FSAV 6e - Errata 041323

1-43
Module 1 | Framework for Analysis and Valuation © Cambridge Business Publishers
Required
a. Prepare the income statement for the year ended April 30, 2018.
b. Prepare the balance sheet as of April 30, 2018.
c. Prepare the statement of cash flows for the year ended April 30, 2018.
d. Compute ROA.
e. Compute profit margin (PM).
f. Compute asset turnover (AT).
g. Compute ROE.
LO6 P1-47. Using Historical Numbers to Forecast Financial Statement Items
ABBOTT Abbott Laboratories reports the following revenue for fiscal years 2006 through 2019.
LABORATORIES
INC (ABT)
Year Revenue in $ millions Year Revenue in $ millions
2006�� $22,476 2013�� $21,848
2007�� 25,914 2014�� 20,247
2008�� 29,528 2015�� 20,405
2009�� 30,765 2016�� 20,853
2010�� 35,167 2017�� 27,390
2011�� 38,851 2018�� 30,578
2012�� 39,874 2019�� 31,904
Required
a. Calculate year-over-year change in Revenue for 2005 2007 through 2019.
b. Assume that an analyst uses the most current year’s revenue growth to forecast next year’s revenue.
Use that method to forecast 2012 revenue for Abbott Labs.
c. Assume that an analyst uses the average of the prior five years’ revenue growth to forecast next year’s
revenue. Use that method to forecast 2012 revenue for Abbott Labs.
d. Compare the forecasts from part b and part c, above. Which method provided the better forecast?
e. Consider revenue growth in 2013. Suggest two reasons for what we observe.
f. In 2016, Abbott Labs announced that it would acquire another pharmaceutical company in 2017. How
would this affect an analyst’s forecast of 2017 revenue?
LO3 P1-48. Formulating a Statement of Stockholders’ Equity from Raw Data
WINNEBAGO Winnebago Industries Inc. reports the following selected information for its fiscal year ended August
INDUSTRIES 25, 2018 ($ thousands).
INC. (WGO)
mework
Ho
Contributed capital, August 26, 2017 �� $ 106,289
MBC Treasury stock, August 26, 2017�� (342,730)
Retained earnings, August 26, 2017�� 679,138
Accumulated other comprehensive (loss) income, August 26, 2017�� (1,023)
During fiscal year 2018, Winnebago reported the following.
Issuance of stock�� $ 5,822 Cash dividends �� $12,738

Repurchase of stock for resale�� 4,644 Other comprehensive income (loss)�� 1,915
Net income �� 102,416
Required
Use this information to prepare the statement of stockholders’ equity for Winnebago’s fiscal year ended
August 25, 2018.
LO5 P1-49. Computing, Analyzing, and Interpreting Return on Equity and Return on Assets
LOGITECH Following are summary financial statement data for Logitech International for 2016 through 2018.
INTER-
NATIONAL
(LOGI) $ thousands 2018 2017 2016
Ho
mework Sales�� $2,566,863 $2,221,427 $2,018,100
MBC Net income �� 208,542 205,876 119,317
Total assets�� 1,743,157 1,498,677 1,324,147
Equity�� 1,050,557 856,111 759,948
Required
a. Compute the return on assets (ROA) for 2018 and 2017.
b. Compute the profit margin (PM) for 2018 and 2017.
c. Compute the asset turnover (AT) for 2018 and 2017.
01_fsav6e_mod01.indd 43 9/28/20 4:14 PM

1-51 Module 1 | Framework for Analysis and Valuation © Cambridge Business Publishers
Review
Review 1-5---Solution
1-4—Solution
a. $ millions
Net sales�� $265,595

Net income �� 59,531
Average assets�� 370,522
ROA = Net income / Average assets = $59,531 / $370,522�� 16.1%

Asset turnover (AT) = Net sales / Average assets = $265,595 / $370,522�� 0.72
Profit margin (PM) = Net income / Net sales = $59,531 / $265,595 �� 22.4%
b. ROE = Net income/Average stockholders’ equity = $59,531/$120,597 = 49.4%.

Review
Review 1-4---Solution
1-5—Solution
1 . a. II
b. I
c. III
d. I
e. II
f. III
2. Both of these companies are strong, but Apple’s ROA is higher than Samsung’s. While asset turnover rates are com-
parable, Apple’s profitability is higher.
$ millions Apple Samsung
Average assets�� $370,522 W320,555

Revenue �� 265,595 243,771
Net income �� 59,531 44,345
ROA = Net income / Average assets�� 16.1% 13.8%

Asset turnover (AT) = Revenue / Average assets�� 0.72 0.76
Profit margin (PM) = Net income / Revenue�� 22.4% 18.2%
Review 1-6—Solution
a. Analysts might be concerned by the significant drop in other non-operating income from 3 billion KRW to 1.5
billion KRW. Questions would include: What sort of items are included in other non-operating income? What
happened during the year to cause the drop? Is the item expected to return to 2017 levels?
b. We forecast the financial statements in the following order: income statement, balance sheet, and statement of
cash flow.
c. We forecast revenue first because it affects many other income statement accounts and various balance sheet
accounts as well.
d. Cost of sales is directly related to revenue, the expense is the cost of the revenue earned and the two items gener-
ally move in tandem.
e. Accounts receivable on the balance sheet is directly related to revenue. Inventory is directly related to cost of
sales on the income statement.
a. Beyond Meat has potential for tremendous growth and the market values that. More and more people are adopt-
ing a plant-based diet and retailers that have added Beyond Burgers and Impossible Burgers to their menus have
struggled to meet demand. Analysts and investors are counting future revenue, profits, and cash flow and are
willing to pay now for those future rewards.
b. The contract announced in September likely had no effect on current year GAAP revenue or profits. But inves-
tors understand that future revenue and profits will be positively impacted and, thus, increase their valuation of
the company, which increases its stock price.
c. The future cash flow is more certain for Huntington Ingalls because a five-year government contract is legally
enforceable and the future amounts are known, whereas hoped-for future retail burger sales could come in lower
or higher than expected.
01_fsav6e_mod01.indd 51 6/2/20 8:40 PM

© Cambridge Business Publishers Module 2 | Review of Business Activities and Financial Statements 2-22
continued from previous page
Balance Sheet, June 30, 2017 Income Statement, For Year Ended June 30, 2018
Assets Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $110,360
Cash �� $ 7,663 Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,789
Noncash assets�� 242,649 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 16,571
Total assets�� $250,312
Liabilities and equity Statement of Cash Flows, For Year Ended June 30, 2018
Total liabilities �� $162,601
Equity Operating cash flows�� $43,884
Contributed capital�� 69,315 Investing cash flows �� (6,061)
Retained earnings�� 17,769 Financing cash flows�� (33,540)
Other stockholders’ equity�� 627
Net change in cash�� 4,283
Liabilities and equity �� $250,312 Cash balance, June 30, 2017�� 7,663
Cash balance, June 30, 2018�� $11,946
Notes: 1 $1,908.
. Stock issuances for the year are $1,098. 4. Change in other stockholders’ equity for the year is $(2,814).
2. Dividends for the year are $12,917. 5. Total assets at June 30, 2018 are $258,848.
3. Other decreases in retained earnings are $7,741.
Solution on p. 2-55.
ANALYZING TRANSACTIONS AND ADJUSTMENTS

Financial statements report on the financial performance and condition of a business. Those state- ectures
eL LO6
ments are tied to a period or point in time. The period of time is referred to as the accounting
MBC Explain the
cycle, and each cycle consists of four steps. accounting
cycle
Four-Step Accounting Cycle and apply the

financial statement
effects template to
■ Step 1 Record transactions in the accounting records. Each transaction is the result of an
analyze accounting
external or internal transaction or event, such as a sale to a customer or the payment of wages transactions.
to employees.
■ Step 2 Prepare accounting adjustments, which recognize a number of events that have
occurred but that have not yet been recorded. These might include the recognition of wage
expense and the related wages payable for those employees who have earned wages but have
not yet been paid or of depreciation expense for buildings and equipment.
■ Step 3 Construct the financial statements.
■ Step 4 Close the books in anticipation of the start of a new accounting cycle.
The purpose of this section is to review the accounting cycle. We use Apple’s financials to
illustrate the four steps in the accounting cycle. Understanding the financial statement preparation
process requires an understanding of the language used to record business transactions in account-
ing records. The recording and statement preparation processes are readily understood once we
learn that language (of financial statement effects) and its mechanics (entries and posting). Even
if we never post a transaction or prepare a financial statement, understanding the accounting
process aids us in analyzing and interpreting accounting reports. Understanding the accounting
language also facilitates our communication with business professionals within a company and
with members of the business community outside of a company.
Financial Statement Effects Template

As of its 2018 year-end, Apple reports total assets of $365,725 million, total liabilities of $258,578
million, and equity of $107,147 million. The accounting equation for Apple follows ($ millions).
Assets Liabilities Equity

= +
$365,725 $258,578 $107,147
02_fsav6e_mod02.indd 22 6/4/20 3:59 PM

3-25 Module 3 | Profitability Analysis and Interpretation © Cambridge Business Publishers
We can disaggregate ROE into operating and nonoperating components.
ROE = Operating return (via NOPAT)

RNOA) + Nonoperating return
Boston Scientific’s ROE of 21.24% consists of an operating return of 12.37% (via NOPAT)
RNOA) and
RNOA).
nonoperating return of 8.87% (ROE − NOPAT).
Financial Leverage As we discussed earlier in the module, financial leverage relates to the
degree to which the company uses borrowed money, rather than shareholder equity investment,
to fund operations and the acquisition of assets. The accounting equation (Assets = Liabilities
+ Equity) highlights the concept well. Holding total assets constant, as the amount of liabilities
increases, means that stockholders’ equity decreases, and consequently, financial leverage increases.
We are interested in financial leverage because it is an important measure of the risk a company
is incurring with its reliance on debt. As debt increases so does the risk that the company is unable
to pay the interest and principal payments on the debt. Financial leverage quantifies this risk.
While financial leverage increases risk, it also increases the return to shareholders but only if the
borrowing rate on the debt is less than the yield on the assets. Thinking again about the accounting
equation, if assets are yielding 12% and liabilities (debt) cost 10%, leverage is a positive force. If
the spread between the asset returns and the debt cost is high, then, stockholders benefit even more
from the borrowed money (debt). There is a trade-off, however, between the added return and the
added risk created by debt. At some level of debt, the risk of default is too high and lenders will
demand a higher rate and stockholders will no longer benefit from financial leverage. Continuing
with the example, if the assets continue to yield 12% and additional debt costs 13%, leverage is a
negative force.
While both the DuPont and Operating approaches consider the impact of financial leverage on
ROE, they measure that impact in markedly different ways:
■ DuPont approach measures the impact of financial leverage on ROE using only balance sheet
numbers:
Average total assets
FL = (and ROE = ROA × FL)
Average stockholders’ equity
■ Operating approach measures the impact of financial leverage on ROE using nonoperating
returns, which captures effects from both the balance sheet and the income statement. Recall,
ROE – RNOA = Nonoperating returns. Nonoperating returns, therefore, provide a way to mea-
sure the impact of financial leverage on ROE. (In Appendix 3B we discuss financial leverage
with an operating focus; that definition of financial leverage is labeled FLEV.)
In the table above, the DuPont approach measures the ratio of ROA/ROE as 39.3% and the
Operating approach measures the ratio of RNOA/ROE as 58.2%. The DuPont approach ascribes a
much smaller proportion of ROE to operating activities (as the effect of financial leverage is greater)
than does the Operating approach. The Operating approach shows that much more of Boston Scien-
tific’s ROE is due to operating activities that make up its core business.
EXHIBIT 3.7 Key Ratio and Acronym Definitions
Ratio Definition
ROE: Return on equity �� Net income attributable to controlling interest/Average equity
attributable to controlling interest
NOA: Net operating assets�� Operating assets − Operating liabilities
NOPBT: Net operating profit before tax�� Revenue − Operating expenses including COGS
NNE: Net nonoperating expense after tax �� Pretax net nonoperating expense × (1 − Tax%)
NOPAT: Net operating profit after tax �� NOPBT − Tax on operating profit
Or: Net income + NNE
RNOA: Return on net operating assets�� NOPAT / Average NOA
03_fsav6e_mod03.indd 25 6/4/20 4:16 PM

© Cambridge Business Publishers Module 4 | Credit Risk Analysis and Interpretation 4-16
Return on equity for Home Depot over the three-year period ended February 3, 2019, follows.
2019 2018 2017
Return on equity (ROE) for 2019: $10,866 / [($1,454 − $1,878)/2]�� (5,125.5)% 298.3% 149.4%
Return on assets (ROA) for 2019: $10,866 / [($44,003 + $44,529)/2]�� 24.5% 19.7% 18.7%
Financial leverage (FL) for 2019: [($44,003 + $44,529)/2] / [($1,454 − $1,878)/2]�� (208.8) 15.1 8.0
Return on equity is a negative 5,125.5%, a ratio that is uninterpretable. It certainly does not imply
that the company is reporting losses of $51.25 for every dollar of equity. The negative ratio is caused
by Home Depot’s negative stockholders’ equity owing to large levels of treasury stock. This also
causes the ROE in prior years to be high, when treasury stock reduced stockholders’ equity to a
small number and inflated the ROE ratio. An outsized treasury stock account is not unique to Home
Depot. In recent years many firms have returned value to shareholders via stock repurchases (buy-
backs). This has created an analysis challenge: interpreting negative and massive ratios.
As discussed in Analyst Adjustments 3.1, one way to handle this analysis challenge is to add
back the treasury stock balance to both equity and total assets. Under this approach the ROE for
Home Depot over the three-year period ended February 3, 2019, follows.
2019 2018 2017
Restated ROE for 2019: $10,866 / [($1,454 − $1,878 + $58,196 + $48,196)/2] �� 20.5% 18.3% 18.9%
Restated ROA for 2019: $10,866 / [($44,003 + $44,529 + $58,196 + $48,196)/2] �� 11.1% 9.8% 10.1%
Restated FL for 2019: [($44,003 + $44,529 + $58,196 + $48,196)/2] / [($1,454 − $1,878 + $58,196 + $48,196)/2] �� 1.84 1.87 1.88
ROE is in the 20% range over all three years, increasing slightly in 2019 as ROA improved from
9.8% to 11.1%. We conclude that the company’s profitability is strong and sustained. The com-
pany’s financial leverage is holding steady and is below 2.0, which is a reasonable level for a
company such as Home Depot. We return to the issue of leverage below.
Expanded ROE Disaggregation A second method of ROE disaggregation distinguishes
between operating and nonoperating returns. (See Module 3 for additional details.) Operating
return, as measured by return on net operating assets (RNOA) is an aggregate measure of the
return from Home Depot’s main operating activities and is a comprehensive profitability measure
that is not affected by the company’s leverage or treasury stock activity. We use the reported bal-
ance sheet numbers and the adjusted 52-week income statement numbers to further disaggregate
RNOA into profitability and productivity components as follows.
NOPAT NOPAT Sales

