Solution Manual for Financial Statement Analysis

10th Edition by Subramanyam

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Solution Manual for Financial Statement Analysis 10th Edition by Subramanyam

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Chapter 9
Prospective Analysis
REVIEW
Prospective analysis is the final step in the financial statement analysis process. It
includes forecasting of the balance sheet, income statement and statement of cash
flows. Prospective analysis is central to security valuation. Both the free cash flow
and residual income valuation models described in Chapter 1 require estimates of
future financial statements. We provide a detailed example of the forecasting
process to project the income statement, the balance sheet, and the statement of
cash flows. We describe the relevance of forecasting for security valuation and
provide an example utilizing forecasted financial statements to implement the
residual income valuation model. We discuss the concept of value drivers and their
reversion to long-run equilibrium levels. In the appendix, we provide a detailed
example of short-term cash flow forecasting.

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OUTLINE
• The Projection Process
Projecting Financial Statements
Application of Prospective Analysis in the Residual Income Valuation Model
Trends in Value Drivers
• Short-term Forecasting (Appendix)

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ANALYSIS OBJECTIVES

• Describe the importance of prospective analysis.

• Explain the process of projecting the income statement, the balance sheet and the
statement of cash flows.

• Discuss and illustrate the Importance of Sensitivity Analysis.

• Describe the implementation of the projection process in the valuation of equity

securities.

• Discuss the concept of value drivers and their reversion to long-run equilibrium
levels.

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QUESTIONS
1. Prospective analysis is central to security valuation. All valuation models rely on
forecasts of earnings or cash flows that are, then, discounted back to the present to
arrive at the estimated value of the security. Prospective analysis is also useful to
examine the viability of companies’ strategic plans, that is, whether they will be able to
generate sufficient cash flows from operations to finance expected growth or whether
they will be required to seek external financing. In addition, prospective analysis is useful
to examine whether announcing strategies will yield the benefits expected by
management. Finally, prospective analysis can be used by creditors to assess
companies’ ability to meet debt service requirements.

2. Prior to the forecasting process, financial statements can be recast to better portray
economic reality. Adjustments might include elimination of transitory items or
reallocating them to past or future years, capitalizing (expensing) items that have been
expensed (capitalized) by management, capitalizing operating leases and other forms of
off-balance sheet financing, and so forth.

3. In addition to trend analysis, analysts frequently incorporate external (non-financial)

information into the prospective process. Some examples are the expected level of
macroeconomic activity, the degree to which the competitive landscape is changing, any
strategic initiatives that have been announced by management, and so forth.

4. The forecast horizon is the period for which specific estimates are made. It is usually 5-7
years. Forecasts beyond the forecast horizon are of dubious value since estimates are
uncertain.

5. Since all valuation models are infinite horizon models, analysts frequently assume a
steady state into perpetuity after the forecast horizon. A common assumption is that the
company will grow at the long-run rate of inflation, that is, remaining constant in real
terms.

6. The projection process begins with an expected growth in sales. Gross profit and
operating expenses are, then, estimated as a percentage of forecasted sales using
historical ratios and external information. Depreciation expense is usually estimated as a
percentage of beginning gross depreciable assets under the assumption that
depreciation policies will remain constant. Interest expense is usually estimated at an
average borrowing rate applied to the beginning balance of interest bearing liabilities.
Projections of expected interest rates are used for variable rate indebtedness and new
borrowings. Finally, tax expense is estimated using the effective tax rate on pre-tax
income.

7. In the first step, balance sheet items are projected using forecasted income sales (COGS)
and relevant turnover ratios. Long-term assets are projected using forecasted capital
expenditures. Long-term liabilities are projected from current maturities of long-term debt
disclosed in the debt footnote, and paid-in-capital is assumed to be constant in this
stage. Retained earnings are projected adding (subtracting) projected profits (losses) and
subtracting projected dividends. Once total liabilities and equities are forecasted, total
assets is set equal to this amount and forecasted cash is computed as the plug figure.

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In the second step, long-term liabilities and equities are adjusted to yield the desired level
of cash. The analyst must be careful to maintain the historical leverage ratio and adjust
liabilities and equities proportionately.

8. The residual income model expresses stock price as the book value of stockholders’
equity plus the present value of expected residual income (RI). Residual income can be
expressed in ratio form as,
RI = (ROEt – k) * BVt-1

Where ROE=NIt/BVt-1. This form highlights the fact that stock price is only impacted so
long as ROE ≠ k. In equilibrium, competitive forces will tend to drive rates of return (ROE)
to cost (k) so that abnormal profits are competed away. The estimation of stock price,
then, amounts to the projection of the reversion of ROE to its long-run value for a
particular company and industry. ROE is a value driver since it impacts our valuation of
the stock price. Its components (asset turnover and profit margin) are also value drivers

9. We can make two observations regarding the reversion of ROE:

a. ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition.
Furthermore, the reversion rate for the least profitable firms is greater than that for the
most profitable firms. And finally, reversion rates for the most extreme levels of ROE
are greater than those for firms at more moderate levels of ROE.

b. The reversion is incomplete. That is, there remains a difference of about 12% between
the highest and lowest ROE firms even after ten years. This may be the result of two
factors: differences in risk that are reflected in differences in their costs of capital (k);
or, greater (lesser) degrees of conservatism in accounting policies.

The reversion of ROA and NPM are similar. While some reversion of TAT is evident, it is
much less than that of the other value drivers.

10. Short-term cash forecasts are key to assessments of short-term liquidity. An asset is
called "liquid" because it will or can be converted into cash within the current period. The
analysis of short-term cash forecasts will reveal whether an entity will be able to repay
short-term loans as planned. This also means such analysis is extremely important for a
potential short-term credit grantor. Short-term cash forecasts often are relatively realistic
and accurate because of the shortness of the time span covered.

