Practise Exam

Question 1 (5 points)

Solution
1. ∆CSE ≠ Comprehensive income – Net payout

2. Free cash flow ≠ OI – ∆NOA

3. Net interest is not after tax

4. Net interest expense is constant while net financial obligations are

growing
Question 2 (5 points)
Below is an excerpt from the cash flow statement of a firm for fiscal year 2003:

Fiscal Year Ended

December 31, 2003
Cash flows from operating activities:
Net income $1,500
Adjustments to reconcile net
income to net cash provided by
operating activities:
Depreciation and amortization 250
Amortization of software 400
Tax benefits of employee 450
stock plans
Special charges 200
(Gains)/losses on investments 20
Change in operating assets and liabilities:
Receivables 600
Inventories 250
Pension assets (475)
Other assets 70
Accounts payable (50)
Pension liabilities 85
Other liabilities __200

Net cash provided by _3,500

operating activities

Cash flows from investing activities:

Payments for plant and other (2,000)
property
Proceeds from disposition of plant 800
and other property
Investment in software (500)
Purchases of marketable securities (1,500)
and other investments
Proceeds from disposition of 1,200
marketable securities and
other investments _____

Net cash used in investing (2,000)

activities __

Additional information:

Cash interest receipts 110

Cash interest payments (200)

From the reformulated equity statement:

Shareholders’ equity December 31, 2002 5,500

Shareholders’ equity December 31, 2003 4,760
Net payout to shareholders 2,500

The firm’s tax rate is 35%.

Solution

Required:

a. Calculate free cash flow for 2003.

Cash from operations, reported 3,500.0

Net interest payments (200-110) 90
Tax @ 35% 31.5 58.5
Cash from operations 3,558.5
Cash investments reported 2,000
Net purchases of financial assets (1500 – 1200) 300 1,700.0
FREE CASH FLOW 1,858.5

b. Calculate net payments to debt holders and issuers for 2003.

Free cash flow = C–I = d + F

1,858.5 2,500 ?

? = – 641.5 (cash in from debt holders and issuers)

c. Calculate comprehensive income for 2003.

Comprehensive income = CSE + Net Payout to Shareholders

= – 740 + 2,500
= 1,760
Question 3 (5 points)
The following are summary income statement and balance sheet numbers for a firm (in
millions of dollars). The firm has a required return for operations of 9%.

2002 2003 2004 2005

Sales 1,906 1,985 2,064 2,147

Core operating expenses 1,773 1,846 1,919 1,997
Core operating income 133 139 145 150
Unusual operating income ------ ----- (45) 60
133 139 100 210
Net financial expense 7 8 8 9
Comprehensive income 126 131 92 201

Net operating assets 945 983 1,022 1,063

Net financial obligations 150 155 175 120
Common equity 795 828 847 943

(a) Prepare a table on the next page giving the following for 2003- 2005. Use beginning-
of-period balance sheet numbers in denominators.

▪ Return on common equity (ROCE)

▪ Return on net operating assets (RNOA)
▪ Core return on net operating assets (Core RNOA)
▪ Free cash flow
▪ Net payments to common shareholders
▪ Net payments to net debt holders
▪ Asset turnover
▪ Core profit margin
▪ Growth rate for net operating assets

Solution

2003 2004 2005

ROCE 16.48% 11.11% 23.73%
RNOA 14.71% 10.17% 20.55%
Core RNOA 14.71% 14.75% 14.68%

OI – ΔNOA = FCF 101 61 169

CI – ΔCSE = Net dividend (d) 98 73 105

 F = FCF – d 3 (12) 64

ATO 2.1 2.1 2.1

Core PM 7.0% 7.0% 7.0%

g (NOA) 4.02% 4.0% 4.0%

Question 4 (5 points)
Describe and explain the following concepts:
1) Normal P/B ratio
A normal P/B implies that the Residual Earnings (RE) of the firm are expected to be 0. That is, the
firm is expected to neither generate nor destroy value, but rather to earn exactly the required rate
of return on its operations.
2) Profit Margin
Profit margin measures the firms ability to turns sales revenues into earnings. It is defined as
earnings / sales. Firms with higher profit margins may sustain lower asset turnover whilst still
generating high RNOA.

3) Abnormal Earnings Growth

Abnormal Earnings growth (AEG) measures the ability of the firm to increase residual earnings
through time. AEG can be defined as the cum-dividend earnings – normal earnings. Cum dividend
earnings includes both current earnings and earnings on last years dividends, ie [[𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝒕 +
𝑾𝑨𝑪𝑪 ∗ 𝒅𝒕−𝟏 ] while normal earnings is last periods earnings from the firm, increased by the wacc.
Since normal earnings are growing at the required rate of return, the only additional value we
should be willing to pay for is growth in excess of this required rate.

4) Operating Leverage
Operating Leverage measures the reduction in net operating assets which has been achieved by
using operating liabilities. In effect, you are borrowing some of the required assets of the firm
from your suppliers. It may be measured u sing Operating liabilities / Net Operating Assets.

