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

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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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EXERCISES E13-16. (30 minutes) a. Stock value per share using Discounted Cash Flow model WFM ($ millions) Reported 2016 Forecast Horizon Terminal Period 2017 2018 2019 2020 Sales ................................................. $ 15,724 $15,881 $16,199 $16,523 $16,853 $17,022 NOPAT .............................................. 526 524 535 545 556 562 NOA ................................................... 3,466 3,500 3,570 3,642 3,715 3,752 Increase in NOA ................................ 34 70 72 73 37 FCFF = (NOPAT - Increase in NOA). 490 465 473 483 525 Discount factor [1 / (1 + r w ) t ] ............. 0.94340 0.89000 0.83962 0.79209 Present value of horizon FCFF .......... 462 414 397 383 Cum present value of horizon FCFF.. $1,656 Present value of terminal FCFF ......... 8,317 Total firm value .................................. 9,973 Less (plus) NNO ................................ 242 Firm equity value ............................... $9,731 Shares outstanding (millions) ........... 318.3 Stock price per share ......................... $30.57 b. Our stock price estimate of $30.57 is only a few cents lower than the WFM market price of $30.96 as of 11/18/16, indicating that WFM is accurately priced. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-7

E13-17 (30 minutes) a. Stock value per share using the Residual Operating Income Model ANF ($ millions) Reported 2016 Forecast Horizon Terminal Period 2017 2018 2019 2020 Sales ............................................... $ 15,724 $15,881 $16,199 $16,523 $16,853 $17,022 NOPAT ........................................... 526 524 535 545 556 562 NOA ................................................ 3,466 3,500 3,570 3,642 3,715 3,752 ROPI = (NOPAT - [NOA Beg × r w ]) ..... 316 325 331 337 339 Discount factor [1 / (1 + r w ) t ] .......... 0.94340 0.89000 0.83962 0.79209 Present value of horizon ROPI ....... 298 289 278 267 Cum present value of horizon ROPI ............................................ $1,132 Present value of terminal ROPI ...... 5,370 NOA ................................................ 3,466 Total firm value ............................... 9,968 Less (plus) NNO ............................. 242 Firm equity value ............................ $9,726 Shares outstanding (millions) ........ 318.3 Stock price per share ...................... $30.56 b. Our stock price estimate of $30.56 is only a few cents lower than the WFM market price of $30.96 as of 11/18/16, indicating that WFM is accurately priced. ©Cambridge Business Publishers, 2018 13-8 Financial & Managerial Accounting for MBAs, 5 th Edition

E13-18. (30 minutes) a. Stock value using the Discounted Cash Flow Model WMT ($ millions) Reported 2016 Forecast Horizon Terminal Period 2017 2018 2019 2020 Sales ................................................ $482,130$486,951 $491,821 $496,739 $501,706 $506,723 NOPAT ............................................. 16,634 17,043 17,214 17,386 17,560 17,735 NOA ................................................. 124,940 126,186 127,448 128,722 130,009 131,309 Increase in NOA ............................... 1,246 1,262 1,274 1,287 1,300 FCFF = (NOPAT - Increase in NOA) ............................................. 15,797 15,952 16,112 16,273 16,435 Discount factor [1 / (1 + r w ) t ] ........... 0.93458 0.87344 0.81630 0.76290 Present value of horizon FCFF ........ 14,764 13,933 13,152 12,415 Cum present value of horizon FCFF $54,264 Present value of terminal FCFF ....... 208,971 Total firm value ................................ 263,235 Less (plus) NNO .............................. 41,329 Less NCI .......................................... 3,065 Firm equity value .............................. $218,841 Shares outstanding (millions) .......... 3,144 Stock price per share ....................... $69.61 b. Our estimated WMT stock price of $69.61 is slightly higher than the market price of $68.80 on March 30, 2016, indicating that we believe the WMT stock is very slightly undervalued on that date. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in estimated stock price may be due to more optimistic forecasts or a lower discount rate compared to other investors’ and analysts’ model assumptions. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-9

