(Test Bank) Valuation Using Financial Statements

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Test Bank

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© Cambridge Business Publishers, 2021 Test Bank, Chapter 1 1-1 Chapter 1 The Link between Valuation and Financial Statement Analysis QUESTIONS 1. Explain whether valuation concepts, tools, and techniques are applicable beyond the valuation of publicly traded firms. The fundamental elements of valuation (i.e., understanding the business, identifying and evaluating the drivers of value creation, forecasting future payoffs culminating in a valuation) are applicable to a variety of settings, including valuation of privately held firms, merger transactions, project analysis, and implementation of accounting standards involving fair value estimates. 2. What is the role of financial accounting with respect to valuation? Financial accounting provides information about the amount, timing, and uncertainty of future payoffs; the essential elements required for valuation. 3. What are the advantages of using accounting-based valuation models over cash flow valuation models? People typically forecast earnings, not cash flows. The earnings forecast is converted to a cash flow forecasts. Accounting based valuation models avoid the additional step of converting the earnings to cash flows. Additionally, firms with negative free cash flows are not problematic with earnings-based forecasts. 4. What is the benefit of valuing the enterprise operations relative to valuing the firm’s equity? By valuing the enterprise operations, the analyst does not need to forecast the firm’s future leverage (i.e., the portion of debt to equity). This approach allows a cleaner analysis with fewer assumptions. 5. Explain why the financial statements need to be reformulated when conducting a valuation. Operating activities are primarily how companies create value. By reformulating the financial statements between operating and financing activities, there is greater visibility of the value creation drivers for the organization. This allows for better historical analysis as well as forecasting future payoffs within the valuation. © Cambridge Business Publishers, 2021 1-2 Valuation Using Financial Statements, 2nd Edition 6. How do revenues and expenses differ from the resulting cash flows? The difference between revenues and expenses from the related cash flows is the accruals. The accruals represent the timing differences between the recognition of the revenue and expense and the cash flows. Additionally, the accruals include accounting estimates (e.g., bad debt expense). For example, the change in accounts receivable including the allowance for bad debts explains the difference between sale revenues and the resulting cash flows. 7. What is a limitation of using a company’s Form 10-K, section 1A, Risk Factors, as the source of the material risks facing the company? The Risk Factors section of the Form 10-K provides an accurate list of potential risks and uncertainties for the company. However, the number of risk factors disclosed can be extensive and it effectively weighs all risks equally. The risks need to be evaluated by their impact and relevance in impacting the firm’s future financial position and performance. 8. How does Understanding the Business and the Business Environment provide a more accurate valuation. Without a solid understanding of the business and its environment, the financial analysis and, subsequent forecasts, can be misleading resulting in poor estimates of expected payoffs. Financial analysis requires a strong understanding of the business to correctly evaluate the firm’s financial position and performance. Additionally, having a strong understanding of the business and its environment allows for better forecasts that reflect the firm’s economic reality. Financial analysis and forecasting resulting in better estimates of future payoffs results in a more accurate valuation. 9. Identify the fundamentals in Understanding the Business and the Business Environment. The essential elements to understanding the business are (1) knowing the company’s primary operating activity(ies), (2) the company’s customers, (3) and suppliers, and (4) identifying the company’s material risk and uncertainties. 