Module 3 Answers to End of Module Questions

Module 3

Profitability Analysis and Interpretation

DISCUSSION QUESTIONS

Q3-1. Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet.

Q3-2.A Increasing leverage increases ROE as long as the assets earn a greater operating return than the cost of the additional debt. 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 their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt.

Q3-3. Gross profit margins can decline because 1) the industry has become more competitive, and/or the firm’s products have lost their competitive advantage so that the company has reduced selling prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-margin/slowly turning products to lower-margin/higher turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed as negatively.

©Cambridge Business Publishers, 2013Solutions Manual, Module 3 3-1

Q3-4. Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D often create long-term economic benefits.

Q3-5. Asset turnover measures the amount of revenue compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Because turnover is one of the components of ROE (via RNOA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.

Q3-6. ROE>RNOA implies a positive return on nonoperating activities. This results from borrowed funds being invested in operating assets whose return (RNOA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.

Q3-7.A Once a business segment has been sold or designated for sale, it is classified as a discontinued operation. Consequently, sales and expenses related to the business segment are reported separately, Thus, the income statement reports income from continuing operations, discontinued operations, and net income (which includes both continuing and discontinued operations). On the balance sheet, the business segment’s assets and liabilities are similarly segregated. Because the business segment was or will be sold, it no longer contributes to the operating activities of the company. One of the primary uses of financial information is to project future financial results so that investors and others can properly price the company’s securities and evaluate strategic plans. The discontinued operations will not affect future results (other than via investment of the proceeds from the sale), and, therefore, should not be considered as a component of operating activities.

©Cambridge Business Publishers, 2013Financial Statement Analysis & Valuation, 3rd Edition3-2

Q3-8. The interest tax shield arises because interest expense is deductible for tax purposes. Thus, interest expense “shields” income from taxes by reducing taxable income. The after-tax cost of interest is, therefore, the pretax cost multiplied by 1 minus the appropriate tax rate (typically the sum of the federal and state tax rates).

Q3-9. The “net” in net operating assets, means operating assets “net” of operating liabilities. This netting recognizes that a portion of the costs of operating assets is funded by third parties. For example, payables and accrued expenses help fund inventories, wages, utilities, and other operating costs. Similarly, long-term operating liabilities also help fund the cost of long-term operating assets. Thus, these long-term operating liabilities are deducted from long-term operating assets.

Q3-10. Companies must manage both the income statement and the balance sheet in order to maximize RNOA. This is important, as too often managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of RNOA into its profit and turnover components focuses analysis on both of these areas.

Q3-11. There are an infinite number of possible combinations of profit margin and asset turnover that will yield a given level of RNOA. The relative weighting of profit margin and asset turnover is driven in large part by the company’s business model. As a result, since companies in an industry tend to adopt similar business models, industries will generally trend toward points along the margin/turnover continuum.

Q3-12. Liquidity refers to cash: how much cash a company has, how much cash is coming in the door, and how much cash can be raised quickly. Companies must generate cash in order to pay their debts, pay their employees, and provide their shareholders a return on investment. Cash is, therefore, critical to a company’s survival.


Q3-13. Ratio analysis uses the balance sheet, income statement and statement of cash flows. It is, therefore, dependent on the quality of those statements. Differences in the application of GAAP across companies or within the same company across time can affect the reliability of the analysis. Limitations of GAAP itself (e.g., immediate expensing of R&D, non-recognition of assets that cannot be reliably measured) and differences in the makeup of the company (e.g., types of products or industries in which the company competes) can also affect the usefulness of ratio analysis.

Q3-14.A Net nonoperating obligations (NNO) consist of the excess of (interest-bearing) debt over investments in nonoperating assets. Net nonoperating obligations can be either positive (excess of debt) or negative (excess of investments). Net nonoperating expense (NNE) is the excess of NOPAT over net income. Net nonoperating expense can also be positive (nonoperating expenses exceed nonoperating income) or negative. If a company reports noncontrolling interest, we adjust NNO by adding the noncontrolling interest reported on the balance sheet, and we adjust NNE by adding the noncontrolling interest reported on the income statement.


MINI EXERCISES

M3-15 (15 minutes)

($ millions) NOA 2008 = $40,125 - $545 - ($10,122 - $1,042) - $2,135 - 272 = $28,093

Note: In the absence of information about “other” current and long-term assets and liabilities, we assume that these “other” assets and liabilities are operating in nature.

M3-16 (15 minutes)

($ millions) Target’s net operating profit before tax = $67,997 - $44,693 - $15,849 - $1,616 = $5,839.

Note: We treat net credit card revenues, and the related credit card expense, as operating because Target maintains its own proprietary credit card to support in-store sales. The assumption, then, is that the credit card operations are an integral part of its operating activities. Given this treatment, the accounts receivable relating to these credit cards is also included as an operating current asset in M3-15.

NOPAT = $5,839 – [$1,935 + ($566 × 0.37)] = $3,695.

