Solution Manual

Chapter 1
Overview of
Financial Statement
Analysis
REVIEW
Financial statement analysis is one important step in business analysis. Business
analysis is the process of evaluating a companys economic prospects and risks. his
includes analy!ing a companys business environment" its strategies" and its financial
position and performance. Business analysis is useful in a #ide range of business
decisions such as investing in e$uity or debt securities" e%tending credit through short
or long term loans" valuing a business in an initial public offering &I'()" and evaluating
restructurings including mergers" ac$uisitions" and divestitures. Financial statement
analysis is the application of analytical tools and techni$ues to general*purpose financial
statements and related data to derive estimates and inferences useful in business
analysis. Financial statement analysis reduces ones reliance on hunches" guesses" and
intuition for business decisions. his chapter describes business analysis and the role
of financial statement analysis. he chapter also introduces financial statements and
e%plains ho# they reflect underlying business activities. +everal tools and techni$ues of
financial statement analysis are also introduced. ,pplication of these tools and
techni$ues is illustrated in a preliminary business analysis of -odak.

Instructor's Solutions Manual 1-1
(./I0E
Introduction to Business analysis
ypes of Business ,nalysis
1redit ,nalysis
E$uity ,nalysis
(ther .ses of Business ,nalysis
2anagers
2ergers" ,c$uisitions" and 3ivestitures
Financial 2anagement
E%ternal ,uditors
1omponents of Business ,nalysis
Business Environment and +trategy ,nalysis
Financial ,nalysis
,ccounting ,nalysis
'rospective ,nalysis
Valuation
Financial +tatement ,nalysis and Business ,nalysis
Financial +tatements*Basis of ,nalysis
Financial +tatements Reflect Business ,ctivities
'lanning ,ctivities
Financing ,ctivities
Investing ,ctivities
(perating ,ctivities
he ,nnual Report
Balance +heet
Income +tatement
+tatement of +hareholders E$uity
+tatement of 1ash Flo#s
/inks Bet#een Financial +tatements
,dditional Information
2anagement 3iscussion and ,nalysis &234,)
2anagement Report
,uditor Report
E%planatory 0otes
+upplementary Information

Financial Statement Analysis, 8th Edition
1-2
+ocial Responsibility Reports
'ro%y +tatements
Financial +tatement ,nalysis 'revie#
,nalysis ools
,reas of 'reliminary ,nalysis
1omparative Financial +tatement ,nalysis
5ear*to*5ear 1hange ,nalysis
Inde%*0umber rend ,nalysis
1ommon*+i!e Financial +tatement ,nalysis
Ratio ,nalysis
Factors ,ffecting Ratios
Ratio Interpretation
Illustration of Ratio ,nalysis
1ash Flo# ,nalysis
+peciali!ed ,nalysis ools
Valuation 2odels
3ebt Valuation
E$uity Valuation
,nalysis in an Efficient 2arket
2arket Efficiency
2arket Efficiency Implications for ,nalysis
Book (rgani!ation
,ppendi% 6, Investment heory and Financial +tatement ,nalysis

,0,/5+I+ (B7E1IVE+
E%plain business analysis and its relation to financial statement analysis
Identify and discuss different types of business analysis
3escribe the component analyses that constitute business analysis
E%plain business activities and their relation to financial statements
3escribe the purpose of each financial statement and linkages bet#een them
Identify relevant analysis information beyond financial statements
,naly!e and interpret financial statements as a previe# to more detailed analyses
,pply several basic financial statement analysis techni$ues
3efine and formulate some fundamental valuation models
E%plain the purpose of financial statement analysis in an efficient market
3escribe important investment theories and their implications for financial analysis
&,ppendi% 6,)

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8.E+I(0+
6. Business analysis is the evaluation of a companys prospects and risks for business
decisions. ,pplicable business decisions include" among others" e$uity and debt
valuation" credit risk assessment" earnings prediction" audit testing" compensation
negotiations" and countless other decisions. he ob9ective of business analysis is to
aid #ith decision making by helping to structure the decision task" including an
evaluation of a companys business environment" its strategies" and its financial
position and performance. ,s a result" the decision*maker #ill make a more informed
decision.
:. Business analysis is the evaluation of a companys prospects and risks for business
decisions. Financial statements are the most comprehensive source of information
about a company. ,s a result" financial statement analysis is an integral part of
business analysis.
;. +ome ma9or types of business analysis include credit analysis" e$uity analysis"
management and control" analysis of mergers and ac$uisitions" and others. 1redit
analysis is the evaluation of the ability of a company to honor its financial obligations
&i.e." pay all of its debts). 1urrent and potential creditors and debt investors perform
credit analysis. E$uity analysis supports e$uity investment decisions. E$uity
investment decisions involve buying" holding" or selling the stock of a company.
1urrent and potential investors perform e$uity analysis.
2anagers perform business analysis to optimi!e their managerial activities. From
business analysis" managers are better prepared to recogni!e challenges and
opportunities and respond appropriately.
Business analysis is also a part of a companys restructuring decisions. Before a
merger" ac$uisition" or divestiture is completed" managers and directors perform
business analysis to decide #hether the contemplated action #ill increase the
combined value of the firm. Business analysis supports financial decisions by
financial managers. Business analysis helps assess the impact of financing decisions
for both future profitability and risk.
E%ternal auditors perform business analysis to support their assurance function.
3irectors of a company use business analysis to support their activities as overseer
of the operations of the company. Regulators use business analysis to support the
performance of regulatory activities. /abor union representatives use business
analysis to support collective bargaining activities. /a#yers use business analysis to
provide evidence regarding litigation matters.

<. 1redit analysis supports the lending decision. ,s such" credit analysis involves
determining #hether a company #ill be able to meet financial obligations over a given
time hori!on. E$uity analysis supports the decision to buy" hold" or sell a stock. ,s
such" e$uity analysis involves the identification of the optimal portfolio of stocks for
#ealth ma%imi!ation.

=. Fundamental analysis is the process of determining the value of a company by
analy!ing and interpreting key factors for economy" industry" and company attributes.
, ma9or part of fundamental analysis is evaluation of a companys financial position
and performance. he ob9ective of fundamental analysis is to determine the intrinsic
value of an entity. 3etermination of fundamental value can be used to support stock
decisions and to price ac$uisitions.
>. otal business analysis involves several component processes. Each process is
critical to the ultimate summary beliefs about the business. he first component is
analysis of the business environment and the companys strategy in the conte%t of
the business environment. From this analysis" $ualitative conclusions can be dra#n
about the future prospects of the firm. hese prospects are crucial in investment
decisions. he second component of business analysis is financial analysis.
Financial analysis is the use of financial statements to analy!e a companys financial
position and performance" and to assess future performance. Financial analysis
supports e$uity decisions by providing $uantified evidence regarding the financial
position and performance of the company. ,ccounting analysis is another component
of business analysis. ,ccounting analysis is the process of evaluating the e%tent that
a companys accounting reflects economic reality. If the accounting information
distorts the economic picture of the firm" decisions made using this information can
be fla#ed. hus" accounting analysis should be performed before financial analysis.
'rospective analysis is the forecasting of future payoffs. his analysis dra#s on
accounting analysis" financial analysis" and business environment and strategy
analysis. he output of prospective analysis is a set of e%pected future payoffs used
to estimate intrinsic value such as earnings and cash flo#s. ,nother component of
business analysis is valuation" #hich is the process of converting forecasts of future
payoffs into an estimate of a companys intrinsic value.
?. ,ccounting analysis is crucial to effective financial analysis. he limitations of
financial analysis in the absence of accounting analysis include@
/ack of uniformity in accounting principles applied by different companies can
impede the reliability of financial analysis. he seeming comparability of
accounting data is sometimes illusory.
/ack of information in the aggregate financial data to inform the analyst on ho#
the accounting of the company #as applied. he analyst needs to analy!e the
e%planatory notes for this information.
Increased fre$uency of AanomaliesB in financial statements such as the failure to
change previous yearsC data for stock splits" missing data" etc.
Retroactive changes cannot be made accurately because companies only change
final figures.
1ertain comparative analyses &leases and pensions) cannot be done since all
companies do not provide full information in the absence of analytical accounting
ad9ustments.
&1F, adapted)
D. he financial statements of a company are one of the richest sources of information
about a company. Financial statement analysis is a collection of analytical processes
that are an important part of overall business analysis. hese processes are applied
to the financial statement information to produce useful information for decision
making. he ob9ective of financial statement analysis is to use the information
provided in the statements to produce $uantified information to support the ultimate
e$uity" credit" or other decision of interest to the analyst.

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E. Internal users@ (#ners" managers" employees" directors" internal auditorsF
E%ternal users@ 1urrent and potential e$uity investors" current and potential debt
investors" current and potential creditors" current and potential suppliers" current and
potential customers" labor unions members and representatives" regulators" and
government agencies.
6G. , business pursues four ma9or activities in a desire to provide a saleable product
andHor service and to yield a satisfactory return on investment. hese activities are@
'lanning activities. , company implements specific goals and ob9ectives. ,
companyCs goals and ob9ectives are captured in its business plans &or strategies)I
that describe the companyCs purpose" strategy" and tactics. he business plan assists
managers in focusing their efforts and identifying e%pected opportunities and
obstacles.
Financing ,ctivities. , company re$uires financing to carry out its business plan.
Financing activities are the means companies use to pay for these ventures. ,
company must take care in ac$uiring and managing its financial resources because
of both their magnitude and their potential to determine success or failure. here are
t#o main sources of business financing@ e$uity investors &referred to as o#ner
financing) and creditors &referred to as non*o#ner financing).
Investing ,ctivities. Investing activities are the means a company uses to ac$uire and
maintain investments for purchasing" developing" and selling products and services.
Financing provides the funds necessary for ac$uisition of investments needed to
carry out business plans. Investments include land" buildings" e$uipment" legal rights
&patents" licenses" and copyrights)" inventories" human capital &managers and
employees)" accounting systems" and all components necessary for the company to
operate.
(perating ,ctivities. (perating activities represent the carrying out of the business
plan" given necessary financing and investing. hese activities involve several basic
functions such as research" purchasing" production" marketing" and labor. (perating
activities are a companyCs primary source of income. Income measures a companyCs
success in buying from input markets and selling in output markets. Jo# #ell a
company does in devising business plans and strategies" and #ith decisions on
elements comprising the mi% of operating activities" determines its success or failure.
66. Business activitiesIplanning" financing" investing" and operatingIcan be
synthesi!ed into a cohesive picture of ho# businesses function in a market economy.
+tep one is the companyCs formulation of plans and strategies. 0e%t" a company
obtains necessary financing from e$uity investors and creditors. Financing is used to
ac$uire investments in resources to produce goods or services. he company uses
these investments to undertake operating activities.
,t the end of a period of timeItypically $uarterly or annuallyIfinancial statements
are prepared and reported. hese statements list the amounts associated #ith
financing and investing activities" and summari!e operating activities for the most
recent period&s). his is the role of financial statementsIthe ob9ect of analysis. he
financial statements listing of financing and investing activities is at a !oint in time"
#hereas the reporting of operating activities cover a !eriod o" time.

