Series 86 Wrong Answers

You are an evaluating the capital structure of The Stevens Company, as a possible takeover candidate. The company has EBIT of $2,000,000 and 650,000 common shares outstanding. Stevens' capitalization also consists of $5,000,000 of 9% convertible bonds, which are convertible into 20 shares of common stock. The bonds are considered a common stock equivalent and the tax rate is 40%. What is the EPS of Stevens?

$1.43 First, compute the earnings without converting the bonds into stock. EBIT$2,000,000Less: interest$450,000(9% x $5 million)Taxable income$1,550,000Less: taxes$620,000($1,555,000 x 40%)Net income$930,000 Divide by the shares outstanding (650,000) and EPS is $1.43 ($930,000 / 650,000). Now, make the calculation assuming conversion of the bonds into stock. Interest expense is eliminated and the number of shares is higher. EBIT$2,000,000Less: interest$0Taxable income$2,000,000Less: taxes$800,000($2,000,000 x 40%)Net income$1,200,000 Each $1,000 face amount of bonds is convertible into 20 shares of common stock, producing an additional 100,000 shares to bring the total number of outstanding shares to 750,000. Dividing the net income of $1,200,000 by 750,000 shares results in $1.60/share. Since the net income per share is higher, this is referred to as an antidilutive situation, and the lower EPS number of $1.43 per share would be reported as the basic earnings per share figure.

The Checkers Corporation pays an annual dividend of $1.20. The dividend is expected to grow at an annual rate of 7% and the required rate of return for equity investors is 12%. What is the present value of this security?

$25.68 Based on the information provided, the present value of this security can be determined by using the Gordon Growth Model. The formula is: P0 = (d x [1.0 + g]) / (k - g) Where:P0 = the present value or intrinsic value of the companyd = the current dividendk = the required rate of return or equity cost of capitalg = the annual growth rate of dividends P0 = ($1.20 x 1.07) / (12% - 7.0%)P0 = $1.28 / 5%P0 = $25.68

Relevant financial information to answer the following question is found by using Exhibit 29. What is the Borgward Company's intrinsic value per share? Dividends: Current 1.50, projected 1.70 EPS: Current 2.50, Projected 2.83 Return on Equity: 9.5% Beta: 0.9 Expected market return: 8.5% T-bill yield: 4.5%

$39.53 The intrinsic value of the Borgward Company would be based on its price as determined by using the Gordon Growth Model. To determine the intrinsic value of the company, it is first necessary to determine the company's growth rate using the formula: g = b x ROE Where:g = the dividend growth rateb = the earnings retention rate (the complement of the dividend payout ratio)ROE = the return on equity The dividend payout ratio is 60% ($1.50 / $2.50).The retention rate is 40%. g = 40% x 9.5%g = 3.8% Next, the price can be determined by using the Gordon Growth Model: P0 = d1 / (k - g) Where:P0 = present priced1 = the dividend in the next periodk = the equity cost of capitalg = the growth rate To determine the equity cost of capital, it is necessary to apply the Capital Asset Pricing Model, where: The expected return of the market = the return on the S&P 500 Index The risk-free rate of return = the yield on the Treasury bill Cost of equity = [(Expected return of the S&P 500 minus the T-bill yield) multiplied by beta] plus the T-bill rate. [(8.5% - 4.5%) x .9] + 4.5% = 8.1%[4.0% x .9] + 4.5% = 8.1%3.6% + 4.5% = 8.1% P0 = $1.70 / (8.1% - 3.8%)P0 = $1.70 / 4.3%P0 = $39.53

A company is considering a project that will generate pretax profits of $18,000,000 over three years. The company wants to record the entire amount this year for tax purposes. If the company's marginal tax rate (MTR) is 38% and its effective tax rate is 31%, it will have a deferred tax asset of:

$4,560,000 When corporate accounting income and taxable income differ, it may create a deferred tax asset or deferred tax liability on a balance sheet. If taxable income is greater than accounting income, this will create a deferred tax asset. (The opposite result will create a deferred tax liability.) In this example, the company's taxable income exceeds its accounting income. In effect, the company prepaid its taxes on the income. To calculate the deferred tax asset, first find the amount of taxable income that exceeds the accounting income and then multiply this amount by the marginal tax rate (not the effective tax rate). The company should have recorded income of $6,000,000 in each of three years. Taxable income exceeds accounting income by $12,000,000 ($18,000,000 − $6,000,000). The deferred tax asset is $4,560,000 ($12,000,000 x .38).

Use the following information to answer the question. Hamilton Golf Industries Income Statement ($ millions) Sales 198.000 Cost of Goods Sold 104.000 Xxxxxx 94.000 Operating Expenses 61.000 Xxxxxx 33.000 Interest Expense 12.000 Taxes 6.300 Xxxxx 14.700 Preferred Dividend 0.525 Xxxxx 14.175 Common Dividend 1.160 Xxxxx 13.015 Shareholder Information Preferred Stock ($50 Par) 7.500 Common Stock ($1.00 Par) 3.000 Additional Paid-In Capital 57.000 Treasury Stock (100,000 Shares) (2.500) Retained Earnings 126.550 What is Hamilton Golf Industries' EPS?

$4.89 The formula for earnings per share is (Net Income - Preferred Dividends) / Number of Shares of Common Outstanding. Earnings available to Common (14.175 million) equals the Net Income - Preferred Dividends. This is divided by the number of shares of common stock outstanding. The common stock account indicates $3 million (at $1.00 par); however, the treasury stock account indicates 100,000 shares. This would mean 2.9 million shares were outstanding. 14.175 / 2.9 = $4.89 EPS.

Use the following information to answer the next question: The company's present value of expected cash flows is $1.2 billion.Currently, there are 19 million shares of common stock outstanding.There are six million employee stock options with an exercise price of $25.The current stock price is $40.The company has $250 million of debt. What's the intrinsic value per share of the company's common stock?

