Valuation
Measuring and Managing the Value of Companies
5th Edition
Chapter 7 Solutions
Reorganizing the Financial Statements
Version 1.0
April 1, 2010
Chapter 7
Questions 1-3
Ratio Company A Company B Company C
Return on assets 14.3% 13.0% 11.4%
Return on equity 15.8% 14.3% 21.8%
Return on invested capital 15.8% 15.8% 15.8%
Question 1
Return on invested capital best measures operating performance. All three companies have the same operating performance!
Question 2
Companies that hold less than 20% of another company (or subsidiary) only record income when dividends are paid. Therefore,
profits will be under reported. This causes return on assets to be distorted downwards. Since Company B
has $50 million in equity investments, but no corresponding income, its ROA is lower than Company A.
Question 3
Company C’s return on equity outpaces both Company A and Company B because the company uses leverage. Leverage
will magnify operating results. Leverage makes good results look great, but can bankrupt companies with poor performance.
Chapter 7
Question 4
HealthCo HealthCo
Reorganized financial statements Ratio Analysis
Prior Current Prior Current Prior Current
NOPLAT Year Year Total funds invested Year Year Ratio Year Year
Revenues 605.0 665.0 Working cash 5 5 ROIC 15.5% 19.5%
Cost of sales (200.0) (210.0) Accounts receivable 45 55
Selling costs (300.0) (320.0) Inventories 15 20 Operating tax rate 27.3% 29.4%
Depreciation (40.0) (45.0) Accounts payable (10) (15) Marginal tax rate 35.0% 35.0%
Operating income 65.0 90.0 Working capital 55 65
Operating taxes (17.8) (26.5) Property, plant & equipment 250 260
NOPLAT 47.3 63.5 Invested capital 305 325
Prepaid pension assets 10 50
Reconciliation of NOPLAT Total funds invested 315 375
Net income 44.0 60.0
Tax audit10.0 0.0
After-tax interest expense 3.3 9.8 Reconciliation of total funds invested
After-tax gain on sale 0.0 (16.3) Short-term debt 20 40
NOPLAT 47.3 53.5 Long-term debt 70 70
Restructuring reserves 20 0
1 Included to be consistent with Question 6 Debt and debt equivalents 110 110
Equity 205 265
Total funds invested 315 375
Chapter 7
Question 5
HealthCo HealthCo
Cash flow available to investors
Current Current
year year
Revenues 665.0 After-tax interest expense 9.8
Cost of sales (210.0) Decrease in short-term debt (20.0)
Selling costs (320.0) Decrease in long-term debt 0.0
Depreciation (45.0) Restructuring reserves 20.0
Operating income 90.0 9.8
Operating taxes (26.5) Dividends 0
NOPLAT 63.5 Cash flow available to investors 9.8
Depreciation 45.0
Gross cash flow 108.5
Increase in working capital (10.0)
Capital expenditures (55.0)
Free cash flow 43.5
Prepaid pension assets (40.0)
After-tax gain on sale 16.3
Cash flow available to investors 19.8
Chapter 7
Question 6
HealthCo
Reconciliation of effective taxes
Prior Current
year year
Statutory taxes 21.0 35.0
Manufacturing investments (5.0) (5.0)
Audit expense 0.0 10.0
Effective taxes 16.0 40.0
Statutory taxes 35.0% 35.0%
Manufacturing investments -8.3% -5.0%
Audit expense 0.0% 10.0%
Effective taxes 26.7% 40.0%
Profits
Earnings before taxes 60 100
Operating profits 65 90
Tax rates
Statutory (marginal) tax rate 35.0% 35.0%
Operating tax rate 27.3% 29.4%
Effective tax rate 26.7% 40.0%
Chapter 7
Question 7
Commentary
Excess cash is not “invested” capital, and is not necessary for core
operations. Therefore, it should be analyzed and valued
separately. Including cash in the computation of ROIC will
incorrectly depress the ROIC.
EXHIBIT7.15 Ratio Analysis: Consolidated Financial Statements
$ millions
CompanyA CompanyB CompanyC
Operatingprofit 100 100 100
Interest 0 0 (20)
Earningsb eforetaxes 100 100 80
Taxes (25) (25) (2 0)
Net income 75 75 60
Balances heet:
Inventory 125 125 125
Propertyand equ ipment 400 400 400
Equityin vestments 0 50 0
Total assets 525 575 525
Accounts payable 50 50 50
Debt 0 0 200
Equity 475 525 275
Liabilities and equity 525 575 525
ExhibitData:
Taxrate 25%