TEST NUMBER This exam comes in two parts Part I involves an

Question

TEST NUMBER 3

This exam comes in two parts. Part I involves an analysis of a set of financial statements and Part II involves forecasting and valuation based on those financial statements.

Part I: Analysis (20 Points)
The following is a comparative balance sheet for a firm for fiscal year 2002 (in millions of dollars):

	2002	2001		2002	2001
Operating cash	60	50	Accounts payable	1,200	1,040
Short-term investments (at market)	550	500	Accrued liabilities	390	450
Accounts receivable	940	790	Long-term debt	1,840	1,970
Inventory	910	840
Property and plant	2,840	2,710	Common equity	1,870	1,430
	5,300	4,890		5,300	4,890

The following is the statement of common shareholders’ equity for 2002 (in millions of dollars):

Balance, end of fiscal year 2001	1,430
Share issues from exercised employee stock options	810
Repurchase of 24 million shares	(720)
Cash dividend	(180)
Tax benefit from exercise of employee stock options	12
Unrealized gain on investments	50
Net income	468
Balance, end of fiscal year 2002	1,870

The firm’s income tax rate is 35%. The firm reported $15 million in interest income and $98 million in interest expense for 2002. Sales revenue was $3,726 million.

a. Calculate the loss to shareholders from the exercise of employee stock options during 2002.

b. The shares repurchased were in settlement of a forward purchase agreement. The market price of the shares at the time of the repurchase was $25 each. What was the effect of this transaction on the income for the shareholders?

c. Prepare a comprehensive income statement that distinguishes after-tax operating income from financing income and expense. Include gains or losses from the transactions in questions (a) and (b) above.

d. Prepare a reformulated comparative balance sheet that distinguishes assets and liabilities employed in operations from those employed in financing activities. Calculate the firms’ financial leverage and operating liability leverage at the end of 2002.

e. Calculate free cash flow for 2002.

Part II: Forecasting and Valuation (20 Points)

Use a cost of capital for operations of 9%.

Sales revenue is forecasted to grow at a 6% rate per year in the future, on a constant asset turnover of 1.25. Operating profit margins of 14% are expected to be earned each year.

a. Forecast return on net operating assets (RNOA) for 2003.

b. Forecast residual operating income for 2003.

c. Value the shareholders’ equity at the end of the 2002 fiscal year using residual income methods.

d. Forecast abnormal growth in operating income for 2004.

e. Value the shareholders’ equity at the end of 2002 using abnormal earnings growth methods.

f. After reading the stock compensation footnote for this firm, you note that there are employee stock options on 28 million shares outstanding at the end of 2002. A modified Black-Scholes valuation of these options is $15 each. How does this information change your valuation?

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