dmp3e ch05 solutions 02.28.10 final

7/27/2019 Dmp3e Ch05 Solutions 02.28.10 Final

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Chapter 5

Analyzing and InterpretingFinancial Statements

Learning Objectives coverage by question

Mini-exercises

Exercises Problems Cases

LO1Prepare and analyzecommon size financial statements.

15, 16, 19,20

35

LO2 Compute and interpretmeasures of return on investment,including return on equity (ROE),return on assets (ROA), and returnon financial leverage (ROFL).

14, 17, 21,

22, 24

25, 26, 27,

28, 29, 30,

31, 34

36, 38,

41, 4550

LO3 Disaggregate ROA intoprofitability (profit margin) andefficiency (asset turnover)components.

14, 17, 21,

22, 24

25, 26, 27,

28, 29, 30,

31, 34

36, 38,

41, 46, 47

48, 49,

50

LO4 Compute and interpretmeasures of liquidity andsolvency.

18, 23 32, 33 37, 39, 42

LO5 Measure andanalyze the effect of operatingactivities on ROE.

40, 43

LO6 Preparepro forma financialstatements.

35 44

Cambridge Business Publishers, 2011

Solutions Manual, Chapter 5 5-1


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Financial Accounting, 3rd Edition5-2


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QUESTIONS

Q5-1. Return on investment measures profitability in relation to the amount ofinvestment that has been made in the business. A company can always

increase dollar profit by increasing the amount of investment (assumingit is a profitable investment). So, dollar profits are not necessarily ameaningful way to look at financial performance. Using return oninvestment in our analysis, whether as investors or business managers,requires us to focus not only on the income statement, but also on thebalance sheet.

Q5-2. ROE is the sum of return on assets (ROA) and the return that resultsfrom the effective use of financial leverage (ROFL). Increasing leverageincreases ROE as long as ROA exceeds the after-tax interest rate.Financial leverage is also related to risk: the risk of potential bankruptcy

and the risk of increased variability of profits. Companies must,therefore, balance the positive effects of financial leverage against theirpotential negative consequences. It is for this reason that we do notwitness companies entirely financed with debt.

Q5-3. Gross profit margins can decline because 1) the industry has becomemore competitive, and/or the firms products have lost their competitiveadvantage so that the company has had to reduce prices or is sellingfewer units or 2) product costs have increased, or 3) the sales mix haschanged from higher-margin/slowly-turning products to lower-margin/higher-turning products. Declining gross profit margins areusually viewed negatively. On the other hand, cost increases that reflect

broader economic events or certain strategic product mix changesmight not be viewed negatively.

Q5-4. Reducing advertising or R&D expenditures can increase currentoperating profit at the expense of the long-term competitive position ofthe firm. Expenditures on advertising or R&D are more asset-like andcreate long-term economic benefits.

Q5-5. Asset turnover measures the amount of revenue volume compared withthe investment in an asset. Generally speaking, we want turnover to behigher rather than lower. Turnover measures productivity and animportant company objective is to make assets as productive as

possible. Since turnover is one of the components of ROE (via ROA),increasing turnover increases shareholder value. Turnover is, therefore,viewed as a value driver.

Q5-6. ROE>ROA implies a positive return on financial leverage. This resultsfrom borrowed funds being invested in operating assets whose return(ROA) exceeds the cost of borrowing. In this case, borrowing moneyincreases ROE.




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Q5-7. Common-size financial statements express balance sheet and incomestatement items in ratio form. Common-size balance sheets expresseach asset, liability and equity item as a percentage of total assets andcommon-size income statements express each line item as apercentage of sales. The ratio form facilitates comparison among firmsof different sizes as well as across time for the same firm.

Q5-8. The asset turnover ratio (AT) is the ratio of sales revenue to averagetotal assets. The ratio is increased by increasing sales while holdingassets constant, or by reducing assets without reducing sales. Themost effective means of improving the ratio is to increase the efficientutilization of operating assets. This is done by improving inventorymanagement practices, improving accounts receivable collection, andimproving the efficient use of PP&E.

Q5-9. The net in net operating assets, means operating assets net ofoperating liabilities. This netting recognizes that a portion of the costsof operating assets is paid for by parties other than the company. For

example, payables and accrued expenses help fund inventories, wages,utilities, and other operating costs. Similarly, long-term operatingliabilities also help fund the cost of long-term operating assets. Thus,these long-term operating liabilities are deducted from long-termoperating assets.

Q5-10. Companies must manage both the income statement and the balancesheet in order to maximize ROA. This is important, as many managerslook only to the income statement and do not fully appreciate the valueadded by effective balance sheet management. The disaggregation ofROA into its profit margin and turnover components facilitates analysisof these two areas of focus.

Q5-11. There are an infinite number of possible combinations of margin andturnover that will yield a given level of ROA. The relative weighting ofprofit margin and asset turnover is driven in large part by thecompanys business model. As a result, since companies in an industrytend to adopt similar business models, industries will generally trendtoward points along the margin/turnover continuum.

Q5-12. Liquidity refers to how much cash a company has, how much cash iscoming in, and how much cash can be raised quickly. Companies mustgenerate cash in order to pay their debts, pay their employees andprovide their shareholders a return on investment. Cash is, therefore,

critical to a companys survival.

Q5-13. Ratio analysis relies on the data presented in the financial statementsand is, therefore, dependent on the quality of those statements.Differences in the application of GAAP across companies or within thesame company across time can affect the reliability of the analysis.Limitations of GAAP itself and differences in the make-up of thecompany (e.g., types of products or industries in which the companycompetes) can also affect the usefulness of ratio analysis.




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MINI EXERCISES

M5-14. (15 minutes)

a. ROE = $5,000/$500,000 = 1%ROA = $20,000/$1,000,000 = 2%ROFL = 1% - 2% = -1%

b. Net profit margin = $5,000/$1,000,000 = 0.5%Asset turnover = $1,000,000/$1,000,000 = 1.0Financial leverage = $1,000,000/$500,000 = 2.0

c. ROFL is negative for Sunder Company, indicating that financial leverage ishurting this company. The return on assets is insufficient to cover the interestcost of the debt. DuPont analysis masks this problem. The financial leverageratio of 2.0 suggests (incorrectly) that leverage doubled the return.

M5-15 (20 minutes)

Target CorporationCommon-size Balance Sheets

2009 2008Cash and cash equivalents.. 2.0% 5.5%Accounts receivable, net. 18.3% 18.1%Inventory.. 15.2% 15.2%Other current assets. 4.2% 3.6%

Total current assets.. 39.6% 42.4%Property and equipment, net 58.4% 54.1%Other noncurrent assets. 2.0% 3.5%Total assets. 100.0% 100.0%

Accounts payable.. 14.4% 15.1%Accrued liabilities.. 6.6% 7.0%Current portion of long-term debt and notes payable... 2.9% 4.4%Total current liabilities 23.8% 26.4%Long-term debt 39.7% 33.9%Deferred income taxes.. 1.0% 1.1%

Other noncurrent liabilities.. 4.4% 4.2%Total shareholders' investment.. 31.1% 34.4%Total liabilities and shareholders' investment 100.0% 100.0%




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M5-18 (continued)

b. 2009 times interest earned = $4,402 / $866 = 5.08

2009 debt-to-equity = ($44,106 - $13,712) / $13,712 = 2.222008 debt-to-equity = ($44,560 - $15,307) / $15,307 = 1.91

Targets debt-to-equity increased slightly but is not at a particularly high level.

c. Target is liquid and not excessively financially leveraged. Its times interestearned ratio indicates that earnings before interest and taxes is just over 5times interest expense. Because the company generates significant operatingprofits and cash flow, we have no solvency concerns about Target.

