978-1285190907 Chapter 5 Part 2

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Chapter 5

Risk Analysis

5-11

in whole or in part.

2004

Working Capital/Assets: 1.2[($3,606 – $5,941)/$21,801] ………………… (0.129)

Retained Earnings/Assets: 1.4[($4,373)/$21,801] …………………………… (0.281)

EBIT/Assets: 3.3[($3,168)/$21,801]……………………………………………… (0.480)

Mkt. Value Equity/Liabilities: .6[(139.8 × $7.48)/$27,320] …………….. 0.023

Sales/Assets: 1.0($15,002/$21,801)………………………………………………. 0.688

Z-Score …………………………………………………………………………………… (0.179)

Probability of Bankruptcy ……………………………………………………………. 88.1%

c. The risk ratios are at very weak levels throughout the five years, and consistent

with these ratio results, the Altman Z-score model shows a high probability of

bankruptcy in all years. One interesting insight is that even in 2000, when Delta

Air Lines was profitable and its deteriorating financial health had not yet

ramped up, it showed weak risk ratios and a fairly high probability of

bankruptcy. The working capital and asset turnover ratios in the Altman model

did not show much deterioration over the five-year period. However, its

declining profitability contributed to increasing operating cash flow problems,

lowered shareholders’ equity, and increased liabilities. The deterioration in

2004 was particularly pronounced. In one sense, the Altman model shows why

the probability of bankruptcy is so high for Delta Air Lines. On the other hand,

one might say that Delta Air Lines remained out of bankruptcy for longer than

the Altman model would predict. Airlines are able to weather financial storms

somewhat longer than manufacturing firms because lenders can rely on the

collateral provided by airplanes and not force liquidation. In addition,

continuing to offer flights is critical to keeping customers, even if the flights are

operated at a net loss. However, despite attempts at cost cutting through 2004,

the airline filed for bankruptcy on September 14, 2005.

5.17 Alternative ROCE Decomposition.

a. ROCE = Net Income to Common/Average Common Shareholders’ Equity

= $1,085,999/0.5($5,125,625 + $4,525,175)

= 22.5%

b. The following shows the allocation of balance sheet and income statement line

items to operating and financing activities:

Operating assets 2012 2011

Cash and equivalents $ 597,461 $ 341,228

Accounts receivable, net 1,222,345 1,120,246

Inventories 1,354,158

1,453,645

Deferred income taxes 140,515 106,717

Other current assets 135,104 166,108

Property, plant, and equipment 828,218 737,451

Intangible assets 2,917,058 2,958,463

Goodwill 2,009,757

2,023,460

Other assets 428,405 405,808

Chapter 5

Risk Analysis

5-12

in whole or in part.

Less: operating liabilities

Accounts payable $ 562,638 $ 637,116

Accrued liabilities 754,142 744,486

Other liabilities 1,346,018 1,290,138

Net operating assets $6,970,223 $6,641,386

Financing obligations

Short-term borrowings $ 12,559 $ 281,686

Current portion of long-term debt 402,873 2,744

Other, net 1,429,166 1,831,781

Noncontrolling interests — (816)

Financing obligations $1,844,598 $2,115,395

Common equity

Common stock $ 110,205 $ 110,557

Additional paid-in-capital 2,527,868 2,316,107

Accumulated other comprehensive income (loss) (453,895) (421,477)

Retained earnings 2,941,447 2,520,804

Common equity $5,125,625 $4,525,991

Total financing obligations and common equity $6,970,223 $6,641,386

Income statement

Net sales $10,766,020 $9,365,477

Royalty income 113,835 93,755

Cost of goods sold (5,817,880) (5,128,602)

Marketing, administrative and general expenses (3,596,708) (3,085,839)

Operating profit $ 1,465,267 $1,244,791

Interest income $ 3,353 $ 4,778

Other income (expense), net 46,860 (7,248)

Adjusted income before income taxes $1,515,480 $1,242,321

Provision for income taxes at effective rate 357,839 292,623

Net operating profit after tax $1,157,641 $ 949,698

Financing expense

Interest expense $93,605 $77,578

× (1 – Effective Tax Rate) × 76.4% × 76.4%

Net interest expense $71,503 $59,305

Net (income) loss attributable to noncontrolling

interests 139

2,304

Net financing expense (after tax) $71,642 $61,609

Net income to common $1,085,999 $888,089

Effective tax rate 23.6% 23.6%

Chapter 5

Risk Analysis

5-13

in whole or in part.

