Answers - Reading 14 Financial Statement Modeling

Question #1 of 26 Question ID: 1472687 Deluxe Toys Inc. produces electronic toys for 2-12 year olds. Ben Sharpe, Analyst with AP Partners, is forecasting Deluxe's operating profit for the next fiscal year. Sharpe notices that Deluxe's selling expenses have increased from 5% of sales to 8% of sales over last few years. This is most likely to be due to the force(s) of: A) Intra-industry rivalry and threat of vertical integration. B) Threat of new entrants and bargaining power of buyers. C) Intra-industry rivalry and threat of substitutes. Explanation Increased selling expenses are consistent with an investment in building brand loyalty, which is an appropriate response to a threat of substitutes and intra-industry competition. By spending more on advertising, Deluxe can build brand loyalty, thus improving its competitive position versus rival toy makers and alternative products. (Module 14.2, LOS 14.i) Question #2 of 26 Question ID: 1472682 Everystate Corporation reports Long-term debt of $3,398 and $3,658 respectively for the year ended Dec 31 2016 and 2015 respectively. Everystate reported an interest expense of $295 and $292 for the years ended 2016 and 2015 respectively. Everystate's interest rate on average gross debt is closest to: A) 8.53% B) 8.68% C) 8.36% Explanation Average gross debt = (3,398 + 3,658)/2 = $3,528 Interest rate = 2016 interest / average debt = 295/3528 = 8.36% (Module 14.1, LOS 14.d) Question #3 of 26 Question ID: 1472697 Deluxe Toys Inc. produces electronic toys for 2-12 year olds. The most-recent income statement for Deluxe is given below: Revenues 1500 Cost of goods sold 630 Selling expenses 120 Administrative expense 330 Operating profit 420 Ben Sharpe, Analyst with AP Partners, is forecasting Deluxe's operating profit for the next fiscal year. Sharpe believes that a new sales tax of 10% is going to be imposed on electronic toys. Sharpe also believes that cost of goods sold will remain the same per unit sold. Selling expenses are a fixed percentage of sales, while administrative expenses are fixed. Deluxe is expected to pass on the entire cost of the sales tax to the consumer. The price elasticity of demand for Deluxe's toys is 0.75 (e.g., volume will decrease by 7.5% when the effective price increases by 10%.) Forecasted operating margin for the next year is closest to: A) 26% B) 21% C) 23% Explanation New sales (including tax) = 1500 × (1 – 0.075) × (1 + 0.10) = 1526.25 Sales tax = (1526.25 / 1.10) × 10% = 138.75 Net sales = 1387.50 Due to 7.5% reduction in units sold, COGS will decline to 630 × (1 – 0.075) = 582.75 Selling expenses currently are 8% of sales. New selling expense = 1526.25 × 0.08 = 122.10 Administrative expenses are fixed at 330. Operating profit = 1387.50 – 582.75 – 122.10 – 330 = $352.65, which is 23.11% of $1526.25. (Module 14.2, LOS 14.l) Question #4 of 26 Question ID: 1472695 Jared Mush is preparing a report on the Everystate corporation. The information below pertains to the year ending 31 December 2015 and 2016. Property-Liability Dec. Dec. 31,2016 31,2015 32,567 31,309 Everystate Financial 3,928 4,309 Corporate and Other 39 35 $ 36,534 $ 35,618 Consolidated revenues Mush believes that for 2017, the growth rate in property/liability is 3%, financial is 2% and corporate and other is 0. The estimated revenues for 2017 is closest to: A) $37,590 B) $38,230 C) $36,678 Explanation 2017 Forecast Property-Liability Dec. 31, 2016 33,544 32,567 Everystate Financial 4,007 3,928 Corporate and Other 39 39 $ 37,590 $ 36,534 Consolidated revenues (Module 14.2, LOS 14.k) Question #5 of 26 Question ID: 1472688 Kerry Winstone covers TVStream Inc., a U.S. based company offering streaming video. She has carried out an analysis using Porter's five forces model. The table below summarizes her main conclusions. Force Threat of substitutes Rivalry Factors Broadcast TV and DVD media are cost-effective substitutes. There are several companies in the industry and TVStream has a 25% market share. Bargaining power of The content must be purchased from the major networks suppliers and movie studios. Bargaining powers of Customers are fragmented and the base consists largely of buyers individual subscribers. Threat of new entrants Major TV networks are in position to launch their own streaming service using existing technologies. Winstone should most appropriately conclude that: