CHAPTER ELEVEN

The Analysis of Profitability

Concept Questions

C11.1 The two rates of return will be the same in either of the following conditions:

(a) The SPREAD is zero, that is, return on net operating assets equals net

borrowing cost.

(b) Financial leverage (FLEV) is zero, that is, financial assets equal

financial obligations.

C11.2 The two rates of return will be the same in either of the following conditions:

(a) The operating liability leverage spread (OLSPREAD) is zero, that is,

ROOA equals the implicit borrowing rate for operating liabilities.

(b) Operating liability leverage is zero, that is, the firm has no operating

liabilities.

C11.3 (a) Positive

(b) Negative

(c) Negative

(d) It depends on whether the operating liability leverage spread is positive

or negative

(e) Positive

(f) It depends on whether the operating spread is positive or negative

(g) Positive

Note: the advertising expense ratio (advertising/sales) might be high in the

current period, producing a negative effect on ROCE. But the large amount of

The Analysis of Profitability – Chapter 11 p. 267

advertising might produce higher future sales, so could be regarded as a positive value

driver (and a positive driver of future ROCE).

C11.4 If the assets in which the cash from issuing debt is invested earn at a rate

greater than the borrowing cost of the debt, ROCE increases: shareholders earn from

the SPREAD.

C11.5 If a firm can generate income using the liabilities that are higher than the

implicit cost that creditors charge for the credit, it increases its RNOA.

C11.6 Not necessarily. If the supplier charges a higher price for the goods to

compensate him for financing the credit, buying on credit may not be favorable. The

operating liability leverage created by buying on credit will be favorable if the return

earned on the inventory is greater than the implicit cost the supplier charges for the

credit.

C11.7 The first part of the statement is correct: A drop in the advertising expense

ratio increases current ROCE. But a drop in advertising might damage share value

as future ROCE might drop because of reduced sales.

C11.8 Return on common equity (ROCE) is affected by leverage. If a firm borrows,

pays dividends, or makes a stock repurchase, it can increase its ROCE. But its return

on operations (RNOA) may not change, or even decline. Always examine increases

in ROCE to see if they are due to leverage.

p. 268 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
C11.9 If the firm loses the ability to deduct interest expense for tax purposes, it does

not get the tax benefit of debt and so increases its after-tax borrowing cost. Of course

the firm also may find that creditors will charge a higher before-tax borrowing rate if

it is making losses.

C11.10 The inventory yield is a measure of the profitability of inventory, the profit

from selling inventory relative to the inventory carried. If gross profit falls or

inventories increase, the ratio will fall.

C11.11 ROA mixes operating and financial activities. Financial assets are in the

denominator and operating liabilities are missing from the denominator. Interest

income is in the numerator. This calculation yields a low profitability measure, as the

return on financial assets is typically lower than operating profitability and the effect

of operating liabilities --- to lever up operating profitability --- is not included.

Exercises

E11.1 Leveraging Equations

(a) By the stocks and flows equation for equity

net dividends = earnings - CSE

= 207  300
= (93) (i.e. net capital contribution)

The Analysis of Profitability – Chapter 11 p. 269

 (This answer assumes no dirty-surplus accounting)

2002 2003 Average

NOA 1,900 2,400 2,150
NFO 1,000 1,200 1,100
CSE 900 1,200 1,050

ROCE = 207/1,050 = 19.71%

Operating income (OI) = Sales  operating expense  tax on

OI
= 2,100  1,677  [106 + (0.34 x 110)]
= 279.6

RNOA = OI/ave. NOA = 279.6/2,150 = 13.0%

ROCE = [PM ATO] + [FLEV  (RNOA  NBC)]

PM = OI/Sales = 279.6/2,100 = 0.1331 (or 13.31%)

ATO = Sales/av. NOA = 2,100/2,150 = 0.9767
FLEV = Ave. NFO/av. NOA = 1,100/1,050 = 1.0476
NBC = Net interest expense/ave. NFO = (110 0.66)/1,100 = 6.6%

So,

19.71% = (0.1331 0.9767) + [1.0476  (13.0% - 6.6%)]

(b)

2002 2003 Average

Operating assets 2,000 2,700 2,350
Operating liabilities (100) (300) (200)
NOA 1,900 2,400 2,150

Implicit interest on operating liabilities (OL) = 200 4.5%

=9

Return on operating assets (ROOA) = (OI + Implicit interest)/ave. OA

= (279.6 + 9)/2,350

= 12.28%

Operating liability leverage = OL/NOA

p. 270 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
 200
=
2,150

= 0.093

So,

13.0% = 12.28% + [0.093  (12.28% - 4.5%)]

(c) This is the case of a net creditor firm (net financial assets).

