Question 1
2. In October 2012, Builtwell Construction Company executives were working on their budget for 2013. Builtwell expects to have the following book value capital structure on December 31, 2012: Debt $12,000,000 Preferred stock (25,000 shares) $ 2,500,000 Common stock (1,000,000 shares) $ 5,000,000 Retained earnings $10,000,000 Total capital $29,500,000 Earnings per share have grown steadily over the past seven years, from $1.65 in 2005 to $3.00 projected for 2012. The investment community expects growth to continue but at a slower rate; the average past growth rate of 9 percent has recently dropped to 5 percent, and it is expected to remain constant at this level. Based on a 5 percent growth rate, the stock now sells at a price/earnings (P/E) ratio of 6x (note, P = EPS x P/E). The last dividend, D0, was $1.88; it is expected to increase at the new 5 percent growth rate. Builtwell's preferred stock, which was issued several years ago, has a book value of $100 per share, and it pays a dividend of $9. The yield currently on preferred stock of this degree of risk is 11.25 percent. The debt consists of $12,000,000 of $1,000 par, 20-year bonds with a 7 percent coupon, payable semiannually. These bonds were issued 7 years ago, and hence have 13 years remaining to maturity. The yield-to-maturity for these bonds is currently 9.227 percent. The corporate tax rate, including state income taxes, is 40 percent. a. What is the weighted average cost of capital based on book value capital structures? b. What is the weighted average cost of capital based on market capital structures?
Question 2
2-48 CVP and Financial Statements for a Mega-Brand Company Procter & Gamble Company is a Cincinnati-based company that produces household products under brand names such as Gillette, Bounty, Crest, Folgers, and Tide. The company?s 2006 income statement showed the following (in millions): Net sales $68,222 Costs of products sold 33,125 Selling, general, and administrative expense 21,848 Operating income $13,249 Suppose that the cost of products sold is the only variable cost; selling, general, and administrative expenses are fixed with respect to sales. Assume that Procter & Gamble had a 10% increase in sales in 2007 and that there was no change in costs except for increases associated with the higher volume of sales. Compute the predicted 2007 operating income for Procter & Gamble and its percentage increase. Explain why the percentage increase in income differs from the percentage increase in sales.,thank you i have two more questions too,2-61 CVP in a Modern Manufacturing Environment A division of Hewlett-Packard Company changed its production operations from one where a large labor force assembled electronic components to an automated production facility dominated by computer-controlled robots. The change was necessary because of fierce competitive pressures. Improvements in quality, reliability, and flexibility of production schedules were necessary just to match the competition. As a result of the change, variable costs fell and fixed costs increased, as shown in the following assumed budgets: Old Production Operation New Production Operation Unit variable cost Material $ .88 $ .88 Labor 1.22 .22 Total per unit $ 2.10 $ 1.10 Monthly fixed costs Rent and depreciation $450,000 $ 875,000 Supervisory labor 80,000 175,000 Other 50,000 90,000 Total per month $580,000 $1,140,000 Expected volume is 600,000 units per month, with each unit selling for $3.10. Capacity is 800,000 units. 1. Compute the budgeted profit at the expected volume of 600,000 units under both the old and the new production environments. 2. Compute the budgeted break-even point under both the old and the new production environments. 3. Discuss the effect on profits if volume falls to 500,000 units under both the old and the new production environments. 4. Discuss the effect on profits if volume increases to 700,000 units under both the old and the new production environments. 5. Comment on the riskiness of the new operation versus the old operation.