$45 The intrinsic value of a company's stock can be calculated using the present value of cash flows. Since the present value of cash flows typically represents the intrinsic enterprise value, the debt must be subtracted and then the result is divided by the number of outstanding shares. Using this method, the equity value of the company is $950 million ($1.2b PV - $250m). The company has 19 million shares outstanding, but also has options with a $25.00 strike price. Using the treasury method, the exercised options will generate proceeds to the company of $150 million (6 million options x $25.00). This permits the company to repurchase 3.75 million shares from the market ($150 million/$40.00 market price). The company will still need to issue 2.25 million shares (6m needed for options - 3.75m bought back). This brings the number of shares outstanding to 21.25 million (19 million outstanding + 2.25 million shares issued for options). The intrinsic value per share is $44.71 or $45.00 rounded to the nearest dollar ($950m equity value / 21.25m shares outstanding). Although equity value can be calculated using the market price of the stock, it would not be an intrinsic value. Intrinsic values are derived from projections or estimates about the company itself, rather than the extrinsic market price.

Use the following information on Amalgamated Faucet Corporation to answer this question. Cash Flow — $200 MM Shares — 100 MM Beta — 1.65 Risk Premium — 3.33% Risk-Free Rate — 4.0% Inflation — 3% Long-Term growth rate — 5% What is the intrinsic value of the Amalgamated Faucet Corporation?

$46.77 The intrinsic value (share price) can be found by using the perpetual growth model, which derives from the Gordon growth model. First calculate the cost of equity using the capital asset pricing model (CAPM). Next, use the perpetual growth model to estimate the aggregate intrinsic value (equity value). Divide the aggregate intrinsic value by the number of shares outstanding to find the value per share. The inflation number can be ignored given that the traditional CAPM does not consider inflation. k = Rf + β(Risk Premium)k = 0.04 + 1.65(0.0333)k = 0.0949 P0 = [CF(1 + g)] / (k - g)P0 = 200(1.05) / (0.0949 - .05)P0 = 210 / 0.0449 P0 = 4,677.06 $4,677MM / 100MM shares = $46.77 per share.

What is the implied equity value range for this company? Sales: $280mm Net Income: $30mm Forward multiple P/E Range: 18x-24x Expected growth rate: 9%

$588,600,000 to $784,800,000

While preparing an assessment on a company, you have been asked to project the company's earnings. The company had owned an asset with a cost of $120 MM which was sold for $105 MM. In the same period, the company reported net income of $52 MM. The company has a marginal tax rate of 21% and an effective tax rate of 15%. What would be the company's net income without the onetime sale?

$63.85 MM An analyst may be asked to adjust a company's earnings due to a nonrecurring gain or loss such as the sale of a business or asset, a onetime charge, or a restructuring, or impairment charge. To calculate the projected income without the nonrecurring loss, add the tax-adjusted loss to the net income. The tax-adjusted loss is $11.85 MM ($15 MM x 79%, the complement of 21%). The net income without the loss would be $63.85 MM ($52 MM + $11.85 MM). For this type of calculation, use the marginal tax rate, not the effective tax rate. The marginal tax rate is the rate for each additional dollar of income, and does not include many of the adjustments made to calculate a company's effective tax rate (which is a blended rate and is usually lower than the marginal tax rate).

A company's average collection period is calculated as:

(Accounts Receivable x 365) / Total Credit Sales A low figure indicates the company collects its outstanding receivables quickly. This ratio is often used to help determine if a company is trying to disguise weak sales. Typically, it is looked at either quarterly or annually (90 or 365 days). EPS is not based on the rate of collection; it is based on the profitability of the company.

Diminishing returns

- occur when average total costs begin to rise - Will not occur as long as average variable costs is greater than marginal costs

Interest rates should increase if

- supply of money decreases - demand for money increases *interest rates are the price of borrowing

Relevant information on the Trident Company to answer this question is found next. Enterprise value of $370 million Debt of $30 million Revenue of $300 million Profit margin of 10% Cash of $10 million Minority interest of $20 million If the market yield is equal to 6.7%, what is the Trident's relative P/E?

0.73 The term market yield refers to the earnings yield of an index (S&P 500) used in the equity markets. The earnings yield is the inverse of the P/E ratio. Therefore, if the market yield is 6.7%, the P/E ratio for the market is, rounded off, 15 (1.00 / .067). The relative P/E is found by dividing a company's P/E ratio by the market P/E. Trident's P/E can be found as follows. Step 1. Calculate the Market Cap or equity value. EV + cash - debt - minority interest = Market Cap$370 + $10 - $30 - $20 = $330 Step 2. Calculate the net income. Revenue x profit margin = net income$300 x 10 % = $30 Step 3. Calculate P/E. Market Cap / Net Income = P/E$330 / $30 = 11 Trident's Relative P/E = P/E ratio / Mkt. P/E = 11 / 15 = .73

Triangle is acquiring Octagon for $400 million, to be financed through a $300 million bond issue and a $100 million line of credit. The quick asset ratio of the combined entity is:

0.77 In this example, the quick assets are cash and accounts receivable. These are divided by the new value of current liabilities. Combining the cash from both balance sheets: 80 + 60 = 140Combining the Accounts Receivables from both balance sheets:100 + 90 = 190 The line of credit (debt) is added to the combined current liabilities.130 + 200 + 100 = 430 The quick asset ratio is: (140 + 190) / (130 + 220 + 100)= 330 / 430= .767 (.77 rounded off)

Relevant financial information to answer the following question is found by using Exhibit 66. Calculate the debt-to-total-capital ratio for S-Works Industries. - shareholders equity =494,500 - long term debt = 115,800 - short term debt = 60,800

19% *short term debt is not included in total capital *total capital is shareholders equity PLUS debt

EZ Games Inc. intends to decrease the price of its adventure game products by 11% to increase sales. At the same time, EZ would like to increase revenues by 6%. What percentage increase in the number of units sold is necessary to produce these results?

19.1% (1.00 + revenue percent increase desired) - complement of the price decrease / complement of the price decrease

A company has earnings before interest and taxes of $455 MM and depreciation and amortization of $82 MM. The company also has cash of $26 MM, debt of $760 MM, and 175 MM outstanding shares. If the sector analysis indicates that the target price of this sector demands an enterprise value to EBITDA multiple of 9.5 times, what is the implied equity price per share?

24.95 The company has an EBITDA of $537 MM ($455 MM + $82 MM).The enterprise value, or implied value based on the given multiple, is $5,101.5 MM ($537 MM x 9.5). To find the equity value of the transaction, the company's debt must be subtracted, while the cash is added. The equity value is $4,367.5 MM ($5,101.5 MM - $760 MM + $26 MM). The implied offer price is $24.95 ($4,367.5 MM / 175 MM).

