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Gap Inc. Equity Valuation and Analysis Valued at November 1, 2006

Brian Vance: [email protected] Jonathan Applegate: [email protected] Kyle Reynolds: [email protected] Chance Baucum: [email protected] Matt Loyd: [email protected]

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Table of Contents
Executive Summary…………………………………………………6 Industry Overview and Analysis…………………………………8 Company Overview………………………………………………….8 Competitive Advantage Analysis…………………………………15 Accounting Flexibility………………………………………………..23 Accounting Strategy Evaluation…………………………………..24
Quality of disclosure…………………………………………………………………………………..25 Potential “Red flags”………………………………………………………………………………...26

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Ratio Analysis and Forecast Financials…………………………28 Liquidity Analysis……………………………………………………..29 Profitability Analysis…………………………………………………30 Capital Structure Analysis………………………………………….31 Benchmark Analysis………………………………………………....31
Liquidity…………………………………………………………………………………………………...32 Profitability ………………………………………………………………………………………………35 Capital structure………………………………………………………………………………………..38

Financial Statement Forecasting…………………………………39

Valuation Analysis……………………………………………………42
Method of comparables Valuation…………………………………………………………….43 Cost of Capital Estimation………………………………………………………………………..44

Summary of Valuations…………………………………………….45 Altman’s Z-Score……………………………………………………..49 References…………………………………………………………….51 Appendices…………………………………………………………….52

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GAP INC.
Ticker Symbol: S&P 500 Price 52 week range Market Cap Sales $Mil SHS OS Div. Yld GPS ROE P/E P/B LT D/E 16.95% 17.77% 3% 0.10% (NYSE:GPS) 20.8 15.91 - 21.39 15.53B 15,837 822.00M 1.5 Industry 22.50% 20.80% 4.50% 0.30% 2004 0.65 Earnings Per Share: 2005 0.74 2006e 0.97 2007e 1.1 Valuations (As of Nov. 1st, 2005) Actual Price 20.64 AEG Model RI Model FCF DPS Beta Stnd Dev. 97 797 1,230 $0.18 0.86 0.56

Total Return% Stock +/- Industry +/- S&P 500

2003 50.3 0.8 23.9

2004 -8.6 -42.7 -17.6

2005 -15.6 -34.7 -18.6

YTD 8.9 -5.4 -4

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Executive Summary
Recommendation: Overvalued firm Through detailed research and valuation, we have concluded that we are a selling opportunity. The clothing retail industry is very competitive with a high number of competitors. This large number of competitors creates strong earnings potential compared to other industries. The industry is characterized by emphasizing differentiation and not cost leadership, which results in the firms not having to have a price war. Along with differentiation, most of the competitors within this industry tend to rely on their brand image. The biggest firms within the industry also tend to create subsidiaries in order to compete with rival firms. The threat of new competitors is relatively low due to the high start up costs of entering the market. Since Gap Inc. and other firms in this industry tend to have a high quality brand image, most firms have power over their suppliers, due to manufacturers competing for business. After analysis, Gap’s accounting practices and policies were found to be fairly aggressive. However, their disclosure and reporting of relevant material is seemingly very transparent. Gap discloses all accounting methods concerning everything from leases and pension plans to inventory and tax methods. They also outline all accounting statements and opinions affecting their business. We found no distortions or discrepancies in their accounting.

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After computing our firm’s core ratios, we felt we were able to grasp Gap’s overall performance as compared to its competitors within the industry. Inventory turnover tended to be lower while gross profit was high throughout the industry. This is most likely due to the fact that most firms in our industry compete with differentiation and brand name. To understand what the future holds for Gap Inc., we forecasted the company’s financial statements through 2015. By analyzing trends, we have concluded that Gap will continue to grow at a current rate; much like the firm has been doing the last 3 years without any unforeseen abnormalities. It was extremely important that our forecasts be calculated as accurately as possible due to the fact that forecasting was the base upon which all valuation methods rested. After thorough evaluation, we have found that Gap Inc. is overvalued in the market. All of our valuation models showed Gap Inc.’s stock to be considerably overvalued. The most accurate valuation model for us was the free cash flows valuation. Using our free cash flow model, we found an estimated price per share at the end of 2005 to be $15.72 while our actual price per share was $17.64. The only model which we considered to be unreliable was the discounted dividend valuation. We feel this was due to our low dividend payout rate in forecasted years. The discounted dividends valuation model is flawed because it values companies based on what they pay per dividend, and many companies pay little or no dividends at all. Based on this all-inclusive, in-depth

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analysis and valuation, we find Gap Inc. to be overvalued and strongly recommend selling.

Business and Industry Analysis
Firm Overview Gap Inc. is one of the largest specialty retailers while leading the world in specialty retail clothing. Gap Inc. owns Banana Republic, Old Navy, and Forth & Towne. They specialize in apparel design while offering clothing and accessories for the whole family. Gap Inc. owns more than 3,000 stores and is reported to have accumulated $16 billion in fiscal year 2005. Their main headquarters is located in the San Francisco Bay Area but their product design offices are located in New York City, San Francisco, and London. As far as what the company does, Gap.com says, “We try to put out affordable, casual designs of shirts and jeans while providing value to the shareholders and making a positive impact in the community.” Abercrombie and Fitch, American Eagle, and Buckle are some of Gap’s competitors within the industry. They all aim to design their clothing around the younger crowds, ages 18-35. Here is a table showing the Total Assets, Price, Sales, and Net Income for Gap Inc. and their direct competitors. 2004 Total Assets GAP Inc. $10,343,000 Abercrombie&Fitch $1,383,000 Buckle $356,222 Price Gap Inc. $21.37 2005 $10,048,00 $1,347,000 $405,543 $17.64 2006 $8,821,000 $1,789,000 $374,266 $18.96 7

Abercrombie&Fitch $47.15 $65.25 $68.00 Buckle $29.90 $32.40 $45.91 Sales Gap Inc. $15,854,000 $16,267,000 $16,023,000 Abercrombie&Fitch $1,707,000 $2,021,000 $2,784,000 Buckle $422,820 $470,937 $501,101 Net Income Gap Inc. $1,030,000 $1,150,000 $1,113,000 Abercrombie&Fitch $204,830 $216,376 $333,986 Buckle $33,679 $43,229 $51,906 As you can see in the table above, Gap Inc. has separated itself from its competitors in the industry by claiming a huge portion of the market share. This can be seen by the huge Net Income compared to industry competitors. Gap aims to sell to the whole family with a cost-leading attitude. Market capitalization or net worth of the company is 14.85 billion. They have more net worth than any of their competitors. They have owned from 8 to 10 million in assets over the past five years. The current price of Gap Inc. Stock is $17.92 per share. Five Forces Model

The five forces model can help a company in a number of ways. It can determine the attractiveness of a particular market. It can also show the relationship between competitors, suppliers, and buyers within an industry. With this information, investors can develop a broad and sophisticated analysis of competitive position which can be used when creating strategy, plans, or investing decisions to use within the business world. Rivalry Among Existing Firms

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Some aspects of rivalry among firms that make this model so important would be the number and size of firms, industry size and trends, product/service range, and differentiation and strategy. The clothing stores industry, which has done extremely well over the last 5-10 years, has a large number of competitors. A few of the competing companies include American Eagle, Abercrombie & Fitch, and TJ Maxx. This large number of competitors creates strong earnings potential compared to other industries. In the clothing store industry there is room to grow, but start up costs can be high. While Gap is definitely looking to gain a larger share of the market, switching costs for consumers is low. This is especially true with one of Gap’s top competitors TJ Maxx. TJ Maxx competes solely on price. In response, Gap is looking to reestablish a larger core of consumers who are brand loyalists. To compete with all these different competitors in the market, Gap Inc. created such higher end clothing lines as Banana Republic, Old Navy, and Forth & Towne. In an industry where the right mix of product differentiation and price play a key role, these three brands allow them to be competitive. Threat of New Entrants Some important factors surrounding the threat of new entrants section of the five forces model include: barriers to entry, brand equity, switching costs, access to distribution and government policies. Understanding these concepts will help a firm understand the industry at a higher level. The popularity of the internet has brought more sales opportunities for all companies within this

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industry, which in turn, has increased the development of online marketing. While Gap and its competitors compete in the clothing store industry, they also have a number of competitors in the fashion industry which includes brands such as Polo, Tommy Hilfiger, and Lacoste. These industries differ slightly because these fashion companies sell their clothing to department stores like Dillard’s, while Gap Inc. operates their own stores. They compete with these companies because switching costs are so low. However, within their own industry, start up costs can be high. Even though there is room to grow within the industry, the threat of new entrants is relatively low. This is largely due to large economies of scale in this industry in which new entrants will initially suffer from a cost disadvantage from existing firms such as GAP Inc. The risk of investing so much to start up deters most new entrants. In conclusion, there will always be the threat of new entrants, but it will be extremely hard and expensive to match Gap’s share in the market. Threat of Substitute Products Some key concepts that go along with the threat of substitute products are buyer propensity to substitute, relative price performance of substitutes, buyer switching cost, and perceived level of product differentiation. Understanding this section will allow a firm to know how to handle any substitute products that is thrown at them by competitors. The threat of substitute products for Gap is very real. This is the main reason they are trying to reestablish a larger group of brand loyalists with their “back to basics” simplistic

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style that consumers had known and loved. Another way Gap Inc. can overcome this problem is with their other brands, especially Old Navy. Brand loyalists will generally buy a particular brand regardless of the price. However, consumers who are not brand loyal tend to seek out substitute products largely because of high prices. This is where Old Navy is able to tap into the industry. Old Navy offers trendier styles with a lower cost, which lessens the threat of substitute products. In an industry as diverse as the clothing industry, every move you make determines when and how many substitute products could possibly enter your market. This is why having more than one line of clothing, an online shop, and sales in more than just the United States is so important. Bargaining Power of Buyers/Customers Understanding the bargaining power of your customers will help a firm decide on the price it wants to sell its products for. Since our industry is, on average, not a price competitive industry, this section is not as important as others in the five forces model. Simply due to the low switching costs of the industry, buyers do have some power. Price sensitivity plays a small role but the majority of buyers are willing to pay for Gap’s moderately priced clothing. Sales at retail locations tend to attract customers with less spending power, but customers generally know what to expect with regard to prices in the industry. On the average, Gap Inc.’s prices are lower than both Abercrombie & Fitch, and Buckle. The Gap brand or Banana Republic may lose a few customers due to prices, but Old Navy was created to appease the price shoppers. In this market,

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it is important to compete on both quality and brand name, as well as price. This is why, for example, Abercrombie & Fitch launched Abercrombie Kids, Hollister Co., and RUEHL 925 campaigns. In conclusion, the customers do not have much bargaining power within this industry. An example of an industry that would have high bargaining power of customers would be lower quality outlets such as Kmart, Payless, and Wal-Mart. Bargaining Power of Suppliers Bargaining power of suppliers is an extremely important aspect of our firm, and the industry in general. If not properly calculated, excess cost and high inventory can occur. There are numerous suppliers of fabrics and other materials like cotton to choose from. Most firms actually shop for manufacturers of clothes and hand their designs over to them. Since the firms in our industry have a high quality brand image, most have real power over their suppliers, due to manufacturer’s vying for their business. In conclusion, there is an extremely high degree of competition within this clothing retail industry. Since these brands rely on the latest fashions, quarterly changes in seasonal products must happen as much as possible. Technology, including online shopping, must be up to date. Branching out to places other than the United States is important. Overall, these firms are relying on brand image and differentiation to gain as much market share as possible. Key Success Factors

