Solution Manual for Financial Reporting and Analysis 7th Edition By Revsine

Solution Manual for Financial Reporting and Analysis

7th Edition By Revsine

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 Financial Reporting and Analysis (7th Ed.)
Chapter 6 Solutions
The Role of Financial Information in Valuation
and Credit Risk Assessment
Problems/Discussion Questions

Exercises
E6-1. Free cash flow valuation
Requirement 1:
Although the exact definition of “free cash flow” varies in practice, most stock
analysts, investment professionals, and valuation experts define the term as
the company’s operating cash flows (before interest) minus cash outlays for
routine operating capacity replacement such as buildings and furnishings. In
this sense, it’s the amount of cash flow available to finance further expansion
of operating capacity (growth), to reduce debt, to pay dividends, or to
repurchase stock. Analysts sometimes include in the free cash flow measure
cash outlays associated with planned growth (new retail store openings) if
management has already announced the growth plans.

Requirement 2:
Free cash flow is operating cash flow minus interest (net of tax) and minus
cash outlays for replacement (or planned) capital expenditures.

Requirement 3:
The key features of the free cash flow approach to valuation involve: (1)
forecasting the company’s estimated future free cash flows each period over
a forecast horizon as well as an estimate of post-horizon annual free cash
flows; (2) determining the appropriate cost of capital; and (3) then discounting
the periodic free cash flow amounts by an appropriate cost of capital discount
rate.

E6-2. Abnormal earnings valuation

Requirement 1:
The sustainable component of a company’s reported earnings is represented
by recurring income from continuing operations (with the possible exception
of unusual or infrequently occurring items). At Whole Foods Markets or
McDonald’s, for example, sustainable earnings are the recurring operating
profits generated by retail grocery stores or fast food restaurants already
open.

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 Requirement 2:
Although the exact definition of “abnormal earnings” varies in practice, most
stock analysts, investment professionals, and valuation experts define the
term as a company’s earnings minus a capital charge (often defined as the
book value of equity multiplied by the equity cost of capital). This capital
charge reflects the level of earnings investors demand from the company as
compensation for the risks of investment. Firms that produce positive
abnormal earnings generate profits in excess of what investors demand as
compensation for risk.

Requirement 3:
The key features of the abnormal earnings approach to valuation involve: (1)
forecasting the company’s future earnings each period over some forecast
horizon (e.g., typically 5 or 10 years); (2) subtracting a capital charge from
each earnings forecast to arrive at forecasted abnormal earnings each
period; (3) developing a terminal value estimate that represents the value of
post-horizon abnormal earnings; (4) then discounting the periodic abnormal
earnings amounts by an appropriate cost of capital discount rate; and then
(5) adding the result to book value.

E6-3. Predicting future cash flow

Requirement 1:
In this setting, the best predictor of next month’s cash collections is this
month’s credit sales rather than this month’s cash collections. For example,
January credit sales are $38,000 but cash collections that month are only
$17,000. February’s cash collection ($37,000) is much more closely
approximated by January’s credit sales than by January’s cash collections.

The reason why can be traced to two features of the company’s business
model: (1) sales transactions are on credit rather than for cash, but customers
typically pay within 30 days; and (2) there is considerable variation month-to-
month in the level of credit sales. This variation in sales levels each month
lessens the ability of past cash collections to predict future cash collections.
At the same time, the company’s reliance on credit sales transactions and a
30-day payment period increases the ability of credit sales to predict next
month’s cash collections.

Requirement 2:
As illustrated by the numerical example in the exercise, accrual accounting
earnings often smoothes out the period-to-period variation in operating cash
flows and thus is a better predictor of future operating cash flows.

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E6-4. Explaining differences in P/E ratios
In general, price/earnings (P/E) ratios are inversely related to risk, and
positively related to both growth opportunities and earnings quality.

These firms are from different industries. Amazon is an e-commerce retailer,

Microsoft is a software development company, Toyota Motors is an
automobile manufacturer, and Whole Foods Market sells organic foods and
natural grocery items. Here are some reasons why the P/E ratios of these
companies differ:

• Differences in P/E ratios reflect differences in future growth opportunities.

Toyota Motors probably has the fewest growth opportunities—automobile
manufacturing is a rather mature industry with significant global
competition. At the other extreme, Amazon continues to expand its
product and service offerings beyond books and CDs, and e-commerce
retailing is still a rather young industry.

• Amazon’s P/E ratio of 882.7 is extremely high, even for a high-growth

firm, suggesting a possible aberration in its earnings. At the time this P/E
ratio was computed, Amazon’s trailing-twelve-months earnings was
$0.70 per share, which included a $0.12 loss in the first quarter of 2015.
Only two quarters later, trailing-twelve-months earnings were $2.43. The
average analyst estimate of full-year 2016 earnings was $5.41, and for
2017 it was $9.83. Although one could view this scenario as high growth,
it also suggests that the trailing-twelve-months earnings figure simply
was not relevant, and is not relevant any time it is so different from
projected earnings levels. Investors will price stocks based on what they
perceive to be the longer run normal earnings levels. Based on
forecasted earnings levels, Amazon’s P/E ratio would seem more normal.

• Differences in P/E ratios reflect differences in business risk. Risky firms

will have higher discount rates assigned to their future cash flows and
earnings, and thus lower share prices and lower P/E ratios. However, risk
differences do not explain the P/E differences for these firms. Toyota is a
large, financially strong company with established products and brands
that operates in a mature industry. Its business risk is relatively low but
so is its P/E. Amazon operates in a evolving industry and the company
first became profitable in 2003. Its business risk is relatively high and so
is its P/E. For these firms, factors other than risk must be influencing the
P/E ratio differences.

• Without a detailed examination of the financial reporting practices and

related disclosures of each company, it is difficult to draw conclusions
about the degree to which the P/E ratio differences might be related to
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 differences in earnings quality. Concerns about earnings quality have
occasionally surfaced in financial press articles on each company.

Absent information about investors’ earnings quality concerns, it is likely to be

the case that most of the variation in P/E ratios is due to differences in growth
opportunities. (For additional insights on why P/E ratios vary across firms,
take a look at E6.5).