Instructor's Solutions Manual 1-#
6:. he four primary financial statements are the balance sheet" the income statement"
the statement of shareholders &o#ners) e$uity" and the statement of cash flo#s.
Balance +heet. he accounting e$uation is the basis of the balance sheet@
,ssets K /iabilities L E$uity.
he left*hand side of this e$uation relates to the economic resources controlled by
the firm" called assets. hese resources are valuable in the sense that they represent
potential sources of future revenues. he company uses these resources to carry out
its operating activities. In order to engage in its operating activities" the company
must obtain funds to fund its investing activities. he right*hand side of the
accounting e$uation details the sources of these funds. /iabilities represent funds
obtained from creditors. hese amounts represent obligations or" alternatively" the
claims of creditors on assets. E$uity" also referred to as shareholdersC e$uity"
encompasses t#o different financing sources@ &6) funds invested or contributed by
o#ners" called Mcontributed capitalM" and &:) accumulated earnings since inception
and in e%cess of distributions to o#ners &dividends)" called Mretained earningsM. From
the o#nersC vie#point" these amounts represent their claim on assets. It often is
helpful for students to re#rite the accounting e$uation in terms of the underlying
business activities@
Investing ,ctivities K Financing ,ctivities.
Recogni!ing the t#o basic sources of financing" this can be re#ritten as@
Investments K 1reditor Financing L (#ner Financing.
Income +tatement. he income statement is designed to measure a companyCs
financial performance bet#een balance sheet datesIhence" it refers to a period of
time. ,n income statement lists revenues" e%penses" gains" and losses of a company
over a period. he Mbottom lineM of an income statement" net income" measures the
increase &or decrease) in the net assets of a company &i.e." assets less liabilities)"
before consideration of any distributions to o#ners. 2ost contemporary accounting
systems" the ..+. included" determine net income using the accrual basis of
accounting. .nder this method" revenues are recogni!ed #hen earned" independent
of the receipt of cash. E%penses" in turn" are recogni!ed #hen incurred &or matched
#ith its related revenue)" independent of the payment of cash.
+tatement of 1ash Flo#s. .nder the accrual basis of accounting" net income e$uals
net cash flo# only over the life of the firm. For periodic reporting purposes" accrual
performance numbers nearly al#ays differ from cash flo# numbers. his creates a
demand for periodic reporting on both income and cash flo#s. he statement of cash
flo#s details the cash inflo#s and outflo#s related to a companyCs operating"
investing" and financing activities over a period of time.
+tatement of +hareholdersC E$uity. he statement of shareholdersC e$uity reports
changes in the component accounts comprising e$uity. he statement is useful in
identifying the reasons for changes in o#nersC claims on the assets of the company.
In addition" accepted practice e%cludes certain gains and losses from net income
#hich" instead" are directly reported in the statement of shareholdersC e$uity.
6;. Financial statements are one of the most reliable of all publicly available data for
financial analysis. ,lso" financial statements are ob9ective in portraying economic
transactions and events" they are concrete" and they $uantify important business

1-8
activities. 2oreover" since financial statements e%press transactions and events in a
common monetary unit" they enable users to readily #ork #ith the data" to relate them
to other data" and to deal #ith them in different arithmetic #ays. hese attributes
contribute to the usefulness of financial statements" both historical and pro9ected" in
business decision*making.
(n the other hand" one must recogni!e that accounting is a social science sub9ect to
human decision making. 2oreover" it is a continually evolving discipline sub9ect to
revisions and improvements" based on e%perience and emerging business
transactions. hese limitations sometimes frustrate certain users of financial
statements such that they look for substitute data. Jo#ever" there is no e$uivalent
substitute. 3ouble*entry accounting is the only reliable system for the systematic
recording" classification" and summari!ation of most business transactions and
events. Improvement lies in the refinement of this time*tested system rather than in
substitution. ,ccordingly" any serious analyst of a companys financial position and
results of operations" learns the accounting frame#ork and its terminology"
conventions" as #ell as its imperfections in financial analysis.
6<. Financial statements are not the sole output of the financial reporting system.
,dditional financial information is communicated by companies through the follo#ing
sources@
2anagementCs 3iscussion and ,nalysis &234,). 1ompanies #ith publicly traded debt
and e$uity securities are re$uired by the +E1 to provide a report of their financial
condition and results of operations in a 234, section of its financial reports.
2anagement Report. he management report sets out the responsibilities of
management in preparing the companyCs financial statements.
,udit Report. he e%ternal auditor is an independent certified public accountant hired
by management to assess #hether the companyCs financial statements are prepared
in conformity #ith generally accepted accounting principles. ,uditors provide an
important check on financial statements prior to their release to the public.
E%planatory 0otes. 0otes are an integral part of financial statements and are intended
to communicate additional information regarding items included in" and e%cluded
from" the statements.
+upplementary Information. 1ertain supplemental schedules are re$uired by
accounting regulatory agencies. hese schedules can appear in notes to financial
statements or" in the case of companies #ith publicly held securities" in e%hibits to
regulatory filings such as the Form 6G*- that is filed #ith the +ecurities and E%change
1ommission.
+ocial Responsibility Reports. 1ompanies increasingly recogni!e their need for social
responsibility. While reports of socially responsible activities are increasing" there is
no standard format or accepted standard.
'ro%y +tatements. , pro%y statement is a document containing information necessary
to assist shareholders in voting on matters for #hich the pro%y is solicited.
6=. Financial analysis includes analysis of the profitability of a company" the risk of the
company" and the sources and uses of funds for the company. 'rofitability analysis

Instructor's Solutions Manual 1-$
is the evaluation of a companys return on investment. It focuses on a companys
sources and levels of profits" and involves identifying and measuring the impact of
various drivers of profitability. 'rofitability analysis includes evaluation of t#o
sources of profitability@ margins and turnover. Risk analysis is the evaluation of a
companys riskiness and its ability to meet its commitments. Risk analysis involves
assessing the solvency and li$uidity of a company along #ith its earnings variability.
,n analysis of sources and uses of funds is the evaluation of ho# a company is
obtaining and deploying funds. his analysis provides insights into a companys
future financing implications.
6>. Financial analysis tools include the follo#ing@
a. 1omparative financial statements
i. 5ear*to*year change analysis
ii. Inde%*number trend analysis
b. 1ommon*si!e financial statements
c. Ratio analysis
d. 1ash flo# analysis
6?. a. 1omparative analysis focuses on e%ceptions and variations and helps the analyst
to formulate 9udgements about data that may be interpreted in various #ays. In
short" the usefulness of comparative analysis is the notion that a number is more
meaningfully interpreted #hen it is evaluated relative to a comparable $uantity.
b. 1omparison can be made against &6) past e%perience" &:) e%ternal dataIindustry
or economy*#ide" or &;) accepted guidelines such as standards" budgets" or
forecasts.
c. , comparison" to be meaningful and fair" must be made bet#een data" #hich are
prepared on a similar basis. If data are not directly comparable" the analyst should
make appropriate ad9ustments before undertaking any comparative analysis. (ne
also must remember that the past is not al#ays an un$ualified guide to the future.
6D. 'ast trend often is a good predictor of the future i" all relevant variables remain
constant or nearly constant. In practice" ho#ever" this is seldom the case.
1onse$uently" the analyst should use the results of trend analysis and ad9ust them in
the light of other available information" including the e%pected state of the economy
and industry. rend analysis #ill" in most cases" reveal the direction of change in
operating performance along #ith the velocity and the magnitude of change.
6E. Both indicators complement one another. Indeed" one indicator in the absence of the
other is of limited value. o illustrate" an increase to N<"GGG of receivables from base
year receivables of N6GG indicates a ;"EGG O P&N<"GGG*N6GG)HN6GGQ increase. Jo#ever"
the huge percent change in this case is misleading given the relatively small base
year amount. his simple case demonstrates that both indicators need to be
considered simultaneously. hat is" reference to the absolute dollar amounts must be
made to retain the proper perspective #hen a significant change in percent is
revealed.
:G. +everal ans#ers are possible. +ince division by !ero is not mathematically defined" it
is impossible to get changes in percent #hen there is no figure for the base year.
,lso" if there is a negative figure in the base year and a positive figure in another year"
or vice versa" a mere mathematical computation of percent change is nonsensical.

1-1%
:6. In inde%*number trend analysis" all figures are e%pressed #ith reference to a base
year figure. +ince the base year serves as the frame of reference" it is desirable to
choose a year that is MtypicalM for the business. If the earliest year in the series
analy!ed is not typical" then a subse$uent &more typical) year should be chosen as
the base year.
::. By utili!ing inde% numbers" the analyst can measure change over time. +uch analysis
enables the analyst to assess managementCs policies and" #hen e%amined in the light
of the economic and industry environment of the periods covered" the ability of the
company to effectively confront challenges and opportunities. 2oreover" trend
analysis of inde%*numbers enables the analyst to uncover important relations among
various components of financial statements. his helps in the evaluation of the
relative change in these components. For e%ample" changes in sales and accounts
receivable are logically correlated and can be e%pected to display a natural relation
#hen e%amining trends.
:;. a. 1ommon*si!e financial statements enable comparisons of changes in the
elements that make up financial statements. he figures in each line item of
financial statements are divided by a reasonable aggregate total and then
e%pressed as percents. he total of these elements #ill add to 6GGO. For e%ample"
the balance sheet items are usually e%pressed as a percentage of total assets and
the income statement items are usually e%pressed as a percentage of total
revenues. his makes it easier for the analyst to identify internal structural
changes in companies that are reflected in financial statements.
b. he analysis of common*si!e financial statements focuses on ma9or aspects of
the internal structure of company operations such as@
1apital structure and sources of financing
3istribution of assets or make up of investing activities
1omposition of important segments of financial position such as current assets
Relative magnitude of various e%penses in relation to sales
2oreover" useful information can be obtained by a comparison of common*si!e
statements of a company across years. he advantage of this temporal analysis is
even more evident in comparisons bet#een t#o companies of different si!es.
+ince analyses can be made on a uniform basis" this tool greatly facilitates such
comparisons.
:<. , ratio e%presses a mathematical relation bet#een t#o $uantities. o be meaningful
&useful in analysis)" a ratio of financial numbers must capture an important economic
relation. 1ertain items in financial statements have no logical relation to each other
and" therefore" #ould not be amenable to ratio analysis.
,lso" some type of benchmark or norm must e%ist for interpretation of the ratio. (ne
can dra# minimal inference from being told that the return on assets for a certain firm
is .G:. Jo#ever" if the analyst is told that the companys return on assets is .G: and
the industry average is .GD" the ratio becomes more useful for interpretation
purposes.

:=. +ince not all relations have meaning and not all ratios are useful for all analytical
purposes" the analyst must be careful in selecting ratios that are useful for the

particular task at hand. .nfortunately" ratios are too often misunderstood and their
significance overrated. Ratios can provide an analyst #ith clues and symptoms of
underlying conditions. Ratios also can highlight areas that re$uire further
investigation and in$uiry. +till" ratios" like all other analysis tools" cannot predict the
future. 2oreover" the usefulness of insights obtained from ratios depends on their
skillful interpretation by the analyst. (f these several limitations on ratio analysis" t#o
are especially problematic@
1hanging 'rice /evels. 3ifferent items on financial statement are valued at different
times" #ith the result that ratios can change over time even though underlying factors
do not. For e%ample" a plant constructed in 6EDG and running at full capacity ever
since might be blindly compared to" say" year :GG: dollar sales in computing a sales
to gross plant ratio. 2oreover" once #e begin multiplying ratios" it becomes more
difficult &if not impossible) to vie# everything in comparable real dollar terms.
3iverse .nderlying Businesses. For most diversified companies" even one reporting
limited diversification of sales and earnings" the ratios calculated from financial
statements reflect composites or appro%imations of operations and financial
condition. his means they can obscure #hat may be significant differences by
product or service line. For e%ample" a utili!ation ratio may conceal markedly
different levels of facility utili!ation for different products. 5et" the overall utili!ation
ratio might sho# a balanced picture #ith no serious problems.
&1F, adapted)
:>. a. 1urrent ratioF ,cid*test &$uick) ratioF 1ash ratioF otal debt ratioF otal debt to
e$uity ratioF /ong*term debt to e$uityF Financial leverage ratioF Book value per
share
b. imes interest earnedF Rross margin ratioF (perating profit margin ratioF 'reta%
profit margin ratioF 0et profit margin ratioF Effective ta% rate
c. Inventory turnoverF 3aysC sales in receivablesF Return on total assetsF Return on
e$uityF 1ash turnoverF ,ccounts receivable turnoverF +ales to inventoryF Working
capital turnoverF Fi%ed asset turnoverF otal assets turnoverF E$uity gro#th rate
:?. Besides the general tools of analysis" many special*purpose tools of financial
analysis e%ist. 2ost of these tools are designed for specific financial statements or
specific segments of statements. (ther special*purpose tools apply to a particular
industry. +pecial*purpose tools include &6) cash flo# analyses" &:) statements of
variation in gross profit" &;) earning po#er analysis" and &<) industry*specific
techni$ues like occupancy to capacity analyses for hotels" hospitals" and airlines.
:D. , dollar is #orth more to an entity today than it is #orth a year from no#. he reason
is that the dollar can be employed today and begin earning additional money &such as
#ith an interest*bearing bank account). In the conte%t of valuation" the time value of
money is important because the timing of pay offs becomes important. ,n investor is
#illing to pay more for cash flo#s that #ill occur sooner rather than later.
:E. In the market" a bonds value is determined by #hat investors are #illing to pay
&supply and demand dynamics). he effective interest implicit in the deal is
determined by finding the rate at #hich the present value of the future cash outflo#s
associated #ith the bond are e$ual to the proceeds received at issuance. hus" the