Net dividends = 339 – 700

= (361)

ROCE = 339/3,050 = 11.11%

Operating income = 2,100 – 1,677 – (174 – (0.34 90))

= 279.6 (as before)

RNOA = 279.6/2,150 = 13.0% (as before)

Return on net financial assets (RNFA) = Net financial income/ave. FA

90  0.66
=
900

= 6.6%

FLEV = -900/3,050 = -0.295

PM and ATO are as before.

So,

11.11% = (0.1331  0.9767) – [0.295  (13.0% - 6.6%)]

E11.2 First-level Analysis of Financial Statements

(a) First reformulate the financial statements:

Reformulated Balance Sheets

2002 2001 Average

NOA 1,395 1,325 1,360
NFO 300 300 300

The Analysis of Profitability – Chapter 11 p. 271

 CSE 1,095 1,025 1,060

Reformulated Income Statement, 2002

Sales 3,295
Operating Expenses 3,048
247
Tax reported 61
Tax on NFE 9 70
OI 177
Net interest 27
Tax on interest 9
NFE 18
Comprehensive Income 159

CSE2002 = CSE2001 + Earnings2002 – Net Dividends2002

1,095 = 1,025 + 159 - 89

Stock repurchase = 89

159
(b) ROCE = = 15.0%
1,060

177
RNOA = = 13.0%
1,360

300
FLEV = = 0.283
1,060

SPREAD = RNOA – NBC

 NFE 18 
= 13.0% - 6.0% = 7.0%  NBC = =
 NFO 300 

C–I = OI - NOA

= 177 – 70

= 107

(c) The ROCE of 15% is above a typical cost of capital of 10% - 12%. So

one might expect the shares to trade above book value. But, to trade at

p. 272 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
 three times book value, the market has to see ROCE to be increasing in

the future or investment to be growing substantially.

E11.3 Relationship Between Rates of Return and Leverage

(a) ROCE = RNOA + [FLEV  (RNOA – NBC)]

13.4% = 11.2% + [FLEV  (11.2% - 4.5%)]

FLEV = 0.328

(b) RNOA = ROOA + (OLLEV  OLSPREAD)

11.2% = 8.5% + [OLLEV  (8.5% - 4.0%)]

OLLEV = 0.6

NFO
(c) First calculate NFO and CSE using the financial leverage ratio ( )
CSE

applied to the net operating assets of $405 million.

NFO
FLEV =
CSE

NOA = CSE + NFO

NFO
So = 1 + FLEV
CSE

= 1.328

As NOA = $405 million

$405 million
Then CSE =
1.328

= $305 million

and NFO = $100 million

Now distinguish operating and financing assets and liabilities

OL
OLLEV = = 0.6
NOA

The Analysis of Profitability – Chapter 11 p. 273

 So OL = 0.6  $405 million

= $243 million

OA = NOA + OL

= 405 + 243

= $648 million

Financial assets = total assets – operating assets

= 715 – 648

= $67 million

Financial liabilities = NFO + financial assets

= 100 + 67

= $167 million

Reformulated Balance Sheet

Operating assets 648 Financial liabilities 167

Operating liabilities 243 Financial assets 67
100
Common equity 305
405 405

E11.4 Measures of Profitability and Leverage: Intel Corporation

(a) Return on assets (ROA) =

Net income  Interest Expense (after tax)  Minority Interest

Average Total Assets

6,068  34  0.62


30,176

= 20.2%

Comprehensive operating income (after tax)

Return on net operating assets =
Average Net Operating Assets

p. 274 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
 5,598
=
11,027

= 50.8%

Comprehensive operating income is calculated in the solution to E9.1 in Chapter 9, as

is NOA for 1998. NOA for 1997 is calculated as:

Common shareholders’ equity 19,295

less Net financial assets
Short-term debt (212)
Current maturities of long-term debt (110)
Long-term debt (448)
Put warrant obligation (2,041)
Cash equivalents 4,000
Short-term investments 5,630
Trading assets 195
Long-tem investments 1,839 8,853
10,442
Average NOA is the average of this 1997 number and the 1998 NOA of $11,611

million given in the solution to E9.1 in Chapter 9.