A) B) C) TVStream is likely to have a large degree of pricing power and above average profitability due to favorable bargaining power of suppliers TVStream is likely to have a high degree of pricing power derived largely from high barriers to entry. TVStream is unlikely to have a large degree of pricing power and below average profitability due to threat of new entrants. Explanation Force Factors Condition Threat of substitutes Broadcast TV and DVD media are costeffective substitutes. Rivalry There are several companies in the industry Neutral and TVStream has a 25% market share. Bargaining power of suppliers The content must be purchased from the major networks and movie studios. Unfavorable Bargaining powers of buyers Customers are fragmented and the base consists largely of individual subscribers. Favorable Threat of new entrants Major TV networks are in position to launch their own streaming service using existing Unfavorable technologies. Unfavorable There is clearly a high threat of new entrants and high bargaining power of suppliers, both of which make the industry relatively unattractive. (Module 14.2, LOS 14.j) Question #6 of 26 Question ID: 1472694 Davide Andreu is concerned about the possible impact of inflation on two German retailers that he covers in his equity analyst role. Andreu has used last year's financials to produce common size income statements for the two retailers as shown below. Tooboola GmbH Sales Portentona GmbH 100% 100% Cost of Goods Sold 38% 48% Gross Margin 62% 52% Sales, General & Admin 40% 20% 5% 15% 17% 17% Depreciation Operating Margin Andreu is forecasting inflation of 10% in cost of goods sold for both companies due to large increases in commodity prices in the next period. Due to the fragile state of the economic recovery does not expect either company to be able to pass these costs on to consumers. Sales, general and admin costs are likely to rise by 5% and accounting depreciation will be unaffected. If Andreu's forecasts are correct, which of the following statements is least accurate? A) The forecasted operating margins will be equal for Tooboola and Portentona. B) Both companies will experience the same decrease in gross margin. C) Tooboola has a larger forecasted gross margin than Portentona. Explanation Tooboola Tooboola Forecast Portentona Portentona Forecast 100% 100% 100% 100% Cost of Goods Sold (x1.10) 38% 41.8% 48% 52.8% Gross Margin 62% 58.2% 52% 47.2% SG&A (x1.05) 40% 42.0% 20% 21.0% Depreciation 5% 5.0% 15% 15.0% 17% 11.2% 17% 11.2% Sales Operating Margin Tooboola's gross margin drops 3.8% to 58.2%. This is a relative drop of 6.1%. Portentona's gross margin drops 4.8% to 47.2%. This is a relative drop of 9.2%. (Module 14.2, LOS 14.k) Question #7 of 26 Question ID: 1472677 Victor Mendoza is an equity analyst for LLT Partners, a private wealth management firm. Mendoza is currently valuing Testo Inc, a seller of smart phones. While reviewing the financials, Mendoza collects sales information of two of Testo's popular models as indicated below (figures in $ millions): Year 20x1 20X2 20X3 Alpinex 88.9 92.3 97.5 Bemax 0 54 433 What percentage of combined growth in 20X3 is due to Bemax? A) 54% B) 99% C) 79% Explanation Combined sales for 20X2 = 92.3 + 54 = 146.3 Combined sales for 20X3 = 97.5 + 433 = 530.5 Increase in sales for both products in 20X3 = 530.5 – 146.3 = $384.20 Increase in sales for Bemax = 433 – 54 = $ 379 Percentage of combined growth attributable to Bemax = 379/384.20 = 98.65% (Module 14.1, LOS 14.a) Question #8 of 26 Question ID: 1472696 PixOut Inc. is a U.S. based manufacturer of waterproof cameras. PixOut's products are typically used by leisure customers wishing to use a camera for snorkeling and deep-sea diving. The cameras come in at a reasonable price point and are aimed primarily at the 'point and shoot' market. Recently, a rival manufacturer has brought an extremely cheap waterproof case for smart phones to the market, and this is having a definite impact on PixOut's sales. Torsten Gruber is forecasting the impact the phone cover may have on PixOut's revenue next year. Gruber's predicted sales figures in units are shown below: 2014E PixOut cameras sold (units) 42,505 Sales of smart phone covers (units) 11,044 Gruber is assuming that a percentage of the phone cover sales have cannibalized PixOut camera sales. In predicting the sales for 2014, he is assuming a 25% cannibalization rate. In