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SOLUTIONS MANUAL for Core Concepts version of Financial Analysis A User Approach 1e Gary Giroux

Chapter 1. What is Financial Analysis? Questions. 1. What is financial analysis and how can it be used for a recommendation for a company asking for a loan? An equity investment decision? 2. Give an example of an internal financial analysis decision. An external decision. 3. Assume you are asked to develop a financial analysis strategy for a 40 year old manager who is restructuring her 401K retirement portfolio. Identify the purpose of the analysis and key points needed. 4. You are asked to evaluate the chemical industry as part of a corporate overview of Dow Chemical. How would you go about this analysis? 5. What are quantitative financial analysis techniques important for both internal and external financial analysis projects? 6. Why is specific accounting knowledge important for external financial analysis? 7. What is comprehensive analysis and why is it a necessary step in the financial analysis process? 1

2 3

Financial analysis is the use of financial and other information to make recommendations and decisions. It is a six step process: Purpose, Overview, Quantitative Financial Analysis, Detailed Accounting Analysis, Comprehensive Analysis, and Financial Analysis Decisions. Credit Decisions: determine line of credit, interest rate, and other terms. Equity Decisions: Buy/Sell based on earnings growth, and other ratios. Internal Analysis: What Managers do to operate and prepare statements. External Analysis: Six Step Approach by outsiders of a company, ratio analysis, etc. In making equity decisions for an older individual, dividend distribution and low-risk may be more desirable and should be analyzed. Her criteria differ from younger investors who may have a focus on long-term appreciation as opposed to dividends and may care less about dividends. Fortune 500 industries are broken into 62 categories. Using Standard Industrial Classification (SIC) codes. These should be used to designate Dow’s industry. Once accomplished, analysts should conduct a thorough analysis of competitors. Knowledge about Dow should help answer questions such as: What do the companies in this industry do? What is the specific industry? How concentrated is it (competition)? What factors are unique to the industry (legal)? How do US and global economic conditions affect the industry? 3 functions of Financial Analysis Techniques 1. Standardized Financial Info. a. Common-size analysis b. Return on Assets, etc. 2. Financial trends analyzed over time. a. ROA better or worse than last year. b. Are projected figures an improvement over current ones.

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3. Ratios and other measures can be compared with direct competitors. 6 Differences often arise as companies use different (legal) procedures to prepare financial data (FIFO, LIFO, Avg. Cost, etc.). For this reason and the complexity of corporate environment, SPECIFIC accounting knowledge becomes important. Notes to financial statement help present specific data to be analyzed. 7 The findings from the financial analysis steps are summarized in Comprehensive Analysis, which stresses the most relevant information for determining whether or not to invest. This includes discussion of Red Flags and Green Flags. Problems: Throughout the book most problems will focus on (1) the chemical industry using Du Pont, Dow and PPG, (2) the Hotel and Resort Industry, and (3) the automotive industry using Ford and General Motors. Problem 1.1. Du Pont’s Corporate Overview and Business Strategy. The following are excerpts from various sources. Industry: The chemical industry is global, with corporations producing both commodities and specialty products. A vast number of products are produced, with companies specializing in everything from bulk products with low margins to high-margin specialty products resulting from research and development. In the Fortune 1,000 34 chemical companies are listed (13 in the Fortune 500), with combined sales of $154 billion. Du Pont is the largest with revenues of $29 million. Economic conditions have a moderate effect on this industry, but have a differential impact on companies depending on specific products. Environmental regulations and other legal concerns have a major impact on this industry, again with differential effects by company. From Hoover’s Company Capsule (www.hoovers.com) E. I. du Pont de Nemours is the largest chemical company in the U.S. Developer of Lycra, Dacron, and Teflon, Du Pont has operations in about 65 countries. Its eight business units make products including coatings, nylon, specialty polymers, and pigments and chemicals. History: From Hoover’s Handbook (1993, p. 249): E. I. Du Pont fled the French Revolution … [and] founded E. I. Du Pont de Nemours [1802] and set up a gunpowder plant [in Delaware]. Within a decade the plant grew to be the largest of its kind in the U.S. … In 1902 Du Pont cousins Pierre, Alfred, and Coleman bought Du Pont and in 1903 instituted a centralized structure with functionally organized departments, an innovation that big business widely adopted. … In the 1920s Du Pont bought and improved French cellophane technology and began production of rayon. Du Pont’s of inventions includes neoprene synthetic rubber (1931), Orlon, Dacron, and many others. Du Pont’s Web page

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DuPont is a science company, delivering science-based solutions in markets such as food and nutrition, health care, apparel, home and construction, electronics and transportation. Two hundred years ago, DuPont was primarily an explosives company. One hundred years ago, our focus turned to global chemicals, materials and energy. Today, entering our third century, we deliver science-based solutions that make real differences in real lives. Look closely at the things around your home and, chances are, you'll find a DuPont imprint. Our ability to adapt to change and our foundation of unending scientific inquiry enabled this two-century journey to becoming one of the world's most innovative companies. But, in the face of constant change, innovation and discovery, our core values have remained constant: commitment to safety, health and the environment; integrity and high ethical standards; and treating people with fairness and respect. From 2001 10-K DuPont was founded in 1802 and was incorporated in Delaware in 1915. DuPont is a world leader in science and technology in a range of disciplines including high-performance materials, synthetic fibers, electronics, specialty chemicals, agriculture and biotechnology. The company operates globally through some 22 strategic business units. Within the strategic business units, a wide range of products are manufactured for distribution and sale to many different markets, including the transportation, textile, construction, motor vehicle, agricultural, home furnishings, medical, packaging, electronics and the nutrition and health markets. The company and its subsidiaries have operations in about 75 countries worldwide and, as a result, about 50 percent of consolidated sales are made to customers outside the United States. Subsidiaries and affiliates of DuPont conduct manufacturing, seed production, or selling activities, and some are distributors of products manufactured by the company. In February 2002, the company announced the realignment of its businesses into five market- and technology-focused growth platforms and its plans for the creation of a Textiles and Interiors subsidiary. The growth platforms are: DuPont Electronic & Communication Technologies; DuPont Performance Materials; DuPont Coatings & Color Technologies; DuPont Safety & Protection; and DuPont Agriculture & Nutrition. DuPont will consider a full range of options to separate DuPont Textiles & Interiors from the company by year-end 2003, market conditions permitting.

