amounts securitized and the retained interest in those securitized receivables separately. It

also reports the charge-off rate for the year (note the decline in 2000) and the year-end delin-

quency rate. These data can be compared with those of similar companies.

Finally, Sears reports the cash ¬‚ows associated with its securitization activities. These

amounts are not reported in the company™s statement of cash ¬‚ows. Sears received more than

$2.6 billion from securitizations in 2000 and reinvested more than $3.5 billion of collections

in previous securitizations. The company received $200 million of servicing fees, consistent

with the 2% fee reported earlier in Note 3. Sears spent $522 million to repurchase charged-

off balances, net of recovery of earlier repurchased receivables.

These disclosures provide the analyst with a reasonable understanding of the importance

of securitization as a source of ¬nancing for Sears. Comparisons can be made with other

¬rms, especially once more years of data are accumulated.

Part C: Disclosures”Sears 2001 Annual Report

Note 3”Credit Card Receivables

The addition of previously uncommitted assets to the securitization trust in April 2001 re-

quired the Company to consolidate the securitization structure for ¬nancial reporting pur-

poses on a prospective basis. Accordingly, the company recognized approximately $8.1

billion of previously unconsolidated securitized credit card receivables and related securiti-

zation borrowings in the second quarter of 2001. In addition, approximately $3.9 billion of

assets were reclassi¬ed to credit card receivables from retained interests in transferred credit

card receivables. The Company now accounts for securitizations as secured borrowings.

In connection with the consolidation of the securitization structure, the Company recog-

nized a non-cash, pretax charge of $522 million to establish an allowance for uncollectible

accounts related to the receivables, which were previously considered sold or accounted for

as retained interests in transferred credit card receivables.

W53

ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION

Accounting for Securitizations”SFAS 125

Prior to April 2001, the issuance of certi¬cates to outside investors was considered a sale of

receivables for which the Company recognized a gain on the sale. The Company recognized

incremental operating income of $40, $128, and $86 million in 2001, 2000, and 1999, re-

spectively, from net securitization activity.

The Company™s retained interests were recorded by the Company at the date of the sale

to the trusts by allocating the original carrying amounts of the credit card receivables held by

the Company between the sold interests and the retained interests based on their relative fair

values. Management used certain assumptions in determining the fair value of its retained in-

terests. Key assumptions used in the ¬rst quarter of 2001 and in ¬scal 2000 were a yield of

19.85%, a monthly principal payment rate of 5.26%, a discount rate of 12.0%, and an annual

charge-off rate of 7.40%.

Securitization Cash Flow Data

The table below summarizes certain cash ¬‚ows that the Company received from and paid to

the securitization trust in 2000. Cash ¬‚ow data has not been provided for 2001 as the securi-

tization trust was consolidated beginning in the second quarter.

Millions 2000

Proceeds from new securitizations $2,620

Proceeds from collections reinvested in previous securitizations 3,547

Servicing fee received 200

Purchase of charged-off balances, net of recoveries (522)

ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION

The Company has signi¬cant ¬nancial capacity and ¬‚exibility due to the quality and liquidity

of its assets, principally its credit card receivables. As such, the Company has the ability to

access multiple sources of capital.

A summary of the Company™s credit card receivables at year-end is as follows:

Millions 2001 2000 1999

Domestic:

Managed credit card receivables $27,599 $27,001 $26,785

Securitized balances sold ” (7,834) (6,579)

Retained interest in transferred credit card ” (3,051) (3,175)

receivables(1)

Other customer receivables $27,640 $16,159 $17,037

Domestic owned credit card receivables $27,639 $16,175 $17,068

Sears Canada credit card receivables $21,682 $11,828 $11,725

Consolidated owned credit card receivables $29,321 $18,003 $18,793

(1)

The 2000 and 1999 retained interest amounts exclude reserves of $82 and $31 million, respectively, and interest-

only strip balances of $136 and $67 million, respectively, related to the transfer of credit card receivables into the

Trust.

As of year-end 2000 and 1999, the credit card receivables balance of $18.0 billion and

$18.8 billion, respectively, excluded credit card receivables transferred to a securitization

Master Trust (“Trust”). Through its subsidiary, SRFG, Inc., the Company obtains funding

by selling securities backed by a portion of the receivables in the Trust. In addition to the re-

ceivables in the Trust, which support securities sold to third parties, the Company transfers

W54 APPENDIX 11-A SECURITIZATION: SFAS 140 REPORTING AND DISCLOSURE REQUIREMENTS” SEARS

additional receivables to the Trust to have receivables readily available for future securitiza-

tions. As discussed in Note 3 of the Company™s Consolidated Financial Statements, the

Company consolidated its Master Trust beginning in the second quarter of 2001, subsequent

to the adoption of SFAS No. 140. The Company continues to utilize securitizations as a key

funding source.

