DRAGON SOUP AND EARNINGS MANAGEMENT
For Case (A)
1. Using Excel sheet provided, and the recommended consequential disclosures as a basis for your analysis, what recommendations would you give Phillips on each of the items listed below? In each case, justify your recommendations and estimate how much the decision will change the true value of the company and its value in the eyes of an investor in a private company. a. The lease or buy decision, including whether to structure an operating lease. b. The regular price of the soup, whether or not to run an end-of year promotion or target end-of-year inventory level. c. Whether or not to ask Dunwood to guarantee accounts receivable. d. Whether or not to reduce the end-of-year provision for bad debts due to recent strong collection experience. e. Whether or not to sell different investments and, if the recommendation is not to sell the mortgage-backed securities, how to value them on the end-of-year balance sheet assuming market conditions do not change. Given your recommendations, how much do you think a potential buyer will offer based upon a valuation earnings multiple of ten times sustainable earnings, plus the value of cash and marketable investments on the balance sheet? 2. In the case, Phillips questioned how far he should push the envelope. Why should he be concerned if all the actions you recommend are legal? Do you think the associated disclosures satisfy the SEC requirement that a company provides a narrative explanation of its financial statements that enables investors to see the company through the eyes of the management?
For Case (B)
As stated in the case, Kerr had given the task of valuing Dragon’s equity for possible acquisition, assuming a valuation of ten times sustainable earnings, plus the value of cash and marketable investments on the balance sheet.
He understood that most companies preparing for the sale would “window dress” their financial statements. However,...
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