10. How does understanding a company’s life cycle stage impact forecasts of operating asset turnover and profit margin. The expectation of operating asset turnover and profit margin change as a company moves through the various life cycle stages. In the Introduction phase, operating asset turnovers and profit margins are generally lower than in growth or mature phase. As the company moves to shake-out or decline, profit margins will decrease as will operating asset turnover. Having an understanding of the firm’s life cycle stage will facilitate more accurate forecasts. © Cambridge Business Publishers, 2021 Test Bank, Chapter 1 1-3 EXERCISES 11. Convert the fundamental accounting equation Assets = Liabilities + Equity to the reformulated Net operating assets (NOA) = Net financial liabilities (NFL) + Common shareholders’ equity (CSE). (1) Assets = Liabilities + Equity (2) (Operating assets + Financial Assets) = (Operating Liabilities + Financial liabilities) + (Preferred stock + Common stock + Retained Earnings) (3) (Operating assets – Operating liabilities) = (Financial liabilities – Financial assets + Preferred stock) + (Common stock + Retained Earnings) (4) NOA = NFL + CSE © Cambridge Business Publishers, 2021 1-4 Valuation Using Financial Statements, 2nd Edition CONTINUING EXAMPLES Throughout the text, we will analyze General Mills (GIS) and move toward valuation of the company. Within the test bank materials, we will repeat the process illustrated within the text by following FedEx (FDX) and United Parcel Service (UPS) which are close competitors as well as Procter & Gamble (PG) and Kimberly-Clark (KMB). This will facilitate the application of the valuation steps to similar real-life firms. 12. Use Dickinson’s (2011) cash flow matrix to evaluate the life cycle stage classification for FedEx (FDX). Based on the fiscal year 2019 Consolidated Statement of Cash Flows, FedEx has positive operating cash flows, negative investing cash flow and negative financing cash flow which indicates that FedEx is in its Mature stage of its life cycle. © Cambridge Business Publishers, 2021 Test Bank, Chapter 1 1-5 13. Use Dickinson’s (2011) cash flow matrix to evaluate the life cycle stage classification for United Parcel Service (UPS). Based on the 2019 Consolidated Statement of Cash Flows, UPS has positive operating cash flows, negative investing cash flow and negative financing cash flow which indicates that UPS is in its Mature stage of its life cycle. © Cambridge Business Publishers, 2021 1-6 Valuation Using Financial Statements, 2nd Edition 14. A Strength, Weaknesses, Opportunities and Threats (SWOT) for the Global Couriers & Local Deliver Services is presented below. FedEx (FDX) and United Parcel Service (UPS) are the two largest companies in this industry with a combined 30 percent market share of industry revenues. Source: IBISWorld What factors would appear to be most important in an industry analysis for FedEx (FDX) and United Parcel Service (UPS)? The global courier and local delivery services industry is most impacted by consumer spending, world trade, e-commerce and the price of oil. Revenues are highly correlated with consumer spending. As the consumer spending increases, demand for items to be delivered increases resulting in increased revenues. A decline in consumer spending will adversely impact revenues. The expanded availability of e-commerce allows for more consumer spending, which increases industry demand. Changes in world trade impact industry revenues similarly as consumer spending. Lastly, Changes in fuel prices are not readily passed on to customers which directly impacts the profit margins for FDX and UPS. © Cambridge Business Publishers, 2021 Test Bank, Chapter 2 2-1 Chapter 2 Role of Accounting QUESTIONS 1. Why do executives focus on earnings? Earnings, as opposed to cash flows, are closely linked to value creation. Thus, executives can more effectively report the firm’s value created through earnings than cash flows. For example, revenues are generally recognized when the good or service is provided while the cash flow can be either prepaid, paid at the time the good or service is provided, or paid later. Correspondingly, expenses are typically recognized when the related good or service is used to generate the revenue. The cash can be paid prior, at the time the good or service is consumed or afterwards. Thus, the accounting earnings provides the financial statement user with a better sense when value is created than the related cash flows. 2. Do analysts typically forecast earnings or cash flows? Explain. Analysts typically forecast earnings. Earnings forecasts follow in line with how analysts view the firm’s value creation process. That is, analysts take the expected growth in revenues along with expected profit margin and supporting net operating assets to build the earnings forecasts. Accordingly, analysts transform the earnings forecasts into cash flow forecasts. 