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Sales in 2001 were $24, 726, down from $28,268 in 2000. Net income in 2001 was $4,339 million, up from $2,314; however, $3,866 million was a gain on the sale of Du Pont Pharmeauticals. We faced the worst economic environment in two decades, unusually high energy prices and unfavorable currency exchange rates. … Overall misson is substantial growth— creating value for our shareholders. From MD&A (2000 Annual Report) Consolidated sales in 2000 were a record $28.3 billion, $1.4 billion or 5 percent above 1999. Specialty Fibers, Specialty Polymers and Pigments & Chemicals segments had the most positive impact on volume. Net income for the year 2000 was $2,314 million compared with $7,690 million in 1999. The decrease in net income principally reflects the absence of a $7,471 million after-tax gain recorded in 1999 of discontinued business … Income from continuing operations was $2,314 million or $2.19 per share in 2000, compared to $219 million of $.19 per share in 1999. Use this information (plus other internet searches) to write a one page Corporate Overview for Du Pont (one paragraph on industry and one paragraph on business strategy). Answers May Vary Industry [size & relative significance, geographic presence (e.g., U.S., global …), current performance (impact of business cycle, etc.), future potential] This paragraph may include: -Chemical Industry is global -produces commodities and specialty products -Total Sales of Industry $154 billion -Economic Conditions have moderate effect on the industry -Environmental Regulations have major impact on industry -DuPont operates globally through 22 strategic business units -Wide range of products -operations in 75 countries Business [historical, major focus & operations, segments, objectives, forecasts] Strategy This paragraph may include: -DuPont is science company, delivering science-based solutions in markets such as food and nutrition, health care, apparel, home and construction, electronics and transportation. -Market Saturation info (pgph. 2 from “DuPont’s Web Page”) -adaptable -In 2002, DuPont realigned its businesses into growth platforms

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Problem 1.2. Hilton’s Corporate Overview and Business Strategy. The following are excerpts from various sources. Industry: The hotel, casino and resort industry includes nine companies on Fortune’s 1000 list, with Hilton at #499 based on revenue. Total revenues for the group were $35 billion in 2001, with income down substantially to $791 million. Marriott is the largest of the group, at #189. These companies have global operations, although their primary focus usually is in the U.S. The corporations operate in somewhat different sectors, although all have major hotel operations. This is a capital intensive industry and depends on tourism for most of its revenue and growth. They were hard hit by the recession of 2001 and the September 11 attacks. From Hoover’s Company Capsule (www.hoovers.com): The company’s lodging empire includes some 2,000 hotels (about 80% are franchised), mostly located in the U.S. Hilton operates 21 vacation resorts [but] has completely cashed out of the gaming industry. History: From Hoover’s Handbook (1993, p. 326) Conrad Hilton got his start in hotel management by renting rooms in his family’s New Mexico home. [He bought] his first hotel in Cicso, Texas. He survived the Great Depression. He began buying hotels again. He founded Hilton International to manage his foreign business (1948) and realized his ambition to run New York’s Waldorf-Astoria (1949). The company began to franchise in 1965. Conrad’s son Baron became president in 1966. From company’s MD&A, 2001 10-K We are primarily engaged in the ownership, management and development of hotels, resorts and timeshare properties and the franchising of lodging properties. Our brands include Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Hampton, Homewood Suites by Hilton. In addition, we develop and operate timeshare resorts through Hilton Grand Vacations Company. Our operations consist of three reportable segments which are based on similar products or services: Hotel Ownership, Managing and Franchising, and Timeshare. The Hotel Ownership segment derives revenue primarily from the rental of rooms as well as food and beverage operations at our owned, majority owned and leased hotel properties and equity earnings from unconsolidated affiliates. The Management and Franchising segment provides services including hotel management and licensing of the Hilton family of brands. This segment generates its revenue from management and franchise fees charged to hotel owners. The Timeshare segment consists of multi-unit timeshare resorts. Development: We intend to grow our hotel brands primarily through franchising and the addition of management contracts, which require little or no capital investment. In addition, we will continue to invest in normal capital replacement and select major

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renovation projects at our owned hotels, and we may seek to acquire hotel properties on a strategic and selective basis. Fiscal 2001 compared with fiscal 2000 (in millions):

Revenue Operating Income Net Income EPS, Basic

2000 $3,451 830 272 0.73

2001 $3,050 632 166 0.45

% Change -12% -24 -39 -39

All operating numbers down, do to a combination of the recession and September 11 attacks. From Hilton’s webpage (www.hilton.com): Conrad Hilton purchased his first hotel in Cisco, Texas back in 1919. The first hotel to carry the Hilton name was built in Dallas in 1925. In 1943, Hilton became the first "coast-tocoast" hotel chain in the United States; and in 1949, open its first hotel outside the U.S. in San Juan, Puerto Rico. Hilton went on the New York Stock Exchange in 1946, and Conrad Hilton purchased the Waldorf Astoria in 1949. Hilton has several worldrenowned, marquee properties; some of which are: Beverly Hilton, Cavalieri Hilton in Rome, Hilton Athens, Hilton San Francisco, Hilton New York, Hilton Hawaiian Village, Hilton Waikoloa Village, Paris Hilton, and others.