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E13-19. (30 minutes) a. WMT ($ millions) Reported 2016 Forecast Horizon Terminal Period 2017 2018 2019 2020 Sales ............................................. $482,130 $486,951 $491,821 $496,739 $501,706 $506,723 NOPAT ......................................... 16,634 17,043 17,214 17,386 17,560 17,735 NOA .............................................. 124,940 126,186 127,448 128,722 130,009 131,309 ROPI = (NOPAT - [NOA Beg × r w ]) .. 8,297 8,381 8,465 8,549 8,634 Discount factor [1 / (1 + r w ) t ] ........ 0.93458 0.87344 0.81630 0.76290 Present value of horizon ROPI ..... 7,754 7,320 6,910 6,522 Cum present value of horizon ROPI .......................................... $28,506 Present value of terminal ROPI .... 109,781 NOA .............................................. 124,940 Total firm value ............................. 263,227 Less NNO ..................................... 41,329 Less NCI ....................................... 3,065 Firm equity value .......................... $218,833 Shares outstanding (millions) ...... 3,144 Stock value per share ................... $69.60 b. Our estimated WMT stock price of $69.60 is slightly higher than the market price of $68.80 on March 30, 2016, indicating that we believe the WMT stock is very slightly undervalued on that date. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in estimated stock price may be due to more optimistic forecasts or a lower discount rate compared to other investors’ and analysts’ model assumptions. ©Cambridge Business Publishers, 2018 13-10 Financial & Managerial Accounting for MBAs, 5 th Edition

E13-20. (20 minutes) ($ millions) a. NOA = Operating assets – Operating liabilities Operating assets = $1,890 + $11,809 + $1,078 + $22,191 + $2,102 + $1,263 = $40,333 Operating liabilities = $6,565 + $1,515 + $476 + $1,566 + $34 + $1,943 + $1,965 + $854 = $14,918 NOA = $40,333 – $14,918 = $25,415 NNO = Nonoperating assets – Nonoperating liabilities Nonoperating liabilities = $350 + $77 + $20,888 = $21,315 Nonoperating assets = $2,216 NNO = $21,315 – $2,216 = $19,099 b. $25,415 = $19,099 + $6,316 (NOA) = (NNO) + (EQ) E13-21. (15 minutes) ($ millions) Tax expense $4,012 Add: Tax shield = $753 x 37% 279 Tax on operating income $4,291 Net operating profit before tax $11,774 Subtract: Tax on operating income (above) 4,291 NOPAT $7,483 An alternative approach is as follows. Consolidated net income $7,009 Add: Net nonoperating expense = $753 x (1- 37%) 474 NOPAT $7,483 ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-11

E13-22. (30 minutes) a. HD ($ millions) Reported 2016 Forecast Horizon Terminal 2017 2018 2019 2020 Sales ..................................................... $88,519 $97,371 $107,108 $117,819 $129,601 $134,785 NOPAT ................................................. 7,483 8,277 9,104 10,015 11,016 11,457 NOA ...................................................... 25,415 27,956 30,752 33,827 37,210 38,698 DCF Model Increase in NOA ................................... 2,541 2,796 3,075 3,383 1,488 FCFF (NOPAT - Increase in NOA) ....... 5,736 6,308 6,940 7,633 9,969 Discount factor [1 / (1 + r w ) t ] ................ 0.91743 0.84168 0.77218 0.70843 Present value of horizon FCFF ............. 5,262 5,309 5,359 5,407 Cum present value of horizon FCFF ..... 21,337 Present value of terminal FCFF ............ 141,247 Total firm value ..................................... 162,584 Less (plus) NNO ................................... 19,099 Firm equity value .................................. $143,485 Shares outstanding (millions) .............. 1,252 Stock price per share ............................ $114.60 b. Our stock price estimate of $114.60 is considerably lower than the HD market price of $130.46 as of March 24, 2016, indicating that we believe that the stock is overvalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our lower stock price estimate may be due to less optimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. It could be that NOPAT includes forecasted savings or synergies that are not evident in the current period income statement. ©Cambridge Business Publishers, 2018 13-12 Financial & Managerial Accounting for MBAs, 5 th Edition