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Every firm in America has to decide, when it first starts, how it wants to position itself in the industry. Our firm, Gap Inc., is no different. Gap had to make the decision of how it wanted to gain a competitive advantage over other firms in its field. There are two strategies a firm can follow. It can either choose a cost leadership plan or a differentiation plan. Cost leadership is essentially just competing with other firms only on cost. A cost leader can offer the same product as a competitor, only at a lower price. Differentiation on the other hand is competing by offering a product that is different in some way. These plans are important because a firm can gain an advantage over its competitors based on either of these strategies. It is also important that a firm choose one or the other and not get stuck in the middle. Not taking one side or the other can cause a firm to earn low profits. The objective of product differentiation is to develop a position that potential customers will understand to be unique. There are two mechanisms for which differentiation affects performance. First, differentiation will reduce price sensitivity. This means that consumers might be willing to pay a higher price for the differentiating factor(s). Second, differentiation should reduce directness of competition. This can be defined by stating that the more your product differs from the industry’s products, categorization becomes more difficult thus your product draws fewer comparisons to competition. At the market level, differentiation can be defined as improving the quality of goods over time due to innovation. In an evolutionary sense, differentiation is

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more of a strategy that is important in adapting to a moving environment and its social groups. Since almost all the firms in our industry have name recognition, success in this market must be achieved by adapting to a moving environment that is obsessed with the latest trends, while producing comfortable and casual styles of dress. Competitive Analysis

Gap Inc. is in the highly competitive, ever changing, clothing retail industry. The Gap is implementing technology into its stores which contain certain intrinsic competitive advantages which give the corporation a head up on the competition. Not only does this new technology allow for more cost effective distribution, but it also offers a more time-efficient experience for both the consumer and the employee. Instead of spending large amounts of money yearly by manually taking inventory, The GAP will now be able to access inventory data quickly and easily through a handheld device. If there is a situation where merchandise is out of stock at a particular location, it can be dealt with quickly and effectively, by communicating with other GAP stores to replenish the missing units. These measures taken to provide technological advantages over other companies will pay off, simply because it is a more convenient way of shopping. It literally bridges inventories from multiple stores in a region, giving the customer a larger selection of sizes and styles. This allows for customers to try

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on clothing at the store, as well as offer the large inventory the internet has been able to offer for many years. These new ways of business improves The GAP with an entirely different shopping experience. This experience in time will increase customer retention and rapport, generating profits. The Gap Web advancements will provide the base for more company expansion. If the GAP can hold their customer base through outstanding customer satisfaction, then people will be drawn to the unique shopping experience. Gap Inc. has chosen a differentiation strategy. “Know who you are and be it. Celebrate your uniqueness with passion and conviction.” That phrase has been the philosophy that has driven GAP for the last three decades. Gap’s purpose has been to appeal to people of all ages, not just teens and young adults in their twenties. This process starts with Gap designers who travel to such fashion and cultural capitals as New York, Paris, London, Milan, and Tokyo. Here, the designers partake in fashion shows and get a feeling for what the target audience’s preferences are. Once these concepts have been developed, the merchants and designers work extremely close together to translate this inspiration into reality. This process of creativity and innovation is very much necessary to differentiate The Gap’s clothing line from such top competitors as Abercrombie & Fitch and American Eagle. Investment in brand image has had a huge impact on GAP Inc. For around thirty years, GAP specialized in basic clothing and had a consistent core group of customers. Around 2000, GAP launched a new campaign to start

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making a newer, trendier style of clothing. GAP also created flashy commercials that included choreographed dance numbers and singing. This change alienated many of Gap’s core customers and as a result, the company lost a sufficient amount of money. Around 2002, then CEP Millard Drexler launched a “back to basic” campaign. This campaign consisted of going back to Gap’s roots and specializing in items such as denim, T-shirts, hooded sweaters, and basic pants. This has improved sales, but it has been an uphill battle. Essentially, Gap’s brand image tries to differentiate itself from competitors by offering very high quality, basic, casual clothing. Differentiation companies require heavy investments in research and development. At GAP Inc., each item is sold and then registered for analysis by planners and distribution analysts. These analysts monitor weekly sales trend reports and determine which stores need to be stocked with what products. These “replenishment shipments” usually occur one to three times per week. This process continues until the season ends. At this point, all customer feedback, performance notes, and suggested improvements are analyzed so GAP is ready to being this cycle again. As far as differentiation goes, Gap’s investment in brand image is by far the most important aspect of value chain management. A bad decision, such as the one made in 2000, can cripple a company. GAP is just now recovering and it has been a slow process. In order to achieve and sustain competitive advantage,

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GAP Inc. needs to stick to its roots and structure its supply chain in a way that is consistent. Even with The Gap implementing a polished product differentiation strategy, with strong focus on brand development and unique advertisement, it is still not at the top of the market. Population groups like the baby boomers are not tailored to by Gap Inc. or any of its subsidiaries. Expansion of Gap Inc. would open up a whole new, highly lucrative, market share. Although The Gap has gone from being a corner shop in California, to a worldwide corporation, they have experienced many peaks and valleys. The company has learned many lessons. First, when creating marketing campaigns, they learned to create their own image and not rely on celebrity status. Second, they have learned how to create their own image. Their image is broad, but specific. It adheres strictly to high quality, basic, casual clothing. Third, The Gap has learned to create sub-brands to tailor to various classifications of people. Fourth, The Gap realizes that they operate within a niche where customers care about fashion but only so long as it can be delivered at a moderate price. The Gap has also learned early that they have to outsource labor in order to keep costs down and remain competitive. The Gap’s commitment to customer satisfaction and ability to reinvent themselves in the volatile fashion industry provides for an expected strong future for the company.

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Accounting Analysis
In the section we analyzed Gap Inc.’s accounting quality by six steps. First, by identifying the key accounting policies that are used. Then, Assess Accounting Flexibility for the firm, and evaluating the accounting strategy. Next, we had to evaluate how easy or less easy managers made it analyst to look at it’s financial statements, and point out any potential “red flags”. Finally, based on this analyzes; we felt that there was no accounting distortions to undo. Gap Inc. has disclosed all of its material very well, and we feel that their accounting practices are not misleading or distorted based off of the ratio analyzes of Gap Inc.’s financial results.

Key Accounting Policies
The Gap’s key success factors are attributed to their strict accounting polices which coordinate with each other to create the present and future financial performance of the company. The financial statements are consolidated to include the accounts of the company and all its subsidiaries. All inter-company transactions and balances have been eliminated. Translation adjustments result from translating foreign subsidiaries’ financial statements into U.S. dollars. Balance sheet accounts are translated at exchange rates in effect at the balance sheet date. Income statement accounts are translated at average exchange rates during the year. The resulting translation adjustments are included in accumulated other comprehensive earnings in the Consolidated Statements of Shareholders’ Equity (Gap 10-K).

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Fiscal year for Gap Inc. ends on the Saturday closest to January 31. The last three years have consisted of 52 weeks while fiscal 2006 will consist of 53 weeks. Revenue and the related cost of goods sold (including shipping costs) is recognized at the time the products are received by the customers in compliance with the rules of Staff Accounting Bulletin No. (“SAB”) 101, “Revenue Recognition in Financial Statements” as amended by SAB 104 (Gap 10-K). The point at which the customer receives and pays for the merchandise is when the revenue is accounted for by means of either cash or credit card. The Gap is in the retail clothing sales industry where transactions are processed very rapidly and easily, explaining their non-reporting of Accounts Receivable. Amounts related to shipping and handling that are billed to customers are reflected in net sales and the related costs are shown in cost of goods sold and occupancy expenses. The Gap uses the historical return gross profit patterns to record its allowances for estimated returns. Cash and equivalents represent cash and short-term, highly liquid investments with original maturities of three months or less. Cash and equivalents are accumulated by finding all accounts in-transit from banks for customer credit card, debit card and electronic transfer transactions that go through or clear in less than a week, which are then classified as cash and equivalents in the Consolidated Balance Sheets. Checks outstanding are classified in accounts payable on the Consolidated Balance Sheets. The restricted cash account serves as collateral for the insurance obligations and recently in 2005 held $55 million (Gap 10-K). Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the related assets. The cost of assets sold or rendered useless and the 19

accumulated depreciation or amortization are removed from the accounts with any records of gain or loss shown in net earnings. The Statement of Financial Accounting Standards No. (“SFAS”) 133, “Accounting for Derivative Instruments and Hedging Activities,” establishes the accounting and reporting principles for hedging activities and derivative instruments (Gap 10-K). Gap measures all derivative instruments at fair value and distinguishes them as either other current assets or accrued expenses and additional current liabilities in their Consolidated Balance Sheets. Merchandise inventory is calculated using the first-in, first-out method (“FIFO”) to determine cost. By means of the cost method the inventory is valued at the lower of the actual cost or market. They also estimate and accrue shortage for the period between the last physical inventory count and the balance sheet date. Gap inc. leases most of their store premises and some headquarter facilities and distribution centers. These operating leases expire at various dates through 2033. Most store leases are for a five year base period and include options that allow Gap to extend the lease term beyond the initial base period, subject to terms agreed to at lease birth. Some leases also include early termination options, which can be exercised under specific conditions. Gap inc. recognizes the related rental expense on a straight-line basis and records the difference between the recognized rental expense and amounts payable under the leases as deferred rent liability. Deferred rent liability was approximately $342 million at January 28, 2006 and $361 million at January 29, 2005. As stated in the initial terms of the lease, the minimal lease payment has no dependency on factors such as future sales volume and contingent rentals. Future payments for maintenance, insurance and taxes to which the Company is obligated are excluded from minimum lease payments. 20

Gap Inc. has acquired three different pension plans for its employees, all with different types of defined benefit or defined contribution plans. The First, “GapShare,” is a qualified defined contribution plan, available to employees who meet certain age and service requirements. This plan allows employees to make contributions up to a maximum limit and Gap matches the contribution total amount or a portion of it according to a predetermined formula. Gaps’ contributions to this plan averaged $30 million over the last three years. Another pension plan of Gap is known as the (“Plan”). This is a nonqualified executive deferred compensation plan. It allows eligible employees to defer compensation up to a maximum amount. Gap does not match any contributions under this plan. Established on January 1, 1999, the asset and liability concerning the Plan was approximately $24 million and $30 million, respectively. As of December 31, 2005 the plan was frozen for additional contributions. In January of 2006 a nonqualified Supplemental Deferred Compensation Plan replaced the (“Plan”).This new nonqualified Supplemental Deferred Compensation Plan now allows for employees and non-employees on the Board of Directors to defer compensation up to a limit. However under this new plan the employee members on the Board of Directors will have their contributions matched under a predetermined formula. Accrued expenses and other current liabilities consist of payroll and related benefits, deferred rent liability and other current liabilities. They use a combination of insurance and self-insurance for a number of risk management activities including workers’ compensation, general liability, automobile liability and employee-related health care benefits, some of which is paid by their employees (GPS 2005 Annual Report). 21

Income taxes are recorded using the asset and liability method in compliance with SFAS 109 “Accounting for Income Taxes” (Gap 10-K). Deferred income taxes come from temporary differences between the tax part of assets plus the liabilities under this method. The reported amounts from the calculations are then shown in the Consolidated Financial Statements. Accounting Flexibility Gap Inc has a significant amount of flexibility in choosing their key accounting policies. Gap Inc. prepares financial statements in accordance with accounting principles commonly accepted in the United States of America. Management is required to use accounting policies in order to make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. Gap Inc. has shown accounting flexibility in many areas on the financial statements. Merchandise Inventory is valued using the cost method. Cost method values inventory at the lower of the actual cost or market. Gap Inc. determines cost using FIFO method, and the market cost is estimated by the net realizable value. Also, depreciation and amortization are calculated using straight-line method. Cost of assets sold or retired and related accumulated depreciation or amortization are removed from the accounts with any resulting gain or loss included in net earnings. Under Financial Accounting Standards No.133, “Accounting Instruments and Hedging Activities”, establishes the accounting and reporting standards for derivative instruments and hedging activities. Gap Inc. recognizes all derivatives instruments as either other current assets or accrued expenses and other current liabilities in Gap’s Consolidated Balance Sheets and measures those instruments at fair value.

