Question of the Day

Percentage point changes in 30Y mortgage interest rates (X) affect the level of new home sales (Y) in $millions according to the relationship Y=115-20.9X determine expected new home sales if mortgage interest rates fell from 7% to 6%.

135.9 = 115 - 20.9*(-1)

Hill O' Beans felt that a merger would be optimal for its corporate strategy. The company started acquiring other local competing organic coffee shops in order to increase its coverage for organic coffee drinkers. The type of growth from such acquisitions can BEST BE DESCRIBED as: A. Organic B. Horizontal C. Conglomerate

B. HOB saw an opportunity to expand their success via the acquisitions of competing coffee shops. This type of merger based on their industry life cycle is most descriptive of horizontal mergers. A is incorrect -- Organic growth is promoting one's business and gaining market share internally C in incorrect -- conglomerate mergers are an option for pioneering companies to purchase other unrelated businesses to diversify away from their original industry operations

An analyst is following a large US energy company that reports inventory under LIFO. If the company is forced to adopt IFRS in a period of rising prices, the MOST likely impact will be: A. A lower return on assets B. A higher return on equity C. Higher after-tax cash flows

B. IFRS does not allow LIFO accounting. If the company adopts IFRS it will need to switch to another method (such as FIFO or average cost). Thus, the reported COGS will most likely be lower and net income higher, relative to LIFO. Even though equity will be higher as well, the income statement effect dominates and overall return on equity will increase. A is incorrect -- both NI and total assets will increase, but the income statement effect will dominate. This will cause the ROA calculation to increase. C is incorrect -- the after-tax cash flows are highest under LIFO because it results in the highest COGS and lowest pre-tax income and tax liability. A change from LIFO to another method of inventory accounting would decrease after-tax cash flows.

The management of Standard Inc. believes the prices of its raw materials will continue to fall. The company uses US GAAP and is considering a switch from the LIFO to FIFO inventory valuation method. Compared to the use of LIFO, what impact would the switch to FIFO have on the subsequent year's reported earnings? A. Increase B. Decrease C. No change

B. If the price of raw materials continues to fall, FIFO will produce lower net income. A is incorrect -- NI will increase if LIFO continues to be used by the firm. C is incorrect -- the switch from LIFO to FIFO will cause a change in reported earnings if raw material prices continue to fall.

Which of the following represents an economically valid reason for a merger to take place? A. Diversification to reduce risk B. Elimination of the acquired company's inefficiencies C. The ability of the combined company to obtain lower financing costs

B. Increasing financial returns through elimination of operating inefficiencies is a valid reason for merging A is incorrect -- diversification efforts do not add value, as it is easier and cheaper if undertaken by the individual investor C is incorrect -- this represents a questionable reason for a merger, especially if the merger occurs after each company has separate borrowings already in place

Serial correlation in the residuals of a regression equation is: A. less serious than conditional heteroskedasticity. B. Potentially a more serious problem than having conditional heteroskedasticity because it can cause the regression coefficients to be biased. C. Usually more serious than conditional heteroskedasticity because it violates one of the key assumptions of regression analysis, whereas conditional heteroskedasticity does not.

B. Regression coefficients are closer to their true value under conditional heteroskedasticity than when serial correlation occurs. Conditional heteroskedasticity still creates problems when making statistical inferences. A is incorrect -- serial correlation of the residuals is more, rather than less, serious than conditional heteroskedasticity. C is incorrect -- conditional heteroskedasticity violates one of the assumptions of regression analysis, as does serial correlation.

Serial correlation in the residuals of a regression correlation is: A. Less serious than conditional heteroskedasticity. B. Potentially a more serious problem than having conditional heteroskedasticity because it can cause the regression coefficients to be biased. C. Usually more serious than conditional heteroskedasticity because it violates one of the key assumptions of regression analysis, whereas conditional heteroskedasticity does not.

B. Regression coefficients are closer to their true value under conditional heteroskedasticity than when serial correlation occurs. Conditional heteroskedasticity still creates problems when making statistical inferences. A is incorrect -- serial correlation of the residuals is more, rather than less, serious than conditional heteroskedasticity. C is incorrect -- conditional heteroskedasticity violates one of the assumptions of regression analysis, as does serial correlation.

The P/S ratio is different from the P/E and P/BV ratios because: A. It can be validly applied to a variety of different companies. B. This method is less influenced by accounting choices than the other measures. C. Sales are a better basis for determining value than either earnings or book value.

B. Sales are less influenced by accounting choices than are other ratios. A is incorrect -- the P/S ratio is no different from the other ratios in its applicability to companies. C is incorrect -- all of the mentioned ratios have merit for determining value.

The Nolon Co. has a significant portion of its mortgage loan receivables in an off-balance sheet special purpose entity. The Noloss Co. keeps all of its mortgage loan receivables on its books, but the spread between its gross and net loan receivables is relatively insignificant. The adjustments made by an analyst to effectively compare the two companies will cause liabilities to increase for: A. Noloss B. Noloan C. Both

B. The analyst must consolidate the off-B/S special purpose entity, increasing Noloan's assets and liabilities. The adjustment will increase Noloan's leverage ratio and percentage of capital attributable to liabilities. For Noloss, the analyst will MOST LIKELY increase the allowance for loan losses, which will decrease the asset and decrease equity.

Free cash flow to the firm must be discounted by: A. The cost of common equity capital B. The weighted-average cost of capital C. The risk-free rate, adjusted upward for an equity risk premium

B. The cash flows to the firm should be discounted by the firm's WACC. Using the wrong discount rate will result in an incorrect value of the firm. A is incorrect -- the cost of common equity would be used to value the firm based on cash flow to common equity. C is incorrect -- this in essence describes the cost of equity. However, the cost of debt financing should also be taken into account and this is done via the WACC.

The constant-growth free cash flow to common equity model is best used if it is assumed that the firm will: A. Achieve a high rate of free cash flow to common equity for a limited number of years and then will grow at a constant, stable growth rate forever. B. Grow free cash flow to common equity at a constant, stable growth rate forever. C. Have declining growth over a period of years until it reaches zero growth.

B. The constant-growth free cash flow to common equity model assumes a constant growth rate. A is incorrect -- this is the definition of the multi-stage free cash flow model; a period of fast growth followed by a slower, steadier growth rate forever. C is incorrect -- this would require a multi-stage free cash flow model. Each period's free cash flow during the declining growth would be discounted and then the terminal value is found when growth reaches zero.

A Corp. acquired B. Corp and experienced an increase in EPS without any perceived synergies from the acquisition. Assuming that A's pre- and post- acquisition P/E were the same, B's pre-acquisition P/E relative to A's must have been: A. Lower B. Higher C. The same or higher

A. An acquirer can "bootstrap" earnings by purchasing a target with a lower pre-acquisition P/E ratio than its own. B is incorrect -- purchasing a higher P/E target will result in lower EPS as the acquirer uses cheap earnings to purchase more expensive earnings. Because the acquirer issues a greater number of shares as the result of its cheap stock price, the combined entity's earnings will be spread among a greater number of shares and EPS will decrease. C is incorrect -- purchasing an equivalent P/E target will result in equal P/E ratios for the pre-acquisition purchaser and the post-acquisition (combined) entity. It will issue a number of shares to purchase the target that maintains the pre-acquisition EPS for the post-acquisition entity

A firm can be acquired without an amicably negotiated merger by: A. Making a tender offer to the shareholders. B. Implementing a poison pill. C. Considering a two-tier offer

A. An offer made directly to the company shareholders can be used as an effective takeover tactic without a negotiated merger. B is incorrect -- this represents takeover defense that existing shareholders can use to avoid a takeover. C is incorrect -- a two-tier offer relates to how the consideration is structured and must be amicably negotiated.

Erin Lacy, CFA, is concerned that recent FASB developments will ultimately result in Windstar Inc. having to consolidate a QSPE (qualified special purpose entity) that it had used to securitize its accounts receivable. Windstar reports $10 billion in total assets and a book value of $2 billion. As part of her analysis, Lacy consolidates the QSPE and the financial leverage ratio increases by 40%. The total accounts receivable securitized by Windstar is closest to: A. $4.0 billion B. $3.2 billion C. $0.8 billion

A. Book value is equity to equity (assets less liabilities), so Windstar's financial leverage ratio after the securitization of the accounts receivable was 5.0 ($10 billion/$2 billion). The adjustments Lacy made, which would have included adding back the asset and the liability associated with the asset sale/secured borrowing, increased the ratio by 40%, or to 7.0. Since the equity would not have changed, it must have been the case that assets increased to $14 billion as a result of the adjustment. B is incorrect -- this incorrectly uses the difference between assets ($10 million) and book value ($2 million) and multiples it by the increase in financial leverage. C is incorrect -- this incorrectly multiples the BV by the increase in financial leverage.

