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You are permitted to have one page of 8.5 X 11 paper with writing on both sides and a
calculator that does not store text.
The exam has 6 pages (including the cover page), 4 questions, and a total of 100 marks.
Make any necessary assumptions and state your assumptions in your answer.
All questions must be answered in the exam answer books distributed during the exam. Extra
booklets will be provided upon request. Work handed in on the question sheet or materials
not distributed during the exam will NOT be graded.
You must hand in the question sheet and the answer booklet(s) at the end of the examination.
Please place the question sheet and the one page notes (cheat sheet) within your answer
booklet(s).
Good Luck!!!
1
Items
Current Assets*1
Non-Current Assets
Current Liabilities *2
Non-Current liabilities *3
2015
($ millions)
400
1,200
230
1,000
*1
*2
Pistachios sales revenue and net income for 2015 were $1,600 million and $40 million
respectively. It incurred an interest expense of $120 million in 2015.
You are to ignore any taxation effects in your calculations.
Required
(a)
Decompose Pistachios ROE using the Advanced Dupont Model (also known as the
alternative approach). You are to base your calculation on year-end equity instead of
average equity or beginning equity.
(15 marks)
Question 1 (continued)
(b)
Almond
Net
Operating
Margin
(NOM)
Net
Operating
Asset
Turnover
(NOAT)
Spread = Return on
Net Operating Asset
(RNOA) less Net
Borrowing Cost
(NBC)
7%
2.5
2%
Leverage =
Net Financial
Obligation
(NFO)
Common
Equity
1.25
ROE
20%
Compare Pistachios performance to that of Almond Ltd. What would you recommend to
Pistachio in order to improve its ROE?
(10 marks)
(c) Allen an independent financial consultant has done some research and found that Almond
Ltd has an excellent credit rating. He concluded that Almonds incremental borrowing cost
will still be below its return on net operating asset (RNOA) even if the company were to
increase its financial leverage. As a result, he commented that Almond could have performed
even better if it had increased its leverage. To what extent do you agree with Allens
comment? Explain your answers.
(5 marks)
2016
2017
2018
2019
2020
Net income.
$14,000
$13,650
$12,865
$12,501
$13,002
Dividends
$6,000
$7,500
$8,000
$11,500
$11,822
For 2021 and beyond, the residual income (also known as abnormal earnings) is predicted to
approximate Year 2020 level forever.
Required
(a)
Calculate Callmenow Companys residual income for each of the years from Year 2016
to Year 2020. Use the residual income model to estimate the value of Callmenows
equity. Callmenow has 10,000 shares outstanding and the current market price is $14 per
share. Will you recommend investing in the firm?
(15 marks)
(b)
You wonder why your intrinsic value estimated from (a) deviates from the current market
price. You call up the CEO of Callmenow and he agrees with all your forecasts except
the terminal growth rate estimate. He believes that the residual income will grow at the
rate of 5% per year from the year 2020 level for year 2021 and beyond, as a result of the
firms successful R&D program. Whats your new estimate of the firms equity value?
(5 marks)
Your colleague, Pete, does not like the residual income model. He believes that you
should use the price multiple approach instead. What are the pros and cons of the price
multiple approach?
(5 marks)
(c)
(d)
The CEO of Callmenow tells you that the firm is planning to use more environmentally
friendly materials to make the mobile phones. Since this change will increase the
manufacturing costs, he is concerned that the firms intrinsic value will decrease as a
result. Please provide two reasons why this change may not necessarily reduce the firms
intrinsic value.
(5 marks)
Required
As part of the accounting analysis process, you decide that Divas accounting treatment to
expense its research and development costs does not meaningfully reflect the companys
underlying business economics. You estimate that 40% of Divas research and development
costs in each year should be capitalized and amortized on a straight-line basis, from the
beginning of the following year over a three-year period.
Compute the effect of capitalizing the research and development costs on Divas income
statements and balance sheets for the financial years 2014 and 2015. Ignore any potential tax
effects.