M5-19 (20 minutes)

3M CompanyCommon-size Balance Sheets

2008 2007Cash and cash equivalent... 8.7% 10.0%Accounts receivable. 12.5% 13.6%Total inventories 11.8% 11.5%Other current assets 4.6% 4.7%Total current assets. 37.6% 39.8%Investments 2.5% 3.2%Property, plant and equipment, net.. 27.0% 26.7%Goodwill.. 22.5% 18.6%

Intangible assets, net.. 5.5% 3.2%Prepaid pension and postretirement benefits.. 0.1% 5.6%Other assets.. 4.8% 2.9%Total assets 100.0% 100.0%

Short-term borrowings and current portion of long-term debt. 6.1% 3.6%Accounts payable.. 5.1% 6.1%Accrued payroll.. 2.5% 2.3%Accrued income taxes. 1.4% 2.2%Other current liabilities 7.8% 7.5%Total current liabilities. 22.9% 21.7%

Long-term debt. 20.2% 16.3%Other liabilities... 18.3% 14.4%Total l iabilities 61.3% 52.4%Stockholders' equity, net 38.7% 47.6%Total liabilities and stockholders' equity 100.0% 100.0%




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M5-20 (15 minutes)

3M CompanyCommon-size Income Statements

2008 2007Net sales..... 100.0% 100.0%

Operating expenses:Cost of sales.. 52.9% 52.1%Selling general and administrative expenses.. 20.8% 20.5%Research, development and related expenses 5.6% 5.6%(Gain)/loss on sale of businesses.. 0.1% -3.5%Total. 79.4% 74.7%

Operating income 20.6% 25.3%Interest expense and income:

Interest expense.. 0.9% 0.9%Interest income. -0.4% -0.5%Total. 0.4% 0.3%

Income before income taxes and minority interest 20.2% 25.0%Provision for income taxes 6.3% 8.0%Minority interest 0.2% 0.2%Net income. 13.7% 16.7%

M5-21 (20 minutes)

($ millions)

a. 2008 EBI = $3,460 + $215 x (1-.35) = $3,599.75

2008 Average total assets = ($25,547 + $24,694)/2 = $25,120.5

ROA = $3,599.75/$25,120.5 = 14.33%

b. PM = $3,599.75/$25,269 = 14.2%

AT = $25,269/$25,120.5 = 1.01

14.25% X 1.01 = 14.39%




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M5-22 (15 minutes)

($ millions)

a. ANF: Average total assets = ($2,848.1 + $2,567.6)/2 = $2,707.85ROA = $272.3/$2,707.85 = 10.06%

TJX: Average total assets = ($6,178.2 + $6,599.9)/2 = $6,389.05ROA = $889.9 /$6,389.05 = 13.93%

b. ANF: PM = $272.3 / $3,540.3 = 7.69%AT = $3,540.3 / $2,707.85 = 1.317.69% X 1.31 = 10.07%

TJX: PM = $889.9 / $18,999.5 = 4.68%AT = $18,999.5 / $6,389.05 = 2.974.68% X 2.97 = 13.9%

c. ANFs ROA is less than TJXs. TJX operates in the value-priced segment of itsindustry which explains its lower PM. As is typical of value-priced retailers,TJXs asset turnover is high its AT is more than double that of ANFs. Onbalance, TJXs business model appears to be more successful in 2008 as it isable to maintain both a high AT and a reasonable PM, resulting in higher ROA.

M5-23 (20 minutes)

($ millions)

a. Verizons current ratio for the two years presented is as follows:

2008 current ratio: $26,075 / $25,906 = 1.012007 current ratio: $18,698 / 24,741 = 0.76

Liquidity is increasing and in 2008, Verizons current ratio nudged above 1.0.We might want to know, however, whether Verizons current assets areconcentrated in cash or relatively illiquid inventories, as well as the maturityschedule of its current liabilities. We would also like to know the averagecurrent ratio for the industry. This would help place Verizons numbers inperspective.

b. Verizons times interest earned ratio for the two years is as follows:

2008 times interest earned = $11,578 / $1,819 = 6.372007 times interest earned = $11,321 / $1,829 = 6.19

Verizons times interest earned ratio has increased.

2008 debt-to-equity = $160,646 / $41,706 = 3.852007 debt-to-equity = $136,378 / $50,581 = 2.70

Verizons debt-to-equity ratio has increased, and is in excess of the 1.13median for companies in the telecommunications industry.




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M5-23 (continued)

Verizons operating cash flow to total liabilities ratio is as follows:2008 OCFCL = $26,620 / [($160,646 + $136,378)/2] = 0.179

c. Verizon is carrying a significant amount of debt. Although its profitability andoperating cash flow are fairly strong, neither is particularly high in relation tothe companys liabilities and interest costs. There is some question, therefore,regarding the amount of additional debt that the company can take on. Givenits significant capital expenditure requirements and its current debt load,Verizon may have to fund future capital expenditures with higher-cost equity.And, to the extent that its competitors are not as highly leveraged, this maynegatively impact Verizons competitive position.

M5-24 (30 minutes)

$ millions Asset Turnover

Procter & Gamble......... $79,029/$139,413 = 0.57

McDonald's.................... $23,522.4/$28,926.6 = 0.81

Valero Energy................ $119,114/ $38,570 = 3.09

$ millions ART

Procter & Gamble......... $79,029/$6,299 = 12.55

McDonald's.................... $23,522.4/$992.5 = 23.7Valero Energy................ $119,114/ $5,294 = 22.5

$ millions INVT

Procter & Gamble......... $38,898/$7,648 = 5.09

McDonald's.................... $5,586.1/$118.4 = 47.18

Valero Energy................ $107,429/ $4,355 = 24.67

$ millions PPET

Procter & Gamble......... $79,029/$20,051 = 3.94

McDonald's.................... $23,522.4/$20,619.6 = 1.14

Valero Energy................ $119,114/ $22,387 = 5.32




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EXERCISES

E5-25 (30 minutes)

a.

($ millions)Target [$2,214 + $866x(1-.35)] / $44,333 = 6.26

Wal-Mart [($13,400 + $1,900x(1-.35)] / $163,472 = 8.95

b.($ millions) PM = EBI / Sales AT = Sales / Avg. Assets

Target [$2,214 + $866x(1-.35)] / $62,884 = 4.42 $62,884/$44,333 = 1.42

Wal-Mart [($13,400 + $1,900x(1-.35)] / $405,607 = 3.61 $405,607/$163,472 = 2.48

c. Wal-Marts ROA is greater than Targets in fiscal 2008. Wal-Marts value pricingstrategy is clearly evident in its lower PM, but this is more than offset by ahigher asset turnover and, hence, Wal-Marts business model is somewhatmore successful.