RNOA = = ×
Average NOA Sales Average NOA
Net operating Net operating

profit margin asset turnover
(NOPM) (NOAT)

As shown below, RNOA for Home Depot has steadily increased over the three-year period ended
February 3, 2019. These returns are high especially compared to other U.S. retail firms. Further,
this increase is due to both profitability and productivity—both NOPM and NOAT are increasing
each year. These increases are steady and are positive signals about cost and asset management.
2019 2018 2017
Marginal tax rate�� 22%

37% 37% 37%
22%
Return on net operating assets (RNOA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46.1% 36.8% 33.7%
Net operating profit margin (NOPM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.0% 9.2% 9.0%
Net operating asset turnover (NOAT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.21 4.01 3.73
2019 NOPAT = $10,866 + ($974 × (1 − 22%))
2019 Average NOA = [$44,003− $1,778 − ($45,881 − $1,339 − $1,056 − $26,807) + $44,529 − $3,595 − ($43,075 − $1,559 −
$1,202 − $24,267)]/2
Based on this analysis, our overall conclusion is positive; Home Depot has strong profitability
and favorable trends.
04_fsav6e_mod04.indd 16 9/28/20 5:41 PM

© Cambridge Business Publishers Module 4 | Credit Risk Analysis and Interpretation 4-20
For the year ended February 3, 2019, Home Depot’s statement of cash flows (not included here)
reported cash from operations of $13,038 million for the 53-week fiscal year. We compute the
52-week operating cash flow as: $13,038 million × 53/52
52/53 = $12,792 million. Home Depot’s cash
from operations to total debt ratio was 0.44 in 2019, computed as $12,792 million/($1,339 million
+ $1,056 million + $26,807 million). This ratio has held steady in the past several years shown
in the graphic that follows.
Free Operating Cash Flow to Total Debt Companies must replace tangible assets
each year to continue operations. Any excess operating cash flow after cash spent on capital
expenditures (CAPEX) is considered “free” cash flow in that the company is free to use the cash
for other purposes including debt repayments. Some creditors use the following free cash flow
measure as another coverage ratio.
Cash from operations − CAPEX

Free operating cash flow to total debt =
Short-term debt + Long-term debt
The free operating cash flow to total debt ratio is argued to reflect a company’s ability to repay
debt from the cash flows remaining after CAPEX. For the year ended February 3, 2019, Home
Depot’s statement of cash flows reported cash spent for capital expenditures of $2,442 million,
which is the number reported on the statement of cash flows (we assume CAPEX is determined
annually and not on a weekly basis). Thus, its free operating cash flow to total debt ratio is 0.35
calculated as ($12,792 million − $2,442 million)/($1,339 million + $1,056 million + $26,807
million). This ratio held steady over the past four years, which is a sign that Home Depot is
managing its debt levels while growing and maintaining its historically strong operating cash
flow (see following graphic).
Home Depot Cash Flow Ratios

0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
2016 2017 2018 2019
Cash From Operations to Total Debt Free Operating Cash Flow to Total Debt
Liquidity Analysis
Liquidity refers to cash availability: how much cash a company has, and how much it can gener-
ate on short notice. In this section, we discuss several of the most common liquidity measures:
the current ratio, working capital, and the quick ratio.
Current Ratio Current assets are assets that a company expects to convert into cash within
the next operating cycle, which is typically a year. Current liabilities are those liabilities that
come due within the next year. An excess of current assets over current liabilities (Current assets
− Current liabilities), is known as net working capital or simply working capital. Positive working
capital implies more expected cash inflows than cash outflows in the short run. The current ratio
expresses working capital as a ratio and is computed as follows:
Current assets
Current ratio =
Current liabilities
04_fsav6e_mod04.indd 20 9/28/20 5:41 PM

© Cambridge Business Publishers Module 5 | Revenue Recognition and Operating Income 5-8
Because of control transferring over time, revenue is recognized based on the extent of progress
towards completion of the performance obligation. . . We generally use the cost-to-cost measure of
progress for our contracts because it best depicts the transfer of control to the customer which occurs
as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress
towards completion is measured based on the ratio of costs incurred to date, to the total estimated
costs at completion of the performance obligation. Revenues, including estimated fees or profits, are
recorded proportionally as costs are incurred.
To illustrate accounting for long-term contracts using the cost-to-cost approach, assume
Raytheon
Raytheon signs a $10 million contract to develop a prototype for a defense system. Bayer esti-esti-
mates construction will take two years and will cost $7,500,000. This means the contract yields
an expected gross profit of $2,500,000 over two years. The following table summarizes costs
incurred each year and the revenue Raytheon recognizes.
Percentage
Costs Incurred Complete Revenue Recognized
$4,500,000
= 60%
Year 1 . . . . . . . . . . . . . . . . . $4,500,000 $7,500,000 $10,000,000 × 60% = $6,000,000
$3,000,000
= 40%
Year 2 . . . . . . . . . . . . . . . . . $3,000,000 $7,500,000 $10,000,000 × 40% = $4,000,000
This table reveals Raytheon would report $6 million in revenue and $1.5 million ($6 million −
$4.5 million) in gross profit on the project in the first year; it would report $4 million in revenue
and $1 million ($4 million − $3 million) in gross profit in the second year.
The following template captures the recognition of revenue and expense over this two-year
period (M indicates millions).
Balance Sheet Income Statement
Cash + Noncash = Liabil- + Contrib. + Earned Rev- − Expen- = Net

Transaction Asset Assets ities Capital Capital enues ses Income
COGS . . . . 4.5M
Year 1: −4.5M −4.5M +4.5M Cash . . . . . .4.5M
Record Cash = Retained
Earnings
– Cost of
Sales
= −4.5M COGS
$4.5M costs 4.5M
Cash
4.5M
Year 1: AR . . . . . 6M
Recog- REV . . . . . . . . 6M
nize $6M +6M +6M +6M AR
revenue Accounts
Receivable
= Retained
Earnings
Revenue – = +6M 6M
REV
on partly 6M
completed
contract
COGS . . 3M
Cash . . . . . . . 3M
Year 2: −3M −3M +3M COGS
Record $3M Cash = Retained

Earnings
– Cost of
Sales
= −3M 3M
Cash
costs 3M
AR . . . . . 4M
Year 2: Rev . . . . . . . . 4M
Recognize AR
$4M rev- +4M +4M +4M
= – =
4M
Accounts Retained Revenue +4M
enue for Receivable Earnings
Rev
4M
completed
contract
05_fsav6e_mod05.indd 8 6/5/20 7:23 AM

© Cambridge Business Publishers Module 5 | Revenue Recognition and Operating Income 5-22
Accounting for Accounts Receivable

To account for uncollectible amounts, companies use an allowance account similar to the ones
discussed above for sales returns and other allowances. The allowance for uncollectible accounts
(also called the allowance for doubtful accounts) reduces the gross amount of receivables that are
reported on the balance sheet.
To illustrate, assume the company sells goods on account for $100,000 and, at the end of the
accounting period, performs an aging analysis and establishes the allowance for uncollectible
accounts in the amount of $2,900. Our financial statement effects for the sale and the estimate of
uncollectible accounts receivable are as follows.

AR . . . . . 100,000
Rev . . . . 100,000
Sale on 100,000 100,000 100,000
account
Accounts
Receivable
= Retained
Earnings
Sales – = 100,000 100,000
AR
Rev
100,000
Establish −2,900
allowance and −2,900 +−2,900 BDE . . . . 2,900
record bad
Allowance for
Uncollectible = Retained
Earnings
– Bad Debts =
Expense
−2,900
AU . . . . . . . 2,900
BDE
Accounts
debts expense 2,900
AU
2,900
The allowance for uncollectible accounts is subtracted from the gross accounts receivable,
and the net amount collectible is reported on the balance sheet.
Accounts receivable (gross amount owed)�� $100,000

Less: Allowance for uncollectible accounts�� (2,900)
Accounts receivable, net (reported on balance sheet) �� $ 97,100
Companies typically report the allowance for uncollectible accounts along with accounts receiv-
able as follows.
Accounts receivable, less allowance for uncollectible accounts of $2,900�� $97,100
By setting up the allowance, the company has established a reserve, or a cushion, that it can use
to absorb credit losses as they occur. To see how this works, assume a customer who owes $500
files for bankruptcy. If the company determines the receivable is now uncollectible, it must write
off the receivable. This is absorbed by the allowance for uncollectible accounts as follows.

AU . . . . . 500
500 AR . . . . . . . . .500
Write off $500 Allowance for
Uncollectible AU
of uncollect-
ible accounts
Accounts
−500
= – = 500
AR
receivable Accounts 500
Receivable
The write-off of the uncollectible account receivable results in the following balances at the end
of the period.
05_fsav6e_mod05.indd 22 6/5/20 7:23 AM

5-61 Module 5 | Revenue Recognition and Operating Income © Cambridge Business Publishers
Part II
1 . Revenue = $3,000,000 × ($500,000/$2,500,000) = $600,000.
Gross profit = $600,000 − $500,000 = $100,000.
2. The cost of $500,000 exceeds the billing of $400,000, and the excess of $100,000 is reported as a current asset
(such as construction in progress).
1. “Charged to costs and expenses” represents the amount of returns allowances recorded during fiscal 2018 for
sales during that year. This amount is included in Tiffany’s income statement for the fiscal year.
2. “Deductions” is the dollar value of actual returns offset by the value of the merchandise returned (that reduces
COGS by the same amount). The actual returns number is $10.1 million, which is close to the estimated amount
charged to costs and expenses of $12.6 million. This indicates that Tiffany & Co is fairly accurate in its estima-
tion process.
3. a. $ millions 2019 2018 2017
Net sales�� $4,442.1 $4,169.8 $4,001.8

Charged to costs and expenses �� 12.6 7.5 2.5
Gross sales�� $4,454.7 $4,177.3 $4,004.3
Allowance at year end�� $17.5 $15 $9.6
Allowance/Gross sales �� 0.39% 0.36% 0.24%
The sales return allowance is small at year end, compared to gross sales, likely because sales returns are made
quickly after the purchase so the balance outstanding at any time is small. In fact, the amount outstanding is
roughly equal to one day’s sales ($4,442.1/365 days = $12.2).The amount has been increasing over time but
is not of concern given its magnitude.
b. $ millions 2019 2018 2017
Charged to costs and expenses �� $ 12.6 $ 7.5 $ 2.5
Gross sales�� $4,454.7 $4,177.3 $4,004.3
% returned merchandise�� 0.28% 0.18% 0.06%
The % of merchandise that Tiffany estimates will be returned has steadily increased over the three years, but
the amount is so low as to be immaterial. There is no cause for concern here.
c. Tiffany’s sales returns allowance seems a bit high considering the following ratio of actual to estimate.
$ millions 2019 2018 2017

Estimated returns
Actual returns for the
during theyearyear�� $12.6 $7.5 $2.5
Actual returns during the year
Estimated returns for the year�� $10.1 $2.1 $1.2
Adequacy�� 125% 357% 208%
The amount of cash received from the customers is the amount added to the liability.
Advanced Billings and Customer Deposits ($ millions)
Balance at 1/1/2018�� $26,656

+ Cash prepayments by customers during the year�� ??
− Revenue recognized during the year�� (55,078)
= Balance at 12/31/2018�� $32,720
Cash prepayments by customers during the year = $32,720 + $55,078 − $26,656 = $61,142
05_fsav6e_mod05.indd 61 6/5/20 7:23 AM

