This case continues the financial statement analysis of Procter & Gamble Co. begun in Minicase 9.1 and developed further in Minicase 11.1. This final installment covers issues in dealing with core income. Financial statements for Procter & Gamble are presented in Exhibit 9.15 in Chapter 9. If you worked Minicase 9.1, you will have reformulated the income statements and balance sheets to distinguish operating activities from financing activities. This case refines the re- formulation to identify core, sustainable earnings. If you worked Minicase 11.1, you will have carried out an analysis of profitability. This case adds an analysis of growth. To start, calculate residual earnings for the years 2006-2008 and note changes over time. Use a required return of 8.5 percent. The risk-free rate was about 4.5 percent in 2008, so an 8.5 percent required return implies a 4 percent risk premium suitable for a firm with a beta less than 1.0. What is the trend? Does P&G appear to be a growth company? Com- ment on the change in residual earnings from 2006 to 2007. For valuation, we are interested in the residual earnings (growth) that a firm can deliver in the future. These past residual earnings numbers are affected by transitory carings that do not bear on the future. So cut to the core: Reformulate the income statement further to identify care (sustainable) income. For Procter & Gamble, this is fairly straightforward, but the accounting for its defined benefit pension plans poses problems. The information given to you at the bottom of the case will be helpful. With sustainable earnings identified, identify core profit margins and carry out an analy- sis of core profitability (core return on net operating assets). Explain how core profitability changed from year to year. Finally, forecast operating income and total eamings for 2009 based on your analysis. What is your forecast of return on net operating assets (RNCA) for 2009? What is your forecast of residual earnings for 2009? Information needed to identify core earnings: 1. Look at the information provided with the financial statements in Exhibit 9.1. 2. The following, from the pension footnote, gives details of the net pension cast included in earnings and also the expected rate of return applied to pension assets. Net periodic benefit cost. Components of the net periodic benefit cost were as follows: Years Ended June 30 2008 2007 2006 2008 2007 2006 Pension Benefits Other Retiree Benefits Service cost $ 263 $ 279 $265 595 5.85 597 interest cost 539 4765 383 236 206 179 Expected return on plan assets (557) (454) (353) (429) (407) 1372] Prior service cost credit amortization 14 13 7 (21) (22) (22) Net actuarial loss amortization 9 45 76 7 2 E Curtailment and settlement gain (36) [176 (1) Gross benefit cost (credit) 232 183 374 (123) (137) (112) Dividends on ESCP prefered stock (85) (78) Net periodic benefit cost (credit) 232 183 374 (218) (190) Assumption used to determine net periodic benefit cost: Years Ended June 30 2008 2007 2008 2007 Other Pension Benefits (%) Retiree Benefits (5%) Discount rate 3.5% 5.2% 6.3% 6.3% Expected return on plan assets 74 72 9.3 9.3 Rate of compensation increase 3.1 30 The pension footnote has the following narrative: Several factors are considered in developing the estimate for the long-term expected rate of re- tum on plan assets. For the defined benefit retirement plans, these include historical rates of return of broad equity and bond indices and projected long-term rates of return obtained from pensive investment consultants. The expected long-term rates of return for plan assets are 8% -9% for equities and 5%-6% for bonds. For other retiree benefit plans, the expected long- term rate of return reflects the fact that the assets are comprised primarily of Company stock. The expected rate of return on Company stock is based on the long-term projected return of 9.5% and reflects the historical pattern of favorable returns What issues does this raise? Real World Connection Minicases M9.1, M11.1, M14.1, and M15.1 also cover Procter & Gamble.