11. A cash forecast, to be most meaningful, must be for a relatively short-term period of time.
There are many unpredictable variables involved in the preparation of a reliable forecast
for a highly liquid asset such as cash. Over a long period of time (that is, beyond the time
span of one year), the difference in the degree of liquidity among items in the current
assets group is usually insignificant. What is more important for long time spans are the
projections of net income and other sources and uses of funds. The focus should be
shifted to working capital (and other accrual measures), and away from cash flows, for
longer forecast horizons of, say, thirty months—where the time required to convert
current assets into cash is insignificant.

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12. Cash inflows and outflows are highly interrelated. These two flows are crucial to a
company’s “circulation system." A deficiency in any part of the system can affect the
entire system. For example, a reduction or cessation of sales affects the vital conversion
of finished goods into receivables or cash, which in turn leads to a drop in the cash
reservoir. If the system is not strengthened by "transfusion" (such as additional
investment by owners or creditors), production must be curtailed or discontinued. Lack
of cash inflows also will reduce other expenses such as advertising, promotion, and
marketing expenses, which will further adversely affect sales. This can yield a vicious
cycle leading to business failure.

13. Most would agree with this assertion. Cash is the most liquid asset and when
management urgently needs to purchase assets or incur expenses, a cash exchange is
the quickest and easiest means to execute a transaction. Moreover, unless management
has a credit line established with a reliable outsider (such as a revolving account at a
bank), lack of cash can mean a permanent loss of profitable opportunities.

14. Ratio analysis is a static measurement tool. Ratios measure relations among financial
statement items as of a given moment and time. In contrast, funds flow analysis is a
dynamic measure covering a period of time. A dynamic model of funds flow analysis uses
the present only as a starting point and utilizes the best available estimates of future
plans and conditions to forecast the future availability and disposition of cash or working
capital. Analyzing funds flow also encompasses the projected operations of a company.
Since one of the fundamental assumptions of accounting is the going-concern concept,
some assert that the dynamic model is more realistic and is superior to static
representations. However, care should be taken in placing too much reliance on funds
flow analysis as it is primarily based on estimates, and not on realized observations.

15. Except for transactions involving the raising of money from external sources (such as
through loans or additional investments) and the investments of money in long-term
assets, almost all internally generated cash flows relate to and depend on sales.
Accordingly, the usual first step in preparing a cash forecast is to estimate sales for the
period under consideration. The reliability of any cash forecast depends on the accuracy
of this forecast of sales. In arriving at the sales forecast, the analyst should consider: (1)
past trends of sales volume, (2) market share, (3) industry and general economic
conditions, (4) productive and financial capacity, and (5) competitive factors, among
other variables.

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EXERCISES
Exercise 9-1 (45 minutes)

Projected Income Statement for Year 12

Quaker Oats Company

Forecasted Income Statement
For Year Ended June 30, Year 12

Revenues [given]................................................................. $6,000.0

Costs and expenses

Cost of goods sold [a] ................................................... $3,186.0

Selling, general, and administrative [b] ....................... 2,439.4

Other expenses [c] ........................................................ 35.2

Interest, net [d] ............................................................... 91.4

Total costs and expenses .................................................. 5,752.0

Income from continuing operations ................................. 248.0

Income taxes [e] .................................................................. 105.9

Income before discontinued operations .......................... 142.1

(Loss) on disposal of discontinued operations [given] ... (2.0)

Net income ........................................................................... $ 140.1

Notes:
[a] Cost of sales is estimated to be at a level representing the average percentage of cost of
sales to sales as prevailed in the four-year period ending June 30, Year 11, which is 53.1%
(19,909.2 – 9,331.3)/19,909.2. Therefore, 6,000 x .531 = $3,186.
[b] Selling, general & administrative expenses in Year 12 are expected to increase by the
same percentage as these expenses increased from Year 10 to Year 11, which is 15%.
Therefore, $2,121.2 x 1.15 = $2,439.4.
[c] Other expenses are expected to be 8% higher in Year 12. Therefore, 32.6 x 1.08 = $35.2.
[d] Interest expense (net of interest capitalized) and interest income will increase by 6% due
to increased financial needs. Therefore, $86.2 x 1.06 = $91.4
[e] The effective tax rate in Year 12 will equal that of Year 11, which is 42.7% ($175.7/$411.5).
Therefore, tax expense = $248 x .427 = $105.9.

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Exercise 9-2 (25 minutes)

Spreadsheet to Compute Forecasts of Sales and Income
Change Change Change Change Change Change Change Change
In Dec. in Dec. In March in March In June In June In Sept. in Sept.
Date Sales N.I. Sales NI Sales NI Sales NI Sales NI
Dec-Y1 $17,349 $1,263
Mar-Y2 12,278 964
Jun-Y2 13,984 1,130
Sep-Y2 13,972 996
Dec-Y2 16,040 1,215 -$1,309 -$48
Mar-Y3 12,700 1,085 $422 $121
Jun-Y3 14,566 656 $582 -$474
Sep-Y3 14,669 1,206 $697 $210
Dec-Y3 17,892 1,477 1,852 262
Mar-Y4 12,621 1,219 -79 134
Jun-Y4 14,725 1,554 159 898
Sep-Y4 14,442 1,457 -227 251
Dec-Y4 17,528 1,685 -364 208
Mar-Y5 14,948 1,372 2,327 153
Jun-Y5 17,630 1,726 2,905 172
Sep-Y5 17,151 1,610 2,709 153
Dec-Y5 19,547 1,865 2,019 180
Mar-Y6 16,931 1,517 1,983 145
Jun-Y6 18,901 1,908 1,271 182
Sep-Y6 19,861 1,788 2,710 178
Dec-Y6 22,848 2,067 3,301 202
Mar-Y7 19,998 1,677 3,067 160
Jun-Y7 21,860 2,162 2,959 254
Sep-Y7 21,806 2,014 1,945 226
Dec-Y7 24,876 2,350 2,028 283
Mar-Y8 22,459 1,891 2,461 214
Jun-Y8 24,928 2,450 3,068 288
Sep-Y8 23,978 2,284 2,172 270
Dec-Y8 28,455 2,671 3,579 321
Mar-Y9 24,062 2,155 1,603 264
Jun-Y9 27,410 2,820 2,482 370
Average
change
for each
quarter $1,586.57 $201.14 $1,683.43 $170.14 $1,918.00 $241.43 $1,667.67 $214.67
Forecast
Sep.Y9* 25,645.67 2,498.67
Forecast
Dec.Y9* 30,041.57 2,872.14
Forecast
Mar. Y0* 25,745.43 2,325.14
Forecast
Jun. Y0* 29,328.00 3,061.43

* Most recent actual quarter + average change for the quarter.