3. How do accruals match the timing of reported earnings to when the change in economic value occurs? Accruals are the timing differences between the revenues and expenses and the related cash flows. Accounting uses accruals to match the revenue and expense recognition in the same period as the related economic activity. For example, consider the accounting for the purchase of a depreciable asset that is depreciated over its service life. The economic value of the depreciable asset is expected to decline over time. The recognition of depreciation expense over the asset’s service life more closely follows the change of the asset’s economic value over than the related cash flow (i.e., at the purchase date). © Cambridge Business Publishers, 2021 2-2 Valuation Using Financial Statements, 2nd Edition 4. Are accounting accruals subject to earnings management? Explain. Yes, where earnings management is defined as the use of accounting discretion to distort reported earnings. Accounting accruals reflect management’s estimation and judgment in its application. Managers who have incentives to manage earnings, for either good or bad purposes, can manipulate the accounting accruals through by the inherent estimation and judgment within accrual recognition process. This manipulation results in earnings management. 5. Over the life of a project, are the project’s accounting earnings equal to its net cash flows? Explain. Yes, the accounting earnings are an allocation of the project’s net cash flows over the project’s life. The difference between the accounting earnings and the net cash flows are the accruals. At the end of a project’s life, there are no accruals. That is, over the project life, the operating cash inflows are recognized as revenues while the operating cash outflows are recognized as expenses. In total the net cash flows will equal the accounting earnings. 6. Are the free cash flows calculated from net operating profit after tax (NOPAT) and the change in net operating assets (NOA) the same as the calculations from the statement of cash flows? Explain. No, in the statement of cash flows the operating and investing cash flow sections are not entirely related to operating activities. Free cash flows are the excess cash flows from the firm’s operating activities. The operating and investing sections of the statement of cash flows contain investment income and interest expense. Additionally, the distinction of income taxes between operating and financing activities is not recognized in the financial statements. Finally, significant non-cash transactions are omitted from the statement of cash flows that may impact operating activities and the calculation of FCF. 7. What do free cash flows represent? Free cash flows are the cash flows between the firm’s operating and financial activities. Positive free cash flows are the excess cash flows from operating activities after funding the changes in net operating assets (NOA). These excess cash flows can be held as financial investments, paid to creditors or distributed to shareholders (i.e., dividends or buybacks). Conversely, negative free cash flows arise when the firm’s operating activities do not sufficiently fund the change in its net operating assets (NOA). Cash from financial investments or from creditors/shareholders will be used to fund operating activities. 8. When a firm generates free cash flows, what are its two potential usages? With free cash flows, a firm makes a financial transfer (Free Cash Flows to Financing or FCFFin) or a shareholder transfer (Free Cash Flows to Equity or FCFEq). A financial transfer is when the firm either holds the excess cash, invests the cash into marketable securities, or makes payments for interest and return of capital to debt holders. Shareholder transfers use the free cash flows for dividend payments and share repurchases. Free cash flows are either held by the firm or paid to debtors or shareholders. © Cambridge Business Publishers, 2021 Test Bank, Chapter 2 2-3 9. Are all firms with negative free cash flows destroying value? Explain. Negative free cash flows can represent investments in value creating projects. When a firm is in its introductory or growth stage of its life cycle, it is not unusual for it experience negative free cash flows as its NOPAT is insufficient to funds its NOA growth needs. As a company expands its operations, additional funding from its financial assets or debtors/shareholders is needed, resulting in negative free cash flows. The underlying assumption is that the investments will generate a return over its cost of capital (i.e., create value). 