JEFF CARTER……………. JEFF.B.CARTER@GMAIL.COM

JAMISON DOVE………….JAMISON.DOVE@GMAIL.COM

SID RAYES……………………….. SID.RAYES@TTU.EDU

MATT STEVENS……………. MTT_STVNS@YAHOO.COM

Table of Contents

Executive Summary 1

Industry Overview 2

Accounting Analysis 3

Financial Analysis, Forecasting, Cost of Capital Estimation 4

Valuations 5

Business and Industry Analysis 6

Company Overview 8

Industry Overview 11

Five Forces Model 12

Rivalry Among Existing Firms 13

Threat of New Entrants

Threat of Substitute Products

Bargaining Power of Buyers

Bargaining Power of Suppliers

Value Chain Analysis

Firm Competitive Advantage Analysis

Accounting Analysis

Key Accounting Policies

Accounting Flexibility

Actual Accounting Strategy

Qualitative Analysis of Disclosure

Quantitative Analysis of Disclosure

Sales Manipulation Diagnostic Ratios

Expense Manipulation Diagnostic Ratios

Financial Analysis

Liquidity Analysis Ratios

Profitability Analysis Ratios

Capital Structure Ratios

SGR / IGR Analysis

Financial Statements Forecasting

Income Statement

Balance Sheet

Cash Flow Statement

Cost of Capital Estimation

Cost of Debt

Cost of Equity

Weighted Average Cost of Capital

Equity Valuations

Method of Comparables

Intrinsic Valuations

Dividends Discount Model

Free Cash Flow Model

Residual Income Model

Long-Run Return on Equity Residual Income Model

Abnormal Earnings Growth Model

Analyst’s Recommendation

Appendix

1

Executive Summary

Analyst Recommendation – Over-Valued as at 1 April, 2008

Baxter International Inc.

BAX - NYSE (5.2.08) $62.80 Altman's Z-Score52 Week High $65.20 2002 2003 2004 2005 2006 200752 Week Low $49.30 Initial 3.93 3.70 3.63 4.35 4.54 4.76Revenue (Millions) $11,263.00 Revised 3.90 3.67 3.59 4.31 4.52 4.77Market Cap (Billions) $39.69Shares Outstanding 632 MPercentage Institutional Ownership 84%

Financial Based Estimated Valuations Initial RevisedInitial Restated

Book Value per Share $10.94 $11.27 Trailing P/EReturn on Equity 27.2% 28.9% Forward P/EReturn on Assets 11.2% 12.4% P.E.G.

P/BP/EBITDAP/FCF

Cost of Capital EV/EBITDA

Estimated Adj. R2 Beta Ke

3 Month 0.1780 0.9490 10.19%6 Month 0.1784 0.9493 10.19% Intrinsic Valuations Initial Revised2 Year 0.1791 0.9525 10.22%5 Year 0.1789 0.9549 10.23% Discounted Dividend10 Year 0.1783 0.9552 10.24% Free Cash Flows

Residual IncomePublished ß 0.61 Long-Run REO Residual IncomeKd Before Taxes 4.30% Abnormal Earnings GrowthWACCAT 8.97%

2

Industry Analysis

Baxter International was founded in 1931, and was the first company to

produce commercially prepared intravenous solutions. Today Baxter is ranked

245 in the Fortune 500, and second in market share in the medical services and

supplies industry. Since its creation, Baxter has become a large multi-national

company that manufactures its products in 28 countries, and distributes its

products to over 100 countries all over the world.

Baxter’s main competitors in the industry are Abbott, Stryker, Wyeth, and

Boston Scientific. The industry competes in innovation, some economies of

scale, and product differentiation. The main area of competition is product

differentiation. The way the industry tries to achieve product differentiation is by

investing large amounts of cash into research and development, and by creating

a working environment that fosters creativity and innovation.

The industry key success factors are creativity and innovation, investment

in R&D, and superior product quality. Companies that produce high quality,

differentiated products efficiently will be highly successful in that industry.

3

Accounting Analysis

The purpose of the accounting analysis is to determine the level and

quality of disclosure, and to determine if a company has distorted it numbers to

improve investors’ financial opinion of the company.

Companies can use flexibility afforded to them by GAAP to alter their

financial statements to falsely increase the value of the company. If companies

do not tamper with their financial statements, they can disclose the minimum

amount of information about the company in the 10-K to investors so that an

educated opinion of the company cannot be formulated, and the company

cannot be accurately valued.

Baxter, overall, was very transparent within their 10-K. They offered

pertinent information within the 10-K that would allow analysts to get a fairly

accurate financial picture of the company. However, there were areas of

concern both occurring in 2004. First, Baxter had a 9.23% in allowance for bad

debt. This increase caused Baxter to understate net income and overstate their

return on assets. We believe the decision was to take a current loss with the

expectation of higher earnings in the future. The second distortion occurred in

the reporting of gross profit. The gross profit margin decrease by more than

3%, indicating that cost of goods sold became a greater percentage of sales.

4

Financial Analysis, Forecasting, and Cost of Capital

A financial analysis of Baxter helped in determining which components of

the financial statement needed to be forecasted. Baxter’s average growth rate

for the period of 6.8% underperforms the industry average of 11.24%. Since

the sales growth rates were highly variable, we neutralized the effect of the

variability in the growth rate by taking a weighted average of the growth rates

from the past five years, which produces an average growth rate of 7.36% for

the ten year forecast. We used an asset turnover ratio of .77 for 2008, however,

we found that the industry average was converging on .70 so we reduced that

number by 3% per year over a three-year period to .70. Retained earnings and

stockholder’s equity were adjusted each year in relation to net income. We used

a CFFO / Sales ratio of .2 to forecast cash flows from operations.

A beta of .9525 was calculated for Baxter, which had the highest adjusted

R2, of.179, of all the regression models. Taking this information, the CAPM

model was used to produce Baxter’s cost of equity, which we determined was

10.22%. Then a weighted cost of debt was calculated using the information

provided in Baxter’s 10-Ks, which we determined as 4.3%. After determining

both cost of equity and cost of debt, we were able to determine weighted

average cost of capital, which is 8.97%.

5

Valuations

In order to value Baxter’s shares we used two different methods. The

first method was the method of comparables. This method compares certain key

price ratios with industry competitors to determine value. The second method

intrinsic valuation seeks to find the present value of future benefits conveyed to

stockholders by the firm.

The seven ratios we analyzed in the method of comparables were Price-

to-Earnings (trailing), Price-to-Earnings (forward), Price-to-book, Dividend Yield,

Price-to-Earnings-to-Growth, Price-to-EBITDA, and Enterprise Value-EBITDA.

These ratios overwhelmingly showed Baxter to be fairly valued.

The intrinsic valuation models we calculated were the discounted

dividends model, the discounted free cash flows model, the residual income

model, the abnormal earnings growth model, and the long run residual income

perpetuity model. Each of these models except for the discounted free cash

flows model demonstrated that shares of Baxter were overvalued.

Due to the fact, that the method of comparables is not grounded in

theory, it is our opinion the method is much less preferable to an intrinsic

valuation. Thus it is our opinion that the evidence has clearly shown Baxter to

be overvalued, and it is our recommendation to sell.

6

Business and Industry Analysis

Company Overview

Baxter was founded in 1931 as the first company to produce commercially

prepared intravenous solutions. During the 1950s, Baxter acquired Hyland

Laboratories and Fenwal Laboratories and established its first international

division for product distribution in Belgium.

Baxter, currently headquartered in Deerfield, Illinois, is ranked 245 in the

Fortune 500 list and is ranked second by market share in the medical supplies

and services industry. Baxter employs over 48,000 employees, manufactures its

products in 28 countries, and distributes to over 100 countries.

7

Baxter consists of three business segments that make up the continuing

operations of the company. The Bioscience segment manufactures plasma-

based and recombinant proteins as well as plasma-based therapies, which are

used for the treatment of multiple disorders, tissue regeneration, and vaccines.

8

Some of this segment’s focus is on the products for the treatment of patients

that suffer from cancer, kidney disease, immune deficiencies, and other diseases.

The Medication Delivery segment manufactures intravenous solutions, pre-mixed

drugs, inhalation anesthetics, and other medication that is distributed to

hospitals, medical research laboratories, kidney dialysis centers, nursing homes,

and doctor’s offices. The Renal segment manufactures products for individuals

with end-stage renal disease or irreversible kidney failure that are undergoing

home therapy peritoneal dialysis.

Baxter’s overall global presence is one of their key strengths. In 2006,

56% of sales and over half of their workforce were located outside the United

States. In Europe alone there are manufacturing and research facilities in more

than twelve countries. Many of their manufacturing and distribution facilities are

located in Latin America. Baxter has also been located in Asia Pacific for over 40

years. Baxter has an overall dominant global presence.

9

finance.yahoo.com

Industry Overview

Baxter and its competitors compete in the healthcare sector with a focus

in the medical services and supplies industry. The healthcare sector consists of

about 391,000 companies, which includes health care providers and

manufacturers. Annual revenues of the healthcare sector are about $1.8 trillion,

$1.5 trillion coming from the health care provider side, while $300 billion is from

the manufacturing side. Today there are approximately 12,000 companies in the

medical services and supplies industry and these companies have combined

annual revenue of about $50 billion. The fifty largest companies in the medical

services and supplies industry account for about 60% of the market share

(firstresearch.com).

10

Baxter’s main competitors in the industry are Abbott Laboratories (ABT),

Boston Scientific (BSX), Wyeth (WYE), and Stryker (SYK). The main product

offerings in this portion of the industry are therapeutic devices and diagnostic

equipment and some pharmaceutical production. These companies are highly

concerned with technological innovation rather than low cost production

(firstresearch.com).

Five Forces Model

The five forces model is a tool used to analyze a firm’s profit potential in

an industry. The analysis is also used to define whether the industry is high,

moderate, or low in competition. The model is broken into two groups: degree

of actual and potential competition and bargaining power of input and output

markets. The degree of actual and potential competition section includes: rivalry

among existing firms, threat of new entrants, and threat of substitute products.

The bargaining power of actual and potential competition section includes

bargaining power of buyers and bargaining power of sellers. Each of these

forces will help to determine what an industry’s profit potential and profit drivers

are.

11

Rivalry Among Existing Firms ModerateThreat of New Entrants LowThreat of Substitute Products LowBargaining Power of Buyers HighBargaining Power of Suppliers Low

Five Forces Model

Rivalry Among Existing Firms

Profitability in an industry is affected by rivalry among existing firms. It is

important to determine how much rivalry exists so that firms can create a

strategy that will allow them to be competitive within the industry. Rivalry

among existing firms is determined by the level of concentration within the

industry. Industries with high rivalry and low concentration will likely compete

more on price causing less profitability the lower prices get. Industries with low

rivalry and high concentration will likely compete on something other than price,

such as innovation. The components of rivalry among existing firms are as

follows: industry growth rate, concentration, differentiation and switching costs,

12

scale / learning economies, fixed-variable costs, excess capacity and exit

barriers.

Industry Growth Rate

The medical services and supplies industry is comprised of 12,000

different companies competing with each other in various segments ranging from

biosciences to pharmaceuticals. This diversity has allowed each company within

the industry the find niches in different segments in which to specialize. Due to

this diverse environment, the industry experienced revenue growth from $46,309

million in 2002 to $73,935 million in 2007 with an average growth rate of 9.8%

over the five-year period.

Industry Sales and Sales Growth (Millions)2002 2003 2004 2005 2006 2007

Baxter 8,110$ 8,916$ 9,509$ 9,849$ 10,378$ 11,263$ - 9.94% 6.65% 3.58% 5.37% 8.53%

Abbott Labs 17,685$ 19,681$ 19,680$ 22,338$ 22,476$ 25,914$ - 11.29% -0.01% 13.51% 0.62% 15.30%

Boston Scientific 2,919$ 3,476$ 5,624$ 6,283$ 7,821$ 8,357$ - 19.08% 61.80% 11.72% 24.48% 6.85%

Wyeth 14,584$ 15,851$ 17,358$ 18,756$ 20,351$ 22,400$ - 8.69% 9.51% 8.05% 8.50% 10.07%

Stryker 3,011$ 3,625$ 4,262$ 4,872$ 5,465$ 6,001$ - 20.39% 17.57% 14.31% 12.17% 9.81%

Industry 46,309$ 51,549$ 56,433$ 62,098$ 66,491$ 73,935$ - 11.32% 9.47% 10.04% 7.07% 11.20%

Another factor that creates an opportunity for growth within the industry

is an aging population. As the world population grows, the need for medical

supplies and services will continue to grow as well. According to the United

States Census Bureau, between the years 2000 and 2050 the 65+ years

population will experience a growth increase of 147%. It can be concluded that

as the world population gets older, the medical services and supplies industry will

experience growth.

13

Concentration

Industry concentration is the number of firms that compete in an industry

and the firm’s size (in terms of market share) relative to its competitors. In an

industry that is not highly concentrated the level of competition will be higher

than that of a highly concentrated industry. Today, the industry includes 12,000

companies with combined annual revenues of $50 billion. In the last decade the

industry has become more concentrated with the top 50 companies controlling

60 percent of the market (firstresearch.com). To put that into monetary

numbers, the top 50 companies control about $30 billion of revenues. It must

also be noted that each segment becomes more concentrated as companies

begin to specialize in different services and products.

Industry Market Share

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

2002 2003 2004 2005 2006 2007

Year

Baxter

Abbott

Boston

Wyeth

Stryker

Differentiation and Switching Costs

Due to the immense segmentation of the industry, no company competes

directly with another company. However, the industry could be viewed as

having two distinct markets: the high tech market, and low-tech market. Low-

14

tech companies produce items such as latex gloves, syringes, surgical masks and

are concerned with high production efficiency and keeping costs low indicating

that the low-tech segment of the industry is moderate to highly competitive.

The fact that it is hard to differentiate latex gloves and syringes, allows

customers buying these products to switch between products with little to no

switching costs. Competition in the high-tech segment is relatively low. This is

due to the fact that this segment of the industry is driven by innovation and

specialization. Companies in this segment produce diagnostic and therapeutic

devices and usually find a device or service and specialize in that one area. This

makes it difficult for customers to switch products without avoiding high

switching costs because similar replacement products can be hard or impossible

to find (firstresearch.com).

Scale / Learning Economies and Fixed-Variable Costs

Both scale and learning economies exist within the medical supplies and

services industry. This can be seen in the large R&D expenditures of each

company. Due to the large R&D costs, companies must achieve high sales

volumes to cover this large cost. Large R&D expenditures show that this

industry has a high learning economy because many of the segments that

companies compete in are driven by innovation and first mover advantages.

R&D (Millions)2007 R&D 2007 Sales % of Sales

Baxter 760$ 11,263$ 6.75%Abbott Labs 2,506 25,914 9.67%Boston Scientific 1,091 8,357 13.05%Wyeth 3,257 22,400 14.54%Stryker 375 6,001 6.25%Industry 7,989$ 73,935$ 10.81%

15

Industry Assets and Asset Growth (Millions)2002 2003 2004 2005 2006 2007

Baxter 12,478$ 13,779$ 14,147$ 12,727$ 14,686$ 15,294$ - 10.43% 2.67% -10.04% 15.39% 4.14%

Abbott Labs 24,259$ 26,715$ 28,768$ 29,141$ 36,178$ 39,714$ - 10.12% 7.68% 1.30% 24.15% 9.77%

Boston Scientific 4,450$ 5,699$ 8,170$ 8,196$ 31,096$ 31,197$ - 28.07% 43.36% 0.32% 279.40% 0.32%

Wyeth 25,995$ 31,032$ 33,630$ 35,841$ 36,479$ 42,718$ - 19.38% 8.37% 6.57% 1.78% 17.10%

Stryker 2,816$ 3,159$ 4,084$ 4,944$ 5,874$ 7,354$ - 12.18% 29.28% 21.06% 18.81% 25.20%

Another indicator that this industry has economies of scale is the large

amounts of assets contained within the industry. Since it is vital for firms within

the industry to produce large quantities of products, it is intuitive that firms will

have to acquire large amounts of assets to be able to achieve sufficient

production to remain competitive within the industry.

Fixed-to-Variable Cost Ratio2002 2003 2004 2005 2006 2007

Baxter 0.69 0.62 0.61 0.54 0.53 0.59Abbott Labs 0.75 0.78 0.85 0.78 1.11 0.87Boston Scientific 1.93 2.13 2.53 1.54 4.16 2.57Wyeth 1.94 2.15 2.25 1.78 1.89 1.59Stryker 1.39 1.42 1.51 1.44 1.50 1.52

This chart shows the medical services and supplies industry maintains a

relatively high fixed-to-variable cost ratio. In comparison, the financial

management services company, Accenture, has a fixed-to-variable cost ratio of

.31. When fixed costs are high relative to variable costs, volume must be high to

cover the fixed costs. This means that companies within the industry lower

prices in order to compete for market share. Therefore, for the medical supplies

industry, the fixed-to-variable cost ratio is a source of increased rivalry.

Excess Capacity and Exit Barriers

16

It is evident from the industry growth rate given earlier that the medical

services and supplies industry is not operating at capacity. The exit barrier

within an industry is high when the assets of a firm are highly specialized. This

is the case in the medical services and supplies industry. Many companies find a

medical service and specialize in the production of products in that segment

making it very expensive to re-tool and attempt to enter another market.

Conclusion

An analysis of individual segments of the industry would reveal varying

levels of concentration, and therefore rivalry. However, when the industry is

taken as a whole, based on the above analysis, it can be concluded that the

medical services and supplies industry is moderately competitive with respect to

rivalry among existing firms.

Threat of New Entrants

The extent to which an industry allows the entry of new firms plays a very

important role in the profitability of that industry. If no significant barriers to

entry exist, and any firm can freely enter the industry, competitive pressures will

rise, exerting downward influence on price until no possibility for abnormal

profits exist. However, if very strong barriers to entry exist in the industry, the

established firms have the privilege of flexibility in pricing and the ability to

continually earn abnormal profits. Some of the key determinates of the threat of

new entrants are economies of scale and scope, first mover advantage, access to

channels of distribution and relationships, and legal barriers (Textbook, 2-2).

Economies of Scale and Scope

17

Economies of scale occur when there is a reduction in costs per unit

resulting from increased production realized through operation efficiencies

(investorwords.com). To remain competitive within the healthcare sector,

companies must produce large amounts of products efficiently. Efficient

production allows firms to allocate more of the cost of production to each

individual unit, which lowers total cost of production. Economies of scale can be

accomplished because as production increases, the cost of producing each

additional unit falls (investorwords.com). Incumbent firms have a competitive

advantage when economies of scale exist in an industry because they are able to

produce a higher volume of sales translating to a higher total contribution margin

to cover fixed costs. A potential new entrant to an industry exhibiting economies

of scale has two strategies. First, it can make large investment expenses up

front for which the initial low volume of sales will not provide enough total

contribution margin to cover fixed costs. Second, it can enter with less

investment expense which will translate to less initial capacity. Either strategy

would force the firm to enter the industry with a competitive disadvantage which

discourages entry altogether.

A valuable tool to discover potential economies of scale is the fixed-to-

variable cost ratio. As previously mentioned, the medical supplies industry had

an average fixed-to-variable cost ratio of 1.43 in 2007. This means that for

every dollar spent on variable costs, the average firm in the medical supplies

industry spent $1.43 on fixed costs. Compare this with the management

services company, Accenture, with a fixed-to-variable cost ratio of .31: the

average medical supplies firm in the industry spent about four and a half times

more than Accenture on fixed cost per variable cost dollar. Also, it’s important to

look at the specific fixed costs being incurred by the industry. The primary fixed

cost incurred by a medical supplies firm is research and development. It is this

cost that drives future profit for firms that compete heavily on the priority of

innovation. For the average medical supplies firm in the year 2007, research and

development expenses were 10.3% of total sales generated. A potential entrant

18

would have great difficulty acquiring enough capital to outlay these enormous

R&D expenditures, and entering the industry without spending a significant

amount on R&D would surely spell disaster. Therefore, the threat of new

entrants into the medical supplies industry is decreased due to economies of

scale creating a barrier to entry.

Another barrier to entry relating to the industry average firm size is

economies of scope. Economies of scope arise when a firm achieves cost

complementarities or other synergies between different product offerings. For

example, “Proctor & Gamble… produces hundreds of products from razors to

toothpaste. They can afford to hire expensive graphic designers and marketing

experts who will use their skills across the product lines. Because the costs are

spread out, this lowers the average total cost of production for each product.”

(http://www.investopedia.com/terms/e/economiesofscope.asp)

Similarly, the medical supplies industry exhibits in many ways the traits of

economies of scope. Many firms in the industry offer different products

marketed to different targets that share costs. For example, Boston Scientific

operates in three primary segments: cardiovascular, endosurgery, and

neuromodulation; Abbott Laboratories in four segments: pharmaceutical,

diagnostic, nutritional, and vascular; and Baxter in three segments: bioscience,

medication delivery, and renal. Baxter communicates the importance of

economies of scope in its 10-K: “Baxter also benefits from cost advantages as a

result of shared manufacturing facilities.” In reality, Baxter and other medical

supplies firms benefit from economies of scope in even more ways. The costs

associated with developing relationships with suppliers and buyers for one

product line are often shared with other product lines. Some production

processes are shared between two product lines thus sharing product cost. Also,

some of these different product lines use the same distribution channels thereby

distributing the cost of marketing over more than one line. However, as is the

case with economies of scale, a company must achieve a certain size to acquire

the capital necessary to realize such economies of scope. A potential new

19

entrant is unlikely to achieve this, so entry is deterred. Therefore, the medical

supplies industry enjoys a barrier to entry related to economies of scope.

First Mover Advantage

A first mover advantage occurs when firms entering the market earlier

gain competitive advantages unavailable to firms that move later. It could be

thought of as the “early bird gets the worm” advantage. There are many ways

that a leading firm could achieve first mover advantages ranging from as simple

as price setting to as complex as exclusive government contracts. First mover

advantages are also inextricably tied to some other barriers of entry. For

instance, leading firms can grow very quickly and establish economies of scale

and scope that themselves function as barriers of entry. Also, a leader has the

advantage of being the first to develop important customer and supplier

relationships that can create barriers to entry for lifetimes. Finally, a leading firm

may acquire important patents, which are legal barriers that severely limit the

ability of a firm to successfully enter the industry. In a somewhat strange

example, even states sometime experience first mover advantages. The state of

Delaware has experienced this advantage in the realm of corporate-friendly law.

20

“Although almost all American states have now copied many of Delaware's

corporate-law innovations, Delaware cemented its market dominance by its early

adoption of such reforms, giving it a "first mover advantage." Delaware fends off

competitors through standing committees of corporate lawyers, scholars and

others that continually propose new reforms that keep Delaware ahead of other

states.” (http://online.wsj.com/article/SB119810493339240635.html)

In some ways, the medical supplies industry exhibits first mover

advantages. The industry relies highly on customer and supplier relationships,

distribution channels, and intellectual property rights. All of these factors are

benefits that a first mover can take advantage of. To a certain extent, however,

the firms in this industry were first movers at some time in the past, and the

barriers to entry they enjoy today were first created with first mover advantage.

These barriers, including economies of scale, customer and supplier

relationships, access to distribution channels, and legal barriers, will be discussed

separately. There is one first mover advantage that Baxter, specifically, enjoys

that should be mentioned here. “Baxter’s Renal business benefits from its

position as one of the world’s leading manufacturers of PD products.” (Baxter

2007 10-K, page 3) This first mover advantage has allowed the company to

have a near-monopoly in this segment increasing its bargaining power with both

suppliers and customers. Also, in this segment particularly, switching costs for

customers are high due to the learning curve associated with using the product.

It is clear, therefore, that due to first mover advantages both in the past and in

the present, the existing firms in the medical supplies industry have been able to

greatly reduce the threat of new entrants.

Access to Channels of Distribution and Relationships

In some industries, it is particularly difficult to get the product to market.

Also, if firms already exist who have developed relationships not only with those

entities who distribute their products but also the end consumers of those

products, distribution can be twice as difficult and can function as a barrier to

21

entry. In some ways, access to distribution channels can be viewed as separate

from access to relationships, but in a certain way they are inextricably tied. For

instance, developing relationships with the end consumer, thereby driving

demand for a firm’s product, puts pressure on distributors to carry it, and

threatens potential monetary harm if they were to drop it. Thus, a new entrant

would have difficulty encroaching on that distribution channel. Also, the stronger

relationship a firm has with its suppliers creates access to better deals and

sometimes leaner operations.

The medical supplies industry appears to strongly exhibit characteristics of

barriers to entry regarding access to distribution channels and relationships.

Medical supplies are typically purchased by independent distributors who

warehouse very large quantities of product in order to provide quick customer

service. Also playing an increasingly prominent role in the medical supplies

industry are GPOs (Group Purchasing Organizations), which pool customers

together to make high volume purchases at lower prices. Relationships with

both distributors and GPOs are essential to the distribution of medical supplies.

An inability for a potential new entrant to establish these relationships would

present a significant barrier to entry. In the special case when an existing firm

can combine their access to distribution channel with a first mover advantage

that has created near-monopoly conditions for a particular segment, such as

Baxter’s renal segment, distributors would be extremely reluctant to drop the

product of the existing firm for fear that there would be no product available to

replace it. In these circumstances the barrier to entry is almost insurmountable.

It is important to note that a new entrant to the medical services industry who

introduces a celebrated, revolutionary new product, and therefore achieves a

first-mover advantage of sorts, would have access to distribution channels due to

the fact that the demand would exist and there would be no substitute available

from the existing firms. However, due to the economies of scope barrier to entry

discussed above, it is unlikely the firm could outlay the R&D expenses to develop

a product that could compete on this level. For these reasons, the existing firms

22

in the medical supplies industry likely enjoy a barrier to entry with regard to

access to distribution channels and relationships.

Legal Barriers

When the legal environment provides protection to existing firms a barrier

to entry exists. There are many ways these legal barriers are created including

patents, copyrights, and licenses. In some extreme cases, the legal environment

for a particular industry provides a perfect barrier to entry, such as the

government-sponsored monopolies like utilities. On the other extreme, there

sometimes exist reverse legal barriers to entry. When the Federal Trade

Commission discovers a firm restricting competition in an industry, it will often

interfere sometimes forcing the divestiture of segments and creation of new

competitors.

In the medical supplies industry, the most prominent legal barrier to entry

is the patent. With research and development being the primary cost driving

profits in the industry, it is important to protect the end result of that process,

intellectual property. Patents allow for a certain time period in which competition

is restrained by mandate of the federal government. Without this protection,

there is less incentive to expend resources on R&D as it would reduce the

probability of abnormal profits. Interestingly, it appears that the Supreme Court

is making moves to significantly lower the power of intellectual property rights in

the United States. The “high court has reinvented patent law, throwing out rigid

rules favoring patent owners in favor of more flexible approaches….Companies

accused of infringing patents, often large manufacturers, now have less incentive

to settle, a shift that could reduce the number of claims by patent holders as well

as the size of financial settlements.”

(http://online.wsj.com/article/SB120044219015792747.html) This change in the

legal environment could reduce the power of this legal barrier to entry. It is also

important to note that the existing firms in the industry sometimes suffer from

the reverse legal barriers to entry previously discussed. In the case, 123 F.T.C.

23

904 (March 24, 1997) the Federal Trade Commission struck down an attempt by

Baxter International to acquire Immuno International citing that it, “raised

competitive problems in both a current goods market where the two firms were

horizontal competitors and an innovation market where the two firms produced a

current product but both were among the few firms with a chance to enter the

market.” The commission concluded that, “New entry in both product lines

would be difficult and time consuming.” To comply with the consent order as

required by the commission, Baxter was forced to divest a portion of its business

to a competitor and to allow another competitor to license a Baxter product.

“Thus, the order brought two competing products to market simultaneously.

Absent the order, only one product likely would have prevailed.”

(http://www.ftc.gov/bc/rxupdate) Clearly, the aforementioned legal actions

function as reverse barriers to entry allowing for an increase in the threat of new

entrants. The threat however is small compared to the benefit of patent

protection even in an environment where that protection is decreasing. Overall,

the legal environment still seems to provide the existing firms with a barrier to

entry.

Conclusion

There is compelling evidence to suggest that the threat of new entrants

into the medical supplies industry is very small. In fact, for every circumstance

discussed that would provide for a barrier to entry to exist, it in fact does to a

certain degree with regard to the medical supplies industry. Therefore, while the

rivalry between existing firms and the threat of substitute products may tell a

slightly different story, the threat of new entrants is not one that adds to the

overall threat of actual or potential competition within the industry.