Note: Reported quarterly sales and net income for General Electric are:
Sales Net income
Sep Y9 $27,200 $2,653
Dec Y9 32,855 3,089
Mar Y0 29,996 2,592

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Exercise 9-3 (40 minutes)

a. To illustrate how predictions of market share and total market sales can be used
in the forecasting process, consider the following example. If an analyst, for
instance, predicts that (i) Cough.com will maintain its 0.08% share of the market
for children's cough medicine and (ii) total Industry sales of children's cough
medicine for year 2006 is $3.2 billion, then a reasonable estimate of Cough.com's
year 2006 sales is $2.56 million. This is computed as 0.08% market share
multiplied by the expected $3.2 billion of industry sales.

b. All relevant data should be sought out, subject to cost-benefit considerations, in

the prediction of sales. The importance of sales to predictions of financial
performance and financial condition cannot be overemphasized. Accordingly,
companies invest considerable research and effort in predicting sales. Regarding
what types of data to seek and how to obtain them, let’s consider a retailer. To
project the sales of a retailer, an analyst might consider visiting outlets that sell
the retailers’ products and observe customer-buying patterns versus the patterns
observed for key competing products. This activity can be done using anecdotal
observation or using formal statistical sampling depending upon the analysts'
perceived need for accuracy. Moreover, the analyst can seek information from
insiders via interview or interpretation of formal or informal disclosures made by
the company. The analyst can also review company strategies and industry
trends. In sum, good predictions involve more than sophisticated models—they
demand that the analyst take the perspective of a customer constrained by the
economic environment predicted to exist.

c. Relying on predicted year 2006 total industry sales of $3.2 billion, the sales of
Cough.com are predicted to be as follows

2006 Market share is 5% greater 2006 Market share is 5% worse

[105% x .08%] x $3.2 billion [95% x .08%] x $3.2 billion
= $2.688 million = $2.432 million

d. What-If industry sales are 10% higher:

[105% x .08%] x [110% x $3.2 billion] [95% x .08%] x [110% x $3.2 billion]
= $2.9568 million = $2.6752 million

What-If industry sales are 10% lower:

[105% x .08%] x [90% x $3.2 billion] [95% x .08%] x [90% x $3.2 billion]
= $2.4192 million = $2.1888 million

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A
Exercise 9–4 (30 minutes)

Lyon Corporation
Cash Forecast
For July, Year 6

Beginning cash balance ..................................................... $ 20

Cash collections
Beginning accounts receivable ............................... $ 20
Sales for month ........................................................ 150
170
Less: Ending accounts receivable .......................... 21 149
Cash available ..................................................................... $169
Cash disbursements
Beginning accounts payable ................................... 18
Purchases (note a) ................................................... 115
133
Ending accounts payable (25% of purchases)....... 29 104
Miscellaneous outlays ............................................. 11
Cash balance ............................................................ $ 54
Minimum cash balance desired .............................. 30
Excess cash .............................................................. $ 24

[a] Ending inventory ....................................................................................................... $ 15

Cost of goods sold (5/6 of sales) ............................................................................. 125
140
Less beginning inventory......................................................................................... 25
Purchases .................................................................................................................. $115

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PROBLEMS
Problem 9-1 (90 minutes)

a.
Coca-Cola
Year 3
INCOME STATEMENT Estimate Year 2 Year 1
Net sales 20,297 20,092 19,889
Cost of goods 6,106 6,044 6,204
Gross profit 14,191 14,048 13,685
Selling general & administrative expense 7,972 7,893 9,221
Depreciation & amortization expense 863 803 773
Interest expense -66 -308 292
Income before tax 5,422 5,660 3,399
Income tax expense 1,620 1,691 1,222
Net income 3,802 3,969 2,177
Outstanding shares 3,491 3,491 3,481

RATIOS

Sales growth 1.02% 1.02%

Gross Profit Margin 69.92% 69.92%
Selling General & Administrative Exp / Sales 39.28% 39.28%
Depreciation (depn exp / pr yr PPE gross) 12.14% 12.14%
INT (int / pr yr LTD) -5.45% -5.45%
Tax (Inc Tax / Pre-tax inc) 29.88% 29.88%

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Problem 9-1 — continued

Year 3
BALANCE SHEET Estimate Year 2 Year 1
Cash 587 1,934 1,892
Receivables 1,901 1,882 1,757
Inventories 1,066 1,055 1,066
Other 2,300 2,300 1,905
Total current assets 5,854 7,171 6,620

Property, plant & equipment 8,305 7,105 6,614

Accumulated depreciation 3,515 2,652 2,446
Net property & equipment 4,791 4,453 4,168
Other assets 10,793 10,793 10,046
Total assets 21,438 22,417 20,834

Accounts payable & accrued liabilities 3,717 3,679 3,905

Short-term debt & cmltd 3,899 3,899 4,816
Income taxes 815 851 600
Total current liab 8,431 8,429 9,321

Deferred income, taxes & other 1,403 1,403 1,362

Long term debt 1,219 1,219 835
Total liabilities 11,053 2,622 2,197

Common stock 873 873 870

Capital surplus 3,520 3,520 3,196
Retained earnings 19,674 20,655 18,543
Treasury stock 13,682 13,682 13,293
Shareholder equity 10,385 11,366 9,316
Total liabilities & net worth 21,438 22,417 20,834

RATIOS
AR turn 10.68 10.68 11.32
INV turn 5.73 5.73 5.82
AP turn 1.64 1.64 1.59
Tax Pay (Tax pay / tax exp) 50.33% 50.33% 49.10%
FLEV 2.06 1.97 2.24
Div/sh $1.37 $1.37 $1.21

