On a systemic level, consider whether the practice of issuing earnings forecasts is good, bad, or indifferent.? Is the practice of issuing earnings forecasts a socially benefi

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The Unicomp, Inc. Case

Finance

This case was developed by Dr. Manuel Velasquez of Santa Clara University with the assistance of Dr. Baruch Lev of the University of California at Berkeley and Dr. Wayne Lee of Santa Clara University. Arthur Andersen & Co, SC thanks them for their contributions to the Business Ethics Program.

Arthur Andersen & Co, SC also thanks Barbara Thomas, Senior Vice President and Group Head, International Private Bank of Bankers Trust, for reviewing an early draft of the case.

Arthur Andersen & Co, SC has sponsored and funded this project to promote discussion and awareness of ethical issues arising in the business world. Arthur Andersen & Co, SC takes no positions and expresses no views with respect to the myriad of ethical issues reflected in this case but hopes that users will facilitate and promote a dialogue on these important issues.

©1991 ARTHUR ANDERSEN & CO. SC All rights reserved. 008889 A-008

BUSINESS ETHICS PROGRAM

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UNICOMP, INC.

SITUATION I (LATE 1985)

John Lungren wasn’t sure what to do. Three years ago, fresh out of his MBA program with a strong background in finance and accounting, John had been hired to work in Unicomp’s financial department at an unusually high salary. He quickly displayed his financial and communication talents and by the end of his second year had been made Special Assistant to the Vice-President of Finance, Tom Krill. John had married, acquired a home with a sizable mortgage, and he and his wife were expecting their first child. Given his promising future at Unicomp, being deeply in debt hardly mattered.

Now Krill and Unicomp’s President and CEO, Frank Percy, had asked him to prepare a report justifying the acquisition of Comptech, a small company that manufactured IBM-compatible microcomputers. Normally John would have welcomed the assignment, but this one made him uneasy.

Unicomp’s Status

Unicomp was incorporated in 1978 in Santa Clam, California, part of the Silicon Valley. Its President, Frank Percy, is a former engineer. Unicomp has revenues of about $50 million. (See Appendix for Unicomp’s financial statements and balance sheets.)

Unicomp began by producing and marketing hard disk drives for microcomputers. In 1980, the company introduced “local area networking” (LAN) which allows several dozen personal computers to exchange information using the same storage device, printer, modem, and other peripherals. By 1981 the company’s LAN system was a successful product.

Unicomp operated in a very competitive environment, however. Larger, better known companies were marketing their own LAN systems, storage devices and microcomputers. To succeed Unicomp offered lower prices and quicker delivery than many of its rivals.

In 1982 the company introduced a microcomputer with its own operating system to serve as a workstation in its LAN system. This was seen as a key strategic step, since revenues from a system including microcomputers were much higher than revenues from a system without.

Unfortunately, Unicomp’s new microcomputer failed. There just wasn’t enough compatible software. Businesses tended to buy IBM microcomputers (for which an array of software existed) and connected them using Unicomp’s LAN. Other computer companies found they could succeed only by making IBM clones—inexpensive PC’s that could use software developed for IBM. By building a non-IBM-compatible computer, Unicomp had locked itself out of this market. Although sales of its LAN remained high, customers ignored Unicomp’s personal computers.

During 1984, Unicomp’s sales slumped due to stiffer competition and even slower sales of its microcomputers. Sales of its LAN systems, however, increased by about 70 percent, accounting for 23 percent of net sales (as compared to 14 percent for 1983). Cost of sales increased over 1983, because larger inventory reserves were set aside due to a buildup of the company’s non-IBM-compatible microcomputer inventory. Although losses at the end of fiscal `84 totaled $10,770,000, considerable belt tightening followed and matters improved the following year. By

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the end of fiscal `85, the company posted losses of $2,707,000. Still it was clear that something more had to happen. One idea was to make an IBM-compatible micro that could be sold as a workstation along with the company’s LAN system.