Hilton Hotels Corporation is recognized around the world as a preeminent lodging hospitality company, offering guests and customers the finest accommodations, services, amenities and value for business or leisure. While the Hilton brand has, for more than 80 years, been synonymous with excellence in the hospitality industry, our acquisition in 1999 of Promus Hotel Corporation expanded our family of brands to include such wellknown and highly respected brand names as Hampton Inn®, Doubletree®, Embassy Suites Hotels®, and Homewood Suites® by Hilton. Through ownership of some of the most recognized hotels in the world and our newly enhanced brand portfolio, Hilton is now able to offer guests the widest possible variety of hotel experiences, including fourstar city center hotels, convention properties, all-suite hotels, extended stay, mid-priced focused service, destination resorts, vacation ownership, airport hotels and conference centers. Today's Hilton can be viewed as a major industry competitor in a number of areas: •

OWNING HOTELS. Hilton owns such unique, irreplaceable hotel assets as New York's Waldorf=Astoria, The Hilton Hawaiian Village® on Waikiki Beach, Chicago's Palmer House Hilton and the Hilton San Francisco on Union Square. These large-scale properties occupy the best locations in the nation's best markets.

•

MANAGING/FRANCHISING HOTELS. The company is a prominent franchisor of hotels across its entire brand family, with income from management or franchise fees accounting for some 30 percent of Hilton's total cash flow. The company will open, through its franchisees, approximately 430 hotels and 63,000 rooms in 2000-01, consisting primarily of Hampton Inn, Homewood Suites by Hilton and Hilton Garden Inn hotels.

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VACATION OWNERSHIP. Hilton Grand Vacations Club, the company's vacation ownership business, operates properties across the country including such desirable locales as Las Vegas, Orlando, Miami and (in 2001) Honolulu.

INTERNATIONAL. A global strategic alliance with Hilton International, the London-based company which owns the rights to the Hilton brand outside of the U.S., brings to customers a single, seamless Hilton system of 2,000 hotels in more than 50 countries throughout the world. Additionally, Conrad International offers five-star luxury hotels in England, Ireland, Belgium, Hong Kong, Singapore, Turkey and Egypt.

Use this information (plus other internet searches) to write a one page Corporate Overview for Hilton (one paragraph on industry and one paragraph on business strategy). Answers May Vary Industry [size & relative significance, geographic presence (e.g., U.S., global …), current performance (impact of business cycle, etc.), future potential] This paragraph may include: -Total Revenues of industry were $35 billion -Industry has global operations, primary focus in US -Capital Investment Industry -Revenue depends on tourism Business Strategy

[historical, major focus & operations, segments, objectives, forecasts] -Mostly located in US -Primarily engaged in ownership, management and development of hotels, resorts, and timeshare properties and the franchising of lodging properties. -Operations consist of 3 segments: Hotel Ownership, Managing and Franchising, and Timeshare. -Development: Hotel growth through franchising and management, normal capital replacement. -acquired Promus Hotel Co. -Info from Webpage bullets describing how it is an industry competitor.

Problem 1.3. Ford’s Corporate Overview and Business Strategy. The following are excerpts from various sources. Industry: The 100 year old motor vehicle industry is global, with major North American, European and Asian markets. Auto manufacturing is among the largest and most complex of the heavy industrials in the world and companies compete in auto, truck, SUV and other markets. Competition is fierce with all companies attempting to gain market share in the major markets. These are durable goods, subject to business cycle conditions. When economic conditions are robust, these companies tend to be immensely profitable. But during recession, massive losses are the rule. Only Ford and General Motors are listed on the Fortune 1000 list. However, the Fortune Global 500 has 16 listed manufacturers, including DaimlerChrysler, Toyota, Volkswagen, Honda and Nissan. Globally, this is a trillion dollar industry (in sales). Individual companies have their own strengths and weakness by geographic area and product. The industry is subject to safety, fuel economy, and environmental regulations. Law suits also are common.