CAPEX 1,200 1188 1165

CAPEX/Sales 5.91% 5.91% 5.86%

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Problem 9-1 — continued

Year 3
Statement of Cash Flows Estimate
Net income 3,802

Depreciation 863

Accounts receivable -19

Inventories -11

Accounts payable 38

Income taxes -36

Net cash flow from operations 4,636

CAPEX -1,200
Net cash flow from investing activities -1,200

Long term debt 0

Additional paid in capital 0
Dividends -4,783
Net cash flow from financing activities -4,783
_____
Net change in cash -1,347
Beginning cash 1,934
Ending cash 587

b. Based on our initial projection of Coca-Cola’s balance sheet, it appears that the
company will require approximately $1.5 billion of external financing in Year 3.
This amount will yield a cash balance of approximately $2 billion, consistent with
prior years.

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Problem 9-2 (95 minutes)

a.

Best Buy
Year 3
Estimate Year 2 Year 1
Income statement
Net sales 18,800 15,326 12,494

Cost of goods 15,048 12,267 10,101

Gross profit 3,752 3,059 2,393

Selling general & administrative expense 2,761 2,251 1,728

Depreciation & amortization expense 304 167 103

Income before tax 688 641 562

Income tax expense 263 245 215

Net income 425 396 347

Outstanding shares 208 208 200

RATIOS
Sales growth 22.67% 22.67%
Gross Profit Margin 19.96% 19.96%
Selling General & Administrative Exp / Sales 14.69% 14.69%
DEPRECIATION (depn exp / pr yr PPE gross) 15.28% 15.28%
Tax (Inc Tax / Pre-tax inc) 38.22% 38.22%

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Problem 9-2 — continued

Year 3
BALANCE SHEET Estimate Year 2 Year 1
Cash 196 746 751
Receivables 384 313 262
Inventories 2,168 1,767 1,184
Other 102 102 41
Total current assets 2,850 2,928 2,238

Property, plant & equipment 3,249 1,987 1,093

Accumulated depreciation 847 543 395
Net property & equipment 2,403 1,444 698
Other assets 466 466 59
Total assets 5,719 4,838 2,995

Accounts payable & accrued liabilities 3,034 2,473 1,704

Short-term debt & cmltd 114 114 16
Income taxes 136 127 65
Total current liab 3,284 2,714 1,785

Long term liabilities 122 122 100

Long term debt 67 181 15
Total long-term liabilities 189 303 115

Common stock 20 20 20
Capital surplus 576 576 247
Retained earnings 1,650 1,225 828
Shareholder equity 2,246 1,821 1,095
Total liabilities & net worth 5,719 4,838 2,995

RATIOS
AR turn 48.96 48.96 47.69
INV turn 6.94 6.94 8.53
AP turn 4.96 4.96 5.93
Tax Pay (Tax pay / tax exp) 51.84% 51.84% 30.23%
FLEV 2.55 2.66 2.74
Div/sh $0.00 $0.00 $0.00

CAPEX 1,262 1029 416

CAPEX/Sales 6.71% 6.71% 3.33%

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Problem 9-2 — continued

Year 3
Statement of Cash Flows Estimate
Net income 425
Depreciation 304
Accounts receivable -71
Inventories -401
Accounts payable 561
Income taxes 9
Net cash flow from operations 827

CAPEX -1,262
Net cash flow from investing activities -1,262

Long term debt -114

Additional paid in capital 0
Dividends 0
Net cash flow from financing activities -114
____
Net change in cash -550
Beginning cash 746
Ending cash 196

b. Based on our projection, it appears that Best Buy will require about $550 Million
of external financing to yield a cash balance of approximately $750 million.
Analysts must allocate this external financing between debt and equity so as to
preserve the financial leverage level presently used by Best Buy.

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Problem 9-3 (90 minutes)

a.

Merck
Year 3
INCOME STATEMENT Estimate Year 2 Year 1
Net sales 56,435 47,716 40,343
Cost of goods 34,272 28,977 22,444
Gross profit 22,164 18,739 17,900
Selling general & administrative expense 7,725 6,531 6,469
Depreciation & amortization expense 1,661 1,464 1,277
Interest expense 237 342 329
Income before tax 12,541 10,403 9,824
Income tax expense 3,762 3,121 3,002
Net income 8,779 7,282 6,822
Outstanding shares 2,976 2,976 2,968

RATIOS
Sales growth 18.27% 18.27%
Gross Profit Margin 39.27% 39.27%
Selling General & Administrative Exp / Sales 13.69% 13.69%
DEPRECIATION (depn exp / pr yr PPE gross) 8.76% 8.76%
INT (int / pr yr LTD) 4.94% 4.94%
Tax (Inc Tax / Pre-tax inc) 30.00% 30.00%

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Problem 9-3 — continued

Year 3
BALANCE SHEET Estimate Year 2 Year 1
Cash 5,254 3,287 4,255
Receivables 6,168 5,215 5,262
Inventories 4,233 3,579 3,022
Other 880 880 1,059
Total current assets 16,536 12,961 13,598

Property, plant & equipment 24,056 18,956 16,707

Accumulated depreciation 7,514 5,853 5,225
Net property & equipment 16,543 13,103 11,482
Other assets 17,942 17,942 15,075
Total assets 51,020 44,007 40,155

Accounts payable & accrued liabilities 6,983 5,904 5,391

Short-term debt & cmltd 4,067 4,067 3,319
Income taxes 1,897 1,573 1,244
Total current liab 12,947 11,544 9,954

Deferred income, taxes and other 11,614 11,614 11,768

Long term debt 4,787 4,799 3,601
Total liabilities 29,347 27,957 25,323

Common stock 30 30 30
Capital surplus 6,907 6,907 6,266
Retained earnings 37,123 31,500 27,395
Treasury stock 22,387 22,387 18,858
Shareholder equity 21,673 16,050 14,832
Total liabilities & net worth 51,020 44,007 40,155

