TUTORIAL 5

1. As discussed in the chapter, abnormal earnings (AE) are

AEt = Xt − (re × BVt−1)

Where

Xt is the firm’s net income,

re is the cost of equity capital, and
BVt-1 is the book value of equity at time t − 1.

Required:
Solve the following problems:

Abnormal earnings (AEt) = Xt − (re × BVt−1).

1. If Xt is $5,000, re = 15%, and BVt-1 is $50,000, what is AEt?

AE = $5,000 − (0.15 × $50,000) = −$2,500.

2. If Xt is $25,000, re = 18%, and BVt-1 is $125,000, what is AEt?

AE = $25,000 − (0.18 × $125,000) = $2,500.

3. Assume the firm in requirement 2 can increase Xt to $30,000 by instituting some cost-
cutting measures. What is the new AEt?

AE = $30,000 − (0.18 × $125,000) = $7,500.

NOTE: Higher net income without additional investment (i.e., the same BVt-1) increases AE.

4. Assume the firm in requirement 2 can divest $25,000 of unproductive capital

with Xt falling by only $2,000. What is the new AEt?

AE = $23,000 − (0.18 × $100,000) = $5,000.

5. Assume the firm in requirement 2 can add a new division at a cost of $40,000, which will
increase Xt by $7,600 per year. Would adding the new division increase AEt?

AE = $32,600 − (0.18 × $165,000) = $2,900.

AE increases by $400 (from $2,500 to $2,900). Adding the division makes sense. The
new division earns a return of 19% ($7,600/$40,000), which is more than the firm’s 18%
required rate of return, so value is added, and the change in AE is positive.

6. Assume the firm in requirement 1 can add a new division at a cost of $25,000, which will
increase Xt by $3,500 per year. Would adding the new division increase AEt?

AE = $8,500 − (0.15 × $75,000) = −$2,750.

AE falls by $250. Adding the new division does not make sense. In essence, the new
division does not earn a high enough rate of return to justify investment. The new division
earns a return of 14% ($3,500/$25,000) which is less than the firm’s 15% required rate of
return, so value is lost, and the change in AE is negative.
2. Recent values of P0 (current stock price), X0 (current reported EPS), and r (equity cost of
capital) for Alpha Company follow:

P0 X0 r
$23.50 $1.47 0.150

Required: Compute Alpha’s NPVGO (net present value of future growth opportunities).

P0 = X0 / r + NPVGO

Rearranging terms yields:

NPVGO = P0 − X0 /r

NPVGO = $23.50 − ($1.47 ÷ 0.15) = $13.70

3. The price/earnings ratios of four companies from the same industry are:
Company P/E Ratio
Ingles Markets 7.9
Kroger 6.6
Sprouts Farmers Market 18.3
Weis Markets 17.4

Source: Based on closing stock prices on March 17, 2019, and trailing-twelve-months earnings per
share, both from Yahoo Finance.

Required:
What factors might explain the difference in the P/E ratios of these companies?

In general, price/earnings (P/E) ratios are inversely related to risk, and positively related to
growth opportunities and earnings quality.

These four firms are all from the same industry—grocery chains—so there is less variation in P/E
ratios among them.

• Sprouts Farmers Market has the highest P/E ratio of the grocery chains listed. It is
relatively small and rapidly expanding.

• It is unlikely that investors assign substantially different risk to any of these companies.
All are in the same industry and face similar economic conditions.

• Differences in earnings quality might also explain why the P/E ratios of these grocery
firms differ so much. However, within an industry, differences in earnings quality may be
less important to explaining differences in P/E ratios. That’s because firms in the same
industry tend to use similar financial reporting practices.

In sum, it is likely that investors believe the growth opportunities are greatest at Sprouts.
[P0 = X0 / r + NPVGO]; P/E = Po / EPS; Po = P/E X EPS
4. Exhibit 7.5 describes the key financial ratios Standard & Poor’s analysts use to assess credit
risk and assign credit ratings to industrial companies. Those same financial ratios for a single
company over time follow. The company was assigned a AAA credit rating three years earlier.

