1

MIT Sloan School of Management

15.511 Financial Accounting Final Examination

July 18, 2007

Name: _________________________________________________________________ Section: (Circle one):

[A] OR [B] Instructions:

1) Exam Length: 3 hours 2) This exam is 22 pages long including the cover page. Please make sure your

copy of the exam is not missing any pages. 3) The exam consists of 6 questions with multiple parts to each question. Make

sure that you answer all of the questions. There are a total of 100 points. 4) A calculator and two double-sided pages of notes may be used during this

exam. 5) Write your answers in the space provided and show any supporting

computations you make. Do not attach additional material.

Honor Code All students in this course are required to fully comply with all of the provisions of the MIT honor code. In addition to pledging that I have neither received nor given aid while taking this exam, my signature also affirms that I have not accessed any notes (other than my own cheat sheet), study outlines, problem sets, old exams, answer keys, or the textbook while taking the exam and that I have not obtained any answers from another student’s exam. I also pledge that following the completion of this exam, I will not discuss or provide information about the exam to any student who has not yet sat the exam. I understand that any alleged honor violations may be forwarded to the MIT Honor Committee who will take any required disciplinary action. Signed ____________________________________ Date _______________________

2

Question 1: Ratio Analysis (15 Points) “Apple designs, manufactures, and markets personal computers and related software, services, peripherals, and networking solutions. The Company also designs, develops, and markets a line of portable digital music players along with related accessories and services, including the online sale of third-party audio and video products.” Apple Inc. is preparing its financial statements for the fiscal year ending on September 30, 2007. Steven P. Jobs, the CEO of Apple Inc., has heard about MIT’s talented Sloan Fellows and has retained you to help him with some financial accounting questions. First, however, he would like you to comment on Apple’s financial condition in fiscal year 2006 (the previous year) using Ratio Analysis and to compare Apple’s condition to that of a few competitors. You have access to the following summary financial information (all values are in millions of dollars): Fiscal Year 2006 Apple Microsoft Dell Total Revenue 19,315 44,282 55,908 Gross Profit 5,598 36,632 9,950 Operating Income 3,145 16,472 4,347 Net Income 1,989 12,599 3,572 Total Current Assets 14,509 49,010 17,706 Total Assets 17,205 69,597 23,109 Total Current Liabilities 6,471 22,442 15,927 Total Liabilities 7,221 29,493 18,980 Total Equity 9,984 40,104 4,129 Fiscal Year 2005 Apple Microsoft Dell Total Revenue 19,315 44,282 49,205 Gross Profit 5,598 36,632 9,015 Operating Income 3,145 16,472 4,254 Net Income 1,989 12,599 3,043 Total Current Assets 14,509 49,010 16,897 Total Assets 17,205 69,597 23,215 Total Current Liabilities 6,471 22,442 14,136 Total Liabilities 7,221 29,493 16,730 Total Equity 9,984 40,104 6,485 Using only the information in the two tables above, answer the following questions:

3

1. For 2006, compute a ratio for each of the three companies, which would capture how much profit the company generates per dollar of assets. 2. There are two key components of profitability: the profit margin and the level of efficiency with which assets are used to generate sales. Which of the three companies has the highest profit margin? Which of the three companies has the highest asset turnover?

4

3. Using ratio analysis, compare the short-term liquidity risk of the three companies. 4. Using ratio analysis, compare the long-term solvency risk of the three companies. 5. Based on the calculations above, which company has the highest level financial risk?

5

Question 2: Revenue Recognition (25 Points) The following information is provided in Apple’s 2006 annual report: “The Company distributes its products through third-party distributors and resellers and directly to certain education, consumer, and commercial customers. … The allowance for doubtful accounts is based on management’s assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition of those specific customers.” On the balance sheet, Apple reported: 2006 2005 Accounts receivable, less allowances of $52 and $46, respectively 1,252 895 On the income statement, Apple reported: 2006 2005 Revenues 19,315 13,931 All values are in millions of dollars. Using the information above, answer the following questions: 1. For 2006, what was the beginning balance of Apple’s allowance for doubtful accounts? 2. For 2006, what was the ending balance of Apple’s allowance for doubtful accounts?