E5-26 (20 minutes)

($ millions) Dell Apple

a. EBI $2,478 + $74x(1-.35) = $2,526.1 $5,704 +$ 0 x(1-.35) = $5,704

Avg. Assets ($26,500 + $27,561)/2 =$ 27,030.5 ($53,851 + $39,572)/2 = $46,711.5

ROA $2,526.1 / $27,030.5 = 9.35% $5,704 / $46,711.5 = 12.21%

b. PM $2,526.1 / $61,101 = 4.13% $5,704 / $36,537 = 15.61%

AT $61,101 / $27,030.5 = 2.26 $36,537 / $46,711.5 = 0.78

c. Avg. Equity ($4,271 + $3,735)/2 = $4,003 ($27,832 + $21,030)/2 = $24,431

ROE $2,478 / $4,003 = 61.9% $5,704 / $24,431 = 23.35%

ROFL 61.9% - 9.35% = 52.55% 23.35% - 12.21% = 11.14%




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E5-26 (continued)

d. Apples ROA exceeds Dells. This is primarily the result of a significantlyhigher PM. Apples PM is the result of the popularity of its brand and its up-scale image. Dells business model is based on outsourcing components and

assembly to order resulting in a higher AT than Apple. Dell uses financialleverage much more effectively than Apple resulting in a higher ROE.

E5-27 (20 minutes)

($ millions) CVS Walgreen

a. EBI $3,212.1+$509.5x(1-.35)=$3,543.275 $2,006+$83x(1-.35)=$2,059.95

Avg. Assets ($60,959.9+$54,721.9)/2=$57,840.9 ($25,142+$22,410 /2 = $23,776

ROA $3,543.275/ $57,840.9 = 6.13% $2,059.95/ $23,776 = 8.66%

b. PM $3,543.275/$87,471.9=4.05% $2,059.95/$63,335=3.25%

AT $87,471.9/$57,840.9=1.51 $63,335/$23,776 = 2.66

c. Avg. Equity($34,574.4+$31,321.9)/2 =

$32,948.15($14,376+$12,869)/2

=$13,622.5

ROE $3,212.1 / $32,948.15= 9.75% $2,006 / $13,622.5 = 14.73%

ROFL 9.75% - 6.13% = 3.62% 14.73% - 8.66% = 6.07%

d. Walgreens ROE and ROA are higher than CVSs. CVSs PM is slightly higherthan Walgreens, but its AT is significantly lower. The low PMs for bothcompanies reflect the highly competitive retail pharmaceutical industry.Walgreens main advantage in 2008 lies in its use of financial leverage and itsefficiency as reflected in its asset turnover.




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E5-28 (30 minutes)($ millions)

a. ROE2008: $5,292 / [($39,088+$42,762) / 2] = 12.93%

2007: $6,976 / [($36,752+$42,762) / 2] = 17.55%

b. ROA2008: [$5,292+$488x(1-.35)] / [($50,715+$55,651) / 2] = 10.55%

2007: [$6,976+$793x(1-.35)] / [($55,651+$48,368) / 2] = 14.40%

ROFL2008: 12.93% - 10.55% = 2.38%

2007: 17.55% - 14.40% = 3.15%

c.Net Profit

Margin

2008: $5,292 / $37,586 = 14.08%

2007: $6,976 / $38,334 = 18.20%

AssetTurnover

2008: $37,586 / [($50,715+$55,651) / 2] = 0.71

2007: $38,334 / [($55,651+$48,368) / 2] = 0.74

FinancialLeverage

2008: [($50,715+$55,651) / 2] / [($39,088+$42,762) / 2] = 1.30

2007: [($55,651+$48,368) / 2] / [($36,752+$42,762) / 2] = 1.31

Intels financial leverage remained relatively stable from 2007 to 2008. Based

on ROFL, leverage increased ROE by about 22% over ROA each year(2.38%/10.55%, 3.15%/14.40%). DuPont analysis suggests that leverage had alarger (30%) impact. This is consistent with the bias in DuPont analysis in thatit tends to overstate the benefits of financial leverage. Offsetting this bias,DuPont analysis calculates the net profit margin, which is lower than PMbecause the numerator is net of interest costs. For comparison purposes,Intels PM ratios are presented below:

PM ratio2008: [$5,292+$488x(1-.35)] / $37,586 = 14.92%

2007: [$6,976+$793x(1-.35)] / $38,334 = 19.54%




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E5-29 (30 minutes)($ millions)

a. ROE 2008: $401 / [($1,210+$1,115) / 2] = 34.49%

2007: $715 / [($1,115+$2,169) / 2] = 43.54%

2006: $678 / [($2,169+$2,093) / 2] = 31.82%

b. ROA 2008: [$401+$131x(1-.35)] / [($5,661+$5,600) / 2] = 8.63%

2007: [$715+$74x(1-.35)] / [($5,600+$4,822) / 2] = 14.64%

2006: [$678+$43x(1-.35)] / [($4,822+$4,921) / 2] = 14.49%

ROFL 2008: 34.49% - 8.63% = 25.86%

2007: 43.54% - 14.64% = 28.9%

2006: 31.82% - 14.49% = 17.33%

c. ROE and ROA should be slightly higher in 2007 because of the extra week.

d. Net ProfitMargin

2008: $401 / $8,272 = 4.85%

2007: $715 / $8,828 = 8.10%

2006: $678 / $8,561 = 7.92%

AssetTurnover

2008: $8,272 / [($5,661+$5,600) / 2] = 1.47

2007: $8,828 / [($5,600+$4,822) / 2] = 1.69

2006: $8,561 / [($4,822+$4,921) / 2] = 1.76

FinancialLeverage

2008: [($5,661+$5,600) / 2] / [($1,210+$1,115) / 2] = 4.84

2007: [($5,600+$4,822) / 2] / [($1,115+$2,169) / 2] = 3.17

2006: [($4,822+$4,921) / 2] / [($2,169+$2,093) / 2] = 2.29

Nordstroms ROA decreased considerably in 2008, though its ROE remainedhigher than in 2006 due to increasing financial leverage. Nordstroms financialleverage increased from 2006 to 2008. Based on ROFL, leverage increasedROA by 2.2 times in 2006 ($31.82%/14.49%) while in 2008, leverage increasedROA by a factor of 4 (34.49%/8.63%). DuPont analysis suggests that leveragehad a slightly larger impact (2.29 in 2006 and 4.84 in 2008) but the trend is the

same. This is consistent with the bias in DuPont analysis in that it tends tooverstate the benefits of financial leverage. Offsetting this bias, DuPontanalysis calculates the net profit margin, which is lower than PM because thenumerator is net of interest costs. For comparison purposes, Nordstroms PMratios are presented below:

PM ratio 2008: [$401+$131x(1-.35)] / $8,272 = 5.88%

2007: [$715+$74x(1-.35)] / $8,828 = 8.64%




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2006: [$678+$43x(1-.35)] / $8,561 = 8.25%

E5-30 (20 minutes)

($ millions)

a. EBI $805.2+$149.8x(1-.35) = $902.57

Avg. Equity ($5,564.2+$5,718.0)/2 = $5,641.1

Avg. Assets ($13,006.0+$9,036.3)/2 = $11,021.15

ROE $805.2 / $5,641.1 = 14.27%

ROA $902.57/ $11,021.15 = 8.19%

ROFL 14.27% - 8.19% = 6.08%

b. PM $902.57 / $23,083.8 = 3.9%AT $23,083.8 / $11,021.15 = 2.09

c. Staples has a relatively low profit margin and an asset turnover that is above2.0. This is consistent with other firms in the retail industry, especially thosewho rely on a low-price, high-volume business model.

