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Financial Reporting and Analysis (7th 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 the company’s operating cash flows
(before interest) minus cash outlays for routine operating capacity
Requirement 2:
Free cash flow is operating cash flow minus interest (net of tax) and
Requirement 3:
The key features of the free cash flow approach to valuation involve:
(1) forecasting the company’s estimated future free cash flows each
period over a forecast horizon as well as an estimate of
E6-2. Abnormal earnings valuation
Requirement 1:
The sustainable component of a company’s reported earnings is
represented by recurring income from continuing operations (with
the possible exception of unusual or infrequently occurring items).
Requirement 2:
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
Requirement 3:
The key features of the abnormal earnings approach to valuation
involve: (1) forecasting the company’s future earnings each period
over some forecast horizon (e.g., typically 5 or 10 years); (2)
subtracting a capital charge from each earnings forecast to arrive at
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, January credit sales are $38,000 but cash collections
The reason why can be traced to two features of the company’s
business model: (1) sales transactions are on credit rather than for
Requirement 2:
As illustrated by the numerical example in the exercise, accrual
accounting earnings often smoothes out the period-to-period
E6-4. Explaining differences in P/E ratios
In general, price/earnings (P/E) ratios are inversely related to risk,
These firms are from different industries. Amazon is an e-commerce
retailer, Microsoft is a software development company, Toyota
Differences in P/E ratios reflect differences in future growth
opportunities. Toyota Motors probably has the fewest growth
opportunities—automobile manufacturing is a rather mature
Amazon’s P/E ratio of 882.7 is extremely high, even for a
high-growth firm, suggesting a possible aberration in its
earnings. At the time this P/E ratio was computed, Amazon’s
trailing-twelve-months earnings was $0.70 per share, which
included a $0.12 loss in the first quarter of 2015. Only two
Differences in P/E ratios reflect differences in business risk.
Risky firms will have higher discount rates assigned to their
future cash flows and earnings, and thus lower share prices
and lower P/E ratios. However, risk differences do not explain
the P/E differences for these firms. Toyota is a large, financially
Without a detailed examination of the financial reporting
practices and related disclosures of each company, it is difficult
to draw conclusions about the degree to which the P/E ratio
Absent information about investors’ earnings quality concerns, it is
likely to be the case that most of the variation in P/E ratios is due to
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
Sprouts Farmers Market has the highest P/E ratio of the
grocery chains listed. It is relatively small and rapidly
It is unlikely that investors assign substantially different risk to
Differences in earnings quality might also explain why the P/E
ratios of these grocery firms differ so much. However, within an
In sum, it is likely that investors believe the growth opportunities are
E6-6. Fair value accounting and goodwill
Requirement 1:
Companies that have recognized accounting goodwill are required
by GAAP to test for goodwill impairment annually and, if the
Requirement 2:
Discounted free cash flow valuation is a Level 3 method in the
FASB’s fair value measurement hierarchy. Level 1 uses quoted
prices from active markets for identical assets or liabilities. Level 2
Requirement 3:
The publishing segment, the business unit for which News
Corporation recorded an impairment charge is not a publicly traded
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 of time. One important dimension of earnings
Requirement 2:
Management can improve reported earnings in the short-run by:
Changing accounting methods.
Adjusting expense estimates (e.g., increasing estimated useful
Requirement 3:
Examples of low-quality earnings items include:
One-time gains and losses from asset sales.
Liberal accounting choices that increase short-run profits.
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, but management also expects to pay out
Requirement 2:
There are at least four steps management can take to reduce the
loan’s credit risk: (1) find ways to increase the projected cash from
Requirement 3:
Encourage management to find ways to increase the projected cash
from operations, and then monitor performance to ensure that the
E6-9. Moody’s Slashes Greek Bond Rating
Requirement 1:
Moody’s and other credit rating agencies provide an independent
assessment of the credit risk associated with corporate debt, state
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 debt issuer have sufficient funds available to make scheduled
Requirement 3:
The rating downgrade signals a deterioration in the creditworthiness
of Greece; i.e., Moody’s believes that the country’s credit risk has
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. Seasonal patterns in sales and operating cash
flow are common in many industries, and the cash flow volatility
Requirement 2:
2016 2017
Q1 Q2 Q3 Q4 Q1
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
