Pace University
FIN 340/ FIN 680F Valuation of the Firm
Prof. P.V. Viswanath

Fall 2008



  1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  3. You may bring in sheets with formulas, but no worked-out examples.
  4. You must explain all your answers.
  5. You have 2 hours to complete the exam; please make sure to attempt all the questions, so I can give you partial credit, if necessary.

Kroger Sales Rise 9%; Net Declines on a Charge
Wall Street Journal, December 10, 2008, By David Kesmodel

Kroger Co. said its quarterly profit fell 6.3%, largely because of a charge related to Hurricane Ike, but the supermarket giant's revenue jumped 9% as its low prices and store brands enticed shoppers battered by the U.S. recession.

The Cincinnati-based retailer also increased its earnings guidance for the full year. Its shares were off 6.7% at $25.47 in 4 p.m. New York Stock Exchange composite trading Tuesday, however, because its profit forecast for the current quarter was slightly below analysts' projections. [Kroger earnings]

Kroger said net income for its fiscal third quarter ended Nov. 8 dropped to $237.7 million, or 36 cents a share, from $253.8 million, or 37 cents a share, a year earlier. Revenue climbed to $17.6 billion from $16.1 billion.

Excluding an after-tax charge equal to three cents a share related to insurance costs for Ike, which damaged Kroger stores, the company said profit would have been $253.6 million, or 39 cents a share.

Analysts had predicted earnings of 38 cents a share and revenue of $17.4 billion, according to a Thomson Reuters survey.

David Dillon, Kroger's chief executive, told analysts in a conference call that he is "feeling pretty good about things, given the environment we're operating in." He said Kroger's strategy of lowering prices, which has reduced its gross margins, "continues to resonate well with customers."

Kroger's same-store sales, a key barometer of the health of grocery stores, rose 5.6%, one of the highest rates in the industry and an improvement from the second-quarter rate of 4.7%. The figures exclude sales of gasoline at stores with fuel pumps.

The retailer's profit partly was damped by higher food inflation, which has affected the grocery industry throughout this year. Kroger said its product-cost inflation in the latest quarter was roughly 6%.

Mr. Dillon also said Kroger "could have done a better job of managing expenses in the quarter."

Kroger is projecting full-year earnings of $1.88 to $1.91 a share, excluding the charge related to the hurricane. It had earlier projected $1.85 to $1.90 a share, while analysts were pegging earnings at $1.92 a share.

The company estimates fourth-quarter profit of 49 cents to 52 cents a share, citing in part expectations for sluggish holiday spending. Analysts had projected earnings of 53 cents a share, according to Thomson Reuters.


Here is some additional information:

The following table (from NetAdvantage) provides revenues in millions of dollars for Kroger Co. (fiscal year ending January). Second set of numbers provide growth rate over sales in same quarter, previous year (except for last line).
2008 2007 2006 2005 2004 2003 2002
 1Q 20,726 19,415 17,948 16,905 16,266 15,667 15,102
 2Q 16,139 15,138 13,865 12,980 12,351 11,927 11,485
 3Q 16,135 14,999 14,020 12,854 12,141 11,696 11,382
 4Q 17,235 16,859 14,720 13,695 13,034 12,470 12,129
 Year 70,235 66,111 60,553 56,434 53,791 51,760 50,098
  2008 2007 2006 2005 2004 2003
 1Q 6.75% 8.17% 6.17% 3.93% 3.82% 3.74%
 2Q 6.61% 9.18% 6.82% 5.09% 3.55% 3.85%
 3Q 7.57% 6.98% 9.07% 5.87% 3.80% 2.76%
 4Q 2.23% 14.53% 7.48% 5.07% 4.52% 2.81%
 Year 6.24% 9.18% 7.30% 4.91% 3.92% 3.32%

The following table from NetAdvantage provides other details from the Income Statement (in millions of dollars):

  2008 2007 2006 2005 2004 2003 2002 2001 2000 1999












Operating Income






















Interest Expense











Pretax Income











Eff Tax Rate











Net Income











The table below shows the same information, but with the numbers for each year as a percentage of revenues for that year:

2008 2007 2006 2005 2004 2003 2002 2001 2000 1999
Revenue 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Operating Income 5.21% 5.31% 5.45% 5.32% 5.85% 7.10% 7.12% 6.93% 6.89% 5.00%
Depreciation 1.93% 1.92% 2.09% 2.23% 2.25% 2.10% 1.94% 1.85% 2.12% 1.52%
Interest Expense 0.67% 0.74% 0.84% 0.99% 1.12% 1.16% 1.29% 1.38% 1.44% 0.95%
Pretax Income 2.60% 2.64% 2.52% 0.51% 1.43% 3.81% 3.42% 3.08% 2.49% 2.53%
Net Income 1.68% 1.69% 1.58% -0.18% 0.59% 2.38% 2.08% 1.80% 1.41% 1.60%

