SolutionofLecture5FRA

1、solutions chapter 6 1 chapter 6 prospective analysis: forecasting question 1. glaxosmithkline is one of the largest pharmaceutical firms in the world, and over an extended period of time in the recent past, it consistently earned higher roes than the pharmaceutical industry as a whole. as a pharmace

2、utical analyst, what factors would you consider to be important in making projections of future roes for glaxosmithkline? in particular, what factors would lead you to expect glaxosmithkline to continue to be a superior performer in its industry, and what factors would lead you to expect glaxosmithk

3、lines future performance to revert to that of the industry as a whole?factors contributing to glaxosmithkline continuing to be a high roe performer: barriers to competition . glaxosmithkline can enjoy superior roes for long period of time if it builds high entry barriers such as patents, economies o

4、f scale arising from large investments in r&d, and a strong brand name due to advertising or past performance. artifacts of accounting methods. the tendency of high roes may be purely an artifact of accounting methods. at glaxosmithkline, major economic assets, such as the intangible value of re

5、search (and development), are not recorded on the balance sheet and are therefore excluded from the denominator of roe. factors causing glaxosmithkline to revert to the industry mean: the economics of competition. abnormally high profit attracts competition. increased competition may lower glaxosmit

6、hklines high roes.increase of investment base. firms with higher roes expand their equity bases more quickly than others, which causes the denominator of the roe to increase. of course, if firms could earn returns on the new investments that match the returns on the old ones, then the level of roe w

7、ould be maintained. however, firms have difficulty pulling that off. in the face of competition, one would typically not expect a firm to continue to extend its supernormal profitability to additional, new projects year after year. it is likely that glaxosmithklines earnings growth will not keep pac

8、e with growth in its equity base, ultimately leading roe to fall. question 2. an analyst claims: “it is not worth my time to develop detailed forecasts of sales growth, profit margins, et cetera, to make earnings projections. i can be almost as accurate, at virtually no cost, using the random walk m

9、odel to forecast earnings.” what is the random walk model? do you agree or disagree with the analysts forecast strategy? why or why not?we dont agree with the analyst. according to the random walk model, the forecast for year t + 1 is simply the amount observed for year t. the random walk model only

10、 describes the average firm s behavior. random walk model may not be applicable to those firms that erect barriers to competition and protect margins for extended periods. the art of financial statement analysis requires knowing not only what the “normal ” patterns are but also how to identify those

11、 firms that will not follow the norm. this can only be done if the analyst performs a strategy analysis. question 3. solutions chapter 6 2 which of the following types of businesses do you expect to show a high of degree of seasonality in quarterly earnings? explain why. supermarket. the sales of su

12、permarkets are not seasonal. there is not likely to be a peak in grocery shopping in any particular month. pharmaceutical company. for a pharmaceutical company whose cold medicine is its major product, the sales of that company may peak in winter. software company. sales of software are high during

13、december, due to holiday sales. many software companies also make efforts to push sales at the fiscal year-end in order to meet their annual targets. auto manufacturer. auto sales are seasonal due to the introduction patterns of new models. note that many new car models are introduced around septemb

14、er. clothing retailer. clothing sales are strongly seasonal; they are highest around holiday seasons. question 4. what factors are likely to drive a firm s outlays for new capital (such as plant, property, and equipment) and for working capital (such as receivables and inventories)? what ratios woul

15、d you use to help generate forecasts of these outlays? first, corporate managers decide the outlays for new capital, based on their expectation of future growth of the company. for example, when large sales growth is expected, a manager may decide to expand the firms plant and equipment. second, the

16、 company may increase investment in plant and property in order to lower future (potential) competition. in some industries, capacity expansion is a strategy that a company can make to deter potential competitors from entering the market. since capital expenditure is a strategic decision, it is diff

17、icult to forecast without some guidance from management. in the absence of such guidance, a good rule of thumb is to assume that the ratio of plant to sales will remain relatively stable and that outlays for new capital will be whatever amount is needed to maintain that ratio. managers may decide to

18、 decrease the outlays for working capital when 1.they expect that the sales will shrink in the future, 2.they expect that operating efficiency will improve, and thus require less working capital (e.g., implementation of just-in-time manufacturing), or 3.the way of doing business is likely to change

19、(e.g., change to oem business). just like the forecast of capital expenditures, it is difficult to estimate future outlays of working capital without understanding managements plans. the rule of thumb, however, is to assume that the ratio of net working capital to sales will remain the same and that

20、 investment for working capital will be the amount which is needed to keep that ratio constant. question 5. solutions chapter 6 3 how would the following events (reported this year) affect your forecasts of a firm s future net profit? an asset write-down:a firm s managers choice to write -down (for

21、example, inventories write-down) could reveal new information about the salability of the inventories or demand for products produced by an existing plant. if so, managements decision to take a write -down would unfavorably affect the expectations of a companys future net profit.a merger or acquisit

22、ion: the way the acquisition is financed and the accounting method used to record the transaction will affect the forecasts of future net profit. further, research shows that the merged firms have a significant improvement in operating cash flow return and net profit after the merger, resulting from