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E13-23. (30 minutes) a. HD ($ millions) Reported 2016 Forecast Horizon Terminal Period 2017 2018 2019 2020 Sales ........................................................... $88,519 $97,371 $107,108 $117,819 $129,601 $134,785 NOPAT ........................................................ 7,483 8,277 9,104 10,015 11,016 11,457 NOA ............................................................ 25,415 27,956 30,752 33,827 37,210 38,698 ROPI Model ROPI (NOPAT - [NOA Beg × r w ]) ................. 5,990 6,588 7,247 7,972 8,108 Discount factor [1 / (1 + r w ) t ] .................... 0.91743 0.84168 0.77218 0.70843 Present value of horizon ROPI .................. 5,495 5,545 5,596 5,648 Cum present value of horizon ROPI ...................................................... $22,284 Present value of terminal ROPI ...................................................... 114,879 NOA .......................................................... 25,415 Total firm value ......................................... 162,578 Less (plus) NNO ....................................... 19,099 Firm equity value ....................................... $143,479 Shares outstanding (millions) 1,252 Stock value per share ............................... $114.60 b. Our stock price estimate of $114.60 is considerably lower than the HD market price of $130.46 as of March 24, 2016, indicating that we believe that the stock is overvalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our lower stock price estimate may be due to less optimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. It could be that NOPAT includes forecasted savings or synergies that are not evident in the current period income statement. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-13

E13-24. (15 minutes) a. Remembering that FCFF = NOPAT – Increase in NOA, we see that both models utilize the same fundamental inputs. As a result, if the firm is in a steady state (e.g., NOPAT and NOA are growing at the same rate so that RNOA is constant), the two models will yield equivalent estimates of stock price. b. Companies can and do manage earnings. They also can and do manage cash flows; that is, they manage the classification of cash flows between operating and nonoperating categories and manage operating cash flows through the use of asset securitizations, operating leases, and other operating decisions (for example, by reducing advertising expenditures or cutting inventories). The fact that earnings can be managed does not render them irrelevant. Accrual accounting provides a wealth of information about future operations. And, generally, earnings over a short (say, five-year) period will capture much more of the value of the firm than will cash flows. Earnings are, arguably, more relevant than cash flows in valuation. Notice that earnings forecasts are generally readily available for most traded firms, while cash flow forecasts are not. This suggests that earnings are, indeed, most often the basis of valuation. E13-25. (15 minutes) a. The ROPI model focuses on NOA and ROPI, where ROPI = NOPAT – (WACC × NOA Beg ). The components of ROPI, then, are the same components used in the computation of RNOA. The components of RNOA, profit margin (NOPM) and turnover (NOAT), are, therefore, called “value drivers” since they determine the value of the company according to this model. b. Managers must manage both the income statement and the balance sheet if they are to achieve high performance. This is the valuable insight that the ROPI model highlights. ©Cambridge Business Publishers, 2018 13-14 Financial & Managerial Accounting for MBAs, 5 th Edition

E13-26. (15 minutes) a. ROPI = NOPAT – (WACC × NOA Beg ) 2017 ROPI = $210 – (7% x $1,350) = $115.5 2018 ROPI = $216 – (7% x $1,500) = $111 b. Actual June 2017 Forecasted June 2018 Action 1 2 3 4 NOPAT $210 $216 $216 $216 $186 3 $216 NOA Beg 1,350 1,500 1,465 1 1,300 2 1,000 4 1,500 5 ROPI = NOPAT – (7% x NOA Beg ) 115.5 111 113.5 125 116 111 1 $1,500 – (10% x 500) +(5% x 300) = $1,465 2 $1,500 – (20% x 1,000) = $1,300 3 $216 - $30 = $186 4 $1,500 – (50% x 1000) = $1,000 5 Increasing debt has no effect on NOPAT because interest expense is not included in NOPAT. The debt is a nonoperating liability and thus, does not affect NOA. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-15