In spite of Unicomp’s problems, John Lungren liked working there. He was paid extremely well for his ability to explain financial concepts. This was a crucial service, since the company was composed largely of engineers. John knew he could never find a comparable position with another corporation and still live in the style to which he and his wife had become accustomed. He enjoyed being able to come to work in blue jeans and address co-workers by their first names. It was an egalitarianism, “hang-loose” organization. Every Friday afternoon they had a TGIF beer and pizza bash.

The only thing that bothered John was the chaos that often reigned within the company. Sometimes it was hard to know who was in charge of a project. Although things always got done, they were often several months late—sometimes a year. Percy and the vice-presidents seemed to view the chaos as the “creative ferment” that kept people bubbling with new ideas.

Unicomp’s Financial History

Originally financed with venture capital from several investment firms, the company’s first years appeared wildly successful. In just a year the founders produced storage devices; at the end of two years the company went public and began selling its stock over the counter. Initially offered for $3 a share in 1982, the stock within days sold for $12 a share. This offering gave the company $10,000,000. A second public offering, in September 1982, netted almost $24,000,000. Since then, the firm’s stock has fluctuated, depending on the boom-and-bust cycles of the computer industry. (See Appendix for Unicomp’s financial sheets and the “historical risk premiums” of small stock companies.) At times the stock has traded for as much as $21 a share and as little as $2. By late 1985 it was holding steady at $3.50. The company had never paid cash dividends and planned to continue reinvesting all earnings in the business.

The investment firms that provided Unicomp’s start-up capital sold off most of their shares when the stock was at $20. The original founders, who held substantial blocks of shares in the company, also sold much of their stock. Eventually all of them left the firm, either to retire and enjoy their wealth or to start up other ventures with their stock proceeds. A headhunter found Frank Percy. He was hired as President and CEO when Unicomp’s founder left. Percy had been working at another Silicon Valley computer company, and when he came to Unicomp he bought several people, including Tom Krill and two other vice presidents.

The Board of Directors now consisted of Percy, Krill, and a representative of an investment firm that owned 5 percent of Unicomp’s stock. Between them, Percy and Krill held 1 percent of Unicomp’s stock. The rest of the stock was distributed among several thousand shareholders, none of whom held large blocks.

The Assignment

About this time (late 1985), Percy and Krill approached John with a special task. John went to Percy’s office to discuss the assignment. As he entered, Krill greeted him and said, “Have a seat, John. We’d like to update you on some important news. We just met with the other vice presidents, and we’ve agreed to purchase Comptech.”

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John knew that Comptech manufactured small IBM-compatible microcomputers and that it started selling products about two years ago. Much of Comptech’s stock was owned by Sam Beuhler, the President of Comptech, and his family. Some of Unicomp’s vice-presidents had helped Beuhler set up his company and probably owned shares of Comptech. John suspected Percy and Krill owned sizable blocks of Comptech stock, which was not publicly traded.

“Isn’t Comptech a little young?” asked John.

“We’ve been trying to find a quick way to make our computer systems compatible,” explained Krill. “Now we've got the perfect opportunity—Comptech. We spoke with the President, Sam Beuhler, and the Board of Directors. They agreed to sell and we’re going to offer them 3.7 million shares of our stock. We’d like you to look over the company and give us an analysis of the purchase. We’ve talked this over with our Board. Percy and I think it’s a good buy, but the guy from the investment firm doesn’t. We could just outvote him, but we want you to write up a purchase analysis that shows him this makes good business sense.”

“I don’t know,” said John. “I’ve heard rumors Comptech isn't doing so great. I know it sustained losses last year. Some people I’ve talked with think it’s because the way the company’s managed.”

“Look, John,” Percy said softly, “Krill and I KNOW Beuhler and his company. We think it’s an excellent company. Like most start-ups, Comptech has been kind of slow reaching a favorable profit picture. That just makes it easier for us to buy them out. Especially since future prospects for their IBM clone are so good. Comptech gave us projections. We’re convinced this will work for us. It’s an easy way to get the IBM compatibles we need for our LANs.”