10. Why are free cash flows described as “operating profits not retained to fund future operations?” As a firm creates cash flows from its operations, the cash can either be reinvested into its operating activities (i.e., increases in NOA) or released to its debtholders or shareholders. If a firm has no change in its net operating assets (NOA) over the period, any net operating profits after tax (NOPAT) would be free cash flow available for financial investment or paid to debtors//shareholders. A firm that is increasing its NOA will have free cash flows if its NOPAT is greater than the increase in NOA; otherwise, the free cash flows are negative. 11. What is an accounting accrual? Accounting accruals are the difference between a revenue or expense and its related cash flow. When a revenue (or expense) is recognized at the same time as the cash flow is received (or paid), there is no accrual. Accruals arise when the revenue (or expense) are recognized separately from the related cash receipt (or payment). For example, revenue earned prior to cash collection from the customer, results in an accrual (e.g., an increase in accounts receivable). Thus, the accruals are the timing differences between the income statement recognition and cash flows reflected in the related balance sheet accounts. 12. What are the typical cash flows for Free Cash Flows to Financing (FCFFin)? Free Cash Flows to Financing represent the cash flows to and from debt holders and cash reserves. These cash outflows include additional investments to cash reserves (e.g., marketable securities), interest payments, and principle repayments to debt holders. Cash inflows from financing are decreases in cash reserves and the proceeds of debt issuances. 13. What are the typical cash flows for Free Cash Flows to Equity (FCFEq)? Free Cash Flows to Equity are the cash flows to and from the firm’s equity holders. The cash outflows are dividends and share repurchases while the cash inflows are stock issuances (e.g., secondary offerings or exercised stock options). © Cambridge Business Publishers, 2021 2-4 Valuation Using Financial Statements, 2nd Edition EXERCISES 14. G.O. May Corp’s December 31, 2019, and 2020 balance sheet lists shareholders’ equity of $750,000 and $800,000 respectfully. Assume May’s transactions with shareholders during 2020 included (1) cash dividends declared and paid in the amount of $40,000 and (2) stock options exercised with an exercise price of $65,000, but with a market value of $120,000, and (3) treasury repurchases (i.e., stock buybacks) of $150,000 for shares that were originally issued years ago for $70,000. What is May’s 2020 net income (loss) assuming no other comprehensive income? Shareholders Equity, Dec. 31, 2019 $750,000 (1) Dividends (40,000) (2) Stock options exercised 65,000 (3) Stock repurchases (150,000) Net Income 175,000 Shareholders Equity, Dec. 31, 2020 $800,000 15. Andrews Company reported the following selected financial results for 2019 and 2020. 2019 2020 Operating assets $350,000 $430,000 Financial assets 25,000 20,000 Operating liabilities 110,000 125,000 Financial liabilities 175,000 210,000 NOPAT $25,000 FEAT 15,000 Comprehensive income (CI) 10,000 continued © Cambridge Business Publishers, 2021 Test Bank, Chapter 2 2-5 a. Calculate Andrews’ NOA, NFL and CSE for 2019 and 2020 NOA2019 = $350,000 – 110,000 = $240,000 NOA2020 = $430,000 – 125,000 = $305,000 NFL2019 = $175,000 – 25,000 = $150,000 NFL2020 = $210,000 – 20,000 = $190,000 CSE2019 = $240,000 – 150,000 = $90,000 CSE2020 = $305,000 – 190,000 = $115,000 b. Calculate Andrews’ FCF, FCFFin and FCFEq for 2020. FCF = NOPAT – DNOA = $25,000 – ($305,000 - $240,000) = $25,000 – $65,000 = ($40,000) FCFFin = FEAT – DNFL = $15,000 – ($190,000 – $150,000) = $15,000 – $40,000 = ($25,000) FCFEq = CI – DCSE = $10,000 – ($115,000 – $90,000) = $10,000 – $25,000 = ($15,000) 16. Demonstrate that the total earnings and the cash flows are the same for the following scenario: Purchase of a specialized machine with a three-year life for $300,000 with an expected salvage value of $60,000. After three years, the actual disposition proceeds are $50,000. Assume straight-line depreciation with a full year’s depreciation in the year of acquisition and year of disposal. Accounting Earnings Cash Flows Initial $ 0 $ (300,000) Year 1 $ (80,000) $ 0 Year 2 $ (80,000) $ 0 Year 3 $ (90,000) $ 50,000 Total $ (250,000) $ (250,000) © Cambridge Business Publishers, 2021 2-6 Valuation Using Financial Statements, 