EF4314 Solution to Self-study Exercise 1

Question 1
Applying Accounting Relations: Balance Sheet, Income Statement, Equity Statement,
and Cash Flow Statement

a. Liabilities = Assets – Shareholder’s equity

= $400 - $250
= $150 million

b. Net Income = Revenues – Expenses

$30 = ? - $175
? = $205 million

c. Ending equity = Beginning equity + Comprehensive Income – Net Payout

$250 = $230 + ? - $12
? = $32 million

As net income (in the income statement) is $30 million, $2 million was reported as “other
comprehensive income” in the equity statement.

d. Change in cash = Cash from operations – Cash investment – Cash paid out in
financing activities
$130 = $400 - ? - $75
? = $195 million

Question 2
Preparing an Income Statement and Statement of Shareholders' Equity

Income statement:

Sales $4,458
Cost of good sold 3,348
Gross margin 1,110
Selling expenses (1,230)
Research and development (450)
Operating income (570)
Income taxes 200
Net loss (370)

Note that research and developments expenses are expensed as incurred.

Equity statement:

Beginning equity, 2012 $3,270

Net loss $(370)

Other comprehensive income 76 (294) ($76 is unrealized gain on securities)
Share issues 680
Common dividends (140)

Ending equity, 2012 $3,516

Comprehensive income (a loss of $294 million) is given in the equity statement. Unrealized
gains and losses on securities on securities available for sale are treated as other comprehensive
income under GAAP.

Net payout = Dividends + share repurchases – share issues

= 140 + 0 – 680

= - 540
That is, there was a net cash flow from shareholders into the firm of $540 million.

Taxes are negative (that is, the effect on income is positive) because income is negative (a loss).
A loss yields a tax benefit that he firm can carry forward to reduce future taxes.

Question 3
Violations of the Matching Principle
a. Expenditures on R&D are investments to generate future revenues from drugs, so are
assets whose historical costs ideally should be placed on the balance sheet and amortized
over time against revenues from selling the drugs. Expensing the expenditures
immediately results in mismatching: revenues from drugs developed in the past are
charged with costs associated with future revenues. However, the benefits of R&D are
uncertain. Accountants therefore do not recognize the asset. Effectively, GAAP treats
R&D expenditures as a loss.

b. Advertising and promotion are costs incurred to generated future revenues. Thus, like
R&D, matching requires they be booked as an asset and amortized against the future
revenues they promote, but GAAP expenses them as incurred.

c. Film production costs are made to generate revenues in theaters. So they should be
matched against those revenues as the revenues are earned rather than expensed
immediately.
Question 4
Using Accounting Relations to Check Errors

Ending shareholders’ equity can be derived in two ways:

1. Shareholders’ equity = assets – liabilities

2. Shareholders’ equity = Beginning equity + comprehensive income – net dividends

So, if the two calculations do not agree, there is an error somewhere. First make the

calculations for comprehensive income and net dividends:

Comprehensive income = net income + other comprehensive income

= revenues – expenses + other comprehensive income

= 2,300 –1,750 – 90

= 460

Net dividend = dividends + share repurchases – share issues

= 400 +150 –900

= - 350

Now back to the two calculations:

1. Shareholders’ equity = 4,340 – 1,380

= 2,960

2. Shareholders’ equity = 19,140 + 460 – (-350)

= 19,950

The two numbers do not agree. There is an error somewhere.

Question 5
Calculating a Price from Comparables
P/E for the comparable firm = 100/5 = 20
P/B for the comparable firm = 100/50 = 2

Price for target, from earnings = $2.50 × 20 = $50 per share

Price for target, from book value = $30 × 2 = $60 per share

Average of the two prices = $55 per share

Question 6
Unlevered (Enterprise) Multiples
Market price of equity = 80 × $7 = $560 million
Market value of debt 140 (assumes book value = market value)
Market value of enterprise $700 million

Book value of shareholders’ equity = $250 - 140 = $110million

a. P/B = 560/110 = 5.09

b. Unlevered P/S = 700/560 = 1.25
c. Enterprise P/B = 700/250 = 2.8

Question 7
Measuring Value Added
(a) Buying a stock:

2 $ 16.67
Value of a share = =
0.12
Price of a share 19.00
Value lost per share $ 2.33

(b) Value of the investments:

Present value of net cash flow of $1M per year for

$ 3.890 million
five years (at 9%)

Initial costs 2.000

Value added $ 1.890 million
Question 8
Share Issues and Market Prices: Is Value Generated or Lost by Share Issues?

This exercise tests understanding of a conceptual issue: do share issues affect shareholder value
per share? The understanding is that issuing shares at market price does not affect the wealth
of the existing shareholders if the share market is efficient: New shareholders are paying the
“fair” price for their share. However, if the shares are issued at less than market price, the
existing shareholders lose value.

(a) Total value of equity prior to issue = 158 million × $55 = $ 8.69B
Value of share issue = 30 million × $55 = 1.65B
Total value of equity after share issue 10.34B
Shares outstanding after share issue = 188 million

Price per share after issue = 10.34B/188 million = $55

A share issue does not affect per share value as long as the shares are issued at the
market price. Existing shareholders can’t be damaged or gain a benefit from the issue.
Of course, if the market believes that the issue indicates how insiders view the value of
the firm, the price may change. But this is an informational effect, not a result of the
issue. Existing shareholders would benefit if the market were inefficient, however. If
shares are issued when they are overvalued in the market, the new shareholders pay too
much and the existing shareholders gain.

(b) Total value of equity prior to exercise = 188 million × 62 = $11.66B

Value of share issue through exercise = 12 million × 30 = 0.36B
Total value of equity after exercise 12.02B
Shares outstanding after exercise 200 million

Price per share = 12.02B/200 million = $60.10

Therefore, the shareholders lost $1.90 per share through the issue: issue of shares at
less than market causes a loss (“dilution”) of shareholder value.