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```									ACCT 6213                              Sample Final Exam                Spring 2012 – Module A
SMU Cox                                200 Points Possible                            Sommers

Name (print):                                Signature:

   By your signature on this cover page, you represent that this exam was completed
without the assistance of others and in accordance with the Cox Honor Code. Evidence
to the contrary will result in forfeiture of all points for this exam.

   The exam will last 170 minutes, budget your time accordingly.

   You are allowed to consult your textbook and notes related to the course in completing your
exam. However, electronics aids (such as computers, PDAs, etc.) other than a basic or
financial calculator are not allowed.

   No questions will be answered during the exam. If you are unsure about the meaning of a
particular question, clearly state any assumptions you are making and answer based on those
assumptions. Make sure you do not contradict information provided in the exam when you
make your assumptions — only plausible assumptions will be considered.

   All companies are December 31 year-end companies and use the accrual basis method of
accounting in accordance with GAAP. All companies close their books only once per year
(at the end of the year). Be sure to note the relevant dates referred to in each question.

   Be sure to show all your work in order to receive partial credit.

Good Luck!!
1. (10 points) Mustang Inc. was traded at \$60 per share at the end of 2011 with a book value per
share of \$40. The analysts also made the following forecasts for Mustang Inc.

2012      2013
Dividends per share         8         4
Book value per share       34        33

Calculate the forecasted premium at the end of 2013 for Mustang Inc. using a cost of equity
capital of 10%.

[(60 * 1.1 – 8) * 1.1 – 4] – 33 = 26.8

or
2012 Net income = End BV – Beg BV + div = 34 – 40 + 8 = 2
2013 Net income = End BV – Beg BV + div = 33 – 34 + 4 = 3

2  0.1 40 3  0.1 34 premium
60  40                                   premium  26.8
1.1          1.12        1.12
2. (12 points) Consider the following balance sheet information:

2011         2010
Operating assets      115,000      90,000
Operating liabilities 50,000       41,000
Common stock           30,000      30,000
Retained earnings      48,000      29,000
Treasury stock         13,000      10,000

The company follows the following financing policy: If the business operations generate
positive cash flows, then the company buys back its own stock; if the cash flows are
negative, then the company sells stock. There are never any interest-incurring debts, regular
cash dividends, or investments in passive marketable securities.

Determine the firm’s free cash flow for 2011.

The change in Treasury stock indicates net transactions with shareholders (that is, d =
\$3,000). There are no financial obligations and no interest expense (that is ΔNFO and
NFE = 0). Hence, FCF = ΔNFO + NFE + d = \$3,000
OR
Change in retained earnings = operating income since there is no financial
expenses/income = \$48,000 - \$29,000 = \$19,000. Change in net operating assets =
(115,000 – 50,000) – (90,000 - 41,000) =16,000. Therefore, FCF = OI – ΔNOA =
\$19,000 – \$16,000 = \$3,000
3. At the end of the fiscal year ending December 31, 2003, Microsoft reported common equity
of \$64.9 billion on its balance sheet, with \$49.0 billion invested in financial assets (in the
form of cash equivalents and short term investments) and no financing debt. For fiscal year
2004, the firm reported \$7.4 billion in comprehensive income, of which \$1.1 billion was
after-tax earnings on the financial assets.

a. (6 points) Calculate Microsoft’s return on common equity (ROCE) for 2004 using a
beginning of year denominator.

ROCE = 7.4/64.9 = 11.40%

Now assume that in January 2004, Microsoft had distributed \$34 billion of financial assets to
shareholders in the form of a special dividend.

b. (12 points) Holding all operations constant what would Microsoft’s ROCE have been
with the payout of the \$34 billion special dividend?

Income statement after payout

OI                   6.30             (As before: 7.4 – 1.1 = 6.3)
NFI (15 × 0.0224)    0.34             (NFA = 49 – 34 = 15)
Comp. income         6.64             (After tax RNFA = 1.1/49 = 0.0224)
CSE = 64.9 – 34.0 = 30.9
ROCE = 6.64/30.9 = 21.49%

Also, with new FLEV of – 0.485 (NFA of 15 / CSE of 30.9),
ROCE = 39.62 + [– 0.485 × (39.62 – 2.24)]
= 21.49%

c. (8 points) Would you expect the payout to increase or decrease earnings growth in
the future? Why?

Increasing leverage always increases expected earnings growth. (See example
about modified forecasts in Week 6 slides.) The payout increases leverage (in this
case, it makes the leverage less negative).

d. (8 points) What effect would you expect the payout to have on the value of a
Microsoft share?

The per-share value of the shares will drop by the amount of the dividend per
share. [Note: if the payout were via a share repurchase, there would be no effect
on per-share value]
4. (9 points) During a lunch with a friend who has just graduated with an MBA from a Big 12
school in Texas your Financial Statement Analysis class comes up. As you discuss with your
firms? We were taught to use them because it is so much quicker and easier.”

Answer should discuss the inherently circularity in using comparables. You assume that
the firm of interest is mispriced and that other firms used as comparables are fairly
priced.