During a period of rising prices, the financial statements of a firm using FIFO inventory costing instead of LIFO reporting would show: A. Higher total assets and higher net income. B. Higher total assets and lower net income. C. Lower total assets and higher net income.

A. If prices are rising, FIFO will result in the most current costs applied to ending inventory, while older, lower cost purchased/produced items will be applied to COGS resulting in higher net income. B is incorrect -- although ending inventory will be higher, since older, lower cost items will be applied to COGS, net income will be higher in a rising price environment under FIFO. C is incorrect -- in an inflationary environment, FIFO results in the latest purchased/produced items being included in the ending inventory balance, resulting in higher total assets.

Assuming that inventory levels are stable or increasing, which of the following is MOST LIKELY to be considered by management as an advantage of the US GAAP LIFO method as compared to the FIFO method? A. Income trends tend to be smoothed as prices change over time. B. Inventory tends to approximate current cost on the balance sheet. C. The costs assigned to inventory parallel the physical flows of goods through the organization.

A. Income smoothing is an advantage of LIFO. B is incorrect -- when FIFO is used, inventory approximates current cost on the B/S. The use of LIFO reflects the application of current costs on the income statement. C is incorrect -- LIFO inventory costing typically does not parallel the physical flow of goods through an organization. Rather, it reverses the natural flow by first attributing the most recently produced/purchased items to COGS.

The adjustments to a company's financial statements to capitalize an operating lease will MOST LIKELY result in: A. Increased financial leverage and debt-to-equity ratios B. Higher EBIT, as long as depreciation expense is greater than rent expense C. A decrease in interest expense, causing an increase in the interest coverage ratio

A. The adjustments to capitalize an operating lease will most likely incorporate higher assets and liabilities to account for the capitalized asset and the liability associated with the lease obligation. The financial leverage ratio is calculated as assets divided by equity, and with a large increase in assets, this will increase the ratio. In addition, the increase in debt will result in a higher debt-to-equity ratio. Equity adjustments are less significant and may be left out of the adjustment process. B is incorrect -- the capitalization of an operating lease will involve the removal of rent expense (associated with the operating lease) and the addition of depreciation expense. If depreciation expense is greater than rent expense, this will decrease (rather than increase) EBIT. C is incorrect -- Interest expense will increase with the adjustment to capitalize a lease.

Why must the error term in a linear regression be normally distributed? A. To permit hypothesis testing on the regression parameters. B. To avoid serial correlation in the error terms. C. To ensure a linear relationship between the dependent and independent variables.

A. The error term must be normally distributed to allow testing of the regression parameters because the statistical tests require this to produce meaningful results. Accurate statistical testing requires that: 1. The expected error term is 0 2. The variance of the error term is consistent across all observations 3. The error terms are uncorrelated across all observations 4. The error terms must be normally distributed B is incorrect -- there should not be serial correlation amongst the error terms, but this is independent of why it must be normally distributed. C is incorrect -- there must be a linear relationship between the dependent variables, but this is independent of why it must be normally distributed.

Johnson calculates a P/E multiple of 8.3x for Andersen Company. If Johnson calculates a median P/E multiple of 8.7x for Andersen's industry group in order to create a justified multiple, then he has MOST LIKELY applied the: A. Method of comparables. B. Justified multiple method. C. Forecasted fundamentals method.

A. The method of comparables holds that similar assets should sell at similar prices. Johnson has applied the method of comparables because he compared Andersen to similar assets. The P/E multiple makes direct comparisons meaningful by scaling each comparable firm's price to the equivalent of $1.00 of earnings. B is incorrect -- the method of comparables & the forecasted fundamentals method create a justified multiple against which Johnson would compare the actual multiple. The method of comparing the justified multiple would depend on whether the method of comparables or the forecasted fundamentals method had been used; that is, there is more than one method used to develop a justified multiple. C is incorrect -- the forecasted fundamentals method would establish a P/E multiple using forecasted values for the fundamental factors of earnings, dividend payout, and required return on equity.

The P/BV ratio: A. Can be used to determine the relative values among a group of comparable companies. B. Is superior to the P/E ratios as a measure of absolute value because it requires no projections. C. Can never be negative.

A. The proper use of P/BV ratios is used to determine the relative value of a company among a group of comparables. B is incorrect -- Both P/E and P/BV ratios measure relative values (not absolute) C is incorrect -- the P/BV ratio can be negative if the firm has a negative BV

Sonny is studying the relationship between oil prices and stock returns and is considering the use of regression analysis. Which of the following might persuade Sonny to use a statistical tool other than linear regression? A. The relationship between oil prices and stock returns can change over time. B. The relationship between oil prices and stock returns is known to be linear. C. Historical oil prices are not random.

A. The relationship between two variables can change over time. This means that the parameters associated with the regression analysis only apply to historical data. Any conclusions that Sonny makes are likely to be invalid in the future. B is incorrect -- linear regression requires that the relationship is linear. C is incorrect -- regression analysis requires that independent variables are not random.

Herman's Sporting Goods and Morsan's Sporting World are identical in all respects except Herman's uses FIFO and Morsan's uses LIFO under US GAAP. Over the last several years, both companies have faced rising prices. Which of the following would be LEAST LIKELY when comparing the financial statements of the two companies? A. The tax liability for Herman's would be less than the tax liability for Morsan's. B. The ending inventory for Herman's would be higher than the ending inventory for Morsan's. C. The retained earnings of Herman's would be higher than the retained earnings of Morsan's.

A. The statement is the LEAST LIKELY because Herman's use of FIFO would result in lower COGS, higher pretax income and greater tax liability vs. Morsan's use of the LIFO method. B is incorrect -- Herman's use of the FIFO method would result in a higher ending inventory in a rising price environment C is incorrect -- Herman's use of the FIFO method most likely increases NI, resulting in higher retained earnings than Moran's use of the LIFO method, which lowers NI and therefore lowers retained earnings

When comparing a company using LIFO under US GAAP to a company using FIFO, which of the following choices best reflects the impact on the current ratio in a rising price environment? A. The LIFO current ratio will be lower, and the difference will increase in size over time B. The LIFO current ratio will be lower, and the difference will decrease in size over time. C. Decreasing working capital. The LIFO current ratio will be higher, and the difference will decrease in size over time.

A. The use of LIFO (vs. FIFO) in an inflationary environment will result in smaller inventory balances and cause a smaller current ratio. Assuming continued rising prices, the difference in the current ratio will increase in size over time as the difference in ending inventory balances due to the use of LIFO and FIFO becomes greater. B is incorrect -- Although the current ratio is lower under LIFO under an inflationary environment, the difference between the ending inventory balances will not decrease over time. C is incorrect -- LIFO will result in lower inventory balances and a comparably lower (vs. FIFO) current ratio. The different will increase in size over time.

If management seeks to maximize cash flows and to preserve the quality of earnings during periods of inflation, which of the following inventory cost flow assumptions should be used under GAAP? A. LIFO B. FIFO C. Weighted average

A. The use of US GAAP LIFO inventory method produces the best quality of earnings and maximizes cash flows during periods of rising prices. B is incorrect -- FIFO neither reports the highest quality of earnings nor maximizes cash flows in an inflationary environment. C is incorrect

The off-B/S liabilities that should be added back to the B/S by an analyst to better reflect economic reality is: A. Operating leases B. Capital leases C. Guarantees of consolidated affiliate debt

A. This represents an off-B/S liability that should be put on B/S by the analyst to reflect the true financial position (economic reality of a company). This represents a non-GAAP adjustment. Capital leases & guarantees of consolidated affiliate debt both represent obligations that are already reflected on the B/S of the parent company.

The MOST LIKELY synergy resulting from a recent acquisition would be? A. Cost reductions achieved through overlapping management B. Increased management compensation C. Selling the target company's under-utilized assets

A. This represents savings obtained by eliminating redundancies, which is a synergy. B is incorrect -- corporate executives may increase firm size to increase their paychecks; this is not a synergy and does not add to shareholder value C is incorrect -- this inefficiency is intrinsic to the acquired company; it is available to the target's management without a merger. However, it will often require a merger to be realized. Synergies are additional returns in the newly combined entity that result from revenue opportunities because of cross-selling or cost reduction opportunities such as those resulting from eliminition of corporate overhead in the acquirer and target.