E5-31 (20 minutes)

($ millions)a. EBI $447.0+$51.2x(1-.35) = $480.28

Avg. Equity ($2,555.8+$2,073.0)/2 = $2,314.4

Avg. Assets ($4,826.3+$4,666.6)/2 = $4,746.45

ROE $447.0 / $2,314.4 = 19.31%

ROA $480.28/ $4,746.45 = 10.12%

ROFL 19.31% - 10.12% = 9.19%

b. PM $480.28 / $3,182.5 = 15.09%

AT $3,182.5 / $4,746.45= 0.67

c. Intuit has a relatively high PM ratio and a low AT ratio. These numbers areconsistent with the business model employed in the software industry.Contrast these numbers with those of Staples (E5-30). Intuit uses financial




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leverage effectively; leverage increased its ROA by a factor of 1.91(19.31%/10.12%).




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E5-32 (30 minutes)

a. ($ millions) Current Ratio

2006 $5,202 / $7,191 = 0.72

2007 $3,667 / $7,952 = 0.462008 $3,716 / $8,939 = 0.42

Comcast has a current ratio less than 1.0 and it has declined from 2006 levels.Comcast is not very liquid. While the current ratio provides a useful pointestimate of liquidity, it would be helpful to know when the cash flows fromcurrent assets will be realized and when the current liabilities will need to bepaid. An excess of current maturities over near-term cash realization willcause a liquidity problem regardless of the level of the overall ratio. As well,we would like to know the current ratio for firms in this industry.

b. ($ millions) Times interest earned Debt-to-equity

2006 $(3,594+2,064) / $2,064 = 2.74 $69,238 / $41,167 = 1.68

2007 $(4,349+2,289) / $2,289 = 2.90 $72,077 / $41,340 = 1.74

2008 $(4,058+2,439) / $2,439 = 2.66 $72,567 / $40,450 = 1.79

The times interest earned ratio is quite low and has remained relatively stablesince 2006. Comcast is able to cover its interest expense, but not by acomfortable margin. Comcasts debt-to-equity ratio is relatively high between1.68 and 1.79, and is increasing.

c. Comcast has a relatively high level of debt. This, coupled with its relativelylow liquidity, and low earnings relative to its interest charges causes someconcern about its ability to increase its debt load significantly. This isespecially troublesome given the significant levels of capital expenditures thatwill be required in order to upgrade its infrastructure in order to remaincompetitive.




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E5-33 (30 minutes)

a. ($ millions) Current Ratio OCFCL

2006 50,014 / 38,964 = 1.28 5,003/[(39,833+38,964)/2] = 0.127

2007 47,932 / 43,894 = 1.09 9,822/[(38,964+43,894)/2] = 0.2372008 43,242 / 42,451 = 1.02 9,281/[(43,894+42,451)/2] = 0.215

Siemens has a current ratio that is above than 1.0 but it has declined from2006 levels. However, its OCFCL ratio improved in 2007 and 2008 relative to2006. While the current ratio provides a useful point estimate of liquidity, theOCFCL ratio suggests that operations are not generating sufficient cash flowto cover short-term obligations. We would like to know the current ratio andOCFCL ratio for other firms in this industry.

b. ($ millions) Times interest earned Debt-to-equity2006 (3,418+525) / 525 = 7.51 61,633 / 25,895 = 2.38

2007 (5,101+897) / 897 = 6.69 61,928 / 29,627 = 2.09

2008 (2,874+834) / 834 = 4.45 67,083 / 27,380 = 2.45

The times interest earned ratio is at acceptable levels, but is decreasing due tohigher interest costs and lower earnings. Siemens debt-to-equity ratio is quitehigh between 2.09 and 2.45.

c. Siemens has a high level of debt. This, along with the decline in the times-interest-earned ratio, raises some concern about its ability to increase its debtload significantly.




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E5-34 (30 minutes)

($ millions)

a. EBI $967+$1x(1-.35) = $967.65

Avg. Equity ($4,387+$4,274)/2 = $4,330.5

Avg. Assets ($7,564+$7,838)/2 = $7,701

ROE $967 / $4,330.5 = 22.33%

ROA $967.65/ $7,701 = 12.57%

ROFL 22.33% - 12.57% = 9.76%

b. PM $967.65 / $14,526 = 6.66%

AT $14,526 / $7,701 = 1.89

c. GPM $5,447 / $14,526 = 37.5%

INVT $9,079 / [($1,506 + $1,575)/2] = 5.89

d. The Gap showed strong performance in the year ended January 31, 2009(hereafter, 2008). Its ROA was 12.57%, which is high in a recession year. ROEwas over 22% indicating the effective use of financial leverage. Interest costswere low, suggesting that most of The Gaps dept is from operating liabilities(accounts payable and accrued expenses). Its profit margin and asset

turnover ratios place The Gap in a strong position for this industry. As a pointof comparison, Nordstrom has a PM ratio of 5.88 and an AT ratio of 1.47 in2008.

The GPM and INVT ratios are two important performance measures for retailcompanies such as The Gap. GPM measures the ability of the firm to sell itsmerchandise at reasonable margins while INVT provides evidence oninventory management and the popularity of its product line. Both measuresare healthy for a retailer in the economy of 2008.




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E5-35 (20 minutes)

The Gap, Inc.Common-size and Pro-forma Income Statements

a., b. 1/31/09 2/2/081/31/10

Pro forma

Net Sales. 100.0% 100.0% $15,000Cost of goods sold and occupancy costs. 62.5% 63.9% 9,450Gross profit 37.5% 36.1% 5,550Operating expenses 26.8% 27.8% 4,050Operating income 10.7% 8.3% 1,500Interest income 0.3% 0.7% 37Interest expense.. 0.0% 0.2% 1Earnings from continuing operations beforeincome taxes. 10.9% 8.9% 1,536Income taxes. 4.2% 3.4% 584Earnings from continuing operations 6.7% 5.5% 952

Loss from discontinued operations, net of incometaxes -------- 0.2% -------Net earnings. 6.7% 5.3% $ 952

c. The Gaps pro forma statements are based on a set of assumptions thatdetermine the relationship between various expense items and sales revenue.The accuracy of the projection depends on the reliability of these estimates,which depends on managements ability to maintain a stable GPM ratio, maintainINVT ratio, and control operating expense ETS ratios.