The RNOA is considerably higher then the ROA: the ROA is weighted down

by the low return on financial assets that obscures the profitability of operations. And

it ignores the leverage from operating liabilities.

Total Liabilitie s
(b) Debt-to-Equity =
Common Equity

9,585
=
19,295

= 0.50

[Some calculations of debt-to-equity include preferred stock in equity rather than

debt.]

NFO
Financial leverage (FLEV) =
CSE

(8,853)
=
19,295

The Analysis of Profitability – Chapter 11 p. 275

 = -0.46

[Net financial assets are calculated above]

Intel has negative leverage because it has financial assets in excess of financial

obligations. The traditional debt/equity ratio ignores the financial assets that

effectively decrease debt. In addition, it confuses debt issued in financing activities

with that incurred in operations. Intel’s debt-to-equity ratio makes it look risky, but it

is not: it has plenty of financial assets to meet claims on it.

The standard debt-to-equity ratio might be referred to in credit analysis, that is,

in assessing the ability of the firm to meet its debts. But even then, one would want to

factor in the financial assets that can pay off debt.

The analyst relies on the FLEV measure in profitability analysis. This

measure gives the profitability leverage in ROCE over RNOA.

E11.5 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A
What-If Question

The effect would be (almost) zero.

Existing RNOA = PM ATO

= 3.8%  2.9

= 11.02%

RNOA from new product line is

RNOA = 4.8% 2.3

= 11.04%

E11.6 Analyzing Borrowing Costs: Reebok

 FO After - Tax Interest on Financial Obligations   FA After - Tax Interest on Financial Assets 
NBC 
 NFO  FO    NFO  FA 

p. 276 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
where FO = Financial obligations

FA = Financial assets

So,

 526 42  (1 - 0.354)   121 11  (1 - 0.354) 

NBC =      405  
 405 526 121

 526   121 
=   5.16%    5.87%
 405   405 

= 4.94%

The components of the borrowing cost are

Borrowing cost on financial liabilities 5.16%

Return on financial assets 5.87%

The two components are weighted by the relative amounts of financial assets and

financial obligations.

The calculation is based on weighting ending balances by 1/3 and beginning

balances by 2/3. This weighting reflects the large debt issue for the stock repurchase

in August of 1996. But the weighting may not be appropriate for financial assets

(cash equivalents) or for other debt on the balance sheet.

Always check NBC calculations against the cost of debt in the debt footnote.

E11.7 A What-If Question: Grocery Retailers

Net operating assets for $120 million in sales and an ATO of 6.0 are $20

million.

An increase in sales of $15 million and an increase in inventory of $2 million

120  25
would increase the ATO to = 6.59.
20  2

With a profit margin of 1.5%, the RNOA would be:

The Analysis of Profitability – Chapter 11 p. 277

 RNOA = 1.5%  6.59

= 9.89%

The current RNOA is:

RNOA = 1.6%  6.0

= 9.6%

So the membership program would increase RNOA slightly.

p. 278 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
E11.8 Financial Statement Analysis: Ben & Jerry’s

First reformulate the financial statements (as in Exercise 10.6 in Chapter 10):

Balance Sheets
1996 1995
Operating assets (OA):

Trade receivables 8.7 11.7

Inventories 15.4 12.6
Other current operating assets 7.1 7.5
Plant, net 65.1 59.6
Equity investments 1.0 1.0
Other long-term operating assets 2.5 2.4
99.8 94.8
Operating Liabilities (OL):