5) Residual Operating Income

Residual Operating Income measures the ability of the firm to earn more than the required rate of
return on the Net Operating Assets. Unlike Residual Earnings, this measure compares the total
assets employed to the earnings of the entire firm. As such, the WACC is used as the required
return. Any earning of the firm above the required rate on employed operating assets generate
additional value for shareholders, and create value. However, if the firm earns less than the
required rate, the Residual Operating Income will be negative, identifying value destruction.
The formula is 𝑹𝒆𝑶𝑰𝒕 = 𝑶𝑰𝒕 − 𝑾𝑨𝑪𝑪 ∗ 𝑵𝑶𝑨𝒕−𝟏
Question 5 (5 points)
At the end of the fiscal year ending June 30, 2003, Microsoft reported common
equity of $64.9 billion on its balance sheet, with $49.0 billion invested in
financial assets (in the form of cash equivalents and short term investments) and
no financing debt. For fiscal year 2004, the firm reported $7.4 billion in
comprehensive income, of which $1.1 billion was after-tax earnings on the
financial assets.

This month Microsoft is distributing $34 billion of financial assets to

shareholders in the form of a special dividend.

a. Calculate Microsoft’s return on common equity (ROCE) for 2004.

ROCE = 7.4/64.9 = 11.40%

b. Holding all else constant what would Microsoft’s ROCE be after the
payout of $34 billion?

Income statement after payout

OI 6.30 (As before: 7.4 – 1.1 = 6.3)

NFI (15 × 0.0224) 0.34 (NFA = 49 – 34 = 15)
Comp. income 6.64 (Rate of return = 1.1/49 = 0.0224)
CSE = 64.9 – 34.0 = 30.9
ROCE = 6.64/30.9 = 21.49%

Also, with new FLEV of – 0.485,

ROCE = 39.62 (– 0.485 × (39.62 – 2.24))
= 21.49%
 c. Would you expect the payout to increase or decrease earnings
growth in the future? Why?

Increasing leverage always increases expected earnings growth. The

payout increases leverage (in this case, it makes the leverage less
negative).

d. What effect would you expect the payout to have on the value of a
Microsoft share?

The per-share value of the shares will drop by the amount of the dividend
per share.

[Note: if the payout were via a share repurchase, there would be no effect
on per-share value]

Question 6 (5 points)
The following is a comparative balance sheet for a firm for fiscal year 2002 (in millions of
dollars):

2002 2001 2002 2001

Operating cash 60 50 Accounts payable 1,200 1,040
Short-term investments
550 500 Accrued liabilities 390 450
(at market)
Accounts receivable 940 790 Long-term debt 1,840 1,970
Inventory 910 840
Property and plant 2,840 2,710 Common equity 1,870 1,430
5,300 4,890 5,300 4,890

The following is the statement of common shareholders’ equity for 2002 (in millions of
dollars):
 Balance, end of fiscal year 2001 1,430
Share issues from exercised employee stock options 810
Repurchase of 24 million shares (720)
Cash dividend (180)
Tax benefit from exercise of employee stock options 12
Unrealized gain on investments 50
Net income 468
Balance, end of fiscal year 2002 1,870

The firm’s income tax rate is 35%. The firm reported $15 million in interest income and $98
million in interest expense for 2002. Sales revenue was $3,726 million.

a. Calculate the loss to shareholders from the exercise of employee stock options during
2002.

12
Compensation expense = = 34
0.35

Tax Benefit 12
Compensation, after tax 22

b. The shares repurchased were in settlement of a forward purchase agreement. The

market price of the shares at the time of the repurchase was $25 each. What was the
effect of this transaction on the income for the shareholders?

Market price of shares repurchased 25

Amount paid for shares 720/24 million 30
Loss per share 5
No. of shares 24 million
$120 million

[These losses are not tax deductible]

c. Prepare a comprehensive income statement that distinguishes after-tax operating
income from financing income and expense. Include gains or losses from the
transactions in questions (a) and (b) above.

Sales 3,726
Operating expenses (3,204)
OI before stock compensation 522
Compensation with options (22)
Operating income 500

Interest expense 98
Interest income (15)
83
Tax benefit 29
54
Unrealized gain on investments (50)
Put option losses 120 (124)
Comprehensive income 376

Comprehensive income = 468 + 50 – 22 – 120 = 376

All other items are unknown, except operating expense that can be
plugged

Question 7
Solution
Profitability Measures for Kimberly-Clark Corporation

The exercise is best worked by setting up the reformulations balance sheet:

2007 2006

Operating assets $18,057.0 $16,796.2

Operating liabilities 6,011.8 5,927.2
Net operating assets (NOA) 12,045.2 10,869.0 a (1)

Financial obligations $6,496.4 $4,395.4

Financial assets 382.7 6,113.7 270.8 4,124.6 a (2)

Common equity (CSE) $ 5,931.5 $ 6,744.4 a (3)

a.

The answers to question (a) are indicated beside the reformulated statement.

b.

Comprehensive income = 2,740.1 – 147.1 = 2,593 million

ROCE = 2,593/6,744.4 = 38.45%

RNOA – 2,740.1/10,869.0 = 25.21%

FLEV = NFO/CSE = 4,124.6/6,744.4 = 0.612

NBC = 147.1/4,124.6 = 3.57%

c.

The financial leveraging equation is:

ROCE = RNOA + [FLEV  (RNOA – NBC)]

= 25.21% + [0.612 × (25.21% - 3.57%)]

= 38.45%

d.
 On sales of $18,266 million for 2007,

PM = 2,740.1/18,266 × ATO = 18,266/10,869

15.00% × 1.68

= 25.2%

Question 8

Solution

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

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