Ah - Sale - Accounting HW - 1604

Accounting 523
Financial Statement Analysis
1. Assume you have $20,000 to invest in the stock market. Which company would you
invest in, Starbucks or Dunkin Donuts? Give supporting calculations to back up your
decision.
Key ratios:
Particulars Starbucks Dunkin Donuts

Profit Margin 13.81% 17.66%
Trailing P/E 23.53 19.47
Enterprise Value/EBITDA 15.75 15.20
Forward P/E 27.32 17.54
On the basis of the above statistics, it is recommended that investment should be made in
Starbucks, being the higher returns and price value to earnings ratio is high.
Source:
https://finance.yahoo.com/quote/SBUX/key-statistics?p=SBUX
https://finance.yahoo.com/quote/DNKN/key-statistics?p=DNKN
2. Calculate the intrinsic value of common stock for XYZ at January 1, year 1 given the
following:
Book value $70
Predicted earnings per share Years 1through 5 respectively:
$15, $12, 18, $22 and $15
Cost of capital: 10%
No residual income is expected for years 6 and after. No dividends are paid.
Would you buy this stock if it were trading at $110 per share?
The value of the stock will be determined by calculating present value of the future cash flows as
under:
Year Cash Flow PVF @ 10% Present Value

1 $ 15 0.909 $ 13.64
2 $ 12 0.826 $ 9.92
3 $ 18 0.751 $ 13.52
4 $ 22 0.683 $ 15.03
5 $ 85 0.621 $ 52.78
Value of Stock $ 104.88
Since the intrinsic value of stock is $ 104.88 per share and is trading as $110 per share, being
overvalued, buying of the stock is not recommended.
3. Define what each of the following SEC reports refers to:
Form 10-K: All the publicly traded companies are required to file Form 10-K with SEC. The
Form highlights the financial performance of the publicly traded companies. Apart from Annual
Report of the companies, Form 10-K also provides for companies’ history, its subsidiaries,
organizational structure, management discussion and analysis, risk factors, etc.
Form 10-Q: These are quarterly reports required to be filed by all public companies. The
comprehensive report provides for the financial performance and position of the company which
are generally unaudited.
Form 8-K: The form provides for major events that are to be announced to the shareholders. The
events include bankruptcy, acquisition, merger, demerger, resignation of directors, etc.
Proxy Statement: The Statement provides the information relating to important decisions that
will be announced by the companies in its annual meeting or any special shareholders meeting.
Some of the issues that are covered in this statement includes additions of directors,
remuneration to directors, information as to bonus or option plans, etc.
4. A company issues $1,000 ten-year bonds with a coupon rate of 6% on January 1, 2014.
Interest is paid at the end of the calendar year. What is the market price of the bonds on
January 1, 2018 assuming a market rate of interest 10%. Are the bonds trading at a
discount or premium and why?
Statement showing market value of the bonds:
Year Cash Flow PVF @ 10% Present Value

1 60 0.909 54.55
2 60 0.826 49.59
3 60 0.751 45.08
4 60 0.683 40.98
5 60 0.621 37.26
6 60 0.564 33.87
7 60 0.513 30.79
8 60 0.467 27.99
9 60 0.424 25.45
10 1060 0.386 408.68
Value of Bond $ 754.22
The Bonds market value is $ 754.22 and face value is $ 1000. Assuming the bonds are trading at
market value, the bonds are trading at discount.
5. Explain what the name “the political cost hypothesis” relates to in the earnings
management literature.
The Political Cost Hypothesis provides that the firms that are subject to government
investigation may have incentives to manage earnings in order to reduce the probability and/or
the amount of government-imposed wealth transfers. As per the Political costs hypothesis, it is
assumed that if managers are under political scrutiny, they are likely to adopt accounting
methods that reduce reported income
6. Given the following information:
Net Income $1,200,000
Preferred Stock, $100 par, 6%, 50,000 shares outstanding
Common Stock Outstanding, 100,000 shares (all year)
Total Common Dividends $200,000
Total Assets $10,000,000
Total Liabilities $3,000,000
Market Price Per Share $120
Calculate: (a) EPS (b) Dividend Yield (c) Market-to- Book Ratio (d) P/E ratio
a) EPS:
Formula = (Net Income – Preferred Dividend ) / Number of Common Shares O/s
Particulars Amount
Net Income (A) 1,200,000
Less: Preferred Stock Dividend (300,000)
(50000 x 100 x 6%) (B)
Earnings Available for Common Shareholders (A 900,000
- B = C)
Number of Shares Outstanding (D) 100,000
EPS (C / D) $ 9.00
b) Dividend Yield = Annual Dividend / Stock’s Price per Share