Unconditional heteroskedasticity means that the variance of the error term is: A. Not correlated with the independent variable and is not a serious problem that affects statistical inferences drawn from the regression model. B. Correlated with an independent variable and is a serious problem that affects statistical inferences drawn from the regression model. C. Constant across the scope of an independent variable.

A. Unconditional heteroskedasticity does not pose a serious problem for satistical inference because there is no correlation with an independent variable. B is incorrect -- the variable of the error term correlates with an independent variable in conditional heteroskedasticity. C is incorrect -- the variance in the error term is constant in homoskedasticity, not heteroskedasticity.

Unconditional heteroskedasticity means that the variance of the error term is: A. Not correlated with the independent variable and is not a serious problem that affects statistical inferences drawn from the regression model. B. Correlated with an independent variable and is a serious problem that affects statistical inferences drawn from the regression model. C. Constant across the scope of an independent variable.

A. Unconditional heteroskedasticity does not pose a serious problem for statistical inference because there is no correlation with an independent variable. B is incorrect -- the variance of the error term correlates with an independent variable in conditional heteroskedasticity. C is incorrect -- the variance of the error term is constant in homoskedasticity, not heteroskedasticity.

A regression analysis between the market return (Y) and return on stock DD (X) produces an intercept of 2.5% and a slope value of 1.33. If the return on the market portfolio is expected to be 12% next year, what would be the expected return for stock DD? A. 18.46% B. 15.96% C. 13.46%

A. Y = a+bX = 2.5 + 1.33(12)

Which of the following conditions would violate the assumptions of linear regression? A. The expected value of the error term is zero. B. The error terms are correlated across observations. C. The error terms are distributed normally.

B. A simple linear regression depends upon the assumption that the error terms are uncorrelated with each other. This assumption prevents the regression model from arbitrarily assigning values to the regression coefficients, which negates regression model usefulness. A is incorrect -- a zero expected value for the error term is an assumption of regression. C is incorrect -- having normally distributed terms is an assumption of regression; this allows hypothesis tests regarding the regression analysis to be performed.

A firm calculated that if it were to use accelerated depreciation instead of straight line depreciation for new equipment next year, depreciation expense would increase by $1,000. Assuming a 30% tax rate, the change in forecasted FCF to the firm would be CLOSEST to: A. An increase of $700 B. An increase of $300 C. A decrease of $700

B. An increase in depreciation expense (a non-cash expense) would lower taxes by the tax rate times the increase in depreciation. Thus, FCFF would increase by $1,000*0.3 = $300 A is incorrect -- this is one minus the tax rate times the change in depreciation instead of the tax rate times the change in depreciation. C is incorrect -- the increase in depreciation expense (a non-cash expense) would reduce taxes paid, thus increasing the forecasted FCFF

Which of the following statements regarding capitalizing vs. expensing costs is the most accurate? A. The decision to capitalize/expense an item will impact the company's pre-tax cash flow total. B. Total assets and shareholders equity are initially higher for a firm that capitalizes the cost of an item. C. Net income and profitability ratios are higher after the initial period for firms that capitalize the cost of an item.

B. Capitalizing costs increases total assets & shareholders equity, with the costs depreciated on the income statement in subsequent periods. A is incorrect -- the decision to capitalize/expense a cost item has no impact on a firm's pretax cash flows C is incorrect -- firms that capitalize costs have lower net income & profitability ratios in subsequent periods than expensing because the assets are depreciated (expensed) over time on the I/S. While expensing a cost reduces net income and profitability in the initial period, expensing has no future period effects on a firm's income statement.

As part of the collection phase of the financial statement analysis framework, an analyst will MOST LIKELY: A. Outline the rationale for while he is collecting the data B. Follow up a phone call to management with a visit to company HQ C. Make the necessary adjustments to the applicable years' financial statements

B. Communicating with management is considered part of the collection phase of the framework. A. is incorrect; the rationale for why the data is being collected would be defined and established in the first phase "define the purpose and context of the analysis" C. is incorrect; adjustments made to the financial data would be made after the collection phase is complete

An analyst using the P/E multiples of comparable companies to assess the relative attractiveness of XYZ Corporation. The comparable companies selected: A. Do not need to have similar growth prospects, as the P/E ratio is independent of growth. B. Must be normalized to adjust for accounting methods and extraordinary items. C. Can vary in size, as the P/E ratio is unrelated to company size.

B. Comparable companies are adjusted for accounting methods and extraordinary items as well as for the dilutive effects of convertible securities. Otherwise, the ratios are not comparable because of these needed adjustments. A is incorrect -- the rate of growth is considered in calculating a company's P/E ratio. Thus companies with varying growth rates are likely to sell at varying P/E ratios. It is best to find comparable companies that have similar growth rates to the growth rate of the company being valued. C is incorrect -- comparable companies have greater usefulness if they are of similar size to the subject company.

Which of the following is MOST ACCURATE with regard to how a corporate governance system might affect a firm's valuation? A. There is no direct valuation effect on a company that has eitehr a strong or weak corporate governance system. B. A company with a strong corporate governance structure will likely generate higher investment performance measures than companies with weaker corporate governance structures in place. C. Valuations are primarily affected inaccurate financial reporting arising from poor corporate governance structures.

B. Current research has shown that companies with strong corporate governance systems exhibit higher profitability and investment performance measures vs. companies that have weaker or no formal coperate governance systems in place A is incorrect -- research does not support this argument. C is incorrect -- weak corporate governance systems can result in increased accounting risk when incomplete, misleading or inaccurate financial statements are released. However, other risk factors also arise from weak corporate governance, including asset risk, liability risk and strategic policy risk. Valuations are not necessarily dominated primarily by accounting risk.

Which of the following represents an economically sound justification for a corporate merger? A. Establish a diversified conglomerate B. Economies of scale C. The sale of overvalued merger assets

B. Economies of scale are a sound motivation for a merger because a company can realize potential cost savings from centralized accounting, greater supplier influence, and/or other reduced upper management overhead. Other primary reasons that justify a merger include: economies associated with vertical integration, complementary resources, eliminating inefficiencies, and as a use of surplus funds A is incorrect -- the merger decision must be founded on improved economic returns. Diversification has not been shown to add value. C is incorrect -- this does not represent a primary justification for a merger because the term "overvalued" means too high of a price was paid for these assets. The sale of overvalued assets is a consequence of a merger and is part of the integration process after the merger is completed.

It is more appropriate to use the FCFE method vs. the FCFF method to value a firm when the firm has a: A. History of leverage changes. B. Relatively stable capital structure. C. Relatively unstable capital structure.

B. FCFE is more direct and easier to use in cases where the firm has a relatively stable capital structure. A is incorrect -- FCFF is preferable for a company with a history of leverage changes, as its growth rate will be more stable than the FCFE growth rate. C is incorrect -- FCFE is more direct and easier to use in cases where the firm has a relatively stable capital structure.

An analyst is performing a credit rating analysis on Bluerock, Inc. If one of her adjustments is to capitalize all of Bluerock's operating leases, the impact of this adjustment will likely result in: A. A higher credit rating B. A higher total asset turnover C. Lower cash outflows from operations

C. When a lease is accounted for as an operating lease, each lease payment is recorded as rent expense and is treated as an operating cash outflow. Under capital lease accounting, each lease payment is divided into a principal portion that reduces the liability on the B/S (a financing cash outflow) and an interest portion that is recorded on the I/S (an operating cash outflow). As a result, cash flows from operations are lower when operating leases are capitalized. A is incorrect -- there will be more debt on the books from this capitalization, which will likely lower the credit rating. B is incorrect -- the total asset turnover will be lower because assets (the denominator) will increase as a result of the capitalization, whereas sales (the numerator) will remain the same.