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effective interest rate might be vie#ed as a function of the bond price set by market
forces.
;G. he present value of cash flo#s often means something different to different people.
For e%ample" some believe that the value of the firm is the present value of operating
cash flo#s or investing cash flo#s or financing cash flo#s. (thers believe value is
derived as the present value of net cash flo#s. (thers define the value of the firm as
the present value of free cash flo#s. hus" there are many definitions of cash flo#s.
,lso" the #idely accepted valuation formula #ritten as a function of future dividends
cannot be #ritten in terms of cash flo#s proper.
;6. he residual income model computes value from accounting variables only. his
model performs $uite #ell relative to cash flo# models &several recent research
articles and #orking papers support this conclusion). hus" this model seems to
refute the argument that the value of an entity can only be determined by discounting
the underlying cash flo#s.
;:. he efficient market hypothesis &E2J) deals #ith the reaction of market prices to
financial and other data. First" note that E2J has its origins in the random #alk
hypothesisI#hich states that at any given point in time the si!e and direction of the
ne%t price change is random relative to #hat is kno#n about an investment at that
given time. +econd" there are three derivatives of this hypothesis. he first is kno#n
as the &ea' "orm of the E2JIit states that current prices reflect fully the information
conveyed by historical time series of prices. he second is the semi-stron( "ormIit
states that prices fully reflect all publicly available information. he third is the stron(
"ormIit asserts that prices reflect all information" including inside information. he
E2J" in all its forms" has undergone e%tensive empirical testing. 2uch of this
evidence supports the #eak form E2J" but there is considerable debate about the
validity of the semi*strong E2J due to various conflicting evidence.
;;. he E2J is dependent on the assumption that competent and #ell*informed analysts"
using tools of analysis" continually evaluate and act on the ever*changing stream of
ne# information entering the marketplace. +till" hardcore theorists seemingly rely on
the notion that since all information is immediately reflected in prices" there is no
obvious role for financial statement analysis. his scenario presents a parado%. (n
one hand" analysts efforts are assumed to keep security markets efficient. (n the
other hand" analysts are sufficiently #ise to recogni!e that their efforts yield no
individual re#ards. Jo#ever" should analysts recogni!e that their efforts are
unre#arded" then the market #ould cease to be efficient.
+everal points may help e%plain this parado%. First" E2J is built on aggregate rather
than individual investor behavior. he focus on aggregate behavior not only
highlights average performance but masks the results achieved by individual ability"
efforts" and ingenuity as #ell as by superior timing in acting on information as it
becomes available. +econd" fe# doubt that important information travels fast. ,fter
all" enough is at stake to make it travel fast. 0or is it surprising that securities markets
are rapid processors of information. 1onse$uently" using deductive reasoning similar
to the hardcore theorist" #e could conclude that the speed and efficiency of the
market is evidence that market participants are motivated by substantial" real
re#ards. hird" the reasoning behind E2JCs alleged implication for the lack of
usefulness of analysis fails to recogni!e the essential difference bet#een information
and its proper interpretation. hat is" even if all the information available on a security

at a given point in time is impounded in price" that price may not reflect intrinsic
value. It may be under* or over*priced depending on the degree to #hich an incorrect
interpretation or evaluation of the available information is made by those #hose
actions determine the price at a given time.
he #ork of financial statement analysis is comple% and demanding. he spectrum of
users of financial statements varies from the institutional analyst #ho concentrates
on only a fe# companies in one industry to a person #ho merely looks at the pictures
in an annual report. ,ll act on financial information" but surely not #ith the same
insights and competence. 1ompetent evaluation of Mne# informationM entering the
marketplace re$uires special skills. Fe# have the ability and are prepared to e%pend
the efforts and resources needed to conduct such analysis. It is only natural that they
#ould reap the re#ards by being able to act both competently and confidently on
information. he vast resources that must be brought to bear on the competent
analysis of securities has caused some segments of the market to be more efficient
than others. For e%ample" the market for shares of larger companies is more efficient
because more analysts follo# such securities in comparison to those #ho follo#
small" lesser*kno#n companies.
(ne must also recogni!e that those #ho 9udge usefulness in an efficient market
construe the function and purpose of analysis too narro#ly. While the search for
overvalued and undervalued securities is an important part of many analyses" the
importance of risk assessment and loss avoidance" in the total frame#ork of business
decision making" cannot be overemphasi!ed. For instance" analysis can evaluate the
reasonableness of a risk premium associated #ith a security. 2oreover" the
prevention of serious investment errors is at least as important as the discovery of
undervalued securities. 5et" a revie# of 1,'2 and beta theory tends to e%plain #hy
strict adherents to these macro*oriented models of security markets neglect this
important function of analysis. 0amely" it is a basic premise of these theories that
analysis of unsystematic risk is not #orth#hile because the market does not re#ard
that kind of risk taking. Instead" such risks should be diversified a#ay and the
portfolio manager should look only to systematic or market risk for re#ards.
In sum" most financial statement analysis assumes that investment results are
achievable through careful study and analysis of individual companies. his
approach emphasi!es the value of fundamental analysis not only as a means of
keeping markets efficient but also as the means by #hich those investors #ho"
having obtained information" are #illing and able to apply kno#ledge" effort" and
ingenuity in analysis to reap re#ards. For those analysts" the fruits of fundamental
analysisIlong before being converted to a Mpublic goodMI#ill yield re#ards. hese
re#ards are not discernable" ho#ever" in the performance of analysts aggregated to
comprise ma9or market segments" such as mutual funds. Instead they remain as
individual as the efforts needed to reali!e them.
;<. +ystematic risk is that portion of total risk attributable to the movement of the market
as a #hole. .nsystematic risk is the residual risk that is uni$ue to a specific security.
While the elements of unsystematic risk cannot be neatly separated from systematic
risk" the various components of unsystematic risk" broadly speaking" are@
Economic RiskIreflects risks of the overall economic environment in #hich the
company operates" including economic risk &fluctuations in business activity)" capital

1-14
market risk &including changes in interest rates)" and purchasing po#er risk &due to
inflation and the subse$uent decrease in purchasing po#er).
Business RiskIreflects the ever*present uncertainty of a companyCs ability to earn a
satisfactory return on its investments as #ell as #ith the multitude of cost and
revenue factors that enter into the determination of this return. It includes the factors
of competition" product mi%" and management ability. Because of the effect of the
market discount rate on systematic risk" #e cannot look at business risk as
distinctive from investment risk.
Financial RiskIreflects capital structure and the ability of a company to meet fi%ed
and senior charges and claims.
,ccounting RiskIreflects risk inherent in the e%istence of alternative accounting
principles" the criteria that define them" and the standards of practice. his lack of
assurance about the principles used" or the method or rigor of their application" can
lead to variation in reporting and uncertainty. ,ccounting risk may also include the
degree of conservatism of accounting principles in use or the lack thereof.
;=. he capital asset pricing model &1,'2) is based on the assumption that investors
desire to hold securities in portfolios that are efficient in the sense they provide a
ma%imum return for a given level of risk. he model is derived under the follo#ing
simplifying assumptions@
here e%ists a riskless security
Investors can borro# or lend unlimited amounts at the riskless rate
Investors have identical investment hori!ons and act on the basis of identical
e%pectations and predictions
Based on these assumptions" it is sho#n that #hen capital markets are in a state of
e$uilibrium" the e%pected return on an individual security E&Ri)" is related to its
systematic risk Si in the follo#ing linear form@
E&Ri) K E&RG) L PE&R2) * E&RG)Q i
his formulation states" in essence" that under conditions of e$uilibrium" a securityCs
e%pected return e$uals the e%pected return of a riskless security" E&RG)" plus a
premium for risk taking. his risk premium consists of a constant" PE&R2 * E&RG)Q"
#hich is the difference bet#een the return e%pected by the market and the return on
a riskless security &such as a short*term government bond) multiplied by the
systematic risk of the security" #hich is kno#n as beta. 1onse$uently" under 1,'2"
each security has an e%pected return related to its risk. his risk is measured by the
securitys systematic movements #ith the overall market and cannot be eliminated by
portfolio diversification.
;>. he concept of trade*off bet#een risk and return means that the higher the risk" the
higher the e%pected returnF similarly" the lo#er the risk" the lo#er the e%pected return.
he greater the perceived degree of risk of an investment or of a loan" the greater the
re$uired rate of return to compensate for this greater risk. his concept is very
significant to portfolio construction provided there is a formal frame#ork for
$uantifying both risk and return.
his t#o*dimensional risk*return approach offers an investor the ability to select the
preferred trade*off bet#een risk and return. It begins #ith the observation that the
future return on a security can be estimated in the form of a probability distribution.
.nder certain assumptions this distribution can be summari!ed in terms of risk and

return. .sing these variables" a frame#ork for deciding ho# much of each security to
hold in constructing a portfolio can be devised.
;?. , revie# of 1,'2" and beta theory" reveals that a basic premise of these theories is
that analysis of unsystematic risk is not #orth#hile because the market does not
re#ard this kind of risk taking. hey maintain such risks should be diversified a#ay
and that an analyst should look to systematic or market risk for re#ards. While this
might be a useful concept" it fails to reveal a valuable role for financial statement
analysis. 0amely" the importance of risk assessment and loss avoidance" in the total
frame#ork of business decision making" is lost. 2oreover" such analysis can help
assess the risk premium associated #ith a security. hese roles can be lost in a
1,'2 frame#ork due to a focus on market aggregates. +uch re#ards are not
discernable. Instead" they remain as individual as the efforts needed to bring them
about.

1-1
ETER1I+E+
E%ercise 6*6 &:G minutes)
a. 1omparative financial statement analysis for a single year reflects a brief
period of a companyCs history. It is essentially an interim analysis of a
companys business activities for that year. 2oreover" the accounting
systems allocation of costs and revenues to such short periods of time is" to
a considerable e%tent" based upon convention" 9udgment" and estimates. he
shorter the time period" the more difficult is the matching and recognition
process and the more it is sub9ect to error. In addition" single*year
comparative analysis may not accurately reflect a companyCs long*run
performance. his is because of the possibility of unusually favorable or
unfavorable economic or other conditions e%perienced in any particular year.
1onse$uently" any comparative financial statement analysis for a single year
cannot provide information on trends and changing relations that might occur
over time. For this reason" the information generated by comparative analysis
of a set of single*year statements is of limited interpretive value. 2oreover" the
financial statements themselves have limitations for analytical and interpretive
purposes by virtue of the inherent limitations of the accounting function
applied to a single year. ,lso" many factors that significantly affect the
progress and success of a firm are not of a financial character and are not"
therefore" e%pressed e%plicitly in financial statements. hese include factors
such as general economic conditions" labor relations" and customer attitudes.
he preparation of comparative statements for a single year #ould not
alleviate these limitations.
b. 1hanges or inconsistencies in accounting methods" policies" or
classifications for the years covered by comparative financial statement
analysis can yield misleading inferences regarding trends or changing
relations. For e%ample" a change in a firmCs depreciation or inventory
methods" even though the alternative procedures are acceptable or preferable"
can inhibit the comparability of corresponding items in t#o or more of the
periods covered. Further" the e%istence of errors &and their correction in
subse$uent periods)" nonrecurring gains or losses" mergers and ac$uisitions"
and changes in business activities can yield misleading inferences from
comparative analysis performed over several years.

Instructor's Solutions Manual 1-1#
E%ercise 6*6Icontinued
o avoid the potential for misleading inferences from these factors" #e must
carefully e%amine footnotes" e%planations" and $ualifications that are
disclosed as part of financial reporting. (ur comparative analysis must be
ad9usted for such possibilities. ,lso" changing price levels for the periods of
analysis can distort comparative financial statements. For e%ample" even
items on a comparative balance sheet or income statement that pertain to a
single year are not all e%pressed in dollars having the same purchasing po#er.
0amely" in an era of rising prices" a given yearCs depreciation represents older
dollars having greater purchasing po#er compared #ith most other income
statement items. Further" inventory methods other than /IF( can add to the
inflationary distortion of the income statement. +imilarly" balance sheet items
for a given year are e%pressed in dollars of varying purchasing po#er.
Beyond these vertical distortions that e%ist #ithin individual years covered by
comparative financial statements" are hori!ontal distortions in the trends and
relations of corresponding items across years. For e%ample" an up#ard trend
in sales may actually reflect a constant level of" or even decline in" actual
sales volume because of increases in prices. Because of the potential for
misleading inferences from comparative analysis during periods of changing
price levels" its usefulness as an analytical and interpretative tool is severely
restricted. his is because price level changes can limit the comparability of
the data in financial statements across time. (f course" analysis of price*level
ad9usted financial statements can restore the comparability of these
statements across time and" thereby" enhance their usefulness as tools of
analysis and interpretation.
E%ercise 6*: &:= minutes)
2%%3 2%%2
+ales.......................................... 6GG.GO 6GG.GO
1ost of goods sold................... >> .G =: .<
Rross profit............................... ;<.GO <?.>O
(perating e%penses................. :6 .G 6E .<
0et income................................ 6; .GO :D .:O
,nalysis and Interpretation@ his situation appears to be unfavorable. Both cost
of goods sold and operating e%penses are taking a larger percent of each sales
dollar in year :GG; compared to the prior year. ,lso" even though sales volume
increased" net income both decreased in absolute terms and declined to only
6;.GO of sales as compared to :D.:O in the year before.

1-18
E%ercise 6*; &:= minutes)
a. 1urrent ratio@
:GG;@ K 6.E to 6
:GG:@ K :.= to 6
:GG6@ K :.E to 6
b. ,cid*test ratio@
:GG;@ K G.E to 6
:GG:@ K 6.; to 6
:GG6@ K 6.? to 6
,nalysis and Interpretation@ 2i%onCs short*term li$uidity position has #eakened
over this t#o*year period. Both the current and acid*test ratios sho# declining
trends. ,lthough #e do not have information about the nature of the companyCs
business" the acid*test ratio shift from U6.? to 6 do#n to UG.E to 6 and the current
ratio shift from U:.E to 6 do#n to U6.E to 6 indicate a potential li$uidity problem.
+till" #e must recogni!e that industry standards may sho# that the :GG6 ratios
#ere too high &instead of :GG; ratios as too lo#).

