Week6Tutorial Questions PDF

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Tutorial in Week 6 (based on Week 5 Lecture) beginning 8th April 2019 TOPIC: Ratio Analysis This tutorial focuses on the attribution of ROCE between operating and financial drivers and the determination using ratio analysis of the drivers of operating performance. There are eight questions of which at least three are included for self-learning outside the tutorial. Q1 and Q2 are simple ratio computation and they should be completed prior to the tutorial and solutions are now on the LMS. Q8 is a case-study of Harvey Norman, only the main concepts will be discussed in the tutorial, the mechanical computations will be provided in the solutions. Q1 Baseline Ratio Computation For Analysis of Financial Statements The company Barooga Ltd financial statements have been reformulated and classified into operations and financing. For this company compute ROCE, RNOA, FLEV and SPREAD and show that the financial leveraging equation holds for this firm (ROCE = RNOA + (FLEV*SPREAD)

Reformulated Balance Sheets NOA NFO CSE

2017 1,395 300 1,095

2016 1,325 300 1,025

Average 1,360 300 1,060

Reformulated Income Statement, 2017 Sales Operating Expenses Tax reported Tax on NFE OI Net interest Tax on interest at 33% NFE Net Income

Start with A = L + E Then break It down corresponding to equation NOA = NFO + CSE NOPAT = NFE + NPAT

3,295 3,048 247 61 9

70 177

27 9 18 159

Q2 Analysis of Profitability: The Coca-Cola Company The reformulated (into operation and financing) profit and loss statement and balance sheet (below) of Coca-Cola Company is provided below. Using these statements (a) Compute RNOA and NBC (Net Borrowing Costs) (b) Compute FLEV (c) Show that ROCE = RNOA + FLEV*SPREAD (d) Calculate profit margin and asset turnover and show that RNOA = PM *ATO Coca-Cola Company Reformulated Income Statement in millions Sales Cost of Sales Gross Margin

2007 28,857 10,406 18,451

Advertising Expense Admin Expense Other expenses

2,800 8,145 81

Operating Income from Sales Tax Operating income from sales after tax Equty Income from bottling subsidiaries

7,425 1,972 5,453 668

Net Operating Income Net Financial Expenses

6,121 140

Net Profit

5,981

Average balance sheet amounts are as follows:

Net operating assets Net financial obligations Common shareholders’ equity

2007 $26,858 5,114 $21,744

2006 $18,952 2,032 $16,920

Ave $22,905 3,573 $19,332

Q3 Corporation's return on net operating assets (RNOA) is 10% and its tax rate is 40%. Its net operating assets ($4 million) are financed entirely by common shareholders' equity. Management is considering its options to finance an expansion costing $2 million. It expects return on net operating assets to remain unchanged. There are two alternatives to finance the expansion: 1. Issue $1 million bonds with 12% coupon, and $1 million common stock. 2. Issue $2 million bonds with 12% coupon. Required: a. Determine net operating income after tax (NOPAT) and net income for each alternative. 1. CSE 5000 NFO 1000 = NOA 6000 NOPAT = 10% x 6000 = $600 RNOA = NOPAT / NOA NFE = NBC X NFO = 0.072 x 1000 = $72 NBC = kd (1- t) = 0.12 (1-0.4) = 7.2% NPAT = 600 – 72 = $528 2. CSE 4000 NFO 2000 = NOA 6000 NOPAT = 10% x 6000 = $600 NFE = 0.072 x 2000 = $144 NPAT = 600 – 144 = $456 b. Compute return on common shareholders' equity for each alternative (use ending equity). 1. ROCE = 528 / 5000 = 10.56% 2. ROCE = 456 / 4000 = 11.40% If increase in profit without equity, return on equity will go up. c. Calculate the FLEV for each alternative. FLEV = NFO / CSE 1. FLEV = 1 / 5 = 0.2

2. FLEV = 2/4 = 0.5

d. Compute return on net operating assets and explain how the level of leverage interacts with it in helping determine which alternative management should pursue. ROCE = RNOA (IF NO LEVERAGE) WITH LEVERAGE: ROCE = RNOA + FLEV x SPREAD SPREAD = RNOA - NBC Q4 A firm has financial assets invested in short-term government bonds but has no financial obligations (for example Apple Inc for long time had no financial obligations but had approx. $70 billion of financial assets). Suppose that RNOA exceeds ROCE. Explain how this can be due to the investment in financial assets. Apple has a lot of financial assets because didn’t want to bring back to America because it will get taxed, so kept money overseas and invested in bonds etc Negative leverage x positive spread, lowers RNOA

Q5 A What-If Question: Grocery Retailers. Many supermarket have shifted from regular storewide sales to issuing membership in discount and points programs. A supermarket chain with $120 million in annual sales an asset turnover of 6.0 ponders whether to institute a customer membership program. It currently earns a profit margin of 1.6 percent on sales. Its marketing research indicates that a customer membership would increase sales by $25million and would require an additional investment in inventories of $2 million but no additional retail floor space. Costs to run the membership program, including the discounts offered to members, would reduce profit margins to 1.5 percent. What would be the effect on the firm’s return on net operating assets of adopting the customer membership program? Net operating assets for $120 million in sales and an ATO of 6.0 are $20 million. An increase in sales of $25 million and an increase in inventory of $2 million would increase the ATO to (120 + 25) / (20 + 2) = 6.59. With a profit margin of 1.5%, the RNOA would be: RNOA = 1.5%  6.59 = 9.89% The current RNOA is: RNOA = 1.6%  6.0 = 9.6% So the membership program would increase RNOA slightly.

Q6 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A What-If Question. A firms earns profit of 3.8 percent on sales of $435million and employs net operating assets of $150 million to do so. It considers adding another product line that will earn a 4.8 percent profit margin with an asset turnover of 2.3. What would be the effect on the firm’s return on net operating assets of adding the new product line? ATO = Sales / NOA = 435 / 150 = 2.9 RNOA = PM x ATO = 3.8% x 2.9 = 11.02% New product line RNOA = 4.8% x 2.3 = 11.04%

Q7 Lets see what the smart guys are doing. I have attached three analysts reports: a J.P Morgan report on JB Hi-Fi Limited/Harvey Norman. A Macquarie Wealth Management report on Harvey Norman and a Macquarie Wealth Management report on Woolworths. Read these reports very lightly and discuss the main performance drivers of ROCE that the analysts focus on? What performance determinant do the analysts discuss that are not very well disclosed in statutory financial reports? What components of ROCE = RNOA + Leverage * Spread (where RNOA = PM*ATO) are not frequently discussed and why? Industry consolidation and housing strength good for assignment

Q8 Obtain Harvey Normans financial reports for the past three years. Reformulate the P&L and the balance sheet into operations and financing activities. Calculate NOPAT both including and excluding non-recurring items. Compute ROCE for each of the past three years and then perform

ratio analysis to understand the primary drivers of any change in ROCE across time (we will use RNOA including non-recurring items as there is little difference between recurring and nonrecurring RNOA). The tutorial will focus on the attribution of Harvey Norman between operations and financing and computation of after-tax financing expenses, there will be a brief discussion of items that could be non-recurring (as we discussed this last week and suggested items will be provided in solutions) and then we will focus on an explanation of the ROCE ratio drivers....