Stephen Penman - Financial Statement Analysis and Security Valuation 4e solution manual-Mc Graw-Hill Irwin (2009 ) PDF

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SOLUTIONS TOEXERCISE AND CASESForFINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATIONStephen H. PenmanCHAPTER ONEIntroduction to Investing and ValuationExercisesDrill ExercisesE1. Calculating Enterprise ValueEnterprise Value = $1,800 millionE1. Calculating Value Per ShareEquity Value = $1,E1 Buy or S...

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SOLUTIONS TO EXERCISE AND CASES For FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION

Stephen H. Penman

CHAPTER ONE Introduction to Investing and Valuation

Exercises Drill Exercises E1.1. Calculating Enterprise Value Enterprise Value = $1,800 million E1.2. Calculating Value Per Share Equity Value = $1,800 E1.3

Buy or Sell? Value = $850 + $675 = $1,525 million Value per share = $1,525/25 = $61 Market price

= $45

Therefore, BUY!

Applications E1.4. Finding Information on the Internet: Dell Computer and General Motors This is an exercise in discovery. The links on the book’s web site will help with the search. Here is the link to yahoo finance: http://finance.yahoo.com E1.5. Enterprise Market Value: General Mills and Hewlett-Packard (a)

General Mills

Market value of the equity = Book value of total (short-term and long-term) debt

=

Enterprise value

Note three points: (i)

Total market value of equity = Price per share × Shares outstanding.

(ii)

The book value of debt is typically assumed to equal its market value, but financial statement footnotes give market value of debt to confirm this.

(iii)

The book value of equity is not a good indicator of its market value. The price-tobook ratio for the equity can be calculated from the numbers given: $20,925/$6,215.8 = 3.37.

(b)

This question provokes the issue of whether debt held as assets is part of enterprise value

(a part of operations) or effectively a reduction of the net debt claim on the firm. The issue arises in the financial statement analysis in Part II of the book: are debt assets part of operations or part of financing activities? Debt is part of financing activities if it is held to absorb excess cash rather than used as a business asset. The excess cash could be applied to buying back the firm’s debt rather than buying the debt of others, so the net debt claim on enterprise value is what is important. Put another way, HP is not in the business of trading debt, so the debt asset is not part of enterprise operations. The calculation of enterprise value is as follows: Market value of equity = $47 × 2,473 million shares = $116,231 million Book value of net debt claims: Short-term borrowing Long-term debt

$ 711 million 7,688

Total debt Debt assets Enterprise value

$8,399 million 11,513

(3,114) 113,117 million

E1.6. Identifying Operating, Investing, and Financing Transactions (a)

Financing

(b)

Operations

(c)

Operations; but advertising might be seen as investment in a brand-name asset

(d)

Financing

(e)

Financing

(f)

Operations

(g)

Investing. R& D is an expense in the income statement, so the student might be inclined to classify it as an operating activity; but it is an investment.

(h)

Operations. But an observant student might point out that interest – that is a part of financing activities – affects taxes. Chapter 9 shows how taxes are allocated between operating and financing activities in this case.

(i)

Investing

(j)

Operations

CHAPTER TWO Introduction to the Financial Statements Exercises

Drill Exercises E2.1. Applying Accounting Relations: Balance Sheet, Income Statement and Equity Statement a. Liabilities = $150 million b. Net Income = $205 million c. Ending equity = $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. Net payout = Dividends + Share repurchases – Share issues As there were no share issues or repurchases, dividend = $12. E2.2. Applying Accounting Relations: Cash Flow Statement Change in cash = $195 million E2.3. The Financial Statements for a Savings Account a. ___________________________________________________________________________ BALANCE SHEET Assets (cash)

$100

INCOME STATEMENT

Owners’ equity

STATEMENT OF CASH FLOWS Cash from operations

$5

$100

Revenue

$5

Expenses

0

Earnings

$5

STATEMENT OF OWNERS’ EQUITY Balance, end of Year 0

$100

Cash investment

0

Earnings, Year 1

Cash in financing activities:

5

Dividends (withdrawals), Year 1 (5)

Dividends

(5)

Change in cash

$0

Balance, end of Year 1

$100

b. As the $5 in cash is not withdrawn, cash in the account increases to $105, and owners’ equity increases to $105. Earnings are unchanged. ______________________________________________________________________ BALANCE SHEET Assets (cash)

$105

INCOME STATEMENT

Owners’ equity

$105

STATEMENT OF CASH FLOWS Cash from operations

$5

Cash investment

0

Cash in financing activities:

Revenue

$5

Expenses

0

Earnings

$5

STATEMENT OF OWNERS’ EQUITY Balance, end of Year 0

$100

Earnings, Year 1

5

Dividends (withdrawals), Year 1 (0)

Dividends

(0)