Instructor's Solutions Manual
N;G"DGG L NDD"=GG L N666"=GG L NE"?GG
N6:D"EGG
N;=">:= L N>:"=GG L ND:"=GG L NE";?=
N?=":=G
N;>"DGG L N<E":GG L N=;"GGG L N<"GGG
N<E":=G
$30,800 + $88,500
$18,!00
$35,"5 + $",500
$#5,50
$3",800 + $$!,00
$$!,50
1-1$
E%ercise 6*< &:G minutes)
2i%on 1ompany
1ommon*+i!e 1omparative Balance +heet
3ecember ;6" :GG6*:GG;
:GG; :GG:
V
:GG6
V
1ash....................................................................... =.EO D.GO E.EO
,ccounts receivable" net..................................... 6?.6 6<.G 6;.:
2erchandise inventory......................................... :6.= 6D.= 6<.:
'repaid e%penses................................................. 6.E :.6 6.6
'lant assets" net .................................................. =; .> =? .; >6 .>
otal assets .......................................................... 6GG .GO 6GG .GO 6GG .GO
,ccounts payable................................................. :<.EO 6>.EO 6;.:O
/ong*term notes payable secured by
mortgages on plant assets .............................. 6D.D :;.G ::.6
1ommon stock" N6G par value............................. ;6.< ;>.= <;.>
Retained earnings ................................................ :< .E :; .= :6 .G
otal liabilities and e$uity.................................... 6GG .GO 6GG .GO 6GG .GO
V
1olumn does not e$ual 6GG.G due to rounding error.

1-2%
E%ercise 6*= &:= minutes)
a. 3aysC sales in receivables@
:GG;@ % ;>G K <? days
:GG:@ % ;>G K <: days
b. ,ccounts receivable turnover@
:GG;@ K D.E times
:GG:@ K E.= times
c. Inventory turnover@
:GG;@ K <.: times
:GG:@ K =.6 times
d. 3ays sales in inventory@
:GG;@ % ;>G K ED days
:GG:@ % ;>G K D> days
,nalysis and Interpretation@ he number of daysC sales uncollected has
increased and the accounts receivable turnover has declined. ,lso" the
merchandise turnover has decreased and days sales in inventory has increased.
While none of these changes in ratios that occurred from :GG: to :GG; appear
dramatic" it seems that 2i%on is becoming less efficient in managing its inventory
and in collecting its receivables.

$88,500
$"#,500
$",500
$530,000
$"#,500
%$88,500 +
$",500&'
$530,000
%$",500 +
$$!,00&'
$$10,5
%$111,500 +
$8,500&'
$3$$,500
%$8,500 +
$53,000&'
$111,500
$$10,5
$8,500
$3$$,500
1-21
E%ercise 6*> &:= minutes)
a. Total debt ratio (solution also includes the equity ratio):
2%%3 2%%2
otal liabilities &and debt ratio)@
N6:D"EGG L NE?"=GG.................. N::>"<GG <; .?O
N?=":=G L N6G:"=GG.................. N6??"?=G ;E .EO
otal e$uity &and e$uity ratio)@
N6>:"=GG L N6:E"6GG................ :E6">GG => .;
N6>:"=GG L N6G<"?=G................ WWWWWWW :>?":=G >G .6
otal liabilities and e$uity............ N=6D"GGG 6GG .GO N<<="GGG 6GG .GO
b. imes interest earned@
:GG;@ &N;<"6GG L ND"=:= L N66"6GG)HN66"6GG K <.D times
:GG:@ &N;6";?= L N?"D<= L N6:";GG)HN6:";GG K <.: times
,nalysis and Interpretation@ 2i%on added debt to its capital structure during
:GG;" #ith the result that the debt ratio increased from ;E.EO to <;.?O. Jo#ever"
the book value of pledged assets is #ell above secured liabilities &:.D to 6 in :GG;
and :.= to 6 in :GG:)" and the increased profitability of the company allo#ed it to
increase the times interest earned from <.: to <.D times. ,pparently" the company
is able to handle the increased debt. Jo#ever" #e should note that the debt
increase is entirely in current liabilities" #hich places a greater stress on short*
term li$uidity.

1-22
E%ercise 6*? &;G minutes)
a. 0et profit margin@
:GG;@ N;<"6GGHN>?:"=GG K =.6O
:GG:@ N;6";?=HN=;G"GGG K =.EO
b. otal asset turnover@
:GG;@ K 6.< times
:GG:@ K 6.; times
c. Return on total assets@
:GG;@ K ?.6O
:GG:@ K ?.?O
,nalysis and Interpretation@ 2i%onCs operating efficiency appears to be declining
because the return on total assets decreased from ?.?O to ?.6O. While the total
asset turnover favorably increased slightly from :GG: to :GG;" the profit margin
unfavorably decreased from =.EO to =.6O. he decline in profit margin indicates
that 2i%onCs ability to generate net income from sales has declined.

$"#,500
%$518,000 +
$$$5,000&'
$530,000
%$$$5,000 +
$3#,500&'
$3$,100
%$518,000 +
$$$5,000&'
$31,3#5
%$$$5,000 +
$3#,500&'
1-23
E%ercise 6*D &:G minutes)
a. Return on common stockholdersC e$uity@
:GG;@ K 6:.:O
:GG:@ K 6:.<O
b. 'rice earnings ratio" 3ecember ;6@
:GG;@ N6=HN:.6G K ?.6
:GG:@ N6<HN6.E; K ?.;
c. 3ividend yield@
:GG;@ N.;GHN6= K :.GO
:GG:@ N.6=HN6< K 6.6O
E%ercise 6*E &:= minutes)
,ns#er@ 0et income decreased.
+upporting calculations@ When the sums of each yearCs common*si!e cost of
goods sold and e%penses are subtracted from the common*si!e sales percents"
net income percents are as follo#s@
:GG6@ 6GG.G * =D.6 * 6<.6 K :?.DO of sales
:GG:@ 6GG.G * >G.E * 6;.D K :=.;O of sales
:GG;@ 6GG.G * >:.< * 6<.; K :;.;O of sales
,lso notice that if :GG6 sales are assumed to be N6GG" then sales for :GG: are
N6G;.:G and the sales for :GG; are N6G<.<G. If the income percents for the years
are applied to these amounts" the net incomes are@
:GG6@ N6GG.GG % :?.DO K N:?.DG
:GG:@ N6G;.:G % :=.;O K N:>.6:
:GG;@ N6G<.<G % :;.;O K N:<.;;
his case sho#s that the companys net income decreased over the three*year
period.

$3$,100
%$!1,"00 + $"#,50&'
$31,3#5
%$"#,50 + $$0,#50&'
1-24
E%ercise 6*6G &;G minutes)
1omparative Report
2esa has a greater amount of #orking capital. But that by itself does not indicate
#hether 2esa is more capable of meeting its current obligations. Further support
is provided by the current ratios and acid*test ratios that sho# 2esa is in a more
li$uid position than Juff. Jo#ever" this evidence does not mean that JuffCs
li$uidity is inade$uate. +uch a conclusion #ould re$uire more information such
as norms for the industry or its other competitors. 0otably" JuffCs acid*test ratios
appro%imate the traditional rule of thumb &6 to 6).
his evidence also sho#s that 2esaCs #orking capital" current ratio" and acid*test
ratio all increased dramatically over the three*year period. his trend to#ard
greater li$uidity may be positive. But the evidence also may suggest that 2esa
holds an e%cess amount of highly li$uid assets that typically earn a lo# return.
he accounts receivable turnover and merchandise turnover indicate that Juff
1ompany is more efficient in collecting its accounts receivable and in generating
sales from available merchandise inventory. Jo#ever" these statistics also may
suggest that Juff is too conservative in granting credit and investing in inventory.
his could have a negative impact on sales and net income. 2esaCs ratios may
be acceptable" but no definitive determination can be made #ithout having
information on industry &or other competitors) standards.
E%ercise 6*66 &:G minutes)
)ear 5 )ear 4 )ear 3 )ear 2 )ear 1
+ales.................................... 6DD 6DG 6>D 6=> 6GG
1ost of goods sold............ 6EG 6D6 6?6 6=D 6GG
,ccounts receivable.......... 6E6 6D; 6?< 6>: 6GG
he trend in sales is positive. While this is better than no gro#th" one cannot
definitively say #hether the sales trend is favorable #ithout additional
information about the economic conditions in #hich this trend occurred such as
inflation rates and competitors performances.
Riven the trend in sales" the comparative trends in cost of goods sold and
accounts receivable both appear to be some#hat unfavorable. In particular" both
are increasing at slightly faster rates &inde%es for cost of goods sold is 6EG and
accounts receivable is 6E6) than sales &inde% is 6DD).
E%ercise 6*6: &6= minutes)
*ollar
+han(e ,ase Amount
-ercent
+han(e
+hort*term investments....... N=:"DGG N6>="GGG ;:O
,ccounts receivable............ &="DDG) <D"GGG *6:O

0otes payable....................... =?"GGG G &not calculable)
E%ercise 6*6; &6G minutes)
a. Bond price K 'resent value &'V) of cash flo#s &both interest payments and
principal repayment)
'resent value of interest payments@
'ayment K N6GG % 6GO K N6G per year at end of each year &ordinary annuity)
'V
int
K N6G % 'V factor for an ordinary annuity &nK=" iK6<O)
K N6G % ;.<;;GD
K N;<.;;
'resent value of principal repayment@
'V
prin
K N6GG % 'V factor for a lump sum &nK=" iK6<O)
K N6GG % G.=6E;?
K N=6.E<
'rice K 'V of interest payments L 'V of principal repayment
K N;<.;; L N=6.E<
K ND>.:?
b. Interest payments &N6"GGG % DO K NDG annually)@
'V
int
K NDG % 'resent value factor for an ordinary annuity &nK=F iK>O)
K NDG % <.:6:;>
K N;;>.EE
'rincipal repayment &N6"GGG in = years hence)@
'V
prin
K N6"GGG % 'resent value factor for a lump sum &nK=F iK>O)
K N6"GGG % G.?<?:>
K N?<?.:>
'rice K N;;>.EE L N?<?.:>
K N6"GD<.:=
c. Interest payments &N6"GGG % DO % &6H:)K N<G)@
'V
int
K N<G % 'resent value factor for an ordinary annuity &nK6GF iK;O)
K N<G % D.=;G:G
K N;<6.:6
'rincipal repayment &N6"GGG in = years hence)@
'V
prin
K N6"GGG % 'resent value factor for a lump sum &nK6GF iK;O)
K N6"GGG % .?<<GE
K N?<<.GE
'rice K N;<6.:6 L N?<<.GE
K N6GD=.;G

1-2
E%ercise 6*6< &6G minutes)
a. Interest payments &N6G"GGG % DO % &6H:) K N<GG semiannually)@
'V
int
K N<GG % 'resent value factor for an ordinary annuity &nK:GF iK;O)
K N<GG % 6<.D??<?
K N="E=G.EE
'rincipal repayment &N6G"GGG in = years hence)@
'V
prin
K N6G"GGG % 'resent value factor for a lump sum &nK:GF iK;O)
K N6G"GGG % G.==;>D
K N="=;>.DG
'rice K N="E=G.EE L N="=;>.DG
K N66"<DD
b. Interest payments &N6G"GGG % DO % &6H:) K N<GG)@
'V
int
K N<GG % 'resent value factor for an ordinary annuity &nK:GF iK=O)
K N<GG % 6:.<>::6
K N<"ED<.DD
'rincipal repayment &N6G"GGG in = years hence)@
'V
prin
K N6G"GGG % 'resent value factor for a lump sum &nK:GF iK=O)
K N6G"GGG % G.;?>DE
K N;"?>D.EG
'rice K N<"ED<.DD L N;"?>D.EG
K ND"?=<
c. Risk is the possibility that 1olin 1ompany #ill not make all of the interest and
principal payments that are called for in the debt agreement. he higher that
an investor perceives the risk of non*payment to be" the more the investor
should discount the cash flo#s. hus" a higher risk of repayment is reflected
in a higher discount rate. By using the higher discount rate" the amount that
the investor is #illing to pay for the bonds is lo#er.