6-11 Module 6 | Asset Recognition and Operating Assets © Cambridge Business Publishers
FIFO equivalents. Once we convert CAT’s inventory and its total assets to FIFO (by adding the
LIFO reserve, as explained above), we find that the company holds 17% of total assets as inventory,
a greater difference than first noted.
Balance Sheet Adjustments for a LIFO Reserve In general, to adjust for LIFO
on the balance sheet, we must make three modifications and then recompute balance sheet totals
and subtotals (current assets, total assets, and total equity).
■ Increase inventories by the LIFO reserve.
■ Increase tax liabilities by the tax rate applied to the LIFO reserve.
■ Increase retained earnings for the difference.
As an example, to adjust CAT’s 2018 balance sheet, we would:
■ Increase inventories by $2,009 million.
■ Increase tax liabilities by $693 million (see our computation above).
on page 6-8).
■ Increase retained earnings by the difference of $1,316 million (computed as $2,009 million
− $693 million).
Income Statement Adjustments for a LIFO Reserve To compare the income

statements of companies that use LIFO, we must adjust cost of goods sold from LIFO to FIFO.
Recall that: Cost of Goods Sold = Beginning Inventories + Purchases − Ending Inventories. To
determine FIFO COGS, we must use the change in the LIFO reserve as follows.
FIFO COGS = LIFO COGS − Increase in LIFO Reserve (or + Decrease)
During 2018, the change in CAT’s LIFO reserve was $75 million ($2,009 million − $1,934
million). Had CAT always used FIFO, its 2018 COGS would have been $75 million lower (mean-
ing gross profit and pretax income would be $75 million higher), and the company would have paid
$16 million ($75 million × 21%) more in taxes. This does not make much difference either in dollar
or percentage terms for CAT in 2018 because the LIFO reserve increased only slightly during the
year. But in other years, and for other companies, the impact can be great.
LIFO Liquidations
When LIFO companies acquire inventory at different costs, they are required to account for
each cost level as a separate inventory pool or layer (for example, there are the $100 and $150
units in our Exhibit 6.3 illustration). When companies reduce inventory levels, older inventory
costs flow to the income statement. These older LIFO costs are often markedly lower than cur-
rent inventory costs, assuming an inflationary environment. The net effect is that the LIFO cost
of sales is lower than the equivalent FIFO cost of sales (the reverse of the typical situation). The
liquidation boosts gross profit as older, lower costs are matched against current selling prices
on the income statement.
The increase in gross profit resulting from a reduction of inventory quantities in the presence
of rising costs is called LIFO liquidation. The effect of LIFO liquidation is evident in the fol-
lowing footnote from Rite Aid’s 10-K for the fiscal year ended March 2, 2019 (which Rite Aid
labels fiscal 2019).
Inventory (in $000s) At March 2, 2019 and March 3, 2018, inventories were $604,444 and
$581,090, respectively, lower than the amounts that would have been reported using the first-in,
first-out (“FIFO”) cost flow assumption. . . During fiscal 2019, 2018 and 2017, a reduction in non-
pharmacy inventories resulted in the liquidation of applicable LIFO inventory quantities carried at
lower costs in prior years. This LIFO liquidation resulted in a $5,884, $2,707 and $2,375 cost of
revenues decrease, with a corresponding reduction to the adjustment to LIFO for fiscal 2019, fiscal
2018 and fiscal 2017, respectively.
06_fsav6e_mod06.indd 11 6/4/20 4:42 PM

ANALYST ADJUSTMENTS 6.3 Continued

Employee termination costs
Income Statement Adjustments ($ millions) 2016 2017 2018†
Tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22% 22% 22%
Reversal
Employee termination costs (reversal of 2018 costs) . . . . . . . . . . . . . . . . . . . . . . . . . . −$459
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +459
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +101
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +358
Allocation
Wages expense (2018 costs allocated: $459/3 years) . . . . . . . . . . . . . . . . . . . . . . . . . +$153 +$153 +153
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −153 −153 −153
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −34 −34 −34
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −119 −119 −119
Total net income (reversal + allocation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −$119 −$119 +$239
Balance Sheet Adjustments ($ millions) 2016 2017 2018†
Wages payable (2018 costs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +$153 +$306 No adjustment*

Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +34 +68 No adjustment*
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −$119 −$238 No adjustment*
* No adjustment is required at current year-end because the year-end balance sheet reflects all prior and current year cost allocations.
†
The computation assumes that the severance occurs near year-end (assuming a mid-year severance would mean the current year numbers are cut
by one-half, and similarly for other fractions of a year).
The two tables below show our adjustments for the 2018 asset impairment charges. The adjustments increase
net income by $155 million in 2018 but decrease net income by $45 million in the prior four years. The total effect
from both termination and impairment charges for 2018 is to increase net income by $420 million ($239 million +
$181 million), which is about 4% of Pfizer’s 2018 net income.
Asset impairment charges

Income Statement Adjustments ($ millions) 2014 2015 2016 2017 2018†
Tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22% 22% 22% 22% 22%
Reversal
Asset impairment charges (reversal of 2018 costs) . . . . . . . . −$290
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +290
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +64
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +226
Allocation
Depreciation expense (2018 charge allocated: $290/5 years) +$58 +$58 +$58 +$58 +58
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −58 −58 −58 −58 −58
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −13 −13 −13 −13 −13
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −45 −45 −45 −45 −45
Total net income (reversal + allocation) . . . . . . . . . . . . . . . . . −$45 −$45 −$45 −$45 +$181
Balance Sheet Adjustments ($ millions) 2014 2015 2016 2017 2018†
Accumulated depreciation (related to 2018 charge) . . . . . . . . +$58 +$116 +$174 +$232 No adjustment*
Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −13 −25 −38 −51 No adjustment*
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −$45 −$ 91 −$136 −$181 No adjustment*
* No adjustment is required at current year-end because the year-end balance sheet reflects all prior and current year cost allocations.
†
The computation assumes that the write-down occurs near year-end (assuming a mid-year write-down would mean the current year numbers are
cut by one-half, and similarly for other fractions of a year).
continued
06_fsav6e_mod06.indd 29 9/28/20 6:08 PM

© Cambridge Business Publishers Module 6 | Asset Recognition and Operating Assets 6-36
mework
Ho
Assignments with the MBC logo in the margin are available in .

See the Preface of the book for details.
MINI EXERCISES
M6-13. Computing Cost of Goods Sold and Ending Inventory Under FIFO, LIFO, and Average Cost LO1
Assume that Madden Company reports the following initial balance and subsequent purchase of inventory. Ho
mework
MBC
Inventory balance at beginning of year�� 1,300 units @ $150 each $195,000
Inventory purchased during the year�� 1,700 units @ $180 each 306,000
Cost of goods available for sale during the year�� 3,000 units $501,000
Assume that 2,000 units are sold during the year. Compute the cost of goods sold for the year and the
inventory on the year-end balance sheet under the following inventory costing methods.
a. FIFO b. LIFO c. Average Cost
M6-14. Computing Cost of Goods Sold and Ending Inventory Under FIFO, LIFO, and Average Cost LO1
Wong Corporation reports the following beginning inventory and inventory purchases. Ho
mework
MBC
Inventory balance at beginning of year�� 400 units @ $12 each $ 4,800
Inventory purchased during the year�� 700 units @ $14 each 9,800
Cost of goods available for sale during the year�� 1,100 units $14,600
Wong sells 600 of its inventory units during the year. Compute the cost of goods sold for the year and the
inventory on the year-end balance sheet under the following inventory costing methods.
a. FIFO b. LIFO c. Average Cost
M6-15. Computing and Evaluating Inventory Turnover for Two Companies LO3
PriceSmart and Nordstrom report the following information in their respective January 2016 10-K PRICESMART
reports relating to their two most recent fiscal years. (PSMT)
JW
NORDSTROM
PriceSmart ($ thousands) Nordstrom ($ millions) (JWN)
mework
Ho
Cost of Cost of MBC
Sales Goods Sold Inventories Sales Goods Sold Inventories
2018�� $3,053,754 $2,610,111 $321,025 $15,480 $10,155 $1,978

2017�� 2,910,062 2,487,146 310,946 15,137 9,890 2,027
a. Compute the 2018 inventory turnover for each of these two retailers.
b. Discuss any difference we observe in inventory turnover between these two companies. Does the dif-
ference confirm our expectations given their respective business models? Explain. (Hint: Nordstrom
is a higher-end retailer and PriceSmart operates no-frills, warehouse stores.)
c. Describe ways that a retailer can improve its inventory turnover.
M6-16. Adjusting Balance Sheet and Income Statement for LIFO to FIFO ANALYST ADJUSTMENTS 6.1 LO2
In its December 2019 10-K, LyondellBasell Industries reported the following information ($ millions). LYONDELL-
BASELL
INDUSTRIES
Cost of Goods LIFO Decrease in LIFO Total (LYB)
Sold Inventories Reserve Reserve Assets Net Income Ho
mework
$29,301 $4,588 $670 $128 $30,435 $3,397 MBC
Adjust the account balance for the following financial statement items assuming the company used FIFO
instead of LIFO for its inventory costing method. The company has a 22% tax rate.
a. Inventories b. Total assets c. Cost of goods sold d. Net income
M6-17. Computing Depreciation LO4
A delivery van costing $37,000 is expected to have a $2,900 salvage value at the end of its useful life of Ho
mework
five years. Assume that the truck was purchased on January 1. Compute the depreciation expense for the MBC
first two calendar years under the straight-line depreciation method.
06_fsav6e_mod06.indd 36 6/4/20 4:42 PM

c. Compute inventory turnover and days average inventory outstanding for 2018.
d. Based on the metrics in parts a, b, and c, how do we assess the two companies’ inventory management?
LO5, 6 I6-50. Estimating Useful Life, Percent Used Up, and Gain or Loss on Disposal
HUSKY ENERGY Husky Energy is one of Canada’s largest integrated energy companies. Based in Calgary, Alberta, Husky
(HSE) is publicly traded on the Toronto Stock Exchange. The Company operates in Western and Atlantic Can-
mework
Ho ada, the United States and the Asia Pacific Region with upstream and downstream business segments.
MBC The company uses IFRS to prepare its financial statements. During 2018, the company reported deprecia-
tion expense of $2,591 million. The property and equipment footnote follows.
Oil and Processing, Retail

Gas Transportation and
Property, Plant and Equipment (in C$ millions) Properties and Storage Upgrading Refining Other Total
Cost
December 31, 2017�� $ 41,815 $ 86 $ 2,599 $ 9,191 $ 2,930 $ 56,621
Additions �� 2,465 12 62 744 151 3,434
Acquisitions�� 64 — — 3 — 67
Transfers from exploration and evaluation �� 79 — — — — 79
Intersegment transfers�� — — — (5) —5 —
Changes in asset retirement obligations�� 43 2 (2) (5) 7 45
Disposals and derecognition�� (632) — — (10) (1) (643)
Exchange adjustments�� 362 1 — 773 3 1,139
December 31, 2018�� $ 44,196 $101 $ 2,659 $10,691 $ $3,095
3,090 $ 60,742
Accumulated depletion, depreciation, amortization, and impairment

December 31, 2017�� $(26,016) $ (47) $(1,462) $ (3,176) $(1,842) $(32,543)
Depletion, depreciation, amortization, and impairment�� (1,811) (2) (123) (503) (152) (2,591)
Disposals and derecognition�� 586 — — 10 — 596
Exchange adjustments�� (138) (1) — (264) (1) (404)
December 31, 2018�� $(27,379) $ (50) $(1,585) $ (3,933) $(1,995) $(34,942)
Net book value
December 31, 2017�� $15,799 $ 39 $ 1,137 $ 6,015 $ 1,088 $ 24,078
December 31, 2018�� 16,817 51 1,074 6,758 1,100 25,800
Required
a. Compute the average useful life of Husky Energy’s depreciable assets in 2018. Assume that land is
10% of “Refining.”
b. Estimate the percent used up of Husky Energy’s depreciable assets in 2018. How do we interpret this
figure?
c. Consider the disposals and derecognition during the year. This refers to assets that were sold and
removed from the balance sheet during 2018. Calculate the net book value of the total PPE disposed
during the year. Assume that Husky Energy received $4 million cash proceeds for the year. Determine
the gain or loss on the disposal.
ANALYSIS DISCUSSION POINTS

LO3, 6 D6-51. Managing Operating Asset Reduction
Return on net operating assets (RNOA = NOPAT/Average NOA, see Module 3) is commonly used to
evaluate financial performance. If managers cannot increase NOPAT, they can still increase this return
by reducing the amount of net operating assets (NOA). List specific ways that managers could manage
the following operating items.
a. Inventories b. Plant, property and equipment c. Accounts payable
06_fsav6e_mod06.indd 49 6/2/20 9:33 PM

© Cambridge Business Publishers Module 6 | Asset Recognition and Operating Assets 6-52
$ millions 2019 2018 2017
1. Gross profit margin �� $22,915 $22,434 $21,674

= 32.1% = 32.7% = 33.3%
$71,309 $68,619 $65,017
2. Days inventory outstanding�� 365 365

= 90.3 = 86.3
$48,394 $46,185
£ $12,561+ $11,393 § £ $11,393 + $10,458 §
2 2
3. Days payable outstanding�� 365 365

= 56.1 = 52.3
$48,394 $46,185
£ $8,279 + $6,590 § £ $6,590 + $6,651 §
2 2
4. Cash conversion cycle�� 0 + 90.3 − 56.1 = 34.2 0 + 86.3 − 52.3 = 34.0

Cashcash
Analysis: The conversion cycle did
conversion notdecreased
cycle improve; the
bycycle got longer
0.2 days (34.2(worsened),
− 34.0). going from 34.0 days to 34.2 days.
5. ∆ Cash = ∆ Cash Conversion Cycle Days × (COGS/365) == -0.2 $(26.5)million

0.2 days × ($48,394/365 days) = $26.5 million
1 . Straight-line depreciation expense = ($95,000 − $10,000)/5 years = $17,000 per year
2. The HD subsidiary reports equipment on its balance sheet at its net book value of $44,000.
Equipment, cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $95,000

