Chapter 3:  Questions

Question 1:    Define the basic DuPont decomposition equation and include a brief description of how to interpret its component terms by relating your description to the major decisions made by a firm.

Question 2:   Calculate and provide a brief description of its meaning the following ratios for Best Buy:

i.               Inventory Turnover

ii.            Accounts Receivable Turnover

Question 3: 

i.              If the Inventory Turnover ratio is X, how many days does it take to sell the inventory?

ii.            If the Accounts Receivable Turnover ratio is X, how many days does it take for accounts to be paid?

Question 4:  Define the ratio “ROE” and describe what major firm decisions influence this ratio.

Question 5:  Define “Fundamental Growth” (also known as “Accounting Growth”).  Describe precisely how this number is influenced by major firm decisions.

Question 6:  Consider the following information on Best Buy and Wal-Mart:

Compare the ROE for Wal-Mart and Best Buy and explain precisely why the two companies have different ROE’s by relating your explanation to the major firm decisions.

Question 7:  Estimating Cost Behavior using Account Analysis

In order to estimate the Degree of Operating Leverage, you need to first separate costs into fixed and variable components.  This requires an understanding of cost drivers, and GAAP compliant statements do not provide an easy way to break total costs into fixed and variable parts.  When studying managerial accounting, you are typically introduced to three techniques to assess cost behavior.

i.               Account Analysis

ii.            High Low Technique

iii.           Regression Analysis/Scatter Plots

In this question you will apply the Account Analysis technique.  With this technique start by reading Item 1, 10-K of Amazon’s 10-K filed with the SEC.  This describes their business model.  From this business model and without referring to any quantitative data, so that your answer is based entirely upon your understanding of the business model for Amazon.com, apply the Account Analysis technique (i.e., professional judgment) to assess the cost behavior for the following three cost categories for Amazon.com.  That is, consider how these costs are likely to be generated given your understanding of Amazon’s business.  This will let you understand what the major cost drivers are likely to be for the following three categories:

a.     Cost of Goods Sold

b.    Selling and General Administration

c.    Research and Development

Estimate the proportion of each of the above cost categories that you assess to be variable and fixed (relative to sales revenue).  The sum of these proportions must equal 1.  Provide brief reasons in support of you assessed proportions in relation to your understanding of Amazon’s business model.

Question 8:  Estimating Cost Behavior using High Low Technique

In this question you will apply the High Low technique to separate total costs into fixed and variable components.

This method uses observations on two dates to estimate fixed costs and the variable cost per dollar of sales revenue.  The Y-Axis variable is the aggregate cost category and the X-axis variable is the volume of activity (usually sales revenue for an outsider).

Data:    Suppose Amazon’s Sales Revenue and COGS for the last 5-years is the following:

Apply the High Low Technique to compute the variable costs per dollar of sales for each of the following categories:

a.    Cost of Goods Sold

b.    Selling and General Administration (S&GA)

c.    Research and Development R&D

Question 9:  Estimating Cost Behavior using Regression Analysis

In this question you will apply the Regression Analysis Technique to separate total costs into fixed and variable components.

This is a statistical technique for estimating fixed and variable costs.span style="mso-spacerun: yes">  The advantage of this technique over the high low technique is that it uses all observations whereas the high/low technique uses only two.  Regression analysis is easy to perform in Excel using the following steps.  WWe show you how to decompose the total COGS into fixed and variable components, the problem you solve is to repeat this for SG&A and R&D using the following information.

Step 1:  In Valuation Tutor select Amazon and then click on Financial Statements, Statements (MSN):

Step 2:  Copy and paste the data into Excel and then use Excel’s Copy/Paste Special Transpose to get the data into the following block form ready for Regression:

The Y-Variable for the regression is in column U (U2..U6) and the X-Variable is in column T (T2..T6).

Step 3: Click on the “Data” menu item in Excel and then select Data Analysis from the Analysis ribbon item

Note:  If the Data Analysis item is not available, then in Excel, click on the Office Button, click on Excel Options, click Add-Ins and at the bottom, under “Manage Excel Add-Ins” – select the Analysis Tool Pack and click OK.  TThen close Excel and re-launch it.

Step 4:  In Data Analysis select Regression:

Note in the above the COGS is the Y-Variable and the Sales Revenue is the X-Variable (cost driver).

Click OK and the regression analysis is performed:

The variable cost per $ of sales is provided above beside X Variable 1 and equals 0.78.span style="mso-spacerun: yes">  In this example it turns out to be very similar to the High/Low method in the previous question – but this is not the norm.  AAgain the variable cost per $ of sales revenue is 0.78.

Repeat the above exercise to estimate the Variable Cost per $ of Sales for both S&GA and R&D respectively.

Question 10:  If you have completed questions 7 and 8 or questions 7 and 9 then answer the following.

In question 7 you assessed cost behavior using the Account Analysis technique.span style="mso-spacerun: yes">  This required professional judgment in relation to your understanding of Amazon’s business model.  In questions 8 or 9 you made use of data to estimate the proportion of variable to fixed costs in each category.  Did your estimates agree or disagree when using these two approaches?  PProvide a brief discussion as to why or why not.

Information for the next three questions:

Question 11:  UUsing the above information for Wal-Mart and Best Buy, define the contribution margin ratio, verify the calculation, and provide a brief description of what it means.

Question 12:  Using the above information for Wal-Mart and Best Buy, provide a brief interpretation of what could explain the differences in the contribution margin ratio for Wal-Mart and Best Buy.

Question 13:  Use the above information for Wal-Mart and Best Buy.  Suppose you expect sales for each company to increase by 3% over the next year.  WWhat is the predicted impact upon EBIT?

Real World Exercises

Exercise 1:  Business Ratios

Select two companies from the Current FTS Dataset that are competitors, or at least are in the same industry even if they do not directly compete with each other. 

Provide a summary report of the results from conducting financial statement analysis of the business ratios for your two stocks relative to each other.  Summarize what you view to be comparative advantages and disadvantages for these two stocks relative to this analysis.  IIn addition, comment on how efficiently you assess each firm is when implementing their business model/business strategy based upon your analysis of their business ratios.

Exercise 2:  Activity Analysis

Select two companies from the Current FTS Dataset that are competitors, or at least are in the same industry even if they do not directly compete with each other. 

By applying Valuation Tutor’s Activity Analysis Calculator (e.g., Asset Turnover and Financial Leverage subsections of the Business Efficiency section), provide a summary report of the results from conducting Activity Analysis for your two stocks and then compare along the following dimensions: 

i.       Degree of Operating Leverage

ii.            Degree of Financial Leverage

iii.           Degree of Total Leverage

iv.           Contribution Margin and Contribution Margin Ratio

v.            Break Even Margin

You will first need to estimate the % variable and fixed costs for each cost category.  You can refer to problems 7-9 above for guidance as to how.