying assumptions made by these strategies?AppenidxLO1
Geoffrey Henley, a professor of finance, states: “The capital market is efficient. I don’t know why anyone would bother devoting their time to following individual stocks and doing fundamental analysis. The best approach is to buy and hold a welldiversified portfolio of stocks.” Do you agree?
Despite many years of research, the evidence on market efficiency described in this chapter appears to be inconclusive. Some argue that this is because researchers have been unable to link company fundamentals to stock prices precisely. Comment.AppenidxLO1
Nancy Smith says she is uncomfortable making the assumption that Sigma’s dividend payout will vary from year to year. If she makes a constant dividend payout assumption, what changes does she have to make in her other valuation assumptions to make them internally consistent with each
Can accounting distortions, if not recognized by an analyst, affect cash flow-based valuations? Construct a numerical example to verify your answer.AppenidxLO1
Can accounting analysis improve accounting-based valuations? Explain why or why not.AppenidxLO1
Calculate the proportion of terminal values to total estimated values of equity and assets under the abnormal earnings method and the discounted cash flow method.Why are these proportions different?AppenidxLO1
Verify the terminal value calculations in Table 12-9. How will the terminal values in Table 12-9 change if the sales growth in years 2004 and beyond is 5 percent(keeping all the other assumptions in the table unchanged)?AppenidxLO1
Verify the present value calculations in Table 12-3. How will the present values in the table change if the cost of equity changes to 15 percent?AppenidxLO1
Calculate Sigma’s dividend payments in the years 1999–2003 implicitly assumed in the projections in Table 12-2. How will these payments change if the ratio of net debt to net capital is changed from 40 percent to 50 percent?AppenidxLO1
Recalculate the forecasts in Table 12-2 assuming that the ratio of net operating working capital to sales is 30 percent, and the ratio of net long-term assets to sales is 50 percent. Keep all the other assumptions unchanged.AppenidxLO1
Recalculate the forecasts in Table 12-2 assuming that the NOPAT profit margin declines by 1.5 percent per year (keep all the other assumptions unchanged).AppenidxLO1
Verify the forecasts in Table 12-2. How will the forecasts change if the assumed growth rate in sales from 1999 to 2003 is changed to 15 percent (and all the other assumptions are kept unchanged)?AppenidxLO1
Janet Stringer argues that “the DCF valuation method has increased managers’focus on short-term rather than long-term performance, since the discounting process places much heavier weight on short-term cash flows than long-term ones.”Comment.AppenidxLO1
Starite Company is valued at $20 per share. Analysts expect that it will generate free cash flows to equity of $4 per share for the foreseeable future. What is the firm’s implied cost of equity capital?AppenidxLO1
Free cash flows (FCF) used in DCF valuations discussed in the chapter are defined as follows:FCF to debt and equity = Earnings before interest and taxes × (1 – tax rate)+ Depreciation and deferred taxes – Capital expenditures –/+ Increase/decrease in working capital FCF to equity = Net
What type of companies have:a. a high PE and a low market-to-book ratio?b. a high PE ratio and a high market-to-book ratio?c. a low PE and a high market-to-book ratio?d. a low PE and a low market-to-book ratio?AppenidxLO1
How can a company with a high ROE have a low PE ratio?AppenidxLO1
Analysts reassess Manufactured Earnings’ future performance as follows: growth in book value increases to 12 percent per year, but the ROE of the incremental book value is only 15 percent. What is the impact on the market-to-book ratio?AppenidxLO1
Given the information in question (3), what will be Manufactured Earnings’ stock price if the market revises its expectations of long-term average ROE to 20 percent?AppenidxLO1
Manufactured Earnings is a “darling” of Wall Street analysts. Its current market price is $15 per share, and its book value is $5 per share. Analysts forecast that the firm’s book value will grow by 10 percent per year indefinitely, and the cost of equity is 15 percent. Given these facts,
Explain why terminal values in accounting-based valuation are significantly less than those for DCF valuation.AppenidxLO1
Joe Watts, an analyst at EMH Securities, states: “I don’t know why anyone would ever try to value earnings. Obviously, the market knows that earnings can be manipulated and only values cash flows.” Discuss.AppenidxLO1
Joe Fatcat, an investment banker, states: “It is not worth my while to worry about detailed long-term forecasts. Instead, I use the following approach when forecasting cash flows beyond three years. I assume that sales grow at the rate of inflation, capital expenditures are equal to depreciation,
How would the following events (reported this year) affect your forecasts of a firm’s future net income?• an asset write-down• a merger or acquisition• the sale of a major division• the initiation of dividend payments AppenidxLO1
What factors are likely to drive a firm’s outlays for new capital (such as plant, property, and equipment) and for working capital (such as receivables and inventory)?What ratios would you use to help generate forecasts of these outlays?AppenidxLO1
Which of the following types of businesses do you expect to show a high degree of seasonality in quarterly earnings? Explain why.• a supermarket• a pharmaceutical company• a software company• an auto manufacturer• a clothing retailer AppenidxLO1
John Right, an analyst with Stock Pickers Inc., claims: “It is not worth my time to develop detailed forecasts of sales growth, profit margins, etcetera, to make earnings projections. I can be almost as accurate, at virtually no cost, using the random walk model to forecast earnings.” What is
Merck is one of the largest pharmaceutical firms in the world. In the period 1985 to 1995 Merck consistently earned higher ROEs than the pharmaceutical industry as a whole. As a pharmaceutical analyst, what factors would you consider to be important in making projections of future ROEs for Merck?