Change in cash

$5

Balance, end of Year 1

$105

______________________________________________________________________ c. With the investment of cash flow from operations in a mutual fund, the financial statements would be as follows: _______________________________________________________________________ BALANCE SHEET Assets (cash)

$100

Mutual Fund

5

Equity

INCOME STATEMENT

$105

Revenue

$5

Expenses

0

Total assets

$105

Total

$105

Earnings

STATEMENT OF CASH FLOWS

STATEMENT OF OWNERS’ EQUITY

Cash from operations

$5

Balance, end of Year 0

Cash investment

(5)

Earnings, Year 1

Cash in financing activities: Dividends Change in cash

$5

$100 5

Dividends (withdrawals), Year 1 (0) (0)

Balance, end of Year 1

$100

$0

E2.4. Preparing an Income Statement and Statement of Shareholders’ Equity Income statement: Sales Cost of good sold Gross margin Selling expenses Research and development Operating income Income taxes Net loss

$4,458 3,348 1,110 (1,230) (450) (570) 200 (370)

Note that research and developments expenses are expensed as incurred. Equity statement: Beginning equity, 2009 Net loss $(370) Other comprehensive income 76 Share issues Common dividends Ending equity, 2009

$3,270 (294) 680 (140)

($76 is unrealized gain on securities)

$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 because income is negative (a loss). The firm has a tax loss that it can carry forward.

E2.5. Classifying Accounting Items a. Current asset b. Net revenue in the income statement: a deduction from revenue c. Net accounts receivable, a current asset: a deduction from gross receivables d. An expense in the income statement. But R&D is usually not a loss to shareholders; it is an investment in an asset. e. An expense in the income statement, part of operating income (and rarely an extraordinary item). If the restructuring charge is estimated, a liability is also recorded, usually lumped with “other liabilities.” f. Part of property, plan and equipment. As the lease is for the entire life of the asset, it is a “capital lease.” Corresponding to the lease asset, a lease liability is recorded to indicate the obligations under the lease. g. In the income statement h. Part of dirty-surplus income in other comprehensive income. The accounting would be cleaner if these items were in the income statement. i. A liability j. Under GAAP, in the statement of owners equity. However from the shareholders’ point of view, preferred stock is a liability

k. Under GAAP, an expense. However from the shareholders’ point of view, preferred dividends are an expense. Preferred dividends are deducted in calculating “net income available to common” and for earnings in earnings per share. l.

As an expense in the income statement.

E2.6. 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 apply the reliability criterion and 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. 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. In this way, the firm reports its ability to add value by producing films.

E2.7. 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.

Applications E2.8. Finding Financial Statement Information on the Internet This is a self-guiding exercise. Students can take it further by downloading financial statements into a spreadsheet. Go to the links of the book’s web site.

E2.9. Testing Accounting Relations: General Mills Inc.

This exercise tests some basic accounting relations. (a)

Total liabilities = Total assets – stockholders’ equity = 12,826

(b)

Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders 6,216 = 5,319 +? – 782 ? = 1,679

Net payout to common = cash dividends + stock purchases – share issues = 782 E2.10. Testing Accounting Relations: Genetech Inc. (a)

Revenue

(b)

ebit

(c)

ebitda

= $4,621.2 million

= $1,136.8 million =$1,490.0 million

Depreciation and amortization is reported as an add-back to net income to get cash flow from operations in the cash flow statement. Long-term assets = $5,980.6 million Total Liabilities = Short-term Liabilities

$2,621.2 million =$1,243.3 million

(c) Change in cash and cash equivalents = Cash flow from operations – Cash used in investing activities + Cash from financing activities Change in cash and cash equivalents is given by the changes in the amount is the balance sheet = $270.1 – 372.2 = -$102.1

So, -$102.1 = $1,195.8 - $451.6 + ? So

?

= -$846.3 million

That is, there was a cash outflow of $846.3 million for financing activities.

E2.11. Find the Missing Number in the Equity Statement: Cisco Systems Inc. Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders a. $32,304 = $31,931 + 6,526 -? ? b.

= $6,153

Net payout to common = cash dividends + stock purchases – share issues 6,153 = 0 + ? – 2,869 = 9,022

E2.12. Find the Missing Numbers in Financial Statements: General Motors a. Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders -56,990 = -37,094 + ? – 283 ? = -19,613

(a loss)

b. Comprehensive income = Net income + Other comprehensive income -19,613 = -18,722 + ? ? = - 891 c. Net income = Revenue – expenses and losses -18,722 = ? – 60,895 ? = 42,173 d. June 30, 2008 Assets 136,046 Liabilities ? = 193,036 Equity -56,990