Trade payables and accrued expenses 17.4 16.5

Deferred tax liability 4.8 22.2 3.5 20.0

Net operating assets (NOA) 77.6 74.8

Net financial assets (NFA):
Short-term investments 36.6 35.4
Other receivables 0.3 0.9
Current debt (0.6) (0.5)
Long-term debt (31.1) 5.2 (32.0) 3.8

Common shareholders’ equity (CSE) 82.8 78.6

Averages for 1996:

NOA 76.2 OA 97.3
NFA 4.5 OL 21.1
CSE 80.7 76.2

Income Statements

1996 1995

Net sales 167.1 155.3

Cost of sales 115.2 109.1
Gross profit 51.9 46.2
SG&A expense (45.5) (36.4)
Other income (expense) 0.2 (0.6)
OI 6.6 9.2
Tax reported 2.4 3.5
Tax on financing income 0.1 2.5 (0.1) 3.4
OI after tax 4.1 5.8
Interest income 1.7 1.7
Interest expense (2.0) (1.5)
Net interest before tax (0.3) .2

The Analysis of Profitability – Chapter 11 p. 279

Tax (35%) (0.1) 0.1
Net financial expense .2 .1
Net comprehensive income 3.9 5.9

[Note: There is no dirty-surplus income as cumulative currency adjustments did not

change.]

NOA 76.2 OA 97.3

NFA 4.5 OL 21.1
CSE 80.7 76.2

NFO  5.2
(a) FLEV = = = -0.063
CSE 82.8

OL 22.2
OLLEV = = = 0.286
NOA 77.6

OI
(b) RNOA =
Ave. NOA

4.1
=
76.2

= 5.38%

(c) RNOA = PM x ATO

4.1
PM = = 2.45%
167.1

167.1
ATO = = 2.19 (use average NOA)
76.2

A Sales PM (before tax) can also be calculated by excluding Other Income:

6.4
Sales PM = = 3.83%
167.1

Decompose PM:

Gross margin ratio 31.06%

SG and A expense ratio (27.23)
Other income ratio 0.12
Tax ratio (1.50)
2.45%

p. 280 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
Decompose ATO

Turnover Inverse

167.1
Accounts receivable turnover = = 16.38 0.0611
10.2

167.1
Inventory turnover = = 11.94 0.0838
14.0

167.1
Other current asset turnover = = 22.89 0.0437
7 .3

167.1
PPE turnover = = 2.68 0.3731
62.4

167.1
Other asset turnover = = 47.74 0.0209
3.5

167.1
Operating liability turnover = = (7.92) -0.1263
21.1

Total ATO 2.19 0.4563

[Average NOA items used in denominators.]

Analyze operating liability leverage:

RNOA = ROOA + (OLLEV  OLSPREAD)

Implicit interest on operating liabilities = OL  4%

= 21.1  4.0%

= 0.844

(A 4% after-tax rate is assumed.)

4.1  0.844
Return on operating assets (ROOA) =
97.3

= 5.08%

OL
Operating liability leverage =
NOA

The Analysis of Profitability – Chapter 11 p. 281

 21.1
= (using averages for
76.2

year)

= 0.277

Operating liability leverage

Spread (OLSPREAD) = ROOA – 4.0%

= 1.08%

So,

RNOA = 5.08% + (0.277  1.08%)

= 5.38%

p. 282 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
Minicases

M11.1. Analysis with Equity Accounting and the Use of Proportional

Consolidation: AirTouch Communications

Introduction

This case provides an opportunity to discuss equity accounting, consolidation

accounting and segment accounting, and to appreciate the frustrations that can arise in

analyzing firms that use equity accounting for affiliate operations.

Equity accounting gives the net income share of affiliates but no detail on the

components of income. Thus this income is difficult, if not impossible, to analyze

unless one can get hold of the affiliates’ financial statements.

Consolidation accounting gives revenue and expense details of affiliates’

income, but the aggregation can be frustrating if it involves different lines of business.

Difficulties in one business and success in another may be obscured. Segmented

disclosures help to some extent but, as we see in this case, those disclosures are

limited. Look at the consolidated statements of News Corp which involve over 100

companies in many countries. They are difficult to penetrate, to say the least.

Before beginning the case, review the accounting for investments in

subsidiaries. See Accounting Clinics III and V. Also review the requirements for

segmented disclosures (in particular FASB Statement No.131).