M3-17 (20 minutes)

($ millions) a. RNOA = NOPAT / Average net operating assets (NOA)

= $693 / [($3,296 + $3,390)/2] = 20.73%

b. NOPM = NOPAT / Revenues = $693 / $9,700 = 7.14%

NOAT = Sales / Average NOA= $9,700 / [($3,296 + $3,390)/2] = 2.90

RNOA = NOPM × NOAT = 7.14% × 2.90 = 20.71% (0.02% rounding difference)


M3-18 (15 minutes)

($ millions) NOA = $33,699 - $652 - $471 - $1,008 - ($7,119 - $36) - $467 - $631 - $833 = $22,554

M3-19 (15 minutes)

($ millions) NOPAT = ($48,815 - $31,663 - $12,006 - $1,586) - [$1,218 + ($332 × 0.37)] = $2,219

M3-20B(20 minutes)

($ millions) a. ROE = Net income / Average equity

= $847 / [($5,530 + $4,653)/2]= 16.64%

b. PM = Net income / Sales = $847 / $25,003 = 3.39%

AT = Sales / Average assets = $25,003 / [($20,631 + $21,300)/2]= 1.19

FL = Average assets / Average equity = [($20,631 + $21,300)/2] / [($5,530 + $4,653)/2]= 4.12

ROA PM × AT × FL = 3.39% × 1.19 × 4.12 = 16.62% (0.02% rounding difference)


M3-21 (15 minutes)

($ millions) a. ANF RNOA = $152 / [($1,032 + $1,055) / 2] = 14.57%

TJX RNOA = $1,364 / [($2,072 + $1,937) / 2] = 68.05%

b. ANF NOPM = $ 152 / $ 3,469 = 4.38%TJX NOPM = $1,364 / $21,942 = 6.22%

ANF NOAT = $ 3,469 / [($1,032 + $1,055) / 2] = 3.32TJX NOAT = $21,942 / [($2,072 + $1,937) / 2] = 10.95

ANF RNOA = 4.38% × 3.32 = 14.54% (0.03% rounding difference)TJX RNOA = 6.22% × 10.95 = 68.11% (0.06% rounding difference)

c. TJX’s RNOA is 4.7 times that of ANF. TJX, despite operating in the value-priced segment of its industry, reports a higher NOPM than does ANF. As is typical of value-priced retailers, TJX’s asset turnover is high: NOAT is over 3 times that of ANF’s. On balance, TJX’s business model appears to be more successful in 2011 in that the company is able to maintain both a high NOPM and a high NOAT relative to ANF, resulting in a RNOA that is considerably greater than ANF’s in this year.


M3-22 (15 minutes)

($ millions)

a. 2010 total liabilities-to-equity = $133,093 / $86,912 = 1.532009 total liabilities-to-equity = $142,764 / $84,143 = 1.70

Verizon’s total liabilities-to-equity ratio has declined somewhat, and is less than the 1.67 average for companies in the telecommunications industry in 2010.

b. Verizon is carrying a significant amount of debt. Although its profitability and operating cash flow are fairly strong, neither is particularly high in relation to the company’s liabilities and interest costs. There is some question, therefore, regarding the amount of additional debt that the company can take on. Given its 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 may negatively impact Verizon’s competitive position.


M3-23 (30 minutes)

a. Home Depot 2011 NOPAT = $5,839 - [$1,935 + ($566 × 0.37)] = $3,695Lowe’s 2011 NOPAT = $3,560 - [$1,218 + ($332 × 0.37)] = $2,219

b. Home Depot NOPAT as a percentage of sales = $3,695 / $67,997 = 5.43%Lowe’s NOPAT as a percentage of sales = $2,219 / $48,815 = 4.55%

M3-24B (35 minutes)

a. Profit margin (Net income / Sales) $4,085 / $26,662 = 15.32%

Asset turnover (Sales / Average assets) ($26,662 / [$30,156 + $27,250]/2) = 0.93

Financial leverage (Average assets / Average equity)

(($30,156 + $27,250)/2) / (($15,663 + $12,764)/2)

= 2.02

b.ROE (Net income / Average equity) $4,085 / (($15,663 + $12,764)/2) =

28.74%

Confirmation 15.32% × 0.93 × 2.02 = 28.78% (0.04% rounding difference)

c. Adjustments to ROA typically focus on the numerator (specifically, adding after-tax interest expense to net income). For 3M, this adjustment follows:

Adjusted ROA = ($4,085 + $163 × [1 - 0.37]) / ($30,156 + $27,250)/2 = 14.59%


EXERCISES

E3-25 (30 minutes)

a. ($ millions) RNOA

CVS.................................................$3,777 / [ ($46,360 + $45,889) / 2] = 8.19%

Walgreen........................................$2,145 / [($14,921+$14,140)/ 2] = 14.76%

b.

($ millions) NOPM = NOPAT / Sales NOAT = Sales / Average NOA

CVS................................$3,777 / $96,413 = 3.92% $96,413 / [($46,360 + $45,889) / 2]= 2.09

Walgreen.......................$2,145 / $67,420 = 3.18% $67,420 / [($14,921 + $14,140) / 2]= 4.64

c. Walgreen’s RNOA is much higher than CVS’s, driven primarily by a much higher turnover rate for NOA as its net operating profit margin is less than CVS’s. This example highlights the importance of managing the balance sheet.


E3-26 (30 minutes)

a.($ millions) RNOA

Abercrombie & Fitch.....................$ 152 / [($1,032 + $1,055) / 2] = 14.57%

The Gap, Inc...................................$1,195 / [($2,419 + $2,318) / 2] = 50.45%

b.($ millions) NOPM = NOPAT / Sales NOAT= Sales / Average NOA

Abercrombie & Fitch...........................

$ 152 / $ 3,469 = 4.38%

$ 3,469 / [($1,032 + $1,055) / 2]= 3.32

The Gap, Inc..................$1,195 / $14,664 = 8.15%

$14,664 / [($2,419 + $2,318) / 2]= 6.19

c. The GAP’s RNOA is more than three times that of A&F. This higher RNOA is the result of a much higher net operating profit margin and a much higher net operating asset turnover rate in comparison with Abercrombie & Fitch in this year.


