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Chapter_16web - (Refer to pp 559-561 Solutions a Firm A...

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EXERCISES FOR CHAPTER 16 With Solutions Exercise 1. Towards the end of 2003, Firm A purchased inventory for $230 million and carried it on its balance sheet at the end of 2003 at that historical cost. In 2004 it sold the inventory for $300 million. Firms B purchased the same inventory for the same amount but, before the end on 2003, wrote it down in its books to $190 million. It also subsequently sold the inventory for $300 million in 2004. a. For both firms, calculate earnings, the rate of return on book value, and residual earnings from selling the inventory in 2004. b. Calculate value added from selling the inventory and compare that value added with the numbers you calculated in part a. If they differ, why? Use a required return of 12% if needed in calculations.
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Unformatted text preview: (Refer to pp. 559-561) Solutions a. Firm A Firm B Sales revenue 300 300 Cost of goods sold 230 190 Income 70 110 Return on book value Firm A: 70/230 30.4% Firm B: 110/190 57.9% Residual earnings Firm A (70 – (0.12 x 230) 42.4 Firm B (110 – (0.12 x 190) 87.2 b. The value added for both firms is 42.4, that is, the residual earnings calculated for Firm A. Firm B’s residual income includes accounting value added as well as economic value added. By writing down book value, Firm B has done two things. First it has decreased cost of goods sold in 2004 (and thus increased earnings to 110) and, second, it has increased the rate of return (to 57.9%) by comparing those higher earnings to lower book values from the write off....
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