addition, he forecasts the average selling price of a PixOut camera is $185 and the average selling price of the smart phone cover is $80. Which of the following is closest to Gruber's estimate of the revenue lost by PixOut due to cannibalization in 2014? A) $510,785. B) $265,056. C) $5,898,000. Explanation Number of phone covers sold 11,044 Cannibalization rate 25% Number of camera sales lost 11,044 × 25% = 2,761 Revenue lost 2,761 × $185 = $510,785 (Module 14.2, LOS 14.l) Question #9 of 26 Question ID: 1472701 Jared Mush is preparing a report on the Everystate corporation. The information below pertains to the year ending 31 December 2015 and 2016. Property-Liability Dec. 31, Dec. 31, 2016 2015 32,567 31,309 Everystate Financial 3,928 4,309 Corporate and Other 39 35 $ 36,534 $ 35,618 Consolidated revenues Mush's growth forecast for 2017 is 3% for property/liability, 0% for financial and 2% for corporate and other. Also, Mush estimates that EBIT margins for the three divisions are 17%, 18% and 23% respectively. Forecasted 2017 EBIT is closest to: A) $6,400 B) $5,700 C) $6,200 Explanation Dec. 31, 2016 Property-Liability 2017 Forecast 2017 EBIT 32,567 33,544 5,702.48 Everystate Financial 3,928 3,928 707.04 Corporate and Other 39 40 9.15 $ 36,534 $ 37,512 $ 6,419 Consolidated revenues Forecast revenue for Property-liability = 1.03 × 32,567 = $33,544 Forecast EBIT for property-liability = 0.17 × 33,544 = 5,702.48 (Module 14.2, LOS 14.g) Question #10 of 26 Question ID: 1472679 Victor Mendoza is an equity analyst for LLT Partners, a private wealth management firm. Mendoza is currently valuing Testo Inc, a seller of smart phones. While reviewing the financials, Mendoza collects sales information of two of Testo's popular models as indicated below (figures in $ millions): Year 20x1 20X2 20X3 Alpinex 88.9 92.3 97.5 Bemax 0 54 433 Mendoza believes that in 20X4 the combined growth rate of Alpinex and Bemax will slow to 30%. Mendoza also believes that Bemax's share of revenue will grow to 90%. The estimated level of sales for Bemax based on Mendoza's assumptions is closest to: A) $621 million B) $563 million C) $507 million Explanation Combined sales for 20X3 = (97.5 + 433) × (1.30) = $690 Bemax's share = 0.90 × 690 = $620.69 (Module 14.1, LOS 14.b) Question #11 of 26 Question ID: 1472676 Victor Mendoza is an equity analyst for LLT Partners, a private wealth management firm. Mendoza is currently valuing Testo Inc, a seller of smart phones. While reviewing the financials, Mendoza collects sales information of two of Testo's popular models as indicated below (figures in $ millions): Year 20x1 20X2 20X3 Alpinex 88.9 92.3 97.5 Bemax 0 54 433 The annual growth rate for both models combined from 20x1 to 20x3 is closest to: A) 144% B) 496% C) 44% Explanation Combined sales in 20X1 = 88.9. Combined sales in 20X3 = 97.5 + 433 = 530.5. Annual growth rate = [530.5 / 88.9]1/2 -1 = 1.44 or 144% (Module 14.1, LOS 14.a) Janet Smith has gathered the following information for the Power Tools Manufacturer market in the U.S. and this is part of the first phase of analyzing the businesses in the industry. The following issues are relevant: 1. Raw material and component purchases consist mainly of plastics (for casing) and motors (for power). Some hardened steel is required to make drills and bits. 2. Access to a reliable and efficient source of supply is critical, especially with regard to the electric motor. 3. Two manufacturers in the U.S. produce over 90% of the electric motors for the U.S. markets. 4. Workers in the industry have a strong and well-organized union. As a result, the rate of compensation growth is a cause for concern, as is the associated health and pension benefits accruing to the work force. 5. Industry revenues have tended to track the fluctuations of the wider economy. 6. Sales growth in the industry has been 5% compounded annually over the past eight years. 7. Non-U.S. sales grew 10% compounded annually over the last eight years. 8. The rate of growth in home ownership and new home starts is directly related to the future volumes of power tool sales. 9. The three largest global producers of power tools control 80% of the U.S. markets, down from 85% five years ago. 10. Economies of scales are critical to efficient and cost effective use of manufacturing resources. 11. High capital expenditure is required to maintain plant and equipment. 