E3-27 (30 minutes)


Nordstrom...................................$693 / [($3,296 + $3,390) / 2] = 20.73%

Limited Brands...........................$826 / [($2,854 + $3,103) / 2] = 27.73%

b.($ millions) NOPM = NOPAT / Sales NOAT = Sales / Average NOA

Nordstrom.....................$693/$9,700 = 7.14%

$9,700/[($3,296 + $3,390)/2]= 2.90

Limited Brands...........................

$826/$9,613 = 8.59%

$9,613/[($2,854 + $3,103)/2]= 3.23

c. The Limited Brands’ higher RNOA is driven by both a higher net operating profit margin and a higher turnover of net operating assets.


E3-28 (30 minutes)

Instructor note: Intel has ROE<RNOA due to its substantial investment in marketable securities.

a.($ millions)

ROE..........................................$11,464 / [($49,430+$41,704) / 2] = 25.16%

RNOA.......................................$11,250 / [($28,652 + $29,232) / 2] = 38.87%


Intel.............. $11,250 / $43,623 = 25.79%

$43,623 / [($28,652 + $29,232)/2] = 1.51

The NOPM of 25.79% means that Intel earns operating profit after all expenses, including tax of more than 26¢ for every dollar of sales. This is a significant profit margin. The NOAT of 1.51 implies that the company generates more than $1.50 of sales for each dollar of net operating assets. The company is both profitable and productive.

c. RNOA is 1.5× ROE: 38.87% / 25.16% = 1.5. We can infer Intel’s nonoperating return by calculating the difference between ROE and RNOA: 25.16% - 38.87% = -13.71%. A negative nonoperating return likely occurs because Intel has a substantial amount of investments, perhaps in marketable securities. This is not uncommon for the high-tech industry where companies need to maintain a greater level of liquid assets to take advantage of opportunities or to respond quickly to strategic moves by competitors. This liquidity requirement adds a layer of costs that depresses Intel’s ROE. Another way of thinking of it is that the marketable securities are earning a return that’s low compared to the return on the company’s operating assets.


E3-29 (30 minutes)

a.($ millions)

ROE.......................................... $ 847 / [($5,530 + $4,653) / 2] = 16.64%

RNOA....................................... $1,209/ [($11,491+$11,665)/ 2] = 10.44%


Macy’s......... $1,209 / $25,003 = 4.84%

$25,003/ [($11,491+$11,665)/2] = 2.16

Macy’s NOPM is higher and its NOAT is lower than the medians for apparel retailers of 4.46% and 2.81, respectively (see exhibit 4.4). Its RNOA is below the median for apparel retailers of 12.33%.

c. The ratio of RNOA to ROE is 63% (10.44%/16.64%). Macy’s debt is financing assets that earn a return in excess of the cost of debt, thus improving the returns to shareholders. In this case, financial leverage is increasing the return to shareholders. We can compute the nonoperating return as follows: ROE – RNOA = 16.64% - 10.44% = 6.20%.


E3-30 (30 minutes)

Instructor note: Cisco has ROE<RNOA due to its substantial investment in marketable securities.

a.($ millions)

ROE..........................................$7,767 / [($44,267 + $38,647) / 2] = 18.74%

RNOA.......................................$7,609 / [($19,708 + $13,971) / 2] = 45.19%


Cisco............ $7,609 / $40,040 = 19.00%

$40,040/[($19,708 + $13,971)/2] = 2.38

c. The ratio of RNOA to ROE is 2.4x (45.19% / 18.74%). A ratio greater than 1.0 means that RNOA exceeds ROE. This is atypical. One explanation for this relation is that Cisco is holding significant nonoperating investments likely in marketable securities. This is not uncommon for the high-tech industry in which companies need to maintain liquidity to take advantage of opportunities or to respond quickly to strategic moves by competitors. This liquidity, which only earns a market rate of return, must be funded by high-cost equity capital. This depresses its ROE.


E3-31 (30 minutes)

a.($ millions) Liabilities-to-equity

2010.............. $74,100 / $44,434 = 1.67

2009.............. $69,922 / $42,811 = 1.63

Comcast’s total liabilities-to-stockholders’ equity ratio of 1.67 is at median for communications companies (see Exhibit 3.6), and has remained fairly constant over the two-year period.

b. Comcast has an acceptable level of debt, but its liquidity is low. That is some cause for concern about the company’s ability to increase its debt load. This is especially troublesome given the substantial levels of capital expenditures that will be required to upgrade its infrastructure in order to remain competitive with Verizon.


E3-32 (30 minutes)

a. ($ millions) Liabilities-to-equity

2010.............. $133,093 / $86,912 = 1.53

2009.............. $142,764 / $84,143 = 1.70

Verizon’s liabilities-to-equity ratio has declined from 2009 as Verizon has used available cash flows to reduce the level of debt relative to equity. The 2010 ratio is 1.53, slightly below the median for communications companies of 1.66 (see Exhibit 3.6).

b. Verizon has an acceptable level of debt relative to equity, which mitigates any concern about its financial leverage. Given the substantial levels of capital expenditures that will be required to upgrade its infrastructure to remain competitive with Comcast, however, it is doubtful whether Verizon will be able to markedly increase its debt. This could be problematic for the firm.