2nd Edition 17. Demonstrate that the total earnings and the cash flows are the same for the following scenario: On October 1, Brundage, LLC paid a $300,000 premium for its Errors and Omission insurance coverage for the coming year (12 months). Sprague has a December 31st year end. Accounting Earnings Cash Flows Oct. – Dec. ($ 75,000) ($ 300,000) Jan. – Sept. ($225,000) $ 0 Total ($300,000) ($300,000) 18. Demonstrate that the total earnings and the cash flows are the same for the following scenario: Grady Construction signs a $12 million contract to construct a new building. Grady estimates construction will take two years and will cost $10,000,000 to build. Progress payments of $500,000 are received each month. Grady uses the cost-to-cost approach for its revenue recognition. Grady anticipates being 40 percent by the end of the first year. Accounting Earnings Cash Flows Year 1 $800,000 $2,000,000 ($6,000,000 – 40% x $10,000,000) Year 2 $1,200,000 $ 0 ($6,000,000 – 60% x $10,000,000) Total $2,000,000 $2,000,000 19. Demonstrate that the relation shown in Equation 2.2, 𝐹𝐶𝐹!≡𝑁𝑂𝑃𝐴𝑇!−∆𝑁𝑂𝐴!, holds for the following transactions: a. Borrow $20,000 to purchase of specialized equipment: FCF ($20,000) Cash inflow from debt holders NOPAT $0 There is no revenue or expense ΔNOA $20,000 Long-term operating assets increase by $20,000 increasing NOA. ($20,000) = $0 – $20,000 b. The equipment’s annual depreciation is $5,000: FCF $0 There is no cash flow to credit or equity holders NOPAT ($5,000) Depreciation expense of $5,000 ΔNOA ($5,000) Decrease in equipment book value of $5,000 $0 = ($5,000) – ($5,000) © Cambridge Business Publishers, 2021 Test Bank, Chapter 2 2-7 c. Management extends the expected life of the equipment reducing depreciation to $4,000: FCF $0 There is no cash flow to credit or equity holders NOPAT ($4,000) Depreciation expense of $4,000 ΔNOA ($4,000) Decrease in equipment book value of $4,000 $0 = ($4,000) – ($4,000) d. Equipment is sold for $3,000 resulting in a $500 gain on sale: FCF $0 There is no cash flow to credit or equity holders NOPAT $500 The gain on sale is a $500 ΔNOA $500 Increase in operating cash of $3,000 and decrease in equipment for $2,500 $0 = $500 – $500 Note that if the cash proceeds of $3,000 was assumed “extra” to be distributed to debt or equity holders and therefore a financial item, the equation would be: FCF $3,000 Cash outflow of $3,000 NOPAT $500 The gain on sale is a $500 ΔNOA ($2,500) Decrease in equipment for $2,500 $3,000 = $500 – ($2,500) 20. Dickinson Ltd. is evaluating a potential project with the following expected future cash flows: Purchase price: $5,000 Payoffs: Year 1 $2,000 Year 2 2,500 Year 3 3,000 Year 4 1,500 At the end of the project, the salvage value for the project assets is estimated at $1,000. The project assets are depreciated on a straight-line basis over its four-year life. continued © Cambridge Business Publishers, 2021 2-8 Valuation Using Financial Statements, 2nd Edition a. Prepare the income statement for the four years of the project. 1 2 3 4 Income Statement Revenues $2,000 $2,500 $3,000 $1,500 Depreciation (1,000) (1,000) (1,000) (1,000) Gain on sale - Net income $1,000 $1,500 $2,000 $500 Notes: Depreciation = (Cost – Residual Value) / # of years = ($5,000 – 1,000) / 4 = $1,000 per year Expected Gain = Est. Selling price – (Cost – Acc. Dep.) = $1,000 – ($5,000 – 1,000) = 0 b. Prepare the “statement of cash flows” for the four years of operation including the acquisition. Statement of Cash Flows 0 1 2 3 4 Contribution to purchase ($5,000) Revenues $2,000 $2,500 $3,000 $1,500 Proceeds from disposition 1,000 Distributions ($5,000) $2,000 $2,500 $3,000 $2,500 c. Prepare the statement of changes in equity for the four years of operation including the acquisition. Statement of Changes in Equity 0 1 2 3 4 Beginning book value of project - $5,000 $4,000 $3,000 $2,000 Plus net income - 1,000 1,500 2,000 500 Less distributions $5,000 (2,000) (2,500) (3,000) (2,500) Ending book value of project $5,000 $4,000 $3,000 $2,000 - © Cambridge Business Publishers, 2021 Test Bank, Chapter 2 2-9 21. Scovill Inc. completed another successful year along with its initial public offering (IPO). The Company earned comprehensive income (CI) of $40 million that included net operating profit after tax (NOPAT) of $45 million. During the year, Scovill completed its initial public offering of $250 million with no prior shareholders selling which brought its common stock equity (CSE) balance at year-end to $400 million. A portion of the IPO proceeds were used to fund the increase of net operating