Company J's financial statements for the year ending 2018 show the following: Accounts receivable: $300Sales: $2,700 On the following year's financials, DSO declines by five days, while sales increase by 9%. Assuming 365 days in a year, what is the new level of accounts receivable?

285 In 2018, Days Sales Outstanding (DSO) can be determined by dividing accounts receivable by net sales and then multiplying by 365 days. In 2018, DSO was 40.55 days [($300 / $2,700) x 365]. In 2019, the DSO is 35.55 days (40.55 - 5). Sales increased by 9% to $2,943 ($2,700 x 1.09). To solve for the new level of accounts receivable, use the following DSO formula. AR / New Net Sales x 365 = DSO 2018AR of 300 / 2,700 x 365 = 40.55 days. 2019AR / 2,943 x 365 = 35.55AR / 2,943 = 35.55 / 365AR / 2,943 = .097AR = 2,943 x .097AR = 285

You have been asked to analyze an M&A transaction involving Bergen Labs, the target company in an acquisition. Bergen Labs current stock price is $91.53. There are 27.48 million shares outstanding and the offer price for Bergen Labs is $108.00 per share. The acquirer, Negiac, has offered 75% stock and 25% cash. Negiac has 231.13 million shares outstanding, and its stock price is $21.50. What percentage of the combined company will Bergen Labs' shareholders own after the merger?

31% To determine Bergen Labs' percentage ownership after the merger, it is necessary to determine the exchange ratio, and calculate the new number of shares issued. The new number of shares to be issued is added to Negiac's outstanding shares to find the total number of shares for the combined company. The new shares issued are divided by the combined company total. The exchange ratio is found by dividing the offer price by Negiac's stock price ($108 / $21.50 = 5.023), multiplied by the percentage of stock offered (75%), which equals an exchange ratio of 3.767 (5.023 x .75). The new shares issued equal 103.52 million (3.767 x 27.48 million). The total number of shares of the combined company is 334.65 million (103.52 + 231.13). Bergen Labs will own 31% of the combined company (103.52 / 334.65).

Company W issued a nonconvertible bond at par that pays 6% interest semiannually. The bonds are currently trading at 98 and mature in 10 years. It pays taxes at a rate of 21%. What is Company W's cost of debt for the bond issue?

4.74% To determine the cost of debt, it is necessary to adjust the nominal yield (the coupon rate) by the tax rate, rather than the current yield of the bond. Multiply the nominal yield by (100% - tax rate) or (100% - 21% = 79%). Although the coupons are paid semiannually, the annual coupon rate for the bond is 6%; therefore, the cost of debt is 4.74% (6% x 79%).

A company has a price-to-earnings ratio of 26 and a dividend yield of 2.95%. Its dividend payout ratio is:

77% The calculation of the dividend payout ratio is determined by dividing the dividend yield by the earnings yield. The earnings yield is the reciprocal of the price-to-earnings ratio. The price-to-earnings ratio is 26 (26/1), therefore, the earnings yield is .0384 (1/26). Divide the dividend yield of .0295 by the earnings yield of .0384 to arrive at .7682 or 77% rounded off. take the P/E ratio and the inverse. then Div yield / earnings yield OR multiply dividend yield by the P/E

Sudsy's Car Cleaners, Inc. is issuing a 5% stock dividend. The common stock price is $25. There are 5,000,000 shares of common outstanding ($1 par). Which of the following statements is NOT TRUE regarding changes to the balance sheet? A) Retained earnings will decline by $250,000 B) The common stock account will increase by $250,000 C) Additional paid-in capital will increase by $6,000,000 D) Net worth is unchanged

A Accounting for stock dividends requires an adjustment to the common stock account (based on par value), additional paid-in capital (for the market value in excess of par), and retained earnings. A 5% stock dividend will require issuing 250,000 additional shares, increasing the common stock account by $250,000. (The additional paid-in capital will increase by $6,000,000: $24 x 250,000.) Retained earnings will decline by $6,250,000 (the market value of the additional shares issued: $25 x 250,000). Alternatively, retained earnings are reduced by the market value of the additional shares issued ($6,250,000). The common stock account increases by the (par) value of the additional shares issued ($250,000). The difference ($6,000,000) is the increase to additional paid-in capital. Net worth is unaffected by these balance sheet changes.

Which of the following actions by a company would provide an additional source of liquidity? A)Creating an accounts receivable securitization program B) Paying off a portion of the long-term debt C) Changing the inventory valuation method from LIFO to FIFO D) Reducing the amount of the commercial paper program

A An accounts receivable securitization program is created when a company transfers a portion of its accounts receivables to a trust and sells interests in that trust. The sale of the receivables to the trust allows the company to receive cash from investors, who then receive payments from the trust. This will lower the accounts receivables on the company's balance sheet. This is a way for a company to raise capital by borrowing funds (it is a type of debt) backed by an asset (accounts receivables). The investors usually will have no recourse against the company beyond the assets held in the trust. Reducing the amount of the commercial paper program will reduce, not increase, a company's liquidity. If a company pays off a portion of its long-term debt, it is using cash and, although it might benefit the company, it would reduce liquidity. Changing the inventory valuation method from LIFO to FIFO would have no impact on a company's liquidity.

Which of the following events signals sales growth in a company? A) Accounts receivable increase; account receivable turnover increases. B) Account receivables decrease; account receivable turnover increases. C) Inventory turnover increases; accounts payable declines. D) Inventory turnover declines; accounts payable increases.

A An increase in accounts receivable is a use of cash by the company. A greater amount of cash is receivable by the company. Growth of the company is indicated by an increase in accounts receivable turnover. If the accounts receivable turnover increases, the company is receiving its payments faster.

Fair value is the: A) Price a firm would pay for another company B) Enterprise value of a company C) Purchase price of an asset minus depreciation B) Book value plus good will

A Fair value is defined as an estimate of the potential market price of goods and services, the value of assets, or the value of a company. It is, therefore, the price a firm would pay to buy another company.

Which of the following descriptions BEST defines the term cost of capital? A) The required rate of return necessary to finance corporate projects B) The rate of return derived on a corporate investment C) The amount of money necessary to invest in a corporation D) The opportunity cost produced after the investment is made

A The cost of capital is considered the required rate of return necessary to enter into and finance corporate projects. It is the opportunity cost of the funds employed as a result of a business decision.