December 31, 2007 148,883 ? = 185,977 -37,094

E2.13. Mismatching at WorldCom Capitalizing costs takes them out of the income statement, increasing earnings. But the capitalized costs are then amortized against revenues in later periods, reducing earnings. The net effect on income in any period is the amount of costs for that period less the amortization of costs for previous periods. The following schedule calculates the net effect. The numbers in parentheses are the amortizations, equal to the cost in prior periods dividend by 20. 1Q, 2001 1Q, 2001 cost: $780 2Q, 2001 cost:

605

3Q, 2001 cost:

760

4Q, 2001 cost:

920

1Q, 2002 cost:

790

Overstatement of earnings

$780

2Q, 2001

3Q, 2001

4Q, 2001

1Q, 2002

$ (39)

$ (39)

$ (39)

$ (39)

605

(30)

(30)

(30)

760

(38)

(38)

920

(46) 790

$780

$566

$691

$813

$637

The financial press at the time reported that earnings were overstated by the amount of the expenditures that were capitalized. That is not quite correct.

E2.14. Calculating Stock Returns: Nike, Inc. The stock return is the change in price plus the dividend received. So, Nike’s stock return for fiscal year 2008 is 12.875/55 = 23.41%. CHAPTER THREE How Financial Statements are Used in Valuation

Exercises Drill Exercises E3.1. Calculating a Price from Comparables Average of the two prices = $55 per share E3.2. Stock Prices and Share Repurchases Market price per share after repurchase = $1,800/90 = $20 E3.3 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

E3.4. Identifying Firms with Similar Multiples This is a self-guided exercise.

E3.5. Valuing Bonds For this question, first calculate discount factors for each of five years ahead. You can also get them from present value tables where the discount factor is given as 1/1.05t. At a 5% required return, the discount factors are: Year Ahead (t) 1 2 3 4 5 a.

Discount factor (1.05t) 1.05 1.1025 1.1576 1.2155 1.2763

The only cash flow is the $1,000 at maturity Present value (PV) of $1,000 five years hence = $1,000/1.2763 = $783.51

b.

This is easy. If the coupon rate is the required rate of return, the bond is worth its face value, $1,000. You can show this by working the problem as in part b, but with an annual coupon of $50.

c.

The yearly cash flows and their present value are: Year Ahead (t) Discount factor (1.05t) Cash Flow 1 1.05 2 1.1025 3 1.1576 4 1.2155

PV 40 40 40 40

38.10 36.28 34.55 32.91

5

1.2763

1, 040

814.86

Total Present Value

$956.70

(Your answers might differ by a couple of cents if you use discount factors to 5 or 6 decimal places.)

E3.6. Applying Present Value Calculations to Value a Building This is a straight forward present value problem: the required return--the discount rate--is applied to forecasted net cash receipts to convert the forecast to a valuation: Present value of net cash receipts of 1.1 million for 5 years at 12% (annuity factor is 3.6048)

$3.965 million

Present value of $12 million “terminal payoff” at end of 5 years (present value factor is 0.5674) Value of building

6.809 $10.774

Applications E3.7

The Method of Comparables: Dell, Inc.

First calculate the multiples for the comparable firms from the price and accounting numbers:

Hewlett-Packard Co. Gateway Inc.

Sales

Earnings

Book Value

Market Value

$45,226 6,080

$ 624 (1,290)

$13,953 1,565

$32,963 1,944

HP: Price/Sales = 0.73 P/E = 52.8 P/B = 2.4 Gateway: Price/Sales = 0.32 P/E (not applicable: negative earnings) P/B = 1.2 Now apply the multiples to Dell: Average Multiples for Comparable Sales Earnings Book value Average of valuations * HP only

0.53 52.8* 1.8

Dell’s Number x x x

31,168 1,246 4,694

Dell’s Valuation = = =

$16,519 million 65,789 8,449 30,252

With 2,602 million shares outstanding, the estimated value per share = $30,252/2,602 = $11.63 Difficulties: -

P/E can’t be calculated for a loss firm The “comparables” are not exactly like Dell The calculation assumes the market prices for the “comps” are efficient Not sure how to weight the three valuation based on sales, earnings and book values; the valuations differ considerably, depending on the multiple used

E3.8. A Stab at Valuation Using Multiples: Biotech Firms Multiples of the various accounting numbers for the five firms can be calculated and the average multiple applied to Genentech’s corresponding accounting numbers. This yields prices for Genentech:

Comparison

Estimated

Firm Mean

P/B

4.16

Genentech Value (millions) $5,610.9

E/P

.0245*

5,077.6

(P-B)/R&D

10.66

4,699.2

6.05

4,809.0

Multiple

P/Revenue Mean over all values

5,049.2

*Excludes firms with losses.

E/P is used rather than P/E because a very high P/E due to very small earnings can affect the mean considerably. The mean E/P also excludes the loss firms since Genentech did not have losses. Research and development (R&D) expenditures are compared to price minus book value. As the R&D asset is not on balance sheets, its missing value is in this difference. The average ratio of 10.66 is a...