Business 30130

Abbie Smith

PRACTICE PROBLEM PRO-FORMAS THE GAP - PART I1

Purpose: The Gap - Part I provides practice in building pro-forma financial statements given specific assumptions. The Gap - Part II will use the pro-formas created in Part I to estimate the value of the equity of The Gap, Inc.. Background Materials: The Gap, Inc. 1996 Annual Report Value Line outlook for Specialty Retailing Selected financial ratios for Retail_Apparel Industry The following excel files, available on Chalk: gap.xls Includes historical financial statements and worksheets for the pro-forma income statements, balance sheets, and cash flow statements. GAP_PROFORMAS (solution Gap I).xls - Contains the proforma financial statements (i.e. the solution) Directions: Prepare a pro-forma balance sheet, income statement, and cash flow statement for The Gap, Inc. for each year 1997-2006 using the assumptions provided below. Pro-forma Assumptions: 1. 2. 3. Sales will grow by 20% per year. The gross margin will be 41.5% each year. Occupancy expenses, excluding depreciation and amortization, will be 0.44% of sales.

This case was developed by Abbie Smith, Jennifer Million, and Terry Quan at Chicago Booth for Business 30130. This case revises and updates a case, The Gap, Inc. by Palepu, Bernard, and Healy, Business Analysis and Valuation, Southwestern College Publishing, 1996.

Pro-forma Assumptions - continued: 4. Depreciation and amortization expense will be 12% of the sum of the beginning gross book value of PPE and the beginning (net) book value of lease rights and other assets. (Any amortization expense associated with restricted stock is immaterial.) Operating expenses will be 24% of sales. Notes payable outstanding as of 2/1/97 will not be replaced upon maturity. No additional funds will be borrowed. Marketable securities and long-term investments will be sold on February 2, 1997 (the first day of fiscal 97) for their book value. The cash will be distributed immediately to shareholders as a cash dividend. No short-term or long-term investments will be purchased. The effective (pre-tax) interest rate (interest expense/ ave. interest-bearing debt) on debt outstanding on 2/1/97 is 9%. Interest revenue will be immaterial and can be ignored. The effective tax rate and the marginal tax rate will be 39.5%. The balance of cash and cash equivalents will be 8% of sales. Inventory turnover will be 6.0. There will be no sales on account. The balance of prepaid expenses and other current assets will be 2% of sales. The fixed asset turnover will be 5.1. Assets are retired each year with accumulated depreciation of 3% of the beginning balance of accumulated depreciation. The net book value of assets retired is zero. No fixed assets are sold. The balance of lease rights and other (noncurrent) current assets will be 2% of sales. There are no sales of lease rights and other assets. The accounts payable turnover will be 10.31. Other current liabilities (the sum of accrued expenses, income taxes payable, deferred lease credits and other current liabilities) will be 6% of sales.

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Pro-forma Assumptions - continued: 21. 22. 23. Deferred lease credits and other (noncurrent) liabilities will be 5% of sales. No shares of stock will be sold or repurchased, and no stock options will be exercised. Deferred tax expenses will be zero. (i.e. no change in deferred tax accounts on the balance sheet). Plug shareholders equity, assuming that the only changes in the balance of stockholders equity will be due to earnings and dividends. Hence, use the plugged balance of stockholders equity to calculate dividends. (Note: This is equivalent to assuming that all free cash flows available each year after investments and after any cash flows to debtholders for after-tax interest or principal will be paid to stockholders during the year as cash dividends.) The tax benefit from the exercise of stock options by employees and from vesting of restricted stock will be zero. The effect of exchange rate changes on cash will be zero.

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