E6-5. Why P/E ratios vary

In general, price/earnings (P/E) ratios are inversely related to risk, and
positively related to both growth opportunities and earnings quality.

These firms are all from the same industry—grocery chains—so there is less
variation in P/E ratios among them than is the case for the firms in E6-4.

• Sprouts Farmers Market has the highest P/E ratio of the grocery chains
listed. It is relatively small and rapidly expanding. Analyst forecasts of
earnings growth over the next five years exceed that of the industry by
more than two percentage points.

• It is unlikely that investors assign substantially different risk to any of

these companies. All are in the same industry and face similar economic
conditions.

• Differences in earnings quality might also explain why the P/E ratios of
these grocery firms differ so much. However, within an industry,
differences in earnings quality may be less important to explaining
differences in P/E ratios. That’s because firms in the same industry tend
to use similar financial reporting practices.

In sum, it is likely that investors believe the growth opportunities are greatest
at Sprouts. (For additional insights on why P/E ratios vary across firms, take
a look at E6-4.)

E6-6. Fair value accounting and goodwill

Requirement 1:
Companies that have recognized accounting goodwill are required by GAAP
to test for goodwill impairment annually and, if the goodwill asset is deemed
to be impaired, reduce its balance sheet book value to current fair value. A
key feature of this impairment test is to establish each year the fair value of
recognized goodwill.

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 Requirement 2:
Discounted free cash flow valuation is a Level 3 method in the FASB’s fair
value measurement hierarchy. Level 1 uses quoted prices from active
markets for identical assets or liabilities. Level 2 includes observable inputs
other than Level 1 quoted prices; e.g., quoted prices for similar (but not
identical) assets or liabilities. Level 3 covers unobservable inputs such as
management’s estimates of the discounted future free cash flows associated
with an acquired business unit.

Requirement 3:
The publishing segment, the business unit for which News Corporation
recorded an impairment charge is not a publicly traded company.
Consequently, News Corporation cannot use “quoted prices from an actively-
traded market for the identical assets” to establish the business unit’s fair
value to determine if recorded goodwill is impaired.

E6-7. Earnings quality

Requirement 1:
Quality of earnings relates to how well accrual accounting earnings captures
the underlying economic performance of an enterprise for a particular period
of time. One important dimension of earnings quality is how sustainable or
persistent the reported earnings number is. Poor earnings quality occurs
when there are transitory components embedded in earnings that are not
sustainable, rendering the current earnings number a poor indicator of future
performance.

Requirement 2:
Management can improve reported earnings in the short-run by:

• Changing accounting methods.

• Adjusting expense estimates (e.g., increasing estimated useful lives of
fixed assets or reducing bad debt expense estimates).
• Altering the timing of revenue or expense recognition (i.e., shifting
revenues or expenses from one period to the next).
• Initiating business transactions that produce one-time gains or losses;
e.g., sell real estate.

Requirement 3:
Examples of low-quality earnings items include:

• One-time gains and losses from asset sales.

• Liberal accounting choices that increase short-run profits.
• Changes in discretionary expenditures for R&D, advertising, and
maintenance.
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 • Illusory profits from LIFO liquidations.

A variety of other examples could be listed here. See articles on earnings

quality referenced in the chapter.

E6-8. Cash flow and credit risk

Requirement 1:
Scheduled loan payments over the next six quarters total $1,000,000.
Operating cash flows are projected to total $1,410,000 over this same period,
but management also expects to pay out $50,000 in dividends and to spend
$475,000 on capital expenditures. Operating cash flows are insufficient by
$115,000 to cover the scheduled debt and dividend payments, and the
planned capital expenditures. This projected net cash flow shortage is why
the loan officer considers the Halifax loan to be of high credit risk.

Requirement 2:
There are at least four steps management can take to reduce the loan’s
credit risk: (1) find ways to increase the projected cash from operations; (2)
reduced planned capital expenditures; (3) eliminate the dividend payment;
and (4) generate cash from other sources (selling non-operating assets or
issuing stock) or seek a loan refinancing arrangement that postpones the
scheduled debt payment.

Requirement 3:
Encourage management to find ways to increase the projected cash from
operations, and then monitor performance to ensure that the new and higher
operating cash flow projections are being achieved. If the loan terms allow,
prohibit capital expenditures or dividend payments without bank
authorization. This approach allows the loan officer to intervene if operating
cash flows appear insufficient.

E6-9. Moody’s Slashes Greek Bond Rating

Requirement 1:
Moody’s and other credit rating agencies provide an independent assessment
of the credit risk associated with corporate debt, state and municipal debt,
and sovereign debt such as Greece’s government borrowings. The credit risk
assessments help investors properly price the debt securities issued by firms
and government agencies.

Requirement 2:
The approach used to assess credit risk for sovereign debt resembles closely
that used for corporate debt. The essential question asked by Moody’s and
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 other credit rating agencies is: Will the debt issuer have sufficient funds
available to make scheduled debt payments when they come due? For
corporate debt, the agency assesses the company’s ability to generate future
free cash flows sufficient to cover scheduled debt payments. The same is
true for sovereign debt: Will the Greek government generate sufficient cash
flow—tax revenues plus investment income (if any), minus operating, defense
and social program costs—that are more than sufficient to cover scheduled
debt payments?

Requirement 3:
The rating downgrade signals a deterioration in the creditworthiness of
Greece; i.e., Moody’s believes that the country’s credit risk has increased.
This should, in turn, prompt a decrease in the price of Greek sovereign debt
to reflect the increased risk of nonpayment to investors.

E6-10. Credit risk and cash flow volatility

Requirement 1:
The quarterly operating cash flows of both firms exhibit seasonal volatility,
meaning that operating cash flow levels change from quarter to quarter.
Seasonal patterns in sales and operating cash flow are common in many
industries, and the cash flow volatility produced by seasonal sales is itself a
contributor to increased credit risk. In addition, Firm B’s operating cash flows
are lower than those of Firm A and are negative in the two most recent
quarters. These two features of Firm B’s operating cash flow make it a
greater credit risk than Firm A.

