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“The counterparties here were banks. So you could see the premium received asa loan from the bank tobe paid back in stock, with the expected interest being any difference between market and strike price. However, this “loan” was not recorded as such, but rather as equity, so enhancing capital ratios and improving book leverage. Effectively, the transactions took loans off balance sheet. Pu it down as another structured finance deal to move deb off the balance sheet. cc. Here is how Floyd Norris described i sn an article in The New York Times, November 8, 2002, page CL Here's how it worked. Household, following the strategy recommended by Wall Street, decided in 1999 that it would embark on a big share-buyback program. It figured the stock was cheap. There was, however, ‘limitation on how many shares Household could buy. It had promised investors that it would maintain certain capital ratios, which required that it limit leverage. If it spent all that money, capital ratios would {all 1 low. It could have just waited to buy back the stock until it could afford to do so, but Household hhad a better idea. It signed contracts with banks in which it promised to buy the shares within a year, for the ‘market price when it signed the contract plus a litle interest to cover the cost of the bank's buying the stock immediately. In reality, that amounted to a loan from the bank. But that is not the way that Household accounted for it It structured the contracts so that it had a right to pay off the loan by issuing new stock, even though that was not what it intended to do. By doing that, it was able fo pretend that the shares it had agreed to buy were still outstanding, and to keep its capital ratios up. All that was in accord with some easily abused accounting rues, Postscript ln early 2003 the FASB began deliberations on dealing with the accounting issues posed by forward purchase agreements, put warrants, and put options. As a result, FASB Statement No. 150 was issued, requiring a lability to be recognized. CHAPTER NINE of the Balance Sheet and Income Statement Exercises Drill Exercises 9.1, Basie Calculations ‘a. Reformulated balance sheet Operating assets $547 Financial obligations $190 Operating liabilities 132 Financial assets Las Net financial obligations 45 ‘Common shareholders’ equity 370 Net operating assets sais, sais, Operating liabilities = $322 — 190 = $132 million >. Reformulated income statement Revenue $4,356 Cost of goods sold 3487 Gross margin 869 Operating expenses 428 Operating income 441 Net financing expense Interest expense $132 Interest income 56 76 Earnings S65 E92 Tax Allocation $8909 million (This is the bottom-up method on Box 9.2) E93 Tax Allocation: ‘op-Down and Bottom-Up Methods Top-down method: Revenue $6,450 Cost of goods sold 3.870 2580 Operating expenses U3 Operating income before tax 737 ‘Tax expense: ‘Tax reported sisi ‘Tax on interest expense 50 Operating income after tax 506 Net interest Interest expense 13s ‘Tax benefit at 37% 0 _85 Earnings aL Bottom-down method Earnings saz Net interest Interest expense 13s ‘Tax benefit at 37% 0 _85 Operating income after tax 3506, Balance sheet Operating cash 82 Accounts receivable 1827 Inventory 2876 PPE 3567 Operating assets 8,293 Operating liabilities: Accounts payable $1,245 ‘Accrued expenses 1549 Deferred taxes 712 Net operating assets Net financial obligations: Cash equivalents, $( 435) Long-term debt 3.678 Preferred stock 432 3.678 ‘Common shareholders’ equity SLU Income statement Revenue $7,493 Operating expenses Operating income before tax ‘Tax expense: ‘Tax reported $295 ‘Tax on interest expense 80. 375 Operating income after tax 797 Net financial expense: Interest expense 221 ‘Tax benefit at 36% 80 141 Preferred dividends 26 167 Net income to common $630 ‘a. Reformulated balance sheet Operating cash s 6 Accounts receivable 940 Inventory 10 PPE 2840 Operating assets 4.150 Operating liabilities: Accounts payable $1,200 Accrued expenses 390 1,590 Net operating assets 3,160 Net financial obligations Short-term investments $( 530) Long-term debt 18a ‘Common shareholders" equity Reformulated equity statement: Balance, end of 2008 $1,430 Net transactions with shareholders: Share issues $822 share repurchases (720) ‘Common dividend 80) (78) ‘Comprehensive income: Net income 8 468 Unrealized gain on debt investments 30, 518 Balance, end of 2009 $1,870 >. Reformulated statement of comprehensive income Revenue $3,726 Operating expenses, including taxes 3.204 Operating income after tax 522 Net financing expense Interest expense $98 Interest income 15 Net interest Tax at 35% Net interest after tax Unrealized gain on debt investments _S0 Comprehensive income 8 —4 x After calculating the net financial expense, the bottom-up method is used to get operating income after tax. That is, nt interest expense is calculated first (= $4 million). Then, as comprehensive income is ‘$518 million, operating income must be 518 + 4 = 522. The number for operating expense (3,204) is then a plug to get back to the $3,726 million revenue number. Bottom up. “The solution has to be worked in the following order: A= Operating revenues ~ operating expenses = 5523-4550 = 7 E = _ Interest expense after tax/ (I ~ tax rate) = 420.65 = 646 Fo = Ba = 26 D = 610442 = 652 =F = 26 Bo = A-c-D = 973-226-652 = 2084 Effective tax rate on operating income = Tax on operating income/ Operating income before tax (BeCyA 33.0% Applications 927. Price of “Cash” and Price ofthe Operations: Realnetworks, Ine. * Price/book = 564.5/876 = 0.64 NOA — =422 million rice of operations = 564.5 — 454 1105 million a. The reformulation: Net Sales 20367 Operating expenses 17484 Operating income from sales (before tax) 288 Taxteponted 1,606 ‘Taxbenelit of debt 88 Taxcon other operating income Gen, Operating income from sales (after ax) Other operating income Gain on asset sales 1.083 Restructuring charge 65 Tors ‘Taxon other operating income, 36.1 367 651 Operating income (after tax) 2207 ‘Net financial expense: Interest expense 363 Interst income us, 2S ‘Taxon net interest (36.1%) 88 1ST Net Income 1327 46.0% cc. Effective tax rate on operating from sale: 2.883 ‘You might ask why the tax rate is so high: Pepsico had a special 10.6 percent extra tax charge on its bottling operations in 1999, E99, Financial Statement reformulation for Starbucks