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From Hoover’s Company Capsule (www.hoovers.com) Ford Motor started a manufacturing revolution with its mass production assembly lines in the early 1900s. Now Ford is firmly entrenched in the status quo as the world’s largest truck maker and the #2 maker of cars and trucks, behind General Motors. It makes vehicles under the Aston Martin, Ford, Jaguar, Lincoln, Mercury, and Volvo brands. Two of its biggest successes are the Ford Taurus and the F-Series pickup. Ford also owns a controlling (33%) stake in Mazda and has purchased BMW’s Land Rover SUV operations. Ford’s finance subsidiary, Ford Motor Credit, is the US’s #1 auto finance company. Ford also owns 81% of Hertz, the #1 car rental firm in the world. The Ford family owns about 34% of the firm’s voting stock. History: From Hoover’s Handbook (1993, p. 280) Henry Ford began the Ford Motor Company in 1903 in Dearborn, Michigan, hoping to design a car he could mass-produce. In 1908 he introduced the Model T. …Ford perfected the moving assembly line. … By 1916 the cars cost $360; by 1920- 60% of all vehicles were Fords. … It was 1956 before the Ford allowed outside ownership. [During the Depression] market share slipped behind GM and Chrysler. … In 1950 Ford recaptured 2nd place from Chrysler. From Management Discussion and Analysis (2001 Annual Report) Our worldwide sales and revenues were $162.4 billion in 2001, down $7.7 billion from 2000, reflecting primarily lower vehicle sales in North America, offset partially by higher vehicle sales in Europe. We sold 6,991,000 cars and trucks in 2001, down 433,000 units … The Company lost $5,453 million in 2001 after a net income of $3,467 in 2000. Results summary: Automotive North America, return on sales of -2.3% Europe, return on sales of 0.8% Rest of world, earned $156 million Financial services: earnings declined 22% Stockholders’ equity was $7.8 billion 12/31/01, down $10.8 billion due to net losses, dividend payments, foreign currency translation, etc. Bond ratings were lowered by Moody’s in 2002 (from A3 to Baa1 on long-term debt), S&P (from A- to BBB) and Fitch (from A+ to A-). From Review of Major Operations (2000 Annual Report) 2000 Operating Highlights • Improved worldwide automotive sales of $170.1 billion in 2000, up $9.4 billion from 1999

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Record 7.4 million vehicles sold worldwide Income from operations for automotive $3.6 billion and $5,410 billion overall Competitive Strengths • Worldwide truck leadership • Total cost management • Global product development capability and distribution network • Global platforms/great brands • Strong union relations • Strong balance sheet • Highest U.S. customer loyalty Breakthrough Priorities • E-Business • Customer Satisfaction From CEO’s Letter (2000 Annual Report) At the start of last year we reconfirmed our commitment to being the leading consumer company for automotive products and services. This makes customers the foundation of everything we do and superior shareholder returns the ultimate measure of our success. Our two breakthrough strategic priorities—customer satisfaction and e-business—are aligned with the customer-driven vision. We made tremendous progress on both initiatives in 2000. Use this and other internet sources to write a one page Corporate Overview for Ford (one paragraph on industry and one paragraph on business strategy). Industry

Business Strategy

[size & relative significance, geographic presence (e.g., U.S., global …), current performance (impact of business cycle, etc.), future potential] This paragraph may include: -global industry, major North American, European and Asian markets. -largest and most complex industry -Fierce competition -durable goods subject to business cycle conditions -massive layoffs during recession -industry subject to safety, fuel economy, and environmental regulations. -Sales were 162.4 bilion -Return on Sales Data -Competitive Strengths [historical, major focus & operations, segments, objectives, forecasts] -Ford started manufacturing revolution, mass production -Controls 33% of Mazda and purchased BMW’s Land Rover SUV ops. Giroux • FINANCIAL STATEMENT ANALYSIS

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-#1 finance company -Owns Hertz -Operating Highlights -Breakthrough Priorities Cases: Case 1.1. Is IBM a direct competitor of Dell? IBM is the world’s largest provider of computer hardware, everything from notebooks to mainframes and network servers. It’s number two to Microsoft in software and also a major player in peripherals and computer services. About 60% of IBM’s sales are outside the U.S. IBM PC sales (part of IBM’s personal systems division) represent a 4% market share, up 1.1% from 1999. IBM is shifting to internet sales. An operating summary from IBM’s 2000 segment reporting note (in millions) is:

Revenue Pre-tax income Total assets

Personal Systems Segment $16,250 -148 2,442

Total Segments $96,370 10,891 69,263

Is IBM a direct competitor to Dell? Yes or no and explain. For more information see www.ibm.com and www.dell.com. The answer is yes & no. That is, either position can be supported. PCs are a small part of IBM’s operations (and not very successful), but still market share in this area. Dell must compete against IBM & all other manufacturers that have PCs as part of their operations. On the other hand, PCs are a minor consideration for IBM. [Note: particularly important numbers are in bold. Usually, these suggest “bad news”.] Ethics Considerations. Many industries are associated with specific public policy issues. Tobacco companies produce products that cause health problems and the companies have been sued by governments and individuals for billions. Chemical companies produce some dangerous chemicals, some that cause environmental damage. Perhaps the most significant problem is chemical dumping in water and land sites. Environmental Protection Agency damage assessments, lawsuits, and regulatory fines have cost the chemical industry hundreds of millions of dollars. Other industries have various public policy problems. Autos cause pollution and are subject to fuel mileage and safety issue, utilities are air polluters, pharmaceutical companies produce drugs with unexpected side effects. a. These are industry problems important to analysts. What should be the major focus? The specific public policy issues involved? Or should the focus be exclusively on the potential for damages that reduce earnings? b. Take the position of a specific user, either potential creditor or equity investor. Does this perspective change your answer from (a) above? a.

The importance of ethics & public policy issues is up to the analyst. Some

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investors stay away from what they consider “unethical” industries or practices (supported on ethics or performance grounds), while others only look at the potential for returns. This answer will vary, but perhaps half will say that there is no difference.

Internet Projects Project 1.1. Pick a company for a Corporate Overview and Business Strategy. Use the company’s annual report, Hoover’s Company Capsule (www.hoovers.com), Fortune’s Fortune 500 industry (www.fortune.com) and other sources to write a one page Corporate Overview for this company (one paragraph on the industry & one paragraph on the business strategy).

