This case continues the financial statement analysis of Procter& Gamble Co. begun in Mini case 9.1 and developed further in Mini case 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 Mini case 9.1, you will have reformulated the income statements and balance sheets to distinguish operating activities from financing activities. This case refines the reformulation to identify core, sustainable earnings. If you worked Mini case 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? Comment 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 earnings that do not bear on the future. So cut to the core: Reformulate the income statement further to identify core (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 analysis of core profitability (core return on net operating assets). Explain how core profitability changed from year to year.

Finally, forecast operating income and total earnings for 2009 based on your analysis. What is your forecast of return on net operating assets (RNOA) for 2009? What is your forecast of residual earnings for2009?

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 cost 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:

The pension footnote has the following narrative:
Several factors are considered in developing the estimate for the long-term expected rate of return 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 pension investment consultants. The expected long-term rates of return for plan assets are 8%-9% for equities and5%---6%forbonds. 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 thisraise?

Year rs Ended June 30 2008 2007 2006 2008 2007 2006 Pension Benefits Other Retiree Benefits Service cost Interest cost 263 279 255 $95$8S 97 539 383 226 476 Experted return on plan assets (557) (45435 (429 (407 372) 206 179 Prir service cost (credit) amortization 14 (21) 22 (22) 13 45 Net atuarial loss amortization 75 Curtailnent and settlement gain Gross benefit cost credit) Dividends on ESOP preferred (36) 76) 232 183 374 (123) i37 12) (95 5 7B) 74 (218) (190) stock Net periodic benefit cost (credit) 232133 Assunption used to deternmine net periodic beneft cost Years Ended June 30 2008 2007 2008 2007 Other Retiree Benefits (%) Pension Benefits (%) 5.5% 3.1 Discount rate Expected return on planssets Rate of compensation increase 52% 7.2 3,0 63% 9.3 6.3% 74 9.3