978-1337614689 Chapter 5 Part 1

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CHAPTER 5

RISK ANALYSIS

Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases

5.1 Interpreting Risk Disclosures. The SEC requires that companies identify the major

risks with Item 1A of Form 10-K. Facebook identifies almost fifty risks. These risks

cover all aspects of its business, such as its users, advertising revenues, user plat-

forms, competition, government regulation, protection of user private information,

5.2 Interpreting the Alternative Decomposition of ROCE with Negative Net

Financial Obligations. Because the firm has more financial assets than financial

obligations, the net financial obligations will be negative. The reformulated balance

Common Equity. However, Net Operating Assets will exceed Common Equity

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5.3 Relation between Current Ratio and Operating Cash Flow to Current Liabili-

ties Ratio. Both ratios use current liabilities in the denominator, although the cur-

5.4 Relation between Current Ratio and Quick Ratio. The current ratio and the

quick ratio both use current liabilities in the denominator. Thus, the explanation

5.5 Relation between Working Capital Turnover Ratios and Cash Flow from

Operations. The steady sales and net income should result in relatively constant

addbacks for depreciation, deferred taxes, and other non-cash expenses. The decrease

5.6 Effect of Transactions on Debt Ratios.

a. The effect of the four transactions on each debt ratio is as follows:

(1) Issue Long-Term Debt for Cash:

(2) Issue Short-Term Debt and Use the Cash Proceeds to Redeem Long-Term

Debt:

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(3) Redeem Short-Term Debt with Cash:

Liabilities to Assets Ratio: decrease

(4) Issue Long-Term Debt and Use the Cash Proceeds to Repurchase Common

Stock:

b. The four debt ratios move in the same direction except for transactions that in

whole or in part involve cash and short-term debt [Transactions (2) and (3)].

5.7 Interest Coverage Ratio as a Measure of Long-Term Solvency Risk. The

interest coverage ratio compares net income before interest and income taxes to in-

5.8 Interest Coverage Ratio as a Measure of Short-Term Liquidity Risk. The

interest coverage ratio uses earnings before interest, interest expense, and income

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5.9 Interpreting Operating Cash Flow to Current and Total Liabilities Ratios.

5.10 Interpreting Altman’s Z-score Bankruptcy Prediction Model. The coefficients

are not relative weights of importance. The size of the coefficient varies in part

because of the usual size of the variable measured. Earnings before interest and

5.11 Market Equity Beta in Relation to Systematic and Nonsystematic Risk. The

characterization of nonsystematic risk as firm-specific risk is a misnomer because

5.12 Levels versus Changes in Altman’s Bankruptcy Prediction Model. One might

argue that there is no inherent advantage of a levels model over a change model for

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5.13 Calculating and Interpreting Risk Ratios.

a. Current Ratio: $1,718/$1,149 = 1.5

b. The changes in the short-term liquidity risk ratios present mixed signals. Hasbro

has built up its balance in cash so that it has more days of revenue held in cash.

This trend provides Hasbro with liquidity and reduces its short-term liquidity

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unduly risky in terms of short-term liquidity risk at the end of Year 4. Its current

and quick ratios are at healthy levels and its days inventory and accounts paya-

ble have been steady for the past two years. The only troublesome aspect is the

declining operating cash flow to current liabilities ratio. This ratio is not at a

level of extreme concern in Year 4, but a continuation of this trend could

become troublesome.

c. Hasbro’s long-term solvency risk has decreased significantly during the three-

year period. Debt levels have declined as Hasbro has redeemed debt. (See

5.14 Calculating and Interpreting Risk Ratios.

a. Current Ratio: $652/$414 = 1.6

b. The short-term liquidity risk of Abercrombie & Fitch appears low, although it

deteriorated between fiscal Year 4 and fiscal Year 5. Using cash to measure only

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levels as well, although both ratios declined sharply in fiscal Year 5. The decline

occurs because of a decline in cash and marketable securities, additional short-

term borrowing, and a stretching out of payments to suppliers. Despite the

additional short-term borrowing and stretching of payments to suppliers, the

operating cash flow to current liabilities ratio remained steady and well above

the 40% threshold for a healthy company. The one worrisome trend is the

increase in the number of days inventory is held. The products of Abercrombie

& Fitch are trendy. A buildup of inventory is undesirable. However, the increase

in days inventory may be simply due to stocking the rapid growth in new stores.

c. The long-term solvency risk of Abercrombie & Fitch appears to be moderate

and worsened between Year 4 and Year 5. The debt ratios are on the high side at

5.15 Interpreting Risk Ratios.

a. Coca-Cola’s short-term liquidity risk is low and did not change significantly

during the three-year period. From the viewpoint of short-term liquidity risk,

b. Coca-Cola’s long-term solvency risk decreased during the three-year period. Its

debt ratios generally declined, particularly its long-term debt ratios. Operating

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5.16 Computing and Interpreting Risk and Bankruptcy Prediction Ratios for a

Firm That Declared Bankruptcy.

a. (1) Current Ratio:

(2) Operating Cash Flow to Current Liabilities Ratio:

(3) Liabilities to Assets Ratio:

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

(5) Operating Cash Flow to Total Liabilities Ratio:

(6) Interest Coverage Ratio:

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b. Altman’s Z-Score

2000

Working Capital/Assets: 1.2[($3,205 – $5,245)/$21,931] ………………… (0.112)

2001

Working Capital/Assets: 1.2[($3,567 – $6,403)/$23,605] ………………… (0.144)

2002

Working Capital/Assets: 1.2[($3,902 – $6,455)/$24,720] ………………… (0.124)

2003

Working Capital/Assets: 1.2[($4,550 – $6,157)/$25,939] ………………… (0.074)

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2004

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

5.17 Alternative ROCE Decomposition.

= 22.5%

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

Balance Sheet Line Items

Operating assets Year 2 Year 1

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Less: operating liabilities

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

Financing obligations

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

Common equity

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

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

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

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

5.18 Computing and Interpreting Risk and Bankruptcy Prediction Ratios for a

Firm That Was Acquired.

a. (1) Current Ratio:

(2) Operating Cash Flow to Current Liabilities Ratio:

(3) Liabilities to Assets Ratio:

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

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

(5) Operating Cash Flow to Total Liabilities Ratio:

Year 1: $567/0.5($7,516 + $8,738) = 0.070

(6) Interest Coverage Ratio:

Year 4: $640/$30 = 21.3

b. Altman’s Z-Score

Year 1

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

Year 2

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Year 3

Year 4

Year 5

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

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

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5.19 Computing and Interpreting Bankruptcy Prediction Ratios.

a. Altman’s Z-Score for Best Buy

2007

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

2008

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

Altman’s Z-Score for Circuit City

2007

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

2008

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

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

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