CAPITAL RESOURCES

Total borrowings outstanding at the end of 2001 and 2000 were $25.6 billion and $25.7 bil-

lion, respectively. Total borrowings, including debt re¬‚ected on the balance sheet and in-

vestor certi¬cates related to credit card receivables issued through securitizations, were as

follows:

% of % of % of

Millions 2001 Total 2000 Total 1999 Total

Short-term borrowings $ 3,557 13.9% $ 4,280 16.7% $ 2,989 12.2%

Long-term debt(1) $22,078 186.1% $13,580 152.8% $15,049 161.1%

Securitized balances sold(2) $22,0” ” 7,834 30.5% 6,579 26.7%

Total borrowings $25,635 100.0% $25,694 100.0% $24,617 100.0%

(1)

Includes capitalized lease obligations.

(2)

Included in long-term debt in 2001 due to the change in securitization accounting; the securitization trust was not

consolidated in 2000 and 1999 (see Note 3 of the Notes to the Consolidated Financial Statements).

Source: Sears 2001 Annual Report

Part D: Discussion

Adoption of SFAS 140 requires consolidation of receivables previously considered sold.

Sears notes (1) the impact of non-recognition of any gain on sale on operating income and

(2) the impact on reported leverage. Although the change in operating income is not signi¬-

cant, reported income better re¬‚ects the earnings process and the impact of charge-offs. Re-

ported leverage shows a signi¬cant increase. Exhibit 11A-1 shows an increase in reported

leverage to approximately 419% from 286% that would have been reported had Sears contin-

ued to report the securitizations as sales. The inclusion of receivables and related borrowings

also better re¬‚ects the liquidity and the interest coverage.

EXHIBIT 11A-1

Sears: Impact of SFAS 140

Capitalization at 12/31/01

Amounts in $millions Pro Forma* As Reported

Short-term debt $ 6,714 $ 6,714

Long-term debt 10,778 18,921

Total debt 17,492 25,635

Stockholders™ equity 6,119 6,119

Debt-equity ratio 286% 419%

*Pro Forma assumes that SFAS 140 was not adopted on April 1

Appendix 18-A

RATIOS USED IN CREDIT AND EQUITY RISK

PREDICTION MODELS

Chapter 18 discusses research that examined the utility of accounting (and other ¬nancial)

measures in risk evaluation and prediction. The exhibits provided in this appendix list the ex-

planatory independent variables (¬nancial risk measures) used in the key research studies in

this area. The topics covered by the exhibits are:

Exhibits 18A-1(a) and (b) Bankruptcy Prediction Models

Exhibit 18A-2 Bond Ratings Prediction Models

Exhibit 18A-3 Beta Prediction Models

The exhibits, except for Exhibit 18A-1(b), are all similar in layout detailing the speci¬c vari-

ables used in each of the studies. Exhibit 18A-1(b) [adapted from Reilly (1991) and work by

Gentry, Newbold, and Whitford (1994)], on the other hand, summarizes the ¬ndings of four-

teen studies that focused on bankruptcy prediction.

As noted in the chapter, for the most part, the ratios found to be useful in the research

correspond to the categories (activity, liquidity, solvency, and pro¬tability) that we have

used throughout the book. Additional new indicators are primarily measures of earnings vari-

ability and size.

W55

W56 APPENDIX 18-A RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-1(a)

Independent Variables Used in Bankruptcy Prediction Models

Ohlson (1980) Altman et al. (1977) Deakin (1972) Altman (1968)

Activity Four asset categories Sales to total assets

divided by sales:

(1) Current assets

(2) Quick assets

(3) Working capital

(4) Cash

Liquidity Current ratio Current ratio Current ratio

Quick ratio

Cash ratio

Four asset categories

divided by total assets:

(1) Current assets

(2) Quick assets

(3) Working capital

Working capital to (4) Cash Working capital to

total assets total assets

Leverage and Solvency Liabilities to assets Equity (market) to Capital Debt to assets Equity (market) to

Times Interest earned debt (book)

Funds from operations Funds from operations

to total liabilities to debt

Dummy variable

indicating if net

worth is negative

Pro¬tability Return on assets Return on assets Return on assets Return on assets

Dummy variable indicating Retained earnings to Retained earnings

if net income was total assets to total assets

negative in last two years

Earnings variability Percentage change in net Standard error of

income return on assets

Size Total Assets Total Assets

W57

RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-1(b)