Corporation, Reformulated Statement of Shareholders’ Equity (In millions) Balance, September 30, 2007 £21728 Note: The closing balance excludes $106.4 million for “Stock-based compensation expense” which is a liability rather than equity. (It is added to operating liabilities in the reformulated balance sheet). a b Net revenues $9,411.5 Cost of sales and occupancy costs 3,999.1 Store opening expenses 3,215.9 Other operating expenses 294.1 Depreciation and amortization 467.2 General and administrative expenses 439.2 Operating income from sales (before tax) 946.0 Tax reported $383.7 Tax benefit of net interest 56 Tax on other operating income (6.5) 3827 Operating income from sales (after tax) 563.3 ‘Other operating income, before-tax item, Gain on asset sales 26.0 Other operating charges {8.9} 17 Tax at (38 66 10.5 Operating income, after tax-items Income from equity investees 108.0 Currency translation gains 377 156.2 Operating income (after tax) 7195 Net financing expenses Interest expense 38.2 Interest income 19.7) Net interest expense 18.5 Realized gain on financial assets 3.8) 147 Tax (at 38.4%) 5.6 9.1 Unrealized loss on financial assets 20.4 29.5 Comprehensive income Note: Interest income and interest expense are given in the notes to the financial statements in the exercise. That note also identifies the other operating income here Reformulated Balance Sheets {in millions) 2007 2006 Operating Assets Cash and cash equivalents 40.0 40.0 Short-term investments—trading securities 736 535 Accounts receivable, net 287.9 224.3 Inventories 6917 636.2 Prepaid expenses and other current assets 148.8 126.9 Deferred income taxes, net 129.5 88.8 Equity and other investments 258.8 219.1 Property, plant and equipment, net 28904 2,287.9 Other assets 219.4 186.9 Other intangible assets 42.0 378 Goodwill 215.6 161.5 Total operating assets 49977 4,063.0 Operating liabilities Accounts payable 390.8 340.9 Accrued compensation and related costs 332.3 288.9 Accrued occupancy costs 746 549 Accrued taxes 92.5, 94.0 Other accrued expenses 257.4 224.2 Deferred revenue 296.9 2319 Other long-term liabilities 460.5 262.8 Total operating liabilities 19050 1497.7 Net operating assets 20927 2.5653 Net financial obligations Short-term borrowing 710.2 700.0 Current maturities of long-term debt os 08 Long-term debt 550.1 20 Cash equivalents (281.3-40.0 in 2008) (241.3) (272.6) Short-term investments (available for sale) (83.8) (87.5) Long-term investments (available for sale) (21.0) 5.8) Net financial obligations 915.0 336.9 Common shareholders’ equity 21716 2,228.5 Notes 1. Short-term investment (trading securities) is operating assets connected to employees. 2. Stock-based compensation, excluded from the equity statement, has been added to other liabilities. £9.10, Reformulation and Effective Tax Rat jome Depot, Ine. First establish the firm's marginal tax rate. ‘This isthe statutory rate (federal plus state at which interest income is taxed (or interest expense gets a tax saving). ‘The footnote gives the effective rate (36.8% for 2005), which isthe effective rate from the income statement (2,911/7,912 = 36.8%). But this is not the ‘marginal rate for it includes tax credits and foreign tax benefits, amongst other things. The marginal rate is, the statutory rate, federal and state combined (with the state rate recognizing that state taxes are deductible in federal tax retwens) “The federal statutory rte is 386, but the state rate isnot given, (Many firms do report it) Home Depot operates in many states; without more information, the statutory rate is somewhat of a guess. Home Depot reports a ratio of state-o-federal taxes of 215/2,769 = 7.79% for 2005. Applied tothe federal rate of 350, this implies a state rate of 2.72%, or a total rate of 37.72%. In the reformulation below, this 37.72% rate is used forthe tax allocation. The top-down approach, proceeds as follows: (S millions) Net sales 73,094 Cost of sales 48,664 Gross profit 24.430 ling and store operating costs 15,105 General and administrative 1,309 16,508 Operating income before tax 7,926 Tax as reported 2911 Tax benefit of net debt aos Operating income after x 5.010 Interest expense 0 Interest income 36 Net interest expense 4 Tax on net interest (37.72%) 3 2 Net income 5,001 16 = 36.79% 7.926 “This effective rat is almost the same as the reported rate because the net Effective tax rate on operating income = terest is almost zero. “The bottom-up approach proceeds as follows (in millions of dollars) Net income 5.001 Interest expense 0 Interest income 56 Net interest expense 4 Tax on net interest (37.72%) 5 9 Operating income after tax CHAPTER TEN ‘The Analysis of the Cash Flow Statement Drill Exercises E10.1. Cla fication of Cash Flows A cash flow that affects cash flow from operation also affects free cash flow, Cash from operations FCF Financing Flows Yes Yes No No No No No Yes No Yes Yes No No No Yes No No Yes Yes Yes No Interest payments affect the GAAP number for cash from operations, but not the real number. Purchases of short-term investments affect the GAAP measure of cash. investment, but not the real investment in operations nor free cash flow. E10.2 Calculating Free Cash Flow from the Balance Sheet and Income Statement First reformulate the balance sheet 2009 2008 NOA 3160 2900 NFO 1290 1470 CSE 1870 1230 Method 1 Free cash =240 Method 2: = 376 (1,870 — 1,430) = -64 So, E10.3. Analyzing Cash Flows a) As there is no debt or financial assets, = $150,000 oR As there is no change in shareholders’ equity and no financial income or expense = $150,000 So, 150,000 (There is no change in net operating assets because there is no change in shareholders’ equity and no net financial obligations.) b) The increase in cash comes from operations dividends decreased the cash) the sale of land (and Cash from operations = $135,000 Sale of land $400,000 $535,000 Dividends 150,000 Change in cash $385,000 ©) No change. The investment in the short-term deposit is a financing activity, not an investment in operations, so free cash flow is not affected. It's a disposition of cash from operations, not generation of free cash flow. 10.4, Free Cash Flow for a Pure Equity Firm So free cash flow is -S26.1 million Another solution Earnings = $25.3 million 26.1 million E105 Free Cash Flow for a Net Debtor By Method 2 in Box 10.1, C-1=NFE- ANFO +d ANFO = 37.4 ~ 54.3 =-16.9 (net debt declined) d=83-343 =-26.1 (negative net payout) So, C = (16.9) + (-26.1) =-5.2 (free cash flow was negative) OR, using Method 1, cl O1- ANOA. OL = Comprehensive income (25.3) + NFE (4.0) = 29.3 ANOA = ACSE - ANFO = 514-169 =34.5 Comprehensive income is plugged from the equity statement. E106. Applying Cash Flow Relations (a) (b) © =~ $40 million (The firm reduced its investment in net operating assets.) =~ $69 million Or, as ANOA is made up of investment and operating accruals, =~ $69 million C-1=NFE-DNFs +d So, with a negative net dividend of $13 million ANFO = - $400 million (The firm reduced its NFO by $400 million by applying free cash flow and the net dividend to reducing net debt), (a) Use the free cash flow generation equation: C - I= O1- ANOA As there was no net financial income or expense, operating income (1) equals the comprehensive income of $100 million. The net operating assets for 2009 and 2008 are as follows: 2009 2008 Operating assets, 640 590 Operating liabilities _20 30 NOA 620 560 cer =$ 40 million (b) Use the free cash flow disposition equation: C - = ANFA - NFI +d The net dividend (d) - $60 million (a net capital contribution) The net financial assets for 2009 and 2008 are as follows: 2009 2008 Financial assets 250 110 Financial liabilities 170 130 NFA 80 c = $40 million The firm invested the $40 million of free cash flow in financial assets. In addition, it raised a net $60 million from shareholders which it also invested in financial assets, (©) Net financial income or expense can be zero if financial income and financial expense exactly offset each other. This firm moved from a net debtor to a net creditor position in 2009 such that the weighted-average net, financial income was zero. Applications E108. Free Cash Flow and Financing Activities: General Electric Company a, General Electric, while generating large cash flow from operations, has had a huge investment program as it acquired new businesses, leaving it with negative free cash flow. b. Given that cash from operations from the businesses in place continues at, or grows from the 2004 level, free cash flow will increase and will become positive (probably by big amounts). Rather than borrowing or issuing shares to finance a free cash flow deficit, GE will have cash to pay out. It can either, 1. But down its debt 2. Invest the cash flow in financial assets 3. Pay out dividends or buy back its stock. ‘The firm would not invest in financial assets for too long, but rather buy back debt, or pay out to shareholders. Indeed, in 2005, the firm announced a large stock repurchase program, E10.9. Method 1 Calculation of Free Cash Flow for General Mills, Inc, By Method 1, Free cash flow = $1,351 million E10.10. Free Cash Flow for Kimberly-Clark Corporation a Reformulate the balance sheet: 2007 2008 Operating assets, $18,057.0 $16,796.2 Operating liabilities 6011.8 927.2 Net operating assets (NOA) 12,045.2 10,869.0 Financial obligations $6,496.4 $4,395.4 Financial assets 382.7 6113.7 2708 4,124.6 Common equity (CSE) $ 5,931.5 $ 6,744.4 By Method 1, Free cash flow = 1,563.9 By Method 2, Free cash flow = 1,563.9 Net payout to shareholders (d) = 3,405.9 b. Cash flow from operations reported $2,429.0 million Net interest payments 142.4 Tax on net interest payments 52.1 90.3 Cash flow from operation 2,519.3 Cash investment reported 898.0 Liquidation of short-term investments 56.0 954.0 Free cash flow $1,565.3 million E10.11. Extracting Information from the Cash Flow Statement with a Reformulation: Microsoft Corporat a. Cash dividends are read off the financing sections of the cash flow statement: $33,498 million. A large dividend indeed! This dividend would also be reported in the statement of shareholders’ equity. Net dividend = 33,672 million As Microsoft has no debt, the net dividend is equal to the total of financing activities. b. Cash flow for operations reported $3,619 million Interest received S378 Tax on interest (at 37.5%) 12 236 Cash from operations 53,383 (Note: there is no interest paid.) c. Cash generated from investments, reported (Positive number means cash has been generated, not used) Net sales of short-term investments Cash generated from investing in operations ‘That is, $177 million was invested in operations. d._ Free cash flow = $3,383 — 177 = $3,206 e, The actual cash invested in operations for 2003 (after adjusting for net investment in interest-bearing securities) was $172, almost the same as 2004. Both year’s numbers are affected by the net investment in interest-bearing securities. f The net investment in financial assets is the net investment in short-term investments (in part d above) plus the change in cash and cash equivalents. (As $60 million of working cash is the same at the beginning and end of the period, the change in cash and cash equivalents (a negative $6,639 million) is all investment in financial assets). Investment in financial ass ts = -$23,591 - $6,639 -$30,230 million ‘That is, Microsoft liquidated $30,230 of financial assets (to pay the large dividend). The Reformulated Cash Flow Statement (in millions of dollars) Cash flow for operations reported $3,619 million Interest received $378 Tax on interest (at 37.5%) 142 Cash from operations Cash generated from investments, reported $23,414 Net sales of short-term investments 23,591 Cash generated from inve in operations 77) Free cash flow Cash in financing activities: Net dividend Sale of financial assets Interest in financial assets, after tax CHAPTER ELEVEN The Analysis of Profitability Drill Exercises E111 Leveraging Equations (@) By the stocks and flows equation for equity Net dividends = (93) (i. net capital contribution) So, So, © (This answer assumes no dirty-surplus accounting) 2007 NOA 1,900 NFO 1,000 CSE 900 ROCE = 207/1,050 = 19.71% Operating income (OL 2008 2,400 = 279.6 Average 2,150 L100 1.050 RNOA = Ol/ave. NOA = 279.6/2,150 = 13.0% ROCE = [PM xATO] + [FLEV x (RNOA ~ NBC)] PM ATO FLEV NBC OVSales = 279.6/2,100 = 0.1331 (or 13.31%) Sales/ave. NOA = 2,100/2,150 Ave. NFO/ave. CSE = 1,100/1,050 Net interest expense/ave. NFO = (110 x 0.66)/1,100 = 6.6% 9767 = 1.0476 19.71% = (0.1331 x 0.9767) + [1.0476 x (13.0% - 6.6%)] (b) Operating assets Operating liabilities NOA Implicit interest on operating liabilities (OL) = 9 Return on operating assets (ROOA) Operating liability leverage 13.0% = 12.28% + [0.093 x (12.28% - 4.5%)] 2007 2,000 100) 1,900 2008 Average 