RATIOS
AR turn 9.15 9.15 7.67
INV turn 8.10 8.10 7.43
AP turn 4.91 4.91 4.16
Tax Pay (Tax pay / tax exp) 50.41% 50.41% 41.45%
FLEV 2.35 2.74 2.71
Div/sh $1.06 $1.06 $0.98
CAPEX 5,100 4312 3641
CAPEX/Sales 9.04% 9.04% 9.03%

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Problem 9-3 — continued

Year 3
Statement of Cash Flows Estimate
Net income $ 8,779
Depreciation 1,661
Accounts receivable -953
Inventories -654
Accounts payable 1,079
Income taxes 323
Net cash flow from operations 10,235

CAPEX -5,100
Net cash flow from investing activities -5,100

Long term debt -12

Additional paid in capital 0
Dividends -3,156
Net cash flow from financing activities -3,168
_____
Net change in cash 1,967
Beginning cash 3,287
Ending cash 5,254

b. Based on our initial projections, it appears that Merck will have excess cash of
approximately $2 billion in year 3. This excess cash should be used to reduce
both debt and equity so as to maintain historical financial leverage.

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Problem 9-4 (90 minutes)

Historical Forecast Terminal

figures Horizon Year
Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 20x8 20x8
Sales growth 8.50% 10.65% 10.65% 10.65% 10.65% 10.65% 10.65% 3.50%
Net profit Margin (Net income/Sales) 6.71% 8.22% 8.22% 8.22% 8.22% 8.22% 8.22% 8.22%
NWC turn (Sales/avg NWC) 8.98 9.33 9.33 9.33 9.33 9.33 9.33 9.33
FA turn (Sales/avg FA) 1.67 1.64 1.64 1.64 1.64 1.64 1.64 1.64
Total operating assets/Total equity 1.96 2.01 2.01 2.01 2.01 2.01 2.01 2.01
Cost of equity 12.5%

($ Thousands)
Sales 25,423 28,131 31,127 34,443 38,112 42,171 46,663 48,297
Net income ($ Mil) 1,706 2,312 2,558 2,831 3,132 3,466 3,835 3,969
Net working capital 2,832 3,015 3,336 3,692 4,085 4,520 5,001 5,176
Fixed assets 15,232 17,136 18,961 20,981 23,216 25,689 28,425 29,420
Total Operating assets 18,064 20,151 22,297 24,673 27,301 30,209 33,426 34,596
L-T Liabilities 8,832 10,132 11,211 12,405 13,727 15,189 16,807 17,395
Total Stockholder's Equity ($ Mil) 9,232 10,019 11,086 12,267 13,574 15,020 16,619 17,201

Residual Income Computation

Net Income 2,558 2,831 3,132 3,466 3,835 3,969
Beginning Equity 10,019 11,086 12,267 13,574 15,020 16,619
Required Equity Return 12.5% 12.5% 12.5% 12.5% 12.5% 12.5%
Expected Earnings 1,252 1,386 1,533 1,697 1,877 2,077
Residual Income 1,306 1,445 1,599 1,769 1,958 1,892
Discount factor 0.89 0.79 0.70 0.62 0.55

Present value of residual income 1,161 1,142 1,123 1,105 1,086

Cum PV residual income 1,161 2,303 3,425 4,530 5,616
Terminal value of abnormal earnings 11,665
Beg book value of equity 10,019
Value of equity - Abnormal Earnings 27,301
Common shares outstanding (mil) 1,737
per share $15.72

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Problem 9-5 (90 minutes)

a.
Telnet Corporation
Pro Forma Income Statement ($000s)
Six Months Ended June 30, Year 2
Sales revenue ($250 x 6 mos.) ................................................................... $1,500
Cost of goods sold (note [a]) ..................................................................... 1,199
Gross margin ............................................................................................... 301
Selling and administrative expenses ($47.5 x 6 mos.) ............................. 285
Expected pre-tax income ............................................................................ 16
Estimated income taxes (at 50%)............................................................... 8
Expected net income .................................................................................. $ 8

Note [a]: We use T-accounts to compute cost of goods sold ($ thousands)

Raw Material Inventory

Beginning (given) 0
Material purchases ($125 x 6 mos.) 750 715 To W.I.P. inventory [a] (plug)

Ending (given) 35

Work in Process Inventory

Beginning (given) 0
From raw materials inventory [a] 715 7 Prepaid expenses (given)
Labor ($30.5 x 6 mos.) 183 1,299 To F.G. inventory [b] (plug)
Variable overhead ($22.5 x 6 mos.) 135
Rent ($10 x 6 mos.) 60
Depreciation ($35 x 6 mos.) 210
Patent amortization ($.5 x 6 mos.) 3

Ending (given) 0

Finished Goods Inventory

Beginning (given) 0
From W.I.P. inventory [b] 1,299 1,199 Cost of goods sold (plug)

Ending (given) 100

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Problem 9-5 — continued

b.

Telnet Corporation
Pro forma Balance Sheet ($000s)
June 30, Year 2
ASSETS
Cash ............................................................................... $ 40 (minimum cash)
Accounts receivable ..................................................... 375 (45 days' sales)*
Inventories ($35 + $100) ............................................... 135 (given)
Prepaid expenses ......................................................... 7 (given)
Total current assets .................................................... 557 (subtotal)
Equipment...................................................................... 1,200 (given)
Less accumulated depreciation .................................. 210 ($35 x 6 mos.)
Equipment, net ............................................................ 990 (subtotal)
Patents ........................................................................... 40 (given)
Less amortization ......................................................... 3 ($500 x 6 mos.)
Patents, net .................................................................. 37 (subtotal)
Total Assets ................................................................... $1,584

LIABILITIES AND STOCKHOLDERS’ EQUITY

Accounts payable ......................................................... $ 125 (30 days' purchases)**
Accrued taxes ............................................................... 8 (from Inc. Stmt.)
Stockholders' equity ..................................................... 1,300 (given)
Retained earnings ......................................................... 8 (from Inc. Stmt.)
Additional funds needed .............................................. 143 "plug"
Total liabilities and equity ............................................ $1,584

* ($250,000 x 6) / 180 days = $8,333 per day x 45 days = $375,000

** ($125,000 x 6) / 180 days = $4,166 per day x 30 days = $125,000

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Problem 9-5 — continued

c.

