QUESTION 1:

Q1a:   Palepu, Healy and Peek, 5th edition, 2019 and the lecture slides advise analysts to “assess accounting flexibility” as one of the six steps of accounting analysis.

Briefly describe the degree of accounting flexibility that firms in the UK or in the  US usually have in their accounting for property, plant and equipment (PPE) and inventory costs.

(6 marks) Q1b:  A company reports the following information about its performance:

In the table above, accounting accruals are equal to the change in      operating working capital less depreciation and amortization expense.

Please provide an answer to all of the following questions.

(i)     What does this information reveal about the quality of the               company’s earnings? Note: earnings can be approximated as cash flow from operations plus accruals.

(3 marks)

(ii)      All other things equal, what is your prediction for the expected

future path of the company’s earnings after 2021?

(2 marks)

(iii)      Provide two examples of accounting line items and/or transactions

that can explain the expected future path of earnings given in your answer to question (ii) above.

(2 marks)

QUESTION 2:

DELL Inc. is a multinational company based in Round Rock, Texas which         develops, manufactures, sells, and supports personal computers, servers, data storage devices, network switches, software, televisions, computer peripherals, and other technology-related products with more than 95,000 employees          worldwide.1

DELL grew during the 1980s and 1990s to become (for a time) the largest seller of PCs and servers.

In 2006, Fortune magazine ranked DELL as the 25th-largest company in the       Fortune 500 list and 8th on its annual Top 20 list of the most-admired companies in the United States.

A 2006 publication also identified DELL as one of 38 high-performance                 companies in the S&P 500 which had consistently out-performed the market over the previous 15 years.

John Karter is in equity research and needs to prepare his upcoming report for

DELL.

Required

Q2a:   Calculate DELL’s ROE in 2005 and show the decomposition of DELL’s

ROE based on the basic DuPont formula (that is, profit margin, asset         turnover and leverage). How does DELL’s performance compare to that of an average US or European firm?

•   Note: DELL’s financial statements are reported in Exhibits 2 and 3  (at the end of this exam) and please use balance sheet figures from the 2005 financial statements.

(5 marks)

Q2b:  The analyst thinks that DELL should have recognised an impairment on   property, plant, and equipment (PPE) and recasts the firm’s financial statements after recognizing such an impairment.

Explain how each of the financial ratios in your answer to question Q2a will be affected by the PP&E impairment.

Be specific about the effect of the impairment on the numerator and the denominator of each ratio (note: you are NOT required to make any      calculations using the information from DELL’s financial statements).

(6 marks)

Q2c:  The advanced DuPont formula decomposes ROE into its three          components: return on net operating assets (RNOA), financial leverage and spread.

Explain the advantages of this advanced decomposition over the basic DuPont decomposition.

(6 marks)

QUESTION 3:

Friedman, Billings, Ramsey Research (FBR), an Arlington-based research firm,   recently came to “troubling conclusions” about the way warranty provisions are    accounted for at DELL. FBR reports that DELL's accounting for warranty accruals “has caused [earnings per share] overstatement of [on average 5] cents in five of the last 12 quarters [ending in 2006].”

To understand the impact of this information on DELL’s financial statements, you should consider the information from the 10-Q form (quarterly report) of DELL in year 2005 (see Exhibit 1).

Required

Q3a:   Assuming that DELL maintains the quality of its products, then the “true”

amount of warranty provisions (i.e., costs accrued for new warranties) can be seen as a constant percentage of current revenues.

Historically the ratio of warranty provisions to revenues from product licenses was 2.1%.

Provide your estimate of the amount by which DELL may have overstated its earnings in 2004 and 2005.

Show all calculation steps. Note: the income statement for DELL can be found in Exhibit 2.

(6 marks)

Q3b:  Consider the information on revenue recognition in Exhibits 1, 2 and 3.

DELL generates revenues from the sale of product licenses and revenues from product support and other services, which include revenues from      extended warranty and service contracts.

Is there evidence that DELL might accelerate sales from product support and other services?

What financial statement items will you adjust to reverse the accelerated  recognition of revenue from the extended warranty and service contracts?

(7 marks)

QUESTION 4:

Q4a:   Using the analysts’ estimates of future average net income in Exhibit 5,

calculate the intrinsic value of equity per share in DELL as at 1 January, 2006 using only the abnormal earnings (residual income) valuation   method. Ignore any of the adjustments you have made in question 3      above. Use the following assumptions:

1.  Net income rises by 25% in the year ended 31 December, 2008.

2.  DELL plans to pay dividends of $22 million in the year ended 31   December, 2006 and $24 million in the year ended 31 December,

2007. No dividends are proposed in future years.

3.  DELL plans to repurchase ordinary shares for $20 million in the    year ended 31 December, 2006 and for $15 million in the year      ended 31 December, 2007. No further repurchases are planned in future years.

4.  Items 2 and 3 above and net income each year account for all changes in the book value of shareholders’ equity each year.

5.  Beyond 31 December, 2008, abnormal earnings are expected to grow at 3% per year indefinitely.

6.  The equity beta for DELL on 1 January, 2006 is 0.84.

7.  The market risk premium on 1 January, 2006 is 6% and the risk free rate is 2% on the same date.

8.  Number of ordinary (common) shares in issue at 31 December,

2005 is 16,528,000 (note that this is the total figure – the figure in thousands is 16,528).

Note   Based only on the information in Q4a above, you are first expected

to prepare a forecast of items needed for the abnormal earnings      (residual income) valuation method, and then apply this method to   estimate DELL’s value. You should undertake your calculations in   thousands of dollars as this is how the figures in Exhibits 2 to 5 are specified (i.e., in thousands of dollars). Show all the calculation        steps.

(39 marks)

Q4b:   One of the key assumptions underpinning the abnormal earnings (residual

income) valuation method is that the ‘clean-surplus relation’ holds.

(i)       Explain what is meant by the ‘clean surplus relation’ .

(4  marks)

(ii)       Does DELL’s accounting violate the ‘clean-surplus relation’? If it

does, indicate where in Exhibits 3 to 4 this is evident.

(3 marks)

Q4c:  Give two reasons why an analyst would use the abnormal earnings       (residual income) valuation method instead of directly taking the book value of equity from the balance sheet as a measure of value?

(6 marks)