E%ercise 6*6= &6= minutes)
End o". 5ear G5ear 65ear :5ear ; 5ear < 5ear =
0et income D 66 :G <G ;G
Book value =G =D
a
>E DE 6:E 6=E
1apital charge &Beg.
book value % :GO
cost of capital) 6G
b
66.> 6;.D 6?.D :=.D
Residual income &:)
c
&.>) >.: ::.: <.:
3iscount factor 6.: &6.:)
:
&6.:)
;
&6.:)
<
&6.:)
=
Value at time t =G L &6.>?) L &.<6?) L ;.=DD L 6G.?G> L 6.>DD K
N><
a@ N=G beginning book value L ND net income * NG dividends
b@ N=G beginning book value % :GO cost of capital
c@ ND net income &pro9ected) * N6G capital charge
1omments@ (ne of the key variables for the residual income model is book
value. Book value is readily available and sub9ected to auditing procedures. he
other key variables are future net income and cost of capital. 0et income is
generally considered easier to predict than future dividends or cash flo#s. hese
points are advantages of the residual income valuation model. he cost of
capital must be estimated in all of the valuation models. he primary limitation of
the residual income model is that it re$uires predictions of earnings for the life of
the firm. +implifying assumptions are usually necessary.

1-28
'R(B/E2+
'roblem 6*6 &;G minutes)
1omparative Report
,rborCs profit margins are higher than -ampaCs. Jo#ever" -ampa has
significantly higher total asset turnover ratios. ,s a result" -ampa generates a
substantially higher return on total assets.
he trends of both companies include evidence of gro#th in sales" total asset
turnover" and return on total assets. Jo#ever" ,rborCs rates of improvement are
better than -ampaCs. hese differences may result from the fact that ,rbor is
only ; years old #hile -ampa is an older" more established company. ,rborCs
operations are considerably smaller than -ampaCs" but that #ill not persist many
more years if both companies continue to gro# at their current rates.
o some e%tent" -ampaCs higher total asset turnover ratios may result from the
fact that its assets may have been purchased years earlier. If the turnover
calculations had been based on current values" the differences might be less
striking. he relative ages of the assets also may e%plain some of the difference
in profit margins. ,ssuming ,rborCs assets are ne#er" they may re$uire smaller
maintenance e%penses.
Finally" -ampa successfully employed financial leverage in :GG;. Its return on
total assets is D.EO compared to the ?O interest rate it paid to obtain financing
from creditors. In contrast" ,rborCs return is only =.DO as compared to the ?O
interest rate paid to creditors.

Instructor's Solutions Manual 1-2$
'roblem 6*: &6GG minutes)
-art 1
1(J(R0 1(2',05
Income +tatement rends
For 5ears Ended 3ecember ;6" 6EE?*:GG;
2%%3 2%%2 2%%1 2%%% 1$$$ 1$$8 1$$#
+ales......................................
6E:.=O 6>D.>O 6=;.<O 6<G.>O 6;6.:O 6::.GO 6GG.GO
1ost of goods sold..............:;=.D 6E6.D 6>=.G 6<<.< 6;<.: 6:=.= 6GG.G
Rross profit...........................6;6.G 6;=.? 6;>.D 6;=.6 6:>.E 66?.G 6GG.G
(perating e%penses.............:>=.> :G?.D 6EG.> 6<G.> 6:6.E 6:G.; 6GG.G
0et income............................ =G.= E:.= 6G<.? 6;6.D 6:E.E 66=.G 6GG.G
1(J(R0 1(2',05
Balance +heet rends
3ecember ;6" 6EE?*:GG;
2%%3 2%%2 2%%1 2%%% 1$$$ 1$$8 1$$#
1ash.......................................>D.?O DD.EO E:.EO E<.EO EE.GO E?.GO
6GG.GO
,ccounts recble." net...........:;;.G :<<.? ::6.< 6>E.E 6<E.= 6<6.? 6GG.G
2erchandise inventory........;;?.= :<=.< :6<.< 6D6.G 6>:.; 6;?.E 6GG.G
(ther current assets............:<:.6 ::6.6 6:>.; :;6.> :GG.G :GG.G 6GG.G
/ong*term investments....... I I I 6GG.G 6GG.G 6GG.G 6GG.G
'lant and e$uip." net............:=?.G :=>.: ::<.= 6:>.= 6;G.? 66>.< 6GG.G
otal assets..........................:<?.; :::.E 6E>.G 6<<.< 6;D.> 6:<.G 6GG.G
1urrent liabilities..................<66.D ;<>.; ::?.: 6DE.G 6><.G 6==.6 6GG.G
/ong*term liabilities.............;G>.: :>>.? :=E.= 6:G.= 6:;.6 6;;.; 6GG.G
1ommon stock.....................6=>.; 6=>.; 6=>.; 6;6.; 6;6.; 6GG.G 6GG.G
(ther contrib. capital...........6=>.; 6=>.; 6=>.; 66:.= 66:.= 6GG.G 6GG.G
Retained earnings................:>:.? :;G.D 6E6.? 6?>.; 6>:.6 6<=.G 6GG.G
otal liabilities 4 e$uity.......:<?.; :::.E 6E>.G 6<<.< 6;D.> 6:<.G 6GG.G
-art 2
he statements and the trend percent data indicate that the company
significantly e%panded its plant and e$uipment in :GG6. 'rior to that time" the
company en9oyed increasing gross profit and net income. +ales gre# steadily for
the entire period of 6EE? to :GG;. Jo#ever" beginning in :GG6" cost of goods sold
and operating e%penses increased dramatically relative to sales" resulting in a
significant reduction in net income. In :GG; net income #as only =G.=O of the
6EE? base year amount.
,t the same time that net income #as declining" assets #ere increasing. his
indicates that 1ohorn #as becoming less efficient in using its assets to generate
income. ,lso" the short*term li$uidity of the company continued to decline.
,ccounts receivable did not change significantly for the period of :GG6 to :GG;"
but cash steadily declined and merchandise inventory sharply increased" as did
current liabilities.

1-3%
'roblem 6*; &:= minutes)
5r. > 5r. = 5r. < 1umulative ,nnual
,mount ,verage
,mount
0et +ales ................................. N>"DDG $3,490 $2,860 N6;":;G N<"<6G
1ost of Roods +old ................ 3,210 :"D6G 6"D6G ?"D;G 2,610
Rross 'rofit ............................. $3,670 $ 680 $1,050 N ="<GG $1,800
(perating E%penses .............. E;G <>= E<= :";<G ?DG
Income Before a%es ............. $2,740 $ 215 $ 105 N ;"G>G N6"G:G
0et Income .............................. $1,485 $ 145 $ 58 N 6">DD N =>;
Interpretation of 1omparative ,nalysis
(verall" this analysis suggests a rather volatile financial picture for Eastman
1orp. For e%ample" net sales have steadily increased for this three*year periodI
almost doubling in 5ear >I#hile gross profit dips in 5ear = but increases
considerably in 5ear >. ,lso" operating e%penses are especially lo# in 5ear =I
this occurs at the same time #hen income ta%es e%pense is lo#.
'roblem 6*< &:= minutes)
5ear ? 5ear > 5ear =
Inde% 1hange Inde% 1hange Inde%
0o. in O 0o. in O 0o.
0et +ales ........................ 6:E 29% 100 66.6O 90
1ost of Roods +old ...... 139 ;E 100 6?.> 85
Rross 'rofit ................... 126 :> 100 :=.G 80
(perating E%penses...... 6:G 20 100 =;.D 65
Income Before a%es .... 66< 14 100 <:.E 70
0et Income ..................... 129 :E 100 ;;.; 75
Interpretation of rend ,nalysis
he gro#th in cost of goods sold e%ceeds the gro#th in net sales in both 5ears >
and ?. , continuation of these trends in both sales and cost of goods sold #ill
limit future gro#th in net income. he gro#th in operating e%penses is erraticI
that is" it is =;.DO in 5ear > and :GO in 5ear ?.

'roblem 6*= &<= minutes)
2E+1( 1(2',05
Balance +heet
3ecember ;6" 5ear =
Assets
1urrent ,ssets@
1ash.................................................................... N 6G":=G
,ccounts receivable.......................................... <>"GGG
Inventories.......................................................... D>":=G
otal current assets........................................... N6<:"=GG
0oncurrent assets................................................ :DG"GGG
otal assets........................................................... N<::"=GG
/ia0ilities and Stoc'holders' E1uity
1urrent liabilities.................................................. N ::"=GG
0oncurrent liabilities............................................ >:"GGG
otal liabilities....................................................... N D<"=GG
Stoc'holders' E1uity
1ommon stock...................................................... N6=G"GGG
,dditional paid*in capital.................................... >G"GGG
Retained earnings................................................ 6:D"GGG
otal stockholdersC e$uity................................... N;;D"GGG
otal liabilities and e$uity................................... N<::"=GG
+upporting computations@
0ote 6@ 1ompute net income for 5ear =
+ales .............................................................................. NE:G"GGG
1ost of goods sold....................................................... >EG"GGG &?=O of sales)
Rross profit .................................................................. N:;G"GGG &:=O of sales)
(perating e%penses..................................................... 6DG"GGG
Income before ta%es..................................................... N =G"GGG
a%es e%pense............................................................... :G"GGG &ta% at <GO rate)
0et income.................................................................... N ;G"GGG
0ote :@ 1ompute +tockholdersC E$uity
1ommon stock &N6= par % 6G"GGG sh.)........................ N6=G"GGG
,dditional paid*in capital &N:6*N6=) % 6G"GGG sh........ >G"GGG N:6G"GGG
Retained earnings" 3ec. ;6" 5ear <.............................. ED"GGG
0et income.................................................................... ;G"GGG
Retained earnings" 3ec. ;6" 5ear =.............................. 6:D"GGG
otal................................................................................ N;;D"GGG

1-32
'roblem 6*=Icontinued
0ote ;@ otal e$uity N;;D"GGG
<
otal debt N D<"=GG
0ote <@ 1ost of goods sold H Inventory K D
N>EG"GGG H Inventory K D
Inventory K ND>":=G
Receivables H &1redit sales;>G) K 6D days
Receivables H &NE:G"GGG;>G) K 6D days
Receivables K N<>"GGG
0ote =@ otal assets K otal e$uity L otal liabilities
K N;;D"GGG L ND<"=GG
K N<::"=GG
1urrent assets K otal assets * 0oncurrent assets
K N<::"=GG * N:DG"GGG
K N6<:"=GG
1ash K N6<:"=GG * N<>"GGG * ND>":=G
K N6G":=G
0ote >@ ,cid*test ratioK &1ash L ,ccounts receivable) H 1urrent liabilities K :.=
1urrent liabilities K &N6G":=G L N<>"GGG)H:.= K N::"=GG
0oncurrent liabilities K otal liabilities * 1urrent liabilities
K ND<"=GG * N::"=GG K N>:"GGG

'roblem 6*> &<= minutes)
F(TT 1(2',05
Balance +heet
3ecember ;6" 5ear :
,++E+ /I,BI/IIE+ ,03 E8.I5
1urrent assets@ 1urrent liabilities....................... N6GG"GGG
1ash..................................... N ?="GGG 0oncurrent liabilities................ 6=G"GGG
,ccounts receivable........... ?="GGG otal liabilities........................... N:=G"GGG
Inventory.............................. =G"GGG
0oncurrent assets............... N;GG"GGG otal e$uity................................ N:=G"GGG
otal assets.......................... N=GG"GGG otal /iabilities and E$uity....... N=GG"GGG
0ote 6@ 1ompute net income for 5ear :
+ales...................................................................................... N6"GGG"GGG
1ost of goods sold .............................................................. =GG"GGG &=GO of sales)
Rross profit........................................................................... N =GG"GGG &=GO of sales)
E%penses............................................................................... <=G"GGG &given)
0et income............................................................................ N =G"GGG
0ote :@ Return on end*of*year e$uity K :GO
0et income H End*of*year e$uityK :GO
=G"GGG H E$uity K G.:G
E$uity K N:=G"GGG
0ote ;@ otal debt to total e$uity K 6
otal debt H N:=G"GGG K 6
otal debt K N:=G"GGG
0ote <@ ,ccounts receivable turnover K +ales H ,verage accounts receivable
Ending accounts receivable K N?="GGG
0ote =@ 3ays sales in inventory K &Inventory % ;>G) H 1ost of goods sold
;> K &Inventory % ;>G) H N=GG"GGG
Ending inventory K N=G"GGG

6> K
: H ) X L =G"GGG N &
6"GGG"GGG N
1-34
'roblem 6*>Icontinued
0ote >@ otal assets K otal liabilities L otal e$uity
K N:=G"GGG L N:=G"GGG
K N=GG"GGG
1urrent assets K otal assets * 0oncurrent assets
K N=GG"GGG * N;GG"GGG
K N:GG"GGG
1urrent ratio K 1urrent assets 1urrent liabilities
: K N:GG"GGG X
1urrent liabilities K N6GG"GGG
0oncurrent liabilitiesK otal liabilities * 1urrent liabilities
K N:=G"GGG * N6GG"GGG
K N6=G"GGG
0ote ?@ 1ash K 1urrent assets * ,ccounts receivable * Inventory
K N:GG"GGG * N?="GGG * N=G"GGG
K N?="GGG