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PROBLEMS P13-27. (60 minutes) ($ millions) a. NOA = ($121,652 – $7,631 – $58,125) – ($58,067 – $24,483 – $4,160) = $26,472 b. 2016 NOPAT = $12,660 – [$2,181 – (0.37× $260] = $10,575 c. CSCO Reported Forecast Horizon Terminal Period ($millions) 2016 2017 2018 2019 2020 Sales growth .................................................. 1% 2% 2% 2% 1% Sales, unrounded .......................................... $ 49,247 49,739.47 50,734.26 51,748.95 52,783.93 53,311.77 Sales, rounded .......................................... 49,247 49,739 50,734 51,749 52,784 53,312 NOPAT 1 ..................................................... 10,575 10,694 10,908 11,126 11,349 11,462 NOA 2 ......................................................... 26,472 26,741 27,276 27,822 28,378 28,662 1 2016 NOPM is calculated as $10,575 / $49,247 = 0.214734 or 21.5% rounded to 3 decimals. We use NOPM to determine NOPAT as Sales (rounded) x 21.5%. 2 2016 NOAT is calculated as $49,247 / $26,472= 1.860343 or 1.860 rounded to 3 decimals. We use NOAT to determine NOA as Sales (rounded) / 1.860. d. CSCO Reported Forecast Horizon Terminal Period ($millions) 2016 2017 2018 2019 2020 DCF Model Increase in NOA ........................................ $269 $535 $546 $556 $284 FCFF (NOPAT - Increase in NOA) ..................................................... 10,425 10,373 10,580 10,793 11,178 Discount factor [1 / (1 + r w ) t ] .................... 0.90909 0.82645 0.75131 0.68301 Present value of horizon FCFF ................. 9,477 8,573 7,949 7,372 Cum PV of horizon FCFF .......................... $33,371 Present value of terminal FCFF ................ 84,830 Total firm value ......................................... 118,201 Less (plus) NNO ....................................... (37,113) Less (plus) NCI ......................................... (1) Firm equity value ....................................... $155,315 Shares outstanding (millions) .................... 5,029 Stock price per share ................................ $30.88 ©Cambridge Business Publishers, 2018 13-16 Financial & Managerial Accounting for MBAs, 5 th Edition

Continued next page ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-17

P13-27. Concluded e. Our stock price estimate of $30.88 is very close to the CSCO market price of $31.47 as of September 8, 2016, indicating that we believe that the stock is appropriately valued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our forecasts for NOPM and NOAT seem to agree with other investors’ and analysts’ model assumptions. P13-28. (60 minutes) a. CSCO Reported Forecast Horizon Termina l Period ($millions) 2016 2017 2018 2019 2020 Sales growth .................................................. 1% 2% 2% 2% 1% Sales, unrounded .......................................... $ 49,247 49,739.47 50,734.26 51,748.95 52,783.93 53,311.77 Sales, rounded .......................................... 49,247 49,739 50,734 51,749 52,784 53,312 NOPAT 1 ..................................................... 10,575 10,694 10,908 11,126 11,349 11,462 NOA 2 ......................................................... 26,472 26,741 27,276 27,822 28,378 28,662 1 2016 NOPM is calculated as $10,575 / $49,247 = 0.214734 or 21.5% rounded to 3 decimals. We use NOPM to determine NOPAT as Sales (rounded) x 21.5%. 2 2016 NOAT is calculated as $49,247 / $26,472= 1.860343 or 1.860 rounded to 3 decimals. We use NOAT to determine NOA as Sales (rounded) / 1.860. CSCO Reported Forecast Horizon Terminal Period ($ millions) 2016 2017 2018 2019 2020 ROPI Model: ROPI (NOPAT - [NOA Beg × r w ]) .................. $8,047 $8,234 $8,398 $8,567 $8,624 Discount factor [1 / (1 + r w ) t ] .................... 0.90909 0.82645 0.75131 0.68301 Present value of horizon ROPI .................. 7,315 6,805 6,310 5,851 Cum PV of horizon ROPI .......................... $26,281 Present value of terminal ROPI ................. 65,448 NOA .......................................................... 26,472 Total firm value ......................................... 118,201 Less (plus) NNO ....................................... (37,113) Less (plus) ................................................ (1) Firm equity value ....................................... $155,315 Shares outstanding (millions) .................... 5,029 Stock price per share ................................ $30.88 b. Our stock price estimate of $30.88 is very close to the CSCO market price of $31.47 as of September 8, 2016, indicating that we believe that the stock is appropriately valued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our forecasts for NOPM and NOAT seem to agree with other investors’ and analysts’ model assumptions. ©Cambridge Business Publishers, 2018 13-18 Financial & Managerial Accounting for MBAs, 5 th Edition

