. 40
( 208 .)


Key Assumptions 1998 1997 1996
Discount rate 6.5% 7.0% 7.5%
Expected return on assets 9.0% 9.0% 9.0%
Current medical cost trend rate 8.65% 9.6% 10.0%
Ultimate medical cost trend rate 5.5% 6.0% 6.0%
Year current medical cost trend rate decreases
to ultimate rate 2007 2007 2007
Effect of a 1% increase in the medical cost
trend rate (millions):
Increase in bene¬t obligation $116% $101% $90%
Increase in annual retiree medical cost $17% $15% $13%
184 Liability and Equity Analysis

Liability and Equity Analysis

Funding Status (in millions) 1998 1997
Fair value of plan assets $503 $448
Bene¬t obligation (543) (475)
Plan assets in excess of (less than) bene¬t obligation (40) (27)
Unrecognized net experience (gain) loss (255) (268)
Unrecognized prior service cost (bene¬t) related to
plan changes (144) (154)
Prepaid (accrued) costs $(439) $(449)
What assumption is Hewlett Packard making about medical cost inflation in 2000
and 2010? What is the firm assuming it will earn on plan assets? As a financial ana-
lyst, how would you evaluate these assumptions? Are these rates reasonable? In
1998, what is the liability for the medical plan reported on the balance sheet? Is the
plan over- or underfunded? What other factors would you consider in evaluating
Hewlett Packard™s liability and risk under its medical plan?
6. Acceptance Insurance Companies Inc. underwrites and sells specialty property and
casualty insurance. The company is the third largest writer of crop insurance products
in the United States. In its 1998 10-K report to the SEC, it discloses the following
information on the loss reserves created for claims originating in 1990:
Cumulative net liability paid through: 12/31/90
One year later 40.6
Two years later 70.8
Three years later 88.5
Four years later 101.2
Five years later 107.5
Six years later 109.7
Seven years later 111.4
Eight years later 111.8
Net reserves reestimated as of:
One year later 100.3
Two years later 102.3
Three years later 107.4
Four years later 110.7
Five years later 112.7
Six years later 112.0
Seven years later 112.5
Eight years later 113.4
Net cumulative redundancy (de¬ciency) “13.4
What was the initial estimate for loss reserves originating in 1990? How has the firm
updated its estimate of this obligation over time? What liability remains for 1990
claims? As a financial analyst, what questions would you have for the CFO on its
1990 liability?
Liability and Equity Analysis

5-19 Part 2 Business Analysis and Valuation Tools

7. At the end of fiscal year 1997, Intel reported that it had set aside a liability of $87.9
million for potential warranty costs. At the end of 1998, Intel increased this estimate
to $115.5 million. As a financial analyst, what questions would you ask the firm™s
CFO about the warranty liability?
8. As discussed in the chapter, Muscocho Explorations Ltd., Flanagan McAdam Re-
sources, and McNellen Resources Inc. signed an agreement in January 1996 with
their principal secured creditor, Canadian Imperial Bank, to restructure the
CA$8.95 million secured debt the three companies owed the bank. Under the agree-
ment, Canadian Imperial received proceeds from the sale of the Magnacon Mill as
well as a $500,000 payment for the Magino Mill. The bank agreed to convert its re-
maining debt to 10 percent of the equity in a new company created by combining
Muscocho, Flanagan, and McNellen. What information would you need to record
the effects of this transaction in the books of the new combined firm? What finan-
cial statement effects of the transaction can you quantify? As a financial analyst,
what questions would you ask management of the new firm about the debt restruc-
9. As discussed in the chapter, on August 11, 1998, Helix Hearing Care of America
Corp. sold $2 million of convertible debentures. The debentures had a five-year
term and a 13 percent coupon rate and were convertible into Helix common shares
at CA$1.70. If Helix™s common stock were valued at $2.50 at conversion, what
would be the financial statement effects of conversion under (a) the book value
method and (b) the market value method? Which method do you consider best
reflects the economics of the conversion? Why?
10. For the first quarter of 1998, Microsoft reported the following reconciliation
between net income and comprehensive income:
Three Months Ended September 30
(millions of dollars): 1997 1998
Net income $663 1,683
Net unrealized investment gains 56 150
Translation adjustments and other (117) 43
Comprehensive income 602 1,876
What types of events give rise to the adjustments made by Microsoft? As a financial
analyst, what questions would you have for the CFO about the comprehensive in-
come statement?