Summary of Most Useful Ratios for Predicting Failure

Category/Ratios Number of Studies in Which the Ratio Was Signi¬cant

Financial Leverage

Cash Flow/Total Debt 7

Total Debt/Total Assets 6

Retained Earnings/Total Assets 5

Short-term Liquidity

Net Working Capital/Total Assets 6

Current Assets/Current Liabilities 6

Cash/Sales 2

Cash/Current Liabilities 4

Pro¬tability

Net Income/Total Assets 5

EBIT/Total Assets 4

Activity

Quick Assets/Sales 2

Adapted from Frank K. Reilly, “Using Cash Flows and Financial Ratios to Predict Bankruptcies,” Analyzing Invest-

ment Opportunities in Distressed and Bankrupt Companies, Charlottesville, VA: The Institute of Chartered Finan-

cial Analysts, 1991, Table 1, P.25

W58 APPENDIX 18-A RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-2

Independent Variables Used in Bond Ratings Prediction Models

Kaplan and Pinches and Pogue and

Belkaoui Belkaoui Urwitz Mingo Soldovsky Horrigan West

(1983) (1980) (1979) (1973) (1969) (1966) (1966)

Activity and Current ratio Current ratio Working capital

liquidity to sales

Sales to equity

Leverage and Long-term debt Long-term debt Long-term debt Total debt to Debt to capital Equity to debt Debt to equity

solvency to capital to capital to assets assets (market

values)

Short-term debt Short-term Long-term debt

to capital debt to to equity

capital

Fixed charge Fixed charge Times interest Times interest Times interest

coverage coverage earned earned earned

Cash ¬‚ow to Cash ¬‚ow to debt

investment in

¬xed assets and

inventory plus

dividends

Pro¬tability Return on assets Return on Return on Operating pro¬t

assets assets

Earnings Accounting beta Years of Coef¬cient of

variability consecutive variation”

dividends ROA

Coef¬cient of Coef¬cient of

variation”net variation”net

income income

Size Total assets Total assets Total assets Issue size Total assets Total assets Bonds

outstanding

Subordination 0-1 dummy 0-1 dummy 0-1 dummy 0-1 dummy 0-1 dummy

Market-based Price to net Price to net Market beta

book value book value

Other Coef¬cient of Industry Period of

variation”total dummy solvency

assets variable

W59

RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-3

Independent Variables Used in Beta Prediction Models

Predictive and Explanatory Explanatory

Rosenberg Mandelker Ball

and and and

Hochman McKibben Beaver et al. Rhee Bildersee Lev Brown

(1983) (1973) (1970) (1984) (1975) (1974) (1968)

Earnings Operating Accounting beta * OLE Variable Accounting

Variability Risk (operating cost % beta

income) (v)

Financial Debt to capital FLE Debt to equity

Risk Preferred equity

to common

equity

Total Standard Standard

Risk† deviation deviation

earnings/ earnings/price

price

Growth Dividend yield Asset growth

Dividends Dividend

payout

Liquidity Current ratio

*See Exhibit 18-8 in text.

†

Earnings variability can be measured as the sum of operating risk and ¬nancial risk.

Appendix 19-A

MULTISTAGE GROWTH MODELS

The original formulation of the discounted models discussed in the chapter is presented below:

kEi

P0

r)i

(1

i1

Theoretically, by predicting each year individually, any assumed growth rate of dividends or

earnings payout (even zero dividends) can be accommodated. From a practical point of view,

of course, one would not attempt to forecast individual periods over a very long horizon.

One palatable approach is to forecast the near future individually and then impose an as-

sumption as to the appropriate valuation after that period. Recall that the preceding expres-

sion is equivalent to

kEn Pn

kE1 kE2

P0

(1 r)n r)n

(1 r) 2 (1

(1 r)

This is the present value of the dividends over the ¬rst n years plus the discounted value at

the end of year n.

For example, assume that you forecast a ¬rm™s net income over the next three years as

year 1 100, year 2 120, and year 3 150. The ¬rm™s k 20% and its r 10%. To use

the preceding equation, one must derive a terminal value for the ¬rm at the end of year 3.