Krill continued. “We’ve looked over Comptech’s books. We’re getting the company for a good price, considering the added value of the synergism that will result. Their microcomputers will help us sell more LANs, our LANs will help them sell more microcomputers. We could offer then chicken feed. But that wouldn’t be ethical, would it?” Krill’s tone changed and acquired a barely noticeable edge. “John, this purchase is very important to all of us who have helped Beuhler set up his company. That report had better be good. Nobody wants a negative report on something so important to everyone here, you know?”

Later, when john made some inquiries, he found that Sam Beuhler was a close friend of Percy, Krill and some of the other vice presidents at Unicomp. In fact, Beuhler, Percy and two Unicomp vice-presidents had all worked together at another Silicon Valley firm some years ago.

When John looked over Comptech’s financial statements (see Appendix) and calculated its value, he became nervous. He wasn’t sure what to do.

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APPENDICES SITUATION I

UNICOMP, INC. FINANCIAL STATEMENTS

A.1 INCOME STATEMENTS

4-YR AVG May-85 May-84 May-83 May-82 May-81

Net Sales 44,568 53,223 50,540 47,673 26,838 10,325 Cost of Sales 28,278 32,900 35,909 27,512 16,792 6,628

Gross Profit 16,290 20,323 14,631 20,161 10,046 3,697

Operating expenses Product development 3,988 5,664 5,605 2,915 1,769 385 Marketing, administrative And general 13,001 15,803 21,279 10,617 4,303 1,820 Pension contributions 138 173 147 125 106 91 Depreciation and Amortization 1,794 3,049 3,116 791 220 83

18,921 24,689 30,147 14,448 6,398 2,379

Net operating income (loss) (2,631) (4,366) (15,516) 5,713 3,648 1,318 Nonoperating (interest) Income 844 606 717 1,643 410 0 Earnings before interest and taxes (1,787) (3,760) (14,799) 7,356 4,058 1,318 Interest expense 75 192 89 14 6 64

Income before taxes (1,862) (3,952) (14,888) 7,342 4,052 1,254 Income tax expense (benefit) (160) (1,245) (4,118) 2,999 1,725 639

Net income (1,702) (2,707) (10,770) 4,343 2,327 615 Common stock dividends 0 0 0 0 0 0

Retained earnings (1,702) (2,707) (10,770) 4,343 2,327 615

Fully diluted common stock shares 9,403 9,939 9,906 9,793 7,974 4,323

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UNICOMP, INC. A.2 BALANCE SHEETS

4-YR AVG May-85 May-84 May-83 May-82 May-81

Cash and marketable securities 7,066 11,635 2,507 12,711 1,414 304 Accounts receivable 7,873 6,702 7,293 10,812 6,686 2,578 Inventories 12,977 9,680 17,342 16,827 8,059 1,967 Prepaid expenses 720 730 1,223 618 309 116 Refundable income taxes 1,240 1,000 3,961 0 0 0

Total current assets 29,876 29,747 32,323 40,968 16,468 4,965

Net property, plant and equipment 6,440 6,992 8,435 7,013 3,318 1,257 Deferred pension benefits 462 579 493 420 357 304 Other assets 304 251 22 599 343 1

Total assets 37,082 37,569 41,273 49,000 20,486 6,527

Short-term debt 0 0 0 0 0 650 Accounts payable 4,753 4,047 4,974 4,379 5,611 3,743

Accrued lease termination cost 375 750 750 0 0 0

Accrued compensation and benefits 864 891 1,138 1,008 418 168 Accrued income taxes 201 0 0 359 445 642 Other accrued liabilities 169 391 186 30 72 72

Total current liabilities 6,362 6,079 7,048 5,776 6,546 5,275

Deferred income taxes 182 30 30 414 254 0

Obligations under capital lease 1,070 1,975 1,975 329 0 0 Long-term debt 0 0 0 0 0 0 Shareholders' equity 29,468 29,486 32,220 42,481 13,686 1,252

Total liabilities and equity 37,082 37,569 41,273 49,000 20,486 6,527

Market price per share for fiscal year-high 12..563 3.125 9.375 21.000 16.750

Market price per share for fiscal year-low 5.375 1.875 3.625 13.250 2.750

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VALUATION: COMPTECH, INC COMPTECH, INC. FINANCIAL STATEMENTS AND SUPPLEMENTS

A.1 INCOME STATEMENTS*

Nov-85 May-85 May-84 (1st 6 mos.)

