Question

Questions 1 to 3:

Janice Leo is the head of bond valuation at UMB Investments Management LLC. She has been very frustrated by the number of investment analysts who seem to have a little understanding of financial statement analysis and corporate finance concepts. She has written a set of conceptual questions and simple problems to screen for the better candidates in the applicant pool. A few of the questions related to cash flow statements, present value, future value and problems are given below:
In response to a few question regarding cash flow statements Mike Grillo, one of the analysts at UMB Investments made the following statements.

Statement -1: Cash flows are generally considered more sustainable if they are generated by a firm investing and financing activities.
Statement -2: If a firm is profitable and reports positive cash flow, this is sustainable over the long term.
Statement -3: The act of factoring accounts receivable will generally result in a decrease in operating cash flows in the current year, and a decrease in operating cash flows in subsequent years.
Statement – 4: The fundamental drivers that underlie operating cash flow are ROE, growth, sustainability, profitability and efficiency.

Is Leo correct with respect to statements 1 and 2?

A.	No for statement 1 because more sustainable cash flows are generated by a firm investment activities.
	B.	No for statement 2 because a firm with negative earnings can report positive cash flow, but in the long run this is not sustainable.
	C.	Both statements 1 and 2 are correct.

With respect to statement 3, Leo is incorrect.

	A.	Because the receivables causes the firm to recognize positive operating cash flows when the receivables are sold. Nevertheless, had the receivables not been sold, they would have been collected in the future. A corollary to that, operating cash flows will be lower during future years than they would have been had the receivables not been sold.
	B.	Because the receivables causes the firm to recognize positive operating cash flows when the receivables are not sold. Nevertheless, had the receivables not been sold, they would have been collected in the future. A corollary to that, investing cash flows will be lower during future years than they would have been had the receivables not been sold.
	C.	Because the receivables causes the firm to recognize positive operating cash flows when the receivables are sold. Nevertheless, had the receivables not been sold, they would have been collected in the future. A corollary to that, operating cash flows will be higher during future years than they would have been had the receivables not been sold.

Leo’s statement 4 is correct with respect to

	A.	ROE Profitability Growth Efficiency Sustainability YES NO YES YES NO
	B.	YES YES NO NO YES
	C.	NO YES YES YES NO

QUESTION 4

1. Leo was wondering whether candidates are familiar with accounting estimates and assumptions that a firm’s management could use to manipulate the firm’s profitability.  MicroMoon (MM) is one of the firms that UMB is considering in investing. In its December 31, 2011 annual report MM reported the following year-end data:

   Depreciation expense	$30 million
   Net income	$30 million
   Dividends	$5 million
   Total assets	$535 million
   Shareholder’s equity	$150 million
   Effective tax rate	35 percent

   Last year, MM purchased equipment for $140 million. For the first year, straight-line depreciation was used assuming a depreciable life of 7 years with no salvage value. However, at year-end MM’s management determined that assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were more appropriate.

   How would the return on assets (ROA) and return on equity (ROE) for last year change due to the change in depreciation assumptions? ROA decreases to:

   	A.	5.7% from 5.6% and ROE decreases to 19.7% from 20.0
   	B.	5.0% from 5.6% and ROE decreases to 18.4% from 20.0
   	C.	5.7% from 21.43% and ROE increases to 21.0% from 20.0

Answer 1

The Solution to Question 4

Calculation of Depreciation using SLM Method

Scenario	Old policy	New Policy
	$ in Million	$ in Million
Original Cost of Equipment	140.00	140.00
Salvage Value	0.00	10%
Expected useful life (in years	7	5
Depreciation	= (140-0)/7 = $ 20.00	=(140-14)/5 = $ 25.20
Incremental Depreciation due to change in policy	-	$ 5.20

The Return on Assets is calculated as

ROA (with old depreciation policy) = $ 30.00 / $ 535.00 = 5.6%

ROA (with new depreciation policy)

The Revise Net Income can be calculated as:

Net Income	$ 30.00
Less: Incremental Depreciation due to change in policy	$ 5.25
Add: Tax saving on additional depreciation	= $5.25 * 35% = $ 1.84
Revised Net Income	$ 26.59

Hence,

ROA (with new depreciation policy) = $ 26.59 / $ 535.00 = 5.0%

Return on Equity is calculated as:

ROE =     

ROE (with old depreciation policy) = $ 30.00 / $ 150.00 = 20%

ROE (with new depreciation policy) = $ 26.59 / $ 150.00 = 18%