Exercise 1.Review of Accounting Relationships

B8110 – Fall 2012

Solution

Exercise Set 2

Exercise 1.Review of Accounting Relationships

1. (i)Total Liabilities = Total Assets – Shareholders’ Equity

= $19,042 – 6,216

= $12,826

(ii) Plug the statement of shareholders’ equity:

______

Shareholders Equity 20075,319

Net payment to shareholders

Dividends 530

Share repurchases 1,385

Share issues(1,133)(782)

Comprehensive income ?

Shareholders equity 20086,216

______

? = 1,679

(iii) Net income = Comprehensive income – other comprehensive income

= $1,679 – 456

= $1,223

1. Common shares outstanding = shares issued – shares in treasury

= 377.3 – 39.8

= 337.5 millions

Book value per share= $6,216 / 337.5

= $18.42

Exercise 2. Working with Accounting Relations

Reconstruct the reformulated statements and plug to the missing numbers:

Statement of Common Shareholders’ Equity

Beginning balance $250

Net payout to shareholders ? = 17

Comprehensive income 40

Ending balance $307

Balance Sheet

2012 2011 2012 2011

NOA ? = 477 450 NFO 170 ? = 200

______CSE 307 250

Totals 477 450 477 450

Income Statement

Operating income ? = 50

Net financial expense (10)

Comprehensive income 40

1. ROCE = 40/250 = 16%
2. RNOA = 50/450 = 11.11%
3. NBC = 10/200 = 5%
4. Net payout to shareholders = -17 (plug in equity statement; this is negative, a net share issue)
5. Net payout = Cash dividends + stock repurchases – share issues

-17 = ? + 0 - 25

? = 8

1. Free cash flow (C –I) = OI – ΔNOA

= 50 – 27

= 23

1. C – I = d + F

23 = -17 + ?

? = 40

1. The financing leverage equations is:

ROCE = RNOA + [FLEV × (RNOA – NBC)]

FLEV = NFO/CSE = 200/250 = 0.8

Thus,

ROCE = 11.11% + [0.8 ×(11.11% - 5%) = 16%]

Exercise 3. Conversion of Stock Warrants: Warren Buffett and Goldman Sachs

The loss to shareholders is the difference between the market price of the shares and the issue price:

1. Market price of shares issued (if warrants are exercised on Oct. 18, 2012):

43.5 million x $125$5,437.5 million

Exercise price 43.5 million x $115 $5,002.5 million

Loss 43.5 million x$(170-115)$ 435.0 million

The loss is not tax deductible

1. No cost is recorded: the share issue is booked at $115 per share rather than $125: low-quality accounting.

Exercise 4. Analysis of the Profitability of an Insurance Company

Reformulated Balance Sheet, 2011

Reformulated Income Statement, 2012

1. Rate of return on investments= 75/1,500

= 5.0%

1. Net operating assets (insurance) = -540

Insurance earnings = -40

Insurance residual earnings = -40 – (0.09 * -540)

= +8.6

Exercise 5. An Analysis of Starbucks Corporation

1. Reformulated statement of common shareholders’ equity

Reformulated Statement of Common Shareholders’ Equity

(in millions of dollars)

Balance, October 3, 2010 (excluding noncontrolling interest) 3,674.7

Net transactions with shareholders

Share issue 19.1

Stock option exercised(216.4 + 256.3) 472.7

Share repurchase (555.9)

Cash dividend (419.5) (483.6)

Comprehensive Income

Net income 1,245.7

Unrealized holding loss (4.4)

Translation adjustment (6.5)

Loss on stock options, after tax 160.2

Stock compensation recognized 147.2 (13.0) 1,221.8

Cost to purchase noncontrolling interest (28.0)

Balance, October 3, 2011 (excluding noncontrolling interest) 4,384.9

Loss on stock options is calculated as follows:

Stock option expense (96.1/0.375) 256.3

Tax benefit 96.1

Stock option expense, after tax 160.2

The shares issued for the exercise of stock options are recorded at their market price in the reformulated statement, that is, the issue price (excluding the tax benefit) plus the before-tax expense. (The before-tax expense is the difference between market price and exercise price.) The after-tax expense is recorded as part of comprehensive income, but is reduced by the stock compensation recognized at grant date (to avoid double counting). See Chapter 9 of the text.

There is a small tax benefit of $0.1 associated with other share issues—there must have been some employee compensation involved—but this is ignored as immaterial.

For Questions 2 – 4, work from a reformulated income statement (although preparing a full reformulated statement is not necessary to answer the questions).

The reformulation of the income statement requires a careful survey of the footnotes to discover income that is not core income. Here is what the notes reveal:

• Trading securities are recorded at fair value with unrealized holding gains and losses included in net earnings (Note 1, investment note). The loss for 2011 was $2.1 million (Note 3: Fair Value Measurements). This loss is included in “interest income and other” on the income statement. The loss is treated as non-core income because the current year gain or loss is not an indication of the future gain or loss.