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Chapter 2. The Financial Environment Questions 1. What is a capital market? What’s the difference between a primary and secondary market? 2. What is the mission of the SEC? The FASB? 3. Why would managers have different financial disclosure objectives than stockholders? 4. Finance theory has been important in evaluating capital markets, especially related to stock prices and investment strategies? Why? Consider portfolio theory, efficient markets and β analysis. 5. What is efficient contracting? What is its relationship to agency cost? 1 Capital Markets are the Source of long and short-term financing for companies, governments, and individuals. Commercial banks, investment banks, stock and bond market. Primary Markets carry first-issue stock (IPO) and bonds. Secondary Markets facilitate buying and selling of already issued bonds and stocks. 2 SEC Mission: “The primary mission…is to protect investors and maintain the integrity of the security markets.” The FASB was created to promulgate accounting standards. 3 Managers are expected to run a corporation in the best interest of its stockholders on the long-term. However, they may be focused on the short term. Managers may use “creative accounting” to accomplish “Earnings Management” which manipulates accounting figures to be more favorable from an operating perspective. 4 Financial Theory is an analysis of past realities to predict future market performance. It provides a guide to maximizing future long-term gains. Equity Capital markets, for example, are assumed to be efficient, which means that the current stock price relies on information which is quickly achieved by the public and is unbiased (managers and investors alike). Earnings Surprise is used to calculate the difference between future actual performance and future expected performance based on historical data. Portfolio Theory insists that investment portfolios should be diversified, so that if one industry busts, other industries will average out less of a loss. This is most effective for long term planning as large gains in an industry will also be averaged to a lower total portfolio gain. Nevertheless, it is conservative. Diversifying with a Beta greater than 1 (high risk) allows investors to limit the high risk between industries. Beta is derived from an equation of market risk. By definition, Beta of 1 is average market risk, Beta less than 1 is lower risk and Beta greater than 1 is higher-than-market risk. 5 Transaction costs are contracting costs and transactions are optimized through efficient contracting (writing contracts to accomplish something with minimum transaction and agency costs). Includes drafting, negotiating, safeguarding a contract, costs of governance structures, and agency costs. Agency Costs are:

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1. Information asymmetries (limited or misinformed information by one side) 2. Adverse Selection 3. Moral Hazard

Problems Problem 2.1. Where would the following information be found? MD&A Next Year’s Expected Operating Performance Business Strategy Retained Earnings Derivatives Gross Profit Projected Benefits Obligation Operating Leases Company’s ß Contingencies Stock Price Trends, Last 12 Months Other Comprehensive Income Analysts’ Forecasts Number of Common Shares Outstanding

Financial Statements

Notes

Market Analysis

X X X X X

X X X X

X X

Problem 2.2. Earnings Expectations and Surprise (PC Companies). The following table relates to quarterly earnings for three companies: Quarterly

Quarterly

Change in

Earnings

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Earnings, Last Period

Earnings, Earnings, Actual Current Current Quarterly Period Period Earnings (Analysts (Actual) ($) Forecasts) Dell $0.16 $0.17 $0.17 $.01 Gateway 0.02 -0.19 -0.20 $(.22) Apple 0.11 0.10 0.11 $0 Current quarter for Dell 1/02; 3/02 for all other companies

Surprise, in $ (Actual – Forecast) $0 $(.1) $.1

Earnings Surprise (Actual – Forecast) / Forecast 0% (5.3)% 10%

Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Problem 2.3. Earnings Expectations and Surprise (Chemical Companies). The following table relates to quarterly earnings for three companies: Quarterly Earnings, Last Period

Quarterly Quarterly Earnings, Earnings, Current Current Period Period (Analysts (Actual) Forecasts) Du Pont $0.12 $0.56 $0.55 Dow -0.01 0.07 0.07 PPG 0.49 0.52 0.58 Current quarter 3/02 for all companies

Change in Actual Quarterly Earnings ($)

Earnings Surprise, in $ (Actual – Forecast)

$.43 $.08 $.09

$.01 $0 $.06

% Earnings Surprise (Actual – Forecast) / Forecast (1.8)% 0% 11.5%

Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Problem 2.4. Earnings Expectations and Surprise (Hotel & Resort Companies). The following table relates to quarterly earnings for three companies: Quarterly Earnings, Last Period

Quarterly Quarterly Change in Earnings, Earnings, Actual Current Current Quarterly Period Period Earnings (Analysts (Actual) ($) Forecasts) Hilton $0.01 $0.05 $0.09 $.08 Marriott 0.25 0.27 0.32 $.07 Mandalay -0.10 0.68 0.71 $.81 Current quarter 3/02 for Hilton & Marriott, 40/02 for Mandalay

Earnings Surprise, in $ (Actual – Forecast) $.04 $.05 $.03

% Earnings Surprise (Actual – Forecast) / Forecast 80% 18.5% 4.4%

Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Giroux • FINANCIAL STATEMENT ANALYSIS

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Problem 2.5. Earnings Expectations and Surprise (Motor Vehicles Companies). The following table relates to quarterly earnings for Ford and GM: Quarterly Earnings, Last Period

Quarterly Quarterly Earnings, Earnings, Current Current Period Period (Analysts (Actual) Forecasts) Ford $-0.48 $-0.14 $-0.06 GM 0.60 1.09 1.29 Current quarter 3/02 for both companies.