Upon payment of a cash dividend: A) Working capital remains the same B) Earnings are reduced C) Retained earnings are reduced D) The current ratio stays the same

A The key here is that the dividend is being paid (as opposed to declared). The cash payment reduces current assets and reduces the liability that was created when the dividend was declared. Reducing current assets and current liabilities by the same amount will maintain the same level of working capital. Retained earnings were adjusted (reduced) when the dividend was declared. The current ratio would change in almost every situation; the exception would be if current assets and current liabilities were the same.

Widgets are sold by numerous wholesalers, none of whom have greater than a 5% market share. Sales of this product are commodity-like, with wholesalers frequently entering and leaving the marketplace. If one of the wholesalers of widgets leaves the industry, the price will: A) Not change B) Decrease in the short term, but will not change over the long term C) Increase in the short term, but will not change over the long term D) Increase in both the short term and long term

A The price of widgets would not be expected to change. No single wholesaler has dominance in the marketplace. The absence of any one wholesaler may increase the market share of others but, since widgets have commodity pricing characteristics, the sales are purely a price-driven event.

If casual dining is more fragmented and less mature than fast food, it's likely to exhibit all of the following, EXCEPT: A) More growth potential B) Less pricing power C) Less competition for market share D) Ability to exploit lifestyle and demographic trends

B Casual dining should have more pricing power, relying less on promotional pricing (couponing) and can take advantage of two income couples and more food dollars spent outside the home.

If an analyst is concerned that a dividend cannot be sustained and that profitability is being consumed by significant interest and lease charges, he would look at: A) Earnings yield B) Fixed-charge coverage ratio C) ROE D) Receivables turnover

B The fixed-charge coverage ratio measures the ability to meet fixed charges such as interest and lease payments. This ratio is a solvency ratio that measures how many times a business can meet its fixed obligations. It is of concern when the debt component of capital is high which can be exacerbated when interest rates are higher than normal or when profitability is low. If there is an insufficient cushion, a dividend can be in jeopardy. The SEC has a precise formula that must be disclosed in a public offering for bonds. An equity analyst exam would not be expected to address those details.

Which of the following factors is MOST important when evaluating a computer retailer? A) The market share of the top five computer retailers B) The occupancy costs of the retailer C) The profitability of computer manufacturers D) The percentage of households that have home computers

B The most significant of the four choices is the occupancy costs of the store. Occupancy costs are the total costs per unit to rent or occupy a store. It includes the lease payments and other costs such as utilities, maintenance, and insurance. Occupancy costs may also include a percentage of the sales generated by the store as part of the lease agreement. This is an important component for stores operating in shopping centers and malls.

You are a research analyst performing due diligence on a company involved in an acquisition. If the book value of the assets is $200 million, the fair value of the assets is $600 million, and the purchase price is $900 million, which of the following statements is TRUE? A) The amount of goodwill created is more than expected B) The amount of goodwill created is less than expected C) This will create negative goodwill D) This will decrease the purchase price

B To calculate the amount of goodwill created after the acquisition, the company's net tangible assets are subtracted from the offer value (purchase price). The book value of the assets is adjusted to their fair market value, usually by an accounting firm on the date of the acquisition. Since the fair value of $600 million is used, the net tangible assets will be higher, resulting in a lower amount of goodwill or less goodwill than expected. The $400 million difference between the fair value and book value of the company's assets is called a write-up. Negative goodwill is created if the purchase or acquisition price is less than the fair value of the assets, and might be considered a bargain for the purchaser. If the assets are undervalued, that may cause the purchase price to increase, not decrease.

Action Traction Corporation has a large number of intangibles on its balance sheet. Which of the following balance sheet items would NOT be included when calculating tangible book value? A) Copyrights and patents B) Goodwill carried on the books of the company C) Inventories of work in process D) Investments in securities

B When calculating the tangible book value of a company, certain intangible assets may have a standalone market value. These assets can be identified on the books of the firm, extracted as separately marketable items, and sold individually. Among such assets are copyrights, formulas, and patents. Goodwill, however, is not such an item and would be deducted from the asset value of the company. While the formula for calculating book value is assets − liabilities, the formula for tangible book value is: Tangible Book Value = Assets − liabilities − goodwill − intangibles with no identifiable market value

Which of the following would increase operating cash flow? A) Increasing accounts receivable B) Lower depreciation C) Increase in accrued vacation payable D) Lower accounts payable

C

Which of the items below could be a reason for a difference between income from continuing operations and net income? A) Non-recurring items B) Additional shares issued C) Loss or gain on the sale of a business segment D) Extraordinary loss on retirement of debt

C A loss or a gain from the sale of a business segment could be the reason for the difference between earnings from continuing operations and net income. An earnings report should distinguish between the income arising from the normal activities of the company and those arising from any special activities or transactions a company engages in. A gain or loss from the sale of an individual asset is reported as a non-recurring item prior to the calculation of income tax. However, the gain or loss from the divestiture of a group of assets, such as an entire division or business segment should be isolated on the income statement as discontinued operations. When reporting discontinued operations, revenue and expense from the discontinued operations are stripped from continuing operations and reported separately on an after tax basis. On the income statement, both Income from continuing operations and discontinued operations must be shown in aggregate, as well as on a per share basis, as illustrated in the example below. Do not confuse discontinued operations with non-recurring items. Non-recurring items represent gains and losses from activities that may be unusual or infrequent. They are reported on the income statement prior to the calculation of income tax. Non-recurring items include such things as bad debt expense, write-offs of obsolete inventory, impairment of goodwill, write offs of worthless assets, employee severance packages, storm repairs, in addition to gains and losses from the sale of individual assets. Because the effect of non-recurring items is included in income from continuing operations, non-recurring items will not cause a difference between income from continuing operations and net income. Because non-recurring items are pretax items, they can skew income from continuing operations. When evaluating a company and projecting future earnings, it is important to identify non-recurring items in order to make adjustments for them by adding back tax adjusted losses or subtracting tax adjusted gains. In contrast, discontinued operations are reported net of tax; therefore, no tax adjustment is required when considering the difference in earnings between continuing operations, discontinued operations and the net of the two, which is called net income. Also do not confuse non-recurring items with extraordinary items, which were previously allowed and reported net of income tax prior to the change in accounting rules in January of 2015. Prior to the elimination of the concept of extraordinary items; for an item to have been considered extraordinary, it must have been unusual and infrequent. Because of the difficulty in determining what is unusual and infrequent, the use of extraordinary items was disallowed by the Financial Accounting Standards Board and is no longer permissible under Generally Accepted Accounting Principles (GAAP). As a result of the rule change, GAAP now coincides with International Financial Reporting Standards (IFRS).

