FIN 420 EXAM 3 CH 11 & 12

Implementing a dividend valuation model to determine the value of the common shareholders' equity requires an analyst to measure three elements. What are the three elements that the analyst needs to measure?

1. The discount rate used to compute the present value of the future dividends. 2. The expected future dividends over the forecast horizon. 3. The expected dividend at the final period of the forecast horizon, called the continuing dividend, along with a forecast of long-term growth.

A disadvantage of the free cash flow valuation method is a. The terminal value tends to dominate the total value in many cases. b. The projection of free cash flows depends on earnings estimates. c. The free cash flow method is not rigorous. d. The free cash flow method is not used widely in practice.

a. The terminal value tends to dominate the total value in many cases.

Investors typically accept a lower risk-adjusted rate of return on debt capital than on equity capital because a. debt is typically less risky because fixed claims bear less residual risk than equity claims. b. equity bears less residual risk than debt. c. equity capital costs are tax deductible. d. the yield to maturity on equity is inversely related to its market value

a. debt is typically less risky because fixed claims bear less residual risk than equity claims.

If an analyst wants to value a potential investment in the common stock equity of a firm, the analyst should discount the projected free cash flows at the a. required return on equity capital b. weighted average cost of capital c. risk free rate d. market risk premium

a. required return on equity capital

When calculating free cash flows to common equity shareholders, financing activities do not include: a. Debt cash flows b. Adjustments for capital expenditures c. Adjustments for Preferred stock cash flows d. Financial asset cash flows

b. Adjustments for capital expenditures

One rationale for using expected dividends in valuation is a. Dividends are a necessary payment in order for a firm to have value. b. Dividends are paid in cash, and cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities. c. Dividends are the most reliable measure of value because most companies payout dividends to shareholders. d. Dividend payout ratios are set based on profitability.

b. Dividends are paid in cash, and cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities.

The conceptual framework for free cash flows separates the balance sheet equation into the following categories: a. CA + LT A = CL + LT L + SE b. OA + FA = OL + FL + SE c. OA + FA = OL + FL + OSE + FSE d. Non-FA + FA = Non-FL + FL + SE

b. OA + FA = OL + FL + SE

When deriving the equity value of a firm, an analyst forecasts the real dividends expected to be paid in the future. In this case, which discount rate should be used? a. The nominal rate of return b. The real rate of return c. The risk free rate of return d. The risk adjusted rate of return

b. The real rate of return

Starting with net cash flow from operations and adjusting for capital expenditures and dividends equals a. free cash flows for all debt and equity capital stakeholders b. free cash flow c. free cash flows to common equity capital shareholders d. free cash flow from operations

b. free cash flow

If an analyst wants to value a potential investment in the net operating assets of a division of another firm, the relevant cash flows the analyst should use are a. free cash flow from operations b. free cash flows for all debt and equity capital stakeholders c. free cash flows to common equity shareholders d. cash flow from operations

b. free cash flows for all debt and equity capital stakeholders

Returns on systematic risk-free securities (like U.S. Treasury securities) should exhibit what type of correlation with returns on a diversified marketwide portfolio of stocks? a. nearly perfect correlation. b. perfect correlation. c. no correlation. d. Unable to tell without specifics about the portfolio.

c. no correlation.

Under the cash-flow-based valuation approach, free cash flows can be used instead of dividends as the expected future payoffs to the investor in the numerator of the general valuation model because: a. this approach focuses on earnings as a measure of the capital that a firm creates. b. over the life of the firm, the free cash flows into the firm and cash flows paid out of the firm in dividends to shareholders will be equivalent. c. over the life of the firm, the free cash flows out of the firm for investments and cash flows paid into the firm in dividends from these investments will be equivalent.

b. over the life of the firm, the free cash flows into the firm and cash flows paid out of the firm in dividends to shareholders will be equivalent.

Continuing free cash flows represent a. the cash flows remaining after deducting cash flows attributable to debt holders b. the free cash flows after the point at which the firm has settled into a long-run steady-state growth rate. c. all sustainable free cash flows d. all after-tax free cash flows

b. the free cash flows after the point at which the firm has settled into a long-run steady-state growth rate.

With respect to dividends and priority in liquidation, what has priority over common stock? a. treasury stock b. debt capital c. preferred stock d. nonconvertible common equity

c. preferred stock

If an analyst wants to value a potential investment in the net operating assets of a division of another firm, the analyst should discount the projected free cash flows at the a. cost of debt capital b. cost of equity capital c. weighted average cost of capital d. risk free rate

c. weighted average cost of capital

Which of the following is not a problem with using a dividend-based valuation formula a. dividends are arbitrarily established b. dividends represent a transfer of wealth to shareholders c. some firms do not pay a regular periodic dividend d. it is a challenge to forecast the final liquidating dividend

b. dividends represent a transfer of wealth to shareholders

Financial liabilities include all of the following except a. mortgages payable b. current maturities of long term debt c. accrued taxes d. bonds payable

c. accrued taxes

Firm-specific factors that increase the firm's nondiversifiable risk include all of the following except: a. exposure to interest rate changes b. exposure to inflation c. exposure to management competence d. exposure to cyclicality

c. exposure to management competence

If an analyst wants to value a potential investment in the common stock equity in a firm, the relevant cash flows the analyst should use are a. free cash flow from operations b. free cash flows for all debt and equity capital stakeholders c. free cash flows to common equity shareholders d. cash flow from operations

c. free cash flows to common equity shareholders

Steady-state growth in free cash flows could be driven by long-run expectations for growth attributable to a. interest rates b. national exports c. general economic productivity d. balance of payments

c. general economic productivity

Financial assets include all of the following except a. Excess cash b. short term investments c. intangible assets d. long trm investments

c. intangible assets

Equity-based valuation models are based on all metrics except a. dividends b. cash flow c. working capital d. earnings

c. working capital

An equity security with systematic risk equal to the average amount of systematic risk of all equity securities in the market a. has a market beta equal to one. b. should expect to earn the same rate of return as the average stock in the market portfolio. c. gives no insight into the risk premium of stock. d. Both a and b are correct.

d. Both a and b are correct.