Change in Actual Quarterly Earnings ($)

Earnings Surprise, in $ (Actual – Forecast)

$.42 $.69

$.08 $.2

% Earnings Surprise (Actual – Forecast) / Forecast 57.1% 18.3%

Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Problem 2.6. Beta and Growth Analysis for the Chemical Industry. Given below are the βs and five-year earnings growth forecasts:

Du Pont Dow PPG

β Portfolio

.73 .76 .83

Low Risk Low Risk Low Risk

5-Year Earnings Growth 11.0% 10.0 8.0

5-Year Growth Portfolio Average Low Low

Assume that the average risk portfolio has βs between .9 and 1.1 and earnings growth between 11%-14%. Low risk portfolios would be lower and high risk higher. Classify the companies in the correct portfolio for each indicator. Do the two measurements indicate the same portfolio for each company or are the signals mixed? Explain. Problem 2.7. Beta and Growth Analysis for the Hotel and Resort Industry. Given below are the βs and five-year earnings growth forecasts:

Hilton Marriott Mandalay

β Portfolio

.72 .93 .92

Low Average Average

5-Year Earnings Growth 13.9% 14.4 13.6

5-Year Growth Portfolio Average High Average

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Problem 2.8. Beta and Growth Analysis. Given below are several Dow Jones Industrial companies, with industries, βs, and projected 5-year earnings growth (www.quicken.com). Assume that an average risk portfolio has companies with ßs between 0.9 and 1.1. Company 3M Johnson & Johnson Boeing Disney McDonalds Caterpillar AT&T IBM Walmart

Industry Conglomerate Pharmaceuticals Aerospace Entertainment Restaurant Machinery Long Distance Computers Discount

Β .59 .80 .83 .88 .92 .94 1.09 1.10 1.18

5 Year Growth 11.1 13.0 16.4 14.8 12.5 10.3 12.8 13.4 14.4

Classify these companies into an investment portfolio based on β: (1) low risk or low ß, (2) average (market) risk, and (3) high risk or high ß. Presumably risk levels should relate to industry and earnings growth rates. On average the S&P 500 companies are expected to grow 12.8% annually over the next five years (the “average” portfolio is expected to have securities with five year average growth rates of 11%-14%). Assuming this is true, which companies seem to be misclassified based on projected 5-year earnings growth rates. [Note: neither β nor projected earnings is necessarily very accurate.] Company

3M Johnson & Johnson Boeing Disney McDonalds Caterpillar AT&T IBM Walmart

Which Portfolio (based on ß)? Low Low

Misclassified (relative to 5 year growth rate)? Yes Yes

Low Low Average Average Average Average High

Yes Yes No Yes No No No

Explain 5-year growth is: Average Average High Average Low

Cases Case 2.1. Dell’s 10-K is attached. Where can Dell’s competitors Gateway and Apple financial statements be found? How can Dell’s accounting policies be compared with other PC companies? The annual reports can be found on the company web sites, the SEC’s EDGAR system Giroux • FINANCIAL STATEMENT ANALYSIS

SOLUTIONS MANUAL • CHAPTER 2  17

or other sources such as lexis/nexis. Policies can be analyzed from various sources that include MD&A, accounting policies (Note 1 in the 10-K), and other sources. Case 2.2. Are financial economists nuts? Peter Lynch makes the following statement in One Up on Wall Street (1989): “I also found it difficult to integrate the efficient-market hypothesis (that everything in the stock market is ‘known’ and prices are always ‘rational’) with the random-walk hypothesis (that the ups and downs of the market are irrational and entirely unpredictable).” What’s wrong with this statement? Lynch has no use for academic finance—after all he substantially outperformed the market for years with his Fidelity Magellan Fund. His definitions are not correctly stated (at least according to academics) and both random walk & efficient markets can both be correct. Note that the meaning of efficient markets is debated in the academic profession. Case 2.3. Stock price response to earnings announcement. NCR reported quarterly earnings on July 25, 2002 of $0.34 (up from $0.04 the previous quarter). Analysts expected $0.34 for the quarter. Is the “earnings surprise” good news or bad news? On July 26, NCR’s stock price dropped2.27 to 23.75. Was this expected? Why? The earnings surprise was 0; that is EPS was right on target based on analyst’s forecasts. Therefore, the price drop was unexpected. Ethic Considerations. Earnings management and earnings manipulation. Corporation are expected to use earnings management to promote their self interest. At some point, accounting and reporting adjustments severely misstate the financial position and performance of the firm. This is commonly called earnings manipulation. Can the distinction be made between earnings management and earnings manipulation in most cases? Explain. Earnings manipulation can be considered an extreme case of earnings manipulation. That is, earnings management is expected, but manipulation (which can be considered unethical) is not. Analyst’s try to “see through” earnings management, but this is even more difficult when earnings manipulation is present. Internet Projects Project 2.1. Go to Project Updates on the FASB web site and pick a project. Use the staff summary to analyze the project description, objectives, and issues in one page or less.

