EXERCISES FOR CHAPTER 13
With Solutions
Exercise 1. Pepsico
Pepsico Inc. reported the following income statement for 1999 (in millions of dollars):
Net Sales / 20,367Operating expenses / (17,484)
Restructuring charge / (65)
Operating profit / 2,818
Gain on asset sales
/ 1,083Interest expense
/ (363)Interest income
/ 118/ 3,656
Provision for income taxes
/ 1,606Net income
/ 2,050(a) Calculate core operating income after tax. The firm’s marginal tax rate is 37%.
(b) Calculate the effective tax rate on core operating income.
Pepsico: Solution
a)
Reformulate the income statement to identify core operating income:
Net sales / 20,367Core operating expenses / 17,484
Core operating expenses before tax / 2,883
Tax reported / 1,606
Tax benefit of debt (0.37 x 245) / 91
Tax on unusual items (0.37 x 1,018) / (377) / 1,320
Core operating income after tax / 1,563
(Unusual items = 1,083 – 65 = 1,018)
b)
Effective tax rate on core OI =
Is this unusual? Adjust core operating income for a 37% tax rate?
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Exercise 2. Explaining Changes in Profitability
The following condensed balance sheets were prepared for a firm (in millions of dollars).
Balance Sheets
2000 / 1999 / 1998 / 2000 / 1999 / 1998Operating Assets / 310 / 285 / 250 / Operating Liabilities / 50 / 35 / 25
Financial Assets / 40 / 20 / 85 / Financial Liabilities / 140 / 120 / 45
Common Equity / 160 / 150 / 265
350 / 305 / 335 / 350 / 305 / 335
The income statements for 2000 and 1999 are as follows (in millions of dollars):
2000 / 1999Sales / 500 / 450
Operating expenses (including taxes) / 475 / 432
Operating income / 25 / 18
Net financial income (expense) after tax / (5) / 2
Comprehensive income / 20 / 20
a) Calculate:
(i) Net cash paid to shareholders in 1999 and 2000
(ii) Free cash flow generated during 1999 and 2000
(iii) Return on beginning common equity (ROCE) for 1999 and 2000
(iv) Return on beginning net operating assets (RNOA) for 1999 and 2000
b) Explain what determined the change in RNOA from 1999 to 2000.
c) Calculate financial leverage for each year, 1998 to 2000
d) Explain why the change in ROCE from 1999 to 2000 is considerably greater than the change in RNOA.
Explaining Changes in Profitability: Solution
The reformulated balance sheets for 1998-2000 are:
2000 / 1999 / 1998Net operating assets (NOA) / 260 / 250 / 225
Net financial obligations (NFO) / 100 / 100 / (40)
Common equity (CSE) / 160 / 150 / 265
a)
(i) Net dividends (d) = Earnings – ΔCommon Equity
1999: d = 20 – (-115) = 135
2000: d = 20 – 10 = 10
(ii) Free cash flow (C – I) = OI – ΔNOA
1999: C – I = 18 – 25 = -7
2000: C – I = 25 – 10 = 15
(iii)
1999: ROCE =
2000: ROCE =
(iv)
1999: RNOA =
2000: RNOA =
(v)
1999: NBC =
2000: NBC =
For 1999, NBC is negative, because the firm had more financial assets than financial liabilities. That is, the firm had a return on net financial assets (RNFA) of 5%.
b)
RNOA = PM x ATO =
1999: RNOA =
2000: RNOA =
The change in RNOA of 2% was due to an increase in profit margin of 1% on constant turnover of 2.0
The calculation can also be made as follows:
Refer to Box 12.7 of the text.
c)
Financial leverage (FLEV) =
d)
ROCE = RNOA + [FLEV x (RNOA – NBC)]
ROCE (1999) = 8.0% + [-0.151 x (8.0% - 5%)]
= 7.55%
ROCE (2000) = 10% + [0.667 x (10.0% - 5%)]
= 13.33%
Note that financial leverage in the calculation is FLEV at the beginning of the year. For 1999, FLEV was negative (so the net borrowing cost (NBC) was also negative, i.e., a return on net financial assets).
So the change in ROCE in 2000 was due to a change in RNOA of 2.0% (because of a 1% change in profit margin) and a change in leverage of 0.818 (from –0.151 to 0.667). The calculation could be made as follows:
= 2.0% + [2% x -0.151] + [0.818 x 5%]
= 2.0% + -0.30 + 4.09
=5.79%
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Exercise 3. P/E Ratios and Differences in Profitability
Firm A has a required return on its equity of 10.0% and trades at a price of 7 times trailing earnings. Analysts expect it to earn a return on its common equity (ROCE) of 15% in the future.
Firm B also has a required return on its equity of 10%, and trades at 17 times trailing earnings. However, analysts expect it to earn an ROCE of only 8% in the future.
Explain how firm B with the lower expected profitability can trade at a higher P/E than firm A with the higher expected profitability.
P/E Ratios and Differences in Profitability: Solution
There are two reasons:
1. The stocks may be mispriced by the market
2. Firm A has a higher ROCE in the future, but currently has an even higher ROCE (giving it a low P/E)
Firm B has a lower ROCE in the future, but has an even lower ROCE currently (giving it a high P/E)
See cell analysis on the chapter.