Finance Chapter 4 1 If both profit margin and asset turnover are expected to continue at their current levels in the future

TEST NUMBER 4

Question 1 (12 points)

At the time that of its 10-Q filing of financial statements for the first half of its January

2002 fiscal year, Home Depot’s shares traded at $50 per share. The following are summaries

from those financial statements.

Balance Sheet, July 29, 2001

(in millions of dollars)

Financial liabilities

1,320

Operating assets

23, 457

Operating liabilities

6,709

Financial assets

1,221

Common equity

(on 2,336 million outstanding

shares)

16,649

24,678

Statement of Earnings, Six Months Ended, July 29, 2001

(in millions of dollars)

Net sales

26,776

Cost of Merchandise Sold

18,795

Gross Profit

7,981

Operating Expenses:

Selling and Store Operating

4,963

Pre-Opening

59

General and Administrative

436

Total Operating Expenses

5,458

Operating Income

2,523

Interest Income (Expense):

Interest and Investment Income

22

Interest Expense

(11)

Interest, Net

11

Earnings Before Income Taxes

2,534

Income Taxes

978

Net Earnings

1,556

According to financial statement footnotes, Home Depot’s statutory tax rate (combined Federal

and State rates) is 39%. Other comprehensive income (not in net earnings above) is negligible.

Use a required six-month return for operations of 4% in calculations below.

(n)

Calculate the following from these statements:

1. Financial leverage

2. Operating liability leverage

3. After-tax profit margin

(o) Home Depot earned a return on beginning net operating assets (RNOA) of 9.3% for the

six months ending July 29, 2001.

1. What was the asset turnover during these six months?

2. What was the residual operating income over the six months?

(p) Calculate the free cash flow generated by operations during the six months.

(q) At the current market price of $50 per share, what growth rate for residual operating

income does the market forecast for the future?

(r) Calculate Home Depot’s price–to-sales ratio for trailing six-month sales.

(s) If both profit margin and asset turnover are expected to continue at their current levels in

the future, what is the sales growth rate forecast implied in the price-to-sales ratio?

Question 2 (5 points)

Below is a summary of part of IBM’s Statement of Cash Flows for the year ended

December 31, 2001 (in millions of dollars). The firm faces a 37% statutory tax rate.

Net cash provided from operating activities

9,274

Cash flow from investing activities:

Payments for plant, rental machines and other property

(5,616)

Proceeds from disposition of plant, rental machines and other property

1,619

Investment in software

(565)

Purchases of marketable securities

(1,079)

Proceeds from marketable securities

1,393

Net cash used in investing activities

(4,248)

Supplemental data:

Cash paid during the year for:

Income taxes

2,697

Interest paid

1,447

Interest received

617

(c) From this information, calculate free cash flow for 2001.

(d) What was the net amount of cash paid out of the firm in financing activities during 2001?

Question 3 (7 points)

The following is from the statement of shareholders’ equity for Intel Corporation for

2000 (in millions of dollars). Intel faces a 38% tax rate.

Balance, December 25, 1999

32,535

Net income

10,535

Unrealized loss on available-for-sale securities

(3,596)

Issuance of shares through employee stock plans, net of tax benefit of $887 million

1,684

Reclassification of put warrant obligation

130

Amortization of unearned compensation

26

Conversion of subordinated notes to common stock (market value of stock was $350 million)

207

Repurchase of common stock

(4,007)

Cash dividends

(470)

Issuance of shares for acquisitions

278

37,322

Calculate comprehensive income to Intel’s shareholders for 2000, being sure to include any

hidden dirty surplus expenses.

Question 4 (10 points)

A firm with a return on common equity (ROCE) of 30% has financial leverage of 37.5%

and a net after-tax borrowing cost of 5% on $240 million of net debt.

(g) What rate of return does this firm earn on its operations?

(h) The firm is considering repurchasing $150 million of its stock and financing the

repurchase with further borrowing at a 5% after-tax borrowing cost. What effect will

this transaction have on the firm’s return on common equity if the same level of

operating profitability is maintained?

(i) Will this repurchase change the per share intrinsic value of the equity? Why?

(j) Will the normal P/E ratio for this firm change because of this transaction? Why?

(k) The firm had an unlevered price-to-book ratio (P/B) of 1.8 prior to the transaction.

What will be the effect of the repurchase on the levered price-to-book ratio?

(l) Would you expect the earnings-per-share growth rate to change after the repurchase

transaction? Why?

Question 5 (6 points)

Cisco Systems traded at $20 per share on December 3, 2001. Analysts are forecasting

earnings per share of 0.22 for 2002 and 0.39 for 2003. The firm does not pay dividends.

Value Cisco on the assumption that abnormal earnings growth forecasted for 2003 will

continue at the same level into the future. Use a cost of equity capital of 10%.