Net sales 3,903 3,273 0 Cost of sales 1,490 1,197 (0)

Gross profit 2,413 2,076 0

Operating expenses Product development 528 972 223 Marketing, administrative and general 1,378 1,594 509 Depreciation and amortization 130 129 42

2,036 2,695 774

Net operating income 377 (619) 247 Nonoperating interest income 81 87 0

Earnings before interest and taxes 458 (532) (527) Interest expense 327 223 0

Income before taxes 131 (755) (527) Income tax expense 52 0 0

Net income (loss) 79 (755) (527) Common stock dividends 0 0 0

Retained earnings 79 (755) (527)

Fully diluted common stock shares 4,145 3,880 3,473

*Figures are in thousands of dollars.

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COMPTECH, INC. A.2 BALANCE SHEETS

Nov-85 May-85 May-84 (1st 6 mos.)

Cash and marketable securities 1,357 1,160 2,602 Accounts receivable 1,992 677 0 Inventories 1,148 344 35 Prepaid expenses 78 51 4

Total current assets 4,575 2,232 2,641

Property, plant and equipment-at cost Land 0 0 0 Machinery and other equipment 44$ 228 66 Furniture and fixtures 165 194 53 Leasehold improvements 71 93 12 Tooling and dies 440 379 148

1,124 894 279

Accumulated depreciation and amortization (293) (172) (42)

Net property, plant and equipment 831 722 237 Net organization costs 73 81 11 Other assets 181 178 35

Total assets 5,660 3,213 2,924

Short-term debt 939 0 0 Accounts payable 1,070 358 28 Accrued interest 43 163 0 Other accrued liabilities 277 75 10

Total current liabilities 2,329 595 38

Deferred taxes 0 0 0 Other liabilities 34 0 0 Long-term debt 488 488 0 Shareholder's equity 2,809 2,129 2,886

Total liabilities and equity 5,660 3,213 2,924

*Figures are in thousands of dollars.

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A.3 SUPPLEMENTARY DATA (COMPTECH VALUATION DATA)

U.S. T-Bills, 3-month* 7.20% 7.56% 9.90 % U.S. Government Bonds, 10-year* 9.78% 10.85% 13.41 % Corporate Bonds, AAA* 10.55% 11.72% 13.28% Corporate Bonds, BAA* 11.99% 13.15% 14.74%

Industry Beta (Electronics) Operating risk beta 0.94 Financial risk beta 0.28

Total risk beta 1.22

*Source: Economic Report of the President, 1985

HISTORICAL RISK PREMIA: 1926-1985*

—————————————————————————————————————————- GEOMETRIC ARITHMETIC

AVERAGE AVERAGE —————————————————————————————————————————- Small stock risk premiums 1966-1985 6.6% 9.0% (small stocks – stocks) 1926-1985 2.8% 6.5% —————————————————————————————————————————- Equity risk premiums 1966-1985 1.4% 2.7% (stocks – bills) 1926-1985 6.5% 8.4% —————————————————————————————————————————- Default risk premiums 1966-1985 0.7% 0.8% (L-T corps – L-T govts) 1926-1985 0.7% 0.7% —————————————————————————————————————————- Maturity risk premiums 1966-1985 1.3% 0���

(L-T govts – bills) 1926-1985 0.7% 0.9% —————————————————————————————————————————-

*Source: Stocks, Bonds, Bills, and Inflation: 1985 Yearbook Chicago, Ibbotson Associates, 1985

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(PROJECTIONS PROVIDED BY COMPTECH BASED ON ASSUMPTIONS GIVEN IN A.6)

A.4 PROFORMA INCOME STATEMENTS

COMPTECH, INC

ACTUAL PROJECTED Nov-85 Nov-86 Nov-87 Nov-88 Nov-89 Nov-90

Net sales 3,903 12,870 16,525 21,219 27,245 34,984 Cost of sales 1,490 4,916 6,313 8,106 10,408 13,364