(1) Net Operating Assets [see above] = $6,970,223

(2) Net Financing Obligations [see above] = $1,844,598

(3) Common Equity [see above] = $5,125,625

(4) NOPAT [see above] = $1,157,641

(5) Net Financing Expense (after tax) [see above] = $71,642

(6) Operating ROA = NOPAT/Average Net Operating Assets

= $1,157,641/0.5($6,970,223 + $6,641,386)

= 17.0%

(7) Leverage = Average Financing Obligations/Average Common Equity

= 0.5($1,844,598 + $2,115,395)/0.5($5,125,625 + $4,525,991)

= 0.41

(8) Net Borrowing Rate = Net Financing Expense (after tax)/Average Net

Financing Obligations

= $71,642/0.5($1,844,598 + $2,115,395)

= 3.6%

(9) Spread = Operating ROA – Net Borrowing Rate

= 17.0% – 3.6%

= 13.4%

Together, the alternative ROCE decomposition is as follows:

ROCE = Operating ROA + (Leverage × Spread)

= 17.0% + (0.41 × 13.4%)

= 22.5%

5.18 Computing and Interpreting Risk and Bankruptcy Prediction Ratios for a

Firm That Was Acquired.

a. (1) Current Ratio:

2005: $7,191/$4,766 = 1.51

2005: $8,460/$6,165 = 1.37

2007: $9,328/$5,451 = 1.71

2008: $7,834/$5,668 = 1.38

2009: $6,864/$5,621 = 1.22

(2) Operating Cash Flow to Current Liabilities Ratio:

2006: $567/0.5($4,766 + $6,165) = 0.104

2007: $958/0.5($6,165 + $5,451) = 0.165

2008: $1,329/0.5($5,451 + $5,668) = 0.239

2009: $457/0.5($5,668 + $5,621) = 0.081

(3) Liabilities to Assets Ratio:

2005: $7,516/$14,190 = 0.530

2006: $8,738/$15,082 = 0.579

2007: $8,659/$15,838 = 0.547

2008: $8,752/$14,340 = 0.610

2009: $7,927/$11,232 = 0.706

Chapter 5

Risk Analysis

5-14

in whole or in part.

(4) Long-Term Debt to Long-Term Capital Ratio:

2005: $1,123/($1,123 + $6,674) = 0.144

2006: $575/($575 + $6,344) = 0.083

2007: $1,264/($1,264 + $7,179) = 0.150

2008: $1,265/($1,265 + $5,588) = 0.185

2009: $695/($695 + $3,305) = 0.174

(5) Operating Cash Flow to Total Liabilities Ratio:

2006: $567/0.5($7,516 + $8,738) = 0.070

2007: $958/0.5($8,738 + $8,659) = 0.110

2008: $1,329/0.5($8,659 + $8,752) = 0.153

2009: $457/0.5($8,752 + $7,927) = 0.055

(6) Interest Coverage Ratio:

2005, 2006, and 2009: The interest coverage ratio is negative and

therefore is not covered.

2007: $622/$39 = 15.9

2008: $640/$30 = 21.3

b. Altman’s Z-Score

2005

Working Capital/Assets: 1.2[($7,191 – $4,766)/$14,190]………………… 0.205

Retained Earnings/Assets: 1.4($1,387/$14,190)……………………………… 0.137

EBIT/Assets: 3.3[$(150)/$14,190]………………………………………………… (0.035)

Mkt. Value Equity/Liabilities: 0.6[(852 × $14.92)/$7,516] ……………… 1.015

Sales/Assets: 1.0($11,070/$14,190)………………………………………………. 0.780

Z-Score …………………………………………………………………………………… 2.102

Probability of Bankruptcy ……………………………………………………………. 13.5%

2006

Working Capital/Assets: 1.2[($8,460 – $6,165)/$15,082]………………… 0.183

Retained Earnings/Assets: 1.4[$(257)/$15,082] ……………………………… (0.024)

EBIT/Assets: 3.3[($(620)/$15,082] ………………………………………………. (0.136)

Mkt. Value Equity/Liabilities: 0.6[(876 × $16.60)/$8,738] ……………… 0.998

Sales/Assets: 1.0($13,068/$15,082)………………………………………………. 0.866

Z-Score …………………………………………………………………………………… 1.888

Probability of Bankruptcy ……………………………………………………………. 18.7%

Chapter 5

Risk Analysis

5-15

in whole or in part.