E3-33 (30 minutes)

a. ($ millions) Liabilities-to-equity

Industrial.............. $95,729 / $123,034 = 0.78

Financial.............. $538,530 / $70,148 = 7.68

Total..................... $627,018 / $124,198 = 5.05

b. GE’s liabilities-to-equity ratio of 5.05 is relatively high. Most of the debt, however, is concentrated in the financial services segment. This segment has the profile of a typical financial institution, with high debt levels and relatively low operating margins. As long as GE’s loans and leases are of good quality (that is, they are collectible), the financial subsidiary should have no problem meeting its debt requirements as the cash flows received from its loans/leases are typically well matched with the debt payment requirements.

c. Consolidated financial statements combine the performance and financial position of the parent company and all of its subsidiaries. As such, they are a blend of financial statements from a variety of “companies.” Segment analysis is often useful to evaluate the financial structure of each segment against its respective business model. In this case, the relatively high debt level for GE as a whole is a weighted average of the less-financially-leveraged manufacturing subsidiary with the highly-leveraged financial services subsidiary.


E3-34A (30 minutes)

a. To calculate FLEV we must first calculate NNO. Recall that NNO is the difference between NOA and Stockholders’ equity. Then to calculate Spread, we require NNEP (NNE / Average NNO). Recall that NNE is the difference between NOPAT and Net income attributable to the Walmart stockholders.

NNO 2011 = $114,040 - $68,542 = $45,498

NNO 2010 = $106,320 - $70,468 = $35,852

FLEV = Average NNO / Average Stockholders’ equity= [($45,498 + $35,852) / 2] / [($68,542 + $70,468) / 2] = 0.585

NNE = $17,222 - $16,389 = $833

NNEP = $833 / [($45,498 + $35,852) / 2] = 2.048%

Spread = 15.63% - 2.048% = 13.582%

b. ROE = 15.63% + (0.585 × 13.582%) = 23.575%

The ROE calculated with FLEV and SPREAD is 23.575% and the ROE from the mid-module review is 23.58%. The difference of 0.005% (0.00005) is a rounding difference.

E3-35 (20 minutes)

The Federal and State tax rate for 2011 as reported in TJX’s tax footnote is 39.1% (35% + 4.1%). Using this Federal and State tax rate, TJX’s NOPAT is computed as follows (amounts in $thousands):

TJX 2011 NOPAT = ($21,942,193 - $16,040,461 - $3,710,053 + $11,550) – ($824,562 + 0.391 × $39,137) = $1,363,364


PROBLEMS

P3-36 (45 minutes)

($ millions) a. 2010 NOPAT = $5,918 - [$1,592 + ($163 × 0.37)] = $4,266

b. 2010 NOA = ($30,156 - $3,377 - $1,101- $540 - $146) - ($6,089 - $1,269) - $2,013 - $1,854 = $16,305

2009 NOA= ($27,250 - $3,040 - $744 - $825 - $103) - ($4,897 - $613) - $2,227 - $1,727 = $14,300

c. 2010 RNOA = $4,266 / [($16,305 + $14,300) / 2] = 27.88%

2010 NOPM = $4,266 / $26,662 = 16.00%2010 NOAT = $26,662 / [($16,305 + $14,300) / 2] = 1.742010 RNOA = 16.00% × 1.74 = 27.84% (0.0004 rounding error)

d. 2010 NNO = ($1,269 + $4,183) - ($3,377 + $1,101+ $540 + $146) + $354= $642

Confirm:2010 NOA = NNO + SE (3M shareholders) $16,305 = $642 + $15,663

2009 NNO = ($613 + $5,097 + $538) - ($3,040 + $744 + $825 + $103)= $1,536

Confirm:2009 NOA = NNO + SE (3M shareholders)$14,300 = $1,536 + $12,764

e. 2010 ROE = $4,085 / [($15,663 + $12,764) / 2] = 28.74%

f. 2010 nonoperating return = ROE – RNOA = 28.74% - 27.88% = 0.86%

g. ROE>RNOA implies that 3M is able to borrow money to fund operating assets that yield a return greater than the cost of the debt. The excess accrues to the benefit of 3M’s stockholders.


P3-37 (30 minutes)

a. 2010 total liabilities-to-equity = $14,139 / $16,017 = 0.882009 total liabilities-to-equity = $13,948 / $13,302 = 1.05

3M’s total liabilities-to-equity decreased during 2010 and is well below the median for publicly traded companies. This ratio indicate modest financial leverage.

b. 3M is fairly liquid (current ratio near 2 and quick ratio greater than 1) and is not highly financially leveraged. The company’s ability to meet its debt requirements is not at issue.

P3-38A (40 minutes)

a. 2010 NNO = NOA – 3M shareholders stockholders’ equity = $16,305 - $15,663= $642

2009 NNO = $14,300 - $12,764= $1,536

2010 FLEV = [($642 + $1,536) / 2] / [($15,663 + $12,764) / 2] = 0.08

2010 NNE = NOPAT – Net income attributable to 3M shareholders = $4,266 - $4,085 = $181

NNEP = $181 / ([$642 + $1,536] / 2) = 16.62%

Spread = RNOA - NNEP = 27.88% - 16.62% = 11.26%


P3-38A (concluded)

b. ROE = 27.88% + (0.08 × 11.26%) = 28.78% (.0004 rounding error)

c. 3M is able to borrow funds and invest the proceeds in operating assets yielding a return in excess of the cost of its debt. The excess (“spread”) accrues to 3M’s stockholders.