23、 increases in asset productivity. these improvements are particularly strong for transactions involving firms in overlapping businesses. a merger or acquisition with related business would affect the expectations of future net profit positively. the sale of a major division: if the motive for sellin

24、g a major division is to concentrate on the companys main activity, the s ale will improve the efficiency, accountability, and future net profit of the company. if the division sold is related to the companys main business, the effect of this transaction is not clear. the initiation of dividend paym

25、ents: dividends initiation may be meaningful when (1) managers have better information than investors about the firms future earnings and (2) managers use that information to initiate dividend payments. the cash dividend initiation of this year can be thought of as management forecast of future earn

26、ings improvement. the initiation of dividend payments sends a good signal to the capital market participants. question 6.(a.) what would be the year 6 forecast for earnings per share for each of the two earnings forecasting models? model 1 (random walk model): ?0.58model 2 (mean-reverting model): ?0

27、.19 (= average of five years eps)question 6.(b.) actual earnings per share for telefonica in 6 were ?0.91. given this information, what would be the year 7 forecast for earnings per share for each model? why do the two models generate quite different forecasts? which do you think would better descri

28、be earnings per share patterns? why? model 1: ?0.91model 2: ?0.25 (= average from year 2 to year 6)model 1 describes earnings per share patterns better than model 2. model 1 is a simple random walk model which uses current year earnings per share as a benchmark, whereas model 2 uses the average of t

29、he prior five years earnings per share as a benchmark. research indicates that, for typical firms, sales information more than one year old is useful only to the extent that it solutions chapter 6 4 contributes to the average annual trend. the average level of sales over five prior years does not he

30、lp in forecasting future eps. question 7. an investment banker, states: “it is not worth my while to worry about detailed, long-term forecasts. instead, i use the following approach when forecasting cash flows beyond three years. i assume that sales grow at the rate of inflation, capital expenditure

31、s are equal to depreciation, and that net profit margins and working capital to sales ratios stay constant.” what pattern of return on equity is implied by these assumptions? is this reasonable? based on the bankers assumptions, the roes after three years will keep increasing forever because, implic

32、itly, he is assuming that the fixed asset turnover ratio will grow every year at the rate of inflation. if all the other ratios (margins and leverage) remain constant, this implies an increasing pattern of roe forever. such a pattern is inconsistent with the evidence that roes revert to a mean on av

33、erage. problem 1. predicting tescos 2009/2010 earnings 1.predict tescos 2009/2010 sales using the information about the companys store space and revenues (per geographical segment). 2.predict the 2009/2010 book values of tescos non-current assets and working capital using the information about the c

34、ompanys investment plans. make simplifying assumptions where necessary. 3.during fiscal year 2008/2009, at least two factors influenced tescos operating expenses: (a) the increase in depreciation and (b) the cost savings of approximately gbp 550 million. assume that all other changes in the companys

35、 operating profit margin were caused by the economic downturn. a.what was the net effect of the downturn on tescos operating margins?b.estimate tescos 2009/2010 operating expense under the assumption that the effect of the economic downturn fully persists in 2009/2010. (estimate the companys depreci

36、ation and amortization expense separately from the other operating expenses.) 4.estimate tesco s 2009/2010 interest expense and net debt-to-equity ratio under the assumption that the company reduces its net debt in 2009/2010, as planned. 5.what do the above estimates (and your estimate of tescos 200

37、9/2010 tax expense) imply for the companys free cash flow to equity holders in 2009/2010? how likely is it that tesco will be able to reduce its net debt in 2009/2010? this problem has an infinite number of acceptable solutions. following is only one of those possible solutions. 1.to predict next ye

38、ars sales, it is helpful to focus on one identifiable sales driver. an obvious sales driver for tesco is square feet store space. we assume that new openings, extensions, adjustments, disposals, and acquisitions contribute half a year of sales, on average. under this assumption, tescos realized stor

39、e productivity (by geographical area) in 2008/2009 was:uk rest of europeasia usrevenues38,1918,8627,068206solutions chapter 6 5 operating profit2,540479343-156square feet store space (x 1,000):beginning-of-year29,54922,51723,363530openings, extensions, adjustments1,7733,5023,006620acquisitions2393,0

40、1500closures/disposals-276-196-1900end-of-year31,28528,83826,1791,150average square feet store space (x 1,000)30,41725,67824,771840sales per square feet store space (x 1,000)1.2560.3450.2850.245if store productivity remains constant in 2009/2010 and new openings, extensions, adjustments, disposals,

41、and acquisitions contribute half a year of sales, as we assumed previously, next years revenues will be close to 58 billion:ukrest of europeasiaussquare feet store space (x 1,000):beginning-of-year31,28528,83826,1791,150openings, extensions, adjustments1,8972,6972,733600acquisitions98000closures/dis

42、posals-2250-630end-of-year33,05531,53528,8491,750average square feet store space (x 1,000)32,17030,18727,5141,450sales estimate (based on 53 weeks)40,39210,4187,851356sales estimate (adjusted for 52 weeks)39,63010,2227,703349total sales57,9032.in the absence of detailed information about future inve