2007

Working Capital/Assets: 1.2[($9,328 – $5,451)/$15,838] ………………… 0.294

Retained Earnings/Assets: 1.4($189/$15,838) ………………………………… 0.017

EBIT/Assets: 3.3($622/$15,838) ………………………………………………….. 0.130

Mkt. Value Equity/Liabilities: 0.6[(884 × $20.76)/$8,659] ……………… 1.271

Sales/Assets: 1.0($13,873/$15,838) ………………………………………………. 0.876

Z-Score …………………………………………………………………………………… 2.587

Probability of Bankruptcy ……………………………………………………………. 5.6%

2008

Working Capital/Assets: 1.2[($7,834 – $5,668)/$14,340] ………………… 0.181

Retained Earnings/Assets: 1.4($430/$14,340) ………………………………… 0.042

EBIT/Assets: 3.3($640/$14,340) ………………………………………………….. 0.147

Mkt. Value Equity/Liabilities: 0.6[(752 × $10.88)/$8,752] ……………… 0.561

Sales/Assets: 1.0($13,880/$14,340) ………………………………………………. 0.968

Z-Score …………………………………………………………………………………… 1.899

Probability of Bankruptcy ……………………………………………………………. 18.4%

2009

Working Capital/Assets: 1.2[($6,864 – $5,621)/$11,232]………………… 0.133

Retained Earnings/Assets: 1.4[$(2,055)/$11,232] …………………………… (0.256)

EBIT/Assets: 3.3[$(2,166)/$11,232]……………………………………………… (0.636)

Mkt. Value Equity/Liabilities: 0.6[(752 × $9.22)/$7,927] ……………….. 0.525

Sales/Assets: 1.0($11,449/$11,232)………………………………………………. 1.019

Z-Score …………………………………………………………………………………… 0.784

Probability of Bankruptcy ……………………………………………………………. 58.5%

c. Sun Microsystems’ problems were primarily operating and not financing despite

fluctuating debt levels and an increase in liabilities to assets. Firms in

technology-based industries tend not to take on substantial debt, particularly

long-term debt. Such firms have short product life cycles and few assets to serve

as collateral for borrowing. The deterioration of interest coverage ratio in 2009

was due to the lack of earnings and cash flows from operations and not from

being overly burdened with debt. The firm appeared to recover from poor

profitability in 2007, but experienced another significant decrease in profitability

and cash flow in 2009. Current liabilities to current assets and total liabilities to

total assets increased in 2009. The operating problems caused its Z-score to drop

from the gray to the high-probability area in 2009. As stated in the question, Sun

did not go bankrupt, but the company was acquired by Oracle in 2010. This

problem highlights the fact that bankruptcy predication models also may be

useful in predicting takeover targets.

Chapter 5

Risk Analysis

5-16

in whole or in part.

