B8110
Practice Exercise Set 2
Solution
Exercise 1. Conversion of Stock Warrants: Warren Buffett and Goldman Sachs
The loss to shareholders is the difference between the market price of the shares and
the issue price:
a. Market price of shares issued (if warrants are exercised on Oct. 31, 2009):
Exercise price
Loss
43.5 million x $170
$7,395 million
43.5 million x $115
$5,002.5 million
43.5 million x $(170-115)
$2,392.5 million
The loss is not tax deductible
b. No cost is recorded: the share issue is booked at $115 per share rather than
$170.
Exercise 2. Working with Accounting Relations
Reconstruct the reformulated statements and plug to the missing numbers:
Statement of Common Shareholders’ Equity
Beginning balance
Net payout to shareholders
Comprehensive income
Ending balance
$250
? = 17
40
$307
Balance Sheet
2009
NOA
Totals
2008
? = 477
___
450
___
477
450
NFO
CSE
2009
2008
170
307
? = 200
250
477
450
Income Statement
Operating income
Net financial expense
Comprehensive income
? = 50
(10)
40
a.
b.
c.
d.
ROCE = 40/250 = 16%
RNOA = 50/450 = 11.11%
NBC = 10/200 = 5%
Net payout to shareholders = -17 (plug in equity statement; this is negative, a net
share issue)
e. Net payout = Cash dividends + stock repurchases – share issues
-17 = ?
+
0
- 25
?
= 8
f. Free cash flow (C –I) = OI – ΔNOA
= 50 – 27
= 23
g. C – I = d + F
23 = -17 + ?
? = 40
h. The financing leverage equations is:
ROCE = RNOA + [FLEV × (RNOA – NBC)]
FLEV = NFO/CSE = 200/250 = 0.8
Thus,
ROCE = 11.11% + [0.8 ×(11.11% - 5%) = 16%]
Exercise 3. An Analysis of Procter & Gamble
I.
The Reformulated Statements
Reformulated Statement of Common Shareholders’ Equity
Year ended June 30, 2008
Balance, June 30, 2007 reported
Less Preferred Stock1
Plus ESOP reserve2
Balance of common equity
Transactions with common shareholders
Dividends
Share repurchase
Share issue
Preferred stock conversion4
Comprehensive income
Net income
Other comprehensive income3
Loss for FIN48
Preferred dividend5
Loss on conversion of preferred stock4
66,760
(1,406)
1,308
66,662
(4,479)
(10,047)
2,480
329
(11,717)
12,075
3,129
(232)
(176)
(289)
14,507
Balance, June 30, 2008
69,453
Notes:
1. Preferred stock is moved to debt portion of the balance sheet.
2. An ESOP is an Employee Stock Ownership Plan. In the reformulation, the ESOP reserve is
taken out of the equity statement and netted against the ESOP loan in the balance sheet.
P&G is guaranteeing the loan to the ESOP, and accounting rules (SOP 76-3) require the
firm record the loan guarantee as a liability and to set up a reserve in equity for this
contingency. However, it is highly unlikely that P&G will have to honor the guarantee (and,
in any case, the reserve is not a reduction of equity to the full face amount). If one deemed
that P&G has a reasonable probability of having to honor the guarantee, the liability would
be retained, but with the debit recorded as an asset (claim on the ESOP) rather than in
equity.
3. Other comprehensive income is listed in the equity statement (largely foreign currency
translation gains and hedging losses).
4. Preferred stock was converted into equity with a loss to shareholders. The loss from issuing
4.982 million common shares is calculated as follows (based on an average of $66 per
share during the year):
Market value of common
shares issued, $66 x 4.982 million = 329
Preferred cancelled
40
289 million
Details of common issued and preferred cancelled are in the equity statement. Note that the
common shares are issued at the market price in “transaction with shareholders.”
