B8110, Fall 2009

Practice Exercise Set 1

Exercise 1. Cash Flow and Earnings: Kimberly-Clark Corporation

Kimberly-Clark Corporation (KMB) manufactures and markets consumer paper products

under brand names that include Kleenex, Scott, Cottonnelle, Viva, Kotex, and WypAll.
For fiscal-year 2004, the firm reported the following numbers (in millions):

Net income (in income statement) $1,800.2

Cash flow from operations (in cash flow statement) 2,969.6
Interest paid (in footnote to cash flow statement) 175.3
Interest income (from income statement) 17.9

The cash investment section of the 2004 cash statement was reported as follows (in
millions):
_____________________________________________________________________
Investing Activities:

Capital spending $ (535.0)

Investments in marketable debt securities ( 11.5)
Proceeds from sales of investments in marketable debt securities 38.0
Net increase in time deposits ( 22.9)
Proceeds from disposition of property 30.7
Other operating investments 5.3
Cash Used for Investing Activities $
(495.4)
______________________________________________________________________

The firm has a combined federal and state tax rate of 35.6 percent.

Calculate:

a. Free cash flow generated in 2004

b. The accrual component of 2004 net income
Exercise 2. Challenging the Level of the S& P 500 Index With Analysts’ Forecasts

The S&P 500 index stood at 1271 on August 1, 2006. Based on analysts’ consensus EPS
forecasts for 2006, the forward P/E ratio for the index was 15.0 at the time. Those same
analysts were giving the S&P 500 a PEG ratio of 1.47, based on forecasts for 2007. The
payout ratio for this portfolio of stocks was 27% at the time and investment banks
typically published estimates of the equity risk premium of 5% over the current 10-year
Treasury rate of 5%.

a. Calculate the abnormal earnings growth for 2007 that is implied by the
forecasts.

b. What should be the level of the S&P 500 if (cum-dividend) earnings are
forecasted to grow at 10 percent after the forward year? Why is the P/E
based on analysts forecasts different?

c. Setting the long-term abnormal earnings growth rate equal to 4% (the

average growth rate for GDP), what do analysts’ forecasts say about the
level of the S&P 500 index?

d. What conclusions can your draw from this analysis?

Exercise 3. Reverse Engineering the S&P 500 Index Using Rates Book Rates of
Return

At the current index level of 1271, the S&P 500 stocks trade at 2.5 times book value. On
most recent (2005) annual earnings, the stocks in the index earned a weighted average
return on their common equity of 18%. Use a required equity return of 10% for this
“market portfolio.”

a. Calculate the residual earnings growth rate that the market is forecasting for
these stocks.

b. Suppose you forecast that a return on common equity of 18% will be

sustained in the future. What is the growth in the net assets that you would
then forecast at the current level of the index?

c. Do you know what the average historical return on equity (since 1960) has
been for U.S. stocks?

d. Do you know what the median historical price-to-book ratio (since 1960) has
been for U.S. stocks?
Exercise 4. Forecasting from market prices: Cisco Systems

In September 2003, Cisco Systems Inc. (CSCO) was trading at 31.25 times forward
earnings (for fiscal year ending July 2004) of $0.64 per share. Analysts were also
forecasting eps of $0.74 for 2005. The firm pays no dividends. Use a cost of equity
capital of 9% in all calculations.

a. Go to the firm’s 10-K for fiscal year ending July 2003 on the SEC’s EDGAR site
and calculate Cisco’s book value per share. Then calculate the price-to-book ratio
at which Cisco’s shares were trading in September 2003. The course web site
provides links to the SEC site.

b. Forecast residual earnings (RE) for 2004 and 2005 from the analysts’ forecasts.

c. Given the market accepts the analysts’ forecasts for 2004 and 2005, what was the
markets’ implicit forecast of growth in residual earnings for 2006 and beyond?

d. What eps was the market forecasting for 2006?

e. From the eps forecasts you now have for 2004-2006, calculate expected abnormal
earnings growth (AEG) for 2005 and 2006.

f. What abnormal earnings growth rate is implied by the market price for years after
2006?

g. Show that expected abnormal earnings growth (AEG) for 2005 and 2006 is equal
to the change in residual earnings for those years.

h. What cum-dividend growth rates in earnings per share was the market forecasting
for 2005 and 2006?

i. Based on your analysis, would you buy a Cisco share at 31.25 times forward
earnings in September 2003? Qualify you answer as much as you wish.
Exercise 5. Inferring Implied EPS Growth Rates: Kimberly-Clark Corporation

In March 2005, analysts were forecasting consensus earnings per share for Kimberly
Clark (KMB) of $3.81 for fiscal year ending December 31, 2005 and $4.14 for 2006, up
from $3.64 for 2004. KMB traded at $64.81 per share at the time. The firm paid a
dividend of $1.60 in 2004 and a dividend of $1.80 was indicated for 2005, with dividends
growing at 9 percent a year for the five years thereafter. Use a required return of 8.9
percent for the following calculations. (Ignore the fact the price is not exactly at fiscal
year end.)

a. Calculate the trailing and forward P/E ratio in March 2005. Also calculate the
normal trailing and forward P/E for KMB.
b. Calculate the market’s implied growth rate for abnormal earnings growth (AEG)
after 2006.
c. What are the earnings-per-share growth rates that the market was forecasting for
the years 2007-2010?
d. Analysts were forecasting an EPS growth rate of 8.0 percent per year over these
years. What do you conclude from the comparison of these growth rates with
those you calculated in part c of the exercise?
e. Analyst average buy/hold/sell recommendation, on a scale of 1 – 5 (with 5 being a
strong buy), was 2.6. Is this rating supported by their forecasts?