Telnet Corporation
Forecasted Statement of Cash Flows
For Six Months Ended June 30, Year 2
Cash balance, beginning ..................................................... $ 60,000
Add collection of accounts receivable *.............................. 1,125,000 $1,185,000
Less disbursements for
Material purchases ** ....................................................... 625,000
Labor.................................................................................. 183,000
Rent.................................................................................... 60,000
Overhead ........................................................................... 135,000
Selling expense ................................................................ 285,000 (1,288,000)
Tentative cash balance ......................................................... $ (103,000)
Minimum cash balance required .......................................... 40,000
Additional borrowing required ............................................. $ 143,000
Ending cash balance ............................................................ $ 40,000
Loan balance .......................................................................... $ 143,000

* Collection of accounts receivable Jan. Feb. Mar. Apr. May June

Sales........................................................................... 250 250 250 250 250 250
Collections ................................................................ 0 125 250 250 250 250
Accumulated Collections ......................................... 0 125 375 625 875 1,125

** Payment of accounts payable Jan. Feb. Mar. Apr. May June

Purchases .................................................................. 125 125 125 125 125 125
Payments ................................................................... 0 125 125 125 125 125
Accumulated Payments ........................................... 0 125 250 375 500 625

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Problem 9-6 (95 minutes)

Quaker Oats
Forecasted Statement of Cash Flows
For Year Ended June 30, Year 12
Cash provided by (used for) operations
Net income (a) ................................................................................................ $ 238.8
Items in income not affecting cash
Depreciation & amortization (b) ................................................................. 196.6
Deferred income taxes (c) ........................................................................... 54.7
Provision for restructuring charges (given) ............................................. 0.0
Increase in receivables (d) ............................................................................ (8.9)
Increase in inventories (e) ............................................................................ (45.2)
Increase in other current assets (f) ............................................................. (25.6)
Increase in accounts payable (g) ................................................................. 42.1
Increase in other current liabilities (h) ........................................................ 24.5
Cash provided by operating activities ......................................................... $ 477.0

Cash provided by (used for) investment activities

Capital expenditures, PP&E (given)............................................................. $ (300.0)
Asset retirements (given) .............................................................................. 20.0
Other changes (given) ................................................................................... (30.0)
Cash used for investing activities ............................................................... $ (310.0)

Cash provided by (used for) financing activities

Repayments of L-T debt (given) ................................................................... $ (45.0)
Net decrease in S-T debt (given) .................................................................. (40.0)
Cash dividend paid (given) ........................................................................... (135.0)
Additions to L-T debt—plug (i) ..................................................................... 55.8
Cash provided by financing activities ......................................................... $(164.2)

Net increase in cash (j) .................................................................................. $ 2.8

Cash, beginning balance .............................................................................. 30.2

Cash, balance at end of year ........................................................................ $ 33.0

Notes:
(a) Average percent of income from continuing operations to sales, Years 9-11
($235.8 +$228.9 + $148.9) / ($5,491.2 + $5,030.6 + $4,879.4) = 3.98%
Net income in Year 12 = $6,000 x .0398 = $238.8

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Problem 9-6 – continued

(b) Depreciation and amortization in Year 12 = $238.8 x .8233 = $196.6

(c) Average percent of deferred income taxes (noncurrent) and other items to income from
continuing operations, Years 9-11: $140.4 / $613.6 = 22.9%
Noncurrent deferred income tax in Year 12 = $238.8 x .229 = $54.7
(d) Ending accounts receivable = $6,000 x (42/360) = $700.0
For Year 12: Accounts receivable, beg $691.1
Accounts receivable, end 700.0
Increase $ 8.9

(e) Year 12 cost of sales = $6,000 x .51 = $3,060

Ending inventory = $3,060 x (55/360) = $467.5
For Year 12: Inventory, beg $422.3
Inventory, end 467.5
Increase $ 45.2
(f) ($13.7 + $14.1 + $48.9)/3 = $25.6
(g) Year 12 purchases = $2,807.2 x 1.12 = $3,144.1
Accounts payable, end = $3,144.1 x (45/360) = $393.0
For Year 12: Accounts payable, beg $350.9
Accounts payable, end 393.0
Increase $ 42.1
(h) ($43.2 + $83.4 - $53.1)/3 = $24.5
(i) Amount required to balance statement.
(j) Percent of cash to revenues in Year 11 = $30.2 / $5,491.2 = 0.55%
Year-end cash in Year 12 = $6,000 x 0.55% = $33
Increase in cash for Year 12 = $33 - $30.2 = $2.8

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CASES
Case 9-1 (60 minutes)

Kodak

INCOME STATEMENT 20x7 Est 20x6 20x5

Net sales 12,515 13,234 13,994
Cost of goods 8,199 8,670 8,375
Gross profit 4,316 4,564 5,619
Selling general & administrative expense
(except depreciation) 1,761 1,862 1,776
Depreciation expense 766 765 738
Research & development costs 737 779 784
Goodwill amortization 0 154 151
Restructuring costs (credits) 0 659 -44
Earnings from operations 1,052 345 2,214
Interest expense 208 219 178
Other expense (income) 18 18 -96
Income before tax 827 108 2,132
Income tax expense 245 32 725
Net income 582 76 1,407
Outstanding shares 290 290 290

RATIOS
Sales growth -5.43% -5.43%
Gross Profit Margin 34.49% 34.49%
Selling General & Administrative Exp / Sales 14.07% 14.07%
DEPRECIATION (depn exp / pr yr PPE gross) 5.90% 5.90%
R&D/sales 5.89% 5.89%
INT (int / pr yr STD and LTD) 6.49% 6.49%
Tax (Inc Tax / Pre-tax inc) 29.63% 29.63%