In a period of rising prices, how would the following ratios be affected by the accounting decision to select LIFO, rather than FIFO, for inventory valuation?• Gross margin• Current ratio• Asset turnover• Debt-to-equity ratio• Average tax rate AppenidxLO1
What are the potential benchmarks that you could use to compare a company’s financial ratios? What are the pros and cons of these alternatives?AppenidxLO1
What ratios would you use to evaluate operating leverage for a firm?AppenidxLO1
ABC Company recognizes revenue at the point of shipment. Management decides to increase sales for the current quarter by filling all customer orders. Explain what impact this decision will have on:• Days receivable for the current quarter• Days receivable for the next quarter• Sales growth
What are the reasons for a firm having lower cash from operations than working capital from operations? What are the possible interpretations of these reasons?AppenidxLO1
Joe Investor claims: “A company cannot grow faster than its sustainable growth rate.” True or false? Explain why.AppenidxLO1
In 1995 Chrysler has a return on equity of 20 percent, whereas Ford’s return is only 8 percent. Use the decomposed ROE framework to provide possible reasons for this difference.AppenidxLO1
James Broker, an analyst with an established brokerage firm, comments: “The critical number I look at for any company is operating cash flow. If cash flows are less than earnings, I consider a company to be a poor performer and a poor investment prospect.” Do you agree with this assessment? Why
Which of the following types of firms do you expect to have high or low sales margins?Why?• a supermarket• a pharmaceutical company• a jewelry retailer• a software company AppenidxLO1
Which of the following types of firms do you expect to have particularly high or low asset turnover? Explain why.• a supermarket• a pharmaceutical company• a jewelry retailer• a steel company AppenidxLO1
The CFO of a large bank argues: “It is ridiculous to recognize any fair-value gains or losses on our debt instruments that we intend holding to maturity. Since we intend holding these securities, we are insulated from the whims of the market.” Do you agree? Explain why or why not. Given your
In a meeting of the Board of Directors over a proposal to restructure, a firm’s CEO states: “I recommend we take as large a charge against current earnings as our auditors will permit, since Wall Street will love us for being tough. Further, in future years our earnings will look improved,
In its 1998 annual report, Eastman Kodak reported the following information on its stock option program:Pro forma net earnings and earnings per share information, as required by SFAS No.123, “Accounting for Stock-Based Compensation,” has been determined as if the Company had accounted for
Eastman Kodak reported the following information on inventory valuation in its 1998 annual report:(In millions) 1998 1997 At FIFO or average cost (approximates current cost) $ 907 $ 788 Work in process 569 538 Raw materials and supplies 439 460 1,915 1,786 LIFO reserve (491) (534)Total $1,424
In the contingent liability section of its 1998 annual report, Dow Chemical Company reported the following:Accruals for environmental matters are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based on current law and
A firm hires a 27-year-old MBA at a salary of $85,000 for the first year. It also agrees to provide a pension upon retirement at age sixty-five and estimates that the present value of that pension is $150,000. What forecasts did management have to make to estimate this value? What factors determine
Procter and Gamble is a consumer products firm that owns such brands as Pampers diapers, Crisco vegetable shortening, Tide laundry detergent, and Crest toothpaste.In its 1998 annual report, the company reported: “Worldwide marketing, research and administrative expenses were $10.04 billion
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