Finman 5e_SM_Mod13_revised 040218

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Module 13 Using Financial Statements for Valuation QUESTIONS Q13-1. Current and historical financial information are the primary sources of information for forecasting future financial performance. Analysts frequently eliminate transitory items from reported earnings to gain a clearer perspective of the expected future earnings of the company, that is, those earnings that are likely to persist into the future. The trend in these persistent earnings is, then, used to form an initial estimate of future earnings. Thus, transitory items are less useful in valuing equity securities. Nonfinancial information, such as order backlog, an assessment of macroeconomic activity, the industry competitive environment, and so forth, is also used in the forecasting process. Q13-2. The DCF and ROPI models define the price of a security in terms of the company’s expected free cash flow to the firm (FCFF) and the expected residual operating income (ROPI), respectively. These expectations are, then, discounted to the present, using the WACC as the discount rate, to calculate an estimated share price. Expectations about the future financial performance of a company, therefore, significantly influence expected market value. There is an inverse relation between securities prices and expected return, the discount rate (WACC in this case). Q13-3. Free cash flows to the firm are equal to NOPAT minus the increase in NOA (or plus the decrease in NOA). The discounted cash flow (DCF) model defines securities prices in terms of the present value of expected free cash flows to the firm (FCFF). Q13-4. The “weighted average cost of capital” captures the average cost of funds that the firm has raised from both debt and equity sources, weighted by the proportion received from each financing source. The cost of debt is measured as the company’s after-tax interest rate. The cost of equity is the expected return required by equity investors, usually approximated using the Capital Asset Pricing Model (CAPM) which posits the expected return as a function of the risk-free rate, the company’s beta (the historic variability of its stock returns), and the “spread” of equity securities over the risk-free rate. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-1

Q13-5. NOPAT is pretax operating profit adjusted for taxes on operating profit. Pretax operating profit is sales less cost of goods sold and SG&A expenses, in short, all income and expenses other than nonoperating items, such as financial income and interest expense related to investments and borrowing. Operating tax expense is total taxes plus the tax shield relating to net interest expense (or minus the additional taxes resulting from net interest income). Q13-6. Net operating assets are equal to total operating assets less total operating liabilities. Typically excluded are nonoperating assets such as cash, investments in marketable securities, non-strategic equity investments (but not equity method investments made for strategic purposes), net assets of discontinued operations, and nonoperating liabilities such as interest-bearing debt and capitalized lease obligations. Q13-7. Residual operating income (ROPI) is NOPAT – (WACC  NOA Beg ), where WACC is the weighted average cost of capital (see Question 13-4). ROPI is, therefore, the excess of reported NOPAT over what we expected NOPAT to be, given the level of NOA and the firm’s WACC. The ROPI model defines the value of the company as its current NOA plus the present value of its expected future ROPI. Q13-8. Disaggregating RNOA into its component parts (as the ROPI model does) highlights that the value of a firm depends critically on both turnover and profit margin. Company value will be increased if managers can increase NOPAT while holding NOA constant, and/or if managers can reduce NOA while holding NOPAT constant. Of course, any action to improve either NOPM or NOAT likely has consequences on the other measure, which points out that the company must manage both measures to increase ROPI and therefore, increase stock price. ©Cambridge Business Publishers, 2018 13-2 Financial & Managerial Accounting for MBAs, 5 th Edition

MINI EXERCISES M13-9. (10 minutes) Earnings are an important determinant of stock prices whether investors view earnings as an indicator of prospective free cash flows or consider earnings within the context of the residual operating income model. Under both models, stock prices incorporate the market’s expectations of future financial performance. Thus, when Facebook reported that earnings and net income were both up significantly over the previous year, most of this increase had already been impounded into Facebook’s stock price. That is, the announcement did not contain any news and, thus, the market price did not react. The stock price effect of the announcement itself, then, is limited to the effect that it has on the market’s expectations of future performance. We don’t know what the market expected but even if the earnings were as expected or higher, the stock price could have fallen. This fall could be related to other information revealed in the earnings announcement such as news that indicated a decrease in future earnings and cash flows. While earnings are related to stock price, they are not the only relevant variable in valuation models. M13-10. (10 minutes) ROPI = NOPAT – (WACC × NOA BEG ) = $7,483 million – (9% × $24,796 million) = $5,251 million. M13-11. (10 minutes) FCFF = NOPAT - increase in NOA = $7,483 million – ($25,415 million – $24,796 million) = $6,864 million M13-12. (15 minutes) a. Texas Roadhouse earned a positive ROPI in 2015 because realized NOPAT exceeds the expected NOPAT (given the cost of capital and the beginning NOA). $102,495 thousand – (7% × $596,104 thousand) = $60,768 thousand. b. Texas Roadhouse will earn a positive ROPI up to a WACC of 17.194%. At this level of WACC, ROPI = $596,104 thousand × 17.194% = $102,495 thousand, the level of NOPAT. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-3

