Model Answers for Extra Practicing Problems

E9.6. Reformulating an Equity Statement with Employee Stock Options

Before the reformulation, calculate the loss on exercise of stock options:
12
34
0.35
Tax Benefit (35%)
12
Loss on exercise

Compensation, after tax

22

The loss is obtained from the tax benefit, reported in the equity statement. The 34 (rounded) is
the amount that draws a tax benefit at a 35% tax rate: Method 1 in the text. The after-tax loss, 22,
goes into comprehensive income.
The reformulation:

Balance, end of 2011

1,430

Net transactions with shareholders:

Share issues from options (810 + 34)
Stock repurchases
Dividends

844
(720)
(180)

(56)

Comprehensive income:
Net income
Unrealized gain on debt investments
Loss on exercise of employee options

468
50
(22)

496

Balance, end of 2012

1,870

E10.1. Basic Calculations

a. Reformulated balance sheet
Operating assets
$547
Operating liabilities 132

Financial obligations
Financial assets
Net financial obligations
Common shareholders equity

Net operating assets $415

Operating liabilities = $322 190 = $132 million.

$190
145
45
370
$415

b. Reformulated income statement

Revenue
Cost of goods sold
Gross margin
Operating expenses
Operating income
Net financing expense:
Interest expense
Interest income
Earnings

$4,356
3,487
869
428
441
$132
56

76
$ 365

E10.2. Tax Allocation

Net interest after tax = $140 x 0.65 = $91 million
Operating income after tax = Net income + net interest after tax
= $818 + $91
= $909 million
(This is the bottom-up method on Box 10.3)

E10.3. Effective Tax Rates

Income before tax = $100 10 = $90 million
Effective tax rate on income before tax = $25/$90 = 27.78%
Operating income
Tax on operating income:
Tax reported
Tax benefit on interest ($10 0.35)
Operating income after tax

$100.0
$25.0
3.5

28.5
71.5

Effective tax rate on operating income = $28.5/$100 = 28.5%

E10.4. Tax Allocation: Top-Down and Bottom-Up Methods

Top-down method:
Revenue
Cost of goods sold
Operating expenses

$6,450
3,870
2,580
1,843

Operating income before tax

Tax expense:
Tax reported
$181
Tax on interest expense
50
Operating income after tax
Net interest:
Interest expense
Tax benefit at 37%
Earnings

737

231
506

135
50

85
421

Bottom-down method:
Earnings
Net interest:
Interest expense
Tax benefit at 37%
Operating income after tax

$421
135
50

85
$506

E10.5 Reformulation of a Balance Sheet and Income Statement

Balance sheet:
Operating cash
Accounts receivable
Inventory
PPE
Operating assets
Operating liabilities:
Accounts payable
Accrued expenses
Deferred taxes
Net operating assets

$ 23
1,827
2,876
3,567
8,293

$1,245
1,549
712

Net financial obligations:

Cash equivalents
Long-term debt
Preferred stock
Common shareholders equity

3,506
4,787

$( 435)
3,678
432

3,675
$1,112

Income statement:
Revenue
Operating expenses
Operating income before tax
Tax expense:
Tax reported
$295
Tax on interest expense
80
Operating income after tax
Net financial expense:
Interest expense
Tax benefit at 36%
Preferred dividends
Net income to common

$7,493
6,321
1,172

375
797

221
80
141
26

167
$630

E10.6. Reformulation of a Balance Sheet, Income Statement, and Statement of

Shareholders Equity
a. Reformulated balance sheet
Operating cash
Accounts receivable
Inventory
PPE
Operating assets
Operating liabilities:
Accounts payable
Accrued expenses
Net operating assets
Net financial obligations:
Short-term investments
Long-term debt
Common shareholders equity

60
940
910
2,840
4,750

$1,200
390

1,590
3,160

$( 550)
1,840
1,290
$1,870

Reformulated equity statement:

