1

P6-2. Assessing credit risk using cash flow forecasts Requirement 1: If Randall’s cash flow forecasts are accurate, it will be unable to repay the loan at the end of Year 4. At the end of Year 1, Randall will have only $95,000 of cash available to make loan interest and principal payments. This amount grows to $1,815,000 by the end of Year 4, a figure that represents the sum of the net change in cash each year ($95,000 + $565,000 + $570,000 + $585,000). But Randall will owe the bank $2,000,000 plus any unpaid interest—interest that totals $200,000 each year using a 10% annual interest rate. Unless Randall has other highly liquid assets that could be sold in Year 4 to generate additional cash, the company will be unable to repay the loan. Consequently, Randall’s credit risk is extremely high. Requirement 2:

There are several ways Randall could enhance its credit worthiness and reduce its credit risk. One approach is to focus on generating more operating cash flow each year by growing sales, reducing costs, or both. A second approach is to contractually agree to not pay dividends without bank approval. Curtailment of the company’s planned dividend payments would add another $400,000 to the cash available for loan repayment in Year 4, for a total of $2,215,000. Although dividend curtailment is helpful, Randall is still an extremely high credit risk because the cumulative cash available to pay the loan is less than the combined amount owed (loan principal and interest payments). A third approach is to request repayment over a 5-year rather than 4-year period. Randall would then have the advantage of one more year of operating cash flow, projected to be in excess of $550,000, which would then be available to repay the loan. Randall might also offer to make partial principal payments of say $500,000 each year beginning

2

P6-3. Valuing growth opportunities

Requirement 1: The cost of equity capital for eBay is higher than that of Wal-Mart because eBay has a riskier cash flow stream than does Wal-Mart. Wal-Mart has a long history of predictable earnings and operating cash flows from its geographically dispersed retail stores. By comparison, eBay is a relatively young company and its earnings and operating cash flows are more volatile. Requirement 2: To find the NPVGO for each company, you need to solve the following expression:

P0 = X 0

r + NPVGO

where P is the current stock price, X is current reported earnings per share for the year, and r is the estimated cost of equity capital. Rearranging terms gives us:

P0 - X 0

r = NPVGO

Using this expression and the data provided in the problem statement gives us the following estimates of NPVGO for each company.

Earnings Cost of Share price per share equity NPVGO P X r X/r = P - X/r

Dell Computer $26.74 $0.82 0.138 $5.94 $20.80 eBay $67.82 $0.82 0.198 $4.14 $63.68 Ford Motor $9.30 $0.99 0.114 $8.68 $0.62 Home Depot $24.02 $1.55 0.121 $12.81 $11.21 Wal-Mart $50.51 $1.83 0.090 $20.33 $30.18

Requirement 3: The NPVGO at Home Depot is lower (in dollar terms and as a percent of share price) than that for eBay because investors believe that eBay has better growth opportunities—a higher rate of growth and more profitable growth. Alternatively,

3

Home Depot’s earnings per share may have been temporarily increased because of a one-time (transitory) gain. If so, the resulting NPVGO estimate will be too low unless the one-time gain is eliminated prior to computing NPVGO. Requirement 4: The NPVGO at Ford Motor is lower (in dollar terms and as a percent of share price) than that for Wal-Mart because investors believe that Wal-Mart has better growth opportunities—a higher rate of growth and more profitable growth. At the same time, Wal-Mart’s earnings per share may have been temporarily decreased because of a one-time (transitory) charge. If so, the resulting NPVGO estimate will be too high unless the one-time charge is eliminated prior to computing NPVGO.

4

P6-7. Determining abnormal earnings: Some simple examples

Abnormal earnings (AE) = NOPAT - (r x BVt-1).

Requirement 1:

AE = $5,000 - (0.15 x $50,000) = $5,000 - $7,500 = -$2,500

Requirement 2:

AE = $25,000 - (0.18 x $125,000)

= $25,000 - $22,500 = $2,500

Requirement 3:

AE = $30,000 - (0.18 x $125,000) = $30,000 - $22,500 = $7,500

NOTE: Higher NOPAT without additional investment (i.e., the same BVt-1) is good. Requirement 4:

AE = $23,000 - (0.18 x $100,000) = $23,000 - $18,000 = $5,000

NOTE: Eliminating unproductive assets that do not earn as high a rate of return as other assets increases AE. In this case, the unproductive assets were earning a return of only 8% ($2,000/$25,000).