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P13-29. (60 minutes) a. Terminal period sales = $2,689,205 × 1.01 = $2,716,097 Terminal period NOPAT = $220,515 × 1.01 = $222,720 Terminal period NOA = $985,779 x 1.01 = $995,637 b. TXRH ($ thousands) Reported 2015 Forecast Horizon Terminal Period 2016 2017 2018 2019 Sales, rounded ....... $1,807,368 $2,060,400 $2,348,855 $2,513,275 $2,689,205 $2,716,097 NOPAT ................... 102,495 168,953 192,606 206,089 220,515 222,720 NOA ....................... 662,502 755,279 861,017 921,288 985,779 995,637 TXRH Reported 2015 Forecast Horizon Terminal Period ($ thousands) 2016 2017 2018 2019 DCF Model Increase in NOA ............................... $92,777 $105,738 $60,27 1 $64,49 1 $9,858 FCFF (NOPAT - Increase in NOA) ............................................. 76,176 86,868 145,81 8 156,02 4 212,862 Discount factor [1 / (1 + r w ) t ] ........... 0.93458 0.87344 0.8163 0 0.7629 0 Present value of horizon FCFF ........ 71,193 75,874 119,03 1 119,03 1 Cum PV of horizon FCFF ................. $385,129 Present value of terminal FCFF ....... 2,706,540 Total firm value ................................ 3,091,669 Less (plus) NNO .............................. (14,680) Less NCI .......................................... 7,520 Firm equity value .............................. $3,098,829 Shares outstanding (thousands) ..... 70,091 Stock price per share ....................... $44.21 c. Our stock price estimate of $44.21 is higher than the actual TXRH market price of $42.13 as of 2/26/16 indicating that we see a very slight undervaluation. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in stock price estimates may be due to our having a slightly more optimistic forecast or a lower discount rate compared to other investors’ and analysts’ model assumptions. d. If WACC had been 7.5%, the stock price would have been $40.51, lower because the discount rate increased. In contrast, with a WACC of 6.5%, stock price would have been $48.59. This is evidence that the modeling assumptions we use can significantly affect our price estimates. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-19

©Cambridge Business Publishers, 2018 13-20 Financial & Managerial Accounting for MBAs, 5 th Edition

P13-30. (60 minutes) a. TXRH Reported Forecast Horizon Terminal ($ thousands) 2015 2016 2017 2018 2019 Year ROPI Model ROPI (NOPAT - [NOA Beg × r w ]) ................. 122,578 139,736 145,818 156,025 153,715 Discount factor [1 / (1 + r w ) t ] .................... 0.93458 0.87344 0.81630 0.76290 Present value of horizon ROPI .................. 114,559 122,051 119,031 119,031 Cum present value of horizon ROPI ...................................................... $474,672 Present value of terminal ROPI ...................................................... 1,954,486 NOA ........................................... 662,502 Total firm value ......................................... 3,091,660 Less (plus) NNO ....................................... (14,680) Less NCI ................................................... 7,520 Firm equity value ....................................... $3,098,820 Shares outstanding (thousands) 70,091 Stock value per share ............................... $44.21 b. Our stock price estimate of $44.21 is higher than the actual TXRH market price of $42.13 as of 2/26/16 indicating that we see a very slight undervaluation. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Differences in stock price estimates may be due to our having a slightly more optimistic forecast or a lower discount rate compared to other investors’ and analysts’ model assumptions. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-21