24

Threat of Substitute Products

The third factor in the five forces model is the threat of substitute

products. “The threat of substitutes depends on the relative price and

performance of the competing products or services and on customers willingness

to substitute” (Textbook, 2-4). When drugs are initially introduced, a patent life

of 17 years begins. After the 17 years expires, it is then legal for generic

substitutes of the drug to be produced. The substitutes generally cost a lot less

and it is estimated that “loss of patent protection can reduce sales by up to

90%” (wikinvest.com). Companies in the industries often purchase the rights to

a competitor-developed drug that might compete with their own drug. An

example of this action is when a company purchases the rights to produce

different pharmaceutical products. This helps to diminish the threat of

substitutes.

25

If a firm acquires its competitors to the effect that it eliminates

competition, it can cause the Federal Trade Commission to intervene to prevent

a potential monopoly. A good example of this was the proposed transaction in

June 8, 2002 between Baxter International and Wyeth. In the proposed deal,

Baxter would acquire a substantial portion of Wyeth’s assets, a subsidiary named

ESI Lederle (ESI). Wyeth’s ESI subsidiary manufactures and supplies injectable

drugs. The complaint by the Federal Trade Commission was that it would violate

Section 7 of the Clayton Act and Section 5 of the FTC Act by allowing Baxter to

monopolize the industry. The concentration of the market makes it more difficult

for a competitor to propose a threat or provide cost effective substitute products

as well as create barriers to entry. Overall, Baxter’s strategy to control the threat

of substitutes is to acquire the divisions that could potentially pose a current or

future threat. The proposed solution from the FTC was for Baxter to divest all of

its interest in Wyeth’s assets to a Commission approved buyer (ftc.gov).

Due to patent protection and the acquisition of potential competitors,

firms in the industry are minimizing the threat of substitute products. In

conclusion, the threat of substitutes is low for the industry due to the minimizing

effect that acquisitions and patents have on substitute products

26

Bargaining Power of Buyers

The bargaining power of buyers influences the profits that are attainable

by a firm. There are two sides to the bargaining power of buyers: input and

output. On the input side, firms enter into transactions with suppliers of labor,

raw materials and components, and finances. On the output side, firms either

sell directly to customers, or enter into contracts with intermediaries in the

distribution chain. Bargaining power of buyers is influenced by two factors: price

sensitivity and relative bargaining power (Textbook 2-5).

Price Sensitivity

Buyers are more sensitive to price when the product is undifferentiated

and switching costs are low. If a firm increases a price above a competitor price

on a similar product, the buyer is likely to switch to the lesser cost. Within the

industry, contracts between a firm and a buyer neutralize the effects of

sensitivity to price. A contract legally obligates a buyer to purchase the products

27

of the seller regardless of price. The benefit for buyers is that there are often

stated price limits in the contract.

When considering price sensitivity within the industry, two segments must

be considered. The first segment concerns generic supplies such as: syringes,

saline solutions, latex gloves, etc. Price sensitivity within this “segment” is

relatively high because these are undifferentiated products that are easily

substituted for cheaper products offered by another firm. The second segment

concerns products that are more specialized in use, such as: IV pumps and

dilation machines. Price sensitivity is relatively low in this “segment” because

products are not easily substituted and the costs of not doing business with

these companies are high.

Relative Bargaining Power

Bargaining power concerns the leverage a buyer has in negotiating a

price. The ability of a buyer to negotiate purchases at lower prices is completely

dependent upon the costs of both buyer and seller not doing business with each

other. When considering the relative bargaining power that exits between

buyers and sellers within the industry, Group Purchasing Organizations, or GPOs,

are the largest influences on strength of relative bargaining power.

GPOs carry considerable power in the buying side. Buyers effectively pull

their bargaining power together to form a stronger buying alliance. Many

customers are joining these types of groups and many of these groups are

developing their own integrated delivery networks, which also carry great appeal

to buyers. GPOs also develop a power to be able to negotiate better agreements

with firms in the industry should these firms not be competitive in the pricing on

the products they offer.

Despite the bargaining power of GPOs in some product lines, firms within

the industry offer some products that are not subject to the bargaining power of

28

buyers. If the firm is the sole supplier, or there are very few suppliers of this

unique product, then the bargaining power of buyers is greatly reduced.

Bargaining Power of Suppliers

The bargaining power of suppliers influences the costs of production of a

firm. The strength of the bargaining power is relative to the ability of firms to

have multiple choices when choosing a supplier. When suppliers do not have

much bargaining power within the industry, prices tend to be lower because the

suppliers do not have much leverage. In contrast, when suppliers have a lot of

leverage over the firms in the industry, they can exercise higher prices to firms.

Price Sensitivity

Firms in the medical services and supplies industry often enter into long-

term supply contracts with their suppliers to provide an assurance of continuing

supply and also to eliminate the risk associated with price increases due to

market fluctuations. Price increases from suppliers are an obstacle because firms

within the industry cannot always offset the price increase by increasing their

prices to customers. This is because they often have contracts with their own

29

buyers that set price limits. Companies within the industry, have varying price

sensitivity when purchasing from suppliers. For the basic undifferentiated raw

materials that they purchase companies within the industry are price sensitive.

They are likely to switch suppliers if the current supplier raises the price relative

to their competition. But, there are possible switching costs involved due to

contracts with certain suppliers that reward loyalty. Other products that these

firms purchase from suppliers have to meet strong quality standards and

switching between suppliers is not always possible.

Relative Bargaining Power

Companies within the industry have more bargaining power relative to

their suppliers. This is because they are a large, diverse medical supplies and

services companies. For example, Baxter purchases simple, undifferentiated

materials and other simple medical instruments from a wide variety of

companies. These suppliers rely more on Baxter than Baxter relies on them. If

a company that only produces two simple products goes out of business, firms in

the industry will have no problem obtaining these resources from another source.

On the other hand, there are not many companies comprising the medical

instruments and supplies industry that are of Baxter’s size. It is crucial for

suppliers to engage in contracts with a company like Baxter to increase their own

sales and financial well-being.

30

Value Chain Analysis

The analysis of a firms or industry’s competitive strategy will reveal

whether the dominant strategy of an industry or firm is cost leadership or

differentiation. Cost Leadership is the clearest way to achieve a competitive

advantage, and involves keeping production costs low in order to pass the

savings on to the customer. Cost Leadership is the most effective competitive

strategy in highly competitive industries in which price competition is fierce.

Differentiation involves creating many new products to meet customer demands

and achieving superior product quality sometimes through large expenditures on

R&D. The medical supplies industry is one that focuses on differentiation, and

the key success factors of any firm in the industry will support that competitive

priority.

Superior Product Quality

The industry tries to achieve a high level a product quality for two

reasons. First, consumers of medical supplies and services demand superior

31

quality. Second, the industry must meet product specifications set by the FDA.

Failure to meet these, results in a product being prohibited from being sold in

the market or, in the worst case, harm to the end consumer resulting in adverse

legal liability, loss of profits and market share. The industry seeks superior

product quality, and this can be seen in the 10-Ks of the companies within the

industry, when they state superior product quality to be an important part of

their competitor’s strategies. Also, each firm within the industry states that they

implement quality management controls within the production process.

Investment in R&D

The medical services and supplies industry spends large amounts of

money on R&D. This fact alone would suggest that the main competitive

strategy in the industry is innovation.

R&D Expense (Millions)2002 2003 2004 2005 2006 2007

Baxter 501$ 553$ 517$ 533$ 614$ 760$ Abbott Labs 1,562 1,734 1,697 1,821 2,255 2,506 Boston Scientific 343 452 569 680 1,008 1,091 Wyeth 2,080 2,094 2,315 2,649 3,109 3,257 Stryker 141 180 332 285 325 375

R&D (Millions)2007 R&D 2007 Sales % of Sales

Baxter 760$ 11,263$ 6.75%Abbott Labs 2,506 25,914 9.67%Boston Scientific 1,091 8,357 13.05%Wyeth 3,257 22,400 14.54%Stryker 375 6,001 6.25%Industry 7,989$ 73,935$ 10.81%

32

Creativity and Innovation

The medical services and supplies industry is driven by the need to create

new products. The industry is one that attempts to create an environment that

encourages and rewards creativity and innovation as can be seen by the

industry-wide R&D expenditures.

Conclusion

The medical services and supplies industry emphasizes differentiation as

the competitive strategy. While the industry participates in some cost

leadership activities, these activities are performed so that differentiation can be

achieved at an acceptable cost. This is to say that cost leadership activities are

not undertaken due to fierce price competition but rather to support its true

priority of differentiation. Concerning differentiation, the industry undertakes

superior product quality, investment in R&D, and investment in creativity and

innovation.

33

Firm Competitive Advantage Analysis

An important part of analyzing a firm is discovering what factors that firm

deems vital to its success. After it has been determined if a firm has obtained

their stated key success factors, it must then be determined whether or not the

firm is pursuing their key success factors in such a way as to make the business

competitive and profitable. Baxter has recognized that its key success factors

are superior product quality, investment in R&D, and creativity and innovation.

Superior Product Quality

To sustain competitive advantage Baxter seeks to achieve superior

product quality. Baxter continuously assesses its suppliers of raw materials and

finished goods. They also have a network of quality systems within their

businesses and facilities, which relate to the design, development,

manufacturing, packaging, sterilization, handling, and distribution of their

products (Baxter 10-K 2006).

34

Investment in R&D

As of 2007, R&D expense constituted 6.75% of Baxter’s revenues. They

stated in their 10-K that the company was looking to enhance the prioritization

and approval of R&D projects, and that they were looking to match R&D

expenditures with the company’s growth (Baxter 10-K 2006). It should be

noted, also, that the acquisitions that have recently dominated the firm’s

operations are an unconventional, but significant method of acquiring R&D.

Therefore looking only at the R&D expenses reported on the income statement

significantly understates the true outlays Baxter makes on R&D.

Creativity and Innovation

To maintain its market share Baxter must create new products. To do

this, they create a business environment that “awards science and innovation”

(Baxter 10-K). One example is there creation of subcutaneous delivery systems,

which is proprietary.

Conclusion

Baxter has done a good job at implementing and pursuing their key

success factors and their chosen competitive strategy will allow them to remain

extremely competitive within the industry.

35

Accounting Analysis

In a structured business analysis of a firm, the accounting analysis is a

method of evaluating the way a company reports its financial statements. The

financial statements include an income statement, balance sheet, cash flow

statement, footnotes to the financial statements, and a management discussion

section. Although GAAP (Generally Accepted Accounting Principles) has several

strict guidelines, there are some guidelines that allow for flexibility. This

flexibility enables management to manipulate some of the numbers in the

financial statements to make the company look better than it actually is. This

analysis will help to identify those distortions and then adjust the numbers to

“undo” the distortions.

The accounting analysis has six steps. The first step is to identify the key

accounting principles. These principles are directly related to the key success

factors, which shows where a firm can obtain a competitive advantage. The

second step is to assess accounting flexibility. The degree of flexibility of a firm

is directly related to their key accounting policies and their key success factors.

36

The third step is to evaluate accounting strategy. Firms that have a lot of

flexibility can choose to disclose all the information or disclose very little.

Managers can also tend to manipulate numbers to overstate net income,

especially if their salary is tied to this number. The fourth step is to evaluate the

quality of disclosure. The less a company chooses to disclose, the less

transparency and the more difficult it is for an analyst to gauge the firm’s quality

of accounting. The fifth step is to identify potential “red flags.” These are areas

of questionable accounting practices, in which an analyst needs to more

thoroughly investigate the item. The final step in accounting analysis is to undo

accounting distortions. This step involves restating balance sheet or income

statement items that have been presented deceptively. The accounting analysis

is a great tool to find misleading or undisclosed information and correct the

financial statements to get a truer view of the firm. (Textbook)

Key Accounting Policies

First, it is necessary to review the key success factors found in the

business strategy analysis. A firm’s key success factors are determined by its

competitive strategy and the industry characteristics. An assessment of

accounting policies concerning these factors could then reveal accounting that

might have misrepresented the firm’s execution of its competitive strategy. Then

one must identify other accounting policies that might materially misrepresent

the value of the company in other ways. It is important for an analyst to be able

to identify and evaluate the policies and estimates the firm uses to measure its

critical factors and risks (Textbook). Baxter’s key success factors identified in the

Firm Competitive Advantage Analysis are superior product quality, investment in

research and development, and creativity and innovation. Accounting policies

that could distort these success factors are research and development expenses

37

and recording of goodwill. Also, the accounting policy concerning the disclosure

of pension plans could materially misrepresent the value of the firm.

Acquisitions are playing an increasingly prominent role in the operations of

Baxter International. Acquisitions are important to consider in the accounting

analysis for Baxter for two reasons. First, when an acquisition takes place, the

amount paid for the acquired company is usually somewhat higher than the

revalued assets less the revalued liabilities. For the books to balance, the

acquiring company must enter a balancing entry called goodwill, an intangible

asset created specifically for this purpose. Another reason that acquisitions are

an extremely important consideration in the accounting analysis for Baxter is

research and development. Research and development performed in-house is

normally written off directly as an expense during the period in which the

expense was incurred. However, though the practice of acquisition may have a

similar effect as that of R&D expenditure, the result of this acquisition serves

only to increase equity unlike R&D, which serves to decrease equity.

Another key accounting policy is how a company handles its defined

contribution benefits. Companies must estimate the pension liabilities and agree

to contribute fixed amounts to cover future benefits. Typically, there is little

forecasting to estimate annual cost since the firm’s obligation is limited to the

annual obligation to contribute to employee retirement funds. The firm’s method

of estimating pension cost can have an impact on their liabilities. (Text)

Potential Accounting Flexibility

The next step in the accounting analysis is to determine the level of

flexibility a firm has relating to the key accounting policies. GAAP allows for

some flexibility with some accounting policies and the way they are disclosed in

the firm’s financial statements could affect the perceived value of the company.

38

However, the opposite also applies. GAAP sometimes does not allow any

flexibility in the way an item is reported. An example of this is the inability of a

firm to capitalize research and development; they are required to expense the

cost as incurred.

Goodwill

Prior to the year 2002, companies had no flexibility in reporting goodwill.

This is because they were required to take a yearly goodwill amortization charge

to reduce net income. Then FASB issued statement FAS No. 142, which applies

to companies with fiscal years beginning after December 15, 2001. Due to this

new statement, “companies will no longer be forced to take regular charges

against goodwill, unless it is discovered that the value of the asset, including

goodwill, is not equal to book value” (FASB). What this basically means is, all

goodwill must be reappraised yearly to determine if the carrying value of the

goodwill exceeds its fair value. If the carrying value exceeds the fair value, the

firm should write down the goodwill to the lower-of-cost-or-market with an

impairment charge that is reported as a loss directly on the income statement.

The new principle was enacted to help managers better present the true value of

the company on the books, but as is always the case when managers are given

greater accounting flexibility, there is an increased probability of manipulation.

Goodwill that is failed to be impaired properly will overstate the value of assets

and therefore overstate equity. The result of these overstatements is a rosier

depiction of the firm than reality.

Research and Development

There is a great debate between those who argue that, according to the

matching principle, research and development should be capitalized and

amortized and those who argue that, according to the reliability principle, it

should be expensed as incurred. The former argument is that investment in

research and development leads to revenues that will extend beyond the period

39

in which the investment took place and, therefore, should be capitalized as

assets and amortized over the time period the revenues occur. FASB, however,

took the side of those arguing for reliability when it released Statement 2 in

1972. (FASB) In the statement, FASB decided that it is too difficult for specific

revenues to reasonably be matched to specific R&D expenses, reducing reliability

to a level to require the expenses to be written off when incurred rather than

capitalized. For in-house R&D there is zero flexibility in this rule and therefore

deserves no further consideration at least in the realm of intentional managerial

accounting manipulation. However, the fact that GAAP allows no flexibility in

external accounting for R&D does not preclude users of this information from

manipulating and interpreting the data in whatever way they see fit. So a

financial analyst may decide that it is better to capitalize R&D rather than

expense it when incurred. In the case of Baxter, the capitalization of R&D would

allow a better comparison with companies for whom the majority of investment

is recordable as assets in the financial statements.

Pensions

A form of flexibility that could be used to distort the view of a company is

when pension expense is recorded on the income statement. This can affect

either assets or liabilities depending upon the actual amount that was paid in the

current period to qualified employees. It contributes to the overall liability of the

company until paid. There may be an attempt to understate liabilities if too high

of a discount rate is used to estimate future pension payments. The

understatement of the liabilities would come from understating pension

expenses, thereby overstating net income and owner’s equity for the period. The

opposite is also true. Additionally, the way that the firm determines the fair

value of their obligations will directly affect the net obligations that will be

realized on the balance sheet.

Companies had great flexibility in the reporting of pension and benefit

plans prior to the adoption of SFAS No. 158 on December 31, 2006. However,

40

after 2006 it became mandatory to fully recognize the overfunded and

underfunded portion of the defined benefits plan and other post employment

benefits. This has greatly decreased the amount of flexibility in recording the

assets and liabilities generated from the programs. Discount rates are another

area of flexibility relating to pensions that could affect the perceived value of

Baxter. As previously discussed, the discount rate that is used to actually

forecast these future expenses can be overstated or understated. If the discount

rate is overstated they are understating their liabilities, overstating equity, and

overstating net income. Overall disclosure relating to pension and plans is

adequate and shows a clear picture.

Actual Accounting Strategy

Accounting flexibility is the main dictator in accounting strategy of the

firm. If there is enough flexibility a firm can choose whether to fully disclose an

item or not. Managers also have an incentive to make financial statements

appear better than they actually are for stakeholders, which are people that are

affected by the company. Overall, Baxter International and its competitors

disclose their information very well in relation to research and development,

goodwill, and pensions.

Goodwill

In the reporting of goodwill, Baxter has an extremely high level of

disclosure. They offer significant figures for each business segment as well as

sufficient discussion and management discussion and analysis. Baxter does not

disclose as well as its competitors. Baxter is aggressive in their reporting of

goodwill because they do not record impairment every year.

41

Medication Delivery BioScience Renal Total

December 31, 2003 860$ 571$ 168$ 1,599$ Other 35 12 2 49

December 31, 2004 895$ 583$ 170$ 1,648$ Divestiture of Tawaiinese Services (28) (28) Other (14) (19) (9) (42)

December 31, 2005 855$ 564$ 133$ 1,552$ Other 15 43 8 66

December 31, 2006 579$ 898$ 141$ 1,618$ Divestiture of Transfusion Therapies (12) (12) Other 20 50 14 84

December 31, 2007 587$ 948$ 155$ 1,690$

Goodwill by Business Segment (Millions)

Source: Baxter's 10K's

Research and Development

The level of disclosure relating to R&D is extremely high in Baxter’s 10-K.

Not only does Baxter disclose all the total amounts of R&D expenditures annually

as required by GAAP, but it also disaggregates these totals into amounts spent

on specific R&D investments. It also describes in the footnotes the successful

results of these investments such as FDA approvals and other significant

business developments related to R&D investment.

Pensions

The level of disclosure concerning pensions and other post-employment

benefit programs is extremely high. Baxter offers a full explanation in Note 8 of

the Notes to Consolidated Financial Statements section in the 10-K explaining the

adoption of SFAS No. 158 and its impact on the company. They have a

disaggregated reconciliation of Pension and OPEB plan obligations, assets,

funded status, and fair value amounts of obligations. They also provide the

interest rates used to estimate the expected pension expenses and expected

future pension expense payments and are very conservative in their reporting.

42

43

Qualitative Analysis of Disclosure

Quality of disclosure measures how useful a company’s financial reports

and management discussion are in the 10-K submitted to the SEC. If the

financial reports are fairly transparent, users of financial information should find

them fairly useful. The more transparent a firm’s financial statements are, the

more of a “true and fair picture” you get of the company from the financial

statements. However, if disclosure is inadequate, stakeholders will be a little

more doubting of the information you provide.

Goodwill

Baxter’s level of transparency concerning goodwill is fair. However,

Baxter makes no effort to give any in-depth explanation as to why goodwill was

only impaired in 2002 and not in any other year for period between 2002 and

2007. The only explanation given as to why consistent goodwill impairments do

not exist on a yearly basis is a very vague restatement of SFA 148, which only

explains the process for impairing goodwill.

44

Research and Development

As stated above, Baxter’s level of disclosure is very high concerning

research and development expenses. Not only do they show total amounts, but

they disaggregate these amounts in numerous ways. Therefore, the company’s

level of transparency is very high concerning R&D.

Pensions

They are very transparent in the discussion of the reporting of their

pension and benefit figures. They discuss in detail how the different accounting

policies that they adopted over the five year period. This can be seen in their

discussion of the impact that the adoption of SFAS 123-R had on the pension and

benefit expenses. Baxter’s overall quality of disclosure in regards to defined

benefits contribution plans is adequate. Overall benefit obligations and fair value

of assets for Baxter have been increasing. The difference between benefits

obligation and fair value of plan assets is the funded status. The funded status

shows that Baxter has been under-funded throughout the years. The next step

of the process is to take the funded status and subtract or add unrecognized net

losses and fourth quarter contributions and benefit payments. The end result is

the realizable amount that will be recognized as an asset or liability due to SFAS

No. 158. After contributions and losses are factored in, it will become a liability if

they are underfunded. If overfunded, it becomes an asset on the balance sheet.

This shows that the last two periods of Baxter’s pension plan have been

underfunded. This under-funding is realized as a liability on the balance sheet

showing a clear view of the actual pension liabilities. Based on this Baxter can

now find new ways to fund future benefit plans ahead of time through

investments.

45

Pension Benefit Obligations (Millions)2004 2005 2006 2007

Fair Value of Plan Assets 1,739$ 2,052$ 2,668$ 2,998$ Year End Benefit Obligation 2,838 3,152 3,220 3,307 Funded Status (1,099)$ (1,100)$ (552)$ (309)$ 4th Quarter Contributions 9 428 9 9 Unrecognized Net Losses 1,366 1,386 - - Net Amount Recognized 276 714 (543) (300) *from Baxter's 10-K's

OPEB Benefit Obligations (Millions)2004 2005 2006 2007

Year End Benefit Obligation 563$ 506$ 511$ 479$ Funded Status (563)$ (506)$ (511)$ (479)$ 4th Quarter Contributions 201 126 6 5 Unrecognized Net Losses 9 5 - - Net Amount Recognized (353)$ (375)$ (505)$ (474)$ *from Baxter's 10-K's

The year prior to 2006 shows that Baxter was actually creating an asset

through their pension benefits. The adoption of SFAS No. 158 has made it

possible to show more transparency to investors so that they have a more

complete view of the company. Baxter currently estimates the present value of

its future pension obligation with a discount rate of 6%. This present value is its

liability on the books. In the last two years they show they have underfunded

pensions meaning that they could likely have an increase in future pension

estimates. An investor would be interested in this information since it would

affect the overall net income of a company through pension expense. The new

adopted rule would also explain to investors why there is now in the last two

years a big shift in pension liability due to the way they are recorded. This may

alleviate some fears an investor might have.

46

Baxter’s discount rate used in recent years is higher than that of its

competitors. This shows that they have higher pension expenses on a common

size platform. Actual pension expense is steadily rising for all competitors. The

fact that Baxter is using a higher discount rate to forecast these expenses may

show that they are more efficient in covering pension cost or they are using too

high of a rate for estimating. One would have to consider the strategy Baxter

uses for alternative investment methods to obtain a return that efficiently funds

future pension cost.

OPEB (Other Post Employment Benefits) are viewed in the same way as

pension expenses but are separated out to better illustrate the difference

between OPEB and defined benefit obligations. After the adoption of SFAS No.

158 in 2006, Baxter’s actual OPEB showed that their medical pension liabilities

grew dramatically. This shows that over time liabilities have increased and the

47

way the company funds these benefits possibly needs to be reevaluated. There

is potential need for a more comprehensive method of funding these future

healthcare benefits of retired persons.

Quantitative Analysis of Disclosure

A quantitative analysis of the level of disclosure is done by analyzing key

accounting ratios. Managers are afforded some flexibility in the reporting of the

financial statements. This flexibility allows managers to use their intimate

knowledge of the industry and their firm to report the financial statements in a

way that more accurately resembles the real impact that their decisions had on

the company. An analysis of the key accounting ratios reveals any area where

an inconsistency in the numbers might exist. It should be noted that an

inconsistency does not necessarily mean that an accounting distortion has

occurred. It is a signal that further analysis should be done to determine the

reason for the inconsistency.

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In order to determine whether a firm is properly accounting for its

business activities with accuracy and dependability, we look at two separate

groups of quantitative indicators. The first group is sales manipulation

diagnostics. This group is composed of ratios that have a direct relationship with

net sales. Performing an analysis of these ratios will help determine whether the

firm is trying to paint a different picture of productivity than its actual

productivity. In this set of diagnostics we will divide net sales by the following:

cash from sales, net accounts receivable, and inventory. On the other hand, we

will take a look at expense manipulation diagnostics. This group of varying ratios

will help us locate unexplained increases or decreases in expenses. An

unexplained increase or decrease in expenses is an indicator that the firm could

be manipulating their expenses in an attempt to create a different perceived

value of the company. Both groups of diagnostics will be analyzed to check the

integrity of the company released numbers along with any red flags that they

establish.

Sales Manipulation Diagnostics

An analysis of the revenue diagnostics of Baxter will allow the

identification of trends that exist with their financial figures. Any deviation from

the ratio trend during the 2002-2007 period will reveal potential distortions in the

financial statements. Baxter is then compared to its competitors to determine if

the deviation is normal throughout the industry or if the deviation is firm specific.

The following section will analyze the key accounting ratios for Baxter measured

against its competitors. (See Figure 1.1 in Appendix)

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Net Sales / Cash from Sales

The ideal value for this ratio is 1:1, meaning that the sale of a firm’s

inventory results in the immediate collection of cash from the sale. In reality,

this ratio is not always 1:1 because firms sell inventory to customers on account

thus delaying the collection of the cash from the sale. If the average for this

ratio is taken for the five year period is ±.02 from 1, this means that sales

increase while cash from sales did not. It would then be necessary to determine

the industry wide trend for this ratio and determine if this fluctuation is isolated

to the firm in question. If the fluctuation is firm specific, analysis should be done

to reveal the reason for the change in numbers.

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Net Sales / Cash from Sales

0.96

0.98

1.00

1.02

1.04

1.06

1.08

Baxter 1.03 1.02 1.01 0.97 1.01 1.02

Abbott 1.01 1.02 1.02 0.99 1.03 1.03

Boston 1.02 1.03 1.07 1.01 1.07 1.01

Wyeth 0.98 1.01 1.02 1.01 1.02 1.01

Stryker 1.03 1.03 1.07 1.00 1.02 1.03

Industry Avg. 1.01 1.02 1.05 1.00 1.04 1.02

2002 2003 2004 2005 2006 2007

Baxter’s five-year trend coincides with the industry five year trend. The

only fluctuation in Baxter’s trend is in the period of 2004-2005 when there was a

sharp decline in the value of the ratio. After further ananlysis, this was due to a

sharp decrease in the amount of accounts recievables.

Net Sales / Accounts Receivable

51

Net Sales / Accounts Receivable

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

Baxter 4.41 4.51 4.55 5.58 5.65 5.56

Abbott 6.04 5.94 5.32 6.25 5.31 5.24

Boston 6.71 6.41 6.25 6.74 5.49 5.56

Wyeth 6.13 6.27 6.20 6.19 6.02 6.35

Stryker 7.40 7.27 5.67 6.32 6.03 5.82

Industry Avg. 6.57 6.47 5.86 6.38 5.71 5.74

2002 2003 2004 2005 2006 2007

An analysis of the ratio trend for Baxter shows that in the period 2003-

2004, that there is a significant change in the value of the ratios. We believe

that an accounting distortion occurred in this period. The reason we believe this

is because an analysis is because there was a significant increase in the amount

for the allowance for bad debt as can be seen in the chart given below.

2002 2003 2004 2005 2006 2007Allowance 70$ 84$ 147$ 147$ 120$ 127$ Accounts Receivable 1,793 1,914 2,091 1,766 1,838 2,026 Gross A/R 1,863 1,998 2,238 1,913 1,958 2,153 Allowance / Goss A/R 3.80% 4.20% 6.60% 7.70% 6.10% 5.90%

The increase in the amount of allowance caused Baxter to understate net

income and overstate their return on assets. We believe that the reason for this

descision was to take a current loss with the expectation of higher earnings in

the future.

Net Sales / Inventory

52

This ratio is used to show that a company’s inventory is supporting its

sales. Inconsistencies in the trend could indicate that a company is distorting its

sales figures because it can be assumed that as sales increase inventories

increase as well. In Baxter’s case, the trend over the five year period id

relatively constant and was also moderately consistent with the industry average

and would indicate that no distortions occurred.