'roblem 6*? &?G minutes)
a.
V(/E- 1(2',05
Balance +heet
3ecember ;6" 5ear >
Assets
1urrent ,ssets
1ash.................................................................... N;"EGG
,ccount receivable............................................ :">GG
Inventories.......................................................... 6"D:G
'repaid e%penses.............................................. 6"<;G
otal current assets........................................... N E"?=G
'lant and e$uipment" net..................................... >"GGG
otal assets........................................................... N6="?=G
/ia0ilities and Stoc'holders' E1uity
1urrent liabilities.................................................. N>"=GG
Bond payable........................................................ >"=GG
+tockholders e$uity............................................ :"?=G
otal liabilities and e$uity................................... N6="?=G
0ote 6@0et incomeH+ales K 6GO
N6";GG H X K 6GO
+ales K N6;"GGG
0ote :@Rross 2argin K +ales % Rross margin ratio
K N6;"GGG % ;GO
K N;"EGG
1ost of good soldK +ales * Rross margin
K N6;"GGG * N;"EGG
K NE"6GG
Inventory K 1ost of goods sold Inventory turnover
K NE"6GG =
K N6"D:G
0ote ;@,ccounts recble. K +ales ,ccounts receivable turnover
K N6;"GGG =
K N:">GG

1-3
'roblem 6*?Icontinued
0ote <@Working capital K +ales +ales to end*of*year #orking capital
K N6;"GGG <
K N;":=G
0ote@ 1urrent assets K 1urrent liabilities L Working capital
1urrent assets K 1urrent liabilities L N;":=G
1urrent liabilities K 1urrent assets * N;":=G
hen@ 1urrent ratio K 1urrent assets 1urrent liabilities
6.= K 1urrent assets &1urrent assets * N;":=G)
1urrent assets H6.= K &1urrent assets * N;":=G)
1urrent assets K 6.= % 1urrent assets * N<"D?=
G.= % 1urrent assetsK N<"D?=
1urrent assets K NE"?=G
,nd@ 1urrent liabilities K NE"?=G * N;":=G
K N>"=GG
0ote =@,cid*test ratio K 6.G
hen@ 1ash L ,ccounts receivable K 1urrent liabilities
1ash K N>"=GG * N:">GG K N;"EGG
0ote >@'repaid e%pensesK 1urrent assets * 1ash * ,ccounts recble. * Inventory
K NE"?=G * N;"EGG * N:">GG * N6"D:G
K N6"<;G
0ote ?@imes interest earned K &Income before ta% L Interest e%p.) H Interest e%p.
= K &N6";GG L Interest e%pense) H Interest e%pense
= &Interest e%pense) K N6";GG L Interest e%pense
< &Interest e%pense) K N6";GG
Interest e%pense K N;:=
'ar value of bonds payable K Interest e%pense H Interest rate on bonds
K N;:= H G.G=
K N>"=GG
0ote D@+hareholdersC e$uity K otal assets * 1urrent liabilities * Bonds payable
K N6="?=G * N>"=GG * N>"=GG K N:"?=G
0ote E@'ar value of preferred stock K 3ividend on preferred 3ividend rate
K N<G G.GD
K N=GG
0ote 6G@ E'+ K &0et income*'referred dividend) H 1ommon shares outstanding
N;.?= K &N6";GG * N<G) H 1ommon shares outstanding
N;.?= % 1ommon shares outstanding K N6":>G
1ommon shares outstanding K ;;>
'ar value of common stock K ;;> % N= K N6">DG

'roblem 6*?Icontinued
0ote 66@ Retained earnings K +tockholdersC e$uity *1ommon stock * 'referred stock
K N:"?=G * N6">DG * N=GG
K N=?G
b. 3ividends paid on common stock@
Retained earnings" 7an. 6" 5ear >................................. N ;=G
0et income for 5ear >.................................................... 6";GG N6">=G
3ividends paid on preferred......................................... <G
3ividends paid on common Y plug.............................. X
Retained earnings" 3ec. ;6" 5ear >............................... N =?G
3ividends paid on common stock K N6"G<G
'roblem 6*D &<= minutes)
Financial ratios for 1hico Electronics@
a. ,cid*test ratio@
&1ash L ,ccounts receivable) otal current liabilities
&N;:= L N;"=EE) N;"E<= K G.EE
Interpretation@ he most li$uid assets can ade$uately cover current liabilities
b. Return on assets@
P0et income L Interest e%pense &6*ta% rate)Q ,verage total assets
PN6":>= L N?D &6 * .<G)Q P&N<"?E: L ND"G=D) :Q K :G.<O
Interpretation@ Return on each dollar invested in assets &this return #ould
seem to be good to very good)
c. Return on common e$uity@
&0et income * 'referred dividends) ,verage common e$uity
PN6":>= * N<=Q P&N:"D>D * N=GG L N;"DG; * N<=G) :Q K <:.?O
Interpretation@ Return on each dollar invested by e$uity holders &this return
#ould seem to be e%cellent)
d. Earnings per share@
&0et income * 'referred dividends) ,verage common shares outstanding
PN6":>= * N<=Q P&==G L D:E) :Q K N6.??
Interpretation@ 0et income earned per each share o#ned &difficult to assess
this E'+ value in isolation)

1-38
'roblem 6*DIcontinued
e. Rross profit margin@
&0et sales * 1ost of goods sold) 0et sales
&N6:"G>= * ND"G<D) N6:"G>= K ;;.;O
Interpretation@ Rross profit for each dollar of net sales &difficult to assess this
value in isolation)
f. imes interest earned@
&0et income before ta% L Interest e%pense) Interest e%pense
&N:":=E L N?D) N?D K ;G times
Interpretation@ 2agnitude &multiple) that net income before ta% e%ceeds
interest e%pense Y a measure of safety" and a value of ;G is probably good to
very good
g. 3ays to sell inventory@
,verage inventory &1ost of goods sold ;>G)
P&N:"<:; L N6"<6=) :Q PND"G<D ;>GQ K D=.D days
Interpretation@ ime it #ould take to dispose of inventory &difficult to assess
the value in isolation)
h. /ong*term debt to e$uity@
&/ong*term debt L (ther liabilities) +hareholdersC e$uity
&N6?E L N6;6) N;"DG; K D.:O
Interpretation@ 'ercent contributed by long*term debt holders relative to e$uity
holders Y this is not a highly leveraged company in terms of long*term debt
i. otal debt to total e$uity@
otal liabilities otal liabilities and shareholdersC e$uity
N<":== &N;"DG; L N<":==) K G.=;
Interpretation@ otal nono#ner financing relative to o#ner financing
9. +ales to end*of*year #orking capital@
0et sales Working capital
N6:"G>= &N>";>G * N;"E<=) K =
Interpretation@ +ales as a multiple of #orking capital Y measure of efficiency
and safety

Instructor's Solutions Manual 1-3$
'roblem 6*E &== minutes)
5ear = 5ear <
,t 3ecember ;6@
1urrent ratio........................................................ :.;G 6.E=
,cid*test ratio .................................................... 6.G= G.DG
Book value per share.......................................... N6:.=G N6G.6D
5ear ended 3ecember ;6@
Rross profit margin ratio................................... ;=O ;GO
3ays to sell inventory......................................... D: D>
imes interest earned......................................... 6D.G 6:.=
'rice*to*earnings ratio....................................... 6?.= 6=.<
Rross e%penditures for plant 4 e$uipment..... N6"6G="GGG NE?="GGG
a. 1urrent ratio@
1urrent assets ....................................................... N6;"=?G"GGG N6:";:<"GGG
1urrent liabilities................................................... N ="EGG"GGG N >";:G"GGG
1urrent ratio ....................................................... :.; 6.E=
b. ,cid*test ratio@
1ash" marketable sec." accts. rec. &net)................. N>"6E="GGG N="G=>"GGG
1urrent liabilities................................................... N="EGG"GGG N>";:G"GGG
,cid*test ratio ....................................................... 6.G= G.DG
c. Book value per common share@
+tockholdersC e$uity............................................... N66"D?="GGG N6G"GEG"GGG
* 'referred stock at li$uidating value..................... ="GGG"GGG ="GGG"GGG
1ommon stockholdersC e$uity................................ N >"D?="GGG N ="GEG"GGG
E$uivalent shares outstanding at year end........ ==G"GGG =GG"GGG
Book value per common share.............................. N 6:.=G N 6G.6D
d. Rross profit margin ratio@
Rross margin &+ales * 1ost of sales)..................... N6>"E<G"GGG N6:"=6G"GGG
0et sales .............................................................. <D"<GG"GGG <6"?GG"GGG
Rross profit margin ratio......................................... ;=O ;GO
e. 3ays to sell inventory@
Inventories@
Beginning of year.................................................... N ?"G=G"GGG N >"D=G"GGG
End of year............................................................... ?":=G"GGG ?"G=G"GGG
N6<";GG"GGG N6;"EGG"GGG
&,) ,verage inventories &otal :).......................... ?"6=G"GGG >"E=G"GGG
&B) 1ost of sales & ;>G).......................................... D?";DE D6"GD;
3ays to sell inventory &, B).................................. D: D>

1-4%
'roblem 6*EIcontinued
f. imes interest earned@
Income before ta%es................................................ N <">?="GGG N ;"<=G"GGG
L Interest e%pense................................................... :?="GGG ;GG"GGG
<"E=G"GGG ;"?=G"GGG
Interest e%pense................................................... :?="GGG ;GG"GGG
imes interest earned.............................................. 6D 6:.=
g. 1ommon stock price*to*earnings ratio@
2arket value" at end of year................................... N ?;.= N <?.?=
Earnings per share............................................... <.: ;.6G
1ommon stock price*to*earnings ratio.................. 6?.= 6=.<
h. Rross e%penditures for plant and e$uipment@
'lant and e$uipment at cost@
End of year............................................................... N ::"?=G"GGG N::"G:G"GGG
Beginning of year.................................................... ::"G:G"GGG :6"<?G"GGG
?;G"GGG ==G"GGG
,dd disposals at cost.............................................. ;?="GGG <:="GGG
Rross e%penditures for '4E................................... N 6"6G="GGG N E?="GGG
,nalysis and interpretation@
/akelandCs financial statements reveal significant improvements across the
board. In terms of li$uidity" both the current and acid*test ratios increase" #hile
the days to sell inventory decreases by < days. he nearly =GO increase in
times interest earned indicates a more solid financial position. 'rofitability
improved as evidenced by the =O increase in gross profit margin. In addition" it
appears that /akeland is poised for additional earnings gro#th based on its
increasing capital e%penditures. he improved performance has not gone
unnoticed by the stock market as the price*to*earnings ratio rose from 6=.< to
6?.=. ,dditional analysis is needed before determining an appropriate price for
the proposed ac$uisition.

'roblem 6Y6G &:G minutes)
1ompany , is the merchandiser Y evidenced by@
/o# gross profit margin ratio
/o# net profit margin ratio
Jigh inventory turnover
Jigh accounts receivable turnover
Jigher advertising to sales ratio
1ompany B is the pharmaceutical Y evidenced by@
Jigh gross profit margin ratio
Jigh research and development costs to sales
+lightly higher advertising costs to sales
1ompany 1 is the utility Y evidenced by@
/o# advertising e%penses to sales
Jigh long*term debt to e$uity ratio
0onapplicable inventory turnover
Jigher interest e%pense to sales

1-42
'roblem 6*66 &:G minutes)
a. he li$uidity of the company appears reasonable. 1urrent assets are ;.<=
times current liabilities and even cash*like assets are fully :.=D times current
liabilities. he company is selling its inventory in reasonable time &6D days).
Jo#ever" the collection period for receivables is a bit slo# &<: days).
he capital structure and solvency of the company also appears reasonable.
/ong*term debt is only ;? percent of e$uity and total debt is >?O of total
e$uity. his debt total #ould seem to be on the high end of the acceptable
range. /ike#ise" the return on assets and e$uity are $uite good &;6O and
=;O" respectively). his is a positive sign for long*term solvency and for long*
term gro#th. 'rofit margins appear relatively strong as #ell.
he strong profit margins reflect healthy asset utili!ation. he company is
turning over its inventory ;G times per year and turning over receivables ?
times per year. he market measures reflect these relatively strong operating
results. he price to earnings ratio of :?.D reflects a strong stock market
valuation. he lack of dividends for this company is not surprising given the
gro#th rate that the company is achieving.
b. he li$uidity of the company is strong. he company has a current ratio that
is strong &;.<=) and slightly above industry average &;.6). he near cash
assets are also strong &acid*test ratio of :.=D versus 6.D=). he si!e of the
acid*test ratio coupled #ith the receivables collection period &<:.6E days
versus ;>.> days) raises a $uestion about the $uality of the receivables for
Best. hat relationship #arrants some additional investigation. 0evertheless"
Best appear to be ade$uately li$uid.
Best also appears strong in terms of solvency and capital structure. he
company appro%imates average industry levels of debt and interest coverage.
/ike#ise" the company is slightly above industry averages in terms of return
on assets and return on e$uity. his provides additional comfort about Bests
ability to remain solvent and to gro#.
he asset utili!ation ratios reflect reasonably healthy operations. he
company is turning over inventory slightly above the industry average and
utili!ing its fi%ed assets efficiently relative to industry norms. ,gain" the
accounts receivable turnover #arrants investigation. he company is turning
over receivables significantly slo#er than industry averages.
he market measures reflect a healthy market capitali!ation for the company.
he slightly lo#er pHe ratio for Best is interesting given the companys above
average performance. his could reflect the markets concern about Bests
ability to convert its sales into cash &i.e." accounts receivable collection).