Requirement 2:
Here are the revised operating cash flow amounts for each firm:

2016 2017
Q1 Q2 Q3 Q4 Q1
Firm A $406.1 $204.2 $729.1 $440.2 $587.8
Firm B (revised) $336.7 $443.1 $908.2 $112.1 $38.6

% change in quarterly cash flow:

Firm A (50%) 257% (40%) 34%
Firm B 32% 105% (88%) (66%)

Firm B now exhibits higher operating cash flows than Firm A in two of the five
quarters, but the sharp decline in the two most recent quarters is still a cause
for concern. The level of operating cash flows in these two most recent

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 quarters, especially when compared to those of Firm A, make Firm B a
greater credit risk.

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 Financial Reporting and Analysis (7th Ed.)
Chapter 6 Solutions
The Role of Financial Information in Valuation
and Credit Risk Assessment
Problems/Discussion Questions

Problems

P6-1 Interpreting stock price changes

Requirement 1:
AMD’s announcement differed from analysts’ expectations and presumably
also from the market’s expectations. One would expect the price to adjust to
reflect the new updated information. Note that the price revision would
capture not only how the current period’s performance differed from
expectations, but also any revision in expectations for future periods that
would result from this period’s announcement. So, one would expect a
decline in AMD’s price on July 10, 2012. In fact, AMD’s price closed at $4.99
that day, down $0.63 (11.2%) from the previous day’s close. In contrast, the
S&P 500 was down 0.8% that same day, indicating it was the news in the
announcement, not a general movement in stock prices, that caused AMD’s
stock to fall.

Requirement 2:
Stock prices change when investors’ beliefs about current or future
performance change. In scenario (a), the reduced revenue was predictable
based on public information available prior to the announcement. This
suggests that at least some of the $200 million difference was due to the
analysts’ forecasts that were available being “stale,” meaning they were
issued before the strike began and have not been updated. Therefore, the
expectations of investors actually trading AMD stock may have already been
lower. There still could have been a surprise and a resulting stock price
reaction if the decline was greater than had been anticipated. In scenario (b),
the revenue decline is unanticipated, suggesting a greater price reaction
would occur than in scenario (a).

P6-2. Assessing credit risk using cash flow forecasts

Requirement 1:
If Randall’s cash flow forecasts are accurate, it will be unable to repay the
loan at the end of 2020. At the end of 2017, Randall will have only $95,000
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 of cash flow available to make loan interest and principal payments. This
amount grows to $1,815,000 by the end of 2020, a figure that represents the
sum of the net change in cash each year ($95,000 + $565,000 + $570,000 +
$585,000). But Randall will owe the bank $2,000,000 plus any unpaid
interest—interest that totals $200,000 each year using a 10% annual interest
rate.

Unless Randall has cash available other highly liquid assets that could be
sold in 2020 to generate additional cash, the company will be unable to repay
the loan. Consequently, Randall’s credit risk is extremely high.

Requirement 2:
There are several ways Randall could enhance its creditworthiness and
reduce its credit risk. One approach is to focus on generating more operating
cash flow each year by growing sales, reducing costs, or both. A second
approach is to agree contractually not to pay dividends without bank
approval. Curtailment of the company’s planned dividend payments would
add another $400,000 to the cash available for loan repayment in 2020, for a
total of $2,215,000. Although dividend curtailment is helpful, Randall is still
an extremely high credit risk because the cumulative cash flow available to
pay the loan is less than the combined amount owed (loan principal and
interest payments). A third approach is to request repayment over a 5-year
period rather than a 4-year period. Randall would have the advantage of one
more year of operating cash flow, then projected to be in excess of $550,000,
available to repay the loan. Randall might also offer to make partial principal
payments of say $500,000 each year beginning in 2018.

P6-3. Valuing growth opportunities

Requirement 1:
The cost of equity capital for eBay is higher than that of Wal-Mart because
eBay has a riskier cash flow stream than does Wal-Mart. Wal-Mart has a long
history of predictable earnings and operating cash flows from its
geographically dispersed retail stores. By comparison, eBay is a relatively
young company and its earnings and operating cash flows are more volatile.

Requirements 2 and 3:
To find the NPVGO for each company, you need to solve for NPVGO in the
following expression:

X0
P0 = + NPVGO
r
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 where P is the current stock price, X is current reported earnings per share
for the year, and r is the estimated cost of equity capital. Rearranging terms
gives us:
X0
NPVGO = P0 -
r

Using this expression and the data provided in the problem statement gives
us the following estimates of NPVGO for each company.

Brunswick $45.46 $2.61 0.095 $27.47 $17.99 39.6%

eBay 26.21 1.84 0.074 $24.86 $1.35 5.2%
Home Depot 127.49 5.33 0.067 $79.55 $47.94 37.6%
Wal-Mart 63.62 4.67 0.044 $106.14 -$42.52 -66.8%
Walgreen Boots Alliance 81.82 4.11 0.086 $47.79 $34.03 41.6%

Requirement 4:
The NPVGO at Home Depot is greater as a percent of share price than that
for eBay because investors believe that Home Depot has better growth
opportunities—a higher rate of growth and more profitable growth.
Alternatively, eBay’s earnings per share may have been temporarily
increased because of a one-time (transitory) gain, or Home Depot’s could
have been temporarily decreased due to a transitory loss. In either of those
cases, the resulting NPVGO estimate would be misleading unless the one-
time gain or loss were eliminated prior to computing NPVGO.

Requirement 5:
On its face, a negative NPVGO suggests and expected earnings growth rate
that is negative. However, the result could also be due to an underestimated
cost of capital or an abnormally high level of earnings per share. The latter
situation could be dealt with by adjusting EPS for transitory items before
doing the calculation.

P6-4. Predicting future cash flow

Requirement 1:
If, as the problem statement indicates, credit customers pay 30 days after the
sale, the month-end accounts receivable balance will be equal to credit sales
that month. Of course, there may also be cash sales that month.

Note that January cash collections ($510) are equal to the previous
December’s outstanding accounts receivable ($500) plus cash sales in
January ($10 = $620 Sales minus $610 month-end balance in accounts
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 receivable). This same pattern persists into March. So, March credit
customers must still owe $790 at month-end because all of the January and
February credit customers have paid their accounts in full.

Requirement 2:
March cash collections ($640) are equal to February’s outstanding accounts
receivable ($630) plus cash sales in March ($10 = $800 sales - $790 month-
end accounts receivable).