5.19 Computing and Interpreting Bankruptcy Prediction Ratios.

a. Altman’s Z-Score for Best Buy

2006

Working Capital/Assets: 1.2[($9,081 – $6,301)/$13,570] ………………… 0.246

Retained Earnings/Assets: 1.4($5,507/$13,570) ……………………………… 0.568

EBIT/Assets: 3.3($2,161/$13,570) ……………………………………………….. 0.526

Mkt. Value Equity/Liabilities: 0.6[(481 × $44.97)/$7,369] ……………… 1.760

Sales/Assets: 1.0($35,934/$13,570) ………………………………………………. 2.648

Z-Score …………………………………………………………………………………… 5.747

Probability of Bankruptcy ……………………………………………………………. 0.0%

2007

Working Capital/Assets: 1.2[($7,342 – $6,769)/$12,758] ………………… 0.054

Retained Earnings/Assets: 1.4($3,933/$12,758) ……………………………… 0.432

EBIT/Assets: 3.3($2,290/$12,758) ……………………………………………….. 0.592

Mkt. Value Equity/Liabilities: 0.6[(411 × $42)/$8,274] ………………….. 1.252

Sales/Assets: 1.0($40,023/$12,758) ………………………………………………. 3.137

Z-Score …………………………………………………………………………………… 5.467

Probability of Bankruptcy ……………………………………………………………. 0.0%

Altman’s Z-Score for Circuit City

2006

Working Capital/Assets: 1.2[($2,884 – $1,714)/$4,007] ………………….. 0.350

Retained Earnings/Assets: 1.4($1,336/$4,007) ……………………………….. 0.467

EBIT/Assets: 3.3($22/$4,007) ……………………………………………………… 0.018

Mkt. Value Equity/Liabilities: 0.6[(171 × $18.47)/$2,216] ……………… 0.854

Sales/Assets: 1.0($12,430/$4,007) ………………………………………………… 3.102

Z-Score …………………………………………………………………………………… 4.790

Probability of Bankruptcy ……………………………………………………………. 0.0%

2007

Working Capital/Assets: 1.2[($2,440 – $1,606)/$3,746]………………….. 0.267

Retained Earnings/Assets: 1.4($981/$3,746) …………………………………. 0.367

EBIT/Assets: 3.3[$(352)/$3,746]………………………………………………….. (0.310)

Mkt. Value Equity/Liabilities: 0.6[(169 × $4.38)/$2,243] ……………….. 0.198

Sales/Assets: 1.0($11,744/$3,746) ………………………………………………… 3.135

Z-Score …………………………………………………………………………………… 3.656

Probability of Bankruptcy ……………………………………………………………. 0.0%

b. The Z-scores of Best Buy were in the range indicating a low probability of

bankruptcy in both years. High profitability and high turnover explain the high

Z-scores. The increase in the Z-score between 2006 and 2007 results from an

increase in the EBIT to assets ratio. The increase in asset turnover is consistent

Chapter 5

Risk Analysis

5-17

in whole or in part.

with Best Buy’s supply chain transformation and inventory management. The

new strategy focuses on pinpointing customer needs rather than pushing large

volumes.

c. The Z-scores of Circuit City also were in the range indicating a low probability

of bankruptcy in both years. The firm’s net income was negative in both years

and decreased significantly between 2006 and 2007. Retained earnings were

positive in both years, but decreased, as did current and total assets. The de-

crease in retained earnings and negative EBIT are a principal factor accounting

for the firm’s Z-score falling, but because assets also have declined, the Z-score

remains in the low probability of bankruptcy area.

d. The Z-scores did not predict that Circuit City or Best Buy would file for bank-

ruptcy in 2008. The Z-scores of Circuit City were lower; thus, its probability of

bankruptcy was technically higher than what the corresponding Z-scores of Best

Buy showed. Three positive signals for Best Buy included (1) a sales increase

between 2006 and 2007, in contrast to the sales decrease for Circuit City; (2) a

higher asset turnover for Best Buy; and (3) a much higher market capitalization

for Best Buy compared to Circuit City. Despite the high Z-scores, the crash of

Circuit City’s market price per common share between 2007 and 2008 sug-

gested that the market perceived the firm’s problems as not correctable or that

there were other indicators of bankruptcy than those captured by the Altman

Z-score.

5.20 Applying and Interpreting Bankruptcy Prediction Models.

a. Altman’s Z-Score for ABC Auto

Year 5

Working Capital/Assets: 1.2[($195,417 – $176,000)/$662,262] ……….. 0.035

Retained Earnings/Assets: 1.4[($115,596)/$662,262] ……………………… (0.244)

EBIT/Assets: 3.3($40,258/$662,262) ……………………………………………. 0.201

Mkt. Value Equity/Liabilities: 0.6[(6,995 × $100.50)/$624,817] ……… 0.675

Sales/Assets: 1.0($631,832/$662,262) …………………………………………… 0.954

Z-Score …………………………………………………………………………………… 1.621

Probability of Bankruptcy ……………………………………………………………. 26.7%

Year 6

Working Capital/Assets: 1.2[($156,226 – $163,384)/$617,705] ……….. (0.014)

Retained Earnings/Assets: 1.4[($184,308)/$617,705] ……………………… (0.418)

EBIT/Assets: 3.3($11,012/$617,705) ……………………………………………. (0.059)

Mkt. Value Equity/Liabilities: 0.6[(7,014 × $85)/$648,934] ……………. 0.551

Sales/Assets: 1.0($824,835/$617,705) …………………………………………… 1.335

Z-Score …………………………………………………………………………………… 1.395

Probability of Bankruptcy ……………………………………………………………. 34.6%

Chapter 5

Risk Analysis

5-18

in whole or in part.

