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YORK UNIVERSITY

SCHULICH SCHOOL OF BUSINESS


ACTG 3000 A
FINANCIAL STATEMENT ANALYSIS
MIDTERM EXAMINATION
November 8, 2016

TIME: 120 Minutes


INSTRUCTOR: Dr. Giri Kanagaretnam

Please read the following instructions very carefully.

Identify yourself on each answer book you use.

You are permitted to have one page of 8.5 X 11 paper with writing on both sides and a
calculator that does not store text.

The exam has 6 pages (including the cover page), 4 questions, and a total of 100 marks.

Make any necessary assumptions and state your assumptions in your answer.

All questions must be answered in the exam answer books distributed during the exam. Extra
booklets will be provided upon request. Work handed in on the question sheet or materials
not distributed during the exam will NOT be graded.

Do not tear out pages from any exam booklets.

Please do not write on unlined pages.

You must hand in the question sheet and the answer booklet(s) at the end of the examination.
Please place the question sheet and the one page notes (cheat sheet) within your answer
booklet(s).

Number each booklet: 1of X, 2 of X, 3 of X, etc.

Please do not leave the room without the proctors knowledge.

Do not communicate with anyone except the proctor.

Good Luck!!!
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Question 1 (30 marks)


You are an analyst who is interested in Pistachio Ltd that is listed in Nut City. Pistachio operates
in a very competitive environment where most companies, including its closest rival Almond
Ltd, which employs the cost leadership strategy. Almonds products are close substitutes to those
from Pistachio.
The following are some information on Pistachios financial data for year 2015:

Selected financial data on 31 December 2015:

Items
Current Assets*1
Non-Current Assets
Current Liabilities *2
Non-Current liabilities *3

2015
($ millions)
400
1,200
230
1,000

*1

Pistachio does not have any cash or marketable securities


Pistachio does not have any short-term debt or current portion of long-term debt due.
*3
All non-current liabilities are interest-bearing liabilities.

*2

Pistachios sales revenue and net income for 2015 were $1,600 million and $40 million
respectively. It incurred an interest expense of $120 million in 2015.
You are to ignore any taxation effects in your calculations.
Required
(a)

Decompose Pistachios ROE using the Advanced Dupont Model (also known as the
alternative approach). You are to base your calculation on year-end equity instead of
average equity or beginning equity.
(15 marks)

Question 1 (continued)
(b)

Assume that you have decomposed Almond Ltds ROE as follows:

Almond

Net
Operating
Margin
(NOM)

Net
Operating
Asset
Turnover
(NOAT)

Spread = Return on
Net Operating Asset
(RNOA) less Net
Borrowing Cost
(NBC)

7%

2.5

2%

Leverage =
Net Financial
Obligation
(NFO)
Common
Equity
1.25

ROE

20%

Compare Pistachios performance to that of Almond Ltd. What would you recommend to
Pistachio in order to improve its ROE?
(10 marks)
(c) Allen an independent financial consultant has done some research and found that Almond
Ltd has an excellent credit rating. He concluded that Almonds incremental borrowing cost
will still be below its return on net operating asset (RNOA) even if the company were to
increase its financial leverage. As a result, he commented that Almond could have performed
even better if it had increased its leverage. To what extent do you agree with Allens
comment? Explain your answers.
(5 marks)

Question 2 (30 marks)


Callmenow is a firm that designs, manufactures and sells mobile phones. The book value of
equity for Callmenow on January 1, 2016 is $60,000. The risk free rate is 6% and the equity risk
premium is 10%. As an analyst, you are assigned to determine Callmenows fundamental value
and make investment recommendations. You estimate that the companys beta is 0.4. In addition,
you have the following forecasts:
December 31 of

2016

2017

2018

2019

2020

Net income.

$14,000

$13,650

$12,865

$12,501

$13,002

Dividends

$6,000

$7,500

$8,000

$11,500

$11,822

For 2021 and beyond, the residual income (also known as abnormal earnings) is predicted to
approximate Year 2020 level forever.
Required
(a)

Calculate Callmenow Companys residual income for each of the years from Year 2016
to Year 2020. Use the residual income model to estimate the value of Callmenows
equity. Callmenow has 10,000 shares outstanding and the current market price is $14 per
share. Will you recommend investing in the firm?
(15 marks)

(b)

You wonder why your intrinsic value estimated from (a) deviates from the current market
price. You call up the CEO of Callmenow and he agrees with all your forecasts except
the terminal growth rate estimate. He believes that the residual income will grow at the
rate of 5% per year from the year 2020 level for year 2021 and beyond, as a result of the
firms successful R&D program. Whats your new estimate of the firms equity value?
(5 marks)
Your colleague, Pete, does not like the residual income model. He believes that you
should use the price multiple approach instead. What are the pros and cons of the price
multiple approach?
(5 marks)