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PROBLEMS

P5-36 (45 minutes)

($ millions) Nike Adidas

a. EBI $1,486.7+$46.7x(1-.35) = $1,517.06 644 + 203x(1-.35) = 775.95

Avg.Equity

($8,693.1+$7,825.3)/2 = $8,259.2 (3,400+3,034)/2 = 3,217

Avg.Assets

($13,249.6+$12,442.7)/2=$12,846.15 (9,533+8,325)/2 = 8,929

ROE $1,486.7/ $8,259.2 = 18.0% 644/3,217=20.02%

ROA $1,517.06/ $12,846.15= 11.81% 775.95/8,929=8.69%

ROFL 18.0% - 11.81% = 6.19% 20.02% - 8.69% = 11.33%

While Adidas reported a higher ROE, Nikes ROA was higher. The difference wascaused by Adidas use of financial leverage which more than doubled its ROA.

b. PM $1,517.06/ $19,176.1 = 7.91% 775.95/10,799 = 7.19%

AT $19,176.1 / $12,846.15 = 1.49 10,799/8,929 = 1.21

Nikes PM ratio is only slightly higher than Adidass. Nikes higher ROA appears tobe driven by more efficient use of assets, as its AT ratio is higher (1.49 vs. 1.21).

c. GPM $8,604.4 / $19,176.1 = 44.87% 5,256/10,799 = 48.67%

OperatingETS $6,149.6 / $19,176.1 = 32.07% 4,186/10,799 = 38.76%

Adidas reports a higher GPM ratio than Nike by about 4%. However, that is morethan offset by higher operating expenses as a percentage of sales.

d. ART$19,176.1/$

[(2,883.9+2,795.3)/2]=6.7510,799/[(1,624+1,459)/2]=7.0

INVT $10,571.7/$[(2,357+2,438.4)/2]=4.41 5,543/[(1,995+1,629)/2]=3.06

PPET$19,176.1/$

[(1,957.7+1,891.1)/2]=9.9610,799/[(886+702)/2]=13.6

Nikes INVT is significantly higher than Adidass, suggesting that Nike may bemanaging inventory more efficiently. Adidas has a higher PPET ratio, though bothcompanies ratios are high. These are consistent with a business model thatoutsources most of the production.

e. The two companies fiscal years overlap by seven months. Nikes incomestatement includes January through May 2009 while Adidas statements coverJanuary through May 2008. (Both cover June through December 2008.)




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Economic conditions were worse in 2009 than 2008, so that should put Nike ata comparative disadvantage.

P5-36 (continued)

f. Normally, we would want to identify any major differences in the valuation of

assets and the measurement of income between these two companies. Forexample, some assets are more likely to be valued at current value (ratherthan historical cost) under IFRS reporting. Such a difference would affectratios such as ROA, AT, INVT and PPET.

P5-37 (20 minutes)

($ millions) Nike Adidas

a. CurrentRatio

2009: $9,734.0/$3,277.0 = 2.97

2008: $8,839.3/$3,321.5 = 2.66

2008: 4,934/3,645= 1.35

2007: 4,138/2,615= 1.58

QuickRatio

2009: $(2,291.1+1,164+2,883.9)/$3,277.0=1.93

2008: $(2,133.9+642.2+2,795.3)/$3,321.5=1.68

2008:(244+141+1,624)/3,645=0.55

2007:(295+86+1,459)/2,615= 0.70

Nike is more liquid than Adidas. Its current ratio is just under 3.0 and its quick ratiois almost 2.0. In fact, Nikes quick ratio is higher than Adidass current ratio.

b. TIE 2009: ($1,956.5+$46.7)/$46.7=42.92008: ($2,502.9+$44.1)/$44.1=57.8

2008: (904+203)/203=5.52007: (815+170)/170= 5.8

Debt-to-Equity

2009: $4,556.5/$8,693.1=0.52

2008: $4,617.4/$7,825.3=0.59

2008: 6,133/3,400=1.80

2007: 5,291/3,034=1.74

Nikes debt-to-equity ratio is very low and decreased slightly in 2009. Adidassdebt-to-equity ratio went up in 2008. Both companies reported declining TIE ratios.

c. Adidas relies on significantly greater amounts of debt financing than does Nike.This is evident by the debt-to-equity ratio. In addition, the TIE ratio for Nike is 8

times higher than for Adidas. Although Adidass TIE ratio is not too low, Nikessmall amount of interest expense produces a very high TIE. Neither companyshould have difficulty meeting its debt obligations, but Adidas may not be able toborrow as much in the future (if needed).




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P5-38 (45 minutes)

($ millions) Home Depot Lowes

a. EBI $2,260+$624x(1-.35) = $2,665.6 $2,195+$280x(1-.35) = $2,377

Avg.Equity

($17,777+$17,714)/2= $17,745.5 ($18,055+$16,098)/2= $17,076.5

Avg.Assets

($41,164+$44,324)/2=$42,744 ($32,686+$30,869)/2=$31,777.5

ROE $2,260/ $17,745.5 = 12.74% $2,195/ $17,076.5 = 12.85%

ROA $2,665.6/ $42,744= 6.24% $2,377/ $31,777.5= 7.48%

ROFL 12.74% - 6.24% = 6.50% 12.85% - 7.48% = 5.37%

These two companies had almost identical ROEs for 2008. Lowes had a higherROA (7.48% vs. 6.24% for Home Depot). Home Depot made up the difference by

using financial leverage to its advantage.

b. PM $2,665.6/ $71,288 = 3.74% $2,377/ $48,230 = 4.93%

AT $71,288 / $42,744 = 1.67 $48,230 / $31,777.5 = 1.52

Lowes higher ROA is driven by a higher PM ratio. Home Depots AT ratio is a bithigher, suggesting that it is managing assets more efficiently.

c. GPM $23,990 / $71,288 = 33.65% $16,501 / $48,230 = 34.21%

OperatingETS

$19,631 / $71,288 = 27.54% $12,715 / $48,230 = 26.36%

These two companies have almost identical profitability ratios. Lowes GPM ratio isslightly higher than that of the Home Depot, and its operating ETS ratio is slightlylower. Thus Lowes performed slightly better with respect to these two profitabilitymeasures.

d. ART $71,288/$[(972+1,259)/2]=63.91 $48,230/0 = N/A

INVT $47,298/$[(10,673+11,731)/2]=4.22 $31,729/$[(8,209+7,611)/2]=4.01

PPET $71,288/$[(26,234+27,476)/2]=2.65 $48,230/$[(22,722+21,361)/2]=2.19

Lowes reports no accounts receivable and Home Depot reports very small amountsof receivables. Neither company relies on customer credit to generate sales, so the

ART ratio is not very informative. More important is the INVT ratio. Home DepotsINVT is slightly higher than Lowes ratio. The same is true for the PPET ratio.These differences are consistent with the difference in the AT ratios noted earlier.Overall, the numbers suggest that Home Depot is managing inventories and PPEassets more efficiently.

e. Overall, the performance of these two companies is very similar. Lowes reportsa slightly higher ROE and ROA due to better profitability ratios (PM, GPM and ETS).Home Depot manages assets more efficiently. However, all differences are small.




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P5-39 (30 minutes)


a. CurrentRatio

2008: $13,362/$11,153 = 1.20

2007: $14,674/$12,706 = 1.15

2008: $9,251/$8,022 = 1.15

2007: $8,686/$7,751 = 1.12

QuickRatio

2008: $(519+6+972)/$11,153=0.13

2007: $(445+12+1,259)/$12,706=0.14

2008: $(245+416)/$8,022=0.08

2007: $(281+249)/$7,751=0.07

The current ratios of these two companies are very close. Both are above one, butnot high. Quick ratios are very low due to the lack of receivables and low cashbalances. Both companies rely on operating cash flow to cover liquidity needs.Given the lack of receivables, the INVT ratio becomes doubly important (see P5-38).Failure to turn inventories quickly would result in lower operating cash flow andliquidity problems. Hence, both companies emphasize inventory management.

b. TIE 2008: ($3,590+$624)/$624=6.75

2007: ($6,620+$696)/$696=10.51

2008: ($3,506+$280)/$280=13.52

2007: ($4,511+$194)/$194=24.25

Debt-to-Equity

2008: $23,387/$17,777=1.32

2007: $26,610/$17,714=1.50

2008: $14,631/$18,055=0.81

2007: $14,771/$16,098=0.92

For both companies, the debt-to-equity ratio decreased from 2007 to 2008 indicatingless reliance on debt financing. Despite this trend, TIE ratios declined due todeclining earnings.

c. The Home Depot utilizes more debt financing than does Lowes. This results in ahigher ROFL (see P5-38), as well as higher debt-to-equity and lower TIE ratios

relative to Lowes. Lowes debt-to-equity ratio is less than 1.0, indicating that morethan 50% of its financing is from owners.