Giroux • FINANCIAL STATEMENT ANALYSIS

Chapter 3. The Financial Statements Questions 1. What are the ten financial statement elements and why are they integral to accounting analysis? 2. The balance sheet also is called the statement of financial position. Why are both terms correct? 3. Does the definition of assets by SFAS No. 5 fit for assets actually presented in the balance sheet? Explain. 4. What is the relationship between liabilities and equity? 5. What are the basic components of income? What is the bottom line? 6. How is the statement of cash flows useful for understanding both liquidity and performance? 7. How is comprehensive income presented on the financial statements? 1 Assets, Liabilities, Equity, Investments by Owners, Distribution to Owners, comprehensive Income, Revenues, Expenses, Gains, and Losses are all elements of the financial statement. These elements make up the basic structure of a company and are assumed to be accurate for financial analysis purposes. 2 The balance sheet shows the financial position of a company at a particular point in time. It demonstrates how Assets (what the company has) equals Liabilities (what the company borrowed) plus Equity (what the company earned). 3 Thee is a poor match between SFAS no. 5 Assets and the assets actually placed on the balance sheet. SFAS No. 5 states that assets should be recorded at current or market value. Many assets, however, such as Plant Property, and Equipment are recorded at Historical Value and reduced to current estimated value through an adjunct account “Accumulated Depreciation,” which is based on the company’s choice of depreciation method. Patents and Research & Development, which have “probable future economic benefit” are not even shown on the balance sheet. 4 Liabilities and Equity are the source of funding for the Assets of a company. Liabilities describe future economic sacrifices (or debt) and Equity represents the amount of the corporation’s Assets the owners are part of through earned income and stock. 5 Components of Net Income: Sales and Other Revenues Less: cost of goods sold. Less Service Costs Less Operating Expenses 6 Since Cash is the most liquid asset, the Statement of Cash Flow is used to track a company’s inflows and outflows of cash in Operating, Financing, and Investing activities. 7 Comprehensive Income is stated as a component of owner’s equity.

SOLUTIONS MANUAL • CHAPTER 3  19

Problems Problem 3.1. Assets of Du Pont. Below is the asset section of the balance sheet of Du Pont for fiscal year 2001. 7 December 31 2001 2000 ----------------ASSETS CURRENT ASSETS Cash and cash equivalents Marketable debt securities Accounts and notes receivable (Note 13) Inventories (Note 14) Prepaid expenses Deferred income taxes (Note 9) Total current assets PROPERTY, PLANT AND EQUIPMENT (Note 15) Less: Accumulated depreciation Net property, plant and equipment

$ 5,763 85 3,903 4,215 217 618 -------14,801 -------33,778 20,491 -------13,287 --------

$ 1,540 77 4,552 4,658 228 601 -------11,656 -------34,650 20,468 -------14,182 --------

GOODWILL AND OTHER INTANGIBLE ASSETS (Note 16) INVESTMENT IN AFFILIATES (Note 17) OTHER ASSETS (Notes 9 and 18)

6,897 8,365 2,045 2,206 3,289 3,017 --------------TOTAL $ 40,319 $ 39,426 ======== ======== This financial statement is much more complicated than that of Dell. Why? What additional items are here, but not on the Dell balance sheet? Various items refer to specific notes. What does this mean and why is it important? Is Du Pont a bigger company than Dell, based on assets? This financial statement discloses more details than the Dell financial sheet. Included are Prepaid and Deferred Income Tax disclosures. In addition, PPE is presented at its historical value and reduced on the balance sheet by Accumulated Depreciation. The references to notes identify that more details are available on the particular asset. Based on assets, Du Pont is a larger company. Problem 3.2. Preferred stock at Du Pont. The balance sheet of Du Pont includes the following: STOCKHOLDERS' EQUITY

Giroux • FINANCIAL STATEMENT ANALYSIS

SOLUTIONS MANUAL • CHAPTER 3  20

Preferred stock, without par value - cumulative; 23,000,000 shares authorized; issued at December 31: $4.50 Series - 1,672,594 shares (callable at $120) $ 167 $ 167 $3.50 Series - 700,000 shares (callable at $102) 70 70 Common stock, $.30 par value; 1,800,000,000 shares authorized; Issued at December 31, 2001 - 1,088,994,789; 2000 - 1,129,973,354 327 339 Additional paid-in capital $ 7,371 $7,659 Du Pont has preferred stock. Is this different than common stock? Explain. Are the amounts of preferred stock material in terms of total paid-in capital. Explain. Preferred Stock is stock which receives preference on dividend distribution. A liability is created if yearly dividends are not paid on Preferred Stock, whereas Common Stock does not ensure yearly dividends to the holders. The amount of preferred stock are material in terms of Paid in Capital in that there is as much Preferred Stock in the corporation as there is Common Stock. Problem 3.3. Revenue and operating expenses for Hilton Hotels. Below is abbreviated information from Hilton’s income statement: 2001 Revenue Owned hotels $1,813 Leased hotels 26 Management & franchise fees 120 Other fees & income 191 2,150 Expenses Owned hotels 1,196 Leased hotels 26 Depreciation & amortization 187 Other operating expenses 173 Corporate expenses, net 73 1,655 Operating Income

$ 495

Hilton is a service company, not manufacturing. The format for revenue and operating expenses is much different than Dell. Why? What are the primary differences? Dell as a manufacturing company focuses on sales and cost of goods sold. Hilton as a service company focuses on major service categories such as revenues from owned hotels. Some expenses categories also are related to revenue categories.

Problem 3.4. Cash flows from operations for Du Pont. CFO from operations for 2001 is presented below. Unlike Dell, CFO is considerably less than net income. Why?