Question 3
On August 25, 1995, Warren Buffett, the CEO of Berkshire Hathaway, announced that his firm would acquire the 49.5 percent of GEICO Corporation that it did not already own. The $2.3 billion deal would give GEICO shareholders $70.00 per share, up from $55.75 per share market price before the announcement. Observers were astonished at the 26 percent premium that Berkshire Hathaway would pay, particularly since Buffett proposed to change nothing about GEICO, and there were no apparent synergies in the combination of the two firms. At the announcement, Berkshire Hathaway?s shares closed up 2.4 percent for the day, for a gain in market value of $718 million. That day, the S&P500 Index closed up 0.5 percent. Conventional academic and practitioner thinking held that the more risk one took, the more one should be paid. Thus, discount rate used in determining intrinsic values should be determined by the risk of the cash flows being valued. The conventional model for estimating discount rates was the Capital Asset Pricing Model (CAPM) which added a premium to the long-term risk-free rate of return (such as the U.S. Treasury bond yield). Buffett departed from conventional thinking, by using the rate of return on the long-term (e.g., 30-year) U.S. Treasury bond to discount cash flows. Defending this practice, Buffett argued that he avoided risk, and therefore should use a ?risk-free? discount rate. His firm used almost no debt financing. Some analysts sought to test the suitability of Buffett?s $70 per share offer for GEICO using the discounted cash flow approach. Analysts used the Capital Asset Pricing model to estimate GEICO?s cost of equity. Value Line estimated GEICO?s beta at 0.75. The equity market risk premium was about 5.5%. And the risk free rate estimated by the yield on the 30 year U.S. Treasury bond was 6.86%. On July 7, 1995, Value Line Investment Survey published a forecast of GEICO?s dividends and future stock price within a range of possible outcomes: Value Line Forecast Information Low End of Range High End of Range Forecasted Dividends 1996 $1.16 $1.16 1997 $1.25 $1.34 1998 $1.34 $1.55 1999 $1.44 $1.79 2000 $1.55 $2.07 Forecasted Stock Price in 2000 $90.00 $125.00 Conclusion Conventional thinking held that it would be difficult for Warren Buffett to maintain his record of 28 percent annual growth in shareholder wealth. Buffett acknowledged that ?A fat wallet is the enemy of superior investment results.? He stated that it was the firm?s goal to meet a 15 percent annual growth rate in intrinsic value. Would the GEICO acquisition serve the long-term goals of Berkshire Hathaway? Was the bid price appropriate? Questions a) If you believe in Buffett?s investment philosophy, what would be the appropriate discount rate to use in your analysis? b) If instead, you believe in the CAPM, what would be the appropriate discount rate to use? c) Based on Value Line?s forecast was Buffett?s offer of $70 per share for GEICO, justified? Support your answer based on your assumptions and calculations.
Question 4
You are the Senior Accountant for the Patty Corporation which has several divisions. They each keep their own accounting books and have chosen the appropriate method of revenue recognition based on their operations. Pat's Electronics Division Pat's Electronics Division sells computers through agents in various cities. Agents send orders and down payments to our company. The division then ships the goods F.O.B. shipping point directly to the customers. Revenue is recognized at the point of sale. Additional Financial Data: Orders for fiscal year 2012 $ 3,000,000 Down Payments collected in 2012 $ 300,000 Billed and shipped in 2012 $ 2,400,000 Freight billed in 2012 $ 70,000 Commissions paid to Agents (after ship to customer) 10% Warranty Returns as % of Sales 1% Pickle Construction Division The Pickle construction division was working on one project for the 2012 fiscal year. They use the percentage of completion revenue recognition method. Contract for new administration building Total Contract Amount $ 60,000,000 Contract Grant Date August 14, 2012 Construction Began September 1, 2012 Estimated Cost to Complete at beginning of contract $ 52,000,000 Estimated Time to Complete Project 2 years As of Dec 31, 2012 Construction Costs incurred to date $ 14,140,000 Billings to date $ 19,500,000 Expected costs to complete $ 36,360,000 Peace Book Distribution Division Our book distribution division sells to national bookstores. Our division allows for up to 25% of sales in returns. For the past 4 years, returns have averaged 20%. We record revenue based on revenue recognition when the right of return exists. Total Sales for 2012 Sales Still Available for return for six months Actual Returns on Sales not returnable 2011 Sales collected in 2012 2011 Sales returned in 2012 Required: (a) We have studied several methods of revenue recognition. Define and describe each of the following methods of revenue recognition, and indicate whether each is in accordance with generally accepted accounting principles. - Point of sale. - Completion-of-production. - Percentage-of-completion. - Installment-sales. (b) Calculate the revenue to be recognized in fiscal year 2012 for each division of Patty Corporation in accordance with generally accepted accounting principles. Show all calculations for full credit.
