International Financial Statement Analysis Midterm Exam 11 November, 2008

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1 Name Student ID Number International Financial Statement Analysis Midterm Exam 11 November, 2008 Instructions: You have 2.5 hours to complete the exam Please show all your calculations Please write clearly and in English so I can read your answers This is an open book exam Do not look at other people s exams or attempt to obtain any information from other people If you have a question, please come to the front of the room to ask. However I may not answer the question. After all, this is an exam Make sure your exam has 14 multiple choice questions and 7 essays/problems o The multiple choice questions are worth 3 points each For those multiple choice questions requiring calculations, you must show those calculations to receive points. Partial credit will be awarded on those multiple choice questions requiring calculations o The essays/problems are worth 11 points each Only do 5 of the 7 essay/problems. You choose which 5 you do. Show all your work. Write clearly so I can read what you wrote. Partial credit is available on all essay questions. o The math wizards will note that equals 97 points. I am giving everyone 3 points for showing up. Yes, I am way too nice! Good Luck!

2 Multiple Choice Questions Choose the best answer. Also if calculations are required, please show your work. Some partial credit may be awarded but only if I can understand how you arrived at your solution. BE SURE IT IS CLEAR WHAT YOUR ANSWER IS (A, B, C, OR D)!! 1. If a company that leases equipment from another company records these leases as operating leases rather than a capital leases, its: (I) recorded liabilities will be lower (II) recorded assets will be higher (III) total cash flows will be higher (IV) leverage ratios will be higher A. I and III B. II and IV C. I only The answer is C D. II, III and IV 2. Hert Corporation acquired a capital lease that is carried on its books at a present value of $100,000 (discounted at 12%). Its annual rental payment of $15,000. What is the amount of interest expense from this lease? A. A above B. B above C. C above D. D above The answer is B: First Year: 100,000 x 12% = $12,000 so $3,000 reduces principal; Second Year: $97,000 x 12% = $11,640 in interest

3 3. If a company engages in off-balance sheet financing generally the effect is: (I) to cause assets to be understated (II) to increase leverage ratios (III) to increase cash flows (IV) to cause liabilities to be understated A. I, II, III and IV B. I, III and IV C. I and IV D. IV only The answer is C as you get both assets and liabilities off the books 4. A company's current ratio is 1.5. If the company uses cash to retire notes payable due within one year, would this transaction increase or decrease the current ratio and return on assets ratio? A. Current Ratio: Increase; Return on Assets: Increase B. Current Ratio: Increase; Return on Assets: Decrease C. Current Ratio: Decrease; Return on Assets: Increase D. Current Ratio: Decrease; Return on Assets: Decrease The answer is A. Just do a numeric example. Current Ratio = 150/100 = 1.5. Pay off 10 in current liabilities, now it is 140/90 = 1.55

4 Use the following information to answer questions 5 and 6 The following information can be found in Manufacturer Company's financial statements. 5. If Manufacturer used FIFO its retained earnings as of the end of fiscal 2005 would be: A. $ 540,000 B. $ 440,000 C. $ 524,000 D. $ 506,000 The answer is C: $500,000 + ($40,000 x 60%) 6. If Manufacturer used FIFO its Net Income for fiscal 2005 would be: A. $ 165,000 B. $ 149,000 C. $ 135,000 D. $ 131,000 The answer is D: $125,000 + (($40,000 - $30,000)x 60%

5 Use the following information to answer questions 7 to 10 Parent Company Inc. successfully bids for Child Company Inc. in year X1. Parent Company Inc. has purchased all of Child's shares outstanding for $8,500. Following are excerpts from both companies' financial statements for year X1, prior to the acquisition. Also assume the following information: the acquisition was accounted for using the purchase method. $1,500 of the excess price relates to depreciable assets, and those assets have an additional useful life of 10 years at the time of the acquisition. Parent Company Inc. uses the straight line depreciation method and has a 34% tax rate. The combined net income for both companies for year X2 (excluding any expenses that need to be recorded as a result of the purchase method accounting for the merger) was $1, What would be total liabilities in the consolidated financial statements for the date in which the merger became effective, assuming any excess purchase price relates to goodwill? A. $28,221 B. $27,231 C. $27,741 D. $25,462 The answer is B: $23,467 + $3, What would be total assets in the consolidated financial statements for the date in which the merger became effective, assuming any excess purchase price relates to goodwill? A. $50,008 B. $49,498 C. $41,508 D. $44,113 The answer is B: $37,234 + $5,379 +($8,500 - $1,615) 9. What would be net income in the consolidated income statement for year X2? A. $1,461 B. $1,560 C. $1,450 D. $1,611 The answer is A: $1,560 (($1,500 / 10) x 66%)