Balance, end of 2011
Net transactions with shareholders:
Share issues
$ 822
Share repurchases
(720)
Common dividend
(180)

$1,430

Comprehensive income:
Net income
$ 468
Unrealized gain on debt investments
50
Balance, end of 2012

78)

518
$1,870

b. Reformulated statement of comprehensive income

Revenue
Operating expenses, including taxes
Operating income after tax

Net financing expense:

Interest expense
$
Interest income
Net interest
Tax at 35%
Net interest after tax
Unrealized gain on debt investments
Comprehensive income

$3,726
3,204
522

98
15
83
29
54
50

4
$ 518

After calculating the net financial expense, the bottom-up method is used to get operating
income after tax. That is, net interest expense is calculated first (= $4 million). Then, as
comprehensive income is $518 million, operating income must be 518 + 4 = 522. The
number for operating expense (3,204) is then a plug to get back to the $3,726 million revenue
number. Bottom up.
E11.5 Free Cash Flow for a Net Debtor
By Method 2 in Box 11.1,
C - I = NFE NFO + d
NFO = 37.4 54.3 = -16.9 (net debt declined)

d = 8.3 34.3 = -26.1

(negative net payout)

So, C I = 4 (-16.9) + (-26.1)

= -5.2

(free cash flow was negative)

OR, using Method 1,

C-I

= OI - NOA
= 29.3 - 34.5
= -5.2

where
OI
= Comprehensive income (25.3) + NFE (4.0) = 29.3
NOA = CSE - NFO
= 51.4 - 16.9 = 34.5
Comprehensive income is plugged from the equity statement.

E11.7. Applying Cash Flow Relations

(a)

Use the free cash flow generation equation: C - I = OI - NOA

As there was no net financial income or expense, operating income (OI) equals
the comprehensive income of $100 million. The net operating assets for 2012 and
2011 are as follows:

Operating assets
Operating liabilities
NOA

2012

2011

640
20
620

590
30
560

C - I = OI - NOA
= 100 - 60
= $ 40 million
(b)

Use the free cash flow disposition equation: C - I = NFA - NFI +d

The net dividend (d) = comprehensive income - CSE
= 100 - 160

= - $60 million (a net capital contribution)

The net financial assets for 2012 and 2011 are as follows:

Financial assets
Financial liabilities
NFA

C-I

2012

2011

250
170
80

110
130
(20)

= NFA - NFI + d
= 100 - 0 - 60
= $40 million

The firm invested the $40 million of free cash flow in financial assets. In
addition, it raised a net $60 million from shareholders which it also invested in
financial assets.

(c)

Net financial income or expense can be zero if financial income and financial
expense exactly offset each other. This firm moved from a net debtor to a net
creditor position in 2012 such that the weighted-average net financial income was
zero.

E12.3. Reformulation and Analysis of Financial Statements

a. Reformulated balance sheet
2012
Operating cash
Accounts receivable
Inventory

2011
$

60
940
910

50
790
840

PPE
Operating assets
Operating liabilities:
Accounts payable
Accrued expenses
Net operating assets
Net financial obligations:
Short-term investments
Long-term debt
Common shareholders equity

2,840
4,750

$1,200
390

2,710
4,390

1,040
450

1,590
3,160

$( 550)
1,840 1,290
$1,870

( 500)
1,970

Reformulated equity statement (to identify comprehensive income):

Balance, end of 2011
Net transactions with shareholders:
Share issues
Share repurchases
Common dividend
Comprehensive income:
Net income
Unrealized gain on debt investments
Balance, end of 2012

$1,430
$ 822
(720)
(180)

$ 468
50

518
$1,870

Reformulated statement of comprehensive income

Revenue
Operating expenses, including taxes
Operating income after tax

Net financing expense:

Interest expense
$
Interest income
Net interest
Tax at 35%
Net interest after tax
Unrealized gain on debt investments
Comprehensive income

$3,726
3,204
522

98
15
83
29
54
50

78)