Less accumulated depreciation ($17,000 × 3) . . . . . . . . . . . 51,000
Equipment, net (end of Year 3) . . . . . . . . . . . . . . . . . . . . . . . $44,000
Part 1.
a. The equipment is impaired since the undiscounted expected cash flows of $40,000 are less than the $44,000 net
book value of the equipment. The HD subsidiary must write down the equipment to its fair value of $36,000.
The effect of this write-down is to reduce the net book value of the equipment by $8,000 ($44,000 − $36,000)
and recognize a loss in the income statement.
b. The HD subsidiary must report a gain on this sale of $6,000, computed as proceeds of $50,000 less the net book
value of the equipment of $44,000 (see Review 6-4, part 2).
Part 2.
a. Coca-Cola’s restructuring expense for 2018 is the increase in the restructuring liability of $508 million.
b. Coca-Cola reports a restructuring liability of $90 million on its 2018 balance sheet.
$ millions 2019 2018
$71,309 $68,619
PPE turnover�� = 3.7 = 3.5
$18,432 + $19,721 $19,721+ $19,949
a b a b
2 2
($18,052 + $18,052
$10,090 ++$18,521
$10,090+ $10,475) / 2 ($18,521
$18,521++$10,475
$10,475+ $18,147 + $10,978) / 2 = 18.9
Average useful life�� $1,454 = 19.4 = 18.8
$1,540
$1,454 = 19.6 $1,540
$17,431
$17,431 $17,219 $17,219
Percent used up �� = 62% / 2 = 59% = 59%
($18,052 + $10,090 + $18,521 + $10,475)
$18,052 + $10,090 ($18,521
$18,521++$10,475
$10,475+ $18,147 + $10,978) / 2
= 61%
06_fsav6e_mod06.indd 52 6/2/20 9:33 PM

9-41 Module 9 | Intercorporate Investments © Cambridge Business Publishers
LO1 M9-14. Interpreting Disclosures of Investment Securities

AMGEN INC. Amgen Inc. reports the following disclosure relating to its accumulated other comprehensive income.
(AMGN)
mework
Ho Foreign Cash Available-
MBC Currency Flow for-Sale
$ millions Translation Hedges Securities Other AOCI
Balance as of December 31, 2017 �� $(529) $(6) $ (144) $— $(679)

Cumulative effect of change in accounting — — (9) — (9)
principle, net of tax�� __ __ (9) __ (9)
Foreign currency translation adjustments�� (141) — — — (141)
Unrealized (losses) gains �� — 61 (556) — (495)
Reclassification adjustments to income�� — 262 365 — 627
Other�� — — — (2) (2)
Income taxes�� (76) 6 — (70)
Balance as of December 31, 2018 �� $(670) $241 $(338) $ (2) $(769)
a. Amgen reports unrealized gains and losses on available-for-sale securities as part of AOCI. Which of
the following types of investments could be included in this account? Select all that apply.
i. Bonds issued by US corporations.
ii. Common stock traded on US stock exchange.
iii. Common stock traded on foreign stock exchange.
iv. Debt securities issued by a foreign government.
v. Municipal bonds.
vi. U.S. Treasury bills.
b. Consider the securities held in the available-for-sale portfolio at December 31, 2018. Which of the
following is true?
i. At December 31, 2018, the fair value of the securities was $338 million less than their amortized cost.
ii. At December 31, 2018, the fair value of the securities was $338 million greater than their amortized
cost.
iii. At December 31, 2018, the fair value of the securities was $338 million lower than their value at
December 31, 2017.
iv. At December 31, 2018, the fair value of the securities was $194 million lower than their value at
December 31, 2017
c. Consider the securities held in the available-for-sale portfolio at December 31, 2018. During the year,
by how much did the market value of those securities increase or decrease?
i. Decreased by $338 million.
ii. Decreased by $556 million.
iii. Increased by $556 million.
iv. Decreased by $191 million.
d. Amgen increased AOCI by $365 million for reclassification adjustments to income. Which of the
following best describes what this line item means?
i. During 2018, Amgen sold available-for-sale securities and realized a loss of $365 million.
ii. During 2018, Amgen sold available-for-sale securities and realized a gain of $365 million.
iii. During 2018, Amgen sold available-for-sale securities that had unrealized gains of $365 million at
December 31, 2017.
iv. During 2018, Amgen sold available-for-sale securities that had unrealized losses of $365 million at
December 31, 2017.
LO4 M9-15. Analyzing Derivatives and Hedging
AMGEN INC. Refer to the information for Amgen in M9-14. This information reports activity related to Amgen’s cash
(AMGN) flow hedges.
a. Explain how this type of hedging works. Provide an example of how Amgen might use this type of
hedging strategy.
b. How did the hedges affect net income for 2018?
c. If these same hedges had instead been fair value hedges, what amount would have been added to
AOCI for the year?
09_fsav6e_mod09.indd 41 6/4/20 4:35 PM

9-55 Module 9 | Intercorporate Investments © Cambridge Business Publishers
$203.9 mil-
$249.0 million. The net $117.5
disclosed includes cash advances to the joint venture partners of $335.4
lion represents the equity method investment.
c. Do you believe the liabilities of these joint venture entities represent actual obligations of General
Mills? Explain.
d . What potential problem(s) does equity method accounting present for analysis purposes?
LO3 P9-49. Financial Analysis for Equity Method Investments ANALYST ADJUSTMENTS 9.1
CUMMINS INC. Refer to the financial information for the equity method investments of Cummins in E9-36. Make the
(CMI) following assumptions about those data.
mework
Ho
• All assets are operating assets.
MBC
• All current liabilities are operating liabilities.
• Non-current liabilities are loans that bear interest at 8%.
• EMI (Equity Method Investments) investees’ tax rate is 22%.
The following information is derived from the 2018 form 10-K for Cummins Inc., the investor company.
$ millions 2018
Revenue �� $23,771

Net operating profit after tax (NOPAT) �� 2,213
Net nonoperating expense (NNE)�� 26
Net income attributable to Cummins Inc.�� 2,141
Net operating assets (NOA) �� 9,210
Net nonoperating obligations (NNO)�� 951
Equity of Cummins Inc. shareholders�� 7,348
Required
a. Compute net operating profit after tax (NOPAT) for the EMI investees.
b. Compute net operating assets (NOA) and net nonoperating obligations (NNO) for the EMI investees.
c. Following the process in Analyst Adjustments box 9.1, reformulate the following ratios for Cummins
for 2018. For simplicity only, use year-end balance sheet numbers provided instead of averages.
1. RNOA 3. NOAT 5. Financial leverage (FLEV)
2. NOPM 4. ROE
d. Does the equity method of accounting for these investments obscure the economic picture? Explain.
LO3 P9-50. Analyzing and Interpreting Disclosures on Consolidations
SNAP-ON Snap-on Incorporated consists of two business units: the manufacturing company (parent corporation)
INCORPORATED
(SNA)
and a wholly-owned finance subsidiary. These two units are consolidated in Snap-on’s 10-K report. Fol-
lowing is a supplemental disclosure Snap-on includes in its 10-K report that shows the separate balance
sheets of the parent and the subsidiary. This supplemental disclosure is not mandated under GAAP but is
voluntarily reported by Snap-on as useful information for investors and creditors. Using this disclosure,
answer the following questions.
Required
a. Do the parent and subsidiary companies each maintain their own financial statements? Explain. Why
does GAAP require consolidation instead of separate financial statements of individual companies?
b. What is the balance of Investments in Financial Services as of December 31, 2018, on the parent’s
balance sheet? What is the equity balance of the financial services subsidiary to which this relates as
of December 31, 2018? Do you see a relation? Will this relation always exist?
c. Refer to your answer for part a. How does the equity method of accounting for the investment in the
subsidiary obscure the actual financial condition of the parent company as compared with the con-
solidated financial statements?
d. Recall that the parent company uses the equity method of accounting for its investment in the sub-
sidiary and that this account is eliminated in the consolidation process. What is the relation between
consolidated net income and the net income of the parent company? Explain.
e. What is the implication for the consolidated balance sheet if the fair value of the financial services
subsidiary (subsequent to acquisition) is greater than the book value of its stockholders’ equity?
09_fsav6e_mod09.indd 55 9/28/20 6:38 PM

10-7 Module 10 | Analyzing Leases, Pensions, and Taxes © Cambridge Business Publishers
Total forecasted lease payments for operating leases are $8,664 million in FY2019. However,
Microsoft’s balance sheet includes liabilities of $7,703 million (current liability of $1,515 million
relating to payments to be made in the upcoming year and long-term liability of $6,188 million),
which is the present value of the forecasted lease payments discounted at 3.15%. Exhibit 10.1
illustrates the present value calculation. The Business Insight box below explains the discount
rate. (The 3.15% discount rate used in this example is consistent with the assumed payment
stream, an approach commonly used in practice. Microsoft’s actual discount rate is 3%, as dis-
closed in its 2019 10-K.)
EXHIBIT 10.1 Present Value of Operating Lease Payments ($ millions)

A B C D E
1 Year Operating Lease Payment Discount Factor (i = 0.0315) Present Value Cell Formula
2 1 $1,678 0.96946 $1,627 =PV($B$10,A2,0,−B2)
3 2 1,438 0.93986 1,352 =PV($B$10,A3,0,−B3)
4 3 1,235 0.91116 1,125 =PV($B$10,A4,0,−B4)
5 4 1,036 0.88333 915 =PV($B$10,A5,0,−B5)
6 5 839 0.85636 718 =PV($B$10,A6,0,−B6)
7 >5 $2,438 ($839 × 2.906 years) 2.73602 × 0.85636 1,966 =PV($B$10,B9,−B6,0,0)*PV(B10,A6,0,−1)
8 Total payments $8,664 $7,703 =SUM(D2:D7)
9 Remaining life 2.906 =B7/B6

10 Discount rate 3.15%
The total operating lease liability of $7,703 million consists of a portion maturing in the next
year, which is reported as a current liability and the remainder, reported as a long-term liability, as
highlighted in Microsoft’s balance sheet above. The table above shows a current portion of $1,627
million, slightly higher than the $1,515 million Microsoft reports in its footnotes. The difference
arises because Microsoft uses a specific discount rate for each lease, whereas we use an average
of 3.15% for all leases.
BUSINESS INSIGHT Imputed Discount Rate Computation for Leases

Microsoft reports total undiscounted minimum operating lease payments of $8,664 million and a
discounted value for those lease payments of $7,703 million. Using Excel, we can use the IRR func-
tion to estimate the implicit discount rate that Microsoft used for its capital lease computations. The
following spreadsheet lays out the calculations.
Amounts in cells B2 through G2 are from Microsoft’s lease footnote shown earlier in this sec-
tion. Cells H2 through J2 sum to $2,438 million, the total lease payments due after 2023 (year 5).
We assume that Microsoft continues to pay $839 million per year (the same as in 2023) with a final
payment of $760 million, until the $2,438 million is used up. The IRR function estimates that Micro-
soft used a discount rate of 3.15% to capitalize its operating leases in its FY2019 balance sheet.
In this method we make assumptions about the remaining useful life of the lease assets (total
remaining payments divided by the payment in year 5). Many firms disclose the weighted average
discount rate and the weighted average remaining lease term used to determine the present value
of future lease payments. If provided, these assumptions are a more exact way to corroborate the
disclosed present value or implicit interest rates.
B3  × ✓ fx =IRR(B2:J2,0.1)
A B C D E F G H I J
1 N 0 1 2 3 4 5 6 7 8
2 Amount (7,703) 1,678 1,438 1,235 1,036 839 839 839 760
3 IRR* 3.15%
4 =2,438
5 *Formula for cell B3 is =IRR(B2:J2,0.1), as shown in the formula bar at the top of the sheet
10_fsav6e_mod10.indd 7 6/4/20 5:06 PM

10-25 Module 10 | Analyzing Leases, Pensions, and Taxes © Cambridge Business Publishers
ANALYST ADJUSTMENTS 10.2 Concluded
$ millions 2015 2016 2017 2018 2019
Cash contributions to pension plan�� $783 $768 $2,115 $2,631 $1,125

Cash contributions at 5-year average�� 1,140 1,437 1,515 1,633 1,697
Adjustment (to level out amounts)�� +357 +669 −600 −998 +572
To adjust the financial statements, we note that cash contributions have no income statement effect (which is dif-
ferent from most other adjustments). Instead, the cash flow statement is impacted via operating cash flows and the
balance sheet is impacted via pension assets. Because cash contributions to pension plans are deductible for tax
purposes (whereas pension expense is recorded in the income statement) there is a deferred tax effect related to
the pension contribution adjustment. We assume a tax rate of 22% and adjust the financial statements as follows.
Adjustments ($ millions) 2015 2016 2017 2018 2019
Statement of cash flows adjustments

Cash contribution�� +$357 +$669 −$600 −$998 +$572
Cash from operations�� −357 −669 +600 +998 −572
Balance sheet adjustments
Cash balance�� −357 −669 +600 +998 −572
Pension
Deferredplan assets. .at
tax liabilities . .22%
. . . . ��
....... +357
−78 +669
−147 -600
+132 -998
+220 +572
−126
Deferred tax assets��
Pension plan liabilities at 22%. . . . . . . -78
+278 -147
+522 +132
−468 +220
−778 -126
+446
Retained earnings. . . . . . . . . . . . . . . . . +78 +147 -132 -220 +126
Other Post-Employment Benefits (OPEB)

In addition to pension benefits, many companies provide healthcare and insurance benefits to
retired employees. These benefits are referred to as other post-employment benefits (OPEB).
These benefits present reporting challenges similar to pension accounting. However, companies
most often provide these benefits on a “pay-as-you-go” basis and it is rare for companies to make
contributions in advance for OPEB. As a result, this liability, known as the accumulated post-
employment benefit obligation (APBO), is largely, if not totally, unfunded. GAAP requires that
the unfunded APBO liability, net of any unrecognized amounts, be reported in the balance sheet
and the annual service costs and interest costs be accrued as expenses each year. This requirement
is controversial for two reasons. First, future healthcare costs are especially difficult to estimate,
so the value of the resulting APBO (the present value of the future benefits) is fraught with error.
Second, these benefits are provided at the discretion of the employer and can be altered or ter-
minated at any time. Consequently, employers argue that without a legal obligation to pay these
benefits, the liability should not be reported in the balance sheet. (For a more complete discussion
of OPEB issues, see: https://www.pwc.com/us/en/corporate-governance/assets/pension-paper.pdf.)
RESEARCH INSIGHT Valuation of Nonpension Post-Employment Benefits