Requirement 3:
An analysis of the inventory account reveals that March purchases must have
been $710. This amount is equal to March cost of goods sold ($640) plus the
increase in March inventories ($70 = $840 - $770).

Requirement 4:
If, as the problem statement indicates, suppliers are paid 60 days after health
care products are purchased, the March cash payment ($525) should
correspond to January purchases. An analysis of the inventory account
reveals that January purchases are indeed equal to $525. This amount is the
January cost of goods sold ($500) plus the increase in January inventories
($25 = $625 - $600).

Requirement 5:
Visual inspection of the data suggests that current month’s gross profit is a
better predictor of next month’s net cash flow than is current month net cash
flow. This intuition is confirmed statistically using regression analysis. The
explanatory power (adjusted R-square) for current month gross profit as a
predictor of next month’s net cash flow is 45.6% compared to 1.2% for current
month’s net cash flow.

Requirement 6:
In general, accrual earnings smoothes out the period-to-period lumpiness that
sometimes arise in operating cash flows. This lumpiness is produced by
period-to-period variations in business activities such as sales, customer
collections, vendor payments, and so on. Consequently, accrual earnings is
often (but not always) a better predictor of future operating cash flow than is
current period operating cash flow.

P6-5. Tail O’ the Dog: Fair value measurement

Requirement 1:
The least relevant measure for purposes of fair value determination is the
parking lot’s 1962 historical cost ($12,000). The price paid 50 years ago to
purchase an asset—the parking lot—has no direct bearing on the asset’s fair
value today.
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 Here’s another example to illustrate why historical cost is irrelevant to fair
value determination. In 1626, Peter Minuit bought Manhattan island from the
local Indians for a load of cloth, beads, hatchets, and other odds and ends
then worth 60 Dutch guilders, an amount we are told is equivalent to about
$24. Clearly, the fair value of Manhattan is considerably more than $24
today.

Requirement 2:
Quoted prices from an active market for identical assets (Level 1 fair value
measurement) are not available in this setting, but observable inputs (Level
2) are available. In particular, there are recent quoted prices for similar
assets: a parking lot ($500,000) and a residential beachfront lot ($1.2 million).
GAAP requires fair value measurements to reflect the “highest and best use”
of the asset, so the most relevant measure is the recent (market) price paid
for the residential beachfront lot.

Requirement 3:
Level 2 fair value measurements include quoted market prices for similar
assets. There are two Level 2 observable inputs present in this fact pattern:
the recent (market) price paid for the parking lot ($500,000) and for the
residential beach front lot ($1.2 million). Neither of the inputs is a perfect
measure of the Tail O’ Dog’s parking lot fair value. There is also a Level 3
fair value measure present in the fact pattern: the model-based fair value
estimate of $600,000 which is based on unobservable inputs.

Requirement 4:
Auditors are especially challenged by Level 3 fair value measurements
because it is difficult (if not impossible) to verify the accuracy and precision of
the forecasted income stream that forms the basis for the parking lot’s
$600,000 estimated fair value in this setting. At the same time, although it is
easier to verify the prices recently paid for similar assets (Level 2
measurements), auditors must still determine whether those similar-asset
prices provide a sound basis for fair value determination of the asset in
question.

P6-6. Sonic Solutions: Discounted cash flow valuation

Requirement 1:
Free cash flow is defined in the spreadsheet as EBITDA minus capital
expenditures and cash taxes, where EBITDA refers to earnings before
interest, taxes, depreciation and amortization. This spreadsheet definition
differs in several ways from how accountants and auditors define free cash
flow. In particular, it ignores: (1) other non-cash revenue and expense items
beyond just depreciation and amortization; (2) changes in working capital
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 investments such as accounts receivable and inventories that affect cash
flows; and (3) cash interest payments. On the other hand, the spreadsheet
definition is a useful approximation for the more complete free cash flow
calculation in some settings.

Requirement 2:
The annual percentage rates of sales growth and free cash flow growth are:

Several features of these growth rates are noteworthy. First, the analyst is
projecting rather high levels of sales growth in 2011 through 2013, which
would be quite unusual for an established company operating in a mature
product market. However, Sonic Solutions develops digital media products,
services and technologies which may be viewed by the analyst as having a
unique competitive advantage. It may also be the case that management has
announced a particularly attractive new product/service launch scheduled for
2011. A second feature is that free cash flows are projected to grow faster
than sales in each year beginning in 2011. The source of this additional
growth is unclear, but may have been explained in the analysts’ published
research report.

Requirement 3:
The 12% weighted-average cost of capital (WACC) serves as the discount
rate used in computing the present values shown in the spreadsheet. WACC
represents a blended discount rate that reflects the cost of both debt and
equity capital in proportion to their contribution to total capital in the company.
Each so-called discount factor is just 1/(1 + .12)t where t denotes the forecast
year; e.g., 1 for 2010, 2 for 2011, and so on.

Requirement 4:
Each forecasted free cash flow amount (e.g., $4.6 in 2010) is multiplied by a
corresponding discount factor (e.g., 0.89286 in 2010) to arrive at a present
value of the future free cash flow (e.g., $4.11 in 2010). The discount rate
used is explained in Requirement 3. These individual present values are
then added together to compute the aggregate present value for 2010-2017
of $155.19.

Requirement 5:
This figure represents the present value of free cash flows occurring beyond
2017. Analysts typically calculate this terminal present value as follows:

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 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑇
𝑇𝑃𝑉 = 𝑥 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟𝑇
(𝑊𝐴𝐶𝐶 − 𝑔𝑟𝑜𝑤𝑡ℎ)

where T denotes the spreadsheet terminal year (2017). If you insert $79.8 as
the terminal-year free cash flow forecast (from the spreadsheet), 0.40388 as
the discount factor, and 0.12 as the WACC value, the calculated TPV will be
$268.58. This zero growth TPV is considerably smaller than the $460.43
figure shown in the analysts’ spreadsheet. The reason why is because the
analyst set the growth rate to be 5%. You should verify that TPV is $460.43
when the growth rate is 0.05.