Requirement 5:

AE = $32,600 - (0.18 x $165,000)

= $32,600 - $29,700 = $2,900

AE increases by $400 (from $2,500 to $2,900). Adding the division makes sense. The new division earns a return of 19% ($7,600/$40,000), which is more than the

5

firm’s 18% required rate of return, so value is added, and the change in AE is positive.

Requirement 6:

AE = $8,500 - (0.15 x $75,000) = $8,500 - $11,250 = -$2,750

AE falls by $250. Adding the new division does not make sense. In essence, the new division does not earn a high enough rate of return to justify investment. The new division earns a return of 14% ($3,500/$25,000) which is less than the firm’s 15% required rate of return, so value is lost, and the change in AE is negative.

6

P6-9. Calculating value creation by two companies

Requirement 1: The abnormal earnings of the two firms for 2007–2011 appear below.

Company A 2007 2008 2009 2010 2011 NOPAT $66,920 $79,632 $83,314 $89,920 $92,690 BVt-1 478,000 504,000 541,000 562,000 598,000 Cost of equity capital 0.152 0.167 0.159 0.172 0.166 Return on capital 0.140 0.158 0.154 0.160 0.155 Abnormal earnings ($5,736) ($4,536) ($2,705) ($6,744) ($6,578)

Company B NOPAT $192,940 $176,341 $227,700 $198,900 $282,964 BVt-1 877,000 943,000 989,999 1,020,000 1,199,000 Cost of equity capital 0.188 0.179 0.183 0.175 0.186 Return on capital 0.220 0.187 0.230 0.195 0.236 Abnormal earnings $28,064 $7,544 $46,530 $20,400 $59,950

Requirement 2: Company B created value each year via positive abnormal earnings, while Company A actually destroyed value each year by earning negative abnormal earnings.

7

Requirement 3: It’s a trick question because the return investors earn from a stock depends on the difference between what must paid to buy the stock—it’s cost or current market price—and what it will ultimately be worth at the time it is sold—it’s value, expressed in current dollars. In an efficient market, the current price (―cost‖) of each stock is approximately equal to what the stock is worth today, and investors only get compensated for bearing risk. Exceptional investment returns are earned only if the stock is somehow mispriced currently. How do these notions apply to company A and B? Well, Company B has clearly outperformed Company A during the years shown. Let’s presume that this favorable performance difference is expected to continue into the future. The performance differences between A and B are likely to be already reflected in the current market prices of each company’s stock: Company A will appear cheap precisely because it underperforms, whereas Company B will have a high market price because it outperforms. Investors who purchase shares in B will, if the stock is correctly priced by the market, simply earn a return that compensates them for bearing risk. But the same holds true for investors who purchase shares in A. If the market is efficient, neither stock will be an exceptional investment because the performance differential has already been baked into the current market price of each company’s shares.

P6-13 Krispy Kreme Doughnuts: Valuing abnormal earnings

Requirement 1: The following table implements the abnormal earnings valuation procedure illustrated in Exhibit 6.9 of the appendix.

8

9

Notes: $1.54 x (1+0.03) = 1.59 1/(11%-3%) =12.5 (1.59/ 0.08)x0.059345 = 11.8 Requirement 2: The value estimate from requirement 1 ($19.63 per share) is substantially below the market price of the stock ($44.00) in August 2003. There are several reasons why the abnormal earnings value estimate might differ from the company’s actual market price:

Investors may be more optimistic about the company’s profit prospects than are analysts, and the value estimate is based on analysts’ less optimistic EPS forecasts.

Investors and analysts may agree about EPS forecasts over the next five years, but the terminal growth assumption (3.0%) used here may be overly pessimistic. A higher terminal growth rate (say 8.5%) will produce a higher share value estimate ($47.60). It is, however, unlikely that Krispy Kreme can grow at 8.5% for ever.