What is the point estimate for the dependent variable when the intercept is 2.8, the slope coefficient is 4.1 and the independent variable is 5? A. 18.1 B. 20.5 C. 23.3

C. Y = a + bX = 2.8 + 4.1(5)

When evaluating the adequacy of a company's corporate governance, which of the following elements is an analyst MOST LIKELY to assess? A. Independence of all board members B. Director compensation levels C. Code of ethics

C. An investor should assess these factors when reviewing a company's statement of corporate governance: director oversight, monitoring & responsibilities, the completion of director self-assessments, and the company's code of ethics; the investor should further review the statement of management responsibility to provide complete information to the board of directors prior to board meetings, directors' reports detailing examinations and findings pertaining to oversight & review functions, management performance assessments completed by directors and training provided by directors A is incorrect -- global best practice recommends that at least 75% of board members be independent; although some experts argue that all board members should be independent, this is not required B is incorrect -- the method/amount of director compensation is the responsibility of a board committee; it is not assessed when evaluating the adequacy of a company's statement of corporate governance

Jenny Low is using a comparable P/E valuation methodology to assess the attractiveness of Smith Hardware. Smith Hardware is a very small company selling only to wholesalers. The company's shares trade infrequently on the OTC market. Smith Hardware is capitalized with only equity (company has no debt). Which of the following is the BEST choice of a benchmark value to use in her analysis? A. The P/E ratio for Home Hardware, which is 40x larger than Smith, sells mostly to retail customers and has debt financing on the B/S. B. The average of the company's historical P/E ratios. C. The P/E ratio for the S&P500 Index.

B. The other benchmarks are invalid as detailed below. A firm's historical P/E ratios may give an indication as to what multiple it will sell at in the future. Thus, this is the best benchmark of those offered. A is incorrect -- Home Hardware is much larger, has debt, and sells to a different customer base. Thus, its P/E ratio is unlikely to be a good measure of what Smith Hardware should sell for. A benchmark using peers should be companies that have similar business mixes. C is incorrect -- The S&P500 is inappropriate given how small Smith Hardware is and the fact that it trades infrequently. The S&P consists of large cap securities that are very liquid.

Which of the following statements is MOST ACCURATE for simple linear regression? A. The possible Y-value associated with every value of X should be skewed. B. For large sample sizes, the possible Y-values associated with every value of X should be normally distributed. C. The standard error of possible Y-values is the average value for the difference for the equation--estimated value of Y and the actual value of Y that correspond to each value of X.

B. The possible values of Y for a given value of X are assumed to be normally distributed around the regression estimated value of Y with the standard error of the estimate describing the degree of dispersion of possible value of Y around the mean estimate of Y from the regression equation. A is incorrect -- possible values of Y are normally distributed around a mean which is the regression estimated value of Y and the degree of dispersion of possible Y values around that mean estimated valued is indicated by the standard error of the estimate (SEE) C is incorrect -- the average difference between the equation-estimated value of Y and the actual value of Y that correspond to each value of X is 0 and the standard deviation of all such differences is the standard error of the estimate (SEE)

EKA Inc. has securitized as significant portion of its mortgage loans receivable using an off-B/S qualified special purpose entity (QSPE). An analyst who assumes that QSPE's will be disallowed by the US FASB in the near future will MOST LIKELY adjust EKA's B/S and ratio calculations in which of the following ways? A. Decreasing leverage B. Increasing total liabilities C. Decreasing working capital

B. The disallowance of QSPE's will force companies to consolidate SPEs used to securitize assets. As a result, the analyst review EKA's B/S may choose to consolidate the QSPE by adding the loans receivable held by the SPE to EKA's total assets and increasing total liabilities by the amount borrowed by the SPE in order to finance the purchase of the loans. As a result of the consolidation, EKA will have higher total assets and liabilities. A is incorrect -- consolidating the QSPE will increase EKA's assets and liabilities. As a result, financial leverage will increase rather than decrease. C is incorrect -- working capital (current assets less current liabilities) is less likely to be impacted by the consolidation of the QSPE because mortgage loans receivable are a noncurrent asset. *NOTE: Both IFRS and GAAP now require the consolidation of SPEs by the sponsoring company when that company controls the SPE (IFRS) or is the primary beneficiary of the SPE (GAAP)

The automobile industry in the US was once littered with numerous manufacturers. Today few major US manufacturers remain. Which stage in the industry life cycle BEST DESCRIBES the reason for this phenomenon of consolidation via mergers in the US automobile industry? A. Pioneering development B. Stabilization and market maturity C. Deceleration of growth and decline

B. The industry saw a period of stabilization & market maturity -- this trend led to its current state of relatively few US manufacturers. A is incorrect -- pioneering development is an excellent reason for the proliferation of manufacturers in the early stages of the auto industry; but does not explain consolidation C is incorrect -- even with increasing gas prices, demand for cars continues in today's economy and a new technology has yet to overhadow current demand. The consolidation is not likely to be attributed to a decline in the industry, but more so to a transfer of market share to the remaining players

Regarding the limitations of regression analysis, which of the following statements is LEAST accurate: A. Once a regression assumption is violated, predictions generated by a regression analysis may become invalidated. B. If a relationship between two variables is discovered and exploited, then this activity may alter the future relationship such that the regression analysis is no longer useful. C. If the regression equation is derived properly, relationships between any two variables will remain static over time.

C. This statement is not true. The derivation of the equation can be expertly calculated, but there is no rule that says two variables can't change behavior patterns. Ultimately, this is a known problem with predictive models and analysts must be vigilant for sources of potential error or a change in variable relationships. A is incorrect -- this is a true statement. regression analysis relies on the mathematic assumptions being observed. Altering or violating assumptions will, by definition, counteract the model's accuracy. B is incorrect -- this is a true statement. If a regression equation is generated, and is found to produce accurate results, the resultant use of the model by others may affect future data points - at which time the regression may need to be reviewed and revised.

An analyst is reviewing the annual financial statements for ABLE Company and BAKER Corp. ABLE has investments in 3 profitable affiliates, each of which is accounted for using the equity method. BAKER does not have any significant affiliate investments. In order to compare the core businesses of the two companies, the analyst will MOST LIKELY make analytical adjustments that: A. Increase BAKER's total asset turnover B. Reduce ABLE's gross profit margin C. Reduce ABLE's return on equity

C. A company which has income from affiliates will show a higher return on equity as a result of the equity in affiliate earnings included in net income. ABLE's net income should be reduced in order to accurately compare the two companies. A is incorrect -- any adjustments should be made to ABLE not BAKER. In addition, increase the assets (and thus decreasing BAKER's total asset turnover) would be the appropriate adjustment to be made to BAKER. B is incorrect -- gross margins should not be impacted, as income from affiliates is reported below gross profit.

If leverage if working beneficially to a firm: A. Free cash flow to common equity growth will exceed free cash flow to firm's growth. B. There will be no initial impact on the firm's share price. C. A decline in the firm's beta will be anticipated.

A. If leverage if beneficial, then the return on equity will be greater than the return on assets and the growth rate of free cash flow to common equity will be greater than the growth rate of free cash flow to the firm. This is true because the equity base is smaller under a leveraged situation. B is incorrect -- effective financial leverage will increase earnings per share without initially impacting the firm's beat and the required return on equity. The likely result is an increase in the share price and value of the firm. C is incorrect - a firm's financial risk will increase as the debt-to-total capital ratio rises. This will eventually result in an increase in the firm's beta.

Jenny Low is using a comparable P/E valuation methodology to assess the attractiveness of Smith Hardware. Which of the following is a valid rationale for using P/E multiples in valuation? A. P/E ratios are easy to understand. B. P/E ratios are not commonly employed, thus using it gives Low an advantage. C. P/E ratios are less subject to manipulation, as accounting practices are not critical to the calculation.

A. P/E ratios are self-explanatory and are easy for most investors to understand. This is an advantage because Low's clients will be more apt to act on her recommendations. B is incorrect -- P/E ratios are commonly employed and this usage is an advantage. C is incorrect -- the denominator (EPS) is subject to manipulation by management through various accounting practices. Thus, a firm can manipulate its P/E ratio (especially its trailing P/E if analysts do not make adjustments)

Which of the following statements regarding simple regression is MOST ACCURATE: A. Regression analysis calculates the relationship between an independent variable and a dependent variable. B. The value of both the dependent variable and the independent variable is known. C. The dependent variable in a regression equation causes the independent variable to change.

A. Regression analysis is a method of finding the relationship between a dependent variable and an independent variable. B is incorrect -- the dependent variable (Y) is a random variable of an unknown rather than known value. The relationship between the independent variable (X) and the dependent variable is described by the regression equation. C is incorrect -- independent variables cause the dependent variable to change.