P3-39 (45 minutes)

($ millions) a. 2011 NOPAT = ($2,114 + $2) - [$714 + ($87 - $51) × 0.37)] = $1,389

b. 2011 NOA = $17,849 - $1,103 - $22 - ($8,663 - $557 - $441) - $1,183 = $7,876

2010 NOA = $18,302 - $1,826 - $90 - ($8,978 - $663 - $35) - $1,256 = $6,850

c. 2011 RNOA = $1,389 / [($7,876 + $6,850) / 2] = 18.86%

2011 NOPM = $1,389 / $50,272 = 2.76%2011 NOAT = $50,272 / [($7,876 + $6,850) / 2] = 6.832011 RNOA = 2.76% × 6.83 = 18.85% (.0001 rounding error)

BBY’s RNOA of 18.86% is significantly higher than the industry median of about 11%. It is driven primarily by the very high turnover of net operating assets of 6.83, well in excess of the industry median of 3.27. BBY’s NOPM is slightly below the median of 3.32%. BBY’s high performance is driven by its exceptional management of its balance sheet.


P3-39 (concluded)

d. 2011 NNO = ($557 + $441 + $711) – ($1,103 + $22) + $690 = $1,274

Confirm:2011 NOA = NNO + BBY’s shareholders stockholders’ equity $7,876 = $1,274 + $6,602

2010 NNO = ($663 + $35 + $1,104) – ($1,826 + $90) + $644 = $530

Confirm:2010 NOA = NNO + BBY’s shareholders stockholders’ equity $6,850 = $530 + $6,320

e. 2011 ROE = $1,277 / [($6,602 + $6,320) / 2] = 19.76%


g. ROE > RNOA implies that Best Buy is able to borrow money to fund operating assets that yield a return greater than the cost of its debt. The excess accrues to the benefit of BBY’s stockholders.

P3-40 (30 minutes)

a. 2011 liabilities-to-equity = ($8,663 + $1,183 + $711) / $7,292 = 1.452010 liabilities-to-equity = ($8,978 + $1,256 + $1,104) / $6,964

= 1.63

(Note: We computed this ratio using total (consolidated) stockholders’ equity, not just the equity of BBY’s shareholders because the liabilities in the numerator include total consolidated liabilities.)

Best Buy’s liabilities-to-equity ratio is at the median for publicly-traded companies. We have no concerns about Best Buy’s ability to meet its debt obligations.

b. Best Buy is not particularly liquid (current ratio near 1.2 and quick ratio near 0.4), but is not financially leveraged. The company generates sizeable operating profits and cash flow. In sum, no solvency concerns are evident for Best Buy.


P3-41A (40 minutes)

a. 2011 NNO = ($557 + $441 + $711) - ($1,103 + $22) + $690 = $1,2742010 NNO = ($663 + $35 + $1,104) - ($1,826 + $90) + $644 = $530

2011 FLEV = [($1,274 + $530) / 2] / ([$6,602 + $6,320] / 2) = 0.14

2011 NOPAT = ($2,114 + $2) - [$714 + ($87 - $51) × 0.37)] = $1,389

2011 NNE = NOPAT – Net income to BBY shareholders = $1,389 - $1,277 = $112

2011 NNEP = $112 / [($1,274 + $530) / 2] = 12.42%2011 Spread = RNOA – NNEP = 18.86% - 12.42% = 6.44%

b. ROE = 18.86% + (0.14 × 6.44%) = 19.76%

c. Best Buy is able to borrow funds and invest the proceeds in operating assets yielding a return in excess of the cost of its debt. The excess accrues to the benefit of its stockholders.


P3-42 (30 minutes)

(Note to instructor: Intel’s ROE<RNOA. This is an example of equity supporting the strategic investment in liquidity at some cost to ROE.)

a. 2010 NOPAT = ($15,588 + $117) - ($4,581 - 0.37 × ($109 + $231))] = $11,250

(Note: We treat gains on equity method investments of $117 as operating since the investments are treated that way in NOA. These investments are more strategic in nature. See Module 7 for a description of these investments. The other equity investments are typical investments in marketable securities and are, therefore, classified as nonoperating.)

b. 2010 NOA = ($63,186 - $5,498 - $11,294 - $5,093 - $1,008) - ($9,327 - $38) - $190 - $926 - $1,236= $28,652

2009 NOA = ($53,095 - $3,987 - $5,285 - $4,648 - $773) - ($7,591 - $172) - $193 - $555 - $1,003

= $29,232

c. 2010 RNOA = $11,250 / [($28,652 + $29,232) / 2] = 38.87%

2010 NOPM = $11,250 / $43,623 = 25.79%

2010 NOAT = $43,623 / [($28,652 + $29,232)/2] = 1.51

d. 2010 NNO = $38 + $2,077 - $5,498 - $11,294 - $5,093 - $1,008= ($20,778)

Confirm: $28,652 = $(20,778) + $49,430

2009 NNO = $172 + $2,049 - $3,987 - $5,285 - $4,648 - $773= ($12,472)

Confirm: $29,232 = $(12,472) + $41,704

e. 2010 ROE = $11,464 / [($49,430+$41,704) / 2] = 25.16%

f. 2010 nonoperating return = ROE – RNOA = 25.16% - 38.87% = (13.71%)

g. RNOA > ROE implies that Intel’s stockholders are funding a sizeable amount of liquidity in the form of investments in marketable securities. This is not uncommon for the high-tech industry where companies need to maintain a sufficient level of liquidity to take advantage of opportunities or to respond to strategic moves by competitors. This liquidity requirement adds a layer of costs that depresses its ROE.