2,700 2,350 G00) 200) 2.400 2.150 ‘This is the case of a net creditor firm (net financial assets). Net dividends ROCE = 339/3,050 = 11.11% Operating income = 279.6 (as before) RNOA = 279.6/2,150 = 13.0% (as before) Return on net financial assets (RNFA) = 6.6% FLEV = -900/3,050 = -0.295 PM and ATO are as before. So, 11.11% = (0.1331 x 0.9767) — [0.295 x (13.0% - 6.6%)] (a) First reformulate the financial statements: Reformulated Balane 2008 2007, Average NOA 1,395 1,325 1,360 NFO. 300 300 300 CSE 1,095 1,060 Reformulated Income Statement, 2008 Sales 3,295 Operating Expenses 3,048 247 Tax reported 61 Tax on NFE 2 _” oO 17 Net interest 7 Tax on interest at 33% 2 NFE _18 Comprehensive Income 159 CSE205 = CSEzqo7 + Earningssoos — Net Dividends2o0s 1,095 = 1,025 + 159 - 89 t Stock repurchase = 89 E11.3. Reformulation and Analysis of Financii ©, (b) (b) 159 ROCE = 5.0% 1,060 RNoA= 17 = 13.0% 1360 FLEV = 2 ~ 283 1,060 SPREAD = RNOA ~ NBC = 13.0% - 6.0% = 7.0% (nsc= NE 4) C-1 =O1-ANOA = 177-70 = 107 The ROCE of 15% is above a typical cost of capital of 10% - 12%. So one might expect the shares to trade above book value. But, to trade at three times book value, the market has to see ROCE to be increasing in the future or investment to be growing substantially. Reformulated balance sheet 2009 2008 Operating cash S$ 60 50 Accounts receivable 940 790 Inventory 910 840 PPE 2.840 2.710 Operating assets, 4,750 4,390 Operating liabilities: Accounts payable $1,200 1,040 Accrued expenses, 390 1,590 450 1.490 Net operating assets 3,160 2,900 Net financial obligations: Short-term investments $( 550) (500) Long-term debt 1.840 1,290 1.970 1,470 Common shareholders’ equity $1870 1,430 Reformulated equity statement (to identify comprehensive income): Balance, end of 2008 $1,430 Net transactions with shareholders: Share issues $822 Share repurchases (720) ‘Common dividend 180) (78) Comprehensive income: Net income $ 468 Unrealized gain on debt investments _50, 518, Balance, end of 2009 $1,870 Reformulated statement of comprehensive income Revenue $3,726 Operating expenses, including taxes 3,204 Operating income after tax 522 Net financing expense: Interest expense $98 Interest income _15 Net interest 83 Tax at 35% _29 Net interest after tax 34 Unrealized gain on debt investments 50 _4 Comprehensive income $518 After calculating the net financial expense, the bottom-up method is used to get, operating income after tax. Free cash flow = 262 Ratio analysis Profit Margin (PM) 14.01% Asset turnover (ATO) 1.285 RNOA = 18% e. Individual asset turnovers Operating cash tumover = 3,726/5 = 74.52 Accounts receivable turnover = 3,726/790 = Inventory turnover = 3,726/840 = 4.44 PPE tumover = 3,726/2,710 = 1.37 Accounts payable turnover = 3,726/1,040 = 3.58 Accrued expenses turnover = 3,726/450 = 8.28 V/individual turnover aggregate to 1/ATO: VATO = 1/1.285 = 0.778 = 0.013 + 0.212 + 0.225 + 0.730 - 0.279 -0.121 (allow for rounding error) f. ROCE = 518/1,430 = 36.22% Financial leverage (FLEV) = 1,470/1,430 = 1.028 Net borrowing cost (NBC) = 4/1,470 = 0.272% ROCE = 36.22% = 18.0% + [1.028 x (18.0% - 0.272%] g. NBC =4/1,470 = 0.272% (as in part e) If RNOA = 6% and FLEV =0.8, ROCE = 6.0% + [0.8 x (6.0% - 0.0.272%] 0.58% Note: it is more likely that NBC will be at the core borrowing rate (that excludes ‘The unrealized gain of debt investments): Core NBC = 54/1,470 = 3.67%. Chapter 12 identifies core borrowing costs h. Implicit cost of operating liabilities = 1,490 x 0.03 = 44,7 522+44,7 Return on operating assets (ROOA) = a 12.91% Operating liability leverage (OLLEV) = 1,490/2,900 = 0.514 RNOA = 18.0% = 12.91% + [0.514 x (12.91% - 3.0%)] (a) ROCE =RNOA + [FLEV x (RNOA - NBC)] 13.4% = 11.2% + [FLEV x (111.2% - 4.5%)] FLEV =0.328 (b) RNOA =ROOA + (OLLEV x OLSPREAD) 11.2% =8.5% + [OLLEV x (8.5% - 4.0%)} OLLEV =0.6 (©) First calculate NFO and CSE using the financial leverage ratio ( we ) applied to the net operating assets of $405 million FLEV = NFO CSE NOA = CSE + NFO so NFO =14FLEV CSE = 1328 AsNOA ‘Then CSE _ $405 million 1328 305 million and NFO = $100 million Now distinguish operating and financing assets and liabilities ourv == - 06 NOA So OL = 0.6 x $405 million = $243 million OA =NOA +OL = 405 +243 = $648 million Financial assets _= total assets — operating assets = 715 ~ 648 = $67 million Financial liabilities = NFO + financial assets = 100 +67 = $167 million Reformulated Balance Sheet Operating assets 648, Financial liabilities 167 Operating liabilities 243 Financial assets 67 100 Common equity 305 405 405 EIL5 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A What-If Question The effect would be (almost) zero. ExistingRNOA = 11.02% RNOA from new product line is RNOA =11.08% Applications E11.6. Profitabi Measures for Kimberly-Clark Corporation The exercise is best worked by setting up the reformulations balance sheet: 2007 2008 Operating as $18,057.0 $16,796.2 Operating liabilities 6.01.8 5,927.2 Net operating assets (NOA) 12,045.2 10,869.0, a(l) Financial obligations $6,496.4 $4,395.4 Financial assets 382.7 6113.7 270.8 4,124.6 a(2) ‘Common equity (CSE) $ 6,744.4 a@) a, ‘The answers to question (a) are indicated beside the reformulated statement. b. Comprehensive income = 2,740.1 ~ 147.1 = 2,593 million ROCE = 2,593/6,744.4 = 38.45% RNOA — 2,740. 1/10,869.0 = 25.21% FOICSE = 4,124.6/6,744.4 = 0.612 57% «. The financial leveraging equation is: ROCE = RNOA + [FLEV x (RNOA - NBC)] = 25.21% + [0.612 x (25.21% - 3.57%)] = 38.45% d On sales of $18,266 million for 2007, PM =2,740.1/18,266 x ATO = 18,266/10,869 15.00% x 1.68 5.2% E117. Analysis of Profitability: The Coca-Cola Company Average balance sheet amounts are as follows: 2007 2006 Average Net operating assets $26,858 $18,952 $22,905 Net financial obligations 5114 2,032 3,573 Common shareholders’ equity $21,744 $16,920 $19,332 a RNOA = 6,121/22,90: NBC = 140/3,573 b. FLEV = 3,573/19,332 = 0.185 c ROCE = RNOA + [FLEV x (RNOA - NBC)] = 26.72% + [0.185 x (26.72% - 3.95%)] = 30.93 % = 5,981/19,332 d PM = 6,121/28,857 = 21.21% ATO = 28,857/22,905 = 1.26 RNOA = 21.21% x 1.26 = 26.72% Gross margin ratio = 18,451/28,857 = 63.94% Operating profit margin from sales = 5,453/28,857 =18.90% Operating profit margin = 6,121/28,857 = 21.21% E118. A What-If Question: Grocery Retailers Net operating assets for $120 million in sales and an ATO of 6.0 are $20 million. An increase in sales of $15 million and