Q1. What inference do you draw from the trends in the free cash flow of the company?

Ans. Firstly, the Free Cash Flow is a Non-GAAP financial measure computed by the company to
determine the actual funds available in Cash to repay their maturing debts, revise their dividend
policy or fund other uses of Capital that would maximize shareholder’s wealth.

The Free Cash Flow (FCF) as computed by the company in Page 18 of the 10K 2009-10
highlights that the total FCF has increased from $21million to $806million, which is an increase
of $785million, i.e. around an increase of 37.38%.

But, the company has not included the amount of Depreciation and Amortization in the
computation of Free Cash Flow, which does not give a true and fair picture of the company’s
financial status.

Hence, Free Cash Flows are newly computed as follows:

$ millions 2009 2008 2007 2006 2005

Cash Flow From Operations 1576 1155 1249 1258 1339

Les
s
CapEx (600) (969) (1243) (772) (535)
Dividend Paid, Common Stock (183) (178) (174) (153) (131)
Ad
d
Sale of Assets 13 13 26 20 31

Free Cash Flow ( As per

company) 806 21 (142) 353 704
Ad
d
Depreciation & Amortization 495 469 426 389 372

Adjusted Free Cash Flow 1301 490 284 742 1076

Hence, in reality, the Free Cash flows of JC Penny have shown an increasing trend from 2006-
2009. In 2005, due to not a significant amount of CapEx and Dividends paid, the overall Cash
available by the company for free use was as high as $1076million. But, from 2007, which had
FCF of $284million to 2009 where FCF increased to $1301million, the company has shown an
outstanding increase in the total FCF, highlighting the strong financial condition and excellent
liquidity position of the company. The dramatic strengthening of financial position, i.e. a 165.5%
increase in the FCF from 2008 to 2009, gives a very strong message to various stakeholders of
the company
From the graph we can interpret that the decrees in free cash flow is due to
increase in CapEx and with increase in CapEx are returns in the next year. Indicated
by cash flow from operations

INVESTORS: The investors would be willing to invest in the shares of the company, as the
dividends paid from the common stock has also increased and also the FCF position of the
company demonstrates the liquidity position of the company, hence, ensuring the investors that
sufficient cash is available by the company to repay its maturing debts and fund its other capital
expenditures. The investors would also be interested in the debt of the company, by investing in
the Debentures that is issued by the company in its Long-term debt component. The Company
has sufficient cash available to meet its interest obligation (fixed financial obligation) and also
for repayment of the principal amount of the Debt. Hence, the investors would be interested in
both the Equity as well as the Debt of the company. The investment made by the company in
assets is justified by the improved operating efficiency

CREDITORS: The Creditors of the company would also be happy and pleased to lend money to
JC Penny as it has sufficient funds available in the name of Free Cash Flow, which can be used
to pay them off. Though the a/c payables have risen by $ 32m in 2009 as compared to last year
the company can manage the payments owing to high cash & cash equivalents. Hence, the risk
involved in lending money (providing debt) or allowing credit purchases is reduced when the
company has surplus cash available which has an increasing trend over a period of five years.

MANAGEMENT VIEWPOINT: The management of JCP can think of retiring a portion of debt
which is not getting matured in next year, to reduce the interest burden, if it doesn’t find any
suitable investment option available at that time to deploy the excess of FCF (FCF less current
maturity of debt, interest on debt, dividend) in order to generate income from investment rather
than holding it idle.

Q2. What estimations do you prefer for the ensuing financial year based on the financial
condition and liquidity?

Ans. Based on the financial condition and liquidity of JC Penny, which is outstanding for the
financial year 2008-09, with Adjusted Free Cash Flows (FCF) at $1301million, and the Cash &
Cash equivalents at $3billion, exhibiting the huge surplus funds that is available with company
for paying off maturing debts, or giving dividends to shareholders or employing funds for future
CapEx and other expansionary projects.

Hence, the financial condition of the company is very sound as well as strong, with high
liquidity. Moreover, over a period of time, the liquidity position of the company is further
enhanced by the increase in cash-to-debt ratio to 89% in 2009, up from 67% in 2008.
The debt-to-capital ratio which is also an important measure to evaluate the liquidity and
financial condition of any business has been consistent over a period of three years from 41.1%
in 2007 to 41.5% in 2009.

The following table gives the key ratios and measures used to assess the financial position and
liquidity of the company:

($ in millions) 2009 2008 2007

41.50 45.80 41.10
Debt-to-Total Capital % % %
88.80 67.10 68.30
Cash-to-Debt % % %
Adjusted Free cash flow 1301 490 284
Cash & Cash Equivalents 3011 2352 2532
Capital Expenditures 600 969 1243
Dividends paid 183 178 174

Hence, as an Investor, a Creditor or as Management of the company, I would like to have a very
positive estimate of the given above ratios and key measures that would further strengthen the
financial position and liquidity of the company.

INVESTORS: The investor can expect better Return on Assets, which has actually significantly
reduced from 9.4% in 2008 to 5.26% in 2009. But, in order to attract further investments from
retail investors, the company should ensure an improvement in the ROA that it provides. When it
comes to dividends, the EPS of the company has also declined from 2.58 to 1.08, which is not
too attractive as an investment; hence both basic as well as diluted EPS should increase in the
ensuing years.