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P13-31. (60 minutes) $ millions a. Operating assets ($21,396 - $3,138 - $2,319) $15,939 Operating liabilities ($9,138 - $44 - $1 - $2,010) 7,083 NOA $8,856 Nonoperating liabilities ($44 + $1 + $2,010) $2,055 Nonoperating assets ($3,138 + $2,319) 5,457 NNO $(3,402) b. There are two approaches to calculating NOPAT, as follows. Nonoperating items before tax ($19 - $140) $ (121) Tax shield at 37% (45) Net nonoperating expense (NNE) (76) Consolidated net income 3,760 NOPAT = Consolidated net income + NNE $ 3,684 Net operating profit before tax (NOPBT) $ 4,502 Tax expense 863 Tax shield (from above) (45) Tax on operations 818 NOPAT = NOPBT - Tax on operations $ 3,684 c. NKE Reported Forecast Horizon Terminal Period ($ millions) 2016 2017 2018 2019 2020 Sales, unrounded ........................................... $32,376 $34,318.56 $36,377.67 $38,560.33 $40,873.95 $41,282.69 Sales, rounded ............................................... 32,376 34,319 36,378 38,560 40,874 41,283 NOPAT 1 ......................................................... 3,684 3,912 4,147 4,396 4,660 4,706 NOA 2 .............................................................. 8,856 9,387 9,950 10,547 11,180 11,292 1 Using the numbers from part a., 2016 NOPM is calculated as $3,684 / $32,376 = 0.11378 or 11.4% rounded to 3 decimals. We use NOPM to determine NOPAT as Sales (rounded) x 11.4%. 2 Using the numbers from part b., 2016 NOAT is calculated as $32,376 / $8,856= 3.655827 or 3.656 rounded to 3 decimals. We use NOAT to determine NOA as Sales (rounded) / 3.656. continued next page ©Cambridge Business Publishers, 2018 13-22 Financial & Managerial Accounting for MBAs, 5 th Edition

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P13-31. concluded d. NKE Reported Forecast Horizon Terminal Period ($ millions) 2016 2017 2018 2019 2020 Increase in NOA ............................... $531 $563 $597 $633 $112 FCFF (NOPAT - Increase in NOA)... 3,381 3,584 3,799 4,027 4,594 Discount factor [1 / (1 + r w ) t ] ............ 0.94073 0.88498 0.83253 0.78319 Present value of horizon FCFF ........ 3,181 3,172 3,163 3,154 Cum PV of horizon FCFF ................. $12,670 Present value of terminal FCFF ....... 67,886 Total firm value ................................ 80,556 Less NNO ........................................ (3,402) Firm equity value .............................. $83,958 Shares outstanding (millions) ........... 1,682 Stock value per share ...................... $49.92 e. Our stock price estimate of $49.92 is considerably lower than the NKE market price of $56.99 as of July 21, 2016, indicating that we believe that Nike’s stock is overvalued. Stock prices are a function of expected NOPAT and NOA as well as the WACC discount rate. Our lower stock price estimate might be due to less optimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. One possible explanation is that the 2016 ratios for NOPM and NOAT (as we computed them) are expected to improve in the horizon period. If we are confident in the valuation techniques, the estimated price suggests that we should sell Nike stock. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-23

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P13-32. (60 minutes) a. (Refer to the solution for P13-31 for NOPAT and NOA computations) NKE Reported Forecast Horizon Terminal Period ($ millions) 2016 2017 2018 2019 2020 ROPI (NOPAT - [NOA Beg × r w ]) .... $3,354 $3,556 $3,769 $3,996 $4,002 Discount factor [1 / (1 + r w ) t ] ........ 0.94073 0.88498 0.83253 0.78319 Present value of horizon ROPI .... 3,155 3,147 3,138 3,130 Cum PV of horizon ROPI ............. $12,570 Present value of terminal ROPI... 59,138 NOA ............................................ 8,856 Total firm value ............................ 80,564 Less NNO .................................... (3,402) Firm equity value ......................... $83,966 Shares outstanding (millions) ...... 1,682 Stock value per share .................. $49.92 b. Our stock price estimate of $49.92 is considerably lower than the NKE market price of $56.99 as of July 21, 2016, indicating that we believe that Nike’s stock is overvalued. Stock prices are a function of expected NOPAT and NOA as well as the WACC discount rate. Our lower stock price estimate might be due to less optimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. One possible explanation is that the 2016 ratios for NOPM and NOAT (as we computed them) are expected to improve in the horizon period. If we are confident in the valuation techniques, the estimated price suggests that we should sell Nike stock. ©Cambridge Business Publishers, 2018 13-24 Financial & Managerial Accounting for MBAs, 5 th Edition