The conversion of the preferred shared was done by the ESOP, so the cost of conversion is
essentially wage cost: P&G pays employees by issuing common shares in conversion of
preferred shares held by ESOP. So we treat the $289 million as an expense of operations in
the reformulated income statement. (The ESOP loan is a loan to purchase the preferred
shares.)
5. Preferred dividends are after tax. Preferred dividends get a tax deduction because they are
paid to the ESOP.
One could reformulate the equity statement for 2007 and 2006, but we need only extract the
comprehensive income:
The comprehensive income for 2007 and 2006 is as follows:
Net income
OTC
Effect of accounting change
Preferred dividends
Loss on conversion of preferred stock by ESOP
2007
10,340
1,468
(333)
(161)
(261)
11,053
2006
8,684
1,048
---(148)
(173)
9,411
Reformulated Income Statements
Net sales
Cost of products sold
Gross margin
Advertising
Research and development
General and administrative
Loss on ESOP preferred stock conversion
Operating income (from sales before tax)
Tax reported
Tax on net interest
Tax on other OI
Operating income from sales (after tax)
Other operating income:
Gains on asset sales
Tax at 38%
Other operating income after tax:
Other comprehensive income
Effect of accounting change
Operating income
Net Financing Expense
Interest expense
Interest income
Net interest expense
Tax at 38%
Preferred dividends
Net financial expense
Comprehensive income
2008
83,503
40,695
42,808
8,667
2,226
14,832
289
16,794
4,003
480
(98)
258
(98)
4,385
12,409
160
2007
76,476
36,686
39,790
7,937
2112
14,291
261
15,189
4,370
386
(105)
277
(105)
2006
68,222
33,125
35,097
7,122
2,075
12,651
173
13,076
3,729
286
4,651
32
10,538
4,047
9,029
(84)
32
(52)
172
3,129
(232)
1,468
(333)
1,048
------
15,466
11,845
10,025
1,467
204
1,263
480
783
176
959
1,304
287
1,017
386
631
161
792
1,119
367
752
286
466
148
614
14,507
11,053
9,411
Notes: Loss on conversion of preferred shares by ESOP (Employee Stock Option Plan) is
effectively wages paid to employees, so is included in operating expenses.
Other Comprehensive Income items are listed in the equity statement. They are all after tax.
Reformulated Balance Sheets
2008
Operating Assets:
Operating cash1
Accounts receivable
Inventories
Deferred income taxes
Prepaid expenses and other
Property, Plant and Equipment
Accumulated depreciation
Goodwill
Other intangibles
Other assets
Operating Liabilities:
Accounts payable
Accrued liabilities
Taxes payable
Deferred taxes
Other liabilities
2007
2006
2005
120
120
120
120
6,761
6,629
5,725
4,185
8,416
6,819
6,291
5,006
2,012
1,727
1,611
1,081
3,785
3,300
2,876
1,924
38,086
34,721
31,881
26,325
(17,446)) (15,181)) (13,111)) (11,993))
59,767
56,552
55,306
19,816
34,233
33,626
33,721
4,347
4,837
4,265
3,564
2,703
140,571 132,578 127,989
53,494
6,775
10,154
945
11,805
8,154
37,833
102,738
5,710
9,586
3,382
12,015
5,147
35,840
96,738
4,910
9,587
3360
12,354
4,472
34,685
93,306
3,802
7,531
2,265
1,896
3,230
18,724
34,770
13,084
23,581
(1,325)
1,366
36,706
12,039
23,375
(1,308)
1,406
35,512
2,128
35,976
(1,288)
1,451
38,267
11,441
12,887
(1,259)
1,483
24,552
Net financial obligations
3,193
228
3,421
33,285
5,234
202
5,436
30,076
6,573
1,133
7,706
30,561
6,269
1,764
8,033
16,519
Common Equity
69,453
66,662
62,745
18,251
Net Operating Assets (NOA)
Financial Obligations:
Debt due in one year
Long-term debt
Less ESOP reserve
Preferred stock
Financial Assets:
Cash equivalents
Investment securities
Note: ESOP reserve in equity has been offset against ESOP loan guarantee (in long-term
debt). See notes to equity statement.