CREDITORS: Creditors already enjoy strong position in the company and can be rest assured of
repayment of their loans as the company has huge FCF and Cash & cash equivalents available
with itself. Hence, a further increase in FCF would be more favorable for the Creditors of the
company. Moreover, the Capital expenditure ratio has increased from 1 in 2007 to 2.62 in 2009,
which shows that the company has surplus funds available for repayment of debt or payment of
dividends. Another important measure for Creditors is the Interest Coverage Ratio which is 2.55
in 2009, demonstrating the company’s ability to generate sufficient profits to cover the interest
payments. Moreover, the company has got good credit ratings for its debt from various Credit
rating agencies and also the highest liquidity rating of SGL-1, giving satisfaction the creditors
with respect to the payments of their dues.

MANAGEMENT: The Management can expect an increase in the operational efficiency of the
company as the Cash-to-debt ratio has improved from 67.1% in 2008 to 88.8% in 2009.
Moreover, as of January 30, 2010, the company is in compliance with the Leverage ratio of
2.3:1, a fixed charge coverage ratio of 3.4:1 and an Asset Coverage ratio of 23:1. Moreover, the
company has got good credit ratings for its debt from various Credit rating agencies and also the
highest liquidity rating of SGL-1, which is helpful for the management to raise the further debt
for future growth plans and overall improvement in the financial as well as operational efficiency
of the company. Again, highly liquid position of the company (from FCF & cash) is highly
important from the management’s perspective.

Q3. Comment on the short-term stability of the company and the acceptable measure
adopted for the same?
Ans. The Short-term stability of the company can be judged on various parameters like:

a. Current Ratio
b. Liquid Ratio
c. Inventory Turnover Ratio
d. Working Capital, etc.

CURRENT RATIO: The Current Ratio of the company has reduced from 2.22 in 2008 to 2.04 in
2009. But, still the Current Ratio is 2:1, which is ideal for the company, as it shows that the
current assets of the company are sufficient to meet the current liabilities of the company, hence,
improving the liquidity position of the company.
Acceptable Measure: 2:1

LIQUID RATIO: The Acid Test Ratio of the company has improved from 0.96 in 2008 to 1.04
in 2009, which again is quite favorably highlighting the liquidity position of the company.
Acceptable Measure: 1:1

INVENTORY TURNOVER RATIO: The Inventory Turnover Ratio has also increased from
5.67 in 2008 to 5.80 in 2009. This means more inventory is converted into Sales, hence, which is
highly beneficial for the company, as the company is into Fashion industry where not much of
goods can be kept as inventory, lest it goes waste.

WORKING CAPITAL: The Working Capital of the company also shows the short-term stability
of the company, and in this case the Working Capital of the company has been consistent at
approx. $3400million, which is a good sign for the overall operational efficiency of the
company.
Investor’s Viewpoint: From investor’s stand the operations are main area to look at when it talks
about the short-term stability. Here it is visible that the company is not facing any problems in
carrying out its operations.

Management Viewpoint: Here if we look at the income statement of the company we find that
though the Gross margin of the company improved to 39.4% from 37.4% but at the same time
the SG&A expenses also increased from 29.2% to 30.7% of the sales. So the management should
control these rising expenses which will directly have an impact on the bottom line of the
company.

Creditor’s Viewpoint: Company in short-term is able to pay its current liabilities and also the
current portion of debt, so presenting a positive outlook for the creditors in the next quarter as
well.

Q4. What could be major objection in the consolidated cash flow statements from
the point of view of non-operational activities?

The major objections could be as follows:

a) The company, in 2007, raised loan which was utilized substantially in repurchase of
common stock ($400m was used in re-purchase from debt of $980m). In a way company
lend itself under definite obligation of interest on debt & its repayment. They could have
used the earnings of 2008 & 2009 to repurchase the stock as in these years they were
having positive free cash flows.
b) In CFI, when CFO was highest, the investment was lowest. i.e. in 2009 the CFO was $
1576m but the net investments were only to tune of $587m also the retirement of debt in
2009 was minimum so leaving the company with very high cash. Contrastingly, in 2007
 when the CFO were $1249m the net investments were to the tune of $1217m (nearly
same to that of CFO).

They should have retired more debt in 2009.

Q5. Justify the estimate adopted by the company?

The Capital expenditure of the company can be justified on the grounds that the economy is
recovering and that the sales will improve in times to come, and hence, the company has been
right in spending heavily on opening up new stores.

The merchandise and services revenue recognition are recognized as the company provides for
the estimated future returns based on historical return rates and sales level. The total net sales are
recorded at the point of sale when payment is received whereas in case of the gift cards, the
revenue is recognized not at the time when gifts are sold but when the gift cards are redeemed for
merchandise. Hence, there exists a discrepancy in the recognition of revenues by the company.

Valuation of Inventory – They valuated the inventory using the Retail Method at FIFO basis
(they changed from LIFO to FIFO in Q4 of 2009). The method is justified as they operate in
retail industry and it will reflect better position of stock levels in there B/S. Also sufficient
markdown and shrinkage has been deducted from the inventory value to report its fair value in
the books. The impact on margins due to these markdowns & shrinkages is not significant.

Valuation of Long-Lived Assets - They are valuing the long-lived assets on recoverable values.
The impairment loss is reported in the period in which occurs. They reported a impairment loss
of $42 million, $21million and $1 million in 2009, 2008 and 2007, respectively. At the same
time, they are not reporting any impairment gain on long-lived assets iff found during valuation
thus following the principle of conservatism which is justified.

Pension Accounting - Total pension plan expense was $337 million in 2009 compared to total
pension plan income of $90 million in 2008, and consisted mainly of the primary pension plan
expense of $298 million in 2009 versus primary pension plan income of $133 million in 2008,
resulting in a negative swing of $431 million, or $1.16 per share on an after-tax basis. The
expense is primarily the result of the amortization of the primary pension plan’s unrealized losses
due to the significant decline in plan assets in 2008.