6 10. What would be net income in the consolidated income statement for year X2 assuming any excess purchase price relates to goodwill, and goodwill was found to be impaired by $830? A. $1,461 B. $1,560 C. $1,012.2 D. $730 The answer is C: $1,560 ($830 x 66%)

7 Brierton Company enters a contract at the beginning of year 1 to build a new federal courthouse for a price of $16 million. Brierton estimates that total cost of the project will be $12 million, and will take four years to complete. 11. If Brierton used percentage-of-completion method to account for this project, what would they have reported as profit in year 2? A. $ 0 B. $ 1.333M C. $ 1.5M D. $ 0.667M The answer is B: (4/12) x ($16 million - $12 million) where they incurred $4 million of the total $12 million in costs in Year 2

8 Use the following information to answer questions 12 to 14 The following information was extracted from Smurm Corporation's 2005 annual report: 12. Basic earnings per share for 2005 was: A. $3.50 Pref Stock Div = 50 million shares x $10 par x 10% = $50 million B. $3.16 # of shares = 90 million + (10 million x 9/12 of the year) = 97.5 million C. $3.08 D. $3.00 The answer is C: ($350 million - $50 million) / 97.5 million shares 13. Using the treasury stock method, the options would result in how many extra shares being recognized in the diluted EPS calculation: A. 500,000 B. 358,975 C. 333,333 D. 285,714 The answer is C: 50 million shares / $75 per share = 666,667 shares bought so you need an additional 333,333 shares to be issued 14. Diluted earnings per share for 2005 was: A. $1.52 B. $1.77 C. $2.00 D. $2.03 The answer is B: $350 million / (97.5 million (a) million (b) +100 million) where the last 10 million is 50 million in P/S converted to C/S

9 Essays/Problems Please write clearly and show any calculations you make 15. Valuation of Bonds (a) It is January 1, 2006 and you are considering buying $20,000 of Hilever Company's 10% bonds, which come due on December 31, The bonds pay interest semiannually on June 30 and December 31 of each year. The prevailing interest rate on bonds of similar risk is 12%. How much would you be prepared to pay for the bond? (b) If coupon rate was 12% on these bonds, how much would you be prepared to pay? (c) If the coupon rate was 10% and the bonds were convertible into common equity (5 shares for every $1,000 face value coupon bond), and common stock is currently trading at $11 per share would this change your answer to part a? Why? Why not? Part a: (n= 20 and i = 6) since these are semi-annual payments. There are 20 semiannual periods in 10 years at an interest rate of 6% per semiannual period. Interest: $20,000 x 10% x 6/12 = $1,000 x = $11,470 Principal: $20,000 x.3118 = $ 6,236 $17,706 Part b: It has to be $20,000 since the stated (coupon) rate and the market rate are both 12% Part c: The price will be a little higher than $17,706 but not much higher given that the stock price is currently at $11 and the break even point is $200 ($1,000 bond / 5 shares)

10 16. Earnings Management Earnings management can be defined as the "purposeful intervention by management in the earnings process, usually to satisfy selfish objectives" (Schipper, 1989). Earnings management techniques can be separated into those that are "cosmetic" (without cash flow consequences) and those that are "real" (with cash flow consequences). The management of a company wishes to increase earnings this period. List three "cosmetic" techniques they could use to achieve this objective and explain why they will achieve the objective There are lots of possible answers here. The key was to be specific. Some possible answers were: Decrease bad debt expense Decrease warranty expense Increase salvage value of depreciable assets Increase the useful life of depreciable assets Change from accelerated depreciation to straight-line depreciation Change from LIFO to FIFO Capitalize expenses like R&D if possible Increase the discount rate on the pension plan Increase the expected rate of return on the pension plan assets