The FASB requires employers to accrue the costs of all nonpension post-employment benefits,
known as accumulated post-employment benefit obligation (APBO). These benefits consist primarily
of healthcare and insurance. This requirement is controversial due to concerns about the reliability
of the liability estimate. Research finds that the APBO (alone) is associated with company value.
However, when other pension-related variables are included in the research, the APBO liability is no
longer useful in explaining company value. Research concludes that the pension-related variables
do a better job at conveying value-relevant information than the APBO number alone, which implies
that the APBO number is less reliable.
These other post-employment benefits can produce large liabilities. For example, Deere’s
footnotes report a funded status for the company’s healthcare obligation of $(4,753) million in
2018, consisting of an APBO liability of $5,472 million and OPEB plan assets of $719 million.
Our analysis of cash flows related to pension obligations can be extended to other post-employ-
ment benefit obligations. For example, in addition to its pension payments, Deere discloses that it
is obligated to make healthcare payments to retirees totaling about $320 million to $345 million
10_fsav6e_mod10.indd 25 6/4/20 5:06 PM

11-9 Module 11 | Financial Statement Forecasting © Cambridge Business Publishers
FORECASTING THE INCOME STATEMENT

ectures
eL
LO2 Exhibit 11.2 presents the FY2019 income statement for Procter & Gamble together with our
MBC Forecast forecast of the statements for FY2020.
revenues
and the Overview Here is a high-level overview—computational details follow.
income statement.
■ Sales estimate. The forecasting process begins with an estimate of the sales growth rate.
For our illustration, we assume a 3.5% growth rate, informed by P&G’s guidance. Given the
assumed 3.5% growth in sales, forecasted 2020 sales are $70,053 million ($67,684 million
× 1.035).
■ Expense estimates. To estimate operating expenses (cost of goods sold and selling, general,
and administrative [SG&A] expenses) we apply a percentage of sales ratio to forecasted
sales. For nonoperating expenses (such as interest expense and interest revenue), we initially
assume they will not change (“no change”) unless we believe interest rates are likely to shift
greatly during the forecast period. (In Appendix 11B, we relax the “no change” assump-
tion because we add debt to achieve a desired level of cash. Additional debt causes interest
expense to increase. We discuss these additional steps in Appendix 11B.)
■ One-time item estimates. One-time items such as asset impairments and discontinued opera-
tions, are, by definition, not expected to recur. We forecast these items to be $0.
■ Tax estimate. Income tax expense is forecasted based on PG’s guidance of 17.5% of pretax
income.
■ Noncontrolling interest estimate. A common assumption is no change in the ratio of
noncontrolling interest to consolidated net income. For our P&G illustration, we adopt that
assumption.
For each line item in the income statement, we summarize our forecasting assumptions in the
rightmost column of Exhibit 11.2, and we discuss those assumptions in depth in the following
sections.
EXHIBIT 11.2 Forecast of P&G’s FY2020 Income Statement

FY2019 % of Net FY2020 % of Net
$ millions Actual Sales Computations Est. Sales Explanation
Net sales�� $67,684 100.0% $67,684 × 1.035 $70,053 100.0% Use P&G’s guidance that sales will increase
about 3.5%. Sales forecast equals current
sales × (1 + growth rate %).
Cost of products sold�� 34,768 51.4% $70,053 × 51.4% 36,007 51.4% Assume COGS as % of sales will remain
unchanged from FY2019.
Selling, general, and administrative expense �� 19,084 28.2% $70,053 × 28.2% 19,755 28.2% Assume SG&A as % of sales will remain
unchanged from FY2019.
Goodwill & indefinite lived intangibles The Goodwill impairment charge is a
impairment charges�� 8,345 12.3% none 0 transitory item and we eliminate that expense
in FY2020.
Operating income �� 5,487 8.1% subtotal 14,291 20.4%
Interest expense �� 509 0.8% computed 483 0.7% Interest expense is discussed below.
Interest income �� 220 0.3% no change 220 0.3% Assume no change in interest revenue.
Other nonoperating income, net �� 871 1.3% none 0 0.0% FY2019 nonoperating income relates to
the dissolution of a partnership and early
extinguishment of debt, and we assume
none for FY2020 given no evidence of
planned divestitures or debt retirement.
Earnings from continuing operations before
income taxes�� 6,069 9.0% subtotal 14,028 20.0%
Income taxes on continuing operations �� 2,103 3.1% $14,028
$14,014 × 17.5% 2,455 3.5% Assume effective tax rate of 17.5% per P&G
guidance.
Net earnings �� 3,966 5.9% subtotal 11,573 16.5%
Less: Net earnings attributable to
noncontrolling interests �� 69 0.1% $11,573
$11,562 × 1.7% 197 0.3% Assume noncontrolling interests as % of net
earnings (1.7%) continues.
Net earnings attributable to P&G�� $ 3,897 5.8% subtotal $11,376 16.2%
11_fsav6e_mod11.indd 9 6/5/20 7:28 AM

million/$30,689 million). P&G begins the FY2020 year with $30,092 million ($9,697 million +
$20,395 million) of short-term and long-term debt and predicts contractual payments of $3,388
for FY2020, yielding an anticipated debt balance of $28,320
$26,704 for FY2020 ($30,092 − $3,388). For
the initial forecast, we assume no additional borrowing during the year (we relax that assump-
tion in Appendix 11B when we perform a multiyear forecast). Our forecast for FY2020 interest
expense is $483 million calculated as 1.7% × ($30,092 + $26,704)/2.
Income Tax Expense Income tax expense (labeled “Income taxes on continuing opera-
tions” by P&G) is often a large expense item. We estimate tax expense by applying an estimated
tax rate to pretax income. For FY2020, we use an effective tax rate of 17.5% as provided in PG’s
guidance. In the absence of company guidance, we can use disclosures in the income tax footnote
to get a tax rate estimate. Following is the effective tax rate disclosure in P&G’s FY2019 10-K.
Years Ended June 30 ($ millions) 2019 2018 2017
U.S. federal statutory income tax rate�� 21.0% 28.1% 35.0%

Country mix impacts of foreign operations �� (0.5)% (4.7)% (6.8)%
Changes in uncertain tax positions�� (0.3)% (0.3)% (2.0)%
Excess tax benefits from the exercise of stock options�� (3.8)% (0.4)% (1.3)%
Goodwill impairment �� 22.8% —% —%
Net transitional impact U.S. Tax Act�� —% 4.5% —%
Other�� (4.5)% (1.2)% (1.8)%
Effective income tax rate�� 34.7% 26.0% 23.1%
The aim of reviewing the tax table in the footnotes is to determine the tax rate to use for our
forecasts. We look for any transitory items that affect the company’s tax rate and we exclude
such items in our forecast. In FY2019, for example, P&G’s effective tax rate increased by 22.8
percentage points due to the Goodwill impairment that reduced pre-tax profit without a conse-
quent reduction of income tax expense (Goodwill write-offs are generally not a tax-deductible
expense). Given that the Goodwill impairment is a one-time occurrence, we would forecast a tax
rate of 11.9% (34.7% effective tax rate less 22.8%). In addition, the line item labeled as “Other”
increased by 2 to 3 percentage points over the previous two years. Adding that amount, then,
results in an estimate of the effective tax rate that is close to the 17.5% rate in P&G’s guidance.
Impact of Acquisitions When one company acquires another, the revenues and expenses of the
acquired company are consolidated, but only from the date of acquisition onward (we discuss the
consolidation process in an earlier module). Acquisitions can greatly impact the acquirer’s income
statement, especially if the acquisition occurs toward the beginning of the acquirer’s fiscal year.
In FY2019 P&G did not have any material acquisitions. Therefore, we use P&G’s acquisition of
Gillette in October 2005 as an example. In its June 30, 2006, fiscal year-end income statement
(ending eight months following the acquisition), P&G reported the following for sales.
Years Ended June 30 ($ millions) 2006 2005 2004
Net sales�� $68,222 $56,741 $51,407
These net sales amounts include Gillette product sales from October 2005 onward (for fiscal
2006), and none of Gillette’s sales is reported in fiscal 2005 or fiscal 2004. P&G’s 2006 sales
growth of 20.2% ([$68,222 million/$56,741 million] − 1) was, therefore, not P&G’s organic
growth, and we would have been remiss in forecasting a 20.2% increase for fiscal 2007.
Importantly, until all three annual income statements in the 10-K include the acquired com-
pany, the acquirer is required to disclose what revenue and net income would have been had the
acquired company been consolidated for all three years reported in the current annual report. This
“what if” disclosure is called pro forma disclosure. Procter & Gamble’s pro forma disclosure in
the footnotes to its 2006 10-K includes the following discussion and table.
11_fsav6e_mod11.indd 11 6/5/20 7:28 AM

© Cambridge Business Publishers Module 11 | Financial Statement Forecasting 11-14
EXHIBIT 11.3 Forecast of P&G’s FY2020 Balance Sheet

2019 % of 2020 % of
$ millions, except per share amounts Actual Sales Computations Est. Sales Explanation
Current assets
Cash and cash equivalents . . . . . . . . . . . . . . . $ 4,239 6.3% Plug $ (1,550) 0.1% Plug to balance the balance sheet.*
Available-for-sale investment securities . . . . . 6,048 8.9% no change 6,048 8.6% Assume no change.
Accounts receivable . . . . . . . . . . . . . . . . . . . . 4,951 7.3% $70,053 × 7.3% 5,114 7.3% Forecast working capital accounts as a
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,017 7.4% $70,053 × 7.4% 5,184 7.4% % of sales using prior year’s % unless
information suggests otherwise.**
Prepaid expenses and other current assets . . 2,218 3.3% $70,053 × 3.3% 2,312 3.3%
Total current assets . . . . . . . . . . . . . . . . . . . . . 22,473 33.2% subtotal 17,108 26.7%
Property, plant, and equipment, net . . . . . . . . 21,271 31.4% $3,328 − $2,604 21,995 31.4% CAPEX estimates are from P&G
guidance, and depreciation expense
is computed as a % of prior year PPE,
gross.
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,273 59.5% no change 40,273 57.5% Assume no changes because goodwill
is not amortized.
Trademarks and other intangible assets, net . . 24,215 35.8% ($359) 23,856 34.1% Apply estimated amortization expense
from footnotes of P&G.
Other noncurrent assets . . . . . . . . . . . . . . . . . 6,863 10.1% no change 6,863 9.8% Assume no change.
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $115,095 170.0% subtotal $110,095 159.5%
Current liabilities
Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 11,260 16.6% $70,053 × 16.6% $ 11,629 16.6% Forecast working capital accounts as
Accrued and other liabilities . . . . . . . . . . . . . 9,054 13.4% $70,053 × 13.4% 9,387 13.4% % of sales unless information suggests
otherwise.
Debt due within one year . . . . . . . . . . . . . . . 9,697 14.3% ($3,388) + $2,009 8,318 16.1% Use footnotes to get current maturities
of long-term debt. Assume other debt
remains unchanged.
Total current liabilities . . . . . . . . . . . . . . . . . 30,011 44.3% subtotal 29,334 46.1%
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . 20,395 30.1% ($2,009) 18,386 24.3% Use footnotes to get current maturities
of long-term debt to be repaid.
Deferred income taxes . . . . . . . . . . . . . . . . . . 6,899 10.2% $70,053 × 10.2% 7,145 10.2% Assume no change as a % of sales.
Other noncurrent liabilities . . . . . . . . . . . . . . . . 10,211 15.1% $70,053 × 15.1% 10,578 15.1% Assume no change as a % of sales.
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 67,516 99.8% subtotal 65,443 95.7%

Shareholders’ equity
Convertible Class A preferred stock . . . . . . . . 928 1.4% no change 928 1.3%
Nonvoting Class B preferred stock . . . . . . . . . 0 0.0% no change 0 0.0% Assume no change in paid-in capital
Common stock, stated value $1 per share . . . 4,009 5.9% no change 4,009 5.7% accounts.
Additional paid-in capital . . . . . . . . . . . . . . . . . 63,827 94.3% no change 63,827 91.1%
Reserve for ESOP debt retirement . . . . . . . . . (1,146) (1.7)% no change (1,146) (1.6)% Assume no change.
Accumulated other comprehensive income
(loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,936) (22.1)% no change (14,936) (21.3)% Assume no change.
Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . (100,406) (148.3)% ($7,000) (107,406) (153.3)% Use P&G guidance.
Retained earnings . . . . . . . . . . . . . . . . . . . . . . 94,918 140.2% $11,376
$11,573 − $7,500 98,794 141.0% Increased by forecasted net income
less forecasted dividends.
Noncontrolling interest . . . . . . . . . . . . . . . . . . . 385 0.6% + $197 582 0.8% Increased by net income allocated to
noncontrolling interests.
Total shareholders’ equity . . . . . . . . . . . . . . . . 47,579 70.3% subtotal 44,652 63.7%
Total liabilities and shareholders’ equity . . . . . $115,095 170.0% subtotal $110,095 159.5%
* $(1,561) = $110,084 − $6,048 − $5,114 − $5,184 − $2,312 − $21,995 − $40,273 − $23,856 − $6,863.
** To simplify, we forecast accounts as a percent of sales, including inventories and accounts payable. Analysts sometimes use a percent of COGS for inventory and for accounts payable
estimates because both are expressed in input (not output) costs. Either approach is reasonable if used consistently. One could also forecast working capital accounts using turnover
rates or days as follows:
Forecasted account balance = Forecasted revenues (or COGS)/Turnover rate, or = Forecasted days outstanding × [Forecasted revenues (or COGS)/365]
P&G’s 2019 statement of cash flows reports CAPEX of $3,347 million, which yields an historical
rate of 4.9% of sales ($3,347 million/$67,684 million). This is consistent with the 4.5% to 5%
range provided in P&G’s guidance.
Depreciation Expense. Depreciation expense is usually reported in the statement of cash flows
(or in the notes). (Note: If depreciation expense is combined with amortization expense, we can
isolate the depreciation component by subtracting amortization expense, which is frequently
11_fsav6e_mod11.indd 14 9/28/20 6:51 PM