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Case 9-1 – continued

BALANCE SHEET 20x7 Est 20x6 20x5

Cash $ 17 $ 448 $ 246
Receivables 2,210 2,337 2,653
Inventories 1,075 1,137 1,718
Other 761 761 874
Total current assets 4,064 4,683 5,491

Property, plant & equipment 13,972 12,982 12,963 (NOTE 4)

Accumulated depreciation 8,089 7,323 7,044
Net property & equipment 5,883 5,659 5,919
Other assets 3,020 3,020 2,802
Total assets $12,967 $13,362 $14,212

Accounts payable & accrued liabilities 3,098 3,276 3,403

Short-term debt 1,378 1,378 2,058
Current maturities of l-t debt 13 156 148 (NOTE 8)
Income taxes 544 544 606
Total current liab 5,033 5,354 6,215

Long term debt 1,653 1,666 1,166

Postemployment liabilities 2,728 2,728 2,722
Other long-term liabilities 720 720 681
Total liabilities 10,134 10,468 10,784

Common stock 978 978 978

Capital surplus 849 849 871
Retained earnings 6,773 6,834 7,387
Treasury stock 5,767 5,767 5,808
Shareholder equity 2,833 2,894 3,428
Total liabilities & net worth 12,967 13,362 14,212

RATIOS
AR turn 5.66 5.66 5.27
INV turn 7.63 7.63 4.87
AP turn 2.65 2.65 2.46
FLEV 4.58 4.62 4.15
Div/sh $2.22 $2.22 $1.88

CAPEX 990 1047 783

CAPEX/Sales 7.91% 7.91% 5.60%

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Case 9-1 – continued

Statement of Cash Flows 20x7 Estim.

Net income $ 582

Depreciation 766

Accounts receivable 127

Inventories 62

Accounts payable (178)

Net cash flow from operations 1,359

CAPEX (990)
Net cash flow from investing activities (990)

Long term debt (156)

Dividends (643)
Net cash flow from financing activities (799)
_____
Net change in cash (431)
Beginning cash 448
Ending cash $ 17

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Case 9-2 (120 minutes)

Miller Company
Cash Forecast
For Years Ended December 31, Years 2 through 4
Year 2 Year 3 Year 4
Cash balance at beginning of period .................. $ 0 $1,929,000 $254,500
Cash received from stockholders ....................... 100,000 0 0
Proceeds of loan (see [a]) .................................... 1,700,000 100,000 0
Cash receipts less cash payments (see [b]) ...... 129,000 125,500 146,500
Payments for construction .................................. 0 (1,700,000) (100,000)
Payments on loan (see [a]) .................................. 0 (200,000) (200,000)
Cash balance at end of period ............................ $1,929,000 $ 254,500 $101,000

Supporting Schedules for the Cash Forecast

[a] Schedule of interest and commitment fees
Amount of Interest
Loan or Fee
Year 2:
To be borrowed 1/1 .................................................................... $ 800,000
To be borrowed 4/1 .................................................................... 500,000
Commitment fee due 4/1 ($1,000,000 x 1% x 1/4) ................... $ 2,500
To be borrowed 7/1 .................................................................... 300,000
Commitment fee due 7/1 ($500,000 x 1% x 1/4) ...................... 1,250
To be borrowed 12/31 ................................................................ 100,000
Commitment fee due 12/31 ($200,000 x 1% x 1/2) .................. 1,000
Interest due on loan:
On $800,000 @ 5% ............................................................... 40,000
On $500,000 @ 5% x 3/4 ...................................................... 18,750
On $300,000 @ 5% x 1/2 ...................................................... 7,500
Total at 12/31/Year 2 .................................................................. $1,700,000 $71,000
Year 3:
To be borrowed 4/1 .................................................................... 100,000
Commitment fee due 4/1 ($100,000 x 1% x 1/4) ...................... 250
Repayment of loan:
Due 6/30 ................................................................................ (100,000)
Due 12/31 .............................................................................. (100,000)
Interest due on loan:
On $1,700,000 @ 5% x 1/4 ................................................... 21,250
On $1,800,000 @ 5% x 1/4 ................................................... 22,500
On $1,700,000 @ 5% x 1/2 ................................................... 42,500
Total at 12/31/Year 3 .................................................................. $1,600,000 $86,500
Year 4:
Repayment of loan:
Due 6/30 ................................................................................ (100,000)
Due 12/31 .............................................................................. (100,000)
Interest due on loan:
On $1,600,000 @ 5% x 1/2 ................................................... 40,000
On $1,500,000 @ 5% x 1/2 ................................................... 37,500
Total at 12/31/Year 4 .................................................................. $1,400,000 $77,500

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Case 9-2 – continued

[b] Schedule of Operating Results

Year 2 Year 3 Year 4
Results of operations
Operating profit (at $.04 per ton handled) ................... $200,000 $212,000 $224,000
Interest and commitment fees (above) ........................ 71,000 86,500 77,500
Cash derived from operations ...................................... 129,000 125,500 146,500
Depreciation (at $.03 per ton handled) ........................ 150,000 159,000 168,000
Operating loss ................................................................ $ 21,000 33,500 21,500
Operating loss from prior year(s) ................................. 21,000 54,500
Accumulated operating loss ......................................... $ 54,500 $ 76,000

Interpretation and Evaluation

As revealed in note [b], reporting on the "results of operations," Miller Company

is expected to record operating losses for each of the next three years under
analysis. Nevertheless, the analysis also reveals that Miller is expected to
generate sufficient cash flow to cover the various cash commitments.

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Case 9-3 (100 minutes)

Royal Company
Cash Forecast
For Years Ending March 31, Years 6 and 7
Year 6 Year 7
Beginning balance of cash ...................................... $ 0 $ 75,000
Cash receipt from customers (see Schedule A) .... 825,000 1,065,000
Cash disbursements
Direct materials (see Schedule B) ........................ 220,000 245,000
Direct labor ............................................................. 300,000 360,000
Variable overhead .................................................. 100,000 120,000
Fixed costs ............................................................ 130,000 130,000
Total cash disbursements ..................................... 750,000 855,000
Operating cash receipts less disbursements ........ 75,000 210,000
Cash from sale of receivables and inventories ..... 90,000 0
Total cash available ................................................. $165,000 $ 285,000
2
Payments to general creditors ................................ 90,000 270,000
1
Ending balance of cash ........................................... $ 75,000 $ 15,000
1
This amount could have been used to pay general creditors or carried forward to the beginning
of the next year.
2
Computed as: ($600,000 x 60%) - ($50,000 + $40,000).