12. The major areas for competition for all the manufacturers are price and delivery times, these are the critical areas of concern for the major retail outlets. 13. China has become the third largest global market for power tools, and significant production facilities in this market have led to the potential for major export growth to the U.S. In other industries, Chinese producers have been able to match and often better local producers on price and delivery times. 14. 75% of sales in the U.S. market are made through 12 major retail chains. They are always looking for ways to reduce the price they pay to manufacturers. 15. Sales of power tools is highly seasonal due to customer buying patterns often related to the weather. 16. Consumers are looking for value for money but surveys indicate that they are not only looking for the lowest price. They do value quality and surprisingly the look of the product is more important than many thought. 17. Taking a broad view of the markets, it is difficult to envisage alternative products and technologies playing a significant role in the development of the market for the foreseeable future. Question #12 - 15 of 26 Question ID: 1472690 Which of the following is the most accurate statement with regard to the bargaining power of buyers? A) This force is strong due to comment (14). B) This force is strong due to comment (16). C) This force is weak due to comment (13). Explanation Strong as per statements (14). (Module 14.2, LOS 14.j) Question #13 - 15 of 26 Question ID: 1472691 Which of the following is the most accurate statement with regard to the bargaining power of suppliers? A) This force is weak due to (2), (3), and (4). B) This force is strong due to comments (2), (3), and (4). C) This force is average due to (2), (3), and (4). Explanation Strong as per statements (2), (3), and (4). (Module 14.2, LOS 14.j) Question #14 - 15 of 26 Question ID: 1472692 Which of the following is the most accurate statement with regard to the threat of new entrants? A) This force is strong due to comments (10) and (11) . B) This force is weak due to comments (10) and (11). C) This force is average due to comments (10), (11), and (13). Explanation Average as statements (10) and (11) reduce the strength and (13) increases it. (Module 14.2, LOS 14.j) Question #15 - 15 of 26 Question ID: 1472693 Which of the following is the most accurate statement with regard to the availability of substitute products? A) This force is weak due to comment (16). B) This force is strong due to comment (17). C) This force is weak due to comment (17). Explanation Weak as per statement (17). (Module 14.2, LOS 14.j) Question #16 of 26 Question ID: 1472678 Ben Lorson is analyzing the revenue growth of Symphonica Inc., a retailer of audio visual equipment. Relevant data for the last two years is shown below: Revenue Total market size Nominal GDP growth 2013 2012 $ millions $ millions 1,408 1,375 17,606 17,450 $ billions $ billions 16,451 16,400 He is looking at three methods of predicting revenue for 2014: 1. Assume that Symphonica retains its 2013 share of the market for 2014, and the total market grows at the same rate as it did last year. 2. Assume that revenue growth rate is equal to previous year's nominal GDP growth rate. 3. A bottom-up approach which assumes that the growth rate of Symphonica's revenue will be the same as last year Which of the following statements regarding Lorson's forecast is most accurate? A) Lorson’s market growth and market share model predicts a higher 2014 revenue figure for Symphonica than his bottom-up approach. B) Lorson’s bottom-up approach predicts the highest revenue for 2014. C) Lorson’s growth relative to GDP growth model predicts a higher 2014 revenue figure for Symphonica than his market growth and market share model. Explanation Market growth and market share approach (method 1) 2013 market share 1,408/17,606 = 8.00% 2013 total market growth 17,606/17,450 − 1 = 0.89% 2014 total market 17,606 × 1.0089 = 17,763 2014 revenue Symphonica 17,763 × 8.00% = 1,421 (Alternatively, as market share is static, revenue growth = market growth = 0.89%) Growth relative to GDP model (method 2) 2013 nominal GDP growth 16,451/16,400 − 1 = 0.31% 2014 revenue Symphonica 1,408 × 1.0032 = 1,412 Bottom-up (method 3) 2013 revenue growth 1,408/1,375 − 1 = 2.4% 2014 revenue Symphonica 1,408 × 1.024 = 1,442 (Module 14.1, LOS 14.b) Question #17 of 26 Question ID: 1472680 When