If the Matarazzo Landscaping Services Company has no beginning inventory, but the cost of goods sold computed under the FIFO method exceeds the cost of goods sold under the LIFO method, the MOST likely conclusion regarding the trend of inventory prices is that prices: A. Increased B. Decreased C. Were stable

B. Because FIFO applies the earlier items purchased/produced to COGS in each period, prices must have decreased if COGS sold under FIFO exceeds COGS under LIFO. A is incorrect -- because LIFO applies the most recent items purchased/produced to COGS, prices must have increased if COGS reported under FIFO is greater than the COGS reported under LIFO C is incorrect -- given that the COGS reported under FIFO is higher than the COGS reported under LIFO, prices are not stable

An analyst generates an extremely accurate regression equation that can predict stock returns on the S&P 500 Index with a very high R2. Suppose that S&P 500 returns are the dependent variable. While of the following independent variables, assuming that all of them apparently have exactly the same predictive capability, is MOST LIKELY to have a sound theoretical basis for use as an independent variable in the equation? A. The sales growth of Japanese cars. B. A G-8 World Composite GDP growth indicator C. The performance of small cap stocks in the US

B. Companies operating in the G-8 countries by and large likely represent the vast majority of companies on an index like the S&P500. Therefore, there is a sound economic argument that the status of these economies will have something to do with the returns on the equities of companies operating within them

Which of the following can be most easily achieved without a merger? A. Economies of scale B. Complementary resources C. Eliminating inefficiencies

A

Prime Kitchen Ware (PKW) sells faucets (earnings of $60mm), sinks (earnings of $56mm) and knives (earnings of $5mm). An analyst comparing PKW to its main competitor in the faucet industry is MOST LIKELY to: A. Apply DuPont analysis to each firm's faucet product line segment B. Compare both the balance sheet and income statement of PKW and its competitor C. De-leverage both the PKW and its competitor's balance sheet to determine which has superior working capital management

A. Analysts hoping to make valid comparisons would necessarily have to evaluate the relative performance of each firm's faucet line. The DuPont model allows analysts to view the components of profitability, leverage and efficiency of the faucet lines for each firm. B is incorrect-- financial statement comparisons are a good place to start but would be an incomplete analysis of the components of the quality of the faucet product line for each firm. C is incorrect-- an evaluation of the effects of leverage will provide only one component of the faucet line's profitability

Alfred Nimmer analyzes equity securities for a major brokerage firm. A subject company in his research universe has had negative earnings over the last two years, although Nimmer expects positive earnings beginning with the current period. Other firms in the industry use a different business model that employs greater fixed assets. Nimmer will MOST LIKELY attempt to determine the subject company's relative valuation based on: A. P/S B. P/E C. P/BV

A. Because the firm has high-variance earnings (including negative earnings) and non-comparable asset bases, Nimmer will most likely choose P/S multiples for comparison. B is incorrect -- negative earnings will make P/E ratios meaningless. C is incorrect -- different business models requiring different levels of assets will make P/BV multiples non-comparable.

Which of the following BEST DESCRIBES the standard error of the estimate (SEE)? A. It is the number that can be used, along with the appropriate reliability factor, to build confidence intervals around a sample statistic. B. It is a standard deviation calculation measuring the inexact relationship in the regression equation. C. It is a standard number used in hypothesis testing for significance in the independent variable(s).

B. SEE is the standard deviation of the regression equation. Std. dev. is a measure of dispersion or variability around a point of central tendancy (or the expected value). This is essentially true in regression analysis, except the variability is measured by the error terms. A is incorrect -- this choices measures the mean standard error (MSE). MSE is related to the central limit theorem and enables us to build confidence intervals around a sample statistic when attempting to describe the true value of the population based on a sample. C is incorrect -- the choice specifically refers to the standard error associated with an independent variable's slope coefficient. This standard error of the sample statistic is used to determine the calculated t-statistic that can be used in hypothesis testing for significance in the coefficient.

It is more important for: A. The intercept to be significant than for the slope coefficients to be significant. B. The slope coefficients to be significant than for the intercept to be significant. C. A regression to pass statistical tests than to have a sound theoretical basis for its specification.

B. The regression model assumes a linear relationship between dependent and independent variables. Therefore, slope coefficient significance is much more important than intercept coefficient significance. In fact, if the relationship is indeed linear, adjustments for an insignificant intercept term can occur. A is incorrect -- significant slop coefficients are more important than significant intercept because intercept adjustment is possible for a linear relationship. C is incorrect -- passing statistical tests yields a model with predictive ability for nothing. Without a sound basis for specifying the relationship, there is no causative basis for the predicted outcome of the model.

In an interview with several analysts, the CFO of SI made numerous statements explaining the motives behind the company's recent acquisition and merger efforts. Which of the following statements made by the CFO is MOST LIKELY to be viewed as a rational merger motive. A. We believe our mgmt team is more seasoned than our industry competitors. Our recent acquisition and merger efforts will give our executives the chance to prove their skills to the business community. B. The company's operations are maturing and we anticipate that our identified merger opportunities will improve our company's diversification and reduce our overall risk. C. Our distribution channels allowed us to achieve greater market penetration for the specialized product lines of several smaller competitors.

C

Least squares regression assumes that the relationship between the dependent and independent is: A. Causal B. Random C. Straight-line

C. A simple linear regression calculates a linear relationship with minimum total squared deviations. The method of least squares calculates this relationship. A is incorrect -- although regression analysis can describe a statistical relationship, it cannot determine a causal relationship. B is incorrect -- although the independent variable is random and unknown, the relationship is parametric rather than random.

When analyzing the relationship between cash flows and earnings, operating cash flows should always be adjusted by: A. Adding depreciation expense B. Subtracting income taxes paid C. Adding interest paid

C. Cash flow and earnings can be compared by adding interest paid & taxes paid back to operating cash flow to enable a comparison of EBIT and operating CF before interest and taxes A is incorrect -- depreciation expense is added back to NI to compute operating CF under the indirect method; an analyst does not need to make this adjustment to compare cash flow and earnings B is incorrect -- income taxes shoudl be added back to (not subtracted from) operating CF in order to facilitate a comparison between EBIT and operating CF before interest & taxes

In periods of rising prices and stable/increasing inventory quantities, the US GAAP LIFO inventory method, compared to FIFO, results in higher: A. Net Income B. Working Capital C. After-tax cash flow

C. The use of LIFO results in higher COGS, lower net income and lower income taxes, which results in higher after-tax cash flow vs. FIFO

Which of the following is MOST LIKELY to be considered a corporate governance issue having negative valuation implications for a company's shareholders? A. Poison pill provisions allowed on a majority vote of company directors B. Prohibiting the re-pricing of options to an 'at-the-money' exercise price C. Management reports higher debt ratios after minimizing off-balance-sheet financings

A. Poison pill provisions allowed in the event of a hostile takeover without the prior approval of the shareholders are a form of strategic policy risk. This is the risk that managers and directors may enter into transactions not in the best interests of company stockholders. B is incorrect -- re-pricing of options is inconsistent with best corporate governance practices that management incentives be structured to maximize long-term performance. A policy to prohibit such re-pricing would have positive valuation implications. Re-pricing represents asset risk, which is the risk that firm assets will be misppropriated by managers or directors in the form of excessive compensation. C is incorrect -- although debt ratios are higher, they are the result of high quilaty financial reporting and reduced accounting risk (the risk that the company's financial statements are incomplete or misleading). This will not have a negative effect of the valuation of the company compared to off-balance-sheet obligations, which are a form of liability risk and are potentially damaging to shareholders' equity

Which of the following is correct regarding tender offers and proxy fights in the context of mergers and acquisitions? A. A proxy fight allows acquirers to solicit the majority of shareholder votes at the next annual meeting. Successful proxy fights allow the acquirer to remove existing management and appoint individuals receptive to the merger proposal. B. Tender offers describe the process of acquirers directly soliciting shareholder votes to replace management with individuals receptive to a merger proposal. C. M&A achieved through proxy fights generally cost the acquiring firm less than tender offers.

A. Proxy fights generally occur after unsuccessful tender offers because existing management at the target firm is attempting to secure a higher offer from the acquirer. Tender offers, by contrast, represent direct offers by the acquiring firm to purchase shares of the target at a specified price. The price generally includes a premium over the market price, providing an incentive for upper mgmt to promote shareholder acceptance. B is incorrect -- describes a proxy fight, not a tender offer. C is incorrect -- proxy fights generally cost the acquiring firm more rather than less. They are time consuming and difficult to win.