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Gap Inc.’s accounting reports seem to have a lot of flexibility for managers.

Accounting Strategy Evaluation Gap’s preparation of financial statements is in conformity with accounting principles generally accepted in the U.S. Managements is responsible to make estimates and assumptions that affect the reported amounts of assets and liabilities. Gap Inc. reports any accounting methods they use or any areas in their consolidated statements that might seem unclear to investors in the footnotes. For example, during the fiscal year of 2005, Gap Inc. accounted for stock-based awards to employees and directors using the intrinsic value method of accounting required by APM, Accounting Principles Board Opinion. Under this method when price of employee stock options equals the market price of the stock on the day it was issued, no compensation expense is recognized in the Consolidated Statements of Operations. Stock options that are less than fair market value are amortized to operating expenses over the vesting period of the stock award, using the straight-line method. In the clothing retail industry, they all record Gift cards at different times. For example, American Eagle, one of Gap Inc.’s competitors, records a gift card as a current liability upon purchase and recognized when the gift card is redeemed for merchandise. AE gives customers 24 months to redeem the gift card or the Company assesses the holder of the card a one dollar per month service fee, which is deducted from the value of the gift card. The fee is recorded in selling, general and administrative expenses. Unlike Gap Inc., who treats gift certificates or gift cards as a liability and income is recorded as net sales upon redemption or as other income, but up to sixty months. After sixty

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months is up, the redemption is remote, and the liability for gift cards and gift certificates is recorded in accounts payable on the consolidated balance sheets. Quality of Disclosure throughout Financial Statements Every manager in a firm has the discretion to disclose information. Accounting rules require a certain amount of disclosure, but beyond that it is up to the manager how much information the firm will disclose. Quality of disclosure is very important to an investor. A manager can make it easy for an analyst to gain an insight into the firm by disclosing a lot of information. On the other hand they can make it quite difficult to assess the business reality by only disclosing the minimum amount required. As an investor you want as much disclosure as possible without threatening the firm’s competitive advantage. If you disclose too much information the competitors will be able to look through the glass and see your strengths and weaknesses, of which they can then turn around and use against you or copy your strengths and gain a profit like yours. GAP does a good job of disclosing its’ business strategy. In the Letter to Shareholders they do not try to sugar coat their performance. They are quite liberal in disclosing bad news. Paul Pressler, CEO of GAP, makes no attempt to explain the drop in Net Sales for 2005. Instead of excuses he clearly lays out a plan to return to growing sales and to regain Gap Inc.’s competitive position. One criticism of disclosure is that there is no real explanation of Gap Inc.’s performance from 2005. Their net sales were down 2% from 2004. Gap Inc. did not try to explain this decrease to any reason. They basically just said they can do better and have a plan in place to return to its’ increased earnings. Another good quality of Gap Inc.’s disclosure is that they break up their finances by different companies. Gap Inc. owns Banana Republic, Old Navy, and Forth and Towne. In their annual report they separate these businesses out so 24

all their performances aren’t lumped together. This can show the investor or analyst which companies are doing well and which aren’t. Gap Inc. is also very good with disclosing numbers that they think are important. Free cash flow is a subject they spend a lot of time on in their financial report. They believe that free cash flow is important because it represents how much cash a company has after the deduction of capital expenditures. Gap Inc. goes above and beyond disclosure for their cash flows to show the analyst how important they feel these cash flows are. They also explain in their footnotes all the forward looking statements that they include in their annual report. In Gap Inc.’s report they use numbers and strategies with forward looking statements that basically anticipate future effects on cash flows, dividend payouts, cash balances vs. cash flows, and new store openings. They explain how they came to these numbers, which makes it easier for the analyst to determine if these numbers are accurate. In conclusion, Gap Inc. does a great job of disclosing information for an analyst or investor. This level of disclosure makes it very easy to determine the reality of Gap Inc.’s position in the industry and to forecast future financial results Identification of Potential “ Red Flags” As far as identifying red flags, we were unable to find any flags in GAP Inc.’s financials statements. Even when performance was down, there were no unexplained changes in the accounting process. There were no unexplained transactions to boost profits. There were no unusual increases in accounts receivable with respect to sales increases. There were no large fourth-quarter adjustments. Inventories did not increase in relation to an increase in sales. After

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analysis, GAP Inc.’s accounting is legitimate with no questionable accounting quality. Quantitative Indicators When you study the quantitative indicators you can then effectively analyze the past performance of Gap inc. The sales manipulation diagnostics shows how sales relate to cash from sales, accounts receivable, and inventory. The core expense manipulation diagnostics shows earnings related to expenses.

Sales Manipulation Diagnostics

GPS
Net Sales/ Cash from Sales Net Sales/ Net Accounts Receivable Net Sales/ Inventory

2001 10.51 N/A

2002 11.63 N/A

2003 7.34 N/A

2004 10.04 N/A

2005 10.33 N/A

8.26

7.05

9.3

8.97

9.45

Sales for Gap have been steady over the last few years. However, their Net Sales/ Cash from Sales ratio has declined a little, meaning they have been getting less cash from sales. Net sales to accounts receivables were N/A due to the fact that the accounts receivable amounts for Gap Inc. were reported as immaterial. Gap’s ratio of sales to inventory has increased from 2001 and 2002. This shows that GAP has been making more profits while spending less on inventory. This is a good sign for the future of the firm.

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Core Expense Manipulation Diagnostics

GPS
Asset Turnover (Sales/Assets) CFFO/ OI CFFO/ NOA

2001 1.82 3.1 0.65

2002 1.46 1.22 0.45

2003 1.48 1.16 0.36

2004 1.62 0.78 0.76

2005 1.82 0.89 0.69

Gap’s asset turnover ratio shows that for every $1 of assets, GAP made $1.82 in sales. GAP has increased its asset turnover after down years of 2002 and 2003. This shows that they are more efficiently using their assets CFFO/OI for the most part remains steady aside from a decrease in 2002. If the CFFO/OI number is smaller, more of the Cash Flow from Operations can be explained by Operating Income. CFFO/NOA starts off relatively high, then dips for a couple years, and finally levels off starting in 2004. The two years in which this figure is low can be explained by GAP using more of their Operating Assets to bring about their Operating Cash Flow.

Ratio Analysis & Forecast Financial
In the next step of evaluating Gap Inc., we have calculated financial ratios to measure the performance of the company. We will attempt to forecast the financial statements of the company for the next ten years. We will compare Gap Inc. with the industry average as a whole in ratio analysis. By doing calculating financial ratios we able to get a more in depth look into the companies, profitability, liquidity, and capital structure. This could prove to be very valuable to investors in the company.

Financial Ratio Analysis
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In order to analyze financial statements of a company we have to calculate different ratio. These ratios can help determine where the cash comes from and where it goes. We have calculated the financial ratios of Gap Inc. over the last five year and compared them to three of our top competitors in the industry. Ratio analysis can also provide us with background in figuring out future performances. With this analysis we can predict future profitability for the company and its shareholders. Financial Ratio Analysis is split into three parts. First, we analyze the liquidity ratios, which determine the quick cash from assets and the ability of a firm to turn assets into cash to meets its debt. Then, we analyze profitability ratios, which tell us how much profit is earned from our sales and assets, and how much of that profit goes to the shareholders. Finally, we analyze the capital structure of a company, which determine where and how much financing for a company is provided.

Liquidity Analysis
Current ratio Quick asset ratio Accounts recevable turnover Days supply of inventory Inventory turnover Days supply of receivables Working capital turnover 2001 0.146 0.146 113.95 3.2 4.52 80.75 -90.496 2001 37.10% 26.5% 6.40% 1.95 12.51% 29.97% 1.39 2002 1.48 0.5 153.63 2.38 5.79 63 14 2002 30% 27.50% -5.61% 1.82 -0.10% -0.26% 15.22 2003 2.11 1.24 125.69 2.9 4.66 78 4.79 2003 34% 27% 3.30% 0.146 4.80% 13% 1.7 2004 2.6842 1.88 226.48 1.612 5.8 63 3.77 2004 37.64% 25.79% 6.49% 1.53 9.95% 21.50% 1.16 2005 2.8 1.82 242.79 1.5 5.45 67 4 2005 39.22% 26.4 7.06% 1.62 11.44% 23.29% 1.03

Profitability Analysis
Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity Debt to equity ratio

Capital Structure Analysis
Times interest earned Debt service margin 2001 19.29 1.66 2002 3.09 31.46 2003 4.07 N/A 2004 8.02 N/A 2005 11.856 N/A

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Liquidity Analysis
2001 0.146 0.146 113.95 80.75 4.52 3.2 (90.5) 2002 1.48 0.5 153.63 63 5.79 2.38 14 2003 2.11 1.24 125.69 78 4.66 2.9 4.79 2004 2.6842 1.88 226.48 63 5.8 1.612 3.77 2005 2.8 1.82 242.79 67 5.45 1.5 4

Current ratio Quick asset ratio Accounts receivables turnover Days supply of receivables Inventory turnover Days supply of inventory Working capital turnover

From 2001 to 2005, Gap Inc.’s current ratio has risen. Their current assets have increased over the last five years, which is allowing them to pay off more of their liabilities. Their quick asset ratio has also risen, which means they have more quick cash on hand to pay for every liability they owe. Gap Inc.’s account receivables turnover has increased over five year, which is reducing the number of days accounts are collected. Account receivables have decreased and could be the cause for the reduction in the number of days receivables are collected. Inventory turnover has improved as well and fewer inventories are hanging around, which means less expense for the company. Over the last five years, Gap Inc. has shown more money coming out of the production cycle due to the increase in inventory turnover. Cost of goods sold has also increased, which can be the cause for the increase in Inventory turnover. Working capital has improved a little but recently has fallen. In 2001 they had more liabilities than asset, making the ratio negative for working capital. A negative working capital implies that they could not pay for all their liabilities from sales and assets. Gap Inc. has continued to improve though and overall they appear to be more liquid and operating efficient over the last five years.

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Profitability Analysis
2001 37.10% 26.5% 6.40% 1.95 12.51% 29.97% 29.96% 1.28% 2002 30.00% 27.50% -5.61% 1.82 -0.10% -0.26% -26.99% 4.38% 2003 34% 27% 3.30% 0.146 4.80% 13% 13% 9.68% 2004 37.64% 25.79% 6.49% 1.53 9.95% 21.50% 21.50% 2.61% 2005 39.22% 26.4 7.06% 1.62 11.44% 23.29% 23.29% 4.49%

Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity SGR Sales Growth

Operating efficiency is what we will measure next. To do this we have to look at gross profit margin, operating expense ratio, and net profit margin. Gap Inc.’s overall profit efficiency has stayed constant through the years. In 2002, they suffered a profit loss, due to an increase in cost of goods sold and operating expenses. Although, they have managed expenses well the last five years and made substantial profit, and they seem to constant on operating efficiency. Next we look at how much Gap Inc. made on their assets, from sales and net income. To measure this we look at asset turnover, which measure sales against assets, and return on assets, which measures net income against assets. Once again, Gap Inc. has kept constant on earning from assets compared to sales. They had their lowest turnover in 2003, because they acquired more assets over the year. On the other hand, their return on assets has fluctuated the past five years. In 2002, Gap Inc. suffered a loss in net income, which caused them to have a negative return on assets. Finally we looked at how much profit shareholders received, by calculating return on equity. Gap Inc. has been pretty profitable for shareholders over the years, except in 2002, when they suffered a loss on net income. Overall, Gap Inc. has made constant profits over the years.