We may have assigned the company a cost of equity capital that is too large. Given the forecasts used in the valuation model, a 7% cost of capital (discount rate) will yield a value estimate slightly in excess of $44 per share. However, this discount rate seems unreasonably low for a company such as Krispy Kreme.

The most interesting possibility is that the stock is ―overvalued‖ at $44 per share. Why might this occur? One reason is that investors are overly optimistic about the company’s profit prospects because they fail to properly consider the company’s growth opportunities and competitive dynamics in the industry.

It is interesting to note that 9 months later (May 2004) the stock was trading at about $20 per share.

10

Solutions to financial statement forecasts question on PowerPoint—Krispy Kreme Doughnuts (source: P6-21, RCJM textbook, 4th edition)

Students may want to build their own spreadsheets to solve this problem, using the procedures outlined in Appendix B. If not, a spreadsheet template is available on the web site. The template contains historical Krispy Kreme financial statement data that corresponds to the data.

Requirement 1: The following financial statement ratios and amounts summarize the forecasts used to generate projected Krispy Kreme financial statements:

Historical Ratios and Forecasts Historical Projected

2001 2002 2003 2004

Sales growth 31.2% 24.6% 33.7% 24.7% Historical Projected

2001 2002 2003 2004

Expense margins Cost of goods sold 80.9% 78.0% 78.0% 78.0% Research & development expense 0.0% 0.0% 0.0% 0.0% Selling, general and administrative expense 6.5% 5.5% 5.5% 5.5% Non-operating income (loss) 0.5% -2.0% 0.0% 0.0% Minority interest 0.3% 0.5% 0.5% 0.5% Other comprehensive income -0.1% 0.0% 0.0% 0.0%

Historical Projected

2001 2002 2003 2004

Operating asset and liability utilization (% of sales) Operating cash & equivalents / sales 5.6% 6.6% 6.6% 6.6% Accounts receivable / sales 9.8% 9.4% 9.4% 9.4% Inventory / sales 4.1% 5.0% 5.0% 5.0% Other current assets / sales 6.3% 7.8% 7.8% 7.8% Property, plant and equipment (cost) / sales 39.7% 51.4% 51.4% 51.4% Other assets / sales 10.4% 13.6% 13.6% 13.6% Accounts payable / sales 3.1% 2.9% 2.9% 2.9% Other current liabilities / sales 9.1% 8.4% 8.4% 8.4% Other liabilities / sales 2.2% 3.1% 3.1% 3.1% Minority interest / sales 0.6% 1.1% 1.1% 1.1%

11

Historical Projected

2001 2002 2003 2004

Financial Structure Debt / Assets 3.3% 15.0% 15.0% 15.0% Current portion long-term debt / debt 54.1% 6.8% 10.0% 10.0% Interest rate on beginning debt 3.5% 2.9% 6.0% 6.0% Dividends ($ in thousands) - - $0 $0 Historical Projected

2001 2002 2003 2004

Depreciation expense / PP&E cost 5.1% 4.9% 4.9% 4.9% Tax expense / pre-tax earnings 37.1% 37.3% 35.0% 35.0%

The historical and projected financial statements are as follows:

($ in thousands) Historical Projected

2001 2002 2003 2004

INCOME STATEMENT Sales $394.4 $491.5 $657.0 $819.0 Cost of goods sold 318.9 383.4 512.5 638.8 Research & development expense - - - - Selling, general and administrative expense 25.6 26.9 36.1 45.0 Depreciation expense 8.0 12.3 16.51 20.6

Pre-tax operating income 41.9 68.9 91.9 114.5 Interest expense 0.3 1.8 3.72 4.9 Non-operating income (loss) 2.1 (10.0) - -

Pre-tax earnings 43.7 57.1 88.2 109.6 Tax expense 16.2 21.3 30.93 38.3 Minority interest 1.1 2.3 3.3 4.1

Net income $26.4 $33.5 $54.0 $67.1

1. 16.5 = 337.72x 4.9% 2. 3.7= 6%x z(4.2+57.2) 3. 30.9= 35% x 88.2

12

Historical Projected

BALANCE SHEET 2001 2002 2003 2004

Operating cash and equivalents $21.9 $32.2 $43.4 $54.1 Accounts receivable 38.7 46.2 61.8 77.0 Inventories 16.2 24.4 32.8 41.0 Other current assets 25.0 38.3 51.2 63.9