Schedule A
Cash Receipts from Customers
Year 6 Year 7
Sales ............................................................................................ $900,000 $1,080,000
Beginning accounts receivable ................................................ 0 75,000
Total ........................................................................................... 900,000 1,155,000
Less: Ending accounts receivable........................................... 75,000 90,000
Cash receipts from customers ................................................. $825,000 $1,065,000

Schedule B
Cash Disbursements for Direct Materials
Year 6 Year 7
Direct materials required for production ..................... $200,000 $240,000
3 4
Required ending inventory ........................................... 40,000 50,000
Total ............................................................................... 240,000 290,000
Less: Beginning inventory ............................................ 0 40,000
Purchases .................................................................... 240,000 250,000
Beginning accounts payable ........................................ 0 20,000
Total ............................................................................... 240,000 270,000
Less: Ending accounts payable ................................... 20,000 25,000
Disbursements for direct materials ............................. $220,000 $245,000
3
Computed as: 12,000 units x 2/12 = 2,000; 2,000 x $20 per unit = $40,000.
4
Computed as: 15,000 units x 2/12 = 2,500; 2,500 x $20 per unit = $50,000.

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Case 9-4 (115 minutes)

a.
(1)
Estimated Total Cash Receipts
Sep. Oct. Nov. Dec.
Total sales............................................. $40,000 $48,000 $60,000 $80,000
Credit sales (25%) ................................ 10,000 12,000 15,000 20,000
Cash sales ............................................ $30,000 36,000 $45,000 $60,000
Receipts of past month's credit sales 10,000 12,000 15,000
Total cash receipts ............................... $46,000 $57,000 $75,000

(2)
Estimated Cash Disbursements for Purchases
Oct. Nov. Dec. Total
Total Sales ....................................... $48,000 $60,000 $80,000 —
Purchases (70% next mo. sales) .... $42,000 $56,000 $25,200 $123,200
Less: 2% purchase discount .......... 840 1,120 504 2,464
Cash disbursements ....................... $41,160 $54,880 $24,696 $120,736

(3)
Estimated Cash Disbursements for Operating Expenses
Oct. Nov. Dec. Total
Sales ................................................. $48,000 $60,000 $80,000 —
Salaries and Wages (15%) .............. $ 7,200 $ 9,000 $12,000 $28,200
Rent (5%) .......................................... 2,400 3,000 4,000 9,400
Other Expenses (4%) ...................... 1,920 2,400 3,200 7,520
Cash disbursements ....................... $11,520 $14,400 $19,200 $45,120

(4)
Estimated Total Cash Disbursements
Oct. Nov. Dec. Total
Purchases [part (2)] ........................ $41,160 $54,880 $24,696 $120,736
Operating expenses [part (3)] ........ 11,520 14,400 19,200 45,120
Plant and equipment (given) .......... 600 400 1,000
Total cash disbursements .............. $53,280 $69,680 $43,896 $166,856

(5)
Estimated Net Cash Receipts and Disbursements
Oct. Nov. Dec. Total
Total cash receipts .......................... $46,000 $57,000 $75,000 $178,000
Total cash disbursements .............. 53,280 69,680 43,896 166,856
Net cash increase............................ $31,104 $ 11,144
Net cash decrease........................... $ 7,280 $12,680

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Case 9-4 — continued

(6)
Estimated Financing Required
Oct. Nov. Dec. Total
Beginning cash balance ................. $12,000 $ 8,720 $ 8,040 $12,000
Net cash increase............................ 31,104 11,144
Net cash decrease........................... 7,280 12,680
Cash position before financing ...... $ 4,720 $(3,960) $39,144 $23,144
Financing required .......................... 4,000 12,000 16,000
1
Interest expense ........................... (180) (180)
Financing retired ............................. (16,000) (16,000)
Ending cash balance ...................... $ 8,720 $ 8,040 $22,964 $22,964
1
Computed as: ($4,000 x .06 x 3/12) + ($12,000 x .06 x 2/12).

b. (1)
Union Corporation
Forecasted Income Statement
For the Quarter Ended December 31, Year 6
Sales [see (1) in part a] ...................................................... $188,000
Deduct
Cost of goods sold (70% of sales)............................... $131,600
Less: Purchase discounts taken [see (2) in part a] ... 2,464 129,136
Gross profit......................................................................... 58,864
Selling and administrative expenses
Salaries and wages [see (3) in part a] ......................... 28,200
Rent [see (3) in part a] .................................................. 9,400
Other expenses [see (3) in part a] ............................... 7,520
Depreciation ($750 x 3 months) ................................... 2,250
Total selling and administrative expenses ...................... 47,370
Operating income ............................................................... 11,494
Interest expense ................................................................. 180
Net income ....................................................................... $ 11,314

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Solution Manual for Financial Statement Analysis 10th Edition by Subramanyam

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Case 9-4 — continued

(2)
Union Corporation
Forecasted Balance Sheet
As of December 31, Year 6
ASSETS
Current Assets
Cash [see (6) in part a] ................................................. $ 22,964
Accounts receivable (25% of Dec. sales).................... 20,000
Inventory [($30,000 + 70% of $36,000) x 98%] ............ 54,096
Total current assets ........................................................... $ 97,060
Plant and equipment .......................................................... 101,000
Less: Accumulated depreciation ...................................... 2,250 98,750
Total assets ........................................................................ $195,810

LIABILITIES AND EQUITY

Liabilities............................................................................. $ 0
Stockholders' equity .......................................................... 195,810
Total liabilities and equity ................................................. $195,810

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