Annual Dividend = $ 200,000
Dividend Per Share = $ 200,000 / 100000 Shares = $ 2.00
Market Price per Share = $ 120
Dividend Yield = $ 2 / 120 = 1.67%
c) Market-to-Book Ratio
Market Price = $ 120
Book value =
Total Equity = Total Assets – Total Liabilities
= 10,000,000 - $ 3,000,000
= $ 7,000,000
Total Equity = Preferred Stock + Common Stock
$ 7,000,000 = $ 5,000,000 + Common Stock
Hence, Common Stock = $ 2,000,000
Number of Shares = 100,000
Book Value = $ 2,000,000 / 100000 = $ 20
Market to Book Ratio = $ 120 / 20 = 6 Times
d) P/E Ratio
P/E Ratio = Market Price per Share / Earnings per Share
= $ 120 / $ 9
= 13.33
7. What are the components of Comprehensive Income? What is the current treatment of
Comprehensive Income and why?
The comprehensive income includes Net Income (or loss) and Other Comprehensive income.
Other Comprehensive income includes, adjustments as to Foreign Currency translations,
unrealized gains / losses for pension and retirement benefit plans, Gains or losses from derivative
instruments, debt securities, available for sale securities, etc.
The comprehensive income does not form part of the income statement. The figures relating to
other comprehensive income is reported under shareholder’s equity in the balance sheet of the
company.
8. What constitutes Extraordinary Items? What was the treatment of 9/11 losses regarding
extraordinary items? Do you agree or disagree with this? What is the current treatment of
extraordinary items?
Such events or transactions which are abnormal or are not in relation to the ordinary activities of
the company and are not likely to occur / recur in foreseeable future are considered as
extraordinary items. Some of the extraordinary items includes, strikes, abandonment of property,
discontinued operations, etc.
The 9/11 losses were not treated as extraordinary event as stated by the FASB Board and the
impact was included as continuing business operations.
I do not agree with the treatment done, as it was not a recurring event, it is not likely to
occur/recur in foreseeable future and is not an event that can be said as ordinary.
Current treatment: Such events are required to be disclosed in the footnotes of the financial
statements.
9. Given the following:
Net income before depreciation and taxes $200,000
Straight-line depreciation $40,000
Accelerated Depreciation $80,000
Tax Rate 25%
Calculate:
Income Tax Expense (Financials)
Income Tax Payable (IRS)
Deferred Tax Asset or Liability
Is the Deferred Tax Asset/Liability current or noncurrent and why?
Straight Line Depreciation is used for preparation of Financial Statements and Accelerated
Depreciation is used for Income tax purposes.
Income Tax Expense:
Particulars Amount
Net Income 200,000
Less: Depreciation 40,000
Net Income before Tax 160,000
Income Tax Expense @ 25% 40000
Income Tax Payable
Particulars Amount
Net Income 200,000
Less: Depreciation 80,000
Net Income before Tax 120,000
Income Tax Payable @ 25% 30,000
Deferred Tax Liability will be generated = ($ 80000 - $ 40000 ) x 25%
= $ 10000

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Accounting 523

Financial Statement Analysis

Particulars Starbucks Dunkin Donuts

Book value $70

Predicted earnings per share Years 1through 5 respectively:

$15, $12, 18, $22 and $15

Cost of capital: 10%

Year Cash Flow PVF @ 10% Present Value

3. Define what each of the following SEC reports refers to:

Statement showing market value of the bonds:

Year Cash Flow PVF @ 10% Present Value

6. Given the following information:

Net Income $1,200,000

Preferred Stock, $100 par, 6%, 50,000 shares outstanding

Common Stock Outstanding, 100,000 shares (all year)

Total Common Dividends $200,000

Total Assets $10,000,000

Total Liabilities $3,000,000

Market Price Per Share $120

b) Dividend Yield = Annual Dividend / Stock’s Price per Share

Market to Book Ratio = $ 120 / 20 = 6 Times

9. Given the following:

Net income before depreciation and taxes $200,000

Straight-line depreciation $40,000

Accelerated Depreciation $80,000

Tax Rate 25%

Income Tax Expense (Financials)

Income Tax Payable (IRS)

Deferred Tax Asset or Liability

Is the Deferred Tax Asset/Liability current or noncurrent and why?

Income Tax Expense:

Income Tax Payable

Deferred Tax Liability will be generated = ($ 80000 - $ 40000 ) x 25%

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