Requirement 6:
Notice that free cash flow is defined for spreadsheet purposes as a “before
interest” figure, and that the discount rate is a weighted-average cost of
capital (WACC). Both spreadsheet features indicate that the present value
calculation is intended to estimate the fair value of the entire company
($615.61), not just the value of its common stock. The analyst then subtracts
the value of net debt to arrive at the value of common stock ($672.11 equity
value).

Requirement 7:
If equivalent assumptions are used, the share value estimate calculated using
an abnormal earnings approach will be identical to the value calculated using
the discount cash flow approach illustrated in the problem statement
spreadsheet. In other words, the abnormal earning approach estimate of
share value also would be $13.00.

Requirement 8:
The share value estimate would have been $19.43 (= $672.11 / 34.60
shares) if the analyst had mistakenly used the incorrect 34.6 million shares
rather than the correct 51.69 million share count.

As you might have already guessed, an analyst covering Sonic Solutions did
indeed mistakenly use the wrong share count (34.60 million) in a research
report published in June 2010. The initial report concluded that the stock was
worth $13 per share based on a discounted free cash flow valuation model
similar to the one shown in the problem statement spreadsheet. Shortly after
releasing the report, the analyst discovered the error and issued a revised
report which used the correct share count (51.69 million) but also concluded
that the stock was worth $13 per share. How was this conclusion supported?
The analyst altered the free cash flow forecasts from their original amounts to
higher figures shown in discounted cash flow valuation model spreadsheet in
the problem statement. By increasing the free cash flow forecasts, the
analyst was able to offset the effect of dividing the equity value estimate by a
larger share count. To an unbiased outside observer, it might appear as
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 though the analyst concocted the forecasts used in the revised DCF model so
that the original $13 share value estimate was confirmed when the share
count was corrected.

Requirement 9:
It is difficult to discern any large stock price reactions, suggesting Rovi
investors viewed the price as fair. Rovi stock was up 1.0% on the December
22 announcement date versus 0.3% for the S&P 500. If the announcement
had been made after the market closed, the price reaction would be observed
the next trading day, December 23. On that day, Rovi was down 1.9% while
the S&P 500 was down 0.2%. In either case, the price movement was small
enough to make it difficult to attribute any price reaction to the
announcement.

P6-7. Determining abnormal earnings: Some simple examples

Abnormal earnings (AE) = NOPAT - (r x BVt-1).

Requirement 1:
AE = $5,000 - (0.15 x $50,000) = -$2,500.

Requirement 2:
AE = $25,000 - (0.18 x $125,000) = $2,500.

Requirement 3:
AE = $30,000 - (0.18 x $125,000) = $7,500.

NOTE: Higher NOPAT without additional investment (i.e., the same BVt-1)
increases AE.

Requirement 4:
AE = $23,000 - (0.18 x $100,000) = $5,000.

NOTE: Eliminating unproductive assets that do not earn as high a rate of

return as other assets increases AE. In this case, the unproductive assets
were earning a return of only 8% ($2,000/$25,000).

Requirement 5:
AE = $32,600 - (0.18 x $165,000) = $2,900.

AE increases by $400 (from $2,500 to $2,900). Adding the division makes

sense. The new division earns a return of 19% ($7,600/$40,000), which is
more than the firm’s 18% required rate of return, so value is added, and the
change in AE is positive.

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 Requirement 6:
AE = $8,500 - (0.15 x $75,000) = -$2,750.

AE falls by $250. Adding the new division does not make sense. In essence,
the new division does not earn a high enough rate of return to justify
investment. The new division earns a return of 14% ($3,500/$25,000) which
is less than the firm’s 15% required rate of return, so value is lost, and the
change in AE is negative.

P6-8. Assigning credit ratings using financial ratios

Requirement 1:
Standard & Poor’s credit analysts would probably assign a credit rating of BB
to Firm 1. The financial ratios for this firm are closest to the median values
for BB rated companies (see Exhibit 6.5).

Requirement 2:
The financial ratios for Firm 2 are closest to the median values for AA rated
companies.

Requirement 3:
All of the financial ratios for Firm 3 tilt toward the median values for AAA rated
companies when compared to those of Firm 2. Consequently, Firm 3
appears to have less credit risk than does Firm 2, although it is doubtful that
this difference in credit risk is large enough to warrant a higher credit rating
than that assigned to Firm 2.

P6-9. Calculating value creation by two companies

Requirement 1:
The abnormal earnings of the two firms for 2013–2017 appear below.
Company A 2013 2014 2015 2016 2017
NOPAT $66,920 $79,632 $83,314 $89,920 $92,690
BVt-1 478,000 504,000 541,000 562,000 598,000
Cost of equity capital 0.152 0.167 0.159 0.172 0.166
Return on capital 0.140 0.158 0.154 0.160 0.155
Abnormal earnings ($5,736) ($4,536) ($2,705) ($6,744) ($6,578)

Company B
NOPAT $192,940 $176,341 $227,700 $198,900 $282,964
BVt-1 877,000 943,000 989,999 1,020,000 1,199,000
Cost of equity capital 0.188 0.179 0.183 0.175 0.186
Return on capital 0.220 0.187 0.230 0.195 0.236
Abnormal earnings $28,064 $7,544 $46,530 $20,400 $59,950

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 Requirement 2:
Company B created value each year via positive abnormal earnings,
while Company A actually destroyed value each year by earning
negative abnormal earnings.

Requirement 3:
The return investors earn from a stock depends on the difference
between what must paid to buy the stock—it’s cost or current market
price—and what it will ultimately be worth at the time it is sold—it’s
value, expressed in current dollars. In an efficient market, the current
price (“cost”) of each stock is equal to what the stock is worth today.
Exceptional investment returns are earned only if the stock is somehow
mispriced currently.

How do these notions apply to company A and B? Company B has

clearly outperformed Company A during the years shown. Let’s assume
that this favorable performance difference is expected to continue into
the future. The performance differences between A and B are likely to
be already reflected in the current market prices of each company’s
stock: Company A will appear cheap precisely because it
underperforms, whereas Company B will have a high market price
because it outperforms. Investors who purchase shares in B will, if the
stock is correctly priced by the market, simply earn a normal return,
given the degree of risk they are bearing. But the same holds true for
investors who purchase shares in A. If the market is efficient, neither
stock will be an exceptional investment because the performance
differential has already been incorporated in the current market price of
each company’s shares.