Current assets 101.8 141.1 189.2 235.9 Property, plant and equipment (gross) 156.5 252.8 337.7 421.0 Accumulated depreciation (43.9) (50.2) (66.7)1 (87.4) Other assets 41.0 66.8 89.4 111.4

Total assets $255.4 $410.5 $549.5 $680.8

Current portion of long-term debt $4.6 $4.2 $8.2 $10.2 Accounts payable 12.1 14.1 19.1 23.8 Other payables 35.8 41.4 55.2 68.8

Current liabilities 52.5 59.7 82.5 102.8 Long-term debt 3.9 57.2 74.2 91.9 Other liabiltiies 8.8 15.0 20.4 25.4 Minority interest 2.5 5.2 7.2 9.0 Shareholders’ equity: Contributed capital 121.1 173.2 211.02 230.4 Retained earnings 66.6 100.2 154.2 221.3

Total shareholders’ equity 187.7 273.4 365.2 451.8

Total liabilities and equity $255.4 $410.5 $549.5 $680.8

Historical Projected

RETAINED EARNINGS 2001 2002 2003 2004

Beginning retained earnings $40.6 $66.6 $100.2 $154.2 + Net income 26.4 33.5 54.0 67.1 + Other comprehensive income items (0.4) 0.1 - - - Dividends - - - -

= Ending retained earnings $66.6 $100.2 $154.2 $221.3

1. 66.7=50.2+16.5 2. A plug in number

13

($ in thousands) Historical Projected

2001 2002 2003 2004

CASH FLOW STATEMENT Net income $26.4 $33.5 $54.0 $67.1 Non-cash expenses: Depreciation 8.0 12.3 16.5 20.6 Changes in non-cash working capital accounts Accounts receivable decrease (14.0) (7.5) (15.6) (15.2) Inventory decrease (4.2) (8.2) (8.4) (8.1) Other current asset decrease (1.9) (13.3) (12.9) (12.6) Accounts payable increase 3.9 2.0 5.0 4.7 Other current liabilities increase 9.3 5.6 13.8 13.6

Cash from operations $27.5 $24.4 $52.4 $70.1

Increase in property, plant and equipment ($55.8) ($102.2) ($84.9) ($83.3) Increase in other assets 12.3 (25.8) (22.6) (22.0)

Cash used in investing activities ($43.5) ($128.0) ($107.4) ($105.3)

Increase in long-term debt $5.0 $52.9 $21.0 $19.7 Increase in other liabilities 4.8 8.9 7.4 6.8 Increase in contributed capital 21.1 52.1 37.8 19.4 Dividends paid - - - -

Cash from financing activities $30.9 $113.9 $66.2 $45.9

Net increase (decrease) in cash $14.9 $10.3 $11.2 $10.7

Requirement 2: In October 2003, Analysts were forecasting Krispy Kreme’s net income to be $50.7 million in 2003 and $65.9 million in 2004. These amounts compare to $54.0 million and $67.1 million, respectively, from Requirement 1 above. Analysts appear to be forecasting high operating expenses in 2003 and 2004 than the solution above would suggest since both sets of forecasts rely on the same projected sales levels. Requirement 3: This assumption may seem odd at first, but it is necessary to ―balance the books.‖ Recall that Appendix B (and the Krispy Kreme template) relies on an explicit forecast of Cash (as a percent of sales). To achieve this desired cash balance—and to make certain that the net income statement, balance sheet, and cash flow statement agree with one another—any cash shortfall or

14

excess must be resolved as part of the forecasting process. A common approach for doing so is to raise needed cash by assuming the company sells stock, and to distribute excess cash by assuming the company buys back stock. This assumption ensures that the resulting financial statement forecasts are internally consistent with one another. Requirement 4: The following amounts (in millions) are from the company’s 2003 and 2004 financial statements: 2003 2004 Revenues $491.5 $665.6 Net income 33.5 57.1 Total assets $410.5 $660.7 Receivables 46.3 76.6 Current liabilities 59.7 53.5 Long-term debt 57.2 135.1 Cash from operations $ 51.0 $ 95.6