an increase in inventory of $2 million would 120 + 042 increase the ATO to = 6.59. With a profit margin of 1.5%, the RNOA would be: RNOA = 9.89% ‘The current RNOA is: RNOA = 9.6% So the membership program would increase RNOA slightly. E11.9. Financial Statement Reformulation and Profitability Analysis for Starbucks Corpora a, To prepare a reformulated income statement, first identify comprehensive income in the equity statement. If you worked Exercise E9.9, you would have done this and produced the statement below. If not, you just need to calculate the comprehensive income of $689.9 million in the statement here. Reformulated Statement of Shareholders’ Equity {in millions) Balance, October 1, 2006 $ 2,228.5 Net payout to shareholders: Stock repurchase 1,012.8 Sale of common stock (46.8) Issue of shares for employee stock options (225.2) (740.8) Comprehensive Income: Net income from income statement 672.6 Unrealized loss on financial assets (20.4) Currency translation geins 327 in Is Balance, September 30, 2007 $2.177.6 Note: The closing balance excludes $106.4 million for “Stock-based compensation expense” which is a liability rather than equity. (It is added to operating liabilities in the reformulated balance sheet). With comprehensive income identified, reformulate the (comprehensive) income statement that totals to comprehensive income: i Net revenues 99,4115 Cost of sales and occupancy costs 3,999.1 Store opening expenses 3,215.9 Other operating expenses 294.1 Depreciation and amortization 467.2 General and administrative expenses 489.2 Operating income from sales (before tax) 946.0 Tax reported $383.7 Tax benefit of net interest 5.6 Tax on other operating income (6.6) 382.7 Operating income from sales (after tax) 563.3 ‘Other operating income, before-tax item. Gain on asset sales 26.0 Other operating charges (3.9) wt Tax at (38.4%) 66 10.5 Operating income, after tax-items Income from equity investees 108.0 Currency translation gains 327 156.2 Operating income (after tax) 7195 Net financing expenses Interest expense 38.2 Interest income 19.7) Net interest expense 18.5 Realized gain on financial assets 3.8) 147 Tax (at 38.4%) 5.6 © Unrealized loss on financial assets Comprehensive income Note: Interest income and interest expense are given in the notes to the financial statements in the Exercise 9.9, That note also identifies the other operating income here. The reformulated balance sheet is as follows: —— Operating Assets Cash and cash equivalents Short-term investments—trading securities Accounts receivable, net Inventories Prepaid expenses and other current assets Deferred income taxes, net Equity and other investments Property, plant and equipment, net Other assets Other intangible assets Goodwill Total operating assets Operating liabilities Accounts payable Accrued compensation and related costs Accrued occupancy costs Accrued taxes Other accrued expenses Deferred revenue Other long-term liabilities Total operating liabilities Net operating assets Net financial obligations Short-term borrowing Current maturities of long-term debt 390.8 322.3 74.6 925 257.4 296.9 4605 1,905.0 Long-term debt 550.1 Cash equivalents (281.3-40.0 in 2008) (241.3) Short-term investments (available for sale) (33.8) Long-term investments {available for sale) (21.0) Net financial obligations 915.0 Common shareholders’ equity 2172.6 Notes: 20 (272.6) (875) 5.8) 68 E E 3. Short-term investment (trading securities) is operating assets connected to employees, 4, Stock-based compensation, excluded from the equity statement, has been added to other liabilities. b. ROCE = 689.9 / 2,228.5 = 30.96% RNOA = 719.5 / 2,565.3 = 28.05% NBC = 29.5 / 336.9 = 8.76% c NEO _ 2B67 agp = 22. 2 ‘LEV we haat 0.154 ROCE = 28.05% + [0.151 x (28.05% - 8.76%)] = 30.96% d Operating profit margin = 719.5/9. Operating profit margin from sales ATO =9,411.5/2,565.3 = 11.5 = 7.64% 563.3/9,411.5 = 5.99% 497.7/2,565.3 = 0.584 Implicit interest on operating liabilit Rooa = 225*33%? _ io. 04% 4063.0 RNOA = ROOA + OLLEVx (ROOA ~ 3.6%) = 19.04% + 0.584 x (19.04% - 3.6%) = 28.05% 0.036 x 1,497.7 = 53.92 a. Reformulation If you have worked Exercise 9.10 in Chapter 9, you will have calculated the tax rate to use in the income statement reformulation for 2005. This is the statutory rate (federal plus. state) at which interest income is taxed (or interest expense gets a tax saving). The footnote gives the effective rate (36.8% for 2005), which is the effective rate from the income statement (2,911/7,912 = 36.8%). But this is not the marginal rate for it includes tax credits and foreign tax benefits, amongst other things. The marginal rate is the statutory rate, federal and state combined (with the state rate recognizing that state taxes are deductible in federal tax returns), The federal statutory rate is 35%, but the state rate is not given. (Many firms do report it.) Home Depot operates in many states; without more information, the statutory rate is omewhat of a guess. Home Depot reports a ratio of state-to-federal taxes of 215/2,769 = 7.79% for 2005. Applied to the federal rate of 35%, this implies a state rate of 2.72%, or a total rate for 2005 of 37.72%. Following the same procedure for 2004, the ratio of state-to-federal taxes for 2004 is 217/2,395 = 9.06% and the implied state tax rate = 9.06% x 35% = 3.17%, giving a total of 38.17%. In the reformulation below, these rates are used for the tax allocation. Of course, given the small net interest, the precise calculation does not matter ($ millions) Net sales Cost of sales Gross profit Selling and store operating costs General and administrative Operating income from sales, before tax Tax as reported Tax benefit of net debt Operating income from sales, after tax Other operating income — currency translation gains Operating income Interest expense Interest income Net interest expense Tax on net interest Comprehensive income 2005 and 2004 70 56 14 2005 73,094 48,664 2004 64,816, 44,236, 20,580 13,734 6,846 2,539 1 2,540 4,306 172 4,478 62 59 3 1 _2 4,476 Note: Currency translations gains are after tax (as are all items in other comprehensive income) Operating assets: Operating cash Receivable Inventories Other current assets PPE (net) Goodwill Other assets Operating liabilities: Accounts payable Accrued salaries Sales tax payable Deferred revenue Income tax payable Other accrued taxes Deferred income tax Other