Answer all the questions
University of Alberta, School of Business Simon Fraser University, Faculty of Business Administration BUS 670 SAMPLE FINAL EXAM Instructor: Dr. Karel Hrazdil Maximum: 150 marks Time: 180 minutes Student: I.D. Number: 1. Read each question carefully before you attempt to answer it. 2. Be sure to state any assumptions that you find necessary and show all calculations and explanations to facilitate the awarding of marks. 3. Provide your answers in the space below each question. 4. Relevant formulas are provided on the last page of the examination. MARK ALLOCATION: Section Marks available Marks awarded 1 45 2 30 3 75 Total 150 CAUTION: In accordance with the Academic Honesty Policy (T10.02), academic dishonesty in any form will not be tolerated. Prohibited acts include, but are not limited to, the following: - Speaking or communicating with other students who are writing examinations. - Copying from the work of other candidates or purposely sharing the answers with other candidates. BUS 670 – Spring 2021, Section G100 Final Exam Page 2 of 25 Section 1 – Independent discussion questions (45 Marks) 1) Peter, the new CFO, is unsure whether he should take a course in business analysis and valuation using financial statements, since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to Peter how financial analysis can add value, even if capital markets are generally seen as being efficient. (12 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 3 of 25 Section 1 – Continued 2) Home Depot continues to be the fastest growing home improvement and building supply retailer in the United States ever since it was founded in 1978. Use the Porter’s five forces framework and your knowledge of the home improvement and building supply retailer industry to explain how Home Depot is able to retain most of the profits in this industry. (15 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 4 of 25 Section 1 – Continued 3) What factors are likely to drive a firm’s outlays for new capital (such as plant, property, and equipment) and for working capital (such as receivables and inventory)? (8 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 5 of 25 Section 1 – Continued 4) Would/should estimates of firm value based on residual income model differ for two otherwise identical firms if one company uses more conservative accounting methods than the other? Explain how accounting analysis would help analysts make their abnormal earnings forecasts? (10 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 6 of 25 Section 2 – Independent true / false questions (30 Marks) State and briefly explain why you agree or disagree with each of the following five independent statements/approaches by your colleague (Vice President at Stock Pickers Inc). Feel free to support your arguments using firms discussed during lectures. a) “We should get rid of the FASB and SEC (i.e., the regulators) since free market forces will make sure that companies report reliable information.” (6 marks) b) “The standards that I like most are the ones that eliminate all management discretion in reporting—that way I get uniform numbers across all companies and do not have to worry about doing accounting analysis.” (6 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 7 of 25 Section 2 – Continued c) “It is not worth my time to develop detailed forecasts of sales growth, profit margins, et cetera, to make earnings projections. I can be almost as accurate, at virtually no cost, using the existing firm’s earnings as a forecast of company’s future earnings.” (6 marks) d) “The critical number I look at for any company is operating cash flow. If cash flows are less than earnings, I consider a company to be a poor performer and a poor investment prospect.” (6 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 8 of 25 Section 2 – Continued e) “Terminal values in accounting-based valuation (i.e., residual income model) are significantly lower than those for discounted cash flow valuation (i.e., dividend or free cash flow models).” (6 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 9 of 25 Section 3 – Comprehensive problem (75 marks) Refer to the 2018 financial statements and ratios of Home Depot (HD) and Lowe’s (L) to answer the questions in this section (the 2018 statements correspond to February 1, 2019 fiscal year-ends for both companies). Note that denominators of all relevant ratios are based on the opening balance sheet amounts. Both firms are major American multinational home improvement retailers. Each company has been in operation for a significant period of time. 1) Evaluate each firm’s ROE by answering the following questions. a) Based on the traditional ROE decomposition, compare the three drivers of 2018 ROE for both Home Depot and Lowe’s and indicate which company has higher return on sales, asset turnover and financial leverage. (6 marks) b) Based on the Alternative ROE decomposition (Scott’s formula), what additional (or different) insights can we learn about the firms’ (Home Depot and Lowe’s) sources of profitability? (6 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 10 of 25 Section 3 – Continued c) Can HD grow faster than its sustainable growth rate? Discuss whether and why HD’s 2018 sustainable growth rate is over/under stated. (8 marks) d) Which expenses are responsible for the Lowe’s lower profit margin in 2018? (4 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 11 of 25 Section 3 – Continued e) If Lowe’s wanted to improve its operating ROA relative to Home Depot, which major classes of operating assets turnover ratios or days calculations offer obvious opportunities for improvement? (6 marks) f) Which of the following two independent scenarios would improve Lowe’s ROE more? First, if Lowe’s achieves the same net financial leverage (Net Debt/Equity) as Home Depot (assume no change in interest rates)? Second, if Lowe’s negotiates a reduction in its interest rate (ROD) on its debt by one half (assume no change in net financial leverage)? (8 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 12 of 25 Section 3 – Continued g) Which firm has a better ability to pay its current obligations? Which firm has a more optimal borrowing capacity? If issuing additional debt is too costly for both firms, what other alternatives do the companies have to boost ROE through the leverage effect? Provide supporting arguments. (9 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 13 of 25 Section 3 – Continued Standard and Poor’s classifies both firms (Home Depot and Lowe’s) in the “Building Materials, Hardware, Garden Supply, and Mobile Home Dealers” industry. The beta for Home Depot is 1.10 and for Lowe’s is 1.30. Assume that the long-term average market return is 8.0%. The 20- year US Treasury bond yield in 2018 is 3.0%. 2) Calculate a cost of equity capital based on the CAPM and CAPM with size effect (premiums available in Table A1) for each firm for 2018. Do not attempt to extrapolate within any size category. (8 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 14 of 25 Section 3 – Continued The following are the assumptions for Lowe’s for the year 2019 and onward. Lowe’s Book Value of Common Equity Growth Rate is expected to be 4%. Your financial analysis reveals that Lowe’s Operating ROA can be permanently improved and thus expect Return on Equity (ROE) to increase 15% (i.e., be 115% of the current ROE level) in 2019 and remain constant onward. The 2019 cost of capital yearbook published by Morningstar reports the cost of equity capital (CAPM + size) for Lowe’s is 9.00%. 3) Based on the given cost of equity capital discount rate by Morningstar, the above stated growth and performance assumptions, and any additional relevant information presented in the financial statements, use the relevant shortcut valuation and determine the price per share for Lowe’s as of May 1, 2019 (note that the 2018 statements correspond to February 1, 2019 fiscal year-ends for both companies). Compare your estimates to the market prices (provided in the financial statements) and determine whether you would buy, hold or sell Lowe’s. Feel free to justify (elaborate on) your recommendations using any additional information presented in the financial statements. (16 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 15 of 25 Section 3 – Continued 4) Are there any problems with valuating Home Depot using the residual income model? If so, what are the problems and what are some alternative approaches that you can use to valuate HD? (4 marks) BUS 670 – Spring 2021, Section G100 Final Exam Page 16 of 25 Standardized Beginning Balance Sheet (in $ millions) Fiscal Year 2018 2017 2018 2017 ASSETS Cash and Marketable Securities 1,778$ 3,595$ 729$ 690$ Accounts Receivable 1,936 1,952 - - Inventory 13,925 12,748 12,561 11,393 Deferred Taxes - Current Assets - - - - Other Current Assets 890 638 938 689 Total Current Assets 18,529 18,933 14,228 12,772 Long-Term Tangible Assets 22,375 22,075 18,432 19,721 Long-Term Intangible Assets 2,252 2,275 303