Capital Structure Analysis

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Capital Structure Analysis
Debt to equity ratio Times interest earned Debt service margin 2001 1.39 19.29 1.66 2002 15.22 3.09 31.46 2003 1.7 4.07 N/A 2004 1.16 8.02 N/A 2005 1.03 11.856 N/A

The last ratio we looked at was the capital structure for Gap Inc. Capital structure analyzes the financing of a company. To do this we calculate three ratios, which are debt to equity, times interest earned, and debt service margin. Gap Inc.’s debt to equity ratio has been pretty low, except in 2002, where they had a lot more debt than equity. Next we measure times interest earned ratio, which measures how much income comes from operations to pay for interest charges. Companies usually like to keep a ratio between four and twelve, and the higher the ratio the more creditworthy a company is. Gap Inc. has had a pretty high times interest earned ratio the past five years, except in 2002, where they had more interest expense that year. Finally we calculated debt service margin, which measures how much cash from operations was paid to service debt. The higher this ratio is the less pressure to use operating cash flows for debt. Gap Inc. has listed notes payable only for two years. In those two years they show a high debt service margin. Overall Gap Inc. has been able to pay off their debt the past five years and shows to be very creditworthy. Sustainable Growth Rate
2001 29.96% 2002 -26.99% 2003 13% 2004 21.50% 2005 23.29%

The sustainable growth rate measures how much a firm can grow without its financial policies unchanged. This is a way to put all the ratios together and measure them. A firm’s return on equity and its dividend payout policy help determine the funds for growth. Gap Inc. has continued to grow the last five

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years. They suffered a loss in 2002, which caused them to not grow. Overall they have kept a constant growth rate around 20 % each year.

Benchmark Analysis
Liquidity
Current ratio 3.5 3 2.5 2 1.5 1 0.5 0 2001 2002 2003 Years 2004 2005

Gap Inc. American Eagle ANF Industry Avg.

Gap Inc.’s current ratio has been increasing the past five years and appears to have risen above the industry average in 2005. Over the years their current assets have increased more than any of their competitors.
Quick asset ratio 2.5 2 Total 1.5 1 0.5 0 2001 2002 2003 Years 2004 2005 Gap Inc. American Eagle ANF Industry Avg.

Gap Inc.’s quick asset ratio has increased more than the industry average. They have been able to pay for the liabilities with quick cash on hand more than any of their competitors.

Total

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Acct. Receivables Turnover
300 250 200 150 100 50 0 2001 2002 2003 Y e a rs 2004 2005 Gap Inc . Americ an Eagle ANF Industry Avg.

They appear to be able to turn more account receivables over then anyone in their industry. They have received more accounts receivables than anyone in the industry.

Days supply of receivables
35 30 25 20 15 10 5 0 2001 200 200 Y ear s 200 2005 Gap Inc. American Eagle ANF Indust ry Avg

Gap Inc. has decreased in the number of days it takes to turnover those accounts receivables into money. More money is coming from those accounts receivables in less days.

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Inventory turnover 30 25 20 15 10 5 0 2001 2002 2003 Years 2004 2005

Gap Inc. American Eagle ANF Industry Avg

Gap Inc. appears of turnover less inventory than their competitors. This is due to a decrease in Sales over the years.

Total

Days supply of inventory 100 80 Days 60 40 20 0 2001 2002 2003 Years 2004 2005 Gap Inc. American Eagle ANF Industry Avg

Gap Inc. has not been able to turn its inventory over so quickly. The industry appears to be able to turn their inventory over faster.

Working capital turnover
60 40 20 0 -20 -40 -60 -80 -1 00 Y e a rs 2001 2002 2003 2004 2005 Gap Inc. American Eagle ANF Industry Avg

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Working capital has been very low in the past few years. In 2001, sales were negative, providing a negative working capital ratio. Gap’s competitors have seem to have accumulated more sales. Profitability

Gross profit margin 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 2001 2002 2003 Years 2004 2005

Percentage

Gap Inc. American Eagle ANF Industry Avg

Gap’s Gross Profit margin has always been low due to increasing cost of goods sold. They have always been below the industry average the past five years .

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Operating exp ratio
30 25 20 15 10 5 0 2001 2002 2003 Y e a rs 2004 2005 Gap Inc American Eagle ANF Industry Avg.

Operating expenses has always been low for the industry. Gap has followed with the trend, until 2004. Their operating expenses seem to have increased while their sales have decreased.

Net profit margin
1 5.00% 1 0.00% 5.00% 0.00% 2001 -5.00% -1 0.00% Y e a rs 2002 2003 2004 2005 Gap Inc. American Eagle ANF Industry Avg

Gap has generated a lower net profit than any of its competitors, due to decreasing Net income and increasing sales. In 2002 they reported a loss in sales.

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Asset Turnover 2.5 2 Total 1.5 1 0.5 0 2001 2002 2003 Years 2004 2005 Gap Inc. American Eagle ANF Industry Avg

They appear to turnover less assets than their competitors. This will cause a decrease in total sales

Return on assets 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00%

Percentage

Gap Inc. American Eagle ANF Industry Avg 2001 2002 2003 Years 2004 2005

From this graph you can tell that gap has made less profit on assets than the industry. They have reported lower net income than any of their competitors.
Return Equity 50.00% 40.00% Percentage 30.00% 20.00% 10.00% 0.00% -10.00% 2001 2002 2003 Years 2004 2005 Gap Inc American Eagle ANF Industry Avg.

Once again, due to lower net income Gap Inc has a lower return on equity than the industry.

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Capital Structure

Debt to equity 20 15 Total 10 5 0 2001 2002 2003 Years 2004 2005 Gap Inc. American Eagle ANF Industry Avg

In 2002, Gap Inc. accumulated more debt than equity compared to its competitors. This caused a huge reduction in net sales.

Times Interest earned 200 150 Total 100 50 0 2001 2002 2003 Years 2004 2005 Gap Inc. American Eagle ANF Industry Avg

Gap’s Interest expense has always been higher than the industry, which causes a lower time interest earned ratio.

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Debt service margin
35 30 25 20 15 10 5 0 2001 2002 2003 Y e a rs 2004 2005 Gap Inc. American Eagle ANF Industry Avg

Some competitors, along with Gap Inc. did not report any notes payable from 2003 to 2005. This graph only compares two accurate years of numbers.

Financial Forecasting
In this section, we are doing a financial analysis of GAP Inc. The goal of a financial analysis is to evaluate the performance of a firm by using their financial statements. In a financial analysis you can determine the value of a firm by looking at it’s profitability and it’s growth. We will be using ratio analysis and cash flow analysis to assess GAP’s performance. After analyzing GAP we will forecast the next ten years based on our findings. In ratio analysis we examine our firm’s balance sheet and income statement. We can either look at ratios for GAP over several years to determine the success of the firm or we can compare the ratios of GAP to other firms in the same industry. These ratios allow us to relate the financial numbers to the business reality. Looking at ratios for our firm over several years is called time series comparison. This allows us to hold some factors constant and determine the firm’s strategy and how well they are implementing this strategy. If we compare the ratios to other firms’ ratios we are doing a cross sectional comparison. This allows us to see how GAP compares to other firms in the same

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industry. This lets us determine in what areas they are lacking and what areas they are excelling in compared to firms in the same industry. In cash flow analysis we study the firm’s cash flow statements to get further insights into the firm’s policies. By looking at the cash flow we can find a number of things that are important to valuing our firm. We can see if our firm has the ability to pay its interest and long term debt payments from the cash generated from operations. We can also find if GAP is making a cash surplus from operations or making enough cash to invest in long term growth. These things can give us a better idea of the risk of our firm. Finally after analyzing GAP’s financial statements, we can forecast the future for the firm. It is important to forecast so we can determine the future of the firm and if the firm is currently undervalued or overvalued. We can use a number of methods to determine our forecasting values. You can average past performances of the firm and assume this past performance will continue. Sometimes this can provide inaccurate numbers. So values are mean-reverting, which means that over time they go back to the industry average. Our financial analysis and forecast of GAP should provide a clearer picture of the performance of GAP then just scanning their financial statement. This will allow us to determine the success that GAP has had in implementing strategies and gaining profitability and growth.

Balance Sheet Forecasting
The accounts on the balance sheet that we feel are the most important to forecast are accounts payable, total current liabilities, total liabilities, common stock, total shareholder’s equity, and sales growth. Accounts payable, current liabilities, and total liabilities show us our debt. Common stock, and total shareholder’s equity shows us how we are financing our firm through equity. Sales growth is important because it is what drives our firm. We need a high

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sales growth to continue creating value for our shareholders. We took the averages of values off the common size balance sheet to forecast for our actual balance sheet. The only account forecasted using another method was the total current liabilities. For this account, we used the current ratio to forecast. While these projections can prove to be extremely helpful, we realize that these numbers may not be 100% accurate. If there are any major changes within the company, the forecasts will deviate from the projections made when forecasted. Even with the weaknesses in our forecasting method, we feel that the methods used were the most appropriate for GAP Inc.( Refer to Exhibit B)

Income Statement Forecasting
We were able to forecast every account in our income statement. The most important ones for GAP are net sales, Cost of Goods Sold, Operating Expenses, and Net Income. Net sales show us how much GAP is selling throughout its many stores. Cost of Goods sold and operating expenses give us an overview of the cost of doing business for GAP. We can analyze this and see where their costs are too high. Net income is also important because it gives us our final dollar amount that we earned for the year. All of the accounts were forecasted by taking the average off the common size income statement. As always the case with forecasting these numbers could be changed by any change in GAP’s operations.

Cash Flow Forecasting
The accounts used in forecasting some of Gap’s Cash Flows were net earnings, depreciation and amortization, loss on disposable and other, accounts payable, deferred lease credits and other long term liabilities, net cash provided by operating activities, net purchase of property and equipment, net cash used for investing activities, net increase/ decrease in cash and equivalents, and cash and equivalents for beginning and year end. The majority of the values derived 41

upon forecasting cash flows come simply from the balance sheet and income statements; either through subtraction of the trailing year, or an average of the percentage change multiplied by a corresponding number in the balance sheet or income statement. However, the loss on disposable and other account was derived through and average of the trailing three years for each year forecasted. Just as the methods used to forecast the balance sheet, the methods used to forecast the cash flows can be helpful for figuring ballpark numbers and aid in decision making. However this forecasting method is based mainly on recent information and is not always a good predictor to future performance.

Valuation Analysis
So far we have calculated the financial ratios and forecasted financial statements for the next ten years, which was the first stage of prospective analysis. In this is section we will complete prospective analysis by valuing Gap Inc. through different methods. Valuation is important because we can price an initial public offering and be able to inform parties involved with Gap Inc. on their actual sales, credit and other business concerns. In order to evaluate a company we use many different methods, because one method alone cannot provide a sound basis for a firm valuation. Intrinsic methods along with comparable ratios must be calculated for the firm in order to get a true picture of what the company is worth. Also, we need to create a sensitivity analysis which will make sure that miscalculated costs of capital and growth rates will not give us bad results. The cost of capital and equity will give us a weighted average cost of

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capital, which is used in many of our intrinsic valuation models. The following sections will demonstrate how we use each intrinsic valuation method to value Gap Inc.