liabilities, Net operating assets Net financial obligations: Cash equivalents Short-term investments Notes receivable Current debt Long-term debt Common equity Averages: Operating assets Operating liabilities Net operating assets Net financial obligations Common equity Reformulated Balance Sheets, 2003-2005 2005 50 1,499 10,076 450 22,726 1,394 228 36,423, 5,766 1,055 412 1,546 161 1,578 1,309 763 72,590 23,833 (456) (1,659) (369) 2.148 (325) 24,158 33,987 11,628 22,359 (923) 23,282 2004 50 1,097 9,076 303 20,063 833 31,551 (1,053) (1,749) (84) 509 856 7521 22,407 79,853 (1,252) 21,105 2003 50 4,072 8,338 254 17,168 575 244 27,701 4,560 809 307 998 227 4,127 362 491 6,881 18,820 (2,138) (65) (107) 4,321 (982) 19,802 b. Analysis of Operating Profitability 2005 2004 Second Level ROCE 22.07% 21.21% RNOA 23.02% 22.56% PM 7.04% 6.91% ATO 3.269 3.265 PMxATO 23.02% 22.56% Income statement rati Profit Margin drivers (9%) Gross margin 33.42 31.75 Selling expense ratio (20.67) (19.42) GBA Expense Ratio (1.91) (1.77) Operating Sales PM before tax 10.84 10.56 Tax expense ratio (3.99) (3.92) Sales PM 685 6.64 Other item PM. 019 0.27 Note that the income statement ratios aggregate to the PM. Turnover ratios (using average balance sheet amounts 2005 2004 Asset turnover drivers ATO. 4/ATO ATO. ATO ‘Accounts receivable turnover 56.31 0.018 59.77 0.017 Inventory turnover 7.63 0.131 7.44 0.134 PPE turnover 3.42 0.293, 3.48 0.287 Other asset turnover 4253 0.024 53.17 0.019 Operating asset turnover 2.15 0.465, 2.19 0.457 ‘Accounts payable turnover 13.38 (0.075) “13.34 (0.075) Other liability turnover “11.86 (0.084) “13.19 (0.076) 3.27 0.306 3.26 0.306 Note that the sum of individual equals —!— forall operating assets and abilities ‘ATO 1 ATO isthe amount of the asset or liability that is put in place to support sales. CHAPTER TWELVE The Analysis of Growth and Sustainable Earnings Drill Exercises E121 Analyzing a Change in Core Operating Profitability ACore RNOA = -1.47% = -0.4% x 2.5) + (-0.1 x 4.7%) “10% =~ 047% J J [Due to APM] [Due to AATO] 12.2. Analyzing a Change in Return on Common Equity ROCE for 2009: 15.2% = 11.28 + [0.4678 x (11.28 -2.9)] ROCE for 2008: 13.3% = 12.75 + [0.0577 x (12.75 - 3.2)] AROCE 1.9% ARNOA -1A7% AROCE due to financing 3.37% This change due to financing is due to a change in leverage and a change in SPREAD: AFLEV 0.4101 ASPREAD -LIT% The explanation of the change in ROCE due to change in operating profitability (ARNOA) is given in Exercise E12.1. Using a similar scheme, the explanation of the change due to financing is, AROCE due to financing = 3.37% = (-1.17% x 0.0577) + (0.4101 x 8.38%) = 0.07% + 3.44% 1 1 [Due to change in spread] [Due to change in leverage] 12.3. Analyzing the Growth in Shareholders’ Equity Change in CSE 5,719 x 0.4) + (0.0167 x 16,754) ~ 1,984 287.6 + 279.8 — 1,984.0 J J J Due to Dueto Due to Sales NOA Borrowing The reformulated statement that distinguishes core and unusual items is as follows (in millions of dollars): Sales 667.3 Core operating expenses 580.1 Core operating income before tax (73.4 +13.8) 872 Tax as reported 183 Tax benefit of net debt (0.39 x 20.5) 80 Tax on operations 263 Tax allocated to unusual items: 5a 317 Core operatimg inome after tax 555 Unusual items Start-up costs (43) Merger charge (13.4) Gain on asset disposals 39 (13.8) Tax effect (0.39) 5a (64) Translation gain 89 0s, Comprehensive operating income 56.0 Note: 1. The currency translation gain is transitory; it does not affect core income, like all items reported in other comprehensive income are after-tax. 3. The gain on disposal of plant may attract a higher tax rate than 39% due to depreciation recapture. Core operating income (after tax) = 555 Core operating income (after tax) Core profit margin Sales 32% 2009 2008 2007 NOA NEO. NOA NFO NOA NEO Cash 100 100 120 AIR 900 1,000 1,250 Inventory 2,000 1,900 1,850 PPE 8.200 9,000 10,500 Acer. Liab. (600) (500) (550) AP (800) (1,000) (1,100) Det. Taxes (480) (500) (600) S/T investments (a00) (300) Bank loan Bonds payable 4,300 4,300 Preferred stock 1,000 1,000 3210 «= 5.000 -10,000 «5.000 11,470 se 4.210 2210 Leverage (NFO/CSE) 1.188 1.000 741 Average leverage 1.086 0.853 Sales cas 13,000 S&A 8,000 Core O1 b/4 tax Tax on Ol Core Ol after tax Restructuring charge 190 Tax Benefit 65 Operating income Net Financial expenses Net interest expenses 406 Tax Benefit (138) 268 Gain on retirement (after tax) 0 28 Preferred divs. 80 Nlavailable for common Tax on Core OI (2009) Tax on Core OI (2008) Net borrowing cost (NBC): Net fin. exp/average NFO 2009: 2008: 348/5,000 248/4,940 96% 02% Return on net operating ass 2009: 2008: 538/9,605 = 5.60% 1,838/10,735 = 17.12% Core profit margin (PM): Core OVSales 2009: 663/22,000 = 3.01% 2008: 1,838/24,000 = 7.66% 22,000 21,000 7,000 337 663 (125) (348) 790 5 (RNOA): OV/average NOA 2008 24,000 13,100 8,250 21,350 2,650 812 7838 405 137) 268 100 Tea 80 248) 1,590, Asset turnover (ATO): Sales/average NOA 2009: 22,000/9,605 = 2.290 2008: 24,000/10,735 = 2.236 ‘Unusual items to net operating assets: UVaverage NOA 2009: -125/9,605 = -1.30% 2008: =0 Spread: RNOA - NBC 2009: -1.36% 2008: 12.10% Explaining AROCE: ROCE (2009) = Cl avail for common/Average CSE = 190/4,605 = 4.13% ROCE (2008) 1,590/5,795 = 27.44% AROCE (2009) -23.31% As ROCE = RNOA + [FLEV x (RNOA - NBO), this change in ROCE is determined by: ARNOA = -11.52% AFLEV = 1.086 - 0.853 = 0.233 ANBC = 1.94% Explaining the A RONA component: ARNOA — =[A core profit margin x turnover (2008)] + [A turnover x core profit margin (2009)] + A unusual items/NOA. [-0.0465 x 2.290] + [0.054 x 0.0766] - 0.0130 -0.1152 In words, the decrease in ROCE is explained by an decrease in profit margin (despite a small increase in asset turnover) that was levered up by an decrease in the spread over net borrowing costs, the effect of which was further increase by an increase in leverage. In addition there were unusual changes in 2009 that reduced operating profitability, eee ‘The ingredients: 2,009 Average CSE 4,560 Growth in average CSE 301 Growth in average NFO 0 Growth in sales 902 Asset turnover (Sales/Average NOA) 3 3 As asset turnover is constant and average net financial obligations did not change from 2004 to 2006, the growth in CSE is explained solely by the growth in sales: Growth in CSE = Growth in sales x ATO =301 Applications E127. Core Income and Core Profitability for The Coca