'roblem 6*66Icontinued
c. he follo#ing ratios deviate from industry norms and #arrant some
investigation@ ,cid*test ratio" collection period" accounts receivable turnover"
#orking capital turnover. hese are all related to accounts receivable.
+pecifically" accounts receivable is higher than normal for the industry. (ne
possible e%planation is that the company offers looser collection terms than
the industry. ,nother possibility is that the company e%tends credit to less
credit#orthy customers. It could also be random variation but this is unlikely
given the magnitude of the difference.
,lso" the times interest earned ratio is interesting. While it is near industry
norms" it is lo# considering the follo#ing. (ne #ould e%pect this to be higher
than the industry average because the company has lo#er than average debt
and higher than average earnings. (ne possible e%planation for this
relationship is that the company paid do#n debt late in the year. hus" the
debt ratios look lo#er at year*end than they #ere most of the year. ,nother
possibility is that the company has higher priced debt than industry average.

1-44
'roblem 6*6: &;G minutes)
a.
:GG; :GG< :GG= :GG> :GG? erminal
Value
3ividend 6.GG 6.GG 6.GG 6.GG 6.GG ?.;G
3iscount factor &6.6)
6
&6.6)
:
&6.6)
;
&6.6)
<
&6.6)
=
&6.6)
=
'resent value .EGE6 .D:>< .?=6; .>D;G .>:GE <.=;:?
Value K ND.;:
b.
:GG: :GG; :GG< :GG= :GG> :GG?
0et income 6.<= 6.6G .>G .:= &.6G)
Book value E.GG E.<= E.== E.6= D.<G ?.;G
1apital charge &Beg.
book value % 6GO
cost of capital) .EG .E<= .E== .E6= .D<G
Residual income .== .6== &.;==) &.>>=) &.E<G)
3iscount factor 6.6 &6.6)
:
&6.6)
;
&6.6)
<
&6.6)
=
'resent value E .=G .6:D &.:>?) &.<=<) &.=D<)
Value at time t K +um of previous line K ND.;:
c.
:GG; :GG< :GG= :GG> :GG? Z erminal
Value
(perating cash flo#s :.GG 6.=G 6.GG .?= .=G Z ?.;G
1apital e%penditures * * 6.GG 6.GG *
Free cash flo#s :.GG 6.=G G &.:=) .=G
3iscount factor &6.6)
6
&6.6)
:
&6.6)
;
&6.6)
<
&6.6)
=
&6.6)
=
'resent value 6.D6D: 6.:;E? G &.6?GD) .;6G= <.=;:?
Value K N?.?;

1,+E+
1ase 6*6 &;= minutes)
0I-E REEB(-
a. Financing K
,mount
Invested
N=";E?.< N6"?=>.6
b. Return on
investment K N;EE.> N6;=.6
profitHaverage
amount
invested)
P&N=";E?.< L N=";>6.:)H:Q P&N6"?=>.6 L N6"?D>.:)H:Q
c. Revenues*
E%penses
NE"==;.6*E%pensesKN;EE.> N;">;?.<*E%pensesKN6;=.6
K0et income E%pensesKNE"6=;.= E%pensesKN;"=G:.;
d. ,nalysis of return on investment@ 0ikes ?.<O return is marginally
satisfactory given the moderate risk 0I-E confronts. +imilarly" Reeboks ?.>O
return is marginally acceptable. Both companies need to #ork on improving
their return on investment.
e. ,nalysis conclusionsI0ikes return is borderline acceptable but its market
share is high. Reeboks return is also borderline acceptable" and it needs
greater market share.

( 0)0#" ( 0)0#$
1-4
1ase 6*: &;= minutes)
a.
2ey "i(ures 0I-E Reebok
1ash and e$uivalents.....
:.GO N 6GD.> 66.EO N :GE.D
,ccounts receivable....... ;6.G 6">?<.< ;:.G =>6.?
Inventories....................... :=.E 6";E>.> ;:.6 =>;.?
Retained earnings........... =>.< ;"G<;.< >=.: 6"6<=.;
1osts of sales.................. >;.= >"G>=.= >;.G :":E<.G
Income ta%es.................... :.> :=;.< G.; 6:.=
Revenues &0I-E).............
0et sales &Reebok)..........
6GG.G
I
E"==;.6
I
I
6GG.G
I
;"><;.>
otal assets...................... 6GG.G =";E?.< 6GG.G 6"?=>.6
b. 0I-E incurred income ta%es at :.>O of revenues #hile Reebok incurred
income ta%es at G.;O of its net sales.
c. Reeboks retained earnings comprises a greater percent of its assets &>=.:O)
as compared to 0I-E &=>.<O).
d. +ince 0ikes costs of sales percent is slightly higher at >;.=O compared to
Reeboks >;.GO" 0I-E has a lo#er gross margin ratio on sales &;>.=O).
e. Reebok has a higher percent of total assets in the form of inventory at ;:.6O"
compared to 0ikes :=.EO.

1ase 6*; &>G minutes)
-art a
*atatech +om!any Si(ma +om!any
1urrent ratio@ K :.= to 6 K :.= to 6
,cid*test ratio@ K 6.G to 6 K 6.G to 6
,ccounts receivable turnover@
K 6D.G times K 6;.= times
2erchandise turnover@
K ?.G times K <.= times
3ays sales in inventory@
% ;>G K >: days % ;>G K DE days
3aysC sales in receivables@
% ;>G K :< days % ;>G K :E days
+hort*term credit risk analysis@ 3atatech and +igma have e$ual current ratios
and e$ual acid*test ratios. Jo#ever" 3atatech both turns its merchandise and
collects its accounts receivable more rapidly than does +igma. (n this basis"
3atatech probably is the better short*term credit risk.

$""0,000
%$3",$00 + $8,100 +
$8,800&'
$$85,100
%$83,$$0 + $5$,"00&'
$83,$$0
$$85,100
$3",$00 +
$8,100
$""0,000
$#80,00
%$5",$00 + $",00 + $53,00&'
$150,$$0
$"0,3$0
$"3,000
$"0,3$0
$33,050
$!,300
$!5,"00
$!,300
$53,500
%$131,500 +
$10",$00&'
$131,500
$53,500
$5",$00 +
$",00
$#80,00
1-48
1ase 6*;Icontinued
-art 0
*atatech +om!any Si(ma +om!any
0et profit margin@
K 6G.;O K 6;.=O
otal asset turnover@
K 6.> times K 6.? times
Return on total assets@
K 6>.=O K :;.6O
Return on common stockholdersC e$uity@
K :<.GO K ;:.DO
'rice*earnings ratio@
K 6:.E K E.D
3ividend yield@
K >.GO K >.GO
Investment analysis@ +igmaCs profit margin" total asset turnover" return on total
assets" and return on common stockholdersC e$uity are all higher than
3atatechCs. ,lthough the companies pay the same dividend" +igmaCs price*
earnings ratio is lo#er. ,ll of these factors suggest that +igmaCs stock is likely
the better investment.

$"#,##0
$""0,000
$""0,000
%$$3$,$$0 +
$388,000&'
$"#,##0
%$$3$,$$0 +
$388,000&'
$"#,##0
%$!$,300 +
$"!,300&'
$5
$1)!$
$1)50
$5
$105,000
$#80,00
$#80,00
%$53",$50 + $3#,500&'
$105,000
%$53",$50 + $3#,500&'
$105,000
%$3$$,150 +
$!5,"00&'
$5
$)5"
$1)50
$5
1-4$
1ase 6*< &;= minutes)
a. 0o. ,lthough the current ratio improved over the three*year period" the acid*
test ratio declined and accounts receivable and merchandise inventory turned
more slo#ly. hese conditions indicate that an increasing portion of the
current assets consisted of accounts receivable and inventories from #hich
current debts could not be paid.
b. 0o. he decreasing turnover of accounts receivable indicates the company is
collecting its debt more slo#ly.
c. 0o. +ales are increasing and accounts receivable are turning more slo#ly.
Either of these trends #ould produce an increase in accounts receivable" even
if the other remained unchanged.
d. 'robably yes. +ince there is nothing to indicate the contrary" cost of goods
sold is probably increasing in proportion to sales. 1onse$uently" #ith sales
increasing" cost of goods sold increasing in proportion" and merchandise
turning more slo#ly" the amount of merchandise in the inventory must be
increasing.
e. 5es. o illustrate" if sales are assumed to e$ual N6GG in :GG6" the sales trend
sho#s that they #ould e$ual N6:= in :GG: and N6;? in :GG;. hen" dividing
each sales figure by its ratio of sales to plant assets #ould give N;;.;; for
plant assets in :GG6 &N6GGH;.G)" N;?.DD in :GG: &N6:=H;.;) and N;E.6< in :GG;
&N6;?H;.=).
f. 0o. he percent of return on o#ners e$uity declines from 6:.:=O in :GG6 to
E.?=O in :GG;.
g. he ratio of sales to plant assets increased from ;.G in :GG6 to ;.= in :GG;.
Jo#ever" the return on total assets declined from 6G.6O in :GG6 to D.DO in
:GG;. Whether these results are derived from a more efficient use of assets
depends on a comparison #ith other companies and on the e%pectations of
the individual doing the evaluation.
h. he dollar amount of selling e%penses increased in :GG: and decreased
sharply in :GG;. ,gain assuming sales figures of N6GG in :GG6" N6:= in :GG:"
and N6;? in :GG;" and multiplying each by its selling e%pense to net sales ratio
gives N6=.;G of selling e%penses in :GG6" N6?.6; in :GG:" and N6;.<; in :GG;.

1-5%
1ase 6*= &?= minutes)
a.
+elected financial analysis ratios 5ear 66 5ear 6G
/i$uidity Ratios@
1urrent ratio &,)................................................................ 6.;> 6.;G
,cid*test ratio &B).............................................................. G.?D G.=?
1ollection period &1)........................................................ << <;
3ays to sell inventory &3)................................................. =? ><
1apital +tructure 4 +olvency Ratios@
otal debt to total e$uity &E)............................................ G.?G G.>E
/ong*term debt to e$uity &F)........................................... 6.;6 6.6=
imes interest earned &R)................................................ <.E= <.GE
Return on Investment Ratios@
Return on total assets &J)................................................ D.>O ?.?O
Return on common e$uity &I)........................................... :6.GO 6=.:O
(perating 'erformance Ratios@
Rross profit margin ratio &7)............................................ <D.;O <>.>O
(perating profit margin ratio &-).................................... E.;O 6G.GO
'reta% profit margin ratio &/)........................................... ?.=O ?.>O
0et profit margin ratio &2)............................................... ;.?O ;.<O
,sset*.tili!ation Ratios@
1ash turnover &0).............................................................. 6D6.D; :D<.:6
,ccounts receivable turnover &()................................... ?.E= ?.EE
+ales to inventories &').................................................... 6;.G 6G.>:
Working capital turnover &8)........................................... 6>.=D 6<.>D
Fi%ed assets turnover &R)................................................ <.<= <.;>
otal assets turnover &+).................................................. 6.D: 6.=6
2arket 2easures@
'rice*to*earnings ratio &)............................................... 6E.D :>.;
Earnings yield &.)............................................................. =.GO ;.DO
3ividend yield &V).............................................................. ;.GO :.=O
3ividend payout Rate &W)................................................ =D.DO >=.6O
'rice*to*book ratio &T)...................................................... <.<= <.:G