Which the following statements is TRUE regarding accounts receivable and inventories, when the company recognizes revenue sooner than permitted under accrual accounting? A) Accounts receivable is overstated, and inventory is overstated B) Accounts receivable is overstated, and inventory is understated C) Accounts receivable is understated and inventory is overstated D) Accounts receivable is understated and inventory is understated

C Accounts receivable will be overstated because sales are recognized earlier and inventory will be understated because inventories are charged earlier than permitted.

Which of the following is a difference in the treatment of a finance lease and an operating lease? A) Assets only increase for an operating lease B) Shareholders' equity only decreases for an operating lease C) An interest expense is only recorded for a finance lease D) Assets only increase for a finance lease

C Both operating and finance leases will increase assets and liabilities. Operating lease payments will be shown as a single expense on the income statement, while finance lease payments will be separated into interest and amortization expenses. Leases don't directly change shareholders' equity.

When analyzing a high-end retailer an analyst would look at: A) Market for collectibles B) Labor market participation C) Stock market levels D) Unemployment rate

C Rising stock market levels result in unrealized gains for stock market participants. Investors perceive they are wealthier when the market rises and are more likely to engage in the purchase of high end goods. This is known as the wealth effect. As the stock market rises, high end retailers typically experience an increase in sales as consumers "spend" their unrealized equity market gains at places like Michael Kors and Tiffany. In general, a rising stock market would have little effect on stores like Dollar General and other discounters whose clientele are less heavily invested in the stock market and less likely to experience the wealth effect.

Under the equity method of accounting: A) Only dividends are recognized by shareholders B) Revenues are consolidated C) Profits and losses are absorbed on a proportionate basic D) It is used only if 100% of another business is purchased

C The equity method of accounting means that profits and losses are absorbed on a proportionate basic. If Shipbottom Corp owns 22% of Lighthouse shares, Shipbottom absorbs 22% of Lighthouse's income or loss on its books as Other Income or Loss. This method is used when ownership is between 20% and 50%.

A company's cash flow will increase as a result of which of the following balance sheet changes? A) Inventory and accounts payable both increase B) Accounts receivable increases and inventory declines C) Inventory declines and accounts payable increases D) Inventory increases and accounts payable declines

C When inventory falls, we anticipate receiving cash for disposing of the inventory. This is a source of cash. When accounts payable rises, we are delaying the payment on a liability. This is also viewed as a source of cash. Changes in balance sheet items affect cash flows and are summarized as follows. Inventory falls—Source of CashInventory rises—Use of CashAccounts receivable falls—Source of CashAccounts receivable rises—Use of CashAccounts payable rises—Source of CashAccounts payable falls—Use of Cash

Company A has $300,000 in fixed costs and $340,000in variable costs. Company B has $340,000 in fixed costs and $300,000in variable costs. Company A has significantly higher capacity utilizationthan Company B. Both companies have excess capacity. Given the facts above, if each of the companies increases unit sales by 10%, which company has faster margin growth?

Company B because of its fixed cost ratio Profit margin growth is based on the impact of increased sales for the companies rather than increased capacity utilization. Since Company B has lower variable unit costs, it will have faster profit margin growth as unit sales increase. Company B has lower capacity; therefore, an increase in unit sales should benefit Company B more than Company A, based on a greater level of capacity utilization. This influences the return on invested capital.

Economies of scope are realized through: A)Vertical integration of production capacity to minimize the costs of producing a single product B) Maximizing value by buying a product in bulk C) Maximizing production to reduce a product's cost D) Integration of related product distribution

D Economies of scope relate to minimizing costs across product line production, marketing, and/or distribution. The marketing department of a consumer products company employs economies of scope by using the same personnel to sell different products produced by the company, often bundling products to sell as a group. All of the other choices describe economies of scale.

Which of the following events will affect EPS and the P/E ratio if the price of common stock remains unchanged? A) Acquiring a company for cash that's neutral to earnings B) An increase in the rate of inflation in the overall economy C) Issuing debt to build an office complex D) Issuing debt at a rate that's lower than WACC

D Issuing debt will decrease the earnings of a business through higher interest costs. As a result, earnings per share (EPS) will fall and, if the stock price remains unchanged, the price-to-earnings (PE) ratio will rise. If a merger is done for cash and is neutral to earnings, the merger will have no effect on EPS or the PE ratio. Issuing debt to build a fixed asset (e.g., office complex) will not impact earnings immediately. Instead, the additional interest from the bonds will be capitalized during the construction period and increase the cost of the fixed asset. As the building is depreciated, the earnings of the company will be lower in subsequent years. Without knowing more about a business, it's hard to be sure how higher inflation will impact a business' earnings.

When measuring the value of the company's stock using the discounted dividend method, all of the following statements are TRUE regarding the dividend, EXCEPT: A) Dividend streams may remain constant B) Dividend streams may grow at a constant rate C) Dividend streams may grow at a variable rate D) Dividend streams may not be discounted

D When valuing a corporation using the dividend discount method, future dividends will be projected and discounted back to their present value. The projection may show a constant growth rate, a variable growth rate, or no growth at all.

Simple Properties is a REIT that has agreed to be acquired. If you are analyzing the fairness opinion in the seller's proxy, multiples based on which TWO of the following measures would NOT be applicable? Earnings growth DCF Book value Funds from operations

Earnings growth and Book Value Multiples based on funds from operations (FFO) and DCF are normally used to value real estate investment trusts (REITs). Earnings growth and book value are not common valuation measures used for real estate-related businesses.

Use the following information to answer this question:. Toro Rosso Common shares outstanding = 40,000,000 Preferred Shares Outstanding = 4,600,000 Cash = 2,600,000 T-Bills = 12,000,000 ST debt = 26,000,000 Finance Lease Obligations = 40,000,000 LT Debt = $92,000,000 *stock trading at $34 *Preferred stock has par value of $100 but trading at 20% discount The common stock has a current market value of $34.The preferred stock has a par value of $100, but is trading at a 20% discount to par. What's the enterprise value of Toro Rosso?