P6-10. Making credit rating changes

Requirement 1:
The company’s credit risk has increased since the first quarter of 2016. At
that time, the company’s financial ratios were closest to the median values for
AAA rated companies (see Exhibit 6.5).

Requirement 2:
Standard & Poor’s analysts are likely to assign a credit rating of AA to the
company that quarter because its Q2 2017 financial ratios are closest to the
median values of other AA rated companies.

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 Requirement 3:
There is a gradual deterioration in credit worthiness throughout 2016 but the
changes are probably not large enough to warrant a ratings downgrade. This
situation changes beginning in the first quarter of 2017 where:
• there are sharp declines in two important financial ratios (FFO/total
debt and Free operating cash flow/total debt):
• and a sizable increase in Total debt/capital.

Credit risk deteriorates even further in the second quarter of 2017. Standard
& Poor’s analysts might have concluded that the credit risk warning signs
were strong enough in Q1 2017 to warrant a ratings downgrade. If not, then
the downgrade would certainly occur in Q2 2017.

P6-11. ENRON: Fair value accounting

Requirement 1:
There are several features of the Bravehart structure that were essential to
achieving the fair value accounting profit boost. First, Enron needed to
isolate the Blockbuster contract in a separate entity (Bravehart partnership)
so that the investment bank loan was not viewed as an Enron obligation and
thus as Enron debt. Second, Enron’s investment in the Bravehart partnership
had to be structured such that consolidation was not required. Back in the
day, this meant that the passive Bravehart entity—remember, it’s just a
conduit for housing the Enron-Blockbuster contract and for distributing cash
to the investment bank—had to involve at least a 3% investment by someone
other than Enron and thus qualify as a special purpose entity. The Bravehart
structure conformed to this requirement, and Enron’s investment (a modest
amount of cash and some Enron stock) in Bravehart shares then was listed
as an investment in financial securities on Enron’s balance sheet. GAAP
requires financial assets to be “marked-to-market”, meaning that fair value
accounting rules automatically applied once the Bravehart investment was
recorded in this way on Enron’s books.

The final piece required for the profit boost involved “monetizing” the Enron-
Blockbuster contract with the aid of an investment bank. The bank loan $115
to Bravehart and in exchange, received from Bravehart a promise to pay the
bank “most” of the earnings generated by the Enron-Blockbuster contract.
This bank loan effectively established the contract’s fair value at $115 million,
which also meant that Bravehart must have a fair value of about $115 million
($115 million for the contract plus $115 million cash from the bank, minus
$115 million loan from the bank). Once the bank loan transaction was
completed, Enron recorded a mark-to-market adjustment of $110 million to its
Investment in Bravehart shares and this adjustment flowed to profits.

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 Requirement 2:
There are two critical judgments required to estimate the bank guarantee’s
fair value: (1) what is the likelihood that Bravehart will default on the loan and
cause the bank to seek payment directly from Enron? and (2) how much of
the loan balance will be unpaid at the time of default if default occurs? The
fair value of the loan guarantee is determined by Enron’s exposure to
Bravehart’s credit risk, and thus by the amount and timing of the net cash
flows expected to arise from the Enron-Blockbuster contract. The higher
these net cash flows, the lower is Bravehart’s credit risk and the smaller is the
fair value of Enron’s loan guarantee because it is unlikely that the bank will
seek cash payments from Enron.

Requirement 3:
Enron’s mark-to-market adjustment to the Bravehart investment would then
have been just $15 million, the difference between Bravehart’s fair value
($115 million) and the loan guarantee’s fair value ($110 million). This point
illustrates the importance of the loan guarantee’s fair value estimate to the
potential profit boost recorded by Enron.

Requirement 4:
This would be an extraordinarily challenging audit task because the fair value
measurement occurs at Level 3, and thus relies on unobservable inputs. The
auditor could turn to independent estimates of the future net cash flows for
the Enron-Blockbuster contract, but the only third party estimates available
would be those from the investment bank. Some would argue that the bank
is hardly independent in this setting because it can always turn to Enron if
Bravehart defaults. Under those circumstances, the bank has little incentive
to accurately forecast the future net cash flows associated with the contract.

P6-12. Calculating sustainable earnings

Requirement 1:
The original income statements for 2011–2014 appear on the next page
along with the calculation of sustainable earnings for each of the three years.
Except for the transitory revenue of $1 billion in 2014, which was given in the
case, all of the adjustments required to calculate each year’s sustainable
earnings appear on the original income statements. The adjustments fall into
two categories: (1) Nonrecurring/transitory losses and expenses that needed
to be added back (on an after-tax basis) to net income; and (2) Gains and
credits that needed to be subtracted (on an after-tax basis) from net income.

Requirement 2:
An interesting conclusion emerges when reported earnings are compared
with sustainable earnings. While the firm’s reported earnings increased each
year from 2011 to 2014, its sustainable earnings fell each year from 2011–
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 2014. This trend points to the importance of identifying and adjusting for the
presence of non-recurring and other transitory Items in the income statement
when attempting to gauge a firm’s potential long-run earnings generating
ability.

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Colonel Electric Inc. (in millions of $) As Reported Earnings Sustainable Earnings Calculation
For Years Ended December 31, 2016 2015 2015 2016 2015 2014
Revenues
Sales of goods $54,196 $53,177 $52,767 $54,196 $53,177 $52,767
Sales of services 11,923 10,836 8,863 11,923 10,836 8,863
Royalties and fees 1629 753 783 629 753 783
66,748 64,766 62,413
Total revenues 67,748 64,766 62,413
Costs and Expenses:
Cost of goods sold (24,594) (24,308) (22,775) (24,594) (24,308) (22,775)
Cost of services sold (8,425) (6,785) (6,274) (8,425) (6,785) (6,274)
Restructuring charges (+ reversals) 1,000 0 (2,500) 0 0 0
Interest charges (595) (649) (410) (595) (649) (410)
Other costs and expenses (6,274) (5,743) (5,211) (6,274) (5,743) (5,211)
Litigation charges (+ income) 550 0 (250) 0 0 0
Losses (+ gains) on sales of investments (75) 0 25 0 0 0
Losses (+ gains) on sales of misc. assets 0 55 0 0 0 0
Losses (+ gains) on sales of fixed assets 25 0 (35) 0 0 0
Inventory write-offs 0 (18) 0 0 0 0
Asset impairments 0 0 (24) 0 0 0
Special item charges (34) 0 (8) 0 0 0
Loss from labor strike 0 (20) 0 0 0 0
Total costs and expenses (38,422) (37,468) (37,462) (39,888) (37,485) (34,670)

