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P6-8. Assigning credit ratings using financial ratios
Requirement 1:
Standard & Poor’s credit analysts would probably assign a credit
Requirement 2:
Requirement 3:
All of the financial ratios for Firm 3 tilt toward the median values for
AAA rated companies when compared to those of Firm 2.
P6-9. Calculating value creation by two companies
Requirement 1:
The abnormal earnings of the two firms for 2013–2017 appear
below.
Company A 2013 2014 2015 2016 2017
Company B
Requirement 2:
Company B created value each year via positive abnormal
Requirement 3:
The return investors earn from a stock depends on the
difference between what must paid to buy the stock—it’s cost
or current market price—and what it will ultimately be worth at
How do these notions apply to company A and B? Company B
has clearly outperformed Company A during the years shown.
Let’s assume that this favorable performance difference is
expected to continue into the future. The performance
differences between A and B are likely to be already reflected
P6-10. Making credit rating changes
Requirement 1:
The company’s credit risk has increased since the first quarter of
Requirement 2:
Standard & Poor’s analysts are likely to assign a credit rating of AA
Requirement 3:
There is a gradual deterioration in credit worthiness throughout
Credit risk deteriorates even further in the second quarter of 2017.
Standard & Poor’s analysts might have concluded that the credit
P6-11. ENRON: Fair value accounting
Requirement 1:
There are several features of the Bravehart structure that were
essential to achieving the fair value accounting profit boost. First,
Enron needed to isolate the Blockbuster contract in a separate
entity (Bravehart partnership) so that the investment bank loan was
not viewed as an Enron obligation and thus as Enron debt. Second,
Enron’s investment in the Bravehart partnership had to be
structured such that consolidation was not required. Back in the
The final piece required for the profit boost involved “monetizing” the
Enron-Blockbuster contract with the aid of an investment bank. The
effectively established the contract’s fair value at $115 million, which
also meant that Bravehart must have a fair value of about $115
million ($115 million for the contract plus $115 million cash from the
Requirement 2:
There are two critical judgments required to estimate the bank
guarantee’s fair value: (1) what is the likelihood that Bravehart will
default on the loan and cause the bank to seek payment directly
from Enron? and (2) how much of the loan balance will be unpaid at
Requirement 3:
Enron’s mark-to-market adjustment to the Bravehart investment
would then have been just $15 million, the difference between
Requirement 4:
This would be an extraordinarily challenging audit task because the
fair value measurement occurs at Level 3, and thus relies on
unobservable inputs. The auditor could turn to independent
estimates of the future net cash flows for the Enron-Blockbuster
contract, but the only third party estimates available would be those
P6-12. Calculating sustainable earnings
Requirement 1:
The original income statements for 2011–2014 appear on the next
page along with the calculation of sustainable earnings for each of
the three years. Except for the transitory revenue of $1 billion in
2014, which was given in the case, all of the adjustments required
Requirement 2:
An interesting conclusion emerges when reported earnings are
compared with sustainable earnings. While the firm’s reported
earnings increased each year from 2011 to 2014, its sustainable
Colonel Electric Inc. (in millions of $) As Reported Earnings Sustainable Earnings Calculation
For Years Ended December 31, 2016 2015 2015 2016
Revenues
Cumulative loss (+ gain) from change in
accounting methods (net of tax) ___(110) 0 _____55 ______0
P6-13. Krispy Kreme Doughnuts: Valuing abnormal earnings
Requirement 1:
Requirement 2:
The value estimate from requirement 1 ($19.62 per share) is
substantially below the market price of the stock ($44.00) in August
Investors may be more optimistic about the company’s profit
Investors and analysts may agree about EPS forecasts over the
next five years, but the terminal growth assumption (3.0%) used
We may have assigned the company a cost of equity capital
that is too large. Given the forecasts used in the valuation
model, a 7% cost of capital (discount rate) will yield a value
The most interesting possibility is that the stock is “overvalued”
at $44 per share. Why might this occur? One reason is that
It is interesting to note that 9 months later (May 2004) the stock was
trading at about $20 per share.