A: Using the GAAP Presentation

Reformulation using the information in GAAP statements:

The Analysis of Profitability – Chapter 11 p. 283

 Reformulated Income Statement

(in millions of dollars)

Operating revenues $1,484

Cost of revenues 323

Selling and customer expenses 464
General, administrative and other 162
Depreciation and amortization 285 1,234

Operating income from sales before tax 250

Other income

Miscellaneous income 21
Merger costs (116) (95)
155
Tax as reported 98
Tax benefit of net debt 12 110
45

Minority interests in consolidated affiliates (46)

Operating income before equity income (1)

Equity in income of unconsolidated affiliates 202

Operating income after tax 201

Net financial expenses

Interest expense 36
Interest income ( 4)
32
Tax benefit (38%) 12
Net interest after tax 20
Preferred dividends 34 54

Net income applicable to common 147

This statement has allocated consolidated taxes to consolidated income but has

left equity income as a net number. So only the income of ventures where there is

more than a 50% interest can be analyzed:

250
Profit margin before tax and other income = = 16.85%
1,484

p. 284 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
 45
Profit margin after tax = = 3.03%
1,484

Individual expense ratios can also be calculated.

But does this give a picture of the profitability of operations. What if the

profitability of unconsolidated affiliates were different from that of the consolidated

operations? And note that a large portion of the profits of the consolidated operations

accrue to the minority interests, not to AirTouch.

B: Using the Proportionate Presentation

The footnote on unconsolidated affiliates gives some information on the

German affiliate, Mannesmann. It has a profit margin before tax of 4.1%, but this is

based on operating income of $522 million that is considerably greater than the $250

million for the consolidated operations.

The proportionate presentation captures the profitability of AirTouch’s

interests:

The Analysis of Profitability – Chapter 11 p. 285

 US Cellular International US Paging Total
and PSC Operations Operations Operations Company

$ % $ % $ % $ %

Revenues 1,116 100.0 1,079 100.0 102 100.0 2,297 100.0

Op. exp. before DA 673 60.3 629 58.3 72 70.6 1,400 60.9
443 39.7 450 41.7 30 29.4 897 39.1
Depr. and amort. 261 23.4 112 10.4 20 19.6 395 17.2
OI before tax 182 16.3 338 31.3 10 9.8 502 21.9

Tax reported 188 8.2

Tax benefit (below) 51 2.2

OI after tax 263 11.4

Interest and other 133

Tax effect 51
82
Preferred dividends 34
116

Net income to common 147

Profit margins and their component parts are identical in this analysis, not only

for the total company but also for segments.

p. 286 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
M11.2 Analysis of the Return on Common Equity and Some “What-
If” Questions: VF Corporation
This case illustrates the profitability analysis in this chapter. To become

familiar with the firm, review the short description of the firm in the case and on the

firms’ web page at www.vfc.com . Also look at the background information of the

firm and its strategy in the annual 10-K report. The more the student is familiar with

a firm’s operations, the more the financial statement analysis comes to life.

The reformulated statements in the case are the basis for the analysis.

Question A: Analysis

Review the analysis tree in Figure 11.1 before proceeding.

1. First-level analysis

Average balance sheet amounts for calculations (in millions of

dollars):

Net operating assets (NOA) 2,596

Net financial obligations (NFO) 629
Common equity (CSE) 1,967

Operating assets (OA) 3,523

Operating liabilities (OL) 927
NOA 2,596

Financial assets (FA) 80

Financial obligations (FO) 709
NFO 629

Financial leverage affect:

ROCE = RNOA + [FLEV  (RNOA – NBC)]

393
ROCE = = 19.98%
1,967

434
RNOA = = 16.72%
2,596

The Analysis of Profitability – Chapter 11 p. 287

 629
FLEV = = 0.320
1,967

41
NBC = = 6.52%
629

Proofing:

19.98% = 16.72% + [0.320 (16.72% - 6.52%)]

Operating liability leverage effect:

RNOA = ROOA + [OLLEV  OLSPREAD]

Implicit interest on operating liabilities = 927  4.0% = 37

(using a 4% rate)

434  37
ROOA = = 13.37%
3,523

927
OLLEV = = 0.357
2,596

OLSPREAD = 13.37% - 4.0% = 9.37%

Proofing:

16.72% = 13.37% + (0.357  9.37%)

p. 288 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
In words:

VF Corporation’s 19.98% ROCE in 1998 was produced by a return on net

operating assets of 16.72% that was levered up by net financial leverage of 32% of

common equity. This leverage geared up a favorable spread of operating profitability

over the net after-tax borrowing cost of 6.52%.