Enterprise value includes the market capitalization of both common and preferred shares. For the common stock, this totals $1,360,000,000 (40,000,000 x $34). For the preferred stock, since it's trading at a 20% discount to par, the market capitalization totals $368,000,000 (4,600,000 x $80). Enterprise value also includes long- and short-term debt as well as cash and equivalents. Long-term lease obligations are included in enterprise value. Investments in Treasury bills are considered a cash equivalent. Market capitalization of common $1,360,000,000 + Market capitalization of preferred 368,000,000 + Short-term debt outstanding 26,000,000 + Finance lease obligations 40,000,000 + Long-term bond obligations 92,000,000 - Cash2,600,000 - Investments in Treasury bills 12,000,000 Enterprise value $1,871,400,000

How to calculate goodwill after an acquisition

Find net assets (assets minus liabilities) then subtract intangible assets and goodwill to find net tangible assets. Then, subtract net tangible assets from acquisition value to find goodwill

Leisure Wear Inc. and Knockoff Designs are suppliers to Floor-Mart. Floor-Mart purchases 92% of the output from both suppliers. Leisure Wear and Knockoff are merging to realize cost synergies. Floor-Mart has not commented on the merger. As an analyst, what would you expect to happen to the share price of Floor-Mart stock?

Floor-Mart's price is unlikely to be affected A monopsony is a single buyer in a market. If Floor-Mart does not comment on the activities of its suppliers, it is unlikely that the merger will have an impact on the price of Floor-Mart's stock.

What would be the effect on a company's financial statements if depreciation declined by $50 MM and the company paid out an $8 MM dividend? I) Depreciation would be added to calculate cash flow from operations II) Depreciation would be subtracted to calculate cash flow from operations III) Retained earnings would increase on the balance sheet IV) Retained earnings would decrease on the balance sheet

I and III

Two large satellite radio companies that have been in operation for a few years, and are listed on the Nasdaq Global Select Market, agree to merge. Both companies have similar EBITDA, derive the majority of their revenue (more than 90%) from subscriber fees, and have less than 5% of their revenue from advertising. Their financials, size, and business models are similar and they have no competitors inasmuch as all other radio companies derive their revenue from advertising fees. The main reasons for the merger are cost synergies, greater programming choices for customers, combining their engineering departments for better advancements in technology, and enhanced shareholder value. If your firm has been hired to perform an analysis of the transaction, which TWO of the following types of analysis would you use? I) A DCF analysis II) A comparable company analysis using companies which have radio divisions III) Precedent merger of equals analysis using companies of similar size that have merged but are in different industries IV) A sum-of-the-parts analysis

I and III Based on the information in the question, only (I) and (III) are suitable. A discounted cash flow analysis, which is frequently used in valuing a company, could be one of the methods used. Although we are not told that the company has had positive cash flows, there is nothing in this question that would lead us to not use DCF analysis of the combined company. The term merger of equals refers to the merger of two companies of similar size, and there is no designated acquirer or target. The boards of the combined company are split relatively evenly, the combined ownership is as close to 50/50 as possible, and there may be a sharing arrangement among the senior management and CEOs. Most transactions are executed as an exchange of stock, and the new name would be a combination of the companies' names prior to the merger. Merger of equals analysis would examine the premiums paid (if any) of other mergers in which the industries and businesses may be different. For example, a comparison could be made using the merger of equals analysis in the banking, media, or telecommunications sector even though two satellite radio companies are merging. In some cases, one of the biggest concerns is whether the merger will pass an antitrust review. Using comparable companies that have radio divisions would not be a suitable method since their primary source of revenue (advertising) is different from the satellite radio companies (subscription fees). Since the two satellite companies operate only one main business, using a sum-of-the-parts analysis would not be recommended.

ABC Corporation will be issuing $100 MM of bonds. The underwriting group expects the bonds to be priced at $1,000 (par value). The effect of the issuance of the bonds is an increase in: I. Working capital II. Current liabilities III. Total assets IV. Stockholders' equity

I and III Working capital equals current assets minus current liabilities. The cash received from the sale increases current assets. The bonds are a long-term liability, not a current liability. Therefore, working capital will increase. The increase in current assets will increase total assets as well. Long-term liabilities and total liabilities will also be increased by the additional debt. However, there's no change in stockholders' equity (total assets minus total liabilities), since the money received will be exactly offset by the amount of additional debt. [60627]

Companies A and B dominate the market for dinkies. Company C enters as a competitor. Soon thereafter, unit prices for dinkies decline. Which TWO of the following choices would explain this? I) The demand for dinkies has increased II) Company C has entered the market with aggressive pricing III) Dinkies are a commodity IV) The market is based on monopolistic competition

II and III The decline in unit pricing is likely due to predatory (aggressive) pricing by Company C. It is unlikely that the companies that dominate the market would lower prices based solely on the entry of a competitor, unless significant pricing pressure existed. The ability to obtain market share through aggressive pricing is associated with commodities, where brand loyalty is not a factor.

Relevant financial information to answer the following question is found by using Exhibit 44. Based on the Consolidated Income Statement for Teenage Clothing Inc., which TWO of the following statements are TRUE? I) The interest coverage ratio declined from 2019 to 2020 II) The interest coverage ratio increased from 2019 to 2020 III) The net profit margin declined from 2019 to 2020 IV) The net profit margin increased from 2019 to 2020

II and III The interest coverage ratio (how many times a company's income covers its interest expense) is calculated by dividing the earnings before interest, taxes, depreciation and amortization (EBITDA) by the interest expense. In 2019, EBITDA was $17,821 ($11,895 + $5,926). This is divided by the interest expense ($2,645) and equals an interest coverage ratio of 6.73. In 2020, the interest coverage ratio increased to 10.24 ($25,814 / $2,520). The net profit margin is based on the company's profitability after interest and taxes have been paid. It is determined by dividing net income by the sales (revenue). In 2019, the net profit margin was 3.46% ($7,798 / $225,559). In 2020, the net profit margin declined to 3.08% ($9,133 / $296,887).