P3-43 (45 minutes)

($ in millions) a. 2011 NOPAT = $1,118 - ($378 + ($127 × 0.37) = $693

b. 2011 NOA = $7,462 - $1,506 - $846 - $375 - $652 - $495 - $292= $3,296

2010 NOA = $6,579 - $795 - $726 - $336 - $596 - $469 - $267= $3,390

c. 2011 RNOA = $693 / [($3,296 + $3,390) / 2] = 20.73%

2011 NOPM = $693 / $9,700 = 7.14%

2011 NOAT = $9,700 / [($3,296 + $3,390) / 2] = 2.90

2011 RNOA = 7.14% × 2.90 = 20.71% (0.0002 rounding error)

Nordstrom’s net operating profit margin is significantly above the industry median of 4.46%, which is not surprising given the company’s high-end product. Nordstrom’s net operating asset turnover rate is also higher than the median of 2.81. Nordstrom is managing both its income statement and its balance sheet very well.

d. 2011 NNO = $6 + $2,775 - $1,506 = $1,275Confirm: $3,296 = $1,275 + $2,021

2010 NNO = $356 + $2,257 - $795 = $1,818Confirm: $3,390 = $1,818 + $1,572

e. 2011 ROE = $613 / [($2,021 + $1,572) / 2] = 34.12%


g. ROE>RNOA implies that Nordstrom is able to borrow money to fund operating assets that yield a return greater than the cost of its debt. The excess accrues to the benefit of Nordstrom’s stockholders.


P3-44 (30 minutes)

($ millions) a. 2010 NOPAT = $5,666 – ($1,147 + 0.37 × $2,024) = $3,770

(Note: we have treated the earnings from and gain on the sale of the discontinued operations as nonoperating. Once the decision is made to sell the operating entity, it is reclassified as nonoperating and any net assets and earnings related to that entity are classified as nonoperating.)

b. 2010 NOA = $95,289 - $2,481 - ($15,660 - $750 - $1,115) - $7,984 - $2,382 - $3,046 - $3,416 = $62,185

2009 NOA = $66,714 - $2,101 - ($11,491 - $453 - $513) - 4,508 - $1,765 - $2,816 - $2,138 = $42,861

c. 2010 RNOA = $3,770 / [($62,185 + $42,861) / 2] = 7.18%

2010 NOPM = $3,770 / $49,207 = 7.66%

2010 NOAT = $49,207 / [($62,185 + $42,861) / 2] = 0.94

2010 RNOA = 7.66% × 0.94 = 7.20% (0.0002 rounding error)

Kraft’s net operating profit margin is significantly above the industry median of 6.22%, but its net operating asset turnover rate is much lower than the median of 1.66. Overall, the low turnover of net operating assets is resulting in a RNOA that is lower than the industry median of over 9%.

d. 2010 NNO = $750 + $1,115 + $26,859 - $2,481 + $108 = $26,351Confirm: $62,185 = $26,351 + $35,834

2009 NNO = $453 + $513 + $18,024 - $2,101 + $96 = $16,985Confirm: $42,861 = $16,985 + $25,876

e. 2010 ROE = $4,114 / [($35,834 + $25,876) / 2] = 13.33%


g. ROE>RNOA implies that Kraft is able to borrow money to fund operating assets that yield a return greater than the cost of its debt. The excess accrues to the benefit of Kraft’s stockholders.


P3-45 (20 minutes)

($ in millions) a.

2010 liabilities-to-equity = $59,387 / $35,942 = 1.652006 liabilities-to-equity = $40,742 / $25,972 = 1.57

The liabilities-to-equity has increased, but this ratio remains at comfortable levels. There are no immediate concerns about Kraft’s ability to meet its debt obligations.

b. Although Kraft is not particularly liquid, it is not highly financially leveraged. There are no immediate concerns about its solvency.

P3-46A (30 minutes)

($‘s in millions) a. 2010 NNO = $750 + $1,115 + $26,859 - $2,481 + $108 = $26,351

2009 NNO = $453 + $513 + $18,024 - $2,101 + $96 = $16,985

2010 FLEV = Avg. NNO / Avg. Kraft’s Stockholders’ equity = [($26,351 + $16,985) / 2] / [($35,834 + $25,876) / 2] = 0.70

NNEP = NNE (NOPAT – Net income to Kraft shareholders) / Avg. NNO = ($3,770 - $4,114) / [($26,351 + $16,985) / 2] = (1.59)%

Spread = RNOA – NNEP = 7.18% + 1.59% = 8.77%

b. ROE = RNOA + (FLEV × Spread) = 7.18% + (0.70 × 8.77%) = 13.32% (0.0001 rounding)

c. ROE>RNOA implies that Kraft is able to borrow money to fund operating assets that yield a return greater than the cost of its debt. The excess accrues to the benefit of Kraft’s stockholders. This year, Kraft has a negative NNE because discontinued operations generated income and or a gain during 2010.


P3-47 (30 minutes)

a.

This graph is similar to the one in the module and reveals the trade-off between profit margin and asset turnover. Basic economics suggest that companies with high turnover have low margin and vice versa.

b. High performing companies are those that exhibit a higher profit margin when holding asset turnover constant, and have a higher turnover when holding profit margin constant. Thus, increasing RNOA requires managers to manage both the income statement and the balance sheet.