assets (NOA) from $350 million at the beginning of the year to $500 million as of the end of the year. The remaining IPO proceeds were held as financial assets. As a result, the net financial liabilities (NFL) decreased during the year. Scovill does not pay a dividend nor did it buyback any outstanding shares. However, Scovill received $5 million from the exercise of employee stock options. a. What is financial expense after tax (FEAT) for the year? $5 million – see the color key below. Color key: Given CI = NOPAT – FEAT Solving for 40 45 5 Previously solved for b. What are free cash flows (FCF) for the year? Negative $105 million First, solve for the Δ in NOA, ΔNOA = NOAEnd – NOABeg 150 500 350 Then solve for free cash flow, FCF FCF = NOPAT – ΔNOA (105) 45 150 © Cambridge Business Publishers, 2021 2-10 Valuation Using Financial Statements, 2nd Edition c. What is the amount of decrease in net financial liabilities (NFL) during the year? $145 million. First, solve for cash flow to equity, FCFEq FCFEq = dividends + buybacks – issuances (255) 0 0 255 Then solve for the change in net financial liabilities (Δ NFL) FCFEq = FCF – FEAT + ΔNFL (255) (105) 5 (145) 22. Sanders Inc. completed another successful year including opening new subsidiaries in Ireland and Chile. Sanders generated $300 million in comprehensive income (CI) of which $330 million was net operating profit after tax (NOPAT) and $30 million was financial expense after tax (FEAT). Due to a positive business climate the firm expanded its operations internationally resulting in an increase in net operating assets (NOA) from $1,250 million to $1,600 million that was financed by an increase in net financial liabilities (NFL) of $130 million from $500 million at the beginning of the year. During the year, the firm paid a cash dividend of $50 million. Additionally issued $10 million in stock from employee stock options exercised. To avoid dilution of existing shareholders, Sanders maintains an active share repurchase (i.e., “buyback”) plan to purchase stock on the open market to support its stock option issuances. a. What are the free cash flows (FCF) for the year? Color key: Given Solving for Previously solved for FCF = NOPAT – ΔNOA (20) 330 350 Negative $20 million. © Cambridge Business Publishers, 2021 Test Bank, Chapter 2 2-11 b. What are the cash flow to equity, FCFEq, for the year (i.e., net payout to shareholders)? FCFEq = FCF – FEAT + ΔNFL 80 (20) 30 130 $80 million c. What is the cost of shares repurchased during the year? FCFEq = dividends + buybacks – issuances 80 50 40 10 $40 million. © Cambridge Business Publishers, 2021 Test Bank, Chapter 3 3-1 Chapter 3 Reformulation to Identify Operating Activities QUESTIONS 1. What are reformulated financial statements? Reformulated financial statements are a firm’s GAAP financial statements separated into the its operating activities (NOPAT & NOA) from its financial activities (FEAT and NFL). Through an understanding of the firm’s business activities, each account from the income statement and the balance sheet is classified as operating or financial. The reformulated allows for analysis, forecasting and valuation of the company’s operations (i.e., its value creation activities). 2. How does an enterprise operations approach avoid the issue of forecasting management’s financing decision? The source of funding is irrelevant when valuing the firm’s operations. The risk of the firm’s operating activities does not change whether the firm is financed by debt, equity, or a combination of the two. The cash flows from operations (i.e., free cash flows (FCF)) available to debt holders or equity holders does not impact the firm’s expected future payoffs. By definition, free cash flows are not required to support current operations and, therefore, management’s decision as to how to distribute the funds will not affect the firm’s operations. Valuing a firm’s enterprise operations does not need to consider the source of funding along with the choice of the destination of any free cash flow distributions. 