25/37

P5-40A (20 minutes)


a. NOPAT$2,312+$(145+624)x(1-.35) = $2,811.85 $2,195+$280x(1-.35) = $2,377

NOA2008: $(41,164-6-36) - $(23,387-1,767-9,667) = $29,169

2007: $(44,324-12-342)-$(26,610-2,047-11,383) = $30,790

2008: $(32,686-416-253) -$(14,631-1,021-5,039) = $23,446

2007: $(30,869-249-509)-$(14,771-1,104-5,576) = $22,020

Avg.NOA

($29,169 + $30,790)/2 = $29,979.5 ($23,446 + $22,020)/2 = $22,733

b. RNOA $2,811.85/$29,979.5 = 9.38% $2,377/$22,733 = 10.46%

c. NOPM $2,811.85/$71,288 = 3.94% $2,377/$48,230 = 4.93%

NOAT $71,288/$29,979.5 = 2.38 $48,230/$22,733 = 2.12

d. Lowes reports a higher RNOA than does The Home Depot. This is consistentwith the ROA numbers computed in P5-38 (ROA=6.24% for Home Depot and 7.48%for Lowes). Overall, operating returns make up 74% of Home Depots ROE(9.38%/12.74%) and 81% of Lowes ROE (10.46%/12.85%). Lowes has a higher netoperating PM while Home Depot has a higher net operating AT.




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P5-41 (30 minutes)

($ millions) 2008 2007

a. EBI $3,003+$442x(1-.35) = $3,290.3 $382+$246x(1-.35) = $541.9

Avg. Assets ($31,879+$39,042)/2=$35,460.5 ($39,042+$33,210)/2=$36,126

ROA $3,290.3/ $35,460.5= 9.28% $541.9/ $36,126= 1.50%

PM $3,290.3/ $51,486 = 6.39% $541.9/ $49,692 = 1.09%

AT $51,486 / $35,460.5 = 1.45 $49,692 / $36,126 = 1.38

While a 2008 ROA of 9.28% is acceptable, UPSs 2007 ROA of 1.50% is extremely low.Although AT increased slightly in 2008, the primary cause of the increase in ROA wasan increase in PM from 1.09% to 6.39%. It would appear from these two years thatUPSs most effective strategy for increasing ROA is to maintain its AT ratio whiletrying to increase PM.

b. CompensationETS

$26,063/$51,486 = 50.62% $31,745/$49,692 = 63.88%

The largest single expense on UPSs income statement is compensation. In 2007, thecompensation was almost 64% of sales. By reducing this expense to just over 50%of sales, UPSs profit margin increased in 2008.

c. Avg. Equity ($6,780+$12,183)/2= $9,481.5 ($12,183+$15,482)/2= $13,832.5

ROE $3,003/ $9,481.5 = 31.67% $382/ $13,832.5 = 2.76%

d. ROFL 31.67% - 9.28% = 22.39% 2.76% - 1.50% = 1.26%

UPS relies heavily on debt financing. In 2008, when ROA was at an acceptable level,ROFL contributed 22.39% to ROE. However, in 2007 when ROA was very low, thehigh leverage only added 1.26% to ROE.




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P5-42 (30 minutes)

($ millions) 2008 2007

a. CurrentRatio

$8,845/$7,817 = 1.13 $11,760/$9,840 = 1.20

QuickRatio $(507+542+5,547+480)/$7,817=0.91 $(2,027+577+6,084+468)/$9,840=0.93

UPS current and quick ratios decreased slightly in 2008. The current ratio is above 1.0and the quick ratio is only slightly lower than the current ratio because UPS does notcarry inventory balances.

b. TIE ($5,015+$442)/$442=12.35 ($431+$246)/$246=2.75

Debt-to-Equity $25,099/$6,780=3.70 $26,859/$12,183=2.20

The TIE ratio increased dramatically in 2008 due to the increase in earnings. However,the debt-to-equity ratio also increased, indicating an increased dependence on debt

financing.c. UPS relies heavily on debt financing. Although the company appears liquid, itsability to meet its obligations depends heavily on operating cash flow. The high (andincreasing) debt-to-equity ratio suggests that UPS may have difficulty borrowingadditional funds if needed.

P5-43A (30 minutes)

($ millions) United Parcel Service (UPS)

a. NOPAT $5,015+$(442-75)x(1-.35) = $5,253.55

NOA2008: $(31,879-542-480) - $(25,099-2,074-7,797) = $15,6292007: $(39,042-577-468) - $(26,859-3,512-440-7,506) = $22,596

Avg. NOA ($15,629 + $22,596)/2 = $19,112.5

b. RNOA $5,253.55/$19,112.5 = 27.49%

UPS RNOA is 87% of its ROE (27.49%/31.67%). Thus, almost all of its returnis from operations.

c. NOPM $5,253.55/$51,486 = 10.20%

NOAT $51,486/$19,112.5 = 2.69

d. These ratios provide a different picture of UPS relative to P5-42. Its high debt-to-equity ratio is caused almost exclusively by operating liabilities. A majorpart of UPSs operating liabilities are related to compensation.




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P5-44B (45 minutes)a.

United Parcel Service, Inc.Income Statements

($ millions)

2008

Actual

2009

Pro formaRevenue $51,486 $55,000Compensation and benefits 26,063 27,842Other. 20,041 21,409Operating profit. 5,382 5,749Investment income 75 75Interest expense (442) (442)Income before income taxes. 5,015 5,382Income taxes. 2,012 2,153Net income. $ 3,003 $ 3,229

United Parcel Service, Inc.Balance Sheets

($ millions)2008

Actual2009

Pro formaCash and equivalents.. $ 507 $ 1,055Short-term investments.. 542 542Accounts receivable, net 5,547 5,926Finance receivables, net. 480 513Income tax receivable.. 167 178Deferred income taxes. 494 528Other current assets. 1,108 1,184

Total current assets. 8,845 9,926Property, plant and equipment.. 18,265 19,512Pension and post retirement benefit assets.. 10 11Goodwill 1,986 2,122Intangible assets 511 546Other assets 2,262 2,416Total assets. $31,879 $34,533

Current maturities of long-term debt.. $ 2,074 $ 2,074Accounts payable. 1,855 1,982Accrued wages and withholdings 1,436 1,534

Other current liabilities 2,452 2,619Total current liabilities. 7,817 8,209Long-term debt. 7,797 7,797Accumulated postretirement benefit obligation.. 6,323 6,755Deferred taxes and other liabilities.. 3,162 3,378Total liabilities 25,099 26,139Shareowners' equity 6,780 8,394Total liabilities and shareowners' equity $31,879 $34,533




29/37

b.United Parcel Service, Inc.