Net Sales / Inventory

3.00

5.00

7.00

9.00

11.00

13.00

15.00

17.00

Baxter 4.65 4.24 4.45 5.12 5.02 4.83

Abbott 7.24 7.19 7.51 8.79 8.01 8.78

Boston 12.01 12.37 15.62 15.03 10.44 11.53

Wyeth 7.32 6.57 7.00 8.04 8.20 7.38

Stryker 7.06 7.75 7.71 8.65 8.07 7.54

Industry Avg. 8.41 8.47 9.46 10.13 8.68 8.81

2002 2003 2004 2005 2006 2007

Conclusion

53

We believe that Baxter has had very little distortion in the reporting of

their sales numbers. The only area where there was distortion was in their

accounts receivables and the distortion was in the amount that Baxter quoted for

allowance for bad debts in 2004 and 2005.

Expense Manipulation Diagnostics

54

The expense ratios are a set of tools that analysts can use to perform an

analysis of a company’s accounting practices concerning the recording of

business expenses. When an analysis of the expense ratios is done, the year by

year results can be compared and any inconsistencies in the trends of the value

of the ratios can be analyzed to uncover any potential inconsistencies in the

recording of expenses by a firm. (See Figure 1.2 in Appendix)

Asset Turnover

55

The explanation for this ratio is that as sales increase, assets increase as

well. Any major fluctuation within the five-year period could mean that

excessive write-offs occurred or that assets are overstated. The industry, as a

whole, did not experience major fluctuations in the asset turnover trend,

however, Boston Scientific did in 2006 because of their acquiring of Guidant. We

believe that there were no distortions in this ratio.

Asset Turnover

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Baxter 0.65 0.65 0.67 0.77 0.71 0.74

Abbott 0.73 0.74 0.68 0.77 0.62 0.65

Boston 0.66 0.61 0.69 0.77 0.25 0.27

Wyeth 0.56 0.51 0.52 0.52 0.56 0.52

Stryker 1.07 1.15 1.04 0.99 0.93 0.82

Industry Avg. 0.76 0.75 0.73 0.76 0.59 0.57

2002 2003 2004 2005 2006 2007

Cash Flows from Operations / Operating Income

56

This ratio gives a picture of how much of operating income is cash. The

first thing you will notice with this ratio, in relation to Baxter, is the huge

increase it had in 2004. We believe that there may have been some

manipulation here. If Baxter knew that sales were lagging for the period and

earnings were going to suffer anyway, they may have decided to take a “big

bath” and take an extra loss ahead of time. Gross profit margin decreased by

more than 3% indicating that cost of goods sold became a greater percentage of

sales. Theoretically, cost of goods sold may have actually been lower than the

amount reported, but Baxter wrote off more inventory, than they actually sold in

the period, in order to increase perceived future earnings.

CFFO / Operating Income

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Baxter 0.82 1.15 2.61 0.99 1.23 1.03

Abbott 1.18 1.13 1.10 1.16 2.58 1.13

Boston 1.21 1.13 1.15 0.93 -0.63

Wyeth 0.06 0.89 0.69 0.53 0.63 0.91

Stryker 0.87 0.90 0.82 0.86 0.81 0.79

Industry Avg. 0.83 1.01 0.94 0.87 0.85 0.94

2002 2003 2004 2005 2006 2007

Cash Flows from Operations / Net Operating Assets

57

This ratio is used to show how much cash a company’s assets generate.

We believe that the sudden increase in the value of the CFFO/NOA ratio is due to

a significant decrease in current assets in 2005. The decrease in current assets

decreases net operating assets and therefore, decreases the ratio. Accounts

receivable was a significant portion of current assets’ decline, but we do not

believe there is any distortion in this ratio.

CFFO / Net Operating Assets

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Baxter 0.91 0.88 0.80 1.63 0.65 0.62

Abbott 1.97 1.41 1.10 1.27 0.22 1.05

Boston 2.58 1.62 2.64 0.78 0.81 0.35

Wyeth 0.03 0.45 0.49 0.29 0.32 0.38

Stryker 0.09 1.19 0.58 0.53 0.40 0.29

Industry Avg. 1.17 1.17 1.20 0.72 0.44 0.52

2002 2003 2004 2005 2006 2007

Pension Expense / SG&A

58

Pension expense / SG&A is an expense diagnostic ratio that reveals how

much of SG&A expenses is made up of pension expense and therefore, pension

expenses could be understated as a percentage of SG&A expense. In the

industry, pension expenses are very small in relation to SG&A expense,

therefore, we believe that this ratio is irrelevant. Even if there is a misstatement

in pension expense, the amount would be insignificant and there is no need to

further analyze.

Pension Expense / SG&A

-0.02

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

Baxter -0.01 0.03 0.05 0.08 0.08 0.06

Abbott 0.03 0.03 0.03 0.03 0.03 0.03

Wyeth 0.03 0.04 0.04 0.04 0.04 0.03

Stryker 0.00 0.01 0.01 0.01 0.01 0.01

Industry Avg. 0.02 0.02 0.02 0.02 0.02 0.02

2002 2003 2004 2005 2006 2007

Conclusion

59

Careful analysis of the expense ratios reveals that a distortion has

occurred in only one area of the financial statements, which was CFFO /

Operating Income.

60

Potential “Red Flags”

The next step is to identify possible “red flags” that might lead to

questionable accounting. If we identify a “red flag” then we should examine the

items more closely or gather information to see if there are possible accounting

distortions. If distortions are found related to accounting flexibility, then the

financial statements will have to be restated.

There were only two “red flags” identified in the diagnostic ratio analysis

and they occurred in the net sales / accounts receivable analysis and the cash

flow from operations / operating income analysis sections. The discussion of

these distortions occurs within the net sales / accounts receivable and the cash

flow from operations / operating income sections.

61

Undo Accounting Distortions

If “red flags” are found, reported financial statements should be restated

to minimize the distortions that are discovered. Even though it is unlikely that

distortions will be completely undone using outside information alone, it is

possible to achieve a clearer picture using a firm’s management discussion

section and the footnotes to financial statements.

Goodwill

If it is found that goodwill has not been impaired properly, one method for

correcting the accounting distortion is to depreciate the goodwill on a straight-

line for a set time period from the time the goodwill is originally recorded. In a

highly technological industry in which innovation is a key success factor, it may

be necessary to depreciate goodwill over a smaller time period. The medical

supplies industry is an industry that can be considered highly technological, and

therefore the value of goodwill can be assumed to depreciate rapidly. Therefore,

it is appropriate in the case of Baxter to correct the financial statements for

failing to impair the value of goodwill in a timely fashion.

Research and Development

A significant distortion occurs when one compares a firm in a highly

innovative industry that relies on research and development expense as its main

profit driver with firms in industries whose main profit drivers are easily

recordable as assets on their balance sheets. The innovative firm is going to

appear undervalued in relation to more conventional asset-based firms because

its main profit driver is required to immediately be written off the books while the

conventional firms main profit-drivers can be written off over many years. In the

short-term this results in greatly understated assets for the innovative firm and

therefore a much lower equity. In order to correct for this, one can remove the

62

R&D expenses from the income statement and add them to the balance sheet as

an asset. However, it is clear that R&D is an asset that has a very short useful

life so it makes sense to then amortize any addition to that balance over a five-

year period.

The following tables show the effects of the restatement of both the

income statements and the balance sheets for goodwill amortization and

research and development capitalization and amortization.

Effects of Goodwill

Restated Income Statement2002 2003 2004 2005 2006 2007

Net Income 778$ 866$ 388$ 956$ 1,397$ 1,707$ GW Amort. (net of tax) 91 166 211 157 115 46

Adj. Net Income 687$ 700$ 177$ 799$ 1,282$ 1,661$

Restated Balance Sheet2002 2003 2004 2005 2006 2007

Total Assets 12,428$ 13,707$ 14,147$ 12,727$ 14,686$ 15,294$ Adj. to Cash for GW Tax Effect 58 98 124 204 232 243

Goodwill 1,445 1,599 1,648 1,552 1,618 1,690Adj. Goodwill 753 701 513 181 103 118

Effect of Amortization (692) (898) (1,135) (1,371) (1,515) (1,572)Adj. Total Assets 11,794$ 12,907$ 13,136$ 11,560$ 13,403$ 13,965$

Total Liabilities and S/E 12,428$ 13,707$ 14,147$ 12,727$ 14,686$ 15,294$ Retained Earnings 1,740 2,145 2,000 2,430 3,271 4,379

Adj. for GW balance (692) (898) (1,135) (1,371) (1,515) (1,572)Adj. for GW tax effect 58 98 124 204 232 243

Adj. Retained Earnings 1,106 1,345 989 1,263 1,988 3,050Adj. Total Liab. and SE 11,794$ 12,907$ 13,136$ 11,560$ 13,403$ 13,965$

63

Effects of Research and Development

Restated Income Statement2002 2003 2004 2005 2006 2007

Net Income 778$ 866$ 388$ 956$ 1,397$ 1,707$ Adj. for R&D Cap. (Net of Tax) (370) (444) (460) (354) (492) (614) Adj. for R&D Amort. (Net of Tax) 299 343 390 315 405 439

Adj. Net Income 849$ 967$ 458$ 994$ 1,483$ 1,882$

Restated Balance Sheet2002 2003 2004 2005 2006 2007

Total Assets 12,428$ 13,707$ 14,147$ 12,727$ 14,686$ 15,294$ Adj. to Cash for R&D Tax Effect (239) (264) (273) (292) (314) (355)R&D (Net of Allow.) 1,302 1,428 1,507 1,564 1,672 1,888

Adj. Total Assets 13,491$ 14,871$ 15,381$ 13,999$ 16,044$ 16,827$

Total Liabilities and S/E 12,428$ 13,707$ 14,147$ 12,727$ 14,686$ 15,294$ Retained Earnings 1,740 2,145 2,000 2,430 3,271 4,379

Adj. for R&D Cap. & Amort. 1,063 1,164 1,234 1,272 1,358 1,533Adj. Retained Earnings 2,803 3,309 3,234 3,702 4,629 5,912Adj. Total Liab. and SE 13,491$ 14,871$ 15,381$ 13,999$ 16,044$ 16,827$

64

Financial Analysis

Financial ratios are a good medium to use when comparing companies

from the same industry. These ratios help to assess the profitability and growth

of a firm; profitability and growth are essential to performing a company

valuation. Not only do ratios serve as a good way of comparing firms, but they

also can be used in forecasting future company financials. To get a stronger

understanding of a firm’s liquidity, profitability, capital structure, and overall

financial standing, three groups of ratios will be analyzed: liquidity ratios,

profitability ratios, and capital structure ratios.

65

Liquidity Ratio Analysis

Analyzing liquidity ratios gives prospective investors and lenders a way of

determining how capable the firm is of meeting its short-term obligations.

Liquidity is a measure of how much of a company’s assets can be easily

converted to cash. A firm with low liquidity will struggle to finance the business

as well as struggle to pay off its’ short term obligations. The current ratio and

quick ratio are specifically important because they are directly related to the

firm’s ability to cover current obligations. Also, within the liquidity analysis are

ratios dealing with inventory and accounts receivable. These ratios help to

assess the operating efficiency of the firm and furthermore the credit worthiness

of the firm. (See Figure 1.3)

66

Current Ratio

The current ratio is current assets divided by current liabilities. This ratio

is used to determine whether the firm has enough current assets to cover its

current liabilities. The greater the ratio is the higher number of current assets in

relation to current liabilities. A ratio of 1 can be interpreted as the firm being

able to satisfy its current liabilities with its current assets. If the firm does not

have enough current assets to satisfy the immediate liabilities the next step is to

begin liquidating long term assets to fulfill these current obligations. In general,

this is not considered a favorable situation. The following graph and table

indicate the current ratios for the five firms in the medical services and supplies

industry for years 2002-2007.

Current Ratio

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

Baxter 1.37 1.45 1.40 1.23 1.93 1.98

Baxter Rest. 1.32 1.40 1.37 1.21 1.91 1.95

Abbott 1.30 1.35 1.57 1.54 0.94 1.54

Boston 1.31 1.35 1.26 1.78 1.86 1.82

Wyeth 2.12 1.78 1.69 1.81 2.43 3.14

Stryker 1.63 1.64 1.92 2.30 2.62 3.68

Industry Avg. 1.59 1.53 1.61 1.86 1.96 2.55

2002 2003 2004 2005 2006 2007

67

The graph shows that Baxter has maintained a current ratio that is very

similar to the industry average. Baxter, as well as its competitors, has continued

to maintain a current ratio greater than one. As previously stated, this means

that all current liabilities can be satisfied with current assets. The current ratio is

highly important because financial institutions use this in determining risk when

lending money. From 2002-2007 Baxter has seen its current ratio increase by

45%. This is an encouraging trend. But, this does not necessarily tell the

complete story. For example, if accounts receivable were the only current asset

increasing the current ratio would increase. If an increasing amount of accounts

receivable were deemed uncollectible the increase in the current ratio would not

mean much. Looking at Baxter’s balance sheet from 2002-2007 it can be seen

that accounts receivable have been, in general, steady. The telling factor in this

analysis is that their cash on hand has increased greatly from 2002-2007 after a

temporary drop in years 2003-2005. This tells us that the increase in Baxter’s

current ratio is significant when accessing the liquidity and stability of the firm.

Baxter’s restated current ratio is lower because of a decrease in current assets.

Current assets decreased because of a slight reduction of cash and equivilants.

68

Quick Ratio

The quick asset ratio is the next liquidity ratio that will be analyzed. The

ratio is quick current assets divided by current liabilities. Quick current assets

are limited to assets that are cash or can quickly be converted to cash. The ratio

is similar to the current ratio in that it also measures the firm’s ability to satisfy

its current liabilities with current assets. The quick ratio is different in that the

numerator of the ratio consists of only cash assets and assets that can quickly be

turned into cash. This excludes, for example, inventory. Inventory is considered

a current asset, but in reality it can not be converted to cash in an instance;

inventory takes time to sell. Assets that are considered quick assets include

short term investments and securities, and accounts receivable. Accounts

receivable can be sold with or without recourse at a discount for immediate cash

payment. The following graph and table indicate the quick asset ratio for the

five firms in the medical services and supplies industry for the years 2002-2007.

Quick Ratio

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

Baxter 0.79 0.77 0.75 0.63 1.20 1.20

Baxter Rest. 0.74 0.72 0.71 0.60 1.18 1.17

Abbott 0.52 0.56 0.72 0.87 0.40 0.81

Boston 0.77 0.87 0.84 1.10 1.18 0.91

Wyeth 0.97 1.02 0.88 1.07 1.41 1.91

Stryker 0.63 0.66 0.99 1.01 0.98 0.99

Industry Avg. 0.72 0.78 0.86 1.01 0.99 1.16

2002 2003 2004 2005 2006 2007

69

Baxter’s quick ratio average for years 2002-2007 is .89. This is very

similar to the industry average and thus is not a concern when evaluating the

company. Wyeth is the industry leader with an average quick ratio of 1.21 for

years 2002-2007. Baxter’s restated quick ratio was lower year-by-year because

of a slight decrease in cash and equivalents.

70

Inventory Turnover / Days Inventory

The inventory turnover ratio is cost of goods sold divided by inventory. It

is a measure a firm’s operating efficiency. The ratio is a good indication of how

efficient the firm is with their inventory processes. A firm will have high

inventory turnover if production is closely tied to demand. But, if a firm

significantly under forecasts sales, thus producing lowers amounts of inventory,

it will also have high inventory turnover. A company with steady, increasing

inventory turnover is getting more efficient over time. It is generally not normal

to have a one year spike in the ratio. A high ratio means that firm does not have

problems moving its inventory out. Inversely, a low ratio signals that the firm is

holding more inventory relative to the cost of the goods they are selling. A low

ratio is also indicative of poor inventory management.

Inventory Turnover

1.50

2.00

2.50

3.00

3.50

4.00

4.50

Baxter 2.46 2.35 2.62 2.99 2.73 2.46

Abbott 3.48 3.46 3.39 4.19 3.50 3.87

Boston 3.58 3.42 3.59 3.32 2.95 3.23

Wyeth 1.97 1.81 2.00 2.33 2.25 2.08

Stryker 2.61 2.80 2.73 2.64 2.39 2.34

Industry Avg. 2.91 2.87 2.93 3.12 2.77 2.88

2002 2003 2004 2005 2006 2007

71

Baxter’s inventory turnover is lower than the industry average in each of

the 6 years looked at, but so is Wyeth’s and Stryker’s inventory turnover. The

Industry average is not a good benchmark to use in this case because it is

inflated due to exceptionally high inventory turnover numbers from Abbott and

Boston for 2002-2007. Baxter’s ratio compares favorably with Wyeth and Stryker

in each year. Boston and Abbott appear to be industry leaders in regards to

inventory management. Overall, Baxter’s inventory turnover is not a concern

because it is not volatile; it is steady and close to the industry average. But, it is

slightly unfavorable in comparison with Boston, Abbott, and the industry

average. Baxter’s restated ratio was not included in the graph because there

was no change in the ratio.

Days’ supply of inventory measures the number of days it takes for a

company to turn its inventory into revenue. The ratio is 365/Inventory Turnover.

A high ratio means that inventory is being held on to longer and a low ratio

means that inventory is being sold fairly quick.

Days Inventory

45.0

65.0

85.0

105.0

125.0

145.0

165.0

185.0

205.0

225.0

Baxter 148.1 155.1 139.3 122.1 133.7 148.3

Abbott 104.8 105.5 107.7 87.2 104.4 94.3

Boston 101.9 106.7 101.7 110.1 123.9 113.0

Wyeth 185.6 201.1 182.8 156.8 162.0 175.5

Stryker 140.1 130.1 133.5 138.1 153.0 155.8

Industry Avg. 133.1 135.9 131.4 123.1 135.8 134.6

2002 2003 2004 2005 2006 2007

72

A company with a low inventory turnover ratio will have a high days’

supply of inventory. Wyeth holds onto its inventory for the highest amount of

days in the industy because they turn their inventory over less times per year.

The industry average for days’ supply of inventory from 2002-2007 is 131 days.

Baxter’s average from 2002-2007 is 141 days.

73

Receivables Turnover / Days Sales Outstanding

Accounts Receivable turnover is sales divided by accounts receivable. This

ratio has a purpose to measure the number of times, on average receivables are

collected during the period. It is inversely related to days’ supply of receivables,

which measures the duration in days that it takes a company to collect

receivables. Therefore, it is best to have a greater accounts receivable turnover

ratio.

Receivables Turnover

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

Baxter 4.52 4.65 4.55 5.58 5.65 5.56

Abbott 6.04 5.94 5.32 6.25 5.31 5.24

Boston 6.71 6.41 6.25 6.74 5.49 5.56

Wyeth 6.13 6.27 6.20 6.19 6.02 6.35

Stryker 7.40 7.27 5.67 5.98 5.67 5.82

Industry Avg. 6.57 6.47 5.86 6.29 5.62 5.74

2002 2003 2004 2005 2006 2007

74

Days Sales Outstanding

45.0

50.0

55.0

60.0

65.0

70.0

75.0

80.0

85.0

Baxter 80.7 78.5 80.3 65.4 64.6 65.7

Abbott 60.4 61.5 68.6 58.4 68.7 69.7

Boston 54.4 56.9 58.4 54.1 66.5 65.6

Wyeth 59.6 58.3 58.8 59.0 60.7 57.5

Stryker 49.3 50.2 64.3 61.0 64.3 62.7

Industry Avg. 55.9 56.7 62.5 58.1 65.0 63.9

2002 2003 2004 2005 2006 2007

As the graph illustrates, Baxter has generally maintained a receivable

turnover ratio that is less than or equal to their competitors. This means that on

average it takes Baxter more days to collect on their receivables. This is not a

favorable indication. The possible reasons behind this are Baxter was selling

more on account than the competition or that they had lower sales than the

competition. Taking a look at the 6-year income statements we can see that it is

in fact a combination of both. Baxter has generally reported lower sales than

Abbott and Wyeth, and has recorded higher accounts receivable than Boston and

Stryker. In recent years, Baxter has closed the gap in regards to receivables

turnover. Overall, Baxter has a slightly unfavorable receivables turnover when

compared to the other industry participants. However, there receivables

turnover has increased over the five-year period, indicating that Baxter is

becoming more efficient in collecting their accounts receivables. Baxter’s

restated receivables turnover was not included in the graph because there was

no change.

75

Cash-to-Cash

The cash to cash cycle expresses the number of days that it takes a firm

to convert their inventory into cash flow. Baxter’s cash to cash flow for the years

2002-2007 is 213.62 days which translates into an average of cash to cash cycle

per year of 1.72 times. This means that it takes 213.62 days for Baxter to turn

inventory into useful cash. Baxter’s restated cash-to-cash cycle showed no

difference.

Cash-to-Cash Cycle

135.00

155.00

175.00

195.00

215.00

235.00

255.00

275.00

Baxter 228.79 233.57 219.57 187.52 198.32 213.97

Abbott 165.17 166.96 176.21 145.64 173.07 163.99

Boston 156.34 163.64 160.11 164.22 190.33 178.59

Wyeth 245.18 259.40 241.67 215.80 222.71 232.97

Stryker 189.39 180.33 197.86 199.12 217.31 218.50

Industry Avg. 189.02 192.58 193.96 181.19 200.85 198.51

2002 2003 2004 2005 2006 2007

76

Cash-to-Cash Cycles per Year

1.25

1.45

1.65

1.85

2.05

2.25

2.45

2.65

Baxter 1.60 1.56 1.66 1.95 1.84 1.71

Abbott 2.21 2.19 2.07 2.51 2.11 2.23

Boston 2.33 2.23 2.28 2.22 1.92 2.04

Wyeth 1.49 1.41 1.51 1.69 1.64 1.57

Stryker 1.93 2.02 1.84 1.83 1.68 1.67

Industry Avg. 1.99 1.96 1.93 2.06 1.84 1.88

2002 2003 2004 2005 2006 2007

77

Working Capital Turnover

The working capital turnover ratio is sales revenue divided by working

capital. Working capital is defined as current assets minus current liabilities.

This ratio is intended to provide an indication of how well management is using

working capital to generate revenue. A larger ratio indicates efficient use of

working capital.

Working Capital Turnover

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Baxter 5.92 5.36 5.49 10.36 3.09 3.01

Baxter Rest. 6.82 5.95 6.00 11.42 3.17 3.10

Abbott 8.34 7.42 5.04 5.63 2.75 5.25

Boston 10.24 7.14 8.22 5.45 3.44 3.13

Wyeth 2.38 2.43 2.94 2.32 1.98 1.43

Stryker 6.78 6.63 4.14 2.84 2.36 1.68

Industry Avg. 6.94 5.91 5.08 4.06 2.63 2.87

2002 2003 2004 2005 2006 2007

*For the year 2006, Abbott had a small negative working capital resulting a turnover of -33.6. For ease in graphical comparison we adjusted this value to the industry average for that year.

The average working capital turnover for the medical services and

supplies industry for years 2002-2007 is 4.6. Baxter’s average over this same

time span is 5.5. In order to get a better picture of how Baxter measures up

against its competitors we remove year 2005 from Baxter’s average calculation

because it is not in the same ballpark as the rest of the years. This provides a

better view of Baxter’s working capital turnover average. The result is the exact

same as the industry average at 4.6. This lets us know that on average Baxter is

in sync with the industry in regards to efficient use of working capital. Baxter’s

78

restated working capital ratio is considerably higher in the first four years,

indicating that Baxter was extremely efficient using working capital to generate

revenue. However, this ratio has now decreased to Baxter’s non-restated level.

Conclusion

Baxter’s current ratio averaged 1.56, meaning that Baxter was more than

capable to meet its short-term debt obligations. Baxter is also consistent with

the industry averages for the quick ratio and inventory turnover, meaning they

are operating efficiently along with the industry. Finally, Baxter has an average

cash-to-cash cycle that exceeds the industry average and it can be concluded

that Baxter is moderately liquid and is in good position to remain competitive

within the industry.

79

Profitability Ratio Analysis

Profitability ratios provide a means of measuring the firm’s revenues while

considering their costs. In general, a higher ratio is more favorable. The ratios

that will be analyzed include asset turnover, return on assets, return on equity,

operating expense, gross profit margin, operating profit margin, and net profit

margin. (See Figure 1.4)

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Gross Profit Margin

Gross profit margin is found when dividing gross profit by sales. It is a

percentage measure that concludes the amount of gross profit a firm is gaining

on its sales. When this operating efficiency ratio is high, it means that the firm is

either keeping cost of goods sold down or receiving a high price on its goods.

The higher gross profit that a company is making, the better the ability to record

sufficient net income figures.

Gross Profit Margin

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

Baxter 46.8% 44.4% 41.2% 41.6% 45.6% 49.0%

Abbott 51.9% 51.9% 54.9% 52.4% 56.3% 55.9%

Boston 70.2% 72.4% 77.0% 77.9% 71.8% 72.0%

Wyeth 73.1% 72.4% 71.5% 71.0% 72.5% 71.8%

Stryker 63.1% 63.8% 64.6% 67.7% 68.6% 68.9%

Industry Avg. 64.6% 65.1% 67.0% 67.3% 67.3% 67.2%

2002 2003 2004 2005 2006 2007

The industry average for gross profit margin is 66.2%. Baxter’s average

gross profit margin is 44.8%. This is not favorable; Baxter is not earning as

much gross profit on its sales as other industry participants. The reason behind

this is Baxter had high cost of goods sold relative to gross profit in the examined

years. Baxter’s restated gross profit margin is no different than Baxter’s non-

restated ratio.

81

Operating Expense Ratio

The operating expense ratio is calculated by dividing operating expenses

by net sales, and is used to evaluate management’s ability to run a company in

an efficient manner. Simply stated, a low ratio indicates that a firm is being run

efficiently. Baxter, as shown in the ratio chart given above, has the lowest

operating expense ratio every year over the five year period, and has positioned

itself to remain competitive within the medical services and supplies industry by

being able to manage its SGA expenses efficiently. Baxter’s restated ratio is no

different than their non-restated ratio.

Operating Expense Ratio

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

Baxter 19.3% 20.3% 20.6% 20.6% 22.0% 22.4%

Abbott 22.5% 25.7% 25.0% 24.6% 28.3% 28.6%

Boston 34.3% 33.7% 31.0% 28.9% 34.2% 34.8%

Wyeth 34.4% 34.5% 33.4% 32.6% 31.9% 30.2%

Stryker 38.7% 39.1% 38.8% 39.9% 39.8% 39.9%

Industry Avg. 32.5% 33.2% 32.0% 31.5% 33.5% 33.4%

2002 2003 2004 2005 2006 2007

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Operating Profit Margin

Operating profit margin is operating income as a percentage of sales.

This measures the percentage of income over sales after incurred operating

expenses have been removed. As the other profitability ratios, a higher ratio is

deemed to be better. A higher ratio is indicative of lower fixed costs and lower

operating expenses relative to sales.

Operating Profit Margin

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Baxter 19.3% 17.9% 15.1% 15.5% 17.7% 19.9%

Baxter Rest. 19.1% 17.2% 13.6% 14.3% 17.5% 21.0%

Abbott 20.0% 16.9% 19.8% 19.5% 9.1% 17.7%

Boston 20.9% 20.1% 28.0% 15.4% 18.1% -0.2%

Wyeth 24.5% 24.7% 23.9% 23.8% 25.3% 27.1%

Stryker 17.6% 18.5% 16.9% 20.2% 20.7% 21.8%

Industry Avg. 20.7% 20.0% 22.2% 19.7% 18.3% 16.6%

2002 2003 2004 2005 2006 2007

*For year 2006, Boston Scientific had a very large net loss resulting in an operating margin of -37.7%. For ease in graphical comparison, we adjusted this value to the industry average for that year.

As expected, Baxter’s operating profit margin has steadily increased since

2004 like the gross profit margin and net profit margin have. Wyeth has

maintained itself as the industry leader in operating profit margin because their

operating income has greatly outdone the competition. Wyeth has a low cost of

goods sold in relation to the amount of their sales and this is also why they have

been near the top of the industry in gross and net profit margins as well.

Baxter’s restated Operating Profit Margin decreased during the first five years

because of research and development capitalization and goodwill amortization.

83

It increased the last year because goodwill amortization was less than previous

years. Research and development capitalization increases operating income,

however, the amortization of R&D decreases operating income, but not to the

same extent, while goodwill amortization decreases goodwill.

84

Net Profit Margin

Net profit margin is one of the most looked at profitability ratios. It is net

income divided by sales. This measures the amount of net profit for each dollar

of sales. The ratio is crucial because of its direct link to net income. Net income

is used by a firm for retained earnings, paying dividends, and investing in assets.

It is important to maintain, on average, a high net profit margin because of how

widely potential investors use it when deciding whether or not to invest in a

company.

Net Profit Margin

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

Baxter 9.6% 9.7% 4.1% 9.7% 13.5% 15.2%

Baxter Rest. 9.3% 9.0% 2.6% 8.5% 13.2% 16.3%

Abbott 15.8% 14.0% 15.8% 15.1% 7.6% 13.9%

Boston 12.8% 13.6% 18.9% 10.0% 14.2% -5.9%

Wyeth 30.5% 12.9% 7.1% 19.5% 20.6% 20.6%

Stryker 11.5% 12.5% 10.9% 14.0% 15.1% 17.0%

Industry Avg. 17.6% 13.3% 13.2% 14.6% 14.4% 11.4%

2002 2003 2004 2005 2006 2007

*For year 2006, Boston Scientific had a very large net loss resulting in a net profit margin of -45.7%. For ease in graphical comparison, we adjusted this value to the industry average for that year.