reported separately in footnotes—or, if not separately reported, we may use the change in accu-
mulated amortization.) It is common to estimate depreciation as:
Forecasted depreciation = _Current IVyear depreciation IVCommon

expense_
Equity x Current IVyear PPE, gross
r r r r
Debt Preferred Equity
expense = = q × Prior r +
year q
PPE, × gross r + q × r
IV IV IV
w d ce pe
Firm Firm Firm
P&G’s 2019 statement of cash flows reports depreciation and amortization expense of $2,824
million. Footnotes report amortization expense in 2019 of $349 million. Thus, we calculate 2019
depreciation expense as $2,475 million ($2,824 million − $349 million). The PPE footnote reports
2018 PPE, gross of $41,487 million, and 2019 PPE, gross of $43,393 million. We calculate a
depreciation expense forecast assumption of 6.0% ($2,475 million expense/$41,487 million PPE,
gross) and an estimated 2020 depreciation expense of $2,604 million (6.0% × $43,393 million).
PPE, net. Drawing on the forecasted CAPEX and forecasted depreciation above, the PPE, net is
forecasted as:
ForecastedD =+Current
IV1 $2++ Forecasted
$41 - Forecasted
IVnet
PPE, 0 =
1
PPE, =net = $39.45 depreciation expense
CAPEX
1 + re 1.09
Forecasted 2020 PPE, net is $21,995 million, computed as $21,271 million + $3,328 million − $2,604
million.
Intangible Assets Intangible assets, other than goodwill, are typically forecasted to
decrease during the year by the amount of amortization (it is common to assume no change in
amortization expense). Forecasted = Current year - Forecasted
D1 assetsD 2 intangible
intangible D 3 assets amortization expense
IV0 = + + +…
1 + re (1 + re )2 (1 + re )3
Alternatively, the company might provide guidance. Footnotes to the P&G’s FY2019 Form 10-K
provide the following schedule of expected amortization expense that we use for its FY2020
forecast. We forecast that intangible assets will decrease by $359 million in FY2020.
Years Ending June 30 ($ millions) 2020 2021 2022 2023 2024
Estimated amortization expense . . . . . . . . . . . . . $359 $309 $290 $278 $267
Long-Term Debt (LTD) Companies report maturities of long-term debt for the next five
years in the long-term debt footnote. We use this disclosure to forecast long-term debt:
Forecasted LTD = Current year LTD − Current maturities of LTD
Footnotes to P&G’s FY2019 Form 10-K provide the following schedule of maturities of LTD that
we use in our forecasts.
Years Ending June 30 ($ millions) 2020 2021 2022 2023 2024
Debt maturities �� $3,388 $2,009 $2,840 $2,465 $2,461
P&G’s balance sheet does not separately report current maturities of long-term debt. Instead, the
current maturities amount is aggregated with other short-term debt and reported as “Debt due
within one year.” To forecast current maturities, we subtract $3,388 million from debt due within
one year to reflect the amount that matures and will be paid in FY2020. We then add $2,009 mil-
lion, the amount that comes due in FY2021. We subtract $2,009 million from long-term debt to
reflect the reclassification from long-term to current.
Retained Earnings We forecast retained earnings as follows.
Forecasted Current year Forecasted Forecasted
retained earnings = retained earnings + net income − dividends
11_fsav6e_mod11 .indd 15 6/5/20 2:47 PM

Dividends. Companies frequently provide guidance as to expected dividends. If not, a com-

mon approach is to estimate dividends using the dividend payout ratio.
Forecasted dividends = ___Current D1 +year
IV1 dividends___ x Forecasted net income
IV0 =
Current year net income
1 + re
This method will be less exact if a company reports significant one-time items. In that case, we
exclude the one-time item in the payout ratio calculation. P&G’s dividend payout ratio for FY2019,
computed on earnings before the intangibles impairment expense, is 60.9% ($7,498 million divi-
dends paid in FY2019 divided by $12,311 million in FY2019 net income before intangibles impair-
ment expense). We estimate FY2020 dividends by applying the FY2019 payout ratio to forecasted
net income ($11,365 million × 60.9% = $6,921 million). P&G’s guidance is for dividends of
“$7.5B+” (see the Company Guidance section). The forecasted dividends of $6,921 million are just
slightly below that guidance. We include the guidance in our forecast because it is more precise.
Treasury Stock Many companies have multiyear stock repurchase programs, which are
disclosed in footnotes or in the MD&A section of the 10-K. Often, in the year-end press release,
companies provide guidance and/or disclosures about their planned treasury stock activity. Absent
explicit disclosures or guidance, we can forecast future repurchases using historic data, either from
the most recent year or by looking for a trend over the past two or three years. For P&G, we use the
midpoint of guidance provided by managers and forecast $7B of additional repurchases in FY2020.
The forecasting process estimates the balances of all assets other than cash, all liabilities, and
all equity accounts. The last step is to compute the amount of cash needed to balance the balance
sheet (the plug).
Cash Plug (the plug) The plug is computed as total assets (equal to total liabilities and
equity) less all other asset balances. We assess the forecasted cash balance and determine if it
deviates from its historical norm. We use the current year cash-to-sales percentage as a normal
level of cash. This assumes the amount reported in the current balance sheet represents an appro-
priate level of cash the company needs to conduct its operations.
Estimating the Normal Cash Level P&G’s cash balance in 2019 is $4,239 million or
6.3% of 2019 sales. Applying that percentage to our forecasted sales of $70,053 million yields a
normal level of cash of $4,413 million ($70,053 million × 6.3%). Our forecasted cash balance of
$(1,550) million in Exhibit 11.3 is, therefore, too low.
When Cash Plug Deviates from Norm When the forecasted cash level deviates from
the target cash balance, we can consider adjusting the forecasted cash balance in two ways.
■ Cash balance much HIGHER than normal This indicates the company is generating more
cash than expected, most typically from operations. Our forecasts might assume that such
excess liquidity can be invested in marketable securities, used to pay down debt, repurchase
stock, increase dividend payments, or any combination of these actions.
■ Cash balance much LOWER than normal This indicates the company is not generating suf-
ficient cash, usually as a result of net losses, significant dividend payments, stock repurchases,
and/or operating assets increasing more than operating liabilities; remember, we are assuming
no changes in debt and equity levels for our initial forecast. To return cash to normal levels, we
might expect the company would borrow money, sell stock, and/or liquidate marketable securi-
ties. Under those assumptions, we would adjust the forecasted balance sheet by increasing cash
to a normal level and adjust debt or equity to reflect the means by which additional cash was
raised. Alternatively, we might expect the company would reduce dividends, cut capital expen-
ditures, slash inventory and/or take other operating action. Raising cash in this way likely has
serious costs and, for that reason, we rarely make assumptions of this sort. It is more likely the
company would raise cash through investing and financing activities.
In Appendix 11B, we illustrate a method to achieve a target level of cash in our multiyear fore-
casts. The method involves adding debt to the balance sheet and adjusting interest expense on the
income statement as needed.
Maintaining the Capital Structure When we adjust cash by forecasting an
increase or decrease in debt and/or stock, we might inadvertently impact the company’s capital
11_fsav6e_mod11.indd 16 6/5/20 7:28 AM

any noncash expenses or revenues, and then recognizes the cash flow effect of changes in working capital followed
by changes in the remaining asset, liability, and equity items. A common method is to compute changes in each of
the line items on the forecasted balance sheet and then classify those changes to either the operating, investing, or
financing sections of the forecasted statement of cash flows.
Exhibit 11A.1 shows the forecasted statement of cash flows for Procter & Gamble. It reveals operating cash
flows of $15,427 million, investing cash outflows of $3,328 million, and a large financing cash outflow of $17,888
million.
EXHIBIT 11A.1 One-Year Forecast of P&G’s Statement of Cash Flows
Statement of Cash Flows

For Fiscal Year Ended 2020
$ millions Computations 2020 Est.
Cash flow from operating activities

Net income �� $11,573
Add: Depreciation �� 2,604
Add: Amortization �� 359
Change in accounts receivable�� $4,951 − $5,114 (163)
Change in inventories�� $5,017 − $5,184 (167)
Change in prepaid expenses and other current �� $2,218 − $2,312 (94)
Change in accounts payable�� $11,629 − $11,260 369
Change in accrued other liabilities�� $9,387 − $9,054 333
Change in deferred income taxes�� $7,145 − $6,899 246
Change in other noncurrent liabilities �� $10,578 − $10,211 367
Net cash from operating activities �� 15,427
Capital expenditures�� $70,053 × 4.75% (3,328)

Change in available-for-sale securities�� no change 0
Net cash from investing activities ��
including noncontrolling interest (3,328)
Dividends�� (7,500)
Increase in short-term debt��
Decrease (1,379)
Decrease in long-term debt�� (2,009)
Purchase of treasury shares�� (7,000)
Net cash from financing activities �� (17,888)
Net change in cash�� (5,789)

Beginning cash �� 4,239
Ending cash�� $ (1,550)
The forecasted statement of cash flows highlights financing cash outflows as the main cause for the forecasted
decline in cash. While operating cash flows continue to be strong, P&G’s guidance includes plans to continue to
repurchase common stock (approximately $7,000 million), pay dividends (approximately $7,500 million), and
purchase CAPEX (approximately $3,328 million). In this first forecasting iteration, we forecast a decrease in cash
of $(5,789) million, which reduces P&G’s cash balance from $4,239 million to $(1,550) million. The drop in cash
arises due to the planned outflows for CAPEX, the payment of dividends, and the repurchase of stock with no
borrowings forecasted at this point. Such a low cash balance is not plausible. In Appendix 11B, we discuss how to
modify the forecasts to derive an appropriate cash balance.
BUSINESS INSIGHT Do Currency Fluctuations Affect Cash Flow?

A stronger $US vis-à-vis other world currencies results in less income as foreign currency-denominated
revenues are translated into fewer $US. As sales decline, so do profits. Because net income is the first line
in the statement of cash flows, it is reasonable to ask whether the profit decline resulting from a strengthen-
ing $US implies P&G’s cash flows will also decline. If so, we would expect such a decline to affect P&G’s
stock price. The short answer is that it is unlikely that P&G’s cash flows will be greatly affected.
continued
11_fsav6e_mod11.indd 20 6/5/20 7:28 AM

© Cambridge Business Publishers Module 13 | Cash-Flow-Based Valuation 13-34
July 27, July 28,

$ millions, except par value 2019 2018
Liabilities and equity

Current liabilities
Short-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,191 $ 5,238
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,059 1,904
Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,149 1,004
Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,221 2,986
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,668 11,490
Other current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,424 4,413
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,712 27,035
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,475 20,331
Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,927 8,585
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,799 8,195
Other long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,309 1,434
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,222 65,580
Equity
Cisco shareholders’ equity
Preferred stock, no par value: 5 shares authorized; none issued
and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — —
Common stock and additional paid-in capital, $0.001 par value:
20,000 shares authorized; 4,250 and 4,614 shares issued and
outstanding at July 27, 2019, and July 28, 2018, respectively . . . . . . 40,266 42,820
(Accumulated deficit) Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . (5,903) 1,233
Accumulated other comprehensive income (loss) . . . . . . . . . . . . . . . . . (792) (849)
Total Cisco shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,571 43,204
Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,571 43,204
Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $97,793 $108,784
Required
a. Compute net operating assets (NOA) for 2019.
b. Compute net operating profit after tax (NOPAT) for 2019, assuming a federal and state statutory tax
rate of 22%. Assume that all items on the 2019 income statement will persist.
c. Use the parsimonious forecast method, as shown in Analysis Insight box on page 13-5, to forecast Cisco’s
sales, NOPAT, and NOA for 2020 through 2023 and the terminal period using the following assumptions.
Sales growth 2020–2023�� 5%

Terminal growth�� 1%
Net operating profit margin �� 2019 rate rounded to three decimal places
Net operating asset turnover�� 2019 rate rounded to three decimal places
d. Estimate the value of a share of Cisco common stock using the discounted cash flow (DCF) model
as of July 27, 2019; assume a discount rate (WACC) of 7.6%, common shares outstanding of 5,029
million, and net nonoperating obligations (NNO) of $(8,747) million (NNO is negative, which means
that Cisco has net nonoperating investments).
e. Cisco stock closed at $48.42 on September 5, 2019, the date the Form 10-K was filed with the SEC.
How does your valuation estimate compare with this closing price? What do you believe are some
reasons for the difference? What investment decision is suggested from your results?
P13-15. Estimating Share Value Using the DCF Model LO2
Following are forecasted sales, NOPAT, and NOA for AT&T for 2019 through 2022.
AT&T INC. (T)
mework
Ho
Forecast Horizon Period
Reported MBC
$ millions 2018 2019 2020 2021 2022
Sales�� $170,756 $181,001 $191,861 $203,373 $215,576

NOPAT �� 20,895 22,082 23,407 24,812 26,300
NOA�� 369,039 390,931 414,387 439,251 465,607
13_fsav6e_mod13.indd 34 9/28/20 7:16 PM

