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Financial Reporting and Analysis (7th Ed.)
Chapter 6 Solutions
The Role of Financial Information in Valuation,
Cash Flow Analysis, and Credit Risk Assessment
Cases
Cases
C6-1. Illinois Tool Works: Abnormal earnings valuation
Requirements 1 and 2:
The template solution (shown on the next page) yields an estimated stock price of $36.08 per share. This
estimate is considerably below the company’s trading range of $56-$64 in the first quarter of Year 4. One
Requirement 3:
When forecasted ROCE is raised to 16%, the value estimate increases to $59.79. This amount corresponds
6-1
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6-2
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C6-2. Sunny Day Stores Inc. : Analyzing debt covenants and
financial distress
Note to instructors: This is a challenging case based on a
real company, Sunshine Junior Stores, Inc. As a result,
some instructors find that it is best suited for class
discussion of the issues surrounding loan renegotiations
Requirement 1:
With regard to the amount of collateral, given that Sunny
Day violated its earlier lending agreements, lenders are
likely to demand collateral in an amount equal to face value
of the debt.
The revised lending agreement stated that: The
Company will pledge as collateral its interest in
Requirement 2:
The fact that Sunny Day defaulted on the earlier lending
agreement is a clear indication that the company’s credit
risk has increased. To compensate for the added risk,
lenders often require a higher interest rate.
The actual revised lending agreement stated the
following: The interest rates on the loan agreements will
6-3
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consent of McGraw-Hill Education.
be increased to 9.43% and prime plus 1.5% for Prudential
and First Florida, respectively.
Requirement 3:
As stated in the revised lending agreement, lenders could
require the company to use the proceeds from any asset
sale to reduce outstanding debt. In addition to limitations on
The actual revised lending agreement stated the
following (with dates changed to correspond to those
in the case): Additional principal reductions in the amount
Requirement 4:
This will be a difficult question for students to answer in a
precise fashion. We recommend making the following point
before sharing the actual revisions with them. Lenders are
The actual revised lending agreement stated the
following: The new financial covenants, all calculated
based on inventories accounted for on a FIFO basis, are as
follows:
Minimum FIFO
Fixed
Coverage
Working
Ratio, as
6-4
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consent of McGraw-Hill Education.
Period ending Net Worth Capital
(deficit) defined
March 2018 $20,000,000
($5,500,000) 1.30:1.0
Note that the revised covenants are based on FIFO
inventory values even though Sunny Day uses LIFO for
financial reporting purposes (see the balance sheet). One
Requirement 5:
Sunny Day defaulted on the earlier loan and is clearly
experiencing some financial difficulty. Allowing the company
company should not be allowed to resume the dividend.
The actual revised lending agreement stated the
following: Negative covenants in the Company’s debt
agreements prohibit the payment of dividends.
C6-3. Microsoft Corporation: Unearned revenues and earnings
management
6-5
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consent of McGraw-Hill Education.
Requirement 1:
The net profit margin is equal to net income divided by
sales. For Microsoft, the rates are:
Fourth quarter of 1996:
Fourth quarter of 1997:
Year 1996:
Year 1997:
By any standard, Microsoft’s net profit margin is very
Requirement 2:
Microsoft just exceeded analysts’ expectations in the fourth
Requirement 3:
Ending balance = Beginning balance + additions -
reductions
Requirement 4:
Income effect per share = increase in income/shares used
Requirement 5:
Ending balance = Beginning balance + additions -
reductions
$1,418 = $560 + additions - $188.0; additions = $1,046.0
Requirement 6:
Income effect per share = increase in income/shares used
to calculate fourth quarter EPS
6-6
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= $1046.0/1,312
= $0.80 or 80 cents
Requirement 7:
This answer is the balance in the account of $1,418 divided
Requirement 8:
In periods when the firm’s earnings are less than
management would like to report, the balance in the
In periods when the firm is doing very well, management
Requirement 9:
This is a tough task for the analyst. One thing that the
analyst might do is monitor the firm’s balance sheets on a
quarter-to-quarter basis, paying special attention to the
Unearned revenues account. What the analyst could watch
for are large increases in the account balance in periods
when the firm is doing very well, and perhaps, more
Requirement 10:
No. It might very well be that the firm’s managers believe
that the proper matching of revenues and expenses
requires that some of the revenues collected from
customers in a given year be deferred and recognized in a
later period when product upgrades are delivered and/or
various types of services are provided.
6-7
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consent of McGraw-Hill Education.
6-8
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consent of McGraw-Hill Education.