An analyst investigating a particular security notes that its price has been increasing at a faster rate than its relevant index. The analyst has used a momentum indicator that could best be described as: A. relative strenghth B. Earnings surprise C. Standardized unexpected earnings

A. Relative strength indicators compare a stock's performance over some period with either an index or with its own past performance. B is incorrect -- earnings surprise (unexpected earnings) equals the actual less expected earnings in a period. C is incorrect -- Standardized unexpected earnings (SUE) is unexpected earnings (earnings surprise) divided by the standard deviation of past unexected earnings over some prior period.

Companies A and B are in the same industry and have the same number of lease arrangements. An analyst notes that A books rent expense on its income statement,while B does not. In comparing the two companies, the adjustments that the analyst will make will MOST LIKELY: A. Increase A's debt to equity ratio B. Increase B's financial leverage C. Reduce B's total assets

A. Rent expense signifies operating leases, which are off-B/S transactions. No assets or liabilities related to the leases appear on the B/S, which means debt and leverage ratios will appear more favorable for the company with the operating leases. In order to properly compare the two companies, the analyst should adjust A's operating leases so that they are reflected as capital leases. This will increase A's total assets and total liabilities, which in turn will increase A's debt to equity ratio.

***Dummy variables: A. Should not be modeled as the dependent variable using linear regression. B. Are useful even if they are redundant because they increase the specificity of the regression. C. Should not be used to represent investor psychology because such factors are easily quantifiable.

A. Sometimes the dependent variable represents a qualitative state of nature that must be stated as a dummy variable and assigned a value of "1" or "0." Linear regression is not suited to performed this kind of analysis. Three other kinds of analysis; however, can be used to model qualitative dependent variables: probit, logit and discriminant analysis. B is incorrect -- redundant dummy variables decrease the specificity of the regression rather than increase specificity. C is incorrect -- investor psychology is one example where dummy variables might be useful in specifying a regression model.

Company C is anxious about ongoing consolidation in their industry. They have significant cash reserves and have encountered an unfortunate series of negative NPV investments as they attempted to find viable expansion opportunities. Company C shareholders are restless and there have been rumors that both Company A and Company B are in acquisition mode. Although no direct merger overtures have been made, the officers and directors have decided to take defensive steps to prevent an unwanted takeover. The most viable pre-merger takeover defense in this situation would be to: A. Adopt charter amendments to require a "supermajority" vote to approve any merger. B. Adopt a "Poison put" allocating share rights to existing shareholders. C. Undertake an asset restructuring to require assets a suitor does not want.

A. Supermajorjority amendments are a common preventative step to block mergers. B is incorrect -- poison puts are offered to bondholders, not shareholders, poison puts are an earlier stage amendment allowing bondholders the right to demand repayment in the event of a hostile takeover. Poison pills are offered to shareholders. Poison pills are put in place pre-offer to refuse control to the bidding company. This is done by triggering a generous share issue to existing shareholders. C is incorrect -- an asset restructuring is the least viable form of takeover defense for this situation. Restructuring assets is largely a post-offer defense.

A junior analyst makes three comments regarding the relationship between inputs in a residual income model and the market price of the firm. Which of the following statements is MOST LIKELY to be a misinterpretation of the relationship? A. Firms generating positive economic profit should have a book value less than market value. B. Firms will be undervalued by the market if they produce a positive economic profit. C. Firms failing to earn their cost of equity will experience a decline in their market value.

B. This statement provides insufficient information to make this evaluation. With any intrinsic value model, the stock price relative to the model's computed price could be over, under or about equal to a residual model value. Generally, higher residual income should correlate with higher market valuations. A is incorrect -- A company generating positive economic profit should have a BV < MV. A company generating positive economic profit has a positive NPV of expected future residual income. If the MV reflects the company's intrinsic value as determined by a residual income model, the sum of the company's current BV/share and the present value of expected future residual income/share will be greater than BV/share alone. C is incorrect -- Generally, a company failing to earn its cost of equity will fall in market value. While a company may have an accounting net profit, if it does not earn enough to cover the costs of both debt and equity capital, its true value erodes.

Which of the following statements is MOST ACCURATE: A. Conditional heteroskedasticity, not unconditional heteroskedasticity, violates the assumptions upon which regression modeling is based. B. Conditional heteroskedasticity presents more problems in m aking accurate statistical inferences from regression models than does unconditional heteroskedasticity. C. Unconditional heteroskedasticity presents more problems in being able to make accurate statistical inferences from regression model than does conditional heteroskedasticity.

B. Unconditional heteroskedasticity in the error terms of a regression equation presents no problem in drawing statistical inferences from the regression model. Conditional heteroskedastciity in the error terms of a regression equation produces deceptively high t-scores because of underestimated standard errors.

Which of the following statements is MOST ACCURATE: A. Conditional heteroskedasticity, not unconditional heteroskedasticity) violates the assumptions upon which regression modeling is based. B. Conditional heteroskedasticity presents more problems in making accurate statistical inferences from regression models than does unconditional heteroskedasticity. C. Unconditional heteroskedasticity presents more problems in being able to make accurate statistical inferences from regression models than does conditional heteroskedasticity.

B. Unconditional heteroskedasticity in the error terms of a regression equation presents no problem in drawing statistical inferences from the regression model. Conditional heteroskedasticity in the error terms of a regression equation produces deceptively high t-scores because of underestimated standard errors. A is incorrect -- both violate regression modeling assumptions. C is incorrect -- conditional heteroskedasticity presents more problems than unconditional in making accurate statistical inferences from regression models.

Which of the following inventory cost flow assumptions result in an income statement that reports the most outdated COGS in an inflationary environment? A. Specific identification method B. FIFO method C. LIFO method

B. Under a rising price environment, FIFO would report COGS based on the earliest inventory (cheapest price), resulting in the most outdated COGS to match against sales. A is incorrect -- in an inflationary environment, the specific identification method can result in the utilization of both current costs and outdated costs. C is incorrect -- in an inflationary environment, the LIFO method reflects the most recently produced/purchased items in the COGS, which are essentially the most current costs.

In reviewing the 20X9 annual report for Cardin Inc, an analyst notes that roughly 8% of Cardin's reported net income is derived from an investment in an associate accounted for using the equity method. The analyst sees in the notes to the financials that the associate investment was financed with 30% debt. Cardin's overall capital structure is 25% debt and 75% equity. In adjusting his DuPont ROE calculations to review Cardin's core business, the analyst will MOST LIKELY increase the: A. Net profit margin B. Financial leverage ratio C. Total asset turnover

C - The numerator (sales) will not change, while the denominator (total assets) will be reduced when the analyst makes adjustments to review Cardin's core business; therefore the overall ratio will increase A is incorrect -- the net profit margin will decrease as the numerator (net income) will decrease as a result of excluding the equity in earnings from the associate, while the denominator (sales) will remain the same B is incorrect -- while adjustments to remove the impact of the associate investment will affect both the numerator (assets) and the denominator (equity) of the financial leverage ratio, the fact that the associate investment was financed with more debt that the company's overall capital structure will result in a reduction in the overall financial leverage ratio EXAMPLE: assume a company's assets (including investment in associates) is 100 and its equity is 75. The financial leverage ratio is 1.33. Assume the associate investment is 10 and is financed with 30% debt. The company's adjusted financial leverage ratio would be 90/68 or 1.32.

Which of the following statements concerning takeover defense tactics is MOST ACCURATE: A. A poison pill is an example of a shark-repellent charter amendment. B. Restricted voting rights are modifications to the corporate charter requiring 80% approval for any proposed merger. C. Bonds issued at deep-discounts, redeemable at par in the event of a hostile takeover, are known as poison puts.

C -- Poison put provisions require that bonds be repaid by the company if a hostile takeover is successful. This results in a steep cost to the acquirer. A is incorrect -- a poison put would be classified as a rights-based defense rather than shark-repellent charter amendment defense B is incorrect -- restricted voting rights are the removal of voting rights for shareholders exceeding a certain percentage ownership

Which of the following is a correct statement regarding mergers? A. Acquirers receive higher returns than targets in a successful takeover attempt. B. Merger activity occurs in waves and often coincides with declining stock markets. C. Unsuccessful bids are often profitable for the bidding firm.

C -- the anticipatory rise in the price of a target's stock allows for substantial gains when an unsuccessful suitor sells back the initial stake to the target at a profit. This is often called "greenmail" A is incorrect -- historic returns show a significantly greater portion of merger gains accrue to sellers B is incorrect -- although merger activity tends to occur in waves, it usually coincides with rising stock markets.