Altman’s Z-Score for XYZ Comics

Year 5

Working Capital/Assets: 1.2[($490,600 – $318,100)/$1,226,310] …….. 0.169

Retained Earnings/Assets: 1.4($114,100/$1,226,310) ……………………… 0.130

EBIT/Assets: 3.3($25,100/$1,226,310) …………………………………………. 0.068

Mkt. Value Equity/Liabilities: 0.6[(101,703 × $10.625)/$948,100] ….. 0.684

Sales/Assets: 1.0($828,900/$1,226,310) ………………………………………… 0.676

Z-Score …………………………………………………………………………………… 1.727

Probability of Bankruptcy ……………………………………………………………. 23.4%

Year 6

Working Capital/Assets: 1.2[($399,500 – $345,800)/$844,000] ……….. 0.076

Retained Earnings/Assets: 1.4[($350,300)/$844,000] ……………………… (0.581)

EBIT/Assets: 3.3[($370,200)/$844,000]………………………………………… (1.447)

Mkt. Value Equity/Liabilities: 0.6[(101,810 × $1.625)/$999,700] ……. 0.099

Sales/Assets: 1.0($745,400/$844,000) …………………………………………… 0.883

Z-Score …………………………………………………………………………………… (0.970)

Probability of Bankruptcy ……………………………………………………………. 97.6%

b. The Z-scores for ABC Auto were in the range indicating a high probability of

bankruptcy in both fiscal Year 5 and fiscal Year 6. The firm has negative re-

tained earnings, indicating a history of net losses. The negative retained earn-

ings is a principal factor accounting for the firm’s Z-score falling in the high

probability of bankruptcy range. The Z-score decreased significantly between

Year 5 and Year 6. The firm operated at a net loss in fiscal Year 6, after generat-

ing net earnings in the preceding two years. The net loss in fiscal Year 6 re-

duced working capital and hurt the short-term liquidity ratios. Sales declined

between fiscal Year 5 and fiscal Year 6 and hurt the asset turnover.

c. The Z-scores of XYZ Comics fall in the range indicating a high probability of

bankruptcy in both years. Weak profitability, high levels of liabilities to assets,

and slow asset turnovers explain the low Z-scores. The decline in the Z-scores

between fiscal Year 5 and fiscal Year 6 results from substantially reduced

profitability. Sales declined between the two years, consistent with the effect of

reduced youth readership and interest in trading cards.

d. Application of the bankruptcy prediction model suggests that XYZ Comics is

more likely to file for bankruptcy during fiscal Year 7. The Z-score of XYZ

Comics is lower and its probability of bankruptcy is higher for fiscal Year 6

than the corresponding ratio for ABC Auto. Three positive signals for ABC

Auto include (1) a sales increase between fiscal Year 5 and fiscal Year 6, in

contrast to the sales decrease for XYZ Comics; (2) a higher assets turnover for

ABC Auto; and (3) a much higher market price per common share for ABC

Chapter 5

Risk Analysis

5-19

in whole or in part.

Auto, suggesting that the market perceives the firm’s problems as correctable or

the market does not perceive the bankruptcy risk of the firm. In addition, the

automobile industry is a more viable industry long-term compared to comic

books and trading cards.

Interestingly, both of these firms filed for bankruptcy during fiscal Year 7.

5.21 Applying and Interpreting Bankruptcy Prediction Models.

a. Altman’s Z-Score for Tribune Company

2006

Working Capital/Assets: 1.2[($1,346 – $2,549)/$13,401] ………………… (0.108)

Retained Earnings/Assets: 1.4($3,138/$13,401) ……………………………… 0.328

EBIT/Assets: 3.3($1,085/$13,401) ……………………………………………….. 0.267

Mkt. Value Equity/Liabilities: 0.6[(307 × $58.69)/$9,081] ……………… 1.190

Sales/Assets: 1.0($5,444/$13,401) ………………………………………………… 0.406

Z-Score …………………………………………………………………………………… 2.083

Probability of Bankruptcy ……………………………………………………………. 13.9%

2007

Working Capital/Assets: 1.2[($1,385 – $2,190)/$13,150] ………………… (0.073)