You may at this point decide to make some general assumptions. One assumption might be

that from the third year on the ¬rm will experience growth of 8%. The implicit forecast for

year 4™s earnings is (1.08 $150) $162, and the terminal value at the end of year 3 (if we

use the constant growth model presented earlier) is equal to

0.2 $162

P3 $1,620

0.10 0.08

The value now will be equal to

$1,620

$100 $120 $150

P0

(1.1) 2 3

(1.1)3

(1.1) (1.1)

$91 $99 $133 $1,217 $1,520

VALUING A NONDIVIDEND-PAYING FIRM

A ¬rm paying zero dividends can also be modeled along these lines. A ¬rm that pays zero

dividends reinvests everything in the ¬rm. Its growth rate is equal to [1 k]r* r* since

k 0. Assume that a ¬rm having an r* of 25% for the next ¬ve years does not plan to pay

dividends for those ¬ve years. If its present earning level is $10, its earnings in year 5 will

equal $10(1.25)5 $30.5. From year 6 and on, assume that its r* will be 20% and the ¬rm will

pay dividends at a rate k 60%. Its growth rate will therefore equal (1 60%) 20% 8%.

Earnings in year 6 will equal $30.5(1.08) $32.9. The ¬rm™s value at the beginning of year

6 will be equal to

0.6 $32.9

$987

0.1 0.08

W60

W61

SHIFTING GROWTH RATE PATTERNS

The value today will be equal to the $987 discounted (back ¬ve years) to the beginning

of year 1 or $987/(1.10)5 $613.

SHIFTING GROWTH RATE PATTERNS

Variations of this approach assume a certain level of growth over some initial phase and dif-

ferent growth rates after the initial phase (Figure 19A-1).

The ¬nite growth model (Figure 19A-1a) assumes that the ¬rm will experience growth

of g (1 k)r* for n years. After that point, the abnormal investment opportunities of r*

r will not exist. The value of equity for such a ¬rm will equal

n

E1 g r (1 k) 1 g

E1

P0 1

r r rg 1 r

Other models commonly referred to as three-phase models assume (Figure 19A-1b) an

initial (phase 1) high abnormal growth rate ga for a number of years that tapers off (in phase

2) to a long-term (phase 3) normal growth pattern of gn. The calculations for these models

FIGURE 19A-1a“c. Simpli¬ed three-phase model

(Fuller and Hsia, 1984). Source: Russel J. Fuller

and Chi-Cheng Hsia, “A Simpli¬ed Common

Stock Valuation Model,” Financial Analysts Jour-

nal, September“October 1984, pp. 49“56 (Figure

B, p. 50, and Figure E, p. 53).

W62 APPENDIX 19-A MULTISTAGE GROWTH MODELS

are somewhat complex. Fuller and Hsia (1984) simpli¬ed these models by assuming a

growth pattern as depicted in Figure 19A-1c. They start with initial above-normal growth,

but assume that it converges gradually to a stable long-term growth pattern. If we stay with

the de¬nitions of ga as the initial growth pattern and gn as the long-term growth pattern to be

reached within n years, the value of the equity is equal to

kE0 n

P0 r gn (1 gn) (g gn)

2a

Appendix 19-B

THE EBO AND TERMINAL VALUE

ASSUMPTIONS

The terminal value calculations in the chapter assume that ROE remains constant after pe-

riod T, at r or some other level. Figure 4-3, however, indicates that it is more likely for ROE

to converge asymptotically to a steady-state level. This appendix presents valuation formulae

that can be used when the rate of convergence can be modeled as an autoregressive process,

that is,

(ROEt ROE) c(ROEt ROE)

1

or

ROEt ROE c(ROEt ROE) where 0 c 1

1

where ROEt converges to the steady-state level ROE. The equation indicates that, in each pe-

riod, the gap between the actual ROE and the steady-state level narrows as a function of the

autoregressive parameter c.

Under these assumptions, the valuation formula becomes

(ROEj r)Bj

T (ROET ROE)c (ROE r)

BT

1 1

P0 B0 rg

T 1 r c(1 g)

j

(1 r)

(1 r)

j1

where g represents the assumed growth rate in book value. Explicit forecasts of earnings

(ROE and book value) are made for T periods, followed by the terminal value calculation in

the braces.

In the chapter, we note that, even if abnormal earnings were to continue inde¬nitely

(ROE r) because of a special situation such as patent protection, it is unlikely that similar

higher returns could be earned on new projects. Thus, the abnormal earnings would not grow

as book value increases. Setting g 0 yields

(ROEj r)Bj

T (ROET ROE)c (ROE r)

BT 1

P0 B0 r

r)T 1rc

r) j (1

(1

j1

If competitive pressures force abnormal pro¬ts to zero, then at steady state, ROE r and the

valuation formula becomes

(ROEj r)Bj

T (ROET r)c

BT 1

P0 B0 T 1r c

j

(1 r)

(1 r)

j1

W63