A company currently has a debt/equity ratio of 28% and it's considering redeeming some of its debt and replacing it with preferred stock. If the company takes this action and its cost of preferred stock is equal to its cost of debt, the WACC is expected to:

Increase The WACC should increase since there's a tax shield (tax advantage) associated with debt. Interest on debt is tax-deductible, while preferred stock dividends are paid after-tax. If the bonds being redeemed have the same cost as the new preferred shares, the company loses the tax deduction on the bonds and ends up with a higher Weighted Average Cost of Capital (WACC). The redemption of debt for preferred shares will not change the total capital of the corporation.

When a high discount rate is used on a defined benefit pension plan:

Liabilities are understated In a defined benefit plan, a pension benefit obligation (PBO) is arrived at by estimating the liabilities using a present value calculation. The higher the discount rate, the lower the present value of those obligations. If PBOs are less than plan assets, the plan is overfunded. If PBOs are greater than plan assets then the plan is underfunded. Using a high discount rate is an aggressive form of accounting, because it will lower the present value of the PBO. If the PBO is less than plan assets, the plan appears to be overfunded. In contrast, if a low discount rate is used to calculate the PBO, the present value of those obligations will be greater. If the obligations are greater than plan assets, the plan is underfunded and will require greater contributions. A low discount rate is a conservative form of accounting.

What are occupancy costs?

Occupancy costs are the total costs per unit to rent or occupy a store. It includes the lease payments and other costs such as utilities, maintenance, and insurance. Occupancy costs may also include a percentage of the sales generated by the store as part of the lease agreement. This is an important component for stores operating in shopping centers and malls.

A corporation's current ratio is 1.8. The corporation uses cash to retire short-term notes payable (due within nine months). What effect will this have on the Current Ratio and Asset Turnover Ratio?

Since the company's current ratio is greater than 1 (i.e., 1.8), when the company uses cash to retire short-term notes payable, both the current ratio and asset turnover ratio will increase. The current ratio equals current assets divided by current liabilities. Paying off short-term debt will decrease current assets and current liabilities by the same amount. However, the current assets are larger than current liabilities; therefore, current assets will fall by a smaller proportionate amount than the current liabilities. The asset turnover ratio equals sales ÷ assets. When the company uses cash, its assets decrease and the asset turnover ratio increases.

The MackLear Corporation has invested capital of $4 billion, its ROIC is 18%, it has a debt to equity ratio of 100%, a pretax cost of debt of 10%, a marginal tax rate of 40%, its WACC is 12%, $200 million of cash and 60 million shares outstanding. An estimate of MackLear's price per share is:

The ROIC to WACC ratio is ROIC divided by WACC. A ratio of greater than 1.0 is an indication that the company is creating value. A ratio of less than 1.0 is an indication that the company is destroying value. The ROIC to WACC ratio can be used to estimate the enterprise value (EV) of a company, which is also required to estimate MackLear's price per share. The model assumes that the ratio of enterprise value to invested capital (IC) is equal to the ratio of ROIC to WACC. (EV ÷ IC) = (ROIC ÷ WACC) Alternatively EV = IC x (ROIC ÷ WACC) EV = $4 billion x (18% ÷ 12%) EV = $4 billion x 150% EV = $6 billion With $4 billion of invested capital and a ROIC to WACC ratio of 150%, MackLear's enterprise value is estimated to be $6 billion. Notice that MackLear's estimated enterprise value is greater than the value of its invested capital of $4 billion. This is because the ROIC - WACC spread is positive. 18% - 12% = 6%. The company is adding 6 cents of value for every dollar invested. The company is earning a return that is greater than its cost of capital. In other words, providers of capital are getting a return on their investment that is greater than they expected. Equity value can be calculated from enterprise value by subtracting debt and adding cash. Because MackLear has invested capital of $4 billion and a debt to equity ratio of 100%, the debt is 50% of total capital. For example, if debt is 100% of equity, then there must be 100 units of debt for every 100 units of equity; therefore, total capital would be debt + equity or 100 units of debt + 100 units of equity, which equals 200 units of total capital. 100 units of debt as a percentage of 200 units of total capital, equals 50% of total capital (100 / 200). Given that MackLear has $4 billion of total capital, 50% of total capital equals $2 billion of debt. The estimated enterprise value of $6.0 billion, less the $2.0 billion of debt, plus the $200 million of cash results in an equity value of $4.2 billion. With 60 million shares outstanding the equity should be valued at $70 per share ($4.2 billion / 60 million shares = $70 per share.

Bad Debt Expense

The amount of the adjustment to the allowance for uncollectible accounts, representing the cost of estimated future bad debts charged to the current period. - reduction in bad debt expense increases profitability by reducing expenses - if there are low reserves for bad debt expenses, it means the company will not have reserves to cover for these losses

Ogden and Pinnacle are competitors in the water filtration business. Ogden has higher fixed costs than Pinnacle. Which of the following statements is TRUE? Neither company has any operating leverage The amount of operating leverage would depend on the amount of debt each company had on its balance sheet Pinnacle has more operating leverage than Ogden Ogden has more operating leverage than Pinnacle

The company with higher fixed costs (as compared to variable costs) in operating its business has greater operating leverage. This leads to a much more impressive bottom line when sales are rising, offset by a much lower bottom line when sales are declining.

A company is required to make a payment in perpetuity of $200,000 per year. Assuming a 10% annual return, how much principal would the company need?

The company would need to deposit $2,000,000. To calculate the required principal, take the annual payment in perpetuity of $200,000 and divide it by the annual rate of return of 10% ($200,000 / .10 = $2,000,000). The phrase in perpetuity may also be referred to as a perpetual payment, meaning that payments will continue to be made forever.

The following information has been extracted from the cash flow statement and income statement for the year ending December 31, 20XX. Dividends paid for the year were $275 million and net income available to common shareholders for the year was $187 million. Which of the following statements is TRUE? The company's capital surplus will decrease The company's stockholders' equity will decrease CThe company has violated GAAP standards DThe company's shareholders' equity will increase

The company's stockholders' equity will decrease A company is permitted to pay cash dividends in excess of its net income. In terms of financial accounting, cash dividends are paid out of retained earnings that are part of shareholders' equity. Therefore, cash dividends paid will reduce shareholders' equity. The company could have easily paid the cash dividend based on retained earnings from the previous year. In cash flow accounting, the company may have sufficient cash flow to pay out a cash dividend in excess of its net income. This may be the case if the company has positive cash flow in its investing or financing activities. In some instances companies have borrowed funds in order to pay cash dividends. Shares are often priced well above par value in an offering. This excess is recorded on the balance sheet as capital surplus. Cash dividends have no effect on capital surplus.