11 17. Leases Compare the effects of operating leases as compared to capitalized leases, in the first year of a lease, on the following items listed. Explain your answer. (1) EBIT (2) Net Income (3) Return on Assets (levered) (4) Cash flow from Operations (5) Current Ratio Ratio/Measure Operating Lease Capital Lease Which is Better EBIT (Earnings Before Interest and Taxes) Rent expense (the full cash flow) Just the portion of the expense associated with depreciation Capital Lease Net Income Rent expense Depreciation expense + the portion of the cash flow associated with interest expense ROA (Return On Assets) Cash Flow from Operations Current Ratio Higher Net Income re (2) above Rent Expense (the full cash flow) Current Assets and Current Liabilities are unaffected Higher asset number since leased asset is on the balance sheet Just the cash flow associated with interest expense. The rest of the cash flow will pay down the Lease Liability Current Assets are unaffected but Current Liabilities are higher due to the current portion of the long-term lease obligation Operating Lease Operating Lease Capital Lease Operating Lease

12 18. Operating Leases Retail Inc. has both operating and capital leases. Below is a portion of its lease footnote taken from their 2005 financial statements. (a) Obtain a crude estimate of the remaining length of the operating and capital leases (b) Estimate the interest rate implicit in the capital leases (Note: No trial and error needed. The information is above where this should be an easy calculation). If you cannot get the answer, come to me and I will give you the answer but you will not receive as many points. (c) Compute the present value of the operating leases Part a: Capital Lease: $1,050 / $145 per year = 7.2 additional years to 2010 = 12.2 years. Operating Lease: $5,941 / $528 per year = additional years to 2010 = years Part b: $233 payment in $100 of that reducing the principal balance means $133 is interest divided by the present value of the obligation of $1,328 = 10% Part c: $8659 / 16 years (a) = $ x (n=16; i=10 (b)) = $4,234

13 19. Equity method versus cost method Wilde Corporation owns 30% of the outstanding stock of Bernie Inc. Bernie recorded net income of $10M and paid dividends of $3M in For each of the following ratios, state the effect (higher, lower or no effect) that the use of the equity method would have on Wilde's financial ratios compared to the use of the cost method in Explain your answers. (i) Gross margin (ii) Total Asset turnover (iii) Cash flow from operations to current liabilities (iv) Debt to Equity Equity Method transactions are: LT Investment(asset) increases $3,000,000 and Investment Income increases $3,000,000 and Cash increases $900,000 and LT Investment decreases $900,000 Versus the Cost Method which is only Cash increases $900,000 and Investment Income increases $900,000 Part (i): Gross Margin is Gross Margin / Sales which is unaffected by the transactions above Part (ii): Total Asset Turnover is Sales / Total Assets. Sales is unaffected by the transactions above but assets are larger under the equity method so the ratio will be lower under the equity method Part (iii): Cash flow from operations to current liabilities is unaffected by the transactions above. Part (iv): Debt to Equity: Debt is unaffected by the transactions above but the equity method will recognize more investment income so the equity method will have a higher net income so the equity method will have a lower debt to equity ratio.

14 20. Foreign Currency Translation (a) Gruber PLC operates in England and is a subsidiary of Szudy International. The functional currency of Gruber is the British pound. Gruber reported net income in 2005 of 350M and paid a 75M dividend on July 1, 2005 when the exchange rate was $1.55 per pound. The current rate is $1.65 per pound and the average rate for 2005 was Compute the change in retained earnings for the period in US dollars. (b) Windsor PLC operates in England and is a subsidiary of Buckingham International. The U.S. dollar is the reporting currency for Buckingham international. The functional currency of Windsor is the British pound, and it prepares financial information in British pounds for internal use. Windsor's 2003 and 2004 net assets were 10,000 and 11,500, respectively. The 12/31/04 exchange rate was 1.56, the 12/31/03 exchange rate was 1.50 and the average rate for the year was What was the translation gain or loss for the year for Buckingham when it converted Windsor's financial statements into the reporting currency? Part a: The effect on retained earnings is the increase due to net income and the decrease due to Dividends + Net Income: 350,000,000 x $1.60 = $560,000,000 - Dividends: 75,000,000 x $1.55 = (116,250,000) Part b: $443,750,000 Beginning of the year balance x change in exchange rates (10,000 x ( ) = Increase in net assets x (end of the year average exchange rate) 1,500 x ( ) = 45 Total = 645 and since the pound strengthened relative to the dollar, this is a translation gain