Earnings from continuing operations

before income taxes 29,326 27,298 24,951 26,860 27,281 27,743
Provision for income taxes (34%) (9,971) (9,281) (8,483) (9,132) (9,276) (9,433)
Earnings from continuing operations 19,355 18,017 16,468 17,728 18,005 18,310
Loss (+ income) from discontinued operations (net
of tax) 0 (250) 1,100 0 0 0
Loss (+ gain) on sale of discontinued
operations (net of tax) 750 0 0 0 0 0
Extraordinary loss (+ gain) on early
debt retirement (net of tax) (50) 0 10 0 0 0
Cumulative loss (+ gain) from change in
accounting methods (net of tax) ___(110) 0 _____55 ______0 ______0 ______0
Net Earnings $19,945 $17,767 $17,633 $17,728 $18,005 $18,310

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P6-13. Krispy Kreme Doughnuts: Valuing abnormal earnings

Requirement 1:
The following table implements the abnormal earnings valuation procedure
illustrated in Exhibit 6.8 of the appendix.

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 Requirement 2:
The value estimate from requirement 1 ($19.62 per share) is substantially
below the market price of the stock ($44.00) in August 2003. There are
several reasons why the abnormal earnings value estimate might differ from
the company’s actual market price:
• Investors may be more optimistic about the company’s profit prospects
than are analysts, and the value estimate is based on analysts’ less
optimistic EPS forecasts.
• Investors and analysts may agree about EPS forecasts over the next five
years, but the terminal growth assumption (3.0%) used here may be
overly pessimistic. A higher terminal growth rate (say 8.5%) will produce
a higher share value estimate ($47.60). It is, however, unlikely that
Krispy Kreme can grow at 8.5% for ever.
• We may have assigned the company a cost of equity capital that is too
large. Given the forecasts used in the valuation model, a 7% cost of
capital (discount rate) will yield a value estimate slightly in excess of $44
per share. However, this discount rate seems unreasonably low for a
company such as Krispy Kreme.
• The most interesting possibility is that the stock is “overvalued” at $44
per share. Why might this occur? One reason is that investors are
overly optimistic about the company’s profit prospects because they fail
to properly consider the company’s growth opportunities and competitive
dynamics in the industry.

It is interesting to note that 9 months later (May 2004) the stock was trading at
about $20 per share.

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 Financial Reporting and Analysis (7th Ed.)
Chapter 6 Solutions
The Role of Financial Information in Valuation,
Cash Flow Analysis, and Credit Risk Assessment
Cases

Cases
C6-1. Illinois Tool Works: Abnormal earnings valuation

Requirements 1 and 2:
The template solution (shown on the next page) yields an estimated stock
price of $36.08 per share. This estimate is considerably below the company’s
trading range of $56-$64 in the first quarter of Year 4. One reason for this
discrepancy is that the spreadsheet does not incorporate a terminal value
estimate—company performance beyond year 10 does not affect the
valuation.

This feature of the spreadsheet is not appropriate for a company like Illinois
Tool Works. Why? Because positive abnormal earnings are being generated
in year 10, and the market (but not the spreadsheet) presumably expects
those economic profits to persist into the future. As a result, the market has
assigned a higher share price to the company than does the valuation model.

Requirement 3:
When forecasted ROCE is raised to 16%, the value estimate increases to
$59.79. This amount corresponds more closely to the stock’s trading range in
the first quarter of Year 4, but this estimate still ignores the (now substantial)
terminal value.

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 Case 6-1 - ILLINOIS TOOL WORKS
Abnormal Earnings Valuation as of Early Year 4
(Dollar amounts in millions)

Cost of capital 9.0%

Initial book value 12/31/ Year 3 $10,624
Dividend payout 25.0%
Forecasted ROCE on beginning equity 9.5%

Year: 4 5 6 7 8 9 10 11 12 13

Beginning book value $10,624 $11,381 $12,192 $13,060 $13,991 $14,988 $16,056 $17,200 $18,425 $19,737
+ Forecasted earnings 1,009 1,081 1,158 1,241 1,329 1,424 1,525 1,634 1,750 1,875
- Forecasted dividends (252) (270) (290) (310) (332) (356) (381) (409) (438) (469)
Ending book value $11,381 $12,192 $13,060 $13,991 $14,988 $16,056 $17,200 $18,425 $19,737 $21,143

Forecasted earnings $1,009 $1,081 $1,158 $1,241 $1,329 $1,424 $1,525 $1,634 $1,750 $1,875
- Normal earnings (956) (1,024) (1,097) (1,175) (1,259) (1,349) (1,445) (1,548) (1,658) (1,776)
Abnormal earnings 53 57 61 66 70 75 80 86 92 99
x Discount factor 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.547 0.5019 0.4604 0.4224
Present value of abnormal earnings 49 48 47 47 45 45 44 43 42 42

Initial book value $10,624

PV of abnormal earnings over 10 years 452
Estimated value of equity 11,076
Number of shares (millions) 307
Predicted share price $36.08

Actual high $64

Actual low $56

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C6-2. Sunny Day Stores Inc. : Analyzing debt covenants and financial distress

Note to instructors: This is a challenging case based on a real company,

Sunshine Junior Stores, Inc. As a result, some instructors find that it is best
suited for class discussion of the issues surrounding loan renegotiations
rather than as a graded homework assignment. A useful feature of the case is
that the revised loan terms are included in the solution. This allows students
to see what lenders actually did. The dates described below in excerpts from
the company’s lending agreement have been modified to conform to the
problem statement.

Requirement 1:
With regard to the amount of collateral, given that Sunny Day violated its
earlier lending agreements, lenders are likely to demand collateral in an
amount equal to face value of the debt.