FY2019 net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,557

Forecasted FY2020 net income including noncontrolling interest�� $4,927 million
Forecasted FY2020 net sales�� $33,002 million
Accounts receivable, less allowance�� 20.4% of net sales
Inventories, net �� 12.3% of net sales
Other current assets �� 7% of net sales
Goodwill�� No change
Tax assets�� 5% of net sales
Other assets �� 3.3% of net sales
Accounts payable �� 6.4% of net sales
Accrued compensation (current liability)�� 7.2% of net sales
Accrued compensation and retirement benefits (noncurrent liability)�� No change
Accrued income taxes (current liability)�� 1.9% of net sales
Other accrued expenses�� 9.6% of net sales
Accrued income taxes (noncurrent liability)�� 9.3% of net sales
Deferred tax liabilities �� 4.2% of net sales
Other liabilities�� 2.5% of net sales
Ordinary shares�� No change
Accumulated other comprehensive loss�� No change
Net income attributable to noncontrolling interest�� $19 million
Dividends in FY2020�� $2,853 million
CAPEX in FY2019 (to be forecast as % of net sales)�� $1,134 million
Depreciation expense in FY2020 �� $950 million
Amortization expense in FY2020�� $1,914 million
Debt due in FY2020�� $838 million
Debt due in FY2021 �� $2,058 million
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . No Change
M11-17. Adjust the Income Statement LO2
Following is information from the tax footnote from the 2018 10-K for Honeywell International. HONEYWELL
INTERNATIONAL
INC. (HON)
Years Ended December 31 2018 2017 2016
The U.S. federal statutory income tax rate is reconciled to

our effective income tax rate as follows:
U.S. federal statutory income tax rate �� 21.0% 35.0% 35.0%
Taxes on non-U.S. earnings�� 0.2 (12.8) (8.0)
U.S. state income taxes�� 1.6 1.4 1.1
Reserves for tax contingencies �� 0.3 1.6 1.2
Employee share-based payments�� (0.7) (2.9) (2.0)
U.S. tax reform�� (5.8) 56.0 —
Reduction on taxes on unremitted earnings�� (14.2) — —
Separation tax costs�� 5.5 — —
All other items—net �� 0.9 (1.1) (2.5)
8.8% 77.2% 24.8%
The effective tax rate for 2018 was lower than the U.S. federal statutory rate of 21% primarily at-
tributable to internal restructuring initiatives that resulted in a reduction of accrued withholding taxes of
approximately $1.1 billion related to unremitted foreign earnings. In addition, we recorded a tax benefit
of approximately $440 million as a reduction to our 2017 provisional estimate of impacts from what is
commonly referred to as the U.S. Tax Cuts and Jobs Act.
The effective tax rate for 2017 was higher than the U.S. federal statutory rate of 35% primarily from
the estimated impacts of U.S. Tax Reform of approximately $3.8 billion, partially offset by lower tax
rates on non-U.S. earnings.
a. What adjustments, if any, should we consider before forecasting Honeywell’s 2020 income?
b. Adjust Honeywell’s effective tax rate for each of the three years to reflect persistent factors.
11_fsav6e_mod11.indd 36 9/28/20 6:52 PM

14-21 Module 14 | Operating-Income-Based Valuation © Cambridge Business Publishers
QUESTIONS
Q14-1. In general, what role do expectations play in pricing equity securities? What is the relation between
security prices and expected returns (the discount rate, or WACC, in this case)?
Q14-2. Define the weighted average cost of capital (WACC).
Q14-3. Define net operating profit after tax (NOPAT).
Q14-4. Define net operating assets (NOA).
Q14-5. Define the concept of residual operating income (ROPI). How is residual operating income used in
pricing equity securities?
Q14-6. What insight does disaggregation of RNOA into net operating profit margin and net operating asset
turnover provide for managing a company?
Q14-7. Explain what is meant by the phrase “steady state” when applied to equity valuation models.
Q14-8. What is one way to refine equity valuation models for companies that have not achieved steady state?
mework
Ho
Assignments with the MBC logo in the margin are available in .

See the Preface of the book for details.
MINI EXERCISES
LO1 M14-9. Interpreting Earnings Announcement Effects on Stock Prices
FACEBOOK On November 2, 2016, Facebook Inc. announced its 2016 third quarter results. Revenues were up nearly
INC. (FB) 50% from 2015 and earnings were up a whopping 180% ($5,944 million compared to $2,127 million).
Yet, in the ensuing days, Facebook’s stock value fell 7% according to CNBC. Why do you believe that
the company’s stock price fell despite the good news?
LO2 M14-10. Computing Residual Operating Income (ROPI)
HOME DEPOT Home Depot reports net operating profit after tax (NOPAT) of $12,073 million for the fiscal year ended
INC. (HD) February 3, 2019. Its net operating assets at the beginning of the fiscal year are $24,887 million. Assum-
mework
Ho ing a 7.85% weighted average cost of capital (WACC), what is Home Depot’s residual operating income
MBC for the fiscal year ended February 3, 2019? Show computations.
LO2 M14-11. Computing, Analyzing, and Interpreting Residual Operating Income (ROPI)
CISCO In its annual report for the fiscal year ended July 27, 2019, Cisco Systems reports net operating income
SYSTEMS after tax (NOPAT) of $11,346 million. As of the beginning of the fiscal year it reports net operating as-
(CSCO)
mework
sets of $22,225 million.
Ho
MBC a. Did Cisco earn positive residual operating income (ROPI) if its weighted average cost of capital
(WACC) is 7.6%? Explain.
b. At what level of WACC would Cisco not report positive residual operating income for the year?
Explain.
LO1, 2 M14-12. Estimating Share Value Using the ROPI Model
TARGET Following are forecasts of Target Corporation’s sales, net operating profit after tax (NOPAT), and net
CORPORATION operating assets (NOA) as of February 2, 2019, which we label fiscal year 2018.
(TGT)
mework
Ho
MBC Forecast Horizon Period

Reported Terminal
$ millions 2018 2019 2020 2021 2022 Period
Sales�� $75,356 $79,124 $83,080 $87,234 $91,596 $93,428

NOPAT �� 3,269 3,402 3,572 3,751 3,939 4,017
NOA�� 23,020 24,197 25,407 26,677 28,011 28,571
Answer the following requirements
assuming a terminal period growth
rate of 2%, a discount rate (WACC) a
. Estimate the value of a share of Target common stock using the residual operating income (ROPI)
of 7.63%, common shares model as of February 2, 2019.
outstanding of 517.8 million, and b . Target Corporation (TGT) stock closed at $77.12 on March 13, 2019, the date the 10-K was filed with
net nonoperating obligations the SEC. How does your valuation estimate compare with this closing price? What do you believe are
(NNO) of $11,723 million. some reasons for the difference?
14_fsav6e_mod14.indd 21 6/3/20 6:58 PM

14-23 Module 14 | Operating-Income-Based Valuation © Cambridge Business Publishers
EXERCISES
LO2 E14-18. Estimating Share Value Using the ROPI Model
Following are forecasts of Illinois Tool Works Inc. sales, net operating profit after tax (NOPAT), and
ILLINOIS TOOL
WORKS INC. net operating assets (NOA) as of December 31, 2018.
(ITW)
mework
Ho Forecast Horizon Period
Reported Terminal
MBC
$ millions 2018 2019 2020 2021 2022 Period
Sales�� $14,768 $15,654 $16,593 $17,589 $18,644 $19,017

NOPAT �� 2,711 2,880 3,053 3,236 3,430 3,499
Answer the following NOA�� 9,462 10,028 10,630 11,268 11,944 12,183
requirements assuming a
discount rate (WACC) of 7.35%, a
terminal period growth rate of a. Estimate the value of a share of Illinois Tool Works Inc. common stock using the residual operating
2%, common shares outstanding income (ROPI) model as of December 31, 2018.
of 328.1 million, and net b. Illinois Tool Works stock closed at $144.21 on February 15, 2019, the date the 10-K was filed with
nonoperating obligations (NNO) the SEC. How does your valuation estimate compare with this closing price? What do you believe are
of $6,204 million. some reasons for the difference?
LO2 E14-19. Estimating Share Value Using the ROPI Model
Following are forecasts of sales, net operating profit after tax (NOPAT), and net operating assets (NOA)
HUMANA (HUM)
mework
as of December 31, 2018, for Humana.
Ho
MBC Forecast Horizon Period

Reported Terminal
Answer the following $ millions 2018 2019 2020 2021 2022 Period
requirements assuming a discount
rate (WACC) of 7.8%, a terminal Sales�� $56,912 $57,766 $58,632 $59,512 $60,404 $61,008
period growth rate of 1%, common NOPAT �� 2,492 2,542 2,580 2,619 2,658 2,684
shares outstanding of 135.6 NOA�� 4,032 4,097 4,158 4,221 4,284 4,327
million, net nonoperating
obligations (NNO) of $(6,129)
million, which is negative because a. Estimate the value of a share of common stock using the residual operating income (ROPI) model as
Humana’s nonoperating assets of December 31, 2018.
exceed its nonoperating liabilities, b. Humana (HUM) stock closed at $307.56 on February 21, 2019, the date the 10-K was filed with the
and no noncontrolling interest SEC. How does your valuation estimate compare with this closing price? What do you believe are
(NCI) on the balance sheet. some reasons for the difference?
LO2 E14-20. Identifying and Computing ROPI Model Inputs
HOME DEPOT Following are the balance sheets and statement of earnings for Home Depot Inc. for fiscal year ended
INC. (HD) February 3, 2019, which the company labels fiscal year 2018.
mework
Ho
MBC THE HOME DEPOT INC.

Consolidated Balance Sheets
February 3, January 28,

$ millions, except par value 2019 2018
Assets
Current assets
Cash and cash equivalents�� $ 1,778 $ 3,595
Receivables, net �� 1,936 1,952
Merchandise inventories �� 13,925 12,748
Other current assets �� 890 638
Total current assets�� 18,529 18,933
Net property and equipment �� 22,375 22,075
Goodwill�� 2,252 2,275
Other assets �� 847 1,246
Total assets �� $44,003 $44,529
continued
14_fsav6e_mod14.indd 23 6/3/20 6:58 PM

© Cambridge Business Publishers Module 14 | Operating-Income-Based Valuation 14-28
$ millions, except par value July 27, 2019 July 28, 2018
Liabilities and equity

Current liabilities
Short-term debt �� $10,191 $ 5,238
Accounts payable�� 2,059 1,904
Income taxes payable �� 1,149 1,004
Accrued compensation �� 3,221 2,986
Deferred revenue�� 10,668 11,490
Other current liabilities�� 4,424 4,413
Total current liabilities�� 31,712 27,035
Long-term debt �� 14,475 20,331
Income taxes payable�� 8,927 8,585
Deferred revenue�� 7,799 8,195
Other long-term liabilities�� 1,309 1,434
Total liabilities�� 64,222 65,580
Equity:
Cisco shareholders’ equity
Preferred stock, no par value: 5 shares authorized; none issued
and outstanding�� — —
Common stock and additional paid-in capital, $0.001 par value:
20,000 shares authorized; 4,250 and 4,614 shares issued and
outstanding at July 27, 2019, and July 28, 2018, respectively�� 40,266 42,820
(Accumulated deficit) Retained earnings�� (5,903) 1,233
Accumulated other comprehensive income (loss)�� (792) (849)
Total Cisco shareholders’ equity �� 33,571 43,204
Total equity�� 33,571 43,204
Total liabilities and equity�� $97,793 $108,784
Required
a. Compute net operating assets (NOA) for 2019.
b. Compute net operating profit after tax (NOPAT) for 2019, assuming a federal and state statutory tax
rate of 22%. Assume that all items on the 2019 income statement will persist.
c. Use the parsimonious forecast method, as shown in the Analysis Insight box on page 14-5 and in Exhibit
14.2, to forecast Cisco’s sales, NOPAT, and NOA for 2020 through 2023 and the terminal period using the
following assumptions.
Sales growth 2020–2023�� 5%

Terminal growth�� 1%
Net operating profit margin �� 2019 rate rounded to three decimal places
Net operating asset turnover�� 2019 rate rounded to three decimal places
d. Estimate the value of a share of Cisco common stock using the residual operating income (ROPI)
model as of July 27, 2019.; assume a discount rate (WACC) of 7.6%, common shares outstanding of 5,029 million, and net nonoperating
e. Cisco stock closed at $48.42 on September 5, 2019, the date the Form 10-K was filed with the SEC. obligations (NNO) of
How does your valuation estimate compare with this closing price? What do you believe are some $(8,747) million (NNO is
negative, which means that
reasons for the difference? What investment decision is suggested from your results?
Cisco has net nonoperating
P14-27. Estimating Share Value Using the ROPI Model investments).
LO2
Following are forecasted sales, NOPAT, and NOA for AT&T for 2019 through 2022.
AT&T INC. (T)
mework
Ho
Reported MBC
$ millions 2018 2019 2020 2021 2022
Sales�� $170,756 $181,001 $191,861 $203,373 $215,576

NOPAT �� 20,895 22,082 23,407 24,812 26,300
NOA�� 369,039 390,931 414,387 439,251 465,607
Required
a. Forecast the terminal period values for Sales, NOPAT, and NOA, assuming a 2% terminal period
growth rate.
14_fsav6e_mod14.indd 28 9/28/20 7:20 PM

© Cambridge Business Publishers Module 14 | Operating-Income-Based Valuation 14-30
Required
a. Compute net operating assets (NOA) and net nonoperating obligations (NNO) for 2019. The com-
pany’s NNO is negative because cash exceeds debt.
b. Compute net operating profit after tax (NOPAT) for 2019 assuming a federal and state statutory tax
rate of 22%.
c. Use the parsimonious forecast method, as shown in the Analysis Insight box on page 14-5 and
in Exhibit 14.2, to forecast sales, NOPAT, and NOA for 2020 through 2023 using the following
assumptions.
Sales growth�� 8%
Net operating profit margin (NOPM)�� 2019 ratios rounded to three decimal places
Net operating asset turnover (NOAT), year-end�� 2019 ratios rounded to three decimal places
Forecast the terminal period value assuming a 2% terminal period growth and using the NOPM and
NOAT assumptions above.
d. Estimate the value of a share of Nike common stock using the residual operating income (ROPI) model
; assume
as of May 31, 2019. For a discount
simplicity, rate (WACC)
prepare of 6.8% and
your forecasts in $common shares outstanding of 1,682 million. For simplicity, prepare your
millions.
e. Nike’s stock closed at $86.70 on July 23, 2019, the date the Form 10-K was filed with the SEC. How forecasts in $ millions.
does your valuation estimate compare with this closing price? What do you believe are some reasons
for the difference? What investment decision is suggested from your results?
P14-29. Estimating Share Value Using the ROPI Model LO2, 3
Following are forecasted sales, NOPAT, and NOA for Colgate-Palmolive Company for 2019 through COLGATE-
2022. PALMOLIVE
COMPANY (CL)
mework
Ho
Colgate Palmolive (CL) Reported MBC
$ millions 2018 2019 2020 2021 2022
Sales�� $15,544 $16,010 $16,491 $16,985 $17,495