43、stments in working capital, non-current intangible assets and non-interest bearing liabilities, a reasonable approach is to assume that the book values of these items follow sales growth: solutions chapter 6 6 balance sheet item2008/2009 ending book value2007/2008 ending book value2008/2009 ending b

44、ook value as % of revenues2007/2008 ending book value as % of revenues2009/2010 ending book value as % of revenues (estimate)2009/2010 ending book value (estimate)net working capital-4,912-3,885-9.04%-8.21%-9.04%-5,235non-current tangible assets23,15219,78742.62%41.83%detailed estimate (see below)de

45、tailed estimate (see below)non-current intangible assets4,0272,3367.41%4.94%7.41%4,292other non-current assets3,4691,7256.39%3.65%6.39%3,697non-interest bearing liabilities-888-954-1.63%-2.02%-1.63%-946total45.74%40.19%the information provided by tesco s management about the companys expected capita

46、l expenditures helps us in producing a more detailed estimate of next-year s ending non-current tangible assets. first, we estimate the initial cost of non-current tangible assets that tesco will dispose of during 2009/2010: disposals of square feet store space (expected) abeginning square feet stor

47、e space ba as % of b = cbeginning non-current tangible assets at cost ddisposals (estimate) = c x ddisposals of non-current tangible assets (at cost)28887,4520.33%29,84498then we calculate the ending value of non-current tangible assets at cost: 2009/2010beginning value of non-current tangible asset

48、s at cost29,844capital expenditures (expected)3,500disposals (estimate)-98ending value of non-current tangible assets at cost33,246finally, we estimate 2009/2010 depreciation and the ending value of accumulated depreciation on non-current tangible assets (ignoring the effect of accumulated depreciat

49、ion on disposals for simplicity): solutions chapter 6 7 depreciation in 2008/2009 a2008/2009 average non-current tangible assets at cost ba as % of b = depreciation ratec2009/2010 average non-current tangible assets at cost bdepreciation in 2009/2010 (estimate) = c x ddepreciation on non-current tan

50、gible assets 1,03627,6973.74%31,5451,1802009/2010beginning value of accumulated depreciation6,692depreciation (estimate)1,180disposals (assumption)0ending value of accumulated depreciation7,872consequently, the estimated ending book value of non-current tangible assets is: balance sheet item2009/201

51、0 ending value at cost2009/2010 ending accumulated depreciation2009/2010 ending book value 2009/2010 ending book value as % of revenuesnon-current tangible assets33,2467,87225,37443.82%note that the expected percentage change in non-current tangible assets exceeds the expected percentage change in r

52、evenues, implying that tescos investment efficiency slightly decreases. in sum, the above calculations imply that tesco s net assets will increase from 24,848 million (45.74 % of sales) in 2008/2009 to 27,182 million (47.12% of sales) in 2009/2010. of course, the prediction that tescos investment ef

53、ficiency will decrease is also partly caused by our assumption that the companys store productivity will not improve. however, in the absence of more detailed information about possible store productivity improvements and given the economic downturn in 2008/2009 and 2009/2010, this assumption is not

54、 unreasonable. 3.the calculations under (a) are: 2008/20092007/2008solutions chapter 6 8 sales54,32747,298operating expenses-51,121-44,507operating expenses as % of sales-94.10%-94.10%depreciation of non-current tangible assets1,036876amortization of non-current intangible assets153116operating expe

55、nses before depreciation and amortization-49,932-43,515cost savings-5500operating expenses before depreciation and amortization and cost savings-50,482-43,515operating expenses before depreciation and amortization and cost savings as % of sales-92.92%-92.00%hence, the effect of the economic downturn

56、 was to decrease tescos (pre-tax) profit margin by approximately 0.9 percentage points. to estimate tesco s 2009/2010 operating expense (requirement (b), we first estimate the companys 2009/2010 depreciation and amortization expense. as discussed under (2), tescos depreciation expense estimate is 1,

57、180 million. the companys amortization rate (based on beginning values for reasons of simplicity) in 2008/2009 equaled 5.20% (153 / 2,944). using the same amortization ra te for 2009/2010, tescos 2009/2010 amortization expense will be close to 249 million (5.20% x 4,790). under the assumption that t

58、escos operating expense before depreciation, amortization and cost savings as a percent of sales will remain constant in 200 9/2010, the companys operating expense will be as follows: estimates2009/2010sales57,903operating expenses before depreciation and amortization and cost savings as % of sales-

59、92.92%operating expenses before depreciation and amortization and cost savings-53,805depreciation-1,180amortization-249cost savings550operating expenses-54,684operating expenses as % of sales-94.44%4.in 2008/2009, tesco s net debt to equity ratio was 92.05 percent (11,910/12,938). tesco s management

60、 wishes to reduce net debt by 1 billion, i.e., from 11,910 million to 10,910 solutions chapter 6 9 million. given the previous estimate of net assets of 27,182 million, tescos 2009/2010 net debt to equity ratio would decrease to 67.05 percent (10,910/27,182 10,910) if the company manages to reduce its d