15 Problem 21: Financial Footprints- Identify Company 1 In this problem, you become a financial analyst/detective. The attached exhibit expresses condensed financial statements for 13 companies on a percentage basis. In the income statement, all figures are presented as a percentage of total sales revenue. In the balance sheet, all figures are presented as a percentage of total assets. The 13 companies (all corporations except for the accounting firm) shown here represent the following industries: (1) Advertising agency. (2) Computer manufacturer. (3) Department store chain (that carries its own receivables). (4) Distiller of hard liquor. (5) Electric utility. (6) Finance company (lends money to consumers). (7) Grocery store chain. (8) Insurance company. (9) Pharmaceutical company. (10) Public accounting (CPA) partnership. (11) Soft drink company. (12) Steel manufacturer. (13) Tobacco products company. Use whatever clues you can to match the companies in the attached exhibit with the industries listed above. You must also give a brief explanation (2 to 3 sentences) justifying each of your choices. 1 Adapted from Clyde P. Stickney & Roman L. Weil, Financial Accounting: An Introduction to Concepts, Methods, and Users, 7th Edition, Dryden Press, 1994.

16 The way I graded this problem was that the groupings of companies had to make sense. I allowed for variations within the group, but the companies in the groups had to make sense. So below are the four groups I split the 13 companies above into and in parentheses is the actual answer from the spreadsheet. First group: Those companies without inventories, i.e. service industries. Given the note at the bottom of the spreadsheet, this group should have been obvious. The companies in this group are the advertising agency (12), finance company (13), insurance company (11) and public accounting (CPA) partnership (2) Second group: These are the companies with high R&D. They are the computer manufacturer (9) and the pharmaceutical company (3) Third group: This is the group with high levels of property, plant and equipment. They are the electric utility (10), the grocery store (1) and the steel manufacturer (8) Fourth group: This is essentially the other group. They don t fit into categories so easily. These companies are the department store chain (5), the distiller of hard liquor (6), the soft drink company (7) and the tobacco products company (4) Some brief explanations based on the spreadsheet columns: Company 1: the grocery store. Lots of fixed assets. Lots of inventory and a terrible profit margin of only 1.9% Company 2: the CPA firm. They have multiple offices so of the no inventory companies they have the most PPE Company 3: the pharmaceutical. Of the two high R&D companies, they have the most intangible assets on the patents for their drugs. Their PPE requirements are lower than the computer manufacturer. Company 4: tobacco. They can t advertise so they have the lowest advertising expense. The other expenses are legal fees for being sued by almost everyone. Company 5: the department store: high receivables and a relatively high amount of inventory coupled with high (for this group) PPE because of their stores Company 6: liquor. This is the one that basically falls out as the others are all identified. But they can advertise and they do but not as much as company 7 Company 7: soft drink. Highest advertising rate in this group and the least amount of inventory as they turn their inventory quickly.

17 Company 8: steel. Huge PPE and not a great profit margin as the cost of production is high and they are in a competitive business. Company 9: computers. See the explanation for company 3except it is the opposite. Company 10: utility. Huge PPE. Yes they have inventory as utilities sell stuff just not a lot of stuff. Good profit margin but not that high as they are regulated. Company 11: insurance company. Huge amount of receivables and current liabilities associated with their premiums being collected and their claims being paid. Company 12: advertising. Within this group, this is the one that just had to go somewhere. Company 13: finance company. Massive interest expense because they borrow so they can lend money. Relatively small operating costs.