Gross profit 2,413 7,954 10,212 13,113 16,837 21,620

Operating expenses All except depreciation 1,906 6,293 8,081 10,376 13,323 17,108 Depreciation and amortization 130 278 428 549 705 905

2,036 6,571 8,509 10,925 14,028 18,013

Net operating income 377 1,383 1,703 2,188 2,809 3,607 Nonoperating (interest) lncome 81 95 95 95 95 95

Earnings before interest and taxes 458 1,478 1,798 2,283 2,904 3,702 Interest expensel 327 171 176 212 257 316

Income before taxes 131 1,307 1,622 2,071 2,647 3,386 Income tax expense 52 523 649 828 1,059 1,354

Net income 79 784 973 1,243 1,588 2,032 Common stock dividends1 0 161 283 356 449 570

Retained earnlngs2 79 623 690 887 1,139 1,462

1 Based upon beginning balances 2 Computed as change in shareholders' equity

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(PROJECTIONS PROVIDED BY COMPETC BASED ON ASSUMPTIONS GIVEN IN A.6)

A.5 PROFORMA BALANCE SHEETS

ACTUAL PROJECTED Nov-85 Nov-86 Nov-87 Nov-88 Nov-89 Nov-90

Cash and marketable securitiesl 1,357 1,357 1,357 1,357 1,357 1,357

Accounts receivable2 1,992 2,200 2,824 3,627 4,657 5,979 Inventories2 1,148 1,230 1,580 2,029 2,605 3,345 Prepaid expenses2 78 106 136 174 224 288

3,218 3,536 4,540 5,830 7,486 9,612

Accounts payable2 1,070 1,178 1,512 1,942 2,493 3,201 Accrued interest2 43 170 218 280 359 462 Other accrued liabilities2 277 290 373 479 616 790

1,391 1,638 2,103 2,701 3,468 4,453

Net working capital 1,827 1,898 2,437 3,129 4,018 5,159 Net property, plant and equipment3 831 1,281 1,644 2,111 2,711 3,481 Net organization costs3 73 73 73 73 73 73 Other assets3 181 295 379 487 625 803

Total capitalization 4,269 4,904 5,890 7,157 8,784 10,873

Deferred taxes4 0 0 0 0 0 0 Other liabilities4 34 0 0 0 0 0 Short and long-term debts 1,426 1,471 1,767 2,147 2,635 3,262 Shareholders' equity6 2,809 3,433 4,123 5,010 6,149 7,611

Total capitalization 4,269 4,904 5,890 7,157 8,784 10,873

1Assumes no change 2Computed based on formula: X(t) = Period x (Sales/Day) 3Computed based on formula: X(t) = Sales/Turnover 4Computed based on formula: X(t) _ % x Sales 5Assumes total debt to assets to total capitalization is maintained 6Assumes preferred stock to total capitalization is maintained 7Assumes equity to total capitalization is maintained

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A.6 ASSUMPTIONS FOR PRO FORMA STATEMENTS ————————————————————————————- (01) Sales growth rate 50% (a)

First year* 25.0% (a) Second year to fifth year**

————————————————————————————- (02) Cost of sales as a % of sales 38.2% (b) ————————————————————————————- (03) Operating expense excluding depreciation as %

of sales 48.9% (b) (04) Depreciation as a % of average ending net plant 33.4% (b) ————————————————————————————- (05) Interest earned on marketable securities 7.0% (b) (06) Average interest rate on debt 12.0% (b) ————————————————————————————- (07) Corporate income tax rate 40.0% (b) ————————————————————————————- (08) Accounts receivable period, days 61.5 (b) (09) Inventories period, days 34.4 (b) (10) Prepaid expenses turnover 121.5 (b) (11) Net property, plant, and equipment turnover 10.1 (b) (12) Net organization costs turnover no change (b) (13) Other assets turnover 43.5 (b) ————————————————————————————- (14) Accounts payable period, days 32.9 (b) (15) Accrued interest period, days 4.8 (b) (16) Other accrued liabilities period, days 8.1 (b) ————————————————————————————- (17) Deferred taxes as % of sales 0.0% (b) (18) Other liabilities as % of sales 0.0% (b) ————————————————————————————- (19) Debt to total capitalization 30.0% (b) (20) Equity to total capitalization 70.0% (b) ————————————————————————————- (a) Assumed values (b) Most recent year

*Note that Comptech actual sales up to Nov. '85 are only for the first six months of that year on the Proforma Statements. **Note that the assumed growth rate of 25 percent is compounded daily. This is equivalent to approximately 28.5% annual rate.