VF’s operating profitability was also levered up by favorable operating

liability leverage of 36% of net operating assets: VF utilized operating credit to its

advantage.

2. Second-level analysis

RNOA = PM  ATO

434
Profit Margin (PM) = = 7.92%
5,479

5,479
Asset turnover (ATO) = = 2.11
2,596

Proofing:

16.72% = 7.92%  2.11

3. Third-level analysis

Analysis of profit margin of 7.92%:

1,892
Gross margin = = 34.53%
5,479

3
Miscellaneous income to sales = = 0.05
5,479

288
Advertising expense ratio = = (5.26)
5,479

911
Administrative expense ratio = = (16.63)
5,479

The Analysis of Profitability – Chapter 11 p. 289

 9
Other expense ratio = = (0.16)
5,479

11
Other income ratio = = 0.20
5,479

699
PM before tax = = 12.76
5,479

265
Tax ratio = = 4.84
5,479

434
PM = = 7.92
5,479

In words:

A dollar of sales yielded 34.53 cents of profit after cost of the goods

sold. Advertising to maintain the sales absorbed 5.26 cents for every dollar of sales

and administrative expenses absorbed 16.63 cents. After taxes of 4.84 cents per dollar

of sales and some minor items, the firm produced 7.92 cents of profit for a dollar of

sales.

Analysis of asset turnover of 2.11:

Reciprocal of
Turnover
Turnover

5,479
Accounts receivable turnover = 8.47 0.118
649
5,479
Inventory turnover = 6.33 0.158
865
5,479
PPE turnover = 7.39 0.135
741
5,479
Intangible turnover = 6.20 0.161
883
5,479
Deferred asset turnover = 28.69 0.035
191
5,479
Other asset turnover = 27.81 0.036
197

p. 290 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
 5,479
Operating liability turnover = (5.91) (0.169)
927

ATO 2.11 0.474

In words:

VF utilized investment in net operating assets to generate $2.11 dollar of sales

for a dollar of investment. Or, stated differently, each dollar of sales used 47.4 cents

of net operating assets, including an investment in accounts receivable of 11.8 cents,

inventory of 15.8 cents, PPE of 13.5 cents, and goodwill on purchased firms of 16.1

cents. The asset turnover was levered up by operating liabilities of 16.9 cents per

dollar of sales.

Analysis of net borrowing cost of 6.52%:

Net interest cost before tax was 8.9% of net financial obligations and 5.5%

after tax. Preferred stock added to the borrowing cost, in the form of preferred

dividends and a loss on conversion of preferred stock to common.

A qualifying note: Calculations are based on averages of beginning and ending

balance sheet amounts. If balances did not change evenly over the year, there will be

approximations in the calculations. Note particularly the large percentage drop in

cash equivalents and the increase in short-term borrowings.

Question B: What-if Questions

(1) At the point where RNOA = NBC, that is, if RNOA fell below 6.52%.

But note that 6.52% includes the loss on the redemption of preferred stock

which may be temporary. So the leverage indifference point will be at the “core”

38,357
borrowing rate of = 6.09% that includes preferred dividends but excludes the
629,393

loss.

The Analysis of Profitability – Chapter 11 p. 291

 (2) This financing transaction will have no effect on RNOA.

(3) There would be no effect on ROCE because net financial obligations

and leverage will not be affected: the cash equivalents are netted out against debt in

the NFO, so actually using the cash to pay off debt will not affect the NFO. (There

would also be a small change in the net borrowing cost if the interest rate on the cash

equivalents is different from the borrowing rate for debt.)