(20 marks)
- EndofExam
6
Question 1
(a)
Net income = 40
NOI = 40 + 120 = 160
NOA = 400 + 1200 230 = 1370
RNOA = 160/1370 = 11.679%
(5 Marks)
OR
NOM = 160 1600 = 10 %
NOAT = 1600 1370 = 1.1679
Return on NOA (RNOA) = NOM NOAT = 10% 1.1679 = 11.679%
NFO = 1000
NBC = 120 1000 = 12%
Spread = RNOA NBC = 11.679% 12% = 0.321%
(5 Marks)
(3 Marks)
(d)
Almond
Pistachio
NOM
NOAT
RNOA
Spread
Leverage
ROE
7%
10%
2.5
1.1679
17.5%
11.679%
2%
0.321%
1.25
2.703
20%
10.811%
Pistachios ROE is lower than that of Almonds for two main reasons:
(i)
(ii)
Pistachio may need to consider lowering its products selling prices. This is because the
industry is very competitive and most competitors are employing the cost leadership
strategy.GiventhatAlmondsproductsareclosesubstitutes,itisunlikelythatPistachiocan
command a premium on its products and earn a high NOM without adverse effect on its
sales. This is probably the main cause of its low NOAT. Lower prices will reduce NOM but
willincreaseNOAT.ThismayleadtohigherRNOAoverall.
(4Marks)
Pistachioshouldloweritsfinancialleverage.Itshighleverageleadtohighborrowingcost,
causingthespreadtobenegative.Loweringleveragewillbringdownitsnetborrowingcost,
thusincreasingitsspreadandROE.Somesuggestionsforloweringleverage:obtainhigher
equity,assetsales,andreducingworkingcapital.
(4Marks)
(e)
No. It is not necessarily beneficial for Almond to increase its leverage even if RNOA is
greater than its incremental borrowing cost.
(2 Marks)
While ROE will increase with higher leverage when RNOA > incremental borrowing
cost, the higher financial risk will increase Almonds required return on equity ke. If ke
increases more than increase in ROE, Almonds residual income will decrease and hence
adversely affect its stock price.
(3 Marks)
Question 2
a)
Residual
income
2016
2017
2018
2018
2019
$8,000
$6,850
$5,450
$4,600
$5,000
(10 marks)
(4 marks)
Given that the stock price of $14 is higher than the intrinsic value per share (i.e., $11.43), you
should recommend against investing in the firm.
(1 mark)
b)
(5 marks)
c)
2012
90,000
2013
2014
2015
105,000 120,000 135,000
54,000
63,000
72,000
81,000
36,000
42,000
48,000
54,000
(4 marks)
12,000
12,000
14,000
12,000
14,000
16,000
26,000
42,000
Amortization expense:
2012 R&D costs
2013 R&D costs
2014 R&D costs
(4 marks)
Capitalized R&D costs, net:
Unamortized balance of 2012 costs
Unamortized balance of 2013 costs
Unamortized balance of 2014 costs
Unamortized balance of 2015 costs
12,000
28,000
48,000
0
14,000
32,000
54,000
Total
88,000
100,000
(4 marks)
10
9,628.27
16,891.62
15,290.46
13,750.84
12,198.20
11,007.75
10,007.40
88,774.54 (7 Marks)
(3 Marks)
(b) For the year ended December 31, 2012, the impact on income would be as follows:
Rental expense reduced by $10,591
Depreciation expense increased by $88,775/7= $12,682
Interest expense increased by $88775 x 0.1 = $8,878
Hence in total, expense will go up by $10,969 and pre-tax income will go down by $10,969
(6 Marks)
(c)
Reporting lease liability may increase leverage and hence leading to debt covenant
violation. Hence, there exists strong incentive for the firm to engage in off-balance sheet
financing by choosing operating lease rather than capital lease.
In this case, Capital lease will lower some profitability ratio such as ROA (earnings
decrease and assets increase). To the extent that bonuses are tied to ROA (or some other
profitability ratios), managers have incentives to choose operating lease rather than
capital lease.
Large firm is likely to attract public attention. By not recognizing capitalized assets
through operating leases, firms are not likely to attract public attention due to its smaller
asset size.
(4 Marks)
11