Method of Comparables
This method values Gap Inc. by taking the average multiple of competitors in the industry. The ratios used in this valuation include: earnings per share, book value per share, price per share, dividends per share, P/E, PEG and P/B ratios. The ratios used in this model to value Gap Inc. and its competitors were very helpful. The ratios were combinations of stock price and earnings to shares outstanding. They help us value a company in terms of how much equity is being provided. We compared Gap Inc. to two of its main competitors, which are American Eagle and ANF. In most of the ratios Gap Inc. has a low percentage than its competitors. Gap Inc. has lower Earnings per share than any of its competitors.
EPS 1.29 2.27 4.217 2.592 DPS 2.09 2.02 N/A 2.055 BPS 6.16 8.973 13.765 9.632667 PPS 17.64 22.98 65.18 35.267 P/E 17.86 21.23 16.11 18.4 PEG 1.33 1.16 0.86 1.116667 P/B 3 5.36 4.96 4.44

Gap Inc American Eagle ANF Avg.

Our averages only have two competitors in it, so it may not be the best comparison for Gap Inc.

Cost of Capital
We calculated Gap Inc.’s cost of equity to be .0874. This is the return shareholder for Gap Inc. require. Gap Inc.’s cost of debt is .05499, which is the

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rate Gap Inc. is paying on all of its debt. Our before tax WACC is .14 and we calculated our after tax WACC to be .12. This is the average expected return on Gap Inc.’s securities. Variables
2 year Beta, RSquared 3 year Beta, RSquared 5 year Beta, RSquared Published Beta Cost of Equity Before Tax WACC After Tax WACC Cost of Debt 0.025614 0.004444 0.006917 0.91 0.107 0.14 0.12 0.05449

We needed to compare Gap Inc.’s stock performance with a benchmark index such as S&P 500. The R- Squared will measure this from a range of 0-1. No correlation is 0 and perfect correlation is 1. Gap Inc.’s R-Squared shows no correlation with the market.

Annual Yield
In order to calculate the average risk free rate to get cost of equity, we decided to use a five year treasury maturity rate as our annual yield. Most investments are made over this period of time rather than three or six months.

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Intrinsic Valuation Methods Free Cash Flow
Free cash flows will give us an estimated share price for the firm. This model uses the WACC based on a flow of free cash flows. We calculated the free cash flows by adding the cash flow from operations and investing activities. We discounted are WACC back to 2005. We calculated the total present value of annual free cash flows to be $ 6,971,364,299.14. Next, we had to find the present value of the continuing terminal value, and with no growth we found it to be $ 19,710,569,476.92. To find the value of the firm we added the present value of the annual cash flows and the present value of terminal value perpetuity. We found the value of the firm for 2005 to be $ 13,532,713,935.34. Finally, we needed to find the estimated price per share at the end of 2005. To do this we first needed to find the market value of equity, which is calculated by subtracting the estimated value of the firm by the liabilities. Our estimated market value of equity came out to be $ 13,527,601,935.34. Finally, divide our estimated market value of Equity by the number of outstanding shares, to find an estimated price per share at the end of 2005 to be $15.72. Gap Inc.’s observed share price at the end of 2005 was 17.64, which tells us that Gap Inc. was slightly overvalued. (Refer to 1.8)

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Sensitivity Analysis WACC 0.095
G

0.1
15.94 17.37 19.13 21.38 24.39

0.105
14.67 15.89 17.39 19.29 21.78

0.11
13.5 14.56 15.85 17.47 19.55

0.115
12.4 13.37 14.49 15.87 17.63

0.12
11.48 12.29 13.27 14.46 15.95

0.125
10.59 11.31 12.17 13.2 14.48

0.13
9.79 10.42 11.17 12.07 13.17

0 0.01 0.02 0.03 0.04

17.41 19.04 21.1 23.8 27.48

The sensitivity analysis shows varying WACC and growth estimates. This shows that as WACC increases with zero growth the share price decreases. The higher the growth rate the higher the share price varies. Gap Inc.’s observed share price at the end of 2005 was 17.64, which tells us that Gap Inc. was slightly overvalued.

Discounted Dividends

This method of valuation uses Ke and the forecasted dividends to value the
firm at a certain time. Gap Inc. kept there dividends constant at $.18 and used a growth rate of zero, because dividends have not changed. Then, we discounted back the dividends to 2005 using Ke. We calculated a share value of $0.17 at the end of 2005. The observed price per share for Gap Inc., at end of 2005, was $17.64. Using the discounted dividends method, Gap Inc. is way over-valued. The reason for this maybe that Gap Inc. pays low dividends and this model only values a company by their dividends. This is not a good model to value Gap Inc.

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Ke g 0.000 0.040 0.060 0.080 0.100 0.120 0.130 0.07 2.5714 6 18 -18 -6 -3.6 -3 0.08 1.2857 1.3846 1.5 4.5 -9 -4.5 -3.6 0.0874 2.05 4 6.569 24.32 -14.3 -5.52 -4.225 0.095 1.894 3.27 5.14 12 -36 -7.2 -5.14 0.105 1.714 2.769 4 7.2 36 -12 -7.2 0.115 1.565 2.4 3.27 5.14 12 -36 -12

From the sensitivity analysis you can see the growth rate cannot be very high. Just to get to price per share, the growth rate would have to be than 1 %. This model is not very accurate in valuing Gap Inc., and should not be considered in the final valuing of this company. (Refer to 1.7)

Residual Income
In this model we calculated a stream of residual incomes for the next 10 years, including a terminal value, and then discounted all the numbers back to the present time. First we had to find the ending book value of equity which we found by adding the book value of equity with the earning per share, then subtracting the dividends per share. Then we needed to find the normal income, which we did by multiplying Ke with the beginning book value of equity from the previous years. The difference between earnings per share and normal income is the residual income. We then discounted the residual income from forecast and found present value of residual income. Adding the book value of equity, present value of RI, and present value of terminal value at the end 2005 we estimated a

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share price of $7.97. The actual share price was $17.64. Using this model, Gap Inc. is way over valued. (Refer to 1.9)

The sensitivity analysis for residual income measures Ke and growth rate. The more growth and higher Ke the lower the share price.

0 Ke 0.08 0.1 0.12 0.14 0.16 $7.59 $5.49 $4.16 $3.26 $2.63

0.05 $7.54 $5.44 $4.11 $3.21 $2.58

0.1 $7.44 $5.34 $4.01 $3.11 $2.48

0.15 $7.29 $5.19 $3.86 $2.96 $2.33

This analysis does not have extreme changed in share price when changing the growth rate. On the other hand, if our Ke increases by a lot then Gap Inc. will have a lower share price.

Abnormal Earnings Growth
The abnormal earnings growth valuation involves calculating the book value of equity plus the present value of expected future abnormal earnings. Abnormal earnings are expected net income minus the normalized income multiplied by the discount rate. The stock will be overvalued or undervalued depending on whether expected earnings are more or less than normal income. If there is a low value for abnormal earnings, then a firm shows negative future stock returns. If there is a high value for abnormal earnings,

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then the complete opposite, positive future stock returns, occurs. In our case, GAP Inc. has a low value for AEG; therefore we can predict that there will be negative future stock returns. ( Refer to 2.1)

Sensitivity analysis for AEG looks at growth rate and Ke. The higher the growth rate and Ke, the less the share price.

Sensitivity Analysis
0 Ke 0.08 0.1 0.12 0.14 0.16 $7.02 $4.99 $3.71 $2.86 $2.27 g 0.05 $6.97 $4.94 $3.66 $2.81 $2.22 0.1 $6.92 $4.89 $3.61 $2.76 $2.17 0.15 $6.87 $4.84 $3.56 $2.71 $2.12

Altman’s Z score
Banks often prefer to look at a company’s Altman Z-Score when determining credit risk before issuing a loan or starting an investment. Gap Inc.’s debt risk for the previous year, according to Altman's Z-score model, is 3.1. This high debt risk is a good sign for investors because it shows Gap Inc. knows how to handle their credit and there fore this lowers the interest rate they will pay on future loans. One of the major incentives to decrease the Z-Score is to rely less on capitol leases and more upon operational leases. Gap Inc. strives in this

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department because they use mainly operational leases for there stores and warehouses. Z score: 1.2(5239-1942/8821)+ 1.4(1113/8821)+ 3.3(1745/8821)+ 0.6(14.6/3396)+ 1.0(16023/8821) = 3.1

Summary of valuations
For Gap Inc., some of the intrinsic valuations do not resemble the valuation for the company. The company appears to be way over valued by each method. Free Cash Flow method comes the closest to valuing Gap Inc.
Estimated share price 11.48 7.97 6.97 11 17.64

Free Cash flow Residual Income Abnormal Earnings Growth LR ROI Actual Price

Free Cash Flows is clearly the best method to use when valuing Gap Inc. The other methods valuate to much on dividends paid or earnings rather than cash from operations or investments.

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References 1. 2. 3. 4. www.finance .yahoo.com www.morngstar.com www.edgarscan.pwcglobal.com www.gapinc.com/public/Investors/investors.shtml

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Appendix 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 Ratio Forecast Balance Sheet Proforma Balance Sheet Income Statement Proforma Income Statement Cash Flows Discounted Dividends Free Cash Flows Residual Income LR ROI AEG Weighted Avg. cost of equity Weighted Avg. cost of debt

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Exhibit 1.1 Ratio Forecast

GAP INC.
Liquidity Analysis
Current ratio Quick asset ratio Accounts recevable turnover Days supply of receivables Inventory turnover Days supply of inventory Working capital turnover 2001 0.146 0.146 113.95 3.2 4.52 80.75 -90.5 2001 37.10% 26.5% 6.40% 1.95 12.51% 29.97% 2001 1.39 19.29 1.66 2001 29.96% 2002 1.48 0.5 153.63 2.38 5.79 63 14 2002 30% 27.50% -5.61% 1.82 -0.10% -0.26% 2002 15.22 3.09 31.46 2002 -26.99% 2003 2.11 1.24 125.69 2.9 4.66 78 4.79 2003 34% 27% 3.30% 0.146 4.80% 13% 2003 1.7 4.07 N/A 2003 13% 2004 2.6842 1.88 226.48 1.612 5.8 63 3.77 2004 37.64% 25.79% 6.49% 1.53 9.95% 21.50% 2004 1.16 8.02 0 2004 21.50% 2005 2.8 1.82 242.79 1.5 5.45 67 4 2005 39.22% 26.4 7.06% 1.62 11.44% 23.29% 2005 1.03 11.856 0 2005 23.29%

Profitability Analysis
Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity

Capital Structure Analysis
Debt to equity ratio Times interest earned Debt service margin

Substainable Growth Rate

American Eagle
Liquidity Analysis
Current Ratio Quick Asset Ratio Accounts Receivable Turnover Days supply of Receivables Inventory Turnover Days supply of Inventory Working capital turnover 2001 2.34 1.61 72.12 5.06 9.05 40.33 5.81 2001 41% 27% 8% 1.76 2002 2.51 1.8 101.7 3.59 7.38 49.46 5.08 2002 39% 25% 6% 1.7 2003 2.44 1.91 62.9 5.8 7.34 49.73 4.46 2003 38% 25% 4% 1.52 2004 3.06 2.18 71.17 5.13 5.88 62.07 3.23 2004 47% 24% 11% 1.42 2005 2.99 2.16 79.23 4.6 5.86 62.29 3.2 2005 46% 23% 13% 1.44

Profitability Analysis
Gross profit margin Operating expense ratio Net Profit Margin Asset Turnover

