MT examination‐ solution‐ FSA 

Q.2

1. Company issues more preferred stock and uses proceeds to reduce accounts payable
i. RNOA is unaffected as total assets do not change, and income from operations is
unchanged
ii. ROCE will decrease. Net income is unchanged, but preferred dividends will increase thus
decreasing the amount available for distribution to common stockholders. Common equity
will also decrease but numerator effect will dominate normally
iii. Earnings per share will decrease as there is less earnings per common shareholder
2. Company has a stock split
i. RNOA will be unchanged. All that has changed is that the number of shares outstanding ii.
has increased
ii. ROCE will be unchanged. See above.
iii. Earnings per share will decrease as there are now more shares outstanding
3. Company converts to just-in-time inventory system (JIT). This allows them to hold half the
levels of inventory for the same amount of sales (sales themselves are not increased by this
change to JIT). RNOA will be increased. The numerator will not be changed but net
operating assets will decrease. (Note in reality operating income may well increase due to
savings on insurance, storage costs, decreased obsolescence, etc.)
i. ROCE will increase for reasons cited above
ii. Earnings per share will stay the same.

Q. 3 Balance sheet: 

  Operating cash                     $    23 

  Accounts receivable             1,827 

  Inventory              2,876 

  PPE                3,567 

  Operating assets            8,293 

  Operating liabilities: 

  Accounts payable      $1,245 

  Accrued expenses        1,549 

  Deferred taxes             712     3,506 

  Net operating assets            4,787 

  Net financial obligations: 

  Cash equivalents      $(435) 

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  Long‐term debt      3,678 

  Preferred stock         432     3,675    

  Common shareholders’ equity                         $1,112 

Income statement: 

    Revenue          $7,493 

    Operating expenses          6,321   

    Operating income before tax        1,172   

                        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 

     

Comprehensive Income      630 
 

Q. 4. a.The treasurer would run through the following calculation to find the cash surplus or
deficit:

Cash flow from operations $ 23.4 billion

Cash investment 3.2
Free cash flow 20.2
Interest receipts $702 million
Taxes 253 0.449
Cash available to shareholders 20.649

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 Net payout to shareholders:
Stock repurchase 40.0 billion
Dividends 4.7
Share issued (2.5) 42.200

Cash surplus (21.551)

As the surplus is actually a cash shortfall, the treasurer must sell debt. He or she does so by
selling part of the $23.7 billion in financial assets on hand.

b. In the treasurer’s plan, $4.2 billion would be added to cash investments:

Cash flow from operations $ 23.4 billion

Cash investment (3.2 + 4.2) 7.4
Free cash flow 16.0
Interest receipts $702 million
Taxes 253 0.449
Cash available to shareholders 16.449

Net payout to shareholders:

Stock repurchase 40.0 billion
Dividends 4.7
Share issued (2.5) 42.200

Cash surplus (25.751)

Now the treasurer must liquidate more of the $23.7 billion in financial assets on hand.

c. With almost all of its financial assets of $23.7 billion distributed, under these scenarios,
Microsoft might need cash for further stock repurchases, dividends, or investments in
operations.
 

Q.No.5 A 

a. Calculate Microsoft’s return on common equity (ROCE) for 2004.

ROCE = 7.4/64.9 = 11.40%

b. Holding all else constant what would Microsoft’s ROCE be after the
payout of $34 billion?

Income statement after payout

OI 6.30 (As before: 7.4 – 1.1 = 6.3)

NFI (15 × 0.0224) 0.34 (NFA = 49 – 34 = 15)
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Comp. income 6.64 (Rate of return = 1.1/49 = 0.0224)
CSE = 64.9 – 34.0 = 30.9
ROCE = 6.64/30.9 = 21.49%

Also, with new FLEV of – 0.485,

ROCE = 39.62 (– 0.485 × (39.62 – 2.24))
= 21.49%

c. Would you expect the payout to increase or decrease earnings

growth in the future? Why?

Increasing leverage always increases expected earnings growth. The

payout increases leverage (in this case, it makes the leverage less
negative).

5 (B) 

 
 

6(A)   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  25
            increase the ATO to  = 6.59. 
20  2

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  With a profit margin of 1.5%, the RNOA would be: 

    RNOA  = 1.5%  6.59 

      = 9.89% 

  The current RNOA is: 

    RNOA  = 1.6%  6.0 

      = 9.6% 

  So the membership program would increase RNOA slightly. 

6.(B) 

General Mills is more typical with more financing debt than debt assets held. Thus it is a net
debtor. The financing strategy involves taking on leverage through borrowing. The firm has
$18.431 billion in operating assets to finance, with considerable investment in land, building,
and equipment and intangible assets. It also has invested a considerable amount in acquisitions,
as indicated by the $6.768 billion goodwill number. With $5.584 billion in operating liabilities,
net operating assets stands at $12,847 billion, of which about half is financed by borrowing and
half by common shareholders plus small minority interests in subsidiaries. Note that minority
interest in a subsidiary is not a financing obligation but rather an equity share that shares in the
subsidiary with the common shareholders at General Mills. Net financial assets (“cash”) are
also strategic assets. Current portion of debt is reduced significantly (by $1292 millions) while
long term debt increases by $1131 Millions, indicating that the firm switching from short term
debt to long term debt.
Reformulated income statements and balance sheets are designed to identify the value added
to strategic balance sheets. The focus is on the operating activities, for that is where the firm
trades with customers and suppliers to add value. We calculated residual earnings for the equity
(we can identify residual earnings from the operating components of the shareholder’s equity).
The value-added measure is referred to as residual operating income (ReOI). It is calculated as
Residual operating incomet= Operating incomet - (Required return x Net operating asset t-1)

RI (2008) = 1901-0.09*12247= 799

RI (2007) = 1602-0.09*5360= 1119.60

Over the periods it is found that RI is decreasing, though operating income increases from 1602
million in 2007 to 1901 million in 2008. That is attributable to some unusual low NOA for
2006.
 

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