Giroux • FINANCIAL STATEMENT ANALYSIS

SOLUTIONS MANUAL • CHAPTER 3  21

CASH PROVIDED BY CONTINUING OPERATIONS Net income $ 4,339 Adjustments to reconcile net income to cash provided by continuing operations: Cumulative effect of a change in accounting principle (Note 11) (11) Depreciation 1,320 Amortization of goodwill and other intangible assets 434 Gain on sale of DuPont Pharmaceuticals (Note 7) (6,136) Other noncash charges and credits – Accounts and notes receivable Inventories and other operating assets Increase (decrease) in operating liabilities: Accounts payable and other operating liabilities interest and income taxes (Notes 4 and 9) Cash provided by continuing operations

435 (362) (634)

Accrued

2,069 $ 2,419

Primarily, the sale of the Pharmaceuticals division created a large gain which leads to less Cash Flow represented by Net Income. This is a large reduction. Inventory and A/P maneuvers also affected the firm’s Cash Flow, making it lesser than Net Income. Cases Case 3.1. Income statement items for General Electric (GE). GE is a conglomerate and on some dimensions the largest company in the U.S. Below are 2001 income statement items: REVENUES Sales of goods Sales of services Other income (note 2) GECS revenues from services (note 3) Total revenues

$ 52,677 18,722 234 54,280 ----------125,913 ----------

COSTS AND EXPENSES (note 4) Cost of goods sold 35,678 Cost of services sold 13,419 Interest and other financial charges 11,062 Insurance losses and policyholder and annuity benefits 15,062 Provision for losses on financing receivables (note 13) 2,481 Other costs and expenses 28,162 ------------Total costs and expenses 106,212 EARNINGS BEFORE INCOME TAXES AND ACCOUNTING CHANGES

$ 19,701

Giroux • FINANCIAL STATEMENT ANALYSIS

SOLUTIONS MANUAL • CHAPTER 3  22

GE has both manufacturing and service subsidiaries. In addition, much of its operations involve the large financing operation, General Electric Capital Services (GECS). How it this reflected on the income statement? Compare GE to Dell. GE is more complicated than Dell, since it is a conglomerate with manufacturing, service and finance operations. Each of these is represented on the Income Statement, with detailed information in the Notes. Since each category requires a somewhat different analysis, GE is relatively more difficult to analyze than Dell.

Ethics Considerations. So What Happened to Corporate Ethics? This was a question poised in a recent Business Week article (J. Byrne, “Restoring Trust in Corporate America,” June 24). Their analysis: The root of the deterioration dates back 20 years, to the start of an unprecedented Era of prosperity that transformed CEOs into cult heroes. From a time when many feared the U.S. would be overwhelmed by a super-efficient Japan, America’s business leaders helped to make the U.S. the world’s most productive economy. A return to business basics, along with a flowering of innovation and entrepreneurship, led to a celebration of corporate chieftains. Capital freely flowed into a financial system based on trust, stability, transparency, and the assurance that checks and balances made the stock exchanges a marketplace for every player. Nobody got fatter during the boom than the newly invincible CEOs, who were increasingly compensated with massive stock-option grants. That meant their success— and take-home pay—became directly related to how high they could nudge their stock price. Indeed, the great paradox of the so-called “shareholder revolution” of the past two decades is that CEOs gained exponentially in power, influence, and certainly pay. Pressures from institutional shareholders unwittingly led to massive transfers of wealth from investors to senior executives, all under the guise of lining up management’s interests with those of shareholders. a. Evaluate this perspective on corporate ethics. b. If this perspective is correct, it suggests that traditional management incentives are a major component of the problem. Do you agree? If so, what can be done about it? This analysis represents an interesting historical perspective on why current financial scandals exist. Scandals are recurring events, but scandals differ somewhat from period to period and this is a partial explanation to the current debacle. a. Opportunism is always a potential problem, but the incentives of managers and others and this analysis gives a useful perspective on current scandals. b. Yes [a not answer will differ]. Potential answers include new regulations such as the Sarbanes-Oxley Act, more scrutiny at the SEC, more prosecutions at the justice department, and perhaps reforms of auditing, investment banking, etc.

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SOLUTIONS MANUAL • CHAPTER 3  23

Internet Projects Internet Project 3.1. Company annual reports can be found at the company web sites and the 10-K at Lexis/Nexis. Download the financial statements of one company and evaluate the financial statements. How do they compare to Dell?

Giroux • FINANCIAL STATEMENT ANALYSIS

4. Quantitative Financial Analysis Using Financial Statement Information Questions 1. Why is a systematic quantitative perspective important for financial analysis? 2. How is standardization achieved in the quantitative process? Why is this important? 3. After a set of ratios is calculated for a company, how can they be analyzed? When is a ratio “good” or “bad”? 4. For each of these financial ratio categories (liquidity, leverage, activity, performance), describe the purpose of analysis and list at least three useful ratios. 5. What is the Du Pont Model and why is it important? 6. Give examples of ratio analysis limitations. 1 There is an immense amount of financial data on statements, in order to act on this data, synthesis is necessary as well as a breakdown of key components. Quantitative systematic processes make this job easier. 2 In the quantitative process, results are presented as ratios (percentages) in order to compensate for relative size differences in companies. 3 Once calculated, ratios should be analyzed for time-trends and in comparison to other companies within and without the industry. A ratio is “good” or “bad” based on the measurement. A good ratio indicates that items such as Net Income, revenues, assets, etc. are increasing due to proper management. 4 Liquidity-tests to see whether the company has the cash and other current assets to pay liabilities as they come due. 1. Current Ratio 2. Quick Ratio 3. Cash Ratio 4. Operating Cash Flow Ratio Leverage-considers the capital structure of the firm (debt/equity) and evaluates relative risks and returns on liability and equity. 1. Debt to Equity 2. Debt 3. Interest Coverage 4. Long Term Debt to Equity 5. Debt to Market Equity Activity-Measures efficiency. 1. Inventory Turnover 2. Receivables Turnover 3. Payables Turnover 4. Working Capital Turnover 5. Fixed Asset Turnover 6. Total Asset Turnover Performance-profitability 1. Gross Margin

Giroux • FINANCIAL STATEMENT ANALYSIS