3. Valuation is a function of future payoffs, so what is the purpose of evaluating prior year financial statements? Past financial trends tend to continue into the future unless there is a change in the business environment or firm strategy. That is, what has held true for the past will hold for the future. The reformulated financial statements allow for a better analysis of the firm’s historical performance and financial position. This understanding provides a better foundation on which to base the forecasts of the firm’s future payoffs. © Cambridge Business Publishers, 2021 3-2 Valuation Using Financial Statements, 2nd Edition 4. When reformulating the balance sheet, what is the criterion for evaluating whether an account is an operating or financing item? The determination for whether an account is operating or financing depends primarily on one’s understanding of the company’s structure and goals. When there is an account that is not clearly operating or financing, a consideration is whether the account is reported at fair value. If there is doubt regarding the valuation, then the account is typically classified as operating. Thus any valuation difference in the account’s reported amount will be reflected in the subsequent enterprise operation valuation. 5. Explain whether a financing division that supports a firm’s sales effort is classified as operating or financing. Firms which have a supporting financial division need to be carefully considered. The classification will impact the valuation as well as the operation’s risk measure. If the supporting financial division’s accounts are reported on the balance sheet at fair value, then the accounts are classified as financial activities. The impact of the financing division activities will be reflected in the firm’s sales and related operating activities. Alternatively, if the accounts are not reported at fair value on the balance sheet, the financial division accounts are classified as operating activities. 6. Why is cash and cash equivalents typically split between operating and financing activities? While firm’s need cash to operate its day-to-day activities, in many instances, the firm holds more cash than needed to support its operating activities. Any excess cash not needed for operating activities is classified as a financing activity as it could have been distributed to debt or equity holders. To determine the operating cash needs, a general rule of thumb of two percent of sales (i.e., one week of sales) is often used. 7. When reformulating the financial statements, does the distinction between current and non-current assets and liabilities need to be maintained? Explain. No, the distinction between current and non-current assets and liabilities does not need to be maintained. The financial analysis and forecasting of future payoffs stages in the valuation process do not require the current/non-current distinction. Thus, there is no need to distinguish the difference in the reformulations. 8. Why is preferred stock classified as a financial item? The valuation approach is taken from the common shareholder, i.e., the residual claimant, perspective. In a liquidation, when all debt and obligations are satisfied, the remaining assets belong to the common shareholders. Preferred shareholders have a liquidation preference before common shareholders and, therefore, are not the residual claimant. Also, preferred shareholders have constant payouts and are typically valued based on those expected payments, similar to debt holders. © Cambridge Business Publishers, 2021 Test Bank, Chapter 3 3-3 9. Why are noncontrolling interests (NCI) classified as a financial item? Noncontrolling interests represent the minority shareholders’ equity interest in a consolidated firm’s subsidiary. Noncontrolling interests have a claim on a portion of the subsidiary’s net assets and income. From a consolidated perspective, noncontrolling interests have claims against the firm, but do not have an equity in the consolidated firm. Similar to debt holders, noncontrolling interests are classified as a financial item. 10. Describe the process to allocate income tax expense between operating and financial activities. The reported income tax expense (or income tax provision) represents the tax impact for both operating and financing items. That is, reported income tax expense = income tax expense (benefit) from operating activities + income tax expense (benefit) from financing activities. Accordingly, the income tax expense needs to be allocated between the two activities. Although the actual tax impact is not known for operating versus financial activities, an estimation is done by estimating the tax impact on the financial activities first. With few deferred tax items associated with the financial activities, estimating the income tax impact is done by multiplying the pre-tax financial expense (income) with the firm’s marginal tax rate yielding the income tax expense (benefit) from financing activities. The next step in allocating the reported income tax expense is to solve for the income tax expense (benefit) from operating activities. 