Cola Company Average balance sheet amounts are as follows 2007 2008 Average Net operating assets $26,858 $18,952 $22,905 Net financial obligations 5,114 132 73 Common shareholders’ equity $21,744 $16,920 $19,332 As no unusual items are reported in the income statement, all income reported is core income. So, Cote income from sales (after tax) Core operating income = $6,121 milion (One might be tempted to teat equity income from bottling subsidiaries as non-core income. However, this is part of Coke’s business of selling beverages (they just do this business through bottling firms). The equity income is not income from top-line sales, however; rather itis income from sales inthe subsidiaries that is reported here on a net basis (after expenses). Here are the measures requested a, Core profit margin from sales = 5.453/28,857 =18.90% b. Core profit margin = 6,121/28,857 = 21.21% cc. Core RNOA = 6,121/22,905 = 26.72% E128. Identification of Core Operating Profit Margins for Starbucks To reformulate the income statement to identify core income, first separate net financial income from ‘operating income, then separate core operating income from unusual items, then separate core operating, income from sales from other core income. Reformulated Comprehensive Income Statement Identifying Core Operating Income, 2007 {in millions) Net revenues $9,411.5 Cost of sales and occupancy costs 3,999.1 Store opening expenses 3,215.9 Other operating expenses 294.1 Depreciation and amortization 467.2 General and administrative expenses 489.2 Operating income from sales (before tax) 946.0 Tax reported $ 383.7 Tax benefit of net interest 5.6 Tax on other operating income (6.6) 382.7 Core O1 from sales (after tax) 5633 Equity income from investees (after tax) 108.9 Core operating income 6713 Unusual items, before-tax item Gain on asset sales 26.0 Other operating charges (8.9) 174 Tax at (38.4%) 66 105 Operating income, after tax-items Currency translation gains 307 Operating income (after tax) 7195 Net financing expenses Interest expense 38.2 Interest income {13.21 Net interest expense 185 Realized gain on financial assets 3.8) 14.7 Tax (at 38.4%) 5.6 e1 Unrealized loss on financial assets 20.4 29.5 Comprehensive income ‘The question only asked for calculations of operating income, but the Financing part ofthe statement is also prepared to calculate the tax benefit ($5.6 million) from financing activities to allocate to the operating activities. (You need only get tothe $5.6 million number.) Note that taxes have also been allocated between (caxable) unusual items and core operating income. The reformulated statement brings in the currency gains and losses from the equity statement (which isan unusual item). Unusual items also include items in “net interest and other income" hat are detailed inthe footnote. (Realized gains on availabe-for-sale investments are gains on financial assets often called “investments as i the footnote) ‘8. Core operating income from sales = $563.3 million 'b. Other core income = $108.0 million (this is income from sales in subsidiaries bu itis a net figure, that is, sales minus expenses) ©. Core operating profit margin from sales = $563.3 millon/S,=9.411.5 million = 5.99%. 4. Unusual items = $48.2 million First reformulate the statements, then carry out an analysis of profitability, followed up with an analysis of the changes in profitability 1. The reformulated statements: Reformulated Income Statements, 2005 and 2004 (S millions) 2005 2004 Net sales 73,094 Cost of sales 48. Gross profit 24,430 Selling and store operating costs 15,105 12,588 General and administrative 1,399 16,504 Operating income from sales, before tax 7,926 ‘Tax as reported 2,911 2,539 64,816 44.236 20,580 Tax benefit of net debt 5 2.916 Operating income from sales, after tax 5,010 Unusual operating income — currency gains 137 Operating income 5,147 Interest expense 70 62 Interest income _56 59 Net interest expense 14 3 Tax on net interest 5 1 Comprehensive income 5,138 Note: Currency translations gains are after tax (as are all items in other comprehensive income). The tax rates for the allocation of taxes were calculated as follows (from the solution for Exercise 9.10 in Chapter 10): The tax rate for the tax allocation is the marginal tax rate. The footnote gives the effecti rate (36.8% for 2005), which is the effective rate from the income statement (2,911/7,912 16.8%). But this, S not the marginal rate for it includes tax credits and foreign tax benefits, amongst other things. The marginal rate is the statutory rate, federal and state combined (with the state rate recognizing that state taxes are deductible in federal tax returns). The statutory tax rates are given in the Exercise. Reformulated Balance Sheets, 2003-2005 2005 2004 2003 Operating assets: Operating cash 50 50 50 Receivable 1,499 1,097 1,072 Inventories 10,076 9,076 8.338 Other current assets “450 303 254 PPE (net) 22,726 20,063, 17,168 Goodwill 1,994 833 875 Other assets 208 129 244 36428 EEG 27,701 Operating liabilities: ‘Accounts payable 5,766 5,189 4,560 ‘Accrued salaries 1,055, 801 809 Sales tax payable 412 419 307 Deferred revenue 1,546 1,281 998 Income tax payable 161 175 207 Other accrued taxes 1,878 4,210 4127 Deferred income tax 1,309 967 362 Other liabilities 763 653 491 72,590 70,665 EEG Net operating assets 23,833 20,886 18,820 Net financial obligations: Cash equivalents (458) (1,053) (2,138) Short-term investments (1,659) (1,749) (65) Notes receivable (369) (64) (107) ‘Current debt 1" 509 7 Long-term debt 2.148 856 1,924 (325) (i524) (282) ‘Common equity 24.158 22.407 19,802 Averages: Operating assets 33,987 29,626 Operating liabilities 9.773 Net operating assets 22,359 79,853 Net financial obligations (923) (1,282) ‘Common equity 23,282 21,105 2. The operating profitability analysis (as in the solution to Exercise E 11.8 in Chapter 11, modified to distinguish core profitability): 2005, 2008, ROCE 22.07% 21.21% RNOA 23.02% 22.56% PM 7.04% 6.91% ATO 3.269 3.265 PM XATO 23.02% 22.56% ‘Core RNOA 22.41% 21.69% UUNOA, 0.61% 0.87% Income statement ratios: Gross margin ratio. 