DEF 14A

The most comprehensive information regarding executive compensation and employee stock options can be found in a firm's proxy. A reporting companies proxies are filed on form DEF 14A and can be found in the SEC's EDGAR disclosure system.

Funds from operations (FFO) is a valuation metric MOST commonly used when performing a relative valuation for which of the following companies?

The most frequently used valuation metric for a REIT is funds from operations (FFO). This is determined by taking the net income plus depreciation, and subtracting gains from the sale of assets.

How do you calculate public float?

The number of shares held by institutional and retail investors The public float of a company is the number of shares held by public investors, both retail and institutional. It excludes stock owned by affiliated persons of a company and is found by subtracting restricted stock from the number of outstanding shares. By contrast, market capitalization is determined by multiplying the number of outstanding shares by the current market price per share. Outstanding shares include those held by institutions, retail investors, restricted shares, and shares held by insiders, but do not include treasury stock (shares repurchased by the company).

The quick asset ratio:

The quick asset ratio is a stringent method of computing liquidity. Cash, marketable securities, and accounts receivables are divided by current liabilities. Inventory is not included. This is not a measurement of solvency, which is the company's long-term ability to stay in business.

The director of research has asked an analyst to produce a pro forma valuation of a company using leveraged buyout analysis. The company has $680 million of EBITDA and the transaction value is 11.5 times EBITDA. The company has existing debt of $2.45 billion and the equity contribution is 20%. If the transaction is completed, what's the resulting debt-to-EBITDA ratio?

The transaction value is equal to $7.82 billion (11.5 x $680 million) and is being financed with 80% debt or $6.256 billion ($7.82 billion x .80). The new debt will be added to the existing debt of $2.45 billion for total debt of $8.706 billion. The resulting debt-to-EBITDA ratio will be 12.8 times ($8.706 billion / $680 million).

When using the constant growth model to calculate the value of common stock, what is the result of an increase of the difference between the required rate of return and the growth value?

The valuation decreases When using the constant growth model for valuation, the formula isD1 / (k - g). Therefore, as the difference between the required rate of return (k) and the growth rate (g) increases, the denominator in the calculation increases making the valuation smaller.

What is the implied value of a stock for a company that has a projected dividend for next year of $1.25, a cost of capital of 9% and a projected growth rate of 4%?

To find the implied value with the information given, the expected dividend is divided by the cost of capital minus the growth rate. $1.25 divided by 5% (9% - 4%) equals $25.

What is the relationship between fixed and variable costs for a high operating leverage company?

When comparing two companies with the exact same total costs, the company with the higher operating leverage will be able to grow its operating margin faster than the company with the lower operating leverage. A company with high operating leverage has a fixed unit cost that exceeds its variable unit cost. Once breakeven has been achieved, the company with the higher operating leverage will be able to grow its operating margin faster. This is because of its comparatively lower variable unit cost. Each unit sold above breakeven will cost less compared to a company that has higher variable costs and lower fixed costs. A company that has higher variable costs versus fixed costs has less operating leverage. A company with less operating leverage will not be able to grow its operating margin as quickly, because of its higher variable costs. Each unit sold above breakeven will cost comparatively more. When comparing two companies that have different total costs, (e.g., the two companies in this question), determining the company with faster margin growth becomes less predictable and is contingent on the company's cost structure, as well as the total costs. Therefore, it is prudent to do the math to determine the company with the faster margin growth.

Company A previously owned 15% of Company B. However, Company A recently increased its ownership in Company B to 60%. The following is selected data from each company. What's the consolidated revenue and net income when Company A becomes a majority owner?

When ownership of an acquired company is less than 20%, the cost method of accounting is used by the acquiring company to account for the value of the acquired company on its balance sheet. Using the cost method involves showing the value of the acquired company in the acquirer's investment account at its original cost basis. Any dividends that are received will be reported as other income. The acquirer may have a gain or a loss when the acquired company is sold. If there's a perceived permanent decline in the stock price of the acquired company, the value of the acquired company may be written down by the acquirer. After acquiring 60% of Company B, Company A will become a majority owner. When an acquirer's ownership interest is greater than 50%, but less than 100%, accounting rules require the use of the consolidation method. In the consolidation method, the balance sheets and income statements of the two companies are combined. Therefore, after increasing its ownership interest to 60%, the combined revenue of the two companies will be $147.50 MM + $50 MM, for a total of $197.50 MM. The combined net income will be $41.5 MM + $13.4 MM, for a total of $54.90 MM. An adjustment may need to be made in other income if the majority owner previously reported other income (e.g., dividends) from the acquired company. In this case, no adjustment is necessary because Company A did not receive any income from Company B. In addition to combining line items on the combined company's balance sheet and income statement, a new line item is created which is referred to as non-controlling interest (NCI), formerly known as minority interest. NCI is an equity item on the balance sheet which represents the portion of ownership in the combined companies that's attributable to the minority stakeholders. A line for NCI is also present on the income statement and shows the portion of combined income that's attributable to the minority stakeholders. NCI is calculated on the income statement by taking the minority company's net income and multiplying by the complement of the majority company's ownership interest (e.g., 1 - 0.60). In this case, net income attributable to Company B shareholders is $5.36 MM ($13.4 x (1 - 0.6)). After subtracting this value from the consolidated earnings, net income attributable to Company A shareholders is $49.54 MM ($54.90 - $5.36).

When would it be appropriate to use the constant growth dividend model for stock valuation? When the stock pays dividends When the dividends grow at a constant rate When the constant growth rate applies for an infinite period When the required rate of return is greater than the growth rate

all

formula for principal needed based on a payment in perpetuity and annual return

annual payment in perpetuity / annual rate of return

Levered Beta to Unlevered beta

levered beta / (1+((1-tax rate) * (debt/equity)))

Calculation for exchange ratio of stock

offer price / buyer's share price

Unlevered beta to levered beta

unlevered beta * (1+((1-tax rate) * (debt/equity)))

When do diminishing returns occur?

when average total costs begin to rise.