B8110 – Fall 2012

EXERCISE SET 2

Due in class November 19 (Section 1) or November 14 (Section 2)

You may leave your work at the assistants’ station in Uris 6W (6th Floor) before class time.

This exercise set must be worked independently—without consultation with fellow students or the TA.

There are five exercises

Exercise 1. Review of Accounting Relations

Here are some accounting numbers for a firm for fiscal years 2012 and 2011 (in millions of dollars):

2012 2011

Total assets 19,042 18,184Shareholders’ equity 6,216 5,319Revenues 13,652 12,442Unrealized gain (loss) on debt securities 456 ( 102) Common share issues 1,133 504 Common dividends 530 505Common stock repurchases 1,385 1,385

The firm has no preferred stock. Unrealized gains and losses is the only item in other comprehensive income.

a. Calculate the following for fiscal year 2012:

(i) Total liabilities at the end of 2012(ii) Comprehensive income (iii) Net income reported in the income statement

(Hint: construct the financial statements and plug for the missing numbers.)

b. The company also reported the following in the shareholders’ equity section of its 2012 balance sheet:

Common shares issued 377.3 million Common shares in Treasury 39.8 million What was book value per share at the end of 2012?

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Exercise 2. Working with Accounting Relations

Below are some numbers from a firm’s financial reports for fiscal year, 2012.

Common shareholders’ equity, beginning of 2012 $250 Common shareholders’ equity, end of 2012 307 Net operating assets, beginning of 2012 450 Net financial obligations, end of 2012 170 Net financial expense, 2012 (after tax) 10 Comprehensive income, 2012 (after tax) 40

Share issues 25

Calculate the following for the year. For measures with balance sheet numbers in the denominator, use beginning-of-period balance sheet numbers.

a. Return on common equity (ROCE) b. Return on Net Operating assets (RNOA) c. Net borrowing cost, after tax (NBC)d. Net payout to shareholderse. There were no share repurchases. What were the cash dividends paid?f. Free cash flowg. Cash flow to net debtholdersh. Apply the financing leverage equation to explain the difference between ROCE and RNOA.

Exercise 3. Conversion of Stock Warrants: Warren Buffett and Goldman Sachs

In September 2008, in the midst of the credit crisis, Goldman Sachs invited Warren Buffett to contribute much needed equity capital to the firm. Buffett seemingly got a very good deal. For a $5 billion cash infusion, he received perpetual preferred equity shares carrying a 10 percent dividend (redeemable by Goldman Sachs) plus warrants to buy 43.5 million common shares at $115 per share. The $115 conversion price was set at the then current share price, a 3-year low for Goldman.

a. If Buffet exercised the warrants at the share price of $125 on October 18, 2012, what would be the loss to Goldman’s shareholders?

b.What would GAAP accounting report as the cost of the warrant arrangement to shareholders?

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Exercise 4. Reformulation of Financial Statements for a Property and Casualty Insurer

A property and casualty insurance company reports the following balance sheet at year end for 2011 (all amounts in millions of dollars):

ASSETS LIABILITIES AND EQUITY

Investments $1,500 Insurance claims 700Insurance assets 300 Unearned premiums 140

Long-term debt 150

____ Equity 810 $1,800 $1,800

Investments are available-for-sale securities marked to market.

The company reports the following income statement for 2012:

Premium revenue $365 Investment income 60 Realized gains on investments 80 Total revenue 505 Insurance losses and expenses 405 Net income 100

In addition, the company reported $65 million in unrealized losses on investments as part of other comprehensive income.

Ignore taxes in answering the following questions:

a. What was the rate of return earned on investments for 2012?

b. Calculate net operating assets in the insurance underwriting part of the business at the end of 2011.

Calculate the earnings and residual earnings from the insurance underwriting part of the business for 2012. Use a required return of 9% for this calculation.

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Exercise 5. An Analysis of Starbucks Corporation

Financial statements for Starbucks Corporation for fiscal year 2011 are provided at the end of this exercise. Refer to the 10-K footnotes if you have any questions on these statements (or cannot see the numbers clearly). See http://www.sec.gov/edgar/searchedgar/companysearch.htmlAs always, the notes to the financial statements in the 10-K contain detail that you may need to answer the questions that follow.

Starbuck’s combined federal and state statutory income tax rate is 37.5%. See the tax footnote, Note 13.

1. Prepare a reformulated statement of shareholders’ equity for 2011 that clearly identifies comprehensive income for the year. Be sure to include the cost to Starbuck’s shareholders from the exercise of stock options during the year.

2. Calculate operating income that comes from sales, after tax, for 2011.

3. Calculate total operating income on a comprehensive income basis.

4. Identify the part of operating income that is core operating income.

5. Calculate net operating assets and net financial assets at the end of fiscal years 2011 and 2010. Treat all but $50 million of cash and cash equivalents as interest-bearing debt investments.

6. Calculate return on common equity (ROCE), return on net operating assets (RNOA), core RNOA, and the financial leverage ratio for fiscal year 2011. Use average balance sheet amounts.

7. Show that ROCE reconciles to RNOA according to the financial leverage equation. One form of the equation is:

ROCE = RNOA + [FLEV × (RNOA – NBC)]

8. Calculate the core profit margin from sales and the asset turnover for 2011.

9. Calculate free cash flow for 2011 based on information in the balance sheet and income statement (without referring to the cash flow statement).

10. If, in fiscal year 2012, Starbucks maintains the same core RNOA and return on its net financial assets that it reported in 2011, what do you forecast will be its ROCE for 2012? If the required equity return is 9%, what do you forecast will be its residual earnings for 2012?

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Financial statements follow…..

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