Baxter’s average net profit margin for years 2002-2007 is 10.3%. Despite

being below the industry average, Baxter has shown a steady increase in net

profit margin since 2004. Thus, Net profit margin is not of concern. Baxter’s

restated net profit margin is slightly lower in the first five years and slightly

higher in 2007. This is due to the capitalization of research and development

and the amortization of goodwill.

85

Asset Turnover

Asset turnover is found by dividing sales by total assets. This measures

the amount of sales in relation to the company’s acquired assets as well as asset

productivity. This profitability ratio is considered to be a measure of operating

efficiency because it is an indicator of how well a firm is using its’ assets to

generate sales. The higher the ratio, the more efficient are the operations of the

firm.

Asset Turnover

0.20

0.40

0.60

0.80

1.00

1.20

1.40

Baxter 0.72 0.69 0.70 0.82 0.77

Baxter Rest. 0.69 0.68 0.69 0.81 0.76

Abbott 0.81 0.74 0.78 0.77 0.72

Boston 0.78 0.99 0.77 0.95 0.27

Wyeth 0.61 0.56 0.56 0.57 0.61Stryker 1.29 1.35 1.13 1.04 1.02

Industry Avg. 0.87 0.91 0.81 0.83 0.66

2003 2004 2005 2006 2007

It can be inferred from the graph that Stryker is most efficient in a

comparison of sales to total assets. The industry average in asset turnover for

years 2003-2007 is 0.82. In the medical services and supplies industry, having

an asset turnover ratio of less than 1 is common because of the large amount of

assets held by the firms. Baxter has maintained a steady ratio of asset turnover

over years 2002-2007 with an average of 0.74. This means that on average,

each dollar of Baxter’s assets is worth .74 dollars in sales. We are not concerned

with Baxter’s asset turnover because it is near the industry average and in 2007

86

it was the second highest amongst the industry. Baxter’s restated Asset

Turnover is slightly lower than its non-restated ratio. This is due to the

capitalization of research and development.

87

Return on Assets

Return on assets is derived by dividing the current year’s net income by

total assets in the previous year. The reason that the previous year’s total assets

are used in the present year’s calculation of ROA is that the measure is intended

to show how previous investments in assets have generated net income in the

current year. A higher ratio is better; it means that more income is being

generated through capital investments.

Return on Assets

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Baxter 7.0% 2.8% 6.8% 11.0% 11.6%

Baxter Rest. 6.2% 1.8% 5.8% 10.7% 12.4%

Abbott 11.3% 11.7% 11.7% 5.9% 10.0%

Boston 10.6% 18.6% 7.7% 11.1% -1.6%

Wyeth 7.9% 4.0% 10.9% 11.7% 12.7%

Stryker 16.1% 14.8% 15.8% 15.7% 17.3%

Industry Avg. 11.5% 12.3% 11.5% 11.1% 9.6%

2003 2004 2005 2006 2007

*For the year 2006, Boston Scientific had a very large net loss resulting in an ROA of -43.6%. For ease in graphical comparison, we adjusted this value to the industry average for that year.

Since 2004, Baxter has seen a steady increase in ROA. This is an

encouraging trend. It means that they are continuing to generate more income

relative to their capital investments. The ROA average in the industry over this

time span is 11.24%. Baxter has an average over the same period of 7.84%.

The average does not tell all because Baxter only had a ROA of 2.8% in 2004.

The reason behind this is that net income in 2004 was considerably less than

what Baxter has historically averaged, which was $388 million. Baxter’s restated

88

return on assets was lower each of the years. This is not only because net

income was lower, but total assets were higher.

89

Return on Equity

Return on equity is found by dividing the current year’s net income by

total stockholder’s equity in the previous year. The result is a percentage of how

much the firm is earning on it’s investment from shareholder’s. This measures

how efficient the firm is using the capital invested from owners. “Large publicly

traded firms in the U.S. generate ROEs in the range of 11% to 13%.” (Business

Analysis and Evaluation, Palepu and Healy.)

Return on Equity

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

Baxter 28.7% 11.5% 25.8% 32.5% 27.2%

Baxter Rest. 23.3% 6.6% 21.3% 31.1% 28.9%

Abbott 25.8% 23.8% 23.5% 11.9% 25.7%

Boston 19.1% 37.1% 15.6% 23.6% -3.2%

Wyeth 25.1% 13.3% 37.1% 35.0% 31.5%Stryker 30.3% 21.6% 23.4% 23.9% 24.3%

Industry Avg. 25.1% 24.0% 24.9% 23.6% 19.6%

2003 2004 2005 2006 2007

*For the year 2006, Boston Scientific had a very large net loss resulting in an ROE of -83.5%. For ease in graphical comparison, we adjusted this value to the industry average for that year.

The medical services and supplies industry typically earns a high rate of

return on equity. The industry average between 2003 and 2007 was 23.5%.

Baxter had an average ROE of 25% over the same period. In fact, since 2005,

Baxter has been second only to Wyeth in ROE. This means that Baxter has been

very efficient in generating income with money invested by owners. If Baxter’s

ROE was low, it would be an indication they financed more with debt than

equity. Baxter’s restated ROE was lower due to a decrease in net income the

first five years, and an increase in net income in the last year.

90

Conclusion

An analysis of the profitability ratios will show that Baxter consistently

underperformed to the industry average on a year-by-year basis. It can be

concluded that Baxter’s ability to generate profit is not as strong as the rest of

the industry.

91

Capital Structure Ratios

The capital structure ratios are used to show how a firm finances its

business activities through the assets that it owns. The capital structure ratios

consist of debt to equity, times interest earned, and debt service margin. Along

with the indication of how a company uses debt to create assets, these ratios

also show how capable a firm is of handling incurred debt along with its interest

expense. (See Figure 1.5)

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Debt to Equity

The debt to equity ratio helps financial analysts measure a company’s

leverage, or more simply put; how a firm is utilizing borrowed money to finance

assets (investorwords.com). If a firm has a high debt to equity ratio, this means

that they have used outside financing to pay for growth, and that there could be

a greater possibility of volatile earnings with this possibility being greater during

periods of rising interest rates (investopedia.com). At the beginning of the five-

year period, Baxter’s debt to equity ratio is the highest of all the firms considered

in the analysis, but experienced a sharp decrease between 2002 and 2005 in the

value of the debt to equity ratio of thirty-five percent. This decrease is explained

by a large decrease in the value of its long-term debt and lease obligations

portion of the balance sheet. Baxter’s restated debt to equity ratio is lower

because retained earnings increased due to R&D capitalization and goodwill

amortization.

Debt to Equity

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Baxter 3.12 3.05 2.82 1.96 1.34 1.21

Baxter Rest. 2.74 2.76 2.66 1.91 1.33 1.18

Abbott 1.27 1.04 1.01 1.02 1.57 1.23

Boston 0.80 0.99 1.03 0.91 1.03 1.07

Wyeth 2.19 2.34 2.41 1.99 1.49 1.35

Stryker 0.88 0.47 0.48 0.52 0.40 0.37

Industry Avg. 1.29 1.21 1.23 1.11 1.12 1.00

2002 2003 2004 2005 2006 2007

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Times Interest Earned / Days to Earn Interest

Times interest earned is a ratio that indicates how many times a firm’s

operating income can cover the interest expenses on a pre-tax basis

(invesropedia.com). Baxter’s average TIE for the five year period is 209.7, but

as mentioned earlier in the discussion of the capital structure analysis, there is

significant decrease in the TIE ratio in the years 2004-2005 because Baxter

began incurring greater amounts of debt. The large decrease in the TIE ratio

during these two years, while important, does not really reflect the current state

of the company, and an analysis should be conducted with the TIE ratio for

these two years being omitted. The results of this analysis produce and average

TIE ratio of 269.62 giving it the second highest TIE ratio behind Stryker

Corporation. Days interest earned is a ratio that indicates how many days it

takes a firm to generate enough income from operations to pay its interest

expense. Baxter’s restated times interest earned is lower in the first five years

due to a decreased operating income and higher in 2007 due to an increased

operating income.

Times Interest Earned

-50.0

0.0

50.0

100.0

150.0

200.0

Baxter 22.1 13.5 11.4 9.2 18.2 18.0

Baxter Rest. 21.8 13.0 10.3 8.5 17.9 19.1

Abbott 14.8 17.7 19.5 18.1 4.9 7.7

Boston 14.2 15.2 24.6 10.8 -6.8 0.0

Wyeth 9.4 13.1 13.5 11.1 9.0 8.7

Stryker 14.3 29.2 120.1 116.5 177.3 186.8

Industry Avg. 13.2 18.8 44.4 39.1 46.1 50.8

2002 2003 2004 2005 2006 2007

94

Days to Earn Interest

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

Baxter 16.5 27.0 32.0 39.6 20.0 20.2

Baxter Rest. 16.8 28.1 35.5 42.9 20.3 19.1

Abbott 24.7 20.7 18.7 20.2 74.4 47.3

Boston 25.7 24.1 14.8 33.9

Wyeth 39.0 27.8 27.1 33.0 40.4 41.9

Stryker 25.5 12.5 3.0 3.1 2.1 2.0

Industry Avg. 28.7 21.3 15.9 22.6 38.9 30.4

2002 2003 2004 2005 2006 2007

*For the years 2006 and 2007, Boston Scientific's Days to Earn Interest was negative because of a negative operating income. For ease in graphical comparison, we omitted the results for these years because they are not applicable to this ratio.

95

Debt Service Margin

Debt service margin is computed by dividing cash flows from operations

by the previous year’s current portion of long-term debt. This ratio tells analysts

how much cash flow from operations is available to pay the current portion of

long-term debt. Over the five-year period, Baxter had an average debt service

margin of 103.2. This means that on average, Baxter had $103.20 of cash flows

from operations generated to cover every dollar of debt. This average is

misleading due to the fact the debt service margin for 2003 is 475.3. If this year

is excluded, the new average becomes $7.62 meaning that Baxter had $7.62 to

pay for every dollar of debt. Using this result, it can be concluded that Baxter

does not have a high risk of defaulting on its debt. Baxter’s restated debt service

margin is considerably higher year-by-year. This is due to capitalization and

amortization being added in to cash flows from operations.

Debt Service Margin

0.0

100.0

200.0

300.0

400.0

500.0

600.0

700.0

Baxter 13.2 460.0 10.1 2.8 13.0

Baxter Rest. 18.5 638.1 13.9 3.6 17.1

Abbott 6.2 0.4 6.0 0.4 11.4

Boston 300.7 1.0 263.6 133.4

Wyeth 3.6 1.9 7.1 250.3 47.4

Stryker 60.6 81.3 89.6 18.3 69.5

Industry Avg. 23.5 96.1 25.9 133.1 65.4

2003 2004 2005 2006 2007

*For the year 2003, Boston Scientific had zero current maturities of long-term debt. This year was omitted because it is not applicable to this ratio.

96

Credit Analysis

Altman’s Z-Score is a multifactor model that measures the financial health

of a company. It also forecasts the probability of a company entering

bankruptcy within a 2-year period. Studies have shown that the Z-Scores are

72%-80% accurate (valuebasedmanagement.net). The score is determined by

using a weighted-average of five ratios. If the score is 3 or above, bankruptcy is

not likely. If the score is below 1.8, bankruptcy is very likely, 95% likely in the

first year and 70% likely in the next two years. Between 1.8 and 3 is the gray

area, which just means either is a possibility. Firms want the highest score they

can attain.

Altman's Z-Scores

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

Baxter 3.93 3.70 3.63 4.35 4.54 4.76

Baxter Rest. 3.90 3.67 3.59 4.31 4.52 4.77

Abbott 5.47 5.46 5.29 5.34 3.42 3.91

Boston 7.71 5.81 4.82 4.99 0.78 1.09

Wyeth 3.55 3.07 2.86 3.01 3.39 3.28

Stryker 14.53 18.52 14.52 12.03 12.09 10.77

Industry Avg. 7.81 8.21 6.87 6.34 4.92 4.76

2002 2003 2004 2005 2006 2007

97

Baxter’s Z-Scores are not problematic at all. Their score has increased the

last three years and they are right at the industry average, assuming Stryker was

removed from the industry average. Baxter’s is exactly where you would want it

to be and really do not have much of a chance to go bankrupt. Their Z-Score

also shows that they have a low chance of default. The most noticeable thing in

these scores is Boston Scientific’s last two-years of scores. They are

considerably below the 1.8 threshold, and have a good probability of going

bankrupt in the next couple of years. The most impressive model of all five firms

in the industry is Stryker. Their Z-Scores are well above any other company in

the industry.

98

Conclusion

An analysis of Baxter’s capital structure ratios will show that Baxter has a

higher debt to equity ratio than the industry, meaning that they consistently use

outside financing to foster growth. Concerning times interest earned, Baxter has

a relatively high ratio, indicating that Baxter is able to cover its interest expenses

with its operating income. In relation to debt service margin, Baxter is below the

industry average, however, Baxter is still highly capable of covering its debt with

its cash flows from operations. Therefore, it can be concluded, that Baxter is in

no immediate risk of default.

99

Internal and Sustainable Growth Rates

IGR and SGR are important because they help analysts determine which

companies in an industry can sustain growth without obtaining financing. This is

important because firms that can sustain growth using their retained earnings,

will achieve a competitive advantage over other firms, and are more likely to be

profitable in the long run.

Internal Growth Rate

The internal growth rate is simply the highest amount of growth that a

firm can achieve without obtaining any outside financing (investopedia.com).

Internal Growth Rate

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Baxter 4.1% 0.2% 4.2% 8.0% 8.5%

Baxter Rest. 3.5% 0.1% 3.6% 7.8% 9.1%

Abbott 5.1% 5.7% 5.3% -7.8% 0.3%

Wyeth 3.2% 0.0% 7.1% 7.9% 8.8%

Stryker 15.3% 13.9% 14.9% 14.8% 15.8%

Industry Avg. 7.8% 6.5% 9.1% 5.0% 8.3%

2003 2004 2005 2006 2007

Baxter’s internal growth rate is relatively low when compared to its

competitors because it has the lowest ROA out of the firms considered with an

average ROA of 7.2 compared with the industry average of 11.2. Baxter’s IGR

100

decreased from 4.1% to 0.2% between 2003 and 2004 because they had

acquired a lot of assets that year, which explains why ROA decreased from 7%

to 2.8% from 2003 to 2004. With an average IGR of 4.1%, Baxter will most

likely have to obtain outside financing to remain competitive. Baxter’s restated

IGR is lower only because of an increase in assets due to capitalizing research

and development and net income decreased because of amortization to goodwill.

Boston Scientific does not have any IGR data due to the fact that they do not

pay out dividends.

101

Sustainable Growth Rate

The sustainable growth rate is simply defined as the percentage growth

that can be sustained by a firm with borrowing more money (investopedia.com).

Sustainable Growth Rate

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

Baxter 16.9% 0.9% 16.0% 23.7% 19.8%

Baxter Rest. 13.0% 0.5% 13.2% 22.6% 21.1%

Abbott 11.6% 11.6% 10.6% -15.8% 0.8%

Wyeth 10.2% 0.1% 24.3% 23.7% 21.8%

Stryker 28.7% 20.3% 22.1% 22.5% 22.1%

Industry Avg. 16.8% 10.7% 19.0% 10.1% 14.9%

2003 2004 2005 2006 2007

With the exception of 2004, Baxter has a moderately high SGR and a five-

year average of 17.58% (this calculation excludes the SGR for 2004). Baxter’s

SGR decreased from 16.9% to 0.9% from 2003 to 2004 because of acquiring a

large portion of assets. This increased their equity a considerable amount, which

led to a much lower ROE. In 2006 and 2007 Baxter’s SGR was considerably

higher than the industry average. This means that Baxter will be able to grow at

a moderately high level without having to increase its leverage, which will help

Baxter remain competitive within the industry. Boston Scientific does not have

any SGR data because they do not pay out dividends.

102

Financial Statements Forecast

Income Statement

The income statement is the easiest of the financial statements to

forecast, however, because it is tied to the forecasting of the balance sheet and

cash flow statement, it is the most critical to the success of forecasting for

Baxter.

First, we found the growth rates of sales, which range from 3.6% to

9.8%. We then took a weighted average growth rate of each of the sales

growth percentages excluding 2005. Because 2005 sales growth of 3.6% was an

anomaly, we did not take it into account when finding an average growth rate.

We found the weighted average growth rate by weighing recent years more

heavily than previous ones. This process involved taking 4 years of sales growth

data and giving each year a factor. For example 2007 has a factor of 4, 2006 a

factor of 3, 2004 a factor of 2, and 2003 a factor of 1. The sum of these factors

is 10. We then take each one of these factors and divide it by the sum of the

factors, which yields a percentage for each year. We multiply each of these

percentages by the sales growth data, which gives us each year’s contribution to

the weighted average. The sum of these contributions equals the weighted

average growth rate, which turned out to be a 7.36% growth rate in sales for

each year of the ten year forecast.

We found that Gross Profit, Operating Income and Net Income, in relation

to sales, have been increasing every year. Between 2005 and 2007, Gross Profit

Margin has increased from 41.6% to 49%, Operating Profit Margin has increased

from 15.5% to 19.9%, and Net Profit Margin has increased from 9.7% to 15.2%.

We forecasted each of these by increasing these three ratios by 2.7% evenly

over the next three years (0.9% increase per year). Cost of Goods Sold was

found by subtracting Gross Profit from Sales, therefore it decreased by 0.9% per

103

year for three years, which is inline with previous years data. SG&A and R&D

Expense were forecasted by using 2007 data in relation to sales. We felt that

this was the most relevant data to use.

Goodwill and Research and Development restatements did not have an

affect on sales, however they had an affect on operating income and net income.

Capitalizing R&D has a positive effect on net income, while Goodwill amortization

has a negative effect on net income.

We used the same method of forecasting Gross Profit, Operating Income,

and Net Income on the restated income statement. We increased each by 0.9%

each year for the next three years.

104

Income Statement2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Sales Growth 9.79% 6.79% 3.58% 5.37% 8.53% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36%Net Sales 8,110$ 8,904$ 9,509$ 9,849$ 10,378$ 11,263$ 12,092$ 12,982$ 13,937$ 14,963$ 16,064$ 17,247$ 18,516$ 19,879$ 21,342$ 22,913$ Cost of Goods Sold 4,318 4,951 5,594 5,756 5,641 5,744 6,058 6,387 6,732 7,227 7,759 8,330 8,943 9,601 10,308 11,067 Gross Profit 3,792$ 3,953$ 3,915$ 4,093$ 4,737$ 5,519$ 6,034$ 6,595$ 7,206$ 7,736$ 8,306$ 8,917$ 9,573$ 10,278$ 11,034$ 11,846$ SG&A Expenses 1,562 1,805 1,960 2,030 2,282 2,521 2,707 2,906 3,120 3,349 3,596 3,860 4,144 4,450 4,777 5,129 R&D Expenses 501 553 517 533 614 760 816 876 940 1,010 1,084 1,164 1,249 1,341 1,440 1,546 In-process R&D (IPR&D) Charges 163 Operating Income 1,566$ 1,595$ 1,438$ 1,530$ 1,841$ 2,238$ 2,512$ 2,813$ 3,146$ 3,377$ 3,626$ 3,893$ 4,179$ 4,487$ 4,817$ 5,172$ Restructuring Charges, Net 26 337 543 (109) 70 Other Special Charges 289 Interest Expense 71 118 126 166 101 124Interest (Income) (20) (31) (27) (48) (67) (102)Other Expense, Net 92 42 77 77 61 32

Earnings Before Income Taxes 1,397$ 1,129$ 430$ 1,444$ 1,746$ 2,114$ Income Tax Expense (Income) 364 222 47 486 348 407

Inc. from Cont. Op. before Accounting Changes 1,033 907 383 958 1,398 1,707 Loss (Gain) from Discont. Op., Net of Tax 255 24 (5) (2) (1) -

Income Before Effect of Accounting Changes 778 883 388 956 1,397 1,707 Effect of Accounting Changes, Net of Tax 17

Net Income 778$ 866$ 388$ 956$ 1,397$ 1,707$ 1,941$ 2,201$ 2,489$ 2,672$ 2,868$ 3,080$ 3,306$ 3,550$ 3,811$ 4,091$

Common Sized Income Statement

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Sales Growth 9.79% 6.79% 3.58% 5.37% 8.53% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36%Net Sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Cost of Goods Sold 53.2% 55.6% 58.8% 58.4% 54.4% 51.0% 50.1% 49.2% 48.3% 48.3% 48.3% 48.3% 48.3% 48.3% 48.3% 48.3%Gross Profit 46.8% 44.4% 41.2% 41.6% 45.6% 49.0% 49.9% 50.8% 51.7% 51.7% 51.7% 51.7% 51.7% 51.7% 51.7% 51.7%SG&A Expenses 19.3% 20.3% 20.6% 20.6% 22.0% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4%R&D Expenses 6.2% 6.2% 5.4% 5.4% 5.9% 6.7% 6.7% 6.7% 6.7% 6.7% 6.7% 6.7% 6.7% 6.7% 6.7% 6.7%In-process R&D (IPR&D) Charges 2.0% 0.0% 0.0% 0.0% 0.0% 0.0%Operating Income 19.3% 17.9% 15.1% 15.5% 17.7% 19.9% 20.8% 21.7% 22.6% 22.6% 22.6% 22.6% 22.6% 22.6% 22.6% 22.6%Restructuring Charges, Net 0.3% 3.8% 5.7% -1.1% 0.0% 0.6%Other Special Charges 0.0% 0.0% 3.0% 0.0% 0.0% 0.0%Interest Expense 0.9% 1.3% 1.3% 1.7% 1.0% 1.1%Interest (Income) -0.5% -0.6% -0.5% -0.8% -1.2% -1.8%Other Expense, Net 5.9% 2.3% 3.9% 3.8% 2.7% 1.3%

Earnings Before Income Taxes 17.2% 12.7% 4.5% 14.7% 16.8% 18.8%Income Tax Expense (Income) 4.5% 2.5% 0.5% 4.9% 3.4% 3.6%

Inc. from Cont. Op. before Accounting Changes 12.7% 10.2% 4.0% 9.7% 13.5% 15.2%Loss (Gain) from Discont. Op., Net of Tax 3.1% 0.3% -0.1% 0.0% 0.0% 0.0%

Income Before Effect of Accounting Changes 9.6% 9.9% 4.1% 9.7% 13.5% 15.2%Effect of Accounting Changes, Net of Tax 0.0% 0.2% 0.0% 0.0% 0.0% 0.0%

Net Income 9.6% 9.7% 4.1% 9.7% 13.5% 15.2% 16.1% 17.0% 17.9% 17.9% 17.9% 17.9% 17.9% 17.9% 17.9% 17.9%

105

Income Statement (Restated)2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Sales Growth 9.79% 6.79% 3.58% 5.37% 8.53% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36%Net Sales 8,110$ 8,904$ 9,509$ 9,849$ 10,378$ 11,263$ 12,092$ 12,982$ 13,937$ 14,963$ 16,064$ 17,247$ 18,516$ 19,879$ 21,342$ 22,913$ Cost of Goods Sold 4,318 4,951 5,594 5,756 5,641 5,744 6,058 6,387 6,732 7,227 7,759 8,330 8,943 9,601 10,308 11,067 Gross Profit 3,792$ 3,953$ 3,915$ 4,093$ 4,737$ 5,519$ 6,034$ 6,595$ 7,206$ 7,736$ 8,306$ 8,917$ 9,573$ 10,278$ 11,034$ 11,846$ SG&A Expenses 1,562 1,805 1,960 2,030 2,282 2,521 2,707 2,906 3,120 3,349 3,596 3,860 4,144 4,450 4,777 5,129 R&D Expenses 501 553 517 533 614 760 Adj. for R&D Cap. (Net of Tax) (370) (444) (460) (354) (492) (614) Adj. for R&D Amort. (Net of Tax) 299 343 390 315 405 439GW Amort. (Net of Tax) 91 166 211 157 115 46In-process R&D (IPR&D) Charges 163Operating Income 1,546$ 1,531$ 1,297$ 1,412$ 1,812$ 2,367$ 2,650$ 2,961$ 3,305$ 3,548$ 3,809$ 4,090$ 4,391$ 4,714$ 5,061$ 5,433$ Restructuring Charges, Net 26 337 543 (109) 70Other Special Charges 289Interest Expense 71 118 126 166 101 124Interest (Income) (20) (31) (27) (48) (67) (102)Other Expense, Net 92 42 77 77 61 32

Earnings Before Income Taxes 1,377$ 1,065$ 289$ 1,326$ 1,717$ 2,243$ Income Tax Expense (Income) 364 222 47 486 348 407

Inc. from Cont. Op. before Accounting Changes 1,013 843 242 840 1,369 1,836 Loss (Gain) from Discont. Op., Net of Tax 255 24 (5) 2 1 0

Income Before Effect of Accounting Changes 758 819 247 838 1,368 1,836 Effect of Accounting Changes, Net of Tax 0 17 0 0 0 0

Net Income 758$ 802$ 247$ 838$ 1,368$ 1,836$ 2,079$ 2,349$ 2,648$ 2,843$ 3,052$ 3,276$ 3,518$ 3,776$ 4,054$ 4,353$

Common Sized Income Statement (Restated)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Sales Growth 9.79% 6.79% 3.58% 5.37% 8.53% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36% 7.36%Net Sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Cost of Goods Sold 53.2% 55.6% 58.8% 58.4% 54.4% 51.0% 50.1% 49.2% 48.3% 48.3% 48.3% 48.3% 48.3% 48.3% 48.3% 48.3%Gross Profit 46.8% 44.4% 41.2% 41.6% 45.6% 49.0% 49.9% 50.8% 51.7% 51.7% 51.7% 51.7% 51.7% 51.7% 51.7% 51.7%SG&A Expenses 19.3% 20.3% 20.6% 20.6% 22.0% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4% 22.4%R&D Expenses 6.2% 6.2% 5.4% 5.4% 5.9% 6.7%Adj. for R&D Cap. (Net of Tax) -4.6% -5.0% -4.8% -3.6% -4.7% -5.4%Adj. for R&D Amort. (Net of Tax) 3.7% 3.9% 4.1% 3.2% 3.9% 3.9%GW Amort. (Net of Tax) 1.1% 1.9% 2.2% 1.6% 1.1% 0.4%In-process R&D (IPR&D) Charges 2.0% 0.0% 0.0% 0.0% 0.0% 0.0%Operating Income 19.1% 17.2% 13.6% 14.3% 17.5% 21.0% 21.9% 22.8% 23.7% 23.7% 23.7% 23.7% 23.7% 23.7% 23.7% 23.7%Restructuring Charges, Net 0.3% 3.8% 5.7% -1.1% 0.0% 0.6%Other Special Charges 0.0% 0.0% 3.0% 0.0% 0.0% 0.0%Interest Expense 0.9% 1.3% 1.3% 1.7% 1.0% 1.1%Interest (Income) -0.2% -0.3% -0.3% -0.5% -0.6% -0.9%Other Expense, Net 1.1% 0.5% 0.8% 0.8% 0.6% 0.3%

Earnings Before Income Taxes 17.0% 12.0% 3.0% 13.5% 16.5% 19.9% 20.8% 21.7% 22.6% 22.6% 22.6% 22.6% 22.6% 22.6% 22.6% 22.6%Income Tax Expense (Income) 4.5% 2.5% 0.5% 4.9% 3.4% 3.6%

Inc. from Cont. Op. before Accounting Changes 12.5% 9.5% 2.5% 8.5% 13.2% 16.3%Loss (Gain) from Discont. Op., Net of Tax 3.1% 0.3% -0.1% 0.0% 0.0% 0.0%

Income Before Effect of Accounting Changes 9.3% 9.2% 2.6% 8.5% 13.2% 16.3%Effect of Accounting Changes, Net of Tax 0.0% 0.2% 0.0% 0.0% 0.0% 0.0%

Net Income 9.3% 9.0% 2.6% 8.5% 13.2% 16.3% 17.2% 18.1% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0%

106

Balance Sheet

Forecasting the balance sheet is a little trickier than the income

statement. First, we need to find something that will link the income statement

to the balance sheet. In our case we used asset turnover. Over the five-year

period, asset turnover averaged out to be .74. However, we found that the ratio

for the industry was converging on .70. We used a 3% decline per year from .77

until it declined to .70.