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Return on Assets Return on Equity

15% 21% 2001 0.24 53.9 1.36

11% 16% 2002 0.29 50.74 0.82

6% 9% 2003 0.35 55.04 1.79

16% 22% 2004 0.38 188.75 3.15

18% 25% 2005 0.39 0 4.25

Capital structure Analysis
Debt to Equity Ratio Times Interest Earned Debt Service Margin

ANF
Liquidity Analysis
Current ratio Quick asset ratio Accounts recevable turnover Days supply of inventory Inventory turnover Days supply of receivables Working capital turnover 2001 1.58 0.91 13.19 27.7 25.5 14.3 41.14 2002 2.42 1.69 11.84 30.8 22.7 16 29.64 2003 2.57 1.79 161.54 2.3 4.4 82.9 21.4 2004 2.48 1.59 78.1 4.7 8.6 42.4 28.13 2005 1.94 0.98 86.23 4.2 6.7 54.5 21.1

Profitability Analysis
Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity 66.50% 17.2% 10.71% 1.59 16.99% 28.8% 66.40% 19.4% 12.01% 1.56 18.70% 25.3% 63.4% 19.6% 12.22% 1.81 22.08% 28.95% 41.1% 19.9% 12.36% 2.01 24.84% 33.34% 40.9% 20.5% 12.78% 2.37 30.24% 43.30%

Capital Structure Analysis
Debt to equity ratio Times interest earned Debt service margin 1.01 82.3 13.4 0.61 67.6 9.1 0.40 90.3 0 0.29 83.9 0 0.395 54.6 0

Industry Avg.
Liquidity Analysis
Current ratio Quick asset ratio Accounts recevable turnover Days supply of inventory Inventory turnover Days supply of receivables Working capital turnover 2001 1.96 1.26 42.655 16.38 17.275 27.315 23.475 2001 54% 22% 2002 2.465 1.745 56.77 17.195 15.04 32.73 17.36 2002 53% 22% 2003 2.505 1.85 112.22 4.05 5.87 66.315 12.93 2003 51% 22% 2004 2.77 1.885 74.635 4.915 7.24 52.235 15.68 2004 44% 22% 2005 2.465 1.57 82.73 4.4 6.28 58.395 12.15 2005 43% 22%

Profitability Analysis
Gross profit margin Operating expense ratio

54

Net profit margin Asset turnover Return on Assets Return on equity

9% 1.675 16% 25%

9% 1.63 15% 21%

8% 1.665 14% 19%

12% 1.715 20% 28%

13% 1.905 24% 34%

Capital Structure Analysis
Debt to equity ratio Times interest earned Debt service margin 2001 0.625 68.1 7.38 2002 0.45 59.17 4.96 2003 0.375 72.67 0.895 2004 0.335 136.325 1.575 2005 0.3925 27.3 2.125

55

Figure 1.2 Balance sheet

Actual Balance Sheet 2001 Assets Current Assets Cash and Equivalents Merchandise Inventory Other Current Assets Total Current Assets Property and Equipment Leasehold Improvements Furniture and Equipment Land and Buildings Construction on Progress 1,899,820,000 2,826,863,000 558,832,000 615,722,000 2,127,966,000 3,327,819,000 917,055,000 246,691,000 ($2,458,241,000) 4,161,290,000 385,486,000 7,591,326,000 2,241,831,000 3,438,805,000 942,845,000 202,839,000 ($3,049,477,000) 3,776,843,000 385,486,000 9,902,004,000 2,224,000,000 3,591,000,000 1,033,000,000 131,000,000 ($3,611,000,000) 3,368,000,000 286,000,000 10,343,000,000 N/A N/A N/A N/A N/A 3,376,000,000 N/A 10,048,000,000 408,794,000 1,904,153,000 335,103,000 2,648,050,000 1,035,749,000 1,677,116,000 331,685,000 3,044,550,000 3,388,514,000 2,047,879,000 303,332,000 5,739,725,000 2,261,000,000 1,704,000,000 300,000,000 6,689,000,000 2,245,000,000 1,814,000,000 368,000,000 6,304,000,000 2002 2003 2004 2005

Forecasted Balance Sheet 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

2,431,616,000 2,156,081,000 7,040,633,600

2,674,777,600 2,418,088,000 7,744,696,960

2,942,255,360 2,711,934,000 8,519,166,656

3,236,480,896 3,041,488,000 9,371,083,322

3,560,128,986 3,411,090,000 10,308,191,654

3,916,141,884 3,825,606,000 11,339,010,819

4,307,756,073 4,290,493,000 12,472,911,901

4,738,531,680 4,811,875,000 13,720,203,091

5,212,384,848 5,396,614,000 15,092,223,400

5,733,623,333 6,052,410,000 16,601,445,740

Accumulated Depreciation and Amortizatio ($1,893,552,000) Propertry and Equipment Net Lease Rights and other Assets Total Assets Liabilities and Shareholder's Equity Current Liabilities Notes Payable Current Maturities of Long Term Debt Accounts Payable Accrued Expenses and other Current Liab Income Taxes Payable Total Current Liabilities Long-term Debt Deferred Lease Credits and other Liabilitie Total Liabilites Shareholder's Equity Common Stock Additional Paid-In-Capital Retained Earnings Accumulated Other Comprehensive Losse Deferred Compensation Treasury Stock, at Cost Total Shareholder's Equity Total Liabilites and Shareholder's Equity 46,961,000 294,967,000 4,974,773,000 (20,173,000) (12,162,000) (2,356,127,000) 2,928,239,000 7,012,908,000 779,904,000 250,000,000 1,067,207,000 684,209,000 17,824,000 2,799,144,000 780,246,000 505,279,000 4,084,669,000 4,007,685,000 357,173,000 7,012,908,000

3,647,424,000 11,052,800,000

4,012,166,400 12,158,080,000

4,413,383,040 13,373,888,000

4,854,721,344 14,711,276,800

5,340,193,478 16,182,404,480

5,874,212,826 17,800,644,928

6,461,634,109 19,580,709,421

7,107,797,520 21,538,780,363

7,818,577,272 23,692,658,399

8,600,434,999 26,061,924,239

41,889,000 N/A 1,105,117,000 909,227,000 N/A 2,056,233,000 1,961,397,000 564,115,000 4,581,745,000

N/A 499,979,000 1,159,301,000 1,067,294,000 193,000,000 2,726,574,000 1,515,794,000 621,424,000 4,863,792,000

N/A 283,000,000 1,178,000,000 872,000,000 159,000,000 2,492,000,000 1,107,000,000 581,000,000 4,180,000,000

N/A N/A 1,240,000,000 924,000,000 78,000,000 2,242,000,000 513,000,000 984,000,000 3,739,000,000 4,484,975,000 4,933,472,500 5,426,819,750 5,969,501,725 6,566,451,898 7,223,097,087 7,945,406,796 8,739,947,476 9,613,942,223 10,575,336,445 3,826,431,304 4,209,074,435 4,629,981,878 5,092,980,066 5,602,278,073 6,162,505,880 6,778,756,468 7,456,632,115 8,202,295,326 9,022,524,859 1,351,218,000 1,486,339,800 1,634,973,780 1,798,471,158 1,978,318,274 2,176,150,101 2,393,765,111 2,633,141,622 2,896,455,785 3,186,101,363

47,430,000 461,408,000 4,890,375,000 (61,824,000) (7,245,000) (2,320,563,000) 3,009,581,000 7,591,326,000

48,401,000 638,306,000 5,289,480,000 (16,766,000) (13,574,000) (2,287,635,000) 3,658,212,000 8,522,004,000

49,000,000 732,000,000 6,241,000,000 31,000,000 (9,000,000) (2,261,000,000) 4,783,000,000 8,963,000,000

49,000,000 904,000,000 7,181,000,000 48,000,000 (8,000,000) (3,238,000,000) 4,936,000,000 8,675,000,000

49,000,000

49,000,000

49,000,000

49,000,000

49,000,000

49,000,000

49,000,000

49,000,000

49,000,000

49,000,000

5,057,525,000 9,542,500,000

5,563,277,500 10,496,750,000

6,119,605,250 11,546,425,000

6,731,565,775 12,701,067,500

7,404,722,353 13,971,174,250

8,145,194,588 15,368,291,675

8,959,714,047 16,905,120,843

9,855,685,451 18,595,632,927

10,841,253,996 20,455,196,219

11,925,379,396 22,500,715,841

Figure 1.3 Proforma Balance sheet
Actual Common Size Balance Sheet Assets Current Assets Cash and Equivalents Merchandise Inventory Other Current Assets Total Current Assets Property and Equipment Leasehold Improvements Furniture and Equipment Land and Buildings Construction on Progress Accumulated Depreciation and Am Propertry and Equipment Net Lease Rights and other Assets Total Assets Liabilities and Shareholder's Equity Current Liabilities Notes Payable Current Maturities of Long Term D Accounts Payable Accrued Expenses and other Curr Income Taxes Payable Total Current Liabilities Long-term Debt Deferred Lease Credits and other Total Liabilities Shareholder's Equity Common Stock Additional Paid-In-Capital Retained Earnings Accumulated Other Comprehensiv Deferred Compensation Treasury Stock, at Cost Total Shareholder's Equity Total Liabilites and Shareholder's Forecasted Common Size Balance Sheet 5.83% 27.10% 4.80% 37.80% 27.10% 40.30% 8.00% 8.80% ($0.27) 57.15% 5.09% 100% 13.64% 22.10% 3.10% 40.10% 28.00% 53.80% 12.10% 3.20% ($0.32) 54.82% 5.08% 100% 34.22% 20.70% 3.10% 58.00% 22.60% 34.70% 9.50% 2.00% ($0.31) 38.14% 3.89% 100% 21.86% 16.50% 2.90% 64.70% 21.50% 34.70% 10.00% 1.30% ($0.35) 32.56% 2.77% 100% 22.34% 18.10% 3.70% 62.70% N/A N/A N/A N/A N/A 33.60% N/A 100% 22.00% 19.51% 64% 22.00% 19.89% 64% 22.00% 20.28% 64% 22.00% 20.67% 64% 22.00% 21.08% 64% 22.00% 21.49% 64% 22.00% 21.91% 64% 22.00% 22.34% 64% 22.00% 22.78% 64% 22.00% 23.22% 64%

33.00% 100%

33.00% 100%

33.00% 100%

33.00% 100%

33.00% 100%

33.00% 100%

33.00% 100%

33.00% 100%

33.00% 100%

33.00% 100%

11.12% 3.56% 15.22% 9.76% 0.25% 39.91% 11.13% 7.20% 58.25%

0.55% N/A 14.56% 11.98% N/A 27.09% 25.84% 7.43% 60.36%

N/A 5.87% 13.60% 12.52% 2.26% 31.99% 17.79% 7.29% 57.07%

N/A 3.16% 13.14% 9.73% 1.77% 27.80% 12.35% 6.48% 46.64%

N/A N/A 14.29% 10.65% 0.90% 25.84% 5.91% 11.34% 43.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