Retained Earnings/Assets: 1.4[$(3,474)/$13,150] …………………………… (0.370)

EBIT/Assets: 3.3($619/$13,150) ………………………………………………….. 0.155

Mkt. Value Equity/Liabilities: 0.6[(239 × $45.04)/$16,664] ……………. 0.388

Sales/Assets: 1.0($5,063/$13,150) ………………………………………………… 0.385

Z-Score …………………………………………………………………………………… 0.485

Probability of Bankruptcy ……………………………………………………………. 69.7%

Altman’s Z-Score for Washington Post

2006

Working Capital/Assets: 1.2[($935 – $812)/$5,381] ……………………….. 0.027

Retained Earnings/Assets: 1.4($4,120/$5,381) ……………………………….. 1.072

EBIT/Assets: 3.3($544/$5,381) ……………………………………………………. 0.334

Mkt. Value Equity/Liabilities: 0.6[(10 × $711.53)/$2,222] ……………… 1.921

Sales/Assets: 1.0($3,905/$5,381) ………………………………………………….. 0.726

Z-Score …………………………………………………………………………………… 4.080

Probability of Bankruptcy ……………………………………………………………. 0.1%

Chapter 5

Risk Analysis

5-20

in whole or in part.

2007

Working Capital/Assets: 1.2[($995 – $1,013)/$6,005] …………………….. (0.004)

Retained Earnings/Assets: 1.4($4,330/$6,005) ……………………………….. 1.010

EBIT/Assets: 3.3($505/$6,005) ……………………………………………………. 0.278

Mkt. Value Equity/Liabilities: 0.6[(10 × $759.25)/$2,543] ……………… 1.791

Sales/Assets: 1.0($4,180/$6,005) ………………………………………………….. 0.696

Z-Score …………………………………………………………………………………… 3.771

Probability of Bankruptcy ……………………………………………………………. 0.4%

b. Altman’s Z-score model indicates an increasing probability of bankruptcy for

Tribune Company. The Z-score increased significantly between 2006 and 2007.

The Z-score is in the high probability of bankruptcy area in 2007. The change in

Z-score is largely due to lower earnings, higher liabilities, and a reduced stock

price. However, the MVE/Liabilities and RE/Assets components signal a

serious bankruptcy risk.

c. Altman’s Z-score model indicates a low probability of bankruptcy for Washing-

ton Post in both years. Three positive signals for Washington Post include (1) a

sales increase between 2006 and 2007, (2) an increase in retained earnings, and

(3) an increasing market price per common share. The Z-score has decreased

slightly due to a small decrease in working capital.

d. Altman’s bankruptcy prediction model suggested that there was a high probabil-

ity that the Tribune Company would file for bankruptcy in 2008. There was

very low probability that Washington Post would file for bankruptcy in 2008.

Even though Tribune Company had assets greater than two times Washington

Post’s assets, Tribune Company had lower income and significantly lower re-

tained earnings. The Tribune Company had a larger asset base and thus a very

poor asset turnover ratio compared to that of Washington Post.

5.22 Reformulating Financial Statements, Preparing an Alternative Decomposition

of ROCE, and Assessing Financial Flexibility.

a. ROCE: $114,524/0.5($1,506,024 + $1,458,804) = 7.73%

b. Effective Tax Rate: $91,995/$206,519 = 44.55%

NOPAT: ($236,238 + $6,697) × (1 – 44.55%) = 134,718

Net Financing Expense (after tax): $36,416 × (1 – 44.55%) = $20,194

Operating Profit Margin: $134,718/$7,953,912 = 1.69%

Net Operating Assets Turnover: $7,953,912/0.5($2,435,194 + $2,219,672) = 3.42

Operating ROA: $134,718/0.5($2,435,194 + $2,219,672) = 5.79%

Leverage: 0.5($929,170 + $760,868)/0.5($1,506,024 + $1,458,804) = 0.57

Spread: 5.79% – [$20,194/.5($929,170 + $760,868)] = 5.79% – 2.39% = 3.40%

ROCE = Operating ROA + Leverage × Spread

= 5.79% + (0.57 × 3.40%) = 7.73%