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UNICOMP, INC.

SITUATION II (JULY 1986)

For the second time, Unicomp’s financial department had been asked to develop an earnings forecast, and John was assigned the task. (See Appendix to Situation II, Earnings Forecast Background Information.)

In the past, Unicomp’s management had refused to provide public forecasts. They felt issuing a forecast focused undue attention on a single number and distracted investors from considering the more important strengths of the company. Also, Unicomp’s management was keenly aware that failure to achieve the projected forecast could have a negative impact on stock price. In the absence of company forecasts, several investment analysts had provided clients with their own estimates of Unicomp’s earnings. More than once these estimates had been too optimistic. When the company failed to attain the estimates, the price of the stock had been adversely affected. As a result, three years ago the company issued an earnings forecast. However, no forecasts were offered the following two years.

In June of `86, John was asked to put together an earnings forecast for fiscal `87. He realized the importance of this assignment since the company was planning to make another stock offering soon.

During fiscal `86 (which ended on May 31 the company had posted a small profit. Net sales had increased by 10 percent, and cost of sales had climbed by only 4.5 percent over 1985. The company had managed to cut its operating expenses by 4 percent, and by the end of the year, the company had after-tax income of $.5 million.

John felt Unicomp had turned the corner, and by late June he thought he had completed the estimate. It looked like Unicomp would have a decent year, even though the company was still trying to integrate Comptech’s operations and several Japanese companies were providing stiff competition. The company anticipated net sales would increase by 20 percent to $70.3 million, and cost of sales would increase to $39.6 million. Operating expenses would climb by 16 percent to $27.4 million. John and his team estimated year-end earnings after taxes would be $1.8 to $2.2 million. This was a welcome change from the losses of previous years.

The day before the forecast was to be released, John had dinner with Pete Sovik, his counterpart at one of Unicomp’s major computer chip suppliers. Pete told John that because of the heavy demand for their specialized computer chips, they were planning to cut the number of chips shipped to Unicomp by 15 percent. Since the chips were custom designed and required special equipment to manufacture, John realized another supplier could not provide the chips without a delay of perhaps three months. The chips were needed in almost every product made by Unicomp. John calculated the shortage would cut their production by at least 10 percent and possibly more. Also, if there was a general shortage of chips, manufacturing costs would surely rise. All this was sure to have a material impact on company earnings.

The next morning John called Krill. “Tom, last night at dinner, Pete Sovik told me our chip supply would be cut by 15%. I need a few more days to recalculate the forecast in that light.”

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“No, they can’t possibly cut our supply;” Krill replied. “I need some time to think about this. Call you back in an hour.”

Later Krill gave John his reply. “Percy and I talked about it, John, and a delay won’t be necessary. You know we’re planning a stock offering in the next few weeks. If the price of stock drops sharply, we won’t be able to raise enough cash to finance our product development.”

“The forecast cannot be pessimistic. Go ahead and issue the forecast prepared. This is really last minute news-really just a rumor. Once the stock offering is out, you can issue a revised forecast if the rumor turns out to be true.”

John hung up and pondered the situation. He was convinced his friend’s information was accurate. Pete was a cautious person and would not pass on the information unless it was reliable.

APPENDIX TO SITUATION II EARNINGS FORECAST BACKGROUND INFORMATION

Surveys show that about 10 to 15 percent of publicly held corporations in the U.S. voluntarily publish annual earnings forecasts. (See Lees, F.A., Public Disclosure of Corporate Earnings Forecasts. New York: The Conference Board, 1981.) Some of these forecasts are in the form of a point estimate, such as a forecast of 4.50 for the forthcoming annual earnings-pe

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