$120 million of cash on cash equivalents has been treated as working cash.
Other liabilities are largely pension obligations and other employee benefits and thus
operating liabilities.
II.
The calculations
To calculate profitability measures, first calculate average balance sheet amounts
for each year:
2008
Operating assets
Operating liabilities
NOA
NFO
CSE
136,575
36,837
99,738
31,681
68,057
2007
2006
130,284
35,262
95,022
30,319
64,703
109,366
30,695
78,672
27,051
51,621
PG acquired Gillette on October 1, 2005. Thus Gillette in included in the financial
statements for 9 months of the year ending June 30, 2006. Accordingly, the average
balance sheet amounts for 2006 are calculated as (0.25 × Beginning balance) +
(0.75 ×Ending balance). (But you need not have done this).
.
(CI/CSE)
2008
2007
2006
21.32%
17.08%
18.23%
15.51%
12.47%
12.74%
15.49%
14.69%
A.
ROCE
B.
RNOA (OI/NOA)
C.
Operating profit margin
(OI/Sales)
18.52%
D.
ATO (Sales/NOA)
0.837
0.805
0.867
(Note that RNOA = PM × ATO)
E.
Operating PM from sales
14.86%
13.78%
13.33%
F.
Advertising/Sales
R&D/Sales
10.38%
2.67%
10.38%
2.76%
10.44%
3.04%
Advertising/Sales has been very constant while R&D/Sales has declined
somewhat. Is PG acquiring new products and brands through
acquisition rather than through internal R&D -- and then maintains the
brands with advertising?
G.
Sales growth rate
9.19%
12.10%
OI (from sales) growth rate 17.75%
H.
NOA growth rate
15.90%
6.20%
3.68%
168.35%
Clearly the Gillette acquisition in 2008 added substantially to NOA.
I.
FLEV (ave. for year)
0.466
ROC E= 15.51% + [0.466  (15.51% – 3.03%)]
= 21.32%
(Note: as the profitability ratios are calculated on average balance sheet amounts, FLEV must
be calculated with average NFO and CSE.)
The insight: PG is earnings a 21.32% return on its equity but 5.81% of this comes from
leverage because leverage (the SPREAD) is favorable. The firm earned 15.51% in its
operations.
J. Carry out the same analysis as in Box 11.4 in Chapter 11 for General Mills, Inc. The
guiding equation is:
RNOA = ROOA + [OLLEV  (ROOA – Short-term Borrowing Rate)]
For the calculation, note that PG financial statement footnote reports a short-term borrowing
rate of 4.2%, or 2.60% after-tax with a 38% tax rate. Other input measures are:
2008
ROOA
12.03%
OLLEV
0.369
(ave. OL/ave. NOA)
For 2008, RNOA is determined as follows:
RNOA = 12.03% + [0.369 × (12.03% - 2.60%)]
= 15.51%
K. PG has many overseas subsidiaries whose assets and liabilities are
converted to US$ in the consolidation. During 2008, the US $ value of
net assets overseas increased as exchange rates changed.
L. The equity statement for 2006 shows $53,371 million common stock
issued for the acquisition. This was a pure acquisition by a share
exchange (no cash), so $53,371 is the purchase price. (If cash had been
involved, it would show up in the cash flow statement as part of cash
investment.)
M. The increase in goodwill is from the Gillette acquisition.
Review acquisition accounting in Accounting Clinic V.
N.
Free cash flow = OI – ΔNOA
2008
2007
9,466
8,413
2006
(48,551)
The large negative free cash flow in 2006 is due to the Gillette acquisition.
This was for stock, not cash, but the calculation treats the transaction as an “as if’
cash flow: Shares were issued for cash, then the cash immediately used to make the
acquisition.