comparing a large company with a much smaller company, which of the following statements regarding economies of scale is most accurate? A) B) C) An analyst will conclude that economies of scale are present in the industry if the larger company has higher revenues and higher gross profit. An analyst will conclude that economies of scale are present in the industry if the larger company has higher revenues and a higher gross profit margin. An analyst will conclude that economies of scale are present in the industry if the smaller company has a higher gross margin and lower revenues. Explanation Economies of scale are evidenced by larger companies displaying larger gross margins. Having a larger revenue figure and a larger gross profit does not necessarily imply a larger margin. (Module 14.1, LOS 14.c) Question #18 of 26 Question ID: 1472684 Question #18 of 26 Question ID: 1472684 Rapid Tech Inc has mistakenly overestimated the useful lives of their PP&E: it has become apparent that due to rapid changes in technology, a significant part of Rapid's PP&E will need to be replaced sooner than anticipated. Rapid's CFO has indicated that the new depreciation schedules will take into account the shortened lives of the PP&E that will be acquired as replacement. The most likely impact on Rapid's future return on invested capital (ROIC) is that ROIC will: A) decrease. B) remain the same. C) increase. Explanation Increases in PP&E will increase invested capital, while higher depreciation expense will reduce earnings. Both factors will reduce the return on invested capital. (Module 14.1, LOS 14.d) Question #19 of 26 Question ID: 1472686 Which of the following statements regarding pricing power is most accurate? A company is most likely to have a high level of pricing power, if it is operating in an industry that: A) is fragmented. B) has low barriers to exit. C) has high fixed costs. Explanation Pricing power is most likely to be low in industries that are fragmented, have limited growth potential, have high barriers to exit, have high fixed costs, and in industries where the product offerings are essentially identical. (Module 14.2, LOS 14.i) Question #20 of 26 Question ID: 1472698 Yolanda Resham is currently developing a forecast horizon for several companies that she covers in her role as an equity analyst. The equities under consideration are part of a portfolio with an average annual turnover of 25%. Which of the following statements is least accurate regarding the choice of time horizon? A) Cyclicality should be considered when developing the timeframe. B) The time horizon should be independent of the average holding period for a stock. C) A time horizon of 4 years would be consistent with the portfolio turnover. Explanation The holding period should be considered. An average annual turnover of 25% is consistent with a holding period of 4 years (1/0.25). (Module 14.2, LOS 14.m) Question #21 of 26 Question ID: 1472699 When an analyst is developing long term projections of earnings for a company, which of the following statements is least accurate? A) B) C) A perpetuity should only be used if the analyst does not anticipate any inflection points occurring in the industry or economic environment. When forecasting long term earnings for a highly cyclical company, an expected mid-cycle level of earnings should be used. Earnings projections should be based on the most recent earnings for growing companies as it reflects the current state of the economy. Explanation The most recent earnings figure may not sustainable. Even growing companies may face a downturn due to changes in the industry. The most recent data is not necessarily the most appropriate. (Module 14.2, LOS 14.n) Question #22 of 26 Question ID: 1472700 Dan Partrino is currently constructing pro-forma accounts for Rooling Inc., an engineering company based in the U.S. He has put together the following forecast for the next 3 years: 2013 2014E 2015E 2016E $millions $millions $millions $millions Sales 935 954 973 993 PPE (NVB) 295 239 253 278 95 107 130 EBITDA Net Income for year Partrino is now forecasting the balance sheet and intends to use the following assumptions: Capital expenditure will remain constant at 2.5% of sales for the foreseeable future. Depreciation will be 1.5% of sales in 2014, 1.7% of sales in 2015 and 1.9% of sales in 2016. Partrino's forecast of the net book value of PPE at the end of 2016 