20X1 20X2
Q1 Q2 Q3 Q4 Q1 Q2
EBIT interest coverage 23.8 22.1 21.6 20.8 20.6 12.4
EBITDA interest coverage 25.3 26.4 25.6 23.2 22.9 16.5
FFO/Total debt (%) 167.8 150.8 130.7 128.4 80.2 76.2
Free operating cash flow/Total debt (%) 104.1 107.3 103.7 98.6 61.5 45.3
Total debt/EBITDA 0.2 0.2 0.2 0.6 0.8 1.0
Return on capital (%) 35.1 34.3 30.6 28.1 25.9 24.7
Total debt/Capital (%) 6.2 6.8 7.5 15.4 27.2 35.6

Required:

1. Did the company’s credit risk increase or decrease over these six quarters?
The company’s credit risk has increased since the first quarter of 20X1. At that time, the
company’s financial ratios were closest to the median values for AAA rated companies
(see Exhibit 7.5).

2. What credit rating should be assigned to the company as of Q2 in 20X2?

Standard & Poor’s analysts are likely to assign a credit rating of AA to the company that
quarter because its Q2 20X2 financial ratios are closest to the median values of other AA
rated companies.

3. Which is the quarter from the table above that Standard & Poor's would first consider
downgrading this company's credit rating?
There is a gradual deterioration in credit worthiness throughout 20X1, but the changes
are probably not large enough to warrant a ratings downgrade. This situation changes
beginning in the first quarter of 20X2 where:

- there are sharp declines in two important financial ratios (FFO/total debt and Free
operating cash flow/total debt)

- a sizable increase in Total debt/capital.

Credit risk deteriorates even further in the second quarter of 20X2. Standard & Poor’s analysts
might have concluded that the credit risk warning signs were strong enough in Q1 20X2 to
warrant a ratings downgrade. If not, then the downgrade would certainly occur in Q2 20X2.

5. The quarterly cash flows from operations for two technology companies are as
follows:

20X1 20X2
Q1 Q2 Q3 Q4 Q1
Firm 1 $ 451.2 $ 220.8 $ 703.5 $ 475.5 $ 601.2
Firm 2 $ 165.9 $ 240.7 $ 698.8 $ (91.8) $ (173.3)

Required:
Explain why Firm 2 has more credit risk than Firm 1.

▪ The quarterly operating cash flows of both firms fluctuate seasonally, i.e., operating cash
flow levels change from quarter to quarter and the changes are not all positive.

▪ Seasonal patterns in sales and operating cash flow are common in many industries, and
the cash flow volatility produced by seasonal sales is one of the contributors to increased
credit risk.

▪ In addition, Firm 2’s operating cash flows are lower than those of Firm 1 and are negative
in the two most recent quarters. These two features of Firm 2’s operating cash flow make
it a greater credit risk than Firm 1.

6. Halifax Products has a $1 million bank loan that comes due next year. Management has
prepared cash flow forecasts for each of the next six quarters, as shown in the table below. Planned
capital expenditures are intended to replace failing manufacturing equipment, upgrade computer
systems, and refurbish the company president’s office. These forecasts have been shared with the
bank loan officer responsible for overseeing the Halifax loan.

Y1Q1 Y1Q2 Y1Q3 Y1Q4 Y2Q1 Y2Q2

Scheduled loan payments $ 500,000 $500,000
Forecasted cash flows:
Cash from operations $ 200,000 $250,000 $ 300,000 $240,000 200,000 220,000
Capital expenditures (150,000) (150,000) (175,000)
Dividends to owners (50,000)
Required:

1. Explain why the loan officer might consider the Halifax loan to be of high credit risk.

▪ Scheduled loan payments over the next six quarters total $1,000,000.

▪ Operating cash flows are projected to total $1,410,000 over this same period, but
management also expects to pay out $50,000 in dividends and to spend $475,000 on
capital expenditures.

▪ Operating cash flows are insufficient by $115,000 to cover the scheduled debt and
dividend payments, and the planned capital expenditures.

▪ This projected net cash flow shortage is why the loan officer considers the Halifax loan to
be of high credit risk.

2. What steps can company management take to reduce the loan’s credit risk?

There are at least four steps management can take to reduce the loan’s credit risk:

(1) find ways to increase the projected cash from operations.

(2) reduced planned capital expenditures.
(3) eliminate the dividend payment; and
(4) generate cash from other sources (selling non-operating assets or issuing stock) or seek a
loan refinancing arrangement that postpones the scheduled debt payment.

3. What steps can the bank loan officer take to reduce the loan’s credit risk?

▪ Encourage management to find ways to increase the projected cash from operations,
and then monitor performance to ensure that the new and higher operating cash flow
projections are being achieved.

▪ If the loan terms allow, prohibit capital expenditures or dividend payments without bank
authorization. This approach allows the loan officer to intervene if operating cash flows
appear insufficient.