14.16% 40.10%

47.00%

47.00%

47.00%

47.00%

47.00%

47.00%

47.00%

47.00%

47.00%

47.00%

0.67% 4.21% 70.94% -0.29% -0.17% -33.60% 41.75% 100.00%

0.62% 6.08% 64.42% -0.81% -0.10% -30.57% 39.64% 100.00%

0.57% 7.49% 62.07% -0.20% -0.16% -26.84% 42.93% 100.00%

0.55% 8.17% 69.63% 0.35% -0.10% -25.23% 53.36% 100.00%

0.56% 10.42% 82.78% 0.55% -0.09% -37.33% 56.90% 100.00%

0.51%

0.47%

0.42%

0.39%

0.35%

0.32%

0.29%

0.26%

0.24%

0.22%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

53.00% 100.00%

56

Figure 1.4 Income Statement
The Gap Inc: Actual Income Statement 2001 Net Sales COGS Gross Profit Operating Expenses (Selling & Other) Operating Income Net Int Inc & Other EBT Income Taxes Net Income 13,673,500,000 8,599,400,000 5,074,000,000 3,629,030,000 1,444,080,000 (62,900,000) 1,381,900,000 504,400,000 877,497,000 2002 13,847,900,000 9,704,400,000 4,143,500,000 3,806,000,000 337,500,000 (95,900,000) 241,600,000 249,400,000 (7,764,000) 2003 14,454,700,000 9,541,600,000 4,913,200,000 3,900,500,000 1,012,600,000 (211,800,000) 800,900,000 323,400,000 478,000,000 2004 15,854,000,000 9,886,000,000 5,968,000,000 4,089,000,000 1,879,000,000 (196,000,000) 1,683,000,000 653,000,000 1,031,000,000 2005 16,267,000,000 9,886,000,000 6,381,000,000 4,296,000,000 2,085,000,000 (213,000,000) 1,872,000,000 722,000,000 1,150,000,000 2006 18,243,765,840 11,858,447,796 6,385,318,044 4,860,139,220 1,525,178,824 (155,920,000) 1,369,258,824 537,434,089 831,824,736 2007 20,460,748,265 13,299,486,372 7,161,261,893 5,450,743,338 1,710,518,555 (155,920,000) 1,554,598,555 610,179,933 944,418,622 Forecast Income Statement 2008 22,947,138,394 14,915,639,956 8,031,498,438 6,113,117,668 1,918,380,770 (155,920,000) 1,762,460,770 691,765,852 1,070,694,918 2009 25,735,674,652 16,728,188,524 9,007,486,128 6,855,983,727 2,151,502,401 (155,920,000) 1,995,582,401 783,266,092 1,212,316,309 2010 28,863,073,835 18,760,997,993 10,102,075,842 7,689,122,870 2,412,952,973 (155,920,000) 2,257,032,973 885,885,442 1,371,147,531 2011 32,370,514,568 21,040,834,469 11,329,680,099 8,623,505,081 2,706,175,018 (155,920,000) 2,550,255,018 1,000,975,095 1,549,279,923 2012 36,304,179,498 23,597,716,674 12,706,462,824 9,671,433,418 3,035,029,406 (155,920,000) 2,879,109,406 1,130,050,442 1,749,058,964 2013 40,715,863,391 26,465,311,204 14,250,552,187 10,846,706,007 3,403,846,179 (155,920,000) 3,247,926,179 1,274,811,025 1,973,115,154 2014 45,663,655,110 29,681,375,821 15,982,279,288 12,164,797,721 3,817,481,567 (155,920,000) 3,661,561,567 1,437,162,915 2,224,398,652 2015 51,212,702,479 33,288,256,611 17,924,445,868 13,643,063,940 4,281,381,927 (155,920,000) 4,125,461,927 1,619,243,806 2,506,218,121

Sustainable Growth Rate = Sales Growth Rate COGS Percent of sales GP=Sales-COGS 2003-2005 Income Tax Provision of NI Average last 3y Shares Outstanding in 2005

29.96% 1.28%

-26.99% 4.38%

13% 9.68%

21.50% 2.61%

23.29% Skepticism Average Growth 4.49% 104.49%

112%

65.00% Plus Growth Average 39.25% 10,158,300 25.96% 38.80% 38.57% 39.25%

Figure 1.5 Proforma Income Statement
Revenue COGS Gross Margin Other Expenses (Selling & other) Operating Margin Net Int Inc & Other EBT Margin Tax Rate Net Margin The Gap Inc: Common-size Income Statement Forecast Financial Statements 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 62.90% 70.10% 66.00% 62.40% 60.80% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 37.10% 29.90% 34.00% 37.60% 39.20% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 26.50% 27.50% 27.00% 25.80% 26.40% 26.64% 26.64% 26.64% 26.64% 26.64% 26.64% 10.60% 2.40% 7.00% 11.90% 12.80% 8.36% 8.36% 8.36% 8.36% 8.36% 8.36% -0.50% -0.70% -1.50% -1.20% -1.30% -1.04% -1.04% -1.04% -1.04% -1.04% -1.04% 16.10% 1.70% 5.50% 10.60% 11.50% 7.32% 7.32% 7.32% 7.32% 7.32% 7.32% 36.50% 103.20% 40.40% 38.80% 38.60% 2.95% 2.98% 3.01% 3.04% 3.07% 3.09% 6.42% 0.06% 3.30% 6.50% 65.70% 4.37% 4.34% 4.31% 4.28% 4.25% 4.23% 2012 100.00% 65.00% 35.00% 26.64% 8.36% -1.04% 7.32% 3.11% 4.21% 2013 2014 2015 100.00% 100.00% 100.00% 65.00% 65.00% 65.00% 35.00% 35.00% 35.00% 26.64% 26.64% 26.64% 8.36% 8.36% 8.36% -1.04% -1.04% -1.04% 7.32% 7.32% 7.32% 3.13% 3.15% 3.16% 4.19% 4.17% 4.16%

Average Growth Sales (Sustainable Growth Rate) COGS Growth Rate GP=Sales-COGS Selling Growth Rate 112.00% 11.45% 3.77% -5.85% -1.82% -5.45% -4.44% -2.56% 2.33% -0.61% -0.04% 99.96% 26.64%

Figure 1.6 Cash Flows

57

2001 Cash Flows from Operating Activities Net earnings (loss) : Depreciation and amortization Tax benefit from exercise of stock options and vesting o Deferred income taxes Loss on disposable and other Change in operating assets and liabilities: Merchandise inventory Prepaid expenses and other Accounts payable Accrued expenses Deferred lease credits and other long-term liabilities Net cash provided by operating activities Cash Flows from Investing Activities Net purchase of property and equipment Proceeds from sale of property and equipment Purcase of short term investments Maturaties and sale of short term investments Restricted cash Acquisition of lease rights and other assets Net cash used for investing activities Cash Flows from Financing Activities Net increase (decrease) in notes payable Proceeds from issuance of long-term debt Payments of long-term debt Issuance of common stock Reissuance of treasury stock Net purchase of treasury stock Cash dividends paid Net cash provided by (used for) financing activities Effect of exchange rate fluctuations on cash Net increase (decrease) in cash and equivalents Cash and equivalents at beginning of year Cash and equivalents at end of year $621,420,000 $250,000,000 $0 $152,105,000 ($392,558,000) ($75,488,000) $555,479,000 ($13,328,000) ($41,558,000) $450,352,000 $408,794,000 $1,035,749,000 ($16,252,000) ($1,874,914,000) $1,291,205,000 ($454,595,000) ($61,096,000) $249,545,000 ($56,541,000) $54,020,000 $1,291,205,000 $590,365,000 $130,882,000 ($38,872,000) $877,497,000

2002 ($7,764,000) $810,486,000 $58,444,000 ($28,512,000)

2003 $478,000,000 $706,000,000 $44,000,000 $5,000,000 $117,000,000

2004 $1,031,000,000 $675,000,000 $7,000,000 $101,000,000 $72,000,000 $385,000,000 $5,000,000 $10,000 ($42,000,000) ($38,000,000) ($26,000,000) $2,160,000,000 ($261,000,000) $1,000,000 ($1,202,000,000) $442,000,000 ($1,303,000,000) $5,000,000 ($2,318,000,000) $0 $0 ($668,000,000) $85,000,000 $26,000,000 ($79,000,000) ($636,000,000) $28,000,000 ($766,000,000) $3,027,000,000 $2,261,000,000

2005 $1,150,000,000 $620,000,000 $31,000,000 ($80,000,000) $21,000,000 ($90,000,000) ($18,000,000) $42,000,000 ($3,000,000) ($112,000,000) $59,000,000 $1,620,000,000 ($442,000,000) $0 ($1,813,000,000) $2,072,000,000 $337,000,000 $6,000,000 $160,000,000 $0 $0 ($871,000,000) $130,000,000 ($976,000,000) ($79,000,000) ($1,796,000,000) $0 ($16,000,000) $2,261,000,000 $2,245,000,000 $ $

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

831,824,736 $ 944,418,622 $ 1,070,694,918 $ 1,212,316,309 $ $510,639 $561,703 $617,873 $679,660

1,371,147,531 $ 1,549,279,923 $ 1,749,058,964 $ 1,973,115,154 $ 2,224,398,652 $ 2,506,218,121 $747,627 $822,389 $904,628 $995,091 $1,094,600 $1,204,060

$70,000,000

$54,333,333

$48,444,444

$57,592,593

$53,456,790

$53,164,609

$54,737,997

$53,786,465

$53,896,357

$54,140,273

$213,067,000 ($13,303,000) $42,205,000 $220,826,000 $22,390,000 $1,317,839,000 ($940,078,000)

($258,000,000) $33,000,000 $47,000 $55,000 $108,000,000 $2,000,000 $1,243,000,000 ($308,000,000) $9,000,000 ($472,000,000) $159,000,000

$62,000 ($342,081)

$111,218 ($262,007)

$135,122 ($293,846)

$148,634 ($329,554)

$163,497 ($369,602)

$179,847 ($414,516)

$197,832 ($464,887)

$217,615 ($521,382)

$239,377 ($584,739)

$263,314 ($655,796)

902,055,294 $ 999,162,869 $ 1,119,598,511 $ 1,270,407,641 $ ($510,639) ($561,703) ($617,873) ($679,660)

1,425,145,843 $ 1,603,032,252 $ 1,804,434,534 $ 2,027,592,944 $ 2,279,044,247 $ 2,561,169,972 ($747,627) ($822,389) ($904,628) ($995,091) ($1,094,600) ($1,204,060)

($10,549,000) ($950,627,000) ($734,927,000) $1,194,265,000 ($250,000,000) $139,105,000 ($785,000) ($76,373,000) $271,285,000 ($11,542,000) $626,955,000 $408,794,000 $1,035,749,000 $408,794,000

($20,000,000) $3,000,000 ($629,000,000) ($42,000,000) $1,346,000,000 $0 $120,000,000 $33,000,000 ($78,000,000) $1,379,000,000 $27,000,000 $2,020,000,000 $1,007,000,000 $3,027,000,000

($510,639)

($561,703)

($617,873)

($679,660)

($747,627)

($822,389)

($904,628)

($995,091)

($1,094,600)

($1,204,060)

$2,242,568,384 $2,245,000,000 $

$ $

(186,616) $ 2,245,000 $ 2,431,616 $

(243,162) $ 2,431,616 $ 2,674,778 $

(267,478) $ 2,674,778 $ 2,942,255 $

(294,226) $ 2,942,255 $ 3,236,481 $

(323,648) $ 3,236,481 $ 3,560,129 $

(356,013) $ 3,560,129 $ 3,916,142 $

(391,614) $ 3,916,142 $ 4,307,756 $

(430,776) $ 4,307,756 $ 4,738,532 $

(473,853) 4,738,532 5,212,385

2,431,616 $

58

Figure 1.7 Discounted Dividends

0 2005 EPS (Earnings Per Share) DPS (Dividends Per Share) BPS (Book Value Equity per Share) Cash From Operations Cash Investments PV Factor PV of Dividends Total PV of Annual Dividends Continuing (Terminal) Value Perpetuity PV of Terminal Value Perpetuity Estimated share value at the end of 2005 0 0.166 0.165532463 6.16

