Financial Reporting and Analysis (7th 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 reflect the new updated information. Note that
the price revision would capture not only how the current period’s
performance differed from expectations, but also any revision in
Requirement 2:
Stock prices change when investors’ beliefs about current or future
performance change. In scenario (a), the reduced revenue was
predictable based on public information available prior to the
announcement. This suggests that at least some of the $200 million
difference was due to the analysts’ forecasts that were available
P6-2. Assessing credit risk using cash flow forecasts
Requirement 1:
If Randall’s cash flow forecasts are accurate, it will be unable to
repay the loan at the end of 2020. At the end of 2017, Randall will
have only $95,000 of cash flow available to make loan interest and
principal payments. This amount grows to $1,815,000 by the end of
Unless Randall has cash available other highly liquid assets that
Requirement 2:
There are several ways Randall could enhance its creditworthiness
and reduce its credit risk. One approach is to focus on generating
more operating cash flow each year by growing sales, reducing
costs, or both. A second approach is to agree contractually not to
pay dividends without bank approval. Curtailment of the company’s
planned dividend payments would add another $400,000 to the
P6-3. Valuing growth opportunities
Requirement 1:
The cost of equity capital for eBay is higher than that of Wal-Mart
because eBay has a riskier cash flow stream than does Wal-Mart.
Wal-Mart has a long history of predictable earnings and operating
Requirements 2 and 3:
To find the NPVGO for each company, you need to solve for
NPVGO in the following expression:
P
0
= X0
r + NPVGO
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 gives us:
0
0
–
X
NPVGO P r
=
Using this expression and the data provided in the problem
Requirement 4:
The NPVGO at Home Depot is greater as a percent of share price
than that for eBay because investors believe that Home Depot has
better growth opportunities—a higher rate of growth and more
profitable growth. Alternatively, eBay’s earnings per share may have
Requirement 5:
On its face, a negative NPVGO suggests and expected earnings
growth rate that is negative. However, the result could also be due
P6-4. Predicting future cash flow
Requirement 1:
If, as the problem statement indicates, credit customers pay 30 days
after the sale, the month-end accounts receivable balance will be
Note that January cash collections ($510) are equal to the previous
December’s outstanding accounts receivable ($500) plus cash
sales in January ($10 = $620 Sales minus $610 month-end balance
Requirement 2:
March cash collections ($640) are equal to February’s outstanding
Requirement 3:
An analysis of the inventory account reveals that March purchases
Requirement 4:
If, as the problem statement indicates, suppliers are paid 60 days
after health care products are purchased, the March cash payment
Requirement 5:
Visual inspection of the data suggests that current month’s gross
profit is a better predictor of next month’s net cash flow than is
current month net cash flow. This intuition is confirmed statistically
Requirement 6:
In general, accrual earnings smoothes out the period-to-period
lumpiness that sometimes arise in operating cash flows. This
lumpiness is produced by period-to-period variations in business
P6-5. Tail O’ the Dog: Fair value measurement
Requirement 1:
The least relevant measure for purposes of fair value determination
is the parking lot’s 1962 historical cost ($12,000). The price paid 50
Here’s another example to illustrate why historical cost is irrelevant
to fair value determination. In 1626, Peter Minuit bought Manhattan
island from the local Indians for a load of cloth, beads, hatchets, and
Requirement 2:
Quoted prices from an active market for identical assets (Level 1 fair
value measurement) are not available in this setting, but observable
inputs (Level 2) are available. In particular, there are recent quoted
Requirement 3:
Level 2 fair value measurements include quoted market prices for
similar assets. There are two Level 2 observable inputs present in
this fact pattern: the recent (market) price paid for the parking lot
($500,000) and for the residential beach front lot ($1.2 million).
Requirement 4:
Auditors are especially challenged by Level 3 fair value
measurements because it is difficult (if not impossible) to verify the
accuracy and precision of the forecasted income stream that forms
P6-6. Sonic Solutions: Discounted cash flow valuation
Requirement 1:
Free cash flow is defined in the spreadsheet as EBITDA minus
capital expenditures and cash taxes, where EBITDA refers to
earnings before interest, taxes, depreciation and amortization. This
spreadsheet definition differs in several ways from how accountants
and auditors define free cash flow. In particular, it ignores: (1) other
Requirement 2:
The annual percentage rates of sales growth and free cash flow
growth are:
Several features of these growth rates are noteworthy. First, the
analyst is projecting rather high levels of sales growth in 2011
through 2013, which would be quite unusual for an established
company operating in a mature product market. However, Sonic
Solutions develops digital media products, services and
Requirement 3:
The 12% weighted-average cost of capital (WACC) serves as the
discount rate used in computing the present values shown in the
spreadsheet. WACC represents a blended discount rate that
Requirement 4:
Each forecasted free cash flow amount (e.g., $4.6 in 2010) is
multiplied by a corresponding discount factor (e.g., 0.89286 in 2010)
to arrive at a present value of the future free cash flow (e.g., $4.11
Requirement 5:
This figure represents the present value of free cash flows occurring
beyond 2017. Analysts typically calculate this terminal present
value as follows:
TPV =FreeCash FlowT
(
WACC −growth
)
x discount factorT
where T denotes the spreadsheet terminal year (2017). If you insert
$79.8 as the terminal-year free cash flow forecast (from the
spreadsheet), 0.40388 as the discount factor, and 0.12 as the
Requirement 6:
Notice that free cash flow is defined for spreadsheet purposes as a
“before interest” figure, and that the discount rate is a
weighted-average cost of capital (WACC). Both spreadsheet
Requirement 7:
If equivalent assumptions are used, the share value estimate
calculated using an abnormal earnings approach will be identical to
Requirement 8:
The share value estimate would have been $19.43 (= $672.11 /
As you might have already guessed, an analyst covering Sonic
Solutions did indeed mistakenly use the wrong share count (34.60
million) in a research report published in June 2010. The initial
report, the analyst discovered the error and issued a revised report
which used the correct share count (51.69 million) but also
concluded that the stock was worth $13 per share. How was this
conclusion supported? The analyst altered the free cash flow
Requirement 9:
It is difficult to discern any large stock price reactions, suggesting
Rovi investors viewed the price as fair. Rovi stock was up 1.0% on
the December 22 announcement date versus 0.3% for the S&P 500.
P6-7. Determining abnormal earnings: Some simple examples
Abnormal earnings (AE) = NOPAT – (r x BVt-1).
Requirement 1:
Requirement 2:
Requirement 3:
NOTE: Higher NOPAT without additional investment (i.e., the same
BVt-1) increases AE.
Requirement 4:
NOTE: Eliminating unproductive assets that do not earn as high a
Requirement 5:
AE increases by $400 (from $2,500 to $2,900). Adding the division
Requirement 6:
AE falls by $250. Adding the new division does not make sense. In
essence, the new division does not earn a high enough rate of