For the rest of the assets in the balance sheet we used a two-year

weighted average of each particular item in relation to total assets. When

studying the balance sheet we discovered abrupt changes in certain accounts

from 2005 to 2006, which indicated a probable policy change that we believe will

remain consistent for our forecasting period. This is why we chose to only use

the weighted average from the last two-years. For instance in 2006 they

decided to carry about 3 times the amount of cash than they did in 2005 and in

2007 it stayed about the same as in 2006.

We used the current ratio to determine current liabilities. Over the last

two years the ratio had risen significantly, hovering around 2.0, which we used

for the duration of the forecast.

Next, we moved on to retained earnings. We calculated retained earnings

by taking the beginning balance, adding net income and subtracting dividends.

We already know the beginning balance and net income, so our goal is to

forecast dividends. We found the dividends by taking the average dividend

payout ratio over the last 6 years, which was right around .5 and multiplied that

by the yearly forecasted net income. Total shareholder’s equity was found by

taking the difference of current and previous year retained earnings and adding

it to the previous year’s shareholder’s equity balance. Total liabilities are the

difference between total assets and total shareholder’s equity.

107

Balance Sheet2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash and Equivalents 1,169 925 1,109 841 2,485 2,539 2,916 3,227 3,571 3,834 4,117 4,420 4,745 5,094 5,469 5,871 Accounts Receivables 1,793 1,914 2,091 1,766 1,838 2,026 2,269 2,512 2,780 2,984 3,204 3,440 3,693 3,964 4,256 4,570 Inventories 1,752 2,104 2,135 1,925 2,066 2,334 2,594 2,871 3,177 3,411 3,662 3,932 4,221 4,532 4,865 5,223 Short-Term Deferred Income Taxes 125 140 297 260 231 261 Prepaid Expenses and Other 268 277 387 324 350 395 Total Current Assets 5,107$ 5,360$ 6,019$ 5,116$ 6,970$ 7,555$ 8,508$ 9,416$ 10,421$ 11,188$ 12,012$ 12,896$ 13,845$ 14,864$ 15,958$ 17,132$

Property, Plant and Equipment, Net 3,912 4,592 4,369 4,144 4,229 4,487 5,088 5,632 6,233 6,691 7,184 7,713 8,280 8,890 9,544 10,246

Goodwill 1,445 1,599 1,648 1,552 1,618 1,690 Other Intangible Assets 526 611 547 494 480 455 Other 1,438 1,545 1,564 1,421 1,389 1,107 Total Non-Current Assets 3,409$ 3,755$ 3,759$ 3,467$ 3,487$ 3,252$ 3,855$ 4,267$ 4,722$ 5,070$ 5,443$ 5,843$ 6,273$ 6,735$ 7,231$ 7,763$

Total Assets 12,428$ 13,707$ 14,147$ 12,727$ 14,686$ 15,294$ 17,451$ 19,315$ 21,376$ 22,949$ 24,638$ 26,452$ 28,399$ 30,489$ 32,733$ 35,142$

Asset Turnover 0.72 0.69 0.70 0.82 0.77 0.74 0.72 0.70 0.70 0.70 0.70 0.70 0.70 0.70 0.70

Accounts PayableShort-Term Debt 112 150 207 141 57 45 Cur. Maturities of LT Debt & Lease Obligations 108 3 154 783 177 380 Accrued Liabilities 3,047 3,107 3,925 3,241 3,376 3,387 Income Taxes Payable 470 438 Other Short-Term LiabilitiesTotal Current Liabilities 3,737$ 3,698$ 4,286$ 4,165$ 3,610$ 3,812$ 4,254$ 4,708$ 5,211$ 5,594$ 6,006$ 6,448$ 6,922$ 7,432$ 7,979$ 8,566$

Current Ratio 1.37 1.45 1.40 1.23 1.93 1.98 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00

Long-Term Debt and Lease Obligations 4,398 4,421 3,933 2,414 2,567 2,664 Other Long-Term Liabilities 1,280 2,206 2,223 1,849 2,237 1,902 Total Non-Current Liabilities 5,678$ 6,627$ 6,156$ 4,263$ 4,804$ 4,566$

Total Liabilities 9,415$ 10,325$ 10,442$ 8,428$ 8,414$ 8,378$ 8,936$ 9,177$ 9,354$ 8,887$ 8,367$ 7,791$ 7,152$ 6,446$ 5,667$ 4,807$

Common Stock 627 649 648 648 683 683 Treasury Stock (1,326) (1,863) (1,511) (1,150) (1,433) (2,503) Additional Contributed Capital 3,236 3,786 3,597 3,867 5,177 5,297 Retained Earnings 1,740 2,145 2,000 2,430 3,271 4,379 5,978 7,601 9,485 11,525 13,734 16,124 18,709 21,505 24,529 27,797 Accumulated Other Comprehensive Loss (1,264) (1,420) (1,288) (1,496) (1,426) (940) Loss from Issuance of Treasury Stock 85 259 Total Shareholder's Equity 3,013$ 3,382$ 3,705$ 4,299$ 6,272$ 6,916$ 8,515$ 10,138$ 12,022$ 14,062$ 16,271$ 18,661$ 21,246$ 24,042$ 27,066$ 30,334$

Total Liabilities and Shareholder's Equity 12,428$ 13,707$ 14,147$ 12,727$ 14,686$ 15,294$ 17,451$ 19,315$ 21,376$ 22,949$ 24,638$ 26,452$ 28,399$ 30,489$ 32,733$ 35,142$

108

Common Sized Balance Sheet2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash and Equivalents 9.41% 6.75% 7.84% 6.61% 16.92% 16.60% 16.7% 16.7% 16.7% 16.7% 16.7% 16.7% 16.7% 16.7% 16.7% 16.7%Accounts and Other Current Receivables 14.43% 13.96% 14.78% 13.88% 12.52% 13.25% 13.0% 13.0% 13.0% 13.0% 13.0% 13.0% 13.0% 13.0% 13.0% 13.0%Inventories 14.10% 15.35% 15.09% 15.13% 14.07% 15.26% 14.9% 14.9% 14.9% 14.9% 14.9% 14.9% 14.9% 14.9% 14.9% 14.9%Short-Term Deferred Income Taxes 1.01% 1.02% 2.10% 2.04% 1.57% 1.71%Prepaid Expenses and Other 2.16% 2.02% 2.74% 2.55% 2.38% 2.58%Total Current Assets 41.09% 39.10% 42.55% 40.20% 47.46% 49.40% 48.8% 48.8% 48.8% 48.8% 48.8% 48.8% 48.8% 48.8% 48.8% 48.8%

Property, Plant and Equipment, Net 31.48% 33.50% 30.88% 32.56% 28.80% 29.34%

Goodwill 11.63% 11.67% 11.65% 12.19% 11.02% 11.05%Other Intangible Assets 4.23% 4.46% 3.87% 3.88% 3.27% 2.98%Other 11.57% 11.27% 11.06% 11.17% 9.46% 7.24%Total Non-Current Assets 27.43% 27.39% 26.57% 27.24% 23.74% 21.26% 22.1% 22.1% 22.1% 22.1% 22.1% 22.1% 22.1% 22.1% 22.1% 22.1%

Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Asset Turnover 0.72 0.69 0.70 0.82 0.77 0.74 0.72 0.70 0.70 0.70 0.70 0.70 0.70 0.70 0.70

Accounts PayableShort-Term Debt 1.19% 1.45% 1.98% 1.67% 0.68% 0.54%Cur. Maturities of LT Debt & Lease Obligations 1.15% 0.03% 1.47% 9.29% 2.10% 4.54%Accrued Liabilities 32.36% 30.09% 37.59% 38.46% 40.12% 40.43%Income Taxes Payable 4.99% 4.24%Other Short-Term LiabilitiesTotal Current Liabilities 39.69% 35.82% 41.05% 49.42% 42.90% 45.50% 47.6% 51.3% 55.7% 62.9% 71.8% 82.8% 96.8% 115.3% 140.8% 178.2%

Current Ratio 1.37 1.45 1.40 1.23 1.93 1.98 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00

Long-Term Debt and Lease Obligations 46.71% 42.82% 37.67% 28.64% 30.51% 31.80%Other Long-Term Liabilities 13.60% 21.37% 21.29% 21.94% 26.59% 22.70%Commitments and ContingenciesTotal Non-Current Liabilities 60.31% 64.18% 58.95% 50.58% 57.10% 54.50%

Total Liabilities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Common Stock 20.81% 19.19% 17.49% 15.07% 10.89% 9.88%Treasury Stock -44.01% -55.09% -40.78% -26.75% -22.85% -36.19%Additional Contributed Capital 107.40% 111.95% 97.09% 89.95% 82.54% 76.59%Retained Earnings 57.75% 63.42% 53.98% 56.52% 52.15% 63.32% 70.2% 75.0% 78.9% 82.0% 84.4% 86.4% 88.1% 89.4% 90.6% 91.6%Accumulated Other Comprehensive Loss -41.95% -41.99% -34.76% -34.80% -22.74% -13.59%Loss from Issuance of Treasury Stock 2.51% 6.99%Total Shareholder's Equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Total Liabilities and Shareholder's Equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

109

Balance Sheet (Restated)2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash and Equivalents 987 759 961 753 2,404 2,427 2,789 3,087 3,399 3,649 3,917 4,206 4,515 4,848 5,204 5,588Accounts Receivables 1,793 1,914 2,091 1,766 1,838 2,026 2,263 2,504 2,758 2,960 3,178 3,412 3,663 3,933 4,223 4,533Inventories 1,752 2,104 2,135 1,925 2,066 2,334 2,578 2,854 3,142 3,374 3,622 3,888 4,175 4,482 4,812 5,166Short-Term Deferred Income Taxes 125 140 297 260 231 261Prepaid Expenses and Other 268 277 387 324 350 395Total Current Assets 4,925 5,194 5,871 5,028 6,889 7,443 8,349 9,241 10,175 10,924 11,728 12,591 13,518 14,513 15,581 16,727

Property, Plant and Equipment, Net 3,912 4,592 4,369 4,144 4,229 4,487 5,350 5,921 6,520 7,000 7,515 8,068 8,662 9,299 9,983 10,718

Adj. Goodwill 753 701 513 181 103 118Other Intangible Assets 526 611 547 494 480 455R&D (Net of Amort.) 1,302 1,428 1,507 1,564 1,672 1,888 2,087 2,310 2,544 2,731 2,932 3,148 3,379 3,628 3,895 4,182Other 1,438 1,545 1,564 1,421 1,389 1,107Total Non-Current Assets 3,409 3,755 3,759 3,467 3,487 3,252 3,841 4,252 4,681 5,026 5,396 5,793 6,219 6,677 7,168 7,696

Total Assets 12,856 14,071 14,370 12,832 14,762 15,498 17,541 19,414 21,376 22,949 24,638 26,452 28,399 30,489 32,733 35,142

Asset Turnover 0.69 0.68 0.69 0.81 0.76 0.74 0.72 0.70 0.70 0.70 0.70 0.70 0.70 0.70 0.70

Accounts PayableShort-Term Debt 112 150 207 141 57 45Cur. Maturities of LT Debt & Lease Obligations 108 3 154 783 177 380Accrued Liabilities 3,047 3,107 3,925 3,241 3,376 3,387Income Taxes Payable 470 438Other Short-Term LiabilitiesTotal Current Liabilities 3,737 3,698 4,286 4,165 3,610 3,812 4,175 4,621 5,087 5,462 5,864 6,296 6,759 7,256 7,790 8,364

Current Ratio 1.32 1.40 1.37 1.21 1.91 1.95 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00

Long-Term Debt and Lease Obligations 4,398 4,421 3,933 2,414 2,567 2,664Other Long-Term Liabilities 1,280 2,206 2,223 1,849 2,237 1,902Total Non-Current Liabilities 5,678 6,627 6,156 4,263 4,804 4,566

Total Liabilities 9,415 10,325 10,442 8,428 8,414 8,378 8,684 8,786 8,704 8,067 7,364 6,590 5,741 4,808 3,785 2,664

Common Stock 627 649 648 648 683 683Treasury Stock (1,326) (1,863) (1,511) (1,150) (1,433) (2,503)Additional Contributed Capital 3,236 3,786 3,597 3,867 5,177 5,297Retained Earnings 2,168 2,509 2,223 2,535 3,347 4,583 6,320 8,091 10,135 12,346 14,738 17,324 20,121 23,144 26,411 29,941Accumulated Other Comprehensive Loss (1,264) (1,420) (1,288) (1,496) (1,426) (940)Loss from Issuance of Treasury Stock 85 259Total Shareholder's Equity 3,441 3,746 3,928 4,404 6,348 7,120 8,857 10,628 12,672 14,883 17,275 19,861 22,658 25,681 28,948 32,478

Total Liabilities and Shareholder's Equity 12,856 14,071 14,370 12,832 14,762 15,498 17,541 19,414 21,376 22,949 24,638 26,452 28,399 30,489 32,733 35,142

110

Common Sized Balance Sheet (Restated)2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash and Equivalents 7.7% 5.4% 6.7% 5.9% 16.3% 15.7% 15.9% 15.9% 15.9% 15.9% 15.9% 15.9% 15.9% 15.9% 15.9% 15.9%Accounts Receivables 13.9% 13.6% 14.6% 13.8% 12.5% 13.1% 12.9% 12.9% 12.9% 12.9% 12.9% 12.9% 12.9% 12.9% 12.9% 12.9%Inventories 13.6% 15.0% 14.9% 15.0% 14.0% 15.1% 14.7% 14.7% 14.7% 14.7% 14.7% 14.7% 14.7% 14.7% 14.7% 14.7%Short-Term Deferred Income Taxes 1.0% 1.0% 2.1% 2.0% 1.6% 1.7%Prepaid Expenses and Other 2.1% 2.0% 2.7% 2.5% 2.4% 2.5%Total Current Assets 38.3% 36.9% 40.9% 39.2% 46.7% 48.0% 47.6% 47.6% 47.6% 47.6% 47.6% 47.6% 47.6% 47.6% 47.6% 47.6%

Property, Plant and Equipment, Net 30.4% 32.6% 30.4% 32.3% 28.6% 29.0%

Adj. Goodwill 5.9% 5.0% 3.6% 1.4% 0.7% 0.8%Other Intangible Assets 4.1% 4.3% 3.8% 3.8% 3.3% 2.9%R&D (Net of Amort.) 10.1% 10.1% 10.5% 12.2% 11.3% 12.2% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9%Other 11.2% 11.0% 10.9% 11.1% 9.4% 7.1%Total Non-Current Assets 26.5% 26.7% 26.2% 27.0% 23.6% 21.0% 21.9% 21.9% 21.9% 21.9% 21.9% 21.9% 21.9% 21.9% 21.9% 21.9%

Total Assets 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Asset Turnover 0.69 0.68 0.69 0.81 0.76 0.74 0.72 0.70 0.70 0.70 0.70 0.70 0.70 0.70 0.70

Accounts PayableShort-Term Debt 1.2% 1.5% 2.0% 1.7% 0.7% 0.5%Cur. Maturities of LT Debt & Lease Obligations 1.1% 0.0% 1.5% 9.3% 2.1% 4.5%Accrued Liabilities 32.4% 30.1% 37.6% 38.5% 40.1% 40.4%Income Taxes Payable 5.0% 4.2%Other Short-Term LiabilitiesTotal Current Liabilities 39.7% 35.8% 41.0% 49.4% 42.9% 45.5% 48.1% 52.6% 58.4% 67.7% 79.6% 95.5% 117.7% 150.9% 205.8% 314.0%

Current Ratio 1.32 1.40 1.37 1.21 1.91 1.95 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00

Long-Term Debt and Lease Obligations 46.7% 42.8% 37.7% 28.6% 30.5% 31.8%Other Long-Term Liabilities 13.6% 21.4% 21.3% 21.9% 26.6% 22.7%Total Non-Current Liabilities 60.3% 64.2% 59.0% 50.6% 57.1% 54.5%

Total Liabilities 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Common Stock 18.2% 17.3% 16.5% 14.7% 10.8% 9.6%Treasury Stock -38.5% -49.7% -38.5% -26.1% -22.6% -35.2%Additional Contributed Capital 94.0% 101.1% 91.6% 87.8% 81.6% 74.4%Retained Earnings 63.0% 67.0% 56.6% 57.6% 52.7% 64.4% 71.4% 76.1% 80.0% 83.0% 85.3% 87.2% 88.8% 90.1% 91.2% 92.2%Accumulated Other Comprehensive Loss -36.7% -37.9% -32.8% -34.0% -22.5% -13.2%Loss from Issuance of Treasury Stock 2.3% 6.6%Total Shareholder's Equity 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Total Liabilities and Shareholder's Equity 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

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Cash Flow Statement

The cash flow statement is perhaps the hardest to forecast, therefore, less

of it is forecasted. In order to find cash flows from operations, we used the

cffo/sales ratio. The ratio made a huge jump between 2005 and 2006 from .157

to .210 then decreased to .205 in 2007. We used a ratio of .2 to forecast out

cash flows from operations. After restatement, the ratio was .27 in both 2006

and 2007. We continued this trend throughout the duration of the restated

forecast.

The cash flows from investing activities were harder to determine a

forecasting methodology. For the actual statements forecasting we used the

change in property, plant and equipment. For the restated statements we used

the sum of the changes in property, plant and equipment and the amortized

research and development balance.

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Cash Flows2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash Flows from OperationsNet Income (Income from Cont. Ops. In 2002) 1,026$ 866$ 388$ 956$ 1,397$ 1,707$ 1,941$ 2,201$ 2,489$ 2,672$ 2,868$ 3,080$ 3,306$ 3,550$ 3,811$ 4,091$ Adjustments

Depreciation and Amortization 440 545 601 580 575 581Deferred Income Taxes 72 108 (141) 201 8 126Impairments 26Stock Compensation 15 9 94 136Restructuring Charges, Net 26 337 543 (109) 70Infusion Pump Charges 163 126 76Hemodialysis Instrument Charges 50Average Wholesale Pricing Litigation Charge 56Other Special Charges 289Other 40 60 134 48 34 (5)

Changes in Balance Sheet ItemsAccounts and Other Current Receivables (261) 3 (189) 178 (16) (278)Inventories (269) (155) 33 88 (35) (211)Accounts Payable and Accrued Liabilities 34 (159) (246) (325) 1 1Restructuring Payments (2) (69) (195) (117) (42) (27)Other (40) (110) 148 (135) 91 149

Cash Flows from Continuing Operations 1,255 1,426 1,380 1,550 2,183 2,305Cash Flows from Discontinued Operations (58)

Cash Flows from Operations 1,197$ 1,426$ 1,380$ 1,550$ 2,183$ 2,305$ 2,418$ 2,596$ 2,787$ 2,993$ 3,213$ 3,449$ 3,703$ 3,976$ 4,268$ 4,583$

CFFO / Sales 0.148 0.160 0.145 0.157 0.210 0.205 0.200 0.200 0.200 0.200 0.200 0.200 0.200 0.200 0.200 0.200

Cash Flows from Investing ActivitiesCapital Expenditures (852) (792) (558) (444) (526) (692)Acquisitions (492) (184) (20) (47) (5) (112)Divestitures and Other 34 87 26 124 189 499

Cash Flows from Investing Activities (1,310)$ (889)$ (552)$ (367)$ (342)$ (305)$ (601)$ (543)$ (601)$ (459)$ (492)$ (529)$ (568)$ (609)$ (654)$ (702)$

Cash Flows from Financing ActivitiesIssuances of Debt 2,412 696 600 1,072 751 584Payments of Obligations (633) (1,477) (627) (2,336) (1,294) (635)Decrease in Debt with Mat. of 3 Mo. or Less (185) 341 (351)Cash Dividends on Common Stock (349) (346) (361) (359) (364) (704) (343) (578) (604) (631) (660) (690) (721) (753) (787) (823)Proceeds from Stock Issued Under PEBP's 180 105 181 176 272 639Other Issuances of Stock 414 644 1,249Purchases of Treasury Stock (1,169) (714) (18) (737) (1,855)

Cash Flows from Financing Activities 670$ (751)$ (576)$ (1,447)$ (123)$ (1,971)$

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Common Sized Cash Flows2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash Flows from OperationsNet Income (Income from Cont. Ops. In 2002) 85.7% 60.7% 28.1% 61.7% 64.0% 74.1% 80.3% 84.8% 89.3% 89.3% 89.3% 89.3% 89.3% 89.3% 89.3% 89.3%Adjustments

Depreciation and Amortization 36.8% 38.2% 43.6% 37.4% 26.3% 25.2%Deferred Income Taxes 6.0% 7.6% -10.2% 13.0% 0.4% 5.5%Impairments 2.2%Stock Compensation 1.1% 0.6% 4.3% 5.9%Restructuring Charges, Net 2.2% 23.6% 39.3% -7.0% 3.0%Infusion Pump Charges 13.6% 8.1% 3.5%Hemodialysis Instrument Charges 3.2%Average Wholesale Pricing Litigation Charge 2.4%Other Special Charges 20.9%Other 3.3% 4.2% 9.7% 3.1% 1.6% -0.2%

Changes in Balance Sheet ItemsAccounts and Other Current Receivables -21.8% 0.2% -13.7% 11.5% -0.7% -12.1%Inventories -22.5% -10.9% 2.4% 5.7% -1.6% -9.2%Accounts Payable and Accrued Liabilities 2.8% -11.2% -17.8% -21.0% 0.0% 0.0%Restructuring Payments -0.2% -4.8% -14.1% -7.5% -1.9% -1.2%Other -3.3% -7.7% 10.7% -8.7% 4.2% 6.5%

Cash Flows from Continuing Operations 104.8% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Cash Flows from Discontinued Operations -4.8%

Cash Flows from Operations 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

CFFO / Sales 0.15 0.16 0.15 0.16 0.21 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20

Cash Flows from Investing ActivitiesCapital Expenditures 65.0% 89.1% 101.1% 121.0% 153.8% 226.9%Acquisitions 37.6% 20.7% 3.6% 12.8% 1.5% 36.7%Divestitures and Other -2.6% -9.8% -4.7% -33.8% -55.3% -163.6%

Cash Flows from Investing Activities 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Cash Flows from Financing ActivitiesIssuances of Debt 360.0% -92.7% -104.2% -74.1% -610.6% -29.6%Payments of Obligations -94.5% 196.7% 108.9% 161.4% 1052.0% 32.2%Decrease in Debt with Mat. of 3 Mo. or Less -27.6% -45.4% 60.9%Cash Dividends on Common Stock -52.1% 46.1% 62.7% 24.8% 295.9% 35.7%Proceeds from Stock Issued Under PEBP's 26.9% -14.0% -31.4% -12.2% -221.1% -32.4%Other Issuances of Stock 61.8% -85.8% -1015.4%Purchases of Treasury Stock -174.5% 95.1% 3.1% 599.2% 94.1%

Cash Flows from Financing Activities 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

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Cash Flows (Restated)2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash Flows from OperationsNet Income (Income from Cont. Ops. In 2002) 758$ 802$ 247$ 838$ 1,368$ 1,836$ 2,079$ 2,349$ 2,648$ 2,843$ 3,052$ 3,276$ 3,518$ 3,776$ 4,054$ 4,353$ Adjustments

Depreciation and Amortization 969 1,178 1,276 1,291 1,225 1,182Deferred Income Taxes 72 108 (141) 201 8 126Impairments 26Stock Compensation 15 9 94 136Restructuring Charges, Net 26 337 543 (109) 70Infusion Pump Charges 163 126 76Hemodialysis Instrument Charges 50Average Wholesale Pricing Litigation Charge 56Other Special Charges 289Other 40 60 134 48 34 (5)

Changes in Balance Sheet ItemsAccounts and Other Current Receivables (261) 3 (189) 178 (16) (278)Inventories (269) (155) 33 88 (35) (211)Accounts Payable and Accrued Liabilities 34 (159) (246) (325) 1 1Restructuring Payments (2) (69) (195) (117) (42) (27)Other (40) (110) 148 (135) 91 149

Cash Flows from Continuing Operations 1,515 1,995 1,914 2,143 2,804 3,034Cash Flows from Discontinued Operations (58)

Cash Flows from Operations 1,457$ 1,995$ 1,914$ 2,143$ 2,804$ 3,034$ 3,265$ 3,505$ 3,763$ 4,040$ 4,337$ 4,657$ 4,999$ 5,367$ 5,762$ 6,186$

CFFO / Sales 0.18 0.22 0.20 0.22 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27

Cash Flows from Investing ActivitiesCapital Expenditures (1,353) (1,345) (1,075) (977) (1,140) (1,452)Acquisitions (492) (184) (20) (47) (5) (112)Divestitures and Other 34 87 26 124 189 499

Cash Flows from Investing Activities (1,811) (1,442) (1,069) (900) (956) (1,065) (1,062) (794) (832) (667) (716) (769) (825) (886) (951) (1,021)

Cash Flows from Financing ActivitiesIssuances of Debt 2,412 696 600 1,072 751 584Payments of Obligations (633) (1,477) (627) (2,336) (1,294) (635)Decrease in Debt with Mat. of 3 Mo. or Less (185) 341 (351)Cash Dividends on Common Stock (349) (346) (361) (359) (364) (704) (343) (578) (604) (631) (660) (690) (721) (753) (787) (823)Proceeds from Stock Issued Under PEBP's 180 105 181 176 272 639Other Issuances of Stock 414 644 1,249Purchases of Treasury Stock (1,169) (714) (18) (737) (1,855)

Cash Flows from Financing Activities 670 (751) (576) (1,447) (123) (1,971)

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Common Sized Cash Flows (Restated)2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cash Flows from OperationsNet Income (Income from Cont. Ops. In 2002) 52.0% 40.2% 12.9% 39.1% 48.8% 60.5% 63.7% 67.0% 70.4% 70.4% 70.4% 70.4% 70.4% 70.4% 70.4% 70.4%Adjustments

Depreciation and Amortization 66.5% 59.1% 66.7% 60.3% 43.7% 38.9%Deferred Income Taxes 4.9% 5.4% -7.4% 9.4% 0.3% 4.2%Impairments 1.8%Stock Compensation 0.8% 0.4% 3.4% 4.5%Restructuring Charges, Net 1.8% 16.9% 28.4% -5.1% 2.3%Infusion Pump Charges 11.2% 5.9% 2.7%Hemodialysis Instrument Charges 2.3%Average Wholesale Pricing Litigation Charge 1.8%Other Special Charges 15.1%Other 2.7% 3.0% 7.0% 2.2% 1.2% -0.2%

Changes in Balance Sheet ItemsAccounts and Other Current Receivables -17.9% 0.2% -9.9% 8.3% -0.6% -9.2%Inventories -18.5% -7.8% 1.7% 4.1% -1.2% -7.0%Accounts Payable and Accrued Liabilities 2.3% -8.0% -12.9% -15.2% 0.0% 0.0%Restructuring Payments -0.1% -3.5% -10.2% -5.5% -1.5% -0.9%Other -2.7% -5.5% 7.7% -6.3% 3.2% 4.9%

Cash Flows from Continuing Operations 104.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Cash Flows from Discontinued Operations -4.0%

Cash Flows from Operations 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

CFFO / Sales 0.18 0.22 0.20 0.22 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27 0.27

Cash Flows from Investing ActivitiesCapital Expenditures 74.7% 93.3% 100.6% 108.6% 119.2% 136.3%Acquisitions 27.2% 12.8% 1.9% 5.2% 0.5% 10.5%Divestitures and Other -1.9% -6.0% -2.4% -13.8% -19.8% -46.9%

Cash Flows from Investing Activities 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Cash Flows from Financing ActivitiesIssuances of Debt 360.0% -92.7% -104.2% -74.1% -610.6% -29.6%Payments of Obligations -94.5% 196.7% 108.9% 161.4% 1052.0% 32.2%Decrease in Debt with Mat. of 3 Mo. or Less -27.6% -45.4% 60.9%Cash Dividends on Common Stock -52.1% 46.1% 62.7% 24.8% 295.9% 35.7%Proceeds from Stock Issued Under PEBP's 26.9% -14.0% -31.4% -12.2% -221.1% -32.4%Other Issuances of Stock 61.8% -85.8% -1015.4%Purchases of Treasury Stock -174.5% 95.1% 3.1% 599.2% 94.1%

Cash Flows from Financing Activities 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

116

Cost of Capital Estimation

Many opinions have been offered as to the correct method of equity

valuation, but all intrinsic valuation methods agree that the value of a firm is the

amount of future benefits discounted to the present by some rate of interest.

The points of contention usually relate to exactly how one defines what is

included in “future benefits” and how one computes the appropriate discount

rate.

Though there is considerable debate concerning the identification of

relevant future benefits, it is clear that it is a firm’s assets that must generate

those benefits. Thus the most important choice faced by a firm is the choice of

how to invest its assets to create profitable returns. In order to understand how

to create profit, however, a firm must understand the costs involved in the

financing of its assets.