Cash Flow Statement

($ millions)2009

Pro forma

Operations:Net income. $3,229Adjustments:Depreciation and amortization..... 1,925Less increase in operating assets:Accounts receivable (379)Finance receivables (33)Tax receivable.. (11)Deferred income taxes (34)Other current assets (76)

Pension and post retirement benefit assets. (1)Other assets.. (154)Plus increase in operating liabilities:Accounts payable 127Accrued wages and withholdings.. 98Other current liabilities.. 167Accumulated postretirement benefit obligation. 432Deferred taxes and other liabilities. 216Cash flow from operations 5,506

Investing activities:

Investment in property, plant and equipment. (3,172)Investment in goodwill and intangible assets. (171)Cash used for investing activities... (3,343)

Financing activities:Dividends paid.. (1,615)Cash used for financing activities... (1,615)

Net increase in cash 548Cash, December 31, 2008.. 507Pro forma cash, December 31, 2009.. 1,055




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P5-45 (20 minutes)

a. Avg. totalliabilities

($25,099+$26,859)/2 = $25,979

Net interest rate

(NIR) $442x(1-.35) / ($25,099+$26,859)/2 = 1.11%

Spread(ROA NIR)

9.28%-1.11% = 8.17%

b. ROFL {[($25,099+$26,859)/2]/[($6,780+$12,183)/2]}x8.17% = 22.39%

c. An ROFL of 22.39% is equal to the difference between ROE and ROA (31.67%-9.28%) as calculated in P5-41. This suggests that 71% of UPSs ROE wasgenerated by the effective use of financial leverage.

P5-46 (45 minutes)

a., b. A summary of the ratios for these five companies appears in the followingtable. Calculations are provided below for each company.

PM GPM R&D ETS SG&A ETS

ABT 17.69% 57.29% 9.44% 28.57%

BMY 26.54% 68.84% 17.46% 30.90%

JNJ 20.76% 70.96% 12.17% 33.71%

MRK 33.42% 76.59% 20.15% 30.93%

PFE 17.83% 83.20% 16.45% 30.10%

c. What is perhaps most remarkable is how similar these five companies are.For example, the SG&A ETS ratio ranges between 28.57% and 33.71%, withthree of the five between 30% and 31%. GPM ranges from a low of 57.29%(ABT) to 83.2% (PFE), but the other three firms are between 68.84% and76.59%. This suggests that the business models employed by these

companies are very similar. The PM ratio shows a fairly wide variation,ranging from a low of 17.69% (ABT) to 33.42% (MRK). Interestingly, ABTappears to be the least profitable, with the lowest PM and GPM, yet it spendsthe least on R&D and SG&A expenses. At the same time, MRK (BMY) has thehighest (second highest) PM and spends the most (second most) on R&D.




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P5-46 (continued)

Calculations of ratios for each firm follow:

($ millions) Abbott Laboratories (ABT)

PM $4,880.7 + $528.5 x(1-.35) / $29,527.6 = 17.69%

GPM ($29,527.6 - $12,612.0) / $29,527.6 = 57.29%

R&D ETS $2,786.0 / $29,527.6 = 9.44%

SG&A ETS $8,435.6 / $29,527.6 = 28.57%

($ millions) Bristol-Myers Squibb (BMY)

PM $5,247 + $310 x(1-.35) / $20,527 = 26.54%

GPM ($20,527 - $6,396) / $20,527 = 68.84%

R&D ETS $3,585 / $20,527 = 17.46%SG&A ETS $6,342 / $20,527 = 30.90%

($ millions) Johnson & Johnson (JNJ)

PM $12,949 + $435 x(1-.35) / $63,747 = 20.76%

GPM ($63,747 - $18,511) / $63,747 = 70.96%

R&D ETS $7,758 / $63,747 = 12.17%

SG&A ETS $21,490 / $63,747 = 33.71%

($ millions) Merck (MRK)

PM $7,808.4 + $251.3 x(1-.35) / $23,850.3 = 33.42%

GPM ($23,850.3 - $5,582.5) / $23,850.3 = 76.59%

R&D ETS $4,805.3 / $23,850.3 = 20.15%

SG&A ETS $7,377.0 / $23,850.3 = 30.93%

($ millions) Pfizer (PFE)

PM $8,104 + $782 x(1-.35) / $48,296 = 17.83%

GPM ($48,296 - $8,112) / $48,296 = 83.20%

R&D ETS $7,945 / $48,296 = 16.45%

SG&A ETS $14,537 / $48,296 = 30.10%




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P5-47 (45 minutes)

a, b, c. ROA PM AT GPM ART INVT PPET

BBY 8.15% 2.59% 3.15 24.43% 37.23 7.19 12.04

KR 6.88% 2.06% 3.34 22.94% 87.86 12.07 5.92JWN 8.63% 5.67% 1.52 36.81% 4.60 5.84 4.08

SPLS 7.47% 3.57% 2.09 27.06% 17.18 7.55 10.37

WAG 8.66% 3.25% 2.66 27.81% 25.21 6.51 6.16

Nordstrom (JWN) has the highest PM (5.67%) and the highest GPM (36.81%). Italso has the lowest AT (1.52), ART (4.60), INVT (5.84) and PPET (4.08). JWNclearly achieves its ROA by emphasizing high profit margin. Kroger (KR) is at theopposite extreme from Nordstrom, emphasizing efficient asset management.Kroger has the highest AT and INVT. Inventory management is critical for a retail

grocer. It also has very few receivables, so its ART is very high (87.86 times).

Retail companies lease much of their store space. As a result, the PPET ratiodepends on how these store leases are reported in the balance sheet. Leaseaccounting is discussed in Chapter 10.

Calculations follow for each firm ($ millions):

Best Buy (BBY)

EBI $1,103 + $94 x (1-.35) = $1,164.1

ROA $1,164.1 / $14,292 = 8.15%

PM $1,164.1 / $45,015 = 2.59%

AT $45,015 / $14,292 = 3.15

ART $45,015 / $1,209 = 37.23

INVT $34,017 / $4,731 = 7.19

PPET $45,015 / $3,740 = 12.04

GPM ($45,015 - $34,017) / $45,015 = 24.43%

Kroger (KR)

EBI $1,249 + $485 x (1-.35) = $1,564.25

ROA $1,564.25 / $22,752 = 6.88%PM $1,564.25 / $76,000 = 2.06%

AT $76,000 / $22,752 = 3.34

ART $76,000 / $865 = 87.86

INVT $58,564 / $4,854 = 12.07

PPET $76,000 / $12,830 = 5.92

GPM ($76,000 - $58,564) / $76,000 = 22.94%




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Nordstrom (JWN)

EBI $401 + $131 x (1-.35) = $486.15

ROA $486.15 / $5,631 = 8.63%

PM $486.15 / $8,573 = 5.67%

AT $8,573 / $5,631 = 1.52

ART $8,573 / $1,865 = 4.60

INVT $5,417 / $928 = 5.84

PPET $8,573 / $2,102 = 4.08

GPM ($8,573 - $5,417) / $8,573 = 36.81%

Staples (SPLS)