CORPORATE OVERVIEW (from NetAdvantage): Kroger is one of the largest U.S. supermarket chains, with 2,486 supermarkets as of February 2008. The company's principal operating format is combination food and drug stores (combo stores). In addition to combo stores, KR also operates multi-department stores, marketplace stores, price-impact warehouses, convenience stores, fuel centers, jewelry stores, and food processing plants. Total food store square footage exceeded 145 million as of February 2008.

Retail food stores are operated under three formats: combo stores, multi-department stores, and price-impact warehouse stores. Combo stores are considered neighborhood stores, and include many specialty departments, such as whole health sections, pharmacies, general merchandise, pet centers, and perishables, such as fresh seafood and organic produce. Combo banners include Kroger, Ralphs, King Soopers, City Market, Dillons, Smith's, Fry's, QFC, Hilander, Owen's, Jay C, Baker's, Pay Less and Gerbes.

Multi-department stores offer one-stop shopping, are significantly larger in size than combo stores, and sell a wider selection of general merchandise items, including apparel, home fashion and furnishings, electronics, automotive, toys, and fine jewelry. Multi-department formats include Fred Meyer, Fry's Marketplace, Smith's Marketplace and Kroger Marketplace. Many combination and multi-department stores include a fuel center.

Price-impact warehouse stores offer everyday low prices, plus promotions for a wide selection of grocery and health and beauty care items. Price-impact warehouse stores include Food 4 Less and Foods Co.

KR also operates convenience stores, jewelry stores, and food processing plants. The company's 782 convenience stores offer a limited assortment of staple food items and general merchandise, and, in most cases, sell gasoline. Convenience store banners include Kwik Shop, Loaf N' Jug Mini Mart, Quik Stop markets, Tom Thumb Food Stores, and Turkey Hill Minit Markets. With 394 jewelry stores, the company is one of the largest U.S. jewelry retailers. Jewelry stores operate under banners such as Barclay Jewelers, Fred Meyer Jewelers, and Littman Jewelers. In addition, KR operates 42 manufacturing plants, consisting of 18 dairies, 11 deli or bakery plants, five grocery products plants, three beverage plants, three meat plants, and two cheese plants.

CORPORATE STRATEGY. Kroger aims to increase shareholder value through its dividend program and sustained earnings growth created by strong identical store sales, slight operating margin improvement, and continued share repurchases. At the beginning of 2008, the company held the number one or number two market share position in 39 of its 44 major markets, which consist of nine or more stores. The company strives to grow market share as this allows it to leverage fixed costs over a wider revenue base.

To generate identical store sales growth and market share gains, the company adheres to its Customer 1st strategy. This strategy focuses company efforts on improving employee communications and training; using customer research and loyalty data analysis to personalize stores on a market by market and store by store basis; improving customer loyalty by improving customers' shopping experience (improved convenience and accessibility through multiple store formats, store cleanliness and security, reducing checkout wait times, etc.); and pricing within an acceptable range of discounters' prices so that price becomes a neutral factor in customers' shopping decisions.

As an important part of its merchandising strategy, KR offers about 14,400 private label items. Products are sold in three tiers. Private Selection is a premium quality brand, designed to meet or beat the gourmet or upscale national or regional brands. The banner brand (Kroger, Ralphs, King Soopers, etc.) represents the majority of KR's private label items, and is designed to be equal to or better than the national brand. The Kroger Value brand is designed to deliver good quality at an affordable price. About 43% of corporate brand volume is manufactured in the company's plants.

FINANCIAL TRENDS. In the five years through FY 08, the company experienced a compound annual growth rate (CAGR) for revenues of 6.3%, reflecting increased same-store sales and square footage expansion. As of February 2008, the company was targeting EPS of $1.83 to $1.90 for FY 09, up 8% to 12% from operating EPS of $1.69 in FY 08. To achieve its EPS target, the company expects to achieve identical food store sales growth, excluding fuel sales, of 3% to 5%, and square footage growth of approximately 2.0% to 2.5%. KR expects capital expenditures for FY 09 of $2.0 billion to $2.2 billion, excluding acquisitions. The company reduced shares outstanding by 12% between 2003 and 2008. As of February 2008, $941 million remained under a $1 billion stock repurchase program that directors approved in January 2008.