Question 5
Shareholder Value Analysis (SVA) is one member of the family of techniques for determining the market value of a firm based on the drivers of its projected cash flows. Other cash-based techniques include Cash Flow Return on Investment (CFROI) and Total Shareholder Return (TSR). SVA is superior to other techniques because valuations are derived from explicitly identified or postulated drivers of value in a strategic framework. SVA starts with fundamental financial theory: the value of an asset is the net present value of its cash flows over the life of the asset. In SVA, the firm is the asset to be valued. One identifies or postulates the drivers of firm cash flows over the life of the firm and integrates the drivers into a model, which generates the estimated free cash flows on a year-by-year basis. Let's look at the drivers of cash/value. Sales growth rate: Everything else being constant, the higher the sales growth rate, the greater the projected cash flows. Operating profit margin: The higher the profit margin (sales - cash operating expenses), the greater the cash flows. Tax rate: The higher the tax rate, the lower the after tax net cash flow. Working capital investment: Increased sales require greater investments in working capital (inventories, cash, receivables, offset by simultaneous financing provided by accounts payable and accruals), which decrease cash flows accordingly. New fixed capital investment: An expansion (growth in sales) of the business requires a larger base of fixed capital investments, which will decrease cash flows. This is equivalent to total projected capital investment for the year less depreciation. Competitive advantage period: In a perfectly competitive market there are no superior profits to be had, given that all firms must price at marginal cost if they want to make sales. However, by making use of technology, positioning oneself in emerging or high growth industries, through superior customer service/relationship management and by developing a differentiated or niche product, firms will be able to set prices above marginal costs. Firms strive to achieve competitive advantage and thus the flexibility to sell at higher prices and realize higher profit margins. The more a firm is able to exploit a competitive advantage and maintain it over time, the more successful it will be and the higher its cash flows. The competitive advantage period affects the estimate of the sales growth rate and the cash profit margin over time. For example, an analysis of Microsoft's core competencies and its ability to develop and maintain competitive advantage over time could provide the basis estimation g at 20% per year for the next five years, 15% per year for years 6-10 and then leveling out after year 10. The cash profit margin would reflect the loss of superior competitive advantage over time accordingly, perhaps being estimated at 35% for years 1-5, 25% for years 6-10 and 10% after year 10. The greater the competitive advantage, the greater the cash flows and the calculated shareholder value. Cost of capital: The cost of capital represents the expectations of stakeholders (stock and bondholders). When the firm earns more on its assets than expected/required by stakeholders, value is created for shareholders. The management actions taken by the firm have an effect on the firm's cost of capital and, the lower the cost of capital, the greater the (net present) value of the firm. Management would be able to decrease the firm's cost of capital and create shareholder value by financing the firm's capital structure with the optimal proportion of debt and by identifying ways to decrease the systematic risk of the firm's investments. Model: Firm Value = PV free cash flows over the forecast period + residual value beyond the forecast period + firm's marketable securities. 1. PV free cash flows over the forecast (competitive advantage) period = Base sales * sales growth * cash profit margin * after-tax cash income rate - new capital investment - incremental working capital investment to support increased sales, over the period that the company is projected to maintain a competitive advantage. Expected cash flows are calculated for each year of the forecast (competitive advantage) period and discounted by the cost of capital. In the Microsoft example above, the forecast (competitive advantage) period of cash flows would be years 1-5 and years 6-10. 