(c)

(d)

The CEO of Callmenow tells you that the firm is planning to use more environmentally
friendly materials to make the mobile phones. Since this change will increase the
manufacturing costs, he is concerned that the firms intrinsic value will decrease as a
result. Please provide two reasons why this change may not necessarily reduce the firms
intrinsic value.
(5 marks)

Question 3 (20 marks)


Diva Limited is the parent company of a group of global subsidiaries that specializes in the
design, production and distribution of apparel and accessories for extreme sports. The extreme
sports industry is defined by youth culture, youths aged 12 to 24, and is forecasted to grow at a
rate of 15% to 18% annually. The industry is made up of several dozens of giant global brands
and is intensely competitive.
In the companys quest for product innovation and design to pursue its differentiation strategy,
Diva Limited incurred substantial research and development costs in the past few years, which
amount to $90 million, $105 million, $120 million, and $135 million for the years ended 2012,
2013, 2014, and 2015 respectively. The research and development costs were expensed off in the
companys income statement in the years they were incurred.

Required
As part of the accounting analysis process, you decide that Divas accounting treatment to
expense its research and development costs does not meaningfully reflect the companys
underlying business economics. You estimate that 40% of Divas research and development
costs in each year should be capitalized and amortized on a straight-line basis, from the
beginning of the following year over a three-year period.

Compute the effect of capitalizing the research and development costs on Divas income
statements and balance sheets for the financial years 2014 and 2015. Ignore any potential tax
effects.
(20 marks)

Question 4 (20 Marks)


You are an analyst following Milky Cow Limited, a listed company in Canada that produces
milk powder and milk-related products. You noticed that Milky Cow has very minimal capital
leases recorded on its balance sheet while most other companies in its industry have substantial
amount of capital leases. Below is the footnote disclosure about the leases from the financial
report of Milky Cow for the year ending December 2011. The aggregate amounts of minimum
lease liabilities to third parties, under non-cancelable capital lease contracts and operating lease
contracts for the next five years and thereafter are as follows:
Year ending
Capital
Operating
December 31
Leases
Leases
(000s)
(000s)
2012
657
10,591
2013
555
20,440
2014
450
20,352
2015
416
20,133
2016
85
19,646
After 2016
20
39,000
Total minimum future rental payments
2,183
130,162
Less amount representing interest
437
Total obligations under capital lease
1,746
Less current portion
475
Long-term obligations under capital leases
1,271
In order to effectively evaluate Milky Cows financial position and compare it to industry
standards, you have decided to capitalize Milky Cows operating leases. To do so, you have
made the following assumptions: (i) Milky Cow uses a discount rate of 10% for the capital
leases; (ii) the after 2016 amount of $39,000 is paid evenly over two years, and (iii) all lease
payments are made at the end of each year.
Required:
(a) What would be the effect of the capitalization of operating leases on Milky Cows balance
sheet on 31 December 2011?
(10 marks)
(b) How would the capitalization of operating leases affect Milky Cows income statement in
2012? Ignore income tax effects. Be specific about the amount.
(6 marks)
(c) Provide two reasons as to why Milky Cow might prefer to account for a lease as an operating
lease rather than as a capital lease.
(4 marks)

- EndofExam
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Question 1
(a)

Net income = 40
NOI = 40 + 120 = 160
NOA = 400 + 1200 230 = 1370
RNOA = 160/1370 = 11.679%

(5 Marks)

OR
NOM = 160 1600 = 10 %
NOAT = 1600 1370 = 1.1679
Return on NOA (RNOA) = NOM NOAT = 10% 1.1679 = 11.679%
NFO = 1000
NBC = 120 1000 = 12%
Spread = RNOA NBC = 11.679% 12% = 0.321%

(5 Marks)

Equity = (400 + 1200) (230 +1000) = 370


OR Equity = NOA NFO = 1370 1000 = 370
Leverage = NFO Equity = 1000 370 = 2.703

(3 Marks)

ROE = RNOA + Spread Leverage = 11.679% + (0.321% 2.703) = 10.811%


(2 Marks)

(d)

The decomposition of ROE is summarized as follows:

Almond
Pistachio

NOM

NOAT

RNOA

Spread

Leverage

ROE

7%
10%

2.5
1.1679

17.5%
11.679%

2%
0.321%

1.25
2.703

20%
10.811%

Pistachios ROE is lower than that of Almonds for two main reasons:
(i)
(ii)

Pistachio has a negative spread; and


Pistachios NOAT is lower, leading to a lower RNOA. (2 Marks)

Therefore, you may recommend the following:

Pistachio may need to consider lowering its products selling prices. This is because the
industry is very competitive and most competitors are employing the cost leadership
strategy.GiventhatAlmondsproductsareclosesubstitutes,itisunlikelythatPistachiocan
command a premium on its products and earn a high NOM without adverse effect on its
sales. This is probably the main cause of its low NOAT. Lower prices will reduce NOM but
willincreaseNOAT.ThismayleadtohigherRNOAoverall.
(4Marks)