1 2006 $0.97 $0.18 $ 902,055,294.00 $ $ (510,639.00) $ 0.919624793 0.1655

2 2007 $1.10 $0.18

3 2008 $1.25 $0.18

4 2009 $1.41 $0.18

5 2010 $1.60 $0.18

6 2011 $1.81 $0.18 1,603,032,252.00 $ (822,389.00) $

7 2012 $2.04 $0.18

8 2013 $2.30 $0.18

9 2014 $2.60 $0.18 $

10 2015 0.18

999,162,869.00 $ 1,119,598,511.00 $ 1,270,407,641.00 $ 1,425,145,843.00 $ (561,703.00) $ (617,873.00) $ (679,660.00) $ (747,627.00) $

1,804,434,534.00 $ 2,027,592,944.00 $ (904,628.00) $ (995,091.00) $

2,279,044,247.00 $ 2,561,169,972.00 (1,094,600.00) $ (1,204,060.00)

2.059496568 Ke g 0.000 0.07 2.5714 6 18 -18 -6 -3.6 -3 0.040 0.060 0.080 0.100 0.120 20.05 g . 0 0.130 0.08 1.2857 1.3846 1.5 4.5 -9 -4.5 -3.6 0.0874 2.05 4 6.569 24.32 -14.3 -5.52 -4.225 0.095 1.894 3.27 5.14 12 -36 -7.2 -5.14 Overvalued (< 90%) Undervalued (> 110%) 0.105 1.714 2.769 4 7.2 36 -12 -7.2 0.115 1.565 2.4 3.27 5.14 12 -36 -12 15.876 19.404

Value of Firm Book Value of Liabilities Estimated Market Value of Equity Number of Shares Observed Price per Share (end of 2005)

12,035,917,819.49 5112000000 13,527,601,935.34 860,559,000.00 17.64

Assume Dividend Perpetuity Grows at 2% per year for initial perpetuity

Vf Market Value Market Value Weights WACC Solve for Ke given previous information 12 14,039,601,935.34 100%

Vd 512000000 4% Kd 6

Ve 13,527,601,935.34 96% Ke

Figure 1.8 Free Cash Flows
0 2005 EPS (Earnings Per Share) DPS (Dividends Per Share) BPS (Book Value Equity per Share) Cash From Operations Cash Investments Cash Flow to Firms Assets (Free Cash Flow) 6.16 $ $ $ 902,055,294.00 $ (510,639.00) $ 902,565,933.00 $ 999,162,869.00 $ (561,703.00) $ 999,724,572.00 $ 1,119,598,511.00 $ (617,873.00) $ 1,120,216,384.00 $ 1,270,407,641.00 $ (679,660.00) $ 1,271,087,301.00 $ 1,425,145,843.00 $ (747,627.00) $ 1,425,893,470.00 $ 1,603,032,252.00 $ (822,389.00) $ 1,603,854,641.00 $ 1,804,434,534.00 $ (904,628.00) $ 1,805,339,162.00 $ 2,027,592,944.00 $ (995,091.00) $ 2,028,588,035.00 $ 2,279,044,247.00 $ (1,094,600.00) $ 2,280,138,847.00 $ 2,561,169,972.00 (1,204,060.00) 2,562,374,032.00 1 2006 $0.97 $0.18 2 2007 $1.10 $0.18 3 2008 $1.25 $0.18 4 2009 $1.41 $0.18 5 2010 $1.60 $0.18 6 2011 $1.81 $0.18 7 2012 $2.04 $0.18 8 2013 $2.30 $0.18 9 2014 $2.60 $0.18 $ 0.18 10 2015

PV Factor PV of Free Cash Flows Total PV of Annual Free Cash Flows Continuing (Terminal) Value Perpetuity PV of Terminal Value Perpetuity Value of Firm Book Value of Liabilities Estimated Market Value of Equity Number of Shares Estimated Price per Share (end of 2005) Observed Share Price $ $ $ $ $ $ 7,700,148,030.76 14,987,981,920.39 G 5,112,000,000.00 9,875,981,920.39 860559000 11.48 17.64 $ 7,287,833,889.63

0.892857143 805862440.2

0.797193878 796974308 WACC

0.711780248 797347895.4

0.6355 807798959

0.56743 809090248.3

0.50663 812562675

0.4523 816643753.3

0.4039 819312683.8 $

0.3606 822240926.6 21,353,116,933.33 0.125 10.59 11.31 12.17 13.2 14.48

0.3220 825015860.4

0.095 0 0.01 0.02 0.03 0.04 5.73581 17.64 g 17.41 19.04 21.1 23.8 27.48 Overvalued (<90% Undervalued (>110%)

0.1 15.94 17.37 19.13 21.38 24.39

0.105 14.67 15.89 17.39 19.29 21.78 15.876 19.404

0.11 13.5 14.56 15.85 17.47 19.55

0.115 12.4 13.37 14.49 15.87 17.63

0.12 11.48 12.29 13.27 14.46 15.95

0.13 9.79 10.42 11.17 12.07 13.17

0

59

Figure 1.9 Residual Income
(0.06) 0 2005 Beginning BE (per share) Earnings Per Share Dividends per share Ending BE (per share) Ke "Normal" Income Residual Income (RI) Discount Factor Present Value of RI BV Equity (per share) 2005 Total PV of RI (end 2005) Continuation (Terminal) Value PV of Terminal Value (end 2005) Estimated Value (2005) 0.20 $7.97 2.55% 100.00% Ke 0.08 0.1 0.12 Actual Price per share Growth $22.01 0.15 0.14 0.16 0 $7.59 $5.49 $4.16 $3.26 $2.63 6.16 1.60 6.16 0.08 0.49 0.48 0.926 0.44 ValuePercent 77.33% 20.12% Sensitivity Analysis g 0.05 $7.54 $5.44 $4.11 $3.21 $2.58 0.1 $7.44 $5.34 $4.01 $3.11 $2.48 0.15 $7.29 $5.19 $3.86 $2.96 $2.33 0.41 avg gr 14.5% 0.56 0.41 0.857 0.35 0.62 0.35 0.794 0.28 0.68 0.29 0.735 0.21 0.75 0.22 0.681 0.15 0.81 0.16 0.630 0.10 0.87 0.10 0.583 0.06 0.94 0.03 0.540 0.02 1.00 (0.03) 0.500 (0.01) (0.03) 1 2006 6.16 $0.97 $0.18 6.95 2 2007 6.95 $0.97 $0.18 7.74 (0.06) 3 2008 7.74 $0.97 $0.18 8.53 (0.06) 4 Forecast Years 2009 8.53 $0.97 $0.18 9.32 2010 9.32 $0.97 $0.18 10.11 2011 10.11 $0.97 $0.18 10.90 2012 10.90 $0.97 $0.18 11.69 2013 11.69 $0.97 $0.18 12.48 2014 12.48 $0.97 $0.18 13.27 2015 (0.06) 5 (0.06) 6 (0.06) 7 (0.06) 8 (0.06) 9 perp

Figure 2.0 LR ROI Perp
1 2005 Beginning BE (per share) Earnings Per Share Dividends per share Ending BE (per share) Ke ROE Growth inBVE Actual Price per share Average ROE Average Growth in BVE LRResInc Perp Value Estimated Value $17.64 15.60% 13.74% -2.2921367 2006 6.16 $0.97 $0.18 6.95 2 2007 6.95 $1.10 $0.18 7.87 3 2008 7.87 $1.25 $0.18 8.94 4 5 Forecast Years 2009 2010 8.94 10.17 $1.41 $1.60 $0.18 $0.18 10.17 11.59 6 2011 11.59 $1.81 $0.18 13.22 7 2012 13.22 $2.04 $0.18 15.08 8 2013 15.08 $2.30 $0.18 17.20 9 perp 2014 17.20 $2.60 $0.18 19.62 2015

6.16 0.0874

15.75% 12.82%

15.83% 15.88% 13.24% 13.60% g

15.77% 13.76%

15.73% 13.96%

15.62% 14.06%

15.43% 14.07%

15.25% 14.06%

15.12% 14.07%

0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08

10.9932 11.6177 12.4274 13.5193 15.0719 17.4548 21.577 30.4373 63.2444

60

Figure 2.1 Abnormal Earnings Growing
1 2005 EPS DPS DPS invested at 17% (Drip) Cum-Dividend Earnings Normal Earnings Abnormal Earning Growth (AEG) $1.29 $0.18 2006 $0.97 $0.18 $0.01 $0.98 $1.40 ($0.41) 2 2007 $0.97 $0.18 $0.01 $0.98 $1.05 ($0.06) 3 Forecast Years 2008 $0.97 $0.18 $0.01 $0.98 $1.05 ($0.06) 2009 $0.97 $0.18 $0.01 $0.98 $1.05 ($0.06) 2010 $0.97 $0.18 $0.01 $0.98 $1.05 ($0.06) 2011 $0.97 $0.18 $0.01 $0.98 $1.05 ($0.06) 2012 2013 2014 $0.97 $0.18 $0.01 $0.98 1.05 ($0.06) $0.00 $0.97 $0.97 $0.18 $0.18 $0.01 $0.01 $0.98 $0.98 $1.05 $1.05 ($0.06) ##### 4 5 6 7 8 9 10 Perp

PV Factor PV of AEG Core EPS Total PV of AEG Continuing (Terminal) Value PV of Terminal Value Total PV of AEG Total Average EPS Perp (t+1) Capitalization Rate (perpetuity) Value Per Share Ke g 0.0817 0 $0.00 ($0.72) $0.57 0.0817 $6.97 $1.29 ($0.72)

0.924 ($0.38)

0.855 ($0.06)

0.790 ($0.05)

0.730 ($0.05)

0.675 ($0.04)

0.624 ($0.04)

0.577 0.534 ($0.04) #####

0.493 ($0.03)

0.456 $0.00

$0.00 Sensitivity Analysis g 0 Ke 0.08 0.1 0.12 0.14 0.16 $7.02 $4.99 $3.71 $2.86 $2.27 0.05 $6.97 $4.94 $3.66 $2.81 $2.22 0.1 $6.92 $4.89 $3.61 $2.76 $2.17 0.15 $6.87 $4.84 $3.56 $2.71 $2.12

Actual Price per share$17.64

Figure 2.2 Weighted Avg. Cost of Equity
5-Year Constant Maturity Risk Free Rate Months Beta -0.24 60 48 36 24 Yahoo Finance -0.31 -0.24 0.63 0.91 R^2 -0.0108 0.00876 -0.0248 -0.0188 Ke 0.0265 0.0216 0.0265 0.0874 0.107

61

Figure 2.3 Weighted Avg. Cost of Debt

Interest Rate LIABILITIES AND STOCKHOLDERS' EQUITY Short-term borrowings ** Current maturities of long-term debt Accounts payable Accrued expenses and other current liabilites Other current liabilities (income taxes pay.) TOTAL CURRENT LIABILITIES 0.0456 0.0524 0.07 0.054

weight

2005

0 0.24256651 0.180751174 0.015258216

0 0.012710485 0.012652582 0.000823944

0 $1,240,000,000 $924,000,000 $78,000,000 $ 2,242,000,000

Long-term debt Senior convertible notes Lease incentives and other liabilities Total Non-Current Liabilities

0.0256 0.0497 0.067

0.100352113 0.268583725 0.192488263

0.002569014 0.013348611 0.012883881

$513,000,000 $1,373,000,000 $984,000,000 $2,870,000,000 $ 5,112,000,000

Total Liabilities WACD 0.054988517

62

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