Preliminary Mandate provides M&A consulting for domestic and international firms. Larry Harlow, CFA, considers the following information for Level 10 Design, which wishes to pursue a potential merger with Automotive Templates Corp: 1. The value today of the combined entity should be $230mm; this value includes $100mm of new stock issued for the acquisition. 2. The value today of the individual entities is $140mm for Level 10 Design and $75mm for Automotive Templates Corp. Assume that Level 10 wishes to purchase only some portions of Automotive Templates. Which of the following correctly describes the process AT would employ to divest part of its operations to Level 10 without Level 10 purchasing shares of AT and without AT issuing new shares in an IPO? A. Spin-off B. Carve-out C. Asset sale & divestiture

C. Asset sales allow an entity to divest a portion of their operations without the acquiring company purchasing stock and without the target company issuing an IPO for divested assets. Generally, asset sales occur in non-core operations of the target company when the acquiring firm my make better use of them than did the target firm. Asset sales often encourage existing shareholders with the impression of renewed focus on core operations. A is incorrect -- spin-off describes creating a new company by separating assets that then operate independently of the remaining business. Existing shareholders receive shares in the new company. Spin-offs allow the remaining company to refocus on the core business. B is incorrect -- carve-out describes a spin-off with new equity issued for the new company through an IPO.

Level 10 Design wishes to pursue a potential merger with Automotive Templates Corp: 1. The value today of the combined entity should be $230 million; this value includes $100 million of new stock issued for the acquisition 2. The value today of the individual entities is $140 million for Level 10 and $75 million for Automotive Templates Assume that Level 10 wishes to purchase only some portions of Automotive Templates. Which of the following correctly describes the process Automotive Templates would employ to divest part of its opertions to Level 10, without Level 10 purchasing shares of Automotive Templates and without Automotive Templates issuing new shares in an IPO? A. Spin-off B. Carve-out C. Asset sale/divestiture

C. Asset sales allow an entity to divest a portion of their operations without the acquiring company purchasing stock and without the target company issuing an IPO for the divested assets. Generally, asset sales occur in non-core operations of the target company when the acquiring firm may make better use of them than did the target firm. Asset sales often encourage existing shareholders with the impression of renewed focus on core operations. A is incorrect -- spin-off describes creating a new company by separating assets that then operate independently of the remaining business. Existing shareholders receive shares in the new company. Spin-offs allow the remaining company to refocus on the core business. B is incorrect -- carve-out describes a spin-off with new equity issued for the new company through an IPO. The goal was not to issue new shares, which is required for a carve-out.

Which of the following is MOST ACCURATE regarding regression analysis based on sample data? A. At least one regression parameter will be significant for every regression equation. B. The correlation coefficients should be tested for significance only if the model is misspecified. C. The regression coefficients should be test for significance.

C. Coefficients must be tested to determine the strength of the relationship between the dependent and independent variables. A is incorrect -- even the best theoretical models sometimes produce insignificant results. B is incorrect -- correlation coefficient significance should be tested in every regression equation.

An analyst following Davenport Machinery Company wants to adjust the company's financial statements to best reflect the company's financial statements to best reflect the economic impact of a period of rising prices. Which of the following inventory cost flow assumptions should the analyst use to calculate ratios based on the B/S and I/S amounts? A. FIFO for both B/S and I/S B. LIFO for both B/S and I/S C. FIFO for B/S and LIFO for I/S

C. During a period of rising prices, the FIFO cost flow assumption results in the most recent, higher cost purchases in inventory on the B/S, while LIFO results in the most recent, higher cost, purchases being reflected in COGS on the I/S. This combination results in the best approximation of the economic impact on the company's financial statements (and ratios) as a result of rising prices A is incorrect -- while the use of FIFO during a period of rising prices results in the most recent, higher cost purchases in inventory on the B/S, the analyst would most likely use LIFO valuation in determining COGS on the I/S

An analyst using enterprise value as a valuation measure wishes to develop the most meaningful metric for comparing companies with varying amounts of debt in the capital structure. The analyst will most likely choose: A. Price/EBITDA B. EV/FCFE C. EV/EBITDA

C. EV/EBITDA includes the value of debt in the numerator. EBITDA includes flows to both debt and equity because it is pre-interest. Therefore, EV/EBITDA will provide the most meaningful metric of firm value for firms with varying degrees of debt. A is incorrect -- P/EBITDA does not include the value of debt in the numerator. B is incorrect -- EV/FCFE includes the value of debt in the numerator. FCFE, however, does not include CF to debt. Therefore, EV/FCFE fails to include the cash flows to debt in evaluating enterprise value.

The impact of firm lowering its forecasted debt ratio on the forecasted Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) would MOST LIKELY be: A. A lower FCFF but no change to FCFE B. No changes to both C. No change to FCFF but a lower FCFE

C. FCFF is calculated before interest and does not adjust for net borrowings, thus it is not affected by changes in the debt ratio. However, decreasing the debt ratio would reduce net borrowings which reduces the FCFE. While the decrease in the debt ratio would also lower the interest expense and increase net income, the drop in interest expense would be much less than the drop in net borrowing. FCFF = EBIT(1-tax rate) + NCC - FC Inv - WC Inv FCFE = NI + NCC - FC Inv - WC Inv + Net Borrow A is incorrect -- the change in the debt ratio would not affect FCFF but would reduce the FCFE due to a decrease in net borrowing. B is incorrect -- FCFE would decrease due to the decrease in net borrowings.

Peninsular has a client who has inquired about the valuation method best suited for a comparison of companies in an industry that has the following characteristics: - Principal competitors within the industry are located in the US, France, Japan and Brazil. - The industry is currently operating at a cyclical low, with many firms reporting losses. - The industry is subject to rapid technological change. What ratio should Jones recommend to this situation? A. P/B because it can be most effective when applied to companies in different companies with major accounting differences. B. P/CF because it is less subject to distortion from currency translation effects. C. P/S because it is less subject to manipulation and works even if the firms are at a cyclical low.

C. For companies in the industry described, the P/S ratio would be superior to any of the other ratios because: - It is more useful in valuing companies with negative earnings or negative BVs (a frequent consequence of technological change) - Better able to compare companies in different countries that are likely to be using different accounting methods (a consequence of the multinational nature of the industry) - Less subject to manipulation (i.e., managing earnings by management--a frequent consequence when firms are at a cyclical low and likely to report losses) - Not as volatile as PE multiples and hence may be more reliable for use in valuation - Less subject to distortion from currency translation effects - Less influenced by accounting values in the presence of rapid technological change A is incorrect -- the effects of accounting differences among companies in different countries may impair the usefulness of P/B B is incorrect -- P/S ratio, but not P/CF, is less subject to distortion from currency translation effects

Which of the following is a valid reason to use a residual income model? A. Residual income models do not rely on accounting data, thus management manipulation of accounting data is not a concern. B. Residual income models require little analyst adjustment, so they are easier to use than models such as economic value added. C. Residual income models generally have an earlier recognition of value than do dividend discount models (DDMs).

C. Generally, a large portion of a DDM's value will be the terminal value; while a large portion of a residual income model's value will be the beginning book value. Thus, more of the value is upfront for residual income models. A is incorrect -- residual income models rely heavily on accounting data. Management can manipulate accounting data and this can lead to incorrect valuations. Analysts have to use their judgment in applying the accounting data. Therefore, this reliance on accounting data is a disadvantage of residual income models as compared to DDMs and FCFs. B is incorrect -- Both residual income models and economic value added (EVA) models require analyst skill in making adjustments. Therefore, residual income is not easier to use than EVA.

Conditional heteroskedasticity: A. Biases the intercept B. Biases the slope coefficients C. Might cause some independent variables to appear significant when they are not

C. Heteroskedasticity reduces the standard error, which serves as the denominator of significance calculations, without actually increasing predictive ability. A smaller standard error increases the apparent significance parameter A is incorrect -- heteroskedasticity has no effect on regression intercept

Which of the following is MOST LIKELY to cause a P/E valuation measure to be inappropriate for use? A. current earnings include a non-recurring gain. B. Prospective earnings information is unavailable. C. Management is manipulating earnings.

C. If management is manipulating earnings, the earnings part of the equation will be incorrect and this can cause this measure to be inappropriate. A is incorrect -- an analyst can remove the effect of the non-recurring gain from earnings and then use the remaining earnings in a P/E ratio. B is incorrect -- trailing earnings may also provide a metric useful in determining value.