(4) ROCE would increase because of an increase in leverage:

1998 1997 Average

NFO, as is 774 485
Liquidation of financial assets 48 48
NFO, as is 822 533 678

CSE, as is 2,066 1,867

Share repurchase 48 48
2,018 1,819 1,919

Financial leverage (FLEV), as is 0.320

Financial leverage (FLEV), as is 0.353

As if ROCE = RNOA + [FLEV + SPREAD]

= 16.72% + 0.353  10.2%
= 20.32%

(5) If prices of inputs were to drop by the amount of the imputed interest

on the credit, the operating income (at an implicit after-tax borrowing rate of 4%)

would be:

Average payables x 4% = $321  0.04 = $ 13

Operating income, as is 434
Operating income, as is 447

NOA, as is 2,596
Loss of payables 321
NOA, as is 2,917

RNOA, as is 16.72%
447
RNOA, as if = 15.32%
2,917

p. 292 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
 As if RNOA = ROOA + (As if OLLEV  As if OLSPREAD)
 606 
= 13.37% +   9.37% 
 2,917 
= 15.32%

(6) ROCE would, of course, be reduced by the change in RNOA from

16.72% to 15.32%. But two other things will change:

1. The operating SPREAD will change because the RNOA changes.

2. The firm will have to finance the purchase of inventory with cash.

Spread effect:

SPREAD, as is = 16.72% - 6.52% = 10.2%

SPREAD, as is = 15.32% - 6.52% = 8.8%

ROCE, as if = 15.32% + (0.320  8.8%)

= 18.14%

Financial leverage effect:

Suppose the firm were to issue shares to raise the cash (with no change in net

debt).

CSE, as is = 1,967
Share issue = 321
CSE, as is = 2,288

629
Financial leverage, as if = = 0.275
2,288
ROCE, as if = 15.32% + (0.275  8.8%)

= 17.74%

The firm might borrow to get the cash in which case FLEV would be 0.483. If

the borrowing were at the same net borrowing cost as existing debt, then ROCE

would be:

ROCE, as if = 15.32% + (0.483  8.8%)

= 19.57%

The Analysis of Profitability – Chapter 11 p. 293

Notice that the increase in leverage increases ROCE even though there is a drop in the

profitability of operations.

(7) An increase in gross profit margin of 1% (before tax) would translate

into an after-tax increase in the profit margin (PM) of 0.62% to 8.54% (for a 38% tax

rate). At the (as-is) asset turnover of 2.11, the RNOA would be:

A- is RNOA = 8.54%  2.11

= 18.02%

(8) As-if ROCE = 18.02%  [0.320  (18.02% - 6.52%)]

= 21.70%

The valuation part of the question servers to introduce students to issues in

Part III of the book. Proceeding naively, the residual earnings model is applied, with

no growth, as follows:

(ROCE - cost of capital)  CSE

V E  CSE 
cost of capital

So, with an assumed cost of capital of 11% (say):

(0.1998 - 0.11)  1,967

VE , as is = 1,967 +
0.11

= $3,573 million

(0.2170 - 0.11)  1,967

VE , as if = 1,967 +
0.11

= $3,880 million

The complete answer can only be given with a forecast of growth in CSE that

will earn at the higher ROCE. The perceptive student will see that such growth will

imply a change in leverage and thus a drop in the cost of capital. Part III finesses this

problem.

p. 294 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
 (9) Maintaining advertising expenses at the same level at 1997 would

increase the 1999 expense by $21.8 million or 0.4% of sales. The effect on the profit

margin, after tax, would have been to reduce it from 7.92% to 7.67%. At an ATO of

2.11, the RNOA would have been 16.19% rather than 16.72%.

The quality of the 1998 RNOA needs to be investigated: is VF generating

higher RNOA at the expense of lost futures sales and profits from reduced

advertising?

Question C: Further Questions

Any question can be addressed that affects the following:

Financial leverage

- debt issues

- debt-for-equity swaps

- stock issues

- change of dividend payout

 New investment in net operating assets

Change in the structure of expenses

 Growth or fall in sales

 New product line

 Efficiency of advertising: sales generated per dollar of advertising

 “Cost cutting”

 Change in tax rates

 Change in borrowing costs

The Analysis of Profitability – Chapter 11 p. 295