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P13-33. (60 minutes) a. Terminal period sales, NOPAT and NOA can be determined by multiplying each number by 1.01. This yields the numbers shown in the table in part b., below. b. CL (DCF model) Reported Forecast Horizon Terminal Period ($ millions) 2015 2016 2017 2018 2019 Sales ........................................... $16,034 $16,836 $17,677 $18,561 $19,489 $19,684 NOPAT ........................................ 2,247 3,199 3,359 3,527 3,703 3,740 NOA ............................................ 5,557 5,836 6,127 6,434 6,755 6,823 Increase in NOA .......................... 279 291 307 321 68 FCFF (NOPAT - Increase in NOA) ........................................ 2,920 3,068 3,220 3,382 3,672 Discount factor [1 / (1 + r w ) t ] ........ 0.93023 0.86533 0.80496 0.74880 Present value of horizon FCFF .... 2,716 2,655 2,592 2,532 Cum PV of horizon FCFF ............ 10,495 Present value of terminal FCFF... 42,301 Total firm value ............................ 52,796 Less NNO .................................... 5,601 Less NCI ...................................... 255 Firm equity value ......................... $46,940 Shares outstanding (millions) ...... 893 Stock value per share .................. $52.56 c. Our stock price estimate of $52.56 is significantly lower than the CL market price of $67.22 as of February 18, 2016, indicating that we believe that the stock is seriously overvalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our lower stock price estimate might be due to more pessimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. If we are confident in the valuation techniques, the estimated price suggests that we should not purchase Colgate-Palmolive stock and if we are holding stock, we should sell. d. If the terminal period growth rate would have been 2%, the stock price would have been $60.72, closer to the actual price but still 10% lower. e. Using Excel What-If analysis and the Goal Seek function, we can determine that WACC would have needed to be 6.24% for the stock price of $67.22 to prevail. ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-25

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P13-34. (60 minutes) a. (Refer to the solution for P13-31 for NOPAT and NOA computations) CL (ROPI model) Reported Forecast Horizon Terminal Period ($ millions) 2015 2016 2017 2018 2019 Sales .............................................................. $16,034 $16,836 $17,677 $18,561 $19,489 $19,684 NOPAT ........................................................... 2,247 3,199 3,359 3,527 3,703 3,740 NOA ............................................................... 5,557 5,836 6,127 6,434 6,755 6,823 ROPI (NOPAT - [NOA Beg × r w ]) ....................... 2,782 2,921 3,067 3,220 3,233 Discount factor [1 / (1 + r w ) t ] .......................... 0.93023 0.86533 0.80496 0.74880 Present value of horizon ROPI ....................... 2,588 2,528 2,469 2,411 Cum present value of horizon ROPI ........................................................... $9,996 Present value of terminal ROPI ...................... 37,244 NOA ............................................................... 5,557 Total firm value ............................................... 52,797 Less NNO ...................................................... 5,601 Less NCI ........................................................ 255 Firm equity value ............................................ $46,941 Shares outstanding (millions) ......................... 893 Stock value per share .................................... $52.57 b. Our stock price estimate of $52.57 is significantly lower than the CL market price of $67.22 as of February 18, 2016, indicating that we believe that the stock is seriously overvalued. Stock prices are a function of expected NOPAT and NOA, as well as the WACC discount rate. Our lower stock price estimate might be due to more pessimistic forecasts or a higher discount rate compared to other investors’ and analysts’ model assumptions. If we are confident in the valuation techniques, the estimated price suggests that we should not purchase Colgate-Palmolive stock and if we are holding stock, we should sell. ©Cambridge Business Publishers, 2018 13-26 Financial & Managerial Accounting for MBAs, 5 th Edition