With regard to the type of collateral, lenders prefer assets that are extremely
marketable and, thus, can be sold quickly if Sunny Day defaults. Receivables
and Inventories are usually good candidates. Less desirable, but still useful
are company-owned stores, furnishing, and fixtures.

The revised lending agreement stated that: The Company will pledge as
collateral its interest in approximately 95 stores which are located outside of
its primary market areas and which it is planning to offer for sale.

Requirement 2:
The fact that Sunny Day defaulted on the earlier lending agreement is a clear
indication that the company’s credit risk has increased. To compensate for
the added risk, lenders often require a higher interest rate.

The actual revised lending agreement stated the following: The interest
rates on the loan agreements will be increased to 9.43% and prime plus 1.5%
for Prudential and First Florida, respectively.

Requirement 3:
As stated in the revised lending agreement, lenders could require the
company to use the proceeds from any asset sale to reduce outstanding
debt. In addition to limitations on cash dividends, this requirement prevents
the management from selling valuable assets and distributing the proceeds to
shareholders, an action that would make the lenders worse off.

The actual revised lending agreement stated the following (with dates
changed to correspond to those in the case): Additional principal
reductions in the amount of $1,000,000 are required on both the note payable
to Prudential and the revolving note payable to First Florida on April 1, 2019.
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 The proceeds from any sales of assets (20% through September 30, 2018;
30% through March 31, 2019; 40% from April 1, 2019 through June 30, 2019;
and 75% thereafter) must be applied toward additional principal reductions.

Requirement 4:
This will be a difficult question for students to answer in a precise fashion. We
recommend making the following point before sharing the actual revisions
with them. Lenders are likely to ask for future profit and cash flow projections
as part of the renegotiations. These projections provide a natural starting
point for determining revised covenant limits. Students should also recognize
that the final outcome here is negotiated.

The actual revised lending agreement stated the following: The new
financial covenants, all calculated based on inventories accounted for on a
FIFO basis, are as follows:
Minimum FIFO
Fixed
Coverage
Working Ratio, as
Period ending Net Worth Capital (deficit) defined

March 2018 $20,000,000 ($5,500,000) 1.30:1.0

June 2018 $20,500,000 ($6,000,000) 1.25:1.0
September 2018 $21,000,000 ($5,500,000) 1.35:1.0
December 2018 $21,000,000 ($5,500,000) 1.40:1.0
March 2019 $21,500,000 ($5,000,000) 1.40:1.0
June 2019 $21,500,000 ($4,000,000) 1.20:1.0
September 2019 $22,500,000 ($4,000,000) 1.30:1.0
December 2019 $22,500,000 ($3,500,000) 1.40:1.0
March 2020 and thereafter $22,500,000 ($3,000,000) 1.40:1.0

Note that the revised covenants are based on FIFO inventory values even
though Sunny Day uses LIFO for financial reporting purposes (see the
balance sheet). One interpretation of this feature is that lenders believe that
FIFO values provide a more accurate indication of the company’s credit risk
than do LIFO values.

Requirement 5:
Sunny Day defaulted on the earlier loan and is clearly experiencing some
financial difficulty. Allowing the company to pay dividends gives management
an opportunity to reorder the claims of bondholders and shareholders.
Payment of cash dividends decreases the likelihood of debt repayment
because there is less cash in the company. The company should not be
allowed to resume the dividend.

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 The actual revised lending agreement stated the following: Negative
covenants in the Company’s debt agreements prohibit the payment of
dividends.

C6-3. Microsoft Corporation: Unearned revenues and earnings management

Requirement 1:
The net profit margin is equal to net income divided by sales. For Microsoft,
the rates are:

Fourth quarter of 1996:

Net profit margin = $559/$2,255 = 24.8%

Fourth quarter of 1997:

Net profit margin = $1,057/$3,175 = 33.3%

Year 1996:
Net profit margin = $2,195/$8,671 = 25.3%

Year 1997:
Net profit margin = $3,454/$11,358 = 30.4%

By any standard, Microsoft’s net profit margin is very high, and it

improved from 1996 to 1997.

Requirement 2:
Microsoft just exceeded analysts’ expectations in the fourth quarter. The firm
earned 80 cents per share, and analysts were expecting 79 cents per share.

Requirement 3:
Ending balance = Beginning balance + additions - reductions
$1,418 = $1,285 + additions - 0; additions = $133.0

Requirement 4:
Income effect per share = increase in income/shares used to calculate fourth
quarter EPS
= $133.0/1,327 = 0.10 or 10 cents

Requirement 5:
Ending balance = Beginning balance + additions - reductions
$1,418 = $560 + additions - $188.0; additions = $1,046.0

Requirement 6:
Income effect per share = increase in income/shares used to calculate fourth
quarter EPS
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Solution Manual for Financial Reporting and Analysis 7th Edition By Revsine

= $1046.0/1,312
= $0.80 or 80 cents

Requirement 7:
This answer is the balance in the account of $1,418 divided by the number of
shares used to calculate 1997 annual earnings.

= $1,418/1,312 = $1.08

Requirement 8:
In periods when the firm’s earnings are less than management would like to
report, the balance in the Unearned revenues account could be drawn down
in order to increase earnings to a level that management would like to report
(subject, of course, to the available balance in the account).

In periods when the firm is doing very well, management could try to “bank”
some future earnings by increasing the amount reported in the Unearned
revenues account.

Requirement 9:
This is a tough task for the analyst. One thing that the analyst might do is
monitor the firm’s balance sheets on a quarter-to-quarter basis, paying
special attention to the Unearned revenues account. What the analyst could
watch for are large increases in the account balance in periods when the firm
is doing very well, and perhaps, more importantly, declines in the account
balance in periods when the firm has done poorly, or periods where the
market expects the firm to do poorly. In either case, since the analyst will get
to observe only the net change in the account balance from period-to-period,
detecting with any degree of reliability that the account is being used to
manage the firm’s earnings will be a very difficult task.

Requirement 10:
No. It might very well be that the firm’s managers believe that the proper
matching of revenues and expenses requires that some of the revenues
collected from customers in a given year be deferred and recognized in a
later period when product upgrades are delivered and/or various types of
services are provided.

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