11. Explain whether discontinued operations are classified as an operating activity or not? Discontinued operations are operating activities when reformulating a firm’s financial statements. While the discontinued operations will not impact future operating results (including forecasted future payoffs), inclusion in historical operating activities (NOPAT and NOA) is appropriate as it reflects management’s operating decisions and performance. 12. In reformulating a balance sheet, equity method investments (e.g., joint ventures, affiliates and partnerships) should be classified as operating or financial? Explain briefly. Equity method investments represent a firm’s equity interest in another company at less than 50 percent (i.e., control) but more than 20 percent. That is, the investor has the ability to exert significant influence on the investee. Equity method investments should be classified as operating activities because joint ventures, subsidiaries, partnerships, etc. represent an operational interest and by the company in the joint venture, and it is intrinsically linked to their enterprise operations. An investment of 20 percent or more into a company’s ownership is more than a financial investment. The investor is creating a strong relationship with the entity. Typically, such investors have a seat (or more) on the board. Also, there is often a supplier/customer relationship or a R&D relationship. These elements demonstrate the investor’s ability to exert significant influence on the investee. © Cambridge Business Publishers, 2021 3-4 Valuation Using Financial Statements, 2nd Edition EXERCISES 13. Below is a recent Balance Sheet for Under Armour (UA). For each item listed, determine the classification that would be used in reformulation from the following list: • O – Operating activities • F – Financial activities • S – Split between operating and financial activities • ? – Desire more detailed information but will initially classify as related to operating activities • CSE – Common shareholders’ equity Note: all of Under Armour’s common stock (Class A, B and C) have identical distribution and liquidation rights. © Cambridge Business Publishers, 2021 Test Bank, Chapter 3 3-5 Cash and cash equivalents – S Accounts receivable, net – O Inventory – O Prepaid expenses and other current assets – ? Property and equipment, net – O Operating lease right-of-use assets – O Goodwill – O Intangible assets, net – O Deferred income taxes – ? Other long-term assets – ? Accounts payable – O Accrued expenses – O Customer refund liabilities – ? Operating lease liabilities – F Current maturities of long-term debt – F Other current liabilities – ? Long-term debt, net of current maturities – F Operating lease liabilities, non-current – F Other long-term liabilities – ? Preferred stock – F (if they had issued some shares) Class A Common stock – CSE Class B Convertible common stock – CSE Class C Common stock – CSE Additional paid-in capital – CSE Retained earnings – CSE Accumulated other comprehensive income – CSE © Cambridge Business Publishers, 2021 3-6 Valuation Using Financial Statements, 2nd Edition 14. Below is a recent Balance Sheet for Netflix (NFLX) For each item listed, determine the classification that would be used in reformulation from the following list: • O – Operating activities • F – Financial activities • S – Split between operating and financial activities • ? – Desire more detailed information but will initially classify as related to operating activities • CSE – Common shareholders’ equity © Cambridge Business Publishers, 2021 Test Bank, Chapter 3 3-7 Cash and cash equivalents – S Current content assets, net – O Other current assets – ? Non-current content assets, net – O Property and equipment, net – O Other non-current assets – ? Current content liabilities – O Accounts payable – O Accrued expenses and other liabilities – ? Deferred revenue – O Non-current content liabilities – O Long-term debt – F Other non-current liabilities – O Common stock – CSE Accumulated other comprehensive income – CSE Retained earnings – CSE © Cambridge Business Publishers, 2021 3-8 Valuation Using Financial Statements, 2nd Edition 15. Below is a recent Balance Sheet for PepsiCo, Inc. (PEP) For each item listed, determine the classification that would be used in reformulation from the following list: • O – Operating activities • F – Financial activities • S – Split between operating and financial activities • ? – Desire more detailed information but will initially classify as related to operating activities • CSE – Common shareholders’ equity