1. See Milton Russell and Kimberly L Davis. “Resource Requirements for NPL Sites: Phase II
Interim Report,” Knoxville, JIEE, September 1995; and U.S. Congress Budget Office, “The Total
Costs of Cleaning Up Nonfederal Superfund Sites,” Washington, D.C., U.S. GPO, 1994.
186 Liability and Equity Analysis

Liability and Equity Analysis

2. See Mary E. Barth and Maureen McNichols, 1994, “Estimation and Market Valuation of En-
vironmental Liabilities Relating to Superfund Sites,” Journal of Accounting Research 32, Supple-
3. See Mary E. Barth, Maureen F. McNichols, and G. Peter Wilson, 1997, “Factors Influencing
Firms™ Disclosures about Environmental Liabilities,” Review of Accounting Studies 2, (1): 35“64.
4. M. Barth, “Relative Measurement Errors Among Alternative Pension Asset and Liability
Measures,” The Accounting Review 66, No. 3, 1991, finds that investors regard these footnote dis-
closures to be more useful than the liability reported in the financial statements.
5. E. Amir and E. Gordon, “A Firm™s Choice of Estimation Parameters: Empirical Evidence
from SFAS No. 106,” Journal of Accounting, Auditing & Finance 11, No. 3, Summer 1996, show
that firms with larger postretirement benefit obligations and more leverage tend to make more ag-
gressive estimates of postretirement obligation parameters.
6. Research by K. Petroni, “Optimistic Reporting in the Property Casualty Insurance Industry,”
Journal of Accounting and Economics 15, 1992; K. Petroni, S. Ryan, and J. Wahlen, “Discretion-
ary and Non-discretionary Revisions of Loss Reserves by Property-Casualty Insurers: Differential
Implications for Future Profitability, Risk, and Market Value,” working paper, Indiana Universi-
ty; and R. Adiel, “Reinsurance and the Management of Regulatory Ratios and Taxes in the Prop-
erty-Casualty Insurance Industry, Journal of Accounting and Economics 22, Nos. 1“3, 1996,
shows that financially weak property-casualty insurers that risk regulatory attention understate
claim loss reserves and engage in reinsurance transactions.
Manufactured Homes, Inc.

T his Winston-Salem company sells affordable Southern comfort:
fully furnished and carpeted mobile homes for as little as $10,000. Robert Sauls,
the 59-year-old founder and chairman, was an orphaned boy who never ¬nished
high school. Through acquisitions, Sauls has built the retailer into the industry™s
largest, with annual sales ballooning to about $180 million in four years. The
Business Analysis and
company sells the homes, built primarily by Fleetwood Enterprises and Redman Valuation Tools
Industries, to rural blue-collar workers in the Southeast. “Our people buy in good
times and bad,” says Sauls. If he can raise the capital, he foresees a doubling of
sales in four to ¬ve years. The stock recently sold at 6.5 times estimated 1988
Jane Edwards, Director of Research at a small Boston-based investment management
¬rm specializing in growth stocks, noted the above review of Manufactured Homes in
the February 15, 1988 issue of Fortune magazine™s Companies To Watch column. She
knew that attractive growth stocks are hard to ¬nd and wondered whether Manufactured Liability and Equity Analysis
Homes would be a good addition to her ¬rm™s growth stock portfolio. She checked the Manufac-
recent performance of Manufactured Homes™ common stock and noted that the stock tured
performed favorably relative to the stock market (see Exhibit 1). Jane Edwards asked her Homes
assistant Peter Herman to gather additional information on the company and to write a
report analyzing the company™s recent ¬nancial statements.

