Question

Mendoza is considering investing in IBM. However he is captivated by IBM's growth. IBM had made a remarkeable change from a strugling company to a leading company in the personal computer market. Mendoza has asked for your advice as to whether or not the growth is genuine. He suspects there might have been some fraudulent or unethical actions taken by IBM to increase its income. After a rief look at the recent history and performance of IBM, you decide to look more closely at the financial statements. As you review the financial statements, you begin to have some concerns about the nature of IBM's growth. Certain accounting procedures cause you to have doubt as to whether the growth came from IBM's core business operations or from carefully planned accounting adjustments that seem to be unethical. As you proceed in your investigations, you pay particular attention to the following areas. Pensions IBM changed its pension plan to a cash balance plan. The returns of this plan exceeded the amount recognized as an expense. Accounting rules require the company to add the excess returns to earnings but the gains cannot be spent on anything other than pension benefits. IBM increased its earnings per share by making this adjustment. Stock repurchases since 1995, IBM has spent a lot of money making stock repurchases. A stock repurchase may be beneficial to a company by increasing earnings per share since there ill be fewer share holders across which to spread the earnings. You conclude that the financial statements were in accordance with generally accepted accounting principles (GAAP) and you are confident that all accounting rules were followed. However, you have to explain to Mendoza whether the behavior was ehtical. What wiould you tell him?

Answer 1

The Question is regarding advising the Mendoza on its proposed investment in IBM. The following are the two aspects that are highlighted

1. Showing excess return from Pension Plan as earnings

2. Repurchasing its own shares.

At the outset, the most important determinant of ultimate investment success revolves around the relationship between the price at which the investor buys and the underlying value of the company.There are only a few things that can influence the intrinsic value of a company, and those things all revolve around the process of generating cash flows. We focus in on Revenue Growth, Profitability, Investment Spending, and likely Future Growth based on the projects in which the company is investing.

With this background, Repurchasing its own shares can be viewed as  IBM has been using a good portion of its profits to buy back its own stock. The buybacks are certainly helping owners more than it is hurting them.

Further, Excess return from pension plan is the normal activity of business.

Hence, You can invest in IBM