P3-48B (35 minutes)

a. Net profit margin (Net income / sales) $1,277 / $50,272 = 2.54%

Asset turnover (Sales / Average assets)

$50,272 / ([$17,849 + $18,302]/2) = 2.78


([$17,849 + $18,302]/2) / ([$6,602 + $6,320]/2= 2.80

b. ROE (Net income / Average equity) $1,277 / ([$6,602 + $6,320]/2 = 19.76%

Confirmation 2.54% × 2.78 × 2.80 = 19.77%(0.0001 rounding error)

c. Adjustments to ROA typically focus on the numerator (specifically, we add back after-tax interest expense to net income). For Best Buy, this adjustment follows:

Adjusted ROA = ($1,277 + [$36 × (1 - 0.37)]) / ([$17,849 + $18,302]/2)= 7.19%


P3-49B (35 minutes)

a. Net profit margin (Net income / Sales) $4,139 / $49,207 = 8.41%

Asset turnover (Sales / Average assets)

$49,207 / ([$95,289 + $66,714] / 2) = 0.607


([$95,289 + $66,714] / 2) / ([$35,834 + $25,876] / 2) = 2.625

b. ROE (Net income / Average equity) $4,139 / ([$35,834 + $25,876] / 2)

= 13.41%

Confirmation 8.41% × 0.607 × 2.625 = 13.40%(0.001 rounding error)

c. Adjustments to ROA typically focus on the numerator (specifically, adding after-tax interest expense to net income). For Kraft, adjusted ROA is: $4,139 + (1 - 0.37) × $2,024 / ([$95,289 + $66,714] / 2) = 6.68%

The unadjusted ROA is: $4,139 / ([$95,289 + $66,714] / 2) = 5.11%

The difference between the two is fairly significant (1.57%). This represents the effect of debt financing – the ROA of 5.11% reflects the interest expense on borrowed money. The adjusted ROA of 6.68% is the return on the assets holding apart the manner in which they were funded.


IFRS APPLICATIONS

I3-50 (15 minutes)


Shell $11,793 / [($169,294 + $148,070)/ 2] = 7.4%

BP $16,800 / [($138,275 + $125,834) / 2] = 12.7%


Shell $11,793/$283,164 = 4.2% $283,164/[($169,294+$148,070)/2]=1.78

BP $16,800/$243,173 = 6.9% $243,173/[($138,275+$125,834)/2]=1.84

c. BP’s RNOA of 12.7% is significantly higher than Shell’s RNOA of 7.4%, for two reasons. First, BP has a higher net operating profit margin; 64% greater than Shell’s NOPM (6.9% compared to 4.2%). Second, BP is more efficient with its net operating asset turnover, which makes the company more profitable overall.


I3-51 (15 minutes)a.

(€ thousands)

ROE €716,931 / [(€10,034,785 + €9,363,243) / 2] = 7.4%

RNOA €526,104 / [(€13,002,350 + €12,028,024) / 2] = 4.2%

b.(€thousands) NOPM = NOPAT / Sales NOAT = Sales / Average NOA

OMV Group €526,104 / €17,917,267 = 2.9%

€17,917,267 / [(€13,002,350 + €12,028,024)/2]

= 1.43

c. RNOA is 57% of ROE, calculated as follows: 4.2% / 7.4% = 0.57 (or 57%). We can infer OMV’s nonoperating return by calculating the difference between ROE and RNOA: 7.4% - 4.2% = 3.2%.

I3-52 (15 minutes)

(€ millions)a.

(€ millions) Liabilities-to-equity

2008 €13,756 / €11,051 = 1.24

2009 €13,761 / €11,888 = 1.16

Schneider Electric’s total liabilities-to-stockholders’ equity ratio is moderate to high between 1.16 and 1.24, but has decreased slightly from 2008 to 2009. To make a more informed assessment, we would like to know the ratio for firms in this industry and geographic area.

b. Schneider Electric’s debt level is not excessive. It has good liquidity and high earnings. It has a strong margin to cover its interest expenses. We would conclude that the company is liquid and solvent.


I3-53 (45 minutes)

(£ millions) a. 2010 NOPAT = £598 + (£60 – £11) × (1 – 0.359) = £629

2009 NOPAT = £460 + (£60 – £44) × (1 – 0.360) = £470

b. 2010 NOA = (£7,666 – £229 + £1,094 – £71 – £245) – (£2,152 – £213 + £1,659 – £1,027) = £5,644

2009 NOA = (£7,160 – £242 – £81 + £1,066 – £327) – (£2,024 – £1 + £1,682 – £1,049) = £4,920

c. 2010 RNOA = £629 / [(£5,644 + £4,920) / 2] = 11.9%2009 RNOA = £470 / [(£4,920 + £4,666) / 2] = 9.8%

2010 NOPM = £629 / £15,410 = 4.1%2009 NOPM = £470 / £14,528 = 3.2%

2010 NOAT = £15,410 / [(£5,644 + £4,920) / 2] = 2.92 2009 NOAT = £14,528 / [(£4,920 + £4,666) / 2] = 3.03

Morrison’s RNOA increased from 2009 to 2010. Its NOPM increased by 0.9 percentage points which increased RNOA. However, the NOAT decreased slightly from 3.03 to 2.92, which decreased RNOA. The net effect of the two was to increase RNOA.

d. 2010 NNO = (£213 + £1,027) – (£229 + £71+ £245) = £6952009 NNO = (£1 + £1,049) – (£242 + £81 + £327) = £400Confirm:2010 NOA = NNO + SE £5,644 = £695 + £4,949

2009 NOA = NNO + SE £4,920 = £400 + £4,520

e. 2010 ROE = £598 / [(£4,949 + £4,520) / 2] = 12.6%2009 ROE = £460 / [(£4,520 + £4,378) / 2] = 10.3%

f. 2010 nonoperating return = ROE – RNOA = 12.6% – 11.9% = 0.7%2009 nonoperating return = ROE – RNOA = 10.3% – 9.8% = 0.5%

g. ROE>RNOA implies that Morrison’s is able to borrow money to fund operating assets that yield a return greater than the cost of the debt. The excess accrues to the benefit of Morrison’s stockholders.