NOPAT �� 2,737 2,818 2,902 2,989 3,079
NOA�� 5,837 6,012 6,193 6,378 6,570
Required
a. Forecast the terminal period values for Sales, NOPAT, and NOA, assuming a 1% terminal period
growth rate.
b. Estimate the value of a share of Colgate-Palmolive common stock using the residual operating income
(ROPI) model. Assume a discount rate (WACC) of 5.7%, common shares outstanding of 862.9 mil-
lion, net nonoperating obligations (NNO) of $5,640 million, and noncontrolling interest (NCI) from
the balance sheet of $299 million.
c. Colgate-Palmolive stock closed at $66.70 on February 21, 2019, the date the Form 10-K was filed
with the SEC. How does your valuation estimate compare with this closing price? What do you be-
lieve are some reasons for the difference? What investment decision is suggested from your results?
d. The forecasts assumed a terminal growth rate of 1%. If the terminal growth rate had been 2%, what
would the estimated stock price have been?
e. What would WACC need to be to warrant the actual stock price on February 21, 2019?
ANALYSIS DISCUSSION POINT

D14-30. Management Application: Operating Improvement versus Financial Engineering LO4
Assume that you are the CEO of a small publicly traded company. The operating performance of your
company has fallen below market expectations, which is reflected in a depressed stock price. At your
direction, your CFO provides you with the following recommendations that are designed to increase
your company’s return on net operating assets (RNOA) and your operating cash flows, both of which
will, presumably, result in improved financial performance and an increased stock price.
1. To improve net cash flow from operating activities, the CFO recommends that your company reduce
inventories (raw material, work-in-progress, and finished goods) and receivables (through selective
credit granting and increased emphasis on collection of past due accounts).
2. The CFO recommends that your company lengthen the time taken to pay accounts payable (lean on
the trade) to increase net cash flows from operating activities.
14_fsav6e_mod14.indd 30 9/28/20 7:20 PM

15-9 Module 15 | Market-Based Valuation © Cambridge Business Publishers
EXHIBIT 15.4 Data for Valuation Using Income Statement Multiples
In millions Dollar General Dollar Tree Big Lots
From market Company assumed value �� — $27,035 $2,256

Equity assumed value�� — $23,020 $1,254
Net operating profit after tax (NOPAT) �� $1,668 $ 1,428* $ 165
From financial
Net income �� $1,589 $ 1,136* $ 157
statements
Common shares outstanding�� 268.7 shares 238.1 shares 40.0 shares
* To reflect persistent numbers, as appropriate for valuation, we adjust net income and NOPAT for an after-tax goodwill
impairment of $2,727 million.
Valuation Using a Net Operating Profit After

Tax (NOPAT) Multiple
We use the data from Exhibit 15.4 to compute a market multiple based on net operating profit
after tax (NOPAT) to estimate the value of Dollar General. We begin by determining the NOPAT
market multiple for both Dollar Tree and Big Lots, which is computed as company assumed value
divided by NOPAT. Exhibit 15.5 reports the results of this computation. Big Lots’ NOPAT mar-
ket multiple is 13.67 computed as $2,256 million/$165 million. Dollar Tree’s NOPAT multiple
is 18.93 computed as $27,035 million/$1,428 million. We use the average of the two multiples,
16.30, as the NOPAT multiple to estimate the company intrinsic value of Dollar General as fol-
lows ($ in millions).
EXHIBIT 15.5 Estimating Intrinsic Value Using a Net Operating Profit after Tax Multiple
In millions, except per share amounts Dollar General Dollar Tree Big Lots
Company assumed value �� — $27,035 $2,256

Net operating profit after tax (NOPAT) �� $ 1,668 $$ (1,299)
1,428 $ 165
NOPAT market multiple�� 16.30 18.93 13.67
Company intrinsic value �� $27,188
Equity intrinsic value�� $24,559
Equity intrinsic value per share�� $ 91.40
Company intrinsic value = Net operating profit after tax × NOPAT market multiple
$27,188 = $1,668 × 16.3
To obtain Dollar General’s equity intrinsic value we subtract from the company intrinsic value,
the net nonoperating obligations (in Exhibit 15.1) including the fair value of any preferred
stock outstanding ($0 for Dollar General). We then divide the equity intrinsic value by shares
outstanding to get the per share intrinsic value of its common equity.
Equity intrinsic value = Company intrinsic value − Net nonoperating obligations

$24,559 = $27,188 − $2,629
Then,
Equity intrinsic value
Equity intrinsic value per share =
Common shares outstanding
$24, 559
$91.40 =
268.7 shares
This estimate suggests that Dollar General was overvalued with respect to its $115.04 closing
price at its fiscal year-end (and vis-à-vis its $117.47 price on the filing date).
15_fsav6e_mod15.indd 9 6/5/20 7:49 AM

© Cambridge Business Publishers Module 15 | Market-Based Valuation 15-10
Valuation Using a Net Income (NI) Multiple

We can repeat the analysis above using a net income multiple as the basis for valuing the com-
pany. This approach produces the intrinsic value of the equity, not of the entire company. This
method relies on different data and, as such, we will not get the same intrinsic values computed
in the prior section.
EXHIBIT 15.6 Estimating Intrinsic Value Using a Net Income Multiple
In millions, except per share amounts Dollar General Dollar Tree Big Lots
Equity assumed value�� — $23,020 $1,254

Net income available to common shareholders�� $ 1,589 $$ 1,589
1,136 $ 157
NI market multiple�� 14.13 20.26 7.99
Equity intrinsic value�� $22,453
Equity intrinsic value per share�� $ 83.56
We begin by computing the net income market multiple for both Dollar Tree and Big Lots, which
is computed as equity assumed value divided by net income available to common shareholders.
Exhibit 15.6 shows the results of this computation. Big Lots’ net income market multiple is
7.99, computed as $1,254 million/$157 million. Dollar Tree’s NI multiple is 20.26 computed as
$23,020 million/$1,136 million. We use the average of the two multiples, 14.13, as the NI market
multiple to estimate the equity intrinsic value of Dollar General as follows:
Equity intrinsic value = Net income × NI market multiple
$22,453 = $1,589 × 14.1
To obtain Dollar General’s equity intrinsic value per share we divide by shares outstanding as follows:
Equity intrinsic value
Equity intrinsic value per share =
Common shares outstanding
$22, 453
$83.56 =
268.7 shares
The $83.56 stock price estimate suggests that Dollar General stock was markedly overvalued based
on a $115.04 closing price at its fiscal year-end (and vis-à-vis its $117.47 price on the filing date).
It is again useful for us to compare estimates of Dollar General’s intrinsic value of equity using
the NOPAT multiple vis-à-vis the NI multiple. Using the NOPAT multiple, we estimated the intrinsic
value of a share of Dollar General to be $91.40, while the NI market multiple gave an estimate of
$83.56. How do we assess the quality of the different estimates? The estimate using the NOPAT
market multiple is likely better (for the same reasons that the NOA multiple was superior to the
BV multiple for balance sheet methods). That is, we did not select comparables with similar capital
structures. When selecting comparables, we should select firms that are similar on profitability,
growth, and risk. Although the comparables do control for operating risk, by choosing companies
in the same industry, we did not control for financial risk. Consequently, because financial risk
affects the equity value, but not the company value, we prefer the NOPAT multiple because they are
unaffected by a firm’s choice of capital structure. But, when using net income multiples to estimate
intrinsic value, it is important to select comparables with similar capital structures.
The estimates of equity value we have computed for Dollar General thus far using multiples
highlight the first issue we raised about the use of this method. The two methods based on net
operating assets and book value market multiples yielded more similar values of $71.49 and
$70.33 per share respectively. The two methods based on NOPAT and net income market mul-
tiples yielded less similar values of $91.40 and $83.56 per share respectively. Given the wide dis-
parity among the balance sheet and the income statement based estimates, we are faced with the
question: which performance measure is the right one? Again, this question has no answer. Often
15_fsav6e_mod15.indd 10 6/5/20 7:49 AM

FSAV 6e - Errata 041323

Uploaded by

Copyright:

Available Formats

FSAV 6e - Errata 041323

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FSAV 6e - Errata 041323

Uploaded by

Copyright:

Available Formats

1-43

Module 1 | Framework for Analysis and Valuation © Cambridge Business Publishers

During fiscal year 2018, Winnebago reported the following.

Issuance of stock������������������������������� $ 5,822 Cash dividends ������������������������������������ $12,738

01_fsav6e_mod01.indd 43 9/28/20 4:14 PM

ROA = Net income / Average assets = $59,531 / $370,522���������������������������� 16.1%

b. ROE = Net income/Average stockholders’ equity = $59,531/$120,597 = 49.4%.

$ millions Apple Samsung

Average assets������������������������������������������������������������������������ $370,522 W320,555

ROA = Net income / Average assets���������������������������������������� 16.1% 13.8%

01_fsav6e_mod01.indd 51 6/2/20 8:40 PM

continued from previous page

ANALYZING TRANSACTIONS AND ADJUSTMENTS

Four-Step Accounting Cycle and apply the

Financial Statement Effects Template

Assets Liabilities Equity

02_fsav6e_mod02.indd 22 6/4/20 3:59 PM

We can disaggregate ROE into operating and nonoperating components.

ROE = Operating return (via NOPAT)

EXHIBIT 3.7 Key Ratio and Acronym Definitions

03_fsav6e_mod03.indd 25 6/4/20 4:16 PM

2019 2018 2017

2019 2018 2017

NOPAT NOPAT Sales

Net operating Net operating

2019 2018 2017

04_fsav6e_mod04.indd 16 9/28/20 5:41 PM

Cash from operations − CAPEX

Home Depot Cash Flow Ratios

04_fsav6e_mod04.indd 20 9/28/20 5:41 PM

Balance Sheet Income Statement

Cash + Noncash = Liabil- + Contrib. + Earned Rev- − Expen- = Net

nize $6M +6M +6M +6M AR

Year 2: −3M −3M +3M COGS

Record $3M Cash = Retained

05_fsav6e_mod05.indd 8 6/5/20 7:23 AM

Accounting for Accounts Receivable

Balance Sheet Income Statement

Cash + Noncash = Liabil- + Contrib. + Earned Rev- − Expen- = Net

Accounts receivable (gross amount owed)��������������������������������������������������������������� $100,000

Accounts receivable, less allowance for uncollectible accounts of $2,900��������������� $97,100

Balance Sheet Income Statement

Cash + Noncash = Liabil- + Contrib. + Earned Rev- − Expen- = Net

05_fsav6e_mod05.indd 22 6/5/20 7:23 AM

3. a. $ millions 2019 2018 2017

Net sales��������������������������������������������������������������� $4,442.1 $4,169.8 $4,001.8

Allowance at year end������������������������������������������� $17.5 $15 $9.6

Allowance/Gross sales ����������������������������������������� 0.39% 0.36% 0.24%

 b. $ millions 2019 2018 2017

% returned merchandise��������������������������������������� 0.28% 0.18% 0.06%

$ millions 2019 2018 2017

Advanced Billings and Customer Deposits ($ millions)

05_fsav6e_mod05.indd 61 6/5/20 7:23 AM

Income Statement Adjustments for a LIFO Reserve To compare the income

FIFO COGS = LIFO COGS − Increase in LIFO Reserve (or + Decrease)

06_fsav6e_mod06.indd 11 6/4/20 4:42 PM

continued from previous page

ANALYST ADJUSTMENTS 6.3 Continued

Tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22% 22% 22%

Issuance of stock�� $ 5,822 Cash dividends �� $12,738

ROA = Net income / Average assets = $59,531 / $370,522�� 16.1%

Average assets�� $370,522 W320,555

ROA = Net income / Average assets�� 16.1% 13.8%

Accounts receivable (gross amount owed)�� $100,000

Accounts receivable, less allowance for uncollectible accounts of $2,900�� $97,100

3. a. $ millions 2019 2018 2017

Net sales�� $4,442.1 $4,169.8 $4,001.8

Allowance at year end�� $17.5 $15 $9.6

Allowance/Gross sales �� 0.39% 0.36% 0.24%

b. $ millions 2019 2018 2017

% returned merchandise�� 0.28% 0.18% 0.06%

2018�� $3,053,754 $2,610,111 $321,025 $15,480 $10,155 $1,978

1. Gross profit margin �� $22,915 $22,434 $21,674

2. Days inventory outstanding�� 365 365

3. Days payable outstanding�� 365 365

4. Cash conversion cycle�� 0 + 90.3 − 56.1 = 34.2 0 + 86.3 − 52.3 = 34.0

Balance as of December 31, 2017 �� $(529) $(6) $ (144) $— $(679)

Revenue �� $23,771

Cash contributions to pension plan�� $783 $768 $2,115 $2,631 $1,125

U.S. federal statutory income tax rate�� 21.0% 28.1% 35.0%

Net sales�� $68,222 $56,741 $51,407

Debt maturities �� $3,388 $2,009 $2,840 $2,465 $2,461