• There were net impairment and disposition losses of $36.2 million, $67.7 million, and $224.4 million in fiscal 2011, 2010, and 2009, respectively (Note 1, Long-lived assets note). For 2011, these are in store opening costs. (Note 1, Long-lived assets note).
• There is a one-time gain in the cash flow statement: Gain resulting from acquisition of joint ventures $55.2 million, This is included in net interest income and other (see Note 17: Acquisitions). The gain on sale of properties of $30.2 million in the cash flow statement is identified in the income statement

.

• The detail of the unrealized loss in Other Comprehensive Income (OCI) is in Note 11, Comprehensive Income. Separate into operating (-4.8) and NFE (+0.4).

• Advertising expenses totaled $141.4 million, $176.2 million, and $126.3 million in fiscal 2011, 2010, and 2009, respectively (Note 1). Separate out from “Other Operating Expenses.”

• The interest income and other is made up of:

Gain on acquisition of joint ventures 55.2 (Note 17)

Unrealized loss on trading securities (2.1) (Note 3)

Interest income (plug) 62.8

Total 115.9

The following is relevant to the reformulation of the balance sheet:

• All securities (beside the trading securities) are debt securities, both short-term and long term (Note 1, investment note and Note 3: Fair Value Measurements).

Reformulated Income Statement, 2011

(in millions of dollars)

Net revenue 11,700.4

Cost of sales4,949.3

Gross margin6,751.1

Core operating expenses

Store operating expenses (3,665.1 - 36.2) 3,628.9

Advertising Expenses 141.4

Other operating expenses 260.6

Depreciation and amortization 523.3

General and administrative expenses 636.1 5,190.3

Core operating income from sales, before tax 1,560.8

Tax reported 563.1

Tax on interest income (11.0)

Tax on non-core income (17.7) 534.4

Core operating income from sales, after tax 1,026.4 (Q2)

Other core operating income

Income from equity invitees (reported after tax) 173.7

Core operating income, after tax 1200.1 (Q4)

Other operating income (non-core, unsustainable)

Before-tax items:

Gain on sale of properties30.2

Gain from acquisition of joint ventures55.2

Unrealized loss on trading securities(2.1)

Impairment losses(36.2)

47.1

Tax @ 37.5%17.7

After-tax items:29.4

Unrealized loss in OCI(4.8)

Translation loss(6.5)

Net loss on exercise of stock options(13.0) 5.1

Operating income1,205.2 ( Q3)

Net Financial Income

Interest income62.8

Interest expense 33.3

Net interest29.5

Tax @ 37.5%11.0

Net interest offer tax18.5

Unrealized gain on debt investments 0.4 18.9

1,224.1

Noncontrolling interest (2.3)

Comprehensive income to common1,221.8

Note that store opening costs are treated as core income because they happen every year. But there is an argument to separate these out as non-core.

Reformulated Balance Sheet

(in millions of dollars)

2011 2012 Average

Net Financial assets:

Cash and cash equivalents (less $50m) 1,098.1 1,114.0

Short-term investments 855.0 236.5

Long-term investments 107.0 191.8

Financial assets 2,060.1 1,542.3

Long-term debt 549.5 549.4

Net financial assets (NFA) 1,510.6 992.9 1,251.8

Net Operating Assets (NOA) 2,876.7 2,689.4 2,783.0

Total Equity 4,387.3 3,682.3 4,034.8

Noncontrolling interest 2.4 7.6 5.0

Common shareholders’ equity (CSE) 4,384.9 3,674.7 4,029.8

Note: Net operating assets are given by a plus: NOA = total equity – NFA. Students cans list our the NOA to confirm this.

Now to the questions:

Read off the answers to Q 2 – 4 from the reformulated income statement.

1. Core operating income from sales, after tax 1,026.4

1. Operating income 1,205.2

1. Core operating income, after tax 1200.1

1. The numbers come from the reformulated balance sheet:

Net Operating Assets (NOA) 2,876.7 2,689.4

Net financial assets (NFA) 1,510.6 992.9

6.

Note: the ROCE to common shareholders is after noncontrolling interest (30.32%). But the ROCE before noncontrolling interest is used for Q7.

7.Using the version of the leveraging equation with negative leverage,

ROCE = RNOA + [FLEV × (RNOA – RNFA)]

=43.31% + [-0.310 × (43.31% - 1.51%)]

=30.34%

This is ROCE before noncontrolling interest. There is an adjustment to get ROCE after noncontrolling interest: See Box 12.5 on Page 372 ot the text. (It is very small here).

(Allow for rounding error)

8.

9.

10..

(This might be reduced by a forecast of the very small amount of noncontrolling interest income, but this is ignored here: noncontrolling interest in the balance sheet now down to $2.4million at the end of 2011).