Pistachioshouldloweritsfinancialleverage.Itshighleverageleadtohighborrowingcost,
causingthespreadtobenegative.Loweringleveragewillbringdownitsnetborrowingcost,
thusincreasingitsspreadandROE.Somesuggestionsforloweringleverage:obtainhigher
equity,assetsales,andreducingworkingcapital.
(4Marks)

(e)

No. It is not necessarily beneficial for Almond to increase its leverage even if RNOA is
greater than its incremental borrowing cost.
(2 Marks)
While ROE will increase with higher leverage when RNOA > incremental borrowing
cost, the higher financial risk will increase Almonds required return on equity ke. If ke
increases more than increase in ROE, Almonds residual income will decrease and hence
adversely affect its stock price.
(3 Marks)

Question 2
a)
Residual
income

2016

2017

2018

2018

2019

$8,000

$6,850

$5,450

$4,600

$5,000
(10 marks)

Equity value = 114,323

(4 marks)

Given that the stock price of $14 is higher than the intrinsic value per share (i.e., $11.43), you
should recommend against investing in the firm.
(1 mark)
b)

The new estimate is $14.8.

Give comparison to market value and the new recommendation.

(5 marks)

c)

PRO: The price multiple approach is simple to use.


CON: it is difficult to find a truly comparable firm. Even firms in the same industry have
different strategies, growth opportunities and profitability.
(5 marks)
d) Reason 1: consumers may appreciate the firms efforts in protecting the environment and
therefore sales/price may increase as a result. It is possible that earnings will increase and so will
residual income.
Reason 2: the firms efforts to protect the environment may reduce the firms risk of being
sued for polluting the environment, which reduces the firms discount rate.
Reason 3: the firms efforts to protect the environment may increase the firms terminal
growth rate i.e., a way to sustain and grow competitive advantage (refer to part b).
You will get full marks if you provide two out of the above three reasons.
(2.5 marks for each reason)

Question 3 (20 Marks)


$000
R & D costs (100%)

2012
90,000

2013
2014
2015
105,000 120,000 135,000

Expensed R&D (60%)

54,000

63,000

72,000

81,000

Capitalized Amount (40%)

36,000

42,000

48,000

54,000
(4 marks)

12,000

12,000
14,000

12,000
14,000
16,000

26,000

42,000

Amortization expense:
2012 R&D costs
2013 R&D costs
2014 R&D costs

(4 marks)
Capitalized R&D costs, net:
Unamortized balance of 2012 costs
Unamortized balance of 2013 costs
Unamortized balance of 2014 costs
Unamortized balance of 2015 costs

12,000
28,000
48,000

0
14,000
32,000
54,000

Total

88,000

100,000
(4 marks)

Net income increased by $48m - $26m = $22m in 2014. (2 marks)


Net income increased by $54m - $42m = $12m in 2015. (2 marks)
Asset and equity increased by $88m and $100m in 2014 and 2015 respectively.
(2 marks each)

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Question 4 (20 Marks)


(a)
Present value of payments under the operating lease agreements
10,591 PV1, 10% = 10,591 .9091 =
20,440 PV2, 10% = 20,440 .8264 =
20,352 PV3, 10% = 20,352 .7513 =
20,133 PV4, 10% = 20,133 .6830 =
19,646 PV5, 10% = 19,646 .6209 =
19,500 PV6, 10% = 19,500 .5645 =
19,500 PV7, 10% = 19,500 .5132 =

9,628.27
16,891.62
15,290.46
13,750.84
12,198.20
11,007.75
10,007.40
88,774.54 (7 Marks)

The effect on the balance sheet as at December 31, 2011 is as follows:


Long term fixed assets and long-term liability both increased by $88,775
No change in Equity

(3 Marks)

(b) For the year ended December 31, 2012, the impact on income would be as follows:
Rental expense reduced by $10,591
Depreciation expense increased by $88,775/7= $12,682
Interest expense increased by $88775 x 0.1 = $8,878
Hence in total, expense will go up by $10,969 and pre-tax income will go down by $10,969
(6 Marks)
(c)

Reporting lease liability may increase leverage and hence leading to debt covenant
violation. Hence, there exists strong incentive for the firm to engage in off-balance sheet
financing by choosing operating lease rather than capital lease.

In this case, Capital lease will lower some profitability ratio such as ROA (earnings
decrease and assets increase). To the extent that bonuses are tied to ROA (or some other
profitability ratios), managers have incentives to choose operating lease rather than
capital lease.

Large firm is likely to attract public attention. By not recognizing capitalized assets
through operating leases, firms are not likely to attract public attention due to its smaller
asset size.
(4 Marks)

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