A firm’s assets can be financed using two options, debt and equity. The

cost of debt is interest payments paid on the debt to creditors while the cost of

equity is the rate of return required by the shareholders. In order to undertake

an investment of its assets, a firm must first determine whether the proceeds of

this investment will exceed the costs of the assets used in the investment. If the

proceeds exceed the costs, the firm will go forward with the investment, and, if

not, will decline in favor of opportunities that do offer profit.

With a little effort one can extrapolate this concept to the broader idea of

investing in whole companies. After all, a firm is, to a certain extent, just the

sum total of its investments. If the total proceeds of a firm’s investments exceed

the cost of its capital it will achieve profit and will therefore be attractive to

investors. The cost of capital also represents the opportunity cost of the

investment. Investors faced with a choice of investing their capital between two

firms with identical costs of capital, and therefore equal risk, will simply choose

the one whose future benefits are greater. It is for this reason that cost of

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capital is an appropriate choice for a discount rate in intrinsic valuation models.

The next step is determining the most accurate method of computing this rate.

An accurate cost of capital estimation, should weigh the different costs

associated with the different types of financing by their percentage of total

financing. The costs associated with debt are fairly straightforward to compute.

Sometimes firms actually publish the interest rates on their debt in the 10-K

annual report. If a firm does not, the analyst must compare the different types

of debt the firm carries with published rates similar in risk and maturity.

Estimating the cost of equity is not quite so simple. In fact, this is one of

the most contentious debates in modern finance. Simply put, the cost of equity

is the return expected by shareholders on their investment. Investors require a

certain amount of compensation for holding risk and for the opportunity cost of

forgoing a risk-free investment. Thus the expected return consists of a risk-free

rate plus a risk premium. It is this risk premium, and the appropriate method of

determining it, that is the subject of great controversy.

One of the most famous methods of estimating a firm’s risk premium was

developed independently by Sharpe, Lintner, and Mossin in the 1960s. The

Capital Asset Pricing Model (CAPM) claims that the risk premium of a firm (j) is a

function of the market (m) risk premium, where beta (ß) represents the volatility

of the firm in the market portfolio.

Rj – Rf = ß * (Rm-Rf)

Using this model, if an analyst is able to estimate a reliable beta, market risk

premium, and risk-free rate; the expected return of the firm and therefore the

cost of equity can be evaluated. While other methods have been advocated

which claim that a firm’s risk premium is a function of more factors than just

market premium, these so-called multi-factor models, such as the Fama-French

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Three Factor model, are much less popular methods of cost of equity estimation

than CAPM.

After an analyst has computed estimates of costs of debt and equity,

these costs must be weighted in proportion to their percentage of total asset

financing to compute a pre-tax weighted average cost of capital (WACC).

Finally, the cost of debt financing, interest, is tax-deductible while dividends are

not. Thus the cost of debt financing must be multiplied by (1 - tax rate) to arrive

at the accurate cost of capital estimate, the after-tax WACC.

Cost of Debt

Our cost of capital estimation for Baxter began with an analysis of its 10-K

for any information about the interest rates associated with its debts. We were

pleased to find the following interest rates related to Baxter’s Long-term debt

and lease obligations:

As of December 31 (in millions)Effective Int. Rate

2007 LT Debt Weight

(Weight x Eff Int Rate)

7.25% notes due 2008 7.30% 29$ 0.0095 0.00079.5% notes due 2008 9.50% 76 0.0250 0.00245.196% notes due 2008 5.40% 251$ 0.0825 0.00454.75% notes due 2010 3.70% 499 0.1639 0.0061Variable-rate loan due 2010 1.10% 143$ 0.0470 0.0005Variable rate loan due 2012 1.20% 125 0.0411 0.00054.625% notes due 2015 4.80% 599$ 0.1968 0.00945.9% notes due 2016 6.00% 598 0.1965 0.01186.625% debentures due 2028 6.70% 155$ 0.0509 0.00346.25% notes due 2037 4.90% 499 0.1639 0.0080Other 70$ 0.0230 0

Totals 3,044$ 1.0000 0.0473

4.73%Weighted Average Interest Rate

We applied this interest rate to both long-term and current maturities of

long-term debt and lease obligations, which account for 36.3% of total liabilities.

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In order to complete the list, we needed to find published interest rates for

financial instruments that exhibit similar qualities of maturity and risk to those

liabilities for which we did not yet have a published interest rate. For short-term

debt and accrued liabilities we applied the 3-month AA Commercial Paper Rate as

quoted on the St. Louis Federal Reserve website. For other long-term liabilities,

we used Baxter’s corporate bond coupon rate as quoted on Yahoo Finance. A

summary of these rates follows:

% of Total Liabilities

Interest Rate

Weighted Rate

Current LiabilitiesShort-term debt 0.54% 3.03% 0.02%Cur. Mat. of LT Debt and Lease Obligations 4.54% 4.73% 0.21%Accrued Liabilities 40.43% 3.03% 1.22%Total Current Liabilities 45.50% 1.46%

Long-Term Debt and Lease Obligations 31.80% 4.73% 1.50%Other Long-Term Liabilities 22.70% 5.90% 1.34%Total Long-Term Liabilities 54.50% 2.84%

Weighted Average Cost of Debt 4.30%

*3 Month AA Commercial Paper Rate from St. Louis Fed 3.03%**Baxter's Corporate Bond Coupon Rate from Yahoo Finance 5.90%***Baxter's Weighted Interest Rate from 10K (see below) 4.73%

Weighting each of these liabilities for their respective percentages of total

liabilities we arrived at a weighted average cost of debt of 4.3%.

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Cost of Equity

The next step in finding Baxter’s cost of capital is to estimate its cost of

equity. We first used the CAPM model to approximate Baxter’s expected return.

As previously mentioned, CAPM claims that a firm’s risk premium is a function of

the market risk premium with a coefficient of beta (ß). In order to use CAPM to

evaluate a firm’s risk premium we must first determine its beta. We can achieve

this through regression analysis.

We first assembled historical market returns proxied by the returns of the

S&P 500. Then we gathered Baxter’s historical stock performance and historical

treasury bill data for maturities of 3 months, 6 months, 2 years, 5 years, and 10

years. Subtracting the t-bill rates from the historical market returns we were

able to calculate historical market risk premiums for each maturity t-bill. Next,

we used Excel’s data analysis tool to run a regression analysis using the market

risk premium as our independent x variable and the firm’s historical return as the

dependent y variable. We ran regressions for each t-bill maturity for observation

periods of 72, 60, 48, 36, and 24 months.

The numbers of particular interest are the coefficient of x variable 1, the

adjusted R squared value, the t-stat, the p-value, and the upper and lower

bounds. The coefficient of the x variable 1 is the number we are attempting to

estimate, Beta (ß). The adjusted R squared value is a measure of reliability. It

describes what percentage of the variation in the dependent variable (historical

stock returns) can be explained by the variation in the independent variable

(historical market returns). The t-stat is a measure of significance. In other

words, a t-stat of 2 signifies that the number of events in which ß is non-zero lies

under a normal distribution curve within two standard deviations away from the

mean. The p-value is related to the t-stat in that it signifies the probability of the

coefficient (ß) being zero. At a t-stat of 2, the p-value is .05 and we can

conclude that ß is significant (non-zero) with a 95% level of confidence. Finally

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the upper and lower bounds in our regression indicate that with a 95% level of

confidence we can estimate the range of our beta to lie between these two

values. Our results are as follows:

3 MonthBeta Adj. R2 T-Stat P-Value Rf Rate Ke

72 1.05524 0.16756 3.91036 0.00021 3.74% 10.92%60 0.94900 0.17803 3.71192 0.00046 3.74% 10.19%48 0.77646 0.12832 2.81402 0.00718 3.74% 9.02%36 0.43049 0.03499 1.50636 0.14121 3.74% 6.67%24 0.59737 0.08303 1.75575 0.09305 3.74% 7.80%

6 MonthBeta Adj. R2 T-Stat P-Value Rf Rate Ke

72 1.05451 0.16741 3.90850 0.00021 3.74% 10.91%60 0.94925 0.17842 3.71652 0.00046 3.74% 10.19%48 0.77707 0.12859 2.81698 0.00712 3.74% 9.02%36 0.43072 0.03508 1.50746 0.14093 3.74% 6.67%24 0.59610 0.08265 1.75276 0.09357 3.74% 7.79%

2 YearBeta Adj. R2 T-Stat P-Value Rf Rate Ke

72 1.05630 0.16880 3.92660 0.00020 3.74% 10.92%60 0.95254 0.17912 3.72481 0.00044 3.74% 10.22%48 0.77952 0.12959 2.82799 0.00691 3.74% 9.04%36 0.43119 0.03529 1.51009 0.14026 3.74% 6.67%24 0.59594 0.08304 1.75583 0.09303 3.74% 7.79%

5 YearBeta Adj. R2 T-Stat P-Value Rf Rate Ke

72 1.05993 0.17036 3.94700 0.00019 3.74% 10.95%60 0.95493 0.17888 3.72192 0.00045 3.74% 10.23%48 0.77961 0.13014 2.83406 0.00680 3.74% 9.04%36 0.43093 0.03554 1.51318 0.13947 3.74% 6.67%24 0.59587 0.08381 1.76182 0.09199 3.74% 7.79%

10 YearBeta Adj. R2 T-Stat P-Value Rf Rate Ke

72 1.06201 0.17110 3.95672 0.00018 3.74% 10.96%60 0.95517 0.17833 3.71554 0.00046 3.74% 10.24%48 0.77862 0.13035 2.83628 0.00676 3.74% 9.03%36 0.43046 0.03575 1.51578 0.13882 3.74% 6.67%24 0.59503 0.08429 1.76557 0.09134 3.74% 7.79%

*Note: Risk-free rate is the 10-year T-Bill rate for 2007

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Our regression analysis yielded some interesting results. First, the

regressions using the 10-year T-bill risk-free rate were the most reliable (highest

Adjusted R2) over every observation period except for 60 months, which yielded

the most reliable results for every one of the treasury bill maturities. The

reliability of the 60 month regression was almost constant with every t-bill

maturity, but peaking very slightly with the 2 year t-bill regression. It appears

that, at least in the case of Baxter, the reliability of CAPM is determined more by

the number of observations chosen in the regression analysis rather than by the

risk-free rate chosen. We also conclude that the most reliable regression we ran

was the 2 year t-bill over an observation period of 60 months. This regression

achieved the highest adjusted R2 in our analysis of 17.9% with a ß of .953. It

also demonstrates that the ß is significantly non-zero with a t-stat of 3.72 which

equates to a confidence interval of 99.96%

Now that we have found the most reliable beta using regression analysis,

we must now compute cost of equity using this beta. Since the value of a firm is

a long run concept, we must use long run inputs in our calculation. “Over the

1926-2005 period, returns to the Standard and Poor’s 500 index have exceeded

the rate on intermediate-term treasury bonds by 6.8 percent.” (Palepu, Healy;

Business Analysis and Valuation) Despite recent trends of declining market risk

premiums, we believe they will return close to the level of 6.8 as seen in the

historical average when investors realize they have failed due to “irrational

exuberance” (Greenspan) to price enough risk into their investments. Therefore,

we will use the market risk premium of 6.8% in our calculation. Also, we will use

the 10-year t-bill rate as our risk-free rate as it represents a longer time horizon.

Using these inputs in the CAPM equation ( Rj = Rf + ß*(Rm-Rf)) we

estimate our cost of equity at 10.22%. Moreover, we know from our regression

analysis that we can estimate the lower and upper bounds of ß at .4406 and

1.4644 respectively. These ß imply that we can estimate with a 95% level of

confidence that our cost of equity lies between 6.74% and 13.70%.

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After the somewhat low adjusted R2 we achieved using CAPM to estimate

ß, we decided we should try some other models to see if we could get more

reliable results. The first alternative model we tried was the Fama-French 3-

Factor model. This model proposes that in addition to market risk premium,

there has historically been a premium of small cap firms over large cap firms and

also of value (high book/market ratio) firms over growth (low book/market ratio)

firms. We discovered historical return data of six portfolios assembled by one of

the founders of the model, Kenneth French, on his website. These portfolios are

small growth, small value, small neutral, large growth, large value, and large

neutral. With the historical returns of these portfolios we calculated size

premiums and value premiums then ran regression analyses on this data. We

were disappointed to achieve a high-adjusted R2 of only 16.9% using this model,

so we had to dismiss the results. We also attempted estimating cost of equity

using the equation:

P/B = 1 + (ROE – Ke)/(Ke – g)

Every part of this equation is observable except for the cost of equity and

one must just plug in and solve for cost of equity. Unfortunately, we found a

cost of equity using this method that we felt was unreasonably high. It actually

exceeded the 95% upper bound found in the CAPM regression analysis. Despite

the low adjusted R2 we achieved using the CAPM model, we still believe that the

estimate we reached is the appropriate estimate for Baxter. Therefore the cost

of equity estimation we will use in the WACC is 10.22%.

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Weighted Average Cost of Capital

Baxter uses debt for only 19% of its asset financing while using equity for

the remaining 81%. Weighting this financing for these relevant proportions we

find a before tax WACC of 9.12% and an after-tax WACC of 8.97%.

MVD 8,378$ MVE 36,830 Total = MVA 45,208$

KD 0.0430KE 0.1022WD 0.1853WE 0.8147Tax Rate 0.193

WACD Before Taxes 0.80%

WACD After Taxes 0.64%

WACE 8.33%

WACC 8.97%

Therefore it is our conclusion that the appropriate discount rate for

valuation is 8.97%.

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Analysis of Valuations

Method of Comparables One popular method of valuation is the method of comparables, which

compares certain key price ratios with the competitors in the industry. Contrary

to an intrinsic valuation, this method does not seek to evaluate a present value

of the future benefits provided by a firm. The method, instead, follows the

conventional wisdom that a firm should be priced at the same multiples of

performance as that of its competitors, which are assumed to have similar risk

profiles. Proponents of this method consider a firm priced at a multiple of

performance higher than its competitors to be overpriced and one priced lower

to be undervalued. By finding the industry average of these price ratios, and

setting that equal to the firm’s ratios, one can solve for the price that investors

should pay in order for the firm to be priced similarly to its competitors.

While this method can be effective in analyzing firms in highly

commoditized industries, the method has certain flaws in other applications. For

instance, it is not always clear exactly which firms constitute the industry. This

could and often does result in comparing apples and oranges. Also, assuming

analysts were to choose very accurate firms to represent the industry, the

method assumes that all firms in the industry should be priced at the industry

average. This greatly undervalues firms with much greater performance

potential than the industry average, and it also greatly overvalues troubled firms

with lower performance potential than its competitors.

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Despite its flaws, the method of comparables is a valuable tool for two

reasons. First, it can be used as a quick screening tool to find potentially under

or overvalued firms worthy of deeper analysis. Second, considering the method’s

popularity, it can be helpful in scrutinizing the psychology of unsophisticated

investors and the investment environment of the industry. We will be

examining seven ratios commonly used in the method of comparables: trailling

price-to-earnings, forward price-to-earnings, price-to-book, dividend yield, price-

to-earnings-growth, dividend yield, price-to-EBITDA, and enterprise value-to-

EBITDA.

Trailing P/E Trailing P/E is calculated by dividing the price per share of a firm at the

end of a 12-month period by the earnings generated during that 12-month

period. Conceptually, the ratio represents how many dollars the market is willing

to pay per dollar of trailing 12-month earnings. Some investors use this ratio as

a valuation metric because they believe high ratios indicate expensive or

overvalued companies while low ratios indicate cheap or undervalued companies.

The flaw in this belief is that price per share is a forward-looking measure

while 12-month trailing earnings is a backward looking measure. For instance, it

is not necessarily true that a high trailing P/E ratio represents an overvalued

company and an opportunity to sell. If the company is expected to greatly

increase its profits in the future, its price will reflect these expectations, and the

trailing P/E ratio will be artificially high. Similarly, a company with a low trailing

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P/E ratio would not necessarily represent a buying opportunity if the company

were expected to post substantial losses in the future.

P/E Trailing Ratio

-60.00

-40.00

-20.00

0.00

20.00

40.00

60.00

80.00

100.00

Baxter 22.17 22.87 57.69 25.52 22.68 23.23

Baxter Rest. 22.77 24.71 90.58 29.13 23.16 21.60

Abbott 22.61 26.74 23.58 18.17 44.01 24.62

Boston 47.31 64.10 28.29 32.95 -7.14 -35.03

Wyeth 11.15 27.57 46.08 16.92 16.32 12.81

Stryker 38.47 37.38 41.72 27.95 28.92 30.18

Industry Avg. 29.88 38.95 34.92 24.00 29.75 22.53

2002 2003 2004 2005 2006 2007

An analysis of the trailing P/E data for the medical supplies and services

industry quickly reveals some interesting points. Boston Scientific posted

negative earnings in fiscal years 2006 and 2007 and is therefore omitted from

the chart and industry average for those years. The year 2004 appears to have

been unfavorable for the industry as a whole as 60% of the firms experienced

low earnings and therefore high trailing P/E ratios. Wyeth began and ended the

observation period with the lowest trailing P/E ratio in the industry with an

average of 17 after omission of the outlier year of 2004. Excluding the results of

volatile Boston Scientific whose trailing P/E ratio was the highest in the industry

in 2002, Stryker began and ended the observation period with the highest

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trailing P/E ratio in the industry with an average of 32.6. Baxter, though trading

at an average trailing P/E of 23.3, which is second-lowest in the industry,

appeared to respond most dramatically to the unfavorable climate of year 2004

trading at a high of 57.7. The effect of our restatements amplified the effect

causing trailing P/E to reach a high of 90.6. Overall, the medical supplies and

services industry exhibited wide variation in the beginning of the observation

period, but has begun to consolidate nearer to the industry average, which

appears to be trending right at 22.

2007 P/E Trailing RatioPPS EPS P/E Ind. Avg. Share Price

Baxter 58.05$ 2.50$ 23.23 22.53 56.32$ Baxter Rest. 58.05 2.69 21.60 22.53 60.56Abbott 56.15 2.28 24.62Boston 11.63 (0.33) (35.03)Wyeth 44.19 3.45 12.81Stryker 74.72 2.48 30.18

If we use trailing P/E in a 2007 valuation of Baxter, we set the industry

average trailing P/E equal to Baxter’s price to earnings ratio in the current year.

Since we want a valuation of the share price we set it as our variable. Solving

for the Price, we multiply the 2007 earnings by the industry average trailing P/E

and obtain a share price of 56.32. This is roughly 3% below the year’s actual

December, 31 2007 share price of 58.05, thus the company is fair valued using

this valuation method. Undergoing this same process using our restated

financial statements, we derived a valuation price of 60.56. This is 4.3% above

the share price, also within the 10% range to be considered fairly valued.

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Forward P/E Forward P/E is calculated by dividing the price per share of the current

year by the expected earnings per share for the next year. This ratio is a

representation of how much the market is willing to pay per share based off of

the expected earnings in the next year. Not unlike the trailing P/E ratio, many

investors look at this ratio when it is high and perceive that the company is

overvalued with an expensive share price. On the other hand, a low ratio is

often indicative of low share price and the company being undervalued.

Conceptually, the Forward P/E is better for valuation than Trailing P/E because

value is derived from future performance rather than historical performance.

However, it is still flawed in that it is only dealing with one period into the future.

P/E Forward Ratio

0.00

5.00

10.00

15.00

20.00

25.00

30.00

Baxter 20.43

Baxter Rest. 19.07

Abbott 17.44

Boston 22.80

Wyeth 12.96

Stryker 25.94

Industry Avg. 19.79

2007

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For 2007, Stryker had the highest forward P/E ratio in the industry at

25.9. Baxter’s ratio was 20.4, very close to the industry average of 19.8. Wyeth

had the lowest ratio by a considerable amount at 13.

2007 P/E Forward RatioPPS EPS P/E Ind. Avg. Share Price

Baxter 58.05$ 2.84$ 20.43 19.79 56.23$ Baxter Rest. 58.05 3.04 19.07 19.79 60.23Abbott 56.15 3.22 17.44Boston 11.63 0.51 22.80Wyeth 44.19 3.41 12.96Stryker 74.72 2.88 25.94

Forward P/E can be used for valuation purposes in the same way that

trailing P/E is. Applying the same valuation technique, a share price of 56.19 is

derived. This is 3.2% below the actual share price, thus it is fairly valued.

Using our restated financials produced a share price of 60.15, 3.6% above the

actual share price, also fairly valued.

Price-Book Ratio The Price to Book Ratio is price per share divided by book value per share,

which relates market value and book value of equity. A higher P/B ratio means

that investors expect the firm to create more value out of its equity. It is

important to note that the Price to Book Ratio does not measure the actual

ability of the firm to generate value. Rather, it is the investors’ expectation of the

firm’s ability to generate value.

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Price / Book Ratio

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Baxter 5.72 5.86 6.04 5.68 5.05 5.73

Baxter Rest. 5.01 5.29 5.70 5.54 4.99 5.57

Abbott 5.92 5.63 5.13 4.25 5.38 4.99

Boston 7.15 10.57 7.46 4.83 1.67 1.15

Wyeth 6.08 6.08 5.77 5.16 4.67 3.25

Stryker 8.87 7.87 7.07 5.53 5.37 5.71

Industry Avg. 7.01 7.54 6.36 4.94 4.27 3.77

2002 2003 2004 2005 2006 2007

It can be seen from the graph that for the most part, all of the industry

players have converged to similar P/B ratios from 2005 to 2007. However, an

outlier clearly exists with Boston Scientific. Due to its frequent and large equity

acquisitions, its P/B ratio has sunk rapidly throughout the period. Baxter’s

average P/B ratio from years 2002 to 2007 was 5.7. The average industry P/B

ratio over this same time period was 5.7 as well.

2007 P/B RatioPPS BPS P/B Ind. Avg. Share Price

Baxter 58.05$ 6,916.00$ 5.73 3.77 38.22$ Baxter Rest. 58.05 7,120.17 5.57 3.77 39.35Abbott 56.15 17,778.50 4.99Boston 11.63 15,097.00 1.15Wyeth 44.19 18,210.50 3.25Stryker 74.72 5,378.50 5.71

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To perform a Price to Book Valuation, we set the industry average P/B

ratio equal to Baxter’s P/B ratio. Since we are determining price, it is the

variable. After multiplying the industry average P/B ratio by Baxter’s book value

per share, we derived a 2007 share price of 38.22. This was roughly 34% less

than the actual share price in 2007. Thus, according to this ratio valuation the

company was over-valued at the time. When performing the same valuation

using our restated financials, results were almost identical.

Dividend Yield Dividend Yield is calculated by dividing dividend payout per share by price per

share. Some investors examine dividend yield when comparing companies in the

same industry with a similar risk premium.

Dividend Yield

0.000

0.005

0.010

0.015

0.020

0.025

0.030

Baxter 0.020 0.017 0.016 0.015 0.011 0.018

Baxter Rest. 0.020 0.017 0.016 0.015 0.011 0.018

Abbott 0.023 0.021 0.022 0.028 0.024 0.022

Wyeth 0.025 0.022 0.022 0.020 0.020 0.024

Stryker 0.002 0.001 0.001 0.002 0.002 0.003

Industry Avg. 0.016 0.015 0.015 0.017 0.015 0.016

2002 2003 2004 2005 2006 2007

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Boston Scientific is not included in the chart or the industry average

because the firm does not pay dividends. Baxter’s dividend yield and restated

dividend yield are the same in each year, thus there is only one series for Baxter.

The chart shows that over the past five years Abbott and Wyeth have paid the

highest dividends relative to their price per share. Stryker pays much less

dividends relative to price per share than the industry average. Their average

dividend yield between years 2002-2007 is .18%. In comparison, the industry

average across the same time span is 1.57%. Baxter’s average dividend yield is

1.62%.

2007 Dividend YieldPPS Dividends Div. Yield Ind. Avg. Share Price

Baxter 58.05$ 704.00$ 1.78% 1.64% 63.02$ Baxter Rest. 58.05 704.00 1.78% 1.64% 63.02Abbott 56.15 1,959.00 2.21%Boston 11.63 0.00 0.00%Wyeth 44.19 1,423.00 2.41%Stryker 74.72 90.00 0.29%

Dividend Yield can be used as a valuation for Baxter by taking the industry

average dividend yield and setting it equal to Baxter’s dividends in 2007 divided

by the share price. To get a valuation on share price, we set price as the

variable, thus dividing the dividends by the industry average dividend yield to

obtain the share price valuation. After doing this we got a valuated share price

of 63.02. This is within 10% of the actual 2007 share price, informing us that

based of this technique the company is fair valued.

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Price Earnings Growth Ratio

P.E.G. Ratio

-4.000

-3.000

-2.000

-1.000

0.000

1.000

2.000

3.000

4.000

Baxter 2.116

Baxter Rest. 2.012

Abbott 2.077

Boston -3.095

Wyeth 2.766

Stryker 1.687

Industry Avg. 2.177

2007

The Price Earnings Growth (P.E.G.) ratio is the Price to Earnings ratio

divided by the expected growth rate of earnings. The industry average P.E.G. is

multiplied by both the estimated earnings growth rate and the earnings per

share to derive the value of price per share. Boston is not included in the

industry average as they are an outlier at -3.1.

2007 P.E.G. RatioP/E Trailing 5 Yr. EG PEG Ind. Avg. Share Price

Baxter 23.23$ 10.98% 2.12 2.18 59.73$ Baxter Rest. 21.60 10.74% 2.01 2.18 62.81Abbott 24.62 11.85% 2.08Boston (35.03) 11.32% (3.09)Wyeth 12.81 4.63% 2.77Stryker 30.18 17.89% 1.69

Using an industry average P.E.G of 2.2%, we derived a share price of

59.84 before restatement. This share price is 3.1% higher than the actual share

135

price, thus signaling that Baxter is fairly valued. The 59.84 share price is 7.8%

higher than the restated price per share, also signaling that Baxter’s share price

is fairly valued.

Price to EBITDA

Price / EBITDA

-20.00

0.00

20.00

40.00

60.00

80.00

100.00

Baxter 10.56 11.52 19.72 11.40 13.46 14.48

Baxter Rest. 8.06 8.65 13.41 8.93 10.65 11.43

Abbott 12.83 14.70 13.37 9.99 18.31 13.24

Boston 23.43 34.18 16.39 15.98 -11.01 42.61

Wyeth 7.31 18.83 94.42 10.97 11.00 8.02

Stryker 18.27 18.79 20.06 14.71 15.90 17.37

Industry Avg. 15.46 21.63 36.06 12.91 15.07 12.87

2002 2003 2004 2005 2006 2007

EBITDA stands for earnings before interest, taxes, depreciation, and

amortization. Dividing price per share by this figure gives the P/EBITDA Ratio.

Price-to-EBITDA is similar to price-to-earnings in that it is a price multiple of

earnings, but dissimilar in that it removes those elements that are considered by

proponents of its use as non-operating activities. It should be noted, however,

that while proponents of this ratio may claim that depreciation and amortization

should not be considered as operating activities, most would argue the opposite.

Depreciation and amortization, though non-cash, are normal consequences of

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business operations and should be treated as such. Boston Scientific is not

included in the industry average due to being an outlier.

2007 P/EBITDAPPS EBITDA P/EBITDA Ind. Avg. Share Price

Baxter 58.05$ 2,738.00$ 14.48 12.87 56.03$ Baxter Rest. 58.05 3,467.35 11.43 12.87 70.95Abbott 56.15 6,706.60 13.24Boston 11.63 407.00 42.61Wyeth 44.19 7,375.70 8.02Stryker 74.72 1,768.00 17.37

Multiplying the industry average P/EBITDA ratio by Baxter’s 2007 EBITDA

gives us a share price of 56.04, which is 3.48% less than the actual 2007 share

price. This is within our range of 10% deviation to be considered fairly valued.

When compared to the post-restatement share price 70.95, it deviates 22.23

percent, indicating undervalued.

Enterprise Value to EBITDA

Enterprise Value / EBITDA

-50.00

-40.00

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

60.00

Baxter 4.08 4.98 9.54 7.07 8.83 10.49

Baxter Rest. 3.20 3.81 6.58 5.57 7.01 8.32

Abbott 9.17 10.89 9.48 6.27 10.53 8.09

Boston 18.88 28.78 12.49 10.93 2.83 -37.63

Wyeth 4.25 9.57 47.05 5.39 6.41 3.28

Stryker 15.77 17.06 18.32 12.93 14.42 16.09

Industry Avg. 12.02 16.57 21.84 8.88 8.55 9.15

2002 2003 2004 2005 2006 2007

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Enterprise Value is the value of productive assets. It is the market value

of equity minus the value of liabilities minus cash. Dividing this figure by

EBITDA, the EV/EBITDA ratio is obtained. A low ratio indicates that the firm

could possibly be undervalued. The investor can “expect higher enterprise

multiples in high growth industries and lower multiples in industries with slow

growth.” (Investopedia)

EV/EBITDA= MVE+BVL-Cash-GW*/EBITDA

*if goodwill represents at least 15% of total assets

2007 EV/EBITDA RatioEV EBITDA EV/EBITDA Ind. Avg. Share Price

Baxter 28,731.15$ 2,738.00$ 10.49 9.15 51.88$ Baxter Rest. 28,842.98 3,467.35 8.32 9.15 61.44Abbott 54,252.55 6,706.60 8.09Boston (15,314.67) 407.00 (37.63)Wyeth 24,156.48 7,375.70 3.28Stryker 28,443.92 1,768.00 16.09

We take the industry wide average of EV/EBITDA, 9, and plug it into the

equation solving for MVE. Boston Scientific is not included in the industry

average due to being an outlier. Next, we divide this figure by the number of

shares to obtain price per share. Comparing the derived figure of 51.88 with the

actual share price in 2007 of 58.05 we determine that there is a 10.64%

difference, thus signaling that the firm is slightly overvalued. In contrast, when

the 51.88 is compared to the restated price per share figure, it is actually 5.83%

higher, but within our 10% threshold and thus fairly valued.