Using the information above, answer the following questions. Please interpret statements by management cautiously -- do not take them as automatically true; at the same time, you don't have to ignore them, either.

  1. (5 points) Forecast revenues for fiscal year 2009 (ending Jan. 2009). Explain. (Keep in mind that this is not so much a forecast, since it's already mid-December and fiscal 2009 ends Jan. 2009 -- so it's more of an estimate than a forecast!)
  2. (10 points) Forecast revenues for fiscal years 2010 through 2012. How would the competitive environment in the retail sector that Kroger operates in affect your forecast of Kroger's revenues? Explain.
  3. (10 points) Forecast operating profit margins for 2009 through 2012. Explain.
  4. (5 points) How long would you set the forecast period at? What stable growth rate would you assume? What drivers would you use to determine the stable growth rate? Explain.
  5. (10 points) What would you infer from the pattern of behavior of depreciation as a fraction of revenue over time?
  6. (10 points) Can you make any inferences about Kroger's financial leverage? Is it too high or too low? Explain.
  7. (5 points) Quoting David Dillon, Kroger's chief executive, the article tells us that Kroger's strategy of lowering prices, which has reduced its gross margins, "continues to resonate well with customers." Interpret Dillon's statement, in the light of the information in the last table.

2. Research and Development Expenses for Deere and Co., according to the 10K filed by the company, for the year ended Oct. 10, 2007 are as shown below in millions of dollars:

2007 817
2006 726
2005 677
2004 612
2003 577
2002 528
2001 590
2000 542
1999 458
1998 445

Company Profile ( Deere & Company engages in the manufacture and distribution of products and services for agriculture and forestry worldwide. It operates in four segments: Agricultural Equipment, Commercial and Consumer Equipment, Construction and Forestry, and Credit. The Agricultural Equipment segment offers a line of farm equipment and related service parts, including tractors; combine, cotton, and sugarcane harvesters; tillage, seeding, and soil preparation machinery; sprayers; hay and forage equipment; integrated agricultural management systems technology; and precision agricultural irrigation equipment. The Commercial and Consumer Equipment segment provides equipment, products, and service parts for commercial and residential uses, such as tractors for lawn, garden, commercial, and utility purposes; mowing equipment, including walk-behind mowers; golf course equipment; utility vehicles; landscape and nursery products; irrigation equipment; and other outdoor power products. The Construction and Forestry segment offers a range of machines and service parts used in construction, earthmoving, material handling, and timber harvesting, including backhoe loaders; crawler dozers and loaders; four-wheel-drive loaders; excavators; motor graders; articulated dump trucks; landscape loaders; skid-steer loaders; and log skidders, feller bunchers, log loaders, log forwarders, log harvesters, and related attachments. Its products and services are marketed primarily through independent retail dealer networks and retail outlets. The Credit segment primarily finances sales and leases by dealers of new and used agricultural, commercial and consumer, and construction and forestry equipment. It also provides wholesale financing to dealers of the foregoing equipment, provides operating loans, finances retail revolving charge accounts, offers certain crop risk mitigation products, and invests in wind energy generation. The company was founded in 1837 and is based in Moline, Illinois.

  1. (5 points) What is the life over which you would capitalize R&D expenses? Use the firm description above. Make any other appropriate assumptions necessary. Explain your arguments.
  2. (10 points) What is the capitalized value of R&D expenses that you would put in a revised balance sheet for 2007? Assume that R&D outlays affect cashflows only in the year following their expenditure.
  3. (5 points) Is it appropriate to use straight line amortization to amortize R&D? Justify your answer.
  4. (5 points) For the year ended Oct. 10, 2007, Net Income was $1822m. Income of the Consolidated Group before Income Taxes was $2676m. Interest expenses were $1151m. Compute Deere and Co.'s operating income after adjusting for the capitalization of Research and Development outlays.

3. (30 points) Answer any three of the following questions:

  1. Free Cashflows to the firm is the sum of Free Cashflows to Equity plus Interest payments to bondholders. Is this true or not? Explain.
  2. There is no reason to consider changes in cash as part of reinvestment, when computing free cashflow because cash is always nonproductive. That is why we compute reinvestment in short-term capital as change in non-cash working capital rather than simply change in working capital. True or not true? Explain.
  3. Figuring out the optimal capital structure of a firm is an integral part of valuation. Explain.
  4. When would you use a dividend discount model instead of a free cashflow model?
  5. Discounted Cashflow Valuation is unreliable because there are so many assumptions that the analyst needs to make. Relative Valuation, on the other hand, is more definitive and less subject to the whims and biases of the analyst. Do you agree or disagree? Explain your answer.