6

3. If Apple’s net write-offs (total write-offs minus total recoveries) equaled $11 for 2006, then how much bad debt expense did Apple charge to earnings in 2006? 4. Using your estimate of bad debt expense as calculated in 3. above, what percentage of revenues was bad debt expense in 2006? 5. Assume that Apple believes that the ratio of bad debt expense to revenues is the same in 2007 as in 2006. Also, assume that Apple’s revenues for 2007 are $28,750. Assume that all sales are initially made on credit. How much bad debt expense does Apple expect to recognize in 2007?

7

Apple also disclosed the following information: “The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The Company provides currently for the estimated costs that may be incurred under its basic limited product warranties at the time related revenue is recognized. … The Company periodically provides updates to its applications and system software to maintain the software’s compliance with specifications. The estimated cost to develop such updates is accounted for as warranty costs that are recognized at the time related software revenue is recognized.” 2006 2005 Accrued Warranty (Liability) 284 188 All values are in millions of dollars. Using the information above, answer the following questions: 6. Assume that Apple spent $267 to cover the cost of warranties during 2006. How much warranty expense did Apple accrue related the sales in 2006? (Hint: Please make use of the beginning and ending balance of the accrued warranty account. It might be helpful for you to record the 2006 cost of warranties in the accrued warranty account.)

8

7. In 2007, Apple introduces a new product: the iPhone. Because this is a new product, Apple expects slightly higher hardware and software related warranty costs on the products it sells during 2007. Assume that Apple estimates the warranty expense to be 2% of revenues during 2007. Again, assume that Apple’s revenues for 2007 will be $28,750. How much does Apple expect to spend on warranty costs related to the products it sells during 2007? 8. Assume that at the end of 2007 the balance of accounts receivable net of allowance for doubtful accounts will be $1,525. Also, assume that Apple does not have unearned or deferred revenues and does not allow returns or refunds. As stated above, assume aggregate credit sales for Apple in 2007 will be $28,750. How much cash Apple will collect from its customers in 2007? (Hint: To answer the question, begin with balances at the end of 2006.)

9

Question 3: Inventory (15 Points) The following information is provided in Apple’s 2006 annual report: “Inventories are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. The Company’s inventories consist primarily of finished goods for all periods presented.” On the balance sheet, Apple reported: 2006 2005 Inventory 1,252 895 On the income statement, Apple reported: 2006 2005 Cost of Sales (COGS) 13,717 9,889 All values are in millions of dollars. Using the information above, answer the following questions: 1. How much inventory did Apple produce in 2006?

10

2. Assume that Apple’s inventory balance would have been $1,653 at the end of 2006 and $1,280 at the end of 2005 if Apple had used LIFO instead of FIFO to account for the cost of sales. Is the cost of the products Apple manufactures for its inventory increasing or decreasing over time? Explain briefly. 3. If Apple used LIFO instead of FIFO, how much would it recognize as cost of sales for 2006? 4. Assume that Apple’s tax rate is 35 percent. Would Apple’s taxes have been higher or lower in 2006 if Apple had used LIFO instead of FIFO? (Bonus point question: By how much?)

11

5. Assume that Apple’s inventory balance (FIFO) at the end of 2007 will be $1,590. Also, assume that Apple’s total production costs during 2007 are $18,798. What would be Apple’s cost of sales (FIFO) for 2007? 6. How many days, on average, will Apple hold products in its inventory during 2007?

12

Question 4: Property, Plant, and Equipment (15 Points) The following information is provided in Apple’s 2006 annual report: “Property, plant, and equipment are stated at cost. Depreciation is computed by use of straight-line method over the estimated useful lives of the assets. … Depreciation expense on property and equipment was $180 million and $141 million during 2006 and 2005, respectively.” 2006 2005 Property, plant, and equipment 2,075 1,481 Accumulated depreciation (794) (664) Net property, plant, and equipment 1,281 817 On the statement of cash flows, Apple reported: 2006 2005 Operating Activities: Loss on disposition of property, plant, and equipment 15 9 Investing Activities: Purchases of property, plant, and equipment (657) (260) All values are in millions of dollars. Using the information above, answer the following questions: 1. Assume that Apple estimates a zero salvage value for all of its property, plant, and equipment (PP&E). Based on the information for the fiscal year 2006, what is the approximate average age of Apple’s PP&E at the end of 2006?

13

2. Based on the information for the fiscal year 2006, what is the approximate average remaining useful life of Apple’s PP&E at the end of 2006? 3. How much did Apple spend to buy new PP&E during 2006?

