Exercises for Chapter 10

EXERCISES FOR CHAPTER 10

With Solutions

Exercise 1. A Reformulation

A firm whose shares traded at three times their book value on December 31, 1998 had the following financial statements. Amounts are in millions of dollars.

Balance Sheet, December 31, 1998

Assets / Liabilities and Shareholders’ Equity
1998 / 1997 / 1998 / 1997
Operating cash / 50 / 20 / Accounts payable / 215 / 205
Short-term investments / 150 / 150 / Long-term debt / 450 / 450
Accounts receivable / 300 / 250
Inventories / 420 / 470 / Common equity / 1,095 / 1,025
Property and plant (net) / 840 / 790 / ____ / ____
1,760 / 1,680 / 1,760 / 1,680

Income Statement, Year Ended December 31, 1998

Sales / 3,295
Interest income / 9
Operating expenses / 3,048
Interest expense / 36
Tax expense / 61 / (3,145)
Net income / 159

The firm’s marginal tax rate is 33%. Short-term investments and long-term debt are at market value on the balance sheet. There are no dirty-surplus income items in the balance sheet.

Reformulate these financial statements.

A Reformulation: Solution

Reformulated balance sheets:

1998 / 1997 / Average
Net operating assets (NOA) / 1395 / 1325 / 1360
Net financial obligations (NFO) / 300 / 300 / 300
Common shareholders’ equity (CSE) / 1095 / 1025 / 1060

Net operating assets: operating cash + accounts receivable + inventories + property – accounts payable

Net financial obligations: long-term debt – short-term investments.

Reformulated income statement:

Separate operating and financing activities and allocate taxes:

Sales / 3295
Operating Expenses / 3048
247
Tax reported / 61
Tax on net interest / 9 / 70
Operating income (OI) / 177
Net interest (36 – 9) / 27
Tax on interest (0.33 x 27) / 9
NFE / 18
Comprehensive Income / 159

Some further calculations:

Free cash flow for 1998 = OI – Δ NOA

= 177-70

= 107

Return on net operating assets (RNOA) =

Average financial leverage (FLEV)=

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Exercise 2. Reformulated Financial Statements: Determining Free Cash Flow

(a)The following is from a Statement of Shareholders’ Equity for 1995. Calculate rate of return on common shareholders’ equity for the year. Amounts in $ thousands.

Balance at January 1, 1995 / 119,546
Issuance of common stock / 14,329
Issuance pursuant to stock option plans / 3,429
Net income, 1995 / 19,572
Preferred stock dividends / (2,279)
Common stock dividends / (3,914)
Foreign currency translation loss / (713)
Unrealized gains on securities available for sale / 427 / 30,851
150,397

(b)The income statement for the same firm is as follows (amounts in $ thousands):

Sales / 151,233
Cost of goods sold / 104,372
46,861
Selling and administrative expenses / 12,483
Interest income / 1,123
Interest expense / (5,479) / 4,356
Income tax / 10,450
Net income / 19,572

The balance sheet at the end of 1994 reveals financial assets of 18,000 and debt of 78,270 and, at the end of 1995, financial assets of 24,000 and debt of 81,400, again in thousands of $. The firm’s marginal tax rate is 37%.

Calculate return on net operating assets and net borrowing costs for 1995.

(c) What was the firm’s free cash flow for 1995?

(d) What was the firm’s net debt financing flow for 1995?

Reformulated Financial Statements: Determining Free Cash Flow – Solution

(a)Calculate comprehensive income for common shareholders:

Net income / 19,572
Foreign currency translation loss / (713)
Unrealized gain on securities / 427
Preferred dividends / (2,279)
(17,007)

Average CSE134,972

ROCE =

The calculation could also be on beginning-of-period CSE. The calculation ignores hidden compensation expense on stock issued to employees pursuant to option plans.

(b)Reformulated income statement:

OI reported (46,861 –12,483) / 34,378
Foreign currency translation loss / (713)
33,665
Income tax reported / 10,450
Tax benefit of interest (0.37 x 4,356) / 1,612 / 12,062
OI, after tax / 21,603
Net interest expense / 4,356
Tax benefit (4356 x .37) / 1,612
2,744
Unrealized gain / (427)
Preferred dividends / 2,279 / 4,596
Comprehensive income / 17,007

Reformulated balance sheets:

1994 / 1995
NFO (FL - FA) / 60,270 / 57,400
CSE / 119,546 / 150,397
NOA (NFO + CSE) / 179,816 / 207,797

(c)

Free cash flow (C – I) = OI – ΔNOA

= 21,603 – 27,981

= (6,378)

(Free cash flow was negative)

(d)

Net debt financing flow (F) = C – I – d

= -6,378 – (3,914 – 17,758)

= 7,466

Even though free cash flow was negative, $7,466 thousand was paid out to the creditors from cash received from share issues, net of cash paid out in dividends.

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Exercise 3. Working with Reformulated Statements

(a)Fill out the missing numbers in the following reformulated financial statements:

Balance Sheet, December 31, 1999
Net operating assets / A
Net financial obligations / 40
Common equity / B
Income Statement, 2000
Sales / C
Operating expenses / 438
Tax on operating income / 22
Operating income after tax / 40
Net financial expenses after tax / D
Comprehensive income / E

The borrowing cost on the net financial obligations is 5% after tax. The firm earned a return on its net operating assets of 10% in 2000.

(b)Calculate the return on common equity (ROCE) for 2000 (on beginning equity) and the financial leverage (FLEV) at December 31, 1999.

Working with Reformulated Statements: Solution

a)

A = 400

B = 360

C = 40 + 22 + 438 = 500

D = 40 x 5% = 2

E = 38

For A:

So, as operating income = 40, then NOA1999 = 400

For D:

Net financial expense (2000) = NFO1999 x 5% = 40 x 5% = 2

b)