138

Method of Comparables Conclusion

P/Earnings (tr.) 2007BAX FAIRBAX (Res.) FAIR

P/Earnings (for.) 2007BAX FAIRBAX (Res.) FAIR

P/Book 2007BAX OVERBAX (Res.) OVER

Div. Yield 2007BAX FAIRBAX (Res.) FAIR

P.E.G. Ratio 2007BAX FAIRBAX (Res.) FAIR

P/EBITDA 2 2007BAX FAIRBAX (Res.) UNDER

EV/EBITDA 2 2007BAX SL.OVERBAX (Res.) FAIR

Conclusion

As one can clearly see in the table above, Baxter is fairly priced by nearly every

ratio using the method of comparables. Therefore, it is our conclusion that the

method of comparables shows Baxter is FAIRLY PRICED.

Intrinsic Valuation Models In theory, a company’s stock price should be worth the present value of

the future benefits the firm will deliver to its shareholders. The most accurate

method of discovering mispriced firms, therefore, is to determine the amounts of

139

these future benefits and discount them back to the present. Intrinsic valuation

models seek to accomplish precisely that goal. It is for this reason that intrinsic

valuation models are far superior to the method of comparables, which has no

basis in theory.

Great difficulty exists, however, in turning the theory into practical

working valuation models. The complication lies in choosing exactly what

constitutes the future benefits that create shareholder value. Dividends, for

instance, are theoretically the most appropriate measure of shareholder return

because they are the clearest examples of cash return to the shareholder. In

reality, however, it is clear that there are firms not paying dividends that are still

valuable to shareholders. In response, other models have been developed to

resolve this issue.

A complete intrinsic valuation analysis should incorporate as many of

these models as possible to get the most accurate picture of a firm’s value. Each

model should also include sensitivity analyses, which show how sensitive the

valuation is to changes in input variables. This analysis includes the Discounted

Dividends, Discounted Free Cash Flows, Residual Income, Abnormal Earnings

Growth, and Long Run Residual Income Perpetuity models.

Discounted Dividends Model

The Discounted Dividends valuation model claims that the relevant future

benefits to discount back to the present to calculate share value are dividends.

140

Dividends are cash payments made directly to shareholders. If an investor were

to hold a stock forever in perpetuity with no intention to ever sell the shares, this

model would indeed most accurately portray share value. This model however is

somewhat unwieldy in reality for a couple of reasons. First, investors rarely

intend on holding a stock forever. Second, and not wholly unrelated to the first,

expected capital gains are priced into most share prices. The result is that this

model usually shows a firm’s shares being overvalued. Indeed, studies have

shown that this model has the least explanatory power of most intrinsic valuation

models. For the sake of completeness, this analysis will nonetheless include this

model.

0.01 0.02 0.03 0.0451 0.06 0.08 0.09 0.10.06470 21.11 24.12 28.86 45.19 164.170.07719 17.00 18.70 21.14 27.68 45.420.08968 14.19 15.24 16.65 19.98 26.59 67.440.10217 12.15 12.85 13.73 15.66 18.91 30.14 49.60 248.400.11378 10.71 11.20 11.80 13.04 14.96 20.17 26.08 40.540.12539 9.56 9.92 10.34 11.19 12.40 15.29 17.96 22.720.13700 8.63 8.89 9.20 9.80 10.61 12.38 13.83 16.06

=====

Sensitivity Analysis: Discounted Dividend ModelDividend Growth Rate

Ke

Value < 80% of observed share price

Legend80% < Value < 90% of observed share price90% < Value < 110% of observed share price110% < Value< 120% of observed share priceValue > 120% of observed share price

To begin, we computed the average growth rate in dividends over the last

ten years, which we found to be 4.51%. We then forecasted dividends out for

141

ten years using this growth rate, and discounted these dividends to the present

using the cost of equity as the discount rate. The terminal value in 2018 was

found using the same 4.51% growth rate. We found the perpetuity by dividing

this terminal value by the cost of equity less the terminal value perpetuity growth

rate. This perpetuity was then discounted back to the present using the cost of

equity once again as the discount rate. The sum of these values equals the

value on December 31, 2007. Computing the future value after three months,

we find the share value time-consistent with the observed share price on April 1.

Our next line of business was to conduct a sensitivity analysis to

determine the amount of variability share price experienced due to changes in

our two variables, cost of equity and dividend growth rate. The results of this

sensitivity analysis can be seen above. Our criteria for judging the share price to

be either over or undervalued required a greater than 20% deviation from share

price in either direction while the criteria to judge the share price only slightly

over or undervalued required a deviation of 10% to 20% from the share price.

Any value computed with a deviation of less than 10% in either direction from

the share price resulted in a judgment that the shares are fairly priced.

The observed share price of Baxter on April 1, 2007, was $58.01. Based

on the previously mentioned criteria, the prices required to make each

judgement are as follows:

142

0 - $46.41 Overvalued$46.41 - $52.21 Slightly Overvalued$52.21 - $63.81 Fairly Valued$63.81 - $69.61 Slightly Undervalued$69.61 - Undervalued

Judgement Criteria

After explaining that the area of the sensitivity analysis in black is the

impossible area where dividend growth would exceed cost of equity, it is very

clear that according to the discounted dividends model Baxter is plainly

overvalued. The only values that result in judgements of fairly or undervalued

are at highly improbable estimates of cost of equity and dividend growth in

perpetuity. It should also be noted that forecasted dividends are the same in the

restated financial statements, which result in the same conclusion. Therefore,

we will conclude that according to the discounted dividends model, Baxter is

OVERVALUED.

143

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20180 1 2 3 4 5 6 7 8 9 10 11

Dividends 704 553 578 604 631 660 690 721 753 787 823 860Shares 683 634 634 634 634 634 634 634 634 634 634 634Div/Share 0.72 0.87 0.91 0.95 1.00 1.04 1.09 1.14 1.19 1.24 1.30 1.36

PV Factor 0.880 0.774 0.680 0.598 0.526 0.463 0.407 0.358 0.315 0.277PV YBY Div. 0.767 0.705 0.648 0.596 0.547 0.503 0.463 0.425 0.391 0.359

Perpetuity 36.63Sum PV YBY Div. 5.40

PV Perpetuity 10.15

Share Price 12/31/07 15.55Share Price 4/1/08 16.06 0.01 0.02 0.03 0.0451 0.06 0.08 0.09 0.1Observed Share Price 58.01 0.06470 21.11 24.12 28.86 45.19 164.17

0.07719 17.00 18.70 21.14 27.68 45.42Ke 0.137 0.08968 14.19 15.24 16.65 19.98 26.59 67.44g 0.1 0.10217 12.15 12.85 13.73 15.66 18.91 30.14 49.60 248.40

0.11378 10.71 11.20 11.80 13.04 14.96 20.17 26.08 40.540.12539 9.56 9.92 10.34 11.19 12.40 15.29 17.96 22.720.13700 8.63 8.89 9.20 9.80 10.61 12.38 13.83 16.06

Discounted Dividends Valuation Model

Sensitivity Analysis: Discounted Dividend ModelDividend Growth Rate

Ke

Discounted Free Cash Flows Model

The Discounted Free Cash Flows valuation model claims that the relevant

future benefits to discount back to the present to calculate share value are free

cash flows to assets. Conceptually, the market value of equity is equal to the

market value of assets less the market value of liabilities. The market value of a

firm’s assets can be defined as the present value of all cash inflows those assets

will provide less the present value of the cash outflows to purchase them. In

other words this can be defined as the sum of the present values of all future

cash flows from operations plus the sum of the present values of all future cash

flows from investing. Subtracting book, which is also market, value of liabilities

from these cash flows should provide us a theoretical approximation of the

144

market value of equity. Then dividing by the number of shares should

approximate the value shares should trade for.

Though this model has a much higher explanatory power than the

discounted dividends model, it, itself, is not without its flaws. Due to the fact

that free cash flows have no upward limit, the model is extremely sensitive to

terminal value growth rates. The result is that this model yields some rather

optimistic results with higher free cash flow growth rates. As we will see,

however, it does offer a picture of Baxter’s valuation much different from that

demonstrated by the discounted dividends model.

0 0.01 0.02 0.03 0.035 0.04 0.045 0.050.05373 92.99 109.77 136.49 185.74 230.09 306.73 471.16 1076.430.06622 70.60 80.04 93.57 114.56 130.09 151.56 183.14 234.180.07871 55.48 61.28 69.06 80.02 87.39 96.66 108.68 124.890.09120 44.62 48.41 53.26 59.69 63.77 68.64 74.57 81.930.10281 36.98 39.63 42.92 47.12 49.68 52.65 56.13 60.270.11442 30.96 32.87 35.19 38.05 39.76 41.69 43.90 46.450.12603 26.11 27.52 29.20 31.22 32.40 33.72 35.20 36.88

=====

Sensitivity Analysis: DFCF ModelFree Cash Flow Growth Rate

WACCBT

Legend

Value < 80% of observed share price80% < Value < 90% of observed share price90% < Value < 110% of observed share price110% < Value< 120% of observed share priceValue > 120% of observed share price

As one can see from the sensitivity analysis above, the discounted free

cash flows model seems to demonstrate a picture of Baxter as a more fairly

priced company. As intuition would suggest lower costs of capital and higher

free cash flow growth rates result in higher estimates of value while higher costs

of capital and lower free cash flow growth rates result in lower estimates of

145

value. The sensitivity of the model to terminal value growth rates is clearly

demonstrated as well with a quite unbelievable share price value of $1076.43 at

the lowest cost of equity and highest free cash flow growth rate. The model

however does seem to suggest that Baxter is fairly priced with values within 10%

of Baxter’s observed share price seen at the more probable estimates of WACC

and free cash flow growth rate. The discounted free cash flow model after our

restatement showed the following sensitivity analysis:

0 0.01 0.02 0.03 0.035 0.04 0.045 0.050.05373 127.89 150.22 185.79 251.35 310.38 412.40 631.28 1436.980.06622 98.10 110.66 128.66 156.61 177.29 205.86 247.90 315.850.07871 77.98 85.70 96.05 110.66 120.46 132.80 148.80 170.370.09120 63.55 68.59 75.04 83.61 89.03 95.52 103.41 113.210.10281 53.39 56.92 61.30 66.88 70.29 74.24 78.88 84.390.11442 45.39 47.93 51.02 54.83 57.10 59.67 62.61 66.010.12603 38.94 40.82 43.05 45.75 47.32 49.08 51.05 53.28

=====

Sensitivity Analysis: Restated DFCF ModelFree Cash Flow Growth Rate

WACCBT

Legend

Value < 80% of observed share price80% < Value < 90% of observed share price90% < Value < 110% of observed share price110% < Value< 120% of observed share priceValue > 120% of observed share price

The same general tendencies exist in this graph as with the pre-restated

data. Higher values appear in the upper right with lower values appearing in the

lower left. A line of fair values run through the center, but it appears that our

restatements have positively affected the value of Baxter according to the

discounted free cash flow model.

In conclusion, though our computation of the free cash flow model has

found a wide range of values from over $1000 to as low as $26, it appears that

146

the more probable estimates of WACC and free cash flow growth rate, Baxter is

FAIRLY VALUED.

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20180 1 2 3 4 5 6 7 8 9 10 11

CF from Operations 2305 2418 2596 2787 2993 3213 3449 3703 3976 4268 4583CF from Investing -305 -601 -543 -601 -459 -492 -529 -568 -609 -654 -702Free Cash Flow 2000 1817 2053 2186 2534 2720 2921 3136 3366 3614 3880 4166

PV Factor 1 1 1 1 1 0 0 0 0 0PV YBY FCFs 1614 1619 1531 1576 1503 1433 1366 1302 1242 1184

Perpetuity 54790

Sum PV YBY FCFs 14370

PV Perpetuity 16719Book Value of Liab. 8378 0 0.01 0.02 0.03 0.035 0.04 0.045 0.05Market Value of Equity 22711 0.05373 92.99 109.77 136.49 185.74 230.09 306.73 471.16 1076.43Shares 634.42 0.06622 70.60 80.04 93.57 114.56 130.09 151.56 183.14 234.18Share Price 12/31/07 35.80 0.07871 55.48 61.28 69.06 80.02 87.39 96.66 108.68 124.89Share Price 4/1/08 36.88 0.09120 44.62 48.41 53.26 59.69 63.77 68.64 74.57 81.93Observed Share Price 58.01 0.10281 36.98 39.63 42.92 47.12 49.68 52.65 56.13 60.27

0.11442 30.96 32.87 35.19 38.05 39.76 41.69 43.90 46.45WACCBT 0.12603 0.12603 26.11 27.52 29.20 31.22 32.40 33.72 35.20 36.88

g 0.05

Discounted Free Cash Flow Valuation Model

Sensitivity Analysis: DFCF ModelFree Cash Flow Growth Rate

WACCBT

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20180 1 2 3 4 5 6 7 8 9 10 11

CF from Operations 3034 3265 3505 3763 4040 4337 4657 4999 5367 5762 6186CF from Investing -1065 -1062 -794 -832 -667 -716 -769 -825 -886 -951 -1021Free Cash Flow 1969 2203 2711 2931 3373 3621 3888 4174 4481 4811 5165 5545

PV Factor 1 1 1 1 1 0 0 0 0 0PV YBY FCFs 1956 2138 2053 2098 2000 1907 1818 1734 1653 1576

Perpetuity 72934

Sum PV YBY FCFs 18934

PV Perpetuity 22255Book Value of Liab. 8378 0 0.01 0.02 0.03 0.035 0.04 0.045 0.05Market Value of Equity 32811 0.05373 127.89 150.22 185.79 251.35 310.38 412.40 631.28 1436.98Shares 634.42 0.06622 98.10 110.66 128.66 156.61 177.29 205.86 247.90 315.85Share Price 12/31/07 51.72 0.07871 77.98 85.70 96.05 110.66 120.46 132.80 148.80 170.37Share Price 4/1/08 53.28 0.09120 63.55 68.59 75.04 83.61 89.03 95.52 103.41 113.21Observed Share Price 58.01 0.10281 53.39 56.92 61.30 66.88 70.29 74.24 78.88 84.39

0.11442 45.39 47.93 51.02 54.83 57.10 59.67 62.61 66.01WACCBT 0.1260 0.12603 38.94 40.82 43.05 45.75 47.32 49.08 51.05 53.28

g 0.05

Restated Discounted Free Cash Flow Valuation Model

Sensitivity Analysis: Restated DFCF ModelFree Cash Flow Growth Rate

WACCBT

147

Residual Income Model

The Residual Income valuation model claims that shareholder value

is derived from the earnings performance of the firm relative to the return

required by its shareholders on their investment. The model approximates this

value by finding the sum of all present values of actual earnings performance in

relation to a benchmark earnings performance (BVE*Ke) and adds this to the

current book value of equity to approximate current market value of equity.

Then dividing by the number of shares should approximate the value shares

should trade for.

This model comes closer to an ideal valuation model in that it, like the

discounted free cash flows model, has a much higher explanatory power than

the discounted dividends model, but unlike the DFCF model, is not near as

sensitive to changes in terminal value growth rates. The reason this model is not

so sensitive to growth rate changes is that firms must perform at their cost of

capital in the long run, and residual income, therefore, must always return to

zero. The result is that this model yields reliable results for a wide range of

variable inputs.

148

-0.1 -0.2 -0.3 -0.4 -0.50.06470 46.13 41.33 39.16 37.93 37.130.07719 39.14 35.92 34.41 33.53 32.960.08968 33.46 31.36 30.34 29.73 29.330.10217 28.82 27.51 26.85 26.45 26.180.11378 25.24 24.44 24.03 23.78 23.610.12539 22.22 21.80 21.58 21.44 21.350.13700 19.67 19.52 19.43 19.38 19.35

=====

Ke

Sensitivity Analysis: Residual Income ModelResidual Income Growth Rate

Value > 120% of observed share price

Legend

Value < 80% of observed share price80% < Value < 90% of observed share price90% < Value < 110% of observed share price110% < Value < 120% of observed share price

It is very clear from the sensitivity analysis above that for all costs of

equity in our 95% confidence interval and all residual income growth rates, the

residual income valuation model has found Baxter to be at least 20% overvalued.

The results were not dissimilar with the restated data:

-0.1 -0.2 -0.3 -0.4 -0.50.06470 48.40 43.39 41.12 39.83 39.000.07719 40.97 37.63 36.06 35.15 34.550.08968 34.95 32.78 31.73 31.10 30.690.10217 30.02 28.68 28.01 27.60 27.330.11378 26.22 25.43 25.02 24.77 24.600.12539 23.02 22.62 22.41 22.28 22.190.13700 20.31 20.20 20.13 20.09 20.07

===== Value > 120% of observed share price

Sensitivity Analysis: Restated Residual Income ModelResidual Income Growth Rate

Ke

Legend

Value < 80% of observed share price80% < Value < 90% of observed share price90% < Value < 110% of observed share price110% < Value < 120% of observed share price

149

As one can see, running the restated data through the model only

changed the results by demonstrating that the value derived at the most

optimistic inputs of cost of equity and residual income growth changed from

overvalued to slightly overvalued. It is an easy conclusion, therefore, that

according to the residual income valuation model Baxter is

OVERVALUED.

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20180 1 2 3 4 5 6 7 8 9 10 11

Book Value of Equity 6916 8304 9927 11812 13852 16060 18450 21036 23832 26855 30124 33658Net Income 1707 1941 2201 2489 2672 2868 3080 3306 3550 3811 4091 4394%² Net Income 13.7% 13.4% 13.1% 7.4% 7.4% 7.4% 7.4% 7.4% 7.4% 7.4% 7.4%Dividends 704 553 578 604 631 660 690 721 753 787 823 860Normal Income 947 1138 1360 1618 1898 2200 2528 2882 3265 3679 4127Residual Income 994 1064 1129 1054 971 879 779 668 546 412 267

PV Factor 0.880 0.774 0.680 0.598 0.526 0.463 0.407 0.358 0.315 0.277PV YBY RI. 874 823 768 630 511 407 317 239 172 114

Perpetuity 419

Sum PV YBY RI. 4855

PV Perpetuity 116Book Value of Equity 6916 -0.1 -0.2 -0.3 -0.4 -0.5Market Value of Equity 11887 0.06470 46.13 41.33 39.16 37.93 37.13Shares 634.42 0.07719 39.14 35.92 34.41 33.53 32.96Share Price 12/31/07 18.74 0.08968 33.46 31.36 30.34 29.73 29.33Share Price 4/1/08 19.35 0.10217 28.82 27.51 26.85 26.45 26.18Observed Share Price 58.01 0.11378 25.24 24.44 24.03 23.78 23.61

0.12539 22.22 21.80 21.58 21.44 21.35Ke 0.137 0.13700 19.67 19.52 19.43 19.38 19.35

g -0.5

Residual Income Valuation Model

Sensitivity Analysis: Residual Income ModelResidual Income Growth Rate

Ke

150

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20180 1 2 3 4 5 6 7 8 9 10 11

Book Value of Equity 7120 8646 10418 12461 14672 17064 19651 22447 25470 28738 32268 36065Net Income 1836 2079 2349 2648 2843 3052 3276 3518 3776 4054 4353 4657Dividends 704 553 578 604 631 660 690 721 753 787 823 860Normal Income 975 1185 1427 1707 2010 2338 2692 3075 3489 3937 4421Residual Income 1104 1165 1220 1135 1042 939 825 701 565 416 237

PV Factor 1 1 1 1 1 0 0 0 0 0PV YBY RI. 971 901 830 679 548 434 336 251 178 115

Perpetuity 372

Sum PV YBY RI. 5244

PV Perpetuity 103Book Value of Equity 7120 -0.1 -0.2 -0.3 -0.4 -0.5Market Value of Equity 12468 0.06470 48.40 43.39 41.12 39.83 39.00Shares 634.42 0.07719 40.97 37.63 36.06 35.15 34.55Share Price 12/31/07 19.65 0.08968 34.95 32.78 31.73 31.10 30.69Share Price 4/1/08 20.29 0.10217 30.02 28.68 28.01 27.60 27.33Observed Share Price 58.01 0.11378 26.22 25.43 25.02 24.77 24.60

0.12539 23.02 22.62 22.41 22.28 22.19Ke 0.137 0.13700 20.31 20.20 20.13 20.09 20.07

g -0.5

Restated Residual Income Valuation Model

sitivity Analysis: Restated Residual Income MResidual Income Growth Rate

Ke

Abnormal Earnings Growth Model

While the residual income model looks at how the present value of a

firm’s future earnings performance relative to a benchmark earnings

performance either increases or decreases the current book value of equity to

approximate the current market value of equity, the abnormal earnings growth

seeks to achieve a similar conceptual result but approaches from a somewhat

more oblique angle. This model treats the sum of the present values of a firm’s

future earnings performance relative to benchmark earnings performance as

adjustments to a base year’s core earnings, and assumes this adjusted core

earnings will be earned in perpetuity.

151

Perhaps the most intriguing aspect of this model is the fact that it works

equally well for both companies who pay dividends and those who do not. The

explanation for this is that it treats all earnings as “dividend income” regardless

whether or not it was paid out as dividends. This makes a great deal of sense

with a little bit of thought. After all, at any point in time 100% of net income

could be given as a dividend or could be entirely reinvested in the corporation.

Another interesting quirk of the model is that these adjustments to core earnings

which are annual measures of abnormal earnings growth are equal to the

change from year to year in residual income as computed in the residual income

model.

-0.1 -0.2 -0.3 -0.4 -0.50.06470 70.74 68.02 66.79 66.09 65.640.07719 52.21 51.23 50.76 50.50 50.320.08968 40.09 39.97 39.91 39.88 39.850.10217 31.68 32.02 32.19 32.29 32.350.11378 26.13 26.65 26.91 27.08 27.190.12539 21.96 22.56 22.87 23.06 23.200.13700 18.78 19.38 19.71 19.92 20.06

===== Value > 120% of observed share price

Sensitivity Analysis: Abnormal Earnings Growth ModelAEG Growth Rate

Ke

Legend

Value < 80% of observed share price80% < Value < 90% of observed share price90% < Value < 110% of observed share price110% < Value < 120% of observed share price

As one can readily see from the sensitivity analysis above, the abnormal earnings

growth results rely greatly upon cost of equity estimation which is used to

calculate benchmark performance. Obviously, lower costs of equity are easier to

152

outperform, and so it should come as no surprise that more optimistic share

price estimates occur in the top row of this sensitivity analysis.

-0.1 -0.2 -0.3 -0.4 -0.50.06470 74.59 71.80 70.54 69.03 69.360.07719 54.95 53.98 53.53 53.27 53.100.08968 42.13 42.06 42.03 42.01 42.000.10217 33.24 33.64 33.84 33.97 34.050.11378 27.36 27.95 28.26 28.45 28.570.12539 22.96 23.63 23.98 24.20 24.350.13700 19.61 20.28 20.65 20.88 21.03

===== Value > 120% of observed share price

Sensitivity Analysis: (Res.) AEG ModelAEG Growth Rate

Ke

Legend

Value < 80% of observed share price80% < Value < 90% of observed share price90% < Value < 110% of observed share price110% < Value < 120% of observed share price

The model computed using the restated data offers no significant difference in

our impression of the valuation of Baxter. The more optimistic values are

achieved at more optimistic and more improbable estimates of cost of equity.

In conclusion, though it is possible according to the AEG model using both

pre-restatement and restated data that Baxter’s shares are undervalued, these

values occur at highly improbably low estimates of the cost of equity. It is our

very confident opinion that according to the abnormal earnings growth model,

shares of Baxter are OVERVALUED.

153

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20180 1 2 3 4 5 6 7 8 9 10 11

Net Income 1707 1941 2201 2489 2672 2868 3080 3306 3550 3811 4091 4394Dividends 704 553 578 604 631 660 690 721 753 787 823DRIP Income 76 79 83 87 90 94 99 103 108Cumulative Div. Income 2277 2568 2755 2955 3170 3401 3648 3914 4199Benchmark Income 2207 2503 2830 3038 3261 3501 3759 4036 4333AEG YBY 70 65 -75 -83 -91 -101 -111 -122 -134 -147PV Factor 0.774 0.680 0.598 0.526 0.463 0.407 0.358 0.315 0.277PV AEG YBY 53.79 44.28 -44.88 -43.62 -42.32 -41.01 -39.69 -38.36 -37.04Growth Rate in YBY AEG -6.40% -215% 10.51% 10.34% 10.18% 10.03% 9.90% 9.77%Average Growth Rate 10.12%Residual Income 994 1064 1129 1054 971 879 779 668 546 412²Residual Inc. YBY 70 65 -75 -83 -91 -101 -111 -122 -134Core Earnings 1941.46Sum PV YBY AEG. -188.85AEG Terminal Value Perp. -64.03 -231.20Total Adj. Perp. Earn. 1688.58Perpetuity Cap. Rate 0.13700Market Value of Equity 12325Shares 634.42 -0.1 -0.2 -0.3 -0.4 -0.5Share Price 12/31/07 19.43 0.06470 70.74 68.02 66.79 66.09 65.64Share Price 4/1/08 20.06 0.07719 52.21 51.23 50.76 50.50 50.32Observed Share Price 58.01 0.08968 40.09 39.97 39.91 39.88 39.85

0.10217 31.68 32.02 32.19 32.29 32.35Ke 0.137 0.11378 26.13 26.65 26.91 27.08 27.19g -0.5 0.12539 21.96 22.56 22.87 23.06 23.20

0.13700 18.78 19.38 19.71 19.92 20.06

Abnormal Earnings Growth Valuation Model

nsitivity Analysis: Abnormal Earnings Growth ModAEG Growth Rate

Ke

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20180 1 2 3 4 5 6 7 8 9 10 11

Net Income 1836 2079 2349 2648 2843 3052 3276 3518 3776 4054 4353 4657Dividends 704 553 578 604 631 660 690 721 753 787 823DRIP Income 76 79 83 87 90 94 99 103 108Cumulative Div. Income 2425 2727 2925 3138 3367 3612 3875 4158 4461Benchmark Income 2364 2671 3010 3232 3470 3725 3999 4294 4610AEG YBY 61 56 -85 -94 -103 -113 -124 -136 -149 -164PV Factor 0.774 0.680 0.598 0.526 0.463 0.407 0.358 0.315 0.277PV AEG YBY 47.02 37.89 -50.91 -49.31 -47.70 -46.09 -44.49 -42.89 -41.32Growth Rate in YBY AEG -8.38% -253% 10.13% 9.99% 9.86% 9.74% 9.63% 9.52%Average Growth Rate 9.81%Residual Income 1104 1165 1220 1135 1042 939 825 701 565 416²Residual Inc. YBY 60.79 55.70 -85.08 -93.71 -103.07 -113.23 -124.26 -136.22 -149.18Core Earnings 2079Sum PV YBY AEG. -237.80AEG Terminal Value Perp. -71.22 -257.18Total Adj. Perp. Earn. 1770.45Perpetuity Cap. Rate 0.13700Market Value of Equity 12923Shares 634.42 -0.1 -0.2 -0.3 -0.4 -0.5Share Price 12/31/07 20.37 0.06470 74.59 71.80 70.54 69.03 69.36Share Price 4/1/08 21.03 0.07719 54.95 53.98 53.53 53.27 53.10Observed Share Price 58.01 0.08968 42.13 42.06 42.03 42.01 42.00

0.10217 33.24 33.64 33.84 33.97 34.05Ke 0.137 0.11378 27.36 27.95 28.26 28.45 28.57g -0.5 0.12539 22.96 23.63 23.98 24.20 24.35

0.13700 19.61 20.28 20.65 20.88 21.03

Restated Abnormal Earnings Growth Valuation Model

Sensitivity Analysis: (Res.) AEG ModelAEG Growth Rate

Ke

154

Long Run Residual Income Perpetuity

The long run residual income perpetuity valuation model simplifies the

residual income method by assuming that the present value of the perpetuity of

the long run percentage outperformance of the cost of equity represents an

appropriate percentage that market value of equity exceeds the current book

value of equity. To calculate this perpetuity, one must compute a reasonable

long-run estimate of return on equity. Subtracting the cost of equity determines

the long-run rate we can expect the firm to outperform the shareholders’

required rate of return. Dividing this measure of outperformance of cost by the

cost of equity less the growth rate of earnings, we calculate the present day

effect of that outperformance forever into the future. We then multiply this

present value percentage of outperformance by the book value of equity to

discover how much in excess of book value the equity is worth. Finally, we add

the current book value to approximate the current market value and divide by

the number of shares to determine what shares should be trading for.