14

4. Assume that during 2007, Apple will purchase $1,001 in additional PP&E, invest $25 in routine maintenance of its PP&E, and spend $12 on PP&E improvements. Additionally, assume that during 2007, Apple will sell or retire some PP&E; the PP&E to be sold or retired during 2007 has a gross value of $98 (historical cost). What will be the gross (historical cost) PP&E balance at the end of 2007? (Hint: To answer the question, begin with balances at the end of 2006.) 5. Assume that Apple uses accelerate depreciation of PP&E for tax purposes. Also, assume that all of the PP&E Apple purchased during 2007 was purchased at the beginning of the year. Would the amount of taxes Apple actually pays in 2007 be higher or lower than the amount Apple reports as a tax expense as a result of depreciation on the PP&E purchased during 2007?

15

Bonus point questions: What was the book value (net of accumulated depreciation) of the property, plant, and equipment that Apple sold or retired in 2006? How much cash did Apple receive from the sale or pay for the retirement of PP&E in 2006?

16

Question 5: Leases (15 Points) The following information is provided in Apple’s 2006 annual report: “The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance-sheet financing arrangements. … Rent expense under all operating leases, including both cancelable and noncancelable leases, was $138 million and $140 million in 2006 and 2005, respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 30, 2006, are as follows (in millions):” Fiscal Year 2007 2008 2009 2010 2011 Thereafter Total $134 $134 $134 $132 $122 $498 $1,154 All values are in millions of dollars. Using the information above, answer the following questions: 1. Apple does not have any capital leases. However, Steve Jobs is curious to see how the financial statements of Apple would be affected if some of Apple’s noncancelable operating leases were capitalized. Specifically, at the beginning of 2007, he asks you to assume that $100 per year of Apple’s minimum lease payments for the next 9 years are due to a capital lease. (For example, of the $134 minimum lease payment during 2007, $100 is now on a capital lease and $34 is on an operating lease.) It is as if, at the end of 2006, Apple had entered a capital lease arrangement with lease payments of $100 per year for the next nine years. Assume that Apple does not have any other lease contracts, does not enter into any additional lease contracts, all lease payments are made at the end of the fiscal year, and that Apple faces an interest rate of 8% per year. What is the present value of the capital lease obligation? (Please use the following page to answer this question.)

17

(Page left intentionally blank.)

18

2. How much depreciation expense would Apple record during 2007 on the capital lease? 3. How much interest expense would Apple record during 2007 on the capital lease obligation? 4. If Apple had capitalized some of its operating leases as described in 1., would Apple’s debt-to-assets ratio increase or decrease at the beginning of 2007?

19

5. Again, assume that the minimum lease payment is the only lease payment that Apple makes during 2007. Ignoring Steve Jobs’ analytical request to capitalize some of the operating lease payments, how would Apple actually account for the $134 operating lease payment at the end of 2007? 6. If Apple had capitalized some of its operating leases as described in 1., would Apple’s net income in 2007 be higher or lower than Apple’s actual reported net income (treating all leases as operating leases) in 2007?

20

Question 6: Bonds (15 Points) Historically, Apple has not had any significant amount of long-term debt. However, assume that at the beginning of 2007, Steve Jobs is considering the option of using debt financing. At this time, Apple faces an 8% market rate of interest. Having consulted with its investment banking advisors, Apple is considering the following two alternatives: Zero-Coupon Bond (A)- Face Value = $10,000 Maturity = 10 years Regular Bond (B) - Face Value = $10,000 Maturity = 10 years Coupon Rate = 10% Assume that all coupons are annual and paid out at the end of each year. Using the information above, answer the following questions: 1. Assume that Apple issues 1000 certificates of Bond A at the beginning of 2007. How much cash would Apple be able to raise from this sale?

21

2. How much interest expense would Apple record at the end of 2007 on Bond A? 3. Assume that Apple issues 1000 certificates of Bond B at the beginning of 2007. How much cash would Apple be able to raise from this sale? 4. How much interest expense would Apple record at the end of 2007 on Bond B?

22

5. Assume that at the beginning of 2008, the market rate of interest for Apple’s bonds declined to 6 percent. Using the balance sheet equation (or journal entries), record all entries for 2008 related to Bond B. Beginning Balance Ending Balance 6. Assume that at the start of 2009, the market rate of interest for Apple’s bonds remained at 6 percent and that Apple decided to repurchase all shares of Bond B from its creditors at that time (the start of 2009). Repurchase means buying the bonds from their owners. How much would Apple have to pay to repurchase the bonds?