1ase 6*=Icontinued
b. 1omments and interpretation@
Both the current ratio and acid*test ratio increased due to larger cash and
receivables relative to current liabilities. ,lso" accounts payable and
inventories both decreased #hile receivables increased. While the collection
period for receivables #as about the same" a complete analysis re$uires that
#e look at the terms of receivables and make industry comparisons. he sales
to inventory ratio sho#ed an improvement" changing from 6G.> to 6;.G. he
total debt to total e$uity ratio #as essentially unchanged" but long*term debt
to e$uity ratio increased by more than 6GO. In addition" the times interest
earned ratio increased from <.GE to <.E=.
8uaker (atsC return on investment ratios sho# significant improvements in
5ear 66. his is primarily due to the rise in net income relative to sales along
#ith reduced interest e%pense. ,mong the operating performance ratios" the
gross profit margin ratio increased due to larger sales relative to cost of sales.
Because of the 6=O increase in selling" general and administrative e%penses"
both the operating profit margin and preta% profit margin ratios slightly
declined. In addition" the net profit margin ratio managed to increase from
;.<O to ;.?O due to a reduction in loss from discontinued operations.
he price*to*earnings ratio dropped in 5ear 66 due to higher earnings per
share and a lo#er average stock price. With higher dividends per share in 5ear
66" dividend yield sho#ed a slight increase. 2oreover" the dividend payout
rate decreased because of higher net income and a proportionally lo#er
dividend increase.
,. 1urrent ratio K 1urrent assets 1urrent liabilities
5ear 6G 5ear 66
N6"<D6.; N6"6;D.= N6":=D.6 P>:Q NE:>.E P?DQ
K 6.;G K 6.;>
B. ,cid*test ratio K &1ash L 1ash e$uiv. L ,cct. recble.) 1urrent liabilities
5ear 6G 5ear 66
&N6?.? L N>:E.E) N6"6;D.= &N;G.: P=;Q L N>E6.6 P==Q) NE:>.E P?DQ
K G.=? K G.?D
1. 1ollection period K ,verage accounts receivable &+ales ;>G)
5ear 6G 5ear 66
P&N=E<.<LN>:E.E)H:Q &N="G;G.>H;>G) P&N>:E.ELN>E6.6)H: P==QQ &N="<E6.: P6QH;>G)
K << K <;
1ase 6*=Icontinued

1-52
3. 3ays to sell inventory K ,verage inventory &1ost of goods sold ;>G)
5ear 6G 5ear 66
P&N<?E.6LN<?;.E)H:Q &N:">D=.EH;>G) P&N<?;.ELN<::.;P=EQ)H:Q &N:"D;E.?H;>G) P:Q
K >< K =?
E. otal debt to e$uity K &1urrent liab L /ong*term liab.) otal liab. and e$uity
5ear 6G 5ear 66
&N6"6;D.=LN6"6>D.;) $;";:>.6 &NE:>.EP?DQLN6"6D;.<P?ELDGLD6Q)
$;"G6>.6PE:Q
KG.>E K G.?G
F. /ong*term debt to e$uity K /ong*term debt E$uity
5ear 6G 5ear 66
N?<G.; L N6GG.; L N;:?.? N?G6.:P?EQLN66=.=PDGQLN;>>.?PD6Q
N6GG * NED.: LN6"G6?.= N6GGPD:Q*NE<.=PD;Q*NG.?PD<QLNEG6PE6Q
K N6"6>D.; H N6"G6E.; K N6"6D;.< H NEG=.D
K 6.6= K 6.;6
R. imes interest earned
a
K Income before interest and ta%es Interest e%pense
5ear 6G 5ear 66
N;D:.< L N6:G.: N<66.= P?Q L N6G6.E P6=>Q
N6:G.: L N:.D N6G6.E P6=>Q L N6.E P6=>Q
K <.GE K <.E=
J. Return on assets K 0et income L Interest e%pense &6 * a% rate)
b
,verage
assets
5ear 6G 5ear 66
N6>E L N6:G.: &6 * .;<) N:G=.D P66Q L N6G6.E P6=>Q &6 * .;<)
&N;"6:=.E L N;";:>.6)H: &N;";:>.6 P>EQ L N;"G6>.6 P>EQ)H:
K .G?? K .GD>
I. Return on common e$uity K 0I * 'referred dividend ,verage common e$uity
5ear 6G 5ear 66
N6>E * N<.= N:G=.D P66Q * N<.; P6:Q
&N6"6;?.6 L N6"G6?.=)H: &N6"G6?.= PE6Q L NEG6 PE6Q)H:
K N6><.= H N6"G??.; K N:G6.= H NE=E.:=
K G.6= K G.:6
7. Rross profit margin ratio K Rross profit H +ales
5ear 6G 5ear 66
N:";<<.? N:">=6.= P6 * :Q
N="G;G.> N="<E6.: P6Q
K G.<? K G.<D

1ase 6*=Icontinued
-. (perating profit margin K &Income before interest and ta%es) +ales
5ear 6G 5ear 66
N;D:.< L N6:G.: N<66.= P?Q L N6G6.E P6=>Q
N="G;G.> N="<E6.: P6Q
K G.GEEE K G.GE;<
/. 'reta% profit margin ratio K 'reta% income H +ales
5ear 6G 5ear 66
N;D:.< N<66.= P?Q
N="G;G.> N="<E6.: P6Q
K G.G?> K G.G?=
2. 0et profit margin ratio K 0et income H +ales
5ear 6G 5ear 66
N6>E N:G=.D P66Q
N="G;G.> N="<E6.: P6Q
K G.G;< KG.G;?
0. 1ash turnover K +ales H 1ash and cash e$uivalents
V
5ear 6G 5ear 66
N="G;G.> N="<E6.: P6Q
N6?.? N;G.: P=;Q
K :D<.:6 K 6D6.D;
(. ,ccounts receivable turnover K +ales H ,ccounts receivable
V
5ear 6G 5ear 66
N="G;G.> N="<E6.: P6Q
N>:E.E N>E6.6 P==Q
K ?.EE K ?.E=
'. +ales to inventories K +ales H Inventories
V
5ear 6G 5ear 66
N="G;G.> N="<E6.: P6Q
N<?;.E N<::.; P=EQ
K 6G.>: K 6;.G
8. Working capital turnover K +ales H Working capital
V
5ear 6G 5ear 66
N="G;G.> N="<E6.: P6Q
N6"<D6.; * N6"6;D.= N6":=D.6 P>:Q * NE:>.E P?DQ
K 6<.>D K 6>.=D

1-54
1ase 6*=Icontinued
R. Fi%ed assets turnover K +ales H Fi%ed assets
V
5ear 6G 5ear 66
N="G;G.> N="<E6.: P6Q
N6"6=<.6 N6":;:.? P>>Q
K <.;> K <.<=
+. otal assets turnover K +ales H otal assets
V
5ear 6G 5ear 66
N="G;G.> N="<E6.: P6Q
N;";:>.6 N;"G6>.6 P>EQ
K 6.=6 K 6.D:
. 'rice*to*earnings ratio K 2arket price H Earnings per share
5ear 6G 5ear 66
N=>.= N=:.= P6;?Q
c
N:.6= N:.>= P6>Q
K :>.; K 6E.D
.. Earnings yield K Earnings per share H 2arket price per share
5ear 6G 5ear 66
N:.6= N:.>= P6>Q
N=>.= N=:.= P6;?Q
c

K ;.DO K =.GO
V. 3ividend yield K 3ividends per share H 2arket price per share
5ear 6G 5ear 66
N6.<G N6.=> P6?Q
N=>.= N=:.= P6;?Q
c

K :.<?O K :.E?O
W. 3ividend payout rate K 3ividends per share H Earnings per share
5ear 6G 5ear 66
N6.<G N6.=> P6?Q
N:.6= N:.>= P6>Q
K .>= K .=E
T. 'rice*to*book ratio K 2arket price per share H Book value per share
5ear 6G 5ear 66
N=>.= N=:.=
N6;.<> N66.DG P6;GQ
K <.:G K <.<=
a
+implified version
b
.sing marginal corporate ta% rate P6=DQ
c
,verage market price P6;?Q
*
'er instructions" end*of*year values are used

1ase 6*> &:= minutes)
, company pursues four ma9or business activities in a desire to provide a
saleable product andHor service" and #ith the goal to yield a satisfactory return
on investment.
'lanning activities. , company e%ists to implement specific goals and ob9ectives.
, companyCs goals and ob9ectives are captured in a business plan" describing the
companyCs purpose" its strategy" and its tactics for activities. , business plan
assists managers in focusing their efforts and identifying e%pected opportunities
and obstacles.
Financing ,ctivities. , company re$uires financing to carry out its business plan.
Financing activities are the means companies use to pay for these ventures.
Because of their magnitude" and their potential to determine success or failure of
a venture" companies take care in ac$uiring and managing their financial
resources. here are t#o main sources of business financing@ e$uity investors
&sometimes referred to as o#ners or shareholders) and creditors.
Investing ,ctivities. Investing activities are the means a company uses to ac$uire
and maintain investments for obtaining" developing" and selling products or
services. Financing provides the funds necessary for ac$uisition of investments
needed to carry out business plans. Investments include land" buildings"
e$uipment" legal rights &patents" licenses" and copyrights)" inventories" human
capital &managers and employees)" accounting systems" and all components
necessary for the company to operate.
(perating ,ctivities. (perating activities represent the Mcarrying outM of the
business plan" given necessary financing and investing. hese activities usually
involve at least five basic components**research" purchasing" production"
marketing" and labor. (perating activities are a companyCs primary source of
income. Income measures a companyCs success in buying from input markets
and selling in output markets. Jo# #ell a company does in devising business
plans and strategies" and #ith decisions on materials comprising the mi% of
operating activities" determines business success or failure.

1-5
1ase 6*? &<= minutes)
a.
3ividend discount model@
GO@ Vt K P&.=GH6.6) L &.=GH6.6
:
) L &.>GH6.6
;
) L &.>GH6.6
<
) L &.?GH6.6
=
) L &&.?GH.6)H 6.6
>
)Q K N>.66
<O@ Vt K P&.=GH6.6) L &.=GH6.6
:
) L &.>GH6.6
;
) L &.>GH6.6
<
) L &.?GH6.6
=
) L &&&.?G % 6.G<)H&.6*.G<))H 6.6
>
)Q K NE.G6
?O@ Vt K P&.=GH6.6) L &.=GH6.6
:
) L &.>GH6.6
;
) L &.>GH6.6
<
) L &.?GH6.6
=
) L &&&.?G % 6.G?)H&.6*.G?))H 6.6
>
)Q K
N6>.:>
Free cash flo# model@
GO@ Vt K P&.=GH6.6) L &.?=H6.6
:
) * &.6GH6.6
;
) L &.>=H6.6
<
) L &.;GH6.6
=
) L &&.;GH.6)H 6.6
>
)Q K N;.;:
<O@ Vt K P&.=GH6.6) L &.?=H6.6
:
) * &.6GH6.6
;
) L &.>=H6.6
<
) L &.;GH6.6
=
) L &&&.;G % 6.G<)H&.6*.G<))H 6.6
>
)Q K N<.=>
?O@ Vt K P&.=GH6.6) L &.?=H6.6
:
) * &.6GH6.6
;
) L &.>=H6.6
<
) L &.;GH6.6
=
) L &&&.;G % 6.G?)H&.6*.G?))H 6.6
>
)Q K N?.>?
Residual income model@
GO@ Vt K66 L &.;=H6.6) L &.:==H6.6
:
) L &.:6H6.6
;
) L &.E:H6.6
<
) L &6.G=H6.6
=
) L &&6.G=H.6)H 6.6
>
) K N6D.DE
<O@ Vt K66 L &.;=H6.6) L&.:==H6.6
:
) L &.:6H6.6
;
) L&.E:H6.6
<
) L &6.G=H6.6
=
) L &&&6.G=%6.G<)H&.6*.G<))H 6.6
>
) K
N:;.:<
?O@ Vt K66 L &.;=H6.6) L&.:==H6.6
:
) L &.:6H6.6
;
) L&.E:H6.6
<
) L &6.G=H6.6
=
) L &&&6.G=%6.G?)H&.6*.G?))H 6.6
>
) K
N;<.66
b. he current stock price appears to reflect an earnings gro#th rate of at least <O in
perpetuity. , <O or higher gro#th rate is difficult to maintain. +imilarly" the forecasts
for both free cash flo#s and dividend do not 9ustify the current stock price.
,ccordingly" one might recommend a sale of this stock from your portfolio.
c. +upport for the residual income model is aided by its ability to directly factor in
current book value and the earnings gro#th potentialIboth readily assessable data.
Each of these data is arguable more predictable than either future cash flo#s or
dividendsIthe latter t#o variables must be estimated to use the other valuation
models.

1ase 6*D &:= minutes)
a. he 1E( appears to have selectively chosen from the 66 available ratios to
present only the ones that sho# trends that are favorable to the company.
&Jo#ever" some analysts may not interpret a decline in selling e%penses as a
percent of revenue as positive since it might imply a scaling back on
advertising campaigns.) he 1E(s motivation might be to make her andHor
the companys performance appear better than it is in the eyes of the analysts.
b. he conse$uences of this action by the 1E( might be mi%ed. It is likely that
the analysts #ill ask other $uestions that may reveal some negative trends
such as the trends in return and profit margins. he 1E(s actions may
become transparent to the analysts as they discover the presence of less
favorable trends through their $uestions. If discovered" such a disclosure
ploy by the 1E( #ill not reflect favorably on the company. Both the 1E( and
the company are likely to suffer losses in reputation and credibility.
Even if the 1E( is able to succeed #ith this strategy in the short term" once
the financial statements are issued all users can compile additional ratio
information and see that some of the trends are unfavorable to the company.
his is likely to damage the credibility of the 1E(.

1-58

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