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MANAGEMENT APPLICATIONS MA13-35. (45 minutes) Your evaluation of the CFO’s proposals might include the following observations. 1. Reducing raw material inventories and work-in-progress is desirable so long as the reduction does not hinder the manufacturing process. This activity must, therefore, be undertaken with care, reducing only those inventories that are deemed to be excessive, and not making cuts to raw materials inventory that will jeopardize the company’s production or manufacturing flow. Finished goods inventories, while costly to hold, are necessary to support the sales process – reducing inventory too much can cause stock- outs. Managers must also take care not to reduce finished goods inventory levels below that which is necessary to support sales. Companies can also improve operating cash flow by reducing receivables. If this reduction can be accomplished by improvements in operating procedures, such as by timely billing and elimination of billing errors, it can be an effective way of improving operating cash flow. Reducing receivables by more restrictive credit standards or aggressive collection efforts may be counterproductive if such tactics create ill will with customers and could cost the firm legitimate sales. Changes to receivables’ policies need to be handled carefully. 2. The sale and lease-back of the office building is a financing decision, not an operating one. The classification of the lease as operating is purely cosmetic (i.e., for financial reporting purposes). Further, this classification is typically accomplished by shortening the base term of the lease and adding a series of renewal options. The shorter base term of the lease may add risk, and that risk needs to be evaluated in our decision. As well, a series of shorter renewal periods is often more costly than one longer lease term. Most analysts capitalize operating leases for analysis purposes, so it is not clear that the lease structure will affect the company’s cost of capital or the stock price. In the final analysis, the cash outflows for the lease payments are the same regardless of the accounting. This is, most likely, a cosmetic rather than a real operating improvement. 3. Lengthening the time to pay our vendors (leaning on the trade) will increase operating cash flow, but may also damage relations with our vendors. This may have longer-term adverse consequences. We need to be careful, therefore, about an across-the-board lengthening of the payable days outstanding, applying this technique judiciously and understanding well the potential adverse consequences. continued next page ©Cambridge Business Publishers, 2018 Solutions Manual, Module 13 13-27

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MA13-35. Concluded 4. Big Baths are common in cyclical downturns as companies seek to purge the balance sheet of assets that represent future expenses in the form of depreciation or impairment charges. By taking the write-off in the current period, we will shift profit from the current period into the future. This is cosmetic, however, as our operating activities have not been improved as a result of the write-off. Further, write-offs that cannot be justified are not in accordance with GAAP and may cause additional audit fees as the external auditor wastes time auditing fictitious charges and accruals. 5. Increasing the expected return on pension investments will decrease pension expense and increase profitability. The expected return, however, is neither typically classified by analysts as an operating activity, nor does it represent a real improvement in our operating activities. Only actual improvement in investment returns will accomplish our objective because higher pension investment balances (from the higher returns) will reduce the need for company contributions and improve operating cash flow. 6. Corporate alliances are becoming increasingly popular as a means to increase throughput, thus lowering unit costs as overhead is spread over a wider volume base. Further, net operating assets will be lower as only the equity investment is recognized on the balance sheet. Even if an analyst proportionally consolidates this investment, only half of the trucking division will appear on our balance sheet. The effect is more than cosmetic. Since the assets are jointly owned, our net investment is reduced in actuality, not only for financial reporting purposes. This approach can have a positive effect on operating performance so long as our joint venture partner’s needs are compatible with ours. We must be careful to separate the cosmetic effects from real operating improvements. In addition, we must also be careful not to implement approaches with short-term benefits and longer- term costs. ©Cambridge Business Publishers, 2018 13-28 Financial & Managerial Accounting for MBAs, 5 th Edition

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Finman 5e_SM_Mod13_revised 040218

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