Q1
A colleague who is aware of your understanding of financial statements asks for help in analyzing the transactions and events of Zett Corporation. The following date are provided:
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Additional data for the period January 1, Year 2, through December 31, Year 2, are:
1. Sales on account, $70,000.
2. Purchases on account, $40,000.
3. Depreciation, $50,000.
4. Expenses paid in cash, $18,000 (including $4,000 of interest and $6,00 in taxes).
5. Decrease in inventory, $2,000
6. Sales on fixed assets for $6,000 cash; cost $21,000 and two-thirds depreciated (loss or gain is included in income).
7. Purchase of fixed assets for cash, $4,000.
8. Fixed assets are exchanged for bonds payable of $30,000.
9. Sale of investments for $9,000 cash.
10. Purchase of treasury stock for cash, $11,500.
11. Retire bonds payable by issuing common stock, $10,000.
12. Collections on accounts receivable, $65,000.
13. Sold unissued common stock for cash, $1,000.
Required
a. Prepare a statement of cash flows (indirect method) for the year ended December 31, Year 2.
b. Prepare a side-by-side comparative statement contrasting two bases of reporting: (1) net income and (2) cash flows from operations.
c. Which of the two financial reports in (b) better reflects profitability? Explain.
Q2
Quaker Oats, in its annual report discloses the Quaker Oats Company following:
Financial Objectives: Provide total shareholder returns (dividends plus share price appreciation) that exceed both the cost of equity and the S&P 500 stock index over time. Quakers total return to shareholders for Year 11 was 34%. That compares quite favorably to our cost of equity for the year, which was about 12%, and to the total return of the S&) 500 stock index, which was 7%. Driving this strong performance, real earnings from continuing operations grew 7.4% over the last five years, return on equity rose to 24.1%. [Quaker Oats stock price at the beginning and end of Year 11 was $48 and $62, respectively, and the Year 11 dividends are $1.56 per share.]
The Benchmark for Investment
We use our cost of capital as a benchmark, our hurdle rate, to ensure that all projects undertaken promise a suitable rate of return. The cost of capital is used as the discount rate in determining whether a project will provide an economic return on its investment. We estimate a projects potential cash flows and discount these cash flows back to present value. This amount is compared with initial investment costs to determine whether incremental value is created. Our cost of capital is calculated using the approximate market value weightings of debt and equity used to finance the company.
Cost of equity + Cost of debt = Cost of capital
When Quaker is consistently able to generate and reinvest cash flows in projects whose returns exceed our cost of capital, economic value is created. As the stock market evaluates the Companys ability to generate value, this value is reflected in stock price appreciation.
The cost of equity. The cost of equity is a measure of the minimum return Quaker must earn to properly compensate investors for the risk of ownership of our stock. This cost is a combination of a risk-free rate and an equity risk premium. The risk-free rate (the U.S. Treasury Bond rate) is the sum of the expected rate of inflation and a real return of 2 to 3%. For Year 11, the risk-free rate was approximately 8.4%. Investors in Quaker stock expect the return of a risk-free security plus a risk premium of about 3.6% to compensate them for assuming the risks in Quaker stock. The risk in holding Quaker stock is inherent in the fact that returns depend on the future profitability of the Company. Quakers cost of equity was approximately 12%.
The cost of debt. The cost of debt is simply our after-tax, long-term debt rate, which was around 6.4%
Required:
a. Quaker reports the return to shareholders
(1) How is this return computed (provide calculations)?
(2) How is this return different from return on common equity?
b. Explain how Quaker Oats arrives at a 3.6% risk premium needed by common shareholders as compensation for assuming the risks of Quaker Oats stock.
c. Explain how Quaker Oats determines the 6.4% cost of debt.
Q3
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a. Calculate return on common equity for Year 9 using year-end amounts and assuming no preferred dividends.
b. Disaggregate Mercks ROCE into operating (RNOA) and nonoperating components. Comment on Mercks use of leverage. (Assume all assets and current liabilities are operating and a 35% tax rate.)
Q4
Refer to the financial statements of Quaker Oats Company. Prepare a forecasted income statement for Year 12 using the following assumptions ($ millions):
1. Revenues are forecast to equal $6,000.
2. Cost of sales forecast uses the average percent relation between cost of sales and sales for the three-year period ending June 30, Year 11.
3. Selling, general, and administrative expenses are expected to increase by the same percent increasing occurring from Year 10 to Year 11.
4. Other expenses are predicted to be 8% higher than in Year 11.
5. A $2 million loss (net of taxes) is expected from disposal of net assets from discontinued operations.
6. Interest expenses, net of interest capitalized and interest income, is expected to increase by 6% due to increased financial needs.
7. The effective tax rate is equal to that of Year 11.
Q5
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a. Use the following ratios to prepare a projected income statement, balance sheet, and statement of cash flows for year 3.
Sales growth…………………………………………………………………………………………… 1.02%
Gross profit margin…………………………………………………………………………….. 69.92%
Selling, general, and administrative expense/Sales……………….. 39.28%
Depreciation expense/Prior-year PPE gross……………………………. 12.14
Interest expense/Prior-year long-term debt……………………………. 5.45%
Income tax expense/Pretax income…………………………………………….. 29.88%
Accounts receivable turnover…………………………………………………………. 10.68
Inventory turnover……………………………………………………………………………… 5.73
Accounts payable turnover……………………………………………………………… 1.64
Taxes payable/Tax expense……………………………………………………………. 50.33%
Total assets/Stockholders equity (financial leverage)………… 2.06
Dividends per share……………………………………………………………………………. $1.37
Capital expenditure/Sales………………………………………………………………… 5.91%
b. Based on your initial projections, how much external financing (long-term debt and/or stockholders equity) will Coca-Cola need to fund its growth at projected increases in sales?
Q6
Refer to the financial statements of Campbell Soup Company
a. Compute the following liquidity measures for Year 10:
1. Current ratio
2. Acid-test ratio
3. Accounts receivable turnover (AR balance at end of Year 9 is $564.1.)
4. Inventory turnover (inventory balance at end of Year 9 is $816.0).
5. Days sales in receivables
6. Days sales in inventory
7. Conversion period (operating cycle).
8. Cash and cash equivalents to current assets.
9. Cash and cash equivalents to current liabilities.
10. Days purchases in accounts payable.
11. Net trade cycle.
12. Cash flow ratio
b. Assess Campbells liquidity position using results from (a).
c. For Year 10, compute ratios 1, 4, 5, 6, and 7 using inventories valued on a FIFO basis (FIFO inventory at the end of Year 9 is $904).
d. What are the limitations of the current ratio as a measure of liquidity?
e. How can analysis and use of other related measures (other than the current ratio) enhance the evaluation of liquidity?