Herman™s preliminary research on Manufactured Homes indicated that the company was
founded in 1975 with two retail outlets for mobile homes. The company grew rapidly
and by March 31, 1987, had a network of 120 retail outlets located in seven southeastern
states. Eighty-¬ve percent of the company™s retail centers were located in North Caroli-
na, South Carolina, Alabama, Georgia, and Florida, with the remaining sales centers in
Virginia and West Virginia. The company went public in 1983 and was listed on the
American Stock Exchange in January 1987.
The southeastern U.S. was the country™s fastest growing market for mobile homes
due to suitable climate, the easy availability of vacant land for mobile-home parks, and

Professor Krishna G. Palepu prepared this case as the basis for class discussion rather than to illustrate either
effective or ineffective handling of an administrative situation. Copyright © 1989 by the President and Fellows of
Harvard College. Harvard Business School case 9-190-090.

188 Liability and Equity Analysis

Liability and Equity Analysis

the region™s demographics. Potential customers for manufactured homes included indi-
viduals seeking a single-family primary residence but lacking the ability to purchase
conventional housing, retirees, and those wanting a second home for vacation purposes.
The company targeted individuals in the low income category, which was a segment
of the manufactured homes market in the company™s seven-state operating area. The
company™s customers were typically between the ages of 18 and 40, blue-collar workers
in manufacturing, service, and agricultural industries, and earned approximately
$20,000 per year. Many of them were seeking single-family accommodations for their
families and turned to manufactured homes because conventional low-cost housing was

Manufactured Homes
becoming increasingly less affordable.
Manufactured homes came in a wide variety of styles, including both single and
multi-sectional units. They typically had a living room, a kitchen and dining area, and
bedrooms and baths, with a wide variety in the size, number and layout of rooms among
the various models. The single-sectional homes ranged in size from 588 to 1008 square
feet and retailed at prices between $10,000 and $25,000, with the majority selling below
$17,000. The multi-sectional homes were 960“2016 square feet and sold at prices rang-
ing from $17,000 to $40,000. Single-sectional homes represented most of the company™s
sales. While approximately 30 percent of all unit sales in the industry in 1986 were
multi-sectional homes, they represented only about 20 percent of Manufactured Homes™
unit volume.
The company believed that its focus on the lower end of the market had two advan-
tages. First, since its customers were seeking to ful¬ll an essential housing need, sales
were less affected by changes in general economic conditions. Second, the company™s
repossession rates were signi¬cantly lower than those of the industry since its customers
were likely to work very hard to keep their primary residences even when times were

Most of Manufactured Homes™ sales were credit sales where the customer paid a down
payment of 5 to 10 percent of the sales price and entered into an installment sales con-
tract with the company to pay the remaining amount over periods ranging from 84 to 180
months. The company generally sold the majority of its retail installment contracts to
unrelated ¬nancial institutions on a recourse basis. Under this agreement, Manufactured
Homes was responsible for payments to the ¬nancial institution if the customer failed to
make the payments speci¬ed in the installment contract.
While the installment sale interest rate that Manufactured Homes charged its custom-
ers was limited by competitive conditions, it was typically higher than market interest
rates. Therefore, the ¬nancial institutions to whom these contracts were sold on a re-
course basis usually paid the company the stated principal amount of the contract and a
portion of the differential between the stated interest rate and the market rate. (The re-
mainder of the interest rate differential was retained by the ¬nancial institutions as a se-
Liability and Equity Analysis

5-23 Part 2 Business Analysis and Valuation Tools

curity against credit losses and was paid to the company in proportion to customer
payments received. The reserve required varied up to seven percent of the aggregate
amount ¬nanced, including principal and interest.) The company therefore had two
sources of revenue: the sale of homes (sales revenue), and the interest rate “spread” (¬-
nance participation income).
Peter Herman noted that Financial Accounting Board™s Statement 77 (FASB-77) gov-
erns the accounting treatment for installment sales receivables that are transferred by a


. 40
( 208 .)