M13-13. (30 minutes) a. TGT ($ millions) Reported 2016 Forecast Horizon Termina l Period 2017 2018 2019 2020 Sales .................................................... 73,785 $75,261 $76,766 $78,30 1 $79,867 $80,666 NOPAT ................................................. 3,312 3,387 3,454 3,524 3,594 3,630 NOA ...................................................... 21,445 21,872 22,309 22,755 23,210 23,443 DCF Model Increase in NOA ................................... 427 437 446 455 233 FCFF = (NOPAT - Increase in NOA) ................................................ 2,960 3,017 3,078 3,139 3,397 Discount factor [1 / (1 + r w ) t ] ................ 0.94340 0.89000 0.8396 2 0.79209 Present value of horizon FCFF ............. 2,792 2,685 2,584 2,486 Cum. present value of horizon FCFF .................................................. 10,547 Present value of terminal FCFF ............ 53,815 Total firm value ..................................... 64,362 Less (plus) NNO ................................... 8,488 Firm equity value .................................. $55,874 Shares outstanding (millions) .............. 602 Stock price per share ............................ $92.81 b. Our stock price estimate of $92.81 is higher than the TGT market price of $81.87 as of 3/11/16, indicating that we believe that Target’s stock is undervalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our higher stock price estimate may be due to more optimistic NOPAT forecasts or a lower discount rate compared to other investors’ and analysts’ model assumptions. ©Cambridge Business Publishers, 2018 13-4 Financial & Managerial Accounting for MBAs, 5 th Edition

M13-14. (30 minutes) a. TGT ($ millions) Reported 2016 Forecast Horizon Termina l Period 2017 2018 2019 2020 Sales .................................................... 73,785 $75,261 $76,766 $78,30 1 $79,867 $80,666 NOPAT ................................................. 3,312 3,387 3,454 3,524 3,594 3,630 NOA ...................................................... 21,445 21,872 22,309 22,755 23,210 23,443 ROPI Model ROPI = (NOPAT - [NOA Beg × r w ]) .............. 2,100 2,142 2,185 2,229 2,237 Discount factor [1 / (1 + r w ) t ] .................... 0.94340 0.89000 0.8396 2 0.79209 Present value of horizon ROPI .................. 1,981 1,906 1,835 1,766 Cum. present value of horizon ROPI .................................................. 7,488 Present value of terminal ROPI ............ 35,438 NOA 21,445 Total firm value ..................................... 64,371 Less (plus) NNO ................................... 8,488 Firm equity value .................................. $55,883 Shares outstanding (millions) .............. 602 Stock price per share ............................ $92.83 b. Our stock price estimate of $92.83 is higher than the TGT market price of $81.87 as of 3/11/16, indicating that we believe that Target’s stock is undervalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our higher stock price estimate may be due to more optimistic NOPAT forecasts or a lower discount rate compared to other investors’ and analysts’ model assumptions. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-5

M13-15. (15 minutes) Project K could have any of the following effects that would improve ROPI:  Reduce raw materials costs which would increase NOPAT (via smaller COGS) and decrease NOA (via lower inventory levels in $ terms)  Increase time to pay suppliers which would increase accounts payable which would decrease NOA  Reduce inventory manufacturing costs (labor contracts renegotiated) which would increase NOPAT (via smaller COGS) and decrease NOA (via lower inventory levels in $ terms)  Reduce inventory held with manufacturing process efficiencies to decrease NOA (via lower inventory levels)  Reduce SG&A costs by negotiating price concessions with third-parties, which would increase NOPAT (via higher sales)  Increase sales (in dollars) by negotiating sales terms with customers, which would increase NOPAT ©Cambridge Business Publishers, 2018 13-6 Financial & Managerial Accounting for MBAs, 5 th Edition

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