2. Residual value after the forecast (competitive advantage) period has expired and the firm's sales and earnings level out: The residual value is the present value of cash flows after expiration of competitive advantage. After some period, the ability of the firm to earn profits greater than the normal economy-wide risk-adjusted return on capital may dissipate. For example, competitors may enter the market and provide work-alike or superior products, or patents might expire. Should this point be reached, no incremental capital investments or additional investments in working capital are required; only maintenance-level investments are required. The expected cash flows are the same each year after the competitive advantage period, or perpetuity. The present value of a perpetuity, you will recall, is just the expected cash flow divided by the discount rate/cost of capital for a no growth perpetuity, or by the cost of capital less the constant growth rate for a growth perpetuity. 3. The firm's marketable securities: We add marketable securities because 1 and 2 above represent the value generated by investments in the business. Marketable securities guarantee liquidity in contingencies and are not considered an investment in the firm's income generating assets. Work through the model to understand the relationships among the value drivers and how the model is used to derive the estimate for firm value. The model provides flexibility by allowing the analyst to 'tweak' the driver values to fit the specific situation for the firm being analyzed. If we want to derive the value of equity, we can simply subtract the market value of the firm's debt from Firm Value, which is the sum of 1, 2, and 3 above (Equity value = Firm Value - Debt). We can then compare the 'fair value' of equity we derived using SVA with the market value equity (# shares outstanding * price per share) to obtain an indication of whether the firm is under- or over-valued. The use of the Shareholder Value Added (SVA) methodology developed by Rappaport extends far beyond a technique for estimating the value of the firm. It is the integration of SVA valuation methodology into a strategic context that makes it especially useful to managers. SVA can be used to evaluate strategic alternatives: Which ones add value? What can be done to create value? How can we extend the competitive advantage period and keep profit margins high? The same answers we arrive at in building a world class strategic plan are the same ones supporting the creation of shareholder wealth in the SVA model. Do the following SVA Exercise: The following information is given: Baseline (last year) sales: $250 million Sales growth rates: Base year = 15% with a fade rate of 1% a year for years 1-10: (increasing sales due to sustained competitive advantage and a differentiated product)[source: Strategic Plan]. Fade rate is the rate of decline per year (each year) from a base year. Sales growth rate in year 10 and forward: 5% (in year 11, the competition has caught up and the market has reached maturity) [source: Strategic Plan] Profit margin: Base year = 20%, with a fade rate of 1% a year for years 1-10: (during the period of competitive advantage, the firm can charge higher prices, but its profit margin slowly declines as competition increases) [source: Strategic Plan] Profit margin in year 10 and going forward: 10% [source: Strategic Plan] Fixed capital investment rate: 15% (for every dollar of new sales, we need an additional investment in fixed plant and equipment of $.15) [source: historical relationship] Working capital investment rate: 8% (for every dollar of new sales we need an additional investment in inventories and receivables of $.08) [source: historical relationship] Cash tax rate: 35% [source: historical relationship] Cost of capital: 12% [source: current yield on firm's debt and the cost of equity estimated using the Capital Asset Pricing Model, weighted average based on the target capital structure] Marketable securities: $20 million Market value of firm's debt: $50 million The firm has 5 million shares of common stock outstanding selling at: Scenario 1 = $50/share and Scenario 2 = $70/share. As indicated, the values assigned to drivers link directly to the strategic plan and the associated strategic analysis. In arriving at these estimates strategic alternatives have been evaluated for their value creation potential, with the set of strategies selected that create the most shareholder wealth. A template has been provided as an attachment -- fill in the shaded cells to answer the following four questions: What is the PV of operating cash flows over the competitive advantage period? What is the residual value of the firm after the period of competitive advantage? What is the value of the firm's equity? Compare the market value of equity ($50/share) with the estimate provided by SVA for scenario 1. What recommendations would you make to top management based on your analysis? Now compare the market value of equity ($70/share) with your SVA estimate. What would you recommend now?