All of the following are steps in the analysis and valuation framework used to understand the fundamentals of a business and determine estimates of its value except: a. Analyze the firm's strategy in terms of the competition. b. Assess the quality of the firm's accounting and financial reporting. c. Derive forecasts of future earnings from the firm's projected financial statements. d. Obtain the national ranking of the firm's external auditors.

d. Obtain the national ranking of the firm's external auditors.

The conceptual framework for free cash flows separates all assets and liabilities into the following categories: a. Current and non-current b. Monetary and non-monetary c. Operating and non-operating d. Operating and financial

d. Operating and financial

The historical discount rate of the firm may be a good indicator of the appropriate discount rate to apply to the firm in the future, when all of the following conditions hold true except: a. The current risk of the firm is the same as the expected future risk of the firm. b. Expected future interest rates are likely to equal current interest rates. c. The existing capital structure of the firm is the same as the expected future capital structure of the firm. d. The current mix of debt and equity financing is equal.

d. The current mix of debt and equity financing is equal.

All of the following are logical steps that enable the analyst to determine reliable estimates of value except: a. understand the economics of the industry b. assess the particular firm's strategy c. evaluate the quality of the firm's accounting d. derive a single point estimate of value for a share's current price

d. derive a single point estimate of value for a share's current price

Nonsystematic risk factors would include all of the following except: a. the sustainability of the firm's strategy b. the firm's ability to generate revenue growth c. the firm's ability to control expenses d. unemployment levels

d. unemployment levels

Equity valuation models based on dividends, cash flows, and earnings have been the topic of many theoretical and empirical research studies in recent years. All of the following are true regarding these studies except: a. share prices in the capital markets generally correlate closely with share value b. share prices do not always equal share values c. temporary deviations of price from value occur d. unexpected changes in earnings, dividends, and cash flows do not correlate closely with changes in stock prices

d. unexpected changes in earnings, dividends, and cash flows do not correlate closely with changes in stock prices

Free cash flows for common equity shareholders are the cash flows specifically available to the common shareholders after making all capital expenditures, _____________________________________________ and ____________________________________________________________.

debt payments to lenders, paying dividends to Preferred shareholders

The cash-flow-based valuation approach measures and values the cash flows that are "free" to be ________________________________________ unencumbered by necessary reinvestments in operating assets or required payments to debt holders.

distributed to shareholders

The present value of future free cash flows valuation method focuses on free cash flows, a base that economists argue has more economic meaning than ____________________.

earnings

A company with a market beta of 1 has systemic risk ____________________ to the average amount of systemic risk of all equity securities in the market

equal

Normally, valuation methods are designed to produce reliable estimates of the value of a firm's ______________________________.

equity shares

If the objective is to value operating assets net of operating liabilities of a firm then the appropriate free cash flow measure to be used is ______________________________________________________________________.

free cash flow for all debt and equity capital

Steady-state growth in ___________________________________ could be driven by long-run expectations for growth attributable to economy-wide inflation, general economic productivity, the population, or long-run growth in industry's sales.

free cash flows

The forecasting and valuation process is particularly difficult for ______________________________ when the near term free cash flows tend to be negative.

growth firms

Dividends measure the cash that ____________________ ultimately receive from investing in an equity share

investors

A company with a new Capital structure will increase the __________ and at the same time the __________ risk.

leverage systematic risk

Because the market equity beta reflects the level of operating leverage, financial leverage, variability of sales, and other characteristics of a firm, there are situations where an analyst might have to adjust the beta because of changes in the capital structure. A situation that might require an analyst to estimate a new levered beta is a ___________________________________.

leveraged buyout

One criticism in using the CAPM to calculate the cost of equity capital is that ______________________________ and the __________________________________________________ are quite sensitive to the time period and methodology used in their computation

market betas excess market rate of return

To determine the appropriate weights to use in the weighted average cost of capital, an analyst will need to determine the ______________________________ of the debt, preferred stock and common equity capital.

market values

If dividend projections include the effect of inflation, then the discount rate used should be a ____________________ rate.

nominal

For most firms, ______________________________ include cash and short-term investment securities, accounts receivable, inventory, property, plant and equipment, intangible assets and investments in affiliated companies.

operating assets

________________________________________ typically include accounts payable, accrued expenses, accrued taxes, deferred taxes, pension obligations and other retirement benefit obligations

operating liabilities

Even in relatively efficient securities markets, ______ is observable but ______ is not; therefore, ______ must be estimated.

price, value, value

Changes in general price levels due to inflation or deflation cause the ______________________________ of the monetary unit to increase or decrease ______________

purchasing power, over time

If a firm generates a rate of return on __________________________________________________ equal to the discount rate used by the investor then it does not matter if an analyst uses cash flows to the investor or cash flows to the firm.

reinvested free cash flow

The risk-adjusted discount rate used to compute the present value of all the projected free cash flows for common equity shareholders equals the _______________________________________________________.

required rate of return on equity capital

In theory, the value of a share of common equity is the present value of ____________________________________________________________.

the expected future dividends

One advantage of the free cash flow valuation method is cash is the medium of exchange and therefore is a fundamental source of ________________________

value

The analyst can use expectations of the dividends to be paid to the investor or the free cash flows to be generated by the firm (that will ultimately be paid to the investor) as equivalent approaches to measure the ____________ expected payoffs to shareholders.

value-relevant