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Financial Reporting and Analysis (6th Ed.)
Chapter 6 Solutions
The Role of Financial Information in Valuation
and Credit Risk Assessment
Problems/Discussion Questions
Exercises
E6–1. Free cash flow valuation
Requirement 1:
Although the exact definition of “free cash flow” varies in practice, most stock
analysts, investment professionals, and valuation experts define the term as
rate.
E6–2. Abnormal earnings valuation
Requirement 1:
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Although the exact definition of “abnormal earnings” varies in practice, most
stock analysts, investment professionals, and valuation experts define the
term as a company’s earnings minus a capital charge (often defined as the
book value of equity multiplied by the equity cost of capital). This capital
(5) adding the result to book value.
E6–3. Predicting future cash flow
Requirement 1:
In this setting, the best predictor of next month’s cash collections is this
month’s credit sales rather than this month’s cash collections. For example,
E6–4. Explaining differences in P/E ratios
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In general, price/earnings (P/E) ratios are inversely related to risk, and
positively related to both growth opportunities and earnings quality.
These firms are from different industries. Amazon is an e-commerce retailer,
Microsoft is a software development company, Toyota Motors is an
$0.60 per share third-quarter loss. During more normal times, Amazon’s
earnings are much greater. Diluted EPS was $1.37 and $2.53 in 2011
and 2010, respectively. If the market expects Amazon’s earnings to
return to a more normal level, its price will anticipate those higher
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differences in earnings quality. Concerns about earnings quality have
occasionally surfaced in financial press articles on each company.
E6–5. Why P/E ratios vary
In general, price/earnings (P/E) ratios are inversely related to risk, and
positively related to both growth opportunities and earnings quality.
These firms are all from the same industry—grocery chains—so there is less
E6–6. Fair value accounting and goodwill
Requirement 1:
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key feature of this impairment test is to establish each year the fair value of
recognized goodwill.
Requirement 2:
Discounted free cash flow valuation is a Level 3 method in the FASB’s fair
E6–7. Earnings quality
Requirement 1:
Quality of earnings relates to how well accrual accounting earnings captures
the underlying economic performance of an enterprise for a particular period
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• Liberal accounting choices that increase short-run profits.
• Changes in discretionary expenditures for R&D, advertising, and
E6–8. Cash flow and credit risk
Requirement 1:
Scheduled loan payments over the next six quarters total $1,000,000.
Operating cash flows are projected to total $1,410,000 over this same period,
and (4) generate cash from other sources (selling non-operating assets or
issuing stock) or seek a loan refinancing arrangement that postpones the
scheduled debt payment.
E6–9. Moody’s Slashes Greek Bond Rating
Requirement 1:
Requirement 2:
The approach used to assess credit risk for sovereign debt resembles closely
that used for corporate debt. The essential question asked by Moody’s and
other credit rating agencies is: Will the corporate debt issuer have sufficient
E6–10. Credit risk and cash flow volatility
Requirement 1:
The quarterly operating cash flows of both firms exhibit seasonal volatility,
meaning that operating cash flow levels change from quarter to quarter.
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Firm B now exhibits higher operating cash flows than Firm A in two of the five
quarters, but the sharp decline in the two most recent quarters is still a cause
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Financial Reporting and Analysis (6th Ed.)
Chapter 6 Solutions
The Role of Financial Information in Valuation
and Credit Risk Assessment
Problems/Discussion Questions
Problems
P6-1 Interpreting stock price changes
Requirement 1:
AMD’s announcement differed from analysts’ expectations and presumably
also from the market’s expectations. One would expect the price to adjust to
expectations of investors actually trading AMD stock may have already been
lower. There still could have been a surprise and a resulting stock price
P6–2. Assessing credit risk using cash flow forecasts
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of cash available to make loan interest and principal payments. This amount
grows to $1,815,000 by the end of 2017, a figure that represents the sum of
the net change in cash each year ($95,000 + $565,000 + $570,000 +
$585,000). But Randall will owe the bank $2,000,000 plus any unpaid
P6–3. Valuing growth opportunities
Requirement 1:
The cost of equity capital for eBay is higher than that of Wal-Mart because
where P is the current stock price, X is current reported earnings per share
for the year, and r is the estimated cost of equity capital. Rearranging terms
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receivable). This same pattern persists into March. So, March credit
customers must still owe $790 at month-end because all of the January and
February credit customers have paid their accounts in full.
Requirement 2:
March cash collections ($640) are equal to February’s outstanding accounts
increase in March inventories ($70 = $840 – $770).
Requirement 4:
If, as the problem statement indicates, suppliers are paid 60 days after health
care products are purchased, the March cash payment ($525) should
correspond to January purchases. An analysis of the inventory account
better predictor of next month’s net cash flow than is current month net cash
flow. This intuition is confirmed statistically using regression analysis. The
explanatory power (adjusted R-square) for current month gross profit as a
predictor of next month’s net cash flow is 45.6% compared to 1.2% for current
month’s net cash flow.
often (but not always) a better predictor of future operating cash flow than is
current period operating cash flow.
P6–5. Tail O’ the Dog: Fair value measurement
Requirement 1:
The least relevant measure for purposes of fair value determination is the
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Here’s another example to illustrate why historical cost is irrelevant to fair
$24. Clearly, the fair value of Manhattan is considerably more than $24
today.
2) are available. In particular, there are recent quoted prices for similar
assets: a parking lot ($500,000) and a residential beachfront lot ($1.2 million).
GAAP requires fair value measurements to reflect the “highest and best use”
of the asset, so the most relevant measure is the recent (market) price paid
P6–6. Sonic Solutions: Discounted cash flow valuation
Requirement 1:
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investments such as accounts receivable and inventories that affect cash
flows; and (3) cash interest payments. On the other hand, the spreadsheet
definition is a useful approximation for the more complete free cash flow
calculation in some settings.
2011. A second feature is that free cash flows are projected to grow faster
than sales in each year beginning in 2011. The source of this additional
growth is unclear, but may have been explained in the analysts’ published
research report.
2017. Analysts typically calculate this terminal present value as follows:
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𝑇𝑃𝑉 = 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑇
(𝑊𝐴𝐶𝐶 − 𝑔𝑟𝑜𝑤𝑡ℎ)𝑥 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟𝑇
$268.58. This zero growth TPV is considerably smaller than the $460.43
figure shown in the analysts’ spreadsheet. The reason why is because the
analyst set the growth rate to be 5%. You should verify that TPV is $460.43
($615.61), not just the value of its common stock. The analyst then subtracts
the value of net debt to arrive at the value of common stock ($672.11 equity
value).
Requirement 7:
If equivalent assumptions are used, the share value estimate calculated using
The analyst altered the free cash flow forecasts from their original amounts to
higher figures shown in discounted cash flow valuation model spreadsheet in