Two companies, JJ and LM, both use US GAAP and are identical except that JJ uses LIFO and LM uses FIFO in its inventory cost flows assumptions. Since both firms commenced operations, they have operated in a deflationary period. Which of the following BEST DESCRIBES the relationship between the current ratios of the two companies? A. JJ and LM current ratios are exactly the same B. LM has the higher current ratio C. JJ has the higher current ratio

C. In a deflationary environment, JJ's use of LIFO will result in the older, higher cost items in inventory on the B/S and a relatively higher current ratio. Likewise, LM's use of FIFO will result in higher COGS and lower reported EBIT, vs. a firm that uses LIFO because the older, higher cost items are applied to the income statement. A & B are incorrect -- JJ will have the higher current ratio because it will have higher assets on the B/S as a result of using LIFO in a period of declining prices.

An analyst performs a multiple regression and there is not a linear relationship between the dependent variables. The analyst will: A. Need to use robust standard errors to determine significance. B. Need to perform a Breusch-Pagan Test C. Get meaningless results.

C. Linear regression requires a linear relationship between the dependent and independent variables. The formulas used in the process calculate what line provides the best 'fit' for the data set. If the relationship is not linear, the analyst will still get an equation, but it will not explain the data properly. A is incorrect -- Robust standard errors are used to compensate for heteroskedasticity and serial correlation, but not for non-linear relationships B is incorrect -- The Breusch-Pagan test is used to determine conditional heteroskedasticity in the error terms.

Which of the following BEST represents an argument related to M&A: A. A merged firm will have lower financing costs given the economies of scale for financing the two entities as one, which represents a benefit to shareholders. B. Firms cannot increase earnings per dollar invested without realizing synergies. C. Individual shareholders can achieve diversification easier and cheaper than can corporations who pursue diversification to reduce risks and effectively allocate excess cash reserves.

C. Markets show no willingness to pay a premium for diversified firms, while holding company discounts to fair value may be commonplace. Firms may have to pay premiums to acquire new holdings. Therefore, investors, could purchase the shares of the acquired company less expensively than holding shares in the acquiring company. A is incorrect -- although per dollar financed the merged entity does not have a lower cost to finance, bondholders will have a better overall protection on their claim to the company's assets through the cross-financing abilities of the merged firm. Increased bondholder claims on assets offset any benefit accumulating to sharehodlers from lower interest costs. B is incorrect -- firms can increasee EPS through M&A without realizing any real economic gain. Often, acquiring firms can accomplish this by purchasing firms with less growth potential and consequently lower P/E ratios. The acquirer purchases immediate earnigns by lower its overall growth rate and decreasing commensurately its P/E ratio.

The adjusted R-squared term is sometimes calculated in a regression analysis to help interpret the results of the formulated regression equation. Which of the following statements is MOST ACCURATE with respect to the adjusted R-squared term? A. An adjusted R-squared is useful for both simple and multiple linear regression because it better reveals the explanatory power of the regression equation than just the R-squared term. B. Calculation of the adjusted R-squared term is impacted by the number of independent variables in the regression, but is independent of the sample size. C. An adjusted R-squared recognized the upward bias in the R-squared term from adding independent variables to the regression equation.

C. Merely adding independent variables (whether they have any incremental explanatory power or not) will systematically increase the value of R-squared, implying that the regression equation is improving. Additional independent variables are likely to appear significant, although the addition of them may create a multicollinearity problem of two+ independent variables explaining the same thing. The adjusted R-squared calculation corrects for this upward bias in the R-squared value. A is incorrect -- an adjusted R-squared would not be material to a simple linear regression. The adjusted R-squared is only relevant when more than one independent variable is considered. B is incorrect -- the formulation of the adjusted R-squared calculation considers both sample size & number of independent variables

Which of the following BEST represents a takeover defense which allows existing shareholders to purchase a significant number of additional shares at discounted prices if an acquirer's stake increases above a certain percentage? A. Equity restructuring B. Golden parachute C. Poison pill

C. Mgmt generally promotes this type of poison pill provision into the corporate charter to allow existing shareholders to purchase additional shares at discounted prices if a purchaser's stake rises above a certain threshold. A is incorrect -- although poison pill purchases represent new equity, no restructuring occurs. Restructuring in the context of M&A generally indicate that the firm either buys assets that the acquirer does not want (asset restructuring) or replaces equity with debt (liability restructuring) B is incorrect -- Golden Parachutes describe generous severance packages for executives who suffer post-merger job losses. These golden parachutes mitigate mgmt reluctance to accept shareholder friendly tender offers

SateLink Co. acquired cable company Cable Form two years ago. Although SateLink retained nearly all of CableForm's upper mgmt and key employees, SL mgmt decided to divest their interest in CF in order to focus on their satellite business. The reason for SL divestiture of CF would MOST LIKELY be described as: A. Poor fit B. Reverse synergy C. Change in strategic focus

C. SL has apparently changed its strategic focus from one of diversifying delivery methods to focusing on satellite delivery. A is incorrect -- Poor fit would occur if the two companies could not create a synergy because they lacked the expertise or resources to exploit an acquisition's opportunities B is incorrect -- a reverse synergy occurs when the acquirer and the target have a higher value after divestiture than while combined.

Which of the following statements is MOST ACCURATE: A. Serial correlation occurs if error terms are correlated with at least one of the independent variables. B. Serial correlation is negative when the test of significance fails. C. Serial correlation is the same as autocorrelation.

C. Serial correlation & autocorrelation are the same A is incorrect -- serial correlation occurs when error terms correlate with prior error terms B is incorrect -- serial correlation is non-existent rather than negative when the test for serial correlation fails. Negative serial correlation occurs when an error term negatively correlates with a positive prior error term

Which of the following statements is MOST ACCURATE? A. Serial correlation occurs if error terms are correlated with at least one of the independent variables. B. Serial correlation is negative when the test of significance fails. C. Serial correlation is the same as autocorrelation.

C. Serial correlation and autocorrelation are the same. A is incorrect -- serial correlation occurs when error terms correlate with prior error terms. B is incorrect -- serial correlation is noneistent rather than negative when the test for serial correlation fails. Negative serial correlation occurs when an error term negatively correlates with a positive prior error term.

In periods of rising prices and stable/increasing inventory quantities, which of the following statements about the impact of LIFO and FIFO accounting on the financial statements is MOST ACCURATE? A. Income taxes will be higher under LIFO and lower under FIFO. B. Cash flows will be lower under LIFO and higher under FIFO. C. Inventory balances will be lower under LIFO and higher under FIFO.

C. The US GAAP LIFO method will produce lower inventory balances than FIFO in rising prices because recent higher priced items are attributed to COGS when LIFO is used. A is incorrect -- FIFO results in a lower COGS and higher pre-tax income in a rising price environment, leading to higher income taxes vs. the use of LIFO. B is incorrect -- Lower income taxes payable will occur under LIFO in a rising price environment and operating cash flows will be higher compared to FIFO.

During periods of inflation, the use of FIFO vs. LIFO as the method of accounting for inventories under US GAAP causes: A. Higher inventory turnover B. Lower ending inventory C. Higher income taxes

C. The application of FIFO in an inflationary environment will resulted in lower COGS and higher pretax incmoe, which will lead to higher income taxes A is incorrect -- the inventory turnover ratio will be lower under FIFO when prices are rising because COGS will be lower and ending inventory balances will be higher B is incorrect -- FIFO in an inflationary environment will result in a higher reported ending inventory than when LIFO is used.

Which of the following would be the most useful ratio from a financial analyst (non-GAAP) perspective assuming a rising price environment? A. Calculating the current ratio by using the current assets determined with the LIFO cost flow method. B. Determining inventory turnover by using COGS prepared using FIFO costs and average inventory prepared using LIFO costs. C. Determining return on assets by using net income prepared using LIFO cost flows and average total assets prepared using FIFO cost flows.

C. The most useful ratio from a financial analyst perspective would be to calculate return on assets using the more conservative net income total derived from using the LIFO cost flow method, but calculating average assets under FIFO to include more current cost data for inventory. A is incorrect -- calculating the current ratio with current assets that use the FIFO inventory cost flow assumption would be more useful. B is incorrect -- the best measure to obtain an adjusted inventory turnover ratio would be to use COGS under LIFO and average inventory prepared using a FIFO cost flow assumption.