EBI $805 + $28 x (1-.35) = $823.2

ROA $823.2 / $11,021 = 7.47%

PM $823.2 / $23,084 = 3.57%

AT $23,084 / $11,021 = 2.09

ART $23,084 / $1,344 = 17.18

INVT $16,837 / $2,229 = 7.55

PPET $23,084 / $2,226 = 10.37

GPM ($23,084 - $16,837) / $23,084 = 27.06%

Walgreen (WAG)EBI $2,006 + $83 x (1-.35) = $2,059.95

ROA $2,059.95/ $23,776 = 8.66%

PM $2,059.95 / $63,335 = 3.25%

AT $63,335 / $23,776 = 2.66

ART $63,335 / $2,512 = 25.21

INVT $45,722 / $7,019 = 6.51

PPET $63,335 / $10,289 = 6.16

GPM ($63,335 - $45,722) / $63,335 = 27.81%




34/37

CASES

C5-48 (30 minutes)

a. Raising prices and/or reducing manufacturing costs are not necessarilyindependent solutions, and are likely related to other factors. The effect of aprice increase on gross profit is a function of the demand curve for thecompanys product. If the demand curve is relatively elastic, a price increasewill likely significantly reduce demand, thereby decreasing, rather thanincreasing, gross profit (an example is a 10% increase in price and a 20%decrease in demand). A price increase will have a more desired effect if thedemand curve is relatively inelastic (a 10% price increase with a 3% decreasein demand).

Cutting manufacturing costs will positively affect gross profit (via reduction ofCOGS) if the more inexpensively made product is not perceived to be of lesser

quality, thereby reducing demand.

b. Raising prices is difficult in competitive markets. As the number of productsubstitutes increases, companies are less able to raise prices. Rather, theymust be able to effectively differentiate their products in some manner in orderto reduce consumers substitution. This can be accomplished, for example, byproduct design and/or advertising. These efforts, however, likely entailadditional cost, and, while gross profit might be increased as a result, SG&Aexpense may also increase with little effect on the bottom line.

Manufacturing costs consist of raw materials, labor and overhead. Each canbe targeted for cost reduction. A reduction of raw materials costs generally

implies some reduction in product quality, but not necessarily. It might be thecase that the product contains features that are not in demand by consumers.Eliminating those features will reduce product costs with little effect on sellingprice.

Similarly, companies can utilize less expensive sources of labor (off-shoreproduction, for example), that can significantly reduce product costs andincrease gross profit provided that product quality is maintained.

Finally, manufacturing overhead can be reduced by more efficient production.Wages and depreciation expense are two significant components ofmanufacturing overhead. These are largely fixed costs, and the per-unit

product cost can often be reduced by increasing capacity utilization ofmanufacturing facilities (provided, of course, that the increased inventoryproduced can be sold).

The bottom line is that increasing gross profit is a difficult process than canonly be accomplished by effective management and innovation.




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C5-49 (30 minutes)

a. Working capital management is an important component of the management ofa company. By reducing the level of working capital, companies reduce thecosts of carrying excess assets. This can have a significantly positive effecton financial performance. Some common approaches to reducing working

capital via reductions in receivables and inventories, and increases inpayables, include the following: Reduce receivables

Constricting the payment terms on product sales Better credit policies that limit credit to high-risk customers

Better reporting to identify delinquencies Automated notices to delinquent accounts Increased collection efforts Prepayment of orders or billing as milestones are reached Use of electronic (ACH) payment

Use of third-party guarantors, including bank letters of credit

Reduce inventories

Reduce inventory costs via less costly components (of equalquality), produce with lower wage rates, eliminate product features(costs) not valued by customers

Outsource production to reduce product cost and/orinventories the company must carry on its balance sheet

Reduce raw materials inventories via just-in-time deliveries

Eliminate bottlenecks in manufacturing to reduce work-in-process inventories

Reduce finished goods inventories by producing to orderrather than producing to estimated demand

Increase payables

Extend the time for payment of low or no-cost payablessolong as the relationship with suppliers is not harmed)

b. The terms of payment that a company offers to its customers is amarketing tool, similar to product price and advertising programs. Manycompanies promote payment terms separately from other promotions (nopayment for six months or interest-free financing, for example). As companiesrestrict credit terms, the level of receivables will likely decrease, therebyreducing working capital. The restriction of credit terms may also have theundesirable effect of reducing demand for the companys products. The costof credit terms must be weighed against the benefits, and credit terms must bemanaged with care so as to optimize costs rather than minimize them. Creditpolicy is as much art as it is science.




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C5-49continued

Likewise, the depth and breadth of the inventories that companies carryimpact customer perception. At the extreme, inventory stock-outs result in notonly the loss of current sales, but also the potential loss of future sales ascustomers are introduced to competitors and may develop an impression of

the company as thinly stocked. Inventories are costly to maintain, as theymust be financed, insured, stocked, moved, and so forth. Reduction ininventory levels can reduce these costs. On the other hand, the amount andtype of inventories carried is a marketing decision and must be managed withcare so as to optimize the level inventories, not necessarily to minimize them.

One companys account payable is anothers account receivable. So, just asone company seeks to extend the time of payment, so as to reduce its workingcapital, so does the other company seek to reduce the average collectionperiod so as to accomplish the same objective. Capable, dependable suppliersare a valuable resource for the company, and the supplier relation must behandled with care. All companies take as long to pay their accounts payableas the supplier allows in its credit terms. Extending the payment terms beyondthat point begins to negatively impact the supplier relation, ultimatelyresulting in the loss of the supplier. The supplier relation must be managedwith care so as to optimize the terms of payment, rather than necessarily tominimize them.




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C5-50 (30 minutes)

a. The list of parties that are affected by schemes to manage earnings is oftenmuch broader than first thought. It includes the following affected parties:1. employees above and below the level at which the scheme is implemented2. stockholders and elected members of the board of directors

3. creditors of the company (suppliers and lenders) and their employees,stockholders, and boards of directors

4. competitors of the company5. the companys independent auditors6. regulators and taxing authorities

b. Managers often believe that earnings management activities will be short-lived, and will be curtailed once its operations turn around. Often, this doesnot prove to be the case. Interviews with managers and employees who haveengaged in these activities often reveal that they started rather innocuously(just managing earnings to make the numbers in one quarter), but, quickly,

earnings management became a slippery slope. Ultimately, the parties thecompany was trying to protect (shareholders, for example) are hurt more thanthey would have been had the company reported its results correctly,exposing problems early so that corrective action could be taken (possibly byremoving managers) to protect the broader stakeholders in the company.

c. Company managers are just ordinary people. They desire to improve theircompensation, which is often linked to financial performance. Managers mayact to maximize their current compensation at the expense of long-termgrowth in shareholder value. The reduction in the average employment periodat all levels of the company has exacerbated the problem.

d. Unfortunately, the separation of ownership and control often leads to lessinformed shareholders who are unable to effectively monitor the actions of themanagers they have hired. To the extent that compensation programs arelinked to financial measures, managers can use the flexibility given to themunder GAAP to their benefit, even without violating GAAP per se. Theseactions can only be uncovered by effective auditing and enforced by aneffective audit committee of the board. Corporate governance has grownconsiderably in importance following the accounting scandals of the early2000s. The Sarbanes-Oxley Act mandates new levels of corporate governance.The stock market and the courts are helping to enforce this mandate.

dmp3e ch05 solutions 02.28.10 final

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