I3-54 (25 minutes)

(£ millions)

a. 2010 total liabilities-to-equity = (£1,659 + £2,152) / £4,949 = 0.772009 total liabilities-to-equity = (£1,682 + £2,024) / £4,520 = 0.82

Morrison’s total liabilities-to-equity decreased slightly.

b. Morrison’s is fairly illiquid (current ratio and quick ratio less than 1), but this may not a big concern if the company is able to turn over its inventory of foodstuffs (stocks) very quickly. The company is not highly financially leveraged. The company’s ability to meet its debt requirements is not at issue.


DISCUSSION POINTS

D3-55 (30 minutes)

a. Raising prices and/or reducing manufacturing costs are not necessarily independent solutions, and are likely related to other factors. The effect of a price increase on gross profit is a function of the demand curve for the company’s product. If the demand curve is relatively elastic, customers are sensitive to price hikes. Thus, a price increase could significantly reduce demand, thereby decreasing, rather than increasing, 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 the demand curve is relatively inelastic (an example is a 10% price increase with a 3% decrease in demand).

Cutting manufacturing costs will increase gross profit (via reduction of COGS) 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 product substitutes increases, companies are less able to raise prices. Rather, they must be able to effectively differentiate their products in some manner in order to reduce consumers’ substitution. This can be accomplished, for example, by product design and/or advertising. These efforts, however, likely entail additional cost, and, while gross profit might be increased as a result, SG&A expense may also increase with little effect on the bottom line.

Manufacturing costs consist of raw materials, labor and overhead. Each can be targeted for cost reduction. A reduction of raw materials costs generally implies some reduction in product quality, but not necessarily. It might be the case that the product contains features that are not in demand by consumers. Eliminating those features will reduce product costs with little effect on selling price.

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


D3-55 (concluded)

Finally, manufacturing overhead can be reduced by more efficient production. Wages and depreciation expense are two significant components of manufacturing overhead. These are largely fixed costs, and the per unit product cost can often be reduced by increasing capacity utilization of manufacturing facilities (provided, of course, that the increased inventory produced can be sold).

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

D3-56 (30 minutes)

a. Working capital management is an important component of the management of a company. By reducing the level of working capital, companies reduce the costs of carrying excess assets. This can have a significantly positive effect on financial performance. Common ways to decrease receivables and inventories, and increase payables, 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 equal

quality), produce with lower wage rates, eliminate product features (costs) not valued by customers

Outsource production to reduce product cost and/or inventories 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 order

rather than producing to estimated demand Increase payables

Extend the time for payment of low or no-cost payables—so long as the relationship with suppliers is not harmed


D3-56 (concluded)

b. Payment terms to customers are a marketing tool, similar to product price and advertising programs. Many companies promote payment terms separately from other promotions (no payment for six months or interest-free financing, for example). As companies restrict credit terms, the level of receivables will likely decrease, thereby reducing working capital. The restriction of credit terms may also have the undesirable effect of reducing demand for the company’s products. The cost of credit terms must be weighed against the benefits, and credit terms must be managed with care so as to optimize costs rather than minimize them. Credit policy is as much art as it is science.

Likewise, the depth and breadth of the inventories that companies carry impact customer perception. At the extreme, inventory stock-outs result in not only the loss of current sales, but also the potential loss of future sales as customers are introduced to competitors and may develop an impression of the company as “thinly stocked.” Inventories are costly to maintain, as they must be financed, insured, stocked, moved, and so forth. Reduction in inventory levels can reduce these costs. On the other hand, the amount and type of inventories carried is a marketing decision and must be managed with care so as to optimize the level inventories, not necessarily to minimize them.

One company’s account payable is another’s account receivable. So, just as one company seeks to extend the time of payment to reduce its working capital, so does the other company seek to reduce the average collection period to accomplish the same objective. Capable, dependable suppliers are a valuable resource for the company, and the supplier relation must be handled with care. All companies take as long to pay their accounts payable as the supplier allows in its credit terms. Extending the payment terms beyond that point begins to negatively impact the supplier relation, ultimately resulting in the loss of the supplier. The supplier relation must be managed with care so as to optimize the terms of payment, rather than necessarily to minimize them.


D3-57 (30 minutes)

a. The parties affected by schemes to manage earnings is often much 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 directors3. creditors of the company (suppliers and lenders) and their

employees, stockholders, and board of directors4. competitors of the company5. the company’s 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 does not prove to be the case. Interviews with managers and employees who have engaged in this activity 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 the company was trying to protect (shareholders, for example) are hurt more than they would have been had the company reported its results correctly, exposing problems early so that corrective action could be taken (possibly by removing managers) to protect the broader stakeholders in the company.

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

d. Unfortunately, the separation of ownership and control often leads to less informed shareholders who are unable to effectively monitor the actions of the managers they have hired. To the extent that compensation programs are linked to financial measures, managers can use the flexibility given to them under GAAP to their benefit, even without violating GAAP per se. These actions can only be uncovered by effective auditing and enforced by an effective audit committee of the board. Corporate governance has grown considerably in importance following the accounting scandals of the early 2000s. The Sarbanes-Oxley Act mandates new levels of corporate governance. The stock market and the courts are helping to enforce this mandate.


Documents

Module 3 Answers to End of Module Questions