5. (10 points) Buckeye Inc. was traded at \$70.30 per share at the end of 2010 with a book value
per share of \$36.05. The analysts were forecasting that the earnings of 2011 for Buckeye
Inc. would be \$6.78 per share and dividends would be \$1.25 per share. Buckeye Inc.’s cost
of equity capital was 15%.

Calculate the implied residual earnings growth rate for Buckeye Inc.

6.78  0.15 * 36 .05
70 .30  36 .05 
(1.15  g )
g  1.11 or 11%
6. Consider the following data for SimpleCalc Corp:

Market price per share (as at 31 December 2005):                   \$276.79
Book value per share at fiscal year-end (31 December 2005):        \$100.00

Forecasted data per share:
Expected Expected
Year Ended    Earnings Dividends
31 December 2006  \$ 20.00    \$ 1.00
31 December 2007    22.00      1.00
31 December 2008    24.10      1.00
31 December 2009    26.41      1.00

SimpleCalc’s expected cost of equity capital is 10 percent.

a. (12 points) Using the residual income valuation model, calculate the intrinsic value of
a share of the company as at 31 December 2005.
2005     2006    2007    2008      2009
Eps                         20.00 22.00 24.10 26.41
Dps                          1.00     1.00    1.00      1.00
Bps               100.00 119.00 140.00 163.10 188.51
RE                          10.00 10.10 10.10 10.10
PV of RE                     9.09
Total PV of RE      9.09
CV (g=0)                   101.00
PV of CV           91.82
V (12/31/05)      200.91

b. (10 points) Using the abnormal earnings growth valuation model, calculate the
intrinsic value of a share of the company as at 31 December 2005.
2005 2006 2007 2008            2009
Dps                                       1.00 1.00 1.00           1.00
Eps                                      20.00 22.00 24.10        26.41
Dps reinvested                                    0.10 0.10        0.10
Cum-dividend Earnings                           22.10 24.20       26.51
Normal Earnings                                 22.00 24.20       26.51
AEG                                               0.10 0.00        0.00
PV of AEG                                         0.09
Total PV of AEG                           0.09
Total earnings to be capitalized         20.09
V (12/31/05)                      200.91
Question 6 Continued:

c. (5 points) Given the value you calculated above, would your recommendation be to
BUY, to SELL, or to HOLD this stock?

SELL because market price is much greater than intrinsic value

d. (10 points) Reverse engineer the residual income valuation model to determine the
market’s implied expected rate of growth in residual income beyond 2009 assuming
that the forecasts of earnings and dividends for 2006 to 2009 are the market’s
expectations of these pay-offs.

2005     2006     2007     2008      2009
Eps                          20.00    22.00    24.10     26.41
Dps                           1.00     1.00     1.00      1.00
Bps                100.00   119.00   140.00   163.10    188.51
RE                           10.00    10.10    10.10     10.10
PV of RE                      9.09     8.35     7.59      6.90
Total PV of RE      31.92

\$276.79 = 100 + 31.92 + 10.10(g)/(1.1 - g) * 1/1.14

(g-1) = 5%

e. (10 points) What is the market’s implied expected rate of growth in abnormal
earnings growth (that is, G as defined in Penman, Chapter 6) beyond 2010? Assume
that the forecast of earnings and dividends for 2006 to 2009 are the market’s
expectations of these pay-offs.

This will be the same as the residual earnings growth rate, which is 5%. (Note
that if this is not apparent try a numerical exercise where you figure out what the
next few REs would be and then calculate the observed growth.)
Question 6 Continued:

f. (10 points) Determine the expected percentage growth in EPS from 2009 to 2010

RE2010 = 10.10  1.05 = 10.605 = Eps2010 – 0.1  (Bps2009)
Eps2010 = 10.605 + 0.1  (188.51) = 29.456
Eps growth rate = (29.456 / 26.41) – 1 = 11.53%

g. (8 points) What is SimpleCalc’s PEG ratio on 31 December, 2005?

PEG = 276.79/[(22-20)*100]
= 1.384
7. (10 points) A fellow classmate has worked Problem E5.5 on page 190 of the textbook which
states:

A firm with a book value of \$15.60 per share and 100 percent dividend payout is
expected to have a return on common equity of 15 percent per year indefinitely in the
future. Its cost of equity capital is 10 percent.

a. Calculate the intrinsic price-to-book ratio.
b. Suppose this firm announced that it was reducing its payout to 50 percent of
earnings in the future. How would this affect your calculation of the price-to-
book ratio?

The student’s solution for part a. is as follows:
Year        0          1          2        3          4         5
Eps                   2.34       2.34     2.34       2.34      2.34
Dps                   2.34       2.34     2.34       2.34      2.34
Bps       15.60      15.60      15.60    15.60      15.60     15.60
RE                    0.78       0.78     0.78       0.78      0.78

The student’s solution for part b. is as follows:
Year        0          1          2        3          4         5
Eps                  2.340      2.516    2.704      2.907     3.125
Dps                  1.170      1.258    1.352      1.453     1.562
Bps       15.60      16.77      18.03    19.38      20.83     22.40
RE                    0.78       0.84     0.90       0.97      1.04
g                               1.075    1.075      1.075     1.075

The answers in part a. and part b. would definitely lead to different values for the firm and
the P/B ratios would be different. However, this cannot be right since the P/B ratio should
not be affected by dividend policy!