93.42% 31.75% Selling expense ratio (20.67) (19.42) GBA expense ratio (1.91) 77) Operating PM before tax 10.84 10.56 Tax expernse ratio 3.99) 3.90) Core PM from sales 85% BEM Unusual operating income to sales 0.19 0.27 Operating PM 708% Bai Note that the income statement ratios agregate to the PM. Currency gains are unusual items (UD), outside core operating income. Turnover ratios (using average balance sheet amounts) 2005 2004 Asset turnover drivers ATO ATO. ATO ATO ‘Accounts receivable turnover 56.31 0.018 59.7 0.017 Inventory turnover 7.63 0.131 7.44 0.134 PPE turnover 3.42 0.293 3.48 0.287 Other asset turnover 42.53 0.024 53.17 0.019 Operating asset turnover 2.15 0.465 2.19 0.457 Accounts payable turnover “13.38 (0.075) “13.34 (0.075) Other liability turnover “11.86 0.084) 13.19 (0.076) Note that the sum of individual equals for all operating assets and liabilities. is the amount of the asset or liability that is put in place to support sales. ATO ARNOA = ACore RNOA + A(UUNOA) 0.46% The increase in RNOA of 0.46% in 2005 was due to an increase in core profitability of 0.72% and a drop in the profitability effect of currency changes of 0.26%. ACore RNOA = ACore PM x ATOscos) + (ATO x Core PMa00s) (0.21% x 3.269) + (0.004 x 6.85%) = 0.69% + 0.03% = 0.72% (allow for rounding error) The increase in core profitability of 0.72% was due to an increase in core profit margin of 0.69% and a 0.03% effect from the increase in ATO, The reasons for the increase in core PM and ATO can be discovered by comparing the 's in expense ratios and individual ATOs above t prepare the reformulated income statements to distinguish core operating income from sales, other core income, unusual items and net financial expenses: 1998 1997 Core operating revenues 8688 8514 Core operating expenses Personnel costs 3.101 3.179 Aviation fuel 23 805 Commissions 519 595 Aierafl rent 440 415 ther rent and landing fees 417 420 Airerafl maintenance 44s 451 ther selling expenses 342 346 Depreciation and amortization 318 401 Other 1.466 1258 ‘Total operating expenses, 7.674 7.930 Core operating income before tax 1014 584 ‘Tax as reported 364 353) Tax benelit of debt (38%)! 4B 56 ‘Tax on unusual items 1 _ 408 _@» _Gm Core operating income from sales 606 954 Other core income: equity income in affiliates 1 30 Core operating income 7 984 ‘Unusual items Other income “ 1B Gain on sale of interests in affiliates 0 180 @ 193 Less tax (38%) L 3 73) 120 Operating income 604 1,104 Net financial expenses Net interest 12 14s Tax effect (38%) 43 56 Cy 2 Preferred dividends 6 a oa __ 156 Net income, adjusted Notes: 1. Marginal tax rate is assumed to be 38%. 2. Gains on sale of securities may be taxed at a lower capital gains tax rate. 3. Net income and net interest are before capitalized interest. ($3million in 1998 and $13 million in 1997). (a) Explaining increase in before-tax operating income from $584 million to $1,014 million; standardizing for the increase in sales: 1998, 1997 AS a percentage of sales: Personnel costs 35.7 37.3 Fuel 72 95 ‘Commissions 60 70 ‘Aircraft rent 5 56 Other rent and landing fees 48 49 ‘Aircraft maintenance 52 33 Other selling expenses 39 41 Depreciation and amortization 37 47 Other expenses 169 168 ‘Total core operating expenses 88.5 932 Core PM before tax pik 6a 100.2 1001 Operating expenses as a percentage of sales declined in 1998; the largest declines were in personnel costs, commissions and depreciation and amortization. But “other expenses" (for which there is limited information) increased. Note that operating income, as reported, does ‘not include all components of operating income. Gains on sale of shares in operating affiliates are also ‘operating income. But reported operating income does identify core income (before tax). While core operating income increased before tax, it decreased after tax. ‘The after-tax decrease was due to negative taxes in 1997 (see below). One could classify the negative taxes in 1997 as an unusual item. (b) The dectine in net income (on an increase in before-tax operating income) can be explained as follows: © Transitory effect of negative taxes in 1997 Transitory gain on sale of shares of affiliates in 1997 Change in interest capitalization Decrease in "other income" Change in net financial expenses: a decrease in both after-tax net interest and preferred dividends. The negative taxes with positive income seems strange. This could be due to either: 1. Tax credits in 1997 from features of operations that are given credits; this is unlikely for an airline. 2. Changes in deferred taxes. The second reason was indeed the case. US Airways had accumulated tax benefits from operating losses in the year prior to 1997. In 1997 it determined that it was "more likely than not” that it would be able to utilize these tax benefits in the future. So it reduced its previous valuation allowance on deferred tax assets substantially. The calculation of 1997 tax expense, relative to 1996, was as follows (in thousands): 1997 1996 Current provision: Federal $ 100,879 $ 6423 State 7.680. 3,000 otal current provision 108.559 9.423 Deferred provision: Federal (406,571) - State 54.651 2,686 ‘Total deferred provision (461,222) 2,086 Provision (credit) for income taxes (352.663: $12,109 You see that taxes were assessed but the change in the deferred tax provision yielded negative taxes. ‘The accounting for the deferred tax asset in the exercise shows the change in the valuation allowance. The change of $642 million should be treated as a transitory item. Accordingly, the tax on core operating income would be calculated as follows: Tax on core operating income before unusual component (370) Change in valuation allowance 642 Core tax on operating income 272 (@) 1998 income is more indicative of future income: 1. Itis the more recent income year. 2. Ithas fewer transitory items E1211. Analysis of Effects of Operating Leverage: US (a) The fixed and variable operating cost breakdown is: Variable cost (VC) $3,636 million Fixed cost (FC) 4,038 One measure of operating leverage is FC=L11 vce Another measure is, OLEV 498 (b) change in core operating income = 4.98% That is, operating income will increase 4.98% for an increase in sales by 1%. This can be proofed: 1 increase in sales $86.88 million Variable cost (at 41.9%) 36.40 Contribution Margin 50.48 Additional contribution as a % of operating income = 28 4.98% (©) Breakeven occurs at the point where sales = fixed costs + variable costs, or where contribution margin equals fixed costs. As fixed costs are $4,038 million, that point is Breakeven = 4,038/0,581 = $6,950 million of sales \where 0.581 is the contribution margin ratio (contribution margin/sales).