4
$ 518

1,490
2,900

1,470
1,430

After calculating the net financial expense, the bottom-up method is used to get operating
income after tax.
b. Free cash flow = OI NOA
= 522 (3,160 2,900)
= 262
c. Ratio analysis
Profit Margin (PM) = 522/3,726 = 14.01%
Asset turnover (ATO) = 3,726/2,900 = 1.285
RNOA
= 522/2,900 = 18%
d. Individual asset turnovers
Operating cash turnover = 3,726/5 = 74.52
Accounts receivable turnover = 3,726/790 = 4.72
Inventory turnover = 3,726/840 = 4.44
PPE turnover = 3,726/2,710 = 1.37
Accounts payable turnover = 3,726/1,040 = 3.58
Accrued expenses turnover = 3,726/450 = 8.28
1/individual turnover aggregate to 1/ATO:
1/ATO = 1/1.285 = 0.778 = 0.013 + 0.212 + 0.225 + 0.730 0.279 0.121
(allow for rounding error)
e. ROCE = 518/1,430 = 36.22%
Financial leverage (FLEV) = 1,470/1,430 = 1.028
Net borrowing cost (NBC) = 4/1,470 = 0.272%
ROCE = 36.22% = 18.0% + [1.028 (18.0% - 0.272%)]
f. NBC = 4/1,470 = 0.272% (as in part e)
If RNOA = 6% and FLEV = 0.8,
ROCE = 6.0% + [0.8 (6.0% - 0.0.272%]
= 10.58%
Note: it is more likely that NBC will be at the core borrowing rate (that excludes
The unrealized gain of debt investments): Core NBC = 54/1,470 = 3.67%.

Chapter 12 identifies core borrowing costs.

g. Implicit cost of operating liabilities = 1,490 0.03 = 44.7
522 44.7
Return on operating assets (ROOA) =
= 12.91%
4,390
Operating liability leverage (OLLEV) = 1,490/2,900 = 0.514
RNOA = 18.0% = 12.91% + [0.514 (12.91% - 3.0%)]

E13.4. Analyzing a Change in Return on Common Equity

ROCE for 2012: 15.2% = 11.28 + [0.4678 x (11.28 2.9)]
ROCE for 2011: 13.3% = 12.75 + [0.0577 x (12.75 3.2)]
ROCE

1.9%

RNOA

-1.47%

ROCE due to financing

3.37%

This change due to financing is due to a change in leverage and a change in SPREAD:
FLEV

0.4101

SPREAD

-1.17%

The explanation of the change in ROCE due to change in operating profitability (RNOA) is
given in Exercise E13.3. Using a similar scheme, the explanation of the change due to financing
is
ROCE due to financing = 3.37% = (-1.17% x 0.0577) + (0.4101 x 8.38%)
=

-0.07%

+ 3.44%

[Due to change in spread] [Due to change in leverage]

E13.6. Calculating Core Profit Margin

The reformulated statement that distinguishes core and unusual items is as follows (in millions of
dollars):
Sales
Core operating expenses
Core operating income before tax
Tax as reported
Tax benefit of net debt
Tax on operations
Tax allocated to unusual items:
Core operatimg inome after tax
Unusual items
Start-up costs
Merger charge
Gain on asset disposals

667.3
580.1
(73.4 +13.8)

87.2
18.3

(0.39 20.5)

8.0
26.3
5.4

31.7
55.5

(4.3)
(13.4)
3.9
(13.8)

Tax effect (0.39)

5.4
(8.4)

Translation gain
Comprehensive operating income

8.9

0.5
56.0

Note:
1. The currency translation gain is transitory; it does not affect core
income.
2. Translation gains, like all items reported in other comprehensive
income are after-tax.
3. The gain on disposal of plant may attract a higher tax rate than 39% due
to depreciation recapture.

Core operating income (after tax) = 55.5

Core profit margin

Core operating income (after tax)

Sales

55.5
667.3

8.32%