is closest to: A) $318 million. B) $304 million. C) $325 million. Explanation Sales 2013 2014E 2015E 2016E $millions $millions $millions $millions 935 954 973 993 2.5% 2.5% 2.5% 24 24 25 1.5% 1.7% 1.9% 14 17 19 305 312 318 Capex (% sales) Capex ($m) Depreciation (% sales) Depreciation ($m) Net PPE (Module 14.2, LOS 14.g) 295 Question #23 of 26 Question ID: 1472675 Garcia Mendoza is currently forecasting revenue for Remnicky Inc., a global provider of sports statistics to broadcasters. Mendoza is forecasting that Remnicky's revenue growth rate will be 100bps (1%) higher than global nominal GDP rate next year due to an increased interest in tracking statistics worldwide. In consultation with his economic research department, Mendoza has predicted that the real global GDP will grow at 1% next year, before flattening out and showing zero growth for the next 4 years. Inflation is predicted to remain steady at 1.5% for the next 5 years. Which of the following statements about Mendoza's forecast for next year is most accurate? A) Mendoza is forecasting growth of using a 3.5% top-down approach. B) Mendoza is forecasting growth of using 2.5% a top-down approach. C) Mendoza is forecasting growth of 3.5% using a hybrid approach. Explanation Mendoza is using a top-down approach as he is modeling revenue by starting with a forecast of the entire economy. The predicted growth rate is 1% higher than nominal GDP rate = 1% + 1.5% + 1% = 3.5%. (Module 14.1, LOS 14.a) Question #24 of 26 Question ID: 1472685 For the purpose of forecasting proforma financial statements, which of the following statements is most accurate? A) B) C) Forecasted capital expenditure is usually based on historic information whereas forecasted depreciation rates are usually based on forecasted data. Forecasted depreciation rates are usually based on historic information whereas forecasted capital expenditure is usually based on forecasted data. Forecasted depreciation rates and capital expenditure are usually based on forecasted data. Explanation Depreciation rates are usually taken from historic disclosures regarding rates used in prior periods. Capital expenditure is usually forecast using analysts' judgment regarding future needs for PPE. (Module 14.1, LOS 14.f) Question #25 of 26 Question ID: 1472681 Roy Banstaza is forecasting 2014 SG&A expenses for Compuland Inc., a provider of online and live basic computing classes in the U.S. Relevant figures for the last 3 years for Compuland are given below: 2011 2012 2013 $ 000's $ 000's $ 000's 20,050 20,062 20,155 5,212 5,218 5,240 $ $ $ 225 220 218 Revenue SG&A Revenue per customer Banstaza is forecasting a 2% fall in SG&A per customer in 2014 compared to 2013 due to an improved online ordering and invoicing system that Compuland has adopted. He also anticipates that the number of customers will continue to grow at the cumulative average growth rate that Compuland has experienced over the last two years. Which of the following is closest to Banstaza's forecasted SG&A expense for 2014? A) $5,231,000.00 B) $5,328,000.00 C) $5,337,000.00 Explanation Number of customers 2011 = $20,050,000/$225 = 89,111 Number of customers 2013 = $20,155,000/$218 = 92,454 SG&A per customer 2013 = $5,240,000/92,454 = $56.68 CAGR customers using past two years = (92,454/89,111)½ − 1 = 1.86% Forecasted number of customers 2014 = 92,454 × 1.0186 = 94,172 Forecasted SG&A per customer 2014 = $56.68 × (1 − 0.02) = $55.54 Forecasted SG&A 2014 = $55.54 × 94,172 = $5,230,637 (Module 14.1, LOS 14.d) Question #26 of 26 Question ID: 1472683 Cynbo Industries Limited operates in two countries Mazat and Napat. The effective tax rates of Cynbo's operations in Mazat and Napat are 15% and 22% respectively. For the most recent fiscal year, Cynbo reported profit before tax of $350 and $200 for Mazat and Napat respectively. For the next year, it is expected that Cynbo's profit will grow at 5% and 8% for Mazat and Napat respectively. The effective tax rate for Cynbo for the next fiscal year is closest to: A) 18.5% B) 17.6% C) 19.4% Explanation Given the growth forecasts, Cynbo's forecasted profit before tax, taxes and profit after tax are 583.50, 102.65, and 480.86 respectively. Effective tax rate = 102.65/583.50 = 17.60% Current PBT Growth Rate Mazat 350 5% 367.50 15% 55.13 312.38 Napat 200 8% 216.00 22% 47.52 168.48 Total 550 102.65 480.86 (Module 14.1, LOS 14.d) E(PBT) 583.50 Tax Rate Tax EAT