Use a sentence (or two) to explain what your classmate did wrong. (Hint: try to isolate the
assumptions the student made in arriving at the solution for part b.)

The dividends retained in the firm should be earning the cost of equity capital of 10%
instead of the ROCE of 15%. The firm’s ROCE may be inflated due to conservative
accounting. Any new additions would be assumed to earn at the economic rate of 10%
rather than at the artificially inflated accounting rate of 15%.
8. Reformulated historical financial statements of Almost Mattel, Inc. and Subsidiaries for the
year ended December 31, 2008 have been provided. Assume a marginal tax rate of 40%.

a. (10 points) Calculate free cash flow for 2008.

NFE                                                             109,800
NFO
NFO2008                                   735,851
NFO2007                                   920,896               185,045
d
Issuance of treasury stock                  25,189
Stock option exercises, net of tax          21,500
Dividends declared on common stock        (115,090)              68,401
363,246

OI                                                             (381,388)
NOA
NOA2008                                  2,138,949
NOA2007                                  2,883,583              744,634
363,246

b. (10 points) Calculate return on common equity for 2008.

 491,188
 29.19%
1 1,962,687  1,403,098
2

c. (10 points) During the year ended December 31, 2008 the realized market rate of
return was 12.8% on Almost Mattel, Inc. Explain in one or two sentences the reason
for the difference between the market rate of return and the return on common equity.

The negative ROCE is an accounting number. The market presumably already
had adjusted price for the dim outlook prior to the year and therefore the stock
still received a reasonable return on its beginning price.
Question 8 Continued:

d. (10 points) Calculate financial leverage for 2008.

(735 ,851  920 ,896 ) / 2
FLEV 2008                                    0.4922
(1,403 ,098  1,962 ,687 ) / 2

e. (10 points) Management has indicated that it expects return on common equity to be
15% in 2009. Assume leverage will remain unchanged from 2008 levels and that net
borrowing cost is expected to be 10% in 2009. What is the implied return on net
operating assets expected by management? Do you think this is attainable and why?

ROCE2009  RNOA2009  FLEV2008 RNOA2009  NBC2009 
0.15  RNOA2009  0.4922RNOA2009  0.10
RNOA2009  13.35%

Probably not attainable given that current RNOA was –15.18%. Even without the
loss on discontinued operations of 601,146 (expected to not repeat), the current
RNOA is only 8.75%. Sounds very optimistic to expect that kind of turn around.
Almost Mattel, Inc. and Subsidiaries
Consolidated Statement of Operations for 2008

Net sales                                                                 \$4,669,942
Cost of sales                                             \$2,569,157
Other selling and admin expenses                             966,998
Restructuring and other charges                               15,900
Amortization of intangibles                                   52,000
Other operating expense, net                                   1,607      (4,291,539)

Provision for income taxes                                      55,247
Net tax benefit of interest                                     61,192      (116,439)

Loss from discontinued operations                             (601,146)
Compensation cost related to stock option modifications          6,171

Operating loss                                                              (381,388)

Interest expense                                               152,979
Net tax benefit of interest (40%)                               61,192
91,787
Unrealized loss on securities                                   14,123
Dividends declared on preferred stock                            3,890      (109,800)

Comprehensive loss                                                        \$ (491,188)

Almost Mattel, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity for 2008

Balance, December 31, 2007                                                \$1,962,687

Issuance of treasury stock                                \$     25,189
Stock option exercises, net of tax                              21,500
Dividends declared on common stock                            (115,090)      (68,401)

Net loss                                                      (430,969)
Unrealized loss on securities                                  (14,123)
Compensation cost related to stock option modifications          6,171
Dividends declared on preferred stock                           (3,890)    (491,188)

Balance, December 31, 2008                                                \$1,403,098
Almost Mattel, Inc. and Subsidiaries
Consolidated Balance Sheet at December 31, 2008 and 2007

Cash                                                         2008         2007
NET OPERATING ASSETS
Cash                                                       \$ 232,389    \$ 247,354
Accounts receivable, less allowances                          839,567    1,001,972
Inventories                                                   489,742      436,316
Prepaid expenses & other assets                               189,799      166,217
Property, plant and equipment                                 647,832      724,791
Intangibles, net                                            1,136,857    1,200,622
Net investment in discontinued operations                      11,540      461,986
3,547,726    4,239,258

Accounts payable                                              338,966      293,277
Accrued liabilities                                           703,382      714,633
Income taxes payable                                          200,933      184,789
Deferred income taxes                                         165,496      162,976
1,408,777    1,355,675

2,138,949    2,883,583

NET FINANCIAL OBLIGATIONS
Short-term borrowings                                         226,403      369,549
Current portion of long-term debt                              32,723        3,173
Long-term debt                                              1,242,396      982,880
1,501,522    1,355,602

Marketable securities                                        765,671      434,706

735,851      920,896

STOCKHOLDERS’ EQUITY                                       \$1,403,098   \$1,962,687

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