155

0.01 0.02 0.03 0.035 0.04 0.045 0.05

0.06470 48.89 57.35 70.69 80.72 94.82 116.08 151.79

0.07719 39.92 44.96 52.13 56.99 63.16 71.24 82.30

0.08968 33.76 37.00 41.34 44.10 47.42 51.48 56.56

0.10217 29.27 31.47 34.28 36.00 38.00 40.35 43.14

0.11378 26.06 27.65 29.61 30.78 32.10 33.62 35.38

0.12539 23.50 24.66 26.07 26.89 27.81 28.84 30.01

0.13700 21.41 22.27 23.30 23.89 24.54 25.27 26.07

9.06% 14.42% 19.78% 25.15% 30.51% 35.87% 41.23%

0.05000 8.69 20.17 31.64 43.14 58.01 66.09 77.57

0.04500 8.91 19.38 29.85 40.35 50.82 61.29 71.76

0.04000 9.09 18.72 28.35 38.00 47.63 57.26 66.89

0.03500 9.25 18.16 27.07 36.00 44.91 53.83 62.74

0.03000 9.38 17.67 25.97 34.28 42.58 50.87 59.17

0.02000 9.60 16.88 24.17 31.47 38.75 46.04 53.33

0.01000 9.77 16.26 22.76 29.27 35.76 42.26 48.75

9.06% 14.42% 19.78% 25.15% 30.51% 35.87% 41.23%

0.06470 20.73 40.71 60.70 80.72 100.71 120.69 140.67

0.07719 14.64 28.75 42.85 56.99 71.10 85.21 99.32

0.08968 11.33 22.24 33.16 44.10 55.02 65.94 76.85

0.10217 9.25 18.16 27.07 36.00 44.91 53.83 58.01

0.11378 7.90 15.52 23.14 30.78 38.40 46.02 53.64

0.12539 6.91 13.56 20.22 26.89 33.55 40.21 46.87

0.13700 6.14 12.05 17.97 23.89 29.81 35.72 41.64

=====

Sensitivity Analysis: Constant ROE; Variable Ke and g

g

110% < Value < 120% of observed share price

Value > 120% of observed share price

ROE = 25.15%

Earnings Growth Rate

Ke

Sensitivity Analysis: Constant g; Variable Ke and ROE

Value < 80% of observed share price

80% < Value < 90% of observed share price

90% < Value < 110% of observed share price

Ke

Sensitivity Analysis: Constant Ke; Variable g and ROEKe =

10.127%Return on Equity

g = 3.5%Return on Equity

Our estimate of long run ROE was calculated by taking the average ROE of the

last five years, which is 25.15%. We then calculated a 95% confidence interval

between 9.06% and 41.23% for use in the sensitivity analysis. As the above

sensitivity analysis shows, the long run residual income model has returned

results similar to the ones we have seen in previous intrinsic valuation models.

While there is some possibility of Baxter shares being undervalued, the

156

probability is low. We also understand that there is a very good probability that

the ROE in perpetuity is much lower than even the average ROE over the last

five years. The main reason this is probably true is that it is unlikely that a firm

will outperform its cost of equity in perpetuity. This however would only shift the

favorable values even further up and to the right causing undervalued shares to

be even less probable. This, therefore, only reinforces the idea that Baxter’s

shares seem overpriced according to the long run residual income perpetuity

model. The restated results appear even less favorable:

157

0.01 0.02 0.03 0.035 0.04 0.045 0.05

0.06470 44.27 51.62 63.21 71.93 84.19 102.66 133.70

0.07719 36.14 40.46 46.62 50.79 56.08 63.01 72.50

0.08968 30.57 33.31 36.97 39.30 42.10 45.53 49.82

0.10217 26.50 28.33 30.66 32.08 33.74 35.68 38.00

0.11378 23.60 24.88 26.48 27.43 28.50 29.74 31.16

0.12539 21.28 22.20 23.32 23.97 24.69 25.51 26.43

0.13700 19.38 20.05 20.84 21.29 21.79 22.35 22.97

3.03% 9.43% 15.83% 22.24% 28.64% 35.04% 41.45%

0.06470 -1.80 22.76 47.33 71.93 96.50 121.07 145.67

0.07719 -1.27 16.07 33.41 50.79 68.13 85.47 102.85

0.08968 -0.99 12.44 25.86 39.30 52.72 66.14 79.58

0.10217 -0.80 10.15 21.11 32.08 43.04 54.00 64.97

0.11378 -0.69 8.68 18.05 27.43 36.79 46.16 55.54

0.12539 -0.60 7.58 15.77 23.97 32.15 40.33 48.53

0.13700 -0.53 6.74 14.01 21.29 28.56 35.84 43.12

3.03% 9.43% 15.83% 22.24% 28.64% 35.04% 41.45%

0.05000 -4.34 9.76 23.87 38.00 52.11 66.21 80.34

0.04500 -2.96 9.92 22.79 35.68 48.56 61.43 74.32

0.04000 -1.79 10.04 21.88 33.74 45.58 57.41 69.27

0.03500 -0.80 10.15 21.11 32.08 43.04 54.00 64.97

0.03000 0.05 10.25 20.44 30.66 40.85 51.05 61.27

0.02000 1.44 10.40 19.35 28.33 37.28 46.24 55.21

0.01000 2.53 10.52 18.50 26.50 34.48 42.47 50.47

======

g

Sensitivity Analysis: Constant g; Variable Ke and ROE

g = 3.5%Return on Equity

Ke

110% < Value < 120% of observed share price

Negative Share Price Does not exist

Sensitivity Analysis: Constant Ke; Variable g and ROEKe =

10.217%Return on Equity

Value < 80% of observed share price

80% < Value < 90% of observed share price

90% < Value < 110% of observed share price

Value > 120% of observed share price

Sensitivity Analysis: Constant ROE; Variable Ke and g

ROE = 22.24%

Earnings Growth Rate

Ke

It is our confident conclusion, therefore, that according to the long run

residual income model shares of Baxter are OVERVALUED.

158

2002 2003 2004 2005 2006 2007-5 -4 -3 -2 -1 0

Book Value of Equity 3013 3382 3705 4299 6272 6916Net Income 866 388 956 1397 1707Return on Equity 28.7% 11.5% 25.8% 32.5% 27.2%

Average ROE 25.15%Absolute Deviation 3.6% -13.7% 0.7% 7.3% 2.1%Variances 0.0013 0.0187 0.0000 0.0054 0.0004

Sum of Variances 0.02586

/(n-1) 0.0065Standard Deviation 8.04% 0.01 0.02 0.03 0.035 0.04 0.045 0.05

95% Conf. Upper ROE 41.23% 0.06470 48.89 57.35 70.69 80.72 94.82 116.08 151.7995% Conf. Lower ROE 9.06% 0.07719 39.92 44.96 52.13 56.99 63.16 71.24 82.30

0.08968 33.76 37.00 41.34 44.10 47.42 51.48 56.56Book Value of Equity 6916 0.10217 29.27 31.47 34.28 36.00 38.00 40.35 43.14Market Value of Equity 48029 0.11378 26.06 27.65 29.61 30.78 32.10 33.62 35.38Shares 634.42 0.12539 23.50 24.66 26.07 26.89 27.81 28.84 30.01Share Price 12/31/07 75.71 0.13700 21.41 22.27 23.30 23.89 24.54 25.27 26.07Share Price 4/1/08 77.57

Observed Share Price 58.01

ROE 0.4123 9.06% 14.42% 19.78% 25.15% 30.51% 35.87% 41.23%Ke 0.10217 0.06470 20.73 40.71 60.70 80.72 100.71 120.69 140.67g 0.05 0.07719 14.64 28.75 42.85 56.99 71.10 85.21 99.32

0.08968 11.33 22.24 33.16 44.10 55.02 65.94 76.850.10217 9.25 18.16 27.07 36.00 44.91 53.83 58.010.11378 7.90 15.52 23.14 30.78 38.40 46.02 53.640.12539 6.91 13.56 20.22 26.89 33.55 40.21 46.870.13700 6.14 12.05 17.97 23.89 29.81 35.72 41.64

9.06% 14.42% 19.78% 25.15% 30.51% 35.87% 41.23%0.05000 8.69 20.17 31.64 43.14 58.01 66.09 77.570.04500 8.91 19.38 29.85 40.35 50.82 61.29 71.760.04000 9.09 18.72 28.35 38.00 47.63 57.26 66.890.03500 9.25 18.16 27.07 36.00 44.91 53.83 62.740.03000 9.38 17.67 25.97 34.28 42.58 50.87 59.170.02000 9.60 16.88 24.17 31.47 38.75 46.04 53.330.01000 9.77 16.26 22.76 29.27 35.76 42.26 48.75

Ke

Sensitivity Analysis: Constant g; Variable Ke and ROE

Long Run Residual Income Perpetuity Valuation Model

Sensitivity Analysis: Constant ROE; Variable K e and g

ROE = 25.15% Earnings Growth Rate

Ke = 10.127% Return on Equity

g

g = 3.5% Return on Equity

Ke

Sensitivity Analysis: Constant Ke; Variable g and ROE

159

2002 2003 2004 2005 2006 2007-5 -4 -3 -2 -1 0

Book Value of Equity 3441 3746 3928 4404 6348 7120Net Income 757.59 802 247 838 1368 1836Return on Equity 23.3% 6.6% 21.3% 31.1% 28.9%

Average ROE 22.24%Absolute Deviation 1.1% -15.6% -0.9% 8.8% 6.7%Variances 0.0001 0.0245 0.0001 0.0078 0.0045

Sum of Variances 0.037

/(n-1) 0.009Standard Deviation 9.61% 0.01 0.02 0.03 0.035 0.04 0.045 0.05

95% Conf. Upper ROE 41.45% 0.06470 44.27 51.62 63.21 71.93 84.19 102.66 133.7095% Conf. Lower ROE 3.03% 0.07719 36.14 40.46 46.62 50.79 56.08 63.01 72.50

0.08968 30.57 33.31 36.97 39.30 42.10 45.53 49.82Book Value of Equity 7120 0.10217 26.50 28.33 30.66 32.08 33.74 35.68 38.00Market Value of Equity 49747 0.11378 23.60 24.88 26.48 27.43 28.50 29.74 31.16Shares 634.42 0.12539 21.28 22.20 23.32 23.97 24.69 25.51 26.43Share Price 12/31/07 78.41 0.13700 19.38 20.05 20.84 21.29 21.79 22.35 22.97Share Price 4/1/08 80.34

Observed Share Price 58.01

ROE 0.4145 3.03% 9.43% 15.83% 22.24% 28.64% 35.04% 41.45%Ke 0.10217 0.06470 -1.80 22.76 47.33 71.93 96.50 121.07 145.67g 0.05 0.07719 -1.27 16.07 33.41 50.79 68.13 85.47 102.85

0.08968 -0.99 12.44 25.86 39.30 52.72 66.14 79.580.10217 -0.80 10.15 21.11 32.08 43.04 54.00 64.970.11378 -0.69 8.68 18.05 27.43 36.79 46.16 55.540.12539 -0.60 7.58 15.77 23.97 32.15 40.33 48.530.13700 -0.53 6.74 14.01 21.29 28.56 35.84 43.12

3.03% 9.43% 15.83% 22.24% 28.64% 35.04% 41.45%0.05000 -4.34 9.76 23.87 38.00 52.11 66.21 80.340.04500 -2.96 9.92 22.79 35.68 48.56 61.43 74.320.04000 -1.79 10.04 21.88 33.74 45.58 57.41 69.270.03500 -0.80 10.15 21.11 32.08 43.04 54.00 64.970.03000 0.05 10.25 20.44 30.66 40.85 51.05 61.270.02000 1.44 10.40 19.35 28.33 37.28 46.24 55.210.01000 2.53 10.52 18.50 26.50 34.48 42.47 50.47

Return on Equity

Ke

Sensitivity Analysis: Constant Ke; Variable g and ROE

Ke = 10.217% Return on Equity

g

Restated Long Run Residual Income Perpetuity Valuation Model

Sensitivity Analysis: Constant ROE; Variable Ke and g

ROE = 22.24% Earnings Growth Rate

Ke

Sensitivity Analysis: Constant g; Variable Ke and ROE

g = 3.5%

160

Intrinsic Valuation Models Conclusion

Although the discounted free cash flows model appears to provide

evidence that Baxter is fairly valued, every other intrinsic valuation model

appears to lean heavily towards overpriced shares. Thus it is our conclusion that

as of April 1, 2007, Baxter was intrinsically OVERVALUED.

161

Analyst’s Recommendation

As we have seen, our valuation of Baxter using the method of

comparables has shown Baxter to be fairly valued in the industry while the

intrinsic valuation models almost unanimously showed Baxter to be overpriced.

It is our opinion that the intrinsic valuation models are more accurate tools for

valuation that the method of comparables so we will weigh the intrinsic

valuations more heavily in our recommendation.

It is our conclusion therefore that Baxter is overvalued. Though we do

believe the company is making great strides in the right direction, this is not

justified in the price. For those already invested in Baxter, we recommend

selling your shares. For those contemplating purchasing stock in Baxter, we

strongly advise to seek more profitable opportunities elsewhere.

Current Shareholders: Sell your shares.

Prospective Investors: Find profits elsewhere.

162

Appendix

Sales Diagnostic Ratios – Figure 1.1

Net Sales / Cash from Sales 2002 2003 2004 2005 2006 2007Baxter 1.03 1.02 1.01 0.97 1.01 1.02Abbott 1.01 1.02 1.02 0.99 1.03 1.03Boston 1.02 1.03 1.07 1.01 1.07 1.01Wyeth 0.98 1.01 1.02 1.01 1.02 1.01Stryker 1.03 1.03 1.06 1.00 1.03 1.03Industry Average 1.01 1.02 1.04 1.00 1.04 1.02

Net Sales / A/R 2002 2003 2004 2005 2006 2007Baxter 4.41 4.51 4.55 5.58 5.65 5.56Abbott 6.04 5.94 5.32 6.25 5.31 5.24Boston 5.49 6.74 6.25 6.41 6.71 5.56Wyeth 6.13 6.27 6.20 6.19 6.02 6.35Stryker 7.40 7.27 5.67 6.32 6.03 5.82Industry Average 6.27 6.56 5.86 6.29 6.02 5.74

Net Sales / Inventory 2002 2003 2004 2005 2006 2007Baxter 4.65 4.24 4.45 5.12 5.02 4.83Abbott 7.24 7.19 7.51 8.79 8.01 8.78Boston 12.01 12.37 15.62 15.03 10.44 11.53Wyeth 7.32 6.57 7.00 8.04 8.20 7.38Stryker 7.06 7.75 7.71 8.65 8.07 7.54Industry Average 8.41 8.47 9.46 10.13 8.68 8.81

163

Expense Diagnostic Ratios – Figure 1.2

Asset Turnover 2002 2003 2004 2005 2006 2007Baxter 0.65 0.65 0.67 0.77 0.71 0.74Abbott 0.73 0.74 0.68 0.77 0.62 0.65Boston 0.66 0.61 0.69 0.77 0.25 0.27Wyeth 0.56 0.51 0.52 0.52 0.56 0.52Stryker 1.07 1.15 1.04 0.99 0.93 0.82Industry Average 0.76 0.75 0.73 0.76 0.59 0.57

CFFO / OI 2002 2003 2004 2005 2006 2007Baxter 0.82 1.15 2.61 0.99 1.23 1.03Abbott 1.18 1.13 1.10 1.16 2.58 1.13Boston 1.21 1.13 1.15 0.93 -0.63 -66.71Wyeth 0.06 0.89 0.69 0.53 0.63 0.91Stryker 0.87 0.90 0.82 0.86 0.81 0.79Industry Average 0.83 1.01 0.94 0.87 0.85 -15.97

CFFO / Operating Assets 2002 2003 2004 2005 2006 2007Baxter 0.91 0.88 0.80 1.63 0.65 0.62Abbott 1.97 1.41 1.10 1.27 0.22 1.05Boston 2.58 1.62 2.64 0.78 0.81 0.35Wyeth 0.03 0.45 0.49 0.29 0.32 0.38Stryker 0.09 1.19 0.58 0.53 0.40 0.29Industry Average 1.17 1.17 1.20 0.72 0.44 0.52

Pension Expense / SG&A 2002 2003 2004 2005 2006 2007Baxter -0.01 0.03 0.05 0.08 0.08 0.06Abbott 0.03 0.03 0.03 0.03 0.03 0.03Boston 0.00 0.00 0.00 0.00 0.00 0.00Wyeth 0.03 0.04 0.04 0.04 0.04 0.03Stryker 0.00 0.01 0.01 0.01 0.01 0.01Industry Average 0.01 0.02 0.03 0.03 0.03 0.03

164

Liquidity Ratios – Figure

1.3Current Ratio 2002 2003 2004 2005 2006 2007Baxter 1.37 1.45 1.40 1.23 1.93 1.98Baxter Restated 1.32 1.40 1.37 1.21 1.91 1.95Abbott 1.30 1.35 1.57 1.54 0.94 1.54Boston 1.31 1.35 1.26 1.78 1.86 1.82Wyeth 2.12 1.78 1.69 1.81 2.43 3.14Stryker 1.63 1.64 1.92 2.30 2.62 3.68Industry Average 1.59 1.53 1.61 1.86 1.96 2.55

Quick Asset Ratio 2002 2003 2004 2005 2006 2007Baxter 0.79 0.77 0.75 0.63 1.20 1.20Baxter Restated 0.74 0.72 0.71 0.60 1.18 1.17Abbott 0.52 0.56 0.72 0.87 0.40 0.81Boston 0.77 0.87 0.84 1.10 1.18 0.91Wyeth 0.97 1.02 0.88 1.07 1.41 1.91Stryker 0.63 0.66 0.99 1.01 0.98 0.99Industry Average 0.72 0.78 0.86 1.01 0.99 1.16

Inventory Turnover 2002 2003 2004 2005 2006 2007Baxter 2.46 2.35 2.62 2.99 2.73 2.46Baxter Restated 2.46 2.35 2.62 2.99 2.73 2.46Abbott 3.48 3.46 3.39 4.19 3.50 3.87Boston 3.58 3.42 3.59 3.32 2.95 3.23Wyeth 1.97 1.81 2.00 2.33 2.25 2.08Stryker 2.61 2.80 2.73 2.64 2.39 2.34Industry Average 2.91 2.87 2.93 3.12 2.77 2.88

Days Inventory 2002 2003 2004 2005 2006 2007Baxter 148.10 155.11 139.31 122.07 133.68 148.31Baxter Restated 148.10 155.11 139.31 122.07 133.68 148.31Abbott 104.75 105.51 107.66 87.19 104.36 94.31Boston 101.95 106.73 101.70 110.08 123.87 112.99Wyeth 185.62 201.15 182.82 156.82 162.03 175.48Stryker 140.09 130.13 133.54 138.11 152.99 155.81Industry Average 133.10 135.88 131.43 123.05 135.81 134.65

Receivables Turnover 2002 2003 2004 2005 2006 2007Baxter 4.52 4.65 4.55 5.58 5.65 5.56Baxter Restated 4.52 4.65 4.55 5.58 5.65 5.56Abbott 6.04 5.94 5.32 6.25 5.31 5.24Boston 6.71 6.41 6.25 6.74 5.49 5.56Wyeth 6.13 6.27 6.20 6.19 6.02 6.35Stryker 7.40 7.27 5.67 5.98 5.67 5.82Industry Average 6.57 6.47 5.86 6.29 5.62 5.74

165

Liquidity Ratios cont.

Days Sales Outstanding 2002 2003 2004 2005 2006 2007Baxter 80.70 78.46 80.26 65.45 64.64 65.66Baxter Restated 80.70 78.46 80.26 65.45 64.64 65.66Abbott 60.42 61.45 68.55 58.44 68.71 69.68Boston 54.39 56.91 58.41 54.14 66.46 65.60Wyeth 59.56 58.25 58.85 58.98 60.68 57.49Stryker 49.29 50.20 64.32 61.00 64.32 62.70Industry Average 55.92 56.70 62.53 58.14 65.04 63.87

Cash-to-Cash Cycle 2002 2003 2004 2005 2006 2007Baxter 228.79 233.57 219.57 187.52 198.32 213.97Baxter Restated 228.79 233.57 219.57 187.52 198.32 213.97Abbott 165.17 166.96 176.21 145.64 173.07 163.99Boston 156.34 163.64 160.11 164.22 190.33 178.59Wyeth 245.18 259.40 241.67 215.80 222.71 232.97Stryker 189.39 180.33 197.86 199.12 217.31 218.50Industry Average 189.02 192.58 193.96 181.19 200.85 198.51

Working Capital Turnover 2002 2003 2004 2005 2006 2007Baxter 5.92 5.36 5.49 10.36 3.09 3.01Baxter Restated 6.82 5.95 6.00 11.42 3.17 3.10Abbott 8.34 7.42 5.04 5.63 2.75 5.25Boston 10.24 7.14 8.22 5.45 3.44 3.13Wyeth 2.38 2.43 2.94 2.32 1.98 1.43Stryker 6.78 6.63 4.14 2.84 2.36 1.68Industry Average 6.94 5.91 5.08 4.06 2.63 2.87

166

Profitability Ratios – Figure 1.4

Gross Profit Margin 2002 2003 2004 2005 2006 2007Baxter 46.8% 44.4% 41.2% 41.6% 45.6% 49.0%Baxter Restated 46.8% 44.4% 41.2% 41.6% 45.6% 49.0%Abbott 51.9% 51.9% 54.9% 52.4% 56.3% 55.9%Boston 70.2% 72.4% 77.0% 77.9% 71.8% 72.0%Wyeth 73.1% 72.4% 71.5% 71.0% 72.5% 71.8%Stryker 63.1% 63.8% 64.6% 67.7% 68.6% 68.9%Industry Average 64.6% 65.1% 67.0% 67.3% 67.3% 67.2%

Operating Expense Ratio 2002 2003 2004 2005 2006 2007Baxter 19.3% 20.3% 20.6% 20.6% 22.0% 22.4%Baxter Restated 19.3% 20.3% 20.6% 20.6% 22.0% 22.4%Abbott 22.5% 25.7% 25.0% 24.6% 28.3% 28.6%Boston 34.3% 33.7% 31.0% 28.9% 34.2% 34.8%Wyeth 34.4% 34.5% 33.4% 32.6% 31.9% 30.2%Stryker 38.7% 39.1% 38.8% 39.9% 39.8% 39.9%Industry Average 32.5% 33.2% 32.0% 31.5% 33.5% 33.4%

Operating Profit Margin 2002 2003 2004 2005 2006 2007Baxter 19.3% 17.9% 15.1% 15.5% 17.7% 19.9%Baxter Restated 19.1% 17.2% 13.6% 14.3% 17.5% 21.0%Abbott 20.0% 16.9% 19.8% 19.5% 9.1% 17.7%Boston 20.9% 20.1% 28.0% 15.4% 18.1% -0.2%Wyeth 24.5% 24.7% 23.9% 23.8% 25.3% 27.1%Stryker 18.1% 18.5% 16.9% 20.2% 20.7% 21.8%Industry Average 20.9% 20.0% 22.2% 19.7% 18.3% 16.6%

Net Profit Margin 2002 2003 2004 2005 2006 2007Baxter 9.6% 9.7% 4.1% 9.7% 13.5% 15.2%Baxter Restated 9.3% 9.0% 2.6% 8.5% 13.2% 16.3%Abbott 15.8% 14.0% 15.8% 15.1% 7.6% 13.9%Boston 12.8% 13.6% 18.9% 10.0% 14.2% -5.9%Wyeth 30.5% 12.9% 7.1% 19.5% 20.6% 20.6%Stryker 11.5% 12.5% 10.9% 14.0% 15.1% 17.0%Industry Average 17.6% 13.3% 13.2% 14.6% 14.4% 11.4%

167

Profitability Ratios cont.

Asset Turnover 2002 2003 2004 2005 2006 2007Baxter - 0.72 0.69 0.70 0.82 0.77Baxter Restated - 0.69 0.68 0.69 0.81 0.76Abbott - 0.81 0.74 0.78 0.77 0.72Boston - 0.78 0.99 0.77 0.95 0.27Wyeth - 0.61 0.56 0.56 0.57 0.61Stryker - 1.29 1.35 1.13 1.04 1.02Industry Average - 0.87 0.91 0.81 0.83 0.66

Return on Assets (ROA) 2002 2003 2004 2005 2006 2007Baxter - 7.0% 2.8% 6.8% 11.0% 11.6%Baxter Restated - 6.2% 1.8% 5.8% 10.7% 12.4%Abbott - 11.3% 11.7% 11.7% 5.9% 10.0%Boston - 10.6% 18.6% 7.7% 11.1% -1.6%Wyeth - 7.9% 4.0% 10.9% 11.7% 12.7%Stryker - 16.1% 14.8% 15.8% 15.7% 17.3%Industry Average - 11.5% 12.3% 11.5% 11.1% 9.6%

Return on Equity (ROE) 2002 2003 2004 2005 2006 2007Baxter - 28.7% 11.5% 25.8% 32.5% 27.2%Baxter Restated - 23.3% 6.6% 21.3% 31.1% 28.9%Abbott - 25.8% 23.8% 23.5% 11.9% 25.7%Boston - 19.1% 37.1% 15.6% 23.6% -3.2%Wyeth - 25.1% 13.3% 37.1% 35.0% 31.5%Stryker - 30.3% 21.6% 23.4% 23.9% 24.3%Industry Average - 25.1% 24.0% 24.9% 23.6% 19.6%

168

Capital Structure Ratios – Figure 1.5

Debt to Equity 2002 2003 2004 2005 2006 2007Baxter 3.12 3.05 2.82 1.96 1.34 1.21Baxter Restated 2.74 2.76 2.66 1.91 1.33 1.18Abbott 1.27 1.04 1.01 1.02 1.57 1.23Boston 0.80 0.99 1.03 0.91 1.03 1.07Wyeth 2.19 2.34 2.41 1.99 1.49 1.35Stryker 0.88 0.47 0.48 0.52 0.40 0.37Industry Average 1.29 1.21 1.23 1.11 1.12 1.00

Times Interest Earned 2002 2003 2004 2005 2006 2007Baxter 22.06 13.52 11.41 9.22 18.23 18.05Baxter Restated 21.77 12.97 10.29 8.50 17.94 19.09Abbott 14.77 17.67 19.49 18.10 4.91 7.72Boston 14.19 15.15 24.59 10.76 -6.78 -0.02Wyeth 9.36 13.13 13.48 11.06 9.04 8.72Stryker 14.77 29.20 120.07 116.51 177.27 186.76Industry Average 13.27 18.79 44.41 39.11 46.11 50.79

Days to Earn Interest 2002 2003 2004 2005 2006 2007Baxter 16.55 27.00 31.98 39.60 20.02 20.22Baxter Restated 16.77 28.14 35.46 42.92 20.35 19.12Abbott 24.71 20.65 18.73 20.16 74.35 47.27Boston 25.73 24.09 14.84 33.94Wyeth 39.00 27.80 27.09 33.00 40.38 41.87Stryker 24.71 12.50 3.04 3.13 2.06 1.95Industry Average 28.54 21.26 15.92 22.56 38.93 30.37

Debt Service Margin 2002 2003 2004 2005 2006 2007Baxter - 13.20 460.00 10.06 2.79 13.02Baxter Restated - 18.47 638.10 13.92 3.58 17.14Abbott - 6.20 0.45 5.99 0.40 11.44Boston - 300.67 0.95 263.57 133.43Wyeth - 3.62 1.90 7.11 250.31 47.39Stryker - 60.61 81.27 89.61 18.29 69.46Industry Average - 23.47 96.07 25.91 133.14 65.43

Altman's Z-Scores 2002 2003 2004 2005 2006 2007Baxter 3.93 3.70 3.63 4.35 4.54 4.76Baxter Restated 3.90 3.67 3.59 4.31 4.52 4.77Abbott 5.47 5.46 5.29 5.34 3.42 3.91Boston 7.71 5.81 4.82 4.99 0.78 1.09Wyeth 3.55 3.07 2.86 3.01 3.39 3.28Stryker 14.53 18.52 14.52 12.03 12.09 10.77Industry Average 7.81 8.21 6.87 6.34 4.92 4.76