Solutions to Exercises & Cases for Financial Statement Analysis and Security Valuation 5th Edition | Stephen H. Penman

SOLUTIONS TO
EXERCISES AND CASES

For

FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION



Stephen H. Penman




Fifth Edition




1

, CHAPTER EIGHT
Viewing the Business through the Financial Statements

Concept Questions

C8.1 Free cash flow is a cash dividend from the operating activities to the financing activities;

that is, it is the net cash payoff from operations that is distributed in the financing activities. The

operations generate free cash flow which is then distributed to investors, namely to the

shareholders in net dividends with the remainder going to the net debtholders: C – I = d + F. To

see the point more clearly, C – I = d in the case where there is no net debt—that is, free cash flow

is the dividend to shareholders. With net debt, this dividend is dividend between the shareholders

and the debtholders.


C8.2 Refer to the cash conservation equation: C – I – d = F. The firm must pass out the excess

of free cash flow after dividends to net debtholders, by buying down to its own financial

obligations or by buying others’ debt as a financial asset.



C8.3 The firm borrows: C - I = d + F. So, if C - I = 0, then the firm borrows to pay the

dividend such that d + F = 0.



C8.4 An operating asset is used to produce goods or services to sell to customers in operations.

A financing asset is used for storing excess cash to be reinvested in operations, pay off debt, or

pay dividends.



C8.5 An operating liability is an obligation incurred in producing goods and services for

customers. A financial liability is an obligation incurred in raising cash to finance operations.

,C8.6 True. From the reformulated balance sheets and income statement,

C-I = OI - ∆NOA. So, with operating income identified in a reformulated income statement and

successive net operating assets identified in a reformulated balance sheet, free cash flow drops

out. See Box 8.3.



C8.7 Operations drive free cash flow. Specifically, value is added in operations through

operating earnings, and free cash flow is the residual after some of this value is added to net

operating assets: C – I = OI - ∆NOA.



C8.8 Free cash flow can be paid out as dividends, but dividends are the residual of free cash

flow after servicing the interest and principal claims of debt (or investing in net financial assets):

d = C – I – NFE + ΔNFO.



C8.9 Net operating assets are increased by earnings from operations and reduced by free cash

flow: ∆NOA = OI – (C – I). Expanding, net operating assets are increased by operating income

(operating revenues less operating expenses), reduced by cash flow from operations, and

increased by cash investment: ∆NOA = OI – C + I.



C8.10 Net financial obligations are increased by the obligation to pay interest, and by dividends,

and are reduced by free cash flow: ΔNFO = NFE – (C – I) + d.




3

, C8.11 True. Free cash flow is a dividend from the net operating assets to the net financial

obligations. So, as ∆CSE = ∆NOA - ∆NFO, free cash flow does not affect CSE.

C8.12. Profitable companies have investment opportunities. New investments expenditures can

be higher than cash from operations, producing negative free cash flow. Starbucks in Chapter 4

is another example.

Exercises

Drill Exercises

E8.1. Applying the Cash Conservation Equation (Easy)

a. Apply the cash conservation:

C–I=d+F
$143 = $49 + ?
? = $94 million

b. Net dividend (d) = $162 + 53 = $215
Debt financing flows (F) = -$86

Now apply the cash conservation equation:

C–I=d+F
= $215 + (-86)
= $129 million

C8.2. A Question for the Treasurer

The correct answer is b. By the cash conservation equation, any free cash flow left over after
paying net dividends can only be used to pay net interest or to buy down net debt (either by
buying back the firm’s own debt or buying other’s debt as a financial asset).

C8.3. What Were the Payments to Shareholders?

a. d = C – I – NFE + ΔNFO
= 410 – 340
= 70
Also,

d=C–I=F
= 410 – 340